TAKING RISK: THE ROLE OF LAWYERS AND BANKERS IN CREDIT RISK MANAGEMENT AND MITIGATION FOR COMMERCIAL BANKS
TAKING RISK: THE ROLE OF LAWYERS AND BANKERS IN CREDIT RISK MANAGEMENT AND MITIGATION FOR COMMERCIAL BANKS
By Francis Ben Kaifala
Banking and risk are inseparable counterparts in the financial system of the economy of every country. While everything possible may be done by bankers and the regulators of the banking sector to reduce the effect of excessive risk-tasking, credit obviously includes the risk of loss. It is in fact risk that is the rationale for a lending bank’s returns (profit) usually measured in interest rate spreads. Like in many spheres of life, risk can neither be avoided nor totally eradicated. It is proper planning and execution that holds the key to a banker’s success; because, like Pierre Corneille (1604-1684) once wrote, “to conquer without risk is to triumph without glory”.
Modern Banking in Sierra Leone, like everywhere else should be open to risk. Avoiding risk is like avoiding lending. Without lending with the attendant risks that go with it, returns to the bank will shrink. Besides that, non-risk taking banking will likely limit bankers to non-risk taking activities and products which are likely not to be attractive to the market and in turn not expand the impact of banking in the economy.
On the other hand, while risk taking should not only be encouraged but expanded, the key concern of the savvy banker should be the methods that should be used to reduce or mitigate risks of counter-party moral hazard. To effectively contain risk, Credit Risk Management Departments of Sierra Leone’s Banks would need both lawyers and finance experts to be able to effectively allocate risk and at the same time mitigate its effect on their operations. This can be done by properly drafted facility documentation and the guarantees or securities provided for the loans.
Facility agreements are the biggest legal and economic fortresses against risk available to the banks. It is a common misconception to believe that guarantees and collaterals are the best mitigators of risk. While collaterals are great support devices to mitigate risk, it is usually the quality of documentation which supports their availability to the banks that provides the actual protection. Even unsecure transactions, if properly documented, will include clauses likely to mitigate risk; and a properly drafted loan agreement will be of as much use to the banker as will be collaterals secured by the banks.
However, what we have seen over the years is loosely drafted agreements, sometimes not even done by lawyers, but by some junior or even experienced bankers which provide room for prolonged litigation and difficulty of enforcement. The clauses that tighten up the economic and legal interests of the banks like events of default, warranties and Conditions Precedent are most times copied from borrowed precedents, without much time being taken to customize them to reflect the commercial exigencies of a particular customer of the bank. Because of the lack of, or poor expertise in Financial Law, these drafters may not understand the legal and/or economic rationale for some of the clauses which are either added or left out with serious consequences on recovery in the event of counter-party non-performance.
While lawyers are very useful in the work of the bank, the actual work which makes the documentation to be tightly drafted so as to avoid loopholes and make the content of the agreement rich so as to guarantee recovery, should be done by the bankers themselves. To this end, the most important pre-contractual work of the banker is the risk assessment process - identifying the nature of the business, the assets of the company, the liabilities the business has, the control mechanisms and the management make-up of this business. This is not done by the Lawyer except where the lawyer is specifically employed for that purpose – which is not common in this jurisdiction.
A prudent banker will seek to understand the nature and scope of the business of the proposed customer and the geographical extent of its entreprise. It will also seek to know the business’ assets, real estate, intellectual property, and customer receivables, etc. A savvy banker will seek to know the borrowings and other financial obligations or security that the borrower has provided to other lenders. In addition, the banker would seek to know the financial position of the borrower - what is the borrower’s net-worth equity or the health of its balance sheet? Equally important is the control system in place in the borrower’s business itself - who are the shareholders? Are they capable of providing support to the borrower? One over-looked area, but a very important one for bankers - in terms of risk assessment - is to carefully assess the management of the proposed borrower so as to determine whether the management is experienced enough or whether they have the requisite competence to avoid default or total failure in the short or long run. It will go a long way in determining the ability of the borrower to repay moneys lent by the Creditor Bank.
