### 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 one 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 analysis. 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 the analyst to conduct a comparative analysis of different banks. From these, the analyst can be able to rank institutions on the basis of the strength of their financial situation.

• Compute various statistical estimates such as the mean and variance, conduct hypothesis tests and also construct confidence intervals so as to arrive at reasonable 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 the 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 the 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, the 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 helps 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 for an analyst. However, it should not be ignored as within that labyrinth lies crucial information that can be pieced together to give a firm idea about the 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 important 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, the analyst should be on the lookout for the management's take on various items as outlined in financial statements. If the bank appears to be relatively illiquid, for example, the analyst should establish whether there's 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 as 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 the bank's accounts provided it with an unqualified opinion.

An unqualified opinion implies 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, but a clean report means that the financial presented reflect at least the minimum acceptable standards.

In most cases, the auditor's opinion is 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 why a qualified opinion may be issued are as follows:

1. There's substantial doubt as to the 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 the bank's business.

Although most auditor's opinions are unqualified and therefore do not provide any useful information about the bank, a qualified opinion is a red flag even if it is phrased in diplomatic language, and even if the bank can conveniently hide behind the leniency of some regulation. Upon coming across a qualified opinion, it is upon the 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 the analyst to find out if the change was valid. Sometimes companies dismiss auditors following a disagreement over one or more accounting treatments or unwillingness 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 the 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. 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). 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.

Of these, the balance sheet and the income statement are the most important when analyzing banks. But 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, as 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 the 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 weeks for its arrival. Annual reports, financial statements, news releases, and a great deal of background information on the bank is now easy to obtain from the web. Banks go to great lengths to improve the appearance, interactivity, and structure of their websites as these pass 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 subsequent event that may occur occurring after the corporate year-end, missing out on a place in the annual report. This includes issues such as 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 is 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:

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, and 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.

Following is a brief description of each of the 5 factors that make up the assessment process.

Capital adequacy assessment looks into a bank's capacity to absorb losses and meet all its obligations towards the customers without ceasing its operations. The capital adequacy raging of a bank is determined in part by the amount and quality of capital the 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 are therefore responsible for the 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 the 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 Questions

1) Which of the following statements is most accurate?

1. Given that bank bonds are often of greater interest, most of the available analysis on banks is produced by credit analysts.
2. Given that bank bonds are often of greater interest, most of the available analysis on banks is produced by equity analysts.
3. Given that bank stocks are often of greater interest, most of the available analysis on banks is produced by credit analysts.
4. Given that bank stocks are often of greater interest, most of the available analysis on banks is produced by equity analysts.