7 Key Drivers Of Credit Risk In Commercial Loan Portfolios (2024)

Credit markets are volatile and regulations are ever evolving, challenging today’s professionals to effectively assess creditworthiness and limit losses. S&P Global Market Intelligence’s Credit Assessment Scorecards provide a framework to help navigate today’s climate and assess the probability of a default (PD). This is especially important for “low default” portfolios that lack extensive internal data necessary for the construction of statistical models that can be robustly calibrated and validated.

This paper focuses on our Scorecards for Global Banks, Project Finance, and Real Estate Developers. The sections that follow describe our methodology and the “7 key drivers of credit risk” for each of these asset classes. It concludes with a summary of important risk assessment recommended guidance you may want to consider.

S&P Global Market Intelligence provides more than 30 Scorecards:

• Including transparent Excel-based tools,
• Broad sector and global coverage, and
• Point-in-time and forward-looking qualitative factors, converging trends, and relationships between key drivers to derive a standalone PD score.
• Plus, scores are broadly aligned to S&P Global Ratings criteria, and further supported by historical default data back to 1981.

I. Global Bank Scorecard

A. Scorecard Methodology

This Scorecard covers deposit-taking institutions including commercial, investment, mortgage, and private banks.

Figure 1: Global Bank Analytic Framework

^{Source: Credit Assessment Scorecards: Global Bank Analytic Framework, S&P Global Market Intelligence, 22 March 2018}

Figure 1 illustrates how we leverage S&P Global Ratings Banking Industry and Country Risk Assessment (BICRA) methodology, which is pre-scored for 89 countries and includes most banking industries in Asia-Pacific. The BICRA is broken down between an Economic Risk Score and an Industry Risk Score. The Economic Score focuses on the resilience, imbalances, and overall credit risk of markets where the bank has operations. The Industry Risk Score centers on the institutional framework, competitive dynamics, and system-wide funding of the banking sector in which the bank is domiciled.

From here, the Scorecard considers four bank-specific risk factors: business position, capital and earnings, risk position, and funding and liquidity. These factors either positively or negatively differentiate a bank from its competitors within the markets in which it operates.

As an example of how this works, if the anchor score derived from BICRA is a ‘bb+’ and the four bank-specific factors are neutral, the stand-alone score remains ‘bb+’. If a bank has a weak business position, however, resulting in a score of -1 (meaning a one notch reduction) and the other risk factors are neutral, the standalone score is ‘bb’. To determine a final score, additional adjustments can be made for group and government, as well as loss-absorbing capacity for countries in which a bail-in resolution framework is in place.

B. 7 Key Drivers of Credit Risk for Commercial Banks

Scorecards from S&P Global Market Intelligence are designed to model the most relevant quantitative and qualitative drivers of underlying credit risk.

• BICRA. Scoring leverages this methodology to broadly align to S&P Global Ratings.
• Geographic and product diversification. These qualitative risk factors consider how revenues generated in different geographies impact a bank’s business position, and how reliant a bank may be on one particular type of product.
• Capitalization. Three capitalization ratios are used to assess the capital of a given bank.
• Profitability. Two profitability ratios supplement the above to help assess the earnings of a given bank and its ability to absorb losses.
• Industry and single-name concentration. Risk concentration is a primary reason for bank failures, so the concentration of exposures to individual debtors, counterparties, industries, or sectors is assessed.
• Risk appetite, complexity, and loss experience. This qualitative assessment aims to capture management’s tolerance to risk and willingness to accept more complexity in growing the business. Evidence of a stronger risk position is reflected in relatively lower recent and projected losses than seen for peers with a similar systemic and product mix, and a better-than-average track record of losses during periods of similar economic stress.
• Liquidity and financial flexibility. This qualitative risk factor assesses the bank’s liquidity and its ability to raise additional capital or funding relative to its potential needs. This incorporates a bank’s financing plans, as well as its flexibility to accomplish its financing program without damaging its creditworthiness, both under unstressed and stressed scenarios.

II. Project Finance Scorecard

A. Scorecard Methodology

This Scorecard applies to all project finance structures used for a range of global Greenfield (starting new) or Brownfield (based on an existing facility) assets. Sectors that commonly use project finance structures include:

• Transportation infrastructure (tolls roads, airports, and ports).
• Energy and water infrastructure (power generation, gas transmission, liquefied natural gas terminals, and water treatment plants).
• Integrated commodity-based projects (oil and gas and mining projects backed by reserves).
• Social projects (hospitals and schools).

The Project Finance Scorecard does not apply to corporate, structured, or public finance assessments.

Figure 2: Project Finance Analytic Framework

^{Source: Credit Assessment Scorecards: Project Finance Analytic Framework, S&P Global Market Intelligence, 22 March 2018}

Our risk assessment framework is designed to reflect the credit quality of a project during the weakest period over the remaining term of the financial obligation that is to be repaid through project cash flows. As such, the project’s credit risk score is defined by the weaker (or higher risk) of the two main components of the analysis, Construction Phase and Operations Phase, which each have a number of distinct risk categories.

In cases where the Construction Phase is the weaker link, once this is completed and related issues are resolved, we adjust the project risk score to reflect the Operations Phase risk level. In cases where the project has already completed construction, only an Operations Phase risk assessment applies.

B. 7 Key Drivers of Credit Risk for Project Finance

Scorecards from S&P Global Market Intelligence are designed to model the most relevant quantitative and qualitative drivers of underlying credit risk.

