THEME 42. CREDIT RISK
Plan:
1. The concept of credit risk.
2. Methods for assessing the risks of lending to legal entities.
3. Risk assessment of lending to individuals based on credit scoring.
4. Credit rating.
1. The concept of credit risk
Traditionally, credit risk is defined as the risk that a debtor will not repay
money in accordance with the terms and conditions of a loan agreement.
There are different approaches to determining the essence of credit risk. So,
for example, the concept of "credit risk" includes the danger of non-payment by
the borrower of the principal and interest due to the creditor.
Others associate the concept of credit risk with the profits received by banks:
credit risk is a possible drop in a bank's profits and even the loss of part of the
equity capital as a result of the inability of the borrower to repay and service the
debt. This approach reflects only one side of the impact of credit risk on the bank's
profit - negative, associated with the negative consequences of lending. At the
same time, the outcome of a loan transaction can be positive, without excluding the
presence of a certain level of risk throughout the term of the loan agreement.
Credit risk is the probability that the value of the bank's assets, primarily
loans, will decrease due to the inability or unwillingness of customers (borrower)
to repay the debt or part of the debt, including interest due under the agreement. In
its most general form, credit risk can be defined as the risk of losing assets as a
result of a borrower's default on contractual obligations.
Another definition of credit risk is based on the lender's uncertainty that the
debtor will be able to meet its obligations in accordance with the terms and
conditions of the loan agreement.
It could also be proposed to understand credit risk as “the probability of
complete or partial non-fulfillment by the borrower of the main conditions of the
loan agreement”.
The inability of the debtor to fulfill its obligations in accordance with the
terms and conditions of the loan agreement may be caused by:
 the inability of the debtor to generate adequate future cash flow due to
unforeseen adverse changes in the business, economic or political environment in
which the borrower operates;
 uncertainty about the future value and quality (liquidity and the possibility of
selling on the market) of collateral for an issued loan;
 crises in the business reputation of the borrower.
Factors affecting the risk of each individual loan:
 appointment of a loan (to increase capital, to temporarily replenish funds, to
form current assets, capital construction);
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 type of credit (consumer, mortgage, investment, payment, leasing);
 loan size (large, medium, small);
 loan term (short-term, medium-term, long-term);
 repayment procedure (as proceeds are received, one-time);
 sectoral affiliation (agro-industrial complex, industry, commerce);
 form of ownership (private, joint-stock);the size of the borrower (by the size
of the authorized capital, by the amount of own funds);
 creditworthiness (in accordance with the rating score);
 the degree of relationship between the bank and the client (the presence of a
current account in the bank, one-time relations);
 degree of awareness of the bank about the client;
 methods of security (collateral, guarantees, guarantees).
Table 1 shows the classification of credit risks.
Table 1
Classification of credit risks
1
1
No.
Criteria
classification
Types of credit risks
1.
Level of risk
risks at the macro level of relations (external);
risks at the micro level of relations (internal).
2.
The degree of risk
independent of the activities of the credit institution;
dependence on the
dependent on the activities of a credit institution.
bank
3.
Sectoral focus of
industrial; trade; agricultural, etc.
lending
4.
Scale of lending
complex risk;
private risk
5.
Loan types
risks by subjects, objects, terms, security
6.
Loan structure
risks at the provision stage; use of the loan by the
borrower; release of resources needed to pay off the
debt; loan repayment
7.
Acceptance stage
solutions
risks at the preliminary stage of lending, the
subsequent stage of lending
Prepared on the basis of materials of Internet-sites
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8.
Degree
acceptance
of
9.
