Methods of Evaluating Credit Risk used by Commercial Banks in ...

International Research Journal of Finance and Economics ISSN 1450-2887 Issue 111 July, 2013 http://www.internationalresearchjournaloffinanceandeconomics.com

Methods of Evaluating Credit Risk used by Commercial Banks in Palestine Suleiman M. Abbadi Faculty of Administrative & Financial Science Arab American University Jenin, Palestine E-mail: [email protected] Tel: + 972599260092; Fax: + 97242510810 Sharif M. Abu Karsh Faculty of Administrative & Financial Science Arab American University, Jenin, Palestine E-mail: [email protected] Tel: + 9720599776711; Fax: + 97242510810 Abstract This paper tries to find the methods that banks operating in Palestine use in evaluating customers’ application for credit using the 5C's, LAPP, 5P's, CAMPARI and FAPE methods, and which element in each method they concentrate on most. It also tries to find whether banks differ in their use of these methods; and whether they differentiate among customers in using these methods. A questionnaire was designed and filled by the credit manager at the head office level of all 17 banks operating in Palestine. Two kinds of tests were used: Average percentages and ANOVA tests. It was found that all banks use most of the above five methods. The average percentages were used to find out the elements the banks concentrate most in each method, and it was found that banks in Palestine concentrate more on collateral, credit records, and ability to pay including liquidity and cash flow. They concentrate less on conditions, purpose and product. It was also found through hypothesis testing that there is no difference between banks in using the LAPP and 5P's methods but they differ in using the 5C's and FAPE method. Another test was conducted found that banks operating in Palestine treat natural persons and NGO's in the same way in evaluating their credit application; but differ in treating business organizations and artificial persons. A new model was developed by the authors called PACT: representing Person, Activity, Collateral and Terms. Each variable contains several elements and a weight (score) for these elements were estimated to make them easy to use by the banks credit managers (These scores can be adjusted by the bank management based on the bank’s credit policy). Then the banks adds the score for the customer and evaluates each customer based on a scale of 100.

Keywords: Bank Credit, 5C's, LAPP, 5P's, CAMPARI, Banks' Risk, Bank Groups of Customers, PACT.

International Research Journal of Finance and Economics - Issue 111 (2013)

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1. Introduction Financial institutions play a crucial role in the economy, as they transfer funds from surplus units to deficit units. This is known as financial intermediation which has been used by all financial intermediaries. Many economists consider it as one of the main function of commercial banks. The popularity of financial institutions came from the deposit account they offer to surplus units in order to help their desire for saving and liquidity. After that these institutions package these funds to provide loans of the size and maturity desired by the deficit units. They accept the risk on the loans provided in lieu of interest margin over the rate they pay on the deposits. Financial institutions have more expertise than individual surplus units to evaluate the credit worthiness of the deficit units. They also diversify their loan portfolio among several borrowers, so they can decrease the default risk, and absorb any defaulted loans better than individual surplus units. Commercial banks serve both private and public sectors as their deposit and lending facilities are utilized by individuals, businesses, and government agencies. This financial intermediation function is very important in the economy, as it improves the rate of economic growth by providing capital to entrepreneurs, which increases investment, employment, and output. The flow of funds from depositary institutions to deficit units can take several form: The first is direct, through extending loans and credit facilities to deficit units. The second flows through purchase of securities issued by finance companies that are transformed into finance company loans for deficit units. The third set of flows reflects the purchase of shares issued by mutual funds which buy debt and equity securities of deficit units. Only the first types of flows are available for commercial banks in Palestine, as the financial markets are not as yet developed to accommodate sophisticated financial transactions. This means that commercial banks in Palestine concentrate on direct credit, which implies that they are more exposed to credit risk more than any other financial institutions, and more than commercial banks in other countries. The recent international financial crisis (2008-2010) hit severely the banking sector in the West, as well as the East and the Gulf countries, mainly due to the relaxed credit policies they were using, in addition to the mismanagement of credit facilities they offered. On the other hand, Palestinian banks were among the least to be affected by the crisis due to three reasons: First, the low levels of international debt securities in their portfolios; Second, its conservative credit policies adopted by Palestinian bank managers, and finally, the tough measures adopted by the Palestine Monetary Authority (PMA) before and during the crises. Banks can choose their credit policies according to the level of risk they are ready to accept. They use different models to accommodate their needs such as the 5C's of credit, the 5P’s, the LAPP methods, the CAMPARI model and Financial Analysis and Past Experiences methods (FAPE). These methods will be discussed in detail in the literature review. The aim of this paper is to investigate the kind of credit policies commercial banks in Palestine use, which model is used the most, and what element of each model is the most frequently used. The paper will also test if these measures differ from one bank to another or from one kind of customers to another. In addition it will try to develop a new model which will include the most important elements of these five methods and put a weight (score) for each important variable element the bank thinks it will have an effect on its credit decision. The suggested weights may be changed by the bank management based on the bank’s credit policy. Based on the score the customer will have, the bank can decide whether to grant credit or not or ask for more requirements. This method is fast and easy to use. It can be obtained immediately after the customer completes the loan application data. Two forms of scores will be used: one for individuals and one for corporations. In order to accomplish the main objectives, this Study will try to provide answers to the following specific sub – problems: 1. What are the main financial intermediaries operating in Palestine, and how did they develop during the past 60 years? 2. How do Palestinian financial intermediaries assess the credit worthiness of their borrowing clients?

