Evaluating Commercial Loan Requests 1 14. Evaluating Commercial Loan Requests and Managing Credit Risk Important Questions Regarding Commercial Loan Requests.

Evaluating Commercial Loan Requests 1 14

Evaluating Commercial Loan Requests and Managing Credit Risk Important Questions Regarding Commercial Loan Requests 1. What is the character of the borrower and quality of information provided? 2. What are the loan proceeds going to be used for? 3. How much does the customer need to borrow? 4. What is the primary source of repayment, and when will the loan be repaid? 5. What is the secondary source of repayment; that is, what collateral, guarantees, or other cash inflows are available? 2

Fundamental Credit Issues There are two types of loan errors Type I Error Making a loan to a customer who will ultimately default Type II Error Denying a loan to a customer who would ultimately repay the debt 3

Fundamental Credit Issues Character of the Borrower and Quality of Data Provided The most important issue in assessing credit risk is determining a borrower’s commitment and ability to repay debts in accordance with the terms of a loan agreement The best indicators are the borrower’s financial history and personal references 4

Fundamental Credit Issues Character of the Borrower and Quality of Data Provided Audited financial statements are preferred in determining the quality of the data because accounting rules are well established so that an analyst can better understand the underlying factors that affect the entries But just because a company has audited financial statements, however, does not mean the reported data are not manipulated 5

Fundamental Credit Issues Use of Loan Proceeds Loan proceeds should be used for legitimate business operating purposes, including seasonal and permanent working capital needs, the purchase of depreciable assets, physical plant expansion, acquisition of other firms, and extraordinary operating expenses Speculative asset purchases and debt substitutions should be avoided 6

Fundamental Credit Issues How Much Does the Borrower Need? The Loan Amount Borrowers often request a loan before they clearly understand how much external financing is actually needed and how much is available internally The amount of credit required depends on the use of the proceeds and the availability of internal sources of funds 7

Fundamental Credit Issues How Much Does the Borrower Need? The Loan Amount For a shorter-term loan, the amount might equal the temporary seasonal increase in receivables and inventory net of that supported by increased accounts payable With term loans, the amount can be determined via pro forma analysis which is the projecting or forecasting of a company’s financial statements into the future 8

Fundamental Credit Issues The Primary Source and Timing of Repayment Loans are repaid from cash flows: Liquidation of assets Cash flow from normal operations New debt issues New equity issues 9

Fundamental Credit Issues The Primary Source and Timing of Repayment Specific sources of cash are generally associated with certain types of loans Short-term, seasonal working capital loans are normally repaid from the liquidation of receivables or reductions in inventory 10

Fundamental Credit Issues The Primary Source and Timing of Repayment Specific sources of cash are generally associated with certain types of loans Term loans are typically repaid out of cash flows from operations, specifically earnings and noncash charges in excess of net working capital needs and capital expenditures needed to maintain the existing fixed asset base 11

Fundamental Credit Issues The Primary Source and Timing of Repayment The primary source of repayment on the loan can also determine the risk of the loan The general rule is not to rely on the acquired asset or underlying collateral as the primary source of repayment 12

Fundamental Credit Issues Secondary Source of Repayment: Collateral Collateral must exhibit three features 1. Its value should always exceed the outstanding principal on a loan  The lower the loan-to-value (LTV) ratio, the more likely a the lender can sell the collateral for more than the balance due and reduce loses  Borrowers are “upside-down” on a loan if the value of the collateral is less than the outstanding loan balance 13

Fundamental Credit Issues Secondary Source of Repayment: Collateral Collateral must exhibit three features 2. The lender should be able to easily take possession of the collateral and have a ready market for its sale 3. A lender must be able to clearly mark the collateral as its own  Careful loan documentation is required to “perfect” the bank’s interest in the collateral If collateral is not readily available, a personal guarantee may be required 14

Fundamental Credit Issues Secondary Source of Repayment: Collateral The borrower’s cash flow is the preferred source of loan repayments Liquidating collateral is secondary There are significant transactions costs associated with foreclosure Bankruptcy laws allow borrowers to retain possession of the collateral long after they have defaulted When the bank takes possession of the collateral, it deprives the borrower of the opportunity to salvage the company 15

Evaluating Credit Requests: A Four-Part Process 1. Overview of management, operations, and the firm’s industry 2. Common size and financial ratio analysis 3. Analysis of cash flow 4. Projections and analysis of the borrower’s financial condition 16

Evaluating Credit Requests: A Four-Part Process Overview of Management, Operations, and the Firm’s Industry Gather background information on the firm’s operations Write a Business and Industry Outlook report Examine the nature of the borrower’s loan request and the quality of the financial data provided 17

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Common size ratio comparisons are valuable because they adjust for size and thus enable comparisons across firms in the same industry or line of business 18

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Most analysts differentiate between at least four categories of ratios: Liquidity ratios  Indicate a firm’s ability to meet its short- term obligations and continue operations. Activity ratios  Signal how efficiently a firm uses assets to generate sales 20

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Most analysts differentiate between at least four categories of ratios: Leverage ratios  Indicate the mix of the firm’s financing between debt and equity and potential earnings volatility Profitability ratios  Provide evidence of the firm’s sales and earnings performance 21

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Liquidity Ratios Current Ratio  CA / CL Quick Ratio  (Cash + A/R) / CL 23

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Activity Ratios Days Cash  Cash/Average Daily Sales Days Inventory on Hand  Inventory/Average Daily Cost of Goods Sold Inventory Turnover  COGS / Average Inventory 24

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Activity Ratios Days Accounts Receivable Collection Period  A/R / Average Daily Sales Days Cash-to-Cash Cycle  Days Cash + Days A/R + Days Inventory on Hand 25

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Activity Ratios Days Accounts Payable Outstanding  A/P / Average Daily Purchases  Purchases COGS + ΔInventory Sales-to-Asset Ratio  Sales/Net Fixed Assets 26

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Leverage Ratios Debt to Tangible Net Worth  Total Liabilities/Tangible Net Worth Debt to Total Assets  Total Debt/Total Assets Times Interest Earned  EBIT/Interest Expense EBIT  Earnings Before Taxes + Interest Expense 27

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Leverage Ratios Fixed Charge Coverage  (EBIT + Lease Payments)/(Interest Expense + Lease Payments) Net Fixed Assets to Tangible Net Worth  Net Fixed Assets/Tangible Net Worth Dividend Payout  Cash Dividends Paid/Net Income 28

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Profitability Analysis Profit Margin (PM)  Net Income/Sales  1 – Expenses/Sales  1 – (COGS/Sales) – (Operating Expenses/Sales) – (Other Expenses/Sales) – (Taxes/Sales) 29

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Profitability Analysis Asset Utilization (AU)  Sales/Total Assets Return on Assets  Net Income/Total Assets  PM × AU 30

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Profitability Analysis Equity Multiplier (EM)  Total Assets/Equity Return on Equity (ROE)  Net Income/Equity  ROA × EM Sales Growth  Demonstrates whether a firm is expanding or contracting 31

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Based Income Statement Modified form of a direct statement of cash flows 33

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format Operations Section  Income statement items and the change in current assets and current liabilities (except bank debt) Investments Section  The change in all long-term assets 37

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format Financing Section  Payments for debt and dividends, the change in all long-term liabilities, the change in short-term bank debt, and any new stock issues Cash Section  The change in cash and marketable securities 38

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format where: A i = the dollar value of the ith type of asset (A) L j = the dollar value of the jth type of liability (L) NW = the dollar value of net worth 39

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format Cash Flow From Operations is defined as: where: ΔA 1 = ΔCash 40

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format 41

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format Sources of Cash  Increase in any liability  Decrease in a non-cash asset  New issue of stock  Additions to surplus  Revenues 42

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format Uses of Cash  Decrease in any liability  Increase in a non-cash asset  Repayments/Buy back stock  Deductions from surplus  Cash Expenses  Taxes  Cash Dividends 43

