ADVANCED CREDIT RISK MANAGEMENT DECEMBER 2023 PAST PAPER

MONDAY: 4 December 2023. Afternoon Paper. Time Allowed: 3 hours.

Answer ALL questions. Marks allocated to each question are shown at the end of the question. Do NOT write anything on this paper.

QUESTION ONE

ZAKA PLC – COMPANY INSOLVENCIES AND CREDIT RISK
There are many big firms mentioned as facing financial difficulties. It is claimed that many companies should not even be trading. It is a known fact that if a company is unable to pay its debts and therefore insolvent, then the company may either be voluntarily or involuntarily liquidated without first being placed under administration.

It is reported that the number of Kenyan firms facing liquidation have more than doubled in the last seven years, highlighting weaknesses in the legal regime on insolvency. Restaurants have not been spared, the latest research analysis by BWK LLP- Accountancy firm shows that at least five restaurants are closing daily in the region. The deterioration in the payment behavior of customers can be part of the pandemic’s collateral damage given that we have not yet overcome the effects of COVID 19 pandemic, and it has brought along a crippling ripple effect on business’s cash flow. Notwithstanding the current international wars and fluctuating foreign exchange rates that have had a severe effect on
the supply side of the economy. The challenge therefore is how to minimise such risks, so as to optimise portfolio and limit credit losses as much as possible.

Zaka Plc being a financial institution in competitive economic environment which is constantly subject to multiple risks and therefore requires the application of rigorous principles for their management, have decided to hire BWK LLP to carry out research on the current economic trends and its impact on firms’ solvencies. Report of the Findings by BWK LLP BWK LLP found out that more and more companies had financial difficulties. The difficulties were caused by both faulty managerial decisions and fiscal pressure or competition increases leading businesses to the verge of insolvencies. In addition, changes in the business environment as a result of entering new markets or restructuring the economy can lead to corporate insolvency. Also, loss of capital, inability to secure new capital and high debt or disputes with a particular creditor can be causes of insolvency. Risk forecasting can economically recover a business whose continuity is threatened.

The risk of insolvency occurs when a company cannot pay its debts based on both internal factors and external factors. However, it is not possible to talk about the existence of an insolvency risk of a business in the absence of a financial accounting diagnosis to determine the state of insolvency, recognised as that state of the patrimony of an entity characterised by insufficient funds for the payment of determined, liquid and matured debts. Indicators specific to liquidity and financial solvency are essential elements in identifying financial problems at the level of the economic entity, providing clues about the ability of the company to pay due tax obligations, the extent to which equity can cover long-term debt, but also the financial resources currently available.

The risk of insolvency cannot be eliminated but it can be identified before it occurs. The causes that lead companies to insolvency are numerous, with negative effects in terms of ability to pay. Thus, there was a major interest in predicting insolvency several years before it manifested itself. The accounting methods to identify the risk of insolvency offer the possibility of a limited interpretation in time and space. Banking methods are the most widely used because they allow the identification of the vulnerabilities of a business based on the use of score-type function.

These methods makes it possible to predict the instability of a business and classify it according to the risk area in which it is located. The most famous insolvency risk-scoring method was developed by Altman (1968). Altman determined a set of observations for solvent and insolvent companies, but also a series of financial rates. The model was appreciated because it predicted insolvencies with an accuracy of 72% two years before their occurrence, being further developed. The objectives of the research were application of various techniques and methods for a period of four years, to measure the failure or financial health; verification of the robustness of the model through sensitivity analysis and multiple discriminant analysis. The companies were classified into financially stable and financially unstable.

Conclusions by BWK LLP
Financial management plays an important role in terms of its applicability within a company. This provides relevant information regarding the risk exposure, the longer and more relevant the predictability period, the better the risks related to the insolvency of a company or in the worst case the appearance of the state of insolvency can be enriched.

The development of an insolvency risk forecasting model has become a widely debated topic in the field of credit risk management. This was also due to the financial instruments used which require a complex calculation analysis to determine the exposure to several risks, from operational risk to reputational risk.
Incorporating the most relevant information obtained from the analysis of economic-financial indicators and developing a model for assessing the risk of insolvency of companies can be considered the easiest way to predict future financial statements. The reason why insolvency forecasting is very important is given by the interdependence between the two financial statements of a company. When a company is in a state of insolvency, the possibility of it going bankrupt due to the inability to comply with the financial recovery plan is extremely high.

The specificity of national legislation, as well as other aspects related to the market in which a company operates, can influence the probability of predicting the risk of insolvency.

Required:

1. Identify FIVE types of risks mentioned in the case study. (5 marks)

2. Explain the “Altman’s Z Score Model”. (2 marks)

Enumerate FIVE limitations of the Altman’s Z Score Model. (5 marks)

3. Propose FIVE techniques that Zaka PLC could consider in order to address reputation risk. (10 marks)

4. Explain FOUR indicators of insolvency that were not mentioned by the research carried out by
BWK LLP. (8 marks)

Outline FOUR negative effects of insolvency that Zaka PLC could suffer in the event the company was
declared insolvent. (4 marks)

5. Summarise THREE benefits that could accrue to Zaka PLC as a result of adopting credit risk modelling. (6 marks)

(Total: 40 marks)

 

QUESTION TWO

1. Explain the term “systemic risk”. (2 marks)

2. Enumerate FIVE principles of credit portfolio management. (5 marks)

3. Explain FOUR types of financial risks that are built into every project, worth of consideration by project financers. (8 marks)

(Total: 15 marks)

 

QUESTION THREE

1. State FOUR advantages of risk-based pricing, of credit products. (4 marks)

2. Explain FIVE weaknesses of Basel Capital Principles revealed during the credit crisis of 2007 to 2009. (5 marks)

3. Describe THREE categories of assets used as collateral by lenders. (6 marks)

(Total: 15 marks)

 

QUESTION FOUR

1. With reference to credit portfolio risk mitigation, highlight THREE uses of credit derivatives. (3 marks)

2. Describe THREE goals of credit risk measurement. (6 marks)

3. Summarise SIX applications of credit in economic capital modelling. (6 marks)

(Total: 15 marks)

 

QUESTION FIVE

1. Assess TWO objectives of the Kenya Banks’ Reference Rate (KBRR), as the prime lending rate. (4 marks)

2.  Identify FIVE factors that affect credit risks at a portfolio level. (5 marks)

3.  Outline SIX symptoms of overtrading. (6 marks)

(Total: 15 marks)

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