Advanced Credit Risk Analysis and Management E-Book

Ciby Joseph

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch

Seitenzahl: 864

Veröffentlichungsjahr: 2013

Beschreibung

Credit is essential in the modern world and creates wealth, provided it is used wisely. The Global Credit Crisis during 2008/2009 has shown that sound understanding of underlying credit risk is crucial. If credit freezes, almost every activity in the economy is affected. The best way to utilize credit and get results is to understand credit risk.

Advanced Credit Risk Analysis and Management helps the reader to understand the various nuances of credit risk. It discusses various techniques to measure, analyze and manage credit risk for both lenders and borrowers. The book begins by defining what credit is and its advantages and disadvantages, the causes of credit risk, a brief historical overview of credit risk analysis and the strategic importance of credit risk in institutions that rely on claims or debtors. The book then details various techniques to study the entity level credit risks, including portfolio level credit risks.

Authored by a credit expert with two decades of experience in corporate finance and corporate credit risk, the book discusses the macroeconomic, industry and financial analysis for the study of credit risk. It covers credit risk grading and explains concepts including PD, EAD and LGD. It also highlights the distinction with equity risks and touches on credit risk pricing and the importance of credit risk in Basel Accords I, II and III. The two most common credit risks, project finance credit risk and working capital credit risk, are covered in detail with illustrations. The role of diversification and credit derivatives in credit portfolio management is considered. It also reflects on how the credit crisis develops in an economy by referring to the bubble formation. The book links with the 2008/2009 credit crisis and carries out an interesting discussion on how the credit crisis may have been avoided by following the fundamentals or principles of credit risk analysis and management.

The book is essential for both lenders and borrowers. Containing case studies adapted from real life examples and exercises, this important text is practical, topical and challenging. It is useful for a wide spectrum of academics and practitioners in credit risk and anyone interested in commercial and corporate credit and related products.

