Transaction Risk Capital in Commercial

Lending
Barry Belkin, Larry R. Forest, Jr., Scott D. Aguais, and Stephan
J. Suchower

In reference [1] we defined the unexpected total return (UTR)

risk premium associated with a commercial loan. We showed
that if the lender chooses to hold the loan but to transfer the
associated unexpected return exposure to a counterparty, then
the UTR risk premium for the loan can be identified as the
cost of the required UTR swap under risk-neutral pricing.
In what follows we first show how one can impute an
allocation of risk capital to a loan transaction from the UTR
risk premium associated with the loan and the lenders hurdle
rate for excess return on capital. We then relate this imputed
risk capital to that derived from the lender's internal risk
capital rules and explore the properties of imputed risk capital
through a series of simple examples. Finally, we provide two
explicit portfolio management strategies that can be used to
support loan origination decisions and loan hold/sell decisions.
Loan Transaction Risk Capital
Our point of departure is the following definition of the
unexpected total return risk premium associated with a loan
transaction:
(1)
Here, E[V] denotes the expected net present value of the loan
cash flows with respect to the natural probability measure for
risk rating migration process of the borrower and
denotes the counterpart expected net present value of the
loan cash flows with respect to the risk-neutral measure for
the borrower rating migration process. Since the unexpected
1

total return risk premium is the only sense in which we use

the term "risk premium," we will drop the "UTR" designation
in what follows.
Suppose that the lender has set a fixed hurdle rate
for the
return on capital he requires in excess of the risk-free rate .
Let (for
) denote a sequence of valuation times
such that
(not necessarily the time of loan origination)
and
. We then set

Like the loan risk premium at time

capital
allocated to the loan at
risk grade of the borrower:

, the (transaction) risk

depends on the current

Since rating migration is governed by a stochastic process,

future values of the loan risk premium and of risk capital
cannot be predicted with certainty. We therefore have to make
precise the sense in which applying the risk premium to risk
capital yields the return
in excess of the risk-free rate. The
requirement we impose is that if the excess rate of return for
capital is , then for any initial state
the expected
present value of the aggregate dollar amount spent on risk
capital from time forward must be equal to the
corresponding risk premium
.
This leads in a natural way to a recursive procedure for
calculating the risk capital values
. For this, we define:

The risk capital values

premiums by

are then related to the risk

(2)
(Note:
.) The
are based on expected cash flow
present values and can be efficiently determined using
backward recursion methods.
As we have defined it, the risk capital allocated to a loan
transaction is an imputed quantity determined in combination
by (i) the risk premium that is available to support risk capital
and (ii) the cost per unit time to "rent" risk capital. An
immediate question is what relationship this imputed
transaction risk capital bears to that obtained by applying the
lenders internal risk capital rules.
We make the assumption that the lenders par credit spreads
(both spot and forward) are calibrated to his internal risk
capital rules as applied to standardized (option-free) term
loans of varying maturity and credit quality. For these
standardized loans, the imputed risk capital and that specified
by the lenders risk capital rules are the same.
The difficulty arises in applying risk capital rules to loans with
structural complexities, such as the option for the borrower to
prepay, grid pricing, and loan covenants. It is likely that the
lenders risk capital rules lack the resolution to capture such
fine elements of loan structure. We argue that a reasonable
alternative to applying rules that are insensitive to key
elements of loan structure is to impute risk capital in the
manner we have described. The rationale is twofold. First, the
risk premium on which imputed risk capital is based fully
reflects loan structure. Second, the use of risk-neutral pricing
in imputing risk capital is consistent with the absence of
internal arbitrage opportunities within the lenders loan
portfolio. We thus take the point of view that our method for
imputing risk capital to loan transactions is an appropriate
3

