Credit appraisal techniques

Credit appraisal techniques A forward looking approach should also be adopted By S. FAHIM AHMAD Nov ,12 - 18, 2001 The Banking sector in Pakistan continues to suffer from a loan problem portfolio, due to a variety of reasons. While there is no guaranteed procedure for ensuring loans do not go bad (certain circumstances can go against the best of borrowers), I have tried to develop a procedure for analyzing credits, as outlined below. This is based primarily on personal experience of over 20 years as a lending offficer, sitting on the Board of Banks besides guidance from earlier supervisors, and training programmes attended. The important thing to remember is not to be overwhelmed by marketing or profit center reasons to book a loan but to take a balanced view when booking a loan, taking into account the risk reward aspects. Generally we remain optimistic during the upswing of the business cycle, but tend to forget to see how the borrower will during the downturn, which is a shortsighted approach. Furthermore we tend to place greater emphasis on financials, which are usually outdated; this is further exacerbated by the fact that a descriptive approach is usually taken, rather than an analytical approach, to the credit. Thus a forward looking approach should also be adopted, since the loan will be repaid primarily from future cash flows, not historic performance; however both can be used as good repayment indicators. Having postulated above guidelines, following is a suggested general procedure for reviewing short term lending proposals Company Profile / Ownership: This should cover the legal structure of company, i.e. is it public / private / listed. If listed then broker reports can be an additional source of information besides share price. Sole proprietorships / partnerships tend to be higher risk. Potential support can be provided by sister concerns, multinationals etc. While this can be a support it can also work as a disadvantage with possible diversion of funds to sister concerns, transfer pricing etc. which should thus be addressed. When dealing with individual Group companies it is essential go review overall Group exposure to ensure that the Group Risk is adequately analyzed and monitored, and Group limits also set. Proposed Transaction: Following key items should be addressed: Purpose of facility: This must be specific and general terms should be avoided, such as "working capital facility." A specific need would be to "finance inventory" or "receivables" (or both). These two assets generally constitute the rationale for short-term borrowings. Source of repayment: The cash cycle including payment and selling terms must be reviewed, which impact cash flow. Normally there should be reliance on identifiable cash flows for the first way out to repay the loan rather than the security itself. The lending officer should understand the cash production cycle and its tenor, and should question how the Bank will be repaid if things do not work out as expected for the customer e.g. slow sales, increases in inventory costs, etc. Credit Limits - Bank experience to date with borrower and use of facility should be reviewed. Limits with other Banks should also be provided, besides ability to obtain additional debt i.e. Bank should avoid being in a situation of lender of last resort. Sole Banking relationships are

undesirable as it shows too much reliance on one source. Proposed Limit will give the overall exposure to the company, which should be reviewed to see if it is warranted, in relation to facility purpose, size of sales, capital etc., besides the usual credit criteria. Security: Full details should be provided, besides description of security as the alternative loan repayment source and its realizable value, where possible. It should be properly insured by a Bank approved Insurance Company and covered against various risks. Documentation must be precise, while security evaluation should cover control, marketability and lending margin, to protect against price fluctuations. Frequent independent verification of the security should take place. If the security taken is not saleable, then this should be recognized and the risk addressed e.g. if there is only a sole seller of the product, then there will be no other buyer for his assets, in event of a forced sale. The Bank will thus be left with an unrealizable asset. Where receivables are taken as security, then quality / ageing should be reviewed, which would enable the Bank to assess the reliability of this asset as a loan repayment source. Banks should not lend in an inferior position; all charges on security should be First Registered and pari passu with other lenders, to ensure the Banks interests are properly covered. If the Directors' guarantees are taken then separate individual Net worth statements or tax returns should be provided to support these guarantees and judge their capacity to repay guaranteed amounts. Financial Analysis: Normally a spread sheet should be used for analysis, which shows ratios, trends etc. At minimum the last three years financials should be spread to analyze trends. Figures should be updated and not more than six months old. Quality of auditors should be ascertained to judge reliability of figures, and check if the accounts are qualified. The figures should be analyzed, not described, in order to judge the financial position of the company. Where possible projected financials should also be obtained as repayment will be from future cash flows. Key items such as trends, market position, industry risk, industry status, capitalization, liquidity, dependence on borrowings, leverage, profitability, inventory/receivables position, besides capital/debt structure should be reviewed. Asset Turnover ratio is useful, besides leverage which shows net worth coverage of liabilities. Days Inventory and Days Receivable are crucial indicators of a Company's liquidity and show the need for an amount of borrowed funds, which are repaid through the liquidation of these assets. Earnings are key to a company's success. Therefore one should review long term earning power, consistency and trend of core earnings, earnings mix, and dividend policy. Balance sheet figures are at a point of time - therefore it is essential to analyze realistically e.g. borrowings/inventory can be reduced for balance sheet date purposes. Thus average figures are more reliable where available. Figures can also be inflated for seasonal factors e.g. inventory build-up during the cotton-buying season, which should be recognized accordingly. For Project Finance one should analyze both historic and projected figures, with full sensitivity analysis, to ascertain repayment ability. The Bank should rank pari passu on cash flows with the lenders i.e. for long-term loans the tenor should not exceed that of other lenders. Periodic project monitoring is essential to check progress of the project both during implementation and after it is completed. Management Evaluation: This aspect is often not given the importance it warrants. It should not be overlooked since the management impacts overall performance of the company and hence its ability to repay loans.

