20240422 125.364 Topic 07 Part 01

SCHOOL OF ECONOMICS & FINANCE
Topic 7 part 1
Credit Risk:
Individual Loan Risk
Textbook Ch10
(p.278-312, i.e. excluding Option Model.)
1
Introduction
• Credit risk: the risk that promised cash flows from loans and securities held by
financial institutions may not be paid in full.
• Problems with junk bonds, less-developed-country (LDC) loans, non-performing
loan (NPL).
e.g. non-payment or delays in payment
of interest and/or principal.
• Default of one major borrower can have significant impact on value and
reputation of many FIs. In the worst case, credit quality problems can cause FI
insolvency or significantly impair the FI's competitiveness.
– e.g.
FIs can use very similar methods and models to assess the subprime mortgage
probabilities of default crisis
on
both bonds and loans
– bond yields, like wholesale loan rates, usually reflect risk premiums that vary with the
perceived credit quality of the borrower and the collateral or security backing of the debt
2
Introduction (cont.)
• Credit risk management is crucial:
– Price a loan correctly;
– Set appropriate limits on the amount of credit
extended to any one borrower (or, the loss
exposure it accepts from any counterparty).
3
CREDIT QUALITY PROBLEMS

• the credit quality of many FIs’ lending and
investment decisions has attracted a great deal of
attention
– tremendous problems with bank loans to less
developed countries (LDCs) as well as with thrift
and bank residential and farm mortgage loans
(1980s’)
– the problems of commercial real estate loans (to
which banks, thrifts, and insurance companies were
all exposed) as well as junk bonds (Early 1990s’)
4

– the rapid growth in low-quality auto loans and
credit cards as well as the declining quality in
commercial lending standards as loan
delinquencies started to increase (Late 1990s’)
– problems with telecommunication companies, new
technology companies, and a variety of sovereign
countries (Early 2000s’)
5
6
Types of Loans
• Business loans Provided by a group of FIs
Has only a general claim to the assets,

– Often syndicated e.g. junior debt.
– Can be secured or unsecured

Backed by a first claim on e.g. loan commitment,
certain assets (collateral) Withdrawn immediately line of credit
– Can be spot or under commitment

– Competitor: bond and/or commercial paper market
 disintermediation
7
Types of Loans (cont.)

• Housing loans: primarily mortgages
– Fixed-rate or adjustable rate mortgages.
– A safer lending option for FIs to provide a better risk-adjusted
return on capital.
A credit line on which a borrower can both
draw and repay many times over the life of the
loan contract, e.g. credit card debts.
• Consumer loans
– Revolving or non-revolving loans. personal loans
e.g. automobile,
• Other loans
– Inter-bank loans, non-bank financial
e.g. institutions,
insurance state and
companies, finance
local government. companies, etc.
8
Calculating the return on a loan:

Contractually Promised Return
• Factors affecting the promised loan return:

– Loan interest rate
– Fees
– Credit risk premium
– Collateral
– Non-price terms such as compensating balances
A proportion of a loan that a
borrower is required to hold on
deposit at the lending institution.
9
• Loan rate = base lending rate (BR) + credit risk premium

or margin (m).
– Base lending rate could be:
Rate charged to the lowest risk
• WACC or marginal cost of funds customer, or a base rate.
• Primary lending rate
• LIBOR (London Interbank Offered Rate), if issued to global market
• Direct and indirect fees and charges:

– Loan origination fee (f)
– Compensation balance requirements (b)
To be held as non-interest-bearing
– Reserve requirement (R) demand deposit; it will raise the
If FIs is required to hold non-interest- effective cost of loans for borrowers.
bearing reserves at the rate R against
compensating balances; it is a cost for FIs.
10
• Gross return on loan (k) per dollar lent:
f  BR  m 
When fees (f) is 0 and compensating
balance (b) is 0, k = BR+m, the credit risk
k
1  b1  R 
premium is the fundamental factor driving
the promised return on the loan once the
base rate on the loan is set.
– Promised gross cash inflow per dollar = direct fee (f) + loan interest rate
(base lending rate (BR) + credit risk premium (m))
– Net out flow per dollar = 1 – reserved adjusted compensating balance
requirement (b(1-R))
= 1 – compensating balance requirement (b) + reserve requirement on the
b (bR)
= 1 – compensating balance requirement (b) + the cost of holding
additional non-interest-bearing reserve requirement (bR) 11
Example 1
Metrobank offers one-year loan with a 9% based rate, charges a 0.25% loan
origination fee, imposes a 10% compensating balance requirement and must pay
a 6% reserve requirement to the central bank. The loans typically are repaid at
maturity.
1) If the risk premium for a given customer is 2.5%, what is the simple
promised interest return on the loan?
2) What is the contractually promised gross return on the loan dollar lent?
1) 0.09 + 0.025 = 0.115=11.5% = ¢11.76/¢90.6

