What You Need to Know About Utilization Risk [RMA Journal, The]

**Borrowers using credit for inappropriate or unauthorized purposes must be monitored and managed.

Banks go to great lengths in their due diligence before authorizing credit commitments to their commercial borrowers. They take securities, collaterals, and guarantees and stipulate covenants, all aimed at building necessary safeguards against nonperformance and defaults. However, less diligence is conducted to address utilization risk (also known as takedown risk), which exists in every credit commitment, whether simple or complex, made by a bank to a borrower.

Bank lending is vulnerable to a multitude of risks, but credit risk-the risk of borrowers defaulting on their obligations-is by far the largest. There are several reasons why borrowers default, among them business failures and unfavorable economic conditions, which are the most common. However, borrowers could also, knowingly or unknowingly, create utilization risk when they use their credit commitments for ineligible purposes (diversion of funds) or choose products not aligned with their business needs (wrong product choice).

For example, a borrower using funds from a seasonal working-capital line of credit to buy trucks (ineligible purpose) or a domestic customer borrowing in foreign currency (wrong product choice) are utilization risks. The good news is that utilization risk is controllable if banks monitor all draws-or at least major draws.

The purpose of this article is to examine utilization risk, focusing particularly on operating lines of credit. How is utilization risk created and how can it be managed? A hypothetical credit-structuring methodology is presented to illustrate how this risk can be managed through a combination of credit structuring and utilization monitoring.

Credit Commitments and Utilization Risks

Term loans and operating lines of credit are the two major types of credit commitments that banks extend to their commercial borrowers. A term loan is a commitment to provide a fixed sum for a specific purpose-say, for acquiring a plant and machinery. The chance for utilization risk on a term loan commitment is minimal because banks have full control over the end use of the funds. In almost all cases, term loan commitments are authorized with the stipulation that the bank advances the loan funds directly to a supplier or service provider.

An operating line of credit is an arrangement by which banks extend a certain amount of credit to finance short-term liquidity needs. It is made available by products such as prime loans, banker's acceptances, standby letters of credit, documentary letters of credit, and so on. International transactions may involve multiple currency borrowings-for example, Canadian and U.S. dollars.

A key control in an operating line of credit is the margining formula that links the draw availability to business assets, mainly accounts receivables (A/R) and inventory. The formula is governed by loan-to-value limits (for example, 75% of uninsured A/R, 90% of insured A/R, 50% of inventory, etc.) based on a specific analysis of that asset with tools such as sales, concentrations, collection cycles, inventory turnover, and so on.

An operating line of credit is quite simple for a borrower to use. The borrower has the discretion to draw under the line as long as margined collaterals offer sufficient availability and other terms, conditions, and covenants of the credit line are satisfied. Except for the margining requirements, lenders seldom place other restrictions on the amount of draw or on the choice of product. All that flexibility, convenience, and discretion add up to utilization risk.

Consider the following transactions put through an operating line of credit. The credit line is authorized for general working-capital purposes and allows multiple products and multiple currency borrowings:

Example 1: A documentary letter of credit is established to import equipment.

Example 2: A standby financial letter of credit is issued to guarantee the borrowings of a subsidiary with another financial institution.

Example 3: A domestic customer borrows in a foreign currency.

These transactions are within the availability of the operating line of credit, but the credit's usages are not within its authorized purpose. These deviations have created new risks for the bank. Let's examine those new risks:

Example 1: Acquiring equipment is a capital expenditure and ought to be financed out of long-term resources. In the absence of a long-term financing arrangement, this mismatch between the source and use of funds is likely to be refinanced out of general cash flows. When capital expenditures are financed out of general cash flows, the business may be vulnerable to cash flow shortages.

Example 2: The lender has no knowledge of the subsidiary. What is the business? How strong is its financial position? What are the risks associated with its operations? If the subsidiary fails to honor its borrowing commitments, the standby financial letter of credit will be called, creating an unsolicited liability in the lender's books.

Example 3: In the absence of a currency hedge in place, the borrower is vulnerable to foreign exchange risk.

