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Credit Analysis Frameworks Should Be Changed To Incorporate COVID-19 Uncertainties And Risks

The severity and uncertainty surrounding COVID-19 globally should compel any credit professional to change existing corporate credit risk management frameworks. For decades, credit risk managers, credit analysts and underwriters analyzing companies have been trained to think like credit ratings analysts when creating and using corporate credit analysis frameworks to determine a corporate borrower’s credit quality.

What is a corporate credit analysis framework? In a very abbreviated manner credit and ratings analysts develop frameworks that incorporate qualitative and quantitative information that they need to quantify what the probability of default of a borrower is and how severe their losses would be if a borrower defaulted. Credit analysis is typically top-down. That is, credit analysts start by analyzing country and economic risk factors that can impact a relevant industry. They analyze the balance sheet, income statement, and cash flow statement of a company in that industry. They compare and contrast important asset quality, liquidity, earnings, and capital ratios of companies. They use the aforementioned information to score a company, and that score is used to determine the loan terms, such as amount to lend to a borrower, for what length of time, the level of interest rate, payment structure, and what covenants, requirements that the borrow must comply with.

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The uncertainty surrounding the trajectory of COVID-19 cases and deaths means that credit analysts and risk managers need to hurry up eliminating, or at least reducing, having a silo mentality about risks. That is lenders, have to develop corporate credit frameworks that include an analysis of other risks that impact companies’ profitability and liquidity, especially operational risk. Operational risk is the potential financial loss at a company or organization that can happen due to problems with people, processes, technology, and external events.

People: Credit analysts should be thinking of the role that human resources divisions play at companies and the professional talent in those groups.  Human Resources will have to be elevated at most companies to play a more important and visible role in companies. Those professionals are the ones that are already dealing with employees’ health, anxieties, behavioral problems and overall well-being, all factors that will impact company performance. It is very likely that more and more companies will have to consider having a health or medical professional on staff.

A company that is not establishing well-written and communicated protocols to cope with the effects of COVID-19 could eventually incur a decrease or depletion in earnings if employees are falling ill, or worse, and hence not performing their duties. Moreover, companies could also be affected by reputation risk if word reaches the media that they are not being provided with personal protection equipment or being allowed to work from home to reduce exposure.

Processes: Any lender should evaluate how companies are changing human resource, production, manufacturing, and service providing processes to cope with COVID-19. This global crisis has caused or exacerbated supply disruptions, bankruptcies, and social unrest. Company managers cannot operate as they did yesterday. As a credit analyst, I would want to know if the company that I am analyzing has well-written and logical succession plans in the event that key executives are impacted by COVID-19.

Technology/Systems: Credit analysts should evaluate companies’ policies and procedures on cyber and data security for the use technology at the company and remotely. Are companies’ management investing more in their systems to reduce cyberattacks and hacks? I would want to know what security protocols companies have for employees when they are accessing company data bases or trading systems from home. Additionally, with employees using a wide range of conferencing platforms, credit analysts should learn how much borrowers are spending on these platforms and how they are securing them to avoid identity or data theft.

External Events: In the context of operational risk, external events encompass threats outside of a firm that can hurt its day-to-day operations and profits. Important examples of external events are public health crises, natural disasters, vendor risk management, fraud, ransomware attacks, data theft, insider trading, litigation and unexpected changes in laws and regulations. Any one of those external events materializing unexpectedly could seriously hurt companies’ earnings and liquidity and hence their ability to repay loans and bonds. Credit analysts need to be thinking not only how COVID-19 is currently impacting companies but also about how those companies’ management is thinking of its operating processes for when future unknown diseases come their way. Additionally, as companies use more and more electronic payment services, credit analysts need to think of how these companies secure their systems to minimize the threat of external fraud and data theft.

Credit risk managers need to update their existing corporate credit frameworks to make operational risk an important part of how they will score corporate borrowers for purposes of underwriting their loans. Just like company managers cannot behave and think like they did before the COVID-19 crisis, neither can anyone who is extending credit to companies.

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