Leseprobe

Contents

Cover

Series

Title Page

Copyright

Preface

Part I: Introduction

Chapter 1: Credit Basics

1.1 MEANING OF CREDIT

1.2 ROLE OF CREDIT

1.3 CREDIT MARKET

1.4 CREDIT – ADVANTAGES AND DISADVANTAGES

1.5 SUPPLIERS OF CREDIT

1.6 CREDIT RISK STUDY

APPENDIX: CREDIT CREATION

QUESTIONS/EXERCISES

Chapter 2: Essentials of Credit Risk Analysis

2.1 MEANING OF CREDIT RISK

2.2 CAUSES OF CREDIT RISK

2.3 CREDIT RISK AND RETURN

2.4 CREDIT RISK ANALYSIS

2.5 HISTORICAL PROGRESS OF CREDIT RISK ANALYSIS

2.6 NEED FOR CREDIT RISK ANALYSIS

2.7 CHALLENGES OF CREDIT RISK ANALYSIS

2.8 ELEMENTS OF CREDIT RISK ANALYSIS

QUESTIONS/EXERCISES

Chapter 3: Credit Risk Management

3.1 STRATEGIC POSITION OF CREDIT RISK MANAGEMENT

3.2 CREDIT RISK MANAGEMENT CONTEXT

3.3 CREDIT RISK MANAGEMENT OBJECTIVES

3.4 CREDIT RISK MANAGEMENT STRUCTURE

3.5 CREDIT RISK CULTURE

3.6 CREDIT RISK APPETITE

3.7 CREDIT RISK MANAGEMENT IN NON-FINANCIAL FIRMS

3.8 CREDIT RISK MANAGEMENT IN FINANCIAL INTERMEDIARIES

QUESTIONS/EXERCISES

Part II: Firm (or) Obligor Credit Risk

Chapter 4: Fundamental Firm/Obligor-Level Risks

4.1 FIRM (OR) OBLIGOR RISK CLASSIFICATION

4.2 RISK MATRIX

4.3 DIFFERENT RISK LEVELS

QUESTIONS/EXERCISES

Chapter 5: External Risks

5.1 BUSINESS CYCLE

5.2 ECONOMIC CONDITIONS

5.3 INFLATION AND DEFLATION

5.4 BALANCE OF PAYMENTS AND EXCHANGE RATES

5.5 POLITICAL

5.6 FISCAL POLICY

5.7 MONETARY POLICY

5.8 DEMOGRAPHIC FACTORS

5.9 REGULATORY FRAMEWORK

5.10 TECHNOLOGY

5.11 ENVIRONMENT ISSUES

5.12 INTERNATIONAL DEVELOPMENTS

5.13 OTHERS

5.14 MONITORING EXTERNAL RISKS

QUESTIONS/EXERCISES

Chapter 6: Industry Risks

6.1 UNDERSTANDING OBLIGOR'S INDUSTRY OR MARKET

6.2 TYPES OF INDUSTRY RISKS

6.3 INDUSTRY LIFE CYCLE

6.4 PERMANENCE OF INDUSTRY

6.5 GOVERNMENT SUPPORT

6.6 INDUSTRY AND FACTORS OF PRODUCTION

6.7 INDUSTRY AND BUSINESS CYCLES

6.8 INDUSTRY PROFITABILITY

6.9 COMPETITOR/PEER GROUP ANALYSIS

QUESTIONS/EXERCISES

Chapter 7: Entity-Level Risks

7.1 UNDERSTANDING THE ACTIVITY

7.2 RISK CONTEXT AND MANAGEMENT

7.3 INTERNAL RISK IDENTIFICATION STEPS

7.4 SWOT ANALYSIS

7.5 BUSINESS STRATEGY ANALYSIS

7.6 PITFALLS IN STRATEGY

7.7 MANAGEMENT ANALYSIS

7.8 OTHER INTERNAL RISKS

QUESTIONS/EXERCISES

Chapter 8: Financial Risks

8.1 IMPORTANCE OF FINANCIAL STATEMENTS

8.2 QUALITY AND QUANTITY OF FINANCIAL STATEMENTS

8.3 ROLE OF HISTORICAL FINANCIAL STATEMENTS

8.4 FINANCIAL ANALYSIS

8.5 ANALYTICAL TOOLS

8.6 SOLVENCY RATIOS

8.7 OPERATIONAL RATIOS

8.8 ENCAPSULATED RATIOS

QUESTIONS/EXERCISES

Chapter 9: Integrated View of Firm-Level Risks

9.1 RELEVANCE OF AN INTEGRATED VIEW

9.2 JUDGEMENT

