Credit Risk

Hull (1989) presents “a general approach to valuing a financial institution’s contracts when there is credit risk. The approach uses a contingent claims pricing theory and is particularly appropriate for an off-balance contract that has either a positive or a negative value of contingency”. Moreover, he discusses how capital requirements are set so that they reflect the credit risk in off-balance sheet items.

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Brice (1992) surveys the international use of risk rating systems in the context of management of credit risk. According to Brice, the use of these systems enters a new phase where they are widely considered a key factor of any credit risk management framework. For example, the risk rating system is used as a basis for such activities as loan review, loan pricing, and loan provisioning. In relation to loan expectations and prediction, Brice identifies several banks that identify default risk as being comprised of two components: (1) expected loss—which involves an actuarial calculation of the anticipated average loss on loans within a particular asset class over a given time period; and (2) unexpected loss – which is the change (volatility) of those expected losses from one year to the next year. Moreover, Brice argues that many banks have started to apply the modern portfolio theory (MPT) with its main thrust – that diversification can reduce the risk of portfolio. According to Brice, these banks develop portfolio measurement and management systems that monitor a range of variables including geographic exposure, industry concentrations, product clustering, a secured versus unsecured mix, and risk rating.

 

In 1997, J. P. Morgan “issued a Technical Document that describes CreditMetrics^TM as a framework for quantifying credit risk in portfolios of traditional credit products, fixed income instruments, and market-driven instruments subject to counterparty default (swaps, forwards, etc.)”. CreditMetrics ^TM “seeks to construct what cannot be directly observed—the volatility of value due to credit quality changes”. More specific, “CreditMetrics ^TM is a tool for assessing portfolio risk due to changes in debt value caused by changes in obligator credit quality”. According to the document, “the primary reason to have a quantitative portfolio approach to credit risk management is so that one can systematically concentrate risk. Concentration of risk refers to additional portfolio risk resulting from increased exposure to one obligator or groups of correlated obligators”.

Bohn (2000) illustrates that the following six characteristics are needed to apply a contingent claims approach to risky debt valuations:

1. “Issuer’s asset value process

2. Issuer’s capital structure

3. Loss given default

4. Term and conditions of the debt issue

5. Default risk-free rate process

6. Correlation between the default risk-free interest rate and the asset price”

After some mathematical derivation, Bohn shows that “the value risky debt is the value of default risk-free debt less the present value of expected loss (EL) given the company defaults”. The value of a risky debt can be presented as follows:

And

Where

D(V_A,F,r, T) = value of the risky debt “when V_A is the firm’s asset value, F is the debt’s face value, r is the risk-free rate, and T is the debt’s maturity”;

P(r,T) = Price of a default-free discount bond; and

EL = Expected Loss.

Sousa (2002) employs “option-pricing methodology in the evaluation of corporate credit risk in a sample banking credit portfolio. First, he explains the credit valuation models that have been produced from research conducted since the 1970s and have generally been categorized as:

1. Structural models where the driver for the occurrence of default is the stochastic process of the firm value and default occurs when it goes below a certain level

2. Reduced-form models, where the driver of the occurrence of default is considered as exogenous variables”.

Wastgaard and Wijst (2002) describe the theoretical background behind the methodology used to evaluate the credit risk that a bank faces. The authors discuss alternative methods to calculate the parameters in Credit Risk Capital (CRC) and Risk Adjusted Return on Capital (RAROC). According to the authors, the KMV approach of estimating expected default loss (EDL) follows three steps, based on option pricing theory. “In the first step, the market value and volatility of the firms are estimated from the market value of its stock and the book value of its liabilities. In the second step, the firm’s default point is calculated from the firm’s liabilities. Using these two values, plus the firm’s volatility, a measure is constructed that represents the number of standard deviations from expected firm value to the default point. And, in the third step, a mapping is determined between the distance to default and the default rate based on historical default experience of companies with different distance-to-default values”. However, Wastgaard and Wijst point out that the unexpected loss is the primary driver of the amount of economic capital required for credit risk.

The Main Task of credit Risk Analysis

The objective of credit risk analyses can be simply stated as: to forecast the ability and willingness of a borrower to meet its debt obligations when due. However, the appropriate analytical process for achieving this objective is not so simply stated. And ultimately it cannot be described in its entirety because it is based to a large degree on judgment and because it pertains to the future, which by definition is uncertain.

The analysis of credit risk may be separated into two stages: qualitative analysis and quantitative analysis.

