HANOI UNIVERSITY

FACULTY OF MANAGEMENT AND TOURISM

Subject Outline
CREDIT ANALYSIS AND LENDING
MANAGEMENT
FALL 2024

HANOI 08 – 2024
Credit Analysis & Lending Management

Subject Details
Subject name Credit Analysis and Lending Management
Units of credit 3
Study length 12 weeks
Prerequisite /
61ACC2POA
Corequisite
Suggested study
Approximately 4 hours per week
commitment
Year Fall 2024
Course staff and Assoc. Prof. Dao Thi Thanh Binh (Ms.), Lecturer [email protected]
contact details Nguyen Thi Minh Hang (Ms.), Tutor [email protected]
The subject outline contains important information. Please ensure that you read it carefully.
It is also strongly recommended that you keep this copy of your subject outline for future
reference.
Subject aim/rationale
This course provides students with essential knowledge about lending as one of the most important
functions of financial institutions; introduce the process of credit assessment, appraisal, risk
assessment and risk management; introduce different types of loans, analyze financial indicators,
monitor and control credit risks of consumer loans and corporate loans. It helps to improve
knowledge of the banking operation in commercial banks and financial institutions on the basis of
learned banking knowledge, helping to orient learners to work in the field of finance - banking.
Learning outcomes
On successful completion of this course, students should be able to:
1. Knowledge
- Understand the legal framework governing lending activities;
- Analysis of lending decisions in banks;
- Analyze lending issues, loan types, techniques and statistics used in lending decisions;
- Analyze and manage credit risk, understand problem debt management.
2. Skills
- Read and understand the bank's financial statements, annual reports, monitor and manage
bad debts in the bank;
- Establish the ability to study, independent research, teamwork skills, task management and
time management skills;
- Synthesize information and legal documents related to the field of finance, banking and
lending;
- Analyze information of financial statements to assess credit and loan risks;
- Credit analysis for business and consumer loans;
- Form work and time management skills;

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Credit Analysis & Lending Management
- Organize team work and independent work skills;
- Present problems and ideas about banking administration in English.
3. Personal effectiveness competencies to have
- Knowledge of banking management and applying it to treasury management process;
- The desire to learn about capital management practices;
- Form a careful, serious, honest and responsible attitude at work;
- Integrate ethical standards and professional behavior standards of the profession.
Course communication
A MS Teams for this course has been created and you will be invited to join prior to the start of the
course. All the materials of the course will be provided on this platform. Students who are not
registered on the MS Teams are not qualified to sit for the Final Examination.
Students with Disability
If you have a disability and are in need of academic accommodations, please notify your lecturer
and/or tutor immediately to arrange needed supports.
Academic Honesty
Faculty of Management and Tourism strictly prohibits all forms of academic cheating, fraud, and
dishonesty. These acts include, but are not limited to, plagiarism, buying and selling of course
assignments and research papers, performing academic assignments (including tests and
examinations) for other persons, and other practices commonly understood to be academically
dishonest. Acts of academic dishonesty may result a failing grade on the exam or assignment for
which the dishonesty occurred or failing the course.
Subject materials
Topics to be covered in this subject will be centered around relevant textbook chapters. Lecture
notes will provide students with major issues in Credit Analysis and Lending Management.
Additional materials may be provided to help students understand subject matters.
Subject structure
The structure of this subject for on-campus students comprises:
● One 2-period-lecture per week
● One 2-period-tutorial per week
Prescribed textbooks
Milind Sathye, & James Bartle 2018, "Credit Analysis & Lending Management", 4th ed., Mirabel
Publishing

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Credit Analysis & Lending Management
Proposed weekly schedule
- Credit Analysis & Lending Management, Milind Sathye & James Bartle
Reading Tutorials (Exercises are
Week Lectures Page
chapter subjected to change)
Principles of Lending and Lending
1 1 3
Basics
Tutorial 1: All questions –
2 Financial Statements Analysis 2 41
Chapter 1 (p.37)
Tutorial 2: All questions –
3 Credit Scoring Techniques 3 87
Chapter 2 (p.84, 85)
Tutorial 3: All questions –
4 Credit Risk Analysis- An Introduction 4 113
Chapter 3 (p.110)
Consumer Lending, 5 145 Tutorial 4: All questions -–
5
Real Estate Lending 6 191 Chapter 4 (p.139, 140)
Tutorial 5: Questions: 1, 3, 5,
Security, Consumer Credit Legislation 6, 7 – Chapter 5 (p.186, 187)
6 7 225
and Legal Aspects of Lending Questions: 1, 4 to 9– Chapter 6
(p.221,222,223)
Corporate Lending Tutorial 6: All questions- –
7 8 267
Midterm Exam Chapter 7 (p.261, 262)
Small Business Lending 9 293 Tutorial 7: All questions –
8
International Lending (Chapter 10) 10 347 Chapter 8 (p.291)
Tutorial 8: All questions–
Credit Risk Measurement and Chapter 9 (p.341. 342)
9 11 375
Management of the Loan Portfolio All questions – Chapter 10
(p.372)
Credit Risk from the Regulator's
12 415 Tutorial 9: All questions –
10 Perspective
13 441 Chapter 11 (p.410, 411, 412)
Problem Loan Management
Tutorial 10: All questions–
Quantitative Finance
Chapter 12 (p.437, 438, 439)
11 Credit Growth & Bank Soundness in 16 519
All questions– Chapter 13
Emerging Europe
(p.458)
Case study/Guideline for group report Tutorial 11: All questions –
12
Research on Crowdfunding Chapter 16 (p.530)
Final Exam will be noticed one week in advance

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Credit Analysis & Lending Management
Assessment
Assessment for ALL students
Assessment for the subject will be on the basis of:

(a) Participation Required assessment Yes 10%

(b) Small tests Required assessment Yes 10%

(c) Mid Term Exam Required assessment Yes 15%

Group Presentation and
(d) Required assessment Yes 15%
Report
(e) Final Exam Required assessment Yes 50%

1. Participation (10%): Students are required to attend at least 80% of lectures and tutorials.
High mark will be given to students who actively participate in lectures and tutorials. Students are
requested to prepare ALL the tutorial questions/exercises BEFORE going to classes. Failure to do
this will result in the issue of marking down your participation’s marks.

2. Small tests (10%): There will be two (02) random small tests (5% each).

3. The mid-semester exam (15%): will be held in Week 7 during the regular lecture period
and will cover the material in Weeks 1-6. Exam format will be discussed in lecture in Week 6.

4. Group presentation and Report (15%): Forms and contents of Report will be discussed in
detail in week 6. See the guideline below for this task.

5. The Final Exam (50%): will be held in the final exam week. The exam will cover the materials
of Weeks 1-13. It will be a two-hour written closed -book examination. Final exam format will be
discussed during revision in the last week of the semester.

Recommended readings

Blaise Ganguin, John Bilardello, 2005, “Standard And Poor´s Fundamentals of Corporate Credit
Analysis”, McGraw-Hill, United State.
Jonathan Golin and Philippe Delhaise, 2013, “The Bank Credit Analysis Handbook: A Guide for Analysts,
Bankers and Investors”, Hoboken, NJ: John Wiley & Sons.
Joel Bessie, 2015, “Risk Management in Banking”, 4th Edition, Wiley Finance.
Peter S. Rose and Sylvia C. Hudgins, 2010, “Bank Management & Financial Services”, 8th Edition,
The Mc Graw-Hill/Irwin (Chapter 16, 17, 18)
Relevant information from newspapers, journals and websites of Commercial banks, State bank of
Vietnam, credit rating agencies, international finance organizations, etc.

Consultation

Available for consultation by appointment.

Email is the preferred method of contact.

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Credit Analysis & Lending Management
Guideline on GROUP PRESENTATION AND REPORT
You are working as Relationship Manager- Commercial Banking for U Bank Vietnam. You are acquiring a new
client and your task is to prepare a credit proposal for the new credit facility of the said company.
REQUIREMENTS FOR THIS TASK:
● Title: Credit Appraisal Report
● Due date: Week 13
● Details of task:
This is a task for a group of maximum 4 students. Select 1 listed company on the list below (the list of this year
can be subject to change later)
Vinamilk (VNM) Bim Son Cement (BCC)
Khanh Hoa Electricity (KHP) Halong Canned Food (CAN)
OR
1. Consumer Staples and Products 2. Energy and Transport
Masan Group Corporation Petrolimex (Vietnam National Petroleum Group)
Mobile World Investment Corporation PV Gas (PetroVietnam Gas)
Saigon Beer Alcohol Beverage Corporation VietJet Air (VietJet Aviation JSC)
(SABECO) Vietnam Airlines JSC
Vietnam Dairy Products JSC (Vinamilk)
3. Industrials 4. Construction and Real Estate
BaoViet Holdings Coteccons Construction JSC
FPT Corporation FLC Faros Construction JSC
Gemadept Corporation No Va Land Investment Group Corporation
Hoa Phat Group Vingroup JSC
Present a credit appraisal report of the company based on the 5 C's of credit evaluation and financial
performance of the company for the past 3 years. The company you have selected intends to increase its sales
by at least 20% and have approached you for a working capital of equivalent to approximately 10% of actual
total assets for 1 year. (a) As the relationship manager of the bank, determine whether this company can be
approved a working capital loan of VND 50 billion for 1 year; (b) As the Relationship Manager of the bank,
what other loan/legal documents would you require to make the loan decision? and (c) As the Relationship
Manager, what other conditions would you impose? NB: Special emphasis should be placed on the role of
lending practices. You could make relevant assumptions if information is not readily available (e.g. interest
rates, economic conditions etc.) Justify your credit facility calculation to support your credit proposal. You are
requested to attach “Appendix: Historical financial statements” (for the latest 3 years) of the analyzed
company.
Presentation: Group members are to prepare and conduct a 15- minute-presentation on your Credit Appraisal
Report. Suppose that you need to defense your credit proposal to the Credit Committee of U bank to get the
approval. You are required to use Power Point slides.
The presentation of your group should be recorded and uploaded onto MS Teams of the subject for Credit
analysis and Lending Management. File name should strictly follow the instructed format:
Lending_TutNo._GroupNo..2022. For example: Lending_Tut1_G1.2022. doc or .ppt
● Word limit: Not exceeding 2,000 words for the Report.
● Weighting/Value: 15%
● Submission details: Both a hard copy and a soft copy should be presented.
You are requested to submit soft-copy of your report by submitting on MS Teams of the subject for Credit
analysis and Lending Management
Hard-copy of the Report should be submitted via the department assignment box at FMT’s office (Room 201
Building C, HANU).
● Penalties for late submission: A penalty of one mark allocated to this report will be deducted for each
day that the assignment is late, Saturday and Sunday will be included as one day also.

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 Learning Objectives
LENDING DECISION

• Identify the basic principles governing bank lending

and explain their performance
• Understand the framework within which credit and
lending decisions are taken
The Principles of Lending and • Understand the lending process

Lending Basics
Chapter 1

1 2
1 2

Learning Objectives Learning Objectives

• Explain the characteristics of various types of bank • Explain the importance of credit culture in a lending
advances/loans. institution.
• Distinguish different types of borrowers and the • Understand how an advances portfolio is designed.
special considerations that apply to them when giving
loans.
• Explain how advances are structured.

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3 4

Introduction The Principles of Good Lending

• The principles of lending have evolved from the • Three basic principles that guide lending decisions:
practice of lending in the real world and are • Safety of loan
universally applicable. • Suitability of loan purpose
• Profitability
• Lending principles should be regarded as an art
rather than science and only serve as a framework • To follow these principles, financial institutions
within which to make a decision. undertake credit analysis of all loan proposals.

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1
 A First Example: The five C’s of Credit Analysis The most important of the 5 C’s …
(Source: Greenbaum/ Thakor: Contemporary Financial Intermediation, and others)

• Untermyer: Is not commercial credit based primarily upon money or property?

• Capacity
Ensures that borrower has legal and economic capacity to borrow • Morgan: No, Sir, the first thing is ........................
• Untermyer: Before money or property?
• Character
• Morgan: Before money or anything else. Money cannot buy it.
Refers to borrower’s reputation and hence desire to settle debt
• Untermyer: So that a man with .................. , without anything at all behind it, can get all the
obligations credit he wants, and a man with the property can not get it?
• Capital • Morgan: That is very often the case
Resolves private information and moral hazard problems • Untermyer: If that is the rule of business, … why do the banks demand … a statement of
what the man has got, before they extend him credit? He does not get it on his face or
• Collateral ………….. ?
Includes both, “inside” and “outside” collateral. These resolve private • Morgan: Yes; he gets it on his …………. Because a man I do not trust could not get money
information and moral hazard problems. Also directly reduce bank’s risk from me on all the bonds in Christendom

• Conditions and later …

These are economic conditions that affect the borrower’s ability to repay • Untermyer: But what I mean is that the banking house assumes no legal responsibility for
the value of the bonds, does it?
the loan
• Morgan: No sir, but it assumes something else that is still more important, and that is the
moral responsibility which has to be defended so long as you live…
Now it is 6C (cash) or even 7C (cash + control/creditworthiness/credit
scoring) Testimony of J. Pierpoint Morgan at the 1912 Money Trust Investigation hearings of the House Banking and
Currency Committee. Samuel Untermyer was the legal counsel for the committee
7 8

Loan Analysis and Rating Scoring and Probability of Default

• Rating: • Scoring:
Ordinal value, assigned as a result of a loan analysis. Different granularities • Cardinal value, assigned as a result of a loan analysis.
may be used: Credit scores are quantitative in nature, they directly assign a
• Acceptable / not acceptable (white/black) numerical value to the credit quality, for example:
• Acceptable / uncertain / not acceptable (white/grey/black)  Output of a logit / probit - model
 Output of a discriminant analysis

• Part of a multi-category rating system

• Probability of Default, PD:
– Ratings are sometimes
also available for groups • Statistical value, based on an estimated loss distribution of a loan
of borrowers, industries, portfolio
transactions, etc.
– Usually
• Usually credit ratings and credit scores cannot be directly converted
7-12 rating categories into probabilities of default. Possible solution: Calibration of rating
– Example: Bond ratings categories

9 10

A Framework for Credit and

Rating and Calibration
Lending Decisions
• Problem: • External Factors
If ratings are to be used in quantitative credit risk models they have to be
• General law of the land: the financial institution must
calibrated
follow the lending regulations in the country that it
• Required data set operates.
• Loan data for at least one full credit cycle • Macroeconomics: the general condition of the economy
• Loan loss distributions for each rating category and year directly affect the lending decisions
• Alternatively: Calibration based on • Industry – specific: lending institution analyze in details
• Bond market data (domestic / foreign) the characteristics of each industry
• Loan data of other banks • The Reserve Bank Act of 1959, The Uniform Consumer
• Loan data of other countries Credit Code, The Australian Securities and Investments
Commission Act 1989, The Australian Competition and
 Significant deviations from “real numbers” are possible …
Consumer Commission

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2
 A Framework for Credit and
The Lending Process
Lending Decisions
• Lending – institution specific factors • The ten-step process:
• The lending policy: each lending institution has • Step 1 – obtain the application form
a policy upon which all lending procedures
mush follow • Step 2 – obtain required documents
• The loan budget: lending has to follow the loan • Step 3 – check the application & documents
budget to fit in the predetermined budget • Step 4 – Decision to make personal loans.
and/or the strategic direction of the institution. Business loans require further steps
• Staff availability: lending institutions might • Step 5 – Appraise detailed aspects the proposed
restrict their lending upon the availability of business borrowers
their skilled loan officers
• Borrower – specific factors: the 5 C’s

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Characteristics of Different Types of

The Lending Process
Advance/Loans
• The ten-step process (con’t):
• Traditional types of advance
• Step 6 – access the financial
• Loans
requirements/project to invest in/equity capital
– Secure (with Collateral) vs. Unsecure
of the borrowers
– Personal vs. Business vs. Government
• Step 7 – inform the borrowers whether the – Long vs. Medium vs. Short term
proposals have been approved or rejected – Sectors, Regions, Purposes…
• Step 8 – in case approved, ensure proper • Overdrafts: revolving accounts, short term; credit card
documents is a type of overdrafts
• Step 9 – monitor the account periodically
• Step 10 – take precaution toward probable
problem loans

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Characteristics of Different Types of Advance Different Types of Borrower

• Modern types of advance for businesses: • Personal Borrowers

• Equity participation • Minors
• Loan syndication • Persons of unsound mind
• Equipment leasing • Insolvents
• Factoring • Joint accounts
• Husband & Wife
• Business Borrowers
• Sole proprietorship
• Partnerships
• Companies

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 Different Types of Borrower Structuring of Advances

• Involves three major aspects

• Special Type of Borrower
– Security: assets taken as insurance, protecting the
– Local authorities: certain local authorities have special lender from uncertainty
borrowing power
– Debt covenants: terms and conditions such as fees,
– Club, literacy societies, and schools interest rate, security, repayments, stamp duty… that
– Unincorporated associations characterize the loan
– Cooperatives Affirmative/Negative covenants!!!!
– Pricing issues:
Lending rate = Base rate /Prime rate + Risk premium
The base rate is the same for every proposal but the
risk premium is determined on a case-to-case basis

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Credit Culture Designing an Advances Portfolio

• The institutional priorities, traditions, and • Typically, a financial institution uses up to

philosophies that surround credit and 70% of its assets in loans and advances
lending decisions • Three steps in designing the loans and
– The fundamental principles that drive lending
activity and how management analyzes risk
advances portfolio:
– Values Driven: Focus is on credit quality – Historical and recent loss experience
– Current-Profit Driven: Focus is on short-term – Standards based on maximum loss tolerance relative to
earnings capital
– Market-Share Driven: Focus is on having the – Risk-adjusted return on capital,
highest market share

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Summary

• basic principles governing bank lending

• framework within which credit and lending
decisions are made
• various steps involved in the lending process
• characteristics of various types of bank
advance
• different types of borrower
• structuring loans and advances
• importance of credit culture
• designing loans and advances portfolios

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 LENDING DECISION Learning Objectives

• Explain key financial statements

• Explain the importance of analysis of financial
statements in lending decisions
• Describe the various methods of analysis where
Financial Statements Analysis project finance is involved
Chapter 2

1 2
1 2

Learning Objectives Learning Objectives

• Describe the special techniques of analysis where • Explain which of the financial ratios are preferred by
project finance is involved loan officers
• Describe how window dressing of financial • Outline the limitations of financial statements analysis
statements can take place

3 4
3 4

Why Lenders Analyse Financial

Introduction
Statements

• The analysis of financial statements plays a key role • Financial statements are analysed to help determine
in assessing potential business loans whether:
• Generally consist of: – The business has adequate liquidity so it can honour
short-term obligations
• Statement of Financial Performance
– The business is run efficiently
• Statement of Financial Position
– The business is run profitably
• Statement of Cashflows
– The proprietor’s stake in the business is high versus the
business carrying excessive debt

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1
 Why Lenders Analyse Financial
Analysis of Financial Statements
Statements

• Analysis helps provide answers to three key • The analysis of financial statements falls into three
questions: broad categories:
– Should the bank give the requested loan? • Cross-sectional techniques, such as ratio analysis and
– If the loan is given, will it be repaid together with interest?
common-size statements
– What is the bank’s remedy if the assumptions of the loan
• Time series techniques, such as identifying trends in
ratios or other measures
turn out to be wrong?
• A combination of the two.

