Upload
colleen-beck-domanico
View
122
Download
0
Embed Size (px)
Citation preview
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
1
JOIN. ENGAGE. LEAD.
HOW TO STACK YOUR BANK’S PORTFOLIO WITH MORE WINNERS AND FEWER LOSERSUnderstanding Prepayment Risk and the Business Cycle
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
2
JOIN. ENGAGE. LEAD.
INTERPRET REPAYMENT RISKS
Understanding how an industry affects a business can help you
interpret the repayment risks associated with lending to that
business.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
3
JOIN. ENGAGE. LEAD.
INTERPRET REPAYMENT RISKS (CONT.)
• Porter, a professor at Harvard Business School, intended his model to help companies create a business strategy that responds to five competitive forces in an industry.
Michael Porter's framework for analyzing industries and competitors helps you assess a company’s ability to succeed.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
4
JOIN. ENGAGE. LEAD.
INTERPRET REPAYMENT RISKS (CONT.)
Lenders use Porter's model to identify an industry's
most significant competitive challenges.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
5
JOIN. ENGAGE. LEAD.
INTERPRET REPAYMENT RISKS (CONT.)
Then they use that knowledge to interpret
whether a borrower has adopted an effective
strategy to counter them.
The five competitive forces in Porter's model are
derived from the relative strengths of the participants
in an industry.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
6
JOIN. ENGAGE. LEAD.
INTERPRET REPAYMENT RISKS (CONT.)
Understanding how an industry affects a
business can help you interpret the repayment risks associated with
lending to that business.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
7
JOIN. ENGAGE. LEAD.
PORTER’S FRAMEWORKOne traditional approach to assessing the influence
of a company's industry on its ability to succeed is Michael Porter's framework for
analyzing industries and competitors. (Porter is a professor at Harvard Business School.)
The model is designed to help
companies create a
business strategy that responds to five competitive
forces in an industry.
Lenders use Porter's model to identify an industry's most
significant competitive challenges.
They use that knowledge to interpret whether a borrower
has adopted an effective strategy to counter challenges.
The five competitive forces in Porter's model
are derived from the relative strengths of the
participants in an industry.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
8
JOIN. ENGAGE. LEAD.
PORTER’S FIVE COMPETITIVE FORCES
02
03
04
05
The bargaining power of customers.
The bargaining power of suppliers.
The threat of new entrants.
The threat of substitute products or services.
The intensity of competitive rivalry.
01
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
9
JOIN. ENGAGE. LEAD.
THE BARGAINING POWER OF CUSTOMERS
There are a few, large-volume buyers.
Products are easily replaced with a
substitute without incurring a large
expense.
Suppliers have high fixed costs and feel pressure to
stem sales losses by lowering prices (to keep plant/equipment running at a break-even point.)
Customers could produce the product
themselves.
The product produced is not of
strategic importance to customers.
01
Customers have high bargaining power when they can impose pressure on the seller’s or the company's margins. Buyers are powerful when:
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
10
JOIN. ENGAGE. LEAD.
THE BARGAINING POWER OF SUPPLIERS
Suppliers have high bargaining power when they exercise control over the price or availability of products needed by their customers. Suppliers are powerful when:
02
The industry's market is dominated by a few
large suppliers.
The industry's customers are not
concentrated in a few large players.
There are no substitutes for the product suppliers
make.
It is expensive for a customer to switch from one supplier to
another.
Suppliers could take their customers' place in the industry product chain and gain scale
economies and higher margins.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
11
JOIN. ENGAGE. LEAD.
THE THREAT OF NEW ENTRANTS
There is a high threat of new entrants in an industry when it is easy and inexpensive to enter that industry's market. A high threat of new entrants to an industry exists when:
03
A company does not need to be large to earn a profit
and higher-volume competitors do not gain a significant cost advantage
compared to smaller companies.
Customers are not influenced by a brand as
they decide which company to purchase
from.
There are no legal barriers, such as
copyrights or patents, to competing in the industry.
Existing competitors do not control access to vital resources, such as raw
materials or creative expertise.
It is not expensive or difficult for customers to switch to a new provider
or product.
There are no regulatory barriers to entering the
industry, such as government-sanctioned monopolies or exclusive
rights.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
12
JOIN. ENGAGE. LEAD.
