Unit 6

Monitoring and Control of

Lending

1
 Learning Objectives

• Describe the benefits of credit risk

management
• Understand the elements of loan
pricing

2
 Introduction

• The aim of credit risk management

is to balance between risk and return
to achieve optimum profitability and
efficiency
• Taking and institutional view banks
could minimise concentration risk
• Lending on a more scientific basis
would help remove subjectivity

3
 Introduction

• Credit risk seeks following objectives:

• a) achieve and appropriate balance
between risk and return;
• b) avoid concentration risk;
• c) manage loans on a portfolio basis; and
• d) take a group of loans off the statement of
financial position.
• This chapter examines some of the
credit risk measurement tools.

4
 Credit Risk Measurement

• Altman’s Z Score
• Relies on multivariate model accounting ratios
that provide best predictors of performance:

Activity Profitability
Liquidity Earnings Variability
Solvency Size
• Credit decision relies on output from equation at
varying cutoff levels
5
 Credit Risk Measurement

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

– X1 = Working Capital / Total Assets,
– X2 = Retained Earnings / Total Assets
– X3 = EBIT / Total Assets,
– X4 = Market Val of Equity / Book Val Debt,
– X5 = Sales / Total Assets
• Z > 2.675 => High Probability of Solvency
• Z < 2.675 => High Probability of Insolvency (Zone of
Ignorance)
• Z < 1.8 => Certain Insolvency
6
 Loan Pricing

– All loans provide a cost to the

Statement of Financial Position
• Statement of Financial Position Costs
– Capital Cost: Capital that must be allocated to
support default risk
– Liquidity: Lending activities must allow sufficient
liquidity on Statement of financial position
– Cost of Funds: Returns must be achieved from
loan including considering Return on Equity,
Return on Liquidity, Market Cost of Deposits
and Return on the Loan

7
 Loan Pricing

• Noncredit Risk Costs

– Interest Rate Risk: Whether loan book has
fixed/floating rate loans
– Pre-payment Risk: Risk that loans will be paid
out earlier than specified term
– Origination Costs: Costs of marketing and
monitoring securitised loans sold
• Credit Costs
– Expected Losses = Default Probability x (1 –
Recovery Rate)
– Unexpected Losses: Generally reflects volatility
of Expected Losses

8
Chapter Twelve

Credit Risk From

The Regulator’s
Perspective

9
 Capital Adequacy

• Recent evidence shows poor credit

decisions play a major part in bank
failures
• Generally, banks required to allocate
a minimum of 8% of a loan’s value
from Capital
• As some loans riskier than others,
risk weighting system adopted
10
 Securitisation

• Clean sale supply of assets:

– Should be no beneficial interest in the
sold assets and absolutely no obligation
on institution
– Should be no recourse (including costs)
to the institution and no obligation to
repurchase loan asset

11
 Securitisation

– Amount paid for loans should be fixed

and received at time asset is
transferred from lending institution
– Any assets provided to the Special
Purpose Vehicle (SPV) as a substitute
or sold below book value do not relieve
credit risk

12
 Securitisation

• Revolving Facilities:
– Defined as assets with ongoing credit
relationship such as credit cards and
home loans
– Rights, details of cashflows and
obligations of each party must be clearly
specified
– As with normal securitisation, institution
cannot supply additional assets to the
pool

13
 Securitisation

– Liquidity shortfalls for the institution

share must not exceed the interest
receivable
– Institution retains right to cancel
undrawn amounts
– Institution must have no obligation to
repurchase

14
Chapter Thirteen

Problem Loan
Management

15
 Introduction

• When financial institutions make

loans, returns generated mean
accepting some default risk
• It is imperative that default risk is
managed so that the solvency of
the bank is not threatened
• Should the problem loan be
foreclosed or actively managed?

16
 Causes of Default

• Default does not necessarily mean that

all of the loan extended is lost.
• Default is defined here as ‘a loan where
repayments are overdue’
• Better lending procedures can minimise,
but not eliminate, the risk of default
• Harder to manage default risk as loan
book becomes larger
17
 Causes of Default

– Likely causes of default

• Lack of compliance with loan policies
• Lack of clear standards and excessively
lax loan terms
• Inadequate controls over loan officers
• Over-concentration of bank lending
• Loan growth exceeding bank’s capabilities
• Inadequate problem loan identification
• Insufficient knowledge of customer’s finance
• Lending in unfamiliar markets

18
 Extent of Problem Loans

• All banks experience bad debts,

but the management of them
becomes critical
• Banks should consider:
• Timing of loan in economic cycle
• Larger exposures to individual borrowers
• Larger exposures to single sectors
• Close monitoring of exposures during
unfavourable economic periods

19
 The Business Cycle

– The business cycle characterised by

three phases:
• Recovery and Expansion:
– Flourishing economy with increased spending
leading to higher deposits and interest rates
• Boom:
– Major asset inflation with business
overconfidence and declining credit standards
• Downturn:
– Declining asset values and economic activity
generally accompanied by increased defaults

20
Problem Loans, Provisions
and Regulatory Issues

– When borrower misses payments, two

questions arise within lending institution
• Is missed payment temporary?
• Is missed payment likely to be permanent?

