Part 4: CREDIT RISK: TRADITIONAL AND INNOVATIVE METHODS FOR MANAGING THE LENDING FUNCTION Chapter 10: The Traditional Approach to Business Lending: Theory and Practice Chapter 11: Modern Method for Analyzing and Managing Credit Chapter 12: Consumer and Small-Business Lending Chapter 10

The Traditional Approach to Business Lending: Theory and Practice CHAPTER 10 The Traditional Approach to Business Lending: Theory and Practice Chapter 10

LEARNING OBJECTIVES TO UNDERSTAND… What credit risk is and why it is so important to banks Lender-borrower agency problems and incentive problems in financial contracting The five Cs of creditworthiness and the focus of credit analysis on cash flow The measurement of credit risk through the loan-review process Risk-based pricing and the measurement of risk-adjusted returns The importance of a bank’s credit culture and loan policies Chapter 10

CHAPTER THEME The major risk banks must measure, monitor, and manage is credit or default risk Since lenders are outsiders, they have a difficult time monitoring what borrowers (insiders) are doing and what they plan to do Credit analysis, loan pricing, and loan review attempt to minimize these agency problems by determining creditworthiness, pricing risk, and monitoring existing borrowers Chapter 10

Traditional Bank Lending Four Components: Originating Funding Servicing Monitoring Chapter 10

The “Five Cs of creditworthiness” Character (honesty, ethical reputation) Capacity (cash flow) Capital (real net worth) Collateral Conditions (vulnerability to economic fluctuations, especially downturns) Chapter 10

Lender-Borrower Agency Problems Lenders are directly concerned with borrowers repaying their loans on a timely basis Lenders must investigate and monitor activities of would-be and existing borrowers “Contractual Frictions” can arise because of moral hazard, adverse selection, or asymmetric information Chapter 10

Bank Risk Management Objective of the lending function is to create value of the bank Danger in granting credit is that the borrower will not repay on a timely basis Many U.S. bank failures in the 1980s relate to credit risk linked to fraud and insider abuse Chapter 10

How the Stock Market Views Credit Risk Banks with lower loan losses have higher stock prices and vice versa Box 10-1, p. 309, provides details Results are not surprising given the importance of loans in a bank’s portfolio of earning assets Chapter 10

Credit Risk and a Bank’s Risk Index (RI) RI = [E(ROA) + CAP]/sROA Since poor loan quality reduces a bank’s expected earnings, eats up its capital, and increases the variability of its earnings, banks with high loan losses will have low RIs and larger Pr(BVE<0) Bottom line: Too much credit risk will kill a bank but not enough will retard its earnings Chapter 10

General Model of Default Risk d = f[I, CF, NW, G] d = probability of default I = information quality, which is a function of character, C CF = cash flow, level and stability NW = real net worth G = guarantee Chapter 10

External Guarantees and Loan Pricing A guarantee may be added to a risky loan so it becomes free of default risk and can be expressed as: Risky Loan + Loan Guarantee = Risk-Free Loan By definition, the value of the guarantee must equal the default-risk premium associated with the risky loan Chapter 10

Loan Pricing r* = [(1+r)/(1-d)] -1 r* = risky loan rate r = risk-free rate d = probability of default If d = 0, then r* = r Also defining s as the survival rate, it equals 1-d Chapter 10

Recovery Rate (lambda, λ) If a loan defaults, normally some recovery of principal occurs, which can be called the recovery rate and expressed as λ (lambda) To account for recovery, we have: r* = {[(1+r)-λd]/(1-d)] – 1, or using s, r* = {[(1+r)-λ(1-s)]/s] – 1 Chapter 10

Examples Insert LAU slides Chapter 10

External Conditions, Customer Relationships, and Forbearance A major difference between intermediated finance (banking) and direct finance (capital markets) is that when adverse external conditions occur, bankers tend to practice forbearance, which is a function of the strength of the bank-customer relationship Chapter 10

Credit Analysis Credit analysis is the evaluation of the financial history and financial statements of credit applicants, designed to assess creditworthiness. Its purpose is threefold: Determine the financial strength of the borrower Estimate the “probability” of full repayment (the opposite of the probability of default, d, therefore, 1-d or the survival rate, s, as discussed above) Determine whether collateral or a co-signer is needed to secure the loan Chapter 10

Four Pillars of Credit Analysis Cash Flow Assessment of Management Forecasting Business and competitive environment Chapter 10

ROE Decomposition Analysis ROE = ROA x EM (stage 1) ROE = PM x AU x EM (stage 2) ROE = Return on Equity PM = Profit Margin ROA = Return on Assets AU = Asset Utilization EM = Equity Multiplier Chapter 10

Analysis of Cash Flow Why should lenders study cash flow? Since cash repays debt and today’s loans are repaid with tomorrow’s cash, cash flow plays a critical role in credit analysis and in determining who gets credit Borrowers have four sources of loan repayment: Cash from operations Cash from sale of assets Cash from refinancing (debt) Cash from a third party (debt or equity) Chapter 10

Keys Items in the Cash-Flow Statement Gross Cash Profit = Cash From Sales – Cash Production Costs Net Cash Income = Gross Cash Profit – Operating Expenses – Taxes Cash After Debt Amortization = Net Cash Income – Debt Repayment Financing Surplus (Requirement) = Cash After Debt Amortization – Capital Expenditures – Long-Term Investments Total External Financing (to meet financing requirement, if any, in item 4) Cash After Financing Reconciled to the Actual Change in Cash Chapter 10

