Credit Risk Management Enhancing Your Bottom Line The AFP 23rd Annual Conference New Orleans November 3-6, 2002 Ebrahim Shabudin Managing Director Deloitte & Touche LLP

Credit Background Thorough identification and accurate measurement of credit risk, supported by strong risk management can help improve the bottom line …..An uncertain and volatile economic environment significantly impacts this ability …..The desire to grow and turn in outstanding results has a tendency to put pressure on the checks and balances within businesses

Value Proposition Credit plays a critical role in “selling” products and services Expands revenue opportunities with creditworthy, incremental customers Utilizes innovative structures to support business relationships Effective credit risk management limits credit losses and provides stable cash flows and earnings Marketplace rewards companies exhibiting earnings and cash flow stability with higher P/E multiples Marketplace penalizes credit induced volatility and “surprises” Raises questions about quality of management

Corporate Credit Risk Companies are exposed to significant levels of credit risk emanating from different sources Accounts Receivables Other Notes Receivables Buyer and Franchise Financing With Recourse Financing Project Finance Structured Transactions Leases with Recourse Derivatives Exposures FX, Interest Rate Risk, Commodities etc. Collateral Risk Parent or Third Party Guarantees Commercial and Standby Letters of Credit Note also that Critical Suppliers to the company may pose specific credit risk

DSO Impact … an example Actual Company A Peer Average Q3 A/R $295,396,000 Q3 Sales $261,201,000 \ DSOs = 124* 51.3 Hypothetical D Cash DSOs \ Q3 A/R = $122,002,230 +$173,393,770 * Equals 295.4M/261.2M x 90(or number of days in sales period) EL affects the income statement, whereas UL is captured in the balance sheet ‘ECONOMIC’ TO DISTINGUISH THE CONCEPT FROM REGULATORY OR ACCOUNTING (BOOK) CAPITAL

Credit as a Facilitator Credit risk management is important Credit is a facilitator of business growth and performance High business margins tend to attract lower quality clients and therefore higher risk profile to manage Clients (buyers) may be concentrated in selected industries and provide limited portfolio diversification opportunity Poor credit risk management resulting in negative impact to bottom-line is heavily penalized by markets

Credit Strategy & Risk Tolerance Credit Strategy Statement and Risk Tolerance Coordination with Business Plan Specific Quantifiable Objectives Management Review Methodology The business strategies and objectives drive the establishment of credit policies and procedures. Measurement and reporting as well as the use of current technologies enhance credit decision-making and improve risk management. The entire process is continually re-evaluated and improved.

Credit Risk Areas to Consider Origination/ Assessment Monitoring/ Control Risk Management Administration Sales Channels Risk Strategy Underwriting Standards Credit Application Analysis Business/ Industry Financial Credit Credit Scoring and Ratings Credit Policy Credit Approval Authority Limit Setting Pricing Terms and Conditions Documentation: Contracts and Covenants Collateral and Security Collections, Delinquencies and Workouts Exposure Management Aggregation Control Periodic Account Reviews Payments/Aging Credit Condition Compliance with Covenants, Terms Technology/Reports Transactions/ Bookings Risk-adjusted Return Portfolio Management Concentration Diversification Allowance for Bad Debts Risk Mitigation Objectives Type of Exposure Instruments or Methods

Business Performance Measures Performance Management Performance-based management utilizes metrics that measure actual performance against predetermined thresholds. The thresholds are established taking into account the organization’s strategy, operating environment and process controls. Value Creation Business Performance Measures Business Strategy Systems Operations Finance Organizations need a rigorous set of measures to support continuous improvement The measures drive value creation and should support problem identification and correction.

