Credit Risk: Loan Portfolio

1
Chapter 12

• Credit Risk Loan Portfolio Concentration Risk

2
Overview

• This chapter discusses the management of credit
  risk in a loan (asset) portfolio context. It also
  discusses the setting of credit exposure limits
  to industrial sectors and regulatory approaches
  to monitoring credit risk. The National
  Association of Insurance Commissioners has also
  developed limits for different types of assets
  and borrowers in insurers portfolios.

3
Simple Models of Loan Concentration

• Migration analysis
• Track credit rating changes within sector or pool
  of loans.
• Rating transition matrix.
• Widely applied to commercial loans, credit card
  portfolios and consumer loans.

4
Web Resources

• For information on migration analysis, visit
• Standard Poors www.standardandpoors.com
• Moodys www.moodys.com

5
Rating Transition Matrix

• Risk grade end of year
• 1 2 3 Default
• Risk grade 1 .85 .10 .04 .01
• beginning 2 .12 .83 .03 .02
• of year 3 .03 .13 .80 .04

6
Simple Models of Loan Concentration

• Concentration limits
• On loans to individual borrower.
• Concentration limit Maximum loss ? Loss rate.
• Maximum loss expressed as percent of capital.
• Some countries, such as Chile, specify limits by
  sector or industry

7
Diversification Modern Portfolio Theory

• Applying portfolio theory to loans
• Using loans to construct the efficient frontier.
• Minimum risk portfolio.
• Low risk
• Low return.

8
Applying Portfolio Theory to Loans

• Require
• (i) expected return on loan (measured by
  all-in-spread)
• (ii) loan risk
• (iii) correlation of loan default risks.

9
Modern Portfolio Theory
Expected Return
Variance
10
KMV Portfolio Manager Model

• KMV Measures these as follows
• Ri AISi - E(Li) AISi - EDFi LGDi
• si ULi sDi LGDi
• EDFi(1-EDFi)½ LGDi
• rij correlation between systematic return
  components of equity returns of borrower i and
  borrower j.

11
Partial Applications of Portfolio Theory

• Loan volume-based models
• Commercial bank call reports
• Can be aggregated to estimate national
  allocations.
• Shared national credit
• National database that breaks commercial and
  industrial loan volume into 2-digit SIC codes.

12
Partial Applications

• Loan volume-based models (continued)
• Provide market benchmarks.
• Standard deviation measure of loan allocation
  deviation.

13
Loan Loss Ratio-Based Models

• Estimate loan loss risk by SIC sector.
• Time-series regression
• sectoral losses in ith sector
• loans to ith sector
• a bi total loan losses
• total loans

14
Regulatory Models

• Credit concentration risk evaluation largely
  subjective.
• Life and PC insurance regulators propose limits
  on investments in securities or obligations of
  any single issuer.
• General diversification limits.

15
Pertinent Websites

• For more information visit
• Federal Reserve Bank www.federalreserve.gov
• KMV www.kmv.com
• Moodys www.moodys.com
• National Association of Insurance Commissioners
  www.naic.org
• Standard Poors www.standardandpoors.com

16
Chapter 13

• Off Balance Sheet Risk

17
Overview

• This chapter discusses the risks associated with
  off-balance-sheet activities. OBS activities are
  often designed to reduce risks through hedging
  with derivative securities and other means.
  However, as several recent events demonstrate,
  OBS risk can be substantial. Regulatory policy
  has been altered as a result of accounting abuses
  and other unethical practices.

18
OBS Activities

• Infamous cases
• Barings.
• NatWest Bank
• Midland Bank
• Chase Manhattan
• Union Bank of Switzerland
• Metallgesellschaft.
• Bankers Trust.
• CSFB/Orange County, CA.
• Sumitomo Corp.
• Long-Term Capital
• AllFirst Bank/Allied Irish Bank

19
Banks and the Enron debacle

• J.P. Morgan Chase and Citigroup
• 2.25 billion loss via credit derivatives
• Sarbanes-Oxley Act of 2002
• Disclosure requirements
• arrangements that may be of material concern to
  the markets.

