lending - unit 6 -monitoring and control of lending
TRANSCRIPT
1
Introduction
• The aim of credit risk management is to balance between risk and return to achieve optimum profitability and efficiency
• Taking and institutional view banks could minimise concentration risk
• Lending on a more scientific basis would help remove subjectivity
2
Introduction
• Credit risk seeks following objectives:• a) achieve and appropriate balance
between risk and return;• b) avoid concentration risk;• c) manage loans on a portfolio basis; and• d) take a group of loans off the statement of
financial position.
• This chapter examines some of the credit risk measurement tools.
3
Credit Risk Measurement
• Altman’s Z Score• Relies on multivariate model accounting ratios
that provide best predictors of performance:
Activity Profitability
Liquidity Earnings Variability
Solvency Size
• Credit decision relies on output from equation at varying cutoff levels
4
Credit Risk Measurement
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5
– X1 = Working Capital / Total Assets,
– X2 = Retained Earnings / Total Assets
– X3 = EBIT / Total Assets,
– X4 = Market Val of Equity / Book Val Debt,
– X5 = Sales / Total Assets
• Z > 2.675 => High Probability of Solvency• Z < 2.675 => High Probability of Insolvency (Zone of
Ignorance)• Z < 1.8 => Certain Insolvency
5
Loan Pricing
– All loans provide a cost to the Statement of Financial Position
• Statement of Financial Position Costs– Capital Cost: Capital that must be allocated to
support default risk– Liquidity: Lending activities must allow sufficient
liquidity on Statement of financial position – Cost of Funds: Returns must be achieved from
loan including considering Return on Equity, Return on Liquidity, Market Cost of Deposits and Return on the Loan
6
Loan Pricing
• Noncredit Risk Costs– Interest Rate Risk: Whether loan book has
fixed/floating rate loans– Pre-payment Risk: Risk that loans will be paid
out earlier than specified term– Origination Costs: Costs of marketing and
monitoring securitised loans sold
• Credit Costs– Expected Losses = Default Probability x (1 –
Recovery Rate)– Unexpected Losses: Generally reflects volatility
of Expected Losses
7
Chapter Twelve
Credit Risk From
The Regulator’s
Perspective
8
Capital Adequacy
• Recent evidence shows poor credit decisions play a major part in bank failures
• Generally, banks required to allocate a minimum of 8% of a loan’s value from Capital
• As some loans riskier than others, risk weighting system adopted
9
Securitisation
• Clean sale supply of assets:
– Should be no beneficial interest in the sold assets and absolutely no obligation on institution
– Should be no recourse (including costs) to the institution and no obligation to repurchase loan asset
10
Securitisation
– Amount paid for loans should be fixed and received at time asset is transferred from lending institution
– Any assets provided to the Special Purpose Vehicle (SPV) as a substitute or sold below book value do not relieve credit risk
11
Securitisation
• Revolving Facilities: – Defined as assets with ongoing credit
relationship such as credit cards and home loans
– Rights, details of cashflows and obligations of each party must be clearly specified
– As with normal securitisation, institution cannot supply additional assets to the pool
12
Securitisation
– Liquidity shortfalls for the institution share must not exceed the interest receivable
– Institution retains right to cancel undrawn amounts
– Institution must have no obligation to repurchase
13
Chapter Thirteen
Problem Loan
Management
14
Introduction
• When financial institutions make loans, returns generated mean accepting some default risk
• It is imperative that default risk is managed so that the solvency ofthe bank is not threatened
• Should the problem loan be foreclosed or actively managed?
15
Causes of Default
• Default does not necessarily mean that all of the loan extended is lost.
• Default is defined here as ‘a loan where repayments are overdue’
• Better lending procedures can minimise, but not eliminate, the risk of default
• Harder to manage default risk as loan book becomes larger
16
Causes of Default
– Likely causes of default• Lack of compliance with loan policies• Lack of clear standards and excessively
lax loan terms• Inadequate controls over loan officers• Over-concentration of bank lending• Loan growth exceeding bank’s capabilities• Inadequate problem loan identification• Insufficient knowledge of customer’s finance• Lending in unfamiliar markets
17
Extent of Problem Loans
• All banks experience bad debts,but the management of them becomes critical
• Banks should consider:• Timing of loan in economic cycle• Larger exposures to individual borrowers• Larger exposures to single sectors• Close monitoring of exposures during
unfavourable economic periods
18
The Business Cycle
– The business cycle characterised by three phases:
• Recovery and Expansion: – Flourishing economy with increased spending
leading to higher deposits and interest rates
• Boom:– Major asset inflation with business
overconfidence and declining credit standards
• Downturn:– Declining asset values and economic activity
generally accompanied by increased defaults
19
Problem Loans, Provisions and Regulatory Issues
– When borrower misses payments, two questions arise within lending institution
• Is missed payment temporary? • Is missed payment likely to be permanent?
