VIEWS: 1 PAGES: 29 POSTED ON: 9/26/2011
Control of Advances Lecture Objectives : 1. To identify the warning signals for bad and doubtful debts 2. To identify the risks of overtrading 3. To review the lesson of credit risk learned from the Asian Financial crisis Warning signals for bad and doubtful debts As lending is a risky business, a banker providing advance facilities to his customers should continuously monitor the performance of the loans and identify the signs that may indicate potential difficulties faced by the customers. In practice, all long- term advances should be fully reviewed at least once a year. If poor conduct such as delay in repayment of loans by the customers emerges, more frequent reviews are warranted. Poor management The fundamental cause of business failure is usually attributable to the poor management of the business and its limited ability to cope with the changing environment. Strong competition, changes in fashion, unexpected economic downturn and political instability will intensify the pressure on management. Poor management Some indications of potential business failure involving poor management : a. Insufficient managerial personnel at various levels of operations b. Disharmony within the management team c. Chaos caused by major re-organization or relocation d. Over-ambitious expansion of operations e. Lack of financial or operating controls Industrial / Market conditions Industrial or market conditions, such as keen competition Production Costs among producers, 200 195 190 Unit Price rs of Dolla 185 180 Profits declining market 175 Millions 170 165 160 demand and 155 150 1990 1991 1992 changes in the preference of consumers, may lead to business failure. Industrial / Market conditions A lending banker should pay particular attention to the following : a. Adverse performance of the company compared to its competitors b. Advanced technology which is expensive to keep up with c. Changes in consumers’ preferences, tastes or fashion d. Threat caused by new entrants to the market and deteriorating market shares e. Monopoly power created by mergers or acquisitions Economic and political conditions A business may be affected by the following unfavourable economic or political situations : a. Economic slow-down or recession b. Deteriorating political stability c. Adverse conditions due to social unrest or pressure groups’ campaigns The implications of a client’s bank accounts A client’s bank accounts basically show the background and financial statistics which serve as a primary source for detecting possible problems in a client’s financial position. For examples : a. Static or hard-core overdrafts b. Growing numbers of cheques with “insufficient funds” claimed by the client’s customers The implications of a client’s bank accounts c. Excessive number of post-dated cheques d. Frequent drawings against uncleared funds e. Frequent excesses over agreed credit limit f. Deficiencies in loan repayments e. Past due import bills Financial position If a company’s financial position deteriorates, the problem will be reflected in its financial statements. A lending banker should be alert to the results of financial analyses. Overtrading Definition of overtrading : The level of activity of a company is too high for the financial resources available to the business and profitability being earned; or the maintenance of a scale of operation with insufficient cash resources. Signals of overtrading 1. Sales are increasing rapidly. 2. Gross trading profit margin is decreasing. 3. Operating expenses are increasing. 4. Liquidity is declining. 5. Stock and stock turnover days are increasing. Signals of overtrading 6. Debtors and debtors turnover days are increasing. 7. Creditors and creditors turnover days are increasing. 8. Amounts due to bank are increasing. 9. Gearing ratio is increasing. Causes of overtrading 1. Over-optimistic outlook of the market 2. Aggressive business expansion without careful planning 3. Debt collection and terms of payment are out of control. 4. Insufficient capital base Causes of overtrading 5. Speculation on inventory 6. Inflation causes costs out of control 7. Misapplication of cash resources, e.g. in capital expenditure, dividend payment, speculation in stock market, etc. Credit risk during the Asian Financial Crisis A review given by Mr. David Carse, Deputy Chief Executive, Hong Kong Monetary Authority, at the Asian International Conference & Trade Credit Workshop 1999. The Asian Financial Crisis happened in 1997 and affected every economy in the region. The exchange rates of the currencies of Thailand, South Korea, Indonesia and the Philippines dropped rapidly and the stock markets of the region almost collapsed. The external shock severely damaged the confidence in the banking systems with non-performing loans increasing. Credit risk during the Asian Financial Crisis Banks lost domestic deposits and found themselves unable to rollover short-term external borrowing. The capital outflows continued to put downward pressure on the exchange rates, forced up interest rates and drove down assets prices. Many customers got into financial difficulties and this further