Ch02 Credit History.docx

CREDIT HISTORY Credit history or credit report is, in many countries, a record of an individual’s or company’s pastborrowing and repaying, including information about late payments and bankruptcy. The term "creditreputation" can either be used synonymous tocredit historyor tocredit score. When a customer fills out an application for credit from a bank, store or credit card Company, their information is forwarded to a credit bureau, along with constant updates on the status of their credit accounts, address or any other changes made since the last time they applied for any credit. This information is used by lenders such as credit card companies to determine an individual's or entity's credit worthiness; that is, determining an individual's or entity's means and willingness to repay an indebtedness. This helps determine whether to extend credit, and on what terms. With the adoption of risk-based pricing on almost all lending in the financial services industry, this report has become even more important since it is usually the sole element used to choose the annual percentage rate How credit rating is determined Credit ratings are determined differently in each country, but the factors are similar, and may include: Payment record - a record of bills being overdue will lower the credit rating. Control of debt - Lenders want to see that borrowers are not living beyond their means. Experts estimate that non-mortgage credit payments each month should not exceed more than 15 percent of the borrower's after tax income. Signs of responsibility and stability - Lenders perceive things such as longevity in the borrower's home and job (at least two years) as signs of stability. Having a respected profession can improve a credit rating. Credit inquiries – An inquiry is a notation on a credit history file. There are several kinds of notations that may or may not have an adverse effect on the credit score. Soft pulls don't affect the credit score and are characteristic of the following examples: A credit bureau may sell a person's contact information to an advertiser purchasing a list of people with similar characteristics, like homeowners with excellent credit. A creditor can check a person's credit periodically. Or, a credit counseling agency, with the client's permission, can obtain a client's credit report with no adverse action. Each of the preceding examples is commonly referred to as a "soft" credit pull. However "hard" credit inquiries are made by lenders. Lenders, when granted a permissible purpose by a borrower for the purposes of extending his credit, can check his credit history. Hard inquiries from lenders directly affect the borrower's credit score. Keeping credit inquiries to a minimum can help a person's credit rating. A lender may perceive many inquiries on a person's report as a signal that the person is looking for loans and will possibly consider that person a poor credit risk. Understanding credit reports and scores The information in a credit report is sold by credit agencies to organizations that are considering whether to offer credit to individuals or companies. It is also available to other entities with a "permissible purpose." The consequence of a negative credit rating is typically a reduction in the likelihood that a lender will approve an application for credit under favorable terms, if at all. Interest rates on loans are significantly affected by credit history—the higher the credit rating, the lower the interest while the lower the credit rating, the higher the interest. The increased interest is used to offset the higher rate of default within the low credit rating group of individuals. International issues Credit history is typically local to one country. Even within the same credit card network information is not shared for different countries. For example, a person who has been using Visa credit cards issued by banks in China or Canada for many years who moves to the United States and immediately applies for a Visa will not be approved because of lack of credit history. An immigrant must establish a credit history from scratch in the new country, which can take years. New immigrants are forced to seek loans from irregular channels, which can create social problems. Adverse credit history also called sub-prime credit history, non-status credit history, impaired credit history, poor credit history, and bad credit history, is a negative credit rating. A negativecredit rating is often considered undesirable to lenders and other extenders of credit for the purposes of loaning money or capital. Adverse Credit A consumer or business' credit history is regularly tracked by credit rating agencies. The data reported by these agencies is primarily provided to them by creditors and includes detailed records of the relationship a person or business has with the lender. Detailed account information, including payment history, credit limits, high and low balances, and any aggressive actions taken to recover overdue debts, are all reported regularly (usually monthly). This information can be quite detailed and arduous to navigate by a potential lender dealing with a new applicant. To address this issue, credit scoring was invented. Credit scores allege to assess the likelihood that a borrower will repay a loan or other credit obligation. The higher the score, the better the credit history and the higher the probability that the loan will be repaid on time; this theory purports. When creditors report an excessive number of late payments, or trouble with collecting payments, a "hit" on the score is suffered. Similarly, when adverse judgments and collection agency activity are reported, even bigger "hits" on this score are suffered. Repeated hits can lower the score and trigger what is called a negative credit rating or adverse credit history. CREDIT RATING A credit rating assesses the credit worthiness of an individual, corporation, or even a country. Credit ratings are calculated from financial history and current assets and liabilities. Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. However, in recent years, credit ratings have also been used to adjust insurance premiums, determine employment eligibility, and establish the amount of a utility or leasing deposit. A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to high interest rates or the refusal of a loan by the creditor. Personal credit ratings In countries such as the United States, an individual's credit history is compiled and maintained by companies called credit bureaus. In the United States, credit worthiness is usually determined through a statistical analysis of the available credit data. A common form of this analysis is a 3-digit credit score provided by independent financial service companies such as the FICO credit score. (The term, a registered trademark, comes from Fair Isaac Corporation, which pioneered the credit rating concept in the late 1950s.) An individual's credit score, along with his or her credit report, affects his or her ability to borrow money through financial institutions such as banks. The factors which may influence a person's credit rating are ability to pay a loan interest amount of credit used saving patterns spending patterns debt Corporate credit ratings The credit rating of a corporation is a financial indicator to potential investors of debt securities such as bonds. These are assigned by credit rating agencies such as Standard & Poor's or Fitch Ratings and have letter designations such as AAA, B, and CC. Sovereign credit ratings A sovereign credit rating is the credit rating of a sovereign entity, i.e. a country. The sovereign credit rating indicates the risk level of the investing environment of a country and is used by investors looking to invest abroad. It takes political risk into account. Short term rating A short term rating is a probability factor of an individual going into default within a year. This is in contrast to long-term rating which is evaluated over a long timeframe. Credit rating agencies •Credit scores for individuals are assigned by credit bureaus (US; UK: credit reference agencies). Credit ratings for corporations and sovereign debt are assigned by credit rating agencies. •In the United States, the main credit bureaus are Experian, Equifax, and TransUnion. A relatively new credit bureau in the US is Innovis. •In the United Kingdom, the main credit reference agencies for individuals are Experian, Equifax, and Callcredit. •In Canada, the main credit bureaus for individuals are Equifax, TransUnion and Northern Credit Bureaus/ Experian. Credit Information Bureau & State Bank of Kenya •The bureau is a repository of credit information of borrowers. The member lending institutions provide credit data (personal and loan information) of their borrowers to the bureau which consolidates, updates, and stores the same and provides this information to its members FIs in the form of credit worthiness reports (CWR). •The Credit Information Bureau also aid financial institutions to make well informed credit decisions in timely manners minimizing the credit risk. •The Credit Information Bureau (CIB) is a public sector credit bureau of Kenya. It was established in 1992 by the State Bank of Kenya (SBP) under Section 25(A) of Banking Companies Ordinance-1962. •The CIB is a part of Banking Surveillance Department of the State Bank of Kenya. All fund and non-fund base credit facilities irrespective of any outstanding amount are being reported to the CIB. Reporting to the CIB is mandatory for all member financial institutions (FIs). •There are three privately owned credit bureaus in Kenya: Data check, News-VIS Credit Information Systems and ICIL/ Pak Biz Info. •The CIB gets information on borrowers from all the member financial institutions. •All Banks, Development Financial Institutions (DFIs), Non- Bank Financial Institutions (NBFIs), Modarabas and Micro Finance Banks operating in Kenya are members of the CIB. Only the financial institutions operating in Kenya are entitled to become member of the CIB. The membership with CIB, as per instructions of SBP and SECP, is mandatory for all Banks/DFIs and NBFCs respectively. No financial institution can access the CIB database without having its membership. What is Credit Worthiness Report (CWR)? A credit worthiness report (CWR) is a factual statement of the borrowers’ credit position, on a certain date, compiled on the basis of information received from the member financial institutions. The CWR contains certain financial and non-financial information on borrowers. The CWR only shows the total liabilities (both fund & non-fund based) but does not reflect the names of lending financial institutions. What is not included in CWR? A CWR does not include race, income, religion, political affiliation, ethnic background, medical history, private affairs details, bank deposit accounts details or other information not related to credit. What is the definition of “consumer” and “corporate” for CIB reporting purposes? For CIB reporting purposes, credit data of individuals and sole-proprietorships is reported under consumer category whereas credit data of all other business concerns like partnerships, private limited companies, public limited companies and corporations etc. is reported under corporate category. Can a borrower prevent the CIB from having his/her information? No. The CIB is legally empowered to collect credit information. The member financial institutions are bound to share their credit information with the CIB. Is any financial institution allowed to access a credit worthiness report (CWR) of a person who is not its customer? Yes. The financial institutions are allowed to access the credit worthiness report (CWR) of any person in the CIB database even if he or she is not its customer. This arrangement is necessary in order to enable the financial institutions to have the CWR of their prospective customer. Why has the CIB placed my name as defaulter? The CIB does not name any