Session 7: Credit risk (Individual Loan Risk)

Student notes

March 8, 2023

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Please note

- Presentation slides are not a complete study aid.

- Students need to read the prescribed textbook and additional materials mentioned in the
learning guide.
- Try to do as many exercises as possible.
- Your own notes will remarkably support your study.
- Discussions are warmly welcome.
- Sometimes, the nal answer is not very important. Instead, the problem solving process is!
Hence, please listen actively and attentively.

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Credit Quality Problems

- The credit quality of many FIs' lending and investment decisions has attracted a great deal of
attention.
- Australian banking system:
• 1980s, 1990s: substantial problems with bank loans.
• Default of one major borrower can have signicant impact on value and reputation of
many FIs.

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Credit Quality Problems

Source: Reserve Bank of Australia, Financial Stability Review, November 2022.

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Credit Quality Problems

Source: Reserve Bank of Australia, Financial Stability Review, March 2014.

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Credit Quality Problems

Figure: Nonperforming Asset Ratio for U.S. Commercial Banks

Source: Federal Deposit Insurance Corporation, Quarterly Banking Prole, various issues. www.fdic.gov

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Types of Loans

Commercial and Industrial Loans:

• Short-term commercial loans: an original maturity ≤ 1 year.
Finance rms' working capital needs and other short-term funding needs
• Long-term commercial loans: maturity > 1 year.
Finance credit needs that extend beyond one year, such as the purchase of real assets
(machinery), new venture start-up costs, and permanent increases in working capital.
- Syndicated loan: A loan provided by a group of FIs as opposed to a single lender.
- Secured loan: A loan that is backed by a rst claim on certain assets (collateral) of the
borrower if default occurs.
- Unsecured loan: A loan that has only a general claim to the assets of the borrower if default
occurs.

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Types of Loans

Real Estate Loans (Housing Loans):

- Typically simple principal and interest or reducible loans made to individuals and families for
the purchase of the family home.
- Maturity may be more than 25 years.

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Types of Loans

Consumer or individual loans:

- Finance household expenditure, personal consumption (e.g., buying a car, laptop...).
• Revolving loan: A credit line on which a borrower can both draw and repay many times
over the life of the loan contract.
Credit cards play an important role in funding household expenditure. The debt provided
by credit cards is called revolving debt.
• Non-revolving loans
Automobile, personal loans.
• Other loans
Farm loans, inter-bank loans, government loans.

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Return on a loan

- There are some factors that impact the promised return an FI achieves on any given dollar
loan amount:
• The interest rate on the loan.
• Any fees relating to the loan.
• The credit risk premium on the loan.
• The collateral backing of the loan.
• Other nonprice terms (especially compensating balances and reserve requirements).
E.g.: a borrower facing a 10% compensating balance requirement on a $100 loan would
have to place $10 on deposit (traditionally on demand deposit) with the FI and could use
only $90 of the $100 borrowed.

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The Contractually Promised Return on a Loan

The contractually promised gross return on the loan, k, per dollar lentor ROA per dollar lent
can be estimated using:

of + (BR + ϕ)
1+k =1+
1 − [b(1 − RR)]
where:
of : A loan origination fee charged to the borrower for processing the application.
BR: Base lending rate.
ϕ: Credit risk premium or margin.
b : A compensating balance requirement to be held as (generally noninterest- bearing demand)
deposits.
RR : Reserve requirement.
BR + ϕ: Simple promised interest return on the loan.

