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Credit Risk: Loan Credit Risk: Loan Portfolio and Portfolio and
Concentration RiskConcentration Risk
Chapter 12
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
K. R. Stanton
McGraw-Hill/Irwin
12-2
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Overview
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.
McGraw-Hill/Irwin
12-3
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Simple Models of Loan Concentration
Migration analysis Track credit rating changes within sector or pool
of loans. Rating transition matrix.
Widely applied to commercial loans, credit card portfolios and consumer loans.
McGraw-Hill/Irwin
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© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Web Resources
For information on migration analysis, visit:
Standard & Poors www.standardandpoors.com
Moody’s www.moodys.com
McGraw-Hill/Irwin
12-5
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin
12-6
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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.
Some countries, such as Chile, specify limits by sector or industry
McGraw-Hill/Irwin
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© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Diversification & Modern Portfolio Theory
Applying portfolio theory to loans Using loans to construct the efficient frontier. Minimum risk portfolio.
Low risk Low return.
McGraw-Hill/Irwin
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© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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.
McGraw-Hill/Irwin
12-9
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Modern Portfolio Theory
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Expected Return:
Variance:
McGraw-Hill/Irwin
12-10
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
KMV Portfolio Manager Model
KMV Measures these as follows: Ri = AISi - E(Li) = AISi - [EDFi × LGDi]
i = ULi = Di × LGDi
= [EDFi(1-EDFi)]½ × LGDi
ij = correlation between systematic
return components of equity returns of borrower i and borrower j.
McGraw-Hill/Irwin
12-11
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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.
McGraw-Hill/Irwin
12-12
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Partial Applications
Loan volume-based models (continued) Provide market benchmarks.
Standard deviation measure of loan allocation deviation.
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McGraw-Hill/Irwin
12-13
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Loan Loss Ratio-Based Models
Estimate loan loss risk by SIC sector. Time-series regression:
[sectoral losses in ith sector]
[ loans to ith sector ]
= + i [total loan losses]
[ total loans ]
McGraw-Hill/Irwin
12-14
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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. General diversification limits.
McGraw-Hill/Irwin
12-15
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Pertinent Websites
For more information visit:
Federal Reserve Bank www.federalreserve.gov
KMV www.kmv.com
Moody’s www.moodys.com
National Association of Insurance Commissioners www.naic.org
Standard & Poors www.standardandpoors.com
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