Managing Credit Risk on the Balance Sheet

8-1McGraw-Hill/IrwinChapter TwentyManaging Credit Risk on the Balance Sheet20-2McGraw-Hill/IrwinCredit Risk ManagementFinancial institutions (FIs) are special because of their ability to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governmentsFIs’ ability to process and evaluate information and control and monitor borrowers allows them to transform these claims at the lowest possible cost to all partiesCredit allocation is an important type of financial claim transformation for commercial banksFIs make loans to corporations, individuals, and governmentsFIs accept the risks of loans in return for interest that (hopefully) covers the costs of funding—and are thus exposed to credit risk20-3McGraw-Hill/IrwinCredit Risk ManagementThe credit quality of many FIs’ lending and investment decisions has been called into question in the past 25 yearsproblems related to real estate and junk bond lending surfaced at banks, thrifts, and insurance companies in the late 1980s and early 1990sconcerns related to the rapid increase of credit cards and auto lending occurred in the late 1990scommercial lending standards declined in the late 1990s, which led to increases in high-yield business loan delinquenciesconcerns shifted to technology loans in the late 1990s and early 2000smortgage delinquencies, particularly with subprime mortgages, surged in 2006 and continue to be a concern20-4McGraw-Hill/IrwinCredit Risk ManagementLarger banks are generally more likely to accept riskier loans than smaller banksLarger banks are also exposed to more counterparty risk off-the-balance-sheet than smaller banksManagerial efficiency and credit risk management strategies directly affect the return and risk of the loan portfolioAt the extreme, credit risk can lead to insolvency as large loan losses can wipe out an FI’s equity capital20-5McGraw-Hill/IrwinCredit AnalysisReal estate lendingmortgage loan applications are among the most standard of all credit applicationsdecisions to approve or disapprove a mortgage application depend onthe applicant’s ability and willingness to make timely interest and principal paymentsthe value of the borrower’s collateralthe ability to maintain mortgage payments is measured by GDS and TDS20-6McGraw-Hill/IrwinCredit AnalysisReal estate lending (cont.)GDS refers to the gross debt service ratio equal to the total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided by gross incomeacceptable threshold generally set around 25% to 30%TDS refers to the total debt service ratioequal to the total accommodation expenses plus all other debt service payments divided by gross incomeacceptable threshold generally set around 35% to 40%20-7McGraw-Hill/IrwinCredit AnalysisReal estate lending (cont.)FIs also use credit scoring systems to evaluate potential borrowerscredit scoring systems are mathematical models that use observed loan applicant’s characteristics to calculate a score that represents the applicant’s probability of defaultloan officers can often give immediate “yes” or “no” answers—along with justifications for the decisionFIs also verify borrower’s financial statementsperfecting collateral is the process of ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default on the loan20-8McGraw-Hill/IrwinCredit AnalysisReal estate lending (cont.)FIs do not desire to become involved in loans that are likely to go into defaultin the event of default lenders usually have recourseforeclosure is the process of taking possession of the mortgaged property in satisfaction of a defaulting borrower’s indebtedness and forgoing claim to any deficiencypower of sale is the process of taking the proceedings of the forced sale of a mortgaged property in satisfaction of the indebtedness and returning to the mortgagor the excess over the indebtedness or claiming any shortfall as an unsecured creditor20-9McGraw-Hill/IrwinCredit AnalysisReal estate lending (cont.)before an FI accepts a mortgage, itconfirms the title and legal description of the propertyobtains a surveyor’s certificate confirming that the house is within the property’s boundarieschecks with the tax office to confirm that no property taxes are unpaidrequests a land title search to determine that there are no other claims against the propertyobtains an independent appraisal to confirm that the purchase price is in line with the market value of the property20-10McGraw-Hill/IrwinCredit AnalysisConsumer and small business lendingtechniques are very similar to that of mortgage lendinghowever, non-mortgage consumer loans focus on the ability to repay rather than on the propertycredit models put more emphasis on personal characteristicssmall-business loan decisions