The Fundamentals of Credit

Credit analysis is the process of determining credit risk by assessing:

• Individual credit risk: the credit risk of an individual facility
• Portfolio credit risk: the impact that this credit risk has on a lender's credit portfolio; and
• Portfolio return and risk: determining the required lending rate for that risk or the acceptability of that risk in the context of the lending rate applied.

Credit risk may be defined as the probability of incurring a loss as a result of extending credit. It is assessed at two levels:

• Individual credit risk: the credit risk of an individual facility; and the
• Portfolio credit risk: the impact that one individual credit risk has on a credit provider’s portfolio.

Assessing credit risk helps lenders and investors make informed decisions about extending credit or investing in financial products, minimizing the chances of default and potential losses.

Globally, credit markets are significantly greater than equity markets. Credit is essential to the operations and financing of most businesses and governments. Domestic and international trade hinge on the provision of credit in one form or another, and the prudent use of credit has positive economic impacts resulting in rising living standards. Granting credit to commercial customers is therefore essential to economic prosperity. The prudent use of credit has positive economic impacts for both borrowers and the economy as a whole, however any imprudent use has negative consequences.

Assessing the credit risk of an individual loan, for example, involves determining how certain we are that the interest will be paid, and the loan repaid, or, more importantly, how likely it is that this will not be the case and a loss will be incurred.

The contemporary credit decision process involves a four-step analytical framework:

• Purpose: this refers to the nature of the obligor and the use of the credit facility. Different types of companies have different financial needs and it is important to understand the purpose of the credit extension if we are to provide an appropriately structured credit facility.
• Payback: this refers to the expected sources of repayment of any credit facility that is utilized. Some sources are quite predictable, whilst others are not.
• Risks: this starts with a top-down analysis of the operating environment of the business (usually a country or region), then the business sector, and then the specific business in question, its operations, management and ownership. It is at this stage that the financial profile of the obligor is assessed and analyzed, financial analysis aiming to provide an overall picture of the potential financial risks and returns.
• Structure: this refers to the type of credit facility, its ranking, the covenants and other safeguards providing protection and, importantly, its pricing.

The ultimate aim of the credit analysis process is to estimate the likelihood of suffering a default, and the losses that are likely arise in that event. Although these aims are both objective, the credit analysis process is far from formulaic, requiring a number of subjective judgments to be made.

Credit risk is assessed through various factors such as the borrower's credit history, income stability, debt-to-income ratio, and the economic conditions of the borrower's industry or sector.

Lenders assess credit risk by evaluating a borrower's credit history, income, debt-to-income ratio, and other relevant factors to determine their ability and willingness to repay the borrowed funds.

The Five C’s of Credit gauge a potential borrower’s creditworthiness, willingness and ability to pay.

1. Character: management and owners
2. Capital: levels of equity, bearing in mind the risk asymmetry
3. Capacity: ability to service debt
4. Collateral: asset protection; and
5. Conditions: purpose, loan structure, economic and industry environment, pricing

Lenders compensate for the increased risk of default by charging more for the borrowed funds through higher interest rates.

The final stage in the credit decision process is to find the right balance between risk and return within the overall lending portfolio, i.e. determining the required portfolio lending rate for the portfolio risk involved or the acceptability of that risk in the context of the lending rate applied.

The ultimate question is whether the lender’s loan portfolio can earn an interest rate that is sufficient to provide an adequate return for the lending risk, taking into account the likelihood of credit losses, within that lending portfolio. The adequacy of the return will, itself, be a function of the lending business’s cost levels and the return it needs to satisfy its providers of finance.

Diversification involves spreading investments across different assets to reduce the impact of a single credit default. This helps mitigate the overall credit risk in a portfolio.

To minimize the volatility of a credit portfolio, a lender should:

• Diversify within sectors: spread their exposure to any one sector over many borrowers within that sector
• Diversify between sectors: spread their risk across many sectors to derive the correlation benefits
• Diversify between markets: spread their risk across many markets/economies to derive the correlation benefits

Ultimately, correlation is a key factor to consider when we are assessing how a credit proposal fits with the existing portfolio.

Strategies include collateral requirements, loan covenants, credit insurance, and using credit derivatives to hedge against potential credit losses.

Systematic or market-wide factors that are outside the control of the company include:

• Global and country risks: the economic and political circumstances of the countries in which the business operates, which encompasses environmental, social and technological risks. A booming economy is generally positive for business performance; however, an economic downturn may be of greater concern to lenders.
• Sector-specific risks influence the specific company in question, e.g. structural changes due to increased adoption of technology or changes in the competitive environment.

Unsystematic or company specific factors that can be influenced by the company and/or its owners include:

• Business risk factors such as the:
• – Business profile of a company, the range of products or services, supply chain and customer diversity.
• – Ownership of the business and the demands the owners place on the business; and
• – Management of the business, including the quality of environmental, social and corporate governance.

• Financial risk factors such as the:
• – Financial structure or the extent to which the business relies on external funds such as loans
• – Financial flexibility and the ability of the business to service its debts and long-term liabilities; and
• – Liquidity levels of the business and its ability to service its short-term liabilities.

Credit agencies assign credit ratings based on an assessment of a borrower's creditworthiness, which includes factors like financial stability, repayment history, and ability to manage debt.

Credit rating agencies assign credit ratings to individuals and businesses based on their credit risk. These ratings reflect the agency's assessment of the likelihood of default. Common rating scales include AAA, AA, A, BBB, etc.

A credit default is a failure on the part of an obligor to meet its financial commitments at the agreed date or within an agreed time. The likelihood of this event arising is known as default risk, which providers of credit facilities need to carefully consider when advancing credit.

Default risk refers to the probability that a borrower will be unable to fulfill their debt obligations. It's a crucial factor in assessing credit risk.