What is “Credit”?
Credit is the process of one party receiving financial (or other) resources of value from another party and repaying at a later date. The most common form is bank credit, where a bank lends money to a borrower who is then obligated to make scheduled or periodic interest payments and repay the principal upon maturity to them.
The amount of credit a company is usually able to borrow (i.e. borrowing capacity) is based on its ‘creditworthiness’. This is typically predicated on factors such as a company’s loan repayment record, credit score, financial standing, collateral on offer, and debt-to-income ratio. Another form of credit is a supplier giving products to a customer and getting paid at a later date. This definition focuses on credit from the perspective of corporate banks.
Key Learning Points
- Depending on the borrower’s needs, banks may provide short-term or long-term credit
- The credit process involves several steps, including an analysis of the borrower’s repaying capacity
- Credit risk measures the risk of a loss, in case the borrower does not meet their repayment obligations
Types of Credit
The type of credit extended by banks depends on the needs of the borrower.
Banks can provide short-term credit to support the working capital requirements of companies or the same is utilized for their operational expenses. Often there is a lag between a company selling goods to its customers and receiving cash short-term credit enables companies to tide over cash flow and liquidity mismatches. Repayment is made to the bank once the assets (such as accounts receivables) are converted into cash. Short-term credit usually needs to be paid off between 6 months to 18 months. A revolving credit facility is an example of short-term credit.
Banks can extend long-term credit to companies for financing longer-term assets such as property, plant, and equipment (PP&E) and acquisitions. Term loans are an example of long-term credit. Such credit has a maturity of longer than one year. Generally, the maturity of such loans could be anywhere ranging from two, five, ten, or even to thirty years.
The Credit Process
The credit process generally involves the following steps:
- The bank’s relationship manager identifies a prospective loan opportunity
- The credit team perform credit analysis of the borrower and assess the business and financial risks related to the loan
- The team prepares an initial risk assessment – if the borrower does not meet the bank’s lending criteria, the request for credit is rejected
- If the borrower passes the initial risk assessment, the loan is structured
- Upon structuring a loan, a credit memo is prepared
- The credit memo is presented to the bank’s credit committee, which will decide whether or not to put the bank’s capital at risk for this loan
- If the project fails to meet the credit committee’s lending criteria, the loan is rejected
- If it passes the credit committee’s standards, the credit will be approved
- The final terms will be negotiated between the borrower and the bank, and if there is mutual agreement on the same the funds will be disbursed
- Finally, the bank needs to constantly monitor the loan to ensure the borrower is meeting its agreed obligations
Quantifying Credit Risk
Despite various checks and balances in the credit process, there is always a risk of default by the borrower. The credit risk measures the risk of the bank suffering a loss because of the borrower or counterparty failing to meet their obligations. One way of quantifying credit risk is by calculating the expected loss, which is calculated as follows:
Expected Loss Formula
Expected loss = Probability of Default (PD) x Exposure at Default (EAD) x Loss given Default (LGD)
PD or the probability of default is the chance that the borrower will fail to fulfill their debt repayment obligation
EAD or exposure at default is the amount owed by the borrower in the event of a default
LGD or loss given default is the proportion of exposure the bank will lose in the eventuality of a default. For example, if the loan is backed by collateral, the bank will not lose its entire loan amount.
Credit Risk – Expected Loss Calculation
Given below is some information relating to a corporate loan. The expected loss has been calculated below using this information