Filling up the lacuna in corporate lending

Criminalising the lender and the defaulter shifts the focus away from the inefficiencies in the corporate lending process

Various reasons have been attributed to the current corporate NPA crisis. That includes legal events, commodity cycle bust and most prominently, errant promoter —and at times senior banker — behaviour. One may conclude that banks have successfully externalised the problem with the message that had it not been for errant promoters and the alleged white color corruption — India’s bad debt problem would not have arisen. It is becoming a regular practice for lenders to ask for forensic audit in the event of a big-ticket default. But is everything okay in the banking sector’s corporate risk management practices? Take the trend of doubting the quality of the borrower’s financial statement post default even though the bank had been assessing those same balance sheets for decades. Then these companies had been getting enhanced credit amounts regularly. Time to raise questions on the effectiveness and competency of the corporate lending process itself.

Post the huge corporate lending losses, very few lenders have meaningfully rehauled their lending processes. In most cases, there have been minor tinkering only. The lending decisions, which were subjective to begin with, have swung to one of extreme risk aversion, creating an illusion of stringent credit standards but arguably with no improvement in the quality of the credit decisions. Currently, even good businesses are getting starved for credit and even honest businessman are being looked at with suspicion.

This is very different from what happened in the aftermath of India's retail credit blow-up of 2007-08. That time, the shortcomings of the existing processes were acknowledged. As a result, the systems and processes were redesigned. Judgmental design-making was replaced by data- and analysis-supported decision making. The result: the retail lending story has been running successfully for a decade. Corporate lending needs to go through a similar transformation. The time has come to make the process more objective and efficient with better governance.

The scope of model-driven automated decision-making in corporate credit on the lines of a retail loan is currently limited. Corporate lending is underwritten on a case-by-case basis. Of course, there are credit policy rules but often they are quite broad and subject to wide interpretation. In addition, the decision-making structures allow for veto rights to credit committee chairpersons, who sometimes use it without well-articulated reasons. In cases where a bespoke quantitative model exists, it is found that the model inputs give high weight to entirely subjective elements such a "quality of management". The cumulative impact is inconsistency credit underwriting decisions. While one credit profile may be rejected in a branch, a comparable profile may get a credit from another. Worse, the whole decision-making process sways under bouts of aggression followed by risk-aversion.

A bare minimum requirement is creating exhaustive benchmarks with more focus on cash-based ratios rather than the current accrual-based ones. Policy rules need more granularity and need to be regularly analysed and back-tested for their risk efficacy. More advanced banks may start with statistical models to support decision-making and move out of the throes of untested ‘expert’ models.

The corporate lending decision-making process is inefficient, taking anywhere between 30 to 120 days. The most palpable manifestation of the quality of decision is the credit memo. The memo embodies the needle-in-a-haystack syndrome. Even for mid-sized companies pages are filled with undifferentiated industry outlook and economic commentary. Quantitative analysis on how the company behaved in different economic or industry situations is given a miss. Likewise, the approaches to the projection of balance sheet are ad hoc and at times amateurish. Such exercises are prone to manipulation. Sometimes the decision flow requires circuitous routing of the credit memo with limited value-addition. This increases the workload of a already overburdened credit team leading to either errors or herd-mentality in decision-making. The result is a credit call which ultimately has limited defensibility and tractability.

More focus is needed on structuring the credit committee with nuanced understanding of the incentives for committee members. Overloading the committees with credit or risk representatives after NPA blow-ups is as ineffective as allowing the business to run on the unfettered veto power of relationship managers during credit up-cycles. More governance is required around the decision-making process but that does not mean more documentation. In several instances, credit calls are collectively taken without detailed minutes being produced which captures the views and voting patterns as well as the rationale of the veto if exercised. What is required is objective decision-making. That is different from the current practice of stating that the committee was ‘comfortable’ with the credit and to create an illusion of detail orientation, an unwieldy credit memo is attached.

It is critical to redesign the corporate lending process to support the next round of growth. Criminalising the lender and the defaulter shifts the focus away from the lack of rigour and inefficiencies in the corporate lending process.

The author is visiting faculty of finance at IIM Calcutta & a risk consultant