Contents
Preface to the New Edition
Chapter 1: The Credit Decision
Definition of Credit
Willingness to Pay
Evaluating the Capacity to Repay: Science or Art?
Categories of Credit Analysis
A Quantitative Measurement of Credit Risk
Chapter 2: The Credit Analyst
The Universe of Credit Analysts
Role of the Bank Credit Analyst: Scope and Responsibilities
Credit Analysis: Tools and Methods
Requisite Data for the Bank Credit Analysis
Spreading the Financials
Additional Resources
Camel in a Nutshell
Chapter 3: The Business of Banking
Banks as Lenders
Banks as Financial Service Providers
Chapter 4: Deconstructing the Bank Income Statement
Anatomy of a Bank Income Statement: An Overview
A Further Dissection
Income Statements Under IAS
Chapter 5: Deconstructing a Bank’s Balance Sheet
Key Differences Between the Balance Sheets of Banks and Nonfinancial Companies
The Essential Line Items of the Bank Balance Sheet: Asset Side
The Essential Line Items of the Bank Balance Sheet: Liability Side
Off-Balance-Sheet Items and Derivatives
Chapter 6: Earnings and Profitability
The Importance of Earnings
Evaluating Earnings and Profitability: An Overview
Earnings Analysis
Profitability Ratio Analysis
Profitability: An Illustration of a Peer Analysis
Macro-Level Influences on Bank Profitability
Micro-Level Influences on Bank Profitability
Quality of Earnings
Chapter 7: Asset Quality
Asset Quality and NPLS: An Introduction
Resolution of NPLS
Accounting for NPLS
What Causes Excessive NPLS
Macroeconomic Influences on Asset Quality—Economic, Business, and Credit Cycles
Data and Ratio Analysis
Loan Book Composition, Credit Culture, and other Soft Factors
Chapter 8: Management and Corporate Governance
An Overview of Management Appraisal
Corporate Governance
Chapter 9: Capital
The Function and Importance of Capital
What is Capital?
Measuring Capital Strength: Traditional Ratios
Regulatory Capital and the First Basel Accord
The Basel II and Basel III Accords and the Concept of Economic Capital
Chapter 10: Liquidity
What is Liquidity and Why is it Important?
Elements of Bank Liquidity Analysis
Chapter 11: Country and Sovereign Risk
Overview
Fiscal, Monetary, and Trade Policies
Chapter 12: Risk Management, Basel Accords, and Ratings
Risk and the Importance of Risk Management
Categories of Bank Risk
Risk Management Methods
Basel II and Basel III
Ratings
Chapter 13: The Banking Regulatory Regime
Overview
The Rationale for Regulation
The Regulatory Regime
The Structure and Strength of the Regulatory Apparatus
The Quality of the Legal System and Creditors’ Rights
Gauging Banking System Fragility
State Ownership and State Support of Banks
Chapter 14: Crises: Banking, Financial, Twin, Economic, Debt, Sovereign, and Policy Crises
An Introduction to Banking and Financial Crises
Early-Warning Systems of Financial Crises
Chapter 15: The Resolution of Banking Crises
Recognizing the Crisis
First Response
Supply Liquidity and Stop the Bleeding
Recapitalization and Restructuring
Asset Disposal and Regulatory Reform
Bank Restructuring in Malaysia During the 1990s Asian Financial Crisis: A Practical Example
About the Authors
Index
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First edition published in 2001.
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Preface to the New Edition
In early 1997, Jonathan Golin applied for a position of bank credit analyst with Thomson BankWatch. He had limited experience in financial analysis, let alone bank financial analysis, but Philippe Delhaise, then president of BankWatch’s Asia division, had long held the view that outstanding brains, good analytical skills, a passion for details, and a degree of latent skepticism were the best assets of a brilliant bank financial analyst. He immediately hired Jonathan.
Jonathan joined a team of very talented senior analysts, among them Andrew Seiz, Damien Wood, Tony Watson, Paul Grela, and Mark Jones. Philippe and the Thomson BankWatch Asia team produced, as early as 1994 and 1995, forewarning reports on the weaknesses of Asia’s banking systems that led to the Asian crisis of 1997.
