HANOI UNIVERSITY

FACULTY OF MANAGEMENT AND TOURISM

Subject Outline
CREDIT ANALYSIS AND LENDING
MANAGEMENT
FALL 2025

HANOI 08 – 2025

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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 2025
Course staff and Assoc. Prof. Dao Thi Thanh Binh (Ms.), Lecturer binhdtt@[Link]
contact details Nguyen Thi Minh Hang (Ms.), Tutor hangntm@[Link]
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
Upon completing the course "Credit Assessment and Lending Management," learners will gain
knowledge related to lending, including the credit evaluation process, credit appraisal, risk
assessment and management, financial ratio analysis, and monitoring and control of credit risk
for both consumer and business loans. In addition, the course offers opportunities for learners to
develop and enhance professional skills that are relevant and valuable to various positions in the
finance and banking sector.
Learning outcomes
On successful completion of this course, students should be able to:
1. Knowledge
- Demonstrate a clear understanding of lending decisions in banks, types of loans, techniques
and statistics used in lending decisions, credit risk, and non-performing loan management.
2. Skills
- Practice analyzing financial statements, assessing credit risk and lending decisions, and
conducting credit analysis for both corporate and personal loans.
3. Personal effectiveness competencies to have
- Proactively conduct self-directed research and deepen understanding of credit activities in
banking to fulfill the tasks and requirements of the course
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

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Credit Analysis & Lending Management
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
1. Sathye, M., & Bartle, J. (2017). Credit analysis and lending management (4th ed.). Mirabel
Publishing.
2. Colquitt, J. (2007). Credit risk management: How to avoid lending disasters and maximize
earnings (3rd ed.). McGraw-Hill USA.

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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
1. Witzany, J. (2017). Credit risk management: Pricing, measurement, and modeling (1st ed.). Springer
International Publishing.
2. Bình, Đào T.T., Yến, Hoàng T. & Trang, Nguyễn V. (2012), Credit Scoring Models for Vietnamese
Market: Z-Score Models for Vietnamese Manufacturers, Non-Manufacturers & Consumers. LAP
Lambert Academic Publishing.
3. 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
OPTION 1: CORPORATE LENDING APPRAISAL
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. Industrial 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 the required amount of working capital; (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 - 5 years) of the analyzed company.

OPTION 2: INDIVIDUAL LENDING APPRAISAL

You are currently working as a Credit Officer at a Commercial Bank in Vietnam. A relative or friend of yours
who could receive 20% financial support from his/her firm, , has approached your bank to apply for a
personal housing loan to purchase a new apartment in a residential building or housing project. The
requested loan amount is equivalent to at least five times the borrower’s annual salary.
Your task is to:
1. assess the borrower's repayment capacity,
2. review and verify the required supporting documents (For example: Borrowers’ documents: name, age,
job title, years of employment, marital status, and number of dependents, salary table, evidence of consistent
income over the past six months, working commitment agreement, etc. ),
3. evaluate the housing project (Information: apartment price, floor area, location, payment terms, and
developer background, apartment sales contract or reservation agreement, developer quotation or brochure,
proof of borrower’s equity, etc.), prepare a loan proposal (requested loan amount, loan tenor (in years), type
of interest, proposed interest rate with justification (based on current market rates or assumptions), etc.)and
4. develop a loan repayment schedule in accordance with standard credit appraisal practices.

All supporting documents must be realistic and verifiable, and must be included in the final report
submission as part of the credit officer's documentation file.

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Credit Analysis & Lending Management
OPTION 3: LITERATURE REVIEW
Understanding the theoretical foundations and current debates in lending is essential for both academic
development and practical application in the banking and financial services sector. This assignment requires
students to conduct a literature review on Factors affecting NPLs

You are expected to review, compare, and critique a selection of academic journal articles, working papers,
reports, and books related to your chosen topic. Your work should highlight key findings, identify research
gaps, and reflect on implications for bank lending practices.

Presentation: Group members are to prepare and conduct a 15-minute presentation on your report. 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..2025. For example: Lending_Tut1_G1.2025. doc or .ppt

● 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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 LENDING DECISION

The Principles of Lending and

Lending Basics
Chapter 1

1
1

Learning Objectives

• Identify the basic principles governing bank lending

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

2
2

Learning Objectives

• Explain the characteristics of various types of bank

advances/loans.
• Distinguish different types of borrowers and the
special considerations that apply to them when giving
loans.
• Explain how advances are structured.

3
3

1
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 Learning Objectives

• Explain the importance of credit culture in a lending

institution.
• Understand how an advances portfolio is designed.

4
4

Introduction

• The principles of lending have evolved from the

practice of lending in the real world and are
universally applicable.
• Lending principles should be regarded as an art
rather than science and only serve as a framework
within which to make a decision.

5
5

The Principles of Good Lending

• Three basic principles that guide lending decisions:

• Safety of loan
• Suitability of loan purpose
• Profitability
• To follow these principles, financial institutions
undertake credit analysis of all loan proposals.

6
6

2
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 A First Example: The five C’s of Credit Analysis
(Source: Greenbaum/ Thakor: Contemporary Financial Intermediation, and others)

• Capacity
Ensures that borrower has legal and economic capacity to borrow
• Character
Refers to borrower ’s reputation and hence desire to settle debt
obligations
• Capital
Resolves private information and moral hazard problems
• Collateral
Includes both, “inside” and “outside” collateral. These resolve private
information and moral hazard problems. Also directly reduce bank’s risk
• Conditions
These are economic conditions that affect the borrower ’s ability to repay
the loan

Now it is 6C (cash) or even 7C (cash + control/creditworthiness/credit

scoring)
7

The most important of the 5 C’s …

• Untermyer: Is not commercial credit based primarily upon money or property?
• Morgan: No, Sir, the first thing is ........................
• Untermyer: Before money or property?
• Morgan: Before money or anything else. Money cannot buy it.
• Untermyer: So that a man with .................. , without anything at all behind it, can get all the
credit he wants, and a man with the property can not get it?
• Morgan: That is very often the case
• 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
………….. ?
• Morgan: Yes; he gets it on his …………. Because a man I do not trust could not get money
from me on all the bonds in Christendom
and later …
• Untermyer: But what I mean is that the banking house assumes no legal responsibility for
the value of the bonds, does it?
• 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…

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
8

Loan Analysis and Rating

• Rating:
Ordinal value, assigned as a result of a loan analysis. Different granularities
may be used:
• Acceptable / not acceptable (white/black)
• Acceptable / uncertain / not acceptable (white/grey/black)

• Part of a multi-category rating system

– Ratings are sometimes
also available for groups
of borrowers, industries,
transactions, etc.
– Usually
7-12 rating categories
– Example: Bond ratings

3
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 Scoring and Probability of Default

• Scoring:
• Cardinal value, assigned as a result of a loan analysis.
Credit scores are quantitative in nature, they directly assign a
numerical value to the credit quality, for example:
 Output of a logit / probit - model
 Output of a discriminant analysis

• Probability of Default, PD:

• Statistical value, based on an estimated loss distribution of a loan
portfolio
• Usually credit ratings and credit scores cannot be directly converted
into probabilities of default. Possible solution: Calibration of rating
categories

10

Rating and Calibration

• Problem:
If ratings are to be used in quantitative credit risk models they have to be
calibrated
• Required data set
• Loan data for at least one full credit cycle
• Loan loss distributions for each rating category and year
• Alternatively: Calibration based on
• Bond market data (domestic / foreign)
• Loan data of other banks
• Loan data of other countries
Significant deviations from “real numbers” are possible …

11

A Framework for Credit and

Lending Decisions

• External Factors
• General law of the land: the financial institution must
follow the lending regulations in the country that it
operates.
• Macroeconomics: the general condition of the economy
directly affect the lending decisions
• Industry – specific: lending institution analyze in details
the characteristics of each industry
• The Reserve Bank Act of 1959, The Uniform Consumer
Credit Code, The Australian Securities and Investments
Commission Act 1989, The Australian Competition and
Consumer Commission

12
12

4
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 A Framework for Credit and
Lending Decisions
• Lending – institution specific factors
• The lending policy: each lending institution has
a policy upon which all lending procedures
mush follow
• The loan budget: lending has to follow the loan
budget to fit in the predetermined budget
and/or the strategic direction of the institution.
• Staff availability: lending institutions might
restrict their lending upon the availability of
their skilled loan officers
• Borrower – specific factors: the 5 C’s

13
13

The Lending Process

• The ten-step process:

• Step 1 – obtain the application form
• Step 2 – obtain required documents
• Step 3 – check the application & documents
• Step 4 – Decision to make personal loans.
Business loans require further steps
• Step 5 – Appraise detailed aspects the proposed
business borrowers

14
14

The Lending Process

• The ten-step process (con’t):

• Step 6 – access the financial
requirements/project to invest in/equity capital
of the borrowers
• Step 7 – inform the borrowers whether the
proposals have been approved or rejected
• Step 8 – in case approved, ensure proper
documents
• Step 9 – monitor the account periodically
• Step 10 – take precaution toward probable
problem loans

15
15

5
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 Characteristics of Different Types of
Advance/Loans

• Traditional types of advance

• Loans
– Secure (with Collateral) vs. Unsecure
– Personal vs. Business vs. Government
– Long vs. Medium vs. Short term
– Sectors, Regions, Purposes…
• Overdrafts: revolving accounts, short term; credit card
is a type of overdrafts

16
16

Characteristics of Different Types of Advance

• Modern types of advance for businesses:

• Equity participation
• Loan syndication
• Equipment leasing
• Factoring

17
17

Different Types of Borrower

• Personal Borrowers
• Minors
• Persons of unsound mind
• Insolvents
• Joint accounts
• Husband & Wife
• Business Borrowers
• Sole proprietorship
• Partnerships
• Companies

18
18

6
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 Different Types of Borrower

• Special Type of Borrower

– Local authorities: certain local authorities have special
borrowing power
– Club, literacy societies, and schools
– Unincorporated associations
– Cooperatives

19
19

Structuring of Advances

• Involves three major aspects

– Security: assets taken as insurance, protecting the
lender from uncertainty
– Debt covenants: terms and conditions such as fees,
interest rate, security, repayments, stamp duty… that
characterize the loan
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

20
20

Credit Culture

• The institutional priorities, traditions, and

philosophies that surround credit and
lending decisions
– The fundamental principles that drive lending
activity and how management analyzes risk
– Values Driven: Focus is on credit quality
– Current-Profit Driven: Focus is on short-term
earnings
– Market-Share Driven: Focus is on having the
highest market share

21
21

7
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 Designing an Advances Portfolio

• Typically, a financial institution uses up to

70% of its assets in loans and advances
• Three steps in designing the loans and
advances portfolio:
– Historical and recent loss experience
– Standards based on maximum loss tolerance relative to
capital
– Risk-adjusted return on capital,

22
22

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

23
23

8
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 LENDING DECISION

Financial Statements Analysis

Chapter 2

1
1

Learning Objectives

• Explain key financial statements

• Explain the importance of analysis of financial
statements in lending decisions
• Describe the various methods of analysis where
project finance is involved

2
2

Learning Objectives

• Describe the special techniques of analysis where

project finance is involved
• Describe how window dressing of financial
statements can take place

3
3

1
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 Learning Objectives

• Explain which of the financial ratios are preferred by

loan officers
• Outline the limitations of financial statements analysis

4
4

Introduction

• The analysis of financial statements plays a key role

in assessing potential business loans
• Generally consist of:
• Statement of Financial Performance
• Statement of Financial Position
• Statement of Cashflows

5
5

Why Lenders Analyse Financial

Statements

• Financial statements are analysed to help determine

whether:
– The business has adequate liquidity so it can honour
short-term obligations
– The business is run efficiently
– The business is run profitably
– The proprietor’s stake in the business is high versus the
business carrying excessive debt

6
6

2
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 Why Lenders Analyse Financial
Statements

• Analysis helps provide answers to three key

questions:
– Should the bank give the requested loan?
– If the loan is given, will it be repaid together with interest?
– What is the bank’s remedy if the assumptions of the loan
turn out to be wrong?

7
7

Analysis of Financial Statements

• The analysis of financial statements falls into three

broad categories:
• Cross-sectional techniques, such as ratio analysis and
common-size statements
• Time series techniques, such as identifying trends in
ratios or other measures
• A combination of the two.

8
8

Analysis of Financial Statements

• Cross-sectional techniques
• Ratios: Financial ratios derived from the financial
statements fall into four main categories:
– Liquidity ratios
– Efficiency ratios
– Profitability ratios
– Leverage ratios

9
9

3
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 Analysis of Financial Statements

• Liquidity ratios
• Used to determine the ability of the firm to meet its
short-term obligations

• Current Ratio

• Quick Ratio

10
10

Analysis of Financial Statements

• Efficiency ratios
• Used to determine how efficiently the firm has
used its assets

– Inventory Turnover
Ratio

– Average Collection
Period
11
11

Analysis of Financial Statements

• Profitability ratios
• Used to assess the profitability of sales generated
through operations

– Gross Profit–Sales
Ratio

– Net Profit–Sales
Ratio
12
12

4
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 Analysis of Financial Statements

• Leverage ratios
• Used to assess the proportions and manageability
of debt carried by a firm

– Debt–Equity
Ratio
– Interest
Coverage
Ratio
13
13

Analysis of Financial Statements

• Leverage ratios
• Fixed Charges Coverage Ratio

14
14

Analysis of Financial Statements

• Common-Size Statements
• Express relationships between the numbers on the
financial statements
• For example, the following items may be expressed as
a percentage of total assets:
– Accounts Receivable
– Inventory
– Equity

15
15

5
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 Analysis of Financial Statements

• Time Series Techniques

• Ratios can be evaluated to detect any improvements or
deteriorations in financial position over time
• Variability Measures: Where trends are not detected,
these may be used to determine the variability over
time

16
16

Analysis of Financial Statements

• Combining Financial Statement and Nonfinancial

Statement Information
• Other information that may be incorporated into the
analysis include:
– Changes in market share
– Market perceptions via share price
– Changes in key management
– Impact of macroeconomic changes

17
17

Techniques of Analysis Used in Project

Finance

• Payback Period: the time it takes for an entity

to recover a project’s initial cash outlay.
• Accounting Rate of Return: earnings from a
project (after tax and depreciation)/investment
outlay.
• Discounted Cashflow Techniques

– Net Present
Value

– Internal Rate
of Return
18
18

6
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 Project Risk Analysis

• Sensitivity Analysis:
– Measures the impact of changes on key variables,
such as the interest rate or prices of key inputs, on
the project’s viability
• Break-Even Analysis
– The level of sales at which revenue equals
expenses and net income is zero
– Requires knowledge of fixed and variable costs

19
19

Project Risk Analysis

• Margin of Safety
– The margin between the profitability of current
operations and break-even point
• Cash Break-Even Point

• Simulation
– Computational approach where one variable is
changed at a time to determine sensitivities across
numerous variables

20
20

Step-By-Step Approach to Financial

Statements Analysis

• Step 1: Obtain relevant financial statements

– Obtain Statement of Financial Performance, Statement of
Financial Position and Cashflow statements for generally
three years
• Step 2: Check for consistency
– Verify names on financial statements, signatures of
partners, corporate seals etc.

21
21

7
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 Step-By-Step Approach to Financial
Statements Analysis

• Step 3: Undertake preliminary scrutiny of financial

statements
– Statement of Financial Performance
– Statement of Financial Position
– Cashflow Statement
• Step 4: Collect data about industry and general
economic trends
– Strength of economy and relevant industry

22
22

Step-By-Step Approach to Financial

Statements Analysis

• Step 5: Comparison with Industry Averages

– How does firm’s financial ratios compare with
competitor’s in same industry
• Step 6: Do Supplementary Analysis
– Break-even and Sensitivity Analysis
• Step 7: Summarise Main Features
– Provide an analytical overview from all relevant data
obtained

23
23

Detecting Window Dressing, Frauds and

Errors

• Overwhelming accounting complexities lead to

potential abuses of the notion of ‘true and fair’ via
manipulation of:
– Valuation of receivables inventory, property, marketable
securities and other assets
– Liabilities including off-balance sheet items
– Changes to accounting methods

24
24

8
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 Use of Financial Ratios by Loan Officers

• Top ten ratios of importance in loan assessment

1 Debt/Equity 6 Net Interest Earned

2 Current Ratio 7 Net Profit Before Tax
3 Cash Flow/LT Debt 8 Financial Leverage
4 Fixed Charge Cover 9 Inv T/O in Days
5 Net Profit After Tax 10 A/c Rec T/O in Days

25
25

Limitations of Financial Statements

Analysis

• Financial statements analysis cannot substitute for

sound judgement:
– Problems with benchmarks: What benchmarks should be
used for multi-industry firms?
– Window Dressing/Creative Accounting
– Historical Data: Accounting reports reveal only history,
not the future
– Qualitative Aspects: Changes in management, the
economy, etc.

26
26

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

27
27

9
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 LENDING DECISION

Credit Scoring Technique

Chapter 3

1
1

Learning Objectives

• List the development of credit scoring techniques

• Discuss the behavioural aspects of credit scoring
• Explain the imperative for credit scoring

2
2

Learning Objectives

• Discuss the application of credit scoring techniques

• List the various modelling techniques used in credit
scoring
• Discuss the steps to take in implementing the credit
scoring program

3
3

1
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 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
using a customer’s credit score
• 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)

4
4

Credit Scoring: Data Collection

• Information being collected by credit bureaus:

• Types of credit
• 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

5
5

Introduction

• Statistical credit scoring technique serves

as a centralized model that can be overlaid
across the whole organization to reduce the
potential for error in credit scoring
• 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

6
6

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 Overview of Credit
Scoring Techniques

• Three basic characteristics of a valid statistical

credit scoring system
• Must not rely on prohibited and unjustified
information
• The information used must contribute positively to
a client’s creditworthiness
• The credit extend should contribute to the credit
health and quality of the lending institution

7
7

The Development of
Statistical Credit Scoring

• Parallels the increase in per person outstanding

credit and the expansion of the credit industry
• The need for a system was identified in the 1960’s
• In the 1980’s technology allows further development
and sophistication of the credit scoring techniques
• In the same period, the application of these
techniques was successfully implemented in the
credit card market
• Credit scoring techniques continued to expand to
other areas of consumer lending
• The techniques are now used for the full range of
lending products, from individuals to larger corporate
loans.
8
8

The Development of
Statistical Credit Scoring

• Judgmental decision-making vs. credit scoring has

been a source of tension within banking circles
• In Australia, the credit scoring techniques have
proven to be a better selection to handle the larger
volume as well as minimize the risk imposed from
human judgment
• Ensures more accurate risk identification
• Significant cost reduction
• More efficient human capital
• The deregulation and modernization approach in
Australia increased the demand for credit scoring
techniques
9
9

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 The Imperative for
Credit Scoring

• Credit scoring enabled banks for the first time to have

a true measure of risk in a given loan portfolio
• Credit scoring could create competitive advantage
from cost savings and efficiency gains
• Handled much higher application volume given
limited resources
• Better managed customer database (needs,
preference)
• Allowed increased flexibility and expansion in SMEs
• Strengthened customer relationship

10
10

Statistical Credit Scoring Techniques vs.

Traditional Judgmental Methods
Topic Statistical Scoring Judgemental Scoring
1. Popular difference Impractical or unsound mixture of Credit officers make an unspecified
population are not sampled adjustment
2. Definition of Precise corporate rules are defined The system relies on individual
creditworthiness and agreed interpretation of what is good and
bad
3. Use of credit rules Credit rules are avoided because Credit rules are often based on
the system will generate its own limited data that dwell on the past
best rules
4. Use of applicant Less information is needed because Wide use is made of data that are
information redundant information is ignored sometimes conflicting
5. Analysis of account Analysis reveals distinctive and Rarely is a precise or accurate
behavior objective pattern of good and bad analysis produced to guide the
behavior future
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
interrelationships information
11
11

Statistical Credit Scoring Techniques vs.

Traditional Judgmental Methods
Topic Statistical Scoring Judgemental Scoring
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
consistency and prediction
8. Operation The system is based on high volume The system can be time consuming
impact/flexibility versus low cost and accordingly expensive
9. Improved Calculations can be made for It is difficult to estimate the value
calculations and decisions on good, bad or reject of a model to measure
expected results behavior performance
10. Management Management sets and defines policy It is difficult to tighten or ease
control by the ability to vary the cut-off score credit policy without causing an
according to conditions overreaction or under-reaction
11. Monitoring and Measures can be monitored against The level of performance can be
wider use current practice and developmental measured but the financial
models institution has no ability to easily
pinpoint scope for improvement

12
12

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 Statistical Credit Scoring Techniques vs.
Traditional Judgmental Methods

• Two broad categories of scoring

• Accounting – based system
• Quantitative credit screening
– Credit approval models which use decision – reaching
analysis
– Behavioral scoring models which are used to improve the
profitability of accounts and products
• The major difference is the predictive nature of the
accounting – based method as opposed to the rear –
view analysis of the quantitative models

13
13

Statistical Decision-making Methods

Used in Credit Scoring Models

1. Probability modelling
2. Application credit scoring models
3. Application derivatives
a) Mail solicitation score
b) Attrition models
c) Authorization scores
4. Judgemental credit scoring
5. Collection models
6. Regression analysis
7. Logistic regression

14
14

Statistical Decision-making Methods

Used in Credit Scoring Models

8. Decision tree models

9. Neural networks
10. Genetic algorithms
11. Mortality models
12. Chi – square automatic interaction detector (CHAID)
13. Expert systems
a) An information module
b) An information database module
c) A learning module

15
15

5
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 Social & Ethical Issues in
Apply Credit Scoring Techniques

• Social issues vs. drive for efficiency and productivity

• Steps to ensure the veracity of the system
1. Solve the problem of volume vs. relationship. Planning
of the financial position is essential for success
2. Understand what the model is meant to achieve and its
impact on the culture of the organization
3. Understand type I and type II errors
1. Type I – approval of a loan when it should have been
rejected
2. Type II – rejection of a loan when it should have been
approved
4. Remove the potential for bias for decision – making
16
16

Error types in credit analysis

• Two main errors:
• Giving out a loan to a “bad” borrower
 Type I error, Alpha error
• Rejecting a “good” borrower
 Type II error, Beta error

Actual Loan Predicted Loan Quality

Quality Good Bad

Good Type I Accuracy Type II Error

Bad Type I Error Type II Accuracy

17
17

Implementing Credit Scoring

within the Organization
• The implementation process requires a marriage
between expertise and technology
• Phrase I – Planning
• Agreement of the board and executives on project objectives,
costs and expected benefits
• Correct and impartial selection of the implementation teams
• Selection of the internal developers and agreement on the
project scope or limitations
• Development of an outline plan and define different interest
groups
• Collect preliminary data on transactions volumes, rejection
rates, levels of delinquency over time
• Investigation of data

18
18

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 Implementing Credit Scoring
within the Organization

• Phrase II
• Review the implementation plan and agree on a definitive
long – term plan between the internal and external teams
• Construct and agree on robust definitions of good, bad,
and intermediate transactions. Calculate good, bad,
acceptance and rejection rate
• 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
19

Implementing Credit Scoring

within the Organization
• 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
20

What are problematic areas of credit

scoring?
• Short history: Most models use data going back only two years
• Bad data: Credit-report data used in the models are sometimes inaccurate
• Score polishing: “Advisors” help borrowers to improve scores by rearranging
finances
• Discrimination potential: Critics mention that scoring unfairly steers minorities
into higher-priced loans
• 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
21

7
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 Covid-19 and credit loss models
• COVID-19 and Credit Loss Models (Source: GARP)
• Credit modeling teams across the U.S. are now reconstructing and refitting
their forecasting models.
• Historically, huge upticks in joblessness have been directly connected to
default upsurges, but government-driven stimulus plans enacted amid the
pandemic have taught modelers that there are other important income
variables to consider when projecting credit losses.
• Example:

22
22

Unemployment and Deliquency Rate

23
23

Impact of Covid-19 (Source: GARP)

• The onset of COVID-19 changed things overnight. Governments imposed

shutdowns on business activity, and the demand for leisure, hospitality and
retail services waned significantly.
• Unemployment rose as a direct consequence. While entirely justifiable, these
atypical acts disrupted the finely-tuned relationship between the
unemployment rate and charge-offs.

24
24

8
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 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
25

Impact of Covid-19 (Source: GARP)

26
26

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 LENDING DECISION

Credit Risk Analysis – An

Introduction
Chapter 4

1
1

Learning Objectives

• Define credit risk

• Analyze various approaches to credit risk analysis
• Explain expert system
• Carry out a five C’s analysis

2
2

Learning Objectives

• Ascertain credit risk from market-based spreads

• Describe various econometric processes
• Carry out a basic Altman analysis
• Describe hybrid systems of credit risk analysis
• Look at company data and carry out a basic credit
analysis

3
3

1
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 Introduction

• It is important to understand credit risk

before learning how to analyze it
• In the past 15 years, there has been an
explosion of analysis with the developments
of many tools

4
4

Credit Risk
• 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.”

Credit Risk according to ChatGPT

2
Page 35 of 157
 What is Credit Risk

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

of a contract not to be fulfilled
• Arises from any service that provided and not paid for immediately
• A contract is the underlying subject of credit risk
• Obligations of the borrower
• Obligations of the lender
• 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
7

How do We Analyze Credit Risk

• Four broad categories of available tools

• Expert systems
• Risk premium analysis
• Econometrics
• Hybrid – system

8
8

How do We Analyze Credit Risk

• Expert Systems
• These systems tend to be manually based
• Computer assistance for simple financial ratios
calculation
• The whole process is paper – based
• The five C’s
– Capacity analysis
– Current ratio
– Inventory turnover ratio
– Net profit – sales ratio
– Debt – equity ratio

9
9

3
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 How do We Analyze Credit Risk
• Risk premium analysis
• Measure credit risk by examining the risk premium
between each corporate credit rating and a risk – free rate
• When there is indifference about investing in corporate
debt and risk-free debt p (1 + r) = 1 + i
– p = the probability of repayment
– r = the interest rate on the corporate bond
– i = the risk free rate
• When there is difference, with e represents the proportion
of the loan can be recovered at default, the risk premium
(r – i) = [(1+ i) /(e + p – pe)] – (1 + i)
– Recover rate e can be provided through
– Rating agencies (rated debts)
– Historical experiences (nonrated debts)
10
10

How do We Analyze Credit Risk

• Risk premiums over time

• The probability of default over time is known as the
Cumulative Default Probability (CDP)
• CDP = 1 – p(1) * p(2) * p(n)
– p(n) the probability of repayment over period n
• Calculate p(n+1) = (1+ i(n+1)) / (1+ r(n+1))
• Using geometric mean
– Power (1 + i(n+1), 2) = (1+ i(n)) * (1 + i(n-1))
– Power (1 + r(n+1), 2) = (1+ r(n)) * (1 + r(n-1))

11
11

How do We Analyze Credit Risk

• Econometric analysis
• Regression analysis
– Only multiple regression applicable for making lending
decisions
– Seeks to use historical data to predict the future
– Cons: unavailability of the probability of the default of
existing borrowers; variables selections
• Advanced regression
– Linear or probit analysis seeks to divide the samples into
two populations based on the outcome of the loans
– 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
12
12

4
Page 37 of 157
 How do We Analyze Credit Risk

• Advanced regression
• The calculated value of p(i) above however does not
always fall in to the [0,1] range. In order to solve this
problem, a new formula was introduced
– f(p(i)) = 1 / [1 + power {e, -z(i)}]
– The formula above provides the value of z
• Discriminant analysis
• The most significant advance in credit analysis
• The Z score Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
• The Z score is a benchmark indicator that decides whether
a company belongs in the defaulting or non-defaulting
category

13

How do We Analyze Credit Risk

• Hybrid system
• Expected default frequency
– Based on the thesis that the above relationship between
borrower and lender is one of options
• Mortality models
– How many loans “die” or default in a year: the marginal
mortality rate
– MMR(t) = Total amount of loans in a credit rating that defaults
/ Total amount of loans issued in that credit rating
– The MMR is calculated for each credit rating and each year
– The MMR can be translated into a value by which the loan
depreciates each year

14

5
Page 38 of 157
 LENDING DECISION

Consumer and Real Estate

Lending
Chapter 5, Chapter 6

1
1

Learning Objectives

• Explain what consumer loans are

• Outline the major types of consumer loan
• Explain how different types of consumer loan
application are evaluated
• Explain, with the help of specimen consumer
loan applications, how the principles of
lending are applied in practice

