20110724 EDITORIAL: Addressing the credit risk problem

EDITORIAL: Addressing the credit risk problem

The Financial Supervisory Commission’s (FSC) warning last week that it might consider asking banks to increase loan provisions to cover potential bad debts — after seeing some banks charge interest rates that are too low for unprofitable companies — revealed how domestic lenders have lost sight of a very basic requirement in this line of business: risk evaluation.

On Tuesday, commission officials told attendees at a forum in Taipei they were worried that cut-throat competition and excess liquidity in the banking sector had prompted some banks to grant excessive corporate loans, or loans at very low lending rates, without paying close attention to borrowers’ credit risks or setting a reasonable target of profitability.

To address this concern, the commission said it would examine whether it should raise the provision ratios on corporate loans and syndicated loans for banks. If banks continue to neglect the importance of credit risks in corporate loans, the commission might then consider imposing fines or withholding approval for a bank’s application to set up branches overseas, commission officials said.

The commission’s warnings on banks’ credit risks came in the midst of incremental growth in corporate loan demand, thanks to Taiwan’s steady economic recovery and the nation’s low interest-rate environment. However, banks have seemingly failed to conduct checks on the credit profile, corporate governance and financial transparency of borrowers as they competed for clients. As the head of the commission’s banking bureau, Kuei Hsien-nung (桂先農), said at the forum, it has been odd to see some large corporations (the borrowers) set the interest rates for banks in recent syndicated loans, not the other way around.

In theory, banks take into consideration a combination of factors when setting interest rates for borrowers, including funding costs, operating costs, risk premiums and profit margins. Yet in reality, banks also take into account government policy and regulations when setting their lending rates. If there is one thing most people know about banks, it is that they depend on a certain level of trust from the general public. Simply put, banks take money from depositors; they then lend the money to others and make investments to make a profit for themselves, while paying interest to depositors.

In other words, with depositors trusting that they can recover the full value of their deposits at any time and under the expectation that banks will honor their contractual obligations, depositors are willing to put their hard-earned cash into bank accounts, allowing banks to use that money to support a functioning economy.

However, what if one day depositors begin to suspect that banks might not meet their obligations because the banks did not use the funds wisely? Large losses and debt defaults could create panic among depositors and lead to bank runs and financial instability. While this is a worst-case scenario for the country’s banking system and is unlikely to occur any time soon, it is this failure by banks to engage in risk management that the financial regulator is so concerned about.

To address the interests of depositors and shareholders, banks need to get out of the cycle of vicious corporate loan competition and consider how their risk evaluation system deals with borrowers. Unfortunately, the commission’s request that banks solve this credit risk problem by setting reasonable lending rates is wishful thinking, because no one knows what reasonable levels of lending rates should be.

The truth is that as long as banks are swamped with excess liquidity, the rates will not go any higher. However, if reckless lending by banks only works to fuel over-investment and create bad debts — similar to what we have already seen in their lending to domestic DRAM companies — this behavior should be stopped immediately.