# LO 16.7: Com pare bank failure and bank insolvency.

LO 16.7: Com pare bank failure and bank insolvency.
Bank insolvency and bank failures are not identical. Banks become insolvent and are often merged into healthier institutions. It is more convenient and less expensive for the government to simply fold a troubled bank into a stronger bank than it is to close the bank. In fact, there is an assumption that bank failures are relatively common, but in reality, it rarely happens in non-crisis periods. Weak banks are merged with healthier banks, and the system avoids outright failures. This is especially true for large, international banks (i.e., banks that are too big to fail). In the United States, only 50 banks failed between 2001 and 2008, half of which failed in 2008. This equates to a rate of approximately 0.1% per year during the period. Following the financial crisis, approximately 2% of banks failed in both 2009 and 2010. An additional 1.2% of banks failed in 2011. Research indicates that bank failures are considerably less likely than nonfinancial firm failures.
In the last few years, beginning with the financial crisis in late 2007, many more large banks in Europe and the United States have suffered from financial stresses. Flowever, it was clear during the crisis that some banks were considered too big to fail. In response, the Financial Stability Board (FSB) created a list of 29 systemically important financial institutions that are required to hold additional loss absorption capacity tailored to the impact of their [possible] default. The concern is systemic risk that spreads to other institutions. There was substantial evidence of this occurrence during the financial crisis.
A bank can remain insolvent (without failing), so long as it has a source of liquidity. The Federal Reserve is one such source and acts as a lender of last resort. A bank failure that results in significant losses to depositors and other creditors is quite rare, although as noted, the incidence increases in times of crisis, such as in 2007. For a credit analyst evaluating a financial institution, the expectation of an outright failure is unlikely. However, because banks are heavily leveraged, the risks cannot be ignored. The analyst must place the bank somewhere on the continuum between pure creditworthiness and bankrupt. At one end of the continuum are banks with AAA-rated debt, and at the other end are banks with default ratings. Thus, thinking about bank risk on a continuum is useful in defining the banks credit risk.
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Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
K e y C o n c e p t s
LO 16.1
Credit risk is the probability that a borrower will not pay back a loan in accordance with the terms of the credit agreement. Credit risk results when an individual or firm defaults on a financial obligation. It arises short of default when there is an increased probability of default on a financial obligation. A more severe loss than expected due to a greater than expected exposure at the time of a default or a more severe loss than expected due to a lower than expected recovery at the time of a default are also components of credit risk. Finally, credit risk can arise from a default on a payment for goods or services that are already rendered (i.e., settlement risk).
LO 16.2
There are four primary components of credit risk evaluation: (1) the borrowers (obligors) willingness and capacity to repay the loan, (2) the effect of external conditions on the borrowers ability to repay the loan, (3) the inherent characteristics of the credit instrument and the extent to which the characteristics affect the borrowers willingness and ability to perform the obligation, and (4) the quality and adequacy of risk mitigants such as collateral and loan guarantees.
LO 16.3
If collateral is used as a credit risk mitigant, a bank or other lender may not have to force a delinquent borrower into bankruptcy but may instead sell the collateral to satisfy the financial obligation. If a loan guarantor is used as a credit risk mitigant, the guarantor accepts liability for debt if the primary borrower defaults. Typically, the guarantor has a greater ability to pay than the primary borrower.
LO 16.4
Qualitative techniques are used primarily to assess the borrowers willingness to repay the loan. Quantitative techniques are used primarily to assess the borrowers ability to repay the loan. Gathering information from a variety of sources about the character and reputation of the potential borrower, face-to-face interviews with potential borrowers, and using past loan payment information to draw conclusions about a borrowers willingness to pay in the future are all qualitative techniques. .Analyzing the borrowers recent and past financial statements is the primary quantitative method used in credit analysis.
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Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
LO 16.5
There are key differences between the analysis of the creditworthiness of consumers, versus that of nonfinancial and financial firms. Individual factors such as a persons net worth, salary, assets, reputation, and credit score are used to evaluate individuals. It is more complex to evaluate firms. Liquidity, cash flow combined with earnings capacity and profitability, capital position (solvency), state of the economy, and strength of the industry are used to evaluate nonfinancial firms. Similar data is used for financial firms in addition to bank-specific measures such as capital adequacy, asset quality, and the banks ability to withstand financial stress. Detailed manual analyses, including financial statement analysis and interviews with management, are used to analyze the creditworthiness of both nonfinancial and financial firms.
LO 16.6
Current measures used to evaluate credit risk are:
The probability of default (PD), which is the likelihood that a borrower will default. The loss given default (LGD), which represents the likely percentage loss if the borrower

does default. Exposure at default (EAD), which can be stated as a dollar amount (e.g., the loan balance outstanding) or as a percentage of the nominal amount of the loan or the maximum amount available on a credit line. Expected loss (EL), which is, for a given time horizon, calculated as the product of the PD, LGD, and EAD (i.e., PD x LGD x EAD).
Time horizon or tenor of the loan. The longer the time horizon, the greater the risk to
the lender.
LO 16.7
Bank insolvency and bank failure are not one in the same. A bank may be insolvent but avoid failure so long as liquidity is available. Also, many insolvent banks are merged with financially sound banks, avoiding outright failure. For the credit analyst, the fact that failure of financial institutions is rare makes analysis easier. However, banks are highly leveraged, placing the bank somewhere on the continuum between fully creditworthy and insolvent.
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Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
C o n c e p t C h e c k e r s
1.
2.
3.
