LO 33.3: Discuss the “dark side” o f retail credit risk and the measures that attempt

LO 33.3: Discuss the dark side o f retail credit risk and the measures that attempt to address the problem.
An unexpected, systematic risk factor may cause losses to rise beyond an estimated threshold, damaging a banks retail portfolio through declines in asset and collateral values and increases in the default rate. This represents the dark side of retail credit risk.
Primary causes include:
The lack of historical loss data due to the relative newness of specific products. An across the board increase in risk factors impacting the economy overall that causes
retail credit products to behave unexpectedly.
An evolving social and legal system which may inadvertently encourage defaults. An operational flaw in the credit process due to its semi-automated structure that results
in credit granted to higher risk individuals.
2018 Kaplan, Inc.
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Topic 33 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 9
The Consumer Financial Protection Act (CFPA), in an attempt to manage the dark side of retail credit risk, requires credit originators to evaluate qualified mortgages and ability to repay.
A borrower with a qualified mortgage is assumed to have the capacity to repay. A qualified mortgage will put a limit on the amount of income allocated to debt repayments (e.g., debt- to-income ratio < 43%). A qualified mortgage cannot have excess upfront fees and points, may not be balloon payment loans or interest-only loans, may not be for longer than 30 years, and may not be negative amortization loans. When a lender is evaluating a customers ability to repay, the following underwriting standards must be considered: Credit history. Current income and assets. Current employment status. Mortgage monthly payments. Monthly payments on mortgage-related items such as insurance and property taxes. Monthly payments on other associated property loans. Additional debt obligations of the borrower. The monthly debt-to-income ratio resulting from the mortgage. Due to the predictable and relative safety of retail credit, banks must set aside a relatively small amount of risk capital compared to requirements associated with corporate loans. Banks must provide regulators with specific statistics associated with differentiated segments of their portfolios. These statistics include: probability of default (PD), exposure at default (EAD), and loss given default (LGD). C r e d i t R i s k S c o r i n g M o d e l s