UNIT 4

Managing a Bank’s Loan Portfolio

Session 4.1 - Credit Risk: Individual Loan Risk

Session 4.2 - Credit Risk: Loan Portfolio and

Concentration Risk

Overview

Most decisions that you make as individuals contain some element of risk reward. Are you
going to enjoy the potential positive impact of driving to the beach on a Sunday afternoon with
your friends not knowing if they can jet ski as successfully as they say they can? With the
possibility of having fun versus experiencing a negative occurrence, how do you ensure that
you benefit at the end of the day? Managing individual loan risks has some elements of such
analysis and subsequent actions to ensure a positive outcome.
The management of individual loan risk is important as it serves to reduce the loss exposure
that financial institutions will experience in their pursuit of profit maximization. The fact that a
financial institution’s most traditional revenue stream involves credit extension to a mass of
individual lenders, who have varying degree of risks characteristics, dictate that management of
individual loan risks and the loan portfolio are extremely important. This unit will introduce us
to loan risks, loan portfolio and liability management.

Unit 4 Learning Objectives

By the end of this Unit you will be able to:

1. Describe the types of loans
2. Note the characteristics of individual loans
3. Assess the credit risk measurement models used to measure individual loan and
portfolio risk

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This Unit is divided into two sessions as follows:
Session 4.1: Credit Risk: Individual Loan Risk
Session 4.2: Credit Risk: Loan Portfolio and Concentration Risk

Reading Resources
Required Reading

Central Bank News. (2012). Reserve Ratios. Retrieved from :
http://www.centralbanknews.info/p/reserve-ratios.html

Dugar, R. (2016). ALCO - Asset Liability Committee: Roles, Functions and

Objectives. Retrieved from https://goo.gl/fnDQeG

Horcher, K. (2005). Essentials of Financial Risk Management (Essentials series Y).

Chapter 5. Hoboken: John Wiley & Sons. [Available at UWIlinC]

Saunders, A. & Cornett, M. M.A. (2014). Appendix 11A: Credit Analysis. In

Financial Institutions Management: A Risk Management Approach (8 th

ed.). McGraw-Hill/Irwin. pp. 190 – 203. Retrieved from

http://bit.ly/2cCROAT

Saunders, A. & Cornett, M. M.A. (2014). Financial Institutions Management: A Risk

Management Approach (8 ed.). McGraw-Hill/Irwin.
th

Wright, R.E. (2012). Finance, Banking and Money (v 2.0). Credit Risk Chapter 9,
Section 9.4. Retrieved from http://bit.ly/2cCQK00. [CC BY-NC-SA 3.0]

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Session 4.1

Credit Risk: Individual Loan Risk

Introduction
As you seek to disburse individual loans to grow your revenue and increase possibility, it will
be important to exercise prudent credit management. In order to achieve this, it will be
necessary for you to be apprised of the management capabilities required. In this session we
will look at the types of loans and their characteristics.

Real Estate

Commercial
& Industrial

Types of
Loans

Consumer
Individual

Figure 4.1 Types of Loans

Commercial and Industrial Loans

A commercial and industrial loan are normally issued to a business or corporation to satisfy its
working capital needs or any other capital expenses. These loans are normally supported by
collateral to secure the loan and it varies in terms from a few weeks to possibly eight years.
(Saunders & Cornett, 2013)

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In the reading that follows, we examine characteristics of commercial and industrial loans as we
try to gain understanding of why it is necessary for prudent management of these portfolios
since the larger commercial entities have been tapping into the commercial paper market for
cheaper funds to use for their financing, which leaves the riskier, smaller companies to be
serviced by financial institutions.

Reading

Saunders, A. & Cornett, M. M.A. (2014). Financial Institutions Management: A Risk

Management Approach (8 ed.). McGraw-Hill/Irwin. pp. 278-280.
th

Real Estate Loans

For the majority of homeowners across the world, it would be virtually impossible to purchase
homes if it were not for the availability of financing to undertake such purchases. Real estate
loan refers to mortgage and home equity loans. Residential mortgages constitute a large portion
of real estate loans, while commercial real estate loans are secured by insurance companies. The
revenue for insurance companies are bolstered whenever there is a newly disbursed real estate
loan as a number of insurance elements has to be acquired for the subject property in order to
facilitate the qualification of the loan.
The subprime mortgage crisis of the mid 2000’s in the USA was as a result of poor credit
management practices that were being undertaken by finance houses. In the readings that
follows you’ll learn more about real estate loans and what caused the financial crisis.

