Credit Risk Mitigation
What is “Credit Risk Mitigation”?
Credit Risk Mitigation (“CRM”) refers to the attempt by lenders, through the application of various safeguards or processes, to minimize the risk of losing all of their original investment (loans or debt) due to borrowers (companies or individuals) defaulting on their interest and principal payments. There can be a range of outcomes. Defaults can lead to significant revenue loss for lenders. There are strategies to mitigate credit risk such as risk-based pricing, inserting covenants, post-disbursement monitoring, and limiting sectoral exposure.
For banks and other types of lending institutions, having robust CRM is pivotal to avoiding a surge in defaults and non-performing assets (NPA), which can very adversely impact their financial performance or even result in insolvency.
Key Learning Points
- Credit risk mitigation refers to the actions taken by lenders to reduce the probability of non-payment by borrowers
- There are several safeguards that lenders take to mitigate risks
- Inadequate risk mitigation can adversely impact lender’s balance sheet and profits
- Banks and other types of lending institutions use various strategies to mitigate credit risk such as the 5 Cs of credit, risk-based pricing, contractual debt covenants, post-disbursement monitoring, and limiting sectoral exposure
Credit Risk Mitigation Strategies
As stated above, there are certain credit risk mitigation strategies, i.e. risk control strategies that banks and other lending institutions deploy to mitigate the probability that borrowers will default on their loans, and to reduce the number of non-performing assets. An outline of each strategy is given below
5 Cs of credit: these provide lenders a framework for credit risk mitigation and help in identifying the inherent risk in a loan. The 5 Cs of credit are character, capacity, capital, collateral, and conditions (purpose of the loan, cost, and tenure).
Initial risk assessment: the credit team performs credit analysis of a company that wants to borrow. This involves assessing business risk and financial risk.
Structuring of loan: the point of structuring a loan is to mitigate risk. It includes details such as to whom the bank is lending, if there are any complexities in the borrower’s corporate structure, choosing the right kind of loan that matches the future cash flows of the borrower with the repayment schedule, etc.
Credit memo: includes details such as debt capacity of the borrower, clarity on risks involved, and mitigating factors to those risks.
Loan syndication: in the case of a larger loan, the lender may seek to mitigate credit risk by going in for loan syndication, which involves selling down the bank’s exposure to the loan to a bank group.
Loan protection: involves the issue of seniority of debt and legal contractual ranking of creditors. Further, the lender takes into account the securities, guarantees, and collateral that a borrower can give.
Pricing of loan: which is encapsulated by risk versus return and is also driven by supply and demand.
Risk-based pricing: in this type of pricing, banks charge different rates of interest to borrowers with different risk profiles. In other words, higher (lower) interest is charged to those borrowers where the chances of default are higher (lower).
Lending institutions attempt to gauge the risk appetite of different borrowers and their respective ability to fully service the loan and accordingly charge them a higher or a lower rate of interest. In attempting to gauge the above, lending institutions analyze how robust or weak is the financial condition of the borrower and/or their past record of servicing debt.
Debt Covenants: Lending institutions often insert loan covenants, which include financial, technical, business level, and operational covenants) into the loan agreements. Such covenants are agreements that stipulate the terms and conditions of loan policies between the borrower and the lending institution before funds are disbursed to the borrower. Here, the lender puts a number of restrictions in place that a borrower agrees to, which are meant to protect the lender from the risks associated with the loan.
For example, if a company is taking out a loan, in order to expand its operations, the bank may ask it to sign a covenant that states the minimum amount of revenue generated by the company that must be reinvested. The underlying intention is to ensure that the company remains profitable so that the ability to repay the loan is not jeopardized. Usually, loan covenants include the maximum debt-to-equity ratios that a company must adhere to.
Post Disbursement Monitoring: lending institutions need to ensure that the borrowers make proper use of the loan that is disbursed to them and they have the adequate cash flow to service their loan on time. Therefore, they may demand of the borrower to furnish them with their financial statements – balance sheet, income statement, and cash flow statements – in a predefined format either every month, quarterly, or annually. This helps them to assess the cash flow of the borrowing company and whether it will be able to easily service the debt or not.
Exposure limits: an important element of credit risk management is the establishment of exposure limits across sectors, to minimize the chances of default and keep non-performing assets at a prudent level. In certain industry sectors, the probability of default is higher than in others, Consequently, lenders may decide to lend less to those sectors where the risk of credit default is higher. For example, the real estate and pharmaceutical sectors are often considered high risk sectors vis-à-vis credit risk.
Collateral: the most common type of credit risk mitigation technique. It refers to the pledging or hypothecating by a borrower to a bank or lending institution. Collateral is used as an item of value to obtain a loan and minimizes risks for lenders. For example, if a borrowing company is unable to service the debt or repay as its cash flows are not adequate, then the lending institution can seize or take control of the collateral that is pledged and sell it to reduce or recoup the loss. The most common type of collateralized loans are mortgages and car loans.
Credit Risk and Profitability
In the example below, we see how adversely a bank’s balance sheet and profits are affected if a bank underestimates credit risk.
The key assumption here is that a traditional bank (Bank A) underestimated the risk vis-a-vis some of the corporate loans that it made and 10% of the high-risk loans went bad. Further, initially, the bank has US$ 1,000 million worth of Risk-Weighted Assets (RWA), which are the sum of loans in its loan portfolios (consisting of US$ 900 million high risks and US$ 100 million low-risk loans). Moreover, as per the BASEL Accord, a lending institution or a bank’s common equity TIER 1 Capital must be greater than 4.5% of its Risk-Weighted Assets (RWA’s).
Having stated the above, we start with TIER 1 Capital on the Balance Sheet as US$ 45 million (i.e. US$ 1,000 (Risk-Weighted Assets) * 4.5%). Moreover, the bank has excess cash of US$ 20 million.
Next, if 10% of loans go bad, then these loans are written off, of equity, so TIER 1 Capital goes down to US$ 35 million, from US$ 45 Million. The maximum risk-weighted assets (RWA) go down i.e. this means that the new Balance Sheet of the bank requires it to dump a part of its loan portfolio. So, post adjustment, three things happen: the excess cash goes up (which does not bring in any returns), the risk-weighted assets go down (i.e. US$ 777.8 million) and the Tier 1 Capital reduces to US$ 35 million (as stated above).
Next, another adverse result of 10% of the high-risk loans going bad is that the new loan portfolio results in lower returns. In other words, in the old loan portfolio, the loans were generating net interest income on loans of US$ 55 million (initial Income Statement) and net interest income was US$ 45.3 million. Now, in the new loan portfolio, the bank is generating net interest income on loans of only US$ 38.9 million (adjusted Income Statement) and net interest income reduces to US$ 29.1 million. In essence, a loss of 10 i.e. 1% of risk-weighted assets due to bad loans reduced the net income of the bank by US$ 16.1 million (or 35.6% of the bank’s profits).
Banks and other types of lending institutions attempt to maintain credit risk exposure within prudent and acceptable parameters, which is the objective of credit risk mitigation within such organizations. CRM enables lending institutions to manage their cash flows more efficiently, lowers non-performing assets, enhances customer management and improves their bottom line (profits).