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Chapter Twenty-one . Managing Risk on the Balance Sheet I: Credit Risk. Credit Risk Management.

Chapter Twenty-one

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Chapter Twenty-one

Managing Risk on the Balance Sheet I:

Credit Risk

- An FI’s ability to evaluate information and control and monitor borrowers allows them to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governments
- An FI accepts credit risk in exchange for a fair return sufficient to cover the cost of funding (e.g., covering the cost of borrowing, or issuing deposits)

- Real Estate Lending
- residential mortgage loan applications are among the most standardized of all credit applications
- Two considerations
- the applicant’s ability and willingness to make timely interest and principal repayments
- the value of the borrower’s collateral

- GDS (gross debt service) ratio - gross debt service ratio calculated as total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided by gross income
- TDS (total debt service) ratio - total debt ratio calculated as total accommodation expenses plus all other debt service payments divided by gross income

- Credit scoring system
- a mathematical model that uses observed loan applicant’s characteristics to calculate a score that represents the applicant’s probability of default

- Perfecting collateral
- ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default

- Foreclosure
- taking possession of the mortgaged property to satisfy a defaulting borrower’s indebtedness

- Power of sale
- taking the proceedings of the forced sale of property to satisfy the indebtedness

- Consumer (individual) and Small-business lending
- techniques for scoring consumer loans very similar to mortgage loan credit analysis but more emphasis placed on personal characteristics such as annual gross income and the TDS score
- small-business loans more complicated and has required FIs to build more sophisticated scoring models combining computer-based financial analysis of borrower financial statements with behavioral analysis of the owner

- Definition of Mid-market
- offered some of the most profitable opportunities for credit-granting FIs
- sales revenues from $5 million to $100 million/year
- recognizable corporate structure
- do not have ready access to deep and liquid capital markets

- Credit Analysis - Five C’s of Credit
- customer’s character, capacity, collateral, conditions, and capital

- Cash Flow Analysis
- provides relevant information about the applicant’s cash receipts and disbursements

- Historical audited financial statements and projections of future needs
- Calculation of financial ratios in financial statement analysis
- Relative ratios offer information about how a business is changing over time
- Particularly informative when they differ either from an industry average or from the applicant’s own past history

Liquidity Ratios

Current Ratio = Current assets

Current liabilities

Quick ratio = Cash + Cash equivalents + Receivables

Current liabilities

(continued)

Asset Management Ratios

Number of days sales = Accounts receivable x 365

in receivables Credit sales

Number of days = Inventory x 365

in inventory Cost of goods sold

Sales to working = Sales

capital Working capital

Sales to fixed = Sales

assets Fixed assets

Sales to total assets = Sales

Total assets

(continued)

Debt and Solvency ratios

Debt-asset ratio = Short-term liabilities + Long-term liabilities

Total assets

Fixed-charge = Earnings available to meet fixed charges

coverage ratio Fixed charges

Cash-flow-to-debt = EBIT + Depreciation

ratio Debt

where EBIT represents earnings before interest and taxes

(continued)

Profitability Ratios

Gross margin = Gross profit Income to Sales = EBIT

Sales Sales

Operating profit margin = Operating profit

Sales

Return on assets = EAT

Average total assets

Return on equity = EAT Dividend payout = Dividends

Total equity EAT

where EAT represents earnings after taxes, or net income

- Analyst can divide all income statement amounts by total sales revenue and all balance sheet amounts by total assets
- Year to year growth rates give useful ratios for identifying trends
- Loan covenants reduce risk to lender
- Conditions precedent
- those conditions specified in the credit agreement or terms sheet for a credit that must be fulfilled before drawings are permitted

- Very attractive to FIs because transactions are often large enough make them very profitable even though spreads and fees are small in percentage
- FIs act as broker, dealer, and adviser in credit management
- The standard methods of analysis used for mid-market corporates applied to large corporate clients but with additional complications
- Financial ratios such as the debt-equity ratio are usually key factors for corporate debt

Used for analyzing publicly traded manufacturing firms

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

where

Z = an overall measure of the borrower’s default risk

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 long-term debt ratio

X5 = Sales/Total assets ratio

The higher the value of Z, the lower the default risk

- Banks can use the theory of option pricing to assess the credit risk of a corporate borrower
- The probability of default is positively related to:
- the volatility of the firm’s stock
- the firm’s leverage

- A model developed by KMV corporation is being widely used by banks for this purpose

- A number of factors impact the promised return that an FI achieves on any given dollar loan
- the interest rate on the loan
- any fees relating to the loan
- the credit risk premium on the loan
- the collateral backing the loan
- other nonprice terms (such as compensating balances and reserve requirements)

1 + k = 1 + f + (L + m)

1 - (b(1 - R))

where

k = the contractually promised gross return on the loan

f = direct fees, such as loan origination fee

L = base lending rate

m = risk premium

b = compensating balances

R = reserve requirement charge

- Rather than evaluating the actual or promised annual cash flow on a loan as a percentage of the amount lent (ROA), the lending officer balances the loan’s expected income against the loan’s expected risk
- RAROC = One-year income on a loan/Loan (asset risk or capital at risk