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Risk assessment for commercial loans Research Paper


Objectives

The purpose of this study is to find out how risk assessment can be used to minimize the losses that are occasioned by the risk and insecurity which are inherent of bad commercial loans that are extended to small and medium enterprises. This paper will discuss points that outline the good practices that risk assessment aims to accomplish.

Using risk assessment to spot latent frauds

Knapp and Knapp (2001, 28) state that: “explicit fraud risk assessment instructions resulted in more effective assessments of the presence of fraud” when it was carried out in the procedures that were used to analyze the possibility of fraud in financial statements. Risk assessment should, as a result be used to dig deeper into scenarios that may look satisfactory in the rating of credit worthiness, but whose particulars may not correspond to the prevailing economic environment of the SME or its financial standing in the concerned industry.

Using risk assessment to predict the insolvency of an SME

Risk assessment can employ predictive scoring to group SMEs into different credit categories. The category that has the lowest score is generally considered as the one posing the greatest risk of issuing slow payments and the one that can easily fall into bankruptcy (Dichev, 1998,1135 ). The lowly rated SMEs would call for a more assertive follow up on their payments and even an outright suspension of their accounts to avoid being burned with a bankrupt customer.

Using risk assessment to make good use of technology

Risk assessment should employ predictive scoring together with technological tools to create a more accurate picture of credit retrieval outcomes. Automated assistive technologies enable the bank to undertake comprehensive analysis of their accounts on a repetitive basis, and at the same time increase the overall efficiency without a corresponding increase in the costs.

Using risk assessment to avoid uneconomical credit evaluations

Risk assessment should be used to avoid the traditional approach of undertaking manual assessments of credit applications. These can easily be manipulated and more likely to become subjective, as the applicant is more likely to paint a particular credit picture with inaccurate data.

Using risk assessment to avoid undertaking bad debt from established SMEs

Existing customers who have passed the initial credit risk assessment procedures may fall into lower credit ratings due to the highly fluid nature of business environments. These SMEs pose risks to future credit relationships with banks and should be constantly monitored for risk.

Methodology

This paper discussed how risk assessment should be used by commercial banks to minimize the risks and uncertainty that is occasioned by bad commercial loans that are extended to SMEs. Risk assessment is an important part of risk management as it predicts potential bad credit of a small and medium sized enterprise and can also be used to forecast the occurrence of a loan default.

This study has shown that the prediction of bad credit is important because it enables better use of a financial institutions monetary resource, and enables them to be channeled to those SMEs that would enable good business to be possible.

Due to the recurring of financial crises, for example those of the 1980’s and 2009, the fairly accurate determination of risk associated with small and medium enterprises has become of paramount importance to banks that extend loan facilities. This study used statistical data that was acquired from loan data that is used by the Canadian government as described by Riding and Orser (2007, 6) to look for predictors of risks of small and medium enterprises in the Prairie Provinces.

According to the data acquired from the data on the financing of small and medium enterprises that is released by the Survey of Suppliers of Business Financing, the data shows that $164 billion was released to enterprises in the Prairie Provinces, while $868 billion was released in Canada whereby 1.6 million of the transactions were dealing with small and medium enterprises.

This study used averages of the number of SMEs provided by the survey on Canadian SMEs in 2004 to determine how many were more likely to have been awarded credit.

Data Collection

This study used data provided by the statistics department of the government of Canada and is usually provided by the Industry Canada and Finance Canada institutes to show how small and medium sized enterprises get access to loans when they are starting up. This study made use of that data to illustrate how banks generally rate different types of small to medium enterprises.

The extra data provided by the statistical arm of the government of Canada was about the awarding of loans to small and medium sized enterprises that tried to access further credit from the financial institutions was also useful in determining how these banks used risk assessment. The small and medium sized enterprises were of varying attributes, thus the data could be used to display how banks assess different types of risks that were occasioned by the enterprises that cut across different industries.

The data that is used in this study is also used by different sectors of the Canadian economy, thus would be of a fairly accurate depiction of how small and medium enterprises are regarded in terms of the risks that they pose to their credit worthiness when they relate with financial institutions. Financial institutions employ the data from this survey to determine the credit worth of small and medium enterprises when they are compared to their counterparts in other industries or when compared to enterprises within the same industry.