0.0025  0.09  0.025
k  0.1297  12.97%
2) 1  0.11  0.06 
12
Calculating the return on a loan:

Expected Return
• Expected return might differ from promised return because of
default risk.
• Expected return: E(r) = p(1+k) – 1
where p = probability of loan repayment.
• If p < 1:
– Default risk exists.
– FI needs to set risk premium.
– FI needs to recognise that higher fees and charges might decrease p.
• FIs can control credit risk from two dimensions:
– Price or promised return
– Quantity or credit availability
13
Retail vs. Wholesale Credit Decisions

• Retail
– Small dollar size loans with higher cost associated with collection of
information.
– Standard loan rate is usually charged.
– Credit risk controlled through credit rationing;
Restriction on theusually
quantityan accept
of loans or
made
reject decision. available to an individual borrower.
• Wholesale
– Credit risk controlled through both interest rates and credit quantities.
– A very high contractual interest rate may induce moral hazard
behaviour.  Better to credit ration the wholesale loans beyond some
interest
Borrowers rate to
will tend level.
invest in high-risky projects, and/or high interest rate encourages
only the risky customers to borrow.
14
Multiple risk factors affecting loans

1. Loan concentrations and related credit quality
2. Counterparty credit risk
3. Economic and market conditions
4. Legislative or regulatory mandates
5. Changes in interest rates
6. Merger and acquisition activities
7. Reputation risk
15
Default Risk Models

• Qualitative models
• Quantitative models
– Credit scoring model
• Linear probability model
• Logit model
• Linear discriminant model
• Some newer [quantitative] models

– Term structure derivation
– Mortality-rate derivation
– Risk-adjusted return on capital (RAROC) model
– Option model (not covered in this course) 16
Qualitative Model
• Borrower-specific factors Higher information asymmetry. Explain
higher costs of debt IPO by small firms.
– Reputation
• An implicit contract for long-term customer relationship.
• Disadvantage to small, newer borrowers.
– Leverage (capital structure)
• A high D/E ratio increases the probability of default.
– Volatility of earnings
• A highly volatile earnings
Explain stream
higher increase
borrowing thefor
costs probability
start-up orofhigh-tech
default. firms.
– Collateral
• Reduces the negative impact in the event of default.
17
Qualitative Model (cont.)

• Market-specific factors
– Business cycle
• FIs are more likely to increase degree of credit rationing in
recessionary phases.
– High level of interest rates
• Funding is scarcer and more expensive.
• May induce moral hazard behaviours.
Encourage taking excess risk and/or encourage only the
most risky customers to borrow.
• Use of covenants to encourage certain borrower

behaviour.
18
Qualitative Model (cont.)

Five Cs
1. Character: customer's willingness to meet credit
obligations
2. Capacity: customer’s ability to meet credit
obligations
3. Capital: customer’s financial reserve
4. Collateral: a pledged asset in case of default
5. Conditions: general economic conditions in the
customer’s line of business.
19
Quantitative Model: Credit Scoring Model
• Quantitative models that use observed borrower

characteristics to:
– Calculate score as a proxy of borrower's default probability, or
– Sort borrowers into different default classes.
• Objective economic and financial measures of risk are

identified, and then a statistical technique is used to quantify
or score the default risk probability or classification.
– Consumer debt: income, assets, age, occupation, location, etc.
– Commercial debt: cash flow, financial ratios, etc.
20
Quantitative Model: Credit Scoring Model (cont.)
• Scoring models might help to:

