Credit Analysis

Prime Lending Rate and Bank Credit

What is the Benchmark Prime Lending Rate (BPLR)?
 The benchmark lending rate of a bank to be followed uniformly across all the branches

Can there be multiple PLRs?

 No. Since all lending rates can be determined with reference to the Benchmark PLR by taking into account term premia and/or risk premia, there is no need for multiple BPLRs. These premia can be factored in to the spread over or below the BPLR.
 Source: RBI
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Prime Lending Rate and Bank Credit

Can there be sub-PLR lending?
 Yes. Banks are free to fix Benchmark Prime Lending Rate (BPLR) for credit limits over Rs.2 lakhs with the approval of their respective Boards.

Can the banks lend at fixed rate?

 Yes. Subject to the conformity with Asset Liability guidelines

Can there be lending without any reference to PLR?

 Yes in specific cases loans for consumer durables, loans against shares and debentures, bills discounting, finance granted to specified intermediary agencies etc.
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Core Credit Products

Cash Credit
 A short term cash loan to a company to meet the working capital requirement  How is it different from ordinary loan?
From marketing point of view it is a joint product: loan and current account bundled into one product. Customer is sanctioned a credit limit and he can keep drawing and depositing cheques in cash credit account. It is more or less a permanent loan.
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Contd..
Legal enforcement is quite weak in case of cash credit.  Pricing Usually based on the credit rating of the company ranging from prime lending rate upwards. Interest is charged on the consumed amount.

Core Credit product

Export Credit
 Banks grant export credit on to meet all the financial requirements of exporters Pre-shipment/Packing credit, Post-shipment credit Exporters having firm export orders or confirmed L/C from a recognized Bank can avail the export credit facilities provided they satisfy the required credit norms. Rupee export credit is usually available for a maximum period of 180- days from the date of first disbursement (can vary from bank to bank)
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Core Credit product

Export Bill Rediscounting
 Banks also offer financing of export by way of discounting of export bills to provide post shipment finance to the exporters at competitive international rate of interest.  The export bills can be purchased/ discounted provided they comply with the norms of the Bank/ RBI.

Pricing of Export Credit

 LIBOR linked and market determined.
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Core Credit Product

Foreign Currency Loans
 External commercial lending
LIBOR linked

Retail Lending
 Housing  Auto  Personal loan etc.

Other Credit Products

Letters of Credit
 A payment undertaking given by a bank (issuing bank) on behalf of a buyer (applicant) to pay a seller (beneficiary) for a given amount of money on presentation of specified documents representing the supply of goods within specified time limits.
How does it work?

How does an LC work?

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Contd..

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Other Credit Products

Bank Guarantees
 Bank provides a guarantee on behalf of the customer that liabilities will be met  Primary liability lies with the customer.

Advances against shares and debentures

 Shares/ debentures/ bonds accepted by banks as security for loans/ advances should be valued at the prevailing market prices.  A uniform margin of 50% has been stipulated for all advances against shares/ debentures.

Others
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Credit Appraisal Process

Approaches to Credit Evaluation
 Five C principle  Financial statements  Scoring model
Altmans Z score model

 Credit rating
J P Morgans CreditMetricsTM

 Market models
Moodys-KMV model
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Five C Principle
Character
 Reputation of the firm, repayment history - age of the firm a good proxy

Capital
 Leverage

Capacity
 Volatility of borrowers earnings

Collateral Cycle or Economic conditions

 Cyclic vs. non-cyclic industries
A subjective model of credit analysis
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Credit Scoring Models

Altmans Z score

Z ! 1.2 X 1  1.4 X 2  3.3 X 3  0.6 X 4  1.0 X 5

Where,
X1 X2 X3 X4 = working capital/total asset ratio = retained earnings/total assets ratio = EBIT/total assets ratio = market value of equity/book value of total liabilities ratio X5 = sales/total assets ratio
Z Score Bankrupt firm 1.81 2.81 Stable firm
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Why do the Conventional Techniques Fail?