The government of Canada relies on the data provided by the survey on small and medium enterprises to enable it to determine how the country’s enterprises are dealing with the prevailing economic conditions thus enables the government to formulate policies to minimize the resulting risks.

Target Population

The small and medium enterprises that were targeted by the survey whose data is used in this study composed of all the enterprises that are officially recorded in the government of Canada’s Business Register. However, this study did not take into account the data that concerned enterprises that were beyond the criteria of being small or medium sized.

This means that all enterprises that had more than five hundred employees, were joint ventures, were a cooperative movement, were grossing more than $50 million in revenues, were part of the government’s municipal initiatives, or were enterprises that have been marked by the North American Industry Classification System (NAICS) as not possible to classify as small and medium enterprises, namely:

  • Enterprises that deal with educational services
  • Enterprises that are involved with the rental or leasing of vehicular equipment
  • Enterprises that deal with the caring of out-patients
  • Enterprises that are comprised of laboratories that carry out medical and diagnostic procedures
  • Enterprises that comprised of wide-ranging medical and surgical practices
  • Enterprises that deal with the renting and leasing of equipment and other gear that is used commercially or industrially.
  • Enterprises that deal with the management of other commercial enterprises and establishments
  • Enterprises that deal with the provision of financial services or insurance services
  • Enterprises that deal with the administration o public interests
  • Enterprises that deal with the provision of ambulance services
  • Enterprises that deal with provision of food stuffs and/or housing services for communities
  • Enterprises that deal with the provision of relief services, or those that deal with the provision of emergency and rescue services

The questionnaire that was used to conduct the survey that is used in this risk assessment study was designed by the government of Canada’s initiative: Statistics Canada while the Industry Canada initiative collaborated to provide an economical and industry-set perspective.

The Statistics Canada initiative analyzed and enforced the policy set forth by the government of Canada when relating to small and medium enterprises. This ensured that the enterprises that were eventually surveyed fit the description of the government of Canada’s definition of a small and medium enterprise.

Sampling

The survey that is used in this study makes use of a design which is cross-sectional while the government of Canada’s registrar of businesses provides the frame of the survey for all small and medium enterprises that form part of the population that is targeted by this study. The total number of enterprises that were sampled in this study was 1,999,000, while the size of the sample that was studied totaled 37,058 small and medium sized enterprises.

The enterprise’s employees determined the size of the enterprise, while the number of years that the enterprise has been in operation was determined by the date that was acquired from the government registrar’s records. The sample that forms the basis of this study was then acquired by taking a randomized selection from the categorized enterprises that formed the small and medium based enterprises in the government of Canada business registrar’s records. The preliminary categorization of the small and medium enterprises was based on:

  • Location of the enterprise
  • The category of industry that the enterprise participates in
  • The size of the enterprise
  • The age of the enterprise

Sources of Data

Data that was used in this study was collected from the answers that were provided by the enterprise’s correspondents of their own free will. The answers to the queries that were posed by this study were recorded from a first person basis.

The data collected from the telephone interviewing system was done using a Computer Assisted Telephone Interviewing (CATI) method which employed the use of live consistency edit checks to note errors that were present in the responses. The extensive use of data processing techniques enabled the detection of other errors that would have been overlooked by the CATI system.

Data consistency inadequacies were compensated for using the data that was garnered from a respondent who fit the same stratification as the source of the inadequate data. This method, thus implanted data from one respondent into another’s, whereby the two respondents were assumed to would provided nearly the same responses.

When data required for the study was found to be missing or wanting, it was estimated from the system that is provided by the Statistics Canada system of data estimation that is called the Generalized estimation System (GES). The government of Canada’s initiative for statistics, Statistics Canada provides data that forms the basis of the estimation system before hand for every industry, and provides this to the concerned researchers.

Data Accuracy

The data that is collected from the survey of the “medium and small businesses” was based on sampling, thus had intrinsic sampling inaccuracies. These sampling errors were then standardized to come up with the quality of errors that the different data sets produced. For example, an error that had standard rating of between 0.025 and 0.05 is considered as being good data.

Findings and Recommendations

This study has been a review of the capacity of different banking institutions to fund small and medium sized enterprises with a keen insight into the risks involved. It is a study of the risk factors. The main aim of this research project was to try and find out the main risk factors through an assessment of the risks involved in lending money to small and medium sized enterprises.

