Asset Quality
Upcoming
1.
2.
3.
4.
Theory of Bank Credit
Analyzing Bank Credit Risk
Credit Process
Credit Derivatives
Asymmetric Information & Adverse
Selection
•
•
Asymmetric Information A condition that
occurs when borrowers have some
information about their opportunities or
activities that they do not disclose to lenders,
creditors or insurers.
Adverse Selection – The problem created by
asymmetric information before a transaction
occurs: The people who are the most
undesirable partners from the point of view of
one party are also the most likely to want to
engage in a particular financial transaction.
Lemon Problem: Used Cars
• Two indistinguishable (to buyers) types of cars:
lemons (often breaking down) and creampuffs
(never breaking down).
• If buyers will pay $3000 for a creampuff and
$3000 for a lemon.
• Sellers will part with a creampuff for $2500 and
part with a lemon for $1000.
• One third of cars are creampuffs and two thirds
are lemons.
Symmetric Information
• If borrowers and sellers
both can easily
distinguish lemons from
creampuffs, there is a
simple market solution.
– Buyers will pay $3000 for a
creampuff and $2000 for a
lemon and sellers will be
happy to sell.
• If neither borrowers nor
sellers can distinguish
between types, there is
still a solution.
– Buyers could pay the
average of their values
(⅔∙$2000)+(⅓∙$3000) =
$2,333.
– This would be higher than
the average value to sellers:
(⅔∙$1000)+(⅓∙$2500) =
$1500.
Asymmetric Information
• What happens if buyers cant distinguish between
types but sellers can?
• Buyers might be willing to offer $2,333 for a car of
unknown type, but owners of creampuffs would
value their car more highly than that. Only lemon
owners would sell at that price. Buyers would
have no reason to offer more than $2000. Only
lemons will be bought and sold.
• No market for creampuffs will exist.
Lemon Problem: Bond Market
• Some firms have risky prospects (lemons) and
some firms have safe prospects (creampuffs).
• Bond buyers cannot distinguish between them.
They offer bond prices which are an average of the
price of creampuff bonds and lemon bonds.
[Another way of putting this is that interest rates
are an average of creampuff and lemon rates].
• Potential borrowers with creampuff prospects may
finance their own projects.
Raising Interest Rates May Not
Compensate for Risks in Bond Markets
• Only borrowers with lemon prospects will join
bond markets.
• Typically we think bond buyers might take riskier
assets if they were offered a higher interest rate.
• But if savers demand a higher interest rate
under asymmetric information this will only
exacerbate the lemon problem if higher interest
rates drive creampuff borrowers out of the
market.
Adverse Selection: The Bond
Market
Consider a bond market with three types of bond
sellers.
1. Safe: Financing a safe, low-return project. Can
only pay 7.5% interest rate but will never default.
2. Speculative: Financing a high risk/high return
project will pay a 15% interest rate, but a high
probability of default.
3. Crooks: Will offer to pay any interest rate, but will
never repay.
Assume that 75% of bond issuers are safe, 20% of
bond issuers are speculative, and just 5% are
crooks.
Bond Buyers
• Bond buyers will pay:
– 97 for a discount bond issued by a borrower identified
as safe;
– 90 for a bond issued by a borrower identified as
speculative
– 0 for bond issued by a crook.
• If they cannot distinguish, they will pay a value
equal to the expected value of the pool.
• In this pool, the expected value is
(.75*97)+(.2*90)+(0.05*0) = 90.75 which implies
a yield to maturity of i = .102.
Borrower
will Pay
Share
at Most
Safe
0.75
7.50%
Speculative
0.2
15%
Crook
0.05 Anything
Unknown Type
Investor
will pay
at Most
97
90
0
90.75
or get
at least
1.030928
3.09%
1.111111
11.11%
∞
1.101928
10.19%
Bond market breaks down!
• Rate of interest offered by uninformed investor is
attractive to speculative borrowers but to
expensive for safe borrowers.
• They will drop out of the market. As bond buyers
begin to realize the riskiness of pool is changing,
they will reassess price that they will pay for
bonds.
• The pool will now be 80% speculative and 20%
crooks. The expected value of bonds in this pool
is (.8*90)+(.2*0)=72 implying a yield of i = .3889.
This is too much for speculative borrowers.
