credit analsys
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8/13/2019 Credit Analsys
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Loan Eligiblity
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Agenda
1. Theory of Bank Credit
2. Analyzing Bank Credit Risk
3. Credit Process4. Credit Derivatives
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Lemon Problem: Used Cars
Two indistinguishable (to buyers) types of cars:lemons (often breaking down) and creampuffs (neverbreaking down).
If buyers will pay $3000 for a creampuff and $3000for a lemon.
Sellers will part with a creampuff for $2500 and partwith a lemon for $1000.
One third of cars are creampuffs and two thirds arelemons.
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Symmetric Information
If borrowers and sellers
both can easily distinguish
lemons from creampuffs,
there is a simple market
solution. Buyers will pay $3000 for a
creampuff and $2000 for a
lemon and sellers will be
happy to sell.
If neither borrowers nor
sellers can distinguish
between types, there is still
a solution.
Buyers could pay the average
of their values
($2000)+($3000) =
$2,333.
This would be higher than the
average value to sellers:($1000)+($2500) =
$1500.
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Asymmetric Information
What happens if buyers cant distinguish between
types but sellers can?
Buyers might be willing to offer $2,333 for a car ofunknown type, but owners of creampuffs would value
their car more highly than that. Only lemon owners
would sell at that price. Buyers would have no reason
to offer more than $2000. Only lemons will be boughtand sold.
No market for creampuffs will exist.
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Lemon Problem: Bond Market
Some firms have risky prospects (lemons) and somefirms have safe prospects (creampuffs).
Bond buyers cannot distinguish between them. Theyoffer bond prices which are an average of the price ofcreampuff bonds and lemon bonds. [Another way ofputting this is that interest rates are an average ofcreampuff and lemon rates].
Potential borrowers with creampuff prospects mayfinance their own projects.
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Raising Interest Rates May Not Compensate
for Risks in Bond Markets
Only borrowers with lemon prospects will join bond
markets.
Typically we think bond buyers might take riskierassets if they were offered a higher interest rate.
But if savers demand a higher interest rate under
asymmetric informationthis will only exacerbate thelemon problem if higher interest rates drive
creampuff borrowers out of the market.
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Adverse Selection: The Bond Market
Consider a bond market with three types of bond sellers.
1. Safe: Financing a safe, low-return project. Can onlypay 7.5% interest rate but will never default.
2. Speculative: Financing a high risk/high return projectwill pay a 15% interest rate, but a high probability ofdefault.
3. Crooks: Will offer to pay any interest rate, but will
never repay.Assume that 75% of bond issuers are safe, 20% of bond
issuers are speculative, and just 5% are crooks.
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Bond Buyers Bond buyers will pay:
97 for a discount bond issued by a borrower identified assafe;
90 for a bond issued by a borrower identified as speculative
0 for bond issued by a crook.
If they cannot distinguish, they will pay a value equal
to the expected value of the pool.
In this pool, the expected value is
(.75*97)+(.2*90)+(0.05*0) = 90.75 which implies ayield to maturity of i = .102.
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Borrower Investor
will Pay will pay or get
Share at Most at Most at leastSafe 0.75 7.50% 97 1.030928 3.09%
Speculative 0.2 15% 90 1.111111 11.11%
Crook 0.05 Anything 0
Unknown Type 90.75 1.101928 10.19%
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Bond market breaks down!
Rate of interest offered by uninformed investor isattractive to speculative borrowers but to expensivefor safe borrowers.
They will drop out of the market. As bond buyers begin
to realize the riskiness of pool is changing, they willreassess price that they will pay for bonds.
The pool will now be 80% speculative and 20% crooks.The expected value of bonds in this pool is
(.8*90)+(.2*0)=72 implying a yield of i = .3889. This istoo much for speculative borrowers.
Only crooks will stay in the market. Ultimately thebond market will disappear.
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Adverse Selection
Actions that lenders take to protect
themselves from consequence of a lack of
information lead to a worsening of the risk
pool.
In the extreme case, adverse selection can
cause an entire market to disappear.
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Business of Banking & Comparative
Advantage
Comparative advantage of banking.
Banking exists as a specialist in acquiringinformation and eliminating adverse selection
problems. A key comparative advantage of banks is their
ability to evaluate information on borrowers.
Banking business should attempt to make bestuse of that advantage.
