5Cs Credit Risk Assessment Framework PDF

SE ) CHAPTER 5 (N O T FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK 5-1 THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK 5. THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK Learning Outcome At the end of the chapter, you will be able to: SE ) Apply the 5Cs credit risk...

SE ) CHAPTER 5 (N O T FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK 5-1 THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK 5. THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK Learning Outcome At the end of the chapter, you will be able to: SE ) Apply the 5Cs credit risk assessment tool to evaluate business creditworthiness. FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO Key Topics In this chapter, you will be able to read about: Introduction The 5Cs Framework Summary Assessment Criteria During the exam, you will be expected to: Demonstrate the application of the 5Cs of Credit when undertaking business credit risk assessment. Distinguish the relevance of each component of the 5Cs in evaluating business credit risk. T 5.1 INTRODUCTION O One of the main concerns of the lending bank is the ability and attitude of the (N borrower to meet loan service obligations. The marketplace is diverse and the many borrowers possess varied financial means and loan repayment habits. Some borrowers have poor debt repayment capacities while others may have negative attitudes causing them to shirk their debt repayment obligations. Yet others may have the means but not the will to repay debt. The borrower may have shown impressive business performance track record and income generation capability at the loan origination stage, but the risk profile may have changed adversely over time to impact its financial standing or debt service capacity. The credit officer will always seek out potential borrowers who possess both the capacity to repay as well as positive behavioural attributes. Figure 5.1 provides a simple reminder of the categories of borrowers in the marketplace based on their loan repayment habits. CERTIFICATE IN CREDIT THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK 5-2 The credit officer should make an interpretation of each type of borrower represented by the boxes A, B, C and D and propose the appropriate credit risk management strategy. To do this, the credit officer should follow the 5Cs Framework, detailed in the following sections. ) FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO PAYMENT HABIT B A SE Good habit D C Poor Ability Good Ability Bad habit CAPACITY TO REPAY Figure 5.1: Matrix describing payment habits and capacity to repay 5.2 THE 5Cs FRAMEWORK The 5Cs Framework refers to five elements that credit officers should take into consideration whilst making a credit risk assessment: Character, Condition, Capacity, Capital, and Collateral (see Figure 5.2). While these considerations, do not provide a sufficient basis to decide on a loan, they are necessary considerations. T This framework serves to remind credit officers of some of the key characteristics (N O that should be found in a potential borrower. CHARACTER COLLATERAL CONDITION CAPACITY CAPITAL Figure 5.2: The 5Cs Framework of credit assessment CERTIFICATE IN CREDIT THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK 5.2.1 Character The discussion of character is not limited to the character of a single person or individual borrower. The term ‘character’ discussed here should be applied to both individual borrowers as well as organisations. Borrowers exhibit different creeds and individual value systems. In general, the ) bank will have to specify the criteria that defines “good character.” The bank SE expects borrowers to possess traditional values of integrity and responsibility. This expectation is driven by the bank’s own promise to its depositors to meet FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO timely obligations without loss. A borrower’s record of poor behaviour and/or lack of responsibility raises the risk to the lending bank. Other positive attributes include being discreet, genuine, honest and prudent. These attributes are considered equally important as traditional values in assessing the character of the individual borrower. These characteristics remain applicable in the same way when assessing companies. Well-run companies typify the character and moral strength of its senior management while poorly run companies show the opposite. In consumer lending, the character of the individual borrower refers to the integrity, sense of responsibility and behaviour. In business lending, character extends beyond the individual to that of the whole management team and the controlling personality, such as a majority shareholder. Most businesses today are operated as organisations with different levels of supporting managers. In an organisation, the key decision maker may be the managing partner or Chief Executive Officer (CEO). He or she is in turn supported by a layer of managers— departmental or functional heads—who have been delegated authority and responsibilities. As each manager has O T own responsibilities, goals and aspirations, conflicts of interest and power struggles invariably arise. (N 5-3 Collectively, the CEO and the management team are expected to show organisational discipline and trustworthiness in their conduct of business with third parties. This, in essence, is the business’ corporate character. In corporate terms, this organisational discipline and trustworthiness