Credit Risk
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DEPARTMENT OF Accounting AND FINANCE
A STUDY ON THE CREDIT RISK MANAGEMENT SYSTEM OF DASHEN BANK IN CASE OF HAWASSA CITY.
A Senior Essay Submitted To The Department Of BANKING BANKING AND FINANCE In The Partial Fulfillment Of The Requirement For The Degree Of Bachelor Of Art (B.A) OF ACCOUNTING AND FINANCE.
BY: SHIMELIS BOGALE
ADVISOR: ADVISO R: Mr. Mr. P. ATHMA ATHMA KARAN REDDY
JUNE, 2012 Hawassa
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Acknowledgement First and for most our thanks goes to God and without whom we could never have been what we are today.
Next our greatest thanks to our advisor Mr. Karan. He gave us a constructive Advice and comments through out our work.
Finally, for myself only I would like to thank my friend Fekadu for editing and Abinet business center who received the burden of typing the essay. Thanks All!
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TABLE OF CONTENTS CHAPTER ONE
PAGES
1. Introduction ………………………………………………………………………………….1 1.1 Background of the study ……………………………………………………………………1 1.2 Background of the organization …………………………………………………………….2 1. 3 Statement of the problem …………………………………………………………………..3 1.4 Objectives of the study …………………………………………………………………..…3 1.5 Objectives of the study ………………………………………………………………….….4 1.6 Scope of The study…………………………………………………………………………5 1.7 Limitation of the study……………………………………………………………………..5 1.8 Methodology of the study………………………………………………………………….5 1.9 Organization of the study ……………………………………………………………….…6 CHAPTER TWO
REVIEW OF LTERATURE
2.1. Definition of credit risk ……………………………………………………………………7 ……………………………………………………………………7 3
2.2. The need of credit risk management ……………………………………………………...7 2.3 Principles of credit risk management ……………………………………………….……9
2.3.1. Establishing an appropriate credit risk environment…………………………..……9 environment …………………………..……9
2.3.2. Operating under a sound credit granting process …………………………….…...10
2.3.3. Containing an appropriate credit
Administration, measurement and monitoring process process ………………………………… …………………………………
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2.3.4. Ensuring adequate controls over credit risk ………………………………………11
…………………………………………………… ………11 2.3.5. The role of supervisor ……………………………………………………
2.4. Credit risk management approach ……………………………………………………..12
2.4.1. Minimal risk Approach ………………………………………………………….12
2.4.2. Price for risk approach ………………………………………………………….13
2.4.3. Diversity of Risk Approach…………………………………………………….15 Approach…………………………………………………….15
2.5. Credit risk management cost……………………………………………………….….15 cost ……………………………………………………….….15 2.6. Credit risk management function ………………………………………………….….17
2.6.1. Credit analysis and appraisal ……………………………………………… …………………………………………………...17 …...17
2.6.2. Work out procedure …………………………………………………………..…19
2.6.3. Loan monitoring and review ……………………………………………………19
CHAPTERTHREE
DATA ANALYISIS AND INTERPRETATION
3.1. Lending activity of Dashen Bank ………………………………………………….…..20 4
3.2. Organs involved in credit risk management……………………………………….…...22 3.3. Credit risk Management practice of Dashen Bank………………………………….…25
3.3.1 Objectives of Credit Risk Management…………………………………….……26 Management………………………… ………….……26
3.3.2. Causes of Credit Risk……………………………………………………………26 Risk………………………… …………………………………26
3.4. Preventive Techniques Method…………………………………………………….…...27 3.5. Mechanism to reduce credit risk ……………………………………………………….29 3.6
Problems in Dashen Banks Credit Risk Management………………………………....…. Management………………………… ……....….33 33
CHAPTER FOUR
FINDINGS, CONCLUSIONS AND RECOMMENDATIONS
4.1 Findings and Conclusions………………………………………………… Conclusions……………… ………………………………………………..…35 ……………..…35 4.2. Recommendation…………………………………………………………………………....37
Reference
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REFERENCE
Carol Alexander 1999, Risk management and analysis volume I Paul S. may land 1993, bank operating cred credit it risk Pony von vestal 20014 credit risk management basic concept.
Tray G.Herrik 1990 Bank analysis Http/www. Bir.org.pdf: Battle committee, on bank supervision (Nov1999), principle for the management of credit risk. 6
Http/www. Erisk.com v. vedson 2003: credit risk assessment in bank
Hawassa University School of Accounting and Finance Department of Accounting and Finance 7
Interview Questions 1. What What are the major major elements elements of credit credit policie policiess and procedure proceduress in this area bank? 2. What is the objective objective of credit credit risk management management process process in this local bank? bank? 3. What What is the cause cause for the the existen existence ce of ccredi reditt risk? risk? 4. What What are the prevent preventive ive techni techniques ques or metho methods ds of credit credit risk? risk?
CHAPTER ONE
Introduction
1.1 Background of the study
In the banking there are various types of services provided by the institutions. Among these, credit operations are one of the most important core businesses of the Bank. The word Credit drives from the Latin word “Creder” which shows the existence of trusts between borrowers and 8
le lende nder. r. Withou Withoutt this, this, th thee de deve velop lopme ment nt of moder modern n indus industri trial al co comm mmuni unity ty would would have have been been impossible. The major principle believed in credit is “Buy now-pay latter”. The principle shows that in the absence of cash on hand business entities in the economy can delay payment until fund is available, by making agreement with seller. Most of the time the counter made between buyer and seller, seller, borrower and lender may may become inefficient inefficient because of many many reasons. The existence of problems in the credit lends to the concepts of “credit risk management” on the other hand the importance of credit for banks can be seen by its being one of the risks bank face. Banks have managed four types of risk to earn profits for maximizing share holder wealth. The risks are credit risks, interest rate risk, liquidity risk and operational risks. And all the risks mentioned above are directly or indirectly related to credit. The credit risk management process of bank is believed to be a good indicator of the quality of the banks portfolio. (Source: Robert J. 1994:4) The importance of credit in the banking industry can be seen position in the financial statement of banks. Loans are the most important asset in any commercial commercial bank. Loans account for half to almost three quarter of the total value of all bank assets. In the income statement of banks interest and fees generated from loans account for most banks. Revenues, normally two-thirds or more of the total income (http://www (http://www.. erisk.com).