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3. Are there any significant differences in the techniques used by the subject financial intermediaries in assessing their clients' credit worthiness when the client are grouped into: • Artificial Persons • Natural Persons • Business Organizations • Non – Government Organizations (NGO’s) 4. Is there a way to standardize these methods and group them into one method that can be used by all banks? The results of this research will be beneficial to bank managers, credit officers, banking regulators (PMA), and borrowers who seek credit from the banks. The rest of the paper is organized as follows: section 2 discusses the development of the banking sector in Palestine, section three overviews the related literature, section 4 discusses the methodology, sample, and hypothesis to be tested in this paper, the results are presented in section 5, and the conclusion will be presented in section 6.

2. Development of the Banking Sector in Palestine This section will be divided into two parts: history of banks in Palestine and development of commercial banks’ balance sheets during the past 20 years. 2.1. Brief History of Palestinian Commercial Bank Before the occupation of the West Bank in 1967, there were 11 commercial banks in Palestine (8 in the West Bank and 3 in Gaza) with 30 branches of which 26 were the West Bank and only 4 in Gaza. At that time their credit facilities represented 71.4 % of their deposits (ESCWA 1987). The Israeli authorities used military orders to close all bank branches on the eve of occupying the land (West Bank and Gaza) in 1967. They froze their assets and confiscated the cash in their vaults and transfer them to the Central Bank of Israel. After a few years, they issued military orders allowing Israeli Banks to open branches in the West Bank and Gaza. Only 4 banks opened with 22 branches distributed in main cities of the occupied area: Bank Leumi 13 branches, Bank Discont, 6 branches; Bank Hapoalim, 2 branches; and Barcklays Bank, 1 branch (ESCWA 1987). They remain alone until 1981, when the Israeli High Court of Justice allowed Bank of Palestine to reopen its closed branches in Gaza. Israeli banks were unable to attract Palestinian deposits, so they were lacking funds, which made them dependent on government money collected from taxes imposed on the Palestinians. Their roles were limited to transferring money and to paying checks to Palestinians who received their salaries in Israeli Shekel. Israeli banks were unable to provide a financial intermediary function, as very few customers agreed to deposit their money with them, and their loan portfolio was less than 8% of their assets. Most of their facilities were overdraft granted to merchants who had business with Israeli partners. Banks also were facilitating trade of Palestinian merchants who needed to open letters of credit or letters of guarantees to import from Israel. Despite this, these facilities were profitable to those banks, as they were charging three times the fees banks charge in neighboring countries; but due to lack of business very few could make a profits and sometimes losses caused many of them to close their branches. In 1987, due to the Intifada, all of these banks were closed (Harris 1988). There were no banks in Palestine until 1994, except one branch of Cairo-Amman Bank, which was reopened in 1986 in addition to the Bank of Palestine in Gaza. After the Oslo agreement in 1993, the Wadi Araba Agreement between Jordan and Israel and the Paris Accord in 1994, Israeli authorities allowed Jordanian banks to reopen their branches closed in 1967. They also allowed the Palestinians to establish the Palestine Monetary Authority in 1995 to overview banks and to give licenses to the newly established banks (Abbadi 1997). Since 1995, the PMA has issued several laws and regulations; the most important are the Banking Law, the PMA law and the Money Changers Law. Recently the PMA drafted a Central Bank Law which is awaiting a Presidential decree. The new law is expected to

