The Areas of Conflict between Cost Control, Service Quality, Desire for Growth and Credit Management in the Framework of Loan Processing
Jeffry Merril Liando (2003)
Lending is the major activity in banking business and the interest thus becomes the primary source of income. Since deposits are assumed already available from the separate operations, new branches are established and new lending officers are hired only for the purpose of expanding loans to satisfy a bank’s desire for growth. However, expanding loans may increase lending cost, which is variable to the number of loans. In order to achieve cost efficiency at an optimum number of loans handled, controlling cost of lending by means of, for example, limiting the time of processing loan may affect service quality. Also, limiting the time of processing loan may cause a bank not applying credit management properly.
Broadly speaking, one of the conflicts comes from the variability of cost concerning the number of loans handled and the time in processing loans. For example, for the same level of growth, a bank has to pay lower cost, put less attention in credit management and process, but serve more accounts. As expanding loans by $1,000, a bank can make either one loan costing $20 includes $10 for one hour origination and servicing plus $10 for one hour analysis and monitoring, or two loans costing $40 includes $20 for two hours origination and servicing plus $20 for two hours analysis and monitoring.
The previous simple illustration shows a broad area of conflict regarding the number of loans handled and the processing time. In the framework of the activities in processing a loan which consists of screening, origination, servicing and monitoring, this essay aims to discuss other specific areas of conflict between the issues of cost control, service quality, desire for growth and credit management. Focusing on cost control and loan process, this essay subsequently tries to find the sources of the conflicts between one subject to other subjects. This essay will suggest relationship lending and loan sales and other relevant concepts in minimizing the conflict. Finally, this essay will conclude that the conflict should be ended up by aligning banks’ goals of cost control and loan growth and customers’ needs of loan received and good service through a good credit management.
Before discussing the areas of conflict, it is relevant to define the issues one by one with respect to the context of lending. The issues of cost control, service quality and desire for growth may have general meanings in bank management and can be interpreted in terms of the other subjects such as cost of funds, marketing and deposit growth rather than in term of lending. Therefore, the interpretation should be related to lending activity. Meanwhile, the issue of credit management can be interpreted straightforward to the subject of lending. After defining all issues, the areas of conflict can be then determined.
As banks normally apply activity-based costing, lending costs are defined according to the activities in loan process consisting of screening, origination, documentation, transaction, maintenance and monitoring. Lending costs can be distinguished into direct cost for the activities of origination, documentation, transaction, maintenance and monitoring; and indirect cost for the activity of screening. As direct cost, in processing a loan, there costs such as origination, servicing (documentation, transaction and maintenance) and monitoring costs normally incurred. Meanwhile as indirect cost, the screening cost generally incurred for several loans or a loan portfolio and appears to be a particular cost regarding the building of credit scoring system.
For all activities, lending costs include the professional cost, the clerical cost, the communication cost and the administration costs. The professional cost is the cost of hiring business development officers, loan officers and loan analyst. The clerical cost is the cost of hiring loan support and servicing staff. The communication cost is the cost of using phone and fax. The administration cost is the cost of using office stationary.
The professional, clerical and communication are counted based on the time used in processing loans whereas the administration cost is counted based on cost allocation. Specifically, the professional cost deals with particular expertise, skills and knowledge and may be charged per term of loan or in hourly basis. The clerical cost is normally charged in hourly basis. Moreover, the personnel costs in wholesale lending incurs per individual loans whereas in retail lending the personnel costs may be treated collectively for several loans.
The major goal of lending cost is actually to cope with information asymmetry, which known as the information cost of lending. This cost mainly incurs as part of monitoring cost as the loan professionals try to gather relevant information about the borrowers and the market as much as they can from many sources. Fulfilling desire for growth, the increase of loans handled would increase the information cost as a bank need more time to get knowledge for new loans. Moreover, coping with information asymmetry, a bank cannot maintain its service quality as the customers will feel bothered when the bank asks so many questions and conducts so many visits. However, a good credit management can be applied properly as increasing the information cost.
As the negative goal of lending activity, there is also a cost of non-performing-loan losses, which is the amount of loans that cannot be repaid. Within the lending environment, it appears that this cost is not relevant to discuss in the issue of cost control as this cost does not really regard the lending activity, has a broad meaning and relates to loan quality. This cost is not discussed further in this essay.
Cost control in lending activity means that a bank try to influence its direct and indirect lending costs to achieve efficiency as still taking great opportunity to produce loans. This can be done by controlling the time or the number of activity in processing loans. This also can be done by combining the transactions needed in servicing loans. The goal of cost control is to produce bigger amount of loans with less lending costs.