Blackstone Credit, Inc., made a loan to a small start-up firm. The firm grew rapidly, and it appeared that Blackstone had made a good credit decision. However, the firm grew too fast and could not sustain the growth. It eventually failed. Blackstone had initially estimated its exposure at default to be $1,200,000. Because of the firms rapid growth and resulting increases in the line of credit, Blackstone ultimately lost$1,550,000. In terms of credit risk, this is an example of: A. default on payment for goods or services already rendered. B. a more severe loss than expected due to a ratings downgrade by a rating agency. C. a more severe loss than expected due to a greater than expected exposure at the
time of a default.
D. a more severe loss than expected due to a lower than expected recovery at the
time of a default.
Brent Gulick, a credit analyst with Home Town Bank, is considering the loan application of a small, local car dealership. The dealership has been solely owned by Bob Justice for more than 20 years and sells three brands of American automobiles. Because of the rural location, most of the cars sold in the past by the dealership have been large pick-up trucks and sports utility vehicles. However, sales have declined, and gasoline prices have continued to increase. As a result, Justice is considering selling a line of hybrid cars. Justice has borrowed from Home Town Bank before but currently does not have a balance outstanding with the bank. Which of the following statements is not one of the four components of credit analysis Gulick should be evaluating when performing the credit analysis for this potential loan? A. The business environment, competition, and economic climate in the region. B. Justices character and past payment history with the bank. C. The car dealerships balance sheets and income statements for the last few years
as well as Justices personal financial situation.
D. The financial health of Justices friends and family who could be called upon to
guarantee the loan.
Sarah Garrison is a newly hired loan officer at Lexington Bank and Trust. Her boss told her she needs to make five commercial loans this month to meet her sales goal. Garrison talks to friends and hears about a local businessperson with a great reputation. Everyone in town says John Johnson is someone you want to meet. Garrison sets up a meeting with Johnson and is immediately impressed with his business sense. They discuss a loan for a new venture Johnson is considering, and Garrison agrees that it is a great idea. She takes the loan application back to the bank and convinces the chair of the loan committee that Lexington Bank and Trust is lucky to be able to do business with someone with Johnsons reputation. This is an example of: A. historical analysis technique. B. qualitative analysis technique. C. quantitative analysis technique. D. extrapolation analysis technique.
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Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
4.
5.
Stacy Smith is trying to forecast the potential loss on a loan her firm made to a mid- size corporate borrower. She determines that there will be a 75% loss if the borrower does not perform the financial obligation. This is the: A. probability of default. B. C. expected loss. D. exposure at default.
loss given default.
Bank of the Plain States has been struggling with poor asset quality for some time. The bank lends primarily to large farming operations that have struggled in recent years due to a glut of soybeans and corn on the market. Bank regulators have recently required that the bank write off some of these loans, which has entirely wiped out the capital of the bank. However, the bank still has some liquidity sources it can use, including a correspondent bank and the Federal Reserve. Bank of the Plain States is: A. an insolvent but not failed bank. B. both a failed bank and an insolvent bank. C. neither a failed bank nor an insolvent bank. D. a failed bank but not an insolvent bank.
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Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
C o n c e p t C h e c k e r An s w e r s
1. C Blackstone lost more than expected due to greater exposure at the time of default than
initially estimated. The borrowing firm was a small start-up, so it was not likely rated. There were no goods or services rendered in this case. In addition, there is no mention of recovery. This is also an example of credit risk arising from default on a financial obligation.
2. D There are four primary components of credit risk evaluation: (1) the borrowers (obligors)
willingness and capacity to repay the loan, (2) the effect of external conditions on the borrowers ability to repay the loan, (3) the inherent characteristics of the credit instrument and the extent to which the characteristics affect the borrowers willingness and ability to repay the loan, and (4) the quality and adequacy of risk mitigants such as collateral and loan guarantees. In this case, the local business environment, Justices character, his payment history, and the businesss financial positions are all relevant. While risk mitigants such as collateral and loan guarantees are part of credit analysis, it is unlikely that a local car dealer who has been in business for 20 years would be seeking a loan guarantee from a friend or family member. In addition, even if Justice were looking at a potential loan guarantor, Gulick would not simply evaluate his friends and family but would evaluate the specific person or business that intended to guarantee the loan.
3. B Name lending is a qualitative technique that is sometimes used to take the place of financial
analysis. It is a technique used to evaluate the borrowers willingness to repay a financial obligation.
4. B Current measures used to evaluate credit risk include the firms probability of default, which
is the likelihood that a borrower will default; the loss given default, which represents the likely percentage loss if the borrower does default; the exposure at default; and the expected loss, which is, for a given time horizon, calculated as the product of the PD, LGD, and EAD. The stated 75% loss if the borrower defaults is the loss given default or LGD.
5. A Bank of the Plain States is insolvent because capital is wiped out. However, the bank has not failed because it is still operating with liquidity from the correspondent bank and the Federal Reserve. Therefore, the bank is insolvent but not failed.
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The following is a review of the Credit Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
T h e C r e d i t A n a l y s t
Topic 17
E x a m F o c u s
This topic focuses on the role and tasks performed by a banking credit analyst. For the exam, understand the objectives of the analyst (e.g., risk management, investment selection) as well as the difference between primary and secondary research. In addition, know the quantitative and qualitative skills that an analyst must possess in order to be successful. Finally, be able to recognize and describe the key information sources used by credit analysts such as the annual report, auditors report, and company financial statements.
C r e d i t A n a l y s t R o l e s