Sri Lanka, Oct. 31 — Banking is synonymous with deposit-taking and lending (credit) for profit. They take deposits by paying interest and lend deposits by charging interest. The difference between interest charged and interest paid is the net income available to cover all operational expenses and a profit margin to bank owners. Therefore, bank credit is a risky business although we think that banks enjoy a ready-made profit to stay in marbled buildings. Deposits also are credit we grant to banks by taking risks as there is no risk-free business in this world.
In economics, currency is first stage of money. Banks deposits and credit that arise from currency are the two sides of the coin that create money. Bank credit is financed by deposits. Proceeds of credit again become deposits and the continuing turnover between credit and deposits creates money. As such, bank deposits constitute the major part of money held by the public (i.e., 93.2% of Broad Money M2). Therefore, bank credit is both business and national money. As the amount of money in the economy has to be guarded for its value and safety to be consistent with the requirements of the real economy and its potential, banking is immensely regulated by the monetary policy and prudential regulation. Therefore, when we deal with banks for deposits or borrowing, we have to be patient as bank-hands are tightly tied by both themselves and regulators for the safety of everybody’s money. This does not mean that the bad never happens. See Graphic
Given the technicality and complexity of the subject, this article covers only how banks mange credit in their business.
Economic Role of Credit
Economies are essentially credit societies with credit instruments ranging from currency to various debt instruments. Currencies are promissory notes to repay their face value by the government. Bank credit is a promissory note signed by the borrower agreeing to repay to the lending bank. Credit market and bank credit are the two layers of credit delivery. In credit markets, credits instruments are designed, priced, issued and re-traded openly. Large corporates and governments with publicly assessed credit-worthiness borrow in the market. Bank credit is the dominant layer of credit in the world while the most part of credit markets also is funded by bank credit.
The intermediation, i.e., banks borrow as own liabilities and lend as own assets, is the bank credit mechanism. Borrowings are mostly short-term and liquid. Deposits (major borrowing) are repayable on demand. Banks pool these savings and lend short-term, medium and long term to finance economic activities, consumption, production, trade etc. Therefore, banks pool and re-distribute both credit and underlying credit risk across the economy as a business which fuels the economy. Nobody can live without credit.
Bank Credit Products and Profit
Banks offer credit products to suit financial needs of the economy, both retail (households and small businesses) and wholesale (large corporate and governments). Overdrafts, corporate credit, business credit, export and import credit, mortgages, micro, small and medium industry finance, agriculture and pawning are some categories. Financial guarantees and credit lines are unfunded credit products offered on fees to facilitate transactions.
Bank balance sheets (assets and liabilities) are generally 90% credit on both sides. Only nearly 10% is capital used for risk-absorption, fixed assets and technology for bank operations. The interest margin (net interest income) is the cost of intermediation to the economy. The margin should be high enough to cover risks of credit, bank operational cost and a return to bank owners/capital, but low enough to reduce the transactions cost to the economy. The lower the margin, greater the efficiency in intermediation. Banking technology, financial literacy and inclusion and credit ecosystem help lower the intermediation cost through better credit discipline and lower cost structure. Therefore, the most single indicator to assess bank efficiency is the interest margin that varies across banks due to differences in their cost and risk structures.
Bank Risks on Credit
As bank operations and balance sheets are credit-based, bank risk profiles also are largely credit-based. Any credit is necessarily risky as it has to be recovered in uncertain future. The credit or default risk is the possible non-repayment of credit with interest as due. The liquidity risk is the cash-flow difficulties to make routine payments, deposit withdrawals, loan disbursements, etc. The liquidity risk is inherent in intermediation due to the tenure mismatch in deposits and credit as longer-term credit (illiquid assets) is funded by short-term deposits (liquid liabilities). Various operational risks also arise from weaknesses in credit delivery and deposit-taking systems. Therefore, banks have to charge a sufficient premium from borrowers to cover all such measured risks that vary across banks due to their different risk profiles.
Credit Risk Management
Bank management is necessarily the credit risk management, given the significance and magnitude of credit portfolio for bank sustainability. Credit losses reduce bank income and assets. If the loss is high year after year, bank capital gets eroded and its solvency is threatened. Unmanaged credit risk is the cause of many problem banks and failed banks around the world.
Therefore, banks must have a well-managed credit delivery system to ensure that suitable credit products are offered, each borrower is assessed to be a good risk and all precautions are in place to cover all possible credit risks. A bank cannot just lend as and when customers request. That is why borrowers confront delays and difficulties when borrowing from banks.
Bank risk-focused credit delivery system contains several layers, a few of which are highlighted below.
