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P2.T6. Credit Risk Measurement & Management

Jonathan Golin and Philippe Delhaise, The Bank

Credit Analysis Handbook

Bionic Turtle FRM Study Notes

By David Harper, CFA FRM CIPM

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Golin, Chapter 1: The Credit Decision

DEFINE CREDIT RISK AND EXPLAIN HOW IT ARISES USING EXAMPLES. ...................................... 3
EXPLAIN THE COMPONENTS OF CREDIT RISK EVALUATION. ..................................................... 4
DESCRIBE, COMPARE AND CONTRAST VARIOUS CREDIT RISK MITIGANTS AND THEIR ROLE IN
CREDIT ANALYSIS. ............................................................................................................... 6
COMPARE AND CONTRAST QUANTITATIVE AND QUALITATIVE TECHNIQUES OF CREDIT RISK
EVALUATION. ...................................................................................................................... 8
COMPARE THE CREDIT ANALYSIS OF CONSUMERS, CORPORATIONS, FINANCIAL INSTITUTIONS,
AND SOVEREIGNS................................................................................................................ 9
DESCRIBE QUANTITATIVE MEASUREMENTS AND FACTORS OF CREDIT RISK, INCLUDING
PROBABILITY OF DEFAULT, LOSS GIVEN DEFAULT, EXPOSURE AT DEFAULT, EXPECTED LOSS,
AND TIME HORIZON............................................................................................................ 12
DESCRIBE AND COMPARE BANK FAILURE AND A BANK INSOLVENCY. ...................................... 13
Golin, Chapter 2: The Credit Analyst
DESCRIBE, COMPARE AND CONTRAST VARIOUS CREDIT ANALYST ROLES............................... 15
DESCRIBE COMMON TASKS PERFORMED BY A BANKING CREDIT ANALYST. ............................. 20
DESCRIBE THE QUANTITATIVE, QUALITATIVE, AND RESEARCH SKILLS A BANKING CREDIT
ANALYST IS EXPECTED TO HAVE. ........................................................................................ 22
DESCRIBE THE VARIOUS SOURCES OF INFORMATION USED BY A CREDIT ANALYST. ................ 25

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Golin, Chapter 1: The Credit Decision

Define credit risk and explain how it arises using examples.

Explain the components of credit risk evaluation.

Describe, compare and contrast various credit risk mitigants and their role in credit
analysis.

Compare and contrast quantitative and qualitative techniques of credit risk

evaluation.

Compare the credit analysis of consumers, corporations, financial institutions, and

sovereigns.

Describe quantitative measurements and factors of credit risk, including probability of

default, loss given default, exposure at default, expected loss, and time horizon,

Compare bank failure and a bank insolvency.

Define credit risk and explain how it arises using examples.

For purposes of practical analysis, credit risk may be defined as the risk of monetary
loss arising from any of the following four circumstances:
1. The default of a counterparty on a fundamental financial obligation.
2. An increased probability of default on a fundamental financial obligation.
3. A higher than expected loss severity arising from either a lower than expected
recovery or higher than expected exposure at the time of default.
4. The default of a counterparty with respect to the payment of funds for goods or
services that have already been advanced (settlement risk).
The variables most directly affecting relative credit risk include:
1. The capacity and willingness of the obligor (borrower, counterparty, issuer, etc.) to
meet its obligations
2. The external environment (operating conditions, country risk, business climate, etc.)
insofar as it affects the probability of default, loss severity, or exposure at default
3. The characteristics of the relevant credit instrument (product, facility, issue, debt
security, loan, etc.)
4. The quality and sufficiency of any credit risk mitigants (collateral, guarantees, credit
enhancements, etc.) utilized
Credit risk is also influenced by
 The length of time over which exposure exists.
 At the portfolio level,
o Correlations among particular assets and
o Level of concentration of particular assets.

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Explain the components of credit risk evaluation.

As a practice, credit risk evaluation is a process of asking questions about four
variables:
 Obligor’s Capacity and Willingness to Repay
 External environment
 Attributes of Obligation (Characteristics of the relevant credit instrument)
 Quality of any credit risk mitigants

The Obligor’s Capacity and Willingness to Repay (suggestive inquiry)

 What is the capacity of the obligor to service its financial obligations?
 How likely will it be to fulfill that obligation through maturity?
 What is the type of obligor and usual credit risk characteristics associated with its
business niche?
 What is the impact of the obligor’s corporate structure, critical ownership, or other
relationships and policy obligations upon its credit profile?
Willingness to pay is difficult to assess. Ultimately, judgments about this attribute, and
the criteria on which they are based, are highly subjective in nature.

Willingness to Repay: Character and Reputation

First-hand awareness of a prospective borrower’s character affords a stepping-stone on
which to base a credit decision. Where direct familiarity is lacking, a sense of the borrower’s
reputation provides alternative footing upon which to ascertain the obligor’s disposition to
make good on a promise. Reliance on reputation can be perilous, however, since a
dependence upon second-hand information can easily descend into so-called name lending.
Name lending can be defined as the practice of lending to customers based on their
perceived status within the business community instead of on the basis of facts and sound
conclusions derived from a rigorous analysis of the prospective borrowers’ actual capacity to
service additional debt.

Willingness to Repay: Credit Record

Assessing a borrower’s integrity and commitment to perform an obligation requires making
unverifiable, even intuitive, judgments. Rather than put a foot wrong into a miasma of
imponderables, creditors have long taken a degree of comfort not only in collateral and
guarantees, but also in a borrower’s verifiable history of meeting its obligations.

As compared with the prospective borrower who remains an unknown quantity, a track
record of borrowing funds and repaying them suggests that the same pattern of repayment
will continue in the future. If available, a borrower’s payment record, provided for example
through a credit bureau, can be an invaluable resource for a creditor. Of course, while the
past provides some reassurance of future willingness to pay, here as elsewhere, it cannot be
extrapolated into the future with certainty in any individual case.

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The External Conditions (suggesting inquiry)

 How do country risk (sovereign risk) and operations conditions, including systematic
risk, impinge upon the credit risk to which the obligee is exposed?
 What cyclical or secular changes are likely to affect the level of that risk? The
obligation (product): What are its credit characteristics?

The Attributes of Obligation from Which Credit Risk Arises (suggestive inquiry)
 What are the inherent risk characteristics of that obligation? Aside from general legal
risk in the relevant jurisdiction, is the obligation subject to any legal risk specific to
that product?
 What is the tenor (maturity) of the product?
 Is the obligation secured; i.e., are credit risk mitigants embedded in the product?
 What priority (e.g., senior, subordinated, unsecured) is assigned to the creditor
(obligee)?
 How do specific covenants and terms benefit each party thereby increasing or
decreasing the credit risk to which the obligee is exposed? For example, are there
any call provisions allowing the obligor to repay the obligation early; does the obligee
have any right to convert the obligation to another form of security?
 What is the currency in which the obligation is denominated?
 Is there any associated contingent/derivative risk to which either party is subject?

The Credit Risk Mitigants

 Are any credit risk mitigants – such as collateral – utilized in the existing obligation or
contemplated transaction? If so, how do they impact credit risk?
 If there is a secondary obligor, what is its credit risk?
 Has an evaluation of the strength of the credit risk mitigation been undertaken?

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Describe, compare and contrast various credit risk mitigants and

their role in credit analysis.

Collateral

Collateral refers to assets that are deposited with a lender, assigned to the lender pending
full repayment of the funds borrowed, or to assets with respect to which the lender has the
right to obtain title and possession in satisfaction of the financial obligation. The lender who
receives collateral and complies with the applicable legal requirements becomes a secured
creditor, possessing specified legal rights to designated assets in case the borrower is
unable to repay its obligation. If the borrower defaults, the lender may be able to seize the
collateral through foreclosure and sell it to satisfy outstanding obligations. Both secured and
unsecured creditors may force the delinquent borrower into bankruptcy. The secured creditor
benefits from the right to sell the collateral without initiating bankruptcy proceedings, and
stands in a better position than unsecured creditors once such proceedings have begun.

