CREDIT RISK

1
 Introduction

Credit risk refers to the risk that

promised cash flows from loans and
securities held by Financial
Institution may not be paid in full

2
Importance

Determines several features of a loan:

interest rate, maturity, collateral and
other covenants.

3
Importance

Determines several features of a loan:

interest rate, maturity, collateral and
other covenants.

If credit risk analysis is inadequate,

default rates could be higher

4
Importance

Determines several features of a loan:

interest rate, maturity, collateral and
other covenants.

If credit risk analysis is inadequate,

default rates could be higher

Riskier projects require more analysis

before loans are approved.
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Types of Loans
Commercial & Industrial loans
• Syndication
• Spot loans
• Loan commitments

Real estate loan

• Fixed-rate,
• ARM (Adjustable Rate
Mortgages)
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Consumer Loans
• Nonrevolving loans
• Automobile, mobile home,
personal loans.
• revolving loans
• Visa, MasterCard

Others loans
• Farm loans
• Other banks
• Broker margin loans
• Government loans
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 Return on a Loan

Pricing factors –
• Base rate set for loans
• Credit risk premium
• Fees & charges
• Collateral backing
• Other non-price terms
• Compensating balance
• Reserve requirements

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 Return = inflow/outflow

𝑜𝑓 + (𝐵𝑅 + 𝑚)
1+𝑘=1 +
1 − 𝑏 1 − 𝑅𝑅

where,
k= promised gross return on the loan
of= origination fee
BR= base rate
m= credit risk premium
b= compensating balance
RR= reserve requirements
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Example: calculating ROA on a loan
Suppose that a bank does the following:

1.Sets a loan rate on a prospective loan at 7 percent

(where BR = 3% and credit risk premium = 4%).
2.Charges 0.15 percent as loan origination
fee to the borrower.
3.Imposes a 6 percent compensating balance requirement
to be held as noninterest-bearing demand deposits.
4.Pays reserve requirements of 12 percent imposed on the
bank’s demand deposits.

Calculate the bank’s ROA on this loan.

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 Solution

k = 7.54%

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When of and b = 0 then
---------

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When of and b = 0 then
1+k = 1 + (BR+m)

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Example

■ A bank offers one year loans with a 8% base rate, credit risk
premium 4%, charges a 0.20% loan origination fee,
imposes a 15% compensating balance requirement and
must hold a 10% reserve requirement at Central Bank.
1. What is the contractually promised gross return on the
loan?

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Solution

K= 14.10%

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Expected return

1 + E(r) = p(1+k) +(1−p)0

→1+ E(r) = p(1+k)

where p equals probability of repayment

E (r)= p(1+k) – 1
p < 1 means default risk present

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Therefore,
1. set m to compensate higher risk

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Therefore,
1. set m to compensate higher risk
2. recognize high of, m and BR may actually
reduce the probability of repayment.

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Therefore,
1. set m to compensate higher risk
2. recognize high of, m and BR may actually
reduce the probability of repayment.

Thus, dimensions of credit risk mgt.

• Price dimensions (k)
• Quantity dimensions (rationing)

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Lending Rates and Rationing
At retail
• Usually a simple accept/reject decision
rather than adjustments to the rate
• Credit rationing: restricting the quantity of
loans made available to individual
borrowers.
• If accepted, customers sorted by loan
quantity
• For mortgages, discrimination via loan to
value rather than adjusting rates

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At wholesale
• Use both quantity and pricing adjustments
• High interest rates may induce the borrowers to
invest in risky projects.
• High risk projects have relatively high
probability that they will fail to realize the big
payoff.

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Measuring Credit Risk

Factors:
• Availability of information
• Quality of information
• Cost of information

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Default risk models

Two types of models –

Qualitative models
Quantitative models

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 Qualitative models

1. Borrower specific factors –

• Reputation
• Leverage
• Volatility of earnings
• Collaterals
2. Market specific factors –
• Business cycle
• Level of interest rates

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 Quantitative models

Credit scoring models using observable

loan applicant’s characteristics either to
calculate a score representing the
applicant’s probability to default or to
sort borrowers into different default risk
classes.

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 Quantitative models

1. Traditional Quantitative models

• Linear probability model
• Logit model
• Discriminant Analysis
2. Sophisticated Quantitative models
• [We do not cover it for the time being]

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 Linear probability models

n
PDi =  j Xi, j  error
j1

• Statistically unsound since the values

obtained are not probabilities at all.
• PD may lie outside 0-1 range.