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis For Prism Industries Cash Flow From Operations Recall Exhibits 14.1, 14.2, & 14.3 Cash Purchases for 2008:  Cash Purchases = -(COGS + ΔInventory – ΔAccounts Payable) 44

Evaluating Credit Requests: A Four- Part Process Cash-Flow Analysis For Prism Industries Cash Flow From Investing Activities ΔNet Fixed Assets = ΔGross Fixed Assets – ΔAccumulated Depreciation  Or ΔNet Fixed Assets = Capital Expenditures – Depreciation  where:  Capital Expenditures = ΔNet Fixed Assets + Depreciation 45

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis For Prism Industries Cash Flow From Financing Activities Although cash-flow statements group payments for financing below the investment section, this is somewhat misleading because payments for financing generally take precedence over capital expenditures and increases in long-term investments 46

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis For Prism Industries Change in Cash Equals cash flow from operations adjusted for discretionary expenditures, cash used for investments, payments for financing, and external financing 47

Evaluating Credit Requests: A Four-Part Process Financial Projections Pro Forma projections of the borrower’s condition reveal: How much financing is required When the loan will be repaid Use of the loan 52

Evaluating Credit Requests: A Four-Part Process Financial Projections Pro Forma Assumptions Sales t+1 = Sales t × (1 + g Sales )  where:  g Sales = Projected Sales Growth COGS t+1 = Sales t+1 × COGS % of Sales Accounts Receivable t+1 = Days A/R Outstanding × Average Daily Sales t+1 Inventory t+ 1 = COGS t+1 /Inventory Turnover 53

Evaluating Credit Requests: A Four-Part Process Financial Projections Pro Forma Assumptions Accounts Payable t+1 = Days A/P Outstanding × Average Daily Purchases t+1  Or Accounts Payable t+1 = Days A/P Outstanding × [(COGS t+1 + ΔInventory t+1 )/365] 54

Evaluating Credit Requests: A Four-Part Process Financial Projections Projecting Notes Payable to Banks Rarely will the balance sheet “balance” in the initial round of pro forma forecasts  To reconcile this, there must be a balancing item or “plug” figure 55

Evaluating Credit Requests: A Four-Part Process Financial Projections Projecting Notes Payable to Banks When projected assets exceed projected liabilities plus equity, additional debt (assumed to be in the form of notes payable) is required When projected assets are less than projected liabilities plus equity, no new debt is required and existing debt could be reduced or excess funds invested in marketable securities 56

Evaluating Credit Requests: A Four-Part Process Financial Projections Sensitivity Analysis Best Case Scenario  Assumes optimistic improvements in planned performance and the economy are realized Worst Case Scenario  Assumes the environment with the greatest potential negative impact on sales, earnings, and the balance sheet Most Likely Scenario  Assumes the most reasonable sequence of economic events and performance trends 57

Evaluating Credit Requests: A Four-Part Process Risk-Classification Scheme After evaluating the borrower’s risk profile along all dimensions, a loan is placed in a rating category ranked according to the degree of risk 58

Credit Analysis Application: Wade’s Office Furniture See Exhibits 14.5- 14.11 60

Managing Risk with Loan Sales and Credit Derivatives Many financial institutions have changed their business models, switching to the originate-to-distribute (OTD) model Under the OTD model, firms make loans and thereby collect fees, then either sell parts of the loan through participations or package the loans into pools and sell them in the marketplace 74

Managing Risk with Loan Sales and Credit Derivatives Larger institutions also form loan syndicates in which one firm serves as a principal in negotiating terms with a borrower who has significant credit needs, but then engages other firms to take part of the credit and thus share the risk Lead Bank The institution that actually underwrites the original loan and sells the participation 75

Managing Risk with Loan Sales and Credit Derivatives There are several inherent risk in loan participations or loan sales General credit risks There is an inherent potential conflict between the originating institution and the investor The loan originator might see the up-front fees and premium to the loan value as an excellent source of revenue that might not be as attractive if these loans were subsequently held in portfolio 76

Managing Risk with Loan Sales and Credit Derivatives Underwriting Loan Sales, Participations, and Syndications The lead lending institution and the participating investor are required to underwrite the loans as if they were making the loans themselves and placing them on their own books 77

Managing Risk with Loan Sales and Credit Derivatives Shared National Credits (SNC) Loan or loan commitment of $20 million or more made generally by three or more unaffiliated supervised institutions under a formal lending agreement The various regulatory agencies established the SNC program in 1977 to monitor and review the risk structure of large syndicated loans 78

Managing Risk with Loan Sales and Credit Derivatives Shared National Credits (SNC) 79

Managing Risk with Loan Sales and Credit Derivatives Credit Enhancements Can take many forms Key terms of credit enhancements potentially include: Excess cash flow  Many securitized assets are placed in pools in which the required payments to investors are less than the contractual payments of borrowers  Thus, even if some borrowers do not make the required payments, there is sufficient cash flow to continue to pay investors 80

Managing Risk with Loan Sales and Credit Derivatives Credit Enhancements Key terms of credit enhancements potentially include: Reserve accounts  The originating institution creates a trust for losses up to an amount allocated for a reserve which is used to make up any deficits in payments by borrowers Collateralization  One or more parties pledge collateral against the loan 81

Managing Risk with Loan Sales and Credit Derivatives Credit Enhancements Key terms of credit enhancements potentially include: Loan guarantees  One or more parties pledge personal or business assets or are contractually bound to meet the obligations of the borrower if that party defaults Credit insurance  Any party can purchase credit insurance, provided either privately or by a governmental unit, for loans that provide payments for losses stemming from default 82

Managing Risk with Loan Sales and Credit Derivatives Credit Enhancements Key terms of credit enhancements potentially include: Credit derivatives  Instruments or contracts that derive their value from the underlying credit risk of a loan or bond 83

Managing Risk with Loan Sales and Credit Derivatives Credit Default Swaps (CDS) CDS contracts are relatively unregulated derivative instruments based on the underlying payments and values of fixed-income securities These contracts are privately negotiated instruments between a buyer and a seller and are traded in over-the-counter markets 84

Managing Risk with Loan Sales and Credit Derivatives Credit Default Swaps (CDS) The buyer pays a premium and thus the CDS is similar to an insurance contract The buyer often owns the underlying debt and uses the CDS as a hedge The seller of the CDS plays a role similar to that of the insurance company Sellers generally do not own the debt and provide longer-term protection If an adverse event occurs the seller pays the buyer the change in value of the underlying asset 85

Managing Risk with Loan Sales and Credit Derivatives Credit Default Swaps (CDS) 86

Managing Risk with Loan Sales and Credit Derivatives Credit Default Swaps (CDS) There are several credit events that potentially trigger a payment from the seller of a CDS to the buyer: Failure to pay principal and interest payments in a timely manner Restructuring of the debt in such a way that the lender (investor in the debt) is negatively affected Bankruptcy or insolvency in which the debt is not paid Acceleration of the principal and interest payments prior to the scheduled date(s) Repudiation or moratorium in which the debt issuer rejects or refuses to pay the debt 87

Managing Risk with Loan Sales and Credit Derivatives Credit Default Swaps (CDS) The credit crisis of 2007–2008 caused many sellers of credit default swaps to make large and unexpected payments for default 88

Evaluating Consumer Loans 89 15

Evaluating Consumer Loans Today, many banks target individuals as the primary source of growth in attracting new business Consumer loans differ from commercial loans Quality of financial data is lower Primary source of repayment is current income

Types of Consumer Loans Evaluating Consumer Loans An analyst should addresses the same issues discussed with commercial loans: The use of loan proceeds The amount needed The primary and secondary source of repayment

Types of Consumer Loans Evaluating Consumer Loans Consumer loans differ so much in design that no comprehensive analytical format applies to all loans

Types of Consumer Loans Installment Loans Require the periodic payment of principal and interest

Types of Consumer Loans Installment Loans 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

Types of Consumer Loans Installment Loans Revenues and Costs from Installment Loans Consumer installment loans can be extremely profitable Costs $100 - $250 to originate loan Typically yield over 5% (loan income minus loan acquisition costs, collections costs and net charge-offs)

Types of Consumer Loans Credit Cards and Other Revolving Credit Credit cards and overlines tied to checking accounts are the two most popular forms of revolving credit agreements In 2007, over 92% of households had credit cards (average of 13 cards)

Types of Consumer Loans Credit Cards and Other Revolving Credit 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

Types of Consumer Loans Debit Cards, Smart Cards, and Prepaid Cards Debit Cards Widely available When an individual uses the card, their balance is immediately debited Banks prefer debit card use over checks because debit cards have lower processing costs

Types of Consumer Loans Debit Cards, Smart Cards, and Prepaid Cards Smart Card Contains a memory chip which can store information and value Programmable such that users can store information and add or transfer value to another smart card Only modest usage in the U.S.

