Credit Risk Black Book | What They Still Do Not Teach You at Banks and Business Schools: Credit-Cue

PROLOGUE | WHY DO YOU NEED THIS BOOK?

AND WHAT CAN YOU DO WITH IT?

PROLOGUE

Fallacies of Sight Versus the Tools of Custodians of Capital

12 minutes read

How do you grasp true reality beyond the financial statements of borrowers and simultaneously carry a heterodox position without organizational squabbles or subservience?

Worldwide bank balance sheets, which reflect corporate counterparty risk, look well capitalized. Credit losses are not out of the ordinary. The stock markets are fluctuating, but still coming off of their historically highs. Real estate and commodity prices are at their recent highs. So why do you need this book?

What if you combine the commercial banks' balance sheets with those of their central banks?

Why does one need to do that? Simply because central banks have warehoused and exchanged questionable bank loans and government bonds with unearned income (newly printed money, a.k.a. quantitative easing).

Unlike commercial banks, central banks are not required to disclose the present market value of these loans and bonds (assets) or write-off the doubtful assets. The central banks attempts to sell these assets have also been rather unsuccessful and have encountered adverse market reactions (taper tantrums).

Thus, it is natural to argue that these assets are of questionable value. The only way to assess the health of commercial banks (which mirror the wider risks in any country) is to combine their aggregate equity with that of their central bank. What kind of picture might arise if you combine the two?

In the US alone, non-treasury-related (private) assets on the Federal bank's balance sheet stand at about $4.8 trillion, which is far in excess of about $2 trillion combined equity of the commercial and investment banks. The mortgage-backed securities, a.k.a. home loans reflecting mostly questionable real estate mortgages from the past decade, stand at an additional $2.6 trillion.

If there is indeed a market for these assets, they should not be sitting in the Federal Reserve's balance sheet for years. These assets have also increased in size even before the pandemic and continue to grow, indicating a lack of marketability. It is not clear if the Federal Bank has the equity capital to cover the potential losses from these assets.

This begets a simple question—is the combined equity of the US Federal (Fed) and commercial banks significantly lower than what we are made to believe, if not negative? Is it possible that the combined US financial system might not be solvent?

The situation does not appear to be very different in major economies such as the EU and Japan, but also in many emerging economies. These economies took the global lead in so-called quantitative easing over the past decade and then went unabashedly into it during the pandemic, creating unearned income in excess of $25 trillion, which equates to a quarter of global GDP or two times the average global annual tax collections of about $12 to 13 trillion.

Ascertaining the impact of this unearned income requires working out the combined equity of global banks. This is a tenuous task indeed, and information on this is hard to come by. However, prorating it in line with the US share of global GDP, we can hazard a guess that the combined equity of global banks may be in the range of 3 to 5 times the aggregate equity of US banks. This equates to a range of $6 trillion to $10 trillion. The majority of the unearned income generated by central banks is created or passed through commercial banks.

When aggregated with the central banks, the combined equity of commercial banks may be significantly diminished. Global credit losses may be high rather than low. The losses continue to be simply undercounted as they have been removed from the commercial banks' financials and parked on the central banks balance sheets away from public discourse. Also, in most countries, the central bank's assets and liabilities are neither held at the market (not reflecting their true present value) nor consolidated with national accounts, which makes the situation further opaque.

Furthermore, the so-called liquidity provided by the central banks against these assets is nothing more than a cover to increase the money supply.

This increased money supply artificially inflates asset prices, inflates the value of collateral held at banks, and inflates government tax receipts. It is thus an unscrupulous tool to overcome excessive national indebtedness by inflating all the way through and avoiding fundamental economic reforms to address competitiveness. We are talking about major economies here, not stereotypical inflationary African states.

So what are we fundamentally saying?

While, on the one hand, bank losses remain undercounted and obfuscated, on the other hand, we continue to overlook the fact that the value of one thing is derived only from another. If we increase the supply of something that especially underpins the measurement of the value of everything (money), it is only natural that the value of other things will increase and, simultaneously, what is more in supply loses value (money).

As an illustration, money supply growth in the US, which stands at 25-30% p.a. in recent times and historically in the 3-7% p.a. range, may have negated economic growth in real terms while creating the illusion of asset price-based growth.

The edifice of growth has also been maintained by devaluing the value of labor through the suppression of wages, especially in the West. In the West, most people can relate to the fact that prices of most goods and services have gone up 10–15% per year while wages have remained the same. This is simply a devaluation of labor. This is what has created unbelievable poverty rates of 15–25% in the richest countries. This has also created a historic high proportion of low market cap-unprofitable–no growth corporates on major stock exchanges (zombie corporates).

