Credit Policy

Credit Policies By Banks
What Is Credit Management ???

About Credit Management We all know that by far the main business of the bank is to accept deposit for the purpose of lending. Lending is an important function of the bank. Banks survival depends very much on effectiveness of this function. Loans and advances constitute nearly 60to 70% of the Assets of the Bank. It is important to know the principles and practices governing this function for ensuring sound, healthy and profitability portfolio. Traditional and Emerging Concepts Overview of lending scenario Growth of credit is linked to Indias industrial development. Over the last 50 years India industries have done reasonably well. Growth in investment, output and employment brought India to position of a major industrial nation of the world. The Indian industry now is on the crossroads of liberalised economy exposed to global market. They are required to re-orient themselves from protected and monopolistic market situation to a liberal and competitive and global market environment. The changes that are sweeping the industrial world-the users of credit are in a way affecting the Banks too. Banks are required to re-orient their lending policies and practices to suit the new market realities. Besides, Banks are themselves affected by the financial sector reforms especially in the area of adoption of international accounting norms and capital requirement coupled with gradual privatization of public sector banks, deregulation, development of disintermediation and breaking of walls between banks and traditional financial service providers; banks and financial institutions.
Credit Policies By Banks The compulsions operating on the Banks are: To strengthen the balance sheet in terms of capital adequacy, to clean the credit portfolio of its non-performing assets, to modernize banking operation and expand banking activities to new financial services like Merchant Banking, Leasing, Hire purchasing, introduce electronic payment System, emphasize Marketing etc. The principles of bank lending therefore will have to be viewed in the context of Banking, Financial, Trade and industrial reforms, which are underway. Credit is essential to modern economics: Credit is fundamental to any economy that has passed beyond the stage of barter. A socalled cash sale is in fact a credit transaction because the acceptance of cash bespeaks reliance upon credit of the issuing government. If the payment is effected by chques the credit of drawer is used. The business of dealing in credit has become the business of banking. The business of banking in todays world encompasses a great deal more than a simple exchange of credit. It is now a full financial service outfit. However, it is able to participate in all phases of a complex financial society naturally and directly based on its based on its genetic capacity to evaluate and deal in credit. Elements of bank credit: Bank credit is a reflection of confidence that banks will meet their engagements. There are three major factors that go to develop this confidence: First the resources of the bank Second is the skill and integrity of its management Third is the Government and Central Bank control and supervision over banks.
Credit Policies By Banks Banks resources consist of its capital funds and borrowings in the form of deposit. These resources are employed in loans and other investments. In this sense, the bank uses its own credit to acquire assets to be used by it for its own benefit. An essential characteristic of the banking business is it lends its assets in the form in which it receives them instead of processing and selling them. An alternative method of employment of bank credit is for the bank to lend its credit rather than its assets. This it does by engaging for the account of its customer, to make money payment at a later date e.g. letters of credit, guarantee, etc. Loans Not Bank Credit: Loans engage the credit of the borrower. What is frequently called bank credit for loans is functionally an employment of the borrowers credit. All the terminology that used in connection with a banks lending operations describes borrowers credit and not bank credit. Credit judgment, so reverently regarded as an attribute of bankers appraisal of a customers ability to repay what he has borrowed. It is generally accepted that a bank cannot lend more money than it has but that it is not so limited in the creation of credit which it extend for the benefit of its customers. When the banker lends his credit rather than money, the process begins with the creation of an assets rather than a liability. The credit transaction thus provides built-in-safeguards against the dangers a borrowings short and lending long. This is because when a banker lends credit rather than money, he undertakes a liability through L/C or acceptance that corresponds precisely in amount and time with his customers promise to put him in funds to discharge that liability. In such circumstances, the only remaining risk is the credit risk. Credit Judgment Shapes the Banking Business: Whether the banker lends money or credit, however, he cannot escape the necessity for making a judgment as to his customers credit, which lies at the successful conduct of the
Credit Policies By Banks banking business. In both categories of transaction, the bank ultimately makes a payment of its own money and must look to its debtor for payment. In the last analysis, then bank credit is no more than a reflection of public confidence that bankers have exercised a skilled and informed judgment as to credit of his debtors. Those who rely on bank credit are further supported in their rely on bank credit are further supported in their reliance by statutory and regulatory requirements that are designed to lesson the adverse impact of a mistake by the banker in his appraisal of the credit of his debtors. Among these are requirements of capital adequacy, prudential norms for lending, accounting norms, loans provision based on assets classification and other administrative controls? The banker however have to perform professional obligation appraise accurately the credit of their customers. The faulty appraisal cannot be well cured by safeguards of overall banking supervision. We have discussed above the resources creating capacity of the bank. The other aspects of bank lending are related to risk and return or in other words Recoverability and Remuneration. Risk in terms of whether the money lent by the bank will be repaid: a) On due date; b) Before due date if require by the bank; c) In the event of default through realization of security Return will be in terms of interest. However, the interest rate is arrived at based on the required yield for a given transaction of loan. Loan pricing is dependent upon: 1) The risk reward ratio 2) The cost of administration and overheads. 3) Reserve asset costs 4) Capital adequacy.
