T.6_BANKING AND FINANCIAL INSTITUTIONS (2017)Apunte Inglés
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BANKING AND FINANCIAL INSTITUTIONS
T-6. CREDIT RISK
In the course of their operations, banks are invariably faced with different types of risks that
may have a potentially negative effect on their business. Risk management in bank operations
includes risk identification, measurement and assessment, and its objective is to minimize
negative effects risks can have on the financial result and capital of a bank.
1 - - - - Reputational risk: Risk related to what financial activity generates opinion among individuals. Risk of loss resulting from damages to a firm's reputation, in lost revenue; increased operating, capital or regulatory costs; or destruction of shareholder value, consequent to an adverse or potentially criminal event even if the company is not found guilty. Adverse events typically associated with reputation risk include ethics, safety, security, sustainability, quality, and innovation. (Activities, sectors, transactions, Evictions, demands, claims). Mitigation through: Social responsibility and Return on society.
Interest rate risk: is the risk that arises for bond owners from fluctuating interest rates.
How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market. Interest rate risk is the risk of negative effects on the financial result and capital of the bank caused by changes in interest rates.
Exchange rate risk: Foreign exchange risk is the risk of negative effects on the financial result and capital of the bank caused by changes in exchange rates. Impact of exchange rate variations over bank profit, Depreciation of investments, Active hedging policy (Use of forward or more sophisticated instruments).
Operational risk: Operational risk is "the risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems, or from external events (including legal risk), differ from the expected losses“ (Basel II definition). It can also include other classes of risk, such as fraud, security, privacy protection, legal risks, physical (e.g. infrastructure shutdown) or environmental risks. As long as people, systems and processes remain imperfect, operational risk cannot be fully eliminated.
Different issues, different risks: - - - - Market risk - Interest rate risk - Exchange rate risk, variable income risk, commodity price risk Underestimation risk - Transparency risk - Moral hazard - Regulatory risk - Unexpected risk - Reputational risk Implicit risk - Credit risk - Default index - Country risk (sovereign risk and transfer risk) - Counterparty risk - Operating risk - Liquidity risk - Systemic Risk - Legal Risk Liquidity risk is the risk of negative effects on the financial result and capital of the bank caused by the bank’s inability to meet all its due obligations.
2 - Credit risk is the risk of negative effects on the financial result and capital of the bank caused by borrower’s default on its obligations to the bank.
- Market risk includes interest rate and foreign exchange risk.
- Interest rate risk is the risk of negative effects on the financial result and capital of the bank caused by changes in interest rates.
- Foreign exchange risk is the risk of negative effects on the financial result and capital of the bank caused by changes in exchange rates.
- A special type of market risk is the risk of change in the market price of securities, financial derivatives or commodities traded or tradable in the market.
- Exposure risks include risks of bank’s exposure to a single entity or a group of related entities, and risks of banks’ exposure to a single entity related with the bank.
- Investment risks include risks of bank’s investments in entities that are not entities in the financial sector and in fixed assets.
- Risks relating to the country of origin of the entity to which a bank is exposed (country risk) is the risk of negative effects on the financial result and capital of the bank due to bank’s inability to collect claims from such entity for reasons arising from political, economic or social conditions in such entity’s country of origin. Country risk includes political and economic risk, and transfer risk.
- Operational risk is the risk of negative effects on the financial result and capital of the bank caused by omissions in the work of employees, inadequate internal procedures and processes, inadequate management of information and other systems, and unforeseeable external events.
- Legal risk is the risk of loss caused by penalties or sanctions originating from court disputes due to breach of contractual and legal obligations, and penalties and sanctions pronounced by a regulatory body.
- Reputational risk is the risk of loss caused by a negative impact on the market positioning of the bank.
- Strategic risk is the risk of loss caused by a lack of a long-term development component in the bank’s managing team.
Default: Default is failure to meet the legal obligations (or conditions) of a loan. "Default" essentially means a debtor has not paid a debt which he or she is required to have paid.
"Insolvency" is a legal term meaning that a debtor is unable to pay his or her debts.
"Bankruptcy" is a legal finding that imposes court supervision over the financial affairs of those who are insolvent or in default.
- Technical default: related to a breach in covenants 3 - Debt service default: payment is not made when scheduled Credit risk: Potential that a bank borrower or counter will fail to meet its obligations in accordance with agreed terms. Risk that a borrower will not be able to repay the debt under ther terms of the original loan agreement.
