Credit Risk Management (Essential Capital Markets)

Book Preface

This book on credit risk management aims to provide the reader with an introduction of the role and mechanics of credit analysis within the lending function of a commercial bank.

In recent years, many banks have, for sake of economy, pared down the credit analyst function and rely increasingly on using outside sources of information such as broker’s reports and credit rating agency reports to rationalize their credit decisions.

It nevertheless remains important for bankers to learn about and understand the framework of credit analysis within the framework of credit risk management. Aside from the arguments of due diligence, which means that every bank ultimately is responsible for the safekeeping of depositors’ funds and accordingly effecting its own credit analysis, is the issue of comprehension. That is to say, for those banks deciding not to invest in the analytical function and rely on outside sources of analysis, it nevertheless remains important for the reader to not only understand the analyst’s arguments but how those arguments have been reached at in the first place.

This book aims to provide the reader with a structural road map of the analytical process and tie it in to the formation of an effective credit risk management policy within the organization.

This book is therefore organized in a classic sequence, that of an analyst undertaking a financial analysis of an entity and taking it through the credit chain for approval and subsequent monitoring and management. The book is presented in eight main chapters:
– Introduction to corporate credit: This first chapter aims to introduce the novice to setting the groundwork in the credit analysis, approval, and management process, and mainly focuses on non-financial criteria. It basically situates the role of credit management in the role of bank credit policy and orients the student to the information gathering and sifting process necessary to enable the formulation of pertinent and intelligent credit proposals enabling informed credit decisions to be made.
– Business risks: This second chapter treats the matter of non-financial risks (vs. financial risks) and describes the importance of the ‘new investment criteria’ of the ‘dot com’ economy, as well as traditional elements of non-financial risks such as the nature of the obligor (limited vs. unlimited liability), management, industry, market, and products. Models such as SWOT, PEST, and Porter’s Five Forces which are used to assess competitor positions, business strategy and plans, as well as legal and documentation risks. The role of auditors is also treated.
– Financial risks: Financial statement analysis (financial statements, annual reports and accounts, balance sheets, profit and loss statements). This chapter takes a more quantitative approach in focusing on the financial analysis of a borrower. A full discourse on the composition, meaning, and analysis of financial statements and company accounts is featured. This comprises the obtaining, processing, and analysis of company annual reports and accounts and some allusion to financial ratio analysis is made. An orientation on PC based spreadsheet methods and processing of a company’s financial ratios in the light of peer group and industry sector averages will be treated. This ratio analysis is useful in taking a photo at a given moment in time and assessing a borrower’s relative positioning in his industry sector and economic environment.
– Transaction risks – term loan agreements and covenants: Loan documentation, financial ratio covenants, and security arrangements are necessary tools in managing credit risk. This chapter will explore how to enhance security from a legal perspective as well as a financial aspect (e.g. by incorporating appropriate financial covenants into the loan agreement based on the materials covered in the previous two chapters: ratios and cash flow forecasting).
– Setting CRM in place via risk rating systems: All of the information in the preceding sections must not only be analysed but developed into a coherent set of guidelines if the bank is to proactively manage its portfolio exposure via any meaningful credit policy. Credit risk management therefore is not only about the information gathering and analytical process, it is using that information to set in place effective policy guidelines that are the bank’s constant tool to ensure portfolio quality.
– Annexes: We provide annexes on information such as the SSAP and FRS reporting standards currently in use in the UK.
– Glossary
– Suggested readings

We trust that this book goes some way in enabling the practitioner to review already known information and consider new concepts and technologies within a framework that can be of use in effective credit risk management.