Comparison of Credit Risk Weightings on Residential Mortgage Loans and Margin Loans

This article compares the credit risk weightings on residential mortgage loans and margin loans using an example of a $600,000 home loan and a $600,000 margin loan, both with 60% LVRs. The article explains the factors that affect credit weighing and presents a numerical example in a table. Based on the credit risk weightings, the article discusses which loan is expected to have a higher interest rate and whether this reflects actual interest rates in the market. The article cites relevant sources to support its arguments.

Question A (1/2 page): Using APS 113 and other sources, Clearly state and compare the
credit risk weightings on residential mortgage loans and margin loans using an $600000
home loan and $600000 margin loan. margin loan which each currently have 60% loan-to-
valuations ratios (LVR’s). The margin loan has a maximum LVR of 80%. State any
assumptions. Explain your answer using references and present your numerical example in
a table.
Banks allocate certain levels of interest to protect themselves against the risk of default of a loan.
In the case of a residential mortgage loan, banks need to determine the capital level which they
nee to allocate against the credit exposures. For instance, when allocated a risk weight of 25%,
they will need to achieve a capital ratio of 10% of the risk weighted assets. The internal ratings-
based approach is used to credit risk and other internal models which have been accredited by the
APRA can be used to derive the risk weights. The internal ratings-based approach is used to
credit risk and other internal models which have been accredited by the APRA can be used to
derive the risk weights. A mortgage for a borrower which has a poor repayment history with a
high loan to valuation ratio may have a weaker rating and a higher probability of default and loss
given default. Other factors which affect the credit weighing include the effective maturity and
probability of default. Also, there might be an additional correlation factor which provides a
measure of the dependence of exposures within a portfolio on the general state of the economy.
On the other hand, a standardized approach can be used where the loan to valuation ratio is used
to calculate the risk associated with the loan (Kallestrup & Murgoci, (2016).
Mortgage loan Margin loan

LVR 60% 60%-80%
Loan amount 600000 600000
Value of property 1000000 1000000
Probability of default* 25%
Effective maturity 20 years
Credit weight 60%* 25%*20 = 30% 60%

Question B (1/2 page): Based on the credit risk weightings you found in the previous
question, would you expect the home loan or the margin loan to have a higher interest
rate? Does this reflect actual interest rates in the market (quote your sources)? If not, what
may be the reason for the difference?
Using the standardized approach, makes the credit weighting reflect a less risk sensitive risk
profile. All the same, the standardized approach reflects a higher risk rating than the IRB
approach and therefore will have higher interest rates (Cummings & Durrani, 2016)
References
Cummings, J. R., & Durrani, K. J. (2016). Effect of the Basel Accord capital requirements on the
loan-loss provisioning practices of Australian banks. Journal of Banking & Finance, 67, 23-36.
Kallestrup, R., Lando, D., & Murgoci, A. (2016). Financial sector linkages and the dynamics of
bank and sovereign credit spreads. Journal of Empirical Finance, 38, 374-393.