borrower as a defaulter at its own. The concerned FIs have reported your name as a defaulter to the CIB. If you want to make correction in the CIB record, please contact the reporting institution. How the negative credit worthiness report (CWR) can be improved? The negative CIB report may be due to some outstanding liabilities of financial institutions that were either not paid or paid after due date. You should discuss the matter with your lending financial institutions and work out a repayment/settlement plan with them. Once your loan account is regular, your credit worthiness report (CWR) will reflect the improved position. How groups are formed and group liabilities determined? The responsibility of formation of group and consequent group liabilities rests with the reporting financial institutions in line with the definition of group and the criteria laid down vide Prudential Regulation for Corporate Commercial Banking. OPERATIONAL REQUIREMENTS FOR GUARANTEES In order for a guarantee to be recognized, the following conditions must be satisfied: on the qualifying default/non-payment of the obligor, the lender may in a timely manner pursue the guarantor for monies outstanding under the loan, rather than having to continue to pursue the obligor. The act of the guarantor making a payment under the guarantee grants the guarantor the right to pursue the obligor for monies outstanding under the loan; the guarantee is an explicitly documented obligation assumed by the guarantor; for the proportion of the exposure covered, the guarantor covers all payments the underlying obligor is expected to make under the loan/exposure, notional amount etc; and the guarantee must be legally enforceable in all relevant jurisdictions. Operational Requirements for Credit Derivatives In order for protection from a credit derivative to be recognized, the following conditions must be satisfied: The credit events specified by the contracting parties must at a minimum include: failure to pay the amounts due according to reference asset specified in the contract; a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals; a reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates; a change in the ranking in the priority of payment of any obligation, causing the subordination of such obligation. Contracts allowing for cash settlement are recognized for capital purposes insofar as a robust valuation process is in place in order to estimate loss reliably. There must also be a clearly specified period for obtaining post-credit-event valuations of the reference asset, typically no more than 30 days. The credit protection must be legally enforceable in all relevant jurisdictions; Default events must be triggered by any material event, e.g. failure to make payment over a certain period or filing for bankruptcy or protection from creditors; The grace period in the credit derivative contract must not be longer than the grace period agreed upon under the loan agreement; The protection purchaser must have the right/ability to transfer the underlying exposure to protection provider, if required for settlement; The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection provider of the occurrence of a credit event; Only credit default swaps and total return swaps that provide credit protection equivalent to guarantees will be eligible for recognition. The following exception applies. Where a bank buying credit protection through a total return swap records the net payments received on the swap as net income, but does not record offsetting deterioration in the value of the asset that is protected (either through reductions in fair value or by an addition to reserves) the credit protection will not be recognized. Other types of credit derivatives will not be eligible for this treatment at this time. Further work is expected in this area. Sovereign Guarantees As described in pervious LECTUREs, a lower risk weight may be applied at national discretion to banks. Exposures to the sovereign (or central bank) of incorporation denominated in domestic currency and funded in that currency. National authorities may extend this treatment to portions of claims guaranteed by the sovereign (or central bank), where the guarantee is denominated in domestic currency and the exposure is funded in that currency. Maturity Mismatches A maturity mismatch occurs when the residual maturity of a hedge is less than that of the underlying exposure. There may be sound economic reasons for acquiring a hedge with a maturity mismatch. For example, a bank may have only a short-term concern in respect of the credit quality of a particular counterparty. Therefore, it may seek to hedge only the front-end credit risk i.e. the counterparty risk in the first year or so of the exposure. The Committee does not wish to discourage such partial hedging but seeks to adopt a prudent approach to the maturity risks arising. Currency Mismatches Where the credit exposure is denominated in a currency that differs from that in which the underlying exposure is denominated, there is a currency mismatch. This currency mismatch is a contingent risk: for a bank to suffer loss, the borrower must fail to pay and the exchange rates must move adversely. This contingent risk should be distinguished from outright FX risk. Collateral / On-Balance Sheet Netting A bank must disclose gross exposures, the amount of exposure secured by collateral and netted by on-balance sheet netting contracts, and risk-weighted assets excluding and including the effects of collateral/on-balance sheet netting. These aggregate values must be split into risk weight bucket/internal risk grade. A bank must disclose the methodologies used (i.e. simple/comprehensive, standard supervisory/own estimate haircuts). A bank must describe its overall strategy and process for managing collateral including, in particular, the monitoring of collateral value over time. Key internal policies for the recognition of collateral, including, for example, the ratio of underlying