The Basics of Credit Analysis and Types of Risk
Credit Analysis is neither entirely a science nor entirely an art. What credit analysis does allow us to do is gain an accurate profile of a subject at a given point in time by not only considering the publicly reported accounting statements of the subject but by also considering the:
- microeconomics of the entity being examined,
- the microeconomics of the industry or service it is in (how its industry or service peer group operate),
- the micro/macroeconomics of the country the subject is domiciled in and/or operates in (how the nation is perceived),
- and the macroeconomics of the world (what business cycle and economic cycle presently exist),
- the structure of the transaction, and whether the Risk/Reward Profile is accurate and adequate.
Remember, a review of a subject's past performance, even the most recent previous quarter, is still nothing more than a history lesson. Conversely, it is impossible to predict the future. Thus, credit analysis does not predict the future of a company or the behavior of markets. Rather, it indicates what can be expected and anticipated from a company. However, no matter how one tries there is still going to be a credit that becomes troublesome no matter what the due dilligence revealed about the subject at the time of a transaction resulting in a loan to, or investment in, the subject. The "Science" of credit analysis is digging through the facts and presenting them coherently and accurately. The "Art" of credit analysis is the experience that one gains and gut feeling that one has about the subject. The past performance of a company is no indication of how it may perform tomorrow and past earnings will not pay tomorrow's expenses.
What recent events from the mid 1990s to 2001 demonstrated was that Credit and Equity Analysts exercised a great deal of power and high public profile in their coverage of companies and financial institutions. There appears to have been a failure by certain analysts of forgetting that they served their institution or clients by being overly optimistic or supportive of their target review subjects. The failure was that the analysts did not remain objective and professional. Anyone can appear to be a financial genius during a boom economic period, and that includes the company and the Analyst. However, one must always be realistic, rational and never be hesitant in being either critical of or expressing an opinion of the operations of a company, even if it may jeapordize the business relationship with the management of the subject. Credit and Equity Analysts are being paid to protect the assets of the institution or clients that they work for. Conversely, Analysts must also always remember that business does not fall from a tree, it has to be developed and maintained. Finding, evaluating and maintaining acceptable credit risks is the true role of the Credit Analyst, however it results in a situation where one is caught between the past and the future of a potential counterparty, between earning a living but perhaps being placed in the position of jeapordizing one's career by having to challenge the status quo, and of knowing how to accurately identify and expose outright fraud.
- Credit and Finance Risk Analysis can provide the credit analyst with the ability for:
- Analysis of the Business and the Industry Category
- Financial Statement Analysis for Strengths and Weaknesses
- Cash Flow Analysis and Projections for Loan Repayment
- Collateral Analysis
- Analysis of Credit Risk
- Adequate Loan Structure and Pricing
- Analysis of Loan Documentation for Completeness
The Five "Cs" of Credit Analysis:
- Capacity to repay from the cash flow of the business, the timing of the repayment to match cash flow, and the probability of successful repayment, payment history on existing credit relationships is an indicator of future performance, contingent sources of repayment.
- Capital is what the owner has invested and what that person(s) have at risk should the business fail.
- Collateral or guarantees are additional forms of security provided to a lender as a repayment in case the loan cannot be repaid under anticipated means, or some other entity agrees to repay the loan in the event of the primary borrower's default.
- Conditions focus on the intended purpose of the loan, the local economic climate and the conditions within the industry that may effect the borrower.
- Character is the subjective opinion/impression (education, experience references and trust) of the borrower by the lender.
- There are only three things you can do with regard to Risk:
- Eliminate it.
- Mitigate it.
- Accept it.
The possibility that the cash available to a bank could be exceeded by customer's calls on it, or the income generated by a corporation, along with the funds it can raise through equity or debt issuance and/or borrowing, are insufficient to cover operating obligations (suppliers, employees, operations) forcing the corporation to cease operations. Can also be caused through thin markets sometimes resulting from disruptions, which result in the unavailability of hedging instruments at economic prices or the inability to sell assets without a reduction in their value.
