Edited by Risk Appetite Solutions & Tutorials

Credit Risk Management (RSK4804)

Exam Period: May/Jun 2023 SOLUTIONS

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QUESTION 1 [15]

In recent years, there has been quite a buzz about credit default swaps. The turn
of events following the 2008 Global Financial Crisis became a test of the systems
that settle credit default swaps.

1.1 Define credit default swaps (CDS) and why they are necessary. (4)

(a) Credit Default Swap (CDS) - CDS allows the creditor (or the protection buyer) to
transfer credit risk to another party by paying a fixed amount (premium), either in one
lump sum or at regular intervals. The other party (the protection seller) makes a
termination payment if a credit event – as per the agreement – is triggered. CDS allows
the protection buyer, for a fee, to transfer the default risk on the reference Asset to the
protection seller. The protection period need not match the maturity of the underlying
reference asset. its relevance to credit risk management is as follows:

(b) Credit Risk Diversification: Diversification of portfolio credit risk is possible through
CDS. CDS allows the transfer of credit risks associated with a credit asset to a third
party. It is not uncommon for banks and FIs to partake in subscriptions to loans and
other credit risk exposures in view of long-term relationships with obligors.

(c) Buying Credit Risk: Conversely, there may be investors who wish to take on credit
exposures to given names, but lack the ability to acquire the necessary assets (due to
competition, funding limitation, etc.). They are natural protection sellers.

1.2 What are the advantages and disadvantages of CDS? (5)

Advantages

1. Swaps protect lenders against credit risk. That enables bond buyers to fund riskier
ventures than they might otherwise. Investments in risky ventures spur innovation
and creativity, which boost economic growth.
2. Companies that sell swaps safeguard themselves through diversification. If a firm or
even an industry defaults, the fees from other successful swaps will cover the gap.
Swaps, when used in this manner, provide a consistent source of payments with little
downside risk.

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Disadvantages

1. Swaps, on the other hand, were mostly uncontrolled until 2010. As a result, there
was no government body to ensure that the seller of the swap had enough
money to pay the bond holder if the bond defaulted. In fact, the majority of
financial firms that marketed swaps lacked sufficient capital. They just had a little
portion of what was required to pay the insurance. The arrangement worked until
the debtors went bankrupt.
2. The swaps offered bond buyers a false sense of security. They bought riskier and
riskier debt, believing that the CDS would protect them from losses.

1.3 Default- Kariba projects will receive R70m from ZimDev Bank in case of default and
they will pay a premium of R1.4m, which results in a speculative profit of R68.6m for
ZimDev. ZimDev Bank will suffer losses unless it has hedged its exposure.

No Default-If there is no default, then the CDS contract will yield a profit of R1.4m for
ZimDev Bank will be a loss for Kariba Projects.

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QUESTION 2 [10]

As a group of credit analysts, during a lunch break at a management committee

meeting, a relationship banker decides to join your discussion and states that
credit plays a crucial part in the economy of the country. Do you believe him?
Please elaborate.

Credit plays a very critical role in the economy; I fully agree with the relationship banker.
It plays a very crucial role to facilitate economic growth. Idle economic resources can be
effectively put into use through credit. Borrowers who do not have enough resources to
pursue an activity can borrow the resources, which can be returned to the lender after
having achieved the objective. There is a practical difficulty for those with surpluses to
identify potential borrowers. This is where financial intermediaries come in. Broadly,
banks and other financial intermediaries collect economic resources mainly in the form
of deposits from the public and engage in intelligent lending. Financial intermediaries
play an important role in any economy. From a macroeconomic perspective, the main
function of the financial system in any country is to mobilize resources for economic
growth. The financial intermediaries not only intermediate between savers and investors
but set economic prices of capital, in line with the monetary policy of the nation.

There is an important role played by financial intermediaries. This role is known as

credit creation. Financial intermediaries play a vital role in making the credit available.
Those financial institutions like banks who can retake the loan proceeds given to one
party from another can in fact increase the credit availability in the economy. Prudent
use of credit results in economic growth of borrowers, which in turn leads to the overall
economic well-being of the society and ultimately the country. Credit stimulates both
household consumption and business investment. Hence, a national credit policy is an
important tool used to encourage industrial development and business investments,
thereby creating employment opportunities and improving the standard of living of the
general population. As purchasing power increases, people will tend to spend more on
consumer goods and this will stimulate further economic growth.

