LO 17.4: Assess the quality o f various sources o f information used by a credit

LO 17.4: Assess the quality o f various sources o f information used by a credit analyst.
Annual Report
Although there is likely bias on the part of management to present the entity in the most favorable way, the annual report does contain some useful information about culture, strategy, company performance, and economic outlook in the Management Discussion and Analysis (MD&A). Other information pertaining to regulation, such as changes to accounting or banking rules, may also be present in the annual report.
A uditors Report
The auditor of a banks financial statements is usually a major international accounting firm, and the staff on the audit engagement would possess specialized knowledge of the accounting rules pertaining to banks in order to successfully audit the bank in question.
The auditor provides an independent opinion on the banks financial statements. If an unqualified opinion (or clean opinion) is provided, then it means that the auditor accepts the financial statements prepared by management as meeting the minimum standards of presentation (i.e., no material misstatements). The opinion assumes that management has provided the auditors with accurate information. Because of the cost-benefit tradeoff of analyzing every single item, auditors utilize a sampling approach and/or focus on high-risk areas during the testing phase. As a result, the financial statements may not be perfect or 100% accurate, but they present a reasonable indication of the financial performance for the stated period (income statement) and financial condition at a given point in time (balance sheet). In addition, it is not the auditors responsibility to detect fraud committed by the
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audited bank. It is up to the analyst to verify that an unqualified opinion has been issued and to watch for any exceptions from the standard wording of an unqualified opinion.
Analysts should be cautious when a qualified opinion is issued. With a qualified opinion, the auditors are saying that the financial statements might not fairly represent the companys financial performance and condition. The wording will be clear in the final paragraph of the report, with the existence of the word except. Common reasons for a qualified opinion include (1) substantial doubt as to the banks ability to continue as a going concern, (2) a specific accounting treatment used by management is inconsistent with accounting rules, and (3) significant amounts of related-party transactions. It is up to the analyst to investigate and determine the exact nature of the qualification, its severity, and its impact on the analysts overall assessment.
Rarely will the auditors issue an adverse opinion where they state that the financial statements do not fairly present the banks financial performance and condition.
Sometimes there will be a change in auditors, and it is up to the analyst to inquire and determine if the change was valid. For example, sometimes management will dismiss its auditors because of a disagreement over one or more accounting treatments or the auditors unwillingness to provide an unqualified opinion. The analyst should generally look upon those situations unfavorably. Alternatively, it is sometimes mandatory in some countries for a change in auditors every few years because they may have developed a comfortable relationship with the audited entity, preventing them from demonstrating independence and objectivity. In such a situation, the change in auditors is valid.
Financial Statements Annual and Interim
The financial statements generally consist of the (1) balance sheet, (2) income statement, and (3) statement of cash flows. The balance sheet documents the net worth of the bank at a given point in time (e.g., year-end), and the income statement provides a quantification of performance over the period (e.g., net income for the year). The statement of cash flows is very useful for analyzing nonfinancial entities but not useful for bank credit analysis. An additional item, the statement of changes in capital funds, is useful for bank credit analysis (and regulatory purposes) because it explains changes in capital levels.
Supplementary footnotes to the financial statements may be included that provide more detail on specific items (e.g., off-balance sheet items such as leases and accounting policies).
Interim financial statements may be issued quarterly or semiannually, and they provide more timely financial information that would be useful to an analyst in making a current assessment of the bank.
Banks Website
On the banks website, the analyst is often able to find valuable information such as the annual report, financial statements, press releases, and background information. The quality, layout, and ease of accessibility of the website itself are often good indications of the stability of the bank.
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News, the Internet, Securities Pricing D ata
The analyst should check for any significant subsequent events (e.g., mergers, acquisitions, or new regulations) occurring after the corporate year-end that might not be covered in the annual report.
Proprietary electronic data services such as Bloomberg or a simple web search may provide necessary data on current bond and equity prices (especially for public listings or debt offerings).
Prospectuses and Regulatory Filings
Prospectuses and regulatory filings tend to minimize the discussion of the benefits of the investment and emphasize more of the potential risks so they could provide some useful information. Notably, prospectuses for equity and international debt issues may provide an effective resource.
Rating Agency Reports and Other Third-Party Research
As stated previously, counterparty credit analysts will find the rating agency reports most useful for their analysis. Other third party research includes investment reports from regulatory agencies and equity analysts.
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K e y C o n c e p t s
LO 17.1
Common credit analyst roles include consumer credit, credit modeling, corporate credit, counterparty credit, rating agency, fixed income, and bank examiner/supervisor. The roles are generally risk management in nature, although the fixed-income credit analyst focuses on investment selection. Primary and/or secondary research methods may be applied, and analysts could be analyzing nonfinancial entities, financial institutions, or sovereigns. Credit analysts are generally employed by banks, nonbank financial institutions, institutional investors, rating agencies, or government agencies.
LO 17.2
A counterparty credit analyst may perform risk evaluations of a given entity on a transaction-by-transaction basis or through an annual review. At times, the duties may extend into decision making (e.g., authorizing credit limits, suggesting guarantees and collateral, authorizing excesses). Additionally, there may be duties related to examining and amending the banks existing credit policies and compliance tasks related to Basel II and III.
Fixed-income and equity analysts provide recommendations whether to buy, sell, or hold securities. Both types of analysts use fundamental and/or technical analysis techniques. Fixed-income analysts focus on determining relative value while equity analysts focus on determining return on equity.
