 Hi everyone, it's MJ the Fellow Actory and in this video, I want to talk about credit risk management, a very very popular exam question. So we're gonna be looking at 10 ways to manage credit risk and the first one is probably the most obvious one and that is to require some sort of collateral. So this tends to be with private debt you lend somebody some money and you say I'm only gonna lend you this money if if I can tie one of your assets to this loan so that if you fail to repay it I can then take ownership of an asset that belongs to you. It tends to be the house, could be a car, could be something else with with porn stars and if you guys have ever watched that show some people will come in and they will pawn a fancy watch or some sort of antique as a form of collateral to get their loan. Now collateral is very very effective because when somebody says okay, hold on if I don't repay this loan I'm gonna lose my house. They're gonna do their utmost best to make sure that they do not default on that loan. So when there's collateral we tend to see a lower default rate. Also if a default does occur you can go take that asset and sell it and that is going to improve your recovery rate which means we're gonna see the severity of the risk lower as well. Of course the big difficulty is that this asset tends to have low marketability because if it was a very marketable asset then instead of them loaning it to using it as collateral they would have liquidated the asset and rather just use the money without having to come to you for credit. But because it tends to have low marketability it means that they can use it as collateral but if the bank or whoever's lending the money needs to liquidate it they have to tend to do it at a below market price. Another big problem with collateral is that it requires a legal framework. So one of the things about let's say doing a loan over the incident if you lend money to somebody in another country and they don't repay it and you say okay I'm going to come take your house they can say well try. If there's not that legal structure in place then it's going to be very difficult to collect. So collateral is very effective but it does require a legal system in order for it to be enforced. Now another way for say public debt or for how how organizations can deal with large amounts of credit risk so think of a bank that's lent money to a whole bunch of people how do they now manage it after the fact they can do something called securitization. This is where you create a special purpose vehicle or an SPV and this allows you to transfer the risk off your balance sheet. So what you do is you give all the loans to the special purpose vehicle and they then give you ownership of that special purpose vehicle and essentially what you're doing through this accounting exercise is you're converting credit risk to market risk and with the original basil accords they were only looking at credit risk this became a form of regulatory arbitrage and it allowed you to basically bypass regulations and hold lower capital because of the way you had structured it but another big advantage of securitization is because you've moved it off the balance sheet to another separate entity you can then sell that entity or shares in that entity on the capital markets and you can then actually offload a lot of your credit exposure if there is a buyer and what tended to happen with the financial crisis is that because China had devalued its currency and was buying lots of American Treasury bonds the American Treasury bonds had come so low that your big pension funds and other institutions were trying to seek yield in weird and wonderful places and so they started you know buying into these mortgage backed securities but that is a story for for another day another thing with credit risk management is to have a two team approach you've got the front office and you've got the back office and here the big idea is to realize that companies or especially banks want to expose themselves to credit risk why because that's how they make quite a lot of money a bank makes money think about if someone deposits money and they pay them five percent interest but they can lend that money after somebody else and they can get ten percent interest then they're making a very juicy spread so banks want to be exposed to credit risk specifically when your frequency of default is very very low so what they'll tend to do is they'll sometimes have a front office which tries to sell loans so somebody will call in and say hey i need twenty thousand dollars in order to buy this truck then you could even have an instance where the salesman at the bank or someone working at the bank says hey listen why don't i've checked your records you know you've got a very good history you've got a good salary why don't i lend you twenty five thousand and you buy the better version of the truck or you use the money to i don't know buy yourself something pretty at the same time and then what tends to happen is to try and prevent the front office from just going too crazy and handing out too much money you'll then have a back office that then actually says okay hold on can the person take twenty five thousand okay yes they'll do the check and we'll look at some of the models that they will incorporate that the back office does of course there's the classic example where the incentive structures of these two officers can sometimes cause them to be in conflict and the classic example is when the front office is paid a bonus on the amount of loans they issue and the back office is penalized by the amount of defaults that they experience because then what happens is front office goes crazy and throws loans to people who don't deserve it or who can't afford it and back office is is saying well hold on um there's so much work for us to do and we're just going to get penalized that they just start blanketly declining everyone because they're still going to get paid their amounts their salaries based on defaults not necessarily on volume so it's very important that if you go with the two team approach you design the incentive structure in a way that is complementary and doesn't conflict your operations then I mean it's kind of goes without saying diversification is always a valid way of managing risk and how you can diversify is through different types of loans there's loans for starting businesses there's loans for mortgages there's different there's student debt there's there's lots and