In this post we will go through the step-by-step methodology of carrying out a profitability analysis of the bank’s loan portfolio. This in itself is a kind of a stress test for credit risk under the Internal Capital Adequacy and Assessment Process (ICAAP) as it also computes a worst case profitability scenario.

# How to carry out a Profitability Analysis

Profitability analysis consolidates the impact of rating transitions, worst case scenarios, cost of funds and exposures and calculated the resulting impact on provisions and earnings. All metrics are calculated at an industry level. Profitability analysis assumes understanding of the transition and stress testing analysis.

The credit portfolio profitability is calculated using the following steps:

a) Estimating income on the current portfolio by applying the yield on loans. We used the loan IRR as a proxy for yield.

b) Estimating the funding cost for the loan amount. As a first step we ignored any capital contribution or equity support provided on the transaction.

c) Estimating the amount of incremental provisions across all performing classes based on historical rating transition from non-classified accounts to classified accounts over the last 6 months.

d) Estimating the amount of provisions required across currently classified accounts on behalf of slippage to lower rated non performing loan classes.

e) Estimating the best case profitability scenario which only includes (b) and (c) above to determine profitability

f) Estimating the worst case profitability scenario which includes (b), (c) and (d) above to determine profitability.

We have reviewed the step-by-step procedure for carrying out a profitability analysis for the bank’s loan portfolio. In the next post we will be looking at how the rating grades transition matrix can be stress tested.