Credit Approval Process:

1. Introduction:

The individual steps in the process and their implementation have a considerable impact on the risks associated with credit approval. Therefore, this chapter presents these steps and shows examples of the shapes they can take. However, this cannot mean the presentation of a final model credit approval process, as the characteristics which have to be taken into consideration in planning credit approval processes and which usually stem from the heterogeneity of the products concerned are simply too diverse. That said, it is possible to single out individual process components and show their basic design within a credit approval process optimized in terms of risk and efficiency. Thus, the risk drivers in carrying out a lending and rating process essentially shape the structure of this chapter.   First of all, we need to ask what possible sources of error the credit approval process must be designed to avoid. The errors encountered in practice most often can be put down to these two sources:   — Substantive errors: These comprise the erroneous assessment of a credit exposure despite comprehensive and transparent presentation.   —   Procedural errors: Procedural errors may take one of two forms: On the one hand, the procedural-structural design of the credit approval process itself may be marked by procedural errors. These errors lead to an incomplete or wrong presentation of the credit exposure.

On the other hand, procedural errors can result from an incorrect performance of the credit approval process. These are caused by negligent or intentional misconduct by the persons in charge of executing the credit approval process.   In the various instances describing individual steps in the process, this chapter refers to the fundamental logic of error avoidance by adjusting the risk drivers; in doing so, however, it does not always reiterate the explanation as to what sources of error can be reduced or eliminated depending on the way in which they are set up. While credit review, for example, aims to create transparency concerning the risk level of a potential exposure (and thus helps avoid substantive errors), the design of the other process components laid down in the inter-nal guidelines is intended to avoid procedural errors in the credit approval process.   Still, both substantive and procedural errors are usually determined by the same risk drivers. Thus, these risk drivers are the starting point to find the opti-mal design of credit approval processes in terms of risk. Chart 1 shows how banks can apply a variety of measures to minimize their risks.  

Chart 1.2

Segmentation of Credit Approval Processes:

In order to assess the credit risk, it is necessary to take a close look at the borrower’s economic and legal situation as well as the relevant environment (e.g. industry, economic growth). The quality of credit approval processes depends on two factors, i.e. a transparent and comprehensive presentation of the risks when granting the loan on the one hand, and an adequate assessment of these risks on the other. Furthermore, the level of efficiency of the credit approval processes is an important rating element. Due to the considerable differences in the nature of various borrowers (e.g. private persons, listed companies, sov-ereigns, etc.) and the assets to be financed (e.g. residential real estate, production plants, machinery, etc.) as well the large number of products and their complexity, there cannot be a uniform process to assess credit risks. Therefore, it is necessary to differentiate, and this section describes the essential criteria which have to be taken into account in defining this differentiation in terms of risk and efficiency.  

2.1 Basic Situation :   The vast majority of credit institutions serve a number of different customer segments. This segmentation is mostly used to differentiate the services offered and to individualize the respective marketing efforts. As a result, this seg-mentation is based on customer demands in most cases. Based on its policy, a bank tries to meet the demands of its customers in terms of accessibility and availability, product range and expertise, as well as personal customer service. In practice, linking sales with the risk analysis units is not an issue in many cases at first. The sales organization often determines the process design in the risk analysis units. Thus, the existing variety of segments on the sales side is often reflected in the structure and process design¹ of the credit analysis units.   While classifications in terms of customer segments are, for example, complemented by product-specific segments, there appears to be no uniform model. Given the different sizes of the banks, the lack of volume² of comparable claims in small banks renders such a model inadequate also for reasons of complexity, efficiency, and customer orientation. Irrespective of a banks size, however, it is essential to ensure a transparent and comprehensive presentation as well as an objective and subjective assessment of the risks involved in lending in all cases.

Therefore, the criteria that have to be taken into account in presenting and assessing credit risks determine the design of the credit approval processes.   If the respective criteria result in different forms of segmentation for sales and analysis, this will cause friction when credit exposures are passed on from sales to processing. A risk analysis or credit approval processing unit assigned to a specific sales segment may not be able to handle all products offered in that sales segment properly in terms of risk (e.g. processing residential real estate finance in the risk analysis unit dealing with corporate clients). Such a situation can be prevented by making the interface between sales and processing more flexible, with internal guidelines dealing with the problems mentioned here. Making this interface more flexible to ease potential tension can make sense in terms of risk as well as efficiency.

2. Accounting for Risk Aspects :

The quality of the credit approval process from a risk perspective is determined by the best possible identification and evaluation of the credit risk resulting from a possible exposure. The credit risk can distributed among four risk components which have found their way into the new Basel Capital Accord (in the fol-lowing referred to as Basel II).³

1. Probability of default (PD)
2. Loss given default (LGD)
3. Exposure at default (EAD)
4. Maturity (M)

The most important components in credit approval processes are PD, LGD, and EAD. While maturity (M) is required to calculate the required capital, it plays a minor role in exposure review.⁴   The significance of PD, LGD, and EAD is described in more detail below.  

2.a Probability of Default :   Reviewing a borrower’s probability of default is basically done by evaluating the borrower’s current and future ability to fulfill its interest and principal repayment obligations. This evaluation has to take into account various characteristics of the borrower (natural or legal person), which should lead to a differentiation of the credit approval processes in accordance with the borrowers served by the bank. Furthermore, it has to be taken into account that — for certain finance transactions — interest and principal repayments should be financed exclusively from the cash flow of the object to be financed without the possibility for recourse to further assets of the borrower. In this case, the credit review must address the viability of the underlying business model, which means that the source of the cash flows required to meet interest and principal repayment obligations has to be included in the review.

2.b Loss Given Default :

The loss given default is affected by the collateralized portion as well as the cost of selling the collateral. Therefore, the calculated value and type of collateral also have to be taken into account in designing the credit approval processes.

