Effective Risk And Profitability Management

By Author: Jim Strange
Total Articles: 21
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Counterparty credit risk is rapidly gaining importance in the financial industry as the key risk that needs to be identified and managed. Credit risk analysis is now the essential element of effective risk and profitability management.
Accurate measurement and efficient management of credit exposures is highly demanded by both C-level management and regulators. The challenge in the current and future credit exposure measurement is efficient combining of all the exposure drivers, which include counterparty as well as market financial analysis elements.
Credit enhancements play a critical role in measuring net credit exposures. Evaluating how much of the gross exposure would be recovered and under which conditions a challenging yet essential part of credit is risk analysis.
What is Credit Risk
Credit risk is the risk of financial loss due to an unexpected deterioration of a counterparty’s credit quality.Credit risk has played a significant role in the majority of financial crises to date, which makes it a very important risk to be able to measure and manage.
Credit risk management starts with an ...
... assessment of credit quality (i.e. rating, probability of default, loss given default) and credit exposure at the counterparty level. Sound single-name credit risk measurement is the necessary foundation stone for building institution wide credit risk measurement and management methodologies
Portfolio credit risk models aggregate the building blocks of single name credit risk measures to obtain a portfolio loss distribution, taking into account interdependencies between counterparties. Various portfolio risk measures can then be derived from the portfolio loss distribution and used for economic and regulatory capital purposes, pricing, provisioning, as well as for general portfolio steering. The two most important risk metrics are expected loss and some measure of unexpected loss, for example Credit Value at Risk.
Credit exposure
Credit exposure calculations concern themselves with the question „How much would I lose if the counterparty defaults?
There is a distinction between current and potential exposure. Current exposure looks at the exposure at the current date. It does not have a time dimension.However, losses from credit risk can evolve over a relatively long time and the exposure may change over time. This could be due to changes in risk factors (e.g.yields, FX rates), because of scheduled repayments or because of new business generated with the counterparty.Potential exposure represents this range of outcomes rather than a single snapshot estimate.
Current exposure can be broken down into its constituent components, i.e. gross exposure, credit enhancements and net exposure. Potential exposure can be calculated using add-ons.
Both current and potential exposures can be grouped according to various attributes and used to for generalcredit control, such as limit, concentration and strategy management.
Moreover they become inputs in credit risk portfolio models as well as regulatory capital calculations.
Using the FRSGlobal RiskPro Credit Risk module, the following elements can be considered and analysed:

Risk mitigation techniques considered include close-out netting, collateral and guarantees. Both, collateral and a guarantee, can be given for one specific exposure or for all the exposures of a given counterparty. A given contract can have any number of pieces of collateral (or guarantees).
This gives the financial institution the freedom to model any contract structure, whether from the corporate, trading or retail business. Close-out netting is also recognised Credit lines are included in the analysis. The expected usage of the undrawn part of the credit line can be modelled.
Besides assets, off-balance sheet positions, that have positive replacement value, are integrated in the credit risk computations. Netting agreements and positions with a negative replacement value are also included in the exposure computation.
The counterparty structure allows drill down to the individual subsidiaries of an organisation. The full legal structure can be implemented with distinction between branches and legally independent subsidiaries. Subsidiaries can be consolidated

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