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
- Diversification of loan portfolio
- 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)
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)
- Payment flows: in case of default, only interest payments are affected
- Netting => netting by novation
- 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