Preface xvii
PART I INTRODUCTION
1 Credit Basics 3
1.1 Meaning of Credit 4
1.2 Role of Credit 6
1.3 Credit Market 6
1.4 Credit - Advantages and Disadvantages 7
1.5 Suppliers of Credit 11
1.6 Credit Risk Study 12
Appendix: Credit Creation 13
Questions/Exercises 14
2 Essentials of Credit Risk Analysis 15
2.1 Meaning of Credit Risk 15
2.2 Causes of Credit Risk 16
2.3 Credit Risk and Return 17
2.4 Credit Risk Analysis 17
2.5 Historical Progress of Credit Risk Analysis 19
2.6 Need for Credit Risk Analysis 19
2.7 Challenges of Credit Risk Analysis 22
2.8 Elements of Credit Risk Analysis 24
Questions/Exercises 25
3 Credit Risk Management 27
3.1 Strategic Position of Credit Risk Management 27
3.2 Credit Risk Management Context 28
3.3 Credit Risk Management Objectives 28
3.4 Credit Risk Management Structure 29
3.5 Credit Risk Culture 29
3.6 Credit Risk Appetite 30
3.7 Credit Risk Management in Non-Financial Firms 31
3.8 Credit Risk Management in Financial Intermediaries 31
Questions/Exercises 34
PART II FIRM (OR) OBLIGOR CREDIT RISK
4 Fundamental Firm/Obligor-Level Risks 37
4.1 Firm (or) Obligor Risk Classification 37
4.2 Risk Matrix 39
4.3 Different Risk Levels 39
Questions/Exercises 42
5 External Risks 43
5.1 Business Cycle 43
5.2 Economic Conditions 46
5.3 Inflation and Deflation 50
5.4 Balance of Payments and Exchange Rates 51
5.5 Political 52
5.6 Fiscal Policy 53
5.7 Monetary Policy 53
5.8 Demographic Factors 54
5.9 Regulatory Framework 55
5.10 Technology 55
5.11 Environment Issues 55
5.12 International Developments 56
5.13 Others 56
5.14 Monitoring External Risks 57
Questions/Exercises 58
6 Industry Risks 61
6.1 Understanding Obligor's Industry or Market 61
6.2 Types of Industry Risks 63
6.3 Industry Life Cycle 64
6.4 Permanence of Industry 65
6.5 Government Support 65
6.6 Industry and Factors of Production 66
6.7 Industry and Business Cycles 66
6.8 Industry Profitability 67
6.9 Competitor/Peer Group Analysis 71
Questions/Exercises 77
7 Entity-Level Risks 79
7.1 Understanding the Activity 80
7.2 Risk Context and Management 81
7.3 Internal Risk Identification Steps 82
7.4 SWOT Analysis 83
7.5 Business Strategy Analysis 84
7.6 Pitfalls in Strategy 89
7.7 Management Analysis 90
7.8 Other Internal Risks 94
Questions/Exercises 97
8 Financial Risks 99
8.1 Importance of Financial Statements 99
8.2 Quality and Quantity of Financial Statements 101
8.3 Role of Historical Financial Statements 102
8.4 Financial Analysis 103
8.5 Analytical Tools 105
8.6 Solvency Ratios 115
8.7 Operational Ratios 123
8.8 Encapsulated Ratios 134
Questions/Exercises 143
9 Integrated View of Firm-Level Risks 147
9.1 Relevance of an Integrated View 147
9.2 Judgement 147
9.3 Identifying Significant Credit Risks 148
9.4 Risk Mitigants 150
9.5 Types of Mitigants 150
9.6 Principles to be Borne in Mind While Selecting Mitigants 153
9.7 Monitoring of Credit Risk 154
Appendix: Credit Risks and Possible Mitigants 155
Questions/Exercises 158
10 Credit Rating and Probability of Default 161
10.1 Credit Risk Grading 161
10.2 Probability of Default 163
10.3 External vs. Internal Rating 166
10.4 PD in Credit Structural Models 169
Questions/Exercises 172
PART III CREDIT RISKS - PROJECT AND WORKING CAPITAL
11 Credit Risks in Project Finance 177
11.1 Distinctive Features of Project Finance 177
11.2 Types of Project Finance 178
11.3 Reasons for Project Finance 179
11.4 Parties Involved in Project Finance 180
11.5 Phases of Project and Risks 182
11.6 Project Credit Risks 183
11.7 Financial Study 187
11.8 Project Credit Risk Mitigants 192
Questions/Exercises 202
12 Credit Risks inWorking Capital 207
12.1 Definition of Working Capital 207
12.2 Assessing Working Capital through the Balance Sheet 208
12.3 Working Capital Ratios 210
12.4 Working Capital Cycle 212
12.5 Working Capital vs. Fixed Capital 216
