Applying Credit Risk Practices Flashcards
What is Credit Scoring? Give examples.
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
What are the Benefits of Credit Scoring?
- Speed – software allows scoring to be completed very quickly
- Consistency and Accuracy – applications are processed in the same way, reducing human error
- Reduction in Bad Debts – high risk customers are identified
- Reduced Personnel Costs
- Collection Activities Prioritised
- Decision Support and Planning Tools
- Compliance with Audit Mandates
How should one Analyse Credit Risk?
- Review the Credit Risk – default risk or any credit exposure or equivalent
- Consider Counterparty Risk – the risk that a counterparty will fail to perform an obligation
- Consider Issuer Risk – the risk that an issuer of securities fails to perform its duties e.g. a bond not paying its coupon
- Basic Checks – due diligence to assess the counterparty’s ability to pay
How does one define Credit Exposure?
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
What is a Credit Ratings Agency?
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
What is the Credit Ratings Agency Business Model?
- Firm wishes to issue debt security
- Issuer requires credit rating from agency
- Security needs credit rating from agency
- Issuance is unlikely to be marketable without a rating
- Issuer pays for credit rating
- Security is sold to investors
What are the Risks of Pricing?
- 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
What types of Pricing the Trading Book are there?
- 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
What is Transfer Pricing?
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.
Give an example of a Credit Default Swap (CDS)
- 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
What happens if there is no default in a Credit Default Swap?
- Seller loses money if premium rises
- Buyer makes money if premium rises
What type of Credit Events affects a CDS?
- Bankruptcy of reference entity
- Failure to pay
- Obligation acceleration
- Modified restructuring
What are the 5 P’s of Credit Risk?
- Person
- Purpose
- Payment
- Protection
- Premium
What does Person entail in the 5 P’s of Credit Risk?
- 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
What does Purpose entail in the 5 P’s of Credit Risk?
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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
- Loan to Value – the ratio of the size of borrowing compared to the asset being purchased/held as security
- Loan Term – all other factors being equal, the longer the repayment terms, the lower the monthly payments
What does Payment entail in the 5 P’s of Credit Risk?
- 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
- Interest Rates – could the customer afford the repayments on a variable rate borrowing if rates increased?
- Employment – could the customer afford the repayments on a borrowing if they lost their job
- Statement of Means – a summary of the income and expenditure of the customer
- Other Sources of Income – bonuses, rental income, dividends/interest payments
What does Protection entail in the 5 P’s of Credit Risk?
When analysing a security a banker considers:
- 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
- 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
- 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
What does Premium entail in the 5 P’s of Credit Risk?
Profiting from Lending – a bank will generate profits from two sources when making lending propositions
- Arrangement Fees – a bank will have to cover a series of costs: interviewing customers, assessing applications, processing the borrowing, documentation and arranging security
- Interest Rates – the interest rate charged will reflect current interest rates, market conditions, credit scoring, term and the bank’s profit margin
What special considerations should be made when lending to Wealthy Individuals?
- 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
What financial analysis must be done before lending to a company?
- 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
Financial information is then analysed using ratios such as:
- Profitability Ratios
- Liquidity Ratios
- Repayment Ratios
- Breakeven Ratios
- Capital Ratios
- Cash-flow Ratios
What Non-Financial Analysis should be done before lending to a company?
Non-financial analysis analyses the economic and operating environment of a company. This can be done by using SWOT and PESTLE
What factors shape competitiveness in an industry?
Porters 5 Forces:
- Existing Rivalry
- Threat of New Entrants
- Threat of Substitutes
- Bargaining Power of Suppliers
- Existing Competition/Rivalry
What are generic strategies for success?
- 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
