Sociologist and psychologist must help in credit rating in banks
By Otieno Odhiambo | April 10th 2018
Commercial banks are important because they channel savings into loans that are a source of finance for the productive sector. In extending loans to their customers, banks are aware that some borrowers will not repay.
They thus put in place systems to handle credit risk - the possibility that expected cash flow from a bank’s asset is not realised.
The strength of a bank depends on how effective it is in managing credit risk. In this respect, banks have come up with models used in discriminating potential loan defaulters from non-defaulters as a first step to managing credit risk.
The problem is that credit rating models are not foolproof. The problem that banks face is analysing and measuring the credit risk or default risk on individual loans. The assumption is that if you can analyse and measure credit risk, then you can manage it.
No financial institution can claim to be perfect in default risk management because if that was the case, there would be no bad loans (non-performing assets).
The first level of credit management would be to screen potential borrowers and only lend to those who will not default.
The reality is that even with the best risk scoring model, perfect screening is unattainable.
The amount of non-performing loans dent the country’s financial system. Credit risk analysis is important to banks because it is the rating status of the borrower that influences the credit decision.
Whether the loan will be extended or not, the terms of the loan depend on credit rating status of the borrower.
The interest the bank will charge the borrower for the loan depends on their credit rating status. The period for which the loan is to be extended to the customer and the value of the collateral the borrower provides are also credit status-driven.
Inadequate credit analysis is associated with higher default rates than if not controlled can impulse a bank into insolvency.
Lenders not sure about the credit rating of the borrower will cover their back by asking the loan seeker to pay exorbitant interest.
It is perhaps this poor credit analysis that explains the high interest rates in Kenya.
Furthermore, lack of an adequate credit rating model makes it difficult for lenders to analyse and differentiate borrowers with respect to their capacity to service their loans.
In the absence of adequate credit rating models, a bank, especially when it comes to small loans, might be forced to charge the rate, thus failing to separate good borrowers from the bad ones.
This arrangement introduces inefficiency in the financial system.
Banks should realise that high interest rates send an adverse signal about the bank loan portfolio.
High interest rates are associated with high-risk borrowers and the likelihood of default is considered high which in turn downgrades the quality of assets in the bank’s balance sheet. It should not be lost on us that high interest rates increase the risk of nonpayment.
The existence of substantial non-performing loans would suggest that the credit management models in place are inadequate.
The current models emphasise borrower-specific and market-specific factors to shape their credit decisions.
The models consider the borrower’s reputation, the amount of existing debt and how volatile their income is and the collateral offered.
One would expect borrowers with a better reputation to be charged less interest on the amount borrowed. A higher existing debt would mean reduced chances of servicing a new loan since heavy debt increases interest to be paid by the borrower.
Where the income or profit to the borrower is volatile or keeps on going up and down, there is a high probability that the borrower could fail to pay the interest.
Over-reliance on credit discrimination scoring model could see an increase in non-performing loans. The problem of credit discriminating model is more obvious when the data is inadequate.
What is the way forward then? One way would be for financial institutions to enlist the services of sociologist and psychologist by making them part of their credit evaluation teams.
It is the mind and attitude of the borrower that determines whether they will default or not. Sociologists and psychologists are in this case better placed to judge the mindset of borrowers.
-The writer teaches at the University of Nairobi
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