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transform the PMA into a fully fledged central bank which will have the authority to issue the national currency whenever the required conditions are met (PMA 2012). Currently three currencies are circulated in Palestine: the US dollar, the Israeli shekel, and the Jordanian dinar. Since its establishment, the PMA has issued several licenses to new banks and allowed banks to open new branches, which made the number of banks to increase from 2 in 1994 to 17 by end of 2012, with over 226 branches and offices. The following table shows the distribution of banks between local and foreign and the number of branches in 2012. Table 1:

Banks and Branches in Palestine as of end 2012

Banks and Branches Number of Banks Local Banks 7 Foreign Banks 10 8 • Jordanian 1 • Egyptian 1 • British 17 Total Source: Palestine Monetary Authority, Annual Report 2012.

No. of Branches 118 108 101 6 1 226

As the table shows, most of the foreign banks are branches of Jordanian Banks, and they have more than half of the total banks branches. There were some mergers over the last two years between some local banks as the PMA forced banks to increase their capital to $ 50 million. This resulted in an increase in total banks capital to $1,257.5 million in 2012 (PMA annual report 2012). The most important feature of the banking sector in Palestine is the concentration of assets in the three major Jordanian banks: Arab Bank PLC, Cairo Amman Bank, and Bank of Jordan which account for about 50% of the commercial banks' assets, more than 50 % of their deposits, and more than 55% of their credit facilities. They also have a large presence in almost all cities, accounting for more than one-third of all branches (78 branches). (Annual Reports of these banks 2012). 2.2. Assets and Liabilities of Commercial Banks The following table summarizes the balance sheet of commercial banks in Palestine during the last 19 years. Table 2:

Assets and Liabilities of Commercial Banks in Palestine (1994-2012) $ Million

Assets Balances with P.M.A Balances with Banks in Palestine Foreign Assets Portfolio Investment Balances with Banks abroad Credit Facilities (Non-Residents) Cash Gold and Precious Metals Credit Facilities (Resident Customers ) Palestinian National Authority Other Resident Customers Portfolio and Investments Other Assets Total Assets and Liabilities Deposits of P.M.A Deposits of Bank Operating in Palestine Deposits of Residents Local Authorities

1994 424.6

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35 48.4 670.6 29.5 588.5

2000 383.5 234.8 2316.2 5.7 2154.3 19.0 137.2 0.0 1262.0 416.7 845.3 103.6 294 4594.2 118.5 228.2 3470.1 76.4

2006 521.7 219.9 2692.6 57.8 2370.6 81.5 173.3 9.4 1761.9 485.9 1275.9 151.0 421.8 5769.0 179.1 191.2 4125.6 100.9

2011 940.9 335.3 3795.9 752.3 2467.5 55.7 496.7 23.7 3495.0 1101.1 2393.9 198.4 571.8 9337.4 178.9 304.7 6777.0 147.4

2012 998.9 372.7 3754.9 655.1 2303.7 45.1 731.1 19.9 4154.1 1407.4 2746.7 220.4 550.9 10051.9 173.1 351.4 7241.6 146.9

150 Table 2:

International Research Journal of Finance and Economics - Issue 111 (2013) Assets and Liabilities of Commercial Banks in Palestine (1994-2012) $ Million - continued

Palestinian National Authority 119.6 Resident Customers 3274.2 Foreign Liabilities 310.2 Deposits of Nonresidents 36.8 Deposits of Banks Operating Abroad 267.1 Capital 14.6 250.1 Provision and Depreciation Other Liabilities 37.7 217.1 Source: Palestine Monetary Authority, Annual Reports Different Issues.

275.5 3749.2 181.4 90.2 91.1 597.0 329.9 168.0

437.1 6192.5 358.6 195.7 162.9 1184.5 394.8 138.9

473.3 6621.3 443.4 242.6 200.8 1257.5 435.8 149.2

As shown in table 2 above, banks in Palestine have been growing very rapidly as their assets grew at an average annual rate of 16.2 % during 1994-2012. They grew more than 10 times during the last 19 years. Their assets increased from $670 mm in 1994 (Hamed 1996) to $10bn in 2012 (PMA 2012). On the other hand, loans and deposits grew at an average annual rate of 19.6% and 15% respectively during the same period. Total credit facilities grew rapidly during the last few years due to the PMA regulation that the credit/deposit ratio has to be more than 40%. Currently this ratio stands at 57%, mainly because of the increase in banks' loans to government, which account for one-third of the facilities. Without these, banks’ facilities are still less than 40% of their deposits. There is still a large portion of Palestinian banks' deposits that are deposited outside the country equal to about one - third of deposits, but far below their 2000 levels of more than 60%. In distributing the credit facilities by sector, the following table summarizes 2012 credit facilities by kind of facility: Table 3:

Credit Facilities by Sector

Type of Facility Loans Overdrafts Financial Leasing Total Source: PMA annual report 2011.