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The Contractually Promised Return on a Loan

Suppose a bank does the following:

1. Sets the loan rate on a prospective loan at 10 percent (where BR = 6% and ϕ = 4%).
2. Charges a 0.125% loan origination fee to the borrower.
3. Imposes an 8% compensating balance requirement to be held as non-interest bearing
demand deposits.
4. Sets aside reserves, at a rate of 10% of deposits, held at the Federal Reserve.
(i.e., the Fed's cash-to-deposit reserve ratio is 10 percent).

of + (BR + ϕ)
1+k =1+
1 − [b(1 − RR)]
0.0125 + (0.06 + 0.04)
1+k =1+ = 1.1091
1 − [0.8(1 − 0.1)]
k = 10.91%

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The Contractually Promised Return on a Loan

Bank X oers one-year loans with a 9% stated or base rate, charges a 0.25 percent loan
origination fee, imposes a 10% compensating balance requirement, and must pay a 6% reserve
requirement to the central bank. The loans typically are repaid at maturity.
a. If the risk premium for a given customer is 2.5 percent, what is the simple promised interest
return on the loan?
b. What is the contractually promised gross return on the loan per dollar lent?
c. Which of the fee items has the greatest impact on the gross return?

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The Contractually Promised Return on a Loan
Bank X oers one-year loans with a 9% stated or base rate, charges a 0.25 percent loan
origination fee, imposes a 10% compensating balance requirement, and must pay a 6% reserve
requirement to the central bank. The loans typically are repaid at maturity.
Answer:
a. If the risk premium for a given customer is 2.5%, what is the simple promised interest return?
Simple promised interest return = BR + ϕ = 0.09 + 0.025 = 0.115 = 11.5%
b. What is the contractually promised gross return on the loan per dollar lent?

of + (BR + ϕ)
1+k =1+
1 − [b(1 − RR)]
0.25 + (0.09 + 0.025)
k= = 0.12969 = 12.969%
1 − 0.1 ∗ (1 − 0.06)
c. Which of the fee items has the greatest impact on the gross return?
If b = 0, k = 11.75% (change = -1.22%); If of = 0, k = 12.69% (change = -0.28%); If RR = 0,
k = 13.06% (change = 0.09%)
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The Contractually Promised Return on a Loan

of + (BR + ϕ)
1+k =1+
1 − [b(1 − RR)]
Special case: If of = 0 and b = 0:

1 + k = BR + ϕ

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The Expected Return on a Loan

The expected return [E (r )] per dollar lent is related to the promised return as follows:

1 + E (r ) = p(1 + k) + (1 − p) ∗ 0

where:
p is the probability of complete repayment of the loan (such that the FI receives the principal
and interest as promised); (1 − p) is the probability of default (in which the FI receives nothing,
i.e., 0). Hence:
E (r ) = p(1 + k) − 1
Note: If p < 1, i.e. default risk is present:
- FIs need to set the risk premium (ϕ).
- FI needs to recognise that higher fees and charges might decrease p .

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Retail vs. Wholesale Credit Decisions

- Retail:
• Small dollar size loans.
• Higher cost associated with collection of information.
• Accept or Reject decision.
• Standard loan rate is usually charged.
• Credit risk controlled through credit rationing rather than by using a range of interest
rates or prices.
Credit rationing: Restricting the quantity of loans made available to individual borrowers.

Example: the FI may oer the wealthy individual a loan of up to $100,000, while the same
FI may oer the less wealthy individual a loan of up to $10,000, both at the same interest
rate.

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Retail vs. Wholesale Credit Decisions

- Wholesale
• FIs use both interest rates and credit quantity to control credit risk.
FIs quote a prime lending rate (BR) to borrowers:
* Lower-risk borrowers may be charged a lending rate below the prime lending rate (ϕ < 0)
* Higher-risk borrowers are charged a lending rate above the prime lending rate (ϕ > 0)

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Measurement of Credit Risk

Group 1: Qualitative Models

Group 2: Quantitative models
• Credit scoring models
• Linear probability models.
• Logit models.
• Linear discriminant analysis.
• Newer Models of Credit Risk Measurement and Pricing
• Term Structure Derivation of Credit Risk.
• Mortality Rate Derivation of Credit Risk.
• RAROC Models.

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Qualitative Models

Borrower-Specic Factors:
• Reputation.
• Leverage.
• Volatility of Earnings.
• Collateral.