Also, not to forget, excessive money printing and the zombification of corporates and banks have reduced the return on societal savings, as banks don’t want anyone's cash. This has exposed working-class families to the vagaries of stock markets, which has further hollowed them out.

Money printed is also a liability on the US Fed's balance sheet, which stands now at about 2 times the gross tax collections of the country and is close to about 40% of the federal debt. Is this not analogous to simply printing twice the country's tax receipts and 40% of the proceeds from its government debt? Is this not simply unearned income gained through unfair means?

The vast majority of economic growth or price increases in assets can be simply explained by an increase in the supply of money, which means a devaluation of money and labor.

How can corporations, which are nothing more than a collection of societal assets, appear to be in shape if governments and the general public are out of shape? How long will they be in shape?

Why are we discussing all this? Gauging true reality versus client-stated financials.

Surprisingly, something of the above nature is usually not of concern to credit risk officers engaged in client counterparty, i.e., borrower's risk assessment at banks and financial institutions (lenders). All risks usually end up as credit risks.

Given that the money supply now forms the ultimate basis of valuation of assets, including borrower's collateral held by banks and borrower's cashflows, why do credit officers and risk managers plainly overlook it and simply focus on client-stated or audited financials?

Can the client counterparts truly be above their money-creation-driven operating environment and for how long? Also, isn’t it better anyway to gauge the borrowers' credit risk using independent information emanating from a wider operating environment than to rely excessively on a client’s financials?

However, gauging the wider operating environment—not just money creation but other factors as well (true reality)—that impacts the borrower's credit risk has been made complicated by a plethora of rules and standards. On the one hand, such rules and standards create a false sense of security, while on the other hand, they remove the credit risk officer from the true operating reality of borrowers.

Gauging the true reality seems like a daunting task indeed, but is the tendency to simply focus on stated financials and collateral often a convenient escape? This tendency is further exacerbated by sample-based portfolio reviews across the banking industry as opposed to comprehensive reviews. Thus, everything seems normal till losses come home, and each time, risk officers are left wondering why they did not do better than last time. This cycle never stops, with losses ever mounting.

Why?

This is because gauging the true reality involves a lot more than what is covered by the client-stated financials or the accompanying standards of the regulatory and financial markets.

Drawing parallels with the medical profession, financial reports and standards are akin to patient blood reports and medical standards. We all know that making blood reports a stand-in for reading the pulse by the doctor is often a recipe for disaster.

Truly grasping reality requires recognizing and overcoming gaps in our perception of the world, particularly perceptual gaps pertaining to the world's unobvious or hidden corners, which are frequently interconnected.

This perceptual understanding involves how societies truly operate as seen through the integrated lenses of crime, historical identities, hidden taxation, the unsaid impact of oil and gas policies, and the unsaid influence of central banking, money supply, and sensuality.

However, all this understanding is rather meaningless unless it is well augmented by the practical ability to conduct a molecular decomposition of the macro factors to distill the relevant factors that can forecast the performance of the entire credit portfolio.

You must be thinking that distilling true reality into meaningful portfolio forecasting tools seems like a herculean task despite all the technology. We will demonstrate that it is not. Also, you will be surprised that we do not need much help from technology. How?

Sage versus expert:

As the saying goes, a sage can tell the entire earth from one grain of sand, while an expert can analyze the entire earth only to be proven wrong by another expert. The sage enlightens you by setting you on a path of perpetual self-learning. An expert ensures you first memorize the mistakes of his predecessors before you even think about the future!

The root cause of the difference between the sage and the expert is information inaccuracy based on their ability to see the way things truly are.

True implies a wide worldview with a focus on discerning relative reality from ultimate reality. Relative implies layers of interlinked factors that influence each other. Information or data inaccuracy is our inability to truly see the way things are. The core reason for this inaccuracy is our tendency to rush to measure before seeing and the absence of spirit to delve into fundamental reality. This leads to the shallowness of thought we encounter every day. 

The key question to ask then is what causes people to rush to measure before they understand.

Firstly, it is the lack of a fundamental worldview, i.e., a fundamental cognitive orientation and an accompanying point of view. The absence of such a worldview means that data is often a source of misguidance rather than wisdom.

