Can credit derivative instruments be utilised by South African banks to effectively hedge the credit risk they face in lending to the small, medium and micro enterprise market?
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Date
2002
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Abstract
The objective of this research proposal is to explore the extent to which credit derivatives
can be used effectively by domestic financial institutions, in particular, Commercial Banks
to hedge the credit risk associated with lending to the Small, Medium and Micro
enterprise (SMME) market segment, thereby making lending to this market segment an
attractive and viable banking proposition.
The financial services sector in South Africa has come under severe criticism from
Government, trade unions and the unbanked, low income earners for not fulfilling their
social responsibility, in terms of, not banking the Small, Medium and Micro enterprise
(SMME) customer base. In particular, financial institutions have been accused of ignoring
or not giving sufficient attention to the financial/credit needs of this market segment.
These parties have argued that many of the domestic financial institutions are applying
standard credit criteria to this market segment, which they feel is incorrect. This has often
resulted in SMME's having their requests for credit facilities declined by domestic
financial institutions and then having to resort to approaching unscrupulous "loan sharks"
for credit facilities, which facilities are often made available to them at exorbitant interest
rates. The alleged reluctance on the part of domestic financial services institutions to make
available credit facilities, in the form of start-up business loans and asset-based finance to
the SMME segment has possibly hindered economic growth, productivity, employment
and resulted indirectly in a host of other social anomalies. Alister Ruiters of the
Department of Trade and Industry has been publicly vociferous in his attack on domestic
financial institutions (Business Day, August18, 1999). It would appear these financial
institutions are only prepared to do business with this market segment in partnership with
Government, where Government bears a large proportion of the risk by providing
guarantees or indemnities on behalf of the client. Examples of such guarantees include
Khula and Sizabantu guarantees issued by agencies controlled within the ambit of the
Department of Trade and Industry.
Financial service institutions have defended their actions by countering that the credit risk
attached to making loans available to the SMME market segment is often unacceptable to
them. Many of these potential clients are characterised by adverse credit records, show
little stability, in terms of, employment and domicilium and often do not have any tangible
collateral available to support their loan requests. That is, the risk from lending to this
market segment far outweighs the potential returns. Further, these financial institutions
have argued that with South Africa having been accepted into the international fold and
following the accelerated pace of globalisation, new markets have opened up for their
shareholders. Hence, shareholders are requiring improved returns (capital gains and/or
dividends); else they are at liberty to move their funds to other investment destinations.
The pressure on domestic financial institutions to deliver consistently better returns on
equity has been and continues to be a difficult one. This is exacerbated by the increasing
competitive pressure from both retail competitors who are now offering financial services,
such as Pick 'n Pay Financial Services, Woolworth's, and foreign financial institutions,
who have entered the domestic scene. For many of the retail competitors the offering of
financial services is seen merely as an extension of their product line. Existing
infrastructure, in the form of, branches /outlets and technology are largely already in place.
Further, they are not bound by the same liquidity reserve requirements imposed by the
South African Reserve Bank (SARB), as are the domestic financial institutions they now
compete against. Hence, the retail competitors' profit margins are likely to be higher.
Further, as many of the foreign financial institutions are not constrained by the same social
responsibility obligations local financial institutions face and as they have not invested
substantially in branch networks and other infrastructure in South Africa, their profit
margins are higher and hence their returns on equity is likely to be significantly higher than
the domestic financial institutions.
Following the increasing popularity of Credit Derivatives in countries, such as, the United
States of America, the United Kingdom and India, it is my intention to explore whether
this instrument can be used effectively by domestic financial institutions as an hedging tool
to insure against what they might otherwise consider unacceptable risk in the SMME
market segment. That is, will the use of credit derivatives make the lending of funds to this
client base an acceptable or attractive proposition to domestic financial institutions.
However, we first need to define credit risk and credit derivatives before we proceed
further. Creditex (Commentary, May 2001) defines credit risk as:
"the risk of loss following default. "
PriceWaterhouseCoopers defines a credit derivative as :
"a credit risk management instrument that allows a financial
institution to transfer credit risk to another party".
Having, in simple terms, defined what we mean by credit risk and credit derivatives, we
proceed by suggesting how credit derivatives can be used as an effective hedging tool and
also some of the possible shortcomings that may be associated with the use of credit
derivatives in South Africa. Cheow and Chiu (Managing Credit Risks, May 23,2001)
suggest credit derivatives have the potential to transform the way in which Commercial
Banks do business. The impact of credit derivatives is likely to result in changes in Bank's
operating and credit models of assessment, pricing policies and offer insight into how
products and services may be developed and implemented. Traditionally Banks appear to
have been involved in all aspects of lending from origination to administration, monitoring
and collection. These authors suggest the resulting credit model emanating from the use of
credit derivatives is likely to only concentrate on origination of the loan with the view of
later selling-off the book itself or insuring the credit risk. This latter alternative involves
credit derivatives.
We turn our attention to highlighting some possible constraints to the effective use of
credit derivatives in South Africa. These are as follows :
Lack of effective infrastructure
Lack of liquidity
Lack Of Transparency
Restrictive Central Bank regulations and exchange controls
limited number of large financial institutions.
Description
Thesis (MBA)-University of Natal, Durban, 2002.
Keywords
Credit--Management., Derivative securities--South Africa., Theses--Business administration.