Bank Controlling

CONTROLLING
1. Bank Controlling.................................................................................... 2
1.1. Controlling principles ........................................................................ 2
1.2. Return/risk controlling....................................................................... 4
1.3. Customer business ............................................................................ 5
1.4. Risk business ..................................................................................... 6
2. Transfer Pricing Method ....................................................................... 9
2.1. Preconditions ..................................................................................... 9
2.2. Opportunity principle......................................................................... 9
2.3. Principle of transfer prices................................................................ 9
2.4. Customer contribution..................................................................... 12
2.5. Interest gap contribution ................................................................. 13
2.6. Difference between transfer pricing method and
present value method (PV) ............................................................. 14
3. Credit Risk............................................................................................ 17
3.1. Definition........................................................................................... 17
3.2. Internal expected loss premiums ................................................... 18
3.3. Cost of equity ................................................................................... 22
4. Credit Risk Evaluation – Balance Sheet Analysis ............................ 23
4.1. Basics of credit quality assessment .............................................. 23
4.2. Methods of risk classification ......................................................... 26
4.3. Quantitative credit analysis............................................................. 28
4.4. Qualitative credit analysis ............................................................... 30
5. Liquidity Risk ....................................................................................... 37
5.1. Definition........................................................................................... 37
5.2. Liquidity costs .................................................................................. 38
© FINANCE TRAINER International Controlling• page 1 of 38

Learning objectives:
You understand balance sheet structure management and its main factors of influence
You know how the transfer pricing method works
You understand the impact of credit risk
You know the different approaches to risk classification methods
You understand the importance of liquidity costs
1. Bank Controlling
1.1. Controlling principles
Bank controlling is a prerequisite for return-oriented bank management. A consistent

controlling concept is characterised by deliberately return-oriented management. This not
only applies to the total bank, the profit centres and the strategic business fields, but also to
each individual transaction.
profitability
return-oriented return-oriented
growth policy risk policy
The controlling cycle as a closed loop ensures the integration of a return-oriented controlling
system:
planning actual analysis monitoring

The cycle makes the controlling department the "return awareness centre“ of a bank. Return
management is only possible if systematic planning activities are implemented and results
are measured by means of variance analysis.
At the same time, the controlling department can be considered as an information centre. It
collects the necessary information, processes it and forwards it to the individual control units.
In this way, the controlling department coordinates the activities of the individual units (profit
centre, service centre, cost centre) with a view to achieving the total bank objectives.
OVERVIEW OF THE MAIN OBJECTIVES OF BANK CONTROLLING:
Result management for

• individual transactions
• business divisions
• total bank
efficient budget management
target/performance comparison and suggestions for improvements
Optimisation of balance sheet structure

1.2. Return/risk controlling
Legal Framework
Total Bank
Management
Return
Optimal RORAC curve
Risk
Customer Business Risk Business
Management Management
Customer Fund transfer pricing

structure Interest gap
contribution
contribution
Credit risk premium structure
GOAL: Optimum fulfilment of GOAL:Generating returns by taking

customer needs targeted market risks
© Finance Trainer 2009
The main problem in bank management is the mixing of customer margin and risk
contribution. Only a consistent and actively implemented fund transfer pricing structure
allows separation of the interest surplus into customer contribution (= profit contribution of the
customer business) and interest gap contribution (= profit contribution of the risk business).
The fund transfer pricing structure is the prerequisite for standardised assessment of the
performance of the bank's customer business. Who is not familiar with the debate on
"whether things couldn't be calculated differently" because, after all, competitors are making
"such attractive offers"?
A consistent fund transfer pricing structure is also a prerequisite for unambiguous
measurement of the performance of the bank's risk business. As in the customer business, a
dynamic fund transfer pricing structure which is consistently applied is the only way of

ensuring that the bank’s management board can delegate clear responsibility for returns from
the risk business.
Effective total bank management will only be possible if the bank creates a clearly defined
interface between customer business (= risk-free provision of services) and risk business.
Risk-free service provision includes all customer business (loans, deposits and payment
transactions).
The credit risk premium structure serves as an instrument for managing credit risks. Credit
risk premiums free the sales department from managing credit risk, but it has to earn the
premiums by means of the customer margin. The credit risk management department
receives the credit risk premiums for the management of the risk contribution from customer
business.
1.3. Customer business
Legal Framework
Total Bank
Management
return
Optimal RORAC curve
risk
Fund transfer pricing

structure
Credit Risk Premium structure
GOAL: Optimum fulfilment of GOAL: Generating returns by

customer needs taking targeted market
risks
All customer business (loans, deposits and payment transactions) is risk free.

The bank's lending transactions are risk-free business as they are “insured” by the bank's
risk business. The risk premium represents costs for the credit division. Risks that turn into
losses will impact the risk portfolio of the risk business.
Deposit business refers to on- and off-balance-sheet securities transactions.
In the service business the bank generates fees and commissions besides a risk-free interest
margin on on-balance-sheet transactions.
The provision of services to customers is geared to the optimum fulfilment of customer needs
and the generation of contribution margins. Here, market, quality, return and cost positions
are managed.
1.4. Risk business
Legal Framework
Total Bank
Management
return
Optimal RORAC curve
risk
Fund transfer pricing

structure
Credit risk premium structure
GOAL: Optimum fulfilment of Generating returns by

customer needs taking targeted market
risks
Risk business incurs risks related to banking operations, i.e. interest rate, foreign exchange,
liquidity and credit risks. The objective of bank management in the risk business is to
generate optimum returns in relation to the risk taken.

