Credit risk management

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C O N T E N T S

Chapter 1 Introduction to credit risk management 1

Chapter 3 Analyzing the transaction: what are the 51

lending objectives

Chapter 5 Company-specific financial performance 127Chapter 6 Company-specific risks: business, industry 175

and management

The following students contributed research to the book under thedirectorship of Dr Andrew Economopoulos at Ursinus College inCollegeville, Pennsylvania

Copyright © 2007 by JoEtta Colquitt Click here for terms of use

Risk Management

1

As the name implies, credit risk management is predicated on theexistence of risk and uncertainty to leverage the earnings from lend-ing to a borrower Credit risk arises whenever a lender is exposed toloss from a borrower, counterparty, or an obligor who fails to honortheir debt obligation as they have agreed and contracted Forlenders who extend credit in the form of loans, trading activities, orthe capital markets, credit risk is inherent in all their businessactivities and is an element in virtually every product and servicethat is provided Typically, the risk of credit-related losses refers tothe type of business transaction that is contracted for and can occurfrom a variety of credit loss scenarios The most obvious is thefailure to repay interest or principal on a direct or contingent loanobligation Credit loss can also occur from failing to honor or repayreciprocal financial agreements that still have some economic value,such as a credit derivative contract Finally, credit loss can occurfrom a decline in a borrower’s credit quality that results in a loss tothe value of the debt obligation These scenarios can be extendedfurther to include additional sources of financial risks when creditrisks are integrated into market, operational, as well as throughoutthe credit provider’s enterprise In fact, compared to 30 years ago,the types of credit loss scenarios found in corporate and businesslending today have served to revolutionize how the extension ofcredit is assessed and managed

Borrowers demand credit that will be used to reinvest in theirbusinesses and for which they expect to earn a return At the sametime, lenders or financial intermediaries supply credit to earn a

Copyright © 2007 by JoEtta Colquitt Click here for terms of use

return when these companies borrow This process for extendingcredit has a multiplier effect on the global money supply, so this iswhy credit is a powerful driver of our economy A more varied but

also descriptive definition of credit is given by the Economist

Dictionary of Economics, which states that credit is “the use or

possession of goods or services without immediate payment,” that

“credit enables a producer to bridge the gap between the tion and sale of goods,” and that “virtually all exchange in manu-facturing, industry and services is conducted on credit.”1

produc-Extending credit would therefore be impractical today, ifnot impossible, without the events that have been brought on

by deregulation, technology, and disintermediation in the cial services industry, all of which have actually changed thepsychology of extending business and corporate credit Beginningwith changes that have transpired in the telecommunicationsindustry, credit has evolved from the assessment of a borrower’screditworthiness into a risk evaluation and measurement method-ology that lenders and suppliers of credit use to analyze, measure,and manage Another change has been the dismantling within thecommercial banking sector among major credit providers thattraditionally had funded corporate and business loans with theliquid deposits of customers However, the growing number ofnonbank competitors that have entered the financial services arena,such as insurance companies, mutual funds, investment financecompanies, and the capital markets, have also transformed thefundamental nature of how credit is extended and managed Thishas created new sources of credit flows, which has allowedbusiness credit to be extended through the services of brokers,pension and mutual funds, insurance companies, and even by thecorporations and suppliers of the goods and services that busi-nesses use The result has been greater economies of scale, alongwith lower transaction costs and, to a lesser extent, an increase inthe volume of credit market debt Despite the increased competi-tion and decline of assets faced by banks, the borrowing capacity ofthe credit markets has nonetheless grown over the years, alongwith the amount of debt outstanding for business lending, as theamount held by commercial banks has declined in favor of otherfinancial service providers

finan-Among the most significant lessons learned from the aboveevents is the potential systematic impact on other financial entitieswhen one financial institution holds a significant aggregate

exposure for a borrower, obligor, or counterparty Another lessonlearned is that when exposures reach imprudent lending limitsbecause of high credit concentrations, the losses may become toolarge relative to the institutions’ capital and overall risk levels.Finally, we learned that the risk of credit defaults can alsooccur from exposures based on the concentrations of correlatedrisk factors that are related to specific risk events such as in thecases of Enron and WorldCom This supports the contention thatcredit risk is the biggest source of risk to financial institutions andcredit-related suppliers.

