Asset Quality

Upcoming

1. Theory of Bank Credit

2. Analyzing Bank Credit Risk

3. Credit Process

4. Credit Derivatives

Asymmetric Information & Adverse Selection

• Asymmetric Information A condition that occurs when borrowers have some information about their opportunities or activities that they do not disclose to lenders, creditors or insurers.

• Adverse Selection – The problem created by asymmetric information before a transaction occurs: The people who are the most undesirable partners from the point of view of one party are also the most likely to want to engage in a particular financial transaction.

Lemon Problem: Used Cars

• Two indistinguishable (to buyers) types of cars: lemons (often breaking down) and creampuffs (never breaking down).

• If buyers will pay $3000 for a creampuff and $3000 for a lemon.

• Sellers will part with a creampuff for $2500 and part with a lemon for $1000.

• One third of cars are creampuffs and two thirds are lemons.

Symmetric Information

• If borrowers and sellers both can easily distinguish lemons from creampuffs, there is a simple market solution. – Buyers will pay $3000 for a

creampuff and $2000 for a lemon and sellers will be happy to sell.

• If neither borrowers nor sellers can distinguish between types, there is still a solution.– Buyers could pay the

average of their values (⅔∙$2000)+(⅓∙$3000) = $2,333.

– This would be higher than the average value to sellers: (⅔∙$1000)+(⅓∙$2500) = $1500.

Asymmetric Information

• What happens if buyers cant distinguish between types but sellers can?

• Buyers might be willing to offer $2,333 for a car of unknown type, but owners of creampuffs would value their car more highly than that. Only lemon owners would sell at that price. Buyers would have no reason to offer more than $2000. Only lemons will be bought and sold.

• No market for creampuffs will exist.

Lemon Problem: Bond Market

• Some firms have risky prospects (lemons) and some firms have safe prospects (creampuffs).

• Bond buyers cannot distinguish between them. They offer bond prices which are an average of the price of creampuff bonds and lemon bonds. [Another way of putting this is that interest rates are an average of creampuff and lemon rates].

• Potential borrowers with creampuff prospects may finance their own projects.

Raising Interest Rates May Not Compensate for Risks in Bond Markets

• Only borrowers with lemon prospects will join bond markets.

• Typically we think bond buyers might take riskier assets if they were offered a higher interest rate.

• But if savers demand a higher interest rate under asymmetric information this will only exacerbate the lemon problem if higher interest rates drive creampuff borrowers out of the market.

Adverse Selection: The Bond Market

Consider a bond market with three types of bond sellers.

1. Safe: Financing a safe, low-return project. Can only pay 7.5% interest rate but will never default.

2. Speculative: Financing a high risk/high return project will pay a 15% interest rate, but a high probability of default.

3. Crooks: Will offer to pay any interest rate, but will never repay.

Assume that 75% of bond issuers are safe, 20% of bond issuers are speculative, and just 5% are crooks.

Bond Buyers• Bond buyers will pay:

– 97 for a discount bond issued by a borrower identified as safe;

– 90 for a bond issued by a borrower identified as speculative

– 0 for bond issued by a crook.

• If they cannot distinguish, they will pay a value equal to the expected value of the pool.

• In this pool, the expected value is (.75*97)+(.2*90)+(0.05*0) = 90.75 which implies a yield to maturity of i = .102.

Borrower Investorwill Pay will pay or get

Share at Most at Most at least

Safe 0.75 7.50% 97 1.030928 3.09%Speculative 0.2 15% 90 1.111111 11.11%Crook 0.05 Anything 0 ∞

Unknown Type 90.75 1.101928 10.19%

Bond market breaks down!

• Rate of interest offered by uninformed investor is attractive to speculative borrowers but to expensive for safe borrowers.

• They will drop out of the market. As bond buyers begin to realize the riskiness of pool is changing, they will reassess price that they will pay for bonds.

• The pool will now be 80% speculative and 20% crooks. The expected value of bonds in this pool is (.8*90)+(.2*0)=72 implying a yield of i = .3889. This is too much for speculative borrowers.

• Only crooks will stay in the market. Ultimately the bond market will disappear.

