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Saturday, August 6, 2011

Lending agreements-increasing trend of outsourcing monitoring to professionals

Conventional financial theory holds that financial intermediaries(like banks) add value('spread'/NIM) by aggregating deposits and lending them to qualified borrowers. For these loans to be profitable, banks should have the expertise in credit risk assessment and monitoring. But the past few years(decades?) trend seems to be negating this theory. While banks are focusing their energies on gathering deposits(more channels, multiple access mechanisms, marketing) and processing loan applications faster('retail loan factories'), their response to scams seems to outsource that monitoring function to a professional. For example
  1. Some banks give 0.25%-0.5% interest rate discount to their SME borrowers with credit ratings. 
  2. Stock audits/financial audits(where not otherwise done) are made mandatory for those with working capital/other operating facilities.Incidentally, this is the mainstay of many a SME practice.
  3. For borrowers with multiple bank relationships('consortium lending etc), RBI has mandated a compliance certificate to be issued certifying governance issues, no fund diversion etc. Interestingly, this circular also contains a best practice of different statutory/internal auditors for group companies, where facilities cross Rs 50crores.
  4. Often, the audit clause contains a 'Big 4' auditor appointment insistence-this is true of the Indian private sector banks, but this trend seems going down though. 
  5. In additional to the general purpose financial statements, auditors are often asked to sign a compliance certificate(under the lending agreement) which contains proforma ratio calculations, covenant compliance affirmation etc. When the auditor is tasked to do this(albeit for extra fees), he is in reality doing the monitoring function of the bank.
  6. Auditor/CAs are often asked to certify the utilization of the earlier sanctioned funds, before the next disbursal is approved. 
 Conceptually, there is little quarrel with the proposition of 'bundling of services' or delegating to experts. When the auditors/credit rating agency are expected to know the client well and perform their tasks with due diligence, then the bank is entitled to rely on them. The only possible issues with this, is that the processing fee/interest rates should reflect this reduced risk, as well as reduced costs for bank. Otherwise, the benefit from these activities directly flow to the bank's bottomline. Btw, the professional referred to in this are practising CAs/CSs/CWAs-most of whom can do the above work. Still, the statutory auditor is preferred for most of this.

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