5530 Ch11

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Chapter 11: 4, 7, 8, 10, 11, 12, 14, 15, 18, 20, 21, 22, 23, 24, 26, 27

Chapter Eleven
Credit Risk: Individual Loan Risk

Chapter Outline

Introduction

Credit Quality Problems

Types of Loans

• Commercial and Industrial Loans
• Real Estate Loans
• Individual (Consumer) Loans
• Other Loans

Calculating the Return on a Loan

• The Contractually Promised Return on a Loan
• The Expected Return on a Loan

Retail versus Wholesale Credit Decisions

• Retail
• Wholesale

Measurement of Credit Risk

Default Risk Models
• Qualitative Models
• Quantitative Models

Summary

Appendix 11A: Credit Analysis (www.mhhe.com/saunders7e)

Appendix 11B: Black-Scholes Option Pricing Model (www.mhhe.com/saunders7e) Solutions for End-of-Chapter Questions and Problems

1.Why is credit risk analysis an important component of FI risk management? What recent activities by FIs have made the task of credit risk assessment more difficult for both FI managers and regulators?

Credit risk management is important for FI managers because it determines several features of a loan: interest rate, maturity, collateral and other covenants. Riskier projects require more analysis before loans are approved. If credit risk analysis is inadequate, default rates could be higher and push a bank into insolvency, especially if the markets are competitive and the margins are low.

Credit risk management has become more complicated over time because of the increase in off-balance-sheet activities that create implicit contracts and obligations between prospective lenders and buyers. Credit risks of some off-balance-sheet products such as loan commitments, options, and interest rate swaps, are difficult to assess because the contingent payoffs are not deterministic, making the pricing of these products complicated.

2. Differentiate between a secured and an unsecured loan. Who bears most of the risk in a fixed-rate loan? Why would FI managers prefer to charge floating rates, especially for longer-maturity loans?

A secured loan is backed by some of the collateral that is pledged to the lender in the event of default. A lender has rights to the collateral, which can be liquidated to pay all or part of the loan. With a fixed-rate loan, the lender bears the risk of interest rate changes. If interest rates rise, the opportunity cost of lending is higher, while if interest rates fall the lender benefits. Since it is harder to predict longer-term rates, FIs prefer to charge floating rates for longer-term loans and pass the interest rate risk on to the borrower.

3.How does a spot loan differ from a loan commitment? What are the advantages and disadvantages of borrowing through a loan commitment?

A spot loan involves the immediate takedown of the loan amount by the borrower, while a loan commitment allows a borrower the option to take down the loan any time during a fixed period at a predetermined rate. This can be advantageous during periods of rising rates in that the borrower can borrow as needed at a predetermined rate. If the rates decline, the borrower can borrow from other sources. The disadvantage is the cost: an up-front fee is required in addition to a back-end fee for the unused portion of the commitment.

4. Why is commercial lending declining in importance in the U.S.? What effect does this decline have on overall commercial lending activities?

Commercial bank lending has been declining in importance because of disintermediation, a process in which customers are able to access financial markets directly such as by issuing commercial paper. The total amount of commercial paper outstanding in the U.S. has grown dramatically over the last twenty years. Historically, only the most creditworthy borrowers had access the commercial paper market, but more middle-market firms and financial institutions now have access to this market. As a consequence of this...
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