Chap 11 Credit Risk Individual Loans

Chapter 11
Credit Risk:
Individual Loan
Risk
McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

11-2
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
11-3
Credit Quality Problems
 Problems with junk bonds, LDC loans, residential and
farm mortgage loans.
 More recently, credit card and auto loans.
 Default of one major borrower can have significant
impact on value and reputation of many FIs
 Emphasizes importance of managing credit risk
11-4

 Over the early to mid 1990s, improvements in
NPLs for large banks and overall credit quality.
 Late 1990s concern over growth in low quality
auto loans and credit cards, decline in quality
of lending standards.
 Late 1990s and early 2000s: telecom
companies, tech companies, Argentina, Brazil,
Russia, South Korea
 Mid 2000s, economic growth accompanied by
reduction in NPLs
 New types of credit risk related to loan
guarantees and off-balance-sheet activities.
 Increased emphasis on credit risk evaluation.
11-5

11-6
Types of US Banks Loans

11-7
Types of Loans:
 C&I loans: secured and unsecured

 Syndication
 Spot loans, Loan commitments (Fixed
Rate/floating)
 Decline in C&I loans originated by commercial
banks and growth in commercial paper
market.
 RE loans: primarily mortgages
 Fixed-rate, ARM (Interest Rate cycle)
 Mortgages can be subject to default risk when
loan-to-value declines.
11-8
Distribution of US Real Estate Loans
11-9
ARM’s share of total loans closed
11-10
Consumer loans
 Individual (consumer) loans: personal, auto,

credit card.
 Nonrevolving loans
 Automobile, mobile home, personal loans
 Growth in credit card debt
 Visa, MasterCard
 Proprietary cards such as Sears, AT&T
 usury ceilings
 Bankruptcy Reform Act of 2005
11-11
Other loans
 Other loans include:
 Farm loans
 Other banks
 Nonbank FIs
 Broker margin loans
 Foreign banks and sovereign governments
 State and local governments
11-12
Return on a Loan:
Number of factors impact promised return FI achieve on
any given dollar lent:
1)Interestrate on the loan

2)Any fees relating to the loan (of)
3)The credit risk premium on the loan (m)
4)The collateral backing of the loan
5)Compensating balance (b) & reserve requirements (RR)

11-13
Return on a Loan:
 Return = inflow/outflow
1+k = 1+{of + (BR + m )}/(1-[b(1-RR)])
 Expected return: E(r) = p(1+k) - 1

 where p equals probability of repayment
 Note that realized and expected return

may not be equal.
11-14
Return on a Loan:
 The numerator is the promised gross cash inflow to
the FI per dollar lent, reflecting direct fees ( of ) plus
the loan interest rate ( BR + of ).
 In the denominator, for every $1 the FI lends, it retains
b as noninterest- bearing compensating balances.
Thus, 1-b is the net proceeds of each $1 of loans
received by the borrower from the FI, ignoring reserve
requirements.
 However, since b (the compensating balance) is held
by the borrower at the FI in a demand deposit account,
the Federal Reserve requires depository institutions to
hold non- (or low) interest-bearing reserves at the rate
RR against the compensating balance.
11-15
Return on a Loan:
 Thus, the FI’s net benefit from requiring compensating
balances must consider the cost of holding additional
reserve requirements.
 The net outflow by the FI per $1 of loans is
1 - [ b (1 -RR )], or 1 minus the reserve adjusted
compensating balance requirement.
11-16
Return on a Loan:
11-17
Return on a Loan: Practice Q1
Calculate the promised return ( k ) on a loan if

the base rate is 13 percent, the risk premium is
2 percent, the compensating balance
requirement is 5 percent, fees are
½ percent, and reserve requirements are 10
percent. (16.23%)
11-18
Return on a loan – Practice Q2

