Credit risk, or the risk that money will not be returned, has been common in the history of banking. This is a major, perhaps the most important type of risk that has been present in the operations of finance, trade and commerce of ancient cultures to the present. Numerous failures, large and small, in combination with the corresponding economic and social impact further accelerated the importance of credit risk management throughout history.
Credit risk management is a process that involves identifying potential risks, the measurement of these risks, appropriate treatment and the actual implementation of risk models. Efficient tools for credit risk management have been vital to allow the phenomenal growth in consumer credit over the past 50 years. Without accurate automated decision tools, no credit loans have allowed banks to expand the portfolio of loans with the speed they have. The level of capital, a cushion to absorb credit and other losses, is matched to the risk of the portfolio according to risk characteristics of individual transactions, concentration and correlation. All organizations, including banks, should optimally allocate capital in relation to selective investments made. Therefore, efficient tools and techniques for risk measurement is a cornerstone of a good credit risk management.
CHAPTER 2: TRADITIONAL & MODERN APPROACHES TO CREDIT ANALYSIS
The process of credit analysis can be conducted using two approaches that are divided into the categories of Traditional methods of credit analysis and Modern methods of credit analysis. The two approaches are further sub-divided into the techniques which will be discussed in detail later in this chapter.
Credit analysis, as mentioned earlier, is the process of judging how risky it is to provide the loan facility to the counterpart is. Many different questions are answered by using the two approaches: Will the loan amount, along with the interest, be paid? Is the collateral provided by the borrower is sufficient enough to back the credit risk? Are borrower's financial abilities qualified to avail the loan facility? What is the borrower's payment history? Are there any loan facility already extended to him/her?
The two approaches are differentiated in a way that Modern credit analysis uses technology and statistical approaches to answer the above and related mentioned questions. Based on such questions such approaches were developed. We will first consider Traditional methods and then Modern methods.
2.1: Traditional Methods of Credit Analysis
Credit Analysis is done and the outcome supports the lender in making decision of whether the loan application is to be approved or rejected.
Once the information is verified, the financier proceeds to the evaluation stage. The objective of credit evaluation is to:
Provide the best tailored loan for the customer and a quality loan for the lender,
Ensure compliance with regulations and bank policy
Keep the goodwill of the consumer, and
Ensure that the level of risk is acceptable.
Classic credit analysis is an "expert system" that relies on the subjective judment of trained experienced professionals. In such an expert system, knowledge tends to warehouse among tenured professionals:
The senior lender is a source of rules of thumb. Banks rely on their senior lending officers on the most important issues under which the bank will make the loan. Lending officers make use of expert systems to provide their professional and expertise advice. Let us now have a look on the the expert systems.
2.1.1: The Five Cs of Credit Analysis
Credit investigation is said to be a typical process. Such standardization of the steps in order to analyze/investigate the existing or a new account enables the lender to minimize adverse situations like slow payments, bad debts etc. The most widely known is the 5 C's of credit that are listed below:
Character
Capacity
Capital
Conditions of the times
Collateral
Character
Character is most important factor for lenders and also it is most difficult to precisely judge anyone's character. In layman terms, character is the collection of the qualities of a person. In credit analysis this has deeper meaning. Character refers to the willingness of the customer to payback hi/her debt, which incorporates other qualities like: reliability, truthfulness, and credibility. The business character of the individual is assessed based on his/her success of the business, the past record of payments, and also a tentative opinion is formed by using various information like employment record, family background and also how is the individual's credit history. Lenders pay a lot of importance to willingness of pay because even if the client has the ability to pay and all the above mentioned qualities as well but lacks the willingness of paying back the loan than the lenders will be reluctant to provide the loan facility at the first place.
In a nutshell, apart from willingness of paying back, lenders judge the character through following means:
Credit history
How stable and old the business/employment is
Qualification and experience
Reputation
Capacity
This refers to the ability of the borrower, whether an individual or a business, to successfully meet the financial obligation of repaying the debt. One way to investigate the capacity of the borrower is to determine whether the borrower is generating sufficient cash flows, required to repay the debt.
