QUALITY OF LENDING Vs. CREDIT RISK
(A Research study on Credit Risk)
Realizing a good quality product in the market (whether it is a physical or service product) gives benefits to both organization as well as their customers. “Quality Control” means a process through which a business seeks to ensure that product or service quality is maintained or improved and errors are reduced or eliminated. Quality control requires the business to create an environment in which both management and employees strive for perfection. This is done by training personnel, creating benchmarks for quality, and testing products or services to check for statistically significant variations.
Bank is a financial institution that undertakes the banking activity i.e., it accepts deposits and then lends the same to earn profit. Lending or extending credit to needy persons is a major bank product.
‘Quality of Credit’ and ‘Credit Risk’ is interrelated. Credit Risk is inversely proportionate to Quality of lending. Credit Risk will decrease, if Quality of lending increases and vice versa. Due to poor quality of lending, banking industry is suffering with huge Non-performing Assets (NPAs). Thereby higher provisions for NPAs, lower profits, additional capital to maintain CRAR and decrease in rating of the bank etc are the side effects of poor quality of credit or lending.
Prerequisites for a good Quality Lending are:
Scrutiny of Credit Proposal:
Scrutiny of proposals submits by prospective borrowers for credit is the first step in Credit Management Process. Whether to lend or not to lend depends on ‘quality scrutiny’ of the credit proposal. Banker has to verify the authenticity of important credit information provided by the applicant in proposal form. Banker has thoroughly scrutinizes the credit proposal, thereby it increases quality of lending. Casual approach in first stage of scrutiny of proposal in credit management process will dilute the quality of lending.
Essentials of a Good Proposal:
Application for credit should be as simple as possible and should contain vital information of proposed loan. Proposal should contain the following important information:
- Brief information about applicant or promoter.
- Purpose and quantum of Loan.
- Particulars of project or proposed activity.
- Applicant’s / Promoter’s experience in the Line of Activity.
- Stake or margin amount in the proposed loan or project.
- Collateral securities to be offered for the proposed loan.
- Success Rate in earlier business (if any).
- Existing borrowing particulars (from other banks and financial institutions).
- Supply and Demand gap of activity for the proposed loan in the market.
- Economic viability and Technical feasibility of the proposed project.
Banker has to study and understand the above particulars in detail by collecting relevant information from other sources or through interview with the applicant to arrive a conclusion on authenticity of data and information provided by applicant for the proposed loan. The banker should not give any scope for wrong data, partial data, and partial answers through interview with the applicant and he should fully satisfy the correctness of information submitted by the applicant.
Skills of the Appraiser:
One of the important factors in increase credit risk is lack of appraisal skills of operating staff in lending function of the bank. After receiving the proposal, the next step is appraisal of loan as per the credit norms defined by the bank. Due to wrong appraisals some of the loans are turn into NPAs. Excess funding or shortage of lending amount will lead either misappropriation of funds or lack of finance for the proposed venture. Hence, good credit appraisal increases the quality of lending in credit function. Hence, banks should take more pre-cautions measures while selecting officials for credit function and trained them in credit management.
How to improve Appraisal Skills?
Study of credit proposal is an art as well as science. After thorough appraisal, appraiser will arrive a conclusion i.e., to accept or reject a credit proposal. This second import stage in credit management requires intelligence and good knowledge in credit management. Following are the critical areas in arriving conclusions on proposed loan to the applicant.
- Strengths of the proposal.
- Suitability of bank credit product to the applicant.
- Future prospects of the business activity / income or surplus generation.
- Access exact credit requirements of proposed activity.
- Margins, collaterals offered by the applicant.
- Valuation of collaterals and rating of the unit based on financials.
- Judgment on information provided by applicant.
- Information provided by the applicant in interview and its authenticity.
While doing the appraisal part, bank should avoid mediators and direct interaction with the prospective borrower throughout the lending process gives good results both to the bank as well as to the prospective borrower / promoter. To improve appraisal skills of credit department officials, banks should provide training or workshops on a continuous basis.
Important aspect of credit assessment:
- Credentials of the Promoters / Individuals:
Determine the character of the prospective borrower is big challenge in the lending process. If the character is good, then 20% of the quality of advance is assured and willful defaulter’s percentage will reduce. Here, character means when he enjoys a loan from the bank, his primary responsibility is to utilize the loan for the purpose he applied and repay the loan as per the terms and conditions of the loan. Hence, while appraising loan proposals, bank should thoroughly verify the loans taken from other banks by the applicant and his credit worthiness. To check this aspect, CIBIL report is one of the important tools and collects or enquires to get market information about the borrower. Due to freely availability of finance from different sources in the financial market, applicants are borrowing amounts from different sources / banks. And some of them are not repay the existing loans and are applying fresh loans from other banks. This aspect should be cross checked by the bank in an intelligent way in addition to the various sources available in this regard.
- Projections or Estimations:
Projections of sales and revenues in case of business organizations and projected income in case of individuals are to be thoroughly checked by credit officials. Over projections or estimates lead to wrong credit appraisal. Thereby account turn into bad.
