Topics 16-18 Flashcards
The four primary components of credit risk evaluation
The four primary components of credit risk evaluation are as follows:
- The borrower’s (or obligor’s) capacity and willingness to repay the loan.
- The external environment and its effect on the borrower’s capacity and willingness to repay the borrowed funds. Factors such as the business climate, country risk, and operating conditions are relevant to the lender. Are there cyclical changes that will affect the level of credit risk? Will political risks affect the likelihood of repayment?
- The characteristics of the credit instrument.
- The quality and adequacy of risk mitigants such as collateral, credit enhancements, and loan guarantees. The use of collateral not only mitigates losses in the event of default, but also lowers the probability of default because the obligor typically does not want to lose the collateral. Historically, banks have substituted collateral for analysis of the borrower’s ability to pay.
Three issues regarding risk mitigants
Three issues regarding risk mitigants include:
- Is the collateral pledged to, or likely to be pledged to, another loan?
- Has there been an estimation of the value of the collateral?
- If there is a loan guarantor, has there been sufficient credit analysis of the third party’s willingness and ability to pay in the event the borrower does not pay?
Qualitative credit analysis techniques
The qualitative credit analysis techniques are largely used to evaluate the borrower’s willingness to repay. Qualitative techniques include:
- Gather information from a variety of sources about the character and reputation of the potential borrower.
- Face-to-face meetings with the potential borrower to assess the borrower’s character are routine in evaluating willingness to pay.
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“Name lending” involves lending to an individual based on the perceived status of the individual in the business community. Some lenders substitute name lending for
financial analysis. -
Extrapolating past performance into the future. Lenders often assume that a pattern of borrowing and repaying in the past (e.g., a credit record compiled from past history with
the borrower and data garnered from credit bureaus) will continue in the future.
Determining the capacity to pay is more important than determining the willingness to pay because the legal system will force those who can pay to honor their commitment. Sovereign risk ratings may be used to evaluate the quality of a country’s legal system and, by extension, the legal risk associated with the country or region. Even in countries with robust legal systems such as Finland and the United States, the creditor must also consider the costs associated with taking legal action against a delinquent borrower. If costs are high, the creditor may be unwilling to take action regardless of the strength of the enforcement of creditor rights. As such, the willingness to pay should never be completely ignored in credit analysis.
Quantitative credit analysis techniques, their limitations
There are limitations associated with quantitative data, which include:
- Historical nature of the data. Financial data is typically historical and thus may not be up-to-date or representative of the future. Also, forecasted financial data is notoriously unreliable and susceptible to miscalculations and/or misrepresentations.
- Difficult to make accurate projections using historical data.
The most effective analysis combines quantitative assessments with qualitative judgments.
Comparison of Borrowers
Two primary differences between nonfinancial firm credit analysis and financial firm credit analysis
The two primary differences between nonfinancial firm credit analysis and financial firm credit analysis are:
- the importance of the quality of assets in financial firms and
- cash flow as an indicator of capacity to repay for nonfinancial firms but not a key indicator of creditworthiness for financial firms. It is clear from the 2007—2009 financial crisis that asset quality is a key indicator of a bank’s financial health. That is why earnings capacity over time is a more relevant indicator of creditworthiness than cash flow.
Describe quantitative measurements and factors of credit risk, including probability of default, loss given default, exposure at default, expected loss, and time horizon.
- Probability of default (PD): The likelihood that a borrower will default is not necessarily the creditor’s greatest concern. Creditors must rely on other measures of risk in addition to PD.
- Loss given default (LGD): LGD represents the likely percentage loss if the borrower defaults.
- Exposure at default (EAD): The loss exposure may be stated as a dollar amount (e.g., the loan balance outstanding).
- Expected loss (EL): Expected loss for a given time horizon is calculated as the product of the PD, LGD, and EAD (i.e., PD x LGD x EAD).
- Time horizon: The longer the time horizon (i.e., the longer the tenor of the loan), the greater the risk to the lender and the higher the probability of default. Also, EAD and LGD change with time. The exposure (EAD) increases as the borrower draws on a credit line and falls as the loan is paid down. The LGD can also change as the terms of the loan or credit line change.
