Credit risk management

Curbing misuse of funds


May 3 - 16, 2010

SBP guideline 2.4.4 states:

"Institutions have to make sure that the credit is used for the purpose it was borrowed. Where the obligor has utilised funds for purposes not shown in the original proposal, institutions should take steps to determine the implications on creditworthiness. In case of corporate loans where borrower owns group of companies, such diligence becomes more important. Institutions should classify such connected companies and conduct credit assessment on consolidated/group basis."

As previously discussed, the diversion of bank funds away from the purpose indicated in the initial credit request is tantamount to misuse of funds and the corporate banker should guard against such happenings. The misuse of bank funds in the stated manner could take different forms which may include:

- Use of funds for some speculative purpose, for example stock market investment, commodity or currency market investment, property investment etc.

- Diversion of funds to another group company that may not qualify for a corporate loan for various reasons.

- Transfer of funds to some other country for the purchase of foreign assets or for non-productive expending.

- Placement of cheaper funds export refinance etc. in high-return investment with varying degrees of risk.

Diversion of funds to speculative markets can have more serious implications than any other form of misuse may have. In market crash scenario, the user of bank funds will not only find himself tied up for an unlimited period of time but will also be exposed to the threat of huge losses. In either case, the borrower wouldn't be able to meet its obligation of observing the mutually agreed repayment schedule.

In case of unsuccessful speculation, there is every possibility and that has been the norm - that the realized losses will be transferred to the books of the company. If so happens, the profitability of the company will be dented and the common shareholders of the company will suffer in consequence. Hiding of these losses behind the core business operations will become the first priority of the speculating borrower, while the timely settlement of bank liability will become a secondary issue.

In market boom scenario, the speculators are very likely to make huge profits if they manage to offload their holdings at the right time. The bank may not feel the heat in such cases as no repayment issue will surface. The damage to the economy in any case will be done as the stock market boom could well be the result of a temporary over investment situation triggered by a mass scale diversion of bank funds loaned for business and industrial activities.

Even if the speculators manage to make huge profits, the common stock investors will be the ultimate sufferers. The same implications will arise in case of commodity, currency and property market speculations. In case the borrower is a manufacturing company, such misuse of bank funds will adversely affect the output besides putting liquidity pressures on the company. If the misuse of bank funds is made on a large scale, the real sector will obviously suffer while the artificially created speculative market booms will hurt the economy in a different way.

The investor confidence will be shaken and foreign funds inflow will be choked. The losses to the uninitiated common investors will also have a long lasting effect on the economy. The cumulative effect of this financial scam could be a marked slippage in macroeconomic indicators.

Diversion of funds to some other group company with weak financials and dubious standing is another common way of misusing bank credit. Loans are generally obtained in the name of the flagship company with strong financials and good market standing. The transfer of funds generally appears on the books of the two companies and could be detected by a shrewd corporate banker. The transaction is showed as inter company borrowing/lending. The loan could be interest free or interest-based. If it is interest free, then the bank borrowing cost is borne by the original borrower company which is unjust and to the detriment of the common shareholders of that company.

Since the bank funds are transferred to another group company in an underhand manner, it is difficult for the bank to keep track of the use of the lent fund. The ultimate user of the bank funds could be a new venture with a low success probability, or a defaulter company with huge unmet commitments. Moreover, it could fall in an altogether different sector of economy and the transaction could mean the circumvention of sector wise credit allocations.

Finally, the ultimate user of the fund could be a special purpose vehicle (SPV) created to use bank funds in an unlawful manner.

To arrest this trend, the borrowers' basic fact sheet should be studied carefully and the borrowing company should be asked to name all of its group companies. Financial accounts of all group companies should be obtained. If the borrower is used to such misuse of funds through inter company transfers, there is every possibility that the corporate banker will be able to detect it through a detailed study of all group companies financial accounts.

In case it is the first attempt and the banker has a reason to doubt the transparency of fund utilization, he may like to involve himself more intensely by attaching a loan disbursement condition that authorizes the bank to make direct payment to the suppliers of goods/assets or providers of services.

If the misuse or unlawful diversion of funds is detected after the disbursement, the bank should reassess the position by compiling the aggregate liabilities of the group besides ascertaining the market value of its mortgaged assets and collaterals.

In case the bank feels that the creditworthiness of the borrower has been materially altered, it may either call its loan or ask for additional collaterals to sufficiently cover its risk.