Chapter Eleven

Credit risk measurement and management

of the loan portfolio

12/13/21 978-0-7346-1164-2 1
Learning objectives

1. Describe the benefits of credit risk management

2. Explain and use Altman’s Z score
3. Explain how stock prices can be used to explain credit risk
4. Suggest how risk-adjusted return on capital can be used for
portfolio purposes
5. Use the Sharpe Index for lending purposes
6. Calculate the risk of a loan portfolio using CreditMetrics™
7. Understand the elements of loan pricing 2
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

3
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.
4
Credit risk measurement

• Altman’s Z Score
• Relies on multivariate model accounting ratios that provide best
predictors of performance:

Activity Profitability
Liquidity Earnings Variability
Solvency Size

• Credit decision relies on output from equation at varying cutoff levels

5
 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 value of equity / nook value 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 6
Using stock prices

• To overcome the problem of using historical data, KMV Moody’s

extended Merton’s option pricing model for risky debt
• Borrower holds equivalent of long call option
• Lender holds equivalent of short put option
• The model incorporates current stock prices to create an
Expected Default Frequency (EDF)

7
• By incorporating returns distributions, we can estimate
probability of default
(Mkt Value of Assets) - (Default Point)
Distance to Default 
(Mkt Value of Assets)(Asset Volatility )

• KMV also incorporates actual default data to assess the risk to produce EDF

Number of Default Firms

Expected Default Probabilit y 
All Firms of Sample
8
Portfolio management

• A portfolio of loans similar to portfolio of other assets

• Risk-Adjusted Return on Capital (RAROC)
Income from loan for one year
RAROC
Capital at Risk
• Capital at risk is defined using a duration approach to measure sensitivity to rate
changes
 ΔR 
ΔL  (-D L )(L) 
1 R L 
9
Altman’s Sharpe Index Approach

Three steps:
N

Step 1: Calculate return on portfolio R p   X i EARi

i 1

N N
Step 2: Calculate variance of the portfolio Vp   X X σ σ ρ
i j i j ij
i 1 j1

Rp
η
Step 3: Maximise the relationship which is the Sharpe Index Vp
10
CreditMetrics™

• Incorporates changing credit risk over time by addressing

migration probabilities, eg, AAA to AA, A to BB etc
• Values securities from a zero-coupon yield curve and then treats
cashflows as:
• First year’s cashflows not discounted
• Subsequent cashflows calculated on annual basis (despite being
generally semiannual)
• Defaulted bonds are treated according to recovery rate, eg 51.13% for
BBB Bond
11
• By adjusting for credit migration, the following factors are considered in
risk assessment and capital allocation decisions
• Year-end rating
• Probability of rating state
• New bonds value plus coupon (per previous calculation discussion)
• Probability-weighted value
• Probability-weighted difference
• The capital allocation for the single security is then the sum of the
probability-weighted differences 12
• Process becomes far more complex when considering portfolio case and
employs four steps:
Step 1: Define the portfolio as individual assets
Step 2: For each asset, define cashflows and calculate PV for each state using
zero-curve
Step 3: Using transition matrix, calculate probability-weighted PV and standard
deviation
Step 4: Calculate portfolio risk by executing above steps for the joint probabilities
for a loan in the portfolio to derive portfolio’s st. deviation 13
Managing the portfolio

• Once portfolio constructed, tools exist to manage

portfolio’s risks
• Securitisation:
• Technique for packaging cashflows from loan assets and selling
them as securities
Includes Useful For
Utility Bills Capital Mgt
Royalties Liquidity Mgt
Car Loans/Leases Interest Rate Risk Mgt
Commercial Rent 14
Managing the portfolio

• Pass-Through Structures
• Loan assets sold completely from statement of financial position
through a Special Purpose Vehicle (SPV)
• SPV Trustee manages all cashflows between borrowers and lenders
• Pay-Through Structures
• Very similar to Pay-Through structure but assets not sold, but only
managed by SPV
15
Managing the portfolio

• Securitisation and Credit Risk Management

• Determine whether securities have recourse
• Loan assets must be sold for fair value
• May interfere with borrower/lender relationship

16
Managing the portfolio

• Credit Derivatives
• Assets can be maintained on the statement of financial position, with
risk management structures in place through credit derivatives
• Three main categories:
• Credit Default Swaps: Swap seller receives a periodic fee for covering any default
losses
• Total Return Swaps: Swap seller receives a periodic fee to cover changes in value of
loans
• Credit Options: Option seller provides protection against widening of credit spreads
17
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
18
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
19
Loan pricing

• Loan Pricing: an example

• Assume we have:
• $150,000, five year housing loan
• 5% liquidity required against lending assets returning 4.9%. At call deposits
cost 3.5% and 5 year swap rate is 5%
• Loan operating costs are $1,000 per annum
• Default probability for housing loans is 2% with 95% recovery rate and capital
required is 8%
• ROE is 20% and tax rate is 30% 20
Loan pricing

• Capital allocation is:

$150,000 x 8% x 50% = $6,000
• After-tax ROE is:
$6,000 x 20% = $1,200
• Amount of liquid assets for 5% policy is:
Liquid Assets = Assets x 5%
• By rearranging we get:
Liquid Assets = $7,500 / 0.95 = $7,985 21
Loan pricing

• First stage simple Statement of financial position (NB – Deposits*

are a balancing figure only)

Loan $150,000
Liquid Assets $7,895
Total $157,895
Deposits* $151,895
Equity $6,000
Total $157,895
22
Loan pricing

• Table requires working backwards from the balancing profit after

tax figure to obtain the yield of 4.48%

Profit $ Yield % Balance $

Loan 6,714.80 4.48 150,000
Liquid Assets 315.80 4.00 7,895
Less: Interest on Deposits 5,316.32 3.50 151,895
Profit Before Tax 1,714.28
Less: Tax at 30% 514.28
Profit After Tax 1,200.00 20.00 6,000
23
Loan pricing

• Practical Loan Pricing

• Two major considerations extend beyond the theoretical
discussion above:
• Competitive forces will largely govern what can be charged for loans
reducing in lower margins;
• Loan pricing much more dependent on fee structures across client’s
products. For example, if the client also has a variety of the bank’s
products, the fees from the other products may offset any slim
margins (or even losses) arising from the loan pricing structure.
24