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Chapter 1
The Credit Decision
CREDIT. Trust given or received; expectation of future payment for property transferred, or of fulfillment or promises given; mercantile reputation entitling one to be trusted;âapplied to individuals, corporations, communities, or nations; as, to buy goods on credit.
âWebsterâs Unabridged Dictionary, 1913 Edition
A bank lives on credit. Till it is trusted it is nothing; and when it ceases to be trusted, it returns to nothing.
âWalter Bagehot1
People should be more concerned with the return of their principal than the return on their principal.
âJim Rogers2
The word credit derives from the ancient Latin credere, which means âto entrustâ or âto believe.â3 Through the intervening centuries, the meaning of the term remains close to the original; lenders, or creditors, extend fundsâor âcreditââbased upon the belief that the borrower can be entrusted to repay the sum advanced, together with interest, according to the terms agreed. This conviction necessarily rests upon two fundamental principles; namely, the creditorâs confidence that:
1. The borrower is, and will be, willing to repay the funds advanced
2. The borrower has, and will have, the capacity to repay those funds
The first premise generally relies upon the creditorâs knowledge of the borrower (or the borrowerâs reputation), while the second is typically based upon the creditorâs understanding of the borrowerâs financial condition, or a similar analysis performed by a trusted party.4
DEFINITION OF CREDIT
Consequently, a broad, if not all-encompassing, definition of credit is the realistic belief or expectation, upon which a lender is willing to act, that funds advanced will be repaid in full in accordance with the agreement made between the party lending the funds and the party borrowing the funds.5 Correspondingly, credit risk is the possibility that events, as they unfold, will contravene this belief.
SOME OTHER DEFINITIONS OF CREDIT
Creditworthy or Not
Put another way, a sensible individual with money to spare (i.e., savings or capital) will not provide credit on a commercial basis7âthat is, will not make a loanâunless she believes that the borrower has both the requisite willingness and capacity to repay the funds advanced. As suggested, for a creditor to form such a belief rationally, she must be satisfied that the following two questions can be answered in the affirmative:
1. Will the prospective borrower be willing, so long as the obligation exists, to repay it?
2. Will the prospective borrower be able to repay the obligation when required under its terms?
Traditional credit analysis recognizes that these questions will rarely be amenable to definitive yes/no answers. Instead, they call for a judgment of probability. Therefore, in practice, the credit analyst has traditionally sought to answer the question:
What is the likelihood that a borrower will perform its financial obligations in accordance with their terms?
All other things being equal, the closer the probability is to 100 percent, the less likely it is that the creditor will sustain a loss and, accordingly, the lower the credit risk. In the same manner, to the extent that the probability is below 100 percent, the greater the risk of loss, and the higher the credit risk.
CASE STUDY: PREMODERN CREDIT ANALYSIS
The date: The last years of the nineteenth century
The place: A small provincial bank in rural Englandâlet us call the institution Wessex Bankâlocated in the market town of Westport
Simon Brown, a manager of Wessex Bank, is contemplating a loan to John Smith, a newly arrived merchant who has recently established a bicycle shop in the townâs main square. Smithâs business has only been established a year or so, but trade has been brisk, judging by the increasing number of two-wheelers that can be seen on Westportâs streets and in the surrounding countryside.
Yesterday, Smith called on Brown at his office, and made an application for a loan. The merchantâs accounts, Brown noted, showed a burgeoning business, but one in need of capital to fund inventory expansion, especially in preparation for spring and summer, when prospective customers flock to the shop. While some of Smithâs suppliers provide trade credit, sharply increasing demand for cycles and limited supply have caused them to tighten their own credit terms. Smith projected, not entirely unreasonably, thought Brown, that he could increase his turnover by 30 percent if he could acquire more stock and promise customers quick delivery.
When asked by Brown, Smith said he would be willing to pledge his assets, including the shopâs inventory, as collateral to secure the loan. But Brown, as befits his reputation as a prudent banker, remained skeptical. Those newfangled machines were, in his view, dangerous vehicles and very likely a passing fad.
During the interview, Smith mentioned in passing that he was related on his fatherâs side to Squire Roberts, a prosperous local landowner well known to Brown and a longstanding customer of Wessex Bank. Just that morning, Brown had seen the old gentleman at the post office, and, to his surprise, Roberts struck up a conversation about the weather and the state of the timber trade, and mentioned that he had heard his nephew had called on Brown recently. Before Brown had time to register the news that Roberts was Smithâs uncle, Roberts volunteered that he was willing to vouch for Smithâs characterââa fine ladââand, moreover, added that he was willing to guarantee the loan.
Brown decided to have another look at Smithâs loan application. Rubbing his chin, he reasoned to himself that the morningâs news presented another situation entirely. Not only was Smith not the stranger he was before, but he was also a potentially good customer. With confirmation of his character from Roberts, Brown was on his way to persuading himself that the bank was probably adequately protected. Robertsâs indication that he would guarantee the loan removed any remaining doubts. Should Smith default, the bank could hold the well-off Roberts liable for the obligation. Through the prospective substitution of Robertâs creditw...
