6880160 Credit Analysis

8/3/2019 6880160 Credit Analysis

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Credit Analysis


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Prime Lending Rate and Bank

Credit What is the Benchmark Prime Lending Rate

(BPLR)? The benchmark lending rate of a bank to be followed

uniformly across all the branches

Can there be multiple PLRs? No. Since all lending rates can be determined with

reference to the Benchmark PLR by taking into

account term premia and/or risk premia, there is noneed for multiple BPLRs. These premia can befactored in to the spread over or below the BPLR.

Source: RBI


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Prime Lending Rate and Bank

Credit Can there be sub-PLR lending?

Yes. Banks are free to fix Benchmark Prime LendingRate (BPLR) for credit limits over Rs.2 lakhs with theapproval of their respective Boards.

Can the banks lend at fixed rate? Yes. Subject to the conformity with Asset Liability

guidelines

Can there be lending without any reference toPLR? Yes in specific cases loans for consumer durables,

loans against shares and debentures, billsdiscounting, finance granted to specifiedintermediary agencies etc.


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Core CreditProducts

Cash Credit A short term cash loan to a company to

meet the working capital requirement

How is it different from ordinary loan? From marketing point of view it is a joint

product: loan and current account bundled intoone product.

Customer is sanctioned a credit limit and he cankeep drawing and depositing cheques in cashcredit account.

It is more or less a permanent loan.


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Contd.. Legal enforcement is quite weak in case of

cash credit.

Pricing

Usually based on the credit rating of thecompany ranging from prime lending rateupwards.

Interest is charged on the consumedamount.


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Core Credit product Export Credit

Banks grant export credit on to meet all the financialrequirements of exporters

Pre-shipment/Packing credit, Post-shipment credit Exporters having firm export orders or confirmed

L/C from a recognized Bank can avail the exportcredit facilities provided they satisfy the requiredcredit norms.

Rupee export credit is usually available for amaximum period of 180- days from the date of firstdisbursement (can vary from bank to bank)


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Core Credit product Export Bill Rediscounting

Banks also offer financing of export by wayof discounting of export bills to provide post

shipment finance to the exporters atcompetitive international rate of interest.

The export bills can be purchased/discounted provided they comply with the

norms of the Bank/ RBI. Pricing of Export Credit

LIBOR linked and market determined.


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Core CreditProduct

Foreign Currency Loans

External commercial lending

LIBOR linked

Retail Lending Housing

Auto

Personal loan etc.


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Other CreditProducts

Letters of Credit

A payment undertaking given by a bank

(issuing bank) on behalf of a buyer(applicant) to pay a seller (beneficiary) for agiven amount of money on presentation ofspecified documents representing the supplyof goods within specified time limits.

How does it work?


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How does an LC work?


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Contd..


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Other CreditProducts

Bank Guarantees Bank provides a guarantee on behalf of the customer

that liabilities will be met

Primary liability lies with the customer. Advances against shares and debentures

Shares/ debentures/ bonds accepted by banks assecurity for loans/ advances should be valued at theprevailing market prices.

A uniform margin of50% has been stipulated for alladvances against shares/ debentures.

Others


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Credit AppraisalP

rocess Approaches to Credit Evaluation

Five C principle

Financial statements Scoring model

Altmans Z score model

Credit rating

J P Morgans CreditMetricsTM

Market models

Moodys-KMV model


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Five CP

rinciple Character

Reputation of the firm, repayment history - age ofthe firm a good proxy

Capital Leverage

Capacity Volatility of borrowers earnings

Collateral

Cycle or Economic conditions Cyclic vs. non-cyclic industries

A subjective model of credit analysis


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Credit ScoringM

odels Altmans Z score

Where, X1 = working capital/total asset ratio X2 = retained earnings/total assets ratio

X3 = EBIT/total assets ratio

X4 = market value of equity/book value of total

liabilities ratio X5 = sales/total assets ratio

543210.16.03.34.12.1 XXXXXZ !

1.81 2.81

Z Score

Bankrupt firm Stable firm


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Why do the Conventional

Techniques Fail? Not really! Rather they are increasingly getting

less relevant vis--vis Basel framework. Why? Basel regulations require the banks quantify the

credit risk/default risk which is not possible in any ofthese models.

Stability of Z-score model is doubtful (though it isstill used in banks as an Early Warning System,refer to ICICI Bank study)

Quantification of credit risk is only possible by somequantitative model of credit risk such as Creditrating.


