Which Are High Risk Default Accounts?

Risk is the effect of uncertainty on objectives; the possibility of loss, injury, or other adverse or unwelcome circumstance; a chance or situation involving such a possibility.

Credit risk is most simply defined as the potential that a borrower will fail to meet his obligations in accordance with agreed terms.

Any measurement of risk is basically an estimate made using simple to complex statistical tools and methods. Simple way to measure risk is by application of probability theory. The probability of default is estimated by using the frequency of past missed payments. This is nothing but delinquency rate (%).

Delinquency rate is the total amount of past due as compared to the total instalments/ EMI billed/ matured, so far. This equals to ‘probability of default’.

Total receivables multiplied by delinquency rate give the total risk amount for a default account. This is very similar to the concept of LGD – Loss Given Default.

Pareto’s Principle - The 80-20 Rule

The 80/20 rule helps identifying high risk accounts. The 80/20 Rule means that in anything a few (20 percent) are vital and many (80 percent) are trivial.

You can apply the 80/20 Rule to almost anything, from the science of management to the physical world.

Applying Pareto rule here, top 20% of rank order list of defaulters based on delinquency rate can be considered as High Risk. Invariably, these high risk accounts will constitute 80% of the credit loss.

Limitation here is that some of ‘early’ defaulters on technical grounds will also appear as high risk accounts. To eliminate such accounts as high risk, DPD (90 days) is used, to differentiate. That is how our Quadrant-I accounts are classified/ segmented as “High Delinquency - High Risk”.

On follow up and serious field investigation, you will be sure to find the following in Quadrant-I:

1. Customer is not traceable
2. Asset is not traceable
3. Skip
4. Asset is with unrelated party
5. Lien is NOT marked
6. Asset is in accident condition
7. Asset is confiscated by authorities for misuse
8. Asset is attached and rotting in the Courts.
9. Asset is with a thug, lawyer or politician
10. File along with contract/ agreement is missing
11. Asset is double financed
12. Fraud

An early and serious action would help salvage; and minimize losses. Will these still constitute 80% of the credit loss?

Yes, it will.

What Do Debtors Do / Say?

They do either one or more of the following:

They pay partly or in full the past due amount, when asked efficiently and effectively

They change phone numbers

They normally do not have landline phones. If they had one, they give up quickly

They do not pick up the phone, at least after the first time

They shift their residences, and even locations

They refuse mail or arrange to be returned as ‘undelivered’

They fraudulently sell the underlying asset

They manipulate the receipts

They threaten debt collectors

They do or try to bribe debt collectors

They close their bank accounts, if they had already issued dated/ post-dated / blank checks to the lenders

They do or refuse to surrender the underlying asset.

They say either one or more of the following:

 “Wrong number”

“I am not the one”

“I am busy”; “in a meeting “; or “driving” and “will call back”

 “Already paid, please check with your banks/ books”

“Paid cash/ gave check to your field collector”

“The check is in the mail”

“Ordered a new check book”

“Have problems with my bankers”

“Did not know the due date”

“’Due date does not suit me”

“You wrongly applied my payment”

“I don't owe anything”

“I don't have any money”

“I will not pay, do what you can”

 “Don’t disturb me; I know my liability and responsibility”

“I will pay with penalty, later”

“Do not phone, proceed legally”

“Your account is wrong”

“I have a dispute with the interest charged / installments / EMIs”

“I have a dispute with the product or after sales service”; “ had a marriage in the family”; “ had a death in the family”; “ met with an accident”; “lost my job”; “illness in the family” ;”paid school fees” and so ‘I cannot pay immediately”

“Will pay next month”

“Expecting money; as soon as received will pay”

I will post in near future as to what debt collectors must do or say in response .

Mother Of All Losses

Losses contribute significantly to the closure of many organizations, especially banks, finance companies (NBFCs in India).

Losses are because of:

1.      Bad credit;

2.      Lower prices;

3.      Manipulation of accounts for varied reasons, including tax;

4.      Inefficient technology, wrong policies, bad processes; and

5.      Frauds.

Frauds are mother of all losses in any organization more so in banks and finance companies. Frauds emerge from external sources and in more cases with help of internal sources.

Internal source, we mean here, are employees. Human Resource (HR) contributes the most by recruiting and continuing with fraudulent employees.

Good, efficient and effective employees are rare; it applies to HR people as well. So, bad HR recruits bad employees. Even Good HR do compromise on reference check, etc., so necessary for employees in financial service companies, because of shortage of people. They come under pressure often, from the top management. Aren’t they expected to be professional? Is it fraud?

Interviewers are manipulated easily by these frauds; they are obviously smarter. It is easier with phone or web com interviews. There was a senior guy who can speak freely, only under influence of alcohol. He was recruited for #2 position of the company by a MNC, on an overseas call; he even hidden his heart ailment by resorting to a medical test in a hospital convenient to him. He went on to become the managing director, by default. He was dismissed unceremoniously when they found that he not only manipulated his resume and credentials, but also policies, processes and the worst, the people. Is it fraud?

The wrong policy and inefficient processes also contribute significantly and go to help frauds, leading to losses. Policies are set by the top management. They take policies which are at times are  high risk, just to achieve, in short term, some advantages over competitors in terms of TAT  = turn-around-time. Very rarely, even top management could orient policies just to facilitate achieving his main KRA/ KPI. Policy and process are commonly compromised when the top man is a sales guy. You cannot blame them, because a top man of any listed company in current times lives by quarters; they are under pressure to announce growth serially, QoQ and YoY.  Is it a fraud?

