Credit Risk

§ Types of Loans

§ Return on Loans

§ Models of Credit Risk measurement

年年年年年年

全全全全全全全全全全
35,000,000

30,000,000
年年年年
25,000,000
年年年年年
20,000,000 年年年年
年年年年
15,000,000
年年
10,000,000

5,000,000

--
81 年 83 年 85 年 87 年 89 年 91 年
年年年年年年年年年年年
單位：百萬元
全體金融機構負債類別 央行發行之國
庫券、定存單
35000000
金融債券
30000000
人壽保險準備
25000000
信託資金
20000000
政府存款
15000000
企業及個人存
10000000 款
通貨發行額
5000000
國外資產
0
81年 83年 85年 87年 89年 91年 資料來源：金融統計月報
 年年年
全全全全全全全全全全全
% 年年年
7.00
年年年
6.00 年年年
年年
5.00 年年年
年年年
4.00
年年年
3.00 年年
2.00 年年年
1.00 年年年

0.00 年年年
86 87 88 89 90 91 92 年年年
年年年年年年年年年年年
年年年年年年

16,000,000
全全全全全全全全
14,000,000

12,000,000

10,000,000 年年年年年年
8,000,000 年年年
年年年
6,000,000
年年年年
4,000,000
年年年年年年
2,000,000 年年年年
--
81 82 83 84 85 86 87 88 89 90 91 92
年年年年年年年年年年年
 全全全全全
45.00%

40.00% 全全全全

35.00%
全全全全全
30.00% 全全
全全全全全
25.00% 全全

20.00% 全全全全全
全全
15.00% 全全全全

10.00%

5.00%

0.00%
84年 86年 88年 90年 92年(年8年)
年年年年年年年年年年年
 金融機構逾放比例

年年年年年年
18.00
全全全全
17.00 全全
16.00
15.00
全全全全
14.00
13.00 (全全全全
12.00 全全全)
11.00
10.00
全全全全
9.00 全全全全
8.00
7.00 全全全全
6.00
5.00 全全
4.00
3.00
2.00
1.00
0.00
84全 86全 88全 90全 92全(全6全)
年年年年年年年年年年年
Types of Loans in Taiwan

全全全全全
50.00%
45.00%
40.00%
35.00%
30.00% 全全全全
25.00% 全全全全
20.00% 全全全
15.00% 全全全全
10.00%
5.00%
0.00%
84年 86年 88年 90年 92年(年8年)
年年年年年年年年年年年
Types of Loans in Taiwan

全全全全全
60.00%
55.00% 全全全全
50.00% 全
45.00% 全全全全
40.00%
35.00% 全全全全
30.00%
25.00%
全全全
20.00%
15.00%
10.00%
5.00%
0.00%
84年 86年 88年 90年 92年(年8年)
年年年年年年年年年年年
 Types of U.S Bank Loans(March 2001)

45.00%
40.00%
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
C&I Real estate Consumer Other
Commercial & Industrial Loans

◆Term
◆Amounts
─ Syndicated Loan
◆Secured & Unsecured
◆Spot Loan & Loan Commitment

Is Commercial Loan still

important ??
 Real Estate Loans

◆Mortgage Loans

◆Revolving Home Equity Loans

 Real Estate Loan in Taiwan
年年年年年年

5,000,000
4,500,000
4,000,000
3,500,000
年年年年年
3,000,000
年年年年
2,500,000
年年年年年
2,000,000
年年
1,500,000
1,000,000
500,000
--
84 85 86 87 88 89 90 91 92(8)
年年年年年年年年年年年
 Residential Mortgage-Lending Process

Function Rewards Risks

Origination Fees Limited

Funding/underwrit Liquidity , interest

Spread
ing rate , credit
Liquidity , interest
Selling Fees & commissions
rate , credit

Servicing Fees Limited

Liquidity , interest
Investor Interest & principal
rate , credit
 Individual Loans

◆Nonrevolving
e.g : Auto Loans ; Mobile Home Loans
◆Revolving
e.g : Credit Card

Other Loans
60.00%
全
55.00% 全
50.00% 全
全
45.00%
全
40.00%
全
35.00% 全
年年年年年
30.00% 年
年年年年年
25.00% 年
年年年年
20.00%
年年年年年
15.00% 年年年年年
年年年年年
10.00% 年年
年年年年年
5.00% 年年年年
年年年年
0.00%
86年 87年 88年 89年 90年 91年 92年(年7年)
 Credit Card in Taiwan

年年年年年

70000
全全全全全全全
65000
60000
55000
50000
45000 全全全
40000 全全全全
35000
30000
25000 全全全
20000 全全全
15000 全全全全
10000
5000
0
77年 81年 83年 85年 87年 89年 91年
年年年年年年年年年年年
 年年年年年年
全全全全全全全
1,000,000
900,000
全全
全全
800,000
700,000
600,000 全全
500,000 全全
400,000
300,000
200,000
全全
全全
100,000
全全
0
76年 80年 82年 84年 86年 88年 90年 92年8年

