The Credit Analyst

After completing this reading, you should be able to:

• Describe the quantitative, qualitative, and research skills a banking credit analyst is expected to have.
• Assess the quality of various sources of information used by a credit analyst.
• Explain the CAMEL system used for evaluating the financial condition of a bank.

The Various Credit Analyst Roles

All credit analysts undertake work that involves some similarities in objectives. Everything revolves around risk management at the level of the individual firm or at the national level. However, the specific roles of analysts in each of these subfields may differ.

Desirable Skills of a Banking Credit Analyst

Quantitative Skills

Quantitative credit analysis helps the analyst to establish an entity’s ability to pay. It follows that quantitative skills are some of the most desirable characteristics of a credit analyst. A banking credit analyst must be able to:

• Read and interpret financial statements to perform a wide range of ratio analyses. In this regard, analysts usually concentrate on three types of ratios – liquidity, solvency, and profitability ratios.

A good example of profitability ratios is the return on equity which measures their ability to earn a return on their equity investments.

Ratio analysis is particularly important because it allows an analyst to conduct a comparative analysis of different banks. From these data, the analyst can rank institutions on the basis of the strength of their financial situations. precisely, the analyst can:

• Compute various statistical estimates such as the mean and variance, conduct hypothesis tests, and construct confidence intervals so as to arrive at reasonable and informative conclusions.
• Compute and interpret macroeconomic data, e.g., GDP growth rates. They must also understand concepts related to monetary policy which usually impact the banking industry.

Qualitative Skills

Qualitative skills involve making subjective judgments based on non-quantifiable information, such as management expertise, industry cycles, and the amount (and strength) of research and development. Qualitative analysis is used to gauge an obligor’s willingness to pay, which is a subjective attribute.

It is important for analysts to be able to think beyond numbers. This is particularly important when we consider that quantitative data has its own weaknesses (e.g., financial statements are highly summarized documents that may leave out certain information about an institution).

Qualitative skills help an analyst to:

• Understand the regulatory environment and the impact that new regulations could have on the operating environment.
• Conduct informative research on banking. For example, an analyst could conduct an extensive analysis of the major players in the sector and assess their impact on the industry in general.
• Interpret quantitative data (the ability to communicate highly technical terms and industrial jargon in a simple easy-to-understand language is highly desired).
• Establish a strong rapport with clients and business associates. A banking analyst, for example, will often rub shoulders with senior management and business “magnates”. Interpersonal skills help the analyst to exercise due diligence during such interactions that help them make important decisions.

Assessing the Quality of Various Sources of Information Used by a Credit Analyst

The items needed to perform a bank credit analysis will depend upon the nature of the assignment undertaken. In general, however, the following resources should be reviewed:

• The annual report, including the auditor’s report, the financial statements and supplementary information, as well as interim financial statements.
• Financial data services and news services
• Rating agencies, data from regulators, and other research sources.
• Notes from primary and field research.

Annual Report

The annual report is usually populated with a lot of corporate “propaganda” and glossy photos that may not be useful to an analyst. However, it should not be ignored because within that labyrinth lies crucial information that can be pieced together to give a firm idea about a firm’s culture, management’s competence, and vision, and business strategy.

The annual report is prepared primarily with shareholders in mind and institutions will often attempt to paint the image of a well-managed company with good performance. For this reason, it is essential to have an understanding of the management’s side of the story so as to develop a useful counterpoint that can help to critically analyze the institution.

While reading the annual report, an analyst should be on the lookout for the management’s take on various items as outlined in financial statements. If a bank appears to be relatively illiquid, for example, the analyst should establish whether there’s a mention of strategies put in place to deal with the situation.

The annual report may also contain information that would otherwise be difficult to find. Such pieces of information include the latest number of branches and employees, as well as important industry and economic data. The report may also outline the latest regulatory changes and the company’s compliance status.

Auditor’s Report

The auditor’s report usually appears just before the financial statements. It is important to establish whether or not the auditor of a bank’s accounts provided it with an unqualified opinion.