Private Sector 2214,0 522.6 10.1 2746.7

Public Sector 692.5 715.0 0.0 1407.5

Total 2906.5 1237.6 10.1 4154.2

We can see from Table 3 above that overdraft still account for about 30% of total credit facilities, but this is an improvement over 2000, when overdraft was more than 50% of total commercial banks credit facilities. When examinig private sector facilities by purpose, we found that construction and real estate account for 21.4% of total credit facilities, followed by local and foreign trade (20.7%) , then consumer credit (20.2%), businesses and consumer services ( 9.6%) and manufacturing and mining (8.9%). Banks operating in Palestine are now well capitalized as their capital adequacy ratio increased to 21.1% in 2011 due to an increase in the minimum bank capital to $50 million. They also maintain a high liquidity ratio of 37.7% of total assets, and 49% of short term liabilities. Non- performing loans to core capital have been declining from 25.3% in 2008 to 9.7% in 2011, while their ratio to gross facilities declined from 15% to 2.8% during the same period. Profitability indicators have been improving as total bank profits increased to $118.4 million, which made the ROA increase to 1.9% and ROE decline slightly to 16.1% in 2011. But both are acceptable by international standards ( PMA 2011).


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3. Review of Literature and Related Studies This section summarizes the pertinent contemporary literature and studies both old and recent which researchers have found in economic and financial literature. These materials facilitated research thrust, and construction of the questionnaire. 3.1 The 5C's is an approach to evaluating credit worthiness using various factors commonly categorized as the 5C's of credit summarized by Peavler (2013) as follows: 1. Capacity refers to borrower's ability to meet the loan payments of interest and principal. 2. Capital is the money invested in the business and is an indicator of how much is at risk should the business fail. 3. Collateral is a form of security for the lender. Banks usually require collateral as a type of insurance in case the borrower cannot repay the loan 4. Conditions refer to the economic and political condition of the country. 5. Character is the obligation that a borrower feels to repay the loan. Since there is not an accurate way to judge character, the lender will decide subjectively whether or not the borrower is sufficiently trustworthy to repay the loan. 3.2 The 5P’s is another method of evaluating credit applications. It was developed by the Federal Reserve Center (Fed 2004) which consists of: 1. People: Does the borrower have a history of being honest, reputable and timely in honoring his or her financial obligations? 2. Purpose: There should be a specific explanation of how the borrower is going to use the funds. Don’t settle for a simple description such as “working capital.” 3. Payment: Knowing the purpose helps identify sources of repayment and aids in structuring the loan repayment schedule based on the timing of the borrower’s receipt of funds (cash flow). 4. Protection: This is collateral and other secondary sources of loan repayment. Protection is last on the list of P's for good reason. 5. Prospective (Plan): How will the loan be supervised, and in the case of borrower default, what will the bank do? The plan to supervise should specify how the loan will be monitored, including financial reporting by the borrower, and periodic inspections of the borrower’s operations. 3.3 LAPP Method developed by Benz (1979) is used more for evaluating corporate credit applications than individual borrowers. LAPP is an abbreviation for the following: 1. Liquidity: which measures the ability of the firm to repay its short term obligations? Banks use quick ratio or liquidity ratio to measure the liquidity of the firm. 2. Activity: which measures the size of the firm and its operations, some percentages are used, such as asset turnover, inventory turnover, average collection period, and average payment period. 3. Profitability: which measures how profitable the firm is. Some ratio is used such as return on assets (ROA), return on equity (ROE), gross or profit margin. 4. Potential: this measures the resources and strength the firm has, such as financial resources, human resources, management level, and other strength the firm might have. 3.4 The CAMPARI Model represents 7 variables the bank can use to evaluate credit applications. Some of them are similar to the 5C's, and some to the 5P's,(Business coaching 2008). They include: 1. Character: similar to the one in 5C's. 2. Ability to pay: similar to capacity. 3. Margin of Finance: This is the amount the customer contributes from the loan. The bank seldom grants 100% financing. For any asset financing the customer has to pay a certain percentage of the value of the asset that needs to be financed. 4. Purpose: the purpose of the loan. Some are risky loans some are not.

