7.5 Managing Risk and Pricing Limits for Credit Risk
Risk management tools linked to VaR measurement can be used to support risk policies
and procedures for credit risk control processes too. While for market risks VaR can be
used, especially to set maximum limits for the trading desks, in the case of credit risk,
potential applications include:
The defi nition of the autonomy limits for lending decisions (at the individual loan
level)
The defi nition of pricing limits (i.e., minimum required pro tability for loans) as
a necessary condition to have a loan approved
We brie y explain how these limits can work and since their implementation can be
extremely different depending on the type of bank and of counterparty we then analyze
their potential application in two extreme cases: the case of a loan to a large corporation
by a large wholesale-oriented investment bank and the case of a small loan to an SME
by a smaller, retail-oriented commercial bank.
7.5.1 Setting Loan Autonomy Limits: From Notional Size
to Expected Loss
Any bank has credit approval policies de ning who is entitled to approve a loan. When
defi ning these policies, the usual problem is how to divide those loans that could be
authorized at lower hierarchical levels from those requiring approval by senior managers,
by credit committees, or even by the board. Traditionally, the notional size of the loan has
been the main driver for defi ning the approval process for a loan. For instance, internal
lending procedures may have stated that any loan with size up to x could be approved by a
senior credit of cer, while loans with size between x and y should require approval by the
central credit committee, and those over y should be approved by the board. Of course, any
bank could defi ne a number of different intermediate steps in any way it considers conve-
nient to promote ef ciency as well as credit control. However, the development of internal
rating systems and credit portfolio models suggests that autonomy limits could be de ned
in terms of either expected loss or value at risk rather than in terms of notional size.
Defi ning autonomy limits in terms of expected loss is easier, and it is possible when-
ever there is an internal rating-based system associating expected loss rates to rating
classes (i.e., even if the bank had not yet developed a credit portfolio risk model reliable
enough to set autonomy limits based on VaR). Since expected loss (EL) can be obtained
as a product of the exposure at default (EAD) times probability of default (PD) times loss
given default (LGD), determining a maximum EL limit implies that the maximum size
of the loan that can be approved by a given decision maker is no longer a constant, but
depends (inversely) on the loans PD and LGD:
max EL max exposure PD LGD max exposure
max EL
PD LGD
×=
×
Hence, loans with a higher internal rating (i.e., lower PD) or more guarantees (and there-
fore lower LGD) can be approved at lower hierarchical levels. At the same time, loans to
riskier customers and with lower guarantees might be checked at a higher hierarchical
MANAGING RISK AND PRICING LIMITS FOR CREDIT RISK 189

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