全全全全全全全 全全全全 全全 全全
全全全全全 18.001 19.893(全全全全全全全 13.14(全全)
全全全全全 19.47318 20(全全全全全全全全 18(全全)
全全全全 19.9735 20(全全全全全) 19.929(HSBC)
Return on Loans
Influence Factor :
◆ Interest Rate
◆ Fees
◆ Credit Risk Premium
◆ Other Factors
 ROA per dollar lent
1+k=1+｛〔f+(BR+m)〕/〔1-〔b(1-R)〕〕｝
k : Gross Return on the Loan
f : Loan Origination fee
BR : Base Lending Rate
m : Credit Risk Premium
b : Compensating Balance Requirement
R : Reserve Requirement
 Expected Return on a Loan

＊ E (r) = p (l+k)

p: probability of repayment of the loan

 Credit Risk
Two Dimensions to Control Credit Risk

◆1+k: price or promised return

◆quantity or credit availability
 Credit Decisions
Retail Wholesale

◆accept or reject ◆Both interest rates &

◆sorted by loan credit quantity
quantity
Default Risk Models –
Qualitative Models
Market-specific
Borrower-specific Factors
Factors ◆Business Cycle
◆Reputation ◆Level of interest
◆Leverage rates
◆Volatility of
Earnings
◆Collateral
Default Risk Models –
Credit Scoring Models
◆Linear Probability Model
n
Z i= ∑ j=1βj X ij + error

◆Logit Model
F(Zi) =1/(1+e-z)
Default Risk Models –
Credit Scoring Models
◆Linear Discriminant Models
Z=1.2X1+1.4X2+3.3X3+0.6X4+1.0X5
X1 ：Working capital /total assets ratio
X2 ： Retained earnings/total assets ratio
X3 ： EBIT/total assets ratio
X4 ： Market value of equity/book value of
long-term debt
ratio
X5 ： Sales/total assets ratio
Discriminant Model

Problems
◆discriminate between extreme behavior
◆Are the weights and Xi constant?
◆Ignore hard-to-quantify factors
◆No centralized database
New Models of Credit Risk
Measurement and Pricing
 Term Structure Derivation of Credit Risk

 Mortality Rate Derivation of Credit Risk

 RAROC Models

 Option Models of Default Risk

Term Structure Derivation
of Credit Risk
 The spreads between risk-free discount bounds issued
by the Treasury and discount bounds issued by
corporate borrowers of differing quality reflect
perceived credit risk exposures of corporate borrowers
for single payments at different times in the future.

 Probability of default on a one –period debt

instrument

 Probability of default on a multiperiod debt

instrument
Probability of default
on a one –period debt instrument
 p = the probability of repayment
p(1  k )  1  i 1 i

1 k
  = the risk premium
  k i
 Example 11-4
Probability of default
on a one –period debt instrument
1  i 1.100
 i = 10%
    0.95
 k = 15.8% 1  k 1.158
 = k - i = 5.8%
 In this case, a probability of default of 5%
on the corporate bond requires the FI to set
a risk premium of 5.8%.
 p , 1-p ,( k-i)
   = the proportion of the loan’s principal
and interest that is collectible on default.
 >0
1    1  k    1  k   1  i
k i  
1 i
 1  i 
     
  and  are perfect substitutes for each
other.
 An increase in collateral  a decline in 
 i = 10%
1  10% 
 1  10% 
p = 0.95   

0.9  0.95  0.9  0.95
 r = 0.9
1.100
  1.100
0.995
 0.005527638
 0.55276%

k = 10% + 0.55276% = 10.55276%

Probability of default
on a multiperiod debt instrument
Cumulative Default probability:

The probability that a borrower will default over a specific multiyear period

 n 
Cp  1    i 
 i 1 
 i: the probability of the debt surviving
in the ith year

Example 1  0.95
 2  0.93  C  1  0.95  0.93  0.1165
Probability of default on a multiperiod debt instrument

 Marginal Default Probability

 No arbitrage
 Forward Rate
Example

1  i2 
2
 1  i1 1  f1  1  f1 
1.11
2
 1.12
1.1
1  k2  2
 1  k1 1  c1  1  c1 
1.18
2
 1.202
1.158
p2 (1  c1 )  1  f1 2  0.9318
Advantages and Problems
 Advantages
 Clearly forward looking and based on market
expectations.
 Liquid markets for Treasury and corporate
discount bonds.
 Problems
 Treasury markets _ deep
 Corporate markets_ small
 Discount yield curve
Mortality Rate Derivation
of Credit Risk
 Mortality Rate
 Historical default rate experience of a
bond or loan
 Marginal Mortality Rate
 The probability of a bond or loan
defaulting in any given year of issue.
Total value of grade B bonds defaulting in year i of issues
MMRi =
Total value of grade B bonds outstanding in year i of issues
Mortality Rate Derivation
of Credit Risk
 MMR curve can show the historic default
rate

 Any shape to the mortality curve is possible

 The higher Mortality rates

 the lower the rating of the bond

Mortality Rate Derivation
of Credit Risk
 Problems
 historic or backward-looking measures.
 Implied future default probabilities tend
to be highly sensitive to the period over
which FI manager calculates the MMRs.

