11Cs for better credit analysis in AsiaBy Md. Touhidul Alam Khan
Loan default is a universal phenomenon associated with all types of business enterprises. However, loan default in case of banks has special significance because extending of credit is almost the exclusive business of banking institutions.
Naturally magnitude of loan default largely determines the destiny of a bank. So, its importance is absolute for the very existence of a bank. As banks deal with other people’s money, quick recovery of loans is one of the most important factors that banks make commercially viable.
Investors and entrepreneurs may default in paying their loans for various reasons. Some of the reasons are as follows:
- When an entrepreneur takes up any project, he/she makes a project profile. The main goals, objectives and the cost of production are set out there. Likewise, the importers are also required to submit their project profile showing therein the proposed rate of profit to the Bank for the purpose of obtaining the loan. Here, it is seen that some entrepreneurs prepare over invoiced proposals in their bids for extra money from the banks for personal gain.
- Some industries turn sick despite getting adequate loans from banks. The main reasons for this are weak management, wrong recruitment and administration of the standard of the commodity and not following correct marketing procedures.
- Inadequate prudential regulation and weak supervision is a recipe for banking problem i.e. creating non-performing assets.
- Poor prudential regulation and supervision are made all the worse by an inadequate legal framework.
- Banks are not the only problem in the financial sector. Capital market is small and do not offer a competitive alternative bank borrowing.
- Many of the classified loans are directive loans which actually given by influence. For any influence, the banks have to lend money to projects without examining their economic viability.
- Ignorance of knowledge for proper analyzing of loan proposal by credit officers.
- Negligence of the credit officers. Many credit officers do not perform his/her assignment sincerely despite getting all possible information about the respective credit.
- Connivance of the Bank personnel with the borrower.
The recovery in fact starts from the selection of borrower. When a loan applicant approaches a loan officer’s/credit officer’s desk or calls over telephone for a loan, then he/she has to look upon each loan request as a challenge and an opportunity, not as a chore.
It is well known that banks have pressing problems owing to bad credits in Bangladesh. To improve the credit portfolio better credit analysis is essential. Through good credit analysis, we can reduce the volume of bad or classified loans and it helps to form a good economic infrastructure for any country.
In this article, it has been emphasized upon 5 C’s for good credit and 5 C’s for bad credit and other 1C for good and bad credit which can be used as a lending tool for any credit officer.
First, lenders must know the Cs of good credit. These Cs are the tried and true rules of good loan making’ consisting of Character, Capacity, Condition, Capital and Collateral. These traditional five Cs make the core of sound commercial loan making.
However, first of all after all analysis we have to believe that credit will be good and it will be refunded as per schedule. As we know that the word “credit” comes from the Latin word “credere”, which means "to believe" or "to entrust".
Character refers to the likelihood that a credit customer will try to repay the debt. This factor is of considerable importance because every credit transaction implies a promise to pay. The principal question is: Will the firm (borrower) make an honest effort to pay the debt, of is it likely to try to get away with something?
Experienced credit managers frequently insist that the moral character of a borrower is the most important issue in a credit evaluation. Thus, credit reports/trade checking is used to provide background information on past performances, both for businesses and for individuals. Credit analysts determine a firms' credit reputation by talking with the bankers, its suppliers, its customers, and even its competitors.
CIB report to be collected from Bangladesh Bank and others Bank report to be collected. No matter how character is determined, it is clear that credit history (reputation) is extremely important in determining whether credit will be granted – both business and individuals should strive to maintain good credit reputations. Trade checking and various tools of market intelligence are used in this case.
Capacity is the subjective judgment of a customer’s ability to pay. Capacity is a measure of the ability of the credit customer to generate cash sufficient to service the debt. Therefore, evaluation of this factor is based primarily on the cash income received by the borrower (business or individual).
It is gauged in part by the customer’s past record and business methods, and, for a firm, it might be supplemented by physical observation of the firm’s plants or stores. Again, credit analysts will obtain judgmental information on this factor from a variety of sources.
Capital is measured by the general financial condition of a borrower as indicated by an analysis of financial statements. The lender will make sure that the company or the person borrowing money is adequately capitalized. Here, capital means net worth of the business.