2
2

Learning Objectives

• Enumerate the precautions to be taken in

assessing consumer loan applications
• Discuss how credit scoring of consumer
loan applications is done
• Briefly explain the laws and regulations
affecting consumer loans
• Outline the trends in consumer credit
• Explain the pricing aspect of consumer
loans

3
3

1
Page 39 of 157
 Learning Objectives

• Explain what real estate loans are

• Explain how real estate loan applications are
evaluated
• Explain, with the help of specimen real estate loan
applications, how the principles of lending are applied
in practice
• Enumerate the precautions to be taken in assessing
real estate loan applications
• Outline the trends in real estate market
• Explain the pricing aspect of real estate loans

4
4

Introduction

• Consumer credit refers to loans that

individuals or households require to meet
personal needs , for finance consumption
and not for productive purposes
• The maturities of consumer loans vary
according to the purpose for which the
loans are given (up to five years)
• The demand for consumer credit has been
rapidly growing in developing nations

5
5

Different Consumer Credit Products …

• Credit Cards
• Bank Overdraft Products
• Payday Lending
• Personal Loans and Peer-to-Peer Lending
• Home-Equity Lending
• Rent-to-own contracts
• Auto-Title Lending
• Pawnbroking
• Refund-Anticipation Loans
• Informal Lending

• Many of these products need a credit scoring system …

2
Page 40 of 157
 Types of Consumer Loan

• Installment Loans
• Require the periodic payment of principal and
interest
• Can be extremely profitable
• Direct
– Negotiated between the bank and the ultimate user of
the funds
• Indirect
– Funded by a bank through a separate retailer that
sells merchandise to a customer

7
7

Types of Consumer Loan

• Credit Cards and Other Revolving Credit

• Credit cards and over-lines tied to checking
accounts are the two most popular forms of
revolving credit agreements
– In 2004 consumers charged approximately $2.5 trillion
on credit cards
• Most banks operate as franchises of
MasterCard and/or Visa
– Bank pays a one-time membership fee plus an annual
charge determined by the number of its customers
actively using the cards

8
8

Types of Consumer Loans

• Credit Cards and Other Revolving Credit

• Credit cards are attractive because they provide
higher risk-adjusted returns than do other types of
loans
– Card issuers earn income from three sources:
• Cardholders’ annual fees
• Interest on outstanding loan balances
• Discounting the charges that merchants accept
on purchases.

9
9

3
Page 41 of 157
 Credit card transaction process

Individual
1 Retail Outlet

4 2
Card-Issuing Clearing Local Merchant
Bank 3 Network 3 Bank
2

10

Types of Consumer Loans

• Overdraft Protection and Open Credit Lines

• Overdraft Protection Against Checking Accounts
– A type of revolving credit
• Open Credit Lines
• A recent trend is to offer open credit lines to
affluent individuals whether or not they have an
existing account relationship
• Typically, the bank provides customers with
special checks that activate a loan when
presented for payment

11
11

Evaluate Consumer Loan Applications

• The assessment of a consumer loan

application follows the 3 fundamental
C’s of lending:
• Character: of the prospective borrower is the
single most important factor
• Capacity to pay: net income, job and other
factors that indicate the borrower’s ability to
repay the loan
• Collateral: assets that can be used as an
insurance in unforeseen circumstances

12
12

4
Page 42 of 157
 Evaluate Consumer Loan Applications

Step by step assessment of personal loans

1. Obtaining a prescribed application form
2. Conducting a preliminary assessment
3. Accepting and loan applications
4. Taking securities
5. Determining interests, fees, and charges
6. Approving/rejecting applications
7. Supervising the loan and following up
The assessment of credit card loans is similar to that
of personal loans, even more simple

13
13

Precautions to be Taken in Granting

Consumer Loans

• Consumer loans are easier to assess and

monitor than business loans
• Some of the challenges include
• The completeness and accuracy of the
submitted information
• The assessment of unforeseen circumstances
• Credit scoring system vs. personal judgment
• Changes in lending policy of the institution
• Changes in regulations related to consumer
lending

14
14

Credit Scoring Consumer Loan Application

• The credit scoring system has advantages

over the traditional 3 C’s assessment
approach
• Can handle larger volume of applications
• Can speed up the assessment process
• Lower operating cost
• More consistent in lending decisions
• Consumers can apply and receive the
application result over the Internet within a
short time frame

15
15

5
Page 43 of 157
 Legal Aspects of Consumer Credit

• Equal Credit Opportunity

• Makes it illegal for lenders to discriminate
• Prohibits Information Requests on:
– The applicant's marital status
– Whether alimony, child support, and public assistance
are included in reported income
– A woman's childbearing capability and plans
• Credit Scoring Systems
– Credit scoring systems are acceptable if they do not
require prohibited information & are statistically justified
– Credit scoring systems can use information about age,
sex, and marital status as long as these factors
contribute positively to the applicant's creditworthiness

16
16

Legal Aspects of Consumer Credit

• Truth In Lending
• Regulations apply to all individual loans up to $25,000 where
the borrower's primary residence does not serve as collateral
• Requires that lenders disclose to potential borrowers both the
total finance charge and an annual percentage rate (APR)
• Fair Credit Reporting Act
• Enables individuals to examine their credit reports provided
by credit bureaus
– If any information is incorrect, the individual can have the
bureau make changes and notify all lenders who obtained the
inaccurate data
• There are three primary credit reporting agencies:
– Equifax
– Experian
– Trans Union

17
17

Legal Aspects of Consumer Credit

• The Uniform Consumer Credit Code – Standardize all

credit activities: report, disclosure
• The Code of Banking Practice – Foster good
relations between banks and customers
• Trade practices legislation – Encourage fair dealing
in all levels of business
• The Australian Securities and Investments
Commission – monitor and promote market integrity
and consumer protection
• Privacy legislation – imposes limits on credit reporting
agencies’ disclosure of personal information

18
18

6
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 Trends in Consumer Credit

• Personal lending is on the rise and banks

occupy a dominant position in providing the
financing
• Revolving credit has been growing in three
areas: personal overdrafts, credit cards, and
margin loans
• The advance of technology has opened up
a range of alternative delivery channels,
supported credit analysis and risk
management
19
19

Pricing and Structuring of

Consumer Loans

• Loan pricing: rate of interest, fees and

other terms on which a bank gives a loan
• Fixed vs. Variable
• Bank fees – vary depending on the type of loan
• Loan Structuring refers to the repayment
patterns and other terms
• Taking securities
• Loan covenants

20
20

Summary

• The nature of consumer loans, types of loans,

evaluation thereof, precautions to be taken in
granting,
• The legislations that impact consumer loans: the
National Credit Code, Anti-discrimination Laws,
Privacy Act.
• Trends in consumer credit

21
21

7
Page 45 of 157
 Real Estate Loans

• Made for longer periods of time, ranging from 10

to 30 years
• Secured by the property
• Largest single type of personal loans
• Other types of real estate loans:
• Home equity loan
• Bridge loan
• Subprime loan

22
22

Evaluating Real Estate Loan Applications

Valuation of property
• The market value approach:
• The market value of the property is determined
based on that of similar properties sold in recent
time
• Easy to execute, specially accurate in case of
bare lands
• Drawbacks: unavailable, incomparable properties;
does not account for intangible values

23
23

Evaluating Real Estate Loan Applications

• The cost approach:

• Value of the property equals the sum of all the cost to
improve the land, deducts depreciation
• Provides a near accurate estimate for newer properties
• Drawbacks: does not account for market supply and
demand, and consumer preferences
• The capitalization approach:
• Uses the rental-sale price ratio from comparable property
to derive the price of the real estate in hand
• The capitalization rate = 100 / price / annual net income
• Easy to execute, often used to value commercial properties
• In practice, all three approaches often are used
together to price a real estate.

24
24

8
Page 46 of 157
Evaluating Real Estate Loan Applications

• Step by step valuation of home loans

1. Obtain the prescribed application
2. Determine the eligibility of the application
3. If the loan is approved, prepare the documents
4. Proceed if the applicant accept the offered loan
5. Arrange for the settlement of the loan
• The bank calculates the loan installment based on
the amount of loan, the period, and the interest rate
• The valuation is more complicated in case of
investment home loan where the projection of
income must also be reviewed

25
25

Trends in Real Estate Credit

• Bank continues to dominate the home loan

market
• The grow of non-traditional home loans:
subprime, bridge loans…
• Home loan pricing has reduced significantly in
recent years
• Changes in the market perspective after the US
housing bubble

26
26

Pricing and Structuring of

Real Estate Loans
• Fixed rate does not change over time while variable
rate does
• Fixed rate if often higher than variable
• Calculation of monthly mortgage payment
• MRP = (P * R * Y) / Z
• P: loan principal; R: monthly loan rate
• Y = Power [(1+R), t*12)
• Z = Y – 1; t: the number of years of the loan
• There are various fees charged by the bank either
front load or back load

27
27

9
Page 47 of 157
 Pricing and Structuring of
Real Estate Loans

• A loan officer often works with the customer

to propose different pricing and loan
structuring plans
• Important documents include:
• Promissory note
• Mortgage deed, sale deed
• A letter of guarantee
• Loan agreement, default clause
• Repayment, interest rates, security, fees

28
28

Asian Housing Markets

([Link]
looking-precarious)

29

Housing Crunch
([Link]
be-most-painful )

30

10
Page 48 of 157
 South Korea’s Housing Crunch
([Link]
warning-for-other-countries)

31

China’s Property Market

([Link]
eroding-faith-in-the-government)

32

China’s Property Slump

([Link]
short-lived)

One reason for the pain was

the government’s attempt to
break the country’s
addiction to debt-financed
property. More than
two-
thirds of urban households’
wealth is tied up in real
estate and the industry .
underpins a fifth of gdp

33

11
Page 49 of 157
 Property Prices and the Economy
([Link]
the-economy)

It explores how high and

rising land prices affect
lending, investment and
ultimately productivity, and
much of it looks closely at
China’s long property boom.
The worrying conclusion is
that high and rising property
prices can also have
damaging economic effects,
by crowding out productive
investment and leading to a
misallocation of .
capital

34

Looking From Outside – Some Headlines

35

Looking From Outside – Some Headlines

36

12
Page 50 of 157
 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

13
Page 51 of 157
 LENDING DECISION

Security, Consumer Credit

Legislation and Legal Aspects
of Lending
Chapter 7

1
1

Learning Objectives

• Understand the legal framework that

governs consumer and real estate
lending
• Explain the various lending documents
that need to be obtained in consumer
and real estate lending and their purpose
• Understand the special legal rights of
lending bankers

2
2

Learning Objectives

• Explain the legal requirements that are

specific to home loans
• Explain other relevant legal aspects
(banker’s lien, the right to sell off and
appropriation of payments) in bank lending
• Prepare a checklist that lending officers
can use to ensure they have satisfy
fundamental legal requirements of lending

3
3

1
Page 52 of 157
 Introduction

• The legal framework widely affects credit

lending decisions.
• In this chapter, we only concern the
legislations in regard with consumer and
real estate loans:
• Contract law Tort law
• Property law Insurance law
• The law relating to guarantees Bankruptcy law
• Consumer protection law

4
4

Overview of the Legal Framework

Phase 1 Pre-loan approval

• Contract law
• The prospect borrower has the legal capacity to
enter into a loan contract
• Consent under the privacy law
• The Privacy Act 1988
• Limits on the disclosure of personal information by
credit reporting agencies

5
5

Overview of the Legal Framework

Phase 1 Pre-loan approval

• The Uniform Consumer Credit Code

• Applies to any business that engages in the
provision of consumer credit
• Documents must be eligible and clearly expressed
• Regulates interest rate calculation
• Allows early repayment
• Requires full disclosure of fees charged
• prohibits harassment and unsolicited visits by a
credit provider
• Imposes civil and criminal penalties for violation

6
6

2
Page 53 of 157
 Overview of the Legal Framework
Phase 1 Pre-loan approval

• The Trade Practices Act 1974

• Encourage fair dealing in all level of business
• Most violations are filed under “misleading and deceptive”
conducts
• The amount of the claim <= $40,000
• Three-year limit applied to all claims
• The Contracts Review Act 1980, the Fair Trading
Acts, and the Consumer Transactions Act 1972
• Are State-level statutes
• Protects consumers and strikes down unfair and unjust
contracts

7
7

Overview of the Legal Framework

Phase 2 Post loan approval

• Promissory note
• Promise to pay the interest and repay the loan
amount borrowed
• Mortgage deed
• Legal mortgage vs. equitable mortgage
• Guarantees
• Contract to perform the promise or discharge the
liability of a 3rd person in the case of default

8
8

Overview of the Legal Framework

Phase 2 Post loan approval

• Bill of sale
• Primary document of evidence of the sale
contract
• An assignment of shares or life policies
• A transfer of a right, property, or debt by one
person to another
• Loan agreement
• General contractual considerations
• Repayment terms, interest, and costs

9
9

3
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 Overview of the Legal Framework
Phase 2 Post loan approval

• Execution of documents
• Parties involved
• Signing of documents: must be executed in the
presence of the authorized representative
• Forms and contents of a loan document: must be
consistent and completed
• Balance confirmation letters: serve as an
acknowledgement of debt
• Stamp duty: ad valorem duty

10
10

Overview of the Legal Framework

Phase 2 Post loan approval
• Special rights of lending bankers
• Banker’s lien
– signifies the right of the lender, in possession of
the goods or security of the debtor until the debt is
fully repaid with interest
– Carries the right of sale and recoupment of the
property
• The right to set-off and the right to
appropriate payments
• Combines the various accounts between the debtor
and the lender to arrive at the net balance payable to
one another

11
11

Overview of the Legal Framework

Phase 2 Post loan approval

• Legal requirements specific to home loan

• Interest in real estate: freehold vs. leasehold
• Encumbrances: a right or interest in a property held
by one who is not the legal owner
• Lien: is a financial encumbrance, a claim against a
specific property
• Foreclosure: gives the lender the right to become a
full owner of the property in case of default
• Statute of limitations: specifies the period within
which a person may claim a legal remedy. For
mortgage, the period of limitation ranges from 12 to
20 years

