Chapter 12 – Credit Risk from the Regulator’s Perspective
Chapter 13 – Problem Loan Management
LENDING DECISION
IntroductionThe sectors that were not specified for
lending assistance would have been subject to credit rationing
Lending institutions might have been subject to concentration risk
Given the directives of the regulator, banks might have approved marginal lending applications in the directed sectors
Prudential regulationCapital adequacyLarge exposures
Capital AdequacyHistory shows that financial institutions normally
fail as a result of poor credit decisionThe board and management control the banks and
decisions could be taken that are not in the interest of the depositors – this is known as moral hazard
Depositors need to be protected against poor decisions by management -> under the base of capital adequacy, financial institutions are required to put aside capital to each credit risk exposure, whether it is on or off the balance sheet
A minimum of 8% of capital need be put aside for risk-weighted assets
Capital AdequacyRisk-based capital ratio = Total capital (Tier
1 + Tier 2)Risk Adjusted Assets
Tier 1 capital exhibits permanence like capital
Tier 2 has the ability to absorb credit losses but is not permanentTier 2 capital cannot make up more than
50% of overall allowable capital
Capital Adequacy
Tier 1 Tier 2
Paid up ordinary sharesGeneral reservesRetained earningsNon-cumulative irredeemable preference sharesMinority interest in subsidiariesLess Goodwill
General provisions for doubtful debts (<= 1.5% of total risk assets)Asset revaluation reservesCumulative irredeemable preference sharesMandatory convertible notesPerpetual subordinated debtRedeemable preference shares and term subordinated debt (min original maturity of at least 7 years and amortization factor of 20% of original amount to apply each year during the last five years to maturity
Risk CategoriesCategory 1 (0% weight) – notes and coins,
balance with the FED, Government papers (<= 12 months of maturity)
Category 2 (10%) – claims on Federal and State Government (> 12 months to maturity)
Category 3 (20%) – claims on banksCategory 4 (50%) – loans fully secured by
mortgage against residential property used for rental or occupied housing (LVR <= 80%)
Category 5 (100%) – loan fully secured by mortgage against residential property used for rental or occupied housing (LVR > 80%); commercial companies
Large Credit ExposureExposure = potential for loss under a finance
facilityA large exposure – an exposure to an
individual or group of counterparties that exceeds 10% of the consolidated capital base.
Securitization – a good credit risk management tool in certain circumstancesClean sale – absolves the financial institution
from any legal recourse from the sale of loansResults in the financial institution not holding
capital against the loan
Clean Sale Supply of AssetsA clean sale
There should be no beneficial interest in the sold assets and absolutely no obligation to the financial institution
No recourse (including costs) to the lending institution; no obligation to repurchase the lending assets
The amount paid for the loans should be fixed and should be received by the time the assets are transferred from the lending institution.
Any assets that are provided to the SPV as a substitute or provided at below book value are not considered as relieving credit risk
Subjected to asymmetric information
Revolving FacilitiesA clean sale
The rights, details and obligations of each party must be clearly specified, including the distribution of cashflows
As with normal asset securitization, the financial institution share cannot supply additional assets to the pool
Liquidity shortfalls for the financial institutions share most not exceed the interest receivable
The financial institution always has the right to cancel any undrawn amounts on the revolving facilities
Like normal lending securitization, the financial institution must be under no obligation to repurchase assets that have defaulted
Credit DerivativesThe effectiveness of credit derivatives becomes an
issue of how well the instrument reduces the requirement of capital adequacy
A credit derivative is deemed to afford protection if the physical settlement has a deliverable obligation.
