APK

Unit II: Philippine Financial System

•Role of Bangko Sentral ng Pilipinas and

Monetary Board
a.History of Currency and Notes
b.Financial Reporting of Banking
Institutions
c.Monetary Policy
d.Financial Regulation
Managing
Credit Risk in
Money Market
By: Joycelyn P. Ituriaga,
MBA
Topic Learning
Objectives
• At the end of the unit, student is expected to:
• Identify the different levels and methods of rating
entities,
• Make recommendation on the results of liquidity and
solvency, and
• Understand how to improve value of collaterals.
Topic Objective
• Unit III: Managing Credit Risk in Money
Market
• Credit Ratings
• Credit Information System Cost or Debt
• Managing Liquidity and Solvency
• Valuation of Collaterals
What is Credit Risk?
• Credit is the possibility of a loss resulting from a
borrower’s failure to pay a loan or meet a
contractual obligation.
Why do we need Credit Risk
Management?
• Credit Risk Management is the process of
mitigating losses by understanding adequacy
of a bank’s capital and loan loss reserves at a
given period of time – a process that has
been a long challenge for financial institutions.
Credit Risk Management

Know Your Customer - are a set of standards used within

Know Your
Know the investment and financial services industry to
Customer
verify customers, their risk profiles, and financial profile.

Credit Evaluation Process - is the process a business or an

Credit individual must go through to become eligible for a loan
or to pay for goods and services over an extended period.
Credit
Monitor
Evaluation
Performance
Process
Structure the Offer - is the terms of a loan with respect to
Credit Risk Structure the various aspects the make up a loan, including the
maturity or tenor, repayment, and risk.
Management

Close Deal - to make an agreement official We were

Close about to close/seal the deal when we realized that there
was a mistake in the contract.

Structure the
Close Deal
Offer
Monitor Performance – to gain feedback about credit
Monitor performance.
What is Credit
Ratings?
• A quantified assessment of the
creditworthiness of a borrower in
general terms or with respect to
a particular debt or financial
obligation.
Individual Credit Score
Credit Bureau - is an organization that collects and researches individual
credit information and sells it for a fee to creditors, so they can make
decisions on granting loans
• CIBI Information, Inc - or CIBI, formerly known as Credit Information
Bureau, Inc., is the first and the only local credit bureau in the
Philippines. The only local firm accredited by the Credit Information
Corporation (CIC) as a Special Accessing Entity.
• TransUnion Philippines
• Compuscan Philippines
• CRIF of Italy
Individual
Credit Score
Credit Score – is a
numerical expression
based on a level analysis of
person’s credit files, to
represent the
creditworthiness of an
individual.
• A three-digit
numerical scale using
a form of Fair Isaac
Corporation (FICO)
credit score.
Companies and Governments
Credit Score
• is generally done by a credit rating agency such as:
1. Standard and Poor’s Global ( S&P Global) – is a
company well known around the world as a
creator of financial market indices—widely
used as investment benchmarks—a data
source, and an issuer of credit ratings for
companies and debt obligations.
2. Moody’s Investors Service – assigns ratings
based on assessed risk and the borrower's
ability to make interest payments.
3. Fitch Ratings - is a credit rating agency that
rates the viability of investments relative to the
likelihood of default.
 Companies and Governments Credit Score

Moody’s S&P Fitch

Approximate Paraphrase
Long Term Shor Term Long Term Short Term Long Term Short Term

Investment Grade: Highest (Triple A) AAA AAA AAA

AA1 AA+ AA+

A-1+ F1+
Investment Grade: Very High AA2 P-1 (Prrime-1) AA AA

AA3 AA- AA-

A1 A+ A+ F1/F1+
A-1
Investment Grade: High A2 A A F1
P-2/P-1
A3 P-2/P-1 A- A- F2/F1
P-2 (Prime-2) A-2
BAA1 BBB+ BBB+ F2

Investment Grade: Good BAA2 P-3/P-2 BBB BBB F3/F2

A-3
BAA3 P-3 (Prime-3) BBB- BBB- F3
 Companies and Governments Credit Score

Moody’s S&P Fitch

Approximate Paraphrase
Long Term Shor Term Long Term Short Term Long Term Short Term

BA1 BB+ BB+

Speculative Grade: Speculative BA2 BB BB

BA3 BB- BB-

B B
B1 B+ B+
Speculative Grade: Highly
B2 B B
Speculative
B3 Not Prime B- B-

CAA1 CCC+

Speculative Grade: Very High Risk CAA2 CCC CCC

CAA3 CCC- C C
CC CC
Speculative Grade: Very near to
CA C C
default
C C
Credit Information System (CIS)
• It is intended and straight forwardly address the need for
dependable credit information of borrowers.
• Credit Information System Act 2008 (CISA) – Republic Act No.
9510 – is an act of establishing Credit Information Corporation.
• CIC is a government owned and controlled corporation providing credit
Information System in the Philippines.
The Term Structure
of Interest Rates
• refers to the relationship between time to maturity
and yields for a particular category of bonds at a
particular point in time.
Uses:
1. Analyzing the returns of asset commitments for
different terms.
2. Assessing consensus expectations of future
interest rates.
3. Pricing bonds and other fixed-payment
contracts.
4. Pricing contingent claims on fixed income
securities.
5. Arbitraging between bonds of different
maturities.
6. Forming expectations about the economy.
 Yield Curve
Yields • The term structure is usually
Upward plotted in the form of a yield
curve, which is a graphical
Sloping

