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Credit Risk Management Enhancing Your Bottom Line. The AFP 23 rd Annual Conference New Orleans November 3-6, 2002. Ebrahim Shabudin Managing Director Deloitte & Touche LLP. Credit Background.

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Credit risk management enhancing your bottom line

Credit Risk ManagementEnhancing Your Bottom Line

The AFP 23rd Annual Conference

New Orleans

November 3-6, 2002

Ebrahim Shabudin

Managing Director

Deloitte & Touche LLP

Credit background
Credit Background

  • Thorough identification and accurate measurement of credit risk, supported by strong risk management can help improve the bottom line

  • …..An uncertain and volatile economic environment significantly impacts this ability

  • …..The desire to grow and turn in outstanding results has a tendency to put pressure on the checks and balances within businesses

Value proposition
Value Proposition

  • Credit plays a critical role in “selling” products and services

    • Expands revenue opportunities with creditworthy, incremental customers

    • Utilizes innovative structures to support business relationships

  • Effective credit risk management limits credit losses and provides stable cash flows and earnings

    • Marketplace rewards companies exhibiting earnings and cash flow stability with higher P/E multiples

    • Marketplace penalizes credit induced volatility and “surprises”

      • Raises questions about quality of management

Corporate credit risk
Corporate Credit Risk

  • Companies are exposed to significant levels of credit risk emanating from different sources

    • Accounts Receivables

    • Other Notes Receivables

    • Buyer and Franchise Financing

    • With Recourse Financing

      • Project Finance

      • Structured Transactions

      • Leases with Recourse

    • Derivatives Exposures

      • FX, Interest Rate Risk, Commodities etc.

    • Collateral Risk

      • Parent or Third Party Guarantees

      • Commercial and Standby Letters of Credit

  • Note also that Critical Suppliers to the company may pose specific credit risk

Credit as a facilitator
Credit as a Facilitator

  • Credit risk management is important

    • Credit is a facilitator of business growth and performance

    • High business margins tend to attract lower quality clients and therefore higher risk profile to manage

    • Clients (buyers) may be concentrated in selected industries and provide limited portfolio diversification opportunity

    • Poor credit risk management resulting in negative impact to bottom-line is heavily penalized by markets

Credit strategy risk tolerance
Credit Strategy & Risk Tolerance

  • Credit Strategy Statement and Risk Tolerance

  • Coordination with Business Plan

  • Specific Quantifiable Objectives

  • Management Review Methodology

The business strategies and objectives drive the establishment of credit

policies and procedures. Measurement and reporting as well as the use of current technologies enhance credit decision-making and improve risk

management. The entire process is continually re-evaluated and improved.

Credit risk areas to consider

Credit Policy

Credit Approval Authority

Limit Setting

Pricing Terms and Conditions

Documentation: Contracts and Covenants

Collateral and Security

Collections, Delinquencies and Workouts

Exposure Management



Periodic Account Reviews


Credit Condition

Compliance with Covenants, Terms


Transactions/ Bookings

Risk-adjusted Return

Credit Risk Areas to Consider








  • Sales Channels

  • Risk Strategy

  • Underwriting Standards

  • Credit Application

  • Analysis

    • Business/ Industry

    • Financial

    • Credit

  • Credit Scoring and Ratings

  • Portfolio Management

  • Concentration

  • Diversification

  • Allowance for Bad Debts

  • Risk Mitigation

  • Objectives

  • Type of Exposure

  • Instruments or Methods

Credit risk management enhancing your bottom line

Performance Management

Performance-based management utilizes metrics that measure actual

performance against predetermined thresholds. The thresholds are

established taking into account the organization’s strategy, operating

environment and process controls.

Value Creation

Business Performance Measures

  • Business Strategy




Organizations need a rigorous set of measures to support continuous improvement

The measures drive value creation and should support problem identification and correction.

Credit risk management enhancing your bottom line

Credit Risk Management’s Inter-related Activities




Disposal / Risk mitigation

Management reporting



Credit Analysis

Sales channels

Financial analysis

Credit analysis


Exposure aggregation

Risk rating

Credit scoring

Exposure measurement

Customer management

Portfolio management

Credit Decisions


Collateral management


Pricing & terms

Credit limit

Collateral acceptance

Contracts & Documentation

Credit risk management
Credit Risk Management

A complete and coherent risk management framework contains the following elements

Credit Strategy & Risk Tolerance

Governance, Control

and Implementation

Credit Policies & Procedures



Technology &

Data Integrity

Analysis &



A new paradigm
A New Paradigm

  • A new business paradigm had evolved: causing a lack of reliance on good fundamental analysis

  • The idea that stock market values would continue to go up indefinitely

  • Increasingly competitive, complex and volatile market place

  • Higher than expected actual debt burdens

  • Extensive reliance on unrealistic future cash flows

  • Failures in corporate governance

  • Questionable personal and corporate ethics

Implications for corporate governance
Implications for Corporate Governance

  • Current organization structures to be revisited

  • Clarity around roles and responsibilities

  • Need for honesty, integrity and independence (self-regulation)

  • Technical expertise of people and strong management processes

  • Improved disclosure requirements

  • Importance and implementation of sanctions

  • Increased legislation and compliance requirements

Credit risk management strategic vision
Credit Risk Management – Strategic Vision

A business model view of Credit Risk Infrastructure components

  • Vision: Managing Risk/Return

    • Pricing decisions,Performance measurement,

    • business and customer segmentation,

    • compensation, etc.