Since collateral may be sold on the default of the borrower (the obligor), it provides security
to the lender (the obligee). The prospective loss of collateral gives the obligor an incentive
to repay its obligation. In this way, the use of collateral lowers the probability of default, and
reduces the severity of the creditor’s loss by providing the creditor with full or partial
compensation for the loss that would otherwise be incurred. Collateral tends to reduce, or
mitigate, the credit risk to which the lender is exposed. Since the amount advanced is
known, and because collateral can be appraised with some accuracy, the credit decision is
simplified.

Guarantees

A guarantee is the promise by a third party to accept liability for the debts of another in the
event that the primary obligor defaults. The use of a guarantee does not eliminate the need
for credit analysis, but simplifies it by making the guarantor instead of the borrower the
object of analysis.

The guarantor will be an entity that either possesses greater creditworthiness than the
primary obligor, or has a comparable level of creditworthiness but is easier to analyze. There
will be some relationship between the guarantor and the party on whose behalf the
guarantee is provided. Where a guarantee is provided, the questions posed with reference to
the prospective borrower must be asked again in respect of the prospective guarantor: “Will
the prospective guarantor be both willing to repay the obligation and have the capacity to
repay it?” These questions are summarized in Exhibit 1.1.

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EXHIBIT 1.1 Key Credit Questions

Binary (Yes/No) Probability

Willingness to Pay Primary subject of Will the prospective What is the
analysis (e.g. buyer be willing to likelihood that a
borrower) repay the funds? borrower will
perform its financial
obligations in
Will the prospective accordance with
Capacity to Pay borrower be able to their terms?
repay the funds
Collateral Secondary subject Will the collateral What is the
of analysis (credit provided by the likelihood that the
risk mitigants) prospective collateral provided
borrower or the by the prospective
guarantees given by borrower or the
a third party be guarantees given by
sufficient to secure a third party will be
repayment? sufficient to secure
repayment?

Guarantees Will the prospective What is the

guarantor be willing likelihood that the
to repay the prospective
obligation as well as guarantor will be
have the capacity to willing to repay the
repay it? obligation as well as
have the capacity to
repay it?

In view of the benefits of using collateral and guarantees to avoid the task of performing an
effective financial analysis, banks and other institutional lenders have placed primary
emphasis on these credit risk mitigants, and other comparable mechanisms such as joint
and several liability when allocating credit. For this reason, secured lending, which refers to
the use of credit risk mitigants to secure a financial obligation, remains a favored method of
providing financing.

In countries where financial disclosure is poor or the requisite analytical skills are lacking,
credit risk mitigants avoid the difficulties involved in performing an effective credit evaluation.
In developed markets, more sophisticated approaches to secured lending such as repo
finance and securities lending have become popular. In these markets, however, the use of
credit risk mitigants is often driven by the need to facilitate investment transactions or to
structure credit risks to meet the needs of the parties to the transaction rather than to avoid
the process of credit analysis.

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Compare and contrast quantitative and qualitative techniques of

credit risk evaluation.

Willingness to pay (subjective) and capacity to pay (quantitative)

The evaluation of willingness to pay tends to be associated with qualitative (including
subjective) techniques. However, ultimately judgments about willingness, and the criteria on
which they are based, “are highly subjective in nature,” says Golin.

In contrast to willingness, the evaluation of capacity to pay lends itself more readily to
quantitative measurement. So the application of financial analysis will go far in revealing
whether the borrower will have the ability to fulfill outstanding obligations as they come due.

The Limitations of Quantitative Methods

While an essential element of credit evaluation, the use of financial analysis is subject
to serious limitations including:
 Historical character of financial data.
o Financial statements are historical in scope and never entirely up to date.
Because the past cannot be extrapolated into the future with any certainty, except
perhaps in cases of clear insolvency and illiquidity, the estimation of capacity
remains just that: an estimate.
 Difficulty of making accurate financial projections based upon such data.
o Even if reports are comparatively recent, the preceding difficulty is not
surmounted. Accurate financial forecasting is problematic, and financial
projections are vulnerable to errors and distortion. Small differences at the outset
can produce an enormous range of values over time.
 The inevitable gap between financial reporting and financial reality.
o Financial reporting is an imperfect attempt to map an underlying economic reality
to a usable but highly abbreviated condensed report. Some degree of distortion is
unavoidable due to at least three reasons:
1. The rules of financial accounting and reporting are shaped by people and
institutions having different perspectives and interests. Influences resulting
from that difference are apt to aggravate these deficiencies. The rules are
almost always the product of compromises by committee that are political in
nature.
2. The difficult of making rules to cover every possible situation means that
companies are frequently afforded a great deal of discretion in determining
how various accounting items are treated. At best, such leeway may
potentially result in inaccurate comparisons; at worst, this necessary flexibility
in interpretation and classification may be used to further deception or fraud.
3. Even the most accurate financial statements must be interpreted. Differing
vantage points, experience, and analytical skill levels may result in a range of
conclusions from the same data. It should be apparent that even the
seemingly objective evaluation of financial capacity retains a significant
qualitative, and therefore subjective, component. Financial analysis remains
at the core of the effective credit analysis.

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Quantitative and Qualitative Elements

 The softer more qualitative aspects of the analytical process should not be given
short shrift. An evaluation of management—including its competence, motivation and
incentives—as well as the plausibility and coherence of its strategy remains an
important element of credit analysis of both nonfinancial and financial companies.
 Not only is credit analysis both quantitative and qualitative in nature, but nearly all of
its nominally quantitative aspects also have a significant qualitative element.
 The best credit analysis is a synthesis of quantitative measures and qualitative
judgments. To reach optimal effectiveness, credit analysis must therefore combine
the effective use of quantitative tools with sound qualitative judgments.

Compare the credit analysis of consumers, corporations, financial

institutions, and sovereigns.
Credit analysis can be divided into four areas according to the type of borrower and
the corresponding credit analysis:

Type of borrower Corresponding credit analysis

Consumers Consumer credit analysis is the evaluation of the
creditworthiness of individual consumers
Nonfinancial companies Corporate credit analysis is the evaluation of
(corporates) nonfinancial companies such as manufacturers, and
nonfinancial service providers.
Financial companies (banks Financial institution credit analysis is the evaluation of
are the most common) and financial companies including banks and nonbank
financial institutions (NBFIs), such as insurance
companies and investment funds.
Government and government- Sovereign/municipal credit analysis is the evaluation of
related entities the credit risk associated with the financial obligations
of nations, subnational governments, and public
authorities, as well as the impact of such risks on
obligations of non-state entities operating in specific
jurisdictions.

Consumer credit analysis is the evaluation of the creditworthiness of individual

consumers.
 The comparatively small amounts at risk to individual consumers, broad similarities in
the relative structure of their financial statements, the large number of transactions
involved, and accompanying availability of data allow consumer credit analysis to be
substantially automated through the use of credit-scoring models.

Case Study: Individual Credit Analysis

Net worth is an individual’s surplus of assets over debt. Consider a hypothetical 33-year-old
woman named Chloe Williams, who owns a small house on the outskirts of a medium-sized
city, Oakport, worth $140,000. There is a remaining mortgage on the house of $100,000 and
Chloe has $10,000 in savings in the form of bank deposits and mutual funds, and no other
debts.

