April 3

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April 3

• Current events
• Credit risk big picture

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Credit Risk
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The Structure of Bank Credit Risk
Credit Risk
TransactionRisk
PortfolioRisk
SelectionRisk
UnderwritingRisk
OperationsRisk
IntrinsicRisk
ConcentrationRisk
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Types of Loans

• Commercial and Industrial
• Real Estate
• Construction
• Residential 1 to 4
• home equity
• other
• residential 5
• Commercial (nonfarm, nonresidential)
• Farmland
• Agr. production
• Consumer (loans to individuals)
• credit card
• other
• Loans to other depository institutions
• Loans to small businesses

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Analysis of Credit RiskBank Reports

• Loan schedule
• Income statement measures
• Nonperforming assets
• Charge-offs
• Maturity and repricing loan data
• Derived revenues
• income statement values for specific categories
  divided by quarterly average loan volume

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Terminology

• Secured vs. unsecured
• Wholesale vs. retail
• Loan commitment
• Adjustable rate mortgages (ARMs)
• Revolving loan
• Loan covenants
• Compensating balances
• Legal lending limits
• Regulatory Requirements
• reasons for denial (Reg. B)
• truth in lending (Reg. Z)
• Loan syndications

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Truth in Lending(key disclosures)

• the amount financed
• the finance charge
• annual percentage rate
• payment schedule
• total of payments
• security interest information

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Borrower Evaluation
Reject
Accept
Loan Terms
Comply withConsumer Protection Laws?

• amount
• price
• collateral
• maturity
• fixed vs. variable interest rate
• covenants
• others

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Credit Risk Evaluation
Ability to Pay

• 5 Cs of Credit
• Character
• Capacity
• Collateral
• Capital
• Condition

CreditRisk
Willingness to Pay
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Commercial Lending

• Competitive environment
• banks
• credit unions
• insurance companies
• credit unions
• investment bankers
• stocks
• bonds
• commercial paper

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Managing Credit Risk

• Avoid high risk loans
• Reduce risk by evaluating credit worthiness
• Monitor the behavior of borrower
• Transfer credit risk by selling loans in
  secondary markets
• Diversify the loan portfolio.

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Written Loan Policy

• establish general guidelines and principles for
  lending activities
• outlines banks lending objectives in terms of
  profitability and risk
• loan supervision

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Example Lending Authorities
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Written loan policy, cont.

• geographical limits
• credit policies
• administration
• types of desirable and undesirable loans
• collateral
• documentation
• procedures for collecting past dues
• charge offs
• overdrafts
• participations

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Ways banks make loans

• solicit loans
• buying loans
• commitment
• refinancing
• loan brokers
• customers request loans

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Process

• loan request
• business plan
• financial data
• initial interview

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Character

• credit records
• credit bureaus
• credit agencies (Dun and Bradstreet)
• other banks
• character check -- fraud

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Capacity

• Financial condition and ability to pay
• Credit analysis
• nature of business
• historical statements
• pro-forma statements
• fundamental assumptions
• realistic
• scenario analysis
• sensitivity analysis
• contingencies
• ratio analysis

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Analysis

• Trends within firm
• Comparisons to other firms in the industry
• RMA
• Industry analysis

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Collateral

• Assets pledged for security
• Characteristics of good collateral
• standardization
• durability
• identification
• marketability
• stability of value

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Types of Collateral

• Accounts receivable
• pledging
• factoring
• Inventory
• floating lien
• trust receipts (floor planning)
• chattel mortgage (security agreement)
• title registered with government authority
• warehouse receipts
• terminal warehouse
• field warehouse
• marketable securities
• natural resources
• real property and equipment
• guarantees

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Capital

• book value
• market value
• liquidation value

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Conditions

• External factors
• tax laws
• regulations
• import restrictions
• technology

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Compliance

• environmental laws
• CRA (community reinvestment act)
• compliance officers

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Structuring Loan Agreement

• Elements
• the amount borrowed
• the method of repayment
• the fees to be paid

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Supervisory Examination Categories

• OAEM
• Substandard
• Doubtful
• Loss

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Why loans go bad20 reasons
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Credit Scoring and Credit Evaluation
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Numerical Credit Scoring

• Mathematical rules/formulas/model that can be
  used to assess default risk on loans
• Typically based on historical ratios
• Credit bureau ratings
• Presumption there is a mathematical metric
  distinguishing good and bad credits