9.3 IDENTIFYING SIGNIFICANT CREDIT RISKS

9.4 RISK MITIGANTS

9.5 TYPES OF MITIGANTS

9.6 PRINCIPLES TO BE BORNE IN MIND WHILE SELECTING MITIGANTS

9.7 MONITORING OF CREDIT RISK

APPENDIX – CREDIT RISKS AND POSSIBLE MITIGANTS

QUESTIONS/EXERCISES

Chapter 10: Credit Rating and Probability of Default

10.1 CREDIT RISK GRADING

10.2 PROBABILITY OF DEFAULT

10.3 EXTERNAL VS. INTERNAL RATING

10.4 PD IN CREDIT STRUCTURAL MODELS

QUESTIONS/EXERCISES

Part III: Credit Risks – Project and Working Capital

Chapter 11: Credit Risks in Project Finance

11.1 DISTINCTIVE FEATURES OF PROJECT FINANCE

11.2 TYPES OF PROJECT FINANCE

11.3 REASONS FOR PROJECT FINANCE

11.4 PARTIES INVOLVED IN PROJECT FINANCE

11.5 PHASES OF PROJECT AND RISKS

11.6 PROJECT CREDIT RISKS

11.7 FINANCIAL STUDY

11.8 PROJECT CREDIT RISK MITIGANTS

QUESTIONS/EXERCISES

Chapter 12: Credit Risks in Working Capital

12.1 DEFINITION OF WORKING CAPITAL

12.2 ASSESSING WORKING CAPITAL THROUGH THE BALANCE SHEET

12.3 WORKING CAPITAL RATIOS

12.4 WORKING CAPITAL CYCLE

12.5 WORKING CAPITAL VS. FIXED CAPITAL

12.6 WORKING CAPITAL BEHAVIOUR

12.7 WORKING CAPITAL, PROFITABILITY AND CASH FLOWS

12.8 WORKING CAPITAL RISKS

12.9 IMPACT OF WORKING CAPITAL RISKS

12.10 WORKING CAPITAL RISK MITIGANTS

12.11 WORKING CAPITAL FINANCING

QUESTIONS/EXERCISES

Part IV: Credit Portfolio Risks

Chapter 13: Credit Portfolio Fundamentals

13.1 CREDIT PORTFOLIO VS. EQUITY PORTFOLIO

13.2 CRITICALITY OF PORTFOLIO CREDIT RISKS

13.3 BENEFITS OF CREDIT PORTFOLIO STUDY

13.4 PORTFOLIO ANALYSIS

13.5 CREDIT PORTFOLIO RISK VS. RETURN

APPENDIX: ORGANIZATIONAL CONFLICT IN CREDIT RISK MANAGEMENT

QUESTIONS/EXERCISES

Chapter 14: Major Portfolio Risks

14.1 SYSTEMATIC RISK

14.2 DIVERSIFIABLE RISK

14.3 CONCENTRATION

14.4 CREDIT PORTFOLIO BETA

QUESTIONS/EXERCISES

Chapter 15: Firm Risks to Portfolio Risks and Capital Adequacy

15.1 OBLIGOR PD AND PORTFOLIO PD

15.2 MIGRATION RISK

15.3 DEFAULT RISK

15.4 LOSS GIVEN DEFAULT (LGD)

15.5 EXPECTED LOSS (EL)

15.6 PROVISIONING

15.7 CREDIT LOSS DISTRIBUTION

15.8 ECONOMIC CAPITAL

QUESTIONS/EXERCISES

Chapter 16: Credit Risk and The Basel Accords

16.1 BASEL ACCORDS

16.2 BASEL I (1988) – FIRST BASEL ACCORD

16.3 BASEL ACCORD II (2006)

16.4 BASEL III

APPENDIX

QUESTIONS/EXERCISES

Part V: Portfolio Risk Mitigants

Chapter 17: Credit Risk Diversification

17.1 TRADITIONAL DIVERSIFICATION

17.2 MODERN DIVERSIFICATION OF CREDIT PORTFOLIO

17.3 CORRELATIONS IN CREDIT RISK MODELS

QUESTIONS/EXERCISES

Chapter 18: Trading of Credit Assets

18.1 SYNDICATED LOANS/CREDIT ASSETS

18.2 SECURITIZATION

18.3 DISTRESSED DEBT

18.4 FACTORING

18.5 DISTRESSED RECEIVABLES

