Final Exam Study Guide 5 C s of Credit 5 questions 1 Character The assessment of the seriousness of the borrower s intent to repay the loan 2 Capacity The legal authority to sign a binding loan contract and the adequacy of the borrower s cash flow available to repay the principal and interest on a loan 3 Collateral Adequate assets to support the loan in the case of default measured by a value ratio a may include personal security of the borrower 4 Conditions Assessing the impact of changing economic conditions on the borrower s ability to repay 5 Capital Assessment of the adequacy of the borrower s capital to prevent insolvency Capital is the net worth of the borrower whereas collateral is the assets pledged to back the security Regulatory Capital 1 question Regulatory Capital Regulator capital is the amount of capital that banks are required to hold to meet minimum capital requirements as determined by regulators Note that regulators are most concerned with the safety and soundness of banks and the banking and financial systems The optimum amount of capital may differ between banks and their regulators since they have different motivations and incentives Regulatory Capital Requirements are a reaction to Negative externalities associated with bank failures and the potential systemic risk o The losses to society resulting from a bank failure significantly exceed the private losses to the stakeholders of the bank The moral hazard problem introduced by deposit insurance Value Discount of deposit insurance Regulators give the deposit insurance at a discount to motivate banks to join Banks are happy to have subsidized deposit insurance but they are unhappy that the regulator requires them to have more capital than they think they need to hold Regulators will give deposit insurance at less than the full value but in return they want to make the banking industry safer overall holding more capital Deposit Insurance 1 Basle II Basle III Z Score Analysis 4 Questions Graphing the Value The moral hazard problem introduced by deposit insurance has provided an incentive for bank regulators to increase regulatory capital requirements The difference between the only tax line and the tax with bankruptcy cost is the value of deposit insurance Basle II requires banks to hold regulatory capital against potential losses from o Credit Risk o Market Risk o Operational Risk Basle III will add liquidity risk to capital requirements but has not yet been formalized by BIS or adopted Z Score Analysis Edward Altman The Altman Model The Z score analysis uses historical data on actual loan or bond performance to determine the performance default vs non default Edward Altman created the original model it used 22 ratios and 615 companies historical information Z Score Analysis has been found to be an accurate predictor of bankruptcy up to 2 years prior to experiencing financial distress Note model predicts bankruptcy with 95 accuracy within one year and with 70 accuracy within 2 years for publicly traded manufacturing firms Altman finds that for commercial loans to publicly held manufacturing firms the following financial ratios are statistically significant in distinguishing between loans that default and those that do not The higher this ratio the more liquid assets the firm has Working Capital Greater liquidity implies a stronger ability to pay off Total Asset debts in the short run The higher retained earnings are to total assets the Retained Earnings greater the firm s ability to generate and keep profits Total Asset This should indicate a greater ability to pay off debt A higher value for this ratio indicates a greater ability to generate profits off the given assets and should indicate a EBIT stronger ability to pay off debt Also a measure of Total Assets financial leverage Tells us whether a firm is paying for assets with profits or debt X2 X3 X1 2 Market Value Equity Book Value LT Debt Book Value Equity Book Value LT Debt Net Sales Total Assets X4 X4A X5 When this ratio is higher it signals that the market believes the firm s ability to generate cash through time is strong relative to the principal owed on the debt thus indicating the equity investors believe the firm s prospects are good Use this formula in place of X4 when the company is not publicly traded This ratio measures the firm s ability to turn dollars invested in assets into sales revenue The higher the ratio the greater the more efficiently managers are using assets to generate sales Sales are a cornerstone of profitability and the ability to pay off debts Z Score Formula Order of Importance Terms Working Capital Current Assets Current Liabilities EBIT Earnings before interest and taxes Net 1 X3 EBIT Total Assets 2 X2 Retained Earnings Total Assets 3 X4 Market Value Equity Book Value of LT Debt 4 X5 Net Sales Total Assets 5 X1 Working Capital Total Assets The Z score formula for commercial loans to publicly held manufacturing firms Z 1 2X1 1 4X2 3 3X3 0 6X4 1 0X5 Suggested a Critical Z Value for rejection 1 81 Grey Area 1 81 2 99 classification errors occur o Any z score higher than 2 99 you should accept Good credit risk o Any z score less than 1 81 should be rejected Bad credit risk o The area between 1 81 and 2 99 is called the Grey Area or Zone of Ignorance is the range of z scores in which misclassification is most likely to occur Fairly high probability that if you are in that zone you will commit a type 1 or type 2 error The 5 financial ratios and z score equation do not give you enough information to make a decision Reject 1 81 Zone of Ignorance 2 99 Accept Decision Rules 3 Usefulness Credit Analysis General Questions 3 questions Credit Analysis Quantitative credit scoring or analysis models such as Altman s z score or the logistic regression approach are most useful for evaluating loan applications for high volume small denomination loans such as auto mortgage and consumer loans Basic idea is to be able to distinguish good from bad credit risks o Determine the probability of default o Loss given default Allow the bank to o Provide a method for screening out risky loans o Allow the bank to price the loans according to their risk o Allow the bank to continue to monitor credit quality of the borrower over the maturity or term of the loan Credit Analysis and Monitoring process usually involves some form of o Credit Scoring Expert Systems Qualitative CS Ratio Analysis Pro Forma Financial Statement Projections Qualitative credit