The qualitative analysis is represented by the credit ratings assigned by the rating agencies, such as Moody’s, Standard & Poor’s and many others. It is a rather simple and useful method to indicate credit risk. In the present environment of tighter regulation and control of financial risk, there is a revolution in risk management – to become more quantitative in its approach to all risks. Many more formal numerical measures for valuing credit risk have been replacing the qualitative tradition in measuring credit quality. The yield spread between a credit-risky security and its corresponding default-free security is usually regarded as the compensation for the credit risk the risky asset assumes. It is often used to indicate the magnitude of the credit risk.

The commercial banking industry in China has been relatively stable. Most of the banks are almost entirely government-owned and few new banks have entered the market. The four largest state-owned commercial banks (SOCBs) possess market power and account for over half of total industry assets. Banks do not have the freedom to choose competitive strategies. For example, interest rates are determined by the central bank instead of the market. The central government used to incorporate the big four in its credit plan to finance the state-owned enterprises (SOEs) and provide financial support to poor economic regions. Therefore, the big four were forced to make loans regardless of the creditworthiness of the borrowers. As part of the WTO accession commitments, China had to open its banking industry to foreign competition by 2007. Many foreign financial firms are therefore poised to open services in China because of its huge market potential. The central government, thereby, was forced to commercialize its banks. A series of reforms that took place after 1994 were intended to commercialize the state-owned commercial banks and to prepare the banks for foreign competition.

The Credit Risk in Banking Industry in China

The banking sector has always played a key role in the national economy. The non-financial sector in China finances mainly through bank loans. In recent years, bank loans have provided around 80% of funding to China’s domestic non-financial sector. In 2006, almost 87% of China’s non-financial sector’s funding is through bank loans.

Despite facing increasing domestic and foreign competition, China’s four largest state-owned commercial banks (SOCBs) remain dominant players in China’s banking industry. As recent as 1998, these institutions were entirely government-owned. Each of the big four focuses on different sectors in the national economy. Agricultural Bank of China (ABC) focuses on rural lending to agriculture and industry; Bank of China (BOC) handles foreign exchange and new policy initiatives; China Construction Bank (CCB) focuses on new investment and infrastructure; Industrial and Commercial Bank of China (ICBC) focuses on industrial lending. Three of the four, BOC, CCB, and ICBC had initial public offerings in Hong Kong. “All three quickly ranked amongst the world’s top ten commercial banks in terms of market value and, as of July 23, 2007, ICB’s rising share price made it the biggest lender in the world by market capitalization” (Ren, 2007).

A growing number of joint-stock commercial banks have been established subject to the central bank’s approval, with majority government ownership and minority private and foreign ownership. They were allowed to expand nationwide in 1993. The largest such institution, the Bank of Communications successfully went public on the Hong Kong Stock Exchange on June 23, 2005. It was recently reclassified as a “large state-owned bank” in April 2007, but remains at only approximately a quarter the size of the other SOCBs in terms of total assets. The remaining industry assets are held by city commercial banks operating at the city level, urban and rural credit cooperatives, three policy banks, foreign banks, and d non-bank financial institutions.

SOCBs are still the major source of loans in China’s capital market. Within the bank loans made nationwide, the SOCBs account for almost 47% in 2005 and 39% in 2006, while percentage of new loans made by joint-stock commercial banks remains constant.

China’s central bank – the People’s Bank of China (PBC) historically controlled all lending and deposit-taking activities in China. The PBC operated as a ‘monobank’ even after China’s economic reforms began in 1978. Its reformulation as a true central bank was approved by China’s State Council in September 1983, and its former responsibility of lending to state-owned commercial and industrial enterprises was transferred to the newly-formed ICBC in 1984. Continuing reform of the PBC intends to transform it to a true central bank. Recently, the PBC’s major roles involves in determining the required reserve ratio, the base interest rates for deposits and loans, and discount rate. PBC’s Open Market Operations becomes the main tool to influence monetary supply and commercial bank liquidity since 1999. OMO are conducted mainly through trading securities and foreign currencies with designated 40 commercial banks and other partners.

Loan and deposit interest rates are not determined by market supply and demand. Before interest rate deregulation in 1995, interest rates on loans and deposits were set by the central bank and were conformed by all commercial banks. Deposits rate were usually set relatively low and sometimes even below inflation rate. Banks therefore had access to large amount of low-cost household deposits while being able to offer favorable rates to SOE borrowers. Interest rates on loans to SOEs and private sectors were set the same and below market clearing price. Therefore, loan interest rates were not determined by expected return on capital. Regulation on interest rate has prevented capital from being allocated efficiently. Gradually, the PBC introduces greater flexibility in interest rates. It began relaxing its control by setting the range of interest rates instead. Since October 2004, the PBC no longer sets a ceiling on RMB loan interest rate. The central bank now influences interest rates by setting the floor on loan interest rate and the ceiling on deposit interest rates. The deregulation of interest rate expectantly will enhance capital allocation efficiency.