12.6 Working Capital Behaviour 216
12.7 Working Capital, Profitability and Cash Flows 223
12.8 Working Capital Risks 225
12.9 Impact of Working Capital Risks 229
12.10 Working Capital Risk Mitigants 230
12.11 Working Capital Financing 232
Questions/Exercises 236
PART IV CREDIT PORTFOLIO RISKS
13 Credit Portfolio Fundamentals 241
13.1 Credit Portfolio vs. Equity Portfolio 241
13.2 Criticality of Portfolio Credit Risks 242
13.3 Benefits of Credit Portfolio Study 242
13.4 Portfolio Analysis 247
13.5 Credit Portfolio Risk vs. Return 249
Appendix: Organizational Conflict in Credit Risk Management 249
Questions/Exercises 251
14 Major Portfolio Risks 253
14.1 Systematic Risk 253
14.2 Diversifiable Risk 255
14.3 Concentration 258
14.4 Credit Portfolio Beta 263
Questions/Exercises 263
15 Firm Risks to Portfolio Risks and Capital Adequacy 265
15.1 Obligor PD and Portfolio PD 265
15.2 Migration Risk 266
15.3 Default Risk 269
15.4 Loss Given Default (LGD) 270
15.5 Expected Loss (EL) 271
15.6 Provisioning 272
15.7 Credit Loss Distribution 274
15.8 Economic Capital 276
Questions/Exercises 282
16 Credit Risk and The Basel Accords 285
16.1 Basel Accords 285
16.2 Basel I (1988) - First Basel Accord 286
16.3 Basel Accord II (2006) 288
16.4 Basel III 296
Appendix 300
Questions/Exercises 302
PART V PORTFOLIO RISK MITIGANTS
17 Credit Risk Diversification 305
17.1 Traditional Diversification 305
17.2 Modern Diversification of Credit Portfolio 309
17.3 Correlations in Credit Risk Models 315
Questions/Exercises 315
18 Trading of Credit Assets 317
18.1 Syndicated Loans/Credit Assets 317
18.2 Securitization 318
18.3 Distressed Debt 321
18.4 Factoring 322
18.5 Distressed Receivables 322
Questions/Exercises 322
19 Credit Derivatives 323
19.1 Meaning of a Credit Derivative 323
19.2 Credit Default Swap (CDS) 324
19.3 Total Return Swap 330
19.4 Credit Option (CO) 332
19.5 Credit Spread Options (CSO) 333
19.6 Credit Derivative Linked Structures 333
19.7 Future of Credit Derivatives 334
19.8 Credit Derivatives and Over-the-Counter (OTC) Markets 334
Questions/Exercises 334
PART VI CREDIT RISK PRICING
20 Pricing Basics 337
20.1 Credit Pricing Factors 337
20.2 Pricing Structure 342
20.3 Credit Risk Pricing Model 344
20.4 Prime Lending Rate 345
Questions/Exercises 348
21 Pricing Methods 349
21.1 RORAC (Return on Risk-Adjusted Capital) Based Pricing 349
21.2 Market Determined 351
21.3 Economic Profit Based Pricing 351
21.4 Cost Plus 353
21.5 Structured Pricing 353
21.6 Grid Pricing 354
21.7 Net Present Value (NPV) Pricing 354
21.8 RANPV (Risk-Adjusted NPV) Pricing 355
Questions/Exercises 355
PART VII THE LAST LINE OF DEFENCE - SECURITY
22 Security Basics 359
22.1 Need for Security 359
22.2 Merits and Demerits of a Security 360
22.3 Attributes of a Good Security 362
22.4 Security and Pricing 362
22.5 Impact of Systematic Risks on Security 364
22.6 Facility Grades 364
Questions/Exercises 366
23 Collaterals and Covenants 367
23.1 Tangible Security 367
23.2 Intangible Security 369
23.3 Methods of Taking Security 371
23.4 Realizing Security 372
23.5 Covenants - A Trigger to Seek Additional Security 373
Questions/Exercises 377
PART VIII CREDIT CRISIS
24 Road to Credit Crisis 381
24.1 Credit and Growth 381
24.2 Role of Banks 382
24.3 Formation of Credit Bubbles 385
24.4 Types of Credit Bubble 386
24.5 Credit Bubble Explosion 387
Questions/Exercises 390
25 2008 Credit Crisis 393
25.1 Credit Asset - Prime vs. Sub-Prime 393
25.2 Securitization 394
25.3 US Housing Bubble 396
25.4 Role of OTC Derivatives 398
25.5 Role of Rating Agencies 400
25.6 Why Did the Bubble Burst? 401
25.7 Consequences 402
25.8 Impact of the Lehman Collapse 403
25.9 Housing Crisis to Credit Crisis to Economic Crisis 404
25.10 Common Factors 1929 vs. 2009 406
25.11 Lessons of the 2008 Credit Crisis 407
Questions/Exercises 410
Bibliography 411
Index 415
