Corporate Credit Risk Analysis
Corporate Credit Risk Analysis denotes Credit Risk Analysis as it applies to medium-to-large sized enterprizes.
Institutions should assess the borrower’s current and future ability to meet the obligations under the loan agreement. Institutions should also analyse the loan application of the borrower in order to ensure that the application is in line with the institution’s credit risk appetite, policies, credit-granting criteria, limits and relevant metrics, as well as any relevant macroprudential measures, where applied by the designated macroprudential authority.
Institutions should consider that cash flow from the ordinary business activities of the borrower and, when applicable within the purpose of the loan agreement, any proceeds on the sale of the assets are the primary sources of repayment.
When assessing the creditworthiness of the borrower, institutions should put emphasis on the borrower’s realistic and sustainable future income and future cash flow, and not on available collateral. Collateral by itself should not be a predominant criterion for approving a loan and cannot by itself justify the approval of any loan agreement. Collateral should be considered the institution’s second way out in case of default or material deterioration of the risk profile, and not the primary source of repayment, with the exception of when the loan agreement envisages that the repayment of the loan is based on the sale of the property pledged as collateral or liquid collateral provided.
When carrying out the creditworthiness assessment, institutions should:
- analyse the financial position and credit risk of the borrower, as set out below;
- analyse the organisational structure, business model and strategy of the borrower, as set out below;
- determine and assess the borrower’s credit scoring or internal rating, where applicable, in accordance with the credit risk policies and procedures;
- consider all the borrower’s financial commitments, such as all drawn and undrawn committed facilities with institutions, including working capital facilities, credit exposures of the borrower and the past repayment behaviour of the borrower, as well as other obligations arising from tax or other public authorities or social security funds;
- assess the structure of the transaction, including the risk of structural subordination and related terms, e.g. covenants, and, if applicable, third-party guarantees and collateral structure.
Institutions should carry out the creditworthiness assessment in relation to the specificities of the loan, such as nature, maturity and interest rate.
Institutions should assess the borrower’s exposure to ESG factors, in particular environmental factors and the impact on climate change, and the appropriateness of the mitigating strategies, as set out by the borrower.
If the borrower is a member of a group of connected clients, institutions should carry out the assessment at individual level and, where relevant, at group level, in accordance with the EBA Guidelines on connected clients, especially when repayment is reliant on cash flow emanating from other connected parties.
If the borrower is a member of a group of connected clients linked to central banks and sovereigns, including central governments, regional and local authorities, and public sector entities, institutions should assess the individual entity.
For lending activities with cross-border elements (e.g. trade finance, export finance), institutions should take into account the political, economic and legal environment in which the foreign counterparty of the institution’s client operates. Institutions should assess the buyer’s potential to transfer funds, the supplier’s capacity to deliver the order, including its capacity to meet the applicable local legal requirements, and the supplier’s financial capacity to handle possible delays in transaction.
In order to identify borrowers that are exposed, directly or indirectly, to increased risks associated with ESG factors, institutions should consider using heat maps that highlight, for example, climate-related and environmental risks of individual economic (sub-)sectors in a chart or on a scaling system. For loans or borrowers associated with a higher ESG risk, a more intensive analysis of the actual business model of the borrower is required, including a review of current and projected greenhouse gas emissions, the market environment, supervisory ESG requirements for the companies under consideration and the likely impacts of ESG regulation on the borrower’s financial position.
Analysis of the borrower’s financial position
For the purposes of the analysis of the financial position within the creditworthiness assessment as specified above, institutions should consider the following:
- both the current and the projected financial position, including balance sheets and capital structure, working capital, income, cash flow and the source of repayment capacity to meet contractual obligations, e.g. debt-servicing capacity, including under possible adverse events (see also sensitivity analysis) – items to be analysed should include but not be limited to free cash flow available for debt servicing of the facility under consideration;
- net operating income and profitability, especially in relation to interest-carrying debt;
- the borrower’s leverage level, dividend distribution, and actual and projected capital expenditure, as well as its cash conversion cycle in relation to the facility under consideration;
- the exposure profile until maturity, in relation to potential market movements (e.g. exposures denominated in foreign currencies and exposures collateralised by repayment vehicles);
- where applicable, the probability of default, based on credit scoring or internal risk rating;
- the use of appropriate financial, asset class- or product type-specific metrics and indicators, in line with their credit risk appetite, policies and limits set out in accordance with Sections 4.2 and 4.3, including considering metrics in Annex 3 to an extent that is applicable and appropriate to the specific credit proposal.
