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CB4 > Applying Credit Risk Practices > Flashcards

Applying Credit Risk Practices Flashcards

1
Q

What is Credit Scoring? Give examples.

A

Credit Scoring is a method of evaluating creditworthiness by using a standard formula or a standard set of rules

  • Statistical Scoring Model – similar to judgemental method but uses statistical models to determine the factor weightings and scorings
  • Judgemental Scoring Model – traditional method that relies on payment history, bank references, financial statements and ratings agencies
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2
Q

What are the Benefits of Credit Scoring?

A
  1. Speed – software allows scoring to be completed very quickly
  2. Consistency and Accuracy – applications are processed in the same way, reducing human error
  3. Reduction in Bad Debts – high risk customers are identified
  4. Reduced Personnel Costs
  5. Collection Activities Prioritised
  6. Decision Support and Planning Tools
  7. Compliance with Audit Mandates
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3
Q

How should one Analyse Credit Risk?

A
  1. Review the Credit Risk – default risk or any credit exposure or equivalent
  2. Consider Counterparty Risk – the risk that a counterparty will fail to perform an obligation
  3. Consider Issuer Risk – the risk that an issuer of securities fails to perform its duties e.g. a bond not paying its coupon
  4. Basic Checks – due diligence to assess the counterparty’s ability to pay
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4
Q

How does one define Credit Exposure?

A

Firms have different ways of defining credit exposure:

  • Gross Exposure – credit exposure that excludes collateral and credit enhancements
  • Credit Risk Premium – the premium over the fair value being paid by the market risk for the credit risk of the product
  • Credit Categories – typically includes loans, contingent liabilities, OTC derivatives and tradable assets
  • Credit Ratings – estimates the credit worthiness of an entity. Poor credit rating = higher risk of default
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5
Q

What is a Credit Ratings Agency?

A

A Credit Ratings Agency assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. AAA is the highest rating and D is the lowest. Agencies include –

  • S&P
  • Moody
  • Fitch
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6
Q

What is the Credit Ratings Agency Business Model?

A
  1. Firm wishes to issue debt security
  2. Issuer requires credit rating from agency
  3. Security needs credit rating from agency
  4. Issuance is unlikely to be marketable without a rating
  5. Issuer pays for credit rating
  6. Security is sold to investors
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7
Q

What are the Risks of Pricing?

A
  • Model Risk – software used to generate prices e.g. Black Scholes for options. Can be flawed and result in losses
  • Other Risks – pricing structure should be considered, Is the correct data being used e.g. licenses, support, volume discounts
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8
Q

What types of Pricing the Trading Book are there?

A
  • Marketing to Market – using market prices to capture daily changes in changes and value positions
  • Marketing to Model – appropriate for complex instruments and where there is no liquid market for pricing
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9
Q

What is Transfer Pricing?

A

Transfer Pricing is employed to capture the price at which internal divisions within a firm transact with one another. For global firms there may be tax consequences when transacting between divisions.

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10
Q

Give an example of a Credit Default Swap (CDS)

A
  • Bank A sells protection (long credit, buying risk) – payment contingent on default of Bond C to Firm B
  • Firm B buys protection (short credit, selling risk) – credit swap premium paid to Bank A
  • Reference Asset (Bond C) – Return of Bond C to Firm B
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11
Q

What happens if there is no default in a Credit Default Swap?

A
  • Seller loses money if premium rises
  • Buyer makes money if premium rises
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12
Q

What type of Credit Events affects a CDS?

A
  • Bankruptcy of reference entity
  • Failure to pay
  • Obligation acceleration
  • Modified restructuring
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13
Q

What are the 5 P’s of Credit Risk?

A
  1. Person
  2. Purpose
  3. Payment
  4. Protection
  5. Premium
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14
Q

What does Person entail in the 5 P’s of Credit Risk?