Credit Policies By Banks Through the above factors have relevance in calculating yields, the yields is itself dependent upon the competitive pricing adopted by the bank. The basic premises of Bank lending have been stated in terms of three considerations, as above namely Resources, Risk and Return. However, these premises require elaborate understanding, as we would explore in the following sections.
Managing Credit To Meet Capital Adequacy Ratio

Banks are required to maintain minimum capital fund ranging from 8% to 10% of its total Risk Weighted Assets. The risk weights in regard to advances are given in Annexure1. While 8% is the minimum requirement, each bank however, would plan to maintain it at higher level. The level of capital adequacy ratio would impact scope to the bank to increase its loan portfolio. A Rs.100 crores. The most cost effective sources of capital would be reserves generated out of profits. A Bank with the help of its quality loan portfolio must generate enough profits for plough back and thereby enhance its capacity to advances further. While developing a loan portfolio by the bank, attention must also paid to the various risk weight attached to types of loans and credit. The bank would prefer to have low risk weighted assets as against high risk weighted ones. This strategy would enable the bank to build higher asset portfolio while remaining within the capital adequacy norm. Earlier deposit and refinance resources were the determinants of the lending capacity of banks. Recovery of loans, loan losses. Capital adequacy requirement were not considered as factors affecting credit creation capacity of the Bank. However, the latter factors have become dominate in the nineties in the credit planning of Banks. The capital fund growth by far depends upon internal generation of funds, which are in turn affected adversely by loan losses. Banks capacity to expand credit and also bear the impact of loan losses is directly dependent upon the adequate capital base. Banks performance in terms of profitability and liquidity depends to a large extent upon performance of advances portfolio in terms of yield and recovery. Liquidity Management: Liquidity Management means that bank has enough cash or other liquid resources to meet the obligations to the depositors as end when they arise.
Credit Policies By Banks Liquidity management to a large extent depends upon the efficient management of lending portfolio besides of course management of other assets and liabilities such as cash, investments, deposits and borrowings, capital, contingent liabilities, etc. The subject of Assets Liability Management (ALM) is of recent origin in India. In the competitive market situation business planning in the form of ALM acquires crucial importance. In order to harmonies and achieve the three contradicting goals of profitability, risk and liquidity, the banks have to evolve policies and strategies best suited to the circumstance in which they are placed. Besides the credit risk, the balance sheet risk in the nature of maturity-mismatch rises. Interest rate risk, particularly, when rates float freely and also the liquidity risk needs to be limited in the course of transacting banking business. The management of banks creditworthiness (portfolio management) will attempt to balance the twin needs of liquidity and return, which are inversely related. The quantum of loan losses cannot exceeds the amount of equity capital as any such higher losses may lead to liquidity problems for the bank. The bank must seek, to maintain the confidence of the depositors. For that, maturity transformation and risk transformation of its credit portfolio is essential.