Secondly, it implies an inability to peel back deeper layers of relative truth that impact each other. A plethora of financial, mathematical, and econometric tools further locks a person into a make-believe, self-sufficing, unreal world.

A person rarely rises above the assumptions of such a make-believe world. Such assumptions and accompanying views, no matter how grand they initially sound, eventually turn out to be mere shallow mental constructs once reality overwhelmingly turns against the views held. Many fundamentally lack awareness of how they are acquiring knowledge and understanding it through their senses (cognition), which limits their inner sight.

The ultimate truth of credit losses is then eventually revealed after immense suffering. By this time, the harm to people, societies, and institutions is often grave and irreparable.

Short memories and a refusal to accept flaws endlessly recreate the bubble of shallowness, until the truth is inevitably revealed, resulting in even greater losses and pain.

Are we letting the gatekeepers of capital down by confusing assets with leverage or liabilities acerbated by outdated credit risk tools?

Human society is today relentlessly rooted in apparent wealth. While it focuses on wealth creation, society has possibly lost the sound means of storing and passing on true wealth across generations.

Instead, society is encountering a world never seen before in terms of liabilities to others and future generations. Most of these liabilities emanate from global debt, derivatives, and wrongly printed currency. All of which are tens of multiples of our hard-earned or productive asset-based true wealth.

How much we borrow against our assets, i.e., financial leverage, and the associated consumption that it feeds, has become the primary driver of the fictitious world of prosperity. The world has for the past few decades stood at the hidden precipice which has been laid bare by the recent pandemic.

The increasing leverage and liabilities of the lenders (both public and private) drive our economies, governments, and societies. The unearned income that comes from this feeds the increasing cycles of boom and bust.

As discussed, contrary to what is commonly believed, financial institutions may actually be facing a rapid erosion of capital. The pandemic-driven loan deferrals and other relief measures, often underpinned by excessive unearned income, are now running their course, leaving behind leverage and liabilities at never-before-seen levels.

However, credit risk managers—who are gatekeepers of the capital of society—are being left behind with outdated credit measurement tools.

The last comprehensive risk bible by the British Bankers' Association was published about two decades ago, possibly reflecting somewhat out-of-context risk knowledge from the preceding decades. The credit risk training offered by most rating agencies and banks' internal training departments is simply more of the same blinkered, narrow assessment of client-stated or audited financials.

Education, regulatory, and financial standards also do not talk about building an intrinsic understanding of the world, i.e., a worldview as a prerequisite to understanding information. Critically, they also do not talk about enhancing cognition or refreshing our system of logic to enable a person to rise above stasis.

Society also overlooks the fact that risk managers are not only gatekeepers but also custodians of institutional equity capital. This capital collectively ensures the continuity of our society by preserving real value generated over generations. It is akin to a social sustenance fund that is earned by hard work. It is not debt or unearned income. Lack of preservation of this capital or sustenance fund has often resulted in wars, starvation, and poverty via the failed financial institutions housed within the failed states controlled by failed elites.

Risk managers play this frontline capital custodian role through independent assessment of financial and corporate borrowers for their banks and financial institutions.

Given the historically high challenges risk managers are now facing, contrary to what you might expect, as a society, we may have astonishingly diminished their ability to gauge counterparty risk. We may have also caused deterioration in their working environments within lending institutions by disregarding humanistic mind development.

How?

Instead of making cutting-edge and simple tools available to them, we have surrounded them with leverage-facilitating central banks' regulatory frameworks, scapegoatable rating agencies, excessive compliance, and financial credit analyses that substitute estimated and often gamed numbers for real-world issues.

Such an environment is further made toxic by superegos, relentless aggression, hidden cronyism, and most critically, the pretense of intelligence that subdues simple humanistic interactions at most banks and financial institutions.

Not to forget that all financial tools and standards have historically proven inadequate in practice for mature risk officers. For the younger generation of risk managers, the tools are particularly dull to learn and assimilate, causing confusion that diminishes their natural intelligence.

The situation is rather grave for senior risk managers. Such managers end up excessively relying on experience or market contacts or common sense—which at some point turn out to be nothing more than invalid assumptions based on ethnocentric group think. No quality tools or literature are available to them to refresh their root skills, deepen their perspective, or enhance their cognition. Senior bankers’ posture suggests they know the world of money but are often oblivious to the fundamentals of money creation itself.

With the recent pandemic causing the central banks and governments to exceed their stimulus capacity, the risk and credit challenges at banks and financial institutions are even higher. This comes on top of decades of drift in credit deterioration.

