Enterprise Risk Management

CHAPTER 15Credit Risk Management

RICK NASON, PhD, CFA

Associate Professor Finance, Dalhousie University Principal, RSD Solutions

The preceding chapter discussed the common elements of credit risk and market risk. Additionally, it covered some of the major principles of managing market risk. This chapter continues the discussion with a focus on credit risk, including an overview of the credit crisis that engulfed international capital markets.

CREDIT RISK ANALYSIS

The rise of credit instruments such as credit derivatives and collateralized debt obligations (CDOs) along with changes in the regulatory capital management rules for financial institutions has generated many new ideas, research, and analytical techniques for the management and trading of credit risk.¹ It is important when conducting credit analysis to remember that unlike market risk, credit risk is almost always a downside risk; that is, unexpected credit events are almost always negative events and are only rarely positive surprises. Second, it is imperative to remember that credit events are almost always unexpected. In other words, no one extends credit to a customer, or executes a loan to a counterparty, expecting that it will not be repaid.

Measuring credit risk is not a trivial task. The size of credit risk is composed of three parts: (1) the size of the potential exposure at the time of default, (2) the probability of a default or credit event occurring, and (3) the loss given that a credit event has occurred. ...