Types of Consumer Loans Debit Cards, Smart Cards, and Prepaid Cards Prepaid Card A hybrid of a debit card Customers prepay for services to be rendered and receive a card against which purchases are charged Use of phone cards, prepaid cellular, toll tags, subway, etc. are growing rapidly

Types of Consumer Loans Credit Card Systems and Profitability Card issuers earn income from three sources: Cardholders’ annual fees Interest on outstanding loan balances Discounting the charges that merchants accept on purchases

Types of Consumer Loans Credit Card Systems and Profitability Despite high charge-offs, credit cards are attractive because they provide higher risk-adjusted returns than do other types of loans

Types of Consumer Loans Overdraft Protection and Open Credit Lines Overdraft Protection Against Checking Accounts A type of revolving credit  A bank authorizes qualifying individuals to write checks in excess of actual balances held in a checking account up to a pre- specified limit

Types of Consumer Loans Overdraft Protection and Open Credit Lines Open Credit Lines The bank provides customers with special checks that activate a loan when presented for payment

Types of Consumer Loans Home Equity Loans Grew from virtually nothing in the mid- 1980s to over $350 billion in 2008 They meet the tax deductibility requirements of the Tax Reform Act of 1986, which limits deductions for consumer loan interest paid by individuals, because they are secured by equity in an individual's home

Types of Consumer Loans Home Equity Loans Some allow access to credit line by using a credit card Borrowers pay interest only on the amount borrowed, pay 1 to 2 percent of the outstanding principal each month, and can repay the remaining principal at their discretion

Types of Consumer Loans Non-Installment Loans aka Bridge Loan Requires a single principal and interest payment Typically, the individual’s borrowing needs are temporary and repayment is from a well-defined future cash inflow

Subprime Loans One of the hottest growth areas during the early 2000s Subprime loans are higher-risk loans labeled “B,” “C,” and “D” credits They have been especially popular in auto, home equity, and mortgage lending Typically have the same risk as loans originated through consumer finance companies

Subprime Loans Many subprime lenders make loans to individuals that a bank would not traditionally make and keep on- balance sheet Subprime lenders charge higher rates and have more restrictive covenants

Subprime Loans What Happens When Housing Prices Fall Subprime loans can be attractive when housing values are rising Individuals who are overextended and cannot make their monthly payments, can often sell the home or refinance and withdraw equity to pay the debts if the price increases are sufficiently high The opposite occurs when housing prices fall

Subprime Loans What Happens When Housing Prices Fall During 2007–2008, banks were forced to charge-off historically high amounts of mortgage loans as delinquencies and foreclosures skyrocketed

Consumer Credit Regulations Equal Credit Opportunity Makes it illegal for lenders to discriminate on the basis of race, religion, sex, marital status, age, or national origin

Consumer Credit Regulations Prohibited Information Requests The applicant's marital status Whether alimony, child support, and public assistance are included in reported income A woman's childbearing capability and plans Whether an applicant has a telephone

Consumer Credit Regulations Credit Scoring Systems Acceptable if they do not require prohibited information and are statistically justified Can use information about age, sex, and marital status as long as these factors contribute positively to the applicant's creditworthiness

Consumer Credit Regulations Credit Reporting Lenders must report credit extended jointly to married couples in both spouses' names Whenever lenders reject a loan, they must notify applicants of the credit denial within 30 days and indicate why the request was turned down

Consumer Credit Regulations Truth In Lending Regulations apply to all individual loans up to $25,000 where the borrower's primary residence does not serve as collateral

Consumer Credit Regulations Truth In Lending Requires that lenders disclose to potential borrowers both the total finance charge and an annual percentage rate (APR) Historically, consumer loan rates were quoted as: Add-On Rates Discount Rates Simple Interest Rates

Consumer Credit Regulations Fair Credit Reporting 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

Consumer Credit Regulations Fair Credit Reporting There are three primary credit reporting agencies: Equifax Experian Trans Union Unfortunately, the credit reports that they produce are quite often wrong

Consumer Credit Regulations Fair Credit Reporting Credit Score Like a bond rating for individuals Based on several factors  Payment History  Amounts Owed  Length of Credit History  Types of Credit  New Credit

Consumer Credit Regulations Community Reinvestment Act CRA prohibits redlining and encourages lenders to extend credit within their immediate trade area and the markets where they collect deposits

Consumer Credit Regulations Community Reinvestment Act Financial Institutions Reform, Recover, and Enforcement Act of 1989 raised the profile of the CRA by mandating public disclosure of bank lending policies and regulatory ratings of bank compliance

Consumer Credit Regulations Community Reinvestment Act Regulators must also take CRA compliance into account when evaluating a bank's request to charter a new bank, acquire a bank, open a branch, or merge with another institution

Consumer Credit Regulations Bankruptcy Reform Individuals who cannot repay their debts on time can file for bankruptcy and receive court protection against creditors

Consumer Credit Regulations Bankruptcy Reform Individuals can file for bankruptcy under: Chapter 7  Individuals liquidate qualified assets and distribute the proceeds to creditors Chapter 13  An individual works out a repayment plan with court supervision

Consumer Credit Regulations Bankruptcy Reform In 2005, Congress passed bankruptcy reform legislation that made it more difficult for individuals to completely avoid repaying their debts In particular, an individual whose income exceeds the state median has to file for Chapter 13 and will repay at least a portion of his or her debts

Credit Analysis Objective of consumer credit analysis is to assess the risks associated with lending to individuals

Credit Analysis When evaluating loans, bankers cite the Cs of credit: Character Capital Capacity Conditions Collateral

Credit Analysis Two additional Cs Customer Relationship A bank’s prior relationship with a customer reveals information about past credit experience Competition Lenders periodically react to competitive pressures Competition should not affect the accept/reject decision

Credit Analysis Policy Guidelines Acceptable Loans Automobile Boat Home Improvement Personal-Unsecured Single Payment Cosigned

Credit Analysis Policy Guidelines Unacceptable Loans Loans for speculative purposes Loans secured by a second lien Other than home improvement or home equity loans Any participation with a correspondent bank in a loan that the bank would not normally approve

Credit Analysis Policy Guidelines Unacceptable Loans Loans to a poor credit risk based on the strength of the cosigner Single payment automobile or boat loans Loans secured by existing home furnishings Loans for skydiving equipment and hang gliders

Credit Analysis Evaluation Procedures: Judgmental and Credit Scoring Judgmental Subjectively interpret the information in light of the bank’s lending guidelines and accepts or rejects the loan Assessment can be completed shortly after receiving the loan application and visiting with the applicant

Credit Analysis Evaluation Procedures: Judgmental and Credit Scoring Credit Scoring Grades the loan request according to a statistically sound model that assigns points to selected characteristics of the prospective borrower

Credit Analysis Evaluation Procedures: Judgmental and Credit Scoring Credit Scoring If the total points exceeds the accept threshold, the officer approves the loan If the total is below the reject threshold, the officer denies the loan

Credit Analysis Evaluation Procedures: Judgmental and Credit Scoring In both cases, judgmental and quantitative, a lending officer collects information regarding the borrower’s character, capacity, and collateral

Credit Analysis An Application: Credit Scoring a Consumer Loan You receive an application for a customer to purchase a 2007 Jeep Cherokee Do you make the loan?

