A robust credit assessment distinguishes between obligor/borrower risk, business (operating) risk, and financial risk, then evaluates how these risks interact across industry, entity, and portfolio levels. This integrated view helps align underwriting with risk appetite, price loans for risk, and anticipate early warning signals.
Obligor/borrower risk
Obligor risk refers to the borrower’s overall capacity and willingness to meet obligations, independent of a specific facility’s structure. It synthesizes qualitative and quantitative factors into a through-the-cycle view of default probability.
- Core lenses: management quality, governance and compliance record, competitive positioning, track record of honoring obligations, and transparency of disclosures.
- Quantitative anchors: profitability durability, cash flow adequacy, leverage and coverage metrics, working capital discipline, and resilience under stress scenarios.
- Outcome: an internal obligor rating or grade used for limits, pricing grids, and monitoring intensity.
Business (operating) risk
Business risk captures the volatility inherent in the borrower’s operations before financing effects. It answers how predictable and defensible the underlying business model is.
- Drivers: industry structure (entry barriers, concentration, substitutes), demand cyclicality, cost structure and operating leverage, supply chain dependence, pricing power, and customer concentration.
- Operational robustness: process reliability, quality control, regulatory compliance in operations, cyber and data risks, and business continuity preparedness.
- Implication: higher business risk raises earnings volatility and increases required risk premium and covenants.
Financial risk
Financial risk assesses how the capital structure and liquidity profile amplify or cushion business variability.
- Capital structure: leverage levels, debt maturity ladder, fixed vs floating mix, and structural subordination.
- Coverage and liquidity: interest and fixed-charge coverage, free cash flow consistency, cash buffers, committed lines headroom, and refinancing flexibility.
- Financial policy: dividend/buyback stance, acquisition appetite, risk management (hedging), and covenant headroom.
- Implication: aggressive leverage or weak liquidity can convert moderate business shocks into default risk.
Interaction: business vs financial risk
The same leverage level can be safe in a stable, high-margin business but hazardous in a cyclical, low-margin one. Assess the interaction explicitly:
- High business risk + high financial risk: fragile profile; require lower leverage, tighter covenants, higher pricing, or enhanced collateral.
- High business risk + low financial risk: equity-cushioned model; monitor operating KPIs and stress paths.
- Low business risk + high financial risk: refinancing and liquidity-focused mitigants (tenor alignment, amortization, liquidity covenants).
- Low business risk + low financial risk: prime credits; pricing and documentation can be calibrated for competitiveness with prudent protections.
Different risk levels
Define consistent rating anchors to map risk levels to actions:
- Investment-grade equivalent: diversified operations, stable cash flows, prudent leverage, strong governance; higher limits, leaner covenants, sharper pricing.
- Crossover: some cyclicality or concentration; moderate leverage; targeted covenants; scenario-based sizing.
- Non-investment grade: elevated volatility or leverage; tighter structures, collateral, amortization, and monitoring cadence.
- Special mention/watch: emerging stress signs; curtail incremental exposure, enhance reporting, activate covenants and action plans.
Sources of external risk
External risk vectors can impair obligor performance even when internal execution is sound.
- Macroeconomic: growth slowdowns, inflation spikes, interest rate shocks, currency volatility.
- Regulatory/policy: industry-specific rules, taxation, environmental norms, trade restrictions, licensing.
- Geopolitical and supply chain: sanctions, logistics disruptions, commodity price shocks, concentration of critical suppliers.
- Environmental and climate: acute events (floods, heatwaves) and transition risks (carbon pricing, technology shifts).
- Technology and cyber: data breaches, outages, obsolescence, and integration risks from rapid digitization.
Industry risk analysis
An industry lens provides the baseline risk premium and informs cycle-aware lending.
- Structure and economics: five-forces intensity, operating margins, ROCE vs cost of capital, capital intensity.
- Cyclicality and sensitivities: demand drivers, inventory dynamics, exposure to rates, FX, and commodities.
- Regulatory posture: compliance burden, licensing, consumer protection scrutiny, and ESG trajectory.
- Disruption vectors: technological substitution, platforms vs incumbents, winner-take-most dynamics.
- Benchmarking: median leverage/coverage, failure rates in downturns, and historical recovery rates for lending structures.
Entity-level risk
Translate industry context into borrower-specific differentiation.
- Competitive moat: cost advantage, brand, IP, switching costs, distribution reach.
- Concentrations: top customers/suppliers, geographic and product concentration.
- Execution quality: project delivery, capex governance, integration of acquisitions, and operational KPIs.
- Governance and control environment: board independence, audit quality, related-party discipline, and risk culture.
- Data quality and timeliness: forecast realism, management MIS cadence, variance analysis.
Deep dive on financial risk
Standardize the quantitative toolkit and interpret in context.
- Profitability resilience: gross/EBITDA margins variability, operating leverage, break-even analysis.
- Cash flow: conversion of EBITDA to operating cash flow, working capital cycles, seasonality, maintenance vs growth capex.
- Leverage and coverage: net debt/EBITDA, debt/EBIT, interest coverage, fixed-charge coverage; adjust for leases and off-balance exposures.
- Liquidity runway: cash + undrawn committed lines vs 12–18 months of uses; covenant cushions and springing triggers.
- Debt structure: amortizing vs bullet risk, covenant-lite exposure, secured vs unsecured mix, intercreditor position.
- Stress testing: apply revenue, margin, rate, and FX shocks; assess covenant breach and liquidity shortfall probabilities.
Practical assessment framework (for credit memos)
- Risk summary: obligor rating rationale, key strengths/weaknesses, and top three external risks.
- Business risk: industry cycle map, demand drivers, operating leverage, concentration analysis, operational resilience.
- Financial risk: base and stress-case metrics, liquidity coverage, debt maturity profile, and covenant headroom.
- Interaction view: matrix of business vs financial risk with mitigants (structure, pricing, covenants, collateral, guarantees).
- Decision enablers: risk-based pricing output, maximum exposure and tenor, monitoring plan and early warning indicators.
Risk mitigation levers
- Structure: amortization, cash sweeps, DSRA, covenants, security, guarantees, intercreditor protections.
- Diversification: customer, product, and geography thresholds embedded in action plans.
- Hedging: interest rate, FX, and commodity risk aligned with policy and accounting implications.
- Information rights: enhanced reporting, site visits, auditor interactions, and KPI triggers.
- Relationship strategy: cross-sell of risk-reducing services (trade, cash management, hedging) that improve visibility and control.
Risk Management Articles related to Model ‘B’ of CAIIB –Elective paper:
