Chapter 20 4122 Credit risk on BS

RAROC (Formula)

(One-year income on loan)/(Loan risk or value at risk)

100 basis points equals?

1%

Base lending rate of 8% (BR), 110 basis point risk premium (m), 1 % origination fee (f), bank requires borrower to maintain compensating balances of 7% of the loan amount (b), Reserve requirement is 10% (RR), loan amount is 1 million, calculate gross return.

1+k=1+[(f+(BR+m))/(1-b(1-RR))] and k = 10.78%

FICO credit Score (Range and average)

300 to 850 range, average between 600 and 800

A bank charges a commercial borrower a 6.55 percent interest rate on a one-year loan. The bank also charges a 0.5 percent origination fee and requires compensating balances of 7 percent in the form of demand deposits. Reserve requirements are 10 percent. What is the promised gross rate of return on the loan? Select one: a. 8.45 percent b. 7.89 percent c. 9.10 percent d. 7.52 percent e. 6.95 percent

7.52 percent

A corporate customer obtains a $1.5 million loan from a bank. The customer agrees to pay a 6.25 percent interest rate and agrees to make compensating balances of 4 percent of the loan amount. These will be held in noninterest-bearing transactions deposits at the bank for one year. The bank charges a 1 percent loan origination fee on the amount borrowed. Reserve requirements are 10 percent. What is the expected rate of return to the bank (k) (to the nearest basis point)? Select one: a. 7.99 percent b. 8.45 percent c. 7.52 percent d. 8.01 percent e. 6.95 percent

7.52 percent

Extreme loss rate

99th percentile

RAROC<ROE

Either adjust loan so RAROC>ROE or decline to make the loan

Credit Allocation

FI makes loans to corporations, individuals, gov'ts & FI accepts risk of loans in return for interest

Credit Scoring Systems

FI's use to evaluate potential borrowers

_____________________ is the process of taking possession of the mortgaged property to satisfy the debt in the event of failure to repay the mortgage and foregoing claim to any deficiency. Select one: a. Power of sale b. Foreclosure c. Conditions precedent d. Perfecting collateral e. Lien enforcement

Foreclosure

Z-score less than 1.81 mean?

High default risk

Altman's Z-score (Higher and lower mean what?

Higher the Z score, lower probability of borrower default

In analyzing credit risk for a loan to a major diversified corporation, the bank typically has which of the following advantages? I. Market-based models to analyze credit risk II. Greater negotiating power due to the size of the loan required III. Ratings agency measures of default risk Select one: a. I and III only b. II and III only c. I only d. I and II only e. I, II, and III

I and III only

Z-score in between 1.81 and 2.99?

Indeterminate default risk

A firm with a low Z-score has high Select one: a. insolvency risk b. interest rate risk c. liquidity risk d. international risk e. none of the options

Insolvency Risk

Who's more likely to accept riskier loans? Large or small banks

Larger banks

______ banks are more exposed to more counterparty risk off-the-balance-sheet than _____ banks

Larger, Smaller

In concept, the RAROC measure indicates a loan is acceptable if the RAROC is greater than the Select one: a. lender's ROA b. NCO rate c. borrower's ROA d. lender's ROE e. borrower's ROE

Lender's ROE

Z-score of 2.99 or more means?

Low default risk

RAROC>ROE

Make the loan

Perfecting Collateral

Process of ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default on the loan

Large C&I lending

Rely on rating agencies and market analysts to aid in their credit analysis

RAROC (Acronym and Def)

Risk-adjusted return on assets - balances loan's expected income against its expected risk

Mid-market commercial and industrial lending

Sales rev of $5 mil to $100 mil, can be short term or long term loans

Consumer and Small business lending

Techniques similar to mortgage lending

One year income on loan

Total Income-Dollar cost to finance the loan

Credit analysis of a mid-market corporate borrower differs from the analysis of a small business in that the analysis of the mid-market borrower is more focused on the business itself and less on the business owners (T/F)

True