Advanced Credit Risk Analysis and Management

Ciby Joseph

• Publisher: Wiley
• Year: 2013
• ISBN:
  9781118604892
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Credit is essential in the modern world and creates wealth, provided it is used wisely. The Global Credit Crisis during 2008/2009 has shown that sound understanding of underlying credit risk is crucial. If credit freezes, almost every activity in the economy is affected. The best way to utilize credit and get results is to understand credit risk.

Advanced Credit Risk Analysis and Management helps the reader to understand the various nuances of credit risk. It discusses various techniques to measure, analyze and manage credit risk for both lenders and borrowers. The book begins by defining what credit is and its advantages and disadvantages, the causes of credit risk, a brief historical overview of credit risk analysis and the strategic importance of credit risk in institutions that rely on claims or debtors. The book then details various techniques to study the entity level credit risks, including portfolio level credit risks.

Authored by a credit expert with two decades of experience in corporate finance and corporate credit risk, the book discusses the macroeconomic, industry and financial analysis for the study of credit risk. It covers credit risk grading and explains concepts including PD, EAD and LGD. It also highlights the distinction with equity risks and touches on credit risk pricing and the importance of credit risk in Basel Accords I, II and III. The two most common credit risks, project finance credit risk and working capital credit risk, are covered in detail with illustrations. The role of diversification and credit derivatives in credit portfolio management is considered. It also reflects on how the credit crisis develops in an economy by referring to the bubble formation. The book links with the 2008/2009 credit crisis and carries out an interesting discussion on how the credit crisis may have been avoided by following the fundamentals or principles of credit risk analysis and management.

The book is essential for both lenders and borrowers. Containing case studies adapted from real life examples and exercises, this important text is practical, topical and challenging. It is useful for a wide spectrum of academics and practitioners in credit risk and anyone interested in commercial and corporate credit and related products.

Part I

Introduction

Credit risk analysis is an art as well as a science. It is a science because the analysis is based upon established principles emanating from a body of knowledge and sound logic. Individual skill and the way the principles are applied constitute the art element.

1

Credit Basics

Historically credit is good, if used wisely. However, there are numerous instances where both lenders (and creditors) and borrowers (or debtors) and even global economies suffer because of credit. The main reason is traceable to poor credit risk analysis and inadequate credit risk management. The purpose of this book is to delve into the realm of credit risk analysis and management in depth so that both lenders and borrowers can make the best use of credit for the common good.

Credit prudently used can create wealth and bring overall prosperity to the economy. Accordingly, credit, nowadays, is pervasive and is a common feature of all global economies. The only places from which it would be probably absent would be among the hunter/gatherer tribes in the deep jungles of Africa, South America or Asia or in similar tribes still living in primitive conditions.

Look around, observe your newspapers, magazines, television or radio or the billboards on highways – you can see invitations to participate in credit. Manufacturers of automobile and consumer durable goods offer credit directly or through their finance subsidiaries at low interest rates or offers instalment schemes with easy repayment terms. Credit card issuers attempt to persuade almost everybody to live on credit and at least some of the credit card holders find themselves living beyond their means and almost in perpetual debt.

Individuals borrow to meet their immediate requirements of physical needs such as house, furniture, car, consumer durable goods or to meet consumption expenditure such as marriage expenses, education or holidays. Business borrows to make investments to facilitate expansion or to meet working capital requirements, amongst others. Governments borrow to keep themselves afloat and hope to repay them from future tax revenues or further loans. Central government and big businesses borrow from abroad, which if not managed properly, can plunge the debtor country into an inevitable foreign exchange crisis, as has been seen in the 1997 Far East Asian Crisis and 2001 Argentina Crisis. The sub-prime lending crisis in the US (2008) and the Greek debt crisis (2010) and Spanish debt crisis (2012) are also linked to credit risks.

While the policy makers and officials scramble to find solutions with the least impact on the economy during such crises, it may be noted that these issues are often complex in nature and reflect the incredible power of financial and credit markets to systematically affect people from all walks of life. The level of credit extended and enjoyed by borrowers has far reaching implications for the economy. The lending, credit and regulatory policies that govern the financial sector and the levels of acceptable debt by the corporate sector require not only adequate monitoring but also sound understanding of the nature of credit risk. Insufficient knowledge of credit risk or its underestimation will result in distress to both lenders and borrowers who will suffer legal cases, bad debts, losses, to name just a few of them.