Risk business is thus banking in the narrower sense of the word. A bank's ability to bear risk
(based on its equity) enables it to effect typical bank risk transactions.
The following risks are typical of banking:

Market risk
• Interest rate risk = the risk of a reduction in the bank's result due to a
change in the interest curve or interest level.
• Foreign exchange risk = the risk of a reduction in the bank's result due to exchange
rate fluctuations.
Credit risk = the risk of a reduction in the bank's result due to loan losses in the bank's
lending operations.
Liquidity risk = the risk of a reduction in the bank's result due to unforeseen increases
in the costs of refinancing caused by tightness of the market or a downgrading of the
credit rating. Its most extreme form is illiquidity.
Business risks are defined as risks due to technical failure (computer, IT breakdown),
fraud or theft. Unlike the above-mentioned risks related to banking operations, they are
not part of risk business.
The fund transfer pricing structure also creates a clear interface between customer and risk
business. It helps answer the following questions:
Credit risk: To which risk-free rate does the risk premium have to be added in lending
transactions?
Interest rate risk: What is the return / expenditure involved in hedging my customer
business?
Liquidity risk: What premium (spread) do I have to pay on the risk-free rate, depending
on maturities?
Individual risks are bundled in the transfer prices and can thus be centrally controlled:

• All risk premiums per credit rating class are summed up in the "hedging pool" of the
bank's lending operation.
• All individual transactions with the same interest rate repricing profile are bundled,
partially offsetting each other, and thus constitute total transaction volumes which can
be traded and hedged in the interbank market.
• All individual transactions with the same maturity profile are bundled and reflect the
bank's refinancing risk.

2. Transfer Pricing Method
2.1. Preconditions
In order to apply the transfer pricing method it is necessary to map all business transactions.
The goal is to separate the net interest income into two parts: the part which results from
customer business (= customer contribution) and the part which results from the
management of interest adjustment profiles (= interest gap contribution). This is the only way
of separating the management of customer business from the management of interest rate
risk business. Each transaction needs a transfer price. Without a transfer price there is no
separation of the net interest income into customer contribution and interest gap contribution.
2.2. Opportunity principle

The opportunity principle of the transfer pricing method provides an orientation for the fund
transfer pricing structure. The opportunity principle states that there is always an alternative
to a customer transaction and this fact has to be accounted for. The alternative exists in the
money and capital markets. In these markets the bank can conclude a transaction with an
interest rate quality equal to that of a transaction with a customer. The transfer price (interest
rate in the money and capital market) thus becomes the benchmark for the customer interest
rate (interest rate agreed upon with the customer).
The focus is therefore on the interest income and expense. It has to be established whether,
as an alternative to a customer transaction, it is possible to conclude a riskless transaction in
the money or capital market with the same interest adjustment profile (e.g. fixed or CMF).
2.3. Principle of transfer prices

The transfer prices allow analysis of the interest margin:
Analysis of the portion generated by the customer business. This is calculated by

establishing the difference between external conditions (= customer interest rate,
effective interest rate) and the transfer price for the individual transaction concerned. It
helps answer the following questions:
• When extending credit at the customer interest rate, how much more does the bank
earn in comparison with the alternative application of the transfer price in the money
and capital markets?

• How much more advantageous is the bank's refinancing via interest on the
customer's savings deposit in comparison with the alternative application of the
transfer price?
Under the transfer pricing method, this portion is called the customer contribution (an
absolute figure) and the customer margin (a percentage).
Another portion which is derived by juxtaposing transfer prices from investments /

refinancing. Under the transfer pricing method, the difference between interest income
(= the sum total of all investment transactions, valued at the respective transfer prices)
and interest expenditure (= the sum total of all refinancing transactions, valued at the
respective transfer prices) is called the interest gap contribution.
The calculation of the net interest income must be maintained; this is the central task of the
fund transfer pricing structure.
Customer contribution + Interest gap contribution = Net interest income
The sum total of the customer contributions of all individual transactions added to the interest
gap contribution will result in the net interest income.
This forms the basis for

account managers being responsible for results;
the ability to evaluate and control interest-risk positions independently of customer
business;
giving the bank's management the ability to control the overall result of the bank.
The transfer pricing method subdivides the interest margin into the
customer contribution (= risk-free customer margin) and the
interest gap contribution (= income from the maturity transformation).
The customer contribution is determined by comparing the actual interest rate (= customer
interest rate, external rate) for every single transaction with the transfer price for the same

fixed interest period. The customer contributions of all assets- and liabilities-side transactions
are added.
In order to calculate the interest gap contribution, transfer prices are assigned to all individual
transactions and the resulting interest paid is deducted from interest income.
Calculation of the interest margin
Transfer price (TP) short-term (one year) = 4.0%

Transfer price (TP) long-term (five years) = 5.5%
ASSETS Volume Interest LIABILITIES Volume Interest

rate rate
Operating loan 500 8.0 % Savings deposit 600 5.0 %
Public-sector loan 300 6.0% Issue 200 5.0 %
Total 800 7.25%1) Total 800 2.75%2)
Net interest margin = 4.5 %
800 x 4.5 % = 36
1) Calculation of interest rate, assets side: ((500 * 8 %) + (300 * 6 %) / 800)) * 100 = 7.25 %
2) Calculation of interest rate, liabilities side: ((600 * 2 %) + (200 * 5 %) / 800)) * 100 = 2.75 %
The fund transfer pricing structure is the core element of the transfer pricing method. For the
development of such a "structure“ some prerequisites have to be provided.
Transfer prices have to be allocated to all balance sheet items according to their interest
adjustment profiles. This not only applies to customer transactions, but also to securities,
own issues, interest-free assets and liabilities and ALM positions (e.g. interest rate swaps,
FRAs).
Many transactions do not have a clear interest adjustment profile. Customer transactions
without a formal interest adjustment and maturity profile (e.g. sight deposits and credits) can
be adjusted daily, but this does not reflect their actual interest rate sensitivity.