• Only crooks will stay in the market. Ultimately the
bond market will disappear.
Adverse Selection
• Actions that lenders take to protect
themselves from consequence of a lack of
information lead to a worsening of the risk
pool.
• In the extreme case, adverse selection
can cause an entire market to disappear.
Business of Banking &
Comparative Advantage
• Comparative advantage of banking.
• Banking exists as a specialist in acquiring
information and eliminating adverse
selection problems.
• A key comparative advantage of banks is
their ability to evaluate information on
borrowers.
• Banking business should attempt to make
best use of that advantage.
Credit Risk: the risk that a borrower
will not pay back interest or
principal on a loan.
Evaluating Bank Credit Risk
• History of Credit Performance (Chargeoffs)
• Future expected losses (non-performing
loans, types of lending, diversification)
• Current Strength of bank preparation
(reserves, earnings coverage).
Net Charge-offs to Loans
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
Total loans &
leases
Total real estate
loans
Commercial &
industrial loans
2007
Statistic on Depository Institutions
2006
2005
Loans to individuals
2004
All other loans &
leases (including
farm)
Stages of Bad Loans
• Past Due Loans: Loans for which contracted
payments have not been made, but which still
are accruing interest.
– More than 90 days past due is Nonperforming Loans
• Nonaccrual Loans: Loans that are habitually
past due and no longer accruing interest.
Total Noncurrent = Past Due + Nonaccrual
• Charge-offs: Loans written off as uncollectable
• Recoveries: Sums later collected on loans
written off.
Net Chargoffs = Charge-offs - Recoveries
Past Due Loans
(Contractual Payment not
Made)
Recovery
Net
Chargeoffs
90 Days
Non
Current Loans
Non Performing
Loans
Full Payment
Not Expected
Collection
Process
Total
Chargeoffs
Uncollect
ible
Loans
Written
off
Non-accrual
Loans
Non Current Assets to Loans
1.80%
1.60%
1.40%
1.20%
1.00%
0.80%
0.60%
0.40%
0.20%
0.00%
Total loans & All real estate Commercial &
leases
loans
industrial
loans
2007
Loans to
individuals
2006
Statistic on Depository Institutions
2005
2004
All other
loans &
leases
(including
farm)
Commercial
real estate
loans not
secured by
real estate
Measuring a Banks Credit Risk/Key
Ratios
• Loans are assets with the most credit risk (also
the most profitable). Other types of assets are
typically more transparent and have less risk of
default.
• Large quantities of loans make banks riskier.
Higher Loans to Assets means higher risk.
• Rapid expansion of credit means banks may not
be discriminating
Higher Loan Growth Rate means higher risk
Measure banks chargeoffs, loan composition, nonperforming & non current loans, earnings coverage,
loan loss allowances on page 8 & page 9 of UBPRs.
Composition of a Banks Loan
Portfolio
• Some loans are riskier than others, so a
high share of loans in risky categories
involves higher risk.
– Banks concentrate on real estate lending
which tends to have very low default rates.
• An undiversified portfolio also exposes a
bank to risk. Concentration in the property
market exposes the bank to systematic
risk of property collapse.
Protection
•
Banks protect themselves from credit risk with
reserves allocated to loan losses. Measures of
these reserves measure banks protection
against credit risk
1. Loan Loss Allowance/Loans
2. Loan Loss Allowance/Net Chargeoffs
•
Banks earnings are also a protection against
losses
Earnings Coverage
= (NII-Burden)/Net Chargeoffs
Protection from Bad Loans
US Commercial Banks, 2004
7
6
5
4
3
2
1
0
2004
Loan Loss/Net Charge Offs
2003
2002
Earnings/Net Charge Offs
2001
Loan Loss/Gross Loans (%)
Source: SDI, FDIC Statistics on Depository Institutions, FDIC
Credit Process
I.
II.
Credit Policy
Business Development and Credit
Analysis .
III. Credit Execution
IV. Loan Review
I. Credit Policy
•
•
Loan Policy
Loan Culture
1. Values Driven – Risk Averse
2. Current Profit Different – High risk/return
lending, Cyclical Profits
3. Market Share Driven – Low returns, large
scale.