This book is therefore designed to look at the total integratedprocess of credit risk management, beginning with the risk assess-ment of a single obligor and then moving on to the risk measure-ment of an entire portfolio To build on the summary of factors thathave led to the current state of credit risk management, Chapter 2begins by discussing the operational practices and structuralprocesses for implementing and creating a sound credit environ-ment Because credit risk is managed using a bottom-up approachand begins with the origination of a new transaction, it is importantfor credit specialists to have a background in the credit selectionprocess Chapter 3 will therefore discuss the credit selection processthat is used to evaluate new business and describe how transactionrisk exposure becomes incorporated into portfolio selection risk.Although the origination of credit must ultimately be consideredfor the effect that it will have on the aggregate portfolio and share-holder’s value, the preservation and growth of a portfolio cannot beachieved without first creating value from the loan origination,which culminates in a credit portfolio Chapter 4 will follow with anoverview of the funding strategies of some of the more commonlyused financial products in the extension of business credit

Another function of an integrated credit risk managementapproach is the analysis of individual borrowers Chapters 5 and 6will therefore focus on some of the techniques that are used in fun-damental credit analysis Beginning in Chapter 5, we will outlinesome fundamental credit analysis applications that can be used toassess transactions through the framework of a risk evaluationguide Chapter 6 will build upon this with additional approaches

to risk in evaluating a borrower’s industry and management.Beginning in Chapter 7, and for the remainder of the book, thefocus will be on quantifying and integrating a transaction into thecredit portfolio with the applications of credit risk measurement In

addition to defining the role of credit risk measurement, the chapterwill also present a basic framework to measure credit risk and dis-cuss some of the standard measurement applications for quantify-ing the economic loss on a transaction’s credit exposure Chapter 8will follow with a discussion of the heart of credit risk managementtoday—how the integration of individual transactions will impactthe aggregate credit portfolio Aside from the techniques and toolsbeing used by lenders to manage their credit risk exposure, creditportfolio risk management also encompasses various markettools that are used to help lenders maximize their earningsand profitability As many of the tools are adapted to the types

of infrastructures and technology that a lender has in place, Chapter

9 will discuss the credit rating systems that have come to play a pivotal role in managing credit risk These tools are furthersupported by the regulatory prescriptions, which will finally be discussed in Chapter 10

2.1 INTRODUCTION

Credit risk arises whenever a lender is exposed to loss from aborrower, obligor, or counterparty who fails to honor their con-tracted debt obligation, as agreed, in a timely manner For lenderswho extend credit in the form of loans or capital market products,credit risk is inherent in all their business activities and is anelement in virtually every product and service that is provided Ingeneral, there are also degrees of differences in the types ofrisks that credit transactions may hold, all of which need to bespecifically understood by the credit organization relative tohow they will impact the credit portfolio Managing the risks thatare contained in providing debt services requires a systematicframework to be established throughout the relevant credit areas;this is known as the credit process This chapter will present anoverview of the credit process in the context of how it has evolved

in the management of extending business credit We will thendiscuss each of the functions having a role in the credit process andhow they can impact the delivery of credit services

The risks associated with delivering credit services can lead

to direct or indirect losses if the processes contain internalprocedures, systems, or staff members that inadequately servicetransactions Similar to the manufacturing and distribution sectorsthat produce and sell products in the marketplace, there is aparallel in how banking institutions distribute credit services to thebusiness community Understanding the distribution functionsthat lenders use to deliver commoditized services requires anoverview of the market environment that has evolved in creditrisk management

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2.2 A CHANGING LANDSCAPE

Over the past decade, the servicing of monetized assets has beenreconfigured to create a more efficient credit process and loanmarket through the application of new technologies, new financialproducts, and new market participants Unlike traditional com-mercial lending, which at one time was predicated on long-termrelationships, today’s emphasis is on short-term value-addedcustomer relationships.* This concept of “value-added” has alsobrought new meaning to commercial lending as customer relation-ships are defined as either profitable or not profitable If they areprofitable, this must be evidenced by returns that are commensu-rate with the overall portfolio objectives and for the financialinstitution’s return on capital A survey taken in 2004 by theBethesda (Maryland) based Association for Finance Professionals(AFP) seems to support this trend In the survey, to over 370corporate finance treasurers from companies earning annualrevenues of $1 billion or greater, approximately 57% of the respon-dents stated that loan issuance for their companies over theprevious five years had been linked to investment banking services

