Chapter 10 1

Part 4: CREDIT RISK: TRADITIONAL AND INNOVATIVE METHODS FOR MANAGING THE LENDING FUNCTION

Chapter 10: The Traditional Approach

to Business Lending: Theory and Practice

Chapter 11: Modern Method for

Analyzing and Managing Credit Chapter 12: Consumer and Small-

Business Lending

Chapter 10 2

CHAPTER 10

The Traditional Approach to Business Lending:Theory and Practice

Chapter 10 3

LEARNING OBJECTIVES

What credit risk is and why it is so important to banks

Lender-borrower agency problems and incentive problems in financial contracting

The five Cs of creditworthiness and the focus of credit analysis on cash flow

The measurement of credit risk through the loan-review process

Risk-based pricing and the measurement of risk-adjusted returns

The importance of a bank’s credit culture and loan policies

TO UNDERSTAND…

Chapter 10 4

CHAPTER THEME The major risk banks must measure, monitor,

and manage is credit or default risk Since lenders are outsiders, they have a

difficult time monitoring what borrowers (insiders) are doing and what they plan to do

Credit analysis, loan pricing, and loan review attempt to minimize these agency problems by determining creditworthiness, pricing risk, and monitoring existing borrowers

Chapter 10 5

Traditional Bank Lending

Four Components:

Originating

Funding

Servicing

Monitoring

Chapter 10 6

The “Five Cs of creditworthiness”

Character (honesty, ethical reputation)

Capacity (cash flow)

Capital (real net worth)

Collateral

Conditions (vulnerability to economic

fluctuations, especially downturns)

Chapter 10 7

Lender-Borrower Agency Problems

Lenders are directly concerned with borrowers repaying their loans on a timely basis

Lenders must investigate and monitor activities of would-be and existing borrowers

“Contractual Frictions” can arise because of moral hazard, adverse selection, or asymmetric information

Chapter 10 8

Bank Risk Management

Objective of the lending function is to

create value of the bank

Danger in granting credit is that the

borrower will not repay on a timely basis

Many U.S. bank failures in the 1980s

relate to credit risk linked to fraud and

insider abuse

Chapter 10 9

How the Stock Market Views Credit Risk Banks with lower loan losses have

higher stock prices and vice versa Box 10-1, p. 309, provides details Results are not surprising given

the importance of loans in a bank’s portfolio of earning assets

Chapter 10 10

Credit Risk and a Bank’s Risk Index (RI) RI = [E(ROA) + CAP]/sROA

Since poor loan quality reduces a bank’s expected earnings, eats up its capital, and increases the variability of its earnings, banks with high loan losses will have low RIs and larger Pr(BVE<0)

Bottom line: Too much credit risk will kill a bank but not enough will retard its earnings

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General Model of Default Risk d = f[I, CF, NW, G] d = probability of default I = information quality, which is a

function of character, C CF = cash flow, level and stability NW = real net worth G = guarantee

Chapter 10 12

External Guarantees and Loan Pricing

A guarantee may be added to a risky loan so it becomes free of default risk and can be expressed as:

Risky Loan + Loan Guarantee = Risk-Free Loan

By definition, the value of the guarantee must equal the default-risk premium associated with the risky loan

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Loan Pricing r* = [(1+r)/(1-d)] -1 r* = risky loan rate r = risk-free rate d = probability of default If d = 0, then r* = r Also defining s as the survival rate,

it equals 1-d

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Recovery Rate (lambda, λ) If a loan defaults, normally some

recovery of principal occurs, which can be called the recovery rate and expressed as λ (lambda)

To account for recovery, we have: r* = {[(1+r)-λd]/(1-d)] – 1, or using

s, r* = {[(1+r)-λ(1-s)]/s] – 1

Chapter 10 15

Examples Insert LAU slides

Chapter 10 16

External Conditions, Customer Relationships, and Forbearance A major difference between

intermediated finance (banking) and direct finance (capital markets) is that when adverse external conditions occur, bankers tend to practice forbearance, which is a function of the strength of the bank-customer relationship

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Credit Analysis

Credit analysis is the evaluation of the financial history and financial statements of credit applicants, designed to assess creditworthiness. Its purpose is threefold:

1. Determine the financial strength of the borrower

2. Estimate the “probability” of full repayment (the opposite of the probability of default, d, therefore, 1-d or the survival rate, s, as discussed above)

3. Determine whether collateral or a co-signer is needed to secure the loan

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Four Pillars of Credit Analysis

1. Cash Flow

2. Assessment of Management

3. Forecasting

4. Business and competitive environment

Chapter 10 19

ROE Decomposition Analysis

ROE = ROA x EM (stage 1)ROE = PM x AU x EM (stage 2)

ROE = Return on Equity PM = Profit Margin

ROA = Return on Assets AU = Asset Utilization

EM = Equity Multiplier

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Analysis of Cash Flow

Why should lenders study cash flow? Since cash repays debt and today’s loans are

repaid with tomorrow’s cash, cash flow plays a critical role in credit analysis and in determining who gets credit

Borrowers have four sources of loan repayment:

1. Cash from operations2. Cash from sale of assets3. Cash from refinancing (debt)4. Cash from a third party (debt or equity)

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Keys Items in theCash-Flow Statement

1. Gross Cash Profit = Cash From Sales – Cash Production Costs

2. Net Cash Income = Gross Cash Profit – Operating Expenses – Taxes

3. Cash After Debt Amortization = Net Cash Income – Debt Repayment

4. Financing Surplus (Requirement) = Cash After Debt Amortization – Capital Expenditures – Long-Term Investments

5. Total External Financing (to meet financing requirement, if any, in item 4)

6. Cash After Financing Reconciled to the Actual Change in Cash

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Cash-Flow Construction Work through the application to