THE THREAT OF SUBSTITUTE PRODUCTS OR SERVICES
A threat of substitute products exists when customers can easily locate alternative products with lower prices, or products are more readily available, and that meet their needs. A high threat of substitute products exists when:
04
Customers have no brand loyalties or there are no
established brands.
Switching to another product saves customers money without causing
them to sacrifice features or performance.
It is easy and inexpensive to change to another
product.
Makers of substitute products have high
margins and can easily attract the new buyers with price reductions.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
13
JOIN. ENGAGE. LEAD.
THE INTENSITY OF COMPETITIVE RIVALRY
Intense competitive rivalry exists in an industry when competitors have opportunities to use various competitive forces against one another. An industry exhibits intense competitive rivalry when:
05
There are many companies of about the same size.
Competitors and their products are indistinguishable, which
invites price competition.
The industry is mature or in a declining life-cycle stage,
(means that growth is possible only at expense of another
company.)
It is expensive for companies to get out of the business.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
14
JOIN. ENGAGE. LEAD.
A SIXTH FORCE
In addition to Porter's five forces, subsequent strategists have suggested a sixth force that contributes to a company's success or failure in an industry. • This force is the influence that non-competitors
or stakeholders exert over a company's ability to succeed in an industry.
• These stakeholders include governments, creditors, employees, and shareholders.
06
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
15
JOIN. ENGAGE. LEAD.
DIFFERENT STAGES OF THE BUSINESS CYCLE
Understanding the cycles that influence a company's
viability and interpreting their effect on company asset
acquisition and operating cycles is equally as important as
evaluating industry competitive forces.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
16
JOIN. ENGAGE. LEAD.
DIFFERENT STAGES OF THE BUSINESS CYCLE (CONT.)
A business cycle is a recurring but irregular long-term period of alternating growth and decline in
the economy.
The official peaks and troughs of the U.S. cycle are determined by the
National Bureau of Economic Research (NBER).
These peaks and troughs are identified by assessing factors such as gross domestic product, or GDP,
and employment growth.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
17
JOIN. ENGAGE. LEAD.
DIFFERENT STAGES OF THE BUSINESS CYCLE (CONT.)
General economic cycles of expansion and contraction affect most businesses in predictable
ways… but not all companies are affected by cycle changes equally
or at the same time.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
18
JOIN. ENGAGE. LEAD.
DIFFERENT STAGES OF THE BUSINESS CYCLE (CONT.)
Understanding the business cycle is a key
factor in understanding a business's ability to
successfully navigate the challenges that these
cycles bring.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
19
JOIN. ENGAGE. LEAD.
FOUR STAGES OF THE BUSINESS CYCLEThe business cycle has a significant impact on companies and their need for funds. The business cycle has four stages:
Early Expansion Late Expansion
Early Contraction Late Contraction
These stages of expansion and contraction are also referred to as economic cycles.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
20
JOIN. ENGAGE. LEAD.
EARLY EXPANSION (RECOVERY)
Occurs when national output begins to recover
after reaching the trough of the prior cycle.
Credit is available to companies, and they respond to this with optimism about the
future.
Companies increase sales and profits, begin
to expand plant/equipment, rebuild
inventories, add employees, start new
business lines, or introduce new products.
Interest rates are relatively low
(during the early stage of the cycle).
Customer and business credit is
plentiful.
Consumers have high levels of disposable income, partly from
secure jobs and increasing wages and partly from available
credit.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
21
JOIN. ENGAGE. LEAD.
EARLY EXPANSION: FUNDING NEEDS
Funding is needed to:
• Support sales growth and working capital.
• Pay for additional inventory.• Cover additional funds tied up in
accounts receivable. • Finance capital expenditures.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
22
JOIN. ENGAGE. LEAD.
LATE EXPANSION (BOOM)Consumer and business
spending and demand for credit increase, pushing interest rates
up.
Capacity utilization climbs and the price of goods and services
stabilizes.
The higher cost of credit, goods, and services begins to slow
consumer spending and business expansion.
Occurs when national output grows quickly and culminates in
the peak of the cycle.
Credit is available to companies and their optimism is at its peak.