by commercial lenders Approximately 63% of respondentsclaimed that credit had either been denied to their firms or hadresulted in the terms and conditions on their loans being shiftedwhen they had failed to grant additional new business to theirbanks.† The survey also found that “the larger the company,the greater the pressures were on them to attain commercial creditservices from the banks.” As a consequence, “half of the compa-nies surveyed said they were unable to meet spending require-ments without having awarded underwriting or strategic advisoryservices” to banking institutions Should these allegationsprove to be true, they reflect how the market environment hasunfolded in commercial banking by illegally tying commercialcredit services to investment banking services It furthermoreimplicates how lenders have fared in transitioning from theclassical approach to realizing a relationship’s profitability under amodern credit approach in order to meet an established hurdle rate

of return

*The exception to this, however, continues to be in emerging markets, where lending is based on size, culture, and traditional banking relationships.

†

Survey of 370 finance executives unearths widespread bank demands that credit be linked

to the purchase of other services; June 11, 2004, Tim Reason, CFO.com

Under the classical or traditional credit process, the concept ofcredit risk management had always been to ensure that adequatecapital was available for loan funding and that reserves wereprovisioned according to the borrower’s credit assessment Creditextensions had always used a static approach whereby subsequent

to the loan origination, the credit risk of the borrower wouldremain on the issuing creditor’s balance sheet until maturity.Figure 2.1 illustrates the key elements of this approach, whichbegan with the transaction’s origination between the accountofficer and the borrower Credit requests were prepared and pre-sented for approval to enter into a transaction that more often thannot would be underpriced for the risks relative to the proposedfacility terms and structure The credit granting and subsequentmonitoring process was oftentimes accompanied by unpredictablefinancial indicators that had been derived from limited financial

F I G U R E 2 1

Traditional Credit Model

analysis and due diligence A supporting credit department wasresponsible for independently assessing and monitoring the risksbased on financial statements, and the account officer providedcredit analysis and, if applicable, collateral appraisals Loansyndications played an active role in the credit markets at the timehowever, the emphasis by most lenders was foremost on mitigat-ing credit risks through risk disaggregation rather than managingloan funding for liquidity purposes In other words pricing was notanalyzed to separately identify all of the cost components thatlenders incurred for the risks of extending credit, so credit special-ists were not able to precisely examine the individual variablesthat influenced price performance A common problem under thisapproach was that the lack of risk-sensitive pricing strategies didnot always result in sufficient capital being allocated against risingunexpected losses This became quite evident as the extension ofloans declined from being a leading product for lenders to one of a

“loss leader,” in anticipation that future ancillary business fromborrowers would compensate for the losses on loans As a result,when defaults did occur, costs were not recovered, which served tofurther depress credit earnings

As the credit markets started to change over the years, therising defaults led to diverging loan costs and firm revenuesthat spiraled out of control for most banks An agency conflictstarted to develop between bank profitability and account officers’performance compensation while funding and administrativecosts on defaulted loans were not being recovered At the sametime, the credit markets were also changing as innovative financialproducts came on stream into the markets, only to reveal theemerging credit quality disparities among borrowers It was at thispoint that banks began to examine their traditional credit riskassumptions by challenging their old assumptions, which hadbeen embedded in a static mindset, and eventually started shifting

to a dynamic perspective that has now become the modern creditrisk management approach

2.4 THE MODERN CREDIT PROCESS

Banks subsequently began to make comparisons between their torically passive approach to loan management and the moreactive style of portfolio managers that used most of the same skillsand techniques for selecting credits They found that a distinction

his-between these alternative credit providers and traditionalcommercial lenders was that portfolio and fund managers didnot retain nonperforming assets if those assets failed to provideexpected portfolio returns For banks, however, this requiredgreater emphasis to be placed on portfolio management techniques

so that single stand-alone credit requests would be extended tonow earn a sufficient economic return so as to maximize theexpected credit portfolio returns

