Corporate credit risk perspective in financial stability analysis

Among other functions of central banks, financial stability analysis is somewhat special – unlike other policy areas, its core concerns are risks, i.e. the tail events, rather than central estimates. For instance, it does not primarily focus on growth projected for the next year, but rather on the depth of possible recession in the same period of time, though its probability would only be limited. This is important as crisis events do occur occasionally, and then it is essential how resilient market participants are.
Analysis of credit risk in portfolios of lenders is an important part in keeping track of risks to financial stability and the resilience of market participants. Thus, it is important to look at their portfolio exposures from a very granular perspective to estimate how risky their investments could be should adverse economic events or a crisis strike. Of course, policymakers have very crude data on every borrower, but it still suffices to gain a broad understanding of the risks to financial stability.

This blog provides some of the key financial indicators that can, at the minimum, be used to estimate the credit risk and the potential impact in various economic scenarios based on a granular credit registry and financial statement data for companies.

Some of the core elements that are relevant for this analysis are the ability of companies to service debt or DSCR (debt service coverage ratio, or free cash flow  to interest and principal payments), the ability to service interest payments or ICR (interest coverage ratio, or free cash flow [1] to interest payments), and the indebtedness or leverage, i.e. Net Debt/EBITDA (or total debt/EBITDA, where EBITDA is usually a uniform EBITDA or free cash flow).

All of the above ratios are often described as being high or low depending on specific "rule of thumb" benchmarks in particular industries, the size of a company, and some other characteristics. And, when financial market players mention some ratios, they may almost always describe them as being "too conservative" or "too opportunistic". Nevertheless, they have been tried and tested over time and in many episodes of crises. There is a reasoning behind them, and though, at times, they may seem inflexible or conservative, exceeding those benchmarks may very likely result in businesses becoming highly cash constrained, underinvesting, and facing the pressure to cut costs and with a high probability of default in times of turbulence instead of using funds to invest and grow in the longer term.

Interest Coverage Ratio

The ICR ratio usually describes to what extent a company's cash flow exceeds the interest payments, and, as a result, it is indicative of the distance from default on its interest payments if a major economic turbulence such as the one caused by COVID-19 strikes, i.e. in the case of forbearance. This means that should the interest rates, i.e. the denominator of ICR, decrease, some otherwise problematic companies with free cash flow that is still positive could be saved from defaulting during the times of stress and vice versa.

There are, however, two caveats. First, the lower the market rate, the greater is the share of the total interest rate from the mark-up or the risk premium. This limits the ability to reduce the actual interest payments to zero (or a negative amount). As a result, the ICR would still hit a finite number and some companies may not be saved even by lower interest rates. Second, if interest rates are low for a long period of time even during normal circumstances, the ICR ratio becomes non-constraining and therefore less relevant. This is elaborated further in the section on the DSCR.

Debt Service Coverage Ratio

The DSCR is one of the ratios that are highly relevant for companies servicing the loans, and it is generally equivalent to the DSTI (Debt Service to Income) ratio, which is widely used as a macroprudential tool for household borrowing. The major difference between the household borrowing and the DSCR is that the latter may not have a universal threshold to be applied to companies by a macroprudential authority, since company exposures are much more diverse.

The denominator of the DSCR consists of two parts: the interest payments and the principal payments. As mentioned above for the ICR ratio, a lower level of interest may in general improve debt serviceability, but it would still be limited by the mark-up that includes a risk premium. When the interest rates become lower, the principal payments start to take up an ever larger share of the denominator resulting in a situation, when the payment schedule plays an ever greater role in determining the ability of a company to pay off its debts.

A lender would want to see that free cash flow exceeds the debt service costs by a reasonable margin. However, there is more to this story. One may ask what would happen in unexpected situations such as COVID-19 and the resulting loan repayment moratorium (postponement of principal payments in unexpected events)? It may seem that it would always be possible to extend the repayment deadline of the principal, so that only the ICR becomes relevant. Yet, whenever the repayment of the principal is delayed beyond the useful life of the assets that generate the respective income for debt service, the lender exposes itself to the future risk of an insufficient free cash flow to service the loan. Then, further down the road, the outstanding loans would also limit the ability of a business to borrow additional funds for the replacement of the old equipment. As a result, the DSTI is primarily limited by the company's free cash flow and the useful life of the assets generating it.