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Qualitative Models

Market-Specic Factors:
• The Business Cycle.
Example: During recessions, rms in the consumer durable goods sector that produce
autos, refrigerators, or houses do badly compared with those in the nondurable goods
sector producing clothing and foods.
Hence, corporate borrowers in the consumer durable goods sector of the economy are
especially prone to default risk.
• The Level of Interest Rates.
High interest rates are correlated with higher credit risk in general.
Reason: high interest rate levels may encourage borrowers to take excessive risks and/or
encourage only the most risky customers to borrow.

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Credit Scoring Models

- Credit Scoring Models: Mathematical models that use observed loan applicant's
characteristics either to:
* Calculate a score representing the applicant's probability of default, or
* Sort borrowers into dierent default risk classes.

- Credit scoring models include these three broad types:

(1) Linear probability models,
(2) Logit models, and
(3) Linear discriminant models.

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The Linear Probability Model

- The Linear Probability Model uses past data, such as nancial ratios, as inputs into a
model to explain repayment experience on old loans.
- Procedure:
• Divide old loans into two observational groups: those that defaulted (PDi = 1) and those
that did not default (PDi = 0).
• Relate these observations by linear regression to a set of j causal variables (Xij ) that reect
quantitative information about the i th borrower, such as size, cash holdings ratio, leverage,
or ROA.
n
X
PDi = βj Xij + error
j=1

• The relative importance of the factors (βj ) used in explaining past repayment performance
then forecasts repayment probabilities on new loans.
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The Linear Probability Model

Example:
Suppose there were two factors inuencing the past default behavior of borrowers: the leverage
or debtequity ratio (D/E) and the salesasset ratio (S/A). Based on past default (repayment)
experience, the linear probability model is estimated as:

PDi = 0.5(D/Ei ) − 0.0525(S/Ai )

• If company X (new borrower) has D/E = 0.3 and S/A = 2.0

PDX = 0.5 ∗ 0.3 − 0.0525 ∗ 2 = 4.5%

• Company Y has D/E = 0.8 and S/A = 1.75

PDY = 0.5 ∗ 0.8 − 0.0525 ∗ 1.75 = %

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Logit model

- Weakness of the Linear Probability model:That the estimated probabilities of default can
often lie outside the interval 0 to 1.
- The logit model overcomes this weakness by restricting the estimated range of default
probabilities from the linear regression model to lie between 0 and 1:
1
F (PDi ) =
1 + e −PDi
where:
e is exponential (equal to 2.718).
F (PDi ) is the logistically transformed of PDi

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Linear Discriminant Models

Altman's discriminant function (credit-classication model):

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

where:
X1 : Working capital/Total assets ratio.
X2 : Retained earnings/Total assets ratio.
X3 : Earnings before interest and taxes/Total assets ratio.
X4 : Market value of equity/Book value of total liabilities.
X5 : Sales/Total assets ratio.
Note:
Two extreme cases:
• Z-score < 1.81: High default risk rm.
• Z-score > 2.99: Low default risk.

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Linear Discriminant Models

Suppose that the nancial ratios of a potential borrowing rm take the following values:
X1 = 0.2; X2 = 0; X3 = 0.20; X4 = 0.10; X5 = 2.0.
Calculate Z.

Z = 1.2*(0.2 ) + 1.4*(0) + 3.3*(-0.20) + 0.6*(0.10) + 1.0*(2.0) = 1.64

Z < 1.81
High default risk.

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Linear Discriminant Models

Weaknesses of the Linear Discriminant Models:

- Only considers two extreme cases (default/no default).
- Weights (βj ) need not be stationary over time.
- Ignores hard to quantify factors including business cycle eects.
- Database of defaulted loans is not available to benchmark the model.

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Newer Models of Credit risk Measurement and Pricing

Term Structure Derivation of Credit Risk

- Market-based method of assessing credit risk exposure and default probabilities.
- If the risk premium is known, practitioners can infer the probability of default.
- Risk premium can be computed using Treasury strips and zero coupon corporate bonds.

