LEARNING UNIT 0: ORIENTATION

Video Activity Text Additional Reading and References

1. Module purpose

The purpose of this module is to equip you with a thorough and comprehensive knowledge of credit risk in a way that would
stimulate an interest in credit risk analysis and management. This module will be helpful to both borrowers and lenders,
especially in understanding the relevant theories and concepts, as well as the application of such knowledge in the credit risk
management setting. You will also understand the complexities that led to the 2008 Global Credit Crisis that shook the
financial world, and appropriate measures which are now in place to prevent a repetition of that phenomenon, and mitigate
any additional risks. Knowledge of this module will give you a better understanding of how to deal with most financial products
on the market, which embed credit risk.

Finally, you should be able to evaluate, through case studies and other examples, the practical application of credit risk
management theory to enhance any risk prevention and related mitigation strategies in the context of your organisation.

In this module, the following topics will be covered:

• Credit risk, analysis and management

• Firm (obligor) credit risk
• Credit portfolio risks and mitigants
• Credit risks – Project and working capital
• The last line of defence – security

2. Why study credit risk management?

A lack of credit risk education in today’s financial world remains a bone of contention. Taking risk remains an important part
of any financial services operation that is hoping to earn a return and contribute to the bottom line. The effective management
of credit risk is a critical component of a comprehensive approach to risk management, because lending is the core activity of
the banking industry. If role players had been armed with a sound credit risk education, the 2008 Global Financial Crisis could
have been easily averted. Furthermore, the introduction of Basel II has incentivised many of the global best practices banks
to invest in better credit risk management techniques and to reconsider the analyses that must be carried out to mitigate
such risk of loss, and benchmark their performance according to market expectations.

Banks are also increasingly facing credit risk in various financial instruments other than known traditional loans. Those include,
among others, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities
and options, the extension of commitments and guarantees, and the settlement of transactions. The higher degree of vigilance
is, therefore, necessary for long-term success in a more complex and competitive global financial market.

The ability of the bank in managing its credit portfolio depends on the quality of its rating system and its usage in order to
take conscious credit decisions. Correct estimation of default probabilities is becoming an increasingly important element of
a bank’s measurement and management of credit exposures. Any wrong estimates of probability of default (PD) could lead
to inappropriate capital allocation and, consequently, destruction of shareholder value due to default.

Recent events related to the 2008 Global Credit Crisis that shook the financial world, have indeed changed the way in which
credit risk has been perceived in the past. The wake-up call has now resulted in a more conservative and comprehensive
approach as well as understanding of the nature of credit risk analysis and management. For those of you who are interested
in credit risk analysis and management, the challenge is to equip yourself with the necessary knowledge, which is not only
practical, but interesting too. This a module that would be useful to you and is an initial step in understanding models in the
management of credit risk, both at individual loan and portfolio level.

3. Structure and learning outcomes

This module is essentially a compilation of the theoretical and numerical tools necessary to influence the decision-making of
role players (bank officials, regulators, credit managers, CFOs, analysts and finance managers) involved in credit risk
management and analysis in any organisation which might be financially exposed. Case studies and examples provided in the
prescribed textbook demonstrate the practicality of these tools in the actual (real-life) environment.

Working through the selected questions and problems should provide you with ample opportunities to develop practical
insights and skills.

The assessments that are due over the course of the year will afford you an opportunity to develop and apply the concepts
and tools.

Various activities should give you a feel for the vast pool of resources in terms of information and research available to those
involved in credit risk analysis and management.

The examination will test your application of important concepts and problem-solving skills to the various concepts and
practical situations.

The learning outcomes indicated at the beginning of each learning unit will give you an overview of what you are expected to
know after studying the material associated with a given topic. Typically, the examination questions will be based on the
materials associated with all the learning outcomes, and as tested throughout the year in the form of various formative
assessments.

4. Prescribed textbooks
The following textbooks are prescribed for this module:

Joseph, C (2013). Advanced credit risk analysis and management. West Sussex, UK: Wiley.

Bandyopadhyay, A (2016). Managing portfolio credit risk in banks. New York: Cambridge University Press.

Witzany, J (2017). Credit risk management: pricing, measurement, and modeling. Cham, Switzerland: Springer.

5. Online student resources

TBA

6. Module outline
This module will unfold as follows:

TOPIC 1: INTRODUCTION

Aim: To provide an understanding of credit risk, advantages of credit as well as the historical challenges of credit risk analysis.
To further explain risk appetite statements, major drivers of credit risk and those factors affecting credit risk.

LU 0: Orientation
LU 1: Credit Risk, analysis and management

TOPIC 2: FIRM (OBLIGOR) CREDIT RISK

Aim: To understand the impact of business cycles on the industry as well as analysis of industry profitability factors. Focus is
also on the in-depth treatment of financial risk analysis, providing credit risk mitigants for obligor risk, probability of default
in credit decisions and how obligor credit risk analysis is converted into risk grades. The aim is furthermore to understand
how the Merton Model and Altman’s z-score are linked to the traditional accounting-based credit risk analysis.

LU 2: Industry risks

LU 3: Rating and scoring systems

LU 4: Expected loss, LGD estimations and measuring probability of default

LU 5: An integrated view of firm-level risks

LU 6: Financial risks

TOPIC 3: CREDIT PORTFOLIO RISKS AND MITIGANTS

Aim: To provide various credit portfolio risk mitigants, and a mathematical way of calculating sector limits, sale of credit
assets and credit derivatives as well as explaining benefits of portfolio risk analysis. Furthermore, issues in the Basel Accords
are explored and explained, including the role of external credit rating agencies and Kelly’s formula in the context of credit
risk management.

LU 7: Credit derivatives

LU 8: Major portfolio risks and assessment of credit risks

LU 9: Credit risk, validation of models and Basel Accords

TOPIC 4: CREDIT RISKS – PROJECT AND WORKING CAPITAL

Aim: To provide in-depth analysis of two common situations – project finance and working capital finance.

LU 10: Credit risks in project finance

LU 11: Credit risks in working capital

TOPIC 5: THE LAST LINE OF DEFENCE – SECURITY

Aim: To elaborate on the role of security as a return enhancer and credit risk mitigant. Furthermore, the importance of both
financial and non-financial covenants is emphasised in managing underlying risks.

LU 12: Security basics, collateral and covenants

Activity

Activity 1: Go to the Discussion forum and introduce yourself to your fellow students.
You are now ready to start with LU1.