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Banking: T & P > Lecture 10: The Loan Portfolio & Commercial and Consumer Lending > Flashcards

Lecture 10: The Loan Portfolio & Commercial and Consumer Lending Flashcards

1
Q

Define Credit Selection

A

the process of assessing the risk

of lending to a business or an individual

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2
Q

Outline the dimensions of risk selection

A
  1. Qualitative

2. Quantitative

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3
Q

What are the 4 basic credit factors

A
  1. Borrower’s character and soundness
  2. Intended use of loan funds
  3. Primary source of loan repayment
  4. Secondary sources of repayment
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4
Q

Describe Qualitative Risk Assessment

A

• Gathering information on the borrower’s record of
financial responsibility,
• Determining the borrower’s true purpose for borrowing
funds
• Identifying the risks confronting the borrower’s business
under future industry and economic conditions
• Estimating the degree of commitment the borrower is
expected to have regarding repayment

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5
Q

Describe quantitative credit risk assessment

A

• Analysing historical financial data and the projections to
evaluate the borrower’s capacity for timely repayment
of the loan
• Establishing borrowers’ ability to survive possible
industry and economic reversals and capacity to repay
loan

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6
Q

What is the importance of assessing the borrowers character and soundness?

A

Check competence, true quality of the business or project,

credit background.

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7
Q

Identify and explain two ways of assessing a borrowers character/soundness?

A

• One way to assess borrower’s character / soundness is to
make use of the internal bank database if the borrower is
an existing customer; and customer interview.
• Alternative, external sources are available from the credit
ratings provided by an independent rating agency.

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8
Q

What are some factors used by rating companies?

A

•Coverage ratios (Ratios of company earnings to fixed costs)
– Low or falling coverage ratios signal possible cash flow difficulties
• Leverage ratios (Debt to equity ratio)
– Too high indicates excessive indebtness; unable to earn enough
to satisfy obligations to its bonds
• Liquidity ratios (Current ratio / quick ratio)
– Ability to pay bills coming due with its most liquid assets
• Profitability ratios (Return on Assets (eg))
– Indicators of overall financial health
• Cash flow to debt (Ratio of total cash flow to outstanding debt)

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9
Q

Briefly Describe the seven risk levels used in country risk rating?

A

A1 The political and economic situation is very good. A
quality business environment has a positive influence on
corporate payment behaviour. Corporate default
probability is very low on average.
A2 The political and economic situation is good. A basically
stable and efficient business environment nonetheless
leaves room for improvement. Corporate default
probability is low on average.
A3 Changes in generally good but somewhat volatile political
and economic environment can affect corporate payment
behaviour. A basically secure business environment can
nonetheless give rise to occasional difficulties for
companies. Corporate default probability is quite
acceptable on average.
A4 A somewhat shaky political and economic outlook and a
relatively volatile business environment can affect
corporate payment behaviour. Corporate default
probability is still acceptable on averageB Political and economic uncertainties and an occasionally
difficult business environment can affect corporate
payment behaviour. Corporate default probability is
appreciable.
C A very uncertain political and economic outlook and a
business environment with many troublesome
weaknesses can have a significant impact on corporate
payment behaviour. Corporate default probability is high.
D A high-risk political and economic situation and an often
very difficult business environment can have a very
significant impact on corporate payment behaviour.
Corporate default probability is very high.

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10
Q

Outline 3 reasons why rating agencies predictions may be considered unreliable ?

A

• Importance of timescales - Many ratings are downgraded just before a known problem
crystallises, i.e. purportedly predictive when looking at historical data,
but only after the entire market knew there was a problem, as well as
exacerbating the problem. Analysts find little evidence of agencies’
ratings being useful leading indicators.

•The practice of unsolicited ratings - Whereby the credit rating agencies rate an organisation ‘in the
public interest’ and then appear to improve the rating subsequent to
being paid by the organisation ‘to better understand the background

• Perceived conflicts of interest in the ownership of the agencies - Should be Government entities?

• Competence of agencies’ employees - The rating task is a multi-disciplinary one - looking at finances sure,
but also markets, consumers, politics, etc. The key skill is
assembling diverse types of data, information and knowledge into an
overall assessment.

