1. LENDING DECISION
Chapter 12 – Credit Risk from the Regulator’s Perspective
Chapter 13 – Problem Loan Management

2. Introduction
The sectors that were not specified for lending assistance would have been subject to credit rationing
Lending institutions might have been subject to concentration risk
Given the directives of the regulator, banks might have approved marginal lending applications in the directed sectors
Prudential regulation
Capital adequacy
Large exposures

3. Capital Adequacy
History shows that financial institutions normally fail as a result of poor credit decision
The board and management control the banks and decisions could be taken that are not in the interest of the depositors – this is known as moral hazard
Depositors need to be protected against poor decisions by management -> under the base of capital adequacy, financial institutions are required to put aside capital to each credit risk exposure, whether it is on or off the balance sheet
A minimum of 8% of capital need be put aside for risk- weighted assets

4. Capital Adequacy
Risk-based capital ratio = Total capital (Tier 1 + Tier 2)
Risk Adjusted Assets
Tier 1 capital exhibits permanence like capital
Tier 2 has the ability to absorb credit losses but is not permanent
Tier 2 capital cannot make up more than 50% of overall allowable capital

5. Capital Adequacy Tier 1 Tier 2 Paid up ordinary shares
General reserves
Retained earnings
Non-cumulative irredeemable preference shares
Minority interest in subsidiaries
Less Goodwill
General provisions for doubtful debts (<= 1.5% of total risk assets)
Asset revaluation reserves
Cumulative irredeemable preference shares
Mandatory convertible notes
Perpetual subordinated debt
Redeemable preference shares and term subordinated debt (min original maturity of at least 7 years and amortization factor of 20% of original amount to apply each year during the last five years to maturity

6. Risk Categories
Category 1 (0% weight) – notes and coins, balance with the FED, Government papers (<= 12 months of maturity)
Category 2 (10%) – claims on Federal and State Government (> 12 months to maturity)
Category 3 (20%) – claims on banks
Category 4 (50%) – loans fully secured by mortgage against residential property used for rental or occupied housing (LVR <= 80%)
Category 5 (100%) – loan fully secured by mortgage against residential property used for rental or occupied housing (LVR > 80%); commercial companies

7. Large Credit Exposure
Exposure = potential for loss under a finance facility
A large exposure – an exposure to an individual or group of counterparties that exceeds 10% of the consolidated capital base.
Securitization – a good credit risk management tool in certain circumstances
Clean sale – absolves the financial institution from any legal recourse from the sale of loans
Results in the financial institution not holding capital against the loan

8. Clean Sale Supply of Assets
A clean sale
There should be no beneficial interest in the sold assets and absolutely no obligation to the financial institution
No recourse (including costs) to the lending institution; no obligation to repurchase 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 SPV as a substitute or provided at below book value are not considered as relieving credit risk
Subjected to asymmetric information

9. Revolving Facilities A clean sale
The rights, details and obligations of each party must be clearly specified, including the distribution of cashflows
As with normal asset securitization, the financial institution share cannot supply additional assets to the pool
Liquidity shortfalls for the financial institutions share most not exceed the interest receivable
The financial institution always has the right to cancel any undrawn amounts on the revolving facilities
Like normal lending securitization, the financial institution must be under no obligation to repurchase assets that have defaulted

10. Credit Derivatives
The effectiveness of credit derivatives becomes an issue of how well the instrument reduces the requirement of capital adequacy
A credit derivative is deemed to afford protection if the physical settlement has a deliverable obligation.
In terms of maturity, a financial institution is deemed to have full protection if the maturity of derivative equals the maturity of the underlying asset
Example: a loan has a term of 5 years and the credit derivative has a maturity of 4 years, only 80% of the exposure is counted for regulatory relieft

11. Development in Regulation
Capital adequacy is the primary tool for the Australian Prudential Regulation Authority to regulate credit risk issues
A new proposal would base the risk weighting on the credit rating of the company. This raises the issue of independence because ratings are assigned when paid for by debt issuers
Basel I – the role of credit ratings and the consideration that banks, with superior skills may be able to use internal systems to allocate capital (“sophisticated” banks)
Advantages: internal ratings are becoming popular in the assessment of a variety of risks
Internal ratings will use more data than used by external ratings
Given that internal ratings will be used for credit risk purposes, there may be an incentive to improve credit risk methods
Disadvantage: there will be a lack of standardized approaches for credit risk

12. Problem Loan Management
Outline why loans default
Highlight the extent of problem loans
Explain why the business cycle is important for problem loans
Define problem loans, provisions and regulatory issues
Discuss the capital issues of problem loans
Define “structure dynamic provisioning”
Restructure problem loans
Illustrate a case from law

