economic events. Hence the need for an outlook in the direction of rating over one-, two-, five- and ten-year periods. Notice that:
● A positive or negative rating outlook does not necessarily imply a rating change is inevitable, and
● Ratings for which outlooks are stable could be upgraded or downgraded in the aftermath of unexpected circumstances.
Analysis of creditworthiness is typically done through metrics and ratios applied to balance sheets and income statements of the company seeking a loan. Ten years of B/S should be a minimum; 20 years is better. Moreover, numbers alone will not reveal all the secrets. A sound methodology demands answers to several other critical queries, some of which are:
● How many new products are in the pipeline?
● Can we prognosticate future product performance?
● Is the company diversified or concentrated in its products pallet? In its cus- tomer base?
● What’s the company’s market appeal? The strengths of its brand?
● Has the company a history of weak credits?
● Is the company confronting a concentration of risks?
● What’s the evidence about its ability to control its exposure?
Other critical qualitative questions concern: the performance of the company’s management; general discipline; functioning of its internal controls; any abnormal losses; a worrying pattern of short-term loans; precedence of creative accounting;
cases of illiquidity that might have been in the past; information about failures in compliance; and the prospective borrower’s cost structure. Costs matter.
Based on counterparty rating as well as on aforementioned qualitative factors and on evidence about concentrations in exposure – currency risk, country risk and other factors – banks establish a system of individual credit limits. Credit limits are one of the traditional means of managing credit risk and of providing for diversi- fication. Its pillars are:
● Establishing individual credit limits by country and counterparty
● Accounting for economic conditions and the business cycle
● Applying a proper credit risk providing methodology, and
● Steadily updating the credit risk pricing structure through feedback.
As the careful reader will recall, exposure due to credit risk can be grouped into two major categories: expected losses (EL) and unexpected losses (UL). Neither of
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these is steady. Expected losses that occur in any one year may be higher or lower than those of previous years. In any year, the amount of expected losses depends on:
● The quality of the credit analysis that preceded them
● Management’s ability to account for the macroeconomic environment
● Changes taking place in interest rates, and other factors.
The charge-offs, or write-downs, for expected losses are also subject to volatility, though they are a reflection of credit quality. Zero charge-offs are unheard off, which means that banks know in advance that some of their clients will be unable or unwilling to perform. Charge-off rates up to 2% are generally considered as ‘nor- mal’. Figure 5.1 presents two decades of statistics of charge-off rates at US commer- cial banks. Write-offs are a lagging indicator of the condition of borrowers’ balance sheets.
During this period, the borrowers’ weak balance sheets show in the 1987, 1992 and 2002/2003 peaks in charge-off rates. The strengthened financial conditions of American corporations are reflected in the low charge-offs of 1994–99, as well as 2005/2006. Further evidence is provided by the very low default rates on cor- porate bonds.
The downside of ‘good time’ is that when delinquencies on business loans extended by commercial banks fall to very low levels, the credit institutions tend to reduce their credit quality watch. This becomes a big negative in the next change in the business cycle, when economic conditions deteriorate and weak borrowers are unable to meet their obligations.
Chapter 5
99 3
1986 1990 1995
2
1
0
2000 2006
Percent of charge-off
Figure 5.1 Two decades of charge-off rates at US commercial banks: 1986–2006
Under certain circumstances, a bank may decide to maintain potentially bad loans with specific provisions on its balance sheet. This is usually done as long as the debtor is in a position to redeem part of the loan, even if this is only interest.
The bank will typically record a loan as non-performing before it finally writes it off. Many non-performing loans are in arrears for some months.
Only when the credit institution actually removes all or part of this bad debt from its balance sheet is the loan deemed a write-off. However, write-offs may also occur in the context of securitizations, as banks sell their bad loans to third parties to recover some of their capital, and/or as a way of financial restructuring.
In conclusion, credit risk must be studied through quantitative and qualitative means. Credit rating is quantitative. The behaviour of the borrower CEO, and that of his or her immediate assistants, is qualitative. Are they over-rewarding them- selves with stock options, morose or bad-tempered even when making money, antisocial and introverted, or status symbol conscious?
It is also wise to ask other, more personal questions. Are the CEO, Chief Finance Officer (CFO) and the heads of Accounting and Auditing heavy drinkers? Do they have large mortgages on large houses? Are they removing floppy drives for ‘secur- ity purposes’? Using a maze of passwords? Is the CEO refusing to talk to the auditors or the regulators?1