Donaldson - Thinking About Credit

THINKING ABOUT CREDIT
Also by T. H. Donaldson and published by Palgrave Macmillan

LENDING IN INTERNATIONAL COMMERCIAL BANKING
THE MEDIUM-TERM LOAN MARKET (with J. A. Donaldson)
UNDERSTANDING CORPORATE CREDIT
HOW TO HANDLE PROBLEM LOANS
Thinking about Credit
T. H. Donaldson, FCIB
M
MACMILLAN
PRESS
© T. H. Donaldson, FCIB, 1988
Sof'tcover reprint of the hardcover 1st edition 1988978-0-333-44907-3
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civil claims for damages.
First published 1988
Published by
THE MACMILLAN PRESS LTD
Houndmills, Basingstoke, Hampshire RG21 2XS
and London
Companies and representatives
throughout the world
British Library Cataloguing in Publication Data
Donaldson, T. H.
Thinking about credit.
1. Credit management-Great Britain
I. Title
658.8/8/0941 HG3729.G8
ISBN 978-0-333-46081-8 ISBN 978-1-349-19279-3 (eBook)
DOI 10.1007/978-1-349-19279-3
Contents
1 Introduction 1
PART I PRESENTATION AND ORGANISATION

2 Making it Easier 7
PART II EXAMPLES
3 Looking Outside the Borrower 39
4 Looking Inside the Borrower 59
PART III THEORETICAL DIVERSIONS

5 Variations on Risk 81
6 Short, Medium or Bust 97
PART IV SUPERVISION
7 The Most Important Job 125
Glossary 137
Index 143
v
1 Introduction
THE PURPOSE OF THE BOOK
The author of this book has spent his working life in credit; first
learning it, then practising it, most recently reviewing and trying to
improve other people's work. In the process he has learned that
credit is easier than most people think if they approach it in the right
way, almost impossibly hard if they do not. The right way requires a
sense of curiosity; a sense of risk; a technical understanding of
financial statements and accounting; a feel for how the nature of a
company's business affects the way it works; common sense; and the
ability to look at the pieces as a whole.
Curiosity and a sense of risk are inherent; some highly intelligent
people lack them, and whatever their other qualities they will never
make good judges of credit. Some people also have difficulty with
financial figures; where this is due to lack of formal training it is not
an insuperable barrier, although it can sometimes indicate a more
serious mental block. Some people find it easier to start from the
company's business, and build their understanding of figures round
their feel for this, rather than developing a knowledge of financial
analysis, and fleshing this out with later knowledge of the business.
Whatever the particular combination of talents and training, the
scarcest quality is the ability to piece together - to look at the balance
sheet, the profit and loss statement, the cash flow and cash needs, and
the nature of the business (internal and external), and then balance
them to come to a sensible conclusion.
This process requires an ability to see the whole picture and
attention to detail, constructive curiosity and an organised approach
to the problem. There is no magic process, but there are areas where
an outsider can provide a helpful insight.
The purpose of this book, therefore, is to provide some insights
which the author's experience suggests can be of value. The book is
largely based on the author's experience as European Credit Officer
of Morgan Guaranty. Much of it was originally conceived to help cure
specific weaknesses which appeared in credit memos which he
reviewed.
1
2 Introduction
THE FUNDAMENTALS OF CREDIT JUDGEMENT
Curiosity is vital in credit. It is rarely the obvious which costs a bank

money, so that the banker needs to question, to dig beneath the
surface, to reject the easy answer. To do this well, he must be
concerned not only with meeting the minimum requirements of a job;
rather he must have a personal need to test an answer before he can
be satisfied. Without this, he may still get the answer right most of the
time; many companies are in fact as sound as they seem. He will,
however, miss the subtle early warning signs, the ability to spot which
can make the difference between a good loan loss ratio and a
disastrous one. The difference is only about 1 per cent of the loan
portfolio. An 0.5 per cent ratio is better than average; a ratio of 1.5
per cent is worrying and 2 per cent is near disaster.
Sensitivity to risk and the ability to distinguish between those risks
a bank should agree to take for an appropriate reward, and those
which no reward justifies, is also crucial. Few people are born with it
fully developed, but many bankers can develop it with experience.
Those few who cannot are again never likely to be sound judges of a
credit.
The more technical aspects of credit can be taught or learned. In
the simplest form they fall into four sections: the balance sheet, the
profit and loss and cash flow, the nature of the business and the
impact of external factors; perhaps a fifth is the intangibles such as
management, brand loyalty, market leadership and so on.
Understanding financial statements - whether balance sheet or
profit and loss - again divides into two parts: the banker must follow
the accounting principles which control their preparation and
recognise the significance of what they show. A knowledge of
accounting is essential to recognise where figures may overstate or
understate profits, assets or liabilities and how changes in accounting
can hide changes in the underlying financial condition, even where
this is not the primary reason for the change. This is best taught by
accountants; some academic accountants, however, are so keen to
expose the ways in which figures can be manipulated that they leave
the impression that the only purpose of financial accounts is to
deceive. In practice, most companies prepare their accounts honest-
ly. Incompetence which allows poor accounting to mislead a non-
financial management is probably more dangerous to a lending bank
than deliberate fraud.
Understanding the significance of the figures for the company's
Introduction 3
credit standing is more complex. It depends on interrelationships

between different parts of the balance sheet; between the balance
sheet and profit and loss or cash flow; and between either aspect of
the figures and the nature of the business.
Relating the business to the figures means asking a series of
questions and then considering how the answer affects the financial
and other requirements. Is it capital intensive? does working capital
turn over fast? does success depend on high marketing expenditure or
tight control of costs? on prompt delivery, on quality or innovation?
Each of these, and many other questions, affect the likely level of
operating profit or margin, the percentage of sales taken by interest
in a given capital structure and what sort of structure is best suited to
each company.
Competition and other factors which create risk (or protect against
it) also change the balance sheet structure most suited to a company's
needs, and the level of profits it must generate to service those needs.
This in turn requires a banker to think about the factors inherent to
each company and how the figures reflect these.
The author's Understanding Corporate Credit (Macmillan, 1984) is
concerned with the overall approach. Thinking About Credit focuses
more narrowly on specific areas which can provide examples of the
type of thinking which should apply to particular analyses the banker
may have to make.
TO UNDERSTAND MAY BE EASIER THAN TO PRESENT
Some bankers find that their understanding is greater than their

ability to present. Sometimes this is illusory, a more or less conscious
attempt to hide their true lack of understanding. Sometimes the
problem is one of poor grasp of written English, greater than this
book can hope to cure. Where the problem is more of a curable
failure to think in any organised way, this book may be able to help,
as it may where the lack of organisation obscures the lack of
understanding. And a well-organised approach may make it clearer
that we do not understand the credit, which in turn is often the first
step to doing so.
A poorly-organised memo is a sign that the writer needs help. A
supervisor should take the time to find out whether the weakness is in
writing or understanding (or both), and do what he can to give the
right help.
4 Introduction
PRESENTATION IS MORE THAN COSMETIC
There is a tendency among some bankers to dismiss time spent on

presentation as more trouble than it is worth; they appear to believe
that it is merely cosmetic and adds no real value. In fact, as Chapter 2
will show, presentation is aimed at organising our thoughts in a way
which helps both the reader and the writer. The greatest benefit is to
ensure that our thinking is well directed and effective. The
organisation which produces a good memo also makes it easier to
work fast; a small investment in time at the beginning can produce a
large and continuing dividend, in the form of better as well as faster
work.
GOING CONCERN APPROACH
There are broadly speaking two approaches to analysing credits. The

going concern approach, also known as cash flow analysis, concen-
trates largely on the company's ability to generate cash to meet its
obligations, fund its capital expenditure and meet its other needs. It
takes the view that companies rarely pay their debts from sale of
assets, except for a few specialised types. The best way to judge a
credit, therefore, is to analyse its business and accounts to develop an
understanding of its need for and ability to generate cash, and the
risks which may undermine the ability or increase the need.
The other approach, known as liquidation analysis, or sometimes
the gone concern approach, focuses much more on asset values and
how far they are likely to diminish in times of trouble.
There are many nuances of analysis and banking practice arising
from these differences, which the author has discussed elsewhere.
The point here is that this book is written against a going concern
background. Much of it is valid on other assumptions, but readers
should be aware of the background.
Part I
Presentation and
Organisation
2 Making it Easier
INTRODUCTION
A credit presentation tries to set out the arguments for and against a
proposal to lend, accept a counterparty in a transaction or otherwise
take a credit risk. To achieve this, the writer must meet certain
targets. The memo must show clearly what the risk is; what reward
the bank receives for taking it; what the company's strengths and
weaknesses are - both generally and in relation to the specific
proposal; and why the combination of all these factors leads him to
recommend the risk.
Even where he understands the factors, he may still present them
poorly. He needs to help the reader to absorb them quickly and to
reach the right decision. To do this, the presentation must not only
be clear, it must be complete, relevant and balanced. It is not a
selling document but a fair presentation of both sides of the case.
Equally, however, it is not the same as an analysis. Analysis should
not start from a conclusion; its purpose is to help reach one. A
presentation is, in logic, the step that follows analysis, although this
does not always happen in practice. Thus while a presentation needs
some analytical content, its purpose is the fundamentally different
one of supporting a position already reached, not helping to reach
the right position. Although analysis and presentation are often
combined in the same memo, it is important to remember the
difference. Failure to do so can make it seem that we are twisting the
analysis to support a position, which may then be suspect as a result.
THINKING ABOUT THE PROBLEM
To present a credit well we need to think about the various aspects of

it, and how they affect each other. What is the nature of the risk we
are proposing to take? what is the worst that can happen if things go
wrong? what do we think is the likelihood either of things going
wrong or of the worst possible result for us if they do? is the company
vulnerable to either the specific risk we see here or to other risks
which can still undermine its ability to pay its debts? How profitable
is the transaction, and the overall relationship? how important is the
7
8 Presentation and Organisation
transaction to the relationship? in other words what is the risk/

reward ratio?
Not all of these questions are equally important in every case; nor
are they equally difficult to answer. So as well as thinking about
them, we have to think about how best to describe them. In what
order, in what amount of detail, in what format? Some banks have a
standard form for credit presentations. This has some advantages. It
ensures that the reader knows where to look for each item and in
effect gives the writer a check list of items to cover. If the bank wants
an exercise in form filling, this fits the bill. Where the bank wants
deeper thought about the credit than this, however, a standard form
inhibits it. Companies are different, and so are bankers. A form may
fit some companies well, but there are bound to be some it does not
fit; these, just because they are in some way unusual, are the ones
that most require imaginative handling.
Equally, all bankers have different ways of expressing themselves.
The better the banker, the greater the damage caused by confining
his ability in the straitjacket of a prescribed form.
This does not mean that bankers cannot develop a format which
suits them, and use it most of the time. Bankers are comfortable with
formats they develop themselves, and which they can vary to suit the
requirements of various types of company.
Nor does it prevent the suggestion that some items belong near the
beginning of almost every memo and help to make them easier to
read, to write and to understand. Later sections of this chapter will
discuss two of these; other sections will discuss other items which are
often useful, but can also be left out in many cases. The important
part about such points is to use them when they are useful in each
case, not because they are prescribed.
We need to think, then, in general terms about the format that
suits us. Do we prefer to write in essay form, in numbered
paragraphs or sections? If sections, do we want to use headings? Or
do we want to vary the choice depending on the type of memo we are
writing or of the company we are writing about?
There is no magic answer to these questions, but there are some
observations we can make. Essay form, for instance, is often easier
to read and usually more elegant; it also exerts less discipline,
making it easier to wander from the point or fail to connect up the
various issues in the best way. Sections make it easier to be sure we
discuss everything we mean to; they may increase the risk that we
will treat each part as separate, and fail to show or to see the way in
Making it Easier 9
which they link to support or offset each other. And finally, if we use
headings we must ensure that they fit the text they cover. A heading
'Comments' for instance tells us little; a heading 'Background' when
the text is talking about sales growth, or 'Performance' covering a
discussion of the company's products, is not helpful.
IF WE DO NOT UNDERSTAND, WE CANNOT PRESENT
Apart from format we have to think about the credit itself. One
benefit of thinking about how to present something is that it makes
us focus more on what it is we want to present, and how well we
understand it.
We may think about how to relate the real asset structure to the
balance sheet for instance. If we present a series of related facts in
different parts of the memo, without highlighting the way in which
they are related, we may never focus on whether the relationship is
sound. If we make a conscious effort to present them as a
relationship, we have to think about what it is and how it works. If
we find that we do not really understand it, this may mean that we
have not thought about the credit hard enough, or that we have
overlooked or misunderstood something.
Equally, if we normally find it quite easy to organise our work, but
in a particular memo the bits just will not fall into place, probably
there is something that we have not fully understood. Once we
recognise that, we have a much better chance of tracking down the
missing link that has prevented us from understanding. If, however,
we do not normally organise our thoughts, any difficulty in doing so
in a particular case will not seem unusual. There will then be no
reason to scrutinise more closely those names which appear sound to
a superficial review, but not on closer analysis.
Look at it another way. A later section of this chapter argues in
favour of identifying the key issues in an early section of each memo.
Whether you accept the argument or not, nobody can understand a
credit properly without recognising these issues. To write a memo -
as many bankers seem to do - without being sure we understand
what makes a company tick, what risks it faces and what strengths it
can use to overcome the risks, makes little sense. For this reason,
thinking about the best organisation of the memo does not just
prettify what we know; rather it is a useful discipline with three main
benefits. First it helps (and in some cases pressures) us to make sure
that we do in fact understand what we are writing about; if we find

we do not, it also gives a framework within which we may think more
effectively than we might otherwise do. Secondly, it helps us to
present our knowledge in a way which is most helpful to the reader.
Finally by helping the reader we help ourselves; the form which helps
him to check whether we have missed anything makes it easier for us
to do so as we read the final draft.
A reader who is using the memo as a tool to help with a critical
decision, or even as the main basis for the decision, is in trouble with
a memo which has not been thought through. At best, all or most of
the information is there, but in a form which requires extensive
analysis to understand; this type of weakness is sometimes called
'emptying the file into the memo'. In effect, the writer says to the
reader 'You are a better judge of a credit than I am, you tell me what
to do'. Even here, because the memo shows no judgement, the
reader cannot be sure that the writer has put in everything needed to
make the decision - unless, of course, he already knows the credit
pretty well.
With memos which are poorly organised but have tried to be
selective, the problem is worse still; the reader has no idea whether
the material left out confirms the indications of the material
included, or contradicts them. Nor can he be sure whether the
exclusions are deliberate (in a more or less conscious attempt to gild
the lily), or whether the writer simply does not know enough to make
a representative selection. Again, where he already knows some-
thing about the borrower, he may make a sensible decision even on
the basis of a poor memo. There are a number of reasons why, even
if he does, he should be concerned.
First, unless he follows the particular name closely he is unlikely to
be fully up to date. Secondly, he will not be expected to monitor the
borrower in detail going forward; but if the banker who is
responsible does not understand the key points in the borrower's
credit, there is little chance that he or she will catch the early signs of
deterioration. This in turn makes it harder to approve credit in
marginal cases. Where in fact the credit is perfectly sound, to turn it
down will risk missing good business and perhaps damaging a good
relationship, or missing the chance to develop one.
Some bankers claim that they never turn down a sound credit
because of a bad memo. Even if this is literally true (and it sounds
rather conceited), there is a lesser but still important sense in which it
is untrue. Any banker with any experience of lending will know of
Making it Easier 11
cases where a weak presentation has biased the decision against the
borrower; it may not have caused the bank to say a flat 'no', but it
has made the reply more restrictive. Perhaps the bank has been less
willing to compete on rate, perhaps it has demanded tighter
covenants or a better margin of collateral, perhaps it has offered a
shorter maturity or less generous amortisation. Whatever the exact
nature of the less favourable terms, the result is often to lose business
which a better presentation might have won, and which on a more
skilled appraisal the bank should have wanted.
Finally, a supervisor should certainly review credit memos,
whether he is the initial reader or someone else. A writer who does
not understand the credit, or cannot express him or herself in writing,
needs help. It is a supervisor's job to recognise the need and provide
the help. Where the writing is well organised, or where a writer is
known to be able to organise, an unclear memo suggests failure to
understand the credit. An obscure memo from a habitually disorga-
nised writer gives no such guidance. A supervisor who can teach his
juniors to organise their work helps himself. He improves the chances
that the junior will use the more organised approach to understand
the individual credits better and faster; and he makes much easier his
own task of assessing the quality of the work and where the junior
needs help.
THINKING ABOUT THE READER
There is an argument that memos should be written in the same way

regardless of the expected reader. There is a counter tendency among
some bankers, particularly where the lending authority is concen-
trated in one strong character, to write specifically for one reader. As
is so often the case, the best answer is between these extremes.
The arguments against writing for one specific reader are both of
principle and practice. First, the intended reader may be ill or absent
when the decision is made; secondly, there is rarely only one reader or
one use for a memo. Its prime purpose and use may be the decision as
to whether to lend; thereafter it will be read by several different
people who will expect it to meet their needs, not just Mr X's. The
exact nature of these extra readers will vary from bank to bank, and
will depend on where within the bank the memo is written. They can
include a senior lender where the amount is beyond Mr X's authority,
or raises policy questions; the credit policy committee or other senior
officials responsible for reviewing the portfolio or the quality of the

bank's credit work; inside or outside auditors or bank examiners;
cOlleagues who have to run with the ball at short notice during a
banker's absence; supervisors trying to ensure that each memo is up
to scratch, and if possible better than the last one; and finally the
successor on the account, who will need to know on what his
predecessor based his view, and what weaknesses to check.
Thirdly, we said earlier that the lack of a set format allowed the
banker to think in his own style and present the credit in a form with
which he was comfortable. To expect memos which conform to the
reader's prejudices is to cancel this benefit. Indeed, refraining from
imposing one's own style on others is an important test of
management. The manager of a small branch can do more harm than
he recognises by insisting too strongly on a set format or even on the
inclusion of certain items in every memo. This is worse when (as is
often the case) he is not an expert on credit and his requirements
conflict with advice or tuition from other parts of the bank. Worst of
all is when a supervisor rejects memos because of faults imposed by
the writer's superior.
On the other hand, we cannot ignore the reader. We must not
waste his time by making him read long explanations of facts he
already knows; and one element of good memo writing is to confine it
to what the reader needs to make the decision. This both saves his
time and ensures that his decision is not confused by irrelevancies.
To tailor the memo to the precise knowledge of one reader will not
work, however, for the reasons outlined above. To meet these
conflicting needs, we have to do two things. First, incorporate an
element of reader's choice into the way we write, and secondly learn
to refer to things briefly, but in a way which allows the reader to be
sure that we understand them.
An example of choice is the Summary discussed in a later section of
this chapter. As advocated, it contains what the writer sees as the key
features of the credit, both favourable and unfavourable. Well done,
it may often be enough for a banker who knows the borrower well to
make the decision, confident that the writer has correctly understood
the credit; this saves him time, while leaving others free to read as
much as they find useful. A second type of choice comes from
highlighting certain parts of the memo, perhaps by using sections with
headings. For instance, a section on 'Business and Background' (also
discussed in a later section of this chapter) can be easily skipped by a
reader who knows the name, while it may be crucial to one who does
Making it Easier 13
not. The same is true of a section describing the different divisions of

a conglomerate.
Referring to items briefly but usefully can take two forms. One is to
recognise early that certain information will be relevant to more than
one aspect of what we want to discuss. To avoid giving partial but still
repetitive descriptions each time it comes up, give a full description,
perhaps again in a short separate section. Thereafter it is easy to refer
to the point in a few words. For instance, some companies rely
heavily on government for business. This reliance could be important
to their competitive position, to their ability to fund research, to the
speed with which they collect their receivables, and to the ultimate
quality of those receivables. In this case, a brief section on the
government connection would be useful background in its own right;
once this had been done a two or three word reference each time it was
relevant should be quite clear. Again, a reader familiar with the
borrower would not necessarily need to read the section; its mere
existence would tell him that the writer had focused on the point.
For those less familiar, the section would both be useful in its own
right and make the rest of the memo easier to absorb.
DOING OURSELVES JUSTICE
In writing credit memos, bankers often forget the extent to which

these memos influence the bank's view of the overall quality of their
work. In many cases, they are almost the only aspect of a junior's
work which a senior sees; this is particularly so when the banker
works in a branch overseas or well away from head office. Even
where this is not the case, the importance of written work should not
be forgotten - particularly work which relates to the most crucial
aspect of a bank's business, the taking of risk. Thus a banker who
neglects his written work or treats credit memos as 'administration',
to be got through as easily as possible, and if possible after the event,
does himself great damage.
Writing in the Journal of the Institute of Bankers in the early 1980s,
Deryk Vander Weyer of Barclays Bank said: 'Management qualities
brought out were at two ends of the spectrum - in the first place, the
absolute need for speedy and rigorous written analysis to isolate the
problem and extract the most viable solution'. Later in the article, he
lists qualities which 'are absolutely essential to successful manage-
ment in any conditions. It is necessary to be able to read, to write or
absorb clear, analytical and effective professional papers that deal

succintly and accurately with problems and isolate the one or two
viable solutions'.
Mr Vander Weyer was talking about the fringe bank crisis in the
UK in the mid-1970s, but the points are equally valid at any time.
Moreover, any feeling that this may be needed in times of crisis but is
overdoing it at other times is wrong in two ways. First, the way to
avoid crises is to give the same care to all proposals; then the poor
ones will not slip through or not enough of them to create a crisis.
Secondly writing the type of memo Mr Vander Weyer describes, and
this book tries to help bankers write, is not a skill to turn on and off.
It takes time, and hard work, to develop. And unless a banker is
known for the mental control and hard analysis which underlies the
ability to write the memo in the first place, he will never get the
opportunity to manage the crisis.
Furthermore, poor written work may damage the relationship with
clients; the ability to keep them happy is often an even more
important indicator of the quality of work than ability to gain
superiors' respect. A previous section discussed the danger that a
poor memo might lead to an adverse decision, whether absolute or
merely too restrictive. The damage to the relationship here hardly
needs stressing. Sometimes the decision maker can be persuaded to
change his mind; this takes time and the delay may annoy the client.
Or the banker may have to get more information to bolster the case.
If this is information the client does not wish to give, or if he feels the
bank is coming back late when it has already asked enough
questions, the result may be a disgruntled client. Even if it gets the
particular piece of business, the bank's long-term prospects may be
weakened. And the client has a point. Sometimes banks do not have
the information because the client was reluctant to give it, and they
may need the implied threat of a refusal to lend to lever it out.
Except in these circumstances, however, repeat visits for information
suggest either that the banker did not know what to ask the first time,
or did not make good use of what he had. Neither impresses the
client.
THE TOOLS
Purpose/Recommendation
Although it is wrong to impose a precise format on memos, there are

Making it Easier 15
two items which should come at the beginning of every memo. The
first is the nature of the decision. Some bankers prefer to put this
later in the memo, on the argument that we need to know the facts
before making the decision. The better argument, however, is that
we are concerned not just with facts but with an appraisal of them in
the light of a request. Unless we know what the request is, we cannot
assess the appraisal; nor can we tell how much time we need to spend
on the decision. A complex term loan, perhaps with an element of
project risk, requires much greater attention than an overdraft or a
short-term, self-liquidating loan.
The section can be called Purpose, in which case it will often start
'To recommend that'; for this reason, many bankers call it
Recommendation. The name is not important; the quality is. The aim
should be to present in the shortest possible space the key elements
of the decision we want to take. We are not here concerned to justify
the decision; that comes later. Nor are we concerned to go into all
the small details of the proposal which may alter the minor ways in
which we implement a positive decision, but are not important to the
basic 'yes/no' question.
The simplest way to present the decision is in a short paragraph, or
perhaps two if the case is unusually complex. For instance:
To lend ABC company £5 million for five years, unsecured, at 0.5

per cent p.a. over six-month LIBOR. Amortisation in equal
annual instalments starting at the end of the second year.
OR
To make available a £10 million unsecured overdraft at 1 per cent

over base for seasonal working capital needs.
With a more complex case, particularly if the proposal is for secured

credit, there are two traps into which people often fall. The first is to
try to elaborate and explain. For instance, with a secured proposal,
they explain the nature and valuation of the security at great length,
when all that we need is something like 'secured by a first mortgage
on a fully rented property with a 50 per cent margin'. At this stage,
this tells all we need to know; naturally, later we will need to judge
the collateral and be sure that it is adequate, but not now. Long
comments on the quality of the building over which the bank will
hold the mortgage, the tenants whose rent will service the debt, etc.
thus simply confuse the issue. Moreover since the memo will almost
certainly need a section discussing the security in detail, anything
more than the barest outline merely involves repetition and
lengthens the memo unnecessarily.
The second mistake is to set out the details in a lengthy table, such
as:
Borrower:
Amount:
Guarantor:
Interest rate:
Commitment fee:
Maturity:
Amortisation:
and so on through a long list. This may seem a clear way to set it out,
but in fact it is surprisingly hard to take in; it uses too much space,
and in complex proposals (or where the memo covers more than one
proposal) it is quite easy to find that by the end we have forgotten the
beginning.
A proposal for two different facilities to the same borrower could
thus read:
To lend XYZ £15 million for five years, guaranteed by the parent
and secured by a first mortgage on a 1984-built tanker, with a 75
per cent margin plus assignment of charterhire. Rate 0.75 per cent
over six-month LIBOR, amortisation in 20 equal semiannual
instalments beginning six months after drawdown. Also a $4
million overdraft to finance operating costs between charter
payments, cross-collateralised with the loan; rate 1 per cent over
dollar base rate.
Reviewing a complex relationship with many different facilities,

simply summarise them:
To review and where appropriate renew for a further year, short-

term facilities totalling £50 million and medium-term totalling $75
million. All unsecured and at the prime rate for the type of facility.
The details of the facilities can be given in an appendix; or they may

be contained in credit approval forms which the reader must sign if
he approves the credit.
Making it Easier 17
One other piece of information worth mentioning here is the

bank's total exposure to the borrower; however much the proposed
facility may seem to stand on its own, it is always useful to know how
many eggs the bank has in that particular basket.
Summary and Conclusion/Reasons for Recommendation/Rationale
The second section that should appear in all memos is the Summary
and Conclusion/Reasons for Recommendation/Rationale. Again the
exact name is not important, and anyone of the three describes some
aspects of the idea. This is to present, briefly but clearly, the key
points on which the writer believes the bank should base the
decision. It should cover plus and minus points, and draw a balance
between them.
Indeed this point about balance is most important in all aspects of
the memo. A credit proposal is not a selling document - or at least
not in the sense that it is trying to sell the proposal regardless of its
merits. Rather it is a decision document. Whatever the precise
arrangements within the bank, the best memos will come from the
banker whose attitude is: 'I have decided that the bank should make
this loan, but due to a tiresome formality I lack the authority to
approve the decision. Therefore I must explain to you clearly how I
came to that decision, so that you can ratify it'.
Setting out the key items in the decision first helps both writer and
reader. Before starting to write - and indeed before making the
decision as to what to recommend - writers must be sure to identify
the key points. Only then can they be sure of assessing all the
weaknesses as well as strengths; and be certain that the strengths
outweigh the weaknesses enough to ensure a sound credit. Moreover,
there are some weaknesses and risks against which the bank or the
company may be able to protect themselves if they know about
them. Setting the key issues out in a rational way can thus help to
analyse the position and reach a conclusion. Even where the analysis
has identified them in some other way, laying them out on paper
gives the chance to review them for omissions, contradictions or
anomalies. Finally, when they come to write the rest of the memo the
Summary gives a framework. It says what are the key points, and
perhaps how they affect each other; now the rest of the memo must
talk about these points. If after a good Summary it rambles on in a
disjointed way about minor issues, the writer has nobody but himself
to blame.
A good Summary gives the reader a clear view immediately of what

the writer aims to demonstrate. For a well-known name or a
straightforward case, this may even be enough the make the decision,
satisfy a decision maker that the writer knows the credit or an auditor
or bank examiner that the credit has been well assessed. More often
we will still need to read on, but we will now know (from the first
section) what is the decision required, and from this one what the
writer expects the rest of the memo to show. This makes it easier to
judge whether the memo in fact proves the case, and whether the
case justifies the risk the bank will take.
All these advantages depend on the Summary being well designed
and presented. This means it must be short and confined to essentials,
but it must cover all of those. To achieve this, it must contain a higher
proportion of opinion and less fact than the main body of the memo.
The purpose, after all, is to state what the key issues are, not discuss
them at length. On the other hand, if there is no factual support, the
section will lack clarity; it may seem like a series of unsupported
generalisations, or may leave the reader asking 'what do you mean by
"good" in this context?' Thus it needs to be brief, mainly giving
conclusions and opinions, but with enough fact to avoid vagueness.
The three examples that follow make the same basic point with
increasing value:
(a) I recommend the proposal because X is an acceptable credit.

