Chapter 20 - CREDIT RISK
FI’s special role:
Ability to: 1) Evaluate information and 2) Control and monitor borrowers. Allows
FI's to transform financial claims of household/savers efficiently into claims (debt and equity) issued to
corporations, individuals, and governments, at the lowest possible cost to all parties, a process of
FI accepts credit risk, in exchange for a fair return, sufficient to cover the cost of funding (e.g.,
covering the cost of borrowing, or issuing deposits) and a competitive profit margin.
See Figure 20-1, p. 555: Nonperforming Loans/Total Asset ratio.
General Improvement during
See Table 20-1, p. 556: Nonperforming Loans/Total LOANS. For loans to individuals, higher default
rate for large banks (1.50-1.65%) than small banks (.80-1.01%).
Large banks more willing to
accept higher risk.
See example page 558, adjustment of balance sheet to loan loss, credit quality problem.
1. Real Estate Lending
- Residential mortgage loan applications are among the most standardized of
all credit applications. Reason?
Two considerations for Mortgages: a) Applicant’s ability and willingness to make timely interest and
principal repayments - credit and savings history, income level and stability, stability of residence, age,
monthly expenditures (car loans, student loans, credit card debt, etc.). Ratios used:
GDS (Gross Debt Service) Ratio
- Annual Housing Expenses (Mortgage + Condominium or
management fees, Property taxes, Insurance, etc.) divided by Annual Gross Income. Should be less
than 25-30%. (Approx. $2,000 to $2,500 per month for $100,000 annual income)
TDS (Total Debt Service) Ratio
- Total Annual Debt (housing, car, student loans, credit cards, etc.)
expenses divided by gross annual income. Should be 35-40% or less. ($3,000 to $3,333 per month for
See Example 20-1 on p. 559.
Credit Scoring System
- Mathematical model that uses observed loan applicant’s characteristics to
calculate a single, numerical value that represents the applicant’s probability of default. Easy to use,
convenient, low cost. See Example 20-2 on p. 560-561. Score < 120 automatically rejected, Score >
190 automatically accepted. Scores between 120-190 are reviewed by committee.
BUS 468 / MGT 568: FINANCIAL MARKETS - CH 20
Professor Mark J. Perry