In the competitive environment, more and more lines of business which need a huge investment are being opened. Some of these huge investments are financed through commercial banks loans. With this respect, banks play a major role in the overall economic development of country. Howe Ho weve ver, r, in this this pr proce ocess ss of ex exten tendi ding ng credi creditt to cu custo stome mer, r, a bank bank sh shoul ould d have have a way way of scrutinizing its borrowers so that it would minimize the risk of default .The effect of default is not limited limited to that of affectin affecting g the profit profit of one particular particular bank but it has a ripple effect effect that extends itself in to the economy at large . Hence, prudent banks are concerned about the quality
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of their loan and the effectiveness of their risk management process in order to safeguarding their business as well as the overall economy. (Herrick,1990:68)
1.2
Background of the organization
According to national bank of Ethiopia /NBE’s/ release on history of banking in Ethiopia; moneta mon etary ry and banking banking proclam proclamatio ation n number number 83 /1994 /1994 and the licensin licensing g and supervis supervision ion of banking business number 84/1994 laid down the legal basis for investment in the banking sector. Conse Co nsequ quent ently ly,, Dashe Dashen n Bank Bank succe succeedi eding ng Awas Awash h Intern Internati ationa onall Bank Bank to be the 2 nd private commercial comme rcial bank on September September 1995. (The history of banking and other financial institutions in .com/ index .htm) Ethiopia, NBE: official website www.dashenbank .com/ The total number of Dashen area Banks had reached 52 excluding the previous four /4/. Foreign exchange bureaus and the additional one at international while the number of cash points, A automated Taler Machine (ATM) and point of sale (POS) terminal ,has reached 45 and 698 respectively (According to annual report of Dashen bank as per June 2010) The bank use common banking solution called flex-Cube to support their banking operation as the current business request. Dashen Bank starts to use FLEXCUBE some years back with latest version 5.1. Thus, it gets much easy for the said bank to use the prospect and current fruits of ICT world to give efficient and reliable service to customers. Dashen Bank is the first bank in Ethiopia to be appointed a principal member of VISA. Payment card usage the bank was prompted by a number of key requirements including the need for a scalable solution to meet transaction growth objectives, support for multiple delivery channels and devices, and the ability to offer world – class card payment services to over 300,000 existing customerr accounts in Ethiopia . “As per information comes from the Bank ,” there are 698 point custome of sale /POS/machines at different merchant outlets and 45 ATMS installed at different place of the country country to serve more more than 30,000 30,000 card holders. holders. As the result result of Bank effort for fully fully 10
networked branches, it has got more read to transfer money with seconds between area branches. Broad Band Local Money Transfer Transfer /BLMT/service /BLMT/service count sometimes sometimes past with in banks, having similar effect of well known money transfer service, Telecom Transfer /TT/, but with more efficient effective result. Dashen Bank in Hawassa Area was established on January 15,1996. As of June 30,2010 the area bank has 27,326 numbers of depositors, 259 numbers loanees and 4,396 payment card holder and 10 point of sale /POS/ merchants. Being a pioneer to introduce the payment card system and with an excellently rated service delivery quality, the area bank has been also to maintain the leading position for the last few years. Dashen Bank with in the country, are hopefully expected to show all achievements in electronic banking and latest technology in use to handle more competitive market in the industry to come.
1. 3 Statement of the problem
Credit risk is the main cause for most bank failure. It can be raised when the debtor can not be able to pay interest or repayment of principal according to the terms specified in credit agreement. agreeme nt. High credit credit risk would reduce earnings earnings and capital, capital, increase increase administration administration cost of bank and induce liquidity problems affecting cash flow. That is why it is essential that management focus much of its attention on managing the loan. This study tries to investigate the following questions. What are the credit policies of the bank?
What are the preventive techniques and control procedure for a loan?
What Wh at ar aree th thee pr prob oble lems ms an and d ch chal alle leng nges es with with re rega gard rd to the the ba bank nk’s ’s cr cred edit it ri risk sk management endeavors?
What is the sources of information to assess credit risk? What methods are used in order to assessing credit risk?
1.4
Objectives of the study
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This study study is to achieve achieve both general and and specific specific objectives objectives related related with
evaluation evaluation of credit credit
risk management practice of Dashen bank in Hawassa branch.
1.4. 1.4.1 1
Gene Genera rall Obje Object ctiv ivee
The general objective of this study is to assess credit risk management system of Dashen bank in Hawassa branch and to find out the problem related with credit risk management practice.
1.4.2 Specific objective
The specific objectives of the study are:
To review credit risk management practice of Dashen Bank (a review of the sufficiency of the information received which is used as a basis for extension of credit ,loan supervision and work out procedure to collect bad debt.)
To identify the major causes of credit risk management practices of Dashen bank
To assess the methodology that the bank has used to reduce credit risk.
To identify problems and challenges that the bank is facing in managing credit risk.
1.5 Significance of the study
An efficient credit risk management system is the determining factor for success in changing business environment environment.. Banks need to predict scientifically scientifically the exact level of risk they are going to assume by entering in to a contract in availing credit to the customer.(Paul,1991: 78) The following are the significance of the study. This Th is study study is useful useful in bring bringing ing in to light light th thee stron strong g an and d weak weak points points in the credit credit ris risk k management.
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This paper mentions several important ideas which is the best reference for the future researcher.
Other organizations organizations use this method to avoid the risk of credit as the organization organization perspective.
This study attempt attempt to find out problem problemss related related with credit credit risk manageme management nt system. And as such better approach to deals with maintaining good credit risk management system level in any organization. It provides information for future research those who want to do.
This study also provides relevant recommendation and conclusion by assessing a theoretical and description for better method for credit risk management practice in the organization.
1.6
Scope of The study
Poor loan quality is not the only outcome of the poor credit management alone. There are other factors that can contribute for the deterioration of quality of a loan, for example natural factors. However, this study is limited to credit risk management of Dashen Bank in Hawassa branch.
1.7
Limitation of the study
We face the following limitations when conducting the study:
Lack of appropriate , accurate and reliable and current data
Financial constraint to collect enough and necessary data from different area Time constraints to conduct the study briefly
Lack of our past experience to conduct this research.
1.8
Methodology of the study
1.8.1. Data type
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We use both quantitative and qualitative data to conduct our study. It consists of graph and tables to conceptualize data analysis. 1.8.2. Source of Data
The paper is based on primary and secondary data source Primary data source:
It is mainl mainly y av avai ailab lable le from from person personal al in inter tervie view w of the the selec selecte ted d divis division ion head head of the the Bank Bank /management /manag ement of the Bank officer, which helps the study to be furnished furnished with first hand information. Secondary data source:
This data is mainly available available from the policy manuals, annual reports and publications also used as backup means of collecting second hand information.
1.8.3 Methods of data analysis
This paper is attempt to summarize more of what already known and inter related the existing knowled kno wledge, ge, data, data, reports, reports, study etc. etc. In this paper descrip descriptive tive and analyti analytical cal techniqu techniques es are employed to show the techniques and methods of credit risk management through manuals, annual reports etc.
1.9
Organization of the study
This paper organized in to four major parts. In the first part , the study have been tried to indicate introduction with background of the study , background of the organization ,statement of the problem ,objective of the study, significance of the study, scope of the study, limitation of the study and research methodology . The second chapter deals with literature review. The third 14
chapter cha pter consists consists of data analysis analysis and interpre interpretati tation on of findings findings.. The final chapter chapter includes includes conclusion and recommendation of the study.
