Preface

The first edition of The Handbook of Credit Risk Management: Originating, Assessing, and Managing Credit Exposures was published at the end of 2012 at a time when the global economy had just started to recover after one of the worst financial crises of modern history (which we refer to as the "2007 crisis" because in 2007, delinquencies on mortgages began occurring on a large scale). The expectation was that leadership teams of financial institutions, risk management professionals, investors, governments, and regulators would reflect on what had gone wrong in the buildup to the crisis and make all necessary changes so that it would not happen again.

As risk professionals, we have been very satisfied by what happened for the most part. We originally wondered how good intentions would translate into concrete actions and changes of behaviors. Then we were skeptical that the changes would last long and feared that, after a while, memories of the 2007 crisis would fade away, regulators would gradually relax their rules and financial institutions and investors would start again making big bets.

It did not happen and we can now clearly see that the financial system is more resilient than it used to be. No major crisis occurred in the last decade although risk management principles were tested by unprecedented events such as a global pandemic, a negative oil price, or a short squeeze of stocks organized by a new breed of investors in their 20s.

Overall, the last decade reinforced the role that credit risk management (CRM) teams play in the world economy. Resources allocated to CRM have increased in many institutions. The opinions of credit risk managers are taken more seriously into account than ever and their voices are heard louder when they ask to improve the structure of a new transaction or to strengthen internal processes.

Since the publication of the first edition of The Handbook of Credit Risk Management, we received numerous testimonials from readers who acknowledged that the book had helped them improve their knowledge of the topics covered and contributed to their professional success. We have also been humbled by the number of universities and companies who used our book to support the education of their students and employees.

The support we received encouraged us to write a second edition. So many things changed since 2012 that we thought that the time was right to publish a completely updated version. What's new? Financial markets are constantly evolving so we updated many concepts and market practices with the latest industry standards. We also updated all data and provided many new examples to illustrate the topics we present. We also did not hesitate to delete entire sections when the content of the first edition was no longer relevant. One example is the ABS CDO market, which was as big as $500 billion prior to the 2007 crisis and which has completely disappeared today and is unlikely to reemerge in the foreseeable future.

Finally, we wrote three completely new chapters we thought would be of interest to our readers. They cover consumer finance, state and local government credit, and sovereign credit risk.

We are still of the opinion that too often credit risk management is viewed only as the art of assessing single name counterparties and individual transactions. For us, CRM remains more than that. The management of a credit risk portfolio involves four sequential steps:

1. Origination
2. Credit assessment
3. Portfolio management
4. Mitigation and transfer

Each one must be individually well understood, but, also, the way they interact together must be mastered. It is only by fully comprehending the entire chain of steps that risk professionals can properly fulfill their task of protecting the balance sheet of the firms employing them.

We provide a comprehensive framework to manage credit risk, introducing one of the four essential steps in each part of the book. This book is based on our professional experience and also on our experience with teaching CRM to graduate students and finance professionals.

We hope that you will find the second edition of The Handbook of Credit Risk Management valuable, whether you are a student, someone new in the field of risk management, or a professional interested in learning more about this important topic.

Next, we provide an overview of each part.

PART ONE: ORIGINATION

Part One focuses on the description of credit risk and on the credit risk taking process in any organization involved in credit products. We also provide a simple checklist to analyze new transactions.

In Chapter 1 ("Fundamentals of Credit Risk"), we define credit risk and present the major families of transactions that generate credit risk for industrial companies and financial institutions. We conclude with the main reasons why properly managing a portfolio of credit exposures is essential to generate profits, produce an adequate return on equity, or simply survive.

In Chapter 2 ("Governance"), we present the strict rules that must be in place within all institutions taking credit risk. It all starts with clear and understandable credit policies or guidelines. Then, in order to control accumulation, we discuss the role of limits on similar exposures. We also provide a concrete framework to approve new transactions. To finish, we discuss the human factor: how a risk management unit must be staffed and where it must be located inside an organization.

In Chapter 3 ("Checklist for Origination"), we introduce nine key questions that must be answered before accepting any transaction generating credit risk. It may sound trivial, but the best way to avoid credit losses is to not originate bad transactions. All professionals involved in risk taking must, therefore, ask themselves essential questions such as: Does the transaction fit the strategy? Does it fit into the existing portfolio? Is the nature of the credit risk well understood? Is the deal priced adequately or is there an exit strategy?

PART TWO: CREDIT ASSESSMENT

Part Two introduces the methods to estimate the amount of exposure generated by transactions of various natures before detailing how to analyze the creditworthiness of a company, government, or of a structured credit product.

The focus of Chapter 4 ("Measurement of Credit Risk") is on the quantification of credit risk for individual transactions. We present the three main drivers influencing the expected loss of a transaction: the exposure, the probability of default, and the recovery rate. The exposure is the evaluation of the amount of money that may be lost in case of default of the counterparty. The probability of default is a statistical measure that aims at forecasting the likelihood that an entity will default on its financial obligations. We introduce a two-step approach to derive a default probability: the assignment of a rating followed by the use of historical data. Finally, there are few transactions that generate a complete loss when an entity defaults. Creditors are usually able to receive some money back. The amount is summarized by the recovery rate. The expected loss is the multiplication of the three parameters presented above.

Chapter 5 ("Dynamic Credit Exposure") is dedicated to the measurement of exposures that are not fixed but change with the changes of financial market values. We present, with examples, two main families of transactions generating a dynamic credit exposure: long-term supply/purchase agreements of physical commodities and derivatives trades involving, for instance, interest rates, foreign exchange, or commodities. We explain that at any given time, the credit exposure of such transactions is the replacement cost of the counterparty and is measured with the concept of mark-to-market (MTM) valuation. We conclude by introducing the concept of value at risk (VaR), which provides a statistical measurement of credit risk for a given time horizon and within a certain confidence interval. One of the key things to remember is that VaR is a useful method, but it does not represent the worst-case scenario. In the real world, actual losses can and have exceeded VaR.

The cornerstone of all credit risk management processes is assessing the credit risk of counterparties. In Chapter 6 ("Fundamental Credit Analysis"), we present the most common method of analysis, which is a quantitative-based review of the counterparty's financial data, and we also present a qualitative-based review of the firm's operations and economic environment in which it operates. We start the analysis by covering basic principles of accounting and the salient features of a company's balance sheet, income statement, and cash flow statement. We then describe the key ratios summarizing the financial health of a company.

We introduce the concept that the interests of the shareholders and of the creditors are not aligned. This is known as an agency conflict. In essence, creditors are not in a position to influence decisions impacting the fate of the money they invest in a company. This is the prerogative of management, appointed by shareholders. We conclude Chapter 6 by outlining a model building of the shareholders-versus-creditors relationship, developed in the 1970s by the Nobel Prize Laureate Robert Merton.

Besides fundamental credit analysis, there are alternative ways for estimating the creditworthiness of a company, including...