An unqualified opinion implies that the auditor’s judgment is that a company’s financial statements are fairly and appropriately presented, without any identified exceptions, and in compliance with generally accepted accounting principles (GAAP). In essence, a clean opinion indicates that the auditor does not disagree with the financial statements presented by management. It does not mean that the auditor would produce a similar set of statements if they had the opportunity to do so; they might have a different view or even feel obliged to disclose additional information. A clean report, however, means that the financial statements presented reflect at least the minimum acceptable standards.

In most cases, the auditor’s opinion is a boilerplate language designed to shield the auditor from possible legal liability. Sometimes the opinion may be long and winding, but what’s important is to watch out for any statement that is “of the ordinary.”

A typical unqualified report contains phrases more or less equivalent to those in Exhibit 1.

$$ \textbf{Exhibit 1 – The Auditor’s opinion: An unofficial Translation Guide} $$

$$ \begin{array}{l|l} \textbf{Boilerplate} & \textbf{What this means}\\ \hline \text{The auditors have audited special} & \text{“We are not to blame for anything that} \\ \text{financial statements of a certain date} & \text{occurred or became apparent after that } \\ \text{} & \text{date”} \\ \hline \text{Financial statements are the} & \text{“We can only base our opinion on data } \\ \text{responsibility of the management } & \text{provided by the company. If the data is } \\ \text{} & \text{inaccurate or fraudulent, blame company } \\ \text{} & \text{management, not us.”} \\ \hline \text{The Financial statements have been } & \text{“The financial disclosure provided meets } \\ \text{prepared in accordance with generally} & \text{minimally acceptable local accounting } \\ \text{accounting standards and are free from } & \text{standards or relevant regulations } \\ \text{material misstatement.} & \text{governing such disclosure. We have not } \\ \text{} & \text{detected any egregious errors or } \\ \text{} & \text{inaccuracies that are likely to have a } \\ \text{} & \text{major impact on any conclusion you may } \\ \text{} & \text{draw about the company for investment } \\ \text{} & \text{purposes.”} \\ \hline \text{The audit involved examining evidence} & \text{“We have not scrutinized every single } \\ \text{supporting the statements on a test basis, } & \text{item of financial data or even most of } \\ \text{which provide a reasonable basis for the } & \text{them. This would cost a small fortune and } \\ \text{auditor’s opinion} & \text{take an exceedingly long time. Instead, as } \\ \text{} & \text{is deemed customary and reasonable in } \\ \text{} & \text{our profession, we have tested some data } \\ \text{} & \text{for discrepancies that might indicate } \\ \text{} & \text{material error or fraud.”} \\ \hline \text{“In the opinion of the auditors, the } & \text{“The financial statements might not be } \\ \text{financial statements present that financial } & \text{perfect, but they present a reasonable } \\ \text{position fairly in all material respects as } & \text{picture of the company’s financial } \\ \text{of the date of the audit.”} & \text{condition, subject to the present standards } \\ \text{} & \text{set forth in law and generally followed in } \\ \text{} & \text{the industry, notwithstanding that higher } \\ \text{} & \text{standards might better serve investors.”} \\ \end{array} $$

If a qualified opinion is issued, analysts should proceed with caution. A qualified opinion means that in the auditors’ professional judgment, the financial statements might not fairly represent the company’s financial performance and condition. In fact, the auditors will often go as far as specifying the areas they do not approve of using words such as “except” in the final paragraph of the report. Some of the reasons a qualified opinion may be issued are as follows:

1. There’s substantial doubt as to a bank’s ability to continue as a going concern.
2. A specific accounting treatment used by management is inconsistent with accounting rules.
3. There are significant amounts of related-party transactions.
4. There exists an unusual condition or event that may have a material impact on a bank’s business.

Although most auditor’s opinions are unqualified and, therefore, do not provide any useful information about a bank, a qualified opinion is a red flag. This is the case even if it is phrased in diplomatic language, and even if a bank can conveniently hide behind the leniency of some regulation. Upon coming across a qualified opinion, it is upon an analyst to investigate and determine the exact nature of the qualification, how severe the problem is, and the impact on the analyst’s overall assessment.