often combine computer-based financial analysis of borrower financial statements with behavioral analysis of the business owner20-11McGraw-Hill/IrwinCredit AnalysisMid-market commercial and industrial lendingis generally a profitable market for credit-granting FIstypically mid-market corporateshave sales revenues from $5 million to $100 million per yearhave a recognizable corporate structuredo not have ready access to deep and liquid capital marketscommercial loans can be for as short as a few weeks to as long as 8 years or moreshort-term loans are used to finance working capital needslong-term loans are used to finance fixed asset purchases20-12McGraw-Hill/IrwinCredit AnalysisMid-market C&I lending (cont.)generally at least two loan officers must approve a new loan customerlarge credit requests are presented formally to a credit approval officer and/or committeefive C’s of creditcharactercapacitycollateralconditionscapital20-13McGraw-Hill/IrwinCredit AnalysisMid-market C&I lending (cont.)FIs perform cash flow analyses, which provide information regarding an applicants expected cash receipts and disbursementsstatements of cash flows separate cash flows intocash flows from operating activitiescash flows from investing activitiescash flows from financing activitiesFIs may also perform ratio analysestime-series analysescross-sectional analyses20-14McGraw-Hill/IrwinCredit AnalysisMid-market C&I lending (cont.)common ratio analysis includesliquidity ratioscurrent ratioquick ratio (i.e., the acid test)asset management ratiosnumber of days in receivablesnumber of days in inventoriessales to working capitalsales to fixed assetssales to total assets (i.e., the asset turnover ratio)20-15McGraw-Hill/IrwinCredit AnalysisMid-market C&I lending (cont.)debt and solvency ratiosdebt-to-assets ratiotimes interest earned ratiocash-flow-to-debt ratioprofitability ratiosgross marginoperating profit marginreturn on assets (ROA) return on equity (ROE)dividend payout ratio20-16McGraw-Hill/IrwinCredit AnalysisMid-market C&I lending (cont.)ratio analysis has limitationsdiverse firms are difficult to compare versus benchmarksdifferent accounting methods can distort industry comparisonsapplicants can distort financial statementscommon-size analysis and growth ratescommon-size financial statements present values as percentages to facilitate comparison versus competitorsyear-to-year growth rates can identify trendsloan covenants can be used as part of the loan agreement to mitigate credit risk20-17McGraw-Hill/IrwinCredit AnalysisMid-market C&I lending (cont.)following approval, the account officer ensures that conditions precedent have been clearedthose conditions specified in the credit agreement or terms sheet for a credit that must be fulfilled before drawings are permittedincludes title searches, perfecting of collateral, etc.FIs typically wish to develop permanent, long-term, mutually beneficial relationships with their mid-market commercial and industrial customers20-18McGraw-Hill/IrwinCredit AnalysisLarge commercial and industrial lendingfees and spreads are smaller relative to small and mid-size corporate loans, but the transactions are often large enough to make them worthwhileFIs’ relationships with large clients often center around broker, dealer, and advisor activities with lending playing a lesser rolelarge corporations often useloan commitmentsperformance guaranteesterm loans20-19McGraw-Hill/IrwinCredit AnalysisLarge C&I lending (cont.)account officers often rely on rating agencies and market analysts to aid in their credit analysissophisticated credit scoring models are also usedAltman’s z-score: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 where X1 = working capital ÷ total assets X2 = retained earnings ÷ total assets X3 = earnings before interest and taxes ÷ total assets X4 = market value of equity ÷ book value of long-term debt X5 = sales ÷ total assetsKMV Credit Monitor Model uses the option pricing model of Merton, Black, and Scholes to calculate expected default frequencies20-20McGraw-Hill/IrwinCredit AnalysisCalculating the return on a loanthe return on assets (ROA) approach uses the contractually promised gross return on a loan, k, per dollar lentwhere f = the loan origination fee b = the compensating balance requirement R = the reserve requirement ratio BR = the base lending rate m = the credit risk premium on the loan20-21McGraw-Hill/IrwinCredit AnalysisCalculating the return on a loan (cont.)the risk-adjusted return on assets (RAROC) model balances a loan’s expected income against its expected riskthe RAROC is compared vis-à-vis the lender’s tax-adjusted return on equity (ROE)if RAROC > ROE make the loanif RAROC ROE or decline to make the loan