Credit risk

1. Managing Credit Risk Under The Basel III Framework 65
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Credit Quality Monitoring
5
KEY CONCEPTS
• Individual borrowers monitoring
• Financial markets monitoring
• Large borrowers monitoring
• CapLogic SiFi credit index
5 Credit quality monitoring
5.1 Credit risk monitoring
Ideally, credit risk monitoring means tracking the credit risk by updating regularly the EL
in case of a single debt and the XCL in case of a debt portfolio. If the credit risk is above
his tolerance level, a lender then takes appropriate actions to bring the credit risk back to
or below his tolerance level. This involves the frequent estimation of the credit risk with
the six underlying credit risk factors: EAD, LGD, PD, RM, concentration of debts and
default dependency.
Nevertheless, among these six credit risk factors, five of them are relatively stable and/or
predictable, leaving only the PD which may vary in a broader range during the lending
period as a result of the change in financial condition of a borrower. As such, in practice,
most of the efforts are concentrated on credit quality monitoring which tracks the credit
quality of borrowers.
5.2 Risk tolerance level
The risk tolerance level of a lender on a single debt is the maximum EL which the lender
can accept. Since the EL cannot be observed directly in the real world (only the default
loss is observable), the risk tolerance level of a lender is determined through an
experiment in which a lender is provided a large number of debts with different EADs,
LGDs, PDs, RMs, default losses and default chances which are acceptable on individual
basis to the lender. During the experiment, the lender agrees to invest in some debts and
refuses to invest in some debts. The maximum EL of the debts invested by the lender
then becomes the risk tolerance level of the lender on a single debt.
The risk tolerance level of a lender on a debt portfolio is the maximum XCL which the
lender can accept. Although the XCL cannot be observed in the real world, it can be well
approximated by the maximum portfolio default loss within a period of one year.
Therefore, a lender can easily determine his tolerance level on a debt portfolio by
suggesting the maximum portfolio default loss which the lender can accept in one year.
Every lender is equipped with his own subjective risk tolerance level. A lender with
limited funds has a tolerance level lower than that of a lender with abundant funds. Also
a lender with more experience in credit risk management has a tolerance level higher than

2. 66 Managing Credit Risk Under The Basel III Framework
Copyright 2018 CapitaLogic Limited
a lender with less experience. As such, there is no single procedure to derive the risk
tolerance level of a lender.
5.3 Individual borrowers monitoring
The credit quality of a borrower can be monitored conveniently by its updated credit
quality indicators, e.g., credit rating for an institutional borrower and FICO score for
retail borrowers.9
By tabulating the credit quality indicators in a time series, the
improvement or deterioration in credit quality of a borrower is observed.
However, credit ratings and FICO scores are updated usually on an annual basis or when
there is a major credit event. This makes the monthly and/or quarterly credit monitoring
less effective. Also, some borrowers have neither credit ratings nor FICO scores if they
are not covered by credit rating agencies and retail credit bureaus. Therefore, internal
credit assessment by a lender himself is necessary to supplement the external credit
assessment.
Theoretically, any method used for internal credit assessment by a lender at debt
origination can be utilized to monitor credit risk by re-assessing the credit quality of a
borrower, riding on the assumption that the most recent status of the explanatory
variables of a borrower could be collected at any time similar to the moment when a debt
is originated. Nevertheless, this assumption is far from reality since most borrowers will
not provide updates of their financial information to their lenders except for the situation
where contractual benefits are exchanged if updates are provided and/or contractual
penalties are applied if updates are not provided.
In practice, a default event starts to emerge on the payment day when a borrower fails to
pay the interest and/or principal in full. As such, a delay in interim interest payment
demonstrates empirically the deterioration in credit quality of a borrower. Professional
lenders thus design debts with regular interest payments, usually monthly for retail
lending and monthly/quarterly/semi-annually/annually for corporate debts.
Some banks request their borrowers to open a regular savings account for monthly
payroll collection purpose. The income, a critical explanatory variable of an individual
borrower, is recorded by the lender through this payroll account. Taking it one step
further, banks may request their borrowers to open an operating account which is utilized
for all incoming and out-going cash transactions. In addition, all major financial
investments are deposited into this operating account. Thus, the complete financial
picture of a borrower is well displayed in front of the lender. A large amount of cash
outflows over cash inflows will trigger the attention from a lender.
Typically, a bank may lend to a large number of different borrowers. Therefore, even
though individual credit assessments can be conducted on an on-going basis by the lender,
the abundant amount of credit assessment results make this micro approach of individual
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Details about credit rating and FICO will be discussed in detail in Part II Credit Assessments.