Companies hire workers, market aggressively, increase sales and profits, invest in plant/equipment, and let their inventories build until
sales growth stops.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
23
JOIN. ENGAGE. LEAD.
LATE EXPANSION: FUNDING NEEDS
Funding is needed
to:
• Support continued sales growth and to finance capital expenditures that add to their capacity.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
24
JOIN. ENGAGE. LEAD.
EARLY CONTRACTION (SLOWDOWN)Consumers and businesses are less optimistic about the future.
Fewer new projects or additions are begun.
Less credit is demanded as borrowers try to reduce reliance on debt and
become more liquid.
Occurs when national output is still growing but the pace of growth
slows and then stops.
Credit is available to companies, but they are less optimistic.
Companies reduce debt and try to become liquid, stabilize or reduce
their inventories, and reduce investment in plant and equipment.
Companies may also relax credit standards to generate new sales and
growth.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
25
JOIN. ENGAGE. LEAD.
EARLY CONTRACTION: FUNDING NEEDS
Funding is needed
to:
• Cover the lengthening of collections, if they relax their terms.
Companies also will reduce inventory to generate funds.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
26
JOIN. ENGAGE. LEAD.
LATE CONTRACTION (RECESSION)
Unemployment goes up and interest rates gradually fall.
Supplies of goods and services shrink
to the point that businesses begin to
see new opportunities for
growth.
The early-expansion stage of the business
cycle begins again.
Occurs when national output declines and
eventually bottoms out at the trough of
the cycle.
Credit is available to only the most creditworthy
companies and companies overall are pessimistic.
Companies lay off workers, reduce inventory at a discount, stop
investments in plant and equipment, watch
sales and profits decrease, and lean on
trade credit.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
27
JOIN. ENGAGE. LEAD.
LATE CONTRACTION: FUNDING NEEDS
Companies need
funds to:
• Cover fixed outlays such as lease and loan payments and also to offset slower collections from weak credit customers.
Companies may generate some funds by inventory liquidation and trade credit.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
28
JOIN. ENGAGE. LEAD.
TYPICAL IMPACT OF THE BUSINESS CYCLE
In the early and late stages of contractions, many companies have financing needs that are
problematic for banks.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
29
JOIN. ENGAGE. LEAD.
FINANCING NEEDS PROBLEMATIC TO BANKS
Earn a profit.
Collect from
customers.
Cover fixed expenditures, such as lease and loan payments. Other fixed
expenses include:
Depreciation of manufacturing buildings and
equipment
Factory overhead.
Maintenance of a base level mgmt./admin. employees so the company can continue to function.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
30
JOIN. ENGAGE. LEAD.
TYPICAL IMPACT OF THE BUSINESS CYCLE (CONT.)
Companies often look to their banks for financial help during contractions; of course, this is
exactly when banks' credit analysts tell them the
companies are in a weakened debt-repayment state.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
31
JOIN. ENGAGE. LEAD.
TYPICAL IMPACT OF THE BUSINESS CYCLE (CONT.)
Analysts and management should discuss a company's susceptibility to the effects of an economic downturn and
how management can respond by reducing
expenses and adopting other strategies.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
32
JOIN. ENGAGE. LEAD.
TYPICAL IMPACT OF THE BUSINESS CYCLE (CONT.)
Some companies are especially vulnerable to sharp swings in business volume,
e.g., firms involved in heavy construction.
These companies need to create a financial condition that
will allow them to weather a downturn without defaulting on
payments.
They also need to trim expenses, including reducing
inventories, without handicapping themselves for a
recovery. This means they need to operate with
less debt, or at least with lower scheduled payments, and lower interest
expense than firms that react more slowly to economic conditions, such as
health care companies.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
33
JOIN. ENGAGE. LEAD.
WHAT TO LOOK FOR
Even if a company is in an industry that is particularly susceptible to economic contractions, it can benefit from a recession. • Look for company characteristics that
suggest potential resilience or weakness.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
34
JOIN. ENGAGE. LEAD.
STRONGER COMPANIES
Stronger companies
can take advantage of a
recession's effect on
weaker competitors.
• For example, strong companies may be able to offer extended payment terms, which can help them retain customers and win business from competitors who cannot extend terms.
• These companies may have the confidence of their suppliers or be a critical customer, which may win them generous pricing terms.
