CCP Advanced Level

Advanced Credit Risk Management flashcards

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What is the difference between passive and active credit portfolio management?

Passive CPM: originated loans are held to maturity, and risk is managed through origination discipline and diversification at the point of lending. Active CPM: the portfolio is managed after origination, through trading credit assets, credit derivatives and securitisation, adjusting exposure without waiting for facilities to mature.

How does systematic credit risk differ from diversifiable risk?

Systematic risk comes from economy-wide factors (a KES depreciation, an interest rate shock, a broad slowdown) that hit most borrowers at once. Diversification cannot eliminate it. Diversifiable risk is borrower- or sector-specific, and spreading exposure across uncorrelated borrowers and sectors can meaningfully reduce it.

What is overtrading, and why can it sink a profitable business?

Growing sales beyond what the business's working capital and financing base can support. Cash is tied up in inventory and receivables faster than collections bring it in, so a profitable business can still fail from cash flow strain.

How is a project's Debt Service Coverage Ratio worked out, and what does 1.50x mean?

DSCR = cash flow available for debt service / debt service due (principal plus interest). Example: KES 45,000,000 / KES 30,000,000 = 1.50x, so the project generates 1.5 times the cash it needs for its debt. Lenders typically require a minimum, commonly around 1.2x to 1.3x for infrastructure, throughout the tenor.

What is the Expected Loss formula? Work it for EAD KES 10,000,000, PD 4% and LGD 45%.

EL = PD x LGD x EAD. 10,000,000 x 0.04 x 0.45 = KES 180,000. This is the average loss the bank should expect on the exposure, the figure provisioning is built to anticipate.

What four components does a risk-based loan price build up from?

1. A base (funding cost) rate. 2. A credit risk margin, compensating for Expected Loss. 3. A capital charge, compensating for the economic capital the facility consumes. 4. An operating margin.

What is the core idea of the Merton model, and what kind of model is it?

It treats a firm's equity as a call option on its assets: default occurs when asset value falls below the firm's debt obligations. It is the foundational structural credit risk model, deriving default from the firm's capital structure.

What shift did IFRS 9 make in credit loss provisioning?

From IAS 39's incurred-loss model, which waited for objective evidence of impairment, to a forward-looking expected credit loss model. Losses are recognised earlier from PD, LGD and EL estimates, with lifetime expected losses for deteriorated exposures. Kenyan banks have adopted it.

What do credit derivatives let a lender do that selling the loan does not?

Instruments such as credit default swaps transfer credit risk to another party without transferring the underlying asset. The lender can hedge a concentrated exposure while keeping the client relationship. Selling the loan typically hands over the relationship too.

What is perfection of security, and why does it matter?

The legal steps that make security enforceable against third parties, such as registering a charge under the Movable Property Security Rights Act or a land charge under the Land Registration Act. It secures the lender's priority on default. Unperfected security can rank behind other creditors or be void against a liquidator.

Why is a credit portfolio's return profile asymmetric compared with an equity portfolio's?