After the crisis erupted, Philippe made countless presentations on all continents, and he conducted, with some of his senior analysts, a number of seminars on the Asian crisis. This led to a contract with John Wiley & Sons for Philippe to produce a book on the 1997 crisis that was very well received, and which we hope the reader will forgive us for quoting occasionally.
When in 1999 John Wiley & Sons started looking for a writer who could put together a comprehensive bank credit analysis handbook, Philippe had neither the time nor the courage to embark on such a voyage, but he encouraged Jonathan to take the plunge with the support of unlimited access to Philippe’s notes and experience, something Jonathan gave him credit for in the first edition of the Bank Credit Analysis Handbook, published in 2001.
Meanwhile, Thomson BankWatch—at one point renamed Thomson Financial BankWatch—merged with Fitch in 2000, but Philippe and Jonathan quit prior to the merger. Philippe carried on teaching finance and conducting seminars on bank risk management in a number of countries. Recently, in Hong Kong, Philippe cofounded CTRisks Rating, a new rating agency using advanced techniques in the analysis of risk. Jonathan moved to London, where he founded two companies devoted to bank and company risk analysis.
During the 2000s, the risk profile of most banks changed dramatically. Many changes took place in the manner banks had to manage and report their own risks, and in the way such risks shaped a bank’s own credit risk, as seen from the outside. Jonathan’s book needed an overhaul rather than a cosmetic update. This is how eventually Jonathan and Philippe joined forces to present this new, expanded edition to our readers.
In the preface of the first edition, Jonathan thanked Darren Stubing for his substantial contribution to several chapters, and most likely some of Darren’s original input still pervades this new version of the book. The same applies to texts contributed by Andrew Seiz in the first edition, and there is no doubt that research done by the Thomson BankWatch Asia team, together with some of their New York–based colleagues, permeates the analytical line adopted both in Jonathan’s first edition and in the present new edition of The Bank Credit Analysis Handbook. The only direct outside contribution to this edition is coming from Richard Lumley in the chapter on risk management. We are thankful to all direct and indirect contributors.
The crisis that started in 2007 is still on at the time of writing. Banks and financial systems should share the blame with profligate politicians, outdated socioeconomic models, and a shift of the world’s center of gravity toward newcomers.
However deep the resentment against banking and finance—often fanned by otherwise entertaining political slogans1—banks are here to stay.
Banks remain a major conduit for the transformation of savings into productive investments. It is particularly so in emerging countries where capital markets are still not sufficiently developed and where savers have limited access to direct credit risk opportunities. Even in advanced economies, access to market risk often involves dealing with banks whose contribution as intermediaries is sometimes—and often justifiably—questionable.
More than most other financial intermediaries, banks do carry substantial credit and market risks. They act as shock absorbers by removing from their depositor’s shoulders—and charging, alas, hefty fees for the service—some of that burden.
As we shall point out in this book, weak banks actually rarely fail—they often merge or get nationalized—or at least their problems rarely translate into losses for depositors2 or creditors. Major disasters do occur, though, and we should not dismiss the view that the mere possibility of such an occurrence is enough for state ownership or state control of banks to gain respect in spite of the huge inefficiencies such models introduce. At the very least, banks should be submitted, within reason, to better regulatory control.
Banks, however, cannot survive unless they take risks. The trick for them is to manage those risks without destroying shareholder value—the fatter the better, from a creditworthiness point of view—and without endangering depositors and creditors.
This book explores the tools available to external analysts who wish to find out for themselves whether and to what extent a bank or a group of banks is creditworthy.
It is a jungle out there. A wide range of theoretical research is available. Extreme opinions exist on most topics, making it difficult to reach a consensus on a middle ground where depositors, creditors, and regulators should confine the banking systems’ risk analysis.
Our book is a modest attempt at balancing the wealth of research and opinions within a useful handbook for analysts, regulators, risk assessment offices, and finance students.
