Corporate Credit Risk Management:Credit Analysis, Portfolio Management

and Market Trend

By Steve Chi ( )Taiwan Corporate Country Risk Manager

( )

March 11, 2009

1

What is Risk ? Uncertainty (Exposure) leads to potential lossType of Risks : Credit Risk: Direct and Contingent, due to Commercial,

Financial, Structural risk factors Counterparty Risk: Pre-settlement / Settlement exposure Market Risk: Due to Mark-to-Market Price Volatility Operation Risk: Due to errors from system, process, people Franchise Risk: Due to reputation damage Regulatory / Legal Risk

Risk Mitigation: Factors can reduce the uncertainty and/or the potential losses as downside protection

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Risk Management Reward as incentive of Risk TakingInstitution: Optimal balance between Risk and Return for Profit MaximizationRisk Management: The Philosophy, Principle, Policy and Procedure exercised to Optimize Risk adjusted Return

Risk

Return

Target Market

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General GuidelineRisk cannot be eliminated, but can be controlled.Banks are in the business of risk taking. They are successful as long as the risks they assume are manageable controlled within defined parameters, and within their financial resources and credit competence.

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General GuidelineThe essence of banking is the management of liquidity. Commercial banks lend to many types of borrowers, for varying periods, in different patterns, on many basis, and for a variety of reasons. Loans therefore will vary in liquidity and risk, and concentrations must be limited so that no single occurrence can have a significant adverse impact.

5

General GuidelineWhen any organizations responsibility, authority, and geographic scope are highly decentralized, elements of control must exist. So must a system of checks and balance Credit Policy.There is one big difference between selling a credit product and selling soap. The sale of money is not final. You expect it back with interest.

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General GuidelineCharacter of every borrowers and the principals of every borrowing entity must be above question.Involvement thats too close could lead to overemphasis of borrowers interest and make it difficult for lending officers to shift the tone of their relationship when problems arise Independent Risk.

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General GuidelineSome of bankings more serious credit problems can be traced to poor basic market decisions.Different target markets may call for different skills. The right people must always be in the right place. Until appropriate lending competence is on hand, units are expected to refrain from extending credit.

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General GuidelinePush for market share with insufficient or unseasoned lending competence, or rapid portfolio build-up that causes assets to be booked without absorbing the complexities of transactions, inevitably invites problems.In todays credit world a lending officer must anticipate, not react.

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Causes of ProblemsCredits made without the applications of sound basic credit criteria in effect, breaking our own rules.Excessive emphasis on profitUnderstaffing, lending officer turnover, and training or experience gaps cause poor loan structuring and other credit mistakes that better-skilled personnel could have avoided.Credit problems created by reactive posture and deficiencies in implementing the credit process.Marginal loans that become credit problems because business fails to develop as forecasted, operating costs rise more sharply than anticipated, interest expense becomes too burdensome, or recession develops.

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Major Categories and Sub-Categories of Risks

Direct

Contingent

Lending

Pre-settlement

Settlement

Counterparty

Issuer

Clearing

Credit Risk

Interest Rate

Commodity Price

Volatility in Options

Price

Funding

Trading

Liquidity

Market Risk

Equity

Country

Fiduciary

Documentation

Disclosure

Legal & Regulatory

Systems

Other Major Risks

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Risks under Credit Risk CategoriesLending Direct : actual customer obligations will not be settled on time. Contingent : potential customer obligations will become actual obligations

and will not be settled on time.

Counterparty Pre-settlement : counterparty may default on a contractual obligation to

the bank before settlement date of the contract. Settlement : On the maturity date when the bank simultaneously

exchanges funds with a counterparty for the same value date and cannot verify that payment has been received until after the banks side of the transaction has been paid or delivered

Issuer : market value of a security or other debt instrument that the bank intends to hold for short period of time may change when the perceived or actual credit standing of the issuer change.