weakened the position of the banks. The Asian Financial Crisis revealed the weakness of the banks in the region in credit policies and procedures. Credit risk during the Asian Financial Crisis 1.Banks overlent to the unproductive sectors, notably the property and stock markets, with the loans funded by short-term capital inflows. When the asset bubble burst, the banks, companies and individuals who had borrowed foreign currencies to finance their investments were unable to repay. The problem was compounded by the depreciation of domestic currencies that increased the real burden of debt repayments. Credit risk during the Asian Financial Crisis 2.Banks in a number of economies were ordered or persuaded by governments to lend heavily to companies that were not commercially viable. This “policy” lending destroyed the banks’ incentive to exercise credit judgment and allowed the companies concerned to become overleveraged and thus vulnerable to economic downturn. Credit risk during the Asian Financial Crisis 3.Much lending in the region was politically influenced or insider in nature, there was not much opportunity to develop a proper credit culture or adequate credit skills. There was also an over-reliance on collateral which sharply diminished when asset values collapsed. 4.The lack of credit skills was a failure to recognize bad debts and to face up to the full scale of the bad debt problem. Banks did not classify loans properly or make adequate provisions against them. Credit risk during the Asian Financial Crisis The Asian Financial Crisis has demonstrated weaknesses in banks’ credit controls. Improvements need to be made to deal with the aftermath of the crisis and to reduce the chances of similar problems in the future. Mr. David Carse recommended the following points : Credit risk during the Asian Financial Crisis 1. Financial institutions (Fis) should be clear about their lending strategy, including the types of risk and the degree of risk to be undertaken. 2. FIs should know their customers, their business and their financial commitments. 3. FIs should keep track of how their loans are actually used for. Credit risk during the Asian Financial Crisis 4. FIs should lend on the basis of cash flow rather than collateral. 5. FIs should maintain an effective early warning system for problem loans and make sure that the loan portfolio is properly graded. 6. FIs should devote sufficient resources to debt recovery and make sure that their workout staff are properly trained. 7. FIs should approach debt workouts in the right spirit of compromise and consensus. Credit risk during the Asian Financial Crisis To conclude the lesson we have learned from the Asian Financial Crisis and the subsequent effect on the financial system, financial institutions should get back to the fundamentals of creditworthiness and apply conventional lending standards. Banks should have a thorough knowledge of their customers’ business and of their real funding needs. Lastly, in granting credit, banks need to undertake proper financial review of their customers based on reliable information. Particular attention needs to be paid to cash flow and the ability to service debt in normal conditions as well as in stress situations. Tutorial Case Study Porche Watches and Clocks Manufacturing Company Limited was one of the participants in the Swiss Watches and Clocks Exhibition. Because of the Atypical Pneumonia, Hong Kong companies were unable to participate in this exhibition in Switzerland. Indeed, one-third of Porche’s orders are used to be acquired from joining this exhibition. Tutorial Case Study The company imports the electronic parts and components from Japan and Europe to manufacture its watches and clocks which are mainly sold to the medium and lower stream markets in the United States and Europe. As the company’s major banker, discuss what problems will be faced by this company and what actions should be taken by the bank. Suggested Answers Students can feel free to advocate their opinions. Firstly, the refusal of the Hong Kong participants by the Swiss government was a change in the political condition because of the outbreak of the Atypical Pneumonia. Secondly, the estimate of loss of orders is a change in the market condition. Suggested Answers Will these changes affect the company’s financial position ? It will certainly be a big challenge to the company’s management. As the company’s banker, you can talk to the company’s top managers to find out how they forecast the adverse effect of the problem on their business volume and how they will deal with the problem. Will they use other methods to contact their buyers to place orders ? Suggested Answers Will the company explore new markets for their products ? If the forecast is pessimistic, will the company adopt a retrenchment strategy to reduce its operation scale so as to lower operational costs ? The banker should be alert on the company’s financial position through analysing its financial statement and keeping an eye on the performance of the company’s bank accounts.
Pages to are hidden for
"Warning signals for bad and doubtful debts"Please download to view full document