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7 8

Analysis of Financial Statements Analysis of Financial Statements

• Cross-sectional techniques • Liquidity ratios

• Ratios: Financial ratios derived from the financial • Used to determine the ability of the firm to meet its
statements fall into four main categories: short-term obligations
– Liquidity ratios
– Efficiency ratios • Current Ratio
– Profitability ratios
– Leverage ratios • Quick Ratio

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9 10

Analysis of Financial Statements Analysis of Financial Statements

• Efficiency ratios • Profitability ratios

• Used to determine how efficiently the firm has • Used to assess the profitability of sales generated
used its assets through operations

– Inventory Turnover – Gross Profit–Sales

Ratio Ratio

– Average Collection – Net Profit–Sales

Period Ratio
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2
 Analysis of Financial Statements Analysis of Financial Statements

• Leverage ratios • Leverage ratios

• Used to assess the proportions and manageability • Fixed Charges Coverage Ratio
of debt carried by a firm

– Debt–Equity
Ratio
– Interest
Coverage
Ratio
13 14
13 14

Analysis of Financial Statements Analysis of Financial Statements

• Common-Size Statements • Time Series Techniques

• Express relationships between the numbers on the • Ratios can be evaluated to detect any improvements or
financial statements deteriorations in financial position over time
• For example, the following items may be expressed as
• Variability Measures: Where trends are not detected,
a percentage of total assets:
these may be used to determine the variability over
– Accounts Receivable
time
– Inventory
– Equity

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15 16

Techniques of Analysis Used in Project

Analysis of Financial Statements
Finance

• Combining Financial Statement and Nonfinancial • Payback Period: the time it takes for an entity
Statement Information to recover a project’s initial cash outlay.
• Other information that may be incorporated into the • Accounting Rate of Return: earnings from a
analysis include: project (after tax and depreciation)/investment
– Changes in market share outlay.
– Market perceptions via share price • Discounted Cashflow Techniques
– Changes in key management
– Impact of macroeconomic changes – Net Present
Value
– Internal Rate
of Return
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 Project Risk Analysis Project Risk Analysis

• Sensitivity Analysis:
– Measures the impact of changes on key variables,
such as the interest rate or prices of key inputs, on
• Margin of Safety
the project’s viability
– The margin between the profitability of current
• Break-Even Analysis operations and break-even point
– The level of sales at which revenue equals • Cash Break-Even Point
expenses and net income is zero
– Requires knowledge of fixed and variable costs
• Simulation
– Computational approach where one variable is
changed at a time to determine sensitivities across
numerous variables

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19 20

Step-By-Step Approach to Financial Step-By-Step Approach to Financial

Statements Analysis Statements Analysis

• Step 1: Obtain relevant financial statements • Step 3: Undertake preliminary scrutiny of financial
– Obtain Statement of Financial Performance, Statement of statements
Financial Position and Cashflow statements for generally – Statement of Financial Performance
three years – Statement of Financial Position
• Step 2: Check for consistency – Cashflow Statement
– Verify names on financial statements, signatures of • Step 4: Collect data about industry and general
partners, corporate seals etc.
economic trends
– Strength of economy and relevant industry

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Step-By-Step Approach to Financial Detecting Window Dressing, Frauds and

Statements Analysis Errors

• Step 5: Comparison with Industry Averages • Overwhelming accounting complexities lead to

– How does firm’s financial ratios compare with potential abuses of the notion of ‘true and fair’ via
competitor’s in same industry manipulation of:
• Step 6: Do Supplementary Analysis – Valuation of receivables inventory, property, marketable
– Break-even and Sensitivity Analysis securities and other assets
• Step 7: Summarise Main Features – Liabilities including off-balance sheet items
– Provide an analytical overview from all relevant data – Changes to accounting methods
obtained

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 Limitations of Financial Statements
Use of Financial Ratios by Loan Officers
Analysis

• Top ten ratios of importance in loan assessment • Financial statements analysis cannot substitute for
sound judgement:
– Problems with benchmarks: What benchmarks should be
1 Debt/Equity 6 Net Interest Earned used for multi-industry firms?
2 Current Ratio 7 Net Profit Before Tax – Window Dressing/Creative Accounting
– Historical Data: Accounting reports reveal only history,
3 Cash Flow/LT Debt 8 Financial Leverage not the future
4 Fixed Charge Cover 9 Inv T/O in Days – Qualitative Aspects: Changes in management, the
economy, etc.
5 Net Profit After Tax 10 A/c Rec T/O in Days

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Summary

• Key financial statements

• Importance of analysis
• Techniques for project risk analysis
• Step-by-step approach and window dressing
• Financial ratios used by lenders
• limitations

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 LENDING DECISION Credit Scoring: An Important Factor

• Credit scoring models have been used in the U.S. for a long time,
and most extensively since the 1990s. Today they are an integral
part of the financial system
• Scoring Models are still predominantly used for consumer credits:
About 70% of the home loans and almost 100% of the $2 trillion
in credit-card, auto, and personal loans outstanding are made
Credit Scoring Technique using a customer’s credit score
Chapter 3 • Furthermore: Scoring is important for asset securitization or asset
sales → hundreds of loans can be evaluated in minutes
• Lenders automatically report all “credit events” to three major
credit reporting agencies (=credit bureaus): Experian, Equifax,
Trans Union.
• Customers are identified by their personal Social Security
Number (Format of SS#: 123-45-6789)

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1

Learning Objectives Credit Scoring: Data Collection

• List the development of credit scoring techniques

• Information being collected by credit bureaus:
• Discuss the behavioural aspects of credit scoring • Types of credit
• Explain the imperative for credit scoring • Length of time accounts have been open
• Payment habits (late payments)
• Amount of credit allowed
• Amount of credit used
• Applications for new credit
• etc.
• The information is usually monthly updated and compiled in a so-called credit
report

2 5
2

Learning Objectives Introduction

• Discuss the application of credit scoring techniques • Statistical credit scoring technique serves
• List the various modelling techniques used in credit as a centralized model that can be overlaid
scoring across the whole organization to reduce the
• Discuss the steps to take in implementing the credit potential for error in credit scoring
scoring program
• The rapid growth of technology has
automated a significant part of statistical
analysis in credit scoring technique,
downgrading the traditional role of a loan
officer

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1
 Overview of Credit The Imperative for
Scoring Techniques Credit Scoring

• Three basic characteristics of a valid statistical • Credit scoring enabled banks for the first time to have
credit scoring system a true measure of risk in a given loan portfolio
• Must not rely on prohibited and unjustified • Credit scoring could create competitive advantage
information from cost savings and efficiency gains
• The information used must contribute positively to • Handled much higher application volume given
a client’s creditworthiness
limited resources
• The credit extend should contribute to the credit
health and quality of the lending institution • Better managed customer database (needs,
preference)
• Allowed increased flexibility and expansion in SMEs
• Strengthened customer relationship

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The Development of Statistical Credit Scoring Techniques vs.

Statistical Credit Scoring Traditional Judgmental Methods
• Parallels the increase in per person outstanding Topic Statistical Scoring Judgemental Scoring
credit and the expansion of the credit industry 1. Popular difference Impractical or unsound mixture of Credit officers make an unspecified
population are not sampled adjustment
• The need for a system was identified in the 1960’s
2. Definition of Precise corporate rules are defined The system relies on individual
• In the 1980’s technology allows further development creditworthiness and agreed interpretation of what is good and
and sophistication of the credit scoring techniques bad
3. Use of credit rules Credit rules are avoided because Credit rules are often based on
• In the same period, the application of these the system will generate its own limited data that dwell on the past
techniques was successfully implemented in the best rules
credit card market 4. Use of applicant Less information is needed because Wide use is made of data that are
information redundant information is ignored sometimes conflicting
• Credit scoring techniques continued to expand to
5. Analysis of account Analysis reveals distinctive and Rarely is a precise or accurate
other areas of consumer lending behavior objective pattern of good and bad analysis produced to guide the
• The techniques are now used for the full range of behavior future

lending products, from individuals to larger corporate 6. Validity of The impact and validity of individual Decisions are made without
characteristics and bits of information can be accessed knowing the true value of items of
loans. interrelationships information
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The Development of Statistical Credit Scoring Techniques vs.

Statistical Credit Scoring Traditional Judgmental Methods

• Judgmental decision-making vs. credit scoring has Topic Statistical Scoring Judgemental Scoring
been a source of tension within banking circles 7. Validation of Scoring formulations can be tested It is not practical to measure the
system used against a variety of samples for precise effect
• In Australia, the credit scoring techniques have consistency and prediction
proven to be a better selection to handle the larger 8. Operation The system is based on high volume The system can be time consuming
impact/flexibility versus low cost and accordingly expensive
volume as well as minimize the risk imposed from
9. Improved Calculations can be made for It is difficult to estimate the value
human judgment calculations and decisions on good, bad or reject of a model to measure
expected results behavior performance
• Ensures more accurate risk identification
10. Management Management sets and defines policy It is difficult to tighten or ease
• Significant cost reduction control by the ability to vary the cut-off score credit policy without causing an
• More efficient human capital according to conditions overreaction or under-reaction
11. Monitoring and Measures can be monitored against The level of performance can be
• The deregulation and modernization approach in wider use current practice and developmental measured but the financial
Australia increased the demand for credit scoring models institution has no ability to easily
pinpoint scope for improvement
techniques
9 12
9 12

2
 Statistical Credit Scoring Techniques vs. Social & Ethical Issues in
Traditional Judgmental Methods Apply Credit Scoring Techniques

• Two broad categories of scoring • Social issues vs. drive for efficiency and productivity
• Accounting – based system • Steps to ensure the veracity of the system
• Quantitative credit screening 1. Solve the problem of volume vs. relationship. Planning
– Credit approval models which use decision – reaching of the financial position is essential for success
analysis 2. Understand what the model is meant to achieve and its
– Behavioral scoring models which are used to improve the impact on the culture of the organization
profitability of accounts and products
3. Understand type I and type II errors
• The major difference is the predictive nature of the 1. Type I – approval of a loan when it should have been
accounting – based method as opposed to the rear – rejected
view analysis of the quantitative models 2. Type II – rejection of a loan when it should have been
approved
4. Remove the potential for bias for decision – making
13 16
13 16

Statistical Decision-making Methods

Error types in credit analysis
Used in Credit Scoring Models
• Two main errors:
1. Probability modelling • Giving out a loan to a “bad” borrower
 Type I error, Alpha error
2. Application credit scoring models • Rejecting a “good” borrower
3. Application derivatives  Type II error, Beta error
a) Mail solicitation score
Actual Loan Predicted Loan Quality
b) Attrition models Quality Good Bad
c) Authorization scores
Good Type I Accuracy Type II Error
4. Judgemental credit scoring
5. Collection models
Bad Type I Error Type II Accuracy
6. Regression analysis
7. Logistic regression

14 17
14

Statistical Decision-making Methods Implementing Credit Scoring

Used in Credit Scoring Models within the Organization
• The implementation process requires a marriage
8. Decision tree models between expertise and technology
9. Neural networks • Phrase I – Planning
10. Genetic algorithms • Agreement of the board and executives on project objectives,
costs and expected benefits
11. Mortality models
• Correct and impartial selection of the implementation teams
12. Chi – square automatic interaction detector (CHAID) • Selection of the internal developers and agreement on the
13. Expert systems project scope or limitations
a) An information module • Development of an outline plan and define different interest
b) An information database module groups
c) A learning module • Collect preliminary data on transactions volumes, rejection
rates, levels of delinquency over time
• Investigation of data

15 18
15 18

3
 Implementing Credit Scoring
within the Organization Covid-19 and credit loss models
• COVID-19 and Credit Loss Models (Source: GARP)
• Phrase II • Credit modeling teams across the U.S. are now reconstructing and refitting
• Review the implementation plan and agree on a definitive their forecasting models.
long – term plan between the internal and external teams • Historically, huge upticks in joblessness have been directly connected to
default upsurges, but government-driven stimulus plans enacted amid the
• Construct and agree on robust definitions of good, bad, pandemic have taught modelers that there are other important income
and intermediate transactions. Calculate good, bad, variables to consider when projecting credit losses.
acceptance and rejection rate • Example:
• Use definitions and a reference period to isolate and list
individual transactions to make up the large sample
needed for later analysis
• Produce and agree on precise methods of coding

19 22
19

Implementing Credit Scoring

within the Organization Unemployment and Deliquency Rate

• Phrase III
• Analyze the characteristics in the main performance groups
• Weight the sample counts of individual transactions
• Inform and discuss with management the testing results and
progress
• Phrase IV
• Formulate and refine future operational practices
• Design and deliver the computer system to be used to support
the accurate operational use of the scoring formulation
• Produce and discuss with management dome three-dimensional
illustrations that show the effect of individual characteristics in
the database on rejection and bad experience rate

20 23
20

What are problematic areas of credit

Impact of Covid-19 (Source: GARP)
scoring?
• Short history: Most models use data going back only two years
• Bad data: Credit-report data used in the models are sometimes inaccurate • The onset of COVID-19 changed things overnight. Governments imposed
shutdowns on business activity, and the demand for leisure, hospitality and
• Score polishing: “Advisors” help borrowers to improve scores by rearranging retail services waned significantly.
finances
• Unemployment rose as a direct consequence. While entirely justifiable, these
• Discrimination potential: Critics mention that scoring unfairly steers minorities atypical acts disrupted the finely-tuned relationship between the
into higher-priced loans unemployment rate and charge-offs.
• More and more “parts of life” are dependent on or influencing credit score
• Renting an apartment, cell phone contracts, utilities, etc.
• Car insurance application is dependent on credit score
• Unpaid parking tickets, library fees, etc. start to influence credit score

21 24

4
 Impact of Covid-19 (Source: GARP)

• Models trained on history knew no better than to send default rates soaring
when unemployment spiked in March and April. But the overall default impact
was offset by the unprecedented amount of government support provided to
households in the form of stimulus checks and unemployment insurance
benefits.
• So, while the unemployment rate soared, household incomes were supported,
and actually rose in many cases. Flush with cash and propped up by generous
forbearance programs, households continued to pay their bills, sending
delinquencies and charge-offs down - exactly opposite from what we expected.
• → Missing-Variable-Problem

25

Impact of Covid-19 (Source: GARP)

26

5
 LENDING DECISION Learning Objectives

• Define credit risk

• Analyze various approaches to credit risk analysis
• Explain expert system
• Carry out a five C’s analysis
Credit Risk Analysis – An
Introduction
Chapter 4

1 2
1 2

Learning Objectives Introduction

• Ascertain credit risk from market-based spreads • It is important to understand credit risk
• Describe various econometric processes before learning how to analyze it
• Carry out a basic Altman analysis • In the past 15 years, there has been an
• Describe hybrid systems of credit risk analysis explosion of analysis with the developments
• Look at company data and carry out a basic credit of many tools
analysis

3 4
3 4

Credit Risk Credit Risk according to ChatGPT

• The Basel Committee on Banking Supervision defines credit risk as “the
potential that a bank borrower or counterparty will fail to meet its
obligations in accordance with agreed terms.”

