BUS FINANCE 826

1
BUS FINANCE 826
2
Overview

• Managing credit risk in a loan (asset) portfolio
  context. It also discusses the setting of credit
  exposure limits to industrial sectors and
  regulatory approaches to monitoring credit risk.
  The National Association of Insurance
  Commissioners has also developed limits for
  different types of assets and borrowers in
  insurers portfolios.

3
Simple Models of Loan Concentration

• Migration analysis
• Track credit rating changes within sector or pool
  of loans.
  
• Rating transition matrix.

4
Web Resources

• For information on migration analysis, visit
• Standard Poors www.standardandpoors.com
• Moodys www.moodys.com

Web Surf
5
Rating Transition Matrix

• Risk grade end of year
• 1 2 3 Default
• Risk grade 1 .85 .10 .04 .01
• beginning 2 .12 .83 .03 .02
• of year 3 .03 .13 .80 .04

6
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.

7
Diversification and Modern Portfolio Theory

• Applying portfolio theory to loans
• Using loans to construct the efficient frontier.
• Minimum risk portfolio.
• Low risk
• Low return.

8
Applying Portfolio Theory to Loans

• Require
• (i) expected return on loan(measured by
  all-in-spread)
  
• (ii) loan risk
• (iii) correlation of loan default risks.

9
Modern Portfolio Theory
10
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.

11
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.
  

12
Partial Applications

• Loan volume-based models (continued)
• Provide market benchmarks.
• Standard deviation measure of loan allocation
  deviation.
  

13
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

14
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.

15
Pertinent Websites

• For more information visit
• Federal Reserve Bank www.federalreserve.gov
• KMV www.kmv.com
• Moodys www.moodys.com
• Standard Poors www.standardandpoors.com

Web Surf