LO 16.4: Compare and contrast quantitative and qualitative techniques o f credit risk evaluation.
The willingness to repay a loan is a subjective attribute. Lenders must make unverifiable judgments about the borrower. In some cases, intuition, or gut feelings, are necessary to conclude whether a borrower is willing to repay a loan. As such, qualitative credit analysis techniques are largely used to evaluate the borrowers willingness to repay. Qualitative techniques include:
Gather information from a variety of sources about the character and reputation of the potential borrower. Old-fashioned lending relied on first-hand knowledge of the people and businesses in a town. In this case, lenders knew (or thought they knew) potential borrowers. It is more difficult in the modern world, where lending decisions are centralized, to know customers personally. Face-to-face meetings with the potential borrower to assess the borrowers character are routine in evaluating willingness to pay. Name lending involves lending to an individual based on the perceived status of the individual in the business community. Some lenders substitute name lending for financial analysis. Extrapolating past performance into the future. Lenders often assume that a pattern of borrowing and repaying in the past (e.g., a credit record compiled from past history with the borrower and data garnered from credit bureaus) will continue in the future.
Historical lending norms relied on the moral obligation of borrowers who could pay to repay their debts. Thus, gauging the borrowers willingness to pay was a critical component of credit analysis. However, in modern society, the moral obligation to pay if one is capable of paying has been replaced by the legal obligation to pay. In other words, in terms of credit analysis, determining the capacity to pay is more important than determining the willingness to pay because the legal system will force those who can pay to honor their commitment. Courts can seize the assets of those who will not fulfill their financial obligations. In corrupt or ineffective states, a borrower will not suffer, even if able to pay but not doing so.
The willingness to pay is more important in countries with less-developed financial markets and legal systems. Creditors must evaluate the legal system and the strength of creditors rights in emerging markets, along with the prospective borrowers ability and willingness to repay the obligation. This is a qualitative endeavor. Sovereign risk ratings may be used to evaluate the quality of a countrys legal system and, by extension, the legal risk associated with the country or region. The lower the score, the greater the legal risk. For example, in 2010, Finland had a Rule of Law Index of 1.97, the United States had a rating of 1.58, Brazil had a rating of 0.0, and Somalia had a rating of 2.43. However, even in countries with robust legal systems such as Finland and the United States, the creditor must also consider the costs associated with taking legal action against a delinquent borrower. If costs are high, the creditor may be unwilling to take action regardless of the strength of the enforcement of creditor rights. As such, the willingness to pay should never be completely ignored in credit analysis.
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Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
The ability of a borrower to repay a loan is an objective attribute. Quantitative credit analysis techniques are largely used to evaluate the borrowers ability to repay The primary quantitative technique used in financial analysis is examining the past, current, and forecasted financial statements of the prospective borrower. This forms the core of the quantitative credit analysis used to determine a borrowers capacity to meet its financial obligations. There are limitations associated with quantitative data, which include:
Historical nature of the data. Financial data is typically historical and thus may not be up-to-date or representative of the future. Also, forecasted financial data is notoriously unreliable and susceptible to miscalculations and/or misrepresentations.
Difficult to make accurate projections using historical data. Financial statements
attempt to represent the economic reality of a firm in a highly abbreviated report. As such, some information is lost in translation that is critical to the loan decision. The rules guiding financial reporting are created by a diverse group with varying interests and are often decided by compromise. Also, firms are given discretion regarding what and how they report financial information, subject to established accounting rules. Firms may use the latitude in financial reporting to deceive interested parties. Even if the reports are accurate, financial data is subject to interpretation. There can be a range of conclusions drawn from the same data due to the variety of needs, perspectives, and experiences of the various analysts. This means there is a subjective, qualitative component to an objective, quantitative exercise.
Given the shortcomings of financial reporting, lenders should not ignore qualitative analysis. The quality of management, the motivation of the firms management, and the incentives of management are relevant for both nonfinancial and financial firms. Even quantitative analysis is subject to interpretation. In fact, many would argue that financial analysis is much more of an art than a science. Judgment is as important as the quantitative analysis supporting it. The most effective analysis combines quantitative assessments with qualitative judgments.
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