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5. Amount: the amount of the loan. How much is too much for a client? This depends on the capacity of the client. 6. Repayment Terms: This is the structure terms of the repayment. 7. Insurance: to see if the borrower has life insurance or not. This is used mainly for long term loans such as housing loans. 3.5 Financial Analysis and Previous Experience Methods (FAPE) This method depends on analyzing the financial records of the applicants and on its past records of credit. The bank analyzes financial statements such as the income statement, Balance sheet, cash flow statement and from these statements computes some ratios, such as the liquidity ratio and profitability ratios such as: ROA, ROE, and operation ratios such as Asset Turnover ratio, and other ratios such as: EPS, Debt Ratio,…..etc. From these ratios the credit officer can evaluate the firm and decide if it is credit worthy or not (Abu Karsh 2005). This method is usually used in addition to some of the above methods and banks do not depend on it alone, because some information is lacking, especially about the customer's attitude and past experience (Credit Records). The following table summarizes the five methods above: Table 4: No 1 2 3 4 5 6 7

Summary of the Five Methods of Evaluating Credit Risk 5C's Character Capital Collateral Conditions Capacity

5P's People Purpose Payment Protection Prospective

LAPP Liquidity Activity Profitability Potential

CAMPARI Character Ability to Pay Margin Purpose Amount Repayment terms Insurance

FAPE Liquidity ratios Profitability ratios Operation ratios Debt ratios Character Credit Record

From the above table, we notice a lot of similarities among the five methods. So banks do not use all of them together, rather, they use one or two of these methods. Sometimes they use parts of each, depending on their needs. 3.6 Recent literature: This section summarizes the pertinent contemporary literature and studies the researchers found in economic and financial literature. These materials facilitated research thrusts, and construction of the questionnaire, in their research on evaluating credit models over the past decade. Beyond ROE, how to measure bank performance, is a study conducted by the European Central Bank (2010). It analyzes banks' performance in terms of their capacity to generate sustainable profitability. The study favored using the ROA, market – based performance such as P/B ratio, and economic-based performance rather than ROE, as ROE gives limited insight about profitability and performance. Al-Obaidan (2008) suggests that large banks are more efficient than small banks in the Gulf region. Tarawneh,(2006) found that a bank with higher total capital, deposits, credits, or total assets does not always have better profitability performance. Financial performance of the banks was strongly and positively influenced by operational efficiency and asset management, in addition to the bank size. Almazari (2011) studied the financial performance of seven Jordanian commercial banks. He used the ROA as a measure of banks’ performance as well as bank size, asset management, and operational efficiency as three independent variables affecting ROA. The results of his analysis revealed a strong negative correlation between ROA and bank size, a strong positive correlation between ROA and asset management ratio, and a weak negative correlation between ROA and operational efficiency. Khizer et.al (2011) conducted a comprehensive study of banks’ profitability in Pakistan, where they found significant relation between asset management ratio, capital and economic growth, and


