Credit Risk Management Enhancing Your Bottom Line Ebrahim Shabudin Managing Director Deloitte & Touche LLP The AFP 23 rd Annual Conference New Orleans.

Credit Risk ManagementCredit Risk ManagementEnhancing Your Bottom LineEnhancing Your Bottom Line

Ebrahim ShabudinEbrahim Shabudin

Managing Director Managing Director

Deloitte & Touche LLPDeloitte & Touche LLP

The AFP 23rd Annual Conference New OrleansNovember 3-6, 2002

Credit BackgroundCredit Background

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

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

……..The desire to grow and turn in outstanding ..The desire to grow and turn in outstanding results has a tendency to put pressure on results has a tendency to put pressure on

the the checks and balances within businesseschecks and balances within businesses

Value PropositionValue Proposition

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

– Expands revenue opportunities with creditworthy, incremental Expands revenue opportunities with creditworthy, incremental customerscustomers

– Utilizes innovative structures to support business relationshipsUtilizes innovative structures to support business relationships

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

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

– Marketplace penalizes credit induced volatility and “surprises”Marketplace penalizes credit induced volatility and “surprises”

Raises questions about quality of managementRaises questions about quality of management

Corporate Credit RiskCorporate Credit Risk

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

Accounts Receivables Accounts Receivables Other Notes ReceivablesOther Notes ReceivablesBuyer and Franchise FinancingBuyer and Franchise FinancingWith Recourse FinancingWith Recourse Financing

– Project FinanceProject Finance– Structured TransactionsStructured Transactions– Leases with RecourseLeases with Recourse

Derivatives Exposures Derivatives Exposures – FX, Interest Rate Risk, Commodities etc.FX, Interest Rate Risk, Commodities etc.

Collateral RiskCollateral Risk– Parent or Third Party Guarantees Parent or Third Party Guarantees – Commercial and Standby Letters of CreditCommercial and Standby Letters of Credit

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

DSO Impact … an exampleDSO Impact … an exampleActualActual Company ACompany A Peer AveragePeer Average

Q3 A/RQ3 A/R $295,396,000$295,396,000

Q3 SalesQ3 Sales $261,201,000$261,201,000

DSOs =DSOs = 124*124* 51.351.3

HypotheticalHypothetical CashCash

DSOsDSOs 51.351.3

Q3 SalesQ3 Sales $261,201,000$261,201,000

Q3 A/R =Q3 A/R = $122,002,230$122,002,230 +$173,393,770+$173,393,770 * * Equals 295.4M/261.2M x 90(or number of days in sales period)Equals 295.4M/261.2M x 90(or number of days in sales period)

Credit as a FacilitatorCredit as a Facilitator

Credit risk management is importantCredit risk management is important – Credit is a facilitator of business growth and Credit is a facilitator of business growth and

performanceperformance

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

– Clients (buyers) may be concentrated in selected Clients (buyers) may be concentrated in selected industries and provide limited portfolio diversification industries and provide limited portfolio diversification opportunityopportunity

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

Credit Strategy & Risk ToleranceCredit Strategy & Risk Tolerance

Specific Quantifiable Objectives

Management Review Methodology

Credit Objectives and Risk

TolerancesCredit Policies

Credit Risk Management

Processes

Improve Profitability

Reporting

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Credit Strategy Statement and Risk Tolerance

Coordination with Business Plan

The business strategies and objectives drive the establishment of creditpolicies and procedures. Measurement and reporting as well as the use of current technologies enhance credit decision-making and improve risk management. The entire process is continually re-evaluated and improved.

The business strategies and objectives drive the establishment of creditpolicies and procedures. Measurement and reporting as well as the use of current technologies enhance credit decision-making and improve risk management. The entire process is continually re-evaluated and improved.

Credit Risk Areas to ConsiderCredit Risk Areas to Consider

Credit PolicyCredit Policy

Credit Approval Credit Approval AuthorityAuthority

Limit SettingLimit Setting

Pricing Terms Pricing Terms and Conditionsand Conditions

Documentation: Documentation: Contracts and Contracts and CovenantsCovenants

Collateral and Collateral and SecuritySecurity

Collections, Collections, Delinquencies Delinquencies and Workoutsand Workouts

Exposure Exposure ManagementManagement– AggregationAggregation– ControlControl

Periodic Account Periodic Account ReviewsReviews– Payments/AgingPayments/Aging– Credit ConditionCredit Condition

Compliance with Compliance with Covenants, TermsCovenants, TermsTechnology/ReportsTechnology/Reports– Transactions/ Transactions/

BookingsBookings– Risk-adjusted Risk-adjusted

ReturnReturn

Sales Sales ChannelsChannels

Risk StrategyRisk Strategy

Underwriting Underwriting StandardsStandards

Credit Credit ApplicationApplication

AnalysisAnalysis

Business/ Business/ IndustryIndustry

FinancialFinancial CreditCredit

Credit Scoring Credit Scoring and Ratingsand Ratings

Origination/Assessment Administration Monitoring/

ControlRiskManagement

Portfolio Portfolio ManagementManagement

ConcentrationConcentration DiversificationDiversification

Allowance for Allowance for Bad DebtsBad Debts

Risk Risk MitigationMitigation

ObjectivesObjectives Type of Type of

ExposureExposure Instruments or Instruments or

MethodsMethods

Value CreationValue Creation

Business Performance

Measures

Business Performance

Measures

Organizations need a rigorous set of measures to support continuous improvement

Performance-based management utilizes metrics that measure actual performance against predetermined thresholds. The thresholds are established taking into account the organization’s strategy, operatingenvironment and process controls.

Performance-based management utilizes metrics that measure actual performance against predetermined thresholds. The thresholds are established taking into account the organization’s strategy, operatingenvironment and process controls.

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

Business Strategy

Systems

Operations

Finance

Performance Management

Sales channels

Contracts & Documentation

Credit analysis

Credit limitPricing &

terms

Credit Analysis

Credit Decisions

Collections

CREDIT POLICY

Collateral acceptance

Portfolio management

Financial analysis

Disposal / Risk

mitigation

Collateral management

Customer management

Exposure measurement

Management reporting

Exposure aggregation

Recoveries

Credit scoring

Risk rating

RISK MANAGEMENT

Credit Risk Management’s Inter-related Activities

Compliance

Origination

Reporting

Transactions

Credit Policies & Procedures

Analysis & Risk

Management

Governance, Controland Implementation

MeasurementMethodologies

Technology & Data Integrity

Credit Strategy & Risk Tolerance

A complete and coherent risk management A complete and coherent risk management framework contains the following elementsframework contains the following elements

Credit Risk ManagementCredit Risk ManagementCredit Risk ManagementCredit Risk Management

Reassessment Credit Strategy & Risk Tolerance

A New ParadigmA New ParadigmA new business paradigm had evolved: causing A new business paradigm had evolved: causing a lack of reliance on good fundamental analysisa lack of reliance on good fundamental analysisThe idea that stock market values would The idea that stock market values would continue to go up indefinitelycontinue to go up indefinitely

Increasingly competitive, complex and volatile Increasingly competitive, complex and volatile market placemarket placeHigher than expected actual debt burdensHigher than expected actual debt burdensExtensive reliance on unrealistic future cash Extensive reliance on unrealistic future cash flowsflowsFailures in corporate governanceFailures in corporate governanceQuestionable personal and corporate ethicsQuestionable personal and corporate ethics

Implications for Corporate GovernanceImplications for Corporate Governance

Current organization structures to be revisitedCurrent organization structures to be revisitedClarity around roles and responsibilitiesClarity around roles and responsibilitiesNeed for honesty, integrity and independence Need for honesty, integrity and independence (self-regulation)(self-regulation)Technical expertise of people and strong Technical expertise of people and strong management processesmanagement processesImproved disclosure requirementsImproved disclosure requirementsImportance and implementation of sanctionsImportance and implementation of sanctionsIncreased legislation and compliance Increased legislation and compliance requirementsrequirements

Foundation: Credit Rating and Underwriting StandardsFoundation: Credit Rating and Underwriting StandardsRisk Identification, Origination, Credit Administration, etc.

Short Term: Managing Expected LossShort Term: Managing Expected LossRisk Identification, Transaction

Structuring, Approval & Pricing Decisions, Reserving, etc.

Near Term: Managing Economic Capital / Credit VaRNear Term: Managing Economic Capital / Credit VaRPortfolio Risk Concentration, Risk Based Limits, etc.

Vision: Vision: Managing Risk/ReturnManaging Risk/ReturnPricing decisions,Performance measurement,

business and customer segmentation,

compensation, etc.

A business model view of Credit Risk Infrastructure components

Credit Risk Management – Strategic VisionCredit Risk Management – Strategic Vision

Development StagesDevelopment Stages– Foundation StageFoundation Stage includes application of risk identification includes application of risk identification

methodologies, risk scoring or rating systems and strong methodologies, risk scoring or rating systems and strong underwriting standardsunderwriting standards

– Basic StageBasic Stage tends to include managing on a transactional basis by tends to include managing on a transactional basis by

evaluating specific attributes such as structuring, collateral and evaluating specific attributes such as structuring, collateral and pricingpricing

– Advanced StageAdvanced Stage represents managing on a portfolio basis represents managing on a portfolio basis

including aspects such as concentrations, correlations and including aspects such as concentrations, correlations and diversificationdiversification

– The Sophisticated StageThe Sophisticated Stage includes application of highly developed includes application of highly developed

measurement techniques for transactions and portfolios, supported measurement techniques for transactions and portfolios, supported by decision-making relating to segments or businesses against by decision-making relating to segments or businesses against established hurdle rates.established hurdle rates.

Credit Risk ClarifiedCredit Risk Clarified

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

– Default in contractual obligations by a customerDefault in contractual obligations by a customer

– Migration in condition and ratingMigration in condition and rating

– Deterioration in performance Deterioration in performance

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

Businesses have to contend with Expected Businesses have to contend with Expected and Unexpected Lossesand Unexpected Losses

Expected LossesExpected Losses– AnticipatedAnticipated– Cost of doing businessCost of doing business– Charged to provisionsCharged to provisions– Captured in pricingCaptured in pricing– Relatively easier to Relatively easier to

measuremeasure

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

Unexpected LossesUnexpected Losses– Unanticipated but Unanticipated but

inevitableinevitable– Must be planned forMust be planned for– Covered by reservesCovered by reserves– Allocated to businessesAllocated to businesses– Difficult to measureDifficult to measure

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

Credit Risk Management ExplainedCredit Risk Management ExplainedAlthough credit risk may be difficult to measure it is Although credit risk may be difficult to measure it is important to estimate and manageimportant to estimate and manage

What does Credit Risk Management mean?What does Credit Risk Management mean?– It represents an institution’s ability to properly identify It represents an institution’s ability to properly identify

and evaluate the potential risk of default in payment of and evaluate the potential risk of default in payment of obligations of customersobligations of customers

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

Important Building BlocksImportant Building Blocks

Effective Credit Risk Management requiresEffective Credit Risk Management requires– Clear origination and underwriting standards Clear origination and underwriting standards – A strong corporate and credit cultureA strong corporate and credit culture– Highly developed risk measurement techniques Highly developed risk measurement techniques – Ability to recognize and cover expected and unexpected Ability to recognize and cover expected and unexpected

losseslosses– Pricing commensurate with risks undertakenPricing commensurate with risks undertaken– Methodologies to assess net profit contributions by Methodologies to assess net profit contributions by

customers and appropriate business segmentscustomers and appropriate business segments– Proper allocation of capital and management resourcesProper allocation of capital and management resources

In order to:In order to:– Improve overall corporate performance, measured by a Improve overall corporate performance, measured by a

higher EPS or P/E ratio (or market value)higher EPS or P/E ratio (or market value)

Credit Policy and ProcessCredit Policy and Process

Credit Policy should be clear and conciseCredit Policy should be clear and concise

Credit Underwriting Standards must be Credit Underwriting Standards must be developed and included in policydeveloped and included in policy