This is far too vague; since a banker rarely recommends a
credit that he considers unacceptable, we gain no insight into
what he considers acceptable or why.
(b) Because X has a strong balance sheet, highly profitable

operations and good cash flow.
This is better, but still too vague. There is a wide range of
possible views on what is a strong balance sheet in any given
case; it should be a matter of fact whether a company is
profitable, but some accounting standards leave that open to
doubt; even where we trust the accounting, 'highly' profitable
is again subjective, as is the phrase 'good cash flow'.
Nevertheless the sentence shows that the writer has at least
focused on these three points, and so adds some credibility to
the opinion.
Making it Easier 19
(c) Because X has:

a strong and liquid balance (TLINW 0.5, current ratio 1.8)
highly profitable operations (NAT margin 8 per cent, ROA 15
per cent)
strong cash flow (OCF/TL 22 per cent).
This is much more informative. The ratios do not prove on
their own that the various points are correct, or give a full view
of the credit. Even taken separately, however, they suggest
what the writer considers each point means; together they go
quite a long way to support the idea that this company has a
sound financial condition.
The basic point - be brief but not vague - applies equally to non-
financial points, although it may not always be as easy to encapsulate
them in a ratio. These points would differ from case to case, but
might be selected from a range of subjects such as: vulnerability to
changes in economic conditions; defensive strengths and weaknesses;
strength and depth - or otherwise - of management; competition;
technical strengths and weaknesses; obsolescence or fashion risk;
diversification or concentration, geographically or by product; brand
names and loyalty; distribution strengths and weaknesses; and other
items which crop up less often but are important when they do. In
addition, the Summary should mention the profitability of the
account, and how this facility will support the overall strategy or
increase profits from the relationship.
When we have chosen the factors which are key, we must then try
to present them with the bare minimum of narrative or fact - just
enough to highlight the specific points. Otherwise facts and descrip-
tion belong elsewhere, some of them perhaps in the Business and
Background section discussed in the next part of this chapter.
There are two ways in which to present this Summary; in
paragraphs, or point by point. Either is acceptable and can be
effective, depending on the style of the writer and the nature of the
points. The examples below present basically the same points in two
different ways:
We recommend this facility because the company is profitable

(NAT margin 10 per cent), well diversified by product and
geographically, and we have a close relationship with and high
regard for management. We recognise that leverage is a little high
(TLINW 3.5: 1) but the strong cash flow (25 per cent of TL) makes
this acceptable. We are also a little concerned that management is
somewhat elderly and the succession is in doubt, but do not believe
this is yet crucial. The interest margin is on the market, the
relationship is already profitable, and agreeing to this facility will
enable us to open accounts in several offices where we have no
relationship at present.
OR
We recommend this facility because:
(i) The strong profitability (NAT margin 10 per cent) and cash
flow (OCF/TL 25 per cent) more than offset the rather high
leverage (TLINW 3.5: 1).
(ii) The diversified product line and geographical spread give
strong defensive qualities.
(iii) Our close relationship with, and favourable view of,
management, outweighs the slight concern about age and
succession.
(iv) Our relationship is profitable and the margin is satisfactory.
This deal should allow us to do business in offices where we
have had no previous contact.
There is a version of the second approach which is less desirable. This

lists points under headings such as 'Advantages' and 'Disadvantages',
but makes no attempt to weigh them and suggest a balance. This is
better than no Summary at all, but still avoids stating a view.
Like any other tool, the value of a Summary depends on how
intelligently we use it. A banker who has been told to use it, but does
not really understand or believe in its value, will get as little out of it
as he puts into it. Even a banker who believes in it must keep
reminding himself of the three key factors. First be sure that we have
done our homework and understand the credit; use the Summary to
help. Secondly, do not make it so short that it has no substance.
Thirdly, keep the detail to the minimum necessary; to clutter it up
with detail, whether factual, argumentative or explanatory, almost
always obscures the key points it is trying to make. Often we end up
obscuring them from ourselves as well as from the reader, so that the
rest of the memo has no real structure because it has no framework to
relate back to.
Making it Easier 21
Business and Background
Many memos contain a section such as this, and many that do not
probably should. Nevertheless, there are many memos where it is not
necessary, either because there is not enough substance to warrant it;
or because it is not particularly illuminating; or because there are too
many complex points to be made about the items which might go in
it, so that it makes sense to give each of them a section of their own.
There are also many memos which have long sections with this or a
similar heading, but add little value, or even make the memo harder
to read. Before we can decide what to include we must be clear what
we want to achieve, or why we need the section.
The section should include material which meets two main criteria.
First, it should provide an insight into one or more aspects of the
company's business which will be useful in other sections of the
memo. To achieve full value it will usually need to come fairly early
in the memo. Putting it here avoids the need to repeat it each time it
is relevant, and allows us to refer back to it. This helps to keep the
memo short and clear because less cluttered with repetitive detail.
Secondly, the length of the comment should not justify a separate
section.
Thus to some extent, this is a catch-all section. In some cases it will
include items which in other memos would warrant a section to
themselves, or would fit naturally as part of another. Overall it should
be brief, and should make the rest of the memo easier to understand.
Against this background, the section should comment on one or
more aspects of the business in a form which helps to shed light on the
rest of the memo. For instance, it may be important to know that the
company relies heavily on its Defence Ministry for business. This can
be relevant in discussing such things as receivable quality and
liquidity; nature of competition; political impact on future orders;
subsidised R&D and perhaps other subjects. Similarly, if the
company has strong brand names it may be useful to comment on
this, and on the extent to which there is an inherent brand loyalty, or
that the company needs to spend so steadily on advertising to
maintain loyalty that it is almost a fixed cost. Then in discussing each
aspect there is no need to clutter up each section with descriptions of
the government involvement or brand names; a brief reference to
'MoD sales', 'government receivables' or 'brand loyalty' sets the
scene.
On the other hand, if the company sells several product lines to
different government agencies, with different economic and political

implications, this might be too complex to describe in Business and
Background. It might warrant a section of its own or it might fit into a
section on 'Operations' or 'Product Lines'. The treatment might
differ if there were a separate analytical review which went into these
factors in detail; a brief reference in the presentation might then be
enough, and that could fit into Business and Background. A
reference to the analytical memo for more detail on the point then
has the advantage of giving the reader a choice; if he is familiar with
this part of the company's business, he does not need to refer to the
other memo.
Other items which might appear in some Business and Back-

ground sections could be a comment on the strength or weakness of
management, overall or in one particular area, such as finance; the
basis on which the product was sold (price, delivery, quality, market
image, etc.); the nature of the competition; the type and concentra-
tion of customers or of factories.
The purpose is to show how each item affects the overall company,
rather than to give a string of facts. For instance, even if the product
names were real not imaginary:
The company makes multi-phased laser controlled analytical

gyroscopes for inclusion in haematological photographic scanners
says nothing useful. On the other hand:
The company's gyroscopes account for a small part of the cost of

the scanners, but are crucial to their operation. Design, and
quality control to ensure reliability, are thus more important to
continued sales than price. Once a customer is lost through poor
quality, he can be very hard to recover.
is genuinely useful in looking at the cost structure, the risks of loss of

business and the skills needed to protect against those risks.
Another example is the difference between:
The company has plants in Paris, Lyons, Marseilles, Tours and

Toulouse.
and EITHER:
Making it Easier 23
The product's high weight and low value limit the economic sales
area; Company X's five well-located plants give it a competitive
advantage over its main rivals.
OR
Modern technology favours large, centrally located plants. Com-

pany X's five small, old factories therefore put it at a serious
disadvantage, which only massive capital expenditure can over-
come.
Note that both the more analytical comments fit the facts given in the
first example, which makes it virtually useless.
Like any other part of the memo, a Business and Background
section is thus a means to an end. The means is relevant comment
presented in a way to make its relevance clear. The primary end is a
better understanding of the overall picture; a secondary benefit is a
shorter memo, with less repetition.
USE TRENDS, NOT SNAPSHOTS
When a bank lends money it expects to be repaid in the future, not in

the past. Most of the information on which it bases its decision is
historical. It is therefore important to use the information to give the
best chance of judging the future accurately. A snapshot does not do
this. Nevertheless, many memos contain or even largely consist of
what Carl Samuelson, a distinguished judge of credit, calls 'upsies
downsies':
in 1986 sales were up, net profit was down, leverage was up, cash
flow was down.
Given that we are trying to foresee the future using facts that relate
to the past, we must be able to link our expectations coherently to
the past. To do this, knowledge of what has happened in the latest
year is not enough. We need to know what has happened over a
longer period, what caused it and whether the causes are likely to
change, and if so in which direction. Only then can we begin to assess
the likelihood that a trend will be extended, reversed, will flatten
out, accelerate or fluctuate. This assessment cannot come from one
year's figures. Any of the graphs in Figure 2.1 are consistent with a
10 per cent improvement in the. latest year, but the implications for the
credit and future are very different.
We may look at the trends first, and then seek reasons to explain
them and the factors which might change them in the future; or we
may look at the company's business to see what pressures it is subject
to, and then analyse its figures to see how well equipped it is to deal
with any problems we foresee resulting from them. Either way, we
must understand the interplay between the business and the figures,
which requires a perspective of several years. In particular, most
companies suffer to some extent either from the general economic
cycle, or from one peculiar to their own industry. Some are more
cyclical than others, but we always need to know whether their
susceptibility to cyclical influences, and ability to survive the down
cycle, is changing. If it is, we need to know why, and whether the
change is likely to threaten the company's survival. All this requires
comparison with a similar period in the previous cycle.
'Upsies downsies' say nothing about the trend, and provide no
basis for judging the factors which could change the present financial
condition for better or worse. They thus provide no real basis for a
credit decision. These general points apply equally to the balance
sheet, the profit and loss account, to ratios covering either of them or
illustrating the relationship between them, and to industry condi-
tions.
How to Present Trends
The discussion of trends may make the memo longer than it

otherwise would be in some cases; where the extra length is truly
needed to display the trends, this is acceptable. Quite often,
however, an intelligent approach will avoid or minimise the extra
length.
Where the credit is straightforward, or where we are renewing
facilities to a well-known company, we can keep it short by using
sensible elision. We do not need to say 'The trend was ... , the result
was ... '. For instance:
Company X and the industry extended the 5 per cent growth in

sales for the fifth year in a row in 1986. This was still behind
inflation ranging from 7 per cent to 9 per cent, and thus continued
to compress margins (NAT 5 per cent in 1986, down from 8 per
Making it Easier 25
% Change
+
o
(a)
Years
% Change
+
o
(b)
Years
% Change
+
o
(c)
Years
Figure 2.1 Use trends, not snapshots
cent in 1980). Overcapacity is only slowly being absorbed, and the

industry does not expect to raise prices in line with raw material
costs until at least 1989.
These three sentences tell us how the past will continue to affect the
future in one particular area. A similar approach can be used in other
cases where the facts fit easily into this pattern. The most important
thing here is to be thinking in terms of trends. The writing reflects
whether we are thinking of the past and separately, if at all, of the
future; or whether we are thinking of a continuous flow of
development, the end of which we cannot yet see with certainty, but
which is linked to the beginning.
In other cases, we may need to deal with the problem by separate
discussion of the facts which cause the trends, and of their results.
For instance, a Business and Background section may cover the
changing conditions the borrower faces. Then a later section,
perhaps on Financial Condition and Performance may be able to
draw on that to discuss trends without repetition. If the figures and
ratios supporting the discussion appear in tables, as suggested in the
next section, this can be shorter and clearer. For example:
Background:
XYZ produces standard widgets for the motor and white goods
industries. About 60 per cent go to original equipment manufac-
turers (OEM) on the basis of tight pricing, quality and reliable
delivery. Until recently, low gross margins were largely offset by
limited marketing and delivery costs, and assured volume.
The other 40 per cent of volume is for replacement, with
negligible direct exports. Replacement sales traditionally com-
manded higher gross margins than OEM. Marketing and distribu-
tion costs were also higher, since ultimate sales to the consumer
went through a wide range of wholesale and retail outlets,
generating little brand loyalty.
The declining fortunes of the UK motor and white goods
industries have made OEM customers even more cost-conscious,
while reducing volume and increasing the level of fixed charges. At
the same time, domestic customers and importers have sought a
larger share of replacement sales, putting both volume and prices
of the traditional producers under pressure.
Making it Easier 27
As recently as 1984, XYZ (along with the rest of the industry)

used only old and labour-intensive plant and equipment, making it
even harder to compete. In 1984 new management, recognising
the need to modernise, embarked on a major re-equipment
programme. The first results of that came into production only at
the end of 1986.
Financial condition:
XYZ woke up to the problems earlier than some and has been
reducing its labour force over several years; however, increases
in wage rates and redundancy costs have meant that money savings
so far are small. The continuous squeeze on volume and prices has
more than offset the limited saving of labour costs, and NBIT
margins have declined in each of the last three years. Higher
interest rates and extra borrowing to finance vital re-equipment
led to a loss in 1985 after several years of declining interest cover.
Cash flow has also declined, despite higher depreciation on the
new investment, and now provides inadequate coverage of
liabilities.
The additional borrowing, and low profitability pending the
benefits of the investment, have increased leverage from a barely
satisfactory level to an uncomfortably high one. This has been only
partly offset by tight control of net working investment, so that
liquidity remains good and short-term debt has actually been
reduced.
Nevertheless, it is now vital that the company begin to see the
benefits of the investment, in the form of lower costs, higher
market share or preferably both. Any further weakening of
earnings, cash flow or balance sheet will quickly leave it in a
critical position.
1981 1982 1983 1984 1985

Sales ($000) 100000 98000 96000 96000 94000
Labour costs ($000) 35000 34800 34600 34500 34000
NBIT (% Sales) 7.5 6.0 5.0 4.5 2.5
Interest cover (x) 3.0 2.5 2.0 1.5 0.8
TLiNW 1.6 1.8 2.1 2.3 2.5
Current ratio 1.5 1.6 1.5 1.6 1.6
Receivable turnover 60 59 60 59 58
THE USE OF TABLES IN CREDIT PRESENTATIONS
Tables can help to cure three common weaknesses in credit

presentations, and can help bankers to understand the credit and
present it so that the reader can absorb it easily and decide whether to
agree or disagree.
Tables help to strike a balance between on the one hand presenting
opinions and conclusions without enough factual support and, on the
other, presenting a mass of factual material without any indication of
the writer's conclusions; they help a writer look at trends, both past
and future, over a reasonable period; and they avoid the tendency to
make the text almost incomprehensible by mixing numerous figures in
with a narrative description.
To obtain these benefits we must use tables intelligently. In
particular, while they are nearly always of value in the financial
analysis section, they are often harder to use in other sections.
Tables work best when they illustrate the text which immediately
precedes them. They allow the text to concentrate on conclusions and
interpretations, and avoid cluttering it up with factual support. Such
support is essential to a well-presented argument, but if intertwined
with the main points distracts attention from them, and makes the
thread of the argument harder to follow. Secondly, tables make it
easier to focus on trends; indeed it could be said that they make it
harder to fail to do so. A table consisting of only one or two years is
an obvious nonsense; even three is too few. Once we extend the table
to four or five years, it is difficult to talk about only the last one in the
text. And, finally, tables are much easier to understand. Even when
separated from the interpretation, figures are very confusing when
presented in a written text; the more detailed the discussion, and the
more figures we need to present, the harder it is to include them as
part of a verbal text.
However, there are no panaceas in credit, and tables are no
exception. They are frequently poorly used, and then give a weak
memo with tables, instead of a weak memo without them. For
instance, if the bank has a standard spread sheet, an extract from
that, or summary of it, inserted in the middle of the text adds little or
nothing to our knowledge. It contains less than is in the full spread; if
presented in lieu of a financial analysis section, it says nothing about
the banker's view of its meaning. Where presented in support of the
text, there is little chance that it fits well with the points being made.
Making it Easier 29
Another common mistake is to include a table which merely

repeats in figures what the text has already said in words. When, as
often happens, even the text contains only facts without interpreta-
tion, the table merely serves to conceal from the writer his own
evasion.
Other common misuses of tables include tables which fail to
support and sometimes contradict the main argument. One of the
benefits of tables is that they allow the writer to check whether the
facts actually coincide with his interpretation. Where they do not, the
table can be a very useful tool to help correct the misinterpretation,
but only where the writer takes the trouble to look at what the tables
show. And the worst misuse of all is the selective use of only those
figures and ratios which support the case. Leaving out the contrary
evidence is wrong everywhere, not only in tables, of course; nor is it
always a deliberate attempt to mislead. It is always serious, however.
Where not deliberately misleading it still often means either that the
writer has so little understanding of the credit that he does not
recognise the negative aspects; or that he is so committed to the
proposal that he is unable to focus on the risks properly.
An exception to this may be where the writer fools himself as well
as anybody who accepts his facts without checking. For instance,
some writers condense the tables by using averages. Where the
average fits the pattern the writer has in mind, this may not matter
much. However, a table which reads:
NAT % Sales Av.1982-5 1986

5.1% 6.2%
appears consistent with a text referring to improving profitability. But

the average could conceal any of the following patterns:
1982 1983 1984 1985 1986

A 2.1 3.0 8.0 7.3 6.2
B 4.5 5.0 5.3 5.6 6.2
C 8.0 7.3 3.0 2.1 6.2
Only B really fits the comment without qualification.

SOME EXAMPLES
Financial condition has strengthened steadily over the last several
years to a satisfactory level; strong cash flow has allowed steady
improvement in leverage and liquidity. It has been supported by
sound and gradually improving control of net working investment
and the reinvestment of a high share of the strong earnings:
1982 1983 1984 1985 1986

TL/NW 1.50 1.20 1.10 0.80 0.70
Current ratio 1.25 1.40 1.50 1.55 1.65
OCF/TL 18 18 19 21 21
Rec. T/O 80 77 76 74 71
(days)
ROA 20 21 21 23 24
Diy. % NAT 35 34 36 37 33
Alone, the opening paragraph is clear but not very specific. The table
provides the detail without reducing the clarity. The table includes
only one ratio each on leverage, liquidity and net working invest-
ment; since there are other ratios which measure aspects of each of
these concepts this implies that they give a similar picture. If there is a
major divergence between, say, TBF/NW and TLlNW, or receivable
and inventory turnover, then both the comment and the table must
be modified. Perhaps as follows:
Overall financial condition is now sound as the result of continuing

reinvestment of a large part of growing earnings and cash flow. A
modest deterioration in TBF INW and NWI results from borrowing
to take advantage of attractive trade discounts. Tighter control of
receivables has more than offset the slight slowdown in inventory
following the opening of several new distribution depots to speed
up delivery:
1982 1983 1984 1985 1986

TLINW 1.50 1.40 1.20 1.10 0.90
TBF/NW 0.40 0.40 0.50 0.50 0.60
Current ratio 1.25 1.40 1.50 1.55 1.65
Rec. T/O (days) 90 85 80 75 73
Iny. T/O (days) 90 91 92 94 95
Payable T/O (days) 45 43 30 25 20
ROA 10 11 11 13 14
Diy. % NAT 35 34 36 37 33
Making it Easier 31
On a superficial view, a banker might easily be tempted to make

the first comment about the second company. If he prepares the
table with due care, however, this will draw the contrasting
movements to his attention; in checking the reasons, he will learn
more about the credit of the company. This is truer, the greater the
contrast; in this example, the reasons for the discrepancies are
favourable or neutral. Where the contrasts point to a deteriorating
situation the resulting investigation can be vital to the decision. For
instance:
TLiNW 4.10 4.00 4.20 4.10 4.00
on its own suggests a stable, if high, leverage. But:
TLiNW 4.10 4.00 4.20 4.10 4.00

TBF/NW 0.80 1.00 1.50 2.00 2.90
suggests that the stability is illusory. There are a number of

possible explanations, some more worrying than others, but it is
clear that we need to know more.
A typical weak comment such as:
1985 leverage as measured by TLiNW was 0.8; current ratio was

1.65 against 1.55 and ROA was 14 against 13
is harder to make, because more obviously inadequate, if it is

followed by a table covering four or five years.
Finally, it would be possible to give the facts from the first example
in the text rather than a table, but it would be hard to avoid a jumble
of figures and comments which lost all clarity. With the more
complicated facts from the second example, it would be a nightmare,
and with really complicated facts it becomes impossible. Something
has to give and usually several things do. An example:
Leverage (TLlNW) improved from 1.5 in 1982 to 1.1 in 1984 but

then deteriorated to 1.7 in 1986. Liquidity (current ratio)
deteriorated sharply from 1.7 in 1982 to 1.1 in 1985 and recovered
slightly in 1986, but receivable turnover, after improving from 90

days in 1982 to 85 in 1984 worsened sharply to 100 in 1985 and 120 in
1986.
Apart from being difficult to read, this gives no indication of the

writer's views and no interpretation of the facts. The writer probably
feels that at least he has shown trends, but in fact they are clear only
with laborious rereading.
In brief, the intelligent use of tables makes memos shorter and
clearer. It helps the writer check that all the facts (not just some of
them) agree with his argument. Sometimes it shows up contradic-
tions or divergences not previously noticed; investigation of the
reasons behind these can improve our understanding of the credit.
To qualify as intelligent, the tables must:
(a) support and illustrate conclusions and interpretations in the

text;
(b) be complete; this does not mean including every possible item,
rather nothing should be left out which would contradict or
modify the conclusion drawn from what is included;
(c) be consistent with what is said in the text; and
(d) be selected only after consideration of all the possible ratios
which might be relevant, not just the first one looked at.
WHY, AND HOW, TO BE BRIEF
Short memos save the reader's time, are easier to understand,

impose an important discipline on the writer and save typing and
photocopying. Not all memos can be short, and difficult credits
warrant a longer treatment. However, a long memo about a name
that does not warrant it gives a false, and damaging, impression.
Brevity is thus not a primary end in itself, but rather a desirable
bonus from clear thinking.
A good memo has several main attributes: relevance, organisa-
tion, technique, recognition of the likely audience and of its
perception of the writer.
Relevance
A good memo contains everything relevant to its purpose, and no

Making it Easier 33
more. This relates first to what points we want to make and secondly
to the material needed to make them. Unless we have thought about
the credit in the right way before we start to write, we shall almost
certainly include material which does not help, as well as excluding
material which we need. Either we end up with a memo which is too
long for its purpose, but still leaves out important parts; or we spend
too much time redrafting, correcting what are faults of organisation
or sloppy thinking, not of basic understanding. Often we get the
worst of both worlds, ending up with a fifth, sixth or even later draft
which still does not satisfy us, or the reader.
Organisation
Even if we get over the first hurdle of thinking through what it is we

want to say, and what material we need to say it, we can still end up
with a lengthy memo if we fail to think about how we want to
organise it. This means thinking about what order to present the
points in, how to relate them to each other and to the main
conclusion, how to present items which appear to (or actually do)
contradict each other in a way which leaves the balance between
them clear, and so on.
Where material is relevant to several of the points we wish to
make, we must think about how to present it with the minimum need
for repetition. And at all times we must make clear the relative
importance of each point, and the balance between them.
To fail in any of these items, or others below, at best leaves the
memo longer than it needs to be; at worst it adds massive length as
we try to explain the items which poor thinking has left unclear;
probably the memo never becomes clear.
Techniques
There are techniques which help keep a memo short. Many of them
have other advantages as well, so that they are mentioned in other
parts of this chapter or other chapters. Nevertheless, this is one case
where repetition is helpful.
A Rationale or Summary can help us with both relevance and

organisation.
- A Business and Background section can highlight points which
come up in more than one section of the memo; or can make the
framework for discussion of key points clearer, thus reducing

the need for explanation in places where it distracts attention
from the main point.
- Tables present essential facts clearly and briefly.
- Good writing avoids unnecessary words and complex sentences.
Phrases such as 'in the event that' for 'if', 'leverage as measured
by total borrowed funds to net worth' for 'TBF/NW' can
lengthen a memo by as much as 10 per cent, while making the
meaning less clear.
The Audience and its Perception of You
Do not leave out key points because 'everybody knows them'.

However, experienced writers writing for an experienced readership
can rely more on brief references to show that they have recognised a
point. Such readers will not need a full explanation; they will both
understand the point, and be confident that the writer understands it.
An inexperienced writer will need to go into more detail, to
demonstrate that he does indeed understand, or make any misunder-
standing clear; when writing for a less experienced reader, we may
need to spell out more that we would expect an experienced banker
to know. In other words, do not teach your grandmother to suck
eggs, but if you are the grandmother do not assume all your readers
are old hands at egg sucking.
Finale
Many people claim that a short memo takes longer to write than a
longer one. There is a sense in which this is true; even the best draft
can be pruned, and a poor draft can take much longer to knock into
shape, with brevity as a side benefit rather than the main purpose.
However, the time taken to think through the credit and organise the
memo will always reduce the writing time. With even a little practice
the net saving will soon be a large one. Thinking first takes less time
than rewriting to cover the early failure to think. Equally, the worst
memos are those which ramble all over the place; because the writer
really does not know what he is trying to say he ends up putting in
every point which might possibly be relevant, in no particular order
and with no obvious connection with the recommendation he is
presumably making. It may not even be clear what the recommenda-
tion is in the very worst memos. The next worst are those where the
Making it Easier 35
writer thinks length is in some way a virtue, and writes a long one for
that reason, not because there is much to say.
Brevity is thus relative. A memo should be as short as is
practicable in view of the nature of its contents. We should not fear
that a short memo will look as if we do not know what to say;
equally, we should not hesitate to write a long one where necessary.
Part II
Examples
3 Looking Outside the
Borrower
INTRODUCTION
In analysing a credit, we need to look both at the borrower itself and

at the conditions in which it operates. These may be general - the
political and economic climate for instance - or they may be more
specific to the company itself, or to the industry in which it operates.
Understanding these external factors is as important as understand-
ing the internal aspects of a company. It is also as easy to jump to
conclusions or make superficial assessments - and as dangerous.
We look at the external factors to see how they affect the company
we are appraising. To understand this, we must of course know what
impact they have on other companies, but we must go further than
that. We must understand why they have that impact, and whether
the general reasons that apply to most companies also apply to our
company, or whether there is some feature which modifies or cancels
the impact in our case. It is not enough to say 'this is a German
company - or a widget maker - and German companies - or widget
makers - are usually highly leveraged, therefore we can accept a
TBF/NW ratio of 5.0 from company X'. Rather we need to know why
the general comment is true, if it is, before we can judge whether it
applies in full to our company. Even then, we still need to be sure
that this is the only reason why our company shows the particular
feature; otherwise we may allow the general trend to hide unusual
(and perhaps unfavourable) features which are unique to our
company.
Too often, however, we see phrases such as 'leverage is acceptable
for a German (or French, etc.) company', or 'leverage is-in line with
the sample of companies with interests in the widget industry'; this
one often comes after a comment that the sample is not very
representative.
As well as looking outside a company to assist us in the analysis, we
also sometimes look outside it for more concrete support. This is
most common when it is owned by another company or by
government, directly or indirectly. However, outside support - or at
least the expectation of it - is not confined to ownership, although
39
40 Examples
most common and least unreliable when ownership is involved.

The types of outside information and support are too numerous
and variable to describe them all in detail. The rest of this chapter
discusses a few of the more common situations in each category. The
hope is that the specific discussion will help bankers deal with similar
cases, but more importantly will suggest an approach to thinking
about the broader problem which will be helpful whatever the precise
form in which it crops up.
INDUSTRY COMPARISONS
Industry comparisons can be valuable when used to support a point.

When, as is too often the case, they are used as an excuse for not
thinking or a substitute for analysis, they can be counter-productive.
Relevance is therefore the first question when considering the use
of industry comparisons. What is the point that we are trying to
make, and how do the industry comparisons help us make it?
Probably the most important use of industry comparisons is to
show how the company is coping with particular problems where
there is no absolute standard. For instance, some industries depend
more than others on research to find new products. For an outsider,
however, it may be impossible to judge how much is enough. It may
then be worth seeing how the research spending of similar companies
compares. Even then, we must remember that quantity of spending is
not the same as quality; what we really need to know is how
effectively the money is being spent. To assess this, we need to know
how many new products the company is introducing as a result of its
research, and how profitable they are. If we can show that these
generate a return which is more than enough to justify the cost of the
research, maybe we do not need the industry comparison to satisfy us
that the company is a sound credit.
More probably, we cannot get the breakdown of the profits of
different products to allow us to make this judgement. Then a
comparison that tells us, for instance, that on average our company
gets at least as high a share of sales from new products as its
competition is better than nothing. It does not tell us conclusively
that the research funds are being well spent, but it leaves us with at
least a favourable inference; depending on the surrounding circumst-
ances we may be able to be more positive. We must, however, avoid
converting the negative inference too easily into a positive belief that
Looking Outside the Borrower 41
the industry comparison proves that the research is well directed.

