Lecture 2

Credit Risk I: Individual Loan Risk

 Review of Last Lecture

• Unique role of financial Institutions

• Credit allocation and Asset transformation

– Efficiently transform household savings into various loans

• FIs need to be cautious with the credit risk of borrowers

– Charge interests and fees to cover the cost of funding from
household savers and the credit risk involved in lending

• Outstanding questions:
– How do FIs choose who to lend to?
– How much to lend?
– How do FIs analyse and measure the credit risk or default risk
on individual loans?
2
 Overview of This Lecture

• Types of loans issued by FIs

– Commercial and industrial loans, real estate, individual,
consumer, and others

• Loan pricing and the expected return from loans

– How interest and fees are incorporated to calculate the return on
a loan
– How do banks decide on the return and amount of a loan

• Models for assessing the credit quality of loans

– Qualitative models, credit scoring models, newer models of
credit risk measurement

3
 Nonperforming Asset Ratio for U.S.
Commercial Banks till GFC

Source: Federal Reserve Bank of St. Louis, Monetary Trends, April 1998; and Federal Deposit Insurance Corporation, Quarterly Banking Profile,
various issues. 4
 Non-performing Loans & COVID-19
• An overall growth of +9% in total loan volumes in US
– Largely due to drawdowns of commercial credit lines.
• Provisions for loan losses increased by +59%

Read this article for more details 5

Hong Kong Non-performing loans

6
 Simple Exercise
• FDIC (Federal Deposit Insurance Corporation)
• Go to this website
https://fred.stlouisfed.org/series/USNP to get the most
recent non-performing loan data for U.S. commercial
banks
• Have fun exploring!

7
 Deposit Insurance in HK

• Hong Kong Deposit Protection Board: oversee the

operation of the Deposit Protection Scheme (DPS).
• The DPS protects your deposits placed with Scheme
members and the protection is statutory.
• The maximum protection is up to HK$500,000
• Eligible deposits are protected by the DPS automatically.

8
 Types of Loans

1) Commercial and industrial loans

2) Real estate loans: E.g., mortgages

3) Individual (consumer) loans, E.g.: personal or auto

loans, etc

4) Other loans, E.g.: government loans, farm loans, etc

9
 Types of Loans
• Breakdown of Loan Portfolios held by U.S. commercial
banks

Source: Federal Reserve Board, Assets and Liabilities of Commercial Banks, September 2006. www.federalreserve.gov

10
 Commercial and Industrial Loans
• Short-term or long-term
– Short-term loans: <= 1 year, to finance working capital needs and other short-
term funding needs
– Long-term loans: > 1 year, to finance the purchase of real assets, new venture
a group
of banks \
start-up costs, etc.
• Syndicated loans:
– Financing provided by a group of lenders, usually to finance large C&I loans,
normally in millions of dollars
• 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)
– Spot loan: the borrower takes down the entire loan amount immediately
– Loan commitment: Can take down anytime any amount, as long as within
a maximum loan amount and a maximum period of time predetermined.
• Commercial paper
– Unsecured short-term debt instruments
– Large corporations with good credit rating

11
 Characteristics of Commercial Loan Portfolios
interbank
overnight
loans

• More short-term (<=1year) than long-term loans

• Most short-term loans are more likely to be made under loan
commitment than long-term loans
• Short-term loans are less likely to be backed or secured by
collateral

Source: Federal Reserve Board Web site, September 2006. www.federalreserve.gov

12
 Calculating the Gross Return on a Loan
• Factors affecting the promised loan return:
– Loan interest rate = base lending rate or prime rate
(BR) + credit risk premium (m) risky borrowers hail higher
m

– Direct fees, e.g, loan origination fee (f) hiring / handling fees
– Indirect fees, for example, compensating balance
requirements (b), reserve requirement (RR).
• A compensating balance is a minimum deposit that must be
maintained in a bank account by a borrower.
– Other non-price terms, such as collateral

• Bank’s return on loan (k) per dollar lent:

𝒇𝒇 + 𝑩𝑩𝑩𝑩 + 𝒎𝒎
𝒌𝒌 =
𝟏𝟏− 𝒃𝒃 𝟏𝟏−𝑩𝑩𝑩𝑩

13
 Credit Risk and the Expected Return on a Loan

• Expected gross return:

