CREDIT RISK ASSESSMENT 2 NOV 2011
SECTION A
Question 1
After successfully completing the IOBM Advanced Diploma Course, your bosses
have promoted you to the post of Branch Credit Manager. Your first task is to
analyze a credit proposal from one of your branch’s reputable customers. Your
Branch Manager says that the customer has always submitted good credit proposals.
a)
Briefly discuss five (5) attributes of a good credit proposal.
(a)
(b)
(c)
(d)
(e)
(f)
b)
(10 marks)
The credit proposal must be well structured, logical and systematically presented.
The proposal must be factually correct and representative of the real situation of the
customer.
The proposal must be technically correct and complete.
The proposal should reflect a balanced approach
The proposal must meet all the requirements of the Credit Policy of the bank.
The proposal must be concise, to the point and reflect no unnecessary information.
Mention three (3) advantages and two (2) limitations of credit scoring
models.
(5 marks)
Advantages of Credit Scoring Models
(a)
The biggest advantage of credit scoring models is that they save time in terms of
the credit risk assessment process. Faster turnaround time can thus be obtained
(b)
Labour/staff costs are saved because it is done on computer, Banks are all
pressured in terms of their cost- to income ratios and labour/staff cost savings are
essential to lower this ratio.
(c)
Credit scoring models bring objectivity and consistency, something which is not
always achieved with manual assessment, because bankers can be biased in their
decision making.
(d)
Most systems will automatically withdraw all the relevant documentation if the
customer scores a value below the qualifying point.
(e)
Banks keep a record of the statistical data contained in applications that are credit
scored and this becomes a valuable source of information to compare against the
performance of scored accounts over time, which in turn aids banks in
continuously assessing their weights and criteria built into the scoring models.
The Limitations of Credit Scoring Models
(a)
If the samples used to develop the scoring model are too small to determine the
correct weights allocated to the different criteria, they tend not to be very specific,
with an unacceptable percentage of inaccurate decisions.
(b)
Credit scoring models have limited application and the banker must often overrule
the decisions made by it. For this purpose the banker must be allowed a mandate
approve or disapprove applications scored by the system if there is justification for
such a decision..
(c)
Credit scoring models can be expensive to research, design and implement and
require the correct equipment to be used.
(d)
(e)
Unless the banker understands the functioning of the credit scoring model very
well, the quality of service and feedback to the customer might affected to his
detriment.
Although a lot of information is extracted programmatically by credit scoring
systems, there is still a lot of information that needs to be captured on the computer
by the bank official. If the information is captured incorrectly or the data is
manipulated, the bank would be exposed to additional credit risks.
Total 15 marks
Question 2
During one of bank Kawawa’s regular credit committee meetings, the committee
members had a heated debate over one loan application. It was a K500, 000.00 loan
application from Miss Mafofofo, a long time customer of the bank. Some members
were of the opinion that the loan was too risky since it was not secured while others
felt the customer was very trustworthy so it was worthy the risk.
a)
Explain three (3) different factors that might have influenced the risk
preferences of bank Kawawa’s credit committee members.
(3 marks)
THE INFLUENCE OF RISK PREFERENCES
The degree, to which an individual will be prepared to take risk, is determined by his
particular risk preference. This in turn is influenced by a number of factors namely:
 The value the individual perceives to obtain from making an investment.
 How the individual feels about the consequences of such action
 The individual’s attitude towards risk taking.
Different reactions to one situation
Let us illustrate how each one of these individuals would react to the same situation.
Suppose one has an opportunity to make between a 50% or nothing return on an
investment K100, 000.
A risk adverse person would rather receive a return of less than 50% with 100%
certainty, even if the return were only 25% than take a gamble at 50% and receive nothing.
A risk indifferent individual on the other hand will not care what the risk is so long as
he/she gets anything up to 50% return.
A risk taking individual will if induced and enticed even be prepared to take more of a
risk, if it is possible that the return can very well be more than the 50% expected.
b)
What is Sensitivity Analysis? Demonstrate your understanding with two
specific examples.
(3 marks)
This simply means that the impact of potential changes, threats, opportunities, strengths
and weaknesses must be taken into consideration and their effect on the cash flow
measured.
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b)
Briefly discuss the relationship between risk and return and how interest
rates, tenure and security impact on this relationship.