CHAPTER TWO Review of Literature 2.1. Definition of credit risk Banks make money by providing services that their customer wants and by granting them credit. There are some risks with these services and the most significance risk is credit risk. According to Paul (1990) credit risk is the risk of loss due to the financial weakness of the bank’s cu cust stom omer ers. s. Gener General ally ly,, that that the the cu cust stom omer erss wi will ll no nott be ab able le to pr provi ovide de fu funds nds,, to se sett ttle le it itss transaction, usually due to bankruptcy or some other liquidity crisis It also defines credit risk by another author as follows:
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It is the risk that a borrower will be unable to meet its obligation. A bank reflects and aims to profit from taking credit risk by charging higher interests margins margins on loans to those customer that is consider present a higher risk.(Brigham,1991:400)
2.2. The need of credit credit risk management
According to (http/www.erisk.com) bank oil the wheels of the economy. They play a pivotal role in mobilizing saving. In doing so, they face risks arising from credit, interest rate, liquidity, exchang exc hangee rate, rate, trans transact action ion,, compli compliance ance,, str strate ategic gic and reputa reputati tion. on. Banks Banks key challe challenge nge in managing risk in understanding the interrelation of this risk factors they may be positively or negatively correlated. To be consistent with the research them the focus here is on credit risk, which is the risk repayment, that is the possibility that an obligor will fail to perform as agreed. Banks Ban ks led to indivi individual duals, s, corpor corporati ations ons and governm government ent who in turn turn contrib contribute ute to growth growth,, employment and better socioeconomic conditions. The goal of credit risk management is to maximize a banks risk adjusted rate of return by maintaining credit risk exposure with in acceptable parameters, Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credit or transactions. Banks should also consider the relationship between credit risk and other risk the effective manag ma nagem ement ent of credi creditt risk risk is a cr crit itic ical al compon componen entt of a co comp mpre rehen hensi sive ve ap appr proa oach ch to ri risk sk management and essential to the long term success of any banking organization. For most banks, loans are the largest and most obvious source of credit risk. However, other sources of credit risk exist throughout the activities of a bank, including the trading book and both on and off the balance sheet. Banks ate increasingly facing credit risk(countered party risk) in various financial instru ins trumen ments ts other other tha than n loans loans ,inclu ,includin ding g accepta acceptance, nce, inter inter bank bank tra transa nsacti ction, on, trade trade fi financ nancing ing foreig for eign n exchang exchangee transa transacti ction, on, financ financial ial future future,, swaps, swaps, bond bondss ,equit ,equities ies,, option optionss and in the extension of commitment and guarantees, and the settlement of transaction. The taking of credit risk is a principal function of banks. How a bank approaches credit risk represents one of its important important policies. The willingness of banks to take take credit risk has provided a major service to market economics throughout banking history. The help of banking business is assessing credit risk not necessarily taking risks, but assessing them. The distinction is important 16
because the ability to assess is asking and whether the credit risk are taken or not taken is a management decision. Since exposure to credit risk continuous to be leading sources of problems in banks and their supervisors should able to draw useful lessons from past experience. Banks should now have a keen awareness of a need to identify measure, monitor and control credit risk as well as to determ det ermine ine that that the hold hold adequat adequatee capital capital against against these these ri risks sks and that that they they are adequat adequately ely compensated for risks incurred. A further particular instance of credit risk relates to the process of setting financial transactions. If one side of transaction is settled but the other fails, a loss may be incurred that is equal to the principal amount of the transaction. Even if one part simply lat in settling, the other party may incurred relating to missed investment opportunities. Settlement risk (i.e. the risk that completion of settlement of financial transaction will fail to take place as expected) thus includes elements of liquidity, market, operational and reputation risks as well as credit risk. The level of risk is determined by particular arrangement for settlement. Factors in such arrangement that have a bearing on credit risk include. The timing of the exchange of value payment settlement finality. finality.
2.3 Principles of credit risk managemen managementt The goal of credit risk management should always be to maximize banks risk adjusted rate of return by maintain credit risk exposure with in the entire portfolio as well as the risk individuals credit or transactions. Bank should also consider the relationships between credit risk and other risk. The effective management of credit risk is a critical component of comprehensive approach to risk management and essential to long term success of any banking business. The Basel Basel commit committee tee promot promotes es sound sound practi practices ces for managi managing ng credit credit ris risk. k. In li line ne with with thi thiss objectives, the committee has outlined principles of credit risk management which are mainly ap appl plic icabl ablee to the the bu busi sine ness ss of le lend ndin ing g an and d it be beli liev eves es th that at ba bank nkss sh shou ould ld no now w ha have ve a ke keen en awaren awa reness ess of the need to identi identify fy,, measur measure, e, monito monitorr and contro controll credit credit risk As well well as to 17
determ det ermine ine that that they they hold hold adequat adequatee capital capital agains againstt these these ris risks ks and that that they they are adequat adequately ely compensated for risk incurred. Although specific credit risk management practices may differ among banks depending upon the nature nat ure and comple complexit xity y of their their credit credit activi activiti ties, es, a compre comprehens hensive ive credit credit ris risk k manage managemen mentt program will address the following four areas of credit risk management identified by the committee.
2.3.1. Establishing an appropriate credit risk environment
Principle 1: The board of director should have responsibility for approving and periodically (at
least annually) reviewing the credit risk strategy and significant credit risk policies of the bank. The strategy should reflect the bank’s tolerance for risk and level of profitability the bank expects to achieve for incurring various credit risks. Principle 2: Senior management should have responsibility for implementing the credit risk strategy approved by the board of directors and for developing policies and procedures for
identifying, measuring, monitoring and controlling credit risk. such policies and procedures should address credit risk in all of the bank’s activities and at both the individual credit and portfolio levels. Prin Princip ciple less 3:
Banks Ban ks should should identi identify fy and manage manage credit credit risk inhere inherent nt in all produc products ts and
activities. Bank should insure the risks of products and activities new to them are subject to adequate risk management procedures and controls before being introduced or under taken and approved the body of director or its appropriate committee. 2.3.2. Operating under a sound credit granting process Principle 4: Banks must operate with in sound, well defined credit granting criteria. These
criteria should include a clear indication of the banks target market and a through understanding of the borrower or counter party, as well as the purpose and structure of the credit and its source of repayment. Principle 5: Banks should established overall credit limits at the levels of individual borrowers
and counter parties and groups of connected counter parties that aggregate in comparable and 18
meaningful manner different types of exposure, the banking and trading book and on and off the balance sheet. Principle 6: Banks should have a clearly established process in place for approving new credits
as well as amendment, renewal and refinancing of existing credits. Principle 7: All extensions of credit must be made on an arm’s length basis. In particular, credit
to related companies and individual must be authorized on the exception basis, monitored with particularly care and other appropriate steps taken to control or mitigate the risks of non-arms length lending.
2.3.3 2.3.3.. Cont Containi aining ng an appr appropri opriate ate cre credit dit Adm Administ inistratio ration, n,
measurement and monitoring process Principle 8: Banks should have in place a system for the ongoing administration of their various
credit bearing portfolios. Principle 9:- Banks should have in place a system for monitoring the condition of individual
credit including determining the adequacy of provision and resources. Principle 10:- Bank is encouraged to develop and utilize an internal risk rating system in Principle managi man aging ng credit credit risk. risk. The rating rating system system should be con consis sisten tentt with with the nature natures, s, size size and complexity of a bank’s activities. activities.
Banks must must have have inform informati ation on system systemss and analyt analytica icall techni techniques ques that that enable enable Principle 11:- Banks Principle management to measure the credit risk inherent in all on and off balance sheet activator. The management information system should provide adequate information on the composition of the credit portfolio, including identification of any concentration of risk. Principle 12:- Bank must have in place a system for monitoring the over all composition and quality of the credit portfolio.
should take in in to consider consideration ation potenti potential al future future changer changer in economic economic Principle Princip le 13:- Banks should conditions when assessing individual’s credits and their credit portfolio and should assess their credit risk exposure under stressful conditions.
2.3.4. Ensuring adequate controls over credit risk
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Principle 14: Banks must establish a system of independent, ongoing assessment of the banks
credit risk management process and the result of such reviews should be communicated directly to the board of director and senior management. Principle 15: Banks must ensure that the credit granting function is being properly managed and
that the credit exposures are with in levels consistent with prudential standards and internal limits. Banks should establish and enforce internal controls and other practices to ensure that ex exce cept ptio ions ns to the the po poli lici cies es,, proc procedu edure ress an and d limi limits ts ar aree re repo port rted ed in a ti time mely ly manne mannerr to th thee appropriate level of management for action. Princip Pri nciple le 16: Banks must have a system in place for early remedial action on deteriorating
credits, managing problem credit and similar workout situations.