way to expand the "repertoire" of the lenders risk capital

rules.
To this point we have focused on the par credit spreads a
lender derives from his internal risk capital rules. These
internal par credit spreads are likely to differ, perhaps
substantially, from those observed in the loan market. A
question then is what risk capital rules is the market applying
to justify its par credit spreads. The market, of course, does
not directly reveal its risk capital rules. However, a set of such
rules is implicit in the market par credit spreads and market
(excess) return on risk capital. (We note that the long-term
average return on capital for the well-diversified "market
portfolio" of corporate stocks as cited in reference [3] is 8.4%
over the risk-free rate.)
To get at these imputed market risk capital rules, consider a
hypothetical lender who holds a well-diversified loan portfolio
approximating the "market portfolio," who sets his par credit
spreads equal to those of the market, and who sets his hurdle
rate for excess return on risk capital equal to the market
excess return on capital. If one applies the methods we have
described for imputing risk capital to the lenders portfolio,
one obtains the imputed market risk capital rules.
In general, a lender should expect to allocate more capital to a
loan than the imputed market capital (and pay more for that
capital than the market rate). By comparing the amount of
risk capital he is required to allocate to a given loan under his
internal risk capital rules with the amount of risk capital the
market would impute to the same loan, a lender can gain
some insight into the penalty he pays for not achieving the
same level of portfolio diversification as the market.
Following [1] we take the view that the lender maintains two
separate internal "accounts": an operating account to manage
loan cash flows and a capital account to support the risk
inherent in those cash flows. The operating account can be
viewed as paying the risk premium to the capital account to
enter into an internal unexpected total return swap as

previously described. This swap transfers all of the risk

associated with the loan cash flows to the capital account.
We carry the analysis a step further by merging the financial
"statements" of the two accounts in order to determine the
consolidated return on risk capital for the loan. It is this
consolidated return that we refer to as the risk-adjusted
return on capital or RAROC value (denoted ) for the loan.
The various definitions we have introduced imply the
relationships summarized in Table 1 below.
Table 1: Relationship Between NPV and RAROC Views of
Loan Value

Expected Cash Flow Into

Capital Account

Risk Premium:

Excess
Return on
Risk Capital

Expected Residual
Value in Operating
Account

Hurdle

Loan Market

Rate:
Consolidated Cash Flow
Value:

RAROC:

Value:
0

The most important of the relationships in Table 1 is that

between the NPV view and the RAROC view of loan value:
(3)
Equation (3) states that a par loan, i.e., a loan that has zero
expected net present value under market (risk-neutral)
valuation, is equivalently a loan that yields the lenders hurdle
rate as its RAROC value. This parity between the NPV and
RAROC views of loan value is a consequence of our

assumption that a par loan must yield the lenders hurdle rate
as return on risk capital.
Numerical Examples
We now turn to some simple numerical examples to
investigate the effect of loan price and structure on risk
capital and RAROC. We restrict attention to an option-free
two-year term loan with $10,000 principal and annual cash
flows. We assume a seven passing grade credit rating system
and par credit spreads, a deterministic value of 40% for loss in
the event of default (LIED), and a constant risk-free rate of
4.5%. We neglect loan origination/monitoring costs and
operating expense. In addition, we take the lender hurdle rate
for excess return on capital to be 15%.
In Table 2 below we show how risk capital is affected by the
remaining loan term. We consider three variations: (i) the
(fixed) risk capital for a one-year loan, (ii) the first year risk
capital for a two-year loan, and (iii) the expected second year
risk capital for a two-year loan.

Table 2: Effect of Remaining Loan Term on Transaction

Risk Capital
Borrower Risk Rating at
Loan Origination
Aaa

Aa

Baa

Ba

Caa

One-Year
Loan: Risk
Capital

$.68

$2.00 $7.33 $14.6 $66.6

7
7

$300.
00

$733.
33

Two-Year
Loan: Year 1
Risk Capital

$.68

$2.00 $7.35 $14.7 $67.0

4
4

$301.
89

$741.
01

Two-Year
Loan:

$.97

$2.67 $8.44 $19.4 $78.9

5
1

$285.
99

$593.
22

Expected
Year 2 Risk
Capital

The first observation based on Table 2 is that for each

borrower risk rating at loan origination, the risk capital for
year 1 of the two-year loan is equal to or marginally greater
than the risk capital for the one-year loan. In the first year,
both loans are exposed to the same risk of loss of principal if
default occurs. However, if a first-year default occurs on a
two-year loan, there is the added exposure to the loss (in
present value) of the net loan revenue that would otherwise
have accrued in the second year.
We next observe that in the case of the two-year loan, there is
a significant difference between the first year risk capital and
the expected second year risk capital. For initial rating grades
Aaa through Ba, the expected second year risk capital is
higher. For grades B and Caa, the relationship is reversed, and
the first year risk capital is higher. For grades Aaa through Ba,
the dominant effect is that of possible downward migration
(short of default) in year 1, with a resulting increased
exposure in year 2. For grades B and Caa, the dominant effect
is that of upward migration (reducing the exposure in year 2)
or default (eliminating any exposure in year 2).
The final point to be made based on Table 2 is that variation in
risk capital with borrower rating is far more significant than
the variation in risk capital with the remaining term of the
loan. One observes that risk capital increases by a factor of
about 1,000 in going from a Aaa borrower down to a
Caaborrower, reflecting the much higher probability of
default.
In Table 3 we examine how the risk premium, initial risk
capital, and RAROC for a loan are affected by pricing. The
borrower rating at loan origination is fixed at Caa (the rating
at which the effect of pricing is most pronounced) and the loan
spread is varied in 10 basis point increments about the par
7

spread of 632 bp.

