Credit risk

Individual Loan risk

Business Studies Department, BUKC

 Overview
• This chapter discusses types of loans, and the
analysis and measurement of credit risk on
individual loans. This is important for purposes
of:
• Pricing loans and bonds
• Setting limits on credit risk exposure

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 What is credit risk?
• Credit risk is the risk of loss that may occur from the failure of
any party to abide by the terms and conditions of any financial
contract, principally the failure to make required payments on
loans due to an entity.
• As a financial intermediary, the project finance division of a bank
is exposed to risks that are particular to its lending and trading
businesses and the environment within which it operates.

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 What is credit risk?
• The major goal of a project finance firm in risk management is to
ensure that it understands, measures, and monitors the various
risks that arise and that the organization adheres strictly to the
policies and procedures established to address these risks.
• Firms have a structured credit approval process which includes a
well-established procedure for comprehensive credit appraisal.

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 Credit Quality Problems
• Problems with junk bonds, residential and farm mortgage loans.
• More recently, credit card and auto loans.
• Crises in Asian countries such as Korea, Indonesia, Thailand, and
Malaysia.
• World Financial crisis 2007-2008
• Default of one major borrower can have significant impact on value and
reputation of many FIs
• Emphasizes importance of managing credit risk

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 Credit Quality Problems
• Over the early to mid 1990s, improvements in NPLs for large banks
and overall credit quality.
• Late 1990s concern over growth in low quality auto loans and credit
cards, decline in quality of lending standards.
• Exposure to Enron.
• Late 1990s and early 2000s: telecom companies, tech companies,
Argentina, Brazil, Russia, South Korea
• New types of credit risk related to loan guarantees and off-balance-
sheet activities.
• Increased emphasis on credit risk evaluation.
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 Types of Loans:
• Consumer & Industrial (C&I) loans: secured and unsecured
• Syndication
• https://www.thenews.com.pk/print/505064-pakistan-raises-500m-t
hrough-islamic-syndicated-loan
• Spot loans, Loan commitments
• Decline in C&I loans originated by commercial banks and
growth in commercial paper market.
• Downgrades of Ford, General Motors and Tyco
• Real Estate (RE) loans: primarily mortgages
• Fixed-rate, ARM (adjustable-rate mortgage)
• Mortgages can be subject to default risk when loan-to-value
declines.
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 Types of Loans:
• Syndicated loans: A loan provided by a group of FIs as opposed
to a single lender.
• Secured: A loan that is backed by a first claim on certain
assets (collateral) of the borrower if default occurs.
• Unsecured loan: A loan that has only a general claim to
the assets of the borrower if default occurs.

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 Types of Loans:
• Spot loans: The loan amount withdrawn by the borrower
immediately.
• Loan commitments: A credit facility with a maximum size
and a maximum period of time over which the borrower
can withdraw funds; a line of credit.
• RE loans: primarily mortgages
• Fixed-rate, ARM (adjustable-rate mortgage ): A mortgage
whose interest rate adjusts with movements in an
underlying market index interest rate.
• Mortgages can be subject to default risk when loan-to-
value declines.

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 Consumer loans
• Individual (consumer) loans: personal, auto, credit card.
• Nonrevolving loans
• Automobile, mobile home, personal loans
• Growth in credit card debt
• Visa, MasterCard
• Proprietary cards such as Sears, AT&T
• Risks affected by competitive conditions and usury ceilings

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 Other loans
• Other loans include:
• Farm loans
• Other banks
• Nonbank FIs
• Broker margin loans
• Foreign banks and sovereign governments
• State and local governments

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 Return on a Loan:
Factors:
1. Interest payments
2. Fees,
3. Credit risk premium
4. Collateral
5. And other requirements such as compensating balances and reserve
requirements.
• Return = inflow/outflow

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 Return on a Loan:
Step 1: Finding Simple promised interest return or interest rate on
loan
1. Bank sets loan rate as follows:
Base lending Rate (BR) = 8%
+ Credit risk premium or margin (m or ø) = 2%
BR + m = 10%

