Credit Risk Management
Enhancing Your Bottom Line
Ebrahim Shabudin
Managing Director
Deloitte & Touche LLP
The AFP 23rd Annual Conference
New Orleans
November 3-6, 2002
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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
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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
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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
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DSO Impact … an example
Actual Company A Peer Average
Q3 A/R $295,396,000
Q3 Sales $261,201,000
\ DSOs = 124*
Hypothetical D Cash
DSOs
Q3 Sales $261,201,000
\ Q3 A/R = $122,002,230 +$173,393,770
* Equals x 90(or number of days in sales period)
EL affects the income statement, whereas UL is captured in the balance sheet
‘ECONOMIC’ TO DISTINGUISH THE CONCEPT FROM REGULATORY OR ACCOUNTING (BOOK) CAPITAL
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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
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Credit Strategy & Risk Tolerance
Specific Quantifiable Objectives
Management Review Methodology
Credit Strategy Statement and Risk Tolerance
Coordination with Business Plan
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.
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Credit Risk Areas to Consider
Credit Policy
Credit Approval Authority
Limit Setting
Pricing Terms and Conditions
Documentation: Contracts and Covenants
Collateral and Security
Collections, Delinquencies and Workouts
Exposure Management
Aggregation
Control
Periodic Account Reviews
Payments/Aging
Credit Condition
Compliance with Covenants, Terms
Technology/Reports
Transactions/ Bookings
Risk-adjusted Return
Sales Channels
Risk Strategy
Underwriting Standards
Credit Application
Analysis
Business/ Industry
Financial
Credit
Credit Scoring and Ratings
Origination/
Assessment
Administration
Monitoring/
Control
Risk
Management
Portfolio Management
Concentration
Diversification
Allowance for Bad Debts
Risk Mitigation
Objectives
Type of Exposure
Instruments or Methods
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Value Creation
Business Performance Measures
Organizations need a rigorous set of measures to support continuous improvement
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.
The measures drive value creation and should support problem identification and correction.
Business Strategy
Systems
Operations
Finance
Performance Management
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Sales channels
Contracts & Documentation
Credit analysis
Credit limit
Pricing & terms
Credit Analysis
Credit Decisions
Collections
CREDIT POLICY
Collateral acceptance
Portfolio management
Financial analysis
Disposal /
Risk mitigation
Collateral management
Customer management
Exposure measurement
Management reporting
Exposure aggregation
Recoveries
Credit scoring
Risk rating
RISK MANAGEMENT
Credit Risk Management’s Inter-related Activities
Compliance
Origination
Reporting
Transactions
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Credit Risk Management
A complete and coherent risk management framework contains the following elements
Credit Policies
& Procedures
Analysis &
Risk
Management
Governance, Control
and Implementation
Measurement
Methodologies
Technology &
Data Integrity
Credit Strategy & Risk Tolerance
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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
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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
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Credit Risk Management – Strategic Vision
Foundation: Credit Rating and Underwriting Standards
Risk Identification, Origination, Credit Administration, etc.
Short Term: Managing Expected Loss
Risk Identification, Transaction
Structuring, Approval & Pricing Decisions, Reserving, etc.
Near Term: Managing Economic Capital / Credit VaR
Portfolio Risk Concentration, Risk Based Limits, etc.
Vision: Managing Risk/Return
Pricing decisions,Performance measurement,
business and customer segmentation,
compensation, etc.
A business model view of Credit Risk Infrastructure components
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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.
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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.
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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
EL affects the income statement, whereas UL is captured in the balance sheet
‘ECONOMIC’ TO DISTINGUISH THE CONCEPT FROM REGULATORY OR ACCOUNTING (BOOK) CAPITAL
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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
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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)
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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
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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
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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
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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
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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)
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Credit Evaluation: Financial Factors
Get the information you need to make a full analysis
Some information will need to be cross-checked 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!
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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
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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
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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
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Concluding Comments
Risk Assessment and Limit Management
Credit Infrastructure and Portfolio Management
Credit Analytics Support
Credit Technology Enablement
Credit Quality
Credit Underwriting
Risk Rating System Effectiveness
Counterparty and Portfolio Limits
Organizational Structure
Policies and Procedures
Technology Selection and Implementation
Problem Asset Management
Risk Rating Calibration
Transaction Pricing, Structure and Support
Default Probability and Recovery Calibration
Credit Reserve Methodology
Risk Based Pricing Models
Risk Adjusted Return Analysis
Portfolio Value Measurement
Credit Risk Measurement
Credit Performance Scorecards
Internal Software
External Vendor Software
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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
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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 . 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
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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
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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
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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
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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
EL affects the income statement, whereas UL is captured in the balance sheet
‘ECONOMIC’ TO DISTINGUISH THE CONCEPT FROM REGULATORY OR ACCOUNTING (BOOK) CAPITAL
EL affects the income statement, whereas UL is captured in the balance sheet
‘ECONOMIC’ TO DISTINGUISH THE CONCEPT FROM REGULATORY OR ACCOUNTING (BOOK) CAPITAL