– Establish factors that help to explain default risk.
– Evaluate the relative importance of these factors.
– Improve the pricing of default risk.
– Sort out bad loan applicants.
– More easily to calculate reserve needs to meet
expected future loan loss.
21
Quantitative Model:
Linear Probability Model
• Use past data as inputs into a model to explain repayment

experience on old loans. Then the relative importance of the factors
is used to forecast repayment probabilities on new loans.
n Part of PD which can’t be explained by X factors.
PDi    j X ij  error
j 1
Where PD is probability of default, j is the estimated importance of

jth variable (Xj, such as leverage) in explaining past repayment
experience of borrower i.
• Weakness: the estimated probabilities of default can lie outside the
interval of 0 to 1.  logit model
22
Example 2
Suppose the estimated linear probability model used by an FI to predict
business loan applicant default probabilities is PD = 0.03X1+0.02X2-
0.05X3+error, where X1 is the borrower’s D/E ratio, X2 is volatility of
borrower earnings, and X3 is the borrower’s profit ratio. For a particular loan
applicant, X1 = 0.75, X2=0.25 and X3=0.10.
1) What is the projected probability of default for the borrower?
2) What is the projected probability of repayment if the D/E ratio is 2.5?
1) PD = 0.03(0.75) + 0.02(0.25) – 0.05(0.1) = 0.0225

2) PD = 0.03(2.5) + 0.02(0.25) – 0.05(0.1) = 0.075
probability of repayment = 1 – 0.075 = 0.925
23
Quantitative Model:
Logit Model
• Overcomes weakness of the linear probability

model using a transformation (logistic function)
that restricts the probabilities to the zero–one
interval:
1
F PDi  
1  e PDi
Where e is exponential (≈ 2.718), F(PDi) is logistically

transformed value of PDi.
24
Quantitative Model:
Linear Discriminant Model
• Divide borrowers into high or low default risk classes contingent on their
observed characteristics (Xj). Credit classification model
• Altman's Z score model for manufacturing firms:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4+ 1.0X5
where: WC = CA – CL
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
• Z > 2.99: low default risk; 1.81 < Z < 2.99: may or may not default; Z < 1.81:
25
Linear Discriminant Model (cont.)

• Weaknesses:
– Broad distinction between borrower categories, that is, good and
bad borrowers.
– Weights in any credit scoring model unlikely to be constant over
longer periods of time.
– Variables in any credit scoring model unlikely to be constant over
longer periods of time.
– Models ignore hard-to-quantify factors such as borrower reputation.
– No centralised database on defaulted business loans.
A common problem for all quantitative models.
26
Example 3
MNO Inc. has provided the following financial information in its application for a loan.
Assets $ Liabilities and equity $

Cash 20 Accounts payable 30
Accounts receivables 90 Notes payable 90
Inventory 90 Accruals 30
Plant and equipment 500 Long-term debt 150
Equity 400
Total Assets $700 Total Liabilities and Equity $700
Sale = $500, cost of goods sold = $360, taxes = $56, interest payments = $40 and net
income = $44. The dividend payout ratio is 50% and the market value of equity is
equal to the book value.
27
1) What is the Altman discriminant function value for MNO?

2) Should you approve MNO’s application to your bank for a $500 capital
expansion loan?
1)
X1 = NWC/TA = (200-150)/700 = 0.07
X2 = RE/TA = 22/700 = 0.03
X3 = EBIT/TA = 140/700 = 0.20
X4 = E/D = 400/150 = 2.67
X5 = S/TA = 500/700 = 0.71
Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.2) + 0.6(2.67) + 1(0.71) = 3.104
2) Z>2.99, application approved.

28
Newer Model:
Term Structure Derivation of Credit Risk
• If we know the risk premium we can infer the probability of default.