Transfer prices show the cost and income from an interest risk hedge without credit risk. The
swap curve is therefore the best reference. Interest rate swaps are available irrespective of
the bank's liquidity position and are virtually free of credit risk.
The calculated hedge costs determine the choice of the correct swap rate. Swap rates are
priced at bid, offer or middle rates. The right hedge price depends on the liquidity situation of
the bank. If the bank needs liquidity because it focuses on lending business, the correct
hedge price is the higher offer rate.
The transfer pricing method is the only way of separating responsibility for the result of the
maturity transformation from the customer margin.
2.4. Customer contribution

In order to determine the customer contribution every individual transaction is compared to
the money and capital market rates for the same fixed-interest period:
The interest adjustment profiles assumed for

the individual product categories are:
Operating loans one year
Public-sector loans five years
Savings deposits one year
Issues five years
Transfer price (one year) = 4.0%

Transfer price (five years)= 5.5%
1 2 3 4 5 6
CC = TP Customer Volume Assets Liabilities Volume Liabilities TP CC =
(2 - 1) * 3 interest (6 - 5) * 4
20.0 4,0 % 8,0 % 500 Operat. Savings 600 2,0 % 4,0 % 12,0
loans deposits
1.5 5,5 % 6,0 % 300 Publ. issues 200 5,0 % 5,5 % 1,0
Sect.
loans
21.5 = CCasset side = CCliabilities side 13.0

The effective interest rate on savings deposits (interest paid and
charged to customers), for example, is 2% below the 4% transfer
price. Hence, savings deposits are 2% cheaper than the opportunity
costs on the money and capital markets.
CCassets side + CCliabilites side = CC

21.5 + 13 = 34.5
The individual product categories, taken together, have a customer

contribution of 34.5. This is their share of the net interest income from
the sale of the products. In the following, the interest gap contribution,
i.e. the cover resulting from the maturity transformation, is
determined.
2.5. Interest gap contribution
For the purpose of calculating the interest gap contribution, it is assumed that the bank has
accepted the same fixed-interest periods as those applying to its customer business. All
individual transactions are valued at the transfer prices. The interest income at transfer
prices less interest paid at transfer prices results in the interest gap contribution.
Interest in TP Volume Assets- Liabilities- Volume TP Interest in

absolut side side absolut
terms terms
20.0 4.0 % 500 1 Jahr 1 Jahr 600 4.0 % 24.0
16.5 5.5 % 300 5 Jahre 5 Jahre 200 5.5 % 11.0
36.5 35.0
Interest income - interest paid = interest gap contribution

36,5 - 35,0 = 1,5

Transfer prices have no influence on the interest margin. They merely
serve as a tool for separating customer business from risk business
(= risk of interest rate fluctuations resulting from maturity
transformation).
Customer contribution - interest gap contribution = interest margin

34,5 - 1,5 = 36 (4,5 %)
In this case, too, the end result is the net interest margin (4.5%) with
net interest income of 36.
2.6. Difference between transfer pricing method and present value

method (PV)
The objective of the transfer pricing method is to represent the risk result of the P&L (profit
and loss account) by means of GAP analysis. The calculation of the interest gap contribution
is done on an accrual basis, which means that interest expense and interest income have to
be calculated for well-defined periods and shown in the profit and loss account.
GAP analysis provides a strategic guideline for the annual interest gap contribution.
Furthermore, it helps to analyse and manage the interest rate risk on a regular basis and is
the interface between the interest result from customer business and the interest result from
maturity transformation.
GAP analysis is an aggregated and structural approach. It shows the capital per interest rate
profile in a maturity structure. The maturity bands are pooled according to the maturity of the
interest rate profiles.
With GAP analysis it is possible to discuss "desired GAPs“ and simulate different scenarios.
The interest gap contribution calculated using GAP analysis shows the contribution of the
interest rate position to the interest margin. In a GAP analysis all transactions continue until
the end of maturity.

Interest rate risk measurement using the present value method is a "mark-to-market“
valuation of the total bank. This valuation method measures the current market value of the
interest result from maturity transformation. This means calculation of the total result of all
interest rate positions until the end of their maturity and not only for one business period.
The present value method permits the management of individual parts of the bank (securities
nostro account, loans receivable…) right down to the single transaction. It serves the short-
term analysis and management of interest rate risk. The total result is the present value of all
interest rate positions.
The positions are shown in a cash-flow presentation (capital and interests) of all individual
transactions, allowing simulation of single transactions.
The present value approach implies that all transactions are closed at valuation date and so
the total result of the interest risk position is realised at this key date.

Comparison of structural approach vs. present value:
Structural approach (GAP- Presen value method

analysis
Question: How much will the bank earn from How much will the bank earn if
maturity transformation assuming all positions are closed today
an unchanged balance sheet structure (income and costs are
within a certain period (normally one discounted to date)?
year)?
Period: Period valuation All positions are matched with

the income/ costs of a hedge
Risk situation: Retention of risk structure Closing of risk
Market interest Variable interest positions are All positions are matched with
fluctuations: newly evaluated, fixed interest the income/ costs of a hedge
positions remain unchanged
Application: overall control detailed control
regular analysis and control daily vaule of positions
of balance sheet structure individual valuation is
overall valulation of balance possible
sheet decision basis for
decision basis for structural limits/remaining within a
objectives limit
Preconditions: use of transfer pricing precise determination of
method all cash flows involved in a
definition of interest rate transaction
profiles
overall analysis of maturities

3. Credit Risk
3.1. Definition
When talking about credit risk we usually distinguish between two different dimensions:
expected loss and

unexpected loss.
While unexpected losses represent real risk for a bank, expected losses just mean costs that
have to be earned. Expected loss is the statistical estimate of average potential loss across a
portfolio. In the lending business, profits are limited to interest income, while on the other
hand high losses due to credit defaults are absolutely possible. This explains why loss has to
be expected when holding a loan portfolio.
A bank’s loan portfolio consists of 100 loans, each with a volume of

EUR 1 m and a coupon of 4%. Accordingly, the bank’s total interest
income equals EUR 4 m.
Based on default experience from recent years, the bank estimates
that this year 1% of all borrowers will default. The default of a loan
would correspond to a loss of EUR 1 m for the bank.
With profits of EUR 4 m combined with profits of EUR 3 m, the bank

expects a total loss of EUR 1 m.
The expected loss figure is based on the assumption that average historical losses will also
occur in the future. Banks take this kind of loss into account right from the start, therefore it
cannot be seen as genuine risk, but as costs which are known as internal expected loss
premiums.