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 Return on a Loan:
- The base lending rate (BR) could reflect the FI’s weighted-average
cost of capital or its marginal cost of funds, such as the commercial
paper rate, the central/federal funds rate, or KIBOR.
- KIBOR is The Karachi Interbank Offered Rate, is a daily reference
rate based on the interest rates at which banks offer to lend unsecured
funds to other banks in the Karachi wholesale (or "interbank") money
market.
https://www.sbp.org.pk/ecodata/kibor/2020/Oct/kibor-21-Oct-20.pdf

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 Return on a Loan:
- Prime lending rate: The prime rate is most commonly used in pricing
longer-term loans, while the central bank’s funds rate and KIBOR
rate are most commonly used in pricing short-term loans.
Traditionally, the prime rate has been the rate charged to the FI’s
lowest-risk customers. Now, it is more of a base rate to which
positive or negative risk premiums (m or ϕ) can be added.
- In other words, the best and largest borrowers now commonly pay
below prime rate to be competitive with the commercial paper
market.
- 6.98 % (2017) in Pakistan

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 Return on a Loan:
- Compensating balances are a percentage of a loan that a borrower
cannot actively use for expenditures. Instead, these balances must be
kept on deposit at the FI.
- Thus, compensating balance requirements act as an additional source
of return on lending for an FI.
- A reserve requirement (RR) imposed by the SBP on the FI’s
(specifically depository institution’s) demand deposits, including any
compensating balances.

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 Return on a Loan:
- Higher fees, high compensating balances, and increased collateral
backing all offer implicit and indirect methods of compensating an FI
for lending risk.
1+k= 1+
K= gross return on the loan or ROA; of=direct fee ; BR+m =loan
interest rate; b= noninterest-bearing compensating balances;
RR= Central Bank’s requires depository institutions to hold non-
(or low) interest-bearing reserves at the rate RR against the
compensating balance

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 Word problem 1
1. Calculate the promised return (k) on a loan if the base rate is 13%, the
risk premium is 2%, the compensating balance requirement is 5%, fees
are ½ percent, and reserve requirements are 10%.
Ans 16.23%

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 Return on a Loan:
Expected return: E(r) = p(1+k)-1
where p equals probability of repayment
• Note that realized and expected return may not be equal.

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 Word problem 2
• What is the expected return on this loan if the probability of default is
5%?

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 Default Risk
• To the extent that p is less than 1, default risk is present. This means
the FI manager must
(1) set the risk premium (ϕ) 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).
That is, k and p are not independent. Indeed, over some range, as fees
and loan rates increase, the probability that the borrower pays the
promised return may decrease (i.e., k and p may be negatively related).

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 Lending Rates and Rationing
• Retail: e.g. consumer loan
• Usually a simple accept/reject decision rather than adjustments to the
rate.
• Credit rationing- Restricting the quantity of loans made available
to individual borrowers.
• If accepted, customers sorted by loan quantity.
• For mortgages, discrimination via loan to value rather than
adjusting rates
• At wholesale: (e.g. C&I)
• Use both quantity and pricing adjustments.

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 Measuring Credit Risk
• Availability, quality and cost of information are critical factors in
credit risk assessment
• Facilitated by technology and information
• Qualitative models: borrower specific factors are considered as
well as market or systematic factors.
• Specific factors include: reputation, leverage, volatility of
earnings, covenants and collateral.
• Market specific factors include: business cycle and interest rate
levels.
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 Credit Scoring Models
• Mathematical models that use observed loan applicant’s characteristics
either to calculate a score representing the applicant’s probability of
default or to sort borrowers into different default risk classes.
• The primary benefit from credit scoring is that credit lenders can more
accurately predict a borrower’s performance without having to use
more resources.
• Credit scoring models include these three broad types:
1. linear probability models
2. logit models
3. linear discriminant analysis
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 Credit Scoring Models
Linear probability models: uses uses past data, such as financial
ratios, as inputs into a model to explain repayment experience on
old loans.
- The relative importance of the factors used in explaining past
repayment performance then forecasts repayment probabilities on
new loans. That is, factors explaining past repayment performance
can be used for assessing p (probability of repayment, a key input
in setting the credit premium on a loan or determining the amount
to be lent) and the probability of default (PD).