is known as “corporate governance.” Reviewing the character of a business borrower is a review of the management team as a whole and its relationship with the controlling parties. In addition to ethics, the demands of the current business environment require that organisations stay competitive to survive and flourish. While honesty and integrity are key values, they do not guarantee business success. In assessing the character of a borrower, a credit officer must assess the expertise and vision within the business. CERTIFICATE IN CREDIT THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK 5-4 ) Continuous learning and development of skills are needed to stay competitive. “Current” knowledge rapidly falls into obsolescence given the pace of the modern marketplace, even as new methods of doing business are being developed every day. A business organisation with people who lack expertise and one that fails to provide adequate training is likely to be less competitive. This poses a business risk, which must be taken into consideration as a risk to the loan. FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO SE Vision is an important component of any business, as it allows the company to anticipate trends and changes to the marketplace. Lack of vision could result in a company becoming a weaker participant in the marketplace. Recognising new trends early and/or having strategic concepts in place ahead of time plays an important role in maintaining market relevance and customer support. This decreases the business risk. In assessing character, credit officers can deploy a number of tools, such as holding personal interviews with the chief executive officer or conducting discreet market checks. The credit officer can look at the company’s track record and reputation in the industry, which may be an indicator of character. The lender’s previous experience with the borrower will provide information on the borrower’s character. For consumer lending, character assessment is a personal process. Areas that need to be considered include the borrower’s age (middle aged and elderly borrowers tend to be more stable and less likely to default), marital status (family commitment reduces the tendency to default) and occupation. O T In addition, “Character” addresses areas including attributes such as integrity, management style (aggressive, speculative, prudent, or conservative), management lifestyle (thrifty or extravagant), and willingness to repay. (N 5.2.2 Condition Condition in lending refers to the external environment when the request for credit facilities is made. Some important considerations include: a. The Current Economic Cycle The economic cycle is one where booms and busts occur on a cyclical basis. At each phase, the inherent risks will impact different types of businesses differently. Some businesses and industries are often protected from the fallout of a recession (for example, rice milling and basic health care services), while others may suffer significant negative impact. CERTIFICATE IN CREDIT 5-5 THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK BACKGROUND: The Economic Cycle The Economic Cycle FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO SE ) GDP Growth D A B Phase C D Which phase has the highest risk to lenders? Phase A shows an economic environment of recovery with optimism that things are getting better. Businesses open and retail outlets expand and employ additional staff, while consumers cautiously increase spending. Phase B indicates boom conditions, with consumers and investors being bullish about prospects and unrestrained in spending. Business is brisk but competition is mounting. Excess demand is building up rapidly and signals from the Central Bank come in the form of slowing rising interest rates and warnings of new lending policies. Phase C shows that the optimism of boom time has evaporated with some amount of panic. In severe cases, panic selling of assets, stocks and properties might happen. Unemployment is rising and businesses are filing for bankruptcy. Phase D is the final phase, where all economic participants take stock of the downturn and recent events to start a recuperating process. The surviving businesses do T housekeeping, while weak competitors are liquidated and closed down. Those O companies and investors with cash positions now capitalise on a weak market (N environment. Some industries are more susceptible to the effects of a recession. For example, borrowers from the construction and tourism industries are likely to have a more difficult time securing loans during a recession than rice milling and agricultural food processing industries. In the construction industry, an economic recession usually hits hard, with severe unemployment, abandoned projects, and higher numbers of bankruptcies among contractors and developers. Additionally, recovery in the construction sector takes a longer time. This contrasts sharply with rice milling and food-processing businesses that are less affected and recover faster. In a recessionary environment, lenders are likely to avoid lending to the construction sector, as there is uncertainty when the environment will stabilise and recover. CERTIFICATE IN CREDIT THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK 5-6 b. The Industry Life Cycle Every industry and its main products have their respective life cycles: from sunrise to sunset. As the cycle reaches the end (sunset), sustainability of sales revenue, cash flows and profitability may