Banking Credit Risk Management

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Table of Contents

Credit Risk Models
Conclusion
References

Credit Risk Models

The Black-Scholes-Merton Model

There are various credit risk models, which have been proposed by researchers in order to reduce the risks associated with future transactions. One of these models is the BSM framework structured models. This model was proposed by Merton in 1974. He derived the value of an option from a company, which could default loan repayment (Merton, 1974).

The Black-Scholes-Merton model assumes that there is a latent firm asset value, which is determined by the company’s future cash flows.

This model is used to determine the firm’s debt and equity value. This model includes components, such as risk free interest rates, asset payment ratio, and asset risk premium. Merton (1974) argues that the asset return rate and the risk free interest rates are the constants which are non-stochastic.

The model also assumes that the company’s capital structure relates to a pure equity and a single zero coupon debt, which matures within a given time. Incase of a default experienced by a company, the stock price of the defaulting firm is expected to go to zero. According to this model, the debtor is assumed to be a seller in the European put option.

On the other hand, the equity holder is assumed to be a buyer of European call option (Merton, 1974). The model uses the Black –Scholes option pricing in order to determine the relationship between the equity market value and the bond market value. Shibita and Yamada (2009) proposed the BSM structural model to a bank, which was just this side of bankruptcy.

This helped the bank in its recovery processes. According to Shibata and Yamada (2009), the bank’s choice to continue operating or be liquidated plays a vital role on the losses of the loan. They assumed that this decision should be made severally at a certain time after the bankruptcy.

Individual-level reduced-form models

This refers to the models which are not of the class of structural models. At the individual level, a reduced form model can also be described as the credit scoring one. This model was developed by Altman (1968). The credit scoring model uses linear and binomial models to regress the defaults among companies.

It identifies various accounting components, which have statistical explanatory capability, in order to differentiate between the defaulting and non defaulting firms. After estimating the coefficients of the model, the loan applicants are given a Z-score in order to classify them as good or bad. Several decades after its proposal, the credit scoring model got a significant development.

Altaman and Saunders (1998) discussed the wide spread of the individual level model and its major developments over the years. Altman and Narayanan (1997) evaluated the historical accounting variables used in the credit scoring models across the world.

According to them, most of the studies proposed the use of financial ratios, which determine profitability, and liquidity. These financial ratios may include market value equity/debt, (EBIT)/sales as well as working capital/debt. Altman (2005) proposed a scoring system known as Emerging Market Score Model to use to define the emerging corporate bonds.

Portfolio reduced form models

These models were proposed by Jarrow and Turnbull (1992). According to them, the idea of these models is related to the concept of risk neutral. Risk neutral is a common technique used to predict the probability of the future cash flow.

It helps in computing the asset prices by using risk neutral default probabilities. Jarrow and Turnbull (1992) used the idea of risk neutral to develop the credit risk premium which is also known as the credit spread. They decomposed the credit risk premium into two components.

Poisson /Cox process model

This is a subclass of the portfolio reduced form models. It was developed by Jarrow and Turnbull (1995), and it can be described as the simplest model of the portfolio reduced form model. In this approach, the default process is assumed to be a Poisson process with a constant intensity where the default time is exponentially distributed.

Markov chain model

This is a credit risk model, which was originally proposed by Jarrow et al. (1997). This model considers the default event as the absorbing state and the default period as the first period when the Markov chain hits the absorbing state.

Factor model

This is a credit risk model, which puts into consideration two vectors of explanation variables. The first vector is a set of macro economic variables, such as interest rate, inflation rate, money supply growth as well as GDP growth. This vector explains the systematic risk, which causes default events.

The second vector involves a set of firm-specific variables, which determine individual risk. According to Pederzoli and Torricelli (2005), the variables are considered simultaneously.

Conclusion

The credit risk models have various shortcomings. For instance, the BSM framework structural model consists of several simplified assumption in its derivation. The simplified assumptions restrict the applied value of the model. This has made the subsequent researchers focus on reducing these assumptions.

The individual level reduced form models may not pick up fast moving developments in borrower’s conditions. This is because the model uses explanatory variables, which are based on accounting data. According to Agarwal and Taffler’s (2008), credit scoring models, such as Altman’s Z-score, may not be used to forecast distress as compared to the structural models.

References

Altman, E 2005, ‘An emerging market credit scoring system for corporate bonds’, Journal of Emerging Markets Review, vol. 6, no. 4, pp. 311-323.

Altman, E, & Saunders, A 1998, ‘Credit risk measurement: Developments over the last 20 years’, Journal of Banking and Finance, vol. 21, pp. 1721-1742.

Gordy, MB, 2000, ‘A comparative anatomy of credit risk models’, Journal of Banking and Finance, pp.119-149.

Jarrow, R, & Turnbull, S 1997 ‘A Markov model for the term structure of credit risk spreads’, Review of Financial Studies, vol. 10, no. 2, pp. 481–523.

Merton, C 1974. On the pricing of corporate debt: The risk structure of interest rates. The Journal of Finance, vol. 29, no. 2, pp. 449–470.

Saunders, A & Allen, L 2002, Credit risk measurement: New Approaches to Value at Risk and Other Paradigms. John Wiley & Sons, New York.

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