Five principles for successful credit provisioning are discussed in section 2.3. These principles can be distinguished from another, but they cannot be separated from each other. Adequate information is the first principle. This refers to the imperative for credit providers to obtain adequate information to evaluate potential agreements. Risk reduction is the second principle, which is discussed in terms of different types of risk.
The third principle is regulation. Although the nature and extent of credit regulation varies with jurisdictions, the universal aspects of regulation are discussed in this section. The fourth principle is customer relations. As credit provisioning is a service, the needs of customers are the drivers of credit provisioning. The fifth principle is competition, the defining principle of free market economies.
1.8.1.2.1 Adequate information
Adequate information is a fundamental principle for credit provisioning (Song, 2002).
In recent history, originating, funding and servicing of mortgages in the United States of America were divided between unrelated finance providing institutions, leading to a paucity of information. The result was that credit was over-extended to customers, which led to a collapse of that country’s credit market in 2007–2008, with international repercussions (Lehnert, 2010). Timely warnings by authoritative writers, such as Bernanke and Blinder (1988), were not heeded: The inadequacy of information leading to the credit crisis of 2007–2008 revolved around informational asymmetry between borrowers and lenders.
A prediction relevant to the present study came from Schmenner (1986) who observed that information and computer technology (ICT) would vastly increase the service efficiency of banks. This would create ‘service factories’, referring to large units, which provide high quantities of standardised services. This would, he opined, open the way for ‘service shops’, referring to small units, which provide specialised services
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individually tailored to the needs of each customer and project. Tinnilä (2013) points to the validity of this prediction. ‘Service factories’ and ‘service shops’ both need adequate information, but have different ways to obtain it. The distinction will be discussed in section 1.6.3.2. On the other hand, the comprehensive relationships of banks enable them to overcome informational asymmetry in customer relations.
Hughes and Mester (2010) discuss two approaches towards information: the structural approach of cost minimisation, profit maximisation and utility maximisation; and the non-structural approach, relying on certain ratios, for example return on assets, return on equity, and ratio of fixed costs to total costs.
Independent providers of asset-backed short-term finance need to be sensitive to their informational advantages and disadvantages, and position themselves accordingly.
While banks have the advantage of access to a customer’s long-term financial information, independent credit providers have to acquire detailed information of a proposed venture, as well as the collateral offered.
Adequate information in the global context is discussed in section 2.3.1, while the South African context is discussed in section3.3.
1.8.1.2.2 Risk reduction
The reduction of risk is a multi-faceted principle in credit provisioning (Heffernan, 2013a; The Banks Act, 1990).
Credit risk is the risk that lenders do not meet their obligations towards the bank, a risk which increases when loans are originated by institutions which are not responsible for the collection of payments (Brunnermeier, 2008, p. 2). Liquidity risk, on the other hand, is the risk that banks cannot meet their obligations towards depositors (Heffernan, 2013, p. 1–2). A perception of pending liquidity risk leads to bank runs, as witnessed during the credit crisis of 2007-2008 (Goldsmith-Pinkham &
Yorulmazer, 2010).
According to Crafts and Toniolo (1996), political risk is beyond the control of individual banks and has forced several reforms of the entire financial system. Other authors, such as Kepplinger and Roth (1979), support this view by describing similar dynamics in the winter of 1973–1974, when the German Federal Republic imported unprecedented quantities of oil. The mass media were warning that an energy crisis
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might occur, which led to a run on petrochemical products, similar to a bank run (Kepplinger & Roth, 1979). El-Gamal and Jaffe (2009) link bank crises to oil crises by alleging that the growing dependence on oil in America and the rest of the world has created a repeating pattern of banking, currency and energy price crises. Young (2014, pp. 10–11) refers to this category of risk as “country risk”.
Systemic risk is the result of increasing integration by the banking sector, causing a crisis to spread across the system (De Bandt, Hartmann, & Peydró, 2010).
Operational risk is defined by Young (2014, p. 21) as follows:
Operational risk is the exposure of an organisation to potential losses, resulting from shortcomings and/or failures in the execution of its operations. These losses may be caused by internal failures or shortcomings of people, processes and systems, as well as the inability of people, processes and systems, to cope with the adverse effects of external factors.
Risk reduction is relevant to all credit providers, as even the oldest (and one of the biggest) investment bank in the United Kingdom, Barings Bank, was in fact destroyed by unauthorised risk taking by a senior official in Singapore (see section 2.3.2.1.8).
Independent providers of asset backed short-term finance have to be acutely aware of the risks involved with each transaction. All the above-mentioned risks of banking (except systemic risk) are relevant to such a business, but some risk-mitigating measures are not. Essential to a structured approach to the provisioning of asset-backed short-term finance, is the management of risk, especially credit risk and operational risk.