E(1+r) = 1+E(r) = p(1+k).
with 1-p: probability of default.
• 0<p < 1, as default risk normally exists
subtract 1 from both sides
I
• E(r)= p(1+k)-1

• How to limit credit risk: KT ,

MT
– Set risk premium (m) sufficiently high, so that k is higher: compensation
– Limit the loan amount exposure to risky borrowers (credit rationing)
attract
g. risky borrowers

• Note: increasing k by setting high risk premiums (m) as well as high

fees (f) and base rates (BR) may actually reduce the probability of
repayment (p).
– i.e. there may exist negative relationship between k and p.

14
 Credit Risk and the Expected Return on a Loan
• k and p are not independent !
• Over some range, as return (k) increase, the probability (p) that the
borrower pays the promised return may decrease (i.e., k and p may be
negatively related).
The borrowers that pay higher loan are risker!
• Simply increasing k does not lead to higher return r.
FIs usually have to control for credit risk along two dimensions:
1) The price or promised return dimension (1 + k )
2) The quantity or credit availability dimension

High k higher E(r)

15
 Credit Risk and the Expected Return on a Loan
• k and p are not independent !
• Over some range, as return (k) increase, the probability (p) that the
borrower pays the promised return may decrease (i.e., k and p may be
negatively related).
The borrowers that pay higher loan are risker!
• Simply increasing k does not lead to higher return r.
FIs usually have to control for credit risk along two dimensions:
1) The price or promised return dimension (1 + k )
2) The quantity or credit availability dimension

High k lower E(r)

due to negative relationship
between k and p

16
Credit Risk Control for Retail versus Wholesale Loans

• Retail loans
– Loan size is usually quite small
– Cost of collection of borrower’s personal credit information is high
Set standard loan rate for every borrower
– How to control credit risk: through credit rationing - limit the total
exposure (amount loaned)

• Wholesale loans: control credit risk via two channels

1) Different interest rates to compensate for different levels of
risks
2) Credit rationing to limit credit exposure

17
 Question Time

• Is it more costly for an FI manager to assess the default

risk exposure of a publicly traded company or a
small, single-proprietor firm?

18
 Measuring Credit Risk

• Qualitative credit risk models

• Credit scoring models

• Newer models:
– Term structure based methods
– Mortality rate models
– RAROC models

19
 Qualitative Credit Risk Models
• Borrower-specific factors:
– Reputation: repayment history, implicit contract
– Leverage (debt/total assets)
– Volatility of earnings
– Collateral: assets backing the loan

• Market-specific factors:
– Business cycle: eg: necessity goods vs luxurious good producers
– Level of interest rates: High interest rates indicate restrictive
monetary policy actions, correlated with higher credit risk in general.

20
 Credit Scoring Models

• Establish factors that help to explain default risk

• Evaluate the relative importance of these factors

• Major types of credit scoring models:

– Linear probability model
– Logit model
– Linear discriminant models

21
 Credit Scoring Models
1) Linear probability model
n
Zi = ∑ β j X i , j + error
j =1

– Z=1 if default, =0 otherwise.

– Weakness: the estimated default probability Z may lie
outside of [0,1]
– Since superior statistical techniques are readily
available, little justification for employing linear
probability model.

2) Logit model
- Overcomes weakness of the linear probability model
using a transformation (logistic function) that restricts
the probabilities to the [0,1] interval.
Pi = exp( Z i ) /(exp( Z i ) + 1) Z=log(p/1-p)
22
 Credit Scoring Models

3) Linear Discriminant Models

• Altman’s Z score model for manufacturing firms
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 values suggested by Altman

– 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
15-23
 Credit Scoring Models
Linear Discriminant Models
• Weaknesses:
– Ignore hard-to-quantify factors such as borrower reputation,
etc
– 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
– 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 vs bad
borrowers.

15-24
 Term Structure Models
• Derivation of credit risk:
– If we know the spread on the loan (i.e., risk premium), we can
infer the probability of default.

