CCP Paper 4 Credit Risk Management

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About Course

UNIT DESCRIPTION

This paper is intended to equip the candidate with the knowledge, skills and attitudes to effectively manage credit risk in an organisation.

LEARNING OUTCOMES

A candidate who passes this paper should be able to:

  • Identify credit risks posed by different customers’ borrowing proposals
  • Assess, analyse and measure risks in borrowing proposals in line with an entity’s risk profile, using appropriate models and methodologies
  • Mitigate credit risks posed by borrowing proposals, based on their driving factors, and minimise their impact on profitability
  • Undertake credit risk monitoring and evaluation and report results, probabilities and impact of risk
  • Understand the working of credit risk insurance
  • Evaluate the impact of credit risk management on stakeholders
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What Will You Learn?

  • This paper is intended to equip the candidate with the knowledge, skills and attitudes to effectively manage credit risk in an organisation.

Course Content

1. Overview of Risk Management.
The overview of risk management involves identifying, assessing, and mitigating potential risks to achieve organizational objectives. This systematic process helps businesses anticipate and manage uncertainties that could impact their goals. Risk management encompasses various activities, such as risk identification, risk analysis, risk evaluation, and risk treatment. It is crucial for organizations to implement effective risk management strategies to enhance decision-making, protect assets, and ensure long-term sustainability. Key components include risk assessment, risk communication, and risk monitoring to create a proactive and resilient approach to challenges in different industries and sectors.

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2. Fundamentals of credit risk
The fundamentals of credit risk revolve around the assessment and management of the potential for financial loss arising from the failure of a borrower to meet their debt obligations. Credit risk is a key consideration for lenders and investors, and understanding its fundamentals is crucial in financial decision-making. Key components include credit analysis, which involves evaluating the creditworthiness of individuals, companies, or other entities seeking financial assistance. Factors such as financial stability, payment history, and economic conditions play a significant role in determining credit risk. Lenders use credit risk management strategies to minimize potential losses through methods like diversification, setting credit limits, and monitoring credit portfolios. Sound credit risk fundamentals are essential for maintaining the stability and health of financial institutions and markets.

3. Assessing Credit Worthiness
Assessing creditworthiness involves evaluating the ability and willingness of an individual, company, or entity to fulfill their financial obligations, particularly related to borrowing or credit arrangements. This process is crucial for lenders, creditors, and financial institutions to make informed decisions about extending credit. Key factors considered in assessing creditworthiness include: 1. **Credit History:** Examining past credit behavior, including payment history, outstanding debts, and any defaults or late payments. 2. **Income and Financial Stability:** Assessing the borrower's current income, employment stability, and overall financial health to determine their capacity to repay. 3. **Debt-to-Income Ratio:** Evaluating the proportion of a borrower's income that goes towards debt repayment, providing insights into their financial strain. 4. **Credit Score:** A numerical representation of creditworthiness based on various financial behaviors, which serves as a quick reference for lenders. 5. **Collateral:** The presence of assets that can be used as collateral can mitigate risk for lenders, as it provides a source of repayment in case of default. 6. **Character and Reputation:** Considering factors like the borrower's reputation, character, and reliability in meeting financial commitments. 7. **Purpose of the Loan:** Understanding the reason for seeking credit and how it aligns with the borrower's overall financial goals and stability. Effective assessment of creditworthiness is essential for responsible lending practices, helping to minimize the risk of defaults and promote financial stability for both borrowers and lenders.

4. Credit governance overview
Credit governance refers to the framework and processes established within an organization to manage and oversee credit-related activities effectively. It is a critical aspect of risk management and financial stability, ensuring that credit decisions align with the organization's objectives and risk tolerance. The key elements of credit governance include: 1. **Policy Development:** Establishing clear and comprehensive credit policies that define the criteria for lending, risk tolerance levels, and the overall credit risk management strategy. 2. **Risk Appetite and Strategy:** Defining the organization's risk appetite and developing a credit strategy that aligns with business goals while managing credit risk effectively. 3. **Organizational Structure:** Designing a structure that delineates responsibilities and accountabilities for credit-related functions, including credit approval, monitoring, and risk assessment. 4. **Credit Culture:** Fostering a credit-conscious culture within the organization, emphasizing the importance of sound credit practices and risk awareness. 5. **Monitoring and Reporting:** Implementing systems for ongoing monitoring of credit portfolios, tracking key risk indicators, and generating regular reports for management review. 6. **Compliance and Regulatory Adherence:** Ensuring that credit activities comply with relevant laws and regulations, and implementing controls to mitigate legal and regulatory risks. 7. **Training and Development:** Providing continuous training and professional development for staff involved in credit-related functions to enhance their skills and keep them updated on industry best practices. 8. **Technology and Data Management:** Utilizing technology to streamline credit processes, enhance data analysis, and improve decision-making accuracy in credit risk assessment. By establishing a robust credit governance framework, organizations can enhance their ability to make informed credit decisions, manage risks effectively, and maintain a healthy credit portfolio. This is crucial for financial institutions and businesses involved in lending activities to sustain stability and achieve long-term success.

