Concentrations of CreditAnalytical Overview

Introduction

• Credit extension is a primary source of revenue for Banks which risks earnings and

capital

• At the Heart is the “accurate identification of a borrower’s credit risk, the

assignment of a risk rating, and setting an adequate provision for loan loss”

• Illustration of FSG Bank risk rating scale mapped to that of rating agencies S&P

and Moody’s:

FSG AQR S&P Moody’s OCC/FDIC/FED

10 AAA Aaa

Pass

20 AA+AAAA-A+AA-

Aa1Aa2Aa3A1A2A3

30 BBB+ Baa1

60 CCC+ Caa1 Junk

Introduction_Cont’d

• However, Credit assessment also encompasses the management of

concentrations/pools of exposure, whose collective performance could

affect a Bank negatively.

• When therefore exposures in a pool are sensitive to the same economic,

financial, or business development, that sensitivity, once triggered could

cause all transactions to perform as though a single large exposure

• The Roles of the Bank with respect to Credit Concentrations then becomes

to:

a) Identify

b) Monitor

c) Measure

d) Control this risk related to Concentrations

What is key/Historic overview

• Understanding how the different exposures would work under stressed economic

situations is very key.

• In most instances in times past, concentrated exposures were booked during periods

of rapid economic expansion that were fueled partly by Bank Credit, frequently

including a weakening of underwriting Standards

• Below is a brief discussion of the 2009 Global Financial Crisis: a situation that

many believe would have been mitigated (in part) by Bank’s closely monitoring

various Credit profiles especially with respect to Real Estate Lending

2009 Global Financial Crisis

• “Caused by Wide Spread failures in financial regulation and supervision…”

• The “Housing Bubble”_ Real Estate Markets typically involve longer boom

and bust periods. They are typically seen as an example of Speculative or

Credit Bubbles.

• Commercial Banks play a substantial role in Real Estate lending by advancing

Mortgages. These typically are easier to foreclose on owing to the availability

of tangible Collateral. However, in the event of a Crush like that of ‘09,

financial Institutions suffer a severe hit.

• The ‘09 Crisis, however, was controlled in large part by different Central Banks

advancing stimulus packages. This is a notion that aligns itself largely to the

Keynesian Economic school of thought that is briefly discussed below.

Keynesian theory: AD=C+G+I+(X-M)

What then?

• In order to avoid situations like these, governing bodies like the OCC have

expectations that Bank Boards implement Board approved policies appropriate to

the size and complexity of their portfolios coupled with risk management, loan

review, and audit oversight.

• This typically involves a long process, and a constant updating of various loan

portfolios in a bid to mitigate risk outcomes.

• In order to asses Credit risk therefore, assets can typically be categorized into

different pools in accordance with similar performance traits.

Examples of Pool classifications

Historically, the OCC has categorized pools of transactions that may perform similarly

(i.e., whose performance is positively correlated) as those that include credit exposures

that are:

• dependent on the same source of repayment (including guarantors).

• extended to independent borrowers who sell the same manufacturer’s product.

• extended to an industry or to economic sectors.

• purchased from a single-source.

• secured by a common debt or equity instrument.

• extended to other financial institutions including but not limited to due from

accounts, federal funds sold, investments, net current exposure of derivatives

contracts, and direct or indirect loans.

• originated within a geographic area that might also be dominated by one or a few

business enterprises.

• owed by a foreign government or related entities.

Illustration _ finding similarities• Assuming you had the following exposures grouped into different pools. Even upon grouping them, it

would be very likely that you would have similarities arise within the pools. This could call for an even

further assessment/grouping as shown below:

• NB: Our exposures are 1, 2, 3, 4, 5, 6, 7, 8, 9

Pool A

Includes exposures 2,5,8

Pool B

Includes exposures 4,3

Pool C

Includes exposures 6,9

Pool D

Includes exposures 1,7

Pool E

Could Include exposures in Pools C and D if

similarities established

Plug In: Aggregating Credit

• In the event that a common enterprise exists, loans from different borrowers can

typically be aggregated. This principle is fairly similar to the above discussed issue

of pool classifications (asset groupings). However, this is dependent on various

prior stipulated conditions. For FSG Bank, these include:

a) The “expected source of repayment” for two or more loans is the same

b) Funds are borrowed for the purpose of acquiring ≥ 50% of voting securities in an

acquisition to a related borrower

c) The borrowers are related through common control and are financially

interdependent or engaged in interdependent businesses

“Common Control”