The “modern credit risk approach,” as illustrated in Figure 2.2,

is considered to be a dynamic application in which all aspects ofcredit risk are built around an ongoing credit portfolio assessmentand measurement process Credit Portfolio Management techniques

z

F I G U R E 2 2

Modern Credit Approach

have become an integral part in credit functions for businessunits throughout banks, beginning with the evaluation of loanoriginations Supporting functions, including relationship man-agers, the credit department, credit administration, and creditportfolio management, all have complementary roles that aredriven by several common themes—to reduce the banks’ cost

of capital and to increase aggregate portfolio performance In eral, transactions are originated by relationship managers inconjunction with each supporting credit function so that when newbusiness is developed it will be based on realizing a hurdle rate ofreturn that is also in line with the banks’ portfolio concentrationlimits When transactions do not yield the required returns or meetthe hurdle rates, the facility is deemed undesirable if the aggregateborrower relationship is found to be unprofitable Whereas theapplication of concentration limits under the traditional creditapproach had been to reduce the amount of exposure to single bor-rowers, the practice is now extended to reducing concentrationlimits to credit events and exposure by borrowers, industries, assetclasses, and geographical regions Credit portfolio analysis is alsoperformed on an aggregate level for borrowers, companies, mar-kets, as well as credit products, all of which are ultimately mea-sured against the desired portfolio’s return As the new vanguards

gen-of the credit process, portfolio managers have empowered banks toadopt a defensive risk posture relative to customer relationships.For credit risk exposures that are not value-added or thatincreasingly outweigh the rewards, lenders will seek to transfer ormitigate them through loan sales, securitizations, or credit deriva-tives Transactions are terminated from the lender’s portfolio sothat they can be quantified, unbundled, and repackaged into newlymanufactured credit products for resale to third-party investors

By repacking corporate credit risk into new pools and classes

of debt that are sold to a broad range of investors, the credit marketshave created a new product segment in the syndicated, secondary,and capital loan markets The expansion and growth of the creditderivative markets among U.S banks over an eight-year period can

be seen in Figure 2.3, showing them to have increased from $100million in 1997 to $1.2 billion by the first quarter in 2004 As a pri-mary hedging product used by financial institutions to mitigate andtransfer risks as well as serve to provide credit enhancements, thestartling growth of these assets has by no means been limited tothe United States Figure 2.4 illustrates the global composition of the

credit derivative markets in 2004, in which approximately 42% ofthe market was concentrated in single named credit default swaps,and 27% in multinamed collateralized debt obligations (CDOs).These assets have afforded banks a vehicle with which to shift theirroles from originating and holding risk to originating and distri-buting risk Another vehicle that has also contributed to the means

to liquidate and remove credit exposures off balance sheets hasbeen the growth of the secondary loan market The growth in sec-ondary loan trading, presented in Figure 2.5 shows a substantialincrease between 1991 and the end of 2003 from $5BN to $148BN,respectively Earnings from these increased sales provide greaterliquidity for banks and are used to reinvest in higher returningassets by extending credit to more profitable borrowers

By adopting the practices of modern credit risk management,the banking industry has also become resilient in managing the deteriorating credit quality among corporate borrowers.Despite having faced two recessionary credit cycles since the 1980s,

Credit Derivatives Outstanding at U.S Commercial Banks, 1997–2004

Source : Office of the Controller of the Currency

F I G U R E 2 4

Global Credit Derivatives Market, 2004

F I G U R E 2 5

Secondary Loan Market Value Traded

Source: Ernst and Young 2004 estimates; Ernst and Young, 2003

including 1,414 bank failures between 1989 and 1993 on assets of

$554BN, industry volatility begin to stabilize over the years.Although corporate defaults increased between 1999 and 2002,strengthened risk management and measurement practices served

to diffuse the impact of these defaults compared to the 1980s As anexample, if we compare bank loan losses during 2001 and 2003 tothe industry situation in the late 1980s and early 1990s, the impact

of modern credit risk management techniques found the bankingsector to be much more resilient Figures 2.6 and 2.7 and Table 2.1highlight that global corporate defaults increased by issuers and bydebt volume amounts during the economic downturn between

1999 and 2002, at the same time as the returns of the U.S bankingindustry in Figure 2.8 exhibit that profitability was at its highestlevel for the first time in thirty years Notwithstanding that prof-itability compared to the rate of loan write-offs more than tripledduring this time as banks began to apply portfolio credit risk man-agement techniques Tighter credit standards were applied, alongwith more stringent credit terms, in response to credit cycle andrecessionary trends well before these patterns reached their nadir

F I G U R E 2 6

Annual Global Corporate Defaults by Issuers

F I G U R E 2 7

Annual Global Corporate Defaults by Amounts

Source : Standard & Poor’s Global Fixed Income Research; Standard & Poor’s CreditPro ® 7.0