5 6

1
 What is Credit Risk How do We Analyze Credit Risk

• Credit/default risk is the potential for the financial obligations

of a contract not to be fulfilled • Four broad categories of available tools
• Arises from any service that provided and not paid for immediately • Expert systems
• Risk premium analysis
• A contract is the underlying subject of credit risk
• Econometrics
• Obligations of the borrower
• Obligations of the lender • Hybrid – system
• Payment dates for interest and principal
• Maturity date
• Credit risk over three stages
• Application
• During the term of the loan
• When a loan becomes problematic
7 8
7 8

How do We Analyze Credit Risk How do We Analyze Credit Risk

• Risk premium analysis
• Expert Systems • Measure credit risk by examining the risk premium
• These systems tend to be manually based between each corporate credit rating and a risk – free rate
• Computer assistance for simple financial ratios • When there is indifference about investing in corporate
calculation debt and risk-free debt p (1 + r) = 1 + i
– p = the probability of repayment
• The whole process is paper – based
– r = the interest rate on the corporate bond
• The five C’s
– i = the risk free rate
– Capacity analysis
• When there is difference, with e represents the proportion
– Current ratio
of the loan can be recovered at default, the risk premium
– Inventory turnover ratio
(r – i) = [(1+ i) /(e + p – pe)] – (1 + i)
– Net profit – sales ratio
– Recover rate e can be provided through
– Debt – equity ratio
– Rating agencies (rated debts)
– Historical experiences (nonrated debts)
9 10
9 10

How do We Analyze Credit Risk How do We Analyze Credit Risk

• Econometric analysis
• Risk premiums over time • Regression analysis
• The probability of default over time is known as the – Only multiple regression applicable for making lending
Cumulative Default Probability (CDP) decisions
• CDP = 1 – p(1) * p(2) * p(n) – Seeks to use historical data to predict the future
– p(n) the probability of repayment over period n – Cons: unavailability of the probability of the default of
existing borrowers; variables selections
• Calculate p(n+1) = (1+ i(n+1)) / (1+ r(n+1))
• Advanced regression
• Using geometric mean
– Linear or probit analysis seeks to divide the samples into
– Power (1 + i(n+1), 2) = (1+ i(n)) * (1 + i(n-1))
two populations based on the outcome of the loans
– Power (1 + r(n+1), 2) = (1+ r(n)) * (1 + r(n-1)) – Multiple regression p(i) = Σβ(i) X (i) + error
– Where p(i) = the probability of default
– β= the estimate of the importance of variable X
– P(i) = 1 if the loan has defaulted and = 0 if otherwise
11 12
11 12

2
 How do We Analyze Credit Risk How do We Analyze Credit Risk

• Advanced regression • Hybrid system

• The calculated value of p(i) above however does not • Expected default frequency
always fall in to the [0,1] range. In order to solve this – Based on the thesis that the above relationship between
problem, a new formula was introduced borrower and lender is one of options
– f(p(i)) = 1 / [1 + power {e, -z(i)}] • Mortality models
– The formula above provides the value of z – How many loans “die” or default in a year: the marginal
• Discriminant analysis mortality rate
– MMR(t) = Total amount of loans in a credit rating that defaults
• The most significant advance in credit analysis
/ Total amount of loans issued in that credit rating
• The Z score Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
– The MMR is calculated for each credit rating and each year
• The Z score is a benchmark indicator that decides whether – The MMR can be translated into a value by which the loan
a company belongs in the defaulting or non-defaulting depreciates each year
category

13 14

3
 LENDING DECISION Learning Objectives

• Explain what consumer loans are

• Outline the major types of consumer loan
• Explain how different types of consumer loan
Consumer and Real Estate
application are evaluated
Lending • Explain, with the help of specimen consumer
Chapter 5, Chapter 6 loan applications, how the principles of
lending are applied in practice

1 2
1 2

Learning Objectives Learning Objectives

• Enumerate the precautions to be taken in • Explain what real estate loans are
assessing consumer loan applications • Explain how real estate loan applications are
evaluated
• Discuss how credit scoring of consumer
• Explain, with the help of specimen real estate loan
loan applications is done
applications, how the principles of lending are applied
• Briefly explain the laws and regulations in practice
affecting consumer loans • Enumerate the precautions to be taken in assessing
• Outline the trends in consumer credit real estate loan applications
• Outline the trends in real estate market
• Explain the pricing aspect of consumer
• Explain the pricing aspect of real estate loans
loans

3 4
3 4

Introduction Different Consumer Credit Products …

• Credit Cards
• Consumer credit refers to loans that • Bank Overdraft Products
individuals or households require to meet • Payday Lending
• Personal Loans and Peer-to-Peer Lending
personal needs , for finance consumption
• Home-Equity Lending
and not for productive purposes • Rent-to-own contracts
• The maturities of consumer loans vary • Auto-Title Lending
• Pawnbroking
according to the purpose for which the • Refund-Anticipation Loans
loans are given (up to five years) • Informal Lending
• The demand for consumer credit has been
• Many of these products need a credit scoring system …
rapidly growing in developing nations

5 6
5

1
 Types of Consumer Loan Types of Consumer Loan

• Installment Loans • Credit Cards and Other Revolving Credit

• Require the periodic payment of principal and • Credit cards and over-lines tied to checking
interest
accounts are the two most popular forms of
• Can be extremely profitable
revolving credit agreements
• Direct
– In 2004 consumers charged approximately $2.5 trillion
– Negotiated between the bank and the ultimate user of
the funds on credit cards
• Indirect • Most banks operate as franchises of
– Funded by a bank through a separate retailer that MasterCard and/or Visa
sells merchandise to a customer – Bank pays a one-time membership fee plus an annual
charge determined by the number of its customers
actively using the cards

7 8
7 8

Types of Consumer Loans Credit card transaction process

• Credit Cards and Other Revolving Credit Individual

1 Retail Outlet
• Credit cards are attractive because they provide
higher risk-adjusted returns than do other types of 4 2
loans Card-Issuing Clearing Local Merchant
Bank 3 Network 3 Bank
– Card issuers earn income from three sources:
• Cardholders’ annual fees 2
• Interest on outstanding loan balances
• Discounting the charges that merchants accept
on purchases.

9 10
9

Types of Consumer Loans Evaluate Consumer Loan Applications

• Overdraft Protection and Open Credit Lines • The assessment of a consumer loan
• Overdraft Protection Against Checking Accounts application follows the 3 fundamental
– A type of revolving credit C’s of lending:
• Open Credit Lines • Character: of the prospective borrower is the
• A recent trend is to offer open credit lines to single most important factor
affluent individuals whether or not they have an • Capacity to pay: net income, job and other
existing account relationship factors that indicate the borrower’s ability to
• Typically, the bank provides customers with repay the loan
special checks that activate a loan when • Collateral: assets that can be used as an
presented for payment insurance in unforeseen circumstances

11 12
11 12

2
 Precautions to be Taken in Granting
Evaluate Consumer Loan Applications
Consumer Loans

Step by step assessment of personal loans • Consumer loans are easier to assess and
1. Obtaining a prescribed application form monitor than business loans
2. Conducting a preliminary assessment • Some of the challenges include
3. Accepting and loan applications • The completeness and accuracy of the
4. Taking securities submitted information
5. Determining interests, fees, and charges • The assessment of unforeseen circumstances
6. Approving/rejecting applications • Credit scoring system vs. personal judgment
7. Supervising the loan and following up • Changes in lending policy of the institution
The assessment of credit card loans is similar to that • Changes in regulations related to consumer
of personal loans, even more simple lending

13 14
13 14

Credit Scoring Consumer Loan Application Legal Aspects of Consumer Credit

• The credit scoring system has advantages • Equal Credit Opportunity

over the traditional 3 C’s assessment • Makes it illegal for lenders to discriminate
• Prohibits Information Requests on:
approach – The applicant's marital status
• Can handle larger volume of applications – Whether alimony, child support, and public assistance
• Can speed up the assessment process are included in reported income
– A woman's childbearing capability and plans
• Lower operating cost
• Credit Scoring Systems
• More consistent in lending decisions – Credit scoring systems are acceptable if they do not
• Consumers can apply and receive the require prohibited information & are statistically justified
application result over the Internet within a – Credit scoring systems can use information about age,
sex, and marital status as long as these factors
short time frame contribute positively to the applicant's creditworthiness

15 16
15 16

Legal Aspects of Consumer Credit Legal Aspects of Consumer Credit

• Truth In Lending • The Uniform Consumer Credit Code – Standardize all

• Regulations apply to all individual loans up to $25,000 where credit activities: report, disclosure
the borrower's primary residence does not serve as collateral
• Requires that lenders disclose to potential borrowers both the
• The Code of Banking Practice – Foster good
total finance charge and an annual percentage rate (APR) relations between banks and customers
• Fair Credit Reporting Act • Trade practices legislation – Encourage fair dealing
• Enables individuals to examine their credit reports provided in all levels of business
by credit bureaus
– If any information is incorrect, the individual can have the
• The Australian Securities and Investments
bureau make changes and notify all lenders who obtained the Commission – monitor and promote market integrity
inaccurate data and consumer protection
• There are three primary credit reporting agencies:
– Equifax • Privacy legislation – imposes limits on credit reporting
– Experian agencies’ disclosure of personal information
– Trans Union

17 18
17 18

3
 Pricing and Structuring of
Trends in Consumer Credit
Consumer Loans

• Personal lending is on the rise and banks • Loan pricing: rate of interest, fees and
occupy a dominant position in providing the other terms on which a bank gives a loan
financing • Fixed vs. Variable
• Revolving credit has been growing in three • Bank fees – vary depending on the type of loan
areas: personal overdrafts, credit cards, and • Loan Structuring refers to the repayment
margin loans patterns and other terms
• The advance of technology has opened up • Taking securities
a range of alternative delivery channels, • Loan covenants
supported credit analysis and risk
management
19 20
19 20

Summary Real Estate Loans

• The nature of consumer loans, types of loans,

evaluation thereof, precautions to be taken in • Made for longer periods of time, ranging from 10
granting, to 30 years
• The legislations that impact consumer loans: the • Secured by the property
National Credit Code, Anti-discrimination Laws, • Largest single type of personal loans
Privacy Act.
• Other types of real estate loans:
• Trends in consumer credit
• Home equity loan
• Bridge loan
• Subprime loan

21 22
21 22

Evaluating Real Estate Loan Applications Evaluating Real Estate Loan Applications

• The cost approach:

Valuation of property • Value of the property equals the sum of all the cost to
improve the land, deducts depreciation
• The market value approach: • Provides a near accurate estimate for newer properties
• The market value of the property is determined • Drawbacks: does not account for market supply and
based on that of similar properties sold in recent demand, and consumer preferences
time • The capitalization approach:
• Easy to execute, specially accurate in case of • Uses the rental-sale price ratio from comparable property
bare lands to derive the price of the real estate in hand
• The capitalization rate = 100 / price / annual net income
• Drawbacks: unavailable, incomparable properties;
• Easy to execute, often used to value commercial properties
does not account for intangible values
• In practice, all three approaches often are used
together to price a real estate.

23 24
23 24

4
Evaluating Real Estate Loan Applications Trends in Real Estate Credit

• Step by step valuation of home loans • Bank continues to dominate the home loan
1. Obtain the prescribed application market
2. Determine the eligibility of the application
• The grow of non-traditional home loans:
3. If the loan is approved, prepare the documents
subprime, bridge loans…
4. Proceed if the applicant accept the offered loan
5. Arrange for the settlement of the loan
• Home loan pricing has reduced significantly in
recent years
• The bank calculates the loan installment based on
the amount of loan, the period, and the interest rate • Changes in the market perspective after the US
housing bubble
• The valuation is more complicated in case of
investment home loan where the projection of
income must also be reviewed

25 26
25 26

Pricing and Structuring of Pricing and Structuring of

Real Estate Loans Real Estate Loans
• Fixed rate does not change over time while variable
rate does • A loan officer often works with the customer
• Fixed rate if often higher than variable to propose different pricing and loan
• Calculation of monthly mortgage payment structuring plans
• MRP = (P * R * Y) / Z • Important documents include:
• P: loan principal; R: monthly loan rate • Promissory note
• Y = Power [(1+R), t*12) • Mortgage deed, sale deed
• Z = Y – 1; t: the number of years of the loan • A letter of guarantee
• There are various fees charged by the bank either • Loan agreement, default clause
front load or back load • Repayment, interest rates, security, fees

27 28
27 28

Asian Housing Markets Housing Crunch

(https://www.economist.com/the-world-ahead/2022/11/18/asian-housing-markets-are- (https://www.economist.com/finance-and-economics/2022/11/24/where-the-coming-housing-crunch-will-
looking-precarious) be-most-painful )

29 30

5
 South Korea’s Housing Crunch China’s Property Market
(https://www.economist.com/finance-and-economics/2023/02/09/south-koreas-housing-crunch-offers-a- (https://www.economist.com/finance-and-economics/2022/09/12/chinas-ponzi-like-property-market-is-
warning-for-other-countries) eroding-faith-in-the-government)

31 32

China’s Property Slump Property Prices and the Economy

(https://www.economist.com/leaders/2023/01/26/chinas-property-slump-is-easing-but-the-relief-will-be- (https://www.economist.com/finance-and-economics/2022/07/28/how-high-property-prices-can-damage-
short-lived) the-economy)

It explores how high and

rising land prices affect
One reason for the pain was lending, investment and
the government’s attempt to ultimately productivity, and
break the country’s much of it looks closely at
addiction to debt-financed China’s long property boom.
property. More than The worrying conclusion is
two- that high and rising property
thirds of urban households’ prices can also have
wealth is tied up in real damaging economic effects,
estate and the industry . by crowding out productive
underpins a fifth of gdp investment and leading to a
misallocation of .
capital

33 34

Looking From Outside – Some Headlines Looking From Outside – Some Headlines

35 36

6
 Summary

• Real estate loans: Nature, valuation, several

precautions necessary
• Application of lending principles to real estate loans:
step-by-step evaluation
• Trends in real estate loans: Banks consider it safe
lending but …. subprime experience/ risk of property
market crisis looms

37
37

7
 LENDING DECISION Learning Objectives

• Understand the legal framework that

governs consumer and real estate
Security, Consumer Credit lending
• Explain the various lending documents
Legislation and Legal Aspects that need to be obtained in consumer
of Lending and real estate lending and their purpose
Chapter 7
• Understand the special legal rights of
lending bankers

1 2
1 2

Learning Objectives Introduction

• Explain the legal requirements that are • The legal framework widely affects credit
specific to home loans lending decisions.
• Explain other relevant legal aspects • In this chapter, we only concern the
(banker’s lien, the right to sell off and legislations in regard with consumer and
appropriation of payments) in bank lending real estate loans:
• Prepare a checklist that lending officers • Contract law Tort law
• Property law Insurance law
can use to ensure they have satisfy
• The law relating to guarantees Bankruptcy law
fundamental legal requirements of lending • Consumer protection law

3 4
3 4

Overview of the Legal Framework Overview of the Legal Framework

Phase 1 Pre-loan approval Phase 1 Pre-loan approval

• Contract law • The Uniform Consumer Credit Code

• The prospect borrower has the legal capacity to • Applies to any business that engages in the
enter into a loan contract provision of consumer credit
• Consent under the privacy law • Documents must be eligible and clearly expressed
• The Privacy Act 1988 • Regulates interest rate calculation
• Limits on the disclosure of personal information by • Allows early repayment
credit reporting agencies
• Requires full disclosure of fees charged
• prohibits harassment and unsolicited visits by a
credit provider
• Imposes civil and criminal penalties for violation

5 6
5 6

1
 Overview of the Legal Framework Overview of the Legal Framework
Phase 1 Pre-loan approval Phase 2 Post loan approval

• Promissory note
• The Trade Practices Act 1974
• Promise to pay the interest and repay the loan
• Encourage fair dealing in all level of business
amount borrowed
• Most violations are filed under “misleading and deceptive”
conducts • Mortgage deed
• The amount of the claim <= $40,000 • Legal mortgage vs. equitable mortgage
• Three-year limit applied to all claims • Guarantees
• The Contracts Review Act 1980, the Fair Trading • Contract to perform the promise or discharge the
Acts, and the Consumer Transactions Act 1972 liability of a 3rd person in the case of default
• Are State-level statutes
• Protects consumers and strikes down unfair and unjust
contracts

7 8
7 8

Overview of the Legal Framework Overview of the Legal Framework

Phase 2 Post loan approval Phase 2 Post loan approval

• Bill of sale • Execution of documents

• Primary document of evidence of the sale • Parties involved
contract • Signing of documents: must be executed in the
• An assignment of shares or life policies presence of the authorized representative
• A transfer of a right, property, or debt by one • Forms and contents of a loan document: must be
person to another consistent and completed
• Loan agreement • Balance confirmation letters: serve as an
acknowledgement of debt
• General contractual considerations
• Stamp duty: ad valorem duty
• Repayment terms, interest, and costs

9 10
9 10

Overview of the Legal Framework Overview of the Legal Framework

Phase 2 Post loan approval Phase 2 Post loan approval
• Special rights of lending bankers • Legal requirements specific to home loan
• Banker’s lien • Interest in real estate: freehold vs. leasehold
– signifies the right of the lender, in possession of • Encumbrances: a right or interest in a property held
the goods or security of the debtor until the debt is by one who is not the legal owner
fully repaid with interest • Lien: is a financial encumbrance, a claim against a
– Carries the right of sale and recoupment of the specific property
property • Foreclosure: gives the lender the right to become a
• The right to set-off and the right to full owner of the property in case of default
appropriate payments • Statute of limitations: specifies the period within
which a person may claim a legal remedy. For
• Combines the various accounts between the debtor
mortgage, the period of limitation ranges from 12 to
and the lender to arrive at the net balance payable to
20 years
one another

11 12
11 12

2
Other Relevant Legal Requirement in Lending Other Relevant Legal Requirement in Lending

• Overdraft and credit cards • Undue influence can occur when bank staff
• Bank charges fees to allow overdraft and provides advice to the customer beyond their
must honor the drawn balance standard practice
• The Electronic Fund Transfer Code of • Duress, coercion and compulsion mean actual
Conduct outlines the rights and obligations violence or threats of violence to the personal
safety or liberty of the other party
of the credit card users and card issuers
• 3rd party advisory often are seek to avoid
• Credit reference about customers must be given
potential charge of economic duress
with care and based on facts
• Anti-discrimination law prevents services from
being denied solely based on religion, sex,
sexual orientation, race, age, or nationality

13 14
13 14

Other Relevant Legal Requirement in Lending Other Relevant Legal Requirement in Lending

• The Bankruptcy Act

• The Code of Banking Practice
• Voluntary code sets out standards of disclosure and
• Provides a method for the equitable distribution of the conduct in dealing with customers
defaulted estate
• Provides for a release of the debtor from their • Australian Banking Industry Ombudsman
debts/obligations, allowing the bankrupt to make a • An authority for the resolution of disputes between
clean start customers and their banks
• Either the debtor or creditor can file a petition for • Australian Securities and Investments
bankruptcy Commission (ASIC)
• The ASIC Act 1989 empowers the commission to monitor
and promote market integrity and consumer protection
• Raises the standard of service delivered by financial
service providers to their customers

15 16
15 16

Checklist for Lending Officers Summary

• Legal framework governing consumer and real estate

• A lending officer must be aware of and comply with lending
all the legal aspects applied in conducting business • lending documents
• Given the complexities of legal requirements, it is • special legal rights of lending bankers
• legal requirements are specific to home loans
suggested that a lending officer follow a checklist to
• other relevant legal aspects in bank lending
ensure completed coverage • a checklist used by lending officers

17 18
17 18

3
 LENDING DECISION Learning Objectives

• Apply the principals of corporate lending

• Explain the application of lending criteria
• List the contents of the loan structuring proposal
• Discuss the importance of financial information
Corporate Lending • Explain the importance of managing the loan
Chapter 8 portfolio
• Demonstrate awareness of available loan
products

1 2
1 2

Introduction Overview of Corporate Lending

• Corporate lending represents the high end of the loan

• Corporate lending is an intuitive process that is more portfolio mix for a modern bank
an art than a science • Highly competitive market
• Credit scoring techniques become increasingly • Lower margin, higher risk
important, providing a quantitative foundation in • Diversification is essential in formulating a successful
making corporate lending decisions portfolio
• Quality of the loan is more important than quantity given
the potential risk
• The competence of the lender in evaluating the loan is
the most important factor
• Two major methods in the approval process:
• Knowledge-based approach (traditional method)
• Credit scoring or statistical method
• Lending criteria plus RAROC
3 4
3 4

The Purpose of Corporate Lending The Principles of Corporate Lending

• The lender’s primary purpose is to ensure the growth of

the loan books in a quality way • Financial institution should clearly define the
principals for corporate lending process in order to
• The loan portfolio
control and minimize risk
• Portfolio creation indicates the key success factor
• Both apparent and underlying risks must be taken
• Diversification in: interest rates, cashflows, and maturities
into account while assessing corporate loan
• Key considerations application
– Asset mix and loan types
• The “hurt money” rule: the resources of the borrower
– Geographic limits
are in the first tranche of funding; the lender
– Personnel expertise
advances funds only after the first tranche if fully
– Policy formulation
committed or spent
– Business environment
– Delegation
– Audit and review
5 6
5 6

