Lending policies and debt portfolio management in banking industry

By Okwunze, Nwude Emmanuel, Executive Director, SKY Inspection Nigeria Limited, Kano - updated: Tuesday 26-08-2008

Chukwuma Soludo,
CBN GovernorIntroduction
There is no doubt that if realisation of the benefits xpected from an investment is automatic, and people are of high moral standard, there will be no problem of risk and uncertainty, and bank lending would be conducted in an atmpsphere where risks and uncertainties are unknown. But expectation goes into the future and the future is not certain. The act of lending, according to Afolabi (1999:209), is to “identify, measure and manage risk and a critical analysis of the above factors should provide sufficient basis for lending decision making.” The belief is that if the evaluation is thoroughly made, and the lending is as objective as possible, then lending policies can be underplayed since a properly evaluated advance should certainly be repaid.”

The problem with economic condition and future is that they are very difficult to forecast. There may be a sudden change in the demand for the borrower’s product to the extent that he is unable to generate money to meet repayment, and business may be a victim of calamities like fire or flood; technological changes and swings in business cycle may affect cash flow forecast, financial position may be irreparably damaged by serious trading reverses arising from unexpected competition and invention, death of key man may set the company in adverse and mistakes can be made even in the world of certainties. What is more, some borrowers just fail to repay even though they have means. It is therefore not possible no matter the depth of analysis, to elicit all the factors that would affect lending and as such, some lendings are bound to be bad.

Having accepted that some lendings are bound to be bad, how do we know the ones that will be bad? In 1930, according to Microsoft Encarta Reference Library (2007), most banking institutions in many countries of the world experienced problems of liquidity due to excessive lending and most of them resulted to bad debts. Bankers, then, were not foolish neither were they unintelligent. The occurrence only helped to show the consequence of bad lending policies as well as the extent to which it is natural for human beings to be over zealous about profit motive to the detriment of other objectives. As most of the highly profitable lending also entails greater risk, bad lending will become inevitable and solvency will be impaired. To make substantial profit, the bank may have to lend most of its funds, not minding to keep enough reserve to meet the exigencies of cash withdrawal. The internal policies of the banks will determine the key features of any lending proposition as well as how much each bank will hold as liquid reserve. Banks, therefore, have three objectives which they strive to balance up and achieve simultaneously, namely liquidity, solvency and profitability in the face of lending and debt portfolio.

It is not possible, out of the portfolio of advances, to know which one will turn bad, which obviously would have been rejected. Ironically, real life experiences have shown that some of the facilities that eventually turn bad are those earlier considered to be first class risk. What option is then available to the bank to be able to recoup its lending in the face of bad debts? The risk asset process, according to Ecobank Manual(1999), is defined as a flow of planned, identifiable and sequential events involved in the bookings of individual credit transactions, which in aggregate make up a risk asset portfolio, and the management of this asset to full recovery.

The 1992 Rio Resolution on Social Investment, which sought to encourage financial institutions to integrate ethical considerations into their investment analysis, and echoed in the July, 2000 amendments of the UK’s Pensions Act, which required pension funds to disclose the extent to which they take environmental, ethical and social issues into account in their investment decisions. This theme has been picked up recently by the think tank the London Principles on Sustainab1e Finance backed by the Department for Environment, Foods and Rural Affairs, which is trying to get broad agreement among financial institutions as part of the UK’s submission for the 2002 World Summit in sustainable development.

Historical Background
Many banking functions such as lending can be traced to the early days of recorded history. According to Encarta Suite (2005), English Goldsmiths provided the model for contemporary banking in the 17th century. Gold was stored with these artisans for safe keeping, and was expected to be returned to the owners on demand. The Goldsmiths soon discovered that the amount of gold actually removed by the owners was only a fraction of the total stored. Thus, they could temporarily lend out some of this gold to others, obtaining a promissory note for principal and interest. In time, paper certificates redeemable in gold coin were circulated instead of gold. Consequently, the total value of these bank notes in circulation exceeded the value of the gold that was exchangeable for the notes.
Two characteristics of this fractional reserve banking remain the basis for present day operations. First, the banking system’s monetary liabilities exceed its reserves. Second, liabilities of the banks (deposits and borrowed money) are more liquid, that is, more readily convertible to cash than are the assets (loans and investments) included on the bank’s balance sheets. This characteristic enables consumers, businesses, and governments to finance activities that otherwise would be deferred or cancelled; at the same time, it opens banks to the risk of a liquidity crisis. When depositors enmasse request payment, the inability of a bank to respond because it lacks sufficient liquidity means that it must either renege on its promises or pay until it fails.

