1. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-1 McGraw-Hill/Irwin Chapter Twenty Managing Credit Risk on the Balance Sheet

2. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-2 McGraw-Hill/Irwin Overview: Credit Risk Management An FI’s ability to evaluate information and control and monitor borrowers allows them to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governments An FI accepts credit risk in exchange for a fair return sufficient to cover the cost of funding An FI’s ability to evaluate information and control and monitor borrowers allows them to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governments An FI accepts credit risk in exchange for a fair return sufficient to cover the cost of funding

3. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-3 McGraw-Hill/Irwin Credit Analysis Real Estate Lending –Two considerations: the applicant’s ability and willingness to make timely interest and principal repayments the value of the borrower’s collateral –GDS (gross debt service) ratio –TDS (total debt service) ratio Real Estate Lending –Two considerations: the applicant’s ability and willingness to make timely interest and principal repayments the value of the borrower’s collateral –GDS (gross debt service) ratio –TDS (total debt service) ratio

4. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-4 McGraw-Hill/Irwin Credit Scoring Credit scoring system Perfecting collateral Foreclosure Power of sale Credit scoring system Perfecting collateral Foreclosure Power of sale

5. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-5 McGraw-Hill/Irwin Credit Scoring Consumer (Individual) and Small-Business Lending –techniques for scoring consumer loans –small-business loans more complicated Consumer (Individual) and Small-Business Lending –techniques for scoring consumer loans –small-business loans more complicated

6. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-6 McGraw-Hill/Irwin Mid-Market Commercial and Industrial Lending Definition of Mid-market Credit Analysis - Five C’s of Credit –character, capacity, collateral, conditions, and capital Cash Flow Analysis –provides relevant information about the applicant’s cash receipts and disbursements Definition of Mid-market Credit Analysis - Five C’s of Credit –character, capacity, collateral, conditions, and capital Cash Flow Analysis –provides relevant information about the applicant’s cash receipts and disbursements

7. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-7 McGraw-Hill/Irwin Ratio Analysis Historical audited financial statements and projections of future needs Financial statement analysis Relative ratios offer information about how a business is changing over time Particularly informative when they differ either from an industry average or from the applicant’s own past history Historical audited financial statements and projections of future needs Financial statement analysis Relative ratios offer information about how a business is changing over time Particularly informative when they differ either from an industry average or from the applicant’s own past history

8. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-8 McGraw-Hill/Irwin Calculating Ratios Liquidity Ratios Current Ratio = Current assets Current liabilities Quick ratio = Current assets - Inventory Current liabilities (continued) Liquidity Ratios Current Ratio = Current assets Current liabilities Quick ratio = Current assets - Inventory Current liabilities (continued)

9. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-9 McGraw-Hill/Irwin Asset Management Ratios Number of days sales = Accounts receivable x 365 in receivables Credit sales Number of days = Inventory x 365 in inventory Cost of goods sold Sales to working = Sales capital Working capital Sales to fixed = Sales assets Fixed assets Sales to total assets = Sales Total assets Asset Management Ratios Number of days sales = Accounts receivable x 365 in receivables Credit sales Number of days = Inventory x 365 in inventory Cost of goods sold Sales to working = Sales capital Working capital Sales to fixed = Sales assets Fixed assets Sales to total assets = Sales Total assets (continued)

10. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-10 McGraw-Hill/Irwin Debt and Solvency ratios Debt-asset ratio = Short-term liabilities + Long-term liabilities Total assets Fixed-charge = Earnings available to meet interest charges coverage ratio Fixed charges Cash-flow-to-debt = EBIT + Depreciation ratio Debt where EBIT represents earnings before interest and taxes (continued) Debt and Solvency ratios Debt-asset ratio = Short-term liabilities + Long-term liabilities Total assets Fixed-charge = Earnings available to meet interest charges coverage ratio Fixed charges Cash-flow-to-debt = EBIT + Depreciation ratio Debt where EBIT represents earnings before interest and taxes (continued)

11. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-11 McGraw-Hill/Irwin Profitability Ratios Gross margin = Gross profit Sales Operating profit margin = Operating profit Sales Return on assets = EAT_____ Total assets Return on equity = EAT Dividend payout = Dividends Total equity EAT where EAT represents earnings after taxes, or net income Profitability Ratios Gross margin = Gross profit Sales Operating profit margin = Operating profit Sales Return on assets = EAT_____ Total assets Return on equity = EAT Dividend payout = Dividends Total equity EAT where EAT represents earnings after taxes, or net income

12. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-12 McGraw-Hill/Irwin Common Size Analysis and After the Loan Analyst can divide all income statement amounts by total sales revenue and all balance sheet amounts by total assets Year to year growth rates give useful ratios for identifying trends Loan covenants reduce risk to lender Conditions precedent Analyst can divide all income statement amounts by total sales revenue and all balance sheet amounts by total assets Year to year growth rates give useful ratios for identifying trends Loan covenants reduce risk to lender Conditions precedent

13. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-13 McGraw-Hill/Irwin Large Commercial and Industrial Lending Attractive to FIs because transactions are often large enough make them very profitable FIs act as broker, dealer, and adviser in credit management The standard methods of analysis used for mid- market corporates applied to large corporate clients but with additional complications Financial ratios are usually key factors for corporate debt Attractive to FIs because transactions are often large enough make them very profitable FIs act as broker, dealer, and adviser in credit management The standard methods of analysis used for mid- market corporates applied to large corporate clients but with additional complications Financial ratios are usually key factors for corporate debt

14. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-14 McGraw-Hill/Irwin Altman’s Z-Score Used for analyzing publicly traded manufacturing firms Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + 1.0X 5 where Z = an overall measure of the borrower’s default risk X 1 = Working capital/Total assets X 2 = Retained earnings/Total assets X 3 = Earnings before interest and taxes/Total assets X 4 = Market value of equity/Book value of long-term debt X 5 = Sales/Total assets The higher the value of Z, the lower the default risk Used for analyzing publicly traded manufacturing firms Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + 1.0X 5 where Z = an overall measure of the borrower’s default risk X 1 = Working capital/Total assets X 2 = Retained earnings/Total assets X 3 = Earnings before interest and taxes/Total assets X 4 = Market value of equity/Book value of long-term debt X 5 = Sales/Total assets The higher the value of Z, the lower the default risk

15. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-15 McGraw-Hill/Irwin The KMV Model Banks can use the theory of option pricing to assess the credit risk of a corporate borrower The probability of default is positively related to: –the volatility of the firm’s stock –the firm’s leverage A model developed by KMV corporation is being widely used by banks for this purpose Banks can use the theory of option pricing to assess the credit risk of a corporate borrower The probability of default is positively related to: –the volatility of the firm’s stock –the firm’s leverage A model developed by KMV corporation is being widely used by banks for this purpose

16. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-16 McGraw-Hill/Irwin Calculating the Return on a Loan A number of factors impact the promised return that an FI achieves on any given dollar loan –the interest rate on the loan –any fees relating to the loan –the credit risk premium on the loan –the collateral backing the loan –other nonprice terms (such as compensating balances and reserve requirements) A number of factors impact the promised return that an FI achieves on any given dollar loan –the interest rate on the loan –any fees relating to the loan –the credit risk premium on the loan –the collateral backing the loan –other nonprice terms (such as compensating balances and reserve requirements)

17. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-17 McGraw-Hill/Irwin Return on Assets (ROA) 1 + k =1 + f + (L + m) 1 - (b(1 - R)) where k = the contractually promised gross return on the loan f = direct fees, such as loan origination fee L = base lending rate m = risk premium b = compensating balances R = reserve requirement charge 1 + k =1 + f + (L + m) 1 - (b(1 - R)) where k = the contractually promised gross return on the loan f = direct fees, such as loan origination fee L = base lending rate m = risk premium b = compensating balances R = reserve requirement charge

18. ©2007, The McGraw-Hill Companies, All Rights Reserved 20-18 McGraw-Hill/Irwin Risk-Adjusted Return on Capital (RAROC) Lending officer balances the loan’s expected income against the loan’s expected risk RAROC = One-year income on a loan divided by either Loan (asset) risk or capital at risk Lending officer balances the loan’s expected income against the loan’s expected risk RAROC = One-year income on a loan divided by either Loan (asset) risk or capital at risk