QUESTIONS/EXERCISES

Chapter 19: Credit Derivatives

19.1 MEANING OF A CREDIT DERIVATIVE

19.2 CREDIT DEFAULT SWAP (CDS)

19.3 TOTAL RETURN SWAP

19.4 CREDIT OPTION (CO)

19.5 CREDIT SPREAD OPTIONS (CSO)

19.6 CREDIT DERIVATIVE LINKED STRUCTURES

19.7 FUTURE OF CREDIT DERIVATIVES

19.8 CREDIT DERIVATIVES AND OVER-THE-COUNTER (OTC) MARKETS

QUESTIONS/EXERCISES

Part VI: Credit Risk Pricing

Chapter 20: Pricing Basics

20.1 CREDIT PRICING FACTORS

20.2 PRICING STRUCTURE

20.3 CREDIT RISK PRICING MODEL

20.4 PRIME LENDING RATE

QUESTIONS/EXERCISES

Chapter 21: Pricing Methods

21.1 RORAC (RETURN ON RISK-ADJUSTED CAPITAL) BASED PRICING

21.2 MARKET DETERMINED

21.3 ECONOMIC PROFIT BASED PRICING

21.4 COST PLUS

21.5 STRUCTURED PRICING

21.6 GRID PRICING

21.7 NET PRESENT VALUE (NPV) PRICING

21.8 RANPV (RISK-ADJUSTED NPV) PRICING

QUESTIONS/EXERCISES

Part VII: The Last Line of Defence — Security

Chapter 22: Security Basics

22.1 NEED FOR SECURITY

22.2 MERITS AND DEMERITS OF A SECURITY

22.3 ATTRIBUTES OF A GOOD SECURITY

22.4 SECURITY AND PRICING

22.5 IMPACT OF SYSTEMATIC RISKS ON SECURITY

22.6 FACILITY GRADES

QUESTIONS/EXERCISES

Chapter 23: Collaterals and Covenants

23.1 TANGIBLE SECURITY

23.2 INTANGIBLE SECURITY

23.3 METHODS OF TAKING SECURITY

23.4 REALIZING SECURITY

23.5 COVENANTS – A TRIGGER TO SEEK ADDITIONAL SECURITY

QUESTIONS/EXERCISES

Part VIII: Credit Crisis

Chapter 24: Road to Credit Crisis

24.1 CREDIT AND GROWTH

24.2 ROLE OF BANKS

24.3 FORMATION OF CREDIT BUBBLES

24.4 TYPES OF CREDIT BUBBLE

24.5 CREDIT BUBBLE EXPLOSION

QUESTIONS/EXERCISES

Chapter 25: 2008 Credit Crisis

25.1 CREDIT ASSET – PRIME VS. SUB-PRIME

25.2 SECURITIZATION

25.3 US HOUSING BUBBLE4

25.4 ROLE OF OTC DERIVATIVES

25.5 ROLE OF RATING AGENCIES

25.6 WHY DID THE BUBBLE BURST?

25.7 CONSEQUENCES

25.8 IMPACT OF THE LEHMAN COLLAPSE

25.9 HOUSING CRISIS TO CREDIT CRISIS TO ECONOMIC CRISIS

25.10 COMMON FACTORS 1929 vs. 2009

25.11 LESSONS OF THE 2008 CREDIT CRISIS

QUESTIONS/EXERCISES

Bibliography

Index

For other titles in the Wiley Finance series

please see www.wiley.com/finance

© 2013 Ciby Joseph

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Library of Congress Cataloging-in-Publication Data

Joseph, Ciby, 1969- Advanced credit risk analysis and management / Ciby Joseph. pages cm Includes bibliographical references and index. ISBN 978-1-118-60491-5 (cloth) – ISBN 978-1-118-60488-5 (ebk) – ISBN 978-1-118-60490-8 (ebk) – ISBN 978-1-118-60489-2 (ebk) 1. Credit--Management. 2. Risk management. I. Title. HG3751.J67 2013 658.15′2–dc23 2013008536

A catalogue record for this book is available from the British Library.