Expected return equals risk-free rate after accounting for probability of
default.
• p (1+ k) = 1+ i  p = (1+i)/(1+k)
Where p is the probability of repayment, k is the contractually promised return
on the one-year corporate security, and i is the return on credit risk-free
government security.
• May be generalised to loans with any maturity or to adjust for varying
default recovery rates.
• The loan can be assessed using the inferred probabilities from
comparable quality bonds.
29
• Assume that γ is the proportion of the loan's principal and

interest that is collectible on default:
[(1 – p) γ(1 + k)] + [p(1 + k)] = 1 + i
The payoff the FI expects to get in case of default.
1 i

1 k
Probability of repayment p = 1 
Probability of default = 1-p

• If γ > 0, the required risk premium As will
lossbe less
in the for can
default anybedefault
covered
1(1
risk probability  i- p): by collateral.
k i    1  i 
  p  p 
Where: Φ is risk premium between k and i. 30

Example 4
Assume that a one-year Treasury strip is currently yielding 5.5% and
an AAA-rated discount bond with similar maturity is yielding 8.5%.
1) Calculate the probability of default, assuming that if the bond is

defaulted, no payment is expected.
p = (1+i)/(1+k) = 1.055/1.085 = 0.9724

probability of default = 1-0.9724 = 0.0276
A probability of default of 2.76% on the corporate bond requires a risk premium of 3%.
31
2) Calculate the probability of default, assuming that the expected recovery

from collateral in the event of default is 50% of principal and interest.
1i 1.055
  0.5
p  1k  1.085  0.9447
1 1  0.5
Probability of default = 1-0.9447 = 0.0553
3) Based on the assumption in question 2 (50% recovery), what is the

1  i
required risk premium  of
k  i   for the probability i
1 default in question 1 (2.76%)?
  p  p 
1  0.055
  1  0.055
0.5  0.9724  0.5  0.9724
 0.01476  1.476% k = 5.5+1.476 = 6.976% is sufficient. 32
Proof:
k  0.055  0.01476  0.06976
1 0.55
 0.5
p  1 0.06976  0.9724
1 0.5
1 p  0.0276
3% risk premium with no recovery and 1.476% risk premium

with 50% recovery have the same probability of default.
33
Term Structure Derivation (cont.):

Multiple Periods
• For a multi-period debt instrument, the probability that the security will
default in any given year (i.e. marginal default probability) is conditional on
the fact that the default has not occurred earlier. Take a two-year security for
example, the cumulative default probability (Cp) = 1 – (p1)(p2)
Where Cp is the likelihood that a borrower will default over a specified multi-year time
horizon, and pt is the probability that a borrower will not default in any given year t.
• 1
In efficient 
f1  market,
i 2 2
the
 1expected one-year forward rate (f 1) is:
1  i1 
a one-period rate of interest expected on an issued security

Where i1 and i2 is current one-year and date
at some two-year T-strip
in the futurerate, respectively.
which should make no arbitrage.
34
Term Structure Derivation (cont.):

Multiple Periods
• Similarly, for the two-year corporate security, the expected one-year

“forward rate” (c1) is:
c1 
1  k2 2
1
1  k1 
• Similar to p (1+ k) = 1+ i, p2 (1+ c1) = 1+ f1, so the expected probability of
repayment on one-year corporate security in one year’s time is:
p2 = (1+f1)/(1+c1)
The expected probability of default in year 2 is: 1 – p2
• Advantage: forward looking and based on market expectation.

• Disadvantage: for some corporate securities the market may not be efficient.
35
Example 5
Calculate the term structure of default probabilities (annual marginal
and cumulative) over three years using the following spot rates from
the Treasury strip and discount corporate bond yield curve.
Spot 1-year (%) Spot 2-year (%) Spot 3-year (%)
T-strip 5.0 6.1 7.0
Bond 7.0 8.2 9.3
T-strip: Bond:
(1+0.05)(1+f12)=(1+0.061)2 (1+0.07)(1+c12)=(1+0.082)2
f12 = 1.0612/1.05 – 1 = 0.0721 c12 = 1.0822/1.07 – 1 = 0.0941
(1+0.061)2(1+f23)=(1+0.07)3 (1+0.082)2(1+c23)=(1+0.093)3
f23 = 1.073/1.0612 – 1 = 0.0882 c23 = 1.0933/1.0822 – 1 = 0.1153
36
Probability of repayment:
P01 = (1+i1)/(1+k1) = 1.05/1.07 = 0.9813
P12 = (1+f12)/(1+c12) = 1.0721/1.0941 = 0.9799
P23 = (1+f23)/(1+c23) = 1.0882/1.1153 = 0.9757
Marginal probability of default:

Period 01: 1- 0.9813 = 0.0187
Period 12: 1 - 0.9799 = 0.0201
Period 23: 1 – 0.9757 = 0.0243
Cumulative probability of default:

cp01 = 0.0187
cp02 = 1-(0.9813)(0.9799) = 0.0384
cp03 = 1-(0.9813)(0.9799)(0.9757) = 0.0618
37
Newer Model:
Mortality-rate Derivation of Credit Risk
For example, MMR in year 2 for a grade B bond =
• Mortality rate: the historic (Total value grade B bond defaults year 2) / (total
default rate experience of a value grade B bonds outstanding year 2)
bond or loan.
• Marginal mortality rates: the
probability of a bond or loan
defaulting in any given year
of issue.
• the second year’s marginal
mortality rate for BBB bonds
(3.07%) is much higher than
those of years 3 and 4 (1.43%
& 1.20%, respectively).
38
Newer Model:
Mortality-rate Derivation of Credit Risk
• Disadvantages: the
probability of default
is estimated from
past data on defaults;
the estimates can be
sensitive to the
period, number of
issue, and relative
size of issue.
39
Risk replying on the Credit rating agencies

• Credit ratings can change over time
– credit ratings can shift
– the higher the credit rating, the higher the rating stability
• Credit ratings tend to lag the market pricing of credit

risk
– Bond prices and spreads frequently move more swiftly
than rating agencies change their ratings.
– Bond prices could move down sharply well before a
rating agency downgrades its credit rating.
40
Risk replying on the Credit rating agencies
• Rating agencies may make mistakes

– mis-ratings of US companies, Enron and WorldCom
– rating agencies could not see the accounting fraud.
• Some risks are difficult to capture

– Litigation risks, for instance, may affect tobacco or
energy, or chemical companies
– some unpredictable events such as earthquakes or
tsunamis may have severe effects on credit quality
41
Newer Model:
RAROC Model
• RAROC = risk-adjusted return on capital.

• Essential idea: balancing of expected interest and fee income
against expected loan risk.
• RAROC = one year income on a loan / loan (asset) risk or
“capital at risk” The difference between
how much capital is exposed to being lost lending and deposit rate
– One year net income on loan = (spread + fee) × dollar value of the
loan outstanding.
– Estimate of loan risk: duration model or loan default rates.
• Loan approval if RAROC > benchmark return on capital (ROE)
42
RAROC (cont.): Estimate Loan Risk
• Duration model
– ΔLN = DLN × LN × ΔR/(1+R)
– Dollar capital risk exposure (i.e. loss amount) = loan’s duration
× risk amount (i.e. size of loan) × expected maximum change in
the loan rate due to a change in the credit risk premium.
– ΔR = MAX[Δ(Ri – RG)>0], while Δ(Ri – RG) is the change in
yield spread between corporate bonds of credit rating class i
(Ri) and matched duration T-bonds (RG). The maximum change
is chosen for the worst-case scenario.
Worse the credit rating, higher the credit
risk premium, higher the spread.
43
RAROC (cont.): Estimate Loan Risk

• Loan default rate
– RAROC = one year income per dollar loaned /
(unexpected default rate × proportion of loan lost
on default) Proportion that cannot be recaptured
– Used by large FIs with good loan default database.
44
Example 6
Assume a $500,000 loan has a duration of 2.5 years. The
current interest rate level is 10 per cent and a sudden change
in the credit premium of 1 per cent is expected. Further
assume that the one-year net income on the loan is $2,500.
What is the loan's RAROC?
Loan risk = -2.5×500,000×(0.01/1.1) = 11,363.64

RAROC = 2500/11363.64 = 0.22
45
Example 7
A bank is planning to make a $5 million to a firm in the steel industry. It
expects to charge a servicing fee of 50 basis points. The loan has a maturity of
8 years with a duration of 7.5 years. The cost of funds (the RAROC
benchmark) for the bank is 10%. Assume the bank has estimated the maximum
change in the risk premium on the steel manufacturing sector to be
approximately 4.2%, based on two year of historical data. The current market
interest rate for loans in this sector is 12%.
1) Using the RAROC model, estimate whether the bank should make the loan.
Net income = [(0.12-0.1)+0.005]×5m = $125,000

