Chapter C11 L1

Management of Financial Institutions
Chapter 11
Credit Risk: Individual Loan

Risk
M. Jahangir Alam Chowdhury

11 -1- 1
Department of Finance, DU
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.
Default risk is the risk of the borrower being unable or

unwilling to fulfill the terms promised under the loan contact.
Credit Quality Problems
Problems with junk bonds, LDC loans, residential and farm

mortgage loans.
More recently, credit card loans and auto loans.

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Types of Loans
C&I loans: secured and unsecured

Fixed rates or floating rates
Spot loans, Loan commitments
Decline in C&I loans originated by commercial banks and

growth in commercial paper market.
RE loans: primarily mortgages

Fixed-rate, Adjustable rate mortgages (ARM)
Mortgages can be subject to default risk when loan-to-

value declines.

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Individual (Consumer) Loan
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.

11 -1- 4
Return on a Loan
Factors that impact the promised return an FI achieve on any

given loan:
interest payments,
fees,
credit risk premium,
collateral, other nonprice terms (compensating balances
and reserve requirements).
Return = inflow/outflow
k = (f + (L + m ))/(1-[b(1-R)])
Where, f = loan originating fee, L = base lending rate, m =

risk premium, b = compensating balance requirement, and
R = reserve requirement.
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The Expected Return on the Loan
E(r) = p(1+k)
Where, p is the probability of repayment of the loan (less than 1).
The FI manager should consider:
(1) Set the risk premium (m) sufficiently high to compensate

for the risk
(2) Setting high risk premium as well as high fees and base
rates may actually reduce the probability of repayment
(p).

11 -1- 6
Relationship between the Promised Loan Rate and the

Expected Return on the Loan

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Retail Vs. Wholesale Credit decisions
Retail:
Most loan decisions made at the retail level tend to be reject

or accept decisions.
All borrower who are accepted are often charged the same
rate of interest and by implication the same risk premium.
FIs control their credit risks by credit rationing

11 -1- 8
Wholesale
At the wholesale level FIs control credit risks through using a

range of interest rates and prices.
FIs use both interest rates and credit quantity to control

credit risk.
Lower risk customers are charged a lending rate below the

prime lending rate. More risky borrowers are charged an
additional markup on prime, or a default risk premium (m),
to compensate the FI for the additional risk involved.
FI may willing to loan funds to lower quality wholesale

borrowers as long as they are compensated by high enough
interest rates

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FI managers need to measure the probability of default to

calibrate the default risk exposure of credit and investment
decisions as well as off-balance-sheet activities of the
financial institution.
The ability to do this largely depends on the amount of

information the FI has about the borrower.
Sources of information
Retail level: (a) internal collection

(b) credit agencies.
Wholesale level, (a) certified accounting statements

(b) stock and bond prices
(c) analysts’ reports
11 -1- 10
The availability of more information, and the lower average

cost of collecting such information, allows FIs to use more
sophisticated and usually more quantitative methods in
assessing default probabilities for large borrowers compared
to small borrowers.
Default Risk Models
Qualitative Models
(a) borrower-specific factors
(b) market-specific factors
Borrower Specific factors
Reputation. The borrower’s reputation involves the

borrowing-lending history of the credit applicant. If over
time, the borrower has established a reputation for prompt
and timely repayment, this enhances the applicant’s
attractiveness to FI.
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Leverage. A borrower’s leverage or capital structure – the

ratio of debt to equity – affects the probability of its default.
This is because large amount of debt, such as bonds and

loans, increase the borrower’s interest charges and pose a
significant claim on its cash flow.
Volatility of Earnings. As with leverage, a highly volatile

earnings stream increases the probability that the borrower
cannot meet fixed interest and principal charges for any
given capital structure.
Collateral. The magnitude and the quality of collateral

increases or decreases the probability of default of a loan.

11 -1- 12
Market Specific Factors
The Business Cycle. The position of the economy in the

business cycle phase is enormously important to an FI in
assessing the probability of borrower default.
The Level of Interest Rates. High interest rates indicate

restrictive monetary policy actions by the Federal Reserve.
FIs not only find funds to finance their lending decisions
scarcer and more expensive but also must recognize that
high interest rates are correlated with higher credit risk in
general.

11 -1- 13
Credit Scoring Models (CSM)

CSM are quantitative models that use observed borrower
characteristics to calculate a score representing the
applicant’s probability of default or to sort borrowers ito
different default risk classes.
Numerically establish which factors are important in
explaining default risk.
Evaluate the relative degree or importance of these
factors.
Improve the pricing of default risk.
Be better able to screen out bad loan applicants.
Be in a better position to calculate any reserves needed
to meet expected future loan losses.

