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THE BASEL II ACCORD ON CREDIT RISK MANAGEMENT:

THE IMPERATIVE OF PROACTIVE CREDIT DISPUTES MANAGEMENT

By Bidemi O. Olowosile

Intro: You need not be an initiate to appreciate the importance of credit in wealth creation. From the ordinary consumer at the local shop to the multi-national organization declaring open its Application List for international bond, credit is esteemed as that key that unlocks the possibilities of economic progress. Indeed credit has assumed the status of an institution in commercial relations. More than any other time in history do we now have laws, regulations and recommendations to advance and protect the credit industry, its providers and consumers. With the re-occurring theme in the mind of every lender being ‘what becomes of me in the event of default’, one is compelled to explore not only the roses that credit represents, but more importantly the thorns that attend it. The import of the loss of credit looms large in the mind of every credit provider, hence the field of credit risk and its management. The nightmare of the traditional bank’s Credit Department had hitherto been ‘How do we realize our loan in the event of default?’ This pitch has however undergone variform re-assessments to unveil the new world thinking of ‘How do we minimize default?’ This new thought pattern has re-branded the Credit Manager as the physician and the Loan Recovery Agent, the undertaker. Whilst not on a venture to unearth the veracity or otherwise of this conclusion, this article does embark on a voyage into the pro-active terrain of credit risk management, the Basel II demands for loan supervision and a proactive credit dispute management system as the lifeblood to effective credit management. Indeed credit management essentially denotes the management of a special relationship. With disputes as universal denominators of all relationships, professionals are obligated to discover ways to estop credit relationships from going off beam on the slightest strain. The enormity of the losses problem loans visit on the global economy will ensure that the Basel II Capital Accord continues to enjoy its deserved prominence in credit loss mitigation; but only if the recommendations of the Accord are stretched to further admit of a system that not only proactively manages credit relationships but is so designed to creatively destroy the red flags that most often attend such relationships.

Of Credit Risks and Collateralization: The Weakened Foundations of Bank Lending

Credit risk, simply put, is the risk of loss of a loan or other lines of credit due to a debtor's non-payment of either the principal amount or the chargeable interest or both. The banker would aptly state credit risk as the potential that a bank borrower will fail to meet its obligations in accordance with agreed terms. Such failures would range from an outright failure of the loan project to an inexcusable refusal of the customer to honour the terms of the loan agreement. In practice the events that inform failed loans majorly border along the lines of financial mismanagement, operational deficiencies, environmental hostility, relationship mismanagement, unforeseeable happenstances and the lack of borrower integrity. The occurrence of any of these informs the traditional bank lending policy to securitize loan obligations; the eternal truth being that, it concerns the lender the least what informed the default as much as the need to fulfill the repayment of the principal and interest obligations as at when due. The collateral or security remains the lenders recourse. In conventional commercial circles an unsecured loan is at best a gamble, a cardinal sin to good banking practice.

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The most scathing blows that have been dealt collateralization in recent time centers majorly on its inability to secure borrower compliance; with the average irredentist borrower ‘satisfied’ that even if I cannot fulfill my obligations, let the bank go realize the security if it can! And bet me, he sure does know what he is saying. It is noteworthy that a substantial number of securities taken by banks have, in more recent times, proven to be unrealiseable and sometimes are insufficient replacement for the disbursed loan. The reality of this is evident in the following scenarios:

• A customer pledges a security for a loan, he defaults in his obligations and while the bank makes moves to realize the security, he rushes to court to take out a restraining interlocutory injunction that would last till the determination of the suit (only heaven knows when!).

• Upon realization of the security, the bank discovers that the security has no value at all or the value is insufficient in liquidating the advanced loan

• The customer successfully forged the documents establishing his title to the collateral and as such the loan becomes unsecured as the customer can certainly not give what he does not have.

• The bank proceeds to realize the said asset, but must do so on the authority of the court, e.g foreclosure of an equitable mortgage, which legal regime may not afford the bank the luxury of its relief by the time-consuming court process and technicalities.

• The bank proceeds to realize the asset and the customer pleads for more time or the injection of more funds; the bank would not hear this and there most often comes an end of a banker-customer relationship.

• It is not unknown that most problem loans are allowed to rest in peace (bad debts) as a consequence of the imprudent costs that would be incurred in recovering it.

