The Practice of Lending: A Guide to Credit Analysis and Credit Risk

The Practice
of Lending
	Preface
	Acknowledgements
	Contents
	List of Figures
	List of Tables
	Part I: The Criteria-Based Approach to Credit Assessment and Credit Rating
	1: Credit Analysis and Credit Management
		1.1	 Introduction
		1.2	 A Framework for Credit Operations
		1.3	 The Credit Underwriting Process
			1.3.1	 Credit Initiation
			1.3.2	 Credit Analysis
			1.3.3	 Loan Structuring
			1.3.4	 Credit Submission and Adjudication
			1.3.5	 Loan Documentation
			1.3.6	 Loan Closing and Credit Disbursement
			1.3.7	 Loan Monitoring and Reporting
			1.3.8	 Problem Loan Management
		1.4	 Credit Culture
		1.5	 The Criteria-Based Approach to Credit Analysis
		1.6	 Information Asymmetry
			1.6.1	 Minimising Adverse Selection and Moral Hazard Risk
		1.7	 Regulatory Environment: Financial and Legal
			1.7.1	 Banking Regulations
			1.7.2	 AML (Anti-Money Laundering) and Anti-Terrorism
			1.7.3	 The Importance of the Regulatory Environment to Credit Risk Assessment
	2: Financial Statement Analysis
		2.1	 Introduction
		2.2	 Financial Reports and Reporting: A Quick Overview
		2.3	 Role of the Auditor
		2.4	 Ratio and Financial Analysis
		2.5	 Categories of Ratios
			2.5.1	 Profit and Profitability
			2.5.2	 Return on Investment
			2.5.3	 Asset Utilisation and Efficiency
			2.5.4	 Liquidity
			2.5.5	 Debt and Solvency
		2.6	 Off-Balance Sheet Debt
			2.6.1	 The Present Value Approach
			2.6.2	 Rent Expense Multiple Approach
			2.6.3	 Financial Statement Effects
		2.7	 Uses and Limitations of Ratio Analysis
	3: The Criteria-Based Approach to Credit Risk Assessment and Credit Risk Rating
		3.1	 Introduction
		3.2	 The Framework of CRA (Credit Risk Assessment)
			3.2.1	 The BRR Scorecard
			3.2.2	 Designing the Risk-Rating Scale and Rating Granularity
			3.2.3	 The Time Horizon: Trade-Off Between Timeliness and Stability of the BRRs
			3.2.4	 The Structure of a BRR Scorecard: Risk Criteria, Risk Factors, Risk Elements, and Weights
			3.2.5	 The Functional Relationship Between Predictors and Default Frequency
		3.3	 Building the Risk Criteria in a Computer Spreadsheet
			3.3.1	 Assignment of Scores to the Risk Factors/Sub-Factors and Calculation of the Risk Scores
			3.3.2	 Assignment of Counterparty Risk Rating after Overrides
		3.4	 Model Validation
		3.5	 Summary
		Appendix 3.1: Function, Variables, and Grouped and Ungrouped Data
		Appendix 3.2: Definition of Financial Variables Used as Predictors
	4: The Building Blocks of Credit Analysis and Credit Risk Rating
		4.1	 Introduction
		4.2	 Country Risk and Sovereign Risk
		4.3	 Industry Risk Assessment
			4.3.1	 Porter’s Five Forces Framework Model of Industry Analysis
			4.3.2	 Industry Life Cycle Model
			4.3.3	 The Business Cycle
			4.3.4	 Costs and Cost Structure
			4.3.5	 Country Risk and Political Risk
			4.3.6	 Demographics and Social Trends
			4.3.7	 Global Markets
		4.4	 Scoring Industry Risk
			4.4.1	 Industry Risk Scorecard
		4.5	 Business Risk Assessment
			4.5.1	 Market Position, Pricing, and Competitiveness
			4.5.2	 Business Consistency and Stability
		4.6	 Scoring Business Risk
			4.6.1	 Designing the Scorecard to Accommodate Cyclical Correction
			4.6.2	 Competitive Position
			4.6.3	 Market Position
			4.6.4	 Cyclical Position: Phase of the Economic Cycle
		4.7	 Management Risk Assessment
			4.7.1	 Management Quality and Addressing Information Asymmetry in BRR Determination
			4.7.2	 Business Strategy
			4.7.3	 Financial Plan
		4.8	 Scoring Management Risk
		4.9	 Financial Risk Assessment
			4.9.1	 Data Sources and the Scope of the Financial Risk Assessment
		4.10	 Scoring Financial Risk
		4.11	 Calculating the Composite BRR
	5: How It All Fits
		5.1	 Introduction
		5.2	 A Case Study of AY Intercontinental Airways
			5.2.1	 Company Background and Profile
			5.2.2	 Industry Risk Assessment (15%)
			5.2.3	 Business Risk Assessment (25%)
			5.2.4	 Management Risk Assessment (20%)
			5.2.5	 Financial Risk Assessment (40%)
			5.2.6	 Spreading Financial Statements for Risk Performance Variables
		5.3	 The Composite Score and Sensitivity Tests
		5.4	 Cash-Flow Projections for AY Intercontinental Airways
			5.4.1	 Performing the Calculations
		5.5	 Summary of the Financial Forecast