Although extremely rare, auditors may also issue an adverse opinion, indicating that a company’s financial statements are misrepresented, misstated, and do not accurately reflect its financial performance and health. This is the gravest qualification and will justifiably give rise to concern on the part of the analyst.

Analysts should also be on the lookout for a change in auditors. It is up to an analyst to find out if the change was valid. Sometimes, companies dismiss auditors following a disagreement over one or more accounting treatments or refusal to “okay” financial statements by issuing an unqualified opinion.

Financial Statements: Annual and Interim

There are three primary financial statements:

• The balance sheet.
• The income statement.
• The statement of cash flows.

The balance sheet is a statement of assets, liabilities, and capital of a business at a particular point in time. It details the balance of income and expenditure over the preceding period.

$$ \textbf{Figure 1 – Balance Sheet Example} $$

$$ \textbf{NIKE Inc. Consolidated Balance Sheet} $$

$$\begin{array}{l|rr}\textbf{} & \underline{\textbf{May 31,}} &  \\ \textbf{(In millions)} & \textbf{2018} & \textbf{2017} \\ \hline \textbf{ASSETS} &  &  \\ \text{Current assets:} &  &  \\ \text{Cash and equivalents} & \$ 4,229 & 3,808 \\ \text{Short-term Investments} & 996 & 2,371 \\ \text{Accounts receivable, net} & 3,498 & 3,677 \\ \text{Inventories} & 5,261 & 5,055 \\ \text{Prepaid expenses and other current assets} & 1,130 & 1,150 \\ \hline \textbf{Total current assets} & 15,143 & 16,061 \\  \hline \text{Property, plant and equipment, net} & 4,454 & 3,989 \\ \text{Identifiable intangible assets, net} & 285 & 283 \\ \text{Goodwill} & 154 & 139 \\ \text{Deferred income taxes and other assets} & 2,509 & 2,787 \\ \hline \textbf{TOTAL ASSETS} & \$ 22,536 & \$ 23,259 \\ \hline \textbf{LIABILITIES AND SHAREHOLDERS’ EQUITY} &  &  \\ \text{Current liabilities} &  &  \\ \text{Current portion of long-term debt} & \$ 6 & \$ 6 \\ \text{Notes payable} & 336 & 325 \\ \text{Accounts payable} & 2,509 & 2,048 \\ \text{Accrued liabilities} & 3,269 & 3,011 \\ \text{Income taxes payable} & 150 & 84 \\ \textbf{Total current liabilities} & 6,040 & 5,474 \\ \text{Long-term debt} & 3,468 & 3,471 \\ \text{Deferred income taxes and other liabilities} & 3,216 & 1,907 \\ \text{Commitment and other contigencies(Note 15)} &  &  \\ \text{Redeemable preferred stock} & – & – \\ \text{Shareholders’ equity} &  &  \\\text{Common stock at stated value} &  &  \\\text{Class A convertible-329 and 329 shares outstanding} & – & – \\ \text{Class B-1,272 and 1,314 shares outstanding} & 3 & 3 \\ \text{Capital in excess of stated value} & 6,384 & 5,710 \\ \text{Accumulated other comprehensive loss} & (92) & (213) \\ \text{Retained earnings} & 3,517 & 6,907 \\ \text{Total shareholders’ equity} & 9812 & 12,407 \\ \hline \textbf{TOTAL LIABILITIES AND SHAREHOLDER’S EQUITY} & \$  22,536 & \$ 23,259 \\ \hline \end{array}$$

The income statement, also known as profit and loss statement, outlines a company’s revenues and expenses during a particular period (e.g., net income).

