Credit Risks Management, Loan Supervision and Bad Debts in Banking

In financial intermediation, when deposited funds are lent out to those who require them, there is an implication of risk taking.  A bank’s loan portfolio is the highest earning asset and at the same time, the most illiquid of bank assets. Lending portfolio is the most risky of bank’s operations. It involves the creation and management of risks assets. It is an important task of bank management. The implied risk in lending is that the repayment of the granted credits may not materialise as planned. As a result of this, the lending institution may be unable to honour withdrawal demands that may be made by the fund depositors. As expectations go far into the future and future events appear uncertain, if follows that the repayment schedules drawn into the future are mere predictions and are full of uncertainties. The uncertainty in the stream of returns from investments makes credit granting by banks a business of risks.

Risk, which could be dynamic or pure, is regarded as the measurable uncertainty identified when decisions are made, be it credit granting or not. Uncertainty is different from risk in that the occurrence and impact of uncertainty cannot be measured and therefore cannot be adequately taken care of in a decision making process. A dynamic risk occurs in a normal course of a bank customer’s business activities like swing in the business cycle, unexpected competition from producers of substitute products, technological changes in the mode of production and distribution, death of a major shareholder or owner, sudden demands for the borrower’s products without a compensatory payment for the products etc. A pure risk can arise as a result of natural disasters like war, fire outbreak, flood, robbery, arson, drought etc.  All these will cause the inability of the borrowing customer to generate the projected cash flow from which the repayment schedule could be met. Consequently, the lending bank will have accumulation of non-performing, doubtful and bad debts and therefore such bank will be unable to meet its statutory functions.   

Most dynamic risks in bank lending exist because of poor analysis of loan proposals. In banking, credit risk is the possibility that a bank borrowing customer will not or willing to fulfill his contractual obligations. Some of the credit risks arise from defaults on loan commitments, violations of written agreements terms, or the abuse of other accompanying conditions. We can view credit risk as an important risk faced by banks. The best way for a lending bank to handle or nip the bud of any credit risk that may arise is to do a pure or thorough loan appraisal before the credits are granted. A good banker must always note that credits are granted with the hope that repayment would follow the agreed terms without recourse to the realisation of the security on offer. Therefore for a bank’s credit risk to be minimised, the credit analyst must do his/her job thoroughly without sentiment or bias while the approval authorities should approve based on verifiable facts as presented by the credit analyst. It suffice to say that the higher the quality of loan management, the quality of loan, competence of loan officers and credit-worthiness of the customer, the less the credit risk.

Credit risk management is an everyday fact of life in banking. However, a lending banker should take the following steps in managing credit risks: (i) proper and articulate loan appraisal and analysis. At least this should follow the cannons of good bank lending (Purpose, Amount, Repayment, Term and Security) and the five C’s of lending (Capital, Capability, Character, Condition and Connection); (ii) proper documentation of all steps taken in the loan analysis and appraisal. This should indicate all factors considered and their likely impacts on the credit; (iii) drawing up the loan agreement and operating modalities for the approved credit. This should be for the knowledge of the customer and the use of the branch that holds the loan account; (iv) perfection of the securities offered by the borrowing customer. This should be carried out by the account holding branch and the relevant legal department of the bank, and should be carried out before loan drawdown is allowed; (v) monitoring of the operations of, and cash flow into the borrowing customer’s account. This becomes the duty of the account holding branch; (vi) disbursement according to the agreed disbursement schedule. Deviations in this respect should be brought to the knowledge of all parties concerned while remedial actions should be taken immediately.

Credit risks can be reduced in banking if banks can: (a) limit their loan and advances primarily to low-risk borrowers; (b) diversify their loan portfolios in order to ensure that credits are not highly susceptible to the failures of a particular industry/sector/segment of the economy. Overconcentration of credit is a sure invitation to unnecessary credit risk; (c) embark on geographical diversification; (d) strike a balance between the kind of assets and liability which they hold so as to ensure that they have sufficient liquidity to meet any likely future demands that could be made on the bank.

From observations and experience, once a borrower notices that his/her operations are not being closely monitored, he/she has every temptation and chances to divert the approved bank loan to other business or riskier activities which could come to nothing but something detrimental to the bank. These, coupled with political and economic environments which bring about uncertainties make it essential and necessary for the lending bank to continuously monitor the borrower’s use of the approved credit.

The management and administration of credits is a very complex matter in banking. This involves the formulation of lending policies and the establishment of loan operating procedures and credit manuals. To a banker, debt management refers to all processes and actions undertaken by a lender/creditor in order to ensure that repayment of loans and advances. A good banker should see the following objectives of debt management as useful and essential guide: (a) to reduce to the barest minimum, the problem loans and advances which are often referred to as non-performing accounts; (b) to keep the incidence of bad debts within tolerable level of total lending portfolio of a bank; (c) to maintain high quality of debt assets (loans and advances). In 1998, the following stages and procedures governing banks’ internal control of credit quality were formulated by the Committee on Banking Regulations and Supervisory Practices: (i) formulation of lending policies and ensuring compliance with the policies; (ii) credit assessment (control of authorisation of new lending); (iii) control of execution of lending (documentation, contracts and collateral); (iv) monitoring of performance of the borrower under the terms of the loan; (v) procedures for early identification of possible losses and for recovery; (vi) application of provision against possible losses.  

