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Credit Risk: Loan Portfolio and Concentration Risk: Chapter 12

Credit Risk: Loan Portfolio and Concentration Risk: Chapter 12. Financial Institutions Management, 3/e By Anthony Saunders. Simple Models of Loan Concentration. Migration analysis Track credit rating changes within sector or pool of loans. Rating transition matrix. Rating Transition Matrix .

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Credit Risk: Loan Portfolio and Concentration Risk: Chapter 12

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  1. Credit Risk: Loan Portfolio and Concentration Risk: Chapter 12 Financial Institutions Management, 3/e By Anthony Saunders

  2. Simple Models of Loan Concentration • Migration analysis • Track credit rating changes within sector or pool of loans. • Rating transition matrix.

  3. Rating Transition Matrix Risk grade: end of year 1 2 3 Default Risk grade: 1| .85 .10 .04 .01 beginning 2| .12 .83 .03 .02 of year 3| .03 .13 .80 .04

  4. Simple Models of Loan Concentration • Concentration limits • On loans to individual borrower. • Concentration limit = Maximum loss  Loss rate. • Maximum loss expressed as percent of capital.

  5. Diversification and Modern Portfolio Theory • Applying portfolio theory to loans • Using loans to construct the efficient frontier. • Minimum risk portfolio. • Low risk • Low return.

  6. Applying Portfolio Theory to Loans • Require • (i) expected return on loan(measured by all-in-spread); • (ii) loan risk; • (iii) correlation of loan default risks.

  7. KMV Portfolio Manager Model • Ri = AISi - E(Li) = AISi - [EDFi × LGDi] • si = ULi = si × LGDi = [EDFi(1-EDFi)]½ × LGDi • rij = correlation between systematic return components of equity returns of borrower i and borrower j.

  8. Partial Applications of Portfolio Theory • Loan volume-based models • Commercial bank call reports • Can be aggregated to estimate national allocations. • Shared national credit • National database that breaks commercial and industrial loan volume into 2-digit SIC codes.

  9. Partial Applications • Loan volume-based models (continued) • Provide market benchmarks. • Standard deviation measure of loan allocation deviation.

  10. Loan Loss Ratio-Based Models • Estimate loan loss risk by SIC sector. • Time-series regression: [sectoral losses in ithsector] [ loans to ith sector ] = a + bi [total loan losses] [ total loans ]

  11. Regulatory Models • Credit concentration risk evaluation largely subjective. • Life and PC insurance regulators propose limits on investments in securities or obligations of any single issuer. • Diversification limits.

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