The context for credit risk analysis

8 mins read

Financial institutions and investors make money by putting capital at risk. The underlying idea is fairly simple – returns from this exercise will not just compensate them for bearing the risk but will also allow the original capital base to grow. Over the years some effective rules of thumbs, guidelines, benchmarks and processes have been developed and tested that allow the industry to identify, understand, measure, allocate and distribute risk.

The risk of non-performance, a.k.a. as default or credit risk is one such risk. An effective credit process reduces (ideally received adequate compensation for bearing) the potential for loss resulting from an actual or perceived deterioration in the financial health of the business. There are two common sub-categories of credit risk that we will work with:

  1. Default Risk: Failure to make interest or principal payment or violation of loan covenants. Factors such as business cycle volatility, excessive leverage or intense competition may lead to default. In corporate bankruptcy or dissolution, secured bondholders and senior debt holders may receive some funds from the distribution of corporate assets, it is rare to recover the entire value of the loan.
  2. Downgrade risk: The risk that credit rating agencies may change their view about a business’ creditworthiness (read: lower credit rating) is called downgrade risk. If a firm’s credit rating is downgraded in a perfect market its cost of borrowing goes up. This, in turn, means
    that the risk of default has increased, and the interest rate currently being charged is not adequate to compensate the lender for the risk he is bearing.

Why is credit analysis important?

Banks are highly leveraged institutions. It is not uncommon for a bank to finance 90% of its assets from deposits and other liabilities. When a bank lends, it puts a large chunk of these deposits at work in combination with a small % of its equity. When a risk is classified and priced accurately, the bank expects to earn a decent return on its capital as well as the borrowed amounts put to work. When a risk is classified and priced inaccurately, the bank is at risk for losing capital as well as borrowed funds. It doesn’t take a large number of these classification and pricing errors to wipe out a bank. Which is why credit analysis and credit decision-making processes have a direct impact on a lending institutions profitability and survival prospects. The following points put this in perspective

  • A scientific assessment of credit risk of borrowers helps minimize losses from default. In the interest of their own profitability, banks have to ensure that the probability of default is low.
  • Banks have limited funds available for lending; hence, they have to make the best possible use of these funds given past experience and current opportunities.
  • Loan pricing and structuring. Based on the creditworthiness (credit profile) of a loan applicant, the lender decides the interest rate that should be charged, the maximum credit limit and the requisite security and documentation required to secure the loan.

There are also strong environmental reasons for improving credit processes such as:

  1. Increasing competition. Before mid 1980’s, banks were the most significant source of financing for businesses. Today, for the right businesses, access to capital, is not a big issue and banks are not the only source of financing. Even though today US businesses rely more on commercial lending and debt as a source of external funds, banking industry has actually lost market share in the last two decades. Public markets & non-traditional lenders such as mutual funds and insurance companies have been very aggressive in capturing business in the commercial lending area. Since credit analysis plays such an important part in pricing a loan – a declined or lost customer due to a mispriced loan is equivalent to throwing good business away.
  2. Capital position. When banks write off (charge off) large non-performing loans, their capital position weakens and their ability to generate new loans diminishes. Over the last two decades, the financial services industry in general and banking in particular have gone through some truly traumatic shifts. One important result has been the negative impact on the capitalization of an average bank and its ability to compete.
  3. Regulatory factors. There are two important trends on the regulatory front. The first is the increasing emphasis on preventive measures, compliance, risk measurement and management, best practices and adequate reserves by industry regulators. This has a direct impact on the cost of doing business, especially in a competitive environment. Second, Bankruptcy and case law is more protective of companies in trouble, and businesses are more aggressive in seeking bankruptcy protection.

Credit Risk and Credit Spreads

The borrowed funds or deposits that a lender works with are not free. The owners of these funds need to be compensated for lending the money to the bank. This compensation is referred to as cost of funds. The most common source of these funds is customer deposits. A bank makes money by combining the borrowed fund with its own capital (equity) and then investing the same in a loan portfolio that earns a higher interest rate than its cost of funds. The rate earned on the loan portfolio is called the earned interest rate. The difference between the earned interest rate and the cost of fund is the spread the bank makes. The spread varies from loan to loan and customer to customer and is a reflection of the risk the bank is taking on and its internal cost structure.

Practically speaking it is possible to break down the interest rate charged to a customer into the following components. (This is a very simplified representation; actual loan pricing models are more complicated)

Interest Rate on Loan =

Cost of Funds * (% of Loan funded with borrowed funds)


Return on Bank Capital * (% of Loan funded with bank equity)


Internal Cost structure (expressed as a % of loan)


Credit Spread (reflecting the credit risk of the customer)

An example should make this clearer. A large manufacturer (credit rating B) of industrial power generators has applied for a real estate backed loan for $10,000,000 for purchasing and rolling out its new distribution warehouse. The following table presents some of the required information

Bank FactorsValue
Cost of Funds6% per annum
Internal Cost Structure1500 per loan, expressed as a % of loan balance
Credit Spread0.00% for AAA0.25% for A0.50% for B1.50% for B-Decline for below investment grade
Bank Targeted ROE18%
Capital Contribution %7%
Tax Rate38%

In this case the bank expects to lend 93% of the funds from existing deposits and 7% from the bank’s capital base. The following table calculates the interest rate on

Interest Rate FactorsValue
Cost of Funds * (% of funds)6% * 93%             =     5.58%
Return on bank capital * % of funds18% * 07%             =     1.26%
Credit Spread0.50% for B            =    0.50%
Internal Cost Structure1,500 / 10,000,000         =    0.015%
Rate Offered to customer5.58% + 1.26% + 0.5% + 0.015% = 7.355%

The calculation above would change depending on a number of factors. Was the targeted ROE before tax or after tax? Does the bank have any deposit requirements, processing or closing fees? Would the bank want to reflect a % of these factors in the offered interest rate or not?

