1. Credit Risk: Loan Portfolio and Concentration Risk Chapter 12 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. K. R. Stanton

2. McGraw-Hill/Irwin 12-2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Overview  This chapter discusses the management of credit risk in a loan (asset) portfolio context. It also discusses the setting of credit exposure limits to industrial sectors and regulatory approaches to monitoring credit risk. The National Association of Insurance Commissioners has also developed limits for different types of assets and borrowers in insurers’ portfolios.

3. McGraw-Hill/Irwin 12-3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

4. McGraw-Hill/Irwin 12-4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources  For information on migration analysis, visit: Standard & Poors www.standardandpoors.com www.standardandpoors.com Moody’s www.moodys.comwww.moodys.com

5. McGraw-Hill/Irwin 12-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

6. McGraw-Hill/Irwin 12-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. Some countries, such as Chile, specify limits by sector or industry

7. McGraw-Hill/Irwin 12-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Diversification & Modern Portfolio Theory  Applying portfolio theory to loans Using loans to construct the efficient frontier. Minimum risk portfolio.  Low risk  Low return.

8. McGraw-Hill/Irwin 12-8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

9. McGraw-Hill/Irwin 12-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Modern Portfolio Theory Expected Return: Variance:

10. McGraw-Hill/Irwin 12-10 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. KMV Portfolio Manager Model KMV Measures these as follows: R i = AIS i - E(L i ) = AIS i - [EDF i × LGD i ]  i = UL i =  Di × 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.

11. McGraw-Hill/Irwin 12-11 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Partial Applications of Portfolio Theory  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.

12. McGraw-Hill/Irwin 12-12 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Partial Applications  Loan volume-based models (continued) Provide market benchmarks.  Standard deviation measure of loan allocation deviation.

13. McGraw-Hill/Irwin 12-13 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Loan Loss Ratio-Based Models  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 ]

14. McGraw-Hill/Irwin 12-14 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulatory Models  Credit concentration risk evaluation largely subjective.  Life and PC insurance regulators propose limits on investments in securities or obligations of any single issuer. General diversification limits.

15. McGraw-Hill/Irwin 12-15 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pertinent Websites  For more information visit: Federal Reserve Bank www.federalreserve.gov www.federalreserve.gov KMV www.kmv.comwww.kmv.com Moody’s www.moodys.comwww.moodys.com National Association of Insurance Commissioners www.naic.orgwww.naic.org Standard & Poors www.standardandpoors.com www.standardandpoors.com