By Gasper Njuu, Professional partner of TIOB
Published: May 2018, The Exchange


We have heard about bad loans or credits of which various reasons have been given to explain the circumstances that lead a credit to go bad. Several reasons which lead a loan to go bad are often put forward by both the borrowers and the lenders. In some cases there is an element of finger pointing and accusing each other or worse enough blaming the market or economic environment. It is to be understood that credit is extended to meet a specific business, commercial or consumption need of the borrower. The understanding between the borrower and the lender is that the loan will be repaid after an agreed period of time. A loan can’t have an infinite life span unless it is a grant which in any case is not a loan.  Furthermore a loan is a product with a predefined life span, it is created to go through specific stages in its lifetime before it is extinguished.


A bad loan is simply a loan of which its repayment is not made as per the agreed timeframe.


There are six main stages of a loan during its life. These stages are; origination, analysis, approval, disbursement, administration & control and finally recovery (if need be). Only bad loans go into the recovery stage, otherwise the loan life cycle is meant to end with administration & control at which stage full repayment is achieved.


Origination; rests with a series of actions made to identify the causes of a cash deficit on the prospective borrower’s side. It is imperative for the borrower and the lender to understand the reason for borrowing. Take an example of a borrower in need of working capital to purchase a stock of raw materials, which are normally classified as current assets in the borrower’s accounts. This request sounds straight forward and indeed the borrower may use the funds to purchase the stock. In absence of a thorough analysis regarding the reason for borrowing the lender might approve a short term loan or an overdraft. Eventually the purchased stock will go through the operating cycle as it is processed into into finished goods (stock) and then sold (either to debtors or  for cash) and finally the proceeds of the sale will be used to repay the loan.


However, if properly analysed it might be revealed that the borrower had purchased a piece of machinery (Fixed Asset) with cash and now does not have the cash to buy the stock. In this regard the need for cash is not of a short-term nature, the business actually requires long term financing. If the granted short term loan/overdraft is not restructured the borrower will probably continue to experience cash shortages. By understanding the true borrowing causes i.e. those factors and events in the asset conversion cycle that are causing cash shortages, the lender will be able to treat the cause rather than the symptoms. If the cause of the loan is not properly diagnosed then the lender will be treating the wrong financial illness.


Analysis; involves a comprehensive assessment of the loan application, a thorough review of the qualitative and quantitative information regarding the borrower’s creditworthiness, financial health, the business, industry/sector, the economy, the key success factors in relation to the activity being financed, the key risks and related mitigates, the structure of the credit including terms and conditions.  


The lender will be looking at what are commonly called the Five C’s of a Credit Application which entails; Character, Capacity, Cash flow, Conditions and Collateral. Note that these C’s are listed in terms of importance in order to help create a good quality credit application. The first three are a must to pass the lender’s specific lending policy and procedures. It requires a lot of disclosure and transparency of which if not thoroughly done the analysis will end up being of limited value. The last two C’s are evaluated only if the lender is satisfied with the first three, this is why the terms & conditions and collateral requirements are set to be different from one borrower to another.


Approval; can only be done by individuals who are versed with credit approval powers. The approvers are independent from the analysts, they rely on the assessment done by the analysts, and in some cases they have never met the borrower in person.


In addition to having information compiled by the analyst the approvers themselves must be well-versed with credit knowledge, skills and experience. Approvers are expected to ask all the relevant questions relating to the credit application in order to satisfy their own individual credit judgement.  Experience suggests that if the analysis is half-baked the approvers will be raising tones of questions that must be addressed before the final decision is made. The approver’s final decision of ‘Yes’ or ‘No’ accounts for credibility of their own judgement and that of the lender as an Institution.


Disbursement; this is the stage of allowing the borrower to access the loan funds, it happens only when all the terms and conditions have been fully met. Credit is always approved with a series of Conditions Precedent (CP) that must be fully perfected before the borrower can access the loaned funds and Conditions Subsequent (CS) that follow the disbursement. For most lenders the disbursement process is usually done by an independent personnel that was not involved in either origination, analysis or approval of the credit. The borrower cannot access the loan funds unless the CP’s are fully met. In rear cases, if release of funds is required prior to completion of the CP’s then the original approvers of the credit must be approached for their approval. If the approvers are satisfied with the presented justifiable business reasons to allow release of funds before the CP’s are fully met then they will either allow for waiver of the CP or defer timeframe for completion of the CP. If a CP is deferred it has to be tracked for completion within the timeframe.