! A bank should also consider the correlations between various risk exposures when analyzing credit risk in a portfolio context.
Compare bank failure and bank insolvency
Bank insolvency and bank failures are not identical.
Banks become insolvent and are often merged into healthier institutions. It is more convenient and less expensive for the government to simply fold a troubled bank into a stronger bank than it is to close the bank.
Research indicates that bank failures are considerably less likely than nonfinancial firm failures.
Describe, compare and contrast various credit analyst roles
There are several methods to describe, compare, and contrast the various credit analyst roles, including:
- Job descriptions (e.g., consumer credit analyst, credit modeling analyst, corporate credit analyst, counterparty credit analyst, credit analysts at rating agencies, sell-side/buy-side fixed-income analysts, bank examiners and supervisors).
- Functional objective (e.g., risk management vs. investment selection, primary vs. secondary research).
- Type of entity analyzed (e.g., consumer, corporate, financial institution, sovereign/municipal).
- Classification by employer (e.g., banks and other financial institutions, institutional investors, rating agencies, government agencies).
Counterparty Credit Analyst, Sell-Side and Buy-Side Fixed-Income Analysts
Counterparty Credit Analyst
- Analyzes typical counterparties (i.e., banks, nonbanks—brokers, insurance companies, hedge funds); usually employed by a financial institution to analyze other institutions with which it contemplates a two-way transaction.
- Performs credit reviews, approves limits, and develops/updates credit policies and procedures.
Sell-Side and Buy-Side Fixed-Income Analysts
- Employed by financial institutions or hedge funds.
- In addition to credit risk, there is a focus on the relative value of debt instruments and their attractiveness as investments.
Primary Research, Secondary Research
Primary Research
Primary research refers to analyst-driven credit research or fundamental credit analysis. This is usually detailed (and often time-consuming) research with human effort that is both quantitative and qualitative in nature. The analysis looks at microeconomic factors (specific to the entity) and macroeconomic factors (e.g., political, industry). Rating agency analysts provide value by performing detailed credit analysis and arriving at independent conclusions, all of which is subsequently relied upon by other analysts. One of the disadvantages of primary research is its high cost; as a result, some financial institutions have an automated credit scoring system for simpler and less expensive transactions.
Secondary Research
It is often difficult for the credit analyst to perform detailed first-hand analysis (e.g., inperson visits), especially if the counterparty is very large or is located in a foreign country. An alternative is to perform secondary research, which involves researching the ratings provided by other rating agency analysts. Such information is combined with other relevant information sources, current information about the counterparty, and the analyst’s own research, to conclude the counterparty’s credit risk assessment. Given the reliance on other research, secondary research reports tend to be much shorter than primary research reports. The goal of using secondary research is for a financial institution to perform counterparty credit analysis in a quick and efficient manner while maintaining reliability.
Rating Advisor
This is a unique role most frequently found in investment banks. The rating advisor has likely been a rating agency analyst and is now working to help a debt issuer obtain the highest rating possible. The rating advisor would perform an independent credit analysis of the issuer to arrive at a likely rating. The advisor would then provide advice to the issuer on how to mitigate any issues and respond to rating agency questions.
Describe common tasks performed by a banking credit analyst
There are three main types of banking credit analysts:
1. Counterparty credit analysts perform risk evaluations (reports) for a given entity. The tasks might be limited to simply covering certain counterparties or even only certain transactions or might be expanded to include decision making, recommendations on credit limits, and presenting to the credit committee.
Should the duties extend into the decision-making process, responsibilities would include the following:
- authorizing the allocation of credit limits,
- approving credit risk mitigants (i.e., guarantees, collateral),
- approving excesses or exceptions over established credit limits, and
- liaising with the legal department regarding transaction documentation.
Some analysts may be required to review and propose amendments to the banks existing credit policies.
Finally, counterparty credit analysts must understand the risks inherent with specific financial products and transactions. Therefore, it is necessary to obtain knowledge of the bank’s products to supplement their credit decisions.
