Overview

1.
2.
3.
4.

5.

Bank Lending As A Source of finance, Responsible

Lending & Bank Credit Culture (case study);
The lending Function,
Consumer Lending,
Credit Risk Measurement: New Approaches specifically
discussing
KMV-EDF
JP Morgan Credit Metrics (VaR)
Credit Risk Management:
Securitisation
Credit Derivatives

Definitions:
Lending:
A contractual agreement in which a borrower
receives something of value now, with the agreement to
repay the lender at some date in the Future.
the expectation of a sum of money within some
limited time

Credit Risk:
The chance that this expectation will not be met.
the risk of loss through the default on financial
obligation Golin
Is the potential for the obligation of a contract not to
be fulfilled - Sathye
2

Credit Risk- BoG (Draft Risk Management Guideline-2013)

54 - Credit risk, also known as counterparty risk, refers to the
possibility of a debtor not able or not willing to pay the interest
and/or principal according to the terms specified in a credit
agreement thus resulting in economic loss to the creditor institution.
55- Credit risk arises mostly from lending and related banking
product activities such as trading and placements:
a)In lending transactions, credit risk arises through non-performance
by a customer or market counterparty for facilities granted. These
facilities are typically loans and advances, including the provision of
securities and contracts to support customer obligations such as
letters of credit and guarantees.
b)In trading activities, credit losses arise due to non-performance by
counterparty for payments linked to trading related financial
obligations
3

Bank Lending As A Source of finance:

Credit plays an indispensable role in modern economy:
Public Expenditure:
Government Treasury borrows to invest in public services
Corporate borrowing: Company borrows for
Expanding capacity, Working capital, Making acquisition
E.g. Uncommitted facilities, Committed facilities,
Syndicated Loans, Commercial Paper
Individual borrowing (Consumer Lending / Retail Markets)
To buy houses, cars, holidays, repay existing loans.
E.g. Overdraft, Personal loan, Mortgage & Credit Card
In sum credit makes modern economy tick
The engine / heart beat of modern economy
4

Principles of Lending
Lending Principles: Provides a framework for the

lender to make sound lending judgements/

decisions. The Three Principles are

Safety of Loan:
Loan lent to safe borrower (ability to pay and
willingness to pay
Collateral, as a backup to recover money when things go
wrong (safety valve)

Suitability Of Loan Purpose:

Legal purpose( illegal activities: narcotics and terrorism)
Legal entity (ability to enter into financial contract)
lending to a minor
Purpose should be in line with the lending policy of the
bank.
5

Principles of Lending
Profitability:
Lending is only completed when principal and interest
are collected. Attempt is made to minimise loss of
income through a & b above.
Pricing of loan: appropriate interest should be charged
based on risk perceived.

Credit Analysis
Credit Analysis:
Is the process / function by which a lender assess the
credit worthiness of the potential borrower.
It seeks to answer the question:
Would the borrower pay the principal and interest?
It does so by assessing the borrower:
Ability to pay
Willingness to pay.

The Lending Function

The lending process / function is not completed until all
principal and interest have been collected.
Anyone can lend, but ensuring repayments of principal and
interest is what distinguishes a good banker from a bad one

There are 4 components of the traditional bank lending

function:
This follows a loan from origination to (full) repayment.

Originating:
Funding
Servicing
Monitoring
8

The Lending Function Contd:

Originating:
Assessing the customer to obtain the customer credit
risk profile
Contracting to reduce the agency problem

Funding:
Traditionally, loans are funded by customer deposits.
Loans kept on Balance Sheet (Banking Books, i.e.
held to maturity) must be funded.

The Lending Function Contd

Servicing:
Collecting interest and principal repayments

Monitoring:
Estimating default probabilities
Provision for losses
Continuous loan quality review

Note:
Securitization eliminates the need for funding.
Where there is no recourse to the lender for the securitize
loans monitoring is eliminated.
Services could become optional- but banks would continue
servicing to provide seamless services for customers.
10

Originating: Credit Analysis

Assessing Customers Credit Worthiness:
Basically two Objectives:
Assess customers willingness to pay
Assess customers ability to pay
All financial and economic conditions that could
affect borrowers ability to pay.
In sum, the bank attempt to measure the credit risk of the
customer.
Credit Risk could simply be defined as the uncertainty
about loan repayment.
This is the major risk that banks measure, monitor and
manage.
Since about 60% of the banks assets are Credits (loans)
11

Originating:
Generally, when the:
Borrowers Assets > loan, the loan is repaid
Borrowers Assets < loan, the loan is defaulted.

