Strategies to ensure financial health of banks

Bankers now-a-days prioritise extending purpose- oriented credit facilities with required security/ collateral support because of growing awareness. They feel the imperative need to exercise due diligence in credit assessment focusing on the borrower's business dynamics and operational aspects. They do it to ensure optimal credit flow to the borrowing concerns matching their requirements and to avoid over or under-financing.
A bank has to ensure that utilisation of credit is in accordance with the purpose for which it is lent i.e. end-use of the lending has to be secured. The bank has to monitor the performance of the borrowing unit to verify whether the assumptions on which the loan was sanctioned continue to hold good with regard to operation and environment.  
It is also to be observed whether the loan recipients are adhering to the terms and conditions of sanction. This is done by devising a mechanism for obtaining information at regular intervals from the borrowing units. The bank will review the performance of the unit from a broader perspective for having better risk perception so that they can extend meaningful advice to them for overcoming any business hurdles.
It is an admitted fact that a bank's financial health is largely dependent upon the extent and size of performing assets, in other words, on performance of the borrowers and how far they can minimise the size of non-performing loans (NPLs).
Credit losses are equivalent to capital losses. An increase in NPL has the multi-pronged adverse impacts on a bank's balance sheet. This is reflected  through key performance indicators. Any compromise with the quality of assets at the sanctioning process will be a contributing factor to enhancement of NPLs so the bank management has no choice but to stay focused on the issue of keeping credit portfolio performing to the maximum possible extent, weathering both internal and external barriers.
A well-structured NPL management strategy covers following areas:
}    No compromise with due diligence in the sanctioning process. Keeping in mind 'prevention is better than cure',
}    Action plan for potential NPLs,
} Identification of highly risk-sensitive borrowers in the credit portfolio,
}    Identification of geographical area-wise risk sensitivity,
}    Targeting high value end NPL accounts (having exposure Tk 50 million and above) depending on the state of condition of portfolio,
}    Prompt action on credit reports,
}    Capacity building of officers and executive posted both had head office and branches.
Goals of monitoring and follow-up:
}    To ensure that funds are utilised for the purpose for which they were sanctioned,
}    To see that the terms and conditions are complied with,
}    To monitor the project implementation for avoiding time lag and consequential cost over-runs,
}    To evaluate the performance in terms of production, sales, profits on a periodic basis for ensuring that the borrower is keeping to the original plan and is having sufficient profits to service the debts as well as for the sake of maintaining normal business momentum,
}    To assess the impact of negative externalities on the performance of the company,
} To detect the symptom of sickness at the early stage for initiating measures at the opportune moment, and
}    To keep track of movement of financial position.
    Supervisory process: Supervisory process may be activated meaningfully in the following manner:
} Off-site Monitoring
     Periodic reports on the risk sensitive clients/borrowers,
    Analysis of financial portrait, i.e, balance sheet, income statement cash flow and fund flow statement etc. to sort out the weaknesses in the business,
     Risk grading in right perspective,
} On-site Monitoring
    Physical visits to the business venue of the clients and Direct interaction/ discussion meeting,
    Preventive measures:
}    Understanding the client's business,
} Analysing the client's financials,
} Frequent visits to clients,
} Ensuring perfection of legal documentation,
} Investigation into market rumours and
}    Use of Credit Bureau checking and Supervision and follow-up of advances can be divided into three main control groups: legal control, physical control, and financial control
*     Legal control:
}    Proper execution of documents,
} Keeping the documents constantly in force.
}    Complying with various legal formalities like:
    i. Registration of charges,
ii.  Creation of mortgage, and
iii. Complying with the directives of the central bank and internal policy guidelines,
* Physical control
iv. Inspection of physical securities charged in favour of the bank,
v. Verification of books of accounts,
vi. Cross-checking with the physical securities, and
vii. Inspection of factory and godown sites/ premises to ascertain the activity levels and stock levels respectively,
Financial control:
} Evaluation of the performance of the company on the basis of periodic financial statements,
}    Monitoring of the utilisation of limits through quarterly information statement and monthly select operational data,
} The credit inspection and supervision pertaining to the account could be off-site or on-site,
