When does a loan go bad?

Credit risk assessment is a significant activity in banking. This is because the primary function of banks accepting deposits from clients and paying them on demand means that they must, at all times, put in measures that will control the leakages that could lead to the loss of clients’ money. When clients’ money is lost through bad lending, banks run into serious problems.

Indeed, because of the importance of the credit risk assessment function to the survival of banks, normally, good banks will put in place credit assessment processes including an initial assessment of loan and credit advances by a credit officer, a credit risk officer’s review and a credit committee assessment of the application.

The credit scoring process therefore works like this: The assessment process starts with when you fill in an application form for a loan facility. When you apply for credit, you complete an application form which tells the lender lots of things about you. So each fact about you is given points.

All the points are added together to give a score. The higher your score, the more credit worthy you are. In some jurisdictions, creditors set a threshold level for credit scoring. If your score is below the threshold, they may decide not to lend to you or to charge you more if they do agree to lend.

You may not necessarily be told what your score is as different lenders use different systems for working out your score. But they will tell you if you ask them for the credit reference agency used to get the information about you. You can then check whether the information they used is right. It is believed that these processes would, all things being equal, lead to low loan default rate. But is that really the case? Certainly not!

Reports by the banks show that loan default rate is high, forcing them to keep interest rates high even when the economic managers have reduced the prime rate. To the banks, interest rates have to be high enough so that the good borrowers can pay for the bad borrowers, effectively.

The other emerging problem for the banks is that the courts, again, according to them, have been slow in passing judgement when loan defaulters are brought before judges.

It is reported that a banker has lamented that “the judicial process is slow. Asset disposal is difficult through the courts because you have to have hearings which could take years to complete”.

Asset disposal in this particular case is referring to assets used by borrowers as collateral for loans. Hear the other argument also: “It takes up to four years to finish a case, and when you juxtapose that to the requirements banks have to meet when it comes to loan quality assessment and all that, it is unrealistic.

“If you want to rely on a judicial process to protect your loan not to be written-off and it is going to take you four years to do, then obviously it creates a constraint for banks to want to lend to individuals or businesses,” a banker is quoted as saying.

But the big question is this: When does a loan really go bad? The simple answer is that a loan does go bad at the point of disbursement and not after disbursement!

Once working as a risk consultant involved in a number of restructuring programmes for some of the rural banks and savings and loans institutions, l faced the problem of credit risk assessment in this country.

Whereas it was very clear, from the documents submitted by an applicant that he was going to struggle with the repayment of the loan, a credit officer was prepared to go ahead to recommend the loan to be granted because according to him, he “knew the loan officer personally and that he never kept good records. Besides, he was making available collateral”.

Indeed, it is completely irresponsible on the part of banks when they lend money to clients without applying their own credit assessment criteria fully because a client has collateral to back the facility.

It is also unethical and unprofessional when banks fail to fully educate clients on the possible problems they will encounter if they fail to repay the loan and the applicable interest. Banks must move beyond the small prints and engage clients in the way attorneys and doctors engage their clients.

Yes, laws such as the Borrowers and Lenders Act, 2008 (Act 773) have been introduced that empower banks to claim properties used as collateral and registered with the Collateral Registry without going to court but that does not mean that they should use that provision to indulge in unethical behaviour. With ethics, the law should always be the minimum consideration; you must move beyond the law.

It is the collective responsibility of borrowers and lenders that can strengthen the loan industry.