(7 marks)
The Relationship between Risk and Return
Return is what one gains or loses on an initial investment over a specific
period of time, expressed as a percentage. Risk is the gamble one takes
when investing. There is a chance in any investment that things might turn
up adversely. Whenever a financial decision is made, it will always involve the
weighing up of expected risk against expected return. It is an acceptable financial
principle that the higher the risk involved, the higher the return the investor will require.
This is so because the investor wants to be rewarded for the higher risk involved in the
investment. The other side of this principle is that lower risks mean lower returns.
Therefore it follows that higher interest rates are expected to be charged on high risk
investments in order to get higher returns and vice versa.
Again higher returns are expected where the tenure is longer because with longer tenure
the risk of default is also higher and vice vers.
Finally, higher returns are expected from unsecured investments because of the high risks
involved with such type of investments and vice versa.
c)
Differentiate between Credit fraud risk and operational risk
(5 marks)
Fraud Risk refers to a situation where there is a deliberate attempt to initiate or alter a
payment for the purpose of misappropriation of funds. There can be many reasons for it,
such as financial gain, to sabotage or create embarrassment for organisation, to get
attention etc. It can be committed by bank employees or an external party who succeeds
to access bank computer systems in an unauthorized manner. It can even be committed by
an organisation or syndicate of parties.
Operational Risk refers to a situation where a transaction is delayed or changed
unintentionally. It could lead to losses for the customer and/or the bank and can include
such things as: Clerical errors
 Computer software and hardware failures
 Not following prescribed procedures
 Natural disasters
 Staff problems such as strikes
Total 15 marks
Question 3
Mr Mandevu, who happens to be your neighbor, has approached you as a student of
banking on mortgage loans. He would like to know more about the product.
a)
Define a mortgage loan.
(1 mark)
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A mortgage is an assurance to the creditor of the legal or equitable interest in property as
security for the discharge of a debt, subject to a proviso that on repayment of the debt the
property shall revert to the borrower.
The characteristic of a mortgage is that possession of the property remains vested in the
mortgagor (the borrower) while the mortgagee (the lender) obtains some or all of the
rights of ownership, or the right to obtain ownership if the debtor defaults. Land is the
form of property most usually mortgaged by Conditional Bill of Sale and chooses in action
( such as insurance policies) can be mortgaged by assignment subject to a condition that
on repayment the chose shall revert to the borrower.
b)
Briefly explain five (5) requirements that must be satisfied for one to get a
mortgage loan?
(10 marks)
Legal and Equitable interests
 It has to be in writing
 It has to be registered in the Deeds Office
 It has to specify the official Title Deed description of the fixed property over which it is
registered.
 It has to specify the identity of the mortgagor, who gives the bond and the mortgage, in
whose favour the bond is registered.
 It has to specify the amount which may be recovered from the proceeds of the fixed
property, as well as a cover clause that specifies the additional amount in respect of
interest and legal costs that may be recovered.
 It has to describe the rights of the mortgagor and mortgagee.
 It gives the mortgagee/bank a preferent and secured claim against the deceased or
insolvent estate of the mortgagor.
 Valuation report must be provided
c)
Discuss the relevance of at least two requirements mentioned in ‘b’ above
to the lending bank.
(4 marks)
Total 15 marks
Question 4
Briefly discuss how a banker would use a SWOT Analysis and Micheal Porter’s
Model when analyzing a customer’s business plan.
(15 marks)
(a) The Michael Porter Model of Competition
This model focuses on five forces that operate in the competitive environment of a business and is
a useful tool to understand the external environment. According to this model the following five
competitive forces must always be taken into consideration by a business if it were to survive and
grow:
The rivalry between businesses
 This is a constant aim of each business to improve its position in the market by gaining a
competitive edge over the other competitors.
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The competitive power of substitute products
This can increase competition substantially and this competition will focus on factors such as
price, quality, availability and the cost involved for clients to switch from one product to another.
The possibility of new competitors
Entry into the market will be determined/limited by such factors as economies of scale, loyalty to
brands, expertise required, capital requirements, cost advantages of established businesses,
government regulations, etc.
In a market where the reactions of existing businesses are expected to be very aggressive by
means of price decreases, huge financial resources, etc, new entries into the market will also be
limited.
