Protection buyers are those who seek to protect the credit asset (e.g. loan or bond) they have or intend to acquire. The following are advantages that derivative instruments bring to the protection buyer:

– It enables credit risk transfer to a third party, significantly reducing the credit portfolio risk.
– As the overall credit risk reduces, the protection buyer may underwrite more, i.e. increase credit capacity.
– The asset remains on the balance sheet of the protection buyer earning income.
– In some cases, where the bank or financial institution reduces its overall credit risk through credit derivatives, it has a favourable impact on the regulatory capital, i.e. reduces the regulatory capital requirements.

Protection sellers provide the protection or insurance on credit risk for a premium. Protection sellers are underwriting credit risk and hence must conduct a thorough credit risk analysis. The following are advantages that derivative instruments bring to the protection seller:

– It offers the opportunity to earn unfunded income.
– The investment remains off-balance sheet and actual cash needs to be deployed only if the ‘credit event’ is triggered.
– The overall return could exceed (i.e. be more than) that of the direct investment.
– Overall transaction cost tends to be relatively lower than the cash or direct investment.

The credit event can be mutually agreed upon by the protection buyer and seller. The credit event usually includes the following:

∙ Default.
∙ Restructuring of the debt.
∙ Cross default clause triggered credit event.
∙ Rating downgrades/migration of the rating to unacceptable levels.
∙ Bankruptcy or moratorium.
∙ Failure to pay.
∙ Any other mutually agreed upon event.

Credit default swap (CDS) allows the creditor (or the protection buyer) to transfer credit risk to another party by paying a fixed amount (premium), either in one lump sum or at regular intervals. The Credit Default Swap (CDS) is the most common credit derivative.

Recovery value is the estimated market price of the collateral (or of the financial instrument) when a credit event has been declared. In cash settlements, the protection buyer receives a cash payment proportional to the severity of the loss on the reference asset (i.e. initial value – recovery value).

Like equity options, credit options may be either American or European style. A Credit option allows the protection buyer to be protected against any credit loss arising from any predefined credit events. If the credit event does not occur during the contracted period, then the protection buyer would let the option lapse. However, on the other hand, if any of the credit events are triggered, the company/bank (the protection buyers) would seek compensation (termination payment) under the option. In exchange for these benefits and protection, the protection buyer will pay a fee upfront known as a premium.

Historically credit is good if used wisely. Lenders (and creditors) and borrowers (or debtors) and even global economies could suffer because of credit in the event of poor credit risk analysis and inadequate credit risk management. Credit prudently used can create wealth and bring overall prosperity to the economy.

Counterparty refers to a financial institution’s opposite number in a bilateral financial contract. Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation.

Bank and financial institution analysts whose role is to evaluate the credit risk associated with the transaction are frequently called counterparty credit analysts. The focus of counterparty credit analysts is on the potential credit risks that result from financial transactions, including settlement risk.

Credit refers to a transaction between two parties in which someone (the creditor or lender) supplies money, goods, services, or securities in return for a promise of future payment by the other party (the debtor or borrower). Such transactions normally include the payment of interest to the lender.

It is not practical to identify all such risks, however, it is essential to understand all material risks. Generally, risk identification is done through the following ways:

– Interviews and questioning.
– Studying market developments/peer comparison against benchmarks.

The person conducting the credit risk analysis must call for background material on the industry and company beforehand, which includes the following:

– Audited annual financial statements for five years.
– Latest management accounts/interim financial statements subsequent to the previous audited.
– Memorandum/articles of association/partnership deed/other legal or government-related documents.
– Product brochures and other descriptive materials on the operations and products/services.
– Industry background and the customer’s position with the industry.
– Industry competition factors.
– Order book.
– Corporate governance.
– Succession plan.
– Nature of activity.
– Competitive advantages.
– Critical success factors.

Management risk refers to the defects, inadequacies, and lack of skill and experience of the people in key positions. The degree of incompetence and unsatisfactory track record of the management team ought to suggest the magnitude of this risk.

Characteristics of good management include that they can turn around a badly managed business or rectify business failures. On the other hand, bad management can break a good business in no time. Bad management is one of the biggest risks at entity level, which can cause a good business to fail, even with all favourable factors.

The following are some common hints, which may point to an operating risk related to the management:

– One-man rule
– Imbalance in the top management team
– Weak finance function
– Lack of skilled managers (or inability to attract skilled managers in key positions)
– Disharmony in management
– Low staff morale
– Fraudulent management
– Inadequate response to change
– Poor corporate governance

Human resources include more than regular full-time employees. They include all management and labor personnel, family and non-family members, full-time and part-time people, and seasonal and year-round employees. The following are among the risks in the category of human resource risks:

– Strikes
– Militant unionism
– Very high staff turnover and poor motivation levels, which will lead to poor productivity levels.

