Ciby Joseph on Advanced Credit Risk Analysis and Management

Published: 19 February 2014

Jacob Bettany: Could you begin by telling us a little bit about your background and how you came to write this book?

Ciby Joseph: I would like to introduce myself as a veteran risk management professional with two decades of banking experience. My expertise includes risk analysis, credit risk management, derivative risk management, financial analysis, relationship management, Basel regulations and investment management. During my banking career, my focus was predominantly on credit risk.

How I came to write this book is an interesting story. In the late 1990s, when I was working with HSBC Saudi Arabia as Senior Credit Analyst, I was assigned the role of teaching credit basics to new recruits under JODP (Junior Officers Development Program). One of the new recruits approached me and asked to refer a good book on credit risk, which described the way credit risk is studied, analyzed and managed in banks and financial institutions. A few books that I got had complex maths on credit risk; however this was not the way the credit risk is handled in banks. Having realized there could be a potential, I decided to convert my teaching notes into a book. Accordingly, the first book was published in 2005.

Thereafter, during my Lloyds days when I was heading the corporate credit function in the Middle East, I was unfortunate to witness the credit crisis of 2008/2009. The lessons learnt were massive. Prior to the crisis, many banks, especially in the USA felt justified in changing their credit underwriting standards so greatly that they placed their trust in mathematical (quantitative) models. They thought they had identified ways for passing off the credit risk to third parties via securitization and credit derivatives. As the credit crisis has shown such methods have their own severe handicaps and cannot withstand tests of time. That was the time to re-emphasis the prudent approach to credit risk analysis and hence the updated & revised version was published in 2013, covering the lessons of the 2008/2009 crisis as well.

JB: Can you provide a brief overview of how the book is structured and why you made those decisions?

CJ: The coverage of this book is comprehensive and especially describes the developments and challenges of today’s credit risk environment and deals with the real nature of credit risk and management in depth. The book attempts to put credit risk at the correct perspective. In fact, the credit risk perception of many – even at the top management – is blurred, resulting in unnecessary assumption of equity risk, which invariably results in higher credit risks without corresponding return. The various events relating to the 2008 Global Credit Crisis are the proof. The rapid growth in credit and credit products in the recent decades is here to stay. However, this comes with a huge responsibility of proper credit risk analysis and management, which has proven a big challenge for the leaders in finance and bank regulators in several countries. The book is structured to facilitate lucid reading and understanding of the concepts related to credit risk. Ample illustrations with a real life touch are given so that the book will help both lenders and borrowers to understand the nature of credit risk analysis and management, and will guide them to the prudent use of credit risk products and financial leverage.

The book provides a thorough treatment on Credit Risk and discusses obligor risk, portfolio risk, capital requirement, credit pricing and Basel accords. The book introduces the nature of credit risk and discusses advantages of credit and the historical progress and challenges of credit risk analysis. Thereafter it explains the strategic role of credit risk culture and risk appetite statements and highlights the importance of separating key credit risk variables and provides guidance on various external risks and effective early warning indicators. After discussing industry factors, it describes how the entity level risks have to be studied and delves into an in-depth treatment of financial risk analysis. Finally the obligor risk analysis is wrapped up with a discussion on integrated credit risk judgement and selection of credit risk mitigation.  It discusses PD, LGD, etc and links Merton Model to the traditional accounting based credit risk analysis. The book then provides in-depth analysis of the credit risks of two common situations – Project Finance and Working Capital Finance. Thereafter the book moves into the portfolio credit risk analysis and covers concepts such as credit portfolio beta, migration risk, credit loss distribution, economic & regulatory capital. It critically examines the role of credit risk in Basel Accords, the role of external credit rating agencies and explores Kelly’s formula in the context of capital adequacy. The book also analyses various methods of credit portfolio risk mitigation techniques and discuss the pros and cons of credit derivatives. Before discussing the credit crisis, with focus on the 2008 US Credit crisis, the book explains credit risk pricing methods and elaborates the role of collateral or security.