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Newer Models of Credit risk Measurement and Pricing

Term Structure Derivation of Credit Risk

- Assume that the FI requires an expected return on a one-year (zero-coupon) corporate debt
security equal to at least the risk-free return on one-year (zero-coupon) Treasury strips.
- p = the probability that the corporate debt will be repaid in full.
- Assumption: If the borrower defaults, the FI is (for now) assumed to get nothing (i.e.,
the recovery rate is zero).
- The contractually promised return on the one-year corporate debt strip = 1 + k.
- The contractually promised return on the credit riskfree one-year Treasury strip as 1 + i.
- The expected return on corporate securities is equal to the risk-free rate:

p(1 + k) = 1 + i

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Newer Models of Credit risk Measurement and Pricing

k = 7.8%; i = 2.05%.
p(1 + k) = 1 + i
1+i 1 + 0.0205
p= = = 0.9467
1+k 1 + 0.078
Probability of default = 1 - 0.9467 = 0.0533 = 5.33%
Hence, a probability of default of 5.33% on the corporate bond (loan) requires the FI to set a risk
premium (ϕ) of 5.75% (k-i).
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Newer Models of Credit risk Measurement and Pricing
Term Structure Derivation of Credit Risk
- If the recovery rate ̸= 0, i.e. the FI lender can expect to receive some partial repayment even if the
borrower goes into bankruptcy.
- If γ is the proportion of the loan's principal and interest that is collectible on default (γ > 0), the
expected return on the loan can be estimated using:
[(1 − p)γ(1 + k)] + [p(1 + k)] = 1 + i
where:
(1 - p)γ (1 + k) is the payo the FI expects to get if the borrower defaults.

- Solve for p (probability of repayment):

1+i
1+k−γ
p=
1−γ
- The required risk premium is as follows:
1+i
ϕ=k −i = − (1 + i)
(γ + p − pγ)
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Newer Models of Credit risk Measurement and Pricing

Term Structure Derivation of Credit Risk

Example: Assume that a one-year Treasury strip is currently yielding 5.5 percent and an
AAA-rated discount bond with similar maturity is yielding 8.5 percent. If the expected recovery
from collateral in the event of default is 50 percent of principal and interest, what is the
probability of repayment of the AAArated bond? What is the probability of default?

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Newer Models of Credit risk Measurement and Pricing
Term Structure Derivation of Credit Risk
Example: Assume that a one-year Treasury strip is currently yielding 5.5% and an AAA-rated discount
bond with similar maturity is yielding 8.5%. If the expected recovery from collateral in the event of
default is 50% of principal and interest, what is the probability of repayment of the AAArated bond?
What is the probability of default?
Answer:

1+i 1+0.055
1+k−γ 1+0.085− 0.5
p= = = 94.47%
1−γ 1 − 0.5
Probability of default = 1 - 94.47% = 5.53%
What happen if the expected recovery from collateral = 94.47%?

1+0.055
1+0.085− 0.9447
p= = 50%
1 − 0.9447
The proportion of the loan's principal and interest that is collectible on default is a perfect
substitute for the probability of repayment should such defaults occur.
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Newer Models of Credit risk Measurement and Pricing

Term Structure Derivation of Credit Risk

Probability of Default on a Multiperiod Debt Instrument
- Marginal default probability: The probability that a borrower will default in any given year.
Example:
1 − p1 : Marginal probability of default in year 1.
1 − p2 : Marginal probability of default in year 2.
- Cumulative default probability: The probability that a borrower will default over a specied
multiyear period.
- The cumulative default probability at some time between now and the end of year 2 is:

Cp = 1 − (p1 )(p2 )
- Similarly, the cumulative default probability at some time between now and the end of year 3:

Cp = 1 − (p1 )(p2 )(p3 )

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Newer Models of Credit risk Measurement and Pricing

Term Structure Derivation of Credit Risk

Probability of Default on a Multiperiod Debt Instrument

Suppose an FI manager wants to nd the probability of default on a two-year loan. For the
one-year loan, 1 − p1 = 0.03 is the marginal and total or cumulative probability (Cp ) of default
in year 1. For the second year, suppose that 1 − p2 = 0.05. Calculate the cumulative
probability of default over the next two years.