To further illustrate the need for more work by the banks itself to mitigate risk, it will not be lawyers who will be responsible for keeping oversight of the asset-to-liability ratio of the business of the debtor but the bankers themselves. Asset to liability ratio of the customer is very important to the banks, as keeping those in check through the life of the facility will likely guarantee repayment. The failure to do so will make room for a rush to the court house by different debtors who may not know themselves and a create fleeting grab on the “shrinked” value of the assets of the company (due to looming liquidation) by competing creditors. It is for this reason that undertakings to the effect that debt-to-equity ratio of the debtor will be kept at a particular level throughout the life of the loan should be embedded in facility agreements for serious loans to established businesses; and the non- adherence to them should be made an event of default.
The above said, it cannot be gainsaid that collaterals play a very important role in the life of the facility. From guarantees, to charges over movable and immovable properties, nothing can secure confidence and protection for the lender than a well-drafted collateral agreement, including guarantees which provide parallel payout obligations. However, collaterals in the hands of the banks will be useless if the foundations upon which they are held are not proper – i.e. the facility document.
Another instrument that bankers have to pay keen attention to is guarantees. Because of the concise nature of this very important facility instrument, more often than not, bankers draft guarantees by themselves. Guarantees are such that one person (not being the debtor) agrees to make payments for another when that other fails to do so under the contract. In this regard, care must be taken that it contains all the necessary ingredients of law so as to ensure enforceability - like offer and acceptance, consideration, an intension to create a legal relation, etc. and conformity with section 4 of the Status of Frauds Act 1677, i.e. it should be a signed memorandum by the parties. As simple as the actual document may look, ignoring these technicalities could be costly for the bank. From my experience, the reason why banks have been getting away with sloppily drafted guarantees is because not many have challenged their enforcement in court.
While modern banking demands that our banks move away from the traditional low-risk taking products to more risky and advanced products like loan sales, asset securitization, derivatives (casino banking) and credit default swaps, the protection of the bank’s lending portfolio and health lies in the hands of two important players – the bankers themselves, on the one hand; and their lawyers, on the other. It is costly to the banks to ignore expertise in this regard because they want to save costs; as the French say, “less expensive” may turn out to be “more expensive” (moins chere est plus chere). In this bi-focal relationship, the bankers do the background work as part of what is colloquially referred to as “due diligence”, then the second phase of ensuring adequate protection through proper and well drafted documentation will be easier for the lawyers assisting the Credit Risk Departments of the banks whether as in-house lawyers or external solicitors..
While it is admitted that the risk of recovery goes beyond what the banker may do or not do, as they, like every other citizen and business, rely on the existing institutions of the state - like the courts - to enforce agreements, and that these institutions have over the years been regrettably ineffective in dealing with commercial claims (although with the emergence of the Fast Track Commercial Court and a and new breed of non-traditional Judges (who do not interpret everything based on rudimentary Law of Contract but modern Law of International Finance and Commercial Law, there seems to be the resurgence of some hope among us Corporate Commercial Lawyers), it will still be worthwhile not to allow sloppy documentation to be used as an excuse by the already ineffective institutions to make good debts become bad. Even with a judicial structure that needs reform, a well-drafted documentation makes litigation, and most likely recovery, easier to handle by commercial lawyers and litigators.
It is no secret that default on loans is a major problem for bankers in the economy and continues to threaten their balance sheets. As the economy continues to expand, bankers continue lend to the same people and the securities provided are sometimes duplicated among creditors. Perhaps the creation of the Credit Reference Bureau will reduce this anomaly and increase lending confidence for bankers. However, the real secret for a successful, robust and resilient banking sector lies in the quality of legal advice available to the commercial banks, the control mechanisms in place to mitigate risks, and the risk management expertise available to them.
Francis Ben Kaifala Esq. is the Managing Partner in the Law Firm Kaifala, Kanneh & Co., Top Floor, 81 Pademba Road, Freetown; He holds the joint LL.M in Law & Economics from Queen Mary University of London. He is currently a Fulbright Scholar at the University of Texas at Austin pursuing the LL.M in Comparative Constitutional Law, Administrative Law & International Human Rights; He is also Human Rights Scholar with the Rapoport Center for Human Rights and Justice in Austin, Texas, United States of America. Email: firstname.lastname@example.org