Not really! Rather they are increasingly getting less relevant vis--vis Basel framework. Why?
 Basel regulations require the banks quantify the credit risk/default risk which is not possible in any of these models.  Stability of Z-score model is doubtful (though it is still used in banks as an Early Warning System, refer to ICICI Bank study)  Quantification of credit risk is only possible by some quantitative model of credit risk such as Credit rating.
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Credit Rating vis--vis Basel II

The Transition Matrix
Transition matrix: probabilities of credit rating migrating from one rating quality to another, within one year. Initial Rating AAA AA A BBB BB B CCC AAA AA 90.81 8.33 0.70 90.65 0.09 2.27 0.02 0.33 0.03 0.14 0 0.11 0.22 0 Rating at year-end (%) A BBB BB B CCC Default 0.68 0.06 0.12 0 0 0 7.79 0.64 0.06 0.14 0.02 0 91.05 5.52 0.74 0.26 0.01 0.06 5.95 86.93 5.30 1.17 1.12 0.18 0.67 7.73 80.53 8.84 1.00 1.06 0.24 0.43 6.48 83.46 4.07 5.20 0.22 1.30 2.38 11.24 64.86 19.79
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Source: Standard & Poor

Prototype Risk Rating Process

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Prototype Risk Rating Process

Two-tier rating system:
 Obligor rating
represents probability of default by a borrower

 Facility rating
represents expected loss of principal and/or interest

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Prototype System: 9 Step Process

5 steps associated with obligor rating
 Financial assessment  Quality of management  Borrowers absolute and relative position within the industry  Quality of financial information  Country risk

4 steps associated with facility rating

    Examining third party support Factoring in the maturity of the transaction Review of the structure of the transaction Assessment of the collateral
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Prototype Risk Rating Process

Collateral

Transaction Structure Maturity of Transaction Third Party Support

Managerial Capability,Competitive Position Quality of Financial Information, Country Risk

Facility Rating

Financial Assessment (Floor)

Obligor Rating

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1.Financial Assessment
Ratings reflect:
 Financial position, performance and trends  Ability of borrower to withstand unexpected financial setbacks  leverage  Access to the capital markets

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1.Financial Assessment Contd..

Key financial ratios assessment areas: include three main

 1. Earnings /cash flows  2. Asset values/ Liquidity/Leverage  3. Financial size & Flexibility/Debt capacity

Need to:
 adjust key ratios for cyclical effect  weight current years performance relative to prior years performance  benchmark results against other firms in the same industry group
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1.Financial Assessment Contd..

On a risk rating scale of say, 1 - 9, Rate the obligor for each of the 3 assessment areas:
Adjusted Obligor Rating

Step # 1.

Risk Factors
Financial Assessment Earnings/Cash Flow Asset Values/Liquidity/Leverage Financial Size & Flexibility/Debt capacity

Risk Rating 6 3 5.5

5.0

The 3 components of the financial assessment indicate average performance with risk ratings of 6,3, and 5.5 for an average of 5 (14.5/3 =4.83, rounded to 5)

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1.Financial Assessment Contd..

Validate against industry financial ratios Example: A. Earnings / Cash flow (solvency)
 EBIT / interest expense = 1.3 (interest coverage)  (corresponds to a risk rating of B+/B, i.e. risk rating= 6)

B. Liquidity
 Current ratio = 2.4  (corresponds to a risk rating of say A, i.e. risk rating=3)

C. Leverage => Debt Capacity

 Total debt / capitalization = 60  (corresponds to a risk rating of BB-, i.e. risk rating=5.5)
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1.Financial Assessment Contd..

Implications for Risk rating 5 in the example:
Risk rating Earnings (E)/ Cashflow (CF) Asset Values (AV)/ Liquidity (LIQ)/ Leverage (LEV) Financial Size (FS) & Flexibility (F)/ Debt Capacity (DC)

adequate earnings and assets of average quality cashflow with additional with possible reliance on coverage intangibles

Market access limited to ability to attract high-yield debt

approaching investment grade positive trends, but may satisfactory working capital (rated BB+) not have been entirely with adequate leeway bank debt easily refinanced by stable in the past other FIs with a good increase average leverage tenor of liabilities to assets available may be slightly mismatched
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2. Quality of Management
Factors (mostly subjective)
 Experience  Succession planning  day-to-day account operation  environmental assessment  effect of contingencies  etc.
Note: use downwards: these factors to adjust obligor rating

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2. Quality of Management Contd

Adjusted Obligor DownGrade by Rating Day-to-Day Account Operation Management Environmental Contingencies Other Factors 0.5 5.5

Step # 2.