Sphere
occurrence
of
10. Type of borrower
minimal, elevated, critical, invalid.
borrower risk, loan product risk, risk of changes in
the external environment of the bank and the
borrower
country risk, corporate lending risk, retail lending
risk
The nature of the
11. manifestation
of moral, business, financial risks, collateral risk
risk
risks arising from loan, leasing, factoring
transactions, as well as the provision of bank
12. Type of operation
guarantees and guarantees, the conclusion of
transactions using promissory notes
Nature of actions of the risk of the borrower's refusal to pay interest and
13. the
(or) principal; misuse of the loan; obstruction of
borrower
bank control
Basic principles of credit risk management in commercial banks:
 compliance with the credit policy developed by the bank;
 accounting for external and internal factors when the bank conducts
credit operations;
 continuity of the nature of managerial decision-making;
 risk control;
 availability of a clear methodology for managing credit risks.
2. Methods for assessing the risks of lending to legal entities.
The work on assessing credit risk in a bank is carried out in the following
three main stages
At the first stage, the quality indicators of the borrower's activity are assessed.
To this end, the bank examines the reputation of the borrower; determines the
purpose of the loan and the sources of repayment of the principal debt and interest
due; assesses the borrower's risks assumed by the bank indirectly.
At the second stage, quantitative indicators are evaluated, i.e. calculation of
financial ratios, analysis of the borrower's cash flows, and assessment of business
risk.
At the final stage, a summary assessment-forecast and the formation of the
final analytical conclusion are made.
What is Altman’s Z-Score Model?
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Altman’s Z-Score model is a numerical measurement that is used to predict
the chances of a business going bankrupt in the next two years. The model was
developed by American finance professor Edward Altman in 1968 as a measure of
the financial stability of companies.
Altman’s Z-score model is considered an effective method of predicting the
state of financial distress of any organization by using multiple balance sheet
values and corporate income. Altman’s idea of developing a formula for predicting
bankruptcy started at the time of the Great Depression, when businesses
experienced a sharp rise in incidences of default.
Altman’s Z-Score Model Explained
The Z-score model was introduced as a way of predicting the probability that
a company would collapse in the next two years. The model proved to be an
accurate method for predicting bankruptcy on several occasions. According to
studies, the model showed an accuracy of 72% in predicting bankruptcy two years
before it occurred, and it returned a false positive of 6%. The false-positive level
was lower compared to the 15% to 20% false-positive returned when the model
was used to predict bankruptcy one year before it occurred.
When creating the Z-score model, Altman used a weighting system alongside
other ratios that predicted the chances of a company going bankrupt. In total,
Altman created three different Z-scores for different types of businesses. The
original model was released in 1968, and it was specifically designed for public
manufacturing companies with assets in excess of $1 million. The original model
excluded private companies and non-manufacturing companies with assets less
than $1 million.
Later in 1983, Altman developed two other models for use with smaller
private manufacturing companies. Model A Z-score was developed specifically for
private manufacturing companies, while Model B was created for non-publicly
traded companies. The 1983 Z-score models comprised varied weighting,
predictability scoring systems, and variables.
Altman’s Z-Score Model Formula
The Z-score model is based on five key financial ratios, and it relies on the
information contained in the financial statements. It increases the model’s accuracy
when measuring the financial health of a company and its probability of going
bankrupt.
The Altman’s Z-score formula is written as follows:
ζ = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
Where:
Zeta (ζ) is the Altman’s Z-score
A is the Working Capital/Total Assets ratio
B is the Retained Earnings/Total Assets ratio
C is the Earnings Before Interest and Tax/Total Assets ratio
D is the Market Value of Equity/Total Liabilities ratio
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E is the Total Sales/Total Assets ratio
What Z-Scores Mean
Usually, the lower the Z-score, the higher the odds that a company is heading
for bankruptcy. A Z-score that is lower than 1.8 means that the company is in
financial distress and with a high probability of going bankrupt. On the other hand,
a score of 3 and above means that the company is in a safe zone and is unlikely to
file for bankruptcy. A score of between 1.8 and 3 means that the company is in a
grey area and with a moderate chance of filing for bankruptcy.
Investors use Altman’s Z-score to make a decision on whether to buy or sell a
company’s stock, depending on the assessed financial strength. If a company
shows a Z-score closer to 3, investors may consider purchasing the company’s
stock since there is minimal risk of the business going bankrupt in the next two
years.