Managing Risk In Lending

Safety of Banks advances is a dominant principle of Bank Management. Hence managing risk in lending becomes very important. Managing credit risk in Banks require the ability to perform a number of key functions. One can broadly divide the Risk Management of credit portfolio into: 1. Customer perspective 2. Financial perspective 3. Internal business processes 4. Organizational learning and personnel aspects. Credit risk is made up of transaction risk and portfolio risk. The primary danger in granting credit is the probability that the borrower will not repay the loan. This uncertainty is known as credit or default risk. The portfolio risk comprises of intrinsic risk and concentration risk. Intrinsic risk is inherent in certain types of lending, namely credit card etc. The concentration risk is on account of disproportionate concentration of loans to specific industrial, sectors regions or types. Lenders also take on interest rate and liquidity risk. Interest rate arises due to volatility in interest rate, which affects the loan yield of the Bank. Liquidity risk arises from loan losses or untimely repayment by the borrowers. The credit risk of a banks portfolio can be studies in two sets of factors-external and internal. The external factors are the states of economy, natural calamities, nationwide strike, change in Government Policy, business cycles, sector/industry recession, etc. The internal factors can be such as loan policy, high propensity to assume risk, high credit deposit ratio, loan mix, lax procedures, and unsound strategies of lending and inexperienced loan officers. 8
Other factors such as quality of information about the customer, his character, level and stability of cash flows, real networth, collaterals, etc., also have a bearing on credit risk. The loan risk management process may be dividend into four parts: 1. 2. 3. 4. Risk rating Risk pricing Risk monitoring And portfolio management.
Risk Rating: Risk rating or credit risk analysis is essentially default risk analysis. It shows the extent of credit worthiness of the borrower. It helps to price the loan and also to set nonprice terms and make distinction between good and bad borrowers. 4 Cs lending namely Character, Capacity, Capital and collateral assesses credit worthiness in traditional approach. The modern system of credit rating is through analysis of financial and non-financial factors relating to the business of the borrowers. They are namely: 1. Business analysis consisting of industry analysis and firms position analysis regarding operating efficiency and marketing potential. 2. Financial Analysis consisting of accounting quality earning protection, adequacy of cash flows and financial flexibility such as alternate sources of funding. 3. Management Evaluation consisting of track record of management. 4. Regulatory and competitive environment-structural and regulatory framework influencing credit deployment. 5. Fundamental analysis comprising of capital adequacy, assets quality, liquidity, profitability and interest and tax sensitivity.
Credit Policies By Banks Credit Rating of individual borrowers can also be worked out on the basis of simple credit scoring models which most of the banks have evolved. Risk Pricing: Pricing is generally done taking into account the credit risk. Return should be commensurate with the risk. In general risk pricing takes two forms, Comparison pricing and Intrinsic value pricing.
Comparison Pricing Comparison pricing is the market pricing a credit with an identical risk rating and with similar terms. The prime lending rates announced by most of the banks in India is typical of comparison pricing. In the present deregulated interest rate scenario, and surplus liquidity with Commercial Banks, the competitive pricing of credit has gained currency. This is all the more evident in the case of highly rated companies. Earlier, in administered interest rate structure, this competitive pressure in pricing was practically absent. Further problem of pricing based on risk levels, cost of overheads and capital adequacy unrelated to market situation is also a reason why comparison pricing is resorted by the Bank. Intrinsic Value Pricing: Under the intrinsic value pricing, the lender calculates the risk cost and other cost of the prospective loan such as cost of fund, loan servicing and non-current expenses and then sets an interest rate that in effect, achieves an appropriate mark up over cost. The risk cost
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Credit Policies By Banks generally comprises premia for default, portfolio, maturity, collateral risk, and for capital adequacy requirement. Indeed Intrinsic Value Pricing would require a moderately sophisticated computer programmes to be able to specify a required yield for any given transaction based on various risk and cost inputs. Further the pricing model can also consider time value of money and working out various combination of either charging margins over cost of funds, along with commitment fees, front-end fees and other fees. Unfortunately it is not easy to consider all these aspects in pricing and yet be market driven. Risk Monitoring: Once the loan is granted it is necessary to review the credit worthiness of the borrower periodically. The credit review process should be conducted once or twice a year for at least major borrowers. In case the Bank use the credit-scoring model, the credit review staff should enter the quarterly financial data of the borrower to update the creditscoring model. Early warning signals in the area of finance, management, operation and banking transaction can be noticed through periodical review. Portfolio Composition Management: Normally banks have prudential limit to restrict the exposure to one single firm or to the group to which the firm belong. Bank may also stipulated industry-wise, region wise and product-wise exposure limits. The credit risk surveillance system in any bank must continuously evaluate the risk exposure of the bank and should suggest portfolio composition. A committee comprising of top executive with Chief Executive Officer as its chairman must periodically review the risk management system in the Bank.