Credit Analysis An Application: Credit Scoring a Consumer Loan The Credit Score At this bank, the loan is automatically approved if the total score equals at least 200 The loan is automatically denied if the total score is below 150 Accept/Reject is indeterminate for scores between 150 & 200

Credit Analysis An Application: Credit Scoring a Consumer Loan The Credit Decision The credit decision rests on the loan officer’s evaluation of the applicant’s character and capacity to repay the debt

Credit Analysis An Application: Credit Scoring a Consumer Loan The Credit Decision The loan officer has numerous grounds for denying credit  Limited credit history  Local residence was established too recently  Employed too recently

Credit Analysis An Application: Credit Scoring a Consumer Loan The Credit Decision The loan officer sees some positive things  Applicant appears to be a hard worker who is the victim of circumstances resulting from her husband’s death  It is unlikely that anyone who puts almost 30 percent down on a new model is going to walk away from a debt

Credit Analysis An Application: Credit Scoring a Consumer Loan The Credit Decision The loan officer sees some positive things  The bank will likely lose Groome as a depositor if it denies the application What would you recommend?

Credit Analysis Your FICO Credit Score Summarizes in one number an individual’s credit history Lenders often use this number when evaluating whether to approve a consumer loan or mortgage Many insurance companies consider the score when determining whether to offer insurance coverage and how to price the insurance

Credit Analysis Your FICO Credit Score Summarizes in one number an individual’s credit history The scores range from 300 to 850 with a higher figure indicating a better credit history  The national average is 670  The higher the score is, the more likely it is a lender will see the individual as making the promised payments in a timely manner

Credit Analysis Your FICO Credit Score An individual’s credit score is based on five broad factors: Payment history 35% Amounts owed 30% Length of credit history 15% New credit 10% Type of credit in use 10%

Credit Analysis An Application: Indirect Lending A retailer sells merchandise and takes the credit application Because many firms do not have the resources to carry their receivables, they sell the loans to banks or other financial institutions

Credit Analysis An Application: Indirect Lending These loans are collectively referred to as dealer paper Banks aggressively compete for paper originated by well-established automobile, mobile home, and furniture dealers

Credit Analysis An Application: Indirect Lending Dealers negotiate finance charges directly with their customers A bank, in turn, agrees to purchase the paper at predetermined rates that vary with the default risk assumed by the bank, the quality of the assets sold, and the maturity of the consumer loan

Credit Analysis An Application: Indirect Lending A dealer normally negotiates a higher rate with the car buyer than the determined rate charged by the bank This differential varies with competitive conditions but potentially represents a significant source of dealer profit

Credit Analysis An Application: Indirect Lending Most indirect loan arrangements provide for dealer reserves that reduce the risk in indirect lending The reserves are derived from the differential between the normal, or contract loan rate and the bank rate, and help protect the bank against customer defaults and refunds

Recent Risk and Return Characteristics of Consumer Loans Revenues from Consumer Loans The attraction is two-fold: Competition for commercial customers narrowed commercial loan yields so that returns fell relative to potential risks Developing loan and deposit relationships with individuals presumably represents a strategic response to deregulation

Recent Risk and Return Characteristics of Consumer Loans Revenues from Consumer Loans Consumer loan rates have been among the highest rates quoted at banks in recent years In addition to interest income, banks generate substantial non-interest revenues from consumer loans

Recent Risk and Return Characteristics of Consumer Loans Revenues from Consumer Loans With traditional installment credit, banks often encourage borrowers to purchase credit life insurance on which the bank may earn a premium

Recent Risk and Return Characteristics of Consumer Loans Consumer Loan Losses Losses on consumer loans are normally the highest among all categories of bank credit Losses are anticipated because of mass marketing efforts pursued by many lenders, particularly with credit cards Credit card losses and fraud amounted to more than $12 billion in 2005

Recent Risk and Return Characteristics of Consumer Loans Interest Rate and Liquidity Risk with Consumer Credit The majority of consumer loans are priced at fixed rates New auto loans typically carry 4-year maturities, and credit card loans exhibit an average 15- to 18-month maturity

Recent Risk and Return Characteristics of Consumer Loans Interest Rate and Liquidity Risk with Consumer Credit Bankers have responded in two ways to deal with the interest rate risk: Price more consumer loans on a floating-rate basis Commercial and investment banks have created a secondary market in consumer loans, allowing loan originators to sell a package of loans

Managing Interest Rate Risk: GAP and Earnings Sensitivity

Managing Interest Rate Risk Interest Rate Risk The potential loss from unexpected changes in interest rates which can significantly alter a bank’s profitability and market value of equity 170

Managing Interest Rate Risk Interest Rate Risk When a bank’s assets and liabilities do not reprice at the same time, the result is a change in net interest income The change in the value of assets and the change in the value of liabilities will also differ, causing a change in the value of stockholder’s equity 171

Managing Interest Rate Risk Interest Rate Risk Banks typically focus on either: Net interest income or The market value of stockholders' equity GAP Analysis A static measure of risk that is commonly associated with net interest income (margin) targeting Earnings Sensitivity Analysis Earnings sensitivity analysis extends GAP analysis by focusing on changes in bank earnings due to changes in interest rates and balance sheet composition 172

Managing Interest Rate Risk Interest Rate Risk Asset and Liability Management Committee (ALCO) The bank’s ALCO primary responsibility is interest rate risk management. The ALCO coordinates the bank’s strategies to achieve the optimal risk/reward trade-off 173

Measuring Interest Rate Risk with GAP Three general factors potentially cause a bank’s net interest income to change. Rate Effects Unexpected changes in interest rates Composition (Mix) Effects Changes in the mix, or composition, of assets and/or liabilities Volume Effects Changes in the volume of earning assets and interest-bearing liabilities 174

Measuring Interest Rate Risk with GAP Consider a bank that makes a $25,000 five-year car loan to a customer at fixed rate of 8.5%. The bank initially funds the car loan with a one-year $25,000 CD at a cost of 4.5%. The bank’s initial spread is 4%. What is the bank’s risk? 175

Measuring Interest Rate Risk with GAP Traditional Static Gap Analysis Static GAP Analysis GAP t = RSA t - RSL t RSA t  Rate Sensitive Assets  Those assets that will mature or reprice in a given time period (t) RSL t  Rate Sensitive Liabilities  Those liabilities that will mature or reprice in a given time period (t) 176

Measuring Interest Rate Risk with GAP Traditional Static Gap Analysis Steps in GAP Analysis 1. Develop an interest rate forecast 2. Select a series of “time buckets” or time intervals for determining when assets and liabilities will reprice 3. Group assets and liabilities into these “buckets” 4. Calculate the GAP for each “bucket ” 5. Forecast the change in net interest income given an assumed change in interest rates 177

Measuring Interest Rate Risk with GAP What Determines Rate Sensitivity The initial issue is to determine what features make an asset or liability rate sensitive 178

Measuring Interest Rate Risk with GAP Expected Repricing versus Actual Repricing In general, an asset or liability is normally classified as rate sensitive within a time interval if:  It matures  It represents an interim or partial principal payment  The interest rate applied to the outstanding principal balance changes contractually during the interval  The interest rate applied to the outstanding principal balance changes when some base rate or index changes and management expects the base rate/index to change during the time interval 179

Measuring Interest Rate Risk with GAP What Determines Rate Sensitivity Maturity If any asset or liability matures within a time interval, the principal amount will be repriced  The question is what principal amount is expected to reprice Interim or Partial Principal Payment Any principal payment on a loan is rate sensitive if management expects to receive it within the time interval  Any interest received or paid is not included in the GAP calculation 180