ISBN 978-1-118-60491-5 (hbk) ISBN 978-1-118-60488-5 (ebk) ISBN 978-1-118-60487-8 (ebk) ISBN 978-1-118-60490-8 (ebk) ISBN 978-1-118-60489-2 (ebk)

Preface

The aim of this book is to present a thorough and comprehensive treatment of credit risk in a way that would be useful to everyone who is interested in credit risk analysis and management. The motivation for the book has emanated from the fact that during my two-decade-long tryst with credit risk management, I have met several people – bank officers, regulators, credit executives, credit officers, chief finance officers, finance managers and business students – who asked me to refer a good book on credit analysis. Firstly, the coverage of this book is more comprehensive, and especially describes the developments and challenges of today's credit risk environment and covers the real nature of corporate credit risk and management in depth. Secondly, the credit risk perception of many – even at top management level – is blurred, resulting in unnecessary assumption of equity risk, which invariably results in higher credit risks without corresponding return. The various events related to the 2008 Global Credit Crisis that shook the financial world are an example. The exponential growth in credit and credit products in the recent decades has proven a big challenge not only to the leaders in finance but also to the bank regulators in several countries. Thirdly, businessmen, auditors, consultants, entrepreneurs and educators also yearn for a practical reference book on credit risk analysis and management. This book will be helpful to both lenders and borrowers in understanding the nature of credit risk analysis and management and will guide them to the prudent use of credit risk products and financial leverage, which is the hallmark of any successful business.

The way corporate credit risk is analyzed and studied in this book is unique. It provides a thorough treatment on Credit Risk and discusses obligor risk, portfolio risk, capital requirement, credit pricing and Basel accords. Amongst others, this book:

Introduces the nature of credit risk and discusses advantages of credit (Chapter 1) and discusses the historical progress and challenges of credit risk analysis (Chapter 2).Explains the strategic role of credit risk culture and risk appetite statements (Chapter 3) and highlights the importance of separating key credit risk variables (Chapter 4).Provides guidance on various external risks and the formulation of effective early warning indicators (Chapter 5).Discusses the impact of business cycles on the industry and analyzes industry profitability factors (Chapter 6). The chapter ends with a detailed case study.Studies the entity level risks, including strategy and management risks (Chapter 7). The chapter ends with a detailed case study.Provides in-depth treatment of financial risk analysis (Chapter 8) with several worked-out examples and a detailed case study. About 50 pages have been devoted to this important topic.Explains how to make integrated credit risk judgements and provides several credit risk mitigants for obligor risk (Chapter 9).Shows how obligor credit risk analysis is converted into risk grades and discusses how PD can drive credit decisions in a logical and mathematical manner (Chapter 10). Links the Merton Model to the traditional accounting-based credit risk analysis.Provides in-depth analysis of the credit risks of two common situations - Project Finance and Working Capital Finance (Chapters 11 and 12). Besides worked-out examples, both chapters end with detailed case studies.Explains the benefits of portfolio risk analysis and the role of systematic and unsystematic risks and credit portfolio beta (Chapters 13 and 14).Shows the importance of Migration Risk and how to construct Credit Loss Distribution and calculate Economic Capital (Chapter 15). The chapter ends with a detailed case study.Digs out the subtle issues in the Basel Accords, explains the role of external credit rating agencies and explores Kelly's formula in the context of credit risk management (Chapter 16).Provides various credit portfolio risk mitigants such as traditional and modern diversification, and a mathematical way of calculating sector limits, sale of credit assets and credit derivatives. Discusses the pros and cons of Credit Default Swaps (Chapters 17 to 19).Explains the importance of credit risk pricing, interest rate hedging and explains several pricing methods, including RAROC, EVA and NPV Pricing (Chapters 20 and 21). Chapter 20 ends with a case study.Elaborates the role of security as a return enhancer and credit risk mitigant. Also discusses various aspects of collateral and how systematic risks may impact collateral (Chapter 22).Discusses the issue of structural subordination and the importance of both financial and non-financial covenants, and how to set covenants to manage the underlying risks (Chapter 23).Examines the reasons for credit crises and links the credit to growth and how and when disconnect can happen, leading to credit bubbles and subsequent credit and banking crises (Chapter 24). The chapter ends with a case study.Explains the 2008 Global Credit Crisis and the role of the US Housing Sector, which in turn was impacted by the sub-prime market bolstered by various credit market players and new credit risk-linked products (Chapter 25).

