TASHKENT INSTITUTE OF FINANCE
ЖЖ
DEPARTMENT «FINANCE»
ЖЖ
PRESENTATION
ЖЖ
Theme 42. «Credit risk»
Lecturer: ass. prof. Ye. Akhunova
Copyright © Ye. Akhunova, 2022
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.
Copyright © Ye. Akhunova, 2022
1. The concept of credit risk
Copyright © Ye. Akhunova, 2022
Essence of credit risk (1)
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.
Copyright © Ye. Akhunova, 2022
Essence of credit risk (2)
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.
Copyright © Ye. Akhunova, 2022
Essence of credit risk (3)
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.
Copyright © Ye. Akhunova, 2022
Factors affecting the risk of each individual loan (1)
• appointment of a loan (to increase capital, to temporarily replenish
funds, to form current assets, capital construction);
• 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);
Copyright © Ye. Akhunova, 2022
Factors affecting the risk of each individual loan (2)
• 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).
Copyright © Ye. Akhunova, 2022
Classification of credit risks (1)
No.
Criteria
classification
Types of credit risks
risks at the macro level of relations (external);
risks at the micro level of relations (internal).
1.
Level of risk
2.
The degree of risk dependence independent of the activities of the credit institution;
on the bank
dependent on the activities of a credit institution.
3.
Sectoral focus of lending
4.
Scale of lending
5.
Loan types
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
industrial; trade; agricultural, etc.
complex risk;
private risk
risks by subjects, objects, terms, security
Copyright © Ye. Akhunova, 2022
Classification of credit risks (2)
No.
Criteria
classification
Types of credit risks
8.
Degree of acceptance
minimal, elevated, critical, invalid.
9.
Sphere of occurrence
borrower risk, loan product risk, risk of changes in the external
environment of the bank and the borrower
10.
Type of borrower
country risk, corporate lending risk, retail lending risk
11.
The nature of the
manifestation of risk
moral, business, financial risks, collateral risk
12.
Type of operation
risks arising from loan, leasing, factoring transactions, as well as the
provision of bank guarantees and guarantees, the conclusion of
transactions using promissory notes
13.
Nature of actions of the
borrower
the risk of the borrower's refusal to pay interest and (or) principal;
misuse of the loan; obstruction of bank control
Copyright © Ye. Akhunova, 2022
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.
Copyright © Ye. Akhunova, 2022
2. Methods for assessing the risks of lending
to legal entities.
Copyright © Ye. Akhunova, 2022
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.
Copyright © Ye. Akhunova, 2022
Altman’s Z-Score Model
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.
Copyright © Ye. Akhunova, 2022
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 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;
•E is the Total Sales/Total Assets ratio.
Copyright © Ye. Akhunova, 2022
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.
Copyright © Ye. Akhunova, 2022
What are Credit Analysis Ratios?
Credit analysis ratios are tools that assist the credit analysis process.
These ratios help analysts and investors determine whether individuals
or corporations are capable of fulfilling financial obligations. Credit
analysis involves both qualitative and quantitative aspects. Ratios
cover the quantitative part of the analysis.
Key ratios can be roughly separated into four groups:
(1)Profitability;
(2)Leverage;
(3)Coverage;
(4)Liquidity.
Copyright © Ye. Akhunova, 2022
Profitability Ratios
As the name suggests, profitability ratios measure the ability of the company to generate
profit relative to revenue, balance sheet assets, and shareholders’ equity. It is important to
investors, as they can use it to help project whether stock prices are likely to appreciate.
They also help lenders determine the growth rate of corporations and their ability to pay
back loans.
Profitability ratios are split into margin ratios and return ratios.
Margin ratios include:
•Gross profit margin;
•EBITDA margin;
•Operating profit margin.
Return Ratios include
•Return on assets;
•Risk-adjusted return;
•Return on equity.
Higher margin and return ratios are an indication that a company has a greater ability to
pay back debts.
Copyright © Ye. Akhunova, 2022
Leverage Ratios
Leverage ratios compare the level of debt against other accounts on a balance
sheet, income statement, or cash flow statement. They help credit analysts gauge
the ability of a business to repay its debts.
Common leverage ratios include:
•Debt to assets ratio;
•Asset to equity ratio;
•Debt to equity ratio;
•Debt to capital ratio.
For leverage ratios, a lower leverage ratio indicates less leverage. For example, if
the debt to asset ratio is 0.1, it means that debt funds 10% of the assets and equity
funds the remaining 90%. A lower leverage ratio means less asset or capital
funded by debt. Banks or creditors like this, as it indicates less existing risk.
