Counterparty Credit Overview
Credit is responsible for the underwriting process associated with extending loans and allowed market lines. Most banks have the relationship management and the credit underwriting/portfolio management separated so that bankers can focus on loan structuring and client demands while a credit team focuses on clearing internal processes. However, some banks continue to have both divisions fused.
An internal risk division must approve incremental and expiring credit before loans can be extended or trading limits can be approved. This includes new loans, increases to loan size, increases to loan tenor and new products allowed for trading lines. For riskier credits, interim reviews may be required as they are more strictly monitored.
A credit officer will write a credit memorandum to the appropriate risk division for approval. This credit memo will include:
- Executive summary of the ask and a comparison of existing and proposed credit extended to the company – George Weston is looking for a $200 million increase to their syndicated revolver of which the pro-rata share to HSBC is $12.5 million
- Business overview of the potential borrower – for example, TELUS has a wireline, wireless and health care segment
- Industry overview – Medium orbit satellites are seeing demand growth so MDA is well poised
- Potential methods of repayment (operating cash flow, cash-on-hand, capital markets access etc.)
- Capital structure (to see where the loan ranks in order of payments)
- Structural subordination issues – Debt belonging to one of Teck’s South American subsidiaries has certain assets ring-fenced
- Recent financial analysis – How has CP Rail performed over the last three years?
- Management and governance overview – Is the management known? How long has the CEO been in charge?
After discussing the aforementioned topics, an internal credit rating is assigned (with external credit ratings, when available from S&P/Moody’s/DBRS – Fitch in the US compared). This will take into account qualitative and quantitative factors specific to the industry. The credit rating implies a probability of default.
After the probability of default is determined, a loss given default or LGD rating must be assigned. This considers what the recovery is expected to be, evaluating the assets vs the liabilities, where the bank ranks in terms of order of payments and any specific security the bank has against the obligor.
When the two are combined, credit determines an expected loss rating on the obligor. This is important from a profitability perspective as it determines the loan loss provisions that must be put up against the loan and the economic return on the capital the bank puts up. As such, corporate bankers will often pressure their counterparty credit teams and risk management to get to a rating that works for the bottom line. It should be noted that credit adjudication is only a function of risk and not of profitability. Credit that receives risk approval but does not clear business return hurdles will fail a subsequent deal committee and not be approved.
When the request is standard, the credit will be approved quickly. If there are questions, risk will ask credit and if they are sufficiently answered, an approval can come after. Sometimes, approvals are fairly time sensitive (especially for large syndicated loans), so both teams may need to work extra hours to address possible concerns. At times, credit may be approved with conditions.
For non-expiring credits, an update will have to be sent to risk to show that there have been no material adverse changes to the business and to report on recent financial results. This is known as an annual review. Compliance tests will also be completed to show that the borrower is not in breach of any of the credit covenants outlined by the loan agreement.
Generally, a letter from the agent will suffice (compliance certificate), but sometimes the credit officer will have to manually calculate Debt/EBITDA or EBITDA/Interest based off of definitions from legal documentation and public financial statements.