1. Chapter Twenty-one Managing Risk on the Balance Sheet I: Credit Risk

2. Credit Risk Management • An FI’s ability to evaluate information and control and monitor borrowers allows them to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governments • An FI accepts credit risk in exchange for a fair return sufficient to cover the cost of funding (e.g., covering the cost of borrowing, or issuing deposits)

3. Credit Analysis • Real Estate Lending • residential mortgage loan applications are among the most standardized of all credit applications • Two considerations • the applicant’s ability and willingness to make timely interest and principal repayments • the value of the borrower’s collateral • GDS (gross debt service) ratio - gross debt service ratio calculated as total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided by gross income • TDS (total debt service) ratio - total debt ratio calculated as total accommodation expenses plus all other debt service payments divided by gross income

4. Credit Scoring • Credit scoring system • a mathematical model that uses observed loan applicant’s characteristics to calculate a score that represents the applicant’s probability of default • Perfecting collateral • ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default • Foreclosure • taking possession of the mortgaged property to satisfy a defaulting borrower’s indebtedness • Power of sale • taking the proceedings of the forced sale of property to satisfy the indebtedness

5. Credit Scoring • Consumer (individual) and Small-business lending • techniques for scoring consumer loans very similar to mortgage loan credit analysis but more emphasis placed on personal characteristics such as annual gross income and the TDS score • small-business loans more complicated and has required FIs to build more sophisticated scoring models combining computer-based financial analysis of borrower financial statements with behavioral analysis of the owner

6. Mid-Market Commercial and Industrial Lending • Definition of Mid-market • offered some of the most profitable opportunities for credit-granting FIs • sales revenues from $5 million to $100 million/year • recognizable corporate structure • do not have ready access to deep and liquid capital markets • Credit Analysis - Five C’s of Credit • customer’s character, capacity, collateral, conditions, and capital • Cash Flow Analysis • provides relevant information about the applicant’s cash receipts and disbursements

7. Ratio Analysis • Historical audited financial statements and projections of future needs • Calculation of financial ratios in financial statement analysis • Relative ratios offer information about how a business is changing over time • Particularly informative when they differ either from an industry average or from the applicant’s own past history

8. Calculating Ratios Liquidity Ratios Current Ratio = Current assets Current liabilities Quick ratio = Cash + Cash equivalents + Receivables Current liabilities (continued)

9. Asset Management Ratios Number of days sales = Accounts receivable x 365 in receivables Credit sales Number of days = Inventory x 365 in inventory Cost of goods sold Sales to working = Sales capital Working capital Sales to fixed = Sales assets Fixed assets Sales to total assets = Sales Total assets (continued)

10. Debt and Solvency ratios Debt-asset ratio = Short-term liabilities + Long-term liabilities Total assets Fixed-charge = Earnings available to meet fixed charges coverage ratio Fixed charges Cash-flow-to-debt = EBIT + Depreciation ratio Debt where EBIT represents earnings before interest and taxes (continued)

11. Profitability Ratios Gross margin = Gross profit Income to Sales = EBIT Sales Sales Operating profit margin = Operating profit Sales Return on assets = EAT Average total assets Return on equity = EAT Dividend payout = Dividends Total equity EAT where EAT represents earnings after taxes, or net income

12. Common Size Analysis and After the Loan • Analyst can divide all income statement amounts by total sales revenue and all balance sheet amounts by total assets • Year to year growth rates give useful ratios for identifying trends • Loan covenants reduce risk to lender • Conditions precedent • those conditions specified in the credit agreement or terms sheet for a credit that must be fulfilled before drawings are permitted

13. Large Commercial and Industrial Lending • Very attractive to FIs because transactions are often large enough make them very profitable even though spreads and fees are small in percentage • FIs act as broker, dealer, and adviser in credit management • The standard methods of analysis used for mid-market corporates applied to large corporate clients but with additional complications • Financial ratios such as the debt-equity ratio are usually key factors for corporate debt

14. Altman’s Z-Score Used for analyzing publicly traded manufacturing firms Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 where Z = an overall measure of the borrower’s default risk X1 = Working capital/Total assets ratio X2 = Retained earnings/Total assets ratio X3 = Earnings before interest and taxes/Total assets ratio X4 = Market value of equity/Book value of long-term debt ratio X5 = Sales/Total assets ratio The higher the value of Z, the lower the default risk

15. The KMV Model • Banks can use the theory of option pricing to assess the credit risk of a corporate borrower • The probability of default is positively related to: • the volatility of the firm’s stock • the firm’s leverage • A model developed by KMV corporation is being widely used by banks for this purpose

16. Calculating the Return on a Loan • A number of factors impact the promised return that an FI achieves on any given dollar loan • the interest rate on the loan • any fees relating to the loan • the credit risk premium on the loan • the collateral backing the loan • other nonprice terms (such as compensating balances and reserve requirements)

17. Return on Assets (ROA) 1 + k = 1 + f + (L + m) 1 - (b(1 - R)) where k = the contractually promised gross return on the loan f = direct fees, such as loan origination fee L = base lending rate m = risk premium b = compensating balances R = reserve requirement charge

18. Risk-Adjusted Return on Capital (RAROC) • Rather than evaluating the actual or promised annual cash flow on a loan as a percentage of the amount lent (ROA), the lending officer balances the loan’s expected income against the loan’s expected risk • RAROC = One-year income on a loan/Loan (asset risk or capital at risk