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ROA. They also found that operating efficiency, asset management and economic growth are significant with the ROE. Sidqui and Shoaib (2011) found in their study “Measuring Performance through Capital Structure in Pakistan” that size of the bank played a significant role in determining its profitability measured by ROE. They used also the Tobin’s Q model as a proxy for determining bank performance while they found that Tobin’s Q is affected by the size of the bank, the leverage ratio and Investments carried out by the bank. Alkhatib (2012) examined the financial performance of five Palestinian commercial banks listed on the Palestine Securities Exchange (PSE). He measured financial performance by using three indicators: internal–based performance measured by Return on Assets, Market-based performance measured by Tobin’s Q model (Price / Book value of Equity) and economic–based performance measured by Economic Value added. The study employed correlation and multiple regression analysis of annual time series data from 2005-2010 to capture the impact of bank size, credit risk, operational efficiency, and asset management on financial performance measured by the three indicators, and to create a good-fit regression model to predict the future financial performance of these banks. It rejected the hypothesis that “there exist statistically insignificant impact of bank size, credit risk, operational efficiency and asset management on financial performance of Palestinian commercial banks”. Lopez and Seidenberg (2000) found that commercial banks have devoted many resources to developing internal models to better quantify their financial risks and assign economic capital. These efforts have been recognized and encouraged by bank regulators. Recently, banks have extended these efforts into the field of credit risk modeling. However, an important question for both banks and their regulators is how to evaluate the accuracy of a model’s forecasts of credit losses, especially given the small number of available forecasts due to their typically long planning horizons. Using a panel data approach, they proposed evaluation methods for credit risk models based on cross-sectional simulation. Specifically, models are evaluated not only on their forecasts over time but also on their forecasts at a given point in time for simulated credit portfolios. Once the forecasts corresponding to these portfolios are generated, they can be evaluated using various statistical methods. Jacobson and Roszbach, (2003) in their research entitled Bank Lending Policy, Credit Scoring and Value-At-Risk, build their paper on the credit-scoring literature and propose a method to calculate portfolio credit risk. Individual default risk estimates are used to compose a value-at-risk (VaR) measure of credit risk. The credit-scoring models suffer from a sample-selection bias. The starting point is therefore to estimate an unbiased scoring model using the bivariate profit approach. They studied how marginal changes in a default-risk-based acceptance rule would shift the size of the bank’s loan portfolio, variance exposure, and average credit losses. Finally, they compared the risk in the sample portfolio with that in an efficiently provided portfolio of equal size. There results show that the size of a small consumer loan does not affect associated default risk, implying that the bank provides loans in a way that is not consistent with default-risk minimization. VaR calculations indicate that efficient selection (by means of a default-risk-based rule) of loan applicants can reduce credit risk by up to 80%. In a practical approach to credit scoring, Min and Lee (2008) proposed credit scoring different from conventional models such as multiple discriminate analyses, logistic regression analysis, and neural networks for business failure prediction, which require extra a priori information, this new approach requires only ex-post information to calculate credit scores. This methodology was applied to current financial data of externally audited 1061 manufacturing firms comprising the credit portfolio of one of the largest credit guarantee organizations in Korea. Using financial ratios, the methodology could synthesize a firm’s overall performance into a single financial credibility score. They proposed a practical credit rating method using the predicted Data Envelopment Analysis (DEA) scores.

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4. Methodology In order to achieve the above objectives of the research, a descriptive and analytical approach was used. A questionnaire was designed and tested before it was used and distributed to all banks operating in Palestine. We gathered data from all Palestinian banks (Head Office or Regional Management Office) on the West Bank and some branches of these banks, as well as interviews of key personnel responsible for studying and approving the customers' credit applications. The questionnaire is divided into two parts. The first concerns general information regarding the bank and the employee who is required to fill in the questionnaire (usually the credit officer or the head of the credit department). The second part consists of twelve questions. The first 5 are about the methods of evaluating the customers' credit worthiness: mainly the 5C's, the 5P's, CAMPARI, LAPP, and FAPE methods. The next five questions relate to methods of evaluating the risk that results from extending credit facilities. The next two questions relate to the differences in evaluating the credit applications of different groups of customers. The questionnaire and the interviews were conducted at the level of credit managers, branch managers and the head of credit department at the head office or regional management. The data was analyzed by using SPSS program and several hypotheses were tested using ANOVAs analysis. 4.1. Study Population and Sample The study population includes all banks operating in Palestine, which include 17 banks (10 foreign and 7 local). We studied all of them at the head office level, because they are the decision makers of main credit for all of their branches. There are credit departments or sections at the branch level of each bank. Their role is mainly to gather information about the customer fills in the credit application and to make recommendations for head office. The credit department at the head office are the one who studies and analyzes the application and make the necessary approvals at different levels. The questionnaire was distributed to all head offices and one or two branches of each bank. But when we gathered the questionnaire we surprisingly found that branches gave the same answers as their head offices. So we decided to use in our analyses only the answers of the 17 head offices, which means we have the answer of all banks in Palestine. This makes the sample 100% of the population. 4.2. Hypotheses Testing As it was discussed earlier in the purpose of the study, two hypotheses will be tested. 1. Do banks in Palestine use the same method of evaluating credit risk, or do they use different methods? 2. Do banks differentiate between one group of customers, or do they use the same method of evaluation for all customers? In order to find the answers to the above questions, we use the following tests: For the first one: H0: Banks do not use the same method of evaluation. H1: Banks use the same method of evaluation. For the second question: H0: Banks differentiate between groups of customers; i.e, use different method for different customers. H1: Banks do not differentiate between groups of customers; i.e, use the same method for each group.

5. Statistical Results The study used SPSS to analyze the data using two kinds of statistical analyses: ratio percentages and the Anova test.