Written Loan Policy
• FDIC recommends, “ A loan policy should address:”
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–
–
–
–
–
–
–
–
–
General fields of lending
Normal trade area
Lending authority of loan officers and committees
Responsibility of the board of directors in approving loans
Guidelines for portfolio mix, risk diversification, appraisals,
unsecured loans, and rates of interest
Limitations on loan-to-value, aggregate loans, and overdrafts
Credit and collateral documentation standards
Collection procedures
Guidelines addressing loan review/grading systems and the
allowance for loan and lease losses
Safeguards to minimize potential environmental liability
•Source
http://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune
_up.html
Business Development & Credit Analysis
• Marketing – Find customers
• Loan Interview – Meet potential borrower and
evaluate for character and sincerity
• Evaluation of Business – Gather information
about the borrowers business.
• Credit Analysis: Numerical analysis of a
businesses financial condition
• Evaluation of Collateral Adequacy: Check
whether collateral that backs loans is of value
commensurate with loan.
Credit Scoring Models
• Banks use numerical models to evaluate
the credit of borrowing firms. Seminal
model was the Z-score model of Edward
Altman
Z  (1.2  WC )  (1.4  RE )  (3.3  ROA)
(0.6  Equity )  (.999  AT )
• WC – Working Capital to
Assets
• RE: Retained Earnings to
Assets
• ROA: EBIT/Assets
Above 3, bankruptcy unlikely; below 1.8
bankruptcy likely.
•Equity: Market to
Book Ratio
•AT: Asset TurnoverSales to Assets
FICO
• In USA, Fair Isaac Corp. develops models that evaluate
consumer households likelihood of default.
• FICO or similar score used for consumer credit
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–
–
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Late payments
The amount of time credit has been established
The amount of credit used versus the amount of credit available
Length of time at present residence
Negative credit information such as bankruptcies, charge-offs,
collections, etc.
• In Hong Kong, recent relaxation of some rules governing
sharing of consumer credit information.
5 C’s of Credit
1. Character – Past history of borrower in
paying bills.
2. Capital – Borrowers Wealth Position
3. Collateral – possession by the borrower of
assets that back up the loan.
4. Conditions - trends and volatility of the
borrower’s industry
5. Capacity – Legal Standing and ability of
the borrower to generate loan payments
on a consistent basis
III. Execution
• Documentation
– Loan Agreements
• Restrictive Covenants
– Perfecting Claims to Collateral
Parts of a Typical Loan Agreement
• The Note: Specifies the principal and the
interest and the timing of repayment.
• Collateral: Specifies assets assigned and
terms under which lender takes
possession of assets.
• Covenants
• Borrower Guarantees.
• Events of Default: Exact conditions under
which a loan is considered in default.
Loan Covenants
• A central part of the credit process is the
monitoring of borrowers.
• Banks restrict borrowers use of funds in the loan
agreement.
– Affirmative Covenants. Actions that the borrower must
take. Maintaining liquidity and equity as measured by
financial ratios, maintaining insurance, file financial
reports, pay taxes, etc.
– Negative Covenants. Actions that the borrower cannot
take. Taking on new debt, buying or selling assets,
paying excessive dividends, paying excessive
salaries or bonuses, etc.
IV. Credit Review
• Monitor Covenants
• Loan Review Process
– Ex post evaluations of lending evaluation
• Loan Workout
– Process for dealing with defaulting creditors
Credit Derivatives
Risk Management Tools Used to transfer risk from
one party to another.
• Credit Swaps – A bank with credit risk exposure
will pay X basis points per year and counterparty will make payment if there is a predetermined credit “event” such as default or
credit downgrade, etc.
• Total Return Swap: Bank with credit risk will pay
the income stream from risky debt while counterparty will pay some fixed rate to bank..
Credit Swap
Bank A
Fee Payment
Payment if negative
credit event
Bank B
Total Return Swap
Bank A
Loan and Principal
Loan and Principal
Loan and Principal
Intermediary
Loan and Principal
Bank B
Credit Derivatives
Global Credit Derivatives
14000
12000
US$ Trillion
10000
8000
6000
4000
2000
0
1H01
2H01
1H02
2H02
Source: www.credit–deriv.com
1H03
2H03
1H04
2H04
1H05
Extra Reading
• HKMA Benefits of Sharing Positive
Consumer Credit Data
• B. Hirtle, NY FED, 2007, Credit
Derivatives and Bank Credit Supply
• BIS 2005 Credit Risk Transfer