For example, industry growth rate of a particular product is 5% average on year-on-year basis. But prospective borrowers who apply for a loan of same product will mention 40% to 50% projections. These areas are to be scrutinized by the Bank with authentic data available in the market. Otherwise excess finance leads to misappropriation of funds and at a later date it is difficult for the bank to recovery loan.
- Availability of Collaterals and Margins:
Collaterals for the proposed finance by the bank are very important in fixing responsibility to repay the loan by the borrower and to create an interest to involve in the proposed line of activity. Collaterals are useful to the bank to recover the dues in case of default or failure of the business or loan. Accurate valuation of the collaterals is another area to reduce the credit risk of lending process. Valuation of collaterals should be on present value and under the circumstance of forced sale and not the future appreciation value etc. Forced sale value is different from present value. In forced sale, the banker may not get even the present value of the property due to lack bidders and demand etc.
A margin of the proposed loan is another important area in mitigating the credit risk. Higher borrower’s stake or margin in the project, lowers credit risk and vice versa. 100% bank financed in certain projects is always dangerous due to borrower’s contribution is zero in the activity. Margins are useful in case of fluctuations in collateral security and also in case forced sale of primary security.
- Credit Rating:
The rating of Business firms depends upon the strength of balance sheet or financial statements, future growth of business, surplus generate from business operations, timely repayment of loans enjoyed by them earlier and also the experience and charter of the promoters or borrowers. Higher Credit Rating is a ‘Extra Collateral Security’ to the Bank. In case of individuals, the rating is depending on the annual income and net income, existing savings, financial obligations etc., In case of individuals banks are normally obtain Form 16 to arrive the income levels of individual. As borrowings are not reflected in IT Returns and personal finance from private lenders are not reflected in CIBIL report, the bankers should verify the flow pattern of credits and debits in savings bank account or current account statements to cross check the multiple lending repayments etc of the applicant.
Bank Guidelines on Credit Products / Exposure Norms:
Based on credit policy guidelines finalized by bank boards, these are advised to the operating staff or to branches i.e., guidelines of various credit products, delegation of financial powers of operating staff and also its exposure norms in various products. Credit department officials of the branches should be well versed with the above guidelines in full without any knowledge Gaps. Banks should communicate the same on an ongoing activity (whenever any changes are happening in product features, delegation of financial powers and exposure norms etc). Without good knowledge and updates on these vital areas to the operating staff, it will lead to high credit risk.
How to overcome this problem:
Communication on credit management guidelines should be on a continuous process in the bank. As changes in credit management is a dynamic and to avoid communication gaps to operating staff, changes are to be informed to the Branches or operating staff on regularly by the bank by using technology tolls like email, e-circulars, dedicated web-sites, SMS (brief information on credit instructions changes) etc. the following strategies will help in this regard.
- Random scrutiny implementation of latest instructions in credit proposals by controllers of the bank.
- Advise operating staff on credit management latest guidelines and get acknowledgement.
- Issue of codified or master circular instructions on credit management by the bank as and when instructions are frequent changes or modifications.
- Tighten the Internal Control System or Internal Audit or Concurrent Audit in credit function.
- Usage of Technology, instant communication on credit management areas or instructions.
Knowledge and communication gaps in credit management should be minimize, otherwise it leads to higher credit risk.
Demand and Supply Gap:
Study demand and supply is one of the important sub-functions in credit management process. Whether in may be a retail or business loans. If operating staff not following this important element in credit assessment, then loans will turn into NPAs due to lack of demand or excess supply for a particular product or activity. Recovery prospectus will increase whenever there is a demand for the product or activity in the market. For proper assessment of demand and supply, market information or data in respect of various credit products offered by the bank should be made available to branches or operating staff of credit department.
For example, in respect of Home Loans, banks should assess the potential of ‘Home Loans’ in the area of operation i.e., Demand and Supply of Houses. In X Town ‘demand for houses’ based on population and other factors is around 100 houses. And the existing houses available for living is 80, thereby potential gap for Housing Loans is ‘20 houses’. Accordingly, bank should finance 20 Houses in that particular area. If bank finance 100 additional Housing Loans, then supply of houses is more than demand, thereby occupancy problems for the additional home loans sanctioned by banks and these will turn into NPAs due to no income to borrowers for repayment of installments.
How to mitigate:
- Bank should arrive demand and supply of bank products in each area of operation, accordingly advance budgets are to be finalized and advise to Branches or operating staff.
- Review the same process on quarterly half yearly intervals or yearly intervals and modify or change the credit business budgets for each product accordingly.
- Collect the information on ‘Credit Gaps’ for various bankable credit products from District Level Bankers’ committee or State Level Bankers’ Committee and pass on this information to the operating staff.
Market Research / Past Trend of Recovery:
Credit department officials should update skills in respect of market information, market trends, failure rate bank loans of other banks etc. This information is not only for Business, Manufacturing and Service sectors but also Retail loans of all financial institutions in the command area of business.
This information is useful to the bank to withdraw some of the existing products, where no demand / poor recovery or excess supply than demand in the market. This information should be made available to the operating staff from time to time. Research on credit needs or requirements, unit cost of various products (maximum and minimum loan amount), credit gaps should happen in zone-wise of the Bank. All bank products will not penetrate equally across the country. Some of the Products are having more demand in certain parts of the country than in other parts.
