The Handbook of Credit Risk Management

Originating, Assessing, and Managing Credit Exposures

Sylvain Bouteille,Diane Coogan-Pushner

• Editore: Wiley
• Anno: 2021
• ISBN:
  9781119835646
• Edizione: 2
• Argomento: Business
• Categoria: Corporate Finance

Discover an accessible and comprehensive overview of credit risk management

In the newly revised Second Edition of The Handbook of Credit Risk Management: Originating, Assessing, and Managing Credit Exposures, veteran financial risk experts Sylvain Bouteillé and Dr. Diane Coogan-Pushner deliver a holistic roadmap to credit risk management (CRM) ideal for students and the busy professional.

The authors have created an accessible and practical CRM resource consistent with a commonly implemented risk management framework. Divided into four sections—Origination, Credit Assessment, Portfolio Management, and Mitigation and Transfer—the book explains why CRM is critical to the success of large institutions and why organizational structure matters.

The Second Edition of The Handbook of Credit Risk Management also includes:

• Newly updated and enriched data, charts, and content
• Three brand new chapters on consumer finance, state and local credit risk, and sovereign risk
• New ancillary material designed to support higher education and bank credit training educators, including case studies, quizzes, and slides

Perfect for risk managers, corporate treasurers, auditors, and credit risk underwriters, this latest edition of The Handbook of Credit Risk Management will also prove to be an invaluable addition to the libraries of financial analysts, regulators, portfolio managers, and actuaries seeking a comprehensive and up-to-date guide on credit risk management.

PART One
Origination

CHAPTER 1
Fundamentals of Credit Risk

WHAT IS CREDIT RISK?

Credit risk is the possibility of losing money due to the inability, unwillingness, or nontimeliness of a counterparty to honor a financial obligation. Whenever there is a chance that a counterparty will not pay an amount of money owed, live up to a financial commitment, or honor a claim, there is credit risk.

Counterparties that have the responsibility of making good on an obligation are called “obligors.” The obligations themselves often represent a legal liability in the form of a contract between counterparties to pay or perform. Note, however, that, from a legal standpoint, a contract may not be limited to the written word. Contracts that are made orally can be legally binding.

We distinguish among three concepts associated with the inability to pay. First is insolvency, which describes the financial state of an obligor whose liabilities exceed its assets. Note that it is common to use insolvency as a synonym for bankruptcy but these are different events. Second is default, which is failure to meet a contractual obligation, such as through nonpayment. Default is usually—but not always—due either to insolvency or illiquidity. Third is bankruptcy, which occurs when a court steps in upon default after a company files for protection under either Chapter 11 or Chapter 7 of the bankruptcy laws (in the United States). The court reviews the financial situation of the defaulted entity and negotiates with its management, creditors, and sometimes equity owners. Whenever possible, the court tries to keep the entity in business by selling assets and/or renegotiating financing arrangements with lenders. Bankruptcy proceedings may end in either a restructuring of the obligor's business or in its dissolution if the business cannot be restructured.

In most cases, losses from credit risk involve an obligor's inability to pay a financial obligation. In a typical scenario, a company funds a rapid expansion plan by borrowing and later finds itself with insufficient cash flows from operations to repay the lender. Other common cases include businesses whose products or services become obsolete or whose revenues simply no longer cover operating and financing costs. When the scheduled payment becomes due and the company does not have enough funds available, it defaults and may generate a credit loss for the lenders and all other counterparties. There are also more and more cases where the inability to pay follows an unexpected and uninsured event that destroys an entity in a short time. Just think of all the small and medium‐sized companies that disappeared in 2020 after the COVID‐19 pandemic or the wildfires in California.

Credit losses can also stem from the unwillingness of an obligor to pay. This is less common, but can lead to the same consequences for the creditors. The most frequent cases are commercial disputes over the validity of a contract. In instances in which unwillingness is at issue, if the dispute ends up in litigation and the lender prevails, there is recovery of the amount owed, and ultimate losses are lessened or even avoided entirely because the borrower has the ability to pay.

Frequently, credit losses can arise in the form of timing. For example, if monies are not repaid on a timely basis, there can be either interest income foregone or working capital finance charges incurred by the lender or trade creditor, so time value of money is at stake.