Risk as a feature of credit provisioning in general is discussed in section 2.3.2, while a discussion of risk focusing on asset-backed short-term finance follows in section 4.7.
1.8.1.2.3 Regulation
Regulation is seen as a principle of credit provisioning, while credit is pivotal to other industries and benefits from a healthy economy. However, the short-term interest of institutions or officials may be in conflict with the common good. Pursuing the common good is regarded as the role of regulatory authorities. In this section, international banking regulation is discussed to confirm the rationale for regulation as principle.
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Banks are regulated to enforce prudence, because banks have the power to create money by turning liquid deposits into illiquid loans (Strahan, 2010). If loans are granted recklessly and a high default rate follows, a liquidity crisis will follow (see 1.6.2.2 above) and depositors’ funds will be at risk. Therefore, capitalist governments are involved in the internal financial policies of banks, while the same involvement in other industries would be unacceptable (Flannery, 2010).
Kane (2010) adds another rationale for the principle of regulation by describing it as a
‘back-office financial service’, which generates benefits and costs, such as any service. Banks benefit by being regulated, because regulation could improve customer confidence and influences the balance of power between role players in the market.
Bank regulation on a global scale is discussed in section 2.3.3, in South Africa in section 3.2.2, and in relevance to asset-backed short-term finance, in section 4.5.
1.8.1.2.4 Customer relations
Customer relations, as a principle for credit provisioning, focuses on the need to engage with those clients whose needs are best met by the specific type of credit provider. Pitta et al. (2006) argue for the need to appraise the value of a client over the lifetime of a customer relationship and not a single encounter or transaction. This contradicts a possible notion that a customer’s needs must be met at all costs.
According to Berger (2010), banks are ‘service factories’ which employ ‘transactional lending technologies’. Private credit providers are ‘service shops’ using ‘relationship lending technologies’ (see section 1.6.1.2.1). This means that banks have the ability to meet standardised needs of customers in a superior way. Private credit providers focus more on ‘soft’ information about how a firm conducts business (Udell, 2008), and are able to meet non-standardised methods in a superior way.
Seiler, Rudolf, and Krume (2013) discuss the link between service value, customer satisfaction and customer loyalty, factors which Aldlaigan and Buttle (2009, p. 354) synthesised into the concept of a positive attachment inventory. O’Loughlin, Szmigin, and Turnbull (2004) investigated the influence of a bank’s image, which they found unimportant to customers. Skudiene, Everhart, and Slepikaite (2013) argue that more empowered frontline employees have a positive effect on the value perceived by customers. These studies are testimony to the importance of the principle of customer relations, but also to its complexity.
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Customer relations in credit provisioning are discussed in detail in section 2.3.4.
In conclusion it can be stated that the principle of customer relations should encourage all credit providers to regard themselves as either service factories or as service shops. The distinction between customers’ standardised and non-standardised needs should lead credit providers to serve customers, or refer them to an appropriate credit provider.
1.8.1.2.5 Competition
Competition is fundamental to the free market (Skerritt, 2009, p. 1). It follows that competition is also a principle to credit provisioning. Porter (2008) proposes a model of five competitive forces. According to this model, the competition for a business is not only direct competitors in the same industry, but also suppliers, customers, substitutes and possible new entrants to the market. All these entities compete for a firm’s profit (Porter, 2008, p. 28).
Moore (1993) suggests an alternative approach to the interaction between firms. He uses the metaphor of an ecosystem, where species both co-operate and compete, at different times. A business ecosystem normally has a recognised leader, which co-evolves with a multitude of other firms, towards a shared vision. The concept of niches is also explained by Moore (1993). A crisis might shift the leader to the periphery, and peripheral firms to the centre. Different ecosystems compete against each other, although all boundaries are blurred. Implications for the management process receive attention in a book titled The death of competition leadership and strategy in the age of business ecosystems (Moore, 1997). The discourse is continued, amongst others, by Moore (2006) and Muegge (2013).
The relevance of Porter’s model for competition (Porter, 2008) as a principle for credit provisioning, is the focus on suppliers and customers, in addition to existing competitors, substitutes and new entrants. The business ecosystem model (Moore, 1997) adds conceptual and practical value to the discussion. In the multi-faceted credit market, role players do not merely compete for the same profits; they also facilitate each other’s activities. Private providers of asset-backed finance, as a case in point, fill a distinct niche. While commercial banks provide long-term finance and facilitate changes of ownership, these banks are not always in a position to solve short-term liquidity crises. This is the specialisation of providers of asset-backed short-term
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finance. Asset-backed short-term finance is a supplement to commercial banks, not a substitute.
Competition in the credit market is discussed in detail in section 2.3.5.
The principles of adequate information, risk reduction, regulation, customer relations and competition are universal to credit provisioning. In the next section, the focus is narrowed to the nature of credit provisioning in South Africa.