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Suppose the estimated linear probability model used by an FI to predict business
loan applicant default probabilities is PD = 0.03X1 + 0.02X2 - 0.05X3 + error,
where X1 is the borrower's debt/equity ratio, X2 is the volatility of borrower
earnings, and X3 is the borrower’s profit ratio. For a particular loan
applicant, X1 = 0.35, X2 = 0.45, and X3 =0.20.

a. What is the projected probability of default for the borrower?

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Suppose the estimated linear probability model used by an FI to predict business
loan applicant default probabilities is PD = 0.03X1 + 0.02X2 - 0.05X3 + error,
where X1 is the borrower's debt/equity ratio, X2 is the volatility of borrower
earnings, and X3 is the borrower’s profit ratio. For a particular loan
applicant, X1 = 0.35, X2 = 0.45, and X3 =0.20.

a. What is the projected probability of default for the borrower?

PD = 0.03(0.35) + 0.02(0.45) – 0.05(0.20) = 0.0095

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Suppose the estimated linear probability model used by an FI to predict business
loan applicant default probabilities is PD = 0.03X1 + 0.02X2 - 0.05X3 + error,
where X1 is the borrower's debt/equity ratio, X2 is the volatility of borrower
earnings, and X3 is the borrower’s profit ratio. For a particular loan
applicant, X1 = 0.35, X2 = 0.45, and X3 =0.20.

a. What is the projected probability of default for the borrower?

PD = 0.03(0.35) + 0.02(0.45) – 0.05(0.20) = 0.0095

b. What is the projected probability of repayment if the debt/equity ratio

is 1.7?

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Suppose the estimated linear probability model used by an FI to predict business
loan applicant default probabilities is PD = 0.03X1 + 0.02X2 - 0.05X3 + error,
where X1 is the borrower's debt/equity ratio, X2 is the volatility of borrower
earnings, and X3 is the borrower’s profit ratio. For a particular loan
applicant, X1 = 0.35, X2 = 0.45, and X3 =0.20.

a. What is the projected probability of default for the borrower?

PD = 0.03(0.35) + 0.02(0.45) – 0.05(0.20) = 0.0095

b. What is the projected probability of repayment if the debt/equity ratio

is 1.7?

PD = 0.03(1.7) + 0.02(0.45) - 0.05(0.20) =0.051

The expected probability of repayment is 1 - 0.051 = 0.949.

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 Logit models

Overcome weakness of the linear probability

models using a transformation (logistic function)
that restricts the probabilities to the zero-one
interval

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Linear Discriminant Models

• These models divide borrowers into high

and low default risk classes.
• Like linear models they use past data to
classify borrowers into risk classes.

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Altman’s Linear Discriminant Model

Z=1.2X1+ 1.4X2 +3.3X3 + 0.6X4 + 1.0X5

• X1 = Working capital/total assets
• X2 = Retained earnings/total assets
• X3 = EBIT/total assets
• X4 = Market value equity/ book value
LTdebt
• X5 = Sales/total assets

• Critical value of Z = 1.81

• Z-score less than 1.81 indicate financial distress
• Z-score more than 2.99 indicate financial
soundness
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Question: Suppose that the financial ratios of a potential
borrowing firm take the following values:

Working capital/total assets ratio (X1) = 0.65

Retained earnings/total assets ratio (X2) = 0.15
Earnings before interest and taxes/total assets
ratio (X3) = 0.10
Market value of equity/book value of long-term
debt ratio (X4) = 0.15
Sales/total assets ratio (X5) = 0.35

Calculate the Altman’s Z-score for the borrower in

question. How is this number a sign of the borrower’s
default risk?

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Z = 1.2(0.65) + 1.4(0.15) + 3.3(0.1) + 0.6(0.15) + 1.0(0.35)
= 1.76

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Linear Discriminant Model

Problems:
• Only considers two extreme cases
(default/no default)
• Weights need not be stationary over time
• Ignores hard to quantify factors including
business cycle effects
• Database of defaulted loans is not
available to benchmark the model

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Term Structure Based Methods

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Term Structure Based Methods

• Expected return equals risk free rate after

accounting for probability of default:
• p (1+ k) = 1+ i
• Risk premium can be computed using
Treasury strips and zero coupon corporate
bonds
• risk premium Ф= k – i
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Example
If the rate on one-year Treasury bills currently is 6
percent, what is the repayment probability for each of
the following two securities? Assume that if the loan is
defaulted, no payments are expected. What is the
market-determined risk premium for the corresponding
probability of default for each security?

a. One-year AA-rated zero coupon bond

yielding 9.5 percent.
 Example
If the rate on one-year Treasury bills currently is 6
percent, what is the repayment probability for each of
the following two securities? Assume that if the loan is
defaulted, no payments are expected. What is the
market-determined risk premium for the corresponding
probability of default for each security?

a. One-year AA-rated zero coupon bond

yielding 9.5 percent.

