Assessing Credit Risk: Methods and Practices

This article discusses various methods and practices used to assess credit risk in financial institutions and entities. It covers topics such as financial ratios analysis, credit scoring, credit history, and more. The article also explores the impact of credit risk on loan losses and income.

TASK 2
Introduction
Credit risk is regarded as the probability of loss which results from the failure of the borrower
in repaying the borrowed amount or meeting contractual covenants. Traditionally it is
regarded as the risk that the lender of money might not get the owed interest amount or
principal amount, whose ultimate outcome would be the interrupted cash flows and the cost of
collection would be enhanced. Defaults in payments can be in form of number of
circumstance like a consumer failing to repay mortgage loan or line of credit or a company
fails to repay asset-secured fixed or floating charge debt (Andrews, Gentzkow and Shapiro,
2020).
In addition to that, the credit risks can be assessed or determined with respect to the
basic ability of the borrowers for the repayment of loan as per the original terms of the
contracts. In order to make an assessment of the credit risks on loans by the consumers, the
lenders consider five Cs which includes capability to repay, credit history, the conditions of
the loan, capital and the collateral attached. Numerous companies and institutions have
different ways of assessing the credit risk which allows the entity to reach a decision about
whether to provide a loan to such entity or not.
How the Credit Risk can be assessed
Different entities and financial institutions utilise different modes of assessing the credit risks
some of the commonly utilised ways of assessing the credit risks includes financial ratios
analysis, Du Point Modelling, Cash flow statement analysis, modelling default, credit scoring,
credit risks equations, reports of the directors, audit report, customer profiling, credit policy,
credit history, stress testing, scorecards, risk rating, credit appraisal, KPI and risk memo. The
organisations all over the world utilises few of these options in order to analyse the credit risk
with respect to a particular loan to a specific lender (Erbuga, 2016). Credit rating agencies
develop their customised models for assessing risks. For example, in order to assess default
risk in credit portfolios backing collateralised debt obligations (CDOs) of asset backed
securities of corporates, Fitch Ratings has developed The Fitch Portfolio Credit Model. It is a
Monte Carlo simulation model which takes into account default probability, recovery rates,
and correlation between assets in portfolios to evaluate risk level. Fitch Model simulates the
default behaviour of individual assets in credit portfolio. It then draws a structural form
methodology which holds that a firm defaults if the value of its assets fall below value of
liabilities. It is not a cash flow model and also disregards payment waterfalls or excess spread

(Kumar, 2019). It gives output in the form of rating default rate, rating loss rate and rating
recovery rate.
The banks and financial institutions utilises the cash flow statement and consider the
cash generated by the business through their operating cash flows, if the operating cash flows
of the entity suggests a consistent growth over the period, or the entity have managed to
reduce the overall cost or both the targets are being achieved. In addition to that, the banks
and lending institutions also utilises the financial ratios to analyse the credit risk in any
investment or lending being made to the consumer. Credit analysis ratios are regarded as the
tools which assists the process of credit analysis. There are numerous sets of financial ratios
which allows the lending institution or the credit rating agency to determine the credit risk
involved in the particular transaction. The liquidity ratios like the current ratios and the quick
ratios help analyse the capability of the entity to pay off its current liabilities which are due in
the next 12 months. Moreover, the coverage credit ratios like interest coverage ratio, cash
coverage ratio, debt service coverage ratio and asset coverage ratio as these ratios measures
the overall coverage cash, income, or assets provides for interest expense or debt. If the
borrowing entity has a higher coverage ratio then it suggests that the entity has a greater
capacity to meet the financial obligations (Polato, 2019).
In addition to that, the lending institutions also utilises the Key Performance Indicators (KPIs)
which is regarded as a value which can be measured that demonstrate how the entities
efficiently achieving major business targets. This actually allows the lending institutions to
determine the success rate of the business entity and whether they would be able to pay off the
principle amount and the interest amount or not. Moreover, it is a common practice on behalf
of the lending institutions to assess the credit risk of the individual business entity or the
individual by looking at its credit profile which shows its credit rating by the banks and other
financial institutions based on the past trends and their capacity as a business entity to pay off
the loan amount and the interest payment. In addition to that, the lending institution also look
at the credit history of the individual consumer or the business entity as it a complete record
of the borrower’s debt repayment in the past in a responsible manner from various sources
including credit card companies, banks, governments and collection agencies as it provides