Regarding the variability of lending cost, the activity in origination and servicing loans positively correlates with the increase of the number of loans handle. This may affect service quality as there are more services have to be provided. Controlling origination and servicing costs can be done by limiting the time of loan officers originating the loans, limiting the time of staff servicing and administering the loan or limiting the number of activity in processing the loan. Consequently, a bank may reduce its service quality and customers may lose attention in loan processing and have an appropriate service. Due to the lack of time in loan processing, a bank might lose some opportunity to have in-depth analysis about the customers’ condition. Also, a bank does not really catch what sort of following adjustments and services customers want regarding their credit accounts.
Moreover, limiting the communication cost by reducing contact effort with customers may cause a bank losing some important information from the customers. In case of suffering financial burden, the customers often hold information as hiding their real condition so that a bank has to be more active to make contact with them. This regards the agency theory burden. Another example, controlling the transaction cost by means of limiting the time of reconciliation or using improper tools may cause the customers having improper reconciliations as the staffs may create errors in processing their accounts.
Cost control may also affect desire for growth as a bank may have difficulties in setting new loans. Expected to concentrate on existing loans, limiting the time of loan officers and business development officers assessing new prospective businesses may cause a bank losing opportunity to create new loans or attract some new prospective businesses to take their loans. Not trying to establish new branches a bank would lose opportunity to expand its loans for a bigger market.
Conversely, expanding loans as fulfilling a bank’ desire for growth may affect cost control. As the number of loans handled increases, the lending costs would also increase. The loan officers and loan staffs would spend more time in processing and servicing the loans. Banks would spend more on phone and fax and the communication cost would increase.
Controlling the origination and servicing costs may cause a bank not applying credit management properly. Some components of origination and servicing costs relate to credit management. Most of the time given to loan officers is used to assess the creditworthiness of the customers which includes the character, the capacity, the capital, the collateral and the condition before the decision is made. The loan officers hired have to have appropriate skills and knowledge to gather, sort out and analyse information according to the nature of loans. Cost control by limiting the working time of loan officers or hiring a low expertise person may cause an appropriate credit decision which is the source of loan default.
Regarding the agency theory burden, a customer as the agent may hide some relevant information from a bank as its principal and act according its interests over a bank’s interests. By increasing the origination and servicing cost a bank as a principal tries to know its agent or customer better and make sure if its customer follow its interests. Moreover, in the context of conducting a delegated monitoring, a bank needs to put much concern on increasing the screening cost and monitoring cost.
In lending activity, loan screening and monitoring are special. Both need extra time and effort and have to be handled deliberately in conducting the prudence manner in lending activity. The screening cost can be defined as a cost incurred in setting a credit scoring system whereas the monitoring cost is a cost incurred when a bank try to cope with information asymmetry by monitoring the possibilities for default risk. For example, as a bank plans to make several loans in agricultural lending creating a loan portfolio, the screening cost is needed to set a credit scoring system and procedure in selecting the prospective farmers and the monitoring cost is needed to put more attention for the financial performance and business progress of the individual loans.
The major activities related to the screening and monitoring costs is conducting research and development and business survey and applying the techniques in financial performance evaluation and analysis. Both costs deal with the training cost of the professional cost and the subcontracting cost as employing business and finance consultants, chartered accountants, credit rating agencies or financial advisers. To some extent, a bank may also employ the academic researchers in building the credit scoring models. Often, some credit scoring models have trade mark and copyright and a bank have to pay much to purchase the models from the academicians. Specialized lending will need more attention in particular types of business, industries or sectors of the economy whereas diversified lending takes more subjects, which means having higher costs.
Credit management also relate to the screening and monitoring cost. As applying a comprehensive credit management, a bank have to spend more in purchasing a good credit scoring model or have more time and effort in research and development to build a good credit scoring model. Regarding the monitoring cost, a bank will need to spend more information cost as actively gathering relevant information from many sources as much as they can. A bank will also need to pay more for business finance consulting and accounting auditing to assist and monitor its customers instead of providing training to its loan professionals to gain more skills and knowledge.
The goal of service quality is to provide a better service in processing loans by means of fulfilling all customers’ need. There are three general loan types, i.e., commercial and industrial loans, residential mortgage loans and personal or consumer loans. Service quality relates to product marketing as finding what type of loan specialisation or diversification that suits to a bank’s competence. In order to achieve higher service quality, a bank needs to increase the capacity in origination and servicing loans by upgrading its competence.
Maintaining service quality, banks cannot control the lending cost effectively. Considering cost control, service quality can be affected by a decision to concentrate in one competence in lending activity. Banks may concern only on loan origination competence as focusing on the origination cost or concern only on loan servicing as focusing on the servicing cost. As not applying cost control, banks still concern on both loan origination and servicing.
For example, a loan may be originated by bank A but the funding is undertaken by bank B whereas bank C offers to originate and servicing the loan to maintain service quality. Bank A concentrate on loan origination and bank B concentrate on loan servicing. Bank A obviously pays the origination cost and bank B only pays the servicing cost. This example appears to be related to the activity of loan sales and securitization. Regarding the previous example, bank A takes advantage in taking lending fee and bank B adds its loan portfolio as funding the loan fulfilling its desire for growth.
