MODULE 200: CREDIT MANAGEMENT

CREDIT ANALYSIS

A bank lending money or extending credit to an individual or juridical entity needs to analyze the
credit to determine two (2) things:
1. Facility Risk (risks involved with the credit)
2. Borrower Risk (likelihood of repayment)

How do banks mitigate these risks? How do they decide to whom credit will be extended and up
to what amount are they going to grant? This is where credit analysis takes its place.

Credit Analysis is the process of inquiry prior to deciding to extend credit to a potential borrower.
Purposes of conducting credit analysis are:
• To keep the number of bad credits to a minimum
• To highlight potential problems early enough for banks to seek early repayment or
withdraw from credit

Financial analysis forms part of the bank’s credit analysis.

Financial analysis focuses on the borrower’s historical financial performance using the
borrower’s submitted financial statements. It determines the financial strength of the borrower.

Financial analysis in loan structuring often focuses on the borrower’s (a) Profitability, (b) Solvency,
(c) Liquidity, and (d) Stability. In addition, financial analysis also forecasts the financial conditions
of a potential borrower and examines if there is growth once credit has been injected to the
business or any other lawful loan purpose.

In credit management, credit analysis goes beyond financial analysis. It includes the review of the
borrower’s character, business engagement and operations, business’s industry, collateral
offered to secure the credit, among others.

The following are the basic credit factors crucial in analysis work:

Borrower's
Character and Loan Purpose
Soundness

Primary Secondary
Repayment Repayment
Source Source
There are three (3) categories of credit information: (a) Historical, (b) Investigational, and (c)
Financial.

Credit analysis is structured to analyze and synthesize the borrower’s data by means of deductive
logic to allow comparison of borrower to its industry, market, and environment.

Credit analysis is composed of the following:

a. Proposed credit accommodation
b. Basis of analysis
c. Current financing sources
d. Company overview
e. Industry overview
f. Management overview
g. Financial statement quality
h. Financial statement analysis
i. Repayment ability
j. Summary of proposal

Furthermore, a credit proposal, which is the output of the credit analysis, establishes the following
details:
Typical questions to be asked to formulate the analysis are:
1. Who is the borrower?
2. How much credit is required?
3. What is the purpose of the loan?
4. How will the specific loan or credit solve the financing requirement or problem?
5. When will the loan be repaid?
6. From where will the funds come from to repay the loan?
7. What financial information is available?
8. What will the loan mean to the borrower and to the bank from a profit standpoint?
9. What is the credit history of the borrower?

Lastly, analysis on the above diagram may be based on the following:

CREDIT PROCESS FLOW

1. Business Strategy
Market scanning, also known as market mapping, is a thorough search and analysis of
potential clients for the bank. It involves the process of collecting information about the
target market, potential market size, competition, among others.

One example would be when bankers, especially those in the lending department, would
drive around an area and determine potential businesses and individuals as borrowers.
Another would be when banks set up booths in malls or highly populated areas to display
their products and services.

2. Loan Origination
This is the process wherein a borrower applies for a credit facility. Loan origination involves
gathering and initially evaluating the relevant data to determine if the potential client
qualifies and to reach the loan decision.

One of the initial evaluations conducted is the acceptance criteria of the borrower. Banks
determine the borrowers’ qualifications by using the 5Cs of credit and other pertinent
banking policies such as but not limited to:

Section 16: Prohibition on Direct or Indirect Grant of Loans, Guaranty and Other Credit
Accommodations to Certain Government Officials and Entities in which they have
controlling interest, Article XI: Accountability of Public Officers of the 1987 Philippine
Constitution

Foreign Investments Act of 1991 (Republic Act No. 7042, as amended) in relation to the
Foreign Negative List issued from time to time

3. Credit Evaluation
This is the process wherein the potential borrower undergoes a thorough assessment
based on submitted application and documents to become an eligible borrower to be
granted a certain amount for a determined period.