Clearing : Bank may not be reimbursed on the same value date for payments that are made on behalf of customers

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Total ExposureTotal Exposure = Direct lending (cash outlay) Contingent liability (non-cash) Counterparty Issuer Settlement and Clearing

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Credit Risk Management Process

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Forecast and ProjectionScenario-driven approach: Usually three scenariosManagement case: what will it look like if management objectives can be ideally achieved within target periodMost Likely case: what will it look like in realistic terms given all risks and mitigations identified Worse case: what things can go wrong as a result that management objectives are completely missed and what will the damages look likeNo elevator analysis

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: ,,

: :

10%

8%

5%

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Concentration Factors for Industry Volatility

Macroeconomic Factors Economic Cycle Exchange Rates Oil Price Interest Rates

Operating environment Industry Cycle Governments Support Entry Barriers Labor cost R&D Level Over Supply WTO Impact Raw Material supply

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Target Market Screening and Risk AppetiteTarget Market Screening Approved industry (certain industry aggregated exposure is

capped within approved limit) Benchmark on financial criteria: sales, TNW, leverage, etc Financial statement availability Minimum rating requirement Management assessment

Goal: Maximize risk adjusted return. Benefit and cost of credit relaxation benefit: increase revenue, gain market share cost: higher default risk, higher financing cost (I.e. better

credit terms to customer)

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Credit Risk Management Process

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Credit Risk Assessment Framework

Rating

Credit Structure

Credit terms

Business Risk Financial Risk Capital Structure Management

Fundamental Analysis

Model generated rating (usually based on financials)

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Business RiskHow does the company make money : business model, and can lose money : earnings and cash flow variability?

Industry dynamics & KSFs Comp AnalysisBusiness model/strategy (& corporate structure, if appropriate)Key dependencies and vulnerabilities/threatsEvent risk

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Financial RiskWhat are the expected, and stressed financial views of the company, given the business profile?Basic financial profile: Core/sustainable earning (and cash flow) power Operating & financial leverage Working capital: A/P, A/R, Inventory Capex:maintenance v.s planned Financing Cash Flow: discretionary v.s fixed obligations

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Capital StructureGiven the business & financial profile, how does the companys capital structure fit in terms of capacity to execute its strategy with due financial flexibility, and withstand periodic stress?

Fit between funding, liquidity and business strategyDebt maturities and refinancing riskInt rate and FX risk and strategyFinancial flexibility under stressed company and market conditions

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ManagementManagement track record: Given the risk profile and the business/industry driven imperatives, does management possess demonstrable capacity to run the company under current/normal conditions, and periodic downturns/stress?

Character and business practiceExpertise and Experience (years in management, in the industry, downturn performance, business scale beyond capability) Management stake on the company (e.g. shareholding) Management personal financial health (e.g. % of shares pledged)M&A Scenario: Strategy and Execution

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Structural Risk and Other Credit IssuesHow will the credit structure protect creditors under expected, and stressed conditions Credit enhancement Risk mitigation options

Structural Risk: Holding company structureStructured Finance Risk: Large off-balance sheet financing (AR financing, SPV, pension liab, etc) (e.g. Enron)Corporate Governance: Disposal of Assets, Carve out of profitable business unit for IPOValuation of collateralsCapital Market: irrational share price movement, transactions dont make sense

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Portfolio Reporting and Management

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(Portfolio Guideline) BB+

B or worse < 5%

< 20%

< 65%

=

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(Risk Assessment)

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(Credit Classification)

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- (BP)

AAA 0

AA 1

A 2

BBB+ 4

BBB 6

BBB- 12

BB+ 31

BB 65

BB- 118

B+ 194

B 296

B- 423

CCC 770

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:

Debt Rating Model

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:

32

o = /

o

710,000/200,000,000=0.00355 35.5BP

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-

34

/

5,0008,000

6.25BP/BBB

3,250500BB

9001,500BBB

6003,000A

2002,000AA

01,000AAA(NT$M)

(NT$BN)

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Effective Risk Management Practice and TrendCulture and Organizational behavior: Independence: Assurance of objective assessment Forward looking: Early problem recognition Solution-driven: Dont just say No BUT Say Yes, if or No,

because..

Risk differentiation: Focus on key issues based on 80-20 rule

Although customized analysis on individual credit is still critical, the rising trend for risk management are: Portfolio approach: to manage risk on portfolio basis Risk Mitigation approach: to adopt risk hedging tools and risk derivatives Convergence approach: to manage risk on converged basis including

credit risk together with market risk

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Q & A