This is a process that has been known to have a variety of implications on the relationship between bankers and their clients who are involved in business. Depending on the criteria that the bank uses to assess the risks in accordance with the investments that it is supposed to be ready to offer has a lot of implications on internal issues like training the staff and such.

Lending by the bank improves the very important relationship between the bank and the clients. It is upon the bank to have a clear cut assessment procedure such that as it seeks to establish a working relationship with its clientele, it does not go down the drains due to losses and bad debts.

Key Findings

Financing Of New Capacities

Proposed and existing small and medium enterprises access various types of financing depending on the relationships that they have with the banks. In order to attract the investors in this pool of money banks have to align themselves to such attitudes as to take greater risks though very carefully.

With the high and the capital intensity of the economy today, the high amount of financing of exports and credits from multilateral companies, the institutions are bound to find higher risks of their financings which tend to balance if they happen to attain their organizational objectives. This argument lays out the fact that the financial institutions which calculate their lending capabilities from risk assessment amongst other factors need to be very careful in their procedures.

To the new investments in proposition, the financing institutions need to apply very strict screening criteria to avert the risks of coming into contact with fraudsters, customers with a bad debt history and the risk of spending too much on loans to a state that they are caught unawares by cases of bankruptcies.

Use of safeguards

Safeguards can be termed as those principles that are applied to those projects that the institutions are proposing to fund. When planning and financing the small and medium enterprises in the initial stages, they have the opportunity of being very effective due to the fact that they have picked the business from a place that was most difficult to commence from.

The safeguards call for a mechanism which will allow for safe and better follow up of the proceeds of the organization by the financiers. The financiers are able to follow up the performance of the organization through key variables (Jeanneau and Micu, 2002). If the safeguards are not met in accordance to the agreement, then there might follow suit an early call for the said loan.

Risk assessment and due diligence

The procedures for risk assessment and due diligence in the lending transactions can reveal practices that are not sustainable. Such practices act as threats to the economic viability of a given project. In cases where some companies are noted to have practices which are not sustainable, there are also other potential risks which are involved in the practice and it is so risky for most investors.

Firms which provide commercial loans have their risks managed on a basis that is portfolio wide. In such a case, the management of credit risks at a macro level basis is precedent over the stringent and stricter control measures over individual loans and individual securities. Pressures arising from competition and the time factor usually discourage appraisals which are specific to the borrowers and the projects.

Limitations of analysis

In any analysis, there has to be some limitations which affect the kinds of decisions that are made. If the company is doing some analysis from an outside source, most of them are found to mostly on projections on price, supply factors and demand factors with less concern being focused on the intricacies of the operations of the companies and the flow of operations.

This is the reason that you will find many Small and medium enterprises are being hailed as fit for loan though at the end of the day, their operations prove to be a burden on debts. Some of these intricacies fail to meet the requirements of the environment and also the social impacts which might cause eventual repercussions to the operational continuity.

Granting of loans

Accounts receivables management commences with making of a decision on whether a customer should be credited. It also looks into how much he or she should be given and also in to how the policy obeys the procedures and the systems of the company. Credit policy should be a balanced operation.

If it happens to be too much, sales as well as profits are lost and when operated at a minimal level, then there is some risk of bad debts and non payments. In order to avoid major risks in the process, the financing organizations need to have some ideal means in which to operate such that the right customers are selected. The company representatives must be aware of the required standards which will favor both sides.

The financing organizations are needed to have credit terms which are understandable and a collection policy which is accessible to all the parties. This helps in the avoidance of credit oriented risks. If an account is doubtful, it is wise to know if the account is famous for bad debts and whether the profits incurred allows for minimally acceptable returns on investment.

If the chosen accounts prove to be successful, the financing institution should rate the amount of profitability that should arise. If the credit account for the particular small and medium enterprise proves to have a high profitability, then the risk factor for that enterprise increases.

Looking at the abovementioned factors, matters of risk assessment are twofold when it comes to the realm of lending and risk management related issues. The higher the risk that a financial institution takes, the more close it happens to get to the client base. The higher the risks taken by the institution, the better it is as there is a greater likelihood to get more returns given that the assessment done by the organization to the small and medium enterprises is perfect and with a greater likelihood to increase returns.