21
Problem Loans, Provisions
and Regulatory Issues

– If payment more than 90 days, loan is

considered an ‘impaired asset’ as
return on loan not achieved
– Value of impaired loan must be
downgraded on statement of financial
position

22
Problem Loans, Provisions
and Regulatory Issues

– BOJ: If one asset is impaired, all loans

to that client considered impaired
– When loans are impaired, institution
must create a ‘provision’ for a loan loss
– Provisions are classified in three ways:
• Specific Provisions
• General Provision
• Bad-Debt Write-Offs

23
Problem Loans, Provisions
and Regulatory Issues

– Specific Provisions:
• These are provisions set aside for a
specifically identifiable loan where the
institution assesses the:
– Condition of the loan;
– Condition of the borrower;
– Impact of economic events.
• Not all of the loan must have provisions
made as lender may assess the likely
losses from the asset.

24
Problem Loans, Provisions
and Regulatory Issues
– General Provisions
• These are provisions that are made as a
proportion of the entire loan portfolio
• Suitable for large loan portfolios of similar
assets, e.g. mortgages, where specific
provisioning unsuitable
• BOJ: Generally minimum provision of 0.5%
of Risk-Weighted Assets
• Can adjust general provisions level
depending on economic activity or risk
levels

25
Problem Loans, Provisions
and Regulatory Issues

– Bad Debts:
• Recognition of bad debts occurs where:
– All security liquidated;
– Guarantees have been enforced;
– Remaining remedial actions explored; and
– No remaining sources of cash can be called.
• Once the above steps are completed, the
financial institution must write off the bad
debt with asset valued at zero and a
charge made against profits.

26
Other Considerations with
Problem Loans
– The provisions made minimise the
efficient use of capital that could
otherwise be used for lending purposes
– Institutions often have provisioning
systems exceeding BOJ requirements
to reflect bank’s risk profile
• Higher provisions indicate higher risk
and/or more conservative management
• Lower provisions indicate lower risk and/or
more aggressive management

27
 Dynamic Provisioning

– The risk profile of the loan portfolio is

sensitive to point in the economic cycle,
e.g. greatest defaults occur at bottom of
economic cycle
– Therefore:
• Credit risk is not static but changes over
time
• Bad debt should not come as a surprise
as modelling should detect changes to
probable default risk in portfolio segments

28
 Dynamic Provisioning

– Key principles in dynamic provisioning:

• Classify loans into homogeneous groups
• Sub-classify groups by maturity length
– Determine probability of loss for each group
– Determine likely severity of loss for each group
• Use the historical loan-loss information to
create predictive model incorporating
economic conditions, interest rates,
investment activity, etc.
• Apply model outcome to current provisions
29
 Dealing with Defaults

– If the loan is in default, bank must act

to minimise the losses arising from
defaulting clients and may reschedule
payments rather than liquidate loan
– Classify defaulting clients into three
categories:
• Mild financial distress;
• Moderate financial distress; and
• Severe financial distress.
30
 Dealing with Defaults

– Mild Financial Distress

• Often occurs when borrower faces short-
term cash flow problems, e.g. late receipts
• If default less than 90 days, remedies
include:
– Changing/lengthening repayment schedules
– Assisting firm if cash flow shortage has risen
from period of rapid growth
– Encouraging firm to sell non-core assets
– Requesting/demanding equity capital injection

31
 Dealing with Defaults

– Moderate Financial Distress

• May occur if cash flow problems coincide
with borrower’s asset values declining
• Course of action determined by nature of
collateral, e.g. foreclose on mortgage or
support manufacturing firm with unique
or limited market for assets
• Lender may consider evaluation of
alternatives via NPV or probabilistic model
of Expected Values for different actions
32
 Dealing with Defaults

– Severe Financial Distress

• Characterised by missed payments and
value of borrower less than loan amount
• Lender needs to very carefully evaluate
whether is is better to:
– Liquidate firm to recover greatest percentage
of loan possible; or
– Restructure debt (inclusive of debts to other
lenders) to maintain operations to allow firm to
trade out of current crisis or be sold as going
concern
33
 Dealing with Defaults

– The coordination problem

• Where numerous classes of debt-holders
observed, e.g. syndicated loans, any
rescheduling will require cooperation of
all debt-holders
• May be difficult to coordinate actions
between junior and senior debt-holders
• Need to restructure debts to ensure all
debt-holders treated equitably or else
rescheduling proposal will fail
34
 Dealing with Defaults

– Other Breaches
• Corporate loans may have a variety of
covenants imposed to protect loan quality
• Lender may place a variety of conditions to
strengthen loan repayment probability:
– No excessive withdrawal of cash flows
– Risk profile of firm to remain unchanged
– Specification of various ratios including gearing,
dividend payout and interest coverage
– Continued involvement of key staff
– Application of risk management strategies

35