Question 4 11 marks

As a senior loan officer at MC Financial Institution (FI), you have a loan application from a firm in the commercial sector. While the loan has been approved on the basis of an individual loan, you must evaluate the loan based on its impact on the risk of the overall loan portfolio. The FI uses the following three models to assess its loan portfolio risk.

a. Concentration Limits Model: The FI currently has lent an amount equal to 40 percent of its capital to the commercial sector and does not lend to a firm in any sector that generates losses in excess of 2 percent of capital. The average historical losses in the commercial sector is 5 percent. Using the Concentration Limits Model, you need to explain whether the FI should approve this loan.

b. Loan Volume-Based Model: National and MC Financial Institutions loan portfolio allocations are as below.

Allocation of Loan Portfolios in Different Sectors (%)

Sectors National MC Financial Institution

Commercial 30% 50%

Real Estate 50% 35%

Consumer 20% 15%

The FI does not want to deviate from the national average by more than 14.72 percent. Using the Loan Volume-Based Model, you need to explain whether the FI should approve this loan.

c. Loan Loss Ratio-Based Model: Based on regression analysis on historical loan losses, the FI estimates the below loan loss ratio models.

XC&I = 0.001 + 0.85XL and Xcon = 0.003 + 0.65XL

where XC&I = loss rate in the commercial sector, Xcon = loss rate in the consumer (household) sector, XL = loss rate for its total loan portfolio.

The FIs increase in the total losses in its loan portfolio is expected to be 12 percent next year. Using the Loan Loss Ratio-Based Model, you need to explain whether FI should approve this loan.

d. There is a situation that a loan application is rejected by FIs although the loan applicant is a creditworthy borrower and the loan application is a strong case (that is, the loan application documents have been assessed thoroughly and passed many of the loan approval criteria). Explain the most likely reason for this rejection.