Most institutions face two types of liquidity risk. The first relates to the depth of markets for specific products and the second to funding the financial-trading activities of the firm. When establishing limits for various major risk types and products, senior managers must factor in the size, depth and liquidity of a particular market or product, because the liquidity of the market/instrument affects the ability of the firm to alter its risk profile quickly and at a reasonable cost. Some firms, for example, even have contract limits for every futures contract based on the volume of turnover and outstandings. Senior managers must also develop procedures to identify and monitor the firm's liquidity sources to ensure it can meet the funding demands of its activities. This is achieved by monitoring the differences in maturities between assets and liabilities and by analyzing future funding requirements based on various assumptions, including the firm's ability to liquidate positions quickly in adverse conditions.
Firms which deal in the over-the-counter market must also draw up contingency procedures to deal with potential liquidity risks that may rise from the early termination of contracts.
Liquidity risk is inherent in banking: financial institutions hold long-term pledges that cannot easily be collected or sold. Liquidity risk also correlates with credit risk (see next) as the more questionable the ability of the borrower to repay the more difficult it is to sell the security or the loan. During 2008 / 2009 liquidity risk became a real issue: banks would not lend to each other due to concern of the quality of the other bank's loan portfolio (banks were holding on to liquidity). Secondly, investors would not purchase securitizations due to the concern of the quality of the underlying assets thus financial institutions ended up holding assets on balance sheet that could not be priced due an inactive market (the assets could not be sold to raise cash). The only way to resolve the situation was for central banks to make billions of dollars available to commercial banks and then ease the terms of borrowing, and to guarantee the value of certain on-balance sheet assets of various institutions.
Credit Risk (Counterparty Risk):
The likelihood of default by the borrower or counterparty such that loans, bonds or leases will not be repaid on time / in full, or the counterparty will fail to perform on an obligation to the institution (trade, OTC derivative contract). The likelihood of this happening is measured through the repayment record/default rate of the borrowing entity, determination of market conditions, default rate of a loan portfolio of similar borrowers (which should not exceed a certain percentage of the total portfolio), and is mitigated / controlled through sound credit analysis guidelines, monitoring, loan covenants and collections. Counterparty Risk usually refers to trading activities.
With loans or bonds, the amount of the total risk is determined by the outstanding balance that the counterparty has yet to repay. However, the credit risk of derivatives is measured as the sum of the current replacement cost of a position plus an estimate of the firm's potential future exposure from the instrument due to market moves and what it may cost to replace the position in the future.
Senior managers must establish how the firm calculates replacement cost. The Basel Committee indicates that it prefers the current mark-to-market price to determine the cost of current replacement. An alternative approach would be to determine the present value of future payments under current market conditions.
The measurement of potential future exposure is more subjective as it is primarily a function of the time remaining to maturity and the expected volatility of the asset underlying the contract. The Basel Committee for Banking Supervisionindicates that it prefers multiplying the notional principal of a transaction by an appropriate add-on factor / percentage to determine potential replacement value of the contract (simply percentages of the notional value of the financial instrument). These percentages are deemed to be an estimate of potential exposure of the instrument and banks are charged regulatory capital based on these add-ons in addition to current exposure.
Senior management may also determine whether this potential exposure should be measured by using simulation (or other modeling techniques such as Monte Carlo, probability analysis or option valuation models). By modeling the volatility of the underlying it is possible to estimate an expected exposure.
Credit risk limits are part of a well-designed limit system. They should be established for all counterparties with whom an institution conducts business, and no dealings can begin before the counterparty's credit limit is approved. The credit limits for each counterparty must be aggregated globally and across all products (i.e. loans, securities, derivatives) so that a firm is aware of its aggregate exposure to each counterparty. Procedures for authorising credit limit excesses must be established and serious breaches reported to the supervisory board. These limits should be reviewed and revised regularly. Credit officers should also monitor the usage of credit risk by each counterparty against its limits. Researching the identity and legal status of a new client should be part and parcel of any credit assessment of new counterparties. Staff should be encouraged to put a face to all counterparties and should not be overwhelmed or seduced by a client's reputation into authorizing unjustified credit lines.
Once a counterparty exceeds the credit exposure limits, no additional deals are allowed until the exposure with that counterparty is reduced to an amount within the established limit. Open contracts remain in force.