Near Term: Managing Economic Capital / Credit VaR

Portfolio Risk Concentration, Risk Based Limits, etc.

  • Short Term: Managing Expected Loss

    • Risk Identification, Transaction Structuring, Approval & Pricing Decisions, Reserving, etc.

  • Foundation: Credit Rating and Underwriting Standards

    • Risk Identification, Origination, Credit Administration, etc.

Development stages
Development Stages

  • Foundation Stage includes application of risk identification methodologies, risk scoring or rating systems and strong underwriting standards

  • Basic Stage tends to include managing on a transactional basis by evaluating specific attributes such as structuring, collateral and pricing

  • Advanced Stage represents managing on a portfolio basis including aspects such as concentrations, correlations and diversification

  • The Sophisticated Stage includes application of highly developed measurement techniques for transactions and portfolios, supported by decision-making relating to segments or businesses against established hurdle rates.

Credit risk clarified
Credit Risk Clarified

  • Credit risk is defined as the risk of loss or potential loss resulting from:

    • Default in contractual obligations by a customer

    • Migration in condition and rating

    • Deterioration in performance

  • Credit risk includes both an expected (predictable) and unexpected (volatile) loss component.

Businesses have to contend with expected and unexpected losses

Unexpected Losses

Unanticipated but inevitable

Must be planned for

Covered by reserves

Allocated to businesses

Difficult to measure

Assessing unexpected loss requires making qualitative judgments around potential volatility of average losses

Businesses have to contend with Expected and Unexpected Losses

  • Expected Losses

    • Anticipated

    • Cost of doing business

    • Charged to provisions

    • Captured in pricing

    • Relatively easier to measure

  • Assessing expected loss includes determining exposure, default probability and severity

Credit risk management explained
Credit Risk Management Explained

  • Although credit risk may be difficult to measure it is important to estimate and manage

  • What does Credit Risk Management mean?

    • It represents an institution’s ability to properly identify and evaluate the potential risk of default in payment of obligations of customers

    • It incorporates the firm’s ability to effectively manage and control this exposure in a way that is consistent with the institution’s business strategy, risk appetite and credit culture

Important building blocks
Important Building Blocks

  • Effective Credit Risk Management requires

    • Clear origination and underwriting standards

    • A strong corporate and credit culture

    • Highly developed risk measurement techniques

    • Ability to recognize and cover expected and unexpected losses

    • Pricing commensurate with risks undertaken

    • Methodologies to assess net profit contributions by customers and appropriate business segments

    • Proper allocation of capital and management resources

  • In order to:

    • Improve overall corporate performance, measured by a higher EPS or P/E ratio (or market value)

Credit policy and process
Credit Policy and Process

  • Credit Policy should be clear and concise

  • Credit Underwriting Standards must be developed and included in policy

  • Credit Processes should be reasonable and allow quick response to clients

  • Healthy balance between sales and credit approval should exist and be respected

Risk monitoring
Risk Monitoring

  • Exposure must be complete and current

  • Regular reporting and updating of clients’ payment performance

  • Minimum annual reviews of clients should be performed

  • Financial conditions should be regularly assessed

  • Required action must be initiated and follow up must take place

Contract terms and documentation
Contract Terms and Documentation

  • Contract negotiations must take place at the right level in the organization

  • Appropriate approvals must be obtained

  • Internal or external legal departments must document completely

  • Terms and conditions should be understood and compliance mechanism put in place

  • Exceptions must be reported and managed urgently to resolution

Risk rating system effectiveness
Risk Rating System Effectiveness

  • Credit Scoring is generally used to “risk rate” homogeneous portfolios

    • Highest applicability is in consumer and retail portfolios

    • Some advanced scoring systems are being migrated for use in rating “middle market” clients

    • Such models are only as good as the underlying assumptions

  • Internal credit rating systems are difficult to assess and are often not independently validated

    • Client relationship may interfere with objective assessment of risks

    • Rating criteria usually a matter of practice rather than written policy

    • Ratings are not consistent over time

    • Qualitative credit assessments often lag current market information

    • Institutions often assumea mapping with external ratings in order to quantify credit risk

Effective risk rating systems
Effective Risk Rating Systems

  • Sufficient granularity of risk rating categories

  • Accurate and timely assignment of ratings

  • Clear and consistent application of default definition

  • Periodic calibration, triangulation and validation of risk ratings

  • Accurate identification of migration of transactions and portfolios (as reflected by upgrades and downgrades in ratings)

Credit evaluation financial factors
Credit Evaluation: Financial Factors

  • Get the information you need to make a full analysis

  • Some information will need to be cross-checked and obtained on a regular and timely basis

  • Be constructively cynical: new business models are difficult to pull off

  • Be cognizant of delaying tactics

  • Numbers don’t tell the whole story!

