Lecture 03

(Chapter 11)
Credit Risk II:
Loan Portfolio and Concentration Risk
 Overview
In this lecture, we discuss methods to measure credit
risks of loan portfolios.
Simple methods for measuring the level of loan concentration.

Modern portfolio theory and its application to Moodys Analytics

Portfolio Manager model.

Other methods based on partial application of MPT.

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 Simple Models of Loan Concentration Risk

Migration Analysis:
A method to measure loan concentration risk by
tracking credit ratings of firms in particular sectors or
ratings class for unusual declines.

Examining how credit risk changes over time for different loan
sectors through credit risk migration or transition matrices.

Step 1: sorting loans into different groups based on credit risk

(measured by external or internal rating) levels

Step 2: calculating the proportions of loans in each (beginning-of-

year) group at various credit risk levels at the end of year.

Step 3: comparing the actual credit deterioration with the historical

numbers. If the credit risk of a sector deteriorates faster than
historical experience, then curtail lending to that sector or loan
class.

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 Migration analysis: (Cont)
Loan Migration matrix:
A measure of the probability of a loan being upgraded, downgraded, or
defaulting over some period.

The numbers in the table are called transition probabilities,

-reflecting the average experience (proportions) of loans that

began the year at particular rating and remaining in that rating class at the
end of the year, being upgraded or being downgraded, or defaulting (D).

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 Simple Models of Loan Concentration Risk
Concentration Limits:

Remember the credit rationing approach to manage credit risk

discussed in the previous lecture?

Setting limits on the maximum loan size (as a fraction of loan

portfolio) to individual borrowers or sectors.

Typically used to reduce exposures to certain industries or

geographical areas.

When two industry groups performances are highly correlated,

an FI may set an aggregate limit of less than the sum of the two
individual industry limits. Why?

FIs may set aggregate portfolio limits or combinations of

industry and geographic limits

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 Concentration limit (cont.)
Calculating Concentration Limits to a single client or sector for a Loan
Portfolio:
Contribution of a single sector j to the loss of a loan portfolio:
portfolio loss ratio due to j = loss ratio j percentage of portfolio j
Setting limit to sector j
Concentration limit j = Maximum expected portfolio loss ratio j / Expected loss
ratio j

Example:

Suppose management is unwilling to permit losses exceeding 10 percent of

an FIs capital to a particular sector. If management estimates that the
amount lost per dollar of defaulted loans in this sector is 40 cents, the
maximum loans to a single sector as a percent of capital, defined as the
concentration limit, is:

Concentration limit = Maximum loss as a percent of capital* (1/Loss rate)

= 10%*(1/.4)=25%
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 Modern Portfolio Theory
Expected return and risk of a portfolio
Expected return ( ) and Variance of returns or risk of the portfolio
(2p):

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 Example

Please note that the Standard deviation (SD)of the

portfolio is less than the SD of either individual asset.
Why?
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 Modern Portfolio Theory
Optimal portfolio allocation
Investor preference: as high return as possible but at the same time
prefer as low risk as possible.
The fundamental question for an investor: how to optimally allocate
funds to different assets, which gives her the lowest risk, volatility
here, for a targeted expected return

Putting the question in the mathematical terms, she is solving the

following optimization problems:
Minimize

subject to the constraint of achieving target return,

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Advantage of diversification:

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 Modern Portfolio Theory
Conclusions & Implications
Market portfolio of risky assets is the optimal portfolio of risky assets
for anyone
Most diversified portfolio
Diversify away any idiosyncratic risk

CAPM
the risk of an individual asset is determined by its systematic risk as
measured by beta (how it co-moves with market)
the idiosyncratic risk (not correlated with market movement) is
irrelevant for pricing or not compensated by higher expected
returns (but still add to your risk if you dont diversify it away!)
Ri = Rf + Betai * (Rm - Rf)
Betai = Covariance(Ri, Rm)/Variance(Rm)
Covariance(Ri, Rm) = im*i* m

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 Applying MPT to credit risk analysis of loan portfolio
Moodys Analytics Portfolio Manager Model
Optimization of loan portfolios
We can basically view a bank issuing loans as an investor
The objective is to choose an optimal allocation (weights) for all
possible loans
maximize the return of the loan portfolio, while at the same time
minimize the risk (volatility of return) of the loan portfolio.

Required inputs for optimization

Expected return on a loan to borrower i (Ri)
Risk of a loan to borrower i (i)
Correlation between returns of loans made to
borrowers i and j (ij)

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 Applying MPT to credit risk analysis of loan portfolio
Moodys Analytics Portfolio Manager Model

(excess) Return on a loan in excess of the funding cost to

borrower i (Ri)

where
1) AIS is the all-in-spread, calculated as the difference between
contractually promised return (k) minus the funding cost (FC%)
2) LGD is the loss if the client defaults (Loss Given Default),
calculated as the contractually promised gross return, 1+k,
multiplying by the loss rate, i.e., 1 recovery rate, 1-
3) EDF is the probability of default, termed as expected default
frequency by Moodys

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 Applying MPT to credit risk analysis of loan portfolio
Moodys Analytics Portfolio Manager Model
Expected (excess) return on a loan in excess of the funding
cost to borrower i
Ri = AISi *(1- EDFi) + (AISi - LGDi)* EDFi = AISi - EDFi * LGDi
where EDFi * LGDi is the expected loss.
Please link to the expected (gross) return calculation in Chapter 10
Risk of a loan to borrower i
i = EDFi (1 EDFi ) LGDi

Correlation between returns of loans made to borrowers

i and j
estimated as correlation between the systematic return
components of the asset returns of borrowers i and j.
Dont worry about the correlation calculation (these are given).

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 Example:

Please calculate the return and risk of this loan

portfolio.

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Example: (Cont.)

i = EDFi (1 EDFi ) LGDi

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 Partial Applications of Portfolio Theory
Loan volume based models:
Comparing the asset allocation in the loan portfolios to the
market benchmarks.
Based on the implication from MPT that market portfolio is
the optimal one because of maximum diversification
A bank (denoted bank j)s deviation from the market portfolio
benchmark indicate the relative degree of its loan
concentration.

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 Loan volume based models: Example

For Bank A:

. /
Therefore, = ( ) = 11.73%

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 For Bank B:

.
Therefore, = ( ) / = 26.69%
Bank B deviates more significantly from national benchmark than Bank A.

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 Partial Applications of Portfolio Theory

Loan loss ratio based models:

Based on the implication of CAPM that an assets risk is determined
by its systematic risk how its return co-move with market return
Estimates the systematic loan loss risk of a sector by regressing the
historical loan loss ratio of the sector on the loan loss ratio of the
total loan portfolio
Sectoral losses in the i th sector Total loan losses
= i + i
Loans to the i th sector Total loans

Where:
i = loan loss rate for a sector with no sensitivity to losses on the aggregate
portfolio,
i = systematic loss sensitivity of the ith sector loans to total loans.
The higher the beta is, the higher the correlation of a sector to the total loan
portfolio, and thus the lower the diversification benefits by having this
sector in the total loan portfolio.
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