P2.5 WHAT WE DISCUSS IN THIS PART
The following list briefly describes the individual topics of this part and explains why they apply to banking, but may also be—or become—relevant for P2P lending in the future.
Chapter 5 (Financial Contracts) introduces the different types of financial contracts, the central element that defines the DNA of financial analysis.
It provides a detailed description of all contract elements that we need to consider in mapping and analyzing financial contract events. It first focuses on the usability and challenges of time and its evolution, on both actual and simulated dimensions, which play a vital role during the lifetime of financial contracts. It then describes the mechanism of the contracts by identifying and describing all combinations of possible pattern events, executed in parallel within fixed or variable time cycles, constructing all financial events.Chapter 6 (Market) covers the first input element of financial analysis defined as markets. Market risk factors, such as interest rates, are the input information linked to many rules defined in the financial contract. The chapter explains the reasoning of risk-neutrality, reflecting the arbitrage, risk, free assumption in valuing and pricing financial instruments. It describes the usability of yield curves and forward rates and prices aligned with risk-neutral expectations. It then moves to economic scenarios based on real world probabilities, by applying what-if, historical and stochastic scenarios. It then explains how spreads, such as credit and liquidity spreads, apply in extending the rates beyond market risk-free and thus discount the cash flows based on the real-worlds risk probabilities. Finally, it highlights the market risk elements in P2P finance.
Chapter 7 (Counterparties) refers to the counterparty, which is the second element of financial analysis. It describes the different possible roles which counterparties could play in financial contractual agreement.
We then highlight the usability of the information referring to counterparty-descriptive characteristics. Moreover, the chapter identifies the distinction and usability of the two-credit status, default and non-default. It also describes the approximation of default probability based on credit spreads and expected recoveries. It also explains the usability for extending the default probabilities by applying credit ratings through different time horizons. It then discusses the differences of real world and risk-neutral default probabilities where the latter is the basis for applying credit spreads. It finally focuses on analyzing the links of counterparties via markets by considering the allocation of the obligors to their own specific risks and to specific or several markets, or by allocating several obligors to a single or several correlated markets.Chapter 8 (Behaviour) is about behaviour, the third input element of financial analysis. It therefore explains the identification and modelling of withdraws, prepayments, remaining principal and sales, all fallen to market driven types of behavior. It then goes on to identify the defaults and downgrading probabilities as well as their migrations through time, driven by behavior characteristics. It also explains the behavior of using credit facilities, lines, and the extent of them for avoiding default. It finally explains the elements of identifying the expected behavior of recoveries.
Chapter 9 (Credit Exposure) covers the topic of financial credit exposure. The chapter goes through the identification and measurements of gross and net exposures, their distribution and evolution through time driven by the evolution of market conditions, counterparty credit status, market and credit behavior, valuation principles, and strategies and types of contracts. It then explains how credit losses are estimated under both default and non-default statuses. We finally explain how counterparties are linked via their credit exposures.
Chapter 10 (Credit Enhancements) refers to credit enhancements and explains their different types and structures. It thus provides an extended description of asset-based credit enhancements including financial and physical collaterals, intangible assets and close-out netting agreements. It then describes the counterparty-based credit enhancements, including guarantees and credit derivatives. The chapter also outlines the cases of allocating collaterals and guarantees to credit exposures as well as the challenges for valuing and adjusting assetbased credit enhancements. It then extends to the additional special elements considered in credit enhancements including the cases of double default, wrong way risk, maturity mismatch, payment times, and the dependencies of contracts and counterparties via credit enhancements. We finally discuss and propose approaches for employing alternative types of credit enhancements in P2P lending, such as by using real estate titles, phone contracts, loyalty points, and other stores of value, as well as life insurance and guarantor systems.
Chapter 11 (Systemic and Concentration Risks) covers the topic of systemic and concentration risks. The first part is about the identification and measurement of systemic risk, which depends on both credit exposure and counterparty analysis. The chapter explains in detail the development of chain reactions after both default and credit downgrading events. It then defines the results of systemic risk in regards to expected losses. The second part refers to concentration risk based on credit exposure and counterparty analysis. It shows how a single event, or a group of similar events, could result in large losses.
Chapter 12 (Liquidity, Value, Income, Risk & New Production) refers to liquidity, value, income, and risk as the main analysis output elements, and it also covers the topic of new production. The chapter starts with the topic of liquidity and describes its role in the performance of financial contracts.
It then analyzes the time factor in liquidity and covers in detail the two important parts of liquidity analysis named market and funding liquidity risks. Moreover, the chapter describes the different methods for measuring and reporting liquidity and its risks resulted by considering the integration of market, credit and behavior risk factors, as well as by combining market and funding liquidity analysis. The chapter continues by covering the topic of value and income elements. It explains the main principles for estimating value and income, their projection to profit and loss analysis and the role of valuation principles. We then explain how to measure the risks on value and income based on deterministic, dynamic, and integrated stress testing, as well as a stochastic process. Furthermore, the chapter defines the measurement of economic capital based on risk measurements, their allocation and how its combination with financial performance is the basis of risk adjustment. It finally provides some key points in applying risk management. We also describe the main elements considered on the design of new production of new or reconstructed financial portfolios, including the considerations of time, dynamics of future markets, counterparties and behavior, definition of strategies of going concern and/or rolling over, targeted volumes, type of new contracts and counterparties and analyzing the output financial elements. Finally, the chapter covers the topic of treasury and funds transfer pricing, and it explains the role of the treasury in financial institutions as well as why and how employing funds transfer pricing. We then discuss the possible role of the treasury in online lending.NOTES
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5. U.S. Department of Commerce, “The Financial Services Industry in the United States” (2014a), http://selectusa.commerce.gov/industry- snapshots/financial- services-industry-united-states
6. Devasabai, Kris (2014) “Hedge funds, securitisation and leverage change P2P game,” Risk.net 12 October 2014, www.risk.net/risk-magazine/feature/2372612/hedge-funds-securitisation-and- leverage-change-p2p-game.