 The number of issues and the relative size of

issues in each investment grade.
RAROC (Risk-Adjusted Return of Capital)
Models
One year income on a loan
 RAROC =
Loan (asset) risk or capital at risk

 RAROC > ROE

the loan should be made
RAROC Models
 The first problem in estimating RAROC
 The measurement of loan risk

L R
  DL
L 1 R

 
L   DL  L   R 

 1  R 
RAROC Models
R  MaxRi  RG   0
 Ri  RG  : The change in the yield spread
between corporate bonds of credit rating class
i (Ri) and matched duration treasury bonds
(RG) over the last year.

 Max [ Ri  RG  ] : only consider the worst-case

scenario.
RAROC Models
 Example 11-6
 RAAA = 10%
 AAA borrower
 DL = 2.7
 400 publicly traded

bonds (AAA)  Spread = 0.2% *

$1m = $2’000
 The range of Risk
Premium is from  Fees = 0.1% * $1m
-2%~3.5% = $1’000

$2000 + $1000
 RAROC = -(2.7) * ($1m)(0.11/1.1)
= 11.1%
 RAROC Models
One-year income on loan
RAROC =
Unexpected default rate  Proportion of loan lost on default
Expected income per dollar lent = 0.3 cents
Unexpected default rate = 4%
Proportion of loan lost on default = 80%

RAROC = 9.375%
RAROC Models
One year income on a loan
RAROC =
Loan (asset) risk or capital at risk


L   DL  L   R 

 1  R 
 Add more interest income or fees
 Curtail the size of the loan

 Shorten the duration of the loan

Option Models of Default Risk
 The Borrower’s Payoff from Loans

 buying a call option on the assets of the firm

 The Debt Holder’s Payoff from Loans

 Writing a put option on the value of the

borrower’s assets with B, the face value of debt,
as the exercise price.
Call option
Payoff to stockholders

B (debt)
0
A1 A2 Assets (A)
-S
Put option
Payoff to debt holders

0 A1 B A2 Assets (A)
(debt)
Option Models of Default Risk
 Applying the Option Valuation Model to
the calculation of Default Risk Premium

F    Be i
1d N h   N h 
1 2

h1       ln d / 
1
2
2


h2      ln d / 
1
2
2

Option Models of Default Risk
 
T  t ,T: the maturity date ; t: today
 d  Be  i / A the borrower’s leverage
ratio

 N( h )  the probability that a deviation

exceeding the calculated value of h will occur

  2
 the asset risk of the borrower
Option Models of Default Risk
k   Required yield on risky debt

  ln N h   1d N h 
k    i   1 2 1

The lender should adjust the required risk premium

as leverage and asset risk change
@ Example 11-7
 h1 
 
1
2 0 .12 2
 ln 0.9 
 0.938
 Example 11-7 0.12
 B = $100,000
N h1   0.174120
  = 1 year
 12 0.12  ln 0.9
2

  = 12% h2   0.818
0.12
 i = 5%
N h2   0.793323
 d = 90%

Lt  
$100,000
0.793323  1.11110.17412
1.05127


$100,000
0.986788  $93,866.18
1.05127
 The required risk spread or premium is

  ln N h   1d N h 
k    i   1 2 1

 (1) ln[ 0.986788]

 1.33%

k    5%+1.33%=6.33%
 The lender’s decision matrix :
Result

Decision Good loan Bad loan

Yes Loan repaid Type 1 error

No Type 2 error Loan denied

H0 is true H1 is true
Accept H0 1  Type 2 error

Reject H0 Type 1 error  1 

 H0:the customer would default
 Not Grant
 H1:the customer could repay
 Grant
 TypeⅠ: reject the true H0
 Bankrupt
 Type Ⅱ: accept the wrong H0
 Damage reputation
A. CreditMetrics
B. Credit Risk+
CreditMetrics---Introduction
 Introduced by J.P. Morgan & its co-
sponsors, 1997
 Based on the conception of VaR
 The difficulties to attain the P and σ of
loans & Methods to solve this problem
1.The borrower’s credit rating
2.The rating Migration matrix
3.Recovery rate of default loans
4.Yield spreads in the bond market

