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Credit Risk Management How to Avoid Lending Disasters and Maximize Earnings . tools that are used to help lenders maximize their earnings and profitability.
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Shortly thereafter, GM sought to obtain a split rating for GMAC separate from its own in order to mitigate the risk exposure that it faced on its long-term funding strategies. The company also had write-offs from the restructuring of its European operations as a result of loss of market share and sales decline.

Monitoring and Backtesting Credit Risk Models -- PD, LGD, EAD -- Basel -- Risk Management

Credit quality for each corporate division must be fully assessed by lenders to determine whether a parent—subsidiary relationship is too complex to monitor. Reports by GE Capital were that its decision was attributed to a clause in the loan agreement that allowed it to cancel the debt in the event of a credit downgrade. Although the cancelled facility that GM had used to provide financing for suppliers was subsequently replaced by GMAC as the new debt provider, it nonetheless placed increased costs and liquidity pressures on GMAC at the time the parent sought to sell it off in portions.

For example, if the loan is to be collateralized by security that resides offshore in another country where the lender may have no jurisdiction or legal claims, the lending strategy and initial assessment must therefore consider how to best protect and minimize credit exposure.


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Suppose, for example, that Comerica, a regional U. In this case, because the borrower is in the same jurisdiction as the lender, the country risk exposure would be minimal. Under this condition, the credit risk may be limited to the amount of the debt facility and secured by the cash flows of the subsidiary as the primary source of repayment.

Alternatively, if the credit facility is extended to GM China as the borrower, the lender would then have country risk exposure to the loan because both the borrower and debt provider would now reside in different legal jurisdictions. Although pri- mary sources of repayment can consist of both onshore and offshore corporate cash flows, lenders usually prefer onshore cash flows as the primary repayment sources, because there is greater control of security when assets reside onshore.

This could increase credit risk exposure on a loan facility in which GM China was the borrower, if a host country placed restrictions on the amount of funds that GM was able to repatriate out of China and back into the U. A strategy that the credit personnel might consider in the con- trol of collateral and security is to require GMAC as the borrower to guarantee the facility for GM. The main point, however, in originating and assessing the transaction is to ensure that a credit extension will not become exposed to a loss for the lender.

The above principle should similarly be considered when a single investor or family controls a group of companies, relative to where the funds will ultimately be disbursed. Controlling share- holders have been known to move cash and assets among various related companies at the banks expense.

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Simply because a borrower requests funding does not imply automatic approval. This becomes even more prevalent for small- and medium-sized firms where credit is often more limited than it is for large corporations.


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  • Although the majority of loans, on average, are usually for additions to current assets and working capital requirements, the specific purpose of the funds may actually be for emergency payroll or to pay overdue suppliers. However, to accept without evidence that the loan will be used for working capital purposes exposes the lender to significant credit risk, particularly if the facility proceeds are otherwise used to support operating losses. Also, the funds may be used for fraud or some other illegal purpose.

    Trade scams such as those that were linked to ABN Amro in December , where shell companies were used as conduits to smuggle illegally generated cash, can also open banks to serious compliance violations. Medium and small companies may not always be aware of the borrowing risks behind certain credit requests and can therefore benefit from the guidance of relationship managers in these matters. Although large corporations are staffed with personnel knowledge- able in the varying loan products, smaller firms may not always know about the appropriate debt products available for their fund- ing needs.

    Analyzing the Transaction: What are the Lending Objectives 63 3. Consequently, the price of credit facilities must be considered in the fourth phase of the preliminary approval and credit risk assess- ment. Under classical credit risk, the lack of pricing transparency for the cost of maintaining unprofitable bank relationships contributed to the decline in bank profitability. In addition, rudi- mentary mechanisms were used in pricing that made it difficult to measure profitability and price facilities that otherwise should have been declined.

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    The growth of the primary syndicated and secondary trading markets, however, brought to the attention of banks the need for credit pricing strategies that could accurately measure performance and profitability of new transactions on the portfolio. This was also aided by the entry of nonbank financial investors, which forced the corporate and commercial banking sector to move away from interest margin pricing towards the practice of transaction pricing.

    Credit Risk Management by Joetta Colquitt (ebook)

    Besides providing a consistent measurement to reflect the risks undertaken on a risk-adjusted basis, transaction pricing also became essential to increase overall bank earnings in order to improve the investment by shareholders. As modern credit risk management techniques continue to be integrated into financial institutions worldwide, lenders now apply pricing based on risk-adjusted performance measures such as RAROC risk adjusted return on capital.

    Additional tools that are also being used include the application of default models in individual risk ratings. Because credit contin- ues to be the greatest risk for financial institutions, the primary reason that loans are still extended is for relationship purposes. Thus, a distinction of modern credit risk is that relationships have to be profitable as well as viable and therefore priced accordingly. This is why, in some banks, credit portfolio managers also participate in loan originations in order to ensure that transactions earn risk-adjusted returns and do not erode portfolio growth.

    Because portfolio transaction pricing is also based on a credit culture that recognizes the advantage in this practice, the credit culture should clearly understand pricing to be inclusive of the credit mission and strategy. New transactions must therefore be evaluated for their profitability relative to the income of the borrowing relationship as well as to allocate the minimum capital requirements.

