Credit Risk: Loan Portfolio and Concentration Risk: Chapter 12

1
Credit Risk Loan Portfolio and Concentration
Risk Chapter 12

• Financial Institutions Management, 3/e
• By Anthony Saunders

2
Simple Models of Loan Concentration

• Migration analysis
• Track credit rating changes within sector or pool
  of loans.
• Rating transition matrix.

3
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

4
Simple Models of Loan Concentration

• Concentration limits
• On loans to individual borrower.
• Concentration limit Maximum loss ? Loss rate.
• Maximum loss expressed as percent of capital.

5
Diversification and Modern Portfolio Theory

• Applying portfolio theory to loans
• Using loans to construct the efficient frontier.
• Minimum risk portfolio.
• Low risk
• Low return.

6
Applying Portfolio Theory to Loans

• Require
• (i) expected return on loan(measured by
  all-in-spread)
• (ii) loan risk
• (iii) correlation of loan default risks.

7
KMV Portfolio Manager Model

• Ri AISi - E(Li) AISi - EDFi LGDi
• si ULi si LGDi
• EDFi(1-EDFi)½ LGDi
• rij correlation between systematic return
  components of equity returns of borrower i and
  borrower j.

8
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.

9
Partial Applications

• Loan volume-based models (continued)
• Provide market benchmarks.
• Standard deviation measure of loan allocation
  deviation.

10
Loan Loss Ratio-Based Models

• Estimate loan loss risk by SIC sector.
• Time-series regression
• sectoral losses in ith sector
• loans to ith sector
• a bi total loan losses
• total loans

11
Regulatory Models

• Credit concentration risk evaluation largely
  subjective.
• Life and PC insurance regulators propose limits
  on investments in securities or obligations of
  any single issuer.
• Diversification limits.