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Newer Models of Credit risk Measurement and Pricing

Term Structure Derivation of Credit Risk

Probability of Default on a Multiperiod Debt Instrument

Suppose an FI manager wants to nd the probability of default on a two-year loan. For the
one-year loan, 1 − p1 = 0.03 is the marginal and total or cumulative probability (Cp ) of default
in year 1. For the second year, suppose that 1 − p2 = 0.05. Calculate the cumulative
probability of default over the next two years.
Answer:
p1 = 1 − 0.03 = 0.97
p2 = 1 − 0.05 = 0.95
Cp = 1 − 0.97 ∗ 0.95 = 7.85%

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Newer Models of Credit risk Measurement and Pricing
Term Structure Derivation of Credit Risk
Probability of Default on a Multiperiod Debt Instrument
How to nd p2 ?
1 + f1
p2 =
1 + c1
where:
c1 : The one-year rate expected on corporate securities.

(1 + k2 )2
1 + c1 =
(1 + k1 )
Forward rate (f1 ): a one-period rate of interest expected on an issued bond at some date in the
future.

(1 + i2 )2
1 + f1 =
(1 + i1 )
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Newer Models of Credit risk Measurement and Pricing
Term Structure Derivation of Credit Risk
Probability of Default on a Multiperiod Debt Instrument

Yields on Treasury strips: i1 = 2.05%; i2 = 3%

(1 + 0.03)2
1 + f1 = = 1.0396
1 + 0.0205
f1 = 3.96%
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Newer Models of Credit risk Measurement and Pricing
Term Structure Derivation of Credit Risk
Probability of Default on a Multiperiod Debt Instrument

Yields on Corporate bonds: k1 = 7.8%; k2 = 10%

(1 + 0.1)2
1 + c1 = = 1.1224
1 + 0.078
c1 = 12.24%
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Newer Models of Credit risk Measurement and Pricing

Term Structure Derivation of Credit Risk

Probability of Default on a Multiperiod Debt Instrument
We have:
c1 = 12.24%
f1 = 3.96%

1 + f1 1 + 0.0396
p2 = = = 0.9262
1 + c1 1 + 0.1224
So that, the probability of default in year 2 = 1 - p2 = 1 - 0.9262 = 0.0738 = 7.38%

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Newer Models of Credit risk Measurement and Pricing

Term Structure Derivation of Credit Risk

Probability of Default on a Multiperiod Debt Instrument
Example:

Spot 1 Year Spot 2 Year Spot 3 Year

Treasury strip (i) 5.0% 6.1% 7.0%
BBB-rated bonds (k) 7.0% 8.2% 9.3%

Calculate the term structure of default probabilities over three years.

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Newer Models of Credit risk Measurement and Pricing

Answer:
Treasury strip BBB-rated bonds
(1+i2 )2 2
1 + f1 = (1+i1 )
1 + c1 = ((11+k 2)
+k1 )
1.0612 (1+0.082)2
1 + f1 = 1.05 1 + c1 = (1+0.07)
f1 = 7.21% c1 = 9.41%

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Newer Models of Credit risk Measurement and Pricing

Answer:
Treasury strip BBB-rated bonds
(1+i2 )2 2
1 + f1 = (1+i1 )
1 + c1 = ((11+k 2)
+k1 )
1.0612 )2
1 + f1 = 1.05 1 + c1 = (1(+1+0.0082
.07)
f1 = 7.21% c1 = 9.41%
3 3
1 + f2 = ((11+i3)
+i2 )2
1 + c1 = ((11+k 3)
+k2 )2
1.073 1.0933
1 + f2 = 1.0612 1 + c2 = 1.0822
f2 = 8.82% c2 = 11.53%

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Newer Models of Credit risk Measurement and Pricing
Answer:
Treasury strip BBB-rated bonds
(1+i2 )2 2
1 + f1 = (1+i1 )
1 + c1 = ((11+k 2)
+k1 )
1.0612 )2
1 + f1 = 1.05 1 + c1 = (1(+1+0.0082
.07)
f1 = 7.21% c1 = 9.41%
3 3
1 + f2 = ((11+i3)
+i2 )2
1 + c1 = ((11+k 3)
+k2 )2
1.073 1.0933
1 + f2 = 1.0612 1 + c2 = 1.0822
f2 = 8.82% c2 = 11.53%

