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Overview

Overview. This chapter discusses the benefits of loan portfolio diversification Credit models used to assess risk in the loan portfolio Concentration limits OSFI regulation used to measure and control the default of a loan portfolio. Simple Models of Loan Concentration.

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Overview

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  1. Overview • This chapter discusses • the benefits of loan portfolio diversification • Credit models used to assess risk in the loan portfolio • Concentration limits • OSFI regulation used to measure and control the default of a loan portfolio

  2. 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.

  3. Web Resources • For information on migration analysis, visit: Standard & Poors www.standardandpoors.com Moody’s www.moodys.com

  4. 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

  5. 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. • OSFI sets large exposure limits to at 25% of a banks risk-based capital adequacy ratio. • Some countries, such as Chile, specify limits by sector or industry

  6. Diversification & Modern Portfolio Theory • Applying portfolio theory to loans • Using loans to construct the efficient frontier. • Minimum risk portfolio. • Low risk • Low return.

  7. 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.

  8. Modern Portfolio Theory Expected Return: Variance:

  9. KMV Portfolio Manager Model KMV Measures these as follows: • Ri = AISi - E(Li) = AISi - [EDFi × LGDi] • AISi = annual all in spread • EDFi = expected default frequency • LGDi = loss given default • si = ULi = sDi × LGDi = [EDFi(1-EDFi)]½ × LGDi • ULi = unexpected loss • rij = correlation between systematic return components of equity returns of borrower i and borrower j.

  10. Partial Applications of Portfolio Theory • Loan volume-based models • Bank regulatory 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. • Commercial databases • Loan Pricing Corporation’s Dealscan database

  11. Partial Applications • Loan volume-based models (continued) • Provide market benchmarks. • Standard deviation measure of loan allocation deviation.

  12. Loan Loss Ratio-Based Models • Estimate loan loss risk by SIC sector. • Time-series regression: [sectoral losses in ithsector] [ loans to ith sector ] = a + bi [total loan losses] [ total loans ] a = measures the loan loss rate for a sector that has no sensitivity to losses on the aggregate loan portfolio (i.e., its b = 0) bi = measures the systematic loss sensitivity of the ith sector loans to the total loans

  13. Regulatory Models • Credit concentration risk evaluation largely subjective. • OSFI issued B-1 (1993) and B-2 (1994) guidelines for Canadian banks and insurance companies which allow them to develop in-house models to measure credit risk, and ensure that staff that is monitoring credit risk is properly trained.

  14. Pertinent Websites • For more information visit: Federal Reserve Bank www.federalreserve.gov KMV www.kmv.com Moody’s www.moodys.com OSFI www.osfi.ca Standard & Poors www.standardandpoors.com

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