Transcript FINANCIAL MARKETS AND INSTITIUTIONS: A Modern Perspective

Chapter Twenty
Managing Credit Risk on
the Balance Sheet
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Credit Risk Management
• Financial institutions (FIs) are special because of their ability to
transform financial claims of household savers efficiently into
claims issued to corporations, individuals, and governments
• FIs’ ability to process and evaluate information and control
and monitor borrowers allows them to transform these claims
at the lowest possible cost to all parties
• Credit allocation is an important type of financial claim
transformation for commercial banks
– FIs make loans to corporations, individuals, and governments
– FIs accept the risks of loans in return for interest that (hopefully)
covers the costs of funding—and are thus exposed to credit risk
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Credit Risk Management
• The credit quality of many FIs’ lending and investment
decisions has been called into question in the past 25 years
– problems related to real estate and junk bond lending surfaced at
banks, thrifts, and insurance companies in the late 1980s and early
1990s
– concerns related to the rapid increase of credit cards and auto
lending occurred in the late 1990s
– commercial lending standards declined in the late 1990s, which
led to increases in high-yield business loan delinquencies
– concerns shifted to technology loans in the late 1990s and early
2000s
– mortgage delinquencies, particularly with subprime mortgages,
surged in 2006 and continue to be a concern
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Credit Risk Management
• Larger banks are generally more likely to accept
riskier loans than smaller banks
• Larger banks are also exposed to more counterparty
risk off-the-balance-sheet than smaller banks
• Managerial efficiency and credit risk management
strategies directly affect the return and risk of the loan
portfolio
• At the extreme, credit risk can lead to insolvency as
large loan losses can wipe out an FI’s equity capital
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Credit Analysis
• Real estate lending
– mortgage loan applications are among the most
standard of all credit applications
– decisions to approve or disapprove a mortgage
application depend on
• the applicant’s ability and willingness to make timely interest
and principal payments
• the value of the borrower’s collateral
– the ability to maintain mortgage payments is measured
by GDS and TDS
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Credit Analysis
• Real estate lending (cont.)
– GDS refers to the gross debt service ratio
• equal to the total accommodation expenses (mortgage, lease,
condominium, management fees, real estate taxes, etc.)
divided by gross income
• acceptable threshold generally set around 25% to 30%
– TDS refers to the total debt service ratio
• equal to the total accommodation expenses plus all other debt
service payments divided by gross income
• acceptable threshold generally set around 35% to 40%
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Credit Analysis
• Real estate lending (cont.)
– FIs also use credit scoring systems to evaluate
potential borrowers
• credit scoring systems are mathematical models that use
observed loan applicant’s characteristics to calculate a score
that represents the applicant’s probability of default
• loan officers can often give immediate “yes” or “no”
answers—along with justifications for the decision
– FIs also verify borrower’s financial statements
• perfecting collateral is the process of ensuring that collateral
used to secure a loan is free and clear to the lender should the
borrower default on the loan
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Credit Analysis
• Real estate lending (cont.)
– FIs do not desire to become involved in loans that are
likely to go into default
– in the event of default lenders usually have recourse
• foreclosure is the process of taking possession of the
mortgaged property in satisfaction of a defaulting borrower’s
indebtedness and forgoing claim to any deficiency
• power of sale is the process of taking the proceedings of the
forced sale of a mortgaged property in satisfaction of the
indebtedness and returning to the mortgagor the excess over
the indebtedness or claiming any shortfall as an unsecured
creditor
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Credit Analysis
• Real estate lending (cont.)
– before an FI accepts a mortgage, it
• confirms the title and legal description of the property
• obtains a surveyor’s certificate confirming that the house is
within the property’s boundaries
• checks with the tax office to confirm that no property taxes
are unpaid
• requests a land title search to determine that there are no other
claims against the property
• obtains an independent appraisal to confirm that the purchase
price is in line with the market value of the property
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Credit Analysis
• Consumer and small business lending
– techniques are very similar to that of mortgage lending
– however, non-mortgage consumer loans focus on the
ability to repay rather than on the property
• credit models put more emphasis on personal characteristics
– small-business loan decisions often combine computerbased financial analysis of borrower financial
statements with behavioral analysis of the business
owner
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Credit Analysis
• Mid-market commercial and industrial lending
– is generally a profitable market for credit-granting FIs
– typically mid-market corporates
• have sales revenues from $5 million to $100 million per year
• have a recognizable corporate structure
• do not have ready access to deep and liquid capital markets
– commercial loans can be for as short as a few weeks to
as long as 8 years or more
• short-term loans are used to finance working capital needs
• long-term loans are used to finance fixed asset purchases
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Credit Analysis
• Mid-market C&I lending (cont.)
