1. 1
RZ131
Credit Assessments in Mainland China
3 IFPHK CE credits
3 SFC CPT hours
3 MPFA non-core CPD hours
Speaker: Dr. LAM Yat Fai (林日辉 博士)
Doctor of Business Administration (Finance)
CFA CAIA FRM PRM MCSE MCNE
6:30pm to 9:30pm Wednesday 6th August 2014

2. 2
 Credit assessments
 Credit rating agencies and credit bureaus
 Financial ratios analysis and Altman’s Z-score
 Financial distress and Altman's ZChina-score
 Earnings manipulation and M-score
 Benford’s law
 Borrower due diligence
 Credit risk mitigations
Outlines

3. 3
What is credit assessment?
 Two strategic questions
 Is a borrower good or bad?
 Good – likely to survive during the lending period
 Bad – likely to default during the lending period
 What is the likelihood of default (default rate) of a
borrower during the lending period?
 Alternatively
 A borrower is subjectively considered as a good
borrower
 How to ascertain objectively that this borrower is
indeed creditworthy?

4. 4
More dimensions to
consider in mainland China
 Ability to pay
 Assuming that financial statements are
largely fair
 Reliability of financial statements
 Willingness to pay
 Connections with government

5. 5
Credit assessment techniques
Credit assessment
External
(by independent
expert)
Corporate
credit rating
Internal
(by lender)
RetailCorporate
Retail
FICO score
Merton’s corporate
default model
Altman’s Z-score
Credit scoring
Credit scoring

6. 6
 Credit assessments
 Credit rating agencies and credit bureaus
 Financial ratios analysis and Altman’s Z-score
 Financial distress and Altman's ZChina-score
 Earnings manipulation and M-score
 Benford’s law
 Borrower due diligence
 Credit risk mitigations
Outlines

7. 7
Major credit rating agencies
 Global credit rating agency
 Moody's Investors Service
http://www.moodys.com
 Standard & Poor's
http://www2.standardandpoors.com
 Fitch Ratings
http://www.fitchratings.com
 Specialist credit rating agency
 A.M. Best
http://www.ambest.com
 Dagong Global Credit Rating
http://dagongcredit.com/dagongweb/english/index.php

8. 8
Solicited vs unsolicited ratings
 Solicited rating
 A corporation provides its confidential information for
the propose of credit assessment and pay a service
charge to a credit rating agency in order to obtain a
credit rating
 Potential conflict of interests
 Business model of the three largest CRAs
 Unsolicited rating
 A credit rating agency takes an initiative to rate a
corporation based on publicly available information
 Lenders pay a fee to access credit ratings

9. 9
Credit rating scales
Grade S&P’s, Fitch Moody’s
Investment AAA Aaa
AA Aa
A A
BBB Baa
High yield BB Ba
B B
CCC Caa
CC Ca
C C

10. 10
Rating definitions (1)
Rating Definition
AAA A corporation rated AAA has extremely strong
capacity to meet its debt obligations.
AA A corporation rated AA has very strong capacity to
meet its debt obligations. It differs from a highest-
rated borrower only to a small degree.
A A corporation rated A has strong capacity to meet
its debt obligations but is somewhat more
susceptible to the adverse effects of changes in
circumstances and economic conditions than a
borrower in higher-rated categories.

11. 11
Rating definitions (2)
Rating Definition
BBB A corporation rated BBB has adequate capacity to meet
its debt obligations. However, adverse economic
conditions or changing circumstances are more likely to
lead to a weakened capacity of the borrower to meet its
debt obligations.
BB A corporation rated BB is judged to have speculative
elements and are subject to substantial credit risk.
B A corporation rated B is more vulnerable than a borrower
rated BB, but the borrower currently has the capacity to
meet its debt obligations. Adverse business, financial, or
economic conditions will likely impair the borrower's
capacity or willingness to meet its debt obligations.

12. 12
Rating definitions (3)
Rating Definition
CCC A corporation rated CCC start to experience
financial distress, and is dependent upon
favorable business, financial, and economic
conditions to meet its debt obligations.
CC A corporation rated CC is currently in financial
distress.
C A corporation rated C is typically in deep financial
distress, with very little prospect to meet its debt
obligations.