Justification for the paper
Banks have three objectives which they strive to balance up and achieve simultaneously namely liquidity, solvency and profitability. Solvency refers to the need to lend prudently and be able to meet financial obligations as and when due. Liquidity refers to the need to maintain sufficient cash balance or such assets that may be described as “near cash” in that they are convertible into cashwithin relatively short time without appreciable loss of value so that the bank can meet its customers’ cash withdrawal requirements on demand and also meet operational expenses that will normally have to be met in cash. The motive of profitability of course is that banks want to earn maximum return so that they can grow and generate good earnings for their shareholders.Banking industry is, therefore, faced with the challenges of sourcing the fund, designing sound lending policies and its administration, and initiating prudence in the management of debt portfolio created thereafter in order to be or continue to be in business as otherwise will result to catastrophe. This is because provision of finance has inherent features that make it susceptible to abuse. In all respect, it involves the application by the banker of money owned by the other persons.

What are lending policies and management of debt portfolio
According to Ecobank Group Credit Policy and Procedure Manual (1999), “The risk asset process is defined as a flow of planned, identifiable and sequential events involved in the booking of individual credit transactions, which in aggregate make up a risk asset portfolio, and the management of those assets to full recovery. I entirely agreed with this definition in the sense that no bank can continue to exist without lending policies and prudent management of debt portfolio created thereof.

Types of Risk Assets
According to Ecobank Manual (1999), credit facilities extended to customers may be short term (up to one year), medium term (one to three years) or long term (over three years) in tenor. Additionally, facilities may be of a direct or indirect nature. Direct facilities are those where the bank actually disburse funds to a borrower, in the form of a loan or other advance, or creates an arrangement whereby the customer may himself draw funds on credit at his volition to an agreed limit. Indirect facilities are indirect or contingent obligations that are created when the bank enters into a contractual obligation to pay a third party at a future date, or upon the occurrence of a certain event, against the indemnity of a customer (who is the direct obligor).

Function of Credit
According to Microsoft Encarta Reference Library (2007), “Credit enables the use of assets that would otherwise lie idle, allowing fuller use of economic resources.” Indeed, I subscribe to this text based on the following functions of credit. The principal function of credit is to transfer money to other assets from those who own them to those who wish to use them, as in the granting of loans by banks to individuals who plan to initiate or expand a business venture. The transfer is temporary and is made for a price, known as interest, which varies with the risk involved and also with the demand for, and supply of, credit. It is indispensable to the modern world economy. It allows businesses to borrow money to invest in schemes that generate more than enough to cover the cost of the credit they have obtained; while it gives those with money to spare extra options to make their savings work for them. It enables the use of assets that would otherwise be idle, allowing fuller use of economic resources. The use of credit also makes many everyday businesses and personal transactions much easier than if real money had to change hands. For example, if a cheque is accepted in payment, the receiver is giving credit, as they will not receive any actual money until the cheque is cleared through the banking system. Other documents of credit known as credit instruments, include bills of exchange, money orders, bank drafts, and promissory notes. These are usually negotiable instruments, they may legally be transferred by the recipient to someone else in the same way as money, unless they have “not negotiable” written on them.

Banking securities
The general consensus, according to Afolabi (1999), is that “The best form of bank security is the ability and integrity of the borrower such that the bank can expect to be repaid as at when due and in the ordinary course of business.” I entirely subscribe to this view because it is owing to this view that emphasis is usually on a critical evaluation of the proposal in bank lending using the lending canons referred to as the “Cs” of lending which are Capital, Capability, Character, Condition and Connection. Capital refers to the own r stake in the business. Experience has shown that the borrower is much likely to show more concern and demonstrate more prudence where his own money is at stake whereas it is easy to gamble with other people’s money. Capability refers to the ability of the borrower to generate income, thus ensuring repayment and this has been found to be a function of the customer’s state of health, level of education, professional skill, industry, acumen, connection, social status, etc. Character refers to the human attributes of honesty, reliability, trustworthiness, integrity, consistency, frankness, reasonableness, courage and loyalty such that people who possess these positive attributes are said to be good and can be entrusted with other people’s money.

