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Credit Risk: Individual Loan Risk
Chapter Eleven
McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Overview
• This chapter discusses types of Loans, and the
analysis and measurement of Credit risk on
individual loans.
• This is important for purposes of:
– Pricing loans and bonds
– Setting limits on Credit Risk Exposure
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What is credit risk
• The risk that a borrower will be unable to
make payment of Interest or Principal in a
timely manner.
• In case of a bank, how much % of the total
assets is invested in Credit Assets?
Traditional models of credit risk analysis
• There are broadly 3 classes of models as
comprising the traditional approach:
1. EXPERT systems
2. Neural networks
3. Credit scoring systems
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EXPERT SYSTEMS
• In an expert system, the credit decision is left to the
local or branch lending officer or relationship
manager.
• Implicitly, this Person’s Expertise, Subjective
Judgment, and weighting of certain Key Factors are
the most important determinants in the decision to
grant credit.
• One of the most common expert systems—the five
“Cs” of credit analyzes five key factors
Measuring Credit Risk
• Availability, quality and cost of information are
critical factors in credit risk assessment.
– Facilitated by technology and information
databases.
• Qualitative models:
• Borrower specific factors
• Market or systematic factors.
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Measuring Credit Risk
• Qualitative models:
• Borrower specific factors
• Reputation
• Leverage
• Volatility of earnings
• Covenants
• Collateral.
• Market or systematic factors.
• Business cycle
• Interest rate levels.
EXPERT SYSTEMS
1. Character
A measure of the reputation of the firm, its willingness to
repay, and its repayment history.
• In particular, it has been established empirically that the
age of a firm is a good proxy for its repayment reputation.
2. Capital
The equity contribution of owners and its ratio to debt
(leverage).
• These are viewed as good predictors of bankruptcy
probability.
• High leverage suggests a greater probability of bankruptcy.
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EXPERT SYSTEMS
3. Capacity
The ability to repay, which reflects the volatility of the
borrower’s earnings.
• Even if repayments on debt contracts follow a
constant stream over the time of business.
• But earnings are volatile (or have a high standard
deviation)
• There may be periods when the firm’s capacity to
repay debt claims is constrained.
EXPERT SYSTEMS
4. Collateral
In the event of default, a banker has claims on the
collateral pledged by the borrower.
• The greater the priority of this claim and the greater
the market value of the underlying collateral, the
lower the exposure risk of the loan.
5. Cycle (or Economic) Conditions
The state of the business cycle is an important element
in determining credit risk exposure, especially for
cycle-dependent industries.
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Problems in Expert systems
Although many banks still use expert systems as part
of their credit decision process, these systems face two
main problems:
1. Consistency.
What are the important common factors to analyze across
different types of borrowers?
2. Subjectivity.
What are the optimal weights to apply to the factors
chosen?
– Quite different standards can be applied by Credit Officers,
within any given bank or FI, to similar types of borrowers.
– Especially in different geographic and economic areas.
2. Artificial Neural Networks
• Neural Networks are characterized by three
architectural features:
• Inputs
• Weights
• Hidden Units
• The n inputs, x1, x2, . . . , xn represent the data
received by the system (for example, company
Financial ratios for the bankruptcy prediction.
• Each piece of Information is assigned a weight (w11,
w21, . . . , wn1) that designates its relative
importance to each hidden unit (yi).
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Artificial Neural Networks
• These weights are “learned” by the network over the
course of “Training.”
• For example, by observing the financial characteristics of
many bankrupt firms (the training process).
• Each hidden unit computes the weighted sum of all inputs
and transmits the result to other hidden units.
• In parallel, the other hidden units are weighting their
inputs so as to transmit their signal to all other connected
hidden units.
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Artificial Neural Networks
• Receipt of the signal from other Hidden Units
further transforms the output from each Node,
and the system continues to repeat until all the
information is incorporated.
• This model incorporates complex correlations
among the hidden units to improve model fit
Imperial Evidence
• Varetto (1994) find that neural networks have about the
same level of accuracy as do credit scoring models.
• Podding (1994) claims that neural networks outperform
credit scoring models in bankruptcy prediction.