Copyright © Ye. Akhunova, 2022
Coverage Credit Analysis Ratios
Coverage ratios measure the coverage that income, cash, or assets provide for debt
or interest expenses. The higher the coverage ratio, the greater the ability of a
company to meet its financial obligations.
Coverage ratios include:
• Interest coverage ratio;
• Debt-service coverage ratio;
• Cash coverage ratio;
• Asset coverage ratio.
Example
A bank is deciding whether to lend money to Company A, which has a debt-service
coverage ratio of 10, or Company B, with a debt service ratio of 5. Company A is a
better choice as the ratio suggests this company’s operating income can cover its
total outstanding debt 10 times. It is more than Company B, which can only cover
its debt 5 times.
Copyright © Ye. Akhunova, 2022
Liquidity Ratios
Liquidity ratios indicate the ability of companies to convert assets into cash. In terms of
credit analysis, the ratios show a borrower’s ability to pay off current debt. Higher
liquidity ratios suggest a company is more liquid and can, therefore, more easily pay off
outstanding debts.
Liquidity ratios include:
• Current ratio;
• Quick ratio;
• Cash ratio;
• Working capital.
Example
The quick ratio is the current assets of a company, less inventory and prepaid expenses,
divided by current liabilities. A person is deciding whether to invest in two companies that
are very similar except that company A has a quick ratio of 10 and the other has a ratio of
5. Company A is a better choice, as a ratio of 10 suggests the company has enough liquid
assets to cover upcoming liabilities 10 times over.
Copyright © Ye. Akhunova, 2022
PARSER method in credit risk analysis
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
1.To identify in what ways any proposition falls short of ideal
2.To establish what the risks are and whether they are acceptable to the Bank
3.If acceptable, to structure the borrowing in such a way as to minimize 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.
Copyright © Ye. Akhunova, 2022
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?
Copyright © Ye. Akhunova, 2022
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 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?
Copyright © Ye. Akhunova, 2022
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?
Copyright © Ye. Akhunova, 2022
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.
Copyright © Ye. Akhunova, 2022
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.
Copyright © Ye. Akhunova, 2022
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.
Copyright © Ye. Akhunova, 2022
CAMPARI METHOD (1)
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
•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.
Copyright © Ye. Akhunova, 2022
CAMPARI METHOD (2)
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.
Copyright © Ye. Akhunova, 2022
CAMPARI METHOD (3)
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.
Copyright © Ye. Akhunova, 2022
CAMPARI METHOD (4)
AMOUNT
Bank managers want to know why you need the amount you’re asking for. In 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.
Copyright © Ye. Akhunova, 2022
CAMPARI METHOD (5)
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.
Copyright © Ye. Akhunova, 2022
3. Risk assessment of lending to individuals
based on credit scoring
Copyright © Ye. Akhunova, 2022
What Is 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.
Copyright © Ye. Akhunova, 2022
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 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.
Copyright © Ye. Akhunova, 2022
https://uaeb.uz/en/scroring (1)
Copyright © Ye. Akhunova, 2022
https://uaeb.uz/en/scroring (2)
Copyright © Ye. Akhunova, 2022
https://uaeb.uz/en/scroring (3)
Copyright © Ye. Akhunova, 2022
https://uaeb.uz/en/scroring (4)
Copyright © Ye. Akhunova, 2022
https://uaeb.uz/en/scroring (5)
Copyright © Ye. Akhunova, 2022
https://uaeb.uz/en/scroring (6)
Copyright © Ye. Akhunova, 2022
https://uaeb.uz/en/scroring (7)
Copyright © Ye. Akhunova, 2022
https://uaeb.uz/en/scroring (8)
Copyright © Ye. Akhunova, 2022
4. Credit rating
Copyright © Ye. Akhunova, 2022
The concept of 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).
Copyright © Ye. Akhunova, 2022
https://tradingeconomics.com/uzbekistan/rating
Copyright © Ye. Akhunova, 2022
https://ipakyulibank.uz/bank-haqida/faoliyat-korsatkichlari/reytinglar
Copyright © Ye. Akhunova, 2022
https://sqb.uz/en/for-investors/ratings-en/
Copyright © Ye. Akhunova, 2022
https://sqb.uz/en/for-investors/ratings-en/
Copyright © Ye. Akhunova, 2022
https://sqb.uz/en/for-investors/ratings-en/
Copyright © Ye. Akhunova, 2022