1
 The Principles of Corporate Lending

• Three overarching principles of corporate lending:

• Safety – the ability to repay loan
• Suitability – lending policy, purpose of the loan, amount of • The lender when structuring the loan will have three ways
the loan, amount of “hurt money,” repayment schedule out (in priority):
• Profitability – adjusted return on investment • True repayment where the loan complies with the loan
agreement
• Three traditional ways to get out of a loan: • Collateral can be recovered
• The borrower fully complies and exit the loan as stated in • Target intangibles
the contract • Methods of assessment (addressed fully in subsequent
chapters):
• The covenants were breached, the lender activates liens • 5 C’s
over the physical security and initiates the recovering • PARSER
process • Statistical methods (Z Score, KMV, etc)
• Once the physical security is exhausted, the lender
targets the intangible assets of the business to recover Credit Analysis and Lending Management

the loan principal

7 8
7

The Principles of Corporate Lending The Principles of Corporate Lending

• There are two main methods to assess corporate • Methods to assess corporate lending (con’t)
lending • The PARSER
• The five C’s – Personal element: the characteristics of the corporate
– Character: history of the company, the management analyzed from a cultural and ethical viewpoint
team, the structure of the company, reputation – Amount required: purpose of the loan, reason for the
– Capacity: the ability to repay the loan and the ability to amount requested
borrow additional debts – Repayment: sources of repayment and its certainty
– Collateral: serves as security to reduce risk – Security: careful analysis and evaluation of both tangible
– Conditions: external and internal and intangible assets
– Capital – Expedience: the proposition of the loan in the lender’s
portfolio as a whole
– analysis of the company’s financial statements,
– debt holders vs. equity holders – Remuneration: the structure of the loan, its profitability,
whether the loan meets the criteria laid down by the
– capital structure including tax implications credit committee
9 10
9 10

The Principles of Corporate Lending

• The lending cycle
• A loan consists of three fundamentally different
activities which can be managed separately or
collectively • The lending cycle:
– Origination • Origination
– Credit check • Funding
– Examination of the credit needs • Monitoring
– Funding
– Types and cost of funding
– Managing
– Review and monitor the loan
• A formal lending cycle is essential to the ongoing
success of the institution and the overall profitability of Credit Analysis and Lending Management

the corporate loan portfolio

11 12
11

2
 The Principles of Corporate Lending The Principles of Corporate Lending

Unforeseen
• The lending cycle
events
Target markets Origin Evaluation Orderly
payment
Loss

Documentation Approval Negotiation

Workout
situation
Repayment
Administration
Disbursement • Orderly payment Write-off
• Unforeseen events

13 14
13 14

The Principles of Corporate Lending

• Structuring the loan proposal

• A loan is used to create cash that is greater than that needed to
expunge the loan
• Products
• Loan structuring is about creating the optimum terms and
conditions from both sides’ view point
• Example of questions to ask when structuring a loan:
– Is the loan amount sufficient to accomplish the task
– Is the cash available and is it identifiable for repayment
– What is the term of the debt
– Does the purpose of the loan match the term
– Does the asset conversion cycle generate sufficient cash for
repayment
Credit Analysis and Lending Management – What is the current debt capacity of the corporation
• Avoid double dipping
15 16
16

The Principles of Corporate Lending The Principles of Corporate Lending

• Product structure and application

• Small corporate entity • Larger corporations have bargaining power and access
• Suspect nature of the financial statements to multiple funding channels beside bank debts
• Large corporate entity – Intercompany loans
• Have access to multiple funding sources – Direct loans
• Demands creative and innovative funding instruments – Back-to-back loans
• Some popular intermediated products
– Revolving credit
– Standby lines
– Revolving underwriting facilities
– Syndicated facilities
– Project finance

17 18
17 18

3
 Credit Process
The Principles of Corporate Lending

• Seven specific features of project finance:

1. The project is a distinct financial entity
Advice Structuring Decision Execution Monitoring
2. Highly geared, often 75% funded by other equity holders
3. Loans are directly linked to the project’s assets and
cashflows
4. Sponsors’ guarantees are in limited amount and scope
5. End users and suppliers often supply credit support
6. The lender’s recourse is limited to the project assets
7. Finance is generally of longer term than conventional
corporate facilities
• Commonly used recourse in project financing
• Nonrecourse financing
• Limited recourse financing
19 20
19

Credit Process: Large Corporate Loan Credit Process

Advice Structuring Decision Execution Monitoring Advice Structuring Decision Execution Monitoring

Task: Outline the main activities for each of the Question: What is the main differences if you
above process steps for a Large Corporate Loan compare process details between the
• Credit Process: Large Corporate Loan
• Credit Process: Digital Consumer Loan

21 22

Credit Process: Digital Consumer Loan

Credit Process: Digital Consumer Loan

Advice Structuring Decision Execution Monitoring Advice Structuring Decision Execution Monitoring

• Predefined
• Client choses structure,
offering once client
based on its choses tenor
need online and amount

23 24

4
 Credit Process: Digital Consumer Loan Credit Process: Digital Consumer Loan

Advice Structuring Decision Execution Monitoring Advice Structuring Decision Execution Monitoring

• Client signs online electronic contract

• Verification of submitted data
• Automated disbursement of loan amount to client
• Check external sources (e.g. credit score) account
• Instant decision based on input from the client • Automated calculation of interest and amortisation
and charging to client

25 26

Credit Process: Digital Consumer Loan Credit Rating Agencies

• Rating provides a basis for comparing the credit risk

Advice Structuring Decision Execution Monitoring
of one organization with that of others
• Credit information allows for some transparency in
the loan pricing process
• Credit rating agencies have an impact on the
reputation of firms under assessment
• Credit reviews base on behaviour data and • It is important to know which agency undertook a
external data particular assessment and what key or legend that
• Monitoring that interest and repayments are agency uses
paid on due dates (ongoing)

27 28
28

Skills Required of the Loan Officer The Importance of Financial Statements

• Skill set for a successful loan officer: • The viability of projected cashflows is essential in making
• Have an ability to understand the complexity of the corporate lending decision
portfolio • The aim of credit analysis therefore is to assess and
• To be subjective and objective in their ability for risk verify the capacity to repay and the sustainability of
analysis future cashflows through the financial statements
• To be wise in credit administration and recording keeping
• Risk can be identified and quantified via the financial
• To exhibit strong attention to details at all times variables demonstrated in the financial statements
• Have a strong credit judgemental skills
• Financial analysis is not number crunching, rather it is a
• Have an ability to use technology and tools central focus on risk analysis
– Statistical credit scoring techniques
• Evaluation of past successes and failures of the entity
• Have clear thinking and early problem recognition
allows analysis of the financial consequences of
outcomes and decisions

29 30
29 30

5
 Managing the Loan Portfolio Managing the Loan Portfolio

• What can go wrong • External factors (con’t)

• Doubtful and bad debts • competition
• 30% of all loan write-offs are bad at the time of • The national economic environment
approval
• Internal factors
• Losses due to errors from the loan process is more
• Poor planning and objective setting
prevalent than that from fraud
• Poor organization and control
• External factors
• Poor profit planning and control
• Government regulations
• Poor resource and personnel management
• Technological advances
• Warning signals
• Rationalization and globalization
• Borrower’s history
• Changing consumer preference
• Management concerns
• Changes in legislation

31 32
31 32

Managing the Loan Portfolio Managing the Loan Portfolio

• Advice from the past

• Warning signals (con’t) • Never work alone
• Credit facts • Avoid procrastination
• The loan structure • Check and recheck
• Changes in established patterns • The separation of loan selling and the loan approval process
• Five C’s of bad credit • Patience and be active
• Only make promises you can keep
• Complacency
• Quantitative and qualitative approach
• Carelessness • Pay attention to quality and the purpose of lending
• Poor or absent communication • Know your client and the project
• Failure to set contingencies • Formal records
• Competition • Professional relationship
• Be proactive
• Have exit plans
33 34
33 34

Project finance

• Project finance is vital for economic • Further to this definition are the following
development of any country. It is defined as characteristics:
follows:

Credit Analysis and Lending Management Credit Analysis and Lending Management

35 36

6
• The following are the two most important ratios.
The first is the debt service coverage ratio (DSCR) • When commodities are involved, the reserve
which looks at cashflows: a conservative result coverage ratio is used.
should be at least 2

Credit Analysis and Lending Management Credit Analysis and Lending Management

37 38

7
 LENDING DECISION Learning Objectives

• Define what a small business is and provide an

overview of the main characteristics of the
market for small business lending in Australia
• Explain the theory underlying small business
Small Business Lending finance, using the concepts of asymmetric
information, credit rationing, adverse selection
International Lending and moral hazard
Chapter 9 & 10

1 2
1 2

Learning Objectives Learning Objectives

• Describe the distinctive risks of lending to small • Outline the main characteristics of
business a credit-scored approach to small business lending
• Outline the main characteristics of a relationship- (using recent experiences in the United States)
managed approach to small business lending • Comment on how lending to small business in
Australia is likely to change over the next decade

3 4
3 4

Introduction to Small Business Lending Overview of Small Business Lending

• Small business lending is a specialised area of lending • What is a small business?

• Small business lending is gaining increased theoretical • Numerous definitions exist including:
support – ABS – Less than 20 employees;
• Two main approaches: – RBA
– Independently owned and operated
• Relationship Management approach;
– Closely controlled by owners/managers who also
• Credit Scoring approach contribute most, if not all, of the operating capital
– Has loans less than $500,000
– Generally has turnover less than $5,000,000

5 6
5 6

1
 Overview of Small Business Lending Overview of Small Business Lending

• Small business in the economy • Small business in the economy

• ABS • RBA
– 1,175,000 small businesses in Australia representing – Higher working hours with 25% working more than
95% of total businesses 51 hours per week
– Produce 30% of all private sector output – In 1995-96, 8% of small businesses stopped
– On average has 3 employees – 40% of total workforce trading, while only 5% of medium to large
and 50% of private sector businesses did so
– Half of business employment in the property and – Legal structure
business services, construction and retail sectors – Company 43% Small v. 70% Larger Businesses
– Sole Proprietorships, Partnerships and Trusts 17%
Small v. 38% of Larger Businesses

7 8
7 8

Overview of Small Business Lending Overview of Small Business Lending

• Some characteristics of Small Business Lending • Floating Rate Loans

(RBA, 1993) – Overdrafts
– SB Lending 1/3 size of Large Business – Very popular representing about 50% of SB
– SBs pay 1.6% higher rates on average to reflect higher
default risk and economies borrowings
of scale – Highly flexible funding source but around
– Financing takes three main forms: 1.5% more expensive than bill finance
– Floating rate finance;
– Fixed rate finance;
– Bill finance

9 10
9 10

Overview of Small Business Lending Overview of Small Business Lending

– Fully Drawn Advance

• Fixed Rate Loans
– Loan fully drawn down at start with – 42% of SB loans are fixed rate for 3–5 yrs
repayments generally made in regular – Generally used to purchase non-current assets such as
instalments property and plant & equipment
– Floating rate finance generally provided at a risk – Risk margin generally added to 3–5 year Treasury Bond
premium over a benchmark rate rates

11 12
11 12

2
 Overview of Small Business Lending Overview of Small Business Lending

• Bill Finance • How do lenders organise their Small Business lending?

– Issuing of discounted securities with most at 90-day – NAB:
maturities – Loans < $250,000 – Centralised Credit
– Lack flexibility compared to overdrafts with all funds – Loans > $250,000 – Relationship Manager
being drawn down on issue – CBA:
– RBA 2001 statistics:
– Loans < $500,000 – Centralised Credit
– Exceptions where complex business, e.g.
Variable Fixed Bills Total importer/exporter using credit finance and
$ Million 33,037 28,042 5,228 66,307 FX risk management products

Share % 50 42 8 100
Wtd Avg Interest Rate 8.3 8.5 6.8 8.2

13 14
13 14

Overview of Small Business Lending Overview of Small Business Lending

–Implications of bank cutoff levels – Cutbacks in relationship managers may lose

• Lower cost ‘vanilla deals’ where strong financials clients seeking ‘solution- providing’ service
support credit- scoring approach – Moving business clients to ‘faceless’ banking and
• May have negative implications for ‘good’ lending must be handled very cautiously
businesses operating just below cutoffs where
notional credit scoring may be prejudicial

15 16
15 16

Overview of Small Business Lending Overview of Small Business Lending

• Competition in SB lending market • Small Business attitudes to lenders

– Fierce competition, particularly where loans backed by
– Source: RBA and Yellow Pages SB Index
borrower’s property resulting in fixed risk-margin pricing
– Changes include – 79% used finance from major banks
– Intensive efforts to reduce cost to income ratio – NAB and CBA held 48% of market share
– Where property used as security, loans can be
assessed via simple credit scoring and capital – 1/3 SB owners unhappy with service
funded at 50% risk-weighting concession v. 100% provided by major banks with ‘poor/no
(up to 150%) for other business loans service’ at 42% and ‘no personalised
– Promotion of centralised credit analysis service’ at 27%

17 18
17 18

3
 Overview of Small Business Lending Overview of Small Business Lending

– Lower dissatisfaction figures for small banks and NBFIs – 45–46% believed institution supportive and cared about
at 37% and 14% respectively them as customers
– 16% changed institution with disproportionate number – Only 1/3 believed institution’s fees for service was value
moving to smaller institutions for money, though better on these measures at smaller
– Main reasons for change were ‘better service’ (47%) institutions
and ‘less/lower fees’ (32%)

19 20
19 20

A Theoretical Basis for Understanding

Overview of Small Business Lending
Lending to SB

• Political Importance of SBs and SB Lending • While considerable emphasis on ratios, cashflow
– Government may become involved if dissatisfaction analysis, etc., many other issues to consider arise:
levels continue to increase – Asymmetric Information: Borrower is much better
informed about the firm than lender (also ‘Informationally
Opaque’
– Credit Rationing: Loan price set too high
– Adverse Selection: Better borrowers depart while
poor borrowers remain
– Moral Hazard: Seeking of riskier projects

21 22
21 22

A Theoretical Basis for Understanding A Theoretical Basis for Understanding

Lending to SB Lending to SB

– Relationship lending helps reduce asymmetries via two – Stronger lending relationships lead to
information types: – Lower interest rates
– Hard: Verifiable financial information – Reduced collateral requirements
– Soft: Borrower’s character/reliability – Lower dependence on trade debt
– Greater protection against interest
rate cycle
– Increased credit availability

23 24
23 24

4
 The Decision to Lend to Small Businesses The Decision to Lend to Small Businesses

• Specialised SB risks: –Risk and SB Failure

– Key-Person Risk: Is one person in the firm the key
to business success/viability? • Over 30,000 fail each year
– Lack of Capital: Due to limited funds, tax strategies, • 1/3 fail in first year
capital flexibility, etc.
• Another 1/3 fail in second and third
– Lack of Track Record: Often new business or first-
time business owner years combined
– Poor Accounting Records: • 3/4 fail after five years
– No audit or lodgement requirements, delays,
emphasis on tax-driven strategies, reporting
freedoms and/or attempted deception

25 26
25 26

The Decision to Lend

The Decision to Lend to Small Businesses
to Small Businesses

–Reasons for failure include • Two approaches to SB Lending

• Inexperienced/incompetent management • Relationship Management approach
• Poor accounting and record-keeping – Analysis of historical financials
– Stage 1: Avoiding GIGO principle on financial
• Problems with financial management and liquidity statements being relied on for lending decision.
• Lack of expert advice Check ratios and financials for consistency
• Too much reliance on debt funding – Stage 2: Detailed analysis of historical financials
including analysis of short-term liquidity ratios, long-
term solvency ratios and business performance
ratios

27 28
27 28

The Decision to Lend to Small Businesses The Decision to Lend to Small Businesses

– Analysis of cashflow projections – be cautious of overoptimistic • Credit Scoring Approach

projections
– Relies on input, such as ratios, etc., into mathematical credit
– Assessment of risks including key person, undercapitalisation, lack assessment models
of track record, etc.
– The importance of security – increasing reliance on property – Background to SB lending in US
collateral – SB loans defined as loans less than $100,000
– Problems with Relationship Management – 8,149 US banks v. 51 Australian banks
– Loan approval and management very labour intensive – Small local banks dominate SB lending
– Greater delegation can lead to credit problems as soft – Past/Present Use of Credit Scoring in US
information is notoriously difficult to assess – Increasing usage due to cost savings, availability of databases, ability
to quantify credit risk in securitisation supported by political and
regulatory change

29 30
29 30

5
The Decision to Lend to Small Businesses The Decision to Lend to Small Businesses

–Structure of US credit-scoring models –Changes in Credit Scoring and Predictions

• At least 30,000 applications needed for model • Helps reduce information asymmetries
• Fair Isaacs starts with 50 variables to determine 10 • Flow of usage from larger to smaller banks
most significant • Greater credit supply to low–medium incomes
• Financial ratios probably less important than previous • Greater reliance on simple form-based and/or online
10 years’ credit repayment history applications for SB lending
• Greater cost reductions

31 32
31 32

Summary LENDING DECISION

● Small business lending: important lending segment for

Aus Banks
● Special problems in credit assessment
● Credit scoring being used increasingly
● Vulnerable to changes in economy.
International Lending
Chapter 10

33 34
33 34

Learning Objectives Learning Objectives

• Overview the structure of the international financial • Explain the importance of international operations to
markets financial institutions
• Apply the principles of international lending • Demonstrate the process of country risk analysis
• Place trade finance products in perspective

35 36
35 36

6
 Introduction to International Lending Overview of International Lending

• International lending forms the heart of the international • Understanding the international banking and lending is
financial system vital to understand the international financial system’s
• Allows intermediation across all financial markets of the structure
world • The international financial system is dynamic and
• International lending accounts for the majority of all change is the norm
lending activities • Important aspects of the international financial system
• The payment system
• World trade and finance
• The availability of funds
• Country risk analysis

37 38
37

International Financial System International Financial System

• The modern system began in the 1950’s • The two components

• Evolved from the Bretton Woods conference of 1944 • The primary market
• 44 countries agreed on the foundations of the post-war • The interbank market
international monetary system • Three main functions
• The international financial markets • Foreign exchange markets (access and risk reduction)
• Foreign exchange • Credit for importers and funding for exporters
• Global capital • International lending
• International bond • Reasons to participate in the international market
• International equity • Profit
• Euro market (predominant) • Take advantage of competitive advantage
• Futures, swaps • Diversification
• Take advantage of deregulated market
39 40

