6/13/2012

Study Unit Objectives CREDIT RISK MANAGEMENT IN BANKING

STUDY UNIT 3 CREDIT RISK MANAGEMENT IN BANKING SUNJAY LUTCHMAN

After completing this unit you should have knowledge of the following:
What is credit risk What is market risk The 5cs of credit management Mastering the cash conversion cycle

The Risk Pyramid

Credit Risk
Definition: Risk of default on given loans
Credit risk management: - Credit scoring models - For consumer and small business credit - Applicant scoring model - Behavioral scoring model - For commercial and corporate clients - Risk limits - Credit derivative contracts - Loan sales

Market Risk
Definition: Loss due to environmental changes Types of market risk: Equity risk Foreign exchange rate and commodity price risk Interest rate risk Debt specific risk Credit spread risk Market risk management: VaR Sensitivity analyses Stress testing

Liquidity Risk
Definition: Not to be able to meet financial commitments as they fall due Liquidity risk management Structural liquidity risk management Tactical liquidity management Contingent liquidity risk management Funding strategy Credit ratings

6/13/2012

Operational Risk
Definition: Relates directly or indirectly to inadequate or failed processes, technology, and human performance or from external events Operational risk management framework: Risk and Control Self-Assessment (RCSA) Loss Event Database (LED) Key Risk Indicators (KRIs)

The Risk Pyramid

Managing the Credit Policy

Should we extend credit?

Should We Extend Credit?

Follow industry practice? Industry norms? Extent and form of credit offered
Type of market to be serviced (consumer vs business market) Credit product offerings Credit cards Debit cards Loans (secured / unsecured) Mortgages

How do we make a credit granting decision?

What are the credit policy components?

Components of Credit Policy

Development of credit standards
profile of minimally acceptable credit worthy customer

Components of Credit Policy

Credit limit
maximum dollar level of credit balances

Collection procedures
how long before initiate collection efforts methods of contact whether and at what point to refer account to legal department

Credit terms
credit period

6/13/2012

Credit-Granting Decision

Credit Standards
Based on five C's of Credit
Character Capital Capacity Collateral Conditions

Development of credit standards

Gathering necessary information

Credit Analysis: Applying credit standards

Risk Analysis

Determine risk classification system Link customer evaluations to credit standards

The Credit Process

Order and credit request received New/increased credit limit Yes Size of proposed credit limit Large Indepth credit invest. Medium Moderate credit invest. Small No Minimal credit invest. Extend Credit Yes No Material change in customer status No Yes Redo credit investigation

Credit Analysis: Applying the Standards

Nonfinancial
concerned with willingness to pay, character

Financial
ability to pay, financial ratios etc.. (other Cs of credit)
Record disposition

Check new A/R total vs credit lmt

Credit scoring models

Example: Y = .000025(INCOME) + 0.50(PAYHIST) + 0.25(EMPLOYMT)

CRM

Factors Affecting Credit Terms

Competition Operating cycle Type of good (raw materials vs finished goods, perishables, etc.) Seasonality of demand Consumer acceptance Customer type Product profit margin Cost and pricing

Key Financial Ratios

Four Categories of key financial ratios:
1.

Liquidity Ratios

Measure a firms ability to meet cash needs as they arise

6/13/2012

Key Financial Ratios

Four Categories of key financial ratios:
2.

Key Financial Ratios

Four Categories of key financial ratios:
3.

Activity Ratios

Leverage Ratios

Measure the liquidity of specific assets and the efficiency of managing assets

Measure the extent of a firms financing with debt relative to equity and its ability to cover interest and other fixed charges

Key Financial Ratios

Four Categories of key financial ratios:
4.

Liquidity Ratios: Short-Term Solvency

Average Collection Period Helps gauge liquidity of accounts receivable (ability to collect cash from customers) and may help provide information about a companys credit policies Net accounts receivable Average daily sales

Profitability Ratios

Measure the overall performance of a firm and its efficiency in managing assets, liabilities and equity

Liquidity Ratios: Short-Term Solvency

Days Inventory Held

(cont.)

Liquidity Ratios: Short-Term Solvency

Days Payable Outstanding

(cont.)

Measures the efficiency of the firm in managing its inventory Inventory Average daily cost of sales

Offers insight into a firms pattern of payments to suppliers Accounts payable Average daily cost of sales

6/13/2012

Cash Conversion Cycle or Net Trade Cycle

The normal cycle of a firm that consists of: Buying or manufacturing inventory, with some purchases on credit Selling inventory, with some sales on credit Collecting the cash

Cash Conversion Cycle or Net Trade Cycle (cont.)

Helps the analyst understand why cash flow generation has improved or deteriorated by analyzing: Key balance sheet accounts that affect cash flow from operating activities
Accounts Receivable Inventory Accounts Payable

Cash Conversion Cycle or Net Trade Cycle (cont.)

Calculated as follows:
Average collection period Plus Days inventory held Minus Days payable outstanding Equals Cash conversion or net trade cycle