Risk Factors
Management/ Qualitative

Monthly financial statement information is constantly late and of poor quality and a 0.5 downgrade applies to day-to-day account operation. The obligor rating is adjusted 5.5 from 5.

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3.Industry Review
Industry Rating (A)
 Competitiveness  Trade environment  Regulatory framework  Restructuring  Technological change  Financial Performance  Long term trends  Vulnerability to macroeconomic environment
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3.Industry Review Contd

Tier Assessment - Relative position within industry (B)
 relevant market share  customer base  cost structure  response to environmental changes

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3.Industry Review Contd

Example:
1 Tier Assessment Within Industry Tier 1 Tier 2 Tier 3 Tier 4 No adjustment

Best possible obligor rating

(given initial industry and tier ratings)

Industry rating
2 3

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3.Industry Review Contd

Adjusted Obligor Rating

Step # 3.

Risk Factors
Industry/ Tier Position Industry Rating (1-5) 3

Best Possible

4 Tier Assessment (1-4) 2

5.5

With Industry rating a 3, and a Tier 2 customer with a good share of the relevant market share, and an average cost structure, the best possible rating is a 4. In this case, there is no effect on the obligor rating.
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4.Financial Statement Quality

Factors
 Auditors report  Accountants review  Internally prepared statements  etc.

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4.Financial Statement Quality Contd

Step # 4.

Risk Factors
Financial Statement Quality Statement Type AUDIT

Best Possible 1

Adjusted Obligor Rating 5.5

The annual statement is audited for a best possible rating of 1 with no change to the Obligor Rating
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5.Country Risk
Factors
 Inability of a counterparty or obligor to pay its obligations due to:
cross-border restrictions convertibility and availability of a given currency.

 Political and legal risk of a country

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5.Country Risk Contd

Adjustment to obligor rating (illustrative only) None Best possible obligor rating is 5 Best possible obligor rating is 6 Best possible obligor rating is 7

Division country ratings Excellent, Very Good, Good or Satisfactory Fair Selectively Acceptable Marginal/Deteriorating

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5.Country Risk Contd

Step # 5.

Risk Factors
Country Risk (if other than India) Country

Adjusted Obligor Rating

5.5 FINAL OBLIGOR RATING COMMENTS: 5.5

As the country is India, there is no effect on the rating leaving the final obligor Rating at 5.5
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Facility Rating: Third Party Support (6) Type of guarantee

Clean guarantee Comfort letter Completion guarantee First Charge Keepwell agreement

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Facility Rating: Third Party Support (6) Contd

FACILITY 1

TYPE: TERM

AMOUNT:

Final Obligor Rating

5.5

Adjusted Facility Rating 6. Third Party Support Type 4

A 100 % clean guarantee is provided by a risk rated 4 client. The client does not provide security to other lenders and the position is not subordinated. Therefore the rating is improved to 4.
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Facility Rating: Term to Maturity (7)

Term to maturity of the facility
 Increased risk in longer term facilities  Decreased risk for very short-term facilities

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Facility Rating: Term to Maturity (7) Contd

FACILITY 1

TYPE: TERM

AMOUNT:

Final Obligor Rating

5.5

Adjusted Facility Rating 7. Term 5.0

The facility is an 8-year term loan resulting in a downgrade from a 4 to a 5.

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Facility Rating: Facility Structure (8)

Facility Structure
 Covenants/Term  Repayment/Amortization  Seniority of loans

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Facility Rating: Facility Structure (8) Contd

Covenants: Covenants are in place which effectively mitigate all (or part) of any increased risk due to term, by means of default clauses that provide a full opportunity to make demands, or by means of repayment arrangements that ensure rapid pay-down
ACTION: Upgrade only to offset (possibly partially) any downgrade for term
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Facility Rating: Facility Structure (8) Contd

 Subordinated/Loans security: The banks loan is subordinated, putting ones position and/or security significantly behind other creditors
 ACTION: Downgrade