exposure to collateral (i.e. LTV ratio) and maturity mismatches, must also be broadly described. A bank must disclose the amount of exposure covered by guarantees/credit derivatives and risk weighted assets excluding and including the effects of guarantees/credit derivatives. These values must be disclosed by risk weight bucket/internal risk grade and by type of guarantor/protection provider. A bank must provide information on its strategy and process for monitoring the continuing credit worthiness of protection providers and administering the guarantees and credit derivatives along the lines required for collateralized transactions. Credit Risk: The Internal Ratings-Based Approach Banks must apply the securitization framework for determining regulatory capital requirements on exposures arising from traditional and synthetic securitizations or similar structures that contain features common to both. Since securitizations may be structured in many different ways, the capital treatment of a securitization exposure must be determined on the basis of its economic substance rather than its legal form. Similarly, supervisors will look to the economic substance of a transaction to determine whether it should be subject to the securitization framework for purposes of determining regulatory capital. Banks are encouraged to consult with their national supervisors when there is uncertainty about whether a given transaction should be considered a securitization. For example, transactions involving cash flows from real estate (e.g. rents) may be considered specialized lending exposures, if warranted. A traditional securitization is a structure where the cash flow from an underlying pool of exposures is used to service at least two different stratified risk positions or tranches reflecting different degrees of credit risk. Payments to the investors depend upon the performance of the specified underlying exposures, as opposed to being derived from an obligation of the entity originating those exposures. The stratified / tranched structures that characterize securitizations differ from ordinary senior/subordinated debt instruments in that junior securitization tranches can absorb losses without interrupting contractual payments to more senior tranches, whereas subordination in a senior/subordinated debt structure is a matter of priority of rights to the proceeds of liquidation. A synthetic securitization is a structure with at least two different stratified risk positions or tranches that reflect different degrees of credit risk where credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of funded (e.g. credit-linked notes) or unfunded (e.g. credit default swaps) credit derivatives or guarantees that serve to hedge the credit risk of the portfolio. Accordingly, the investors’ potential risk is dependent upon the performance of the underlying pool. CREDIT RISK: THE INTERNAL RATINGS-BASED APPROACH Banks’ exposures to a securitization are hereafter referred to as “securitization exposures”. Securitization exposures can include but are not restricted to the following: asset-backed securities, mortgage-backed securities, credit enhancements, liquidity facilities, interest rate or currency swaps, credit derivatives and tranched cover as described in Basel Accord. Reserve accounts, such as cash collateral accounts, recorded as an asset by the originating bank must also be treated as securitization exposures. Underlying instruments in the pool being securitized may include but are not restricted to the following: loans, commitments, asset-backed and mortgage-backed securities, corporate bonds, equity securities, and private equity investments. The underlying pool may include one or more exposures. Definitions & General Terminology Originating bank For risk-based capital purposes, a bank is considered to be an originator with regard to a certain securitization if it meets either of the following conditions: The bank originates directly or indirectly underlying exposures included in the securitization; or The bank serves as a sponsor of an asset-backed commercial paper (ABCP) conduit or similar program that acquires exposures from third-party entities. In the context of such programs, a bank would generally be considered a sponsor and, in turn, an originator if it, in fact or in substance, manages or advises the program, places securities into the market, or provides liquidity and/or credit enhancements. Asset-Backed Commercial Paper An asset-backed commercial paper (ABCP) program predominately issues commercial paper with an original maturity of one year or less that is backed by assets or other exposures held in a bankruptcy-remote, special purpose entity. Clean-up call A clean-up call is an option that permits the securitization exposures (e.g. asset backed securities) to be called before all of the underlying exposures or securitization exposures have been repaid. In the case of traditional securitizations, this is generally accomplished by repurchasing the remaining securitization exposures once the pool balance or outstanding securities have fallen below some specified level. In the case of a synthetic transaction, the clean-up call may take the form of a clause that extinguishes the credit protection. Credit Enhancement A credit enhancement is a contractual arrangement in which the bank retains or assumes a securitization exposure and, in substance, provides some degree of added protection to other parties to the transaction. Credit-enhancing interest-only strip credit-enhancing interest-only strip (I/O) is an on-balance sheet asset that: represents a valuation of cash flows related to future margin income, and is subordinated. Early Amortization Early amortization provisions are mechanisms that, once triggered, allow investors to be paid out prior to the originally stated maturity of the securities issued. For risk-based capital purposes, an early amortization provision will be considered either controlled or non-controlled. A controlled early