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?

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.