Following items should be noted when assessing management: • Quality and depth of management, particularly the CEO. • Experience, qualifications, and capability. • Succession and back up plans. • Management style i.e. conservative, centralized/ decentralized approach, Organization Culture, Corporate strategy. • Career progression, training and development policies. • Staffturnover/personnel policies. • Training, motivation, morale, besides staff quality. The CEO sets the pace for the Company and can determine its success with the necessary teamwork e.g. Jack Welch of General Electric, who has been enormously successful as CEO. People are the most important resource a Company has and are crucial for its successful running. Those Companies are successful which treat and recognize its talent properly and have a clear, careful and thought out business strategy, formalized in a Business Plan which is then followed accordingly. Besides this they have a organized change culture, solid customer relationships and a strategic brand management / differentiation. Above items are not found in the Balance Sheet, and should be analyzed by the lending officer, after careful scrutiny and discussion with management. Risk Areas: The lending order should review all risks officer relating to the lending point wise along with the mitigants and justified why lending is warranted, i.e. can the risks be covered or are these acceptable risks. Each borrower will have different risk profiles and therefore it is important to ensure there are adequately understood and addressed. Checkings: Written checkings from other lenders should be obtained. Trade/market checkings can be obtained from various sources e.g. suppliers, etc. Talking to suppliers and other market information can give updated input on the company's financial position, e.g. if company is delaying payment to suppliers this could indicate liquidity problems. Also checks should be made from the market how the company's product is selling in the market or if it suffers from quality problems - these items are important since they impact sales and ultimately cash flow. Loan Profitability: Again this is an important area which helps evaluate the risk / reward aspects of a transaction. It is important to earn an acceptable spread on a loan, and therefore to arrange necessary funding, to compensate for the credit risk. Apart from this the Bank should make an adequate return on the loan to help build the up net worth which is a cushion to absorb loan losses. The Bank should maximize return on assets not only through spread income but other non funds income such as commissions, exchange etc. which are generated from contingent risk and do not involve the use of Bank funds. There is no insurance against loan losses or problems, nor is lending a rocket science. The lending officer must therefore exercise common sense and follow basic lending rules when analyzing a credit. There is no short cut to this - after disbursement it is also essential to maintain contact with the company and remain abreast of its financial position. A lending officer must not only have requisite credit skills, but develop problem recognition abilities to enable him to take necessary and timely action, as and when required.

The above is a basic guideline to reviewing short-term credits and is not all exhaustive. It should thus be reviewed on a case by case basis. Each borrower has different circumstances and should be reviewed as such. I have attempted to cover short-term borrowings only - project finance and other form of lending have different risk criteria, which have not been addressed here. However 3 'C' s of a credit are crucial and relevant to all borrowers / lending which must be kept in mind at all times • Character • Capacity • Collateral If any one of these are missing in the equation then the lending officer must question the viability of the credit. There is no guarantee to ensure a loan does not run into problems; however if proper credit evaluation techniques and monitoring are implemented then naturally the loan loss probability / problems will be minimized, which should be the objective of every lending officer. About the Author The author has a honors degree in Economics / Accounting and a MBA, both from British Universities. Subsequently he has gained over 20 years lending experience with Citibank and American Express Bank, in Pakistan and the Middle East. He has served on the Board of Directors of NDFC and Orix Investment Bank besides other Companies and is presently working as a Credit Advisor with Pakistan Kuwait Investment Company (Pvt.) Ltd. The above article has been derived from presentations the author has made to Bankers on Credit Analysis. It has been written in view of the positive responses obtained, recognizing the need to reach a wider audience on this relevant subject.

The effect of credit growth on NPAs A. S. Ramasastri N. K.Unnikrishnan FINANCIAL year 2004-05 has seen substantial growth in bank credit. As on March 18, 2005, the annual credit growth was 26.2 per cent against a much lower 16 per cent in the previous year. In this context, it is important to look at the trend in non-performing assets (NPAs) of banks. NPAs are largely a fallout of banks' activities with regard to advances, both at the management and implementation levels (including overall controls by the top management), the credit appraisal system, monitoring of end-usage of funds and recovery procedures.