Dividing bank credit analysis in separate chapters was a headache. Asset quality has an impact on earnings and on capital adequacy, liquidity on asset quality and earnings, management skills on asset quality, earnings on capital, accounting rules on earnings and capital—all on convoluted Möbius strips.
The first three chapters explore the notions associated with the credit decision, with the tools used in creditworthiness analysis and generally with the business of banking, more specifically with those activities that expose banks to risk.
Chapters 4 and 5 explore the earnings—or income, or profit and loss—statement and the balance sheet of a bank, together with the increasingly important off-balance sheet. Those documents are the first documents an analyst will be confronted with. Except for the reader already familiar with bank financial statements, those chapters are essential to understand how the various activities of the bank find their way into the final published documents that disclose—and sometimes conceal or disguise—the facts, figures, and ratios that should shape the analyst’s opinion on the bank’s creditworthiness.
The two accounting chapters pave the way for the introduction, in separate chapters, of the five basic elements of CAMEL, the mainstream model for assessing a bank’s performance and financial condition. Each of those five chapters relates back, in some way, to the two accounting chapters.
Chapter 6 discusses earnings and profitability, with their many indicators. Chapter 7 is the most important as it attempts to describe how the analyst can assess the asset quality of a bank, and how the bank monitors its assets and deals with nonperforming loans and with its exposure to other impaired assets or transactions.
Management and corporate governance are covered in Chapter 8, where the analyst will, among other things, learn how to appraise a bank’s overall management skills, which, in spite of tighter external regulations, remain a critical factor.
Chapter 9 is about capital and its various definitions and indicators. This is where a first round of comments touches on the Basel Accords, because the earlier versions of those accords focused almost exclusively on capital adequacy.
Liquidity, which is in Chapter 10, has become a major issue in the wake of the 2007–2012 crisis. It is also a very difficult parameter to analyze. No single indicator is able to describe a bank’s liquidity position, to the point where even the proposed liquidity requirements under Basel III do not bring much light to the debate.
Chapter 11 is about country and sovereign risks, which used to be relevant only to emerging markets but came to the fore during the 2011–2012 debt crisis in Europe. Globalization and the free circulation of funds around most of the world have now pushed the analysis of country and sovereign risk way beyond the traditional ratios describing such basic factors as inflation or balance of payments. Bank creditworthiness is more than ever influenced by macroeconomic factors.
Risk management is analyzed in Chapter 12, together with the second part of our exploration of the Basel Accords, to which we added a section on ratings. Risk management is no doubt the topic that saw the most changes over the past few years.
The banking regulatory regime is explored in Chapter 13, with its structural and prudential regulations as well as its impact on systemic issues.
The regional and worldwide crises of the past 20 years have generated considerable research on the causes of, and remedies to bank crises, financial crises, debt crises, sovereign crises, and their various combinations. Those crises are described and explained in Chapter 14, while Chapter 15—our last chapter—is devoted to the resolution of banking crises specifically.
We decided against offering a glossary of financial terms, as the book is already heavy and, in this day and age, the reader will no doubt find excellent glossaries on the Internet.
In our attempt to render the reader’s task easier by dividing the book into 15 chapters, we created the need for many cross-references to other chapters. We believed that the reader would have neither the courage nor the need to swallow many chapters in one sitting, and we wanted, as much as possible, our chapter on, say, asset quality to cover most or all of what the reader would want to know when reading that chapter in isolation. Inevitably, as a result, there is a—small—degree of duplication here or there.
We would like to beg our readers’ forgiveness for offering many examples from Asia. Both authors are thoroughly familiar with banking systems in that region—which admittedly is no justification in itself—while, more importantly, Asia is by far the largest financial market outside of the EU and the United States. In addition, whatever the definition of an emerging market, Asia without Japan arguably harbors the biggest emerging market banking system in the world, a fertile ground for dubious banking practices.
Considerable research is available on banking systems, banking crises, and other topics relevant to the bank credit analyst. As a matter of fact, so much information and so many opinions are offered that the analyst would need to invest a year of her life just to get acquainted with the existing literature on bank creditworthiness. Our modest ambition was to distill academic research into something palatable, to pepper our findings with information gathered over our many years of experience in bank credit analysis, and to offer our reader a useful reference handbook.