12
12

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Other Relevant Legal Requirement in Lending

• Overdraft and credit cards

• Bank charges fees to allow overdraft and
must honor the drawn balance
• The Electronic Fund Transfer Code of
Conduct outlines the rights and obligations
of the credit card users and card issuers
• Credit reference about customers must be given
with care and based on facts

13
13

Other Relevant Legal Requirement in Lending

• Undue influence can occur when bank staff

provides advice to the customer beyond their
standard practice
• Duress, coercion and compulsion mean actual
violence or threats of violence to the personal
safety or liberty of the other party
• 3rd party advisory often are seek to avoid
potential charge of economic duress
• Anti-discrimination law prevents services from
being denied solely based on religion, sex,
sexual orientation, race, age, or nationality

14
14

Other Relevant Legal Requirement in Lending

• The Bankruptcy Act

• Provides a method for the equitable distribution of the
defaulted estate
• Provides for a release of the debtor from their
debts/obligations, allowing the bankrupt to make a
clean start
• Either the debtor or creditor can file a petition for
bankruptcy

15
15

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Other Relevant Legal Requirement in Lending

• The Code of Banking Practice

• Voluntary code sets out standards of disclosure and
conduct in dealing with customers
• Australian Banking Industry Ombudsman
• An authority for the resolution of disputes between
customers and their banks
• Australian Securities and Investments
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

16
16

Checklist for Lending Officers

• A lending officer must be aware of and comply with

all the legal aspects applied in conducting business
• Given the complexities of legal requirements, it is
suggested that a lending officer follow a checklist to
ensure completed coverage

17
17

Summary

• Legal framework governing consumer and real estate

lending
• lending documents
• special legal rights of lending bankers
• legal requirements are specific to home loans
• other relevant legal aspects in bank lending
• a checklist used by lending officers

18
18

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 LENDING DECISION

Corporate Lending
Chapter 8

1
1

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
• Explain the importance of managing the loan
portfolio
• Demonstrate awareness of available loan
products

2
2

Introduction

• Corporate lending is an intuitive process that is more

an art than a science
• Credit scoring techniques become increasingly
important, providing a quantitative foundation in
making corporate lending decisions

3
3

1
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 Overview of Corporate Lending

• Corporate lending represents the high end of the loan

portfolio mix for a modern bank
• Highly competitive market
• Lower margin, higher risk
• Diversification is essential in formulating a successful
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
4
4

The Purpose of Corporate Lending

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

the loan books in a quality way
• The loan portfolio
• Portfolio creation indicates the key success factor
• Diversification in: interest rates, cashflows, and maturities
• Key considerations
– Asset mix and loan types
– Geographic limits
– Personnel expertise
– Policy formulation
– Business environment
– Delegation
– Audit and review
5
5

The Principles of Corporate Lending

• Financial institution should clearly define the

principals for corporate lending process in order to
control and minimize risk
• Both apparent and underlying risks must be taken
into account while assessing corporate loan
application
• The “hurt money” rule: the resources of the borrower
are in the first tranche of funding; the lender
advances funds only after the first tranche if fully
committed or spent

6
6

2
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 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 loan, amount of “hurt money,” repayment schedule
• Profitability – adjusted return on investment
• Three traditional ways to get out of a loan:
• The borrower fully complies and exit the loan as stated in
the contract
• The covenants were breached, the lender activates liens
over the physical security and initiates the recovering
process
• Once the physical security is exhausted, the lender
targets the intangible assets of the business to recover
the loan principal
7
7

• The lender when structuring the loan will have three ways
out (in priority):
• True repayment where the loan complies with the loan
agreement
• Collateral can be recovered
• Target intangibles
• Methods of assessment (addressed fully in subsequent
chapters):
• 5 C’s
• PARSER
• Statistical methods (Z Score, KMV, etc)

Credit Analysis and Lending Management

The Principles of Corporate Lending

• There are two main methods to assess corporate

lending
• The five C’s
– Character: history of the company, the management
team, the structure of the company, reputation
– Capacity: the ability to repay the loan and the ability to
borrow additional debts
– Collateral: serves as security to reduce risk
– Conditions: external and internal
– Capital
– analysis of the company’s financial statements,
– debt holders vs. equity holders
– capital structure including tax implications

9
9

3
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 The Principles of Corporate Lending

• Methods to assess corporate lending (con’t)

• The PARSER
– Personal element: the characteristics of the corporate
analyzed from a cultural and ethical viewpoint
– Amount required: purpose of the loan, reason for the
amount requested
– Repayment: sources of repayment and its certainty
– Security: careful analysis and evaluation of both tangible
and intangible assets
– Expedience: the proposition of the loan in the lender’s
portfolio as a whole
– Remuneration: the structure of the loan, its profitability,
whether the loan meets the criteria laid down by the
credit committee
10
10

The Principles of Corporate Lending

• The lending cycle
• A loan consists of three fundamentally different
activities which can be managed separately or
collectively
– Origination
– Credit check
– Examination of the credit needs
– 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
the corporate loan portfolio
11
11

• The lending cycle:

• Origination
• Funding
• Monitoring

Credit Analysis and Lending Management

12

4
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 The Principles of Corporate Lending

• The lending cycle

Target markets Origin Evaluation

Documentation Approval Negotiation

Administration
Disbursement • Orderly payment
• Unforeseen events

13
13

The Principles of Corporate Lending

Unforeseen
events

Orderly
payment
Loss

Workout
situation
Repayment

Write-off

14
14

• Products

Credit Analysis and Lending Management

15

5
Page 62 of 157
 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
• 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
– What is the current debt capacity of the corporation
• Avoid double dipping
16
16

The Principles of Corporate Lending

• Small corporate entity

• Suspect nature of the financial statements
• Large corporate entity
• Have access to multiple funding sources
• Demands creative and innovative funding instruments

17
17

The Principles of Corporate Lending

• Product structure and application

• Larger corporations have bargaining power and access
to multiple funding channels beside bank debts
– Intercompany loans
– Direct loans
– Back-to-back loans
• Some popular intermediated products
– Revolving credit
– Standby lines
– Revolving underwriting facilities
– Syndicated facilities
– Project finance

18
18

6
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 The Principles of Corporate Lending

• Seven specific features of project finance:

1. The project is a distinct financial entity
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
19

Credit Process

Advice Structuring Decision Execution Monitoring

20

Credit Process: Large Corporate Loan

Advice Structuring Decision Execution Monitoring

Task: Outline the main activities for each of the

above process steps for a Large Corporate Loan

21

7
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 Credit Process

Advice Structuring Decision Execution Monitoring

Question: What is the main differences if you

compare process details between the
• Credit Process: Large Corporate Loan
• Credit Process: Digital Consumer Loan

22

Credit Process: Digital Consumer Loan

Advice Structuring Decision Execution Monitoring

• Client choses
offering
based on its
need online

23

Credit Process: Digital Consumer Loan

Advice Structuring Decision Execution Monitoring

• Predefined
structure,
once client
choses tenor
and amount

24

8
Page 65 of 157
 Credit Process: Digital Consumer Loan

Advice Structuring Decision Execution Monitoring

• Verification of submitted data

• Check external sources (e.g. credit score)
• Instant decision based on input from the client

25

Credit Process: Digital Consumer Loan

Advice Structuring Decision Execution Monitoring

• Client signs online electronic contract

• Automated disbursement of loan amount to client
account
• Automated calculation of interest and amortisation
and charging to client

26

Credit Process: Digital Consumer Loan

Advice Structuring Decision Execution Monitoring

• Credit reviews base on behaviour data and

external data
• Monitoring that interest and repayments are
paid on due dates (ongoing)

27

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 Credit Rating Agencies

• Rating provides a basis for comparing the credit risk

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
• It is important to know which agency undertook a
particular assessment and what key or legend that
agency uses

28
28

Skills Required of the Loan Officer

• Skill set for a successful loan officer:
• Have an ability to understand the complexity of the
portfolio
• To be subjective and objective in their ability for risk
analysis
• To be wise in credit administration and recording keeping
• To exhibit strong attention to details at all times
• Have a strong credit judgemental skills
• Have an ability to use technology and tools
– Statistical credit scoring techniques
• Have clear thinking and early problem recognition

29
29

The Importance of Financial Statements

• The viability of projected cashflows is essential in making

corporate lending decision
• The aim of credit analysis therefore is to assess and
verify the capacity to repay and the sustainability of
future cashflows through the financial statements
• Risk can be identified and quantified via the financial
variables demonstrated in the financial statements
• Financial analysis is not number crunching, rather it is a
central focus on risk analysis
• Evaluation of past successes and failures of the entity
allows analysis of the financial consequences of
outcomes and decisions

30
30

10
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 Managing the Loan Portfolio

• What can go wrong

• Doubtful and bad debts
• 30% of all loan write-offs are bad at the time of
approval
• Losses due to errors from the loan process is more
prevalent than that from fraud
• External factors
• Government regulations
• Technological advances
• Rationalization and globalization
• Changing consumer preference
• Changes in legislation

31
31

Managing the Loan Portfolio

• External factors (con’t)

• competition
• The national economic environment
• Internal factors
• Poor planning and objective setting
• Poor organization and control
• Poor profit planning and control
• Poor resource and personnel management
• Warning signals
• Borrower’s history
• Management concerns

32
32

Managing the Loan Portfolio

• Warning signals (con’t)

• Credit facts
• The loan structure
• Changes in established patterns
• Five C’s of bad credit
• Complacency
• Carelessness
• Poor or absent communication
• Failure to set contingencies
• Competition

33
33

11
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 Managing the Loan Portfolio

• Advice from the past

• Never work alone
• Avoid procrastination
• Check and recheck
• The separation of loan selling and the loan approval process
• Patience and be active
• Only make promises you can keep
• Quantitative and qualitative approach
• Pay attention to quality and the purpose of lending
• Know your client and the project
• Formal records
• Professional relationship
• Be proactive
• Have exit plans
34
34

Project finance

• Project finance is vital for economic

development of any country. It is defined as
follows:

Credit Analysis and Lending Management

35

• Further to this definition are the following

characteristics:

Credit Analysis and Lending Management

36

12
Page 69 of 157
• The following are the two most important ratios.
The first is the debt service coverage ratio (DSCR)
which looks at cashflows: a conservative result
should be at least 2

Credit Analysis and Lending Management

37

• When commodities are involved, the reserve

coverage ratio is used.

Credit Analysis and Lending Management

38

13
Page 70 of 157
 LENDING DECISION

Small Business Lending

International Lending
Chapter 9 & 10

1
1

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
finance, using the concepts of asymmetric
information, credit rationing, adverse selection
and moral hazard

2
2

Learning Objectives

• Describe the distinctive risks of lending to small

business
• Outline the main characteristics of a relationship-
managed approach to small business lending

3
3

1
Page 71 of 157
 Learning Objectives

• Outline the main characteristics of

a credit-scored approach to small business lending
(using recent experiences in the United States)
• Comment on how lending to small business in
Australia is likely to change over the next decade

4
4

Introduction to Small Business Lending

• Small business lending is a specialised area of lending

• Small business lending is gaining increased theoretical
support
• Two main approaches:
• Relationship Management approach;
• Credit Scoring approach

5
5

Overview of Small Business Lending

• What is a small business?

• Numerous definitions exist including:
– ABS – Less than 20 employees;
– RBA
– Independently owned and operated
– Closely controlled by owners/managers who also
contribute most, if not all, of the operating capital
– Has loans less than $500,000
– Generally has turnover less than $5,000,000

6
6

2
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 Overview of Small Business Lending

• Small business in the economy

• ABS
– 1,175,000 small businesses in Australia representing
95% of total businesses
– Produce 30% of all private sector output
– On average has 3 employees – 40% of total workforce
and 50% of private sector
– Half of business employment in the property and
business services, construction and retail sectors

7
7

Overview of Small Business Lending

• Small business in the economy

• RBA
– Higher working hours with 25% working more than
51 hours per week
– In 1995-96, 8% of small businesses stopped
trading, while only 5% of medium to large
businesses did so
– Legal structure
– Company 43% Small v. 70% Larger Businesses
– Sole Proprietorships, Partnerships and Trusts 17%
Small v. 38% of Larger Businesses

8
8

Overview of Small Business Lending

• Some characteristics of Small Business Lending

(RBA, 1993)
– SB Lending 1/3 size of Large Business
– SBs pay 1.6% higher rates on average to reflect higher
default risk and economies
of scale
– Financing takes three main forms:
– Floating rate finance;
– Fixed rate finance;
– Bill finance

9
9

3
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Overview of Small Business Lending

• Floating Rate Loans

– Overdrafts
– Very popular representing about 50% of SB
borrowings
– Highly flexible funding source but around
1.5% more expensive than bill finance

10
10

Overview of Small Business Lending

– Fully Drawn Advance

– Loan fully drawn down at start with
repayments generally made in regular
instalments
– Floating rate finance generally provided at a risk
premium over a benchmark rate

11
11

Overview of Small Business Lending

• Fixed Rate Loans

– 42% of SB loans are fixed rate for 3–5 yrs
– Generally used to purchase non-current assets such as
property and plant & equipment
– Risk margin generally added to 3–5 year Treasury Bond
rates

12
12

4
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 Overview of Small Business Lending

• Bill Finance
– Issuing of discounted securities with most at 90-day
maturities
– Lack flexibility compared to overdrafts with all funds
being drawn down on issue
– RBA 2001 statistics:

Variable Fixed Bills Total

$ Million 33,037 28,042 5,228 66,307
Share % 50 42 8 100
Wtd Avg Interest Rate 8.3 8.5 6.8 8.2

13
13

Overview of Small Business Lending

• How do lenders organise their Small Business lending?