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Chloe’s Assets $ Chloe’s Obligations $ Remarks

and Equity

2-bedroom house at
128 Bayview Drive,
Current market value
Chloe’s House Liabilities—mortgage $140,000
owed to bank (Chloe’s
Portion of house value A single major liability—
mortgage on her
STILL owned to bank the funds she owes to
100,000 house: financial
the bank which is an
obligation to bank) 100,000 obligation secured by
Portion of house value her house.
NOT owned by bank –
relatively illiquid 40,000 Home Equity—
unrealized if she sells
the house 40,000
Cash and Securities
Owns in full without Chloe’s Net Worth =
Equity in securities—
margin loans – liquid $50,000
10,000 unrealized unless she
assets sells them
150,000 10,000
150,000

Leaving aside the value of Chloe’s personal property—clothes, jewelry, stereo, computer,
motor scooter, for instance—she would have a net worth of $50,000. Chloe’s salary is
$36,000 per annum after tax. Since her salary is paid in equal and regular installments in
arrears (at the end of the relevant period) on the fifteenth and the last day of each month, we
can equate her after-tax income with cash flow. Leaving aside nominal interest and dividend
income, her total monthly cash flow would be $3,000 per month.

Exhibit 1.4

Annual ($) Monthly ($)

Chloe’s after-tax income 36,000 3,000
Less: salary applied to (26,000) (2,167)
living costs and mortgage
payment
Net cash flow available to 10,000 833
service debt

Net cash flow is what remains after taking account of Chloe’s other outgoings: utilities,
groceries, mortgage payments and so on. To analyze Chloe’s capacity to repay additional
obligation, it is reasonable to consider her net worth and income, together with her net cash
flow, her track record in meeting obligations, and her level of job security, among other
things. That Chloe has an impeccable credit record, has been with her company for six
years, with a steadily increasing salary and significant net worth would typically be viewed by
a bank manager as credit positive.

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Corporate (nonfinancial) credit analysis is the evaluation of nonfinancial companies

such as manufacturers, and nonfinancial service providers. The process of evaluating
the capacity of a firm to meet its financial obligations. Enterprises vary in the character of
their assets, the regularity of their income stream and the degree to which they are subject to
demands for cash. Also, the financial structure of firms is more complex than it is for
individuals. The amount of funds at stake is higher for companies than it is for consumers.
Consequently, the credit analysis of nonfinancial companies tends to be more detailed and
more hands-on than consumer credit analysis. It is customary and helpful to divide the credit
analysis of organizations according to the attributes to be analyzed.

As a rule, the analyst will be particularly concerned with the following criteria and this
will be reflected in the written report that sets forth the conclusions reached:
 The company’s liquidity
 Its cash flow together with
 Its near-term earnings capacity and profitability
 Its solvency or capital position.
Each of these attributes is also relevant to the analysis of financial companies.

Financial institution credit analysis is the evaluation of financial companies including

banks and nonbank financial institutions (NBFIs), such as insurance companies and
investment funds. The attributes of liquidity, solvency and historical performance are all
relevant to financial institutions. As with corporate credit analysis, the quality of
management, the state of the economy, and the industry environment are vital factors in
evaluating financial company creditworthiness.
The key areas that a credit analyst will focus on in evaluating a bank include:
 Earnings capacity—the bank’s performance over time, particularly its ability to
generate operating income and net income on a sustained basis and thereby
overcome any difficulties it may confront.
 Liquidity—the bank’s access to cash or cash equivalents to meet current
obligations.
 Capital adequacy (a term frequently used in the context of financial institutions that
is essentially equivalent to solvency)—that is, the cushion that the bank’s capital
affords it against its liabilities to depositors and the bank’s creditors.
 Asset quality—the likelihood that the loans the bank has extended to its customers
will be repaid, taking into account the value and enforceability of collateral provided
by them.
The two differences in criteria applied to corporate credit analysis and credit analysis are:
 The importance of asset quality.
 The omission of cash flow as a key indicator

Sovereign/municipal credit analysis is the evaluation of the credit risk associated with the
financial obligations of nations, subnational governments, and publish authorities, as well as,
the impact of such risks on obligations of non-state entities operating in specific jurisdictions.

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Describe quantitative measurements and factors of credit risk,

including probability of default, loss given default, exposure at
default, expected loss, and time horizon.

Probability of Default
Probability of default (PD), while highly relevant to the question what constitutes a “good
credit” and what identifies a bad one, is not the creditor’s only, or in some cases even her
central concern.
 A default could occur, but should a borrower through its earnest efforts rectify matters
promptly and resume performance without further breach of the lending agreement,
the lender would be made whole and suffer little harm.
 Non-payment for a brief period could cause the lender severe consequential liquidity
problems, should it have been relying on payment to satisfy its own financial
obligations, but otherwise the tangible harm would be negligible.

Loss Given Default

In addition to the probability of default, the creditor is equally concerned with the severity of
the default that might be incurred. It is easier to comprehend retrospectively.
 Was it a brief, although material default that was immediately corrected so that the
creditor obtained all the expected benefits of the transaction? Or was it the type of
default in which payment ceases and no further revenue is ever seen by the creditor,
resulting in substantial loss as a result of the transaction? All other things being
equal, it is the expectation of the latter that most worries the lender.
 The probability of default and the severity of the loss resulting in the event of default
are crucial in determining the tangible expected loss to the creditor. The loss given
default (LGD) captures the likely percentage impact, under default, on the creditor’s
exposure.

Exposure at Default
The third variable that must be considered is exposure at default (EAD). EAD may be
expressed either in percentage of the nominal amount of the loan or in absolute terms.

Expected Loss
The three variables—PD, LGD and EAD—when multiplied, give us expected loss for a
given time horizon. All three variables are easy to calculate after the fact. Examining its
entire portfolio over a one-year period, a bank may determine that the PD, adjusted for the
size of the exposure, was 5%, its historical LGD was 70%, and EAD was 80% of the
potential exposure. Leaving out asset correlations within the loan portfolio and other
complexities, expected loss (EL) is simply the product of PD, LGD and EAD. EL and its
constituents are more difficult to estimate in advance, although past experience may provide
some guidance.

The Time Horizon

 All the foregoing factors are time dependent. The longer the tenor of the loan, the
more likely it is that a default will occur. EAD and LGD will change with time, the
former increasing as the loan is fully drawn, and decreasing as it is gradually repaid.
LGD can change over time, depending on the specific terms of the loan. The nature
of the change depends upon the specific terms and structure of the obligation.

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Describe and compare bank failure and a bank insolvency.

While bank credit analysis resembles corporate credit analysis in many respects, it
differs in several ways. The most crucial difference is that modern banks, in sharp
contrast to nonfinancial firms, do not fail in normal times. Weak banks are conveniently
merged into other banks. Most bank analysts will acknowledge the declaration as valid,
when applied to the more prominent and internationally active institutions that are the subject
of the vast majority of credit analyses.

Granted, the present time, in the midst of a substantial financial crisis, does not qualify as
normal time.
 In each of 2009 and 2010, roughly 2 percent of U.S. banks failed, and in 2011, so did
roughly 1.2% of them.
 The rate of failure between 1935 and 1940 was about 0.5% per year, and it remained
below 0.1% per year in the 20 years after World War II.
 Between 2001 and 2008, only 50 banks failed in the United States—half of them in
2008 alone, but that left the overall ratio of that period below 0.1% per year.
 In the United States alone, other data show that the volume of failures of publicly
traded companies numbered in the thousands, with total business bankruptcies in the
millions.
The universe of banks is much smaller than that of nonfinancial companies, but other data
confirms that bank collapses are substantially less probable than those nonfinancial
enterprises. This is not to say that banks never fail. It is evident the economic history of
the past several centuries is littered with the invisible detritus of many long-forgotten banks.

