The goal of loan risk management is to maximise a bank?s risk-adjusted rate of return by maintaining loan risk exposure within acceptable parameters. Banks need to manage the loan risk in the whole portfolio as well as transactions. Banks should also consider the relationships between loan risk and other risks. The effective management of loan risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organisation.? For most banks, loans are the largest and most obvious source of credit risk.? Lenders can limit their risk in several ways. Different techniques are subsequent described.
A collateral can be an asset (a house, land, stocks, etc) or the warranty of the third parts. A bank demands a collateral, which can be sold after the borrower?s default to repay loan, thus the lender can reduce consequently his credit risk.? As the collateral?s market value is generally volatile during loan repayment time the bank has to consider the possible lowest value of the collateral before lending the capital. If the borrower defaults, lenders will have to foreclosure the collateral and sell it to cover possible financial losses. There might arise a problem with liquidity, especially, if real estate property has been used as collateral. Real estate is generally illiquid asset and selling can take a long time. Also banks have to consider additional collateral?s selling fees, which can swallow easily 2-5 percent of the collateral?s price (Kask, 1997).
A bank requires a mortgage down payment ? which is the difference between the value of a property and the amount of a given loan. Down payment is estimated by using the loan-to-value (LTV)- it depends on the property type and market volatility, but the amount of down payment is usually around 20-30 percent of a collateral?s market value. LTV is usually calculated by dividing the loan amount by the appraisal value of the underlying collateral, and it is a clear and measurable lending standard for real estate loans (Kask, 1997).
Lenders impose LTV restrictions to allow for the risk of a fall in real estate prices and to cover costs generated when the lender has to sell the collateral. Based on past experience of crises, this ratio can play a key role in the development of banking crises.? If LTV ratios are sufficiently low, the rate of borrower defaults could remain on same level. If LTV ratios are high, banks could incur losses even if the real estate prices decline was not drastically. The smaller the size of the down payment paid by the borrower, the higher the default risk to the lender. The dimension of banks? losses in the case of borrower?s defaults is equal to the difference between the amount of the loan and the value of the collateral (European Central Bank, 2000).
As you can see in Table 2, loan-to-value ratios (LTV ratios) are highly country-specific. The ratios are average values and vary with the risk of the project. The loan to value ratios in the United States are imposed by the Federal Reserve Board as maximum ratio guidelines for lenders (Ciochetti, 1999).? But in all cases there is one main principle: the higher the risk of default, the lower the LTV ratio.
The loan to value ratios for commercial properties compared to residential properties are smaller, thus commercial properties are more risky.
For borrowers in commercial real estate market, the bank has to estimate the debt service coverage ratio for each real estate company or development project. The debt service coverage ratio (DCR) is defined as the ratio of net operating income to mortgage payment. The amount of loan and therefore the amount of the monthly payments is decided by analysing the company?s future cash flows and net operating incomes. The debt service coverage ratio is the ratio of net operating income (NOI) and debt payment.
The lower the DCR relative to the net operating income, the higher the default risk for the lender. In USA, for example, lenders usually require a debt coverage ratio of at least 1.2 percent.?The maximum amount of loan to commercial property is calculated as follows
For borrowers in residential market (home buying loans), the bank has to estimate the mortgage debt service ratio for each borrower, which shows how much of the mortgage payment can the borrower ?afford?? The larger the mortgage payment relative to the borrower?s income, the higher the default risk for the lender.
Generally there are two main rules of thumb for borrowing mortgage funds:
- 28% Rule: Mortgage payment (principal and interest payments, property taxes, mortgage insurance payments) should not exceed 28% of the gross monthly income.
- 36% Rule: Mortgage payment plus revolving credit payments (i.e., credit card payments, car payments) should not exceed 36% of the gross monthly income (Kask, 1997).
Another way to prevent bank?s possible financial losses is monitoring. A bank should monitor conditions in the real estate and construction markets in its lending area so that it can react quickly to changes in market conditions that are relevant to its lending decisions. The following market supply and demand factors must be included:
- ?Demographic factors, like population and employment trends
- ?Zoning and planning requirements
- ?Current and projected vacancy and absorption rates
- ?The volume of available space, including completed, under construction, and new projects approved by local building authorities but not yet under construction
- Current and projected lease terms, rental levels, and sales prices
- Current and projected operating expenses for different types of projects
- Economic indicators, including trends and diversification of the market
- Valuation trends, including discount and direct capitalization rates (OCC, 1999)
Generally credit scoring determines the probability of default when granting customers a credit. Banks use credit-scoring systems to evaluate loan applicants (Case and Shiller, 1995). The evaluation of the credit worthiness of an individual or of a company is based on relevant factors indicating ability and willingness to pay obligations (payment record) as well as net worth (Woelfel, 1998). The objective of such credit scoring models typically is to minimize default rates or the number of incorrectly classified loans. From an utility maximizing perspective it is not only important to know if but also when a loan will default. Loans are granted in a way that conflicts with both default risk minimization and survival time maximization.? There is thus no trade-off between higher default risk and higher return in policy of banks.
The starting point of every loan is the application. When lending institutions receive an application for a loan, the process by which it is evaluated and its degree of sophistication can vary. Most use rather simple, subjective evaluation procedures. This could be non-formalized analysis of an applicant?s personal characteristics or ?scoring with integer numbers? on these characteristics. Some banks, however, have started to use a statistical ?credit scoring? model to separate loan applicants that are expected to pay back their debts from those who are likely to fall into arrears of payment or go bankrupt (Roszbach, 1998).
Tags: loan risk management ?
Source: http://www.estonianrealestate.net/market/risk-management.htm
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