An Instructional Model of Bank Portfolio Credit Risk and Return

Abstract

The measurement of bank portfolio credit risk and risk-adjusted return is increasingly important to banking institutions. Banking curriculum needs to reflect this trend with instructional models that present and integrate these topics. This paper presents a model that allows students to experiment with the interaction of several components of credit risk, risk-adjusted return, and capital risk. It further provides a tangible estimate of the benefits of diversification and allocates these gains to the contributing loan division. Finally, the proposed model illustrates several factors affecting credit pricing and shows how bank profits can be allocated to customers (borrowers or depositors), managers, regulators, or shareholders. The model is assessable to upper level undergraduate finance students or MBA finance students in a few class periods.