CREDIT RISK:

INDIVIDUAL
LOAN RISK
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Answer: CREDIT QUALITY PROBLEMS
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Answer: TYPES OF LOANS
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Answer: RETURN ON A LOAN
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Agenda 01 Introduction

02 Credit Quality Problems

03 Types of Loans

04
Calculating the Return
on a Loan
Introduction
Credit Risk is the risk of loss associated with a
borrower or counterparty default. Credit risk exists
with many of our assets and exposures such as debt
security holdings, certain derivatives, and loans.

Credit risk is managed by establishing what we

believe are sound credit policies for underwriting new
business while monitoring and reviewing the
performance of our existing loan portfolios.

Donaire
LEARN MORE
 01
Junk Bonds
Credit Quality Bonds are rated as speculative or less than
investment grade by bond-rating agencies
Problems
such as Moody's.

Donaire
 Commercial and Industrial Loans

01 Syndicated Loan
A loan provided by a group of Fis as opposed to a single lender.

Types of 02 Secured Loan

Loans A loan that is backed by a first claim on certain assets
(collateral) of the borrower if default occurs

03 Unsecured Loan
A loan that has only a general claim to the assets of the
borrower if default occurs.

Donaire
 Commercial and Industrial Loans

01 Spot Loan
The loan amount withdrawn by the borrower immediately.

Types of 02 Loan Commitment

Loans A credit facility with a maximum size and a maximum period
of time over which the borrower can withdraw funds; a line of
credit.

03
Commercial Paper
Unsecured short-term debt instrument issued by corporations.

Donaire
 Real Estate Loans

01 Adjustable-Rate Mortgage (ARM)

Types of A mortgage whose interest rate adjusts with movements in an

Loans underlying market index interest rate.

Donaire
 Individual (Consumer) Loans

01 Revolving Loan
A credit line on which a borrower can both draw and repay
many times over the life of the loan contract.

Types of
Usury Cellings
Loans 02

National, state-, or city-imposed ceilings on the maximum rate

Fls can charge on consumer and mortgage debt.

Donaire
 CALCULATING THE RETURN ON A LOAN

LIBOR Prime Lending Rate Our Mission

The London Interbank Offered
Rate, which is the rate for
interbank dollar loans of a given
maturity in the offshore or
Eurodollar market.
The base lending rate is
periodically set by banks.
Compensating
Balance
A percentage of a loan that a
borrower is required to hold on
deposit at the lending institution.

Donaire
 Example

Donaire
The Expected Return on Loan

01
Default Risk
The risk that the borrower is unable or unwilling to fulfill the
terms promised under the loan contract.

Donaire
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Answer: CREDIT RISK
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Answer: RETAILING
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Answer: WHOLESALE
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Agenda 05 Retailing Versus Wholesale
Credit Decisions

06 Measurement of Credit Risk

07 Default Risk Models

08
Newer Models of Credit Risk
Management and Pricing
 Retail
• Most loan decisions made at the retail level tend
to be accept or reject decisions.
• Regardless of their credit risk, borrowers who
are accepted are often charged the same rate of
interest and by implication the same credit risk
premium.
• Fl controls its credit risks by credit rationing
rather than by using a range of interest rates or
prices.
Wholesale
• In contrast to the retail level, at the wholesale
(C&l) level FI's use both interest rates and
credit quantity to control credit risk.
• Thus, when FI's quote a prime lending rate (BR)
to C&I borrowers, lower-risk borrowers may be
charged a lending rate below the prime lending
rate.
• Higher-risk borrowers are charged a markup on
the prime rate, or a credit (default) risk
premium, to compensate the Fl for the
additional credit risk involved.
Danlag
 Measurement of Credit Risk

To calibrate the default risk exposure of credit and investment

decisions as well as to assess the credit risk exposure in off
balance-sheet contractual arrangements such as loan
commitments, an Fl manager needs to measure the probability of
borrowers default.

Credit risk measurement techniques can vary depending on the

complexity of the lending environment and the availability of
data.

Given this, FI's can use many of the following models that
analyze default risk probabilities either in making lending
decisions or when considering investing in corporate bonds
Danlag offered either publicly or privately.
 Default Risk Models

01 Qualitative Models

• Borrower-Specific Factors
• Market-Specific Factors

02 Quantitative Models

• Credit Scoring Models

• Linear Probability Model and Logit Model
• Linear Discriminant Models

Danlag
Borrower-Specific Factors Market-Specific Factors

• Reputation • The Business Cycle

• Leverage • The Level of Interest Rates
• Volatility of Earnings
• Collateral

Danlag
 QUANTITATIVE MODELS
Linear Discriminant
Linear Probability
Credit Scoring Our Mission
Models
Models Model and Logit Model Discriminant models divide borrowers into
high or low default risk classes contingent on
their observed characteristics. Similar to
Mathematical models that use observed
The linear probability model uses past linear probability models, Iinear discriminant
loan applicant's characteristics either to
data, such as financial ratios, as inputs models use past data as inputs into a model
calculate a score representing the
into a model to explain repayment to explain repayment experience on old
applicant's probability of default or to sort
experience old loans. The relative loans. The relative importance of the factors
borrowers into different default risk
importance of the factors used in used in explaining past repayment
classes.
explaining past repayment performance performance then forecasts whether the loan
then forecasts repayment probabilities on falls into the high or low default class.
new loans.

