Chapter 4b: Risk Management (sections 8 - 13)

Question 1

What is the internal ratings based approach and what is required?

Answer 1

When a bank’s credit risk management system is used to establish risk weighted assets and minimum capital in relation to credit risk under the Basel framework

It requires permission of the PRA to be used by a UK bank

Question 2

Give a description of ‘expected loss’?

How must a bank respond to an expected loss?

Answer 2

Expected losses are the losses a bank can expect since any borrower can default.

The level of interest rate must be sufficient compensation for this expected loss and it must suit the bank’s risk appetite

Question 3

What are expected losses the result of?

What is the calculation of expected loss (EL)?

What is the recovery rate?

Answer 3

Result of:

1) Exposure at default (EAD) –> total exposure at risk in the event of a default
2) Loss given default (LGD) –> likely level of loss in the event of default
3) Probability of default (PAD) –> likelihood of the borrower defaulting

EL = PD x LGD x EAD

The amount that the lender expects to recover in the event of default, so 1 - LGD

Question 4

Define credit score

Answer 4

A method of evaluating the credit worthiness of customers by using a standardised formula or standard set of rules

Question 5

How do credit scoring models arrive at a score for an individual’s credit risk

Answer 5

Considers an applicant’s characteristics and past behaviour
Uses information in the loan application,
The individual credit report
Past conduct of their accounts

Question 6

How is a credit score used?

What does reliance depend on?

Answer 6

To approve an application an applicant’s credit score must exceed a given threshold . Used as the main indicator of an applicant’s credit strengthen.

Depends on:
1) The product e.g. unsecured (like personal loans) the score is used more heavily. Where as secured products like mortgages it is secondary

2) How automated the appraisal process is - so is there scope for judgement

Question 7

What are the key benefits for banks credit scoring?

Answer 7

1. Speed and Efficiency - credit decisions can be made quickly with limited human involvement
2. Cost effectiveness - lack of involvement of bank personnel
3. Consistency - uses a fixed set of rules to ensure fairness
4. Accuracy - fixed set of rules reduces human error

Question 8

How does risk appraisal differ for companies compared to individuals?

Answer 8

Credit scoring is insufficient to appraise their credit risk as the risk is of higher value and products aren’t standardised

Loans to companies are typically larger and individually significant, so it more critical that the risk is correctly established

Question 9

What is an average bank’s methodology to appraising risk for commercial lending?

What questions are they trying to find the answers to?

What three principal areas analysis will cover?

Answer 9

Need to form a full picture through detailed analysis of the applicant and loan application. This involves analysing quantitative and qualitative factors

a) How likely is the potential borrower to be able to repay the loan?
b) What are the consequences of them not doing so?
c) Is the risk acceptable to it’s risk appetite and rewards?

1) Creditworthiness of the borrower
2) Terms and structure of the loan
3) Available return

Question 10

Describe Qualitative assessment

Answer 10

Involves considering issues that could affect the ability of the borrower to repay i.e.
State of the economy
State of the industry sector
Competitive environment 
Management

Question 11

Describe Quantitative analysis

Answer 11

This involves the scrutiny of the numbers underlying the loan proposal i.e.
Historical performance from audited FS
Management forecasts
Looking at key ratios

Question 12

What are the 5 things involved in the creditworthiness of the borrower

Answer 12

External Factor
Competitive environments
Financial Information
Obtaining assurance for information provided by the client
Management

Question 13

What are the external factors affecting the business’ ability to repay?

Answer 13

Political
Economic
Social
Technological
Environmental
Regulatory/Legal

Question 14

What’s the main tool banks use to examine the competitive environment of the applicant?

Answer 14

Porter’s five forces:

1) Threat of new entrants to the industry
2) Rivalry amongst existing competitors
3) Threat of substitute products
4) Bargaining power of buyers
5) Bargaining power of suppliers

Question 15

How can bank’s analyse financial information?

Answer 15

1) Analysing audited financial statements of the past
2) Looking at financial forecasts for future periods which include the impact of the loan/repayments, cash generation.
Must make sure the forecasts are robust and built on reasonable assumptions

3) Understanding key ratios and their movements over time

Question 16

How do banks gain assurance over the reliability and credibility of forecasts and other unaudited information?

Answer 16

1) Comparing the information to that of similar companies - benchmarking
2) Verifying information against other sources
3) Obtaining a company credit report e.g. suppliers and other finance providers
4) Visiting their premises to get physical verification
5) Obtaining verification of contracts

Question 17

When considering management and their affect on the creditworthiness of the client, what are the 4 things the bank should consider?

Answer 17

1) Management track record - do they have a proven record of success in their current or previous companies?
2) Past credit behaviour - have they been responsible for loan defaults? their personal credit history?
3) Personal stake - do they have any personal financial involvement in the business? personal guarantees?
4) Succession planning - are their any succession plans in place if management gets fired or died?

Question 18

What issues relating to the structure of the loan need to be addressed?

Answer 18

Amount: Is it appropriate? Not too high or too low

Term: Is the length of time before repayment appropriate? Too long or too short?

Repayment: How will repayment be structured?

Interest: Is interest fixed or floating?