It is therefore essential for banks to be able to

estimate borrowers:

Assets value
Liabilities
Cash flows
Probability of defaults &
Recovery rates in event of defaults

These could be done:

Scientifically: Modern approach
or rely on proxies: Traditional approach

12

Traditional Approach: Expert System

The lending decision is left with the lending
officer, based on his/her expert knowledge.
The expert analyses 5 factors, subjectively weights
them and reach a decision.
The Five Cs of Credit lending:

Character
Capital
Capacity
Collateral
Cycle (economic) conditions

Note a 6th C: Compliance i.e. abiding by the necessary regulations

The 5Cs could be applied to both business and

consumer lending

13

Expert System: The 5Cs:Contd

Character: attempt to measure the borrowers
willingness to pay.
Most important but most subjective to measure;
done by proxy
Reputation & Willingness (honesty, integrity,
prudent, thrifty)
Affects the quality of information provided by
borrower
Payment history, current and previous application
forms, financial news (paper, internet etc), credit
agencies, employers

Capital: measure the

Leverage i.e. Equity vs. Debt
Capital contribution to project & mortgage. Why?

High leverage indicates high tendency to default

14

Expert System: The 5Cs:Contd

Capacity: measures
Volatility of earning or Cash flow
Cash flow or earnings is the primary source of payments
High volatility suggest some restrain on firm capacity to
repay
Individuals: details of income and expenditure (Bank statement
and payslips)
Business: audited financial statement and cash flow statement

Note:
Lending is done against the strength of your cash flow rather
the strength of the security.
Would you lend on basis of profitability?
Would you lend to a firm that makes losses but has good
15
stream of cash flow?

Expert System: The 5Cs:Contd

Collateral:
This is a secondary source of loan repayment
Requirement depends on the purpose/ size of the loan
Quality of the collateral:

Priority of claim
Market value (ascertainable and stable)
Durability (not perishable)
Marketability / how liquid

Problems with collateral

Legal issues
Damage customer relationship
Time consuming and costly
16

Expert System: The 5Cs:Contd

Cycle (Economic Conditions)

General economic conditions

Particularly industry specific
Competition; both locally + international
External Conditions: prevailing conditions in the
general economy, the particular industry. Is it
favourable to the borrower?
Prevailing conditions of the international economy
Internal Conditions: Lending policies, loan budget

17

Expert System: The 5c Contd

Problem with Expert System:
Consistency: How to apply these factors consistently
across
different sizes
types of loans
Types of borrowers

Subjectivity:
Mainly a question of weighting
What weight to attach to each of the 5 factors.
18

CAPMARI on ICE CN Rouse

Character: honesty and integrity of the business and its management.
Ability: in managing financial affairs, capable to enter into a contract,
managerial capabilities, management commitment)

Means: borrowers technical, managerial and financial means

Purpose: for granting the loan. Must be legal and in line with bank
area of business, acceptable to bank i.e. risk appetite)

Amount: should be consistent with the purpose and sufficient in amount.

Repayment: ability to repay, probability of repayment, sources of cash
flows

Insurance: collateral / security for the loan.

on
Interest
Commissions
Extras legal fees ( the hidden additional fees)
19

Interest rate vs. Return on loan

Relationship between interest rate and expected
return on loan is highly non-linear.
At lower interest rates, a rise could increase returns
At higher interest rate, a further rise may decrease the
returns due to:
Adverse Selection: good borrowers will drop out of
the loan market to self finance
Risk shifting: Those left are those with limited
equity at stake have the incentive to borrow to
finance high risk projects.

20

Lending Function: Monitoring Loan Quality Review

Objective of Lending function is to create value for the bank.
Weakness in the Originating process: E.g.
Lax lending policies
Inadequate information

Leads to poor lending, destroying value through:

Non performing loans
Loan loss provisions

Asset quality problems leads to:

Reduced net interest income

higher provisions,
writes off
depletion of capital,
potential liquidity problem.
If market gets know of excessive poor asset quality then could lead to a
bank run
21

Lending Function: Monitoring Loan Quality

Review
Prudent and proper banking requires Monitoring the loan
portfolio: i.e.
Conduct quality loan review:
To classify the loans portfolio
To establish probable losses (i.e. create a loss reserve)
To take remedial actions to reduce losses

22

Generally Accepted Loan Classification:

Performing Loans (Current Loans):
Loan is being paid back on schedule and perceived to be
acceptable banking risk.