No doubt credit is ubiquitous and all important in the proper day-to-day functioning of the economy. Any disruption to the credit flow in the economy will have serious consequences for the economy itself.1 As we will see in the rest of the book, credit is the life blood of business activities and the economy. Hence, the importance of credit risk and credit risk management.

1.1 MEANING OF CREDIT

Credit had a role to play from the early days of civilization. Nowadays credit implies monetary or monetary equivalent transactions. However, given the more accurate and realistic definition of credit, it includes non-monetary and/or barter transactions. Roughly, we can define credit as ‘A transaction between two parties in which one (the creditor or lender) supplies money, goods, services or securities in return for a promise of future payment by the other (the debtor or borrower). Such transactions normally include the payment of interest to the lender.’2

The second part of this definition is interesting, it shows that credit is not cost free. The creditor parts with the resources because he has the incentive – either directly or indirectly. The incentive is required because the lender has an opportunity cost – he can deploy the resources elsewhere gainfully. Accordingly, for the sacrifice of this opportunity, the lender expects a return, which is normally known as interest. Over history, how much a lender can charge as interest has been under dispute prompting certain segments of society to view interest as an evil. However, it is an undeniable fact that interest is a type of cost of capital, charged by lenders, who do not have the right to enjoy the fruits of ownership. Another way of looking at interest is that it is equivalent to rent. Just as the owner or supplier of the building will charge rent, the interest is the rent charged by the supplier of credit or debt capital. While excessive or imprudent borrowings can be catastrophic, cost of capital cannot be blamed for the imprudence.

Of course, interest rates that do not justify the underlying economic realities and result in deprival of economic assets of the borrower are exploitation and a strategy followed by bigger powers. The East India Company ensured dependency of some its vassal states in India by lending them large sums of money at exorbitant interest rates. The book The Honourable Company by Mr John Keay, describes loans by the East India Company to the Nawab of Arcot at exorbitant interest rates of 20–25%. This ensured not only the indebtedness of the Nawab to the company but the revenues of the Carnatic also found their way into the East India Company without all the hassle and recrimination.

The novel Money Changers by Arthur Hailey depicts loan sharks in the US, who charge excessive interest rates and their collection technique is purely muscle power. This category of suppliers of credit, who exist in almost all countries, do not belong to mainstream suppliers of capital and their actions do not serve any social justice or contribute to the economic progress of the public. No court of law will approve their ridiculous interest rates or their collection methods. However, the main reason for their existence is akin to the Stock Market Theory called the Greater Fool Theory. This theory refers to the buyers of stock/shares at ridiculously high prices (inflated valuations) with the hope of finding somebody who will buy them at an even higher price! Similarly are those who borrow at exorbitant rates. The probability of using the credit productively is very low, but not impossible, at least theoretically.

So, the borrower is responsible for the debt service obligations and should be aware of the consequences of the borrowings. So the caveat is ‘Let the borrower be aware’.

Naturally, a small percentage of debtors won't pay back the credit as promised, sometimes even sending the creditor into bankruptcy. But the majority of debtors meet their commitments. That is why the World Economy survives. Credit losses or bad debts occur in both finance and non-finance businesses. The reasons vary. In certain cases, if the credit is extended to crooks, it is a bad debt from inception. However, the bulk of credit losses happen because of genuine business failures. The reasons vary from increase in competition, new technology, substitutes, increase in prices, decline in demand, over-estimation of demand, over-supply position in the market, government regulations, union problems, mismanagement, death of key persons, business cycles, over-ambitious projects, financial losses, excessive leverage, concentrated exposure, defective diversification and so on. A proper credit risk analysis will bring to light the probability of credit loss arising out of genuine business factors.