• Circumstances are not unheard of where bank officials have been man-handled or injured by mercenaries employed by defaulting and non-bulging debtors to deter realisation.

• The bad publicity that attends a banks realization of a security continues to ensure that more people prefer not to do any form of business with them; hence a probable reason for the billions of unbanked money in Nigeria.

Although it may be readily argued that the above situations would arise as a result of unprofessional credit practices, reality however offers a different tale as even the most professional of credit managers had fallen prey to problem loans. The reason is simply that assumed integrity is the currency that runs the global lending industry. Credit managers would readily recount the 9Cs of credit analysis, to wit, Capital, Character, Capacity, Conditions, Consistency, Compliance, Consultancy, Creativity and Collateral; ensuring that moral and intellectual qualities comprise 6 of the 9Cs. It is the above pitch that has informed the more recent calls to re-work the foundations of credit policies to reflect more the assertion that ‘Integrity and competence should be the most valuable and important security; the so-called unsecured loans are after all really secured by the borrower’s integrity.’ Layi Afolabi in his book “Law and Practice of Banking” submitted that “The general consensus is that the best form of banking security is the ability and integrity of the borrower such that the bank can expect to be repaid as and when due in the ordinary course of business.” Little or no mention is however made of the fact that integrity is nurtured on the platform of a system that promotes full disclosure without a flaying. The quest for more practicable credit policies has informed the field of credit risk management to explore revolutionary, yet practicable approaches to lending, and consequently came to the pitch it

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readily tags best practices in modern credit risk management practice. These best practices advocate the need for banks to:

• Establish the appropriate credit risk environment by the emergence of organizations that perform credit rating, credit report, credit monitoring, credit derivative and credit bureau services.

• Operate under a sound credit granting process • Maintain the appropriate credit administration, portfolio management, risk measurement and

credit monitoring procedures • Ensure adequate controls over the credit risk management function

The Basel Committee of Banking Supervision, a Committee of the Bank of International Settlement, went ahead to unbundle these four requirements into 17 specific and measurable principles. The principles aptly put are:

1. The bank’s Board of Directors should have responsibility for approving and periodically reviewing its Credit Risk Strategy and significant Credit Risk Policies. This Strategy in essence reflects the bank’s risk tolerance and the credit risk-related profit projections.

2. The Senior Management should have responsibility for implementing the Credit Risk Strategy approved by the Board of Directors and develop policies and procedures for identifying, measuring, monitoring and controlling credit risk. Such policies and procedures should address credit risk in all of the bank’s activities and at both the individual credit and portfolio levels.

3. Banks should identify and manage credit risk inherent in all its products and activities; and with particular regards to new products and activities, subject same to adequate procedures and controls before introduction or implementation. The board of directors or its appropriate committee should have granted an advance approval.

4. Banks must operate under sound, well-defined credit grant/approval criteria. These criteria must include a thorough understanding of the borrower as well as the purpose and structure of the credit, and source of repayment.

5. Banks should establish overall credit limits at the level of individual borrowers and groups of connected borrowers that aggregate in a comparable and meaningful manner different types of exposures.

6. Banks should have a clearly-established process in place for approving new credits as well as the extension of existing credits.

7. All extensions of credit must be made on an arm’s-length basis. In particular, credits to related companies and individuals must be monitored with particular care and other appropriate steps taken to control or mitigate the risks of connected lending.

8. Banks should have in place a system for the ongoing administration of their various credit risk-bearing portfolios.

9. Banks must have in place a system for monitoring the condition of individual credits, including determining the adequacy of provisions and reserves.

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10. Banks should develop and utilise internal risk rating systems in managing credit risk. The rating system should be consistent with the nature, size and complexity of a bank’s activities.

11. Banks must have information systems and analytical techniques that enable management to measure the credit risk inherent in all on and off balance sheet activities. The management information system should provide adequate information on the composition of the credit portfolio, including identification of any concentrations of risk.

12. Banks must have in place a system for monitoring the overall composition and quality of the credit portfolio.

13. Banks should take into consideration potential future changes in economic conditions when assessing individual credits and their credit portfolios, and should assess their credit risk exposures under stressful conditions.

14. Banks should establish a system of independent, ongoing credit review and the results of such reviews should be communicated directly to the board of directors and senior management.