13. 13
Average 1-year default rates
Group Rating Moody’s (%) S&P’s (%) Fitch (%)
1983 - 2012 1981 - 2012 1990 - 2012
Excellent AAA 0.00 0.00 0.00
Good
AA 0.03 0.02 0.03
A 0.07 0.07 0.09
BBB 0.20 0.22 0.21
Moderate
BB 1.14 0.96 1.24
B 4.04 4.29 2.72
Financial
distress
CCC 13.76
26.85 27.61
CC and C 41.40

14. 14
Only 4 AAA corporations
in the world
 Manufacturing firms
 Johnson & Johnson
 Exxon Mobil Corporation
 Technology firms
 Microsoft Corporation
 Automatic Data Processing, Inc.
These corporations are richer
than most countries in the world

15. 15
Basel III ECAI rating scale
Rating 3-year DR (%)
AAA and AA 0.10
A 0.25
BBB 1.00
BB 7.50
B 20.00

16. 16
Basel III ECAI Plus rating scale
Group Rating 3-year DR (%) PD (%)
Excellent AAA 0.03 0.0100
Good
AA (+,-) 0.10 0.0333
A (+,-) 0.25 0.0834
BBB (+,-) 1.00 0.3345
Moderate
BB (+,-) 7.50 2.5652
B (+,-) 20.00 7.1682
Financial
distress
CCC 40.00 15.6567
CC 65.00 29.5270
C 95.00 63.1597

17. 17
Domestic credit rating agencies
in China
 Solicited rating
 Dagong Global Credit Rating
 Pengyuan Credit Rating
 Chengxin International Credit Rating
(Moody’s 49%)
 China Lianhe Credit Rating (Fitch 49%)
 Shanghai Brilliance Credit Rating & Investor
Service (strategic alliance with S&P)
 Unsolicited rating
 China Credit Rating

18. 18
Major retail credit bureaus
 Individual persons
 TransUnion
 Equifax
 Experian
 Small and medium enterprises
 Dun & Bradstreet

19. 19
Where comes personal credit data?
 Banks’ contribution
 Public records
 Negative data
 Overdue records, bankruptcy records, court orders
 Positive data
 Loan types, no. of mortgages and no. of credit cards

20. 20
Composition of FICO score
 Payment history (35%)
 The historical records of default, bankruptcy, lawsuit, court order and delayed payment will
reduce the FICO score
 The more recent, more frequent and more severe the negative payment history is, the
lower the FICO score will be
 Credit utilization (30%)
 A large ratio of outstanding debt amount to total credit limit will reduce the FICO score
 Credit history (15%)
 Credit history is represented by the age of the oldest loan account and the average age of
all loan accounts
 A longer credit history will increase the FICO score
 Credit experience (10%)
 Credit experience means the history of using different types of credit products
 A more diversified credit experience will increase the FICO score.
 Recent enquiry (10%)
 The recent enquiries from a large number of loan applications will decrease the FICO
score

21. 21
FICO score
Group From To
Super prime 740 850
Prime 680 739
Alt-A 620 679
Subprime 550 619
Deep
subprime
350 549

22. 22
FICO scores vs default rates
From To 1-year DR (%)
800 850 1
750 799 2
700 749 5
650 699 14
600 649 31
550 599 51
500 549 70
350 499 83

23. 23
Credit bureaus in China
 People’s Bank of China
 http://www.pbccrc.org.cn
 Huaxia D&B China
 http://www.huaxiadnb.com
 Crediteyes
 http://www.crediteyes.com
 > 60

24. 24
 Credit assessments
 Credit rating agencies and credit bureaus
 Financial ratios analysis and Altman’s Z-score
 Financial distress and Altman's ZChina-score
 Earnings manipulation and M-score
 Benford’s law
 Borrower due diligence
 Credit risk mitigations
Outlines

25. 25
Financial statements
 Balance sheet
http://finance.yahoo.com/q/bs?s=F+Balance+S
heet&annual
 Income statement
http://finance.yahoo.com/q/is?s=F+Income+Stat
ement&annual
 Cash flow statement
http://finance.yahoo.com/q/cf?s=F+Cash+Flow
&annual