Whilst the above provides a glimpse of the contents of this book, the readers will find that the topics have a unique and practical treatment that will enable them to look at credit risk with clarity and better understanding. There are several examples in the book which are adapted from real life and have a practical touch.

During the two decades of my career I got the opportunity to play several roles in corporate credit risk: Relationship manager, credit analyst, credit reviewer, credit project leader, and credit approver are some of them. Whilst I sanctioned credit facilities, I also participated in the development of credit risk analysis software, Basel I and II implementation and credit risk training. I extended credit advice to corporate clients and helped them to raise debt through bi-lateral or syndication deals and guided the clients in effective utilization of credit facilities. I have dealt with almost all business sectors such as Construction, Contracting, FMCG, Hospitality, Airlines, Healthcare, Education, Wholesale Trading, Retail, Imports and Exports, Ceramics, Aluminium, Steel, Petrochemicals, Glass, Utilities, Financial Services, Telecoms, Food Industry, Poultry Farms, Dairy Industry, Textile Industry, Precious Metals Industry, etc. Over and above the experience and insight from my career, considerable research has also gone into this book as well as discussions and dialogues with senior credit professionals from different parts of the world.

One of the serious issues facing today's financial world is that there is a lack of serious credit risk education, which might have been a contributing factor to the recent credit crises. A plethora of financial products are available in the market which imbed credit risk, and dealing in such products requires thorough knowledge of credit risk. For example, many issuers of Credit Default Swaps (CDS) thought of them as an insurance product; however, fundamentally they are a credit risk product. Because they equated CDS to insurance they tried to replicate ‘laws of large numbers’, which is successfully applied in regular insurance products, with disastrous consequences. Whilst credit markets dwarf equity markets, it is arguable that not enough academic attention is given to credit risk; equity risk analysis gets a lot of attention in academic circles. It is a welcome measure that, realizing the importance of Credit Risk in the financial market, more and more universities now offer dedicated credit risk courses or treat them as part of the curriculum. The 2008 Global Credit Crisis probably acted as a wake-up call.

I have summarized most of the lessons learnt during my two-decade-long credit career and topped it off with extensive research and dialogues with credit experts. I take this opportunity to express my special thanks to Jeff Peanick, former Senior Vice President, HSBC, New York; Christopher Lewis, former Head of Trade Finance, HSBC, Hong Kong; Roy Philip, Head of Credit (Wholesale) HSBC, Dubai; Ian Spowart former Head of Credit, Lloyds TSB Middle East; Mammad Kuniyil, Head of Risk Management, Sharjah Islamic Bank as well as my colleagues Bhupesh Bansal and Brian Yau in Lloyds TSB Middle East. Many of my friends and well-wishers in HSBC, Lloyds TSB, Standard & Chartered, Emirates NBD, National Bank of Abu Dhabi and Crowe Horwath, who prefer to remain anonymous, have provided their insights. I also take this opportunity to thank businessmen, CEOs and CFOs who shared their views on credit risk, especially Michael Boocher, a young and dynamic entrepreneur and Ahmed Al Raqbani, Managing Director of East Coast Group. My sincere thanks to Dr. (Prof.) Stephen Mathews and my father P D Joseph (ex-banker) who performed the initial review of the manuscript and provided valuable suggestions, and to Werner Coetzee and the team at John Wiley & Sons for their timely guidance on several issues related to the publication of the book. Finally, special thanks go to Dr. Teena, my wife and my wonderful daughters for their support during the rigorous (but enjoyable) process of authoring this book. Whilst the views expressed herein are the result of a lot of experience, efforts and research, with humility I seek from esteemed readers suggestions to improve the book further.

Ciby Joseph April 2013

Part I

Introduction

Credit risk analysis is an art as well as a science. It is a science because the analysis is based upon established principles emanating from a body of knowledge and sound logic. Individual skill and the way the principles are applied constitute the art element.

