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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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