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Credit Risk: the risk that a borrower will not
pay back interest or principal on a loan.Evaluating Bank Credit Risk
History of Credit Performance (Charge-offs)
Future expected losses (non-performing
loans, types of lending, diversification)
Current Strength of bank preparation
(reserves, earnings coverage).
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Net Charge-offs to Loans
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
Total loans &
leases
Total real estate
loans
Commercial &
industrial loans
Loans to individuals All other loans &
leases (including
farm)
2007 2006 2005 2004
Statistic on Depository Institutions
http://www2.fdic.gov/sdi/index.asphttp://www2.fdic.gov/sdi/index.asp -
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Stages of Bad Loans
Past Due Loans: Loans for which contracted
payments have not been made, but which still areaccruing interest.
More than 90 days past due is Nonperforming Loans
Nonaccrual Loans: Loans that are habitually past due
and no longer accruing interest.
Total Noncurrent = Past Due + Nonaccrual
Charge-offs: Loans written off as uncollectable
Recoveries: Sums later collected on loans written off.
Net Chargoffs = Charge-offs - Recoveries
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Past Due Loans
(Contractual Payment not
Made)
90 Days Non Performing
Loans
Full Payment
Not Expected
Non-accrualLoans
NonCurrent Loans
Total
Chargeoffs
Uncollect
ible
Loans
Written
off
Collection
Process
Recovery
Net
Chargeoffs
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Non Current Assets to Loans
0.00%
0.20%
0.40%0.60%
0.80%
1.00%
1.20%
1.40%
1.60%
1.80%
Total loans &
leases
All real estate
loans
Commercial &
industrial
loans
Loans to
individuals
All other
loans &
leases
(including
farm)
Commercial
real estate
loans not
secured by
real estate
2007 2006 2005 2004
Statistic on Depository Institutions
http://www2.fdic.gov/sdi/index.asphttp://www2.fdic.gov/sdi/index.asphttp://www2.fdic.gov/sdi/index.asp -
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Measuring a Banks Credit Risk/Key Ratios
Loans are assets with the most credit risk (also themost profitable). Other types of assets are typically
more transparent and have less risk of default.
Large quantities of loans make banks riskier.
Higher Loans to Assets means higher risk.
Rapid expansion of credit means banks may not be
discriminating
Higher Loan Growth Rate means higher risk
Measure banks chargeoffs, loan composition, non-
performing & non current loans, earnings coverage,
loan loss allowances on page 8 & page 9 of UBPRs.
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Composition of a Banks Loan Portfolio
Some loans are riskier than others, so a highshare of loans in risky categories involveshigher risk.
Banks concentrate on real estate lending whichtends to have very low default rates.
An undiversified portfolio also exposes a bankto risk. Concentration in the property marketexposes the bank to systematic risk ofproperty collapse.
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Protection from Bad Loans
US Commercial Banks, 2004
0
1
2
3
4
5
6
7
2004 2003 2002 2001
Loan Loss/Net Charge Offs Earnings/Net Charge Offs Loan Loss/Gross Loans (%)
Source: SDI, FDIC Statistics on Depository Institutions, FDIC
http://www2.fdic.gov/sdi/index.asphttp://www2.fdic.gov/sdi/index.asphttp://www2.fdic.gov/sdi/index.asp -
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Credit Process
I. Credit Policy
II. Business Development and Credit Analysis .
III. Credit ExecutionIV. Loan Review
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I. Credit Policy
Loan Policy
Loan Culture
1. Values DrivenRisk Averse
2. Current Profit DifferentHigh risk/return
lending, Cyclical Profits
3. Market Share DrivenLow returns, large scale.
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Written Loan Policy FDIC recommends, A loan policy should address:
General fields of lending Normal trade area
Lending authority of loan officers and committees
Responsibility of the board of directors in approving loans
Guidelines for portfolio mix, risk diversification, appraisals, unsecured
loans, and rates of interest Limitations on loan-to-value, aggregate loans, and overdrafts
Credit and collateral documentation standards
Collection procedures
Guidelines addressing loan review/grading systems and the allowance
for loan and lease losses Safeguards to minimize potential environmental liability
Source
http://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune
_up.html
http://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune_up.htmlhttp://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune_up.htmlhttp://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune_up.htmlhttp://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune_up.html -
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Business Development & Credit Analysis
MarketingFind customers
Loan InterviewMeet potential borrower andevaluate for character and sincerity
Evaluation of BusinessGather information aboutthe borrowers business.
