Chapter 12 – Credit Risk from the Regulator’s Perspective

Chapter 13 – Problem Loan Management

LENDING DECISION

IntroductionThe sectors that were not specified for

lending assistance would have been subject to credit rationing

Lending institutions might have been subject to concentration risk

Given the directives of the regulator, banks might have approved marginal lending applications in the directed sectors

Prudential regulationCapital adequacyLarge exposures

Capital AdequacyHistory shows that financial institutions normally

fail as a result of poor credit decisionThe board and management control the banks and

decisions could be taken that are not in the interest of the depositors – this is known as moral hazard

Depositors need to be protected against poor decisions by management -> under the base of capital adequacy, financial institutions are required to put aside capital to each credit risk exposure, whether it is on or off the balance sheet

A minimum of 8% of capital need be put aside for risk-weighted assets

Capital AdequacyRisk-based capital ratio = Total capital (Tier

1 + Tier 2)Risk Adjusted Assets

Tier 1 capital exhibits permanence like capital

Tier 2 has the ability to absorb credit losses but is not permanentTier 2 capital cannot make up more than

50% of overall allowable capital

Capital Adequacy

Tier 1 Tier 2

Paid up ordinary sharesGeneral reservesRetained earningsNon-cumulative irredeemable preference sharesMinority interest in subsidiariesLess Goodwill

General provisions for doubtful debts (<= 1.5% of total risk assets)Asset revaluation reservesCumulative irredeemable preference sharesMandatory convertible notesPerpetual subordinated debtRedeemable preference shares and term subordinated debt (min original maturity of at least 7 years and amortization factor of 20% of original amount to apply each year during the last five years to maturity

Risk CategoriesCategory 1 (0% weight) – notes and coins,

balance with the FED, Government papers (<= 12 months of maturity)

Category 2 (10%) – claims on Federal and State Government (> 12 months to maturity)

Category 3 (20%) – claims on banksCategory 4 (50%) – loans fully secured by

mortgage against residential property used for rental or occupied housing (LVR <= 80%)

Category 5 (100%) – loan fully secured by mortgage against residential property used for rental or occupied housing (LVR > 80%); commercial companies

Large Credit ExposureExposure = potential for loss under a finance

facilityA large exposure – an exposure to an

individual or group of counterparties that exceeds 10% of the consolidated capital base.

Securitization – a good credit risk management tool in certain circumstancesClean sale – absolves the financial institution

from any legal recourse from the sale of loansResults in the financial institution not holding

capital against the loan

Clean Sale Supply of AssetsA clean sale

There should be no beneficial interest in the sold assets and absolutely no obligation to the financial institution

No recourse (including costs) to the lending institution; no obligation to repurchase the lending assets

The amount paid for the loans should be fixed and should be received by the time the assets are transferred from the lending institution.

Any assets that are provided to the SPV as a substitute or provided at below book value are not considered as relieving credit risk

Subjected to asymmetric information

Revolving FacilitiesA clean sale

The rights, details and obligations of each party must be clearly specified, including the distribution of cashflows

As with normal asset securitization, the financial institution share cannot supply additional assets to the pool

Liquidity shortfalls for the financial institutions share most not exceed the interest receivable

The financial institution always has the right to cancel any undrawn amounts on the revolving facilities

Like normal lending securitization, the financial institution must be under no obligation to repurchase assets that have defaulted

Credit DerivativesThe effectiveness of credit derivatives becomes an

issue of how well the instrument reduces the requirement of capital adequacy

A credit derivative is deemed to afford protection if the physical settlement has a deliverable obligation.

In terms of maturity, a financial institution is deemed to have full protection if the maturity of derivative equals the maturity of the underlying assetExample: a loan has a term of 5 years and the credit

derivative has a maturity of 4 years, only 80% of the exposure is counted for regulatory relieft

Development in RegulationCapital adequacy is the primary tool for the Australian

Prudential Regulation Authority to regulate credit risk issues

A new proposal would base the risk weighting on the credit rating of the company. This raises the issue of independence because ratings are assigned when paid for by debt issuers

Basel I – the role of credit ratings and the consideration that banks, with superior skills may be able to use internal systems to allocate capital (“sophisticated” banks)Advantages: internal ratings are becoming popular in the

assessment of a variety of risksInternal ratings will use more data than used by external ratingsGiven that internal ratings will be used for credit risk purposes,

there may be an incentive to improve credit risk methodsDisadvantage: there will be a lack of standardized approaches

for credit risk

Problem Loan ManagementOutline why loans defaultHighlight the extent of problem loansExplain why the business cycle is important

for problem loansDefine problem loans, provisions and

regulatory issuesDiscuss the capital issues of problem loansDefine “structure dynamic provisioning”Restructure problem loansIllustrate a case from law