Other Loan especially mentioned (OLEM)

Loan has some minor problems (poor or inadequate
documentation)
borrowers financial conditioning is worsening, but does not
deserve substandard classification

Substandard
Over 90 days over due, borrowers weakness is visible with chance
of default, with inadequate collateral

Doubtful
Well over 90 days considerable weakness & serious problems,
full repayment is highly improbable

Loss (Bad loans)

Expected total loss, uncollectible debts; usually written off
Note: possibility of some partial recovery in the future.

23

Bank of Ghanas classification of

advances and loan loss reserves
Loan Class

Due Days Passed

Loss Provision

1-30days

1%

31 - 90 days

10%

SUBSTANDARD

91 180 days

25%

DOUBTFUL

181 360 days

50%

>360 days

100%

CURRENT
OLEM

LOSS

24

Problem Loans: Prevention, Identification & Resolution:

Causes Of Problem Loans:
Internal
Aggressive policies ( excessive growth beyond the banks
ability to manage: managers, organisation structure (IT, people,
system etc)
Lax procedures ( non compliance with loan policies)
Indiscipline (bad) people ( inadequate controls over loan
officers)
Lending outside banks risk profile ( outside familiar market)
Insufficient knowledge about customers
Over concentration of bank lending
Inadequate systems to identify loan problems

External ( good customers could turn bad)

Recession, Competition
Natural disasters, regulatory changes
Demographic changes
Borrowers management team

25

Prevention occurs:
At the origination process,
preventing type 1 errors (lending to bad borrowers)
reducing non-performing loans,loss revenue, loss reserve.

If banks credit standard is too tight, then type 2 error occurs(rejecting good borrowers).
Tight credit standard leads to reduction in:

loan volume
Customer base
Cross selling opportunities
Could lead to loss in revenue

Prevention therefore involves a risk-return trade off.

Bank has to find the optimal credit standard:
That maximize the banks equity value

Prevention should focus on:

Information gathering and processing,
analysing the quality information
i.e. accuracy and timeliness.

26

Problem Loans: Identification

Loan monitoring
Problem loan identification starts with loan monitoring
Help to classify loans ( Current, NPL, Needing more information)
Early Warning Signals- Companies:
Financial
Focus on financial performances
Balance sheet, income statement, cash flow statements, debt analysis

Operational
Production & inventory management
Relationship with suppliers & distributors
Customer and employees relationship

Banking
Falling deposit balances
Frequent Loan request for working capital

Managerial
Changes in behaviour of management
Attitude towards risk
Change in daily practices

27

Problem Loans: Resolution

Decide if problem is solvable: YES OR NO
If No, then Payout / Liquidation
If YES, then there is a Workout situation
An attempt to recover the banks money from a borrower
having financial difficulties.
Objective is to minimise losses
Is workout : +NPV or NPV
-NPV, then Payout / liquidation
+NPV, then
Cost reductions
Asset Sales
Revenue generation
New Mgt/ Bank on Board
Reschedule
Then finally PAYOUT
28

CONSUMER LENDING

29

Consumer Lending
"Neither a borrower nor a lender be
(Hamlet, Act I Scene 3).
If you lend money, you make a secret
enemy; if you refuse, an open one
Voltaire

The holy passion of friendship will last

through a whole lifetime if not asked to
lend money.
Mark Twain
30

Consumer Lending
Conditions / Factors affecting the personal lending market:
Increase in demand for credit (esp. credit card)
Evolution of technology
Highly competitive environment (that creates pressure
for )
Timely (quick) credit decisions (and need for )
Lower cost structure resulting in use of technology
and
larger customer base
Types of Loans:
Personal loans and Overdrafts
Residential Mortgages / home equity loans
Instalments Loans: cars, furniture ( durable goods)
Credit Card
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Credit Analysis: Individual Appraisal or Credit Scoring

Principles / Canons of Lending relevant to consumer
lending.
Safety, suitability & profitability.
These should be our guiding principles, whatever method use in
the decision making

Rouse identifies 5 stages in the analysis of new request for

loans:
Initial contact / introduction to customer
Credit Application by customer
Review of the application/ credit analysis
Gathering information
Use of models like CAMPARI or 5cs (the canons of good
lending)
Evaluation:
Assess repayment plan is it feasible?
What could realistically go wrong and it impact on the bank.
32
Monitoring and control

Individual Appraisal:
Decision framework:
5Cs or Reduced form of 3Cs :
character, capacity (incl. Capital) & Collateral (incl.
conditions)

Character:
Track record of customer the longer the better
Own customer ( data already available at bank)
Other Bank customer ( reports from customers bank)
Use credit reference agencies (customer consent is needed)

Integrity of Borrower:
willingness to pay? - timely repayments.