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Linear probability model:

n
PDi = ∑ β j X i , j + error
j =1
Statistically unsound since the Z’s obtained are not

probabilities at all.
The major weakness is that estimated probabilities of

default can often lie outside the interval 0 to 1.
Logit model
Overcome weakness of the linear probability models using a

transformation (logistic function) that restricts the
probabilities to the zero-one interval.

11 -1- 15
1
F (Z ) =
1+ e −z
Where e stands for exponential, F(Z) is the cumulative

probability of default of the loan and Zi is estimated by
regression in a similar fashion to the linear probability model.
Its major weakness is the assumption that the cumulative

probability of default takes on a particular functional form that
reflects a logistic function.
The Probit Model
The probit model also constraints the projected probability of

default to lie between 0 and 1, but differs from the logit model
in assuming that the probability of default has (cumulative)
normal distribution rather than the logistic function.

11 -1- 16
Altman’s Linear Discriminant Model
Discriminant models divide borrowers into high or low default

risk classes contingent on their observed characteristics (Xj).
Z=1.2X1+ 1.4X2 +3.3X3 + 0.6X4 + 1.0X5
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.
Critical value of Z = 1.81.

11 -1- 17
According to Altman’s credit scoring model, any firm with Z

score of less than 1.81 should be placed in the high default
risk region. Thus, the FI should not make a loan to this
borrower until it improves its earnings.
Suppose, that the financial ratios of a potential borrowing

firm took the following values:
X1 =0.2, X2 =0, X3 =-0.20, X4 =0.10, and X5 =2.0
Z = 1.2(0.2) + 1.4(0) + 3.3(-0.20) + 0.6(0.10) + 1.0(2.0)
Z = 1.64,
That means, the FI should not make loan to this borrower.

11 -1- 18
Limitations:
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.
Thank You

11 -1- 19

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Chapter C11 L1

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Management of Financial Institutions

Credit Risk: Individual Loan

M. Jahangir Alam Chowdhury

This chapter discusses types of loans, and the analysis and

Pricing loans and bonds

Default risk is the risk of the borrower being unable or

Problems with junk bonds, LDC loans, residential and farm

M. Jahangir Alam Chowdhury

C&I loans: secured and unsecured

Spot loans, Loan commitments

Decline in C&I loans originated by commercial banks and

RE loans: primarily mortgages

Mortgages can be subject to default risk when loan-to-

M. Jahangir Alam Chowdhury

Individual (Consumer) Loan

Individual (consumer) loans: personal, auto, credit card.

Automobile, mobile home, personal loans

Growth in credit card debt

Risks affected by competitive conditions and usury

M. Jahangir Alam Chowdhury

Factors that impact the promised return an FI achieve on any

Where, f = loan originating fee, L = base lending rate, m =

The Expected Return on the Loan

Where, p is the probability of repayment of the loan (less than 1).

The FI manager should consider:

(1) Set the risk premium (m) sufficiently high to compensate

M. Jahangir Alam Chowdhury

Relationship between the Promised Loan Rate and the

M. Jahangir Alam Chowdhury

Retail Vs. Wholesale Credit decisions

Most loan decisions made at the retail level tend to be reject

FIs control their credit risks by credit rationing

M. Jahangir Alam Chowdhury

At the wholesale level FIs control credit risks through using a

FIs use both interest rates and credit quantity to control

Lower risk customers are charged a lending rate below the

FI may willing to loan funds to lower quality wholesale

M. Jahangir Alam Chowdhury

FI managers need to measure the probability of default to

The ability to do this largely depends on the amount of

Retail level: (a) internal collection

Wholesale level, (a) certified accounting statements

The availability of more information, and the lower average

Default Risk Models

Borrower Specific factors

Reputation. The borrower’s reputation involves the

Leverage. A borrower’s leverage or capital structure – the

This is because large amount of debt, such as bonds and

Volatility of Earnings. As with leverage, a highly volatile

Collateral. The magnitude and the quality of collateral

M. Jahangir Alam Chowdhury

Market Specific Factors

The Business Cycle. The position of the economy in the

The Level of Interest Rates. High interest rates indicate

M. Jahangir Alam Chowdhury

Credit Scoring Models (CSM)

M. Jahangir Alam Chowdhury

Linear probability model:

Statistically unsound since the Z’s obtained are not

The major weakness is that estimated probabilities of

Overcome weakness of the linear probability models using a

M. Jahangir Alam Chowdhury

Where e stands for exponential, F(Z) is the cumulative

Its major weakness is the assumption that the cumulative