This is presumed to exist when:

• One or more persons acting in concert directly or indirectly have the power to vote

20% of any class of voting securities, or

• One or more persons acting in concert control in any manner, the election of a

majority of the directors, trustees, or persons exercising similar functions, or

• Any other circumstances exist which indicate that one or more persons acting in

concert exercise a controlling influence over management or policies of the entity

(for example, a general partner).

“Financial Interdependence”

Financial Interdependence is said to exist when:

• Fifty percent or more of one borrower’s annual gross receipts or gross expenditures

are derived from or paid to one or more related persons through common control.

Gross receipts and expenditures are defined to include loans, dividends, capital

contributions and similar receipts or payments.

Other considerations

Loans are also to be aggregated under the circumstances described below even though

there is no common enterprise:

• Loans are always to be combined when loans to a second borrower are made for

the “tangible economic benefit” of a first borrower, whether or not a legal exposure

is provided in the loan documents.

• Loans to partnerships, joint ventures, and associations are always to be combined

with loans to members, except for limited partners or members whose partnership

or membership agreements provide that they are not to be held liable for the debt or

actions of the partnership, joint venture, or association.

• Loans are to be combined when funds are borrowed for the purpose of acquiring

any interest in a partnership, joint venture, or association, without regard to the

percentage interest to be owned after the acquisition.

House and Portfolio limits

Concentrations or aggregations of risk significantly increase the potential for volatility

in portfolio credit quality and earnings. In that respect, the Bank’s Board has

established the following limits:

House Limits AQR Limits

Exceptions to

House Limits

require approval at

the next highest

required level

(not to exceed

CLC)

10,20 $7.5MM

30 $6.0MM

40 $4.0MM

50 $2.0MM

60 $1.0MM

Aggregation of 10 largest borrowers: 100% of Tier 1 Capital

Limits _ cont’d

Aggregate relationships representing exceptions to the House Limits above shall not exceed:

100% of Tier 1 Capital

Relationships with multiple entities having different AQR’s shall be subject to general

interpolation to determine the appropriate House Limit based on weighted AQR.

Industry, property type: 50-75% of Tier 1 Capital

Excluded from House Limits

• Obligations of, or obligations guaranteed by, the GOOD FAITH and CREDIT of the United States of America, or any public body or municipal entity or any political subdivision with taxing powers and representing general obligations rated “A” or better thereof;

• Obligations which the Bank would be authorized to acquire without limit as investment securities;

• Guarantees or commitments or agreements to take over or purchase made by any department, bureau, board, commission or establishment of the United States of America or any corporation owned directly or indirectly by the United States of America; or

• Any obligation fully secured by either:

Pledged cash on deposit with FSG, or

Readily marketable securities within the possession or control of FSG and subject to prudent margin maintenance requirements

The Value of Stress Testing

A Brief Discussion

• Stress Test can be defined as an “analysis conducted under unfavorable economic

scenarios which is designed to determine whether a Bank has enough Capital to

withstand the Impact of Adverse Developments.”_ Investopedia

• Key Issues focused on can include:

a) Credit Risk: The risk of loss of principal or loss of a financial reward stemming

from a borrower's failure to repay a loan or otherwise meet a contractual obligation

b) Market Risk: The possibility for an investor to experience losses due to factors that

affect the overall performance of the financial markets, and

c) Liquidity risk: The risk stemming from the lack of marketability of an investment

that cannot be bought or sold quickly enough to prevent or minimize a loss

Conclusion: MIS is valuable

• With respect to Mitigation of risk therefore, it is imperative that financial

institutions have Management Information Systems that they can greatly monitor in

a bid to safe guard themselves while providing quality services.

• Data quality is vital BUT so is the scope of data elements that are captured; these

should be proportional to the portfolio’s diversity and risk profile.

Sources cited:

• Comptroller’s Handbook Booklets

• OCC Issuances

• FSG Bank Loan Policy

• Investopedia

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