Why banks should be worried about credit risk
I kept my composure and took him through the guidelines despite his negative nonverbal communication. He looked to be a risky client.
The loans officer processed all the necessary documents. Good enough, Zimbe met all the requirements that bank asked for. He was given a loan facility of Ugx10m payable within five years despite my colleagues having advised me not to approve the loan. Zimbe walked out of the bank with smiles all over his face. Ten months later, Zimbe did not make any payment in regard to the loan settlement. This is what is called credit risk in financial institutions.
Credit risk arises out of a borrower’s failure repay a loan and that the lender may lose the principal of the credit facility extended to the borrower or the interest associated with it. Credit risk arises because borrowers expect to use future cash flows to pay current debts; it’s almost never possible to ensure that borrowers will definitely have the funds to repay their debts. Interest payments from the borrower or issuer of a debt obligation are a lender’s or investor’s reward for assuming credit risk.
Why on the rise?
According to a senior home loans officer at one of the leading banks whom the writer spoke to noted “people want to borrow money to improve the status of either their businesses or homes. This is understandable. Problems set in when the borrowers do not have stable sources of earning alternative incomes. Our biggest challenge as a bank is some people who are actually borrowing are relatives to some of the staff. So, you are forced to extend a loan facility based on personal judgement.”
Borrowers are less likely to pay back their loans due to the following;
Failure to appreciate the 5 Cs of credit at appraisal stage.
Any lender has to have these at his fingertips. Failure to do so increases the chances of credit risk in financial institutions.
Sometimes called credit history – refers to a borrower’s reputation or track record for repaying debts. This information appears on the borrower’s credit reports. Generated by the credit reference bureau of Bank of Uganda. Credit reports contain detailed information about how much an applicant has borrowed in the past and whether he has repaid his/her loans within the stated time.
These reports also contain information on collection accounts, judgments, liens and bankruptcies, and they retain most information for seven years.
Character doesn’t stop at the credit history, it goes beyond. It includes the physical location of the borrower. Unfortunately in Uganda, the one of the biggest challenge is lack of accurate data for decision making. There are just a few individuals with a track record of their bio data.
In this case, banks rely on information from loan officers who ascertain the credit worthiness of the borrowers. The challenge with this is the officers can easily be bribed by the person seeking for the credit facility.
This measures a borrower’s ability to repay a loan by comparing income against recurring debts and assessing the borrower’s debt-to-income (DTI) ratio. In addition to examining income, lenders look at the length of time an applicant has been at his job and job stability. Giving credit to start-ups can be a cause of credit risk.
Lenders consider any capital the borrower puts toward a potential investment. A large contribution by the borrower decreases the chance of default. For example, borrowers who have 80% of the total project budget can easily get loan facilities. Down payments indicate the borrower’s level of seriousness, which can make lenders more comfortable in extending credit.
The recent news of the auctioning of Bwebajja Hotel on Entebbe over failed bank debt is one way how banks recover their money. Borrowers get loan facilities against their collateral security. This gives the lender minimum assurance that if the borrower defaults on the loan, bank repossess the collateral. For example, car loans are secured by cars, and mortgages are secured by homes.
The conditions of the loan, such as its interest rate and amount of principal, influence the lender’s desire to finance the borrower. Conditions refer to how a borrower intends to use the money. For example, if a borrower applies for a car loan or a home improvement loan, a lender may be more likely to approve those loans because of their specific purpose, rather than a signature loan that could be used for anything.
It goes without saying that repayment is character but some unavoidable circumstances may also increase credit risk.
Variety of choice of banks
Gone are the days when loan approvals could take for forever. People have so many options from where to borrow. Regulated money lending financial intuitions are on the rise. Telecom companies are intensifying the market. It started with airtime borrowing, it is now reported that one is able to borrow mobile money from one of the telecom service provider.
Collapsing businesses due to city decongestion
Many businesses have been affected as a result of decongesting the city and yet the owners have to service several loans. This has increased credit risk.
Financial consumer protection guidelines
The bank of Uganda financial consumer protection guidelines have made clients lame and lazy to pay their due obligations. It’s like telling a parent not to discipline their children using a cane yet ‘spare the rod and spoil the child.’
I know of a friend of mine who had consistently failed to pay back the principle plus the interest charged. The bank served him notices of late payment. He instead ran to Bank of Uganda for protection.
Most people borrow with no clear plan for use of the money. As such it gets spent up and repayment becomes hard. Many banks have noted this and have since embarked on rigorous customer education programs. These range from preparing a simple spreadsheet to keep records to advanced business plans. Some banks do employ investment advisors to help their customers wisely use the borrowed funds. Whichever way it is done, this program is reaping dividends for both the banks and the customers.
Know Your Customer (KYC)
Another key measure being applied is obtaining more information about the customer. Banks are deliberately taking more time to find out some key details about the customers like;
• Their permanent residential address
• Credit worthiness
• Details of their next of kin
• With the advancement of the digital era, their social media activity
These help banks have important facts on the character of their customers as well as capacity to repay the loans.
Some banks are constantly exploring ways of increasing their revenue streams while reducing on the credit risk. Measures like embracing internet and mobile banking are being looked at. Others are taking to investing in the lucrative bancassurance among others.
Provide for worst outcome
Of course, the prudent accountant will always anticipate the worst and be prepared for it. Provisions for default must be made for every loan to avoid hits that wipe out all profits (ask Standard Chartered Bank).
Obviously the other risk is the exchange rate volatility. A balance must be struck with lending in Shillings vs foreign currency. This requires having very good analysts in your ranks.