20
OBS Activities and Solvency

• Off-balance-sheet assets
• Off-balance-sheet liabilities
• Valuation of OBS items
• Delta of an option
• Notional value of an OBS item
• Delta equivalent or Contingent asset value
• Delta Face value of option

21
Valuation

• True picture of net worth
• Should include market value of on- and
  off-balance-sheet activities.
• E (A L) (CA CL)
• Exposure to OBS risk just as important as other
  risk exposures

22
Changes in OBS (Billions)
23
Incentives to Increase OBS Activities

• Losses on LDC loans and reduced margins produced
  profit incentive.
• Increases in fee income.
• Avoidance of regulatory costs or taxes.
• Reserve requirements.
• Deposit insurance premiums.
• Capital adequacy requirements.

24
Schedule L Activities

• Loan commitments
• Letters of credit
• LCs SLCs
• Futures, forwards, swaps and options
• When issued securities
• Loans sold
• OBS only if sold without recourse

25
Schedule L OBS Activities

• Loan commitments and interest rate risk
• If fixed rate commitment the bank is exposed to
  interest rate risk.
• If floating rate commitment, there is still
  exposure to basis risk.
• Take-down risk Uncertainty of timing of
  take-downs exposes bank to risk. Back-end fees
  are intended to reduce this risk.

26
Other Risks with Loan Commitments

• Credit risk credit rating of the borrower may
  deteriorate over life of the commitment
• Aggregate funding risk During a credit crunch,
  bank may find it difficult to meet all of the
  commitments.
• Banks may need to adjust their risk profile on
  the balance sheet in order to guard against
  future take-downs on loan commitments.

27
Commercial LCs and SLCs

• Particularly important for foreign purchases. If
  creditworthiness of the importer is unknown to
  seller, or lower than the banks,
• then gains available through using an LC.
• SLCs often used to insure risks that need not be
  trade related.
• performance bond guarantees.
• Property casualty insurers also prominent in
  selling SLCs.

28
Derivative Contracts

• Used by FIs for hedging purposes
• Or FIs acting as dealers
• Big Three Dealers J.P. Morgan Chase, Bank of
  America, Citigroup.
• 87 of derivatives held by user banks
• Futures, forwards, swaps and options.
• Forward contracts involve substantial
  counterparty risk
• Other derivatives create far less default risk.

29
When Issued Trading

• Commitments to buy and sell securities prior to
  issue. Example commitments taken in week prior
  to issue of new T-bills.
• The risk is that the bank may overcommit as with
  Salomon Brothers in market for new 2-year bonds
  in 1990. Caused the Treasury to revise the
  regulations governing the auction of bills and
  bonds.

30
Loans Sold

• Exposure to risk from loans sold unless no
  recourse
• Ambiguity of no recourse qualification
• Reputation effects may amplify the FIs
  contingent liabilities

31
Schedule L and Nonschedule L OBS Risks

• FIs other than banks may engage in many of the
  OBS activities discussed so far.
• Banks have to report the five OBS activities
  (discussed in preceding slides) each quarter as
  part of Schedule L of the Call report.

32
Non-Schedule L Activities

• Settlement Risk
• FedWire is domestic. CHIPS is international and
  settlement takes place only at the end of the
  day. Leaves the bank with intraday exposure to
  settlement risk. During the day, banks receive
  provisional messages only.

33
Non-Schedule L Risk Affiliate Risk

• Affiliate risk occurs when dealing with BHCs.
• Creditors of failed affiliate may lay claim to
  surviving banks resources.
• Effects of source of strength doctrine.

34
The Role of OBS Activities

• OBS activities are not always risk increasing
  activities.
• In many cases they are hedging activities
  designed to mitigate exposure to interest rate
  risk, foreign exchange risk etc.
• OBS activities are frequently a source of fee
  income, especially for the largest most
  credit-worthy banks.

35
Pertinent Websites

• American Banker www.americanbanker.com
• Federal Reserve Bank www.federalreserve.gov
• Bank One Corp. www.bankone.com
• Citigroup www.citigroup.com
• CHIPS www.chips.org
• FDIC www.fdic.gov
• J.P. Morgan/Chase www.jpmorgan.com
• NY Board of Trade www.nybot.com
• OCC www.occ.treas.gov
• U.S. Treasury www.ustreas.gov