• Technology and design risk: In the Construction Phase, we assess whether a project will be built on time and within budget, and whether it will meet performance requirements during the Operating Phase. For example, we ask: Does the project use a proven design or a modified or first-of-a-kind design? Does the technology have a track record under the project operating conditions? Will the technology be able to meet contractual performance requirements?
• Construction risk: We assess the potential level of difficulty for construction and the experience of contractors involved in the delivery. We also look at the project’s management risks and the risk that the final construction cost may exceed the budget.
• Performance risk: We compare the expected performance of the technology against the actual project performance to determine if the project performs as designed under the range of expected conditions.
• Market risk: We consider the level of exposure of the project’s cash flows to market forces, such as price and volume variability.
• Financial risk: During the Construction Phase, the amount of financing available to fund a project is typically limited to a committed level, and we evaluate whether such funding is sufficient to complete a project, even if there is a cost overrun or delay. During the Operations Phase, the financial risk looks at forecasts of debt service coverage ratios, as well as debt structure, liquidity, and refinancing risk.
• Counterparty risk: If a portion of performance and market risk has been transferred to a counterparty through a contract, we need to consider counterparty dependency and implications for the project’s success. The role and risk exposure to key counterparties can vary over the project life.
• Transaction structure: The governance framework determines the scope of a project’s operations and type of business and financial risks that it can incur. Our analysis of transaction structure assesses the level of protections granted to debt lenders related to: the parent/sponsor, single-purpose status, and limitations on additional debt.

III. Real Estate Developers

A. Scorecard Methodology

This Scorecard is designed for use by entities that derive the majority of their revenues and earnings from the development and sale of newly constructed properties, including the sale of newly constructed, detached, single-family houses. It is not intended for real estate companies that derive a majority of EBITDA from property rental income, nor those real estate development or income producing real estate assets¹.

Figure 3: Real Estate Developers Analytic Framework

^{Source: Credit Assessment Scorecards: Real Estate Developers Analytic Framework, S&P Global Market Intelligence, 22 March 2018}

The analytical framework follows the corporate assessment criteria where the combination of business risk and financial risk determines the entity’s anchor score. The anchor score is then adjusted upwards or downwards based on credit risk modifiers that measure:

• Diversification/Portfolio effect of the company
• Capital structure
• Financial policy
• Liquidity
• Management and governance

Once the stand-alone credit profile of the entity is derived, it is possible to factor in any explicit external support that might come from a group or government.

B. 7 Key Drivers of Credit Risk for Real Estate Developers

Scorecards from S&P Global Market Intelligence are designed to model the most relevant quantitative and qualitative drivers of underlying credit risk.

• Portfolio size/Market share. For developers, large size infers competitive advantage, helping companies with greater scale and market share attract capital, gain access to well-situated land parcels, garner pricing advantage, and retain the best sub-contractors and vendors. Looking at a developer’s market share over the last three to five years, the valuation of their development portfolio, and average lot size can help determine current market share and its sustainability.
• Land procurement. Some developer’s maintain very long land positions, reducing the risk that revenue could be constrained by limited supply. Others choose to employ a land-light strategy, minimizing capital needs and facilitating quick inventory adjustments during industry downturns. Both strategies have potential drawbacks. For example, long positions are capital intensive, while land-light positions require managing demand during periods of rapid industry growth. It’s important to assess which strategy is the most appropriate based on the dynamics of the relevant real estate markets.
• Marketing strategy. The variety and appeal of a developer’s property designs, and the attractiveness of its development areas, is also important, as is the developer’s reputation for completing projects on time at the agreed asset quality.
• Geographic diversification. A company that participates across a variety of markets is expected to be less exposed than others to concentrated cyclical downturns or secular changes in competitive conditions.
• Product diversity and price segment. We consider whether cash flows are generated by a single, medium-to-high risk asset type (such as offices or industrial) or a range of assets. This diversification will generally benefit a developer’s cash flow stability and its ability to repay obligations.
• Performance and functionality. This refers to a developer's ability to pass along any increases in construction costs. We look to see if there is a standardized and integrated operations management that can monitor the cost base and aide operating efficiency, considering such things as a developer’s land, unit construction, and financing costs.
• Portfolio management. Construction of a property typically begins when a customer has entered into a sales contract, generally involving payment of a significant deposit. In some markets, however, developments are started without a contract, exposing the property to market price volatility near completion. Developers need to manage the amount of speculative home inventory so as to not disproportionately expose the portfolio to sudden changes in the systemic environment throughout the construction phase.

Scorecards from S&P Global Market Intelligence are designed as “out-of-the-box” solutions.

They come ready to use, so your company resources can be deployed more efficiently. Scoring criteria and User Guides are also kept up-to-date with a rigorous annual methodology review. As you look to develop your credit risk assessment requirements, consider the following checklist:

Your Checklist for Credit Risk Assessment

• Use detailed, attribute-driven criteria that can provide consistency, stability, and robustness to credit risk assessment.
• Help better predict default risk with sector-specific qualitative and quantitative risk factors.
• Focus on transparency to help obtain regulatory support with clear risk factor weights, financial benchmarks, and scoring algorithms used to generate a final PD outcome.
• Given the lack of empirical data for low default portfolios, use a criteria-driven approach that can be linked to default rates.
• Provide the developmental evidence for your models by going through a calibration and testing process.

To find out more about our Scorecards, visit our website.

Want to learn more?

To watch the webinar “7 Key Drivers of Credit Risk in Commercial Loan Portfolios”, click here.

¹ ^{S&P Global Market Intelligence provides a different set of criteria and scoring tools for these cases.
Contact S&P Global Market Intelligence to learn more.}