University of Macau GARP Chapter

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1 University of Macau GARP Chapter Risk Management and Credit Lending December 15th, 2011 Presented by Prof. Albert Ip Independent Non Executive Director Eagle Asset Management Company AND Hopewell Highway Infrastructure Executive Fellow in Asia Washington University in St. Louis Lingnan University Council & Court Member Cornell University Council Member City University Int l Advisory Board Member College of Business Washington University in St. Louis Advisory Board Member Center for Finance & Accounting Research University of Macau Member of International Advisory Committee The Better Hong Kong Foundation Council Member Technological & Higher Education Institute of Hong Kong Member and Governor The Boys and Girls Clubs Association of HK Investment Task Committee

2 Outline I. Purpose of Credit II. Credit Risk III. Credit Culture IV. Traditional Credit Model V. Risk Evaluation Framework VI. Lending Is Three Dimensional VII. Credit Lending Process Flow VIII. Market Definition Process Flow IX. Documentation & Disbursement X. Credit Portfolio XI. Risk Management Actions XII. The Art of Lending XIII. Unusual Risk XIV. Causes of Credit / Lending Problems XV. Causes and Outcomes of the Financial Crisis in 2008 XVI. Characteristics of a Good Lending Officer XVII. Principles of 3C s XVIII. Summary 1

3 (I) Purpose of Credit Credit enables the use of goods or services without immediate payment. Credit enables a producer to bridge the gap between the production and sale of goods. Credit enables a real estate company to construct a project before the units are sold In short, credit drives the economy. Without banks providing credit ( willing and able ), the economy will not grow. Credit is a powerful tool for economic progress. 2

4 (II) Credit Risk If credit is defined as the expectation of a sum of money within some limited time, then credit risk is the chance that the expectation will not be met. Credit risk is a consequence of contracted and contingent financial transactions between the providers and users of funds. Moderate leverage undoubtedly boosts the capital stock and the level of output... the greater the degree of leverage in any economy, the greater its vulnerability to unexpected shortfalls in demand and mistakes. Alan Greenspan, Board of Governors of the Federal Reserve System,

5 (III) Credit Culture Commercial Banks Credit culture is the embodiment of the banks in underwriting, managing and monitoring credit risk Credit culture is the glue that binds the credit process and forms the foundation for credit discipline Underwriting Managing Monitoring Credit Process Credit Discipline 4

6 (III) Credit Culture Commercial Banks (cont.) Credit Culture at Goldman Sachs Sophisticated, detailed understanding of risks by senior management Culture of overcommunication Escalation, Escalation, Escalation Cooption of business unit professionals into risk management Accountability Long history of promoting best risk managers Intolerant of lack of control focus Learn from past mistakes 5

7 (IV) Traditional Credit Model Client Transaction Credit Risk Management Capital Structuring Provisioning Risk Syndication Origination Credit Function Credit Limit Transaction Origination Preparation of Credit Request Structuring / Pricing Administration Credit Assessment Monitoring Credit Limit and Administration 6

8 (V) Risk Evaluation Framework Financial Specific Market Industry Management Facility Key Questions to Ask Key Questions to Ask Key Questions to Ask Key Questions to Ask Key Questions to Ask Profitability Efficiency Liquidity Solvency Availability of finance Consumer demand Inflation State of financial Markets Barriers to entry Supplier power Buyer power Threat to substitution Jostling for position Strength & Breadth Track record Integrity Board composition Account Expected loss Unexpected loss Exposure at default Loss given default Maturity Credit decision is personal, which is enhanced & refined through one s professional career from experience and skills gained in reviewing many transactions. Lending isn t static; a lending officer s prime adversary is change. George Moore, previously Chairman of Citicorp 7

9 (VI) Lending Is Three Dimensional (A) Borrower 3C s Capacity Collateral Character (B) Competition Key Competitors in business Product superiority (differentiation) Cost advantage (C) Market / Industry Supply / Demand balance (or imbalance) Heavy capital requirements Barriers to entry (Ease of entry) 8

10 (VII) Credit Lending Process Flow Market Definition and Target Markets INITIATION ORIGIN EVALUATION NEGOTIATION APPROVAL Client Request Prospect Discovery Outside referral (?) Purpose Business Management Figures Tenor Repayment Covenants Security Other Sponsoring officer(s) Senior(s) Independent risk sign off 9

11 (VIII) Market Definition Process Flow Strategic Planning Business Environment Market Information Base Analyses Strategy Annual Business Planning Business/Marketing Plan Risk Acceptance Criteria Market Priorities Target Market Segments/Names Priority Products Minimum account/size/profitability standards Resource allocation, including assets and appropriate staffing Portfolio Implementation Account Assignments Name by name planning Call reports Account Profitability, Strategy and Risk Profile Market Intelligence reports