All commercial banks organization structure is more or less in similar i.e., Zonal Office or Regional Office. Zones or Regions should study the demand of their bank loan products. For example, Home Loans demand is not similar across all places in the country. Wherever development activities are more and employment opportunities available, home loans demand natural is more.
Banks should develop:
- Zone-wise studies on bankable credit products.
- Utilize the services of chamber of commerce and industries department located in the particular zone.
- Government plans and development activities and develop suitable bank products.
- Suitable studies on agriculture, industries and service sectors and its penetration levels are to be made by the respective Zonal Office of the Bank or District Bankers committee.
- Branch-wise business dossiers are to be prepared and this helps as a tool in credit management of the bank branches.
After appraisal of credit, the loan proposal to be sanctioned by higher ups as per delegation of financial powers fixed by the Bank. While sanctioning proposals either by Controllers or Committee Approach in case of Large Proposals, scrutiny of proposals is very important. It should not be in a causal approach. It is as good as Quality Control Check of credit product released by the Bank.
While sanction a credit proposal by sanctioning authority, proposals should be thoroughly scrutinize. If any gaps, like additional information requires and wrong information in the proposal, the proposal should send back to the appraiser with full details for re-submission or rejection. Common irregularities committed by operation staff from time to time should communicate to all branches. Thereby, same mistakes will not repeat and it will improve quality of lending. These points are to be discussed by the bank during training or workshops for credit department officials.
Scrutiny of proposals is an utmost important factor in improving the quality of credit of bank advances. This is a “second eye concept” of verification of proposal and sanctioning authority is as good as Quality Control Department of Bank Advance Products.
End use of funds is one of the important aspects in the credit management process. Purpose of the loan and utilization of loan should be matched. Funds diversification is always dangerous and advance account will turn into NPA. Here, banker should ensure the objective of loan and it should not be mis-utilized by the borrower. Credit officials should pay more attention in disbursement stage. When funds or installments amount release by the bank, each and every stage ensure end use of credit.
How to ensure? :
- Credit officials should strictly implement the terms and conditions of sanction a loan and disbursement schedule without any deviation.
- If the disbursements are in stages, each stage of disbursement, the earlier amount disbursement amount is fully utilized by the borrower as per the purpose of loan.
- Frequent visits are to be made by the Credit Officials and verify the Primary Security (i.e., Asset created with Banks Funds) of the bank loan.
- If any deviations are to be noticed, further disbursement should be stopped and inform to the controllers for further action.
- Verify the documents like bills / invoices submitted by the borrower after purchase the assets with bank finance. Rates, quantity and type of product are to be verified from independent source and it should be matched with the project report submitted by the borrower.
Due to increase in volume of advance accounts, banks are not focusing on post sanction formalities of loans and advances sanctioned by them. In post sanction, end use of funds, follow-up stock statements, and activity is continue or not results timely recovery of loan and possibility for the bank to rectify the slippage of loan accounts.
Formalities to be fulfilled in Follow-up of Advances:
- Continuous contacts with the borrower.
- Frequent visits to the units and ensure proper utilization of funds.
- Timely recovery of EMI or Installments of the Loan.
- Ensure to submit stock statements etc.
- Identify major deviations or irregularities happen in the Unit and timely action.
- Both physical visit and communication should be established with the unit.
- In case of negative symptoms, legal action is to be initiated.
- Use of various Statutory Acts in recovery processes in time.
Credit Risk Mitigation Measures:
Credit Risk means default risk. Banks are trustees for the public funds. Banks are sanctioning Loans and advances with the help of depositor’s funds. High credit risk in the bank means decrease safety to depositors’ funds. Once the depositors’ lost their confidence on the bank, then it leads to Asset Liabilities Mismatch due to heavy withdrawal of funds by them. Hence, banks should give lot of efforts / energy in minimizing credit risk. Following Ten Commandments are useful to mitigate the credit risk:
- Selection of right personnel in the credit function.
- Train them on continuous basis to improve credit appraisal skills.
- Quality of lending bench mark to be fixed i.e., (99%).
- Incentives and accountability to officials of credit function.
- Post-sanction process should be strengthened.
- Strengthen internal controls & concurrent audit in credit function.
- Instant legal action in slippage accounts.
- Optimum utilization of technology and communication credit function.
- Study on regular basis on credit gaps, credit requirements, region-wise to develop and to withdraw of credit products of the bank.
- “Quality Control” in credit is to be established in each and every process or step of Credit Management.
Prevention is better than cure. Instead of putting more efforts on side effects of Credit Risk like providing more provisions, decrease in net profit and net worth, attracting more Tier-I and Tier-II Capital to maintain the required CRAR etc., banks should give more focus on “Quality of Lending”. This is only one way or remedy or best solution to overcome all problems relates to the Credit Risk in the Banks. ‘Quality Control’ of each and every step of credit delivery process is the need of hour to mitigate the credit risk in the banks.
By CMA Dr. P. Siva Rama Prasad