Policy Loans

The central government originally incorporated the four major banks into its credit plan to finance its state-owned enterprises (SOEs). Under the credit plan, the big four SOCBs were forced to make loans to politically motivated projects, regardless of the credit worthiness of the borrowers. Luo (1993) estimated the policy lending as a percent of total lending, and found as follow: BOC, 67%; ABC, 51.2%; CCB, 58%,; and ICB, 25%.

The credit plan prevented the allocation of credit from being determined by market forces. Under each year’s credit plan, the SOCBs received loan quotas to every region. In fact, “regions with low growth potential tended to be highly dependent on SOEs, and, as such, received relatively large amounts of loans”. Chiu and Lewis (2006) observe that a strict quota system was implemented by the central government, and the loan quota listed the number of firms in each province to receive bank loans, and SOEs had priority. Other political factors also affected commercial bank lending. Shih (2004), for example, shows that although the province of Liaoning had a high concentration of SOEs it did not receive the lending rates enjoyed by the neighboring province of Jilin – a province whose leaders appear to have enjoyed much closer ties to the central government elite than did Liaoning’s.

Policy lending quotas were set without any reference to the bank’s ability to meet the quotas. In high growth areas where deposits were high, the bank’s lending options were constrained and they typically kept large excess reserves with the People’ Bank. Low growth areas, meanwhile, tended to have high quotas that the banks could not meet through their deposits alone; therefore, they had to turn to the PBC for funds, leaving the central bank redistributing funds from high deposit areas to low deposit areas. Mo (1999) estimates that CCB borrowed about one-half policy lending from the central bank, the other half from deposits. ICBC financed all of its policy lending by borrowing from the central bank. BOC and ABC financed only about one-fifth and one-fourth of their policy lending by deposits.

The formal loan quota system was removed in 1998. However, “the historical burden of prior bad loans plus ongoing protection of many SOEs continued to hamper full commercialization of the SOCBs. SOE managers were not made accountable for non repayment of loans in the past and, even if an SOE had previously defaulted on loans, the banks still lacked the authority to independently cut off new lending to that SOE”. This essentially forced the banks to make new loans to cover defaulted interest payments, reporting phantom interest profits in the process. For example, even though the SOE’s share of industrial output had declined to 28% in 1999 from 78% in 1978, they still received half of total investment funds in that year (Bajona and Chu, 2004, p. 7). Chui and Lewis (2006) estimate that SOEs still receive 45% of SOCB’s short-terms loans and probably about 60% of SOCB’s medium-to long-term loans, for fixed assets in 2003.

China’s commercial banks strengthen their credit risk management process with the following three components through careful analysis to strictly control risk so as to keep good asset quality.

1. Credit policy includes the formulation of risk management policies and lending policies, and definition of customer credit rating and risk limits.

2. Credit granting includes authorization management of credit extension, due diligence investigations and risk reviews.

3. Credit monitoring includes the monitoring of asset quality, follow-up evaluations and examinations of policy and regulation implementations.

 

At the mean time, the private sector has limited access to bank funding. Banks charge the same below-market interest rates on loans to SOEs and to the private sector, which creates excess demand for loans. When it requires administrative distribution of funds SOEs certainly have priority. Therefore, Chiu and Lewis (2006) find that private firms are less likely to receive funding from the banking system. A survey by Garnaut et al. (2001) shows that 91% of initial capital and 62% of established business financing for the private firms came from internal sources in 1998. Only 7% of initial capital and 18% of business financing was contributed by loans from financial institutions.

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References

Brice, R. (1992). “Improving Credit Quality” in Australian Institute of Bankers Scholarship Report, pp. 1-102.

Chiu, Becky and Mervyn K. Lewis. (2006). Reforming China’s State-owned Enterprises and Banks. Northampton, MA: Edward Elgar.

Hull, J. (1989). “Assessing Credit Risk in a Financial Institution’s Off-Balance Sheet Commitments” in Journal of Financial and Quantitative Analysis 24 (4)

Luo, Jiwei. (1993). “Financial System and Policy”, paper presented to the Harvard Institute of International Development, Workshop on China’s Economic Reforms, p. 1.

Ren, Daniel. (2007). “Rally Puts ICBC on Top of the World”, South China Morning Post, p. B1.

Souse, N. Q. (2002). “Corporate Credit Risk Valuation Using Option Pricing Theory Methodology: A Practical Application to a Banking Credit Portfolio”. Working Paper.

Westgaard, S. and N. Wijst. (2002). “A Framework for Corporate Portfolio Credit Risk”. Working Paper.