Strategic Electronics Corp. using Tables Tables 10-2 and 10-3, p. 322, and Table 10-4, p. 324

Critical concepts: Fundamentals and Swing Factors

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Critical Concept: Fundamentals Fundamentals include

1. Gross margin = gross profits/net sales

2. Expense control = SG&A expense/net sales

SG&A = selling, general, and administrative

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Critical Concepts: Swing Factors (3) Net accounts-receivable days

(NARD = (AR/sales) x 365) Days inventory on hand (DIH =

(INV/COGS) x 365) Accounts-payable days (APD =

(AP/COGS) x 365) COGS = cost of goods sold

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Ratio Analysis and Growth Variables

10 Variables:

1. Net Sales Growth

2. Gross Margin or Profit

3. SG&A (Selling, General, and Administrative) Expense

4. Operating Profit Margin

5. Current Ratio

6. Quick or Acid-Test Ratio

7. Debt/Net Worth – a measure of leverage

8. Net Accounts Receivable Days (NARD)

9. Days Inventory on Hand (DIH)

10. Accounts Payable Days (APD)

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Progression to Statement of Cash Flow

Balance Sheet ►Income-Expense or Profit-and-Loss Statement ► Sources and Uses of Funds Statement ► Cash-Flow Statement

First Two Statements Provide Inputs for the Sources and Uses:

Sources of Funds (Source of Cash) Use of Funds (Use of Cash)

Revenue ExpenseDecrease in Assets Increase in AssetsIncrease in Liabilities Decrease in LiabilitiesIncrease in Capital Decrease in Capital

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Credit Analysis and the Job of a Credit Analyst

Credit Analyst – Assess the financial performance (past, current, and projected or pro forma) of credit applicants to determine their creditworthiness.

Four key areas in a credit memo that a credit analyst would construct in their analysis:

1. Management (who are we lending to?)

2. Company Operations (what do they do and how do they do it?)

3. Industry (what does the company face?)

4. Financial Performance (what is quantitative ability to repay?)

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Measuring Credit Risk and Loan Quality: Loan Review

Prescribe a methodology (micro vs.

macro)

Determine the adequacy of the loan-

loss reserve (LLR) or allowance for

loan and lease loss (ALLL)

Adjust PLL, the flow variable, to meet

the target ALLL

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Indicators of Loan Quality Net loan losses ALLL relative to nonperforming

loans Percentage of examiner classified/

criticized loans

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Classified/Criticized Loans

Banks are examined by their regulators and assigned CAMEL ratings based on their performance.

Loans or assets considered loss, doubtful, or substandard are sometimes described as “classified” while “special mention” loans are labeled as “criticized”.

Problem banks have CAMEL ratings of 3, 4, or 5 (5 being the weakest).

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Risk-Based Pricing

Risk-based pricing requires lenders a rate that compensates for the riskiness of the loan.

The idea is straightforward: AAA borrowers pay less for credit than BBB borrowers and so on.

Implementation for banks is not that easy so many banks do not attempt to fine tune their risk-based pricing.

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Risk-Adjusted Return on Capital (RAROC)

Technique pioneered by Bankers Trust of New York to precisely price credit risk.

Idea is to compare a loan’s expected income, including fees, to its risk amount.

RAROC = E(Y)/L* E(Y) = one-period expected income on a loan L* = amount of the loan at risk For example, if E(Y)=10 and L*=100, the

RAROC is 10%

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Limiting Risk Exposure Asset restrictions

View in terms of the option-pricing model of default risk (Fig. 10-3, p. 334)

Monitoring Broker margin loans are effectively monitored

because of Possession of the collateral Marking the collateral to market Right to liquidate the collateral to meet margin calls

Contrast these with what bankers have/can do

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Risk-Adjusted Returns (RAR, 1993-1996) RARi = (Ri – Rf)/σi

Financial asset RARLoan-pricing index 2.80%High-yield bonds 2.25S&P 500 1.40Mortgage bond index 0.50T-bond index 0.45

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Monitoring Technology and the Borrower-Information Continuum Inside debt (low info and costly to

obtain) Intermediated debt (middle ground) Public debt (high info and low cost) Figure 10-4, p. 339 Commercial paper as a substitute

for bank loans (Box 10-3, p. 340)

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The Lending Function as the Prevention, Identification, and

Resolution of Problem Borrowers

Prevention – refers to the decision to

grant or not to grant credit

Identification – refers to the monitoring

of existing borrowers for signs of

weakness.

Resolution – refers to working out

problem loans.

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Spilled Milk and the Psychology of Loan Workouts Denial Anger Bargaining Depression Acceptance

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A Bank’s Written Loan Policy

1. General Policies,

2. Specific Loan Categories,

3. Miscellaneous Loan Policies,

4. Quality Control, and

5. Committees

Chapter 10 39

CHAPTER SUMMARY The major risk banks face is credit risk,

which is the uncertainty associated with borrowers’ loan repayments

A bank’s risk index (RI = [E(ROA) + CAP]/sROA] highlights the adverse effects of mismanaged credit risk as loan losses reduce expected earnings, eat up capital, and increase the volatility of earnings

Credit analysis, risk-based pricing, and loan review represent three ways for managing credit risk

Chapter 10 40

Chapter Summary (concluded) Regulatory discipline focuses on the quality

of banks’ loan portfolios in two ways: 1. Classified loans (substandard, doubtful, loss) 2. Risk-based capital requirements: Credit risk

and bank capital Market discipline rewards banks with lower

loan losses via higher stock prices and punishes banks with higher loan losses via lower stock prices