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 Credit Scoring Models
1. Linear probability models:

n
PDi =   j X i , j  error
j 1
• where βj is the estimated importance of the jth variable (e.g.,
leverage) in explaining past repayment experience.

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 Other Credit Scoring Models
• Logit models: overcome weakness of the linear probability
models using a transformation (logistic function) that restricts
the probabilities to the zero-one interval.
• Other alternatives include Probit and other variants with
nonlinear indicator functions.
• Quality of credit scoring models has improved providing
positive impact on controlling write-offs and default

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 Credit Scoring Models
Linear probability models Limitations:
1. Statistically unsound since the PD’s obtained are not probabilities at all.
2. Since superior statistical techniques are readily available, little
justification for employing linear probability models.

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 Altman’s Linear Discriminant Model:

• Z=1.2X1+ 1.4X2 +3.3X3 + 0.6X4 + 1.0X5

Critical value of Z = 1.81.
• 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.

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 Linear Discriminant Model
Problems:
• Only considers two extreme cases (default/no default).
• Weights need not be stationary over time.
• Ignores hard to quantify factors including business cycle
effects.
• Database of defaulted loans is not available to benchmark the
model.

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 Term Structure Based Methods
• If we know the risk premium we can infer the probability
of default. Expected return equals risk free rate after
accounting for probability of default.
p (1+ k) = 1+ i
• May be generalized to loans with any maturity or to
adjust for varying default recovery rates.
• The loan can be assessed using the inferred probabilities
from comparable quality bonds.
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 Mortality Rate Models
• Similar to the process employed by insurance companies to price
policies. The probability of default is estimated from past data on
defaults.
• Marginal Mortality Rates:
MMR1 = (Value Grade B default in year 1)/(Value Grade B outstanding
yr.1)
MMR2 = (Value Grade B default in year 2)/(Value Grade B outstanding
yr.2)
• Many of the problems associated with credit scoring models such as
sensitivity to the period chosen to calculate the MMRs

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 RAROC Models
• Risk adjusted return on capital. This is one of the more widely
used models.
• Incorporates duration approach to estimate worst case loss in
value of the loan:
• DLN = -DLN x LN x (DR/(1+R)) where DR is an estimate of
the worst change in credit risk premiums for the loan class
over the past year.
• RAROC = one-year income on loan/DLN

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 Option Models:
• Employ option pricing methods to evaluate the option to
default.
• Used by many of the largest banks to monitor credit risk.
• KMV Corporation markets this model quite widely.

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 Applying Option Valuation Model
• Merton showed value of a risky loan
F(t) = Be-it[(1/d)N(h1) +N(h2)]
• Written as a yield spread
k(t) - i = (-1/t)ln[N(h2) +(1/d)N(h1)]
where k(t) = Required yield on risky debt
ln = Natural logarithm
i = Risk-free rate on debt of equivalent maturity.
t = remaining time to maturity

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 CreditMetrics
• “If next year is a bad year, how much will I lose on my loans and loan
portfolio?”
VAR = P × 1.65 × s
• Neither P, nor s observed.
Calculated using:
• (i)Data on borrower’s credit rating; (ii) Rating transition matrix; (iii)
Recovery rates on defaulted loans; (iv) Yield spreads.

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 Credit Risk
• Developed by Credit Suisse Financial Products.
• Based on insurance literature:
• Losses reflect frequency of event and severity of loss.
• Loan default is random.
• Loan default probabilities are independent.
• Appropriate for large portfolios of small loans.
• Modeled by a Poisson distribution.

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 References
• Saunders, A. & Cornett, M.M. (2017). Credit risk: Individual loan risk
(9th edition), Financial institutions management: A risk management
approach. McGraw-Hill Education.

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