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Credit Risk What We Know, What We Dont Know And What We Should Know 1
Credit Risk: What We Know, What We Don’t Know And What We Should Know
What we know
Credit risk has been for a long time been accredited to a number of financial crises in the world most recently the collapse of asset backed commercial paper (ABCP) in 2006 and 2007 which was caused by massive defaults of mortgages which had been issued by various financial institutions in the US with very high rates. This collapse set out a chain of happenings to result in a very serious global financial crisis ever since the Great Depression in the 1930s. This has been one of the major negative impacts of credit risk to organizations. Improper management of credit risk has led to fall of major financial institutions in the world e.g. Lehman Brothers.
In this essay credit risk and Credit Risk Grading (CRG) will be discussed and the importance of CRG to an organization will be spelt out.
CRG is a very crucial activity which organization needs to include in their risk management processes. We all know that no type of risk can be completely eliminated but organizations should continually pursue ways in which they can mitigate its impacts incase the unexpected happens.
Credit Risk
This is the possibility that a counter party or borrower will not meet the agreed upon obligations. More than 50% of the entire risk elements in banks and financial institutions worldwide are Credit risk alone. Managing credit risk in attaining efficient management of financial institutions has increasingly become an important task. Management of credit risk is about identifying, measuring, matching mitigations, monitoring and controlling of the exposures of credit risk (Nickell, et al 1998).
Credit risk mostly does not happen in isolation. For instance, an interest rate rise can be detrimental to the creditworthiness of the issuer of the bond hence increasing the credit risk of the financial institution holding the bonds. On the other hand a fall in the bond value increases the market risk for the financial institution.
What we don’t know
Credit Risk Grading
Credit risk grading (CRG) refers to a pre-specified scale which reflects the credit risk which is underlying for a given level of exposure. Credit risk uses employs the use of alphabet/symbol/number which represents the risks associated with a certain credit exposure. CRG is the appropriate module for establishing a system of credit risk management.
Credit Risk Grading is a crucial element that helps in the process of credit risk management as it helps the various financial institutions in understanding the dimensions of risk that come along when dealing with credit transactions. This task of credit risk grading of lines of business, borrowers and business activities provides a better view of the credit portfolio quality of a financial institution. Credit risk grading systems are important in taking appropriate decisions at both post and pre-sanction stages (Carey, 1998).
Credit grading helps at the pre-sanction stage to sanction authority in deciding on whether to lend or not, the extent of exposure, what the lending price should be, the various facilities, appropriate credit facility and the numerous risk mitigation techniques to put a cap on the level of risk (Lopez, 1999a).
CRG can be beneficial at the post-sanction stage in helping financial institutions decide about the depths of the renewal or review, the frequency of the review, frequency of the grading and several other measures to be taken. CRG should be invoked at the start of lending and it should be updated annually. Grading of credit risk should however be reviewed in instances of adverse events. Portfolio monitoring entails that financial institutions should come up with reports concerning credit risk exposure by risk grade. Enough migration and trend analysis should be done to come up with any credit facility deterioration. Accuracy and consistency of the grading of the credit risk should be periodically examined by a function for instance an independent credit review.
What we should know
Functions of Credit Risk Grading
CRG systems that are well managed promote soundness and safety in financial institutions through enhancing decision making which is informed. Credit risk is measured by grading systems which also differentiates groups and individual credits by the risks they offer. CRG allows management and examiners of financial institutions to observe trends and changes in their levels of risk. CRG further allows the management of financial institutions to efficiently manage risk and optimize their results (Kupiec, 1995).
Use of Credit Risk Grading
The CRG matrix allows the use of standards which are uniform to credits in order to attain a common standardized view in order to easily asses the credit portfolio of a business, unit, line or the financial institution as a whole, or the quality of individual obligor.
Grading of credit risk would be relevant in monitoring and surveillance and assessing the risk profile of a financial institution.
