Recap 04 -- Credit Transformation and Credit Risk

Recap 04 -- Credit Transformation and Credit Risk - FINS...

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FINS 5550 / FINS 3650 — International Banking Recap 04A — Credit Transformation and Credit Risk Credit Risk More than eighty percent of the average bank’s capital is held against credit risk. If credit risk accounts for >80% of the bank’s inventory cost, it’s a fair bet that credit transformation accounts for a similarly large portion of bank profits. Credit risk arises whenever the bank has an exposure which requires a counterparty to remit funds. The exposure can arise from a loan or loan-type product derived from a given origination channel (direct solicitation, agent solicitation, brokered, or reverse inquiry). [Please read the S&P primer(s) on syndicated loans, posted on Blackboard.] The exposure also can arise from a contingency such as a line of credit [What’s the difference between a line of credit and a revolving line of credit?] , letter of credit [What’s the difference between a letter of credit and a line of credit?] , or performance bond. Alternatively, the exposure can arise from a swap exposure. [Describe an example of when a bank has an exposure due to an interest-rate swap. How does one quantify the exposure?] While this recap generally refers to the exposure as a loan, the form of the exposure doesn’t really matter. What does matter is the likelihood that the exposure will be repaid. Traditional Underwriting Traditional banking calls for each exposure — actual or potential — to be individually underwritten — a process which demands time, effort, and expertise. Many discussions of credit underwriting begin with the so-called Four Cs of underwriting ( see Dun & Bradstreet’s take at http://smallbusiness.dnb.com/business-finance/business-loans- business-credit/12154-1.html , or a longer laundry list at http://www.creditguru.com ). Not everyone agrees what constitutes the Four Cs, and what is indisputable is that more than four aspects should be taken into account: The Five Original Four Cs Character — D&B lists a number of factors, mostly speaking to the business history of the counterparty. IMHO, the real meaning of “Character” is integrity. There is an old adage that, if you’ve picked the wrong party to lend to, you can’t make it better by negotiating tougher terms. Capacity — the ability of the counterparty to pay debt service (principal and interest) on the exposure, with a focus on free cash flow. Implicit in this C is the notion that the proceeds of a loan increases the capacity of the counterparty to generate cash, for example, where the counterparty builds a new factory or adds new equipment. The late economist Hyman Minksy has an interesting spin on this. Read Paul McCulley’s brief discussion at http://www.pimco.com/EN/Insights/Pages/Global%20Central%20Bank%20Fo cus%20May%202009%20Shadow%20Banking%20and%20Minsky%20McCu lley.aspx , [Find your own examples of speculative or Ponzi borrowing. Where does Australian housing fit on the spectrum? Chinese housing? Owning a professional sports team?]
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Recap 04 -- Credit Transformation and Credit Risk - FINS...

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