26. 26
Financial ratios
 Liquidity ratios
 Leverage ratios
 Return on investment ratios
 Operating profitability ratios
 Operating efficiency ratios
 Turnover ratios
 Coverage ratios
 Growth ratios

27. 27
Liquidity ratios
Current assets
Current ratio =
Current liabilities
Cash + Marketable securities
+ Account receivables
Quick ratio =
Current liabilities
Cash + Marketable securities
Cash ratio =
Current liabilities

28. 28
Leverage ratios
Total liabilities
Liabilities-to-equity ratio =
Total equity
Total liabilities
Liabilities-to-assets ratio =
Total assets
Total equity
Equit-to-assets ratio =
Total assets

29. 29
ROI ratios
Earnings before interest and taxes
Return on total assets =
Total assets
Earnings before interest and taxes
Return on total equity =
Total equity
Earnings before interest and tax
Return on common equity =
es
Common equity

30. 30
Peer analysis and trend analysis
 Peer analysis
 Comparison with
 Other similar corporations
 Industry statistics
 average, median, mode
 lower bound, upper bound
 Trend analysis
 Comparison with
 A corporation’s own history

31. 31
Financial ratios
 Advantages
 Direct measure of a company’s financial healthiness
 Published regularly
 Audited at least annually
 Disadvantages
 Financial ratios highly industry specific
 Large no. of financial ratios
 Inconsistency among less related financial ratios
 Book value <> economic value
 Subject to accounting cosmetics
 Peer figures and industry statistics difficult to collect from
emerging industries and private firms

32. 32
Survival and default groups
 Assume that personal credit quality is driven by
 x1 : monthly income
 x2 : outstanding loan amount
 Historical record
 Based on bank’s internal records, plot the default and survival
borrowers into two groups
 Preferable at least 60 in each group
 Determine the centre of two groups
 Potential borrower
 Classified as good borrowers if near the centre of survival
group
 Classified as bad borrowers if near the centre of default group

33. 33
Historical distribution

34. 34
Three-group classification

35. 35
Borrower distribution in a real bank

36. 36
Explanatory variables (1)
 EBIT/Total tangible
assets
 Net available for total
capital/Total capital
 Sales/Total tangible
assets
 Sales/Total capital
 EBIT/Sales
 Net available for total
capital/Sales
 Log tangible assets
 Interest coverage
 Log(Interest coverage)
 Fixed charge coverage
 Earnings/Debt
 Earnings, 5-year
maturity
 Cash flow/Fixed charges
 Cash flow/Total debt

37. 37
Explanatory variables (2)
 Working capital/Total
debt
 Current ratio
 Working capital/Total
assets
 Working capital/Cash
expenses
 Retained earnings/Total
assets
 Book equity/Total capital
 Market value of equity
equity/Total capital
 5-year market value of
equity equity/Total
capital
 Market value of equity
equity/Total liabilities
 Standard error of
estimate of EBIT/Total
tangible assets
 EBIT drop
 Margin drop
 Capital lease/Assets
 Sales/Fixed assets

38. 38
Altman’s Z-score for
listed manufacturing companies (1)
 Explanatory variables
1
2
3
4
5
Market value of equity
X =
Book value of liabilities
Current assets - Current liabilities
X =
Total assets
Retained earnings
X =
Total assets
Earnings before interest and taxes
X =
Total assets
Sales
X =
Total assets

39. 39
Altman’s Z-score for
listed manufacturing companies (2)

 Good – Z > 2.99 [AA to BBB]
 Moderate – 1.81 < Z < 2.99 [BB to B]
 Bad – Z < 1.81 [CCC to C]
1 2 3 4 5Z = 0.6X + 1.2X + 1.4X + 3.3X + 0.999X

40. 40
Altman’s Z’-score for
private manufacturing companies (1)
 Explanatory variables
1
2
3
4
5
value of equity
X =
Book value of liabilities
Current assets - Current liabilities
X =
Total assets
Retained earnings
X =
Total assets
Earnings between interests and taxes
X =
Total assets
Sales
X =
Book
Total assets

41. 41
Altman’s Z’-score for
private manufacturing companies (2)

 Good – Z’ > 2.90 [AA to BBB]
 Moderate – 1.23 < Z’ < 2.90 [BB to B]
 Bad – Z’ < 1.23 [CCC to C]
1 2 3 4 5Z' = 0.42X + 0.717X + 0.847X + 3.107X + 0.998X

