Background Early warning system is widely discussed in banking industry, especially in relation to credit risk management. Taking risks is an essential element of banking. But in today’s complex financial […]
Early warning system is widely discussed in banking industry, especially in relation to credit risk management.
Taking risks is an essential element of banking. But in today’s complex financial services environment, the types and potential severity of risks to which all institutions are exposed have multiplied. Many small banks, however, lag behind their larger counterparts when it comes to devoting resources to risk management. This is mainly them believing that less complex institutions do not have the same need, or capacity, to manage risk as do larger banks. However, the reality is that banks of all sizes face the same risks and have access to the same methods, markets and products to manage those risks.
Risk to a bank manifests itself in a variety of ways, e.g, credit risk, interest rate risk, liquidity risk, operational risk, foreign exchange risk, and environmental risk. However, the focus of this article is upon early signals of credit risk, and the implications for specific segments of the bank’s portfolio. As such, the early warning system provide warning of possible and imminent problems in borrowers’ enterprises and, in consequence, possibly in the lender’s own business.
Objectives of the System
The objectives of an early warning system are to:
enable the lender to take corrective action before the position becomes irretrievable;
minimize the risk of loss; and
improve the lender’s prospects of recovery in the event of default.
Causes of Business Decline
It is important to understand the primary causes of business decline of borrowers to identify the symptoms of potential distress. Such causes are described below in detail.
Some of the businesses fail from a single cause while others from several causes. Each case is unique but there are common causes of business decline. The primary causes of decline is described below:
Inadequate information for decision making
Inadequate information for making business decision is evidenced by following:
poorly prepared budgets or no budgets,
no accounts or limited management accounts,
no costings/unit costs,
limited analysis/planning for stock, and
capital expenditure not planned/budgeted
Poor management of the entity is demonstrated by the following:
indecisiveness in making decisions;
inadequate knowledge of the product, the process and the market;
lack of vision/strategies, and
Lack of commitment:
Sector/industry/product decline has the following characteristics, among others:
changes in demand,
High cost base
A high cost base of an entity is evidenced by the following factors:
rising labor costs,
expanding distribution costs,
increasing cost of raw materials,
high reorganization costs
Inadequate financial control
Inadequate financial controls are indicated by following:
poor debt management/structure
(measured by debt to equity ratio and cash flow analysis),
cash flow not monitored,
poor asset/liability management,
Poor marketing strategy
Poor marketing strategy can be indicated by:
absence of strategy statements,
absence of marketing plan,
lack of market knowledge, and
weak/inappropriate promotional activity
Diversification can also create problems when resources are
diverted from core business areas to areas of low expertise.
For many borrowers, financial decline is the outcome of a series of problems, not the cause of the problems. There are numerous reasons why a borrowers’ business and financial position may be declining, among which are:
low margin sales
short term debt
Reasons for decline in borrowers’ position
Early Warning System: How does it Work?
need for early identification of problem loans is one of the principles of the
Basle Committee for the management of credit risk. Problem loans most commonly
arise from a cash crisis facing the borrower. As the crisis develops, internal
and external signs emerge, often subtly. Frequency and quality of information
is the key.
A typical early warning system consists of various elements that are listed below:
continuous monitoring by credit
scheduled loan reviews,
examination (internal audit and central
asset classification against
management information reporting, and
early detection of business decline
through warning signs.
Continuous Monitoring by Credit Officers
Credit officers should know their clients and should be trained to be alert to indicators or early warning signs and to be able to interpret them. Monitoring by credit officer is the first means of identifying problems in loans and the requirement should show prominently in the credit officer’s job description.
Credit officers should have regular contact with their clients during which they should compare the results declared in the management accounts submitted by the borrower with the targets set out in the contract/business plan. Also, they should monitor the work agreed for the period during the previous visit – the variance guides the further enquiry.
Site visits should be scheduled and the schedule should be driven by priorities based on susceptibility to harm which is signaled by the loan classification. The frequency of visits might be:
Standard Accounts (good or pass) – a visit every quarter;
Sub-Standard Accounts – a visit every month, more frequently if the need demands: these accounts are most likely to repay attention and to respond to remedial action;
Doubtful Accounts – a visit each month for as long as there are signs that performance might improve. However, if performance does not respond to attention, frequency should fall back to a visit each quarter to ensure that the enterprise remains in operation and the assets remain on site and in good (working) condition;
Loss Accounts – scheduled half-yearly visits to ensure that the assets remain and are properly secured and maintained and call-in visits whenever the credit officer responsible for the loan account is passing in the neighbourhood: a surprise or two may obviate sale or abandonment of assets.
When a problem is identified, the credit officer’s task is
incomplete until preventive or remedial action has been formulated and is being
implemented – the reaction time of the credit officer is often critical to the
successful outcome. Credit officers should be encouraged to bring problems to
the notice of his/her superiors in the confidence that his/her superiors will
give support; if the culture is one of blame, problems will be concealed, to
the detriment of the portfolio, the lender and the client.
Problem loans should not come as a surprise to credit
officer at annual review.
Examinations may be made as inspections by the central bank
or its agents (second tier institutions) or by internal audit.
However, if problems are identified at this stage, some
options for recovery may have lapsed and, in some cases, it may be too late to
take effective remedial action.
Loan covenants should be such that a borrower has financial reporting obligations and a commitment to providing unconditional access to accounting and financial records.
