9781118604915

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.

Ciby Joseph (FCA, FRM) is a veteran credit and finance professional with two decades of banking experience. His expertise includes credit risk analysis, credit risk management, financial analysis, relationship management, Basel regulations, investment management, derivatives and feasibility studies. His banking exposure included banks such as CSB, HSBC and Lloyds TSB. University Rank holder (1989) and a recipient of a ‘Letter of Appreciation’ from HSBC (2003) for best credit risk analysis, Ciby headed the corporate credit risk of Lloyds TSB Middle East where he enjoyed corporate credit sanction authority. He is currently a Director at Crowe Horwath, UAE and a Partner of Transcend Investments & Credit Advisory, India. Ciby advises CEOs, CFOs and senior executives on optimum credit/borrowing strategies and participates in strategic assignments with respect to financing, debt syndication and risk management and conducts classes on credit risk. He has also contributed articles to various publications including Global Association of Risk Professionals, (GARP) USA.

Preface xvii

PART I INTRODUCTION

1 Credit Basics 3

1.1 Meaning of Credit 4

1.2 Role of Credit 6

1.3 Credit Market 6

1.4 Credit – Advantages and Disadvantages 7

1.4.1 Merits of Credit 7

1.4.2 Demerits of Credit Usage 9

1.4.3 Is Wealth Creation Through Use of Credit Easy and Simple? 10

1.5 Suppliers of Credit 11

1.6 Credit Risk Study 12

Appendix: Credit Creation 13

Questions/Exercises 14

2 Essentials of Credit Risk Analysis 15

2.1 Meaning of Credit Risk 15

2.2 Causes of Credit Risk 16

2.3 Credit Risk and Return 17

2.4 Credit Risk Analysis 17

2.5 Historical Progress of Credit Risk Analysis 19

2.6 Need for Credit Risk Analysis 19

2.7 Challenges of Credit Risk Analysis 22

2.7.1 The Art and Science of Credit Risk Analysis 22

2.8 Elements of Credit Risk Analysis 24

Questions/Exercises 25

3 Credit Risk Management 27

3.1 Strategic Position of Credit Risk Management 27

3.2 Credit Risk Management Context 28

3.3 Credit Risk Management Objectives 28

3.4 Credit Risk Management Structure 29

3.5 Credit Risk Culture 29

3.6 Credit Risk Appetite 30

3.7 Credit Risk Management in Non-Financial Firms 31

3.8 Credit Risk Management in Financial Intermediaries 31

3.8.1 Stages of Credit Risk Management in Financial Intermediaries 31

3.8.2 Credit Risk Management Process 33

Questions/Exercises 34

PART II FIRM (OR) OBLIGOR CREDIT RISK

4 Fundamental Firm/Obligor-Level Risks 37

4.1 Firm (or) Obligor Risk Classification 37

4.1.1 Business Risks or Operating Risks (OR) 37

4.1.2 Financial Risks (FR) 38

4.2 Risk Matrix 39

4.3 Different Risk Levels 39

4.3.1 Low Operating Risk and Low Financial Risk 39

4.3.2 Low Operating Risk and Medium Financial Risk 39

4.3.3 Low Operating Risk and High Financial Risk 40

4.3.4 Medium Operating Risk and Low Financial Risk 40

4.3.5 Medium Operating Risk and Medium Financial Risk 40

4.3.6 Medium Operating Risk and High Financial Risk 40

4.3.7 High Operating Risk and Low Financial Risk 40

4.3.8 High Operating Risk and Medium Financial Risk 41

4.3.9 High Operating Risk and High Financial Risk 41

Questions/Exercises 42

5 External Risks 43

5.1 Business Cycle 43

5.1.1 Benefits of Study of Business Cycles 45

5.1.2 Credit Risk in the Business Cycle 46

5.2 Economic Conditions 46

5.2.1 Private Consumption 47

5.2.2 Government Spending 47

5.2.3 Investment 48

5.2.4 Imports and Exports 48

5.2.5 How to Link NI Components to the Firm 48

5.2.6 Benefits of Study of National Income 49

5.3 Inflation and Deflation 50

5.4 Balance of Payments and Exchange Rates 51

