Increased Importance of Credit Appraisal Process in Today's Banking Landscape
The recent economic crisis has seen a spate of defaults on loans across banks and one of the key reasons behind this seems to be inadequate credit appraisal processes. Through this interview with Mrs. Ranjana Kumar, Vigilance Commissioner and former Chairperson and Managing Director, Indian Bank, we have tried to examine some of the key issues in credit appraisal in the context of recent events to gauge the place it holds or should hold in today's banking landscape.
Importance of credit appraisal process
tejas@iimb: What risk assessment mechanisms are typically used to assess borrowers - with the increased focus post the global financial crisis, what changes have been made to strengthen the process?
RK: As far as the credit appraisal in India is considered, we ask for the balance sheet when we get a new account. If it is an existing concern, we'd go through the balance sheet and the profit and loss statement for the past three years, analyze it, have the project report of the company to see how it has been doing and then, on the basis of the project report, we would assess what the requirement is - whether it is a term loan required to purchase plant and machinery etc. or it is just working capital required for running the concern.
It is better that the bank which handles the financing of the term loan also takes care of the working capital.
It is better that the bank which handles the term loan financing also takes care of the working capital. In the past, organizations like IDBI and IFCI which were basically term lending institutions at that point of time, got into a lot of problems of high non-performing assets (NPAs) because they gave only term loans. They never kept the working capital accounts with them. That was being done by the various commercial banks and they were the ones who had the operation's income from them.
Most importantly, when we now give these types of loans, we take charge of the plant and machinery and the mortgage of the land. The bank can also consider taking some collateral security but this is just a comfort factor, not the main source of recovery for the bank. The main source of repayment to the bank is from the operations of the company.
Over a period of time, there has been an increased emphasis in monitoring the account. For instance, we take monthly information now where earlier it used to be quarterly. Everything is computerized so it's easy for the borrowers to give the required information to us - their actual sales against what their projections were, what they have done etc.
Know your borrower like the back of your palm.
One thing I would stress a lot is regular contact with the customer. Traditionally we say, know your borrower like the back of your palm. Judge the promoters also - their policies, their scheme of things, for example, if they have participated in a fair abroad, the number of enquiries they generated; the number of those enquiries that have fructified as orders and the number that have just remained as enquiries etc. Then, their business clientele - are they spread out or are they just banking on 2-3 clients, how are they manning their receivables etc.
tejas@iimb: In your past role as the MD of Indian Bank, one of the problems you handled was the high NPAs on the balance sheet. Did you find a causal relationship of this problem to the credit appraisal process? If yes, what measures did you take to improve the process?
RK: Yes, one of the important reasons for the high NPAs was faulty credit appraisal. There was no in-depth appraisal at all and in a large number of accounts, people were being judged based on the fact that they were well known or that their company was well known. Banking is not like that. An in-depth analysis is required.
In Indian bank, subsequent to the restructuring, we demarcated accounts. We decided to have corporate branches or credit intensive branches such that large credit would be given only through those branches. Every branch would not be doing it. It would be done only through certain specialized branches which would have proper policies in place on how the appraisal would be done.
Also, officers with thorough knowledge and experience would be posted in those branches. That was very important. Again these officers, at all levels, were trained in an institute of the SBI which is known for its credit appraisal. Further, internal audit was also strengthened.
Credit Rating Agencies
tejas@iimb: Foreign credit appraisal firms incorporate non banking information into their credit rating process, which results in a more comprehensive process. Do you see this as a necessity in India and is it feasible to implement?
It's like having complete knowledge of your customer. Even if you have the best account, everything won't go well all the time. So you have to find out whether the promoter has the wherewithal to come out of a difficult situation i.e. how resilient your borrower is. For this, you would need to know about everything, not just the balance sheet. That means their expertise, their experience, the people who head their departments, and their internal policies.
For example, take the gems and jewellery business which is basically a family business. What a prudent banker should do is find out which father is separating from his son, which brother is separating from his brother, which father is going to go with his son-in-law etc. Suppose a banker wants to reduce exposure in a unit - he has to act well in time while the account is still a standard asset.
If you meet those people regularly you will be able to sense that something may come up and take a decision well in time to limit your exposure. That means you understand the customer, which will come only if you meet them regularly. Therefore, we should aim to be in touch with customers all the time and get market information from them directly. I'm not saying that has to be completely relied on, but judiciously use what you can and use it to your benefit.
tejas@iimb: With the emergence of multiple credit rating agencies in India, do you see a problem in terms of data integrity and increased transaction costs?
RK: Of course, there will be a cost to that but we don't know whether the cost will be paid by the borrower or the bank. Suppose an SME wants to get itself rated, when it goes to the banker, it shows that rating as a plus point. It would involve a cost of course, that's how those rating agencies sustain themselves. But the most important thing would be the objectivity and the acceptability of the rating agency. Perhaps another issue that could come up is the various yardsticks that the rating agency uses to come up with the ratings - do they keep that a secret or not.
tejas@iimb: Given that the current ratings are not freely accessible to borrowers, does this data asymmetry pose a threat to consumers by potentially allowing financial institutions to charge higher rates than warranted?
RK: Very right. I think it's been suggested now that the borrowers must know on what basis they are rated. In this kind of interest rate regime, where interest rates have been deregulated (though banks are by and large following the same interest rates) there are differences. So borrowers would like to know how they are being judged. I think in all fairness the borrower should know how he's being rated and the bankers should have a very open policy on that. Of course, there would always be some kind of subjectivity at times.