Table 3: Effect of Loan Spread on Risk Premium, Risk

Capital, and RAROC
Loan principal: $10,000
Loan term: 2 years
Initial borrower credit rating:
Caa
Loan Spread
(bps)

Risk
Premium

Initial
Risk
Capital

RAROC

$187.35

$737.52

12.24%

$187.60

$739.26

13.62%

$187.85

$741.01

15.00%

$188.10

$742.76

16.37%

$188.35

$744.50

17.74%

One observes from Table 3 that the loan risk premium, initial
risk capital, and RAROC are each increasing functions of the
loan spread. In each case, the variation is approximately
linear in the
bp neighborhood of the par spread shown.
Both the risk premium and the initial risk capital are seen to
be relatively insensitive to changes in the loan pricing. A 10
bp change in spread induces a $.25 change in risk premium
and a $1.75 change in risk capital.
By contrast, the dependence of RAROC is pronounced about
1.38% increase in RAROC per 10 bp increase in the loan
spread. The overall implication of Table 3 is that very little of a

loan price increase is lost to the associated increase in the

cost of risk capital. Correspondingly, very little of a price
decrease is recovered by the lender through the associated
reduction in the cost of risk capital.
So far, we have focused our attention entirely on the
individual loan transaction. To gain further insight into the
workings of risk capital, it is instructive to consider the
implications of our definition of risk capital at the portfolio
level.
For this purpose, we imagine two banks (A and B), such that
bank A maintains a portfolio of exclusively one-year term
loans, while B maintains a portfolio of exclusively two-year
term loans. Both banks follow the policy of originating loans
only to borrowers with a specific rating grade. Borrowers who
migrate out of the specific rating class (including those who
default) do not have their loans renewed. Rather, they are
replaced by new borrowers with the required rating grade.
Suppose, for example, that banks A and B each decide to
originate loans only to borrowers with risk rating Ba. Under
our assumptions, at any point in time, bank A will hold a
portfolio made up exclusively of Ba loans. Bank B, on the other
hand, will hold a mixture, in roughly equal proportions, of twoyear loans in their first year (all Ba rated) and two-year loans
in their second year (mostly Ba rated).
The question we address in Table 4 is how the risk capital
requirements of the two bank compare. Results are shown for
each possible origination rating grade.
Table 4: Effect of Loan Term on Portfolio Risk Capital
Value shown is average risk capital per $10,000 loan
Borrower Risk Rating at
Loan Origination

Bank A

Aaa

Aa

Baa

Ba

Caa

$.67

$2.00

$7.33

$14.6

$66.6

$300.

$733.

Portfolio:
One-Year
Loans
Bank B
Portfolio:
Two-Year
Loans

$.83

$2.34

$7.89

00

33

$17.0
9

$72.9
3

$294.
10

$670.
72

Interestingly, the results in Table 4 show that which of the two

banks would hold more risk capital depends on the rating
class of borrowers to which they originate loans. If that rating
class is in the range Aaa to Ba, then bank B would require the
greater risk capital. If the two banks decide to go down
market and originate loans only to B or only to Caa borrowers,
then bank A would have to hold the greater risk capital.
In the more realistic case where both banks originated loans
to borrowers of all rating classes but maintained their strict
policies with regard to loan term, which one of the two banks
requires more risk capital would depend on the mix of
borrower ratings in the portfolios of the two banks.
The point to be made from Table 4 is that the decision by bank
B to write only two-year loans does not automatically imply
that bank B must hold more risk capital than bank A, which
writes only one-year loans. This behavior is consistent with
our open-end loan portfolio paradigm, under which the lender
renews maturing loans and originates new loans to maintain
an effective portfolio composition equilibrium. Under the
open-end portfolio paradigm, risk capital is driven by
instantaneous risk exposure.
This contrasts sharply with the closed-end portfolio paradigm,
where the lender is presumed to hold a fixed set of loans until
they mature. If bank A and bank B were operating under the
closed-end paradigm and were seeking to liquidate their
respective portfolios, then it certainly would be the case that
bank B would have the greater cumulative credit risk
exposure and would be forced to hold the larger amount of
risk capital.
10