			5.5.1	 Forecast Results from Stress Testing
			5.5.2	 Forecasting the Financing Gap
	6: Credit Risk Analysis and Credit Risk Rating of Commercial Real Estate
		6.1	 Introduction
		6.2	 Application of the Criteria-Based Methodology to CRE
		6.3	 Risk Assessment Factors
		6.4	 Business Risk Assessment
			6.4.1	 Multifamily Property
			6.4.2	 Retail Property
		6.5	 Financial Risk Assessment
			6.5.1	 The Calculation of NOI
			6.5.2	 Comparison Method
			6.5.3	 Replacement Cost Method
			6.5.4	 The Income Method
		6.6	 Creating Descriptors for DSC and LTV
			6.6.1	 Preliminary Considerations
			6.6.2	 Creating the Descriptors
		6.7	 Calculating the Composite BRR of ABC Shopping Plaza
		6.8	 Summary of Key Points
	7: Bank Credit Risk Analysis and Bank Credit Rating
		7.1	 Introduction: Banking and the Banking System
		7.2	 The Quality of the Business Environment
			7.2.1	 Legal and Financial Regulatory Framework
			7.2.2	 The Economy
		7.3	 The Criteria-Based Approach to Bank Credit Risk Analysis
		7.4	 Risk Criteria: Qualitative Analysis
			7.4.1	 Business Risk
			7.4.2	 Management and Governance Risk
			7.4.3	 The Enterprise-Wide Business Plan and Operations
			7.4.4	 Risk Management and Internal Controls
			7.4.5	 Corporate Governance
		7.5	 Risk Criteria: Quantitative Financial Analysis
			7.5.1	 The Income Statement
			7.5.2	 The Balance Sheet
		7.6	 Creating the Descriptors
			7.6.1	 Operating Environment
			7.6.2	 The Descriptors
			7.6.3	 Defining Descriptors of Financial Risk
		7.7	 Putting It All Together
		Appendix 7.1: A Note on Bank Size
		Appendix 7.2: Bell Curve for Three Standard Deviations from the Mean
	Part II: Statistical Methods on Credit Scoring
	8: Statistical Methods of Credit Risk Analysis
		8.1	 Introduction
		8.2	 Probability Models
			8.2.1	 Linear Probability Model
			8.2.2	 Alternative Formulation: Probit Model
			8.2.3	 Alternative Formulation: Logit Model
		8.3	 Case Study: Probit Model to Predict Default
		8.4	 Example of Linear Probability (LP) and Logit Models
		8.5	 Choice Between Probit and Logit Models
		8.6	 Interpretation of the Estimated Coefficients
		8.7	 Practical Applications of the Logit Function
			8.7.1	 Predicting the Probability of Default
			8.7.2	 Scaling the Log-Odds Ratio
			8.7.3	 Scaling Calculation
			8.7.4	 Cautionary Notes on the Reliance on Credit Scorecard in Credit Decisions
	9: Statistical Methods of Predicting Country Debt Crisis
		9.1	 Introduction
		9.2	 Country and Sovereign Risk
			9.2.1	 Approaches to Country Risk Assessment
		9.3	 Providers of Country Risk Ratings and Sovereign Risk Ratings
		9.4	 Applying Logit Analysis to Predict Sovereign Debt Crisis
			9.4.1	 Rationale for the Expected Signs of the Predictors
			9.4.2	 The Estimated Logistic Function: Key Criteria for Choosing the Best Fit
		9.5	 Introduction to Discriminant Analysis
			9.5.1	 Forming Population Groups
			9.5.2	 Classification Test
			9.5.3	 Accounting for Prior Information
			9.5.4	 Misclassification
			9.5.5	 Related Statistics
		9.6	 Applying Discriminant Analysis to Predict Sovereign Debt Crisis
			9.6.1	 Classification Test
			9.6.2	 Checking the Group Assumptions
		9.7	 Choosing Between Probit, Logi, and Discriminant Analysis
			9.7.1	 Practical Uses of the Discriminant Analysis in Credit Assessment
		Appendix 9.1: Countries and Debt Crisis Episodes
	Part III: Credit Management
	10: Credit Monitoring and Compliance
		10.1	 Introduction
		10.2	 Reasons for Loan Monitoring
		10.3	 Best Practices of Loan Monitoring
			10.3.1	 Covenant Monitoring
			10.3.2	 Periodic Credit Review Process
			10.3.3	 Watch List Process
			10.3.4	 Monitoring Loan Documentation and Collateral
		10.4	 Compliance Status
		10.5	 Requirements of an Effective Monitoring System
			10.5.1	 Automation of the Monitoring Process
	11: Problem Loan Management
		11.1	 Introduction
		11.2	 Management Structure
		11.3	 Provisioning for Problem Loans
			11.3.1	 Specific Provision
			11.3.2	 General Provision
			11.3.3	 Bad Debt Write-Off (or Charge-Off)
		11.4	 Problem Loan Management Process and Policies
			11.4.1	 Problem Loans Documentation
			11.4.2	 Remarketing the Loan
			11.4.3	 Rehabilitation
			11.4.4	 Troubled Debt Restructure (TDR)
			11.4.5	 Compulsory Liquidation of Collateral
	Index