Cash-Flow Construction Work through the application to Strategic Electronics Corp. using Tables Tables 10-2 and 10-3, p. 322, and Table 10-4, p. 324 Critical concepts: Fundamentals and Swing Factors Chapter 10

Critical Concept: Fundamentals Fundamentals include 1. Gross margin = gross profits/net sales 2. Expense control = SG&A expense/net sales SG&A = selling, general, and administrative Chapter 10

Critical Concepts: Swing Factors (3) Net accounts-receivable days (NARD = (AR/sales) x 365) Days inventory on hand (DIH = (INV/COGS) x 365) Accounts-payable days (APD = (AP/COGS) x 365) COGS = cost of goods sold Chapter 10

Ratio Analysis and Growth Variables Net Sales Growth Gross Margin or Profit SG&A (Selling, General, and Administrative) Expense Operating Profit Margin Current Ratio Quick or Acid-Test Ratio Debt/Net Worth – a measure of leverage Net Accounts Receivable Days (NARD) Days Inventory on Hand (DIH) Accounts Payable Days (APD) Chapter 10

Progression to Statement of Cash Flow Balance Sheet ►Income-Expense or Profit-and-Loss Statement ► Sources and Uses of Funds Statement ► Cash-Flow Statement First Two Statements Provide Inputs for the Sources and Uses: Sources of Funds (Source of Cash) Use of Funds (Use of Cash) Revenue Expense Decrease in Assets Increase in Assets Increase in Liabilities Decrease in Liabilities Increase in Capital Decrease in Capital Chapter 10

Credit Analysis and the Job of a Credit Analyst Credit Analyst – Assess the financial performance (past, current, and projected or pro forma) of credit applicants to determine their creditworthiness. Four key areas in a credit memo that a credit analyst would construct in their analysis: Management (who are we lending to?) Company Operations (what do they do and how do they do it?) Industry (what does the company face?) Financial Performance (what is quantitative ability to repay?) Chapter 10

Measuring Credit Risk and Loan Quality: Loan Review Prescribe a methodology (micro vs. macro) Determine the adequacy of the loan-loss reserve (LLR) or allowance for loan and lease loss (ALLL) Adjust PLL, the flow variable, to meet the target ALLL Chapter 10

Indicators of Loan Quality Net loan losses ALLL relative to nonperforming loans Percentage of examiner classified/ criticized loans Chapter 10

Classified/Criticized Loans Banks are examined by their regulators and assigned CAMEL ratings based on their performance. Loans or assets considered loss, doubtful, or substandard are sometimes described as “classified” while “special mention” loans are labeled as “criticized”. Problem banks have CAMEL ratings of 3, 4, or 5 (5 being the weakest). Chapter 10

Risk-Based Pricing Risk-based pricing requires lenders a rate that compensates for the riskiness of the loan. The idea is straightforward: AAA borrowers pay less for credit than BBB borrowers and so on. Implementation for banks is not that easy so many banks do not attempt to fine tune their risk-based pricing. Chapter 10

Risk-Adjusted Return on Capital (RAROC) Technique pioneered by Bankers Trust of New York to precisely price credit risk. Idea is to compare a loan’s expected income, including fees, to its risk amount. RAROC = E(Y)/L* E(Y) = one-period expected income on a loan L* = amount of the loan at risk For example, if E(Y)=10 and L*=100, the RAROC is 10% Chapter 10

Limiting Risk Exposure Asset restrictions View in terms of the option-pricing model of default risk (Fig. 10-3, p. 334) Monitoring Broker margin loans are effectively monitored because of Possession of the collateral Marking the collateral to market Right to liquidate the collateral to meet margin calls Contrast these with what bankers have/can do Chapter 10

Risk-Adjusted Returns (RAR, 1993-1996) RARi = (Ri – Rf)/σi Financial asset RAR Loan-pricing index 2.80% High-yield bonds 2.25 S&P 500 1.40 Mortgage bond index 0.50 T-bond index 0.45 Chapter 10

Monitoring Technology and the Borrower-Information Continuum Inside debt (low info and costly to obtain) Intermediated debt (middle ground) Public debt (high info and low cost) Figure 10-4, p. 339 Commercial paper as a substitute for bank loans (Box 10-3, p. 340) Chapter 10

The Lending Function as the Prevention, Identification, and Resolution of Problem Borrowers Prevention – refers to the decision to grant or not to grant credit Identification – refers to the monitoring of existing borrowers for signs of weakness. Resolution – refers to working out problem loans. Chapter 10

Spilled Milk and the Psychology of Loan Workouts Denial Anger Bargaining Depression Acceptance Chapter 10

A Bank’s Written Loan Policy General Policies, Specific Loan Categories, Miscellaneous Loan Policies, Quality Control, and Committees Chapter 10

CHAPTER SUMMARY The major risk banks face is credit risk, which is the uncertainty associated with borrowers’ loan repayments A bank’s risk index (RI = [E(ROA) + CAP]/sROA] highlights the adverse effects of mismanaged credit risk as loan losses reduce expected earnings, eat up capital, and increase the volatility of earnings Credit analysis, risk-based pricing, and loan review represent three ways for managing credit risk Chapter 10

Chapter Summary (concluded) Regulatory discipline focuses on the quality of banks’ loan portfolios in two ways: 1. Classified loans (substandard, doubtful, loss) 2. Risk-based capital requirements: Credit risk and bank capital Market discipline rewards banks with lower loan losses via higher stock prices and punishes banks with higher loan losses via lower stock prices Chapter 10