1+i
p1 = = 1.05/1.07 = 98.13%
1+k
1 + f1
p2 = = 1.0721/1.0941 = 97.99%
1 + c1
1 + f2
p3 = = 1.0882/1.1153 = 97.57%
1 + c2
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Newer Models of Credit risk Measurement and Pricing

Answer:
The cumulative probability of default:

Cp2 = 1 − p1 ∗ p2 = 1 − 0.9813 ∗ 0.9799 = 3.84%

Cp3 = 1 − p1 ∗ p2 ∗ p3 = 1 − 0.9813 ∗ 0.9799 ∗ 0.9757 = 6.18%

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Newer Models of Credit risk Measurement and Pricing

Mortality Rate Derivation of Credit Risk

- The FI manager may analyze the historic or past default risk experience (i.e. the mortality
rate) of bonds and loans of a similar quality.
- If p1 is the probability of a grade B bond or loan surviving the rst year of its issue.
So (1-p1 ) = the probability of the bond or loan defaulting in the rst year of issue = Marginal
Mortality Rate.
- Marginal mortality rate can be estimated from actual data on bond and loan defaults. For
example, for grade B bonds:
Total value of grade B bonds defaulting in year 1 of issue
MMR1 =
Total value of grade B bonds outstanding in year 1 of issue

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Newer Models of Credit risk Measurement and Pricing

Mortality Rate Derivation of Credit Risk

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Newer Models of Credit risk Measurement and Pricing

RAROC (risk-adjusted return on capital) models.

- Lending ocer balances expected inter- est and fee income less the cost of funds against the
loan's expected risk.

One − year net income on a loan

RAROC =
Loan (asset) risk or capital at risk
Note: A loan is approved only if RAROC is suciently high relative to a benchmark return on
capital (ROE) for the FI.

One − year net income = (Spread + Fees) ∗ Loan outstanding in $

∆R
Loan risk = ∆LN = −DLN ∗ LN ∗
1+R

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Tutorial exercise 1

Suppose the estimated linear probability model used by an FI to predict business loan applicant default
probabilities is:
PD = 0.03X1 + 0.02X2 − 0.05X3 + error
where X1 is the borrower's debt/equity ratio, X2 is the volatility of borrower earnings, and X3 is the
borrower's prot margin ratio.
For a particular loan applicant, X1 = 0.75, X2 = 0.25, and X3 = 0.10.
a. What is the projected probability of default for the borrower?
b. What is the projected probability of repayment if the debtequity ratio is 2.5?

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Tutorial exercise 2

The nancial ratios of a potential borrowing rm take the following values:
- Working capital/Total assets ratio (X1 ) = 0.75
- Retained earnings/Total assets ratio (X2 ) = 0.10
- Earnings before interest and taxes/Total assets ratio (X3 ) = 0.05
- Market value of equity/Book value of total liabilities (X4 ) = 0.10
- Sales/Total assets ratio (X5 ) = 0.65
Calculate the Altman's Z score for the borrower in question. Provide your comment.

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Tutorial exercise 3

If the rate on one-year Treasury strips currently is 6%, what is the repayment probability for
each of the following two securities? Assume that if the loan is defaulted, no payments are
expected. What is the market determined risk premium for the corresponding probability of
default for each security?
a. One-year AA-rated zero-coupon bond yielding 9.5 percent.
b. One-year BB-rated zero-coupon bond yielding 13.5 percent.

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Tutorial exercise 4

A bank has made a loan charging a base lending rate of 10 percent (k = 10%). It expects a
probability of default of 5 percent. If the loan is defaulted, the bank expects to recover 50
percent of its money through the sale of its collateral. What is the expected return on this loan?

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Thank you for your attention.
Q&A

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