Loan risk = -7.5×5m×(0.042/1.12) = -$1,406,250
RAROC = 125,000/1406,250 = 0.0889, reject. 46
2) What should be the duration in order for this loan to be approved?
125,000/ ΔLN = 0.1

Þ ΔLN = 125000/0.1 = 1,250,000
DLN × 5m × (0.042/1.12) = 1250,000
DLN = 1250,000/(5m × (0.042/1.12)) = 6.67 years
3) Assuming that the duration cannot be changed, how much additional

interest and fee income will be necessary to make the loan acceptable?
Net income/1406,250 = 0.1  income = $140,625

So additional income = 140625 – 125000 = $15,625
47
4) Given the proposed income stream and the negotiated duration,

what adjustment in the loan rate would be necessary to make the
loan acceptable?
125,000/ ΔLN = 0.1

Þ ΔLN = 125000/0.1 = 1,250,000
7.5× 5m × (ΔR/1.12) = -1250,000
ΔR = -1250,000×1.12/(-7.5×5m) = 0.0373
48

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SCHOOL OF ECONOMICS & FINANCE

CREDIT QUALITY PROBLEMS

CREDIT QUALITY PROBLEMS

CREDIT QUALITY PROBLEMS

Has only a general claim to the assets,

– Can be secured or unsecured

– Can be spot or under commitment

Types of Loans (cont.)

Calculating the return on a loan:

• Factors affecting the promised loan return:

• Loan rate = base lending rate (BR) + credit risk premium

• Direct and indirect fees and charges:

• Gross return on loan (k) per dollar lent:

1) 0.09 + 0.025 = 0.115=11.5% = ¢11.76/¢90.6

Calculating the return on a loan:

Retail vs. Wholesale Credit Decisions

Multiple risk factors affecting loans

Default Risk Models

• Some newer [quantitative] models

Qualitative Model (cont.)

• Use of covenants to encourage certain borrower

Qualitative Model (cont.)

Quantitative Model: Credit Scoring Model

• Quantitative models that use observed borrower

• Objective economic and financial measures of risk are

Quantitative Model: Credit Scoring Model (cont.)

• Scoring models might help to:

• Use past data as inputs into a model to explain repayment

Where PD is probability of default, j is the estimated importance of

1) PD = 0.03(0.75) + 0.02(0.25) – 0.05(0.1) = 0.0225

• Overcomes weakness of the linear probability

Where e is exponential (≈ 2.718), F(PDi) is logistically

Linear Discriminant Model (cont.)

Assets $ Liabilities and equity $

1) What is the Altman discriminant function value for MNO?

2) Z>2.99, application approved.

• If we know the risk premium we can infer the probability of default.

• Assume that γ is the proportion of the loan's principal and

Probability of default = 1-p

Where: Φ is risk premium between k and i. 30

1) Calculate the probability of default, assuming that if the bond is

p = (1+i)/(1+k) = 1.055/1.085 = 0.9724

2) Calculate the probability of default, assuming that the expected recovery

Probability of default = 1-0.9447 = 0.0553

3) Based on the assumption in question 2 (50% recovery), what is the

3% risk premium with no recovery and 1.476% risk premium

Term Structure Derivation (cont.):

a one-period rate of interest expected on an issued security

Term Structure Derivation (cont.):

• Similarly, for the two-year corporate security, the expected one-year

• Advantage: forward looking and based on market expectation.

Marginal probability of default:

Cumulative probability of default:

Risk replying on the Credit rating agencies

• Credit ratings tend to lag the market pricing of credit

Risk replying on the Credit rating agencies

• Rating agencies may make mistakes

• Some risks are difficult to capture

• RAROC = risk-adjusted return on capital.

RAROC (cont.): Estimate Loan Risk

RAROC (cont.): Estimate Loan Risk

– Used by large FIs with good loan default database.

Loan risk = -2.5×500,000×(0.01/1.1) = 11,363.64

Net income = [(0.12-0.1)+0.005]×5m = $125,000