Credit Risk Assessment and Rating
What the exam tests
This domain tests how you convert analysis into a risk grade: probability of default, loss given default, exposure at default, scorecards, and the use of collateral and guarantees. It also tests rating migration and the discipline of applying a consistent scale.
Core rules
- PD, LGD, and EAD are separate inputs; expected loss is their product.
- Quantitative factors include leverage, coverage, liquidity, and cash-flow volatility; qualitative factors include management quality, industry outlook, and account conduct.
- Collateral lowers LGD, not PD. A weak borrower with strong security is still a weak borrower.
- Guarantees are only as good as the guarantor's capacity and willingness to pay.
- Ratings must be reviewed on new information, not only at annual review; migration should trigger action.
Worked example
Exposure ₦500m, PD 2%, LGD 45%. Expected loss = 500 × 0.02 × 0.45 = ₦4.5m. If perfected collateral cuts LGD to 25%, expected loss falls to ₦2.5m. The rating, however, stays anchored to the borrower's PD; the collateral improves recovery, not the likelihood of default. If the borrower's leverage rises and PD moves to 5%, expected loss becomes ₦6.25m at 25% LGD, showing why rating migration matters even with good security.
Traps
Using the facility amount instead of EAD when commitments are undrawn; double-counting collateral; treating a guarantee as a transfer of risk without assessing the guarantor; and letting a relationship override the scorecard. Also watch for stale ratings and for scorecard overrides that are undocumented.
Key points
- Expected loss = PD × LGD × EAD.
- Collateral affects recovery, not the borrower's default probability.
- Rate the guarantor before taking credit for the guarantee.
- Review ratings when new information arrives, not only annually.