the capital history of the individual or an entity. For example, HSBC Bank has a separate
committee for credit risk evaluation which is known as Credit Risk Analytics Oversight
Committee which checks the overall risk portfolio of the company and further guides
subordinate teams on the guidelines to be followed for assessing credit worthiness and the
underlying risk analysis. It uses 5C model and checks capacity, collateral, capital, character
and condition of the applicant. Credit score given by credit rating agencies like Fitch Ratings
play a very important role followed by the detailed assessment of the historical payments by
the applicant (Orna, 2017).
Considering the practical application of the Barclays Bank of the United Kingdom, as
it is evident from their annual report that the entity utilises the framework provide in Basel 2
as part of the strategy of capital management. As per this particular framework which is
developed of three basic pillars, under the first pillar the entity calculates the risk weighted
assets for credit risks, under the pillar 2 the entity consider a view on whether the bank
requires to hold an additional capital for dealing with the credit risks, whereas, the third pillar
covers the overall communication with respect to the credits risks of the consumers and the
credit risk face by the entity. Barclays bank also carry-out a test on a regular basis under
which the comparison of the credit exposure is being made with the other banks of the
industry. This would allow the entity to manage their respective credit risk and maintain the
capital requirement. The Bank of England have also stated a certain amount of minimum
capital requirement which is also been followed by the Barclays Bank. As per the
standardised approach method requirement for credit risk is monitored by the entity on a
regular basis and the credit exposure of the entity is managed based on the credit risk capital
requirement as per the internal SOPs of the entity and the regulations provided by the Bank of
England.
Conclusion

In the end it can be concluded that there are numerous options available to the entities,
financial institutions and non-financial institutions to assess the credit risk which are being
discussed already. It is evident that the entities utilised more than one option for assessing the
credit risk some of the basic options include the relevant financial ratios, cash flow statement
especially the net cash flows from operating activities, Du Point analysis and there are
numerous credit rating agencies which maintains the credit profile of an individual or an
entity and helps in determining their capacity of principal repayment and interest payments.
Same is the case with Barclays Bank who has maintained its minimum capital requirement in
order to deal with the exposure and credit risk.
TASK 3
Name of organisation:
Wood Green Timber
Main objectives:
The main objective of the credit risk management of the particular financial is to minimize
the losses generated from the loans provided to the consumer while enhancing the overall
income of the entity.
Management and governance:

The entity has developed a particular management and governance structure within an
organization and a specific department which is solely developed for the purpose of the
managing the credit risk of the organization and helps the entity in achieving its overall
objective of enhancing the overall income and the reducing the loan losses. In my chosen
organization there is a comprehensive governance committee and under this particular
committee, there is a sub-department of credit risk management which directly reports to the
board of directors after consulting the governance committee of the Board of Directors.
Credit Risk Management is regarded as one of the major issue with respect to banking
industry.
Regulation and responsibility for credit risk
Sox throughout the nation, it impacts all public corporations by forcing them to comply with
the terms of the 11 parts of the Act. In contrast to publicly listed entities, Sarbanes-Oxley
often controls financial firms which conduct audits for each and every U.S. public
corporation, alongside their subsidiaries including international companies which are wholly
owned while doing business in this Country (Lemieux, 2017). In an attempt to enable visitors
to stay forward to expose alleged illegal activity in wood green timber company, Sarbanes-
Oxley provides security for squeal. Experts also said that the stringent sanctions for officers,
major shareholders, and accountants for losing company records are clearly illegal and will
extend to non-profit entities and also law-targeted market capitalisation firms.
Bad debt provision for company
The provision for bad debts may apply to the set of accounts, also referred to this as
the Bad Debts Payment, Questionable Liabilities Income, or Unpayable Account Exemption
(Sharma, Kanchan and Krishan, 2018). So then, a contra asset fund is the account Allowance
for Doubtful Debt (an asset account with a credit balance). In addition, for the capital
structure of company for the credit risk it is to disclose the valuation adjustments valuation of
the deferred revenue records of the business, it has been used together with the payroll
Consumer Receives. The entry in such contrary transactions to raise the monthly payment is a
deduction to the Bad Debts Cost balance sheet report. In the context of wood green timber, it
is also stated that to record the credit losses corresponding to the duration of the balance sheet,

