Question

Distinguish between credit risk of individual loans and the credit risk of loan portfolios. How are they related?

Answer 1

One of the major risks that banks must measure, monitor and manage is credit or default risk. Credit risk is 'the potential a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.

Individual loan credit risk

1. When lenders offer mortgages, credit cards, or other types of loans, there is a risk that the borrower may not repay the loan. Similarly, if a company offers credit to a customer, there is a risk that the customer may not pay their invoices. Credit risk also describes the risk that a bond issuer may fail to make payment when requested or that an insurance company will be unable to pay a claim.
2. Credit risks are calculated based on the borrower's overall ability to repay a loan according to its original terms. To assess credit risk on an individual consumer loan, lenders look at the five Cs: credit history, capacity to repay, capital, the loan's conditions, and associated collateral.
3. All the financial institutions including companies have established departments solely responsible for assessing the credit risks of their current and potential customers. Significant resources and sophisticated programs are used to analyze and manage risk.
4. The lender may also use the third party provided intelligence. Companies like Standard & Poor's, Moody's, Fitch Ratings, Rapid Ratings International etc. provide such information for a fee.
5. Individual (Consumer) Loans are of following types :-
   • Consumer loans: personal, home, auto, credit card
   – Non-revolving loans :- Automobile, mobile home, personal loans
   – Revolving loans :- Credit card debt (i.e., Visa, MasterCard)
     Proprietary cards, such as Sears and AT&T
6. Other loans include:
   – Farm loans
   – Other banks
   – Nonbank FIs, such as broker margin loans
   – Foreign banks and sovereign governments
   – State and local governments
7. Availability, quality, and cost of information are critical factors in credit risk assessment of individual loans.
8. Qualitative models consider borrower specific factors as well as market, or systematic, factors. Borrower-specific factors include reputation, leverage, volatility of earnings, and collateral of the individual borrower. Market specific factors include business cycle and interest rate levels of the borrowing firm.
9. Credit scoring models/ linear probability models are quantitative models that use borrower characteristics to gauge an applicant’s probability of default.
   There are also other credit risk measuremnet modesl i.e. Logit models – It overcomes weakness of the linear probability model by restricting the estimated range of default probabilities from the linear regression model to lie between 0 and 1. Quality of credit scoring models have improved over time, providing positive impact on controlling write-offs and default.
10. Another credit risk measuring model is Mortality Rate Models. In this model, similar to the process employed by insurance companies to price policies; the probability of default (or mortality rate) is estimated from past data on defaults. Marginal Mortality Rates:-
    MMR1  = (Value Grade B default in the year 1) / (Value Grade B outstanding year 1)
    MMR2 = (Value Grade B default in year 2) / (Value Grade B outstanding year 2)
11. One of the widely used credir risk measurement model is Risk-adjusted return on capital (RAROC). Loan risk is estimated from loan default rates, or using duration.For denominator of RAROC, duration approach is used to estimate loss in value of the loan.

Credit risk differs from banking portfolio and trading portfolio. Some of the financial products where credit defaults can take place are loans given to the retail customers, small or medium (SME) businesses or large borrowers. In the banking portfolio risk of default of a small number of important customers can generate higher losses which may potentially lead to insolvency of a financial institution. Such defaults can be of different types such as, a) default in payment obligation, b) restructuring of loan due to major deterioration of the credit standing of the borrower, or c) bankruptcies of the borrowing fiems.
For the majority of banks loans given to individuals or corporate firms are the most obvious source of credit risk; however banks may face credit risk in trading portfolio i.e. in security market, foreign exchange transactions, financial futures, swaps, etc. Unlike the loans in banking book, the credit risk of traded debts is indicated by the agencies' ratings, assessing the quality of public debt issues or through changes in the value of stock market.

Lenders mitigate Individual loan credit risk in a number of ways, including:

• Risk-based pricing – Lenders may charge a higher interest rate to borrowers who are more likely to default, a practice called risk-based pricing.
• Covenants – Lenders may write stipulations on the borrower, called covenants, into loan agreements, such as:- Periodically report its financial condition,
  Refrain from paying dividends, repurchasing shares, borrowing further, or other specific, voluntary actions that negatively affect the company's financial position, and
  Repay the loan in full, at the lender's request, in certain events such as changes in the borrower's debt-to-equity ratio or interest coverage ratio.
• Credit insurance and credit derivatives – Lenders may hedge their credit risk by purchasing credit insurance or credit derivatives. The most common credit derivative is the credit default swap.