F I G U R E 2 8

Returns of All FDIC Commercial Banks (1996–2002)

Referring to Figure 2.9, it can be seen that commercial loan offs represented approximately 45% of commercial loans in 1991, atwhich time they started to level off until the 2001 credit cycle, whenthey peaked at their highest level of 50% Compared to the priorcredit cycle in 1991, the volume of distressed debt had fallen from58% to 35% by 2001, although it rose slightly to 42% by 2003 due tothe secondary market trading of 2001 defaults The decline inwrite-offs and distressed debt trading between 1991 and 2003reflects the tighter credit standards imposed by banks prior to the

charge-2003 credit cycle recession

At the same time, the application of the modern creditapproach has resulted in creating additional credit risk as loantransactions now have multiple counterparties and intermediaries.Having so many counterparties involved in related transactionswith a diverse range of risk appetites, requires that they areclassified, managed, and monitored according to their multiple riskperspectives This has led to the development and implementation

of analytic applications that offer greater precision in the tion of credit risk Credit risk analytics and measurement

evalua-F I G U R E 2 9

Distressed Loan Trading and Commercial Banks

Charge-Offs

techniques (e.g., including scenario analysis and portfoliooptimization) are applied to both single transactions that supportthe credit assessment of existing and potential borrowers andcounterparties as well as in evaluating portfolios to assess cus-tomers’ profitability and relationships’ viability Although mostbanks in the early 1990s were initially slow to embrace creditrisk measurement tools, at least among the major and regionalbanks such tools are now incorporated into credit risk infrastruc-tures and management practices An example of a lender that tran-sitioned from the traditional to the modern approach of creditrisk management is highlighted in the case study on Citibank (CaseStudy 1), which emphasizes how one leading commerciallender came to understand the impact of portfolio credit risk in theearly 1990s.

CASE STUDY 1 CITIBANK

Citibank is a practical and realistic example of a commercial lender thatsome have said was forced into a role of leadership under the marketstresses that have led to modern credit risk management techniques.Like most of the banking industry during the late 1980s and early1990s, the high concentration of leveraged buyout and commercial realestate loan defaults that besieged Citibank provoked former CEO andChairman John Reed to take an active role in reassessing the bank’scredit risk management practices During an interview with

U.S Banker in 1989, Reed stated that “he was becoming concerned,

somewhat belatedly, that Citi was getting “unduly transactionoriented.”1 Reed also stated at the time that “the business was notperforming the way people said it was I didn’t sense that theyproperly understood what was happening or could work it.’’ Theproblems were exacerbated after bank auditors and loan reviewpersonnel missed warning signs that almost brought Citibank toinsolvency In the book by Philip Zweig on “Citibank and the Rise andFall of American Financial Supremacy,” he summarizes Citibank’scredit problems by stating:

Citi’s problems were heavily concentrated: domestic real estate, Australia, Brazil, and highly leveraged transactions The biggest chunk

of the leveraged deals—16 percent—were in media and entertainment.

By 1991, Citibank had made more than $13 billion in commercial real estate loans, more than a third in the western United States Nearly

43 percent of them were now nonperforming Citibank had lent up to

80 percent or more of the value of the properties, putting Citibank’s

investment underwater when values plunged 40 percent or more.” “ By the mid-1990s, cross border, real estate, and LBO’s had cost Citicorp upward of $9 billion in write-offs alone, enough, in theory at least, to have bought Chase Manhattan, with Wells Fargo thrown in for good measure (based on year-end 1992 valuations) Reed concluded that the problem with the loan portfolio was not the structure of individual deals but the portfolio concentrations “We never have had a focus on portfo- lio management,’’ Reed said Now they were plagued by self-doubt and uncertainty about the survival of their institution First and foremost, Reed had to repair the damage to the bank’s risk-management systems, including its credit culture and methods for monitoring loans As the portfolio grew, Citibank had not felt it needed a system for monitoring loans and establishing exposure limits by industry and location Now, humbly, it set up a system to do just that Reed was determined to give credit policy officers a more “independent’’ check-and-balance role than they had enjoyed in the past, and to focus on market risk as well as

