Lecture 3

Credit Risk II:

Loan Portfolio and Concentration Risk
 Review of Last Week

• Credit risk of individual loans

• Four main types of loans
𝒇 + 𝑩𝑹 + 𝒎
• Return on loan 𝒌 =
𝟏− 𝒃 𝟏−𝑹𝑹
• Expected return: E(1+r)=p(1+k)
• Models for assessing the credit quality of loans
– Qualitative models
– Credit scoring models: logit model, linear discriminant model
– Term structure based methods
– Mortality rate models
– RAROC models

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 Overview of Today’s Lecture

• Identify issues involved in managing loan portfolios

– Measure credit risk in a loan (asset) portfolio context
– Benefit from portfolio diversification

• Measuring the level of loan concentration.

– Use of loan portfolio models in setting maximum concentration
limits for certain industry

• Modern portfolio theory (MPT)

– Application of MPT to KMV approach

• Other methods based on partial application of MPT

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Credit Risk in China’s Banking Sector

4
 Where Do Chinese Banks Lend?

"

[ performing
bans

http://thecorner.eu/world-economy/china-private-banks-versus-state-sector-where-do-banks-lend/49537/

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 Characteristics of Credit Risk in Chinese Bank

• Concentrated credit risk in State-owned Banks

• Concentrated credit risk in certain industry

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 Hong Kong Banks

Source from HKMA: https://www.hkma.gov.hk/eng/data-publications-and-research/data-and-statistics/monthly-statistical-bulletin/ 7

 Portfolio
• How much to invest in each category

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 Models of Loan Concentration Risk
in 1 basket
don't put all
eggs
• Too much concentration: risky

• Two simple models to manage credit risk concentration in the

loan portfolio
1. Migration analysis
2. Concentration limit

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 Loan Concentration Risk Model 1:
Migration Analysis

1. Migration analysis:
• How credit risk changes over time for different loan sectors

• Loan migration matrix (or transition matrix): reflect the historic

experience of a pool of loans in terms of their credit rating
migration over time.

• Measure loan concentration risk by tracking credit ratings of

firms in particular sectors or ratings class for unusual declines.

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 Loan Concentration Risk Model 1:
Migration Analysis

– Step 1: Sort loans into different groups based on initial credit

risk levels (eg: by credit ratings)
– Step 2: Calculate the proportions of loans in each (beginning-of-
year) group at various credit risk levels at the end of year.
– Step 3: Compare the actual credit deterioration with the
historical numbers.

Decision rule:
– If the credit quality of a sector declines faster than historical experience, then
curtail lending to that sector or loan class.
– If the credit quality of a sector improves faster than historical experience, then
increase lending to that sector or loan class.

= 100% 11
 Loan Concentration Risk Model 2:
Concentration Limits

2. Concentration Limits
• Set limits on the maximum loan size to individual
borrowers or sectors.
• Used to reduce exposures to certain industries or
geographical areas.

• Calculating Concentration Limits for a Loan Portfolio:

Maximum loss = concentration limit*loss rate
→
1
Concentrat ion limit = Maximum loss as a percentage of capital
Loss rate

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 Calculation of Concentration Limits
Indicator to see if it's too
risky
Example: Calculating Concentration Limits for a Loan Portfolio
Question
Suppose management is unwilling to permit losses exceeding 10% of
an FI’s capital to a particular sector. If management estimates that the
amount lost per dollar of defaulted loans in this sector is 40 cents, the
maximum loans to a single sector as a percent of capital, defined as
the concentration limit, is:
lost $0.40
for each $1 invested , you
Answer: I
Concentration Limit =Maximum loss / Loss Rate
=10% * 1/0.4
=25%

What would the concentration limit be if the maximum loss (as a

percent of capital) is 15% instead of 10%? 15% 5%
= 37 .