London and Port Arthur
September 2012
1. Malaysia’s Prime Minister Mahathir produced an interesting opinion in a speech on September 20, 1997 reported by the Manila Standard newspaper on September 22, 1997: “Currency trading is unnecessary, unproductive and immoral. . . . It should be illegal.” As reported in French by Le Parisien newspaper on January 12, 2012, socialist François Hollande said on that day in a meeting during his campaign for the French presidency “Dans cette bataille qui s’engage, mon véritable adversaire n’a pas de nom, pas de visage, pas de parti, mais il gouverne; cet adversaire c’est le monde de la finance,” which freely translates as: “In the battle that is starting, my true opponent has no name, no face, no party, but it reigns; this opponent is the world of finance.”
2. Especially so where deposit insurance schemes exist.
CREDIT. Trust given or received; expectation of future payment for property transferred, or of fulfillment or promises given; mercantile reputation entitling one to be trusted;—applied to individuals, corporations, communities, or nations; as, to buy goods on credit.
—Webster’s Unabridged Dictionary, 1913 Edition
A bank lives on credit. Till it is trusted it is nothing; and when it ceases to be trusted, it returns to nothing.
—Walter Bagehot1
People should be more concerned with the return of their principal than the return on their principal.
—Jim Rogers2
The word credit derives from the ancient Latin credere, which means “to entrust” or “to believe.”3 Through the intervening centuries, the meaning of the term remains close to the original; lenders, or creditors, extend funds—or “credit”—based upon the belief that the borrower can be entrusted to repay the sum advanced, together with interest, according to the terms agreed. This conviction necessarily rests upon two fundamental principles; namely, the creditor’s confidence that:
The first premise generally relies upon the creditor’s knowledge of the borrower (or the borrower’s reputation), while the second is typically based upon the creditor’s understanding of the borrower’s financial condition, or a similar analysis performed by a trusted party.4
Consequently, a broad, if not all-encompassing, definition of credit is the realistic belief or expectation, upon which a lender is willing to act, that funds advanced will be repaid in full in accordance with the agreement made between the party lending the funds and the party borrowing the funds.5 Correspondingly, credit risk is the possibility that events, as they unfold, will contravene this belief.
Put another way, a sensible individual with money to spare (i.e., savings or capital) will not provide credit on a commercial basis7—that is, will not make a loan—unless she believes that the borrower has both the requisite willingness and capacity to repay the funds advanced. As suggested, for a creditor to form such a belief rationally, she must be satisfied that the following two questions can be answered in the affirmative:
Traditional credit analysis recognizes that these questions will rarely be amenable to definitive yes/no answers. Instead, they call for a judgment of probability. Therefore, in practice, the credit analyst has traditionally sought to answer the question:
What is the likelihood that a borrower will perform its financial obligations in accordance with their terms?
All other things being equal, the closer the probability is to 100 percent, the less likely it is that the creditor will sustain a loss and, accordingly, the lower the credit risk. In the same manner, to the extent that the probability is below 100 percent, the greater the risk of loss, and the higher the credit risk.
Credit risk and the concomitant need for the estimation of that risk surface in many business contexts. It emerges, for example, when one party performs services for another and then sends a bill for the services rendered for payment. It also arises in connection with the settlement of transactions—where one party has advanced payment to the other and awaits receipt of the items purchased or where one party has advanced the items purchased and awaits payment. Indeed, most enterprises that buy and sell products or services, that is practically all businesses, incur varying degrees of credit risk. Only in respect to the simultaneous exchange of goods for cash can it be said that credit risk is essentially absent.
While nonfinancial enterprises, particularly small merchants, can eliminate credit risk by engaging only in cash and carry transactions, it is common for vendors to offer credit to buyers to facilitate a particular sale, or merely because the same terms are offered by their competitors. Suppliers, for example, may offer trade credit to purchasers, allowing some reasonable period of time, say 30 days, to settle an invoice. Risks arising from trade credit form a transition zone between settlement risk and the creation of a more fundamental financial obligation.