Credit evaluation qualitative factors
Credit Evaluation: Qualitative Factors

  • Evaluation of subjective factors is often times more important than the numerical analysis

  • People make a business: visions, values and strategies are only words unless people implement them

  • Management, industry, product, geography, competition etc. all influence results and must be properly assessed

  • Analysis-paralysis may lead to wrong decisions

Art and science of judgment
Art and Science of Judgment

  • Getting access to the best clients and all the relevant information is a challenge

  • Ensuring proper analysis is done requires a strong corporate culture

  • Utilizing qualified resources both internally and externally enhances the results

  • Often the lack of the will to act is what causes high losses

Concluding comments
Concluding Comments

  • Companies that measure and manage credit risk in a pro-active manner will benefit from a favorable risk profile resulting in

    • Higher revenue

    • Lower losses

    • Improved efficiencies

    • Higher EPS, P/E ratios and market values

Concluding comments1
Concluding Comments

Risk Assessment and Limit Management

Credit Infrastructure and Portfolio Management

  • Credit Quality

  • Credit Underwriting

  • Risk Rating System Effectiveness

  • Counterparty and Portfolio Limits

  • Organizational Structure

  • Policies and Procedures

  • Technology Selection and Implementation

  • Problem Asset Management

Credit Analytics Support

  • Risk Rating Calibration

  • Transaction Pricing, Structure and Support

  • Default Probability and Recovery Calibration

  • Credit Reserve Methodology

  • Risk Based Pricing Models

  • Risk Adjusted Return Analysis

  • Portfolio Value Measurement

Credit Technology Enablement

  • Credit Risk Measurement

  • Credit Performance Scorecards

  • Internal Software

  • External Vendor Software

Appendix business proposal checklist
Appendix: Business Proposal Checklist

  • Business Proposal Summary

    • Customer, Rating, Legal Status, Line of Business

    • Guarantor, if any…same

    • Collateral, if any…true value explained

    • Other Support, if any... Legal or moral only

    • The Transaction…risks and mitigation

    • Amount, purpose, terms and conditions

    • Sources of repayment… clearly identified

    • Client payment history and relationship

Appendix business proposal checklist1
Appendix: Business Proposal Checklist

  • Rationale and Analysis

    • Customer, Guarantor, Collateral, Support

    • Facility Description

      • Amount, purpose, tenor, pricing, terms, conditions, covenants, restrictions etc.

      • Consider affect on above e.g. new leverage

      • Facility Rating?

    • Repayment Capacity

      • Future cash flow, conversion of assets etc.

    • Consistency with Credit Strategy and Policy

      • Confirm, and identify any exceptions to policy, underwriting standards, or process

      • Risk adjusted return acceptability

Appendix business proposal checklist2
Appendix: Business Proposal Checklist

  • Client Relationship

    • Business strategy: increase, maintain or decrease exposure or exit relationship

    • Consider relation to rating, latest risk profile and payment performance

    • Customer profitability: risk adjusted return, revenue, fees, direct and allocated costs etc.

    • Any conflicts of interest or special concerns

Appendix business proposal checklist3
Appendix: Business Proposal Checklist

  • Macro Analysis

    • Business Environment Review

      • Customer’s competitive market position and future industry prospects: size, cycle, volatility, new entrants

      • Strength of customer’s business and financial strategies

    • Management Evaluation: competency, experience and effectiveness

Appendix business proposal checklist4
Appendix: Business Proposal Checklist

  • Customer Analysis

    • Company history, background, objectives and performance

    • Relevance and strength of future business plans

      • Consider seasonality and scenario analysis

    • Primary and secondary sources of repayment

    • Historical financial capacity and analysis of future performance: sales, profitability, working capital, liquidity, cash flow, leverage, tangible net worth etc.

      • Quality of earnings

      • Absolute and ratio analysis

      • Peer comparisons

Appendix business proposal checklist5
Appendix: Business Proposal Checklist

  • Strengths, Weaknesses and Recommendation

    • Key factors that could jeopardize collection: environment or company specific

    • Any mitigating factors

    • Consider probability and impact

    • Consider all sources of repayment: primary, secondary and tertiary, including access to capital markets, refinancing etc.

    • Summarize strengths and weaknesses and conclude with a recommendation