CREDIT RISK Credit risk, also called default risk, is the risk associated with a borrower going to default

(not making payments as promised). Investor losses include lost principal and interest, decreased cash flow, and increased collection costs. This risk mainly exist due to following reasons: (a) Inability of a consumer in making payments due on loans. (b) Failure of any business to make timely payments for mortgage, credit card or any other kind of loan. (c) A business or government which have issued bonds fails to make payments of coupon or principal when due. TYPES OF CREDIT RISK (1) Financial Risk: Financial risk mainly focuses on borrowers financial condition and performance. Financial risk provides a broader view of borrowers strengths and weaknesses. To determine financial risk associated with a borrower various financial statements related to business of borrower are analysed in detail. This helps lender to determine each and every aspect and component related to business of borrower. Once financial risk is analysed by lender in detail probability of borrower defaulting can be known and accordingly lending decisions can be taken. (2) Business Risk: Business risk is associated with environment in which company functions. Functioning of a company is affected by various internal and external factors. Internal ones include business strategy, plans framed by company. External ones are market condition, competitive forces etc. Analysis of business risk is done by SWOT analysis, PEST, Porters risk assessment Matrix and Five Forces Model. (3) Facility Risk: Once analysis of financial risk is completed next step is to set up an efficient facility structure so that transactions work smoothly. Facility structure arises due to failure of facility itself. This risk mainly arises for complex transactions such as multi currency loans, large number of participants etc. (4) Documentations Risk: This risk is related to legal documents which specify role and responsibilities of various participants. Main source of this risk is improperly drafted loan documentation.

MEASUREMENT OF CREDIT RISK: Various techniques used for measurement of credit risk are as follows: (1) Credit Rating: Credit rating is one of the most widely used techniques to determine the creditworthiness of borrower. Banks and other lending institution used credit rating assigned to borrower to analyse debt repaying capacity of borrower. Credit ratings are assigned to firms by Credit Rating Agencies (CRA). CRAs are required to be registered with

appropriate regulator (SEBI in India). CRAs take into consideration various factors like financial performance of the firm, track record of promoters firm, past default record of firm etc. Following table shows example of rating assigned by CRAs

CREDIT RATING AAA

RANKING 1/Minimal

AA A BBB

2/Moderate 3/Average 4/Acceptable

BB

5/Acceptable with care

6/Management attention

CCC

8/Substandard

CC

9/Doubtful

10/Loss

DESCRIPTION Firm have excellent debt repaying capacity. Firm is very strong fundamentally and have no default history. Firm have good debt repaying capacity. Firm is of average size and have average debt repaying capacity. Firm may not be able to sustain major setbacks. Firm have asset quality of acceptable standards of acceptable standards which are less than average. Firm have considerable risk associated with it. In-depth analysis must be done by investor before investing in company. Continuous attention towards firms performance and financial position is necessary for lender or investor. Firm in poor financial position. Insufficient net worth and debt repaying capacity. Firm in extremely poor financial position. High probability that firm will default. Total loss for investors as firm have little or no debt repaying capacity.

(2) Expert system: This system requires analysing five Cs of credit related to borrower. They are: (a) Character: It is a measure of reputation of firm. It takes into consideration past repayment record of borrower. (b) Capital: It refers to ratio of own fund to borrowed fund. It helps lender to determine probability of borrower going bankrupt.

(c) Capacity: It refers to ability of a firm to repay its borrowings. Higher is volatility of earnings for a firm more will be risk associated with firm. (d) Collateral: It refers to asset pledged by borrower for borrowing funds. Higher is market value of collateral lower will be credit risk. (e) Cycle (Economic Risk): There are certain industries which follow a certain cycle. For eg. Cement industry will grow at high rate when economy develops because with economic developments there is increase in infrastructure and hence demand for cement increases. However, same is not the case when economic growth slows down. Hence it is very necessary to evaluate cycle risk related to borrower especially of cycle- dependant industries. Usually in Expert System a weight is assigned to each factor and accordingly credit risk of borrower is calculated. (3) Ratio Analysis: Leverage ratios are an efficient tool to measure long term financial strength or soundness of a firm. These ratios determine ability of a firm to pay interest on time and repay principal on due dates. Various leverage ratios used to judge long term solvency of a firm are: (a) Debt-Equity ratio = Debt/Equity This ratio reflects relative contribution of creditors and owners to finance the business. (b) Debt-Asset ratio = Total Debt/Total Assets Here debt comprises of long term debt plus current liabilities. (c) Interest Coverage Ratio = EBIT/Interest This ratio indicates firms ability to fulfil its interest paying ability. Higher the ICR better is ability of firm to fulfil its interest obligations. (d) Debt Service Coverage Ratio = PAT + Depreciation + Other non cash expense + Repayment of term loans + Interest on Term Loans Interest on Term Loans + Repayment of Term Loans DSCR is a better measure to determine the debt repaying capacity of a firm. (4) Value at Risk (VaR): VaR refers to maximum loss on a given asset over a given period of time at a given confidence level. VaR methodology is one of the most preferred techniques to determine credit risk associated with an asset. Key inputs in calculating the VaR of a marketable instrument are its current market value and the volatility or standard deviation of that market value. By assuming a suitable confidence level (95%, 99%, etc) VaR can be calculated directly. VaR methodology is widely used in stock exchanges worldwide for managing credit risk. However one major disadvantage of VaR is that it is suitable more for marketable securities only. For securities which are not traded, market prices are difficult to determine and hence volatility cannot be calculated.

TECHNIQUES TO HEDGE CREDIT RISK: (1) Risk-based pricing: This technique involves deciding interest rates on case to case basis. Those borrowers which have higher probability of defaulting are charged with higher rate if interest. This technique requires lender to consider various facts related to borrower like loan purpose, credit rating, leverage ratios etc. (2) Use of derivatives: Lenders and bond holders can hedge risk through credit insurance or credit derivatives. These contracts transfer the risk from lender to the seller in exchange for payment. Most commonly known credit derivatives are Credit Default Swap and Total Return Swap. Credit Default Swap is like buying credit insurance. Here lender pays fixed amount to seller of CDS who is also known as insurer. If borrower does not default, lender will receive nothing from insurer. However if borrower defaults, insurer will have to cover the default loss and make payment to lender. Total Return Swap is an agreement where lender agrees to pay counterparty an annual rate plus change in market value of the loan. In return lender will receive a floating rate. Thus it provides protection to lender in case of increase in credit risk of borrower. Assume that par value of a loan is Rs.100. At the beginning of swap period value of loan is same as par value but after a year credit risk of borrower increases and hence value of loan reduces to Rs.90. Fix rate to be paid by lender to TRS seller is 12%. Now payment to be made by lender to TRS seller will be 12-10. Hence lender pays only 2% to TRS seller. On the other hand seller pays MIBOR to lender which we assume is around 10%. Hence lender receives 10% where as pays only 2%. Therefore, total gains to lender are 8%. (3) Diversification: Lending to small number of borrowers can increase credit risk. To reduce credit risk, lending institutions should diversify investor pool and should increase the number of people to whom credit is given. (4) Covenants: Lenders may write conditions on the borrower, called covenants into loan agreement. Some of these are: (a) Periodically report its financial conditions. (b) Restrict borrower from paying dividends, repurchasing shares, further borrowings or any action which have negative impact on companys financial performance. (c) Repayment of loan at request of lender if there is change in borrowers Debt Service Coverage Ratio and Interest Coverage Ratio.