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Information Technology And Credit Management

Absorption of technology in banking is required to manage risk and to facilitate credit decision. Technology is not merely a tool to reduce monitoring of transaction processing, but a strategic weapon to strengthen the bottom-line. The development of the comprehensive risk management system presupposes the existence of a strong credit information system. Information is required for: a) Risk identification b) Risk measurement and c) Monitoring and control of risk Each of the facts of risk management requires a lot of quantitative and qualitative data. Further the four point assets classification namely standard, sub-standard, doubtful and loss assets and income recognition accounting standards require use of information technology to capture the data from million of loan accounts of a commercial bank and make it available as and when required for management decision. Various monitoring reports can be generated by the use of information technology. While Information Technology becomes important tool for risk management, it can be also widely used in the various other areas of credit management especially in the area of loan pricing, marketing of credit, audit, Management Information System relating to credit, etc. One of the key variables for the success of the Bank is the quality of lending portfolio. The quality of credit portfolio depends upon the quality of management which are represented by function such as identification of borrower, appraisal of credit proposal, credit delivery system, monitoring, early warning system, recovery and rehabilitation, etc. Computers can be used for efficiently handling this function. Computers can be also used to train credit officers. Credit management in future especially at controlling points will be heavily data based. In this context computers will have a leading role. In the area of credit decision-making, 12
Credit Policies By Banks computers can strengthen the management information system to provide critical information input to decision-making. Further one can develop computer based informationoriented tutorials; slide shows, decision support models, etc. Decision Support System (DSS) can support credit related activities like forecasting, planning, appraising, monitoring, rehabilitation, etc. A typical DSS model contains Data Base Management System (DBMS) Model Base Management System (MBMS) and Dialogue Generator Management System (DGMS). Computers can more specifically, be used in the following areas of Credit Management. 1. Follow-up and monitoring of Accounts 2. Credit appraisal and Review of Accounts 3. Credit Rating 4. Trigger Early Warning System 5. Monitoring Health Code of Advances Portfolio Further, computers can aid credit delivery system by speeding up, processing of credit proposals and decision-making.
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Marketing Of Credit- Lending Option And Strategies

Banking especially the lending operations of the banks are affected greatly by the financial sector reforms. The Banks are prospecting good borrowers as never before and the good borrowers have more option to borrow outside banking fold. They are also in position to influence terms of borrowing favorable to them. Major Corporates are sourcing funds from international capital market because of their better credit ratings than many of the banks. Thus they are able to raise money at a chapters rate not only from the domestic market but also from the international markets. Under the changing realities of the market situations banks have to evolve strategy and options to make their credit operations viable and at the same time serve the needs of the borrowing community. The banks will have to review the lending strategy to build up profitable advances portfolio by identifying Greenfield or Sunrise Industries and the same time taking their legitimate share of financing the infrastructure projects both in private and public sector. This would involve training the staff to achieve credit appraisal and monitoring proficiency to undertake new business. The quantitative dimension of financing can be viewed from plan documents giving the sectoral investment patterns. As regards qualitative dimensions of lending banks will have to quickly restructure their credit portfolio to avoid severe strain emerging out of the process of industrial and commercial restructuring. The process of disintermediation can be gauged from the ratio of bank borrowing to total borrowings of the large public limited companies, it went down from 47.4 per cent in 198081 to 33.0 per cent by 1989-90 and further to about 33 per cent in 1992-93. 14
Credit Policies By Banks In taking a view about likely direction of the transition of the lending portfolio of the Indian Commercial banks in the future, it is pertinent to take into consideration. 1. The direction of change in the funding mix and the related cost 2. The mix of assets portfolio particularly advances and its interest rate profiles. Banks as part of their lending strategy has to continue the allocative function for efficient and speedier economic development. Banks while lending have to also keep in view the function of maturity transformation and risk transfer. They have to reduce cost by concentrating on the economies of scale of operations. The approach towards future lending activities of the Bank is to at the short-term to come out of the bad loans in their balances sheets. There is overall slowdown in the credit take off in our country. This phenomenon is also experienced in similar way by even the advanced countries like U.S, U.K., Japan and France. Banks are faced with the problem of 9+weakening capital position, deterioration in loan quality and increasing charge-off rates. This is impairing the banks ability and willingness to lend. The bank has to develop institutional relationship between the corporate units instead of individual relationship. This would better serve the customer and the banks interest on sustained basis. Banks are giving more customer offering customized solution rather than ready-made solution. For this specialized branches, like Industrial Finance Branches, SSI branches, Hitech Agricultural branches, overseas branches, etc., are being created. The operational efficiency of the branches has to be constantly improved to subserve the market Demands.
