Credit Risk Management
Enhancing Your Bottom Line
The AFP 23rd Annual Conference
New Orleans
November 3-6, 2002
Ebrahim Shabudin
Managing Director
Deloitte & Touche LLP
Credit Background
Thorough identification and accurate
measurement of credit risk, supported by strong
risk management can help improve the bottom
line
…..An uncertain and volatile economic
environment significantly impacts this ability
…..The desire to grow and turn in outstanding
results has a tendency to put pressure on the
checks and balances within businesses
Value Proposition
Credit plays a critical role in “selling” products and services
– Expands revenue opportunities with creditworthy, incremental
customers
– Utilizes innovative structures to support business relationships
Effective credit risk management limits credit losses and provides
stable cash flows and earnings
– Marketplace rewards companies exhibiting earnings and cash flow
stability with higher P/E multiples
– Marketplace penalizes credit induced volatility and “surprises”
Raises questions about quality of management
Corporate Credit Risk
Companies are exposed to significant levels
of credit risk emanating from different sources
Accounts Receivables
Other Notes Receivables
Buyer and Franchise Financing
With Recourse Financing
– Project Finance
– Structured Transactions
– Leases with Recourse
Derivatives Exposures
– FX, Interest Rate Risk, Commodities etc.
Collateral Risk
– Parent or Third Party Guarantees
– Commercial and Standby Letters of Credit
– Note also that Critical Suppliers to the company
may pose specific credit risk
DSO Impact … an example
Actual
Q3 A/R
Q3 Sales
\ DSOs =
Hypothetical
DSOs
Q3 Sales
\ Q3 A/R =
*
Company A
$295,396,000
$261,201,000
124*
Peer Average
51.3
D Cash
51.3
$261,201,000
$122,002,230
+$173,393,770
Equals 295.4M/261.2M x 90(or number of days in sales period)
Credit as a Facilitator
Credit risk management is important
– Credit is a facilitator of business growth and
performance
– High business margins tend to attract lower quality
clients and therefore higher risk profile to manage
– Clients (buyers) may be concentrated in selected
industries and provide limited portfolio diversification
opportunity
– Poor credit risk management resulting in negative
impact to bottom-line is heavily penalized by markets
Credit Strategy & Risk Tolerance
 Credit Strategy Statement and
Risk Tolerance
 Coordination with Business
Plan
 Specific Quantifiable Objectives
 Management Review
Methodology
Credit Objectives
and Risk
Tolerances
Credit Policies
Credit Risk
Management
Processes
Common
Performance
Metrics
Credit
Strategy/ Plan
Improve Profitability
Reporting
The business strategies and objectives drive the establishment of credit
policies and procedures. Measurement and reporting as well as the use of
current technologies enhance credit decision-making and improve risk
management. The entire process is continually re-evaluated and improved.
Credit Risk Areas to Consider
Origination/
Assessment

Sales
Channels

Risk Strategy

Underwriting
Standards

Credit
Application

Analysis




Business/
Industry
Financial
Credit
Credit Scoring
and Ratings
Administration
Credit Policy
Credit Approval
Authority
Limit Setting
Pricing Terms
and Conditions
Documentation:
Contracts and
Covenants
Collateral and
Security
Collections,
Delinquencies
and Workouts
Monitoring/
Control
Exposure

Management
– Aggregation
– Control

Periodic Account 
Reviews
– Payments/Aging
– Credit Condition
Compliance with 
Covenants, Terms
Technology/Reports
– Transactions/

