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How we make Credit Risk decisions

Date: June 1, 2014 Author: Ramzi Watfa
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A bank entered into a lending proposition some 8 years back in which it financed the importation of cars. Despite the high collateral security (the cars), the deal was a disaster, with the cars still held by the bank unsold to date. In a more recent similar transaction, the same bank financed another set of car purchases on the belief that the new cars were popular and their resale was “guaranteed”. The objections of the credit risk department went unheeded.

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Another favorite example of mine is when an older, more experienced banker advises a more junior one that over time, a banker need not analyze figures and facts; instead from his knowledge of the industry, the management, and its reputation, a credit risk decision can be taken with confidence on the fly. In discussions to finance obligors, have you ever heard the following arguments before:

  1. Don’t worry, I know the client …
  2. I know these cash flows are negative, but look how well it is capitalized ….
  3. Look how high the Current Ratio is, this is the best in this industry ….
  4. This is the practice in this country, so either you lend to those without cash flow or you are out of the market ….
  5. If we were to look for positive cash flows then we will never lend again ….

So why the seemingly irrational decision? What is it about bankers’ decisions that seem illogical? Why do bankers tend to repeat the same mistakes over again without learning from them? Why are the majority of bankers reactive in their decision making, reacting to problems after they manifest, rather than proactive, calculating risks and taking effective measures to manage them from the outset?

Perhaps the answers lie in the way bankers think, coupled with lack of proper training in decision making in Credit Risk management.

The two brains affect According to current psychology theory, humans have two brains:

1. One that is intuitive in nature, making fast and quick decisions on practically all the functions we undertake during a normal day: spend impulsively, be influenced with what others think, scratch our heads when we think deeply, reacting negatively to unfamiliar environments and so on. This brain evolved over 35 million years, and was responsible for our ability to survive our evolving environments over millennia.

2. The other is a more logical but slower brain, one that does the logical thinking part. This is where logic is used to assess situations and provide answers based on reasoning. However sometimes the logic backfires, and it is used to justify the decisions made by the more intuitive brain. This explains why some people become racist, or vengeful, or practice maliciousness etc..

These reactions are better known as “cognitive biases”, and one particular one which we seem to always face is the one where we tend to pay more attention to present rather than future events (the “present bias”) as described by Kahneman and Tversky. For example, if we were to offer you a toy in one year’s time or two toys in one year plus one day, you are most likely to choose the two toys option. Both these events are far away, and a one day difference (the perceived relativity) is minimal. However if we were to offer you a toy today or two toys tomorrow, you are most likely to go for the one today. The difference of one day is the same in both situations, but taking advantage for situation now is much more alluring than a promise of a future gain. Other biases include “Confirmation bias”, such as looking for information that confirmed what we already know, like buying a newspaper that agrees with our views.

Similarly, the lure of revenue generated from a new relationship based on familiar yet shallow analysis is much higher than a credit decision based on thorough due diligence that will take time and effort to complete.

This science led to the creation of what is termed Behavioral Economics, and provided its creator, professor Kahneman (a psychologist) a Nobel Prize for economics. His argument was that humans respond to losses differently than to gains. In the case of a banker I guess, the loss of potential revenue is much more appealing than the gain of good credit and a sound portfolio.

The biases and entrenched behavior In another experiment, Dr Santos, of Yale University taught a troop of monkeys to use money. It’s called monkeynomics, and she wanted to find out whether monkeys would make the same mistakes as humans. She taught the monkeys to use tokens to buy treats, and found that monkeys also show loss aversion, as with humans. Her conclusions were that these biases were so deep rooted in our evolutionary past, they may be impossible to change.

This bias problem is also compounded by the fact that as humans, we can handle only 7 pieces of information at a time. When the amount of data received increases to beyond 4, the brain automatically begins to categorize it, and in the process store the information in short term memory. Unfortunately for us, the short term memory seems to reside in the motor-skills area of the brain, and hence as data are stored, we feel the exhaustion of motion, akin to hard labor. To avoid this painful experience, humans tend to either (a) not bother too much with excessive data, and/or (b) try to use familiar experience or peer analysis as substitute to ease the thought process. Obviously both of these processes are fraught with errors and misjudgment.

