Finance Policy and Practice - Interest Rate Risk - Literature review Example

751307 VBST 0 Introduction According to Qi and Yang (2009), under the Basel II framework the calculation of the minimum regulatory capital requirescorrect estimates of the parameters that are used to determine a banks credit risk in terms of its loan and other asset portfolios. These parameters include: probability of default (PD); loss given default (LGD); and exposure at default (EAD). The LTV ratio is used to determine whether the borrower is likely to default. A borrower who is considered rational is likely to default when the value of the collateral falls below the value of the loan by an amount which equates to the net cost of the transactions such as relocation expenses, future payments for being deficient and the stigma attached to the situation (Crawford and Rosenblatt 1995, cited in Qi and Yang 2009). There are various ways in which a bank such as VB may become exposed to default and these are discussed. 1.1 Assessment of Estimated Property Values In assessing the value of a property and the annual rental price a number of formulas are used. The gross rent yield and the price/rent ratio are very useful formulas. Global Property Guide (2012) indicates that the gross rental yield is 3.43% and the price rent ratio is 29 yrs. The price/rent ratio was used to calculate the property values and the gross rental yield was used to calculate the rental. The information suggests that the current rental income reflects the current estimated value of the properties. The information on the revaluation is shown in attached spreadsheet on sheet 1. 2.0 Assessment of Existing Portfolio after Revaluation The loan-to-value (LTV) ratios and interest cover (the number of times interest is covered by rental income) will be used to assess Virtual Bank’s existing property loan portfolio. 2.1 Loan-to-Value Ratio The loan-to-value (LTV) ratio is used as a standard risk analyser in by lending institutions. The formula for calculating LTV is: current value of property/loan. LTVs are rated as high, moderate or low. LTV’s in excess of 80% are considered high, 60 to 80% moderate and below 60% low. Appendix 1 shows that the LTV ratios after the revaluation are 52% and less. This means that loans are properly secured and so VB faces no major risks as borrowers are not likely to default under the current valuation. 2.2 Assessment of Interest Cover The interest cover represents the number of times interest is covered by the operating profit from the property. The formula is operating profit/interest expenses. Interest cost of 3 times or more are generally considered acceptable while 2 times and under are considered low (BPP 2009). The information on the spreadsheet labelled Sheet 3 indicates that the interest cover for all but three (3) loans is in the acceptable range of 3 and above. However, the loans to Plane (5,100), Russet (4,000), and Pearmain (8,000) show interest cover of 2.4, 2.1 and 2.5 respectively. These loans represent 4% ((17,100/428,448)*100) of the total loans drawn. This s a small percentage and there is no cause for concern because the interest cover although not in the acceptable region is still above 2. 3.0 Strategy for risk reduction The overall risk on the loan portfolio is considered low. However, there are some strategies that can be used to further reduce the risks on loans with LTV above 40%. Property values have not yet stabilized and the recession threatens to double dip. This means that the tenants of properties for which rent will be reviewed soon are likely to move into more modern affordable spaces if the rent is adjusted upwards. The current rent reflects the price/rent ratio in the UK generally and the valuation estimates suggests that the current valuation was taken into account in setting the rental amounts that currently exist. This will of course depend on the amount of business generated at the current location. It is suggested that the rent be kept at the current levels in order to keep the current tenants. The calculations of gross rent yield and price/rent ratio indicate that valuation and the rental price are in keeping with market rates. The cross collaterised loans represent 17.7% ((75,876/428,448)*100) of the portfolio. A cross collaterised loan means that the collateral was used to guarantee more than one loan. The LTV for the group in the initial stages was 62% (75,876/122,600) and none of these properties have declined in value based on the current estimated valuation. Therefore there is no need for alarm. Sheet 4 of the spreadsheet shows the value of collaterised loans 4.0 Assessment of the diversity of the loan portfolio VB’s property loan portfolio consists of loans which have difference in loan expiry dates, lease expiry dates, customer/group, property type, tenants, risk exposure, property age and obsolescence. This means that the risk of exposure is spread over several years. However, the lease expiry date may either occur before or after the loan is paid up. Where the lease expires before the loan, there s no guarantee that rental income will continue to flow and if so at the existing levels. In the current market scenario, the rent could fall and this would result in a revaluation of the property and therefore the LTV ratio. 