1. Irwin/McGraw-Hill 1 Credit Risk: Loan Portfolio and Concentration Risk: Chapter 12 Financial Institutions Management, 3/e By Anthony Saunders

2. Irwin/McGraw-Hill 2 Simple Models of Loan Concentration n Migration analysis Track credit rating changes within sector or pool of loans. Rating transition matrix.

3. Irwin/McGraw-Hill 3 Rating Transition Matrix Risk grade: end of year 123Default Risk grade: 1|.85.10.04.01 beginning2|.12.83.03.02 of year3|.03.13.80.04

4. Irwin/McGraw-Hill 4 Simple Models of Loan Concentration n Concentration limits On loans to individual borrower. Concentration limit = Maximum loss  Loss rate. »Maximum loss expressed as percent of capital.

5. Irwin/McGraw-Hill 5 Diversification and Modern Portfolio Theory n Applying portfolio theory to loans Using loans to construct the efficient frontier. Minimum risk portfolio. »Low risk » Low return.

6. Irwin/McGraw-Hill 6 Applying Portfolio Theory to Loans n Require (i) expected return on loan(measured by all-in- spread); (ii) loan risk; (iii) correlation of loan default risks.

7. Irwin/McGraw-Hill 7 KMV Portfolio Manager Model R i = AIS i - E(L i ) = AIS i - [EDF i × LGD i ]  i = UL i =  i × LGD i = [EDF i (1-EDF i )] ½ × LGD i  ij = correlation between systematic return components of equity returns of borrower i and borrower j.

8. Irwin/McGraw-Hill 8 Partial Applications of Portfolio Theory n Loan volume-based models Commercial bank call 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.

9. Irwin/McGraw-Hill 9 Partial Applications n Loan volume-based models (continued) Provide market benchmarks. »Standard deviation measure of loan allocation deviation.

10. Irwin/McGraw-Hill 10 Loan Loss Ratio-Based Models n Estimate loan loss risk by SIC sector. Time-series regression: [sectoral losses in ith sector] [ loans to ith sector ] =  +  i [total loan losses] [ total loans ]

11. Irwin/McGraw-Hill 11 Regulatory Models n Credit concentration risk evaluation largely subjective. n Life and PC insurance regulators propose limits on investments in securities or obligations of any single issuer. Diversification limits.