Once a credit commitment is made available, a bank expects its borrower to use the credit only for its authorized purpose. When utilizations do not conform to the authorized purpose, new risks and unfamiliar exposures are created that are harder to learn about and assess fully. The bank may be compelled to divert scarce resources and management time to mitigate those new risks.

How Utilization Risks Arise and the Need to Control Them

Although the specifics of a risk management agenda and risk management architecture vary among banks, common to all risk management frameworks are pre-lending risk assessment and post-lending risk monitoring.

Utilization risk resides somewhere between these two phases. Business units focus on marketing and business growth, while the back-office teams that monitor risk do not vet transactions initiated by borrowers. This gap in the roles and responsibilities of business units and risk-monitoring teams may allow unauthorized transactions to slip through.

There are various reasons why borrowers indulge in such practices. Lack of financial discipline is perhaps the most obvious. This trend is typical of small borrowers who find it convenient and necessary to use an existing credit line, especially an open-ended facility like an operating line of credit, to satisfy an immediate or unexpected need, regardless of its appropriateness and risk implications. Monitoring the utilization offers a bank these benefits:

* It is usual for borrowers to dip into their unused credit commitments in down cycles. By monitoring and controlling utilizations, a bank can deter attempts by borrowers to put through large draws in times of deteriorating business conditions. When such attempts are observed, they serve as effective early warnings of a borrower's financial stress and allow for timely intervention.

* Capital charges on credit commitments necessitate active monitoring of utilizations to manage this cost of doing business.

* Monitoring also helps maintain ongoing dialogues with borrowers. Such informal communications may help banks 1) learn about company affairs, good or bad; 2) benefit from opportunities; 3) gain an edge over the competition; and 4) respond proactively if changes in risk conditions are imminent.

Managing Utilization Risks

A good risk management framework should capture the entire spectrum of risks, including utilization risks. Indeed, utilization triggers other risks inherent in credit commitments. Banks must have systems and processes to deal with the risks effectively before they arise.

Banks in some Middle Eastern and South Asian countries have developed their own lending models to deal with problems created by utilization risk. Although their risk management frameworks differ depending on their size, operational complexity, and risk management capabilities, these institutions use some common building blocks to address utilization risks:

* Borrowing needs are based on financial projections.

* Credit facilities from other financial institutions (for multibanked clients) and alternative financing sources (for example, supplier credit) are identified.

* Only products appropriate for the borrower's needs and risk characteristics are authorized.

* Business teams of relationship managers/associates authorize transactions above some minimal threshold level.

The banks' product selection process generally adheres to the following order of priority:

* Term loans.

* Self-liquidating credit lines.

* Working-capital loans.

Here are the reasons behind this approach and the special features of each product type:

Term loans are granted for specific purposes, such as financing capital expenditures. They are collateralized by the assets financed and are repaid in periodic intervals. They are nonrevolving facilities, and the amount repaid cannot be used again. Term loans offer the highest protection against utilization risk because the bank controls the end use of the funds by directly advancing them to a supplier or service provider.

Self-liquidating credit lines are mostly short-term facilities that get repaid from the conversion of the asset financed or the cash flows attached to the asset. Export bills discounting, local bills/invoice discounting, contract loans, overdraft against contract, overdraft against progress claims, or even a seasonal working-capital line of credit are considered self-liquidating credit lines.

Authorization terms for these credit lines are very specific to the business, contract, or projects financed. Utilization is meant strictly for the authorized purpose only. The bank completes a security interest over the project or contract cash flows, which serves both as a collateral and as a repayment source for the credit line.

Trust receipt (T/R) is provided to refinance imports. It is a facility where the bank owns the merchandise, but the borrower is allowed to hold the merchandise in trust for the bank. Proceeds from the sale of merchandise are remitted to the bank. This allows the borrower to use the merchandise in its business, while the bank's interest in ownership of the merchandise is protected.

Documentary credits and standby letters of credit are also considered self-liquidating because eventually they get converted into a funded exposure. A documentary credit requirement is estimated based on total import requirements, type of documentary credit (sight or deferred), and average turnaround times. A limit requirement on a standby letter of credit is estimated on a similar basis.

Working-capital loans1 are vanilla commercial loans granted for periods ranging from 60 to 180 days. Usually, a cleanup is required after two or three rollovers.