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QUESTION 3 [20]

3.1 What is your understanding of the Basel III Accord? Can financial crises, like
the 2008 Global Financial Crisis, be prevented in future by the Basel III Accord?
Explain your views.

Basel III overwhelmingly focuses on initiatives to reduce the probability of future crises –
although it cannot eradicate this risk. Basel III is also expected to promote financially
prudent and conservative policies in the banking and financial sectors to build the
capacity to absorb shocks, irrespective of the source. Some of the aspects of Basel III
are expected to be effective from 2013 while others will be phased in over several
years. The gradual phasing-in of the requirements is important to allow transitional costs
to be managed and ensure this can be undertaken in a controlled manner. In order to
enhance the banking and financial systems’ shock absorbing capacity, Basel III
prescribes more liquidity measures and buffers along with tighter control on leverage.
The Basel III regulations will affect all banks; however, the impact may differ across
types and sizes. of bank. Implementation of Basel III will result in increase in quantity
and quality of capital, liquidity and improved leverage ratios, amended Pillar 2 and
capital preservation.

b) Use of stress-tested PD: Whilst PD estimates in internal ratings-based (IRB) will

continue to drive capital requirements; the PD estimates will be more conservative. It
will be arrived at by using the PD estimates for a bank’s/FI’s portfolios in downturn
conditions. Accordingly, current PD estimates will not be used for capital purposes, but
the stress tested PD for worst-case scenarios.

(c) Strengthens the requirements for the capital against credit risk: An additional
capital charge for possible losses associated with deterioration in the creditworthiness
of obligors is needed. Basel III proposes tighter rules to capture on and off-balance
sheet risks. Banks must determine their capital requirement for counterparty credit risk
using stressed inputs, helping to remove the pro-cyclicality that inevitably arises when
using volatility-based risk inputs. An additional 1.25x multiplier is to be applied to the
asset value correlation of exposures to regulated financial firms with assets of a certain
criterion.

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(d) Tighter controls on OTC derivatives: Banks will only qualify for zero risk weight for
OTC counterparty risk exposure if they deal with centralized exchanges (i.e. clearing
houses).

Can financial crises like the 2008 Global Credit Crisis be prevented in future by
the Basel III Accord? Explain your views.

One of the major questions now being asked by concerned parties is whether Basel III
can prevent the next possible financial crisis or banking sector collapse. The quick
answer is negative. The ‘black swan’ nature of the risk triggers would lead us to
conclude that that all possible risks and impacts cannot be covered through a
framework of ‘within the box’ solutions. No amount of regulation and guidance can
substitute prudent risk management by the bank. Hence, we can conclude that it is the
quality of the risk management of a bank that will decide its future survival and
profitability and not the procedural compliance with Basel III guidelines.

3.2 Capital to be committed = (1-PD) − (PD∕edge ratio)

Edge ratio = 216/4800

= 0.045

= 0.988 − (0.012/0.045)

= 0.988 − 0.1778

= 0.721

If 10% capital adequacy is followed and assuming risk assets = $8,000m, the capital
adequacy would be $8,000 × 10% = $800m. Kelly’s Criterion says that this is to be
equal to 72% and hence the actual capital would be $1109.57m ($800m/72%). Hence,
the capital buffer required would be $1109.57 − $800m = $309.57m.

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QUESTION 4

4.1 Discuss the working capital requirements. (9)

Working capital requirements= Current assets- Current liabilities

(15 000 +19 000 + 5 000 + 6 000) - (21 500 + 8 000 + 0)

(45 000 − 29 500)

= 15 500

From the perspective of the company the working capital requirement is 15 500. The
current Assets requirements are not being fully funded by creditors and Bank overdraft
there is a shortfall of 15 500.