Security: Can reduce the level of loss in the event of a default by a borrower but shouldn’t be seen as a secondary means of repayment
Fixed charges: This is attached to a specific asset which can’t be sold
Floating charges: Over specified classes of current assets and only crystallises if they default. Still free to dispose of the assets. If a default occurs the bank can realise the value of the charged asset(s) - may be less than expected

Loan support: Guarantees are another form of risk reduction. Banks may seek a guarantee from directors
(making them personally liable) or from a more credit worthy company in the same group

Covenants: These will to loans listing conditions and obligations on the borrower to reduce credit risk e.g. a specified ratio value or required disclosure.

Question 19

What are the two categories of banking covenants? (not types)

Answer 19

1) Financial covenants
Examples: Restriction on dividiend pay outs, limits on share issues or additional borrowing, minimum levels of performance/liquidity

2) Non-financial covenants
Examples: Notification of significant changes or litigation, providing audited financial statements or management accounts, bank approval for board changes, requiring insurance

Question 20

What are the two types of banking covenants (not categories)?

Answer 20

Negative covenants - where a restriction is placed on the borrower

Positive covenants - where the borrower has to take a certain action

Question 21

Why is the available return considered in the analysis of a loan application?

Answer 21

The bank can’t consider the risk alone and must include the return
The risk and return profit must be compared to the bank’s risk appetite to see if it can be accepted

Question 22

What should be considered when looking at the return of a loan?

Answer 22

1) The rate of interest - so how much interest will be earned over the loan. This can be fixed or floating above market rate
2) Other remuneration from the loan - arrangement/underwriting/facility fees
3) The value of other relationships - the company may have other lucrative relationships with other divisions or share directors with another valuable business

Question 23

Banks typically have a standardised credit analysis process. What qualitative and quantitative areas does this process typically focus on:

Hint: LAVSFCM

Answer 23

1. Loan suitability
2. Affordability
3. Viability
4. Security
5. Financial stability
6. Capital Structure
7. Management

Question 24

Describe loan suitability?

Answer 24

This is where a bank considers if the finance structure suitable for the purpose? e.g. if project’s cash flow is heavy in the later years then maybe repaying the principal at the end is better than amortising it over the loan terms

Maybe using overdrafts for the short term
Using leases or hire purchase agreements for asset purchases

Question 25

How should a bank analyse affordability?

Answer 25

They should focus on the business' ability to generate enough profits and cash to cover the interest and capital repayments Also look at the company's business plan and financial forecasts - are they reasonable?

Question 26

Describe viability? How should a bank analyse this?

Answer 26

This is the ability of a business to repay the principal | The bank should consider gearing (debt to equity)

Question 27

How should a bank analyse security?

Answer 27

Evaluate the availability of assets with the characteristics to be good security which charges may be taken and see what assets are already secured against other loans

Question 28

How should a bank assess the financial stability?

Answer 28

Assessment is based on forecasts from the borrower. But banks must question the credibility of the forecasts and the assumptions behind them

Question 29

Describe analysing capital structure?

Answer 29

Involve examining the way in which the business is funded by equity and debt

Question 30

How does a bank make a decision once the credit analysis has been performed? Why is a lending criteria needed an what does it include?

Answer 30

Banks need to make a decision whether the credit is acceptable and the loan should be approved. They will typically have a lending policy in place which sets out a criteria for a loan to be acceptable ``` Its needed to achieve some consistency and make sure it fits with the bank's risk appetite. It includes: Max loan term Min levels of security Min levels for forecast ratios Size of loan ```

Question 31

How does the 'collections and recoveries' department monitor an approved loan?

Answer 31

Their actions include: 1) Restructuring/Rescheduling - working with management to develop an achievable repayment plan 2) Selling the loan - distressed dent market enables the bank to realise some value and avoid costs 3) Realise the value of security - bank can initiate legal proceedings to take possession of charged assets 4) Collection against guarantors - in some cases action may need to be taken to enforce guarantees 5) Abandonment - sometimes pursuing an outstanding loan is costly so they may decide to take no further action

Question 32

Define forbearance (in the context of rescheduling and restructuring a loan)

Answer 32

The lender chooses to hold back from enforcing its full legal rights by altering the terms of the loan, in order to decrease the likelihood of repayment and reduce the chance of default

Question 33

What are some of the main elements of forbearance?

Answer 33

1. Lengthening the term of the loan = so the capital can be repaid over a longer period of time 2. A temporary payment moratorium = gives borrower a period where no loan repayments are required to be made (breathing space) 3. Conversion of a loan to interest only = reduces the size of loan payments and the repayment of capital is deferred 4. Reduction in the interest rate = reduce the interest rates to make repayments achievable. May be temporary or permanent 5. Debt to equity swaps = the lender may agree to waive the outstanding debt in exchange for shares in the company 6. Covenant waivers = the lender may choose to waive the covenant rather than treating it as a default

Question 34

When a bank is lending to another bank, what are the other things they need to consider in relation to credit risk? (other than term and interest)

Answer 34

1. Credit rating of the institution 2. Risk concentration - they may have other credit exposure to that same party e.g. OTC derivatives. So they don't want a concentration of risk 3. Systematic Risk - the fear that one bank failure could undermine the stability of others