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Credit Appraisal
INTRODUCTION: A Banker is a person who will lend you an umbrella when the sun is shinning and will want it back the when it starts to rain is often quoted by the customers who are unable to borrow on terms and at times they need. It is also complained that the banker lend money only to those who have no need for it, or that he will attempt to negotiate terms which his borrower will not accept or which are not sought by other banks bidding for the same business. In this section, we shall explore how a banker resolves the conflict of risk and return. We shall take a look at a framework for analyzing the credit worthiness of a customer and also structuring a credit proposal. WHY CREDIT APPERAISAL? Bank Vulnerability: Credit is crucial-Banks as financial intermediaries mobilize deposits for the purpose of investment and lending. The primary use to which banks put the funds received from the depositors is in lending to various categories of borrowers ranging from government undertakings to personal customers. The primary source of funds tends to be short-term or on demand deposits from a mix of customers. Deposits are of course, legally repayable in full to the depositors on their due dates, whether or not the bank is successful in investing the money received at a profit. Bank generally lens on demand or for fixed periods. The actual duration of loans vary from more then 1 year up to 3 years in the case of demand loans and term loans over 3 years to 5 years. In select cases it extends beyond 5 years to 7 or 10 years particularly in the case of project loans.
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A core role of a bank can therefore be seen as the conversion of short-term, risk-averse, money into committed investment for considerably longer periods. By doing so, it adds value to the raw materials of banking (deposits) and thereby seeks to make a profit. This creates two potential problems-liquidity and credit worthiness. Both require active management. The management of bank credit worthiness (Portfolio Management) will attempt to ensure that a bank does not expose itself to a risk of loss of money enough to endanger its ability to satisfy its obligations to its depositors. The illiquid or non-performing loans are a major threat to confidence that a bank must seek at all times from its depositors. The maintenance of confidence is often helped by implicit government-backed guarantees of repayment as in the case of public sector banks and deposit insurance. In this context, credit assessment is therefore a fundamental banking skill acquired partly by a study of the principles but, more importantly, by experience of putting those principles into action in the real world. What is Credit Assessment? Any exercise of credit assessment would involve examination and analysis of the following four characteristics: a) Repayment-the facility will be serviced and repaid when due. b) Remuneration-a reasonable return will be earned for the bank in the context of the risk assumed and the administration/management time required. c) Relationship-the relationship with the customer will be enhanced production opportunities for other banking business with him. d) The loaning portfolio leading to opportunities with other customers will enhance reputation-the banks reputation in the market. Of the four characteristics, the first must be regarded as the most important one. In the current market where spreads on banks funds are reducing it requires a large volume of
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Credit Policies By Banks successful landing business to overcome any major write-off. The primary focus therefore is how a facility will be repaid, what threats to successful repayment are there and how those may be mitigated. Devising answers to these simple questions can be a complex process. It involves not only, or even mainly, financial analysis but rather a combination of analysis, judgment and problem solving based on critically research and questioning. The process is not scientific albeit that it is not an intuitive. Essentials Of Credit Appraisal: Basically credit worthiness is assessed in the following context: 1. Industry Analysis 2. Company Analysis: Within the company analysis the following aspects are seen more closely to ascertain corporate credit worthiness; a) Management b) Financial Performance Information Source: Never be afraid to use all the sources of information available to you. These will include 1. The customer. You will not know many things until you ask the customer. 2. The customers competitors and other industry participants. However great care should be taken about the banks duty of confidentiality. 3. The clients bank account. 4. The bankers report 5. Introducers of the account 6. Annual Reports and Accounts plus interim statement