• Related research can be found in Yang, Platt, and Platt
(1999), Hawley, Johnson, and Raina (1990), Kim and
Scott (1991)
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Disadvantages of Neural Networks
• A major disadvantage of neural networks is their
Lack Of Transparency.
Credit Scoring Systems
• Pre-identify certain Key Factors that determine
the probability of default (as opposed to
repayment), and combine or weight them into a
Quantitative Score.
• The score can be used as a classification system:
• It places a potential borrower into either a good
or a bad group, based on a score and a cut-off
point.
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Altman- Z score
• One of the oldest credit scoring model is the
Altman-Z model developed by Altman
Z = 1.2X1+ 1.4X2 +3.3X3 + 0.6X4 + 1.0X5
Critical value of Z = 1.81.
• X1 = Working Capital/Total assets.
• X2 = Retained Earnings/Total assets.
• X3 = EBIT/ Total assets.
• X4 = Market value equity/ Book value LT debt.
• X5 = Sales/total assets.
Credit Scoring Systems
• Customers who have a Z-score below a critical
value (in Altman’s initial study, 1.81),
• They would be classified as “Bad” and the loan
would be refused.
• The choice of the optimal cut-off credit score can
incorporate changes in economic conditions.
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Return on a Loan:
• Return = inflow/outflow
1+k = 1+(of + (BR + m )) / (1-[b(1-RR)])
• BR (Base Lending Rate, LIBOR etc)
• m (Credit Risk Premium)
• of (Loan Origination fee)
• b (Compensating Balance)
• RR (Reserve Requirement)
Return on a Loan:
• Suppose a bank does the following:
• Sets the loan rate on a prospective loan at 14 percent (where BR 12% & m 2%).
• Charges a 1/8 percent (or 0.125 percent) loan origination fee to the borrower.
• Imposes a 10 percent compensating balance requirement to be held as non-
interest-bearing demand deposits.
• Sets aside reserves, at a rate of 10 percent of deposits, held at the Federal
Reserve (i.e., the Fed’s cash-to-deposit reserve ratio is 10 percent).
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Newer Models of Credit Risk Measurement
• The newer credit risk models use Financial Theory
and more widely available Financial Market Data to
make inferences about Default Probabilities on Debt
and Loan Instruments.
1. Term structure of credit risk approach
2. Mortality rate approach
3. RAROC models
4. Option models (including the KMV credit monitor model)s
Term structure of credit risk approach
• Assessing Credit Risk Exposure and Default Probabilities on
the basis of Risk Premiums inherent in the current structure of
Yields on Corporate Debt or Loans to different borrowers.
• Rating agencies such as Standard & Poor’s (S&P) categorize
corporate bond issuers into at least 7 major classes according
to perceived credit quality.
• The first four quality ratings—AAA, AA, A, and BBB—indicate
investment-quality borrowers.
• National Banks are only restricted to investment grade
• While Insurance Company can invest in noninvestment-grade
securities with ratings such as BB, B, and CCC, but with
restrictions on the aggregate amounts.
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Term Structure of Credit Risk Approach
• Look at the Spreads shown in Figure.
• Zero-coupon Corporate (grade B) bonds
• Zero- Coupon Treasuries (called Treasury strips).
• The spreads reflect perceived Credit Risk Exposures of
Corporate Borrowers at different times in the future.
• FIs can use these Credit Risk Probabilities to decide whether or
not to issue debt to a particular Credit Risk Borrower.
Term Structure of Credit Risk Approach
• Probability of Default on a One-Period Debt Instrument
• Lets assume that the FI requires an expected return on a
1-year (zero-coupon) Corporate Debt Security equal to at least
the risk-free return on 1-year (zero-coupon) Treasury bonds.
• Let p be the probability that the corporate debt, will be repaid
in full.
• Then probability of default = (1 - p)
• If the borrower defaults, the FI is assumed to get nothing.
• Then
p * (1 + k) = (1 + i)
• Where k= return of (zero-coupon) Corporate bond
• And i = return of risk-free 1-year (zero-coupon) Treasury bonds
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Term Structure of Credit Risk Approach
• Suppose, as shown in Figure, i = 10% and k= 15.8%
• So the Probability Of Repayment(p) on the security
• =>
• If the Probability Of Repayment is 0.95
• This implies a Probability Of Default (1 - p) equal to 0.05
• Thus, a Probability Of Default of 5% on the corporate bond
(loan) requires the FI to set a Risk Premium (φ) of 5.8 percent.
