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Part 4: C REDIT 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. - PowerPoint PPT Presentation
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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
Chapter 10 11
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
Chapter 10 13
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
Chapter 10 14
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
Chapter 10 17
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
Chapter 10 18
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
Chapter 10 20
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)
Chapter 10 21
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
Chapter 10 22
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
Chapter 10 23
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
Chapter 10 24
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
Chapter 10 25
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)
Chapter 10 26
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
Chapter 10 27
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?)
Chapter 10 28
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
Chapter 10 29
Indicators of Loan Quality Net loan losses ALLL relative to nonperforming
loans Percentage of examiner classified/
criticized loans
Chapter 10 30
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).
Chapter 10 31
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.
Chapter 10 32
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%
Chapter 10 33
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
Chapter 10 34
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
Chapter 10 35
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)
Chapter 10 36
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.
Chapter 10 37
Spilled Milk and the Psychology of Loan Workouts Denial Anger Bargaining Depression Acceptance
Chapter 10 38
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