Country Risk and International Credit Evaluation Country Risk and International Credit Evaluation

• Information sources • The step-down approach

• The efficient and reputation of local commercial banks • The geography and demographics
• An honest and independent central bank • Governmental relationship
• Available, reliable, and accurate information from • The foreign bank’s viability and credibility
government agencies • The strength of the corporate and other institutions in the
• Rating agencies foreign country
• Local personnel and press • The step-down approach provides a framework for
• Country risk assessment is the process of gaining a Marco-level analysis
degree of comfort about dealing with an institution or
individuals in a foreign country
• Main problem areas: legal, time, communication, country
insolvency, government interference, and distance
41 42

7
 Trade Finance Trade Finance

• A large volume of overseas trade is covered by short • Methods of payment and financing techniques
term finance (up to 180 days) • Important factors
• Forms of trade finance – The safety of the transactions
• Overdrafts – Whether the exporter is prepared to extend credit to the
• Loans importer
• Negotiations – The importer’s views
• Specialized advances • Prepayment
• Trade credit – Absolute trust between parties
• Factoring – Confident in the government
• Leasing – Certainty of the the buyer’s sufficient financial position
• Hire purchase • Documentary export bills for collection
• Forfaiting – Term draft
• discounting

43 44

Trade Finance Trade Finance

• Methods of payment and financing techniques • Methods of payment and financing techniques
• Pre-shipment finance facility • The bankers’ acceptance market
• Post-shipment finance facility – Access to competitive source of finance
• Documentary bill of exchange – Exporter can provide terms to an importer
• Foreign currency trade finance facility – The provision of access to pre-shipment finance
• Documentary letter of credit – The enablement of importers to obtain discount purchases
– Red clause credits – The ability to swap USD proceeds for other major currencies
– Head and counter credits (back-to-back credits) • Forfeiting
– Transferable documentary credits – Unburdens the statement of financial position of the exporter
• Documentary credits providing for term drawings – Improves liquidity
– Helps mitigate risks
• Clean remittance after the buyer receives or sells the
– Shifts the exchange rate fluctuation risks
goods
– Removes all administrative and collection problems and
• Trade finance – medium to long term
related risks
45 46

Supply Chain Financing: Definition Risks in Foreign Trade

Supply Chain Finance
• Performance risk
Receivables Purchase Advanced Payables Loan
Non-performance of the contract, inadequate performance, late
Financing is obtained by selling
receivables to finance provider; the
This category includes techniques, where
the payables are paid early without being
The finance provider is financing the
seller / buyer against e.g. receivables or
performance
receivables will be transferred into the
ownership of the finance provider. It
purchased by the finance provider. inventory. The ownership of the
receivables / inventory etc. is not
• Manufacturing risk
must therefore be ensured that the
receivable exists, are assignable and are
transferred to the finance provider.
The buyer cancels or modifies his order. Are the goods sellable
enforceable in the debtor’s jurisdiction. elsewhere?
Techniques
Receivables Discounting: Finance
Techniques Techniques
• Political Risk
 Corporate Payment Undertaking Loan against Receivables: Also
Extraordinary measures of foreign countries and political events
 
provider buys individual or multiple (CPU): Buyer sends payment known as Receivables Finance or
receivables at a discount from a seller instruction to the bank which pays Invoice Financing
of goods the seller early based on the payment abroad, e.g. war, revolution, misappropriation, civil war which make it
undertaking from the buyer  Distributor Finance: Financing for a
 Forfaiting: Without recourse
financing or discounting of promissory
distributor of a large manufacturer to impossible for the buyer to comply with the contract
 Dynamic Discounting: An advance cover holding of goods for re-sale
notes payment made directly from the
buyer to the seller; no finance  Loan against Inventory: Loan against • Transfer Risk
Factoring: The finance provider Inventory over which the finance
Currency measures of foreign governments which make it impossible

(factor) typically becomes responsible provider is involved
provider usually takes a security
for managing the debtor portfolio  Bank Payment Undertaking (BPU):
Payment undertaking by a bank
interest
for the buyer to allocate and transfer foreign exchange currencies
 Payables Finance: Buyer-led Pre-Shipment Finance: Finance
programmes to offer sellers in the which may be the basis for a
financing

provided to a seller before the goods abroad
supply chain access to finance by are shipped, e.g. Purchase Oder
means of Receivables Purchase.
Synonyms: Approved Payables
Financing. Sometimes involves a
Letter of Credit
• Currency risk
Finance, Reverse Factoring, Supply
Chain Finance and many more
Revaluation or devaluation of a foreign currency
47 48
Source: ICC Standard Definitions for Techniques of Supply Chain Finance & Global Supply Chain Finance Forum

8
 Risks in Foreign Trade The Confirmed Documentary Credit

• Credit Risk / Insolvency Risk Unconfirmed documentary credit Confirmed documentary credit
The buyer is unable or unwilling to pay the goods, or  The issuing bank (the importer's  Both the issuing bank (importer's
bank) is obliged to pay as soon as the bank) and Exporters bank are liable
the seller is unable or unwilling to pay back the down for the payment.
conditions of documentary credit
payment have been met.  As confirming bank, Exporters bank
• Reputational risk  The exporter’s bank only takes on an bears the del credere risk and the
advisory role. country risk (political and transfer
The reputation of one of the parties is involved due risks) of the issuing bank.
 The del credere risk of the issuing
to the transaction or by the fault of the other party bank and the country risk (political
• Transactional risk and transfer risks) stay with the
exporter.
Non-conformity of documents, other operational
failures Issuing bank Exporters
Bank
Issuing bank Exporters
Bank

• Transport risk Payment

obligation No liability Payment Payment

Goods get damaged, lost or stolen on their way to Exporter

Seller
obligation Exporter

Seller
obligation

the country of destination

49 50
In the case of a confirmed documentary credit, both banks are liable independently of each other.

Documentary Credit with Sight or Uniform Customs and Practice

Deferred Payment for Documentary Credits

• The International Chamber of Commerce formulated the

Sight payment Deferred payment Uniform Customs and Practice for Documentary Credits
 Payment to the beneficiary is made  Payment is not affected immediately to minimize confusion and establish standardize related
immediately, i.e. as soon as credit- upon presentation of the documents, to
confirm documents have been but only after a period specified in the
presented Documentary Credit, i.e. when
• International practice in establishing and advising
payment is due (e.g. 180 days after documentary letters of credit and negotiation drawings
Secure Pay
dispatch).
 If the Documentary Credit is
Other means of utilization confirmed by the advising bank, the
proceeds of the credit can be prepaid
 Acceptance: Later payment date with (discounted). This allows the buyer
the presentation of a bill of exchange (importer) to be granted an extended
 Negotiation: Purchase of drafts payment terms without the seller
and/or documents by nominated (exporter) having to wait for the
bank proceeds.
Secure Pay Finance
51 52

International Lending
Principles
Summary

• international financial system

• Safety
• country risk
• Security • trade finance products
• Financial standing of clients • UCP600
• Economic/political factors
• Ongoing risk assessment
• Suitability
• Profitability
• Liabilities
• Bank guarantees

53 54

9
 LENDING DECISION Learning Objectives

1. Describe the benefits of credit risk management

2. Explain and use Altman’s Z score
Credit risk measurement 3. Explain how stock prices can be used to explain

and management credit risk

4. Suggest how risk-adjusted return on capital can be
of the loan portfolio used for portfolio purposes
Chapter 11 5. Use the Sharpe Index for lending purposes
6. Calculate the risk of a loan portfolio using
CreditMetrics
7. Understand the elements of loan pricing

1 2
1 2

Introduction Introduction

• The aim of credit risk management is to balance between • Credit risk seeks following objectives:
risk and return to achieve optimum profitability and a) achieve and appropriate balance between risk and
efficiency return;
• Taking and institutional view banks could minimise b) avoid concentration risk;
concentration risk c) manage loans on a portfolio basis; and
• Lending on a more scientific basis would help remove d) take a group of loans off the statement of financial
subjectivity position.
• This chapter examines some of the credit risk
measurement tools.

3 4
3 4

Earlier predicted Evolution of Credit Risk Management

(Source: The seven stages of risk management, www.erisk.com, April 1999) Operationalized Credit Risk Measurement
• Selected steps of the loan analysis process are frequently formalized/operationalized
in order to achieve
• Increased objectivity
• Rationalization of an often „obscure“ process
• Improved quality of loan decision
• Formalized approaches typically follow the same steps:
• Collection of loan data from the past (typically at least 300 „bad“ loans
necessary)
• Analysis of the loan decision process at the time the loan was given
• Analysis of credit monitoring data collected over the life of the loan
Loan Application, Other Infos

Forecasting the Future

Analysis of the past

Today Key Assumption:
Loan Application
Patterns of the past repeat
themselves in the future

5 6

1
 Operationalized Credit Risk Measurement Credit risk measurement
• During the last couple of decades several formalized credit risk measurement
techniques have been developed, for example:
Statistical Methods Pattern Recognition Methods • Altman’s Z Score
Discriminant Analysis Artificial Neural Networks / – Relies on multivariate model accounting ratios that
Artificial Intelligence (AI)
Regression Analysis provide best predictors of performance:
Logit/Probit Models Cluster Analysis
Recursive Partition Algorithms

• Basic Approach:
Credit Scoring Model

Black Box

Credit Score
Past Data

-Function generation
-Test sample – Credit decision relies on output from equation at
-Validation sample
-Quality of function Feedback loop
varying cutoff levels

7 8
8

Altman’s Z-Score: Original Version Altman’s Z-Score: Extensions

• In 1968 Altman published the first scientific paper that described how discriminant analysis
could be used as a „bankruptcy predictor“. • Lateron Altman published several revisions of his model, among others
• His so-called Z-Score for listed companies was - in its first form - calculated as follows: also a “Z-Score” für private (i.e. non-listed) companies:

Z  0.012X1 0.014 X2 0.033X3 0.006X4 0.999X5 Z  0.717X1  0.847X2  3.107X3  0.420X4  0.998X5
whereas whereas
X(1) = working capital / total assets X(2) = retained earnings / total assets X(1) = working capital / total assets X(2) = retained
X(3) = earnings before interest and taxes / total assets X(4) = market value equity / book value of earnings / total assets
total liabilities X(5) = sales / total assets X(3) = earnings before interest and taxes / total assets
oZ > 2.675 => high probability of solvency X(4) = Net worth / total liabilities
oZ < 2.675 => high probability of insolvency (Zone of Ignorance)
oZ < 1.8 => certain insolvency X(5) = sales / total assets

•His article in the Journal of Finance became one of the most cited Finance The following decision rules applied: Z<1.23 
articles of the last 30 years bankrupt
•His scientific methodology has been applied to a number of other Z>2.90  non-bankrupt
Z between 1.23 and 2.90  “grey area”
countries, like
Canada, Malaysia, Singapore, Vietnam, Korea, etc.

9 10

Using stock prices

• To overcome the problem of using historical data, • In constructing the Z score, Altman utilised the
KMV Moody’s extended Merton’s option pricing following process:
model for risky debt
• Borrower holds equivalent of long call option
• Lender holds equivalent of short put option
• The model incorporates current stock prices to
create an Expected Default Frequency (EDF)

11 12
11
Credit Analysis and Lending Management

2
• Properly used the Z score will divide the loans/companies into two
• The zone of ignorance is bounded 2.99 (above this
groups as follows: you would lend) and 1.81 (below this you would
reject).
• When developed, companies were dominated by
asset heavy manufacturing companies.
Developments since then have been:
• A private company Z score
• A Z score for non-manufacturing companies
• You will note that, except in exceptional circumstances, there will
be an overlapping of distributions. This creates a zone of • A Z score which incorporates size
ignorance. Lending in this zone is dependent on the risk appetite
of the lender.

13 14
Credit Analysis and Lending Management Credit Analysis and Lending Management

Using stock prices

• Many have criticised Altman’s Z score as it uses financial ratios which implicitly • From the shareholders’ view, they will repay money
look backwards. when the value of assets will rise above the
• KMV Corporations expected default frequency (EDF) model seeks to overcome
this by using option theory.
borrowings as follows:
• The proposition is that if a bank lends money to a company, the value of its
assets will rise and the company will repay debt as follows:

15 16
Credit Analysis and Lending Management Credit Analysis and Lending Management

• By incorporating returns distributions, we can estimate

• We then have to relationships:
probability of default
(Mkt Valueof Assets)- (Default Point)
Distance to Default 
(Mkt Valueof Assets)(Asset Volatility)
• KMV also incorporates actual default data to assess the
• The problem is that we cannot observe asset values risk to produce EDF
and volatilities.
• However, using a propriety software approach, it is Number of Default Firms
Expected Default Probabilit y 
suggested that the market value of assets is a function All Firms of Sample
of equity.

17 18
18
Credit Analysis and Lending Management

3
 Actuarial approaches

• The approaches we have examined have threads

that may invalid them. Altman’s Z score looks back
while KMV assumes capital structure is important.
• Creditrisk+ has no assumption except that loans can
default and do.
• Creditrisk+ builds a distribution around default, which
is a Poisson distribution.
• The approach has three stages…

19 20
Credit Analysis and Lending Management Credit Analysis and Lending Management

Portfolio Management Portfolio management

• A portfolio of loans similar to portfolio of other

• The majority of the text considers the risk of a single
loan. But what happens when you bring them
assets
together into a portfolio. Decisions can be quite o Risk-Adjusted Return on Capital (RAROC)
different.
• While modern portfolio theory (MPT) influences Income from loan for one year
portfolios of loans, there are a number of key issues:
RAROC 
Capital at Risk
• MPT assumes normal distributions which loan portfolios are
one sided.
• MPT assumes that assets can be revalued. Some loans are o Capital at risk is defined using a duration approach to
difficult to revalue. measure sensitivity to rate changes
• Lending managers don’t always have the same options
available as equity managers.  ΔR 
• Is concentration risk a problem ΔL  (-D L )(L) 
1 R L 
21 22
22
Credit Analysis and Lending Management

• Bank of America (BofA) uses unexpected losses as

• The biggest contention is how to measure capital at follows:
risk. BT use duration:

• BoA use 6 confidence intervals while rating agencies

use 10.

23 24
Credit Analysis and Lending Management Credit Analysis and Lending Management

4
 Altman’s Sharpe Index Approach CreditMetrics

Three steps • Incorporates changing credit risk over time by

N
addressing migration probabilities, eg, AAA to AA,
Step 1: Calculate return on portfolio R p   Xi EARi
i 1 A to BB etc
• Values securities from a zero-coupon yield curve
Step 2: Calculate variance of the portfolio
N N and then treats cashflows as:
Vp   X X ¶ ¶ p
i j i j ij – First year’s cashflows not discounted
i1 j1
– Subsequent cashflows calculated on annual basis
Step 3: Maximise the relationship which is the Sharpe (despite being generally semiannual)
Index
Rp – Defaulted bonds are treated according to recovery
η rate, eg 51.13% for BBB Bond
Vp

25 26
25 26

CreditMetrics

• By adjusting for credit migration, the following factors are

considered in risk assessment and capital allocation decisions
• Year-end rating
• Probability of rating state
• New bonds value plus coupon (per previous calculation
discussion)
• Probability-weighted value
• Probability-weighted difference • For a BBB credit rating, for example, this means a rise
• The capital allocation for the single security is then the sum of to AAA has a 0.02% chance, BB 0.33% and so on.
the probability-weighted differences

27 28
27
Credit Analysis and Lending Management

• Given the following information (yield curve) we can calculate the distribution
of BBB bonds:
• The distribution looks as follows (notice it doesn’t look normal):

29 30
Credit Analysis and Lending Management Credit Analysis and Lending Management

5
• We can now calculate the standard valuation:

• Using the standard deviation we can estimate the

capital needed to be put aside:

• Which is less than the normal minimum $8 required

31 32
Credit Analysis and Lending Management Credit Analysis and Lending Management

CreditMetrics

• To extend to portfolios, the following is executed. • Framework:

33 34
34
Credit Analysis and Lending Management

CreditMetrics Managing the portfolio

• Process becomes far more complex when considering • Once portfolio constructed, tools exist to manage
portfolio case and employs four steps: portfolio’s risks
• Securitisation:
Step 1: Define the portfolio as individual assets
– Technique for packaging cashflows from loan assets
Step 2: For each asset, define cashflows and calculate PV for and selling them as securities
each state using zero-curve
Step 3: Using transition matrix, calculate probability-weighted
PV and standard deviation
Step 4: Calculate portfolio risk by executing above steps for
the joint probabilities for a loan in the portfolio to derive
portfolio’s standard deviation

35 36
35 36

6
 Managing the portfolio Managing the portfolio

• Pass-Through Structures • Securitisation and Credit Risk Management

o Determine whether securities have recourse
• Loan assets sold completely from statement
o Loan assets must be sold for fair value
of financial position through a Special o May interfere with borrower/lender relationship
Purpose Vehicle (SPV)
• SPV Trustee manages all cashflows
between borrowers and lenders
• Pay-Through Structures
• Very similar to Pay-Through structure but
assets not sold, but only managed by SPV
37 38
37 38

Managing the portfolio Loan pricing

• Credit Derivatives • All loans provide a cost to the Statement of Financial

o Assets can be maintained on the statement of financial Position
position, with risk management structures in place through • Statement of Financial Position Costs
credit derivatives – Capital Cost: Capital that must be allocated to
o Three main categories: support default risk
– Credit Default Swaps: Swap seller receives a periodic – Liquidity: Lending activities must allow sufficient
fee for covering any default losses liquidity on Statement of financial position
– Total Return Swaps: Swap seller receives a periodic fee – Cost of Funds: Returns must be achieved from loan
to cover changes in value of loans including considering Return on Equity, Return on
– Credit Options: Option seller provides protection against Liquidity, Market Cost of Deposits and Return on the
widening of credit spreads Loan

39 40
39 40

Loan pricing Loan pricing

• Noncredit Risk Costs • Loan Pricing: an example

• Interest Rate Risk: Whether loan book has fixed/floating rate loans o Assume we have:
• Pre-payment Risk: Risk that loans will be paid out earlier than – $150,000, five year housing loan
specified term
– 5% liquidity required against lending assets
• Origination Costs: Costs of marketing and monitoring securitised
loans sold returning 4.9%. At call deposits cost 3.5% and 5
• Credit Costs year swap rate is 5%
• Expected Losses = Default Probability x (1 – Recovery Rate) – Loan operating costs are $1,000 per annum
• Unexpected Losses: Generally reflects volatility of Expected – Default probability for housing loans is 2% with 95%
Losses recovery rate and capital required is 8%
– ROE is 20% and tax rate is 30%
41 42
41 42

7
 Loan pricing Loan pricing

• Capital allocation is: • First stage simple Statement of financial position (NB –
Deposits* are a balancing figure only)
$150,000 x 8% x 50% = $6,000

• After-tax ROE is:

$6,000 x 20% = $1,200

• Amount of liquid assets for 5% policy is:

Liquid Assets = Assets x 5%

• By rearranging we get:

Liquid Assets = $7,500 / 0.95 = $7,985

43 44
43 44

Loan pricing Loan pricing

• Table requires working backwards from the balancing • Practical Loan Pricing
profit after tax figure to obtain the yield of 4.48% o Two major considerations extend beyond the theoretical
discussion above:
– Competitive forces will largely govern what can be
charged for loans reducing in lower margins;
– Loan pricing much more dependent on fee
structures across client’s products. For example, if
the client also has a variety of the bank’s products,
the fees from the other products may offset any slim
margins (or even losses) arising from the loan
pricing structure.