On the other hand risk assessment should be done in a very careful manner. Policies in use by the organization should be stricter and more stringent to mitigate the risk of unwanted losses. In the objectives of this study, there was a bid to look into some of the critical factors affecting lending to commercial investors in Small and medium enterprises.

In one of the objectives, there is focus on the contribution of the customer to bad debt, and identification of potential fraudsters. Fraudsters may appear in form of a well organized small and medium enterprise which is in its initial phases though the real culprits are just purporting to be starting a nonexistent business. With such knowledge as found in the data, the financiers should remain wary of such potential mishaps and keep the potential losses away from their list of people that they can lend.

Recommendations

It is highly recommended that all stakeholders are base their decisions on behaviors that are observable and not on those behaviors which are theoretical as they can confuse and lead to unwarranted results to either sides. In such a time and situation, there needs to be a provision of more details in the reporting activities of the operational data and financial proceedings by the companies.

In order for the said practices of sharing the required information voluntarily without any compulsion, a basis should be adopted by all the stakeholders. This basis should lie on the principle that standards of operation in place are lower than best operating practices.

The regulatory authorities which are responsible for disclosing the relevant information on the companies and the debts that are owed by certain companies or the securities for the equities should report in a concise manner the operational variables for the specific requirements for the period. When regulating the procedures of lending by the institutions, the regulators should take into account to due diligence which is specific to the loans and also risk assessment for the credit in the farfetched visions (Rich, 1994).

The small and medium enterprises should enhance that their operations are better understood in order to raise their levels of disclosure. This would be well id the operations disclosure was set within some of the existent principles.

With this in place, the financing institutions can have a simple time through the establishment of a common standard of reporting by all the organizations in the lending list. Such a standard would prove to be excellent if it involved a clear cut mapping of the resources getting into the organization and also the final product or the output which helps in giving the right estimate.

Observance of the principles that have been recommended, transparency in all the instructions would not just be beneficial to the banking institutions but would be the best to the small and medium enterprises in a number of ways; the organizations will be able to earn trust from the bank and in case of some future requirement of a bigger loan for business expansion, the banks would be more than willing to cooperate with the individuals involved in the organization management (Rich, 1994).

The financial institutions should improve their networks with the other institutions which might help them be able to get the real data and in follow up circumstances. Such institutions are like chambers of commerce and the global reporting initiatives. These companies not only help the financing organizations to have the best possible deals but also they are able to get proper and professional financial advice o matters of lending to Small and medium enterprises.

Banks should be ready to take more risks in their lending procedures though at calculated steps founded by observation. In this case, they will be able to exploit potential opportunities that can bring along very huge profit margin. This is also a tactical way in which the banks will be able to improve how they relate with their customers.

Improvement of bank to customer relationship can lead to an increase in customer loyalty which is the dream of every financial institution. It is obvious that any business dreams at having its clients loyal to them such that the business can proliferate (Jeanneau and Micu, 2002).

References

Dichev, I. D. (1998). Is the Risk of Bankruptcy a Systematic Risk? The Journal of Finance , 53 (3), 1131–1147.

Jeanneau, S and Micu, M (2002). Determinants of International Bank Lending to Emerging Market Countries. BIS Working Papers No. 112.

Knapp, C. A., & Knapp, M. C. (2001). The effects of experience and explicit fraud risk assessment in detecting fraud with analytical procedures. Accounting, Organizations and Society , 26 (1), 25-37.

Rich, B. (1994). Mortgaging the Earth: the World Bank, Environmental Impoverishment and the Crisis of Development. Boston: Beacon Press.

Riding, A., & Orser, B. (2007, September). Small and Medium-Sized Enterprises in the Prairie Provinces. small business financing profiles , 6-7.

Links to the sources

  1. Small and Medium-Sized Enterprises in the Prairie Provinces. Web.
  2. . Web.
  3. The effects of experience and explicit fraud risk assessment in detecting fraud with analytical procedures. Web.
  4. Determinants of International Bank Lending to Emerging Market Countries. Web.
  5. Is the Risk of Bankruptcy a Systematic Risk? Web.
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IvyPanda. (2020, May 14). Risk assessment for commercial loans. Retrieved from https://ivypanda.com/essays/risk-assessment-for-commercial-loans/

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IvyPanda. 2020. "Risk assessment for commercial loans." May 14, 2020. https://ivypanda.com/essays/risk-assessment-for-commercial-loans/.

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