The increased complexity of risks that had evolved underincreasing regulatory restraints, made Reed feel the “lack of a real-timeportfolio information system had become obvious.”3 In response

to this, Citibank began to restructure the corporate lending and creditfunctions to incorporate a credit portfolio management strategy.Citibank began to emphasize the development of credit risk measure-ment techniques for loans similar to an options valuation model thatwould support mark-to-market analysis and portfolio credit risk forthe bank’s entire portfolio Although the focus was primarily on largecorporate and middle market facilities, it eventually led to the devel-opment of the Citibank Loan Index (CLI) The index was designed tofunction like an equity or bond portfolio through which loans arebought and sold based on performance objectives It contained over1,000 credits for 600 public companies totaling $400BN, and was used

to monitor and control obligor risk and bank profitability Loans thatdid not meet performance objectives were either sold off or transferredaccording to index objectives Although the CLI was discontinued in

1996 for more advanced risk applications, it represented the initialstages of Citibank’s efforts to develop measurement tools that wouldmonitor and control its credit risk exposure Overall, success of thebanking sector’s modern credit risk management practices, and in par-ticular Citibank’s resurgence, was revealed in the following statement

by the Economist Magazine, which stated that “America’s banks revealed

record profits for 2003, $120 billion in all The biggest of them, Citigroup, clocked up $17.9 billion, the most ever made by a single bank.”4

Although some have argued that the increase in debt amongcorporate and business borrowers globally serves to also explainwhy Citigroup earned record profits in 2003, it is nonetheless afact that cannot be disputed that commercial banks, on aggregate,realized improved industry performance These achievements,however, have been aided by leveraging transactional informationwith credit risk analytics to provide a higher level of financialtransparency for lenders in credit risk management.

2.5 RISK ASSESSMENT VERSUS

RISK MEASUREMENT

At this point, it is important that the distinction between credit riskassessment and credit risk measurement is clarified A rule ofthumb that can be used to distinguish these applications is tounderstand what the three fundamental goals are that each seeks

to determine The credit assessment process is a holdover from traditional credit risk management, which is grounded infundamental credit analysis to identify and control risks bydetermining the borrower’s probability of repaying the debt.Through credit analysis, an assessment is made of the borrower’sincome, balance sheet, and cash flow statements, along with char-acter, capacity, and capital adequacy, all of which are dependentupon data that are provided by the obligor The second goal ofcredit assessment is to identify a borrower’s primary source ofdebt repayment that will be available to repay an extended creditobligation Similarly, the third goal of credit assessment is toevaluate the probability that a secondary repayment source will beavailable in the event that the primary source becomes unavailable.Whereas credit assessment relies on the borrower’s providedinformation, credit risk measurement, on the other hand, relies onthe lender’s analytics and risk measurement tools rather than theborrower’s Credit risk measurement also has three goals, the first

of which is to limit the credit risk exposure that the lenders accept

when extending the debt By determining the probability of aloss and the loss exposure amount over a period of time, the debtfacility can be better structured and managed A second goal of

credit risk measurement is to ensure that adequate compensation

and profit margins earned on the credit products and services that

lenders provide Credit risk measurement tools and techniques areused to ensure that the credit risks on loans are appropriatelypriced and that portfolio returns yield the targeted establishedfinancial values Finally, the third goal of credit risk measurement

is to mitigate the credit risk exposure by structuring transactions

to protect against loss as well as into asset classes that can be keted to third-party investors Credit risk measurement modelswill quantify transaction exposures and attempt to reduce the risk

mar-of credit loss by deriving the asset classes to sell units mar-of risk based

on risk analytics When transaction yields do not equal the lender’sdesired rate of portfolio returns, then the credit may be transferred,neutralized, or sold off Although we will discuss the respectivecredit risk techniques and tools throughout this book, it is impor-tant to point out here that the basis for determining the creditprocess is grounded in the functions that are performed within thecredit organization Aside from being responsible for the creditpolicies and procedures related to all new and existing transac-tions, the credit organization also ensures that appropriate controlsexist throughout the credit process

2.6 THE DRIVERS OF THE CREDIT

ORGANIZATION

Although every banking or lending organization has a designed credit process, the fundamental framework is essentiallysimilar At the center is the ability to earn profits while alsoensuring that an organization has adequate regulatory capital foreconomic losses and shareholders’ requirements This requires ahierarchical structure throughout the credit organization tailored

custom-to the credit process, although it can vary in procedures, size, andfunctions, as well as be designed along geographic, product, indus-try, or international divisions A small bank, for example, mightonly have a minimum number of relationship managers to performdifferent aspects of the credit process, while a larger bank mayhave more support staff and credit specializations A hypotheticalexample of the credit organization in a large bank is exhibited inFigure 2.10, operating under the management of senior vice presi-dents that oversee various divisions When credit responsibilitiesare divided across geographical regions or product lines, as well asborrowers and industries, international lenders or those withniche market positions advocate the benefits of specialization In

