Principles of Lending PDF

T O (N SE FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO ) CHAPTER 4 PRINCIPLES OF LENDING 4-1 PRINCIPLES OF LENDING 4. PRINCIPLES OF LENDING Learning Outcome At the end of the chapter, you will be able to: ) Illustrate the credit process cycle including lending principles and risk assessment...

T O (N SE FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO ) CHAPTER 4 PRINCIPLES OF LENDING 4-1 PRINCIPLES OF LENDING 4. PRINCIPLES OF LENDING Learning Outcome At the end of the chapter, you will be able to: ) Illustrate the credit process cycle including lending principles and risk assessment FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO Key Topics SE criteria. In this chapter, you will be able to read about: Introduction to Lending The Credit Risk Process Cycle Principles of Lending Credit Analysis: Credit Risk Assessment Scope of Credit Risk Assessment Assessment Criteria During the exam, you will be expected to: Describe the constituents of the credit risk process cycle. Explain the principles of lending. O T Demonstrate the approach and process to credit risk assessment. (N 4.1 INTRODUCTION TO LENDING Lending is the primary commercial activity of a commercial bank (see Figure 4.1 for the goals of lending). The bank utilises the funds received from depositors in the form of savings, time and current account deposits to provide loans to individuals, businesses, and government agencies. A lending institution’s key to success is the ability to channel depositors’ funds into loans in a controlled manner, thus ensuring: The risk of borrowers failing to repay their loans on time or repay at all, otherwise known as default, is minimal; There are sufficient funds in reserve to provide depositors with access to their funds on demand, when needed; The amount of interest received from loans exceeds the amount of interest paid to depositors to generate a profit. CERTIFICATE IN CREDIT PRINCIPLES OF LENDING 4-2 Lending is always fraught with risk; the process requires highly proficient credit officers who can minimise the risk by making the right decisions based on complete information on loan applications. Failure to do so could result in impaired loans to hinder the institution’s ability to meet its payment obligations to depositors. Impaired loans can adversely impact both the profitability and liquidity of a lending institution. This, in turn, could trigger a loss of confidence in the lending institution. ) The worst-case scenario could see the collapse of the institution, or intervention by FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO SE Bank Negara Malaysia (BNM). Funds received from depositors Loans are made to borrowers Borrowers repay loan with interest Interest is paid to depositors Profits are generated from the difference in interest received and paid Figure 4.1: The goals of lending 4.2 THE CREDIT RISK PROCESS CYCLE The credit risk process cycle (see Figure 4.2) illustrates the entire operational flow of the lending process, from the origination of a new loan application to full repayment. The credit risk process must be consistently and efficiently applicable to all new loan applications. Full responsibility for the function of the end-to-end credit risk process cycle belongs (N O T to the credit officer. Defining a written report Analysing credit risk and structuring loans for decision Acceptance of facilities offer by borrower & perfection of security documentation Monitoring loan performance Figure 4.2: The credit risk process CERTIFICATE IN CREDIT Settling or recovering the loan PRINCIPLES OF LENDING The credit risk process is generally divided into five discrete parts: 1. Defining a written report 2. Analysing credit risk and structuring loans for decision 3. Acceptance of the credit facilities offer by the customer and perfection of security documentation SE FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO 5. Repayment or recovery of the loan, in the event of default ) 4. Monitoring loan performance 4.2.1 Defining a Written Report The commercial bank start the process with a written report identifying the following: Priority sectors and target markets for lending Lending products that are relevant to the target markets Key businesses and corporations that are potential business loan customers Key groups of individuals that are potential consumer loan borrowers This phase is conducted based on the bank’s business plan and internal lending policies; it must also fall in line with BNM’s periodic directives and guidelines. Each identified target market’s risk asset acceptance criteria (RAAC) is set based on factors such as potential repayment ability, sources of income and T cashflow, availability of collateral, and performance track record. O 4.2.2 Analysing Credit Risk and Structuring Loans for Decision Making Credit risk analysis is the second phase of the credit risk process cycle and (N 4-3 involves the review and analysis of the loan applicant, based on the following: Financial information, e.g., audited financial statements and financial forecast and plan Non-financial information, e.g., product information, type of business, management acumen, character, industry and business conditions Other information, such as past