5.5 Political 52

5.6 Fiscal Policy 53

5.7 Monetary Policy 53

5.8 Demographic Factors 54

5.9 Regulatory Framework 55

5.10 Technology 55

5.11 Environment Issues 55

5.12 International Developments 56

5.13 Others 56

5.14 Monitoring External Risks 57

Questions/Exercises 58

6 Industry Risks 61

6.1 Understanding Obligor’s Industry or Market 61

6.1.1 Sector vs. Industry vs. Market Segment 61

6.1.2 Challenges of Industry Classification 62

6.2 Types of Industry Risks 63

6.3 Industry Life Cycle 64

6.4 Permanence of Industry 65

6.5 Government Support 65

6.6 Industry and Factors of Production 66

6.7 Industry and Business Cycles 66

6.8 Industry Profitability 67

6.8.1 Competition Among the Existing Firms Within the Industry 68

6.8.2 Threat of New Entrants 68

6.8.3 Threat of Substitute Products 69

6.8.4 Bargaining Power of Buyers 69

6.8.5 Bargaining Power of Suppliers 70

6.9 Competitor/Peer Group Analysis 71

Questions/Exercises 77

7 Entity-Level Risks 79

7.1 Understanding the Activity 80

7.2 Risk Context and Management 81

7.3 Internal Risk Identification Steps 82

7.3.1 Interviews and Questioning 82

7.3.2 Market Developments and Peer Comparison 83

7.4 SWOT Analysis 83

7.5 Business Strategy Analysis 84

7.5.1 Cost Leadership 85

7.5.2 Differentiation 86

7.5.3 Contraction 86

7.5.4 Market Penetration 86

7.5.5 New Markets 87

7.5.6 New Products/Product Synergy Diversification 87

7.5.7 Product/Market Diversification 87

7.5.8 Consolidation 87

7.5.9 Merger/Takeover 87

7.5.10 Expansion 88

7.5.11 Cost Control 88

7.5.12 Focus 88

7.6 Pitfalls in Strategy 89

7.7 Management Analysis 90

7.7.1 One-Man Rule 91

7.7.2 Joint Chairman/CEO/MGD Position 91

7.7.3 Imbalance in Top Management Team 91

7.7.4 Weak Finance Function 92

7.7.5 Lack of Skilled Managers (or Inability to Attract Skilled Managers in Key Positions) 92

7.7.6 Disharmony in Management 92

7.7.7 Change in Ownership 92

7.7.8 Cultural Rigidity 92

7.7.9 Lack of Internal Controls 93

7.7.10 Low Staff Morale 93

7.7.11 Fraudulent Management 93

7.7.12 Myopic Vision 93

7.7.13 Big Projects 93

7.7.14 Inadequate Response to Change 94

7.7.15 Poor Corporate Governance 94

7.8 Other Internal Risks 94

Questions/Exercises 97

8 Financial Risks 99

8.1 Importance of Financial Statements 99

8.2 Quality and Quantity of Financial Statements 101

8.2.1 Quality of Financial Statements 101

8.2.2 Quantity of Financial Statements 102

8.3 Role of Historical Financial Statements 102

8.4 Financial Analysis 103

8.4.1 Balance Sheet 103

8.4.2 Income Statement (or) Profit and Loss Account 104

8.4.3 Cash Flow Statement (CFS) 105

8.5 Analytical Tools 105

8.5.1 Accounting Analysis 105

8.5.2 Common Sizing Analysis (CSA) 107

8.5.3 Indexed Trend Analysis (ITA) 110

8.5.4 Ratio Analysis 113

8.6 Solvency Ratios 115

8.6.1 Liquidity Ratios 115

8.6.2 Long Term Solvency Ratios 117

8.6.3 External Finance Ratios 120

8.6.4 Dividend and Equity Ratios 120

8.6.5 Cash Flow Ratios 121

8.7 Operational Ratios 123

8.7.1 Performance Ratios 123

8.7.2 Profitability Ratios 124

8.7.3 Return on Investment (ROI) Ratios 125

8.7.4 Asset Management (or Activity) Ratios 126

8.7.5 Leverage (Operating and Financial) Ratios 128

8.7.6 Cost-Volume-Profit (CVP) Ratios 133

8.8 Encapsulated Ratios 134

8.8.1 Dupont Model 134

8.8.2 Predictive Power of Ratios 135

Questions/Exercises 143

9 Integrated View of Firm-Level Risks 147

9.1 Relevance of an Integrated View 147

9.2 Judgement 147

9.3 Identifying Significant Credit Risks 148

9.4 Risk Mitigants 150

9.5 Types of Mitigants 150

9.5.1 Qualitative Mitigants 150

9.5.2 Quantitative Mitigants 152