However, if a company shows a Z-score closer to 1.8, the investors may
consider selling the company’s stock to avoid losing their investments since the
score implies a high probability of going bankrupt.
The Five Financial Ratios in Z-Score Explained
The following are the key financial ratios that make up the Z-score model:
1. Working Capital/Total Assets
Working capital is the difference between the current assets of a company and
its current liabilities. The value of a company’s working capital determines its
short-term financial health. A positive working capital means that a company can
meet its short-term financial obligations and still make funds available to invest
and grow.
In contrast, negative working capital means that a company will struggle to
meet its short-term financial obligations because there are inadequate current
assets.
2. Retained Earnings/Total Assets
The retained earnings/total assets ratio shows the amount of retained earnings
or losses in a company. If a company reports a low retained earnings to total assets
ratio, it means that it is financing its expenditure using borrowed funds rather than
funds from its retained earnings. It increases the probability of a company going
bankrupt.
On the other hand, a high retained earnings to total assets ratio shows that a
company uses its retained earnings to fund capital expenditure. It shows that the
company achieved profitability over the years, and it does not need to rely on
borrowings.
3. Earnings Before Interest and Tax/Total Assets
EBIT, a measure of a company’s profitability, refers to the ability of a
company to generate profits solely from its operations. The EBIT/Total Assets
ratio demonstrates a company’s ability to generate enough revenues to stay
profitable and fund ongoing operations and make debt payments.
4. Market Value of Equity/Total Liabilities
The market value, also known as market capitalization, is the value of a
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company’s equity. It is obtained by multiplying the number of outstanding shares
by the current price of stocks.
The market value of the equity/total liabilities ratio shows the degree to which
a company’s market value would decline when it declares bankruptcy before the
value of liabilities exceeds the value of assets on the balance sheet. A high market
value of equity to total liabilities ratio can be interpreted to mean high investor
confidence in the company’s financial strength.
5. Sales/Total Assets
The sales to total assets ratio shows how efficiently the management uses
assets to generate revenues vis-à-vis the competition. A high sales to total assets
ratio is translated to mean that the management requires a small investment to
generate sales, which increases the overall profitability of the company.
In contrast, a low or falling sales to total assets ratio means that the
management will need to use more resources to generate enough sales, which will
reduce the company’s profitability.
Parser method.
As a borrower carefully consider the following: The Lending Manager’s task
is the MANAGEMENT OF RISK and to be successful at this he needs to be
conversant with certain principles which can best be remembered by
the mnemonic PARSER.
There are very few ideal propositions and as a result it is a matter of
judgement whether funds can be safely and profitably lent.
The Lending Manager’s function in this respect is
To identify in what ways any proposition falls short of ideal
To establish what the risks are and whether they are acceptable to the Bank
If acceptable, to structure the borrowing in such a way as to minimise that risk
and negotiate an acceptable reward in return.
Whether the funds are to be advanced by short, medium or long term financer
or through equity capital or export finance the general principles stay the same.
P = PERSONALITY
CHARACTER – Who is the borrower? How long has he been a customer?
What is his background? Is he a man of integrity and reliability?
COMPETENCE – What is his record? Has he the management, accounting
and technical skills? What is his experience in the particular field for which the
finance is required? What is the strength of the management team?
CAPACITY – Has he the energy for hard work to use the advance and make
sufficient profit to ensure repayment? What is the condition of existing resources?
Are they adequate? Are there any constraints of an economic, legal or local nature?
What are market conditions? Has he put together a business plan? Has he taken
advice or had training?
A = AMOUNT & PURPOSE
AMOUNT – How much is required? Is it sufficient or too much? Is the
proposition supported by a cash flow forecast and accurate costings? Has
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allowance been made for increased working capital requirements? Is the
proprietor’s stake acceptable?
PURPOSE- What is the reason for the advance? Is it suitable as a banking
proposal? How should the borrowing be structured? Is a ‘Group’ package worth
considering? Is it a new venture?