Spending habits
spending in excess of income, overdrafts,
used credit cards (multiple debts),
life styles inconsistent with earnings

Purpose of loan: genuine?

33

Individual Appraisal
Capacity to repay:
Net Income: net earnings of borrower ( income & expenditure)

Deposit balances (savings)

Average balances on current account or savings

Stability / continuity of Job

Permanent or contractual (continuity
Length of stay

Stability of residences
Indication of stable personal situation
Home ownership, telephone ( land or mobile?)

Borrowers Margin ( Capital)

Borrowers contribution ( mortgages, cars)

Collateral (inc. Conditions)

As a secondary source of repayment
Conditions to be attached to loan
General conditions of the economy

34

System Approach: Credit Scoring

Credit Scoring is a system used

pre-identify certain key factors of probability of default
Weight these factors to produce a quantitative score
Assign customers into a class of either Good or Bad
Based on a cut off point
Mostly used for:
Credit card application
Small business loan
Personal loans
Information about content and methods are scarce since credit score models
are proprietary in nature.
Rouse:
for consumer lending a system approach, as opposed to dealing with
each customer individually, is cost effective for most personal lending
Hall & Cloonen:
Judgemental processing of consumer credit applications is rapidly being
assisted and in some cases replaced entirely by computerised scoring
systems.
35

Credit Score: Variables or Determinants

Model by FICO: Fair, Isaac & Co. Credit Scoring system

Payment History

refers to payments being made on time or late, judgments,

bankruptcies, collection accounts, and so on.

Outstanding Debt
examines the number of outstanding balances, average balance, and ratio
of total balances to total credit limits on revolving debt (i.e. credit cards)

Credit History
refers to how long you have had your oldest account.

Pursuit of new credit

examines when and how many inquiries and new accounts there are.

Types of Credit in Use:

refers to the number of reported accounts in the various credit card
categories (bank cards, travel & entertainment, and so on).

FICO ratings ranges from 375 to 900

>=660 is good credit

b/n 620 to 660 marginal, but not bad credit
< 620 small chance of getting credit
Lenders set their own guidelines, according to risk appetite

36

Some more Variables of Credit Score

Large retailers Models may include the following
variables:
Good credit record (supplied by credit bureau or
internal)
Married/Single/divorce or separated
Number of dependents, Age
Primary monthly income & Presence of extra income
Home owner/ renter
Home telephone
Credit investigation made.

37

Pro & Cons: Credit Scoring

Advantages:
Cost Advantages:
Fewer and lower level experience staff required
Cost saved shared b/n lender and borrower
Time advantages:
Large volume of applications processed
Increase availability of credit
Time used on sales,cross sales & relationship rather
than on number crunching
Objective, not judgemental:
non-emotional decision in distinguishing b/n good
and bad loans.
Identifying and eliminating (Reducing) crosssubsidisation
Therefore appropriate loan pricing is done

38

 Disadvantages:
Lost of relationship
Treat customers as commodity
i.e. Commodity Loan as against relationship Loan

Relationship allows for discretion

39

Pro & Cons: Credit Scoring

Palmieri (1991):
the only time a human evaluator can beat automated
scoring systems is when the person is highly experienced
lender and has a personal knowledge of the borrower. There
are not enough of those people to go around

Domis:
Blind use of computerized credit scoring is bad banking

Sinkey:
Lenders should recognise that credit bureau reports and

credit scoring models need to be tempered with judgement

and common sense.

All quotations are from Joseph F Sinkey- Commercial

Bank Management, Chap.12
40

Monitoring and control

Reasons for monitoring
Be aware of the most current situation of the borrowers capacity to pay,
confirm information supplied by borrower during application.
Observe any adverse trends so that early action could be taken.
To discover irregular practices money laundering
Update with customer character new habits, e.g. gambling, excessive
spending
Ensure loan is used for purpose.