Comparisons may be useful, too, where some companies are more
informative than others. We can use the greater information
available on some companies to draw inferences about others which
are similar in the areas we do know, but about which we know less
overall.
When the industry is either declining overall or faces a particular
problem which may be fatal for at least some companies in it,
comparisons can help identify the weaklings and the survivors. If we
believe that only some of the industry will survive, then we may want
to use comparisons to help us to find the survivors. But the
comparison makes sense only if we are satisfied that some part of the
industry will survive, which means (among other things) that we
know something about the industry; otherwise, to know that our
customer will be the last to fail is of limited value.
For instance the tyre and car battery industries are in decline for a
broadly similar set of reasons relating to the decline of their end
customer, longer life of their product undermining profitable replace-
ment sales, and import competition. But while cars continue to be the
main form of transport, they will need batteries and tyres. Thus while
it seems inevitable that some companies will leave each industry, we
can expect both industries to survive in some form. A lender to either
can sensibly compare companies to identify survivors.
Before the comparison can be of much help, however, we need to
identify the factors which will decide success. It is of little value to
compare financial ratios such as leverage if they prove to have only a
minor influence on survival. And in view of its essentially passive
nature, balance sheet strength is likely to be of secondary import-
ance. The deciding factors will probably need to be selected from
things like technical ability; cost control (which may combine with
technical ability; in a declining industry research may be aimed as
much at improving production methods and costs as at new products);
marketing ability in any of its many aspects; distribution; brand
loyalty if that can be separated from marketing; and perhaps pure
luck in being a major supplier to successful manufacturers. Manage-
ment will also certainly be a key factor in either taking advantage of
strength, or offsetting weakness.
Whether we will know enough about these factors to compare
them usefully is another matter. There may be some proxies; for
instance, margins may give a pointer to cost control, or market share
to marketing ability. Or it may be possible to point to partial answers.
42 Examples
For instance, financial controls do not in themselves guarantee lower

costs, nor do turnover ratios guarantee that overall financial controls
are at the same level. Nevertheless if cost and financial controls are
key, it is reasonable to infer that a company with faster than average
turnover of inventory and receivables manages other aspects better
than average as well.
Where our information does not allow us to compare the key
factors, it is almost certainly better not to attempt industry
comparisons than to have a string of comparative ratios. These can
take quite a long time to prepare and add nothing to the analysis.
Even where the industry is not declining, there may be pressures
which threaten to drive some companies out of business. Then we
may need to identify features which decide relative success, and
assess whether our company can match the competition in them.
After declining industries, the young and fast-growing are the most
likely to suffer a major shakeout; therefore we most need to be able
to compare (and choose) winners in these. The rise and fall of many
companies in the personal computer business is perhaps the best
recent example of this, but not the only one.
Here, too, the same basic point applies. Unless we can identify the
factors which will decide who stays and who goes, industry
comparisons are of little value. While there are some general pointers
to financial strength, these do not depend for their value on industry
comparisons. We can assess whether a company has the financial
strength to meet the demands on it, if we know what the demands are
likely to be, without needing to compare its ability with that of
others.
In brief, we can make useful industry comparisons only when we
understand the industry concerned. Only then can we use the
comparisons to illustrate key points.
The Wrong Way
The wrong way, then, is to use industry comparisons to cover up lack

of real knowledge about the industry, and about what are the key
factors. Too many industry comparisons consist of long lists of ratios,
which enable us to say that our company is more highly leveraged,
has a higher cash flow, is more liquid, has higher margins on sales (or
worse in each case) than the average for its industry. They do not,
however, tell us how much each ratio matters to this industry. Nor do
they tell us anything about the strength of the industry, nor what
prospect our company has of repaying its debt. If an industry as a
whole is in decline with little or no prospect that it will exist in a few
years, it is not much consolation to know that our company will
probably be the last to collapse. What we want to know is whether
being 'the last' means that it will not collapse at all, or whether it
merely means we have a year to get out while others only have six
months. The same point applies to comments such as 'Company X's
ratios are better than its competition; leverage is lower, liquidity
higher, CF tTL higher'. If the industry is a disaster, this is much more
important than that our company is the smallest disaster in the
industry.
Industry comparisons are thus useless - and may be harmful -
unless:
- We know how good the industry is. The comparison itself may
tell us, or there may be a discussion elsewhere in the memo.
Otherwise we risk taking comfort from being told that a company
is above average for its industry, without realising that the
average is bankrupt and above average merely means that it is
not quite bankrupt - yet. Equally, we risk taking an unnecessari-
ly gloomy view about a company that is slightly below average
in a strong and profitable industry.
We have identified the factors which are important to success in
the industry, and understand their impact on ratios or the other
bases for comparison. Without this, the comparison does not
tell us how well the industry as a whole is coping with the
problems, nor in which areas a divergence from the norm is
essential (or at least favourable) and in which areas it is
undesirable, or even disastrous.
- We focus on ways in which our company's business differs from
the industry norm, and whether these differences undermine the
validity of the comparison. For instance, a chain of supermar-
kets can normally afford a low or negative current ratio because
it turns its inventory into cash very quickly and pays its suppliers
more slowly. A comparison of pure supermarkets with a chain
which also sold a range of slower-moving goods, and which
perhaps even manufactured some of them, could give entirely
the wrong impression. The chain would have a much greater
need for working capital; a comparison which showed it at the
same level as pure supermarkets might be taken to show a
44 Examples
sound position when in fact the company was running into a

liquidity crisis.
- We are sure that, even where the comparison is valid as far as it
goes, there are no offsetting factors elsewhere. In other words,
the comparison must be complete. Companies may be stronger
in some areas and weaker in others than the industry average.
An incomplete comparison may focus on the area of strength,
and lead to an over-optimistic assessment, and subsequent bad
debts; or on the area of weakness, leading to a too gloomy
assessment and the unnecessary loss of good business. This
again re-emphasises the need to understand the industry before
using industry comparisons; otherwise it is impossible to judge
the relative importance of strengths and weaknesses.
The argument thus ties in with one of the main themes of this book:
industry comparisons, particularly in the form of financial ratios,
provide largely factual information; this is crucial to support
conclusions, but is useless (and sometimes dangerous) in their
absence.
THE NATIONAL CONTEXT
Bankers working in an overseas branch of an international bank, or

reviewing foreign credits in its head office, face a problem of
different standards. For instance, German companies have (or at least
report) higher leverage than most British or American companies of
otherwise broadly comparable nature. It is therefore very easy to fall
into the trap of classifying leverage that would be a clear warning
sign in a British company as 'acceptable by German (or French,
Italian, Spanish, etc.) standards'. Equally it is easy to use average
ratios for the country concerned, from a range of companies with
little in common, as a yardstick. Both these practices compare a
particular company with averages. Even if the averages have validity
in some circumstances - which is by no means always true - there is
no reason why they should be relevant to every company. Banks lend
to individual companies, not to averages. Average companies repay
their debts; that is no comfort to the banker who has lent to the one
that does not fit the average.
It would, of course, be wrong to ignore the different conditions in
each country; or the effect these have on financial statements and
needs. Equally, it is wrong to assume that their effect is the same in

each case. The rest of this section therefore discusses ways of
assessing national differences and their effects more accurately.
The Reasons for National Differences
There are several categories of reasons why financial statements in

one country differ from those in another. In some cases they
combine to accentuate the difference, in others they partly offset
each other.
One category reflects underlying differences of practice or law; a
second pure accounting, so that the difference is in the reporting
rather than the underlying situation; a third results from different
standards in local markets. Each category has different implications
for the strength of the companies in the country concerned.
Differences in Law and Practice

This category focuses on different behaviour by companies in each
country, and the effect of this on the balance sheet and profit and loss
account. However, the differences will not apply in full to every
company, nor affect them in the same way.
For example, German companies usually turn over receivables
and payables faster than Italian companies. This makes these two
items a larger item in Italian than in German balance sheets, for
otherwise similar companies. It follows that Italian companies
usually have the higher TLiNW ratios, more short-term borrowings
and thus higher TBF/NW and TBF/sales.
However, this generalisation is not true in every case, nor are its
implications the same when it is true. Some Italian companies collect
their receivables faster than the Italian average; if such a company
does not show proportionately lower leverage we need to seek
another reason. Equally, some companies have raw material costs as
much as 50-60 per cent of sales, others as low as 20-30 per cent. The
relationship between receivables and pay abies is obviously very
different, and so is the implication for the extra leverage we can
expect in an Italian company. It particularly affects the extent to
which the company has to borrow to finance the slow receivables.
Equally, some companies may find it easier to recoup the cost of
financing the receivables than others, thus changing the impact.
Knowing that Italian receivables and payables turn over slower, on
average, than German thus does not tell us whether the level
46 Examples
attained by a specific Italian company is sound; it does, however,

give us a better knowledge of the background, and therefore a better
chance of assessing the credit accurately. In some cases, where the
inventory costs are high, the slower payable turnover may mean that
there is little extra borrowing; we can then accept a higher TLiNW
ratio, but worry if there is also a higher TBF/NW. In other cases, we
can accept the higher borrowing as well, provided the profit margins
are there to absorb the higher interest cost - bearing in mind the
higher interest rates also common in Italy.
A second example is the treatment of pension funds. German
companies carry them as reserves on the balance sheet, while the
British and some Americans carry them off balance sheet in a
trusteed or insured fund. Many German companies have far larger
reserves than is actuarially necessary, so that the reserves, although
carried as a liability, have many characteristics of equity. In these
cases the higher TL/NW (and sometimes TBF/NW) ratios common
in Germany are easy to justify. But German companies which are
not doing well may not build up adequate reserves, or even if they
have a reserve on the balance sheet, it is unfunded. At best, the
reserve is thus a genuine liability, rather than quasi-equity; at worst,
there is a major liability which does not show on the balance sheet at
all.
Even where these extremes do not apply, the implications of a
given reserve differ widely depending on the age pattern of the work
force, to mention only one factor. A company may have an elderly
work force, and a large group of pensioners, all of whom have given
many years of loyal service; or it may have a relatively young force,
many of whom it expects to leave before qualifying for a pension. In
the first case, the company either is (or soon will be) paying out more
from its pension reserves than it is putting in; the pension is then a
medium- or even a short-term liability. In the second case, the
company is paying out little or nothing, and expects to pay in more
than it takes out for many years yet. If we are sure the amount it is
paying in will eventually be needed, the reserve is still a genuine
long-term liability; in some cases, we do not expect that it will ever
use the full amount, so that at least part of the reserve is equity. This
may also affect the quality, and sometimes the amount, of reported
earnings.
Accounting Differences
There are two categories of accounting differences in this context;
those where we know the impact and can thus make the necessary
adjustments, and those where we think we know the general nature
and direction of the change but cannot judge the amount of the
difference.
As an example of the first type, Anglo-Saxon accountants deduct
depreciation and some other reserves from assets to show a net
figure. Many Continental European companies show the asset gross,
and the reserve as a liability. Then again, many countries show as
reserves (sometimes liability and sometimes equity) items which
Anglo-Saxons show as retained earnings. In these and other similar
cases, we normally understand the difference well enough to adjust
the reported figures so that the underlying reality is clear. Unless we
do so, however, the different reporting may make the reality appear
different. It is misleading to say 'German standards are different'
when what we mean is 'German companies report the same facts
differently' .
In the second category, however, we know less of the effect of the
differences. In some cases we may be only guessing at their existence;
in others, we may be sure that they exist but not know whether a
particular company uses them, and if so to what extent or even in
what direction. Some of these variations are in valuation (LIFO v.
FIFO, or historic cost v. replacement cost), or legitimate reduction of
assets or profits to reduce tax. (In some countries, the law requires
the published accounts to be the same as those on which tax is
assessed, with obvious implications for their bias.) Although widely
accepted in many countries, the use of hidden reserves to conceal
both the true balance sheet and profit and loss position is less
legitimate. Companies often claim that it is conservative, since it
understates net worth and earnings; thus, they will imply, the bank
does not need to worry. Apart from the fact that even distortions in
this direction can mislead, the main point is more serious. The only
real point of having hidden reserves is to be able to draw on them
secretly when things go wrong. Thus when the bank knows there are
hidden reserves, and transfers to and from them, it can often guess
the direction of the misstatement, even if not the extent; but that is all
it is, a guess. We may say 'leverage looks high and cash flow coverage
low, but because of the local practice of hidden reserves they
probably are not as bad as they look'. If we are right about the
direction of the transfers, and at least the general extent of the
reserve, we are probably also right to accept the apparently weak
condition. But we need to be sure we are right. A company may start
48 Examples
with an apparently weak balance sheet which is stronger than it looks

because of its hidden reserves. If it then dissolves the reserves to
avoid reporting losses (and a weakening balance sheet) when the
bank thinks it is making profits and building up hidden reserves
further, the result can be disastrous. But in a climate where hidden
reserves are accepted practice, we can hope to judge which company
is doing which only on a case by case basis. Averages are no help at
all.
We should remember, too, that the banks in some countries are
among the most convinced users of hidden reserves. They will be able
to judge better from their familiarity with this objectionable practice,
and from their often closer contacts with local companies, when
reserves are being used to cover losses. Foreign banks, which do not
use hidden reserves and do not understand the mentality which does,
should be doubly careful about assuming their existence.
Local Market Standards

There is no doubt that different local markets, which usually means
the local banks, accept different standards. As markets grow more
international, and securitisation increases everywhere, some of the
differences may be shrinking, but for the moment they remain for all
except the largest multinationals. We need therefore to understand
what the standards are in each market, and why they exist. Only then
can we be sure that we are applying the standard correctly, and that
the local market will agree that our borrower fits it.
There are active equity markets in the United States and England.
British and American banks can therefore often insist on lower
leverage than would be practicable in countries with weaker equity
markets. In some markets banks hold large equity interests in their
borrowers; they may be willing to allow higher leverage as lenders
because if the company is successful they benefit as shareholders.
Banks which cannot share in the upside potential of leverage may be
less inclined to accept the risk. Perhaps, too, some banks allow the
more relaxed approach to spill over into lending, even to companies
in which they hold no shares.
Economic conditions are more favourable in some countries than
in others. Low and stable interest rates and good general profitability
in Germany justify a higher leverage than the volatile rates and low
economic growth in the United Kingdom. The general truth of that
statement did not protect many highly-leveraged (by British though
not necessarily by German standards) companies in the German
recession of 1981-2; they faced at the same time a sharp reduction in

demand, even higher borrowing and a sharp increase in interest
rates. Not all survived.
In all countries (but particularly where figures are unreliable or
unavailable), local banks may place less weight on them than Anglo-
Saxon banks do. They often have pointers which foreign banks lack,
or they lend secured. In Britain, for instance, the clearing banks can
monitor the flow of payments in and out of the main operating
account; a foreign bank rarely has the main account of a British
company, and so lacks that way of checking its customer's health. In
most countries local banks have a wide range of local contacts and
are likely to hear of a company's slow payments of suppliers, failed
product launch, technical or servicing problems (to give only a few
examples) before foreign banks do. They may in some cases even
lend more than they strictly should out of a sense of duty to the local
community.
In other words when banks in one centre say that the local markets
accept higher leverage than is customary at home, that is quite often
true. It is not, however, a complete answer to the question whether a
particular company can support that level. It is only a lead in to
supplementary questions: 'Why does the market accept different
standards? Can we be sure that they apply both to us and to the
particular companies which borrow from us? Can our monitoring
detect a divergence from the standard by our borrower before the
local banks do? How sure are we that the standard is sound even for
local banks and therefore that we should accept it?'
Conclusion
The above are not the only factors which affect financial structures,
but they are the main ones. They should be enough to establish that
banks should not accept 'national standards' as sufficient explanation
of apparent financial weakness without further investigation. Banks
should decide whether a weak condition is acceptable only after
analysing the reasons for it in the particular case; they must judge
whether the reasons are in line with the local practice, or are caused
by other less reassuring factors. They must also decide whether a
company has perhaps stretched the local practice beyond the level
that the local banks find acceptable, in which case foreigners
certainly should not accept it. Of course the reverse is true for banks
used to weaker standards lending into countries with stronger. A
50 Examples
German bank lending to an American company should not ignore

what seems high leverage to an American bank just because it is low
by German standards; nor should it condemn the borrower out of
hand without understanding why it is more highly leveraged than its
compatriots.
The point in brief is not that we should ignore local conditions or
the differences they make, but rather that we cannot tell how
important they are until we have analysed the key features of the
company. It is unsound to say 'this company has high leverage, but
so do many other local companies, so we can ignore it'. It is quite
reasonable to say 'this company has high leverage; however, we have
analysed the reasons for it and are satisfied that it is sound in the light
of local practice and standards'.
WHAT IS GOVERNMENT RISK?
'Government risk', 'state risk' and similar phrases cover a wide range
of government involvement in a credit. In an extreme case, a
memorandum gave a borrower a high rating because of government
support, but then commented: 'however, certain circumstances such
as a change in attitude towards government-owned companies, or a
change in the importance of this company and its products to the
local environment or nationwide, could change the government's
interest in the company'. The writer apparently did not see anything
incongruous in a high rating based mainly on a factor which could
change, but where he had not analysed the chances or possible
causes of change.
The rest of this section identifies the levels of government support,
and suggests ways to focus on their credit implications. Banks should
avoid blanket phrases such as 'government risk', and replace them
with an assessment of how badly they need the support and how sure
they are of getting it.
Degrees of Support
There are three main levels of government involvement in a credit,
from which banks can take a descending degree of comfort. There are
of course many finer gradations which are not critical to this
discussion.
The strongest government support, which we will call Class I
support, is the government's clear legal liability . This exists when the
government is the borrower directly, or when a department of

government borrows; when the government guarantees debt; or
when there is a statutory obligation on the government which has the
same effect as a guarantee. Even here, we need to be sure that we
have a correctly-documented claim which the country's courts will
enforce if necessary. This almost certainly means taking legal advice.
Class II government support covers the situation where the legal
obligation is not entirely clear, but where there is a strong moral
obligation. This includes most cases where there is a written
keepwell; private (or, better, public) statements by ministers or other
properly-authorised officials; often government ownership (the larger
the percentage the greater the moral obligation; beware, however, of
imputing too much to partial government ownership acquired as part
of a previous rescue: government may feel it has already done
enough); or such close regulation that any failure of a company would
probably be the result either of the regulations themselves or some
failure in their enforcement. (Again, however, be wary of this one;
governments dislike taking responsibility for failure, and may be even
more reluctant than usual to admit a fault which costs money.) There
are other cases which create some degree of moral obligation. For it to
qualify as Class II, however, there must be a threat of direct damage
to the government. This will probably be to its credit standing
(domestic or international), and therefore to its ability to borrow; in a
few cases, however, the bank may be able to sue with a good chance
of winning, but less than the clear case needed for Class 1. In either
case, the bank must be sure that the government recognises the
threat, and takes it seriously. In other words, Class II requires more
than a feeling that governments are honourable people; it requires
the bank to be able to make life unpleasant for a government which
lets it down.
Class III support carries such a weak moral obligation that a breach
would be unlikely to hurt the government's standing. Therefore the
main reason for expecting support for a company is that it serves the
government's interest in some way. This leaves three adverse
possibilities, apart from the risk that the assessment of the gov-
ernment's interest was wrong in the first place. The government's
interest may change; it may be able to meet its primary objective
without protecting the banks; or it may expect the banks to share in
the cost of a rescue, so that it only partly protects them. 'Equality of
sacrifice' is a phrase that attracts some governments in this type of
situation.
52 Examples
Analysis and Presentation
Whenever a bank lends in reliance on government support to a

borrower which is not itself legally part of the government, it should
consider the following questions:
1. How likely is it that we will need to rely on the government's

support? Can the borrower now - or do we expect it to be able
to in the future - service all or most of its debt itself? I.e., is the
government's support needed only to protect the bank against
more or less unlikely contingencies? Or is the borrower wholly
uncreditworthy in its own right, so that government support is
the only, or certainly the major, source of repayment for the
foreseeable future?
2. How expensive will it be to the government to support the loan?
In particular, is the cost of support:
(a) An existing cost which the bank can quantify?
(b) A contingent future cost?
(c) Likely to be permanent? or
(d) Reasonably expected to be temporary?
3. What is the benefit to the government of continuing support?
Again, is it:
(a) Present and actual?
(b) Future and contingent?
(c) Monetary and quantifiable?
(d) Intangible, perhaps subjective?
(e) Lasting or subject to change, unpredictably?
4. How sure are we that the government must protect the banks to
achieve the benefit?
These questions are less critical with a full government guarantee.

They are vital when looking at Class III support. There is also, mainly
in relation to Class III, a broader question about the government
itself, rather than just about the specific case. Has the government
given, or been taken as giving, support in so many cases that its
ability to meet the expectations threatens to run into political or
economic limitations? If so, how well do we understand these
limitations? Is their impact stable? Where will the cut off point come
and how does our borrower relate to it?
Even with a Class I risk we need to ask some of these questions.

They also affect the government's overall credit standing. It is
dangerous to classify something as government risk, even correctly,
without considering the quality of the government concerned.
The bank thus requires some analysis of the borrower, as well as of
the government obligation. Often this can be quite brief, but just to
say 'This borrower is obviously not creditworthy, therefore we
classify it as government risk' is not enough.
Assessment
It is particularly difficult for credit officers outside the country to

judge in which class a particular item belongs. Accurate assessment
requires a close familiarity with the legal, ethical and political
framework, not just in general but in this specific context. Only
bankers closely familiar with (and probably living in) the country can
expect to have this knowledge. Outside supervisors and credit
officers must at least make them show that they have applied the
knowledge sensibly in making their recommendation. The statement
'Spanish (or French, German, British, etc.) practice makes it
impossible to let this company go' must be justified.
KEEPWELLS: THEIR NATURE, STRENGTHS AND

WEAKNESSES
There are conflicting pressures when banks lend to subsidiaries, but

rely on a parent's support as a major (or sometimes the only) basis
for the credit decision.
In pure logic, if a parent fully stands behind a subsidiary's credit, a
guarantee puts in writing only what the parent intends anyway.
Refusal to give a guarantee should then be a cause of concern to a
bank which regards the parent's support as crucial.
In practice, there are a number of reasons - such as exchange
control, tax, debenture and bond issue restrictions and sheer
corporate machismo - which make companies reluctant to give a
guarantee. The same companies often refuse, however, to accept
that lack of a guarantee weakens the credit standing of the borrower;
it requires greater faith in the parent and either higher pricing or
better protection in other ways.
Some companies have walked away from weak keepwells; others
54 Examples
have tried but failed to do so in the face of determined opposition

from the banks. Banks which wrongly relied on the parent's name or
self-interest as evidence that it would support the subsidiary have lost
money. As a result, some banks are taking a strict approach to
anything less than a full legal guarantee. Others feel that their
portfolio makes this less appropriate, or that they can be more
selective.
This section therefore discusses the main points affecting the value
of a keepwell or other support. It should help bankers to judge when
to accept a keepwell and to help get the best one possible once they
have decided to accept one. (Some banks use other words, such as
letter of comfort, letter of awareness; others use different phrases to
denote different strengths of support. This section uses the word
'keepwell' to describe any form of parent support short of a full,
legally-binding guarantee.)
The Difference and the Implications
A properly-drawn guarantee is legally enforceable, contractually

against the borrower and in bankruptcy against the liquidator. (Note
the emphasis on 'properly-drawn', however. Guarantees are prob-
ably more subject to minute legal scrutiny and technicalities than any
other document.) A keepwell may be legally enforceable in some
circumstances (see the next subsection), but the bank can rarely be
sure of this in advance; nearly always the only safe assumption is that
it is not. The bank therefore relies mainly (often almost wholly) on a
mixture of the parent's willingness to meet a moral obligation and its
self-interest in keeping the subsidiary alive, which may include the
need to protect its own credit standing.
This carries four main implications. First, banks should accept
keepwells only from strong credits. A weak company is more likely
to feel pressure to save money by ignoring a moral obligation; in
some countries, it may even be subject to shareholder suits if it pays
out funds without a legal obligation to do so. Management of a weak
company is more likely to change, and the new management may not
feel bound by its predecessor's moral commitments. In the extreme
case, a liquidator or his equivalent is probably prohibited from
paying, and certainly has no concern with credit standing.
Secondly the bank must be sure that the issuer is conscious of the
moral obligation at all times. In particular, the issuer of an oral
keepwell may not have recorded it in his files; the bank must be sure
both to do so and to recheck the position if the person who gave the
oral keepwell moves on. Equally, banks should never assume that 'X
will never let its subsidiary go' without X knowing of, and endorsing
at least implicitly, the assumption - and, indeed, the transaction. A
company may have perfectly valid reasons for declining to support a
subsidiary about which the bank knows nothing. If it does not know
that the bank expects support, a parent has no legal or moral
obligation. Banks should therefore remind the issuer regularly
(probably annually) of their reliance on its support. Certainly,
whenever the bank's main contact at the issuer changes, the bank
should make sure that the new contact knows of, and agrees with, the
support. Where a bank has different levels of support for different
subsidiaries, it should consider establishing a regular annual discus-
sion of them all together.
Thirdly, because a keepwell is less formal than a guarantee, a bank
may accept less in the way of formal evidence - board resolutions,
and so on - than it would require with a guarantee. The bank should
nevertheless always be sure, and able to show, that the support is
known to and approved by people who have the undoubted power to
commit the company.
Fourthly, the lack of formality often also means that a keepwell is
rather vaguely worded. This can lead to misunderstandings as to the
nature of the issuer's intentions. To give two examples:
1. A keepwell rarely specifies whether it covers only commercial

risk or political risk as well. If exchange control or other factors
beyond the borrower's control prevent it paying even though it
has the local currency funds, it is important that both the bank
and the issuer of the keepwell agree who takes the loss.
2. Banks normally regard even the weakest keepwell as intended
to see that they get paid. Issuers may see them more literally:
they promise a specific degree of effort; the bank is being paid
to take the risk that that is not enough. Banks should always put
their reliance on the keepwell in writing, and clearly, so that the
issuer cannot say 'you never told me you were relying on me to
that extent'.
Pricing
Any support less than a full guarantee clearly involves the bank in an
extra credit risk, which justifies an increase in price. On the other
56 Examples
hand, to increase the price too much may suggest that the bank
recognises that it was not taking a parent risk, and therefore cannot
expect the same degree of commitment from the parent. The weaker
legal position clearly justifies some increase in price, but banks must
be careful not to be so greedy that they undermine their claim on the
parent.
Legal Status of Keepwells
A guarantee should be enforceable in any circumstances, and is

normally carefully drafted to ensure that it is. Even so, lawyers
sometimes get it wrong.
A keepwell is rarely as carefully drafted, but should be contractual-
ly enforceable against a solvent issuer, and sometimes in insolvency.
Banks should be careful about the wording for two reasons:
1. Keepwells rarely actually promise that the issuer will pay if the
borrower does not. Rather, they undertake some form of
obligation which makes it more likely that the borrower will be
able to pay. If anything in a keepwell is legally enforceable, it is
this obligation.
For instance, a company may undertake to use its 'best
endeavours' to ensure that its subsidiary pays. Under English
and New York law the phrase 'best endeavours' puts a
considerable burden on the company. If the bank can show that
the parent failed to make sufficient effort, it may be able to
recover damages; but if genuine best endeavours fail, the bank
probably has no further recourse to the parent. A parent might
thus successfully argue that it had no power to effect the
exchange control or other local government action which
prevented its subsidiary paying. Or the undertaking may be to
'ensure that the subsidiary is managed in a prudent way likely
to enable it to meet its obligations'. If the parent can show that
the subsidary was prudently managed, it may have met its legal
obligation.
Thus the weaker the keepwell, and the less specific its terms,
the harder it may be to prove breach of contract. The exact
impact of the words may also vary with the law under which
they are judged.
2. Banks often rely heavily on the goodwill of the issuer of a
keepwell. If the issuer calls in lawyers and has the wording
carefully vetted, this may be a warning that the bank's trust is

misplaced. A weak keepwell at least leaves an experienced
banker under no illusions as to what he is getting. A weasel-
worded one, which at first glance looks quite strong, and which
only careful analysis shows to say nothing meaningful, may be
designed to avoid liability under any circumstances. Companies
may have good reasons for avoiding liability, without intending
to deceive; they may also be trying to hide an underlying
reluctance to support their subsidiary.
Credit Standing
The need for a strong issuer of a keepwell has already been

mentioned. Banks also need to consider the standing of the
borrower. Where both it and the amount are small, and the parent
strong, this may not take much effort. But the larger and weaker the
borrower, and the greater the cost of meeting the keepwell, the
greater the risk that the parent will try to avoid liability. Where the
subsidiary is an important part of the overall group, its weakness may
even undermine the parent to such an extent that it can no longer
meet the debt, however good its intentions. The other reason for
looking at the issuer is therefore to see whether there is an offset to
these factors. The subsidiary may appear to lose money on its own
but may contribute to the parent's profits in ways which are clear
only with careful analysis. It may absorb parent overheads through
intercompany pricing, for instance, or pay large royalties or
management fees; or in some other way contribute so that the parent
has a strong self-interest in its continued existence, as well as the
moral obligation.
This relationship can change over time. If a bank accepts a
keepwell because it sees a real parent interest in keeping alive the
flow of profits, it needs to be sure that they continue to flow. In
particular, if a subsidiary begins to deteriorate, the bank should be
sure that the parent is aware of the problem, and that it does not
change either the will or the ability to support the subsidiary. Clearly
the bank may need to be tactful in criticising the subsidiary, but not
so tactful that the parent misses the point.
The Key Points Again
- A keepwell carries greater risks than a guarantee.

58 Examples
- The greatest of these is that the issuer is really trying to evade

his responsibilities.
- A bank cannot be sure that a keepwell will be legally
enforceable, but can make it more likely by paying attention to
the wording.
- Parents will live up only to moral obligations they see in the
same terms as the bank does. The bank must always ensure that
this is the case.
- A bank which accepts a keepwell makes a judgement about the
credit of both parties. It must monitor both to ensure that the
judgement remains correct.
- In accepting a keepwell, a bank also makes a judgement about
an intangible. This is the hardest type of judgement there is, and
should not be taken carelessly.
4 Looking Inside the
Borrower
INTRODUCTION
There are two parts to the analysis of any company. One looks at the
company itself, the nature of its business, of the risks it faces and
what it needs to protect itself against those risks - or, to put it
another way, its business strengths and weaknesses. The other looks
at the financial condition, profit and loss and cash flow. Neither on
its own gives a complete picture. Only when we match the nature
of the company's assets with the type of finance they require, and the
ability to generate profits and cash flow with the demands for cash to
meet the day-to-day payments, do we begin to get a balance. Only
when we know what a company needs can we know whether it has
enough.
A company which uses heavy and inflexible fixed assets thus needs
a different liability structure from a company with no fixed assets, but
fast-moving receivables and inventory as almost its sole assets. This
different structure in turn means that, as a percentage of sales, the
structure of the profit and loss statement looks different - or should
do.
Bankers need not and cannot be experts in the intricacies of
production, R&D, marketing and so on; nor do they need to be
experts in every industry to which they lend. Indeed, while there are
some industries where expertise is essential and others where it is a
help, there are more where the wrong sort of expertise is a positive
hindrance. If expert knowledge of the tensile strength needed in a
widget diverts a banker's thoughts from the financial implications of
producing widgets, then the banker is thinking about the wrong
things. A banker is paid to think about - and a good banker is good at
thinking about - how to finance a company. His expert knowledge
tells him what sort of financing requirement arises from. different
types of production process, marketing needs, selling terms, etc. He
should be able to anticipate a company's needs as they result from its
structure. For instance, a heavy-machinery manufacturer usually has
massive fixed assets, a high break-even point, a long-drawn out
production cycle and slow-moving receivables. These need to be
59
60 Examples
financed differently from a commodity trader's fast-moving receiv-

ables and inventory of goods which are traded on an exchange, and
which usually turn into cash very quickly.
Between these two extremes the differences are not always so
obvious, but it is a banker's job to think about them. Part of the art of
credit analysis - and, indeed, any financial analysis - is comparing
what the company's figures actually show with what we might
reasonably expect them to show from what we know of the business.
We thus need to look at more than the actual figures. We should look
at the nature of the business and its financial needs, and then look to
see whether the needs are being met. This process will sometimes
mean that we decide that a company is not as creditworthy as we at
first thought; this may happen where a company with unusual needs
has conventional finances which cannot meet them. Conversely, we
may sometimes find that a company which at first glance looks weak
is in fact as strong as it needs to be because its needs are small.
We must, however, look at more than just what a company does in
the narrow sense. We must also look at any unusual risks it runs.
These may relate specifically to the line of business - some companies
are more prone to product liability suits than others, for instance. Or
they may relate to the context within which it does the business -
some companies are more subject to political interference than
others. Or to where it does its business - this can affect its ability to
borrow, the currency in which it borrows or its exposure to exchange
risk through some other cause. Or whether it is independent or a
subsidiary - in which case it is subject both to instructions from and
the failure of its parent.
No short book - and probably no long one which anybody would
have both the time and inclination to read - can cover all the
possibilities. The rest of this chapter gives a few examples which
illustrate the approach the banker should adopt.
CAPTIVE SALES COMPANIES
There seems to be a general feeling that captive sales companies are

inherently weak credits, or at least that they depend so heavily on
their parent that they have no independent standing and borrow only
with tacit or explicit parent support.
It is often true that sales companies rely on their parent for the
supply of goods, and for technical and perhaps other support.
Looking Inside the Borrower 61
However, it need not follow that they have no independent credit

standing. Indeed, the classic pattern of a sales company outlined
below gives prima facie evidence that, even when economically
dependent on a parent, such a company may be a sound credit. We
must check that each borrower conforms to this pattern; the analysis
is fairly simple, and will often give confidence in the sales company in
its own right.
Note, for the avoidance of any doubt, that this comment does not
advocate lending to the subsidiary where the parent is known to be in
difficulties, or where there are serious doubts about its integrity.
Even though the argument is valid, there are too many possibilities
for loss when a parent collapses, or from fraud. The point is rather
that analysis of the subsidiary will tell us the extent to which we need
to rely on positive support, or can accept the mere absence of
negative features. It will also help us, if the parent does get into
trouble, to decide how much risk we need to accept to salvage our
loan. If the parent is the only hope of recovery, we may need to
contribute to its survival, even at some risk to ourselves; if we can
expect to recover all or most of our loan from the subsidiary, we can
leave the direct lenders to the parent to support it if they think fit.
The Analysis
The main features of a sales company are the self-liquidating nature of

it balance sheet and its low fixed costs. The balance sheet should have
only five or six items of any significance on it:
Assets Liabilities
Cash Current bank debt
Trade receivables Trade payables (usually mostly intercompany)
Inventory Net worth
The profit and loss in turn will consist of sales, goods purchased for
resale (a very high proportion of sales), interest on bank debt and a
small amount of SG&A.
Given these characteristics, if business declines both sides of the
balance sheet shrink proportionately; however, there is little impact
on profit margins although the absolute profit may decline; the ability
to repay debt remains almost unchanged. Why?
If sales decline, the company reduces its purchases but continues to
62 Examples
collect its receivables, using the cash to pay down bank debt and
intercompany payables. Current assets thus continue to cover current
liabilities with the same absolute margin, but by a higher percentage.
If the parent stops supplying, the process goes on to its logical
conclusion of an orderly liquidation; the modest net worth provides a
cushion against any loss on the sale of inventory. If instead sales
recover, increased purchases will create higher bank debt and
payables, which after a short delay will generate cash from the
resulting higher receivables.
In the profit and loss statement, goods purchased usually account
for 70-90 per cent of costs, and decline roughly pro rata to sales. The
reduction in debt reduces the interest cost, again almost pro rata.
Only the SG&A expense is unchanged, but as this is a small
proportion of the total it has relatively little impact. The company can
therefore shrink substantially without impairing its ability to expand
again later. (This point applies to all companies whose assets are
largely cash, fast-moving receivables and inventory and which have
low fixed costs: commodity companies, for example. Equally the
reverse is true of companies which have the bulk of their balance
sheet tied up in slow-moving assets, and high fixed costs. They need a
high capital cover, and most of any debt they have should be long
term and fixed rate.)
Of course, there are qualifications to the scenario outlined above.
Some products require extensive warehouse space; the company may
borrow to buy the space, or may rent it, but both create a fixed
financing cost, with possible additional fixed costs for maintenance
and taxes. Other products require heavy servicing; if the company
hires full-time employees to do this, rather than an independent
group of agents, their salaries and other expenses will be a fixed cost
or their redundancy costs may be a prior charge in liquidation. Either
way, the balance sheet is less self-liquidating, and profit more
dependent on volume. The credit may still be sound, if the company
has the extra capital and profits to provide a cushion; however, the
decision to lend without being able to rely on the parent will require a
different analysis, and may be harder to justify.
The speed of turnover of receivables and inventory is also vital.
There will always be some delay before the lower sales volume feeds
through to receivables, inventory, bank debt and interest charges as
outlined above. A slow turnover may increase this delay and affect
profits more than expected; larger working capital and equity
cushions will be needed to cover this risk. The chance of receivables
realising their full value is also relevant, as is the precise nature of the
inventory. Finished goods with a famous brand name can probably be
sold, even in bad times, fairly quickly and at only a small discount to
book value. Other types of product, particularly specialised compo-
nents, may take much longer to sell and require a big discount; yet
other types may sell on the expectation of servicing and be unsaleable
without its assurance. The ability to generate cash fast is thus a
working hypothesis only, until it has been checked in each case.
High-technology products which require skilled servicing may also
lead to poor collection of receivables in liquidation; buyers may
argue that continued servicing was a condition of sale and wish to
return the goods. The same point can affect the saleability of
inventory.
We also need to know whether the subsidiary can independently
reduce its purchases from the parent. If it cannot, it will not be able
to shrink the business easily or with certainty. On the other hand, its
value to the parent may then be greater since it provides an assured
outlet for its production. Thus this, like some of the other points,
may not be an argument against lending at all, only one in favour of
making sure of parent support.
This section does not pretend to cover all the items that we may
need to consider in every case; even for a credit as simple in concept
as a captive sales company the possibilities are too numerous to
cover in the space available. However, if the analyst compares the
balance sheet and profit and loss with the brief outline given above,
considers the implications of any variation, and checks intelligently
for possible qualifications, he will establish the company's creditwor-
thiness, or reliance on the parent, quite quickly. Even if the decision
is to rely on the parent, the analysis will often be useful in deciding
what we expect from the parent and whether we need a guarantee or
can accept a keepwell.
BORROWING FOREIGN CURRENCY FOR DOMESTIC USE
One aspect of a company's business which bankers often accept too

readily is its requirement, or otherwise, for foreign currency. Where
there is a natural need, and other conditions make borrowing
appropriate, there is no reason to avoid foreign currency borrowing.
Where there is no such natural requirement, foreign currency
64 Examples
borrowed will be converted into domestic currency and used to

finance domestic activity.
Banks should be wary of lending foreign currency for purely
domestic use. This is most risky where the domestic currency is
inherently weak. There are three common excuses for such borrow-
ing: lack of access to domestic currency; high domestic interest rates;
and export receivables which provide cover.
A company may lack access to local markets because local lenders
distrust its credit or because money is tight. In the first case, foreign
banks should not assume that they know better than the local banks.
In the second, management probably ought to be reducing total
borrowing, not increasing the risks it already takes. Either way a
bank lender takes a greater-than-usual risk.
Export receivables may appear to provide sound cover for foreign
currency borrowing, but on closer inspection this is subject to two
conditions which are rarely met. First the borrowing must be
essential to finance the exports or a conscious hedge against a
stronger local currency; otherwise the borrower merely eliminates a
possible profit from his strong currency receipts. Secondly the
exporter must repay each borrowing from the export proceeds and
reborrow against new exports.
Often companies borrow foreign currency medium term for purely
domestic use, with no direct relationship between the debt and the
exports. Many then report the exchange gain on the exports each
year but not the loss on the borrowing, either in the profit and loss
account or balance sheet. They thus overstate their ability to service
debt while understating the debt. At first, this may not seem to
matter, since interest is the only cash outflow. However, when
companies have to repay the debt this concentrates the extra cash
outflow in a short, unmanageable period often in harsh economic
conditions.
Some governments use tight money and high interest to strengthen
their currency and economy solely through market reactions. They
put no pressure on the private sector to borrow foreign currency and
they allow it full freedom to take out forward cover.
Until the shift towards freer financial markets in the mid-1980s,
too many governments used 'tight' money and high interest rates to
avoid sound policies, rather than to support them. They offset the
impact of the 'tight' money on favoured industries by subsidised
credit; they encouraged less-favoured companies to borrow foreign
currency which they then had to sell to the central bank for domestic
currency. This was not a true tight money policy, more a way of
borrowing abroad without committing the government's credit.
These governments forbade companies to cover foreign currency
borrowings forward or imposed minimum lives on the debt. Thus the
company could not protect itself against a weakening domestic
currency. When the policy failed, as it usually did, private-sector
borrowers bore a heavy burden from the weaker currency. In the late
1970s and early 1980s many companies borrowed dollars. When the
dollar strengthened because of high interest rates, they lost even the
interest savings.
Since the early 1980s there has been a change in fashion; many
governments have relaxed their exchange controls and allowed new
instruments such as interest rate and currency swaps, which provide
cover against exchange or interest fluctuations. Thus the immediate
risk of government interference on these lines is less than it used to
be, at least in the more developed countries. Nevertheless fashions
can change; certainly there are some countries where the instinctive
reaction to a problem is to increase government control. And even in
the absence of control, companies can still make mistakes on their
own, or follow poor advice from banks.
When a major company with heavy borrowings in foreign currency
runs into trouble it can rarely continue to carry the exchange risk.
The government can in theory allow the company to cover forward in
the markets; however unless there is a market in the long dates the
central bank will often be the only source for such cover. (In some
cases the swap market may help, but even here if the currency is a
minor one with little international appeal, it may have little depth.)
Or the government can lend local currency, perhaps under guaran-
tees from the lending banks, to allow the company to buy dollars.
This solves only the exchange risk problem, not the borrowing one,
and leaves the banks with the credit risk. Or government can allow
the company to borrow on the domestic money market to repay its
foreign currency debt. Apart from the disruption this may cause if
money is already tight in the local market, the central bank is again
the only source of foreign currency.
Governments which have succumbed to the temptation to push
their companies in this direction are thus faced with a dilemma. If
they accept the exchange risk in any form, they set a precedent which
may apply to whole industries. Even a government prepared to
accept the risk in one case may not wish to do so for the whole
private sector.
66 Examples
However, if it refuses it may be seen as repudiating a moral

obligation. It is sadly true that many banks lend expecting govern-
ment support, even when charging a higher rate than the government
would pay, and without any formal government undertaking. Where
the government has contributed to the company's difficulties, or
holds the key to its recovery (though price controls, subsidies, low
cost borrowings and so on), the banks may have a stronger case,
although still not usually as strong as the less prudent seem to think.
More importantly, the government has received the main benefit
and controls the only source of foreign currency. Banks may argue
that the government has defaulted if it refuses to allow a private-
sector solution which would cause an outflow from the reserves. This
feeling could harm the government's own credit standing; it would
certainly make the banks suspicious of private-sector borrowers and
perhaps of those in the grey area between public and private sector.
On the other hand, too generous support to the private sector may
harm the government's credit standing. Banks which lend both to the
private sector and the government face an inherent conflict of
interest. Not all seem to recognise this.
If the government will not accept exchange risks and the company
cannot, the banks must. Certainly, insolvency procedures in most
countries leave the risk squarely with the banks, although the
distribution of risk between domestic and foreign banks will vary in
each country.
Banks considering a debt restructuring recognise that failure to
agree a plan leaves them with the exchange risk, as does one which
puts more of the burden on the company than it can carry.
Moreover, equitable treatment of all banks in a restructuring is a
cardinal principle. It can be hard, however, to agree what is
equitable between, say, a bank which lends Swiss francs to a Spanish
borrower at 6 per cent but stands to suffer heavily from the exchange
loss, and a bank which lends pesetas at 25 per cent. If the
restructuring requires interest forgiveness, for instance, there will be
endless argument as to whether the Swiss lender who forgives his 6
per cent is bearing an equal share of the burden with a Spanish
lender who forgives 25 per cent, but has no exchange risk.
The Concept of Financial Costs
All these arguments and more were explored in the long negotiations
to restructure the debt of a major European company. When the
government refused to accept the exchange risk, Jorge Bermudez of

Citibank suggested the concept of 'financial costs'. The concept is
simple: the cost of borrowing local currency is interest alone; the cost
in, say, peseta terms of borrowing foreign currency is interest plus or
minus the exchange difference. Over the long run, the cost of
borrowing either should in theory be roughly equal. In the short run,
this will rarely be true but the exchange fluctuations are always part
of the cost of borrowing and are a revenue item.
This view of exchange costs makes it easier to treat banks equally.
The agreement freezes the exchange rate of foreign currency debt at
an agreed date; this also establishes the pro rata shares of principal
repayments. Interest and exchange fluctuations are then treated as a
single item; if the domestic currency weakens from 100 to 110 to the
dollar the payment due (in local currency) is equal to the dollar
interest plus 10 units of local currency. If the agreement defers
payment of interest, or calls for it to be paid in equity, the same is
true of exchange losses. When a payment of principal is made, the
foreign currency lender's share is in two parts. One is its pro rata
share, calculated at the frozen exchange rate; the other is the
exchange difference, paid in cash or equity or deferred, as the
agreement prescribes.
Although developed to meet a specific problem, this concept has
wider applications.
A major accounting weakness in many countries is failure to
revalue debt; this can grossly understate liabilities in local currency.
Even where they recognise the increase in debt, however, companies
and banks often treat it as a capital item, almost as an act of God, and
ignore the growing cost. In fact it is a direct result of a clear decision
on how to finance the company; the cost of getting it wrong can break
the company.
The concept can therefore be a standard accounting and reporting
tool which would more clearly compare the true costs of borrowing in
local and foreign currency. Even if companies refuse to report their
figures in this way, banks should insist on management figures
showing financial costs; the most dangerous aspect oflax accounting,
after all, is where management fools itself.
Secondly, the concept is a tool for forecasting and sensitivity
analysis. Before agreeing to large foreign currency loans, banks
should assess the impact of differing exchange and interests rates,
treating financial costs as a cash charge. Where appropriate the bank
can also advise the borrower of the risk of such borrowing.
68 Examples
Thirdly, banks should use financial costs in their medium-term

loans. As well as insisting that they receive financial figures
containing details of financial costs, they should require the borrower
to pay financial costs rather than interest alone. The borrower thus
offsets the growth in its local currency debt which the weak currency
would otherwise cause. On the other hand, the bank reduces its
foreign currency loan by an amount related to the borrower's
lessened ability to service it. If the local currency strengthens, the
borrower has the full use of the local currency funds he originally
received for the foreign currency, and no need of an offsetting
adjustment.
The concept could also be used in ratio covenants. One of the most
sensitive of these, interest cover, loses its value if the borrower
reduces interest cost by borrowing strong currencies. A ratio using
financial costs instead of interest would close this loophole.
All foreign currency borrowing carries a mixture of benefits and
costs; even borrowing for domestic use can be sound in some cases.
The concept of financial costs can help to identify cases where the risk
outweighs the benefit, and perhaps to guard against the risk being
greater than it at first appears.
This section, based on an article in Banking World (December
1984), points up one aspect of the need to consider a company's
business. The importance of understanding whether a company's
tolerance for foreign currency debt matches its actual debt leads us to
consider the impact in troubled times, and the measures both to
control the problem and to prevent it in other cases. The willingness
to think a problem through is not crucial in every case; however, it-
and the ability to extrapolate from one case to more general and
useful principles - is one of the factors distinguishing a deep from a
shallow understanding of credit.
HOW BANKS USE COVENANTS
Covenants, and in particular ratio covenants, are a useful tool in

protecting the banks from a decline in a borrower's credit status; not
that the covenants in themselves change the chance of decline
(although there is an argument that they may even do that in a few
cases), but they do give the bank the power to take action in limited
circumstances.
Borrowers in Europe (including the United Kingdom) generally
resist the idea of covenants more than they do in the United States.
There are several reasons for this, but one is the concern that the
banks may use a branch to call an almost arbitrary default. No author
can speak for all banks, but the description which follows applies to
any bank which takes covenants seriously as a way to follow its
credits, and to help the customer almost as much as the bank. It is not
a full discussion of the arguments for and against covenants, but an
aide memoire to bankers in discussing one point with their customers.
In discussing the concepts in this way, however, bankers must take
care to say nothing which might compromise or appear to waive their
legal right to call a default if the borrower breaches a covenant. The
last three paragraphs of this section address this point in more detail.
A bank's policy on covenants should be considered against the
background of its general approach to lending, of which it should be
an integral part. Covenants work best when a bank believes, and the
borrower agrees, that it is in both parties' interest for lenders to have
a thorough and continuing understanding of their borrowers' busi-
ness. This is desirable at all times. It is essential if the bank is to work
constructively with a borrower in identifying and remedying financial
weakness, and to continue to support the borrower through difficult
periods. (Some borrowers may object to the apparent assumption
that there will be difficult periods. The bank's answer is twofold: first
if there is never such a period the covenants will do no harm; but
secondly, that whatever may happen to an individual borrower,
banks lend to many borrowers, some of whom inevitably do run into
trouble. Since the bank cannot tell in advance which will prove
troublesome, it has to be prepared for each one to do so.) The basic
principle of understanding the borrower's business is applied most
rigorously to medium-term lending, because of the greater chance of
a major change during the life of the agreement, which neither party
foresaw when they signed it. In particular, the bank needs a
mechanism to enable it to take protective action if a change threatens
the soundness of its loan. Some banks use a material adverse change
clause or rely on a cross-default to a short-term facility; banks which
understand covenants regard these expedients as being as unsatisfac-
tory for the borrower as they are for the bank.
The better approach is to tailor a package of covenants (including
but not confined to ratio covenants). Ideally, these covenants are
based on a study of financial projections and knowledge of forward
plans and industry conditions. They are then agreed with the
borrower's management as being the best combination to meet the
following requirements:
70 Examples
1. They cover valid management criteria and therefore do not

create extra work, or distortion of financial management, for
the borrower.
2. They are set at a level which management does not expect to
reach; the ideal is where management says 'of course, if we got
close to that level, we would take strong remedial action'. But
3. At the time of any breach, the borrower would still be strong
enough to allow positive action to turn it around.
While these criteria are rarely met in full, ratio covenants still have
two advantages for the bank and borrower:
1. They enable the borrower to know, well in advance of any

breach, that a danger point is approaching. This enables it to
take remedial action, and reduces the chance that the covenant
will in fact be breached.
2. The knowledge also encourages the company to discuss with
the bank before the event the reasons which it thinks threaten a
breach, the remedial action being taken and how soon it
expects to cure the breach.
Sometimes, of course, a ratio may become inappropriate due to a

change in the company's business with no weakening in its credit
standing. Whatever the particular facts, banks prefer to be able to
take considered and informed decisions as to whether to amend, or
temporarily waive, a covenant; they regard it as dangerous to
themselves and to the borrower if the covenant is so loose that a
breach means that there is an immediate danger of collapse. Banks
feel it is just as dangerous if their understanding of the situation is
too poor to allow them to assess the danger of collapse. Banks are
more likely to play safe and insist on their legal rights if they have
little idea of the nature of the problem, and no means of telling
whether management is reacting competently; where they understand
the problem and have confidence in management, they have more
incentive to work with it to save the company.
In brief, then, banks which take this approach see ratio covenants
as part of a wider attempt to be well informed about a company's
business. They wish to be able to take sound decisions and provide
constructive advice should a company in difficulty need their
support.
However, the ability to demand repayment of loans if convenants
are breached remains important, even though it is not their sole

benefit. It gives banks a sanction to persuade management to keep
them informed and to take seriously any suggestions the banks may
make as to remedial action. Secondly, it allows the banks to make
the final judgement, even where the company has cooperated fully,
where further attempts to save the company may merely result in
higher losses. Thirdly, it gives a bank some chance to recover if the
covenant was set too loosely, for whatever reason.
In this sense, banks regard ratio covenants as deterrents, whose
main function is to see that they are never needed. If a bank has to
use a breach to accelerate a loan, the covenant has failed in its
primary purpose; if the acceleration follows immediately on the
breach, the failure is even more complete. On the other hand the
knowledge that banks will use breaches of covenant to accelerate if
they have to is vital if the whole exercise is to retain credibility; and
banks may have to use it to minimise the cost of the occasional
failure.
Thus while it is a sound policy to avoid using covenants as a means
to accelerate, banks can accept no restriction on their right to do so.
Indeed, they must be very careful in discussing them with their
clients; any suggestion that the bank had said it would not enforce its
rights or had in any way restricted its right to do so could have
serious legal repercussions.
PRESENTING A SUBSIDIARY TO ANOTHER OFFICE
Introduction
Most banks with any sort of international branch network have some
system for allocating the responsibility for following companies
where the bank lends to both parent and subsidiary. In some, the
branch with the main relationship with the parent is responsible for
all credit decisions; in others, the responsibility depends on whether
there is a guarantee or lesser form of support; in others again, it
depends on whether the local office is satisfied with the credit of the
subsidiary. Whatever the system, there will be cases where one office
writes to another about a subsidiary whose parent banks with the
addressee office. Broadly speaking, the memo in these cases can be
one of two types; it can explain why the subsidiary credit is
acceptable even without the parent support, or it can explain why
72 Examples
such support is needed. The first type poses few problems - or at least
few that are peculiar to themselves. The rest of this section therefore
deals with the second.
Many memos of this type are too long and cover the wrong sort of
detail. (This is also true when the reliance is on government support
rather than a private-sector parent.) Clearer thinking about what the
memo is trying to do, and why, may make it more useful, as well as
shorter and easier to read.
The Questions
The first point to recognise is the difference between the questions in

this type of memo and a normal one. In a normal memo,
recommending that the bank lend to a borrower on its own credit
standing, the basic questions are quite clear, although there are
many ramifications. They are: 'why do we think this credit is sound,
what are the risks, and how do we get paid?' In the type of memo
under discussion, these questions no longer make sense, since we
have decided that the credit is not strong enough to lend without
support. We have then to consider what the office following the
parent needs to help it make the best decision. To do this, it must ask
- and answer - two primary questions: 'can the parent support the
subsidiary?" and 'will it?'. The second question is more important
the weaker the wording of the support. To answer them, the office
following the parent must relate what it knows about the parent to
what it knows of the subsidiary; the memo from the lending office is
sometimes the only source, and always an important one.
There are four basic questions to which the parent office needs
answers before it can be sure that the parent both can and will
support the subsidiary. The memo from the subsidiary office should
provide material with which to answer them as briefly as the facts of
each case permit.
The questions are:
1. How likely is it that the parent will in fact need to support the
subsidiary? Or, put another way, why is the office not prepared
to take responsibility for the decision itself?
2. In the 'worst reasonable case' would the support needed to
keep the subsidiary alive cost the parent enough to risk
damaging its own credit standing?
3. What value does the parent obtain, or do we reasonably expect
it to obtain in the future, to justify the cost of the support?

4. What changes have occurred, or are reasonably foreseeable,
which might affect the answers to one or more of the first three
questions?
The Answers
There is no standard best way to provide information to answer these

questions which is valid for all types of subsidiary. A conscious effort
to answer the questions, rather than put down a mass of information
without considering its relevance, is most likely to give the best
result, however. Even then, the office receiving the report still has to
relate it to the parent.
Three hypothetical examples may help to demonstrate the
approach.
A Sales Company
In its purest form a sales company has a simple and liquid balance
sheet, and very little in the way of fixed costs. Provided they are of
the right quality, fast-moving receivables and inventory provide good
asset coverage for debt; and if the transfer prices are reasonable, the
company can make a small turn on sales which translates into quite a
nice return on equity, because of the high leverage. Of course, as
described in the first section of this chapter, there are various factors
which can change this idyllic picture.
Nevertheless, in most cases the chances of a pure sales company
requiring support are small; if it does, the cost to the parent should be
small as well; and the return to the parent from the extra sales volume
should make the cost readily acceptable. In a few cases, particularly
where the sales company is operating at break-even or a loss, the
parent may be taking profits in its own accounts for tax or other
reasons, in which case the support is even more likely.
A presentation on such a company should therefore be quite brief.
After describing the proposed exposure it might consist solely of a
rationale, the credit part of which might read something like:
XYZ SA is the French sales subsidiary of XYZ Corp., handling its

speciality chemicals for the brewing and food processing industries.
Sales have grown at a steady 10 per cent p.a., reaching FF150
74 Examples
million in 1985 and profit margins have been consistent at 1 per

cent giving a return on net worth of 8 per cent. We understand that
the parent takes a useful domestic profit on its sales to XYZ SA.
Receivable and inventory turnover have been steady at 45 and 30
days respectively for several years; net worth has grown at 10 per
cent p.a. to FF15 million in 1985 as a result of retained earnings, so
that TLiNW has been held at 6:1.
It seems likely that XYZ SA could payout its debt in full from
liquidation of assets. However, we have no detailed information on
the quality of receivables and in addition the main factors affecting
the company's future are:
1. the parent's ability to produce new products which are
technically as good as the competition, and
2. the parent's decisions on pricing.
For these reasons, combined with the high leverage even for a sales
company, we believe this is not an independent credit and that
Head Office should take the credit decision.
This gives a clear view of the low probability that the subsidiary will
collapse; but also the extent to which the risk, even if limited, is
controlled by the parent rather than the local company. The
judgement to be made by Head Office is a simple one if they have
confidence in the parent; if not, there is still a clear self-interest on
the part of the parent to keep this company alive. If that is not
enough to satisfy them, one wonders why they continue to do
business with the parent at all.
A Manufacturing/Assembly Company
This example is more of a satellite manufacturing operation than
truly independent. It designs some products, but mainly assembles or
mixes items supplied by the parent, with only minor adaptations of
design to local requirements; it has developed local sources of supply
for some components and even a few products of its own, but these
are less than 20 per cent of its total sales. If it were well capitalised it
might have some claim to be a viable credit in its own right. However,
the parent has been reluctant to inject capital, and instead has
withdrawn most of the profits in royalties, management fees and
dividends.
The risks of urgently needing parent support, and its potential cost
to the parent, are higher than the sales company, but fall into two
parts. One is that the sound local operation deteriorates; the other is
that the parent's policies inflict excessive damage. However the
parent is gaining from these policies in several ways; a substantial
outlet for a major product; profits on transfer pricing; cash inflow
from royalties, dividends, etc.; and all at a low capital cost. As long as
the operation remains sound, the return on these policies should
justify the cost of any purely financial needs. The proviso is
important, however. If the operations slipped, the return might drop
quite quickly just when the cost of support escalated. It might then be
essential to judge whether the problem was temporary - reflecting a
recession, perhaps, or product changeover - or whether it was more
permanent, reducing or eliminating the parent's return on invest-
ment.
The credit part of the Rationale might therefore read as follows:
ABC Ltd is a well-managed and successful producer of widgets,

with sales growth of 15 per cent p.a. compound (3 per cent more
than inflation) over the last six years and a stable operating margin
(25 per cent on sales, 28 per cent on assets before deducting
royalties, etc.). However, the parent keeps the company severely
undercapitalised, with heavy withdrawals of royalties, manage-
ment fees and dividends. Cash return on parent investment from
these sources alone has averaged 20 per cent p.a.; ABC also
imports 35-40 per cent of its sales in components from the parent,
which is known to make a fat margin on these sales.
As a result, ABC's balance sheet is highly leveraged (TBF/NW
2.4) and illiquid (current ratio 1.05); interest cover (1.2), cash flow
cover (OCF/TBF 15 per cent) and ROA (1 per cent) are wholly
inadequate. Even a moderate decline in operating profits, or
increase in interest rates, would make ABC heavily dependent on
its parent for support.
The risks of such a decline arise froin the dominance of the
managing director, who could not easily be replaced; the depend-
ence on the British motor industry and particularly The English
Car and Lorry Co., whose future is in doubt; possible import
competition from Japan and East Europe; and adverse currency
fluctuations. For these reasons, and the poor capitalisation already
mentioned, we feel ABC cannot be considered a viable indepen-
dent credit. Head Office has agreed to accept responsibility on the
basis of their relationship with, and confidence in, the parent, an
AA rated company.
76 Examples
If the parent is strong and ABC relatively small in the overall

picture, we would need little more. Any additional comment might
focus on the risk of a decline in operating profit, the factors that
might cause it, and the strength of ABC's defences. Head Office may
not be able to assess these itself. If the risks are important it needs
the input to judge whether, in the light of all the factors, the parent
can support ABC if necessary; and, equally important, whether it
will.
A Deteriorating but Independent Company
This example considers an old-established manufacturing operation

with heavy local fixed costs. Its product and sales are largely
independent of the parent and it obtains most of its raw materials
and components locally. After several decades of success, it has lost
market position over the last three or four years; margins have
deteriorated, as have balance sheet ratios; weaknesses in financial
control and investment policies throw doubt on the quality of both
current and fixed assets. In the two most recent years the company
has shown major losses after tax, and the bank's credit analytical
department is unhappy about prospects. The local management
seems complacent about the problems and the bank has no reason to
believe the parent is aware of their magnitude. Finally, the company
is embarking on a costly capital-expenditure programme; this will
certainly weaken the balance sheet dramatically before any benefits
flow through, and the bank is unsure whether the programme is well
judged.
It is tempting to say 'the credit is so weak that it is not worth
analysing, and we must ask Head Office to take responsibility'.
However, of the three examples this one needs the most careful and
perceptive analysis. The benefits to the parent of a major investment
are not clear, the cost of support could well be large, and the parent
does not even seem to be in control. The officer following the parent
has a difficult decision as to whether to take responsibility and stay
with the customer, or whether to authorise the local office to
withdraw as quietly as it can so as not to rock the boat. He must also
consider whether he should warn the parent in tones strong enough
to damage the relationship if the parent takes it the wrong way.
Finally he must assess whether the position is bad enough to
undermine even the parent's credit if it does support the subsidiary
but fails to turn it around; or even if it deserts it.
To make these difficult judgements correctly, and if necessary to