2.3.5. The role of supervisor
Principle Princip le 17: Supervisors should require that banks have an effective system in place to identify
measure, monitor and control credit risk as part of an overall approach to risk management .Supervisors should conduct an independent evolution of a banks strategies, procedures and practices related to the granting of credit and the ongoing management of the portfolio. Supervi Supe rvisor sorss should should conside considerr settin setting g prudent prudential ial limits limits to restr restrict ict bank bank exposu exposure re to single single borrowers or groups of connected counter parties.
2.4. Credit risk management approach
According to Herrick (1990) banks manage their credit risks there are three approaches. They are minimizing risk, price risk and diversity of risk approach. All approach requires an ability to assess credit risks. The difference between the three approaches is the way assessment of risk is used by the banks.
2.4.1. Minimal risk Approac Approach h
The minimal risk approach to credit risk management attempts to separate loans, securities and other assets in to two groups. The first group includes credit in which there is no reasonable doubt that the asset will be redeemed at face value, or in the case of equity investment, no reasonable doubt that the environment will provide a significant return over a period of years. 20
The other group include all assessments of credit risk where it appears that a credit might not be redeemed redeem ed or an equity investment investment might not provide a good return. return. Many young bankers of the time told themselves that they would do that what ever was needed to prevent the experience from happening again. One preventive measure was to look carefully at qualify the loan application. Little could be done about past loans. Many of them were either on the workout basis or on salvageable. But new loans and some renewed loans were the type of business over which a banker had some discretion .Banker did not feel confident about drawing fine lines of various degrees of risk and credit worthier. Loans which were not likely to be repaid, beyond reasonable doubt simply were made. The minimal risk approach relies on the classic three C’s of credit; character, capital and capaci cap acity ty.. The risk approa approach ch to credit credit risk requir requires es that that bankers bankers act as a helpfu helpfull fri friend, end, a consultant and an advisor who user firm persuasion when necessary. This informal relationship adds a subtle, but strong, pressure to the management of any organization to keep its affairs in good shape. Moreover, if a banker approach credit risk from the minimal risk approach, his effort is directed to prevent any losses risk from occurring. There is no place in his thinking for losses and he makes extra ordinary efforts to full fill this outlook. To a banker with this credit risk approach and with dedication to his customers, there is often a feeling of person’s failure if loss occurs. This psychological incentive to prevent losses provides an important part of attitudes of bankers with a strategy that strives to minimize risk. The effect of the minimal risk approach is that it tends to keep activities restricted to areas that are already well known to a bank new areas of banking involve greater uncertainties then areas that are part of daily banking activity. A step outside this circle of knowledge and friends reduces the value of years of banking acquaintance in other established areas of business or government .Although the minimal minimal risk approach has this impor important tant limitati limitation on built into its philosophy philosophy , many banks have very successful for many years following this policy of credit risk. 2.4.2. Price for risk approach
Risks pricing recently has developed as an alternative approach to credit risk. The interest that charged for a loan of greater risk. In recent years, this approach also has relied on the basic
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method of credit analysis noted with the minimal risk approach, but carries the conclusion much further. The risk pricing approach looks at all degrees of risk as a normal part of the banking business. In effect, it views the assets of the bank loans, securities, and investment in various shades of white and grey and accepts all o\f them as legitimate ,worth while assets . Assets of greater credit risk involves greater risk of loss but these of greater credit risk involve greater risk of loss , but these assets are expected to be priced to earn enough more interest income to offset their credit risk , a profit for the bank . Assets of little little credit risk involve low risks of loss. These assets are expected to earn lower interest rates and also earn profit for a bank. If risk pricing is done properly, assets of all types of credit risk should show approximately the same profit to a bank. The risk pricing approa app roach ch reflec reflects ts two trends trends in bankin banking g during during the past decade decade.. Fir First st,, has been a growin growing g assurance among many banks that they possess the technical capabilities of assessing risk to greater extent than did an earlier generation of bankers. New techniques have been applied to banking that did not exist a generation ago. Computers have enabled banks to handle much greater quantities of information. Operations research and system research have opened new ways generation of analyzing information. Operations research and system research have opened new ways of analyzing information. A ne new w gener generat atio ion n of thin thinki king ng ha hass rise risen n whic which h be beli liev ever er th that at it can make make more more ac accu cura rate te conclusions based on factual experience than on the rule –of – thumb guides and the personal judgment
of credit officers ,loans officers and securities traders .Many banker have been
emboldened embol dened by these greater greater technical technical resources resources in much the same same way and at about the same same time that many economists developed their confidence in being able to “fine tune” the economy and many psychologists psychologists developed developed their confidence confidence about “motivating” “motivating” people. All of these approa app roach ch to knowle knowledge dge rest rest on suprem supremee confid confidence ence that that there there are highly highly refine refined d ways ways of conducting operation that will bring superior results. The second trend underlies the growth of risk pricing is the recent emphasis for the banks to show strong earnings gains. Risk pricing opens the door to major expansion in banking. Business a large proportion of a business that would be turned down on the basis of the minimal risk approach becomes choice bankable business. To work successfully over a long period, the risk price approach requires three conditions. The first requirement is a need for a large number of assets in the banks asset 22
portfolio. The basis of risk pricing is that a banker does not know which loan, security or investment will require emergency efforts, reduced terms of fail, but he should have good idea of likelihood that these difficulties could occur in large portfolio. The second requirement is that the bank needs a staff with considerable analytical skills. The process of assessing various degrees of risks is not a task that a one or two main credit department can easily handle. The development of risk pricing format for a bank involves major statistical operation. Moreover, the risk pricing format for one bank would not necessarily be appropriate for another bank. A risk pricing pricing format provides specific guidelines shown the way particular bank will price a loans, security, security, or investment and reflects the franchise of a particular bank,its personnel and its ongoing business relationship with customers. customers. The third requirement is that a bank needs to possess an outstanding forecasting capability. Risk pricing is concerned about the future and must make much more complete and accurate assumptions concerning the future conditions of credit markets, business activities and attitudes of debtors.
