Lecture 7: Loan Portfolio and Credit Risk Management Flashcards
What are the 4 learning objectives of this lecture?
Types of Loans
Return on a loan
Credit Risk Analysis
- Qualitative
- Quantitative
Structuring loan portfolio to minimise risk
What is the key function of an FI that involves providing credit?
Asset Transformation- taking in deposits from households and transforming them into claims/loans issued to corporations
What is Credit Risk?
possibility of a loss resulting from a borrower’s failure to repay a loan.
I.e. refers to the risk that a lender may not receive the owed principal and interest
Why is measurement of Credit risk crucial?
enable FI to price a loan correctly and set appropriate limits on the amount of credit to extend
Default of ____ major borrower can have ______ impact on
the value and _____ of the FI.
one
significant
reputation
Which financial event in history emphasises the importance of managing credit risk?
GFC 2007-2009
What are non performing loans?
Differ in jurisdiction.
Mainly mean loans that are 90+ day past due from borrower
What are the 2 types of business loans?
Secured- Has collateral
Unsecured- loan given to borrower with NO collateral being put up in case of default
What is a syndicated loan?
Bank selling part of loan away to other banks.
- Results in Sharing out risk
What is a spot loan?
Spot- Loans made at current point in time i.e. made today.
Contingent asset (off balance sheet item) until the bond is exercised.
What is a loan commitment?
Loan in future
What is commercial paper?
St loan to cover some operating cost while long term loans come in.
- liquid market
What are Real Estate (RE) Loans?
Mostly types of mortgages
What are the 2 types RE (mortgage loans)?
Fixed rate mortgages
Adjustable rate mortgages (ARM) ie variable rate
When can mortgages be subject to default risk?
When loan to value increases
What is the core business of banking?
Profitable management of risk
What factors are needed to achieve the core business of banking?
Credit analysis and lending function
Managing credit risk requires a clean ______ in order to set management’s priorities with respect to the ____ _____
philosophy
market place
What are the 4 factors that affect the type of credit philosophy taken on?
Highest quality loan portfolio
Conservative underwriting standards
Aggressive loan growth
Flexible underwriting standards
What are the 2 factors considered when pricing a loan?
Credit risk A certain level of defaults is expected
Loan default is a cost to the loan portfolio performance
What are the 5 factors that affect the promised loan return?
Loan interest rate
Fees
Credit risk premium
Collateral
Non price terms such as compensating balances
What is the effect of collateral on the return of a loan?
- Backing up loan if case default happens.
- Having collateral either lowers returns or removes the incentive for charging higher interest rates when there is NO collateral
What is Loan rate and the formula?
- Rate in which Bank charges customer
base lending rate (BR) + credit risk premium or margin
How can an FI compensate for higher credit risk in relation to their promised return on a loan?
by implicit and indirect method such as: Direct and indirect fees and charges: – Loan origination fee (f) – Compensating balance requirements (b) – Reserve requirement (RR)
• Gross return on loan (k) per dollar lent:
What does compensating balance mean?
Set aside a separate account and put money in it. i.e. Borrowed $100 but $10 of $100 should be in compensating account with no interest
What is an expected return on a loan?
amount of profit or loss an investor can anticipate receiving on an investment/loan.
calculated by multiplying potential outcomes by the odds of them occurring and then totaling these results.
What is the formula for The expected return on a loan?
E(r) = p( 1 +k)
Why might expected return differ from a promised return?
Default risk
Note: If there is 100% probability of repayment then there is NO default
When p = probability of loan repayment. What happens when p =1?
if p = 1, then E[R} = promised return
What happens when p < 1?
Default risk exists
FI needs to set risk premium sufficiently high to compensate
for this risk
However, higher risk premiums and higher fees and charges
might decrease p
Why is k and p not independent?
as charges may DECREASE p.
Up to a certain point where you ask for a higher credit risk premium (neg related over some range) you put force the customer in a worse situation.
Regarding Credit Risk Analysis, what is Credit Selection?
process of assessing the risk of lending to a business or an individual
What are the 4 basic credit factors, when determining whether to give credit?
1. Borrower’s character and soundness 2. Intended use of loan funds - why borrow? 3. Primary source of loan repayment - i.e. how are you able to service the loan like your primary source of income taking in consideration years of employment 4. Secondary sources of repayment
What are the 2 dimensions for credit selection risk?
Qualitative
Quantitative
For qualitative models; what are the qualitative factors considered when giving credit?