Flat
depiction of the relationship
Downward
Sloping
between yields and time for
bonds that are identical
Maturity
except for maturity.
Term Structure Theories
• A theory of term structure of interest rates is needed to
explain the shape and slope of the yield curve and why it
shifts over time.
Three important term structure theories are:
1. Expectations Theory
2. Market Segmentation Theory
3. Liquidity Premium Theory
Expectations Theory
• The theory predicts future short-term
interest rates based on current long-
term interest rates.
• The theory suggests that an investor
earns the same amount of interest
by investing in two consecutive one-
year bond investments versus investing
in one two-year bond today.
• In theory, long-term rates can be used
to indicate where rates of short-term
bonds will trade in the future.
Market Segmentation
Theory
• The theory states that long- and short-
term interest rates are not related to
each other because they have
different investors.
• Related to the market segmentation
theory is the preferred habitat theory,
which states that investors prefer to
remain in their own bond maturity
range due to guaranteed yields. Any
shift to a different maturity range is
perceived as risky.
Liquidity Premium
Theory
• The liquidity premium is a form of extra
compensation that is built into the
return of an asset that cannot be
cashed in easily or quickly.
• Illiquidity is seen as a form of
investment risk. At the very least it can
be an opportunity risk if better
investments emerge while the money is
tied up.
• The more illiquid the investment, the
greater the liquidity premium that will
be required.
 Default Liquidity
Risk Risk
Risk Inherent
to Financial
Transactions Legal Market
Risk Risk
Default Risk
• Default risk is the risk that a lender takes on in
the chance that a borrower won’t be able to
make required debt payments.
• A free cash flow figure that is near zero or
negative could indicate a higher default risk.
• Default risk can be gauged by using FICO
scores for consumer credit and credit ratings
for corporate and government debt issues.
• Rating agencies break down credit ratings for
corporations and debt into either investment
grade or non-investment grade.
Liquidity Risk
• Liquidity is the ability of a firm,
company, or even an individual to
pay its debts without suffering
catastrophic losses.
• Investors, managers, and creditors
use liquidity measurement ratios
when deciding the level of risk within
an organization.
• If an individual investor, business, or
financial institution cannot meet its
short-term debt obligations, it is
experiencing liquidity risk.
Legal Risk
• Litigation risk is the risk an individual or
company will face legal action.
• This legal action could be the result of the
individual or company’s products, services,
actions, or another event.
• Large companies are especially susceptible to
legal action given the large potential reward
for plaintiffs.
• Assessing litigation risk involves looking at
possible resolutions (e.g., settlements) and the
costs of a legal defense.
• Legal action can come from a company’s
customers, vendors, other businesses, or even
shareholders.
Market Risk
• Market risk, or systematic risk, affects
the performance of the entire
market simultaneously.
• Market risk cannot be eliminated
through diversification.
• Specific risk, or unsystematic risk,
involves the performance of a
particular security and can be
mitigated through diversification.
• Market risk may arise due to changes
to interest rates, exchange rates,
geopolitical events, or recessions.
Liquidity and
Solvency
• An asset’s liquidity
describes the ease with
which I can be
converted to cash.
• Liquidity ratios evaluate
a firm’s ability to
generate sufficient cash
to meet its short-term
obligations.
Liquidity and
Solvency
• Solvency is a company’s
ability to meet the obligations
created by its long-term debt.
• Solvency ratios are of most
interest to stockholders, long-
term creditors, and company
management.
Liquidity vs. Solvency

Basis for Comparison Liquidity Solvency

Solvency means the firm's
Liquidity implies the measure
ability of a business to have
of the ability of the firm to
Meaning sufficient assets to meet its
cover its immediate financial
debts as they fall due for
obligations.
payment.
Obligations Short term Long term
How easily the assets can be How well the firm sustain itself
Describes
converted into cash. for long time.
Current ratio, acid test ratio, Debt to equity ratio, interest
Ratio
quick ratio, etc. coverage ratio, etc.
Risk Low High
Valuation of Collaterals
• Collateral value refers to the amount
of assets that have been put up to
secure a loan.
• Lenders often use this value to
estimate the level of risk associated
with a particular loan application.
• Various methods estimate collateral
value, including reviewing
comparable transactions, relying on
tax assessments, and consulting with
subject-matter experts.
References:

• Investopedia.com
• Collateral Valuation: Credit Risk: Importance of collateral valuation to
credit risk management | FinanceTrainingCourse.com
End of module
Thank you.