Reprinted by permission from www.cpifinancial.net

Given the volumes and size of assets at risk, retail lending should be the safest form of bank lending, followed by corporate and then investment. However, as many banks found out to their costs, the high returns associated with high risks often pushed them into business strategies that ultimately failed. The credit risk challenge continues to bedevil banks. Is there a practical solution?

General George Patton (a man who was very attuned to the subtleties of Arab culture), despite his hard charging reputation, had a very mature attitude to risk.

"Take calculated risks. That is quite different from being rash," he once growled in his uncompromising, but inspirational style. He might have done well as a regulator, or even a bank manager. How General Patton would have dealt with the challenges facing banks today, will never be known, but he would undoubtedly have been the first to acknowledge that risk, especially credit risk, should never be underestimated. The huge provisions that banks in the Middle East have been setting aside for non-performing loans are a case in point.

Credit risk is the subject that, unlike some of the more controversial 'toxic derivatives' and issues like subprime, refuses to go away. In fact it continues to bedevil regulators and bankers around the world, not just in the Middle East.

One criticism by regulators (which is ruefully conceded by bankers) is that there was/is no shortage of solid data on credit risk, even in the Middle East and other emerging markets. However, most banks are sitting on what can only be described as priceless amounts of data, but aren't aware of it or don't know what to do with it.

"This region's approach to credit risk has traditionally been a heavily labour- intensive one, in other words, lots of manual and paper-driven processes, creating long and inconsistent decision-making processes and a lack of centralised control and monitoring," said Ian Jiggens, Lead Consultant at PIC Solutions International.

"Credit risk, especially retail credit risk, is about doing simple things in a repeatable, consistent, automated and low-cost way, whilst making sure that data, intelligence and insight is applied at all times to ensure the right credit decisions are made. This second approach requires a very different mindset from the first, however, and a commitment from senior management and the bank's executive to make it work. Under-funded, under-resourced and under-skilled credit risk departments are more harmful than they are useful and, with a few exceptions, we tend to see a lot of this in the Middle East. Hopefully, this will change in time..." he said.

The volatile state of the global (and indeed, regional) economy has meant that credit risk keeps popping up on virtually every agenda. Governments are keen to reinvigorate economies by getting banks to boost lending to Small and Medium Enterprises (SMEs), but some banks remain reluctant to lend, citing (once again) the vexing issue of credit risk.

"Emerging markets need to guard against overheating and a build-up of financial imbalances, as rebounding capital inflows combine with strong credit growth and rising inflation." - IMF

The International Monetary Fund (IMF) in a paper on the impact of legislation on credit risk pointed out that a central aspect of concern for investors to engage in foreign markets, particularly if it comes to credit risk, "is to have a meaningful understanding of differences in legislations across countries - in order not to face 'unexpected' losses."

"Emerging markets need to guard against overheating and a build-up of financial imbalances, as rebounding capital inflows combine with strong credit growth and rising inflation. Corporate leverage is also rising and weaker firms are increasingly accessing capital markets, making corporate balance sheets more vulnerable to external shocks," the IMF said in the April 2011 edition of its Global Financial Stability Report.

Some Middle Eastern banks have been so badly exposed by their lack of credit risk controls that it is surprising that more heads haven't rolled, even up to the level of chief executive.

PIC Solutions has pointed out that, for credit grantors, effective management of customer information is a critical business task. This ranges from the gathering of data found on account application forms, to utilising the ongoing performance information available on existing client portfolios. "The correct handling of these data-rich environments often determines whether the business remains competitive and successful," it explained.

State of Affairs
"In recent years, credit granting organisations have also realised that internal information sources can be supplemented with the value that comes from exchanging data with other businesses. By grouping this centrally, using credit bureaux to hold the data, a large database of shared information became available. In particular, the data contributors focussed on submitting monthly information as to how customers conducted accounts held with each organisation," the specialist credit risk solutions company said.

In response to the current credit risk state of affairs, it rolled out the PIC Capability Assessment (PCA) solution in April 2011. "Our clients often mention that they are so focussed in addressing immediate priorities that they find it challenging to devote the time to consider where they should be taking their risk capabilities strategically. This is a recurring issue in the region," Jiggens said.

Focusing on the areas of risk strategy, processes, systems and people, PIC Solutions said its consultants will take the business' subject matter experts through a rigorous process that will enable them to objectively 'plot' the organisation within a capability matrix. The output from the process and the matrix will be utilised to develop a roadmap with recommendations for improvement.

Meanwhile, the Export Credit Guarantee Agency (ECGA) of Oman has reported that export credit insurance policies being taken out by local companies rose from OMR 2 million ($5.1 million) in 2004 to OMR 10.6 million ($27.5 million) 2009.

"We don't expect further deterioration in Egypt's credit risk by credit agencies, however, Egypt's CDS is expected to continue its recent volatile movements but at an expected lower pace due to regional political unrest, especially in oil producing countries such as Iran, Libya, Algeria, and Bahrain" Prime Holding said in a report on Egypt, post revolution.

Perspective
"Although we expect inflation to record an average of 12 per cent in [financial year] FY11 compared to 11.1 per cent in FY10, we doubt that the CBE [Central Bank of Egypt] will start raising interest rates anytime soon. In our perspective, the CBE will focus more on targeting growth in order to create jobs. Moreover, inflationary pressures can be contained through FX intervention to reduce imports costs as well as fiscal policy through subsidies," it added.

"Banks should be encouraged to self regulate and credit bureaux should be encouraged and supported (why this has not happened in the UAE remains a mystery) to develop. These measures, along with more global initiatives such as the Basel II and Basel III accords, coupled with robust consumer protection legislation should be adequate supervision and regulation," Jiggins told Banker Middle East.

"By and large, the regulators are using an extremely big hammer to crack a relatively small nut. Recent central bank directives in the UAE and Qatar, which mirror similar, longer standing legislation in Saudi Arabia, Kuwait and Bahrain, have taken away much of retail lending opportunities that exist in these markets and stifled the banks' ability to compete, responsibly, in these areas. In my opinion, the restrictions are far too onerous and give the banks far too little room to grow and develop their retail lending portfolios. Whilst these measures will certainly help reduce and cap over borrowing in the retail sectors in these markets, they also run the very real risk that banks will simply exit from the retail lending space and thus create another retail credit crunch, which will adversely affect the wider economies, especially as regards consumer durables, auto and travel," he added. Under-funded, under-resourced and under-skilled credit risk departments are more harmful than they are useful.