2.4.3. Diversity of Risk Approach
Credit risk management often diversifies a portfolio of loans, securities and investments at a simple yet. Effec Effectiv tivee way of keeping keeping proble problems ms of credit credit risk risk under under contro control. l. However However,, the approac approach h is sometimes mistakenly used to justify taking greeter individual credit risk or slimmer risk price premium than otherwise would be justified, which is mistaken. mistaken. In fact, diversity can only partially control risk and it is not an approach to credit risk that can stand independently of other approaches. For example ,if credit department of bank is covered by other departments , or is not well managed , and low quality assets are acquired with no appreciable risk premium , a program to diversity these assets would not eliminate their risk . It would mean that the bank would hold a wide variety of low quality assets. Diversity permits the 23
more fundamental approaches to credit risk minimal and risk pricing to be fulfilled in true colors. If reduces the likely hood that random or accidental occurrence will have an appreciable effect on one of these fundamental policies. A major practical problem in diversifying credit risk is determining what constitutes diversity. There are literally thousands of ways of classifying assets, and a case could be made that many of the categories represent diversity on logical ground. Yet to be effective, risk diversity requires relevant categories and the determination of the relevant categories is not an easy matter.(Herrick matter.(Herrick ,1990: 135)
2.5. Credit risk management cost
The starting point for efficient credit control is recognition of the cost of credit and its potential effects on profit and liquidity. Techniques for managing operating credit risk build on the board principles of risk management that are already deeply ingrained in banking practice. There are three basic ways to manage carry costs to consider. consider. They are: 1. Exposur This cr cred edit it expos exposur uree could could be el elim imin inat ated ed by re requi quiri ring ng th thee Exposuree reduction: reduction: - This customer to provide collateral or guarantees. Banks have their own specialist lenders and credit cre dit risk risk assess assessors ors who have have the skill skill s and experi experienc encee to assess assess risk reduct reduction ion.. Althou Alt hough gh exposur exposuree reduct reduction ion techni techniques ques are genera generally lly not expensi expensive ve for banks banks to implement, they often result in higher customer costs. 2. Risk control:control:-Programs to control risk on the other hand can involve a change on operations and are often expensive expensive to implement. This is designed to monitor the actual level of risk or it changes and to refer to transaction to the proper credit authority for approval before the exposure is carted. 3. Loss funding:- provision must also be made for any an y losses that do occur. Although banks ensure loans losses by deducting a provision from earnings to create are sere, must do not use this mechanism to ensure against losses from operating services. Ideally, reserves should be built and capital allocated to operating services in proportion the risk they incur. The determine the level of credit risk to be funded , the following have to be considered : how much much risk risk re rema main inss af afte terr im impl pleme ement ntin ing g ex expo posu sure re re reduc ducti tion on an and d ri risk sk co cont ntro roll
24
procedures , the operation dependability of the efforts and an analysis of the likelihood of loss from the remaining exposure.(Paul exp osure.(Paul F.,1991:132) F.,1991:132) Credit risk management is divided in to two faces according to Churchill and Dancoster (2001) I. Prior to issuing a loan, a lender reducer credit risk through control, that reduce the potential for delinquency or loss commonly known as preventive steps before issuing a loan and it includes : loan terms , loan amount reflecting the clients repayment capacity ,legibility , criteria for a loan request , repayment frequencies , collateral, ability and willingness of borrowers to repay a loan and check credit history with suppliers and other credit organizations. II. Once the loan is issued a lenders risk management expands control that reduce actual losses, commonly know or controls after extending loans. It includes the following features
Periodically analyzing the portfolio quality with intent to modify procedures and policies before the loan quality deteriorates
Field staff and clients must understand that late payments are not acceptable and clients should be penalize for the late payments or rewards to early payments.
There should be effective follow up procedures
The consequence of loan default must be successfully unappealing to clients.
Al Alll credi creditt de depa part rtme ment ntss sh shou ould ld have have cr cred edit it manag managem emen entt manu manual al in or orde derr to st stan anda dard rdiz izee procedures. The manual should be regularity updated to account for changes in procedure and circumstances. The manual contains :- statements of credit policy , methods of payment for various of account, specimen of management information forms and reports and the time table for completion and procedures for account collection , credit sanction ,legal action, disputes ,bad debits, credit limits etc. 2.6. Credit risk management function
According to Bass (1998) credit risk management is the core to achieve the desired objective credit cre dit risk risk manage management ment contain containss three three basic basic functi functions ons and these these are: are: credit credit analysi analysiss and appraisal, credit monitoring and review and workout procedures 2.6.1. Credit analysis and appraisal
25
Havi Ha ving ng co comp mpil iled ed a ba basi sicc file file of info inform rmat atio ion n an and d in inves vesti tiga gate ted d re reven venue uess su sugge ggest sted ed by incon in consi sist sten enci cies es,, de dero roga gato tory ry co comm mment ents, s, and fa favo vora rabl blee opini opinion ons, s, th thee an anal alys ysis is as asse sess ss th thee willingness and ability of the applicant to repay. Each of these describes an area of the persons or firm’ss credit worthiness. firm’ 1. Character: - The quality of desiring to repay debates when due is tanked above all other considerations. Of course, honesty is a necessity, but character implies integrity and empath emp athy y for the lender lender posit position ion as well. well. An establ establish ished ed credit credit record record (s (subs ubstan tanti tial al borrowing and voluntary repayment) is one of the best evidences of business or individual willingness to repay. Also, character is implied by the applicants’ position of trust accepted and full filled in business and social organizations follows that of top management, its facilities for keeping records, the reutilization of office functions and relations with employees. 2. Capacity: Capacity is the ability to repay debuts as scheduled for households, the employment of the working member provides most of the income which is spent for consumer expendables, and debt repayment .consumer capacity is a reflection of safety margin mar gin between income income and committed outflows outflows and the stability stability of each. The analysts must consider the effects of unusual events such as prolonged illness or unemployment on the economic capacity of the household. Business capacity, like wise, depends upon sales income expenditure patterns, and debt commitments. However, the complexities of business operations are substantially greater than that of household, requiring analysis highly highl y trained trained in corporate finance and knowledge knowledge about the accounting, marketing marketing and financial peculiarities of the firm and its industry. 3. Capi Capital: tal: This faces of the applicant refers to his or her financial strength, that is, the ability to raise funds from the liquidation of assets or other businesses. As last resort the borrower’s capital may repay the debt, but such actions generally mean the termination of the borrower’s business and, of course, the relation ship with the leading institution. 4. Conditions : - Borrowers may be subject to unfavorable economic conditions beyond their control. Repayment depends not only upon character, capacity and collateral, but those factors over which the borrowers exercise little or no control. The long-run and short run business cycle affects nearly all persons and individuals, but certain industrials are especially prone to oscillate o scillate between prospect and depression. Credit analysis monitor 26
industrial patterns, looking for early signs of weakness which lead to unemployment, say declines and/or operating losses. Under the extreme adverse pressures of falling sales and loss of income, even strong, honest character ch aracter may subvert the loan relationship in order to pressure their economic position. 5. Collateral: - It is an asset, normally moveable property pledged against the performance of an obligation. Bank can sell the collateral if the borrower defaults, while collateral reduces banks risk; it enhances the cost in terms of documentation and monitoring the collateral. The factor determines suitability of the collateral is standardization, durability, identification, marketability and stability of value. Standardization helps in identifying the nature of asset that is being used as collateral. Durable refers to useful life or ability to with stand wear and tear. Durable asset make better collateral. Identification is possible if the collat collatera erall has define defined d charact characteri eristi stics cs like like a buildi building ng or a serial serial number number (motor (motor ve vehi hicl cle) e).. Mark Market etabl ablee co coll llat ater eral al al alon onee is of va valu luee to th thee bank bank if it ha hass to se sell ll it it.. Marketability must be distinguished from liquidity. Liquidity refers to quick sale with little of no loss from current of loan (Robabruce, 1997: 199 7: 808).
2.6.2. Work out procedure
Works out procedure are important aspect of credit risk management. If timely action is not taken to address the problem loans, opportunities to collect poor quality asset will soon vanish. Work out procedure involves the following process. Identification of the problems loans, reviewing loan history and documentation and meet the customer and openly discuss the problem. The first element of workout procedures is to ensure collection. In the absence of ensuring collection with in short period of time, arranging new agreements for the borrower if it helps to get out of problem is an other alternative. The arrangement may be in terms of extending the loan period for injecting additional capital c apital if the problem is working capital shortage. The last step in work out procedure is to collect the loan through litigation if possible.
2.6.3. Loan monitoring and review
27
Proper credit risk management involves due credit credit analysis, analysis, having propositi proposition on approv approved, ed, cash disbursed and ultimately follow up the loan in order to have the extended credit rapid back good credit could become problem loans unless a continuous follow up is made which enables to detect signs that reveal difficulties. The objective of credit monitoring and review among others includes: ensuring the loan are directed to the intended purpose, ensuring that loan convenient are compiled with following up borrowers business conditions , maintaining good quality of loan and identifying emerging problems. Attention should be given to the following while conducting monitoring and review of credit. Check on all early working signals:- check the end use of the loan funds , assess all conditions of the borrowers , assess financial need of the borrowers and state finding and interpret them /improvements, deterioration and changes.
