Charta is on Google Play: practise on the go. Get the app
Charta

Outline how the scope and allocation of a bank's credit facility are handled, and the bank-level policies and steps used to cut credit risk.

FRM® Part II · Credit Risk Measurement and Management · Credit Risk Management · FRM2.CR.3.c

The idea

A credit facility's scope is its amount, purpose, type, tenor, repayment structure, pricing, security and covenants. It should match the borrower's real need and cash flows, so a long-lived asset is not financed with a short revolver. Allocation is the decision, within limits and risk appetite, of how much lending capacity goes to each obligor, sector, region and business line, judged by return on risk. The bank also reduces credit risk through diversification, limits, collateral and guarantees, covenants, close-out netting and margining on derivatives, credit default swaps, syndication or loan sales, securitisation, risk-based pricing and early monitoring. Each step transfers or reduces some risk but can create another, such as protection-seller default or wrong-way collateral risk.

A practice question

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

Which description best captures the scope of a credit facility?

  1. Only the committed amount and the interest rate.Why not: Too narrow; tenor, repayment, security and covenants also define a facility.
  2. The borrower's internal rating and probability of default.Why not: Confuses the facility's terms with the credit analysis of the borrower.
  3. The bank's total lending capacity across all of its borrowers, sectors and regions.Why not: Describes allocation of lending capacity, not the scope of one facility.
  4. Its amount, purpose, tenor, repayment structure, pricing, security and covenants. - correct

The scope defines what is being lent and how: size, purpose, instrument, maturity, repayment profile, price, security and conditions. Ratings and bank-wide capacity are separate concepts.

A harder one

A bank has two derivative trades with one counterparty under an enforceable close-out netting agreement: one has a market value of +USD 40 million to the bank and the other -USD 25 million. Credit exposure to the counterparty is:

  1. USD 40 millionWhy not: Counts only the positive trade, as if there were no netting agreement.
  2. USD 65 millionWhy not: Adds the absolute values of the two trades, which overstates exposure.
  3. USD 25 millionWhy not: Uses the size of the negative trade, which is not the net exposure.
  4. USD 15 million - correct

With enforceable netting, exposure is the net value: 40 - 25 = 15 million, if positive. Netting is a bank-level step that cuts exposure without changing the trades.

The hardest tier

A bank holds a USD 100 million loan to a borrower with PD 4 percent and LGD 60 percent. It buys credit protection on USD 60 million of the loan from a seller with a 10 percent PD, independent of the borrower, and assumes the seller pays the protected portion of loss only if it has not defaulted. Expected loss after hedging is closest to:

  1. USD 0.96 millionWhy not: Treats the protection as risk-free and ignores the seller's possible default.
  2. USD 1.10 million - correct
  3. USD 2.40 millionWhy not: Ignores the hedge altogether.
  4. USD 0.14 millionWhy not: Counts only the double-default term and omits the unprotected USD 40 million.

Unhedged part: 4% x 60% x 40 = 0.96. Hedged part loses only if both default: 4% x 10% x 60% x 60 = 0.144. Total = 1.10, down from 2.40 unhedged. Protection leaves a residual double-default risk.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in Credit Risk Management