Risk management errors, which would have been a source of learning in the past, can now be existential, especially with government support tapering and social pressures increasing.

It doesn't stop here.

Measure credit risk and forget the forecast.

To make things worse, traditional financial credit risk tools and the accompanying financial, regulatory, or accounting standards continue to focus mostly on credit risk measurement as opposed to credit risk forecasting.

The traditional tools were never forward-looking or forecasting oriented to start with, and thus severely deficient in present times. Even the best financial institutions are forced to limit their tools to a narrow, sample-based review approach that misses the problems in the wider portfolio.

Forecasting tools such as value at risk and accompanying methodologies when available are obfuscated by excessive statistics and complex math, limiting their adoption or practical everyday utility.

To conclude the prologue , effective and simple but total portfolio-based borrowers' credit risk forecasting is the foundation of early risk redressal and capital preservation. It enables banks and financial institutions to proactively not only weed out bad debts but also assist their deserving customers.

Effective forecasting across the portfolio requires deep insight that cuts through layers of interlinked variables and causations that do not respect any industry segment, political or knowledge borders. This book redresses these gaps in credit risk measurement and forecasting. It aims to deliver a credit risk toolkit that is refreshing and forward-looking. It is based on street-smart applications interwoven with deep philosophy.

In this book, we will travel from a 35,000-foot view to the last few feet while still retaining a sharp borrowing counterparty focus. During our journey, we will be akin to a landscape photographer who does not overlook the sharpness of the near-most objects close to his feet while focusing on the symmetry of faraway key elements of his bigger picture.  

Most critically, during the journey, we will not lose sight of the fact that it is the inner transformation and realization of knowledge that matters more than the awareness of the knowledge per se. 

The book delivers this inner transformation and realization with a 5-step journey based on a pithy examination of the following 5 key aspects under the Credit-Cue approach:

1. Root Tools 2. Worldview 3. Molecular Portfolio 4. Exalted Mind 5. Heterodoxy

Step 1. Sharpen Your Root Tools To Measure And Forecast: A sharper but narrower set of credit risk tools for tactical counterparty assessment. Confront your assumptions about the basics to develop incisive new tools that bite hard and fast.

Step 2. Develop A Worldview To See Comprehensively Before You Measure. No Riffraff: Examine hidden corners of the world. Understanding how societies truly operate through the integrated lenses of crime, historical identities, hidden taxation, the unsaid impact of oil and gas policies, the unsaid influence of central banking, money supply, and sensuality. We also take a short digression and examine fundamental and idealistic factors for creating an equitable society.

Step 3. Harness Entire Portfolio To Vanquish Blindspots Forever: Develop tools for molecular decomposition of the entire portfolio and form the basis for an ultra-fast, comprehensive, and continuous stress-based full portfolio review as opposed to limited sample-based reviews. Surprise your bosses and auditors with your speed and accuracy.

Step 4. Hone And Anchor Your Deep Mind: Psycho-analytical tools for developing a deeper mind and cognition without endless information. What is the fundamental nature of reality and the gaps in the system of logic used by us? How to stop your faults such as ego and fear from outgrowing your ability to learn?

Step 5. How To Be A Successful Heterodox: How to successfully carry out heterodox positions in toxic organizational bureaucracies without burning your valuable bridges or leaning on self-degrading subservience? Why is heterodoxy the best tool to rejuvenate your inner self and also help others, including your adversaries?

We hope the above 5-step journey will lead to an inner change that can truly liberate the credit risk officers from their daily frustration by creating a healing and nourishing environment both internally and externally.

This may also enable wider societies to break free from endless cycles of credit pain and suffering. Before we go on the 5-step journey, let us first analyze the tragic flaws in current credit risk management procedures as well as the specific deliverables of the Credit-Cue strategy in the next two chapters.

CHAPTER ONE

THE TRAGIC FLAWS

THE TRAGIC FLAWS IN CURRENT RISK MANAGEMENT PRACTICES

6 minutes read

Any perspective that does not discern the future value of the borrower's equity will bear nothing but an imperfect insight.

Before we get into the tragic flaws in credit practices, let's quickly delve into the background of root-level causes and conditions that have created these flaws.

With increasing financialization of everything, as market volatility has increased manifolds and credit cycles have become shorter, credit skills in the financial industry have surprisingly suffered rather precipitously.

This has led to lenders’ eroding their true equity (see prologue). As noted, so much so that in many countries, including the US, the commercial banking industry may have eroded most of its equity once the commercial banking industry is consolidated with the central banks.