15. Banks must ensure that the credit-granting function is being properly managed and that credit exposures are within levels consistent with prudential standards and internal limits. Banks should establish and enforce internal controls and other practices to ensure that exceptions to policies, procedures and limits are reported in a timely manner to the appropriate level of management.

16. Banks must have a system in place for managing problem credits and various other workout situations.

17. Supervisors should require that banks have an effective system in place to identify, measure, monitor and control credit risk as part of an overall approach to risk management. Supervisors should conduct an independent evaluation of a bank’s strategies, policies, practices and procedures related to the granting of credit and the ongoing management of the portfolio. Supervisors should consider setting prudential limits to restrict bank exposures to single borrowers or groups of connected counterparties.

Late September 2007, the Central Bank of Nigeria in the spirit of Principle 17 above and more generally, the recommendations of the Basel II Capital Accord, drew its guidelines for the management of all risks (credit, market, operational and liquidity) in the banking industry. The adoption of these guidelines is believed would facilitate Nigerian Banks’ preparation for the implementation of the Basel II Accord. According to the guidelines:

• Each bank should develop and implement appropriate and effective systems and procedures to manage and control its risks in line with its risk management policies.

• The overall responsibility of the board and management of each bank is to ensure that adequate policies are put in place to manage and mitigate the adverse effects of all risk elements in its operations.

• The board’s responsibilities should include: defining the bank’s overall strategic direction and tolerance level for each risk element; ensuring that the bank maintains the various risks facing it at prudent levels; and making sure that senior managements as well as individuals responsible

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for managing individual risk facing the bank possess sound expertise and knowledge to accomplish the risk management function.

• Banks must implement sound fundamental principles that facilitate the identification, measurement, monitoring and control of all risks facing it and ensure that appropriate plans and procedures for managing individual risk elements are in place

• On the composition of the Board Risk Management Committee (BRMC), the chairman of the Board shall not be a member of the committee in line with the Code of Corporate Governance for Banks in Nigeria in order to secure the independence of the BRMC

• Membership of the BRMC shall include at least two non-executive directors, one of whom should be an independent director; the non-executive directors shall serve as chairman while the managing director and chief executive officer shall be a member of the BRMC in order to compliment his oversight role as the chief executive officer of the bank.

• Each bank should submit a copy of its Risk Management Framework (RMF) highlighting its assessment of each risk element and any amendments thereto, to the Central Bank of Nigeria and the Nigeria Deposit Insurance Corporation (NDIC) for appraisal.

• Banks should submit periodic reports/returns in respect of their Risk Management Process (RMP) as they relate to individual risk elements in their respective banks to the regulatory authorities as may be required from time to time

What exactly are the objectives of these regulations and guidelines? What has informed these new practice directions in banks’ (with particular reference to credit risks) risks management operations? At this stage it may be prudent to take a calculated turn to the features and objectives of this new thinking encapsulated in the recommendations of the much-talked of the second of the Basel Accords.

The Base II Accord and its Credit Risk Management Requirements: The Challenges of the New Era

The Basel II Accord, formally known as the “International Convergence of Capital Measurement and Capital Standards: A Revised Framework”, was drafted by the Basel Committee on Banking Supervision (the “Committee”) of the Bank of International Settlement (BIS). Headquartered in Basel, Switzerland, BIS is an international organization that fosters cooperation among central banks and other agencies in pursuit of monetary and financial stability. Its banking services are provided exclusively to central banks and international organizations. The Basel II Accord is essentially a recommendation on banking laws and regulations with the primary purpose of creating an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of credit, market and operational risks they face. In layman terms the Basel II standards demand that the greater risk to which the bank is exposed, the greater the amount of capital reserve the bank needs to hold and maintain in order to safeguard its solvency and overall economic stability. This is believed will help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapses. Apart from the above objective, known as Minimum Capital Reserve Requirements, the other two pillars of the 3 Pillared Basel II Accord are Supervisory Review Requirements and Market Discipline