– NAB:
– Loans < $250,000 – Centralised Credit
– Loans > $250,000 – Relationship Manager
– CBA:
– Loans < $500,000 – Centralised Credit
– Exceptions where complex business, e.g.
importer/exporter using credit finance and
FX risk management products

14
14

Overview of Small Business Lending

–Implications of bank cutoff levels

• Lower cost ‘vanilla deals’ where strong financials
support credit- scoring approach
• May have negative implications for ‘good’
businesses operating just below cutoffs where
notional credit scoring may be prejudicial

15
15

5
Page 75 of 157
 Overview of Small Business Lending

– Cutbacks in relationship managers may lose

clients seeking ‘solution- providing’ service
– Moving business clients to ‘faceless’ banking and
lending must be handled very cautiously

16
16

Overview of Small Business Lending

• Competition in SB lending market

– Fierce competition, particularly where loans backed by
borrower’s property resulting in fixed risk-margin pricing
– Changes include
– Intensive efforts to reduce cost to income ratio
– Where property used as security, loans can be
assessed via simple credit scoring and capital
funded at 50% risk-weighting concession v. 100%
(up to 150%) for other business loans
– Promotion of centralised credit analysis

17
17

Overview of Small Business Lending

• Small Business attitudes to lenders

– Source: RBA and Yellow Pages SB Index
– 79% used finance from major banks
– NAB and CBA held 48% of market share
– 1/3 SB owners unhappy with service
provided by major banks with ‘poor/no
service’ at 42% and ‘no personalised
service’ at 27%

18
18

6
Page 76 of 157
 Overview of Small Business Lending

– Lower dissatisfaction figures for small banks and NBFIs

at 37% and 14% respectively
– 16% changed institution with disproportionate number
moving to smaller institutions
– Main reasons for change were ‘better service’ (47%)
and ‘less/lower fees’ (32%)

19
19

Overview of Small Business Lending

– 45–46% believed institution supportive and cared about

them as customers
– Only 1/3 believed institution’s fees for service was value
for money, though better on these measures at smaller
institutions

20
20

Overview of Small Business Lending

• Political Importance of SBs and SB Lending

– Government may become involved if dissatisfaction
levels continue to increase

21
21

7
Page 77 of 157
 A Theoretical Basis for Understanding
Lending to SB

• While considerable emphasis on ratios, cashflow

analysis, etc., many other issues to consider arise:
– 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

22
22

A Theoretical Basis for Understanding

Lending to SB

– Relationship lending helps reduce asymmetries via two

information types:
– Hard: Verifiable financial information
– Soft: Borrower’s character/reliability

23
23

A Theoretical Basis for Understanding

Lending to SB

– Stronger lending relationships lead to

– Lower interest rates
– Reduced collateral requirements
– Lower dependence on trade debt
– Greater protection against interest
rate cycle
– Increased credit availability

24
24

8
Page 78 of 157
 The Decision to Lend to Small Businesses

• Specialised SB risks:
– Key-Person Risk: Is one person in the firm the key
to business success/viability?
– Lack of Capital: Due to limited funds, tax strategies,
capital flexibility, etc.
– Lack of Track Record: Often new business or first-
time business owner
– Poor Accounting Records:
– No audit or lodgement requirements, delays,
emphasis on tax-driven strategies, reporting
freedoms and/or attempted deception

25
25

The Decision to Lend to Small Businesses

–Risk and SB Failure

• Over 30,000 fail each year
• 1/3 fail in first year
• Another 1/3 fail in second and third
years combined
• 3/4 fail after five years

26
26

The Decision to Lend

to Small Businesses

–Reasons for failure include

• Inexperienced/incompetent management
• Poor accounting and record-keeping
• Problems with financial management and liquidity
• Lack of expert advice
• Too much reliance on debt funding

27
27

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The Decision to Lend to Small Businesses

• Two approaches to SB Lending

• Relationship Management approach
– Analysis of historical financials
– Stage 1: Avoiding GIGO principle on financial
statements being relied on for lending decision.
Check ratios and financials for consistency
– Stage 2: Detailed analysis of historical financials
including analysis of short-term liquidity ratios, long-
term solvency ratios and business performance
ratios

28
28

The Decision to Lend to Small Businesses

– Analysis of cashflow projections – be cautious of overoptimistic

projections
– Assessment of risks including key person, undercapitalisation, lack
of track record, etc.
– The importance of security – increasing reliance on property
collateral
– Problems with Relationship Management
– Loan approval and management very labour intensive
– Greater delegation can lead to credit problems as soft
information is notoriously difficult to assess

29
29

The Decision to Lend to Small Businesses

• Credit Scoring Approach

– Relies on input, such as ratios, etc., into mathematical credit
assessment models
– Background to SB lending in US
– SB loans defined as loans less than $100,000
– 8,149 US banks v. 51 Australian banks
– Small local banks dominate SB lending
– Past/Present Use of Credit Scoring in US
– Increasing usage due to cost savings, availability of databases, ability
to quantify credit risk in securitisation supported by political and
regulatory change

30
30

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The Decision to Lend to Small Businesses

–Structure of US credit-scoring models

• At least 30,000 applications needed for model
• Fair Isaacs starts with 50 variables to determine 10
most significant
• Financial ratios probably less important than previous
10 years’ credit repayment history

31
31

The Decision to Lend to Small Businesses

–Changes in Credit Scoring and Predictions

• Helps reduce information asymmetries
• Flow of usage from larger to smaller banks
• Greater credit supply to low–medium incomes
• Greater reliance on simple form-based and/or online
applications for SB lending
• Greater cost reductions

32
32

Summary

● Small business lending: important lending segment for

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

33
33

11
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 LENDING DECISION

International Lending
Chapter 10

34
34

Learning Objectives

• Overview the structure of the international financial

markets
• Apply the principles of international lending
• Place trade finance products in perspective

35
35

Learning Objectives

• Explain the importance of international operations to

financial institutions
• Demonstrate the process of country risk analysis

36
36

12
Page 82 of 157
 Introduction to International Lending

• International lending forms the heart of the international

financial system
• Allows intermediation across all financial markets of the
world
• International lending accounts for the majority of all
lending activities

37
37

Overview of International Lending

• Understanding the international banking and lending is

vital to understand the international financial system’s
structure
• The international financial system is dynamic and
change is the norm
• Important aspects of the international financial system
• The payment system
• World trade and finance
• The availability of funds
• Country risk analysis

38

International Financial System

• The modern system began in the 1950’s

• Evolved from the Bretton Woods conference of 1944
• 44 countries agreed on the foundations of the post-war
international monetary system
• The international financial markets
• Foreign exchange
• Global capital
• International bond
• International equity
• Euro market (predominant)
• Futures, swaps

39

13
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 International Financial System

• The two components

• The primary market
• The interbank market
• Three main functions
• Foreign exchange markets (access and risk reduction)
• Credit for importers and funding for exporters
• International lending
• Reasons to participate in the international market
• Profit
• Take advantage of competitive advantage
• Diversification
• Take advantage of deregulated market
40

Country Risk and International Credit Evaluation

• Information sources
• The efficient and reputation of local commercial banks
• An honest and independent central bank
• Available, reliable, and accurate information from
government agencies
• Rating agencies
• Local personnel and press
• Country risk assessment is the process of gaining a
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

Country Risk and International Credit Evaluation

• The step-down approach

• The geography and demographics
• Governmental relationship
• The foreign bank’s viability and credibility
• The strength of the corporate and other institutions in the
foreign country
• The step-down approach provides a framework for
Marco-level analysis

42

14
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 Trade Finance

• A large volume of overseas trade is covered by short

term finance (up to 180 days)
• Forms of trade finance
• Overdrafts
• Loans
• Negotiations
• Specialized advances
• Trade credit
• Factoring
• Leasing
• Hire purchase
• Forfaiting
• discounting

43

Trade Finance

• Methods of payment and financing techniques

• Important factors
– The safety of the transactions
– Whether the exporter is prepared to extend credit to the
importer
– The importer’s views
• Prepayment
– Absolute trust between parties
– Confident in the government
– Certainty of the the buyer’s sufficient financial position
• Documentary export bills for collection
– Term draft

44

Trade Finance

• Methods of payment and financing techniques

• Pre-shipment finance facility
• Post-shipment finance facility
• Documentary bill of exchange
• Foreign currency trade finance facility
• Documentary letter of credit
– Red clause credits
– Head and counter credits (back-to-back credits)
– Transferable documentary credits
• Documentary credits providing for term drawings
• Clean remittance after the buyer receives or sells the
goods
• Trade finance – medium to long term
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 Trade Finance

• Methods of payment and financing techniques

• The bankers’ acceptance market
– Access to competitive source of finance
– Exporter can provide terms to an importer
– The provision of access to pre-shipment finance
– The enablement of importers to obtain discount purchases
– The ability to swap USD proceeds for other major currencies
• Forfeiting
– Unburdens the statement of financial position of the exporter
– Improves liquidity
– Helps mitigate risks
– Shifts the exchange rate fluctuation risks
– Removes all administrative and collection problems and
related risks
46

Supply Chain Financing: Definition

Supply Chain Finance

Receivables Purchase Advanced Payables Loan

Financing is obtained by selling This category includes techniques, where The finance provider is financing the
receivables to finance provider; the the payables are paid early without being seller / buyer against e.g. receivables or
receivables will be transferred into the purchased by the finance provider. inventory. The ownership of the
ownership of the finance provider. It receivables / inventory etc. is not
must therefore be ensured that the transferred to the finance provider.
receivable exists, are assignable and are
enforceable in the debtor’s jurisdiction.

Techniques Techniques Techniques

 Receivables Discounting: Finance  Corporate Payment Undertaking  Loan against Receivables: Also
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
undertaking from the buyer  Distributor Finance: Financing for a
 Forfaiting: Without recourse distributor of a large manufacturer to
financing or discounting of promissory  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
 Factoring: The finance provider Inventory over which the finance
(factor) typically becomes responsible provider is involved
provider usually takes a security
for managing the debtor portfolio  Bank Payment Undertaking (BPU): interest
 Payables Finance: Buyer-led Payment undertaking by a bank
which may be the basis for a  Pre-Shipment Finance: Finance
programmes to offer sellers in the provided to a seller before the goods
supply chain access to finance by financing
are shipped, e.g. Purchase Oder
means of Receivables Purchase. Financing. Sometimes involves a
Synonyms: Approved Payables Letter of Credit
Finance, Reverse Factoring, Supply
Chain Finance and many more
47
Source: ICC Standard Definitions for Techniques of Supply Chain Finance & Global Supply Chain Finance Forum

Risks in Foreign Trade

• Performance risk
Non-performance of the contract, inadequate performance, late
performance
• Manufacturing risk
The buyer cancels or modifies his order. Are the goods sellable
elsewhere?
• Political Risk
Extraordinary measures of foreign countries and political events
abroad, e.g. war, revolution, misappropriation, civil war which make it
impossible for the buyer to comply with the contract
• Transfer Risk
Currency measures of foreign governments which make it impossible
for the buyer to allocate and transfer foreign exchange currencies
abroad
• Currency risk
Revaluation or devaluation of a foreign currency
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 Risks in Foreign Trade

• Credit Risk / Insolvency Risk

The buyer is unable or unwilling to pay the goods, or
the seller is unable or unwilling to pay back the down
payment
• Reputational risk
The reputation of one of the parties is involved due
to the transaction or by the fault of the other party
• Transactional risk
Non-conformity of documents, other operational
failures
• Transport risk
Goods get damaged, lost or stolen on their way to
the country of destination
49

The Confirmed Documentary Credit

Unconfirmed documentary credit Confirmed documentary credit

 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
conditions of documentary credit for the payment.
have been met.  As confirming bank, Exporters bank
 The exporter’s bank only takes on an bears the del credere risk and the
advisory role. country risk (political and transfer
 The del credere risk of the issuing risks) of the issuing bank.
bank and the country risk (political
and transfer risks) stay with the
exporter.

Issuing bank Exporters Issuing bank Exporters

Bank
Bank

Payment
obligation No liability Payment Payment
Exporter obligation Exporter obligation

Seller Seller

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

Documentary Credit with Sight or

Deferred Payment

Sight payment Deferred payment

 Payment to the beneficiary is made  Payment is not affected immediately
immediately, i.e. as soon as credit- upon presentation of the documents,
confirm documents have been but only after a period specified in the
presented Documentary Credit, i.e. when
payment is due (e.g. 180 days after
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
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 Uniform Customs and Practice
for Documentary Credits

• The International Chamber of Commerce formulated the

Uniform Customs and Practice for Documentary Credits
to minimize confusion and establish standardize related
to
• International practice in establishing and advising
documentary letters of credit and negotiation drawings

52

International Lending
Principles

• Safety
• Security
• Financial standing of clients
• Economic/political factors
• Ongoing risk assessment
• Suitability
• Profitability
• Liabilities
• Bank guarantees

53

Summary

• international financial system

• country risk
• trade finance products
• UCP600

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 LENDING DECISION

Credit risk measurement

and management
of the loan portfolio
Chapter 11

1
1

Learning Objectives

1. Describe the benefits of credit risk management

2. Explain and use Altman’s Z score
3. Explain how stock prices can be used to explain
credit risk
4. Suggest how risk-adjusted return on capital can be
used for portfolio purposes
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

2
2

Introduction

• The aim of credit risk management is to balance between

risk and return to achieve optimum profitability and
efficiency
• Taking and institutional view banks could minimise
concentration risk
• Lending on a more scientific basis would help remove
subjectivity

3
3

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 Introduction

• Credit risk seeks following objectives:

a) achieve and appropriate balance between risk and
return;
b) avoid concentration risk;
c) manage loans on a portfolio basis; and
d) take a group of loans off the statement of financial
position.
• This chapter examines some of the credit risk
measurement tools.

4
4

Earlier predicted Evolution of Credit Risk Management

(Source: The seven stages of risk management, [Link], 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

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 Operationalized 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

Discriminant Analysis Artificial Neural Networks /

Regression Analysis Artificial Intelligence (AI)
Logit/Probit Models Cluster Analysis
Recursive Partition Algorithms

• Basic Approach:
Credit Scoring Model

Black Box

Credit Score
Past Data

-Test sample
-Function generation
-Validation sample
-Quality of function Feedback loop

Credit risk measurement

• Altman’s Z Score
– Relies on multivariate model accounting ratios that
provide best predictors of performance:

– Credit decision relies on output from equation at

varying cutoff levels

8
8

Altman’s Z-Score: Original Version

• In 1968 Altman published the first scientific paper that described how discriminant analysis
could be used as a „bankruptcy predictor“.
• His so-called Z-Score for listed companies was - in its first form - calculated as follows:

Z  0.012X1 0.014 X2 0.033X3 0.006X4 0.999X5

whereas
X(1) = working capital / total assets X(2) = retained earnings / total assets
X(3) = earnings before interest and taxes / total assets X(4) = market value equity / book value of
total liabilities X(5) = sales / total assets
oZ > 2.675 => high probability of solvency
oZ < 2.675 => high probability of insolvency (Zone of Ignorance)
oZ < 1.8 => certain insolvency

•His article in the Journal of Finance became one of the most cited Finance
articles of the last 30 years
•His scientific methodology has been applied to a number of other
countries, like
Canada, Malaysia, Singapore, Vietnam, Korea, etc.

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 Altman’s Z-Score: Extensions

• Lateron Altman published several revisions of his model, among others

also a “Z-Score” für private (i.e. non-listed) companies:

Z  0.717X1  0.847X2  3.107X3  0.420X4  0.998X5

whereas
X(1) = working capital / total assets X(2) = retained
earnings / total assets
X(3) = earnings before interest and taxes / total assets
X(4) = Net worth / total liabilities
X(5) = sales / total assets

The following decision rules applied: Z<1.23 

bankrupt
Z>2.90  non-bankrupt
Z between 1.23 and 2.90  “grey area”

10

Using stock prices

• To overcome the problem of using historical data,

KMV Moody’s extended Merton’s option pricing
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
11

• In constructing the Z score, Altman utilised the

following process:

12
Credit Analysis and Lending Management

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• Properly used the Z score will divide the loans/companies into two
groups as follows:

• You will note that, except in exceptional circumstances, there will

be an overlapping of distributions. This creates a zone of
ignorance. Lending in this zone is dependent on the risk appetite
of the lender.

13
Credit Analysis and Lending Management

• The zone of ignorance is bounded 2.99 (above this

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
• A Z score which incorporates size

14
Credit Analysis and Lending Management

Using stock prices

• Many have criticised Altman’s Z score as it uses financial ratios which implicitly
look backwards.
• KMV Corporations expected default frequency (EDF) model seeks to overcome
this by using option theory.
• 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
Credit Analysis and Lending Management

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 • From the shareholders’ view, they will repay money
when the value of assets will rise above the
borrowings as follows:

16
Credit Analysis and Lending Management

• We then have to relationships:

• The problem is that we cannot observe asset values

and volatilities.
• However, using a propriety software approach, it is
suggested that the market value of assets is a function
of equity.

17
Credit Analysis and Lending Management

• By incorporating returns distributions, we can estimate

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
risk to produce EDF
Number of Default Firms
Expected Default Probabilit y 
All Firms of Sample

18
18

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 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
Credit Analysis and Lending Management

20
Credit Analysis and Lending Management

Portfolio Management

• The majority of the text considers the risk of a single

loan. But what happens when you bring them
together into a portfolio. Decisions can be quite
different.
• While modern portfolio theory (MPT) influences
portfolios of loans, there are a number of key issues:
• MPT assumes normal distributions which loan portfolios are
one sided.
• MPT assumes that assets can be revalued. Some loans are
difficult to revalue.
• Lending managers don’t always have the same options
available as equity managers.
• Is concentration risk a problem

21
Credit Analysis and Lending Management

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 Portfolio management

• A portfolio of loans similar to portfolio of other

assets
o Risk-Adjusted Return on Capital (RAROC)
Income from loan for one year
RAROC 
Capital at Risk

o Capital at risk is defined using a duration approach to

measure sensitivity to rate changes
 ΔR 
ΔL  (-D L )(L) 
1 R L 
22
22

• The biggest contention is how to measure capital at

risk. BT use duration:

23
Credit Analysis and Lending Management

• Bank of America (BofA) uses unexpected losses as

follows:

• BoA use 6 confidence intervals while rating agencies

use 10.

24
Credit Analysis and Lending Management

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 Altman’s Sharpe Index Approach

Three steps N
Step 1: Calculate return on portfolio R p   Xi EARi
i 1

Step 2: Calculate variance of the portfolio

N N
Vp   X X ¶ ¶ p
i j i j ij
i1 j1

Step 3: Maximise the relationship which is the Sharpe

Index
Rp
η
Vp

25
25

CreditMetrics

• Incorporates changing credit risk over time by

addressing migration probabilities, eg, AAA to AA,
A to BB etc
• Values securities from a zero-coupon yield curve
and then treats cashflows as:
– First year’s cashflows not discounted
– Subsequent cashflows calculated on annual basis
(despite being generally semiannual)
– Defaulted bonds are treated according to recovery
rate, eg 51.13% for BBB Bond

26
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
• The capital allocation for the single security is then the sum of
the probability-weighted differences

27
27

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• For a BBB credit rating, for example, this means a rise
to AAA has a 0.02% chance, BB 0.33% and so on.

28
Credit Analysis and Lending Management

• Given the following information (yield curve) we can calculate the distribution
of BBB bonds:

29
Credit Analysis and Lending Management

• The distribution looks as follows (notice it doesn’t look normal):

30
Credit Analysis and Lending Management

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• We can now calculate the standard valuation:

31
Credit Analysis and Lending Management

• Using the standard deviation we can estimate the

capital needed to be put aside:

• Which is less than the normal minimum $8 required

32
Credit Analysis and Lending Management

• To extend to portfolios, the following is executed.

33
Credit Analysis and Lending Management

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 CreditMetrics

• Framework:

34
34

CreditMetrics

• Process becomes far more complex when considering

portfolio case and employs four steps:
Step 1: Define the portfolio as individual assets
Step 2: For each asset, define cashflows and calculate PV for
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
35

Managing the portfolio

• Once portfolio constructed, tools exist to manage

portfolio’s risks
• Securitisation:
– Technique for packaging cashflows from loan assets
and selling them as securities

36
36

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 Managing the portfolio

• Pass-Through Structures
• Loan assets sold completely from statement
of financial position through a Special
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
37

Managing the portfolio

• Securitisation and Credit Risk Management

o Determine whether securities have recourse
o Loan assets must be sold for fair value
o May interfere with borrower/lender relationship

38
38

Managing the portfolio

• Credit Derivatives
o Assets can be maintained on the statement of financial
position, with risk management structures in place through
credit derivatives
o Three main categories:
– Credit Default Swaps: Swap seller receives a periodic
fee for covering any default losses
– Total Return Swaps: Swap seller receives a periodic fee
to cover changes in value of loans
– Credit Options: Option seller provides protection against
widening of credit spreads

39
39

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 Loan pricing

• All loans provide a cost to the Statement of Financial

Position
• Statement of Financial Position Costs
– Capital Cost: Capital that must be allocated to
support default risk
– Liquidity: Lending activities must allow sufficient
liquidity on Statement of financial position
– Cost of Funds: Returns must be achieved from loan
including considering Return on Equity, Return on
Liquidity, Market Cost of Deposits and Return on the
Loan

40
40

Loan pricing

• Noncredit Risk Costs

• Interest Rate Risk: Whether loan book has fixed/floating rate loans
• Pre-payment Risk: Risk that loans will be paid out earlier than
specified term
• Origination Costs: Costs of marketing and monitoring securitised
loans sold
• Credit Costs
• Expected Losses = Default Probability x (1 – Recovery Rate)
• Unexpected Losses: Generally reflects volatility of Expected
Losses

41
41

Loan pricing

• Loan Pricing: an example

o Assume we have:
– $150,000, five year housing loan
– 5% liquidity required against lending assets
returning 4.9%. At call deposits cost 3.5% and 5
year swap rate is 5%
– Loan operating costs are $1,000 per annum
– Default probability for housing loans is 2% with 95%
recovery rate and capital required is 8%
– ROE is 20% and tax rate is 30%
42
42

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 Loan pricing

• Capital allocation is:

$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
43

Loan pricing

• First stage simple Statement of financial position (NB –

Deposits* are a balancing figure only)

44
44

Loan pricing

• Table requires working backwards from the balancing

profit after tax figure to obtain the yield of 4.48%

45
45

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 Loan pricing

• Practical Loan Pricing

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.

46
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 LENDING DECISION

Credit risk from regulator’s perspective

Problem Loan Management
Chapter 12 & 13

1
18/08/2025 1 1

Objectives

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

regulators
2. Relate capital adequacy to credit risk considerations
3. Express the issues of large exposures
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.

Regulators

• Central Bank (Reserve Bank, FED, State Bank of

Vietnam)
• System liquidity.
• Australian Prudential Regulatory Authority (APRA)
• Regulates banks, credit unions and building societies using
the Bank of International Settlements (BIS) capital
adequacy guidelines

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 Regulators

• Australian Securities Investment Commission (ASIC)

• Market integrity
• National Consumer Credit Protection Act (for retail
borrowers):
– Those who are engaged in lending must be licensed by ASIC.
– The rights that the borrower.
– The obligations of the lender.
– The nature of the contracts.

Capital adequacy

• Capital adequacy seeks to ensure capital is put aside

depending on the credit risk to cushion potential losses.
• The general formula is:
• Risk-based capital ratio= Total capital (Tier 1+Tier
2)/Risk-adjusted assets
• See text pages 403 to 406 for risk weightings

Regulatory aspects of credit risk

• Basel Accord (1988) – Basel 1 (Table 12.2 – Credit risk

categories)
• Basel 2 (2006) - 3 main pillars
• Minimum capital requirements
– Credit risk
– Standardized approach
– Foundation internal rating approach (Foundation IRB)
– Advanced internal rating based approach (Advanced IRB)

2
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 Regulatory aspects of credit risk

• Minimum capital requirements

– Operational risk
– Market risk
– Basic capital requirement : 8% of risk weighted assets

• Supervisory review
• Market discipline through disclosure

Regulatory aspects of credit risk

• Method of risk quantification

Standardized Approach Internal Rating Based Approach

Based on external ratings IRB Foundation

Given risk weights - Own estimation of PD
- Other parameters given

Overall higher capital Overall lower capital requirements

requirements

Large credit exposures

• APRA requires that lenders recognise exposures greater than

10% of the capital base (APS 221).
• The need to ensure of related groups need to be recorded
correctly.
• These exposures can create concentration for which additional
capital needs to be allocated (Chapter 16).

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 Securitisation

• Securitisation requirements are found in APS 120

• For entities supervised by APRA, the main issue is a clean sale to remove the
asset completely from the balance sheet:
• There should be no beneficial interest in the sold assets and absolutely no obligation
to the financial institution.
• 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
assets.
• 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

10

Credit card securitisation

• Credit card securitisation has the following requirements:

• The rights, details and obligations of each party must be clearly
specified, including the distribution of cashflows.
• As with normal asset securitisation, the financial institution cannot
supply additional assets to the pool.
• Liquidity shortfalls for the financial institution share must not exceed
the interest receivable.
• The financial institution always has the right to cancel any undrawn
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

Credit derivatives

• The following requirements are required to get capital relief

for credit derivatives:
• The underlying and reference assets are the same.
• The underlying asset is an obligation under the terms of the
contract. An obligation is defined as a financial obligation.
• The reference asset ranks lower than the underlying asset.
• The maturity of the credit derivative is the same as the underlying
loan may be required.

12

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 Developments in regulation

• Credit ratings are now used in capital adequacy. Table

16.2 outlines the definition of credit ratings.
• They are generated by the investigation of the following:
• Business risk:
– Industry characteristics
– Evaluation of management
– Industry specific factors

13

Developments in regulation

• Financial risk
• Accounting quality
• Financial policy
• Profitability and coverage
• Capital structure
• Financial flexibility
• The issue of the commercial secrets behind credit ratings in
public policy

14

Problem loan management

15
18/08/2025 15

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

16
16

Introduction

• When financial institutions make loans, returns

generated mean accepting some default risk
• It is imperative that default risk is managed so that the
solvency of the bank is not threatened
• Should the problem loan be foreclosed or actively
managed?

17
17

Causes of default

• Default does not necessarily mean that all of the loan

extended is lost.
• Default is defined here as ‘a loan where repayments are
overdue’
• Better lending procedures can minimise, but not eliminate, the
risk of default
• Harder to manage default risk as loan book becomes larger

18
18

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 Likely causes of default

• Lack of compliance with loan policies

• Lack of clear standards and excessively lax loan terms
• Inadequate controls over loan officers
• Over-concentration of bank lending
• Loan growth exceeding bank’s capabilities
• Inadequate problem loan identification
• Insufficient knowledge of customer’s finance
• Lending in unfamiliar markets

19
19

Extent of problem loans

• All banks experience bad debts,

but the management of them becomes critical
• Banks should consider:
• Timing of loan in economic cycle
• Larger exposures to individual borrowers
• Larger exposures to single sectors
• Close monitoring of exposures during unfavourable economic
periods

20
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
21

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 22
22

Problem loans, provisions and regulatory issues

• When borrower misses payments, two questions arise

within lending institution
• Is missed payment temporary?
• Is missed payment likely to be permanent?

23
23

• If payment more than 90 days, loan is considered an ‘impaired

asset’ as return on loan not achieved
• Value of impaired loan must be downgraded on statement of
financial position

24
24

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 • APRA: If one asset is impaired, all loans to that client
considered impaired
• When loans are impaired, institution must create a
‘provision’ for a loan loss
• Provisions are classified in three ways:
– Specific Provisions
– General Provision
– Bad-Debt Write-Offs

25
25

Specific provisions

• These are provisions set aside for a specifically identifiable loan

where the institution assesses the:
– Condition of the loan;
– Condition of the borrower;
– Impact of economic events.

• Not all of the loan must have provisions made as lender may
assess the likely losses from the asset.

26
26

General provisions

• These are provisions that are made as a proportion of the

entire loan portfolio
• Suitable for large loan portfolios of similar assets, e.g.
mortgages, where specific provisioning unsuitable
• APRA: Generally minimum provision of 0.5% of Risk-
Weighted Assets
• Can adjust general provisions level depending on economic
activity or risk levels

27
27

9
Page 113 of 157
 Bad debts

• Recognition of bad debts occurs where:

– All security liquidated;
– Guarantees have been enforced;
– Remaining remedial actions explored; and
– No remaining sources of cash can be called.

• Once the above steps are completed, the financial institution

must write off the bad debt with asset valued at zero and a
charge made against profits.

