TOPIC: CREDIT RISK MANAGEMENT AND INSOLVENCY RISK

(i) Credit analysis

(ii) Credit investigation
(iii) Loan policy
(iv) Altmans Z-score

Credit Risk Management

FIs in the purest form of their function are asset transformers. They provide savers with low risk,
liquid claims that savers desire and channel funds to borrowers by granting higher risk, less
liquid loans to funds demanders. To put it succinctly, FIs take people’s money and invest it in
risky claims. As such, the ability to assess, monitor and appropriately price the riskiness of loans
is of paramount importance to many FIs. Loan defaults must be written off against equity; thus,
high levels of defaults can quickly impair an institution’s capital.

From a macroeconomic perspective a sound private banking system is necessary to

appropriately price risk and allocate capital to its best uses. It is rare for countries to generate
substantial sustained economic growth without private internal capital allocation methods. These
methods usually center on the banking industry.

Sound banking systems are also often precursors to strong internal capital markets. Japan’s
protracted economic difficulties have been significantly worsened by the problems and lack of
competitiveness of the Japanese banking system. U.S. FIs had significant credit problems in the
1980s and into 1990. In the early 1980s problems in residential and farm mortgages, particularly
in certain regions of the economy, led to the failures of many banks and S&Ls. S&Ls had
difficulties with junk bond holdings in the latter part of the 1980s.

Problems in commercial real estate and LDC loans developed and hurt the profitability of both
the banking and thrift industries. In the 1990s there were worries about high credit card debt
levels, major defaults in Russia and moratoriums on debt repayments in Indonesia and Malaysia.
The end of the 1990s saw improvements in the credit quality of most bank loan portfolios
however and the level of non-performing loans (loans 90 days or more past due or not accruing
interest) and loss reserves declined.

The recession in the early part of this century reversed these trends, but as the economy
improved in the mid 2000s loss rates again fell, particularly on C&I loans as corporations
improved their balance sheet positions dramatically and began to hold large cash balances.

Personal bankruptcy filings have continued to grow, but recent changes in bankruptcy laws may
slow this trend. Overseas, in 2001 Argentina defaulted on $130 billion of government issued debt
and in September 2003 defaulted on a $3 billion loan from the IMF. In 2005 Argentina
unilaterally announced it would pay only $0.30 per dollar on loans and bonds outstanding from
its 2001 debt restructuring. Mortgage delinquency rates increased dramatically beginning in the
last quarter of 2006 and remained high through 2007. Foreclosure filings increased 93% in July
2007 from the same month in the prior year. Losses from subprime mortgages are expected to
reach $400 billion worldwide. Large U.S. institutions have written off $130 billion in loans
related to the subprime markets. Insured institutions set aside a record $31.3 billion in provision
for loan losses in the fourth quarter of 2007 and one quarter of all institutions larger than $10
billion reported a net loss for the quarter. Institutions associated with subprime lending and those
with significant trading activity had the largest earnings declines. Net charge offs (NCOs) rose to
5 year highs in the fourth quarter as well reaching $16.2 billion, up from $8.5 billion in the
fourth quarter of 2006. NCOs on residential mortgages increase 144.2% and NCOs on home
equity lines increased 378.4% while charge offs on credit card loans were up 33% and charge
offs on loans to individuals increased 58.4%.64 This made the annual ROA at 0.86% the lowest
since 1991. In the first quarter of 2008 new loan volume in the riskier parts of the lending market
fell dramatically with some parts of the market dropping upwards of 80%-90%. These areas
included collateralized loan obligations, loans funding LBOs and high yield bonds. Banks were
also beginning to restrict higher quality lending. For instance, as banks focused on capital
restoration credit lines less than one year became increasingly popular as they carry lower capital
requirements.

