Assessing Credit Risk: Methods and Practices

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: