Financial Institutions - Chapter 11: Credit risk of a loan portfolio

What are the three components of credit risk for a loan portfolio

1. Probability of default

2. Loss given default

3. Correlations of default

List the simple models of loan concentration

1. Migration analysis

2. Concentration limits

Briefly explain the purpose of migration analysis in assessing for credit risk of a portfolio

Banks track the credit rating changes within a pool of loans by performing a rating transition matrix, which shows the probability of a borrowers rating staying the same or fluctuating over a year.

How is a transition matrix beneficial for assessing credit risk exposure?

By comparing current transition probabilities with what the norm used to be, the bank can decided to limit the exposure to credit risk.

Briefly explain how concentration limits help assess credit risk of a loan portfolio

Banks can place concentration limits on loans to individual borrowers. In Canada OFSI sets large exposure limits to a maximum of 25% of a banks total capital. The formula for concentration limit is the maximum loss as a % of capital divided by the loss rate.

Why is portfolio theory not used when assessing credit risk of a loan portfolio?

To be able to apply this theory you must know the expected return on the loan, the loan risk, and the correlation of default risks. This is not possible because you can’t observe those correlations

What are partial applications of portfolio theory?

1. Loan volume-based models: Banks find the amount of loans for different categories. It establishes a market benchmark for individual FI’s

2. Loan-Loss ratio Model: Banks estimates how much they may lose on their loans per industry

Briefly explain what the loan volume-based model entails

• Banks are required by Bank of Canada to classify their loans as business, personal, residential/non-residential mortgages. This is used to estimate national allocations

• There are commercial databases that banks use to separate loan volumes into 2-digit SIC codes

Briefly explain the loan loss ratio based model

The bank uses this model to estimate the loan loss risk of each industry or sector, relative to the loan loss risk of the portfolio. Divide each sector losses by loans and then consider all losses regardless of the sector and divide by total loans.

What does beta represent in-terms of the loan loss ratio model?

It measures the systematic loss sensitivity of a certain sector compared to the total loans. If beta is greater than 1 the specific sector has a higher risk than the total, which means banks should limit loans to that sector.