Credit Risk ManagementCredit Risk Management

Chapters 11 & 12Chapters 11 & 12

Credit Risk ManagementCredit Risk Management

uniqueness of FIs as asset transformersuniqueness of FIs as asset transformers– What do we mean?What do we mean?– What type of risk do FIs incur due to this role?What type of risk do FIs incur due to this role?– What are important things FIs must do to deal What are important things FIs must do to deal

with/reduce these risks?with/reduce these risks? importance of sound banking system for importance of sound banking system for

economic healtheconomic health– JapanJapan– US credit problems in 1980s and 1990sUS credit problems in 1980s and 1990s

Credit AnalysisCredit Analysis

all analysis should be geared to one all analysis should be geared to one decisiondecision– Does FI grant the loan or not?Does FI grant the loan or not?– stated loan policystated loan policy– clear documentationclear documentation– criteria not discriminatorycriteria not discriminatory– minimum credit standardsminimum credit standards– standard application formsstandard application forms

Types of LoansTypes of Loans

Commercial and Industrial loansCommercial and Industrial loans– maturitiesmaturities– usesuses– amountsamounts

syndicated loanssyndicated loans

– secured or unsecuredsecured or unsecured– spot/loan commitmentspot/loan commitment– importance of commercial paperimportance of commercial paper

Types of LoansTypes of Loans

Real Estate loansReal Estate loans– mortgage loans and home equity loansmortgage loans and home equity loans– commercial vs. residential mortgage loanscommercial vs. residential mortgage loans– ARMsARMs

Consumer loansConsumer loans– i.e., personal or auto loansi.e., personal or auto loans– revolving loanrevolving loan– usury ceilingsusury ceilings

Real Estate LendingReal Estate Lending

large secondary market forces large secondary market forces standardization of applicationsstandardization of applications

major factors in accept/reject decisionmajor factors in accept/reject decision– applicant’s ability and willingness to repayapplicant’s ability and willingness to repay– value of borrower’s collateralvalue of borrower’s collateral

characteristics/standards used to assess characteristics/standards used to assess requirementsrequirements

Real Estate LendingReal Estate Lending

GDS (gross debt service) ratioGDS (gross debt service) ratio - gross debt - gross debt service ratio calculated as total accommodation service ratio calculated as total accommodation expenses (mortgage, lease, condominium, expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided management fees, real estate taxes, etc.) divided by gross incomeby gross income

TDS (total debt service) ratioTDS (total debt service) ratio - total debt ratio - total debt ratio calculated as total accommodation expenses plus calculated as total accommodation expenses plus all other debt service payments divided by gross all other debt service payments divided by gross incomeincome

Credit ScoringCredit Scoring

expresses applicant’s credit quality numerically – expresses applicant’s credit quality numerically – removes some subjectivityremoves some subjectivity

helps FI manager:helps FI manager:– numerically establish which factors are important in numerically establish which factors are important in

explaining default riskexplaining default risk– evaluate the relative importance of factorsevaluate the relative importance of factors– improve pricing of default riskimprove pricing of default risk– be better able to screen out bad loan applicantsbe better able to screen out bad loan applicants– be in better position to calculate any reserves needed to be in better position to calculate any reserves needed to

meet expected future loan lossesmeet expected future loan losses

Credit AnalysisCredit Analysis

Consumer and Small Business lendingConsumer and Small Business lending Mid-Market Commercial and IndustrialMid-Market Commercial and Industrial

– firms with annual sales of about $5-$100 millionfirms with annual sales of about $5-$100 million– subjective and objective in evaluationsubjective and objective in evaluation

Credit Scoring ModelsCredit Scoring Models linear probability and logit modelslinear probability and logit models

– use past data as inputs into model to explain repayment experience use past data as inputs into model to explain repayment experience on old loanson old loans

– relative importance of factors in explaining past repayment is used relative importance of factors in explaining past repayment is used to forecast repayment probabilities of new loansto forecast repayment probabilities of new loans

Linear discriminant modelsLinear discriminant models– while above models project a value for expected probability of while above models project a value for expected probability of

default if a loan is made, discriminant models divide borrowers into default if a loan is made, discriminant models divide borrowers into high or low default risk classes contingent on observed high or low default risk classes contingent on observed characteristicscharacteristics