– generally at least two loan officers must approve a new
loan customer
– large credit requests are presented formally to a credit
approval officer and/or committee
– five C’s of credit
•
•
•
•
•
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character
capacity
collateral
conditions
capital
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Credit Analysis
• Mid-market C&I lending (cont.)
– FIs perform cash flow analyses, which provide
information regarding an applicants expected cash
receipts and disbursements
– statements of cash flows separate cash flows into
• cash flows from operating activities
• cash flows from investing activities
• cash flows from financing activities
– FIs may also perform ratio analyses
• time-series analyses
• cross-sectional analyses
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Credit Analysis
• Mid-market C&I lending (cont.)
– common ratio analysis includes
• liquidity ratios
– current ratio
– quick ratio (i.e., the acid test)
• asset management ratios
– number of days in receivables
– number of days in inventories
– sales to working capital
– sales to fixed assets
– sales to total assets (i.e., the asset turnover ratio)
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Credit Analysis
• Mid-market C&I lending (cont.)
• debt and solvency ratios
– debt-to-assets ratio
– times interest earned ratio
– cash-flow-to-debt ratio
• profitability ratios
– gross margin
– operating profit margin
– return on assets (ROA)
– return on equity (ROE)
– dividend payout ratio
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Credit Analysis
• Mid-market C&I lending (cont.)
– ratio analysis has limitations
• diverse firms are difficult to compare versus benchmarks
• different accounting methods can distort industry comparisons
• applicants can distort financial statements
– common-size analysis and growth rates
• common-size financial statements present values as
percentages to facilitate comparison versus competitors
• year-to-year growth rates can identify trends
– loan covenants can be used as part of the loan
agreement to mitigate credit risk
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Credit Analysis
• Mid-market C&I lending (cont.)
– following approval, the account officer ensures that
conditions precedent have been cleared
• those conditions specified in the credit agreement or terms
sheet for a credit that must be fulfilled before drawings are
permitted
• includes title searches, perfecting of collateral, etc.
– FIs typically wish to develop permanent, long-term,
mutually beneficial relationships with their mid-market
commercial and industrial customers
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Credit Analysis
• Large commercial and industrial lending
– fees and spreads are smaller relative to small and midsize corporate loans, but the transactions are often
large enough to make them worthwhile
– FIs’ relationships with large clients often center around
broker, dealer, and advisor activities with lending
playing a lesser role
– large corporations often use
• loan commitments
• performance guarantees
• term loans
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Credit Analysis
• Large C&I lending (cont.)
– account officers often rely on rating agencies and market analysts
to aid in their credit analysis
– sophisticated credit scoring models are also used
• Altman’s z-score: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
where X1 = working capital ÷ total assets
X2 = retained earnings ÷ total assets
X3 = earnings before interest and taxes ÷ total assets
X4 = market value of equity ÷ book value of long-term debt
X5 = sales ÷ total assets
• KMV Credit Monitor Model uses the option pricing model of
Merton, Black, and Scholes to calculate expected default frequencies
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Credit Analysis
• Calculating the return on a loan
– the return on assets (ROA) approach uses the
contractually promised gross return on a loan, k, per
dollar lent
f  BR  m 
1 k  1
1  b1  R 
where
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f = the loan origination fee
b = the compensating balance requirement
R = the reserve requirement ratio
BR = the base lending rate
m = the credit risk premium on the loan
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Credit Analysis
• Calculating the return on a loan (cont.)
– the risk-adjusted return on assets (RAROC) model
balances a loan’s expected income against its expected
risk
RAROC 
one - year income on a loan
loan (asset) risk or value at risk
• the RAROC is compared vis-à-vis the lender’s tax-adjusted
return on equity (ROE)
– if RAROC > ROE make the loan
– if RAROC < ROE either adjust the loan such that
RAROC > ROE or decline to make the loan
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