Methods of monitoring:
inconceivable to monitor every customer / borrower and so attention is
focused on those accounts that are likely to cause problems:
The use of computer generated management reports on the historical
trends of the accounts are essential tool in monitoring.

Worst balance trend; overdraft, account in excess of undisclosed limit?

Best balance trend, what periods
Average balance on the account is it getting worse?
Turnover of the accounts number of entries going through accounts, payees
41
Receipts of credit, regularly

Problem loans when things go wrong

1. Identifying problem accounts: warning signals.
Monitoring will reveal most problem accounts. Some indication of problem
loans:

Overdrawn above agreed /unadvised limits

Sudden overdraft on unused account
Cheques returned unpaid-evidence of cross firing
Credits not received on the accounts loss of job?
Defaults on loan repayments

2. Deal with problem accounts:

Initial contacts by letter to correct the position or to ascertain if customer has a
problem, and discuss if possible.
If not responded to with in reasonable time (2 weeks), follow up by telephone.
Consider the following actions:
Return cheques drawn by customer
Cancel standing order and direct debits
Request for cheque book / cheque guaranteed card to be returned.
42
Search a credit reference agency for information.

Problem loans when things go wrong

3. Reschedule Loan:
Loan may have to be rescheduled when it clear that the customer
would not be able to abide by the original agreed schedule.
Obtain a list of customers present commitment
If over committed:
then it is possible to agree with other lenders to reduce
repayment amount,
or even the amount owed,
or sale of assets to reduce amount owed,
extend period of repayment

reschedule is last resort for customer

No further overdraft allowed.

4. Recovery:
Endeavour to make full recovery of amount, if not possible, a maximum
possible recovery; however action must be proportionate, a sense of the
banks social responsibility must be shown.

5. Legal proceedings: this is really the last resort

43

Problem Loans: Identification (FT Fri, Feb 28th 2009)

Early Warning Signals: Individuals
Customers that were likely to run into difficulties over the next
year had their credit card withdrawn, even if they have not
defaulted.
Credit reference agencies trying to predict whether a borrower
will be able to afford the debt in future.
Early warning signal used:
Potential debt: Too many other credit cards: therefore with
large combined credit limit
Outstanding balance building each month and approaching
the maximum limit.
Missed payments on another card or in the past.
Pay only the minimum amount each month.
Income versus outgoings ( spending pattern monitored,
overdrafts)

44

Seminar Questions
What factors are influencing the use of credit scoring system
in bank lending?
Outline the features / elements when constructing a credit
scoring system.
How appropriate is a credit scoring system for evaluating
the credit worthiness of
a) Individual / consumer lending ?
b) Small business lending ?
c) Large business lending ?
Your bank is introducing a new product credit card. As the
banks risk manager, explain to the board of directors and
management the risk departments role in the introduction of
a new consumer product
Credit scoring: what is the business implication for the
growing use of the credit scoring approach for the banking
industry?
Lending Is an Art not a Science. Discuss this statement
with reference to the article What is the point in credit
45
scoring?

CORPORATE LENDING

46

Credit Risk Management & Credit Risk

Measurement
Credit Risk Management:
The process of identification, analysis and either
acceptance or mitigation of uncertainty in granting
loans.
Purpose:
Achieve balance between risk and return
Avoid concentration risk
Manage loans on portfolio basis (as against relationship
basis)
Remove loans off financial statement when required.
New tools available for Credit Risk Management:
Securitisation
Credit derivatives
47

Credit Risk Measurement

To manage credit risk effectively attempt must be made to
measure it.
Credit Risk Measurement:
Attempts to quantify the credit risk the bank is exposed to.