Reading

Saunders, A. & Cornett, M. M.A. (2014). Financial Institutions Management: A Risk

Management Approach (8 ed.). McGraw-Hill/Irwin. pp. 280-282.
th

NUES. (2018). What Caused the Financial Crisis? Retrieved from

https://web.northeastern.edu/econsociety/what-caused-the-financial-
crisis/

Individual & Consumer Loans

Loans to purchase automobiles, for personal expenses, and financing through credit cards are
referred to as consumer loans. The nature of credit cards and the financial laws in some
countries allowing for bankruptcy filing to protect consumers makes it a bit more challenging
for financial institutions to proactively manage these loan portfolios (Saunders & Cornett, 2014).

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In the reading that follows note:
- How regulations have now made it relatively simple for financial institutions, among
other selected corporations, to issue individual and consumer loans, especially in the
form of credit cards
- The ease with which these revolving lines of credit can be issued without adequate risk
assessment impacts the annual credit card charge offs for financial institutions

Reading

Saunders, A. & Cornett, M. M.A. (2014). Financial Institutions Management: A Risk

Management Approach (8 ed.). McGraw-Hill/Irwin. pp. 282-284.
th

Further Reading
Wright, R.E. (2012). Finance, Banking and Money (v 2.0). Credit Risk Chapter 9,
Section 9.4. Retrieved from http://bit.ly/2cCQK00. [CC BY-NC-SA 3.0]

REFLECTION
Why are secured loans an important method of lending for financial
institutions? 


RETURN ON A LOAN
You should note that within the management process, the pricing of
these instruments are extremely important as they help to decide the
profitability and cash flow of the financial institution. In the following
reading please focus on:
- The interest rate on the loan.
- Any fees relating to the loan.
- The credit risk premium on the loan.

- The collateral backing of the loan and

- Other non price terms.
Which will all impact the projected return on a loan to be issued by the
financial institution.

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 Reading

Saunders, A. & Cornett, M. M.A. (2014). Financial Institutions Management: A Risk

Management Approach (8 ed.). McGraw-Hill/Irwin. pp. 284 – 288.
th

LEARNING ACTIVITY 4.1 (2 HOURS)

Activity Topic: Calculating Return on a Loan

1. Calculate the promised return (k) on a loan if the base rate is 13

percent, the risk premium is 2 percent, the compensating balance
requirement is 5 percent, fees are 1⁄2 per- cent, and reserve
requirements are 10 percent. (16.23%)

2. What is the expected return on this loan if the probability of default is

5 percent? (10.42%)

Source:
Saunders, A. & Cornett, M. M.A. (2014). Financial Institutions Management: A
Risk Management Approach (8 ed.). McGraw-Hill/Irwin. A
th

Measurement of Credit Risk

Now that you know how to calculate the return on a loan, you will now discover how the
return on a loan versus the quantity of credit made available for lending is used by FIs to make
decisions on wholesale (C&I) versus retail (consumer) lending. When addressing credit risk at
the retail and the wholesale levels cash flow and ratio analysis normally come into play.

In order to make a good assessment of potential borrowers, as a manager you will need to
gather as much information as possible about the potential credit customer. Information can be
bought from credit agencies and it is also available from public bodies. The availability of more
information allows FIs to use more sophisticated and usually more quantitative methods in
assessing default probabilities for large borrowers compared with small borrowers (Saunders &
Cornett, 2014). As you get acquainted with the credit scoring models in the reading below you
will discover the primary benefit of accurately predicting a borrower’s performance. It includes:
ü Being better able to screen out bad loan applicants; and
ü Being in a better position to calculate any reserves needed to meet expected future loan
losses

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 Reading

Saunders, A. & Cornett, M. M.A. (2014). Financial Institutions Management: A Risk

Management Approach (8 ed.). McGraw-Hill/Irwin. pp. 291 – 298.
th

Management of Credit Risk

To be profitable, financial institutions must overcome the various problems that make loan
defaults more likely. Financial institutions therefore need to make attempts to solve these
problems by employing a number of principles for managing credit risk: screening and
monitoring, establishment of long-term customer relationships, loan commitments, collateral,
compensating balance requirements. In the reading that follows you will discover more about
these principles which aid in managing credit risk.

Reading
Wright, R.E. (2012). Finance, Banking and Money (v 2.0). Credit Risk Chapter 9,
Section 9.4. Retrieved from http://bit.ly/2cCQK00. [CC BY-NC-SA 3.0]

Further Reading
Horcher, K. (2005). Essentials of Financial Risk Management (Essentials series Y).
Chapter 5. Hoboken: John Wiley & Sons. [Available at UWIlinC]

Session Summary

This session exposed the varying approaches to measuring and managing credit or default risk
on individual loans. The different types of loans made by FIs and some of their basic
characteristics were first examined while expected return on a loan was shown to depend on a
number of factors such as, interest rates. We also examined where the models used to assess
individual loan risks were both qualitative and quantitative models. In the next session we will
focus on loan portfolio and concentration risk.

