Problem Set 15

What is the range of scores in the FICO system?

FICO scores range from a minimum of 300 to a maximum of 850. Average scores cluster near 675 with a median of 710, and scores are grouped from "Poor" (579 and below) to "Exceptional" (800 and above

Identify the three aspects of analyzing the financial condition of a business for credit.

The three aspects are:

• Analysis of balance sheet and income statements

• Analysis of cash flows (often through UCA analysis)

• Analysis of financial ratios

Together, these allow the analyst to assess profitability, liquidity, leverage, and repayment capacity, both historically and in forecast form

What are the top two determinants (factors) in developing the FICO score for an individual?

The two top factors for individual FICO scores are: Payment history (35%) - whether the borrower has paid past obligations on time•

Amount of money owed (30%) - total outstanding balances relative to credit limits

Together these two factors make up roughly 65% of the total FICO weighting

Define what credit risk is

Credit risk: risk that a borrower will fail to repay a loan in full or on time, resulting in financial loss to the bank. It arises from uncertainty in repayment, affecting both income and capital adequacy

Identify at least three key elements that are contained in a bank's loan policy

Lines of authority (who can approve loans and at what limits)

Loan rates and terms (defining pricing and repayment parameters)•

Quality standards (criteria for acceptable credit quality and documentation)

What is the primary source for mitigating credit risk?

Cash flow - the borrower's ability to generate sufficient ongoing cash from operations to repay debt

What are the typical types of collateral that a bank may seek from the borrower

• Real or personal property (e.g., buildings, equipment, vehicles)

• Cash or deposit accounts

• Securities or investment

Name the six Cs of credit and briefly identify what they represent.

• Character - borrower's integrity and intent to repay

• Capacity - borrower's legal and practical ability to repay

• Cash - the primary repayment source, derived from operations or income

• Collateral - pledged assets serving as secondary repayment

• Conditions - external factors such as economic or industry environment

• Control/Competition - compliance with bank policy and regulatory limits, plus market competitiveness of the loan terms

Identify the two types of loan covenants and what they do

• Positive (affirmative) covenants - require the borrower to perform certain actions, such as providing financial statements or maintaining insurance.

• Negative covenants - restrict the borrower from specific actions, such as incurring additional debt or exceeding financial ratios.

Name at least three evaluation items in a consumer loan application

• Job or occupation and employment stability

• Income level and consistency

• Outstanding debt levels

Credit risk arises primarily from changes in interest rates that reduce a loan's market value.

FALSE

That is market risk, not credit risk.

Credit risk = refers to the borrower's potential failure to repay principal or interest

Market risk = deals with value fluctuations caused by interest rate changes

All collateral eliminates credit risk because it guarantees full recovery in default

FALSE

Collateral reduces potential loss but cannot eliminate credit risk. Asset values can decline, and legal or timing issues can limit recovery. The bank's true protection still depends on the borrower's ability to generate cash flow.

A borrower can be profitable and still represent high credit risk.

TRUE

Profitability doesn't guarantee liquidity or repayment capacity. A company might show strong net income but have weak cash flow due to slow collections or overtrading. Credit risk focuses on cash generation, not accounting profit.

Rising loan‐loss provisions while charge-offs remain stable often signal deteriorating credit expectations.

TRUE

Higher provisions signal that management expects future losses. Even if current charge-offs are stable, banks build reserves when portfolio quality begins to weaken. This is a proactive step in managing expected credit losses.

Under the Six Cs, "Control" refers mainly to the borrower's market power overcompetitors.

FALSE

"Control" in the Six Cs refers to compliance, legal environment, and policy consistency, not market influence. Competitive advantage would be assessed under "Conditions" instead.

A loan policy should allow relationship managers to override covenants to protect customer loyalty.

FALSE

Loan policies exist to enforce consistency and protect against excessive risk. Relationship managers cannot freely override covenants, since that would undermine credit discipline.

A FICO score of 620 would likely receive subprime pricing even if payment history is good.

TRUE

Most banks treat scores below 660 as subprime, regardless of good payment history. Pricing models rely heavily on quantitative thresholds rather than personal judgment. A 620 score would typically trigger higher rates or collateral requirements

If a bank's NPL ratio rises while coverage ratio stays constant, the overall asset quality has improved.

FALSE

Rising non-performing loans indicate asset-quality deterioration. If coverage (reserves) stays flat, the bank's protection per dollar of bad loans has actually weakened. True improvement requires falling NPLs or stronger reserve ratios.

When analyzing a UCA cash-flow statement, increasing inventory is treated as a cash inflow.

FALSE

An increase in inventory absorbs cash rather than providing it. In UCA analysis, this is shown as a use of cash under changes in working capital. Only a decrease in inventory would represent a cash inflow.

Consumer credit risk is generally higher than commercial credit risk because consumer loans are unsecured and information is limited.

UNCERTAIN

Individual consumer loans carry higher default probabilities, but portfolios are highly diversified and often better priced for risk. Commercial loans are larger and more concentrated, so a single default can cause greater loss severity. The overall comparison depends on product mix and portfolio management.

Which statement best defines credit risk?

The risk a borrower will fail to meet payment obligations

Which of the following is most likely a negative covenant?

Do not incur additional debt without consent

In UCA analysis, which item is deducted after operating cash flow but before debt service?

Capital expenditures

A borrower with DSCR = 0.95× most likely:

Needs additional borrowing or equity to service debt

Which of the Six Cs evaluates a borrower's integrity and willingness to repay?

Character

A credit card portfolio with high yield and high default frequency mainlydemonstrates:

Risk-based pricing

Which metric best measures asset quality in a bank's CAMELS rating?

Non-performing loans / total loans

In the Traverse Bank case, declining DSCR and rising leverage most likely indicate:

Overtrading and working-capital strain

If a borrower violates a covenant but remains current on payments, the loan is typically:

Subject to waiver or modification review

Which change would most likely increase a consumer's FICO score?

Paying down balances below 30% of limits