Chapter 11 - Credit Risk: Individual Loan Risk
Chapter Eleven
Credit Risk: Individual Loan Risk
Chapter Outline
Introduction
Credit Quality
... [Show More] Problems
Types of Loans
• Commercial and Industrial Loans
• Real Estate Loans
• Individual (Consumer) Loans
• Other Loans
Calculating the Return on a Loan
• The Contractually Promised Return on a Loan
• The Expected Return on a Loan
Retail versus Wholesale Credit Decisions
• Retail
• Wholesale
Measurement of Credit Risk
Default Risk Models
• Qualitative Models
• Quantitative Models
Summary
Appendix 11A: Credit Analysis (www.mhhe.com/saunders7e)
Appendix 11B: Black-Scholes Option Pricing Model (www.mhhe.com/saunders7e)
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Chapter 11 - Credit Risk: Individual Loan Risk
Solutions for End-of-Chapter Questions and Problems
1. Why is credit risk analysis an important component of FI risk management? What recent
activities by FIs have made the task of credit risk assessment more difficult for both FI
managers and regulators?
Credit risk management is important for FI managers because it determines several features of a
loan: interest rate, maturity, collateral and other covenants. Riskier projects require more analysis
before loans are approved. If credit risk analysis is inadequate, default rates could be higher and
push a bank into insolvency, especially if the markets are competitive and the margins are low.
Credit risk management has become more complicated over time because of the increase in offbalance-sheet activities that create implicit contracts and obligations between prospective lenders
and buyers. Credit risks of some off-balance-sheet products such as loan commitments, options,
and interest rate swaps, are difficult to assess because the contingent payoffs are not
deterministic, making the pricing of these products complicated.
2. Differentiate between a secured and an unsecured loan. Who bears most of the risk in a
fixed-rate loan? Why would FI managers prefer to charge floating rates, especially for
longer-maturity loans?
A secured loan is backed by some of the collateral that is pledged to the lender in the event of
default. A lender has rights to the collateral, which can be liquidated to pay all or part of the loan.
With a fixed-rate loan, the lender bears the risk of interest rate changes. If interest rates rise, the
opportunity cost of lending is higher, while if interest rates fall the lender benefits. Since it is
harder to predict longer-term rates, FIs prefer to charge floating rates for longer-term loans and
pass the interest rate risk on to the borrower.
3. How does a spot loan differ from a loan commitment? What are the advantages and
disadvantages of borrowing through a loan commitment?
A spot loan involves the immediate takedown of the loan amount by the borrower, while a loan
commitment allows a borrower the option to take down the loan any time during a fixed period
at a predetermined rate. This can be advantageous during periods of rising rates in that the
borrower can borrow as needed at a predetermined rate. If the rates decline, the borrower can
borrow from other sources. The disadvantage is the cost: an up-front fee is required in addition to
a back-end fee for the unused portion of the commitment.
4. Why is commercial lending declining in importance in the U.S.? What effect does this
decline have on overall commercial lending activities?
Commercial bank lending has been declining in importance because of disintermediation, a
process in which customers are able to access financial markets directly such as by issuing
commercial paper. The total amount of commercial paper outstanding in the U.S. has grown
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Chapter 11 - Credit Risk: Individual Loan Risk
dramatically over the last twenty years. Historically, only the most creditworthy borrowers had
access the commercial paper market, but more middle-market firms and financial institutions
now have access to this market. As a consequence of this growth, the pool of borrowers available
to banks has become smaller and riskier. This makes the credit assessment and monitoring of
loans more difficult, yet important.
5. What are the primary characteristics of residential mortgage loans? Why does the ratio of
adjustable-rate mortgages to fixed-rate mortgages in the economy vary over an interest rate
cycle? When would the ratio be highest?
Residential mortgage contracts differ in size, the ratio of the loan amount to the value of the
property, the maturity of the loan, the rate of interest of the loan, and whether the interest rate is
fixed or adjustable. In addition, mortgage agreements differ in the amount of fees, commissions,
discounts, and points that are paid by the borrower.
The ratio of adjustable-rate mortgages to fixed-rate mortgages is lowest when interest rates are
low because borrowers prefer to lock in the low market rates for long periods of time. When
rates are high, adjustable-rate mortgages allow borrowers the potential to realize relief from high
interest rates in the future when rates decline.
6. What are the two major classes of consumer loans at U.S. banks? How do revolving loans
differ from nonrevolving loans?
Consumer loans can be classified as either nonrevolving or revolving loans. Automobile loans
and fixed-term personal loans usually have a maturity date at which time the loan is expected to
have a zero balance, and thus they are considered to be nonrevolving loans. Revolving loans
usually involve credit card debt, or similar lines of credit, and as a result the balance will rise and
fall as borrowers make payments and utilize the accounts. These accounts typically have
maturities of 1 to 3 years, but the accounts normally are renewed if the payment history is
satisfactory. Many banks often recognize high rates of return on these loans, even though in
recent years, banks have faced chargeoff rates in the range of four to eight percent.
7. Why are rates on credit card loans generally higher than rates on car loans?
Car loans are backed by collateral (the car), while credit card loans are not. Thus, in the event of
default on a car loan, the FI can take possession of the car to recoup at least some the lost interest
and principal payments. In the event of a default on a credit card loan, the FI has no such
collateral available with which to recover lost interest and principal payments. Accordingly, the
FI charges a higher rate on the credit car loan.
8. What are compensating balances? What is the relationship between the amount of
compensating balance requirement and the return on the loan to the FI? [Show Less]