Risks that affect the entire company and its future direction fall under Corporate risks. Huge losses in a subsidiary may carry the risk of cash down streaming while the hostile takeover threat may cause the top management to divert attention from normal operating activities.

Financial risk refers to the chances of the collapse of business due to wrong financing decisions/strategies such as lopsided capital structure, asset-liability mismatch, etc. Financial risks can plunge a successful business into bankruptcy, if not managed properly.

Financial analysis is done based on financial statements. Credit risk due diligence relies on financial statements for financial analysis which ought to have a cash flow-oriented approach. Financial analysis serves mainly three purposes:

1. It digs deep and brings out the financial risks.
2. It triggers questions that lead to a meaningful operating/business analysis.
3. To determine the extent of financial support needed by the prospective borrower.

The balance sheet shows the financial position of a business as at a particular date, usually the end of a period – say a year, a quarter, or a month. A balance sheet is a critical tool for effective credit evaluation. It answers a lot of questions that a financial analyst is likely to ask while ascertaining creditworthiness.

A balance sheet is a critical tool for effective credit evaluation. It answers a lot of questions which a financial analyst is likely to ask while ascertaining creditworthiness, such as the following:

– What is the capital structure of the business? Is it appropriate? Have the owners of business put sufficient capital into the business?
– What are the short-term and long-term liabilities (i.e. debt) of the business? Are they properly structured? Is it possible to relate each source of finance to a particular asset item?
– What is the credit period provided by trade suppliers? Did the suppliers alter trade terms?
– What are the taxation and other statutory liabilities outstanding?
– What is the quantum of fixed assets and are they put to optimum use?
– What is the level of stocking required and what are the stock management policies, in broader terms?
– What is the level of trade debtors?

Sometimes the financial analyst will require certain adjustments to the balances sheet variables as presented in audited accounts. This is because of the fact that the accountants and auditors prepare financial statements generally for the shareholders and many items are classified accordingly, based on IFRS or GAAP followed by each country. The following are certain instances where the financial analyst would have to recast the balance sheet, sometimes through the profit and loss account:

– Adjusting inventory valuation.
– Reassessing the values of balance sheet variables.
– Converting off-balance sheet items into on-sheet items.
– Dividends payable.
– Intangibles.
– Unsubordinated shareholders loan.
– Dues from/to related parties.
– Alternative accounting.

Risk mitigants refer to certainties that ensure adequate financial resources or means to repay the credit despite the presence of risks. Risk mitigants are sought as a comfort to the credit risks identified.

Risk mitigants can be broadly categorized into two main categories: Qualitative mitigants and quantitative mitigants. Many mitigants can be traced to the income, assets, wealth or strengths of the obligor, some of which can be identified by financial analysis.

Qualitative mitigants derive force from the factors that provide excellence or superiority to the obligor in certain areas, which ensure adequate repayment ability by ensuring a sufficient volume of business or profitability.

Qualitative mitigants vary from case to case, however, they can be broadly classified into three: Strengths, strategies, and other factors. Most of the qualitative mitigants depend upon the strengths of the company or the management techniques adopted by the company.

Quantitative mitigants are quantifiable and often the creditor or lender can estimate the level of comfort quantitatively. Letters of credit or guarantees provided to a manufacturer by buyers and mortgages of land and buildings by a borrower to secure a bank loan are some of the examples of quantitative mitigants.

Two of the common quantitative type mitigants are transfer of risks and security. Transfer of risks is usually done by insurance, where the specifications of insurance are spelt out. Tangible and intangible securities are sought by the creditor/lender to mitigate the credit risks.

The following principles are to be borne in mind while selecting mitigants:

– Integrity and an excellent track record of the obligor are the best mitigants. Whilst ‘willingness’ and ‘capacity’ to repay are both important, willingness is more important.
– If the credit is not able to stand alone or be justified in itself, it is often too risky to extend it just on the basis of the mitigants.
– A source of repayment ought to be embedded in the purpose of the credit, as far as possible.
– Since the cash flows are the source of repayment, the mitigants should either protect the cash flows or open up another source (of cash flow) in the event of risk occurrence.
– Always seek as a minimum, two sources of repayment.
– Although tangible security is a mitigant, it is not the same as the source of repayment.
– In the case of term loans, Free Cash Flow (FCF) must be checked and if insufficient, it must be understood how the obligor will meet the repayment commitments.

The essential differences between qualitative and quantitative mitigants are as follows:

– Qualitative mitigants rely on the repayment ability from within the organization while the quantitative mitigants are usually from a third party or source.
– The creditor can be reasonably assured about the sum or amount in quantitative mitigants, as the name implies, i.e. they are more quantifiable.