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International Research Journal of Finance and Economics - Issue 111 (2013) 5.1. Ratio Percentages

Ratio percentages were used in analyzing the five methods of evaluation. Credit officers were asked to sort the measures used for evaluating the credit risk of the customer by giving 5 to the most important element and 1 to the least important. Thus the variable that gets the highest mean are the most important and the one that get the lowest mean is the least important. First question: Which method does your bank use in evaluating credit application: the 5C's, the LAPP the 5P's, CAMPARI or FAPE method?. It was found that they use all of the five methods in different ways. But consent rate on some ratios and other banks on other ratios. Second question: If your bank use the 5C's in evaluating the credit application of your customers please rank them applying 1 to the least important, 2 to the next and so on. The highest grade to the most important. The third to six questions were the same as above, but for the other four methods: The results of the averages of the five methods are shown in the following table. Table 5: No 1

2

3

4

5

The averages of the four methods of credit evaluation The Methods The First Method: The 5C's Character Capacity Capital Conditions Collateral The Second Method: The LAPP Method Liquidity Activity Profitability Potential The Third Method: The 5P's People Product /purpose Payment Protection Prospective The Fourth Method: The CAMPARI Method 1. Character 2. Ability to Pay 3. Margin of Finance 4. Purpose 5. Amount 6. Repayment Term 7. Insurance The Fifth Method: The FAPE Method 1. Liquidity Ratio 2. Profitability Ratio 3. Operation Ratios 4. Debt Ratios 5. Character 6. Credit Record

The Averages Max 5 2.33 4.40 3.67 1.23 4.47 Max 4 3.38 1.96 3.33 1.17 Max 5 4.35 2.87 3.67 2.87 1.14 Max 7 4.55 6.33 1.76 2.33 1.55 6.18 5.68 Max 6 5.13 4.56 1.27 2.35 3.70 5.20

From the table above, we can see that in the case of 5C's banks use collateral and capacity as their main concern for sources of payment, while capital, character, and conditions are their least concern. This shows that Palestinian banks are conservative in their credit policies since they concentrate on collateral and sources of payments.

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In the second method (LAPP), the main concerns of Palestinian banks are the liquidity and profitability of the firms, which again reflects their concern to get their money, back (conservative policies). They are less concerned with the potential or the activity of the firm. In using the 5P’s banks first concentrate on people, then payment (source of payment, timing, and probability of default). They concentrate less on prospective, product or the purpose of the loan. The CAMPARI method is used by Palestinian banks to support the three other methods, since some variables are duplicated in the first and third method. It was found that Palestinian banks concentrate more on the ability to pay and repayment term. They are less concerned with amount, margin, or purpose of finance. These results are consistent with the 5C's, the 5 P's, and the LAPP, and also reflect the conservative policies for extending credit: they concentrate more on collateral and sources of payment. Finally, the FAPE method has been used mainly for corporations, in which they concentrate on the analysis of income statement and balance sheet. It was found that they concentrate more on liquidity, profitability and credit records of the firm and less on other ratios. This conservative policy used by Palestinian banks helped the banks to decrease their non performing loans portfolio to less than 3% of their total credit facilities. 5.2. Hypothesis Testing Two tests were conducted to find out whether there is a statistical difference between banks in using the five methods. The first test: H0: Banks use the same method of evaluating credit application but in different ways. H1: Banks use the same method in evaluating credit application and in the same way. We apply the test to each method separately; the results show that the F statistics equal 0.759 with significance of 0.664 in the 5C's method, 0.85 and 0.34 in the CAMPARI, and 1.20 and 0.58 in the FAPE method. We therefore accept the null hypothesis and reject H1, which means that banks use these methods differently; i.e, they differ from one bank to another. But the other two, LAPP and 5P's, we found F statistics 8.77 and 15.33 respectively with 0.00 significance for both. So we reject the null hypothesis and accept the alternative hypothesis, which means that banks do indeed use these methods in the same way. The second test is designed to find out whether banks differentiate between different kinds of customers. Four groups of customers were used: natural persons, artificial persons, business organizations, and NGO's. The test was conducted for the four groups on the five methods for all banks. H0: Banks do not differentiate between groups of customers; i.e, they use the same method for each group. H1: Banks differentiate between groups of customers; i.e, they use different methods for different groups of customers. It was found that there is no statistical difference between banks in dealing with credit applications by natural persons and NGO's in using all five methods: 5C's, LAPP, 5P's, CAMPARI, and FAPE. At the same time there is a statistical difference between the other two groups, artificial persons and business organizations, so banks do differentiate among these groups. The test was done separately and combined all five methods; it shows the same result. For the combination of all five methods, F statistics was found 16.059 with significance 0.00, so we reject the null hypothesis that banks do not differentiate between groups of customers (business organizations and artificial persons), and accept H1, which means that banks do differentiate between these two groups of customers. On the other hand for natural persons and NGO’s, F was found equal to .953 with significance of 6.32, so we accept the null hypothesis H0 and reject H1for the other two groups. Banks do not differentiate between customers in case of natural persons and in the case of NGO’s regarding use of the 5 methods of evaluation.

