Definition of Credit

The expectation that advanced funds will be repaid in full and in honor of the conditions agreed upon by the lending party and the borrower of funds, upon which a lender is willing to act, is the most basic definition of credit.

Creditworthy or Not

On a commercial basis, unless a borrower exhibits willingness and ability to repay monies advanced to them, a person who has money in the form of savings or capital to spare will lack willingness to provide credit.

These two factors, willingness, and ability, are a call for judgment of possibility. Practically, all factors remaining constant, the higher the probability that a borrower will be able and willing to repay the advancement as per an agreement, the lower the risk of encountering a loss by the creditor and vice versa.

Credit Risk

Since competitors might be willing to offer sells on credit terms, vendors and other nonfinancial enterprises may be compelled to offer the same terms despite the fact that they can completely avoid the credit risk by applying only cash and carry transactions. This, therefore, leads to a risk as a result of trade credit from a transition zone between settlement risk and the creation of a financial obligation that is more fundamental.

Crucial financial obligations will occur if explicit terms of financing are offered by traders to prospective buyers, which is a different scenario when dealing with trade credit or risk settlement coming about when consummating a sell.

However, banks and other financial institutions cannot avoid the credit risk as opposed to nonfinancial terms. One of the most important reasons for the existence of banks is being able and willing to advance credit in form cash and a consecutive making of financial obligations. It is through effective selection and management of those credit risks that banks can be successful hence their need for credit analysis.

Credit Analysis

The following conditions facilitate the risk of losing money and are, therefore, a good definition of credit risk:

1. Financial obligation default by the counterparty;
2. Increased probability of condition I;
3. At the time of default, an exposure that is higher than expected or a lower than expected recovery resulting in a loss of severity that is higher than expected; and
4. Counterparty default on payment of already advanced funds for goods or services.

Relative credit risk is impacted directly by the following variables:

1. How willing an obligor meets its obligations;
2. An external environment which includes factor like operating conditions, the climate of the business, risk in the country, etc;
3. The instrument of credit that is relevant and its behaviors;
4. The standard of any credit risk mitigants and its sufficiency; and
5. The time interval for the existence of exposure.

Components of Credit Risk

Solutions to the following concerns can be determined by the process of evaluating and analyzing credit risk:

Obligor’s capacity and willingness to repay

1. The obligor’s capacity to honor its financial obligations;
2. The probability of the obligation to be fulfilled through maturity;
3. Credit risk features associated with a particular obligor with the niche of its business; and
4. The correlation and policy obligations of an obligor upon its credit profile.

External conditions

1. The effect of credit risk impingement exposed on the obligee by country risk and operation conditions like systemic risk; and
2. The impact of cyclical and secular changes to the risk level and the credit features of that risk level.

Obligation attributes from which credit risk arises

1. An obligation’s inherent risk features;
2. The product’s tenor or maturity;
3. Security of the obligation;
4. The creditor-assigned priorities;
5. Ways each party benefits from particular agreements hence reducing or increasing the creditor’s credit risk exposure
6. The dominant currency in the obligation; and
7. The existence of associated contingent or derivative risk subjected to either party.

Credit risk mitigants

1. Whether credit risk mitigants in existing obligations or transaction that is contemplated are utilized;
2. The credit risk of a secondary obligor if any; and
3. Instances of credit risk strength evaluation being undertaken.

Credit Risk Mitigation

As opposed to focusing only on the likelihood of default, credit risk mitigation also focuses on the degree of uncertainty forecasting the likelihood is related to. For credit risk to be mitigated, securities in the form of guarantees or collaterals are demanded by lenders due to the aforementioned uncertainties.

Collateral-Assets Functioning to Secure a Loan

Collaterals are assets a lender take pending full settlement of advanced monies. In the event that a borrower is unable to honor the obligation and the lender has complied with legal requirements, he then becomes the secured creditor. Hence, the lender has specific legal rights to seize the collateral to offset the obligation not honored.

Collaterals, classified as credit risk mitigants, provide security to the lender, hence compelling the obligor to honor his/her obligation.

Guarantees

In the event of default by the primary obligor, a third party can take liability for debts by another party. This credit risk mitigation strategy is referred to as the guarantee.

Compared to the primary obligor, the guarantor should be more creditworthy and have easily analyzed creditworthiness. With the provision of a guarantor, the questions asked to the obligor must again be asked to the guarantor.

Significance of Credit Risk Mitigants

In credit allocation, banks and other financial institutions stress the importance of credit risk mitigants and other mechanisms that are comparable. Therefore, the best method in finance providing is secured lending.

As opposed to countries with poor financial disclosures leading to difficulties in credit risk evaluation, developed markets are more complicated in approaching secured lending hence becoming more popular.

Willingness to Pay

Based on the reputation of the obligor, willingness can be said to be subjective. This, therefore, calls for the need for a qualitative evaluation by the oblige using data from various sources or even face to face meeting for due diligence. To maintain an unbroken link with the past, modern-day credit analysis must account for willingness to pay.

Indicators of Willingness

This is an attribute that can prove difficult to investigate despite being very real therefore making its judgment to be highly subjective.

Character and Reputation

First-hand information about an obligor’s character is a good first point a credit decision can be based on. In case there is none, another alternative is relying on the obligor’s reputation to ascertain his/her disposition to honor an obligation. This can lead to name lending which involves lending based on the perceived status of individuals rather than facts and data.

Credit Record

Using a borrower’s verifiable record to ascertain his/her willingness to honor an obligation is a comfortable way for creditors to get a guarantee of willingness to pay. Future continuity can be suggested by a track record of borrowing and paying behaviors in comparison to a borrower who remains mysterious. However, this fact cannot be certainly extrapolated to the future.

Creditor’s Rights and the Legal System

Compared to willingness, ability to pay has always been ranked as a more crucial point since, without ability, willingness is not applicable. A legal framework that is effective overcomes the situation of ability while willingness is lacking. Stronger and effective justice frameworks give a creditor confidence while enforcing a judgment against obligors.

With great efficiency and understanding of commercial requirements, creditor-friendly justice framework enables creditors to lend comfortably without worrying about borrowers who can pay but will not pay.

However, with weak legal frameworks, willingness to pay will still remain a critical determinant. In this scenario, when analyzing the credit risk, we have to put into consideration how efficient the legal system is when protecting creditors’ rights.

Through professional surveys, credit analysts can determine a country’s comparative legal risk which is important while making investment decisions. The limitation of the legal system is that cost-wise and time-wise is not affordable compared to the pursued benefits.

Evaluating the Capacity to Repay

Generally, this is more of a quantitative measure strategy. This analysis seeks to establish whether the obligor is able to honor an obligation. Numerical data from recent statements are evaluated to establish the capacity of a party to fulfill his/her part of the agreement.

Limitations of Quantitative Methods

The following are limitations of quantitative methods:

1. Financial data’s historical behavior;
2. Making accurate projections from such data is not easy; and
3. The gap between financial reporting and financial reality.

Historical Character of Financial Data

Since financial statements cover fiscal reporting periods that are past, they are invariably historical and never up to date. This, therefore, implies that the results are merely estimates as extrapolating the past into the future is impossible.

Vulnerability to errors and distortion is yet another issue as exact forecasting is almost impossible no matter how recent the reports are. Over time, these small errors and distortion can put a lot at risk.

Financial Reporting Is Not Financial Reality

An attempt to map underlying economic realities into a report that is condensed is totally imperfect and therefore posing serious limitations since some degree of deformation is unavoidable as some data might be omitted as others are selected.

A difference in perspective and interests is the driving factor of institutions to set rules of financial accounting and reporting. Hence, this implies that the rules may be subject to politics.

To determine the treating accorded to various accounting items, a great deal of discretion is given to companies. This, therefore, poses difficulty when rules to cover situations are made.

Varying conclusions drawn from the same data due to different experiences, vantage points and analytical skill levels can be very confusing and also pose another serious limitation.

Therefore, financial analysis by quantitative methods should not be completely relied upon as a means of credit risk assessment.

Quantitative and Qualitative Elements

Almost all aspects of credit analysis that are nominally quantitative have some elements of qualitative measure and, therefore, credit analysis has both qualitative and quantitative nature.

The implication is that as much as credit analysis is science, it is also an art and application can rely on both judgment and the mathematics.

Credit Analysis versus Credit Risk Modeling

There are clear distinctions between credit risk analysis, credit risk modeling and credit risk management. When analyzing counterparty credit, the process is different from managing or modeling credit risk for banks or enterprise level.

Categories of Credit analysis

According to the type of borrower, credit analysis can be categorized into 4 areas: consumers, government and government-related entities, financial and non-financial (corporate) companies. In light of this, the four credit analysis areas are:

1. Evaluating the creditworthiness of an individual consumer is called consumer credit analysis;
2. Nonfinancial companies are evaluated through corporate credit analysis;
3. Evaluation of banks and other financial institutions is called financial institution credit analysis; and
4. iv. Nations, subnational governments, and public authorities have credit risk associated with them. This evaluated through sovereign/municipal credit analysis.

We begin by looking at how to evaluate an individual’s ability to repay their debts.

Individual Credit Analysis

The most basic measure of an individual’s ability to honor his obligations is by assessing their net worth. Another attribute of ability is amounts of cash inflows either from returns on investment or salaries receivable.

Just as an individual’s household expenditures are fairly regular so are cash flows represented by an individual’s salary. Therefore, most consumers will default due to loss of income by unemployment, increased expenses, and some other reasons.

The use of statistical tools when correlating risk to a limited number of variables when analyzing an individual’s credit risk is fairly and naturally simple.

Evaluation of Nonfinancial Companies’ Financial Conditions

When evaluating a firm’s ability to honor its financial obligations, we use the same formalities as the one in individual credit analysis. However, the financial structure of firms is complex as compared to that of individuals with hinge variations experienced in their assets behavior, income stream regularity and rate of their demands for cash.

Finally, nonfinancial companies tend to have detailed credit analysis as a result of high fund amounts at stake for companies.