Probability of repayment = p = (1 + i)/(1 + k)

For an AA-rated bond = (1 + 0.06)/ (1 + 0.095) = 0.968
=> probability of default = 1 – 0.968 = 0.032, or 3.20%

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44

Example
If the rate on one-year Treasury bills currently is 6
percent, what is the repayment probability for each of
the following two securities? Assume that if the loan is
defaulted, no payments are expected. What is the
market-determined risk premium for the corresponding
probability of default for each security?

b. One-year BB-rated zero coupon bond yielding

13.5 percent.
 Example
If the rate on one-year Treasury bills currently is 6
percent, what is the repayment probability for each of
the following two securities? Assume that if the loan is
defaulted, no payments are expected. What is the
market-determined risk premium for the corresponding
probability of default for each security?

b. One-year BB-rated zero coupon bond yielding

13.5 percent.

For BB-rated bond = (1 + 0.06)/(1 + 0.135) = 93.39 percent

=> probability of default = 1 – 0.9339 = 0.0661, or 6.61%

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46

More Realistic Term Structure Based

Methods

• FI lender can expect some partial repayment

even if the borrower goes into bankruptcy.
• Let γ be the proportion of the loan’s principal
and interest that is collectible on default.

• In such a scenario, we have

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More Realistic Term Structure Based

Methods

• FI lender can expect some partial repayment

even if the borrower goes into bankruptcy.
• Let γ be the proportion of the loan’s principal
and interest that is collectible on default.

• In such a scenario, we have

• [(1-p)γ(1+k)] + [p(1+k)]=1+i
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More Realistic Term Structure Based

Methods
• FI lender can expect some partial repayment
even if the borrower goes into bankruptcy.
• Let γ be the proportion of the loan’s principal
and interest that is collectible on default.

• In such a scenario, we have

• [(1-p)γ(1+k)] + [p(1+k)]=1+I
• Prob of repayment is

1 i

1 k
p
1
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Example
Assume a one year TB is currently yielding
5.5 % and AAA rated discount bond with
similar maturity is yielding 8.5%

If the expected recovery form collateral in

the event of default is 50% of principal and
interest, what is the probability of
repayment of AAA rated bonds? What is
the probability of default?
 Example

1 i
  1.055  0.5
1 k
p  1.085  0.9447 or 94.47 percent
1  1 0.5

probability of default is 1.0 - 0.9447 = 0.0553 or 5.53 percent.

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51

RAROC (Risk Adjusted Return on Capital) approach

• A loan is approved only when RAROC is higher

than cost of equity or RoE

• RAROC = One year net income on the loan

Loan risk

Income on loan= (spread +fees)* value

- cost of funds
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Loan risk can be calculated using

• Duration based model
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Using Duration to Estimate Loan Risk

For denominator of RAROC, duration approach

used to estimate worst case loss in value of the
loan:
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Using Duration to Estimate Loan Risk

For denominator of RAROC, duration approach

used to estimate worst case loss in value of the
loan:

LN /LN = -DLN x (R/(1+R))

LN = -DLN x LN x (R/(1+R))

where R is an estimate of the worst change in credit risk

premiums for the loan class over the past year
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Example
A bank is planning to make a loan of $5,000,000 to a firm in the steel
industry. It expects to charge a servicing fee of 50 basis points. The
loan has a maturity of 8 years with a duration of 7.5 years. The cost of
funds (the RAROC benchmark) for the bank is 10 percent. The bank has
estimated the maximum change in the risk premium on the steel
manufacturing sector to be approximately 4.2 percent, based on two
years of historical data. The current market interest rate for loans in
this sector is 12 percent.

a. Using the RAROC model, determine whether the bank should

make the loan?
Example
a. Using the RAROC model, determine whether the bank should
make the loan?

Loan risk, or LN = -7.5 x $5m x (0.042/1.12) = -$1,406,250

Expected interest = 0.12 x $5,000,000= $600,000
Servicing fees = 0.0050 x $5,000,000= $25,000
Less cost of funds = 0.10 x $5,000,000= -$500,000
Net interest and fee income = $125,000

RAROC = $125,000/1,406,250 = 8.89 percent.

Since RAROC is lower than the cost of funds to the bank, the bank should not
make the loan.

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57

Example
b. What should be the duration in order for this loan to be approved?
Example
b. What should be the duration in order for this loan to be approved?

For RAROC to be 10 percent, loan risk should be:

$125,000/LN = 0.10  LN = 125,000 / 0.10 = $1,250,000
 -DLN x LN x (R/(1 + R)) = 1,250,000

DLN = 1,250,000/(5,000,000 x (0.042/1.12)) = 6.67 years.

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