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Credit Rating vis--vis Basel IIThe Transition Matrix

Transition matrix: probabilities of credit rating migrating from one

rating quality to another, within one year.

Initial Rating at year-end (%)

Rating AAA AA A BBB BB B CCC Default

AAA 90.81 8.33 0.68 0.06 0.12 0 0 0

AA 0.70 90.65 7.79 0.64 0.06 0.14 0.02 0

A 0.09 2.27 91.05 5.52 0.74 0.26 0.01 0.06

BBB 0.02 0.33 5.95 86.93 5.30 1.17 1.12 0.18

BB 0.03 0.14 0.67 7.73 80.53 8.84 1.00 1.06

B 0 0.11 0.24 0.43 6.48 83.46 4.07 5.20

CCC 0.22 0 0.22 1.30 2.38 11.24 64.86 19.79

Source: Standard & Poor


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Prototype Risk RatingProcess


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P

rototype Risk RatingP

rocess Two-tier rating system:

Obligor rating

represents probability of default by a borrowerFacility rating

represents expected loss of principal and/orinterest


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Prototype System: 9 Step Process

5 steps associated with obligor rating Financial assessment

Quality of management

Borrowers absolute and relative position within theindustry

Quality of financial information

Country risk

4 steps associated with facility rating

Examining third party support Factoring in the maturity of the transaction

Review of the structure of the transaction

Assessment of the collateral


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P

rototype Risk RatingP

rocess

TransactionStructure

Collateral

Maturity of

Transaction

Third Party Support

Managerial Capability,Competitive Position

Quality of Financial Information, Country Risk

Financial Assessment

(Floor)

Obligor

Rating

Facility

Rating


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1.Financial Assessment Ratings reflect:

Financial position, performance and trends

Ability of borrower to withstand unexpectedfinancial setbacks

leverage

Access to the capital markets


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1.Financial AssessmentC

ontd.. Key financial ratios include three main

assessment areas: 1. Earnings /cash flows

2. Asset values/ Liquidity/Leverage

3. Financial size & Flexibility/Debt capacity

Need to: adjust key ratios for cyclical effect

weight current years performance relative to prioryears performance

benchmark results against other firms in the sameindustry group


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riskratingsof6,3, and 5.5 foranaverage of5 (14.5/3 =4.83, roundedto 5)

Step

# RiskFactors

Adjusted

Obligor

Rating

Earnings/Cash Flow 6

Asset Values/Liquidity/Leverage 31.

Financial

Assessment

Financial Size & Flexibility/Debtcapacity

RiskRating

5.5 5.0


ontd..On a risk rating scale of say, 1 - 9, Rate theobligor for each of the 3 assessment areas:


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1.Financial Assessment Contd..

Validate against industry financial ratios

Example:

A. Earnings / Cash flow (solvency) EBIT / interest expense = 1.3 (interest coverage) (corresponds to a risk rating of B+/B, i.e. risk rating= 6)

B. Liquidity Current ratio = 2.4 (corresponds to a risk rating of say A, i.e. risk rating=3)

C. Leverage => Debt Capacity Total debt / capitalization = 60 (corresponds to a risk rating of BB-, i.e. risk rating=5.5)


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Riskrating Earnings (E)/Cashflow (CF)

Asset Values (AV)/

Liquidity (LIQ)/

Leverage (LEV)

Financial Size (FS) &

Flexibility (F)/

Debt Capacity (DC)

5 adequate earningsand

cashflow with additional

coverage

positive trends, butmaynot have been entirely

stable inthe past

assetsofaverage quality

with possible reliance on

intangibles

satisfactory workingcapitalwith adequate leeway

average leverage

tenorofliabilitiestoassets

maybe slightlymismatched

Marketaccesslimitedtoabilityto

attract high-yielddebt

approachinginvestmentgrade

(rated BB+) bankdebt easilyrefinancedby

otherFIs with agoodincrease

available

Implications for Risk rating 5 in the example:


ontd..


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2

. Quality ofM

anagement Factors (mostly subjective)

Experience

Succession planning

day-to-day account operation

environmental assessment

effect of contingencies

etc.

Note: use these factors to adjust obligor ratingdownwards:


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0.5

-

-

-

-

Day-to-DayAccountOperation

Management

Environmental

Contingencies

OtherFactors

Monthlyfinancialstatementinformationisconstantlylate andofpoorqualityanda 0.5

downgrade appliesto day-to-dayaccountoperation. The obligorratingisadjusted 5.5 from 5.