A
  • Commitment – how much of the total cost of the financing is the customer paying e.g. mortgage deposit
  • Assets – property, stock & shares, Government securities, life assurance policies, bank/BSoc accounts
  • Liabilities – outstanding mortgages, loans/credit card debts, guarantees
  • Personal Factors – marital status, dependents, employment, connections with the bank
  • Capacity – age of customer, customer’s sector of employment, experience and reputation
  • Character – respectable and trustworthy, honest, dependable
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15
Q

What does Purpose entail in the 5 P’s of Credit Risk?

A
  1. Primary Assessment
    • Is it legal?
    • Doe it fall within the parameters of credit policy?
    • What are we being asked to fund?
    • Size of the borrowing
  2. Loan to Value – the ratio of the size of borrowing compared to the asset being purchased/held as security
  3. Loan Term – all other factors being equal, the longer the repayment terms, the lower the monthly payments
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16
Q

What does Payment entail in the 5 P’s of Credit Risk?

A
  1. Primary Factors
    • Can the customer afford to pay back principal and interest?
    • Will the new asset increase customer expenditure e.g. running costs of a second home?
    • Will the new asset generate additional income e.g. rental
  2. Interest Rates – could the customer afford the repayments on a variable rate borrowing if rates increased?
  3. Employment – could the customer afford the repayments on a borrowing if they lost their job
  4. Statement of Means – a summary of the income and expenditure of the customer
  5. Other Sources of Income – bonuses, rental income, dividends/interest payments
17
Q

What does Protection entail in the 5 P’s of Credit Risk?

A

When analysing a security a banker considers:

  1. Simplicity of Title – ideally the subject of the security should be free from all liabilities e.g. un-mortgaged property. This allows the security to be transferred quickly and cheaply
  2. Stability of Value – the value places on a security must be reliable. Cash deposits and quoted securities are easy to value, whereas specialist property and unquoted shares are harder to value
  3. Realisability – a banker may have to realise collateral held as a security. Banks discount the value of the security. If security value drops behind a certain level, the rate of interest on the borrowing may be increased to reflect additional risk
18
Q

What does Premium entail in the 5 P’s of Credit Risk?

A

Profiting from Lending – a bank will generate profits from two sources when making lending propositions

  1. Arrangement Fees – a bank will have to cover a series of costs: interviewing customers, assessing applications, processing the borrowing, documentation and arranging security
  2. Interest Rates – the interest rate charged will reflect current interest rates, market conditions, credit scoring, term and the bank’s profit margin
19
Q

What special considerations should be made when lending to Wealthy Individuals?

A
  • Reason for borrowing
    • Borrowing to diversify investment portfolios?
    • Borrowing for tax and inheritance purposes?
    • Borrowing to diversify concentrated stock?
  • Unique Collateral Pledges
    • Private aircraft
    • Yachts
    • Rare and classic cars
    • Rare art collections
    • Fine wine and jewellery
20
Q

What financial analysis must be done before lending to a company?

A
  • Profit and Loss – the revenues and costs of the company
  • Balance Sheet – the financial position of the company
  • Cash Flow Statement – the net cash inflows and outflows
21
Q

Financial information is then analysed using ratios such as:

A
  • Profitability Ratios
  • Liquidity Ratios
  • Repayment Ratios
  • Breakeven Ratios
  • Capital Ratios
  • Cash-flow Ratios
22
Q

What Non-Financial Analysis should be done before lending to a company?

A

Non-financial analysis analyses the economic and operating environment of a company. This can be done by using SWOT and PESTLE

23
Q

What factors shape competitiveness in an industry?

A

Porters 5 Forces:

  1. Existing Rivalry
  2. Threat of New Entrants
  3. Threat of Substitutes
  4. Bargaining Power of Suppliers
  5. Existing Competition/Rivalry
24
Q

What are generic strategies for success?

A
  1. Focus Cost Leadership – decide whether to target a specific market or the mass market
    • Cost Leadership – the lowest selling price in a market segment
    • Differentiation – offer a unique product for a premium price

CB4 (13 decks)

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