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11
Q

Why is it important to understand the use of the loan funds when assessing credit worthiness?

A

Ensure that the purpose is lawful - Equator Principles: Westpac, ANZ, NAB & CBA adopting “Not to
fund projects that endanger communities or the environment”

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12
Q

What are primary sources of repayment?

A

cash flows generated from business operations.

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13
Q

What are secondary sources of repayment?

A

• Collateral – should cover loan amount, interest due, legal
costs etc.

• Guarantor

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14
Q

Identify three ways of structuring the loan portfolio to minimise credit risk?

A

– Diversifications
– Transferring risk & Moving to off-balance sheet
– Insurance

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15
Q

How would you best minimise credit risk by diversification?

A 
Diversification through
– Different industries
– Various sizes
– Various geographic locations
• Different countries to avoid country specific risk
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16
Q

Describe why diversification is important by referring to the risk associated with different political, economic and natural environments?

A 
• Political
– War, civil war, sabotage, disruption etc
– Nationalization of company
– Change of government
– Tax changes
– Changes in local laws
• Economic/Financial
– Insolvency of Coy
– Exchange rate fluctuation/devaluation
– Inflation
• Natural
– Disease, earthquake, flood and other natural
disasters
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17
Q

Describe Securitisation

A

FIs pool similar loans and sell them in the secondary

markets to investors

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18
Q

What are the 4 common assets that are securitized?

A 
– Mortgages
– Credit card
receivables
– Commercial loans
(US)
– Student loans
(UK)
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19
Q

Define and describe the CMA and their key influence as collateral managers?

A

1 - is a tripartite
arrangement between the banker, the borrower and the collateral
manage

2 -– Impose controls on-the-ground discipline as the
commodity moves through the supply chain
– Provide insurance

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20
Q

What are some of the specific credit event that banks attempt to insure against?

A 
– Bankruptcy
– Insolvency
– Receivership
– Some other failure to meet repayment
obligations
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21
Q

What are some examples of insurance to US investors in emerging markets and developing countries made by the Overseas Private Investment Corporation?

A

– Currency inconvertibility- the inability to convert profits, debt
service and other investment remittances from local currency
into U.S. dollars or the inability to transfer funds;

– Expropriation – loss of an investment due to expropriation,
nationalization, or confiscation by a foreign government; &

– Political violence – loss of assets or income due to war,
revolution, insurrection, or civil strife. Coverage is available
for new investments, privatizations, and investments to
expand or modernize existing operations. Equity, debt, loan
guarantees, leases and most other forms of long-term
investment can be insured. Special programs or contracts are
also available for contractors, exporters, oil and gas projects
and small businesses.

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22
Q

What are three types of loans?

A
  • Commercial and industrial loans
  • Housing loans
  • Individual (consumer) loans
  • Other loans (e.g. govt loans, margin loans, leases).
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23
Q

Define Loan Covenants

A

Activities which must be adhered to or not
done, if the loan is granted
– A condition that the borrower must comply in order to adhere to the terms
in the loan agreement. If the borrower does not act in accordance with the
covenants, the loan can be considered in default and the lender has the
right to demand payment (usually in full).

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24
Q

Describe Affirmative Covenant ?

A

– Affirmative covenants set out borrower’s obligation to carry
out activities for reporting on company activities
• Provide financial statements;
• Repay loan;
• Take out insurance etc

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25
Q

Describe Negative Covenants?

A

Negative covenants require reasonable financial health to
prohibitions on activities
• No other borrowings
• Limit dividend payments

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26
Q

Define and describe the 3 objectives of covenants?

A

• 3 Objectives of covenants
– Cash flow control
• Cash flow available to service the interest &
principal.
– Trigger call / restructuring of loan
• Give rights to lender to call the entire loan if certain
min. ratios not met
– Statement of financial position control
• Restricting actions to prevent unacceptable ratios.

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27
Q

Define default risk?

A

Credit (Default) risk is the risk that borrowers of
FIs are not able or willing to pay the promised amount
due on their loans.

28
Q

What are the five factors that can affect return on a loan?

A
  1. Interest rate on the loan;
  2. Any fees relating to the loan;
  3. Credit risk premium on the loan;
  4. Collateral backing of the loan;
  5. Other non-price items
29
Q

Outline the quantitative models used to group borrowers into various risk classes?