be at risk. Lending at the wrong end of the cycle may raise the risk of impaired loans. Greeting cards and facsimile machines are examples of sunset products, while the jury ) is out whether the digital camera and bicycle manufacturing are sunset FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO SE industries. BACKGROUND: The Industry Life Cycle The Industry Life Cycle Pioneering development Growth Maturity Decline During the pioneering development phase (sunrise industries), industry initiatives are announced and encouraged. However, since the ventures are new, risks are high and businesses spend substantial amounts on new investments and product promotion. At the growth stage, the industry is clearly viable and is showing signs of T growth accompanied by strong profits. Early participants are likely to be (N O rewarded with large payoffs. Once an industry has matured, there tends to be overcrowding, with a large number of competitors. Profit margins typically drop, while terms of trade become highly competitive. As the industry begins to decline (sunset industries), competitors start to leave the industry owing to shrinking profits and stagnating or declining sales. Profits and cashflow start to decrease and equipment often falls into disrepair. High-cost companies can be expected to post losses. c. The Product Life Cycle Similar to the industry lifecycle, products fall into obsolescence, such as film cameras and VCR machines. Lenders need to be aware of product trends, as businesses producing obsolete products or products near obsolescence will face challenging business conditions. CERTIFICATE IN CREDIT THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK BACKGROUND: The Product Life Cycle FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO SE ) The Product Life Cycle Sunrise Sunshine Sunset A product is at the sunrise stage when it is new and there is no established market yet. Businesses marketing these products will likely still be exploring potential markets and the customer base. Responses to the product are often slow initially, and the product runs the risk of not being well received by the consumers. At the “sunshine” stage, the product has a proven track record, and strong markets and demand established. At this stage, companies will likely be jostling for market leadership even as sales continue to grow. There is a possibility of declining profit margins due to the presence of more competitors. When the product is challenged by new designs or by an alternative product, it begins to move into the sunset stage. Customers begin to shift to new products or simply opt for something else. For example, consumers are unlikely to purchase film cameras now that digital cameras are available at competitive prices. Smartphones are another example; T consumers are always looking for the newest models and likely to ignore O older ones. When the main product of a business is at the sunset stage, (N 5-7 the business is likely to see falling profits and even losses, unless there are product replacements. The credit officer should recognise products and services that are evergreen or in perpetual demand, such as home furniture, clothing and airline services. Demand for these items, however, is often affected by the economic cycle. Other concerns include the state of industry competition, both global and domestic, and the regulatory environment. Both can be challenging for the borrower to generate revenue and cashflow to meet bank commitments. CERTIFICATE IN CREDIT THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK 5-8 5.2.3 Capacity “Capacity” essentially refers to the sufficiency of future cashflow generation for debt repayment. Unless the borrower is able to clearly show sufficient capacity to generate cashflow, the lending bank would likely consider the borrower high risk. For individual borrowers, the credit officer will need SE adequacy and reliability for loan repayment. ) to identify and understand the borrower’s source of personal income, its The capacity of a borrower to repay debt is anchored in potential future FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO business or employment prospects. To assess the sufficiency of this capacity, the credit officer needs to assess the business and sales potential of the borrower, using the borrower’s financial forecast or business plan. Emphasis must be placed on the potential cashflow generation during the loan period. The credit officer must pay due attention to tax liabilities and the timing of tax payments. A business is likely to need more financing in the future, for growth as well as to replace aging assets or acquiring additional ones. These considerations will have an impact on the amount of cash available to service loans. An assessment of the borrower’s current and future business funding requirements is relevant as is the borrower’s capacity for cash generation. For an individual borrower, an assessment of current income from various sources is necessary. This must be adjusted for the borrower’s living expenses, income tax deductions and other current loan commitments such as vehicle loans. The legal capacity of the borrower must be determined, e.g. if he is a foreigner or under 18 years old. O T 5.2.4 Capital (N Business lending is potentially high-risk. The lending bank, in this context, should only be willing to take credit risk, but not business risk. Business risk is the responsibility of the borrower, who must provide sufficient capital. Lenders need