In terms of maturity, a financial institution is deemed to have full protection if the maturity of derivative equals the maturity of the underlying assetExample: a loan has a term of 5 years and the credit
derivative has a maturity of 4 years, only 80% of the exposure is counted for regulatory relieft
Development in RegulationCapital adequacy is the primary tool for the Australian
Prudential Regulation Authority to regulate credit risk issues
A new proposal would base the risk weighting on the credit rating of the company. This raises the issue of independence because ratings are assigned when paid for by debt issuers
Basel I – the role of credit ratings and the consideration that banks, with superior skills may be able to use internal systems to allocate capital (“sophisticated” banks)Advantages: internal ratings are becoming popular in the
assessment of a variety of risksInternal ratings will use more data than used by external ratingsGiven that internal ratings will be used for credit risk purposes,
there may be an incentive to improve credit risk methodsDisadvantage: there will be a lack of standardized approaches
for credit risk
Problem Loan ManagementOutline why loans defaultHighlight the extent of problem loansExplain why the business cycle is important
for problem loansDefine problem loans, provisions and
regulatory issuesDiscuss the capital issues of problem loansDefine “structure dynamic provisioning”Restructure problem loansIllustrate a case from law
Causes of DefaultThe primary issue of problem loans is that
they can impair the value of a financial institution -> threaten its solvency
A default – a loan for which the repayments are overdue for the following reasons
Lack of compliance with loan policiesLack of clear standards and excessively lax loan termsInadequate controls over loan officersOver-concentration of bank lendingLoan growths in excess of the bank’s ability to manageInadequate systems for identifying loan problemsInsufficient knowledge about customers’ financeLending outside the market which the bank is familiar
Many problem loans could be avoided by better lending procedures and policies
Causes of DefaultCredit risk is never static and many loans
that were validly granted can become bad for many different reasons Recession affects firms that rely on cashflowFirms wind up because their products have
become outdatedMonitoring a loan portfolio becomes more
complex as the financial institution becomes larger -> higher costs
Monitoring models should provide warnings of developing problem loans
The Extend of Problem LoansHow should bankers should manage their problem
loansWhat are the various types of problem loan? How do we
define themHow do lenders manage the impact of problem loans on
profitability? Can they anticipate problem loansIs there a pattern of when problem loans occur?Is a grading attached to the severity of the problem
loan and how its is managed?What are the legal implications for managing problem
loansLiquidation – selling the borrower’s assetsDynamic provisioning – statistical method that seeks
to forecast doubtful debts and spread them over a number of years
The Business CycleRecovery & Expansion
High confidence in the economy and new investments increase
-> increased spending -> higher bank deposits -> banks have more money to lend -> relaxation of lending standards
Interest rates increase slightlyBoom
High asset inflation -> higher borrowing to invest in real assets
Overconfidence -> declining credit standardsInterest rates are rising
DownturnAsset prices decline -> less spending -> decline cashflowBanks experience their greatest problem loans
Problem Loans, Provisions & Regulatory
Borrower miss a repayment on loan -> is this permanent or temporary
If the situation persists for longer than 90 days -> impaired asset or non-performing loan
When a lending institution recognizes a problem, it needs to raise provisionsSpecific provisions – written off incomeGeneral provisions – written off incomeBad-debt write-offs – written off balance sheet
A provision is recognition that income may not be received on a loan
ProvisionsSpecific provisions
Attached to loans or impaired assets Specific provision is less than full value of the
loan because banks expects that some of the debt if recoverable
General provisionsAre like specific provisions but they are not
charged against a particular loanThe APRA views that 0.5% of total risk-
weighted credit risk-weighted assets should be used as a benchmark for general provisioning
Bad debt write-offsA debt is no longer recoverable
Dynamic ProvisioningThe internal policy will reflect the risk appetite
of the lenderLenders need recognize
Credit risks change over timeBad debts should not come as a surprise
A number of principles for dynamic provisioningClassify the loans into homogenous groupsThe different types of loan should be further broken
down into groupings by maturityGenerates the probability of default for each loan class
and the likely severity of lossDetermines the historical loan loss ratiosHistorical loan loss ratios are then transformed to be
predicative by the adjustment for economic circumstances
The transformed loan loss ratio applied to the current loan portfolio to determine provisions
Dealing with DefaultsThe three situations
Mild financial distressModerate financial distressSevere financial distress
Two principles always appliedThe primary aim of the bank is to minimize
the loss to the bank. In many cases, liquidity is not the optimal choice
To manage these problems correctly, the economic worth of the loan is compared with the economic worth of the borrower
Mild Financial DistressCompanies experience temporary cashflow
shortagesNever enters the public arena and is not captured
by the regulator’s definitions (< 90 days)Most common cause of illiquid is overly rapid
growth of the firm A number of remedies can be used
The bank agrees to an extension on the repaymentThe bank would charge penalties to ensure there
are disincentives to prevent the situation arising again
Banks should take further views or actions to ensure that their position is protected
Moderate Financial DistressA temporary cashflow shortage is evident
but the economic worth of the company is less than the repayment schedule of the loan
Remedial actionsLiquidation – not always the optimal choiceRestructure the loan to give the owner the
incentive to continue. This restructure is determined by calculating the break-even amount of the loan under the circumstances that the company would continue
Severe Financial DistressMissed debt payment and the borrower
having an economic worth less than the repayment schedule
Issues to be consideredWhether the borrower has a sound businessIs the default due to reasons other than the
nature of the businessWill the company worth more death or aliveHow much can be recovered under each
scenario
Other BreachesNot all defaults are generated by missed loan
repaymentsAlso when loan covenants are violated
Cashflow will not be unduly withdrawn from the company that would be available to repay loans
The overall risk of the company cannot be substantially changedGearing ratiosDividend pay-out ratiosInterest coverage
What is the correct procedure to follow when a company breaches its covenants?Remedial actions: renegotiate covenants