• Under the market equilibrium, expected return of a

risky loan should equal to risk-free rate after accounting
for probability of default (1-p).
1- 0.05
p
=

0,95
p: probability of repayment
=
p
•
• k: return on the corporate debt 0.95-(11-0.5) 0.425
It i =

i
=

• i: expected return on the risk-free treasury security

• Assuming a zero default recovery rate
p (1+ k) = 1+ i
25
 Extract Prob(Default) from Term Structure
Question: what is the default probability for a one-year corporate bond?
• i =10% expected return on the risk-free treasury bond
• k =15.8% expected return on the risky corporate debt
p (1+ k) = 1+ i
𝟏𝟏+𝒊𝒊
𝒑𝒑 = =1.1/1.158=0.95 , so Prob(default) = 1-p=0.05
𝟏𝟏+𝒌𝒌
Note: 5% default probability leads to risk premium 𝜱𝜱 = 𝒌𝒌 − 𝒊𝒊 = 𝟓𝟓. 𝟖𝟖𝟖

Corporate and Treasury Bond Yield Curve 26

 The More Realistic Case
• What if we can recover partially even if default occurs?
– Realistically, the FI lender can expect to receive some partial
repayment even if the borrower goes into bankruptcy.

• Altman and Bana (2004) estimated that when firms defaulted

on their bonds in 2002, the investor lost on average 74.7 cents
on the dollar (i.e., recovered around 25.3 cents on the dollar).

• γ: recovery rate when default occurs

• (𝟏𝟏 − 𝒑𝒑) 𝜸𝜸(𝟏𝟏 + 𝒌𝒌) : payoff to FI when default occurs.
• [𝒑𝒑(𝟏𝟏 + 𝒌𝒌)]: payoff when no default

[(𝟏𝟏 − 𝒑𝒑) 𝜸𝜸(𝟏𝟏 + 𝒌𝒌)] + [𝒑𝒑(𝟏𝟏 + 𝒌𝒌)] = 𝟏𝟏 + 𝒊𝒊

We can calculate p given γ, k and i

27
 Recovery Rates by Type of Debt

• Recovery Rates on Defaulted Debt, 1988–2004

• Source: E. I. Altman, “The Link between Default and Recovery Rates,” Working Paper, New York
University Salomon Center, May 2006.

28
 Cumulative Prob(Default) on a Multi-Period Debt

• The probability that a bond will default in any given year t is the
marginal default probability for that year.
• It is conditional on the fact that the default has not occurred earlier.
• 1 − 𝒑𝒑𝒕𝒕 : Marginal probability of default in period 𝑡𝑡
• E.g.: a 2-period bond
– Default probability in period 1: 1 − 𝑝𝑝1
– Marginal default probability in period 2: 1 − 𝑝𝑝2
Cumulative Probability of default over two periods
𝑪𝑪𝒑𝒑 = 𝟏𝟏 – 𝒑𝒑𝟏𝟏 ∗ 𝒑𝒑𝟐𝟐
• We can extract from these yield curves the market’s expectation of the multi-
period default rates for corporate borrowers
𝟏𝟏 + 𝒊𝒊𝟐𝟐 𝟐𝟐 = 𝟏𝟏 + 𝒊𝒊𝟏𝟏 𝟏𝟏 + 𝒇𝒇𝟏𝟏 𝒇𝒇𝟏𝟏
𝟏𝟏 + 𝒌𝒌𝟐𝟐 𝟐𝟐 = 𝟏𝟏 + 𝒌𝒌𝟏𝟏 𝟏𝟏 + 𝒄𝒄𝟏𝟏 𝒄𝒄𝟏𝟏
𝒑𝒑𝟐𝟐 𝟏𝟏 + 𝒄𝒄𝟏𝟏 = 𝟏𝟏 + 𝒇𝒇𝟏𝟏
𝒑𝒑𝟐𝟐 =(𝟏𝟏 + 𝒇𝒇𝟏𝟏 )/ 𝟏𝟏 + 𝒄𝒄𝟏𝟏
29
 Example

• Given the required yields on one- and two-year Treasuries: 𝑖𝑖1=10%, 𝑖𝑖2 =11%
𝟏𝟏+𝒊𝒊𝟐𝟐 𝟐𝟐 𝟏𝟏.𝟏𝟏𝟏𝟏 𝟐𝟐
one-year forward rate on risk-free T-bond: f1= − 𝟏𝟏 = − 𝟏𝟏 = 𝟏𝟏𝟐𝟐𝟖
𝟏𝟏+𝒊𝒊𝟏𝟏 𝟏𝟏.𝟏𝟏𝟏𝟏