Measuring Interest Rate Risk with GAP What Determines Rate Sensitivity Contractual Change in Rate Some assets and deposit liabilities earn or pay rates that vary contractually with some index These instruments are repriced whenever the index changes  If management knows that the index will contractually change within 90 days, the underlying asset or liability is rate sensitive within 0–90 days. 181

Measuring Interest Rate Risk with GAP What Determines Rate Sensitivity Change in Base Rate or Index Some loans and deposits carry interest rates tied to indexes where the bank has no control or definite knowledge of when the index will change. For example, prime rate loans typically state that the bank can contractually change prime daily  The loan is rate sensitive in the sense that its yield can change at any time  However, the loan’s effective rate sensitivity depends on how frequently the prime rate actually changes 182

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Rate, Composition (Mix) and Volume Effects All affect net interest income 183

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Changes in the Level of Interest Rates The sign of GAP (positive or negative) indicates the nature of the bank’s interest rate risk  A negative (positive) GAP, indicates that the bank has more (less) RSLs than RSAs. When interest rates rise (fall) during the time interval, the bank pays higher (lower) rates on all repriceable liabilities and earns higher (lower) yields on all repriceable assets 184

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Changes in the Level of Interest Rates The sign of GAP (positive or negative) indicates the nature of the bank’s interest rate risk  If all rates rise (fall) by equal amounts at the same time, both interest income and interest expense rise (fall), but interest expense rises (falls) more because more liabilities are repriced  Net interest income thus declines (increases), as does the bank’s net interest margin 185

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Changes in the Level of Interest Rates If a bank has a zero GAP, RSAs equal RSLs and equal interest rate changes do not alter net interest income because changes in interest income equal changes in interest expense It is virtually impossible for a bank to have a zero GAP given the complexity and size of bank balance sheets 186

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income 187

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Changes in the Level of Interest Rates GAP analysis assumes a parallel shift in the yield curve 188

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Changes in the Level of Interest Rates If there is a parallel shift in the yield curve then changes in Net Interest Income are directly proportional to the size of the GAP: ∆NII EXP = GAP x ∆i EXP  It is rare, however, when the yield curve shifts parallel. If rates do not change by the same amount and at the same time, then net interest income may change by more or less 189

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Changes in the Level of Interest Rates Example 1  Recall the bank that makes a $25,000 five- year car loan to a customer at fixed rate of 8.5%. The bank initially funds the car loan with a one-year $25,000 CD at a cost of 4.5%. What is the bank’s 1-year GAP? 190

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Changes in the Level of Interest Rates Example 1  RSA 1 YR = $0  RSL 1 YR = $25,000  GAP 1 YR = $0 - $25,000 = -$25,000  The bank’s one year funding GAP is - $25,000  If interest rates rise (fall) by 1% in 1 year, the bank’s net interest margin and net interest income will fall (rise)  ∆NII EXP = GAP x ∆i EXP = -$25,000 x 1% = -$250 191

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Changes in the Level of Interest Rates Example 2  Assume a bank accepts an 18-month $30,000 CD deposit at a cost of 3.75% and invests the funds in a $30,000 6-month T- Bill at rate of 4.80%. The bank’s initial spread is 1.05%. What is the bank’s 6- month GAP? 192

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Changes in the Level of Interest Rates Example 2  RSA 6 MO = $30,000  RSL 6 MO = $0  GAP 6 MO = $30,000 – $0 = $30,000  The bank’s 6-month funding GAP is $30,000  If interest rates rise (fall) by 1% in 6 months, the bank’s net interest margin and net interest income will rise (fall)  ∆NII EXP = GAP x ∆i EXP = $30,000 x 1% = $300 193

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Changes in the Relationship Between Asset Yields and Liability Costs Net interest income may differ from that expected if the spread between earning asset yields and the interest cost of interest-bearing liabilities changes The spread may change because of a nonparallel shift in the yield curve or because of a change in the difference between different interest rates (basis risk) 194

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Changes in Volume Net interest income varies directly with changes in the volume of earning assets and interest-bearing liabilities, regardless of the level of interest rates For example, if a bank doubles in size but the portfolio composition and interest rates remain unchanged, net interest income will double because the bank earns the same interest spread on twice the volume of earning assets such that NIM is unchanged 195

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Changes in Portfolio Composition Any variation in portfolio mix potentially alters net interest income There is no fixed relationship between changes in portfolio mix and net interest income  The impact varies with the relationships between interest rates on rate-sensitive and fixed-rate instruments and with the magnitude of funds shifts 196

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.0 198

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.0 Interest Income  ($500 x 8%) + ($350 x 11%) = $78.50 Interest Expense  ($600 x 4%) + ($220 x 6%) = $37.20 Net Interest Income  $78.50 - $37.20 = $41.30 199

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.0 Earning Assets  $500 + $350 = $850 Net Interest Margin  $41.3/$850 = 4.86% Funding GAP  $500 - $600 = -$100 200

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.1 What if all rates increase by 1%? 201

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.1 What if all rates increase by 1%? With a negative GAP, interest income increases by less than the increase in interest expense. Thus, both NII and NIM fall. 202

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.2 What if all rates fall by 1%? 203

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.2 What if all rates fall by 1%? With a negative GAP, interest income decreases by less than the decrease in interest expense. Thus, both NII and NIM increase. 204

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.3 What if rates rise but the spread falls by 1%? 205

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.3 What if rates rise but the spread falls by 1%? Both NII and NIM fall with a decrease in the spread. Why the larger change?  Note: ∆NII EXP ≠ GAP x ∆i EXP Why? 206

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.4 What if rates fall but the spread falls by 1%? 207

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.4 What if rates fall and the spread falls by 1%? Both NII and NIM fall with a decrease in the spread.  Note: ∆NII EXP ≠ GAP x ∆i EXP 208

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.5 What if rates rise and the spread rises by 1%? 209

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.5 What if rates rise and the spread rises by 1%? Both NII and NIM increase with an increase in the spread.  Note: ∆NII EXP ≠ GAP x ∆i EXP 210

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.6 What if rates fall and the spread rises by 1%? 211

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.6 What if rates fall and the spread rises by 1%? Both NII and NIM increase with an increase in the spread.  Note: ∆NII EXP ≠ GAP x ∆i EXP 212

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.7 What if the bank proportionately doubles in size? 213

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 3.7 What if the bank proportionately doubles in size? Both NII doubles but NIM stays the same. Why? What has happened to the bank’s risk? 214

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.0 Bank has a positive GAP 216

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.1 What if rates increase by 1%? 217

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.1 What if rates increase by 1%? With a positive GAP, interest income increases by more than the increase in interest expense. Thus, both NII and NIM rise. 218

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.2 What if rates decrease by 1%? 219

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.2 What if rates decrease by 1%? With a positive GAP, interest income decreases by more than the decrease in interest expense. Thus, both NII and NIM fall. 220

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.3 What if rates rise but the spread falls by 1%? 221

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.3 What if rates rise but the spread falls by 1%? Both NII and NIM fall with a decrease in the spread. Why the larger change?  Note: ∆NII EXP ≠ GAP x ∆i EXP Why? 222

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.4 What if rates fall and the spread falls by 1%? 223

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.4 What if rates fall and the spread falls by 1%? Both NII and NIM fall with a decrease in the spread. Note: ∆NII EXP ≠ GAP x ∆i EXP 224

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.5 What if rates rise and the spread rises by 1%? Both NII and NIM increase with an increase in the spread. Note: ∆NII EXP ≠ GAP x ∆i EXP 226

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.6 What if rates fall and the spread rises by 1%? 227

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.6 What if rates fall and the spread rises by 1%? Both NII and NIM increase with an increase in the spread. Note: ∆NII EXP ≠ GAP x ∆i EXP 228

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.7 What if the bank proportionately doubles in size? 229

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 4.7 What if the bank proportionately doubles in size? Both NII doubles but NIM stays the same. Why? What has happened to the bank’s risk? 230