borrowing history and security offered A loan applicant’s credit risk identification and analysis provide a basis to derive an opinion regarding the applicant’s ability to repay the loan. If the repayment risk is high, the loan can be declined or modified (in terms of the amount, tenor, interest margin and/or imposition of covenants) to mitigate the key risks identified. In short, the credit officer needs to be satisfied that the CERTIFICATE IN CREDIT PRINCIPLES OF LENDING 4-4 applicant has sufficient potential cashflow from core operations for future loan repayments. Once the applicant is acceptable to the bank, the credit officer will structure the proposed credit facilities to meet the borrower’s needs while complying with the bank’s lending guidelines. The credit officer will obtain a credit decision on the loan application from the Credit Authority normally based in SE ) Credit Risk Management. Credit risk analysis is revisited in greater detail in Section 4.5 Scope of Credit FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO Risk Assessment. 4.2.3 Loan Issuance and Security Documentation When a loan application has been approved, the applicant will be notified with a letter of facilities offer. Should the applicant accept the facilities offer, a loan agreement and other security documentation, as appropriate, will be prepared for the applicant to execute and return to the bank’s legal documentation department or to the bank’s solicitors, if outsourced. The documentation will be stamped for legal effect and registered with relevant government agencies, if required. The authorised loan documentation officer will issue a security compliance certificate to the loan administration department when all necessary documentation steps have been completed. Loan Administration will place the facilities at the borrower’s disposal, usually by keying in the limits into the transaction processing system. At this point, the loan applicant is deemed the legal borrower. It is important to ensure there is a separation of duties and responsibilities T between the credit marketing officer, the officer in charge of legal/security O documentation and the officer in charge of loan administration. This provides (N independent check and control within the lending institution (see Figure 4.3). All legal documentation must be complete and maintained securely by the lender for future reference; this is especially useful in case legal issues arise in the future, including lawsuits against defaulting borrowers. The lending institution’s legal department will advise on general matters relating to law and banking operations. The drafting of legal agreements and filing of documents are often prepared by professional lawyers who are responsible for the legal advice and services provided to the lender. CERTIFICATE IN CREDIT PRINCIPLES OF LENDING 4.2.4 Monitoring Loan Performance The credit risk process does not end with the disbursement of the loan. The lender must monitor the loan account to ensure the borrower meets all obligations, including loan repayments, in timely fashion. The credit officer remains accountable and responsible for the end to end ) account relationship. The credit officer will be assisted by the loan monitoring SE department in monitoring the daily account operation and promptly alert the credit officer to any red flags. The department is responsible for carrying FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO out regular reviews of the borrower and the credit facilities, at which time the borrower’s credit risk profile may be revisited to determine whether the facilities can be renewed or otherwise need to be modified. At the very minimum, loan review should be conducted annually; however, adverse changes in risk profile may require more frequent reviews. The loan administration department is responsible for the tracking of antecedent conditions, renewal of fire insurance, computation of drawing limits as well as related matters. Once specific weaknesses in the loan are identified, the loan monitoring department must advise the appropriate credit officer to take immediate O T action to avoid further weakening of the loan. (N 4-5 CERTIFICATE IN CREDIT PRINCIPLES OF LENDING 4-6 SE ) CREDIT OFFICER Assesses and makes a recommendation on the loan application The recommendation is based on principles of lending after a thorough assessment of the applicant’s credit risk FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO CREDIT AUTHORITY Makes a decision on the loan application submitted by the Credit Officer OFFICER IN CHARGE OF DOCUMENTATION Facilities offer accepted by customer Draws up documentation based on the approved terms and conditions Ensures that loan terms are made in accordance with the bank’s risk acceptance criteria and internal loan policies T LOAN ADMINISTRATION OFFICER Disburses loans in accordance with loan compliance certificate and bank policies Monitors collateral (if any) and loan performance conditions, covenants and renewal of insurance policies, licences, etc (N O This critical separation of roles ensures adequate check and balance are in place, and minimises the risk of conflicts of interest and fraud. Figure 4.3: Checks and balance accorded by the separation of duties and responsibilities 4.2.5 Repaying or Recovering the Loan The final phase of the credit risk process, namely the repayment, will ultimately decide the success of the loan. There are two possible scenarios: a. If all repayment obligations are met within the specified time period, the settlement of the loan is deemed ‘regular.’ b. If the borrower encounters problems in servicing the loan, the bank may have to take necessary action to recover the outstanding balance. These actions could include the renegotiation of the terms of the credit facility to CERTIFICATE IN CREDIT PRINCIPLES OF LENDING extend the tenor of the loan; it could also mean the transfer of the account to the Bank’s loan recovery unit for rehabilitation and/or initiation of legal action to recover the loan, if necessary. The bank may undertake the sale of assets held as security against the loan, depending on the circumstances. Observations and historical data of past loans performance indicate loan recovery actions typically require the bank to write off part of the loan (interest, ) outstanding principal sum, or both). As such, it is in the lender’s best interest SE to ensure that each loan undergoes a thorough credit risk analysis process FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO at the outset and loan monitoring is effective to identify potential problems early for prompt remedial action. 4.3 PRINCIPLES OF LENDING Lending is a well-established discipline that has evolved over centuries of practice. Although the final shape of the loan will depend on the individual circumstances of the applicant and the results of the credit risk analysis, the loan will ultimately be based on several key lending principles. The key lending principles are: 1. Principle of Risk-Taking in Credit and Lending 2. Principle of Prioritising Credit Quality 3. Principle of Risk Diversification 4. Principle of Productive and Purposeful Lending 5. Principle of Protection 6. Principle of Control T 7. Principle of Proportionate Stakeholding O 8. Principle of Tenor Matching 9. Principle of Pari-passu (N 4-7 Each of these principles is described in more detail in the following sections. 4.3.1 Principle of Risk-Taking in Credit and Lending Risk is part and parcel of the lending process; there can be no lending without risk. For effective, non-defaulting loans, credit officers must be able to: identify risks that can cause the credit to be vulnerable; and mitigate or control the risks with measures imposed on the borrower or through the structure of the loan at the outset. CERTIFICATE IN CREDIT PRINCIPLES OF LENDING 4-8 While risks cannot be completely eliminated, they can be managed effectively. To do so, the risks associated with the loan must first be identified. If the identified risks cannot be adequately mitigated and controlled, then the credit proposal may have to be turned down. Hence, credit officers must view risk identification as a crucial step in risk management. However, the identification of risk does not, automatically ) mean that a loan application must be rejected; it is an intermediate step in SE the credit cycle and serves as a basis upon which to undertake in-depth risk FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO analysis. Finally, risk management does not mean risk avoidance or risk aggression. Given that there are multiple stakeholders in a financial institution who will be impacted by the results of poor credit decisions, ranging from depositors and shareholders to borrowers, credit risk should be taken on a measured basis with due regard to regulatory requirements and financial prudence. The bank’s credit culture guides the practice of good credit. “Credit culture” can be defined as an accepted set of values within the institution that protects the organisation from poor quality loan assets. As a bank-wide culture, it is to be shared and embraced by bank staff at all levels regardless of their roles within the credit function or outside of the credit function. A strong credit culture helps govern the business strategies and administrative actions of the bank’s management and its officers, and develops positive recognition from the external market environment. It engenders confidence among its depositors and investors, and brings pride among its credit officers. It also discourages bad practices, fraudsters and high-risk entrepreneurs from taking advantage of the bank. T The credit culture is initially articulated at the board level using published O information from BNM. It must then be deliberated, delivered and accepted (N by the directors of the bank and the stakeholders. Once approved, the key aspects of the credit culture are restated into a policy for all levels of bank management, encompassing the directors, the Chief Executive, senior management and operational managers. A strategy is then formulated to promote the credit culture among all bank employees, who are expected to uphold its key values at all times. Important steps in promoting the credit culture would generally include: bank-wide dissemination of the credit culture and its policy content; promotion of the importance of the credit culture and communication of the expected adherence to the credit culture across all bank levels; adoption of ‘quality first’ policies in all credit decisions with little or no exceptions; CERTIFICATE IN CREDIT PRINCIPLES OF LENDING continuing training and reminders of credit ideals at all levels of operations; and recognition and awards for best credit practices within the bank. 4.3.2 Principle of Prioritising Credit Quality ) The safety of a loan is always a higher priority over the value of the loan or SE of its potential profit. The cost of an impaired loan can potentially be very FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO high, as it comprises not just the loss of the principal sum but also the loss of interest income and significant staff time to manage an impaired loan. The following figure illustrates the impact of a credit loss (see Feature Box): SCENARIO: An illustration of the impact of credit loss If a loan of RM1,000,000 earning an interest rate of 10% p.a. has defaulted with no chance of recovery, the total loss for the lender would be: Principal loss RM1,000,000 Interest loss 1 year RM100,000 Total loss for the year RM1,100,000 If the bank makes a net interest spread of 2% (interest charged to borrower, less interest cost paid for depositors’ funds), then the bank must generate new loans worth RM55,000,000 to recover RM1,100,000: Net interest spread 2% New loans to cover loss RM1,100,000 / 2% T = RM1,100,000 / 0.02 = RM55,000,000 O (N 4-9 If the initial RM1,000,000 loan as described above is an average loan size for the bank, then the bank must work 55 times harder just to cover the loss from this single bad loan. Thus, loan safety must always remain the foremost priority for the lender, over and above the demand for profit and asset (loan) growth. 4.3.3 Principle of Risk Diversification Good risk management practice requires that lenders avoid concentrating their loan exposure to a few borrowers or a particular industry. For this reason, Bank Negara Malaysia (BNM) imposes restrictions on single counterparty exposure (for more information, see sub-topic 2.3.2 in Chapter 2). This is to avoid serious CERTIFICATE IN CREDIT PRINCIPLES OF LENDING 4-10 weakness in the loan portfolio should one or two borrowers’ default on their loans. For example, if a bank were to tie up all its assets by lending all its money to one company, the failure of that one company would be disastrous for the bank. No matter how hard a lender works to minimise the risk of a loan ) default, it is impossible for the risk to be completely mitigated. SE However, by spreading loans over a diverse group of borrowers, lenders can reduce the risk of catastrophic losses to their statement of financial position. FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO The same argument is true when it comes to concentrating loans in specific industries, as a downturn in that industry could cause loan losses to the lender. 4.3.4 Principle of Productive and Purposeful Lending Business loans should be for productive purposes. This means that they are disbursed for a specific purpose that will help the borrower generate greater income and cashflow for future loan servicing. A productive loan has built-in income generation from the activities it finances, as compared to a non-productive loan. In other words, the loan extended to the borrower will generate the required cashflow to repay the loan. Business loans are generally assessed based on this criterion. Example: Productive vs Unproductive Loans Productive Loans Unproductive Loans Loan made to a manufacturer to Loan made to a company to purchase equipment or expand (N O T premises repay another loan Loan made to an importer to pay Loan made to a company to pay Loan made to a company to Loan made to a manufacturer for wholesale goods purchased invest in proven technology dividends to its shareholders which is to be used in a manner that does not fit its business model In this context, the credit officer should have a clear understanding of the borrower and its business and be able to analyse how the loan would be used, as well as the identifiable sources of cashflow for repayment and major risks associated with the business. In essence, this is the core principle of credit risk assessment. CERTIFICATE IN CREDIT PRINCIPLES OF LENDING In consumer lending there is a shift of focus from the loan and its use to the productivity of the borrower. Housing and personal consumption loans can be granted to a borrower who is economically productive even though the loans are not used to enhance income or cashflow. So long as the consumer is capable of generating income, he or she is deemed productive. If the borrower remains productive and services the loan, the loan can be SE FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO 4.3.5 Principle of Protection ) deemed acceptable. A bank is obligated to protect its loan exposure from default to ensure the integrity of its business and maintain the confidence of its depositors and investors. Loan protection requires that the bank obtain necessary security, also known as collateral, or other support such as guarantees, to ensure the borrower has an alternative means to repay outstanding loan obligations. Assets used as security against a loan may be considered strong protection of the loan, if that asset value is adequate, i.e., it