What differentiates a bank from its competitors is the quality of its employees, and in particular, its credit officers and analysts. Here is how a credit analyst can better identify and mitigate credit risk
Credit is considered to be one of the major sources of earnings for a bank. However, failure in assessing overall credit risk may lead to an increase in non-performing loans (NPLs). So, the credit analyst has to play a vital role in ensuring a sustainable business environment.
The banking industry is going through some tough challenges, tackling which in an ever-challenging business environment requires a 360-degree analysis of all credit propositions.
We should not forget, at the same time, that the challenge creates opportunities.
However, harvesting opportunities requires a high degree of professionalism, managerial tact, strategic planning, and, at the same time, compliance with regulatory prescriptions. So, conducting banking business and achieving the desired business target is challenging and calls for expanding earning assets with sustainable income sourcing.
Simultaneously, top priority should be given to restraining the growth of default loans, which eat into the vitality of the health of any financial institution.
What differentiates a bank from its competitors is the quality of its employees, and in particular, its credit officers and analysts. Identification and mitigation of credit risk are essential tasks for a credit analyst.
Despite intense competition in procuring new business, the credit analyst should focus on the following vital issues in addition to analysing information like group liability as per the Credit Information Bureau (CIB), sales growth and turnover, credit rating, cash flow, the purpose of the loan, industry analysis, and the overall business experience and background of the entrepreneur.
If it is a trading business, the credit analyst should look into the following at the initial stage of processing the credit proposal:
Price volatility: The credit analyst needs to identify whether the product price is volatile. If the price is volatile, it should be checked to see whether customer demand for it is price inelastic or not.
Dominance of major market players: Due to the dominance of a major market player, small or medium-sized traders incur losses in their businesses. In some cases, large traders or importers sell their products much below the imported or cost price, which becomes a challenge for small or medium-sized traders to survive — a regular phenomenon in the Khatungonj area of Chattogram, the country’s largest wholesale market.
Information: To know the customer’s market reputation and overall standing, the credit analyst should collect information from their buyers and suppliers.
Seasonality: Businesses based on seasons, like the trading of ACs whose demand peaks in summer and dips in winter, require more working capital in summer and less in winter.
Demand and supply: The existing demand and supply status of the particular product need to be taken into consideration.
Competition: A quick response to customer needs is mandatory if the industry is competitive. Therefore, a higher level of inventory is maintained. Liberal credit terms are also mandatory with good service to survive in the market. So, the higher the competition, the higher the requirement for working capital.
If it is a manufacturing concern, the credit analyst should look into the following, in addition to others:
Total production capacity of existing units: The production capacity of existing manufacturing units for a particular product needs to be determined to assess whether further investment in producing this type of product would be feasible. In this case, it is mandatory to ascertain the demand-supply gap for the product to be manufactured. Among others, the cement industry and local independent power producers are suffering because of idle or unutilised capacity.
For the assessment of working capital for any manufacturing concern, it is also required to assess the production capacity of the existing plant, and the sales turnover must be commensurate with the capacity of the same so that the assessment of working capital can be done accurately. The root cause of a high percentage of NPL in the Chattogram region was the wrong assessment of working capital requirements, a consequence of which was that the customers were overfinanced. Now, it has become a burden for the banks.
Availability of raw materials: To ensure an uninterrupted production process, the availability of raw materials is inevitable. The credit analyst should inquire about it during the initial interview with the customer. In this case, more than one supplier is preferable.
If the raw material supply is not smooth for any reason. In that case, the customer tends to store more raw materials than needed, and that may increase the requirement for working capital at a particular point in time.
Price competitiveness: The per-unit production cost in comparison to imports needs to be checked.
Modern marketing strategy: How far the entrepreneurs are ready to cope with modern marketing strategies should be assessed; otherwise, at some point in time, they might be in a position to generate sufficient cash because of intense competition.
Tax/VAT policy: The likely impact of tax and VAT policies should be taken into consideration by the credit analyst; otherwise, the net profit margin may be inflated or misleading.
Technological obsolescence: Technological obsolescence might increase production costs, so the likely effect of technological obsolescence should also be considered.
Environmental and social risks: Potential environmental risk may not seem significant at the time of approval of a loan but may become so during execution due to higher regulatory standards and increased levels of enforcement. In some cases, projects have to be abandoned because of a lack of environmental and social due diligence.
If it is a construction company (work order finance), work order financing is known as supervisory credit. It needs close follow-up and monitoring until the liability is adjusted in full. Nowadays, it is being observed that, despite the proper assignment of bills and completion of other standard documentation formalities, a significant amount of loans against work orders become overdue or classified.
Here, it is pertinent to mention that in some cases, for the purpose of winning the bid, the bidding price may be lower than the actual cost to win the bid. In this respect, to safeguard the bank’s interest, the credit analyst should know the quoted price of the second-lowest bidder. If the 2nd lowest price is much higher (the difference is big) than the winning price, then it can be assumed that the work order value may be revised in the future, and in that case, the customer might require additional funding.
On the other hand, if the work order value is not increased, the customer will not be able to complete the work within its validity or will have to incur a loss.
Consequently, the liability with the bank will remain unadjusted or be classified. Before allowing credit facilities, the credit analyst should also inquire whether the work to be financed is on the government’s priority list so that repayment against the said work order can be ensured.
If it is an export-oriented RMG business, the syphoning of funds through inter-unit transactions is a common phenomenon in export-oriented RMG businesses. The alleged Hallmark scam exploited the system of issuing BTB L/C in favour of different sister concerns within the same group.
While structuring the credit limits, the credit analyst should determine the actual working capital requirement, or BTB L/C limit, based on installed capacity. The factory of the local BTB L/C beneficiary should also be visited by the credit analyst, or RM when processing credit proposals.
Credit should not be given to support excessive business growth. Lending to an expanding company that has won a new contract may sound reasonable. However, a request from a similar company that has won five new contracts might raise doubts in the lender’s mind, as the company may not have planned for its growth adequately.
In December 1963, Hugh McCulloch, the Comptroller of the Currency and later Secretary of the Treasury of the USA, addressed a letter to all national banks. One of the paragraphs of that letter is appended below, which is very much needed to cope with the challenges of today’s banking:
“Distribute your loans rather than concentrate them in a few hands. Large loans to a single individual or firm, although sometimes proper and necessary, are generally injudicious and frequently unsafe. Large borrowers are apt to control the bank, and when this is the relation between a bank and its customers, it is not difficult to decide which, in the end, will suffer. Every dollar that a bank loans above its capital and surplus it owes for and its managers are therefore under the strongest obligations to its creditors as well as to its stockholders, to keep its discounts constantly under its control.”
To minimise credit risk, the total loan concentration of a bank should be diversified based on geography, economic sector or industry, and different groups or customers like retail, SME, and large corporations. A high concentration on a single customer or borrower should also be avoided. A bank with a well-diversified credit portfolio is more resilient to absorb the shock in case of any economic debacle in a particular sector or concentrated area.
The banking industry has become a turbulent ocean because of the huge burden of NPL and the true extent of problem loans. Under this prevailing scenario, distributing loans to different sectors and customers rather than concentrating them in a few hands is considered the right strategy for navigating a smooth and safe journey in a turbulent ocean.