amortization provision must meet all of the following conditions. The bank must have an appropriate capital/liquidity plan in place to ensure that it has sufficient capital and liquidity available in the event of an early amortization Throughout the duration of the transaction, including the amortization period, there is the same pro rata sharing of interest, principal, expenses, losses and recoveries based on the bank’s and investors’ relative shares of the receivables outstanding at the beginning of each month. The bank must set a period for amortization that would be sufficient for at least 90% of the total debt outstanding at the beginning of the early amortization period to have been repaid or recognized as in default; and The pace of repayment should not be any more rapid than would be allowed by straight-line amortization over the period set out in criterion (3). An early amortization provision that does not satisfy the conditions for a controlled early amortization provision will be treated as a non-controlled early amortization provision. Excess Spread Excess spread is generally defined as gross finance charge collections and other income received by the trust or special purpose entity (SPE, specified in Basel II) minus certificate interest, servicing fees, charge-offs, and other senior trust or SPE expenses. Implicit Support Implicit support arises when a bank provides support to a securitization in excess of its predetermined contractual obligation. Special purpose entity (SPE) An SPE is a corporation, trust, or other entity organized for a specific purpose, the activities of which are limited to those appropriate to accomplish the purpose of the SPE, and the structure of which is intended to isolate the SPE from the credit risk of an originator or seller of exposures. SPEs are commonly used as financing vehicles in which exposures are sold to a trust or similar entity in exchange for cash or other assets funded by debt issued by the trust. Operational requirements for traditional securitizations An originating bank may exclude securitized exposures from the calculation of risk weighted assets only if all of the following conditions have been met. Banks meeting these conditions must still hold regulatory capital against any securitization exposures they retain. Significant credit risk associated with the securitized exposures has been transferred to third parties. The transferor does not maintain effective or indirect control over the transferred exposures. The assets are legally isolated from the transferor in such a way (e.g. through the sale of assets or through sub participation) that the exposures are put beyond the reach of the transferor and its creditors, even in bankruptcy or receivership. These conditions must be supported by an opinion provided by a qualified legal counsel. The transferor is deemed to have maintained effective control over the transferred credit risk exposures if it: is able to repurchase from the transferee the previously transferred exposures in order to realize their benefits; or is obligated to retain the risk of the transferred exposures. The transferor’s retention of servicing rights to the exposures will not necessarily constitute indirect control of the exposures. The securities issued are not obligations of the transferor. Thus, investors who purchase the securities only have claim to the underlying pool of exposures. The transferee is an SPE and the holders of the beneficial interests in that entity have the right to pledge or exchange them without restriction. Clean-up calls must satisfy the conditions. The securitization does not contain clauses that require the originating bank to alter systematically the underlying exposures such that the pool’s weighted average credit quality is improved unless this is achieved by selling assets to independent and unaffiliated third parties at market prices; allow for increases in a retained first loss position or credit enhancement provided by the originating bank after the transaction’s inception; or increase the yield payable to parties other than the originating bank, such as investors and third-party providers of credit enhancements, in response to deterioration in the credit quality of the underlying pool. Operational requirements for synthetic securitizations For synthetic securitizations, the use of CRM techniques (i.e. collateral, guarantees and credit derivatives) for hedging the underlying exposure may be recognized for risk-based capital purposes only if the conditions outlined following are satisfied: Credit risk mitigate must comply with the requirements as set out in Basel II Section II-D of this Framework. Eligible collateral is limited to that specified in Basel II paragraphs 145 and 146. Eligible collateral pledged by SPEs may be recognized. Eligible guarantors are defined in paragraph 195. Banks may not recognize SPEs as eligible guarantors in the securitization framework. Banks must transfer significant credit risk associated with the underlying exposure to third parties. The instruments used to transfer credit risk may not contain terms or conditions that limit the amount of credit risk transferred, such as those provided following: Clauses that materially limit the credit protection or credit risk transference (e.g. significant materiality thresholds below which credit protection is deemed not to be triggered even if a credit event occurs or those that allow for the termination of the protection due to deterioration in the credit quality of the underlying exposures); Clauses that require the originating bank to alter the underlying exposures to improve the pool’s weighted average credit quality; Clauses that increase the banks’ cost of credit protection in response to deterioration in the pool’s quality; Clauses that increase the yield payable to parties other than the originating bank, such as investors and third-party providers of credit enhancements, in response to deterioration in the credit quality of the reference pool.