Credit Risk
Credit Risk
Credit Risk
Types of Loans
Standalone financing: When a FI is provided
funds to a single client is known as stand along
financing.
Syndicated financing: When a group of FI is
provided funds to a single client is known as
syndicated financing.
Secured loan: A loan that is backed by a first claim
on certain assets (collateral) of the borrower if
default occurs.
Unsecured loan: A loan that only has a general
claim to the assets of the borrower if default occurs.
5 Cs of Credit
Character
Capital
Capacity
Collateral
Conditions
N U M E R I C A L
Metrobank offers one-year loans with a 9% stated
or base rate, charges a 0.25% loan origination
fee, imposes a 10% compensating balance
requirement, and must pay a 6% reserve
requirement to the Federal Reserve. The loans
typically are repaid at maturity.
If the risk premium for a given customer is 2.5%, what
is the simple promised interest return on the loan?
What is the contractually promised gross return on the
loan per dollar lent?
Which of the fee items has the greatest impact on the
gross return?
??
Why could a lenders expected return be lower when
the risk premium is increased on a loan? In addition to
the risk premium, how can a lender increase the
expected return on a wholesale loan? A retail loan?
An increase in risk premiums indicates a riskier pool of
clients who are more likely to default by taking on riskier
projects. This reduces the repayment probability and
lowers the expected return to the lender. In both cases
the lender often is able to charge fees that increase the
return on the loan. However, in both cases also, the fees
may become sufficiently high as to increase the risk of
nonpayment of default on the loan.
??
Why are most retail borrowers charged the
same rate of interest, implying the same risk
premium or class? What is credit rationing?
How is it used to control credit risks with
respect to retail and wholesale loans?
??
Why are most retail borrowers charged the same rate of interest, implying the
same risk premium or class?
Most retail loans are small in size relative to the overall investment portfolio of an FI,
and the cost of collecting information on household borrowers is high. As a result, most
retail borrowers are charged the same rate of interest that implies the same level of risk.
What is credit rationing? How is it used to control credit risks with respect to retail and
wholesale loans?
Credit rationing involves restricting the amount of loans that are available to individual
borrowers. On the retail side, the amount of loans provided to borrowers may be
determined solely by the proportion of loans desired in this category rather than price or
interest rate differences, thus the actual credit quality of the individual borrowers. On
the wholesale side, the FI may use both credit quantity and interest rates to control
credit risk. Typically more risky borrowers are charged a higher risk premium to control
credit risk. However, the expected returns from increasingly higher interest rates that
reflect higher credit risk at some point will be offset by higher default rates. Thus
rationing credit through quantity limits will occur at some interest rate level even though
positive loan demand exists at even higher risk premiums.
??
Why is the degree of collateral as specified in
the loan agreement of importance to the
lender? If the book value of the collateral is
greater than or equal to the amount of the
loan, is the credit risk of the lender fully
covered? Why, or why not?
Collateral provides the lender with some assets
that can be used against the amount of the loan
in the case of default. However, collateral has
value only to the extent of its market value, and
thus a loan fully collateralized at book value may
not be fully collateralized at market value.
Further, errors in the recording of collateralized
positions may limit or severely reduce the
The primary benefit from credit scoring is that credit lenders can more accurately
predict a borrowers performance without having to use more resources.
With commercial loan, credit scoring models taking into account all necessary
regulatory parameters and posting an 85% accuracy rate on average, according to
credit scoring experts, 25 using these models means fewer defaults and write-offs
for commercial loan lenders.
To use credit scoring models, the manager must identify objective economic and
financial measures of risk for any particular class of borrower.
For consumer debt, the objective characteristics in a credit scoring model might
include income, assets, age, occupation, and location. For commercial debt, cash
flow information and financial ratios such as the debtequity ratio are usually key
factors. After data are identified, a statistical technique quantifies, or scores, the
default risk probability or default risk classification.
Credit scoring models include these three broad types: (1) linear probability
models, (2) logit models, and (3) linear discriminant analysis.
Example 11-2
Estimating the Probability of Repayment on a Loan Using Linear Probability Credit Scoring Models
Example 11-3
Calculations of Altmans Z-Score
With a Z score less than 1.81 (i.e., in the high default risk
??
What are the purposes of credit scoring models? How do these
models assist an FI manager in better administering credit?
Credit scoring models are used to calculate the probability of
default or to sort borrowers into different default risk classes.
The primary benefit is to improve the accuracy of predicting
borrowers performance without using additional resources. This
benefit results in fewer defaults and charge offs to the FI.
The models use data on observed economic and financial
borrower characteristics to assist an FI manager in (a) identifying
factors of importance in explaining default risk, (b) evaluating the
relative degree of importance of these factors, (c) improving the
pricing of default risk, (d) screening bad loan applicants, and (e)
more efficiently calculating the necessary reserves to protect
against future loan losses.
??
Suppose the estimated linear probability model is
PD = .3X1 + .2X2 0.5X3 + error, where X1 =
0.75 is the borrowers debt/equity ratio, X2 =
0.25 is the volatility of borrower earnings, and X3
= 0.10 is the borrowers profit ratio.
