Credit risk process

Hindsight is better than foresight. These wise words are commonly uttered by professionals across the world. However, the architects of risk management model take into account both aspects mentioned in the aforementioned saying. In a bank or financial institution, the credit risk assessment process involves an in-depth evaluation of client (borrower), industry and economic scenario. The client may be an individual, business enterprise or a public sector institution.
The creditworthiness of the borrowers is mainly probed through an analytical view of their past performance shown in financial statements along with the repaying capacity that arises out of their ability to generate funds from main operations. In order to arrive at a fair figure, a discounting factor is too applied in line with the degree of uncertainties inherited therein. The industry or sector is reviewed in terms of its past performance, current position and the future outlook or growth potential. A favourable economic situation or adverse economic factors do carry a significant weightage in the process.
Whilst applying both, hindsight and foresight, the analysts delineate a judicious opinion for the ultimate decision-makers either in internal committees (comprising senior management) or board members. Obviously the past is easy to assess as the entire chain of events or trail we pass through is recorded and serves as data for analysis and decision. Whereas, prediction of the future outcome is a difficult exercise fraught with enumerable factors of uncertainties. The assessment techniques or methodologies are considered more important than the consequence of the past in order to determine whether the process was fair by applying all the appropriate tools or the other way round.
Imagine the level of embarrassment to a risk analyst once the outcome appears in contrast with his initial view. In a situation when the upshot appears adversely, anyone can put a question mark over his analytical competence. Besides there are several instances in the local financial market wherein some financial institutions have been trapped in a distressful situation due to non-adherence to the credit covenants in contrast to their projections. Therefore, it calls for a very critical view in the assessment techniques and methodologies.
In has also been observed that despite defined risk parameters, some financial institutions take a very generous view on certain credit profiles owing to their greater risk-absorbing capacity or appetite. In fact, it must be kept in mind that such actions lead the situation to an adverse point by endangering their liquidity position, triggered as a result of persistent failure in meeting financial obligations on the part of the borrowers.
While making a credit decision, sometimes key consideration is given to the rating assigned by external agencies that may snare the institution in an awkward position. There are numerous examples of default made by onetime big names, though they were initially accredited by rating agencies in highest level of rating categories like A plus or Double A. It was surprising to see a five-year debt instrument of over one billion rupees rated in 2007 as AA had fallen deeply into a default category at a time when repayments were due. The rating agency in its report highlighted the name of the sponsoring group as the key rating factor and did not emphasise the repaying capability of the issuer. It is important to mention that the State Bank of Pakistan (SBP) in their guidelines for risk management has categorically said that a bank must not grant credit simply on the basis of the fact that the borrower is perceived to be highly reputable, ie name lending should be discouraged. The SBP further instructs that while structuring credit facilities institutions should appraise the amount and timing of the cash flows as well as the financial position of the borrower and intended purpose of the funds.
Despite the SBP guidelines, such kind of credit was accepted by the institutions. The institutions who subscribed the said debt instrument are now caught in a tough situation with remote chances of repayment. Thus the source of temptation needs to be understood, either the enticing price or the comfort level suggested by the rating agency.
According to the latest reports, defaults in bank loans have increased to an alarming level. This may create hurdles for the private sector in obtaining new loans as in such a situation banks normally adopt a more cautious approach while granting fresh credit. That is not a good sign for the banking sector. The banks with higher volume of non-performing loans (NPLs) and substantial provisions become severe victims of a liquidity crunch that further cause them escalation in the cost of funds. In general, macroeconomic conditions are purported to be the cause of such misfortune. However, the banks which have established a very sound risk management framework and compliance function, resist major shocks even in downtimes. As such, in order to maintain resilience in difficult macroeconomic conditions and sustain profitability with a sound financial position, the banks should desist from compromising the credit quality and its internal risk assessment parameters.
Obviously taking risk is the key component of the banking system for the generation of income base but there are predefined tolerance levels that are required to be followed in a careful and prudent manner. The risk management process is not merely limited to the people who are responsible for assessing or reviewing the risk, but the decision-makers at the final stage are too responsible who form a favourable opinion prior to or at the time of approval. The skills and knowledge-base of the key team members involved in the process should regularly be improved through proper training programmes in order to equip them for guarding effectively the interest of the institution.
The financial institutions including banks constantly monitor the quality of their credit portfolio and give wake-up calls at the right rime. More importantly, a robust process needs to be developed in the institutions to take stock of their previous decisions with a progressive approach so that the causes of adverse outcomes are identified and it is ensured mistakes of that past are not repeated in the future.
(The writer is a senior financial consultant in a financial advisory firm)