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Quantifying the reality of financial risk

EVERYONE HAS A VIEW on risk. Given the central role taken by risk in everything we do, we seem surprisingly reluctant to address it. The notion that it can be quantified is often viewed with suspicion. Yet stochastic analysis is designed precisely to address this question.

Proper risk technology is available to anyone, and can be applied without first gaining a PhD in statistics. This is also available, therefore, to the banking sector. People assume it is already in use in places where they expect to find it. The current financial situation might suggest otherwise.

Most businesses will – at some point – want to apply for loan finance. The cost of the loan should really be related to the risk associated with it. By using suitable models and mathematics, an FD can evaluate that risk. These processes may not be perfect, or applicable to every situation, but they are an improvement on the present position.
The safest position for the lender is to base a loan entirely on the collateral offered.

This collateral should be able both to service the loan and, at maturity, either to repay or to refinance it. Contrary to the popular view, this does not require any judgement to be made on a borrower’s ability – or inclination – to repay the loan, even under adverse conditions. Furthermore, the analytical approach to risk can be applied to a wide range of revenue streams and assets.

By definition, all collateral will have some minimum “base” value, even when the very worst economic conditions imaginable are considered. This “base” value, less its disposal costs, therefore represents a “risk-free” value, and can be used to underpin a loan for that amount of loan finance at “no risk”.

Collateral graphHowever, most borrowers want to borrow more than this against their collateral. This increases risks, as illustrated in the diagram by the overlap area between the range of possible revenue values and the range of possible service costs as they change over time. In the overlapped area, the costs exceed the allocated revenues. But if the borrower deposits this value in reserve as a “support fund”, it can cover this risk if required by the lender. This sum would usually be much lower than the charges normally demanded for such loans, and any unused residue can revert to the borrower at the end of the loan term – a welcome bonus.

Some general features of loans include covenants, slotting, swaps and capital retention. These four features have one element in common: they all try to compensate for the same components of risk and, when they are applied, they are all added together. The net effect is one of overcompensation for the same risk, to the detriment of new bank lending.

The fact is that the absence of adequate risk evaluation can lead to very hazardous loan proposals when times are good, and worse, to massive overcompensation for risk when times are bad.

Proper risk analysis can greatly reduce the cost and difficulty of raising loan finance. It can even offer a government an opportunity to tax precisely just the risk component of the loan, or of other financial transactions such as the European Commission’s proposed ‘Tobin’ tax (a levy on all financial transactions between banks) in the eurozone. This could raise fiscal revenues, improve control over lending, and at the same time discourage high-risk lending by accurately targeted progressive taxation. ?

How can proper risk evaluation improve this situation?

Covenants: Most loans have written into their facility agreements some form of covenants which check the ability of the collateral to service and repay the loan. Providing a risk-evaluated “support fund” can reduce or eliminate the need for such covenants in credit facility agreements.
Slotting: This is a process that can sometimes be applied by the bank to assess the risk level of the collateral. It places the collateral into one of about five bands, and usually makes this decision on a cautious and pessimistic basis. This is simply a feeble way of accommodating risk that is not well assessed, and not well defined. A proper risk analysis would render this process unnecessary.
Swaps: Interest rate hedging – many borrowers prefer to borrow at a fixed rate, as this provides some certainty to their future overheads. This is usually accommodated through a swap, which effectively calculates and applies an interest rate that corresponds to the average expected LIBOR over the term of the swap, augmented by the increased risk attached to it.
Since suitable analysis can evaluate the risk attached to LIBOR separately from that attached to the collateral risk, these can now be decoupled.
Capital retention: Under the terms of Basel III, a bank must make provision for a loan through capital retention as a protection in the event of default. A “support fund” should also largely remove the need for increased retained capital by banks, since the risks attached to loans would be identified, evaluated, and accommodated entirely by the borrower.

Simon Bibby is the owner of Crucial Analytics

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