R = REPAYMENT
SOURCE – Where is repayment to come from? income? sale of assets?
profits? Is it reliable and reasonably certain? Do we have a profit and/or cash
forecast? Is there a secondary source of repayment as a ‘back-up’?
WHEN – Have repayments been fully appraised and related to existing and
future commitments? Are repayment proposals realistic or optimistic?
IF THE P, A AND R ARE NOT ACCEPTABLE – GO NO FURTHER
S = SECURITY
SECURITY – Unsecured advances are the exception rather than the rule. No
amount of security will make a bad proposition good. Balance risk with reward.
APPROPRIATE– Is the security appropriate to the advance and to the
structure of the business? Is it easily valued, readily realisable and of stable or
increasing value? Is it properly valued?
COMPLETION – It is essential that security is completed or perfection can be
finalised without further recourse to borrower before advance is made. Suitable
Insurance cover should be completed when appropriate.
E = EXPEDIENCY
PERSPECTIVE – There are occasions when the principles of good lending
are breached in favour of expediency, but this should be kept in the right
perspective. To be fully – OBJECTIVE, consideration of this factor should be
ignored and in any event expediency should not lead us to lend unwisely and
unsafely.
R = REMUNERATION
TERMS – need to be negotiated from the outset with provision for periodic
review if considered necessary.
MAY VARY – in the light of economic conditions and the market place in
which we operate.
RISK – The REWARD should relate to the RISK entailed and the
customer AFFORD to borrow without impediment to his repayment programme.
CAMPARI METHOD
Bank loans are an important source of funding for any business, helping to
fulfil orders, employ staff or finance patent protection applications. This guide uses
a handy acronym to help you fully prepare for a loan application and maximise
your chances of receiving capital.
THE CAMPARI METHOD STANDS FOR
Character
Ability
Means
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Purpose
Amount
Repayment
Insurance
The principles it outlines are used by banks and investors worldwide. It’s an
easy way of making sure that you are fully prepared when you apply for any
business finance – maximising your chance of securing the funds you need. We
will take you through each part of this process and explain what each letter means.
CHARACTER
Banks take a gamble when providing loans. The more confidence they have in
your ability to deliver, the more likely you are to receive the capital you require.
Naturally, presentation is very important. Dress and act like a professional and
don’t be late. Interact well with your bank manager and show you are a capable
business leader. Be willing to show evidence of a good trading history and the
ability to provide quality services to customers while making a profit.
ABILITY
You must be unequivocal when telling the bank what you need the capital for
and how you’ll be able to afford the repayments. There is no room for ambiguity.
Many applications fail because the entrepreneur does not directly and clearly show
how a profit will be made on the initial capital; bank managers cannot clearly see
how they will get the money back and therefore consider the application to be too
risky. When presenting your case, it must be obvious how you’ll repay the loan;
use illustrations or bring in an accountant if necessary.
MEANS
Your business plan must be logical, display knowledge of your industry and
target markets and be professionally presented. Business plans are important
variables in whether a firm succeeds or fails; bank managers will be very keen to
see your business plan is viable and can produce a return. Make sure yours is
watertight; ask a professional to help you if required.
Additionally, ensure your business model is solid. If your business model is
poorly monetised, irrational or hard to make sense of, this is going to dent your
chances of getting a loan.
PURPOSE
You must clearly show why you need the money and how you’re going to use
it. There needs to be a good business case for the capital rather than simply
because your business will benefit from increased revenue. Some examples are:
You have an order that needs fulfilling but there’s not enough liquidity in the
business to do so
You need a specific piece of machinery in order to expand your range of
products and services
Whatever the reason for the loan, you need to show that it’s a good reason,
and one that will generate a return.
AMOUNT
Bank managers want to know why you need the amount you’re asking for. In
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specific detail, you need to show precisely what the money will be spent on. This is
more than about telling the bank manager the purpose of the loan. You need to
explain how you’ve arrived at the figure you’re requesting and how it’s going to be
spent.
REPAYMENT
Bank managers must be confident you’ll meet repayment terms, or your
application will get rejected. Be prepared to show substantial documentation
relating to profit margins, cashflow forecasts and other key financial information.