Adverse Selection

• Actions that lenders take to protect themselves from consequence of a lack of information lead to a worsening of the risk pool.

• In the extreme case, adverse selection can cause an entire market to disappear.

Business of Banking & Comparative Advantage

• Comparative advantage of banking. • Banking exists as a specialist in acquiring

information and eliminating adverse selection problems.

• A key comparative advantage of banks is their ability to evaluate information on borrowers.

• Banking business should attempt to make best use of that advantage.

Credit Risk: the risk that a borrower will not pay back interest or

principal on a loan. Evaluating Bank Credit Risk

• History of Credit Performance (Charge-offs)

• Future expected losses (non-performing loans, types of lending, diversification)

• Current Strength of bank preparation (reserves, earnings coverage).

Net Charge-offs to Loans

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

Total loans &leases

Total real estateloans

Commercial &industrial loans

Loans to individuals All other loans &leases (including

farm)

2007 2006 2005 2004

Statistic on Depository Institutions

Stages of Bad Loans• Past Due Loans: Loans for which contracted

payments have not been made, but which still are accruing interest. – More than 90 days past due is Nonperforming Loans

• Nonaccrual Loans: Loans that are habitually past due and no longer accruing interest.

Total Noncurrent = Past Due + Nonaccrual • Charge-offs: Loans written off as uncollectable• Recoveries: Sums later collected on loans

written off.

Net Chargoffs = Charge-offs - Recoveries

Past Due Loans(Contractual Payment not

Made)90 Days Non Performing

Loans

Full Payment

Not Expected

Non-accrual Loans

Non Current Loans

TotalChargeoffs

Uncollectible Loans

Written off

Collection Process

Recovery

NetChargeoffs

Non Current Assets to Loans

0.00%0.20%0.40%0.60%0.80%1.00%1.20%1.40%1.60%1.80%

Total loans &leases

All real estateloans

Commercial &industrial

loans

Loans toindividuals

All otherloans &leases

(includingfarm)

Commercialreal estateloans not

secured byreal estate

2007 2006 2005 2004

Statistic on Depository Institutions

Measuring a Banks Credit Risk/Key Ratios

• Loans are assets with the most credit risk (also the most profitable). Other types of assets are typically more transparent and have less risk of default.

• Large quantities of loans make banks riskier.

Higher Loans to Assets means higher risk.• Rapid expansion of credit means banks may not

be discriminating

Higher Loan Growth Rate means higher riskMeasure banks chargeoffs, loan composition, non-performing & non current loans, earnings coverage, loan loss allowances on page 8 & page 9 of UBPRs.

Composition of a Banks Loan Portfolio

• Some loans are riskier than others, so a high share of loans in risky categories involves higher risk.– Banks concentrate on real estate lending

which tends to have very low default rates.

• An undiversified portfolio also exposes a bank to risk. Concentration in the property market exposes the bank to systematic risk of property collapse.

Protection

• Banks protect themselves from credit risk with reserves allocated to loan losses. Measures of these reserves measure banks protection against credit risk

1. Loan Loss Allowance/Loans2. Loan Loss Allowance/Net Chargeoffs

• Banks earnings are also a protection against losses

Earnings Coverage = (NII-Burden)/Net

Chargeoffs

Protection from Bad LoansUS Commercial Banks, 2004

0

1

2

3

4

5

6

7

2004 2003 2002 2001

Loan Loss/Net Charge Offs Earnings/Net Charge Offs Loan Loss/Gross Loans (%)

Source: SDI, FDIC Statistics on Depository Institutions, FDIC

Credit Process

I. Credit Policy

II. Business Development and Credit Analysis .

III. Credit Execution

IV. Loan Review

I. Credit Policy

• Loan Policy

• Loan Culture 1. Values Driven – Risk Averse

2. Current Profit Different – High risk/return lending, Cyclical Profits

3. Market Share Driven – Low returns, large scale.

Written Loan Policy • FDIC recommends, “ A loan policy should address:”

