A loan in default presents the ultimate test of the quality of a lender's documentation practices. Loan documents are all that stand between charging off a loan or recovering against collateral and/or guarantors. The environment of a loan in default is highly adversarial. For this reason, loans must be documented to ensure the highest level of scrutiny to safeguard bank's interest as well as to withstand legal challenge.
Banks are exposed to six core risks through their operation, which are: credit risk, asset/liability risk, foreign exchange risk, internal control & compliance risk, IT risk, and money laundering risk. Among these risks, management of credit risk gets most attention. Credit risk arises due to the possibility that the borrower may fail to repay the loan. Following the recent global financial crisis, which originated from poor management of credit risk, credit risk is the most discussed topic in the banking industry.
Lending process includes the following phases: application, investigation, evaluation, decision documentation, administration, and collection. All of these phases require some form of documentation in order to protect bank's interest. This part of the lending process is essential in order to avoid loan losses due to poor documentation. Many banks/NBFIs assign this important responsibility to loan officers and loan administrators. If not performed accurately, poor documentation can cause loans to be insecure or unguaranteed.
In this context the term "estimated credit losses" is highly pertinent, which means an estimate of the current amount of the loans and advances portfolio (net of unearned income) that is not likely to be collected; that is, net charge-offs that are likely to be realised for a loan, or pool of loans. The estimated credit losses should meet the criteria for accrual of a loss contingency i.e., a provision to the Allowance for Loan and Lease Losses (ALLL) set forth in generally accepted accounting principles (U.S. GAAP). When available information confirms specific loans and leases, or portions thereof, to be uncollectible, these amounts should be promptly charged-off against the ALLL.
Estimated credit losses should reflect in consideration of all significant factors that affect repayment as of the evaluation date. Estimated losses on loan pools should reflect historical net charge-off levels for similar loans, adjusted for changes in current conditions or other relevant factors. Calculation of historical charge-off rates can range from a simple average of net charge-offs over a relevant period, to more complex techniques, such as migration analysis.
Loan documentation is basically executed by Credit Administration Department (CAD) of bank through Relationship Manager (RM) who works in the front line and are responsible for customer service and delivery. The major function of CAD are: (i) to ensure that all security documentation complies with the terms of approval and is enforceable; (ii) to monitor insurance coverage to ensure appropriate coverage is in place over assets pledged as collateral, and is properly assigned to the bank; (iii) to control credit disbursements only after all terms and conditions of approval have been met and all security documentation is in place; (iv) to maintain control over all security documentations; (v) to monitor borrower's compliance with covenants and agreed terms and conditions and general monitoring of account conduct/ performance.
Credit administration and credit controls are the two key components in the active management support of the frontline credit processes of making individual loans and client management. Credit administration (organizing and managing credit processes) and credit controls (tools for minimising and managing risks) are both essential to manage portfolio quality and to operate efficiently.
As financial institutions grow in terms of volume, diversity, and complexity, risks increase disproportionately and it becomes increasingly challenging to analyse and manage credit portfolios. Institutions grow in terms of the number and size of loans, diverse products and clients, multiple locations and more employees, and more complex processes and procedures. At the same time, larger financial institutions are often subject to increased regulatory, governance, transparency requirements and have rapidly changing risk profiles as they grow and become more formalised. One of the most effective ways to address a larger institution's new reality where proactive risk management is critical is to create a dedicated Credit Administration Department and expand and upgrade credit controls.
Although specific credit risk management practices may differ among banks depending upon the nature and complexity of their credit activities, a comprehensive credit risk management programme will address these four areas. These practices should also be applied in conjunction with sound practices related to the assessment of asset quality, adequacy of provisions and reserves, and disclosure of credit risk.
Credit administration is a critical element in maintaining the safety and soundness of a bank. Once a credit is granted, it is the responsibility of the business unit, often in conjunction with a credit administration support team, to ensure that the credit is properly maintained. This includes keeping the credit file up to date, obtaining current financial information, sending out renewal notices and preparing various documents such as loan agreements.
In developing their credit administration areas, banks should ensure:
* efficiency and effectiveness of credit administration operations, including monitoring documentation, contractual requirements, legal covenants, collateral, etc.;
* accuracy and timeliness of information provided to management information systems;
* adequate segregation of duties;
* adequacy of controls over all "back office" procedures; and compliance with prescribed management policies and procedures as well as applicable laws and regulations.
The credit files should include all information necessary to ascertain the current financial condition of the borrower or counterparty as well as sufficient information to track the decisions made and the history of the credit. For example, the credit files should include current financial statements, financial analyses and internal rating documentation, internal memoranda, reference letters, and appraisals. The loan review function should determine that the credit files are complete and that all loan approvals and other necessary documents have been obtained.
Disbursements under loan facilities will only be made when all security documentations are in place and preconditions for disbursement are met. For all cases, the Business Unit and Disbursement Authority will be separated from each other to minimise the risk. As per sanction advice, CAD will issue a documentation check list and provide it to the respective Business Unit. Upon receiving the documentation requirement, Business Unit will arrange all required documents (without deferrals) duly signed by the customer as applicable and will forward it to CAD. The charge documents to be signed by the customers in presence of the RM of respective Business Unit or CAD and they will put their signature as witness. After completion of the documentation formalities, CAD will issue Disbursement Note/Security Satisfactory Certificate prior to limit loading and preserve it with the original file. Credit Administration Department will set and authorise the limit. All disbursement / drawings will be in line with the sanction advice. Excess over Limit (EOL) will be allowed under pre-facto approvals and to be set in the system by CAD.
The credit administration function is critical in ensuring that proper documentation and approvals are in place prior to the disbursement of loan facilities. For this reason, it is essential that the functions of credit administration be strictly segregated from Relationship Management/ Marketing in order to avoid the possibility of controls being compromised or issues not being highlighted at the appropriate level.
Mohd. Jamil Hossain works at the Premier Bank Limited as SEVP & Head of Corporate Banking. [email protected].
The views expressed in the write-up are of the writer's own and not necessarily of the organisation he represents.