This provides a caution for any loss that may occur and helps to keep the bank from ending up in bankruptcy and court haggling over the remains of a dead company. Special emphasis is given to the risk ratios such as the debt/asset ratio, the current ratio, and the times-interest-earned ratio.
The borrower might offer assets as security in order to obtain credit represent collateral. “The lender will make sure that collateral does not drive the lending decisions.” Especially, for large loans or long-term loans the lender may require some type of collateral.
If the borrower fails to live up to the terms of the credit agreement the collateral can be sold to satisfy the debt. As per experts opinion, collateral is the last resort for any credit officer.
Conditions refer both to general economic trends and to special developments in certain geographic regions or sectors of the economy that might affect the borrower's ability to meet its obligations.
Some firms perform very poorly during economic downturns, so creditors need to exercise greater caution when lending to such firms during poor economic periods.
These traditional Cs of credit should be thought of as commandants: Do this, check this, and look for that. These rules have worked fairly well in the past, but in recent years, bankers have learnt a few more Cs: Complacency, Carelessness, Communication, Contingencies and Competition. The five things of bad credit to guard against the lessons learnt from the most recent lending mistakes.
This is one of the most important lessons to be drawn from the past few years and is to guard against complacency. Many bankers have said something like, “I don’t need to worry about that borrower, he has always paid us on time”- that is obviously an incorrect assumption. Three things can influence to make complacency. First, over reliance on guarantors has been a problem.
Bankers who accepted those “solid” personal guarantees are creating worsening conditions. Second, overemphasis on past performances is another concern. The old adage that past success is very true. But it was ignored. Third, over reliance on large net worth is yet another concern. This is simply “good old boy” lending.
The second rule of bad credit, or mistake to be learnt from is, carelessness. It was easy to say, “Don’t worry about the loan documentation. I will get later.”
There are a lot of loans with improper documentation, incomplete of conditions precedents (CPs), incomplete financials and inadequate loan appraisal and no one knows where to find the information because the officer responsible is no longer working for the bank and it is all because someone was careless. A lender must be aware of the following facts:
- Lack of current financial information (minimum 3 years audited financial statement).
- Personal Net-worth statement.
- Lack of protective loan instruments.
- Information not kept in files.
A communication breakdown is a simple problem, but it can easily destroy a whole bank. Poor communication, up and down the line, is deadly. For up standard the communication system a lender must concern about credit quality objectives and upward communication system. Credit quality can be judged through various information software in this modern IT era.
So, IT knowledge is very much essential for all credit officers. Without IT knowledge, it is not possible to communicate properly for better judgment of credit proposal in this 21st century which is called “the century of technology”.
Many bankers may think that they are the brightest financiers, but no one looked at what would happen to his or her loan if the economy slowed down. Bankers are supposed to look at every bad thing that may happen and then decide how likely it is that and of those things will happen.
Competition is probably the most important of five C’s of bad credit. Bankers decided to win the business decide to win the business. Unfortunately, that meant making his or her credit standard as loose as or looser that everyone else’s.
The Banker must think how his/her product can be sold to the consumers and consumers will buy only this Bank’s product not another Bank’s (competitor) products.
Last C: Co-operation
This C can solve all the problems of bad Cs. This is Co-operation. Co-operation from and to each other both lender and borrower which may drive any credit facility the good and bad credit also.
A lender must remember that he/she is not only a lender but also a consultant/guardian of the borrower. And a bank is not also lender but also a financial partner. So, a hand of co-operation to increased to the borrower any time to the borrower when it is necessary.
Moreover, as a Project Financier, it has to remember that managing a project is more difficult than trade financing. It is very difficult to generate sufficient cash flow from the project to meet its debt obligation during the early stage of the project.
As such, in every project financiers need to extend their utmost co-operation even determining installment sizes to make the project a successful one only after making detailed analysis of all the aspect properly.
By co-operation attitude, a credit officer must understand the business cycle of the borrower. Credit officer will talk to the customer in co-operation minded. A lender should understand that without co-operation monitoring on the credit is not possible.
As a lending officer he must keep a vigilant eye on the project i.e. when a project could be started and how much fund is necessary for this purpose. So, where the better co-operation there will be the customer. But it should remind that co-operation will not be the customer’s interest only but also the Bank’s interest as here all the depositors’ money.