1. Banking Supervision and Credit Reporting Systems October 6, 2006 Regional Conference on Credit Reporting Systems in Africa Cape Town, South Africa Philip F. Bartholomew Senior Economist Monetary and Capital Markets Department International Monetary Fund For Discussion Purposes Only

2. Analysis of credit quality is fundamental to financial analysis of bank soundness. While many of the most costly bank failures involve fraud or severe misbehavior, most bank failures in G-10 countries, and most banking crises have involved credit quality problems.

3. Bank lending is typically the major source of bank income Bank income comes from interest earned and fees charged; Interest income comes from loans and securities investments (typically government securities); Interest income represents more than half of a bank’s total revenue.

4. First Order Consequences of High Default Rates—Bank Losses, Bank Failures If borrowers do not repay their loans, banks suffer losses; If banks suffer sufficient losses, then they fail.

5. Second Order Consequences of High Default Rates—Higher Cost of Borrowing High default rates not only cause banking problems, but increase the prices of individual bank and banking industry lending; As banks are joint producers of related multiple products, prices of bank services other than lending are affected; Rather than passing on higher prices to riskier customers (i.e., customers with higher propensity to default), bank pass higher costs to customers with highest demand inelasticity—usually, less sophisticated, smaller balance customers.

6. Third Order Consequences of High Default Rates—Reduces Private Sector Finance While banks adjust their lending rates to account for risk, the risk-adjusted rates may be lower in other banking markets; High default rates may make it more profitable for banks to lend to the government sector, through purchases of government securities, than lending to the private sector; Banks which are foreign subsidiaries may transfer funds to home markets.

7. Theory of Credit Reporting Systems By sharing information on borrowing applicants or current borrowers, banks can improve their predictions that the borrower will repay the loan with interest; This should reduce default rates because better loans are made, better conditions imposed on borrowers, better prices are charged on loans.

8. Prudential Supervision Different countries have different practices both for supervision and credit quality analysis. For example, some countries rely more on intensive on-site examination, some more on information reported by banks audited by external accountants.

9. Prudential Supervision—Credit Quality Supervision American-type credit quality supervision is typically performance based (i.e., whether the credit is current in its payments or in arrears or has history of past due payments); Supervisors can examine classification and provisioning easily with this criteria—comparing bank reports with exam sampling; Sampling of specific credits also checks for factors other than performance—sampling is both random and selected. Danish examination is very thorough in looking at loan files relying less on pure performance criteria. The examination process challenges banks both on whether or not a credit is classified correctly and how much should be provisioned against it.

10. History Sometime in the 19 th Century, some continental European banks were required to report credits (i.e., loans) with balances greater than some amount to the supervisor; For example; the French and Germans maintain credit reporting systems used for supervision to help evaluate customer credit ratings—especially customers using more than one bank for financing; Anglophone banking systems typically left the sharing of customer credit quality information to banks or private sector firms such as credit bureaus.

11. Systems with banks reporting performance of specific credits provides timely access to credit quality changes—so long as they are appropriately audited; The Americans do use a system of shared national credits to supplement their credit quality examination system; The Canadians can require banks to electronically report each and every credit.

12. Current Practice We now find that most continental European bank supervisory systems require regular systematic sharing of credit-specific information to the supervisor; These systems are key to bank credit quality supervision in Germany and many central and eastern European countries, and, where available in other countries, at least as an available tool. In Anglophone banking systems such as the U.S., Canada, and the U.K., supervisors do not use credit-specific information systems other than for supplemental information; In at least Anglophone and Lucaphone African countries, we do not find much if any type of credit-specific information system used by supervisors.

13. Multiple Bank Financing Using more than one source of bank finance is good for banks because it reduces individual exposure to a credit or a customer and spreads it among lenders; It’s good for customers because it reduces risk of finance re-pricing or credit line termination; BUT, a major risk to banks comes from customers who pyramid credit exposure through paying one loan off with another.

14. Connected Lending It is easier to ascertain multiple bank financing and assess its quality if the supervisor has information on customers; Most banking supervision focuses on individual banks; Credit quality analysis is benefited by looking at customer overall credit quality—both in terms of all loans made at a bank and all borrowings from all institutions.

15. Loan Portfolio Data Systems Banks should maintain electronic data on each and every credit in a uniform data structure in such a way that the entire lending portfolio, with all relevant information, can be downloaded at any point in time; The data should be identified with a unique customer number.

16. Banks should be doing this anyway! It is important for their own management of credit quality; It facilitates supervision of banks governing their credit quality risk; It facilitates supervision of the banking sector’s overall credit risk.

17. There are mixed practices of internal bank credit reporting systems Many systems are paper-based; Many systems do not link customers for consolidated customer appraisal; Many banks use multiple information systems which may or may not be compatible.

18. Electronic Loan Data Base Could be used by bank supervision for off- sight monitoring and for pre-on-site examination process; Part of the information could be used by banks or other eligible lenders for a credit bureau.

19. Loan Portfolio Data Base Customer Customer information Type of loan Loan amount Price of loan Term of loan Risk-grade of loan Payment structure of the loan Collateral of Loan Current performance status Customer performance history on this loan Bank review of loan

20. Credit or Loan Reporting System Regardless of what form shared information on credits or credit customers is adopted, credit-specific reporting systems facilitate banking supervision; Structured well, the data base of information reported by banks to supervisors can facilitate information reporting needs of credit registries or credit bureaus.

21. One Data Base—Multiple Reporting Systems Rather than have banks report to their supervisor and the supervisor run or share information with the credit registry or credit bureau, it seems wise to keep the reporting systems separate; BUT, banks should order their data so that they can report to both from the same data base.

22. Differences in credit-specific reporting between credit bureau and bank supervisory needs Pricing information should never be shared among banks through such a system; It may not be wise to share details of loan term structure other than with supervisors—an alternative is to categorize such structures (i.e., revolving accounts, fixed term, overdraft, etc.); Details of collateral might only be shared with supervisors.