The CRG provides a measurement of risk which is quantitative which gives the level 0f risk of the borrower hence enabling fast decision making.
CRG offers a quantitative framework used for assessing the requirement in provisioning of the portfolio of credits of financial institutions.
The CRG results are relevant for credit selection at individual level, as borrowers and their risk exposure is already rated (Carey, 1998).
In summary
In taking lessons from the sub-prime mortgage lending crisis also commonly known as ‘mortgage meltdown’ or ‘mortgage mess’ that started in the US mortgage market, financial institutions can now understand better the concept of credit risk that existed in the sub-prime borrowing by individuals and lending by financial institutions.
After considering the importance of credit risk grading, it is therefore a noble idea for players in the financial system to develop carefully a model for grading credit risk which is in line with the objective outlined above (Berkowitz, 1999).
References
Altman, E.& Saunders, A., (1997). “Credit Risk Measurement: Developments over the Last Twenty Years,” Journal of Banking and Finance, 21, 1721-1742.
Basle Committee on Banking Supervision, (1999). “Credit Risk Modelling: Current Practices &Applications,” Basle Committee on Banking Supervision, Basle. (http://www.bis.org/press/index.htm)
Berkowitz, J., (1999). “Evaluating the Forecasts of Risk Models,” Manuscript, Trading Risk Analysis Group, Federal Reserve Board of Governors.
Carey, M., (1998). “Credit Risk in Private Debt Portfolios,” Journal of Finance, 53, 1363-1388.
Diebold, F.X., Gunther, T. & Tay, S., (1997). “Evaluating Density Forecasts with Applications to Financial Risk Management,” International Economic Review, 39, 863-883.
Diebold, F.X., Hahn, J. &Tay, A.S., (1998). “Real-Time Multivariate Density Forecast Evaluation and Calibration: Monitoring the Risk of High-Frequency Returns on Foreign Exchange,” Manuscript, Department of Economic, University of Pennsylvania.
Diebold, F.X. and Lopez, J.A., (1996). “Forecast Evaluation and Combination,” in Maddala, G.S. and Rao, C.R., eds., Handbook of Statistics, Volume 14: Statistical Methods in Finance, 241-268.Amsterdam: North-Holland.
Diebold, F.X. and Mariano, R., (1995). “Comparing Predictive Accuracy,” Journal of Business and Economic Statistics, 13, 253-264.
Kupiec, P., (1995). “Techniques for Verifying the Accuracy of Risk Measurement Models,” Journal of Derivatives, 3, 73-84.
Lopez, J.A., (1999a). “Regulatory Evaluation of Value-at-Risk Models,” Journal of Risk, forthcoming.
Lopez, A., (1999b). “Methods for Evaluating Value-at-Risk Estimates,” Federal Reserve Bank of San Francisco Economic Review, forthcoming.
Nickell, P., Perraudin, W. & Varotto, S., (1998). “Ratings- Versus Equity-Based Credit Risk
Modelling: An Empirical Analysis.” Manuscript, Conference on Credit Risk Modelling & Regulatory Implications.
The Chinese Cultural Values in Individual Roles And Responsibilities As Derived From Confucius Philosophy
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The Chinese Cultural Values in Individual Roles And Responsibilities As Derived From Confucius Philosophy
Individual duties and responsibilities to our families, friends, government and society are beyond our capacity to act as we deem fit. However, the shared interests and beliefs attained through participation and cooperation both at the individual level, and the societal level founds the responsibilities. To live a fulfilling life, according to early Chinese culture, it is essential to understand the shared beliefs and the common interests of people living in that community. These values determine people’s behaviour, which reflects the roles of individuals to society. Early Chinese culture require individuals to accomplish duties and responsibilities to families, friends, government and society at large by aligning their actions with commitment, harmony, honesty, benevolence, and righteousness, these values are derived from the philosophy of Confucius.