$$ \textbf{Figure 2 – Income Statement Example} $$

$$ \textbf{NIKE Inc. Consolidated Statement of Income} $$
$$\begin{array}{l|rrr}
& \underline{\textbf{Year Ended May 31,}} & & \\
\text{(In million except per share data)} & \textbf{2018} & \textbf{2017} & \textbf{2016} \\ \hline
\text{Revenues} & \$ 36,397 & \$ 34,360 & \$ 32,376 \\
\text{Cost of sales} & 20,441 & 19,038 & 17,405 \\ \hline
\text{Gross profit} & 15,956 & 15,312 & 14,971 \\
\text{Demand creation expenses} & 3,577 & 3,341 & 3,278 \\
\text{Operating overhead expenses} & 7,934 & 7,222 & 7,191 \\ \hline
\text{Total selling and administrative expenses} & 11,511 & 10,563 & 10,469 \\
\text{Interest expenses(income), net} & 54 & 59 & 19 \\
\text{Other expenses(income), net} & 66 & (196) & (140) \\ \hline
\text{Income before income taxes} & 4,325 & 4,886 & 4,623 \\
\text{Income tax expenses} & 2,392 & 646 & 863 \\ \hline
\textbf{NET INCOME} & \$ 1,933 & \$4,240 & \$3,760 \\ \hline
& & & \\
\text{Earnings per common share} & & & \\
\text{Basic} & \$ 1.19 & \$ 2.56 & \$2.21 \\
\text{Diluted} & \$ 1.17 & \$ 2.51 & \$2.16 \\
& & & \\
\text{Dividend declared per common share} & \$ 0.78 & \$ 0.70 & \$ 0.62\\ \hline
\end{array}$$

The statement of cash flows, on the other hand, shows how changes in balance sheet accounts and income affect cash and cash equivalents. It goes further to show the cash flows attributable to operating, investing, and financing activities.

$$ \textbf{Figure 3 – Cash Flow Statement Example} $$

$$ \textbf{NIKE Inc. Consolidated Statements of Cashflows} $$

$$\small{\begin{array}{l|rrr}
& \underline{\textbf{Year Ended May 31,}} & & \\
\text{(In millions)} & \textbf{2018} & \textbf{2017}  & \textbf{2016} \\ \hline
\textbf{Cash provided by operations:} & & & \\
\text{Net income} & 1,933 & 4,240 & 3,760 \\
\text{Adjustments to reconcile to net cash} & & & \\ \text{ provided by operations:} & & & \\
\text{Depreciation} & 747 & 706 & 649 \\
\text{Deferred income taxes} & 647 & (273) & (80) \\
\text{Stock-based compensation} & 218 & 215 & 236 \\
\text{Amortization and other} & 27 & 10 & 13 \\
\text{Net foreign currency adjustments} & (99) & (117) & 98 \\
\text{Changes in certain working capital components} & & & \\ \text{and other assets and liabilities:} & & & \\
\text{Decrease(increase) in accounts receivable} & 187 & (420) & 60 \\
\text{Increase in inventories} & (256) & (231) & (590) \\
\text{Decrease (increase) in prepaid expenses and } & &  & \\ \text{other current and non-current assets} & 35 & (120) & (161) \\
\text{Increase(decrease) in accounts payable, accrued} & & & \\ \text{liabilities and other current and non-current liabilities.} & 1,515 & (158) & \\ \hline
\text{Cash provided by operators} & 4,965 & 3,846 & 3,399 \\
\textbf{Cash provided(used) by investing activities:} & & & \\
\text{Purchases of short-term investments} & (4,783) & (5,928) & (5,367) \\
\text{Maturities of short-term investments} & 3,613 & 3,623 & 2,924 \\
\text{Sales of short-term investments} & 2,496 & 2,423 & 2,386 \\
\text{Investment in reverse repurchase agreement} & – & – & – \\
\text{Additions to property, plant and equipment} & (1,028) & (1,106) & (1,143) \\
\text{Disposal of property, plant and equipment} & 3 & 13 & 10 \\
\text{Other investing activities} & (25) & (34) & 6 \\ \hline
\text{Cash provided(used) by investing activities} & 276 & (1,008) & (1,034) \\
\textbf{Cash used by financing activities} & & & \\
\text{Net proceeds from long-term debt activities} & – & 1,482 & 981 \\
\text{Long-term debt payments, including current portion} & (6) & (44) & (106) \\
\text{Increase(decrease) in notes payable} & 13 & 327 & (67) \\
\text{Payments on capital lease and other financing obligations} & (23) & (17) & (7) \\
\text{Proceeds from exercise of stock options} & & &  \\ \text{and other stock issuances} & 733 & 489 & 507 \\
\text{Repurchase of common stock} & (4,254) & (3,223) & (3,238) \\
\text{Dividends-common and preferred} & (1,243) & (1,133) & (1,022) \\
\text{Tax payments for net share settlement of equity awards} & (55) & (29) & (22) \\ \hline
\text{Cash used by financing activities} & (4,836) & (2,148 & (2,974) \\
\text{Effect of exchange rate changes on cash and equivalents} & 45 & (20) & (105) \\ \hline
\text{Net increase(decrease) in cash and equivalents} & 441 & 670 & (714) \\
\text{Cash and equivalent beginning of year} & 3,808 & 3,138 & 3,852 \\ \hline
\textbf{CASH AND EQUIVALENT, END OF YEAR} & \$ 4,249 & \$ 3,808 & \$ 3,138 \\ \hline
\textbf{Supplemental disclosure of cash flow information} & & & \\
\text{Cash paid during the year for:} & & & \\
\text{Interest, net of capitalized interest} & 125 & 98 & 70 \\
\text{Income taxes} & 529 & 700 & 748 \\
\text{Non-cash additions to property, plant and equipment} & 294 & 266 & 252 \\
\text{Dividends declared and not paid} & 320 & 300 & 271\\ \hline
\end{array}}$$

