Please enable JavaScript.
Coggle requires JavaScript to display documents.
Lecture 7: Credit risk - loan portfolios - Coggle Diagram
Lecture 7: Credit risk - loan portfolios
Introduction
spread
the loans to different sectors
set
maximum concentration limits
for certain business or borrowing sectors
apply
Modern Portfolio Theory (MPT)
to loan portfolio management
Loan sales and securitisation (p.54-55)
Removal of credit risk
Reduction of concentration risk
Capital adequacy regulations
Moral hazard issues
Measuring risk of loan portfolios
Diversification of loan portfolio
Modern Portfolio Theory (
MPT
) assumptions
Underlying loans are trade-able
Returns are normally distributed
imperfect correlation
of returns of different assets => FI can significantly reduce risk
Minimum risk portfolio
Moody's analytics: not included assumptions from the MPT
Regulatory models
Simple models of loan concentration risk
If
actual rating
deteriorates faster than historical experience =>
curtail lending
to that sector/ loan class
Historical credit migration
measured through
loan migration
or
transition matrices
(provides measurement of probability being upgraded, downgraded or defaulting over some period -
transition probabilities
)
concentration limits
maximum loan size
to individual borrowers/ sector
should reduce the number of industries that are
highly correlated
geographical limits
: don't want to lend too much to one region
concentration limits = maximum loss as % of capital x (1/ loss rate)
regulatory treatment (p.13)
Partial applications of portfolio theory
Loan volume based models
Direct application of MPT is often difficult due to
lack of information on market prices
Deviations
from
market portfolio benchmark
indicate the relative degree of
loan concentration
Deviation might not necessary bad
. Banks may specialize in sectors where it has
comparative advantages
Loan loss ratio based models
systematic loan loss risk
:
sensitivity
of loan losses in a particular sector relative to losses in an FI's loan portfolio
Managing credit risk using derivatives
Decoupling of risk
: efficient transfer of risk across counter-parties
Moral hazard
: hedged credit risk => start giving out the riskier loans
Credit forward contracts
hedges against an
increase in default risk
(for seller)
CSF:
agreed forward credit spread
at the time contract is written
CST:
actual credit spread
at maturity of forward
CST > CSF
: Seller receives: (CST - CSF) x MD x A
CSF > CST
: Buyer receives: (CSF - CST) x MD x A
maximum loss to seller is limited
because credit spread can not fall below 0
Futures contracts and catastrophe risk
Credit spread call option (p.42)
Digital default option: pays a
stated amount
in the event of loan default
CAT call spread option
hedge the risk of unexpectedly high losses as a result of catastrophe (disasters)
call option written on loss ratio incurred in writing catastrophe insurance
example: p.45
Credit default swaps (CDS)
Banks issue loans and insurance companies bear credit risk
Buyer of credit risk (banks) makes
periodic payments
(like premiums) to seller until the end of life of swap/
occurrence of credit event
default risk is hedged but there is still counter- party credit risk
Total return swaps
Pure credit swaps
diff between credit risk on swaps and loans
credit risk is lower in swaps (generally)
Payment flows: in case of default, only
interest payments
are affected
Netting => netting by novation
Standby letters of credit: p.53