Risk-Based SME Lending

Introductions Introduce trainers Introduce participants Leveling of expectations Introducing the course

Risk-Based SME Lending 2 day seminar, with 4 actual cases Designed for banks, coops and financial institutions involved in SME lending Student Handbook contains all handouts, notes and materials.

Risk-Based SME Lending Session 1 – Opening session Introductions Leveling of expectations Course objectives Course outline Methodology Rules of the game

Common abbreviations BRR – means Borrower Risk Rating FRR – means Facility Risk Rating SBC – Small Business Corporation PD – Probability of Default LGD – Loss Given Default CAMP – Cash, Admin, Marketing, Prodn CR – Current Ratio DSC – Debt Servicing Capacity

Basic definitions Credit risk - is defined as the risk a bank won’t receive money lent and interest earned on its loans. Repayment of funds and accompanying interest must occur if a bank is to succeed. If the loan principle is not returned, the bank will quickly fail. If the bank does not receive interest earned, its failure will be slower, but just as sure.

Basic definitions Risk-based - simply means the bank or financial institution has a systematic way of assessing, measuring and managing credit risks. Banks are in the risk management business – they assess, assume and manage risk. Those that do it well succeed and prosper. Those that do not manage risk perform poorly and in some instances, fail .

Biggest risk Biggest Risk of All – out of the 4 or 5 major risks that a bank faces, it is CREDIT RISK which is the biggest. It comprise 80% of all risks. A bank which fails to manage its credit risks is doomed to fail. A Bank which manages its credit risks well is likely to become profitable and sustainable.

Why risk-based Importance of doing risk-based lending. Why is it important? Better way of identifying and measuring risks in the SME businesses being financed

Course objectives Learn about BRR and FRR system and tools Practice doing BRR rating on cases Identify key risks in businesses Learn about SBC’s financing programs Learn how to design your own BRR and FRR system

Course outline 19 sessions Introduce BRR and FRR Four actual SME cases Plenty of practice to hone skills Small group discussion

Methodology Will use adult education techniques Case discussion method Ask questions anytime, please… Quizzes every day; final quiz at the end Attendance recording is a must Come on time.

Rules of the game Sign attendance sheet daily. Ask questions if anything is unclear. Participate actively in group discussions Share your views and experiences. Respect the views of your peers.

Rules of the game Do your best in the quizzes. Its an opportunity to test your learning. Bring your Student Handbook every day. Bring a calculator too. Certificate of Participation to be given to everyone who completes the 3 day seminar

Basic definitions Loan delinquency Loan default Probability of default (PD) Loss given default (LGD)

Session 2 Why do pilots check their plane before taking off? Why do you think it is important to check the backgrounds and risks of business of borrowers? Potential problems may come if there is no proper credit assessment

Global trend There is now a global trend for banks to carefully examine and measure borrower risks before a loan is disbursed. (This is in contrast to old traditional way of banking which relied heavily on collaterals).

Risk rating Global trend in banking: systematic risk assessment of borrower-clients Basel II – endorses 2 tier approach: BRR and FRR Basel II includes both qualitative and quantitative analyses BSP endorses and requires credit risk assessments; could increase CAMELS rating of banks

BRR introduction Quantitative and qualitative evaluations are used in BRR. Not a purely numerical exercise Human judgement is still very important

BRR introduction BRR analyses should help in making credit decision of the bank; whether a loan will be given to a borrower or not, and what conditions to impose. FRR analyses should help in making decisions on loan size, loan terms, loan pricing and conditions on collaterals.

BRR introduction BRR makes use of a score card; various aspects of the business are analyzed and given a score. Risks are identified as each component of the business is analyzed Total score is obtained; BRR score translated to BRR rating; Grade 1 to 10. See Handbook page 18

BRR introduction Four major components of the business are analyzed deeply C – cash – financials (50% weight) A – administration (20% weight) M – marketing (15% weight) P – production (15% weight)

BRR introduction Under C- cash / financials, 4 items are analyzed CR – current ratio DER – debt-equity ratio DSC – debt-servicing capacity ARL – accounts receivable level

BRR introduction Under A- administration, 4 items are analyzed EOM – experience of owners/ managers OHS – owner’s health, age, succession FC – financial capacity AB – attitude to banks

BRR introduction Under M- marketing, 2 items are analyzed Sales – concentration of sales Growth – increase of sales past 3 years

BRR introduction Under P- production, 4 items are analyzed Supplier – concentration of suppliers Inventory speed – turnover Production service capacity Business location

BRR introduction BRR ratings range from 1 to 10. Grade 1 is high-quality, excellent client; very low risk involved; Grade 10 is a very poor, bankrupt client Grade 5 is considered acceptable. Qualitative descriptions shown in Student Folder BRR User Guide is used in BRR rating exercise

Will it be useful? What are the possible benefits to the banks? To the SMEs? To the economy?

Session 3 Introduce briefly how BRR rating is done using a first actual SME case SBC has developed a good BRR system BRR scorecard Groupings into 4 or 5 groups.

BRR introduction Work in small groups. Introduce briefly the case Read the case briefly Work together in rating the borrower Question-and-answer portion

Report back What is the BRR rating? Will you lend to this company? What risks did you identify? What loan covenants should you require or impose? Question–and-answer

Session 4 BRR and its links to various aspects and components of the bank. Banks faces many risks – operational risks, liquidity risks, market risks, etc. But the biggest risk of banks is credit risk BRR will help screen out bad accounts and identify good and bad credit risks

BRR User Guide SBC has developed a BRR User Guide Brief explanations about the User Guide

BRR introduction BRR is related to many things in the organization. They are: Loan pricing Loan portfolio quality and overall profitability Intensity of loan monitoring Number and kind of loan covenants or conditions Loan loss provisioning Organizational structure Calculation of PD and LGD

BRR and PD BRR is related to Probability of Default It is logical to think that a company with a high BRR rating (meaning high business risk) should have PD and higher loan loss provisions in the books of the bank, while a company with a lower BRR rating (lower risks) shall have a lower PD and loan loss provisions.

FRR introduction What is FRR? Facility Risk Rating, where a tool is used to systematically assess the collateral or security being offered by the borrower as security for the loan. A bank should also conduct a risk assessment of the collateral and such an FRR rating complements the BRR rating. FRR factors should only affect the pricing of the loan and conditions but not the basic credit decision

FRR and LGD FRR is directly related to LGD – Loss Given Default. Why? The quality of the security or collateral being offered by the client as measured by an FRR rating will allow the bank to have a good estimate of the amount of monetary loss that may be suffered by the bank in case the client actually defaults. This is called LGD – Loss Given Default. If the security is of high quality the LGF will be probably low, but if the quality is poor, then the LGF will be probably high.

FRR introduction A FRR rating table provides clear guidance on how to rate a business using the collateral being offered as security for the loan. See the FRR rating table in the 113 FRR rating of zero is very high quality collateral while an FRR rating of 10 means very poor or no collateral at all.

Bangko Sentral The BSP requires all banks to put in place a credit risk management system. See BSP circular in Appendix 2 Several BSP circulars released.

Session 5 Let us do a BRR rating of one actual SME company. A brief introduction to the case Work in small groups; within time limit Report back