Bring your accountant or consult them in advance of the appointment if you’re
unsure. Don’t exaggerate forecasts or profit margins. If your loan is secured, you
may lose your property or business assets if repayment terms are not adhered to.
INSURANCE
Ensure you’ve taken steps to protect yourself should things go worse than
expected. You’ll need a backup plan to ensure you can still pay off the loan should
you receive a less than satisfactory return. Take out adequate insurance where need
be and take steps to diversify revenue streams to ensure you’ll still be making a
profit should the loan capital fail to make a return.
INFORMED FUNDING
Workspace are proud to partner with informed Funding (iF) who frequently
offer free conferences, seminars and one-to-one financial consultations for our
customers. They work both on and offline to help businesses identify financing
issues and raise the funds they need.
3. Risk assessment of lending to individuals based on credit scoring
Credit scoring is a method of separating groups of potential borrower clients
in the context of the availability of information not about the parameters separating
these groups, but only about some secondary variables.
The idea of separating groups according to secondary characteristics was first
proposed in 1936 by R.A. Fisher, who introduced a method for determining
varieties of iris by measuring the size of plant parts, and a few years later the idea
to use a similar approach to identify borrowers with a high and low probability of
default was put forward by D. Duran.
Durand's scoring model
D. Duran singled out a group of factors that, in his opinion, make it
possible to determine with sufficient certainty the degree of credit risk when
providing a consumer loan to a particular borrower.
He used the following coefficients in scoring:
age: 0.1 points for each year over 20 years old (maximum 0.30);
sex: women - 0.40, men - 0;
length of residence: 0.042 for each year of residence in the area (maximum
0.42);
occupation: 0.55 for a low-risk occupation, 0 for a high-risk occupation, and
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0.16 for other occupations;
work in the industry: 0.21 - public utilities, government agencies, banks and
brokerage firms;
employment: 0.059 - for each year of work at this enterprise (maximum 0.59
points);
financial indicators: 0.45 for having a bank account, 0.35 for owning real
estate, 0.19 for having a life insurance policy.
Applying these coefficients, D. Duran determined the boundary separating
"good" and "bad" customers - 1.25 points. A client who scored more than 1.25
points was considered creditworthy, and a client who scored less than 1.25 was
considered undesirable for the bank.
Thus, the scoring method allows for an express analysis of a loan application.
What Is a Credit Score?
A credit score is a number from 300 to 850 that rates a
consumer’s creditworthiness. The higher the score, the better a borrower looks to
potential lenders.
A credit score is based on credit history: number of open accounts, total levels
of debt, repayment history, and other factors. Lenders use credit scores to evaluate
the probability that an individual will repay loans in a timely manner.
There are several different credit bureaus in the United States, but only three
that are of major national significance: Equifax, Experian, and TransUnion. This
trio dominates the market for collecting, analyzing, and disbursing information
about consumers in the credit markets.
The credit score model was created by the Fair Isaac Corp., now known
as FICO,
and
is
used
by financial
institutions.
While other credit
scoring systems exist, the FICO Score is by far the most commonly used. There are
a number of ways to improve an individual’s score, including repaying loans on
time and keeping debt low.
How Credit Scores Work
A credit score can significantly affect your financial life. It plays a key role in
a lender’s decision to offer you credit. For example, people with credit scores
below 640 are generally considered to be subprime borrowers. Lending institutions
often charge interest on subprime mortgages at a rate higher than a conventional
mortgage to compensate themselves for carrying more risk. They may also require
a shorter repayment term or a co-signer for borrowers with a low credit score.
Conversely, a credit score of 700 or higher is generally considered good and
may result in a borrower receiving a lower interest rate, which results in their
paying less money in interest over the life of the loan. Scores greater than 800 are
considered excellent. While every creditor defines its own ranges for credit scores,
the average FICO Score range is often used.
Excellent: 800–850
Very Good: 740–799
Good: 670–739
Fair: 580–669
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Poor: 300–579
A person’s credit score also may determine the size of an initial deposit
required to obtain a smartphone, cable service, or utilities, or to rent an apartment.
And lenders frequently review borrowers’ scores, especially when deciding
whether to change an interest rate or credit limit on a credit card.
Credit Score Factors: How Your Score Is Calculated
The three major credit reporting agencies in the U.S. (Equifax, Experian, and
TransUnion) report, update, and store consumers’ credit histories. While there can
be differences in the information collected by the three credit bureaus, five main
factors are evaluated when calculating a credit score:
Payment history
Total amount owed
Length of credit history
Types of credit
New credit
4. Credit rating
A credit rating is an integral assessment of the financial stability and solvency
of a country, a borrower or a particular loan product. Credit ratings are usually
issued and published by specialized rating agencies, the most famous of which are
Standard & Poor's, Moody's, FitchRatings.
The rating expresses the agency's opinion on the future ability and intention
of the borrower to make payments to creditors in repayment of principal and
interest on it in a timely manner and in full.
Each agency applies its own methodology for assessing creditworthiness and
expresses the result of this measurement using a special rating scale. Typically, an
alphabetic scale is used, which allows you to show ratings that reflect the agency's
opinion on the relative level of credit risk in the range, for example, from AAA to
D. The credit rating scale is usually divided into two ranges: investment quality
(rating not lower than BBB on the S&P scale) and speculative quality (rating is
lower than investment quality).
What Is a Sovereign Credit Rating?
A sovereign credit rating is an independent assessment of
the creditworthiness of a country or sovereign entity. Sovereign credit ratings can
give investors insights into the level of risk associated with investing in the debt of
a particular country, including any political risk.
At the request of the country, a credit rating agency will evaluate its economic
and political environment to assign it a rating. Obtaining a good sovereign credit
rating is usually essential for developing countries that want access to funding in
international bond markets.
Understanding Sovereign Credit Ratings
In addition to issuing bonds in external debt markets, another common
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motivation for countries to obtain a sovereign credit rating is to attract foreign
direct investment (FDI). Many countries seek ratings from the largest and most
prominent credit rating agencies to encourage investor confidence. Standard &
Poor's, Moody's, and Fitch Ratings are the three most influential agencies.
Other well-known credit rating agencies include China Chengxin
International Credit Rating Company, Dagong Global Credit Rating, DBRS, and
Japan Credit Rating Agency (JCR). Subdivisions of countries sometimes issue
their own sovereign bonds, which also require ratings. However, many agencies
exclude smaller areas, such as a country's regions, provinces, or municipalities.
Investors use sovereign credit ratings as a way to assess the riskiness of a
particular country's bonds.
Sovereign credit risk, which is reflected in sovereign credit ratings, represents
the likelihood that a government might be unable—or unwilling—to meet its debt
obligations in the future. Several key factors come into play in deciding how risky
it might be to invest in a particular country or region. They include its debt service
ratio, growth in its domestic money supply, its import ratio, and the variance of
its export revenue.
Many countries faced growing sovereign credit risk after the 2008 financial
crisis, stirring global discussions about having to bail out entire nations. At the
same time, some countries accused the credit rating agencies of being too quick to
downgrade their debt. The agencies were also criticized for following an "issuer
pays" model, in which nations pay the agencies to rate them. These potential
conflicts of interest would not occur if investors paid for the ratings.
Examples of Sovereign Credit Ratings
Standard & Poor's gives a BBB- or higher rating to countries it
considers investment grade, and grades of BB+ or lower are deemed to be
speculative or "junk" grade. S&P gave Argentina a CCC- grade in 2019, while
Chile maintained an A+ rating. Fitch has a similar system.
Moody’s considers a Baa3 or higher rating to be of investment grade, and a
rating of Ba1 and below is speculative. Greece received a B1 rating from Moody's
in 2019, while Italy had a rating of Baa3. In addition to their letter-grade ratings,
all three of these agencies also provide a one-word assessment of each country's
current economic outlook: positive, negative, or stable.
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