1) Bank Credit Policy
This covers credit products, terms of conditions and internal controls. Banks have to do market surveys and design credit products to gain a market share within its capital base/size. Credit evaluation process, internal controls on approvals and credit administration including credit follow-ups and recoveries also are key parts of the credit policy.
2) Credit Evaluation – 6Cs
Banks should lend only if the borrower is fully trustworthy to borrow and payback. Bank credit literature contains 6Cs of borrower/credit evaluation. They are Capacity, Capital, Collateral, Conditions, Character and Confidence, that each borrower has to pass.
Capacity is the borrower’s economic hygiene such as cash-flow stability and established business profile. Capital is the borrower’s contribution to the activity to be financed by credit. Collateral covers external securities such as property and sureties that the borrower has to provide as safeguards to banks in the event the loan goes sour. Condition is the general economic environment and borrower’s business industry. Character is the personal profile of the borrower. Confidence is the trust the borrower creates in the bank by satisfying other five Cs. Although 6Cs have been evolved from business/corporate customers, it is equally applicable to all borrowers, but at different strengths.
Banks have developed internal credit rating/scoring systems covering various data items under each C to test individual borrowers. Therefore, prospective borrowers have to satisfy their banks with necessary information to pass the 6Cs based-evaluation test. Borrowers treated outside the above test, e.g., related-party lending, invariably end up as sour risks.
3) Non-performing Loans (NPL) Monitoring
Loans that become arrears against the repayment plan are NPL. In general, banks wait for 3 monthly installments or 90 days in arrears of the due repayment to classify loans as NPL, inclusive of all loans of respective borrowers. To be more prudent, one installment or 30 days in arrears are adequate to detect early warnings of sour loans. Borrowers confronting repayment problems even if repayment is in order are classified as NPL for better monitoring. No further loans should be granted to keep loans performing (ever-greening). In rescheduling of NPL, rescheduled loans should continue to be in NPL category at least one year to re-test the borrower.
The NPL classification helps banks in two ways. First, banks can keep a close follow up/extra caution on doubtful borrowers. Second, banks can assess and monitor the bank’s overall perceived credit risk estimated as the ratio (%) of NPL to total loan book. The NPL ratio is a test on the efficiency of bank credit evaluation system. Given the real-world uncertainties, an NPL ratio of 1% to 2% may be manageable but alarming. A 2% of NPL ratio means that the bank capital ratio, if 10% of assets, is effectively around 8%.
Banks must not take interest receivable/accrued on NPL into income and loans/assets to avoid over-statement of profit and loan book. It should be kept in suspense account until interest is recovered in cash.
4) Loan Loss Provisioning/Impairment
In general, banks further classify NPL to identify bad and doubtful NPL and allocate funds out of bank income regularly to cover those NPL losses. Loans in arears in 6-12 installments (doubtful loans) and more than 12 installments (loss loans) are allocated with specific provisions such as 50% and 100%, respectively, on the outstanding loan net of interest in suspense and the realizable value of underlying collaterals. However, more prudent banks identify all borrowers with bad track-record as doubtful and make provisions. A general provision at least 1% of total performing loan base is also prudent to keep an additional cushion to cover general credit risk. Otherwise, bank profit is over-stated and used for payment of bonuses and dividends while the bank bottom line is weak. Such provisions can be written back to income when NPL are recovered or set-off without a threat to solvency when NPL become losses.
Banks also can compute Net NPL ratio, net of specific provisions and interest in suspense, to monitor the actual bank exposure to NPL. If the net NPL ratio is 0.5%, it can be easily written off to clean up bank books, pending realization of collaterals.
5) Collateral Valuation
Value of credit collaterals such as property, equities and debt securities fluctuate in markets. Bursts of asset bubbles from time to time erode asset collateral values and foreclosures. Therefore, banks must regularly value collaterals based on average trend values to estimate their recovery values. Otherwise, loan loss provisions may be under-stated. Further, collateral values should be discounted to calculate provisions as the recovery of total collateral value is quite problematic.
6) Control of Credit Concentrations
Excessive concentrations of credit in certain big customers, volatile sectors/industries and asset markets must be controlled in proportion to bank capital and total loan book in order to avoid excessive dependence because such concentrations are risky and contagious across banks. In western markets, bank exposures to asset markets have been the cause for almost all banking crises when asset bubbles burst. Periodical bursts of asset bubbles funded by bank credit hit banks twice, first, default of credit granted for asset purchases and second, erosion of asset collaterals on existing credit.
Sri Lankan banks experienced a burst of world gold bubble in 2013 causing a significant rise of pawning NPL from 0.8% to 13% and a fall of pawning portfolio to a half (i.e., pawning declined to 8% from 23% of total loan book). Banks have to adopt conventional loan-to-value ratios (LTV) based on trend average value of assets/collaterals to reduce the excessive exposure to asset markets. Therefore, a largely diversified loan book with prudent LTV helps bank sustainability although it may affect bank profitability.