Of these, the balance sheet and the income statement are the most important when analyzing banks. However, when analyzing nonfinancial companies, the statement of cash flows is considered the most important.

In addition to the three primary financial statements, a fourth financial statement, the statement of changes in capital funds, is considered a useful tool when analyzing both financial and nonfinancial companies. It is particularly helpful in bank credit analysis since it shows changes in the capital levels reported by the institution.

Interim financial statements cover a period of less than one year and present a more timely tool used by analysts in making a current assessment of an institution. Interim financial statements contain the same information as will be found in annual financial statements.

The Bank Website

The internet has simplified credit analysis for analysts. Gone are the days when analysts would be forced to make a request for a bank’s annual report and wait for weeks for its arrival. Annual reports, financial statements, news releases, and a great deal of background information on the bank are now easy to obtain from the web. Banks go to great lengths to improve the appearance, interactivity, and structure of their websites since this passes a “silent message” about the bank and its online strategy. In addition, many banks often post webcasts as they discuss results with analysts, together with the accompanying presentation.

News, the Internet, Securities Pricing Data

Analysts should remain alert to any significant event that may occur post-corporate year-end and obviously miss out on the annual report. Such events may include mergers, acquisitions, layoffs, and corporate restructuring. The internet, other digital media as well as and print media are important sources of such information.

There are also proprietary electronic data services that provide real-time data on current bond and equity prices (especially for public listings or debt offerings). A good example would be Bloomberg.

Prospectuses and Regulatory Filings

Prospectuses and offering circulars are published to enable prospective investors to better evaluate the potential investment. In most jurisdictions, their content and format are restricted by regulation to minimize the risk of issuers painting an overly positive financial situation of the company in an attempt to win investors over. Information is presented in a highly conservative manner to highlight possible risks.

Rating Agency Reports and Other Third-party Research

Rating agency reports are very useful for counterparty credit analysts. Other third-party research includes investment reports from regulatory agencies and renowned equity analysts. Thomson Reuters provides reports at a fee.

The CAMEL System

CAMEL is an international rating system developed by U.S. bank supervisors in the 70s. It is used by regulatory banking authorities and counterparty analysts to rate financial institutions, according to the five factors represented by its acronym. The five factors are:

C for Capital Adequacy.

A for Asset Quality.

M for Management.

E for Earnings.

L for Liquidity.

Analysts give financial institutions a rating with respect to each of these five factors. A rating of one is considered the best while a rating of five is considered the worst for each factor. More generally, financial institutions with an average score of less than two are considered to be high-quality institutions. Those with scores greater than three are considered to be less-than-satisfactory and draw regulatory scrutiny.

All but the assessment of the quality of management are amenable to ratio analysis. However, liquidity assessment is one of the so-called murky waters of the assessment process. Assessing the quality of management usually involves the use of qualitative techniques.