The economic strength and power of suppliers
This can give suppliers strong bargaining power if
 their products are important to the buyer,
 the supply is controlled by a few large producers
 switching to other products is difficult to achieve
 there are no substitute products
 the forward integration into the buyer’s operations is a possibility
The bargaining power of customers can become very strong when
 only a few of them buy large quantities
 there are many small suppliers
 alternative suppliers of similar products are active in the market
 it is feasible to rather buy from several suppliers
 there is a real threat of backward integration,
 the products bought are not critical/essential input and
 the customer experiences no real saving when buying the product (s)
(b) SWOT-Analysis of the External Environment
The SWOT-analysis is a very popular method to determine the strength(s), weaknesses (w)
opportunities (o) and threats (t) that must be taken into consideration by the business for its
long term survival and growth.
The strengths and weaknesses of a business refer to its internal environment 0 in other words
the factors that it can control such as financial policies, expertise, etc.
The opportunities and threats refer to the external environment of the business and it has no
control over these factors, for example the fluctuating exchange rate, legislation, and so forth
Bankers can use SWOT-analysis to their advantage to
 determine the potential credit risks involved
 analyse to what degree the business plan of an enterprise makes the necessary provision to
deal with the threats and weaknesses
 determine to what degree strengths and opportunities are used in total strategy and
business planning.
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A SWOT-analysis assists the banker to obtain focus on what the real CRITICAL ISSUES
at stake are when doing a credit risk assessment.
SECTION B
Question 5
As Head of Credit Department at your bank, you have been asked to train one of the
newly recruited employees posted to your department. During the training, you
observe that the recruit is having difficulties in understanding the concept
underlying the factors that influence credit risk.
a)
Explain to him four internal factors that influence credit risk of a bank .
(8 marks)
The Internal Environment
The internal environment of a bank refers to those factors or variables that can affect the credit
risk, but may be influenced indirectly by the management of the bank, in other words they do
have some degree of control over these variables.
Factors that affect credit risk include:
- The Credit Policy of the bank
- Credit Management and Control Systems
- Employees of the Bank
- Products and Markets
The Credit Policy of the Bank
The Credit Policy of a bank should be the document that will give staff involved with credit the
necessary guidelines and principles to be applied when granting credit. It should be used as the
official reference document to determine what types of credit may be granted, the credit terms
required acceptable, security or collateral and qualifying principles and criteria.
The Credit Policy must be developed by senior levels of management and be approved by the
Board of Directors. It is of vital importance that the document is constantly updated and
streamlined to deal with the current issues on credit risks faced by the bank. All credit staff must
be well trained and conversant with the content and implications of the Credit Policy at all times.
Credit Management and Control Systems
Customer information, the monitoring of customers’ conduct in terms of their contracts,
facilities, record keeping in terms of contracts and securities, credit reports, etc. are mostly
computerized in modern times. There is however, some information that cannot be dealt
with on computer and must be kept in files and safely stored.
The credit control systems of a bank are vital for the continuous management of credit risk
in terms of both the current and pro-active identification of potential risk areas. Credit
control systems and the monitoring of credit risk must therefore be updated and modified
to meet the requirements of both effective and efficient credit control.
Employees of the Bank
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Credit decisions are made by employees and if they are not knowledgeable and competent
in their job, the bank will be exposed to credit risks. Credit training programmes are used
to give staff the necessary skills and knowledge. Most banks will only be prepared to
authorise credit staff to grant credit up to certain specified limits once they have
successfully completed the required training programmes.
It is important that the correct profile employee is placed in a credit position, as it is a
highly complex environment with a lot of stress involved. The wrong type of person in
this situation can be a great risk to the bank.
Fraud and deliberate bad credit decision making also constitute major risks to the bank,
especially in situations where staff are not objective in granting credit.
Products and Markets
It is essential for a bank to do thorough research as to the type of products it wants to sell
to the specified target markets. The risk involved when selling current accounts and
overdraft facilities to high income individuals will be substantially different from the
scenario where the same product is sold to small businesses.
b)
Briefly discuss six external factors that influence credit risk in general.
(12 marks)
Total 20 marks
The External Environment
The external environment of the bank refers to those factors or variables that can have an
effect on the credit risk, but cannot really be influenced by the management of the bank.