45 46
45 46

8
 LENDING DECISION
Objectives

1. Understand the issues of credit risk from the perspective of the

regulators
Credit risk from regulator’s perspective 2. Relate capital adequacy to credit risk considerations
Problem Loan Management 3. Express the issues of large exposures
Chapter 12 & 13 4. Identify securitisation issues for regulators
5. Identify credit derivative issues for regulators
6. Describe the credit rating process
7. Discuss the new capital adequacy guidelines.

1 2
13/08/2024 1 1

Regulators Regulators

• Central Bank (Reserve Bank, FED, State Bank of • Australian Securities Investment Commission (ASIC)
Vietnam) • Market integrity
• System liquidity. • National Consumer Credit Protection Act (for retail
• Australian Prudential Regulatory Authority (APRA) borrowers):
• Regulates banks, credit unions and building societies using – Those who are engaged in lending must be licensed by ASIC.
the Bank of International Settlements (BIS) capital – The rights that the borrower.
adequacy guidelines
– The obligations of the lender.
– The nature of the contracts.

3 4

Capital adequacy Regulatory aspects of credit risk

• Capital adequacy seeks to ensure capital is put aside • Basel Accord (1988) – Basel 1 (Table 12.2 – Credit risk
depending on the credit risk to cushion potential losses. categories)
• Basel 2 (2006) - 3 main pillars
• The general formula is:
• Minimum capital requirements
• Risk-based capital ratio= Total capital (Tier 1+Tier – Credit risk

2)/Risk-adjusted assets – Standardized approach

– Foundation internal rating approach (Foundation IRB)
• See text pages 403 to 406 for risk weightings – Advanced internal rating based approach (Advanced IRB)

5 6

1
 Regulatory aspects of credit risk Regulatory aspects of credit risk

• Minimum capital requirements • Method of risk quantification

– Operational risk Standardized Approach Internal Rating Based Approach
– Market risk
Based on external ratings IRB Foundation
– Basic capital requirement : 8% of risk weighted assets
Given risk weights - Own estimation of PD
• Supervisory review - Other parameters given
• Market discipline through disclosure
Overall higher capital Overall lower capital requirements
requirements

7 8

Large credit exposures Securitisation

• Securitisation requirements are found in APS 120

• APRA requires that lenders recognise exposures greater than • For entities supervised by APRA, the main issue is a clean sale to remove the
10% of the capital base (APS 221). asset completely from the balance sheet:
• There should be no beneficial interest in the sold assets and absolutely no obligation
• The need to ensure of related groups need to be recorded to the financial institution.
correctly. • There should be no recourse (including costs) to the lending institution. In addition,
there should be no obligation for the lending institution to re-purchase the lending
• These exposures can create concentration for which additional assets.
capital needs to be allocated (Chapter 16). • The amount paid for the loans should be fixed and should be received by the time the
assets are transferred from the lending institution.
• Any assets that are provided to the special-purpose vehicle as a substitute or
provided at below book value are not considered as relieving credit risk

9 10

Credit card securitisation Credit derivatives

• Credit card securitisation has the following requirements: • The following requirements are required to get capital relief
• The rights, details and obligations of each party must be clearly for credit derivatives:
specified, including the distribution of cashflows.
• The underlying and reference assets are the same.
• As with normal asset securitisation, the financial institution cannot
• The underlying asset is an obligation under the terms of the
supply additional assets to the pool. contract. An obligation is defined as a financial obligation.
• Liquidity shortfalls for the financial institution share must not exceed
• The reference asset ranks lower than the underlying asset.
the interest receivable.
• The maturity of the credit derivative is the same as the underlying
• The financial institution always has the right to cancel any undrawn loan may be required.
amounts on the revolving facilities.
• Again, like normal lending securitisation, the financial institution must
be under no obligation to re-purchase assets that have defaulted.

11 12

2
 Developments in regulation Developments in regulation

• Credit ratings are now used in capital adequacy. Table • Financial risk
16.2 outlines the definition of credit ratings. • Accounting quality

• They are generated by the investigation of the following: • Financial policy

• Business risk: • Profitability and coverage

– Industry characteristics • Capital structure

– Evaluation of management • Financial flexibility

– Industry specific factors • The issue of the commercial secrets behind credit ratings in
public policy

13 14

Learning objectives

1. Outline why loans default

2. Highlight the extent of problem loans
3. Explain why the business cycle is important for problem loans
4. Define problem loans, provisions and regulatory issues

Problem loan management 5.

6.
Discuss the capital issues of problem loans
Define ‘structure dynamic provisioning’
7. Restructure problem loans
8. Illustrate a case from law

15 16
13/08/2024 15 16

Introduction Causes of default

• When financial institutions make loans, returns • Default does not necessarily mean that all of the loan
generated mean accepting some default risk extended is lost.
• It is imperative that default risk is managed so that the • Default is defined here as ‘a loan where repayments are
solvency of the bank is not threatened overdue’
• Should the problem loan be foreclosed or actively • Better lending procedures can minimise, but not eliminate, the
managed? risk of default
• Harder to manage default risk as loan book becomes larger

17 18
17 18

3
 Likely causes of default Extent of problem loans

• Lack of compliance with loan policies • All banks experience bad debts,
• Lack of clear standards and excessively lax loan terms but the management of them becomes critical
• Inadequate controls over loan officers • Banks should consider:
• Over-concentration of bank lending • Timing of loan in economic cycle
• Loan growth exceeding bank’s capabilities • Larger exposures to individual borrowers
• Inadequate problem loan identification • Larger exposures to single sectors
• Insufficient knowledge of customer’s finance
• Close monitoring of exposures during unfavourable economic
• Lending in unfamiliar markets periods

19 20
19 20

The business cycle

• The business cycle characterised by three phases:

1. Recovery and Expansion:
– Flourishing economy with increased spending leading to higher deposits and interest
rates

2. Boom:
– Major asset inflation with business overconfidence and declining credit standards

3. Downturn:
– Declining asset values and economic activity generally accompanied by increased
defaults

21 22
21 22

Problem loans, provisions and regulatory issues

• When borrower misses payments, two questions arise • If payment more than 90 days, loan is considered an ‘impaired
within lending institution asset’ as return on loan not achieved
• Is missed payment temporary? • Value of impaired loan must be downgraded on statement of
financial position
• Is missed payment likely to be permanent?

23 24
23 24

4
 Specific provisions

• APRA: If one asset is impaired, all loans to that client • These are provisions set aside for a specifically identifiable loan
considered impaired where the institution assesses the:
• When loans are impaired, institution must create a – Condition of the loan;
‘provision’ for a loan loss – Condition of the borrower;

• Provisions are classified in three ways: – Impact of economic events.

– Specific Provisions • Not all of the loan must have provisions made as lender may
– General Provision assess the likely losses from the asset.
– Bad-Debt Write-Offs

25 26
25 26

General provisions Bad debts

• These are provisions that are made as a proportion of the • Recognition of bad debts occurs where:
entire loan portfolio – All security liquidated;
– Guarantees have been enforced;
• Suitable for large loan portfolios of similar assets, e.g.
mortgages, where specific provisioning unsuitable – Remaining remedial actions explored; and
– No remaining sources of cash can be called.
• APRA: Generally minimum provision of 0.5% of Risk-
Weighted Assets • Once the above steps are completed, the financial institution
must write off the bad debt with asset valued at zero and a
• Can adjust general provisions level depending on economic charge made against profits.
activity or risk levels

27 28
27 28

Regulatory issues Other considerations with problem loans

• APRA Guidance Notes AGN 220.1, 220.2 and 220.3 govern • The provisions made minimise the efficient use of capital
bad-debt provisioning that could otherwise be used for lending purposes
– Category 1: Registered first and second mortgages with LVR < 80% have no • Institutions often have provisioning systems exceeding
provision
APRA requirements to reflect bank’s risk profile
– Category 2: Same as Category 1 but where LVR is between 80% and 100%
• Higher provisions indicate higher risk and/or more conservative
– Category 3: Same as Categories 1 and 2 but where LVR > 100% (i.e. declining asset
management
values)
– Category 4: Covers overdrawn revolving-type facilities where longer default periods • Lower provisions indicate lower risk and/or more aggressive
produce higher provisioning requirements management

29 30
29 30

5
 Dynamic provisioning

• The risk profile of the loan portfolio is sensitive to point in • Key principles in dynamic provisioning:
the economic cycle, e.g. greatest defaults occur at bottom • Classify loans into homogeneous groups
of economic cycle • Sub-classify groups by maturity length
– Determine probability of loss for each group
• Therefore: – Determine likely severity of loss for each group
• Credit risk is not static but changes over time • Use the historical loan-loss information to create predictive model
incorporating economic conditions, interest rates, investment activity,
• Bad debt should not come as a surprise etc.
as modelling should detect changes to probable default risk in
• Apply model outcome to current provisions
portfolio segments

31 32
31 32

Dealing with defaults Mild financial distress

• If the loan is in default, bank must act to minimise the • Often occurs when borrower faces short-term cash flow
losses arising from defaulting clients and may problems, e.g. late receipts
reschedule payments rather than liquidate loan
• If default less than 90 days, remedies include:
• Classify defaulting clients into three categories: – Changing/lengthening repayment schedules
• Mild financial distress; – Assisting firm if cash flow shortage has risen from period of rapid growth
• Moderate financial distress; and – Encouraging firm to sell non-core assets

• Severe financial distress. – Requesting/demanding equity capital injection

33 34
33 34

Moderate financial distress Severe financial distress

• May occur if cash flow problems coincide with borrower’s • Characterised by missed payments and value of borrower
asset values declining less than loan amount
• Course of action determined by nature of collateral, e.g. • Lender needs to very carefully evaluate whether is is better
foreclose on mortgage or support manufacturing firm with
unique to:
or limited market for assets – Liquidate firm to recover greatest percentage
of loan possible; or
• Lender may consider evaluation of alternatives via NPV or – Restructure debt (inclusive of debts to other lenders) to maintain operations to
probabilistic model of Expected Values for different actions allow firm to trade out of current crisis or be sold as going concern

35 36
35 36

6
 The coordination problem Other breaches

• Where numerous classes of debt-holders observed, e.g. • Corporate loans may have a variety of covenants imposed to protect
syndicated loans, any rescheduling will require cooperation loan quality
of • Lender may place a variety of conditions to strengthen loan repayment
all debt-holders probability:
– No excessive withdrawal of cash flows
• May be difficult to coordinate actions between junior and
– Risk profile of firm to remain unchanged
senior debt-holders
– Specification of various ratios including gearing, dividend payout and interest coverage
• Need to restructure debts to ensure all debt-holders treated – Continued involvement of key staff
equitably or else rescheduling proposal will fail – Application of risk management strategies

37 38
37 38

7
 Learning Objectives
LENDING DECISION

• Create a framework for modelling

• Explain and measure concentration risk
Quantitative Finance • Define expected losses
Credit Growth and • Define and measure probability of loss
• Define and measure loss given default
Bank Soundness in • Define and measure prepayment risk
Emerging Europe • Identify problems with quantative modelling
Chapter 16

1 2
1 2

Introduction Concentration risk

• There are two important issues with quantitative

modelling: • The two types of risk:
• What are we trying to measure? • Name
• What are the underlying issues • Sectorial
• This chapter focusses on economic capital as • If concentration risk exists, then the portfolio is not
opposed to regulatory capital. granular
• Assumptions: • The normal way to measure concentration risk is to
• Models are single factor - asymptotic single risk factor use the Hefindahl-Hirschman index (HHI)
(ASRF) mode
• Granuality (an addition loan will not affect the portfolio risk)
• If these assumptions do not hold then measurements
will have errors

3 4
3 4

Individual Loans and Loan Portfolio

• The expected loss on an individual loan is determined by three factors:
• Exposure at Default, EAD
• Probability of Default, PD
• Loss Given Default, LGD
 Expected Loss = EAD x PD x LGD

• Value-at-Risk approaches are increasingly used at the loan portfolio level. Two
main categories:
• Expected loan losses: (Ø of anticipated losses, in the long run, and under
normal economic conditions)
 Annual loan loss provisions
• Note that the measure is not related to credit risk • Unexpected loan losses: Deviation of realized loan losses from expected
loan losses
 Economic Capital (equity) required

5 6
5

1
 Portfolio Loan Loss Vizualisation Expected losses

• Expected losses are a fact of life in lending and has

been addressed in a number of chapters in this book.
The empirical measure of expected loss is:

7 8
8

Probability of default

• Probability of loss is dependent on a lender’s policies,

• While satisfying (and looking like the KMV model) it is
culture and systems. So there will be no one way of
not satisfying as it proven that default can have
modelling.
internal and external factors.
• The starting point is:
• The model then looks like:

• And functionally

9 10
9 10

Loss given default (LGD) Prepayment risk

• This methodology is difficult because the distributions • This is the risk associated with income loss from
are not normal. Therefore, methodologies such prepayments
fractional response regressions are used:

11 12
11 12

2
 Conclusion

• Much of the modelling is still in the early stages.

• More importantly, modelling tends to occur in good
times and is not really tested until economic stress Credit Growth and
occurs.
Bank Soundness in
Emerging Europe

13 14
13

Rapid credit growth in the region... ...increasingly funded through capital inflows
60 60
Real Credit to the Private
NMS: Net Capital Flows, 1999-2006
55
55
Sector, 2006 (In percent of GDP)
50 (annual percentage change) 50
Baltics CEECs
45 45
12.0 12.0 12.0 12.0
40 40 Portfolio
10.0 10.0 10.0 Investment 10.0
35 35 Other
30 30 Investment
8.0 8.0 8.0 FDI 8.0
25 25

20 20 6.0 6.0 6.0 6.0

15 15
4.0 4.0 4.0 4.0
10 10

5 5 2.0 2.0
2.0 2.0
0 0

-5 -5 0.0 0.0 0.0 0.0

Malta

Finland

Greece

Lithuania
Austria

France

Latvia
Luxembo

Czech

Bulgaria

Ireland

Spain

Poland
Slovenia

Estonia
Germany

Italy

Hungary

Cyprus
Portugal

Slovak
Belgium

Romania

-2.0 -2.0 -2.0 -2.0

1999 2001 2003 2005 1999 2001 2003 2005

Sources: Eurostat; IFS, National Statistical

Offices; and IMF staff estimates.
Source: IMF, World Economic Outlook.

15 16

...concentrated in the household sector Rising euroisation of domestic credit

80 90
Hous ehold Loans Foreign Currency Loans 2001
2001
(In percent of total outstanding loans (In percent of total outstanding loans
2005 2005
70 to the private sector) 80 to the private sector)

70
60

60
50

50
40

40

30
30

20
20

10
10

0 0
c

ic

lic
d

ia

a
ia

a
y

nia

nd
ry

ia

ia
ia
bli

bli
ni
lan

ni
ar

bl

en

tv

ub

en

tv
on
ga
ua

la
pu

to

pu

ua
pu
ng

La

La
ov
Po

ep

ov
un

Po

st
Es

th

i th
Re

Re

Re
Hu

E
Sl

R
Li

Sl
H

L
h

ak

ak
ch
ec

ov

ov
ze
Cz

C
Sl

Sl

17 18

3
Rapid credit growth reflects financial deepening... ...and rising financial integration
600
Financial Deepening in Selected Countries, 2001-05 External Assets and Liabilities
40 (In percent of GDP)

500
Difference between Private Sector Credit Growth and GDP

35 Lithuania
Latvia
30
Estonia Western
400
25 Europe
Growth (In percent)

20

300
15
Mexico Hungary
10 Emerging
Slovenia Australia Markets
New Zealand 200
5
Czech Rep. Rep. of Korea
Thailand Euro area
Slovak Rep.
0 Poland Chile
Japan Emerging
Malaysia
100
-5 Europe

-10
0 20 40 60 80 100 120 140 160 180 0
Private Sector Credit (In percent of GDP)

85

87

89

91

93

95

97

99

01

03
19

19

19

19

19

19

19

19

20

20
Sources: National Banks, International Financial Statistics, and IMF staff estimates.
Source: Lane and Milesi-Ferretti (2006).

19 20

NMS: Macroeconomic Environment and Credit to the Private Sector, 1994-2005

(Annual percent change, unless indicated otherwise)
...as are supply-side factors
Baltics CEECs
60 60
Real Credit Growth

Macroeconomic and
50 50
40 40 120
30 30
Share of Foreign-Owned Banks
20
10
20
10 financial conditions (In percent of total assets) • Privatization
have been
0 0
-10 -10
100
-20 -20
-30
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
-30
supportive... • Entry of foreign banks
12 12 50 50

10
Real GDP Growth
10
40
Consumer Price Index
40
• Disinflation 80
• Strategic expansion
8 8

6 6
30 30
• Improved economic
4

2
4

2
20 20
prospects
60 • High profitability
0 0
10 10
-2 -2
• EU accession
+ subsidies and tax
-4 -4 0 0
40
1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004

• Pent-up demand for

policies
14 14 130 130
Real Lending Rate Real Effective Exchange Rate 1/
12
10
(In percent per annum)
12
10
120 120 credit
8 8
20
110 110
6
4
6
4 100 100
• Easy global monetary
2

0
2

0
90 90 conditions 0
-2 -2
80 80 Czech Hungary Poland Slovak Slovenia Estonia Latvia Lithuania
-4
-6
-4
-6 70 70
• Ample global liquidity Republic Republic

1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004
21 22
Sources: IMF International Financial Statistics, and staff estimates.
1/ CPI-based index with 2000 as base year.