External ratings
Altman Z Score
KMV EDF & Portfolio mgt
JP Morgan Credit Metrics

Credit Risk Measurement:

reduces subjectivity in credit assessment, more scientific, makes
monitoring effective

Remember: - If you can Measure it, You can Manage it

48

External Ratings:
Evaluates credit worthiness of corporate,
municipal and sovereign issuers of debt
Disintermediation has made their services more
valuable.
Investors rely on these ratings for lending
decisions
Borrowers also pay attention to their own external
ratings as it affects the credit spread paid by them
49

External Ratings
E.g. Moodys, S&P and Fitch.
Each Agency uses a system of letter grades
from triple A to D ( Quality to Default)
Types of ratings issued include:
Issuer rating: Foreign & Domestic currency
Debt Specific: long term debt & Short debt

Ratings are revised as necessary in light of

new information
50

S&P External Ratings

51

Moodys External Ratings

52

External ratings
Agencies are not forthcoming with their
rating process.
S&P however offer the following emphasis:
Business Risk:
industry characteristic
Competitive position e.g. marketing, technology

Management: calibre
Financial Risk:
Policy, profitability, capital structure, cash flow
53

Credit Scoring Systems

Is a system used
pre-identify certain key factors of probability of
default
Weight these factors to produce a quantitative score
Assign customers into a class of either Good or Bad
Based on a cut off point

Mostly used for:

Credit card application (97% of Banks use)
Small business loan (70% of banks use)
Personal loans
54

Credit Scoring Systems: The Z Score

Z score is a credit scoring system used to predict
bankruptcy of a company.
It is multivariate system, attempts to describe
overall performance of the company.
Financial ratios are uni-variate: each financial
ratio cannot give a complete picture of the firm.
The formula:

Z = 1.2x1 + 1.4x2 +3.3x3 +0.6x4 +1.0x5

55

Z Score
Co-efficient are predetermined weightings
Xs are predetermined factors of probability of
default
X1= working capital/Total assets:
Indication of liquidity

X2= Retained Earnings/Total assets:

Cumulative profitability

X3= EBIT/ Total assets :

return on assets ( current profitability)

X4= Mkt Value of Equity/Bk Value of Total liabilities:

Leverage of the company

X5= Sales/Total Assets:

Asset Utilization: how effectively is assets used to generate sales
(how effectively has managers invested assets)
56

Z Score
Cut off point:
If Z< 2.675, assign firm to bankrupt group
If Z >=2.675, assign to non-bankrupt group
Z score range of 1.81 to 2.99: area of ignorance due to
misclassification.

Criticism:
Relies on accounting data:
Past and historical data,
account data provided at discrete intervals
As such cant pick companies that are rapidly deteriorating

The Z score function is independent of the loan amount.

The model is a linear relationship, while path to
bankruptcy is non-linear.
57

Z Score

58

Some Implications of Z Score

Quantitative complement to qualitative and
intuitive approach.
Altman recommends his quantitative approach to
complement the more qualitative and intuitive
approach of loan officers.

Symptoms:
Indicate symptoms not the causes.
Z score indicates overall performance
Individual ratios pinpoint the problem areas

Early warning system, not a a bankruptcy

sentence.
59

Moodys KMV Credit Monitor

Remember the criticism of Z score:
financial ratios: accounting data are backward looking,
however defaults are forward looking.

Defaults is a function of :
market price of assets and market value of debts.
And both are forward looking.

KMV exploits this knowledge to calculate:

the distance to default &
default probability (EDF), using the option theory.

The premise is that:

When money is lent to a firm and the money is used well,
then the value of the assets will rise, the firm will payback
the loan. If fund are used badly value of the assets will fall,
the firm will not be able to repay the loan
60

Moodys KMV Credit Monitor

The KMV EDF model is a

is a default prediction model

it applies the option theory
to value risky loans.
it produces the probability of default
termed as Expected Default Frequency (EDF)
See diagram below

61

Diagram: Put Option On The firms Assets

Pay off
Pay off To A lender

Fixed (P+I)

A1

A2

Value of Assets

62

Pay Off To Lender

B is the $ amount borrowed
A1& A2 are Market value of the firms asset
If at maturity the firms asset is valued at A2 then
the borrower will pay the Loan $B.
If asset is valued at A1, then the firm will default
and turn over the asset to the bank.
Note:
the borrowing firm is limited liability
The bank receives only fixed payment if the Asset is
valued over B ( i.e. principal and interest)
The diagram is similar to the pay off of a put option.
63

Option Theory vs. Loan : Merton

The bank is the writer of a put option on the
borrowers asset
The buyer (borrower) of the put option has the right to
sell the stock (asset) to the bank at price B, the strike
price (Loan amt)
The writer receive a fixed margin (P+I)
If the price of the stock is above B, then the borrower
will not exercise the option,
Rather choose to sell the stock on the market for a
higher price. (i.e. keep asset and trade with it)
If price of the stock is below B, then will exercise the
right to sell the asset at B.
In other words, turn over the firms asset to the bank.

