Chapter 11 Flashcards
(19 cards)
How can a banks reduce credit risk with their loans?
By having diversified loans meaning you lend to people in different industries so not on industry is too concentrated (ex: lend to restaurant and lend to pawn shop. When one goes down, the other may go up)
Can banks have negatively correlated loans?
Yes
What is migration analysis
It is a system that tracks credit rating of firms in a particular industry
Draw an example of a loan migration matrix and explain it
Can it happen where a loan starts as an AAA and go to other ratings?
Yes loans can go up and down in terms of rating
What is special about the D category in the loan matrix?
No matter what rating the loan started at, if the rating goes to D that means it is a default loan. You would add up the D rating in loan matrix and that would be the percentage of default loan
What is concentration limits in terms of loans? Give an example
It is where the bank will limit the amount of money they loan out in certain industries.
(ex: bank has 20% of their loans dedicated to mortgages)
What is large exposure limits
It is the max amount of credit a bank can have to a single borrower which is 25% in Canada. The 25% is amount of capital (equity) of the bank NOT percentage of their assets
What are the 2 ways the concentration limits are set
1) Based on the chances of the loan defaulting
2) Based on how much they can lend in regards to their capital
What is minimum risk portfolio
One that applies modern portfolio theory which is a combination of assets that reduce portfolio risk to the lowest feasible level
How do you calculate interest spread
Interest customer is paying - cost of interest for the bank
What is “potential loss of capital” for bank
Means if the loan defaults, the bank is exposing themselves to that amount of capital
(ex: potential loss of capital is 25%. That means if the loan defaults, the bank is exposing themselves to 25% of the amount the lent out on that specific loan)
What is the formula for calculating the expected return
(Interest spread + annual fees) - (prob of default x potential loss)
What is the formula of the risk
(square root of (prob of default x prob of not defaulting)) x potential loss
Give 5 ways to say which loan is riskier than the other
1) higher spread in interest is riskier
2) higher probability of default is riskier
3) higher potential loss of capital is riskier
4) higher fees on the loan is riskier
5) higher standard deviation is riskier
With a two security portfolio, how do you calculate expected return of the portfolio
Expected return = (weight A x return A) + (weight B x return B)
When combining two securities, how do you know if modern portfolio theory is being applied?
You look at risk of both securities alone but when they are put together, the overall risk should go down
What are SIC codes
They are standard industry codes based on the industry the business is in. This makes it easy for banks to classify their loans and determine the weight of their portfolio based on how much loan is in each SIC code to allow the bank not to over expose themseleves
What are the two types of regulatory aspects to remember regarding the bank loans given out compared to their capital and bank loans given out compared to their assets?
1) The bank cannot loan more than 25% of their capital to one entity
2) The bank cannot loan out any more than than 5% of their assets to any sort of policy for property, casualty or life insurance