to assess the sufficiency of shareholders’ financial commitment in their business, relative to the permanent assets owned by the business. Financial commitment is often measured by shareholders’ funds in the business and should include any subordinated loans, as well as third party collateral provided by the owners. CERTIFICATE IN CREDIT THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK For consumer lending, an applicant must disclose the availability of backup capacity to repay if unfavourable situations develop. Thus, the lender needs to analyse the relationship between the applicant’s assets and liabilities. Lenders design their credit application forms to obtain this information. Capital contribution is deemed a commitment by the borrower in a business. It demonstrates the borrower’s confidence in the busines. The inability to SE inability to put up more financial support in times of need. ) provide an appropriate level of initial capital raises the risk of the borrower’s FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO A borrower with little capital contribution would be less motivated to stay committed and have a higher propensity to ‘walk away’ in times of crisis. The situation is the same for all borrowers, business and personal, especially when acquiring assets such as properties. Loan repayment is an on-going obligation that can stretch over many years. Changes in circumstances in the future can cause a good loan with adequate security today to subsequently become bad. Without a sense of commitment in place, the lending bank can only depend on the loan collateral. 5.2.5 Collateral Collateral refers to both security and guarantee provided by the borrower to function as protection for the loan. As future events cannot be predicted, credit officers often need to be prudent and seek additional support. While a lender would prefer to structure a loan that does not require collateral, i.e. a loan that is safe enough on the merit of the borrower’s business, such loans are not always possible. The need for security suggests that the loan T is not completely safe; hence, the need for security as additional protection O against potential loss. Collateral is known as a “second way out”, with the “first way out” being the core business cashflow to meet debt repayments. (N 5-9 In order for collateral to serve its purpose, it must hold some value to the borrower, who will do all in its power to avoid the risk of losing the collateral. In other words, assets used as collateral must be of value to the borrower in addition to its nominal monetary value to the borrower requirements. An old car, a painting, or a disused building put up as security for a loan does not put sufficient pressure on the borrower. On the other hand, a key asset, such as a strategic block of shares with voting rights in a family company, would be a better influence on the borrower’s behaviour. “Collateral of value” should be assessed for the following: Its value in relation to the loan amount Potential marketability in the near future CERTIFICATE IN CREDIT THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK 5-10 Characteristics of the collateral, such as depreciation rate or need for safekeeping Clear title ownership and restrictions, if any Transferability of ownership if the asset is sold Ease of locating and taking possession of the asset, if needed ) A deterioration of collateral occurs when its ability to protect the loan has SE diminished. Among the possible reasons for this deterioration is a decline in asset security value; for example, a piece of property declared unfit for FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO occupation, or a case where the guarantor for a loan loses the income generating capacity. The lending bank must be vigilant in monitoring deterioration of collateral value. SUMMARY In conclusion, the 5C framework is viewed as a risk identification framework to guide a credit officer’s enquiry into the credit application. In each element or ‘C’, relevant issues are raised to aid the credit officer in the analysis of creditworthiness before reaching a credit risk opinion. PRACTICE QUESTIONS (INDICATIVE ANSWERS CAN BE FOUND IN THE TOPICS LISTED FOR THE RESPECTIVE QUESTIONS) Explain the difference between good credit standing and a good payment habit. (5.1) T 1. O 2. An assessment of character of a loan applicant would require an examination of certain (N traits. Explain the type of traits that the credit officer hopes to uncover. (5.2.1) 3. Differentiate between the product life cycle and the economic cycle and describe each cycle’s relevance in making an effective loan. (5.2.2) 4. Loan repayment arises from future cash flow, but the future is uncertain. How then can a loan be justified? (5.2.3) 5. Discuss cashflow as a component of capacity in the 5C Framework. (5.2.3) 6. Capital reflects commitment. Would you agree? Explain. (5.2.4) 7. Collateral is intended to protect the loan. Discuss how collateral serves this purpose. (5.2.5) 8. Discuss collateral as a safe source of loan repayment. (5.2.5) 9. What are the possible lending strategies for each phase of the economic cycle i.e., from boom to bust? (5.2.2) CERTIFICATE IN CREDIT 5-11 THE 5Cs CREDIT RISK ASSESSMENT FRAMEWORK First way out Capital Guarantee Cashflow Industry life cycle Character Product life cycle FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO SE 5Cs Framework ) KEY TERMS Current economic cycle Second way out (N O T Security CERTIFICATE IN CREDIT