Bank Financial Management

(FINS 3630)
Lecture 2
(Chapter 10)
Credit Risk I:
Credit Risks for Individual Loans
 Overview
This chapter discusses different approaches to measuring
credit or default risk of individual loans.

We first introduce different types of loans issued by FIs.

We then discuss the relationship between default risk and
expected return of loans, and how to incorporate credit risks in
loan pricing.
We also discuss different approaches to address credit risks in
loan issuance and pricing decisions for retail loans and industrial
loans.
We finally learn different methods for assessing the credit
quality of loans.

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Nonperforming Asset Ratio for U.S. Commercial
Banks

http://www.rba.gov.au/publications/fsr/2013/sep/graphs/graph-1.16.html
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 Types of Loan
Commercial and industrial loans,
Real estate loans
Adjustable Rate Mortgages (ARMs)
Fixed Rate Mortgages
-The proportion of FRM to ARM in FIs portfolio varies with the interest rate
cycle

Individual (consumer) loans

personal or auto loans
Other loans
government loans, margin loans, farm loans.
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 Commercial and Industrial Loans
Short-term or long-term
Short-term loans: to finance working capital needs and other short-term
funding needs,
Long-term loans: to finance purchase of real assets, new venture start-up
costs and permanent increases in working capital.
Syndicated loans:
Finance provided by a group of lenders, usually to finance large C&I loans.
Secured or unsecured
Secured (asset-backed) loan: loan backed by first claim on certain assets.
Unsecured loan (junior debt): loan with a general claim only.
Fixed rate or floating rate
Spot loan or loan commitment (line of credit)
loan commitment is a revolving credit facility with a maximum size and
a maximum period of time.
Declining importance of C&I loans
Commercial paper and disintermediation
Commercial papers: unsecured short-term debt instrument
Large corporations with good credit rating can get direct access to funds in capital
markets by issuing commercial papers.

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 Gross return: return if no default
Factors affecting the promised loan return:
The interest rate on the loan
Any fees relating to the loan
The credit risk premium on the loan
The collateral backing of the loan
Other nonprice terms (especially compensating balances and reserve
requirements).
Base-lending rate:
Could reflect the FIs weighted-average cost of capital or its
marginal cost of funds (Commercial paper rate, the Federal fund
rate, or LIBOR.
- Tremendous growth of Euro-dollar market has resulted in
the LIBOR becoming the standard rate compared to Fed
funds rate
- CP market in the US now quotes rates as spread over LIBOR rate
rather than Treasury bill rate.
- Business Loans, some bonds and interest rate swaps also use
LIBOR as their benchmark.
- Alternatively, base lending rate could reflect Prime lending rate-
most commonly used in pricing longer-term loans.

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 Gross return: return if no default (Cont.)
Compensating balance:
Percentage of a loan that a borrower is required to hold on
deposit at the lending institution. Raises the effective cost of
borrowing and an additional source of return on lending for FI.
Reserve requirement (RR):
imposed by the Federal Reserve on FIs demand deposit,
including any compensating balances
Currently, RR on compensating balances held as demand
deposits is 10%, however is zero (0) percent for time deposit.

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 Gross return: return if no default (Cont.)
Contractually promised Gross return on loan (k) per dollar
lent:
1+k = 1 + [of + (BR+m)] / [1- b(1-R)].
Example:
Suppose that a bank does the following:
1. Sets a loan rate on a prospective loan at 8 percent (where BR
= 5% and credit risk premium, m = 3%).
2. Charges a 1/10 percent (or 0.10 percent) loan origination fee to the
borrower.
3. Imposes a 5 percent compensating balance requirement to be
held as noninterest-bearing demand deposits.
4. Pays reserve requirements of 10 percent imposed by the
Federal Reserve on the banks demand deposits.

Calculate the banks ROA on this loan.

( ) . ( . . )
1+ =1+ =1+ = 1.0848
[ ] [ . . ]

Think about situation when of=0 and b=0.

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 Credit Risk and the Expected Return on a Loan
(Ex-post) Actual return on a loan:
No default case with a probability of p to happen: 1+k
Default case with a probability of (1-p) to occur: (1+k), where
is the proportion of loan recovered upon default and 0 1
(Ex-ante) Expected return on a loan
E(1+r) = p(1+k) + (1-p) (1+k).
Where:
p: probability of loan repayment
and
1-p: probability of loan default
p is just a symbol (for probability in our discussion), and thus
pay attention to which probability is given.

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 Credit Risk Control
To simplify the discussion, assuming a zero recovery rate upon default,
i.e., = 0. Then expected gross return:
E(1+r) = p(1+k).
Expected return decreases with the probability of default.