1

Credit Basics

Historically credit is good, if used wisely. However, there are numerous instances where both lenders (and creditors) and borrowers (or debtors) and even global economies suffer because of credit. The main reason is traceable to poor credit risk analysis and inadequate credit risk management. The purpose of this book is to delve into the realm of credit risk analysis and management in depth so that both lenders and borrowers can make the best use of credit for the common good.

Credit prudently used can create wealth and bring overall prosperity to the economy. Accordingly, credit, nowadays, is pervasive and is a common feature of all global economies. The only places from which it would be probably absent would be among the hunter/gatherer tribes in the deep jungles of Africa, South America or Asia or in similar tribes still living in primitive conditions.

Look around, observe your newspapers, magazines, television or radio or the billboards on highways – you can see invitations to participate in credit. Manufacturers of automobile and consumer durable goods offer credit directly or through their finance subsidiaries at low interest rates or offers instalment schemes with easy repayment terms. Credit card issuers attempt to persuade almost everybody to live on credit and at least some of the credit card holders find themselves living beyond their means and almost in perpetual debt.

Individuals borrow to meet their immediate requirements of physical needs such as house, furniture, car, consumer durable goods or to meet consumption expenditure such as marriage expenses, education or holidays. Business borrows to make investments to facilitate expansion or to meet working capital requirements, amongst others. Governments borrow to keep themselves afloat and hope to repay them from future tax revenues or further loans. Central government and big businesses borrow from abroad, which if not managed properly, can plunge the debtor country into an inevitable foreign exchange crisis, as has been seen in the 1997 Far East Asian Crisis and 2001 Argentina Crisis. The sub-prime lending crisis in the US (2008) and the Greek debt crisis (2010) and Spanish debt crisis (2012) are also linked to credit risks.

While the policy makers and officials scramble to find solutions with the least impact on the economy during such crises, it may be noted that these issues are often complex in nature and reflect the incredible power of financial and credit markets to systematically affect people from all walks of life. The level of credit extended and enjoyed by borrowers has far reaching implications for the economy. The lending, credit and regulatory policies that govern the financial sector and the levels of acceptable debt by the corporate sector require not only adequate monitoring but also sound understanding of the nature of credit risk. Insufficient knowledge of credit risk or its underestimation will result in distress to both lenders and borrowers who will suffer legal cases, bad debts, losses, to name just a few of them.

No doubt credit is ubiquitous and all important in the proper day-to-day functioning of the economy. Any disruption to the credit flow in the economy will have serious consequences for the economy itself.1 As we will see in the rest of the book, credit is the life blood of business activities and the economy. Hence, the importance of credit risk and credit risk management.

1.1 MEANING OF CREDIT

Credit had a role to play from the early days of civilization. Nowadays credit implies monetary or monetary equivalent transactions. However, given the more accurate and realistic definition of credit, it includes non-monetary and/or barter transactions. Roughly, we can define credit as ‘A transaction between two parties in which one (the creditor or lender) supplies money, goods, services or securities in return for a promise of future payment by the other (the debtor or borrower). Such transactions normally include the payment of interest to the lender.’2

The second part of this definition is interesting, it shows that credit is not cost free. The creditor parts with the resources because he has the incentive – either directly or indirectly. The incentive is required because the lender has an opportunity cost – he can deploy the resources elsewhere gainfully. Accordingly, for the sacrifice of this opportunity, the lender expects a return, which is normally known as interest. Over history, how much a lender can charge as interest has been under dispute prompting certain segments of society to view interest as an evil. However, it is an undeniable fact that interest is a type of cost of capital, charged by lenders, who do not have the right to enjoy the fruits of ownership. Another way of looking at interest is that it is equivalent to rent. Just as the owner or supplier of the building will charge rent, the interest is the rent charged by the supplier of credit or debt capital. While excessive or imprudent borrowings can be catastrophic, cost of capital cannot be blamed for the imprudence.