From the Banks perspective

Working capital from bank’s view = Current Assets − Current Liabilities (excluding
bank finance)

(15 000 + 19 000 + 5 000 + 6 000) − (21 500 + 8 000)

(45 000 − 29 500)

=15 500

Working capital requirement from the bank’s point of view is 15 500. Since the overdraft
facility is not being current used the bank can make use of the overdraft facility to fund
the working capital requirements. In this scenario as well, there is underfinancing since
there is a clear working capital requirement but the appropriate financing in the form of
an overdraft has not been employed yet. If the facility was to be made available it
should not be too much as this might be used for non-working capital purposes by the
company. The bank should not also fully fund the needs. It should fund 80% of the
needs that is 15 500x 80%= 12 400 the rest should be funded by contributions from
long term sources known as Net Working Capital.

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4.2 What is your view on the liquidity of Wisani Enterprises? (7)

Current Ratio

= (Current Assets/Current Liability)

= (15 000+19 000+5 000+6 000)/(21 500+8 000)

= 45 000/29 500= 1.5: 1

Quick Ratio

= (Current Assets – Stock)/Current Liability

= (19 000+5 000+6 000) / (21 500+8 000)

= 1.02:1

The company is in a relatively comfortable position it can pay off its current liabilities at
the current position. Also, if you focus on the liquid assets only the company still is able
to pay off its debtors. Therefore, the position is relatively comfortable.

4.3 What would be the working capital situation if Wisani Enterprises doubles
sales, without changes in the current terms of trade?

If they double their sales without a change in the term of trade this will only increase the
figure for the debtors in the balance sheet. This will translate to an increase in the
Current assets due to the debtors’ figures and this will further strengthen the current
ratio and the quick ratio putting the company in a better liquidity position.

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QUESTION 5

Quick Ratio= Current Assets- Inventory/Current liabilities

= (14 000 000-x)/8 000 000 = 1

=14 000 000 −x = 8 000 000

= 6 000 000

Hence Inventory = 6 000 000

Debtors’ collection period = Receivables/Sales X 365

=x/35 000 000 x 365= 30

=x/35 000 000=30/365

Receivables =2 876 712

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QUESTION 6 [10]

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5

(1.2 x 25%) + (1.4 x 32%) + (3.3 x 30%) + (0.6 x 150%) + (0.999 x 180%)

4.4362

4.4362> 2.99, Mochudi Brickworks (Pty) Ltd firm is in a good shape (Green signal) there
is a low risk of bankruptcy.

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QUESTION 7 [15]

7.1 List the types of industry risks. (3)

• Risks Emanating from External Environment

• Industry Specific Risks
• Risks Emanating from Industry Drivers

7.2 Identify the key demand driving factors (and the potential impact) for each of
the following industries:

A. Pharmaceutical industry- Consumer demand is a critical factor influencing

pharmaceutical sector growth. Customers are now more informed and have access to
more accurate drug information. As a result, the persistent need for affordable
pharmaceuticals is fast expanding, affecting both the direct and indirect growth of the
pharmaceutical business. Consumer demand for medicines as maintenance therapy
and lifestyle medications that improve health and well-being has skyrocketed. This rise
is a significant driver of industry expansion. Tailored medicine is gaining a larger
percentage of the pharmaceutical business as genetic testing enables new, highly
tailored therapies for a variety of illnesses.

B. Oil rigs industry (3)- When the price of oil rises, oil companies dig deeper and
deeper in offshore oil fields, increasing output or exploration activities. This raises rig
hire prices and increases capital spending on oil-rigging assets, which benefits the rig
sector.

C. Information technology industry (3)- The driving forces are divided into internal
and external driving forces. Internal driving force includes entrepreneurship, business
objectives and the nature of enterprise innovation. External driving force includes
market competition, demand pull, technology development and government
intervention. These accelerate the rate of growth of the technological industry.

D. Aviation industry (3)- Rising incomes, the expansion of low-cost carriers, and
technological improvements. Each of these factors uniquely shapes the aviation
industry and drives demand for air travel. Rising incomes play a significant role in

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driving demand for air travel. As people's incomes increase, they have more disposable
income to spend on discretionary items such as travel. Increased revenue has
increased demand for air travel, particularly in emerging markets with rapidly rising
incomes. The development of low-cost airlines has significantly impacted the aviation
industry. Low-cost carriers have made air travel more affordable and accessible to more
people, which has increased demand for air travel, particularly for short-haul flights.
Advances in technology have significantly impacted the aviation industry's growth.
Advancements in technology have made air travel more efficient, convenient, and safe.

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