National College of Science and Technology

BSBA-Financial Management 22A1

Credit and Collection
 GROUP 1:

Alican, Andrea
Barrientos, Arlyn
Bejer, Jendel
Lumagui, Kim Angela
Macaso, Keann Pearleen
Sapar, Mary Ann
Tayoto, Joed
Templo, Alliah Mae
Verano, Donabel
Villanueva, Cassandra Claire
Yao, Aira Lei Jasmin

February 15, 2020

Submitted to:
Ms. Mary Rose Naire I. Ilagan
 Chapter 1:

Credit Risk

Credit Risk is the possibility of losing money due to the inability, unwillingness, or non-
timeliness of a counterparty to honor a financial obligation. Counterparties that have the
responsibility of making good on an obligation. These are called “obligors.”
There are three concepts associated with the inability to pay. First is insolvency, which
describes the financial state of an obligor whose liabilities exceed its assets. Second is default,
which is failure to meet a contractual obligation, such as through nonpayment. Third is
bankruptcy, which occurs when a court steps in upon default after a company files for protection.

Three fundamental questions in the forthcoming chapters:

1. What is the amount of credit risk, how much can be lost or what is the total cost if the obligor
fails to repay or perform?

2. What is the default probability of the counterparty? What is the likelihood that the obligor fails
to pay or perform?

3. How much can be recovered in case of bankruptcy? In the case of non-payment or no

performance, what is the remedy and how much can be recovered, in what time frame and at
what expense?

Types of transaction that create credit risk

Credit risk refers to the probability of loss due to a borrower’s failure to make payments
on any type of debt. Credit risk management is the practice of mitigating losses by understanding
the adequacy of a bank’s capital and loan loss reserves at any given time – a process that has
long been a challenge for financial institutions.

The global financial crisis – and the credit crunch that followed – put credit risk
management into the regulatory spotlight. As a result, regulators began to demand more
transparency. They wanted to know that a bank has thorough knowledge of customers and their
associated credit risk. And new Basel III regulations will create an even bigger regulatory burden
for banks.

To comply with the more stringent regulatory requirements and absorb the higher capital
costs for credit risk, many banks are overhauling their approaches to credit risk. But banks who
view this as strictly a compliance exercise are being short-sighted. Better credit risk management
also presents an opportunity to greatly improve overall performance and secure a competitive
advantage.
Who is exposed to credit risk?

All institutions and individuals are exposed to credit risk, either willingly or unwillingly.
But the following financial institutions to be discussed would specifically identify how
companies are engaged and exposed with credit risk.

Financial Institutions

Financial Institutions are the companies engage in business dealing with financial and
monetary transactions such as deposits, loans and investments. Financial Institution is the most
exposed in credit risk. And the following would describe how does the credit risk affects them.

The first financial institutions are banks. Banks because literally, they are the most
exposed in terms of credit risks. Banks have the largest credit portfolio and possess the most
sophisticated risk management organizations. Why because first the main operation of the bank
is to provide money, provide loans. Through this they are opening their doors widely to risks.
They minimized risk through credit card limits and financial intermediaries for risk management.

Asset Managers are one of the most really important in making business and also to
clarify the short-term and high quality standard debts. They should also focus in emerging their
equities. They can also be in worldwide just like when a company wants to borrow a worker into
another company and do their work and continue business. And also they can invest a huge
amount of money. Hedge fund is the limited partnership of investors that uses high risk methods,
such as investing with borrowed money in hopes of realizing large capital gains. Hedge funds
are also alternative investments using pooled funds that employ different strategies to earn active
return.

Insurance Company, companies which may be for-profit, non-profit or government-

owned, that sells the promise to pay for certain expenses in exchange for a regular fee, called a
premium. For example, if one purchases health insurance, the insurance company will pay for
the client's medical bills, if any. Likewise, in life insurance, the company will give the client's
beneficiary a certain amount of money when the client dies. The insurance company covers its
expenses and/or makes a profit by spreading the risk of any one client over the pool of premiums
from many clients.

A pension fund is a pool of funds that have been contributed by employers and their
employees, and which is being invested to provide employees with retirement benefits. The
earnings of a pension fund are usually tax-deferred, and are only recognized as income by plan
recipients after they have reached retirement age. Those individuals responsible for making
management decisions for a pension fund have a fiduciary responsibility to make prudent
investments. Pension funds are usually underfunded, since the sponsoring organizations are not
able to contribute the full amount indicated by an actuarial analysis of the funds that will be
needed to ensure that adequate payouts are made in accordance with the schedule of plan
benefits.

Corporates

Corporates do not like credit risk but cannot avoid it. There are three major source of
credit risk for a corporates First, account receivables. Second, from the circumstances in which
they have significance amount of cash to invest. Third, is by choice-or by obligations.

Corporates also have options to mitigate this credit risk exposure.

1. They can buy insurance from their receivables, and an insurer identifies them in the
event they are not paid.

2. They can sell their receivables to factoring companies which provide cash and credit
insurance at the same time.

3. Foreign transactions can be secured by documentary credit

Why manage credit risk?

An important aspect of credit risk is that it is controllable. Credit exposure does not be
fall a company and its credit risk managers out of nowhere. If credit risk is understood in terms
of its fundamental sources and can be anticipated, it would be inexcusable to not manage it.

Credit risk is also the product of human behavior; that is of people making decisions.
Precarious financial circumstances that obligors may find themselves in result from the decisions
that the company's managers have made. The decisions that they make are consequences of their
incentives and the incentives of the shareholders whom they represent. Understanding what
motivates the shareholders and managers is an important aspect of counterparty’s credit risk
profile.

Firms should give attention and resources to credit risk management for their own
survival, primarily concern to financial institution like banks and non-financial companies,
which don't take in deposits. Next is profitability especially on low margin businesses and last is
return of equity to have a long term survival of all businesses. In short your objective is to
maximize your profit.