Introduction

The aim of credit risk management is to balance between risk and return to achieve optimum profitability and efficiency Taking and institutional view banks could minimise concentration risk Lending on a more scientific basis would help remove subjectivity
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Introduction
Credit risk seeks following objectives:
a) achieve and appropriate balance between risk and return; b) avoid concentration risk; c) manage loans on a portfolio basis; and d) take a group of loans off the statement of financial position.

This chapter examines some of the credit risk measurement tools.

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Credit Risk Measurement

Altmans Z Score
Relies on multivariate model accounting ratios that provide best predictors of performance: Activity Liquidity Solvency Profitability Earnings Variability Size

Credit decision relies on output from equation at varying cutoff levels

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Credit Risk Measurement

Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5
X1 = Working Capital / Total Assets, X2 = Retained Earnings / Total Assets X3 = EBIT / Total Assets, X4 = Market Val of Equity / Book Val Debt, X5 = Sales / Total Assets Z > 2.675 => High Probability of Solvency Z < 2.675 => High Probability of Insolvency (Zone of Ignorance) Z < 1.8 => Certain Insolvency
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Loan Pricing
All loans provide a cost to the Statement of Financial Position
Statement of Financial Position Costs
Capital Cost: Capital that must be allocated to support default risk Liquidity: Lending activities must allow sufficient liquidity on Statement of financial position Cost of Funds: Returns must be achieved from loan including considering Return on Equity, Return on Liquidity, Market Cost of Deposits and Return on the Loan
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Loan Pricing
Noncredit Risk Costs
Interest Rate Risk: Whether loan book has fixed/floating rate loans Pre-payment Risk: Risk that loans will be paid out earlier than specified term Origination Costs: Costs of marketing and monitoring securitised loans sold

Credit Costs
Expected Losses = Default Probability x (1 Recovery Rate) Unexpected Losses: Generally reflects volatility of Expected Losses
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Chapter Twelve Credit Risk From The Regulators Perspective

Capital Adequacy
Recent evidence shows poor credit decisions play a major part in bank failures Generally, banks required to allocate a minimum of 8% of a loans value from Capital As some loans riskier than others, risk weighting system adopted
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Securitisation
Clean sale supply of assets:
Should be no beneficial interest in the sold assets and absolutely no obligation on institution Should be no recourse (including costs) to the institution and no obligation to repurchase loan asset

Securitisation
Amount paid for loans should be fixed and received at time asset is transferred from lending institution Any assets provided to the Special Purpose Vehicle (SPV) as a substitute or sold below book value do not relieve credit risk

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Securitisation
Revolving Facilities:
Defined as assets with ongoing credit relationship such as credit cards and home loans Rights, details of cashflows and obligations of each party must be clearly specified As with normal securitisation, institution cannot supply additional assets to the pool
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Securitisation
Liquidity shortfalls for the institution share must not exceed the interest receivable Institution retains right to cancel undrawn amounts Institution must have no obligation to repurchase

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Chapter Thirteen Problem Loan Management

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Introduction
When financial institutions make loans, returns generated mean accepting some default risk It is imperative that default risk is managed so that the solvency of the bank is not threatened Should the problem loan be foreclosed or actively managed?
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Causes of Default
Default does not necessarily mean that all of the loan extended is lost. Default is defined here as a loan where repayments are overdue Better lending procedures can minimise, but not eliminate, the risk of default Harder to manage default risk as loan book becomes larger
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Causes of Default
Likely causes of default
Lack of compliance with loan policies Lack of clear standards and excessively lax loan terms Inadequate controls over loan officers Over-concentration of bank lending Loan growth exceeding banks capabilities Inadequate problem loan identification Insufficient knowledge of customers finance Lending in unfamiliar markets
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Extent of Problem Loans

All banks experience bad debts, but the management of them becomes critical Banks should consider:
Timing of loan in economic cycle Larger exposures to individual borrowers Larger exposures to single sectors Close monitoring of exposures during unfavourable economic periods
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The Business Cycle

The business cycle characterised by three phases:
Recovery and Expansion:
Flourishing economy with increased spending leading to higher deposits and interest rates

Boom:
Major asset inflation with business overconfidence and declining credit standards

Downturn:
Declining asset values and economic activity generally accompanied by increased defaults
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Problem Loans, Provisions and Regulatory Issues

When borrower misses payments, two questions arise within lending institution
Is missed payment temporary? Is missed payment likely to be permanent?