 Corporate organization: The borrower is highly cash flow dependent on related operating companies that have their own financing
 ACTION: Downgrade

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Facility Rating: Facility Structure (8) Contd

FACILITY 1

TYPE: TERM

AMOUNT:

Final Obligor Rating

5.5

Adjusted Facility Rating 8. Structure Upgrade 0.5 4.5

Repayment is well ahead of schedule due to an unexpected principal reduction that partially offsets the downgrade in step 7 resulting in an upgrade of 0.5 to a rating of 4.5
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Facility Rating: Collateral (9)

Collateral
 Pledged assets are of very high caliber (generally no reliance on inventory) and provide substantial over-coverage (using conservative valuations, with liquidation appraisals held where warranted).  Background support also adds strength.

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Facility Rating: Collateral (9) Contd

FACILITY 1

TYPE: TERM

AMOUNT:

Final Obligor Rating

5.5

Adjusted Facility Rating 9. Collateral Category

Back ground

Upgrade

.5

4.0 4.0

FINAL FACILITY RATING COMMENTS:

Strong security. A first charge is held over all company assets including state of the art commercial buildings. Upgrade by 0.5 to a final facility rating of 4
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Appendix

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Appendix
Letters of Credit Bills discounting Comfort letter Keep well agreement Pre-shipment credit Post-shipment credit

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Letters of Credit
Beneficiary
 The beneficiary is entitled to payment as long as he can provide the documentary evidence required by the letter of credit. The letter of credit is a distinct and separate transaction from the contract on which it is based. All parties deal in documents and not in goods. The issuing bank's obligation to the buyer, is to examine all documents to insure that they meet all the terms and conditions of the credit. Upon requesting demand for payment the beneficiary warrants that all conditions of the agreement have been complied with. If the beneficiary (seller) conforms to the letter of credit, the seller must be paid by the bank.
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Letters of Credit
Issuing bank
 The issuing bank's liability to pay and to be reimbursed from its customer becomes absolute upon the completion of the terms and conditions of the letter of credit.  The issuing banks' role is to provide a guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due and to examine the documents, and only pay if these documents comply with the terms and conditions set out in the letter of credit.

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Letters of Credit
Advising/Confirming bank
 An advising bank, usually a foreign correspondent bank of the issuing bank will advise the beneficiary. Generally, the beneficiary would want to use a local bank to insure that the letter of credit is valid. In addition, the advising bank would be responsible for sending the documents to the issuing bank. The advising bank has no other obligation under the letter of credit. If the issuing bank does not pay the beneficiary, the advising bank is not obligated to pay.

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Letters of Credit
Negotiability
 Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are passed freely from one party to another almost in the same way as money. To be negotiable, the letter of credit must include an unconditional promise to pay, on demand or at a definite time.
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Bills Discounting
Discounting with recourse
 Discounting with recourse is the discounting of bills of exchange, when a risk of the issuer of the bill is run by the company: if the bill is not paid at maturity, the bank receives the amount thereof from the company which had discounted the bill of exchange.

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Bills Discounting
Discounting without recourse
 Discounting without recourse is a straight sale of customer receivables, wherein the bank has no recourse to its customer if the bill remains unpaid at maturity.

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Comfort Letters
Usually, a letter issued to a lending institution by a parent company/bank acknowledging the approval of a subsidiary company's attempt for financing.
 See the sample comfort letter issued by a bank.

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Keep well Agreements

Usually, a contract between a parent company and its subsidiary to maintain solvency and financial backing throughout the term set in the agreement.

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Pre-shipment Credit
Banks offer pre-shipment credit to exporters by way of packing credit, enabling them to finance operations like purchase/import of raw materials or processing and packing of export goods. Exporters can avail of this pre-shipment credit either in rupees or foreign currency.
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Post-Shipment Credit
Banks offer post-shipment credit to exporters, helping them finance export sales receivable for the time lag between shipment of goods and date of realization of export proceeds. Exporters can avail of the following services:
 Negotiation/ payment/ acceptance of export documents under letter of credit  Purchase/ discount of export documents under confirmed orders/export contracts etc.  Advances against export bills sent on collection

Exporters can avail of this credit either in rupees or in foreign currency.

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