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Credit Policies By Banks 7. Financial press-Local press and business magazines-financial express, Economic Times, The Business Standards, Business India, Business Today, etc. 8. Association of Trade, Commerce and Industry. 9. Stock market reports. 10. Register of charges, valuation reports, etc. 11. Credit Rating agencies like CRISIL, CARE and ICRA and other specialist agencies 12. Lawyers and accountants for information on legal, tax and accounting issues. 13. Memorandum and Articles of Association, etc. Industry: You cannot judge the credit worthiness of a company unless you understand the business, the company is in and the opportunities and risk associated with it. The characteristics of an industry is examined in terms of: 1. The potential for growth 2. The cyclicality of performance 3. The strength of competition 4. Its typical needs for finance COMPANY: One should then go on to look at features, which determine a companys likely ability to survive and prosper in the context of the characteristics of that industry, those features being: 1. Market Share or Niche 3. Technological Position 4. Labour arrangements 5. Reliability of supply and demand
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Credit Policies By Banks These characterized partitioning to industry and company should be examined in detail. These are covered in the chapter on credit rating. There are, further important related consideration for determining corporate creditworthiness, which are as follows: Management: According to many annual reports, corporate managements are innocent victims of depressed market conditions, unprecedented interest rates or irresponsible competition. Yet in the final analyses management can, should and will be held fully responsible for the companys result. This is because at some point management all the basic decisions as to what business to be in chose competitive strategies and determined how the business should be financed. Successful companies are constantly rethinking these issues. Analysis of the credit worthiness of a company therefore would call for understanding of managements balance of experience, sensitively and responsiveness to change in its environment, together with its philosophy towards business and financial risk. This is derived from: a) Interaction with the companies management b) Study of annual reports. a) Interaction With The Corporate Management: Meeting key figures in the management structure both in business and social settings enables a banker to investigate the thought process, personalities and motives influencing the strategies which are being devised and implemented. These strategies will be crucial determinants of a businesses successes or failure in the future. Often effective interaction will be achieved by setting up relationships at several different levels. In addition, plans toward and the like enable the observant and experienced banker to judge morale and efficiency in the work place.
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Credit Policies By Banks The danger in this process is for a bank to become too close and thereby to lose the ability to make judgments about a company in a detached manner. This is why credit relationship is termed as an exercise of brinkmanship where you have to go nearer to the brink without falling. b) Study of Annual Reports: Outside this interaction it is possible to learn a significant amount about the quality of management from annual reports and accounts. Firstly, familiarize with the companys core activities by means of the industry analysis and then examine the accounting polices and notes for sings of either an overly cautious or creative accounting approach to presenting the results of the business. Secondly, analyses the track record in terms of profitability and cash flow. Compare it with the performance of the competitor. View the track record in the context of economic and market conditions. Make judgments on both the track record and managements role in achieving it. Identify the causes for improvement of profitability like higher sales of volume, greater productivity, new product, etc which can be contributed to the managerial ability from other causes like reduction in energy prices, prices of raw material or interest cause, etc. which may be due to external factors outside management control. Finally look at how the company presents and explains the track record. Are the successes advertised and failures ignored? Are promises and expectations fulfilled? Are explanations coherent? If after your findings, you have detailed discussions with the company, the true position of the company will be clear.
