Loan Portfolio and its Risk Management.ppt

Loan and Risk Management

1. Ethiopian Institute Ethiopian Institute
of Financial Studiesof Financial Studies
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Agenda
1.Introduction
2.Passive Loan Portfolio Management
3.Monitoring Loan Portfolio Quality
Loan Portfolio Management

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First chapter
Introduction

3. Ethiopian Institute Ethiopian Institute
of Financial Studiesof Financial Studies
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CREDIT RISK MANAGEMENT CYCLE
Loan
Analysis
Loan
Application
Loan
Administration
Loan
Monitoring
Collection
1
2
4
5
6
CREDIT
RISK
MANAGEMENT
Loan
Decision
3

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In addition to individual credit risk, credit portfolio as a whole
is subject to a set of risks
Individual
repayment
capacity and
willingness
External
influences
(e.g. economic
sector risk,
regional risk)
Portfolio risk
Individual
repayment
capacity and
willingness
Individual
repayment
capacity and
willingness
Individual
repayment
capacity and
willingness

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of Financial Studiesof Financial Studies
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Portfolio risk factors come from three major sources
Sector risk
Regional risk
Loan
concentration
risk

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of Financial Studiesof Financial Studies
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Sector Risk
Market structure
risks
Exposure to
macroeconomic risks
Expected sector
growth
Expected sector
profitability
Political
conditions
In spite of high diversification, SME portfolios are subject to In spite of high diversification, SME portfolios are subject to
sector riskssector risks

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Portfolio Risk: Regional
Regional Risk
Socio-demographic
conditions
Macroeconomic
conditions
Geographic conditions
(e.g. microclimates)
Ecological conditions
Infrastructure
conditions
Political
conditions

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In a typical SME portfolio loan concentration risk is well managedIn a typical SME portfolio loan concentration risk is well managed
Loan
Concentration
Risk
Loan structureMaturity structure
Loan sizes Currency
concentration risk

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How diversified is this bank portfolio?
Rice Corn
Soya beans Sugarcane
Poultry Livestock
Handicrafts Agri-processing
Small industry Small shops
Restaurants Hotels
Koskosans Warungs
Kiosks Bicycle and motorcycle workshops
Renting agricultural equipmentCleaning services
Veterinarian services Wartels
Consumption loans

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of Financial Studiesof Financial Studies
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How diversified is this rural bank portfolio?
Consumption
Loans to
Individuals
29%
Warungs,
restaurants and
related
businesses
16%
Agriculture and
agriculture
related
businesses
12%
Small
production
0% Wartels
7%
Small services
2%
Koskosans
6%
Hotels
2%
Small shops
and Kiosks +
related
26%Agriculture and agriculture related b usinesses
Warungs and warung-related b usinesses
Small shops and Kiosks + related
Hotels
Koskosans
Small services
Wartels
Small production
Consumption Loans to Individuals

11. Ethiopian Institute Ethiopian Institute
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07.10.24.
Summary
Credit is the main risk of a bank risk profile . There is a trade off
between risk and profit.
•Portfolio risk can be defined as the degree of exposure of individual
loans to a range of risks.
•The key idea of loan portfolio management is to reduce portfolio risk
by keeping covariance and risk interdependencies at a minimum.
Simply speaking, the basic idea behind sound loan portfolio
management is “not putting all eggs in the same basket”.
•Portfolio risks primarily stem from concentrating lending operations in
economic sectors and/or geographic regions or specific customer
groups with a high risk exposure.
•Sector and geographic risk analysis as well as customer segment risk
is therefore an important component of loan portfolio management
practices

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Second chapterSecond chapter
Passive Loan MonitoringPassive Loan Monitoring

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Passive loan portfolio management is as much a science as an Passive loan portfolio management is as much a science as an
artart
Managers should act like ‘fortune-tellers”
Key is should try to assess the potential impact of risks on the key
segments of their portfolios

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Risk impact analysis matrix
Severity of Risk Effects
L
ik
e
lih
o
o
d

o
f

R
is
k

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Best Practice Agrees on a Set of Portfolio Management Rules (I):
Be aware of the risk concentrations and risk exposures in your Portfolio
Measure your Risks – look at historical trends as well as forecasts
Be prepared for potential crisis!
Develop a set of Loan Portfolio Management Policies, such as:
Set sector limits for the affected sectors
Price in extra risk into the interest rate
Request extra collateral from the borrowers in the affected sectors
In the riskiest sectors - accept only repeat borrowers
In extreme cases – try to limit exposure in specific sectors