42. 42
Altman’s Z’’-score for
non-manufacturing companies (1)
1
2
3
4
Book value of equities
X =
Book value of liabilities
Current assets - Current liabilities
X =
Total assets
Retained earnings
X =
Total assets
EBIT
X =
Total assets
 Explanatory variables

43. 43
Altman’s Z’’-score for
non-manufacturing companies (2)

 Good – Z” > 2.60 [AA to BBB]
 Moderate – 1.10 < Z” < 2.60 [BB to B]
 Bad – Z” < 1.10 [CCC to C]
1 2 3 4Z" = 1.05X + 6.56X + 3.26X + 6.72X

44. 44
 Credit assessments
 Credit rating agencies and credit bureaus
 Financial ratios analysis and Altman’s Z-score
 Financial distress and Altman's ZChina-score
 Earnings manipulation and M-score
 Benford’s law
 Borrower due diligence
 Credit risk mitigations
Outlines

45. 45
Default vs financial distress
 Default
 Many defaults but very few default records
 Data removed from major financial information
providers
 Some countries apply confidential treatments to
records of defaulted corporations
 Horizon
 No. of defaults in 3 years > No. of defaults in 1 year
 Financial distress
 A boarder definition of poor credit quality
 Records of financial distress corporations are
accessible

46. 46
Basel III ECAI Plus rating scale
Group Rating 3-year DR (%) PD (%)
Excellent AAA 0.03 0.0100
Good
AA (+,-) 0.10 0.0333
A (+,-) 0.25 0.0834
BBB (+,-) 1.00 0.3345
Moderate
BB (+,-) 7.50 2.5652
B (+,-) 20.00 7.1682
Financial
distress
CCC 40.00 15.6567
CC 65.00 29.5270
C 95.00 63.1597

47. 47
Financial distress of listed companies
 Rated “CCC” to “C” by credit rating agencies
 Listed companies
 Delisted due to reasons other than privatization
 Special treatment in China
 Negative cumulative earnings over two consecutive
years
 Equity value < registered capital
 Likely to be dissolved
 Re-organization, settlement or bankruptcy liquidation
 Opinions from auditors
 Concerns from CSRC

48. 48
High credit quality borrower
 Differentiation
 Good – to stay as investment grade in
following three years
 Bad – to migrate to high yield grade or
default in following three years

49. 49
Altman’s ZChina-score for
listed companies in China
6
7
8
9
Total liabilities
X =
Total assets
Net profit
X =
Average total assets
Currrent assets - Current liabilities
X =
Total assets
Retained earnings
X =
Total assets
 Explanatory variables

50. 50
Altman’s ZChina-score for
listed companies in China

 Good – ZChina > 0.9 [AA,A]
 Moderate – 0.5 < ZChina < 0.9 [BBB]
 Bad – ZChina < 0.5 [BB,B]
 Market value of equity/Total assets not an
explanatory financial ratio
http://finance.google.com
China 6 7 8 9Z = 0.517 - 0.460X + 9.320X + 0.388X + 1.158X

51. 51
New lending operations
 Even financial distress records over 3
years are not available
 Proxy by a similar group of listed
companies in terms of asset size and
industry
 Cutoff scaled up in accordance with the
experience of and subjective view from a
lender

52. 52
 Credit assessments
 Credit rating agencies and credit bureaus
 Financial ratios analysis and Altman’s Z-score
 Financial distress and Altman's ZChina-score
 Earnings manipulation and M-score
 Benford’s law
 Borrower due diligence
 Credit risk mitigations
Outlines

53. 53
SEC’s 2008 report on
financial statement frauds
38%
12%12%
38%
Earnings manipulation Expenses manipulation
Improper disclosures Others

54. 54
How good is the quality
of financial statements?
 All financial statements are subject to
accounting cosmetics
 To reject ALL loan applications assuming
unreliable quality
 Loss all lending businesses
 Good borrowers cannot obtain finance
 To accept ALL loan applications by assuming
good quality
 Potentially large default loss