It also depends on the overall economic environment, the business cycle and the legal environment for recovery of defaulted loans. Since the overall environment is more or less same for all banks, non-performing loans of individual banks are mainly a result of management controls and systems put in place by them. A bank with an efficient credit appraisal and loan recovery system will grow stronger over the years. Such banks have good management control and also inherent strengths in terms of a highly motivated staff, good checks and balances, which are further enhanced by a regulatory and supervisory system. As the growth in advances is largely determined by the economic and business environment, such banks will be able to push their credit portfolio aggressively, especially when the economy is booming. Also, as such banks have a diversified credit portfolio, it would act as a cushion during economic downturns. This will result in lower NPAs, allowing them to grow stronger and even adopt a more aggressive growth strategy and, thereby, withstand marginally higher incidences of default. However, a bank without inherent strengths will not be able to push their credit portfolio the way they want to. They are characterised by poor management control, inadequate credit appraisal and even low levels of motivation among the staff. When such banks push their advances portfolio, chances of their asset quality deteriorating are higher. Since asset quality will be visible only after credit disbursal, which itself depends on the regulatory definition of NPAs, any deterioration will be reflected after a time lag. Thus, banks without inherent strength will have higher NPA levels, especially when the economy has seen above average credit growth. Factors affecting NPAs

General environmental factors: These include business cycles, the legal framework, ethical standards, the regulatory and supervisory system, and the political environment. Bank specific factors: The credit appraisal system; credit recovery procedures; controls, checks and balances adopted by the top management; the risk management system in place; and the motivation level of staff. Thus, for both healthy and not-so-healthy banks, asset quality after an above average credit growth has a major effect on NPAs. One way to capture the effect of deterioration in the asset quality is to consider cumulative growth rates of credit, which also captures the time-lag effect of credit migration.

A quick analysis (see Table 1) shows that high cumulative growth of advances (2000-01 over 1997-98) was followed by a spurt in NPAs in later years for a majority of the banks. Of the 18 banks with more than 80 per cent cumulative growth, 12 witnessed increased NPA levels. While State Bank of Indore, Jammu & Kashmir Bank, Andhra Bank and UTI Bank reduced their NPAs in 2000-01 over 1999-00, United Western Bank, Global Trust Bank and ICICI Bank, among others, saw substantially higher NPA levels. Such comparison may not be fully relevant now. Banks have managed to reduce their NPAs substantially over the years, thanks to higher provisions and an improved legal framework for pursuing bad loans. Thus, while comparison with the past may not be fair, lessons from the past may not be inappropriate. Banks with an aggressive approach to credit growth may

have to handle their advances portfolio with care, especially after a spurt in overall credit growth. Given the cumulative growth in advances, which can be classified as low or high credit growth compared to an average `middle' growth, it may be appropriate to look at resulting NPAs, which can also classified as low or high, again as compared to an average or middle level NPA. In statistical jargon, this could be viewed as an attempt to create 2 x 2 contingency tables, with one variable as cumulative credit growth and the other as NPAs. The classifications are based on average cumulative growth for each year.

To reduce the effect of outliers on classification, extreme observations are excluded while averaging. Such classification is done for four years from 2000-01 to 2003-04 on the basis of three years' cumulative growth of advances (Table 2). From Table 2 it can be seen that banks fall in four categories along with number of years it appeared in the category. For instance, State Bank of India has low cumulative credit growth followed by low NPAs for all the four years from 200001 to 2003-04 and IndusInd Bank had high cumulative credit growth followed by low NPAs for 2000-01 and 2003-04. Some major observations can be made based on Table 2:  Banks with high credit expansion followed by low NPAs are the ones with a good credit appraisal system in place and with ability to recover it. It may be possible for a bank to perform well in this sense for one year, but not consistently.

Only HDFC Bank was able to perform this way over four years, that is, from 2000-01 to 2003-04. Jammu & Kashmir Bank and IDBI Bank have been in this category for three years.  Banks with high credit expansion followed by high levels of NPAs cannot perform consistently and they invariably fall behind; it is an unsustainable approach. Banks such as Development Credit Bank fall in this category. Aggressive credit expansion along with non-recovery till 2001-02, forced it to substantially curtail its operations, ending up with low advance growth during 2003-04. Lord Krishna Bank has been in this category since 2001-02.  Banks with low credit expansion and low NPAs adopt a cautious approach towards credit expansion. And those that consistently belong to this category have low growth in advances, despite low levels of NPAs. As per Table 2, only State Bank of India has been in this category consistently. Perhaps, the credit market in India does not have the capacity to absorb the funds available. Sangli Bank, one of the old private sector banks, has been in this category for three years. Banks with comparatively larger balance-sheets, such as State Bank of Saurashtra and Bank of Baroda, were also members of this group for two years.  As mentioned, banks with low credit growth and high NPAs are the ones to be monitored. These banks may have to review their credit assessment and monitoring systems. Based on the four years, the banks commonly in this group are Dena Bank, Ganesh Bank of Kurundwad and SBI Commercial & International. Further, for the last three years, Punjab & Sind Bank has been in this category. United Western Bank and erstwhile Global Trust Bank were in this category for two years. It is worth mentioning that United Western Bank had extended high credit despite having high NPAs during 1997-98 to 2000-01.  The common perception that listing of a bank in the stock market improves quality of management may not be always correct, as illustrated in the Dena Bank, United Western Bank and Global Trust Bank cases.  Also, ownership pattern does not necessarily have a bearing on performance of banks. Both private and government entities have appeared in the important categories discussed. To conclude, higher than average credit expansion can further strengthen banks if there is a good credit appraisal systems, strict recovery procedures and overall checks and balances by the top management. (The authors are in the Division of Banking Studies, RBI, Mumbai.) Article E-Mail :: Comment :: Syndication :: Printer Friendly Page