9.5.3 Difference between Qualitative and Quantitative Mitigants 153

9.6 Principles to be Borne in Mind While Selecting Mitigants 153

9.7 Monitoring of Credit Risk 154

Appendix: Credit Risks and Possible Mitigants 155

Questions/Exercises 158

10 Credit Rating and Probability of Default 161

10.1 Credit Risk Grading 161

10.1.1 Linking EIIF Evaluation to Credit Risk Grades 161

10.1.2 Benefits of Credit Risk Grade System 163

10.2 Probability of Default 163

10.2.1 Benefits of PD Values 165

10.2.2 PD Values and Credit Decisions 165

10.3 External vs. Internal Rating 166

10.3.1 Reliability of External Ratings 167

10.3.2 Internal Ratings 168

10.4 PD in Credit Structural Models 169

10.4.1 The Merton Model (1974) 169

Questions/Exercises 172

PART III CREDIT RISKS – PROJECT AND WORKING CAPITAL

11 Credit Risks in Project Finance 177

11.1 Distinctive Features of Project Finance 177

11.2 Types of Project Finance 178

11.3 Reasons for Project Finance 179

11.3.1 Scarce Resources 179

11.3.2 Risk Sharing 179

11.3.3 Off-Balance Sheet Debt 179

11.3.4 Avoidance of Restrictive Covenants 179

11.3.5 Tax Considerations 180

11.3.6 Extended Tenor 180

11.4 Parties Involved in Project Finance 180

11.4.1 Sponsors 180

11.4.2 Project Lenders 180

11.4.3 Project Contractors/Consultants/Lawyers/Accountants 181

11.4.4 Governments 181

11.4.5 Multilateral Agencies 181

11.5 Phases of Project and Risks 182

11.5.1 Construction Phase Risks 182

11.5.2 Start-Up Phase Risks 182

11.5.3 Operational Phase Risks 183

11.6 Project Credit Risks 183

11.6.1 EIIF Risks 183

11.6.2 Project Specific Risks 184

11.6.3 Project Financial Viability Risks 186

11.7 Financial Study 187

11.7.1 Cash Flow Forecasts 187

11.7.2 Estimation of the Economic Worth of the Project 189

11.7.3 Assessing Creditworthiness – Building a Lender’s Case 190

11.8 Project Credit Risk Mitigants 192

Questions/Exercises 202

12 Credit Risks inWorking Capital 207

12.1 Definition of Working Capital 207

12.1.1 Working Capital Cycle – Finance Manager’s Key Concern 207

12.1.2 Working Capital Cycle – Lending Bank’s Point of View 208

12.2 Assessing Working Capital through the Balance Sheet 208

12.3 Working Capital Ratios 210

12.4 Working Capital Cycle 212

12.5 Working Capital vs. Fixed Capital 216

12.6 Working Capital Behaviour 216

12.6.1 Availability of Finance 217

12.6.2 Changes in Trade Terms 218

12.6.3 Changes in Business Volume 219

12.6.4 Price Changes 222

12.6.5 Others 222

12.7 Working Capital, Profitability and Cash Flows 223

12.8 Working Capital Risks 225

12.8.1 Over-trading 225

12.8.2 Diversion Risk 227

12.8.3 Inadequate Financial Management 228

12.8.4 Inflation Risk 228

12.8.5 Inadequate Provisioning of Working Capital in Original Project Costs 228

12.8.6 Losses and Reducing Profitability 228

12.8.7 Inadequate Structuring of Facilities by Banks 229

12.8.8 Unforeseen Contingencies 229

12.9 Impact of Working Capital Risks 229

12.10 Working Capital Risk Mitigants 230

12.10.1 Covenants 230

12.10.2 Cancellation/Tightening/Temporary Freeze of Facilities 230

12.10.3 Increase Pricing 231

12.10.4 Liquidation of Non-Core Assets 231

12.10.5 Owners’ Injection/Strengthening Net Working Capital 231

12.10.6 Improvement of Working Capital Management 231

12.10.7 Insure against the Risk from Unforeseen Contingencies 231

12.11 Working Capital Financing 232

Questions/Exercises 236

PART IV CREDIT PORTFOLIO RISKS

13 Credit Portfolio Fundamentals 241

13.1 Credit Portfolio vs. Equity Portfolio 241

13.2 Criticality of Portfolio Credit Risks 242

13.3 Benefits of Credit Portfolio Study 242

13.3.1 Active Credit Portfolio Management 242