11-19
Return on a loan – Practice Q3

11-20
 The true cost is the

= loan rate ÷ (1 – compensating balance rate)
= 9% ÷ (1.0 – 0.1)
= 10 percent.
 For compensating balance rates of 15 percent and 20

percent, the true cost of the loan would be 10.59
percent and 11.25 percent respectively.
 Note that as the compensating balance rate increases
by a constant amount, the true cost of the loan
increases at an increasing rate.
11-21
Return on loan – Practice Q4

11-22

(a) The simple promised interest return on the loan is
= BR + m
= 0.09 + 0.025
= 0.115 or 11.5 percent.
11-23
of  ( BR  m) 0.0025  (0.09  0.025)

k 1  1 1  1 12.97 percent
1  [b(1  RR)] 1  [0.1(1  0.06)]
11-24
Expected Return on a loan

 Expected return: E(r) = p(1+k) - 1
 where p equals probability of repayment
 To the extent that p is less than 1, default risk is

present. This means the FI manager must
1) set the risk premium sufficiently high to compensate
for this risk
2) recognize that setting high risk premiums as well as
high fees and base rates may actually reduce the
probability of repayment ( p )
11-25
Lending Rates and Rationing

 At retail: Usually a simple accept/reject
decision rather than adjustments to the
rate.
 Credit rationing.
 If accepted, customers sorted by loan
quantity not pricing
 For mortgages, discrimination via loan to
value rather than adjusting rates
 At wholesale:
 Use both quantity and pricing adjustments.
11-26
Lending Rates and Rationing

11-27
Measuring Credit Risk

 Availability, quality and cost of information are critical
factors in credit risk assessment
 Facilitated by technology and information
 The availability of more information, along with the

lower average cost of collecting such information,
allows FIs to use more sophisticated and usually more
quantitative methods in assessing default probabilities
for large borrowers compared with small borrowers.
 Also, bonds, like loans, include covenants restricting
or encouraging various actions to enhance the
probability of repayment. Covenants can include limits
on the type and amount of new debt, investments, and
asset sales the borrower may undertake while the loan
or bonds are outstanding.
11-28
Measuring Credit Risk

 Default Risk Models:
1) Qualitative Models
a) Borrower Specific Factors
b) Market Specific Factors
2) Quantitative Models
a) Credit Scoring Models
i. Linear Probability Models
ii. Logit Models
iii. Linear Discriminant Analysis
3) Newer Models of Credit Risk Measurement

11-29
Measuring Credit Risk – Qualitative Models
 Qualitative models: borrower specific

factors are considered as well as market
or systematic factors.
 Borrower specific factors include:
 reputation
 leverage
 volatility of earnings
 collateral
 Market specific factors include:
 business cycle
 interest rate levels.
11-30
Measuring Credit Risk – Credit Scoring Models
 Credit scoring models are quantitative models that use

observed borrower characteristics either to calculate a
score representing the applicant’s probability of default
or to sort borrowers into different default risk classes.
 This enables FI to:
u Numerically establish which factors are important in
explaining default risk.
u Evaluate the relative degree or importance of these
factors.
u Improve the pricing of default risk.
u Be better able to screen out bad loan applicants.
u Be in a better position to calculate any reserves needed
to meet expected future loan losses.
11-31
 Three types of Credit Scoring Models:

1) Linear Probability Models
2) Logit Models
3) Linear discriminant analysis
11-32
Linear Probability Models:

 The linear probability model uses past data, such as
financial ratios, as inputs into a model to explain
repayment experience on old loans.
 The relative importance of the factors used in
explaining past repayment performance then forecasts
repayment probabilities on new loans.
 That is, factors explaining past repayment
performance can be used for assessing p, the
probability of repayment (a key input in setting the
credit premium on a loan or determining the amount to
be lent) and the probability of default (PD).
11-33
Credit Scoring Models
 Linear probability models:

n
Zi =   j X i , j  error
j 1
 Statistically unsound since the Z’s obtained

are not probabilities at all.
 *Since superior statistical techniques are
readily available, little justification for
employing linear probability models.
11-34
Credit Scoring Models - Example

11-35
Credit Scoring Models - Example

11-36
Credit Scoring Models – Practice Q5
11-37
11-38
PD = 0.3(.75) + 0.2(.25) - 0.05(.10)

= 0.27
11-39
PD = 0.3(2.5) + 0.2(.25) - 0.05(.10)

= 0.795
The expected probability of repayment is 1 ‑ 0.795 = 0.205.