– Altman’s ZAltman’s Z Z = 1.2XZ = 1.2X11 + 1.4x + 1.4x22 + 3.3x + 3.3x33 + 0.6x + 0.6x4 4 + 1.0x+ 1.0x55

XX1 1 = working capital / total assets= working capital / total assets XX22 = RE / total assets = RE / total assets XX33 = EBIT / total assets = EBIT / total assets XX44 = MV equity / BV LT = MV equity / BV LT

debtdebt XX55 = sales / total assets = sales / total assets

The KMV ModelThe KMV Model

Banks can use the theory of option pricing to Banks can use the theory of option pricing to assess the credit risk of a corporate borrowerassess the credit risk of a corporate borrower

The probability of default is positively related The probability of default is positively related to:to:– the volatility of the firm’s stockthe volatility of the firm’s stock– the firm’s leveragethe firm’s leverage

A model developed by KMV corporation is A model developed by KMV corporation is being widely used by banks for this purposebeing widely used by banks for this purpose

Banks can use the theory of option pricing to Banks can use the theory of option pricing to assess the credit risk of a corporate borrowerassess the credit risk of a corporate borrower

The probability of default is positively related The probability of default is positively related to:to:– the volatility of the firm’s stockthe volatility of the firm’s stock– the firm’s leveragethe firm’s leverage

A model developed by KMV corporation is A model developed by KMV corporation is being widely used by banks for this purposebeing widely used by banks for this purpose

Return on LoanReturn on Loan methods to calculatemethods to calculate

– ROA (return on assets)ROA (return on assets)– RAROC (risk-adjusted return on capital)RAROC (risk-adjusted return on capital)

factors that affect FI’s return on loan:factors that affect FI’s return on loan:– The base lending rate on the loan (L)The base lending rate on the loan (L)– The credit risk premium (m)The credit risk premium (m)– Fees earned as a result of the loan (e.g. origination fee and credit Fees earned as a result of the loan (e.g. origination fee and credit

line fees)line fees)– Whether the borrower repays in full on timeWhether the borrower repays in full on time– The value of collateral and ease and cost of collections if the The value of collateral and ease and cost of collections if the

borrower defaultsborrower defaults– The nonprice terms and conditions on the loan (other than fees):The nonprice terms and conditions on the loan (other than fees):

Origination feeOrigination fee (f) (f) Compensating balancesCompensating balances (b) (b) Reserve requirementsReserve requirements (R) (R)

ROAROA

ROA per dollar lent by FI isROA per dollar lent by FI is

ROA per $ lent is going to be greater than simple ROA per $ lent is going to be greater than simple promised interest return on loan if b>0 because FI promised interest return on loan if b>0 because FI gets to keep compensating balancegets to keep compensating balance

)]R1(b[1

)mL(f1k1

Example 1Example 1

A bank has a base lending rate of 8% (L), A bank has a base lending rate of 8% (L), and charges a certain customer a 110 basis and charges a certain customer a 110 basis point risk premium (m). The bank also point risk premium (m). The bank also charges a 1% origination fee (f). The bank charges a 1% origination fee (f). The bank requires the borrower to maintain requires the borrower to maintain compensating balances of 7% of the loan compensating balances of 7% of the loan amount. The reserve requirement is 10% amount. The reserve requirement is 10% and the loan amount is $1 million. and the loan amount is $1 million.

Example 2Example 2

A corporate customer obtains a $1 million line of credit A corporate customer obtains a $1 million line of credit from a bank. The customer agrees to pay a 9% interest from a bank. The customer agrees to pay a 9% interest rate and agrees to make compensating balances of 6% of rate and agrees to make compensating balances of 6% of the total credit line and 3% of the amount actually the total credit line and 3% of the amount actually borrowed. These will be held in non-interest bearing borrowed. These will be held in non-interest bearing transactions deposits at the bank for one year. The bank transactions deposits at the bank for one year. The bank charges a 1% loan origination fee on the amount borrowed charges a 1% loan origination fee on the amount borrowed and a 0.25% commitment fee on the unused line of credit. and a 0.25% commitment fee on the unused line of credit. The expected draw down (loan amount) is 60% of the line The expected draw down (loan amount) is 60% of the line for one year. Reserve requirements are 10%. What is the for one year. Reserve requirements are 10%. What is the expected rate of return to the bank?expected rate of return to the bank?