13.3.2 Overall Credit Risk Reduction 243

13.3.3 Optimizes Liquidity 244

13.3.4 Assists Sales and Marketing 244

13.3.5 Insights into Sectoral Risk Exposures 244

13.3.6 Solves the Capital Dilemma 245

13.3.7 Portfolio Management Strategies 246

13.3.8 Credit Quality Issues 247

13.4 Portfolio Analysis 247

13.5 Credit Portfolio Risk vs. Return 249

Appendix: Organizational Conflict in Credit Risk Management 249

Questions/Exercises 251

14 Major Portfolio Risks 253

14.1 Systematic Risk 253

14.1.1 Triggers of Systematic Risk 254

14.1.2 Consequences of Systematic Risk 254

14.2 Diversifiable Risk 255

14.3 Concentration 258

14.3.1 Industry or Sector Concentration 258

14.3.2 Exposure or Name Concentration 259

14.3.3 Region/Location/Country Concentration 259

14.3.4 Foreign Currency Concentration 259

14.3.5 Collateral Risk 260

14.3.6 Maturity Risks 260

14.3.7 Funding Risk 261

14.3.8 Correlation Risks 262

14.4 Credit Portfolio Beta 263

Questions/Exercises 263

15 Firm Risks to Portfolio Risks and Capital Adequacy 265

15.1 Obligor PD and Portfolio PD 265

15.2 Migration Risk 266

15.2.1 Firm Credit Risk Migration 266

15.2.2 Portfolio Risk Migration 268

15.2.3 Benefits of Migration Risk Study 269

15.3 Default Risk 269

15.3.1 Firm-Level Defaults 269

15.3.2 Portfolio-Level Defaults 270

15.4 Loss Given Default (LGD) 270

15.5 Expected Loss (EL) 271

15.5.1 Obligor EL 271

15.5.2 Portfolio EL 271

15.6 Provisioning 272

15.6.1 Provisioning – Firm Level 272

15.6.2 Portfolio-Level Provisioning 273

15.7 Credit Loss Distribution 274

15.7.1 Characteristics of Credit Loss Distribution 275

15.7.2 Benefits of Developing a Credit Risk (or Loss) Distribution 275

15.8 Economic Capital 276

15.8.1 Regulatory Capital vs. Economic Capital 277

15.8.2 Measuring Economic Capital 278

15.8.3 Optimizing Economic Capital 279

Questions/Exercises 282

16 Credit Risk and The Basel Accords 285

16.1 Basel Accords 285

16.2 Basel I (1988) – First Basel Accord 286

16.2.1 Criticisms of Basel I 287

16.3 Basel Accord II (2006) 288

16.3.1 Alternative Approaches for Credit Risk in Basel II 289

16.3.2 Risk Weighted Assets (RWA) and Capital Adequacy in Basel II 293

16.3.3 Do Higher LGD and PD Always Translate into Higher RWA under the IRB Approach? 294

16.3.4 Criticisms of Basel II 295

16.4 Basel III 296

16.4.1 Credit Risk Measurement in Basel III 297

16.4.2 Other Key Features of Basel III 298

16.4.3 Can Basel III Prevent Future Financial/Credit Crises? 299

Appendix 300

Questions/Exercises 302

PART V PORTFOLIO RISK MITIGANTS

17 Credit Risk Diversification 305

17.1 Traditional Diversification 305

17.1.1 Industry Limit 306

17.1.2 Counterparty Limit 307

17.1.3 Region-Wise Restriction 307

17.1.4 Size 308

17.2 Modern Diversification of Credit Portfolio 309

17.2.1 Portfolio Selection Theory 309

17.2.2 Application of PS in Credit Portfolio 310

17.2.3 More Tools to Study Diversification of Portfolio Risks 314

17.3 Correlations in Credit Risk Models 315

Questions/Exercises 315

18 Trading of Credit Assets 317

18.1 Syndicated Loans/Credit Assets 317

18.2 Securitization 318

18.2.1 Asset Backed Securities (ABS) 319

18.2.2 Collateralized Debt Obligations (CDO) 319

18.2.3 Downfall of CDOs (and Similar Securitized Instruments) 321

18.3 Distressed Debt 321

18.4 Factoring 322

18.5 Distressed Receivables 322

Questions/Exercises 322

19 Credit Derivatives 323

19.1 Meaning of a Credit Derivative 323

19.1.1 Credit Event 324

19.2 Credit Default Swap (CDS) 324

19.2.1 Is CDS an Insurance? 326

19.2.2 CDS and Speculation 327

19.2.3 Uses of CDS 327

19.2.4 Sovereign CDS 329

19.2.5 Criticism of CDS 329

19.3 Total Return Swap 330

