One well-known principle for evaluation of a credit proposal is five 'C's of credit--character, capacity, conditions, capital, and collateral. This article recapitulates those five 'C's and also tries to introduce a new dimension to the evaluation process by introducing what we call five 'Cs of bad loans'.
THE FIVE CS OF GOOD LOANS: Character: There is a saying that when money is lost some thing is lost but when character is lost every thing is lost. It underlines the importance of assessing the character of the person you are lending to. A man of doubtful character, however intelligent or wealthy he may be, will always look out for opportunities to cheat the bank by providing spurious collateral security or avoiding his obligation to repay the loan. He will probably concoct many cock and bull stories of how the last flood or change of government policy or the long-drawn hartals organised by the political parties had ruined his business. On the other hand, a man of character will face an adverse situation with courage and fortitude and will not exaggerate the turn of his fortune and the calamities in order to secure concession from the bank in terms of remission of interest or even loan forgiveness. Â
Capacity: You shall be sure that the person or the company you are lending to has the capacity to repay the loan. If a company is not making money or generating a positive cash flow, there will not be enough money to pay off its debt. Remember, bankers are in the business of getting paid back for the loans they make. And remember also that prospective applicants will always try to give you the impression that they are the most capable business people around.
Conditions: While assessing a loan proposal you must take into account the future trends of business and the economic conditions. It is dificult to prescisely predict the future, but being alert will allow you to react to deteriorations in the market quickly. The best way of illustrating it would be to cite the slumps that followed the booms in the share market in 1996 and 2009-10 that found many bankers licking their wounds for lending to the speculators at the height of the booms. Similarly, the bankers who could not read the downturn of jute industry in the 1970s following the advent of cheaper synthetic packing materials found their loan portfolios cluttered with non-performing loans given to this sector.
Capital: You shall make sure that the company borrowing money is adequately capitalised. This provides a cushion for any loss that may occur and helps keep the bank from ending up in bankruptcy court haggling over the remains of a dead company.
Collateral: You shall make sure that collateral does not drive lending decisions. Credit factors should always be the primary consideration. This is particularly important in Bangladesh where you will have many claimants - some real, some fraudulent - to a property that you have taken on mortgage when you start to foreclose it. Â
THE FIVE CS OF BAD LOANS: This new set of lending criteria we call Five Cs of Bad Loans consists of complacency, carelessness, communication, contingencies, and competion.
Complacency: Complacency means a feeling of quiet pleasure or security, ignoring the danger or defect. I have heard some bankers saying "I don't need to worry about that borrower, he has always paid us on time". Such complacency may spell disaster.
Complacency with regard to those "solid" personal guarantees is also common. Guarantors have two faces: one that is shown to you when providing the guarantee and the other - a completely changed one - when you invoke the guarantee. The probability is that you will never get to see even that new face; your notice will come back from the post office or courrier company with the note - 'addresee not found'. He or she might have in the meantime made it to the USA, Canada or, as is common these days, to Australia. Â
Carelessness: The second rule of bad credit is carelessness. It is easy to say, "Don't worry about the loan covenants or documentation, I'll get to it later." Well, later is here, and there are a lot of loans out there with improper documentation, incomplete financials, and inadequate loan covenants, and no one knows where to find the information because the officer responsible is no longer working for the bank. Â
Communication: A communication breakdown can easily destroy a whole bank. Officers will say, "we didn't know that we shouldn't have been making those types of loans, nobody told us." Managers will say, "We didn't know there was a problem, the line never told us." The bank board will say, "We didn't know we shouldn't have done that, the credit department people never told us." Poor communication, up and down the line, is deadly.
To avoid the communication breakdown, the management must be clear on credit quality objectives and provide guidelines for acceptable and unacceptable loans and ensure that these are followed down the line in letters and spirit.
Contingencies: Many bankers think they are the brightest financiers on the planet, but no one looks at what would happen to his loan if the economy slows down. Rarely does any one ask the obvious, such as "Can this developer really build another housing complex when there is already a 30 per cent vacancy rate? If the economy slows down and no more jobs are created, who's going to fill up all these shiny new buildings that collateralise our loans?"
Competition: Competition is probably the most important of the five Cs of bad credit. Bankers start making decisions because of what the bank down the street is doing, rather than concentrating on the merits of the loan in front of them. They decide to do whatever it takes to win business. Unfortunately, that means making their credit standards as loose as, or looser than, everyone else's. Instead of any one bank winning, all of the banks end up losing.
   Bankers often tend to think that they are not going to lose deals, no matter what. If a borrower said he could get a loan at 14 per cent at a bank down the street, the banker up the street would offer 13.5 per cent. It does not occur to them that they should not have touched the deal with a 10-foot pole.
(This piece is a sequel to my two articles printed by the Financial Express last month on the                   principles of sound lending.)             Â
The writer is a former banker. saali40@yahoo.com
The Cs of good and bad loans
Syed Ashraf Ali | Published: May 11, 2014 00:00:00 | Updated: November 30, 2024 06:01:00
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