Credit Analysis
Credit analysis is geared towards one decision, “Does the FI grant the loan?”
The purpose of credit analysis is to generate profitable loans that do not expose the lender to
excessive amounts of risk. The reason for the accept or reject decision should be clearly
documented and the decision should be in accordance with the bank’s stated loan policy. Criteria
used must not be discriminatory; thus, the determinants of the decision cannot be race, gender,
location, ethnicity or religious persuasion. If the loan officer is to err, the errors should be
conservative. In the long run it will cost the lender much more to handle a failed loan than to
incorrectly turn down a loan that would not have failed. This is true because lending has
asymmetric outcomes.

Distributions of returns on loans exhibit negative skewness. Lowering credit quality tends to
increase the negative skewness, although if the risk is priced this may also increase the average
rate of return on the loan portfolio. Regulators impose quality standards on lenders to help ensure
they do not take on too much risk in attempting to increase the average return on the loan
portfolio. The bank’s loan policy includes the desired portfolio of loans by category and
includes minimum credit standards such as collateral requirements and minimum ratios. Other
provisions include lending limits for certain loan officer positions, standards for grading loans,
requirements for monitoring existing loans, policies on inside loans and the documentation
required to evaluate a loan application. Many banks now use standard application forms for each
type of loan. The loan officer will be trained in the specific form the bank uses.
Credit analysis sectors:
a) Real Estate Lending
Residential mortgage applications are usually very standardized because of the active secondary
market for these claims. The two major factors in making accept or reject decision for the
mortgage loan are
1) The applicant’s ability and willingness to repay the loan
2) The value of the borrower’s collateral.

In assessing the first requirement standard ratios and/or credit scoring models may be used. The
character of the borrower is also very important. Character is assessed by examining the stability
of the borrower as indicated by family status, time in residence, time in job, savings history,
payment history and any personal knowledge the lender may have of the borrower.

Assessing character is essentially assessing two factors:

1. Whether the potential borrower is mature enough to manage credit, and
2. Whether the borrower will consider the debt as a moral obligation that he or she will work
hard to repay even if difficulties arise.

The second aspect of the first requirement is the borrower’s ability to repay the loan. To assess
sufficiency of income the lender may calculate the following ratios:

Gross Debt Service(GDS)

GDS = (Annual mortgage payments + Property taxes) / Annual gross income

The maximum for loan approval is usually 25% to 30%.

Total Debt Service(TDS)

TDS = Annual total debt payments / Annual gross income
The maximum for loan approval is usually 35% to 40%.
Based on these ratios the applicant would not be granted a loan because the TDS ratio is too
high.

A credit score may be calculated to provide a broader assessment of the various factors that
underlie the loan evaluation process.
A credit score is a mathematical model that uses loan applicant characteristics to assist the lender
in deciding whether or not to grant the loan.
Credit scoring models can be developed by examining the characteristics of both good and bad
loans the bank has previously made, and then attempting to ascertain what characteristics can be
used to discriminate between the good and bad loans.
Typical credit scoring attributes include
• Annual income,
• A score based on TDS and or the GDS ratios,
• History with the lender,
• Age,
• Whether the borrower’s residence is owned or not,
• Length of time in the current and prior residence and time in the current job,
• Credit history, etc.

Based on scores of past good and bad loans, the lender can establish a minimum credit score
below which a loan will not be granted, an intermediate score where additional credit analysis is
warranted and another level beyond which a loan will automatically be granted.