Risk Capital at the Portfolio Level

The important question remains whether the aggregate
portfolio risk capital that results from these individual capital
allocations at the transaction level is actually adequate to
cover the lenders exposure to credit risk.
There are various ways for a lender to judge the adequacy of
his portfolio risk capital. One approach is for the lender to set
a target value for his rating agency credit grade and then
determine whether he holds sufficient risk capital to justify
that credit grade. A specific risk horizon is chosen (one year is
typical). Relative to this risk horizon, let
denote the value of
the lenders loan portfolio,
denote the risk capital the
lender allocates to his loan portfolio, and denote the
published probability of default for the target risk rating.
Let be the probability distribution for
. Then the test for
the adequacy of the lenders portfolio risk capital is
,
(4)
i.e., the probability must be at most that the lenders
portfolio risk capital will be insufficient to cover any
shortfall
in the value of his loan portfolio relative to
expectation. We denote the
quantile of
by .
Following general practice (see reference [4]), we refer to
as the portfolio value at risk (VAR).
One way to quantify the credit exposure attributable to an
individual transaction is to determine its effect on VAR. For
this we define the following quantities (all relative to the risk
horizon):

11

Then the following relationship holds

.
(5)
If the relative contribution of any single transaction to the
volatility of the overall portfolio is small, then to a close
approximation
(6)
Suppose that has been chosen so that the amount of
portfolio risk capital
produces exact equality in (4) and
just earns the lender his targeted credit rating grade. Then
based on (6), the appropriate amount of risk capital
lender to allocate to transaction i is

for the

(7)
(Note: Since
, equation (7) defines a partitioning of
portfolio risk capital into amounts of transaction risk capital.)
We previously described how to impute an amount of risk
capital to a transaction consistent with the lenders targeted
hurdle rate. Equation (7) provides an alternative way to assign
risk capital to a transaction based on its relative contribution
to the portfolio exposure. We refer to the risk capital as given
by equation (7) as the exposure risk capital allocated to the
transaction.
Our analysis here in combination with that in reference [1]
supports two separate tests to apply to a transaction:
value test: originate (or buy) a transaction if it has a
positive expected net present value under the riskneutral measure calibrated to the market par credit
spreads.
exposure test: hold transaction in portfolio if its
exposure risk capital is less than or equal to its imputed
risk capital.

12

Note that in applying the value test, it is the market par credit
spreads that are relevant since value is measured in relation
to market pricing. A "good" loan to originate is one that the
lender should be able sell at a profit. In applying the exposure
test, it is the lenders internal par credit spreads that are
relevant. A "good" deal to hold is one that is "risk efficient" in
the sense that the actual exposure it adds to the lenders
portfolio is at most that implied by the lenders internal
pricing of risk. Since imputed risk capital and exposure risk
capital are equal for the standardized loans used to calibrate
the lenders internal par credit spreads, the standardized
loans will necessarily pass the exposure test.
We observe that a transaction can pass the value test but fail
the exposure test. The incentive then is for the lender to
originate (or buy) the transaction but then sell it for a quick
profit. The lender does not want to hold the deal in his
portfolio because he does not expect to be adequately
compensated for the incremental exposure it adds to his
portfolio.
It is also the case that certain transactions in the lenders
portfolio can pass the exposure test but fail the value test. For
such a deal, the expected loss is a sunk cost. The lender can
realize the loss by selling the deal immediately or defer the
loss by holding onto the loan. If the lender chooses to hold the
deal, he will at least be adequately compensated for the
incremental risk capital it ties up.
It is certainly possible that many (perhaps most) of the
transactions in a given lenders portfolio will fail the exposure
test. That would suggest an inconsistency between the return
on capital required by the lenders shareholders and the "risk
efficiency" of the portfolio. Given the risk characteristics of
the lenders portfolio, the lenders shareholders may be
unwilling to accept a lower return on risk capital than the
target hurdle rate. The lender would then be obliged to
eliminate from his portfolio those loans that are the most "risk
inefficient" in an effort to improve the portfolio return on
capital.