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Session 4.2

Credit Risk: Loan Portfolio and

Concentration Risk

Introduction
In the previous session you were exposed to various ways of measuring and managing risks on
individual debt. The amalgamation of individual debts gives rise to portfolios that are
compartmentalized by their distinguishing characteristics. The challenge within this context is
for managers of financial institutions to make decisions with regards to how these portfolios can
be diversified to increase the revenue of the institution.

Of importance is the fact that the individual risk return of each loan in the portfolio is of equal
importance as the overall portfolio is to the manager.

Models of Loan Concentration Risk

Two models that managers of FIs use to measure risk concentration in a loan portfolio are:
Ø Migration Analysis - a method to measure loan concentration risk by tracking credit
ratings of firms, in particular sectors or ratings class for unusual declines.
Ø Concentration limits - external limits set on the maximum amount of loans that will be
made to an individual borrower (Saunders & Cornett, 2014)

In the reading that follows you should note the following:

• Simple loan concentration risk models (migration analysis, concentration limits)

Reading
Saunders, A. & Cornett, M. M.A. (2014). Financial Institutions Management: A Risk
Management Approach (8 ed.). McGraw-Hill/Irwin. pp. 326 – 328.
th

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Portfolio diversification models are also used to measure and control the FI’s aggregate credit
risk exposure. By estimating the expected return on each loan, the manager can calculate the
portfolio return as well as take advantage of its size; an FI can diversify considerable amounts of
credit risk.
In the reading that follows you should note the following:

Ø Moody’s Portfolio Manager Model

Ø Partial Applications of Portfolio Theory
Ø Loan Loss Ratio–Based Models
Ø Regulatory Models

Reading
Saunders, A. & Cornett, M. M.A. (2014). Financial Institutions Management: A Risk
Management Approach (8 ed.). McGraw-Hill/Irwin. pp. 328 – 340.
th

LEARNING ACTIVITY 4.2 (2 HOURS)

Activity Topic: Sovereign Risk
Read the case below and respond to the questions:
Republic Bank has two $20,000 loans with the following
characteristics:

Loan A has an expected return of 10 percent and a standard deviation

of returns of 10 percent. The expected return and standard deviation
of returns for loan B are 12 percent and 20 percent, respectively.

a. If the correlation between loans A and B is .15, what are

the expected return and the standard deviation of this
portfolio?
b. What is the standard deviation of the portfolio if the
correlation is −.15?
c. What role does the covariance, or correlation, play in
the risk reduction attributes of modern portfolio
theory?

Adapted from:
Saunders, A. & Cornett, M. M.A. (2014). Financial Institutions
Management: A Risk Management Approach (8 ed.). McGraw-
th

Hill/Irwin.

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Session Summary

This session focused on the various approaches available to an FI manager to measure and
manage credit portfolio and concentration risk. It showed how portfolio diversification can
reduce the loan risk exposure of an FI. Two simple models that allow an FI to monitor and
manage its loan concentration risk were also discussed: migration analysis, which relies on
rating changes to provide information on desirable and undesirable loan concentrations, and a
model that sets concentration limits based on an FI’s capital exposure to different lending
sectors. We also looked at portfolio diversification models. In the next session we will examine
liquid assets and liabilities that a financial institution manager utilizes.

Unit 4 Summary

This unit has taken us a little further into liquidity management and how its close relationship
with liability management has dynamic implications for the FI manager. The decision by the FI
manager on the amount of liquid assets to hold influences the revenue of the institution by the
costs associated with them.
By managing its liabilities in a manner that affects the withdrawal risk of its funding portfolio
the requirement is for the availability of liquid assets to meet such withdrawals. Making them
available, on the other hand, increases the costs to the institution and reduces the income
earning potential of these assets since they are held as cash or near cash instruments. In the next
unit we will explore banking operations and related challenges in the Caribbean.

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References

Business Dictionary (n.d.) Liquidity Risk. Retrieved from

http://www.businessdictionary.com/definition/liquidity-risk.html

Investing Answers (n.d.). Liquidity Risk. Retrieved from http://bit.ly/2cEYxdp

Saunders, A. & Cornett, M. M.A. (2014). Financial Institutions Management: A Risk Management
Approach (8 ed.). McGraw-Hill/Irwin.
th

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