matches or is worth more than the value of the loan, and legally realisable to recover the loan. Otherwise, the security is considered weak protection. Although the Principle of Protection suggests that lenders must protect the loan in some manner, it does not demand that loans must always be secured. The manner of protection required will depend on how the loan is structured. For example, the viability of a business and its foreseeable cashflow can offer some protection for the loan, as the borrower is likely to be capable T of generating the cash necessary to repay the loan at a future date. In O contrast, highly volatile business prospects with uncertain cashflow offer little protection for a loan. (N 4-11 If the credit has been predicated on the need for collateral in addition to business viability, then the lender must ensure that the loan is protected by collateral of adequate quality and value, and is backed by a viable business model. However, if the credit is not predicated on the need for collateral, for example in unsecured project lending, then the lender may impose covenants to ensure that cashflow from the project will be available to repay the loan. 4.3.6 Principle of Control This principle concerns proper structuring of facilities to ensure that the lender is in control of the loan. Businesses often make the mistake of using a loan proceeds for unintended purposes, which may hurt the prospects CERTIFICATE IN CREDIT PRINCIPLES OF LENDING 4-12 of repaying the loan. Hence, the structure of the loan facility must give the lender sufficient control such that funds drawn from the facility are used for the original purpose when the loan was first approved. To achieve this, the loan will be structured to enable the credit officer to monitor the use of the loan proceeds. Any deviation from the original intended ) purpose must be regarded as a warning signal. SE Control can also be placed on the potential sources of funds for the repayment of a loan. This will ensure that funds are not diverted, which may jeopardise FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO loan repayment. Example: Principle of Control ABC Bank has extended a loan worth RM50,000 to XYZ Bhd to purchase a neighbouring piece of land to expand XYZ’s manufacturing capacity. To ensure that the additional revenue derived from the usage of the purchased land is used only for expanding manufacturing capacity, John, the credit officer, obtains the Borrower’s instruction to put in place an auto-debit system that will transfer the monthly loan obligations from XYZ Bhd’s revenue account into ABC Bank. XYZ Bhd makes use of the additional land to generate greater revenue, which is then used to repay ABC Bank. The loan is repaid on schedule, concluding a successful loan transaction. It is easy to see how the funds can be misused without these precautions put in place. Let’s say John does not make the above arrangements for the auto-debit and XYZ Bhd uses the cash from the additional revenue received to provide an advance to XYZ’s shareholders. XYZ Bhd’s cash flow T may not be adequate to service its loan. (N O The company will fail and ABC Bank will have to take the necessary loan recovery action. 4.3.7 Principle of Proportionate Stakeholding The Principle of Proportionate Stakeholding states that the borrower should invest sufficient capital in the business and not rely solely on the lender to finance all of its business and investment requirements. The lending bank must ensure that business owners are sufficiently committed to their business. For this purpose, the borrower must prove to the lending bank that it has invested sufficient capital as evidence of the commitment. A low capital commitment increases the risk of default as the loss suffered by the borrower is minimal compared to that of the lender. CERTIFICATE IN CREDIT PRINCIPLES OF LENDING In addition, the borrower who owns the equity of the company and enjoys the profit derived from taking the business risk should fully assume the business risk. The lending bank should only be expected to take the lending risk. As the equity owner of the company, the borrower should also be the risk taker and show more upfront commitment compared to the lending bank. For the same reason, a margin of contribution by the borrower is stipulated for SE margin of financing will always be less than 100%. ) loan proposals; this includes consumer loans. In other words, in a loan, the FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO For example, if the borrower intends to invest in a property, its margin of contribution may be 30%, which means the borrower has to invest its own capital, up to 30% of the value of the property. Correspondingly, the margin of financing will be 70%. 