Problems in Unsecured Loans
tejas@iimb: A common blame that has been laid in the loans business (specifically unsecured loans) is the chase for new customers which results in relaxation of creditworthiness criteria. What is your reading of the situation?
RK:Absolutely right. Bankers say that there has to be a y-o-y growth and the government also expects it. Assume an annual growth of 18%. Now this may not be possible y-o-y. For any credit institution, some time must be given for consolidation and an 18% growth is very high. For example, in today's circumstances, the bankers have said in the recent meeting of the IBA, that this year, they may grow by a maximum of 16%. Some may be able to achieve this; some may not be able to grow by even 16%. The question is the expectation.
The fact is the economy has to grow so people have to be given loans so credit has to expand. But it has to be done with proper analysis and reasoning based on data. It cannot be a wild goose chase and it shouldn't be that kind of pressure. Then the quality of advance will definitely suffer.
Work doesn't end in the sanctioning of the account, that's where it starts.
Even more important than the quality of advance is the monitoring process. A second grade appraisal followed by first grade monitoring can still help the account to be healthy whereas a first grade appraisal followed by second grade monitoring will definitely end up as a problem. Work doesn't end in the sanctioning of the account, that's where it starts.
tejas@iimb: The past few years have seen many players exiting the UPL (Unsecured Personal Loan) space, particularly in small ticket personal loans. Would a microfinance model through SHGs be a viable form of risk reduction given the difficulty of assessing the creditworthiness of this segment?
RK: Microfinance has been here for almost 15-20 years. It started in a big way in South India with Andhra being one of the first and Karnataka and Tamil Nadu, all in a very big way. But in the last decade, it has come to states like Madhya Pradesh, Rajasthan, Gujarat etc. There is, of course, a lesser risk in doing it through SHGs. And one of the reasons why banks went gaga over these people, apart from the fact that social lending was mandatory also in a way, was because their recoveries were 98-100%. Which banker would not want to go for them?
These SHGs are not necessarily agriculture. It could be products or other activities such as making things in the rural areas. Today people are becoming much more quality conscious. So SHGs should also be conscious of the market, the quality standards and they should get trained/ equipped.
So the success of microfinance will come provided you train the staff, equip them, make them conscious of the market, upgrade their skills and most important, don't have a middle man between them and the buyer. The benefit of this is that they meet the consumer and they are able to understand the needs of the consumer. That is a sustainable model. It shouldn't be a flash in the pan.
Future of Credit Appraisal
tejas@iimb: How will the Unique ID scheme, if successfully implemented impact the credit appraisal process and the role of credit rating agencies in India?
RK: A lot of progress has been made in the implementation of this scheme. But I think a lot has to do with financial inclusion, especially in the rural and semi-urban areas. Information on those people through this scheme will definitely help. Credit rating agencies perhaps could use this as a tool for their own ratings.
I think the real benefit would also be that if everybody gets this number, then there would be no situation where somebody gets a benefit which is actually to be given to somebody else. These things do happen sometimes in rural areas. That's why for the last couple of years we are talking about financial inclusion where we want every person in the rural and semi-urban areas to have a bank account. But this scheme will definitely help. It's a great thing to happen to the country frankly.
tejas@iimb: Initially in the US, incentives were given in order to make housing affordable to everyone, especially low-income segments. Going forward, from a government regulation standpoint, how can a balance be maintained between stricter credit appraisal to reduce risk, and ensuring affordability and credit access to lower income groups?
RK: In the US, if I understand right, in some cases at least they did not insist on any stake of the borrower in a loan. Only if the borrower has some stake in the loan, will there be a reason for him to repay it. You are not going to sell the property to get your goods. The important thing is the income generating capacity of the person to pay.
There has to be some stake of the borrower in any loan. Then only there will be a reason for him to repay back.
Take agriculture which is a state subject. It is for the state to see that the farmer is provided with the right fertilizers, the right quality of seeds, and the right pesticides. The bank can only give a loan. But the seeds, fertilizers etc. should be made available well in time before the crop. If the critical period goes away and then you give the loan, obviously it will be misused in other things. So it is a joint responsibility.
It is not just the bankers who are responsible; it is also the state government. And they must take very strong action against those flooding the market with spurious things. And if this is taken care of, then there is no reason for the standard of living not to increase for the farmer. So help him in this way - don't just give him free credit. Then he becomes more accountable, more responsible and his self-esteem goes up.
Post the recent crisis, there has been an increased focus on credit appraisal with an emphasis on acquiring a thorough understanding of all aspects of the customer and his business. Further, there is a growing realization that there is a need to go beyond just credit appraisal to proper monitoring of the account post the sanctioning of the loan. Going forward, initiatives like the Unique ID scheme and proliferation of SHGs, leading to financial inclusion are expected to play a critical role in credit appraisal and risk management.
Mrs. Ranjana Kumar is a prominent Indian banker. Known as the 'Turnaround Queen of India', she was responsible for the turnaround of Indian Bank in her role as Chairman and Managing Director. Post her retirement as Chairperson of the National Bank for Agriculture and Rural Development (NABARD), she is currently the Vigilance Commissioner in the Central Vigilance Commission.