Condition refers to the state of the economy as to be able to justify the investment channel. Forecast of future economic condition is most important as repayment will be made in future. Will there continue to be demand for the goods to be invested on? Will the raw material importation be banned or restricted?, etc. Connection refers to other accounts with which customers have linkage or can more businesses be gained through the advance? Will it build goodwill for other profitable businesses? According to Whiting (1985), “It is easy to lend money but not always easy to get it back from the borrower and while the bank must be prepared to take some risks when lending money, it does not want to incur bad debts.” I agree with this view based on the following criteria for lending: Basic considerations: Before a bank manager agrees to make an advance or recommends to his head office that such an advance should be made, he must be satisfied on a number of counts. The questions that have to be answered are as follows: i. How much is required? ii. How long is it required for? iii. What is the purpose ofthe advance? iv. Has the customer the ability to service the debt? v. What is the source of repayment? vi. Is the customer credit worthy? vii. How much is the customer putting into it? viii. Are there any national interest considerations? ix. What security is being offered? All of these factors need to be looked at more closely and some of them in greater details than the others before the manager can make his decision as to whether to advance the money or not.

How much and for how long:
These are obvious pieces of information that must be ascertained at the outset. The customer may not know just how much he does need and may be relying on the manager to help him determine his needs. Some judicious enquiries about the timing of his proposed expenditure and of his expected items of income will usually produce the required answer. A larger business concern will be continually examining its cash flow situation and should be able to furnish soundly-based information to justify the advance it requires.

For how long is the advance required:
The above requirement should also help in deciding for how long the advance is required. This is an important consideration because the bank will not want to lend the money for an indefinite period.” It will want to see the debt either gradually repaid over a fixed period or (if the circumstances warrant it) repaid at the end of that agreed period.

What is the purpose of the advance?
The reason for the advance will usually determine the type of lending. If the customer is a private customer and requires finance to tide him over until his salary or some other expected payment is received, an overdraft would suit his needs better than a loan or personal installment loan. If, on the other hand, he is buying a car or a larger item of domestic equipment or furniture, an instalment loan would be appropriate. Similarly, a business concern is likely to need an overdraft to supplement its working capital, whereas a fixed loan or an installment loan would be more appropriate for the purchase of capital equipment. The bank must, therefore, carefully ”consider whether the proposed purchase, e.g. of equipment or raw materials, is most suited to the needs of the firm. What are the prospects of using these purchases to advantage? Is there sufficient demand for the firms finish’ed products to justify the expenditure? If the firm is’takingit undue risk in buying the goods in that their resale is highly speculative, the bank will obviously be less willing to make the advance. Servicing the Debt Clearly the customer must be able to service the debt, i.e. pay the interest and charges when they are due, and for this purpose, the bank will require details of his income and expenditure or that of the firm if a private customer is not involved. A customer who is living beyond his means and cannot afford to meet his commitment to the bank is hardly likely to persuade the bank to lend him the money.

Source of Repayment
It is vital that the source of repayment is established at outset. If it is to come from a definite source such as the maturity of an insurance policy, sale of property, completion of a contract, or some other expected payment, then the situation is quite clear. The bank might even ensure’ that the repayment comes from the source by requiring the customer to sign an instruction to the insurance company or solicitor etc concerned, to the effect that the proceeds should be paid to the bank. If repayment is to come from normal income then the bank is going to need to be satisfied that there will be sufficient surplus of income over expenditure for this to be possible. In the case of a firm or company, the bank will want to see its cash flow forecasts to ensure that the repayments will be possible without the firm running into liquidity problems through the uneven flow of income.

Credit Worthiness: If the customer is an established one who has had an account with the bank for some years, the manager will have the history of the account as a record of the customer’s credit worthiness. He will know, or be able to ascertain, whether the customer has run his account in a satisfactory manner. Have cheques been returned unpaid through lack of funds? Has the customer overdrawn his account without making prior arrangement? Has he repaid previous advances in the way and in the time he said he would? Has he maintained a reasonable average balance over the years? If the customer is a relatively new one (or possibly a brand new one seeking a personal installment loan) then enquiries must be made through his previous bank, if there was one, or through a credit reporting agency. The bank manager may know his customer and his business acumen and his credit worthiness from that knowledge. If the firm is a large one then it will have a local, and possibly a national, reputation on which to make a judgement. A number of previous years’ balance sheets would be helpful in assessing credit worthiness.