What I would like to stress at this point is that the book has a unique and practical treatment that will enable the reader to look at credit risk with clarity and better understanding. There are several examples in the book which are adapted from real life and have a practical touch.

JB: A great deal had been written about Credit Risk, both before and since the Financial Crisis of 2008. Why was this book necessary? What makes it stand out?

CJ: This is the question we asked before proceeding ahead with the book. While there are books on credit risk, the coverage of ‘Advanced Credit Risk Analysis & Management (ACRAM)’ is more comprehensive. For example, a book on credit risk published by one of the US based rating agency has only 11 chapters and just covers corporate credit risk analysis and is very light on the ‘credit risk management’ aspect.

” The biggest challenge in Credit Risk is the lack of credit risk expertise where it is required the most. It won’t be an exaggeration to say that there is ignorance of the nature of credit by those who make a living out of it.”

As you know, ACRAM has 25 chapters and covers not only ‘credit risk analysis’ but ‘credit risk management’ also in a comprehensive manner. It covers (i) Credit Portfolio Risks- credit portfolio fundamentals, connects obligor risk to portfolio risk to economic capital (ii) Credit Portfolio Risk Mitigation Techniques – diversification, credit derivatives, etc (iii) Credit Risk Pricing – basics & different methods (iv) Role of Security/ Credit Enhancement (v) Reasons for Credit Crisis (vi) 2008 Credit Crisis and (vii) Basel Accords. Moreover, the book also covers credit risks in the two most common type of financing (i) Project Finance and (ii) Working Capital risks.

JB: Who is this book for?

CJ: The motivation for the book has emanated from the fact that during my two decade long tryst with credit risk management, I have met several people – bank officers, regulators, credit executives, credit officers, chief finance officers, finance managers and business students – who are interested in a good book on credit analysis and management. Businessmen, auditors, consultants, entrepreneurs and educators also yearn for a practical reference book on credit risk analysis and management. The book will be helpful to both lenders (i.e. banks and financial institutions) and borrowers to understand the nature of credit risk analysis and management and will guide them to the prudent use of credit risk products and financial leverage, which is the hallmark of any successful business.

JB: What, in your view, are the open questions (or challenges) in Credit Risk, and what is being done to address them?

CJ: There are several challenges facing Credit Risk. The biggest challenge in Credit Risk is the lack of credit risk expertise where it is required the most. It won’t be an exaggeration to say that there is ignorance of the nature of credit by those who make a living out of it. There is a risk within credit risk management functions in banks, financial institutions and even at regulators. During my career I have come across astute credit risk managers, from whom I have learnt the tricks of the trade. In order to become proficient credit risk managers, one requires passion for the topic, right exposure, experience and willingness to put extra effort. This makes astute credit risk managers a rare breed. At the same time, I have also come across credit risk managers who are not proficient. The former category of credit risk professionals are unable to pass on their skills and talent to a wider next generation due to the inadequate attention paid by academics on this important topic i.e. credit risk.

Many banks and financial institutions are poor in credit risk analysis and management. Even Basel Accords casts a doubt on the ability of some of the banks to conduct proper credit risk analysis.  This is evident under Standardised Approach, because the Accord asks the banks to set aside their credit risk assessment and follow the ratings of the external rating agencies for capital adequacy purposes. This is a tacit acknowledgement of inadequate credit risk expertise of banks and financial institutions.

The other credit concerns include lack of reliable data, unhealthy or too much competition, inadequate regulations, increasing cost of doing business, model risks, unknown unknowns, etc.

JB: Do you have a view on the way that Credit Risk is taught in higher education and are there any areas where you would like to see the emphasis changed?

CJ: Many senior banking officials I met recently have complained about the lack of credit skill among relationship/credit managers. A few banks have conducted credit risk tests and the results were abysmal.

