What is Credit Risk?
Credit risk is the risk of loss that may occur from the failure of any party to abide by the terms and conditions of any financial contract, principally the failure to make required payments on loans due to an entity.
As a financial intermediary, the project finance division of a bank is exposed to risks that are particular to its lending and trading businesses and the environment within which it operates. The major goal of a project finance firm in risk management is to ensure that it understands, measures, and monitors the various risks that arise and that the organization adheres strictly to the policies and procedures established to address these risks.
Firms have a structured credit approval process which includes a well-established procedure for comprehensive credit appraisal.
What factors are used to assess Credit Risk?
In order to assess the credit risk associated with any financial proposal, the project finance division of the firm first assesses a variety of risks relating to the borrower and the relevant industry.
The borrower credit risk is evaluated by considering:
- The financial position of the borrower by analyzing the quality of its financial statements, its past financial performance, its financial flexibility in terms of the ability to raise capital, and its capital adequacy
- The borrower’s relative market position and operating efficiency
- The quality of management by analyzing the track record, payment record, and financial conservatism
Industry-specific credit risk is evaluated by considering:
- Certain industry characteristics, such as the importance of the industry to the economic growth of economy and government policies relating to the industry
- The competitiveness of the industry
- Certain industry financials, including return on capital employed, operating margins and earnings stability
How are credit ratings used?
After conducting an analysis of the specific borrower’s risk, the credit risk management group assigns a credit rating to the borrower. Generally firms accept a scale of ratings ranging from AAA to BB (varies from firm to firm) and an additional default rating of D. Credit ratings are the critical input for the credit approval process as it helps the firm to determine the desired credit risk spread over its cost of funds by considering the borrower’s credit rating and the default pattern corresponding to the credit rating.
Every proposal for a facility is reviewed by the appropriate industry specialists in the credit risk management group before being submitted for approval to the appropriate approval authority. Generally, the approval process for non-fund facilities is similar to that of fund based facilities.
How frequently are credit ratings assessed?
Credit rating for every borrower is reviewed at least annually and is typically reviewed on a more frequent basis for high credit risks and large exposures. Generally, the ratings of all borrowers in a particular industry are also reviewed upon the occurrence of any significant event impacting the industry.
Working capital loans are generally approved for a period of 12 months. At the end of the 12 month validity period, the loan arrangement and the credit rating of the borrower is reviewed and the firm makes a decision on continuation of the arrangement and changes in the loan covenants as may be necessary.
To learn more about debt and credit, CFI offers the following resources.