4.1 Concentration of exposure by expiry date The information in Sheet 5 shows that the £130,311 of the total £428,448 property loan portfolio expires in the current year. This amount represents 30.4% of the loan portfolio. A small amount of £17,700 will expire in 2013, £70,026 in 2015, £25,843 in 2016, £28,844 in 2017, £70,795 in 2018, £8,250 in 2020 and £76,679 in 2021. This means that after 2012, it will take another nine 9 years before the current loan portfolio is paid up. The information also indicates that £210,411 of the approximately £300,000 balance at the end of December 2012 will be due after 2015. At the end of the year approximately £130,000 will be available for lending. The market for properties is still soft and further declines in value are expected. This however depends on the use for which properties can be put and location. Longer loan repayment periods increases uncertainty and therefore the level of risk of default. However, property values appear to be sufficient to cover the loans drawn at this time. 4.2 Lease expiry date The Lease expiry dates provide an indication of the risk of declining income from property rental. Lease valuing £39,326 expired in 2010. The loan expiry dates for the loans related to these properties is 2015. If the lease is not renewed there is no guarantee that it will continue or even at the same rate until the loan expires. Most of the leases representing £247,328 of the loans will expire after 2021 when the loans would be fully paid up while £181,120 will expire within the same timeframe of the loans. Therefore, VB should not have any major problems collecting repayments. 4.3 Exposure to customer/group Exposure to a customer/group means that a particular group of customers have loans representing a large portion of the loan portfolio. A loan amount of over 5% represents a substantial amount for any one customer. The company’s exposure to the various customer/groups is shown in Table … in Appendix 3. The table indicates that VB has a high rate of exposure to the Nut group with loans of £24,326 (5.7%), Wellingtonia - £44,758 (10.5%), Cedar - £25,000 (5.8%), Larch - £25,250 (5.9%), and Olive - £45,320 (10.6%). Offering loans of a less than 5% of the total loan facility to any one group of customer as well as increasing the facility will help to reduce the VB’s current exposure. 4.4 Exposure to property type VB has made loans in relation to the purchase of several types of properties. A total of seven (7) types of property are included. The company is highly exposed to property loans on office space. Property loan of £201,643 which represents 47% of the total property loan portfolio is used to purchase office space. This type of property is followed by shops with £97,178 or 22.7% of the loans. This information suggests that loan repayment is dependent mainly on income from two (2) types of property. This is very risky as a number of shops and offices ceased business during the recession. If there is indeed a double-dip several others are likely to follow suit. 4.5 Exposure to tenant Exposure to a particular tenant implies that a large portion of the properties to which the loan relate is leased to a particular tenant. VB is exposed to HMG with £92,500 representing 21.6% of the property loans drawn and Mix with £79,448 representing 18.5% of the total property loans drawn. This means that if these businesses collapse VB will have difficulties with collections. 4.6 Exposure to interest rate risk Interest rate risk is potential impact on VB’s earnings as a result of a change in the interest rate. Kramer (n.d.) indicates that the amount of risk is dependent on ‘the magnitude and direction of interest rate changes and the size and maturity structure of the mismatch position.’ This information on Sheet 5 of the spreadsheet shows a mismatch in the interest rate on loans for different property types. The interest rates is either fixed, swaps or it changes every three months. The interest rate base varies and does not depend on the type of property. 4.7 Property Age and Obsolescence The age of the properties ranges from 5 to 248 years. Loans of £197,673 have been made for properties of ages between 5 and 10 years, £188,750 on properties with ages from 13 to 102 years. All other properties were constructed over 114 year ago. The normal life for buildings is 50 years. Loans granted on properties that are currently over 50 years old is £88,728 representing 21% of the total loan drawn. This proportion is very high and VB should carefully consider age and obsolescence when granting loans. See Sheet 5 for additional information. 4.8 Exposure to specific groups The banks exposure to specific groups and tenants is relatively moderate. However, setting an exposure limit to any one customer should not surpass 5% and to any group of borrowers or tenant 10%. This would suggest that the bank should control in some way who the customer leases the property to. If the bank is highly exposed then any loss of an individual loan or group of customers would have implications for interest income. However, VB may be able to recover the principal but this would take some time and therefore have implications for continuous income generation. 5.0 Future Expansion References BPP (2009) Paper F7 Financial Reporting. 3rd ed. London: BPP Learning Media Ltd Global Property Guide. (2012). United Kingdom Statistics. [Online] Retrieved from http://www.globalpropertyguide.com/Europe/United-Kingdom/Country-Statistics. [Accessed 17 November 2012] Kramer, J. (n.d.). Interest rate risk. [Online] Retrieved from http://bankaudit.net/ALM_ALCO%20Reviews/ALCO%20-%20IRarticle.html [Accessed 18 November 2012] Qi, M and Yang, X. (2009) Loss given default of high loan-to-value residential mortgages. Journal of Banking & Finance, 33, p. 788-799 Read More