The financial capacity of the individual is determined using the information related to: income, month expenses, and even the borrower's marketability or the ability to switch jobs. Moreover, any prior obligations of the borrower can also be used to decide about his/her capacity.
Another aspect of capacity is legal capacity which means that the borrower should be mature enough to enter into the contractual agreement and should also be of sound mind.
Contribution
The lenders view capital from two aspects:
The total contribution by the applicant and
The net worth of the applicant which is basically used to ease the lender from the probability of nonpayment.
The first aspect is best described as how much would the lender be investing and how much will the borrower be investing. The bank will only finance part of the total investment and the remaining portion is to be invested by the borrower.
Whereas, the second aspect uses information like: increase in sales, net profit, liquid assets, sources of income, and other positive trends.
Covenants
When the objective is to determine the conditions, two factors are evaluated: Internal and external. The same evaluation applies here.
External conditions refer to the economic conditions and situations, government policies, social environment, competition and what impact does the external environment has on the borrower. If the borrower has the ability to survive even if the conditions are adverse for him/her, the likelihood of the lender to finance the investment will increase.
Evaluation of the internal conditions refers to whether the applicant meets the policies of the bank and whether or not the bank has the availability of the skilled staff to monitor the loan, if provided. In short these are the terms and condition of the lending agreement.
Covenants are of two types:
Affirmative covenants; specify the responsibilities of the borrower like payment of interest in time, maintenance of assets, and various other.
Negative covenants; restrict the borrower in performance of certain activities. There are few tests that are designed and are to be met by the borrower:
Maintenance tests, which specify minimum level of earnings that should be available, to pay the debt and also the maintenance costs.
Debt incurrence test identifies conditions under which the borrower may acquire added debt
Cash flow tests which compare the inflows and the outflows of the loan applicant.
Prohibition on borrowing from any other source, except the parent company, may also be imposed on the subsidiary company seeking for loan.
Collateral
This refers to security and is also known as second way out. This helps the lender to secure itself when the borrower goes insolvent and is unable to pay the entire loan. In such cases assets of the borrower, such as property, are used by the lender which is sold and the proceeds are used to set off the unpaid portion of the loan. Second way out denotes the payment of the loan through the sale of the security and not from the primary source, which is the borrower. Moreover, lenders decide whether the collateral is sufficient enough or not by considering the factors that include disposability and marketability.
A sample of how 5 Cs would be analyzed is follows:
Strengths
Weakness
Character
Purchasing a house
15 years of residence
Professional - Doctor
Previous Job - Long term
Wife standing as surety
Bills are settled on time
Purchase of an illegal commodity for future business.
New to the country
Not a professional person therefore skepticism is to be applied with greater degree
Current job is on probation
Wife is employed only 6 months ago
Poor bill payment record
Capacity
Debt to income ratio is 31 % of net salary
Low debt to income ratio
Capital
The borrower is willing to contribute substantial amount of capital
Borrower reluctant to contribute the standard ratio of capital, prevailing in the market
Condition
Demand for doctors are prevailing in the market
No demand of the profession or already excess supply of doctors with similar expertise as the applicant.
Collateral
Table 1: How 5 Cs would be analyzed by the lender.Unsecured loan
Secured loan.
2.1.2: Other C'S
The above stated 5 Cs are not the only laws that one should follow. For better credit analysis, other Cs can also be used as mentioned below:
Cash flow
This refers to the future cash flow that a borrower would generate. The lender has to be certain that the loan should be repaid and this is only possible if the borrower has enough earnings in the future. Therefore apart from past 3 years cash flows, projected cash flows are also required by the lender who then compares to judge the actual picture by incorporating the element of skepticism.
This evaluation is done using various metrics, but most common one is referred as Debt Service Coverage Ratio (DSCR) that denotes the ability of the borrower to generate free cash flow per dollar.
Compliance
This C refers to the compliance with the rules and regulations and banking policies while the loan facility is provided. Banks have to comply with the Uniform Consumer Credit Code, the Banking Code of Practice, and other such laws that are to be followed in order to avoid the lender being liable for the losses and compensations.
Control
This refers to the monitoring of the loan that is ensuring that the loan is being repaid as per the agreement. If there are problems in the process of repayment, then in order to prevent a loan going bad, rescheduling or restructuring is done.
It is only kept as the last way to cover the loan amount, which is by utilizing the second way out that is selling the collateral.
Competition
This is taken into consideration when the bank wants to remain and lead in the market it is operating. This is quite commonly found in newly set up banks.
Credit Structure
There are possibilities that the loan is structured in a way that the borrower is unable to service the debt. If any such situation arises, the bank has to consider restructuring the loan.
The significance of each element varies from one applicant to another. This evaluation of the loan applicant should be done before making any final decision regarding:
Whether supplementary information is required
What definite terms are suitable
What credit limit seems to be appropriate
Are any personal guarantee required
As the Cs are not exhaustive, similarly there are other alternatives available, to the 5 Cs of credit, which includes the following:
2.1.3: The CAMPARI Model & Other Alternatives
Character - factor where the willingness to pay is compared with the ability to pay.
Ability -Sufficient cash availability to repay the debt.
Margin - The client must invest or contribute part of the total investment needed which is termed as margin, the equity contributed by the borrower.
Some authors do consider the factor of Marketing along with Margin and by marketing they refer to cross selling.
Purpose - The loan should be utilized for the purpose it is taken for and the purpose must be defined as well as legal which also has to be in coherence with the policies of the bank.
Amount - This refers to the contribution of the bank which is decided by taking into consideration that the contribution of the bank should not be beyond the repayment capacity of the borrower.
Repayment -This refers to the structuring of the loan and also the terms and conditions that will be associated with loan and are to be fulfilled.
Insurance - This refers to a security for the banker in case the borrower dies. In such situations, the loan can be offset through insurance proceeds.
Other models that can be used as an alternative or in addition to 5 Cs of credit are given in the table below:
PARSER
PARTLAMPS
Personal characteristics of the borrower
Purpose
Amount required and why
Amount
Repayment capacity
Repayment
Security
Time
Expedience or future profitable opportunities
Laws
Return from the loan.
Accounts
Management
Profitability
Security
Table 2: PARSER & PARTLAMPS - Other Alternatives to 5 Cs
2.1.4: The Credit Scoring Approach
While the 5 Cs and other alternatives, as mentioned above, help financier in assessing the credit application other method called the Credit scoring approach, can also be used. The elements and their corresponding weight vary from bank to bank.
The credit evaluation process can rely on a combination of approaches namely the subjective 5 Cs, CAMPARI approach and the objective credit scoring approach for balanced decision making.
The best test of a credit is when the credit is repaid by the identified repayment source and not by sale of the collateral. Which takes one to the question, how much is too much credit for a consumer? The answer any amount, which is beyond the repayment capacity of the borrower, is too much.
2.1.5: Rating systems
There are many rating agencies of which we all have heard like Moody's or Standard & Poor's. Such agencies rate various bonds. Similarly US banks have developed loan-rating systems, which are given on a 10 point scale. 1 denotes excellent business conditions like debt capacity etc. As the rating goes higher the scenario gets worse.
These points are awarded based on the information provided on the loan application. When the accumulated points exceed the pre-determined cut-off the loan is awarded.
CHAPTER 1: CONCLUSION
Expert systems are the judgmental systems that have no set patterns or defined procedure to follow. It depends on the model and also the experience of the person, who is applying them, how far the model can be extended or what additions can be made to the model.
Similarly the Cs of the credit are not bound to be 5 in number. There are many Cs that can be used to judge whether the borrower qualifies for the loan or not.
Other than traditional methods there are modern methods as well that are more accurate, cost effective and as well as efficient in analyzing the credit risk but directly or indirectly traditional methods are still in practice.