13. Causes of Default
The primary issue of problem loans is that they can impair the value of a financial institution -> threaten its solvency
A default – a loan for which the repayments are overdue for the following reasons
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 growths in excess of the bank’s ability to manage
Inadequate systems for identifying loan problems
Insufficient knowledge about customers’ finance
Lending outside the market which the bank is familiar
Many problem loans could be avoided by better lending procedures and policies

14. Causes of Default
Credit risk is never static and many loans that were validly granted can become bad for many different reasons
Recession affects firms that rely on cashflow
Firms wind up because their products have become outdated
Monitoring a loan portfolio becomes more complex as the financial institution becomes larger -> higher costs
Monitoring models should provide warnings of developing problem loans

15. The Extend of Problem Loans
How should bankers should manage their problem loans
What are the various types of problem loan? How do we define them
How do lenders manage the impact of problem loans on profitability? Can they anticipate problem loans
Is there a pattern of when problem loans occur?
Is a grading attached to the severity of the problem loan and how its is managed?
What are the legal implications for managing problem loans
Liquidation – selling the borrower’s assets
Dynamic provisioning – statistical method that seeks to forecast doubtful debts and spread them over a number of years

16. The Business Cycle Recovery & Expansion Boom Downturn
High confidence in the economy and new investments increase
-> increased spending -> higher bank deposits -> banks have more money to lend -> relaxation of lending standards
Interest rates increase slightly
Boom
High asset inflation -> higher borrowing to invest in real assets
Overconfidence -> declining credit standards
Interest rates are rising
Downturn
Asset prices decline -> less spending -> decline cashflow
Banks experience their greatest problem loans

17. Problem Loans, Provisions & Regulatory
Borrower miss a repayment on loan -> is this permanent or temporary
If the situation persists for longer than 90 days -> impaired asset or non-performing loan
When a lending institution recognizes a problem, it needs to raise provisions
Specific provisions – written off income
General provisions – written off income
Bad-debt write-offs – written off balance sheet
A provision is recognition that income may not be received on a loan

18. Provisions Specific provisions General provisions Bad debt write-offs
Attached to loans or impaired assets
Specific provision is less than full value of the loan because banks expects that some of the debt if recoverable
General provisions
Are like specific provisions but they are not charged against a particular loan
The APRA views that 0.5% of total risk-weighted credit risk- weighted assets should be used as a benchmark for general provisioning
Bad debt write-offs
A debt is no longer recoverable

19. Dynamic Provisioning
The internal policy will reflect the risk appetite of the lender
Lenders need recognize
Credit risks change over time
Bad debts should not come as a surprise
A number of principles for dynamic provisioning
Classify the loans into homogenous groups
The different types of loan should be further broken down into groupings by maturity
Generates the probability of default for each loan class and the likely severity of loss
Determines the historical loan loss ratios
Historical loan loss ratios are then transformed to be predicative by the adjustment for economic circumstances
The transformed loan loss ratio applied to the current loan portfolio to determine provisions

20. Dealing with Defaults The three situations
Mild financial distress
Moderate financial distress
Severe financial distress
Two principles always applied
The primary aim of the bank is to minimize the loss to the bank. In many cases, liquidity is not the optimal choice
To manage these problems correctly, the economic worth of the loan is compared with the economic worth of the borrower

21. Mild Financial Distress
Companies experience temporary cashflow shortages
Never enters the public arena and is not captured by the regulator’s definitions (< 90 days)
Most common cause of illiquid is overly rapid growth of the firm
A number of remedies can be used
The bank agrees to an extension on the repayment
The bank would charge penalties to ensure there are disincentives to prevent the situation arising again
Banks should take further views or actions to ensure that their position is protected

22. Moderate Financial Distress
A temporary cashflow shortage is evident but the economic worth of the company is less than the repayment schedule of the loan
Remedial actions
Liquidation – not always the optimal choice
Restructure the loan to give the owner the incentive to continue. This restructure is determined by calculating the break-even amount of the loan under the circumstances that the company would continue

23. Severe Financial Distress
Missed debt payment and the borrower having an economic worth less than the repayment schedule
Issues to be considered
Whether the borrower has a sound business
Is the default due to reasons other than the nature of the business
Will the company worth more death or alive
How much can be recovered under each scenario

24. Other Breaches
Not all defaults are generated by missed loan repayments
Also when loan covenants are violated
Cashflow will not be unduly withdrawn from the company that would be available to repay loans
The overall risk of the company cannot be substantially changed
Gearing ratios
Dividend pay-out ratios
Interest coverage
What is the correct procedure to follow when a company breaches its covenants?
Remedial actions: renegotiate covenants