General methodology: Identification (what? why?), Measurement and Assessment (how?), Minimization or Mitigation, Control (coverage and analysis) - Identification: IDENTIFYING THE SOURCE OF CREDIT RISK, UNDER WHAT CIRCUMSTANCES THE BORROWER MIGHT UNPAY THE LOAN? WHY DO YOU NEED A LOAN? WHAT ARE YOU BUYING? WHAT ARE YOUR CURRENT DEBT COMMITMENTS? o Why is unpaid? Lack of funds to face the payments (debtor’s insolvency) No income or any resources Failure in a business Mistake in forecasting results Problem with collaterals Related transactions don’t actually existed Unexpected events (death, illness, unemployment) o Lack of willingness to pay? Balance between loan/personal contribution - Measure and Assessment: What do I need to know to decide about the loan request? Where is available information? INFORMATION REQUIREMENTS (external sources of information): INCOME STATEMENT FOR FAMILIES (INCOME TAX, PROPERTY DOCUMENTS), ANNUAL ACCOUNTS FOR CORPORATES, CUSTOMER CREDIT PROFILE – internal sources of information (HISTORY, EXPERIENCE, POSITION IN THE BANK, SCORING, RATING) Coverage, supervision, control: Two stage process: - Pre-signature: coverage instruments - Post-signature: follow up instruments Looking for instruments trying to minimize detected risks. Controlling performance of the facility by looking evolution of main aspects related to borrower. ADDITIONAL GUARANTEES (PLEDGING), INSURANCES (unemployment, life, business activity,…) SUPERVISION OF BORROWER’S BEHAVIOUR (define limits for his/her performance or activities), CREDIT RISK JUST BEGINS WHEN THE LOAN IS SIGNED!! - General criteria: Objectivity, caution and common sense. Diversification and asset allocation (sectors, borrowers or countries). Correct valuation of additional guarantees or collaterals.
Knowledge and deep borrowers’ analysis. Extensive documentation: any information you should request to make a secure decision. Personal opinion and global report.
Guarantees: Guarantees are additional collateral in banking credit transactions which help the bank to get full/partial repayment if the borrower fails to meet payments. Guarantees need to be: 4 Reduced volatility (if more volatile, repayment probability is reduced) Reduced management costs LTV: key ratio to see how good are guarantees or collaterals in the transaction.
Credit cathegories: - Families: - Transaction development: - Customer information: Salaries receipts, Ownership documentation, Bank statements, Loans payments, Income tax form - Personal and professional analysis: Why are you applying for this loan? How will the loan proceeds be used? What is the total amount of the investment? What assets need to be purchased, and who are your suppliers? What other business debt do you have, and who are your creditors? - Payment profile analysis: Cash Balance: INCOME (fixed or variable), EXPENDITURES (known or unknown). NET INCOME = INCOME – EXPENDITURES. NET INCOME/ INSTALLMENT > 1.00 - Solvency analysis: guarantees. Additional guarantees?Additional coverage? Rethinking loan features(term, structure, details) - Transaction analysis: term, destiny, ..
- Scoring: Credit scoring systems are the set of tools a bank uses to make credit decisions about its customers. Depends on Type of transaction, borrower’s profile, economic details, banking experience - Decision: Preparing contract, Keeping documentation, Signing the contract, Control and supervision.
- Signature and control : Prepare specific documents. Post signing evolution: See customers performance, If any problem arises, see if we could help to improve situation (includes restructuring process if necessary). In case of complete default, execution - Corporations: Specific features: higher amounts, more variety of products (and associated risks). Need to have more information, Economic information, Additional report, External references, Suppliers, customers, external files, Information about the sector, where the company operates.
Related ideas: • default probability: What is the likelihood that the counterparty will default on its obligation either over the life of the obligation or over some specified horizon, such as a year? • credit exposure: In the event of a default, how large will the outstanding obligation be when the default occurs? 5 • recovery rate: In the event of a default, what fraction of the exposure may be recovered through bankruptcy proceedings or some other form of settlement? credit quality of an obligation, this refers generally to the counterparty’s ability to perform on that obligation. This encompasses both the obligation’s default probability and anticipated recovery rate.
Optimal capital structure: A simple measure of capital structure is the ratio of long-term debt to total capital.
Most financial statementbased risk analysis focuses on a comparison of the supply of cash and demand for cash.