2. Fixed-income analysts
In an effort to make profits for the entity, fixed-income analysts provide recommendations regarding the decision to buy, sell, or hold debt securities. Both fundamental and technical analyses are generally performed in arriving at investment decisions.
3. Equity analysts
Equity analysts analyze publicly traded financial institutions to help in determining whether an investor should buy, sell, or hold the shares of a given financial institution. Similar to fixed-income analysts, there are two general approaches to equity analysis. Analysts could choose to perform fundamental analysis, technical analysis, or a combination of the two.
Describe the quantitative, qualitative, and research skills a banking credit analyst is expected to have
Quantitative skills are necessary to assist in determining the ability of the entity to repay debt.
Qualitative skills are necessary to assist in determining the willingness of the entity to repay debt (e.g., reputation, repayment track record). It is critical for analysts to think beyond numbers and apply considerable judgment, reasoning, and experience in determining which factors are relevant for making decisions (e.g., management competence, bank’s credit culture, and the robustness of credit review process).
An analyst should have basic research skills in order to analyze an unfamiliar banking sector. Some preliminary research on overall sector structure, sector characteristics, and nature of regulation should be performed first.
A rating agency analyst would most frequently utilize primary research skills while a counterparty credit analyst would most frequently utilize secondary research skills.
- Primary research skills include detailed analysis of (audited) financial statements for several years together with annual reports and recent interim financial statements. In addition, the rating analyst would usually need to make one or more due diligence visits to the bank to meet with senior management to discuss operational and business strategy. In addition to the visit, a questionnaire may also be provided to management to complete and return to the analyst.
- Secondary research skills involve using the research published by others (e.g., rating agencies). The counterparty credit analyst would not make frequent visits to banks. Any site visits would tend to be brief and focused on very specific areas.
Sources of information used by a credit analyst
Sources of information used by a credit analyst
- Annual Report
- Auditor’s Report
- Financial Statements - Annual and Interim
- Banks Website: the quality, layout, and ease of accessibility of the website itself are often good indications of the stability of the bank
- News, the Internet, Securities Pricing Data
- Prospectuses and Regulatory Filings
- Rating Agency Reports and Other Third-Party Research
Define default risk, recovery risk, exposure risk and calculate exposure at default.
Default Risk
Determining the probability of default (PD) can be based on the following approaches:
- Analyzing historical default frequencies of a borrower’s homogenous asset classes.
- Using mathematical and statistical tools. Statistical models are typically used for large portfolios with hundreds or even thousands of positions, which allows for segmentation into different risk classes, measuring risk on an ex ante basis (i.e., before an event).
- Using a hybrid approach that combines mathematical and judgmental analyses.
- Extracting implicit default probabilities from market prices of publicly listed counterparties.
Recovery Risk
The amount of recovery depends on the following factors:
- The type of credit contracts used and the relevant legal system.
- General economic conditions. Firms operating in more volatile sectors may see larger swings in asset values.
- Covenants. Negative covenants restricting the sale of assets that are important to the borrower should be considered in LGD estimations.
Exposure Risk
Evaluate the marginal contribution to portfolio unexpected loss
- A beta greater than one would imply that the marginal risk from the ith loan is greater than the average portfolio risk and would, therefore, increase portfolio concentration risk.
- A beta less than one would reduce portfolio risk and increase the effect from diversification.
Define risk-adjusted pricing and determine risk-adjusted return on risk-adjusted capital (RARORAC)
As VaR increases, so does the expectation of higher returns and economic capital. The cost of capital multiplied by VaR needs to be incorporated into lending decisions as a cost for banks that are price takers, or as a lending cost (to be included in credit spreads) for banks that are price setters.
The risk-adjusted return on capital (RAROC) has been widely used by banks in measuring risk-adjusted performance. A common variant of RAROC is the risk-adjusted return on risk-adjusted capital (RARORAC). Both of these measures are used by business lines to assess whether returns generated exceed the market risk premium required by capital. The market risk premium should be in proportion to the credit spread. Transactions create value if RARORAC exceeds a minimum target, for example, a target return on equity (ROE):