make a case to the parent, he needs a full understanding of the risks
the subsidiary faces; the reasons the local management believes the
capital expenditure will solve the problem and the counter reasons
why his own people doubt it; the largest amount that the parent
could have to put in to support the subsidiary if there is a crisis; the
local competitive, governmental and economic environment and
how they affect the borrower's prospects.
These and other factors, depending on the nature of the company,
are needed for a sound decision. Head Office must decide whether
the parent can afford to support the voracious cash demands of a
company which may never yield an adequate return on the
investment; whether even if it can it will; and even whether the bank
should advise it not to do so for fear it will get in too deep. This might
threaten its ability to pay the much larger amounts the parent owes
the bank.
Conclusion
Here again, we see the need to know and understand the nature of a
company's business and to focus on what is relevant. It is easy either
to write reams of perfectly sound but irrelevant facts, or to miss the
need for analysis completely; one is almost as bad a mistake as the
other.
Part III
Theoretical Diversions
5 Variations on Risk
THE NEED TO DEFINE 'RISK'
There are many types of risk in banking. We need therefore to be

clear what we mean by 'risk', and what type of risk we mean.
The risk a bank faces is usually that of loss of money, although
sometimes it is also of loss of reputation. The risks which can cause it
to lose money fall into several categories, some of which overlap.
The most important risk, for commercial banks at least, is credit
risk: the risk that a bank loses money because a borrower or
counterparty to a transaction cannot pay what it owes when it owes it;
or that a borrower who can pay is able to avoid paying because of
some weakness in the bank's handling of the deal. The next most
important is market risk: the risk that a change in market conditions
will cause a loss where the bank has an exposed position or has taken
a wrong view. Then there is operating risk: here the bank loses
money, and perhaps reputation, because an operating mistake
creates a loss for someone else. The bank is legally or morally liable
for the negligence which caused the loss.
There are also many subdivisions and variations of risk. For
instance, credit risk can be direct (as with a loan), or indirect (as with
a guarantee or letter of credit). It can relate to a borrower or issuer of
a bond; or it can relate to a counterparty who is due to pay for a
security which the bank has already delivered. This is often known as
settlement risk. Similarly market risk can relate to interest or
currency risk or a mixture of both; but it also relates to the market
perception of those risks, and of the borrower/issuer. Underwriting
risk is in one sense a variant of market risk, but with the difference
that the judgement is made about a new issue which is not yet
trading. The underwriter has to assess the market reaction to the new
instrument, sometimes using existing issues by the same issuer, or
ones with similar characteristics, as a benchmark. However he makes
the judgement, he always risks being wrong, or market conditions
changing between the time he commits and the date of issue; the gap
varies depending on the market into which he is selling the issue.
The nature of the risk decides the skills needed to assess it, and
where possible reduce it. A credit man may be, indeed usually is, a
poor judge of market risk; equally most bankers shudder at the idea
81
82 Theoretical Diversions
of traders making credit judgements. If traders fail to recognise that

the risk they are considering is wholly or partly credit risk, they may
thus expose the bank to risks they do not even realise exist, let alone
know how to judge.
If a credit man takes a risk without recognising that it is wholly or
partly a market risk, the same is true. And in the operating areas of a
bank - money transfer, securities settlement and similar departments
- people are constantly exposing a bank to credit risk as well as
operating risk. Again, unless someone focuses on these areas of risk,
and controls them, the bank will find itself with losses which are both
unnecessary, and a nasty surprise.
For all these reasons, banks need a sound approach to defining and
identifying risk; only then can they control it. And while part of the
answer to the problem lies in systems, which today usually means
computers, the first and most important part lies in management's
ability to instil the right attitude to risk in all a bank's people.
PROBLEMS IN DEFINING RISK
At first glance, defining risk might seem quite simple. A loan is credit
risk, a forex (forward exchange) deal is market risk, a securities
delivery is operating risk. Or are they?
A loan is certainly primarily credit risk, but it also gives the bank's
treasury the chance to take a market risk. It may fund short; or it may
use a different currency as the funding base, and swap into the
currency of the loan. There are then two types of market risk
attached to the loan. First, whatever mismatch risk the treasury
takes; secondly, the risk, that if the borrower defaults, the treasury
will find itself with the opposite market position and therefore taking
the market risk which the loan had previously enabled it to avoid.
Much the same is true the other way round with a forward
exchange deal. The bank takes a position when it sells currency
forward to a customer. Depending on the bank's overall position and
view of the market, it will either cover the position so created, or run
it. If the counterparty does not pay its side of the contract, it again
has at best the opposite market position to the one it intended. At
worst it pays out on the contract before it realises that the
counterparty cannot pay. In that case, it loses the whole amount it
pays, plus any adverse market movement.
Variations on Risk 83
Almost every form of risk in fact has facets that are not
immediately visible. With long-standing instruments, these risks have
been recognised and are provided for so much as a matter of course
that many bankers are no longer really conscious of them. This does
not matter if precautions are built into the system and generally
recognised as necessary. The proliferation of new instruments coming
onto the market, however, includes risks outside the standard
precautions, and banks are struggling to define and then control the
risk.
Part of the problem is that the maximum risk - or exposure, as
described in a later section - is unclear. With a loan, the maximum
amount a bank can lose, and the amount it will actually lose on a
given percentage payout, are both clear. But in many treasury
products the possible loss is uncertain. It is not even sure that the
bank will lose money at all. If the counterparty fails at a time when
the bank would lose money on the completed transaction, the bank
could theoretically profit from the failure. In practice it is unlikely to
do so, but at least it loses nothing from the credit risk. On the other
hand (as discussed in more detail in a later section), if the bank is in
profit from the completed transaction, failure to complete will cost
the bank that profit. If the position was hedging another, it may mean
that the loss on the other position, which the profit should have
offset, is now an unqualified loss.
Equally, the complication of some of the transactions which are
now possible makes it difficult to recognise which aspect gives rise to
which risk. Suppose, for instance, that a bank underwrites a yen
fixed-rate bond for a customer who actually wants floating-rate
dollars. The bank can provide these in a variety of ways, the simplest
of which involves two steps. First, it does a currency swap to generate
fixed-rate dollars; then it does an interest rate swap with another
party to convert the fixed dollars into floating.
Question: how many credit risks does the bank carry, and to
whom?
With full information as to the transaction, the answer is not too
difficult to work out. But it needs working out, and this is a fairly
simple example. With some of the more complex deals being done,
the concern is that the dealers will not recognise that there is a credit
risk. As a result no one will work out, until it is too late, where the
credit risk lies, and how serious it is.
RISK VERSUS EXPOSURE
Many people use the words 'risk' and 'exposure' as synonymous.

They are not, or at least should not be. Exposure is used in this book
as a quantitative measure of the most that the bank could possibly
lose on the worst possible assumptions on each facility. For a loan
facility this is simple: it is the face amount of the loan - or, for an
undrawn facility, the maximum amount that could be drawn. For
other facilities the concept may raise more complex problems of
measurement, as discussed in the next section. But the concept of the
worst case with no redeeming features remains clear. Exposure
implies no judgement as to probability that the worst will happen; it
measures only what is the worst that can happen.
'Risk', on the other hand, is a qualitative measure of the chances
that the bank will lose money - and, if so, in what amount. To assess
the risk a banker needs to know the size of the exposure, its nature
(including security, guarantors, etc.) and maturity; the credit
standing of the borrower and the relationship between this and the
total exposure. This means assessing such things as the borrower's
financial strength, management (or political stability for a country)
and so on; whether the exposure is direct or contingent, short-term,
self-liquidating or long-term balance of payments finance and so on.
The amount outstanding and prospect of usage will also affect the
degree of risk.
Exposure is thus primarily an accounting and control concept. It
measures a bank's assets, actual or potential, on a standard basis. It is
usually the basis on which banks decide how to allocate lending
authority; if the exposure is large, it requires a higher degree of
judgement to decide that the risk is acceptable. It gives consistency to
a bank's systems. It allows the bank's financial statements to
reconcile to internal reports such as country limits and a wide range
of transactions to be stated in a common language which all the
bank's computers can understand. It is becoming increasingly
important in bank regulation, too.
Because risk is a matter of jUdgement, banks use their assessment
of it as a tool in deciding whether to accept exposure. The question
'what is our exposure?' can be answered by a computer. No computer
- yet - can answer the questions 'should we accept this exposure?' or,
later, 'is the exposure still sound?'. Banks use risk management skills
to answer these questions in the light of factors such as reward, bank
standards on risk, etc.
It has always been important to be clear on these points. Failure to

understand them has often confused discussion about credit deci-
sions, but the advent of swaps and other vehicles has made the point
even more important. To understand the new instrument, banks
need to distinguish clearly between risk and exposure, particularly
when exposure is theoretically infinite. In setting a finite proxy for
exposure banks need to use an assumption which is pessimistic,
perhaps unreasonably so, but still theoretically possible. In looking
at interest rate swaps for instance, some bankers in the early days
argued that $ LIBOR rates have been above 20 per cent in the fairly
recent past, which makes it possible that they could go as high as 30
per cent and stay there for some time. In assessing the exposure for a
swap the bank might therefore decide to use 30 per cent as the
average LIB OR rate for the life of the swap, and to report exposure
on that assumption.
However, the bank might also decide that since rates started out
well below 30 per cent, and since the agreement requires semi-
annual payments, the risk is very small. If the counterparty fails
quickly, interest rates will not have time to reach 30 per cent; if the
counterparty fails later, at least a part of the interest will have been
received, thus reducing the exposure. And of course the bank is
usually confident that the counterparty will not fail. The bank might
thus assess this as a low risk, even though the exposure was rather
high. The bank might then decide that the return was acceptable in
relation to the risk, although it seemed rather low in relation to the
exposure. (Subsequently the assessment of exposure in swaps
became more sophisticated, but the need to pick the worst
reasonable prospect remains.)
Most people would find it easy to accept the statement: 'Two
facilities of $10 million each involve the same exposure. However, if
one is a short-term, fully-secured self-liquidating loan, and the other
a ten-year bullet, the risk is different.' Or, put another way, both
loans show on the balance sheet as an asset of $10 million, but the
risk is greater with a ten-year bullet.
RISK IN NEW INSTRUMENTS VERSUS TRADITIONAL RISK
Traditional credit risk can be defined as the risk that a loan is not
paid for credit reasons; or that some failure causes a contingent
liability, such as a guarantee or letter of credit, to become a direct
liability. When the bank meets the liability and seeks to recover, the
same failure makes the client unable to reimburse the bank. In other
words, the bank faces the loss of a specific amount of money, and
knows the maximum loss in advance.
Risk in new instruments varies in several ways. 111 some cases,
(including some older instruments) the risk is of a market fluctuation
rather than a fixed loss. Thus with a forward exchange contract, the
risk if a counterparty fails is, at first glance, only one of market
fluctuation. A bank sells $1.5 million forward to a client in return for
£1 million. If when the contract matures the client cannot pay, the
loss to the bank depends on the exchange rate. If the bank can buy £1
million for $1.2 million, there is no loss but rather a profit. (For this
reason, a liquidator surely will adopt the contract and pay the £1
million in order to receive dollars now worth more. Thus banks
should not expect to make a profit from a client's failure, but need
suffer no loss.)
This is the traditional view on which banks assess risk in forward
exchange, and led to practices such as valuing exposure on exchange
contracts at 10 per cent of the face value. However, there are in fact
two additional elements in the risk. First, the settlement risk. Since
the contract involves two different currencies, settlement takes place
in two different cities, which may be in different time zones. Thus the
normal defence against settlement risk, delivery against payment, is
not available. There are of course various ways of protecting against
the risk, but they all involve delays in payment somewhere in the
process. The market could not operate if they were used regularly.
Some banks therefore control them by 'daily settlement lines', or
some similar name. This is in addition to the overall line for forward
contracts. It limits the amount of contracts, including spot, which
may mature on one day.
The other risk arises from the power of a liquidator to pick
whether to adopt or repudiate contracts. Apart from the ability to
'cherry pick' - i.e. adopt those which favour him and reject those
which favour the bank - there is the danger that the market will
move before he decides. A bank which covers a position on the
assumption that the liquidator will reject, or leaves it uncovered on
the opposite assumption, may then suffer a double loss.
Market risk is also the determinant of loss from a credit failure
with swaps. With pure interest rate swaps (fixed interest against
floating in the same currency) the market risk is that of interest rates;
a bank which stands to make a profit when the contract is completed
runs the risk of losing that profit if the counterparty fails. Equally
where the bank is using the swap as a hedge against another
transaction the failure of the hedge exposes it to loss. The credit risk
is thus the same whatever the precise use the bank makes of the
swap, a point some bankers tend to confuse. There is an additional
risk in at least some swaps, however. This is that the interest
payments will be due on different days. If the bank pays first, and the
counterparty fails to pay, the bank may lose the whole interest
payment, not just any market differential. Finally there is the same
risk of 'cherry picking' as with forward exchange, but it tends to
concern banks more. Swaps, on average, have a longer life than
forex contracts, and with the great activity in them in the mid-1980s
the amounts that could be caught up in a liquidation of a major
company are greater.
Currency swaps carry a similar risk on the interest payment
portion, with the addition that the payments are in different
currencies. Any movement in interest rates may counteract (or may
multiply) the possible loss on currency movements. However,
currency swaps are also swaps of principal as well as interest; they
thus carry the same risks as a forward contract with the interest risk
added on.
There are many other instruments where the risk is market-
related, although which market depends on the instrument. Bullion
forwards carry a similar risk to forex contracts, for instance, except
that the risk relates to changes in the price of bullion rather than a
currency. Forex options - and, indeed, all options related to their
specific markets - carry a credit risk only for the buyer of the option;
the seller takes no credit risk once he has received his fee. This is true
whether the option is a put or call option. The seller of an option
commits either to buy a security or commodity at an agreed price,
but only if the buyer requires him to (a put), or to sell the same item
at an agreed price with the same proviso. Either way, the buyer will
choose to exercise the option only if the market has moved in his
favour. He therefore stands to lose a profit (which may be hedging a
loss on an offsetting transaction) if the seller defaults. The seller of
an option, on the other hand, can lose only if the option is exercised;
if he would profit from its exercise the buyer would lose and would
therefore not exercise. The seller has thus no credit risk, apart from a
brief risk on his fee for selling the option.
In considering the degree of risk involved in these market
transactions banks tend to assume that there is a smaller risk than
with a loan. This will often prove true in practice, but it need not.
The risk is of a market fluctuation, whether of interest, currency
rate, price of bullion or some combination; and usually market
movements are less than 100 per cent, in which case so is the
potential exposure.
A movement of more than 100 per cent is possible, however, and
becomes more likely the longer the life of the instrument. For
instance, assume a ten-year swap, dollars against sterling, done in
March 1987 when the exchange rate is $1.60 to £1. At maturity in
1997, a rate of less than $0.80 to £1 would expose one party to the
swap to a greater risk than a sterling loan of the original amount; a
rate of more than $3.20 would expose the other party to a greater
risk than an original dollar loan. Given the trends since the Second
World War, most bankers would probably think the lower rate more
likely than the higher, but it would be hard to call either impossible.
With an interest rate swap, the movement may have to be more
than where there is principal involved, because the interest is usually
only a fairly small percentage of the notional principal. However, at
least in the early days of a swap, this is partly offset by the fact that the
percentage is payable over several years, an offset which is more
important the longer the life of the swap. Put another way, interest
rate swaps amortise at least annually, often more frequently, so that
even a fairly large risk may be acceptable where the life is short
enough that the benefit of amortisation starts to be felt quite quickly.
A further factor in risk, although not in exposure, is volatility. If
the currency swap outlined above were deutschemarks against Dutch
guilders instead of £ against $, the chances of 100 per cent moves in
either direction would be rated as much lower than in the £/$ rate:
not impossible in theory, but almost so in practice. With interest rate
swaps the point applies to both the level and volatility of rates. An
interest rate swap in sterling, for instance, might start with a fixed
rate of 10 per cent and a six-month rate of about the same, but which
within the last ten years had been as high as 17 or 18 per cent, with no
certainty that it could not do so again. A similar swap in SF might
start with a fixed rate of 5 per cent, and a floating rate of 2 or 3 per
cent which had not been in double figures in living memory. The risk
of an adverse movement causing a loss comparable to that of a loan is
clearly much less than in sterling.
Forward-rate agreements provide a similar market risk. Here a
bank agrees to a notional loan for a specified period at a fixed rate but
starting at an agreed date in the future. For instance, it might agree to
a one-year notional loan starting one year from now at 10 per cent
p.a. If on the agreed future date the actual rate for one-year loans is
above 10 per cent, the bank pays the difference; if the rate is below,
the bank receives it. The risk is thus a factor of the length of the
forward period, the length of the notional loan and the volatility of
interest rates in the market concerned. For instance, the one-year
forward described above would carry an exposure of 5 per cent of
notional principal if a 5 per cent movement in one year interest rates
was the maximum reasonably possible; for a three-month loan three
months forward all aspects of the risk are less.
(Note that there is no actual loan, only a notional figure on which to
base interest calculations.)
It is not practicable, nor in line with the approach of this book, to
catalogue all the possible types of market risk and how to assess
them. Indeed, there are so many combinations, some of which are
used only once or twice, that it would be pointless. But it is necessary
to understand the basic approach to apply it to each case as it comes
up.
Only if bankers, and traders, get into the habit of thinking about
the various types of risk that can apply, will they recognise them
quickly in new types of transaction. And the more complicated the
transactions get, the greater the chance that they contain exposures
which are not immediately obvious but which are none the less
damaging.
There are too many ways in which such risks can arise to try to
describe them all. A simple example and a more complicated one
may make the approach needed to identify them easier to understand.
The simple example is the common case of the bank which takes an
issue by (usually) a sovereign issuer and repackages it into something
different. Probably the most common case is where the issue is
floating and the market is looking for fixed-rate debt or vice-versa;
but it may be a change in currency. The mechanism is to establish a
vehicle company which purchases the underlying security, and to
arrange a swap into the desired form. The vehicle then sells units
which represent the original bonds plus a pro rata share of the swap.
Assume one bank does the entire swap; the swap exposure may then
appear on its books in the name of the vehicle company. But its true
exposure is to the issuer, since the only source of funds the vehicle
has is the payments due to it under the original bonds. As long as
these payments come in, it can meet its side of the swap; once they
cease it has no prospect of paying and the bank is faced with an
unmatched swap position. No banker or trader could argue with this,

but it is easy to overlook in the rush to get the issue ready, and
perhaps in the relief of getting off the books at a profit (or at worst
only a modest loss) a position which looked like being costly.
An investor buying the repackaged instrument can easily think of
this as a Kingdom of Ruritania DM fixed-rate bond, and his only
credit risk as being the standing of the Kingdom.
In fact, he has a dual risk. If Ruritania fails to meet the basic
obligation he loses everything; but if the counterparty to the swap
fails then the investor is paid only the original interest rate or
currency, which may expose him to loss. How much this matters
depends on why the investor chose the repackaged instrument over
the original, but presumably there is some loss. Whether the investor
recognises this risk, and whether he can even identify the counterpar-
ty whose credit he is taking, depends on the exact circumstances of
the issue.
In a more complicated case, an issuer might have access on
favourable terms to the SF bond market, but wish to raise floating-
rate funds, partly in dollars and partly in sterling. He therefore asks a
bank to arrange swaps. The bank may be unable or unwilling to stand
in the middle of the swap, in which case the issuer's counterparties
may be one or more US and UK companies which have favourable
access to their respective markets but want fixed-rate Swiss francs.
They may be able to raise floating-rate funds and swap them direct
for the fixed SF; or it may be cheaper for them to raise fixed-rate
money. In that case, the bank can swap these funds into floating
before swapping with the SF issuer; or it may use the first swap to
provide its client with fixed dollars and then swap these into floating;
or it can do a combination of both if it cannot find one counterparty
for the whole amount. And, rather than merely arranging these swaps,
the bank may be the original SF issuer's counterparty and then go out
and arrange covering swaps with other counterparties.
Thus, depending on the exact facts, either the issuer has a series of
credit risks on corporate counterparties and they on it, or the bank
does. In the bank's case, the risk is a two-way one: if the issuer fails, it
is exposed if the market has moved in one direction, while if one or
more of the counterparties fails it is exposed to the opposite market
movement. And if the bank finds that it cannot swap profitably
directly from SF into sterling, but must go through dollars or DM to
get the best rate, this is just one more complication.
Much the same applies when a bank creates synthetic assets.
Suppose, for instance, a bank requires a floating rate asset in dollars;

the most profitable way to create this may be to buy a fixed-rate
yen bond and convert it into floating-rate dollars by one or more
swaps. If the bank does so, it then has an extra risk on the issuer of
the bond; not only would its failure mean loss of principal and
interest, but it would also mean the loss of the position created by the
synthetic asset, and possible further loss as a result. Moreover, one of
the advantages of buying a bond rather than making a loan is its
marketability; this is often offset by weaker protection in the
documentation than a bank would require for a loan. With a synthetic
asset, some at least of the benefit of marketability is lost. It may not
matter that it is illiquid from a treasury point of view, since that was
known and intended from the start. However, from a credit point of
view it can be serious. When a credit starts to weaken, a bank wants
to be able to sell the bond quickly, without worrying about any other
factors. With a synthetic asset it cannot do so without exposing the
bank to market loss; it may therefore decide that the credit risk is less
than the loss on the swap which would result. If it later changes its
mind, the bond may by then be genuinely unsaleable, if the
deterioration is well known; or it may be saleable only at a greater
loss than previously, with the added risk that the breach of the swap
may also be more expensive.
All these trading risks are contingent on the credit risk in one
sense, but are independent risks in another. When a swap or other
instrument hedges a position, the hedge remains effective as long as
the counterparty's credit stays good. Only when, or if, the counter-
party fails does the bank need to worry about losing the cover and
finding itself with a trading exposure it had planned to avoid. Even
where the position was an outright one rather than a hedge, the credit
risk is still there. If the counterparty fails the bank finds that it no
longer has the long or short position it thought it had. If its judgement
in taking that position was correct, it has lost a profit opportunity; if
its judgement was wrong and it is sitting on a loss, it is most unlikely
that the counterparty, or its liquidator, will let the bank take the
benefit. But even if the credit judgement was correct, the bank can
still lose money if the trading judgement was wrong.
The other main type of risk which is largely new is the insurance
risk, or what might be called the all swings, no roundabouts risk.
Banks have always provided some insurance in lending; an unused
overdraft has an element of insurance, as does a committed
acceptance facility or revolving commitment. However, as the next
section describes, the recent developments of NIFs, RUFs and loan

sales have added new elements to these risks, as well as new
opportunities.
RISK AND EXPOSURE IN INSURANCE, AND THE PRICING

IMPLICATIONS
There are two types of insurance provided by bank lending facilities:

the traditional one of credit availability, and the more recent arrival
of assured cost, or at least an assured margin over a floating cost.
The overdraft, etc. mentioned at the end of the last section
provide availability assurance. Overdrafts and acceptances are of
long standing, while the formal, legally-binding commitment to a
fixed price or margin for several years was imported to London from
America in the 1960s as part of the developing eurodollar market. It
became important in the sterling market in the early 1970s, after the
Bank of England introduced a new regulation, Competition and
Credit Control. This was intended to overturn the old clearing bank
interest-rate cartel and allow more competition and innovation, while
keeping the growth of credit overall under the Bank's control. It was
more successful in the first function than in the second.
Until the early 1980s, the insurance element in a specific facility
might be sizeable, but it was relatively small in bank portfolios as a
whole. With fixed-term facilities the drawing was predictable; and
once they were drawn, the availability insurance lapsed. Usage of
revolving commitments was less predictable in individual cases.
However, most revolvers were either used or cancelled after a
reasonable time, when the risk, against which they protected,
passed. Unused commitments were thus a manageable part of the
total loan portfolio for most banks and for the banking system as a
whole.
Pricing contributed to manageability of unused commitments. For
a long time the commitment fee was standard at 112 per cent p.a. on
the unused amount. The fee both discouraged borrowers from
maintaining large unneeded commitments and earned the banks a
fair return on those kept in place. The higher margins in the 1960s
and early 1970s also made commitments easier to accept. Margins
then ranged between 11/4 and % per cent above LIBOR in the
euromarkets, and broadly comparable levels in other markets. Even
as late as 1978 margins were at or close to I/Z per cent.
Thus, when borrowers used revolvers to protect themselves

against rising margins, the banks still earned sensible returns, in
contrast to the few basis points in 1986-7. In the United States, the
combination of prime rate and compensating balances achieved the
same end.
In the 1980s, however, this pricing has become a memory. Both
fees and margins are now more often measured in basis points than
fractions of a percentage point. This eroded pricing, together with
the growing competition among banks and from new sources of
finance (the 'securitisation of lending') has swollen the volume of this
type of insurance snapped up by companies in the marketplace.
There has also been an important change in the nature of this
insurance. Previously, banks provided insurance against the custo-
mer's need to borrow and, when the need arose, the customer
borrowed from them at the agreed price. Now much of the insurance
is against the customer's inability to borrow cheaply from sources
other than the banks. The customer calls on his cheap bank
insurance policy only if the other sources will not lend at a
competitive price.
This change began in the United States, with lines to backstop
commercial paper; the upfront pricing which was at first standard for
these facilities has been largely eroded. In the euromarkets, NIFs,
RUFs, MOFs and similar animals now give access to many markets,
instruments and interest mechanisms, with banks committing to lend
at unattractive spreads if none of these alternative methods provides
the borrower with a lower cost.
Thus, the insurance that formerly was only a small factor in the
facility, which the customer used in favourable as weB as unfavour-
able conditions, now often constitutes almost the whole of the
lending bank's function.
Banks can expect borrowers to call on a standby commitment in
three types of condition:
When the borrower itself is in trouble. Although in theory

banks may avoid lending to a weakening borrower by calling a
default, in practice the uncommitted lenders will probably get
uneasy first. Most agreements covering NIFs, etc. lack ratio
covenants or other predictive events of default which might
reduce this risk.
- When one borrower gets into trouble, causing the market to
take fright about other borrowers. And
- When tight money, general market conditions or regulation

make investors unwilling to continue to hold paper.
Bankers who have lived only through periods of easy money and
progressive deregulation may have to learn that the pendulum can
swing both ways.
A bank with a large portfolio of unused commitments must be
prepared for a rapid swing from virtually no usage to nearly full
usage; it must recognise that such a gyration will greatly increase the
size of its balance sheet, and therefore its need for capital. If most of
the new assets are seen as being of poor quality, the market may
become nervous just when the bank can least afford a loss of
confidence. It may thus also be unable to take on any new loans at
the much higher returns made possible by the difficult conditions.
These points do not add up to an argument against standby
commitments at any price. They do suggest that it is important to
recognise the true value of the commitment to the client as well as
the risk and capital cost to the bank. This value depends in large part
on the bank's ability to meet the commitment. Yet pricing on all
facilities is so low in the late 1980s that some corporate treasurers are
beginning to worry about the creditworthiness of banks and their
ability to live up to the commitments they are making.
British and Continental European banks have never placed the
same importance on borrowers paying for commitments as have
American banks. They appear to ignore the risk involved in unused
commitments - although recent steps by the Bank of England may
make this harder at least for British banks. On at least one occasion a
British banker has argued heatedly that there was no credit risk until
a commitment was drawn. In fact, since the facility can be drawn at
any time the exposure - as defined above - is the same whether a
facility is drawn or not. The risk, based on a reasonable assessment
of the chances of drawing followed by loss, may sometimes be less;
but the risk of drawing is largely outside the bank's control in view of
the lack of protective measures in most agreements.
We are not talking purely about credit risk here. Most banks
accept the need for a certain minimum capital coverage of
outstanding loans, even good ones. Banks which hold no capital
cushion against unused commitments will find any usage soon pushes
their capital ratios below acceptable levels. Even if other central
banks follow the lead of the Federal Reserve and the Bank of
England in requiring capital to be allocated against unused commit-
ments, this only reduces the risk, it does not eliminate it. The Anglo-
American proposals call for varying percentages of the unused
amounts to be included when calculating the minimum capital
requirements, depending mainly on maturity of the commitment.
However, in a crisis the increase in outstandings which carry a higher
capital requirement may still be greater than the bank can handle
even though it is better equipped than a bank which has allowed
nothing in its capital for the risk of usage. If the increase in
outstandings comes at a time when difficult conditions generally
cause the market to look for a higher capital cover than usual, or
than the regulators require, the risk is even greater.
Maintaining adequate capital cover carries a cost for all banks. The
exact level of that cost depends on each bank's capital position,
access to external capital, return on assets and leverage. A bank may
choose to carry enough capital to cover the full risk of undrawn
commitments from the beginning. It may rely on retained earnings to
build up its capital base; the argument might be that it is unlikely that
all (or even many) of the standbys will be drawn down in the first few
months of their lives. Or it may rely on a mixture of a sound starting
capital and the enhancement of a stream of retained earnings.
Whatever the precise choice, the bank needs to be able to see a sound
return. To ensure that return it probably needs to allocate part of its
capital, at least notionally, against its unused commitments and to
ensure that the fees on the commitments earn, provided they remain
unused, an acceptable return on that notional amount. This can be
retained to provide capital, or distributed in dividends to increase the
ability to go to the market for larger amounts.
Many banks claim that they already allocate capital against
unused commitments; however, the level of fees in the market in
1986-7 permits a sound return only if the level of risk (and therefore
capital) is regarded as virtually non-existent. This premise ignores
past experience, when banks found themselves with problems as a
result of risks which were too lightly discounted.
The Bank of England's initial requirement for a 50 per cent capital
cover for the unused commitments for NIFs, etc. will presumably be
superceded by the more detailed Anglo-American capital adequacy
rules once these are finalised. Both are pushing banks in the right
direction. But banks should not need this type of regulation to
persuade them to do what is self-evidently in their own best interests.
Individual banks should recognise the risks inherent in granting
commitments for almost no remuneration. In many cases, such
commitments can become a self-inflicted wound, sometimes a serious

one.
Banks would be wiser to follow the lead of those few that refuse to
issue commitments unless there is a prospect of a sensible return.
This may force customers to consider the value of the commitment
and to reduce the total insurance they demand. By reducing the risk
and increasing the return banks will among other things improve
their ability to meet their commitments, if they are ever called, and
thus their value to those who really need them.
If the banks do not move in this direction on their own, it is hard to
see how even the more reluctant regulators can avoid taking steps to
stiffen capital requirements in this area. Such regulation might be a
second best solution to the problem, but the banks would have only
themselves to blame.
It is clear that for borrowers today a commitment is a form of
insurance policy. So are performance guarantees, standby letters of
credit and other instruments which insure against non-lending risks.
That being the case, the borrower should be willing to pay an
economic premium. Once that premium is paid, there is no reason
for banks to refuse to enter into commitments.
Insurance companies which charge too Iowa premium lose money
and, in the extreme case, may even fail to meet their claims. Banks
which issue massive commitments without fully understanding and
charging for the risk face a similar fate. In both cases, customers who
accept insurance on unsound terms may find themselves uninsured at
the worst possible moment.
6 Short, Medium or Bust
PERMANENT LENDING - DOES IT EXIST, AND DOES IT