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

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

Risk MonitoringRisk Monitoring

Exposure must be complete and currentExposure must be complete and currentRegular reporting and updating of clients’ Regular reporting and updating of clients’ payment performance payment performance Minimum annual reviews of clients should Minimum annual reviews of clients should be performedbe performedFinancial conditions should be regularly Financial conditions should be regularly assessedassessedRequired action must be initiated and Required action must be initiated and follow up must take placefollow up must take place

Contract Terms and DocumentationContract Terms and Documentation

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

Appropriate approvals must be obtainedAppropriate approvals must be obtained

Internal or external legal departments must Internal or external legal departments must document completelydocument completely

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

Exceptions must be reported and managed Exceptions must be reported and managed urgently to resolutionurgently to resolution

Risk Rating System EffectivenessRisk Rating System EffectivenessCredit Scoring is generally used to “risk rate” homogeneous portfoliosCredit Scoring is generally used to “risk rate” homogeneous portfolios

– Highest applicability is in consumer and retail portfoliosHighest applicability is in consumer and retail portfolios– Some advanced scoring systems are being migrated for use in rating Some advanced scoring systems are being migrated for use in rating

“middle market” clients“middle market” clients– Such models are only as good as the underlying assumptionsSuch models are only as good as the underlying assumptions

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

– Client relationship may interfere with objective assessment of risksClient relationship may interfere with objective assessment of risks– Rating criteria usually a matter of practice rather than written policyRating criteria usually a matter of practice rather than written policy

– Ratings are not consistent over timeRatings are not consistent over time

– Qualitative credit assessments often lag current market informationQualitative credit assessments often lag current market information

– Institutions often assumeInstitutions often assume a mapping with external ratings in order to a mapping with external ratings in order to quantify credit riskquantify credit risk

Effective Risk Rating SystemsEffective Risk Rating Systems– Sufficient granularity of risk rating categoriesSufficient granularity of risk rating categories

– Accurate and timely assignment of ratings Accurate and timely assignment of ratings

– Clear and consistent application of default definitionClear and consistent application of default definition

– Periodic calibration, triangulation and validation of risk Periodic calibration, triangulation and validation of risk ratings ratings

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

Credit Evaluation: Financial FactorsCredit Evaluation: Financial Factors

Get the information you need to make a Get the information you need to make a full analysisfull analysisSome information will need to be cross-Some information will need to be cross-checked and obtained on a regular and checked and obtained on a regular and timely basistimely basisBe constructively cynical: new business Be constructively cynical: new business models are difficult to pull offmodels are difficult to pull offBe cognizant of delaying tacticsBe cognizant of delaying tacticsNumbers don’t tell the whole story!Numbers don’t tell the whole story!

Credit Evaluation: Qualitative FactorsCredit Evaluation: Qualitative Factors

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

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

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

Analysis-paralysis may lead to wrong decisionsAnalysis-paralysis may lead to wrong decisions

Art and Science of JudgmentArt and Science of Judgment

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

Ensuring proper analysis is done requires Ensuring proper analysis is done requires a strong corporate culturea strong corporate culture

Utilizing qualified resources both internally Utilizing qualified resources both internally and externally enhances the resultsand externally enhances the results

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

Concluding CommentsConcluding Comments

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

– Higher revenueHigher revenue

– Lower lossesLower losses

– Improved efficienciesImproved efficiencies

– Higher EPS, P/E ratios and market valuesHigher EPS, P/E ratios and market values