Danlag
 Newer Models of Credit Risk
Measurement and Pricing

01 Term Structure Derivation of Credit Risk

02 Probability of Default on a One-Period Debt

Instrument
03 Probability of Default on a Multiperiod Debt
Instrument
04 Mortality Rate Derivation of Credit Risk

Danlag
Term Structure Derivation of Credit Risk

The Term Structure Derivation of Credit Risk refers to the

process of estimating the probability of default at different
maturities or time horizons for a specific borrower or a portfolio
of credit instruments. It aims to capture the dynamics of credit
risk over time, considering the changing likelihood of default as
the maturity of the debt instruments varies.

Danlag
Probability of Default on a One-Period Debt
Instrument

The Probability of Default (PD) on a one-period debt instrument

refers to the likelihood that the issuer of the debt instrument will
fail to meet its financial obligations within a single specified
period, such as a year. It is a key measure used to assess credit
risk associated with a particular debt instrument or borrower.

Danlag
Probability of Default on a Multiperiod Debt
Instrument

The Probability of Default (PD) on a multiperiod debt instrument

refers to the likelihood that the issuer of the debt instrument will
fail to meet its financial obligations over a specified period
consisting of multiple periods or time intervals. It is a measure
used to assess the credit risk associated with a debt instrument or
borrower over an extended timeframe.

Danlag
Mortality Rate Derivation of Credit Risk

Rather than extracting expected default rates from the

current term structure of interest rates, the FI manager
may analyze the historic or past default risk experience,
the mortality rates, of bonds and loans of a similar
quality.

Danlag
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Answer: LOAN CONCENTRATION
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Answer: RAROC MODEL
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Answer: LOAN PORTFOLIO
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 Padermal

Agenda 9
RAROC Model

10 Option Models and Default Risk

Chapter 11 Credit Risk: Loan Portfolio and

Concentration Risk

11 Introduction

Simple Models of Loan Concentration

12
 RAROC Models
01

RAROC (risk-adjusted return on capital)

pioneered by Bankers Trust (acquired by Deutsche Bank in
1998) and has now been adopted by virtually all the large
02 banks in the United States and Europe, although adopted by
virtually all the large banks in the United States with some
significant proprietary differences between them.

03
Option Models of Default Risk
Theoretical Framework
In recent years, following the pioneering work of Nobel Prize winners
01
Merton, Black, and Scholes, we now recognize that when a firm raises
funds by issuing bonds or increasing its bank loans, it holds a very
valuable default or repayment option. That is, if a borrower's investment
projects fail so that it cannot repay the bondholder or the bank, it has the
02 option of defaulting on its debt repayment and turning any remaining
assets over to the debtholder.

03
The Borrower's Payoff from Loans
Look at the payoff function for the borrower in Figure 10-9, where $
is the size of the initial equity investment in the firm, B is the value of
outstanding bonds or loans (assumed for simplicity to be issued on a
discount basis), and A is the market value of the assets of the firm.
 CREDIT RISK:
LOAN PORTFOLIO
AND
CONCENTRATION
RISK
 Introduction
The models discussed in the previous chapter describe
alternative ways by which an FI manager can measure the
default risks on individual debt instruments such as loans and
bonds. Rather than looking at credit risk, one loan at a time,
this chapter concentrates on the ability of an FI manager to
measure credit risk in a loan (asset) portfolio context and the
benefit from loan (asset) portfolio diversification. Indeed, it has
been documented that using pool-level data rather than loan-
level data for mortgage portfolio analysis can lead to
substantially different conclusions about the credit risk of the
portfolio.
SIMPLE MODELS OF LOAN
CONCENTRATION RISK

Migration Analysis
A method to measure loan concentration risk by tracking credit ratings
of firms in a particular sector or ratings class for unusual declines.

Loan Migration Matrix

A measure of the probability of a loan being upgraded, down-graded, or
defaulting over some period.

Concentration Limits
External limits set on the maximum loan size that can be made to an
individual borrower.
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Answer: MODERN PORTFOLIO THEORY
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Answer: MOODY'S ANALYTICS
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Answer: REGULATORY MODELS
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Agenda 13 Loan Portfolio Diversification and
Modern Portfolio Theory

14 Moody’s Analytics Portfolio Manager

Model

15 Partial Application of Portfolio theory

16 Regulatory models

Alfante
 Alfante

Loan Portfolio Diversification and

Modern Portfolio Theory

• Portfolio diversification models can be used to

measure and control the FI's aggregate credit risk
exposure.