It is evident that as opposed to trade credit, as well as settlement risk that emerges during the consummation of a sale or transfer, fundamental financial obligation arises where sellers offer explicit financing terms to prospective buyers. This type of credit extension is particularly common in connection with purchases of big ticket items by consumers or businesses. As an illustration, automobile manufacturers frequently offer customers attractive finance terms as an incentive. Similarly, a manufacturer of electrical generating equipment may offer financing terms to facilitate the sale of the machinery to a power utility company. Such credit risk is essentially indistinguishable from that created by a bank loan.
In contrast to nonfinancial firms, which can choose to operate on a cash-only basis, banks by definition cannot avoid credit risk. The acceptance of credit risk is inherent to their operation since the very raison d’être of banks is the supply of credit through the advance of cash and the corresponding creation of financial obligations. Success in banking is attained not by avoiding risk but by effectively selecting and managing risk. In order to better manage risk, it follows that banks must be able to estimate the credit risk to which they are exposed as accurately as possible. This explains why banks almost invariably have a much greater need for credit analysis than do nonfinancial enterprises, for which, again by definition, the shouldering of credit risk exposure is peripheral to their main business activity.
For purposes of practical analysis, credit risk may be defined as the risk of monetary loss arising from any of the following four circumstances:
The variables most directly affecting relative credit risk include the following four:
Credit risk is also influenced by the length of time over which exposure exists. At the portfolio level, correlations among particular assets together with the level of concentration of particular assets are the key concerns.
At the level of practical analysis, the process of credit risk evaluation can be viewed as formulating answers to a series of questions with respect to each of these four variables. The following questions are intended to be suggestive of the line of inquiry that might be pursued.
The Obligor’s Capacity and Willingness to Repay
The External Conditions
The Attributes of Obligation from Which Credit Risk Arises
The Credit Risk Mitigants
In this book, our primary focus will be on the obligor bank and the environment in which it operates, with consideration of the credit characteristics of specific financial products and accompanying credit risk mitigants relegated to a secondary position. The reasons are twofold. One, evaluation of the first two elements form the core of bank credit analysis. This is invariably undertaken before adjustments are made to take account of the impact of the credit characteristics of particular financial products or methods used to modify those characteristics. Two, to do justice to the myriad of different types of financial products, not to speak of credit risk mitigation techniques, requires a book in itself and the volume of material to be covered with regard to the obligor and the operating environment is greater than a single volume.
While the foregoing query concerning the likelihood that a borrower will perform its financial obligations is simple, its simplicity belies the intrinsic difficulties in arriving at a satisfactory, accurate, and reliable answer. The issue is not just the underlying probability of default, but the degree of uncertainty associated with forecasting this probability. Such uncertainty has long led lenders to seek security in the form of collateral or guarantees, both to mitigate credit risk and, in practice, to circumvent the need to analyze it altogether.
Collateral refers to assets that are either deposited with a lender, conditionally assigned to the lender pending full repayment of the funds borrowed, or more generally to assets with respect to which the lender has the right to obtain title and possession in full or partial satisfaction of the corresponding financial obligation. Thus, the lender who receives collateral and complies with the applicable legal requirements becomes a secured creditor, possessing specified legal rights to designated assets in case the borrower is unable to repay its obligation with cash or with other current assets.8 If the borrower defaults, the lender may be able to seize the collateral through foreclosure9 and sell it to satisfy outstanding obligations. Both secured and unsecured creditors may force the delinquent borrower into bankruptcy. The secured creditor, however, benefits from the right to sell the collateral without necessarily initiating bankruptcy proceedings, and stands in a better position than unsecured creditors once such proceedings have commenced.10
It is evident that, since collateral may generally be sold on the default of the borrower (the obligor), it provides security to the lender (the obligee). The prospective loss of collateral also gives the obligor an incentive to repay its obligation. In this way, the use of collateral tends to lower the probability of default, and, more significantly, reduce the severity of the creditor’s loss in the event of default, by providing the creditor with full or partial recompense for the loss that would otherwise be incurred. Overall, collateral tends to reduce, or mitigate, the credit risk to which the lender is exposed, and it is therefore classified as a credit risk mitigant.