• Given the required yields on one- and two-year Treasuries: 𝑘𝑘1 =15.8%, 𝑘𝑘2 =18%
𝟏𝟏+𝒌𝒌𝟐𝟐 𝟐𝟐 𝟏𝟏.𝟏𝟏𝟖𝟖 𝟐𝟐
one-year forward rate on corporate bond: 𝒄𝒄𝟏𝟏 = − 𝟏𝟏 = − 𝟏𝟏 = 𝟐𝟐𝟏𝟏. 𝟐𝟐𝟖
𝟏𝟏+𝒌𝒌𝟏𝟏 𝟏𝟏.𝟏𝟏𝟓𝟓𝟖𝟖

𝒑𝒑𝟐𝟐 𝟏𝟏 + 𝒄𝒄𝟏𝟏 =(𝟏𝟏 + 𝒇𝒇𝟏𝟏 ) 𝒑𝒑𝟐𝟐 =0.9318

the expected probability of default in year 2: 1- 𝒑𝒑𝟐𝟐 =6.82𝟖 30
 Marginal Mortality Rate (MMR)
• Forward-looking: extract expected default rates from the
current term structure of interest rates,
• Backward looking: analyse the historic or past default risk
experience, the mortality rates, of bonds and loans of a
similar quality

• P1: no-default probability in year 1,

– MMR1=1-p1

• P2: the probability of the loan surviving in the second year

given that default has not occurred during the first year, i.e.,
p2= Prob(no default in year 2|survive year 1)
– MMR2=1-p2

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑣𝑣𝑇𝑇𝑇𝑇𝑣𝑣𝑣𝑣 𝑇𝑇𝑜𝑜 𝑏𝑏𝑇𝑇𝑏𝑏𝑏𝑏𝑏𝑏 𝑏𝑏𝑣𝑣𝑜𝑜𝑇𝑇𝑣𝑣𝑇𝑇𝑇𝑇𝑏𝑏 𝑖𝑖𝑏𝑏 𝑦𝑦𝑣𝑣𝑇𝑇𝑦𝑦 𝑇𝑇

• MMRt = 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑣𝑣𝑇𝑇𝑇𝑇𝑣𝑣𝑣𝑣 𝑇𝑇𝑜𝑜 𝑏𝑏𝑇𝑇𝑏𝑏𝑏𝑏𝑏𝑏 𝑇𝑇𝑣𝑣𝑇𝑇𝑏𝑏𝑇𝑇𝑇𝑇𝑏𝑏𝑏𝑏𝑖𝑖𝑏𝑏𝑜𝑜 𝑇𝑇𝑇𝑇 𝑇𝑇𝑡𝑣𝑣 𝑏𝑏𝑣𝑣𝑜𝑜𝑖𝑖𝑏𝑏𝑏𝑏𝑖𝑖𝑏𝑏𝑜𝑜 𝑇𝑇𝑜𝑜 𝑦𝑦𝑣𝑣𝑇𝑇𝑦𝑦 𝑇𝑇

31
 Cumulative Mortality Rate (CMR)
• Cumulative Mortality Rate is just the cumulative
probability of default.
1-CMR2 = (1-MMR1)*(1-MMR2)
• Weakness of MMR method:
– Backward-looking, based on historic data
– Highly sensitive to the period over which the FI manager
calculates the MMRs.

1-CMR2

1-MMR1 1-MMR2

T0 T1 T2

32
 Mortality Rates of Corporate Bonds by Rating

Source: Altman and Bana (2003)

The CMR over 3 years for CCC-rated corporate bonds is 33.17 percent.
CMR , =
I -

(I -
MMR , ) (I -

MMR , )( 1- MMR,)

= t -
Ll -

6.7% ) ( I -14.57%111-16.16%1
33
 RAROC Models

• Essential idea: modified ROA concept which balances

expected interest income against expected loan risk.

• Loan approval if RAROC > benchmark return on capital,

for example, Return on Equity (ROE).