There may also be restrictions on the payment of dividends,
additional borrowing, new investments or changes in the Board or
Where such requirements are in place, the credit officer
should ensure that scheduled and call-in visits cover these points. Should the
borrower fail to abide by loan covenants, the loan is in default and the loan
classification should be reviewed immediately and the matter reported to
Loan Performance Classification
Asset classification is a process of regular review, the
minimum frequency of review should be:
at the time of every transaction on the
loan account, once the first drawdown has been made;
after each site visit, and
at such time as the institution
requires the submission of financial statements and management accounts.
The review process is not lengthy and should be reported on
a standard form (Loan Classification and Provision Report) which guides the
credit officer in the performance of the review. A copy of the report should be
placed on the working file of the loan account and the original should be
passed to the Credit Manager.
Sometimes, quality of performance may suggest that the classification should be downgraded. However, there may be mitigating circumstances (debtors payments in process of being cleared, seasonal cash flow fluctuations, etc). In such a case, the credit officer should complete the ‘mitigation action plan’. The mitigation action plan should provide the details of risks and what can or is being done to manage the risk.
Management Information Reporting
Information has traditionally played a major role in lending
decisions. The manner in which this information is stored, accessed, and
analyzed, however, has changed markedly over the last ten years.
Evaluation of a borrower’s credit worthiness has typically rested upon historical information gleaned from credit bureau reports, credit scoring models, and current financial statements. The underlying assumption often voiced is that if the borrower could make payments on schedule in the past, then he/she must represent good future credit risk as well. The following MIS reports should be available, as a minimum for early warning system:
Loan concentration reports showing the portfolio concentration by industry, geography and borrower segments each month;
Account activity reports to identify any unusual transactions or no transactions (large transactions, inactive accounts) each month;
Loan payments due reports issued daily, one month in advance of the due dates of loan payments;
Overdue loan payments reports should be issued daily, showing in days the number of days a loan payment (or payments) is (are) overdue;
Weekly summary overdue loan payment reports showing all accounts on which loan payments are still overdue at the end of a week;
Monthly summary overdue loan payment report showing all accounts on which loan payments are still overdue at the end of each month;
New limits reports – for checking that all input details including name of borrower, amount, interest rate, term and amount of repayments are correct; and
Larger loans reports issued on a weekly basis listing major exposures above a threshold as set by Senior Management
Detection of Business Decline through Warning Signs
Credit officers need to be aware of the early warning signs that prelude business failure. Warning signs can be classified into non-financial, financial and fraudulent.
Non financial warning signs
Under early warning system, non financial warning signs include the following:
delays in presentation of financial
information/late filing of accounts,
incomplete financial information,
covenant waiver and amendment requests,
changes in management and board
changes in auditor/accounting policies,
non co-operation with bank requests,
changes in business strategy
(diversification into a new and unfamiliar business),
illogical borrower behaviour,
constantly or frequently postponing
lack of planning,
poor record-keeping (discontinued
reports may be a symptom of breakdown of accounting and control system),
changes in personal habits of key
deteriorating working conditions,
evidence of low morale/staff unrest,
offices/premises in state of neglect,
emphasis on cash sales with little
regard for profit,
clerical backlog of work,
cessation of trade discounts,
sudden discounting of accounts
lawsuits against the borrower,
adverse news affecting the borrower’s
failure to acknowledge problems,
mortgages being taken over other assets
of the borrower or his/her guarantors,
adverse shift in exchange rates,
establishment of new corporate entity,
recurrence of problems previously
Financial warning signs
Financial warning signs include the following:
missed and late loan payments,
repeated requests for increased
facilities or rollovers/extension of terms,
slowdown in accounts receivable
(increase in days outstanding),
increase in creditors days outstanding,
short-term loans to finance long-term
borrowing to pay operational expenses,
excessive inventory (number of days of
stock held increasing),
unexpected increase in borrowing
borrower breaches loan covenants,
borrower is technically insolvent,
debt to equity ratio increases,
liquidity ratios reveal deteriorating
continual requests for excesses or hard
core debt evident on overdraft account, and
banks dishonour borrower’s cheques.
Fraudulent warning signs
warning signs include:
false valuation/appraisal of assets,
unusually large funds transfers,
significant cash balances in
non-interest earning accounts,
management overrides of internal
incomplete, missing or destroyed
asset sales to related parties,
unusual supplier relationships,
staff working unusually long hours,
signs of deceit, and
inappropriate attitudes and reactions
An early warning system can help management identify pockets of potential risk in time to be proactive in its lending and portfolio decisions. Credit officers and staff need to be alert to signs of business distress. It is vital to identify signs of distress that diminish the borrower’s capacity to repay debt. Early recognition followed by appropriate action is essential if a lender is to minimize loss.
LD Mahat is a Chartered Accountant, Financial Adviser and Risk Management Specialist possessing over 29 years of diverse experience across several sectors covering a wide spectrum of assurance, business advisory and taxation disciplines. LD is a committed, highly motivated and result-oriented professional, consistently developing and nurturing client relationship and building long-lasting relationships with diverse clients. He has the ability to define issues, propose customized solutions that significantly add value and contribute to client’s success.
LD has got master’s in risk management form New York University, Stern Business School. He has undergone executive education at Harvard Business School and Insead Business School. He was risk management specialist in several Asian Development Bank Funded projects. He has provided risk management advisory services in various Nepalese corporate sectors.
LD has worked on large projects jointly with big 4 international accounting firms ~ PwC, Deloittee, Ernst & Young and KPMG in the field of Assurance, Diagnostic Review, Capacity Building, e-Government Procurement, e-Governance, Special Review, Investment Climate, and IFRS Implementation.
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