Senior managers should try to reduce counterparty risks by putting in place master netting as well as collateral agreements. Under a master netting agreement, losses associated with one transaction with a counterparty are offset against gains associated with another transaction so that the exposure is limited to the net of all gains and losses related to the transactions covered by the agreement. The Basle Committee for Banking Supervision estimates that netting reduces current (gross) replacement value on average by 50% per counterparty. However, board members, senior management and line personnel must be aware that netting agreements are not yet legally enforceable in several European and Asian countries; a factor which they must take into consideration in their daily dealings with counterparties in these countries; not to do so will engender a false sense of security. The forms of collateral generally accepted are cash and government bonds.
Another type of counterparty risk is Pre-settlement risk, the risk that a counterparty will default on a forward or derivative contract prior to settlement. The risk of a default event prior to the settlement of a transaction. The specific event leading to default can range from disavowal of a transaction, default of a trading counterparty before the credit of a clearing house is substituted for the counterparty's credit, or something akin to Herstatt risk, where one party settles and the other defaults on settlement.
Connected to counterparty risk is also Sovereign Risk, which is the risk that a government action will interfere with repayment of a loan or security. This is measured, again, by the past performance of the nation and present default rate and conditions (political, social and economic), and is controlled by strict credit analysis, limiting exposure as a percentage of portfolio, and incorporating covenants into the loan documents.
Market risk deals with adverse price or volatility that affects the assets contained in a firm's or fund's portfolio. It is the possibility that sharp downward movements in market (stock, bond, commodity and currency) prices will destroy a financial institution's capital base (i.e. sensitivity of a bank's trading portfolios to changes in market prices), or the sensitivity of an asset or open contract to a movement of the market. Secondly, it can also be defined as the uncertainty of a financial institution's earnings resulting from changes in market conditions such as the price of an asset, interest rates, market volatility and market liquidity. It can be defined in absolute terms as a dollar amount or as a relative amount against some benchmark.
Market risk is different from an asset's mark-to-market calculation, which is the current value of the firm's financial instruments. Market risk represents what the firm could lose if prices or volatility changed in the future. A firm must measure the market risks resulting from its portfolio of financial instruments and senior managers must decide the frequency of this measurement. Firms with active portfolios should calculate their exposures daily while those with small portfolios could do so less frequently.
Market risk is measured as the potential gain or loss in a position or portfolio that is associated with a price movement of a given probability over a specified time horizon. This is the value-at-risk (VAR) approach. How it should be measured is a decision taken by the board of directors on the advice of senior managers; external consultants and auditors can be consulted if senior managers feel that they have inadequate knowledge to deal with this very technical issue.
Related to credit risk but not identical, settlement risk is the risk that an expected settlement payment on an obligation will not be made on time due to bankruptcy, inability or time zone differential. A common example involves bilateral obligations in which one party makes a required settlement payment and the counterparty does not. Settlement risk provides an important motivation to develop netting arrangements and other safeguards. It is sometimes also called Delivery Risk.
When related to currency transactions, the term Herstatt Risk* is sometimes used. This is the risk that one party to a currency swap will default after the other side has met its obligation, usually due to a difference in time zones. The settlement of different currencies in different markets and time zones from the moment the sold currency becomes irrevocable until the purchased currency receipt is confirmed (duration and amount of risk faced by market participants affects ability to accurately determine actual exposure). The two parties are paid separately in local payment systems and may be in different time zones, resulting in a lag time of three days and mounting exposure that may exceed a party's capital.The risk is reduced by improved reconciliation (such as including unreconciled trades) and netting agreements.
* Bankhaus Herstatt (a private German bank); On June 26, 1974, the bank was closed by German financial regulators (Bundesaufsichtsamt für das Kreditwesen) who ordered it into liquidation during the banking day but after the close of the interbank payments system in Germany. Prior to the announcement of Herstatt's closure, several of its counterparties had, through their branches or correspondents, irrevocably paid Deutsche Mark (approximately $620 million) to Herstatt on that day through the German payments system against anticipated receipts of US dollars later the same day in New York in respect of maturing spot and forward transactions. Upon the termination of Herstatt's business at 10.30 a.m. New York time on 26th June (3.30 p.m. in Frankfurt), Herstatt's New York correspondent bank suspended outgoing US dollar payments from Herstatt's account. This action left Herstatt's counterparty banks exposed for the full value of the Deutsche Mark deliveries made (credit risk and liquidity risk). Moreover, banks which had entered into forward trades with Herstatt not yet due for settlement lost money in replacing the contracts in the market (replacement risk), and others had deposits with Herstatt (traditional counterparty credit risk). (Bank For International Settlements, Settlement Risk In Foreign Exchange Transactions, March 1996) www.bis.org/publ/cpss17.pdf (.pdf format).