Risk analysis using financial statement data typically examines - short-term liquidity risk, the near term ability to generate cash to service working capital needs and debt service requirements, and - long-term solvency risk, the longer-term ability to generate cash internally or from external sources to satisfy plant capacity and debt repayment needs The field of finance identifies two types of risks: - credit risk, a firm’s ability to make payments on interest and principle payments, and - bankruptcy risk, the likelihood that a firm will be liquidated Framework for Financial Statement Analysis of Risk Activity Ability to Generate Cash Need to Use Cash Financial Statement Analysis Performed Operations Profitability of Goods and Services Sold Working Capital Requirements Short-Term Liquidity Risk Investing Sales of Existing Plant Assets or Investments Plant Capacity Requirements Long-Term Solvency Risk Financing Borrowing Capacity Debt Service Requirements 6 Analysis of Short-Term Liquidity Risk The analysis of short-term liquidity risk requires an understanding of the operating cycle of a firm! - Current Ratio: mainly used to give an idea about the company’s ability to pay back its short-term liabilities and a sense of the efficiency of the firm’s operating cycle and its ability to turn its products into cash (ratio ≥ 1.0 preferred) - Quick Ratio: known as acid test, measures the firm’s ability to pay off its short-term debt from current liquid assets; draws a more realistic picture (trend towards 0.5) - Operating Cash Flow Ratio: using cash flow as opposed to accounting items provides a better indication of liquidity (40% typical of a healthy firm) Short-term liquidity problems also arise from longer-term solvency difficulties! Financial Ratio Formula Measurements Current Ratio Current Assets / Current liabilities A measure of short-term liquidity. Indicates the ability of entity to meet its short-term debts from its current assets Quick Ratio Current Assets less inventory / Current liabilities A more rigorous measure of short-term liquidity.
Indicates the ability of the entity to meet unexpected demands from liquid current asses Operating Cash Flow Ratio Cash Flows from Operations/Av erage Current Liabilities Measures a company's ability to pay its short term liabilities. Indicates whether the company has generated enough cash over the year to pay off short term liabilities as at the year end Analysis of Long-Term Solvency Risk Increasing the proportion of debt in the financial structure intensifies the risk that the firm cannot pay interest and repay the principle on the amount borrowed. Analysis of long-term solvency risk must begin with an analysis of short-term liquidity risk. Firms must survive in the short-term if they are to survive in the long-term! - Interest Coverage Ratio: gives a sense of how far earnings can fall before a firm will start defaulting on its payments (risky if ≤ 2.0) 7 - Long-Term Debt to Long-Term Capital Ratio: way of looking at the debt structure and determine what portion of total capitalization is comprised of long-term debt (what if ≥ 1?) Financial Ratio Formula Measurements Debt ratio Total Liabilities / Total assets Measures percentage of assets provided by creditors and extent of using gearing Capitalization ratio Total assets / Total shareholders’ equity Measures percentage of assets provided by shareholders and the extent of using gearing Debt to Capital Ratio Total Debt/(Total Shareholders’ Equity + Total Debt) The debt-to-capital ratio gives users an idea of a company's financial structure, or how it is financing its operations, along with some insight into its financial strength.
Times interest earned Operating profit before income tax + Interest expense / Interest expense + Interest capitalized Measures the ability of the entity to meet its interest payments out of current profits.
Univariate analysis The six ratios with the best discriminating power (and the nature of the risk each ratio measures) were as follows: - Net Income plus Depreciation, Depletion, and Amortization/Total Liabilities (long-term solvency risk) Net Income/Total Assets (profitability) Total Debt/total Assets (long-term solvency risk) Net Working Capital/Total Assets (short-term liquidity risk) Current Assets/Current Liabilities (short-term liquidity risk) Cash, Marketable Securities, Accounts Receivable/Operating Expenses excluding Depreciation, Depletion and Amortization (short-term liquidity risk) 8 Multivariate Bankruptcy Prediction Models Altman’s Z-Score: Net Working Capital Re tained Earnings Z score 1.2 1.4 Total Assets Total Assets Earning Before Interest and Taxes Market Value of Equity 3.3 0.6 Total Assets Book Value of Liabilities Sales 1.0 Total Assets We can convert the Z-score into a probability of bankruptcy using the normal density function within Excel. The formula is: =NORMSDIST(1-Z score). Altman developed this model so that higher positive Z-scores mean lower probability of bankruptcy Each ratio captures a different dimension of profitability or risk: - Net Working Capital/Total Assets: the proportion of total assets comprising relatively liquid net current assets (current assets minus current liabilities). It is a measure of short-term liquidity risk.