MATTER?
Unsecured medium-term lending is a relatively recent development,

and came later to Europe, including Britain, than to the United
States. Banks in the United States developed an approach, including
covenants and amortisation, to controlling the credit risk that worked
well. However, when the Americans introduced the concept to
Europe, most European companies and banks failed to understand
the logic. Economists in banking, such as Geoffrey Bell, argued that
good companies never repay their debt because they can use the
funds to better advantage themselves. This was an argument against
amortisation which largely ignored the importance of bank liquidity
or credit control, both of which are crucial to the need for
amortisation. Mr Bell's arguments, probably unintentionally, came
close to saying both that only good companies borrow medium term,
and that all good companies remain good for ever.
Whatever the merits of the academic argument, the weight of
competition eventually caused some practical bankers to accept the
argument, even if only in carefully-defined circumstances. Others still
felt that the arguments were to some extent an excuse for giving in to
market pressures, rather than well founded in their own right; that
there was some sloppy thinking as to what 'permanent' means in this
context; and finally that the practical implications for credit control
were not very great anyway, if the whole process was closely
examined.
The discussion that follows consists of three parts: it highlights the
areas of agreement between the two sides; the areas where the
emphasis differs; and where if at all the argument about permanent
lending would cause banks to analyse credit differently or write
different types of loan agreement.
The Areas of Agreement
Those who believe that banks should lie back and enjoy permanent
lending and those who believe that we may be stuck with it, or
97
something close to it, but do not have to approve of it, can still agree
on many points:
- Many companies including some (but not all) good ones do not
for many years reduce borrowing in absolute terms; a few state
quite firmly that they do not expect to do so in the future.
- This position can be sound financial management.
- As long as the market accepts permanent lending, so called,
banks which disagree may have little choice but to go along with
it. They must, however, recognise that that is what they are
doing and structure their lending and monitoring techniques
accordingly. It would be dangerous for banks to fool themselves
that their loans would be repaid from cash flow if there was no
intention on either side that this should in fact happen.
- Banks, however, need to exercise great care in choosing the
borrowers to which they are willing to be permanent lenders.
They must retain the ability to analyse and structure repayable
loans to those companies which do not meet the permanent
criteria.
- This means that the proper use of analytical tools is even more
important than when all borrowers are expected to repay their
debt; banks cannot afford to accept permanent lending to
companies which do not warrant it.
Differences in Emphasis
The differences in emphasis are not such as to lead experienced

lenders to different conclusions in most cases. Even where they
disagree about the principles on which to make the decision, they will
usually agree as to the right action in practice. But the wrong
principles could discourage inexperienced bankers from thinking
rigorously, and lead to wrong conclusions.
The main differences therefore are:
1. Between those who believe that accepting permanent lending is

the best way to make bankers focus on the greater risk involved,
and those who believe that making a wrong idea respectable is
more likely to lead bankers to take an over-relaxed approach,
the exact opposite of what both parties to the argument desire.
2. The latter differentiate more strongly between companies
which:
Short, Medium or Bust 99
(a) Borrow permanently because they do not generate the cash

flow to retire debt.
(b) Have profitable opportunities for reinvestment and a strong
balance sheet. Investment then strengthens their net worth
and improves their earning and debt service capacity. More
importantly, they (and to some extent the bank) keep the
option to reduce the debt if it becomes excessive, or if
profitable opportunities dry up.
This in turn heightens the need for a clear definition. Perhaps

we should distinguish between permanent, as in (a) above and
indefinite, as in (b).
We can define permanent lending 'as relying on other lenders
to repay us because normal asset liquidation or cash flow is not
available to do so'.
This can cover two separate situations: 'when we rely on
other lenders because asset liquidation or cash flow are
inadequate or do not exist' (permanent and high risk); or 'when
we rely on other lenders because assets and cash flow are
committed to another, sensible use' which is indefinite and
lower risk.
Neither in these definitions nor when discussing permanent
lending (as opposed to permanent borrowing) does the question
depend on the form of the facility. A short-term line of credit,
as discussed in more detail in the next section, can be just as
much permanent or indefinite lending as a seven-year term
loan; the bank must be confident that the borrower can and will
repay it in the normal course of business. Indeed, there is a
greater risk of failing to recognise that lending is permanent
when the form of the facility is short term than when it is
formally medium term.
3. The distinction between permanent borrowing and permanent
lending. Companies which borrow a stable amount need not
always borrow from the same lenders. This is more than just
semantics, it relates to a sound capital structure. There are
several reasons for borrowing medium rather than long term.
Nevertheless, borrowers should keep a balance between short-,
medium- and long-term debt, and between floating rate and
fixed rate. Floating rate is more likely to be bank debt (or to be
held by banks as FRNs or some similar instrument) than fixed
rate.
Thus even a company with stable or increasing debt may

sometimes reduce bank debt. The ability to do this depends on
the structure of local financial markets, access to international
markets and the level of interest rates. A company which has
access to long-term debt but does not use it may raise a
question. A company which has no access to fixed-rate debt can
afford only a lower level of permanent debt, particularly in
high-rate or inflationary environments.
4. A similar comment applies to equity. Many companies allow
their borrowing to grow for quite long periods until it
approaches the limit on their present equity base. They then
raise enough equity to fund further growth over the next few
years. This allows a temporary reduction in debt. Again, if a
company has no access to new equity except from retained
earnings, this limits its ability to borrow; to refuse to use access
which is available raises a question as to the quality of financial
management, which again may restrict banks' willingness to
lend.
5. Permanent lending in the literal sense of the word has many of
the characteristics of equity, but without the reward. This type
of risk without adequate reward must be very carefully
controlled.
6. To summarise the last few points:
(a) an acceptable permanent borrower is permanent from
choice (his and the bank's) not from need;
(b) a sound permanent (or indefinite) borrower will always
have unused financing capacity for emergencies; he can
(and probably should) use it to rest some lenders occasio-
nally;
(c) there can be fluctuations round even the most permanent
trends.
7. The reluctantly permanent also question the argument that
good companies 'never' repay debt. Certainly some go for long
periods without repaying, but normally only where reinvest-
ment is increasing their capacity to service debt. This will in the
end grow to a level greater than can be invested profitably, and
without loss of management control; during the consequent
consolidation the borrower will use the cash flow to reduce
debt. If there is not an occasional pause, either management
may lose control, or the opportunities for investment may

become less attractive. In either case, the question arises 'Is this
still a good company which can borrow permanently?'
The doubters also point to the numerous good companies
which either never borrow large amounts or, if they do, repay
the debt rapidly. Finally, they point to companies which either
are in trouble, or which might be expected to be but are not.
Many case-study problem borrowers were 'good companies'
once; their problems were rarely caused by debt, but debt has
made other difficulties much more damaging and harder to deal
with. Failure to control debt in such cases may make the
difference between survival and ultimate insolvency. Other
companies, even after several years of declining profits and
writeoffs, have managed to reduce their debt substantially and
have survived, and eventually been able to take advantage of
more favourable market conditions.
8. The doubters also qualify their acceptance in the light of
national differences. A general statement that is true in some
countries is not necessarily true in others. Apart from some of
the factors already discussed, banks should look at the general
level of, and attitude to, profitability in a country - both
absolutely, and in relation to the availability and cost of fixed-
rate debt. In some countries, social attitudes put profit low on
the scale even though almost all debt is floating rate and
interest rates are high and volatile. The desirability of perma-
nent borrowing there may be lower than in countries where the
reverse is true. Social attitudes may reduce the ability to lay
people off, cut costs or change course in other ways necessary
to avoid being overwhelmed by the burden of a debt which
once appeared manageable but has become less so for reasons
outside management's control. Legal and political barriers
make such action almost impossible in some countries, and
expensive in others; they make the risks from excessive or
permanent debt correspondingly higher. Other aspects, such as
union strength and enlightenment, government interference,
industrial structure and market capacity to refinance may make
permanent borrowing harder to justify in some countries than
in others. Permanent borrowing will probably happen in these
countries anyway, but banks can reduce the risks if they are
aware of them and more selective about which they accept.
The Approach to Analysis and Documentation
Very few experienced bankers would carry the belief in permanent

lending as far as some commentators; these appear to think that it
obviates the need for a full loan agreement, analysis of cash flow and
above all any requirement for amortisation.
A more realistic approach accepts that some companies can
borrow indefinitely, but that even those that do may deteriorate to a
level which makes it wise to withdraw. If anyone bank is to do this
alone, it must monitor the borrower more effectively than other
lenders to recognise the weakening while other lenders still regard
the borrower as a 'good' credit and will therefore lend to replace it.
Clearly, the market as a whole (whether banks or holders of bonds,
FRNs, commercial paper or other instruments) cannot get out in this
way; clearly, too, it would be a very conceited bank that thought it
could do so every time. A bank which thinks it can be ahead of the
market most of the time must still pick those companies which will be
able to pay it off before other lenders notice. They must not need to
refinance more than the market will handle in an adverse period; this
probably means that they must have some unused borrowing
capacity and no major concentration of need, including repayment/
refinancing of existing borrowings, in anyone year. A bank which
expects to be able to get out ahead of the crowd must also consider
what this will do to its image in the market. How will it show its good
customers that it is committed to them and a reliable source of
support in times of temporary setback? A bank which mishandles
these points may find that good borrowers no longer wish to borrow
from it. Equally where it finds these points inhibit it from getting out
early, or where it fails to be the first to notice the problem, it must
still be on top of the situation well enough to take other remedial
action in time.
Thus a sound approach is very similar whether banks think of debt
as medium term or permanent. They still need to review the
combination of cash flow and refinancing ability (including equity)
which is available in each particular case. Different banks may draw
different conclusions from the same information, depending on how
they think about permanent borrowing; the tools needed to draw the
conclusion are the same. In particular, banks need to compare likely
cash flow with the cash needs, to see what the balance is. Figures
which show that a company is dangerously overextended in a
particular year are worrying in either case, while figures showing a
moderate shortfall may also show how to cover it.

A parallel argument applies to amortisation. Even where banks
believe the borrower has no need to repay debt, it is still better to
have the notional maturities well spaced out: a bunching may cause
lenders concern, or may coincide with a difficult period in the
market. In those conditions, even a company that is strong may find
the refinancing more difficult or more expensive than it should. In an
extreme case, it may run into quite unnecessary difficulty. And if it
and the banks both expect that it will repay the debt, then both
should know the expected source of repayment and tie the
amortisation in with the availability of that source.
There is also a parallel with the argument about covenants,
although perhaps not quite so strong. The argument on permanent
lending suggests that a company can reduce debt, even when things
are going well, only at a risk to its long-term prospects. If this is so
banks, and the company, need a mechanism to tell them when the
company is approaching the critical stage where its refinancing ability
is threatened; covenants provide that mechanism, as they do where
the bank recognises in advance that certain key factors are crucial to
the company's ability to service its debt.
Summary and Conclusion
There is a real sense in which the argument about permanent or

temporary lending is a non-argument; when looked at correctly,
either view tends to much the same conclusions as to what action to
take. However there are three reasons why the argument merits
consideration and at least partial rebuttal:
The argument for permanent lending is easily misunderstood as

a justification for slack lending policies and controls; it can thus
reinforce the natural tendency to take the easy way out when a
client resists the measures necessary to ensure sound lending.
The argument can too easily be applied to shorter-term facilities
where even its strongest supporters would agree that it is
inappropriate.
- Securitisation involves an implicit acceptance of the argument in
some areas, and conceals its impact in others. For instance,
FRNs rarely have any amortisation and very little in the way of
documentary protection for holders. Whether they know it or
not, holders of FRNs are relying on the truth of the permanent
lending argument for their repayment, since they have made no

other provision. Similarly, when investors buy eurocommercial
paper or other instruments relying on a bank backstop, they are
doing the same; so is a bank which gives such a backstop
without due care and documentary protection. But where there
is no drawing under the backstop it is very easy to forget that the
client is in fact borrowing heavily from investors who rely,
rightly or wrongly, on the bank to lend in their place in a crisis.
All of this makes close scrutiny of the lender even more important, if
the bank is to give the backstop commitment in the first place, and
avoid being caught in a declining situation as a result. It must satisfy
itself whether the company is and remains a 'good company' to which
the permanent lending arguments apply.
WHEN IS LENDING SHORT TERM, AND WHY?
It is very easy to accept without thinking that short-term lending is

less risky than medium or long term. In one sense, it is almost a
truism; but in another it ignores a number of questions: what do we
mean by short term? why is short term less risky? are all types of
short term equally low risk or are there other factors which we have
to combine with the maturity in assessing risk? Unless they think
these questions through, banks can fall into a serious trap.
The Trap
There are two reasons usually given why short-term debt is 'safer'
than medium- or long-term debt. The first, which is valid when true,
is that short-term debt finances short-term needs; it is therefore often
directly self-liquidating; or at least it can be paid either from the
liquidation of assets in the normal course of business or from cash
flow in the short run. In neither case does repayment threaten the
company's ability to continue to do business. The second argument is
more facile, and of dubious validity; that banks can call short-term
debt at any time. This ignores the question of whether the company
can meet the call; in practice, it can do so only if the first point is true
(in which case the bank should not even need to call), or from
unused facilities, often referred to as refinancing ability. In the latter
case, the borrowing is permanent within the meaning discussed in the
previous section. Lending may still be sound, but the risk is no longer
a short-term one. A decision or recommendation to lend which treats
it as short term misses the point and misunderstands the risk.
There is unfortunately plenty of evidence that this distinction is
rarely made with sufficient force.
The Correct Approach
There are broadly speaking three types of situation where debt can be
considered genuinely short term in purpose and use, rather than in
form only. These are:
1. The cyclical borrower. The most common short-term cycle is

seasonal. A classic example is the toy company, which finances
the build-up of inventory and then receivables before Christmas
by short-term borrowing; it repays it after Christmas, as sales
drop. Other examples are fertiliser and other producers of
goods for agriculture, and many processors of fruit and
vegetables. The exact cycle, and the cause of it, are different in
each case, but the underlying pattern is the same: an increase in
borrowing to finance a build-up of current assets, which are then
sold and the proceeds used to repay debt.
2. The contractual borrower. Some companies undertake very
large individual contracts, or suffer from other factors which
create large swings in cash flow. Some construction companies
are good examples; they build up work-in-progress inventory
and the related costs over periods from several months to
several years. When the project is complete and paid for, they
repay the borrowing. In some cases, they will borrow separately
for each contract, so that even when borrowing is building up
for a new contract, they still repay the original debt. Other
companies of this sort include the major computer and related
equipment manufacturers, and others. They offer the option of
purchase or lease on their products; changes in their customers'
view as to which is better can cause big swings, sometimes at
short notice, in their cashflow. It is reasonable to use short-term
borrowings to cover the resulting needs.
3. The ad hoc borrower. Companies may borrow for a specific
need with a clear source of repayment in mind, but no clear
pattern of doing so regularly. This may be to finance introduc-
tion of a new product; or for the temporary financing of
medium- or longer-term projects, until the amounts are large

enough to justify the effort and expense of longer-term funds;
or for one of a number of other possibilities. But always, if it is
genuinely short term, the company will know how (and when) it
expects to repay the debt.
Of course, most companies have minor fluctuations in their cash flow,

but borrowings to bridge these are small in most cases, and can be
ignored for these discussions. Many companies also use short-term
facilities to finance longer-term needs. This can include current
assets, which many bankers think of as being a short-term need.
Where, as in some of the examples above, the need fluctuates, this
may be true. But for non-cyclical companies - and particularly for
growing ones - it is not. As a company collects old receivables, it
generates new ones; as it converts components or raw materials into
finished goods and sells them, it buys new inventory. The financing
requirement remains or grows, unless profits are large enough to
allow the company to finance a growing proportion of new business
internally. But repaying debt from cash flow is the classic sign that the
debt is medium term; short-term debt is repaid from asset liquidation
in the normal course of business. To finance permanent working
capital needs with short-term debt is thus inherently misguided; what
makes it dangerous is the failure to recognise what is happening. The
same point is true where the activity being financed is more obviously
medium term in nature; but because it is more obvious it may be less
risky in practice, although no less wrong in concept. Where a
borrower uses an overdraft to finance the construction of a factory
over a three-year period, for instance, the bank is unlikely to fool
itself that the borrower can repay the whole overdraft half way
through the construction period.
Requirements
The rating systems which banks use for internal purpses will often
show short-term debt as higher-quality risk than medium term.
Equally, bankers in recommending a facility for approval will often
refer to the low risk 'due to the short-term nature'.
Bank managements and decision makers should accept this
argument only where the purpose for which the borrower intends to
use the funds and the source of repayment are clear; and where these
factors clearly establish that the debt is truly short term. Sometimes
competitive factors will make it hard to demand to know the precise

purpose for which the borrower wants the loan. In that case, the bank
should try to review the pattern of usage over the last two or three
years - not just of its own lending, but of all borrowing. It should be
possible to judge whether there has been any major fluctuation in
usage - suggesting genuine short-term needs and ability to repay; or
whether borrowing has been stable or rising without interruption.
Moreover, once established the reason for the fluctuations must be
monitored. One of the most insidious forms of credit risk arises when
a company begins to use permanently facilities which once were
genuinely short term. This suggests one or more serious types of
deterioration, a failure to notice which can easily make the difference
between escaping with little or no loss and a major bad debt.
Supervisors and decision makers should insist that any proposal for
'short-term' credit should justify the phrase; bank managements
should in turn ensure that their supervisors and trainers impress the
point on staff responsible for recommending credit, and monitoring it
once lent.
WHAT SHOULD WE EXPECT FROM A GOOD INSOLVENCY

LAW?
Introduction
Most of this book, and many other books on credit, is about how to
avoid insolvency. But no bank can avoid some bad debts; moreover
the spread of international banking, and the difficult economic
conditions experienced in many parts of the world, have involved
banks in problem loans in countries with unfamiliar insolvency laws
and practices.
At the same time countries are recognising that their laws are
inadequate. Some, induding the United States and United Kingdom,
have already upgraded their laws; in the United Kingdom the change
is still too recent to judge how effective the new rules will be. Some
other countries have made piecemeal changes, in some cases for
political reasons; yet others are only beginning to realise that either
their laws, or the way in which they are enforced, or both, are wholly
out of date. In particular, some countries are finding that the
traditional and often cosy arrangements between banks, government
and debtors do not work when a large part of the debt is due to
international banks. These have no incentive to join the arrange-

ments, even if they understood them, which usually they do not.
Thus there is, or should be, much thought being given to the
objectives of an insolvency law, and how best to achieve them. The
exact answers to these questions will depend on the legal and
commercial framework within each country; this section tries to
suggest a set of criteria against which both drafters and users of the
law can assess its adequacy.
Primary Objectives
Historically, there have been three main objectives to corporate

insolvency laws. Since they conflict with each other to some extent,
the balance between them is important, and differs from country to
country. It also affects the balance between the secondary, but still
important, features.
The three main objectives were:
- To punish culpable managers, and others, either for allowing the

failure in the first place, or for continuing to trade when the
company is unable to meet its debts as they fall due.
- To protect the failing company from its creditors while a
recovery plan is worked out and put in place.
- To realise the maximum value for the assets and share the
proceeds equitably - or in a prescribed fashion - among the
creditors.
The trouble is that to take too harsh a line with the managers
encourages them to rush for the cover of the law too soon, and
discourages new management from coming in to try to rescue a failing
company. To put too much weight on restructuring runs the risk that
if the effort goes wrong the creditors realise even less in the final
insolvency. And to put too much weight on recovery for the creditors
may reduce the chance of a solution that keeps the company alive at
some cost to the creditors. To make these points is not to express a
preference for anyone approach, only to highlight fairly crudely the
need for legislators to make up their minds what balance they want
between the objectives. Otherwise, the actual balance may turn out
to be very different from their intentions.
Much the same is true of the judges and practitioners who have to
put the law into practice. If their priorities are different from those of
the legislators, or if the legislators fail to make their priorities clear,

the result can be that one or other objective attains a priority it was
never intended to have, and that few people think it should have.
Secondary Objectives
Along with these primary objectives there are several which are
secondary in the sense that they follow from the primary objectives,
rather than being necessarily less important. These in turn contain
some inherent conflicts, both within themselves and with the
primaries. Some of the more important are:
- The need to protect secured creditors.

- The need to prevent secured creditors realising their security in a
way which damages the other creditors' interests.
The need to encourage management to stay with the company
and work to rescue it, rather than run for cover at the first sign of
trouble.
- In particular, the need to enable new managers to come into a
company in trouble to rescue it without having to worry about
being blamed for the errors of their predecessors.
The contrary need to hold management accountable for
irresponsible behaviour.
The similar need to allow banks to support a sick company
without adding to the risk which they already face.
And still to hold banks responsible if they encourage a company
to continue to trade beyond a certain point. Nor may banks, in
trying to protect themselves, damage the interests of other
creditors.
- The need to protect the legitimate interests of employees who
are not responsible for the failure.
- The need to ensure that too rigid employment rules do not
undermine the company's flexibility. To do so may cause a
company to fail, with much greater long-term damage to the
main body of employees, as well as to other creditors who are
just as blameless.
The need for a system of handling insolvency and pre-
insolvency that allows maximum commercial flexibility and
encourages development of a body of insolvency experts.
The need to ensure that the courts or creditors are in control
and that the insolvency manager does not feather his own nest,
or prefer one creditor over others. And in cases where the

original management still has a role to play, to ensure that it is
not allowed to cover up its blame for the failure.
Not all of these points are necessarily covered by insolvency laws;
some are covered in more general company law, others may be seen
as social rather than insolvency concerns.
The Present Pattern
Most countries now have an insolvency law which provides for

reorganisation under court supervision; this is normally a separate
procedure from insolvency, though covered by the same law.
Examples are Chapter 11 in the United States, Suspension de Pagos
in Spain, the newly-introduced (1986) administrator in the United
Kingdom. Some countries even have two or more reorganisation
procedures for different types of situation, or to allow the govern-
ment to intervene in what it regards as special cases affecting the
national interest, or to prevent groups hiding inequitably behind the
corporate veil.
Despite the similarity in outline appearance, the laws in practice
work very differently. None are regarded as completely successful,
but that is probably inevitable given that they are working with
companies that have failed or are in imminent danger of failing.
Nevertheless, some such as Chapter 11 are regarded as sound in
concept, and bankers and businessmen use them relatively willingly
when necessary. Others such as Suspension de Pagos are seen as
disasters to be avoided by the creditors at almost any cost, thus
giving the debtor an overwhelmingly strong hand in negotiations.
Indeed, partly because of the ease with which Spanish companies can
enter Suspension, and the difficulty of getting them out of it,
corporate bankruptcy in Spain is rare.
It is possible to identify a number of features both in the
insolvency law itself and in the surrounding law and practice which
either contribute to or undermine the effectiveness of the process.
The favourable factors include:
- The ability for either management or creditors to apply for
reorganisation as weB as liquidation.
- A quick decision, at least on reorganisation. The receiver/
liquidator must take control without a long interregnum during
which the company runs downhill in a state of paralysis.
A strong influence by the creditors on the choice of receiver in

reorganisation or liquidator in full insolvency.
- Payment of the receiverlliquidator which eliminates the tempta-
tion to feather his nest in other ways; which attracts highly-
qualified practitioners; and which encourages them to put the
interests of the creditors as a whole above those of management
or of anyone creditor or group of creditors.
- Clear criteria for admission to reorganisation rather than
liquidation.
A timetable in reorganisation which provides a degree of
flexibility, but is tight enough to prevent procrastination.
Accountability of the receiver/liquidator to the court on an
overall basis, rather than item by item.
The existence of an insolvency profession used to working for
creditors and geared to the need to recover as much as possible
for them, rather than to protect management or shareholders.
Leading unfavourable factors include:
Management alone having power to petition for reorganisation.

