Credit Management

Credit Management Introduction

Introduction • The term credit is derived from the Latin credo, “I believe" or "I trust." • Credit implies a condition of trust between borrower and lender that the funds (or goods) lent will be repaid.

Introduction/ Cont’d • In the past, when the economy operated on a simpler basis and Biblical prohibitions against usury were taken more seriously, a person would lend money to a friend on trust. • The success of this arrangement depended upon the assessment of the friend's creditworthiness. ("Neither a borrower, nor a lender be." –Shakespeare/Bible)

Credit Assessment What lenders look for in a Loan applications • Regardless of where you seek funding - from a bank, a non bank lender, a building society or any credit provider - the prospective lender will always review your creditworthiness prior to making a decision as to whether your loan application will be ‘approved’.

The Five ‘C’s of Credit: • The "Five C's" of credit are the basic components of any credit analysis /assessment. The 5 ‘C’s give an insight into what a lender is thinking and what the key issues that will be assessed.

5C’s /Con’t 1). Capacity-the capacity to repay a loan is the most critical of the five credit factors. 2). Credit-your credit history. 3). Collateral- asset or assets that a lender ‘secures’ by way of a loan to protect themselves in the event of borrower loan default .

5C’s /Con’t 4). Conditions- the ‘conditions’ that lenders regard when considering the economic circumstances of the overall national economy, the state and regional economies. 5).Character - the general impression you make on a prospective lender.

5C’s /Con’t • The five ‘C’s of Credit are issues that all lenders consider in one way or another. • Today’s lenders have developed robust statistical credit models that isolate poor credit risks based on historical data.

Credit approval • The process a business or an individual undergoes to become eligible for a loan. • Depends on the creditor’s willingness to lend money in the current economy and her assessment of the ability and willingness of the borrower to return the money—plus interest—in a timely fashion.

Approval/cont’d • Lenders today use new techniques and technologies to evaluate loan applicants’ business and financial prospects. • Data mining,(sorting through data to identify patterns and establish relationships ) for instance, is used by banks to analyze large pools of information and obtain insight into general trends including potential new customers and fraudulent transaction patterns

Loan Pricing • Loan-pricing decisions directly affect the safety and soundness of financial institutions through their impact on earnings, credit risk, and capital adequacy.

Pricing/cont’d • Banks must price loans in a manner sufficient to cover costs, provide the capitalization needed to ensure financial viability, protect the Bank against losses, provide for borrower needs, and allow for growth.

Loan-Pricing Methodologies • matching the competition • targeted net interest rate spread • complex, risk-adjusted return on capital (RAROC) modeling.

Factors to consider in Loan Pricing Specific consideration should be given to; • the cost of funds, • the cost of servicing loans, • costs of operations, • credit risks, • interest rate risks (IRR), and • the competitive environment.

Factors /Cont’d • A shift in any one of these components could warrant a pricing adjustment. • Banks should consider all these factors to ensure a successful loan-pricing program. Failure to do so could result in insufficient earnings to meet capital needs

Differential Loan Pricing • Institutions may employ differential or tier-based pricing programs to ensure loan rates reflect inherent risks and costs associated with specific loans or loan types.

Differential/cont’d • Differential pricing allows Banks to reflect the variances in costs associated with various loan products and provides banks with a means of "targeting" certain groups of borrowers, to ensure that equitable rate treatments are achieved within categories of borrowers as required by law.

Differential/cont’d • Interest rates may be differentiated by risk factors (e.g., credit score, risk rating, or classification), loan characteristics (e.g., size, enterprise, servicing costs, or credit factors), geographic area, or a combination of these and other factors.

LOAN RESTRUCTURING • During the term of loan, borrowers may request to restructure the loan for their project that will simplify the operation of the project or help address financial distress due to factors beyond the borrower’s control.

Restructuring/cont’d • E.g. when a borrower requests that loans be restructured to reduce administrative burden, improve cost-effectiveness and efficiency, or • A project is experiencing negative cash flow due to increases in local taxes and utilities that are rising faster than area rents.

