Banks need to size up to risks of credit defaults

The drying up of the wholesale funds market, the steep descent of the real estate market, the stock market and the oil price, as well as the increased risk of default by businesses and individuals, have resulted in banks revisiting their lending policies.

Most banks, in the recent past, have reduced the credit limits of customers across the board irrespective of their creditworthiness as a defensive measure. Further, they have raised the interest rates on loans to new and existing customers in order to compensate for the rise in losses from defaults.

Experience suggests that such repricing of loans can work adversely and push borrowers who could initially afford to make their loan payments, or are barely making payments, towards delinquency.

Industry experts explain that cutting down credit limits on customers' credit cards to their current card balances can result in increasing the instances of default, as customers may not find the utility they once perceived to get from the card, making it more attractive for them to just walk away from the debt.

Responsible borrowers, on the other hand, are unfairly penalised and such limit cuts may result in banks losing out on their good customers to other banks.

This is a classic case of the effects that adverse selection can have on the financial service sector.

Banks are faced with a challenging situation. They not only have to protect themselves from potential losses from payment defaults, which are on the rise as retrenchment increases, but being in the business of lending, they can no longer solely rely on risk management strategies that require them to indiscriminately cut credit limits and raise rates to all customers, as this is not a long term solution.

On another hand, if the number of defaults rise, credit collections units will need to gather pace. This can be quite challenging particularly when banks are under pressure to layoff staff in order to cut overall operational costs causing collection staff's performance to falter under the pressure.

The first step banks need to take before they implement any risk management strategy is to size up the problem. They need to understand the magnitude of the situation they are in and get an idea of their customer's total exposure and the current health of their loan portfolios.

The most effective way of understanding and sizing up the risk profile of their customer is though the sharing of credit information amongst banks.

Credit bureaus facilitate such sharing of information in an organised and technical manner. Banks need to monitor not just how their customers are performing on loans with them but also how their customers are performing on loans with other banks.

Such information, with the added predictive analytics power derived from it, provides a better indication of that customer's credit health. For example, information about an individual's tardy payment behaviour with other banks is a strong indicator of default risk on facilities extended to that customer by your bank.

Collectively, this type of information when applied to the entire portfolio allows for the segmentation of customer according to their risk profile. This enables banks to devise and implement appropriate preventative measure.

Additionally credit bureaus help create what is known as "reputational collateral" and through international alliances with credit bureaus in other countries, they can help in exporting one's credit information to other countries.

This will discourage people from simply fleeing the country, leaving trails of debt behind as their credit characters will reflect their past performance and affect their ability to get any further credit.

Now is the time for banks to reward and retain their good performing customers. This can be done by building and growing their relationships through extending further lines of credit, cross-selling other banking products, as well as providing them with preferential interest rates based on risk premium pricing.

The true test of leadership is at the time of crisis. The sooner banks begin sharing information, the earlier they will be able to curtail their losses, maximise their profit margins and put more timely risk management tools in place.

The writer is chief business officer at Emcredit.