Literature Policy Debate

• Financial deepening but “excesses,” credit booms are a

risk
– Schadler et al (2004); Cottarelli et al (2005); Egert (2007); ECB
(2007) • How to manage macroeconomic and prudential risks...

• Credit growth improves bank soundness, unless it is

“excessive” • ...and “not to kill the goose that lays the golden eggs”?
– Maechler, Mitra, and Worrell (2006)

• FSIs are favorable, but backward looking

– Hilbers et al (2005); Iossifov and Khamis (2006)

• Foreign banks are more efficient, but loan growth is similar

– Aydin (2006); de Haas and van Lelyveld (2005)

23 24

4
 Focus of This Study Bank-level Analysis

• How significant are prudential risks in the NMS? • Bank balance sheet data (Bankscope)
– Has credit growth affected bank soundness? – Ugo Panizza’s (IDB) data set, updated
– Are weaker banks expanding faster? – 217 banks during 1995-2004 in 8 NMS
– 7 observations per bank, on average
– Unconsolidated data, where available
• Do prudential risks differ across...? – Commercial banks and leasing companies
– Countries
– Banks (foreign/domestically owned) • Breakdowns of loans by currency and purpose
– Purpose of credit (household/corporate) (supervisory data)
– Currency of denomination/indexation (foreign/ domestic) – 6 NMS (except Hungary and Latvia)

25 26

Distance to default—a proxy for

The sample covers most NMS banks... insolvency risk
• The number of STD a return realization has to fall for equity
to be exhausted~probability of default
Number of Banks Proportion of Banks Included in the Sample 1/ Average Number of
Total Bankscope Number Assets Observations per Bank

Czech Republic 35 26 74.3 97.6 7.2 DD ≡(equity capital+average return)/STD of return,

Hungary 36 23 63.9 81.7 8.3
Poland 60 33 55.0 85.6 7.6
Slovak Republic
Slovenia
21
22
20
18
95.2
81.8
83.1
79.9
7.1
7.8
• Bank account data
Estonia 6 5 83.3 94.1 7.9
Latvia 22 21 95.5 93.2 8.0
Lithuania 13 9 69.2 93.7 6.2 • STD deviation for the entire sample period
Sources: European Central Bank; Bankscope; and IMF staff estimates.
1/ In percent of the total number of banks and total bank assets, respectively.
• Robustness to alternative ways of measuring volatility of
returns; NPL ratios; loan loss reserves

27 28

Uniformly higher credit growth; Baseline empirical specification controls for

stronger, but more heterogeneous Baltic banks macroeconomic and bank-specific variables...
Equation 1: Bank Credit Growth
1995-2000 2001-2004
BankCreditGrowthijt  f ( BankCreditGrowthij ,t 1 , GDPperCapita j ,t 1 , GDPgrowth j ,t 1 , RIR j ,t 1 , RER j ,t 
CEECs Baltics CEECs Baltics
DistanceToDefaultij ,t 1 , CostToIncomeij ,t 1 , InterestMarginij ,t 1 , Liquidity ij ,t 1 ,
Standard Standard Standard Standard
Sizeij ,t 1 , Foreignijt , Public ijt ),
Variable Mean deviation Mean deviation Mean deviation Mean deviation
Bank credit growth 17.9 40.1 28.7 56.6 27.3 32.7 46.8 43.8
Distance to default 14.0 12.5 7.7 9.2 14.8 13.0 12.5 15.3 Equation 2: Distance to Default
Net interest margin 4.5 2.6 6.1 2.5 3.6 3.1 3.3 1.3
Cost-to-income ratio 67.4 99.7 95.5 107.8 71.9 31.8 69.6 19.2 DistanceToDefaultijt  f ( BankCreditGrowthij ,t 1 , GDPperCapita j ,t 1 , GDPgrowth j ,t 1 , RIR j ,t 1 , RER j ,t 1 ,
Liquidity ratio 17.4 16.1 11.2 9.8 17.2 18.0 17.1 18.0
DistanceToDefaultij ,t 1 , CostToIncomeij ,t 1 , InterestMarginij ,t 1 , Liquidity ij ,t 1 ,
Bank size 6.4 1.3 4.8 1.3 7.0 1.3 5.8 1.3
Real GDP growth 2.9 2.4 5.3 3.5 3.3 1.9 8.1 1.2 Sizeij ,t 1 , Foreignijt , Public ijt ),
GDP per capita 58.1 23.5 30.9 3.9 70.1 25.7 45.8 10.6
Real interest rate 3.2 3.5 -0.5 4.5 2.5 3.7 0.5 1.9
Real depreciation 0.2 0.3 -0.1 0.8 -0.4 0.3 -0.5 0.7 where i denotes individual banks, j denotes countries, and t is the year index.
Foreign ownership 36.2 44.4 31.1 39.7 52.2 46.3 41.1 42.8 BankCreditGrowth is the annual percent change in real bank credit to the private sector. RIR
Public ownership 15.3 33.7 12.5 29.2 6.1 21.5 3.7 15.0 is the real interest rate and ΔRER is the annual percent change in the real exchange rate.
Source: IMF staff estimates. CostToIncome and InterestMargin stand for the cost-to-income ratio and the net interest
margin. Public and Foreign are measures of public and foreign ownership.
29 30

5
 Baseline Specification: Bank Credit Growth Equation

Three-stage Least Squares 1995-2004 1995-2000 2001-2004

Bank credit growth (lagged) 0.096*** 0.100*** 0.095***

[5.83] [3.89] [4.71]
• Commonly used technique Distance to default (lagged) 0.229** 0.350* 0.147
[2.16] [1.94] [1.20]
– Linear models using panel data
Real GDP growth (lagged) 2.646*** 2.415*** 2.475***
– A relatively short time dimension [5.53] [2.92] [4.38]
– Lags of dependent variables GDP per capita (lagged) -0.116** -0.301*** -0.057
[1.99] [3.19] [0.73]
• Advantages vis-à-vis Arellano-Bond Net interest margin (lagged) 0.689 1.757** 1.200**
– Two-equation estimation [1.47] [2.25] [2.00]
Cost-to-income ratio (lagged) -0.017 -0.037** 0.046
– Subsample analysis [1.13] [1.96] [1.49]
• Advantages vis-à-vis 2SLS Real interest rate (lagged) -0.558*
[1.65]
-0.864
[1.58]
-0.999**
[2.24]
– Efficiency gains Real depreciation (lagged) -4.911* 14.750** -7.414***
– Unbiased in models with lagged dependent variables [1.95] [2.45] [2.65]
Public ownership -0.178*** -0.153** -0.067
• No apparent specification problems [3.73] [2.39] [0.89]
– Unit roots rejected Constant 16.366*** 15.992** 12.721*
[3.37] [2.17] [1.87]
– Hausman specification tests inconclusive
– Residual analysis validates inclusion of lagged dependent variable R -squared 0.13 0.16 0.15
– No multicollinearity Observations 881 424 457

• Robustness to single-equation estimation Source: IMF staff estimates.

Notes: Absolute value of z statistics in brackets; * significant at 10 percent; ** significant at 5 percent; ***
31 32
significant at 1 percent. The dependent variable in the first (reported) equation is annual percent change in
outstanding loans. In the second (unreported) equation, the dependent variable is distance to default.

Credit growth in the NMS has been largely Baseline Specification: Distance to Default Equation

demand-driven... 1995-2004 1995-2000 2001-2004

NMS: Decomposition of Predicted Credit Growth, 1997-2004
(In percent per year) Bank credit growth (lagged) -0.002 -0.002 -0.001
50 50 [1.14] [0.76] [0.54]
1997-2000 2001-2004
Distance to default (lagged) 0.896*** 0.854*** 0.927***
40 40 [85.84] [59.85] [62.15]
GDP per capita (lagged) 0.017*** 0.029*** 0.007
30 30 [2.83] [3.90] [0.77]
Liquidity ratio (lagged) 0.020*** 0.013 0.027**
20 20 [2.67] [1.17] [2.55]
Bank size (lagged) 0.311*** 0.240** 0.324**
10 10 [3.33] [2.07] [2.22]
Foreign ownership 0.008*** 0.012*** 0.003
0 0 [2.80] [3.28] [0.69]
Constant -2.668*** -2.660*** -2.252**
-10 -10
Bank credit growth Distance to default
[4.10] [3.18] [2.25]
Real GDP growth GDP per capita
Net interest margin Cost-to-income ratio
-20 -20
Real interest rate Real depreciation R -squared 0.91 0.92 0.90
Public ownership Explained
Actual Observations 881 424 457
-30 -30
Source: IMF staff estimates.
c
c

ary

ania
ia

c
nia

tvia

c
d

ry

nia
ia

tvia
ia
d
bli
bli

bli

bli
lan

lan
ven

ven

ton
nga
Esto
ng

hua
pu

pu

La

pu

pu

La
hu
Po

Po

Es
Slo
Hu

Slo
Hu
Re

Re

Re

Re
Lit

Notes: Absolute value of zstatistics in brackets; * significant at 10 percent; ** significant at 5 percent; ***
Lit
ech

vak

ech

vak

significant at 1 percent. The dependent variable in the first (unreported) equation is annual percent change in
Cz

Slo

Cz

Slo

Source: IMF staff estimates. 33 outstanding loans. In the second (reported) equation, the dependent variable is distance to default. 34

Is the glass half empty or half full? These results are robust to...

• No evidence that credit growth has weakened banks • Including additional macro and bank-level variables
– Consistent with FSI analysis • Controlling for year- and country-specific factors
– Not surprising in an upward stage of the credit cycle
• Using alternative measures of bank ownership
• Using alternative measures of bank soundness
• During 2001-04 weaker banks started to expand just as
fast as sounder banks • Controlling for nonlinear effects
– New result, not detectable in aggregate data • Assuming faster feedback effects
– Some weaker banks are weak in the absolute sense • Single equation estimation

35 36

6
 Robustness Analysis: Using a Narrower Measure of Bank Soundness—Nonperforming Loan Ratio Robustness Analysis: Using a Narrower Measure of Bank Soundness—Loan Loss Reserves

1995-2004 1995-2000 2001-2004 1995-2004 1995-2000 2001-2004

Bank credit growth (lagged) 0.075 0.089 -0.011 Bank credit growth (lagged) 0.086*** 0.085*** 0.100***
[1.43] [1.28] [0.17] [4.04] [2.70] [3.66]
Nonperforming loans (lagged) -0.006 -0.025 0.262*** Loan loss reserves (lagged) 11.592*** 11.837*** 59.944*
[0.14] [0.47] [2.75] [4.12] [3.83] [1.76]
Real GDP growth (lagged) 2.625*** 3.129** 2.109** Real GDP growth (lagged) 2.808*** 1.970** 2.299***
[2.58] [2.15] [2.23] [4.86] [2.07] [3.28]
GDP per capita (lagged) -0.280** -0.386** -0.219* GDP per capita (lagged) -0.085 -0.235** -0.002
[2.16] [2.02] [1.86] [1.22] [2.20] [0.03]
Net interest margin (lagged) 2.097* 2.506 5.397*** Net interest margin (lagged) 0.417 2.607*** 0.242
[1.82] [1.59] [3.04] [0.58] [2.62] [0.19]
Cost-to-income ratio (lagged) -0.085*** -0.099*** 0.099 Cost-to-income ratio (lagged) -0.041** -0.059*** 0.192**
[3.22] [3.09] [1.48] [2.11] [2.71] [2.25]
Real interest rate (lagged) -1.332** -1.674** -1.245* Liquidity ratio (lagged) -0.744* -0.984 -0.839
[2.33] [2.00] [1.84] [1.65] [1.49] [1.35]
Real depreciation (lagged) 3.792 13.587 -10.722** Bank size (lagged) -2.961 14.165** -2.938
[0.68] [1.52] [2.26] [1.02] [2.15] [1.01]
Public ownership -0.204*** -0.198* -0.119 Real interest rate (lagged) -0.230*** -0.177** -0.158*
[2.63] [1.92] [1.12] [4.15] [2.40] [1.85]
Constant 28.265** 28.711* 0.711 Constant 21.241*** 16.696* 5.478
[2.55] [1.73] [0.05] [3.32] [1.84] [0.51]

R -squared 0.23 0.24 0.46 R -squared 0.15 0.18 0.17

Observations 221 145 76 Observations 585 301 284
Source: IMF staff estimates.
Source: IMF staff estimates.
Notes: Absolute value of z statistics in brackets; * significant at 10 percent; ** significant at 5 percent; ***
Notes: Absolute value of z statistics in brackets; * significant at 10 percent; ** significant at 5 percent; ***
significant at 1 percent. The dependent variable in the first (reported) equation is annual percent change in
significant at 1 percent. The dependent variable in the first (reported) equation is annual percent change in 37 38
outstanding loans. In the second (unreported) equation, the dependent variable is loan loss reserves as a
outstanding loans. In the second (unreported) equation, the dependent variable is the ratio of nonperforming
proportion of total loans.
loans to total loans.

Weaker Baltic banks are expanding faster

Possible explanations
than other banks...
1995-2004 1995-2000 2001-2004

Bank credit growth (lagged) 0.096***

[5.84]
0.095***
[3.64]
0.094***
[4.70] • Real credit growth in the Baltics is several times
Distance to default (lagged) 0.313***
[2.59]
0.241
[1.23]
0.433***
[3.01] higher than in the CEECs
Distance to default of Baltic banks (lagged) -0.346 0.684 -0.961***
[1.43] [1.46] [3.72] – Ensuring sound lending decisions and risk management
Real GDP growth (lagged) 2.522***
[4.43]
2.514***
[2.85]
1.790**
[2.35] is much more difficult
GDP per capita (lagged) -0.118* -0.293*** -0.05
[1.74] [2.84] [0.56] • Higher degree of foreign participation in the Baltics
Net interest margin (lagged) 0.703 1.758** 1.467**
[1.50] [2.25] [2.47] – Additional comfort that the banking system can withstand
Cost-to-income ratio (lagged) -0.018 -0.035* 0.054*
[1.17] [1.87] [1.78] shocks
Real interest rate (lagged) -0.477 -0.944 -0.817*

Real depreciation (lagged)

[1.30]
-5.078**
[1.53]
15.087**
[1.82]
-8.315***
• More foreign affiliates are branches
Public ownership
[1.99]
-0.178***
[2.49]
-0.155**
[3.01]
-0.076
– Supervision is more challenging
[3.74] [2.42] [1.03]
Baltic banks 5.086 -6.839 18.209***
[0.96] [0.81] [2.77]
Constant 15.241*** 17.060** 7.321
[2.91] [2.15] [1.04]

R -squared 0.13 0.16 0.17

Observations 881 424 457
Source: IMF staff estimates.
Notes: Absolute value of z statistics in brackets; * significant at 10 percent; ** significant at 5 percent; *** significant at 1
percent. The dependent variable in the first (reported) equation is annual percent change in outstanding loans. In the second 39 40
(unreported) equation, the dependent variable is distance to default.

Foreign banks are taking greater risks than Lending through Nordic banks seems the
domestic banks... least related to bank soundness
1995-2004 1995-2000 2001-2004
Summary of Country-Specific Results for Different Foreign Bank Owners, 2001-04 1/
Bank credit growth (lagged) 0.097*** 0.104*** 0.096***
[5.91] [4.03] [4.75]
Distance to default (lagged) 0.429*** 0.456** 0.398** Are Banks with Weaker Parents Expanding Has Rapid Credit Growth Weakened
[3.10] [2.15] [2.26]
Distance to default of foreign-owned banks (lagged) -0.448** -0.380 -0.466**
More Rapidly? Banks?
[2.12] [0.96] [1.96] (1) (2)
Real GDP growth (lagged) 2.665*** 2.436*** 2.485***
[5.54] [2.89] [4.42] Austria Yes? No?
GDP per capita (lagged) -0.134** -0.293*** -0.094
[2.18] [2.88] [1.17] Germany No? Yes?
Net interest margin (lagged) 0.652 1.874** 1.158*
[1.36] [2.27] [1.94] France Yes? Yes?
Cost-to-income ratio (lagged) -0.016 -0.036* 0.048
[1.01] [1.88] [1.57] Nordic countries Yes Yes?
Real interest rate (lagged) -0.539 -0.900 -0.947**
[1.60] [1.64] [2.13] United States Yes? No?
Real depreciation (lagged) -5.123** 15.275** -7.924***
[2.02] [2.52] [2.82] Italy Yes? Yes?
Foreign ownership 8.069** 8.709 5.85
[2.09] [1.31] [1.29] Belgium Yes? No?
Public ownership -12.897*** -9.254 -5.129
[2.75] [1.43] [0.72] Netherlands No? Yes?
Constant 12.857** 10.782 11.156
[2.31] [1.19] [1.51] Source: IMF staff estimates.
1/ "Yes (?)" indicates a negative and statistically significant (insignificant) coefficient; "No (?)" indicates a
R -squared 0.14 0.16 0.16
Observations 881 424 457 positive and statistically significant (insignificant) coefficient. The coefficients correspond to the interaction
terms of the parent bank's distance to default and country dummies and measure the marginal effect of bank
Source: IMF staff estimates.
Notes: Absolute value of zstatistics in brackets; * significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent. soundness of parent banks from a given country vis-à-vis the average effect for all other banks. In other respects,
The dependent variable in the first (reported) equation is annual percent change in outstanding loans. In the second (unreported) the models used for the analysis of the country-specific effects pertaining to parent banks follow the baseline
equation, the dependent variable is distance to default.
specification.