 Rating Migration---changing credit

spread
CreditMetrics---Rating Migration

 Eg. 5yr $100m 6%

loan for BBB Rating Transition
Prob
borrower
AAA 0.02%
 Rating Migration
AA 0.33%
Probabilities A 5.95%
 Valuation BBB 86.93%
P=6+6/(1+r1+s1)+6/(1+r BB 5.30%
+s )2+ B 1.17%
2 2
6/(1+r3+s3)3+106/(1+r4+ CCC 0.12%
s4)4 Default 0.18%
CreditMetrics---Prob. Distibution

Year- End Loan Value

Rating
AAA $109.37
AA $109.19
A $108.56
BBB $107.55
BB $102.02
B $98.10
CCC $83.64
Default $51.13
CreditMetrics---VaR & Capital Requirements
Credit Risk+---Introduction

 Developed by Credit Suisse Financial

Products (CSFP)
 Derive from the conceptions of fire
insurance
 Unlike CreditMetrics, Credit Risk+ focus
on
1.The frequency of Defaults
2.Severity of Losses
Credit Risk+---Assumptions
 The prob. of any individual loan defaulting in the
portfolio of loans is random
 The correlation between the defaults on any pair of
loans is 0
 Poisson Distribution is applied

 More appropriate for analyzing the default

rate on a large portfolio of small loans rather than a
portfolio of just a few loans
Credit Risk---pdf

1.Prob. of n defaults=e-m*mn
n!
e=2.71828
m: Historic #of defaults for loans of this type
n: # of defaults

2.Severity of Losses---average $ loss per

loan defaults
Credit Risk---calculations

 E.g.. A FI makes 100 loans, each of

$10,0000
 M=3
 Severity of loss:20 cent per$1
Prob. of 4 loans defaulting = e-3*34
4!
Dollar loss of 4 loans
defaulting=4*20C*$100,000=$80,000
 Possible Drawbacks of this model
Loan Portfolio and Concentration
Risk
Simple Models of Loan
Risk Grade at Yr End
Concentration Risk

Risk Grade at yr beginning

 FI widely 1 2 3 D

employed two 1 0.85 0.10 0.04 0.01

simple models to
measure the
2 0.12 0.83 0.03 0.02
credit risk of a
loan portfolio : 3 0.03 0.13 0.80 0.04
1.Loan migration
matrix Concentration limit=Maximum loss(% of capital)
1
2.Concentration
* Loss rate
limits
KMV Portfolio Manager Model---
Conceptions
MPT Applied to Bank Lending
Modern Portfolio Theory

ALM LINE
Purchasing
Fed Funds

Selling
Fed
Funds
FI Portfolio Diversification
N

 Rp=∑ Xi Ri
i=1 C

Σσp2=∑Xi2σi2+ B A

∑∑XiXjσij

Σσp2=∑Xi2σi2+
∑∑XiXjρijσiσj
KMV Portfolio Manager Model

 σi=ULi=σDi* LGDi=√EDFi(1-EDFi) *LGDi

 Ri=AISi-E(Li)=AISi -(EDFi*LGDi)
 Comparing with Benchmark
4 National Bank A Bank B

σj= ∑(Xij-Xi)2
Real 10% 15% 10%
i=1 Estate
N
C&I 60% 75% 25%

Individua 15% 5% 55%

ls

Others 15% 5% 10%

σA=10.61% σB=26.69%
Loan Loss Ratio-Based Models

 Involves estimating the systematic loan loss risk

of a particular section or industry relatives to
the loan loss of an FI’s total loan portfolio

Sectoral losses in the ith sector

Loans to the ith sector

=α+βi( Total loan losses/Total loans)
Credit Derivates---Introduction(1/3)
 Usually OTC, Off-balance sheet contracts
 Banks can use credit derivatives to achieve more
efficient risk-return combinations without hurting
customer relationships
 Four Components

1.The notional amount

2.The term or maturity
3.The reference party whose credit is being traded
4.Reference Assets

 Payment of credit derivatives

1.Cash Settlement
2.Physical Delivery
Credit Derivates(2/3)
 Types of credit derivatives
 Pure-credit (default) Swap
premium

Party1 Party 2

Loss Compensation

 Total-return Swap
premium
Party 2
Party1

Promised int. + Mkt Value Loss

Credit Derivates(3/3)
 Hedge ratio=LIED for the loan/LIED for the
reference assets
 LIED( loss in the event of default)=1-recovery
rate
e.g.. A Bank holds a $10m,senior, syndicated,
floating rate loan (estimate recovery rate=70%)
Reference asset: a Bond with 50% recovery
rate

Hedge ratio=(1-0.7)/(1-0.5)=60%

$10m*60%=6m
Thanks for Paying
Attention