• Also, these companies may be able to acquire weaker competitors as an inexpensive way to grow permanent market share, enter new markets, or add new technology.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
35
JOIN. ENGAGE. LEAD.
WEAKER COMPANIES
Weak companies
are those unable to
receive or provide supplier
financing.
• They will see both sales and cash flow squeezed.
• If unable to reduce expenses enough to avoid non-recoverable losses during a recession, they may go out of business or sell to strong competitors to avoid bankruptcy.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
36
JOIN. ENGAGE. LEAD.
RESPONSES TO CYCLE CHANGES
Some companies and industries are less susceptible than others to the challenges of contractions because the
business cycle does not, necessarily, influence
economic activity at the same time or to the same extent in
all regions of the country.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
37
JOIN. ENGAGE. LEAD.
RESPONSES TO CYCLE CHANGES
Regional economies can be stronger than the national economy. And while some industry sectors are immediately
affected by a contraction, others generally experience a reprieve before feeling the full brunt of a recession.
E.g., manufacturing experiences an early
reduction in demand as retailers and wholesalers
begin to reduce inventories.
E.g., businesses in the service sector respond more
slowly to contractions.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
38
JOIN. ENGAGE. LEAD.
INDUSTRIES AFFECTED BY A CONTRACTION
Highly Susceptible Industries
• Construction.• Household furniture and appliances. • Personnel supply services. • Plumbing supplies. • Stone, clay, and miscellaneous
mineral products. • Metal coating and engraving. • Concrete, gypsum, and plaster
products. • Cutlery, hand tools, and hardware. • Carpet and rugs. • Motor vehicles, equipment. • Retail trade.
Less Susceptible Industries
• Beverages. • Agricultural chemicals. • Accounting and auditing. • Educational services. • Commercial sports. • Communications equipment. • Membership organizations. • Museums and botanical gardens. • Pharmaceuticals. • Insurance. • Grocery and food services. • Energy. • Medical and health-related. • Federal, state, and local
government-related services.
According to a study that reviewed recessions from 1977 to 1997, certain industries are greatly affected by a contraction. It is likely that the conclusions will hold true in all periods of contraction.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
39
JOIN. ENGAGE. LEAD.
INDUSTRIES AFFECTED BY A CONTRACTION (CONT.)
Highly Susceptible Industries
• Many of the highly susceptible industries provide products and services that consumers and businesses can postpone purchasing during a recession.
• Others are tied directly or indirectly to construction industries, which are particularly sensitive to recessions.
Less Susceptible Industries
• Many of the less susceptible industries provide necessities or public goods for which demand remains strong throughout the business cycle.
• Other industries listed, such as professional sports and museums, illustrate that demand for entertainment is resilient.
• Similarly, many economists have observed that sin industries, such as tobacco and liquor, are recession-resistant.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
40
JOIN. ENGAGE. LEAD.
EXAMPLE OF HOW A PRODUCT'S LIFE-CYCLE STAGE CAN INFLUENCE A COMPANY'S SUSCEPTIBILITY TO
BUSINESS-CYCLE DOWNTURNS.
Technology-related industries can enjoy prosperity during an overall
economic contraction.
This occurs when introductions of new
technology create high demand for new or
substantially upgraded products.
For example, in a recession, when
companies must reduce costs to survive, new
technology that introduces efficiency and thus lowers costs can be
very appealing.
The weakest companies may not have the means
to acquire the technology, but stronger
companies with the support of capital
providers often acquire the technology to reduce
current costs.
Stronger companies also achieve permanent
efficiency improvements that will pay off
significantly when demand for their own
product rebounds during a recovery.
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
41
JOIN. ENGAGE. LEAD.
Visit
The Lending Decision Process
(http://www.rmahq.org/lending-decision-process/).
Or contact
your regional manager.
Or email
ABOUT THE LENDING DECISION PROCESSFor In-depth Information:
Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
42
JOIN. ENGAGE. LEAD.
SHARE THIS PRESENTATION
Visit http://www.rmahq.org for information on risk management
RMA is a member-driven professional association whose sole purpose is to advance sound risk principles in the financial services industry.
RMA helps its members use sound risk principles to improve institutional performance and financial stability, and enhance the risk competency of individuals through information, education, peer sharing, and networking.
Become a member today.