A lot of financial experts have attributed the recent crises in the financial sector to several factors; prime amongst them being bad corporate governance.
I had the opportunity to read the detailed report issued by the Bank of Ghana highlighting the activities leading to the revocation of the licenses of some financial institutions and in there, it was very obvious that most of the institutions had weak credit risk assessment and management frameworks, improper credit policies and procedures as well as monitoring and controls.
As I keep saying, banking practice is about taking risk and it is, therefore, a serious business. For this reason, managers must have mental fortitude as they handle financial transactions. Any business venture perceived to be serving as a financial intermediary must have a robust framework to absorb any internal and external shocks.
Managing credit risk is a complex multidimensional problem and as a result, there are several different approaches in use today by lenders, some of which are quantitative while others involve qualitative judgments.
Whatever the method used, the key element is to understand the behaviour and predict the likelihood of particular persons or individuals defaulting on their obligations. When the amount that can be lost from a particular set of firms is the same, a higher likelihood of loss is indicative of greater credit risk.
So in cases where the amount that can be lost is different, there is the need to factor in not just the probability of default (PD) but also the expected loss given default (LGD) on credit facilities.
In effect, determining which client may default on a loan facility is the art and science of credit risk management. Some approaches use judgment, deterministic or relationship models, or make use of statistical modelling to classify credit quality and predict likely default. Once the credit evaluation process is complete, the amount of risk to be taken is then determined.
Simply put, Credit risk is the risk of loss from exposure to financial institutions that undergo credit events. This might be that the obligor defaults.
In other cases, it is that adverse changes in credit quality that can lead to losses. There are a great many events that can have a credit impact, which complicates the definition, analysis and management of the process.
Credit risks can be an informational problem where lenders do not know enough about the quality of the credit taker and how the obligor will perform in the future.
In looking at credit risk management, it involves identifying the source of risk, selecting the appropriate evaluation method or methods and managing the process. This will mean setting an appropriate cut-off point that balances the conflicting demands of any financial institution with regard to credit exposure.
Again, credit risk management can be seen as a decision problem. The assessment involves determining the benefit of risk-taking versus the potential loss. Decisions about extending credit are complex and subject to change, but at the same time are critical elements of risk control within most organizations.
While it is easy to outline the credit analysis decision, implementing an effective approach is more complicated. At its simplest, it requires an assessment of the likelihood that a particular counterparty will default on a contract and of the loss given default (LGD
In essence, before you decide to advance loans, there are a number of questions that need to be addressed. Though I may not be able to cover and exhaust all the important areas, the following pointers are worth considering. I will largely focus on the judgmental approach to risk assessment as follows;
The character of the firm and Management (C)
For me, the first and most important point any financial institution may want to consider in advancing credit is the character of the borrower. By character, I am referring to the integrity of the business and its management. People who are honest in their borrowing habit are most likely to meet their financial obligations than dishonest people.
In the context of Bank of Ghana Guidelines which were issued after the collapse of some of the institutions, this may be viewed in the ‘fit and proper’ guidance. It is important to do due diligence on the management of the company before any credit to support the business. Are they fit for the credit facility?
The ability of Management and Directors (A)
In recent times, one particular ‘transaction’ on the Ghanaian market raised some eyebrows and brouhaha over the legitimacy of an individual/firm who signed off a guarantee. With the ability, I am referring to the legality of the contract between the lender and the borrower.
It is important to find out if the so-called directors and management of a company are acting within the legal authority granted to them in their Articles of Incorporation. These things should not be taken lightly because there has been an instance where directors who don’t have delegated authority have authorized big-ticket transactions without any formal mandate.
In the event that the transaction results in a court action, the ability of the individual or firm who acted comes into consideration.
Figure: CAMPARI methodology of credit risk management framework.
Means of Repayment of credit (M)
Fundamentally, you won’t want to extend a credit facility to a counterparty that hasn’t gotten the capacity to pay back. It is important to access the cash flows and creditworthiness of the borrower. This has become very important because lack of proper risk assessment has led to high defaults and non-performing loans. Meanwhile, these institutions made low provisions and low coverage ratios. So in effect, repayment sources based on financial resources is crucial as lenders extend credit facilities to clients.
Purpose of credit facility (P)
The purpose of advancing credit to a client must be explicitly known. By purpose, I refer to the reason for granting credit, it must be unambiguous and acceptable to the lender. For example, an acceptable purpose would be borrowing to fund faster growth of a company etc. understanding the purpose is very necessary because there is instance where extended credit facilities were diverted to other unintended purposes. The rational and proceeds from loans must be tracked and this must be clearly stated.
Amount of Loan (A)
The amount of loan you require must take into consideration the relative and absolute terms how much you need for your funding purposes. This must be carefully thought through in the sense that, loans are repaid at high-interest cost. People go for loans creating huge exposures on the balance sheet without the requisite muscles to pay back.
Repayment Sources (R)
There is no point in granting loans when there are no clear cash flows to back repayments. In looking at repayment sources, it relates to the ability of the borrower to repay the loan, by considering the source of repayment.
This repayment ability is obviously of critical importance in lending and should be demonstrated not through projected future accounting profits but from projected cash generation.
In deciding the form of lending, a credit provider would also need to consider the repayment structure being considered, e.g. bullet (a one-off lump sum repayment of the principal) or amortising (that is, principal repayment through instalments).
Insurance Cover (I)
Credit facilities extended to clients with Insurance as collateral provides cover in the event of default. Credit insurance aims at reducing and mitigating credit risk.
Insurance is a safety net that the bank or any financial institution can rely on if the loan is not repaid at any point in time. This might be collateral or the security provided in the loan, the conditions under which the loan is granted or third-party credit enhancement.
In summary, using this popular judgmental template (CAMPARI methodology) widely used in first-class financial institutions has helped many lenders to take right decisions in extending credit. This is, in essence, a summary of good lending practices for financial institutions. Lenders are encouraged to adopt this methodology and embrace the new technologies in a credit risk management framework.
Credit: Peter brown and ken mole, credit risk management Edinburgh business school. Miriam Amoako
Disclaimer: The views expressed are personal views and doesn’t represent that of the institution the writer work for or the publishing firm.
About the writer
Carl Odame-Gyenti is a third-year PhD (Financial Management) candidate, a Finance and Telecom enthusiast, managing local and global Investors, Intermediaries, Non-Bank Financial and Financial Institution relationships with an international bank in Ghana. He has embarked on several international assignments in London, Singapore, Dubai, Kenya, Nigeria and Southern African markets. He has a passion for youth and community development.