Evaluating a potential borrower in an efficient, repeatable, and accurate manner helps to

minimize the risks that a bank undertakes, protect margins, and consequently, maximize
the profits. In addition, it assesses the creditworthiness of the potential borrower which
would spell out the difference in the credit administration.

The following evaluation methods are employed during the evaluation stage:
a. Credit Investigation
b. Property Appraisal and Validation
 c. Project Verification and Validation
d. Credit Analysis

4. Negotiation
Banks have their standard terms and conditions for the loans to be granted to borrowers;
however, not all of these are applicable to every borrower and not all potential borrowers
are amenable to every term and condition implemented by the bank.

Negotiation, in any aspect of business, is a discussion aimed at reaching an agreement.

As bankers, all aspect of the proposed loan, interest rate, tenor, additional fees, required
collateral, among others, should be properly communicated to the borrower.
Communication builds trust, engagement, and client retention.

5. Credit Proposal and Approval

Credit Proposal is a document prepared by an account officer detailing all pertinent
information about the borrower and credit facility to be availed which will be presented to
the credit approving authorities.

Presented below is a sample format of a credit proposal:

Credit proposals should be structured properly benefiting both the bank and the borrower
wherein they will be protected throughout the term of the loan.
6. Documentation
Once the credit facility has been approved by the corresponding approving authority, a
loan agreement will be executed which will bind both parties to the commitment of lending
and borrowing a specified amount to be repaid at a determined period.

7. Credit and Portfolio Management

Responsibilities of account officers does not end when the credit facility has been
approved and disbursed. All accounts handled by a bank must be annually reviewed to
determine its progress and any positive or negative developments involving the borrower
and its project. This is to be conducted until the full payment of the loan.

On the other hand, there are times wherein accounts are mismanaged and would result
to being past due. This is when remedial management will be conducted.
BANK CREDIT UNIVERSE
Conceptual View of the Bank Credit Universe
Potential Risks The Transaction Defining the Credit Culture
Credit
Liquidity
Interest Rate
Foreign Exchange
Sovereign/Cross-Border
Trading
Business and Environmental
Legal and Regulatory
Operational
Political
Concentration

1: Analysis of everything 1: Policy – a bank’s credit

related to credit per se. conscience

2: Pertinent knowledge of 2: Process – line-driven

industry and borrower’s operational arm of lending
position. and lending strategy

3. Political, social, cyclical, 3: Audit – Evaluation of

regulatory, and other conformance with lending
influences policy, practices, and
procedures

4: Behavior – a bank’s value

system and attitude

A bank is in a business of taking risks. A good bank can effectively and efficiently manage the
risks it faces.

First, let us identify the risks that banks commonly face:

1. Credit Risk: it is the risk that a borrower will be unable to make regular payments of
principal and interest due causing the credit to default.

2. Liquidity Risk: it is the risk that a borrower will be unable to generate sufficient cash to
meet maturing obligations on time.

3. Interest Rate Risk: it is the risk that changes in the market interest rates will reduce the
value of a loan and adversely impact the bank’s as well as the borrower’s financial
performance.

4. Foreign Exchange Risk: it is the risk that an uncovered foreign currency-denominated

credit will decline in value due to a change in exchange rate.
 5. Trading Risk: it is the risk that the project or program financed through the loan availed
will not be traded.

6. Sovereign Risk: it is the risk that a foreign government will default on its loan/s or fail to
honor other business commitments due to a change in national policy.

7. Business and Environmental Risk: it is the risk that the general business and economic
climate in which borrower operates is headed for a downturn and may result in non-
payment of loan.

8. Legal and Regulatory Risk: it is the risk that the borrower’s business will be severely
restricted, hampered, or rendered illegal by a legislative or regulatory act.

9. Operational Risk: it is the risk that the borrower will cease or downsize operations due to
product, service, or management failure, or adverse public reaction

10. Political Risk: it is the risk of nationalization or other adverse government action against
borrower.

11. Concentration Risk: it is the risk associated with concentrating loan/s to a particular
borrower, group of borrowers, industry, or region.