Leverage

Net Debt/EBITDA (or some may prefer Debt/EBITDA) is one of the most universal and widely known indicators of leverage. In general, it is equivalent to the DTI (Debt to Income) ratio, which is also widely used as a macroprudential tool for household borrowing. The benchmark ratios may vary between 2.5x and 4.5x or even more. If the ICR and the DSCR were not the limiting factors, the Net Debt/EBITDA would not have a strict natural upper limit unless the EBITDA wasn’t volatile and unknown for the future. The volatility of EBITDA is highly individual to specific industries and market factors, and this volatility may easily be overlooked, when analysing the return and leverage data on an aggregate level in normal times(in this case, the tails of the distribution matter more than the averages). To a large extent, this ratio does not discriminate between various types and purposes of loans, but is a simple, straightforward and comparable indicator that offers good understanding of the risks of a company irrespective of the loan servicing schedules (unlike the DSCR, which largely depends on the type and the repayment schedule of the outstanding loans).

Volatility of free cash flow

Free cash flow is a key element that unites the ICR, the DSCR, and the Net Debt/EBITDA ratios. It is also a key element that holds the most uncertainty and is the most instrumental in explaining why otherwise similar economic conditions may have different outcomes depending on the leverage, and why analysis at a more granular level is essential.

To start, let us define three potential situations that a company may face. First, it may already be at default, when its free cash flow is most likely insufficient to service the debt over the investment horizon even in cases, when the payment schedules are extended as far as they could reasonably be (let us call this situation Stage 3 due to its similarity to the concept in IFRS 9). Second, a company may be close to breaching the financial covenant, i.e. it has sufficient current ability to service the debt, but there is a high probability that it will not be able to service the debt throughout the investment cycle (let us call this Stage 2). And lastly, a company may have free cash flow that by far exceeds the amount necessary to service the debt (let us call this Stage 1). When a loan is granted originally, a company would most likely be somewhere between Stages 1 and 2. But as the events unfold, it may end up in any of the three stages.

In the following sets of diagrams the three stages are illustrated in terms of the probability (on the vertical axis) of having a certain amount of free cash flow (on the horizontal axis). The red lines mark the threshold debt service (the DSCR ratio of 1) (for simplicity, we may assume that it is a "stressed" debt service, when the payment schedules are extended to the maximum, considering the constraint on the useful life of the cash generating assets). The green lines mark the amount of the debt service that is "at risk" considering the ability of the company to service the debt, where the probable losses to the left from the green line would be considered acceptable and compensated by the respective applied interest rates. If the green line is on the left of the red line (i.e. the ideal debt service is lower than the current break-even), a company is either not able to service the debt, or is quite unlikely to be able to service the debt (in other words it is overleveraged).

It is clear that there is a very high probability that a company is insolvent in Stage 3. In Stage 2, a company would still be solvent, but with a high risk of insolvency. As a result, it would experience a strong push to deleverage. Furthermore, it would also be very prone to risk-taking as a sort of a gamble. And finally, in Stage 1, a company could be described as very "bankable". In this situation, it would not use the leverage to the full extent. This may even point to a higher risk aversion of the management or the owners, conservative target capital ratios, a low opportunity cost of the capital, the lack of growth potential or, alternatively, untapped growth potential.

Should the level of interest rates decrease, it would move the red lines to the left (see the dashed lines), i.e. the DSCR would increase reflecting the reduced debt service burden.

This may not suffice to make the nearly bankrupt companies in Stage 3 bankable, but it may give them an opportunity to deleverage or to remain in a "zombie" mode. It may also put Stage 2 companies in a situation, where they no longer need to deleverage excessively. Whereas for Stage 1 companies, the problem of the opportunity cost of capital would become more evident and some of them might be inclined to take on more investment projects, to increase and pay dividends, or to do nothing and to continue deleveraging. Thus, over time lower interest rates would likely result in increased leverage and sometimes hidden “zombie” companies. There may be other interactions with the level of interest rates and the leverage depending on the stage of a borrower, as well as the productive use of the borrowed capital.

Combining the outcomes

In financial stability analysis, it is not so relevant to focus on each and every borrower, as there are many other factors that affect their loan performance and are not covered by this discussion. But their financials act as building blocks to determine the total amount of loans that are more likely to reach the threshold of financial hardship affecting loan portfolios and the economy at large. It is also important to consider the cyclical nature of some industries, where the companies operate. For instance, the demand for basic consumer goods is more stable through good and bad times. Companies offering such goods may be expected to have more stable cash flows (in the charts above, they would have a narrower probability distribution). Thus, they would be less likely to exceed the critical thresholds, if they are not overleveraged to begin with. Whereas companies in cyclical industries may experience volatile cashflows (wider distribution) and may face the risk of exceeding the threshold even when they are not overleveraged.
 

[1] It is often referred to as EBITDA, but usually it is an analytically adjusted or a uniform EBITDA, where the "free cash flow" best describes the meaning of the resulting indicator.