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Requirements. Whilst the Supervisory Review pillar deals with regulatory response to issues arising from the Minimum Capital Reserve pillar, the Market Discipline pillar greatly increases the amount of regulatory and marketplace disclosures that complaint banks must make. Springing from its adoption by the G10 (comprised of 11 industrial nations – Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States), international banks were expected to have adopted the Basel II recommendations in January 2007 although current events in the US suggests the time-frame for its full adoption would likely extend to 2015. It need be stressed that although Basel II compliance is highly voluntary, the quest for international appeal will see most progressive (and indeed aggressive) international banks adopting it; not more so if the benefits of its risk-specific and operating environment-sensitive model of loan interest valuation and capital reserve requirement is put into consideration. Basel II had essentially built and consolidated on the progress achieved by those leading banking organizations (majority of which complied with the Basel I Accord of 1988) which demanded for more efficiency and resilience through the instrumentality of quantitative risk assessment models, improved and upgraded risk management systems, model capital strategies and disclosure standards. Whilst the Basel I Accord had set 8% Capital Reserve requirements on banks to cover expected losses on their outstanding loans, Basel II introduced a more sophisticated and quantitative approach that compels banks to evaluate the riskiness of each customer and consequently use their estimate of the customer’s default probability to set loan rates and obligations. Indeed Basel II affords its adopters the opportunity to utilize their best of judgment in risk analysis and consequential loan interest valuation; apparently a product of sound credit management experience The fact above brings in its wake the challenge of banks being able to create their own mix of variables as to present their own market-appealing formulas for credit risk assessment and management. In truth Basel II demands a new clime of banking innovativeness and credit-customisation. In market-drive terms, this is spelt ‘competition’ as each bank is left on its own to formulate credit-risk assessment policy that would ensure its profitability and continued patronage; as opposed to the one size fits all Basel 1 recommendations. With Pillars 2 and 3 requiring the transparency of banks risk assessment policy make-up, the credit risk policies of Basel II complaint banks hence becomes public information both for the reviews and inspections of banking regulators and ultimately for the use of the credit market to ‘reward’ banks with customer-friendly credit policies and ‘penalize’ those without. Who dares question the kingship of the consumer? A vital component of the new competition regime would be the need to design attractive credit packages based on the above principles. With so much left to the innovativeness of compliant banks, one is compelled to state that an essential feature of a good credit package is its ability to effectively manage the likely problems that might arise in its operation. Indeed, the Basel principles could not foreclose the eventuality of disputes in lending services. Principle 16 of the 17 specific and measurable principles discussed above had made a direct pitch on the effective management of credit disputes in the form of problem credits. In reality, the precursors to problem credits are minor lapses in the implementation or over implementation of all or any of the 16 other principles. A universal truth remains that disputes are a feature of all natural processes; yea, all human relations. The realisation of this universal truth is the precursor to the field of disputes management. The Basel II Accord must be taken to the full length of its implications with the demand for functional credit disputes management systems within the banks. After all, the Accord had not been set on the

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assumption that banks would have to inevitably fall back on their minimum capital reserves as a result of poor credit-relationship management; for in truth Basel II is premised on the pitch of the probability of credit loss and not the certainty of it. This thinking is what has informed the assertion that if the regime of credit risk management is to make any sense at all the entire process of credit administration must be heralded by formidable credit relationship management practice; hence the call for a pro-active credit disputes management system.

What is a Pro-active Credit Dispute Management System?

The foundational principles of the field of dispute management basically states that disputes are a constant feature of human relations and as such adequate provisions must be made for its effective resolution, even before they arise. The traditional notions of this idea informed the conventional disputes resolution clauses found in contracts. Interestingly, and as it is with everything else, evolution has taken its toll to ensure that these traditional clauses cannot resolve the disputes that arise from the most intricate and technical relationships of today, credit relationships being a typical example. The above has informed the relatively-recent call for the design of dispute management systems within organizations. These dispute management systems embody the step by step approach the organization and all that deal with it must take in resolving all eventual disputes. In reality the system transcends the conventional notion of policy, as it is effectively a system that tracks, prevents and resolves disputes only to feed the database of the system back with the outcome of the process, all in a bid to serve as a reference guide in similar future situations. The dispute resolution procedures aspect of the system can be readily incorporated into new formal contracts or relationships. A fact remains that organizations will in the nearest future be assessed by the disputes management systems they have working for them. With the dispute management system essentially existing as an organisation within an organisation, the question then will be: “What code do you live by?” Indeed it will be the unique selling point of a typical international organization that is destined to survive the competitive marketplace.