Example of the Credit Organization in a Large Bank

contrast, lending organizations that seek to have greater focus onproduct development for structuring, mitigating, and transferringrisk emphasize client groups and product lines such as inFigure 2.11

Whatever functional approach is established within the creditorganization, the credit process will typically begin with the origi-nation of new business and revolve around the supporting creditfunctions that are highlighted in Figure 2.12 Marketing or

F I G U R E 2 1 1

Example of Credit Organization Focusing on Product

Development

development or loan department and is the original and times primary contact with borrowers Because RelationshipManagers (RM) are also charged with having full knowledge aboutthe borrower’s business and industry, they will usually propose

some-to the credit department or approving authorities the supportingreasons to extend new credit transactions in the credit application.The credit application therefore becomes a primary document todrive the credit process in that it serves as a basis to derive histor-ical borrower information that will subsequently be used in creditrisk measurement Information relevant to borrower characteris-tics, exposure amounts, and facility types will be gathered andcollected from credit applications to measure future potentiallosses from credit exposures Credit risk approval is then based onthe credit assessment and risk measurement applications afterassigned risk ratings are given to support the credit analysis andquantify a borrower’s probability of default to exposure loss.Credit rating systems have been a significant development inmodern credit applications and, depending on the type of systemthat is used, the credit process can be integrated to appropriateinformation systems technology so that credit functions caninclusively perform a variety of tasks As we will discuss inChapter 9, dual-tier rating systems such as those used by largerorganizations to risk rate both borrowers and facilities can provideaccounting information and monitor credit limits as well as per-form quantifying calculations on credit risk exposures Approvedtransactions also require that the credit organization have a creditprocess in place that oversees loan documentation prior andsubsequent to the disbursement of funds

Once all of the required documentation is obtained and thefunds are disbursed, an established system will need to be in placefor the ongoing servicing and monitoring of facilities CreditAdministration is therefore a vital function in the credit processthat requires the lender to monitor transactions through customerreviews on annual or more frequent terms This will allow thelender to understand the borrower’s financial and operating con-ditions, as well as to better identify problem credits CreditAdministration will also support portfolio objectives by monitor-ing and controlling collateral in order to ensure that the appropri-ate liens remain current and are perfected on security along withany required covenants Monitoring the total exposure limits for

the maximum transaction amounts is also essential to prevent therisk of credit loss, particularly for lenders that engage in capitalmarket activities By assessing the concentration and credit expo-sure limits on a daily basis, lenders can remain abreast of how cred-

it assets are performing throughout the term of the facilities.Because lenders cannot avoid having some losses, even if only aminimal amount, a workout unit or group to manage borrowertransactions that do default is also a required credit process andfunctions to recover funds from defaulted credit obligations

A distinguishing factor that is illustrated in Figure 2.13relative to modern credit risk is that the entire credit processrevolves around credit portfolio management to ensure that appro-priate pricing and portfolio returns are attained on creditextensions As an active part of the credit organization that hastaken on an increasingly visible role, credit portfolio management

is charged with reducing the cost of capital while also increasingportfolio performance For example, Figure 2.14 depicts how

F I G U R E 2 1 2

Functional Approach to the Credit Process

the extension of a credit facility to a firm that is below investmentgrade, but accompanied by high yields, may contain a creditdefault swap to mitigate future loss exposure Credit portfoliomanagement is also a subcomponent of the credit monitoringfunction that heavily relies on advanced information systemapplications to measure daily analytic credit risk activities onthe overall credit portfolio composition and asset quality Variousapplications and approaches are used to address particularquestions relevant to credit risk on individual transactions andportfolios Techniques such as Value-at-Risk (VaR) along with otherscenario conditions are applied to stress-testing circumstancesunder various conditions to determine how credit portfoliotransactions can impact capital allocations and earnings profitabil-ity However, the management of the credit process by each of theabove credit functions is driven by the supporting creditdepartments and functions that establish the credit foundation Anoverview of each of these supporting functions is important tobuild a credit process.

