LENDING DECISION
Chapter 12 – Credit Risk from the Regulator’s
Perspective
Chapter 13 – Problem Loan Management
Introduction
 The sectors that were not specified for lending assistance
would have been subject to credit rationing
 Lending institutions might have been subject to
concentration risk
 Given the directives of the regulator, banks might have
approved marginal lending applications in the directed
sectors
 Prudential regulation
 Capital adequacy
 Large exposures
Capital Adequacy
 History shows that financial institutions normally fail as a
result of poor credit decision
 The board and management control the banks and decisions
could be taken that are not in the interest of the depositors –
this is known as moral hazard
 Depositors need to be protected against poor decisions by
management -> under the base of capital adequacy, financial
institutions are required to put aside capital to each credit
risk exposure, whether it is on or off the balance sheet
 A minimum of 8% of capital need be put aside for riskweighted assets
Capital Adequacy
 Risk-based capital ratio = Total capital (Tier 1 + Tier 2)
Risk Adjusted Assets
 Tier 1 capital exhibits permanence like capital
 Tier 2 has the ability to absorb credit losses but is not
permanent
 Tier 2 capital cannot make up more than 50% of overall
allowable capital
Capital Adequacy
Tier 1
Paid up ordinary shares
General reserves
Retained earnings
Non-cumulative irredeemable
preference shares
Minority interest in subsidiaries
Less Goodwill
Tier 2
General provisions for doubtful debts (<=
1.5% of total risk assets)
Asset revaluation reserves
Cumulative irredeemable preference
shares
Mandatory convertible notes
Perpetual subordinated debt
Redeemable preference shares and term
subordinated debt (min original maturity
of at least 7 years and amortization factor
of 20% of original amount to apply each
year during the last five years to maturity
Risk Categories
 Category 1 (0% weight) – notes and coins, balance with the
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FED, Government papers (<= 12 months of maturity)
Category 2 (10%) – claims on Federal and State Government
(> 12 months to maturity)
Category 3 (20%) – claims on banks
Category 4 (50%) – loans fully secured by mortgage against
residential property used for rental or occupied housing
(LVR <= 80%)
Category 5 (100%) – loan fully secured by mortgage against
residential property used for rental or occupied housing
(LVR > 80%); commercial companies
Large Credit Exposure
 Exposure = potential for loss under a finance facility
 A large exposure – an exposure to an individual or group of
counterparties that exceeds 10% of the consolidated capital
base.
 Securitization – a good credit risk management tool in
certain circumstances
 Clean sale – absolves the financial institution from any legal
recourse from the sale of loans
 Results in the financial institution not holding capital against the
loan
Clean Sale Supply of Assets
 A clean sale
 There should be no beneficial interest in the sold assets and
absolutely no obligation to the financial institution
 No recourse (including costs) to the lending institution; no
obligation to repurchase the lending assets
 The amount paid for the loans should be fixed and should be
received by the time the assets are transferred from the lending
institution.
 Any assets that are provided to the SPV as a substitute or
provided at below book value are not considered as relieving
credit risk
 Subjected to asymmetric information
Revolving Facilities
 A clean sale
 The rights, details and obligations of each party must be clearly
specified, including the distribution of cashflows
 As with normal asset securitization, the financial institution
share cannot supply additional assets to the pool
 Liquidity shortfalls for the financial institutions share most not
exceed the interest receivable
 The financial institution always has the right to cancel any
undrawn amounts on the revolving facilities
 Like normal lending securitization, the financial institution must
be under no obligation to repurchase assets that have defaulted
Credit Derivatives
 The effectiveness of credit derivatives becomes an issue of
how well the instrument reduces the requirement of capital
adequacy
 A credit derivative is deemed to afford protection if the
physical settlement has a deliverable obligation.
 In terms of maturity, a financial institution is deemed to have
full protection if the maturity of derivative equals the
maturity of the underlying asset
 Example: a loan has a term of 5 years and the credit derivative
has a maturity of 4 years, only 80% of the exposure is counted
for regulatory relieft
Development in Regulation
 Capital adequacy is the primary tool for the Australian Prudential
Regulation Authority to regulate credit risk issues
 A new proposal would base the risk weighting on the credit rating of
the company. This raises the issue of independence because ratings are
assigned when paid for by debt issuers
 Basel I – the role of credit ratings and the consideration that banks, with
superior skills may be able to use internal systems to allocate capital
(“sophisticated” banks)
 Advantages: internal ratings are becoming popular in the assessment of a
variety of risks
 Internal ratings will use more data than used by external ratings
 Given that internal ratings will be used for credit risk purposes, there may be an
incentive to improve credit risk methods
 Disadvantage: there will be a lack of standardized approaches for credit risk
Problem Loan Management
 Outline why loans default
 Highlight the extent of problem loans
 Explain why the business cycle is important for problem
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loans
Define problem loans, provisions and regulatory issues
Discuss the capital issues of problem loans
Define “structure dynamic provisioning”
Restructure problem loans
Illustrate a case from law
Causes of Default
 The primary issue of problem loans is that they can impair
the value of a financial institution -> threaten its solvency
 A default – a loan for which the repayments are overdue for
the following reasons
 Lack of compliance with loan policies
 Lack of clear standards and excessively lax loan terms
 Inadequate controls over loan officers
 Over-concentration of bank lending
 Loan growths in excess of the bank’s ability to manage
 Inadequate systems for identifying loan problems
 Insufficient knowledge about customers’ finance
 Lending outside the market which the bank is familiar
 Many problem loans could be avoided by better lending
procedures and policies
Causes of Default
 Credit risk is never static and many loans that were validly
granted can become bad for many different reasons
 Recession affects firms that rely on cashflow
 Firms wind up because their products have become outdated
 Monitoring a loan portfolio becomes more complex as the
financial institution becomes larger -> higher costs
 Monitoring models should provide warnings of developing
problem loans
The Extend of Problem Loans
 How should bankers should manage their problem loans
 What are the various types of problem loan? How do we define
them
 How do lenders manage the impact of problem loans on
profitability? Can they anticipate problem loans
 Is there a pattern of when problem loans occur?