For a loan officer, it is critical to understand the relationship between credit risk of a customer and the interest rate charged on the loan. Companies with respectable credit ratings or credit profiles are generally in a position to ask or bargain for lower interest rates. These are called ‘investment grade’ companies (low-risk companies). However, the return on lending to such companies is low because of the small difference between the cost of funds and the rate charged on the loan.

This brings us to the most important point in this discussion. Are there enough investment grade companies in the world to lend to? What if a lender wishes to target the non-investment grade businesses? Aren’t there banks that specialize in working with businesses whose risk is at best described as speculative? How do they do that?

The key to this answer is accepting the fact that lending is an informational game. Why is a business classified as a speculative risk? The primary reason is that there is not enough information available about the future prospects of the business. This may be because the business operates in very volatile environment, or because there is no prior history to work with, or because not enough is known about how markets would react to its products. Lenders specialize in solving informational problems like these. In instances where there is not enough information, information-signaling tools like collateral & personal guarantees are used.

Remember the statement with which we started this section. Banks make money by putting Capital at Risk. Higher the risk, higher the return! The Board of Directors working with the bank’s Management Committee decides the level of risk with which a bank is comfortable. The fact is that banks don’t just lend to investment grade businesses. The interest rate charged from risky businesses is much higher than the rate charged to investment grade businesses. It is upto the credit analysis and decision-making process to solve the informational issues that arise when dealing with riskier businesses. A bank’s effectiveness in designing and implementing these processes has a tremendous impact on its profitability.

Credit Analysis Process

At a high enough level, all processes have the same attributes and definitions. The most common three-step breakdown is

Credit Process

  1. Gather Information
  2. Process Information
  3. Present Information

In a credit analysis and decision making context we would add smaller processes at the beginning and end of the above list. Think of these as interfaces that allow the process to work with your organization

Front end Interface

  1. Setting objectives and guidelines

Credit Process

  1. Gathering information
  2. Processing information
  3. Present Information

Back end Interface

  1. Decision Making
  2. Documentation

We will walk through these six sub processes one by one

i. Setting Objectives and guidelines

Each lender is different from any other lender in terms of risk preferences, access to capital, market positioning, profitability, growth objectives and strategies, risk identification, measurement and management. All of these factors drive the definition of the customers that the bank would want to work with. A credit function aware of this profile (perfect as well as acceptable customer) will do well compared to a credit function, which is not. Objectives and guidelines are set by the Board of Directors and implemented by the management committee.

ii. Gathering information

We have said this above – lending is an informational game. The side with the best information generally wins. Effective loan officers know the information they need and where they can find it. They will work with customers to make sure that information is accurate, reliable, can be crosschecked and is available on time. Since everything else is so dependent on the quality of the output generated at this step, banks do well by improving the effectiveness and accuracy of this function.

iii. Processing information

Once reliable and accurate information is available, the next step is to pass it through a number of banking functions that generate additional reports used in the decision making process. This includes generating credit score and credit classifications, evaluate fit with the acceptable customer profile, assess profitability and relationship potential, estimate business & financial risk, review historical performance and future prospects and compare effectiveness and competence of the management team with similar teams at comparable businesses.

iv. Presenting information

Gathered and processed information is then organized and presented in pre-approved formats to credit officers, members of the different credit committees, syndicate members and members of the board (for big enough loans).

v. Decision-making

There are a number of objectives as well as subjective factors that go into the final accept / decline / price decision. No two businesses are the same and the same is true for banks. We will talk a lot about these issues in the decision-making session later on.

vi. Documentation

Just as with informational games, the side with the best information wins, in litigations it is the side with the best documentation. Documentation is the most important part of the lending process. This is where a bank establishes a claim on the customer’s assets in case of default. However, just documenting the fact is not enough. There are a number of internal, external, industry and regulatory agencies that need to be informed. Documentation also needs to remain current with changes in the loan structure, business environment, market conditions and relationships.

As part of the credit analysis process, bankers usually project three scenarios – worst case, best case and all things normal. The worst-case scenario considers the ability of a potential borrower to pay back the loan if everything that can go wrong does go wrong. The all things normal scenario is where everything in the firm goes according to plan and cash flows and other sources of payment are generated by the firm as expected, so that the bank receives its payments as expected. The best-case scenario is where everything in the firm goes much better than expected.

When you are working with a real customer and end up walking through the six sub processes above, think about what you need to do now (today) to make it work in the worst-case scenario.

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