Credit Risk Management’s Inter-related Activities CREDIT POLICY Reporting Disposal / Risk mitigation Origination Management reporting Recoveries Credit Analysis Sales channels Financial analysis Credit analysis Collections Exposure aggregation Risk rating Credit scoring Exposure measurement Customer management Portfolio management Credit Decisions Compliance Transactions Collateral management Pricing & terms Credit limit Collateral acceptance Contracts & Documentation

Credit Risk Management A complete and coherent risk management framework contains the following elements Credit Strategy & Risk Tolerance Governance, Control and Implementation Credit Policies & Procedures Measurement Methodologies Analysis & Risk Management Technology & Data Integrity

A New Paradigm A new business paradigm had evolved: causing a lack of reliance on good fundamental analysis The idea that stock market values would continue to go up indefinitely Increasingly competitive, complex and volatile market place Higher than expected actual debt burdens Extensive reliance on unrealistic future cash flows Failures in corporate governance Questionable personal and corporate ethics

Implications for Corporate Governance Current organization structures to be revisited Clarity around roles and responsibilities Need for honesty, integrity and independence (self-regulation) Technical expertise of people and strong management processes Improved disclosure requirements Importance and implementation of sanctions Increased legislation and compliance requirements

Credit Risk Management – Strategic Vision A business model view of Credit Risk Infrastructure components Vision: Managing Risk/Return Pricing decisions,Performance measurement, business and customer segmentation, compensation, etc. Near Term: Managing Economic Capital / Credit VaR Portfolio Risk Concentration, Risk Based Limits, etc. Short Term: Managing Expected Loss Risk Identification, Transaction Structuring, Approval & Pricing Decisions, Reserving, etc. Foundation: Credit Rating and Underwriting Standards Risk Identification, Origination, Credit Administration, etc.

Development Stages Foundation Stage includes application of risk identification methodologies, risk scoring or rating systems and strong underwriting standards Basic Stage tends to include managing on a transactional basis by evaluating specific attributes such as structuring, collateral and pricing Advanced Stage represents managing on a portfolio basis including aspects such as concentrations, correlations and diversification The Sophisticated Stage includes application of highly developed measurement techniques for transactions and portfolios, supported by decision-making relating to segments or businesses against established hurdle rates.

Credit Risk Clarified Credit risk is defined as the risk of loss or potential loss resulting from: Default in contractual obligations by a customer Migration in condition and rating Deterioration in performance Credit risk includes both an expected (predictable) and unexpected (volatile) loss component.

Businesses have to contend with Expected and Unexpected Losses Unanticipated but inevitable Must be planned for Covered by reserves Allocated to businesses Difficult to measure Assessing unexpected loss requires making qualitative judgments around potential volatility of average losses Expected Losses Anticipated Cost of doing business Charged to provisions Captured in pricing Relatively easier to measure Assessing expected loss includes determining exposure, default probability and severity EL affects the income statement, whereas UL is captured in the balance sheet ‘ECONOMIC’ TO DISTINGUISH THE CONCEPT FROM REGULATORY OR ACCOUNTING (BOOK) CAPITAL

Credit Risk Management Explained Although credit risk may be difficult to measure it is important to estimate and manage What does Credit Risk Management mean? It represents an institution’s ability to properly identify and evaluate the potential risk of default in payment of obligations of customers It incorporates the firm’s ability to effectively manage and control this exposure in a way that is consistent with the institution’s business strategy, risk appetite and credit culture

Important Building Blocks Effective Credit Risk Management requires Clear origination and underwriting standards A strong corporate and credit culture Highly developed risk measurement techniques Ability to recognize and cover expected and unexpected losses Pricing commensurate with risks undertaken Methodologies to assess net profit contributions by customers and appropriate business segments Proper allocation of capital and management resources In order to: Improve overall corporate performance, measured by a higher EPS or P/E ratio (or market value)

Credit Policy and Process Credit Policy should be clear and concise Credit Underwriting Standards must be developed and included in policy Credit Processes should be reasonable and allow quick response to clients Healthy balance between sales and credit approval should exist and be respected

Risk Monitoring Exposure must be complete and current Regular reporting and updating of clients’ payment performance Minimum annual reviews of clients should be performed Financial conditions should be regularly assessed Required action must be initiated and follow up must take place

Contract Terms and Documentation Contract negotiations must take place at the right level in the organization Appropriate approvals must be obtained Internal or external legal departments must document completely Terms and conditions should be understood and compliance mechanism put in place Exceptions must be reported and managed urgently to resolution

