The Handbook of Credit Risk Management, Second Edition presents a comprehensive overview of the practice of credit risk management (CRM) for a large institution. We introduce readers to credit risk by defining it, outlining how institutions are exposed to it, explaining why its management is critical to the success of an institution, and why an institution’s organizational structure matters. The book is then divided into four sections, each covering an essential step of CRM: Origination, Credit Assessment, Portfolio Management, and Mitigation & Transfer.
The Handbook offers a holistic treatment of credit risk management, unlike some highly technical books on particular facets of CRM such as credit scoring and distance-to-loss models, is specifically written to be readable and simple to understand, and presented in a logical format that is consistent with a commonly employed risk management framework: Identification, Measurement, Pricing/Capital Allocation, Mitigation and Transfer/Distribution.
Sylvain Bouteillé, the primary author, is a senior credit professional who has managed credit and portfolio teams in numerous credit-related transactions. Diane Coogan-Pushner, formerly the Chief Risk Officer of a public company, the secondary author, spent a career in industry and at the onset of the financial crisis, had the mission of developing graduate risk management programs to bridge financial theory with practical applications, and founded the Risk Management profile of Queens College, which belongs to the largest urban university in the US.
Sylvain Bouteillé is Head of Trade Credit for the Americas at AIG, the global insurance company. Prior to AIG, Sylvain worked more than 20 years at Swiss Re, one the world’s leading providers of reinsurance and insurance. In his last role, Sylvain was a Managing Director and a Member of the Global Business Management Committee of Swiss Re Corporate Solutions. Sylvain held various leadership positions at Swiss Re including Head of Credit Risk Management NA and Head of Structured Credit Underwriting NA. Sylvain holds a MSc degree in Civil Engineering from ENTPE (France) and an MBA from INSEAD (France). He has been teaching Financial Statement Analysis and Credit Risk Management to graduate students at Queens College, City University of New York since 2011.
Diane Coogan-Pushner is a financial economist who has held the positions of Chief Risk Officer of The Navigators Group, Inc., a publicly traded commercial insurer, and Managing Director for structured reinsurance solutions at Swiss Re. During the financial crisis, Diane founded the Risk Management program for the Queens College, City University of New York, where she was Director, Associate Dean, and a full-time faculty member. Earlier in her career, Diane headed the Market Analysis and Forecasting Division for AT&T’s consumer markets and was a portfolio manager for insurance focused funds. Diane has served on Standard & Poor’s Insurance Advisory Council and on the board of a privately held insurance company. Diane received her PhD from Boston University and began her career at the World Bank working with the financial institutions of East Africa. She is a Chartered Financial Analyst.
Preface xi
PART ONE
Origination
CHAPTER 1
Fundamentals of Credit Risk 3
What is Credit Risk? 3
Types of Transactions that Create Credit Risk 5
Who is Exposed to Credit Risk? 9
Why Manage Credit Risk? 19
CHAPTER 2
Governance 21
Guidelines 22
Skills 25
Setting Limits 30
Oversight 30
Final Words 33
CHAPTER 3
Checklist for Origination 35
Does the Transaction Fit into My Strategy? 36
Does the Risk Fit into My Existing Portfolio? 37
Do I Understand the Credit Risk? 38
Does the Seller Keep an Interest in the Deal? 39
Are the Proper Mitigants in Place? 40
Is the Legal Documentation Satisfactory? 41
Is the Deal Priced Adequately? 41
Do I Have the Skills to Monitor the Exposure? 42
Is There an Exit Strategy? 43
Final Words 44
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PART TWO
Credit Assessment
CHAPTER 4
Measurement of Credit Risk 47
Exposure 47
Probability of Default 52
The Recovery Rate 62
The Tenor 63
Direct versus Contingent Exposure 64
The Expected Loss 65
CHAPTER 5
Dynamic Credit Exposure 67
Long-Term
Supply Agreements 68
Derivative Products 70
The Economic Value of a Contract 73
Mark-to-
Market
Valuation 75
Value at Risk (VaR) 78
CHAPTER 6
Fundamental Credit Analysis 81
Accounting Basics 83
A Typical Credit Report 91
Agency Conflict, Incentives, and Merton’s View of
Default Risk 100
Final Words 105
CHAPTER 7
Alternative Estimations of Credit Quality 107
The Evolution of an Indicator: Moody’s Analytics EDF™ 108
Credit Default Swap Prices 114
Bond Prices 120
Final Words 121
CHAPTER 8
Consumer Finance 123
What Is Consumer Finance? 126
Segmentation of Consumer Finance Products 127
Major Families of Consumer Finance Products 129
Assessment of Credit Quality 136
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Contents vii
Decisions by Lenders 139
Regulatory Environment 143
CHAPTER 9
State and Local Government Credit 145
State and Local Governments 145
Exposure Types 146
Assessing Credit Risk 151
Managing Credit Risk 157
Final Words 160
CHAPTER 10
Sovereign Credit Risk 161
Sovereign Borrowers 161
Types of Sovereign Bonds 162
Sovereign Debt Market 163
Credit Analysis 163
Mitigation 166
Default and Recovery 167
Final Words 168
CHAPTER 11
Securitization 169
Asset Securitization Overview 171
The Collateral 174
The Issuer 178
The Securities 179
Main Families of ABSs 182
Securitization for Risk Transfer 186
Credit Risk Assessment of ABS 189
Warehousing Risk 191
Final Words 192
CHAPTER 12
Collateral Loan Obligations (CLOs) 193
Overview of the Corporate Loan Market 194
What Are CLOs? 194
Arbitrage CLOs 196
Balance Sheet CLOs 200
ABS CDOs 205
Credit Analysis of CLOs 207
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PART THREE
Portfolio Management
CHAPTER 13
Credit Portfolio Management 213
Level 1 215
Level 2 219
Level 3 224
Organizational Setup and Staffing 226
The IACPM 227
Final Words 227
CHAPTER 14
Economic Capital and Credit Value at Risk (CVaR) 229
Capital: Economic, Regulatory, Shareholder 230
Defining Losses: Default versus Mark-to-
Market
(MTM) 232
Credit Value at Risk or CVaR 235
Creating the Loss Distribution 242
Active Portfolio Management and CVaR 249
Pricing 251
Final Words 252
CHAPTER 15
Regulation 255
Doing Business with a Regulated Entity 256
Doing Business as a Regulated Entity 262
How Regulation Matters: Key Regulation Directives 263
Final Words 271
CHAPTER 16
Accounting Implications of Credit Risk 273
Loan Impairment 274
Loan-Loss
Accounting 275
Regulatory Requirements for Loan-Loss
Reserves 277
Impairment of Debt Securities 278
Derecognition of Assets 279
Consolidation of Variable Interest Entities (VIEs) 280
Accounting for Netting 281
Hedge Accounting 282
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Contents ix
Credit Valuation Adjustments, Debit Valuation Adjustments,
and Own Credit Risk Adjustment 284
IFRS 7 285
Final Words 285
PART FOUR
Mitigation and Transfer
CHAPTER 17
Mitigating Derivative Counterparty Credit Risk 289
Measurement of Counterparty Credit Risk 289
Mitigation of Counterparty Credit Risk through
Collateralization 290
Legal Documentation 298
Dealers versus End Users 299
Bilateral Transactions Versus Central Counterparty Clearing 299
Prime Brokers 303
Repurchase Agreements 304
Final Words 306
CHAPTER 18
Structural Mitigation 307
Transactions with Corporates 308
Transactions with Special Purpose Vehicles 317
CHAPTER 19
Credit Insurance, Surety Bonds, and Letters of Credit 325
Credit Insurance 326
Surety Bonds 332
Letters of Credit or LoCs 335
The Providers’ Point of View 339
Final Words 342
CHAPTER 20
Credit Derivatives 345
The Product 345
The Settlement Process 349
Valuation and Accounting Treatment 354
Uses of CDSs 356
Credit Default Swaps for Credit and Price Discovery 360
Credit Default Swaps and Insurance 360
Indexes, Loan CDSs MCDSs, and ABS CDSs 361
CHAPTER 21
Bankruptcy 363
What Is Bankruptcy? 364
Patterns of Bankrupt Companies 365
Signaling Actions 368
Examples of Bankruptcies 369
Final Words 372
About the Authors 373
Index 375
