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Fundamentals of credit - lecture #1
Published on April 27, 2016 30 min
A selection of talks on Finance, Accounting & Economics
My name's Marwa Hamman and I'm the Executive Director of the Cambridge Master of Finance program. I also lecture on credit. I've developed a course called Fundamentals of Credit, which I teach here on the MFin program and another course that covers more advanced topics. Today's talk is looking at credit. Credit as an asset class, but also the skill set and the toolkit required to analyze credit from a qualitative as well as a quantitative perspective.
So before getting into the specifics of credit instruments and credit risk, I'd like to start by setting the stage, perhaps, by starting with a big picture on how credit is generated and the banking space and regulatory pressures in general. Banks are intermediaries between depositors and investors. They have an important role to play in creating money in the economy. By creating money or extending credit in the form of loans to their clients, they are naturally taking on credit risk. In order to offset that risk, banks are required to set aside reserves to ensure that they are sufficiently capitalized and that those reserves are commenced with a level of risk within the loans that they have extended. Loans constitute one of the largest elements of the asset side of any typical commercial bank's balance sheet. On the next slide, I will be showing you a sample balance sheet where you'll see that they can go up to about two-thirds of the size of the assets book.
As I just mentioned, loans constitute a very large part of the balance sheet of a typical commercial bank. They provide an opportunity for the banks to generate accrual income in the form of the interest that is paid as well as any commitment fees, but they're also very expensive to maintain on the book because of the capital charge that I've just explained. So the loan loss reserves are maintained, these are almost allowances for loan losses or provisions that are set aside in order to offset any potential risk arising from credit default. The allowances are largely there in order to absorb any losses resulting from probability of default migrating over the life of the loan or the loans within the portfolio. Any actual losses that are incurred are written off, so they are charged against the provisions, and the provisions would then need to be replenished through the income statement. And this would obviously be an expense that hits the bank's P&L. In the case of asset-backed loans where there is a form of security, the loss sustained by the bank generally reduces. This is a concept called "loss given default." So I've already referred the probability of default, the other piece of estimating or in estimating expected credit loss is loss given default, which is basically the amount or the quantum of the loss in the event of a default situation unfolding.