Transcript Credit Risk: Loan Portfolio and Concentration Risk: Chapter 12

Credit Risk: Loan Portfolio and
Concentration Risk: Chapter 12
Financial Institutions Management, 3/e
By Anthony Saunders
Irwin/McGraw-Hill
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Simple Models of Loan Concentration

Migration analysis
• Track credit rating changes within sector or pool of
loans.
• Rating transition matrix.
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Rating Transition Matrix
Risk grade:
beginning
of year
1|
2|
3|
Risk grade: end of year
1
2
3
Default
.85 .10 .04 .01
.12 .83 .03 .02
.03 .13 .80 .04
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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.
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Diversification and Modern Portfolio
Theory

Applying portfolio theory to loans
• Using loans to construct the efficient frontier.
• Minimum risk portfolio.
» Low risk
» Low return.
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Applying Portfolio Theory to Loans

Require
• (i) expected return on loan(measured by all-inspread);
• (ii) loan risk;
• (iii) correlation of loan default risks.
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KMV Portfolio Manager Model
• Ri = AISi - E(Li) = AISi - [EDFi × LGDi]
• si = ULi = si × LGDi
= [EDFi(1-EDFi)]½ × LGDi
• rij = correlation between systematic
return components of equity returns of
borrower i and borrower j.
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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.
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Partial Applications

Loan volume-based models (continued)
• Provide market benchmarks.
» Standard deviation measure of loan allocation
deviation.
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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 ]
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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.

• Diversification limits.
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