LOAN PORTFOLIO MANAGEMENT

1
LOAN PORTFOLIO MANAGEMENT

• Components of the Loan Portfolio
• Measurement of Credit Risk
• Counteracting Credit Risk
• Early Detection of Problem Loans
• Written Loan Policy

2
Components of the Loan Portfolio

• Commercial and Industrial Loans
• Real Estate Loans
• Consumer Loans and Credit Cards
• Broker Call Loans and Interbank Loans

3
The Return on a Loan

• Stated Interest Rate, Compounding Period,
  Frequency of Repricing
• Fees
• Credit Risk Premium
• Collateral Backing of the Loan
• Non-price items (Compensating Balances, Reserve
  Requirements)

4
Measurement of Credit Risk

• Quantitative Models
• Credit scoring models
• Linear probability models
• Logit and Probit models
• Multiple Discriminant analysis models
• Option models

• Qualitative Models
• Borrower-specific factors
• Reputation
• Leverage
• Volatility of Earnings
• Collateral
• Market factors
• Business cycle
• Interest rates

5
Credit Scoring

• General Concept
• Use observed borrower characteristics
• Estimate probability of default OR
• Sort borrowers into risk classes

• What do you accomplish by doing this?
• Identify factors explaining default risk and
  their importance
• Improve pricing of risk
• Screen out bad apps
• Calculate reserves

6
Linear Probability Models

• Uses past info as inputs into a model to
  statistically explain past defaults, creating a
  regression equation
• where ?j is the weight for the jth
  variable
• Derive a Z for ith borrower that is the
  probability of default

7
Multiple Discriminant Models

• Divide borrowers into 2 classeshigh risk of
  default vs. low risk of default
• Use past data to develop the equation for a
  sample of those who defaulted and a sample of
  those who didnt
• Create the discriminant boundary between the two
  groups
• Place new apps in one group or the other

8
Discriminant Score Distribution
Zone of Ignorance
No default
Default

• predicted

• predicted

FREQUENCY DISTRIBUTION OF Z SCORES using past
data of known defaulting loans
9
Option Models--Payoff to Borrower (Stockholders)
Payoff to stockholders
0 A1
Debt A2 Assets
10
Option Models--Payoff to Debtholder/Lender (Bank)
Payoff to debtholders
0 A1
Debt A2 Assets
11
Counteracting Credit Risk
12
PORTFOLIO DIVERSIFICATION
CORRECT LOAN PRICING

• FI makes loans with less than perfect correlation
• Difficult to apply portfolio theory in case of
  individual loans
• Can partially do it with national databases of
  loans--use info to set portfolio allocations to
  different segments of borrowers

13
PORTFOLIO DIVERSIFICATION
EARLY DETECTION SYSTEMS
CORRECT LOAN PRICING

• Requires judgement of default risk and portfolio
  effects
• Can include non-price items in protective
  covenants
• Choice of variable vs. fixed interest rates
• Default risk, interest rate risk, operating
  expenses all need to be included in loan pricing

14
EARLY DETECTION SYSTEMS
CORRECT LOAN PRICING

• Monitor the value of collateral assets
• Use monitoring technology to gather and
  evaluate info on continuous basis
• Identify problem loans and create workout
  strategies early

15
WARNING SIGNS

• Financial
• standard financial analysis of performance
• Operational
• production, inventory management
• relationships with suppliers, distributors, etc.
• physical appearance of the premises

• Banking
• declining balances
• frequent loan requests
• slow payments
• Managerial
• personal and business habits
• risk-taking attitudes
• day-to-day involvement
• turnover

16
CREDIT CULTUREImportance of a Written Loan Policy

• CREDIT CULTURE
• Organizational design
• Reporting arrangements amongst loan officers
• Communication practices
• Incentive schemes for loan officers

17
WRITTEN LOAN POLICY

• General policies
• Specific loan category policies
• Miscellaneous loan policies
• Quality control policies
• Committees