11-40
Credit Scoring Models – Logit Model
 While linear probability model technique is
straightforward as long as current information on the X
ij is available for the borrower, its major weakness is
that the estimated probabilities of default can often lie
outside the interval 0 to 1.
 The logit model overcomes this weakness by
restricting the estimated range of default probabilities
from the linear regression model to lie between 0 and
1.
11-41
Credit Scoring Models – Linear Discriminant Models
 While linear probability and logit models project a

value for the expected probability of default if a loan is
made, discriminant models divide borrowers into high
or low default risk classes contingent on their
observed characteristics ( X ij ).
 Similar to linear probability models, linear discriminant

models use past data as inputs into a model to explain
repayment experience on old loans. The relative
importance of the factors used in explaining past
repayment performance then forecasts whether the
loan falls into the high or low default class.
11-42
Altman’s Linear Discriminant Model:
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.
11-43
Altman’s Linear Discriminant Model:
 The indicator variable Z is an overall measure of the
default risk classification of a commercial borrower.
 This in turn depends on the values of various financial

ratios of the borrower ( X ij ) and the weighted
importance of these ratios based on the past observed
experience of defaulting versus non-defaulting
borrowers derived from a discriminant analysis model.
 According to Altman’s credit scoring model, any firm

with a Z score of less than 1.81 should be considered a
high default risk firm; between 1.81 and 2.99, an in-
determinant default risk firm; and greater than 2.99, a
low default risk firm.
Altman’s Linear Discriminant Model: 11-44
Example
 Suppose that following are the financial ratios of
potential borrowing firm. Calculate z-score
Altman’s Linear Discriminant Model: 11-45
Example
11-46
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.
11-47
11-48
11-49
11-50
Altman’s discriminant function is given by:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
X1 = (20+90+90‑30‑30-90)/ 700 = .0714

X2 = 44(1-.5) / 700 = .0314
X3 = (500-360) / 700 = .20
X4 = 400 / 150 = 2.67
X5 = 500 / 700 = .7143
11-51
Altman’s discriminant function is given by:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
X1 = (20+90+90‑30‑30-90)/ 700 = .0714

X2 = 22 / 700 = .0314
X3 = (500-360) / 700 = .20
X4 = 400 / 150 = 2.67
X5 = 500 / 700 = .7143
Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.20) + 0.6(2.67) + 1.0(0.71)

= .0857 + .044 + .66 + 1.6 + .7143
= 3.104
11-52
Newer Models of Credit Risk Measurement & Pricing
1. Term structure of credit risk approach

(Reduced form models)
2. Mortality Rate Approach
3. RAROC Models (Risk adjusted return on
Capital)
4. Option Models / Structural Models
11-53
Term Structure derivation of credit risk
11-54
Term Structure derivation of credit risk
 Because Treasury strips and zero-coupon corporate
bonds are single-payment discount bonds, it is
possible to extract required credit risk premiums and
implied probabilities of default from actual market data
on interest rates.
 That is, the spreads between risk-free discount bonds
issued by the Treasury and discount bonds issued by
corporate borrowers of differing quality reflect
perceived credit risk exposures of corporate
borrowers for single payments at different times in the
future.
 FIs can use these credit risk probabilities on existing
debt to decide whether or not to issue additional debt
to a particular credit risk borrower.
11-55
Term Structure derivation of credit risk – One year case
 Assume that the FI requires an expected return on a

