Determining the economic value of ambiguous loan portfolios

• Published in: Finance research letters 2015-05, Vol.13, p.148-154
• Main Author: Parnes, Dror
• Format: Article
• Language: English
• Subjects: Ambiguous loan portfolios; Beta-Binomial distribution; Binomial distribution; Economic value; Economic value added; Internal auditors; Mathematical models; Portfolio management; Relationship lending; Sensitivity; Specificity; Studies
• ISSN: 1544-6123; 1544-6131
• DOI: 10.1016/j.frl.2015.02.002

•A framework to assess the fair economic value of ambiguous loan portfolios.•Ambiguous loans cannot be evaluated through traditional credit techniques.•A Beta-Binomial distribution model that captures possible economic valuations.•Illustrative simulations show the economic importance of the proposed scheme.•Contribution to regulatory and auditory bodies of community and regional banks. This study presents a framework to assess the fair economic value of ambiguous loan portfolios, i.e. when the credit qualities of the loans within are deeply masked or simply undetermined through traditional techniques. In this case, the second best choice for approximating the portfolio’s economic value would be to lean on the past performance of the designated credit officer who either approved or rejected the loan applications. The article presents a Beta-Binomial distribution model that captures the entire spectrum of possible economic valuations and their respective likelihoods and shows that this dissemination can be summarized to a single fair economic value for any ambiguous loan portfolios. This methodology exhibits high importance to regulators, policy makers, and internal auditors.