There are situations where the creditor ends up losing even if the debtor settles the dues on time. Three such situations are described below:

• One instance is inflation. If the rate of inflation exceeds interest rates, the suppliers of credit are badly affected. In such situations, inflation actually redistributes money from lenders to borrowers. If interest rates are 10% and inflation is 20%, the saver will lose 10% of the real value of the savings. However, the banks and other financial intermediaries do not lose much in an inflationary situation because they in turn pass on the reduction in purchasing power to the depositors. (Moreover, the central bank of any economy will increase the interest rates, to bring down the inflationary pressure by dampening the credit off-take.)
• In the second instance of devaluation of a foreign currency, in which the debt is denominated, the creditor loses to the extent of the rate of devaluation. For instance, during the 2001 crisis, the devaluation of the Argentinian currency, the peso, had taken its toll in many banks in the US, Spain and leading exporters to that country. Accordingly, a US creditor who had a receivable of one million Argentinian pesos in early 2002 (when the peso had parity with the dollar) would find the value in dollars plunging from $1 million to $333K in a period of six months. Banks and financial intermediaries would have suffered losses if they were holding open their own exposures in Argentinian pesos.
• Another instance will be non-compliance with anti-money laundering measures implemented by the central banks of most of the countries. Money laundering is a menace of the modern day world, hence the importance of Know Your Customer (KYC) policies and procedures. In most cases the loss will be through the penalties imposed by the respective authorities if the institution aids or abets money laundering activities knowingly or unknowingly. Similarly, if sanctions are imposed on certain countries, then dealing with or lending to the customers in such countries can also spell trouble and result in losses.

Whilst the risk that a borrower (whether individual or corporate) may default on obligations is known as Credit Risk, the risk that a foreign government may fail to honor the credit related obligations is defined as Sovereign Risk. It may be noted that the legal remedies in the event of sovereign risk are limited. Hence when extending credit to a business firm located in a foreign country, it is better to ascertain the level of sovereign risk, than to study the credit risk of the business firm.

1.2 ROLE OF CREDIT

Idle economic resources can be effectively put into use through credit. Borrowers who do not have enough resources to pursue an activity can borrow the resources, which can be returned to the lender after having achieved the objective. There is a practical difficulty for those with surpluses to identify potential borrowers. This is where financial intermediaries come in. Broadly, banks and other financial intermediaries collect economic resources – mainly in the form of deposits – from the public and engage in intelligent lending. Financial intermediaries play an important role in any economy. From a macroeconomic perspective, the main function of the financial system in any country is to mobilize resources for economic growth. The financial intermediaries not only intermediate between savers and investors but set economic prices of capital, in line with the monetary policy of the nation.

Financial intermediaries play a vital role in making the credit available. Those financial institutions like banks who can retake the loan proceeds given to one party from another can in fact increase the credit availability in the economy. This is called ‘credit creation’ by banks. Please see the Appendix for details.

Prudent use of credit results in economic growth of borrowers, which in turn leads to the overall economic well-being of the society and ultimately the country. Credit stimulates both household consumption and business investment. Hence, a national credit policy is an important tool used to encourage industrial development and business investments, thereby creating employment opportunities and improving the standard of living of the general population. As purchasing power increases, people will tend to spend more on consumer goods and this will stimulate further economic growth. Remember how Allan Greenspan attempted to accelerate credit off-take, especially after 9/11, by slashing the interest rates to the lowest in the last 40 years.

Usually the state of the credit markets will reflect the relative health of a larger economy as well. Often the prevailing interest rates and risk appetite for various grades3 of credit risk are some of the indicators of the state of the credit markets.

1.3 CREDIT MARKET

The credit markets dwarf the equity markets. An equity market crisis usually impacts a limited number of financial players; however a credit crisis often shakes the foundations of the economy. However, since both equity market and credit markets are part of larger capital market, sometimes both markets may move together.

A business firm or a large corporation or multinational company finds that the market can absorb even if production is doubled. But they do not have enough funds to expand the operation. What is the easy solution? Similarly, if you want to buy a car or travel abroad but you currently do not have sufficient cash in hand, what would you do? The answer is probably to approach a bank or financial institution or ask the supplier of the good or service to extend credit. Governments are also active in credit markets. Many governments act through their central bank and buy and sell credit to meet their funding needs.

The demand for credit is ubiquitous, as the economic agents feel scarcity – while pursuing unlimited wants with limited resources. Borrowers or users o...