• φ = k - i = 5.8%
• Clearly, as the Probability Of Repayment (p) falls and the
Probability Of Default (1 - p) increases,
• The required Spread between k and i increases.
Term Structure of Credit Risk Approach
• Realistically FIs does not lose all Interest and Principal if the
corporate borrower defaults.
• Infect, a lender do receive some partial repayment.
• e.g., Altman and Bana estimated from 1988 to2004 that when
firms defaulted, the investor lost on average 74.7 % (i.e.,
recovered around 25.3 %).
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Term Structure of Credit Risk Approach
• As discussed earlier in this chapter, many loans and bonds are
secured or collateralized by different types of Assets.
• Let γ be the proportion of the loan’s principal and interest that
is collectible on default,
• γ where in general is positive.
• The equation for Loan Return will become
• The new term here is [(1- p) γ (1+k)] is the Payoff the FI
expects to get if the borrower defaults
Term Structure of Credit Risk Approach
• Collateral requirements are a method of controlling
Default Risk.
• They act as a direct substitute for Risk Premiums in
setting required loan rates.
• To see this, solve for the risk premium φ between k
(the yield corporate debt) and i (the risk-free rate of
interest)
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Term Structure of Credit Risk Approach
• If i = 0.10, and p = 0.95, and γ= 0.9,
• Then the Required Risk Premium φ= 0.6 percent.
• The γ and p are perfect substitutes for each other.
• That is, a bond or loan with collateral backing of γ= 0.7 and p
=0.8 would have the same required risk premium as one with
γ=0.8 and p =0.7.
• An increase in collateral is a direct substitute for an increase
in default risk (i.e., a decline in p ).
Term Structure of Credit Risk Approach
• Probability of Default on a Multiperiod Debt Instrument
• We can extend this type of analysis to derive the credit risk or
default probabilities occurring for longer-term loans or bonds.
• Marginal Default Probability: The probability that a borrower
will default in any given year. (1 − pt).
• Cumulative Default Probability: The probability that a
borrower will default over a specified multiyear period.
• If we use Marginal Default Probabilities, the Cumulative
Default Probability at some time between now and the end of
year 2 is:
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Term Structure of Credit Risk Approach
• Examples: Suppose the FI manager wanted to find out the
probability of default on a two-year bond.
• 1- p1 = 0.05 Marginal probability of default in year 1
• 1- p2 = 0.07 Marginal probability of default in year 2
Cp = [ 1 - (.95)(.93) ] =>
Cp = (1 - 0.8835)
Cp = 0.1165
There is an 11.65 % Probability of default over this period of
2-years
Term structure of credit risk approach
• We now want to derive the probability of default in Year-2,
Year-3, and so on.
• If we look at previous Figure; The yield curves are rising for
both Treasury issues and Corporate Bond issues.
• We will extract these yield curves the multi-period default rates
for corporate borrowers classified in the grade B.
• In Perfect Market the return of 2-years bond will be exactly
equal to the return of 1-year bond which is reinvested with
principle and interest in 2-year.
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Term structure of credit risk approach
• We can directly infer the market’s expectation of the one-year
T-bond forward rate, f 1 :
• Similarly for Corporate Bond yield curve to infer the one-year
forward rate.
• The expected Probability of repayment on one-year corporate
bonds.
Then
• Thus, the expected probability of default in year 2 is:
= (1 - p2)
• Similarly, we can be derived Corporate term structures so as
to derive p 3 , and so on.
Term structure of credit risk approach
• The Figure indicates that 1-year Corporate bonds are yielding
k1= 15.8% and 2-year bonds are yielding k2 = 18%.
• So =>
• From the T-bond yield curve in Figure i1 = 10% and i2 = 11%
• So =>
• Now : =>
• The expected probability of default in year 2 is
or p2 =6.82%
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Term structure of credit risk approach
• The probabilities we have estimated are marginal
probabilities conditional on default not occurring in a
prior period.
• We also discussed the concept of the cumulative
probability.
• So the cumulative probability that corporate grade B
bonds would default over the next two years is:
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