4.3.8 Principle of Tenor Matching Generally, the risk of default to lenders is higher if the tenor of the loan is longer. This is because risk increase with time due to a higher level of uncertainty. However, credit officers should not only focus on the risk aspect and ignore the borrower’s needs. Lenders should not structure short tenors for loans where borrowers clearly require a longer period of time to repay. This is tantamount to the bank lending with an expectation that the borrower will default. The Principle of Tenor Matching states that the duration of the loan must match the borrower’s needs and cash flow availability based on the purpose of the loan. For instance, a short-term loan given for a long-term requirement increases the prospects of the borrower defaulting, while a T long-term loan given for a short-term requirement can lead to abuse of the O facility after the need has been met. (N 4-13 4.3.9 Principle of Pari-passu ‘Pari-passu’ in Latin means equal standing. The principle of pari-passu relates to the relationship between a lending bank and the borrower, and between the same borrower and other lending institutions. In any loan, the lending bank should always avoid having a lesser or disadvantaged position in comparison to another lending bank. For example, security arrangements and credit support for a loan from a borrower should be made available to all lending banks on an equal priority or a pari-passu basis. Any lender who has a lower priority would be at a disadvantage. CERTIFICATE IN CREDIT PRINCIPLES OF LENDING 4-14 The lender should be mindful of the type of borrowing in deciding whether it should be on a pari-passu basis with other lenders. For instance, some bank policies state that it is acceptable for trade facilities which are short-term to be granted on an unsecured basis and term loans which have a longer tenor to be granted on a secured basis. For example, if a borrower has been granted trade finance facilities on an unsecured basis ) by all its lenders, then all the lenders are on a pari-passu basis. If one of the SE lenders, subsequently provides a term loan secured by a factory building, FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO the other lenders should not insist that the factory building be shared proportionately to maintain the pari-passu status. 4.4 CREDIT ANALYSIS: CREDIT RISK ASSESSMENT Credit analysis is the second part of the credit risk process cycle and is the basis of any credit decision. The risk analysis begins when there is sufficient information and data about the loan applicant and its business activities. If the information is out of date or incomplete, the credit risk analysis process would result in a flawed judgment of the repayment prospects of the loan applicant. The goals of completing a credit analysis are to: examine the nature of the borrower’s business in the context of its industry; identify and quantify the business risks; evaluate the borrower’s cashflow projection and the underlying assumptions to establish the likelihood of repayment during the loan duration; and recommend a suitable structure of loan facility in light of the perceived financing T needs and risks. O A credit risk analysis exercise is an objective appraisal of the borrower and its (N business. It involves making a credit decision in an environment where there is uncertainty and often a lack of complete information. These elements of uncertainty and incomplete information stem from the fact that typically credit officers are unable to obtain perfect, timely, relevant or accurate information about the borrower. The problem is further exacerbated when borrowers intentionally withhold information that may have an adverse effect on the borrower’s creditworthiness. The competitive and dynamic market environment invalidates current information quickly, which means obtaining accurate information is almost impossible. Nonetheless, credit officers must always try to get the most current and accurate available information, even if perfectly complete information is unavailable. Information for the credit risk assessment can be obtained from various sources, including, but not limited to, the borrowers themselves, trade associations, government agencies and industry peers. Public domain publications such as magazines, newspapers, trade journals and the internet can be a source of CERTIFICATE IN CREDIT 4-15 PRINCIPLES OF LENDING information. The lender’s database can be an important source of information. The credit officer must be discerning when mining the various sources for relevant information. External credit reports include the Central Credit Information System (CCRIS), Financial Information System (FIS), BASIS, CTOS, CBM and Experian. The CCM, and Jabatan Insolvensi Malaysia are also valuable sources of information. They provide ) essential information about a borrower’s payment track record and other details. SE Further information can be obtained from the DCHEQS, as well as the lender’s FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO database. Information from the various sources will affirm an applicant’s credit status and/or impending legal issues. It is the responsibility of the credit officer to assess the reliability of information sources. It is particularly important to verify information provided by the borrower to prevent fraud or undue optimism. The credit officer should always be objective in undertaking a risk assessment on a borrower. Care must be exercised in distinguishing facts from opinions as thirdparty influences and opinions are abundant. Lending is a commercial activity but prudence in risk acceptance criteria must take priority over maximising return to shareholders. 