Basic Understanding


What is Credit?


Price is not a good allocator .Information is asymmetric .Definition and Nature of Credit Credit is derived from the Latin word ‘Credere’ – trust or belief “ the capacity to get economic value on trust…in return for expected future payment” i. “promise and trust” Credit markets are different: .e.Contracts are incomplete .Information is crucial 3 .

credit account Consumer/House hold fixed term loans/revolving credit(OD/Cards) Bank Credit Trade Credit Consumer Credit Trade & Consumer Credit 4 Utilities Household/Busi ness (deferred payment or payment plans) .Typology of Credit Financial Institutions Corporate Sector Financial Institutions Company Loan/OD Secured/Unsecured Companies deferred payment.

Credit Crisis and Lending: What went wrong ? 5 .

Opaque structured products .The Credit Crisis Causes: .LCFI’s (Large Complex Financial Institutions) Universal Banks.Shadow Banking Sectors (SIC’s) to side-step Basel II 6 . a housing bubble and a crash………… debt/income increases house prices 11% pa . hedge funds .Securitization process .But why was such a severe financial crisis? widespread failure of financial institutions freezing of capital market reduced supply of capitals to creditworthy companies/individuals amplification of crisis .Bad lending decisions (why) .there was a credit boom. insurance companies. Investment Banks.

“The Ascent of Money’ (2008) . 40% of all homes purchased were ‘investments or second homes’ In 2006 home equity withdrawal was equivalent to 10% of personal disposable income During this period the growth in wages and salaries was ‘mediocre’ (except in ‘planet finance’(1): in 2007 the Chief Exec of Goldman Sachs was paid $68 million) 7 Source: George Soros “New Paradigms for Financial Markets” (2008) (1) ‘planet finance’ is a term used by Niall Ferguson.The US Housing and Mortgage Market  In the period 2000-2005 house prices increased by over 50%  In 2005 over 50% of GDP growth in the US was housing related  Between 1997-2007 over $9 trillion was withdrawal from home     equity In the 2000’s home equity withdrawal financed 3% of total personal consumption In 2005.


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standardization of older innovations Growing sophistication of the major players in the credit markets in terms of techniques and strategies Increased use of scientific and mathematical models (credit scoring.TOP 10 Changes in Credit Markets in the Last Decade  New product innovations. correlation) New Basel accords shaped the banking markets (regulatory capital arbitrage) Growth of credit information globally – available 24/7 and on‐line Source: Altman 2008 11 . particularly in the credit     derivatives and structured finance areas.

TOP 10 Changes in Credit Markets in the Last Decade  Growth in technology and systems capabilities at     affordable prices leading to better reporting and modeling Huge changes in markets – size. globality Emergence of hedge funds as major investors in markets Growing influence of rating agencies Lower levels of loss and higher liquidity led to reduced credit spreads Source: Altman 2008 12 . liquidity.

Micro‐level lending decisions  imperfect credit information becomes more distorted and unreliable as credit expands Governance  key decision‐makers decision internal to the lender loose sight of the risk models underpinning their business model and decisions  have insufficient understanding of ‘complex financial instruments’ 13 .Where it all disconnects……..

2008) Cutting and Splicing: Diversified or Correlated ? -losing sight of the underlying assets (CDO. lack of transparency ‐ Failures of ‘self‐regulation’ “bankers deciding the rules for 14 bankers” . CDO2.” (Ferguson. CDO3) “transferring ownership of mortgages from bankers who knew their customers to investors who did not” Regulation of new financial instruments ‐ nobody looking at the ‘whole picture’.. Globalization and Financial Intermediation creates a new world – old world methods and data applied to ‘planet finance’ “ they overestimate the predictability of the past and hence underestimate the surprise of the future .Where it all disconnects……..

cash bonuses)  Regulators: micro regulation (individual risk) macro (systematic risk) Fix:  Regulatory overlay to tackle systemic fragility but encourage innovation and economic growth • .think about it ! 15 . profit centers.The Credit Crisis Blame: Bankers & Regulators  Banks: incentive structure (short term.

have eliminated the purpose of the banking system.Lending Decisions Principles and Practice “… We should not forget that the basic economic function of these regulated entities (banks) is to take risk. we will.” Alan Greenspan President. by definition. If we minimize risk taking in order to reduce failure rates to zero. Federal Reserve Board 16 .

experience. competition.Capacity (sufficient cash flow to service debt) . (net worth to cover unforeseen events) . industry risk) 17 .) .Credit Risk Assessment : Pre‐Automation Lending the ‘old fashioned’ way The 5 C’s of credit: The borrower should demonstrate: . guarantees etc. market structure e.conditions (economic outlook.g. motor industry.) .collateral (assets to secure the debt.Character (quality of management. operational risk etc.

Overview of Credit Risk Three types of Risks for Banks For Trade Creditors • Political Risk • Economic Risk • Currency Risk Credit Risk : Corporate and Retail (default) Country Risk Operational Risk: Internal or external events Market Risk: Value of financial instruments Industry Risk Corporate Risk • Business Risk • Financial Risk Management 18 .

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I.Essential Readings:  Altman. et. Chapter 1. (2008). Measuring Credit Risk. John Wiley USA. E. Chapter 1. al. 2nd Edition. 20 .  Study Material.

Assignment: Group assignment followed by presentation on:  Asian Crisis  The Great Depression of 1930s  Recent Euro-Zone Crisis  Financial Crisis of 2007-2008 The assignment should be about 3-4 pages in length and the presentation will be of 15 minutes not exceeding 12 slides. 21 . Please submit the assignments latest by the next class and presentation date and time will be provided in the next class.

Forthcoming Session: Credit Rating Agencies 22 . by jairaj gupta e-mail: get a copy of this presentation visit 23 .