Some of these concerns are well recognized and reflected by high global leverage in the public and corporate sectors. However, the unrecognized extent of the challenge is only reflected in the leverage of the central banks, some of which may have touched historic highs of about 80 to 100x or more. This has been further acerbated by government budgets being in deficit.

As noted, the central banks’ balance sheets are often not consolidated with government budgets or national accounts. This allows them to continue to accumulate questionable assets in plain sight without public oversight.

Regardless, excessive unearned income via currency printing and government debt seems to have run its full course, especially with the West falling behind the East in poverty alleviation and economic growth.

While the major economies stagnate or are trying to work their way through old-style inflation via currency printing, regulatory standards may have accommodated or even encouraged leverage by focusing on credit and capital measurement but not credit forecasting.

One way this has been done is by setting lower capital or equity requirements for derivatives, regardless of the fact that such financial products are riskier than other products such as corporate loans.

Another way this has been achieved is ‘risk-weighted' capital requirements, which simply means a different level of equity is required to be applied for different types of loans based on their riskiness. Banks themselves are then allowed to undertake categorization of the riskiness of loans they make (assets in their books). This often leads to underreporting of the risk the banks carry and thus overestimates their equity capital. Under this approach, risk grading remains highly subjective no matter what the risk models say.

Risk models often end up as capital modeling tools as opposed to risk indicators or forecasters. As a side note, regular corporates do not enjoy any such provision on modeling their capital in line with the riskiness of their counterparts, such as buyers to whom they sell on credit. Why? Is that because they are not yet directly part of leverage-based currency printing?

Going back to banks and lenders, accounting standards have aimed to belatedly catch up with new standards such as IFRS 9. However, such standards are still focused on putting aside capital for expected and/or unforeseen credit losses (credit provisioning), leaving the forecasting of risk to the individual banks.

Not to forget, crisis after crisis, rating agencies have been found to be wanting. Crucially, when things fall apart, the borrower’s collateral, which the banks simply rely on, often covers only a small part of the loan.

Matters have come to a point where the solvency of many developed and some emerging countries appears to be simply dependent on demand for their currencies (as global raw materials, freight, and financial asset prices are referenced in their currencies). This is an unsaid but continuing driver of ever-increasing leverage.

Unworthy currencies simply look to enhance their value by increasing their reference to a wide variety of financial and real assets under the garb of making their availability wide and convenient, a.k.a. liquidity.

In the midst of all of this, the credit risk focus of banks and regulators remains limited to mere capital risk measurement.

This goes to the heart of the deficiencies in credit skills.

What truly matters in such an environment is credit forecasting.

This is especially relevant as the initial decision to provide a loan (underwriting) can never be perfect. Why? simply because initial underwriting views credit as a singular, but self-sufficient slice of a much larger reality.

Consequently, the vast reality, which seems daunting, is inappropriately shrunk to a self-sufficient small reality. This is done by shrinking the reference time perspective of the underwriter and by simplifying the complex underlying cause and effect underpinning the borrower's business.

As opposed to underwriting, forecasting measures the future risk of the loan in the vast and unpredictable reality created by the social and economic factors that the underwritten loan is now cast into.

This vast reality is made up of multiple social, scientific, economic, and geopolitical factors that are interacting and influencing each other in complex ways. All within the subjective compartmentalization of the world made by the often faulty perimeters of human awareness and cognition.

Scanning these large numbers of factors for relevance and deciphering their complex interactions sounds like a daunting task that few risk officers even come close to undertaking; most simply lack the required training in economics, let alone the social sciences or cognition.

Thus, unfortunately, the ability to proactively gauge or forecast credit risk continues to be lacking, especially within commercial banks and credit funds. What does this exactly mean?

The ability to forecast credit essentially relies on two aspects:

The deep but wide perspective of the underwriter or portfolio manager to enable relevant assessment of the socio-economic linkages in the operating environment of the client that truly cause cascading credit effects and

Accurate estimation and forecast of the client's true leverage and the future value of their equity.

Unfortunately, among the underwriters' community, a wide perspective has been hard to cultivate and hone.

This is due to the rising dispersion of information sources, as well as the growing impact of superficial news reporting and social media. On top of this, you have multiple rapid changes in macroeconomic, geopolitical, social, and science/technology aspects.

The formal training that underwriters go through, such as accountancy and business management, continues to be bereft of awareness of wider and deeper social, historical, economic, and scientific factors that