Maintaining service quality may also affect desire for growth as putting too much concern on existing loans may ignore the effort of establishing new loans or the opportunity to take more qualified customers. Here a bank tries to build a good relationship with the existing customers particularly the good ones by offering other types of loans to their account so that the customers do not have to search other opportunity from other banks. For example, in personal lending, a bank may offer an automobile loan to a customer who has an overdraft account instead of finding new customers for such loan. The existing customer gets benefit from this service as he or she does not need to go to other banks or credit unions to get a loan to buy a car. However, the capacity of funds taken from the existing customer may not be as big as the bank could take from new customers. In wholesale lending, this kind of example is more significant and can be related to relationship lending as banks try to build relationship with the existing customers as well as taking opportunity for a bigger capacity of funds from them.
The goal of credit management in lending activity is actually to apply a strict policy to the customers in analysing and processing their loans. In contrast, banks may apply a soft policy in credit management in maintaining service quality to the customers. The conflict obviously arises between credit management and service quality. Moreover, credit management would need costs as banks need longer time in analysing the character, capacity, collateral, capital and condition. However, applying a comprehensive credit management is essential in lending activity.
Fulfilling desire for growth, banks open new branches and hire new loan officers. As it has been mentioned in the beginning, this needs more lending costs. Banks will need more time to analyse and monitor the loans. There is a possibility banks will mismanage the credit if work loading to their loan professionals is too big. As expanding loans has to be followed by finding good borrowers, credit management has to be conducted effectively.
In minimizing the conflicts, a relationship lending can be applied instead of a transaction lending which is a conventional way of lending. Relationship lending is a way in how a bank offers a flexible permanent service of lending in a multiple loan account to a single borrower. In transaction lending, a bank normally undertake a single account from numerous customers and do not concern on continuing the account after the loans are repaid by the individual customers. In relationship lending, banks can undertake multiple accounts from the single borrowers and offer the single borrowers to continue the service after the loans are repaid or offer other services, such as trust services, insurance and cash management. Even though the loans have not been repaid, in relationship lending, banks offer a flexible term and calculation to work out the loans instead of classifying as non-performing loans. In relationship lending, loan origination, servicing and monitoring is combined in a one deeper process. Moreover, relationship lending is suitable for both wholesale and retail banking.
Instead of maintaining a better service quality, relationship lending can reduce direct lending costs particularly the servicing and transaction costs. Banks are still able to fulfil their desire for growth as expanding loans for the existing customers. As building relationship to the existing customers, banks can also apply credit management in a more comprehensive and effective way. Banks already understand with the character, capacity and condition to their customers. Therefore, relationship lending is only applied to the good customers.
Another way in minimizing the conflict is conducting loan sales. A loan sale is a way of lending when a bank sells a loan after originating the loan for a customer. A bank which sells the loan can control the lending costs by undertaking the origination cost and eliminate the servicing and monitoring cost and also does not need much concern on credit management. A bank which buys the loan can fulfil its desire for growth without taking the origination cost. However, a buyer bank has to put much concern on credit management. Service quality can still be maintained, as a correspondent relationship is built between the seller bank and buyer bank. Normally, a loan sale is applied as a small bank buys a loan from a big bank.
In strategic level, the areas of conflict can be minimized by merger and acquisition as a bank can achieve cost efficiency by eliminating branches and expand loans by taking other banks loan. A bank can reduce the lending cost from eliminating branches. A bank can maintain its service quality as expanding the service geographically to a wider area of service. A bank can still apply credit management properly as sharing the competence in loan screening, analysis and monitoring with other banks that already have other kind experience in particular types of loans, which the bank does not have.
The areas of conflict can also be minimized by applying proper management information system and technology in lending activity. With a comprehensive computer database and credit scoring software, a bank can save time in processing loan as well as conducting a good credit management. Even though a bank undertakes so many loans handled as a result of expanding loan, a bank can still maintain service quality for all loan applications loaded.
In conclusion, within the lending environment, the source of conflict regards the situation when a bank tries to control its lending costs, which include the origination, servicing, screening and monitoring cost. Fulfilling its desire for growth, a bank tries to expand loans as well as to find good borrowers. Expanding loans, the lending cost would increase. Finding good borrowers, a strict credit management has to be applied. Also, it appears that maintaining service quality affects a soft credit management and needs more costs. There are ways such as relationship lending, loan sales and merger and acquisition and application of proper management information system and technology in lending activity which can minimize the conflict. However, to achieve all the goals together, a bank has to align its goal in expanding loans and finding good borrowers along with the effort of fulfilling customers’ need of lending and coping with information asymmetry and agency burden.
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