Portraying the acts of honesty, wisdom, righteousness and benevolence from how the people advocated the same during the particular times, explains the sources of these values in the Chinese culture. According to (Cua, n.d) the basic virtues are considered important, leading and guiding, cardinal and very compendious. The core societal value is harmony as it brings coordination between humankind and nature and people of the society. Harmony leads to the growth of other values such as honesty, commitment, benevolence and righteousness. Harmony enhances the relationship between the government and the people of the community. Duties and Responsibilities of individuals were based on the societal and government roles or service to friends and family. The Chinese culture provided the foundation of societal roles, especially in families and service to the society, as well as the government in providing services to the community.
Individuals are expected to accomplish their duties and obligations with honesty through trustworthiness, integrity and credibility. (Lau, 66) In one Confucius quotes says, “I do not see how a man can be acceptable who is untrustworthy in his word”. Through this quote, the Chinese culture understood that honesty is a vital value in gaining trust from society. A man has to be honest to be accepted by the community. Most importantly, in obtaining wealth, an individual should consider other individuals to acquire wealth reasonably through their labour and not by committing crimes or cheating. From the master’s words in (Lau 61), “poor yet delighting in the way, wealthy yet observant of the rites”. Lau still stresses on honesty in acquiring wealth through this saying. The Chinese Culture embraced this value among its people to improve the services to family, friends and society. Honesty in work develops acceptance from the community and trust from friends and family.
According to Confucius philosophy, (Lau 59) gives a quote that, “It is rare indeed for a man with cunning words and an ingratiating face to be benevolent”. The quote links honesty to benevolence. An honest individual could easily acquire the value of benevolence to other people of the society. Honesty is a foundation for one to possess different values. Possession of the value of openness creates a good relationship with the people in the society. When one is honest, they are trusted by individuals, which creates kindness and love to other people of the community. The Chinese culture leadership and governance is based on honesty since its citizens believe an honest government. Honesty can also be applied to familial connections in efforts to make it stronger as it creates trust and kindness towards fellow family members.
Individuals should extend the virtue of benevolence to familial ties and blood connections. Using the Confucius philosophy, (Lau 73) through a quote says, “benevolent man is attracted to benevolence because he feels at home in it”. The quote shows the importance of familial ties and the satisfaction brought by the same. Benevolence is valued in the Chinese culture as it states the benefits of the familial relations, by blood, in friendships and the relationship between people in the society. Benevolence has kept the Chinese people together through their cultural values. Confucius philosophy is the source of these values, and it encourages values such as wisdom, loyalty and self-discipline among people in the society hence instilling peaceful coexistence. The peaceful coexistence motivates individual and societal prosperity. It founds the importance of performing one’s roles to the community in the Chinese culture. When an individual develops benevolence within oneself, it drives them towards the same value as it creates the feeling of completeness and peace, which makes it easy for the individual to dwell in that situation.
A quote from Confucius philosophy says, “when a man sets his heart on benevolence, he will be free of evil” (Lau 73). The quote shows that benevolence is a very vital virtue as it brings one too close to heart. It directs an individual to practice honesty and depart from evil activities. Benevolence makes it possible to express love and kindness from the heart hence gives the sense of equality for every individual. Therefore, loving everyone and being kind to them prevents one from planning evil against one another and instead wish for the best for them and even by being part of their happiness and successes. Benevolence creates the togetherness in the Chinese culture hence justifies the service to one another. Equality indeed supports prosperity for every individual, therefore, frees the society from evil. By bringing family and blood relatives close shows love and commitment to one’s specific duties.
Individuals should accomplish their duties with commitment. Just as Lau 66 says in one of Confucius philosophy quotes, “Faced with what is right, to leave it undone shows lack of courage”. This quote means that individuals should commit themselves to do right regardless of the obstacles. Challenges are a part of human life, and it requires courage to overcome them. When people have the interest and are committed to achieving successful lives, they attain prosperity. In Chinese society, when an individual performs their roles regardless of the challenges they face, it defines courage and becomes an example to others. Failure to tackle the issue at hand describes cowardice; hence, the individual cannot earn respect from society. Confucius founded this value and embraced by Chinese culture. It also states that duties accomplished by a committed individual are usually perfect and to the standard required by the society and government, which contributes to the growth of people and society.