Small local and provincial banks, as well as—mostly in emerging markets—sometimes

larger institutions are routinely closed by regulators, or merged or liquidated, or taken over
by other healthier institutions, without creating systemic waves.

The proportion of larger banks going into trouble has dramatically increased in the
past few years, particularly in the UK and in the United States, but also in Europe. The
notion of too big to fail has always been accepted in context of each separate market. In
November 2011, that notion was extended to include a systemic risk of contagion, with the
publication by the Financial Stability Board (FSB) of a list of 20 “systemically important
financial institutions” which would be required to hold “additional loss absorption capacity
tailored to the impact of their possible default.

The notion of “too small to fail” also exists since it is cheaper and more expedient for
governments to arrange the quiet absorption of a small bank in trouble. A wide danger zone
remains in between those two zones.

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Bank Insolvency Is Not Bank Failure

The proposition that banks do not fail is meant to illustrate a general rule. There is no intent
to convey the notion that banks do not become bankrupt, for especially with regard to banks
(as opposed to ordinary corporations) insolvency and failure are two distinct events.

Bank insolvency is more common, even in the twenty-first century than many readers are
likely to expect. Insolvent banks can keep going on and on like a notorious advertising icon
so long as they have a source of liquidity, such as a central bank as a lender of last resort.
 The bankruptcy or collapse of a major commercial banking institution that actually
results in a significant loss to depositors or creditors is an extremely rare event. Or at
least it did remain so until the crisis that started in 2008.
 For the vast majority of institutions that a bank credit analyst is likely to review, a
failure if highly improbable.
 Because banks are so highly leveraged, these risks and the risks that episodes of
distress that fall short of failure and may potentially cause harm to investors and
counterparties, are of such magnitude that they cannot be ignored.

Why Bother Performing a Credit Evaluation?

If major bank failures are so rare, why bother performing a credit evaluation? There
are several reasons:
1. First, evaluating the default risk of an exposure to a particular institution enables the
counterparty credit analyst working for a bank to place the risk on a rating scale,
which helps in pricing that risk and allocating bank capital.
2. Second, even though the risk of default is low, the possibility is a worrisome one to
those with credit exposure to such an institution. Consequently, entities with such
exposure, including nonfinancial and nonbank financial organizations, as well as
investors, both institutional and individuals, have an interest in avoiding default-prone
institutions.
3. Third, it is not only outright failure that is of concern, but also events short of default
can cause harm to counterparties and investors.
4. Fourth, globalization has increased the risk of systemic contagion. As a result, the
risk on a bank has become twice-remote risk—or in fact a risk compounded many
times—on that bank’s own risk on other financial institutions with their own risk
profile.

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Golin, Chapter 2: The Credit Analyst

Describe, compare and contrast various credit analyst roles.

Describe common tasks performed by a banking credit analyst.

Describe the quantitative, qualitative, and research skills a banking credit analyst is
expected to have.

Describe the various sources of information used by a credit analyst.

Describe, compare and contrast various credit analyst roles.

The role of most credit analysts is to facilitate risk management whether at the level of
the individual firm or at the level of national policy. Although all credit analysts perform
work that is somewhat similar with respect to broad objectives, the specifics of each
analytical role may vary a great deal. The sort of risk management with which a credit
analyst is concerned is credit risk management. A key distinction is between the majority of
credit analysts who are engaged in credit risk management, and fixed-income analysts who
are involved in investment selection.

Within the private sector, the main responsibility of credit analysts operating in a risk
management capacity is to:
 Research prospective customer and counterparties
 Prepare credit reports for internal use;
 To make recommendations concerning transactions and risk limits; and
 To generally facilitate the risk management of the organization as a whole.
Within the public sector, bank examiners are employed by agencies that regulate financial
institutions. As part of their supervisory function, they undertake independent reviews of
specific institutions, typically from a credit perspective.

Rating agency analysts evaluate issuers, counterparties, and debt issues from a similar
perspective. Their mission is to provide unbiased analysis as the basis upon which to assign
ratings to issuers or counterparties, as well as to specific debt issues or classes of debt
issues, when required. These ratings are used to facilitate both risk management and
investment selection.

Credit analysts involved in investment selection represent a smaller portion of the field.
Most credit analysts that perform this function can be classified as fixed-income analysts.
In analyzing a fixed-income security, the risk of default is always an underlying condition.
 Equity analysts implicitly take account of credit concerns, and do address those
concerns explicitly in investment reports.
 For both the fixed-income analyst and the equity analyst, the main objective is to
reach a conclusion as to whether a particular investment will generate the expected
return and whether it is more apt to exceed expectations or fall short of them.
 Within a financial institution the functions of risk management and investment
selection are largely separate domains.

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Credit analysis can be categorized (into four fields) by the type of entity analyzed:
1. Consumer
2. Corporate
3. Financial institution
4. Sovereign/municipal (subnational)

1. Consumer Credit Analysis

 The consumer credit analysis only rarely engages in intensive examination of an
individual’s financial condition.
 Because case-by-case intensive analysis of individuals for personal lending purposes
is seldom cost-effective, most consumer credit analysis is highly mechanized through
the use of scoring models and similar techniques.
 Unless concerned with modeling, systems development, or collateral appraisal,
consumer credit roles often tend to be broadly clerical in nature.

2. Corporate Credit Analysis

Corporate credit analysts evaluate the risk of nonfinancial companies, such as industrial
enterprises, trading firms, and service providers, generally for purposes of either lending to
such organizations, holding their securities, or providing goods or services to them.
 Corporate credit analysis tends to not only be more specialized by industry, but also
more oriented toward specific transactions as opposed to the establishment of
continuing relationships.
 The largest of the three main areas in which analyst-driven research is performed,
corporate credit is also the most diverse, ranging considerably in terms of the
industrial and service sectors, products, scale and the geographical regions of the
firms that are the targets of evaluation.
 While corporate credit analysis itself is an area of practice, within the field as a whole
analysts frequently concentrate on particular industry sectors such as retailing, oil
and gas, utilities, or media, applying sector-specific metrics to aid in their assessment
of credit risk.

Corporates can often be broadly classified into one of the following sectors:

 Transportation and vehicle manufacture  Property

 Paper and forest products  Telecom/media
 Natural resources (excluding forest products)  Utilities
 Chemicals  Sovereigns
 Energy

Since cash flow analysis is especially critical in evaluating corporate credit risk and the
analyst is likely to assess the creditworthiness of firms in more than one industry, accounting
skills perhaps take on somewhat greater importance in the corporate credit realm than in
respect to financial institutions.

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3. Bank and Financial Institution Analysts

The objective of bank and financial institution analysts is to assess the creditworthiness of
financial intermediaries. This function will only be infrequently performed for the purpose of
making conventional lending decisions.
 The analysis of a particular bank is generally undertaken either in contemplation of
entering into one or more usually multiple bilateral transactions with the bank as a
counterparty.
 Banks and other financial institutions can also be assessed with reference to and as
a part of an analysis of debt instruments or securities issued by such institutions.

Counterparty Credit Analyst

 The term counterparty refers to a financial institution’s opposite number in a bilateral
financial contract.
 Credit risk that arises from such transactions is called counterparty (credit) risk.
 The bank and financial institutions analysts whose role is to evaluate the credit risk
associated with the transaction are called counterparty credit analysts.
 The focus of counterparty credit analysts is on the potential credit risks that result
from transactions, including settlement risk.
 Counterparty credit analysts may also have responsibility for setting exposure limits
to individual institutions or countries, or participate in the process of making a
decision as to whether to extend credit or not.
 Because the vast majority of financial transactions involve banks or other financial
institutions on at least one side of the deal, counterparty credit analysts are generally
employed mainly by such organizations.