13

Possible Extensions
There are a number of directions in which our approach to
measuring credit risk can be extended.
We have assumed that LIED is deterministic. The calculation
of the risk-neutral measure for credit rating migration then
follows reference [6]. However, we have been able to extend
the methods of [6] to the case in which LIED is a random
variable with known mean and variance. The definitions of
risk premium, risk capital, and RAROC then directly carry
over.
The risk-free rate used to discount cash flows has been
assumed fixed. It is possible to combine an arbitrage-free
stochastic interest rate model (such as the Heath-JarrowMorton model in reference [7]) with the arbitrage-free credit
migration model we have described to obtain a joint model for
interest rate risk and credit risk. Again, our basic definitions
carry over without change. However, with more state
variables required to describe the stochastic evolution of loan
value, the joint model entails a significant increase in
computation.
Our focus has been primarily on commercial loans. However,
the framework we have described for measuring credit risk
extends to bonds, credit derivatives, and generally to any
structured set of cash flows subject to credit risk. The key
requirement is that one must be able to calculate the expected
net present value of those cash flows under both the natural
and risk-neutral rating migration process measures in order to
obtain the associated risk premium.
The authors are currently working on a factor model for credit
rating migration that builds on the continuous state model for
risk rating described in reference [8]. The model incorporates
a single "business cycle" factor that drives the stochastic
evolution of rating grade transition probabilities, LIED
distribution parameters, and par credit spreads. It also
accounts for the correlation between the credit migration
processes of different borrowers without imposing the
14

requirement that the probability distribution for portfolio

value at the risk horizon be Gaussian.
Summary
We have introduced specific definitions for three important
quantities related to the measurement of credit risk at the
transaction level: risk premium, risk capital, and risk-adjusted
return on capital (RAROC). The key element in our approach
is linking (through risk-neutral pricing methods) the marginal
pricing of credit risk implicit in one-period par credit spreads
to the pricing of the aggregate risk inherent in a multi-period
credit instrument.
We have identified the risk premium associated with a credit
transaction as the cost of a form of total return swap which
transfers the unexpected return risk on the trans-action to a
counterparty (which could be the lenders risk capital
account). This risk premium supports an imputed amount of
risk capital consistent with the lender realizing a targeted
hurdle rate as excess return on capital. We differentiated this
imputed transaction risk capital from the exposure risk capital
allocated to the transaction based on consideration of the risk
characteristics of the lenders credit portfolio and his targeted
credit rating. We defined the RAROC associated with a loan as
the excess return on imputed risk capital generated by the
loan revenue. We then explored the properties and
interrelationships of these risk quantities through a series of
simple examples based on a two-year term loan.
Two loan portfolio management guidelines emerged from our
analysis: (1) originate (or buy) loans with positive expected
net present value under the risk-neutral credit migration
process measure (i.e., loans for which
) and (2) hold
those loans for which exposure risk capital is less than or
equal to imputed risk capital.
References

15

[1] Belkin, B., L. R. Forest, Jr., S. D. Aguais, and S. J.

Suchower, "Credit Risk Premiums in Commercial
Lending," Risk, to appear.
[2] Modigliani, F. and M. H. Miller, "The Cost of
Capital, Corporation Finance and the Theory of
Investment," American Economic Review, 48, June
1958, pp. 261-297.
[3] Brealey, R. A. and S. C Myers, "Principles of
Corporate Finance." McGraw Hill, 1996
[4] KPMG Peat Marwick, "VAR: Understanding and
Applying Value-at-Risk," Risk Publications, 1997.
[5] Belkin, B., S. J. Suchower, and L. R. Forest, Jr.
"The Effect of Systematic Credit Risk on Loan
Portfolio Value-at-Risk and Loan Pricing."
CreditMetrics Monitor, First Quarter 1998, pp.1728
[6] Ginzburg, A., K. J. Maloney, and R. Willner. "Debt
Rating Migration and the Valuation of Commercial
Loans." Citibank Portfolio Strategies Group Report,
December 1994
[7] Heath, D., R. Jarrow, and A. Morton, "Bond
Pricing and the Term Structure of Interest Rates: A
New Methodology for Contingent Claims Valuation,"
Econometrics, Vol. 60, No. 1, January 1992, pp. 77105.
[8] J. P. Morgan & Co. Incorporated,
"CreditMetricsTM: The Benchmark for
Understanding Credit Risk," 1997.

16