Besides courage in commitment, (Lau 66) uses Confucius Quote that,” Commitment bears positive results”. This quote means that with commitment to duties as dictated by the society and government, one is predisposed to succeed. Chinese culture uses its rites to encourage involvement in its individuals. Just as derived from Confucius philosophy, with the laid-out responsibilities and roles of every individual, commitment is essential. It pushes one to ensure they are successful in their work. This value applies to the functions in the families, to friends and those developed by society. To add on, the government also gives responsibilities to individuals in society, and it is only possible to perform them if one is committed to attaining the set objectives and goals. Committed individuals work to the expectation of the society hence bear positive results of growth and an excellent example to other people. Exemplary commitment to doing things is well advocated in ancient Chinese culture.
Justice and correctness should dictate our daily activities and decisions. Righteousness is key to success in ancient Chinese culture. According to (Lau 63) book, a quote from Confucius analects, says, “When your parents are alive, comply with the rites in serving them; when they die, comply with the rites in burying them; comply with the rites in sacrificing to them”. Confucius, through the quote, stresses on compliance to rites to at all times. Conforming to rights depicts righteousness to the culture. In addition, according to (Tsai, 159) righteousness is the inner core of morality that guides an individual in their lives. The Chinese culture, currently complies to the rites during every occasion, either during ceremonious times and also during funerals and sad moments. The quote gives the importance of righteousness as it is the basis of harmonious relationships with friends, society and the family. The citation uses parents as the example hence showing that being righteous to the rites guides on the roles one has to their families and society. Justice and correctness develop the value of righteousness in people, that help in daily activities and decision making, on matters affecting individuals and society.
The Chinese culture holds their rites in high esteem as it guides them in performing their culture and in their responsibilities in society. As (Lau 70) says, “You will be looked upon as obsequious by others if you observe every detail of the rights in serving the lord”. The quote stresses more on righteousness to the culture’s rites and the impact that one receives from complying with the rites. The quote is from Confucius philosophy but is used by the Chinese culture to ensure respect and obedience to the rites of their culture. As one earns respect from other people because of observing rights, they can serve society and their families with ease. Trust is earned through respect. Confucius provides the importance of righteousness to the community hence is adapted to by the Chinese culture. Righteousness is a virtue that cannot be omitted in our daily life as it dictates the choices made in performing the daily activities.
It is essential to understand the shared beliefs and the common interests of people living in a particular place to understand what individual people owe to their friends, families, societies, and governments. Commitment to one’s responsibilities and roles, honesty towards one’s sources of wealth, benevolence towards people of the family and community, as well as righteousness encompassing correctness and justice, are the virtues aligned with one’s obligations and duties as expected by the society and the government. (Confucius-1.com, 2019) article states that the Confucius analects has been the foundation of Chinese education for almost two thousand years. This statement proves that the Chinese culture values were derived from the Confucius Philosophy. It is from the philosophy that the culture was able to set its societal values in performing individual roles and responsibilities to the society, family, friends and the government.
In general commitment, honesty, benevolence, and righteousness are the basis for peaceful coexistence and fulfilment of obligations to families, friends, government and the society in the Chinese culture and derived from the Confucius Philosophy.
List of References
Confucius-1.com. (2019). Analects of Confucius. [online] Available at: http://www.confucius-1.com/analects/ [Accessed 21 Nov. 2019].
Cua, A. (n.d.). Confucian philosophy, Chinese. Routledge Encyclopedia of Philosophy.
Lau, D.C. Confucius: The Analects (New York: Penguin, 1979).