A potential reason for biases One reason why such biases dictate the way we behave may be the need to generate endorphins. Endorphins are naturally occurring chemicals that in short make us feel good. The more routine are our lives, the more we seek biases that create endorphins such as smoking, drinking, emotional drama, and the like. Various cultures have referred to this phenomena, some associate it with Karma, Nirvana, others the Yin and the opposite Yang. The way it manifests itself in bankers is simply the promise of profits now (the Yin) versus credit risk later (the Yang). As the Yin produces the endorphins, then the decision is taken to do the business with little regard to the Yang.

How to overcome biases and subjective reasoning So the tendency is to take quick, seemingly “educated” decisions based on familiarity and “experience”. As long as the problems do not surface for a relatively long time, then the decision is thought to have been the right one at the time, and the problems that surface in future were due to changes in circumstances that were not evident at the time the decision was made (the logical brain finding excuses).

There are essentially two ways to ensure that the decisions we make as bankers are appropriate:

  1. Instill discipline and thoroughness in the process. You need to realize that there are around 177 criteria that need to be analyzed before a decision is made. Knowing the obligor’s reputation, account behavior, and the personal characteristics of the owner(s) covers only three of them (these are generally used in Name Lending). That leaves over 173 other criteria not addressed. Hence decisions made on a finite set of data are really shallow, and tend to fall into the biases that we addressed earlier.
  2. Reach enlightenment, which creates its own endorphins, and which in the world of banking means Training. In the world of forward looking default, cash flow analysis (and its ratios) become centric to analysis, whilst peer analysis proves to be very misleading (the blind leading the blind syndrome). The earlier the bank can detect defects in an obligor (early problem recognition), and keep an eye on them, the better control the bank has on its portfolio. In our Credit Analysis e-learning module, we train bankers to structure their thinking in a methodical manner, allowing them to manage only 3 or 4 major criteria at a time, and methodically filtering through each one of them to capture all the relevant ones that help make that decision. The central ethos of the exercise is to ask yourself three basic questions:
  •  Can the obligor create cash flow (the Engine or Business Model)?
  • Is the cash flow enough to repay bank debt?
  • What’s the obligor’s behavior in terms of using the cash and bank facilities?

By managing the data in three lots, the process of logical thinking, data absorption and manipulation becomes less burdensome; and allows for objective reasoning in assessing Credit Risk.

If you are interest in the psychology of the making decisions, we recommend the following further references:

If you are interested to learn more about how to evaluate business engines, subscribe to our modules on http://www.credit-risk-store.com/online-courses/financial-analysis/

© 2014 6 Sigma Group While the information contained herein is believed to be accurate, neither 6 Sigma nor any of its affiliates or subsidiaries or its employees makes any representation or warranty, express or implied, as to the accuracy or completeness of the information set out in this document or that it will remain unchanged after the date of issue of this document, and accordingly neither 6 Sigma nor any of their respective affiliates or subsidiaries or employees has any responsibility for such information. This document is not intended by 6 Sigma to provide the sole basis of any credit decision or other evaluation and should not be considered as a recommendation by 6 Sigma that any recipient of this document should purchase an equity stake in, provide credit facilities to, or conduct any business with any company(ies) listed in this document. Each recipient should determine its interest in the information provided herein upon such independent investigations as it deems necessary and appropriate for such purpose without reliance upon 6 Sigma. WANT TO USE THIS ARTICLE IN YOUR NEWSLETTER OR WEB SITE? You can, as long as you include this complete phrase with it: “6 Sigma Group teaches bankers around the world how to become better bankers. Get the “5 Mistakes Bankers Do in Credit Analysis” at www.credit-risk-store.com
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