The writer faces an unlimited loss.

64

Diagram
Pay off of Put option

B
Strike Price
Loan Amout

Stock Price

65

Option Theory v Loan

According to BSM (Black, Scholes &
Merton)
Px of Put Opt. on a stock is=f(s, x, r, v, t)

S= Stock price
X= exercise price
R= short term interest rate
V= std dev (volatility of the firms equity)
T= maturity of the option
66

Option Theory v Loan

Merton noted that value of default option on a risky
loan is similar: = f (a, b, r, v, t)
A=

Market Value of the firm assets

B = The Value Of the Loan
R = short term interest rate
V = std dev (volatility of the MV of the firms asset)
T = maturity or time horizon

All the variable in the BSM model are directly

observable (on the Market)
However in the case of the loan A and V are not.
The loan equation with 2 unknown variable cannot be
solved.
67

Option Theory, Loan & KMV

KMV solved the problem
From the borrowers perspective (Equity holder of the
borrowing firm)
i.e. equity holder has a call option on a firm
Option to buy the firms assets
Equity holder has invested a fixed amount in shares
If value of assets is less than B, the option will lapse.
What the equity holder actually looses is Shares *
market value
Share price is observable, so variable A is solved.
Same inference is made for the Standard deviation
(volatility) of the MV of the assets.
The EDF could now be calculated.
68

Diagram
Pay off Call Option

B
Asset Value

69

Calculating the EDF

A = Market value of the Firms Asset
B = Amount Borrowed
$80m

$100m

This is the default exercise point:

Value of Short term debt (< 1yr)
(Long term debt)

V= Std Deviation, $10m

Distance to Default (DD):
(A-B)/v
(100-80)/10= 2stdvn
The firm will default if the Market Value decreases by more
than 2StdDev.
70

EDF Calc
2StdDev implies that 95% of the time, the asset
will vary between $80m and $120m.
But for 5% of the time Asset value could exceed
$120m or be below $80m.
Since we are only interested in default, we have
2% probability that the asset will fall below
$80m. i.e. an EDF of 2%.
Observation:
EDF increases if:
Asset Volatility Increase
Market value decreases
Debt increases
71

Empirical EDF:
The above calculated EDF is theoretical EDF.
KMV calculates the empirical EDF from a large
database of firms defaults, loan repayments &
theoretical EDFs.
Logic:
What percentage of Firms in the database with EDF of
2% actually defaulted in the last year? = 50
How does it compare to the total population of firms
with 2% EDF (2 std dev from .) ? = 1000
Empirical EDF = 50/1000 = 5%
72

EDF of M&S

73

EDF- Capital Structure

74

EDF-Drivers

75

Enron Corp: EDF & Agency Rating

76

LOAN PRICING

77

Elements of loan pricing

When loans are not priced correctly, better rated obligors
tend to subsidise the less credit worthy customers.
3 elements to be considered:
Balance sheet cost (cost relating to the financial position)
Capital cost
Liquidity cost
The cost of funds

Credit cost:
Expected losses
Unexpected losses

Non-Credit Cost
interest rate risk
Pre-payments risk
Origination cost
78

Balance sheet cost:

Cost associated with the financial position:
Capital cost:

Capital is needed to fund loans

Use Basle CAR guidelines for capital contribution
Equity holders demand returns on this contribution
Returns is set by the board

Liquidity cost:
Loans are the most illiquid assets
Prudence require providing for liquidity against loans
Is set by the market

Cost of funds: mainly made up of:

Deposits: these funds the lending asset and the liquid
assets.
Required capital as in capital cost

79

Credit risk costs

To cover for the possibility of default:
Expected losses
Unexpected losses

Expected losses:
Lender expect some loans to default and this is included in
the loan pricing.
Expected losses = Default probability x (1 - Recovery Rate)
Default probability, recovery could be determined
internal models or
credit agencies.

Unexpected losses:
this reflects the volatility of the expected losses.
Indicated by the left tail of VAR (creditmetrics)
See pages 90 & 91 (Saunders)

80

Non Credit risk Cost

Interest rate risk
Mismatch in maturity between funding (shorter) and
loans assets (longer)
Variable loans funded by at call deposits
Obligor may switch to fixed, while cost of funding increases
( as interest rate rising environments)

Pre-payment risk
Fixed rate loans: borrowers seek to refinance when
interest rate falls
Lenders may not be able to re-invest the loan pre-paid at
previous higher rates
Often there is a penalty for pre-payments.

