Compensating balances and monitoring of business transactions
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Often, loans are granted with the commitment by the borrower of maintaining a balance with the bank. This increases the likelihood that the loan will be repaid. The commitment may also take the form of a current account with an undertaking that all transactions by the borrower in the business for which the loan was granted are conducted through the current account. This enables the bank to monitor the business of the borrower.
The obvious tool to mitigate credit risk (i.e. to overcome the adverse selection problem) is the careful screening of potential borrowers. This involves information gathering. Much personal information is gathered in from individuals who wish to borrow, and there are grades of information gathering. In the case of a small sum for the purchase of say a washing machine, the information required is far less than that required for the mortgage loan. In the latter case, the information required would include:
• Work history and record.
• Salary and salary history.
• Other bank accounts.
• Other debt.
• Credit card payment history.
• Statement of liabilities and assets.
In addition to such information the lender may require references, which in many cases are followed up on, and some lenders (particularly the banks) put in place local boards of "directors" comprised of persons well known and connected in their relevant areas in order to provide information on the borrowers of the area. The information gathered enables the lender to statistically calculate a score for each borrower. It should be apparent that in many cases the score is borderline in terms of credit risk, and the lender uses a measure of discretion, rather than send the client off to a competitor.
Information gathering in the case of loans to companies is similar except that much emphasis is placed on past financial statements and a business plan for the future, including of course the purpose for which the loan is required.
Monitoring is also an information gathering exercise, but after the event of granting of the loan, and this links with the problem of moral hazard. A client may be suitably screened and ultimately selected as a client, but may engage in nefarious activities once the money is in his/her hands. To reduce the risk of this coming about, many lenders include restrictive covenants (provisions) in their loan contracts, and monitor adherence or not to these on a regular basis.
Long-term relationship building
Lenders encourage long-term relationship building between loan officers of the institution and their clients. This practice reduces the cost of information gathering because records already exist and monitoring procedures are already in place. The borrower also has an incentive for encouraging a long-term relationship with the lender, and this is because a good credit record not only reduces the risk for the lender but also the borrowing rate for the borrower.
The credit risk mitigating tool loan commitment is related to the former. Many lending intermediaries provide borrowers with a commitment of a loan up to a specified amount that can be utilised at any time. This provides the borrower with flexibility in loan utilization, and encourages a long-term relationship with the lender, which in turn reduces the information gathering cost. The loan interest rate reflects the long-term relationship.
Collateral means the ceding of assets (usually property, equipment financed, the debtors book, deposit, policy - at appropriate discounted values) as security for the loan. This is a legal commitment to surrender the underlying assets to the lender in the event of default, which the lender is able to sell in order to recover the amount of the loan.
Collateral is the most common method of "insurance" against credit risk, and reduces the problems of adverse selection and moral hazard. A dubious borrower will be reluctant to borrow if collateral is required because s/he has much to lose in the event of default.
Credit rationing takes on two forms: outright rejection and providing less credit that sought. Outright rejection refers to loans where the borrower is willing to pay a higher interest rate to compensate the lender for the risk, but the bank rejects the application because the higher interest rate will contribute toward the failure of the project.
Providing credit less that sought is often a tactic of the lender to thwart moral hazard. A loan that is smaller than sought will tend to ensure that the funds are efficiently allocated, whereas a loan of the desired size may bring about a case of moral hazard.
Specialisation in lending
Some lenders practice specialisation in lending; this may refer to geographic area of industry. In the former case the lenders rely on personal relationships to ensure prompt and full repayment of interest and principal: for example, Grameen Bank in Bangladesh, relies on peer pressure in the community for repayment (as a matter of interest in the case of Grameen Bank, the repayment rate is 98%, higher than any other financial intermediary.)
Certain other lenders specialise in making loans to specific industries. For example, a bank may specialise in leasing contracts with the medical fraternity. The line of reasoning here is that information costs are reduced because the lending institution is concerned with gathering information about only one industry (and its related industries). The counter-argument is that a downturn in the particular industry (which is inevitable because it occurs to all industries at some stage) may place the bank at risk. This brings one back to the first tool, diversification, which is a major risk mitigation factor.
The use of credit derivatives consists of the purchase and sale of credit risk (or credit protection) across sectors and countries. Credit derivatives are bi-lateral financial contracts with payoffs attached to a credit related event such as a default, bankruptcy or credit downgrade. Generally, the largest banks are net buyers of credit protection.
Sovereign credit risk
Sovereign risk, also called country risk, straddles credit risk and currency risk (see below); it may be defined as the risk that a foreign government may proclaim the suspension of repayment of loans or investments made in that country.
There are a number of examples of such suspensions. In 1982, for example, the governments of Mexico and Brazil announced a moratorium on the debt of foreign investors, i.e. the domestic debt owned by foreign investors. The debt was frozen and repaid over a long period when the foreign exchange was available. Under sanctions, South Africa declared a debt standstill in 1985, and took more than 10 years to repay the debt.
Other countries that have declared debt moratoriums are a number of African countries, Thailand, South Korea, Malaysia, Indonesia, and Russia. Argentina rescheduled its debt in 2001.
Banking statute returns in respect of credit risk
Because credit risk is so pervasive the banking regulator / supervisor requires a number of monthly returns. The main return required usually stares its purpose as follows:
"...to determine...(a) the classification of all direct and indirect extensions of credit, including, but not limited to, loans and advances, accounts receivable, property acquired by the bank in satisfaction of debt previously contracted, investments, equity participation and credit substitutes, such as general guarantees of indebtedness and standby letters of credit serving as financial guarantees; (b) the adequacy of overall provisions to absorb estimated credit losses; (c) asset quality; (d) distribution of assets based on profitability; (e) distribution of discounts, loans and advances in accordance with the directives contained in, and based on the sectors identified in, the Standard Industrial Classification of all Economic Activities; (f) distribution of discounts, loans and advances in accordance with selected geographical sectors"
Other returns usually require information on:
• Large exposures in relation to capital.
• Loans not disposed of within a given period.
• Funding of specific sectors.