LO 17.3
As a fundamental skill, banking credit analysts should be able to read and interpret financial statements in order to perform ratio analysis. They should also have a reasonable background in statistical concepts, in order to properly process and analyze data, and in macroeconomics, in order to understand the given banks performance within the context of the overall economic environment. Additionally, significant judgment and skill in choosing relevant information to analyze is required in order to capture the important qualitative elements of any analysis.
LO 17.4
The annual report, auditors report, financial statements (annual and interim), banks website, internet, rating agency reports, other third-party research, prospectuses, and regulatory filings are some of the many available sources of information that may be used by a credit analyst. The annual report, together with financial statements, is the usual starting point for the analyst. For example, a counterparty credit analyst will rely heavily on rating agency reports.
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C o n c e p t C h e c k e r s
Richard Marshall, FRM, is a rating agency analyst who is currently performing financial statement analysis on a major bank. Which of the following financial statements would be least useful for bank credit analysis? A. Balance sheet. B. Income statement. C. Statement of cash flows. D. Statement of changes in capital funds.
Krista Skujins, FRM, is a bank credit analyst who is examining the financial statements of a bank. She notices that there is a paragraph noted in the auditors report that states that although the auditors agreed with virtually all of the banks accounting treatments of the financial statement items, the auditors did not agree with the banks decision to treat some of the leases as operating leases instead of capital leases. Based on that information, which of the following audit report opinions has the auditor most likely issued? A. Adverse opinion. B. Denial of opinion. C. Qualified opinion. D. Unqualified opinion.
Which of the following statements regarding a banking credit analysts skills is most likely correct? A. High earnings quality suggests that the bank is profitable. B. Peer analysis is facilitated by the standardized nature of financial performance
C. Although qualitative analytical skills are required, quantitative analytical skills
are more important.
D. In analyzing an unfamiliar banking sector, an analyst should start by performing
detailed reviews of the major banks.
Which of the following types of credit analysts would most likely be performing fundamental and/or technical analysis on a day-to-day basis? A. Equity analyst only. B. Fixed-income analyst only. C. Counterparty analyst and equity analyst. D. Equity analyst and fixed-income analyst.
Which of the following statements regarding the role of a corporate credit analyst is most likely correct? A. Earnings analysis is by far the most important analyst task. B. The larger the size of the firm, the lower the cost of analysis. C. Analysts are generally required to cover multiple industry areas given the huge
diversity among corporations.
D. The smaller the firm, the lower the cost of analysis.
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C o n c e p t C h e c k e r An s w e r s
1. C Although the statement of cash flows is most useful for analyzing nonfinancial entities (uses of cash and sources of cash differentiated between operating, investing, and financing), it is not useful for bank credit analysis.
2. C This situation is one where a specific accounting treatment used by the banks management is inconsistent with the accounting rules. It is an isolated instance and so a qualified opinion would most likely be issued.
3. B Peer analysis refers to the comparison (financial and creditworthiness) of a subject bank to
similar banks and financial institutions.
High earnings quality does not necessarily mean a bank is profitable. Earnings quality refers to the reliability and consistency of the reported earnings.
Quantitative and qualitative analytical skills are equally important and serve different (but related) purposes; qualitative skills are necessary to assist in determining the willingness of an entity to repay debt while quantitative skills are necessary to assist in determining the ability of an entity to repay debt.
In analyzing an unfamiliar banking sector, the analyst should start with preliminary research on the overall structure, characteristics, and nature of regulation. After that, a detailed review of the largest (followed by smaller) banks could be performed.
4. D Both fixed-income analysis and equity analysis can be divided into two broad approaches:
fundamental and technical analysis. Those approaches are valid because both types of analysts have the objective to earn profits for their respective employers and/or clients. In contrast, counterparty credit analysts are not likely to use either approach and are more focused on performing risk evaluations and possibly making some decisions on granting credit.
5. B With a large public company, there may be a lot of publicly available information that would only necessitate secondary research, thereby reducing costs. With a smaller private company, less information is likely available, and, as a result, more due diligence and primary research would be required, thereby increasing costs.
Although the basic analytical principles are the same, there is huge diversity in the business sectors, products, size, and geographic locations of the firms being analyzed. As a result, the corporate credit analyst must possess specific industry knowledge in order to be effective. An analyst will most likely focus on only one or two industry areas.
Corporate credit analysts specifically analyze firms that are NOT financial institutions.
Cash flow analysis, not earnings analysis, is key to assessing corporate credit risk.
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The following is a review of the Credit Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
C l a s s i f i c a t i o n s a n d K e y C o n c e p t s o f C r e d i t R i s k
Topic 18
E x a m F o c u s
In this topic, we look at the various classifications of credit risk, how to measure individual and portfolio credit risks, and how to apply risk-adjusted pricing when making credit decisions. For the exam, be able to distinguish between default-mode valuations (default, recovery, and exposure risks) and value-based valuations (migration, spread, and liquidity risks). Also, understand the differences between expected and unexpected losses, since they have materially different implications on risk expectations and measurement. Value at risk (VaR), marginal VaR, and concentration risks are important measures of unexpected losses. Finally, understand risk-adjlisted pricing, and be ready to interpret and calculate risk-adjusted return on risk-adjusted capital.
T h e R o l e o f C r e d i t R a t i n g s