Step

# RiskFactors

Adjusted

Obligor

Rating

2. Management/Qualitative

Down-

Grade by

5.5

2. Quality ofManagement Contd


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3.Industry Review Industry Rating (A)

Competitiveness

Trade environment

Regulatory framework

Restructuring

Technological change

Financial

Performance

Long term trends

Vulnerability to macroeconomic environment


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3.Industry Review

C

ontd Tier Assessment - Relative position within

industry (B)

relevant market sharecustomer base

cost structure

response to environmental changes


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Industryrating1 2 3 4 5

Tier

Assessment

Within

Industry

Tier1

Tier2

Tier3

Tier4

Bestpossible obligorrating(giveninitialindustryandtierratings)Example:

3.Industry Review

C

ontd

No

adjustment


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With Industryratinga 3, anda Tier2customerwith agoodshare ofthe relevant

marketshare, andanaverage coststructure, the bestpossible ratingisa 4. In

thiscase, there isno effectonthe obligorrating.

Step

# RiskFactors

Adjusted

Obligor

Rating

IndustryRating (1-5)

TierAssessment (1-4)

3. Industry/TierPosition

4 5.5

3

2

Best

Possible

3.Industry Review Contd


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4.Financial Statement

Quality

Factors

Auditors report

Accountants review

Internally prepared statements

etc.


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The annualstatementisauditedforabestpossible ratingof1

with nochange tothe ObligorRating

Step

# RiskFactors

Adjusted

Obligor

Rating

4. 1 5.5

Best

Possible

Financial Statement

Quality

Statement Type AUDIT

4.Financial Statement QualityContd


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5.Country Risk

Factors

Inability of a counterparty or obligor to payits obligations due to:

cross-border restrictions

convertibility and

availability of a given currency.

P

olitical and legal risk of a country


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Divisioncountryratings

Adjustmenttoobligorrating

(illustrative only)

Excellent, Very Good,

GoodorSatisfactoryNone

Fair Bestpossible obligorratingis 5

SelectivelyAcceptable

Marginal/Deteriorating

Bestpossible obligorratingis 6

Bestpossible obligorratingis 7

5.Country Risk Contd


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Asthe countryis India, there isno effectonthe ratingleavingthe final

obligorRatingat 5.5

Step

# RiskFactors

AdjustedObligor

Rating

5.

5.5

CountryRisk

(ifotherthan India)

Country

FIN

AL OBLIGORRATIN

G 5.5COMMENTS:

5.Country Risk Contd


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Facility Rating: Third Party Support(6)

Type of guarantee

Clean guarantee

Comfort letterCompletion guarantee

First Charge

Keepwell agreement


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A 100 % cleanguarantee isprovidedbyariskrated 4 client. The clientdoes

notprovide securitytootherlendersandthe positionisnotsubordinated.

Therefore the ratingisimprovedto 4.

FACILITY 1 TYPE: TERM AMOUNT: Final

Obligor

Rating

Adjusted

Facility

Rating

TypeThird Party

Support

5.5

46.

Facility Rating: Third Party Support(6) Contd


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Facility Rating: Term to Maturity(7)

Term to maturity of the facility

Increased risk in longer term facilities

Decreased risk for very short-term facilities


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The facilityisan 8-yeartermloanresultinginadowngrade froma 4 toa 5.

FACILITY 1 TYPE: TERM AMOUNT: FinalObligor

Rating

Adjusted

Facility

Rating

Term

5.5

5.07.

Facility Rating: Term to Maturity(7) Contd


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Facility Rating: Facility Structure(8)

Facility Structure

Covenants/Term

Repayment/AmortizationSeniority of loans


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Facility Rating: Facility Structure(8) Contd

Covenants: Covenants are in place whicheffectively mitigate all (or part) of any

increased risk due to term, by means ofdefault clauses that provide a fullopportunity to make demands, or bymeans of repayment arrangements that

ensure rapid pay-down ACTION: Upgrade only to offset (possibly

partially) any downgrade for term


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Subordinated/Loans security: The banks loan issubordinated, putting ones position and/or securitysignificantly behind other creditors

ACTION: Downgrade

Corporate organization: The borrower is highly cashflow dependent on related operating companiesthat have their own financing

ACTION: Downgrade


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Repaymentis wellaheadofschedule due toanunexpectedprincipal

reductionthatpartiallyoffsetsthe downgrade instep 7 resultinginan

upgrade of0.5 toaratingof4.5


ObligorRating

Adjusted

Facility

Rating

Structure

5.5

4.50.58. Upgrade



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Facility Rating: Collateral (9)

Collateral

Pledged assets are of very high caliber(generally no reliance on inventory) andprovide substantial over-coverage (usingconservative valuations, with liquidationappraisals held where warranted).