The majority of counterparty transactions involve the following product categories:

 Financing or obtaining funding directly through the interbank market on a senior
unsecured basis
 Financing or obtaining funding through repurchase (repo) / reverse repurchase
(reverse repo) transactions
 Financing or obtaining funding through the lending or borrowing of securities
 Factoring, forfeiting, and similar types of receivables finance
 Holding or trading of debt securities of banks and other financial companies for
trading or investment purposes
 Foreign exchange (FX or forex) dealing, including the purchase or sale of FX options
and forwards
 Arranging or participating in other derivative transactions including interest rate
swaps, foreign-exchange swaps, and credit derivatives
 Holding or participating in securitizations or structured finance that gives rise to
counterparty credit risk
 Correspondent banking services, including trade finance effected through
documentary letters of credit
 Custodial and settlement services

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4. Sovereign/Municipal Credit Analysis

Governments throughout the world borrow funds through the issue of fixed-income
securities in local and international markets. Sovereign risk analysts are employed to
assess the risk of default on such obligations.
 Sovereign analysis is relevant not just to profiling the risk associated with
government debt issues. It also provides the context for evaluating credit risk in
respect to other exposures.
 Sovereign appraise the broader risks arising from cross-border transactions as well
as from transactions directly with a nation, its subnational units or governmental
agencies.

Sovereign Risk and Bank Credit Risk

Sovereign risk and bank credit risk are closely linked, and each affects the other. The
strength of a nation’s financial system affects its sovereign risk and vice versa. The level of
country or sovereign risk associated with a particular market is a significant input in the credit
analysis of banks located in that market.

As part of the process of forming a view about the impact of the local operating environment
on a particular banking industry, many bank analysts engage in a modicum of sovereign risk
analysis while also relying upon the sovereign risk ratings and accompanying analyses
published by the rating agencies or from internal divisions responsible for in-house
assessments of sovereign risk.

Sovereign risk has two distinct but related aspects:

 One is the evaluation of a sovereign entity as a debt issuer as well as the evaluation
of specific securities issued by a sovereign nation, or by subnational entities within
that nation.
 The other is the evaluation of the operating environment within a country insofar as it
affects the banking system.
While sovereign risk is in itself relevant to the analytical process, bank credit analysts are
particularly interested in the systemic risk associated with a given banking industry. Systemic
risk refers to the degree to which a banking system is vulnerable to collapse, and
conversely, to the strength and stability (or conversely the fragility) of the banking sector as a
whole. Exhibit 2.1 depicts the universe of credit analysis in a graphic format.

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Credit analysis can be categorized by the employer type. A bank credit analyst generally
works in one of four primary types of organizations:
1. Banks and related financial institutions
2. Institutional investors, including pension funds and insurance firms
3. Rating agencies
4. Government agencies

1 and 2. Banks, NBFI’s, and Institutional Investors

Banks constitute the largest single category of financial institutions, and they are the largest
employer of credit analysts. Aside from banks, nonbank financial institutions (NBFI’s) are
also significant users of this skill set.

A major subcategory of NBFI’s is comprised of investment management organizations. As

discrete organizations, mutual funds, unit trusts and hedge funds fall within this grouping.

3. Rating Agencies
Rating agency analysts are credit analysts who work for rating agencies to evaluate
creditworthiness of banks, corporations, and governments.

The three major global agencies are Moody’s Investor Services, Standard & Poor’s
Rating Services, and Fitch Ratings. In addition, local rating agencies in various countries
may play a big role in connection with domestic debt markets.

The three-step purpose of a rating agency analyst performing a credit evaluation for
the first time will be to:
1. Undertake an overall assessment of the credit risks associated with the issuer
2. Evaluate the features of any securities being issued in respect to their impact on
credit risk
3. Make a recommendation concerning an appropriate credit rating to be assigned to
each

4. Government Agencies
Governments function both as policy makers and regulators on the one hand, and as market
participants on the other, issuing debt or investing through government-owned organizations.
Government bank and insurance examiners are essentially credit analysts who function in a
regulatory capacity, assessing the riskiness of a bank or insurance company to determine
the institution’s soundness and its eligibility to continue to do business.

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A Special Case: The Structured Finance Credit Analyst

Structured finance refers to the advance of funds secured by certain defined assets or
cash flows. The credit analysis of structured products is complex because the resulting
credit risk depends primarily on the manner in which such assets and cash flows are
assembled, and upon the forecasting of the probability of various contingencies that affect
the ownership of such assets and the amount and timing of the associated cash flows to
create a transaction framework.
 Although, in principle, structured finance methods resemble ordinary secured lending
backed by collateral, they are often considerably more complex, and the additional
security is typically provided in a considerably more sophisticated manner, either by
means of the transfer of assets to a special purpose vehicle (SPV) or synthetically,
for example, through the transfer of credit risk using credit derivatives.
 Instead of being based solely on the intrinsic creditworthiness of the issuer or
borrower, structured products analysis takes account of a large variety of other
criteria. In the wake of the global credit crisis of 2007-2010, demand for structured
products fell significantly. It can be expected that demand may resume, albeit not to
the same extent as previously nor the breadth of complex instruments as existed
before the crisis.

Describe common tasks performed by a banking credit analyst.

The Counterparty Credit Analyst

The counterparty credit analyst is concerned with evaluating banks and other financial
intermediaries as part of his or her own organization’s larger risk management function.
 Banks take on credit exposure in respect to other banks in a number of different
circumstances. With regard to trade finance, banks seek to cultivate correspondent
banking relationships globally in order to build up their capacity to offer their
importing and exporting customers’ trade finance services.
 In addition to the need of many banks to have international relationships with other
banks around the world, under normal market conditions, banks frequently lend to
and borrow from other banks. Such interbank lending serves to maintain a market for
liquid and loanable funds among participating banks to meet their liquidity needs.

Credit Analyst versus Credit Officer

The counterparty credit analyst’s research efforts are undertaken with the objective of
reaching conclusions and recommendations that will influence business decisions. This often
takes the form of a recommendation that a particular internal rating be assigned to the
institution just analyzed. The context for such recommendation may be an annual review or
a specific proposal for business dealings with the subject institution.
 The scope of analytical responsibility varies from bank to bank. At some institutions,
the roles are entirely separate.
o The credit analyst’s responsibility may be limited to analyzing a set of
counterparties, but might not extend to making credit decisions, or undertaking
the related work of recommending credit limits and making presentations to the
credit committee. Instead, this function might be the sole responsibility of the
credit officer. At other banks, these roles might be more closely integrated. The
credit officer may also perform relevant credit analysis or reviews, and prepare
applications for new credit limits or for annual reviews of existing limits.
The term credit officer implies a greater degree of executive authority than that associated
with the term analyst, which tends to connote an advisory rather than an executive function.

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At the executive level, the principal objectives of the counterparty credit risk team are:
 To implement the institution’s credit risk management policy with respect to financial
counterparties by subjecting them to a periodic internal credit review, and with the
aim of establishing prudent credit limits with respect to each counterparty.
 To evaluate applications for proposed transactions, recommending approval,
disapproval, or modification of such applications, and seeing the process through to
its financial disposition.
As a practical matter, the relevant decision-making responsibility customarily extends
to:
 Authorizing the allocation of credit limits within a financial institution’s group or among
various product lines.
 The approval of credit risk mitigants including guarantees, collateral, and relevant
contractual provisions, such as break clauses.
 The approval of excesses over permitted credit limits, or the making of exceptions to
customary credit policy.
 Coordination with the bank’s legal department concerning documentation of
transactions in order to optimize protection for the bank within market conventions.