19.3.1 Uses of TR Swap 331

19.4 Credit Option (CO) 332

19.5 Credit Spread Options (CSO) 333

19.6 Credit Derivative Linked Structures 333

19.7 Future of Credit Derivatives 334

19.8 Credit Derivatives and Over-the-Counter (OTC) Markets 334

Questions/Exercises 334

PART VI CREDIT RISK PRICING

20 Pricing Basics 337

20.1 Credit Pricing Factors 337

20.1.1 Credit Risk Premium 337

20.1.2 Portfolio Risk 339

20.1.3 Cost of Capital 340

20.1.4 Cost of Leverage 340

20.1.5 Sector Risks 340

20.1.6 Overheads 341

20.1.7 Other Factors 341

20.2 Pricing Structure 342

20.2.1 Interest Rates 342

20.2.2 Commission and Fees 344

20.3 Credit Risk Pricing Model 344

20.4 Prime Lending Rate 345

Questions/Exercises 348

21 Pricing Methods 349

21.1 RORAC (Return on Risk-Adjusted Capital) Based Pricing 349

21.2 Market Determined 351

21.3 Economic Profit Based Pricing 351

21.4 Cost Plus 353

21.5 Structured Pricing 353

21.6 Grid Pricing 354

21.7 Net Present Value (NPV) Pricing 354

21.8 RANPV (Risk-Adjusted NPV) Pricing 355

Questions/Exercises 355

PART VII THE LAST LINE OF DEFENCE – SECURITY

22 Security Basics 359

22.1 Need for Security 359

22.2 Merits and Demerits of a Security 360

22.2.1 Advantages to the Creditor 360

22.2.2 Disadvantages to the Creditor 360

22.2.3 Advantages to the Borrower 361

22.2.4 Disadvantages to the Borrower 361

22.3 Attributes of a Good Security 362

22.4 Security and Pricing 362

22.5 Impact of Systematic Risks on Security 364

22.6 Facility Grades 364

Questions/Exercises 366

23 Collaterals and Covenants 367

23.1 Tangible Security 367

23.1.1 Deposits (with Banks, Financial Institutions, etc.) 367

23.1.2 Stock and Shares 367

23.1.3 Property/Land 367

23.1.4 Goods 368

23.1.5 Gold or Other Precious Metals 368

23.1.6 Bank Guarantees/Letters of Credit 368

23.2 Intangible Security 369

23.2.1 Unregistered Charges 369

23.2.2 Assignment of Debtors 369

23.2.3 Corporate Guarantee 369

23.2.4 Letter of Comfort (LOC) 370

23.2.5 Letter of Awareness 370

23.2.6 Letter of Negative Pledge 370

23.3 Methods of Taking Security 371

23.3.1 Mortgage 371

23.3.2 Pledge 371

23.3.3 Hypothecation 372

23.3.4 Lien 372

23.4 Realizing Security 372

23.5 Covenants – A Trigger to Seek Additional Security 373

23.5.1 Financial Covenants 373

23.5.2 Non-Financial Covenants 376

Questions/Exercises 377

PART VIII CREDIT CRISIS

24 Road to Credit Crisis 381

24.1 Credit and Growth 381

24.2 Role of Banks 382

24.2.1 Credit Creation 382

24.2.2 Confidence in Banking 383

24.2.3 Ultimate Use of Credit 384

24.3 Formation of Credit Bubbles 385

24.4 Types of Credit Bubble 386

24.5 Credit Bubble Explosion 387

Questions/Exercises 390

25 2008 Credit Crisis 393

25.1 Credit Asset – Prime vs. Sub-Prime 393

25.2 Securitization 394

25.2.1 Higher Risk Appetite 394

25.2.2 Availability of CDS 395

25.3 US Housing Bubble 396

25.4 Role of OTC Derivatives 398

25.4.1 Reasons for Popularity of OTC Derivatives 399

25.4.2 Complexity and Opaqueness – the Hallmark of OTC Derivatives 399

25.4.3 Systemic Risk and OTC Derivatives 400

25.5 Role of Rating Agencies 400

25.6 Why Did the Bubble Burst? 401

25.7 Consequences 402

25.7.1 2007 402

25.7.2 2008 402

25.7.3 2009 403

25.8 Impact of the Lehman Collapse 403

25.9 Housing Crisis to Credit Crisis to Economic Crisis 404

25.10 Common Factors 1929 vs. 2009 406

25.11 Lessons of the 2008 Credit Crisis 407

Questions/Exercises 410

Bibliography 411

Index 415

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Advanced Credit Risk Analysis and Management

Advanced Credit Risk Analysis and Management

1118604911

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