5. Measurement of credit risk
The measurement of credit risk involves assessing and quantifying the potential financial losses that may arise from the failure of a borrower to meet their credit obligations. It is a crucial aspect of risk management for financial institutions, investors, and lenders. Several methods and metrics are used to measure credit risk: 1. **Credit Scoring Models:** Utilizing statistical models that analyze various factors, such as credit history, income, and other financial behaviors, to assign a numerical credit score to individuals or entities. 2. **Credit Ratings:** Assessing credit risk through credit rating agencies, which assign ratings to issuers of debt based on their creditworthiness. Common rating agencies include Moody's, Standard & Poor's, and Fitch. 3. **Probability of Default (PD):** Calculating the likelihood that a borrower will default on their credit obligations over a specific time frame, often expressed as a percentage. 4. **Credit VaR (Value at Risk):** Estimating the maximum potential loss in the value of a credit portfolio within a given confidence level over a specified time period. 5. **Credit Migration Analysis:** Evaluating changes in credit quality over time by tracking the movement of borrowers between credit rating categories. 6. **Stress Testing:** Simulating adverse economic scenarios to assess how credit portfolios would perform under extreme conditions, helping identify vulnerabilities and potential losses. 7. **Loan-Loss Provisioning:** Setting aside reserves or provisions to cover expected credit losses, based on historical data, economic indicators, and the overall credit portfolio quality. 8. **Credit Concentration Analysis:** Evaluating the distribution of credit exposures to ensure that risk is adequately diversified and not concentrated in specific sectors or borrowers. 9. **Credit Portfolio Models:** Using advanced mathematical models to analyze the overall risk and return characteristics of a portfolio of credit instruments. Effectively measuring credit risk is essential for making informed lending decisions, managing capital adequacy, and ensuring the financial health of institutions exposed to credit-related activities. It allows organizations to balance the pursuit of returns with prudent risk management practices.

6. Firm (or Obligor) credit risk
Firm or obligor credit risk refers to the potential that a specific company, entity, or borrower may fail to meet its financial obligations, leading to financial loss for creditors or investors. This type of credit risk is specific to individual obligors or firms and is distinct from broader systemic or market-wide risks. Key aspects of firm credit risk include: 1. **Creditworthiness Assessment:** Evaluating the financial health, stability, and repayment capacity of a specific firm or obligor. This assessment involves analyzing financial statements, business operations, and relevant economic factors. 2. **Credit Ratings:** Assigning credit ratings to firms by credit rating agencies based on their creditworthiness. These ratings serve as indicators of the likelihood of timely repayment and are crucial for investors and creditors in making informed decisions. 3. **Default Probability:** Estimating the likelihood that a specific obligor will default on its debt obligations. This probability is influenced by factors such as the obligor's financial strength, industry conditions, and economic environment. 4. **Industry and Sector Risks:** Considering the specific risks associated with the industry or sector in which the firm operates. Industries may face unique challenges, and economic conditions can impact firms differently based on their sector. 5. **Collateral and Guarantees:** Assessing the presence and quality of collateral or guarantees provided by the firm to mitigate credit risk. Collateral serves as a form of security for creditors in case of default. 6. **Credit Limits:** Setting appropriate credit limits for individual firms to manage exposure and control risk. Credit limits are often based on the obligor's creditworthiness and the lender's risk tolerance. 7. **Credit Monitoring:** Regularly monitoring the financial health and performance of individual obligors to identify early warning signs of potential credit deterioration. This includes staying informed about changes in the obligor's financial condition and industry dynamics. Managing firm credit risk is essential for financial institutions, investors, and creditors to safeguard their interests and make informed decisions about lending or investment activities. By understanding and actively monitoring the credit risk associated with specific firms, stakeholders can take proactive measures to mitigate potential losses.

7. External Risks

8. Overview of Industry risks

9. Entity level risks

10. Integrated view of firm-level risks

References

CLASS RECORDINGS JAN – APR 2024

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