A
  1. Linear probability model
  2. Logit model
  3. Probit model
  4. Linear discriminant model
30
Q

3 of the quantitative models use a form of probability estimation write down the general equation forming the base of these models?

A

z cons t x error i j ij   

tan 

31
Q

Describe the Linear Discriminant model

A

– Divides borrowers into high/low default risk groups based on
their observed attributes
– Altman (1968) built a linear discriminant model based only on
financial ratios, matched sample (by year, industry, size)

32
Q

Write the general equation for the linear discriminant model , define each of the terms and how z scores are categorised?

A

Z = 1.2 X1 + 1.4 X2 + 3.3 X3 +0.6 X4 + 1.0 X5

• X1 = working capital / total assets
• X2 = retained earnings / total assets
• X3 = earning before interest and taxes / total assets
• X4 = market value of equity / book value of long term
debt (or total liabilities)*
• X5 = sales / total asset

– Low Z-score => high Default risk (cutoff = 1.81)
• Lower than 1.81 – high probability of bankruptcy
• Above 3.00 – low probability of bankruptcy

33
Q

Credit Selection is?

A

the process of assessing the risk of lending to a business or an individual.

34
Q

Selection risk has 2 dimensions;

A
  1. Qualitative

2. Quantitative

35
Q

In credit selection there are 4 basic credit factors of:-

A
  1. Borrower’s character and soundness
  2. Intended use of loan funds
  3. Primary source of loan repayment
  4. Secondary sources of repayment
36
Q

Qualitative Credit Risk Assessment what is the process?

A

• Gathering information on the borrower’s record of
financial responsibility,
• Determining the borrower’s true purpose for borrowing
funds
• Identifying the risks confronting the borrower’s business
under future industry and economic conditions
• Estimating the degree of commitment the borrower is
expected to have regarding repayment
• Analysing historical financial data and the projections to
evaluate the borrower’s capacity for timely repayment
of the loan
• Establishing borrowers’ ability to survive possible
industry and economic reversals and capacity to repay
loan

37
Q

Assessing Credit Worthiness - Borrower’s character and soundness what is this checking for?

A

Check competence, true quality of the business or project,

credit background.

38
Q

Credit Worthiness -Borrower’s character and soundness: what are the 2 ways to assess this?

A

• One way to assess borrower’s character / soundness is to make use of the internal bank database if the borrower is an existing customer; and customer interview.
• Alternative, external sources are available from the credit
ratings provided by an independent rating agency.

39
Q

Rating companies:

A

– Moody’s Investor Service*

– Standard & Poor’s*

40
Q

In-between what ratings is investment grade? and below what rating is non-investment grade?

A

AAA => BBB (investment grade)

BB =>D (non-investment grade)

41
Q

From 1 January 2010, credit rating agencies will be required to hold an Australian Financial
Services (AFS) licence. Under the AFS licensing regime, general licensee obligations set
out in the Corporations Act will require credit rating agencies to:

A

– manage conflicts of interest that may arise in their businesses;
– have resources available (including financial, human and information technology
resources) that are adequate for the nature, scale and complexity of their
businesses;
– ensure their credit analysts are trained and competent to be involved in the
preparation of credit ratings;
– ensure credit rating services are provided efficiently, honestly and fairly; and
– have in place risk management systems.

42
Q

Factors used by rating companies; Includes some financial ratios such as :

A

•Coverage ratios (Ratios of company earnings to fixed costs)
– Low or falling coverage ratios signal possible cash flow difficulties
• Leverage ratios (Debt to equity ratio)
– Too high indicates excessive indebtness; unable to earn enough
to satisfy obligations to its bonds
• Liquidity ratios (Current ratio / quick ratio)
– Ability to pay bills coming due with its most liquid assets
• Profitability ratios (Return on Assets (eg))
– Indicators of overall financial health
• Cash flow to debt (Ratio of total cash flow to outstanding debt)

43
Q

There are also ratings of countries available to provide some idea of risk
when dealing with various governments?

