Future of Credit Appraisal

8/3/2019 Future of Credit Appraisal

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Future of CreditAppraisal

Problems inUnsecured Loans

Credit Rating Agencies

Importance of creditappraisal process

tejas@iimbAn IIMB MANAGEMENT REVIEW Initiative

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INCREASED IMPORTANCE OF CREDIT APPRAISALPROCESS IN TODAY'S BANKING LANDSCAPE

withMrs. Ranjana Kumar

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 withMrs. 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 assessborrowers - 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 sheetwhen we get a new account. If it is an existing concern, we'd go through the balancesheet and the profit and loss statement for the past three years, analyze it, have theproject report of the company to see how it has been doing and then, on the basis of theproject report, we would assess what the requirement is - whether it is a term loanrequired to purchase plant and machinery etc. or it is just working capital required for

running the concern.

Our Kno

FEATU

Mr. Sanjay
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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 theworking capital. In the past, organizations like IDBI and IFCI which were basically termlending 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 theworking capital accounts with them. That was being done by the various commercialbanks 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 plantand machinery and the mortgage of the land. The bank can also consider taking somecollateral security but this is just a comfort factor, not the main source of recovery forthe bank. The main source of repayment to the bank is from the operations of thecompany.

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 requiredinformation to us - their actual sales against what their projections were, what they havedone 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 - theirpolicies, 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 havefructified as orders and the number that have just remained as enquiries etc. Then, theirbusiness clientele - are they spread out or are they just banking on 2-3 clients, how arethey manning their receivables etc.

tejas@iimb: In your past role as the MD of Indian Bank, one of the problems youhandled 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 measuresdid 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 werebeing 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 tohave corporate branches or credit intensive branches such that large credit would begiven only through those branches. Every branch would not be doing it. It would bedone only through certain specialized branches which would have proper policies inplace on how the appraisal would be done.

Also, officers with thorough knowledge and experience would be posted in thosebranches. That was very important. Again these officers, at all levels, were trained in aninstitute of the SBI which is known for its credit appraisal. Further, internal audit wasalso strengthened.

Credit Rating Agencies

tejas@iimb: Foreign credit appraisal firms incorporate non banking information

Sourav Mu

on Knowle
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into their credit rating process, which results in a more comprehensive process. Doyou see this as a necessity in India and is it feasible to implement?

RK: It's like having complete knowledge of your customer. Even if you have the bestaccount, everything won't go well all the time. So you have to find out whether thepromoter 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 balancesheet. That means their expertise, their experience, the people who head theirdepartments, 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 intime while the account is still a standard asset.

If you meet those people regularly you will be able to sense that something may comeup 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 shouldaim to be in touch with customers all the time and get market information from themdirectly. I'm not saying that has to be completely relied on, but judiciously use what youcan and use it to your benefit.

tejas@iimb: With the emergence of multiple credit rating agencies in India, do yousee 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 bepaid by the borrower or the bank. Suppose an SME wants to get itself rated, when itgoes 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 thatcould come up is the various yardsticks that the rating agency uses to come up with theratings - 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 whatbasis they are rated. In this kind of interest rate regime, where interest rates have beenderegulated (though banks are by and large following the same interest rates) there aredifferences. 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 avery open policy on that. Of course, there would always be some kind of subjectivity attimes.

Problems in Unsecured Loans

tejas@iimb: A common blame that has been laid in the loans business (specificallyunsecured 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 thegovernment also expects it. Assume an annual growth of 18%. Now this may not bepossible 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 havesaid in the recent meeting of the IBA, that this year, they may grow by a maximum of


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tejas@iimb: Initially in the US, incentives were given in order to make housingaffordable to everyone, especially low-income segments. Going forward, from agovernment regulation standpoint, how can a balance be maintained between

stricter credit appraisal to reduce risk, and ensuring affordability and credit accessto lower income groups?

RK: In the US, if I understand right, in some cases at least they did not insist on anystake of the borrower in a loan. Only if the borrower has some stake in the loan, willthere be a reason for him to repay it. You are not going to sell the property to get yourgoods. 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 isprovided with the right fertilizers, the right quality of seeds, and the right pesticides. Thebank can only give a loan. But the seeds, fertilizers etc. should be made available well intime 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 theymust 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 toincrease for the farmer. So help him in this way - don't just give him free credit. Then hebecomes more accountable, more responsible and his self-esteem goes up.

Conclusion

Post the recent crisis, there has been an increased focus on credit appraisal with anemphasis 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 justcredit 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, leadingto financial inclusion are expected to play a critical role in credit appraisal and riskmanagement.

Profile

Mrs. Ranjana Kumar is a prominent Indian banker. Known as the 'Turnaround Queenof India', she was responsible for the turnaround of Indian Bank in her role as Chairmanand 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.

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