1. Off-site supervision is generally done at bank's desk level.
2. On-site supervision is done at the borrower's place of business.
    Basic indicators: Bankers are required to remain vigilant over the status of their credit portfolio and if any indication of deterioration of performance of the particular borrower is found, immediate measure of retrieval should be initiated. Some of the indicators are enumerated as under:
}    Apparent stagnation in the business as reflected by slow/negligible turnover in the account,
} Frequent request for overdrawing or issue of cheques without ensuring availability of funds in the account,
} In case of term-loan nonpayment of overdue installment,
} Unexplained delays in submission of stock statement,
}    Slow movement/stagnation of stocks observed during inspection,
}    Diversion of fund to sister units/acquiring capital assets not relevant to the business /large personal withdrawals,
}    Non-adherence to project schedules causes time over-run having consequential effect of cost over-run requiring additional funding,
}    Pressure on liquidity leading to non-payment of wages to workers /statutory dues/rents of office and factory premises,
}    Current liabilities exceeding current assets,
}    Basic weakness found in the financial statement,
} The borrower is not traceable,
}    The borrower does not have any property to be proceeded against or the particulars of the borrower's properties are not available,
} Although the matter of non-repayment of banks' debt has been brought to the notice of the borrower  he/she expresses inability to pay or does not respond,
}    The borrowers' business has suffered a setback and he/she has asked for further loan for reviving the business,
} The borrower is an influential person and maintains political clout that hinders the banker to progress with the issue of recovery,
}    The borrower has died and the responsibility of repayment of the loan cannot be fixed up easily/involves wrangle of legal procedures,
}    Documentations are irregular or securities are insufficient or not properly charged,
} Unusual or unexplained delays in receiving promised repayments or in communicating with bank personnel,
}    For business loans, restructuring outstanding debt or experiencing a change in credit rating,
}    Unusual build-up of the borrowing customers  accounts receivables/inventories,
}    Rising debt to net worth ratio (leverage ratio),
}    Reliance on reappraisal of assets to increase the borrowing customer's net worth,
}    Adverse changes in the price of a borrowing customer's stock,
}    Net earnings losses in one or more consecutive years especially as measured by returns on borrower's assets (ROA), or equity capital (ROE) or earnings before interest and taxes,
} Adverse changes in the borrower's capital structure (equity/debt ratio) , liquidity (current ratio or activity levels (ratio of sales to inventory),
} Deviations of actual sales or cash flow from those projected when the loan was sanctioned, and
}    Sudden unexpected and unexplained changes in deposit balance maintained by the customer.
Causes of growth of NPLs:
Pre approval phase (controllable variables)
}    Defectiveness in selection of potential borrower,
} Mistake in selection of business - where to finance/not to finance,
}    Long-drawn appraisement/ approval process,
} Poor appraisal technique,
} End use/ purpose not identified,
} Defective structuring of credit,
} Under/over financing,
} Mismatch of Asset (NWA),
} Imprudent judgment/wrong conception about sectoral viability/ volatility,
} Unusual attachment of importance on collateral security, and
}    Wrongly conceived projections and not supported by adequate assumptions,
    Post-approval phase:
} Poor monitoring,
} Improper/inadequacy in loan documentation,
} Poor IMS,
} Unfavourable investment climate,
} Economic recession,
}    Inconsistent and erratic government fiscal policy and
}    Credit culture promotes loan default.
    Steps for recovery:
}    Bankers must always keep the goal of loan workouts firmly in mind,
}    Rapid detection and reporting of any problem related to borrower or business are essential as delay often worsens a problem loan situation and the situation thereby spins out of control,
}    The loan workout responsibility should be separate from the lending function to avoid possible conflict of interest,
}    The concerned credit officer should discuss with the troubled borrower quickly on possible options especially for cutting expenses, increasing cash flow and improving management control. S/he should develop a preliminary plan of action after determining the bank's risk exposure and sufficiency of loan documents, especially any claim against customer's collateral other than that held by the bank.
     Indicators of poor lending policies:
}    Poor selection of risks  among borrowing customers,
}    Lending money contingent on possible future events,
}    Lending money because a customer  promises a large deposit,
}    Failure to specify a plan for the liquidation of each loan,
} High proportion of loans made to borrowers  outside the bank's territory/ beyond the common measure,
}    Incomplete credit file,
}    Tendency to overreact to competition (making poor loans to keep customers from going to other banks,
}    Lending money to support speculative purchase, and
}    Lack of sensitivity to changing economic conditions both domestic and world economy.
Professional bank management requires matured prudence level, clear-cut perceptions on different core risk areas of banking operations, existing and potential revenue drivers which ultimately will prove instrumental to navigate the institutions in the right directions overcoming the hurdles on the pathway.     
The writer is Deputy Managing Director, Mercantile Bank Limited. [email protected]