Methods The methods used to help accomplish the objectives of restructuring include; Loan agreement (or loan resolution consolidation),- an administrative action whereby the loan agreements, or loan resolutions, for multiple projects held by the same borrower are consolidated and assigned a single new project number. The borrower still has separate loan notes and the lender still tracks each loan individually, but all projects are administered by the lender as if they were a single project;

Restructuring/cont’d • Loan consolidation, - the consolidation of multiple loans for a single property into a single loan, with one note and one payment; and • Loan adjustments (write-downs), - are reductions of the amount of the borrower’s debt, allowing an otherwise sound project experiencing financial difficulties beyond its control to continue operating as a program property.

LOAN PORTFOLIO MANAGEMENT • Effective loan portfolio management starts with the evaluation of individual credits. • Rating the risk of each loan in timely credit evaluations is fundamental to loan portfolio management. Some banks apply risk ratings to relationships, others prefer to rate each facility, and still others rate both relationships and facilities. • These evaluations allow the prompt detection of changes in portfolio quality, enabling management to modify portfolio strategies and intensify the supervision of weaker credits in a timely manner.

Introduction/Cont’d • In grading loans for supervisory purposes, there are five categories: pass, special mention, substandard, doubtful, and loss. Banks are encouraged to use these regulatory classifications as a foundation for their own risk rating systems. They are also encouraged to expand their risk ratings for “pass” credits. Using multiple ratings to differentiate the risks of “pass” credits facilitates portfolio risk measurement and analysis, pricing for risk, and early warning objectives.

Introduction/Cont’d • After each loan has been risk rated, the ratings of individual credits should be reviewed, and they should be analyzed in the context of the portfolio segment and the entire portfolio.

Introduction/Cont’d • Risk ratings can help the bank’s portfolio managers in other ways as well when they set underwriting standards, asset diversification goals, and pricing levels, for example. • Loan policy should designate who is accountable for the accuracy of risk ratings.

Introduction/Cont’d • A process should be in place to ensure that risk ratings are updated in a timely fashion and that appropriate changes are made anytime there is a significant occurrence.

Exceptions to Policy, Procedures, and Underwriting Guidelines. • Lending exceptions generally either relate to documentation or underwriting. • Banks should have systems to analyze and control both types of exceptions. • While it is advisable to identify, mitigate, and monitor all exceptions, the level of attention and reporting should correspond with the materiality of the exception.

Documentation Exceptions • “Loan documentation” refers to the documents needed to legally enforce the loan agreement and properly analyze the borrower’s financial capacity. • When a document is missing, stale, or improperly executed, it becomes an exception. Common loan documents are promissory notes, note guarantees, financial statements, collateral agreements, and appraisals.

Doc/Cont’d • Documentation exceptions can worsen problem loans and seriously hamper work-out efforts. For example, failure to ensure that financial information is received and reviewed in a timely manner can frustrate the early identification of potential problems and the opportunity to give those problems immediate attention or

Doc/Cont’d • Failure to promptly review financial information can delay the identification of covenant violations, which may jeopardize the enforceability of the loan agreement.

Doc/Cont’d • Banks should analyze document exception patterns to identify problems in the origination process as well as to identify officers, units, or geographic locations that need to strengthen their compliance with policies on documentation. The effectiveness of this control function should be reviewed by audit and loan review.

Policy and Underwriting Exceptions • Policy and underwriting exceptions are conditions in approved loans that violate the loan policy or underwriting guidelines.

Policy/Cont’d • Because underwriting guidelines are the primary means by which the bank steers lending decisions toward planned strategic objectives and maintains desired levels of risk within the portfolio, deviations from these guidelines should be well documented and justified.

Exceptions Summary • Identifying and approving exceptions is part of effective portfolio risk management. The loan approval document should clearly identify exceptions and provide mitigants that justify the decision to underwrite. This information should be kept in the permanent loan file.