Institutions should ensure that the projections used in the analysis are realistic and reasonable and are in line with the institutions’ economic and market expectations. When institutions have material concerns about the reliability of these financial projections, they should make their own projections of the borrowers’ financial position and, when relevant, use them to challenge the projections provided by the borrowers.
Institutions should also assess the borrower’s capacity for future profitability, to measure the impact of retained earnings and hence the impact on equity, particularly in cases where the borrower has been unable to generate positive profits over time.
Institutions should perform an assessment of the cash conversion cycle of the borrower, to measure the time it takes for the business to convert the investment in inventory and other resource inputs into cash through the sale of its specific goods and services. Institutions should be able to understand the cash conversion cycle of a borrower to estimate working capital needs and identify recurring costs, in order to assess the ongoing capacity to repay credit facilities over time.
Institutions should, when relevant, assess these financial metrics against the metrics and limits set out in their credit risk appetite, credit risk policies and limits, in accordance with Sections 4.2 and 4.3.
Institutions should assess the financial position when granting loans to holding companies, both as a separate entity, e.g. at consolidated level, and as a single entity, if the holding company is not itself an operating company or institutions do not have guarantees from the operating companies to the holding company.
Sensitivity analysis in creditworthiness assessment
Institutions should assess the sustainability and feasibility of the borrower’s financial position and the future repayment capacity under potential adverse conditions that may occur in the duration of the loan agreement. To this end, institutions should carry out a single- or multifactor sensitivity analysis, considering market and idiosyncratic events, or a combination of any of them.
This sensitivity analysis should account for all general and asset class and product-specific aspects that may have an impact on the creditworthiness of the borrower.
When carrying out a sensitivity analysis of the borrower’s repayment capacity under negative future conditions, institutions should take into account the following events that are most relevant to the specific circumstances and the business model of the borrower:
- a severe but plausible decline in a borrower’s revenues or profit margins;
- a severe but plausible operational loss event;
- the occurrence of severe but plausible management problems;
- the failures of significant trading partners, customers or suppliers;
- a severe but plausible reputational damage;
- a severe but plausible outflow of liquidity, changes in funding or an increase in a borrower’s balance sheet leverage;
- adverse movements in the price of assets to which the borrower is predominantly exposed (e.g. as raw material or end product) and foreign exchange risk;
- a severe but plausible macroeconomic downturn;
- a severe but plausible downturn in the economic sectors in which the borrower and its clients are operating;
- a significant change in political, regulatory and geographical risk;
- a severe but plausible increase in the cost of funding, e.g. an increase in the interest rate by 200 basis points on all credit facilities of the borrower.
Analysis of the borrower’s business model and strategy
Institutions should assess the business model and strategy of the borrowers, including in relation to the purpose of the loan.
Institutions should assess the borrower’s knowledge, experience and capacity to manage business activities, assets or investments linked to the loan agreements (e.g. specific property for the CRE loan).
Institutions should assess the feasibility of the business plan and associated financial projections, in line with the specificities of the sector in which the borrower operates.
Institutions should assess the borrower’s reliance on key contracts, customers or suppliers and how they affect cash flow generation, including any concentrations.
Assessment of guarantees and collateral
Institutions should assess any pledged collateral against the requirements for collateral set out in the institution’s credit risk appetite, policies and procedures, including the valuation and ownership, and check all relevant documentation (e.g. whether property is registered in appropriate registers).
Institutions should assess any guarantees, covenants, negative pledge clauses and debt service agreements that are used for the purposes of risk mitigation. Institutions should also consider if the value of the collateral is in some way correlated with the borrower’s business or capacity to generate cash flow.
Institutions should assess the borrower’s equity and credit enhancements, such as mortgage insurance, take-out commitments and repayment guarantees from external sources.
If a loan agreement involves any form of guarantees from third parties, institutions should assess the level of protection provided by the guarantee and, if relevant, conduct a creditworthiness assessment of the guarantor, applying the relevant provisions of these guidelines, depending on whether the guarantor is a natural person or an enterprise. The creditworthiness assessment of the guarantor should be proportionate to the size of the guarantee in relation to the loan and the type of guarantor.
If, in the syndicated lending or project finance transactions, the payment streams pass through a third party to the transactions, e.g. a designated agent, institutions (or mandated lead arrangers or their nominated agents) should assess the soundness of the agent. For cross- border lending and project finance transactions, the agent should be the sole issuer of any guarantees, letters of credit or similar documents issued on behalf of the supplier in the transaction.
- EBA, Guidelines on loan origination and monitoring EBA/GL/2020/06