Major facilitator for fraud perpetrators are the decentralized credit underwriting, decentralized accounting and decentralized collateral storage. Common thread here is ‘decentralization’ and half the frauds can be stopped by having a centralized control on credit underwriting, customer accounts and collateral storage. With banks’ current service offerings and available technology on high speed Internet, centralization is cheap, efficient and effective. Branches and different regions cry foul for TAT (read ‘power’) and data. All are possible with advent of high technology, today. Inaccurate customer accounts are what all it starts with, in a decentralized environment. Is it fraud?

Credit underwriting is compromised quickly, when there is a pressure for numbers as month gets close. Many losses occur out of these end-of-month syndrome accounts. I knew a branch manager in Madurai, who would approve every file on the last days of any month while those were rejected by him at the beginning of the month. Fraudulent subordinates and the manager knew this too well, but this happened regularly every month till the company lasted. Is it a fraud?

Losses out of internal frauds are about 1% of assets under finance and run into a few thousand crores for India. Unfortunately, a fraction of it only goes to these internal frauds; remaining goes to facilitators.

What are they worth in terms of sales?

Monthly, Structured Reviews Are Important

 

He was a Telugu, retired and aged banker, living in Mumbai. I do not know how he has got associated with a mumbai based promoter who ran a finance company in south India

He was on the board of this company, till the rot was let out. There used to be  a monthly review meeting and he used to be there almost all the time along with all directors including promoter directors. All senior executives , regional managers and  branch managers were invitees. The marketing team - car and truck finance  used to have sleepless night as the meeting date approached, all the time, without fail. Their problem was either number or rate; worse delinquency/ overdue.

Howsoever better prepared the team appeared and sounded before the meeting, they were almost molested by this man. Any finance professional would like him because he knew the business thoroughly and appeared more prepared than the top executives of the companies. He was sharp and too good at data crunching. He was capable of finding a current slide logically inconsistent with past slides very accurately; he was never wrong.

He used to call hoax - a hoax; especially when it was projected as a hype in the previous meetings.

His way of summing up was too good and it was enough for anybody to be there to understand what went through the whole day in the meeting and what was expected to be improved upon by the next meeting.

One wonders why this smart man did not question  the absence of CFO in all those meetings. Was it because that accounting figures of marketing never tallied with performance claims of marketing? May be, he knew always that accounting figures would never match the marketing because both are questionable. I read somewhere that Japanese always ensured that there are unshakable facts and figures for review, so that strategy and remedial measures are right.

There were hardly any  serious review of delinquency levels and losses even in those meetings; No wonder the company went belly up. Was it also because of window dressing of annual reports at such disproportionate levels?

All said and done, he was a great guy and each company needs an analyst like him, who could review threadbare in monthly meetings. MNCs are averse to such meetings; they favour tele-conference. is it effective?

Are there  serious review meetings in finance companies and banks ? In recent times, the trend,  I believe, is that  many such meeting are scheduled  in Bangkok and I sincerely hope that the right figures are reviewed.

Loan-to-Value = LTV

Loan-to-Value = LTV

It is good to be in asset financing as assets become collateral to the loans offered by banking and non-banking institutions. It is on the premise that when loan repayments are delayed, the lenders could have recourse to assets by taking possession of assets and disposing them to realise the  outstanding.
It may be true if the lien is marked, the company has capacity to repossess and loan to value, say LTV is appropriate.

Many lenders may not verify, inspect assets and may not ensure lien marking properly and accurately. When the lien is not marked, it becomes 'clean' loans, call it unsecured loans,etc. This is a major operational problem especially when the loan is already disbursed. Worse, many lenders depend on 'service providers' to complete the lien marking. The lenders and its executives never get to see or verify the originals as only 'copies' are churned out by the services providers, leading to huge ineffectiveness, inefficiency or even fraud in this area. Non-lien marking helps the borrowers to dispose the asset fraudulently and bonafide buyers will never know that the assets are tainted.

This apart, loan-to-value (LTV) wrongly and fraudulently applied by appraisers create huge losses to lenders. Appraisers and underwriters are,  many a time misled by inflated information on value of the assets. Some marketing jokers in finance business use their clout with management to dismantle any good underwriting policy and process in place. They are forced to have different definitions at different times , leading to LTV exceeding the acquisition cost of the asset by borrowers; it is precisely the intention of bad customers. Lenders end up buying the 'pure' risk.

 Many companies try to finance, to win more customers and to achieve higher sales, all that borrowers spend on the assets.  For example, many governments collect huge money as road tax upfront for life time. This does not add any value to the working of an asset, say Truck. The same must be allowed to be financed by borrowers from his own funds; companies may take only ex-dealers price as 'value' and it may not include any add-ons/ extra-fittings' values.

Value of an used-asset is too difficult to arrive,especially if they are depreciating assets like auto cars, trucks,etc.In the case of used-vehicles financing, many valuation  models and processes are followed to arrive at the 'right ' value. Very little success is achieved in India, with lack of red/ blue books available elsewhere as reference. Appraisers are misled by wrong valuation reports generated by influenced  insurance surveyers/ valuers, to achieve the desired 'finance amount'.

The best policy and process are to have a own quantitative discounting model based on brand, make, model, age, usage, etc. This should reflect, may be up to maximum of 120% of sale price of its repossessed / seized vehicles, sold by the company.

More importantly, LTV may not be model or asset specific but borrower specific. Again, a quantitative score model developed on factors/ information which may reveal his 'ability' and 'intention' to repay.The score may decide the range of LTVs that may be considered as good , read along with many qualitative information in application,  that appraiser may have access to.

What if the top man is a 'sales guy' and thinks that profits flow from sales, so sales alone are important. He may not agree in the short term that credit losses reduce profits in the long run.

LTV is also called Loan-to-Cost or Credit-to-Cost. This ratio claculated accurately for the company as a whole is used a measure of credit; lower LTV/LTC/CTC means better credit underwriting and lower risk.