CHAPTER THREE
DATA ANALYISIS AND INTERPRETATION
This chapter of the paper focuses on presentation and analysis of data and information collected through interview, from annual report and manual .However it seems appropriate to start with lending activity of Dashen Bank. 3.1. Lending activity of Dashen Bank
In Dashen banking system, loans and advanced constitute the largest parts of the total asset of the bank. The percentage of total loans of advances to the aggregate asset of Dashen bank lie between 61-74% over the last four years as shown in table 3.1.
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Description
2007
2008
2009
2010
Total asset
108,232,098
142,857,857,143
208,482,868
256,826,392
94,285,714
145,527
189,925,113
66%
70%
74%
3,300,000
4,656,876
5,317,903
3.5
3.2%
2.8%
11,316,260
15,892,926
20,952,381
Tota To tall loan loanss an and d 66,021,378 advances Loans as percent 61% of total asset Provision
for 2,508,820
doubtful loans as 3.8
Provision
pe perc rcen entt of tota totall loans
and
advances Capital
and 8,562,736
reserve
Sources: annual reports of Dashen Bank
As we can seen from the above table the total capital of Dashen Bank reached to 20,952,381 birr at the end of June 30,2006. Review of the trend of stock of outstanding loans and advances shows that there has been a significant increases over the four years. The total outstanding loan has increased from birr 315,402,493 in June 2007 to birr 563,021,789 in June 2010 as shown in table 3.2 below. Table 3.2 Outstanding loans and advancement Categorization 2007
2008
2009
2010
71 71,269,000
97,726,000
102,000,000
127,267,000
trad tradee 60,325,600
71,593,000
98,254,000
123,260,000
56,112,700
63,000,000
87,900,000
115,789,000
loan Manufacturing Dome Do mest stic ic
Year
and services Building
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construction Import
47,297,980
36,917,000
71,500,000
96,229,000
Transport
43 43,463,834
59,371,250
67,327,000
86,911,000
Export
23,481,379
36,000,000
41,289,000
72,539,000
Agricultural
13,452,000
18,229,000
25,886,370
56,700,000
494,156,370
563,021,789
Total 315,402,493 402,836,250 Source: annual reports from 2007-2010
The above table can simply explain the positions of outstanding loans and advance of Dashen bank through four years. It can also see the position in chart I to show the trend of outstanding loan were growing for the period from June 2007 to June 2010.
Chart I: outstanding loans and advances
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From Fro m the total total loan loan and adva advance ncess grant granted ed to its custom customers ers the trans transpor portt sector sector is more more emphasized. Because the transport sector is usually risky, purchased vehicles using the banks assistance are held as collateral. The promoters defaults and disappears from the area hiding the vehicle. 3.2. Organs involved in credit risk management
The credit risk management department is principally in charge of overseeing the overall credit risk management of the bank. This involves initiating new credit policies, enforcing the existing ones and periodically revising the credit policies and procedures and ensuring that loans are processe processed d in accorda accordance nce with with the credit policies policies and proced procedures ures and for warding credit proposals for credit decisions. The board of director and the president and bodies on the top of the organizational structure that are involved in credit risk management issues. The BOD attends to the overall strategic credit and risk management issue of the Bank. It approves credit policies and over sees the overall credit and risk management of the Bank. The president is responsible for issuing 31
credit cred it policy policy and ensuring ensuring their proper proper executi execution. on. He is also responsibl responsiblee for obtaining obtaining appropriate appropria te feed back reports from the credit risk management management department of loan status and in the overall credit management performance and taking remedial actions on irregularities. The organizational structure of Dashen Bank is presented to the next page.
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Organizational structure Organizational
Board of Director President (CEO) Senior Risk Management Advisor
Controller Corporate Corporat e Planning And Development Execuve Secretary Vice President System And Resource Management
Vice Presid Pre sident ent
Ope Opera raon onss
Man Manage agemen mentt
Chief Of Security
Area Bank
Coordinator Execuve Secretary Execuve Secretary
Informaon Informao n
Fund Mgt and Accounts
Credit Risk Mgt
Technology
Promoon
Customer
Related Service
Engineering And Building
Human Resource And Logiscs Internaonall Banking Internaona
Legal
Area
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banks
3.3. Credit risk Management practice of Dashen Bank
As per the interview interview conducted, credit risk management, management, credit risk management management department department the major element of credit policy are eligibility eligibility criteria for every sector being financed by the bank and 5c’s. 5c’s. And it modifies modifies the policy policy regularly regularly Dashen Dashen bank bank gathered information information by formal and informal in order to assess the credit the credit risk of potential borrower. Concerning the customers previous bank credit Exposure, the NBE credit information data center provides the requited information. Besides through different approaches, including implementation of the 5c’s approach and the customer is properly studied.
Dashen bank to get the NBE credit information, the bank initiates, requesting letter to the NBE. The rest information could be obtained through evaluating the organization financial statement and assessing the background of the customers. Based on the previous credit performance of borrowed engaged in similar line of business and the current status of the borrower by it self. Besides external factors such as social, technology, economic and political factors also evaluated to assess the credit riskiness of potential borrowers. Credit risk, both on hand and off balance sheet, it managed and monitored in accordance with credit policy and procedures. The credit worthiness of each counter party credit risk the bank insures, whenever necessary, that all loans are secured by acceptable form of collateral .Although the bank has not established credit limit across industries and product, it regularly reviews its credit exposure. The primary roles of banks are to gather and deposits with safety and lend them on sound basis for attainm attainment ent of the ultimate ultimate objectiv objectivee which which is generat generation ion of revenue revenue through through providin providing g lo loans ans .As .As a Comm Commerc ercia iall Bank Bank Dash Dash Bank Bank prime prime task task conce concent ntrat rates es aroun around d the the proce process ss of borrowing borrowin g and lending money that involve collection of idle fund from different sources by way 34
of accepting deposit with the commitment to pay interest and deployment of fund mobilized in the form of credit to areas where it is needed to support commercial activities that have economic importance.
As consequence of the financial intermediary it assumes, Dashen bank takes the responsibility to safe guard the interest of depositors who provided the fund used for credit extension strength of the bank to safeguard the interest of depositors emanate from effectiveness of the system applied to manage its asset and liability to honor the claim of deposits as and when they occur without supperss supp erssing ing extensio extension n of legitima legitimate te credit. credit. Hence, Hence, the primary primary concern concern of manage management ment in availing loans, which is as a result of risk management, places.
3.3.1 Objectives of Credit Risk Management
Credit risk management is the process of maximization of banks return on it assets while maintaining maintai ning its credit risk exposure with in acceptable acceptable limits because effective risk management management is the foundation of any business. According to business development division head of the bank with whom the interview is conducted, credit risk management is a necessity and not an option to ensure sustainability of the bank, which is to a large extent governed by the quality of its assets. There are, the credit administration standards of Dashen Bank deserves emphasis because the level of competence exercised to effectively managed credit risk measures success or failure of Bank. In general the objectives of the credit risk management are assurance of healthy loan portfolio, which is pivotal for the growth and expansion of the bank.
