This chapter discusses the management of credit risk in a loan (asset) portfolio context. It also discusses the setting of credit exposure limits to industrial sectors and regulatory approaches to monitoring credit risk. The National Association of Insurance Commissioners has also developed limits for different types of assets and borrowers in insurers portfolios.
3 Simple Models of Loan Concentration
Track credit rating changes within sector or pool of loans.
Rating transition matrix.
Widely applied to commercial loans credit card portfolios and consumer loans.
4 Web Resources
For information on migration analysis visit
Standard Poors www.standardandpoors.com
5 Rating Transition Matrix
Risk grade end of year
1 2 3 Default
Risk grade 1 .85 .10 .04 .01
beginning 2 .12 .83 .03 .02
of year 3 .03 .13 .80 .04
6 Simple Models of Loan Concentration
On loans to individual borrower.
Concentration limit Maximum loss Loss rate.
Maximum loss expressed as percent of capital.
Some countries such as Chile specify limits by sector or industry
7 Diversification Modern Portfolio Theory
Applying portfolio theory to loans
Using loans to construct the efficient frontier.
Minimum risk portfolio.
8 Applying Portfolio Theory to Loans
(i) expected return on loan (measured by all-in-spread)
(ii) loan risk
(iii) correlation of loan default risks.
9 Modern Portfolio Theory Expected Return Variance 10 KMV Portfolio Manager Model
KMV Measures these as follows
Ri AISi - E(Li) AISi - EDFi LGDi
si ULi sDi LGDi
rij correlation between systematic return components of equity returns of borrower i and borrower j.
11 Partial Applications of Portfolio Theory
Loan volume-based models
Commercial bank call reports
Can be aggregated to estimate national allocations.
Shared national credit
National database that breaks commercial and industrial loan volume into 2-digit SIC codes.
12 Partial Applications
Loan volume-based models (continued)
Provide market benchmarks.
Standard deviation measure of loan allocation deviation.
Life and PC insurance regulators propose limits on investments in securities or obligations of any single issuer.
General diversification limits.
15 Pertinent Websites
For more information visit
Federal Reserve Bank www.federalreserve.gov
National Association of Insurance Commissioners www.naic.org
Standard Poors www.standardandpoors.com
16 Chapter 13
Off Balance Sheet Risk
This chapter discusses the risks associated with off-balance-sheet activities. OBS activities are often designed to reduce risks through hedging with derivative securities and other means. However as several recent events demonstrate OBS risk can be substantial. Regulatory policy has been altered as a result of accounting abuses and other unethical practices.
18 OBS Activities
Union Bank of Switzerland
CSFB/Orange County CA.
AllFirst Bank/Allied Irish Bank
19 Banks and the Enron debacle
J.P. Morgan Chase and Citigroup
2.25 billion loss via credit derivatives
Sarbanes-Oxley Act of 2002
arrangements that may be of material concern to the markets.
20 OBS Activities and Solvency
Valuation of OBS items
Delta of an option
Notional value of an OBS item
Delta equivalent or Contingent asset value
Delta Face value of option
True picture of net worth
Should include market value of on- and off-balance-sheet activities.
E (A L) (CA CL)
Exposure to OBS risk just as important as other risk exposures
22 Changes in OBS (Billions) 23 Incentives to Increase OBS Activities
Losses on LDC loans and reduced margins produced profit incentive.
Increases in fee income.
Avoidance of regulatory costs or taxes.
Deposit insurance premiums.
Capital adequacy requirements.
24 Schedule L Activities
Letters of credit
Futures forwards swaps and options
When issued securities
OBS only if sold without recourse
25 Schedule L OBS Activities
Loan commitments and interest rate risk
If fixed rate commitment the bank is exposed to interest rate risk.
If floating rate commitment there is still exposure to basis risk.
Take-down risk Uncertainty of timing of take-downs exposes bank to risk. Back-end fees are intended to reduce this risk.
26 Other Risks with Loan Commitments
Credit risk credit rating of the borrower may deteriorate over life of the commitment
Aggregate funding risk During a credit crunch bank may find it difficult to meet all of the commitments.
Banks may need to adjust their risk profile on the balance sheet in order to guard against future take-downs on loan commitments.
27 Commercial LCs and SLCs
Particularly important for foreign purchases. If creditworthiness of the importer is unknown to seller or lower than the banks
then gains available through using an LC.
SLCs often used to insure risks that need not be trade related.
performance bond guarantees.
Property casualty insurers also prominent in selling SLCs.
28 Derivative Contracts
Used by FIs for hedging purposes
Or FIs acting as dealers
Big Three Dealers J.P. Morgan Chase Bank of America Citigroup.
Commitments to buy and sell securities prior to issue. Example commitments taken in week prior to issue of new T-bills.
The risk is that the bank may overcommit as with Salomon Brothers in market for new 2-year bonds in 1990. Caused the Treasury to revise the regulations governing the auction of bills and bonds.
30 Loans Sold
Exposure to risk from loans sold unless no recourse
Ambiguity of no recourse qualification
Reputation effects may amplify the FIs contingent liabilities
31 Schedule L and Nonschedule L OBS Risks
FIs other than banks may engage in many of the OBS activities discussed so far.
Banks have to report the five OBS activities (discussed in precedings) each quarter as part of Schedule L of the Call report.
32 Non-Schedule L Activities
FedWire is domestic. CHIPS is international and settlement takes place only at the end of the day. Leaves the bank with intraday exposure to settlement risk. During the day banks receive provisional messages only.
33 Non-Schedule L Risk Affiliate Risk
Affiliate risk occurs when dealing with BHCs.
Creditors of failed affiliate may lay claim to surviving banks resources.
Effects of source of strength doctrine.
34 The Role of OBS Activities
OBS activities are not always risk increasing activities.
In many cases they are hedging activities designed to mitigate exposure to interest rate risk foreign exchange risk etc.
OBS activities are frequently a source of fee income especially for the largest most credit-worthy banks.
35 Pertinent Websites
American Banker www.americanbanker.com
Federal Reserve Bank www.federalreserve.gov
Bank One Corp. www.bankone.com
J.P. Morgan/Chase www.jpmorgan.com
NY Board of Trade www.nybot.com
U.S. Treasury www.ustreas.gov
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