Product Knowledge
The objective of the credit risk management framework within which counterparty
credit analysis takes place is to optimize return on risk-adjusted capital. The myriad of
financial products that a bank offers to its customers, together with the various trading and
investment positions it takes in the operation of its business, engender a multitude of specific
credit exposures.

Exhibit 2.2: Selected Financial Products

Simple Financial Products More Complex Financial Products

Term loans Mortgage-backed securities
Documentary letters of credit Asset-backed securities
Money market investments/ obligations Credit default swaps
Investments in bonds/ bond issues Structured investment facilities
Spot transactions Structured liquidity facilities
Interest rate swaps Weather derivatives

Bank go beyond a “rating exercise” to make decisions concerning specific limits on exposure
and the approval or disapproval of proposed transactions, together with required
modifications if not approved in full. Such decisions cannot be made without product
knowledge, which refers to the in-depth understanding of the characteristics of a broad
range of financial products.

These characteristics include:

 The impact of the proposed transaction on the borrower’s financials
 The features of the obligation or product and its risk attributes
 The amount and type of credit risk mitigation
 Any covenant agreed to by the borrower

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The Fixed-Income Credit Analyst

Credit analysts may function not only as risk analysts, assessing and managing risk,
but also as investment analysts assisting in the selection of investments. A small
proportion of these fixed-income analysts cover financial institutions. These analysts may
specialize in banks, or banks may just comprise a portion of their portfolio. Fixed-income
analysts make recommendations on whether to buy, sell or hold a fixed-income security
such as a bond.

The fixed-income analyst’s goal is to hep his or her institution make money by making
appropriate recommendations to traders and to clients. As part of this objective, the fixed-
income analsyst seeks to determine the value of any debt securities issued by the bank,
taking account of market perceptions, pricing, and the issue’s present and prospecitve
creditworthiness. This analysis is used to make recommendations to traders or investors to
help them decide whether to buys, sell or hold a given security.

Describe the quantitative, qualitative, and research skills a banking

credit analyst is expected to have.

Quantitative Analysis
The quantitative element of the credit assessment process involves the comparison
of financial indicators and ratios. For example, percentage rates of net profit growth, or, in
the case of a bank, its risk-weighted capital adequacy ratios. The juxtaposition of such
indicators allows the analyst to compare a company’s performance and financial condition
over time, and with similar companies in its industry.

The quantitative aspect of credit analysis is underpinned by ratio analysis.

Ratio analysis refers to the use of financial ratios (i.e. return on equity) to measure various
aspects of an enterprise’s financial attributes for the purpose of identifying rankings relative
to other entities of a similar character and discerning trends in the subject institution’s
financial performance or condition.
 Ratios are fractions or multiples in which the numerator and denominator each
represent some relevant attribute of the firm or its performance.
 The most useful financial ratios are those in which the relationship between such
attributes is such that the ratio created becomes in itself an important measure of
financial performance or condition.
o For Example: Return on equity (ROE) equals net income divided by
shareholders’ equity. ROE shows the relationship between funds placed at risk
by the shareholders and the returns generated from such funds, and for this
reason has emerged as a standard measure of a firm’s profitability.

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Qualitative Analysis
The qualitative element of credit analysis concerns those attributes that affect the
probability of default, but which cannot be directly reduced to numbers. The evaluation
of such attributes must be primarily a matter of judgment.
 For example: The competence of management is relevant to a firm’s future
performance. It is management that:
o Determines a firm’s performance targets;
o Plans how to reach these objectives while effectively managing the company’s
risks; and
o Is ultimately responsible for a company’s success or failure.
Ignoring such qualitative criteria handicaps the analyst in arriving at the most accurate
estimation of credit risk. Management competence should be considered in the process of
evaluating the firm’s creditworthiness. Taking it into account, however, is very much a
qualitative exercise.

The qualitative and quantitative aspects of credit analysis are summarized in Exhibit 2.3
below.

Exhibit 2.3: Quantitative and qualitative credit analysis

Quantitative Qualitative
The drawing of inferences from The drawing of inferences from criteria not
numerical data. Largely equivalent to necessarily in numerical form. Nominally
ratio analysis. Nominally objective. subjective.

Requires criteria to be reducible to Relies heavily on analyst’s perceptions,

figures. More amenable to statistical experience, judgment, reasoning, and intuition.
techniques and automation.
Pros Cons Pros Cons
Good starting Ignores assumptions Holistic approach Making the relevant
point for and choices that that does not ignore distinctions may be
analytical underpin the figures what cannot be difficult—more labor-
process easily quantified intensive than quantitative
analysis
Permits use of Numbers may often Takes account of Works best when analyst
various only approximate human judgment— is highly skilled and
quantitative economic reality does it pass the experienced so requires
techniques leading to erroneous sniff test? more training and
conclusions judgment
Shows Ratios may not be Potentially allows May encourage
correlations answering the financial inconsistency in ratings
explicitly relevant questions vulnerabilities and owing to differing
ill-timed strategies individual views of the
to be identified as importance of different
early as possible factors
Facilitates Not all elements of
consistency in credit analysis can
evaluation be reduced to
numbers

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Intermingling of the Qualitative and Quantitative

Certain elements of credit analysis are inherently more qualitative in nature while other are
more quantitative, as seen in Exhibit 2.4.

Exhibit 2.4: Quantitative-Qualitative Matrix

Emphasized
Method of evaluation
Element Evaluation mode Mainly affects
Obligor Capacity Financial analysis Quantitative PD
Willingness Reputation, track Qualitative
record
Conditions Country/systemic Mix All
risk analysis
Obligation Product analysis Qualitative
characteristics
Collateral Appraisal (for Mix LGD and EAD
(credit risk collateral) and
mitigants) characteristics of
obligation (if a
financial collateral);
capacity and
willingness (for
guarantor), etc.

Nearly all facets of credit analysis simultaneously include both quantitative and qualitative
elements.
 For example: A bank’s loan book can be evaluated quantitatively in terms of
nonperforming loan ratios, but a review of the character of a bank’s credit culture and
the efficacy of its credit review procedures is largely a qualitative exercise.

Those essentially qualitative elements of credit analysis, such as economic and industry
conditions are often amenable, to a greater or lesser degree, to quantitative measurement
through statistics such as GDP growth rates or levels of nonperforming loans.

Macro and Micro Analysis

In the process of bank analysis, the analyst must be aware of the risk environment of the
markets in which the bank is situated and in which it is operating, as well as the economic
and business conditions in the financial sector as a whole.
 To rank a bank’s comparative credit risk, the analyst needs to judge the bank he or
she is appraising with reference both to the bank’s own historical performance and to
its peers, while taking into account of operation conditions affecting players within
and outside of the financial industry.

 Exhibit 2.5 summarizes the principal micro- and macro-level criteria to be considered
in the analytical process.

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Exhibit 2.5: Micro and Macro level criteria

Micro level criteria Macro level criteria

Found at the individual bank level and Found in the operating environment; e.g.,
in relation to close peers, for example, market/sectoral trends, sovereign/systemic/legal
financial performance, financial and regulatory risk, economic and business
condition (liquidity, capital, etc), conditional, industry conditions, government
management competence support
Quantitative Qualitative Quantitative Qualitative
Comparing a Evaluation of bank Establishing Reviewing systematic risk
bank’s earning management, its correlations and impact of changes in
and profitability reputation and between financial the business
with its peers; business strategy variables such as environment—e.g., from
observing increasing sector new legislation
changes in loan growth and
bank’s capital NPL ratios
strength over
time
Projecting Judging the quality Noting changes in Assessing the likelihood
future changes of reported results industry profitability of government
in financial over time; intervention (support)
attributes forecasting future
changes
Shows Ratios may not be Potentially allows May encourage
correlations answering the financial inconsistency in ratings
explicitly relevant questions vulnerabilities and owing to differing
ill-timed strategies individual views of the
to be identified as importance of different
early as possible factors
Facilitates Not all elements of
consistency in credit analysis can
evaluation be reduced to
numbers

Peer Analysis
It is evident that a comprehensive bank credit analysis incorporates both quantitative and
qualitative reviews of the subject bank, and comparing it against its peers and with the
bank’s historical performance. The comparison with peers is called peer analysis, and the
comparison with historical performance is called trend analysis.