When evaluating credit exposure, credit analyst will use the following criteria reflected in the report that will be generated from the conclusions: liquidity of the company, cash flows, profitability and near-term earnings and finally solvency or capital position.

Evaluation of financial Companies

Banks and other financial institutions apply credit analysis elements that are similar to those applied to nonfinancial enterprises. Crucial factors in evaluating their creditworthiness include management quality, economic state, and the environment of the industry.

A credit analyst will focus on the following areas during the process of evaluating a bank: the capacity of earnings, liquidity, adequacy of capital and asset quality.

There are differences between key criteria applied to corporate credit analysis and the ones in the nonfinancial and financial companies, which are: asset quality importance and cash flow omission as a key indicator.

A Quantitative Measurement of Credit Risk

The likelihood of a borrower defaulting on its obligation to the obligee implies the creditor will incur a loss. Therefore, credit and default risks are synonymous. Market participants have been compelled to revisit this strategy by the financial industry’s developments and regulatory changes.

Probability of Default (PD)

Lenders can be made whole and little harm suffered when matters are rectified promptly by an obligor who make good on late payments by paying accrued interest and penalties.

Consequent liquidity problems that are severe can be suffered by lenders due to brief nonpayment should they be relying upon payment in order to honor a financial agreement. The tangible harm would be otherwise negligible.

Loss Given Default (LGD)

On top of the possibility of a default, lenders get worried about the severe effects of defaults likely to be incurred. One concern is whether it was brief which immediately was corrected for the obligee to get all expected benefits of the transaction.

Another concern is on the default type whereby payment ceases and the creditor losses all revenue from the transaction. All factors remaining constant, the explanation to this concern worries the creditor greatly. The probable percentage effect under creditor’s default exposure is encapsulated in the loss given default.

Exposure at Default(EAD)

EAD can be presented as a percentage of a loan’s nominal amount or terms that are absolute. This variable should always be considered at default.

Expected Loss

For a given time horizon, the product of variables PD, LGD, and EAD determines the expected loss. All the three variables are easily examined hence the examination of an entire portfolio is easy and possible. Although past experience may provide guiding, the estimation of EL and its constituents for future events may not be easy.

The Time Horizon

Longer tenors imply increased chances of defaulting. For EAD, increases are experienced when loans are fully drawn and reducing when loans are repaid. In a similar manner, LGD is time changing based on the specific loan terms.

Application of the Concept

For comparison purposes, assuming the period of time to be 12 months, the expected loss is affected by four variables with a fifth variable which is the correlation between credit exposure within a credit portfolio affecting expected loss.

Reasons for Credit Evaluation

1. An analyst can be able to rate the risks hence ease in pricing the risk and bank capital allocation;
2. Despite reduced risk of defaulting, a likelihood of occurrence worries those with credit exposure;
3. Events short of default can harm counterparties and investors in addition to outright failure; and
4. Systemic contagion risk is greatly increased by globalization hence the risk on a bank is twice as remote.

Default as a Benchmark

Placing the reviewed bank in the continuum of risk and accounting for where the subject institution will stand in terms of financial strength are the roles of an analyst.

A spectrum of expected loss probability and sensible definition of credit risk can be created by the potential for failure thus causing the ratings to facilitate a bank debt’s external pricing and internal allocation of bank capital.

Pricing of Bank Debt

The connections between risks and rewards in determining the value of an investment is facilitated by the examination of credit risks of banks that are distilled into an external rating. A rating yield curve depicts the connection between credit risk and the return required by investors to compensate for increased risk levels.

Allocation of Bank Capital

A counterparty credit risk analyst can apply the same approaches for the institutions to allocate its risk and its capital in a prudent manner while still complying with regulatory requirements.

With respect to the advance of funds, exposure to derivatives and settlement, exposure limits setting is facilitated by the analysis of banks for the purposes of internal risk management.

Events Short of Default

In defining a default risk spectrum, risk default is conceptually crucial. A technical default is likely to have consequences that are very critical. The means by which to avoid fragile banks are provided by the credit analysis of banks, despite the probability of a bank failure.

Banks are Different

Since their assessments are highly qualitative, banks are considered to be very different. Among the most tightly regulated industries globally is the banking sector. Therefore, the scope, character, and effectiveness of the technique of regulation affect the performance of these financial institutions.

The actions and health of banks have important impacts on the economy hence the need for stricter regulations. For most societies that are market-driven, failure of banks is very concerning and sets economic bells ringing as their survival depends solely on the depositor confidence.

Governments will, therefore, try to avoid to irate depositors.

Practice Questions

1) According to the type of borrower, credit analysis can be categorized into which of the following four areas?

1. Character, reputation, credit record, creditor’s right and legal system
2. Consumers, government and government-related entities, financial companies and non-financial companies.
3. Character, capacity, capital, and collateral
4. Probability of default, loss given default, exposure at default, expected loss.

The correct answer is B.

According to the type of borrower, credit analysis can be categorized into 4 areas: consumers, government and government-related entities, financial and non-financial (corporate) companies.

Option C is the 4’Cs of Credit, which is to know the creditworthiness of a business/individual.