(Sometimes the legal requirement may be for the shareholders
to do so, but in most countries this in practice gives manage-
ment the power.)
- Management remaining in effective control in the reorganisation.
- Creditors having no effective power to end the reorganisation
period, or even change management during it, when there is no
progress towards an agreement acceptable to them.
The absence of a competent professional group of insolvency
specialists to run the company, or at least provide some rein on
management.
Excessively detailed court involvement in the process.
- Rigid requirements regarding the sale of assets; sometimes all
assets, sometimes those over which there is a charge.
- Excessive and indiscriminate penalties on management in case
of bankruptcy. Failure to distinguish between genuine efforts to
save a weak company and the factors which caused it to be weak
in the first place. And - perhaps worst of all - failure to
distinguish between management brought in to try to solve the
problem and management which caused the problem.
- Excessive ability of employees or individual creditors to block
the process.
The Requirements
The exact form of insolvency law and practice must be adapted to the
legal and social framework in each country. Even new legislation
cannot hope to create entirely new conditions overnight, but only to
improve on the existing environment. This subsection should
therefore be taken as only a broad outline. Nevertheless, experience
suggests that the criteria are realistic in general terms even though
the extent to which - and the way in which - each country can best
meet them must vary.
The first point is that any good insolvency law should recognise
that even the best legal process is expensive; that its mere existence
will be seen by many outsiders as a sign of failure, making recovery
that much harder; that it will often demoralise key personnel, whose
loss will again make recovery harder; and that the recovery rate in
the best systems is low.
Wherever possible the law should thus encourage the company
and its creditors to try to find a solution on their own outside the
insolvency system. However, this is often made harder (and
sometimes impossible) by over-stringent penalties for failure. Man-
agement needs some reminder of its duty to shareholders; however,
it cannot be permitted to go on desperately trying to turn the
company around when the only possible result is to lose more money
for the creditors and perhaps to suck in new ones. Nor can banks be
permitted to keep the company alive only for their own purposes,
again at the expense of other creditors. Equally, however, the
decision to try to rescue a company carries a risk of failure; if
managements and banks run the risk of being penalised for failure of
even an honest and responsible attempt to save a company, many
companies will die which could be saved.
A good insolvency law, therefore, should clearly define the criteria
by which management will be judged in this context. It should
provide, for instance, that management will not be penalised for
acting in what it in good faith believes to be the interests of the
creditors as a whole; or where its sole and reasonable purpose is to
avoid insolvency.
Equally, it should make as clear as possible the risks that banks
can face, and what the courts can treat as genuine attempts to save
the company. The concept of a shadow director, for instance, is
explicit in the British Act, but is only implicit in some laws. As a
result, in Britain banks and their lawyers are being very careful to
protect themselves; even where a lawyer advises that a particular

action carries little risk of causing the bank to be treated as a shadow
director, there is less confidence until there are some cases to show
how the courts actually interpret the rules.
The law should contain a clear definition of the purpose (or
purposes) for which the reorganisation process is intended; and of
the conditions which a company must meet to be allowed to use it.
The purpose(s) must be consistent with the criteria for entering the
process. In particular, the lawmakers must be clear in their own
minds - and make it clear in the legislation - whether reorganisation
and bankruptcy can be alternative ways of handling the same
problem, or mutually inconsistent ways of handling different stages
of a decline.
For instance, in some countries a company must have a positive
net worth (although the law is often expressed in ways which make
the exact requirement less clear). There are at least three possible
ways of interpreting this rule in relation to reorganisation. The
strictest would require the company to go into the full bankruptcy
process if it proved to have a negative net worth at any time during
the reorganisation. The next would allow reorganisation, once
started, to go its full course, but debar any company with a negative
net worth from entering reorganisation. The third (and best) would
allow any company with a negative net worth to reorganise if it meets
the other criteria, but otherwise put it into full bankruptcy. The
implications for banks and managements trying to rescue a company
without recourse to the courts are very different. The difference can
be aggravated if there are penalties which management can avoid by
going into reorganisation, even where it is not the right process.
The power to apply for either bankruptcy or reorganisation should
always be available to as wide a range of interested parties as
possible. At the very least it should include both management and the
creditors, or any combination of creditors. It is important that
management be able to petition, because it may be the only way it
can obtain the breathing space necessary to pull the situation
together. But it is dangerous to allow only the management this
power; this is particularly so where management remains in control
and cannot be forced into full bankruptcy if the reorganisation
fails.
Indeed, it is always undesirable that management should remain in
full control in either reorganisation or bankruptcy. Few if any
countries permit this in bankruptcy, but some do in reorganisation;
while there is always provision for either the court or the creditors to
supervise the management, it is sometimes ineffective. The danger of
an incompetent or dishonest management remaining in control while
blocking the creditors' ability to bankrupt the company is frightening,
but happens in some countries.
There should therefore be provision for a competent outsider, with
relevant experience, to be appointed at least to supervise and often to
run the reorganisation. Where in his view the management is not
mainly to blame for the company's problems, or has some specific
contribution to make, he should be able to keep them in place, or use
them as consultants; where he believes they have been incompetent,
irresponsible or dishonest, he should have power to remove them
entirely.
Defining what is meant by a 'competent outsider' may not be easy.
The new British Act introduces the concept of an 'insolvency
practitioner' and lays down fairly specific requirements. This is
possible in Britain because there is already a body of professionals,
mainly accountants, specialising in the subject. In countries where
this does not apply the definition may be harder to make realistic, but
the law and the definition should encourage the development of a
professional body. It should also be wide enough to include a
businessman with experience as a 'company doctor'.
The outsider (or administrator to use the new British term) should
have duties clearly spelled out, but in general rather than specific
terms. It should be clear, for instance, whether he is expected to give
priority to social or national interest factors over the interests of the
creditors; if so, just what are the factors, and how great is the
priority? Some countries regard reorganisation as a way of keeping
companies alive to save jobs; others relax the rules on maintaining
employment only when a reorganisation is under way. Others have
special (if often unwritten) rules for some products regarded as in the
national interest; these may be defence, high-technology, or infant
industries, but may also be as mundane as explosives or fertilisers.
These priorities need to be spelled out more clearly than in the past;
the growing number of international creditors (not just banks) lack
the automatic knowledge of the national priorities that a local
creditor has.
Subject to these priorities, the administrator's first duty should be
to the creditors, and after them to the shareholders; there should be
no obligation to the management. The administrator, and liquidator
when necessary, should thus be chosen or ratified normally by the
creditors. The shareholders should have the right to influence the

choice only when there is a real chance of the creditors being paid in
full, or when the creditors cannot agree among themselves.
To reinforce this point, the administrator/liquidator should be paid
by results, normally a percentage of the amount recovered for the
creditors (or shareholders in the few cases where that is relevant).
However, a successful reorganisation can lead to a complicated plan,
with debt being converted into equity or other types of debt rather
than paid in cash; there may then be a need for a special form of
payment when a plan is approved by the required majority of the
creditors. Either way, however, the point is that the payment should
reflect the quality of work on behalf of the creditors; it should also be
set at a level which makes the reward well worthwhile for a successful
job, but not for a failure. A statutory level of say 5 per cent of
recoveries, but with the ability to negotiate a lower figure for large
companies, should ensure that the work is sufficiently lucrative and
challenging to attract a high calibre of professional without also
attracting cowboys or crooks.
In general, it is important for any insolvency law to remember that
the process is primarily a commercial one. Even where the law
chooses to punish managements, it is because they have allowed a
commercial enterprise to fail, or have taken commercial credit they
could not repay. The process of trying to set a company back on its
feet - or if that fails of recovering the maximum for the creditors - is
also commercial.
There are specifically legal aspects which require some extra
supervision by the court. These are mainly aimed at checking for any
criminal or culpable behaviour by management or by anybody who,
properly or improperly, has influenced management; and at ensuring
that the sums recovered are correctly distributed among the creditors.
Indeed the first requirement can be seen as a part of the second, since
any culpable act is likely either to damage all the creditors or to
prefer some ahead of others. The efforts by the court, or under its
supervision, to correct this should therefore lead either to a fairer
distribution among creditors, or to a larger total recovery.
To recognise that the courts must playa larger part in insolvency
than in normal business relationships does not, however, detract
from the basically commercial nature of insolvency. The best systems
reconcile the two points by having the creditors choose and reward
the insolvency practitioner and allowing him to get on with the job
within the specific guidelines. The practitioner can call on the court
for guidance whenever a legally contentious point comes up; he must

justify his actions to the court whenever required; he must report
periodically in a prescribed form and any dissatisfied creditor can
apply to the court for relief or guidance. But the practitioner makes
the day-to-day decisions - and, indeed, all the commercial decisions,
such as whether to complete a contract; whether and if so at what
price to sell assets or even whole subsidiaries; whether to try to tum
an operation round with a view to selling it at a better price. No court
can in practice take this sort of decision effectively. Those systems
which require it to do so are invariably cumbersome and a disaster
for creditors.
The creditors should have some direct input into the process. In a
reorganisation at least, the larger ones should be able to negotiate
with the administrator on the terms of any restructuring; they should
not, as happens in many countries, merely be called on to vote on a
scheme into which they have had no input.
Equally, in both reorganisation and liquidation, they should have
the chance to review the major decisions such as sale of assets or
subsidiaries critical to the business, whether or not to close down
certain operations, whether to compromise or fight doubtful claims
and so on. Since a large body of creditors is too cumbersome a
forum, there should be a creditors' committee to do this; it should be
chosen by the creditors to represent a cross-section of themselves,
but once appointed each member should serve in a private capacity
for all the creditors, not represent an employer.
The ranking of creditors and the position of secured creditors is
important. Preferential creditors (i.e. those who are granted priority
by law over all unsecured creditors and sometimes some secured
creditors as well) should be kept to a minimum. They normally
represent government's attempt to protect itself at the cost of others.
The treatment of secured creditors and their ranking should be
spelled out clearly, and they should be required to register the details
of their security where interested parties can review it before making
a decision to grant credit.
. The value of security is impaired, sometimes seriously so, if the
secured creditor cannot choose when to realise it. On the other hand,
an administrator can be in serious difficulty if a key asset is sold from
under his nose at a crucial moment; equally he may need to sell the
asset which is pledged as part of a larger sale which may be in the
interests of the creditors as a whole. There needs therefore to be
balance between the administrator's power to sell or prevent a sale
and the secured creditor's power to realise his collateral. Where the
administrator exercises the power to sell, the proceeds must be held
for, and paid as quickly as possible to, the secured creditor.
Furthermore if he sells at less than the full market price, or if the
creditor can prove he could have obtained a better price, the
administrator must pay the difference. Where the administrator
refuses to allow the secured creditor to sell at a time of his choosing,
he must protect against loss of value. This may mean ensuring proper
maintenance and repairs of pledged equipment used in the business;
or covering the creditor when the value of a subsidiary declines
below the level at which it could have been sold. (These points apply
equally to liquidators.)
This is roughly the situation under the new British Act. Some
lawyers claim that it undermines the value of the security and that
banks will be reluctant to lend to weaker borrowers or will be more
inclined to put in a receiver. This seems a little far fetched. It may be
theoretically possible for an administrator to reduce the value of a
particular piece of security; but he will have no interest in doing so
unless it is essential for the success of his task. At worst, the bank
may be prevented from taking a view of the movement in the asset's
value; this is as likely to save it the cost of taking a wrong view as it is
to cost anything significant. Moreover, a sale at below maximum
value will hurt only a bank which has no margin in its collateral;
often when that is the case it will be well undersecured, and will
therefore have an interest in the administrator recovering as much as
possible from the other assets. And, of course, many banks have
more than one loan to a company, and not all of them are secured.
This again gives the bank an interest in getting the best recovery on
all the assets, which may override any minor loss it may make on the
secured assets. Of course, the administrator should exercise his right
to int\!rfere with the collateral rights only where it is vital to the best
recovery overall; he should not be able to do so arbitrarily.
The ranking among creditors and the way in which they can vote
on any scheme prepared by the administrator also needs to be clear.
Most countries have one ranking of unsecured creditors, with no
distinction or priority among them. This is certainly better than, for
instance, the Spanish system of requiring debt to be registered and
ranking recovery in the order of registration (in bankruptcy only).
On the other hand, it ignores the possibility of subordinated debt, an
American import to many countries which is becoming steadily more
popular. Where, as in Britain, the insolvency law makes no specific
provision for subordination, it can still work. It may, however, be

more complicated to draft and less certain in its effect than in
countries whose law specifically allows for it in liquidation as well as
administration.
Where the administrator proposes a scheme to continue the
business rather than liquidate it, at least some (perhaps all) creditors
must usually give up some of their rights. To do this, most laws
require a vote with a majority usually of either 66.67 per cent or 75
per cent by amount and a bare majority by numbers. In considering
the size of vote required, the legislators must balance two risks: a
factious minority may block the chances of a majority; or the
majority may impose its will on creditors who have good reasons for
resisting a proposal.
There is also the question of whether all the affected parties should
vote in one group, or whether there should be several classes each.of
which must approve the scheme by the requisite majority. The
second clearly makes it much harder to get a scheme approved. It
may give people who stand to lose (or gain) little by the decision a
veto power which will affect people who have much more at stake.
For instance, the secured creditors may be fully covered and the
scheme may not threaten their collateral at all; if they are allowed to
vote as a class - or, indeed, at all - they may impose a damaging
decision on those who have much more at risk. On the other hand,
the success of some schemes may depend on the cooperation of the
secured creditors, or some of them. In this case, they should clearly
be able to vote, and perhaps even to vote as a class and thus exercise
a veto. Or their security may be hard to value, so that nobody can be
sure whether it will prove enough to payoff their whole debt or
whether they will be left with a part that is effectively unsecured. In
this case, they will have an interest in the scheme as a potentially
unsecured creditor. They may then be concerned about any aspect of
the scheme which threatens the value of their security, or their
flexibility in dealing with it, however slightly.
Similarly with subordinated debt. In a liquidation, which the
scheme is designed to avoid, the subordinated lenders will normally
get nothing or very little. If they are allowed a class vote and effective
veto, they may use it to extort more than they are entitled to by
threatening to veto the scheme. On the other hand to refuse them a
vote in all cases may mean that they are unfairly treated in those cases
where they could expect to recover much of their debt in liquidation.
The treatment of shareholders is equally delicate. Their shares are
almost certainly worthless at the time the scheme is being negotiated;

any value they may have in the future will be as a result of the
creditors' cooperation. The creditors therefore often feel that part of
their reward should be a large share of the equity of the reorganised
company (or at least they do in some countries; other countries seem
to put much less weight on the point).
If the shareholders can vote as a class, they may take an unrealistic
view of the present value of the shares; while if they cannot, they may
again be badly treated in those few cases where their shares would
have some value in liquidation.
The solution to these points is probably multiple. First, the
administrator should have to recommend and the court approve any
scheme as equitable to all parties. Secondly the administrator should
prepare the scheme in accordance with principles as to priorities laid
down in the relevant law, but in consultation, even negotiation, with
the main groups. Only then can he be sure to take all interests into
account in preparing the scheme. In this way it is more likely to be as
well balanced as the conflicting interests permit. The worst way is to
have a scheme prepared solely by a management which either is itself
a large shareholder or which is trying to preserve its own position.
While it may be voted down, it often will not where the alternative is
an inefficient liquidation. Even if the process allows for changes in
the scheme it will be much harder to change an unsatisfactory scheme
into a sound one than to get a sound one in the first place.
The legislators should also allow for some variation in voting rights
according to the facts of each case. Secured creditors should be
allowed to vote, for instance, if the administrator certifies that any
one or more of them stands to lose money. If only one or two secured
creditors stand to lose, he should value their collateral on a
conservative basis, and they should have votes for the uncovered
balance as unsecured creditors. If secured creditors as a class are
uncovered, or if the scheme impairs the value of their collateral or
their freedom to realise it in any serious way, then they should vote
as a class. A similar approach should be applied to other actual or
potential classes of creditors; except that for subordinated creditors
or shareholders the criteria should be that they can vote if their asset
would have value in liquidation.
Finally, the law must balance speed of liquidation against the
chance of a higher recovery over a longer time. Higher interest rates
and inflation than when most insolvency laws were written may make
speed more attractive than it once was. On the other hand, time to
complete work in process, refurbish a building, sell a subsidiary as a

going concern, avoid extra claims by working through a profitable
service contract or other items may enhance the value for creditors
more than any lost interest or inflation can reduce its value. And in
many cases the web of claims and counterclaims between parent,
subsidiaries, joint ventures, etc. may take so long to sort out that the
benefit of cashing in assets quickly is largely lost.
Nevertheless, small creditors in particular suffer from the long
delays in liquidation. The laws should probably put more emphasis
on speed, and in particular speed of partial payout, than most seem
to do.
There could be a threefold process; something like it already
happens in many liquidations, but it might be better to lay down
more formal requirements. This would give a liquidator the
necessary sanction for doing early what some of them are reluctant to
do, particularly where there are disputed claims.
First, the law should require the liquidator to cash in as quickly as
possible all assets where to do so neither reduces their value nor that
of other assets; the rule should be: 'when in doubt, cash it in'.
Secondly, claims (other than preferential claims) should be divided
into three categories. Those which are agreed in full; those where it
is agreed that there is a valid claim, but the amount is in dispute; and
those where the validity of the claim itself is disputed. The middle
category should then be further split; the maximum agreed claim
should be put into the first category and the disputed amount in the
third. And thirdly the liquidator should satisfy the court that all the
assets he has excluded from immediate realisation genuinely need
the extra time; he should provide a tentative timetable for their
recovery. He cannot in practice be held to this timetable, since there
are too many unknowns and factors outside his control; but at least
he should periodically have to explain divergences from it.
As soon as cash (after payment of preferential creditors) equals,
say, 5 per cent of total potential claims, the liquidator should be
required to pay a first dividend and a second, etc. as a new 5 per cent
becomes available. Creditors in the first category should receive their
payment in cash; maximum amounts due to the disputed claims
should go into a suspense account. As claims are agreed or rejected,
the funds should either be paid to the successful claimants or
released in to the pool for the next dividend. Interest earned on the
suspense account should be payable only to holders of unpaid but
agreed claims, to give an extra incentive to the disputatious to settle.
This process probably describes the best practice among English

liquidators, except that they will often pay only a rather larger, and
later, first dividend. But they are not obliged to pay anything early,
and where there are large disputed claims it may take a certain
amount of courage to do so. The balance in most countries needs to
shift somewhat towards putting more emphasis on speed and less on
certainty.
Part IV
Supervision
7 The Most Important Job
RECOGNISING THE IMPORTANCE
This book has been mainly about approaches to analysis and how to
present the results in writing. There will always be the occasional
natural talent who can reach a high standard quickly with little help
or supervision. However the majority will need help, sometimes to
reach a high standard at all, at others merely to reach it as quickly as
possible. The written work is primarily a tool to assist the prompt
making of sound decisions. It also enables the banker to show how
well he or she understands the credit of the borrower and the
supervisor to see whether (and in what area) the banker needs help.
Supervisors should therefore use credit proposal memoranda as an
effective supervisory tool, even though editing them and teaching
from them may seem to take up time that they can iII spare. Several
factors may make some supervisors reluctant to spend as much effort
as they ought to on supervision.
This section therefore first briefly discusses why it is important for
supervisors to spend time and effort on editing and improving credit
proposal memoranda. To do this it has to look at the excuses
sometimes put forward for not giving this a high priority. (Few
supervisors will argue that they should not edit at all; they will rather
come up with a series of reasons why perhaps they do not need a
memo, or that the editing discourages the banker or that as long as
the banker understands the credit it does not matter if he cannot
write it up very well.) These excuses were perhaps best summed up in
one sentence by a senior banker responding to criticism of the quality
of the credit memoranda written by his juniors: 'However, given the
level of experience of the account officer, our familiarity with the
credit, our confidence in the credit decision, and also given our profit
targets as budgeted and the time constraints under which we work,
we believe that the quality of the memorandum comes at best second
after the quality of the credit decision.'
In response, the credit officer concerned first quoted the remarks
by Deryk Vander Weyer, already quoted in Chapter 2, on the
importance of written analysis. Clearly the abilities he cites do not
spring into being ready made at the onset of a crisis; they have to
develop over time and it is an important part of a supervisor's
function to see that they do.
125
126 Supervision
Bad Tools - Good Results?
To be more specific about credit proposal memoranda, unless they

cover the key points of the credit the bank cannot be sure of making
the best decision. This may seem to matter less in a small office where
the decisions are taken by people who are familiar with the major
names and can discuss any questions face to face with the proposing
banker. Even here, however, there are residual risks of missing key
points and particularly of overlooking recent developments. Moreov-
er, to approve a credit because a senior understands it even though
his junior does not misses the chance of helping the junior. Even
more important, the bank will rely on the junior to follow the
borrower on a continuing basis. But if he does not understand the
credit in the first place he is less likely to spot expanding weaknesses
early. So that even if the initial decision is sound, the follow up may
not be.
In most banks, major decisions are made by senior and busy
executives in regional or global headquarters. They are often not
familiar in detail with more than a small percentage of the companies
whose credit they approve. They therefore have to rely quite heavily
on the quality of the memoranda used to present the proposal. An
experienced lender may recognise that there are weaknesses in the
memo. He may then refuse to lend, in which case the risk is of losing
good business more than of making bad loans, though both will
happen to some extent. Even where the senior does not turn the
proposal down flat, a bad memo may cause him to lack confidence in
both the writer and his subject matter. He may therefore impose
harsher conditions than the quality of the credit justifies, and again
lose good business, or at least upset a good client for a poor reason.
Or he may be able to come to the right decision by spending time
talking to the writer or others to confirm his feeling that the memo
does not do the credit justice. Unless this takes so long that the client
goes elsewhere in a huff, the bank has not lost the business, but it has
taken up senior time doing work which a junior should have done. A
bank that does this at all frequently is not getting value out of its
senior people; few banks can afford to let that happen for long.
Bad Memo - Good Understanding?
It is not clear that it is possible for someone who knows the credit well
to be unable to write down the key points (excluding people with
The Most Important Job 127
dyslexia and similar complaints). It is quite possible to know about

some aspects of the business - who buys its widgets, what they use
them for, how they compare with other people's widgets, what
currencies it sells in, etc. In conversation this can sound as if the
banker is really on top of his credit, and in a sense he is; but
knowledge is useful only as a means to understanding. It is harder to
conceal lack of understanding in writing than it is orally; but if a
banker never writes a clear memo, it may be much harder to pick up
the cases when he does not understand from those where he merely
cannot write. It ought to be possible to express true understanding;
not necessarily in stylish English, but at least with clarity.
Low Value to Other Readers
Apart from those involved in the decision, there are many other
people who use the memo. These include whatever internal mechan-
isms each bank has for credit review. It may be a loan audit,
inspectors, a credit committee or an individual credit officer. Without
a clear and well-thought-out memo, their job is much harder. They
can give less support in maintaining the quality of the portfolio. This
is equally true for external auditors and, for those subject to them,
bank examiners. The value of their work will be less or the cost more
(or both), if the memos in file tell them little about the quality of the
credit.
Colleagues also need to be able to discover the key points about
the credit to deal with urgent requests when the banker is away. And
a new banker on the account needs to be able to pick up the key
points quickly.
For all of these reasons, supervisors need to give high priority to
the supervision and editing of credit memos. Despite this, many
supervisors feel too hard pressed to find the time. They should
recognise that supervision here is an investment; it may take up time
in the early stages, but in the medium to longer run it will save time.
A banker who does not know what he is doing will take longer to
write the memo; it will often be longer and harder to read than it
needs to be. If the understanding of the credit is poor, it will take
longer to reach the decision, quite apart from the risk of making the
wrong one. Spending some time at the beginning helping a banker to
understand the credit and present it clearly and briefly is thus a good
way of saving time in the long run.
Some supervisors find it hard to appear critical and feel it
128 Supervision
undermines the banker's confidence. Obviously, poorly-presented

criticism can have this effect, but constructive criticism is highly
positive. If nobody tells a banker (or anyone else for that matter)
what he is doing wrong and how to do it better, it is much harder to
correct the weakness.
Finally some supervisors lack confidence in their ability to teach,
the 'I can do it but I cannot describe it' syndrome.
The rest of this chapter therefore aims to describe some of the signs
that a banker has not understood the credit, or that a poor memo is
due to other problems, and the specific reasons behind the various
difficulties; and to suggest ways in which the supervisor can help such
bankers, and in the process do his own job better.
WHAT TO LOOK FOR
The most important aspect of supervision is to be sure that the writer

has in fact understood the credit. This may be easier for a supervisor
who does not know the particular credit. If, after reading the memo,
he still does not understand it, then clearly the memo is weak. The
most probable explanation is that the banker does not understand it
either. A weak memo which nevertheless leaves the supervisor
feeling he can make a decision is more likely to suffer from some of
the other difficulties described later than a pure lack of understand-
ing. However, where the supervisor knows the credit well, he is
relying less on the memo for understanding and may not notice its
failure.
In this situation, the supervisor has to look even more closely for
pointers that the banker has difficulty, although all supervisors should
look for them. To help identify the weaknesses it may be helpful to
break down the various causes, and the signposts which point to
them. There is of course some overlap and oversimplification, but the
process should be useful nevertheless. The list below is not
exhaustive but covers the major items and illustrates the approach.
Writer Lacks Confidence in the Recommendation
The main pointer here is an almost entirely factual memo, with no

indication of the writer's interpretation of the facts and no specific
conclusions. Sometimes this is just poor presentation. More often it
means that the writer either:
- Does not agree with the recommendation but feels under some
pressure to make it; or
- Has not been able to justify the decision on credit grounds, but
recommends it anyway for marketing or other reasons; or
- Does not know enough to come to any decision; or
- Has reached a conclusion but lacks the confidence (or sense of
responsibility) to put it forward strongly.
Writer Does not Understand Business
Some moderately competent bankers can be thrown out of their

stride if presented with a company in a line of business they do not
know. They may either say nothing at all about what the company
does or the implications of the business for the credit; or they may,
again, provide purely factual information: lists of products or brand
names, plant locations, etc., but with no interpretation or link with
their view of the other aspects. A more sophisticated - and in some
ways more worrying - reaction to a new industry is to speculate
without any real foundation in knowledge or understanding. Some-
times this is done without any reference to the facts; sometimes it can
cite in support facts which a close look will show are irrelevant to the
argument, occasionally even contradict it.
Poor Understanding of the Financial Tools
Some bankers either have a weak overall understanding of financial

concepts and ratios, or have difficulty with one or two particular
ones. This can apply even to people who have quite a good
instinctive feel for other aspects of credit. The signs are reference to
a particular ratio or other concept in a way which is either clearly
wrong, or which seems distorted to fit the argument. (This can also
be a sign of loss of objectivity, discussed below.) For instance, some
bankers will write in a way which suggests they think capital intensity
justifies high leverage, rather than requiring low. Or they may put
forward vague arguments that the ratio is 'acceptable by x standard'.
x may be the borrower's nationality or industry. The latter may be
supported by a detailed industry comparison which on a closer look
tells nothing about whether the ratio is important to the particular
industry, or what level is required for a strong company. It is by no
means unknown for an entire industry to be weak, after all; but even
if this is not the case, for one company to have a stronger ratio than
130 Supervision
others helps the analysis only if the writer knows why the ratio is
important and what its strength implies. Thus a comment which puts
forward a set of ratios and then says they are the best in the industry
suggests the banker does not know whether the company is sound; if
the ratios themselves seem to be weak or irrelevant this strengthens
the chance that the banker is out of his depth and needs help. (There
is of course some overlap between this and the previous point. It is
rarely easy to be sure whether the banker does not know how to use
the tools of his trade, or does not understand the particular industry.
Quite often he will have trouble with both.)
Inability to Organise
There are broadly three reasons why a memo may be badly

organised. The writer may not understand the credit, in which case
other aspects of the memo will demonstrate this. Or the writer may
be one of those people who, while often very intelligent, simply
cannot cope with an organised approach. If anyone can help them it
is unlikely to be a banker. But the third reason is that bankers have
not been taught to organise their thoughts, and here a supervisor can
help.
Some disorganised memos simply have no shape; the writer has no
clear idea of what it is he is trying to present, and this shows in the
way he presents it. Most memos are a little better than this; the shape
may not be very clear but there is a shape of sorts. Nevertheless in
some each section covers a series of unrelated points, so that the
apparent shape turns out to be unreal. Others refer to related points
in different parts of the memo, without explaining the connection or
even seeming, in most cases, to recognise it. Still others use section
headings that have no relation either to each other, or to the subject
matter covered in the section.
Less serious signs of poor organisation include a tendency to mix
information and comments on several factors without showing which
the writer considers important, or how he thinks they relate to each
other. An early pointer to this may be seen in the Summary and
Conclusion or similar section, if there is one. The lack of one makes
good organisation harder to achieve, although in banks where there
is no custom of one it clearly does not preclude it on some different
basis. Nor does a good Summary guarantee that the rest of the memo
is well organised; it just makes it more likely. A poorly-organised
Summary on the other hand almost guarantees that the rest of the
memo will be poorly organised as well. The signs are the lack of any
substance in the Summary; or so much detail that it fails in its main
function of highlighting key points; or so much stress on the plus
points that it reads more like a selling document than a balanced
appraisal.
Failure to Recognise the Relevant
There are two sides to recognising the relevant; one is knowing what
to put in, the other what to leave out. Where a memo has failed to
address the key points at all, there must be doubt as to how well the
writer understands the credit; more subtle and harder to spot is
where he has hit most of the points but missed one or two; if these
are unfavourable to his case, they may come under the next
subsection. The undigested mass of facts which suggests poor
organisation can also mean that the writer cannot pinpoint in his own
mind which facts are important to the case, and thus relevant, or
why. Possibly he has some ideas on which are relevant, but lacks the
courage to separate them and leave out the less relevant.
Lack of Objectivity, Leading to Loss of Credibility
Credit proposal memoranda should never read like selling docu-

ments, stressing only the positive points and ignoring or glossing over
the risks and weaknesses. If a supervisor sees this, the writer needs
help urgently. It takes only a few of these to lose all credibility; once
lost, it is hard to recover.
Almost as bad, and sometimes harder to spot, is the misuse or
selective use of facts, or statements of opinion which are not
supported by facts; or where the facts quoted in support do not tally
with the opinion stated. References to 'leverage good at 3.5:1' or
'satisfactory liquidity with a current ratio of 1.2' may be perfectly
sound in the right context, or if properly explained. But for a
medium or light manufacturing company, they are on the surface
poor ratios. A writer who fails to recognise this may be ignorant or
may be reluctant to admit that the borrower has some weaknesses
which require explanation. If he fails to recognise the weakness from
ignorance, this is more a failure to use the tools than a cover up. The
cover up, even where it is unconscious, requires urgent action by the
supervisor. If, as is usually the case, the cover up is genuinely
unconscious, he must teach the writer to be more objective. Failure
132 Supervision
leaves the bank with doubts about the writer's integrity; such doubts
are fatal to a banking career. Even where the ratios fit better than
seems likely at first glance, the writer should still explain why; if he
does not know why, the doubts remain.
Another example is the tendency to quote for each year the figures
which look good in that year. A memo which refers to net before tax
in 1985 and operating profit in 1986, without mentioning the off-year
ratio at all is immediately suspect. So is a reference to 'satisfactory
profitability' when the company made a loss in the previous year and
showed a profit only by taking extraordinary profits above the line in
the current one. With more subtle versions it may even not be
possible to tell from just the memo that these imbalances exist.
Tables can distort the picture in two ways, valuable though they
are when properly used. First there is a temptation to use averages,
but these can be misleading. For instance, it may be perfectly true to
say that the profit in 1986 was above the average for 1981-5. But this
can hide a number of different patterns; if the profits were growing
steadily in the period the favourable implication is probably true,
though averages are rarely the best way to illustrate the trend. But if
the pattern is J-shaped with 1981 being easily the best year in the
sequence and 1986 well below it and only marginally above 1985, the
comment is still true but the implication is misleading. There are
other patterns which also mislead to a greater or lesser extent.
Tables can also be misleading when they are quoted in support of
an argument without due care. The table may not support the
argument at all; It may either be neutral or actually contradict it. It is
easy to be so confident of a conclusion that we fail to notice the
discrepancy - easy but undesirable.
One point that needs to be made is that bankers rarely deliberately
set out to mislead. More often they believe the recommendation is
right, but more out of a general sense of optimism than specific
understanding; or because the bank already has £50 million outstand-
ing, which senior people approved, so it must be sound for another £5
million or £10 million; or because we are talking about a renewal of
an existing facility 'and nothing seems to have changed for the worse
even though I do not exactly understand the basis on which we
approved it then'; or because the relationship is very profitable.
The other general point is that the biggest give-away that
something is wrong is the memo that is either all facts with no opinion
based on them, or all opinion with no facts to support it. A sound
credit memo uses facts to develop ideas and conclusions about the
credit, and presents both the ideas and the facts on which they are
based in a coherent way which demonstrates how each supports or
arises from the other.
HOW TO HELP THE WEAK BANKER
Strategy
The most important question in deciding how to handle poor memo