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 5.0 Bank has zero GAP 232

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 5.1 What if rates increase by 1%? 233

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 5.1 What if rates increase by 1%? With a zero GAP, interest income increases by the amount as the increase in interest expense. Thus, there is no change in NII or NIM! 234

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 5.2 What if rates fall and the spread falls by 1%? 235

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 5.2  What if rates fall and the spread falls by 1%? Even with a zero GAP, interest income falls by more than the decrease in interest expense. Thus, both NII and NIM fall with a decrease in the spread. Note: ∆NII EXP ≠ GAP x ∆i EXP 236

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Example 5.3 What if rates rise and the spread rises by 1%? Even with a zero GAP, interest income rises by more than the increase in interest expense. Thus, both NII and NIM increase with an increase in the spread. Note: ∆NII EXP ≠ GAP x ∆i EXP 238

Measuring Interest Rate Risk with GAP Factors Affecting Net Interest Income Summary of Base Cases If a Negative GAP gives the largest NII and NIM, why not plan for a Negative GAP? 239

Measuring Interest Rate Risk with GAP Rate, Volume, and Mix Analysis Many financial institutions publish a summary in their annual report of how net interest income has changed over time They separate changes attributable to shifts in asset and liability composition and volume from changes associated with movements in interest rates 240

Measuring Interest Rate Risk with GAP Rate Sensitivity Reports Many managers monitor their bank’s risk position and potential changes in net interest income using rate sensitivity reports These report classify a bank’s assets and liabilities as rate sensitive in selected time buckets through one year 242

Measuring Interest Rate Risk with GAP Rate Sensitivity Reports Periodic GAP The Gap for each time bucket and measures the timing of potential income effects from interest rate changes 243

Measuring Interest Rate Risk with GAP Rate Sensitivity Reports Cumulative GAP The sum of periodic GAP's and measures aggregate interest rate risk over the entire period Cumulative GAP is important since it directly measures a bank’s net interest sensitivity throughout the time interval 244

Measuring Interest Rate Risk with GAP Strengths and Weaknesses of Static GAP Analysis Strengths Easy to understand Works well with small changes in interest rates 246

Measuring Interest Rate Risk with GAP Strengths and Weaknesses of Static GAP Analysis Weaknesses Ex-post measurement errors Ignores the time value of money Ignores the cumulative impact of interest rate changes Typically considers demand deposits to be non-rate sensitive Ignores embedded options in the bank’s assets and liabilities 247

Measuring Interest Rate Risk with GAP GAP Ratio GAP Ratio = RSAs/RSLs A GAP ratio greater than 1 indicates a positive GAP A GAP ratio less than 1 indicates a negative GAP 248

Measuring Interest Rate Risk with GAP GAP Divided by Earning Assets as a Measure of Risk An alternative risk measure that relates the absolute value of a bank’s GAP to earning assets The greater this ratio, the greater the interest rate risk Banks may specify a target GAP-to-earning- asset ratio in their ALCO policy statements A target allows management to position the bank to be either asset sensitive or liability sensitive, depending on the outlook for interest rates 249

Earnings Sensitivity Analysis Allows management to incorporate the impact of different spreads between asset yields and liability interest costs when rates change by different amounts 250

Earnings Sensitivity Analysis Steps to Earnings Sensitivity Analysis 1. Forecast interest rates. 2. Forecast balance sheet size and composition given the assumed interest rate environment 3. Forecast when embedded options in assets and liabilities will be exercised such that prepayments change, securities are called or put, deposits are withdrawn early, or rate caps and rate floors are exceeded under the assumed interest rate environment 251

Earnings Sensitivity Analysis Steps to Earnings Sensitivity Analysis 4. Identify when specific assets and liabilities will reprice given the rate environment 5. Estimate net interest income and net income under the assumed rate environment 6. Repeat the process to compare forecasts of net interest income and net income across different interest rate environments versus the base case The choice of base case is important because all estimated changes in earnings are compared with the base case estimate 252

Earnings Sensitivity Analysis The key benefits of conducting earnings sensitivity analysis are that managers can estimate the impact of rate changes on earnings while allowing for the following: Interest rates to follow any future path Different rates to change by different amounts at different times Expected changes in balance sheet mix and volume Embedded options to be exercised at different times and in different interest rate environments Effective GAPs to change when interest rates change Thus, a bank does not have a single static GAP, but instead will experience amounts of RSAs and RSLs that change when interest rates change 253

Earnings Sensitivity Analysis Exercise of Embedded Options in Assets and Liabilities The most common embedded options at banks include the following: Refinancing of loans Prepayment (even partial) of principal on loans Bonds being called Early withdrawal of deposits Caps on loan or deposit rates Floors on loan or deposit rates Call or put options on FHLB advances Exercise of loan commitments by borrowers 254

Earnings Sensitivity Analysis Exercise of Embedded Options in Assets and Liabilities The implications of embedded options Does the bank or the customer determine when the option is exercised? How and by what amount is the bank being compensated for selling the option, or how much must it pay to buy the option? When will the option be exercised?  This is often determined by the economic and interest rate environment Static GAP analysis ignores these embedded options 255

Earnings Sensitivity Analysis Different Interest Rates Change by Different Amounts at Different Times It is well recognized that banks are quick to increase base loan rates but are slow to lower base loan rates when rates fall 256

Earnings Sensitivity Analysis Earnings Sensitivity: An Example Consider the rate sensitivity report for First Savings Bank (FSB) as of year-end 2008 that is presented on the next slide The report is based on the most likely interest rate scenario FSB is a $1 billion bank that bases its analysis on forecasts of the federal funds rate and ties other rates to this overnight rate As such, the federal funds rate serves as the bank’s benchmark interest rate 257

Earnings Sensitivity Analysis Explanation of Sensitivity Results This example demonstrates the importance of understanding the impact of exercising embedded options and the lags between the pricing of assets and liabilities. The framework uses the federal funds rate as the benchmark rate such that rate shocks indicate how much the funds rate changes Summary results are known as Earnings- at-Risk Simulation or Net Interest Income Simulation 261

Earnings Sensitivity Analysis Explanation of Sensitivity Results Earnings-at-Risk The potential variation in net interest income across different interest rate environments, given different assumptions about balance sheet composition, when embedded options will be exercised, and the timing of repricings. 262

Earnings Sensitivity Analysis Explanation of Sensitivity Results FSB’s earnings sensitivity results reflect the impacts of rate changes on a bank with this profile There are two basic causes or drivers behind the estimated earnings changes First, other market rates change by different amounts and at different times relative to the federal funds rate Second, embedded options potentially alter cash flows when the options go in the money 263

Income Statement GAP An interest rate risk model which modifies the standard GAP model to incorporate the different speeds and amounts of repricing of specific assets and liabilities given an interest rate change 264

Income Statement GAP Beta GAP The adjusted GAP figure in a basic earnings sensitivity analysis derived from multiplying the amount of rate- sensitive assets by the associated beta factors and summing across all rate- sensitive assets, and subtracting the amount of rate-sensitive liabilities multiplied by the associated beta factors summed across all rate- sensitive liabilities 265

Income Statement GAP Balance Sheet GAP The effective amount of assets that reprice by the full assumed rate change minus the effective amount of liabilities that reprice by the full assumed rate change. Earnings Change Ratio (ECR) A ratio calculated for each asset or liability that estimates how the yield on assets or rate paid on liabilities is assumed to change relative to a 1 percent change in the base rate 266

Managing the GAP and Earnings Sensitivity Risk Steps to reduce risk Calculate periodic GAPs over short time intervals Match fund repriceable assets with similar repriceable liabilities so that periodic GAPs approach zero Match fund long-term assets with non- interest-bearing liabilities Use off-balance sheet transactions to hedge 268

Managing the GAP and Earnings Sensitivity Risk How to Adjust the Effective GAP or Earnings Sensitivity Profile 269

