Fundamentals of credit - lecture #1

Published on April 27, 2016   30 min

Other Talks in the Series: Hot Topics

0:00
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.
0:30
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.
1:33
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.
3:07
The purpose of the reserves, as I was just saying in the meta, is to ensure that the banks offset the risk that they take on. This is driven by the riskiness of the assets as quantified by a risk-weighted asset or RWA multiplier. This is governed by the rules set by the Basel Accord, whereby 8 percent regulatory capital needs to be set aside. So the 8 percent is basically 8 percent of the risk-weighted assets on a typical balance sheet have to be set aside in the form of regulatory capital in order to offset that risk. And this is basically to offset the risk of the client defaulting or a portfolio of credit sustaining default loss. One of the key items when analyzing a bank is the level of NPLs, or non-performing loans, and capital adequacy in relation to that. There have been huge headwinds hitting the banking space in the form of added stringent regulations in the form of TLAC, which is the total loss-absorbing capital requirements enforced by the FSB, or the Financial Stability Board here in Europe. This mainly impacts on banks that are classified as global systemically important banks or G-SIBs for short. This is to ensure that the banking system is resilient and the expensive bailouts that were footed by the tax payers in the past do not recur again. This will obviously have a huge bearing on cost structures for European banks and will eat into their profits going forward.
4:41
Now I would like to drill down into what actually causes credit risk. So far, we have spoken about how credit risk is generated by banks extending facilities or a loan to their clients and the key components that drive credit risk, which are the probability of default, the loss given default and exposure default, which are used by banks to estimate the expected credit loss. Now we're going to focus in on what actually is credit risk and what causes it. A default event, which is typically what comes to mind when we talk about credit risk is just one of a number of credit events. Credit events do not necessarily mean that the client will just fail to pay or go into bankruptcy, but if there is a loan reconstructing event or if loan payments are being exhilarated by other lenders, that is also classified as a credit event, which can trigger default. Breach of covenants that are embedded within the loan agreements or a bond indenture could also qualify as a credit event, which can result in default occurring or a loan moratorium. This is where an under bankruptcy law, it's illegally binding halt of the right to collect debt, this gives the clients or the counterparties an opportunity to stabilize their finances before dealing with the potential problems associated with foreclosure or loan restructuring.
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Fundamentals of credit - lecture #1

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