How to compensate for credit risk: two dimension

Price or promised return dimension
Quantity or credit availability dimension

Set risk premium: increasing k with decreasing p.

This is referred as pricing tool also.
Is k and p are independent?
To the extent that p is less than 1, default risk is present. This means the FI
manager must
(1) set the risk premium ( ) sufficiently high to compensate for this risk and
(2) recognize that setting high risk premiums as well as high fees and base rates
may actually reduce the probability of repayment ( p ).

limit the exposure to default risk (credit rationing): decreasing loan

amount to a client or groups of clients when the default risk is high (i.e.,
p is too low).
This is referred as quantity tool also.

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 Credit Risk Control
Why pricing tool (increasing k) does not fully address the
problem of credit risk?
Adverse selection issue
And hence a negative relationship between k and p
So expected return initially increases with k, but after certain
threshold level, decreases with k

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Credit Risk Control for Retail Versus Wholesale Loans
Information about borrowers credit quality is critical for
the use of pricing tool to set a higher rate for more
risky loans
Retail loans
Small dollar size loans,
Higher cost associated with collection of information
Standard loan rate is usually charged,
Credit risk controlled through credit rationing - limit the total
exposure to the sector, and accept or reject decision for
individual loans
Whole-sale loans: control credit risk via
the use of differential interest rates to compensate for different
levels of risks
credit rationing to limit credit exposure.

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 Measuring credit risk

Qualitative credit risk models

Credit scoring models

Term structure based methods

RAROC models

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 Qualitative credit risk models

Borrower-specific factors include:

Reputation: implicit contract,
Leverage (capital structure),
Volatility of earnings,
Collateral.
Market-specific factors include:
Business cycle ( consumer durable producers are less likely to
perform)
Level of interest rates.

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 Credit Scoring Models

Quantitative models that use observed borrower

characteristics to:
Calculate score as a proxy of borrowers default probability, or
Sort borrowers into different default classes.

A scoring model needs to:

Establish factors that help to explain default risk
Evaluate the relative importance of these factors

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 Credit Scoring Models
Linear probability model

PD: probability of default

Xs: different borrower characteristics which are
supposed to be related to the borrowers credit quality
Statistically unsound, since the PDs obtained are not
probabilities at all.

Logit model
- overcomes weakness of the linear probability model using a
transformation (logistic function) that restricts the
probabilities to the zeroone interval.

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 Credit Scoring Models-Linear Discriminant Models

Altmans Z score model for manufacturing firms

Z=1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
Z: credit score, which is related to default/repayment probability
but not necessarily a probability concept
X1 = Working capital/total assets.
X2 = Retained earnings/total assets.
X3 = EBIT/total assets.
X4 = Market value equity/book value LT debt.
X5 = Sales/total assets.

Make a sense of the relationship between these factors and credit

quality

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Credit Scoring Models-Linear Discriminant Models

Critical values suggested by Altman to classify

(discriminate) borrowers into high/low credit risk groups
Z >= 2.99, high quality loans, low default risk
Z < 1.81, very low quality loans, high default risk
1.81 <= Z < 2.99, hybrid

A few notes
Altman estimated his model (deciding on factors, estimating
coefficients on those factors, and calculating critical values for
classification) based on the data of U.S. industrial firms up to
1980s.
It is just an example of how to estimate credit scoring model
Any empirical credit scoring model is: sample dependent (on what
types of firms and what period of data used for estimation).

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Credit Scoring Models-Linear Discriminant Models

Limitations:
Models ignore hard-to-quantify factors such as borrower
reputation, business cycle
Variables in any credit scoring model unlikely to be
constant over longer periods of time,
Weights in any credit scoring model unlikely to be constant
over longer periods of time,
There is no centralized database on defaulted business
loans for proprietary or other reasons hard to test the
validity of any model or develop new models.
Broad distinction between borrower categories, i.e. good
and bad borrowers.

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 Term structure models
Use Finance theory and financial market data
Under the market equilibrium, expected return of a risky loan should
equal to risk-free rate after accounting for probability of default (1-p),
where we denote the probability of payment as p.
[(1 - p) (1 + k)] + [p(1 + k)] = 1 + i
Here,
(1+k) is the contractually promised return on one year corporate debt
security
(1+i) is return on credit-risk-free one year Treasury strip
To simplify the discussion, we will assume a zero default
recovery rate ( =0) in the term structure model discussions:
p (1+ k) = 1+ i

If we know the risk premium and thus the interest rate (k), we
can infer the probability of default.
p = (1+ i)/ (1+ k)
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Corporate and treasury discount bond yield curves

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 Term structure models - application
Estimate default probability over the life of a loan applying the
equality of expected returns to the cumulative returns of loans and
risk-free assets.

