Chapter 10: Credit Risk: Individual Loans Flashcards
Why is credit risk analysis an important component of FI risk management?
Credit risk management is important for FI managers because it determines several features of a loan: interest rate, maturity, collateral and other covenants. Riskier projects require more analysis before loans are approved. If credit risk analysis is inadequate, default rates could be higher and push a bank into insolvency, especially if the markets are competitive and the margins are low.
What recent activities by FIs have made the task of credit risk assessment more difficult for both FI managers and regulators?
Credit risk management has become more complicated over time because of the increase in off-balance-sheet activities that create implicit contracts and obligations between prospective lenders and buyers. Credit risks of some off-balance-sheet products such as loan commitments, options, and interest rate swaps, are difficult to assess because the contingent payoffs are not deterministic, making the pricing of these products complicated.
Differentiate between a secured and an unsecured loan.
A secured loan is backed by some of the collateral that is pledged to the lender in the event of default. A lender has rights to the collateral, which can be liquidated to pay all or part of the loan.
Who bears most of the risk in a fixed-rate loan?
With a fixed-rate loan, the lender bears the risk of interest rate changes. If interest rates rise, the opportunity cost of lending is higher, while if interest rates fall the lender benefits.
Why would FI managers prefer to charge floating rates, especially for longer-maturity loans?
Since it is harder to predict longer-term rates, FIs prefer to charge floating rates for longer-term loans and pass the risks on to the borrower.
How does a spot loan differ from a loan commitment?
A spot loan involves the immediate drawdown of the loan amount by the borrower, while a loan commitment allows a borrower the option to draw down the loan any time during a fixed period at a predetermined rate.
What are the advantages and disadvantages of borrowing through a loan commitment?
This can be advantageous during periods of rising rates in that the borrower can borrow as needed at a predetermined rate. If the rates decline, the borrower can borrow from other sources. The disadvantage is the cost: an up-front fee is required in addition to a back-end fee for the unused portion of the commitment.
What are the primary characteristics of residential mortgage loans?
Residential mortgages contracts differ in size, the ratio of the loan amount to the value of the property, the maturity of the loan, the rate of interest of the loan, and whether the interest rate is fixed or adjustable. In addition, mortgage agreements differ in the amount of fees, commissions, and discounts that are paid by the borrower.
What are compensating balances?
A compensating balance is the portion of a loan that a borrower must keep on deposit with the credit-granting deposit-taking FI. Thus, the funds are not available for use by the borrower.
What are covenants in a loan agreement? What are the objectives of covenants?
Covenants are restrictions that are written into loan or bond contracts that affect the actions of the borrower.
How can these covenants be negative? Positive?
Negative covenants in effect restrict actions, that is, they are “thou shall not…” conditions. Positive covenants encourage actions such as the submission of quarterly financial statements. In effect both types of covenants are designed and implemented to assist the lending firm in the monitoring and control of credit risk.
What are the purposes of credit scoring models?
Credit scoring models are used to calculate the probability of default or to sort borrowers into different default risk classes. The primary benefit of credit scoring models is to improve the accuracy of predicting borrower’s performance without using additional resources. This benefit results in fewer defaults and chargeoffs to the FI.
Describe how a linear discriminant analysis model works.
Linear discriminant models divide borrowers into high or low default classes contingent on their observed characteristics. The overall measure of default risk classification (Z) depends on the values of various financial ratios and the weighted importance of these ratios based on the past or observed experience. These weights are derived from a discriminant analysis model.
What is meant by the phrase marginal default probability? How does this term differ from cumulative default probability?
Marginal default probability is the probability of default in a given year, whereas cumulative default probability is the probability of default across several years.
What is the mortality rate of a bond or loan? What are some of the problems with using a mortality rate approach to determine the probability of default of a given bond issue?
Mortality rates reflect the historic default risk experience of a bond or a loan. One major problem is that the approach looks backward rather than forward in determining probabilities of default. Further, the estimates are sensitive to the time period of the analysis, the number of bond issues, and the sizes of the issues.