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Best practice agrees on a set of portfolio management rules (ii):
Most current sector information is incorporated in loan appraisal of
new loans
Individual loan limits and sector limits are applied
Loan monitoring is accommodated to most current sector information,
So if an issue is identified monitoring is intensified

17. Ethiopian Institute Ethiopian Institute
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07.10.24.
Key questions
What percentage of the loan portfolio is non-performing due to
borrower default?
What is the ratio between delinquent borrowers and active borrowers?
How many of the currently delinquent loans are expected loan losses?
Do we reserve sufficient resources to be protected against the
expected loan losses?
What is the loan portfolio lost due to borrower default?
How strong is the loan portfolio concentrated in economic sectors,
regions or credit amounts?
In what way is portfolio concentration related to portfolio quality?
Is portfolio quality increasing or decreasing over time?

18. Ethiopian Institute Ethiopian Institute
of Financial Studiesof Financial Studies
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Summary of key indicators
Individual credit risk is measured by…
•A
rrears ratio
•P
ortfolio at risk ratio (PAR)
•D
elinquent borrowers ratio
•L
oan loss reserve ratio
•L
oan loss ratio
Concentration risk is measured by…
•R
egional concentration ratio
•S
ector concentration ratio
•L
oan concentration ratio

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of Financial Studiesof Financial Studies
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Third chapter
Monitoring Loan Portfolio Quality

20. Ethiopian Institute Ethiopian Institute
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Portfolio report
The following data from the daily portfolio report is needed to define credit
risk indicators:
Portfolio outstanding: Refers to the principal amount of loans outstanding (due
and past due) at the end of the period, i.e. it does not include projected future
interest income out of existing loans.
Value of payments in arrears: Includes the amount of payments that are in
arrears.
Number of loans in arrears: Refers to the aggregated number of loans that have
payments in arrears.
Value of outstanding balance of loans in arrears: Includes both the loan
installments that are in arrears and the remaining outstanding balance of those
loans that has not yet become due.
Value of loans written off during the period: Shows the value of loan losses
accounted for.

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Amount of Payments in Arrears
Amount of Loans Outstanding
Definition:
Arrears Ratio
This indicator measures portfolio quality only on the basis of the loan
amounts that have become due but not being paid yet. Therefore the arrears
rate understates the risk to the portfolio and the potential size of delinquency
problems as it limits the risk exposure to the payments that have become due
and not being received, while not considering the entire amount of the loans
outstanding that are actually under risk.

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Balance of Loans in Arrears
Amount of Loans Outstanding
Definition:
Portfolio at Risk (PAR) Ratio
PAR is based on a “worst case scenario” with regard to the future
repayment behavior of currently delinquent borrowers and their impact
on loan portfolio quality. Aging of PAR must be related to repayment
schedules; for monthly repayment use: PAR up to 30 days; PAR 31 –
60 days; etc. The aging definitions have to be clarified prior to setting
benchmarks or comparing loan portfolio quality between different s.

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Number of delinquent borrowers
Total number of active borrowers
Definition:
Delinquent borrowers ratio
This ratio is used in portfolio analysis to identify if delinquency
is concentrated in smaller or in larger loans. If the ratio of
delinquent borrowers is lower than PAR and arrears ratios,
then it can be assumed that delinquency is concentrated in
larger loans.

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07.10.24.
Loan Loss Reserve
Amount of Loans Outstanding
Definition:
Loan Loss Reserve Ratio
Loan loss reserves have to be built up according to the amount of
outstanding principal that is not expected to be recovered. The loan
loss reserves reduce the value of the net portfolio outstanding. Loan
loss reserves are established on the assumption that the longer a
borrower is delinquent the higher will be the probability that also future
installments are at risk. Therefore the LLR is based on an aging report
for the PAR.

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07.10.24.
Loan amount written off in the period
Average portfolio outstanding for the period
Definition:
Loan Loss Ratio
Loans are written off (taken off the balance sheet) if there is little or no
chance of loan recovery. However, the bank maintains its legal claim to
recover the loan. A comparison of the loan loss ratio over time informs the
bank about the quality of its risk policies. In addition, the value of loan write
offs can be compared to the value of loan loss reserves to determine if the
loan loss reserve is sufficient when compared to the amount of historical
loan losses.

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Total value of risky loans outstanding
Total value of loans outstanding
Definition:
Loan concentration ratio
Risky loans have to be defined in the credit policy, based on past
experience. For example: banks usually define “big loans” as loans
with more than 10 -15% of the institution’s equity. Other problem
loan categories can be bullet repayment loans or grace period
loans. The limits must be set by management.