28
28

Regulatory issues

• APRA Guidance Notes AGN 220.1, 220.2 and 220.3 govern

bad-debt provisioning
– Category 1: Registered first and second mortgages with LVR < 80% have no
provision
– Category 2: Same as Category 1 but where LVR is between 80% and 100%
– Category 3: Same as Categories 1 and 2 but where LVR > 100% (i.e. declining asset
values)
– Category 4: Covers overdrawn revolving-type facilities where longer default periods
produce higher provisioning requirements

29
29

Other considerations with problem loans

• The provisions made minimise the efficient use of capital

that could otherwise be used for lending purposes
• Institutions often have provisioning systems exceeding
APRA requirements to reflect bank’s risk profile
• Higher provisions indicate higher risk and/or more conservative
management
• Lower provisions indicate lower risk and/or more aggressive
management

30
30

10
Page 114 of 157
 Dynamic provisioning

• The risk profile of the loan portfolio is sensitive to point in

the economic cycle, e.g. greatest defaults occur at bottom
of economic cycle
• Therefore:
• Credit risk is not static but changes over time
• Bad debt should not come as a surprise
as modelling should detect changes to probable default risk in
portfolio segments

31
31

• Key principles in dynamic provisioning:

• Classify loans into homogeneous groups
• Sub-classify groups by maturity length
– Determine probability of loss for each group
– Determine likely severity of loss for each group
• Use the historical loan-loss information to create predictive model
incorporating economic conditions, interest rates, investment activity,
etc.
• Apply model outcome to current provisions

32
32

Dealing with defaults

• If the loan is in default, bank must act to minimise the

losses arising from defaulting clients and may
reschedule payments rather than liquidate loan
• Classify defaulting clients into three categories:
• Mild financial distress;
• Moderate financial distress; and
• Severe financial distress.

33
33

11
Page 115 of 157
 Mild financial distress

• Often occurs when borrower faces short-term cash flow

problems, e.g. late receipts
• If default less than 90 days, remedies include:
– Changing/lengthening repayment schedules
– Assisting firm if cash flow shortage has risen from period of rapid growth
– Encouraging firm to sell non-core assets
– Requesting/demanding equity capital injection

34
34

Moderate financial distress

• May occur if cash flow problems coincide with borrower’s

asset values declining
• Course of action determined by nature of collateral, e.g.
foreclose on mortgage or support manufacturing firm with
unique
or limited market for assets
• Lender may consider evaluation of alternatives via NPV or
probabilistic model of Expected Values for different actions

35
35

Severe financial distress

• Characterised by missed payments and value of borrower

less than loan amount
• Lender needs to very carefully evaluate whether is is better
to:
– Liquidate firm to recover greatest percentage
of loan possible; or
– Restructure debt (inclusive of debts to other lenders) to maintain operations to
allow firm to trade out of current crisis or be sold as going concern

36
36

12
Page 116 of 157
 The coordination problem

• Where numerous classes of debt-holders observed, e.g.

syndicated loans, any rescheduling will require cooperation
of
all debt-holders
• May be difficult to coordinate actions between junior and
senior debt-holders
• Need to restructure debts to ensure all debt-holders treated
equitably or else rescheduling proposal will fail

37
37

Other breaches

• Corporate loans may have a variety of covenants imposed to protect

loan quality
• Lender may place a variety of conditions to strengthen loan repayment
probability:
– No excessive withdrawal of cash flows
– Risk profile of firm to remain unchanged
– Specification of various ratios including gearing, dividend payout and interest coverage
– Continued involvement of key staff
– Application of risk management strategies

38
38

13
Page 117 of 157
 LENDING DECISION

Quantitative Finance
Credit Growth and
Bank Soundness in
Emerging Europe
Chapter 16

1
1

Learning Objectives

• Create a framework for modelling

• Explain and measure concentration risk
• Define expected losses
• Define and measure probability of loss
• Define and measure loss given default
• Define and measure prepayment risk
• Identify problems with quantative modelling

2
2

Introduction

• There are two important issues with quantitative

modelling:
• What are we trying to measure?
• What are the underlying issues
• This chapter focusses on economic capital as
opposed to regulatory capital.
• Assumptions:
• Models are single factor - asymptotic single risk factor
(ASRF) mode
• Granuality (an addition loan will not affect the portfolio risk)
• If these assumptions do not hold then measurements
will have errors

3
3

1
Page 118 of 157
 Concentration risk

• The two types of risk:

• Name
• Sectorial
• If concentration risk exists, then the portfolio is not
granular
• The normal way to measure concentration risk is to
use the Hefindahl-Hirschman index (HHI)

4
4

• Note that the measure is not related to credit risk

5
5

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
• Unexpected loan losses: Deviation of realized loan losses from expected
loan losses
 Economic Capital (equity) required

2
Page 119 of 157
 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:

8
8

Probability of default

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

culture and systems. So there will be no one way of
modelling.
• The starting point is:

9
9

3
Page 120 of 157
• While satisfying (and looking like the KMV model) it is
not satisfying as it proven that default can have
internal and external factors.
• The model then looks like:

• And functionally

10
10

Loss given default (LGD)

• This methodology is difficult because the distributions

are not normal. Therefore, methodologies such
fractional response regressions are used:

11
11

Prepayment risk

• This is the risk associated with income loss from

prepayments

12
12

4
Page 121 of 157
 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
occurs.

13
13

Credit Growth and

Bank Soundness in
Emerging Europe

14

Rapid credit growth in the region...

60 60

55
Real Credit to the Private 55
Sector, 2006
50 (annual percentage change) 50

45 45

40 40

35 35

30 30

25 25

20 20

15 15

10 10

5 5

0 0

-5 -5
Czech
Malta
Germany
Austria

France

Luxembo

Lithuania
Cyprus

Bulgaria

Ireland
Slovak
Spain

Poland

Latvia
Estonia
Finland

Greece

Slovenia
Hungary

Belgium
Italy

Portugal

Romania

Sources: Eurostat; IFS, National Statistical

Offices; and IMF staff estimates.

15

5
Page 122 of 157
...increasingly funded through capital inflows
NMS: Net Capital Flows, 1999-2006
(In percent of GDP)
Baltics CEECs
12.0 12.0 12.0 12.0
Portfolio
10.0 10.0 10.0 Investment 10.0
Other
Investment
8.0 8.0 8.0 FDI 8.0

6.0 6.0 6.0 6.0

4.0 4.0 4.0 4.0

2.0 2.0 2.0 2.0

0.0 0.0 0.0 0.0

-2.0 -2.0 -2.0 -2.0

1999 2001 2003 2005 1999 2001 2003 2005

Source: IMF, World Economic Outlook.

16

...concentrated in the household sector

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

60

50

40

30

20

10

0
c

lic
d

ia

a
ia
ry

nia
li

ni
la n

en
ub

ub

tv
a

ua
to
ng

La
ov
Po
p

ep

Es

th
Re

Hu

Sl
kR

Li
h
ec

a
ov
Cz

Sl

17

Rising euroisation of domestic credit

90
Foreign Currency Loans 2001
(In percent of total outs tanding loans 2005
80 to the private s ector)

70

60

50

40

30

20

10

0
c

lic

a
ry

ia
a
b li

ni
ni
ni
lan

ub

tv
a
pu

ua
e

to
ng

La
ep

ov
Po

Es

th
Re

Hu

kR

Sl

Li
h
ec

a
ov
Cz

Sl

18

6
Page 123 of 157
Rapid credit growth reflects financial deepening...

Financial Deepening in Selected Countries, 2001-05

40
Difference between Private Sector Credit Growth and GDP

35 Lithuania
Latvia
30
Estonia
25
Growth (In percent)

20

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

-10
0 20 40 60 80 100 120 140 160 180
Private Sector Credit (In percent of GDP)
Sources: National Banks, International Financial Statistics, and IMF staff estimates.

19

...and rising financial integration

600
External Assets and Liabilities
(In percent of GDP)

500

Western
400
Europe

300

Emerging
Markets
200

100 Emerging
Europe

0
85

87

89

91

93

95

97

99

01

03
19

19

19

19

19

19

19

19

20

20

Source: Lane and Milesi-Ferretti (2006).

20

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

(Annual percent change, unless indicated otherwise)

Baltics CEECs
60 60
50 Real Credit Growth 50
40
30
40
30
Macroeconomic and
20
10
20
10 financial conditions
0 0
-10
-20
-10
-20
have been
-30
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
-30
supportive...
12 12 50 50

10
Real GDP Growth
10
40
Consumer Price Index
40
• Disinflation
8 8

4
6

4
30 30
• Improved economic
2 2
20 20
prospects
0 0
10 10
-2

-4
-2

-4 0 0
• EU accession
1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004

14 14 130 130 • Pent-up demand for

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

0
2

0
90 90 conditions
-2 -2
80 80
-4
-6
-4
-6 70 70
• Ample global liquidity
1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004
21
Sources: IMF International Financial Statistics, and staff estimates.
1/ CPI-based index with 2000 as base year.

7
Page 124 of 157
 ...as are supply-side factors
120
Share of Foreign-Owned Banks
(In percent of total assets) • Privatization
100

• Entry of foreign banks

80
• Strategic expansion

60 • High profitability

40
+ subsidies and tax
20
policies

0
Czech Hungary Poland Slovak Slovenia Estonia Latvia Lithuania
Republic Republic

22

Literature

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

risk
– Schadler et al (2004); Cottarelli et al (2005); Egert (2007); ECB
(2007)

• Credit growth improves bank soundness, unless it is

“excessive”
– 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

Policy Debate

• How to manage macroeconomic and prudential risks...

• ...and “not to kill the goose that lays the golden eggs”?

24

8
Page 125 of 157
 Focus of This Study

• How significant are prudential risks in the NMS?

– Has credit growth affected bank soundness?
– Are weaker banks expanding faster?

• Do prudential risks differ across...?

– Countries
– Banks (foreign/domestically owned)
– Purpose of credit (household/corporate)
– Currency of denomination/indexation (foreign/ domestic)

25

Bank-level Analysis
• Bank balance sheet data (Bankscope)
– Ugo Panizza’s (IDB) data set, updated
– 217 banks during 1995-2004 in 8 NMS
– 7 observations per bank, on average
– Unconsolidated data, where available
– Commercial banks and leasing companies

• Breakdowns of loans by currency and purpose

(supervisory data)
– 6 NMS (except Hungary and Latvia)

26

The sample covers most NMS banks...

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

Hungary 36 23 63.9 81.7 8.3
Poland 60 33 55.0 85.6 7.6
Slovak Republic 21 20 95.2 83.1 7.1
Slovenia 22 18 81.8 79.9 7.8
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
Sources: European Central Bank; Bankscope; and IMF staff estimates.
1/ In percent of the total number of banks and total bank assets, respectively.

27

9
Page 126 of 157
 Distance to default—a proxy for
insolvency risk
• The number of STD a return realization has to fall for equity
to be exhausted~probability of default

DD ≡(equity capital+average return)/STD of return,

• Bank account data

• STD deviation for the entire sample period

• Robustness to alternative ways of measuring volatility of

returns; NPL ratios; loan loss reserves

28

Uniformly higher credit growth;

stronger, but more heterogeneous Baltic banks
1995-2000 2001-2004
CEECs Baltics CEECs Baltics
Standard Standard Standard Standard
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
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
Liquidity ratio 17.4 16.1 11.2 9.8 17.2 18.0 17.1 18.0
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
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
Foreign ownership 36.2 44.4 31.1 39.7 52.2 46.3 41.1 42.8
Public ownership 15.3 33.7 12.5 29.2 6.1 21.5 3.7 15.0
Source: IMF staff estimates.

29

Baseline empirical specification controls for

macroeconomic and bank-specific variables...
Equation 1: Bank Credit Growth

BankCreditGrowthijt  f ( BankCreditGrowthij ,t 1 , GDPperCapita j ,t 1 , GDPgrowth j ,t 1 , RIR j ,t 1 , RER j ,t 

DistanceToDefaultij ,t 1 , CostToIncomeij ,t 1 , InterestMarginij ,t 1 , Liquidity ij ,t 1 ,
Sizeij ,t 1 , Foreignijt , Public ijt ),

Equation 2: Distance to Default

DistanceToDefaultijt  f ( BankCreditGrowthij ,t 1 , GDPperCapita j ,t 1 , GDPgrowth j ,t 1 , RIR j ,t 1 , RER j ,t 1 ,

DistanceToDefaultij ,t 1 , CostToIncomeij ,t 1 , InterestMarginij ,t 1 , Liquidity ij ,t 1 ,
Sizeij ,t 1 , Foreignijt , Public ijt ),

where i denotes individual banks, j denotes countries, and t is the year index.
BankCreditGrowth is the annual percent change in real bank credit to the private sector. RIR
is the real interest rate and ΔRER is the annual percent change in the real exchange rate.
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.
30

10
Page 127 of 157
 Three-stage Least Squares

• Commonly used technique

– Linear models using panel data
– A relatively short time dimension
– Lags of dependent variables
• Advantages vis-à-vis Arellano-Bond
– Two-equation estimation
– Subsample analysis
• Advantages vis-à-vis 2SLS
– Efficiency gains
– Unbiased in models with lagged dependent variables
• No apparent specification problems
– Unit roots rejected
– Hausman specification tests inconclusive
– Residual analysis validates inclusion of lagged dependent variable
– No multicollinearity
• Robustness to single-equation estimation
31

Baseline Specification: Bank Credit Growth Equation

1995-2004 1995-2000 2001-2004

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

[5.83] [3.89] [4.71]
Distance to default (lagged) 0.229** 0.350* 0.147
[2.16] [1.94] [1.20]
Real GDP growth (lagged) 2.646*** 2.415*** 2.475***
[5.53] [2.92] [4.38]
GDP per capita (lagged) -0.116** -0.301*** -0.057
[1.99] [3.19] [0.73]
Net interest margin (lagged) 0.689 1.757** 1.200**
[1.47] [2.25] [2.00]
Cost-to-income ratio (lagged) -0.017 -0.037** 0.046
[1.13] [1.96] [1.49]
Real interest rate (lagged) -0.558* -0.864 -0.999**
[1.65] [1.58] [2.24]
Real depreciation (lagged) -4.911* 14.750** -7.414***
[1.95] [2.45] [2.65]
Public ownership -0.178*** -0.153** -0.067
[3.73] [2.39] [0.89]
Constant 16.366*** 15.992** 12.721*
[3.37] [2.17] [1.87]

R -squared 0.13 0.16 0.15

Observations 881 424 457
Source: IMF staff estimates.

