This is the second installment of the How to be an effective credit analyst series. If you missed it, you may read part 1 here.

Today, we look at going beyond Financial Analysis.

Tip#2: Beyond financial analysis

An effective credit analyst knows that financial analysis is more than just about the numbers.

An analyst can extract and form an opinion from the numbers about the company and link it to the risk analysis to make a better conclusion about the company’s credit worthiness.

It’s not enough to know how to calculate the cash flow and financial ratios of a company but how to interpret these tools that is important to analysis.

In order to achieve the above, you need to keep in mind the following for your credit applications:

• You should base the analysis on as many sources as possible (this is easy to do for listed companies). If you’re analysing a non-listed company, you need to corrobrate the financial reports with discussions with management and (if possible) vendors and customers of the company.
• For listed companies, while annual reports should also be used in the analysis, it should only be used selectively and with a critical eye since directors have vested interest in presenting their company’s financials in a positive light.
• When analysing the company, you should keep in mind the ultimate purpose of the analysis: Why a credit is acceptable (or why it should be terminated in some cases)?

If you want to learn more about being an effective credit analyst and need to be trained up quickly, you’ll be interested in this Credit Analysis training course.

Overview:

The issue of loan quality and building incentive systems for lenders is a recurring issue. Often the issue is poorly managed with dire consequences for the organisation. Below I have attempted to provide a link between a risk rating structure, incenting lenders and implications on the loan loss reserves for a financial institution.

Risk rating System:

The most common form of risk rating system used by financial institutions has eight levels. This model is also consistent with U.S. bank regulatory practices. Deviations in terminology and definitions exist between financial institutions. A description of each risk rating level is outlined below:

Level 1 credits are almost risk-free. They are loans that are fully secured by term deposits, Treasury bonds or similar instruments.

Level 2 credits are exceptionally creditworthy public and private companies that are generally rated by a rating agency such as S&P or Moody’s. These credits are typically referred to as “top tier” credits, with a rating of AA1 or above.

Level 3 credits are public companies, rated by a rating agency, or private companies with strong financial performance. If rated, they would be regarded as “investment-grade” securities.

Level 4 credits represent higher than normal risk. Most commercial and middle-market lending falls into this category. Typically this level is the largest category in many financial institution portfolios.

Some institutions re-rate sub categories of level 4, in order to better differentiate this large grouping. For example there may be A and B sub categories, or a 4W category for accounts placed on a “watch-list” for possible regrading to level 5.

Level 5 credits represent some concern about capital risk. This typically means that the quality of the borrower (and the loan) has slipped or changed materially over one or more prior periods. For example a business may have recorded its second or third periodic loss, with no likely improvement in sight. A write-off is possible with loans in this level.

In the USA, regulators require quarterly, and frequently monthly, reports on the status of credits from this level and to level 8.

Level 6 credits represent substantial concern about whether or not the loan principal will be repaid. This level, like those that follow, requires the application of lender judgement.

Level 7 credits reflect the expectation that not all the principal will be repaid. It is at this level, if not before, that loans are transferred to a “work-out” unit.

Level 8 credits represent write-offs. Loans are classified level 8 when they become uncollectable.

Loan Loss reserve:

Credits rated level 5 or below are generally referred to as “adversely rated credits”. The Account Manager or Lender has the responsibility to monitor the situation of accounts in their portfolio to initiate any regrading of credits. It is generally a “black mark” against the lender if Credit Administration regrades a credit before the lender does. Similarly, it is a “black mark” on both the lender and Credit Administration if the internal audit function initiates a regrading of a credit. Worst of all is when external auditors or other outsiders, such as regulators, regrade a credit prior to anyone else taking that step.

Early emphasis on identification of credit deterioration is critical because of the impact on the loan loss reserve. Below is a table that provides typical approximate loan loss reserve percentages based on a typical financial institution balance sheet.

Grade level	Reserve Percent	Loan Loss Reserve for a $5 Million Credit
4	.59%	$29,500
5	4.9%	$245,000
6	18%	$900,000
7	32%	$1,600,000
8	100%	$5,000,000

The Reserve Percent column represents the percent of face value of a loan that must be provisioned. The last column shows the actual dollar amount of reserve for a $5 million loan. A financial institution may also supplement their loan loss reserves for levels 6 and 7 to reflect any more pessimistic forecasts.

This is also applicable where not only is the loan capital at risk, but security value has diminished or there are other complicating factors (such as partial drawdowns for property development). If taking a pessimistic view, one strategy is to increase the reserve so that it equals the difference between the pessimistic view and the total loan amount.

Theoretically, there is a difference between the expense provisions that a financial institution takes and the loan loss reserve that appears on the balance sheet. If an institution’s position were already strong enough, it may not need to increase the expense provisioning after downgrading credit quality.

Typically few financial institutions are “over-reserved”. Then the practical reality is that a downgrading of credit quality reflects in an immediate increase in the loan loss provision, so that the loan loss reserve is built up to its required level.

Non-Accrual Loans:

A “non-accrual” loan is one where the interest on a loan has not been “met” or paid in a given period, usually the last 90 days. Non-accrual means that the interest can no longer be recognised as revenue. At this stage all interest payments that are received are used to offset the original principal outstanding, at least from the financial institution viewpoint.

From the borrower perspective, they only see how much overdue interest remains to be paid. Often the impact of a loan becoming non-accrual is that the financial institution is obliged to go back at least for the prior 90 days of interest accruals, to reverse revenue already recognised as income.

Lender Performance Review Systems:

There are three major factors against which Account managers or Lenders should be evaluated. These are credit administration, risk recognition and problem loan management.

Credit Administration reflects the process of selling or underwriting, booking and documentation of the credit.

Risk recognition evaluates a manager’s effective monitoring and review of credits in their portfolio. This includes the downgrading of credits as appropriate. These reviews and downgradings should precede any enforced downgradings by Credit Administration, Audit, or outside influences, as mentioned earlier.

Problem loan administration recognises how well a manager or lender manages adversely rated credits. These are those credits rated at level 5 or higher.

Conclusion:

A $5 million loan, which was fully drawn, was rated at level 5. Because the credit was deteriorating, the lender felt it was necessary to regrade the loan to level 6. What volume of additional loans would need to be written for that lender to break even on their net interest margin, less the new additions to loan loss reserves? Assume a three-percent net interest margin is earned on these loans.

Answer: $21.83 million* in new loan outstandings is required to make up for a $5 million loan moving from level 5 to level 6. That is a lot of new business!

Don’t shoot the messenger. Encourage a credit culture of sound lending and early reporting. Support and work with managers and lenders who actively manage their portfolio for both business opportunities and credit risk. Build incentive schemes for ALL lending that reflect more than just volume targets, and hold lenders accountable for dealing with credit issues in their portfolio, in conjunction with Credit Administration and policy guidelines.

Calculation:

• The increased provisioning represents $655,000. This is the additional reserves required for the loan at Level 6, compared to Level 5 ($900,000 – $245,000).
• At a 3% net interest margin, this means new business of $21.8333 million to earn the equivalent net interest margin to the increased loss reserve provision ($655,000/.03).

by: Steve Lesser

Learn more about Commercial Lending from Steve Lesser.