7) Control of Maturity Mismatch
Banks generally classify their assets and liabilities in different time/maturity buckets based on their remaining maturity periods such as less than one month, 1-2 months and 3-4 months in rising order and manage portfolios in each time-bucket to keep the negative assets-liabilities mismatch cumulative up to a short period, e.g., 3 or 6 months, at a low rate of total balance sheet (i.e., 10%). This helps to reduce fundamental liquidity problems. Accordingly, cash-flows can be managed to iron out routine daily mismatches.
8) Beware of Structured Credit Products
During the last three decades, western financial markets underwent a considerable rate of financial engineering to invent innovative credit products such as securitization, asset-backed securities and credit-default-swaps (CDS) to trade bank credit in the market. Therefore, banks started selling their credit portfolios to investment banks who repackaged them, sliced them into marketable bonds with external credit ratings and issued bonds in the market for trade among investors. CDS (credit insurance products) were structured to trade credit risks underlying such bonds in the market.
As a result, banks gave up conventional relationship-based retail banking and credit evaluation. Instead, banks borrowed heavily from money markets to lend. Unevaluated loans and sell-off such loan books to investment banks, mostly owned and supported by banks with warehouse credit lines, were bank routines to take credit risk out of bank books. This resulted in excessive leverage, subprime lending (liars’ ledger) and heavy exposures to asset markets. Some banks heavily invested and traded in such structured products. This innovative credit risk management strategies opened up banks to both market risk and liquidity risk excessively in place of the sold-credit risk and largely contributed to the last global financial crisis 2007/09.
These innovative products prevail in markets. Therefore, banks should be extra cautious if they go after such innovative products, despite banking is essentially relationship-based retail lending and deposit-taking.
9) Capital Charge for Credit Risk
Banks generally estimate credit risk ratings (weights) for various loan categories and calculate bank capital required to cover estimated risks. For example, risk rates of 0% for government loans, 20% for high rated corporates, 35% for residential housing loans and 100% for commercial property loans can be applied to calculate minimum capital, i.e., 12% of risks, required to cushion credit risk. This means that credit risk not covered by capital is 88% which has to be managed by banks externally. Capital charge helps banks to build up capital without waiting until credit risks actually hit causing bankruptcies. Banks can economize capital by cleaning up high risk-rated loans.
10) Control of Leverage
Banks are highly leveraged (rate of assets over bank capital) as they grow excessively on borrowed funds with less capital. All bank problems and crises are connected with excessive leverage. Therefore, banks should control their balance sheet growth by monitoring the leverage at a sustainable level (i.e., 10 or less) by building up capital. The risk-based capital (i.e., Basel Capital Standard) is one of leverage restraints.
Tracking the credit-to-deposits ratio (CDR) at around 70% is a conventional measure to keep the credit expansion/leverage as well as bank liquidity within the control. If the CDR is 110%, the bank has lent all deposits and an additional 10% from market borrowing which is risky. A CDR is 70% means that 30% of deposits are in liquid assets which is a prudential safeguard.
11) Data Warehousing and Mining
Banks must use modern IT to have all borrower information, both current and past (at least 10 years) in a data base environment to analyze portfolio characteristics by types of business, purpose, borrower-status (sex, age, corporate, retail, etc.), geographic location, economic shocks, loan size, etc. Such information can be used to estimate credit risk ratings across identified categories. The best practice is to apply these risk ratings for prospective borrowers in similar categories at the time of credit evaluation. For example, if the loss rate on retail trade credit to young borrowers in middle income is 2%, there is no harm in applying a 2% risk rate in credit evaluation of all new borrowers in this category.
12) Credit Ecosystem
Bank regulation and supervision, loan recovery laws, credit information bureau, external credit raters, external auditors and external valuers cover the ecosystem that promotes the credit culture and discipline of both banks and borrowers and provides a guarded pitch to take prudent risks. The system has immensely helped credit risk management as reflected from the significant reduction of banking sector net NPL ratio (net of interest in suspense) from 14.7% in 1998 to 2.5% in 2017.
As both credit and deposits are inter-related in banking businesses with risks, banks and customers may look at the NPL ratio along with other prudential ratios of individual banks published in their quarterly financial disclosures to assess differences in risks on both sides of bank balance sheets. However, such statistics involve in complex accounting definitions and judgements that general public will never grasp. Therefore, banks need to distribute customer-hand books in a common format approved by the regulator to educate the public for better discipline among both customers and bank staff on banking business and its hygiene.
Accordingly, all bank depositors and borrowers need to understand the environment in which banks operate to serve them with prudential safeguards.
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