Change management and credit culture

Factors impeding development of credit skills, lending culture highlighted.

Lending opportunities for banks have been on the rise in recent years which need to be effectively managed systematically, utilising proper credit criteria. This is particularly necessary to avoid being carried away by “irrational exuberance” which evaporates when downturns occur. Banks need to create a culture of prudent lending, which far too many do not appear to be doing.

The failure of a few smaller private banks and a steady build-up of a heavily infected bad debt portfolio (estimated at around Rs460 billion) in the banking sector reinforce the need for a much improved credit culture.

There are six factors that appear to have impeded the desired development of credit skills and lending culture in financial institutions.

Firstly, the nationalisation of banks in the early 1970s resulted in banks following social objectives and other criteria for lending. Thus credit was not given due priority in lending decisions. Secondly, foreign currency deposits were encouraged in the 1990’s against which financial institutions were lending in rupees. Credit analysis was therefore not required since such loans were collaterised against liquid security.

The third factor is the high interest rates which have been prevailing on government securities encouraged banks to invest in these under sovereign risk rather than book corporate or other credit risk. Fourthly, few banks have developed expertise in risk assessment for lending to the SME & agriculture sector.

Fifthly, the rapid growth of the financial sector and outflow of talent abroad has not allowed proper credit training as juniors were required to become productive much earlier prior to completing their training periods. And lastly, centralized organisation structures are not an enabling environment for professional development and thus credit judgment/skills not developed at lower levels.

There are, however, ways in which this culture can be turned around, though it will require significant commitment on the part of the banks and the regulator.

To reinforce responsibility and accountability for a loan it becomes necessary to ensure the “relationship management concept”, besides providing clear job descriptions. This will enable due attention to be accorded to the loan by the lending officer and management. In order to provide motivation, training and incentives to the concerned lending units the credit approval process can be further decentralized.

A specialised credit manager can then oversee the credit process both for training & control purposes. Consequently the importance of significantly improving credit analysis cannot be over-emphasized with a need to focus on key basic areas such as purpose of facility, repayment source, management, collateral, risk areas, financial analysis/projections, reputation etc.

Though credit initiation is critical, equally important is the credit administration & control function which must be independent to ensure documentation (requiring legal counsel input) and other conditions precedent are met prior to loan disbursement. This would include other requirements which need to be monitored during the life of the loan. Thus it is necessary for banks to have proper procedures, systems & controls to manage its risk portfolio whether it is corporate, treasury, consumer, financial institutions, SME, agriculture lending or project finance. A relevant organization structure is important to ensure proper functioning of the desired credit process.

The three C’s of credit play an important part in the credit process, namely “character, capacity and collateral”.  Risk reward ratios should also be given due attention to ensure sufficient earnings are available on the credit (after allowing for intermediation costs) to compensate for the credit risk undertaken, besides developing a cushion for potential write-offs and to maintain an adequate net equity base. The proposed Basel 3 rules will ensure the latter is implemented over time, if approved and adopted by State Bank.

Lending officers should also beware of borrowers willing to pay higher pricing as they usually pose a higher level of credit risk. It should be noted that loan portfolio quality affects a bank’s rating with its repercussions such as pricing on its borrowings, which impacts its income statement. Rating companies rate both institutions and the instruments they issue. While ratings provide a useful guideline, lending officers must make their own independent judgements on a credit & not rely excessively on ratings. Over dependence on collateral should be avoided as its value can be considerably reduced in a distress or forced sale situation, which will ultimately impact loan & interest recovery amounts.

Once the loan has been disbursed necessary monitoring should take place (including frequent site visits) on an ongoing basis in order to monitor the progress or otherwise on the loan. This will enable the relationship managers to spot any potential issues and help them acquire problem recognition skills.

Proper judgment is critical in such situations ie. identify a problem & manage accordingly. Conversely one should not to overreact to a problem which could trigger a default or worsen a temporary loan problem.

Though it is a basic tenet of lending that not any one individual should have the power to sanction a loan, it is important for a lending officer to develop independent judgment, ie. a bottom up rather than top down approach is required with credit committee screening. This will enable different views to be obtained on a loan through this committee, generally leading to a consensus.

The above is a basic guideline for changes required in credit culture and elementary tools for credit process. While the credit culture can be considerably strengthened and improved in Pakistan there is no guarantee that a loan will not run into any problems e.g. a genuine default can occur due to unforeseen macro issues (circumstantial default). Other unique defaults can occur due to political risk factors which simply cannot be forecast or evaluated. However if proper credit evaluation techniques and monitoring are employed then the loan loss probability and problems can be reduced which should be the objective of every lending officer.

For this to happen, the credit culture must be further enhanced and strengthened. It can be achieved through necessary focus and management/board backing and teamwork, with due attention and importance accorded to this important area.

The writer is a retired banker who has worked in the United States, the Middle East and Pakistan. He can be reached at: [e-mail]

Published in The Express Tribune, April 11^th,  2011.