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Unformatted text preview: Chapter 20 - Managing Credit Risk on the Balance Sheet Answers to Chapter 20 Questions 1. Credit risk management is important for bank managers because it determines several features of a loan: interest rate, maturity, collateral and other covenants. Riskier projects require more analysis before loans are approved. If credit risk analysis is inadequate, default rates could be higher and push a bank into insolvency, especially if the markets are competitive and the margins are low. 2. The techniques used for mortgage loan credit analysis are very similar to those applied to individual and small business loans. Individual consumer loans are scored like mortgages, often without the borrower ever meeting the loan officer. Unlike mortgage loans for which the focus is on a property, however, nonmortgage consumer loans focus on the individuals ability to repay. Thus, credit scoring models put more weight on personal characteristics such as annual gross income, the TDS score, and so on. Small business loans are more complicated because the FI is frequently asked to assume the credit risk of an individual whose business cash flows require considerable analysis, often with incomplete accounting information available to the credit officer. The payoff for this analysis is also small, by definition, because loan principal amounts are usually small. A $50,000 loan with a 3 percent interest spread over the cost of funds provides only $1,500 of gross revenues before loan loss provisions, monitoring costs, and allocation of overheads. This low profitability has caused many FIs to build small business scoring models similar to, but more sophisticated than, those used for mortgages and consumer credit. These models often combine computer-based financial analysis of borrower financial statements with behavioral analysis of the owner of the small business. 3. The monthly payment for this mortgage will be $587 ($80,000 = PMT(PVIFA 8%/12, 30 12 )), the tax payment is $100 per month and she earns $2,500 per month. So her GDS = (587+100)/2,500 = .2748. Thus Jane is eligible for the loan. 4. Jane Does credit score is calculated as follows: Characteristic Value Score Annual gross income $45,000 20 TDS 10% 40 Relations with FI Checking account 10 Major credit cards 5 10 Age 27 25 Residence Own/Mortgage 20 Length of residence 2 2 years 25 Job stability 5 2 years 50 Credit history Missed 2 payments 1 year ago -15 Score 185 The loan request will go to the credit committee for review and decision. 20-1 Chapter 20 - Managing Credit Risk on the Balance Sheet 5. Besides the obvious difference in the sizes the borrowers, there is also a more well defined corporate structure and a clearer delineation of the corporate assets from the personal assets of the owners. The mid-market borrower is also more likely to have a track record to use as a basis for future performance.for future performance....
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This note was uploaded on 02/28/2012 for the course FINE 442 taught by Professor Larbihammami during the Spring '12 term at McGill.
- Spring '12