Identifying possible risks that a bank may face in dealing with a particular borrower would enable
the bank to mitigate them by applying existing bank policies and structuring the credit correctly.

In preparing the proposal for the account, the credit transaction diagram may be adopted.

As presented, there are three (3) layers into the transaction. These are areas wherein the account
officer must be acquainted with in addition to the bank policies.

The first one is the analysis of everything related to the account especially a borrower’s financial,
character, and management and operation (if it is a business). Why are these essential matters?
It is because a bank is lending the deposits entrusted by their clients to other people. It is rightful
for them to scrutinize the borrower.

It is also important to determine the position of the borrower in the industry it is classified under,
especially if it is a business loan and determine how is that industry is performing.
Where would you grant credit? In a sunrise industry or sunset industry?

Lastly, the overall situation that may influence a borrower’s performance must be considered such
as but not limited to political, social, regulatory, and cyclical.

During the administration of former President Rodrigo Duterte, mining was controversial industry
as extra permits were needed to be secured from regulatory bodies to be determined as legal
mining. This is in addition to its obvious environmental and social issues. Although the
administration lifted the mining ban, one of the questions raised by financial institutions granting
loans to mining companies is if it is environmentally ethical? Would they be a contributor to
environmental and social destruction?

Part 1.E 143 of the BSP MORB is specially devoted for bank’s credit risk management. It would
ensure FIs under BSP supervision to have an adequate and effective credit risk management
systems commensurate with their credit risk-taking activities.

It guides the FIs by further articulating sound principles and practices that shall be embedded in
the credit risk management framework of FIs and covers the following areas:
a. Establishing an appropriate credit risk environment
b. Operating under a sound credit granting process
c. Maintaining appropriate credit administration, measurement, monitoring, and control
processes over credit risk

The principles set forth in the credit risk management guidelines are used in determining the
adequacy and effectiveness of an FI’s Credit risk management process and adequacy of capital
relative to exposure. The following factors were considered:
a. The FIs business strategies, operating environment, and the competencies of its officers
and personnel
b. The major sources of credit risk exposure and the complexity and level of risk posed by
the assets, liabilities, and off-balance sheet activities.
ELEMENTS OF SOUND CREDIT
There are numerous violations resulting from non-compliance of the basic policies of granting
sound credit especially in the use of approved loans for purposes other than what has been
approved or used by recipients of the loan other than the borrower.

As prudent bankers, it should be kept in mind the fundamental principles in the granting of sound
credit.

The 5 Cs of Credit are as follows:

CHARACTER
Loans are granted to individuals or entities such as corporations. Loans are negotiated with
people and people manage loan repayment. Therefore, the character of every borrower and the
principal borrowers of every entity must be above question. It should be the priority consideration.
Moral standing, integrity, and business capability of borrowers must be thoroughly checked before
any substantive loan negotiations begin.

Objectivity must be always maintained. Involvement that is too close to the borrower could lead
to overemphasis of the borrower’s interest and make it difficult for bankers to shift the tone of their
relationship when problems arise. All positive and negative information regarding the borrower
must be fully disclosed in loan proposals for the information of approving authorities.

It is unwise to extend large amounts of credit to a borrower who has demonstrated a definite
tendency to use numerous other banks and its credit facilities simultaneously when there is no
evidence that such use was necessary for the borrower’s financing requirements. Proper
evaluation must be conducted by the banks.

CAPACITY / CAPABILITY
The borrower’s ability to repay is a function of earning power. The single ingredient that is present
in sound bank credits, secured or unsecured, is proven earning power of the borrower. The
borrower’s total spending and indebtedness should be confined to amounts which can be
managed comfortably out of unpledged income over the near term.

A key consideration in evaluating a request for credit is the question: how will the loan be repaid?
Repayment should be expected from the normal activities of the borrower. Repayment must be
sourced from the cash flow from operating activities of the borrower. The transaction must be
realistically conceived, and the repayment program should be well within the flow od cash that
can be reasonably anticipated from the borrower’s business or activities. It is not prudent to make
a loan that will depend on unusual windfall or sale of assets for repayment.