When and if banks do have some effect on these factors, it will mostly be negligible. The
external environment can be classified under the following eight categories:The marketing environment
The economic environment
The physical environment
The international environment
Legislative and the institutional environment
The social environment
The technical environment
The political environment
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Question 6
A customer of your branch, Mrs Chinyamula, has applied for a one year overdraft
facility worth K3Million for the purpose of purchasing an incomplete residential
house at Chilomoni Fargo. Upon close examination as Branch Manager, you
recommend for a term loan instead of an overdraft. However, Mrs Chinyamula
insists that she will be able to clear off the facility within the indicated period using
funds she gets from her transportation business.
a) Briefly discuss the implications of financing such a project with the requested
facility.
(4 marks)
SOME PRACTICAL IMPLICATIONS OF “MISMATCHING” OF SOURCES OF
FINANCE AND NEEDS
- When a business needs long term finance to cater for purchase of fixed assets such as
machines, vehicles, etc, and it were to finance it by means of short term funds such as
an overdraft on the current of the business, the financial impact would be:
-
b)
First of all it will have a very serious cash flow implication, as the total value of the
asset needs would have to be paid back in one year, whilst its productive life could
span over up to five years. Secondly it could require that the business should actually
uses some of its cash resources needed for the working capital requirements and this
could lead to serious illiquidity. It could also force the business to sell assets at a loss
to generate cash to meet its commitments.
Briefly substantiate your answers on how you would finance the
following:
i. Bank GC Head Office Building
ii. 4x4 Vehicles for Heads of Department
iii. Inventory for peak period
iv. Company computers
(4 marks)
Finance required for:
Bank GC Head Office Building
Company Computers
4x4 Vehicles
Department
for
Inventory for peak period
Heads
How do you think it should be financed –
substantiate
It could be financed by EQUITY issuing
shares; or LONG TERM DEBT such as a
Commercial Mortgage Loan. It is a long
term asset and requires long term funds.
It is a medium term need and a financial
lease can be considered as it will only last 3
years anyway.
of It is long term, but normally the lifeexpectancy of company cars for Heads of
staff will be 2 – 3 years. Once again a
financial lease might be the better option
with no residual value as these cars have
high mileage after this type of usage
Short Term need i.e OD will do.
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c)
Sources of finance are in general classified into two broad categories of Long
Term and short Term. Briefly describe 3 sources under long term and 3
sources under short term.
(12 marks)
THE SOURCES OF SHORT TERM FUNDS
Short term finance is mainly used to finance working capital requirements ensuring that the
business is liquid. We discussed the cash cycle of the business in detail in “Credit Risk
Assessment 1” to illustrate the functioning and role of working capital. The Cash Cycle of the
business can be financed by using the following sources of finance:
 Trade Creditors
 Bank Overdrafts(BAs)
 Letters of Credit ( LCs)
 Factoring the debtor’s book
 Invoice discounting
 Short term foreign loans
The Sources of Long Term Funds
Equity or Owners’ Funds
Ordinary Shares
Rights Issue
Preference Shares
Retention of Profits
Long Term Debt
 Debentures
 Long-term loans
 Mortgage loans
 Instalment Credit
 Credit market finance
 Long term foreign loans
Instalment Credit
Capital Market Finance
Deferred Tax
Project Finance
Long Term Foreign Loans
Total 20 marks
Question 7
Lungalunga has been a customer of Penacle Bank for over ten years but he is now
thinking of closing the account because of frustration. Recently he applied for a
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K300, 000.00 loan in order to boost his working capital but the bank declined the
application due to unavailability of good security. You are a Credit Officer at the
branch so he storms into your office demanding an explanation.
a) Briefly explain to him the role of security in lending
(3 marks)
Protection to the customer
Security does not provide a buffer against risk for the bank only. It also protects the customer in
the event of unforeseen or unforeseeable future events.
It must also be kept in mind that is prudent for a banker to first determine whether a specific
lending proposal is acceptable in principle in terms of the principles discussed in this subject and
that no amount of security will make a bad advance good.