Managing Interest Rate Risk: Economic Value of Equity 270

Managing Interest Rate Risk: Economic Value of Equity Economic Value of Equity (EVE) Analysis Focuses on changes in stockholders’ equity given potential changes in interest rates 271

Managing Interest Rate Risk: Economic Value of Equity Duration GAP Analysis Compares the price sensitivity of a bank’s total assets with the price sensitivity of its total liabilities to assess the impact of potential changes in interest rates on stockholders’ equity 272

Managing Interest Rate Risk: Economic Value of Equity GAP and Earnings Sensitivity versus Duration GAP and EVE Sensitivity 273

Managing Interest Rate Risk: Economic Value of Equity Recall from Chapter 6 Duration is a measure of the effective maturity of a security Duration incorporates the timing and size of a security’s cash flows Duration measures how price sensitive a security is to changes in interest rates  The greater (shorter) the duration, the greater (lesser) the price sensitivity 274

Managing Interest Rate Risk: Economic Value of Equity Market Value Accounting Issues EVE sensitivity analysis is linked with the debate concerning whether market value accounting is appropriate for financial institutions Recently many large commercial and investment banks reported large write-downs of mortgage-related assets, which depleted their capital Some managers argued that the write-downs far exceeded the true decline in value of the assets and because banks did not need to sell the assets they should not be forced to recognize the “paper” losses 275

Measuring Interest Rate Risk with Duration GAP Duration GAP Analysis Compares the price sensitivity of a bank’s total assets with the price sensitivity of its total liabilities to assess whether the market value of assets or liabilities changes more when rates change 277

Measuring Interest Rate Risk with Duration GAP Duration, Modified Duration, and Effective Duration Macaulay’s Duration (D) where P* is the initial price, i is the market interest rate, and t is equal to the time until the cash payment is made 278

Measuring Interest Rate Risk with Duration GAP Duration, Modified Duration, and Effective Duration Macaulay’s Duration (D) Macaulay’s duration is a measure of price sensitivity where P refers to the price of the underlying security: 279

Measuring Interest Rate Risk with Duration GAP Duration, Modified Duration, and Effective Duration Modified Duration Indicates how much the price of a security will change in percentage terms for a given change in interest rates Modified Duration = D/(1+i) 280

Measuring Interest Rate Risk with Duration GAP Duration, Modified Duration, and Effective Duration Example Assume that a ten-year zero coupon bond has a par value of $10,000, current price of $7,835.26, and a market rate of interest of 5%. What is the expected change in the bond’s price if interest rates fall by 25 basis points? 281

Measuring Interest Rate Risk with Duration GAP Duration, Modified Duration, and Effective Duration Example Since the bond is a zero-coupon bond, Macaulay’s Duration equals the time to maturity, 10 years. With a market rate of interest, the Modified Duration is 10/(1.05) = 9.524 years. If rates change by 0.25% (.0025), the bond’s price will change by approximately 9.524 ×.0025 × $7,835.26 = $186.56 282

Measuring Interest Rate Risk with Duration GAP Duration, Modified Duration, and Effective Duration Effective Duration Used to estimate a security’s price sensitivity when the security contains embedded options Compares a security’s estimated price in a falling and rising rate environment 283

Measuring Interest Rate Risk with Duration GAP Duration, Modified Duration, and Effective Duration Effective Duration where: P i- = Price if rates fall P i+ = Price if rates rise P 0 = Initial (current) price i + = Initial market rate plus the increase in the rate i - = Initial market rate minus the decrease in the rate 284

Measuring Interest Rate Risk with Duration GAP Duration, Modified Duration, and Effective Duration Effective Duration Example  Consider a 3-year, 9.4 percent semi-annual coupon bond selling for $10,000 par to yield 9.4 percent to maturity  Macaulay’s Duration for the option-free version of this bond is 5.36 semiannual periods, or 2.68 years  The Modified Duration of this bond is 5.12 semiannual periods or 2.56 years 285

Measuring Interest Rate Risk with Duration GAP Duration, Modified Duration, and Effective Duration Effective Duration Example  Assume that the bond is callable at par in the near-term.  If rates fall, the price will not rise much above the par value since it will likely be called  If rates rise, the bond is unlikely to be called and the price will fall 286

Measuring Interest Rate Risk with Duration GAP Duration, Modified Duration, and Effective Duration Effective Duration Example  If rates rise 30 basis points to 5% semiannually, the price will fall to $9,847.72.  If rates fall 30 basis points to 4.4% semiannually, the price will remain at par 287

Measuring Interest Rate Risk with Duration GAP Duration, Modified Duration, and Effective Duration Effective Duration Example 288

Measuring Interest Rate Risk with Duration GAP Duration GAP Model Focuses on managing the market value of stockholders’ equity The bank can protect EITHER the market value of equity or net interest income, but not both Duration GAP analysis emphasizes the impact on equity and focuses on price sensitivity 289

Measuring Interest Rate Risk with Duration GAP Duration GAP Model Steps in Duration GAP Analysis Forecast interest rates Estimate the market values of bank assets, liabilities and stockholders’ equity Estimate the weighted average duration of assets and the weighted average duration of liabilities  Incorporate the effects of both on- and off-balance sheet items. These estimates are used to calculate duration gap Forecasts changes in the market value of stockholders’ equity across different interest rate environments 290

Measuring Interest Rate Risk with Duration GAP Duration GAP Model Weighted Average Duration of Bank Assets (DA): where w i = Market value of asset i divided by the market value of all bank assets Da i = Macaulay’s duration of asset i n = number of different bank assets 291

Measuring Interest Rate Risk with Duration GAP Duration GAP Model Weighted Average Duration of Bank Liabilities (DL): where z j = Market value of liability j divided by the market value of all bank liabilities Dl j = Macaulay’s duration of liability j m = number of different bank liabilities 292

Measuring Interest Rate Risk with Duration GAP Duration GAP Model Let MVA and MVL equal the market values of assets and liabilities, respectively If ΔEVE = ΔMVA – ΔMVL and Duration GAP = DGAP = DA – (MVL/MVA)DL then ΔEVE = -DGAP[Δy/(1+y)]MVA where y is the interest rate 293

Measuring Interest Rate Risk with Duration GAP Duration GAP Model To protect the economic value of equity against any change when rates change, the bank could set the duration gap to zero: 294

Measuring Interest Rate Risk with Duration GAP Duration GAP Model DGAP as a Measure of Risk The sign and size of DGAP provide information about whether rising or falling rates are beneficial or harmful and how much risk the bank is taking  If DGAP is positive, an increase in rates will lower EVE, while a decrease in rates will increase EVE  If DGAP is negative, an increase in rates will increase EVE, while a decrease in rates will lower EVE  The closer DGAP is to zero, the smaller is the potential change in EVE for any change in rates 295

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks 296

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks Implications of DGAP The value of DGAP at 1.42 years indicates that the bank has a substantial mismatch in average durations of assets and liabilities Since the DGAP is positive, the market value of assets will change more than the market value of liabilities if all rates change by comparable amounts  In this example, an increase in rates will cause a decrease in EVE, while a decrease in rates will cause an increase in EVE 297

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks Implications of DGAP > 0 A positive DGAP indicates that assets are more price sensitive than liabilities  When interest rates rise (fall), assets will fall proportionately more (less) in value than liabilities and EVE will fall (rise) accordingly. Implications of DGAP < 0 A negative DGAP indicates that liabilities are more price sensitive than assets  When interest rates rise (fall), assets will fall proportionately less (more) in value that liabilities and the EVE will rise (fall) 298

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks Duration GAP Summary 300

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks DGAP As a Measure of Risk DGAP measures can be used to approximate the expected change in economic value of equity for a given change in interest rates 301

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks DGAP As a Measure of Risk In this case: The actual decrease, as shown in Exhibit 8.3, was $12 302

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks An Immunized Portfolio To immunize the EVE from rate changes in the example, the bank would need to:  decrease the asset duration by 1.42 years or  increase the duration of liabilities by 1.54 years DA/( MVA/MVL) = 1.42/($920/$1,000) = 1.54 years or  a combination of both 303