0.4 13
 Modern Portfolio Theory
Expected Return and Risk of a Portfolio
e.
g
3 assets in a
portfolio

• Expected return (Rp) on a portfolio of assets: variance = w ? Oi wioitwjoj-2w.hr

+
,
0,02

_ n _
Rp = Wi R i
i =1

Ri = expected returns of each asset in the portfolio

Wi = the proportion of the portfolio invested in the ith asset
• Variance of returns or risk of the portfolio (σ2p):
𝜎𝑝2 = σ𝑛𝑖=1 𝑊𝑖 2 𝜎𝑖 2 + σ𝑛𝑖=1 σ𝑛𝑗=1,𝑗≠𝑖 𝑊𝑖 𝑊𝑗 ρij𝜎𝑖 𝜎𝑗
• Or 𝜎𝑝2 = σ𝑛𝑖=1 𝑊𝑖 2 𝜎𝑖 2 + 2 σ𝑛𝑖=1 σ𝑛𝑗=1,𝑗>𝑖 𝑊𝑖 𝑊𝑗 ρij𝜎𝑖 𝜎𝑗 ← recommended

σ2i = the variance of returns on the i-th asset

ρij = the correlation between the returns on the i-th and j-th asset
ρij σi σj = the covariance of returns between the i-th and j-th asset

Key point: we can diversify considerable amounts of credit risk as long

as the returns on different assets are imperfectly correlated (ρij <1).
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 Example: Expected Return and Risk of a Portfolio

Suppose that an FI holds two loans with the above characteristics

The return on the loan portfolio is:
𝑹𝒑 = 0.4(10%)+0.6(12%) =11.2%

The risk of the portfolio is:

𝜎𝑝2 = 0.42 ∗ 0.007344 + 0.62 ∗ 0.009694 + 2(.4)(.6)(−.84)(.0857)(.0980)
= 0.0012462
𝝈𝒑 = .0353 = 3.53%

• Question: why the risk of the portfolio (3.53%) is less than the risk of either
individual asset (9.8% and 8.57 %, respectively)?
concentrated correlation is < I
Less ,

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 Modern Portfolio Theory
Optimal portfolio allocation

• View a bank holding a portfolio of loans as an investor

• Objective: choose an optimal allocation (weights) for loans such that

– Maximize the return of the loan portfolio
– At the same time, minimize the risk (volatility of return) of the loan
portfolio

• Required inputs for optimization

– Expected return on a loan to borrower i (Ri)
– Risk of a loan to borrower i (σi)
– Correlation between returns of loans made to borrowers i and j (ρij)

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 Modern Portfolio Theory
Optimal portfolio allocation
• Investor preference:
– High return
– Low risk

• The fundamental question for an investor:

– How to optimally allocate funds to different assets, which gives her the
lowest risk (i.e., volatility), for a targeted expected return

• The optimization problems:

Minimize portfolio risk
σ𝑛𝑖=1 𝑊𝑖 2 𝜎𝑖 2 + σ𝑛𝑖=1 σ𝑛𝑗=1,𝑗≠𝑖 𝑊𝑖 𝑊𝑗 ρij𝜎𝑖 𝜎𝑗
subject to the constraint of achieving target portfolio return
n _ _
Wi R i = R p
i =1

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 Efficient Frontier
• A modern portfolio theory tool that shows investors the best
possible return they can expect from their portfolio, given the
level of risk that they’re willing to accept.

• Every possible combination of assets that exists can be plotted

on a graph, with the portfolio's risk on the X-axis and the
expected return on the Y-axis.

• The efficient frontier reveals the most desirable portfolios.

• Portfolios that lie below the efficient frontier are sub-optimal

because they do not provide enough return for the level of
risk.

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 Portfolio Diversification
We have three portfolios in the graph
• A: an undiversified portfolio
• B: efficient portfolio with return 𝑅𝑝 , mininum risk
portfolio
• C: on the efficient frontier

risk -1 return
can take higher
can
be

retirees
f

)
.
: . .

ii.
|÷
return
•

get higher
-
.
' for same risk
. .
.
. ,

i.
.

notas
.

desirable

19
 Question Time
• Why would an FI not always choose to operate with a
minimum risk portfolio?
• Should we just choose portfolio B always?
No ,
depends on risk appetite

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 Modern Portfolio Theory
Conclusions & Implications
• Market portfolio of risky assets is the optimal portfolio of risky assets
for anyone
– Most diversified portfolio
– Diversify away any idiosyncratic risk

• CAPM (Capital Asset Pricing Model)

– The risk of an individual asset is determined by its systematic risk
as measured by beta (how it co-moves with market)
– The idiosyncratic risk (not correlated with market movement) is
irrelevant or not compensated by higher expected returns

Ri = Rf + 𝛽i * (Rm - Rf)
where 𝛽i = Covariance(Ri, Rm)/Variance(Rm)

Efficient Portfolio
CAMP
Frontier
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 KMV Portfolio Manager Model