Below are brief descriptions of the 5 factors that make up the assessment process.

Capital Adequacy

Capital adequacy assessment looks into a bank’s capacity to absorb losses and meet all its obligations towards customers without ceasing its operations. The capital adequacy raging of a bank is determined, in part, by the amount and quality of capital a bank can access. Other elements considered include compliance with interest and dividend rules, growth plans, economic environment, and investment concentrations.

Asset Quality

Asset quality assessment looks into the quality of a bank’s loans, which reflects the earnings of the institution. It involves identifying investment risk factors that the bank may face and comparing them with the bank’s capital earnings. Also scrutinized is the ratio of Gross Non-Performing Loans to Gross Advances which gives an idea about the effectiveness of the bank’s credit decisions.

Management Quality

This involves a critical look at a bank’s board of directors and top-level managers. These are the key persons who make most decisions and are therefore responsible for a bank’s performance. Some of the aspects scrutinized include: how well the management responds to changing market conditions, how well duties and responsibilities are delegated, and how well compensation policies are designed.

Earnings

Here, analysts assess a bank’s ability to generate returns needed for expansion and attainment of required capital levels. Among the items assessed include the bank’s growth, stability, net interest margin, and net worth level.

Liquidity

This is an assessment of a bank’s ability to convert assets into cash. A key determinant of liquidity is the ratio of cash maintained by banks and balances with the central bank to total assets. Also assessed is a bank’s dependence on short-term volatile financial resources.

Practice Question

Alexis, a risk manager at a regulatory authority, is evaluating Stellar Bank’s recent financial reports using the CAMEL system. Stellar Bank’s capital ratios are above the required minimums, but there are concerns about the quality of some of its loan assets. The bank’s management has made some questionable investment decisions in the past year, which had an adverse effect on its earnings. However, the bank has been able to maintain a stable and satisfactory liquidity position.

Alexis discusses the CAMEL analysis with her team. One of her team members, Benjamin, argues that the bank’s strong capital adequacy and liquidity position should offset concerns about its management and asset quality.

Based on the principles of the CAMEL system, which of the following best represents Alexis’s potential response to Benjamin’s argument?

A. Each component of CAMEL is evaluated independently, so strong performance in one area doesn’t offset weaknesses in another.

B. While capital adequacy and liquidity are important, the management decisions directly affect future capital and liquidity positions, making it a higher priority.

C. Liquidity and capital adequacy are the two primary factors in the CAMEL system, so other factors can be given lesser weight.

D. Asset quality and earnings are derivates of management decisions, so they can be combined into a single factor for ease of analysis.

Solution

The correct answer is A.

The CAMEL system evaluates each of the five components—capital adequacy, asset quality, management, earnings, and liquidity—independently. While each component provides insight into the overall health and stability of a bank, strong performance in one area does not necessarily compensate for weaknesses in another.

B is incorrect. While it’s true that management decisions can influence future capital and liquidity positions, the CAMEL system doesn’t necessarily prioritize one component over another. All components are important and are evaluated on their own merits.

C is incorrect. The CAMEL system does not prioritize liquidity and capital adequacy over the other components. Each factor in the CAMEL system is important in its own right for assessing the overall health and risk profile of a bank.

D is incorrect. The CAMEL system assesses asset quality, earnings, and management separately. Although management decisions can impact asset quality and earnings, these components are not combined into a single factor for analysis within the CAMEL framework. Each component provides distinct insights into the bank’s financial condition and operations.

Things to Remember

• The CAMEL system provides a comprehensive framework to assess banks’ overall health, stability, and risk profile.
• Each of the five CAMEL components—Capital Adequacy, Asset Quality, Management, Earnings, and Liquidity—provides a unique lens to view different facets of a bank’s operations.
• While each component has its significance, they’re not meant to offset each other. A deficiency in one area can’t be “compensated” by strength in another.
• The system is designed to pinpoint vulnerabilities in banks. Therefore, even if a bank is doing well in some areas, weaknesses in others can’t be overlooked.
• Regulatory authorities use the CAMEL system, among other tools, to ensure that banks maintain sound practices and don’t pose systemic risks to the financial system.