Home ›› 31 May 2022 ›› Editorial
What is the most significant indicator if not the single most important to understand the credit requirement, repayment capacity to improve the possibility of getting the money lend to someone be it organisation or an individual? This question is covered to a great extent if someone looks at the Cash Conversion Cycle (CCC) to whom the money is lent. While for an individual the residual amount of disposable income, whether sufficient and regular to repay. For an enterprise, this is a measure of how long cash is tied up in working capital. It quantifies the number of days it takes a company to convert cash outflows into cash inflows and, therefore, the number of days of funding required to pay current obligations and stay in business.
Cash Conversion Cycle in days for a business is derived by deducting the payable in days from the sum of inventory in days and receivables in days. The longer the inventory and/or receivable in days, the higher the inefficiency in working capital management. This may be due to slow down in demand for seasonality, quality, disruption in the business or overall macroeconomic situation. The shorter the cash cycle, the healthier a company generally is. However, in case of any distressed scenario, whether internal or external, may result in call on by the creditors can create a stressed scenario for the enterprise.
Credit risk refers to the probability of loss due to a borrower’s failure to make payments on any type of debt. Credit risk management is the practice of mitigating losses by understanding the adequacy of a bank’s capital and loan loss reserves at any given time – a process that has long been a challenge for financial institutions. Credit risk is the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection. Excess cash flows may be written to provide additional cover for credit risk. When a lender faces heightened credit risk, it can be mitigated through cash cycle based credit structuring and risk based pricing, which provides for greater cash flows. One way to do this is by checking what’s called the five C’s of credit: character, capacity, capital, collateral and conditions. The phenomenon of a credit crunch shows the importance of data analytics in making credit rating decisions. Accurate risk assessment is key. Combining a variety of up-to-date data on a debtor’s life situation and their credit history into insightful reports is vital to single out at-risk borrowers. Understanding these criteria may help you boost your creditworthiness and qualify for credit.
The global financial crisis – and the credit crunch that followed – put credit risk management into the regulatory spotlight. As a result, regulators began to demand more transparency. They wanted to know that a bank has thorough knowledge of customers and their associated credit risk. And new Basel III regulations will create an even bigger regulatory burden for banks.To comply with the more stringent regulatory requirements and absorb the higher capital costs for credit risk, many banks are overhauling their approaches to credit risk. But banks who view this as strictly a compliance exercise are being short-sighted. Better credit risk management also presents an opportunity to greatly improve overall performance and secure a competitive advantage.
The first step in effective credit risk management is to gain a complete understanding of a bank’s overall credit risk by viewing risk at the individual, customer and portfolio levels.While banks strive for an integrated understanding of their risk profiles, much information is often scattered among business units. Without a thorough risk assessment, banks have no way of knowing if capital reserves accurately reflect risks or if loan loss reserves adequately cover potential short-term credit losses. Vulnerable banks are targets for close scrutiny by regulators and investors, as well as debilitating losses. An observer sits in the Board of Directors to ensure the safeguard of the depositor interest in these vulnerable banks.
The key to reducing loan losses – and ensuring that capital reserves appropriately reflect the risk profile – is to implement an integrated, quantitative credit risk solution. This solution should get banks up and running quickly with simple portfolio measures. It should also accommodate a path to more sophisticated credit risk management measures as needs evolve.
The Basel Accords were formed with the goal of creating an international regulatory framework for managing credit risk and market risk. Their key function is to ensure that banks hold enough cash reserves to meet their financial obligations and survive in financial and economic distress. They also aim to strengthen corporate governance, risk management, and transparency.
The Basel Accords are extremely important for the functioning of international financial markets. They can never be constant and need to continuously be updated based on present market conditions and lessons learned from the past.
Credit rating agencies use both qualitative and quantitative techniques to determine the sovereign credit rating of a country. A 1996 paper published by Richard Cantor and Frank Packer titled “Determinants and Impacts of Sovereign Credit Ratings” outlined various factors that explain the difference in credit ratings assigned by the various rating agencies. The factors include:
1. Per capita income
Per capita income estimates the income earned per person in a specific area. It is calculated by taking the total income earned by individuals in a given area divided by the number of people residing in that area. A high per capita income increases the potential tax base of the government, which subsequently increases the government’s ability to repay its debts.
2. GDP growth
The GDP growth rate of a country refers to the percentage growth in the GDP of a country from one quarter to another as the economy navigates a business cycle. Strong GDP growth means that a country will be able to meet its debt obligations since the growth in GDP results in higher tax revenues for the government.
3. Rate of inflation
Sovereign debts are susceptible to changes in the rate of inflation, and an increase in inflation will affect a country’s ability to finance its debt. A high inflation rate points to structural problems in a country’s finances, and it is likely to cause political instability as the public becomes dissatisfied with the increasing inflation.
4. External debt
Some countries rely heavily on external debts to finance their development and infrastructure projects. Increasing debt levels translate to a higher risk of default, which may affect its ability to access funding from international lenders. This burden increases if the foreign currency debts exceed the foreign currency income earned by a country in the form of exports.
5. Economic development
During the 1970s, two large oil price shocks created current account deficits in many Latin American countries. At the same time, these shocks created current account surpluses among oil-exporting countries. With the encouragement of the US government, large US money-center banks were willing intermediaries between the two groups, providing the exporting countries with a safe, liquid place for their funds and then lending those funds to Latin America (FDIC 1997).
Latin American borrowing from US commercial banks and other creditors increased dramatically during the 1970s. At the end of 1970, total outstanding debt from all sources totalled only $29 billion, but by the end of 1978, that number had skyrocketed to $159 billion. By 1982, the debt level reached $327 billion (FDIC 1997).
Credit rating agencies consider the level of development when determining the sovereign credit rating of a country. Usually, once a country has reached a certain level of development or per capita income, it is considered less likely to default on its debt obligations. For example, economically developed nations are considered less likely to default compared to developing countries.
6. History of defaults
A country that defaulted on its debt obligations in the past is considered to have a high sovereign credit risk by rating agencies. It means that countries with a record of defaults receive low ratings, making them less attractive to investors looking for low-risk investments.
The eurozone, at the time of the U.S. financial crisis in 2008, was comprised of 16 member nations who, among other considerations, had adopted the use of a single currency, namely the euro. During the early 2000’s, fuelled largely by an extremely accommodative monetary policy, these countries had access to capital at very low interest rates. The economic troubles of Portugal, Italy, Ireland, Greece, and Spain (PIIGS) reignited debate about the efficacy of the single currency employed among the eurozone nations by casting doubts on the notion that the European Union can maintain a single currency while attending to the individual needs of each of its member countries. Critics point out that continued economic disparities could lead to a breakup of the eurozone. In response, EU leaders proposed a peer review system for approval of national spending budgets to promote closer economic integration among EU member states.
The writer is MD and CEO of Community Bank. He can be contacted at [email protected]