3.2. Internal expected loss premiums
Internal expected loss premiums serve the purpose of covering the expected losses on the
bank's entire loan portfolio. Therefore, the bank has to allocate these losses across the
whole loan portfolio and charge them to borrowers as costs.
The allocation of internal expected loss premiums across a bank’s loan portfolio is usually
done in a risk-adequate way. This means that the internal expected loss premiums allocated
to a loan have to correspond to the loan’s risk structure. After all, borrowers exhibiting
excellent credit quality grades are less likely to default than borrowers with lower ratings.
Lower credit qualities add to the amount of expected loss, which is why these exposures are
charged relatively higher internal expected loss premiums in order to cover expected losses.
This risk-adequate concept of internal expected loss premiums is in line with what has long
been accepted as good practice in the bond market. Here, the risk premium (= credit spread)
is the higher the worse the rating of the issuer. The same principle should apply to a bank’s
borrowers. Otherwise, the bank runs the risk of exclusively attracting and financing lower-
rated borrowers and thus of holding all these low credit qualities in its loan portfolio.
Figure 1 illustrates why risk-indifferent allocation of internal expected loss premiums will
attract borrowers carrying lower ratings.
Given that the bank does not differentiate between different credit qualities when allocating
risk premiums, then high-rated borrowers would have to pay a higher risk premium and low-
rated borrowers a lower risk premium than their respective risks would suggest. Naturally,
well-rated borrowers would look for cheaper financing elsewhere, while the bank would
attract even more low-rated borrowers.
Risk Premium
<-- High Ratings---- ---- Low Ratings -->
Figure 1: Risk-adequate allocation of internal expected loss premiums

Calculating internal expected loss premiums
In order to be able to cover its expected losses, the bank has to be able to charge each loan
its adequate amount of internal expected loss premiums. The first step in the allocation of
internal expected loss premiums is to determine risk-adequate rates per rating category and
maturity. In principle, there are three ways to determine the internal expected loss premiums
Estimation from bank-internal data

Calculation based on market data
Calculation using option pricing models
Computing the internal expected loss premiums
In order to determine the expected loss, banks may either estimate expected loss or make
separate estimates of the figures ‘probability of default’ and ‘loss given default'. Which option
is chosen usually depends on the availability of data. In the end, both methods aim to provide
a table of adequate internal expected loss premiums.
Given that internal expected loss premiums are supposed to cover expected losses, the
following equation can be stated:
Internal expected loss premiums = Expected Loss
Expected Loss = Probability of Default (PD) * Loss given Default (LGD)
The probability of default gives the probability that a borrower will default within a specified
period of time. Default probabilities are usually estimated from historical data per rating class.
It is assumed that all borrowers belonging to the same rating category have the same
probability of default.
The probability of default indicates the general credit quality of a borrower and therefore
takes no account of transaction-specific characteristics of loans. For this reason, PD
estimates are based on the number of borrowers and not on the volume of lending.

The number of borrowers assigned to the internal rating category "3“
equalled 4600 last year. 23 of them defaulted. What is the one-year
PD of rating category “3” based on last year’s data?
Probability of Default (PD) = Number of defaults / Number of

borrowers
PD rating category 3 = 23 / 4600 = 0.5 %
The degree of loss intensity, on the other hand, is related to the type and volume of
collaterals used. It shows the amount of loss in percent at the time of a borrower’s default.
Next to collateralization, the seniority of a loan plays an important role. The seniority of a loan
gives the order in which the debts of the corresponding borrower are serviced in the event of
a default. More senior loans will be serviced earlier, which means that they have a better
recovery rate.
The loss intensity (= loss given default) is defined as:

Loss Given Default = 1 – recovery rate
Given that the default probability equals 2% and loss given default
equals 50%, the expected loss amounts to 1 % (0.02 * 0.5 = 0.01).
This means that the bank expects a loss equalling 1% of the volume
of the loan on these lending transactions.
The standard risk cost table shows which standard risk cost rates are adequate depending
on the rating category and maturity of a loan. For loans stretching over a number of years,
internal expected loss premiums are usually spread linearly over time. More sophisticated
methods are also available to spread internal expected loss premiums in the case of multi-
year loans.

In general, the weaker the ratings and the longer the maturities, the higher internal expected
loss premiums should be.
Maturity
Rating 1 2 3 5 7 10
AAA 0.00%
AA 0.00%
A 0.22%
BBB 0.53%
BB 1.50% 1.55% 1.62% 1.72% 1.88% 2.40%
Table 1: Standard Risk Cost Rates According to Rating and Maturity (p.a.)
A BB-rated borrower intends to take out a five-year loan of EUR

500,000. What amount of annual internal expected loss premiums
does the bank charge according to Table 1?
EUR 500,000 * 1.72 % = EUR 8,600
Exact calculation of the

Loss Given Default for unsecured loans and the
recovery rates for collaterals
is an essential prerequisite for the calculation of internal expected loss premiums according
to this methodology.
Calculating the internal expected loss premiums – unsecured loan approach
It is also possible to calculate internal expected loss premiums for the unsecured portion of a
loan if there are no adequate historical data available with which to apply the ‘expected loss
approach’.