“The price of this ignorance of credit risk is huge – it freezes credit markets and holds the entire economy for a ransom.”

In fact we cannot blame the relationship/credit managers for this situation. It is a systemic issue. There is lack of focus on credit risk education. You train engineers over 5 years before they get out and try to design or construct buildings – but not credit risk managers.

As you know there is financial innovation and results in the development of complex products that embed credit risk. i.e. such products carry credit risk indirectly. A plethora of financial products are available in the market, which imbed credit risk and dealing in such products requires thorough knowledge of credit risk. For example, many issuers of Credit Default Swaps (CDS) thought this as an insurance product; however fundamentally it is a credit risk product. As they equated CDS to insurance, they tried to replicate ‘laws of large numbers’ which is successfully applied in regular insurance products, with disastrous consequences. I would like to stress again that one of the serious issues facing today’s financial world is that there is lack of serious credit risk education.

Whilst credit markets dwarf equity markets, it is arguable that enough academic attention is not given to the credit risk. Of course, equity risk analysis is taught extensively in business schools. And quite often, equity risk analysis is adapted into credit risk analysis. However, this is dangerous as both risks have key differences, although some aspects are common. It is a welcome measure that realizing the importance of Credit Risk, more and more universities now includes credit risk as part of the curriculum. Probably, the 2008 Global Credit Crisis might have acted as a wake-up call.  However, in my humble opinion, more dedicated courses focusing on credit risk are required. More research and academic attention to this important topic is necessary.

JB: On the theme of the financial crisis, the book offers a discussion of the way in which the principles of Credit Risk could have been applied to avoid it. Could you describe this argument and in the process outline what went wrong?

CJ: Credit risk analysis is an art and a science. It is a science as the analysis is based upon established principles and sound logic. However, like accountancy, law or medicine, credit risk analysis is not an exact science. Individual skill is the art element and the application of the principles will differ from practitioner to practitioner. Credit risk is as important as accountancy or law for the smooth functioning of economy and must be taught in a similar manner. The book stresses the credit risk principles and elucidates them throughout the book with examples and situations adapted from real life.

During the financial crisis, many of the lending principles were violated. The lending principles such as “know your counterparties”, “invest only in credit products you understand”, “avoid overreliance on external credit ratings”, “do not extensively rely on quantitative models, etc are often not followed due to lack of credit risk awareness.  As the events in the recent past show, central banks, financial institutions and commercial banks globally, continue to face challenges in managing credit risk. This underlines the importance of a book that elucidates credit risk principles and ensures that the lessons that we learnt in 2008 credit crisis are not fading away.

JB: To what extent are institutions paying heed to the lessons of the financial crisis, and what more could be done to avoid future catastrophes?

CJ: What have credit risk managers, banks and financial institutions learnt from the crisis? Almost everyone acknowledges that the most important lesson is that the crash was avoidable. This would have been possible, had the risk managers, banks and financial institutions been more risk-aware. Another important lesson, often not highlighted, is the fact that there is lack of ‘risk-awareness’ among leaders in financial markets. Such ‘risk awareness’ requires serious knowledge and expertise of the risk itself.

The price of this ignorance of credit risk is huge – it freezes credit markets and holds the entire economy for a ransom. Even well managed companies and sound businesses had been pushed to the brink of collapse because they were not able to get the loans and credit facilities to run their businesses. Finally governments intervened using tax payers’ money to rescue the system.

Prior to the 2008 crisis, the credit risk products or credit risk embedded products proliferated in the market. CDO, ABS, MBS, Synthetic CDOs, etc were some of them. Such products are the result of financial innovation and there is nothing wrong about that. What has gone wrong is the fact that the credit risk within such products was ignored – because of lack of awareness of the nature of credit risk. Hence, one of the ways to avoid such future catastrophes is to take up credit risk education very seriously and introduce the topic from undergraduate courses in finance.  Currently, credit risk analysis is mostly taught through ‘on the job’ training. Many banks send their staff for periodical credit risk training conducted by third parties, who are often not well versed in the nature of credit risk. This results in the phenomenon ‘blind leading blind’.