...but commensurate with the strength of parent banks41 42

7
 Weaker banks with large foreign currency Weaker banks with large household
exposures are expanding faster exposures are expanding faster
1995-2004 1995-2000 2001-2004
1995-2004 1995-2000 2001-2004

Bank credit growth (lagged) 0.105*** 0.157*** 0.073** Bank credit growth (lagged) 0.127*** 0.180*** 0.086***
[4.40] [4.25] [2.51] [6.42] [5.45] [3.80]
Distance to default (lagged) 0.346*** 0.422** 0.279* Distance to default (lagged) 0.417*** 0.613*** 0.355**
[2.70] [2.44] [1.68] [3.36] [3.33] [2.38]
Distance to default of banks exposed to foreign exchange risk (lagged) -0.680* 0.006 -0.794* Distance to default of banks exposed to households (lagged) -0.791** -0.886** -1.889***
[1.66] [0.01] [1.74] [2.28] [2.16] [2.86]
Real GDP growth (lagged) 2.681*** 3.497*** 3.495*** Real GDP growth (lagged) 2.483*** 3.991*** 3.585***
[4.46] [3.91] [4.27] [4.31] [4.49] [4.64]
GDP per capita (lagged) -0.123* -0.225*** -0.118 GDP per capita (lagged) -0.154*** -0.375*** -0.065
[1.96] [2.77] [1.32] [2.59] [4.68] [0.79]
Net interest margin (lagged) 0.881 3.754*** 1.242 Net interest margin (lagged) 0.955 2.318*** 1.830**
[1.62] [3.00] [2.05]
[1.28] [4.54] [1.00]
Cost-to-income ratio (lagged) 0.023 0.006 0.03
Cost-to-income ratio (lagged) 0.011 0.007 -0.037
[1.20] [0.30] [1.01]
[0.49] [0.36] [0.52]
Real interest rate (lagged) -0.725* -0.447 -0.766
Real interest rate (lagged) -0.638 -0.133 -1.015* [1.84] [0.76] [1.57]
[1.55] [0.23] [1.94] Real depreciation (lagged) -2.586 26.291*** -4.706
Real depreciation (lagged) -3.919 26.407*** -4.679 [1.06] [5.04] [1.61]
[1.54] [4.98] [1.51] Public ownership -0.172*** -0.103* -0.059
Public ownership -0.160*** -0.075 -0.079 [3.49] [1.76] [0.76]
[3.16] [1.28] [0.96] Banks exposed to households 33.672*** 50.436*** 28.312***
Banks exposed to foreign exchange risk 33.429*** 23.238 29.541*** [4.22] [4.35] [2.68]
[3.69] [1.48] [2.80] Constant 10.593** -8.001 7.025
Constant 9.808* -20.243*** 18.981* [2.02] [1.16] [0.93]
[1.78] [2.85] [1.90]
R -squared 0.24 0.45 0.24
R -squared 0.21 0.41 0.22 Observations 500 215 285
Observations 455 197 258 Source: IMF staff estimates.
Source: IMF staff estimates.
Notes: Absolute value of z statistics in brackets; * significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent. The
dependent variable in the reported equation is annual percent change in outstanding loans. Banks that are exposed to households are defined as
Notes: Absolute value of z statistics in brackets; * significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent. The dependent variable
those with higher-than-average proportion of loans to households and higher-than-average rate of growth in the proportion of loans to
in the reported equation is annual percent change in outstanding loans. Banks that are exposed to foreign exchange risk are defined as those with higher- households. The sample is composed of Czech, Estonian, Lithuanian, Polish, Slovak, and Slovenian banks.
than-average proportion of foreign-currency-denominated loans and higher-than-average rate of growth in the proportion of foreign-currency-denominated
loans. The sample is composed of Czech, Estonian, Lithuanian, Polish, Slovak, and Slovenian banks.
43 44

The negative correlation between bank soundness

and credit growth is the highest in household credit
Regional Policy Implications

NMS: Effect of Bank Soundness on Credit Growth, 2001-04 1/

(In percent per year)
• Weaker banks in the NMS have recently started to
1.5 expand at least as fast as sounder banks (but credit
1.0 Local
Dom.
owned
growth per se has not weakened banks)
CEEC
currency banks – Forward-looking and risk-based supervision
0.5 loans Corporate loans
– Supportive market infrastructure (credit bureaus)
0.0 – Sufficient disclosure of information
Foreign-
-0.5 owned – Financial sector surveillance and analysis
Baltics Foreign banks
-1.0 currency • Weaker banks’ expansion is most pronounced in
-1.5
loans
household and foreign currency lending
Household loans – Closer monitoring of risk exposures and lending practices in
-2.0
these markets
Source: IMF staff estimates.
1/ The effect of a one-unit increase in distance to default on bank credit growth, • Foreign banks are taking on greater risks, consistent
corresponding to the coefficient on distance to default in the credit growth
equation. Distance to default is measured by the number of standard deviations a with parent banks’ strength
return realization would have to fall for equity to be depleted.
– Effective cross-border cooperation between supervisors

45 46

Calibrating Policy Response to Concluding Remarks

Country-Specific Circumstances
• In the Baltics, weaker banks are expanding faster (Latvia, • Probabilistic conclusions
Lithuania) or credit growth has weakened banks (Estonia) – Quality of banks’ lending decisions and risk management
– Macroeconomic conditions

• In the Czech Republic, Hungary, and Slovenia, weaker

banks are expanding as fast as sounder banks • Cross-country econometric analysis using
publicly available data
– Not a substitute for country-specific stress tests using
• In Poland and the Slovak Republic, stronger institutions supervisory data
are growing faster – A complement because it draws on a regional set of
information in a systematic manner
– Different intensity of risk-based policy instruments (Hilbers et al, 2005)
– Country-specific regulatory framework (e.g., supply-side measures)
– Basel II, EU Capital Requirements Directive, IFRS

47 48

8
 Tutorial 1: Principles of Lending and Lending Basics C1

1. What factors have to be taken into account by a bank in considering an application for an

advance?

2. What is creditworthiness and how can it be determined?

3. Why do banks require a customer to contribute some of the capital required for a project?

4. Distinguish between a loan and an overdraft.

5. What are the advantages of a framework for credit and lending decision-making?

6. What is credit analysis? What are the various steps involved in credit analysis?

7. What does structuring of advances mean?

8. What are the different types of borrowers?

9. What is meant by credit culture? Why is it so important?

10. ‘Lending is an art not a science’. Do you agree with this statement?

Page 61 of 84
 Tutorial 2: Financial Statements Analysis C2

1. What characteristics should a business have before it can be considered to be financially

sound?

2. What are the various types of financial ratios that lenders use in analysing the financial

position of a firm?

3. Explain the advantages and limitations of financial statements analysis.

4. What is break-even analysis? Why should a lender be interested in break-even analysis?

5. What is the difference between indexed analysis and commonsize analysis?

6. What is a discounted cash flow? What are the various discounted cash flow methods?

7. What is ‘creative accounting’? Explain by giving examples.

8. Which ratios do loan officers generally use in credit assessment?

9. Imagine the current assets and current liabilities of a firm are $3200 and $2000 respectively.

How much can the firm borrow on a short-term basis without reducing the current ratio below 1.5?

10. Read the comparative statement of financial position and the statement of financial

performance of Imaginary Computers Limited. Prepare a credit assessment report using the

techniques of financial statements analysis as explained in this chapter. Comment on the financial

strengths and weaknesses of the firm.

Page 62 of 84
Page 63 of 84
 Tutorial 3: Credit Scoring Techniques C3

1. What is statistical credit scoring? How does it differ from judgmental methods?

2. Does the adoption of credit scoring add value to a financial institution? What potential exists

for an adverse outcome?

3. Credit scoring methods have mushroomed in recent years. What are three applications of the

differing methods? How do they add value to the financial institution?

4. Why is logistic regression the most common technique in generating a credit scorecard?

5. How many variables are used in a typical scorecard? Why aren’t more explanatory variables

used?

6. Credit scoring developed in response to the need of financial institutions to be able to

process an ever-growing number of applications with ever-decreasing resources. Discuss this

development.

7. What are the two broad categories of credit scoring? How do they relate to each other? Are

they mutually exclusive and do they create tension within the credit assessment structure?

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 Tutorial 4: Credit Risk Analysis- An Introduction C4

1. Define credit risk.

2. What are expert systems? Outline the problems with relying on expert systems.

3. What is the basis of using market-based risk premiums? Why do credit analysts not use them

more regularly?

4. How has the development of statistical tools help credit analysts? Explain why these tools

cannot be the sole basis for decision-making.

5. Explain the basis of discriminant analysis for credit analysis and compare it with hybrid

systems of analysis.

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Page 66 of 84
 Tutorial 5: Consumer Lending & Real Estate Lending C5+6

CHAPTER 5

1. What is consumer lending? What are its various types?

2. What are credit-scoring

scoring models?

3. Changing demographics in Australia are expected to have substantial effects on a bank’s

consumer credit programs. Outline the changes taking place in demographics in Australia and how

these may have an impact on consumer credit programmes.

4.

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5.

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 CHAPTER 6

1. What are real estate loans and why are they important?

2. What is LVR? What is the importance of LVR in consumer lending?

3. When interest rates on corporate/business loans are much higher compared with home loans,

why do you think banks still push home loans?

4. The following cost breakdown is available for a property situated on the North Shore in

Sydney: Land $1,124,000, excavation $51,300, Foundation $47,250, Framing $162,300,

Corrugated steel exterior wall $167,500, Brick façade (glass) $56,000, Floor furnishing concrete

$61,000, Interior finish $28,900, Lighting, fixtures and electrical work $45,000, Plumbing

$114,500, Heating A/C $100,225, Parking $32,000, Solicitor, architect, and accountants fees $250,

000. Using the summation method find the value of the property.

5. A house situated at 17 Dalzel Crescent, Toowoomba is a five-year-old brick house. It is in

good condition with five bedrooms, three bathrooms, and an area of 210 square feet. It is located

in a medium-quality neighbourhood. Comparable houses B (four years old) and C (six years old)

are situated about 5 minutes walk away and have four bedrooms each.

They were sold for $140,000 and $132,000 respectively about two weeks ago. House B has two

bathrooms and house C has only one bathroom.

Using this information, work out the market value of property at Dalzel Crescent.

6. Using the market value approach, find the value of the following property.

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An apartment building is generating annual income of $250,000. Operating expenses, including

vacancies, total 55 per cent of this income. The market supports a capitalization rate of 12 per cent.

Find how much the property is worth using the capitalisation (income) approach.

7. A local banker has

as estimated the value of the property at 23 Sunnyholt Road, Brisbane, to be

$180,000 using market value approach, $175,000 using cost approach and $179,000 using the

income approach. If the banker puts weights of 30 per cent, 30 per cent and 40 per cent oon the

three values respectively, how much loan should the manager advance if the LVR is 80 percent?

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 Tutorial 6: Security, Consumer Credit Legislation and Legal

Aspects of Lending C7

1. What are the various legal aspects that a lending officer must take into account before a

consumer loan is approved?

2. What are the important provisions of the National Credit Code?

3. Does the code provide for criminal penalties on lending officers?

4. What is unconscionable conduct? How is it different from deceptive conduct?

5. Who administers the Competition and Consumer Act 2010 in Australia? What are the

important provisions of this Act that a lending banker should consider?

6. ‘Banker’s lien is a general lien’. Do you agree with this statement? How does banker’s lien

help the banker in recovering dues?

7. What legislation enacted by the Commonwealth Government seeks to prohibit

discrimination?

8. Explain the salient features of the Australian Banking Industry Ombudsman

8. Does the Australian Securities and Investment Commission have any role in protecting

consumers in credit transactions?

9. What important points should a lending officer bear in mind for consumer lending?

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 Tutorial 7: Corporate Lending C8

1. What are the three main principles applied to corporate lending proposals?

2. The five Cs is one method of structuring a loan approval process. What fundamental piece of

information does it ignore or fail to highlight?

3. What are the three components of a corporate loan?

4. Do you think that an understanding of the three components noted in question 3 would allow

for a correct segmentation of loan duties and functions within a financial institution?

5. In recommending approval of a loan, how does a loan officer reconcile the needs of the

borrower with the bank’s objective of making a profit?

6. Discuss the veracity and value of the lending cycle.

7. An evaluation of the worth of the three ways out of a loan may lead to a modification of the

loan approval process. What changes may occur? What additional information may be needed?

8. Attempt to overlay the five Cs and PARSER on the formalized lending cycle shown in

figure 8.1.

9. Refer to the lending products listed in this chapter to meet the needs of corporates. Are any

of them practical to offer as a replacement for a large corporate’s interaction in the direct market?

10. Should a loan officer be involved in the cross-selling of various institutional products or

should this be the function of other parties employed by the financial institution? In your

discussion, define and develop what is meant by a ‘full relationship with the client’

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 Tutorial 8: Small Business Lending & International Lending

CHAPTER 9

1. Distinguish between ‘hard’ and ‘soft’ information about a small business. Give seven

different examples of soft information about a small business. If you had to choose, would you

prefer to use hard or soft information in making a lending decision to a small business?

2. Go to the website for Fair Isaac (www.fico.com). What information can you find on the role

that Fair Isaac plays in developing credit scoring models for small business lending applications?

3. The National Australia Bank’s ‘Business information form’ at www.national.com.au

specifically requests the submission of a cashflow budget. Why do you think the National

Australia Bank places so much emphasis on a cashflow budget in assessing a loan to a small

business?

4. Explain in your own words what you understand by the phrase ‘asymmetric information

problems’. Choose a large business that you know something about and comment on the

information asymmetries that may arise for a lender to this business. Choose a small business that

you know something about and comment on the information asymmetries that may arise for a

lender to this business. Do you think information asymmetries are more or less pronounced with

large businesses?

5. Read the two articles in the ‘Industry insight’ (Small businesses and bank fees. Small

businesses fees not unfair, says banks) Comment on whether you find the argument of the

Australian Bankers Association convincing. Overall, do you think that the banks’ small business

fees are unfair?

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6. Refer to the ‘A day in the life of …’ (A small business lender) .

How do you think this ‘day’ would change if the bank concerned moved from using a relationship

lending model to a credit scoring model?

7. Explain whether you feel it is an advantage to be classified as a ‘small proprietary company’

under the Corporate Simplification Act. What impact do you think a borrower being a small

proprietary company would have on a lender’s attitude to that borrower?

8. Explain the ten lending technologies identified in this chapter. Which of the technologies are

commonly used in Australia?

9. Outline the various lending channels that are used for financing SMEs. Which of the

lending channels are relevant in the Australian context?

10. What are the different types of risks faced by small business as identified by the CPA

Australia

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 CHAPTER 10

1. Explain the difference between pre-payment and open account payment.

2. What is country risk analysis?

3. What points are taken into consideration by rating agencies when assessing country risk?

4. What are the principles of international lending?

5. Explain the following concepts:

a) documentary letters of credit,

b) back-to-back credit

c) red clause credit.

6. What is LIBOR?

7. Why is LIBOR important in international lending?

8. What are the contents of a typical documentary credit?

9. Distinguish between pre-shipment and post-shipment credit.

10. Explain the importance of UCP600.

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Tutorial 9: Credit Risk Measurement and Management of the

Loan Portfolio C11

1. Outline the problems of traditional lending methods and possible solutions. Are there any

problems with the solutions?

2. Compare and contrast the approach of the Z score model and the KMV expected default

frequency model.

3. Use the following extracts from the Harvey Norman 2000 annual report to calculate the

Altman Z score

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Page 77 of 84
 Would you lend to Harvey Norman? What is the difficulty in using the Altman Z score?

1. Under what circumstances does KMV’s expected default frequency model not work correctly?

2. Explain the limitations of the concept of the risk-adjusted

risk return on capital.

3. What financial basis does Altman use to construct his portfolio management model? Why does he

use constraints in maximising the return on the portfolio?

stand-alone risk for a

4. In the examplee given for Creditmetrics™ (page 345), we calculated the stand

rated bond. Using the same data, calculate the stand-alone

BBB-rated stand year AA
risk of a five-year AA-rated bond

find unusual?
with a coupon of 5 per cent. Is there anything regarding your answer that you find

5. Explain the circumstances in which you would use securitisation and the circumstances in which

you would use credit derivatives.

6. Is securitisation a credit risk management tool?

risk of a loan, why does the

7. If a protection seller under credit derivatives is assuming the risk

protection seller not just provide the loan?

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 Tutorial 10: Credit Risk from the Regulator's Perspective &

Problem Loan Management C12+13

CHAPTER 12

1. Explain how the capital adequacy guidelines deal with the regulator’s concern for credit risk.

2. Westpac’s 2001 statement of financial position is presented in the following table. Calculate

the capital adequacy ratio.

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Page 80 of 84
3. Discuss the shortcomings of the current capital adequacy guidelines.

4. How do the proposed capital adequacy guidelines deal with the shortcomings that you noted

in question 3?

5. Referring to the Westpac financial statement again, what difficulties do you encounter if you

need to calculate capital adequacy under the new guidelines?

6. Should all financial institutions be able to use internal ratings?

7. What would be the difficulty in identifying large exposures?

8. Discuss the advantages and disadvantages of concentrated credit portfolios.

9. From a regulatory point of view, what are problems with securitisation as a credit ri
risk tool?

10. Credit derivatives are an effective credit risk tool. Why are the regulators concerned about

them?

11. Read the ‘Industry insight’ (Regional banks and the Basel II capital standards)
standards). Consider

which sections of a regional bank’s lending portfolio are riskier than those of a major bank’s

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lending portfolio. Then, assess what you consider to be an appropriate capital adequacy provision

for regional banks. You should consider the difficulty of distinguishing between regional banks

and major banks.

12. What are the difficulties with using credit rating agencies in the due regulatory process?

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 CHAPTER 13

1. Why are problem loans an issue?

2. Explain the difference between accounting, regulatory and internal provisioning policies.

3. Why are some parts of the business cycle identified with increased numbers of problem

loans?

4. Compare and contrast dynamic provisioning and other methods of assessing provisioning.

5. Discuss the advantages and disadvantages of dynamic provisioning.

6. Explain how to distinguish between the various forms of financial distress.

7. Would the timing of the business cycle influence the management of the business cycle?

8. Ifi Corporation has two loans outstanding. One loan is to Certain Bank for $400, while a

senior bond holder is owed $150. Ifi Corporation wants to put itself into liquidation and default on

its loans. The liquidation value is $160. The management of Ifi Corporation has special qualities

that would result in a pay-off of $420 with a probability of 0.8, otherwise zero. For the

management to continue, it would have to be paid $10. Carefully outline the options available to

Certain Bank.

9. In the case of a syndicated loan, there are often senior and junior debt providers. Where a

borrower defaults under this arrangement, the senior debt providers would be assumed to be

relatively well protected. Under what circumstances does this not occur? What steps should be

taken to protect senior debt providers?

10. What steps would you take if a borrower breached a covenant, leading it to technical

default? Your answer should highlight the contract issues.

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 Tutorial 11: Quantitative Finance & Credit growth C16

1. Why are the assumptions of Basel II important when discussing concentration risk?

2. What is the major problem with the Herfindahl-Hirschman index?

3. What are unexpected losses used for?

4. What have been the developments in the development of probability of default models

5. When developing probability of default models, what would you use as major variables if

you are addressing a portfolio of mortgages?

6. Do the same ask as Question 5 above for a portfolio of construction loans.

7. What is the problem with using ordinary least squares when measuring loss given default?

8. What are the alternatives to ordinary least squares when estimating loss given default?

9. What is the problem in using interest rates as the major variable when estimating

prepayment risk.

10. What are the overall issues in developing credit models?

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