Bookings
– Risk-adjusted
Return

Risk
Management
Portfolio
Management
Concentration
Diversification
Allowance for
Bad Debts
Risk
Mitigation
Objectives
Type of
Exposure
Instruments or
Methods
Performance Management
Performance-based management utilizes metrics that measure actual
performance against predetermined thresholds. The thresholds are
established taking into account the organization’s strategy, operating
environment and process controls.
Business Strategy
Systems
Operations
Business
Performance
Measures
Value Creation
Finance
Organizations need a rigorous set of measures to
support continuous improvement
The measures drive value creation and should support
problem identification and correction.
Credit Risk Management’s Inter-related Activities
CREDIT POLICY
Origination
Sales
channels
Reporting
Management
reporting
Credit Analysis
Financial
analysis
Recoveries
Collections
Credit
scoring
Exposure
measurement
Credit
Decisions
Customer
management
Portfolio
management
Compliance
Transactions
Pricing &
terms
Disposal /
Risk
mitigation
Credit
analysis
Exposure
aggregation
Risk rating
RISK MANAGEMENT
Credit limit
Collateral
acceptance
Contracts &
Documentation
Collateral
management
Credit Risk Management
A complete and coherent risk management
framework contains the following elements
Credit Policies
& Procedures
Measurement
Methodologies
Credit Strategy &
Risk Tolerance
Governance, Control
and Implementation
Analysis &
Risk
Management
Reassessment
Credit Strategy & Risk Tolerance
Technology &
Data Integrity
A New Paradigm
A new business paradigm had evolved: causing
a lack of reliance on good fundamental analysis
The idea that stock market values would
continue to go up indefinitely
Increasingly competitive, complex and volatile
market place
Higher than expected actual debt burdens
Extensive reliance on unrealistic future cash
flows
Failures in corporate governance
Questionable personal and corporate ethics
Implications for Corporate Governance
Current organization structures to be revisited
Clarity around roles and responsibilities
Need for honesty, integrity and independence
(self-regulation)
Technical expertise of people and strong
management processes
Improved disclosure requirements
Importance and implementation of sanctions
Increased legislation and compliance
requirements
Credit Risk Management – Strategic Vision
A business model view of Credit Risk Infrastructure
components
Vision: Managing Risk/Return
Pricing decisions,Performance measurement,
business and customer segmentation,
compensation, etc.
Near Term: Managing Economic Capital / Credit VaR
Portfolio Risk Concentration, Risk Based Limits, etc.
Short Term: Managing Expected Loss
Risk Identification, Transaction
Structuring, Approval & Pricing Decisions, Reserving, etc.
Foundation: Credit Rating and Underwriting Standards
Risk Identification, Origination, Credit Administration, etc.
Development Stages
– Foundation Stage includes application of risk identification
methodologies, risk scoring or rating systems and strong
underwriting standards
– Basic Stage tends to include managing on a transactional basis by
evaluating specific attributes such as structuring, collateral and
pricing
– Advanced Stage represents managing on a portfolio basis
including aspects such as concentrations, correlations and
diversification
– The Sophisticated Stage includes application of highly developed
measurement techniques for transactions and portfolios, supported
by decision-making relating to segments or businesses against
established hurdle rates.
Credit Risk Clarified
Credit risk is defined as the risk of loss or potential
loss resulting from:
– Default in contractual obligations by a customer
– Migration in condition and rating
– Deterioration in performance
Credit risk includes both an expected (predictable)
and unexpected (volatile) loss component.
Businesses have to contend with Expected
and Unexpected Losses
Expected Losses
– Anticipated
– Cost of doing business
– Charged to provisions
– Captured in pricing
– Relatively easier to
measure
Assessing expected loss
includes determining exposure,
default probability and severity
Unexpected Losses
– Unanticipated but
inevitable
– Must be planned for
– Covered by reserves
– Allocated to businesses
– Difficult to measure
Assessing unexpected loss
requires making qualitative
judgments around potential
volatility of average losses
Credit Risk Management Explained
Although credit risk may be difficult to measure it is
important to estimate and manage
What does Credit Risk Management mean?
– It represents an institution’s ability to properly identify
and evaluate the potential risk of default in payment of
obligations of customers
– It incorporates the firm’s ability to effectively manage
and control this exposure in a way that is consistent
with the institution’s business strategy, risk appetite
and credit culture
Important Building Blocks
Effective Credit Risk Management requires
–
–
–
–
Clear origination and underwriting standards
A strong corporate and credit culture
Highly developed risk measurement techniques
Ability to recognize and cover expected and unexpected
losses
– Pricing commensurate with risks undertaken
– Methodologies to assess net profit contributions by
customers and appropriate business segments
– Proper allocation of capital and management resources
In order to:
– Improve overall corporate performance, measured by a
higher EPS or P/E ratio (or market value)
Credit Policy and Process
Credit Policy should be clear and concise
Credit Underwriting Standards must be
developed and included in policy
Credit Processes should be reasonable
and allow quick response to clients
Healthy balance between sales and credit
approval should exist and be respected
Risk Monitoring
Exposure must be complete and current
Regular reporting and updating of clients’
payment performance
Minimum annual reviews of clients should
be performed
Financial conditions should be regularly
assessed