Origination cost:
Originating and operating costs (overheads)

81

Loan Pricing: E.g.

a) Briefly explain the elements of loan pricing. (10 marks)
b) A five-year mortgage application has been made to purchase a house
that costs 200,000 (two hundred thousand pounds). The bank requires
its customers to contribute 5% of the cost of the house as deposit.
The bank provides for 5% liquidity against lending assets. The liquidity
investment earns 4.9%. The loan will be funded by a time deposit,
which attracts 3.5%.To protect its exposure against interest rate risk,
the bank engages in a five-year swap rate to cover the loan duration at
5%. The overheads relating to this loan is $1500.
The banks internal model estimates that house loans have a 2.5%
defaults probability and a recovery rate of 95%. To cover for the
possibility of customers paying earlier than maturity, the bank includes
30bp in its pricing
Note: Basle II, Capital Adequacy Requirements: Loans secured by
mortgages on residential property will be risk weighted at 35%.
Required:
Calculate the price of the loan, if shareholders require an after tax return
on equity of 20%. The company tax rate is 33%. (15 Marks)

82

Steps: Loan Pricing

Step 1: Consider how much capital the bank should contribute
Then determine the equity returns, which should be the minimum
profit to shareholders.
Calculate the amount of liquid assets to be set aside
Construct a financial position (balance sheet) for the loan this helps
to know the funds elements in funding the loan.
Construct a mini profit and loss statement for the loan- derive the cost
of the loan. Note all the charges and ancillary income to included in the
PnL.
NOTE:

liquid assets (income)

Pre-payments charges (income)
Hedging - Interest rate swap- (cost)
Overhead cost
Expected loss (cost)
Unexpected loss Should add to capital requirement
Corporation tax.
83

Loan Pricing
Suggested Answer: Loan Pricing
Loan Pricing: For Purchase Of House which cost 200,000

Cost Of The House:

200,000
Deposit Required:
5%
Liquidity Asset against lending;
5%
Returns on the liquid investment
4.90%
Loan is funded by Deposits- attracts
3.50%
Five year swap rate (interest rate Risk)
5%
Overheads related loan:
1,500
Default probability on house loans:
2.50%
Recovery Rates on house loans:
95%
Pre-payment Risk 30bp
0.30%
Shareholders required return:
20%
Tax rate
33%
CAR RWA on House loan by Basle II guidelines:
35%
CAR=
8%
Loan Amount To be given: (200k less Deposit. [200kx95%))

84
190,000

Loan Pricing
a

Calculate the bottom line profit: return on equity:

Capital contributed: CAR: 35% * 190,000*8% =
After tax return is 20%*5,320 =
Amount of Liquid Assets Required:
Eqn 1:
Liquid Assets = Assets * 5%
Where
Eqn 2:
Assets = (Loans + Liquid assets)
Substitute eqn 2 into eqn 1
Eqn 3:
Liquid Assets = (Loans + Liquid assets) x 5%
i.e.
Liquid Assets=(190,000+liquidAssets)x 5%
Liquid Assets=(190,000x 5%) + (Liquid Assets x 5%)
LqA'=9500 + 0.05LqA
Rewritten as:
= LqA - 0.05LqA =9500
=0.95LqA = 9,500
There4 LqA =
Proportion of Liquid Assets

5,320
1,064

9500
0.95
95%

10,000

10,000

Deduce the Amount of Deposit Required to fund the Loan and the liquidity investment:
Construct a simple Balance Sheet:
Assets
Loan
Liquid Assets
Total Assets
Liabilities:
Deposit
(balancing Item)
Equity

190,000
10,000
200,000

194,680
5,320
200,000

85

Loan Pricing
Charge for Pre-payment

570

Gross Interest Income

Expenses
Interest on Deposits
Overheads related loan:
Default probability on house loans:
Expected Loss= Default Prob x (1-Recovery Rate)*Loan

Profit before Tax

Less Corporation Tax 33%
Profit After Tax (i.e. 20% on Capital Contributed)

524.06

0.30%

190,000

3.50%

194,680

238 0.00125

190,000

10,139
6,814
1,500

1,588.06
524.06
1,064

20%

5,320

Interest on Deposit: Could pass the cost of Swap to customers. Use 5% instead.
86