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

Analyse the credit exposure, along with the other risks, that retail banking creates.

FRM® Part II · Credit Risk Measurement and Management · Credit Scoring and Retail Credit Risk Management · FRM2.CR.7.a

The idea

Retail banking lends to individuals and small businesses through mortgages, credit cards, auto loans, personal loans and overdrafts, so the credit exposure is a very large number of small, similar positions rather than a few big names. CCF is the credit conversion factor applied to the undrawn limit, and EL is expected loss. Exposure at default must include undrawn commitments, so EAD = drawn balance + CCF × undrawn limit. Expected loss then follows by multiplying the three components together, so EL = PD × LGD × EAD. Credit risk is not the only risk. Funding long fixed-rate mortgages with short deposits creates interest rate and liquidity risk, prepayment changes the cash flows, fraud and process failures create operational risk, and mis-selling or unfair practice creates conduct, legal and reputational risk. These risks interact, because a rate rise on floating-rate mortgages becomes a credit problem through payment shock. Exam questions usually ask you to classify a loss by root cause or to include undrawn limits in exposure.

Formulas

Exposure at default of a retail credit line

EAD = drawn balance + CCF × undrawn limit

drawn balance
the amount already drawn
CCF
the credit conversion factor, the share of the undrawn amount expected to be drawn by default
undrawn limit
the limit minus the drawn balance

Cards and overdrafts. Leaving out the undrawn part, or forgetting to add the drawn balance, are the usual errors.

Expected credit loss

EL = PD × LGD × EAD

PD
the probability of default over the horizon
LGD
loss given default, as a share of the exposure
EAD
the exposure at default

EAD must include the expected drawdown of undrawn commitments. Different books can differ far more in EL than in exposure.

A practice question

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

Which statement best describes the credit exposure created by a retail bank's loan book?

  1. Very many small, similar exposures to households and small firms, such as mortgages and cards. - correct
  2. A handful of large single-name loans whose individual default would dominate portfolio losses.Why not: Describes a wholesale or corporate book where lumpy single-name concentration drives losses.
  3. Mainly derivative counterparty exposures that are netted and collateralised under master agreements.Why not: Confuses retail lending with counterparty credit risk in the trading book.
  4. Mostly sovereign bond holdings whose credit risk is observed in market spreads every day.Why not: Treats the retail book as a traded-securities portfolio with market-implied credit information.

Retail credit exposure is granular: many small, similar loans to individuals and small firms. This contrasts with corporate books, where a few large names matter.

A harder one

A credit card has a limit of USD 8,000 and a drawn balance of USD 3,000. The bank applies a credit conversion factor of 50% to the undrawn amount. The one-year PD is 4% and LGD is 85%. The expected loss on the card is closest to:

  1. USD 102Why not: Uses only the drawn balance as EAD and ignores the undrawn commitment the customer may draw before default.
  2. USD 272Why not: Assumes the full limit is drawn, i.e. a CCF of 100% instead of the stated 50%.
  3. USD 187 - correct
  4. USD 85Why not: Uses CCF x undrawn only (USD 2,500) and forgets to add the drawn balance to get EAD.

EAD = 3,000 + 0.5 x 5,000 = 5,500. EL = EAD x PD x LGD = 5,500 x 0.04 x 0.85 = USD 187. Undrawn commitments belong in retail exposure.

The hardest tier

A bank holds mostly adjustable-rate mortgages funded by deposits whose rates adjust quickly. Policy rates rise by 300 basis points over a year. Which description of the consequences is most accurate?

  1. Rate risk is largely passed to borrowers, but higher payments raise delinquency, so it reappears as credit risk. - correct
  2. Rate risk disappears and credit risk is unchanged, because the loans simply reprice with the market rate.Why not: Ignores payment shock: repricing moves the burden onto borrowers and raises their default probability.
  3. Credit risk falls because higher coupons increase interest income relative to the principal still at risk.Why not: Confuses higher interest income with lower loss; the higher payment increases PD and the loan balance is unchanged.
  4. Liquidity risk falls to zero because floating-rate assets can always be sold at par.Why not: Mortgages are illiquid and cannot be assumed saleable at par; repricing does not remove funding risk.

Adjustable rates shift market risk from the lender to the borrower. The risk does not vanish: affordability falls and PD rises, so interest rate risk converts into credit risk. Risks in retail banking interact.

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

Start free →

More in Credit Scoring and Retail Credit Risk Management