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.