Interest Rate Risk:
The risk that changes in interest rates will result in financial losses related to asset/liability management. It is measured by past and present market volatility and the profile of the asset/liabilities of the bank and its possible exposure through gap management, and it is controlled by hedging (swaps, futures and options) the assets and liabilities and accurately researching and quantifying pending changes and scenarios.
Foreign Exchange Risk:
The risk that foreign exchange rate changes will cause foreign exchange denominated assets to fall in value or foreign exchange denominated liabilities to rise in expense (trading positions; loans; overseas branches). It is measured by marking-to-market the value of the asset, or increase of the liability, by the actual movement of the exchange rate between the currency of the asset/liability and the currency of the booked or pending asset or liability, or country of earnings repatriation. It is controlled by hedging (swaps, futures and options) the assets and liabilities and researching pending changes and scenarios.
The risk that the institution has inadequate capital for losses it may incur, which can result in bankruptcy or regulatory closure; or that it has a sub-optimal equity-debt capital profile which negatively impacts the market price of its stock. It has controlled by provisions and reserves from past earnings sufficient enough to cover operating losses; and by evaluating the loan, securities and trading operations accurately for any pending losses or deterioration.
The risk that the bank's own employees or its customers will defraud the bank. This is one of the most difficult situations to measure or control as demonstrated by trader problems at Barings, Daiwa and Sumitotmo. It is controlled by separating trading and settlement functions, periodic internal and external audits, and a centralized computer system to track and quickly/accurately reconcile the bank's position, portfolio and operations.
The risk that fraud, poor service, poor regulatory compliance or other improper behavior by the employees of a company or organization that can cause defection of customers, the ability to establish new relationships or services, or continue servicing existing relationships. The risk is present throughout all levels of the organization: the behavior of senior management or rank and file employees can be equally damaging.
The risk that potential for lawsuits from disgruntled employees, clients, improper documentation, criminal or negligent conduct, workplace regulations or environmental contamination will severely disrupt the company's operations.
The risk that human or machine (hardware/software) error/failure will result in financial losses due to documentation deficiency, securities processing, clearing issues, and systems failure. It is difficult to measure errors but the loss could be substantial related to settlement problems or customer liability suits. It is controlled through back-up data processing systems, computerized accounting/audit system that can flag a problem, and reserves for related losses.
The risk that overhead expenses will excessively burden the company's viability. It is measured by the ratio of total other expenses/net interest income and total other income; other expenses (expenses other than interest expense and loan loss provisions, such as salaries and employee benefits plus occupancy plus depreciation and amortization plus provisions) tend to rise faster than income in a time of inflation. It can also be measured as a percentage of operating income to determine the portion of the income stream available to cover overhead. It is also measured by the Efficiency Ratio, the ratio of operating non-interest expenses as a percentage of net operating revenues, which is a measure of productivity of the bank. It is controlled by keeping a lid on expenses within prudent ratio guidelines, funding expansion through internally generated capital, and monitoring the efficiency of the bank and reducing staff if necessary.
The risk that change in regulations will adversely affect. It is measured by how a change will affect an established operation or curtail entry into a new operation, or affect capital reserve requirements, or operating requirements of the respective national banking regulator. It is controlled by lobbying federal and state legislature to keep abreast of pending changes and attempt to influence the decision making process.
Economic Conditions Risk:
The risk that an adverse change in economic conditions would unduly put the bank at risk. It is measured by how the loan portfolio would perform, what interest rates would do, how the securities portfolio may decline in market value, how liabilities may increase, deposit withdrawals increase resulting in liquidity problems. It is controlled through sound credit analysis, prudent investment, asset/liability gap management, and prudent expansion/business operations plan.
Credit Rating Agency Risk:
This really did not exist prior to 2007 through 2009, and who would think that it would ever really be a problem. However, the substanial amount, in both number and dollar amount, of various types of securities that were assigned AAA ratings by the three major credit rating agencies, and then were marked down (some to below investment grade) within 12 to 18 months of issue essentially turned the whole concept of "credit rating" on its head. The credit issue is whether the ratings assigned by these companies can really be relied upon.