3.3. Cost of equity
To shareholders, a bank’s equity capital represents risk capital. In the event that the bank
runs into financial difficulties, the shareholders are liable up to the amount of the capital
made available by them. As a compensation for this liability they expect a return above the
return on risk-free investments. If this expected return cannot be attained, the shareholders
will in the medium term reconsider their financial commitment to the bank.
In addition, the legislator stipulates that the equity capital of banks be employed to offer
specific creditor protection. This demand has been implemented by the provision that banks
are required to hold equity capital corresponding to a minimum of 8% of the total value of
lending transactions involving a credit risk.
As a bank’s management can no longer freely determine the ratio between equity capital and
outside capital, this legal provision also imposes a ceiling on potential leverage effects: it is
no longer possible for a bank to replace equity capital by cheap borrowings at its own
discretion, but it must hold (expensive) equity capital accounting for a minimum of 8% of its
total lendings. Hence the risk premium on equity capital must be earned through asset-side
items creating an equity capital need. Such risk premiums fall within the category "cost of
equity”.
Assumption: 12 % target return on equity

Risk-free rate = 5 %
Risk premium of shareholders on the risk-free rate: 7%
Assets Liabilities
Lending 100 Refinancing 100
Equity investments 8 Equity capital 8
Target return Current Additional Equity capital

on equity - = * = Cost of equity
capital equity costs backing
market rate
12% - 5% = 7% * 8% 0.56%

4. Credit Risk Evaluation – Balance Sheet Analysis
Ratings are formal assessments of the future ability of an issuer to repay principal and
interest on debentures issued or the ability of a borrower to repay a loan fully and on time.
Ratings provide information about the probability of payment disruption during the term of an
obligation/loan.
The term rating as it is commonly used in the international capital market means the
systematic and periodical evaluation of a borrower, i.e. its credit quality. A distinction is made
between internal and external ratings, the former being used within banks and the latter
being used in the capital market. Evaluation of the credit risk of a transaction or a company in
order to use it for determining adequate prices constitutes a traditional practice in the capital
market. The best-known external ratings are those of international rating agencies like
Moody’s or Standard & Poor’s.
Ratings do not provide information about other risks like price changes due to exchange rate
fluctuations, changes in the interest rate curve or the risk of amortisation prior to maturity.
Furthermore, unlike stock analyses, ratings do not provide predictions about future price
movements.
4.1. Basics of credit quality assessment

Balance sheet analysis represents the fundament of credit quality evaluation and thus of all
lending decisions. The quantitative methods of credit quality evaluation in particular, which in
the first instance mean balance sheet analysis, have proven to be indispensable for the daily
practice of credit business. The high explanatory power of quantitative indicators with respect
to the credit quality of a certain borrower gives them a strong weight in any lending decision.
On the basis of credit quality evaluation, it is possible to place each borrower into a particular
risk category. That way, each borrower is assigned a specific probability of default that enters
into pricing via its translation into imputed credit risk costs. A rating system covering all
borrowers is a necessary prerequisite for the assessment and management of credit risk at
the portfolio level. It provides the information that allows us to
calculate risk at the individual exposure level as well as at the portfolio level
take the right business and risk management actions

determine, via the evaluation and classification of customer transactions, the need for
action with respect to lending operations
determine the criteria for evaluation of credit exposures.
Balance sheet analysis
The evaluation of the balance sheet is an important component of granting loans in

commercial lending. Together with additional internal and external information, it represents
a cornerstone of the lending process. Annual financial statements are the main source of
information for evaluating the possible amount of lending. They comprise the asset and
liability statement as well as the profit and loss (P&L) statement, where the former serves to
verify objective creditworthiness and the latter to verify forward-looking creditworthiness.
Balance sheet analysis is the practice of scrutinising the economic development of the
respective company based on the balance sheet evaluation. This enables us to pinpoint
already perceivable and potentially emerging risks and subsequently judge whether it is
prudent to grant a loan. The goal of balance sheet evaluation is to make a judgement on the
state and development of the respective company using objective and reproducible criteria.
These demands are primarily met by using ratios.
Ratios
Ratios are quantitative figures (in absolute or relative terms) that also allow period-to-period
and inter-company comparison because of their exactly specified definitions. It is important
that an analysis or evaluation is not carried out on the basis of a single ratio, but on the basis
of a whole set of current ratios and their development. Within the framework of balance sheet
evaluation, ratios may be roughly grouped into four categories
Profitability
Liquidity
Leverage (debt-equity structure)
Operating efficiency
Basic principles of rating procedures
A number of basic principles direct the approach to determining the probability of default via
a thorough balance sheet analysis of customers:

Determining quantitative risk parameters
The starting point of the rating process is a comprehensive quantitative analysis of the
customer using financial statements and other data. This serves as an objective basis
for determining credit quality .
To ensure that the industry sector a customer is associated with is taken into account,
industry sectors have to be assigned their own risk parameter weightings. These risk
weightings have to be calculated from empirically verifiable, representative ratios.
Long-term view
Bonds as well as loans often feature longer maturities. Accordingly, rating systems must
take account of factors that might affect the long-term ability to repay debts so as to be
indicative of credit quality risks.
Industry sector specifics
It should be noted that the interpretation of ratios depends to a large extent on the
respective industry sector. In the case of an industrial enterprise, for example, the
capitalisation ratio (= fixed assets to balance sheet total) has a much stronger weighting
in the determination of a rating than it does in the case of a trading firm.
Consistency of ratios
Ratios have to be constantly examined with respect to their plausibility.
Volume and predictability of future cash flows
Here, it is crucial to assess the risk that future payments will not be made. For this
reason the expected volume and predictability of a company’s future cash flows has to
be related to the company’s future redemption payments.
Plausible scenarios
To test the financial flexibility of the borrower, a set of adverse but plausible scenarios is
applied to the expected economic development.
Adjusting for national accounting regulations
In order to be able to conduct a meaningful balance sheet analysis, adjustments have to
be made for the effects of national accounting standards. The goal is to look behind
national accounting peculiarities and identify the economic and financial resources that
will enable the company to generate redemption payments.
Allowing for qualitative factors

To further improve the explanatory power of the rating, qualitative factors also have to be
taken into account. Qualitative factors point to future opportunities of a company by
interpreting the strengths and weaknesses of its non-material aspects.

