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Chapter 11 Credit Risk Individual Loans.docx

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FIN 701
Patricia Mc Graw

FIN701 Financial Institutions Management CHAPTER 11 Credit Risk: Individual Loans CREDIT QUALITY PROBLEMS  Credit quality problems can cause FI to become insolvent or result in such significant drain on capital and net worth that they adversely affect growth prospects and ability to compete with other domestic and international FIs TYPES OF LOANS Business Loans  Loans can be short-term or long-term ranging from $100,000 to $10 million or more to major corporations  Syndicated loan – loan provided by group of FI as opposed to single lender o Structured by the lead FI (or agent) and the borrower and once terms are set (rates, fees, and covenants), pieces of the loan are sold to other FIs  Secured loan – loan that is backed by first claim on certain assets (collateral) of the borrower if default occurs  Unsecured loan – loan that has only a general claim to assets of the borrower if default occurs  Loans can be made at either fixed or floating rates of interest o Fixed-rate loan has rate of interest set at beginning of contract period o Floating-rate loan has rate that can be periodically adjusted according to a formula so that interest rate risk is transferred in large part from FI to the borrower  Spot loan – loan amount is withdrawn by borrower immediately  Loan commitment – credit facility with maximum size and maximum period of time over which borrower can withdraw funds; a line of credit  Business loans have declined in importance in bank loan portfolios because of the rise in non-bank loan substitutes, especially commercial paper o Commercial paper – unsecured short-term debt instrument issued by corporations Mortgage Loans  Characteristics of loans differ widely, including size of the loans, ratio of loan to property’s price, maturity of mortgage, and mortgage interest rate  Variable rate mortgages (VRMs) – mortgage whose interest rate adjusts with movements in underlying market index interest rate  Residential mortgages are long-term loans, usually based on amortization period of 25 years o House prices can fall below amount of loan outstanding (loan-to-value ratio rises) and residential mortgage portfolio susceptible to default risk  Canada subject to conservative policies of CHMC and the limited use of subprime mortgages by lenders Personal (Consumer) Loans  Personal lines of credit – revolving loan that allows consumers to borrow and pay back an amount up to approved credit limit  Personal loan plans – consumer loans that have fixed-rate, fixed-term loans, and amortized payments  Revolving loan – credit line on which borrower can both draw and repay many times over the life of the loan contract  Rates differ depending on collateral backing, maturity, default rate experience, and non-interest rate fees Other Loans  “Other” loans category includes secured call loans (also called demand loans) and other short-term loans to investment dealers and brokers, loans to federal and provincial/territorial government, loans to municipal and school corporations, and loans to foreign (sovereign) governments CALCULATING THE RETURN ON A LOAN The Contractually Promised Return on a Loan  Factors that impact promised return an FI achieves on any given dollar loan (asset) amount 1. Interest rate on the loan 2. Any fees relating to the loan 3. Credit risk premium on the loan 4. Collateral backing of the loan 5. Other non-price terms (especially compensating balances and, in some countries, reserve requirements) FIN701 Financial Institutions Management  Base lending rate (BR) reflects FI’s weighted average cost of capital or its marginal cost of funds o LIBOR – London Interbank Offered Rate, which is the rate for inter-back dollar loans of given maturity in the offshore or Eurodollar market (short-term loans) o Prime lending rate – base lending rate periodically set by banks (long-term loans)  Direct and indirect fees and charges relating to loan fall into three categories: 1. Loan origination fee (of) charged to borrower for processing application 2. Compensation balance requirement (b) held as non-interest-bearing demand deposit  Compensating balances: percentage of loan that borrower is required to hold on deposit at lending institution o Acts as additional source of return on lending for an FI 3. Reserve requirement (RR) imposed by central bank on FI’s demand deposits, including any compensating balances  Contractually promised gross return on loan, k, per dollar lent – ROA per dollar lent  Commercial and corporate lending markets have become more competitive, both origination fees (of) and compensating balance (b) are becoming less important Assume of=0 and b=0 Expected Return on a Loan  Default risk – risk that borrower is unable or unwilling to fulfill terms promised under loan contract P = probability of complete repayment of loan (1-p) = probability of default  To the extent that p is less than 1, default risk is present and FI manager must 1. Set risk premium (m) sufficiently high to compensate for this risk
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