Stress Testing • Stress testing is a risk management concept, and all banks will derive benefits, regardless of the sophistication and structures. • Banks commonly employ a form of stress testing when they subject various assets and liabilities to hypothetical “rate shock” scenarios to determine their exposure to changes in interest rates.

Stress Testing/Cont’d • Consumer portfolios that are securitized (e.g., mortgages, credit cards, home equity loans) are heavily stress tested during the structuring process to better gauge their risk and to determine the level of credit enhancements. • Stress testing would allow bank management to determine at what level the project could no longer service its debt. The test results could then be used to identify what percentage of the portfolio is vulnerable.

Allowance for Loan and Lease Losses (ALLL) • Banks must have a program to establish and regularly review the adequacy of their allowance for loan and lease losses (ALLL). • The ALLL exists to cover any losses in the loan (and lease) portfolio of all banks. As such, adequate management of the allowance is an integral part of managing credit risk. A major function of effective loan portfolio management is establishing and maintaining an effective process to ensure the adequacy of the ALLL. Credit management is normally responsible for developing and implementing a method of determining whether the ALLL is adequate. The method should include periodic assessments of the level of risk in the loan portfolio and an analysis to ensure that the allowance is adequate to absorb inherent losses.

ALLL/Cont’d • Credit management is normally responsible for developing and implementing a method of determining whether the ALLL is adequate. • The method should include periodic assessments of the level of risk in the loan portfolio and an analysis to ensure that the allowance is adequate to absorb inherent losses.

Credit Management Information Systems(MIS) • The effectiveness of the bank’s loan portfolio management (LPM) process heavily depends on the quality of management information systems (MIS). • Credit-related MIS helps management and the board to fulfill their respective oversight roles.

MIS/Cont’d • An ideal system would enable a banker to query, track, and aggregate all loan data fields; prepare a standard array of reports; and prepare ad hoc reports. • Bank management should assess the adequacy and accuracy of the bank’s MIS based on the size and scope of lending activities and any planned changes in the portfolio.

LENDING CONTROL FUNCTIONS • Besides the loan policy, the primary controls over a bank’s lending activities are its • credit administration, • loan review, and • audit functions.

Lending control/Cont’d • Independent credit administration, loan review, and audit functions are necessary to ensure that the bank’s risk management process, MIS, and internal and accounting controls are reliable and effective.

a).Independence- Independence- the ability to provide an objective report of facts and to form impartial opinions. • Without independence, the effectiveness of control units may be jeopardized. -Independence generally requires a separation of duties and reporting lines.

b).Credit Policy Administration Credit policy administration is responsible for the day-to-day supervision of the loan policy. The unit decides whether the policy provides adequate guidance for lending activities, determines whether employees are following loan policy, reports policy violations, and administers policy and underwriting exceptions.

c).Loan Review • Loan review is a mainstay of internal control of the loan portfolio. Periodic objective reviews of credit risk levels and risk management processes are essential to effective portfolio management. • The loan review function should go beyond transactional testing to include evaluation of how well individual departments perform.

d). Audit • While loan review has primary responsibility for evaluating credit risk management controls, audit will generally be responsible for validating the lending-related models (e.g., loan pricing models, funds transfer pricing, financial analysis software, credit scoring). • Audits should be done at least annually and whenever models are revised or replaced.

e).Administrative and Documentation Controls • The responsibilities of credit administration will vary widely from bank to bank. Credit administration is the operations arm of the lending function. • Credit administration is normally reviewed periodically by audit, loan review, or both. Concerns about the adequacy of credit administration may signal the need for more extensive testing.

NON-PERFORMING LOANS • Non-performing loans can lead to efficiency problem for banking sector. • There are evidences that even among banks that do not fail; there is a negative relationship between the non-performing loans and performance efficiency.

NPL/Cont’d • The NPL leads to a phenomena that banks are reluctant to take new risks and commit new loans- the ‘”credit crunch” problem. • Credit crunch is “a situation in which the supply of credit is restricted below the range usually identified with prevailing market interest rates and the profitability of investment projects”.

Credit Management