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Overview

Overview.

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Overview

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  1. 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.

  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. • 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] • si = ULi = sDi × LGDi = [EDFi(1-EDFi)]½ × LGDi • 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 • 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.

  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 ]

  13. 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.

  14. Pertinent Websites • For more information visit: Federal Reserve Bank www.federalreserve.gov KMV www.kmv.com Moody’s www.moodys.com National Association of Insurance Commissioners www.naic.org Standard & Poors www.standardandpoors.com

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