use the summary clause for consumer debt on the cash flow statement. In any case, it will be a
financial statements account to provide for bad loans.
Collateralisation and securities
Usually, the principal balance required in a collateralized lending is dependent on the estate's
appraised credit quality. Around 70 percent to 90 percent of the cost of the assets would be
loaned by most insured lenders. Collateralized mortgages are intrinsically better and thus
usually have lower returns than non-collateralized mortgages. Savings accounts and consumer
lending provide non-collateralized, or unprotected, loans. Securities at other side, enable the
lender to profit both from the debt and the portfolio of securities whereas the mortgage is
already being repaid while the portfolio of securities stays underneath the ownership of the
investor. The borrower takes a higher risk, nevertheless, since the valuation of the bonds can
fluctuate dramatically (Linder and Williander, 2017).
Actions to manage and reduce credit risks
Risk based pricing: The Lender normally owes the Creditors a higher interest rate
here the, because they see a danger of defaults to see the financial situation or the Creditor's
background experience. Therefore, under this form of credit risk management framework,
regarding the risk tolerance as well as the willingness to repay the loan, varying rates would
be adapted to various creditors. For both the loan granted to beginning firms, the company
charges a higher interest rate only comparatively low the rate of interest as and then when the
economy wants to succeed. In this, any default to a lower rate better borrower is paid by the
other consumer to which the mortgage has also been granted much high rate.
Inserting covenants: Throughout the Term Loan, the Borrower may attach certain clauses or
assumable before distributing the funding to the Borrower. Capital Covenants, Organizational
Covenants, Technological Covenants & Company Level Contractual obligations may be
categorized into them. Any violation of the Covenant pursuant to the Arrangement would
cause a warning signal to the Borrower that even a failure will occur in the coming years, and
reasonable steps should be taken to protect the amount of the loan. For instance, according to
the recent amendments in the RBI Guidance, the Capital Adequacy is among the most
significant agreements for all the NBFC to retain up to 15 percent. It will be a compliance
violation for the NBFC at any point whether that ratio falls under 155 and would in fact have
significant consequences for the firm as well as its lenders to never track the very same
effectively (Menna, Agrafiotis and Georgopoulos, 2018).

Limiting sectors exposure: In this, since it would have a huge effect mostly on NPA
levels of the wood green timber, the investor will determine the industries in which he will be
involved in lending the resources to the lender. Throughout optimising its returns and retain
leverage over the potential customers instead of distributing the deposits at different stages,
the Lender can often opt to loan to a certain state or city.
Risk score and impact
Types of credit risk Score
Default risk 9
Concentration risk 8
Country risk 6
Impact of such risks
 Default risk: It impacts on the Wood Green Timber company in negative manner
because a higher default risk main related with the higher interest rates and problems
of bonds bring higher default risk will often it difficult to analysis of capital markets.
This risk impact on the income and yields negatively as a result company unable to
make the required payments on their debt obligation.
 Concentration risk: This risk arises in business when any particular exposure and
group conduct activities with the potential to increase losses large enough to threaten.
It is impact on Wood green timber on investment portfolio when people and group
move together. Along with portfolio will be liquidated and face bankruptcy.
 Country risk: This risk based on the uncertainty that based on the investment in
specific country but it leads to losses for investor. It impacts on Wood Green timber
operational activities that is noticeable and decrease in equity prices where nations
facing higher credit risk in regard of their business and reduced their foreign direct
investment.
Gap analysis: It is a method that used by the different organisations to analysis the
differences in performance in between information system as well as software application to
analysis of requirements of business entity. Accordingly, business take appropriate steps to
meet financial goals. The Wood Green Time use this method to recognise and review the
objectives to be achieved after that set up ideal future state. Moreover, company analysis of
current state with ideal state that define the gap and quantify the differences (Nair, 2018).

General requirements for credit risk management (please complete grid)
Requirement Measure of Risk
Date/Method of
Assessment
Meets
Requirement
Criteria?
Yes/No
Efficient
management of
the data
Ability to access the most
appropriate data when it is required
The Centralized
Information
system of the
organization
present on a
daily basis.
Yes
Framework of
Groupwide risk
Modelling
Ability of the financial institutions
to develop meaningful risk
measures and develop a
comprehensive picture of risk at the
group level.
Credit Value at
risk (CVAR)
method is being
used. After a
specific interval.
Yes

Sufficient Risk
tools
Banks and financial institutions
must have a strong risk solution.
They must have the ability to
determine the concentration of
portfolio and regrade portfolios
quite regularly for managing the
overall credit risk.
Probability of
Default and
Calculation of
Expected Loss No
Convenient
Reporting
Reporting processes is based on
Spreadsheet which are developed
through computer software and the
analysts and IT employees must not
feel overburden by the task in their
hand.
Efficient internal
risk reporting
mechanism.
No