4.5 SCOPE OF CREDIT RISK ASSESSMENT A Credit Risk Assessment can be based on information from many different sources. To obtain the most accurate picture of a borrower’s potential risk and repayment ability, the following issues must be answered as completely as possible: Background information and credit base identification O T Key information, especially if the borrower is an organisation (N External operating environment, including competition and political climate Management acumen Financial feasibility and sources of future cashflow Commitment to the present and future, especially business plan and strategic initiatives Details regarding collateral offered for the loan 4.5.1 The Borrower’s Background The credit officer needs to establish the identity, location and the legal status of the borrower as a business organisation. Relevant details include shareholders’ and directors’ information, as well as important information regarding related parties such as parent companies and subsidiaries. CERTIFICATE IN CREDIT PRINCIPLES OF LENDING 4-16 Details of the applicant should be captured in a formal loan application proposal or a standard loan application form provided by the bank. The information is important for legal and other future purposes, such as verification. Applicants of dubious background or with insufficient information represent heightened risk. Barring exceptional circumstances, the credit risk 4.5.2 Key Information about the Borrower SE ) process should not continue beyond this point. FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO A comprehensive description of the business organisation and its activities should be obtained to provide an overview of the applicant’s business, products and/or services together with a description of its markets. Additional information about key processes, including the production and marketing of products and services, should be included in the application. Other important information that must be added to the assessment file include: Information on senior people managing the business, including their experience and expertise An organisational chart, to identify key roles The business management processes Credit officers can obtain such information through company visits and meetings with the borrower’s senior officers. On-the-ground observation of the company premises, stockyards, processes and level of business activities T will contribute to a better understanding of the borrower’s business. O 4.5.3 The Borrower’s External Operating Environment (N The loan applicant’s business will typically operate alongside other competitors, and will be subject to the various external factors that impact the industry as a whole. Industry-wide statistical information, as well as a comprehensive knowledge of the various regulations and market trends affecting the business, will significantly help to make well-informed judgments. Credit officers must also be aware that some businesses are more sensitive than others to macro events; an economic downturn will affect some businesses more than others. In considering an application, the credit officer must consider the following factors: a. The likelihood of a negative change in the operating environment; b. How would the change affect the borrower’s business; and c. Whether the borrower would be able to service the loan if a negative change occurred. CERTIFICATE IN CREDIT PRINCIPLES OF LENDING Each sector has its own specific nuances and sensitivities, and credit officers must determine what those are, through applicant interviews as well as other means of research. For instance, the palm oil industry is highly dependent on the availability of unskilled labour to operate efficiently, and a shortage in the workforce may have significant consequences for the industry. A credit officer should also be aware of political swings or impending changes ) to economic policy, which may influence the business sector for better or SE worse. A credit officer must be knowledgeable and keep abreast on current FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO events. 4.5.4 Management Acumen The integrity of the company’s board of directors and senior management team, including the latter’s business acumen and performance track record are important considerations in building confidence during the credit risk evaluation process. Other considerations include the borrower’s understanding of its risk management processes, problem-solving abilities, and forward-looking capabilities in a volatile economic environment. 