– General fields of lending – Normal trade area – Lending authority of loan officers and committees – Responsibility of the board of directors in approving loans – Guidelines for portfolio mix, risk diversification, appraisals,

unsecured loans, and rates of interest – Limitations on loan-to-value, aggregate loans, and overdrafts – Credit and collateral documentation standards – Collection procedures – Guidelines addressing loan review/grading systems and the

allowance for loan and lease losses – Safeguards to minimize potential environmental liability

•Source http://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune_up.html

Business Development & Credit Analysis

• Marketing – Find customers• Loan Interview – Meet potential borrower and

evaluate for character and sincerity• Evaluation of Business – Gather information

about the borrowers business. • Credit Analysis: Numerical analysis of a

businesses financial condition• Evaluation of Collateral Adequacy: Check

whether collateral that backs loans is of value commensurate with loan.

Credit Scoring Models• Banks use numerical models to evaluate

the credit of borrowing firms. Seminal model was the Z-score model of Edward Altman

• WC – Working Capital to Assets

• RE: Retained Earnings to Assets

• ROA: EBIT/Assets

(1.2 ) (1.4 ) (3.3 )

(0.6 ) (.999 )

Z WC RE ROA

Equity AT

•Equity: Market to Book Ratio

•AT: Asset Turnover- Sales to Assets

Above 3, bankruptcy unlikely; below 1.8 bankruptcy likely.

FICO

• In USA, Fair Isaac Corp. develops models that evaluate consumer households likelihood of default.

• FICO or similar score used for consumer credit– Late payments – The amount of time credit has been established – The amount of credit used versus the amount of credit available – Length of time at present residence – Negative credit information such as bankruptcies, charge-offs,

collections, etc.

• In Hong Kong, recent relaxation of some rules governing sharing of consumer credit information.

5 C’s of Credit

1. Character – Past history of borrower in paying bills.

2. Capital – Borrowers Wealth Position3. Collateral – possession by the borrower of

assets that back up the loan.4. Conditions - trends and volatility of the

borrower’s industry5. Capacity – Legal Standing and ability of

the borrower to generate loan payments on a consistent basis

III. Execution

• Documentation– Loan Agreements

• Restrictive Covenants

– Perfecting Claims to Collateral

Parts of a Typical Loan Agreement

• The Note: Specifies the principal and the interest and the timing of repayment.

• Collateral: Specifies assets assigned and terms under which lender takes possession of assets.

• Covenants• Borrower Guarantees. • Events of Default: Exact conditions under

which a loan is considered in default.

Loan Covenants

• A central part of the credit process is the monitoring of borrowers.

• Banks restrict borrowers use of funds in the loan agreement.– Affirmative Covenants. Actions that the borrower must

take. Maintaining liquidity and equity as measured by financial ratios, maintaining insurance, file financial reports, pay taxes, etc.

– Negative Covenants. Actions that the borrower cannot take. Taking on new debt, buying or selling assets, paying excessive dividends, paying excessive salaries or bonuses, etc.

IV. Credit Review

• Monitor Covenants

• Loan Review Process– Ex post evaluations of lending evaluation

• Loan Workout– Process for dealing with defaulting creditors

Credit Derivatives

Risk Management Tools Used to transfer risk from one party to another.

• Credit Swaps – A bank with credit risk exposure will pay X basis points per year and counter-party will make payment if there is a pre-determined credit “event” such as default or credit downgrade, etc.

• Total Return Swap: Bank with credit risk will pay the income stream from risky debt while counter-party will pay some fixed rate to bank..

Credit Swap

Bank A

Bank B

Fee Payment

Payment if negative credit event

Total Return Swap

Bank A

Intermediary

Bank B

Loan and Principal

Loan and Principal

Loan and Principal Loan and Principal

Credit DerivativesGlobal Credit Derivatives

0

2000

4000

6000

8000

10000

12000

14000

1H01 2H01 1H02 2H02 1H03 2H03 1H04 2H04 1H05

US

$ T

rill

ion

Source: www.credit–deriv.com

Extra Reading

• HKMA Benefits of Sharing Positive Consumer Credit Data

• B. Hirtle, NY FED, 2007, Credit Derivatives and Bank Credit Supply

• BIS 2005 Credit Risk Transfer