Suppose you are a senior loan officer at MC Bancorp, you have the following loan applications waiting for review. The bank uses Altmans Z score, default probabilities, mortality rates, and RAROC to assess loan acceptability. The banks cost of equity (the RAROC benchmark) is 8 percent. The banks loan policy states that the maximum probability of default for loans by type is as follows:

Loan Type and Maturity Maximum Allowable Default Probability

AAA-rated 0.50%

A-rated 1.25%

A $2 million, five-year loan to a BBB-rated corporation in the computer parts industry. MC Bancorp charges a servicing fee of 75 basis point (1 bps = 0.01%). The duration on the loan is 4.5 years. The cost of funds for the bank (the RAROC benchmark) is 8 percent. Based on four years of historical data, the bank has estimated the maximum change in the risk premium on the computer parts industry to be approximately 5.5 percent. The current market rate for loans in this industry is 10 percent.

=

()

Net income on a loan = Expected interest income + Servicing fees Cost of funds

Loan (asset) risk or capital at risk = = [(1 + )]

: dollar capital risk exposure or loss amount

: duration of the loan

: risk amount or size of loan

(1 + ): expected maximum change in the loan rate due to a change in the credit risk premium () or risk factor on the loan

The RAROC model

Expected interest income=

Servicing fees=

Cost of funds=

Net income on the loan=

Duration=

Value of the loan=

Change in R/ (1+R)=

Change in the value of the loan=

RAROC=

Recommendation=