The comparison with peers is undertaken to establish how a bank rates in terms of financial
condition and overall creditworthiness among comparable institutions in the banking system.

Describe the various sources of information used by a credit

analyst.
While time available and depth of any accompanying written analysis may vary, the analyst’s
principal tool remains the same. It is evident in Exhibit 2.6 that the volume of resources
applied to each type of bank credit analysis will differ according to the analyst’s situation and
aims, as well as availability.

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Exhibit 2.6 Basic Source Materials for Bank Credit Analysis

Material Contents Remarks

Annual Income statement, balance sheet, and Accompanying web-based
Reports supplementary financial statements. analyst/investor presentations
These are generally, but not in all information. Financial data for a minimum
cases, available on the web. If not, of three years is recommended.
they are usually available by request.
Interim Interim financials are often limited to In some jurisdictions, interim statements
financial an unaudited balance sheet and will only be provided in a condensed or
statements income statement. rudimentary form with considerably less
detail than in the annual statements.
Financial A variety of electronic databases and Although it is always good practice to
data sources other search data services may be a consult the original financial statements,
part of the bank credit analyst’s kit. proprietary data services such as
Some key ones include Bankers’ Bankscope are widely employed.
Almanac, Bloomberg, and Bankscope. Financial data services provide the
Bankscope, in particular, is widely advantage of consistency in presentation
used by bank credit analysts. It but many not always be available in a
provides re-spread data and ratios timely fashion for all institutions required
drawn from bank end-year and interim to be evaluated. In addition, regulatory
financial statements. In addition, a agencies in various markets may provide
range of informational databases, data useful to the analyst. In the United
statistical data sources, credit States, the Securities and Exchange
modeling and pricing tools are also Commission’s EDGAR database is one,
available from various vendors. while the bank database maintained by
the Federal Reserve Bank is another.
New services News articles containing acquisitions, Newspaper and magazine clippings can
capital raising, changes in be helpful but are time consuming to
management, and regulatory collect; proprietary data services such as
developments are important to Factiva function as electronic clipping
consider in the analysis. Among the services can collect reams of news
most well-known providers of articles very quickly. Where there is no
proprietary news databases are access to such services, much of the
Bloomberg, Factiva, and LexisNexis. same information can be obtained free of
charge from the web.
Rating Reports from regulatory authorities, Counterparty credit analysts with
agency rating agencies and investment banks. necessarily rely to a great extent on
reports and Reports from the major rating rating agency reports when preparing
third-party agencies, Moody’s, S&P, and Fitch their own reviews. Fixed-income analysts
research Ratings, are invaluable sources of will engage in their own primary research
information to counterparty credit but compare their own findings with
analysts and fixed-income analysts. those of the agencies in seeking
investment opportunities.
Prospectuses Prospectuses and other information Documents prepared for investors often,
and offering prepared for the benefit of prospective as a matter of law or regulation, must
circulars investors may include more detailed enumerate potential risks to which the
company and market data than investment is subject. This can be quite
provided in the annual report. helpful to bank analysts. In many
jurisdictions, however, prospectuses are
not easily accessible or may not add
much new data.
Notes from For rating agency analysts, the bank Banks often prepare a packet of
the bank visit visit is likely to be supplemented by a information for rating agency analysts
and third questionnaire submitted by the agency reviewing or assigning a rating. In
parties and completed by the bank. Fixed- addition to information formally obtained
income analysts ordinarily will in the course of a bank visit, the analyst
frequently make bank visits. may also seek to obtain informal views
Counterparty credit analysts are likely about the bank from various sources.
to make such visits only occasionally.

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Primary Research
Fundamental to any bank credit analysis are:
 the annual financial statements, preferably audited and preferably available for the
past several years—three to five is the norm—accompanied by relevant annual
reports;
 recent interim statements;
 regulatory filings;
 prospectuses;
 offering circulars and other internal or public documents
Thorough primary research would encompass making a visit to the bank in question,
preferably to meet with senior management to gain a better understanding of the banks
operating methods, strategy, and the competence of its management and staff.

The Bank Visit

 Fixed-income analysts and equity analysts, will also frequently visit with bank
management. Often such meetings will take place collectively at analysts’ meetings
conducted by management. They usually coincide with the release of periodic
financial statements.
 Counterparty analysts tend to make bank visits less frequently. There are two
principal reasons:
1. In view of the larger universe of banks that counterparty credit analysts generally
cover, they will usually have comparatively little time available to make bank
visits.
2. Senior bank officers cannot afford to be continually meeting with the hundreds of
correspondent banks and other institutions with which they have a relationship.
Unless the transaction is an especially important one to the counterparty, the
analyst may be relegated to less senior staff, whole role it is to manage
correspondent and counterparty banking relationships.
 The bank visit is practically a prerequisite for the rating agency analyst. Where such
a due diligence visit is made, the rating agency analyst will almost invariably submit
written questions or a questionnaire to the bank, and visit management.
Best practice is for a team of at least two analysts to make a formal visit to the bank,
with the visit lasting the better part of a day or more. The exception to this procedure
comes in the case of unsolicited ratings, which are prepared by the rating agency analyst on
the basis of information publicly available.
 The agency analyst may nevertheless visit the institution and have an informal
discussion with bank staff.
 For the bank rating analyst such visits will normally be made whenever possible.
 For the counterparty credit analyst, the decision whether to attempt to make a bank
visit will naturally be contingent upon the resources available in terms of time and
budget, the importance of the relationship with the entity to be analyzed, and the
degree of market consensus on the entity’s financial condition, as well as, the
likelihood that significant information will be gleaned from such a visit.

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Requisite Data for the Bank Credit Analysis

The items needed to perform a bank credit analysis will depend upon the nature of the
assignment undertaken, but in general the following resources should be reviewed:
 The annual report, including the auditor’s report, the financial statements and
supplementary information, as well as interim financial statements
 Financial data services and news services
 Rating agencies, data from regulators, and other research sources
 Notes from primary and field research

The Annual Report

Much can be learned from the annual report about the culture of the bank, how the
bank view’s business and economic conditions, and management’s strategy.

 As the annual report is prepared for the bank’s shareholders and perspective equity
investors, its thrust will be on putting the bank’s operating performance in the best
possible light. An understanding of the management’s side of the story can provide a
useful counterpoint to a more critical examination of bank performance.
 The bank’s annual report will sometimes supply information or particular aspects of
the bank’s operations not available in the financial statements. It may contain a
wealth of mundane factual information, such as the institution’s history and the
number of branches and employees, as well as useful industry and economic data.

The Auditor’s Report or Statement

The analyst should turn to the auditor’s report at the start of the analysis to determine
whether or not the auditor of the bank’s accounts provided it with a clean or
unqualified opinion. The auditor’s report will normally appear just prior to the financial
statements.
 A clean opinion communicates that the auditor does not disagree with the financial
statements presented by management. It does not mean that the auditor might not
have presented the financial information differently, choosing a different accounting
approach or disclosing additional data. An unqualified opinion means that the
financial statements as presented meet at least the minimum acceptable standards
of presentation.