Building the Credit Processing Functions Around the

Credit Postfolio

F I G U R E 2 1 4

Managing the Credit Risk Transaction

2.7 SUPPORTING CREDIT DEPARTMENTS AND FUNCTIONS

Bank Credit Departments have traditionally been considered the

“gatekeepers” for managing credit risk by serving as the making and approval functions for credit extension Although theycontinue to operate in an independent capacity, the specific role oftheir functions has been reconfigured to assume credit portfolio

decision-management responsibilities Many banks have now expandedcredit portfolio management into existing credit departments as anactive support to business and credit divisions, while others haveestablished their functions into becoming centralized departments.Depending on the organization, credit departments will work withmarketing in specific line-business or industry groups to structuretransactions as they are originated Proponents of this approachfeel that having everyone involved in the loan approval processwill contribute to a more efficient understanding of the credit atboth the transaction and the borrower level In other organizationsthere may be highly centralized credit departments that operate toretain strong barriers and controls on the credit-granting functions.

As risks have become more integrated and regulatory concernshave advocated for designated management to be separate fromthe marketing and credit functions, some organizations have feltthat this was most effective to manage overall credit portfolio risks

If, for example, questions need to be answered by the credit ment before loans can be approved, those organizations that prefer

depart-to maintain strict segregation from business units will prefer not depart-tomeet with clients, but rather separately interact with relationshipmanagers The argument against this structure is that it slowsdown the credit processing time by excluding credit departmentpersonnel along with the account officer from meeting with thecustomer

Lenders that have supporting credit portfolio groups separatefrom the credit department emphasize that the basic objectives are

to reduce event and concentration risks, to improve portfolio valueand liquidity, and to support business growth Credit organiza-tions that have centralized these groups are typically operated byinstitutions that have a strong Board of Directors who believes inthe utility of this function as a separate business unit In addition

to implementing the bank’s credit risk strategy, individual ment credit portfolio groups also oversee other business units asindividual profit centers for specific asset classes Having acentralized credit portfolio management function has resulted inthis group evolving from a monitoring and reporting function into

depart-a more depart-active role thdepart-at pdepart-articipdepart-ates in lodepart-an origindepart-ations depart-along withdeciding on hedging techniques and engaging in secondary mar-ket sales as well as asset acquisitions Among some lenders, it hasbrought an active support role to business departments Creditportfolio managers, for example, among certain major European

lenders, now act as the preliminary approvers on individual alone transactions as well as provide suggestions for structuringthe credit requests At the same time, in other banks, they arerestricted to solely managing credit portfolios, where the focus is

stand-on whether to transfer or sell facilities that are not yielding therequired returns

A more common approach used by small- and medium-sizedlenders is a decentralized process that extends lending limits andauthority based on strict standards and guidelines After questionsare answered relevant to the facility structure and credit analysis,credit requests can either be approved by authorized credit officers

or forwarded to a Loan Committee More often practiced inthe United States, lending decisions based on limits and authorityhave been controversial in Europe and other regions of the world

In the United States, the trend has been to centralize credit decisionsand approvals by using a limited number of highly trained andspecialized credit professionals that focus on regional markets.Proponents believe that this approach is more cost effective thanhaving many industry specialists involved in lending decisions,because approval is concentrated among fewer individuals.Alternatively, critics argue that the approach results in a lack ofthe specialty skills needed in particular sectors, as well as reducingthe time spent understanding the obligor and its business

Although the use of loan committees has become less of

a trend at many of the larger banks, some of the regional andsmaller banks have continued to use Loan Committees to finalizetheir credit decisions Other institutions, on the other hand, havechosen to delegate approval to a Chief Credit Officer, based onlending limits or according to their credit policies and procedures

In general, Loan Committees are represented by the most seniormembers of a bank’s credit organization and are viewed as a means

to remove any bias or criticism that comes from extendingapproval limits and authority to a single credit officer The benefits

of a loan committee vary from taking on greater credit portfoliomanagement applications to structuring transactions, given thatthe individual members have valuable professional experience andhave seen many “faux pas.” Portfolio functions that are performed

by loan committees include decisions on balance sheet implicationssuch as whether or not to accept a particular asset into the port-folio Loan committees are also known to resolve disputes that mayoccur with lending officers, such as whether or not to downgrade