Credit Risk 2

Simple models Portfolio diversification Analytics Portfolio Manager Other applications
Credit risk
Part 2: Portfolio credit risk

Saunders, chapter 11
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Content
Simple models
Portfolio diversification
Analytics Portfolio Manager
Other applications
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Credit risk of the loan portfolio
• Top executives care more about aggregate credit risk exposure

of the bank
• Measure and assess credit risk for the bank’s loan portfolio
• Simple models
• Portfolio diversification models
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Simple models
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Loan migration analysis
• Credit ratings of borrowers can change, or migrate away from

original ratings
• Banks can keep track of how a historical loan pool changes
over time in terms of credit ratings
• Analyze patterns of migration for a sector or rating class (e.g.,
AAA, BBB)
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Example: migration matrix
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Loan migration analysis
• The bank then compares its loan portfolio migration against

this benchmark
• Adjust weights of loan classes, or change credit risk premium
if needed
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Example
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Loan concentration limit
• Limit the proportion of the loan portfolio that can go to any

single customer, industry, or geographical location
• U.S.: loan to a single customer ≤ 15% of the institution’s
capital and surplus; or 25% if the loan is secured Ref
• VN: ≤ 15% for banks, and ≤ 25% for non-bank financial
institutions Ref
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Example
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Portfolio diversification models
• Applies modern portfolio theory to measure and control

aggregate credit risk exposure
• Estimate
• Portfolio expected return
• Portfolio risk (variance )
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Portfolio expected return
n
X
Rp = w1 R1 + w2 R2 + · · · + wn Rn = wi Ri
i=1
• Ri : return of asset i in the portfolio

• wi : proportion of portfolio invested in asset i
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Portfolio return variance
n
X n X
X n
σp2 = wi2 σi2 + wi wj ρij σi σj
i=1 i=1 j=1
i̸=j
n
or n X
n
X X
σp2 = wi2 σi2 + wi wj σij
i=1 i=1 j=1
i̸=j
• σi : standard deviation of return on asset i

• ρij : correlation between returns on assets i and j
• σij : covariance of returns between assets i and j
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• Since −1 ≤ ρij ≤ 1, portfolio risk ≤ sum of individual risk

• Small ρij will help diversify away non-systematic risk
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Example
• Loan portfolio with two loans A and B.

• RA = 8%; σA = 5%, wA = 0.4
• RB = 10%; σB = 6%, wA = 0.6
• ρAB = −0.2
• Calculate return and standard deviation of the portfolio
• Which asset weighting scheme minimizes the portfolio risk?
Excel file
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Problem with loan portfolio diversification
• Full diversification brings benefit

• But loans are not publicly traded
→ can small/local banks diversify successfully?
• What about specialization in lending for small banks?
• Is loan return normally distributed?
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Analytics Portfolio Manager
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Moody’s Analytics Portfolio Manager Model
• Does not require return to be normally distributed

• Proprietary model to estimate the return and variance of
individual loans
• Then use standard modern portfolio theory to measure return
and variance of portfolio
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Individual loan return
Ri = AISi − E (Li ) = AISi − EDFi × LGDi

• AISi : all-in spread (including fees)
• E (Li ): expected loss
• EDFi : expected default frequency
• LGDi : loss given default ratio
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Individual loan risk
p
σi = ULi = σDi × LGDi = EDFi (1 − EDFi ) × LGDi
• ULi : unexpected loss
• σDi : volatility of loan default rate (binomial)
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Example
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Other applications
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Loan volume-based models
• Banks may not have market information on asset prices

• They can apply portfolio theory partially with loan volume
data (sector allocations)
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Example
• Xij is bank j’s loan allocation in sector i

Bank A’s loan allocation in Real estate is X1A = 65%
• Xi is the national average asset allocation in sector i
For real estate X1 = 45%
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Loan volume-based models
• Quantify the bank’s deviation from the norm in terms of asset

allocation v
u N
uX
u
u (Xij − Xi )2
t i=1
σj =
N
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Loan loss ratio-based models
• Estimate systematic loan loss risk of a sector relative to that

risk of whole portfolio
• Run a time-series regression of quarterly losses of sector i’s
loss rate on the quarterly loss rate of the bank’s total loans
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Problem sets
• Chapter 11: 4, 5, 7, 8, 11, 13, 15, 17, 18, 19, Minicase
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Simple models Portfolio diversification Analytics Portfolio Manager Other applications

Part 2: Portfolio credit risk

Analytics Portfolio Manager

Credit risk of the loan portfolio

• Top executives care more about aggregate credit risk exposure

Loan migration analysis

• Credit ratings of borrowers can change, or migrate away from

Example: migration matrix

Loan migration analysis

• The bank then compares its loan portfolio migration against

Loan concentration limit

• Limit the proportion of the loan portfolio that can go to any

Portfolio diversification models

• Applies modern portfolio theory to measure and control

Portfolio expected return

• Ri : return of asset i in the portfolio

Portfolio return variance

• σi : standard deviation of return on asset i

• Since −1 ≤ ρij ≤ 1, portfolio risk ≤ sum of individual risk

• Loan portfolio with two loans A and B.

Problem with loan portfolio diversification

• Full diversification brings benefit

Analytics Portfolio Manager

Moody’s Analytics Portfolio Manager Model

• Does not require return to be normally distributed

Individual loan return

Ri = AISi − E (Li ) = AISi − EDFi × LGDi

Individual loan risk

Loan volume-based models

• Banks may not have market information on asset prices

• Xij is bank j’s loan allocation in sector i

Loan volume-based models

• Quantify the bank’s deviation from the norm in terms of asset

Loan loss ratio-based models

• Estimate systematic loan loss risk of a sector relative to that

• Chapter 11: 4, 5, 7, 8, 11, 13, 15, 17, 18, 19, Minicase

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