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

Measuring risk of loan portfolios

  1. Diversification of loan portfolio
  1. Regulatory models
  1. 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)

Modern Portfolio Theory (MPT) assumptions

imperfect correlation of returns of different assets => FI can significantly reduce risk

Minimum risk portfolio

Underlying loans are trade-able

Returns are normally distributed

Moody's analytics: not included assumptions from the MPT

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)

  1. Payment flows: in case of default, only interest payments are affected
  1. Netting => netting by novation
  1. Standby letters of credit: p.53

Loan sales and securitisation (p.54-55)

Removal of credit risk

Reduction of concentration risk

Capital adequacy regulations

Moral hazard issues