Tsai, D. (2005). The bioethical principles and Confucius’ moral philosophy. Journal of Medical Ethics, 31(3), pp.159
Credit default swap
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Credit default swap
Credit default swap is a financial agreement whereby a seller of the CDS agrees to compensate the buyer in a situation where he defaults to repay a loan or other types of credit. The buyer makes several payment to the supplier after which he receives a payoff in the event that the payment is defaulted. In a default situation, the CDS buyer is compensation and the seller retains possession of the loan defaulted. There are situations whereby anyone is allowed to buy CDS including buyers who do not have an insured interest in the credit advance. Such CDS are known as Naked CDS.
CDS may act as credit insurance in that a bond holder may hedge against its risk of default. Investors may also buy or trade off protection if even if they may not be in possession of debt of entity in reference. The naked CDS enables dealers to guess on the credit worthiness of entity being referenced. Naked CDS constitutes the larger number of CDS in the market. CDS can also be utilized in the capital structure of a business. The reference entity is usually a government or a corporation. It should be noted that the reference person is not included in the contract. In a situation where the reference obligor defaults, the seller compensates the purchaser based on the worth of the bond in exchange for actual and tangible delivery of the bond. Settlement may be done through cash or through auction.
Credit Default Swaps were discovered in the early 1990s following trades that were conducted by bankers trust in early 1991. Later in 1994, JP Morgan Bank introduced the modern CDS. JP Morgan had extended a loan to Exxon, The bank then faced damages charges of more than the money it had extended. As a result the bank sold its credit to EBRD. The bank did this in order to improve its balance sheet. Increase in default risk increased which made regulators to have concern about and the risk was viewed as the cause of Saving & Loan crisis. They found the use of CDS to reduce default risk more appealing. In 2000, CDS became independent and was deregulated where the regulatory bodies held that CDS could not be categorized as either futures or securities.
Initially, banks formed the major players in CDS market. This was because CDS was basically used to hedge against risks of banks’ lending activities. This gave banks an opportunity to liberalize capital that was under heavy regulation. The banks eventually lost the high market share they held with credit default swaps as other asset managers noted opportunities in them. By 2002, investors dominated CDS market as speculators, unlike banks which were hedgers. The market for credit non-payment exchanges expanded greatly in from 2000 to 2007. But in 2008, it was hit by portfolio compression and the market dramatically dropped.
In 2009, there were changes that were done to oversee on the way CDS operated. This resulted into concerns of the safety of the financial instrument. The concerns followed the events of 2008 that led to decrease of CDS’ market by 38%. The European and the United States regulators are working to bring stability to derivative markets. The major changes are in two dimensions. The first one is introducing central clearing houses. The clearing houses serve as the main party existing between the buyer and the seller. This would reduce the difficulties that exist between the buyer and the seller in undertaking transactions using the instrument. The other one is the international standardization of contracts involving CDS. This would reduce legal disputes that involve determination of payout. Analysts and strategists argued that the two major changes would boost the market for CDS and enhance the environment at which transactions are conducted.
There are various criticisms about credit default swaps. The critics argue that the market of CDS has been left to expand extensively without proper regulation. They also argued that the contracts are negotiated privately hence the market lacks transparency. They also argue that the CDS market contributed largely to the 2008 financial crisis. In contrast, proponents of CDS argue that reduction of confidence causes confusion in the cause and effect and that spreads reflects that a particular user is in dire financial troubles.
Critics have also held that CDS contributed to breakdown in negotiations during reorganization of General Motors in 2009. They argued that bondholders would benefit event where the company would be declared bankrupt. They argued that the creditors of the company were pushing the company to be declared bankrupt. They add that it would be difficult to determine the writers and the buyers since transactions of the contract lacked transparency. They argued that the absence of transparency contributed to the buyers and protection writers being omitted from the negotiations. This means that credit swap risks is a financial risk that can be used to hedge against risk as well as increasing portfolio in which investors speculate in financial markets.