Content and Meaning of the Auditor’s Opinion

 The auditor’s opinions vary somewhat in length and content depending upon the
jurisdiction in which the audit was performed and the standards applied.
 Much of the content will be boilerplate language used as a standard format, and
designed primarily to shield the auditor from any legal liability.
 It is important to watch out for any language that is out of the ordinary. A typical
unqualified auditor’s report will contain phrases more or less equivalent to those in
Exhibit 2.7.

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Exhibit 2.7 The Auditor’s Opinion: An Unofficial Translation Guide

Boilerplate What this means:

The auditors have audited specified financial “Do not blame us, the auditors, for anything that occurred
statements of a certain date. or became apparent after the date.”
Financial statements are the responsibility of the “We can only base our opinion on data provide by the
management of the company. company. If the data is inaccurate or fraudulent, blame
company management, not us.”
The financial statements have been prepared in “The financial disclosure provided meets minimally
accordance with generally accepted local acceptable local accounting standards or relevant
accounting standards and are free from material regulations governing such disclosure. We have not
misstatement. detected any egregious errors or inaccuracies that are
likely to have a major impact on any conclusion you may
draw about the company for investment purposes.”
The audit involved examining evidence “We have not scrutinized every single item of financial
supporting the statements on a test basis, which data or even most of them. This would cost a small
provide a reasonable basis for the auditor’s fortune and take an exceedingly long time. Instead, as is
opinion. deemed customary and reasonable in our profession, we
have tested some data for discrepancies that might
indicate material error or fraud.
In the opinion of the auditors, the financial “The financial statements might not be perfect, but they
statements present that financial position fairly present a reasonable picture of the company’s financial
in all material respects as of the date of the condition, subject to the present standards set forth in law
audit. and generally followed in the industry, notwithstanding
that higher standards might better serve investors.”

Qualified Opinions
A qualified opinion, one in which the auditors limit or qualify in some way their opinion that
the financial statements provide a fair representation of the bank’s financial condition, can be
discerned in cases where additional items other than those mentioned above are added.

Although most auditors’ opinions are unqualified and therefore generally do not
provide any useful information about the bank, a qualified opinion is a red flag even if
it is phrased in diplomatic language, and even if the bank can hide behind the leniency of
some regulation. The irregularities noted should be closely scrutinized for their impact on
financial reporting.

A qualified opinion is easily identifiable by the presence of the word except in the auditor’s
statement or report. It is typically found in the concluding paragraph which usually starts with
“In our opinion.”

Typical situations in which an opinion will be qualified by the auditors include the
following:
 The existence of unusual conditions or an event that may have a material impact on
the bank’s business
 The existence of material related party transactions
 A change in accounting methods
 A specific aspect of the financial reports that is deemed by the auditor to be out of
line with best practice
 Substantial doubt about the bank’s ability to continue as a going concern

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The last type of qualification is the most grave and will justifiably give rise to concern on the
part of the analyst. Not all qualifications are so serious and should be considered bearing in
mind what else is known about the bank’s condition and prospects, as well as the prevailing
business environment.

An extremely rare phenomenon is the adverse opinion, in which the auditors set forth their
opinion that the financial statements do not provide a fair picture of the bank’s financial
condition.

Case Study: The Auditor’s Opinion: The Case of the Philippine National Bank
Consider the case of the Philippine National Bank (PNB), one of the banks in the Philippines
that were hardest hit by the Asian financial crisis in 1997. The auditor, SGV & Co., said in
the last paragraph of the financial report: “In our opinion, except for the effects on the 2004
financial statements of the matters discussed in the third paragraph, the financial statements
referred to the above present fairly in all material respects the financial position of the Group
and the parent company as of December 31,2004 and 2003, and the results of their
operations and their cash flows for each of the three years in the period ended December
31, 2004, in conformity with accounting principles generally accepted in the Philippines.”

In the third paragraph, the auditor described a transaction involving PNB’s sale of
nonperforming assets to a special-purpose vehicle. The losses from the sale of the
transaction were deferred over a 10-year period in accordance with regulatory accounting
principles prescribed in the Philippine central bank for banks and other financial institutions
availing of certain incentives established under the law.

SGV & Co. noted that had such losses been charged against current operations, as required
by generally accepted accounting principles, investment securities holdings, deferred
charges, and capital funds as of December 31,2004, would have decreased by P1.9 billion,
P1.1 billion, and P3.0 billion, respectively, and net income in 2004 would have decreased by
P3.0 billion. This would have been taken against the posted net income of about P0.35
billion in 2004.

In his report on the 2010 accounts, the auditor still had to qualify his opinion as the reporting
of the transaction did not comply with the rules of the Philippine GAAP for banks. This is not,
of course, to say that the bank was doing anything illegal or was attempting to conceal the
transaction.

The Financial Statement: Annual and Interim

There are three primary financial statements:
1. The balance sheet—the include off-balance-sheet items
2. The income statement
3. The statement of cash flows
Of these, the balance sheet and the income statement are the most important to the analysis
of the banks. In respect to nonfinancial companies, the statement of cash flows is often
considered the most important

A fourth financial statement, the statement of changes in capital funds, is useful in both
financial and nonfinancial company credit analysis. It is particularly helpful in bank credit
analysis, as it shows changes in the capital levels reported by the institution.

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Timeliness of Financial Reporting

The more timely the financial statements, the more useful they are in painting of an
institution’s current financial condition.
 Not all banks issue their annual reports as soon as might be preferred. At best,
publication of annual reports will follow within one to two months following the end of
the financial year. On occasion, circumstances such as the need to restate figures as
a result of a regulatory action may delay publication. This is usually not a positive
sign.
 In other circumstances, the reasons for late publication are more innocuous. The
bank may still be in the process of translating the report into another language, or
there may be delays in printing. In such cases, depending upon the purpose and
urgency of the review, the analyst might attempt to obtain preliminary or unaudited
figures directly from management.
 As a rule of thumb, the less developed the market, the longer the delay in the
publication of the financial reports tend to be. In extreme cases, an interval of up to
two years may pass following the end of fiscal year before audited or official financial
data are available for state-owned banks.

Additional Resources
 The bank website: Annual reports, financial statements, news releases, and a great
deal of background information on the bank and its franchise can be obtained from
the web.
 News, the Internet, and Securities Pricing Data: Annual reports are just about out-
of-date the day they are published. Much can happen between the end of the
financial year and the publication of the annual report, and the analyst should run a
check to see if any material developments have occurred.
o A web search or the user of proprietary electronic data services such as
Bloomburg, Factiva, or LexisNexis can be valuable in turning up changes in the
bank’s status, news of mergers or acquisitions, changes in capital structure, new
regulations or recent developments in the bank’s operations.
o Bond pricing will be a concern of the fixed-income analyst, but the counterparty
credit and rating agency analysts can make constructive use of both bond and
equity price data when the bank is publicly listed or is an issuer in the debt
markets. The market will be the first to pick up the news affecting the price of the
bank’s securities.
o Real-time securities data in emerging markets, as provided by Bloomburg, for
example, can be costly, but the web with the emergence of search engines like
Google has leveled the playing field making much of the same or similar business
and financial news easy to access.

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 Prospectuses and Regulatory Filings: Prospectuses and offering circulars

intended for prospective investors are published to enable them to better evaluate
the potential investment. Their content and format is restricted by regulation to
compel securities issuers to present the benefits of the investment in a highly
conservative manner and to highlight possible risks.
 Secondary Analysis: Reports by Ratings Agencies, Regulators, and Investment
Banks: The use of secondary research will depend on the type of bank credit report
being prepared.
o Rating agency analysts will often review official reports from central banks and
government regulators, but like fixed-income analysts, will avoid the use of
competitor publications.
o Bank counterparty credit analysts will rely to a greater extent on secondary
research sources and less on primary sources.
o Investment reports prepared by equity analysts can be useful in helping to form a
view concerning a bank.

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