LDM | Risk Management

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 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.

Businesses failure

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

Poor management of the entity is demonstrated by the following:

• indecisiveness in making decisions;
• inadequate knowledge of the product, the process and the market;
• failing self-confidence;
• lack of vision/strategies, and
• Lack of commitment:

Sector/industry/product decline

Sector/industry/product decline has the following characteristics, among others:

• competitive weakness,
• declining market,
• changes in demand,
• over-capacity,
• price war.

High cost base

A high cost base of an entity is evidenced by the following factors:

• rising labor costs,
• falling productivity,
• 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,
• overtrading.

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:

Early Warning System: How does it Work?

The 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 officers,
• scheduled loan reviews,
• examination (internal audit and central bank inspection),
• loan covenants,
• asset classification against performance quality,
• 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.

Scheduled Reviews

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.

Examination

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

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 organisational.

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 management.

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 structure,
• 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 meetings,
• 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 people,
• deteriorating working conditions,
• evidence of low morale/staff unrest,
• offices/premises in state of neglect,
• emphasis on cash sales with little regard for profit,
• understaffing,
• clerical backlog of work,
• cessation of trade discounts,
• sudden discounting of accounts receivable,
• lawsuits against the borrower,
• adverse news affecting the borrower’s industry,
• 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, and
• recurrence of problems previously resolved.

Financial warning signs

Financial warning signs include the following:

• missed and late loan payments,
• repeated requests for increased facilities or rollovers/extension of terms,
• rapid sales or asset growth,
• losses for two or more years,
• withdrawal of facilities by other banks,
• short-term loans continue beyond seasonal requirements,
• cash balances lower than projected,
• unusual account activity,
• qualified audit opinion,
• slowdown in accounts receivable (increase in days outstanding),
• increase in creditors days outstanding,
• speculative investments,
• short-term loans to finance long-term expenditure,
• borrowing to pay operational expenses,
• excessive inventory (number of days of stock held increasing),
• unexpected increase in borrowing requirements,
• borrower breaches loan covenants,
• borrower is technically insolvent,
• debt to equity ratio increases,
• liquidity ratios reveal deteriorating trends,
• continual requests for excesses or hard core debt evident on overdraft account, and
• banks dishonour borrower’s cheques.

Fraudulent warning signs

Fraudulent warning signs include:

• overstated sales,
• overstated inventory,
• understated liabilities,
• false valuation/appraisal of assets,
• audits cease,
• unusually large funds transfers,
• significant cash balances in non-interest earning accounts,
• management overrides of internal controls,
• incomplete, missing or destroyed documents,
• asset sales to related parties,
• unusual supplier relationships,
• staff working unusually long hours,
• signs of deceit, and
• inappropriate attitudes and reactions to questions.

Summary

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.