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Motivations

• improve operating efficiency
• improve credit risk management
• price loans
• used by lenders unfamiliar w/industry

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Uses

• Make loan acceptance decisions
• Credit rating determination
• Credit pricing
• Monitoring of existing loans
• Early warning signals
• Quality appraisals of loan portfolios
• Secondary market applications
• Workout strategies

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History

• 1950s, Bill Fair and Earl Isaac
• Housing last 10 years
• MBS analysts
• Small business and agricultural lenders

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Range of Potential Applications
Range of Possible Application of Quantitative
Credit Risk Models
Large Corporate
Middle Market
Middle Market and
Commercial Real
Residential and Real
Borrowers
Borrowers
Private Borrowers
Small Businesses
Estate
Estate
Consumer
Stock not publicly
No publicly traded
Reliance on collateral
No financial
Publicly traded.
Publicly traded.
No stock.
traded
stock
value.
statements.
Extensive disclosure
Moderate disclosure
Many institutional
Unaudited financial
Approval based on
Fewer information
Little or no publicly
No public debt. More
Greater use of
investors with
information.
cash flow projections
problems because of
traded debt.
information problems.
financial data.
research capabilities
Information problems.
and collateral value.
credit bureaus.
Reliance on financial
Lower use of credit
Reliance on
Moderate monitoring.
Reliance on
statements. Close
Low monitoring
scoring models.
individuals. Close
More reliance on
Increasing use of
demographic
monitoring. Reliance
(annual cycle)
Greater emphasis on
monitoring. Collateral
collateral. Less
credit scoting models.
variables.Collateral
on collateral and
management.
Covenants.
reliance on covenants.
only for consumer
covenants.
durables. No
covenants. Heavy use
Potential for higher
of credit scoring
Limited use of credit
Moderate use of credit
use because of better
models.
scoring models.
scoring models.
data.
Source Managing Credit Risk, The Next Great
Financial Challenge. (Cauette, Altman, Narayanan).
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OCC (Regulator) Statement

• Shorten processing time
• Help lenders control risk
• Manage credit losses
• Evaluate new programs
• Improve lender profitability
• Cautions
• consistent implementation
• use on appropriate products

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Design of Credit Scoring Models
Cutoff score
Good Accounts
Bad Accounts
Percent of Accounts
Credit Score
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Firm Models Based on Accounting Market Data
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Altmans Z-Score

• 1968 article Journal of Finance
• Based on ratio levels and categorical responses
• Based on multiple discriminant analysis
• Looked at 22 possible variables
• 5 variable model

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Initial model

• X1 working capital to assets
• X2 retained earnings to total assets
• X3 Earnings before interest and taxes divided
  by total assets
• X4 market value of equity divided by book value
  of liabilities
• X5 sales divided by total assets
• Lower bound 1.80 (fail)
• Upper bound 2.99 (nonfail)
• Zone of ignorance 1.80 to 2.99

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Modifications for private firmsNo market value
of equity
X1 working capital to assets X2 retained
earnings to total assets X3 Earnings before
interest and taxes divided by total assets X4
book value of equity divided by book value of
liabilities X5 sales divided by total
assets Lower bound 1.80 (fail) Upper bound 2.99
(nonfail) Zone of ignorance 1.80 to 2.99
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Adjustments for Industry Effects

• Sales / assets (X5) varies widely across
  industries
• Model with X5 excluded

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Zeta ModelAltman, Halderman and Narauanan

• Second generation model adapted from Z score
• 7 Variables
• Return on assets (EBIT/Assets)
• Stability of earnings (normalized standard error
  around 5-10 year trend)
• Debt service (EBIT/total interest)
• Retained earnings/assets
• Liquidity current assets/current liabilties
• Capitalization common equity/total capital
• Size (log of firms total assets)

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KMV Corporation model

• Applies only to publicly traded firms
• Uses the market value of equity of the firm as an
  equivalent call option with the amount of debt
  used as the exercise price
• Link the implied volatility of equity and market
  value of assets to determine the probability of
  defaults
• Performs well, but only applies to publicly
  traded entities

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Credit Metrics

• Evaluate current rating category
• Estimate migration probabilities
• Probability of going from AAA to AA, AAA to A,
  and so on.
• Use to estimate probability of default
• My research is applying this approach to small,
  nonpublic firms