- Retained Earnings/Total Assets: accumulated profitability.
- EBIT/Total Assets: this ratio measures current profitability.
- Market Value of Equity/Book Value of Liabilities: this is a form of debt/equity ratio, but it incorporates the market’s assessment of the value of the firm’s shareholders’ equity.
This ratio measures long-term solvency risk and the market’s overall assessment of the profitability and risk of the firm.
- Sales/Total Assets: this ratio is similar to the total assets turnover ratio and indicates the ability of a firm to use assets to generate sales.
In applying this model, Altman found that Z-scores of less than 1.81 indicated a high probability of bankruptcy, while Z-scores higher than 3.00 indicates a low probability of bankruptcy. Scores between 1.81 and 3.00 were in the gray area.
Profitability Analysis Two main questions: - - How much risk economic and strategic factors pose for the operations of a firm, its profitability and long-term solvency? We use the Rate of Return on Assets (ROA) to answer this question.
Can the firm generate the expected return on the capital invested by the lenders and shareholders without compromising the future of the firm? That is, how much of ROA is left to shareholders (owners) after subtracting the amounts owed to lenders.
9 Financial Ratio Formula Measurements Return on Total Assets Operating profit before income tax + interest expense/ Average total assets Measures rate of return earned through operating total assets provided by both creditors and owners Return on ordinary shareholders’ equity Operating profit & extraordinary items after income tax minus Preference dividends / Average ordinary shareholders’ equity Measures rate of return earned on assets provided by owners Gross Profit Margin Gross Profit / Net Sales Profitability of trading and markup Profit Margin Operating profit after income tax / Net Sales Revenue Measures net profitability of each dollar of sales Net sales revenue / Average receivables balance Measures the effectiveness of collections; used to evaluate whether receivables balance is excessive Inventory turnover Cost of goods sold / Average inventory balance Indicates the liquidity of inventory.
Measures the number of times inventory was sold on the average during the period Total Asset turnover ratio Net sales revenue / Average total assets Measures the effectiveness of an entity in using its assets during the period.
Net Sales / Fixed Assets Measure the efficiency of the usage of fixed assets in generating sales Receivables turnover Turnover of Fixed Assets Debt is not bad. Some companies with no debt are actually running a sub-optimal capital structure. If a company raises a significant issue of new debt, the company should specifically explain the purpose. Be skeptical of boilerplate explanations; if the bond issuance is going to cover operating cash shortfalls, you have a red flag. If debt is a large portion of the capital structure, take the time to look at conversion features and bond covenants. Try to get a rough 10 gauge of the company's exposure to interest rate changes. Consider treating operating leases as balance sheet liabilities.
Rating systems: Short term discount receivables: Accounts Receivable (A/R) Discounted. Advancing receivables to our customer. Short term financing for our customer sales. Provides working capital. Relies on the strength of a business's customers. Risk sources: Receivable quality (risk that the debtor will not satisfy the obligation) Commercial transaction quality (verifying invoice) Unpayment reaction (temporary financial strenght) Impact of continuous unpayment from customers (structural financial health) Long term: loans, leases… Key point: Payment capacity. You need to assess both economic and financial situation of the company in the specific period of time you are lending the money (Historic financials (financial statements), Future forecast, business plan, Pay back (long term/short term/total), NFD/EBITDA). The longer is the loan, the higher is the risk.
Total debt number of years for repaying debt CF Macroeconomics details: - Default index Doubtful assets/ Total risk (credit investment). Information about total amount of investments which are not going to be recovered Example: if this index is 7%, it means 7 euros from each 100 euros invested in loans are not recovered from borrowers Risk management must consider 11 Economic situation (economic growth) (-) Interest rate evolution (+) Inflation (-) Expectations (-) Additional information: Sound credit risk analysis would depend on a number of Critical piece of information such as; Purpose of the loan/credit: This is one of the key information required from the borrower in order for the banker to base his/her judgment as to whether to proceed with further credit appraisal. There is nothing wrong for a bank to finance the repayment of another loan, if the new loan means sound refinancing of the existing debt. Banks would not certainly engage in the financing of loans or credits, which are outside its scope of business or finance illegal business activities. (e.g. gambling, speculative transactions, drug trafficking, environmentally unfriendly projects). The purpose of the loan/credit must be clear from the outset once the borrower submits his/her application.
Amount required: In as far as due consideration for the amount of the loan is concerned, the loans officer or executive must adhere to the principles of lending.
