Credit Risk: Loan Credit Risk: Loan Portfolio and Portfolio and

Concentration RiskConcentration Risk

Chapter 12

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K. R. Stanton

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Overview

This chapter discusses the management of credit risk in a loan (asset) portfolio context. It also discusses the setting of credit exposure limits to industrial sectors and regulatory approaches to monitoring credit risk. The National Association of Insurance Commissioners has also developed limits for different types of assets and borrowers in insurers’ portfolios.

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Simple Models of Loan Concentration

Migration analysis Track credit rating changes within sector or pool

of loans. Rating transition matrix.

Widely applied to commercial loans, credit card portfolios and consumer loans.

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Web Resources

For information on migration analysis, visit:

Standard & Poors www.standardandpoors.com

Moody’s www.moodys.com

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Rating Transition 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

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Simple Models of Loan Concentration

Concentration limits On loans to individual borrower. Concentration limit = Maximum loss Loss

rate. Maximum loss expressed as percent of capital.

Some countries, such as Chile, specify limits by sector or industry

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Diversification & Modern Portfolio Theory

Applying portfolio theory to loans Using loans to construct the efficient frontier. Minimum risk portfolio.

Low risk Low return.

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Applying Portfolio Theory to Loans

Require (i) expected return on loan (measured by all-in-

spread); (ii) loan risk; (iii) correlation of loan default risks.

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Modern Portfolio Theory

n

iiip RXR

1

n

i

n

jjijiji

n

i

n

ijiji

n

jiip

XX

XXX

1 1,

1 1,

1

222

Expected Return:

Variance:

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KMV Portfolio Manager Model

KMV Measures these as follows: Ri = AISi - E(Li) = AISi - [EDFi × LGDi]

i = ULi = Di × LGDi

= [EDFi(1-EDFi)]½ × LGDi

ij = correlation between systematic

return components of equity returns of borrower i and borrower j.

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Partial Applications of Portfolio Theory

Loan volume-based models Commercial bank call reports

Can be aggregated to estimate national allocations. Shared national credit

National database that breaks commercial and industrial loan volume into 2-digit SIC codes.

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Partial Applications

Loan volume-based models (continued) Provide market benchmarks.

Standard deviation measure of loan allocation deviation.

N

XXN

iiji

j

1

2, )(

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Loan Loss Ratio-Based Models

Estimate loan loss risk by SIC sector. Time-series regression:

[sectoral losses in ith sector]

[ loans to ith sector ]

= + i [total loan losses]

[ total loans ]

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Regulatory Models

Credit concentration risk evaluation largely subjective.

Life and PC insurance regulators propose limits on investments in securities or obligations of any single issuer. General diversification limits.

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Pertinent Websites

For more information visit:

Federal Reserve Bank www.federalreserve.gov

KMV www.kmv.com

Moody’s www.moodys.com

National Association of Insurance Commissioners www.naic.org

Standard & Poors www.standardandpoors.com