writing is whether to insist on having memos rewritten. Do we
continue until they are wholly acceptable or pass a second or third
draft that is still not perfect, but shows real improvement? Secondly,
quite apart from rewriting, how far do we push the teaching/
criticising in each case? At what level does it become counter-
productive to insist on a further detailed discussion or rewrite?
In developing a strategy to deal with these questions, the
supervisor needs to distinguish between three levels of weakness,
which call for different responses. The first is where the bank cannot
justify a credit decision on the basis of the memo and subsequent
discussions. Here there is no choice but to learn about the credit as
fast as possible to take the decision; the supervisor must use the
memo writer in the process but initially the priority is not training but
making the correct decision. Moreover, the decision maker may not
be the immediate supervisor, but a senior official in another office; in
that case, he must remember to pass on to the immediate supervisor
the need to help the banker.
At the second level, the supervisor is clear as to the decision. This
may be because of prior knowledge of the borrower, or the memo
may at least enable an experienced lender to analyse it and come up
with a sound decision. But the supervisor feels that the writer has not
readily understood the credit and needs help to do so. And at the
third level the supervisor is satisfied that the writer understands the
credit, but the memo is clumsy, difficult to read and suggests that the
writer is taking longer than necessary to obtain a poor result.
Against this background, the need to rewrite should be kept to a
minimum for the struggling banker. Even a minimum for him will be
several drafts as he improves from the completely hopeless to the
barely passable. To make him do further drafts, or spend further time
going over the details that he has only partly absorbed in the first
sessions will become counter-productive. There is a limit to how
134 Supervision
much anybody can learn from one case; once that limit has been
reached further hammering only undermines confidence. We can
hope only that the banker has assimilated enough to understand the
next one better.
In the second level, it is enough to satisfy ourselves that the banker
either did or now does fully understand the credit; if in fact it was
poor writing rather than lack of understanding at least one rewrite
may be necessary just to make sure he has the point. But where a
writer is learning fast and well on top of the job, rewrites or endless
discussion of the minutiae soon lose their effect. At the third level,
because it is a writing problem rather than a wholly inadequate
memo, it may be enough to ensure that the point is taken for the next
memo.
Apart from the level of understanding it is always right to assess the
level of rewrites for a struggling banker, even a stronger one who
should understand the credit, in the light of how much more he can
learn without losing confidence; where a strong banker writes a
memo beneath his capabilities, on the other hand, there may be a
case for a rewrite as a reminder to keep the mind on the job.
Tactics
There are some dos and don'ts of how to apply the strategy:
- Make sure that the points you spend time on are the important
ones. In other words, do your own homework and thinking
before trying to teach someone how to improve their work.
- A weak memo probably has more things wrong with it than the
junior can reasonably be expected to absorb in one go. To try to
cover all of them risks failing to get through on any of them. In
those cases pick a few items you really want to correct; you can
always go after the lesser points when the next memo shows he
has got the key ones right.
- Do not confuse your own style and idiosyncracies with
substance. Every supervisor has his own style; and every credit
man has his favourite ratios or other benchmarks. Do not
impose them on others. The aim is not to produce myriad
bankers all writing and thinking alike; it is to help people
understand the essence of credit and then express it in a way
which makes sense to them. Do not say 'this is the way to do it'
when you mean only that this is how you like to do it. Moreover
if you are free to impose your style, so are other people; the last
thing any bank should want is a whole series of rewrites because
supervisor A insists on one approach which supervisor B
abominates, and the poor banker whose work they both review
is shuttled back and forth.
It is hard to tell people how to improve their work without at
least an implied criticism. Be sensitive to that and make the
comments constructive so that the critical aspect becomes less
important to the recipient than the value of the comment. A
comment such as 'Lousy memo; do it again' undermines
confidences without telling the writer how or why his memo is
lousy and what he ought to do about it. Even 'This memo
rambles and misses most of the key points' does not help very
much. On the other hand, a specific example of the areas in
which it rambles and brief discussion of the key points is helpful.
Do not carry sensitivity to seeming critical so far that you do
nothing. Most bankers welcome comments on a memo which
shows that you have read it carefully and are trying to help
them. Some know they are struggling and almost beg for help, if
you give it in the right spirit; those who do not know they are off
course may never find out if nobody tells them. There are of
course a few people who will resist even constructive criticism;
this says more about them than about the validity of the
criticism or its value.
Do not accept too easily that a badly-written memo reflects only
poor writing. Sometimes that will be true, but often failure to
understand makes the writing worse. And when a normally
competent writer turns in a badly written piece of work the
answer is very often that he has failed to get hold of the key
points.
Prevention Better than Cure
One way to reduce the time spent on editing and improving poor
memos is to help people writer better ones before they start:
- Always spend some time with new bankers making sure they
know what you require in a credit memo. If there are any
internal guidelines on the subject make sure they read these
before they write their first memo, and have them available for
reference at all times.
136 Supervision
- Focus on bankers who seem to have difficulty wrItmg and

consider how they can improve their first draft. For instance, it
may help a poor writer if you suggest that before he starts the
first draft he should jot down some notes, perhaps an outline
summary, and discuss them with you. This will help you to see
whether he really has understood the credit, or whether the
weakness is more than just writing. In the former case, the
effort of jotting down the notes will force the banker to do some
organised thinking before he writes; often this will go more than
half way to solving the problem. You can then discuss how to
organise the memo around the points in the notes, and this
again should make the organisation much easier.
- One of the best ways of learning to recognise weaknesses in
one's own work is to read and comment on other people's. A
supervisor in charge of a small group should consider having the
members read and comment on each other's memos, perhaps
before he sees them, or perhaps sometimes more publicly as an
exercise. The best test and trainer might be to have A make an
oral presentation of a credit he does not know, based only on
B's written presentation. Both should then be able to see more
clearly what such a memo needs, and why.
SUMMARY AND CONCLUSION
Good supervision, like good credit work, involves the investment of

time and thought now to save time and eradicate weaknesses later.
When it is well done, the supervisor benefits as well as the
supervisee, perhaps even more so. When it is done badly - or not
done at all - everybody suffers, and so does the bank.
Glossary
Administrator. Official appointed to a company in difficulties to
enable it to try to recover under protection of the insolvency law.
Used to indicate officials in all countries who perform a similar
function, whatever the formal name in their own country.
Amortisation. The payment of medium-term debt in instalments.
Analysis. See under 'Going concern analysis' and 'Liquidation
analysis' .
Capital Adequacy (Ratio). The measure of whether a bank has
enough capital to protect it against the risk of loss. Currently a
subject of discussion and innovation by regulators.
Captive Sales Company. A company the sole or major purpose of
which is to sell the products of its parent.
Cherry Pick(ing). The ability of a liquidator or similar official to
choose to adopt or reject contracts. The fear is that the banks are
held to the contracts which cost them money, and the liquidator
cancels those where the bankers would otherwise make an offsetting
profit.
Commercial Paper. Promissory notes issued by companies to
investors to raise short-term debt, from a wider range of sources, and
more cheaply, than by borrowing from the banks. Originated in the
United States, spread to the euromarkets (eurocommercial paper or
ECP), and is now establishing itself in a number of domestic markets.
Details vary from market to market, but the underlying concept is the
same in all.
Commitment Fee. The amount payable on the unused portion of a
committed facility.
Corporate Veil. The feature of company law in most countries that
separates the assets and liabilities of one company from those of
other companies, even where the ownership and management are the
same.
Counterparty(ies). The other party(ies) to a transaction which
involves credit risk but is not a loan. Examples include swaps,
forward exchange deals, and settlement of security or other
transactions.
Covenant. An undertaking by a company in a loan agreement that it
will abide by certain standards; failure to do so is normally an event
of default, giving the bank the right but not the obligation to declare
137
138 Glossary
the loan due and payable immediately. See also under financial
covenants and ratio covenants.
Credit Risk. The risk of loss due to insolvency, or financial
weakness threatening insolvency, of the borrower; or to the
borrower's dishonest ability to avoid paying what is due.
Current Ratio. The ratio of current assets to current liabilities,
often used as a measure of liquidity.
Exposure. The maximum amount a bank can lose on a particular
facility, on the worst possible assumptions. Put another way, the
maximum amount of the asset which could appear on the bank's
balance sheet if the facility were fully drawn. The concept involves no
judgement as to how likely the worst is to happen.
FIFO (First In, First Out). A method of valuing inventory. It
assumes that raw materials, components, etc., are used in the order
purchased. Thus, the costs used in calculating profit are for the oldest
inventory in stock, while the balance sheet values use the most
recent. FIFO thus tends to overstate both profits and balance-sheet
values in times of rapid inflation.
Financial Covenants. Covenants relating to specific financial
aspects. They include ratio covenants (see below), but also things
such as dividend restrictions or minimum net worth.
Forward Rate Agreement. An agreement to payor receive the
difference between an assumed future interest rate and the actual rate,
when known. For instance, with a three-months' deal three months
forward at 10 per cent, where the actual three-month rate quoted on
the agreed date was above 10 per cent, Bank A would pay Bank B the
difference; where the rate was below 10 per cent Bank B would pay
Bank A. Only the rate differential would change hands; there would
be no exchange of principal, only a notional principal amount on
which to calculate the amounts due. The agreement allows one bank
to fix its earnings on a deposit, and the other to fix its cost of
borrowing.
Gearing. See Leverage.
Going Concern Analysis. The analysis of a company's credit on the
assumption that it will continue to operate, and will pay its debts in
the normal course of business, rather than by realising its assets and
going out of business. Therefore concentrates substantially on ability
to generate cash from operations to service debt.
Historic Cost/Replacement Cost Accounting. Two approaches to
accounting. The first relates all asset values to their original money
cost, regardless of the impact of inflation on their subsequent value.
Glossary 139
Replacement cost tries to take account of inflation by valuing assets

at what it would cost to replace them at current prices.
Interest Cover. The extent to which earnings before tax and interest
but after all other normal expenses (NBIT) exceed interest. The ratio
is normally expressed as a multiple, hence the expression sometimes
used 'times interest covered'.
Keepwell. A form of undertaking, short of a guarantee, by a parent
company to reassure a bank that it will not lose money by doing
business with a subsidiary. The exact nature, and the bank's chances
of enforcing it in case of need, vary widely.
Leverage. The extent to which a company finances itself with debt
rather than equity. Relevant ratios include TLlNW, TBF/NW and
TBF/Sales.
LIFO (Last In, First Out). An alternative to FIFO. It assumes that
the most recently purchased raw materials, etc., are used first. Costs
used in calculating profits are therefore the most recent, and those
used for valuing inventory on the balance sheet the oldest.
Liquidation Analysis. The analysis of a company's credit by
assessing the value of its assets on a forced-sale basis. Also sometimes
known as 'gone concern analysis'.
Liquidity. A company's ability to meet its short-term liabilities as
they come due. Ratios such as the current and quick ratios, as well as
turnover rates, indicate the liquidity of each company. Alternatively,
an indicator of the depth and consistency in a particular market or
security. Liquidity is important to investors and traders, both of
whom wish to be sure they can sell quickly without moving the
market price against themselves.
Margin. Either the percentage of sales for a particular level of
profit - thus operating margin is the percentage of sales represented
by operating profit, gross margin by gross profit, etc. Or the amount
of interest above the actual or notional cost of money a bank charges
on loans; thus a cost to the borrower of 0.5 per cent over LIBOR
gives the bank a margin of 0.5 per cent.
Market Risk. The risk of loss when a transaction fails to settle when
due, and the price moves against the non-defaulting party before he
can cover the position opened up by the failure.
NAT (Net After Tax). Net profit after tax and all ordinary expenses,
but usually before any extraordinary expenses; in some countries
these are charged direct to reserves but in others they are charged to
the profit and loss account but recognised as being outside the
ordinary business of the company.
140 Glossary
NBIT (Net Before Interest and Tax). Net profit after charging all
ordinary expenses except interest and taxes. A useful general
measure of ability to generate profits from operations, before
allowing for the impact of the financial structure. Also a vital tool in
measuring interest cover.
Net Working Investment. The difference between a company's
assets arising directly from its volume of business, which need
financing, and its liabilities arising also from the volume of business,
which provide finance. NWI is thus a measure of the net financing
needs directly related to the volume of business. In its simplest form
it is the sum of receivables and inventory less trade payables, which
provide automatic finance for the inventory purchased; in more
complex cases, it can allow for things such as advance payments, or
other items which relate directly to the business being done.
Operating Risk. The risk of loss due to an operating error. This can
cause, or aggravate, a credit risk: or it can generate a risk of loss for
non-credit reasons.
Project Finance or Risk. The finance of a specific project where the
project itself is the sole or main source of repayment. In pure project
finance there may be an initial equity contribution to the project, but
apart from that the owning company(ies) need contribute nothing; if
the project fails the banks lose money. Other forms of project loan
provide limited or partial recourse to the owners, but the project is
still the expected source of repayment, and if it fails puts the bank at
serious risk.
Ratio Covenants. Covenants under which a company undertakes to
meet certain financial ratios throughout the life of a facility. Most
commonly used are current ratio, leverage ratios and coverage of
interest or cash flow, but there are many other possibilities.
Ratios. A shorthand for various aspects of financial strength, under
the subheadings balance sheet, operations and combined. Balance
sheet ratios measure leverage and liquidity (total liabilities to net
worth or TL/NW; total borrowed funds to net worth or TBF/NW;
current ratio, or current assets divided by current liabilities; and the
turnover ratios). Operating ratios measure various levels of cost and
profit as a percentage of sales, plus interest cover. Combined ratios
relate aspects of the balance sheet to operations, or vice-versa.
Examples include the various return ratios; return on assets (ROA),
on liabilities (ROL), on equity (ROE), cash flow coverage (operat-
ing cash flow (OCF) to TL, TBF, medium-term debt, etc. and TBFI
Sales.
Glossary 141
Securitisation. The process whereby forms of finance which were

once provided by bank loans are now available by the issue of
various types of security. Prime examples are floating-rate notes,
commercial paper and notes issued under NIFs, MOFs, RUFs, etc.
Self-liquidating. The finance of a transaction the completion of
which generates the funds to repay the finance.
Spread. Either the comparative sheet on which banks set out
consecutive years' financial statements for analysis; or the margin
over cost of money - see Margin.
Swap. An agreement between two parties to exchange payments in
differing forms over a period of time. For instance, in an interest rate
swap one party normally agrees to a fixed annual payment, or fixed
rate payment, in return for a floating rate payment. The floating rate
may be a margin over or under LIBOR, or some other recognised
benchmark. Both rates will be calculated in relation to the same
notional capital sum, though no such sum will change hands. A
currency swap involves the exchange of capital sums in different
currencies, and payments of interest on them throughout a period
followed by the reexchange of the capital at maturity.
Synthetic Asset. An asset the nature of which has been transformed
through the swap market. For instance, the holder of a fixed-rate
bond might enter into a swap under which he received floating-rate
interest and paid fixed; by applying the fixed-rate payments received
on the bond to meet his obligation under the swap he puts himself
into the same position as if he had bought a floating-rate issue in the
first place; however, inefficiencies in the market may enable him to
achieve a better return through the swap. The same concept applies
where the holder of a fixed rate bond in one currency wishes to receive
interest, whether fixed or floating, in another currency.
Trading Risk. The risk of loss through misjudgement of move-
ments in interest rates, exchange rates, security prices or commodity
(including bullion) prices.
T/O (Turnover). A phrase applied to receivables, inventory and
payables. It measures the speed with which they are moved off the
balance sheet, either by payment (receivables and payables), or by
conversion into receivables (inventory).
Turnovers. The rate at which receivables, inventory and payables
move off the balance sheet. For receivables it is the average period
between issuance of the invoice and collection of the cash payment,
also known as the collection period or days sales outstanding. For
inventory it is the period between the purchase of raw materials or
142 Glossary
components - or expenditure to convert them into finished goods -

and the delivery of the finished goods and issuance of the invoice.
For pay abies it is the period between the receipt of the supplier's
invoice and its payment. In each case, the figure is the average for all
items in each category and is calculated by dividing the balance sheet
figure into the annual sales. (Purists will argue that inventory and
payables should be divided into cost of goods sold rather than sales,
but in Europe at least this figure is rarely available.) This gives the
number of times each year the item turns over, and thus the number
of days which the process takes.
Index
accelerate, 71 capital expenditure, 4, 76, 77
acceptance, 91, 92 capital intensive(ity), 3, 129
accounting, accounts, 2, 4, 18,45-7, captive sales, 60, 61, 63, 73, 74, 137
67,84 cash, 4, 43, 59-63, 75, 77, 115, 120;
administrator(ion), 110, 114-19, 137 charge, 67; outflow, 64
advertising, 21 cash flow, 1,2,3, 18-20,27,30,42,
America(n), 44, 46, 48, 50, 68, 90, 59,98-100, 102, 104-6;
92-4,97,107,110,117 analysis, 4, 102; coverage, 47,
amortise(ation), 11, 15, 16,88,97, 75; operating (OCF), 19,20,30,
102, 103, 137 43,75
Anglo-Saxon, 47, 49 central bank, 65, 94
auditors, 12, 18, 127 charge, see secured
averages, 29, 42,44, 45, 48,132 charterhire, 16
cherry pick, 86, 87, 137
background, see business and collateral, 11, 15, 16, 117-19
backstop, 93, 104 commercial paper, 93, 102, 137; euro
bad debts, 44, 107 (ECP),104
balance-sheet, 1-3, 18, 19,24,27, commitment fee, 16,92, 95, 137;
41,45-8,61-4,73,76,85,94, standby, 93-5
99 company doctor, 114
bank examiners, 12, 18, 127 comparison, 40, 41,43,44; industry,
Bank of England, 92, 94, 95 40-4
Banking World, 68 compensating balance, 93, 129
bankruptcy, see insolvency competition(ive), 3, 13,19,21,22,
base rate, 15, 16 40-2, 74, 77, 92, 93, 97, 107;
basis point, 93 and credit control, 92
Bell, Geoffrey, 9 concentration, 19,22
Bermudez, Jorge, 67 Continental Europe( ean), 47, 94
best endeavours, 56 corporate treasurer, 94; veil, 110,
bond, 53, 81, 83, 89-91, 102 137
brand loyalty, 19,21,26,41; name, cost(s), 3, 26, 40, 42, 45, 46, 52, 57,
19,21,129 62,67, 73-75,94,95, 105, 117;
break-even, 59, 73 control, 41; fixed, 21, 26, 62, 73,
brevity, brief, 32, 34, 35 76; labour, 27; raw material, 45;
Britain(ish), 44, 46, 48, 49, 53, 56, redundancy, 27,.62; selling,
68,90,94,97,107,110,112, general and administrative
114,117,121 (SG&A), 61, 62; structure, 22
bullet, 85 counterparty, 7, 81, 83,85-7,90,91,
bullion, 87, 88 137
business and background, 9, 12, 19, covenants, 11, 68-71, 93, 97, 103,
21-3,26,33 137
cover up, 131
capital cover, 94, 95; ratio, 94, 137; credit approval, 16; officer, 53, 127
structure, 99 credit (policy) committee, 11, 127
143
144 Index
creditors' committee, 116 going concern analysis (approach),

cross-default, 69 4,137
current assets, 62, 76, 105, 106; gone concern analysis (approach), 4
liabilities, 62; ratio, 30, 31, 43, goodwill, 56
75, 131, 137 government, 13, 22, 39, 50-3, 101,
cycle, cyclical, 24, 105, 106 107, 110, 116; risk, 50, 53, 64-7,
72,77
daily settlement line, 86 guarantor, guarantee, 16, 51-7, 63,
debenture, 53 65,71,81,84,85; performance,
default, 69, 83, 87,93; see also cross- 96
default
delivery against payment, 86 hedge, 64, 83, 87, 91
depreciation, 27, 47 historic cost, 47, 137
deregulation, 94
distribution, 19, 26, 30, 41 indefinite lending, see permanent
diversification, 19 lending
dividend, 74, 75, 95, 120, 121 information, 14, 16,23,41,42,44,
documentation( ary), 91, 102-4 73, 102, 129, 130
drawdown, 16 innovation, 3, 92
insolvency, 54, 56, 66, 101, 107-15,
earnings, 27, 30, 99; retained, 95 117-19; practitioners, 108, 109,
111, 114-16
easy money, 93
economy, economic(s), economical, insurance, 91-3, 96
39,52,61,64,77,96,107 interest cover, 27, 68, 75, 139
England, English, see under Britain inventory, 30, 43, 46, 59-63, 105,
Europe, 68, 97; East, 75 106; turnover (TO), 30, 31, 42,
exchange, 67; control, 53, 55, 56, 65; 62,74
risk, 60, 65, 66, 67 Italy(ian), 44-6
exposure, 16,73,83-6,88-92,94,137 Japan, 75
Journal of the Institute of Bankers, 13
Federal Reserve, 94
financial condition, strength, 19, 24, keepwell, 51, 53-8, 63,139
26,27,30,42,59,69,84; key factors, issues, points, 18,34,41,
controls, 42, 76; statements, 2, 42,57,125, 127, 131, 135
44,45,84; structures, 49
financial costs, 66, 67, 68 labour-intensive, intensity, 27
fixed assets, 59, 76 law(yer), 45, 56, 107, 108, 110, 112-
fixed cost, charge, see under costs 20
floating rate note (FRN), 99, 102, lending authority, 84
103 letter of credit, 81, 85; standby, 96
forecast(ing), 67 letter of comfort, awareness, see
foreign currency, 63-8 under keepwell
forward cover, 64, 65; rate, 88, 89, leverage(d), 19,20,27,30,31,39,
137; exchange, 82, 83, 86, 87 41-5,47,48,50,73-5,95,129,
fraud, 61 131, 139
French, 39, 44, 53, 73 LIBOR, 15, 16, 85, 92
fringe bank crisis, 14 LIFO, 47, 139
liquidation, 62, 63, 74, 87, 110,111,
German, 39, 44-8, 50, 53 116, 118-20; analysis, 4, 139
Index 145
liquidator, 54, 86, 91,110, 111, 114, objective(ity), 129, 131

115,117,120,121 obsolete, obsolescence, 19
liquid(ity), 21, 27, 30, 31,42-4,73, operating cost, profit, margin, 3, 16,
91,97, 131, 139 132; risk, 81, 82, 140
loan agreement, see documentation options, 87
loan audit, 127 original equipment manufacturers
loan loss ratio (OEM), 26
London, 92 overdraft, 15, 16,91,92, 106
long-term debt, facility, 46, 62, 84, overheads, 57
99, 100, 104, 106 ownership, 39, 40
Lyons, 22
parent, 53, 54, 56-8, 60-63, 71-7,
management, 2, 12, 13, 19, 20, 22, 120
27,41,54,64,67,69-71,76,77, Paris, 22
84,97,100,101,107-15,119; payables, 45, 61; intercompany, 62;
fees, 57, 74, 75; figures, 67 turnover(T/O), 31, 46
margin(s), 15, 16,20,24,26,27,41, pension funds, 46
42,46,61,62,74-6,92,93,117, permanent borrowing, 99-102;
139 lending, 97-100, 102-4
market, 45, 48, 49, 64, 65, 81, 86-9, personal computer, 42
91-5,97,98, 100-3; equity, 48, politics, political, 39, 52, 53, 60, 84,
100; place, 93; risk, 81-3,139; 107; risk, 55
share, 27, 41, 76 portfolio, 12, 127
marketability, see liquidity pre-insolvency, see insolvency
marketing, 3,26,41,59,129 presentation, 4, 7, 8, 11, 22, 28, 52,
Marseilles, 22 71, 73, 128, 136
material adverse change, 69 price, pricing, 22, 26,27, 55, 56, 74,
maturity, 11, 16,84,103,104 88, 92-4, 116; control, 66;
medium-term loan, facility, 16, 46, intercompany, 57; transfer, 73,
64,68,69,97,99,102,104,106 75; upfront, 93
mismatch, 83 prime rate, 16, 93
monitor(ing), 10,49,58,98, 102, 107 private sector, 65, 66, 72
Morgan Guaranty, 1 product liability, 60
mortgage, 15, 16 profit and loss, 1-3,24,45,47,59,
multinationals, 48 61-4
multiple option facility (MOF), 93 project loan, risk, 15, 140
projections, 69
net (profit) after tax(NAT), 19,20, purpose, see recommend(ation)
24,29,30,31,139
net(profit) before interest and quality, 3, 22, 26, 40, 74, 125, 127
tax(NBIT), 27, 140
net (profit) before tax(NBT), 13 ratio, 19, 24, 29, 30, 32, 39, 42-6,
net working investment, 27, 29, 30, 68-71,76,93, 129, 130, 132,
140 134, 135, 140
net worth(NW), 19,20,30,31,34, rationale, 17, 33, 73-5
39,45-7,61,62,74,75,99,113 receivables, 13, 21, 45, 59-64, 73,
New York, 56 74, 105, 106; turnover(TO),
note issuance facility(NIF), 92, 93, 30-2, 42, 62, 74
95 receiver, see administrator
146 Index
recommend(ation), 14, 15, 17, 34, state, see government

53, 105-7, 128, 129, 132 subordinated(ion), 117-19
regulation(or), 51, 95, 96 subsidiary, 53-7, 60, 61, 63, 71-4,
relationship, 8, 9, 14, 19,20,24,45, 76,77,116,117,119,120
57, 71, 75, 76, 84, 132 summary, 12, 17-20, 28, 33, 130,
relevance, relevant, 32, 33, 40, 44, 131, 136
73,77,131 supermarket, 43
reorganisation, see restructuring supervisor(ion), 3, 11, 12,53, 107,
rescue, 51, 59, 108, 109, 112, 113 125-36
research, 13, 40, 41; and suppliers, 43, 49
development (R&D), 21 support, 39, 40, 50-5, 60, 61, 63, 66,
reserves, 46-8 71-75
restructuring, 66, 108, 110, 111, Suspension de Pagos, 110
113-16 swap, 82, 85-7, 89-91, 141;
return, 40, 75, 77, 85, 92-6; on currency, 65, 83, 87, 88;
assets (ROA), 19,30,31,75,95 interest, 65, 83, 85-8
revolver, see revolving commitment Swiss, 66
revolving commitment, 91-3 synthetic assets, 90, 91, 141
revolving underwriting
facility(RUF), 92, 93 tables, 28-32, 34, 132
risklreward ratio, 8 tax, 53, 62, 76
royalties, 57, 74, 75 term loan, 15, 99
tight money, 64, 65, 94
sacrifice, 51 total borrowed funds(TBF), 30, 31,
sales, 3, 42, 45, 59, 61, 62, 73-5, 34, 39, 45, 46, 75
105; loan, 91; see also captive total Jiabilities(T/L), 19, 20, 30, 31,
Samuelson, Carl, 23 43, 45, 46, 75
Second World War, 88 Toulouse, 22
secured, security, 15, 16,81-2,84, Tours, 22
85,87,89, 108, 111, 116-19 Treasury, 83, 91
securitisation, 48, 93, 103, 141 trends, 23, 24, 26, 28, 32, 39
self-liquidating, 15, 61, 62, 84, 85,
104, 141 underwriting risk, 81
selling documents, 131 United Kingdom, see Britain
sensitivity analysis, 67 United States, see America(n)
servicing, 63 unsecured, 97, 117-19
settlement risk, 81, 86 upsies, downsies, 23, 24
SG&A, see cost(s)
shadow director, 112, 113 valuation, 47
shareholders, 48, 111, 114, 115, 118, Vander Weyer, Deryk, 13, 14, 125
119; suits, 54 volatility, 88, 89
short-term debt, loan, facility, 15, volume, 26, 27, 62, 73, 93
16,27,46,69,84,85,99,103-7
Spain, Spanish, 44, 53, 66, 110, 117 widget, 39, 59, 74, 75, 126
spread sheet, 28, 141 working capital, 3, 43, 62

Donaldson - Thinking About Credit

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Donaldson - Thinking About Credit

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THINKING ABOUT CREDIT

Also by T. H. Donaldson and published by Palgrave Macmillan

First published 1988

PART I PRESENTATION AND ORGANISATION

PART III THEORETICAL DIVERSIONS

THE FUNDAMENTALS OF CREDIT JUDGEMENT

Curiosity is vital in credit. It is rarely the obvious which costs a bank

credit standing is more complex. It depends on interrelationships

TO UNDERSTAND MAY BE EASIER THAN TO PRESENT

Some bankers find that their understanding is greater than their

PRESENTATION IS MORE THAN COSMETIC

There is a tendency among some bankers to dismiss time spent on

GOING CONCERN APPROACH

There are broadly speaking two approaches to analysing credits. The

THINKING ABOUT THE PROBLEM

To present a credit well we need to think about the various aspects of

transaction to the relationship? in other words what is the risk/

IF WE DO NOT UNDERSTAND, WE CANNOT PRESENT

that we do in fact understand what we are writing about; if we find

THINKING ABOUT THE READER

There is an argument that memos should be written in the same way

officials responsible for reviewing the portfolio or the quality of the

not. The same is true of a section describing the different divisions of

DOING OURSELVES JUSTICE

In writing credit memos, bankers often forget the extent to which

absorb clear, analytical and effective professional papers that deal

Although it is wrong to impose a precise format on memos, there are

To lend ABC company £5 million for five years, unsecured, at 0.5

To make available a £10 million unsecured overdraft at 1 per cent

With a more complex case, particularly if the proposal is for secured

Reviewing a complex relationship with many different facilities,

To review and where appropriate renew for a further year, short-

The details of the facilities can be given in an appendix; or they may

One other piece of information worth mentioning here is the

Summary and Conclusion/Reasons for Recommendation/Rationale

A good Summary gives the reader a clear view immediately of what

(a) I recommend the proposal because X is an acceptable credit.

(b) Because X has a strong balance sheet, highly profitable

(c) Because X has:

We recommend this facility because the company is profitable

There is a version of the second approach which is less desirable. This

Business and Background

different government agencies, with different economic and political

Other items which might appear in some Business and Back-

The company makes multi-phased laser controlled analytical

says nothing useful. On the other hand:

The company's gyroscopes account for a small part of the cost of

is genuinely useful in looking at the cost structure, the risks of loss of

The company has plants in Paris, Lyons, Marseilles, Tours and

Modern technology favours large, centrally located plants. Com-

USE TRENDS, NOT SNAPSHOTS

When a bank lends money it expects to be repaid in the future, not in

How to Present Trends

The discussion of trends may make the memo longer than it

Company X and the industry extended the 5 per cent growth in

cent in 1980). Overcapacity is only slowly being absorbed, and the

As recently as 1984, XYZ (along with the rest of the industry)

1981 1982 1983 1984 1985

THE USE OF TABLES IN CREDIT PRESENTATIONS

Tables can help to cure three common weaknesses in credit

Another common mistake is to include a table which merely

NAT % Sales Av.1982-5 1986

appears consistent with a text referring to improving profitability. But