Loan Portfolio Credit Risk

• Loan portfolios are the major asset of banks, thrifts, and other lending institutions. The value of a loan portfolio depends not only on the interest rates earned on the loans, but also on the quality or likelihood that interest and principal will be paid. A portfolio loan is a loan that is serviced by the lender that issued the money.
• In many cases, loans that are issued by a lender are packaged together with other loans and sold in the secondary market to form loan portfolio.
• Typically, those loans that have a good credit score and are considered to be a good credit risk are those that are considered to be eligible for being part of a portfolio. Lenders like to keep those loans that have a good credit history on hand because it lowers the amount of risk in the portfolio.
• Freddie Mac and Fannie Mae are two of the most prominent players in this market; they purchase portfolios of loans, which originate as residential mortgages, from banks and credit unions. This, in turn, helps these financial institutions improve their liquidity by turning loans into cash, which can then be used to make additional loans. Freddie Mac and Fannie Mae perform due diligence on the pooled loans to make sure that they meet their credit requirements and are appropriately documented.
• A financial institution can diversify part of the credit risk by an intelligent composition of the loan portfolio across regions, industries and countries. Thus in order to assess credit risk of a loan portfolio, a bank must not only investigate the creditworthiness of its clients, but also identify the concentration risks and possible co-movements of risk factors in the portfolio.
• For an appropriate measure of risk/return on the portfolio loan exposure, we need to accurately measure the credit loss volatility. Only then can we price an exposure appropriately. The loss volatility is optimum when the portfolio is diversified.
• Correlation is an important measure of credit risk. The classical linear correlation coefficient is an inadequate measure of dependence between defaults in a portfolio of loans.
  Correlation is of two types – correlation across the borrowers on credit loss or credit drivers, and correlation of credit drivers with each other.
• Management of credit risk in a loan (asset) portfolio comprises of following steps:-
  Setting credit exposure limits
  Regulatory approaches to measuring credit risk
  NAIC has set limits for different types of assets and borrowers in insurers’ portfolios.
• To manage credit risk of portfolio of loans, there are two loan concentration models:-
  Migration analysis - It tracks credit rating changes within sector or pool of loans . Uses Rating transition matrix which reflects history of ratings changes. This analysis is widely applied to commercial loans, credit card portfolios, and consumer loans.
  Cincentration Analysis - Concentration limits are placed on loans to individual borrower or sector. Concentration limit = maximum loss / loss rate ; ( Maximum loss expressed as percent of capital) .
  FIs typically set geographic concentration limits.
• One example credit risk measure for loan portfolio developed by Credit Suisse Financial Products based on insurance literature.
  In this measure :- Losses reflect frequency of event and severity of loss, Loan default is random, Loan default probabilities are independent. This measure is appropriate for large portfolios of small loans This measure is modeled by a Poisson distribution.

Managing Risks at Portfolio Level

The two-step treatment for portfolio risks is as follows:

Portfolio/correlation risks

Step I: Identify risk concentration at the portfolio level (as a first level to recognize correlation)

• Use of securitization
• Use of credit derivatives

Step II: Measure concentration risks

• Assume, either explicitly or implicitly, average correlations across the whole or large parts of the credit portfolios. While this approach is sensitive to large, single exposures, it is insensitive to the build-up of industry and geographic risk concentrations.
• Estimate credit quality correlations based on a multi-factor analysis of equity market prices. The problem here is averaging out of correlation over a period of time.

There can be two types of loan portfolios : a portfolio whose repayment is driven by the income generated by the assets or, a portfolio whose repayment is driven by income generation and sale of the collateral.

Traditionally, banks have focused on oversight of individual loans in managing their overall credit risk. While this focus is important, banks should also view credit risk management in terms of portfolio segments and the entire portfolio.
Effective management of the loan portfolio’s credit risk requires that the board and management understand and control the bank’s risk profile and its credit culture. To accomplish this, they must have a thorough knowledge of the portfolio’s composition and its inherent risks, the portfolio’s product mix, industry and geographic concentrations, average risk ratings, and other aggregate characteristics. They must be sure that the policies, processes, and practices implemented to control the risks of individual loans and portfolio segments are sound and that lending personnel adhere to them.