Advanced Credit Risk Analysis and Management

15

Firm Risks to Portfolio Risks and Capital Adequacy

In this chapter we will discuss more about PD and consider LGD and EL, which are covered from both the obligor and credit portfolio perspectives. We will also discuss the quantum of capital to be maintained by a lending institution with sizeable credit portfolio.

15.1 OBLIGOR PD AND PORTFOLIO PD

Study of both individual PD and Portfolio PD is necessary for effective management of a credit portfolio. If we know the individual PDs and LGD of all constituents in a portfolio, we can arrive at ‘portfolio-level PD and LGD’. At portfolio level, the calculation is complicated as it is impacted by the correlation between the various credit assets or obligors. However, it may be noted that if the credit portfolio is well diversified, then the inherent sector or similar correlation risks ought to be insignificant.

Once a customer defaults, the probability of credit loss zooms. Usually, the banks and financial institutions include high risk customers in the watch list and monitor them closely, probably on a weekly or monthly basis. Sometimes, even better rated customers are included in the watch list, provided there are serious business developments that could harm repayment capacity – for example a massive fire in one of the main factories of a borrower.

Most of the default situations trigger negotiations with the obligor with the aim of full settlement. Whilst all defaults do not lead to credit loss, the probability of credit loss in ...