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Credit Portfolio Risks

What is Portfolio Credit Risk?

Credit exposure to a group of similar borrowers is called portfolio credit risk While firm-level credit risk analysis focuses on micro-credit risk or borrower level, credit portfolio risk analysis focuses on the macrocredit risks or studies the credit risk behaviour of a group of borrowers / credit assets

Why Portfolio Credit Analysis

Credit portfolio cannot be managed efficiently unless portfolio credit risks are known Awareness of portfolio is a must to identify, monitor, and control risk concentrations and correlations on an ongoing basis To monitor the credit quality of the loan portfolio All banks with sizeable credit portfolio desire to have optimum diversification

Benefits of Portfolio Credit Risk Study

Proper management of portfolio credit risk can reduce the portfolio risk below the total or average of firm credit risks Facilitates active credit portfolio management Enables maturity matching Optimises liquidity Helps Sales and Marketing Gives insights into sectoral/ industrial risk exposures To calculate the risk based capital requirement Helps in devising portfolio management strategies

Basel Accords and Credit Portfolio

Basel accords adopt a portfolio approach in determining credit risks and fixing capital needs At portfolio level, controls are imposed in the form of risk weights

Credit portfolio Risk Variables

Credit Portfolio Risk

Systematic Risk

Non- Systematic Risk

External Risks

Asset Class

Exposure Risk

Industry Risk

Location Risk

Quality Risk

Maturity Risk

Currency Risk

Collateral Risk

Systematic Risks

Systematic Risk is common to the economy or country as a whole, Cannot be eliminated by combining the assets in a large and well diversified portfolio Hence, known as non- diversifiable risk Examples are economic shocks and foreign exchange crises In depth awareness of systematic risks helps the bank to design appropriate policies to protect and enhance the quality of the portfolio, ensuring adequate returns

Diversifiable Risks
1. Asset Class: Credit assets are derived from many types of customers small, medium and large. Each type of customers shows distinct features If the credit portfolio consists mainly of one asset class, portfolio risk tends to be relatively higher

Diversifiable Risks
2. Exposure Risk: The amount exposed to s credit risk is termed as exposure risk Even when the firm credit risk is acceptable, concentration of exposures in a few customers can spell doom

Diversifiable Risks

3. Industry Risks: An ideal portfolio ought to be balanced, with a differing mix of obligors originating from different industries, and of various sizes and types Modern methods determine scientifically the type and extent of diversification required in the portfolio.

Diversifiable Risks
4. Region / Location/ Country Risks Portfolio scattered over a wide area offers comfort from the portfolio risks point of view If the external credit exposure has a significant role, it is better to disperse among several countries

Diversifiable Risks

5. Quality Risks Ideally, it is better to fill the credit portfolio with AAA category credit assets. Usually, banks have a target quality of portfolio in mind- say 92% to 95% of the total portfolio ought to be higher than BBB (medium credit risk) and devise strategies to attain this Both default and migration probabilities of a particular industry sector or a group of customers or different risk grades should be studied to understand the quality risk of the portfolio

Diversifiable Risks
6. Maturity Risks: The average maturity of the portfolio should be effectively managed in order to avoid liquidity problems Maturity depends on the nature of the business Constant watch on the asset-liability situation is necessary

Diversifiable Risks

7. Currency Risks When obligations to be met from the realisation of credit assets are denoted in different currencies, currency risk impacts Diversification and hedging are considered effective solutions to currency risks

Diversifiable Risks

8. Collateral Risk If the banks accept only one kind of security, a sharp fall in the value of the security impacts the portfolio risk Market correlation among the collateral securities the concentration risks of the collateral portfolio and The capacity of the market to absorb the sale of the collateral in times of counter party default, Necessitates diversification of collaterals

Firm Risks and Portfolio Risks

Portfolio Risks and firm credit risks are interlinked, Because a portfolio does not exist unless there are several credit assets Portfolio credit risk is the agglomeration of several individual firm risks The major milestones on the road to credit loss are migration, default, loss given default an ultimate write offs A study of the above helps the bank in assessing the firm and portfolio credit risks

Impact of Portfolio Credit Risks

In the case of a reasonably spread portfolio, not all firm credits will default at the same time By intelligent diversification, the portfolio risks can be lowered below the sum of the individual credit risks Study of migration risks, default risk and credit loss at portfolio level is often linked to the stages of the business cycle Portfolio managers try to rein in migration risks by shuffling portfolio, seeking altered collaterals and by using other portfolio management measures

Portfolio Credit risk Mitigants

Traditionally, all unsystematic risks can be diversified The three principal types of diversification are: 1.Counter- party limit : The central bank usually stipulates maximum credit to a specific party. For example, it may be stipulated that a single credit exposure to any counter- party should not exceed 10% of the TNW of the creditor 2.Region wise restriction: Usually large and multinational banks adopt this 3.Industry Limit: Industries are categorised according risks and exposures to each industry is regulated according to this Credit Derivatives have been heralded as path-breaking products that enable financial institutions to manage credit risks

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