To achieve the objectives of debt management in banking, there must be in place, an effective surveillance which entails the twin processes of efficient supervision and monitoring at branch offices, area/regional offices and head office. Loan supervision and monitoring is a very vital function in bank lending. It is prudent for the lending banker to continuously assess the borrower’s use of the credit facility together with the performance of the business of the customer. This will prevent abrupt or sudden collapse. Most collapses show warning sign which only an alert banker could spot before things get worse. A variety of unexpected happenings could develop and the lending banker should be quick to spot these in order to take the necessary action. It is possible for the lending banker to salvage a customer’s deteriorating situation by timely advice and action. The popular saying in banking is that it is easier to revive a flagging account than a dead one.

A lending banker can take the following loan supervision and monitoring steps: (a) regular review of the periodic financial statements of the borrowing customer so as to reveal useful information about the performance of the business; (b) monitoring the compliance of the borrowing customer, with loan agreement; (c) continuous contact with the borrowing customer so as to derive information on the use of fund, the performance, problems and prospects; (d) monitoring the account of the borrowing customer at the branch in order to control the outflow of fund as well as payments into the account; (e) monitoring adherence to the disbursement schedule and other drawdown conditions

A consequence of diversion and misuse of borrowed fund by a borrowing customer is bad debt and bad debts are discovered be more difficult to manage. Virtually all businesses make bad debts. Banks cannot be excluded in this regard. In banking, a customer’s debt to the bank becomes bad when it is apparent that the customer would be unable to make further repayment of credit outstanding against him or her. No matter how well lending is secured at the outset, it can never be completely devoid of risks. Risks of non repayment and non performance are the greatest risks in bank lending. Total elimination of bad debt in banking is difficult but it is believed that it could still be managed to an appreciable level. Danger signal of bad debts are usually not lacking, though sometimes, they descend like sudden thunder. Apart from the instinct, the following points will serve as useful bad debt signal guide to a watchful banker: (i) excessive rigidity in the account (difficulty in obtaining cover for cheques, dwindling monthly swings, low or no turnover on the account); (ii) evidence of delay in payment of trade accounts; (iii) long delays in producing financial statements – particularly audited accounts; (iv) heavy borrowing from other sources; (v) inability to meet loan repayment instalments; (v) increase in number of cheques stopped at customer’s instance or returned for lack of fund; (vi) poor quality of current assets; (vii) failure to honour bank’s invitation to come for discussions, particularly if the customer used to make frequent calls at the bank in the past.

Bad debts in the books of banks could be traced to the outstanding list of risks assets (loans and advances) that are not serviceable by customers. However, bad debts in banks’ credit portfolio are attributed to: (a) poor analysis of lending proposals by the lending banker; (b) poor quality of financial accounts and statements prepared by quack bookkeepers/accountants; (c) insider abuses which include lending to officers and directors of banks without proper appraisals; (d) lending bank’s bad management of customers’ accounts and operations; (e) lending banker’s incomplete knowledge of the activities of the borrowing customer; (f) lending banker’s bad judgement of the lending proposition of the borrowing customer; (g) poor loan supervision and monitoring by the lending bank; (h) lending banker’s inadequate monitoring of the project involved; (i) dishonesty on the part of the borrowing customer; (j) excessive lending by the bank, on security value; (k) concentration of high volume of bank’s fund as credit in the hand of a single customer; (l) Insensitivity of the lending banker to political , economic and other environmental trends; (m) matters beyond the control of the borrowing customer (like fire, burglary, flood etc.); (n) frauds and forgeries; (o) unpaid interests, charges, commission on turnover, allowed by a liberal banker.      

The Prudential Guidelines of the Central Bank of Nigeria categorise banks’ credits into performing and non-performing. While the category of performing loan and advances contains credits which are active as regards loan servicing and repayments, the non-performing accounts represent credits which are possible loss of funds due to loan defaults Debts within the non-performing category are further classified into three categories: (i) Sub-standard loans and advances (repayment of principal and payment of interest outstanding for more than 90 day but less than 180days); (ii) Doubtful loans and advances (repayment of principal and payment of interest outstanding for more than 180 days but less than 360days, and are not well secured); (iii) Lost loans and advances (repayment of principal and payment of interest overdue for over 360 days). Lost accounts are regarded as bad debts. Banks are required under the guidelines, to make 10% provisions of the outstanding principal and interests on sub standard accounts, into a suspense account. Provisions for doubtful and lost accounts are 50% and 100% respectively.

It is important and therefore a good practice in banking for a lending bank to manage its credit risks effectively and embark on effective supervision and monitoring of its loan portfolio in order to avoid the incidence of bad debt that may cause the bank to start witnessing the beginning of the end of its banking business.

Presentation made at the Annual Conference of the Corporate Bankers’ Club of the Federal Polytechnic, Ado-Ekiti, Nigeria on 23 May, 2006.