Administration & Control; At this stage the funds are now in the hands of the borrower after the lender is satisfied with all the early stages of the credit. However, now that funds are out of the doors of the lender there is no assurance that the credit will remain good. It is important that the lender has to ensure that all the terms and conditions set for the credit are followed without failure. At this stage both the CP’s and CS’s have to be constantly tracked and perfected. It entails monitoring the performance of the loan account, all qualitative and quantitative factors including the identified risks.  Any discrepancies or deviations such as, delays on scheduled repayments, submission of financial statements, security documents, change in management, business volumes, risk parameters etc. must be proactively identified and addressed to satisfy the ongoing quality of the credit. Up to this stage it is expected that the life of the credit will end here and this will mark a perfect life span of a good credit. 


Recovery; A loan moves into this stage only when the pre-arranged repayment plan fails. It is the moment when both the lender and the borrower must cooperate even more in order to identify what went wrong and work on the solutions in order to recover the money.


Credible and trustworthy borrowers will offer their full cooperation with the lender until the credit is recovered. However, there are a few uncooperative borrowers who will deliberately push the recovery process to the law courts.


From the lenders point of view going to a Court of Law is the last resort bearing in mind that it is a costly process both in terms of time and money, the outcome of the case is uncertain and may end up ruining the reputation of the lender as well as the borrower.  It is to the best interest of both the lender and the borrower to avoid going through the Court process to recover the credit facility.


Now that we have summarised the stages of a loan cycle lets address the question, “at what stage does a loan go bad?”  


In trying to answer this question we must understand why credit goes bad notwithstanding all efforts made by the lender during the first five stages of its life. Experience shows that a loan can go bad either for reasons caused by the lender or the borrower or both. Some of the reasons are;


The Lender

  • Extending credit for the wrong purpose. Not financing the real cash deficit gap including financing an incorrect amount and at the wrong time.
  • Extending credit to the wrong borrower. Weak credit due diligence, credit risk assessment and forecast of the future.
  • Ineffective terms and conditions.
  • Poor credit administration and monitoring. Trusting that the borrowers will do it.
  • Accepting insufficient or imperfect
  • Inadequately skilled personnel with poor credit skills and experience.
  • Underestimating changes in the market, product, technology, competition, change in Government polices & regulations.
  • Pressure to generate income not correctly corresponding to the underlying risks.


The Borrower

  • Weak financial management including diversion of borrowed funds, inadequate capitalization and limited sources of financing.
  • Lack of transparency. Not disclosing the correct picture of the business but rather preparing reports to entice the lender.
  • Non-compliance with the credit terms and conditions. Accepting the terms and conditions without having clear legal and commercial interpretation.
  • Lack of good governance.
  • Weak business management. Underestimating changes in the market, product, technology, competition, change in Government polices & regulations.
  • Ill intentions not to honour the credit terms and conditions.


So at what stage is a bad loan created?  All six stages of a loan are important. None of the loan stages can work exclusively without close consideration of all other stages. In all stages all relevant credit risk matters must be addressed and a decision made on whether the credit facility is bankable or not, and if bankable then whether it will remain so during the entire life of the loan. It is for this reason that some credit facilities are terminated, amended or reduced prematurely to eliminate or avoid the risk of the credit going bad.


However, experience from most credit gurus suggests that a credit facility goes bad from day one. It is at the origination stage that lenders produce either a good or bad credit facility.  The rest of the stages during the life of the loan are meant to complement all efforts made during the origination. Lenders need to ensure that the process to originate credit is efficiently and effectively human resourced. Apparently discussions with few lenders indicate that the amount of money spent on training credit personnel involved in origination, analysis, approval, disbursement and administration & control  is very small compared to the cost of credit recovery and credit losses.


For how long can lenders continue to afford such a scenario is a question to be pondered by all lending Institutions.