3.3.2. Causes of Credit Risk
As per the intervie interview w conduct conducted ed with business business division division head of Dashen Bank, most of the employees of the loan officer are assigned their position based on their job experience or loans stay officers are assigned their position based on their job experience experience or loans stay on the job. A
35
bank is successful when risk it takes are reasonable, controlled with in its financial resources and credit competence. Esperance Esperan ce has proved that the pivotal issue for preservation of the quality of loan is existence of well developed policies and procedures, effective credit control and the most critical element of al alll a well well train trained ed staff staff th that at is qu qual alifi ified ed to im imple pleme ment nt the syste system. m. Conve Converse rsely ly busine business ss development division head of Dashen bank also stressed that absence of adequate guideline to monitor administration of the leading function pave the way for occurrence of substantial amount of problem loans. Ther Th erefo efore, re, the ba basic sic ca cause use for the occurr occurren ence ce of credi creditt ris risks ks ar aree incom incomple plete te inform informat ation ion,, weaknes wea knesss in collater collateral al arrangem arrangements ents,, technic technical al incompe incompetenc tencee the ability ability to analyze analyze financia financiall statements and to obtain and evaluation other credit information , lack of adequate supervision of old familiar borrowers etc.
3.4. Preventive Techniques Method
As per the interview conducted with credit risk management department, Dashen bank face problem due to the fact some of the loans and advances granted to various users turned to be bad loans. Different factors can be considered for some loans and advances to turn out to be bad loans. One of the main reasons is that borrowers do not use the fund for the purpose they had taken it for . Some loans become sick due to weak follow up business by the debtor. To overcome this problem before granting a loan, branch manager and the credit investigator go and visit the working place of the applicant. Howeve How ever, r, the loan processing processing is not consider considered ed comple complete te simply simply because because it is processe processed, d, approved and disbursed. It should be supported by adequate loan follow up to ensure the beset
36
performance perform ance of the bank in collections collections repayments as scheduled. After loan is granted it must be managed to ensure that it is repaid loan management is the most important responsibility of a lending officer. Also the credit risk management considers the following signals before the collateral is approved. A.
Early management warning signals
Change in behavior / personal habit / lifestyle of the key people
Change in attitude towards banks especially a seeming lack of cooperation
Failure to perform personal obligation
Lack of experience in line of business
Illness or death of key personnel
In ability to meet commitments on schedule
Poor financial reporting and control
Change in the business of industry
Unusual or unrealistic plans for the future
A. Early financial warning signals Balance sheet
Failure to get statements in timely fashion
Deterioration in customers cash position
Deterioration of working capital position
Rapidly changing concentration in fixed asset
Deterioration increase in current debt or decline in the current ratio
Refusal to provide audited statements
Income statements
Decline gross profit margin
Decline of revenue
B. Early operation warning signals
Changes in the nature of the company’s business Poor financial records and operation controls
Poor employee attitude and moral on banking
C. Early banking warning signals
Inability to get timely financial information
Sudden and excessive borrowing 37
Declining bank balances
Transfer or operation account to another bank Marked changes in borrowing or repayment patterns
Early detection of warning signal is crucial to maximize corrective action and minimize potential losses. Supervision is particularly important when loans mature or become past due or terms of agreeme agre ements nts are violate violated. d. Assessm Assessment ent of these these reviews reviews leads leads to the expansio expansion, n, modific modificatio ation, n, renewal or collection of existing facilities. Final Finally ly as inte intervi rview ew co condu nducte cted d the credit credit mana managem gement ent depar departm tmen entt ab abou outt the preve prevent ntive ive techniques used to reduce risk are occurrence of risk Sick loans could be minimized through prudent analysis analysis made prior to release of the of the loan. Moreover, if things are not as expected and the loans is trouble, trouble, work out loans loans loans procedu procedure re is implem implement ented ed strong and regular regular follow foll ow up practice practice is exercis exercised. ed. Besides, Besides, control controlling ling method methodss and approac approaches hes are revised revised periodically to fit the dynamic business environment.
3.5. Mechanism to reduce credit risk
This study also tries to indicate some methodologies that are used in Dashen bank to reduce credit. In Dashen Bank there are two stages to implement different mechanism to reduce credit risk. One is before disbursement new loan and the other is after disbursement. I.
Befo Before re di disb sbur urse seme ment nt mech mechan anis isms ms
In Dashen Bank before disbursement mechanisms include proper credit analysis, proper design and implementation of loan eligibility criteria and proper loan disbursement procedure. Credit analysis in Dashen Bank Credit analysis should include a clear indication of the banks target. This analysis should set out who eligible for credit and for how much ,what type of credit type are available and what term 38
and condition the credit should be granted .According to Dashen bank loan manual the 5 C’s of credit are practicable techniques in the bank. The 5 c’s of credit are already mentioned in chapter two or credit analysis factors.
Loan eligibility criteria in Dashen Bank
In evaluation of loans subjective judgment are to some extent unavoidable. But Dashen bank Set loan eligibility criteria to minimize the effective of individual perceptions in loan evaluation. One Dashen Bank manual these eligibility criteria are state broadly according to the purpose of lo loan an an and d type type of the loan. loan. But But in gener general, al, th thee basic basic loan loan eli eligi gible ble criter criteria ia are:are:- proof proof of engagement in licensed business, presentation of financial statements. or filling of financial credit report presentation of collateral to secure the loan, and the feasibility study in the case of project finance.
Credit Disbursement procedure in Dashen Bank
According to the loan manual, try to explain how the loans process starts, how a series of duties are performed at the various stages of the proccess. That is initiation, evaluation and approval. Initiation: - The basic document necessary necessary to proceed loan processing processing is the loan application. It
is simply a letter lodged by customer to a bank that explains his desire to have a bank loan. The loan application application should be accompanied accompanied by valid and cu currently rrently renewed renewed trade licenses. licenses. This helps to prove the legal formation of the business organization and its existence. Once the loan application is found in older and copy of relevant trade license are proved valid and genuine the next step to be followed would be evaluation. 39
Evalua Eva luatio tion: n: is a process process through through which which applican applicant’s t’s actual need for bank loan is assessed assessed,,
viability of the business he/she runs is studied, and repayment capacity is measured. However, handling this task is not as such simple. It requires analysis of financial statements of the borrower to check financial soundness and gathering relevant information regarding character, credit worthiness of the applicant. Assessment of financial soundness can be done by analyzing financia fina nciall stateme statements nts of the applica applicant nt (Balanc (Balancee sheet sheet and income income stateme statement) nt) which which could could be audited or provisional. provisional. But, it is not always possible possible to base the analysis on financial statements, as most of the customers do not maintain accounting records. Therefore, banks result to fill in the information required for analysis in a format prepared to serve the purpose. The next step is collecting credit information.
Credit information: information: - Is information related to applicant performance and reputation. Personal
integrity, character and credit worthiness have to be collected from different sources carefully and as much as possible genuinely .Useful sources could be other banks. In recent time National National Bank of Ethiopia has started new system of sharing credit information of any borrower’s with in all banks. Loan approval: All the steps taken in the evaluation process could only serve one purpose that
is to give decision on a loan request of a customer whether the analysis made on the financial statements, and credit information collected gives positive or negative results, the request for a loan has to have an answer. Thus, the next stage of the loan processing cycle will be decision making that is approval or rejection. To arrive at a fair decision, analysis made on the financial statements and information gathered is summarized in Bank format knowledge loan approval form (LAF). All the information given under the LAF is meant to serve the final stage of the loan process that is approval. The individual or the committee authorized to pass decision on loan requests thus have summarized information about the loan request, hence after reviewing the information 40
available in the LAF, and decisions are made with the committee members, decisions will be made. The decision is written on the decision space of LAF and signed by the committee member .Approval date is also written. If there are deviations from recommendations reasons will be given here. Deviations from recommendation reasons will be given here. Once it has approved it ahs to be communicated to the customer. Then there should be a loan contact con tact.. Moreove Moreoverr securiti securities es should should be register registered ed and even if type and extent extent of insuranc insurancee coverage differ from property to property and the risk involved in any case the borrower is required to ensure the property completion of the contract registration, recipients of documentary evidence of properties held as collateral and insurance policy end or seed in the name of bank proves formalities for disbursement of the loan. Documentation: All documents beginning from the loan application application up to the last paper have to
be properly filled filled in loan file. Loan file have to be pro properly perly filled in loan file .Loan .Loan file have to be properly kept under the control of responsibility person security documents ,such as land holding certificates , can ownership booklet ,and the like together with original contracts are separately kept in safe under lock. I.