Very often, greed has been highlighted as one of the reasons for the crisis. Whilst this is partly true, the main element is the ignorance of the nature of credit risk, which is not emphasized enough in the analysis of reasons for the crisis. The participants (including sophisticated investors like hedge funds, investment banks, etc) didn’t realize the massive risks they have added to the books. To give a simple example, financial intermediaries do not invest in ‘smuggling activities’, because they are fully aware of the risks, despite its high potential profitability.  Similarly had they realised the full extent of the risks that were added to their books during the immediately preceding years of 2008, they would have refrained from such actions! It is pertinent to note a few banks and financial institutions who realized the real nature of credit risk, kept away from such risky assets and survived the crisis.

JB: As Credit Risk becomes an increasingly important theme in corporate finance and banking, the expertise of managers necessarily comes under more scrutiny. What makes a good Credit Risk Manager, and what makes a great one?

CJ: In banks and financial institutions, the originators of credit deals will not have the approval authority.  The credit sanctioning or approval authority often rests with a different individual or committee. Although this separation is done for internal control purposes, this could lead to some kind of conflicts. The pressure tactics on the credit approvers are not uncommon, who may be called ‘business stoppers’ ‘non-commercial’ and ‘unconstructive’ by the frontline.

“Good credit risk managers ought to have at least two strengths – strong analytical skills and good communication skills so that they can tactfully explain their positions. A great credit risk manager is the one who can build up a profitable credit portfolio that can withstand the business cycles and other stress scenarios.”

It may be noted that both functions are complementary. Good credit risk managers ought to have at least two strengths – strong analytical skills and good communication skills so that they can tactfully explain their positions. A great credit risk manager is the one who can build up a profitable credit portfolio that can withstand the business cycles and other stress scenarios.

JB: The role of rating agencies, auditors and OTC derivatives in the financial crisis are still topics which are very much in peoples’ minds. Do you have a view on where the blame lies?

CJ: An audit has inherent limitations and the users of audited financials must be aware of them. One of limitations is that there is a risk that some material misstatements may remain undetected, even though the audit is properly planned and performed because it is based on intelligent sampling. It is the management (not auditor) who is responsible for the preparation, presentation and integrity of the financial statements. During an audit process not all of the transactions or assets/liabilities are verified. It is a well-known fact that cleverly camouflaged frauds are not easily detectable during a normal audit. It calls for a forensic audit or due diligence or management audit or some other type of assurance services.

Credit rating agencies play an important role. When Enron Corp. disintegrated in 2001, many lost faith in the big credit-rating agencies. Sensing the market mood, it was widely believed that the rating agencies have worked to rebuild the credibility of the ratings that companies pay them to assign. However, the rating agencies repeated ‘a bigger Enron’ while assigning ratings to CDOs. Despite inherent limitations rating agencies are here to stay. The banks and financial institutions shall not solely rely on external ratings. Use the ratings by external agencies for sense check purposes only i.e. never replace the internal rating results with the external ratings.

Most FIs have massive off-balance sheet liabilities largely in the form of OTC derivatives. In a crisis scenario, the unwinding of these OTC derivative contracts is not easy. OTC derivatives also carry counterparty risks. More than 70% of global derivatives are traded OTC. Absence of an active secondary market is an enormous problem. Clearing and settlement through an appropriate regulatory body or oversight of these OTC derivatives is necessary and would have lessened the impact of the 2008 crisis.

Read more interviews on MoneyScience

Moorad Choudhry’s Principles of Banking

Counterparty credit risk, collateral and funding – an interview with Professor Damiano Brigo

JB: Thank you very much for your time Ciby, it’s been very interesting.