Credit Analysis: Numerical analysis of a businessesfinancial condition
Evaluation of Collateral Adequacy: Check whethercollateral that backs loans is of value commensuratewith loan.
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Credit Scoring Models
(1.2 ) (1.4 ) (3.3 )
(0.6 ) (.999 )
Z WC RE ROA
Equity AT
Banks use numerical models to evaluate thecredit of borrowing firms. Seminal model wasthe Z-score model of Edward Altman
WCWorking Capital to Assets
RE: Retained Earnings to Assets
ROA: EBIT/Assets
Equity: Market toBook Ratio
AT: Asset Turnover-
Sales to AssetsAbove 3, bankruptcy unlikely; below 1.8bankruptcy likely.
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FICO
In USA, Fair Isaac Corp. develops models that evaluateconsumer households likelihood of default.
FICO or similar score used for consumer credit
Late payments
The amount of time credit has been established
The amount of credit used versus the amount of credit available
Length of time at present residence
Negative credit information such as bankruptcies, charge-offs,collections, etc.
In Hong Kong, recent relaxation of some rules governingsharing of consumer credit information.
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5 Cs of Credit
1. CharacterPast history of borrower in payingbills.
2. CapitalBorrowers Wealth Position
3. Collateralpossession by the borrower ofassets that back up the loan.
4. Conditions - trends and volatility of theborrowers industry
5. CapacityLegal Standing and ability of theborrower to generate loan payments on aconsistent basis
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III. Execution
Documentation
Loan Agreements
Restrictive Covenants
Perfecting Claims to Collateral
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Parts of a Typical Loan Agreement
The Note: Specifies the principal and theinterest and the timing of repayment.
Collateral: Specifies assets assigned and terms
under which lender takes possession of assets. Covenants
Borrower Guarantees.
Events of Default: Exact conditions underwhich a loan is considered in default.
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Loan Covenants
A central part of the credit process is the monitoringof borrowers.
Banks restrict borrowers use of funds in the loanagreement.
Affirmative Covenants. Actions that the borrower musttake. Maintaining liquidity and equity as measured byfinancial ratios, maintaining insurance, file financialreports, pay taxes, etc.
Negative Covenants. Actions that the borrower cannottake. Taking on new debt, buying or selling assets, payingexcessive dividends, paying excessive salaries or bonuses,etc.
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IV. Credit Review
Monitor Covenants
Loan Review Process
Ex post evaluations of lending evaluation
Loan Workout
Process for dealing with defaulting creditors
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Credit Derivatives
Risk Management Tools Used to transfer risk from oneparty to another.
Credit SwapsA bank with credit risk exposure willpay X basis points per year and counter-party willmake payment if there is a pre-determined creditevent such as default or credit downgrade, etc.
Total Return Swap: Bank with credit risk will pay theincome stream from risky debt while counter-partywill pay some fixed rate to bank..
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Credit Swap
Bank A
Bank B
Fee Payment
Payment if negative
credit event
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Total Return Swap
Bank A
Intermediary
Bank B
Loan and Principal
Loan and Principal
Loan and Principal Loan and Principal
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Credit Derivatives
Global Credit Derivatives
0
2000
4000
6000
8000
10000
12000
14000
1H01 2H01 1H02 2H02 1H03 2H03 1H04 2H04 1H05
US$
Trillio
n
Source: www.creditderiv.com
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Extra Reading
HKMA Benefits of Sharing Positive Consumer
Credit Data
B. Hirtle, NY FED, 2007, Credit Derivatives and
Bank Credit Supply
BIS 2005 Credit Risk Transfer
http://www.info.gov.hk/hkma/eng/public/qb200603/fa1.pdfhttp://www.info.gov.hk/hkma/eng/public/qb200603/fa1.pdfhttp://www.newyorkfed.org/research/staff_reports/sr276.htmlhttp://www.newyorkfed.org/research/staff_reports/sr276.htmlhttp://www.bis.org/publ/joint13.pdf?noframes=1http://www.bis.org/publ/joint13.pdf?noframes=1http://www.newyorkfed.org/research/staff_reports/sr276.htmlhttp://www.newyorkfed.org/research/staff_reports/sr276.htmlhttp://www.info.gov.hk/hkma/eng/public/qb200603/fa1.pdfhttp://www.info.gov.hk/hkma/eng/public/qb200603/fa1.pdf
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