Concluding CommentsConcluding Comments

Risk Assessment and Limit Management Credit Infrastructure and

Portfolio Management

Credit Analytics Support

Credit Technology Enablement

• Credit Quality

• Credit Underwriting

• Risk Rating System Effectiveness

• Counterparty and Portfolio Limits

• Organizational Structure

• Policies and Procedures

• Technology Selection and Implementation

• Problem Asset Management

• Risk Rating Calibration

• Transaction Pricing, Structure and Support

• Default Probability and Recovery Calibration

• Credit Reserve Methodology

• Risk Based Pricing Models

• Risk Adjusted Return Analysis

• Portfolio Value Measurement

• Credit Risk Measurement

• Credit Performance Scorecards

Internal Software Internal Software

External Vendor SoftwareExternal Vendor Software

Appendix: Business Proposal ChecklistAppendix: Business Proposal Checklist

Business Proposal SummaryBusiness Proposal Summary– Customer, Rating, Legal Status, Line of BusinessCustomer, Rating, Legal Status, Line of Business– Guarantor, if any…sameGuarantor, if any…same– Collateral, if any…true value explainedCollateral, if any…true value explained– Other Support, if any... Legal or moral onlyOther Support, if any... Legal or moral only– The Transaction…risks and mitigationThe Transaction…risks and mitigation– Amount, purpose, terms and conditionsAmount, purpose, terms and conditions– Sources of repayment… clearly identifiedSources of repayment… clearly identified– Client payment history and relationshipClient payment history and relationship

Appendix: Business Proposal ChecklistAppendix: Business Proposal Checklist

Rationale and AnalysisRationale and Analysis– Customer, Guarantor, Collateral, SupportCustomer, Guarantor, Collateral, Support– Facility DescriptionFacility Description

Amount, purpose, tenor, pricing, terms, conditions, Amount, purpose, tenor, pricing, terms, conditions, covenants, restrictions etc.covenants, restrictions etc.Consider affect on above e.g. new leverageConsider affect on above e.g. new leverageFacility Rating?Facility Rating?

– Repayment CapacityRepayment CapacityFuture cash flow, conversion of assets etc.Future cash flow, conversion of assets etc.

– Consistency with Credit Strategy and PolicyConsistency with Credit Strategy and PolicyConfirm, and identify any exceptions to policy, underwriting Confirm, and identify any exceptions to policy, underwriting standards, or processstandards, or processRisk adjusted return acceptability Risk adjusted return acceptability

Appendix: Business Proposal ChecklistAppendix: Business Proposal Checklist

Client RelationshipClient Relationship– Business strategy: increase, maintain or Business strategy: increase, maintain or

decrease exposure or exit relationshipdecrease exposure or exit relationship– Consider relation to rating, latest risk profile Consider relation to rating, latest risk profile

and payment performanceand payment performance– Customer profitability: risk adjusted return, Customer profitability: risk adjusted return,

revenue, fees, direct and allocated costs etc.revenue, fees, direct and allocated costs etc.– Any conflicts of interest or special concernsAny conflicts of interest or special concerns

Appendix: Business Proposal ChecklistAppendix: Business Proposal Checklist

Macro AnalysisMacro Analysis– Business Environment ReviewBusiness Environment Review

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

Strength of customer’s business and financial Strength of customer’s business and financial strategiesstrategies

– Management Evaluation: competency, Management Evaluation: competency, experience and effectivenessexperience and effectiveness

Appendix: Business Proposal ChecklistAppendix: Business Proposal Checklist

Customer AnalysisCustomer Analysis– Company history, background, objectives and Company history, background, objectives and

performanceperformance– Relevance and strength of future business plansRelevance and strength of future business plans

Consider seasonality and scenario analysisConsider seasonality and scenario analysis

– Primary and secondary sources of repaymentPrimary and secondary sources of repayment– Historical financial capacity and analysis of future Historical financial capacity and analysis of future

performance: sales, profitability, working capital, performance: sales, profitability, working capital, liquidity, cash flow, leverage, tangible net worth etc. liquidity, cash flow, leverage, tangible net worth etc.

Quality of earnings Quality of earnings Absolute and ratio analysisAbsolute and ratio analysisPeer comparisonsPeer comparisons

Appendix: Business Proposal ChecklistAppendix: Business Proposal Checklist

Strengths, Weaknesses and RecommendationStrengths, Weaknesses and Recommendation– Key factors that could jeopardize collection: Key factors that could jeopardize collection:

environment or company specificenvironment or company specific– Any mitigating factors Any mitigating factors – Consider probability and impactConsider probability and impact– Consider all sources of repayment: primary, Consider all sources of repayment: primary,

secondary and tertiary, including access to capital secondary and tertiary, including access to capital markets, refinancing etc.markets, refinancing etc.

– Summarize strengths and weaknesses and conclude Summarize strengths and weaknesses and conclude with a recommendationwith a recommendation