After disbursement mechanisms
According to the loan manual and different internal memos, in Dashen bank broadly used after disbursement mechanisms to reduce credit risk is proper credit follow up.
Credit follow up in Dashen Bank
In practicing proper follow up, once funds are disbursed the concerned bank officer can not afford to rest and expect that a repayment will be collected as schedule. Therefore, the loan officer prepare schedule schedule which contain the repayme repayment nt date and telephone telephone address of the loans in
41
order to make the follow up task easy. After this the officer is expect to call when payment is not made on the payment date. Even if the payment is regular follow up by visiting customers business or factory is necessary to create cre ate long lasting friendly friendly relation relationship ship.. This This may elicit elicit future future payment paymentss and develop developmen mentt partnership relation. Sometimes borrowers seem to ignore repayment for one reason or another. In such case, Dashen Bank undertakes the following follow up activities.
Giving verbal reminder after calling the customer and discussing the matter. If this fails and no payment is made then the bank choose to the second step personal visit is more reproductive than telephone calls. This should be performed with in one week after the installment is due.
Sending first written remainder using language language of general persuasion and explaining explaining that the money the bank lent out belongs to the bank’s depositors and that is accountable. This should be done if installment is our due by a month.
If the first remainder fail second written reminder that shows the bank is legally and morally bound to collect the debt would follow. The reminder will be order in such a way as to show the bank’s determination to proceed with further measures if repayments are not forth forth co comi ming ng.. It is ve very ry impo importa rtant nt th that at the bank use every every mean meanss to make make the the borrower come up with alternative proposal if possible until the bank make fairly certain that payments are unlikely to come. If the customer does not show any cooperation than we would write and send the third reminder.
On the third reminder the loan officer tell the borrower that if payments are not made with in 15 days the bank would be compiled to pass the matter to the legal services.
In addition to the above mechanism to reduce credit risk the bank also use training for loan officers and related staff especially the credit analysis. 42
3.6
Problems in Dashen Banks Credit Risk Management
For convenience of presentation, the problems are grouped in to two broad categories. They are internal and external problems.
Internal problems
Poorr credi Poo creditt asses assessme sment nt in de deter termi mini ning ng the viab viabili ility ty of a busin business ess du duee to lack lack of information and this forced the bank to follow collateral based lending process.
A very long property (collateral) valuation and documents checking process irrespective of the type of customer and requested product type.
Absence of research work to provide the credit staff with appropriate information about the national, international, geographical, sector information, which could increase their performance.
Unneces Unne cessary sary delay in credit credit informa information tion processing processing as a result result of poor internal internal and external communication media ,negligence of the credit staff to timely initiate a request and responding to a request and absence accountability.
Absen Ab sence ce of transp transpare arenc ncy y among among th thee staffs staffs of the the bank bank at differ differen entt and the bank bankss customers.
Loan diversion is the main cause for reaching loan agreement.
43
Poor negotiation skill from the credit staff side and absence of any guidance to this effect from the top management and absence of standard, which creates lack of confidence to the staffs.
External problems
Presence Pres ence of unfavora unfavorable ble econom economic ic develop developmen mentt like drought, drought, effect effect of the world world economy.
Absence Abse nce of record record keeping keeping,, which which creates creates difficul difficulties ties in preparin preparing g true financia financiall statements and disclosing actual performance of the business.
Lack of cooperation among banks on sharing customer’s credit information. And they said that centralized credit information system is not up to date and it is operating in efficiently.
44
Chapter Four
Findings Conclusions and Recommendations
4.1 Findings and Conclusions Since credit risk is a fact of life in banks, it is not possible to eliminate loan problems all together. Even in the best run banking systems, the optimal rate of bank failure is not zero, since there is always risk inherent in banking. Nevertheless, by taking 45
prompt, well throughout any consistent actions banks and regularly authorities can minimize the chance of disruption. Early warning signals must be developed. Dashen bank has both strong and weak sides. The strong sides are assessing the borrowe borr owers rs past financial financial history history and credit credit worthin worthiness. ess. Details Details analysi analysiss of past finan fin anci cial al histo history ry of th thee borrow borrower erss an and d forec forecast asting ing of the the future future prospe prospect ctive ive development will enable the bank to identify the capacity of the borrowers and to process loans in the safest condition this is of the bank’s strong points. The other strong point of the bank is introduction of the wide area network (WAN) which makes the bank to have efficient communication system with its branches easily and all current information will reach to the management of time, so that timely decision will be made without savior damage or loss. Unfortunately however, the weak sides out weight their antagonistic. In the lending lending front front through through the balance balance of the outstanding outstanding loan has increas increasing ing through the last four years. Dashen Bank provides various credit lines to different sectors. This economic sector also defined as loan categories in banking industry . However concentration levels to geographic areas, credit product and maturities are not developed to data. According to the study conducted the major4 cause of credit risk management in Dashen bank summariazed in to two basic levels. The first is at borrower’s level. Under this level of diversion of borrowed fund to other purpose the second is at bank leve level. l.
Unde Underr th this is level level mi mista stake ke on estim estimati ation on of collate collateral ral and evalu evaluati ating ng the
borrowers report take the highest under this level. Dashen Bank implements different mechanisms to reduce credit risk. Among this mechani mec hanism sm proper proper credit credit analysi analysis, s, loan eligibil eligibility ity criteria criteria,, credit credit disburse disbursemen mentt 46
procedure and follow up are the major applicable .From this proper analysis of the red borrower air request and document indicated at the best mechanism to reduce credit risk.
When Wh en we ar aree tal talki king ng about about probl problem em of cr credi editt ri risk sk mana manage geme ment nt it is inevi inevitab table le technique to reduce the balance of the existing sick loans and entrance of the fresh loan is important in Dashen Bank. Most of them have been cited above in the analysis of the finding. Just to highlight of some of them, the bank should make the employees to aware about the policies, procedures and strategies risk management so that every employee will be a risk manager.
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4.2. Recommendation Based on th thee major find ndiings of the the st stu udy dy,, we forward the fol follow lowing recommendations.
The staffing system of the Dashen bank is based on long stay on the job rather than qualification. Therefore, the bank should assign qualified, professional and experienced individual top their proper positions.
Dashen bank needs to organize periodic training session which would enable the credit personal of the bank to improve their skills in the identification, measurement measure ment and control credit risk. More over, helping employees to update theirr knowled thei knowledge ge and skill skill in risk identifi identificati cation, on, measure measuremen mentt and control control credit risk.
Dashen Bank should implement effective credit risk evaluation system by designing cost effective and efficient techniques in order to minimize risk of management cost and increase the overall return of the Bank.
The protection against risk of lending should consist maintaining high credit standards, appropriate diversification and intimate knowledge of borrower’s affairs.
Dashen bank should should invest more in its; people, people, technology technology and system so as to register better performance in credit risk management.
It also recommended for future researcher to study the subject matter by widening its scope.
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