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Total value of loans outstanding in problem sectors
Total value of loans outstanding
Definition:
Sector concentration ratio
Problem sectors and acceptable ratios must be defined in the credit
policy, e.g. max. 10% of portfolio in those sectors that historically
have PAR two times higher than average PAR. Observe the ratio
over time (trend analysis).

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Total value of loans outstanding in problem regions
Total value of loans outstanding
Definition:
Regional concentration ratio
Problem regions and acceptable ratios must be defined in the credit
policy, e.g. max. 10% of portfolio in those regions that historically
have PAR two times higher than average PAR. Observe the ratio
over time (trend analysis).

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Example: loan volume concentration riskExample: loan volume concentration risk
SAMPLE LOAN PORTFOLIO
Accounts Portfolio outstanding
Portfolio at risk
>30days
Credit size (Br)# % Value (Br)% Value (Br)%
< 250 990 22% 123,750 3% 1,2501.01%
251-500 1,125 25% 421,875 12% 9,8602.34%
501-1.000 1,350 30%1,012,500 28% 35,8003.54%
1.001-2.000 585 13% 877,500 24% 57,0906.51%
> 2.000 450 10%1,165,500 32% 47,2004.05%
Total 4.500100%3,601,125100% 151,2004.20%

30. Ethiopian Institute Ethiopian Institute
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Example: loan volume concentration risk - Explanation
•Average loan size is Br800
•26% of the outstanding loans are above Br1,000
•Loans of more than Br1,000 contribute strongly to portfolio at risk
•Repayment discipline of loans up to Br500 is excellent
•Data has to be compared with reports from previous periods to define
if the average credit size has increased and if the relative distribution of
the credits has changed.
•Credit policies may have to be revised.

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Sector concentration riskSector concentration risk
SAMPLE LOAN PORTFOLIO
Accounts Portfolio outstanding
Portfolio at risk
>30days
Sector # % Value (Br)% Value (Br) %
Trade 1,350 30% 612,000 17% 15,2002.48%
Construction 450 10% 540,000 15% 27,8005.15%
Transport 225 5% 216,000 6% 8,6003.98%
Coffee 360 8% 540,000 15% 13,5002.50%
Rice 315 7% 288,000 8% 4,1001.42%
Poultry 1,125 25% 792,000 22% 77,2009.75%
Other 675 15% 612,000 17% 4,8000.78%
Total 4,500100%3,600,000100% 151,2004.20%

32. Ethiopian Institute Ethiopian Institute
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Sector concentration risk - Explanation
Bank has a well diversified customer base: microenterprises in six
major economic sectors and 15% other sectors.
However, 45% of portfolio outstanding is in agriculture. Check whether
there are any risks that could affect the entire agriculture sector.
Poultry and Construction sectors have a high portfolio at risk. Take
immediate action to reduce delinquency in these sectors.
Prior to a strategic decision whether to alter the current portfolio
structure, the management should decide to evaluate the past
performance of the problem sectors in order to determine whether their
performance has improved or deteriorated in the recent past.

33. Ethiopian Institute Ethiopian Institute
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Regional concentrationRegional concentration
SAMPLE LOAN PORTFOLIO
Accounts Portfolio outstanding
Portfolio at risk
>30days
Region # % Value (Br)% Value (Br) %
Subtotal urban 2,361 52%1,915,200 53% 53,8202.81%
Branch A 1,464 62%1,115,000 58% 28,7002.57%
Branch B 354 15% 345,200 18% 16,9204.90%
Branch C 543 23% 455,000 24% 8,2001.80%
Subtotal rural 2,139 48%1,684,800 47% 97,3805.78%
Branch D 449 21% 290,600 17% 28,3009.74%
Branch E 898 42% 789,000 47% 28,5003.61%
Branch F 791 37% 605,200 36% 40,5806.71%
Total 4,500100%3,600,000100% 151,2004.20%

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Portfolio is well diversified: 47% rural and 53% urban borrowers.
58% of urban borrowers live in location A. Rural portfolio is much better
diversified.
Rural borrowers have 5.78% PAR, while urban borrowers have only 2.81%.
However, not all rural locations are bad.
Three regions have to be classified as problem regions: Location B (4.9%),
Location D (9.74%) and Location F (6.71%).
Look at historic data to see whether there are any upward or downward trends
in PAR for different locations and find out the reasons.
Immediate action is necessary in locations with bad PAR.
Long term disinvestment may be necessary in those areas that continue to be
problematic.
Regional concentration - Explanation