Credit Products and Credit Risk.
Loan Loss Reserves.
Banking
Lecturer: Nino Kurdiani, CFA
Learning Outcomes:
• Bank credit types
• Information for creditworthiness. Credit Cycle.
• Wholesale (business) loans
• Retail (individual) loans
• Loan pricing
• Loan loss reserves
Types of Loans
Wholesale (business) loans
• Term business loan
• Working Capital Loans with scheduled payments
• Revolving credit Lines
Retail (individual) loans
• Mortgage loan
• Consumer loan
• Overdrafts / credit cards
• Cash Cover
Steps in the Lending Process (pg. 528)
• Finding prospective loan customer
• Evaluating a prospective customer’s character and sincerity of
purpose
• Making site visits and evaluating a prospective customer’s
credit records
• Evaluating a prospective customer’s financial conditions
• Assessing possible loan collateral and signing the loan
agreement
• Monitoring compliance with the loan agreement and other
customer service needs
6 Cs (pg. 531)
• Creditworthiness
• Capacity
• Cash
• Collateral
• Conditions
• Control
Safety Zones (pg. 537)
Creditworthiness
• Past Payment records
• Purpose of loan
• Credit rating
• Presence of guarantors
Common ratios to use
• PTI (Payment To Income)
• LTV (Loan To collateral Value)
• EBITDA / loan payment
• Free cash / loan payment
• Current and Quick (Acid test) ratios
• Interest coverage ratio (EBIT/interest payment)
• Leverage ratio (debt / net worth; liabilities/ assets)
• Debt-to-sales
• Net liquid assets
Note: look at Common size BS and IS
Payment schedules
• Equal principle payments
• Annuity
• Grace period
• Season payment (Calibrated to seasonality)
• Prepayments
Loan pricing
Cost-plus loan pricing model
Interest rate = base rate + markups
This could be rewritten as:
Interest rate on loan = cost of capital + markup for banks costs +
bank profit + expected credit loss
Credit Loss
Expected Loss (amount) = EAD x PD x LGD
EAD – Exposure at Default
PD – Probability of Default
LGD – Loss Given Default
Expected Loss (rate) = PD x LGD
Recovery Rate: RR = 1 - LGD
Recall for conditional probability :
Recovery Rates Moody’s: 1982 to 2004
Class Mean(%)
Senior Secured 57.4
Senior Unsecured 44.9
Senior Subordinated 39.1
Subordinated 32.0
Junior Subordinated 28.9
Estimating Default Probabilities
• Credit Ratings
• Altman’s Z-score
• Use Historical Data
• Use Credit spreads (bond prices)
• Other (CDS spreads, Merton’s model)
Credit Ratings
• In the S&P rating system, AAA is the best rating. After that
comes AA, A, BBB, BB, B, and CCC
• The corresponding Moody’s ratings are Aaa, Aa, A, Baa, Ba, B,
and Caa
• Bonds with ratings of BBB (or Baa) and above are considered
to be “investment grade”
• Most banks have their own internal ratings systems for
borrowers
Altman’s Z-score
• X1=Working Capital/Sales
• X2=Retained Earnings/Total Assets
• X3=EBIT/Total Assets
• X4=Market Value of Equity/Book Value of Liabilities
• X5=Sales/Total Assets
Z=1.2X1+1.4X2+3.3X3+0.6X4+0.999X5
Z>3.0 - default is unlikely;
2.7<Z<3.0 - we should be on alert;
1.8<Z<2.7 - there is a moderate chance of default;
Z<1.8 - there is a high chance of default.
Cumulative Average Default Rates
(%) (1970-2003, Moody’s)
1 2 3 4 5 7 10
Aaa 0 0 0 0.04 0.12 0.29 0.62
Aa 0.02 0.03 0.06 0.15 0.24 0.43 0.68
A 0.02 0.09 0.23 0.38 0.54 0.91 1.59
Baa 0.2 0.57 1.03 1.62 2.16 3.24 5.1
Ba 1.26 3.48 6 8.59 11.2 15.4 21
B 6.21 13.8 20.7 26.7 32 40.8 50
Caa 23.7 37.2 48 55.6 60.8 69.4 77.9