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BUFN 722

BUFN 722. ch-12 Credit Risk Loan Portfolio and Concentration Risk. outline. Simple Models of Loan Concentration Loan Portfolio Diversification and Modern Portfolio Theory (MPT) KMV Portfolio Manager Partial Applications of Portfolio Theory Loan Loss-Ratio Models Regulatory Models

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BUFN 722

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  1. BUFN 722 ch-12 Credit Risk Loan Portfolio and Concentration Risk BUFN722- Financial Institutions

  2. outline • Simple Models of Loan Concentration • Loan Portfolio Diversification and Modern Portfolio Theory (MPT) • KMV Portfolio Manager • Partial Applications of Portfolio Theory • Loan Loss-Ratio Models • Regulatory Models • Summary BUFN722- Financial Institutions

  3. 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. BUFN722- Financial Institutions

  4. Simple Models of Loan Concentration • Migration analysis • Track credit rating changes within sector or pool of loans. • Rating transition matrix. BUFN722- Financial Institutions

  5. 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 BUFN722- Financial Institutions

  6. 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. BUFN722- Financial Institutions

  7. Diversification and Modern Portfolio Theory • Applying portfolio theory to loans • Using loans to construct the efficient frontier. • Minimum risk portfolio. • Low risk • Low return. BUFN722- Financial Institutions

  8. 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. BUFN722- Financial Institutions

  9. Modern Portfolio Theory BUFN722- Financial Institutions

  10. KMV Portfolio Manager Model • Ri = AISi - E(Li) = AISi - [EDFi × LGDi] • si = ULi = si × LGDi = [EDFi(1-EDFi)]½ × LGDi • rij = correlation between systematic return components of equity returns of borrower i and borrower j. BUFN722- Financial Institutions

  11. 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. BUFN722- Financial Institutions

  12. Partial Applications • Loan volume-based models (continued) • Provide market benchmarks. • Standard deviation measure of loan allocation deviation. BUFN722- Financial Institutions

  13. 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 ] BUFN722- Financial Institutions

  14. 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. • Diversification limits. BUFN722- Financial Institutions

  15. Pertinent Websites • For more information visit: Federal Reserve Bank www.federalreserve.gov KMV www.kmv.com For information on migration analysis, visit: Moody’s www.moodys.com Standard & Poors www.standardandpoors.com Web Surf BUFN722- Financial Institutions

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