CREDIT RISK MANAGEMENT - SYSTEMS & PROCEDURES
Apr 19 - 25, 2010
SBP Risk Management Guideline 2.4.2, under the subheading credit origination, states: "In case of new relationships consideration should be given to the integrity and repute of the borrowers or counter party as well as well as its legal capacity to assume the liability. Prior to entering into any new relationship the banks must become familiar with the borrower or counter party and be confident that they are dealing with individual or organization with sound repute and credit worthiness. However, a bank must not grant credit simply on the basis of the fact that the borrower is perceived to be highly reputable i.e. name lending should be discouraged."
As previously discussed, the integrity and repute of a borrower can be assessed from various sources namely business and industry circles, other banks and financial institutions, stock market etc. A company's current and past financial accounts provide an easy access to the printed record of its relationship with its lenders. These accounts also give an indication of company's capacity to obtain further credit. The notes to the accounts indicate the names of company lenders who, on the condition of strict confidentiality, can be approached to share their experience with a particular borrower. Sharing of borrower information for mutual benefit is common practice among the banks and financial institutions. In case the borrower is a listing company, the trading of its shares on stock market can reveal a lot about its financial strength, profitability and dividend policy. The high volatility of its share prices should strike suspicion in the mind of a banker and he should strive to get further information about the financial stability of the company in question. Similarly an abrupt shrinkage or expansion in share trading volume should also alert a banker to an impending change of management or a sell-off.
A limited company's memorandum and articles of association clearly spell out the company's legal capacity to assume liabilities in the shape of bank credit. Proper vetting of these company documents by the legal department is the standard procedure at all banks and financial institutions. The company's financial capacity to incur fresh bank liabilities or seek enhancement of the existing ones shall be determined from company's financial accounts as well as the credit and charge registration reports issued by SBP and SECP. The rider advising avoidance of name lending purports to alert the banks against over-leveraging attempts on the part of some very reputable companies/group. These attempts might shield some speculative or uncalled for expansionary motives of an over ambitious management. In such cases a deep study of company's existing loan liabilities and the corresponding value of collaterals would be in order. The bank management may well like to abort company attempts to overburden itself with more credit by insisting for some prime security in addition to a high price tag attached to the new credit.
GUIDELINE 2.4.3 STATES:
"While structuring credit facilities institutions should appraise the amount and timing of cash flows as well as the financial position of the borrower and the intended purpose of the funds. It is utmost important that due consideration should be given to the risk-reward trade off in granting a credit facility and credit should be priced to cover all embedded costs. Relevant terms and conditions should be laid down to protect the institution's interest."
The timing and amount of borrower company cash flows can be ascertained from the company-prepared future cash flow and funds flow statements. These statements will seemingly be favorable to the company. A critical examination of these statements and its comparison with the past actual cash flow statements must be undertaken by the lending bank. Any significant variances revealed during the course of critical study should be debated with the company representatives. The structuring of facility in accordance with the company cash flows is of great importance. Every company strives to avoid the periods of liquidity crunch during low cash flow cycles. The repayment schedule should be drawn in such a way that does not land the borrower company in liquidity crisis zone. Similarly the company might experience high cash flow cycles due to seasonal sales upturns. In such situations the company may have the option of paying off its bank liabilities to the maximum as no company allows its excess cash to sit idle. Therefore, in cases of borrower companies having high-low cash inflow cycles, the banks may be required to make use of repayment schedules that allow for staggered-payments or ballooned-payments.
To ensure utilization of borrowed funds for the purpose mentioned in the borrower's initial credit request is the prime responsibility of the banks. The stated purpose might well appear to support the economy, for example setting up of an import-substitution project, etc. However, there have been incidents where the funds were diverted to a sphere of activity that held no relationship with the one declared in the initial credit request. Since the banks are required to maintain a sector wise credit allocation record, the unethical diversion of funds from one sector to another not only distorts economic indicators but also hurts the interest of various economic groups. Funds borrowed for textile sector should be used in the textile sector. There diversion, say, to stock exchange will not only create false boom conditions in the stock market but will also lower the textile output level which in turn will affect our exports. If any such thing happens, the banks will be rightly deemed to be a party to the economic misuse of funds.
Bank management decision to write new loans especially corporate loans on the basis of risk-reward trade off will largely depend on bank's liquidity position and its risk appetite. Risk appetite in turn will depend on the size of bank's NPL portfolio. A rising NPL portfolio will naturally strain bank's liquidity. So, growing size of infected loans will deter the bank from extending new credit to borrowers with low credit worthiness. On the other hand, a bank with ample, free investment funds and a small NPL portfolio might like to extend credit to not-so-sound borrowers attaching to it a higher price tag. Some special documents might also be drawn and executed to save the bank from loss in case of borrower company default to meet its obligations.