2.c Exposure at Default (EAD):

In the vast majority of the cases described here, the exposure at default corresponds to the amount owed to the bank.⁵ Thus, besides the type of claim, the amount of the claim is another important element in the credit approval process.  Thus, four factors should be taken into account in the segmentation of credit approval processes:

1. type of borrower

2. source of cash flows
3. value and type of collateral
4. amount and type of claim

3. Approaches to the Segmentation of Credit Approval Processes:

The following subsections present possible seg-mentations to include the four factors mentioned above in structuring the credit approval process. The lending business in which banks engage is highly heterogeneous in terms of volume and complexity; this makes it impossible to define an optimal model, and therefore we will not show model segmentation.   After the description of possible seg-mentations, two principles are dealt with that have to be included in the differentiation of the credit approval processes along the four risk components to ensure an efficient structure of the credit approval processes.   — distinction between standard and individual processes in the various segments; —  taking into account asset classes under Basel II  

3.1 Type of Borrower:   In general, type of borrower is used as the highest layer in credit approval processes. This is due to the higher priority of reviewing legal and economic conditions within the substantive credit review process. The way in which the economic situation is assessed greatly depends on the available data. The following segments can be distinguished: —  sovereigns —  other public authorities (e.g. regional governments, local authorities) —  financial services providers (incl. credit institutions) —  corporate —  retail   Usually, at least the segments of corporate and retail customers are differentiated further (e.g. by product category). Credit Approval Process and Credit Risk Management

3.2 Source of Cash Flows:   The distinction of so-called specialized lending from other forms of corporate finance is based on the fact that the primary, if not the only source of reducing the exposure is the income from the asset being financed, and not so much the unrelated solvency of the company behind it, which operates on a broader basis. Therefore, the credit review has to focus on the asset to be financed and the expected cash flow. In order to account for this situation, the segmentation of the credit approval processes should distinguish between —  credits to corporations, partnerships, or sole proprietors; and —  specialized lending     Credit institutions have to distinguish between the following forms of specialized lending in the calculation of regulatory capital.

1. project finance
2. object finance
3. commodities finance
4. finance of income-producing commercial real estate

This subdivision of Basel II primarily serves to determine the required cap-ital correctly, but it can also prove useful from a procedural point of view. This chapter does not separately address the specific design of credit approval processes in specialized lending transactions. The general procedural provisions that should be heeded to minimize the risk also apply to the forms of finance collectively referred to as _specialized lending.  

3.3 Value and Type of Collateral: Value and type of collateral have a significant impact on the risk involved in lending. Of particular relevance in this context are those types of collateral which afford the lender a claim in ram on the collateral, and those product constructions under which the lender has legal and economic ownership of the asset to be financed. Two forms of finance are particularly relevant in practice:   —  mortgage finance and —  leasing finance     Mortgage finance and leasing are those forms of finance which often give the lender a substantial degree of control over the asset being financed. The strong legal position resulting from such collateral may warrant special treatment of the relevant forms of finance. Please refer to 2.4.2.4 for a description of the types of collateral usually accepted by banks and the valuation of such collateral.  

3.4 Level of Exposure: The level of exposure has an immediate impact on the exposure at default (EAD). Therefore, any increase in the level of exposure should trigger a more detailed credit review of the respective borrower. This aspect and the risk min-imization that can be achieved by standardization and automation are the ration-ale behind the separation of low-volume and high-volume lending business that can often be found in the way in which credit approval processes are designed. In practice, the ensuing sub-segmentation within the claims segments is now commonly referred to as standard process and individual process.  

3.5 Standard and Individual Processes:   The distinction between standard and individual processes does not create a separate segment. It is rather a common process differentiation within claims segments which are defined in accordance with the criteria described above. In the vast majority of cases, the level of engagement is the decisive element in the differ-entiation between standard and individual processes. In addition to the level of exposure, it is possible to describe some general differentiating criteria that characterize the process type in question. Generally speaking, the objective of establishing standard processes is more efficient process execution. As most segments show concentrations of certain product specifications, it is possible to develop processes that specifically address these characteristics. Standard processes are characterized by the fact that they are only intended and suitable for handling certain credit products with limited features and options.  

Limiting the process to certain products and maximum exposure volumes allows for simplifications and automations within the process (in particular with regard to credit decisions by vote⁹ and highly automated credit decisions). Credit Approval Process and Credit Risk Management     Individual processes are characterized by an adaptive design which makes it possible to deal with a variety of products, collateral, and conditions. Typically, this will be required especially for high-volume corporate customer business, as both the borrowers_ characteristics to be taken into account in the credit review and the specifics of the products wanted are very heterogeneous. The higher risk involved with loans examined in an individual process should be addressed by using a double vote (one vote by the front office, and one vote by the back office).  

Chart 2 :  As already mentioned above, the new Basel Capital Accord — in its incorporation into European and thus Austrian law — presents mandatory rules for the regulatory capital requirements of claims under any and all banking book transactions¹⁰ of credit institutions and investment firms. Basel II provides two approaches to determine the capital requirement:

1. a standardized approach and
2. an internal ratings-based approach (IRB approach)

The IRB approach¹¹ allows a more risk-sensitive calculation (based on the banks internal estimates) of the capital required to cover the risks associated with claims than was or will be possible under Basel I and the newly modified standardized approach. The goal is to use the capital required from an economic point of view as the yardstick for the regulatory capital requirement. However, this will only happen if the banks measure the risks in accordance with the regulatory criteria.

• The IRB approach distinguishes 7 asset classes:
  1. sovereign exposures
  2. bank exposures
  3. corporate exposures
  4. retail exposures
  5. equity exposures
  6. securitization
  7. fixed assets