Ch 12 fully revised 2011

Ch 12 fully revised 2011 - 1 Chapter 12 Credit Risk: Loan...

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Chapter 12 1
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Overview Last chapter: focused on individual loan or asset risk This chapter: focuses on the ability of an FI manager to measure credit risk in a portfolio context and the benefit from diversification. Simple models of loan concentration risk. a Migration Analysis. a Concentration Limits. Modern Portfolio Theory. a Diversification and Efficient Portfolio Frontier. a KMV Portfolio Manager Model. Partial Applications of Portfolio Theory. a Loan Volume-Based Models. a Loan Loss Ratio Models. Regulatory Models. 2
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Simple Models of Loan Concentration FIs widely employ two simple models to measure credit-risk concentration in the loan portfolio: Migration analysis. Concentration limits. 3
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Migration Analysis Migration analysis: track credit rating changes within a sector or pool of loans. Loan Migration Matrix: measures the probability of a loan being upgraded, downgraded, or defaulting over some period. a Backward looking, based on past frequencies. Widely applied to commercial loans, credit card portfolios, and consumer loans. 4
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Migration Analysis Example of a credit migration matrix: Risk grade: end of year 1 2 3 Default Risk grade: 1| .85 .10 .04 .01 beginning 2| .12 .83 .03 .02 of year 3| .03 .13 .80 .04 5
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Migration Analysis Example of a credit migration matrix: Loans that began the year with a grade 2: a 12% have been upgraded to 1. a 83% remained at 2. a 3% downgraded to 3. a 2% defaulted. Looking at the matrix, the FI should try to stay away from lower quality loans (i.e., rated 2 or 3) because they have a higher probability of default. 6
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Concentration limits: Management sets some external limit on the maximum amount of loans that will be made to an individual borrower or sector. Concentration limit = Maximum loss as a percentage of capital ÷ Loss rate. a In US, bank regulators limit loans and other exposures to individual borrowers to a maximum of 10% of a bank’s capital. a
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Ch 12 fully revised 2011 - 1 Chapter 12 Credit Risk: Loan...

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