Case Example

Let's consider how these rules operate with our hypothetical client Sunrise Automotive, for which a simplified credit structuring methodology is presented. Sunrise deals in two automobile brands and also sells tires and accessories. Its sales projection for the next fiscal year follows:

The first step is to estimate the documentary credit limit requirement:

It is assumed that all documentary credits are on sight terms. Sunrise needs to establish $9,855,000 worth of documentary credits to achieve the target sales of $12,600,000. Assuming a lead time of four months for each documentary credit, this translates into a limit requirement of $3,285,000, rounded off to $3,300,000.

The next step is to estimate the trust receipt (T/R) financing needs:

Again, it is assumed that the T/R financing is allowed to cover the time it takes for sales to occur (for example, for the 1-3 months sales category, three months of T/R financing is required). A reasonable assumption would be the midpoint-say, 1.5 months in this example, which means the T/R financing requirement will be lower than calculated above.

The next step is to estimate the standby letter of credit requirement:

We assumed 20% of Sunrise's sales are on a credit basis. With a 40% historical bid success rate, Sunrise has to submit bids minimum to the value of $6,300,000 to achieve the $2,520,000 credit sales targeted. Assuming each bid is 1% of the sales and remains valid for three months, the bid bond limit requirement is estimated at $15,750. The performance bond limit requirement is a further $252,000, assuming each performance bond is 10% of the contract value and remains valid for 12 months. The total standby letter of credit limit requirement is thus estimated at $267,750, and a limit rounded off to $275,000 is approved.

The final step is to estimate the working-capital loan limit. With the required financing having been provided in a combination of customized facilities aligning with the borrower's financial projections, the working-capital loan limit forms a small fraction of the overall credit need.

Utilization Covenants

An example of the standard covenant to control utilization risks would look like this:

"All requests for bid bonds (regardless of the amount) and other facility requests (except working capital loans) above $250,000 are to be preauthorized by the relationship team."

Banks tend to be stringent in the utilization of bid bond limits to prevent borrowers from bidding for jobs beyond their capabilities.

A borrower's needs and risk levels will determine the appropriate facility limits, product mix, and type of utilization controls. Suppose a borrower's imports are by means of documentary collection; in that case, there will be no need for the documentary credit limit. However, T/R financing may be required to refinance the imports. Similarly, the bank may decide not to have any utilization controls for an AAA-rated company with large business volumes, because having too many controls may work against the bank if it is seeking to optimize business opportunities with that company.

Conclusion

Utilization risk exists in all credit commitments, regardless of whether they are simple or complex. Left uncontrolled, this type of risk could lead to a borrower using the credit line for inappropriate and unauthorized purposes.

Banks can mitigate utilization risk with proper controls and systems at the appropriate level. There is no standard solution, and different approaches will be applicable for different banks and different client situations. Regardless of the approach adopted, banks' risk-monitoring functions ought to be able to control this risk in a meaningful way.

Except for the margining requirements, lenders seldom place other restrictions on the amount of draw or on the choice of product.

A good risk management framework should capture the entire spectrum of risks, including utilization risks.

A borrower's needs and risk levels will determine the appropriate facility limits, product mix, and utilization controls.

Note

1. Overdraft is a popular form of working-capital facility provided by banks in Middle Eastern and South Asian countries. Banks feel comfortable with overdrafts since, having provided the required financing in customized facilities such as documentary credit, trust receipt, bills discounting, etc., the amount of the overdraft facility is always a small percentage of the overall credit need.

Sethupathy Kuppuswamy is a credit risk analyst at the Canadian Imperial Bank of Commerce in Toronto. He has also worked in National Bank of Oman, Oman, and Hatton National Bank, Sri Lanka, in the areas of commercial lending and credit risk management. He holds an MBA (UK) and Professional Risk Manager (PRM) certification. He can be reached at sethu_akshi@yahoo.com.

Sethupathy Kuppuswswamy is a credit risk analyst at the Canadian Imperial Bank of Commerce in Toronto. He has also worked in National Bank of Oman, Oman, and Hatton National Bank, Sri Lanka, in the areas of commercial lending and credit risk management.

(His article can be found on page 54)