55. 55
Beneish’s M-score for
earnings manipulation
Net income - Cash flow from operations
TATA =
Total assets
Receivables
DSRI =
Total sales
SGI = Total sales
Fixed assets in current year - Property, plant and equipment
AQI =
Total assets
Total liabilit
LVGI =
ies
Total assets
Selling, general and administrative expenses
SGAI =
Income
Gross profit
GMI =
Total sales
Depreciation
DEPI =
Depreciation + Property, plant and equipment

56. 56
Beneish’s M-score for
earnings manipulation

 Lower manipulation – M > 2.22
 Moderate manipulation – 1.78 < M < 2.22
 Higher manipulation – M < 1.78
DSRI current year
M = 4.84 - 4.679 × TATA current year - 0.92 ×
DSRI previous year
SGI currrent year AQI current year
- 0.892 × - 0.404 ×
SGI previous year AQI previous year
LVGI current year
+ 0.327 ×
LVGI
SGAI current year
+ 0.172 ×
previous year SGAI previous year
GMI previous year DEPI previous year
- 0.528 × - 0.115 ×
GMI current year DEPI current year

57. 57
Two-dimensional assessment

58. 58
 Credit assessments
 Credit rating agencies and credit bureaus
 Financial ratios analysis and Altman’s Z-score
 Financial distress and Altman's ZChina-score
 Earnings manipulation and M-score
 Benford’s law
 Borrower due diligence
 Credit risk mitigations
Outlines

59. 59
Benford’s law
 For computed numbers
 
10
1
1
log 1
Prob st digit x
x

 
  
 

60. 60
Occurrence of 1st digit

61. 61

62. 62
When Benford’s law is useful?

63. 63
 Credit assessments
 Credit rating agencies and credit bureaus
 Financial ratios analysis and Altman’s Z-score
 Financial distress and Altman's ZChina-score
 Earnings manipulation and M-score
 Benford’s law
 Borrower due diligence
 Credit risk mitigations
Outlines

64. 64
Borrower due diligence
 Financial reporting due diligence
 Corporate governance due diligence
 Regulatory due diligence
 Business partner due diligence
 Counterparty due diligence

65. 65
Forensic accounting
 Forensic accounting utilizes accounting,
auditing, and investigative skills to
conduct an examination into a company's
financial statements, thus providing an
accounting analysis that is suitable for
court
 Forensic accountants are trained to look
beyond the numbers and deal with the
business reality of a situation

66. 66
Business partners
 Joint venture agreement with large
projected revenues
 Newly incorporated company
 Low shareholders’ capital
 Small office
 No licence

67. 67
Muddy water report
 Field enquiries confirmed that
Zhangzhou Lusheng operates
at the address on the 5th floor.
There are four desks in
Zhangzhou Lusheng’s office,
which appeared to be
approximately 180 m2 with 5-
6 employees in the office at
the time of visit. This implies
that Lusheng has an
extremely efficient computer
system (given that it
processes so much money
and so many payments with a
small staff).

68. 68
Onsite due diligence
 Observations on Sino Forest by Muddy Waters
 Very few employees reporting duty every day
 Very few number of trucks in and out every day
 Do not match the transaction volume
 Onsite visits are expensive
 Brach offices in different cities
 Joint ventures with onsite examination experts
 E.g. annual ISO 9000 examinations by SGS

69. 69
 Credit assessments
 Credit rating agencies and credit bureaus
 Financial ratios analysis and Altman’s Z-score
 Financial distress and Altman's ZChina-score
 Earnings manipulation and M-score
 Benford’s law
 Borrower due diligence
 Credit risk mitigations
Outlines

70. 70
Credit risk mitigations
 Credit substitution
 Credit guarantees
 Credit default swaps
 Collateral
 Properties
 Financial assets
 Plants and equipments
 Local partner
 Each city and industry has its own
characteristics

71. 71
Property price
 Between purchaser and seller
 CNY 1,000,000
 Real estate agency
 CNY 1,500,000
 Registration with Land Resources
Department
 CNY 850,000
 Mortgage
 CNY 2,000,000

72. 72
My contacts
 Personal e-mail
 quanrisk@gmail.com
 Personal website
 https://sites.google.com/site/quanrisk
 Book website
 https://sites.google.com/site/crmbasel

73. 73
Q & A

74. 74
Thank You

75. 75
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