What is the projected probability of default for the
borrower?
What is the projected probability of repayment if
the debtequity ratio is 2.5?
What is a major weakness of the linear probability
model?
??
Describe how a linear discriminant analysis model
works. Identify and discuss the criticisms which have
been made regarding the use of this type of model to
make credit risk evaluations.
??
Accounts
receivables
90 Notes payable
90
Inventory
90 Accruals
30
Long-term debt
$30
150
Plant and
500 Equity
400
equipment
Also assume
sales $500, cost of goods sold $360, taxes $56, interest
payments
net income $44,
dividend
ratio is$700
50 percent,
Total $40,
assets
$700the Total
liab.payout
+ equity
and the market value of equity is equal to the book value.
What is the Altman discriminant function value for MNO, Inc.?
Should you approve MNO, Inc.s, application to your bank for a $500 capital
expansion loan?
If sales for MNO were $300, the market value of equity was only half of
book value, and the cost of goods sold and interest were unchanged, what
would be the net income for MNO? Assume the tax credit can be used to
offset other tax liabilities incurred by other divisions of the firm. Would your
credit decision change?
Would the discriminant function change for firms in different industries?
??
Consider the coefficients of Altmans Z score.
Can you tell by the size of the coefficients
which ratio appears most important in
assessing creditworthiness of a loan
applicant? Explain.
??
If the rate of one-year T-Bills currently is 6 percent, what is
the repayment probability for each of the following two
securities? Assume that if the loan is defaulted, no
payments are expected. What is the market-determined
risk premium for the corresponding probability of default for
each security?
a. One-year AA rated bond yielding 9.5 percent?
b. One-year BB rated bond yielding 13.5 percent?
??
A bank has made a loan charging a base lending
rate of 10 percent. It expects a probability of
default of 5 percent. If the loan is defaulted, it
expects to recover 50 percent of its money through
the sale of its collateral. What is the expected
return on this loan?
??
Assume that a one-year T-bill is currently yielding 5.5
percent and an AAA rated discount bond with similar
maturity is yielding 8.5 percent.
If the expected recovery from collateral in the event of
default is 50 percent of principal and interest, what is the
probability of repayment of the AAA rated bond? What is the
probability of default?
What is the probability of repayment of the AAA-rated bond
if the expected recovery from collateral in the case of
default is 94.47 percent of principal and interest? What is
the probability of default?
What is the relationship between the probability of default
and the proportion of principal and interest that may be
recovered in case of default on the loan?
RAROC Models
An increasingly popular model used to evaluate
(and price) credit risk based on market data is the
RAROC model.
The RAROC (risk-adjusted return on capital) was
pioneered by Bankers Trust (acquired by
Deutsche Bank in 1998) and has now been
adopted by virtually all the large banks.
The essential idea behind RAROC is that rather
than evaluating the actual or contractually
promised annual ROA on a loan, the lending
officer balances expected interest and fee income
less the cost of funds against the loans expected
risk.
RAROC Models
Further, rather than dividing annual loan income by assets lent, it is divided
by some measure of asset (loan) risk or what is often called capital at risk,
since (unexpected) loan losses have to be written off against an FIs
capital:
RAROC
RAROC Models
The idea here is that a loan should be made only if the risk-adjusted return
on the loan adds to the FIs equity value as measured by the ROE required
by the FIs stockholders. Thus, for example, if an FIs ROE is 15 percent, a
loan should be made only if the estimated RAROC is higher than the 15
percent required by the FIs stockholders as a reward for their investment in
the FI. Alternatively, if the RAROC on an existing loan falls below an FIs
RAROC benchmark, the lending officer should seek to adjust the loans
terms to make it profitable again. Therefore, RAROC serves as both a
credit risk measure and a loan pricing tool for the FI manager.
The numerator of the RAROC equation is relatively straightforward to
estimate. Specifically,
One year net income on loan = (Spread + Fees) x Dollar value of the loan
outstanding
??
A bank is planning to make a loan of $5,000,000 to a firm in the steel
industry. It expects to charge a servicing fee of 50 basis points. The loan has
a maturity of 8 years with a duration of 7.5 years. The cost of funds (the
RAROC benchmark) for the bank is 10 percent. Assume the bank has
estimated the maximum change in the risk premium on the steel
manufacturing sector to be approximately 4.2 percent, based on two years of
historical data. The current market interest rate for loans in this sector is 12
percent.
Using the RAROC model, determine whether the bank should make the
loan.
What should be the duration in order for this loan to be approved?
Assuming that the duration cannot be changed, how much additional
interest and fee income will be necessary to make the loan acceptable?
Given the proposed income stream and the negotiated duration, what
adjustment in the loan rate would be necessary to make the loan
acceptable?
Facility Rating
A. Facility
a. Nature and purpose of loan
b. Loan structure
c. Product type
d. Priority of rights in case of bankruptcy
e. Degree of collateralization
f. Composition of collateral
Facility Rating
B. Collateral
a. Nature
b. Quality
c. Liquidity
d. Market value
e. Exposure of the collateral to different
risks
f. Quality of the charge