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
($2000)+($3000) =
$2,333.
This would be higher than
the average value to sellers:
($1000)+($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 Investor
will 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 estate
loans
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
Total
Chargeoffs
Uncollect
ible
Loans
Written
off
Collection
Process
Recovery
Net
Chargeoffs
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 estate
loans
Commercial &
industrial
loans
Loans to
individuals
All other
loans &
leases
(including
farm)
Commercial
real estate
loans not
secured by
real 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 risk
Measure 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/Loans
2. Loan Loss Allowance/Net Chargeoffs

Banks earnings are also a protection against
losses
Earnings Coverage
= (NII-Burden)/Net Chargeoffs

Protection from Bad Loans
US 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 Cs of Credit
1. Character Past history of borrower in
paying bills.
2. Capital Borrowers Wealth Position
3. Collateral possession by the borrower of
assets that back up the loan.
4. Conditions - trends and volatility of the
borrowers industry
5. 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 Derivatives
Global Credit Derivatives
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Source: www.creditderiv.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