one-year (zero-coupon) corporate debt security equal
to at least the risk-free return on one-year (zero-
coupon) Treasury strips.
 Let p be the probability that the corporate debt will be
repaid in full; therefore, (1-p) is the probability of
default.
 If the borrower defaults, the FI is assumed to get
nothing (i.e., the recovery rate is zero or the loss given
default is 100 percent).
11-56
 By denoting the contractually promised return on the

one-year corporate debt strip as 1+k and on the credit
risk–free one-year Treasury strip as 1 + i, the FI
manager would just be indifferent between corporate
and Treasury securities when:
p(1 + k) = 1 + i
11-57
Example
11-58
Example
11-59
Practice Q9
11-60
Practice Q9
 One year AA Rated Zero coupon bond:
P = (1 + 0.06) / (1 + 0.095)
= 0.968
Market Risk Premium = 0.095 – 0.06

= 0.035 or 3.5 %
11-61
Practice Q9
 One year BB Rated Zero coupon bond:
P = (1 + 0.06) / (1 + 0.135)
= 0.9339
Market Risk Premum = 0.135 – 0.06

= 0.075 or 7.5%
11-62
 Recovery rate is not equal to zero

 Then FI manager will be indifferent between Corporate
& treasury security when:

Expected Return on Corporate = Expected return on
Treasury
When,
Expected Return on Corporate loan
= (1-P)(Return in case of default) + (p*(1+k)) - 1
= (1-P)(Recovery rate*(1+k)) + (p*(1+k)) - 1
Term structure derivation of credit risk –11-63
Practice Q10
Term structure derivation of credit risk –11-64
Practice Q10
Expected Return on loan
= (1-P)(Recovery rate*(1+k)) + (p*(1+k)) - 1
= [(0.05)(0.5)(1.10)] + [(0.95*(1.1)] - 1
= 0.0275 + 1.045 - 1
= 7.25%
11-65
 Recovery rate is not equal to zero

 Then FI manager will be indifferent between Corporate
& treasury security when:

Expected Return on Corporate = Expected return on
Treasury
 Credit Risk Premium (k – i)

11-66
 Recovery rate is not equal to zero (Example)

 I = 5.05%, p = 0.948, recovery rate = 0.9, Solve for
credit risk premium
11-67
 Recovery rate is not equal to zero (Example)

 I = 5.05%, p = 0.948, recovery rate = 0.9, Solve for
credit risk premium
K–i
= [(1 + 0.0505) / (0.9 + 0.948 – (0.948*0.9))] – (1.0505)
= 1.05599 – 1.0505
= 0.55%
11-68
Term Structure derivation of credit risk – Practice Q12
11-69
1 i

1 k
p
1 
11-70
1 i
  1.055  0.5
1 k
p  1.085  0.9447 or 94.47 percent
1  1  0.5
11-71
1 i
  1.055  0.9447
1 k
p  1.085  0.5000 or 50.00 percent
1  1  0.9447
Term Structure Based Methods – Multi 11-72
Period Case
 Marginal Probability of default
Probability that a borrower will default in any
given year
 Cumulative probability of default

Probability that a borrower will default over a
specified multi year period
Term structure based methods - 11-73
Example
 1 – P1 = 0.05
 1 – P2 = 0.07
 CP = ??
Term structure based methods - 11-74
Example
 P1 = 0.95
 P2 = 0.93
 CP = 1 – [(0.95)(0.93)]
= 0.1165
There is 11.65% probability of default over

two years.
Term structure based methods – 11-75
Practice Q13
Practice Q13
 1 - P1 = 0.03
 1 - P2 = 0.05
 CP = 1 – (0.97)(0.95)
= 0.0785
Term structure based methods – Multi year 11-77
case
case Example
case Example
case Example
case Example
case Example
Term structure based methods – Multi 11-83
year case Example

 P1 = 0.984
 P2 = (1- 0.0719) = 0.9281
 CP = ??
year case Example

 P1 = 0.984
 P2 = (1- 0.0719) = 0.9281
 CP = 1 – (0.984)(0.9281)
= 0.0867 or 8.67%
year case Example