Since the amount advanced is known, and because collateral can normally be appraised with some degree of accuracy—often through reference to the market value of comparable goods or assets—the credit decision is considerably simplified. By obviating the need to consider the issues of the borrower’s willingness and capacity, the question—What is the likelihood that a borrower will perform its financial obligations in accordance with their terms?—can be replaced with one more easily answered, namely: “Will the collateral provided by the prospective borrower be sufficient to secure repayment?”11
As Roger Hale, the author of an excellent introduction to credit analysis, succinctly puts it: “If a pawnbroker lends money against a gold watch, he does not need credit analysis. He needs instead to know the value of the watch.”12
A guarantee is the promise by a third party to accept liability for the debts of another in the event that the primary obligor defaults, and is another kind of credit risk mitigant. Unlike collateral, the use of a guarantee does not eliminate the need for credit analysis, but simplifies it by making the guarantor instead of the borrower the object of scrutiny.
Typically, the guarantor will be an entity that either possesses greater creditworthiness than the primary obligor, or has a comparable level of creditworthiness but is easier to analyze. Often, there will be some relationship between the guarantor and the party on whose behalf the guarantee is provided. For example, a father may guarantee a finance company’s loan to his son13 for the purchase of a car. Likewise, a parent company may guarantee a subsidiary’s loan from a bank to fund the purchase of new premises.
Where a guarantee is provided, the questions posed with reference to the prospective borrower must be asked again in respect of the prospective guarantor: “Will the prospective guarantor be both willing to repay the obligation and have the capacity to repay it?” These questions are summarized in Exhibit 1.1.
In view of the benefits of using collateral and guarantees to avoid the sometimes thorny task of performing an effective financial analysis,14 banks and other institutional lenders traditionally have placed primary emphasis on these credit risk mitigants, and other comparable mechanisms such as joint and several liability15 when allocating credit.16 For this reason, secured lending, which refers to the use of credit risk mitigants to secure a financial obligation as discussed, remains a favored method of providing financing.
In countries where financial disclosure is poor or the requisite analytical skills are lacking, credit risk mitigants circumvent some of the difficulties involved in performing an effective credit evaluation. In developed markets, more sophisticated approaches to secured lending such as repo finance and securities lending17 have also grown increasingly popular. In these markets, however, the use of credit risk mitigants is often driven by the desire to facilitate investment transactions or to structure credit risks to meet the needs of the parties to the transaction rather than to avoid the process of credit analysis.
With the evolution of financial systems, credit analysis has become increasingly important and more refined. For the moment, though, our focus is upon credit evaluation in its more basic and customary form.
Willingness to pay is, of course, a subjective attribute that can be ascertained to a degree from the borrower’s reputation and apparent character. Assuming free will,18 it is also essentially unknowable in advance, even perhaps to the borrower. From the perspective of the lender or credit analyst, the evaluation is therefore necessarily a qualitative one that takes into account information gleaned from a variety of sources, including, where possible, face-to-face meetings that are a customary part of the process of due diligence.19
The old-fashioned provincial banker who was familiar with local business conditions and prospective borrowers, like the fictional character described earlier, had less need for formal credit analysis. Instead, the intuitive judgment that came from an in-depth knowledge of a community and its members was an invaluable attribute in the banking industry. The traditional banker knew with whom he was dealing (or thought he did), either locally with his customers or at a distance with correspondent banks20 that he trusted. Walter Bagehot, the nineteenth-century British economic commentator put it well:
A banker who lives in the district, who has always lived there, whose whole mind is a history of the district and its changes, is easily able to lend money there. But a manager deputed by a central establishment does so with difficulty. The worst people will come to him and ask for loans. His ignorance is a mark for all the shrewd and crafty people thereabouts.21
In general, modern credit analysis still takes account of willingness to pay, and in doing so maintains an unbroken link with its past. It is still up to one or more individuals to decide whether to extend or to repay a debt, and manuals on banking and credit analysis as a rule make some mention of the importance of taking account of a prospective borrower’s character.22
Willingness to pay, though real, is difficult to assess. Ultimately, judgments about this attribute, and the criteria on which they are based, are highly subjective in nature.