Background support also adds strength.


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Strongsecurity. Afirstcharge is heldoverallcompanyassetsincludingstate ofthe art

commercialbuildings. Upgrade by 0.5 toafinalfacilityratingof4


Obligor

Rating

Adjusted

Facility

Rating

Collateral Category

5.5

4.0.59. Upgrade

4.0FINAL FACILITY RATING

COMMENTS:

Facility Rating: Collateral (9)Contd

Back

ground


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Appendix


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Appendix

Letters of Credit

Bills discounting

Comfort letter Keep well agreement

Pre-shipment credit

Post-shipment credit


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Letters of Credit

Beneficiary The beneficiary is entitled to payment as long as he

can provide the documentary evidence required bythe letter of credit. The letter of credit is a distinct

and separate transaction from the contract on whichit is based. All parties deal in documents and not ingoods. The issuing bank's obligation to the buyer, isto examine all documents to insure that they meetall the terms and conditions of the credit. Uponrequesting demand for payment the beneficiarywarrants that all conditions of the agreement havebeen complied with. If the beneficiary (seller)conforms to the letter of credit, the seller must bepaid by the bank.


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Letters of Credit

Issuing bank The issuing bank's liability to pay and to be

reimbursed from its customer becomes absoluteupon the completion of the terms and conditions ofthe letter of credit.

The issuing banks' role is to provide a guarantee tothe seller that if compliant documents are presented,the bank will pay the seller the amount due and to

examine the documents, and only pay if thesedocuments comply with the terms and conditions setout in the letter of credit.


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Letters of Credit

Advising/Confirming bank An advising bank, usually a foreign correspondent

bank of the issuing bank will advise the beneficiary.

Generally, the beneficiary would want to use a localbank to insure that the letter of credit is valid. Inaddition, the advising bank would be responsible forsending the documents to the issuing bank. Theadvising bank has no other obligation under the

letter of credit. If the issuing bank does not pay thebeneficiary, the advising bank is not obligated topay.


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Letters of Credit

Negotiability

Letters of credit are usually negotiable. Theissuing bank is obligated to pay not only thebeneficiary, but also any bank nominated bythe beneficiary. Negotiable instruments arepassed freely from one party to anotheralmost in the same way as money. To be

negotiable, the letter of credit must includean unconditional promise to pay, on demandor at a definite time.


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Bills Discounting

Discounting with recourse

Discounting with recourse is the discountingof bills of exchange, when a risk of theissuer of the bill is run by the company: ifthe bill is not paid at maturity, the bankreceives the amount thereof from thecompany which had discounted the bill of

exchange.


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Bills Discounting

Discounting without recourse

Discounting without recourse is a straightsale of customer receivables, wherein thebank has no recourse to its customer if thebill remains unpaid at maturity.


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Comfort Letters

Usually, a letter issued to a lendinginstitution by a parent company/bankacknowledging the approval of asubsidiary company's attempt forfinancing.

See the sample comfort letter issued by a

bank.


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Keep well Agreements

Usually, a contract between a parentcompany and its subsidiary to maintainsolvency and financial backingthroughout the term set in theagreement.


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Pre-shipment Credit

Banks offer pre-shipment credit toexporters by way of packing credit,enabling them to finance operations likepurchase/import of raw materials orprocessing and packing of export goods.Exporters can avail of this pre-shipment

credit either in rupees or foreigncurrency.


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Post-Shipment Credit

Banks offer post-shipment credit to exporters,helping them finance export sales receivablefor the time lag between shipment of goodsand date of realization of export proceeds.

Exporters can avail of the following services: Negotiation/ payment/ acceptance of export

documents under letter of credit Purchase/ discount of export documents under

confirmed orders/export contracts etc.

Advances against export bills sent on collection Exporters can avail of this credit either in

rupees or in foreign currency.

6880160 Credit Analysis

Documents

Transcript of 6880160 Credit Analysis