Managing Credit Risk - New York University

MANAGING CREDIT RISK: THE CHALLENGE FOR THE NEW MILLENNIUM Dr. Edward I. Altman Stern School of Business New York University Credit Risk: A Global Challenge In Low Credit Risk Regions (1998 - No Longer in 2003) • New Emphasis on Sophisticated Risk Management and the Changing Regulatory Environment for Banks • Enormous defaults and bankruptcies in US in 2001/2002. • Refinements of Credit Scoring Techniques • Large Credible Databases - Defaults, Migration • Loans as Securities • Portfolio Strategies • Offensive Credit Risk Products – Derivatives, Credit Insurance, Securitizations 2 Credit Risk: A Global Challenge (Continued) In High Credit Risk Regions • Lack of Credit Culture (e.g., Asia, Latin America), U.S. in 1996 - 1998? • Losses from Credit Assets

Threaten Financial System • Many Banks and Investment Firms Have Become Insolvent • Austerity Programs Dampen Demand - Good? • Banks Lose the Will to Lend to “Good Firms” - Economy Stagnates 3 Changing Regulatory Environment 4 1988 Regulators recognized need for risk-based Capital for Credit Risk (Basel Accord) 1995 Capital Regulations for Market Risk Published 1996-98 Capital Regulations for Credit Derivatives 1997 Discussion of using credit risk models for selected portfolios in the banking books 1999 New Credit Risk Recommendations • Bucket Approach - External and Possibly Internal Ratings • Expected Final Recommendations by Fall 2001 • Postpone Internal Models (Portfolio Approach) 2001 Revised Basel Guidelines • Revised Buckets - Still Same Problems • Foundation and Advanced Internal Models 2004 Final Draft of Consultative Paper • Final Version - June, 2004 • Implementation in 2007 Capital Adequacy Risk Weights from Various BIS Accords (Corporate Assets Only) Original 1988 Accord All Ratings 100% of Minimum Capital (e.g. 8%) 1999 (June) Consultative BIS Proposal Rating/Weight AAA to AA- A+ to B- Below B- Unrated 20% 100% 150% 100% 2001 (January) Consultative BIS Proposal AAA to AA- A+ to A- BBB+ to BB- Below BB- Unrated 20% 50% 100% 150% 100% 5 Altman/Saunders Proposal (2000,2001) AAA to AA- A+ to BBB- BB+ to B- Below B- Unrated 10% 30% 100% 150% Internally Based Approach Debt Ratings 6 Moody's S&P Aaa AAA Aa1 AA+ Aa2 AA Aa3 AA- A1 A+ A2 A A3 A- Baa1 BBB+ Baa2 Investment BBB Baa3 Grade BBB- Ba1 High Yield BB+ Ba2 BB Ba3 BB- B1 B+ B2 B B3 B- Caa1 CCC+ Caa CCC Caa3 CCC- Ca CC C CD Corporate Default Probabilities Typically Increase Exponentially Across Credit Grades (2001 Consultative Paper) 7 0 5 7 8 9 10 11 20 30 50 75 100 150 260 600 1000 AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- Probability of default Modified (2003) Corporate Risk Weight Curve 8 0% 5% 10% 15% 20% 25% 30% 35% 3 10 25 50 75 100 125 150 200 250 300 400 500 1000 2000 Probability of Default (bp) Cap i t al Req u i rem e n t Recent Basel Credit Risk Management Recommendations • Establishes a four-tier system for banks for use or not of internal rating systems to set regulatory capital. Ones that can set loss given default (LGD) estimates...

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