4.5.5 Financial Feasibility and Sources of Future Cashflow The applicant should provide a business plan and a forecast of its future business that shows prospective income and expenses, as well as cashflow projection for loan repayment. The company’s cash generated from core operating activities is the primary source for loan repayment, and is typically referred to as “the first way out.” T The credit officer’s responsibility is to evaluate the risks that can cause the O plan to fail, rendering financial objectives unachievable. The plan must contain assumptions such as the quantity of sales, selling prices, and costs (N 4-17 of operations over a period of 12 months. The forecast must also provide estimates of customer purchasing patterns and payment arrangements. Examples of risk events that can jeopardise the business plan include events such as economic recessions, the emergence of other competitors in the market, and potential increase in raw material costs. The credit officer must evaluate the likelihood of these risks and the impact on the business plan. The credit officer’s assessment of these items will become integral to the lending decision. Loan applicants should have this information at hand with well-researched data backing their forecast data. Applicants that do not have well-organised information should raise a warning flag; this signifies that the applicant may not be managing the business well. CERTIFICATE IN CREDIT PRINCIPLES OF LENDING 4-18 4.5.6 Commitment for the Present and Future Loan officers must establish that a borrower is committed and confident in its business before agreeing to consider the loan. Some questions that a loan officer should consider include: performance? SE b. How much control does the borrower have over the company? ) a. Is the borrower a key beneficiary of the business and committed to its FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO c. How much initial capital has the borrower placed in the company? A loan commitment extends into the future when conditions can vary and numerous changes occur. The borrower needs to convince the bank that it is serious about the business and has the capacity to meet its debt-service obligations. 4.5.7 Collateral Arrangement for Protection Procurement of collateral from the loan applicant plays a dual role in that they are both indications of the applicant’s commitment to the business as well as assets securing the bank loan. Insufficient collateral raises the lending bank’s dependence on the borrower’s prospective cashflow for the full repayment and protection of the loan. Informational details about the collateral should be available and verifiable by the bank. Valuation reports, certificates of ownership and purchase invoices are all suitable for verification. Collateral values change from time to time due to economic conditions as well T as other factors. Assets can depreciate over time, while personal guarantors O can become financially distressed. At the same time, property values fluctuate (N and can be affected by natural disasters, such as earthquakes, floods or by changes in government policies. In light of these potential changes, the lending bank must regularly monitor the value and performance of the borrower’s collateral and take appropriate action should the value of the secured asset drop below a certain percentage. CERTIFICATE IN CREDIT 4-19 PRINCIPLES OF LENDING PRACTICE QUESTIONS (INDICATIVE ANSWERS CAN BE FOUND IN THE TOPICS LISTED FOR THE RESPECTIVE QUESTIONS) 1. Describe the credit process cycle and its components. (4.2) 2. Explain the difference between credit risk analysis and loan structuring. (4.2.2) 3. It is advisable that the processes of credit risk analysis and loan disbursement are handled SE ) by two separate officers. Give the reason why, and provide an example of a worst-case scenario that could occur should the same person handle both roles. (4.2.3) FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO 4. What is meant by risk diversification and how can it be achieved in a bank? (4.3.3) 5. Identify and explain any three principles of lending and how they apply to credit. (4.3) 6. Describe the Principle of Protection in credit and lending and how it is applied. (4.3.5) 7. Describe the Principle of Proportionate Stakeholding and its relevance in credit risk analysis. (4.3.7) 8. Consider the following scenarios and identify which principle(s) of lending they violate: (4.3.1 to 4.3.9) a. 70% of bank’s loan portfolio is in a single client’s name. (4.3.3) b. A bank decides to lend a substantial sum to a new start-up with no proven track record or collateral. (4.3.1) c. A bank decides to lend RM50,000 to a borrower who wants to start a business that will be worth RM50,000. (4.3.7) d. A borrower hides the fact that he already has credit facilities with another bank when making a loan application. (4.3.6) e. After the loan has been disbursed by credit administration department, the credit officer immediately proceeds to work on other accounts while ignoring the existing T loan. (4.3.2) O 9. Credit risk analysis requires information for the purpose of assessment. Discuss how the (N information can be obtained. (4.4) 10. In making a credit risk assessment of a loan applicant, identify and discuss the main issues that should be addressed. (4.4) 11. A loan is never repaid by past earnings and historical cash flow. Comment. (4.5.4) 12. How would a credit officer make a judgment on the loan repayment ability of a borrower? (4.5.4) CERTIFICATE IN CREDIT PRINCIPLES OF LENDING 4-20 KEY TERMS Principle of proportionate stakeholding Credit process Principle of protection Credit risk analysis Principle of tenor matching Impaired loans Productive and purposeful lending FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO SE ) Business plan Non-performing Regular Principle of control Risk acceptance criteria Principle of pari-passu Risk management practice (N O T Stamped CERTIFICATE IN CREDIT T O (N SE FO P R RIN C T O A M B M LE ER C CO IA P L Y PU R PO )