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International Research Journal of Finance and Economics - Issue 111 (2013) 5.3. The New Model

To simplify the analysis for the banks to study the clients application for bank credit, a new model that contains most of the elements of the 5 methods above was developed; weights for these elements were estimated to make them easy to use by the banks credit managers. Then the banks add the score for the customer and evaluate based on a scale of 100. These scores can be adjusted by the bank management based on the bank's credit policy. The following table summarizes the new model, which will be called PACT: representing Person, Activity, Collateral and Terms: Table 6:

Elements of The New Model of Credit Evaluation

Credit Evaluation of Corp Item Score 1. Personal/Business Management Credit Record Sector Operation risk Concentration Risk 2. Ability Capacity Cash Flow Liquidity Debt Ratio Profitability 3. Collateral Fiscal Assets (Protection) Financial Assets Personal Guarantee 4. Terms Kind of Facility (direct/indirect Purpose Payments Amount Margin Total

Max 30 6 6 6 6 6 35 7 7 7 7 7 20 10 5 5 15 3 3 3 3 3 100%

Credit Evaluation of Individuals Item Score 1. Personal Character Employer Credit Record

Max 30 10 10 10

2. Ability Sources of Payment(income) Repayment Term Other salaries

20 8 6 6

3. Collateral Fiscal Assets Financial Assets Personal Guarantee 4. Terms Payment Purpose (Housing, Cars, Personal…) Amount Margin

35 15 10 10 15 4 4 4 3

Total

100%

6. Summary and Conclusion This paper seeks to determine whether banks in Palestine use scientific methods to evaluate their customers' applications for credit and tries to find which elements of each method is the most important to the bank. It also tested the differences among banks in dealing with their customers regarding credit evaluation. A questionnaire was designed and distributed to all banks operating in Palestine and filled out by the credit officers of these banks at the head office level; 17 filled out questionnaire were collected. Two methods were used for analysis: the averages and the Anova tests. The tests found that banks in Palestine use the five methods of evaluation: the 5C's, the LAPP, 5P's, CAMPARI, and FAPE methods. Each method was analyzed separately, and it was found that in the 5C's method, banks concentrate more on collateral, capital, and capacity of the debtor more than character and conditions, while in the LAPP method banks concentrate more on liquidity and profitability of the debtor rather than activity or potential. In the 5P's, banks concentrate more on people and payment rather than on product, purpose, or protection. The last one contradicts the 5 C's capacity of the debtor, which was considered among the priorities for evaluating credit applications. In CAMPARI method, banks in Palestine use more ability to pay and payment terms and less character, margin of finance, purpose,

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and amount. Finally, in the FAPE method banks use more liquidity, cash flow, and credit records, and less other ratios Hypothesis testing was conducted to find out whether banks operating in Palestine differ in using the five methods of evaluating credit application. It was found that there is no difference between banks in using the LAPP and 5P's methods but they differ in using the CAMPARI, FAPE and 5C's methods. Another test was conducted to find out whether banks operating in Palestine differentiate between customers in using these methods of evaluating credit application. Customers were divided into four groups: natural persons, artificial persons, business organizations, and NGO's. It was found that banks operating in Palestine treat the natural persons and NGO's the same way in evaluating their credit application, but they differ in evaluating the business organizations and artificial persons. To simplify the analysis for the banks to study clients applications for bank credit, a new model that contains most of the elements of the 5 methods above was developed. It is called PACT: representing Person, Activity, Collateral, and Terms. Weights for these elements were estimated to make them easy to use by the banks' credit managers. (These scores can be adjusted by the bank management based on the bank's credit policy). Then the bank adds the score for the customer and evaluates each customer based on a scale of 100.

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