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Problem Loans, Provisions and Regulatory Issues

If payment more than 90 days, loan is considered an impaired asset as return on loan not achieved Value of impaired loan must be downgraded on statement of financial position

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Problem Loans, Provisions and Regulatory Issues

BOJ: If one asset is impaired, all loans to that client considered impaired When loans are impaired, institution must create a provision for a loan loss Provisions are classified in three ways:
Specific Provisions General Provision Bad-Debt Write-Offs
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Problem Loans, Provisions and Regulatory Issues

Specific Provisions:
These are provisions set aside for a specifically identifiable loan where the institution assesses the:
Condition of the loan; Condition of the borrower; Impact of economic events.

Not all of the loan must have provisions made as lender may assess the likely losses from the asset.
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Problem Loans, Provisions and Regulatory Issues

General Provisions
These are provisions that are made as a proportion of the entire loan portfolio Suitable for large loan portfolios of similar assets, e.g. mortgages, where specific provisioning unsuitable BOJ: Generally minimum provision of 0.5% of Risk-Weighted Assets Can adjust general provisions level depending on economic activity or risk levels
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Problem Loans, Provisions and Regulatory Issues

Bad Debts:
Recognition of bad debts occurs where:
All security liquidated; Guarantees have been enforced; Remaining remedial actions explored; and No remaining sources of cash can be called.

Once the above steps are completed, the financial institution must write off the bad debt with asset valued at zero and a charge made against profits.
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Other Considerations with Problem Loans

The provisions made minimise the efficient use of capital that could otherwise be used for lending purposes Institutions often have provisioning systems exceeding BOJ requirements to reflect banks risk profile
Higher provisions indicate higher risk and/or more conservative management Lower provisions indicate lower risk and/or more aggressive management
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Dynamic Provisioning
The risk profile of the loan portfolio is sensitive to point in the economic cycle, e.g. greatest defaults occur at bottom of economic cycle Therefore:
Credit risk is not static but changes over time Bad debt should not come as a surprise as modelling should detect changes to probable default risk in portfolio segments
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Dynamic Provisioning
Key principles in dynamic provisioning:
Classify loans into homogeneous groups Sub-classify groups by maturity length
Determine probability of loss for each group Determine likely severity of loss for each group

Use the historical loan-loss information to create predictive model incorporating economic conditions, interest rates, investment activity, etc. Apply model outcome to current provisions
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Dealing with Defaults

If the loan is in default, bank must act to minimise the losses arising from defaulting clients and may reschedule payments rather than liquidate loan Classify defaulting clients into three categories:
Mild financial distress; Moderate financial distress; and Severe financial distress.
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Dealing with Defaults

Mild Financial Distress
Often occurs when borrower faces shortterm cash flow problems, e.g. late receipts If default less than 90 days, remedies include:
Changing/lengthening repayment schedules Assisting firm if cash flow shortage has risen from period of rapid growth Encouraging firm to sell non-core assets Requesting/demanding equity capital injection
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Dealing with Defaults

Moderate Financial Distress
May occur if cash flow problems coincide with borrowers asset values declining Course of action determined by nature of collateral, e.g. foreclose on mortgage or support manufacturing firm with unique or limited market for assets Lender may consider evaluation of alternatives via NPV or probabilistic model of Expected Values for different actions
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Dealing with Defaults

Severe Financial Distress
Characterised by missed payments and value of borrower less than loan amount Lender needs to very carefully evaluate whether is is better to:
Liquidate firm to recover greatest percentage of loan possible; or Restructure debt (inclusive of debts to other lenders) to maintain operations to allow firm to trade out of current crisis or be sold as going concern
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Dealing with Defaults

The coordination problem
Where numerous classes of debt-holders observed, e.g. syndicated loans, any rescheduling will require cooperation of all debt-holders May be difficult to coordinate actions between junior and senior debt-holders Need to restructure debts to ensure all debt-holders treated equitably or else rescheduling proposal will fail
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Dealing with Defaults

Other Breaches
Corporate loans may have a variety of covenants imposed to protect loan quality Lender may place a variety of conditions to strengthen loan repayment probability:
No excessive withdrawal of cash flows Risk profile of firm to remain unchanged Specification of various ratios including gearing, dividend payout and interest coverage Continued involvement of key staff Application of risk management strategies
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