Credit Risk Analysis - A tryst with strategic prudence

354 Pages·2007·11.146 MB·English

by  Ciby Joseph

C r e d i t R i s k
A n a l y s i s
A Tryst with Strategic Prudence

C r e d i t R i s k
A n a l y s i s
A Tryst with Strategic Prudence
Ciby Joseph,FCA,
Manager, Financial Analysis,
Credit Risk Management Dept,
HSBC Bank Middle East Ltd
Tata McGraw-Hill Publishing Company Limited
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This book is dedicated to my daughter, Angela
Preface
The aim of the book is to present a reasonably rigorous treatment of credit risk in a way that would
be accessible both to students and professionals involved in credit risk management. The book can
act as a reference book for practitioners in credit and students who have finance as one of their
major topics. The reader is provided with several tools that will enhance analytical skills to be
applied to various situations and problems. Gone are the days where ‘big names’ acted as the
litmus test of credit risk. There are cases where many credit decision takers, even at the top level
innocently assume ‘equity risk’ as credit risk, which ultimately lead to avoidable credit losses. The
book emphasizes the true nature of credit risk and would enable avoidance of such situations.
Part I introduces the reader to the meaning and other fundamentals of credit. Merits and the
demerits of credit, importance of credit and precautions of using credit have been discussed.
The role of Credit Risk Management in the overall context of an organization has been discussed.
Part II deals with Firm Credit Risk through EIIF (External Risk, Industry Risk, Internal Risk and
Financial Risk) Model. The EIIF Model is one of the unique features of this book. Part III contains
unique credit risks of two common situations, Project Finance and Working Capital Finance.
Part IV covers Credit Portfolio Construction, Portfolio Level Credit Risks and Mitigation Tools
among others. It also shows how the core fundamentals of Markowitz Portfolio Selection principles
can be adapted for credit portfolio management. Part V describes How to Price Credit Risk and
Part VI discusses the Relevance of Security and covers main topics such as Essentials of Good
Security, Role of Security and Types of Security.
My special thanks to Jeff Peanick and Srinivasan, who encouraged me to look at the credit
risk from a lateral angle as well. Besides, during my tryst with credit risk exceeding a decade, I
have been fortunate to have dealt with some of the most complicated credit risks in India and
abroad, without which this book would not have been possible. My sincere thanks to
Christopher, Dr. (Prof) Stephen Mathews and Ali Al Abkari for their useful suggestions and
Deepa Varadarajan of Tata McGraw-Hill for her inspirational guidance. While the views
expressed herein are the result of lot of experience,effort, thoughts and interest in the topic, with
humility,I seek suggestions to improve the contents of the book, from my esteemed readers.
CIBY JOSEPH
OCTOBER2005
Author’s Profile
Ciby Joseph, a Fellow Member of Institute of Chartered
Accountants of India with expertise in corporate credit analysis
and corporate finance exceeding a decade, has handled diverse
credit risk assignments both in India and abroad. A university
rank holder, his professional interests cover a variety of areas
including project evaluation, business valuation, financial
modelling, risk management, credit rating and credit opera-
tions. Mr. Joseph currently heads Financial Analysis Unit in
Credit Risk Management of HSBC Middle East Bank Ltd. in
Dubai, United Arab Emirates.
Contents
Preface vi
Author’s Profile vii
PART 1 BASICS OF CREDIT RISK 1
CHAPTER 1 INTRODUCTION TO CREDIT 3
1.1 Meaning of Credit 3
1.2 Credit Loss 4
1.3 Role Of Credit 5
1.4 Credit Market 6
1.5 Credit—Analogous to Fire 7
1.6 Suppliers of Credit 11
CHAPTER 2 CREDIT RISK 15
2.1 Meaning of Credit Risk 15
2.2 Causes of Credit Risk 17
2.3 Credit Risk and Return 18
2.4 Credit Risk Analysis 18
2.5 Historical Progress of Credit Risk Analysis 19
2.6 Need for Credit Risk Analysis 20
CHAPTER 3 MANAGING CREDIT RISK 25
3.1 Strategic Position Of Credit Risk Management 25
3.2 Credit Risk Management Context 26
3.3 Credit Risk Management Objectives 27
3.4 Credit Risk Management Structure 27
3.5 Credit Risk Culture 28
3.6 Credit Risk Management in Non-Financial Firms 28
3.7 Credit Risk Management in Financial Intermediaries 29
CONTENTS ix
PART 2 FIRM CREDIT RISK 33
CHAPTER 4 FUNDAMENTAL FIRM-LEVEL RISKS 35
4.1 Firm Risk Classification 35
4.2 Risk Matrix 37
4.3 Different Risk Levels 38
4.4 Migration 40
CHAPTER 5 EXTERNAL RISKS 41
5.1 Business Cycle 42
5.2 Economic Conditions 44
5.3 Inflation/Deflation 48
5.4 Balance of Payments & Exchange Rates 50
5.5 Political 51
5.6 Fiscal Policy 51
5.7 Monetary Policy 52
5.8 Demographic Factors 52
5.9 Regulatory Framework 53
5.10 Technology 54
5.11 Union Involvement 54
5.l2 International Developments 55
CHAPTER 6 INDUSTRY RISKS 57
6.1 Types of Industry Risks 58
6.2 Defining an Industry 58
6.3 Industry Life Cycle 59
6.4 Permanence of Industry 61
6.5 Government Attitude & Industry 61
6.6 Factors of Production 62
6.7 Business Cycles 63
6.8 Industry Profitability 63
6.9 Competitor Analysis 68
Illustration 69
x CONTENTS
CHAPTER 7 INTERNAL RISKS 75
7.1 Understanding the Activity 76
7.2 Risk Context & Management 77
7.3 Risk Identification Steps 78
7.4 SWOT Analysis 80
7.5 Strategy Analysis 82
7.6 Pitfalls in Strategy 87
7.7 Management Analysis 88
7.9 Other Internal Risks 93
CHAPTER 8 FINANCIAL RISKS 95
8.1 Importance of Financial Statements 95
8.2 Quantity of Financial Statements 97
8.3 Financial Analysis 97
8.4 Analytical Tools 100
8.5 Financial Leverage Ratios 109
8.6 Operational Ratios 116
8.7 Encapsulated Ratios 127
Illustration 130
CHAPTER 9 INTEGRATED VIEW OF RISKS 139
9.1 Relevance of Integrated View 139
9.2 Judgment 139
9.3 Identifying Significant EIIF Risks 140
9.4 Risk Mitigants 142
9.5 Types of Mitigants 142
9.6 Principles to be borne in mind
while selecting Mitigants 146
9.7 Monitoring of Credit Risk 147
9.8 Credit Rating 148
9.9 Five Cs and EIIF Models 153
Illustration: Credit Risks And Possible Mitigants 154