A

The Coface Group

44
Q

Ratings for over 165 countries are based on threefold expertise
developed by Coface :

A

• macroeconomic expertise in assessing country risk based on a
battery of macroeconomic financial and political indicators
• expertise on business environment. The score is based on internal
and external sources.
• microeconomic expertise that draws on Coface databases covering
44 million companies worldwide and 50 years experience with
payment in trade flows it guarantees.
– Coface ranks country ratings on seven risk levels, A1, A2, A3, A4, B, C
and D, in the order of increasing risk

45
Q

Coface ranks country ratings on seven risk levels, A1, A2, A3, A4, B, C and D, in the order of increasing risk. What does rating A1-A4 indicate?

A

A1: The political and economic situation is very good. A quality business environment has a positive influence on corporate payment behaviour. Corporate default probability is very low on average.

A2:The political and economic situation is good. A basically stable and efficient business environment nonetheless leaves room for improvement. Corporate default probability is low on average.

A3: Changes in generally good but somewhat volatile political and economic environment can affect corporate payment behaviour. A basically secure business environment can nonetheless give rise to occasional difficulties for companies. Corporate default probability is quite acceptable on average.

A4:A somewhat shaky political and economic outlook and a relatively volatile business environment can affect corporate payment behaviour. Corporate default probability is still acceptable on average.

46
Q

Coface ranks country ratings on seven risk levels, A1, A2, A3, A4, B, C and D, in the order of increasing risk. What does rating B-D indicate?

A

B:Political and economic uncertainties and an occasionally difficult business environment can affect corporate payment behaviour. Corporate default probability is appreciable.

C: A very uncertain political and economic outlook and a business environment with many troublesome weaknesses can have a significant impact on corporate payment behaviour. Corporate default probability is high.

D: A high-risk political and economic situation and an often very difficult business environment can have a very
significant impact on corporate payment behaviour. Corporate default probability is very high.

47
Q

Criticism of ratings: Concerns have been expressed about what, and what company collapses caused this doubt?

A

Concerns have been expressed about the timeliness and predictive accuracy of ratings, given the high-profile collapses of Enron and WorldCom in the United States.
-Similar scenarios have arisen in Australia too: HIH insurance had an investment-grade rating only a few weeks before it became insolvent.

48
Q

Criticism of ratings: What is selective coverage and why is it a problem?

A

Financial analysts point to the fact that selective coverage (larger rating agencies do not provide consistent, universal coverage at the level of detail of, say, all German banks or all large Korean companies) means that ratings turn out to be of little use in detailed financial analysis.

49
Q

Criticism of ratings: Importance of timescales:

A

Many ratings are downgraded just before a known problem crystallises, i.e. purportedly predictive when looking at historical data, but only after the entire market knew there was a problem, as well as exacerbating the problem. Analysts find little evidence of agencies’ ratings being useful leading indicators.

50
Q

Criticism of ratings:The practice of unsolicited ratings:

A

Whereby the credit rating agencies rate an organisation ‘in the public interest’ and then appear to improve the rating subsequent to being paid by the organisation ‘to better understand the background’.

51
Q

Assessing Credit Worthiness - Use of Loan Funds;

Ensure that the purpose is lawful (Equator Principles) means?

A

Equator Principles: Westpac, ANZ, NAB & CBA adopting “Not to fund projects that endanger communities or the environment”
=good corporate social responsibility

52
Q

Determining the true need for and use of funds requires what skills and why is this information useful?

A

Determining the true need for and use of funds require good analytical skills in accounting and business finance.
• An understanding of the loan’s intended use helps the analyst to understand whether the loan request is reasonable and acceptable.

53
Q

Assessing Credit Worthiness – Source of Repayment (2)?

A

• Primary Source: cash flows generated from business operations
• Secondary Source:
• Collateral – should cover loan amount, interest due, legal costs etc.
–ADIs hope to avoid foreclosing on collateral because foreclosure
entails much time and expense.

•Guarantor: However, collection from a guarantor often requires expensive
litigation and can result in ill-will between the ADI, borrower and guarantor.

54
Q

Structuring the loan portfolio to minimise risk. Ways to minimise credit risk include (3 things):-

A

– Diversifications
– Transferring risk & Moving to off-balance sheet
– Insurance

55
Q

Diversification what is it? How to diversify?