• AIS is the all-in-spread, calculated as the difference between contractually

promised return minus the funding cost

• LGD is the loss if the client defaults (Loss Given Default), calculated as the
contractually promised return multiplying by the (1 – recovery rate)

• EDF is the probability of default, termed as expected default frequency by

KMV

• Expected loss of the loan i: E(Li) = EDFi * LGDi

• Expected return on a loan i:

Ri =AISi + fees - E(Li) = AISi + fees - EDFi * LGDi

• Risk of a loan to borrower i (𝜎𝑖 )

i = EDFi (1 − EDFi ) LGD i
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 Two-Asset Portfolio Using KMV Model
• Calculation of Return and Risk on a Two-Asset Portfolio Using KMV
Portfolio Manager

• Example: Suppose that an FI holds two loans with the following

characteristics: 5%+2%-3%11256

Loan Weight Spread Fee LGD EDF Return Risk

1 0.60 5.0% 2.0% 25.0% 3.0% ? ?
2 0.40 4.5% 1.5% 20.0% 2.0% ? ?
Correlation = -0.25

The return and risk of the portfolio are then:

Return(p)= ?
Risk(p)= ?

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 Two-Asset Portfolio Using KMV Model
• Calculation of Return and Risk on a Two-Asset Portfolio Using KMV
Portfolio Manager
• Suppose that an FI holds two loans with the following characteristics:
Loan Weight Spread Fee LGD PD Return Risk
1 0.60 5.0% 2.0% 25.0% 3.0% 6.25% 4.26%
2 0.40 4.5% 1.5% 20.0% 2.0% 5.60% 2.80%
Correlation = -0.25

The return and risk of the portfolio are then:

Return(p)= ?
Risk(p)= ?

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 Two-Asset Portfolio Using KMV Model
• Calculation of Return and Risk on a Two-Asset Portfolio Using KMV
Portfolio Manager
• Suppose that an FI holds two loans with the following
characteristics:
Loan Weight Spread Fee LGD PD Return Risk
1 0.60 5.0% 2.0% 25.0% 3.0% 6.25% 4.26%
2 0.40 4.5% 1.5% 20.0% 2.0% 5.60% 2.80%
Correlation = -0.25

The return and risk of the portfolio are then:

Return(p)= 5.99%
Risk(p)= 2.52%

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 Partial Applications of Portfolio Theory
Loan Volume Based Models
• Based on the implication from MPT that market portfolio is the
optimal one because of maximum diversification
– Compare the asset allocation in the loan portfolios to the market
benchmarks
– Deviations from the market portfolio benchmark indicate the relative
degree of loan concentration.

N
(W − Wi )
2
ij
j = i =1
• For each bank j, we have N
• σj = deviation of bank j’s asset allocation proportions from the
national benchmark
• Wij = asset allocation proportions of bank j
• Wi = national asset allocation to loan category i (market benchmark)
• N = total number of loan categories

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 Partial Applications of Portfolio Theory
Loan Volume Based Models
• National composition of a loan portfolio represents a more diversified market
portfolio, as it aggregates across all banks, the asset proportions derived nationally
are likely to be closer to the most efficient portfolio composition than that of the
individual bank.
• How to get market benchmark against which an individual FI can compare
its own internal allocations of loans
– Commercial bank call reports
– Data on shared national credits
– Commercial databases
• Example: Allocation of the Loan Portfolio to Different Sectors

Category Benchmark Bank A Bank B (XAj-XA)^2 (XBj-XB)^2

1 Real estate 45% 65% 10% ? ?
2 C&I 30% 20% 25% ? ?
3 Individuals 15% 10% 55% ? ?
4 Others 10% 5% 10% ? ?
Sum 100% 100% 100% ? ?
Loan allocation deviation ? ?
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 Partial Applications of Portfolio Theory
Loan Volume Based Models
• Step 1: calculate (Xj-X)^2 for each category j for each
bank A and B

N
(W
ij − Wi )
2

j = i =1

Category Benchmark Bank A Bank B (XAj-XA)^2 (XBj-XB)^2

1 Real estate 45% 65% 10% 0.0400 0.1225
2 C&I 30% 20% 25% 0.0100 0.0025
3 Individuals 15% 10% 55% 0.0025 0.1600
4 Others 10% 5% 10% 0.0025 0.0000
Sum 100% 100% 100% 0.0550 0.2850
Loan allocation deviation ? ?