 Is a grading attached to the severity of the problem loan and how its
is managed?
 What are the legal implications for managing problem loans
 Liquidation – selling the borrower’s assets
 Dynamic provisioning – statistical method that seeks to forecast
doubtful debts and spread them over a number of years
The Business Cycle
 Recovery & Expansion
 High confidence in the economy and new investments increase
 -> increased spending -> higher bank deposits -> banks have more
money to lend -> relaxation of lending standards
 Interest rates increase slightly
 Boom
 High asset inflation -> higher borrowing to invest in real assets
 Overconfidence -> declining credit standards
 Interest rates are rising
 Downturn
 Asset prices decline -> less spending -> decline cashflow
 Banks experience their greatest problem loans
Problem Loans, Provisions & Regulatory
 Borrower miss a repayment on loan -> is this permanent or
temporary
 If the situation persists for longer than 90 days -> impaired
asset or non-performing loan
 When a lending institution recognizes a problem, it needs to
raise provisions
 Specific provisions – written off income
 General provisions – written off income
 Bad-debt write-offs – written off balance sheet
 A provision is recognition that income may not be received on
a loan
Provisions
 Specific provisions
 Attached to loans or impaired assets
 Specific provision is less than full value of the loan because
banks expects that some of the debt if recoverable
 General provisions
 Are like specific provisions but they are not charged against a
particular loan
 The APRA views that 0.5% of total risk-weighted credit riskweighted assets should be used as a benchmark for general
provisioning
 Bad debt write-offs
 A debt is no longer recoverable
Dynamic Provisioning
 The internal policy will reflect the risk appetite of the lender
 Lenders need recognize
 Credit risks change over time
 Bad debts should not come as a surprise
 A number of principles for dynamic provisioning
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Classify the loans into homogenous groups
The different types of loan should be further broken down into
groupings by maturity
Generates the probability of default for each loan class and the likely
severity of loss
Determines the historical loan loss ratios
Historical loan loss ratios are then transformed to be predicative by the
adjustment for economic circumstances
The transformed loan loss ratio applied to the current loan portfolio to
determine provisions
Dealing with Defaults
 The three situations
 Mild financial distress
 Moderate financial distress
 Severe financial distress
 Two principles always applied
 The primary aim of the bank is to minimize the loss to the bank.
In many cases, liquidity is not the optimal choice
 To manage these problems correctly, the economic worth of the
loan is compared with the economic worth of the borrower
Mild Financial Distress
 Companies experience temporary cashflow shortages
 Never enters the public arena and is not captured by the
regulator’s definitions (< 90 days)
 Most common cause of illiquid is overly rapid growth of the
firm
 A number of remedies can be used
 The bank agrees to an extension on the repayment
 The bank would charge penalties to ensure there are
disincentives to prevent the situation arising again
 Banks should take further views or actions to ensure that
their position is protected
Moderate Financial Distress
 A temporary cashflow shortage is evident but the economic
worth of the company is less than the repayment schedule of
the loan
 Remedial actions
 Liquidation – not always the optimal choice
 Restructure the loan to give the owner the incentive to
continue. This restructure is determined by calculating the
break-even amount of the loan under the circumstances that the
company would continue
Severe Financial Distress
 Missed debt payment and the borrower having an economic
worth less than the repayment schedule
 Issues to be considered
 Whether the borrower has a sound business
 Is the default due to reasons other than the nature of the
business
 Will the company worth more death or alive
 How much can be recovered under each scenario
Other Breaches
 Not all defaults are generated by missed loan repayments
 Also when loan covenants are violated
 Cashflow will not be unduly withdrawn from the company that
would be available to repay loans
 The overall risk of the company cannot be substantially changed
 Gearing ratios
 Dividend pay-out ratios
 Interest coverage
 What is the correct procedure to follow when a company
breaches its covenants?
 Remedial actions: renegotiate covenants