A bank shall grant loans and other credit accommodations only in amounts and for the periods of
time essentials for the effective completion of the operations to be financed. Such grant of loans
and other credit accommodation shall be consistent with safe and sound banking practices.

The purpose of all loans and other credit accommodations shall be stated in the loan proposal
and in the contract between the bank and the borrower. If the bank finds that the proceeds of the
loan or other credit accommodation have been employed, without its approval, for purposes other
than those agreed upon with the bank, it shall have the right to terminate the loan or other credit
accommodation and demand immediate repayment of the obligation.
Before granting any credit accommodation, a bank must ascertain that the borrower can fulfill
his/her commitments to the bank.

COLLATERAL
Collateral does not make a bad loan good. Reliance on security should be secondary to exacting
credit evaluation and analysis. It is important that legal title is not clouded and that there is a ready
market for the collateral in obtaining collateral.

The conditions for marketability are:

a. The item should have an economic use
b. It should be needed or sought by a significant number of people or firms
c. It should be capable of being sold at close to its ordinary market values without too high a
discount in price resulting from forced sale
d. The asset should be situated close to market sources so that transportation cost where
chattels are involved can be kept at a minimum

CAPITAL
The depository aspect of the relationship must always be considered to assure that the total
relationship will grow as the bank enables its borrowers to grow through the lending process.
Thus, as a matter of policy, borrowers shall be required to maintain deposit accounts with the
bank in an amount proportionate to the bank’s position as creditor.

Equity contribution is regarded as a major aspect of credit analysis as it would show, among
others, the seriousness of the borrower’s involvement and faith in his own project. Pledges of
collateral, even if they adequately cover the proposed loan value, should normally not suffice.
Equity participation, therefore, must be scrutinized and the required equity contribution must be
made available prior to any loan exposure to the borrower.

CONDITIONS
In condition, the lender will consider the local and international economic and social climate
(macro factors), as well as conditions both within the company and in the industry wherein the
borrower belongs (micro factors).

Macro factors include government regulations, political situation, economic climate, and
environmental factors. Micro factors, on the other hand, refer to the borrower’s rank in the industry,
market share, competition, technological innovation, and product life cycle.

The 5C’s of credit previously mentioned is one of the ways to structure and identify good credit.
Opposing to the 5 C’s of sound credit, there are bankers who do not practice such. Presented
next are the 5 C’s of bad credit.

COMPLACENCY
Being complacent on a borrower is over emphasizing on past performances. Past success does
not guarantee future success, vice versa.

Complacency is also when a banker is overly reliant with a client. “I know him and his family. They
have banked with us for years. He would not default on us.”
Complacency is being overdependent of the collateral offered and exulting confidence on an
incorrect assumption.
Therefore, policies require credit administration and monitoring wherein each loan account are
annually reviewed.

CARELESSNESS
A careless banker reflects how the bank. Carelessness could lead to serious downturn for the
bank. This may be a result of inadequate or improper loan documentation, lack of current financial
information and updated reports, lack of protective loan terms and conditions, disorganized loan
files, among others.

COMMUNICATION
In any life scenario, poor communication, up and down the line, is deadly. This will cost the bank
good relationship and profits.

Bad communicate results to unclear credit quality objectives, not only hurting the profits but could
also lead to destroying the bank’s reputation.

CONTINGENCIES
Bankers are supposed to look at every serious matter that happened or can happen and then
decide how likely it is that any of those things will happen or reoccur.

A banker should always ask especially in structuring the loan “What could go wrong?”. This is in
relation to risk mitigation. When potential risks have been identified, then mitigants can be in
place. Otherwise, it may seem that bankers have insufficient attention to the downside risks and
higher and more stressful price for it will be paid after the problem has exploded.

COMPETITION
Bankers make decisions because of what the other banks are doing rather than concentrating on
the merits of the borrower in front of them. They tend to follow the decisions and actions of others
instead of formulating their own.

Usually based on competitive euphoria, market share, and revenue growth objectives.