Staying above Water – Challenges to Credit Risk Management in the Pacific
Improving indigenous peoples’ access to infrastructure, funding energy efficient housing, restoring marine life in shoreline villages, improving food security or funding especially women-led micro and small enterprises – these are just a few ways in which development banks can ameliorate living standards. As they are wholly or partially publicly funded and have a development mandate, development finance institutions (DFIs) serve as a model funding platform for riskier projects that provide public goods and services and for developing new market segments. As with any organisation engaged in lending, the management of credit risk is a key factor for development banks, yet they additionally have to balance economic sustainability with development impact. To this end, a solid credit risk management is key for DFIs, to ensure that they can bear the risks they incur and can continue to provide their services in the longer term.
This articles builds on a roundtable on Credit Risk Managament (CRM) held with DFIs in the Pacific on 23rd July, which was organised by the ICR Facility in cooperation with the Development Bank of Samoa. The event was part of the ICR Facility’s second component which supports national and sub-regional DFIs. In the ICR Facility’s interactions with DFIs, Credit Risk Management was identified as a prevalent challenge that the DFIs are eager to collaberate on. Twelve participants from five DFIs in Pacific island economies participated in the roundtable and exchanged their challenges with the credit risk management process, especially in light of the recent economic downturn, and explored opportunities to collaborate.
Why automate Credit Risk Management?
In the discussions, recurring issues among Pacific DFIs were the lack of appropriate systems for initial loan appraisal and the lack of a risk rating of borrowers and a periodic credit risk review.
One solution could be programmable CRM software, which reduces the time a DFI needs to assess and process a loan application and also allows the DFI to effectively grade the credit risk of each borrower: the grading of each credit provides the basis for the bank to develop a sound Credit Risk Management Framwork. The credit screening could be accompanied by a comprehensive appraisal and monitoring of credit risks – i.e. a regular review of the credit risk itself as well as its rating. CRM software allows DFIs to facilitate this assessment and grading and can also send automated alerts and reminders to borrowers before and after payment dates. By ensuring that the borrower is aware of the payment schedule, DFIs can deepen customer relationships, ultimately improving customer experierence along with financial literacy.
Further, the grading of credit risks allows the DFI to better manage the risks it incurs and to develop suitable approaches to address higher risks in their portfolio, e.g. by engaging more frequently with such clients. As processes are automated, less intensive customer care may be needed for less risky clients. This, in turn, frees resources for more intensive care for riskier clients and other activities of the bank. Ultimately, this will result in tailor-made product and service offerings by DFIs and greater customer satisfaction.
Which system to choose?
While development banks are in the position to promote technological innovations, smaller DFIs may lack ICT infrastructure themselves. When delopoying a CRM tool, such DFIs face the question of which CRM tool is most suitable for them.
During the roundtable, different aspects that DFIs should consider before investing in CRM software were presented and discussed. These range from understanding capabilities and specification gaps in the current system, clarifiying the DFI’s expectations to a new tool, training employees to use a new software to considerations of data transition to the new system.
In order to maximise the benefits of adopting a new CRM tool, a DFI should have a clear understanding of its own expectations from the new tool, which processes it will automate or move to the new system, and how the new system shall fit in into the DFI’s existing CRM framework. Further, DFIs may explore options to partner up with private or public data pools with access to credit records to speed up their credit appraisal processes and thus improve borrower experience. Some CRM tools allow linkages with such data pools, such as national data bureaus.
Despite all advantages of automated CRM processes, the experience of the Pacific DFIs also showed that the personal interaction with clients especially at the beginning of the engagement, cannot be replaced, as banking is based on trust. Therefore, the introduction of a CRM tool should be closely aligned with the DFI’s customer management system.
Also, in programming such CRM software to a bank’s needs, experiences from the customer base should be included. For instance, a participant raised the risk that by detecting any delays in instalment payments, an automated CRM tool might decline follow-up loan applications. If it is known that the customer may have a delay in the repayment by a day or two but has in the past always repaid loans, this should be considered in the programming of the CRM tool, e.g. by including higher thresholds for declining loan applications.
“We learnt from the expert’s presentation and found we have similar challenges with counterparts in the Pacific. Our CRM at the Development Bank of Samoa is mainly manual, but the Bank of Cook Islands banking system is more advanced in the use of digital innovation. The Tonga Development Bank has also made progress in digitizing loan processing which provides linkages to performance appraisals and application of IFRS9. We've picked up on these developments and would like to learn more. Therefore, we have agreed to hold another roundtable to continue the collaboration to share resources and experience to improve the DFIs of all the countries. We also want to extend this collaboration to other Pacific Islands countries to strengthen capacity of DFIs in the Pacific.
Another outcome of the roundtable is for us to submit a proposal to the ICR Facility to support the collaboration initiative in the future. We really appreciate the organization and flexibility the ICR Facility which has allowed us to include other DFIs of the Pacific and to share the resources. We are very grateful for this opportunity.”
And what do regulators say?
The regulatory requirements imposed on a bank – be it a commercial or a development bank – strongly impact its room for maneuver – i.e. its opportunities to finance new market segments or technologies, but also provide guidance. Regulation usually also includes requirements or recommendations on the risk management processes of banks, including credit risk management. In reality, several scenarios can be observed:
Some development banks, for instance those in the Federated States of Micronesia and Palau, are not regulated by an independent authority, leaving them to analyse best practices from other regions for themselves without guidance. Adapting policies and practices to the context of small island economies remains an ongoing challenge for these banks.
Others are regulated like commercial banks, limiting their options to fulfil their development mandate; an example being the Bank of Cook Islands which has a commercial and a development arm, both falling under the commercial bank regulation.
If regulated differently than their commercial counterparts, development banks may have other capital provision requirements or borrower appraisal metrics than their commercial counterparts. This is especially relevant for counter-cyclical investments of development banks, for instance when governments channel COVID-recovery funds via their national development banks. This may lead to an increasing overall credit risk in DFIs’ portfolios in the post-pandemic era, requiring an even better credit risk management.
Key takeaways from the roundtable:
- Credit risk rating of borrowers and accounts is one of the first steps to building a good Credit Risk Management framework.
- Regular risk review of borrowers is an instrumental aspect of a solid risk management and should be integrated in Credit Risk Management structure of development banks.
- Risk rated pricing is a good avenue to offset high-risk lending, but it may result in negative borrower sentiment in small communities.
- When considering a loan application system, the loss of customer contact at different stages of the loan process as well as the lower capability of technology to detect non-programmed nuances compared to individual assessments are trade-offs that need to be considered.
- Banks should know their basic functionalities, compatibilities and staff expertise when investing in a new system or application.
The roundtable kick-started the discussions on Credit Risk Management and the participants voiced interest to continue this exchange in the future. The ICR Facility will continue to support this exchange, and other Pacific DFIs will be invited to join.
The ICR Facility can provide short-term technical assistance to DFIs upon request to the above mentioned aspects. For more information about the technical assistance the ICR Facility provides and the application procedure, please see Request form | ICR Facility (icr-facility.eu).
The ICR Facility supported the production of this publication. It is co-funded by the European Union (EU), the Organisation of African, Caribbean and Pacific States (OACPS) under the 11th European Development Fund (EDF), the German Federal Ministry for Economic Cooperation and Development (BMZ) and the British Council. The ICR Facility is implemented by GIZ, the British Council, Expertise France, and SNV. The contents of the publication are the sole responsibility of the author and do not necessarily reflect the views of the EU, OACPS, BMZ or of the implementing partners.