Risk Rating System Effectiveness Credit Scoring is generally used to “risk rate” homogeneous portfolios Highest applicability is in consumer and retail portfolios Some advanced scoring systems are being migrated for use in rating “middle market” clients Such models are only as good as the underlying assumptions Internal credit rating systems are difficult to assess and are often not independently validated Client relationship may interfere with objective assessment of risks Rating criteria usually a matter of practice rather than written policy Ratings are not consistent over time Qualitative credit assessments often lag current market information Institutions often assume a mapping with external ratings in order to quantify credit risk

Effective Risk Rating Systems Sufficient granularity of risk rating categories Accurate and timely assignment of ratings Clear and consistent application of default definition Periodic calibration, triangulation and validation of risk ratings Accurate identification of migration of transactions and portfolios (as reflected by upgrades and downgrades in ratings)

Credit Evaluation: Financial Factors Get the information you need to make a full analysis Some information will need to be cross-checked and obtained on a regular and timely basis Be constructively cynical: new business models are difficult to pull off Be cognizant of delaying tactics Numbers don’t tell the whole story!

Credit Evaluation: Qualitative Factors Evaluation of subjective factors is often times more important than the numerical analysis People make a business: visions, values and strategies are only words unless people implement them Management, industry, product, geography, competition etc. all influence results and must be properly assessed Analysis-paralysis may lead to wrong decisions

Art and Science of Judgment Getting access to the best clients and all the relevant information is a challenge Ensuring proper analysis is done requires a strong corporate culture Utilizing qualified resources both internally and externally enhances the results Often the lack of the will to act is what causes high losses

Concluding Comments Companies that measure and manage credit risk in a pro-active manner will benefit from a favorable risk profile resulting in Higher revenue Lower losses Improved efficiencies Higher EPS, P/E ratios and market values

Concluding Comments Risk Assessment and Limit Management Credit Infrastructure and Portfolio Management Credit Quality Credit Underwriting Risk Rating System Effectiveness Counterparty and Portfolio Limits Organizational Structure Policies and Procedures Technology Selection and Implementation Problem Asset Management Credit Analytics Support Risk Rating Calibration Transaction Pricing, Structure and Support Default Probability and Recovery Calibration Credit Reserve Methodology Risk Based Pricing Models Risk Adjusted Return Analysis Portfolio Value Measurement Credit Technology Enablement Credit Risk Measurement Credit Performance Scorecards Internal Software External Vendor Software

Appendix: Business Proposal Checklist Business Proposal Summary Customer, Rating, Legal Status, Line of Business Guarantor, if any…same Collateral, if any…true value explained Other Support, if any... Legal or moral only The Transaction…risks and mitigation Amount, purpose, terms and conditions Sources of repayment… clearly identified Client payment history and relationship

Appendix: Business Proposal Checklist Rationale and Analysis Customer, Guarantor, Collateral, Support Facility Description Amount, purpose, tenor, pricing, terms, conditions, covenants, restrictions etc. Consider affect on above e.g. new leverage Facility Rating? Repayment Capacity Future cash flow, conversion of assets etc. Consistency with Credit Strategy and Policy Confirm, and identify any exceptions to policy, underwriting standards, or process Risk adjusted return acceptability

Appendix: Business Proposal Checklist Client Relationship Business strategy: increase, maintain or decrease exposure or exit relationship Consider relation to rating, latest risk profile and payment performance Customer profitability: risk adjusted return, revenue, fees, direct and allocated costs etc. Any conflicts of interest or special concerns

Appendix: Business Proposal Checklist Macro Analysis Business Environment Review Customer’s competitive market position and future industry prospects: size, cycle, volatility, new entrants Strength of customer’s business and financial strategies Management Evaluation: competency, experience and effectiveness

Appendix: Business Proposal Checklist Customer Analysis Company history, background, objectives and performance Relevance and strength of future business plans Consider seasonality and scenario analysis Primary and secondary sources of repayment Historical financial capacity and analysis of future performance: sales, profitability, working capital, liquidity, cash flow, leverage, tangible net worth etc. Quality of earnings Absolute and ratio analysis Peer comparisons

Appendix: Business Proposal Checklist Strengths, Weaknesses and Recommendation Key factors that could jeopardize collection: environment or company specific Any mitigating factors Consider probability and impact Consider all sources of repayment: primary, secondary and tertiary, including access to capital markets, refinancing etc. Summarize strengths and weaknesses and conclude with a recommendation