4.2. Methods of risk classification
Mathematical and statistical methods and credit scoring
Mathematical and statistical methods aim to subdivide the loan portfolio into different
borrower classes by using selected combinations of qualitative and quantitative factors (e.g.
financial ratios) based on analysis of the historical credit defaults. Factors that have proven
to have explanatory power in separating bad credit qualities from good ones are used to
forecast the expected losses of individual credit exposures as well as of the loan portfolio as
a whole. Accordingly, these factors are used to determine which rating class each borrower
is assigned to.
Examples of mathematical and statistical methods are, among others, discriminant analysis,
regression analysis and neural networks. All these methods share the goal of minimising the
costs of ‘erroneous classification’.
As for the method of credit scoring, an overall credit score is calculated which consequently
has to be translated into a measure of probability of default. Other methods directly measure
the probability of default of a borrower.
Expert systems
Computer-based expert systems attempt to reproduce the problem-solving capacity of

human specialists. Bank-internal information is therefore combined with a question-and-
answer dialogue, so that all decision-relevant information can be gathered and consequently
evaluated.
The result is an analysis and in some cases a recommended course of action, as well as a
documentation of how the result was reached. Expert systems are sold commercially, mainly
as standardised products.
Option pricing models to evaluate credit quality
The credit quality evaluation of companies via option pricing models determines the causal
relationship between the market price of a company and its probability of default. The
following assumption forms the basis of this approach:
Each borrower has the (theoretical) opportunity to either pay back debt capital or file for
bankruptcy. From the financial theory perspective, this choice corresponds to a call option

belonging to the owner, while the market value of the company represents the underlying.
This option can be valued using an option pricing model (e.g. Merton / Black / Scholes).
The owner will only pay back his/her debts and thus exercise the call option in the event that
the market value of his/her company is higher than the value of the aggregated debts (= the
call option is “in the money”). Vice versa, the owner will not exercise the option and file for
bankruptcy if the value of outside capital exceeds the market value of the company. In this
case the call option is “out of the money”.
By comparing the market value of the company (= underlying) to the value of outside capital
(= strike price), it is possible to calculate the probability of the option being exercised and
thus the likelihood of default.
Credit rating
Credit rating has established itself in practice as the risk classification system of European
banks. Credit quality criteria are commonly subdivided into “qualitative” and “quantitative” risk
parameters or credit quality criteria. The rating system is thus based on a balance sheet
analysis that provides sufficient differentiation between the credit qualities of the individual
borrowers.
The most commonly used parameters from the balance sheet are ratios relating to equity,
capital structure and indebtedness (leverage), profitability and cash flows. In the selection of
these parameters or ratios it is crucial that the following conditions are adhered to:
measurement and determination of probability of default

low level of correlation between the individual parameters and
as much explanatory power as possible.
The goal is to determine the borrower's economic capacity to meet contractual interest and
capital payments as well as making a statement about the credit quality of the individual
borrowers and the probability of a loan being redeemed. As a result of the risk appraisal,
each borrower is assigned a rating and a corresponding probability of default. Over the
course of time, the bank obtains a risk profile of its total credit business. What is more, the
basic principles of decision-making are standardised and the decision-making process is
simplified.

4.3. Quantitative credit analysis
The quantitative credit quality analysis (“hard facts”) focuses on business activities, economic
circumstances and values that can be measured and depicted using ratios. Insights and
results are usually gained from relating ratios to each other or relating ratios to the
corresponding ratios of typical companies from the same industry sector.
The quantitative credit quality analysis obtains its information from traditional balance sheet
analysis on the one hand, and from project and feasibility studies like cash-flow analysis, flow
of funds statements, financial planning or intra-company and sector-to-sector comparisons
on the other. In this way, the strengths and weaknesses of a company with respect to profits
and prospects are revealed and analysed.
The lending bank has to judge whether the borrowing company features a well-balanced
debt-equity structure. In this respect, the most important risk parameters for quantitative
credit quality analysis are:
Profitability and its stability

Liquidity and thus the capacity to redeem debt capital
Equity ratio
Profitability
Cash flow is one of the most important profitability ratios. It is calculated from the difference
between earnings and expenses affecting payment and gives evidence of a company’s self-
financing capacity. Cash flows are supposed to cover all ongoing repayment obligations,
private withdrawals and necessary replacement investments. Therefore, (gross) cash flow
figures are well-suited to assess the borrowing power of a company.
Cash flow = profit or loss on ordinary activities - capitalised services +depreciation +/- cash
flow adjustment
Two other ratios used to evaluate profitability are “return on assets” (ROA) and “return on
investment” (ROI):
Return on assets (%) = (net income + interest expense) x 100 / average total assets
This ratio reflects differences in financial leverage as well as in operating performance, which
is why it is misleading if it is used to compare firms with different capital structures. Thus, this

measure should not be used to compare companies from different industry sectors (which
often means different capital structures) without adjusting for leverage.
This ratio shows the return on all the firm’s assets irrespective of the capital structure.
Return on investment (%) = net income x 100 / average total assets

This ratio shows net return on all the firm’s assets.
The literature often classes these three ratios (cash flow, ROA, ROI) as dynamic ratios.
Liquidity and capital structure
A sound capital structure (debt-equity structure) is one crucial prerequisite for the successful
operation of a company. This means sufficient equity being available as well as long-term
assets being long-term financed (maturity matching).
Debt-equity ratio (%) = equity x 100 / total assets
The debt-equity ratio expresses equity as a percentage of total assets in terms of book
values. Hidden reserves or losses are not taken into account. The higher the proportion of
fixed assets, the higher the proportion of equity is supposed to be. From a financing point of
view, a lack of equity should be made up for by raising long-term outside capital. Otherwise,
pecuniary difficulties are inevitable. The finance literature classes the debt-equity ratio as a
static ratio.
(Net) working capital
If the level of (net) working capital (= current assets – current liabilities) has been rising over
the years, this can usually be interpreted as a good sign with respect to the financial
soundness of a company. However, it is important to make sure that this development is not
due to a regrouping of assets or other extraordinary measures (e.g. sale and lease back).
The biggest advantage of quantitative credit quality analysis is that its application is proven
and generally understandable. Also, the results and conclusions of quantitative credit quality
analysis are reproducible and manageable.
The biggest disadvantage of balance sheet analysis is that by definition it is a backward-

looking measure. This means that conclusions are derived from data that are at least partially
outdated. Moreover, accounting is not always geared to presenting a true and fair view of a
company’s financial standing, but to reducing taxes payable.