12 (IX) Documentation & Disbursements DOCUMENTATION Legal drafting Document review Collateral checks Waiver of terms Other PORTFOLIO MANAGEMENT ADMINISTRATION Figures Covenants Collateral Payments Credit reviews DISBURSEMENT Notes valid Documentation executed Orderly Payment Unforeseen events WORKOUT Early recognition Strategy Management of plan - Terms renegotiation - Collection efforts - Legal efforts - Reorganization Independent Credit Consultation, if appropriate REPAYMENT Principal in full Interest in full LOSS Principal Interest 10

13 (X) Credit Portfolio Purpose of Loan Define repayment source: CDO At least 2 sources of repayment Define pattern of repayment Demand Loan not desirable CDO Types of Loan Commercial and industrial Export import trade financing Real Estate Consumer Shipping Standby letters of credit Share Financing Leverage Buy Out Financial institution lending Banks are in the business of taking risk. They are successful as long as the risks taken are reasonable, which are controlled and compatible with their financial resources and credit competence. 11

14 (XI) Risk Management Actions Risk Management actions are both anticipating and after-the-fact: Principal anticipatory actions: Reviews industry and geographical concentrations Recommends appointment of senior credit officers and senior credit officer specialists Ensures appropriate training for all levels of credit officer Anticipates and spots flaws or deficiencies in individual credits and in the credit process After-the-fact: Monitors loan portfolio, and advises senior management with particular attention to geographic, business segment and currency mix, tenor, classified credits or unused trends Tracks quality of loans of large amounts (e.g. over $50,000,000) Reviews strategy on significant adverse exposures 12

15 (XII) The Art of Lending Those who cannot remember the past are doomed to repeat it. (LBO, NJR / Nabisco) When history repeats, it may vary its earlier patterns. Know your customer Know your industry Sound Credit judgment Balanced risk assessment Ensure multiple ways out for loan Multiple lenders Risk diversification Effective documentation 13

16 (XIII) Unusual Risks Unavailable financial statement Holding company Inferior position (e.g. second mortgages, unsecured) Non amortizing secured or unsecured term loan Multiple levels involvement Bank acts as financial advisor/underwriter and lender Lender to company and owner of company Bridge loan Loan to replace other lender Hostile takeover Gambling Very large transactions (reduced liquidity, concentration) 14

17 (XIV) Causes of Credit / Lending Problems Credit made without the application of sound credit criteria Excessive emphasis on profits Inadequate credit checking and improper documentation Understaffing, Lending officer turnover Specific Examples Borrowers that borrow excessively One way out lending Lack of clear purpose or firm liquid source of repayment Family dominated companies which are unprofessionally managed A significant change in a borrower s size, business plan and strategy inconsistent with management s capacity and capability A change in economic condition 15

18 (XV) Causes and outcomes of the Financial Crisis in 2008 Definition of Financial Crisis Causes Excess leverage Something that happens every 5 to 10 years. Jamie Dimon, Chairman of JP Morgan Over reliance on risk rating (Standard & Poor s) and ignore basics of risk Over complacence Over reliance on security for repayment (LBO, CDO) Negative effects of incentive 16

19 (XV) Causes and outcomes of the Financial Crisis in 2008 (cont.) Outcomes De leveraging of banking system Strengthen governance Differentiated risk based capital allocation Higher capital requirements for banks (Bassel III) More expensive credit Motivate and reward decisions to create long term value for shareholders Back to Basics serving clients with traditional financial products / services Further rise of China 17

20 (XVI) Characteristics of a Good Lending Officer Integrity Good team skills Common sense Judgment Analytical ability Willingness to say NO Willingness to take risk o Citibank Chairman James Stillman said to Citibank President Frank Vanderlip in 1915: The ablest banker is one who knows not to do business, meaning what kind to do and when to do as little as possible 18

21 (XVII) Principles of 3C s Extension Character Character Character For Real Estate Locatio n Locatio n Locatio n For Hong Kong Real Estate 19

22 (XVIII) Summary Deleveraging of banking system; Credit will be more expensive and harder to get; Return on commercial and investment banking separately justified; Tighter regulatory oversight; More rigorous and differentiated risk assessment (term lending, specialized industry, concentrated loans, etc); Encourage and reward decisions that create long term value for shareholders 20

23 (XVIII) Summary (cont.) A Corporate / Commercial banker career is both challenging and fraught with opportunities: Banking is back to basics (Liu Ming Kang, Chairman, China Banking Regulatory Commission 劉 明 康, 中 國 銀 行 業 監 督 管 理 委 員 會 主 席 ); Differentiated risk assessment is crucial as economy re enters into growth phase; Companies appreciate the increasing importance of banks role and value in their operations, in particular lending; Markets are global. 21

24 (XVIII) Summary (cont.) To be a successful corporate / commercial banker, you must: Know the customer; Know the industry; Be an effective cross seller; Be a good team player; Possess analytical aptitude; Have Integrity; Be willing to take risk; also know when to say No ; Recognize problem before it surfaces. 22

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