Ch 12 2012 - 1 Chapter 12 Credit Risk Loan Portfolio...

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Chapter 12 Credit Risk: Loan Portfolio & Concentration Risk 1
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Overview Last chapter: focused on individual loan or asset risk This chapter: Loan Portfolio & Concentration 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. Migration Analysis. Concentration Limits. Modern Portfolio Theory. Diversification and Efficient Portfolio Frontier. KMV Portfolio Manager Model. Partial Applications of Portfolio Theory. Loan Volume-Based Models. 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. 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 Example of a credit migration matrix: Loans that began the year with a grade 2: 12% have been upgraded to 1. 83% remained at 2. 3% downgraded to 3. 2% defaulted. The FI should try to stay away from lower quality loans (i.e., rated 2 or 3) because they have a higher PD. 5
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Concentration Limits Concentration limits: Management sets some external limit on the maximum amount of loans or other exposures (loan commitments, standby letters of credit, derivatives, etc.) that will be made to an individual borrower or sector. Concentration limit = Maximum loss as a percentage of capital ÷ Loss rate. In US, bank regulators limit loans and other exposures to individual borrowers to a maximum of 10% of a bank’s capital. Some countries also specify limits by sector or industry ( US does not do this).
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