Risk Parameters
Quantitative Factors Qualitative Factors

Result measurement Assessment of overall
framework
Advantage Operable results, generally Forward-looking
accepted
Disadvantage Backward-looking Results not operable, not
generally accepted
Table 2: Comparison "qualitative“ vs. "quantitative“ factors
4.4. Qualitative credit analysis

Qualitative factors have to complement the rating information that has been gathered on the
basis of balance sheet data. Qualitative credit quality analysis features risk parameters that
are not quantifiable (“soft facts”). These parameters contribute just as well to the final risk
evaluation, as is evidenced by studies on causes of insolvencies. Moreover, the systematic
categorisation of qualitative factors adds to the risk sensitivity of a rating system and its
selectivity.
Four areas are primarily analysed and evaluated:

Management and strategy
Corporate governance
Business environment (market position, competition, industry sector)
Company size
The evaluation of these areas is often conducted via a verbal strength-weakness analysis.
The assessment of the future development of factors relating to these four areas constitutes
the decisive criterion of the analysis. It is therefore necessary that the individual qualitative
risk parameters offer a high degree of specific explanatory power and that they exhibit a low
correlation with other risk parameters.
The biggest disadvantage of qualitative credit quality analysis remains that its results are not
definitely measurable. There is always some scope for interpretation.
The combination of quantitative and qualitative factors finally results in the respective
customer rating.

annual balance environ-
financial sheet ment customer
quantitative qualitative
statement factors factors rating
Figure 2: Rating System
External rating methods
Moody’s rating methodology

The principles of the rating system that was introduced for the first time by John Moody more
than 90 years ago are still valid today. At its core is the distinction between long-term and
short-term credit ratings, depending on the maturity of the underlying financing. In this way,
diverging results (= ratings) may be obtained regarding the credit quality of the same
borrower, depending on the nature of the credit exposure. A second feature is the general
classification of ratings into two classes. The first class includes the following ratings:
Ratings for long-term and short-term obligations
Ratings for structured financing
Ratings for preferred stock
Ratings for issuers
The second class includes:

Ratings for bank deposits
Financial strength ratings for banks
Financial strength ratings for insurance companies
Ratings for investment funds
Additionally, a distinction has to be made between issues ratings and issuer ratings. Issues
ratings stand for the capacity of an issuer to redeem the contractual interest and capital
repayments of a specific obligation. Issuer ratings refer to the general capacity of an issuer to
repay all of its obligations.

Rating symbols
Moody‘s Aaa to C rating symbols are used as ratings for obligations with an original maturity
of more than one year. The symbol C at the lower end of the scale indicates a very high level
of risk concerning timely and full payment.
Long-term Short-term
Aaa
Aa1
Aa2
Investment grade
Aa3 Prime –1
A1
A2
A3
Prime –2
Baa1
Baa2
Prime -3
Baa3
Ba1
Ba2
Ba3
Speculative grade
B1
B2 Not Prime
B3
Caa
Ca
C
Table 3: Moody’s rating symbols

Standard & Poor’s rating methodology
The rating methodology of Standard & Poor’s very much resembles that of Moody’s. A
Standard & Poor’s rating shows the agency’s opinion on the creditworthiness of a borrower
with respect to a certain obligation or a specific financial programme. It takes the credit
quality of guarantors into account as well as other measures to improve creditworthiness.
Ratings are based on up-to-date information that is either delivered by the borrower or
derived from reliable sources. The following points in particular form the basis of ratings:
Probability of repayment
Type of obligation
Expected recovery rate in the case of bankruptcy
The ratings are defined so that they express the probability of default in payment concerning
senior obligations of a borrower. Ratings do not make statements on market prices and are
not recommendations as to whether to enter a risk position or not.

Standard & Poor’s also distinguishes between long-term and short-term ratings.
S&P Interpretation
AAA exceptionally strong

AA+ very strong
Investment Grade
AA
AA-
A+ strong
A
A-
BBB+ good
BBB
BBB-
BB+ marginal
BB
BB-
Non-Investment Grade
B+ weak
B
B-
CCC+ very weak
CCC
CCC-
CC extremely weak
C
SD, D payment default
Table 4: Standard & Poor’s rating symbols

Mapping of internal ratings
Risk categories
Via its default probabilities for each rating category, a bank’s internal rating model should be
comparable with the ratings of the internationally recognised rating agencies. Internal rating
models should be based on similar definitions as the ones used by internationally recognised
agencies to allow the mapping of internal ratings into capital market ratings. The design of an
internal rating model includes a number of steps to ensure comparability:
To begin with, the probabilities of default and (rating) migration have to be recorded for
each risk category of the bank's own (internal) rating system.
Secondly, a basis for internal risk grading has to be provided. If the bank’s own pool of
data is not sufficient to yield valid results, there is the alternative of establishing the risk
grading via a comparison with external ratings. At any rate, the sum of expected loss
has to correspond to the default probabilities associated with the individual risk category
assigned.
Thirdly, the derived results have to be repeatedly controlled via the application of back-
testing. In this way, the bank ensures that the probabilities of default and migration have
been adequately calculated and mapped into the respective rating.
The probability of default (PD) determines the likelihood that a borrower will default within a
specified period of time (t). These probabilities of default are estimated for each rating
category on the basis of historical data. PD is calculated by dividing the number of defaults in
t by the total number of borrowers of a certain rating class. The international standard is to
calculate one-year probabilities of default, which also corresponds to the Basel II definition of
default.
PD t, per rating category = number of defaults t, per rating category / number of borrowers t, per rating category

Seven performing and two non-performing risk categories are
mapped into the risk categories used by S&P.
Internal Rating System Standard & Poor’s Ratings
Risk category PD Rating PD Description

AAA 0.00 % Exceptionally strong
1 0.01 %
AA 0.00 % Very strong
2 0.04 % A 0.05 % Strong
3 0.10 %
BBB 0.22 % Adequate
4 1.30 %
BB 0.94 % Less vulnerable
5 3.63 %
6 7.28 % B 8.38 % More vulnerable
7 13.41 %
CCC 21.94 % Currently vulnerable
Default D Default
Table 5: Standard & Poor’s Ratings Definition
Interpretation:
Customers assigned to risk category 3 defaulted at a rate of 0.10% over the course of the
last few years. That rate corresponds to the probability of default of S&P ratings in the range
of A to BBB. However, this does not automatically mean that externally rated credits within
the risk category 3 are always rated either A or BBB.
It is absolutely possible that borrowers that are rated higher than A or lower than BBB are
also assigned to risk category 3 because of internal assessment criteria. The probability of
default assigned to the risk category serves as the basis for the mapping.

5. Liquidity Risk
5.1. Definition
Liquidity costs are the costs of long-term refinancing. They have to be charged to the
products giving rise to these costs.
Depending on the credit rating and life of a loan, a debtor pays markups on the transfer price
(swap curve). The credit spread that corresponds to the maturity profile is charged to lending
transactions.
Liquidity costs depend on the maturity profile. The longer the maturity, the higher the liquidity
costs. The second aspect is the bank’s credit rating: the poorer the credit rating, the higher
the liquidity costs.
In costing procedures, liquidity costs must be taken into account. Depending on the maturiy
profile, liquidity costs are charged to assets, whereas they are credited to refinancing costs.
A L
EURIBOR loan 10 years REFINANCING 10 years fixed Î liquidity costs

interest rate
Federal bonds + 70 BP
(∼ IRS + 30 BP)
IRS 10 Jahre EURIBOR
Table 6: Liquidity costs (IRS = interest rate swap)
If a bank refinances a EURIBOR loan at a federal bond yield + 70 BP fixed, the interest risk
position can be hedged through the sale of an interest swap. The difference between the
swap rate and the issuing costs (federal bond + 40 BP vs. federal bond + 70 BP = 30 BP)
represents the bank's liquidity costs.

5.2. Liquidity costs
Liquidity costs (funding spreads) are accounted for in costing in order to guarantee the long-
term solvency of a bank (i.e. the ability of a bank to meet all its payment obligations in time
and without restrictions).
Basically, refinancing is effected with primary means (savings deposits, sight deposits etc.).
As primary means are not readily available to a large extent, the capital market is becoming
an increasingly important source of refinancing.
Amount of liquidity costs
Spread over transfer price

Volume assets 0.0 % (= interest rate swap)
0.10 % 0.20 % 0.30 %
Call money
3
3 mths
12 mths
15
2 years
5 years
20
10 years
> 10 years
25
According to the above table, the liquidity costs for 5-year maturity and the current rating
amount to 20 basis points.

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CONTROLLING

© FINANCE TRAINER International Controlling• page 1 of 38

1.1. Controlling principles

Bank controlling is a prerequisite for return-oriented bank management. A consistent

planning actual analysis monitoring

© FINANCE TRAINER International Controlling• page 2 of 38

OVERVIEW OF THE MAIN OBJECTIVES OF BANK CONTROLLING:

 Result management for

© FINANCE TRAINER International Controlling• page 3 of 38

Optimal RORAC curve

Customer Fund transfer pricing

GOAL: Optimum fulfilment of GOAL:Generating returns by taking

© Finance Trainer 2009

© FINANCE TRAINER International Controlling• page 4 of 38

1.3. Customer business

Optimal RORAC curve

Fund transfer pricing

Credit Risk Premium structure

GOAL: Optimum fulfilment of GOAL: Generating returns by

© FINANCE TRAINER International Controlling• page 5 of 38

1.4. Risk business

Optimal RORAC curve

Fund transfer pricing

Credit risk premium structure

GOAL: Optimum fulfilment of Generating returns by

© FINANCE TRAINER International Controlling• page 6 of 38

The following risks are typical of banking:

© FINANCE TRAINER International Controlling• page 7 of 38

© FINANCE TRAINER International Controlling• page 8 of 38

2.2. Opportunity principle

2.3. Principle of transfer prices

 Analysis of the portion generated by the customer business. This is calculated by

© FINANCE TRAINER International Controlling• page 9 of 38

 Another portion which is derived by juxtaposing transfer prices from investments /

Customer contribution + Interest gap contribution = Net interest income

This forms the basis for

© FINANCE TRAINER International Controlling• page 10 of 38

Calculation of the interest margin

Transfer price (TP) short-term (one year) = 4.0%

ASSETS Volume Interest LIABILITIES Volume Interest

Net interest margin = 4.5 %

© FINANCE TRAINER International Controlling• page 11 of 38

2.4. Customer contribution

The interest adjustment profiles assumed for

Transfer price (one year) = 4.0%

© FINANCE TRAINER International Controlling• page 12 of 38

CCassets side + CCliabilites side = CC

The individual product categories, taken together, have a customer

2.5. Interest gap contribution

Interest in TP Volume Assets- Liabilities- Volume TP Interest in

Interest income - interest paid = interest gap contribution

© FINANCE TRAINER International Controlling• page 13 of 38

Customer contribution - interest gap contribution = interest margin

2.6. Difference between transfer pricing method and present value

© FINANCE TRAINER International Controlling• page 14 of 38

© FINANCE TRAINER International Controlling• page 15 of 38

Structural approach (GAP- Presen value method

Period: Period valuation All positions are matched with

© FINANCE TRAINER International Controlling• page 16 of 38

 expected loss and

Result management for

Analysis of the portion generated by the customer business. This is calculated by

Another portion which is derived by juxtaposing transfer prices from investments /

expected loss and

Estimation from bank-internal data

Allowing for qualitative factors

measurement and determination of probability of default

Profitability and its stability