- A term loan is a credit product where a lender provides a principal amount to a borrower who is expected to repay the principal plus fixed interest payments on scheduled dates. In the event of default, the lender can pursue debt collection to recover outstanding amounts. The expected default amount (EAD) is the principal plus accrued interest, and the loss given default (LGD) is high at around 90% since legal recourse is limited. - A credit card allows revolving credit up to a pre-set limit, where consumers make purchases that are accumulated in a monthly statement balance. Consumers must pay the balance in full or incur interest charges, and outstanding balances cannot exceed the credit limit.

1. Managing Credit Risk Under The Basel III Framework 25
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Credit Products
2
KEY CONCEPTS
• Term loan
• Credit ard
• Mortgage
• Corporate bond
2 Credit products
2.1 Lending business
A lending business is originated through demands from borrowers who need cash and
supplies from lenders who have spare cash that could be put aside for some time and
desire to seek a return higher than the risk-free rate.
Over the years, many credit products have been developed to serve various financial
needs of the community, taking into account the risk-return preferences and investment
horizons of the lenders, and the payment amounts and schedules affordable by the
borrowers. This chapter introduces four common credit products: term loan, credit card,
mortgage and corporate bond, by referencing the following dimensions:
• Functional purpose: Why do a borrower need and a lender design this credit product?
• Cash flow: What are the cash outflows and inflows from a lender’s perspective?
• Risk measurement: What are the credit risk factors and credit risk level?
• Actions upon default: What actions will a lender take when a borrower defaults?
Among the four credit risk factors, the EAD, LGD and RM are properties of a credit
product. They are controlled largely by a lender who designs the credit product.
Conversely, the PD relates solely to the characteristics of a borrower.
2.2 Term loan
With a term loan, a lender advances a principal to a borrower at loan origination. This is
the only cash outflow from the lender. The borrower promises to: (i) return the principal
to the borrower at maturity; and (ii) pay the borrower a fixed amount of interest on
scheduled days, usually on a monthly basis. Since the lender faces the risk that the
borrower may default during the lending period, he must demand a nominal yield higher
than the risk-free rate in order to compensate the credit risk.
In case a borrower does not pay the interest and/or principal in full on a payment day, the
borrower is taken to be in default. Upon the default of a borrower, which can only be
observed on a payment day, the lender carries out debt collection actions to recover the
principal and interest that remain outstanding.

2. 26 Managing Credit Risk Under The Basel III Framework
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Therefore, the EAD is equal to the sum of the principal and monthly interest.
EAD = Principal + Monthly interest
The debt collection actions can be taken by the lender himself or a professional debt
collection agency who charges the lender a service charge from 40 to 60 percent of the
collected amount.
When a borrower defaults on a term loan, neither the lender nor the professional debt
collection agency has recourse to collect the EAD, except to keep on warning and then
take liquidation actions against the borrower. Therefore, the LGD of a term loan is
relatively high, at a typical estimate of 90 percent.
The lending period of a term loan, i.e., the initial RM, is determined by referencing: (i)
how fast the borrower can release his financial burden and accumulate certain wealth to
pay back the principal; and (ii) the investment horizon of the lender. The lending period
usually ranges from one year to five years. This short to medium term lending period
ensures that the LGD and PD of a term loan can be estimated with sufficient accuracy.
A term loan is generally considered as a credit product with moderate risk due to its
higher LGD. As such, even at a lower interest rate environment in 2016 when the
medium term US treasury rates were typically below 2 percent, the normal yield of a term
loan demanded by a bank was often over 12 percent.
2.3 Credit card
In essence, a credit card represents a revolving loan up to a certain amount (credit limit)
advanced by a card issuer (lender) to a consumer (borrower). When a consumer buys a
good or enjoys a service with his credit card, the card issuer pays on behalf of the
consumer and becomes the lender to the consumer. The more utilization on the credit
card, the larger the amount that is owed by the consumer to the card issuer, noting that
the outstanding amount, after incorporating the interest, must not exceed the credit limit
agreed upon previously by the card issuer.
The transaction amounts are accumulated and summarized as a statement balance on a
monthly basis and conveyed in a monthly statement to the consumer who must settle the
statement balance in full or in part by the statement due day. If the consumer pays the
statement balance in full by the statement due day, no interest will be charged. However,
if only part of the statement balance is paid by the statement due day, interest will be
charged on all outstanding transaction amounts starting from the corresponding
transaction days. The total unsettled amount is bound by the credit limit such that the
card issuer will not facilitate any transaction amount beyond the credit limit. Thus, a
credit card is essentially an agreement from a card issuer to lend on a net basis up to the
credit limit.