Credit Risk
What the exam tests
Credit risk tests borrower assessment, expected loss, collateral, covenants, concentration, and portfolio management. You should be able to calculate expected loss and explain how credit risk is priced and controlled.
Core rules and concepts
- Credit risk is loss because a counterparty fails to meet its obligations.
- The five Cs are character, capacity, capital, collateral, and conditions. Collateral affects loss given default, not the probability of default.
- Expected loss = PD × LGD × EAD. PD is probability of default, LGD is loss given default, and EAD is exposure at default.
- EAD includes drawn balances plus a credit conversion factor applied to undrawn commitments.
- Credit risk mitigation through collateral, guarantees, and netting reduces LGD or exposure, but legal enforceability matters.
- Concentration risk arises from large single obligors, sectors, or correlated exposures.
- SBP prudential regulations set classification, provisioning, and large-exposure rules for Pakistani banks.
Worked example
A borrower has drawn PKR 200 million and an undrawn committed line of PKR 100 million. The bank applies a 50% credit conversion factor to the undrawn amount, so EAD = 200 + (50% × 100) = PKR 250 million. PD is 1.5% and LGD is 40%. Expected loss = 0.015 × 0.40 × 250 million = PKR 1.5 million. The loan spread and capital allocation must cover expected loss plus the cost of unexpected loss; collateral would reduce LGD, not PD.
Traps that cost marks
Do not ignore undrawn commitments in EAD. Do not say collateral lowers PD. Do not confuse expected loss with unexpected loss. Do not annualise a multi-year PD incorrectly. Do not assume a guarantee is effective without legal enforceability. Do not treat a low PD as sufficient if concentration is high.