A Risk Professional's Survival Guide: Applied Best Practices in Risk Management

CHAPTER 5 Credit Risk Theory

OVERVIEW

One of the major risks that SifiBank faces is from borrowers who default on their obligations to the bank. The financial crisis of 2008–2009 underscores the need to pay close attention to the level of credit risk that, at that time, drove a number of banks with household names such as Countrywide Financial and Washington Mutual out of existence, largely due to excessive amounts of mortgage credit risk on their balance sheets.

Borrowers can be individuals, corporations, or even governments seeking credit. And while the drivers of default for each may differ, the underlying theory of default remains the same. This chapter discusses a theory of default first introduced by Robert Merton and presents the foundation for efforts to measure and manage credit risk exposure. It views default as an embedded put option available to the borrower when circumstances are economically attractive for the borrower to “exercise” their option to default. This option-theoretic framework can be characterized for any type of borrower and used as the basis for default modeling. Credit loss estimates are formed on the basis of combining the borrower’s probability of default (or default frequency) with their loss given default (LGD), or loss severity. The Merton default model provides a way to conceptually determine both loss components.

With a basic theory of credit risk established, the remainder of the chapter examines three important approaches to measuring ...