Required action must be initiated and
follow up must take place
Contract Terms and Documentation
Contract negotiations must take place at the
right level in the organization
Appropriate approvals must be obtained
Internal or external legal departments must
document completely
Terms and conditions should be understood and
compliance mechanism put in place
Exceptions must be reported and managed
urgently to resolution
Risk Rating System Effectiveness
Credit Scoring is generally used to “risk rate” homogeneous portfolios
– Highest applicability is in consumer and retail portfolios
– Some advanced scoring systems are being migrated for use in rating
“middle market” clients
– Such models are only as good as the underlying assumptions
Internal credit rating systems are difficult to assess and are often not
independently validated
– Client relationship may interfere with objective assessment of risks
– Rating criteria usually a matter of practice rather than written policy
– Ratings are not consistent over time
– Qualitative credit assessments often lag current market information
– Institutions often assume a mapping with external ratings in order to
quantify credit risk
Effective Risk Rating Systems
– Sufficient granularity of risk rating categories
– Accurate and timely assignment of ratings
– Clear and consistent application of default definition
– Periodic calibration, triangulation and validation of risk
ratings
– Accurate identification of migration of transactions and
portfolios (as reflected by upgrades and downgrades in
ratings)
Credit Evaluation: Financial Factors
Get the information you need to make a
full analysis
Some information will need to be crosschecked and obtained on a regular and
timely basis
Be constructively cynical: new business
models are difficult to pull off
Be cognizant of delaying tactics
Numbers don’t tell the whole story!
Credit Evaluation: Qualitative Factors
Evaluation of subjective factors is often times
more important than the numerical analysis
People make a business: visions, values and
strategies are only words unless people
implement them
Management, industry, product, geography,
competition etc. all influence results and must be
properly assessed
Analysis-paralysis may lead to wrong decisions
Art and Science of Judgment
Getting access to the best clients and all
the relevant information is a challenge
Ensuring proper analysis is done requires
a strong corporate culture
Utilizing qualified resources both internally
and externally enhances the results
Often the lack of the will to act is what
causes high losses
Concluding Comments
Companies that measure and manage credit
risk in a pro-active manner will benefit from a
favorable risk profile resulting in
– Higher revenue
– Lower losses
– Improved efficiencies
– Higher EPS, P/E ratios and market values
Concluding Comments
Risk Assessment and
Limit Management
Credit Infrastructure and
Portfolio Management
• Credit Quality
• Organizational Structure
• Credit Underwriting
• Policies and Procedures
• Risk Rating System Effectiveness
• Technology Selection and
Implementation
• Counterparty and Portfolio Limits
• Problem Asset Management
Credit Analytics Support
• Risk Rating Calibration
• Credit Reserve Methodology
• Transaction Pricing, Structure and
Support
• Risk Based Pricing Models
• Default Probability and Recovery
Calibration
• Risk Adjusted Return Analysis
• Portfolio Value Measurement
Credit Technology Enablement
• Credit Risk Measurement
• Credit Performance
Scorecards
 Internal Software
 External Vendor Software
Appendix: Business Proposal Checklist
Business Proposal Summary
–
–
–
–
–
–
–
–
Customer, Rating, Legal Status, Line of Business
Guarantor, if any…same
Collateral, if any…true value explained
Other Support, if any... Legal or moral only
The Transaction…risks and mitigation
Amount, purpose, terms and conditions
Sources of repayment… clearly identified
Client payment history and relationship
Appendix: Business Proposal Checklist
Rationale and Analysis
– Customer, Guarantor, Collateral, Support
– Facility Description
Amount, purpose, tenor, pricing, terms, conditions, covenants,
restrictions etc.
Consider affect on above e.g. new leverage
Facility Rating?
– Repayment Capacity
Future cash flow, conversion of assets etc.
– Consistency with Credit Strategy and Policy
Confirm, and identify any exceptions to policy, underwriting
standards, or process
Risk adjusted return acceptability
Appendix: Business Proposal Checklist
Client Relationship
– Business strategy: increase, maintain or
decrease exposure or exit relationship
– Consider relation to rating, latest risk profile
and payment performance
– Customer profitability: risk adjusted return,
revenue, fees, direct and allocated costs etc.
– Any conflicts of interest or special concerns
Appendix: Business Proposal Checklist
Macro Analysis
– Business Environment Review
Customer’s competitive market position and future
industry prospects: size, cycle, volatility, new
entrants
Strength of customer’s business and financial
strategies
– Management Evaluation: competency,
experience and effectiveness
Appendix: Business Proposal Checklist
Customer Analysis
– Company history, background, objectives and
performance
– Relevance and strength of future business plans
Consider seasonality and scenario analysis
– Primary and secondary sources of repayment
– Historical financial capacity and analysis of future
performance: sales, profitability, working capital,
liquidity, cash flow, leverage, tangible net worth etc.
Quality of earnings
Absolute and ratio analysis
Peer comparisons
Appendix: Business Proposal Checklist
Strengths, Weaknesses and Recommendation
– Key factors that could jeopardize collection:
environment or company specific
– Any mitigating factors
– Consider probability and impact
– Consider all sources of repayment: primary,
secondary and tertiary, including access to capital
markets, refinancing etc.
– Summarize strengths and weaknesses and conclude
with a recommendation