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Bank credit risk-management for long-term loan financing: financial analysis and assessment of credit quality of the borrower Saribekian K. (Russian Federation) Управление рисками долгосрочного кредитования: финансовый анализ
кредитоспособности заемщика Сарибекян К. А. (Российская Федерация)
Сарибекян Карен Альбертович /Saribekian Karen - бакалавр экономики, магистрант, кафедра финансового менеджмента, Финансовый университет при Правительстве Российской Федерации, г. Москва
Abstract: in this article, the process of financing durable and strategic capital investments is studied. It is examined how and by which quantitative criteria banks make decisions when granting long-term investment loans.
Аннотация: в данной статье рассмотрен процесс банковского кредитования долгосрочных капиталовложений компаний. Описаны показатели анализа финансово -хозяйственной деятельности, на основе которых кредитные организации принимают решения о предоставлении долгосрочных займов.
Key words: long-term debt, capital investments, capital structure, credit risk management, financial analysis of creditworthiness, bank loans.
Ключевые слова: долгосрочное кредитование, капиталовложения, структура капитала, управление кредитным риском, анализ кредитоспособности, банковское кредитование.
Basically, long term bank loan is a loan with a repayment period of more than one year. It is usually taken by companies with longer investment or payback horizons, such as building of a new factory or purchase of new production equipment. A bank term loan is usually repaid via periodic installments. In contrast to short-term borrowings, long-term debt is used to finance business investments that have longer payback periods. For example, the purchases of machinery, which may help the company, produce goods over a 5 -year period.
Long-term loans are usually due within 3 to 7 years but may extend to 15 or 20 years. A term-loan agreement is a promissory note that requires the borrower to repay the loan with interest in specified monthly or annual installments. A major advantage is that the interest is tax deductible. Long-term loans are both larger and more expensive to the firm than short-term loans. Since the repayment period can be quite long, lenders assume more risk and usually require collateral, which may be real estate, machinery, equipment, company stock, or other items of value. Lenders may also require certain restrictions to force the firm to act responsibly. The interest rate is based on the adequacy of collateral, the firm's credit rating, and the general level of market interest rates. The greater the risk a lender takes in making a loan, the higher the rate of interest. This principle is known as the risk/return trade-off.
The main features of long term investment financing are as follows:
1) The bank grants credit by limits to meet the investment demand of customers by project (expansion, upgrade, replacement, new establishment).
2) The Bank grants credit for investment purposes arising from the needs of the project. The portfolio may include land, construction, plant and equipment and working capital for the operation of the project.
3) Medium and long term credit with a period of more than 1 year and not exceeding 10 years.
4) Forms of granting finance: by investment project (construction, plant and equipment, transportation means and working capital).
It is important to determine how companies choose the debt structure and how do they organize financing of capital investment projects with debt financing. If we consider long-term and short-term bank financing separately we will see that the latter entails roll over risk while the former does not. Recent banking theory holds that durable firm-bank relationships are valuable to both parties. Firms with extended relationships face lower credit costs. As the bank-borrower relationship matures credit costs decline. Second, long-term customers are asked to provide fewer personal guarantees. Third-party guarantees are an efficient alternative to collateral in certain circumstances, and long-term clients are asked to provide fewer guarantees. Third, long-term bank customers more likely to have loan terms renegotiated during a credit crunch. The structure of debt maturity is an important component of the firm's financial policy that can have significant effects on real corporate behavior in the presence of credit and liquidity shocks [6]. A firm that uses more short-term debt faces more frequent renegotiations and, therefore, is more likely to be affected by a credit supply shock and to face financial constraints. The debt maturity structure had important real effects for industrial firms during the 2007 -2008 financial crisis [7]. The traditional view of corporate finance states that debt is generally cheaper than equity as a source of investment finance implying that a firm's average cost of capital becomes lower as it increases its debt relative to equity. Thus, as the firm's average cost of capital reduces with increases in its debt to equity ratio, the corresponding company market value schedule rises and therefore the optimal leverage is determined at the point where the firm's weighted average cost of capital is minimized and the value of the firm is maximized. In contrast to the traditional view, Modigliani and Miller developed three well-known propositions relating to the
value of the firm, the behaviour of equity cost of capital, and the cut-off rate for new investment. The first proposition states that, the market value of any firm is independent of its capital structure; hence, the firm's average cost of capital is also independent of its capital structure.