• MPT is that by taking advantage of its size, an FI can

diversify considerable amounts of credit risk as long
as the returns on different assets are imperfectly
correlated with respect to their default risk-adjusted
returns
Loan Portfolio Diversification and
Modern Portfolio Theory
 Alfante

Moody’s Analytics Portfolio Manager

Model

• A model that applies modern portfolio theory to the

loan portfolio
 Alfante

RETURN ON THE LOAN (Ri)

• Measured by the so-called annual all-in-spread (AIS),

which measures annual fees earned on the loan by the FI
plus the annual spread between the loan rate paid by the
borrower and the FI's cost of funds. Deducted from this is
the expected loss on the loan.

• This expected loss is equal to the product of the expected

probability of the borrower defaulting over the next year,
or its expected default frequency times the amount lost by
the FI if the borrower defaults the loss given default.
 Alfante

RISK ON THE LOAN (σi)

• The risk of the loan reflects the volatility of the loan's
default rate (σDi) around its expected value times the
amount lost given default (LGDi). The product of the
volatility of the default rate and the LGD is called the
unexpected loss on the loan (ULi) and is a measure of the
loan's risk or σi .

• To measure the volatility of the default rate, assume that

loans can either default or repay (no default) then defaults
are "binomially" distributed, and the standard deviation of
the default rate for the ith borrower (?Di) is equal to the
square root of the probability of default times 1 minus the
probability of default √ ( EDF) (1-EDF)1/2.
 Alfante

CORRELATION (ρij)

• To measure the unobservable default risk correlation

between any two borrowers, the KMV Portfolio
Manager model uses the systematic return components
of the stock or equity returns of the two borrowers and
calculates a correlation that is based on the historical
comovement between those returns.
 Alfante

Partial Application of Portfolio theory

• Loan Volume-Based Models - measures how different a bank’s
lending activity is from the average bank in a peer group.
Sources of loan volume data include:
• Commercial bank call reports
• Data shared on the national credit
• Commercial databases
• Loan Loss Ration-Based Models
Systematic Loan Loss Risk - a measure of the sensitivity of loan
losses in a particular business sector relative to the losses in an FI's
loan portfolio
 Alfante

Regulatory models

• The method adopted is largely subjective and is based on

examiner discretion. The reasons given for rejecting the
more technical models are that

(1) current methods for identifying concentration risk are not

sufficiently advanced to justify their use and
(2) insufficient data are available to estimate
more quantitative-type models, although the
development of models like KMV, as well as
CreditMetrics and Credit Risk may make bank
regulators change their minds.
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Answer: CREDITMETRICS
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Answer: RATING MIGRATION
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Answer: VALUATION
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Agenda 17 Creditmetrics

18 Rating Migration

19 Valuation

20
Calculation of Var
 CreditMetrics

CreditMetrics was introduced in 1997 by J.P.

Morgan and its co-sponsors (Bank of America,
Union Bank of Switzerland, et al.) as a value at risk
(VAR) framework to apply to the valuation and risk
of non-tradable assets such as loans and privately
placed bonds.

Amadora
 RATING MIGRATION

On the basis of historical data collected by S&P,

Moody's, and other bond analysts, it is estimated
that the probability of a BBB borrower's staying at
BBB over the next year is 86.93 percent. There is
also some probability that the borrower of the loan
will be upgraded (e.g, to A), and there is some
probability that it will be downgraded (eg, to CCC)
or even default.

Amadora
 VALUATION

The effect of rating upgrades and downgrades is to impact the

required credit risk spreads or premiums on loans and thus the
implied market value (or present value) of the loan. If a loan is
downgraded, the required credit spread premium should rise
(remember, the loan rate in our example is fixed at 6 percent)
so that the present value of the loan to the FI should fall.

Amadora
 CALCULATION OF VAR

• Identify possible loan values at year 1 based on scenarios

or factors impacting the loan.
• Assign probabilities to loan values based on data,
judgment, or statistical models.
• Multiply each loan value by its corresponding probability.
• Sum the products to obtain the expected value,
representing the average loan value at year 1.

Amadora
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Answer: REQUIREMENTS
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Answer: FREQUENCY
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Answer: PORTFOLIO
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Agenda 21 Capital Requirements

22 CreditRisk+

23 The Frequency Distribution of

Default Risk
Capital Requirements
• Capital requirements refer to the minimum amount of
capital that financial institutions, such as banks and
thrifts, must maintain as a regulatory measure.

• Regulators aim to enhance the resilience of financial

institutions, reduce the likelihood of insolvency, and
promote the stability of the financial system.

Arcilla
CreditRisk+

• CreditRisk+ model developed by Credit Suisse Financial

Products (CSFP)
• Focuses on estimating expected loss of loans and distribution
of losses, it calculates capital reserves required to meet losses
above a certain level

Arcilla
The Frequency Distribution of Default Risk

• The frequency distribution of default risk refers to

the statistical distribution that describes the
likelihood or probability of different levels of loan
defaults within a portfolio.
• It helps to quantify the potential losses arising from
loan defaults and assess the overall credit risk
exposure.

Arcilla
Where:
e= exponential function (2.71828)
m=historic average of default (3 of 100 or 3 %)
n!= number of loans The Frequency
Distribution of
Default Risk

Arcilla