lots of different types of loans I mean even credit cards so you can diversify by type you can also diversify by regions if you're an international bank you know lenty in South Africa then a little bit of America then a little bit of Australia um and then another idea with diversification is you can make lots and lots of small loans uh so imagine like you're lots of small loans with your capital that you have instead of a few big ones so it's just also having a different strategy on what part of the market you want to access of course diversification does fall flat when we're in a bit of a pandemic situation like with coronavirus or when there's a big recession and everyone around the world just starts defaulting at the same time so diversification is not bulletproof but it is always going to be a valid management technique in the exam but maybe even mention a little bit of its downside or when it will be ineffective then when it comes to credit risk management don't forget to mention the soft approaches um anyone who's been a little bit behind in their their mortgage repayments will will probably know quite a few more than these but essentially sending letters to people reminding them that they have payments sometimes just putting a little bit of pressure or just saying hey listen you need to repay me is enough to get people to to start repaying their their loans in an extreme situation you could send a debt collector this is normally a very large person who is intimidating um although you kind of think of the movies they don't really have baseball bats and break your legs um like you know in like I say in some of those gangster movies but they will kind of intimidate and maybe say hey um you need to actually make the payment or you could be more forgiving create a grace period restructure the terms maybe say instead of repaying the the the amount within the next 10 years you can repay it over the next 20 years so there are various soft approaches that you can take in order to prevent a default from occurring um like I say there's quite a lot of soft approaches so make sure you read up and expose yourself to quite a few of them then there's hedging um specifically let's say your credit model says okay well a 1% increase in interest rates is going to cause a 3% increase in default rates um this is because especially if it's a if it's an adjusted mortgage and interest rates increase maybe some people are unable to pay that extra amount and therefore they will default so what you can do is you can say okay let's maybe use a a financial instrument such as an interest rate swap that allows us to therefore make money when the interest rate increases and we can use that additional gains to hedge the losses from the defaults that we would experience so this is kind of where interest rates can can can come in and I mean interest rates are a form of derivative you could be a little bit more direct with your derivatives by using credit default swaps which you know it's not really a swap it's more a form of insurance but they called it a swap in order to bypass insurance regulations we won't go there right now but you can use these credit defaults to change your risk profile and what's quite nice is you can use it also to increase your credit risk exposure remember banks want this risk yes it's it's bad if someone doesn't pay but if they do pay banks make money and if they feel like they've got a really good book they might call up and say let's have a credit default swap where they can actually magnify or leverage their exposure on their own um book or they could even do it on on other people's books so you can actually get exposure credit risk exposure without having to go through the whole hassle of setting up face-to-face meetings or or having models or having a bank you can use these instruments to change your risk profile to how you want it to be um what you can also do is buy and sell loan books we saw this during just before the financial recession the big banks what they were doing is going around to the smaller mortgage originators and just buying all their books from them of course that caused the big problem because then those smaller companies had no incentive to implement any form of risk management so where people had to say what their job was they just left it blank they just wanted to you know throw out these loans because they could then offload it to the bigger institutions who then chopped it up into mortgage-backed securities who then threw it on to somebody else and this is kind of where the whole crisis of 2008 stemmed from but what you can do if you feel like you've got too much credit risk you could sell a chunk of your book or you could if you want more go to another company and buy their book of course this is a more complicated trade it's not necessarily something you can do on a on a market this will normally be a deal between two institutions that tend to have maybe a good relationship one another look you can also manage your credit risk at the start you can have stricter underwriting requirements so before if you had oh you needed the person to be earning so much excessive income now you could increase that proportion you could maybe say we're only going to be lending money to to actuaries and people of financial degrees anybody else we're just going to tell them no they're too risky so you can change your underwriting requirements you could increase the amounts of collateral that they want to hold you know there's lots of different things that you can can do at the underwriting stage and then finally you can also dispose of public debt as soon as it becomes it well as soon as it loses this investment great status so instead of buying a bond and holding it for this whole duration and if the credit starts deteriorating your rate of default goes up and maybe to an uncomfortable area you could always tap out of course selling out means you're going to incur a little bit of a little bit of a loss so it depends very much on your strategy and your appetite for credit risk but job as soon as let's say you only want investment grade as soon as selling loses investment grade and goes into the bees then you can say okay let's dispose it take that loss on on the chin so like I said there's various ways on how to manage your credit risk and these are just 10 ways like I say for this exam you maybe want to come up with a few more on your own and just add it to your own notes but this should get you off to a very good start