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• Scott David Aguais

To do so, however, requires that banks acquire a deeper understanding of loan valuation and apply the newer techniques of the bond market to the loan market. Specifically, the new standards to credit analysis require the following steps to be taken:

Loans must be accurately rated, monitored, and tracked through time. This history will prove important, not only for the existing loan, but also for all subsequent loans that can benefit from the migration pattern that is unique to the specific institution.

A. The credit officer must more accurately value the underlying pricing conventions built into the loan market. These are often neglected when loans are priced as bonds. The existence of a repricing grid, a periodic fee structure and various repricing techniques are often neglected in favor of the assertion that loans are merely small bonds.

B. Structure must be more accurately priced. Towards this end, it is necessary for the individual institution to recognize that structure has value. It should be quite apparent that the options imbedded in the loan portfolio have value; we have known the value of options imbedded in bonds for some time. As the derivative market has expanded, we trade these options that are part of the collective loan agreement in isolation. It is incumbent upon the banking community to more accurately price these options and to incorporate them into the pricing of loans that have imbedded options.

To do all this would result in an improvement in the ability of banking institutions to value their loans, define their required spreads, and to both aggressively and accurately compete. It is often the case that structure and repricing are powerful tools to be employed in the competitive financial community. At the moment, however, structure is often given away and options are often neglected in competitive bidding. Banks can compete more effectively for their customers and have higher yielding loan portfolio to the extent that they have the ability to price the value of these options, to use the repricing of the credit spread and to know the migration of credit quality that is specific to the credit portfolio of their particular bank.

There is no question that the market for credits is under severe competitive pressure. In such an environment, knowledge of the underlying portfolio and its value is the only true weapon for successful competition. Those that lag behind will be gamed by competitors and gamed by their customers. They will find they are subject to what academics call "the winner's curse." They will lose the good deals and win the bad ones. In today's world, information about the underlying lending relationship is the only adequate defense for a successful banking firm.

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Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 98-06.

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Date of creation: Dec 1997
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Handle: RePEc:wop:pennin:98-06

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1. Anthony M. Santomero, 1997. "Commercial Bank Risk Management: An Analysis of the Process," Center for Financial Institutions Working Papers 95-11, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
2. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management. [Downloadable!]
   Other versions:
   • Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May. [Downloadable!] (restricted)
3. Jarrow, Robert A & Lando, David & Turnbull, Stuart M, 1997. "A Markov Model for the Term Structure of Credit Risk Spreads," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 10(2), pages 481-523.
4. Anthony Santomero, 1997. "Commercial Bank Risk Management: An Analysis of the Process," Journal of Financial Services Research, Springer, vol. 12(2), pages 83-115, October. [Downloadable!] (restricted)
5. Babbel, David F. & Merrill, Craig & Panning, William, 1995. "Default risk and the effective duration of bonds," Policy Research Working Paper Series 1511, The World Bank. [Downloadable!]
6. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March. [Downloadable!] (restricted)

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