A 
“Not to put all eggs in one basket”
Diversification through
– Different industries
– Various sizes
– Various geographic locations
• Different countries to avoid country specific risk

Reduce non-systemic risk. However, not all risks are related directly to the project itself. Risks can arise under a number of headings – political, economic and natural

56
Q

Potential risks that diversification cannot move investor away from:
• Political:
• Economic/Financial:
• Natural:

A 
• Political
– War, civil war, sabotage, disruption etc
– Nationalization of company
– Change of government
– Tax changes
– Changes in local laws

• Economic/Financial
– Insolvency of Coy
– Exchange rate fluctuation/devaluation
– Inflation

• Natural
– Disease, earthquake, flood and other natural disasters

57
Q

Common assets which are securitized:

A 
– Mortgages
– Credit card
receivables
– Commercial loans
(US)
– Student loans
(UK)
58
Q

Credit Default Insurance is:

A

• Banks can made periodic payment in return for a
contingent payment should some specific credit event
happen:
– Bankruptcy
– Insolvency
– Receivership
– Some other failure to meet repayment obligations

• All the risks are transferred for a price, but the Bank will still have to consider the counter party risk of their insurer.

59
Q

Some banks are introducing collateral management agreements, what are they?

A

You have collateral you can take from your borrowers- make sure you check on the collateral to ensure the collateral is well looked after.

60
Q

A Collateral Management Agreement (CMA) is agreement between what parties?

A

a tripartite arrangement between the banker, the borrower and the collateral manager

61
Q

Some of the key influence collateral managers have on the system include:

A

– Impose controls on-the-ground discipline as the
commodity moves through the supply chain
– Provide insurance

62
Q

What is the major problem with CMAs?

A

can be very costly to the banks

63
Q 
Other Insurance:
The Overseas Private Investment Corporation offers the following insurance to U.S. investments in emerging markets and developing countries:
– Currency inconvertibility: Define?
– Expropriation: Define?
– Political violence: Define?
A

– Currency inconvertibility- the inability to convert profits, debt
service and other investment remittances from local currency
into U.S. dollars or the inability to transfer funds;

– Expropriation – loss of an investment due to expropriation, nationalization, or confiscation by a foreign government;

– Political violence – loss of assets or income due to war,
revolution, insurrection, or civil strife. Coverage is available for new investments, privatizations, and investments to expand or modernize existing operations. Equity, debt, loan guarantees, leases and most other forms of long-term investment can be insured. Special programs or contracts are also available for contractors, exporters, oil and gas projects and small businesses.

64
Q

Types of Loans;

A

• Commercial and industrial loans
– Small business lending (large by volume, small by value)
– Corporate loans (typically large in value)
– On average, about 27% of total loans and advances

• Housing loans
– Substantial part of Australian banks’ total loans
– On average, nearly 64% of total loans and advances

  • Individual (consumer) loans
  • Other loans (e.g. govt loans, margin loans, leases). – Eg finance lease : non cancellable, lessor expects to recover entire cost of leased asset plus some profit(vs operating lease where lessee pay for use of the equipment with no risks and rewards associated with ownership)
65
Q

What are Loan Covenants –

A

Activities which must be adhered to or not done, if the loan is granted:

A condition that the borrower must comply in order to adhere to the terms in the loan agreement. If the borrower does not act in accordance with the covenants, the loan can be considered in default and the lender has the right to demand payment (usually in full).

66
Q

Loan Covenants: Affirmative versus negative covenants

A

Affirmative covenants set out borrower’s obligation to carry
out activities for reporting on company activities
• Provide financial statements;
• Repay loan;
• Take out insurance etc

Negative covenants require reasonable financial health to
prohibitions on activities
• No other borrowings
• Limit dividend payments

67
Q

Loan Covenants: 3 Objectives of covenants?

A
  1. Cash flow control:
    • Cash flow available to service the interest & principal.
  2. Trigger call / restructuring of loan:
    • Give rights to lender to call the entire loan if certain min. ratios not met
  3. Statement of financial position control:
    • Restricting actions to prevent unacceptable ratios

• Ultimately, is to protect lender from default by borrower.

Banking: T & P (7 decks)

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