• Risk-adjusted return on capital

𝑇𝑇𝑏𝑏𝑣𝑣 𝑦𝑦𝑣𝑣𝑇𝑇𝑦𝑦 𝑏𝑏𝑣𝑣𝑇𝑇 𝑖𝑖𝑏𝑏𝑖𝑖𝑇𝑇𝑖𝑖𝑣𝑣 𝑇𝑇𝑏𝑏 𝑇𝑇 𝑇𝑇𝑇𝑇𝑇𝑇𝑏𝑏
RAROC =
𝐿𝐿𝑇𝑇𝑇𝑇𝑏𝑏 (𝑇𝑇𝑏𝑏𝑏𝑏𝑣𝑣𝑇𝑇) 𝑦𝑦𝑖𝑖𝑏𝑏𝑟𝑟 𝑇𝑇𝑦𝑦 𝑖𝑖𝑇𝑇𝑐𝑐𝑖𝑖𝑇𝑇𝑇𝑇𝑇𝑇 𝑇𝑇𝑇𝑇 𝑦𝑦𝑖𝑖𝑏𝑏𝑟𝑟
– Numerator:
𝑜𝑜𝑛𝑛𝑒𝑒 𝑦𝑦𝑒𝑒𝑎𝑎𝑟𝑟 𝑛𝑛𝑒𝑒𝑡𝑡 𝑖𝑖𝑛𝑛𝑐𝑐𝑜𝑜𝑚𝑚𝑒𝑒 𝑜𝑜𝑛𝑛 𝑎𝑎 𝑙𝑙𝑜𝑜𝑎𝑎𝑛𝑛 =(spread + fees)*Dollar value of loans outstanding
– Denominator: two methods of estimation
1) Use duration to estimate loan risk
2) Use loan default rate to estimate loan risk

34
 RAROC
Method 1: Use Duration to Estimate Loan Risk

• Loan risk: The percentage change in market value of a loan (∆LN / LN )

– Related to the duration of the loan and the interest rate shock (∆R /(1 + R ))
• ∆LN/LN = - Duration * [∆R / (1+R)]

• Capital at risk: the potential loan loss under adverse credit scenarios

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

such as 95 or 99 percentile value of the distribution

35
 RAROC Example
Suppose we want to evaluate the credit risk of a $1 million loan with a
duration of 2.7 years to a AAA borrower.
The current risk premium on AAA bonds is 10%.
Increase in risk premium under adverse credit scenarios is 1.1%.
Spread is 0.2% and fee is 0.1% of the loan amount.

Step1: The estimate of loan (or capital) risk

∆LN = - Duration * LN*[∆R / (1+R)]
= -2.7*$1 million*(0.011/1.1) = - $27,000

Step2:
Suppose the projected (one-year) spread plus fees is
Spread = 0.2%*$1 million = $2,000;
Fees = 0.1%*$1 million = $1,000
The loan’s income (spread over the FI’s cost of funds plus fees on the
loan) = $3,000

RAROA = one year net income on the loan/loan risk

= 3,000/27,000 = 11.1%
36
 RAROC
Method 2: Use Loan Default Rates to Estimate Loan Risk

• A different way of calculating ∆𝐿𝐿𝐿𝐿

• Estimate loan loss risk from loan portfolios
• Usually the largest FIs with very good loan default
databases
• Unexpected default rate is the default rate under adverse
credit scenarios from historical distributions.

Net income per dollar loaned

RAROC=
Unexpected default rate∗Loss given default

37
 Example
• Suppose expected income per dollar lent is 0.3 cents.
• The 99th percentile historic (extreme case) default rate
for borrowers of this type is 4%.
• The dollar proportion of loans of this type that cannot be
recaptured is 80 percent.
i.e., Given Unexpected default rate = 4%
LGD = 80%

Net income per dollar loaned

𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
Unexpected default rate∗Loss given default
0.003
= = 9.375𝟖
4𝟖∗80𝟖

38
 Summary

• Types of loans issued by FIs

• Loan pricing and the expected return from loans
– Calculate the return on a loan.
– Return on a loan and the quantity of credit
• Qualitative models
• Credit scoring models, and newer models of credit risk
measurement

• Reference: Textbook Chapter 11

39