Example 3Example 3

The credit risk premium (m) can be set based on historical The credit risk premium (m) can be set based on historical default rates on loans of this category and rates of return default rates on loans of this category and rates of return on defaulted loans. For instance in order to earn the base on defaulted loans. For instance in order to earn the base loan rate of say 9% if the default history of a given loan loan rate of say 9% if the default history of a given loan category is as follows:category is as follows:

% of loans% of loans Default experience Default experience RoR on category RoR on category 98%98% No defaultNo default 9% + m 9% + m 1.5%1.5% Limited defaultLimited default 0% 0%[1][1] 0.5%0.5% Total writeoffTotal writeoff -100%-100%

[1][1] The percent of loans and the rates of return The percent of loans and the rates of return numbers should both be net of recoveriesnumbers should both be net of recoveries

RAROCRAROC

The risk adjusted return on capital (RAROC) The risk adjusted return on capital (RAROC) originated by Banker’s Trust is now widely originated by Banker’s Trust is now widely used instead of the ROA method of loan used instead of the ROA method of loan pricing presented above. pricing presented above.

riskatCapital

loantheonincomepretaxnetryeaOneRAROC

Example 4Example 4 Continuing with Example 1 from above and adding the additional Continuing with Example 1 from above and adding the additional

necessary information will illustrate how to calculate the RAROC:necessary information will illustrate how to calculate the RAROC: The loan had income of $101,000. Suppose the dollar cost rate The loan had income of $101,000. Suppose the dollar cost rate

(including interest and noninterest costs) of providing the loan is (including interest and noninterest costs) of providing the loan is 10.3%. The net loan amount was $937,000 so the dollar cost is thus 10.3%. The net loan amount was $937,000 so the dollar cost is thus $96,511 (=$937,000 $96,511 (=$937,000 0.103). 0.103).

Suppose that typical default rates may be 0.3% in a given year. Suppose that typical default rates may be 0.3% in a given year. However, according to historical default rates, the 99th percentile, or However, according to historical default rates, the 99th percentile, or the extreme loss rate, for this loan category is 3%.the extreme loss rate, for this loan category is 3%.[1][1] This means that This means that the bank believes that in the worst case scenario (which in this case the bank believes that in the worst case scenario (which in this case should happen only once every hundred years), 3% of the loans will should happen only once every hundred years), 3% of the loans will default instead of the typical 0.3%. default instead of the typical 0.3%.

Suppose further that based on historical data the bank can expect to Suppose further that based on historical data the bank can expect to eventually recover 25% of the loans that default. eventually recover 25% of the loans that default.

Loan Portfolio RiskLoan Portfolio Risk

credit scoring and RAROC and other credit scoring and RAROC and other methods helped FI analyze risk of individual methods helped FI analyze risk of individual loanloan

also need to measure credit risk to entire also need to measure credit risk to entire loan portfolioloan portfolio

simple models of loan concentration risksimple models of loan concentration risk– migration analysismigration analysis– concentration limitsconcentration limits

Concentration LimitsConcentration Limits

external limits set on the maximum loan size external limits set on the maximum loan size that can be made to an individual borrowerthat can be made to an individual borrower

set limits by assessing the borrower’s set limits by assessing the borrower’s current portfolio, its operating unit’s current portfolio, its operating unit’s business plans, its economists’ economic business plans, its economists’ economic projections, and its strategic plansprojections, and its strategic plans

Example 5Example 5

Suppose management is unwilling to permit losses Suppose management is unwilling to permit losses exceeding 10% of an FI’s capital to a particular exceeding 10% of an FI’s capital to a particular sector. If management estimates that the amount sector. If management estimates that the amount lost per dollar of defaulted loans in this sector is 40 lost per dollar of defaulted loans in this sector is 40 cents, the maximum loans to a single sector as a cents, the maximum loans to a single sector as a percent of capital, defined as the concentration percent of capital, defined as the concentration limit, islimit, is

CL = maximum loss as % of capital * (1/loss rate)CL = maximum loss as % of capital * (1/loss rate)= 10% * (1/0.4)= 10% * (1/0.4)= 25%= 25%