Credit scores provide objective, low cost, quick evaluation methods that are particularly suitable
for smaller loan amounts that can utilize standard evaluation methods.

b) Consumer and Small Business Lending

Consumer loans are typically scored similarly to real estate loans. There will be a greater
emphasis on examining whether the individual has the capacity (cash flow) to repay the loan and
on the individual’s character.
The credit scoring models are likely to reflect these different weights. Evaluation of small
business loans is more difficult. Many young firms find themselves in financial difficulty at
some point in their history.
Some FIs employ minimum time in business requirements to grant a loan, or may include the
time in business in a credit scoring model. Profitability on small business loans is generally not
large considering the extra time and effort needed to evaluate the loan. The ‘life blood’ of most
small businesses is cash flow, and the credit evaluation process is likely to emphasize cash flow,
the soundness of the business plan and the character of the borrower.

c) Mid-Market Commercial and Industrial Lending

Mid-market loans consist of loans to corporations with annual sales of sh. 5 million to sh. 100
million. Loan maturity ranges from a few weeks to eight years or more and loan amounts range
from very small amounts such as sh.100, 000 to sh.1 billion or more to major corporations.
In mid-market lending on up, the evaluation Foreclosure is seizing the collateral in the event of
non-repayment of the loan in exchange for discharging the debt. The power of sale is the process
of seizing collateral and selling it to pay off the loan when the borrower fails to repay the loan. In
this case any excess sale value beyond the loan amount & costs would be returned to the
mortgagor and if the sale value is not sufficient to discharge the debt the lender would then
become an unsecured creditor for the difference. Process will normally be more detailed and
require the lender to both objectively and subjectively evaluate the loan application. Steps in the
process may include: Meeting the applicant’s customers and suppliers, particularly if there is one
or only a few major buyers or suppliers of the product or service Procuring a credit history.

Application of the Five C’s of Credit:

 Character
 Capacity (cash flow to service the loan)
 Collateral: There may be a specified maximum loan to value ratio in the loan policy.
 Conditions: Assessing the impact of changing economic conditions on the borrower’s
ability to repay the loan.
 Capital: Assessing the adequacy of the borrower’s capital to prevent insolvency.

d) Large Commercial and Industrial Lending

We normally picture the banker as the tight fisted Scrooge type to whom we have to prove we
don’t really need the money before he or she is willing to lend to us! In reality the market for
lending to large corporations is quite competitive and the bargaining power of the bank lender is
very limited. Large corporations have other funding alternatives, including the U.S. and foreign
money and capital markets and other banks, both domestic and foreign.

Even though banks cannot often charge large fees to these borrowers, nor earn large spreads over
costs on their loans, the loan amounts are large enough to make lending profitable. In addition,
lending activities may bring other business to the bank that generates substantial fee income. The
growing overlap between commercial and investment banking creates a potential conflict of
interest in credit evaluation.

A bank may pressure its own credit officials to grant more questionable loans in order to
generate (or keep) the investment banking business of that loan applicant. Credit analysis of
large commercial borrowers entails the same process as described above in the analysis of mid-
market borrowers, but there are some additional complicating factors:
 If the bank lends to a holding company whose assets are its investments in operating
subsidiaries, the bank’s claim is subordinated to the debtors of the operating
subsidiaries.
 The corporate borrower is likely to be a large, diversified firm that operates in many
locations, probably even in different countries and in various industries. This greatly
complicates the task of assessing the creditworthiness of the borrower. Banks also have
some advantages in lending to large corporate borrowers:
 Ratings agencies such as Moody’s and Standard and Poor’s provide information about
the credit risk of the borrower.
 Market analysts such as Value Line, Hoovers and a plethora of Wall Street analysts
provide current (albeit biased) forecasts of future earnings and growth prospects.

Sophisticated credit scoring models have been developed for these firms:
Altman’s Z-Score
Z = 1.2X +1.4X + 3.3X + 0.6X +1.0X
X1 = Working capital / Total assets
X2 = Retained earnings / Total assets
X3 = EBIT / Total assets
X4 = Market value of equity / Book value of long term debt
X5 = Sales / Total assets

The higher the Z-score, the lower the probability of borrower default. A borrower with a Z-score
less than1.81 is considered to have high default risk, a Z score of 2.99 or more indicates low
default risk and a Z– score between 1.81 and 2.99 indicates that the loan applicant’s default risk
is indeterminate (i.e. the applicant cannot be classified as either high or low risk).