Risk management and control constitute the basic core of banking activity. This has always been the case, but recently new regulations have been introduced to avoid the repetition of new financial crises.
The foundation of the banking business lies in stable and direct relationships with customers. A recurring, well-managed business model based on long-term customer relationships fosters profitability for financial institutions and provides businesspersons with value, services and products tailored to their needs.
In this context, clients should be aware that risk management policies must be approved by the banks’ boards of directors, as well as developing methodologies, procedures and criteria for transaction approval.
The approval criteria must be linked to the borrower’s payment capacity to comply, in a timely manner, with the total financial obligations incurred. Such payment capacity will be valued based on the funds or net cash flows from their businesses or usual sources of income, without depending on guarantors, sureties or assets provided as collateral. These should always be considered when evaluating the approval of the transaction as a second and exceptional way of recovery for when the first means have failed.
In this sense, the approval procedures must require in each transaction the identification and quantification of the sources of generation of ordinary funds of each borrower, which will serve as the first and fundamental way of transaction funds recovery. For these purposes, the established procedures will include minimum documentation requirements.
Banks must prudently manage risk as this is the essence of their business, not accepting disproportionate levels of indebtedness from their clients and adequately assessing every risk incurred when approving a transaction. That risk may already arise upon receipt of the adequate documentation, at the time of carrying out the analysis of the transaction, in the correct formalization of the contracts and guarantees provided and in the monitoring of the transaction and the client. That monitoring involves consulting and periodically checking the problems that occur, such as delays in payment commitments towards the institution, negative records in external sources, adverse changes in the value of the collateral, etc.
Adequate risk management is at the heart of the banking sector’s activity and, in a first and fundamental instance, must be based on a “know your customer” process.
The supervisory authorities of the credit institutions, require them to take the utmost care and diligence in the rigorous and individualized analysis of the transactions’ credit risk not only at the time of its approval, but also continuously during its term.
They also require that every transaction should be adequately documented and that the available information should be updated with new financial statements and economic information that allow analysing the solvency and payment capacity of clients and guarantors.
Likewise, in the case of financing to companies and businesses in general, the main source to meet the commitments taken (debt and interest) must be the generation of cash flows estimated from the financial statements of the business and from realistic forecasts.
In this sense, the quality of the annual accounts prepared by the companies and the availability of reliable and justified forecasts are of particular relevance. Regarding the annual accounts, a first element of assessment of the company by financial institutions is precisely the quality and quantity of information provided in the annual report. The use of forecasts is destined to have an increasing importance in customer and transaction analysis.
In all credit transactions, the following points must be clearly identified:
- Purpose of the transaction: Carry out an investment project, financing of working capital, etc.
- Repayment sources: Detail of the resources with which it is expected to meet the capital repayment and interest payment commitments.
- Guarantees provided: Specification of the existing guarantees in the event that the borrower / debtor cannot meet their obligations under normal conditions.
Know your customer
A transaction cannot be analysed leaving the client aside. In order to meet the financing requirements of companies, while adequately managing risk in financial institutions, a “know your customer” process is essential not only from a quantitative point of view, based on their financial statements, but also from a qualitative point of view:
- Experience in the sector of both company and its managers.
- Analysis of its facilities: Location, age, maintenance, ownership, mortgage charges, etc.
- Products manufactured or marketed, distribution of sales by products and markets, marketing channels, etc.
- Clients: Main clients, possible concentrations, collection methods and terms, etc.
- Suppliers: Main suppliers, possible dependences, payment methods and terms, etc.
Information sources
The sources of information that the financial system uses to analyse its clients can be classified into three groups:
- Documentation provided by the client. This documentation can be classified into several types.
- To prove its personality and the exercise of powers (articles of incorporation, powers of attorney, identity card, etc.).
- To justify its ability to pay and solvency (annual accounts, detail of indebtedness, declaration of assets, etc.).
- To justify the destination and substantiate the viability of the requested transaction.
- External sources. These are the primarily used ones:
- Databases of records of payment problems, lawsuit events, etc.
- Commercial or financial reports prepared by specialized companies.
- Internal sources of the institution: Account statements,experience as a customer in previous years, etc.
The following are some guidelines for action in terms of risks that financial institutions usually pass on to their employees when they join the area of credit financing:
- Credit quality is more important than achieving short-term business goals.
- Clients accept decisions based on an objective analysis of their economic-financial position and their business forecasts.
- If the business is not known, it is very risky to extend credit. It is essential to verify that the money borrowed is actually used for its intended purpose.
- The track record of the managers and the composition of the company’s shareholders are first-class qualitative factors.
- The purpose of the loan should normally be the basis for repayment. Defining a realistic payment schedule at the time the loan is approved is essential to avoid future difficulties, so it is necessary to adjust the repayments to the amounts and times for collection of the company.
- Collateral is not a substitute for repayment ability.
- When in doubt, ask yourself “would I lend my own money?”.
The knowledge by businesspersons of the way of acting of financial institutions when extending financing will undoubtedly imply a better banking-company relationship, faster decision-making and more durable and comfortable relationships for both parties.
