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Evaluation of Credit Risk

This document discusses various methods that financial institutions use to evaluate credit risk and measure the risk of individual loans. It describes qualitative models, credit scoring models like linear probability and logit models, term structure based methods, mortality rate models, RAROC models, option models, CreditMetrics, and Credit Risk+ models. The goal of these models is to quantify the probability of default and expected loss to help institutions price loans and manage risk in their portfolios.

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372 views16 pages

Evaluation of Credit Risk

This document discusses various methods that financial institutions use to evaluate credit risk and measure the risk of individual loans. It describes qualitative models, credit scoring models like linear probability and logit models, term structure based methods, mortality rate models, RAROC models, option models, CreditMetrics, and Credit Risk+ models. The goal of these models is to quantify the probability of default and expected loss to help institutions price loans and manage risk in their portfolios.

Uploaded by

riska
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Credit Risk: Individual Loan Risk

Chapter 11
Financial Institutions Management, 3/e
By Anthony Saunders

Irwin/McGraw-Hill
1
Evaluation of Credit Risk

• Popular press attention to junk bonds and LDC


loans. More recently, credit card loans and auto
loans.
• In mid-90s, improvements in NPLs for large banks.
• New types of credit risk related to loan guarantees
and off-balance-sheet activities.
• Increased emphasis on credit risk evaluation.

Irwin/McGraw-Hill
2
Types of Loans:

• C&I loans: secured and unsecured


• Spot loans, Loan commitments
• Decline in C&I loans originated by commercial
banks.
• RE loans: primarily mortgages
» mortgages can be subject to default risk when loan-
to-value declines.
• Individual (consumer) loans: personal, auto,
credit card.
Irwin/McGraw-Hill
3
Return on a Loan:

• Factors: interest payments, fees, credit risk


premium, collateral, other requirements such as
compensating balances and reserve
requirements.
• Return = inflow/outflow
k = (f + (L + M ))/(1-[b(1-R)])
• Expected return: E(r) = p(1+k)

Irwin/McGraw-Hill
4
Lending Rates and Rationing

• At retail: Usually a simple accept/reject


decision rather than adjustments to the rate.
» Credit rationing.
» If accepted, customers sorted by loan quantity.
• At wholesale:
» Use both quantity and pricing adjustments.

Irwin/McGraw-Hill
5
Measuring Credit Risk

• Qualitative models: borrower specific factors


are considered as well as market or systematic
factors.
• Specific factors include: reputation, leverage,
volatility of earnings, covenants and collateral.
• Market specific factors include: business cycle
and interest rate levels.

Irwin/McGraw-Hill
6
Credit Scoring Models:

• Linear probability models: Z = XB + residuals.


Statistically unsound since the Z’s obtained are
not probabilities at all.
» *Since superior statistical techniques are readily
available, little justification for employing linear
probability models.
• Logit models: overcome this weakness using a
transformation (logistic function).
» Other alternatives include Probit and other variants
with nonlinear indicator functions.
Irwin/McGraw-Hill
7
Altman’s Linear Discriminant Model:

• Z=1.2X1+ 1.4X2 +3.3X3 + 0.6X4 + 1.0X5


Critical value of Z = 1.81.
• X1 = Working capital/total assets.
• X2 = Retained earnings/total assets.
• X3 = EBIT/total assets.
• X4 = Market value equity/ book value LT debt.
• X5 = Sales/total assets.

Irwin/McGraw-Hill
8
Linear Discriminant Model

 Problems:
• Only considers two extreme cases (default/no
default).
• Weights need not be stationary over time.
• Ignores hard to quantify factors including
business cycle effects.
• Database of defaulted loans is not available to
benchmark the model.

Irwin/McGraw-Hill
9
Term Structure Based Methods:

• If we know the risk premium we can infer the


probability of default. Expected return equals
risk free rate after accounting for probability of
default.
p (1+ k) = 1+ i
• May be generalized to loans with any maturity
or to adjust for varying default recovery rates.
• The loan can be assessed using the inferred
probabilities from comparable quality bonds.
Irwin/McGraw-Hill
10
Mortality Rate Models

• Similar to the process employed by insurance


companies to price policies. The probability of
default is estimated from past data on defaults.
• Marginal Mortality Rates:
MMR1 = (Value Grade B default in year 1)
(Value Grade B outstanding yr.1)
MMR2 = (Value Grade B default in year 2)
(Value Grade B outstanding yr.2)

Irwin/McGraw-Hill
11
RAROC Models

• Risk adjusted return on capital. This is one of


the more widely used models.
• Incorporates duration approach to estimate
worst case loss in value of the loan:
• DL = -DL x L x (DR/(1+R)) where DR is an
estimate of the worst change in credit risk
premiums for the loan class over the past year.
• RAROC = one-year income on loan/DL

Irwin/McGraw-Hill
12
Option Models:

• Employ option pricing methods to evaluate the


option to default.
• Used by many of the largest banks to monitor
credit risk.
• KMV Corporation markets this model quite
widely.

Irwin/McGraw-Hill
13
Applying Option Valuation Model

 Merton showed value of a risky loan


F(t) = Be-it[(1/d)N(h1) +N(h2)]
 Written as a yield spread
k(t) - i = (-1/t)ln[N(h2) +(1/d)N(h1)]
where k(t) = Required yield on risky debt
ln = Natural logarithm
i = Risk-free rate on debt of equivalent maturity.
Irwin/McGraw-Hill
14
*CreditMetrics

 “If next year is a bad year, how much will I


lose on my loans and loan portfolio?”
VAR = P × 1.65 × s
 Neither P, nor s observed.
Calculated using:
• (i)Data on borrower’s credit rating; (ii) Rating
transition matrix; (iii) Recovery rates on
defaulted loans; (iv) Yield spreads.
Irwin/McGraw-Hill
15
* Credit Risk+

 Developed by Credit Suisse Financial Products.


• Based on insurance literature:
» Losses reflect frequency of event and severity of loss.
• Loan default is random.
• Loan default probabilities are independent.
 Appropriate for large portfolios of small loans.
 Modeled by a Poisson distribution.

Irwin/McGraw-Hill
16

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