Alternative source of payment
It must also be borne in mind that it is prudent for a banker to first determine whether a specific
lending proposal is acceptable in terms of principles of lending . No amount of security will
make a bad lending good.
 the role of security, namely to provide an alternative source or repayment in the
event of the borrower’s default and

the bank’s legal rights and ability to realise this source.
b) Discuss what constitutes good security. Give 4 characteristics. (12 marks)
Characteristics of Good Collateral
 Ownership
 Value
 Control
 Realisation.
c) Discuss Cession of Book Debts as a form of security
(5marks)
This means that the bank becomes the legal owner of all the Accounts Receivable of the customer
from time to time. Book debts are not considered as good security as they do not have all the
characteristics of good security. For instance not only does the bank have no control over the size,
as this is determined by the amount purchased on account from the customer and the efficiency of
the company’s debt collateral. BUT it is also difficult and very costly to realize. For this reason
most banks will only take a small percentage of the actual value of the debtors’ book into
consideration, as value of the collateral.
As discussed earlier, this is not a good form of security. It becomes somewhat more desirable to
the banker if the debtors are in fact insured and this insurance is also ceded to the bank.
Total 20 marks
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Question 8
a)
Banks have been issuing out loans to many employees of various
organizations under what is termed employer guaranteed loans.
I. Define a guarantee.
(2 marks)
Definition of guarantee
A guarantee, or surety contract is an undertaking ‘to be answerable to the debt, default or
miscarriage of another,’ Statute of Frauds ,1677 s 4.
Guarantees may be either specific or continuing.
(a) A specific guarantee relates to one isolated debt only. (Where a bank accepts a specific
guarantee of a single loan, a separate account should be opened for that loan; otherwise the
guarantee may be cancelled by operation of the Rule in Clayton’s Case)
(b) A continuing guarantee is one covering a series of transactions e.g. a guarantee of an
overdraft on a current account at a bank (A bank, in order to enforce such a guarantee of an
overdraft, should stipulate expressly in the guarantee form that the guarantee shall cover the final
balance . Otherwise it will be interpreted as covering only the overdraft as it existed as the date of
the agreement, and payments in after that date would thus reduce the guarantor’s
liability)
II. Briefly describe roles played by three parties to a guarantee.
(6 marks)
(a) There are three parties: principal creditor, principal debtor and guarantor (or
surety)
(b) Primary liability to pay must attach to the principal debtor. The surety only
becomes liable to pay if the debtor defaults.
(c) The guarantor has no interest in the contract between the principal debtor and the
principal creditor, except in so far as he agrees to accept liability if the debtor fails to
pay..
For the guarantors it means that the bank could call on them to repay the debt of the
principal debtor in the case of default. They could be called upon to repay the full
amount of the liability or part thereof is the guarantee is for a limited amount.
III. Discuss Guarantees not uberrimae fidel.
(2 marks)
Guarantees not uberrimae fidel
Neither the principal creditor nor the principal debtor are under any legal duty to
disclose to the guarantor facts which might influence him against the contract. Thus
if A offers to guarantee B’s account, the bank is under no obligation to reveal matters
which show that B is bad risk: Wythes v Labouchere (1859)
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b)
Discuss the effects of Asset Revaluation on Ratios and its impact on credit
analysis.
(10 marks)
The Effect of Asset Revaluation of Ratios
It must be very clear from the discussion so that that a banker’s revaluation of assets can bring
about a substantially different financial picture in comparison to the one reflected in the
customer’s financial statements. The question is ‘How will this impact on the ratio analysis
results? Most ratios will be affected in some way or another. Let us take a few examples to
illustrate this point
Ratio
Return on
assets (ROA)
Return on Equity
(ROE)
Financial
Leverage
Turnover of
Fixed assets
Solvency ratio
(debt ratio)
Possible Effect of Asset Revaluation
If the total asset value is reduced, it will increase the (ROA), if the
total asset value is increased, it will reduce the ROA. This is so
because we use the total asset value below the line in the formula.
If the shareholders funds are reduced by deducting fictitious
(intangible} assets such as goodwill from it, the ROE will increase
because we use the equity figure below the line in the formula.
This figure will change because ROA and ROE are Leverage used
in the formula and if they change, it must affect this ratio.
In the formula, we use fixed assets and if they are increased or
decreased due to revaluation, it will increase or decrease the
turnover figure obtained.
In this formula we used total assets below the line and if it is to
increase or decrease, it will either improve or reduce this figure
It is essential that the effect of these changes due to revaluation of assets be addressed in the
comments written on the credit proposal. They need to be highlighted and placed into context to
facilitate a meaningful interpretation during credit risk assessment.
Total 20 marks
THE END
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