Causes of DefaultThe primary issue of problem loans is that

they can impair the value of a financial institution -> threaten its solvency

A default – a loan for which the repayments are overdue for the following reasons

Lack of compliance with loan policiesLack of clear standards and excessively lax loan termsInadequate controls over loan officersOver-concentration of bank lendingLoan growths in excess of the bank’s ability to manageInadequate systems for identifying loan problemsInsufficient knowledge about customers’ financeLending outside the market which the bank is familiar

Many problem loans could be avoided by better lending procedures and policies

Causes of DefaultCredit risk is never static and many loans

that were validly granted can become bad for many different reasons Recession affects firms that rely on cashflowFirms wind up because their products have

become outdatedMonitoring a loan portfolio becomes more

complex as the financial institution becomes larger -> higher costs

Monitoring models should provide warnings of developing problem loans

The Extend of Problem LoansHow should bankers should manage their problem

loansWhat are the various types of problem loan? How do we

define themHow do lenders manage the impact of problem loans on

profitability? Can they anticipate problem loansIs there a pattern of when problem loans occur?Is a grading attached to the severity of the problem

loan and how its is managed?What are the legal implications for managing problem

loansLiquidation – selling the borrower’s assetsDynamic provisioning – statistical method that seeks

to forecast doubtful debts and spread them over a number of years

The Business CycleRecovery & Expansion

High confidence in the economy and new investments increase

-> increased spending -> higher bank deposits -> banks have more money to lend -> relaxation of lending standards

Interest rates increase slightlyBoom

High asset inflation -> higher borrowing to invest in real assets

Overconfidence -> declining credit standardsInterest rates are rising

DownturnAsset prices decline -> less spending -> decline cashflowBanks experience their greatest problem loans

Problem Loans, Provisions & Regulatory

Borrower miss a repayment on loan -> is this permanent or temporary

If the situation persists for longer than 90 days -> impaired asset or non-performing loan

When a lending institution recognizes a problem, it needs to raise provisionsSpecific provisions – written off incomeGeneral provisions – written off incomeBad-debt write-offs – written off balance sheet

A provision is recognition that income may not be received on a loan

ProvisionsSpecific provisions

Attached to loans or impaired assets Specific provision is less than full value of the

loan because banks expects that some of the debt if recoverable

General provisionsAre like specific provisions but they are not

charged against a particular loanThe APRA views that 0.5% of total risk-

weighted credit risk-weighted assets should be used as a benchmark for general provisioning

Bad debt write-offsA debt is no longer recoverable

Dynamic ProvisioningThe internal policy will reflect the risk appetite

of the lenderLenders need recognize

Credit risks change over timeBad debts should not come as a surprise

A number of principles for dynamic provisioningClassify the loans into homogenous groupsThe different types of loan should be further broken

down into groupings by maturityGenerates the probability of default for each loan class

and the likely severity of lossDetermines the historical loan loss ratiosHistorical loan loss ratios are then transformed to be

predicative by the adjustment for economic circumstances

The transformed loan loss ratio applied to the current loan portfolio to determine provisions

Dealing with DefaultsThe three situations

Mild financial distressModerate financial distressSevere financial distress

Two principles always appliedThe primary aim of the bank is to minimize

the loss to the bank. In many cases, liquidity is not the optimal choice

To manage these problems correctly, the economic worth of the loan is compared with the economic worth of the borrower

Mild Financial DistressCompanies experience temporary cashflow

shortagesNever enters the public arena and is not captured

by the regulator’s definitions (< 90 days)Most common cause of illiquid is overly rapid

growth of the firm A number of remedies can be used

The bank agrees to an extension on the repaymentThe bank would charge penalties to ensure there

are disincentives to prevent the situation arising again

Banks should take further views or actions to ensure that their position is protected

Moderate Financial DistressA temporary cashflow shortage is evident

but the economic worth of the company is less than the repayment schedule of the loan

Remedial actionsLiquidation – not always the optimal choiceRestructure the loan to give the owner the

incentive to continue. This restructure is determined by calculating the break-even amount of the loan under the circumstances that the company would continue

Severe Financial DistressMissed debt payment and the borrower

having an economic worth less than the repayment schedule

Issues to be consideredWhether the borrower has a sound businessIs the default due to reasons other than the

nature of the businessWill the company worth more death or aliveHow much can be recovered under each

scenario

Other BreachesNot all defaults are generated by missed loan

repaymentsAlso when loan covenants are violated

Cashflow will not be unduly withdrawn from the company that would be available to repay loans

The overall risk of the company cannot be substantially changedGearing ratiosDividend pay-out ratiosInterest coverage

What is the correct procedure to follow when a company breaches its covenants?Remedial actions: renegotiate covenants