Analysis of findings (please complete tables below; expand as necessary):
Strengths Evidence
Credit Scoring
The entity has developed and acquired the
ability to develop scorecard cheaper, faster,
more flexibly and the entity have developed the
entity to monitor credit scorecard.
Expected Credit Loss Calculation
It is evident that the entity has met the
challenges posed by IFRS 17, CECL and IFRS
9 in a flexible centralized and high-
performance analytics environment.
Orchestrate all the relevant aspects of
credit loss and financial stress test
reserving processes and perform
consolidation of results related to various
systems through a centralized hub.
It is evident that the entity have shown an
efficient ways of determining and estimating
the credit losses with precision.
Areas for development

The organization is required to improve the overall communication among different
branches of the financial institutions with respect to the credit risk management and
assessing the credit risk.
The entity is also required to develop and gather the credit risk assessment tools and
regrade the portfolios on a regular basis based on modification with respect to the credit
risk in a portfolio.
Overall commentary and judgement
Considering the entire credit risk management of the entity it is evident that the
organization has an efficient mechanism of estimating the credit risk. In addition to that the
organization’s specific department also utilizes various tools to manage the credit risk
through manoeuvring the capital requirement and managing the cash in hand.
Priorities for action Target
It is necessary on the part of the entity to have an efficient and effective
communication mechanism among the credit management department
and the entity’s top management.
Efficient
Coordination in
managing credit
risk.

Effective management to the data and the information related to the
consumers and the borrowers from the entity.
Centralized IT
system of the
entity where the
entire data can
be stored.

Action plan
KEY:
By
when
By
whom/with
whom
Resources
Monitoring/
other
comments
GENERAL REQUIREMENT:
Area requiring Action:
Management of the data Mechanism
Within
3
Months
By the Top
Management
of the entity
Centralized
IT system
It would
assist the
entity in
managing the
credit risk.
Appropriate risk tools in place
6
Months
Middle tier
of
management
with the
operational
staff.
Different
tools
including
CRM
software
Consistent
monitoring
of the CRM
software and
gather any
new
information
available.
Assessing the Credit Risk Management of the Department

The Credit risk management of process followed by the entity is quite comprehensive and
this is the reason why the entity faces a minimal amount of loss with respect to loss from the
loans provided by the them to the consumer. The department initiates the determination of
the credit risk after assessing the ability of the borrowers to repay a loan as per the
contractual agreement between the parties. To assess the overall risk of credit with respect
to the consumer loan, the lending party or the entity which provides goods on credit which
includes 5Cs. The entity looks at the credit history of the individual borrower or the person
require to acquire goods on credit, the second element followed by the entity includes the
capacity of the entity to repay the total amount of borrowed cash or payment of the goods
acquired. The conditions of the loans are the third element which is assessed by the entity in
order to determine the total amount which the entity would receive and time frame in which
the cash would be recovered. The final element which the entity or the department
considered by the entity includes the associated collateral, how much is the worth of the
associated asset.
Recommendation of Improvements after the Evaluation
There is a huge room for improvement with respect to the Credit Risk Management of the
entity’s Risk management department some of the recommendations are as follows:
- Credit Scoring
Establish, validate and keeping the focus upon the overall credit scorecards at a rapid pace, in
the cheapest possible manner and more flexibly through the outsourcing method (Luo et al.,
2017).
- Regulatory Risk Management

Operational Software in place must manage regulatory risk through-out several jurisdictions
with a singular risk management environment which works end to end.
- Estimated Credit Loss
The designed operational software meets the specific challenges posed by the CECL, IFRS 9
and IFRS 17 and other standards with a flexible, centralized, high performance analytics
overall environment.
- Implementation Platform
The adopted and implemented software efficiently and effectively execute a wider range of
models utilized in the tests of bank stress and various other risk assessment processes.
- Finance and Risk Workbench
Arrange all the features of the financial stress test and the loss of credit reserving processes,
and it is also necessary to consolidate the results from different systems through a centralized
mechanism.
- Workbench of Risk Modelling
Reduction in the overall cost and minimize the operational risk linked with the development
of risk model.
Conclusion
In the end it can be concluded that the basic objective of credit risk management is to
minimize the or mitigate the overall losses by understanding the adequacy of the capital and
the reserve for the loan losses managed by the entity at a specific time. As the risk assessment
procedure of the entity is concerned it is evident that the entity has an appropriate credit risk

management process and mechanism but still there are some room for improvement for the
entity.

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