20
Problem Loans, Provisions and Regulatory Issues
– If payment more than 90 days, loan is considered an ‘impaired asset’ as return on loan not achieved
– Value of impaired loan must be downgraded on statement of financial position
21
Problem Loans, Provisions and Regulatory Issues
– BOJ: If one asset is impaired, all loans to that client considered impaired
– When loans are impaired, institution must create a ‘provision’ for a loan loss
– Provisions are classified in three ways:• Specific Provisions• General Provision• Bad-Debt Write-Offs
22
Problem Loans, Provisions and Regulatory Issues
– Specific Provisions:• These are provisions set aside for a
specifically identifiable loan where the institution assesses the:
– Condition of the loan;– Condition of the borrower;– Impact of economic events.
• Not all of the loan must have provisions made as lender may assess the likely losses from the asset.
23
Problem Loans, Provisions and Regulatory Issues
– General Provisions• These are provisions that are made as a
proportion of the entire loan portfolio• Suitable for large loan portfolios of similar
assets, e.g. mortgages, where specific provisioning unsuitable
• BOJ: Generally minimum provision of 0.5% of Risk-Weighted Assets
• Can adjust general provisions level depending on economic activity or risk levels
24
Problem Loans, Provisions and Regulatory Issues
– Bad Debts:• Recognition of bad debts occurs where:
– All security liquidated;– Guarantees have been enforced;– Remaining remedial actions explored; and– No remaining sources of cash can be called.
• Once the above steps are completed, the financial institution must write off the bad debt with asset valued at zero and a charge made against profits.
25
Other Considerations with Problem Loans
– The provisions made minimise the efficient use of capital that could otherwise be used for lending purposes
– Institutions often have provisioning systems exceeding BOJ requirements to reflect bank’s risk profile
• Higher provisions indicate higher risk and/or more conservative management
• Lower provisions indicate lower risk and/or more aggressive management
26
Dynamic Provisioning
– The risk profile of the loan portfolio is sensitive to point in the economic cycle, e.g. greatest defaults occur at bottom of economic cycle
– Therefore:• Credit risk is not static but changes over
time• Bad debt should not come as a surprise
as modelling should detect changes to probable default risk in portfolio segments
27
Dynamic Provisioning
– Key principles in dynamic provisioning:• Classify loans into homogeneous groups• Sub-classify groups by maturity length
– Determine probability of loss for each group– Determine likely severity of loss for each group
• Use the historical loan-loss information to create predictive model incorporating economic conditions, interest rates, investment activity, etc.
• Apply model outcome to current provisions
28
Dealing with Defaults
– If the loan is in default, bank must act to minimise the losses arising from defaulting clients and may reschedule payments rather than liquidate loan
– Classify defaulting clients into three categories:
• Mild financial distress;• Moderate financial distress; and • Severe financial distress.
29
Dealing with Defaults
– Mild Financial Distress• Often occurs when borrower faces short-
term cash flow problems, e.g. late receipts• If default less than 90 days, remedies
include: – Changing/lengthening repayment schedules– Assisting firm if cash flow shortage has risen
from period of rapid growth– Encouraging firm to sell non-core assets– Requesting/demanding equity capital injection
30
Dealing with Defaults
– Moderate Financial Distress• May occur if cash flow problems coincide
with borrower’s asset values declining • Course of action determined by nature of
collateral, e.g. foreclose on mortgage or support manufacturing firm with uniqueor limited market for assets
• Lender may consider evaluation of alternatives via NPV or probabilistic model of Expected Values for different actions
31
Dealing with Defaults
– Severe Financial Distress• Characterised by missed payments and
value of borrower less than loan amount• Lender needs to very carefully evaluate
whether is is better to:– Liquidate firm to recover greatest percentage
of loan possible; or– Restructure debt (inclusive of debts to other
lenders) to maintain operations to allow firm to trade out of current crisis or be sold as going concern
32
Dealing with Defaults
– The coordination problem• Where numerous classes of debt-holders
observed, e.g. syndicated loans, any rescheduling will require cooperation ofall debt-holders
• May be difficult to coordinate actions between junior and senior debt-holders
• Need to restructure debts to ensure all debt-holders treated equitably or else rescheduling proposal will fail
33
Dealing with Defaults
– Other Breaches • Corporate loans may have a variety of
covenants imposed to protect loan quality• Lender may place a variety of conditions to
strengthen loan repayment probability:– No excessive withdrawal of cash flows– Risk profile of firm to remain unchanged– Specification of various ratios including gearing,
dividend payout and interest coverage– Continued involvement of key staff– Application of risk management strategies