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 Partial Applications of Portfolio Theory
Loan Volume Based Models

• Step 2: calculate deviation from the benchmark

N
(W
ij − Wi )
2

j = i =1

Category Benchmark Bank A Bank B (XAj-XA)^2 (XBj-XB)^2

1 Real estate 45% 65% 10% 0.0400 0.1225
2 C&I 30% 20% 25% 0.0100 0.0025
3 Individuals 15% 10% 55% 0.0025 0.1600
4 Others 10% 5% 10% 0.0025 0.0000
Sum 100% 100% 100% 0.0550 0.2850
Loan allocation deviation 11.73% 26.69%

Implication: Bank B deviates more significantly from the benchmark than bank
A because of its heavy concentration on loans to individuals.

Question: is it always bad?

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 Partial Applications of Portfolio Theory
Loan Loss Ratio Based Models

• Based on historic loan loss ratios

• Estimate the systematic loan loss risk of a sector by regressing
the historical loan loss ratio of the sector 𝑖 on the loan loss
ratio of the total loan portfolio
Sectoral losses in the i−th sector Total loan losses
= α + βi
Loans to the i−th sector Total loans

• α = loan loss rate for a sector with no sensitivity to losses on the

aggregate portfolio, (i.e., its beta=0)
• βi = systematic loss sensitivity of the ith sector loans to total loans.
• The higher the beta is, the higher the correlation of a sector to the
total loan portfolio
• → The lower the diversification benefits by having this sector in the
total loan portfolio.

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 Loan Loss Ratio Based Models
Example
Using regression analysis on these historical loan losses, a finance
company has estimated the following:
𝑋𝑟𝑒𝑎𝑙 𝑒𝑠𝑡𝑎𝑡𝑒 = 0.003 + 0.75𝑋𝐿
𝑋𝐶𝑜𝑚𝑚𝑒𝑟𝑖𝑐𝑎𝑙 = 0.005 + 1.25𝑋𝐿
𝑋𝑟𝑒𝑎𝑙 𝑒𝑠𝑡𝑎𝑡𝑒 : the loss rate in the real estate loan sector
𝑋𝑐𝑜𝑚𝑚𝑒𝑟𝑐𝑖𝑎𝑙 : the loss rate in the commercial loan sector
𝑋𝐿 : the loss rate for the finance company’s loan portfolio

If the finance company’s total loan loss rate is 15%,

the expected loss rate in the real estate loan sector will be ?
the expected loss rate in the commercial loan sector will be ?

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 Loan Loss Ratio Based Models
Example
Using regression analysis on these historical loan losses, a finance company
has estimated the following:
𝑋𝑟𝑒𝑎𝑙 𝑒𝑠𝑡𝑎𝑡𝑒 = 0.003 + 0.75𝑋𝐿
𝑋𝐶𝑜𝑚𝑚𝑒𝑟𝑖𝑐𝑎𝑙 = 0.005 + 1.25𝑋𝐿
𝑋𝑟𝑒𝑎𝑙 𝑒𝑠𝑡𝑎𝑡𝑒 : the loss rate in the real estate loan sector
𝑋𝑐𝑜𝑚𝑚𝑒𝑟𝑐𝑖𝑎𝑙 : the loss rate in the commercial loan sector
𝑋𝐿 : the loss rate for the finance company’s loan portfolio

If the finance company’s total loan loss rate is 15%, the expected loss rate in
the real estate loan sector will be:
→ 𝑋𝑟𝑒𝑎𝑙 𝑒𝑠𝑡𝑎𝑡𝑒 = 0.003 + 0.75 ∗ 0.15 = 11.55%
→ 𝑋𝐶𝑜𝑚𝑚𝑒𝑟𝑖𝑐𝑎𝑙 = 0.005 + 1.25 ∗ 0.15=19.25%

Implication: To protect against this increase in losses, the finance

company should consider reducing its concentration of commercial loans.

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 Summary
• Two simple models to measure concentration risk
– Migration analysis: rely on rating changes to provide
information on desirable and undesirable loan concentrations
– Concentration limits
• Modern Portfolio Theory
• KMV Portfolio Manager model
• Partial Applications of MPT to determine loan
concentrations
– Loan volume based models
– Loan loss ratio in different sectors or categories

• Reference: textbook Chapter 12

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