First-hand awareness of a prospective borrower’s character affords at least a stepping-stone on which to base a credit decision. Where direct familiarity is lacking, a sense of the borrower’s reputation provides an alternative footing upon which to ascertain the obligor’s disposition to make good on a promise. Reliance on reputation can be perilous, however, since a dependence upon second-hand information can easily descend into so-called name lending.23 Name lending can be defined as the practice of lending to customers based on their perceived status within the business community instead of on the basis of facts and sound conclusions derived from a rigorous analysis of the prospective borrowers’ actual capacity to service additional debt.
Although far more data is available today than a century ago, assessing a borrower’s integrity and commitment to perform an obligation still requires making unverifiable, even intuitive, judgments. Rather than put a foot wrong into a miasma of imponderables, creditors have long taken a degree of comfort not only in collateral and guarantees, but also in a borrower’s verifiable history of meeting its obligations.
As compared with the prospective borrower who remains an unknown quantity, a track record of borrowing funds and repaying them suggests that the same pattern of repayment will continue in the future.24 If available, a borrower’s payment record, provided for example through a credit bureau, can be an invaluable resource for a creditor. Of course, while the past provides some reassurance of future willingness to pay, here as elsewhere, it cannot be extrapolated into the future with certainty in any individual case.25
While the ability to make the requisite intuitive judgments concerning willingness to pay probably comes more easily to some than to others, and no doubt may be honed with experience, perhaps fortunately it has become less important in the credit decision-making process.26 The concept of a moral obligation27 to repay a debt—which perhaps in the past arguably bolstered the will of the faltering borrower to perform his obligation in full—has been to a large extent displaced in contemporary commerce by legal rather than ethical norms.
It is logical to rank capacity to pay as more important than willingness, since willingness alone is of little value where capacity is absent. Capacity without willingness, however, can be overcome to a large degree through an effective legal system.28 The stronger and more effectual the legal infrastructure, the better able a creditor is to enforce a judgment against a borrower.29 Prompt court decisions backed by the threat of the seizure of possessions or other means through the arm of the state will tend to predispose the nonperforming debtor to fulfill its obligations. A borrower who can pay but will not, is only able to maintain such a position in a legal regime that is ineffective or corrupt, or very strongly favors debtors over creditors.
So as legal systems have developed—along with the evolution of financial analytical techniques and data collection and distribution systems—the attribute of willingness to repay has been increasingly overshadowed in importance by the attribute of capacity to repay. It follows that the more a legal system exhibits creditor-friendly characteristics—combined with the other critical attributes of integrity, efficiency, and judges’ understanding of commercial requirements—the less the lender needs to rely upon the borrower’s willingness to pay, and the more important the capacity to repay becomes. The development of capable legal systems has therefore increased the importance of financial analysis and as a prerequisite to it, financial disclosure. Overall, the evolution of more robust and efficient legal systems has provided a net benefit to creditors.30
Willingness to pay, however, remains a more critical criterion in less-developed markets, where the quality of the legal framework may be lacking. In these instances, the efficacy of the legal system in protecting creditors’ rights also emerges as an important criterion in the analytical process.31
While the quality of a country’s legal system is a real and significant attribute, measuring it is no simple task. Traditionally, sovereign risk ratings functioned as a proxy for, among other things, the legal risk associated with particular geographic markets. Countries with low sovereign ratings were often implicitly assumed to be subject to a greater degree of legal risk, and vice versa.
In the past 15 years, however, surveys have been conducted in an attempt systematically to grade, if not measure, comparative legal risk. Although by and large these studies have been initiated for purposes other than credit analysis—to assess a country’s investment climate, for instance—they would seem to have some application to the evaluation of credit risk. The table in Exhibit 1.2 shows the scores under such an index of rule of law. Some banks have used one or more similar surveys, sometimes together with other criteria, to generate internal creditors’ rights ratings for the jurisdictions in which they operate or in which they contemplate credit exposure.
Source: World Bank.