Credit Risk Management and Recovery
Credit risk management identifies, measures, monitors and controls the risk that a borrower fails to meet obligations. Candidates must understand risk identification, risk appetite and limits, portfolio diversification, and the distinction between expected loss and unexpected loss. Know the components of expected loss: probability of default (PD), exposure at default (EAD) and loss given default (LGD), where expected loss = PD x EAD x LGD. Understand credit scoring, rating models, early-warning signals, watch lists, and provisioning.
Recovery covers the process when default occurs: early contact, restructuring or rescheduling, legal action, enforcement of security, and write-off. Understand the recovery rate, the cost of recovery, and the importance of documentation and security in maximising recovery. Know the role of a collections function, escalation triggers, and the difference between rescheduling (extending tenor) and restructuring (changing terms materially).
Traps: confusing PD with LGD; treating expected loss as unexpected loss; assuming a restructure cures a default without assessing viability; and ignoring early-warning signals until legal action is the only option. Another trap is forgetting that recovery costs reduce net recovery.
Worked example: a portfolio has PD of 3%, EAD of 500 million and LGD of 40%. Expected loss = 0.03 x 500 x 0.40 = 6 million. If recovery costs average 10% of gross recoveries, net recovery is reduced accordingly, so LGD should be adjusted upward to reflect costs.