Practice Q14
Practice Q14
One year forward rate on the treasuries:
f1 = [(1.055)^2 / (1.0465)] – 1
= 6.509%
One year forward corporate bond rate:

C1 = [(1.1025)^2/(1.085)] – 1
= 12.02%
Practice Q14
Marginal Probability of repayment in year 1:
P1 = [(1.0465) / (1.085)]
= 0.9645

P2 = [(1.065)/(1.12)]
= 0.9508
Practice Q14
CP = 1 – (0.9645)(0.9508)
= 0.0829 Or 8.29%
Practice Q15
Practice Q15
One year forward rate on the treasuries:
f1 = [(1.061)^2 / (1.05)] – 1
= 7.21%
One year forward corporate bond rate:

C1 = [(1.082)^2/(1.07)] – 1
= 9.41%
Practice Q15
Two year forward rate on the treasuries:
f2 = [(1.07)^3/ (1.061)^2] – 1
= 8.82%
Two year forward corporate bond rate:

C2 = [(1.093)^3/(1.082)^2] – 1
= 11.53%
Practice Q15
P1 = [(1.05) / (1.07)]
= 0.9813

P2 = [(1.0721)/(1.0941)]
= 0.9799
Marginal Probability pf repayment in year 3:

P3 = [1.0882/1.1153]
= 0.9757
Practice Q15
CP2 = 1 – (0.9813)(0.9799)
= 0.0384 Or 3.84%
CP3 = 1 – (0.9813)(0.9799)(0.9757)
= 0.0617 Or 6.17%
11-95
Mortality Rate Derivation of credit Risk
 Rather than extracting expected default rates from the
current term structure of interest rates, the FI manager
may analyze the historic or past default risk
experience, the mortality rates , of bonds and loans of
a similar quality.
 Consider calculating p1 and p2 using the mortality rate

model.
 Here, p1 is the probability of a grade B bond or loan
surviving the first year of its issue; thus 1- p1 is the
marginal mortality rate , or the probability of the bond
or loan defaulting in the first year of issue.
11-96
Mortality Rate Derivation of credit Risk
 While p2 is the probability of the loan surviving in the
second year given that default has not occurred during
the first year, 1 - p 2 is the marginal mortality rate for
the second year.
 Thus, for each grade of corporate borrower quality, a

marginal mortality rate (MMR) curve can show the
historical default rate experience of bonds in any
specific quality class in each year after issue on the
bond or loan.
11-97
Mortality Rate Models

 Similar to the process employed by
insurance companies to price policies. The
probability of default is estimated from past
data on defaults.
 Marginal Mortality Rates:
11-98
Mortality Rate Models – Practice Q16
11-99
Mortality Rate Models - Example

11-100
Mortality Rate Models – Practice Q17
11-101
RAROC Models
 The essential idea behind RAROC is that rather than
evaluating the actual or contractually promised annual
ROA on a loan, the lending officer balances expected
interest and fee income less the cost of funds against
the loan’s expected risk.
 A loan is approved only if RAROC is sufficiently high
relative to a benchmark return on capital (ROE) for the
FI, where ROE measures the return stockholders
require on their equity investment in the FI.
 The idea here is that a loan should be made only if the
risk-adjusted return on the loan adds to the FI’s equity
value as measured by the ROE required by the FI’s
stockholders.
11-102
RAROC Models
 Risk adjusted return on capital. This is one
of the most widely used models.
 RAROC =
(one year net income on loan)/(loan risk)
 Loan risk estimated from loan default rates,

or using duration.
11-103
RAROC Models
 One year Net income on loan:
= (Spread + fees) * dollar value of the loan outstanding

11-104
RAROC Models - Example

11-105

11-106

11-107
RAROC Models – Practice Q18

11-108

 Capital at risk:
LN = -DLN x LN x (R/(1+R))
= - 4.3 * 5,000,000 * (0.012/1.08)
= -238,889
 Net Income = ??
11-109