Banks normally set their loan policy in accordance with their financial resources. Too high an amount of the loan will be outside the bank’s mandate. In the modern day banking environment, if a bank cannot finance a loan application on its own and the project is economically feasible, it may act as the lead banker to call for a syndicate lending.
Repayment capacity of the borrower: This test would give the banker a fair idea on how to assess the repayment capacity of its borrowers. The repayment schedule is calculated on the basis of a projected financial statement over time. If a borrower expects to make surplus cash from its activities then the source of repayment will come from the cash flow. It is one of the key data required by any banker. It must be noted that a bank does not lend money to a customer on security only. The key priority for the banker is the ability for the customer to service its loan/credit efficiently.
Duration of the loan/credit: The time it takes to service a loan/credit cannot exceed a Bank’s normal credit policy. (e.g. if a bank has a policy not to lend beyond 5 years for a credit type, then it cannot lend beyond this specific time frame). In addition, if a project has a life time of say 7 years, it is expected that the project should be in a position to repay the bank in full within this time limit. There can only be exception, when the bank would extend the duration of the loan, subject to satisfying that the borrower will honor its commitment within the foreseeable risk. The duration of a loan is always tied to the rate of interest.
Borrower’s contribution: A borrower’s contribution towards the total borrowing application is very vital for the banker to gauge the degree of seriousness of the applicant. A small or no contribution towards the total loan applied represents to the bank that the borrower is very uncertain or uncommitted towards the entire 12 obligation. It is one of the indicators that the banker would be mindful when due consideration is given to the application. Even, when a customer makes a significant contribution towards the whole project, there is no assurance that the project will succeed. Nevertheless, it gives an indication as to the strength of the entire business concept.
Security aspects & insurance protection: Strictly, from a commercial lending viewpoint, the security aspects and insurance protection is the last resort. It is considered as a back up position in the event that the customer defaults on his/her obligations to repay the loan. It is important to note that a good banker should not lend the shareholders’ funds purely on the security offered by the borrowers. If this is the case, then the bank is in the business of substituting credit for asset purchases. This approach to lending can be very dangerous for the bank and its group of shareholders.
Lending should be based on the capacity to repay the loan.
Borrower’s character: A very vital piece of information that will allow the banker to decide “to lend, or not to lend”. A banker should not deal with a customer or potential customer that he/she cannot trust. The business of banking is all about trust, confidentiality & risk involved. The principle of lending is also about knowing your customer at all times, otherwise, the bank is likely to experience serious problem of “bad debts” on its books of accounts. Banks are not in the business of issuing credits for free. It is the shareholders’ funds together with other suppliers of capital, which are placed at risk.
Business plan & projections: Good banking practice is not about making a promise to repay the debt incurred by the borrower or debtor. It must be focused on sound financial plan, which would allow the banker to identify the strength and weakness of the credit application at the time of its submission. A business plan & its projections is equivalent to an architect’s plan, which provides all the information about the proposed building to be constructed. A customer, who fails to produce a projected financial plan is a signal to bank that there is something wrong about the whole business concept being asked to finance. A sharp banker is most likely to turn down the application.
Environmental considerations: During the last decade or so, the conservation/protection of the environment took centre stage in whatever business decision is taken. Banks have been accused of financing many projects at the destruction of the environment. In fact, repeated threats have been issued against the banks that engages into such projects. In order to avoid the bad publicity from the environmentalists who are also bank customers, banks have had to re-assess their lending policies. They are now having to behave like good corporate citizen by refusing to lend to projects, which are not friendly to the environment.
Other considerations: Banks are now also conscious to take into consideration the likely impact on its borrowers’ obligations due to changes in the weather conditions. In the last decade, the world has witnessed the catastrophic events, which had had adverse impact on the level of business risks, and eventually turning into default risk. A number of businesses have had to re-style their business proposition in a manner that they are insured against the scope of natural catastrophes. Some businesses are also compelled to subscribe to the “weather risk insurance” before they can be considered 13 eligible for financing by the banks or financial institutions. Some banks would not be prepared to lend to their corporate customers, if they are not in possession of a rating from either Standard & Poor's, or Moody’s. Other consideration can also be linked to an assessment of the sector, which the business operates. Is the sector in growth stage, or decline? The economic business cycle will also be one of the major considerations, that will be assessed before a final decision is reached. Banks restraint its credit expansion, when the economy is suffering from a downturn as opposed to an economic boom.