How does it work?

A pro-active dispute management system explores the terrain of dispute resolution first from a preventive posture; the Dispute Prevention Procedures. Such procedures are wound around the dispute resolution principle of ‘prompt and effective communication’. The procedure provides for regular updates between parties, instant grievance notifications, meeting forums, grievance analyses & feedback processes. The pitch of the prevention procedures is simply: an unresolved grievance is a brooding complicated dispute. The field of dispute resolution is awash with seemingly one lane disputes with numerous factual detours. Uncommunicated and unresolved grievances are these winding detours. From preventive procedures the system graduates into the Interest-based Procedures. This is the heart of dispute resolution; for in truth, only the results of an effective implementation of Interest-based Procedures can be tagged dispute resolution, all others after it are simply dispute settlement. The Interest-based Procedures boast of mechanisms such as Integrative Negotiations and Mediations. Each of these affords the disputants a supermarket of procedures and options to pick from, with the overall objective being a resolution of the present dispute within the context of the existing relationship; indeed the song at this level is “we would not allow this thorn prevent us from savouring the roses”.

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Suffice it to say that a pro-active dispute resolution system coupled with a few other variables ensures that most disputes are determined at this stage. Rights-based Procedures come immediately after Interest-based Procedures. These procedures comprise of such mechanisms as Neutral Evaluations, Arbitration, Mini-trials and Litigation. The mechanisms are aimed at resolving the questions that border on a party’s assumed rights. Most often this procedure is the aftermath of an interest-based procedure that did not sufficiently highlight the disputing interests or the result of the existence of a party with unrealistic interests. Experience in dispute management systems have shown that due to the time and finance-consuming nature of Rights-based Procedures especially, litigation, there evocation is largely curtailed to a strict procedural step that flows in the order: Neutral Evaluations, Mini-trials, Arbitration and Litigation, with severe penalties imposed on the consistently loosing party; this is to ensure that there is a balance between the constitutional right to dispute in a court and the need for respect of contractual obligations and the losses that flow from a frivolous bid to renege on them. Though considered to be of lesser appeal compared with Interest-based Procedures, Rights-based Procedures have their essential fervor in ensuring that the proclaimed-words of the law be the peace-giver. I don’t see why not, especially in the light of the fact that legal and constitution traditions have so established it. However, it is only most reasonable that the social and economic losses that attend a bid to be right and the other wrong should primarily be taken to account when embarking on such venture. Power-based procedures, which come next, must provide for how pronounced or conventional powers that attend a particular relationship is exercised. For an example, while it is the law that a legal mortgagee can effect his power of sale without recourse to court, it is only commercially sane that such power be exercised with as much civility as possible, all in the bid to ensure that as much good as possible can be salvaged from the process and more importantly to ensure that an established power is not frivolously hampered by a rights-determinant procedure like litigation. The avalanche of interim and interlocutory injunctions that spring from an equity-appealing premise testifies to this. In this bid, a Power-based Procedure that ensures that both parties participate in the exercise of a party’s pronounced or conventional power is advocated. “Yes, you have the power to sell my house, but thanks for giving me the opportunity to present the purchaser (who I am at liberty to structure any deal with)” The regulation of the exercise of powers that arise from a contract must be appreciated from the stand-point that the law hardly leaves anyone powerless; not with the ubiquity of professional defense attorneys. As stated earlier, pro-active dispute management commences with the design of a system and continues with the adaptation of the system’s database to admit of the knowledge gained in every new experience. Indeed the beauty of the system lies in its database of the specific situations it had been applied to; thus, its update and feed-back feature avails an organisation, an encyclopedia of sort, as a reference in budding grievances and disputes.

Conclusion This piece is written with the objective of eliciting an out-of-the-box thinking for credit management practitioners in the banking industry and more importantly for legal practitioners who are always to be called upon when disputes arise. Indeed it calls for the establishment of a credit dispute management system within banks as a necessary corollary to the positive challenges the Basel II Accord brings in its

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wake. If credit management is to make any sense at all, then it should evolve for itself a system that effectively manages the highly volatile relationship it births; hence the call for a pro-active dispute management system. Indeed if professionalism must continue to maintain its toga of excellence, then professionals must resolve to maintain a wardrobe of pro-active solutions for the client in today’s market-place.