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Consumer and Residential Real Estate Models
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Use of credit repositories

• Equifax Beacon Score
• Experian (TRW) FICO
• Trans Union Emperica Score

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• range 365 to 850
• typically need score 660
• assured if greater 700
• number of credit lines
• level of credit line usage
• length of history
• derogatory items
• past bankruptcy
• number of credit inquiries

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Other common screening criteriaConsumer lending

• Maximum debt to salary of 60
• Must be 25 years old
• Length of time on job 2 years
• At least one year at current residence
• Income per dependent
• Number of credit cards
• Rent or own

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Limitations

• Implementation of model
• Quality of information
• Accounting issues
• Variation of businesses types/characteristics
• Standardization issues
• Discrimination issues
• Collateral??

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Other Issues

• Discrimination

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Sample Small-Business Models
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Sample Small Business Credit Scoring Model
Characteristic Value and Weights
Variable
Measure
Profitability
Return on equity
0-4
5-9
10-14
15-19
20
score
0
1
2
3
4
5
Liquidity
Current ratio
0.50-0.99
1.00-1.49
1.50-1.99
2.00-2.49
2.50
score
0
2
4
6
8
10
Solvency
Debt-to-equity ratio
2.50
2.00-2.49
1.50-1.99
1.00-1.49
0.50-0.99
score
0
2.5
5
7.5
10
12.5
Repayment capacity
Term debt coverage ratio
0.50-0.99
1.00-1.49
1.50-1.99
2.00-2.49
2.50
score
0
2.5
5
7.5
10
12.5
Collateral
Secured assets/max loan
1.00 -1.19
1.20-1.39
1.40-1.59
1.60-1.79
1.80
score
0
2
4
6
8
10
Score
Credit Class
0 - 9.99
Non-acceptable loan
10-19.99
Very High Risk Loan
20-29.99
High-Risk Loan
30-39.99
Intermediate-Risk Loan
40-50
Low-Risk Loan
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Suppose a small business has the following data
Measure
Value
Score
Return on equity
6
2
Current ratio
1.50
6
Debt to equity ratio
0.75
10
Term debt coverage ratio
1.75
7.5
Secured asset to max loan
1.50
6
Total score
31.5
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Suppose a small business has the following data
Measure
Value
Score
Return on equity
6
2
Current ratio
1.50
6
Debt to equity ratio
0.75
10
Term debt coverage ratio
1.75
7.5
Secured asset to max loan
1.50
6
Total score
31.5
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Example Credit Classification Model for an Small
Business Revolving Operating Loan.
Class 1 Criteria, Very Low Risk
Debt to equity must not be greater than 0.33
Current ratio must be 2.0 or greater
Operating funds to borrow must be less than 40
of projected gross revenue
Term debt repayment margin must be 1.5 or greater
Three year average equity change must be greater
than 15
Class 2 Criteria, Low Risk
Debt to equity must not be greater than 0.66
Current ratio must be 1.5 or greater
Operating funds to borrow must be less than 50
of projected gross revenue
Term debt repayment margin must be 1.25 or greater
Three year average equity change must be greater
than 9
Class 3 Criteria, Moderate Risk
Debt to equity must not be greater than 1.00
Current ratio must be 1.25 or greater
Operating funds to borrow must be less than 60
of projected gross revenue
Term debt repayment margin must be 1.1 or greater
Three year average equity change must be greater
than 6
Class 4 Criteria, High Risk
Debt to equity must not be greater than 1.50
Current ratio must be 1.1 or greater
Operating funds to borrow must be less than 70
of projected gross revenue
Term debt repayment margin must be 0.9 or greater
Three year average equity change must be greater
than 0
Class 5 Criteria, Very High Risk
Debt to equity must not be greater than 2.33
Current ratio must be 0.85 or greater
Operating funds to borrow must be less than 75
of projected gross revenue
Term debt repayment margin must be 0.8 or greater
Three year average equity change must be greater
than -6
Evaluation
All Class 1 borrowers receive base interest rate
All Class 2 borrowers receive base interest rate
0.50
All Class 3 borrowers receive base interest rate
1.00
All Class 4 borrowers receive base interest rate
1.50
All Class 5 borrowers or below are not normally
considered a new credit.
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Development of Credit Scoring Systems

• Judgment
• Econometric techniques
• Neural networks
• Optimization models
• Rule-based and Expert Systems
• Hybrid Systems