Credit risk can be coupled with political risk. Obligors doing business in different countries may have both the ability and willingness to repay, but their governments may, without much warning, force currency conversion of foreign‐currency denominated accounts. This happened in 2002 in Argentina with the “pesification,” in which the government of Argentina forced banks to convert their dollar‐denominated accounts and debts to Argentine pesos. Companies doing business in Argentina saw their U.S. dollar‐denominated bank deposits shrink in value, and their loans and trade credits shrink even more, since the conversion rate was even more egregious for loans than deposits.

A common feature of all credit exposures is that the longer the term of a contract, the riskier that contract is, because every additional day increases the possibility of an obligor's inability, unwillingness, or nontimeliness of repayment or making good on an obligation. Time is risk, which is a concept that we will explore further throughout the book.

For each transaction generating credit risk, we will address three fundamental questions in the forthcoming chapters:

1. What is the amount of credit risk? How much can be lost or what is the total cost if the obligor fails to repay or perform?
2. What is the probability of default of the counterparty? What is the likelihood that the obligor fails to pay or perform?
3. How much can be recovered in case of bankruptcy? In the case of nonpayment or nonperformance, what is the remedy and how much can be recovered, in what time frame, and at what expense?

TYPES OF TRANSACTIONS THAT CREATE CREDIT RISK

Managing credit risk requires first identifying all situations that can lead to a financial loss due to the default of a counterparty. Long gone are the days when it was an easy task. Today, there are many different types of financial transactions, sometimes very sophisticated, that generate credit risk.

Traditionally, credit risk was actively managed in bank lending and trade receivables transactions. A rule of thumb for identifying credit risk was to look for an exchange of cash or products at the beginning of a commercial agreement. The risk was that the money would not be repaid or the products not paid for. Recently, however, the development of modern banking products led to transactions generating large credit exposures without lending money or selling a product, as we explain in Chapter 5, which is dedicated to dynamic credit exposures mostly generated by derivatives transactions.

Credit risk is present in many types of transactions. Some are unique but some are rather common. In the following paragraphs, we will describe seven common business arrangements that generate credit risk.

Lending is the most obvious area. There is a cash outflow up front, from the lender to the borrower, with a promise of later repayment at a scheduled time. A second transaction type involves leases, when a piece of equipment or a building is made available by an entity (the lessor) to another entity (the lessee) that commits to make regular payments in the future. The lessor typically borrows money to finance the asset it is leasing and expects the future cash flow from the lessee to service the debt it contracted. The third type is the sale of a product or a service without immediate cash payment. The seller sends an invoice to the buyer after the product has been shipped or the service performed, and the buyer has a few weeks to pay. This is known as an account receivable.

Prepayment of goods and services is a fourth type of transaction that involves credit risk. Delivery is expected at a certain time and of a certain quality and/or performance, and the failure of the counterparty may lead to the loss of the advanced payments and also generates business interruption costs. A fifth type of transaction that creates credit risk involves a party's claim on an asset in the custody of or under the management of another party, such as a bank deposit. Most individuals choose their bank more for the services they offer or the proximity to their home rather than after a detailed analysis of its financial conditions. Large corporates think differently because they have large amounts of cash available. They worry that the banks with their deposits may default. Before trusting a financial institution, they review its creditworthiness. They also spread their assets among many banks to avoid a risk concentration, as the Federal Deposit Insurance Corporation's (FDIC) coverage limit of $250,000 per account is insufficient to cover most deposits of large corporations. The bankruptcy of MF Global in 2011 reminded many individuals and businesses to think twice about cash left in brokerage accounts and to carefully evaluate limits under the Securities Investor Protection Corporation (SIPC) or, outside the United States, its equivalent.

A sixth type of transaction is a special case of a claim on an asset—a contingent claim. The claim is contingent on certain events occurring, such as a loss covered by an insurance policy. At policy inception, the policyholder has no claim on the insurer. However, once the insured suffers a covered loss, the insured has a claim. If the insurer fails to pay the claim, this would constitute a credit loss. Another example of a contingent claim would be a pension fund that has a claim on the assets of its sponsor, should the fund's liabilities exceed its assets. Nothing has been prepaid and no funds were lent, but there is credit risk borne by the pension participants in the event that the sponsor cannot honor the fund's liabilities.

Finally, a seventh type of transaction involves not a direct exposure but a derivative exposure. It arises from derivatives transactions like interest‐rate swaps or foreign‐exchange futures. Both parties commit to make future payments, the amounts of ...