Notes: Absolute value of z statistics in brackets; * significant at 10 percent; ** significant at 5 percent; ***
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

demand-driven...
NMS: Decomposition of Predicted Credit Growth, 1997-2004
(In percent per year)
50 50
1997-2000 2001-2004

40 40

30 30

20 20

10 10

0 0

-10 -10
Bank credit growth Distance to default
Real GDP growth GDP per capita
Net interest margin Cost-to-income ratio
-20 -20
Real interest rate Real depreciation
Public ownership Explained
Actual
-30 -30
b lic

b lic
ry

ia

nia
nia

tvia

lic

lic
d

ry

ia

nia
nia

tvia
nd
lan

ve n

ve n
nga

n ga

pu b
pub

la
hu a
Esto

h ua
Esto
e pu

e pu

La

La
Po

Po
S lo
Hu

S lo
Hu
Re

Re
Lit

Lit
hR

R
ak

ech

ak
ec

v
Cz

Slo

Cz

Slo

Source: IMF staff estimates. 33

11
Page 128 of 157
 Baseline Specification: Distance to Default Equation

1995-2004 1995-2000 2001-2004

Bank credit growth (lagged) -0.002 -0.002 -0.001

[1.14] [0.76] [0.54]
Distance to default (lagged) 0.896*** 0.854*** 0.927***
[85.84] [59.85] [62.15]
GDP per capita (lagged) 0.017*** 0.029*** 0.007
[2.83] [3.90] [0.77]
Liquidity ratio (lagged) 0.020*** 0.013 0.027**
[2.67] [1.17] [2.55]
Bank size (lagged) 0.311*** 0.240** 0.324**
[3.33] [2.07] [2.22]
Foreign ownership 0.008*** 0.012*** 0.003
[2.80] [3.28] [0.69]
Constant -2.668*** -2.660*** -2.252**
[4.10] [3.18] [2.25]

R -squared 0.91 0.92 0.90

Observations 881 424 457
Source: IMF staff estimates.

Notes: Absolute value of zstatistics in brackets; * significant at 10 percent; ** significant at 5 percent; ***
significant at 1 percent. The dependent variable in the first (unreported) equation is annual percent change in
outstanding loans. In the second (reported) equation, the dependent variable is distance to default. 34

Is the glass half empty or half full?

• No evidence that credit growth has weakened banks

– Consistent with FSI analysis
– Not surprising in an upward stage of the credit cycle

• During 2001-04 weaker banks started to expand just as

fast as sounder banks
– New result, not detectable in aggregate data
– Some weaker banks are weak in the absolute sense

35

These results are robust to...

• Including additional macro and bank-level variables

• Controlling for year- and country-specific factors
• Using alternative measures of bank ownership
• Using alternative measures of bank soundness
• Controlling for nonlinear effects
• Assuming faster feedback effects
• Single equation estimation

36

12
Page 129 of 157
 Robustness Analysis: Using a Narrower Measure of Bank Soundness—Nonperforming Loan Ratio

1995-2004 1995-2000 2001-2004

Bank credit growth (lagged) 0.075 0.089 -0.011

[1.43] [1.28] [0.17]
Nonperforming loans (lagged) -0.006 -0.025 0.262***
[0.14] [0.47] [2.75]
Real GDP growth (lagged) 2.625*** 3.129** 2.109**
[2.58] [2.15] [2.23]
GDP per capita (lagged) -0.280** -0.386** -0.219*
[2.16] [2.02] [1.86]
Net interest margin (lagged) 2.097* 2.506 5.397***
[1.82] [1.59] [3.04]
Cost-to-income ratio (lagged) -0.085*** -0.099*** 0.099
[3.22] [3.09] [1.48]
Real interest rate (lagged) -1.332** -1.674** -1.245*
[2.33] [2.00] [1.84]
Real depreciation (lagged) 3.792 13.587 -10.722**
[0.68] [1.52] [2.26]
Public ownership -0.204*** -0.198* -0.119
[2.63] [1.92] [1.12]
Constant 28.265** 28.711* 0.711
[2.55] [1.73] [0.05]

R -squared 0.23 0.24 0.46

Observations 221 145 76

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 37
outstanding loans. In the second (unreported) equation, the dependent variable is the ratio of nonperforming
loans to total loans.

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

1995-2004 1995-2000 2001-2004

Bank credit growth (lagged) 0.086*** 0.085*** 0.100***

[4.04] [2.70] [3.66]
Loan loss reserves (lagged) 11.592*** 11.837*** 59.944*
[4.12] [3.83] [1.76]
Real GDP growth (lagged) 2.808*** 1.970** 2.299***
[4.86] [2.07] [3.28]
GDP per capita (lagged) -0.085 -0.235** -0.002
[1.22] [2.20] [0.03]
Net interest margin (lagged) 0.417 2.607*** 0.242
[0.58] [2.62] [0.19]
Cost-to-income ratio (lagged) -0.041** -0.059*** 0.192**
[2.11] [2.71] [2.25]
Liquidity ratio (lagged) -0.744* -0.984 -0.839
[1.65] [1.49] [1.35]
Bank size (lagged) -2.961 14.165** -2.938
[1.02] [2.15] [1.01]
Real interest rate (lagged) -0.230*** -0.177** -0.158*
[4.15] [2.40] [1.85]
Constant 21.241*** 16.696* 5.478
[3.32] [1.84] [0.51]

R -squared 0.15 0.18 0.17

Observations 585 301 284
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 38
outstanding loans. In the second (unreported) equation, the dependent variable is loan loss reserves as a
proportion of total loans.

Weaker Baltic banks are expanding faster

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

Bank credit growth (lagged) 0.096*** 0.095*** 0.094***

[5.84] [3.64] [4.70]
Distance to default (lagged) 0.313*** 0.241 0.433***
[2.59] [1.23] [3.01]
Distance to default of Baltic banks (lagged) -0.346 0.684 -0.961***
[1.43] [1.46] [3.72]
Real GDP growth (lagged) 2.522*** 2.514*** 1.790**
[4.43] [2.85] [2.35]
GDP per capita (lagged) -0.118* -0.293*** -0.05
[1.74] [2.84] [0.56]
Net interest margin (lagged) 0.703 1.758** 1.467**
[1.50] [2.25] [2.47]
Cost-to-income ratio (lagged) -0.018 -0.035* 0.054*
[1.17] [1.87] [1.78]
Real interest rate (lagged) -0.477 -0.944 -0.817*
[1.30] [1.53] [1.82]
Real depreciation (lagged) -5.078** 15.087** -8.315***
[1.99] [2.49] [3.01]
Public ownership -0.178*** -0.155** -0.076
[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
(unreported) equation, the dependent variable is distance to default.

13
Page 130 of 157
 Possible explanations

• Real credit growth in the Baltics is several times

higher than in the CEECs
– Ensuring sound lending decisions and risk management
is much more difficult
• Higher degree of foreign participation in the Baltics
– Additional comfort that the banking system can withstand
shocks
• More foreign affiliates are branches
– Supervision is more challenging

40

Foreign banks are taking greater risks than

domestic banks...
1995-2004 1995-2000 2001-2004

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**
[3.10] [2.15] [2.26]
Distance to default of foreign-owned banks (lagged) -0.448** -0.380 -0.466**
[2.12] [0.96] [1.96]
Real GDP growth (lagged) 2.665*** 2.436*** 2.485***
[5.54] [2.89] [4.42]
GDP per capita (lagged) -0.134** -0.293*** -0.094
[2.18] [2.88] [1.17]
Net interest margin (lagged) 0.652 1.874** 1.158*
[1.36] [2.27] [1.94]
Cost-to-income ratio (lagged) -0.016 -0.036* 0.048
[1.01] [1.88] [1.57]
Real interest rate (lagged) -0.539 -0.900 -0.947**
[1.60] [1.64] [2.13]
Real depreciation (lagged) -5.123** 15.275** -7.924***
[2.02] [2.52] [2.82]
Foreign ownership 8.069** 8.709 5.85
[2.09] [1.31] [1.29]
Public ownership -12.897*** -9.254 -5.129
[2.75] [1.43] [0.72]
Constant 12.857** 10.782 11.156
[2.31] [1.19] [1.51]

R -squared 0.14 0.16 0.16

Observations 881 424 457
Source: IMF staff estimates.
Notes: Absolute value of zstatistics 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 (unreported)
equation, the dependent variable is distance to default.

...but commensurate with the strength of parent banks41

Lending through Nordic banks seems the

least related to bank soundness
Summary of Country-Specific Results for Different Foreign Bank Owners, 2001-04 1/

Are Banks with Weaker Parents Expanding Has Rapid Credit Growth Weakened
More Rapidly? Banks?
(1) (2)

Austria Yes? No?

Germany No? Yes?
France Yes? Yes?
Nordic countries Yes Yes?
United States Yes? No?

Italy Yes? Yes?

Belgium Yes? No?
Netherlands No? Yes?
Source: IMF staff estimates.
1/ "Yes (?)" indicates a negative and statistically significant (insignificant) coefficient; "No (?)" indicates a
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
soundness of parent banks from a given country vis-à-vis the average effect for all other banks. In other respects,
the models used for the analysis of the country-specific effects pertaining to parent banks follow the baseline
specification.

42

14
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Weaker banks with large foreign currency
exposures are expanding faster
1995-2004 1995-2000 2001-2004

Bank credit growth (lagged) 0.105*** 0.157*** 0.073**

[4.40] [4.25] [2.51]
Distance to default (lagged) 0.346*** 0.422** 0.279*
[2.70] [2.44] [1.68]
Distance to default of banks exposed to foreign exchange risk (lagged) -0.680* 0.006 -0.794*
[1.66] [0.01] [1.74]
Real GDP growth (lagged) 2.681*** 3.497*** 3.495***
[4.46] [3.91] [4.27]
GDP per capita (lagged) -0.123* -0.225*** -0.118
[1.96] [2.77] [1.32]
Net interest margin (lagged) 0.881 3.754*** 1.242
[1.28] [4.54] [1.00]
Cost-to-income ratio (lagged) 0.011 0.007 -0.037
[0.49] [0.36] [0.52]
Real interest rate (lagged) -0.638 -0.133 -1.015*
[1.55] [0.23] [1.94]
Real depreciation (lagged) -3.919 26.407*** -4.679
[1.54] [4.98] [1.51]
Public ownership -0.160*** -0.075 -0.079
[3.16] [1.28] [0.96]
Banks exposed to foreign exchange risk 33.429*** 23.238 29.541***
[3.69] [1.48] [2.80]
Constant 9.808* -20.243*** 18.981*
[1.78] [2.85] [1.90]

R -squared 0.21 0.41 0.22

Observations 455 197 258
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 foreign exchange risk are defined as those with higher-
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

Weaker banks with large household

exposures are expanding faster
1995-2004 1995-2000 2001-2004

Bank credit growth (lagged) 0.127*** 0.180*** 0.086***

[6.42] [5.45] [3.80]
Distance to default (lagged) 0.417*** 0.613*** 0.355**
[3.36] [3.33] [2.38]
Distance to default of banks exposed to households (lagged) -0.791** -0.886** -1.889***
[2.28] [2.16] [2.86]
Real GDP growth (lagged) 2.483*** 3.991*** 3.585***
[4.31] [4.49] [4.64]
GDP per capita (lagged) -0.154*** -0.375*** -0.065
[2.59] [4.68] [0.79]
Net interest margin (lagged) 0.955 2.318*** 1.830**
[1.62] [3.00] [2.05]
Cost-to-income ratio (lagged) 0.023 0.006 0.03
[1.20] [0.30] [1.01]
Real interest rate (lagged) -0.725* -0.447 -0.766
[1.84] [0.76] [1.57]
Real depreciation (lagged) -2.586 26.291*** -4.706
[1.06] [5.04] [1.61]
Public ownership -0.172*** -0.103* -0.059
[3.49] [1.76] [0.76]
Banks exposed to households 33.672*** 50.436*** 28.312***
[4.22] [4.35] [2.68]
Constant 10.593** -8.001 7.025
[2.02] [1.16] [0.93]

R -squared 0.24 0.45 0.24

Observations 500 215 285
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
those with higher-than-average proportion of loans to households and higher-than-average rate of growth in the proportion of loans to
households. The sample is composed of Czech, Estonian, Lithuanian, Polish, Slovak, and Slovenian banks.

44

The negative correlation between bank soundness

and credit growth is the highest in household credit

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

(In percent per year)
1.5
Dom.
1.0 Local owned
currency banks
CEEC Corporate loans
0.5 loans

0.0
Foreign-
-0.5 owned
Baltics Foreign banks
-1.0 currency
loans
-1.5
Household loans
-2.0
Source: IMF staff estimates.
1/ The effect of a one-unit increase in distance to default on bank credit growth,
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
return realization would have to fall for equity to be depleted.

45

15
Page 132 of 157
 Regional Policy Implications

• Weaker banks in the NMS have recently started to

expand at least as fast as sounder banks (but credit
growth per se has not weakened banks)
– Forward-looking and risk-based supervision
– Supportive market infrastructure (credit bureaus)
– Sufficient disclosure of information
– Financial sector surveillance and analysis
• Weaker banks’ expansion is most pronounced in
household and foreign currency lending
– Closer monitoring of risk exposures and lending practices in
these markets
• Foreign banks are taking on greater risks, consistent
with parent banks’ strength
– Effective cross-border cooperation between supervisors

46

Calibrating Policy Response to

Country-Specific Circumstances
• In the Baltics, weaker banks are expanding faster (Latvia,
Lithuania) or credit growth has weakened banks (Estonia)

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

banks are expanding as fast as sounder banks

• In Poland and the Slovak Republic, stronger institutions

are growing faster

– 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

Concluding Remarks

• Probabilistic conclusions
– Quality of banks’ lending decisions and risk management
– Macroeconomic conditions

• Cross-country econometric analysis using

publicly available data
– Not a substitute for country-specific stress tests using
supervisory data
– A complement because it draws on a regional set of
information in a systematic manner

48

16
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 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.

Page 67 of 84
5.

Page 68 of 84
 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.

Page 69 of 84
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?

Page 70 of 84
 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?

Page 71 of 84
 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’

Page 72 of 84
 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 ([Link]). 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 [Link]

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

Page 74 of 84
 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.

Page 75 of 84
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?

Page 78 of 84
 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

Page 81 of 84
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?

Page 82 of 84
 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.

Page 83 of 84
 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 expected 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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