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks An Immunized Portfolio With a 1% increase in rates, the EVE did not change with the immunized portfolio versus $12.0 when the portfolio was not immunized 305

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks An Immunized Portfolio If DGAP > 0, reduce interest rate risk by:  shortening asset durations  Buy short-term securities and sell long- term securities  Make floating-rate loans and sell fixed-rate loans  lengthening liability durations  Issue longer-term CDs  Borrow via longer-term FHLB advances  Obtain more core transactions accounts from stable sources 306

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks An Immunized Portfolio If DGAP < 0, reduce interest rate risk by:  lengthening asset durations  Sell short-term securities and buy long-term securities  Sell floating-rate loans and make fixed-rate loans  Buy securities without call options  shortening liability durations  Issue shorter-term CDs  Borrow via shorter-term FHLB advances  Use short-term purchased liability funding from federal funds and repurchase agreements 307

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks Banks may choose to target variables other than the market value of equity in managing interest rate risk Many banks are interested in stabilizing the book value of net interest income This can be done for a one-year time horizon, with the appropriate duration gap measure 308

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks DGAP* = MVRSA(1 − DRSA) − MVRSL(1 − DRSL) where MVRSA = cumulative market value of rate- sensitive assets (RSAs) MVRSL = cumulative market value of rate- sensitive liabilities (RSLs) DRSA = composite duration of RSAs for the given time horizon DRSL = composite duration of RSLs for the given time horizon 309

Measuring Interest Rate Risk with Duration GAP A Duration Application for Banks DGAP* > 0 Net interest income will decrease (increase) when interest rates decrease (increase) DGAP* < 0 Net interest income will decrease (increase) when interest rates increase (decrease) DGAP* = 0 Interest rate risk eliminated  A major point is that duration analysis can be used to stabilize a number of different variables reflecting bank performance 310

Economic Value of Equity Sensitivity Analysis Involves the comparison of changes in the Economic Value of Equity (EVE) across different interest rate environments An important component of EVE sensitivity analysis is allowing different rates to change by different amounts and incorporating projections of when embedded customer options will be exercised and what their values will be 311

Economic Value of Equity Sensitivity Analysis Estimating the timing of cash flows and subsequent durations of assets and liabilities is complicated by: Prepayments that exceed (fall short of) those expected A bond being A deposit that is withdrawn early or a deposit that is not withdrawn as expected 312

Economic Value of Equity Sensitivity Analysis EVE Sensitivity Analysis: An Example First Savings Bank Average duration of assets equals 2.6 years Market value of assets equals $1,001,963,000 Average duration of liabilities equals 2 years Market value of liabilities equals $919,400,000 313

Economic Value of Equity Sensitivity Analysis EVE Sensitivity Analysis: An Example First Savings Bank Duration Gap  2.6 – ($919,400,000/$1,001,963,000) × 2.0 = 0.765 years Example:  A 1% increase in rates would reduce EVE by $7.2 million  ΔMVE = -DGAP[Δy/(1+y)]MVA  ΔMVE = -0.765 (0.01/1.0693) × $1,001,963,000 = -$7,168,257  Recall that the average rate on assets is 6.93%  The estimate of -$7,168,257 ignores the impact of interest rates on embedded options and the effective duration of assets and liabilities 315

Economic Value of Equity Sensitivity Analysis EVE Sensitivity Analysis: An Example 316

Economic Value of Equity Sensitivity Analysis EVE Sensitivity Analysis: An Example First Savings Bank The previous slide shows that FSB’s EVE will fall by $8.2 million if rates are rise by 1%  This differs from the estimate of -$7,168,257 because this sensitivity analysis takes into account the embedded options on loans and deposits  For example, with an increase in interest rates, depositors may withdraw a CD before maturity to reinvest the funds at a higher interest rate 317

Economic Value of Equity Sensitivity Analysis EVE Sensitivity Analysis: An Example First Savings Bank Effective “Duration” of Equity  Recall, duration measures the percentage change in market value for a given change in interest rates  A bank’s duration of equity measures the percentage change in EVE that will occur with a 1 percent change in rates:  Effective duration of equity = $8,200 / $82,563 = 9.9 years 318

Earnings Sensitivity Analysis versus EVE Sensitivity Analysis Strengths and Weaknesses: DGAP and EVE-Sensitivity Analysis Strengths Duration analysis provides a comprehensive measure of interest rate risk Duration measures are additive  This allows for the matching of total assets with total liabilities rather than the matching of individual accounts Duration analysis takes a longer term view than static gap analysis 319

Earnings Sensitivity Analysis versus EVE Sensitivity Analysis Strengths and Weaknesses: DGAP and EVE- Sensitivity Analysis Weaknesses It is difficult to compute duration accurately “Correct” duration analysis requires that each future cash flow be discounted by a distinct discount rate A bank must continuously monitor and adjust the duration of its portfolio It is difficult to estimate the duration on assets and liabilities that do not earn or pay interest Duration measures are highly subjective 320

A Critique of Strategies for Managing Earnings and EVE Sensitivity GAP and DGAP Management Strategies It is difficult to actively vary GAP or DGAP and consistently win Interest rates forecasts are frequently wrong Even if rates change as predicted, banks have limited flexibility in changing GAP and DGAP 321

A Critique of Strategies for Managing Earnings and EVE Sensitivity Interest Rate Risk: An Example Consider the case where a bank has two alternatives for funding $1,000 for two years A 2-year security yielding 6 percent Two consecutive 1-year securities, with the current 1-year yield equal to 5.5 percent  It is not known today what a 1-year security will yield in one year 322

A Critique of Strategies for Managing Earnings and EVE Sensitivity Interest Rate Risk: An Example Consider the case where a bank has two alternative for funding $1,000 for two years 323

A Critique of Strategies for Managing Earnings and EVE Sensitivity Interest Rate Risk: An Example Consider the case where a bank has two alternative for funding $1,000 for two years For the two consecutive 1-year securities to generate the same $120 in interest, ignoring compounding, the 1-year security must yield 6.5% one year from the present  This break-even rate is a 1-year forward rate of :  6% + 6% = 5.5% + x so x must = 6.5% 324

A Critique of Strategies for Managing Earnings and EVE Sensitivity Interest Rate Risk: An Example Consider the case where a bank has two alternative for investing $1,000 for two years By investing in the 1-year security, a depositor is betting that the 1-year interest rate in one year will be greater than 6.5% By issuing the 2-year security, the bank is betting that the 1-year interest rate in one year will be greater than 6.5%  By choosing one or the other, the depositor and the bank “place a bet” that the actual rate in one year will differ from the forward rate of 6.5 percent 325

Yield Curve Strategies When the U.S. economy hits its peak, the yield curve typically inverts, with short- term rates exceeding long-term rates. Only twice since WWII has a recession not followed an inverted yield curve As the economy contracts, the Federal Reserve typically increases the money supply, which causes rates to fall and the yield curve to return to its “normal” shape. 326

Yield Curve Strategies To take advantage of this trend, when the yield curve inverts, banks could: Buy long-term non-callable securities Prices will rise as rates fall Make fixed-rate non-callable loans Borrowers are locked into higher rates Price deposits on a floating-rate basis Follow strategies to become more liability sensitive and/or lengthen the duration of assets versus the duration of liabilities 327

Evaluating Commercial Loan Requests 1 14. Evaluating Commercial Loan Requests and Managing Credit Risk Important Questions Regarding Commercial Loan Requests.

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Evaluating Commercial Loan Requests 1 14. Evaluating Commercial Loan Requests and Managing Credit Risk Important Questions Regarding Commercial Loan Requests.

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Presentation on theme: "Evaluating Commercial Loan Requests 1 14. Evaluating Commercial Loan Requests and Managing Credit Risk Important Questions Regarding Commercial Loan Requests."— Presentation transcript:

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