Long term debt financing is usually more risky to the financier as it involves longer payback periods and thus higher credit risks. Hence, long-term debt financiers would usually require the borrowing company to pledge some form of asset as collateral. Such assets can range from inventories to factories and properties. The amount of funds that the company is able to obtain through long term debt financing would depend greatly on the value of assets, which the company is able and willing to pledge. Generally, long term debt financiers will also look at the credit worthiness of the borrowing company, in terms of its long term business prospects, cash flows, profitability, capital structure (debt-equity ratio) and other qualitative factors such as the transparency of operations, credibility and integrity of management etc. Long-term debt financiers such as financial institutions would usually require a set of up-to-date audited financial statements to perform their credit evaluation.
Here are some quantitative factors that are commonly used by long-term debt financiers to evaluate borrowers.
1) Profitability (Profitable companies will find it easier to obtain long term debt financing. Indicators: Profit margins, ROI, ROA).
2) Cash Flows (Businesses that have growing sales turnover show good business viability and prospects).
3) Capital Structure (Companies with lower debt to equity mix are less risky, and thus will find it easier to obtain long term debt financing).
4) Liquidity (Companies that have better liquidity ratios are less risky, and thus will find it easier to negotiate credit terms for long term financing).
Considering the often large amounts of funds involved, long term debt financing is a relatively risky source of financing. Breach of debt covenants may result in the company going into financial distress. For example, certain clauses state that if a certain covenant is breached, the entire loan amount has to be repaid in full immediately, or the mortgaged asset confiscated. Secured creditors may take actions against the company if it is not able to meet payments. If the interest charge is based on a floating rate, interest rates may move adversely against the company, causing huge unplanned and un-hedged increases in interest expenses and cash outflows. Financing and risk management are fundamentally linked. Many banks have invested significantly in improving their credit risk management in the past few years. Credit risk is most simply defined as the possibility that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximize a bank's risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions.
Banks should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any bank. Specifically, banks have invested in methods, resources, processes, and technology to assess, monitor, manage, and model their credit risk. Most of the effort has focused on compliance with Basel II and other regulatory requirements, and some banks continue to struggle as they work through the approval process. Leading banks, however, already have risk management frameworks in place and are now seeking to make the process significantly more relevant to management decision-making. These banks are evaluating how to build on lessons learned from Basel II implementation, regulatory approval preparations, and regulators' feedback. An emerging goal is to leverage their investments in credit risk management to make better decisions and enhance business performance.
Long term bank loan financing has its own advantages for funding strategic capital investments. Long term debt financing is usually less prone to short term shocks as it is secured by formally established contractual terms. Hence, they are relatively more stable than short-term debt. Long term debt financing is directly linked to the growth of the company's operating capacity (purchase of capital assets such as machinery). Long-term debt is normally well structured and defined. Thus fewer resources have to be channeled to monitor and maintain long-term debt financing accounts (compared to short term debt financing such as supplier credit which, changes overtime and need to be monitored on a regular basis). Long-term debt financing options such as leases offer a certain degree of flexibility, compared to having to purchase the asset.
References
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Economic Behavior & Organization, Volume 71, Issue 2, 2009, p. 372 -383.
2. Claudia Custodio, Miguel A. Ferreira // Why are US firms using more short-term debt? Journal of Financial
Economics, Volume 108, Issue 1, 2013, p. 182-212.
3. Almeida, Campello, Laranjeira and Weisbenner // Corporate debt maturity and the real effect on 2007 credit
crisis, NBER Working Paper n. 14990, 2007.
4. Joshua D. Rauh, Amir Sufi // Capital Structure and Debt Structure, The Review of Financial Studies, Volume
23, n. 12, 2010.
5. Amir Sufi // Bank Lines of Credit in Corporate Finance: An Empirical Analysis, The Review of Financial Studies, Volume 22, n. 3, 2009.