LN = -DLN x LN x (R/(1+R))
= - 4.3 * 5,000,000 * (0.012/1.08)
= -238,889
 Net Income = (0.003+0.0025) * 5,000,000

= 27,500
 RAROC = ??
11-110

LN = -DLN x LN x (R/(1+R))
= - 4.3 * 5,000,000 * (0.012/1.08)
= -238,889
 Net Income = (0.003+0.0025) * 5,000,000

= 27,500
 RAROC = 27,500 / 238,889

= 11.51%
11-111

11-112

LN = -DLN x LN x (R/(1+R))
= - 7.5 * 5,000,000 * (0.042/1.12)
= -1,406,250
 Net Income = (0.005+0.02) * 5,000,000

= 125,000
 RAROC = 125000 / 1406250

= 8.89%
11-113

 0.10 = 125000 / Capital at Risk
Capital at Risk = 125000/0.10

= 1,250,000
Capital at risk:
LN = -DLN x LN x (R/(1+R))
1,250,000 = - Duration * 5,000,000 * (0.042/1.12)
Duration = 1250,000/(5000,000 * 0.0375)

= 6.67 years
11-114

 0.10 = Net income on loan / 1406,250
Net income on loan = 0.10 * 1,406,250

= 140,625
Additional Income = 140,625 – 125,000

= 15,625
11-115
Net income on loan = 0.10 * 1,406,250

= 140,625
140,625 = (0.005 + Spread) * 5,000,000
Spread = (140,625/5,000,000) – 0.005

= 2.31%
Loan Rate must be increased to 12.31% from 12% to

make the loan acceptable.
11-116
Thank you for your time &

Patience 

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Chapter 11

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

 This chapter discusses types of loans,

Credit Quality Problems

Credit Quality Problems

Types of US Banks Loans

 C&I loans: secured and unsecured

 Individual (consumer) loans: personal, auto,

1)Interestrate on the loan

3)The credit risk premium on the loan (m)

4)The collateral backing of the loan

5)Compensating balance (b) & reserve requirements (RR)

 Expected return: E(r) = p(1+k) - 1

 Note that realized and expected return

Return on a Loan: Practice Q1

Calculate the promised return ( k ) on a loan if

Return on a loan – Practice Q2

Return on a loan – Practice Q3

 The true cost is the

 For compensating balance rates of 15 percent and 20

Return on loan – Practice Q4

Return on loan – Practice Q4

Return on loan – Practice Q4

of  ( BR  m) 0.0025  (0.09  0.025)

Expected Return on a loan

 To the extent that p is less than 1, default risk is

Lending Rates and Rationing

Lending Rates and Rationing

Measuring Credit Risk

 The availability of more information, along with the

Measuring Credit Risk

3) Newer Models of Credit Risk Measurement

 Qualitative models: borrower specific

 Credit scoring models are quantitative models that use

 Three types of Credit Scoring Models:

Linear Probability Models:

Credit Scoring Models

 Linear probability models:

 Statistically unsound since the Z’s obtained

Credit Scoring Models - Example

Credit Scoring Models - Example

PD = 0.3(.75) + 0.2(.25) - 0.05(.10)

PD = 0.3(2.5) + 0.2(.25) - 0.05(.10)

The expected probability of repayment is 1 ‑ 0.795 = 0.205.

 While linear probability and logit models project a

 Similar to linear probability models, linear discriminant

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

Critical value of Z = 1.81.

 X1 = Working capital/total assets.

 This in turn depends on the values of various financial

 According to Altman’s credit scoring model, any firm

Linear Discriminant Model

Altman’s discriminant function is given by:

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

X1 = (20+90+90‑30‑30-90)/ 700 = .0714

Altman’s discriminant function is given by:

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

X1 = (20+90+90‑30‑30-90)/ 700 = .0714

Z = 1.2(0.07) + 1.4(0.03) + 3.3(0.20) + 0.6(2.67) + 1.0(0.71)

1. Term structure of credit risk approach