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Talk through why institutions choose to manage credit risk or to accept it deliberately.

FRM® Part II · Credit Risk Measurement and Management · Fundamentals of Credit Risk · FRM2.CR.1.e

The idea

Institutions manage credit risk because unmanaged losses threaten capital, funding costs, ratings and earnings stability, and because regulators link capital to it. Managing does not mean eliminating. Banks accept credit risk deliberately because it is their business. Lending margins and credit spreads compensate for expected loss, for the cost of capital held against unexpected loss, and for operating costs. Tools include limits on single names and sectors, diversification, collateral, netting, pricing, credit derivatives and securitisation. Risk transfer has its own costs, basis risk and counterparty risk, and it may damage client relationships, so retaining small or well-priced exposures can be rational. The decision rule is risk-adjusted. Accept a risk when return after expected loss, costs and capital charge, for example measured by RAROC, exceeds the hurdle rate. Credit risk is managed, priced and limited, not avoided.

Formulas

Risk-adjusted return on capital

RAROC = (revenue − costs − EL) ÷ economic capital

revenue
the unit's revenue
costs
its operating costs
EL
its expected loss
economic capital
the capital held against its unexpected loss

Accept the credit only if it beats the hurdle rate. Leaving out expected loss or costs overstates the return.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which statement best explains why a bank deliberately accepts credit risk?

  1. Lending is its core business, and the margin over funding cost compensates for expected loss, capital and costs. - correct
  2. Credit risk is fully diversifiable at no cost, so it needs no compensation.Why not: Diversification reduces but does not remove risk; the claim that it is free is wrong, and the compensation is why banks lend.
  3. Central banks guarantee all bank loans made to customers, so credit losses cannot occur at a bank.Why not: No such guarantee exists; banks bear credit losses and hold capital against them.
  4. Regulation requires banks to hold a fixed share of their assets in the form of defaulted loans.Why not: No regulation requires holding defaulted loans; regulators require capital against credit risk instead.

A bank earns a return on lending by taking credit risk. The interest margin is priced to cover expected loss, capital cost and expenses, so accepting the risk is deliberate.

A harder one

A bank buys credit default swap protection on a single large corporate loan that exceeds its single-name limit. Which risk management response does this represent?

  1. Avoiding the risk by deciding not to lend.Why not: The bank has made the loan and still holds it, so the risk has not been avoided.
  2. Transferring (hedging) part of the credit risk to another party. - correct
  3. Accepting the full risk and holding capital against it.Why not: The protection reduces the bank's net exposure to the borrower, so it is not retaining the full risk.
  4. Diversifying by adding new uncorrelated exposures to the portfolio.Why not: Buying protection on one loan transfers risk and does not add new uncorrelated exposures.

A CDS transfers default risk on the loan to the protection seller. It reduces the bank's net exposure, but leaves counterparty risk on the seller.

The hardest tier

A bank considers a USD 100 million loan priced at 1.8 percent over its funding cost. Probability of default is 1.2 percent and loss given default is 45 percent, so the expected loss is deducted. Operating costs are USD 0.3 million a year and economic capital is USD 8 million. The loan's risk-adjusted return on capital (RAROC) is closest to:

  1. 18.8 percentWhy not: Omits the expected loss, so (1.8 - 0.3) / 8, and overstates the return.
  2. 15.8 percentWhy not: Omits the operating costs, so (1.8 - 0.54) / 8, and overstates the return.
  3. 1.0 percentWhy not: Divides by the loan amount of 100 million instead of the 8 million of economic capital.
  4. 12.0 percent - correct

Expected loss = 0.012 x 0.45 x 100 = 0.54 million. RAROC = (1.8 - 0.54 - 0.3) / 8 = 0.96 / 8 = 12.0 percent. The bank accepts the risk only if this exceeds its hurdle rate.

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