Week 10: The loan portfolio and Comercial and Consumer Lending Flashcards
What is the core business of banking and how do they try and achieve their core business
Core business of banking: the profitable management of risk.
Credit analysis and lending function is important to achieve
the above.
Explain how credit risk is managed
Managing credit risk requires a clear philosophy in
order to set management’s priorities with respect to
the marketplace.
Credit philosophies may range from an emphasis on
consistent performance of the highest quality loan portfolio,
based on highly conservative underwriting standards, to an
emphasis on aggressive loan growth and market share with
highly flexible underwriting standards
Explain Credit Selection, the dimensions it has and basic credit factors
Credit Selection: the process of assessing the risk
of lending to a business or an individual.
Selection risk has 2 dimensions
Qualitative
Quantitative
4 basic credit factors of
- Borrowers characters and soundness
- Intended use of loan funds
- Primary source of loan repayment
- Secondary sources of repayment
What is the process of qualitative credit risk Assessment
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
What is the process of quantitative credit risk Assessment
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
What are the investment grade and non investment grade from rating agency
Rating are from AAA => D
AAA => BBB (investment grade)
BB => D (non-investment grade)
What are the factors used by rating companies to determine the credit rating of companies
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)
What are the criticism of ratings (4 points)
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.
In terms of use of loan funds, how is the credit worthiness assessed
Ensure that the purpose is lawful
Equator Principles: Westpac, ANZ, NAB & CBA adopting “Not to fund projects that endanger communities or the environment”
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.
In terms of source of Repayment, how is credit worthiness assessed
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.
What are the three ways of structuring the loan portfolio to minimise risk
Ways to minimise credit risk include
– Diversification
– Transferring risk & Moving to off-balance sheet
– Insurance
Explain the process of diversification and how this can reduce the risk of the loan portfolio and how not all risks can be diversified
Diversification through
– Different industries
– Various sizes
– Various geographic locations, Different countries to avoid country specific risk
However, not all risks are related directly to the project
itself. Risks can arise under a number of headings –
political, economic and natural
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
Explain the process of transferring Risk and Moving to off-balance sheet - Securitisation
FI has $10m of housing loans on its books as an assets. This money is tied up and only recovered from the borrowers as they repay their loans.
By packaging them up (ie setting up of a Special Purpose Vehicle, SPV) for investors (typically fund managers), the FIs receive the value of their portfolio of loans immediately.
They act only as a manager, collecting the payments from borrowers and passing them on to the investors. They
make money from the fees charged and the $10m (or whatever they have received for the portfolio of loans) can be lent to other borrowers.
For these loans to not attract CAR, FIs must not guarantee payments to investors or hold any residual investment or guarantee to repurchase the securitised loans
What are some common assets that are securitized
Mortgages
Credit Card Receivables
Commercial loans
Student Loans
Explain how Credit Default Insurance can reduce the risk of the loan portfolio and the risk that the bank is undertaking through this strategy
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.
Explain how a collateral management agreement works and the main downside
The Collateral Management Agreement (CMA) is a tripartite
arrangement between the banker, the borrower and the collateral manager
Some of the key influence collateral managers have on the system include :
– Impose controls on-the-ground discipline as the
commodity moves through the supply chain
– Provide insurance
But, such CMA can be very costly to the banks.
What are the Four type of loans
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)
Explain what a loan Covenant is,
Loan Covenants – 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).
What is the difference between affirmative and negative covenants
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
What are the 3 objectives of covenants and what do they try and achieve
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
Ultimately, is to protect lender from default by borrower
Define default risk
Credit (Default) risk is the risk that borrowers of FIs are not able or willing to pay the promised amount due on their loans
What are the models FI’s use to factor in borrowers attributes in estimating the probability of default or grouping them into appropriate risk classes:
- Linear probability model
- Logit model
- Probit model
- Linear discriminant model
The first 3 models use some form of probability (default)
estimation
Explain how the Linear discriminant model works
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)
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 assets
Low Z-score => high Default risk (cutoff = 1.81)
• Lower than 1.81 – high probability of bankruptcy
• Above 3.00 – low probability of bankruptcy