Borrower
specific factors are considered as well as market or
systematic factors.
•Specific factors include
-Reputation
–Leverage (capital structure)
–Volatility of earnings
–Collateral
Market specific factors include
–Business cycle
–Level of interest rates
•Use of covenants to encourage certain borrower behaviour
What does each of the borrower specific factors mean?
•Reputation: Based on the borrowing lending history of the borrower better reputation implies lower risk premium
•Leverage: measure of the existing debt of the borrower the
larger the debt, the higher the risk premium
- Volatility of earnings: The more stable the earnings, the lower the risk premium
- Collateral: If collateral is offered, the risk premium is lower
What does each of the market specific factors mean?
- Business cycle: Lenders are less likely to lend if a recession is forecasted
- Level of interest rates: A higher level of interest rates may lead to higher default rates, so lenders are more reluctant to lend under such conditions
What is a Loan Covenant?
Terms and Conditions in loan contract.
If 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)
Why do FIs also employ loan covenants?
to monitor and control their credit risk
What are 2 types of FI covenants?
Positive and Negative covenants
What are positive covenants?
sets borrower’s obligation to carry out certain activities
What are 3 examples of positive covenants obligations?
- Provide financial statements
- Repay loan
- Take out insurance
What are negative covenants?
restrict certain types of actions by the borrower: T hey are ‘thou shall not conditions
What are 2 examples of negative covenants obligations?
1.No other borrowings:
cant take another borrowings elsewhere without permission. Because risk won’t be able to repay the initial loan
2.Limit dividend payments (such as disallowing increase of dividend payments without permission of lender
What are the 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 - Control financial position of borrower
- Restricting actions to prevent unacceptable
financial ratios
What is the ultimate purpose of a loan covenant?
protect lender from default by borrower
What is credit scoring model?
Quantitative model that use observed borrower
characteristics to
- Calculate score as a proxy of borrower’s default probability,
or
–Sort borrowers into different default classes
How can scoring model help?
–Establish factors that help to explain default risk
–Evaluate the relative importance of these factors
–Improve the pricing of default risk
–Sort out bad loan applicants
–Rank or classify loans by expected default risk
What are the 3 major types of credit scoring models?
–Linear probability model:
– Logit model
– Linear discriminant models (main focus)
What is a Linear Probability model?
Uses past data, such as financial ratios, as inputs into a model to explain repayment experience on old loans.
to forecast repayment probabilities of new loans.
What is the linear discriminant model?
Divides borrowers into high/low default groups based on their observed attributes (i.e. ratios etc)
What is Altman’s Z-Score Model for manufacturing firms?
Multiple regression model
According to Altman’s cred scoring model what does a score of < 1.81, above 2.99 and between 1.81 and 2.99 mean?
score of less than 1.81 would place the potential borrower into a high default risk category
score above 2.99 is regarded as a low default risk
score between 1.81 and 2.99 is in the ‘zone of ignorance’ where a borrower may or may not default
What are the 5 weaknesses of the Linear discriminant model?
–Broad distinction between borrower categories, that is, good and bad borrowers
–Weights in any credit scoring model unlikely to be constant over longer periods of time
–Variables in any credit scoring model unlikely to be constant over longer periods of time
–Models ignore hard to quantify factors such as borrower reputation
–There is no centralised database on defaulted business loans for proprietary or other reasons
What do newer models for assessing default risk consist of?
more rigorous quantitative models make use of both
financial theory and financial data
i.e. RAROC Model (risk-adjusted return on capital)
What is the RAROC model?
this model balances expected interest
and fee income against the loan’s expected risk.
Instead of of evaluating the actual or contractually
promised annual ROA on a loan ie net interest and fees
divided by amount lent).
What does the RORAC model use to measure loan risk/credit risk?
Duration and credit risk premium
Note: duration = how sensitive assets and liabilities are to interest rate movements
What are the 3 methods for FI to structure loan portfolio to minimise risk?
–Diversification
–Transferring risk & Moving to off balance sheet
–Insurance
What does diversification mean?
Not to put all eggs in one basket
How can you diversify?
–Different industries
–Various sizes
–Various geographic locations
•Different countries to avoid country specific risk
Note: not all risks are related directly to the project itself i.e. political, economic risk
How can you diversify?
–Different industries
–Various sizes
–Various geographic locations
•Different countries to avoid country specific risk
What are the 3 risks that are NOT related directly to the project itself?
Political
Economic/Financial
Natural
What is an example of political change:
- Tax change/ nationalisation of company