Estimate default probability over a single period for a loan (whether

current period or a period in the future) applying the equality of
expected returns to the returns in a current or future period for loans
and risk-free assets.

Why it is useful?
We can estimate the probability of default for a new loan based on
the inferred probabilities of default of (existing) loans/bonds with
comparable credit quality.
The probability of default for the (existing) comparable loans
could be inferred based on the equality of expected returns.

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 Example:
Suppose, as shown in figure, the interest rates in the market for one-year
zero-coupon Treasury bonds and for one-year zero-coupon grade B
corporate bonds are, respectively: i=10% and k=15.8

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 Default and partial recovery
This analysis can easily be extended to the more realistic case in which
the FI does not expect to lose all interest and all principal if the
corporate borrower defaults

FI lender can expect to receive some partial repayment even if the

borrower goes into bankruptcy.

Let be the proportion of the loans principal and interest that is

collectible on default, where in general is positive

If i =10 percent and p = .95 as before but the FI can expect to collect 90
percent of the promised proceeds if default occurs (= 0.9), then the
required risk premium, = 0.00552 percent

Interestingly, in this simple framework, and p are perfect substitutes

for each other.
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 Probability of Default on a Multi-period Debt Instrument

Marginal default probability

The probability that a borrower will default in any given year.
Cumulative default probability
The probability that a borrower will default over a specified multiyear
period.

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 Probability of Default on a Multiperiod Debt Instrument

Now derive the probability of default in year 2, year 3, and so on.

Yield curves are rising for both Treasury issues and corporate bond
issues.
We want to extract from these yield curves the markets expectation
of the multi-period default rates for corporate borrowers classified
in the grade B rating class.

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 Probability of Default on a Multi-period Debt Instrument
The condition of efficient markets and thus no arbitrage profits by
investors requires that
(1 + ) = (1 + )(1 + )

or
(1 + )
1+ =
(1 + )
Here,
i2 is the return on the two-year treasury-strip
i1 is the return on the one-year treasury-strip
f1 is the one-year forward rate
use the same type of analysis with the corporate bond yield curve to
infer the one-year rate expected on corporate securities ( ) one
year into the future
(1 + )
1+ =
(1 + )
!
Since 1+ =1+ then =
"!
-The one-year rate expected on corporate securities one year into
the future
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 Example-continued
From the figure, the current required yields on one- and two-year
Treasuries are i1 = 10 percent and i2 = 11 percent, respectively. The
one-year forward rate, f1, is

Thus, f1=12%
The one-year rate expected on corporate securities, c1, is:

Thus, c1=20.2%
the expected probability of repayment on one-year corporate bonds
in one years time, p2, is:

Therefore, cumulative probability of default

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 RAROC Models
All previous models are somewhat backward looking except
for the term-structure models.

RAROC Models
RAROC (Risk Adjusted Return On Capital)
#$% &%'( $%) $ # % #$ ' *#'$
=
*#'$ ('++%)) ( + #( ' )'* ') ( +

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 RAROC Models
Measuring net income
Net income = value of loans outstanding * all-in-spread (AIS)
Where AIS = contractually-promised return on the loan (taking
into account of interest rate and all explicit and implicit fees)
funding cost

Measuring loan risk

Capital at risk (VaR approach): the potential loan loss under
adverse credit scenarios
L = - D * L * [R / (1+R)]

Alternatively, estimate loan loss risk from loan portfolios

unexpected default rate proportion of loan lost on default
Unexpected default rate is the default rate under adverse credit
scenarios from historical distributions.

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 RAROC Models

R is the increase in risk premium under adverse credit scenarios,

such as 95 or 99 percentile value of the distribution
We will cover Duration in lectures 4 and 5.

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 RAROC: Example
Example: Suppose the following
LN=$1 million (AAA borrower)
Duration, DLN =2.7 years
the 99 percent worst-case scenario is chosen (1.1%)

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RAROC: Example (Cont.)

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 RAROC Models

Essential idea: modified ROA concept which balances expected

interest income against expected loan risk.
If there is no loan risk (no default and thus loss), then the fair return
should be the funding cost (under market equilibrium).
So any excess income (over the funding cost) should be for
compensation of loan risk.
Apply RAROC in loan decision
Loan approval if RAROC > benchmark return on capital, for example,
Return on Equity (ROE).
RAROC serves as both a credit risk measure and a loan pricing tool for
FI managers
Changing the different parameters of the model we can make decision
about providing the loan under different situation
-For example, what should be duration of the loan to be approved?
-How much additional interest and fee income will be necessary to
make the loan acceptable?

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