    Alternatively, the credit request can be submitted and recommended to higher management authority, or presented to a Loan Committee to decide on whether the credit should be approved, declined, or approved on specified conditions. Although the particular format for documenting and recommending proposed credit requests may differ among financial institutions, it generally should include a summary of the facility characteristics along with all of the risks and mitigating factors relevant to the transaction and portfolio credit exposure.

    Decisions to approve a facility transaction should also be accompanied by any supporting data e. The clarity and detail in a credit memorandum is also essential for loan moni- toring and regulatory reviews. Furthermore, account officers should be aware of the consequences and legalities in minimizing risks. Lender liability has become quite prevalent, with higher credit risk exposure for what some investors perceive to be a failure by financial intermediaries to undertake the appropriate due diligence and credit assessment on approving transactions.

    Credit facilities should always be reviewed on an annual basis to include site visits, interviews, and verification of covenant compliances. Many banks find that, if the borrower is highly rated and is meeting its loan obligations, then annual loan monitoring should be sufficient.

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    However, as has been seen with Enron and Worldcom, for example, this may not always be the best practice for detecting any changing credit qualities. Banks that do have ongoing and continuing monitoring processes in place such as quarterly covenant compliance checks, industry competitor reviews, and that follow newspaper and trade journal updates, are in the best position to monitor their portfolios.

    Although we have used the current situation with the U. Next is the concern for the ability to repay the debt and how the lender can protect itself from structural subordination. The ability to monitor and control debt repayment must also be addressed, especially as it relates to collat- eral and security matters. The purpose and use of the funds must also be evaluated to ensure that the lender will not be contributing to operating losses or other fraudulent means.

    Pricing the facility on a risk-adjusted basis is important for credit quality and overall portfolio growth. The findings of the preliminary credit assessment should therefore be placed in a proposed credit request and appli- cation, for which the credit organization will use in risk measure- ment and other tasks. Among these tasks will be monitoring and servicing the transaction throughout the life of the facility, which will be dependent on the funding strategy that is structured.

    This will be the topic of Chapter 4. What are the six steps in a typical loan approval process?

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    When extending credit, what are the objectives of the loan officer, credit specialist, and credit organization? Why is it important to document the credit proposal in a credit memorandum? You are engaged in a credit assessment and preliminary loan approval process. The assessment is for a long-established consumer products company that cooperates in a mature market, producing detergents and soaps globally, and wants to diversify its product line. The credit request is to purchase equipment to expand into herbal health products, which is a new sector in which the company has not previously been involved.

    The product is intended to be manufactured in Mexico, and will include new and previously untested technology. Would you approve or decline the preliminary loan approval? If so, for what reason? The firm approaches the lender for a project finance facility to build a chemical plant in Mexico that will be government-owned and -operated. The firm has no experience in constructing a chemical plant, although it does have several long-term chemical purchase agree- ments with global pharmaceutical suppliers. According to the purchase contract, the primary source of revenue is expected to be derived from a new research chemical that the entity will produce and be used in a new cancer drug.

    Although the construction entity has experience in several major road construction projects in the United States, it does not have experience in constructing and operating chemical plants and this will be the first time it is undertaking such a project. Based on the above, what have you already determined in your preliminary loan approval and credit assessment process and why?

    Pacific Holdings is a diversified conglomerate that has rapidly expanded over the past five years. Pacific has various subsidiaries that operate in a range of sectors including health services, leasing, and tubing, among others. Prior relationship with the borrower has been good, but limited to only hedging products for swaps and foreign exchange.

    Although the corporate structure of the holding company has always been obscure, you notice in your credit assessment that Pacific Holdings derives all of its revenues from the operating divisions. Would you extend or decline the preliminary loan approval? What would be the probable primary and secondary sources of repayment and the potential credit risks to approve this credit request?

    What is our preliminary assessment of the facility and what, if any, additional information would you like to have? Gearin, William F. Caouette, John B. Dahiya, S. James, C. Simpson, Glenn R. In this chapter we will discuss some of the common funding strategies that companies use to finance their current operations and support future growth.

    Our focus will be to emphasize some of the more common types of credit facilities that credit specialists should be familiar with, along with a brief description on the analytical techniques that are used to evaluate related transaction credit requests. Under classical credit risk management, financial service firms often segmented credit specialists into categories for loans, equity, and fixed-income analysts. The rationale was that the market required uniquely contrasting specialized assessment skills for each of these credit sectors.

    However, the advanced applications that have been developed under modern credit risk management have led to credit specialists having to assess a broad range of debt transac- tions that are structured to encompass all aspects of corporate finance. As deregulation has eroded the protection that had traditionally been afforded commercial banks and other financial entities, credit specialists should have a general familiarity with the products that have converged into the loan and trading books.

    This chapter will provide an introductory understanding of the funding strategies and analytical techniques used in their assessment, as well as serve as a foundation to build upon for Chapters 5 and 6. To meet the funding strategies for commercial and corporate business, lenders have a range of credit products that they provide to service cash flow, asset conversion, or refinancing needs. In the next section, we will begin our discussion of these strategies by high- lighting how companies use short-term funding products for asset conversion needs. These short-term debt products are typically used to finance seasonal inventory and temporary working capital needs for up to eighteen months or less.

    Asset Conversion Loan Products are used to finance the production of inventories into finished goods that will eventually be sold.


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