PrecisionLender breaks risk into four major "buckets":
- Operational risk
- Market risk
- Interest rate risk
- Credit (default) risk.
In practice, folks will often choose to get even more granular than this, but we have found this set to work pretty well. Of these four "buckets", the first two, operational risk and market risk, are (after normal measures such as fire alarms, security systems, etc. are taken) largely unmitigatable and as such are addressed with a fixed allocation of capital. In PrecisionLender this is often 1-2% of assets. Interest Rate risk is mitigatable - it can be hedged through the use of interest rate swaps or simply match funding (these two are essentially two different ways of reaching the same economic outcome), but this has a DIRECT COST based upon the repricing structure of the loan (fixed, floating, adjustable). This cost is reflected in the yield curve used and flows into the loan income statement directly into the Interest Expense.
The final bucket for risk in PrecisionLender is Credit (or default) Risk. It is driven by the following high-level factors:
- Probability of Default (PD): the likelihood that this obligor (borrower) will default (fail to repay the principal in full)
- Loss Given Default (LGD): the loss that we (the lender) will incur in the event of a default.
- Exposure at Default (EAD): the exposure that the bank will have in the case of default. For example, the EAD for a Line of Credit may exceed the current/average balance if we assume that the line will be drawn fully just prior to default (see note below).
For LOCs, there are some industry data that we have that shows that Usage Given Defaults (UGDs or the percentage of the unused balance that we should expect to be used in the case of a default) for LOCs are not 100% and that they are higher for better credit grades. So a "1" credit might have a 75% UGD and a "4" credit might have a 40% UGD.
There are several reasons for this:
- Better credit grades typically have lower utilization until just before default
- Better credit grades are more credit savvy
- Better credit grades are sometimes monitored less frequently or have less stringent covenants.