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Credit Policies By Banks Negative Features Affecting Credit Worthiness: During the interaction with the companys management and study of financial statement of the company, the credit analyst has to check the following dangers signals adversely effecting credit worthiness of the corporate management. 1. Whether the company has undertaken undue business risk or financial risk, aggressive dividend policy out of line with profit increases and cash flow generation mindless diversification into unrelated areas of activity, financed mainly by debt and the undertaking of a major project out of sale with the size of the company, the failure of which might endanger the business as a whole; 2. An aging management team, no obvious path of succession. Undue reliance on one figure, perhaps a founder chairman, chief executive or a team lacking adequate breadth of experience and expertise. 3. High management turnover, which may imply discoed in management team. 4. Low levels of new investment implying stagnation or loss of direction. 5. Possible failure to identify and tackle problems by adoption of new accounting principles or accounting-driven financing techniques to make the figure look better, For e.g.: restoring to sale and lease back transaction, factoring arrangements and operating lease deals, etc. Management Style: A credit analyst has to ascertain whether the management of the company is exercising any restraints or fostering entrepreneurship The restraints can be beneficial in keeping a company management focused on (hopefully long term) profitability and prosperity rather then glamour or empire building; there can also be stifling of enterprise and demoralizing. A market capitalizing, high or low compared to its net worth or price-earnings ratio, which is high, or low by the standards of its industrial sector can be a factor-influencing prospectus of rising of the capital from the market.
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Analyzing Financial Performance

A bankers reliance on financial accounts in making credit decision is considerable. The person analyzing the accounts may sometime lose sight of what he is trying to achieve or the context in which the numbers are pretends. Financial statements are a key tool in assessing the ability to service and to pay the debt. They also indicate the soundness of company to take care of adverse situations. In case the company is not in a position of discharge its obligations from current cash flow on the principle of a going concern, whether it will be made to honor its debt obligations from sale of assets and investments. Financial performance of the company should be viewed in the following perspectives: 1. The result should be appreciated in the context of the importance of the industry the economy. 2. Implications to the lender because of the corporate structure with limited liability of shareholder. The way of group companies are structured can have impact on the quality and priority of recourse to the cash flows and cash flow generating assets of the group. 3. The need to be familiar with the rules and conventions of the language of accounting and appreciate the strengths and limitations of accounts in presenting the true health of the business. 4. The need to remember that accounts are historic and out-off date. They are useful to us only in acting as a guide for the further; we therefore need to focus on trends over the years and, where possible, on management projections. in
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Credit Policies By Banks 5. The need to recognize that, not with standings good historic results, the companies ability to prosper in the future will be largely determined by the quality of management in shaping events and responding to challenges pretends by the industrial environment. Financial analysis is thus important but not all embracing. It requires both an appreciation of its purpose and knowledge of its limitations. It is not synonymous with, nevertheless a key part of credit assessment. Against this background, we shall examine how to extract the necessary information from accounts in terms of: 1. Profitability: The measure of business performance to be analyzed both in terms of quantity of earnings and the quality or reliability of those earnings. 2. Cash Flow: The measure of the business ability to convert reported profits to cash available both to finance business operations and growth of business and also to service organizations to creditors and shareholders. 3. Capital: The measure of the protection available to creditors in the value of business assets should operating performance be disappointing. 4. Liquidity: The measure of the availability to the business ready sources of cash including unutilized source of finance to satisfy short-term obligations.
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Credit Policies By Banks A bank can on the bases of the assessment, assign internally a risk rating has a readily understood indication of the attractiveness of the credit proposal. The topic of the credit is discussed in a separate unit.
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Structuring A Credit Proposal

An analysis of credit worthiness needs to be supplemented by a detailed examination of the terms of the exposure to be assumed by the bank. The following of are the key issues to be discussed in the proposal: 1. Purpose: The purpose of the financing sets the main parameters for designing the credit structure, because it affects the safety of repayment and earnings from the business. The proposal should be bankable. The following points are generally seen in the proposal. a) Compliance of bank internal policy (for e.g. financing for preferred sectors and sunrise industries). b) The commercial and economic logic of the purpose to be finance c) The ability and experience of the management to handle the proposed venture; d) Compliance with banks legal requirements e) Legal complications arising from the purpose of the financing which may impair the credit worthiness of the advance 2. Amount: Is it adequate for the purpose? A bank that lends inadequately not caring how the balance requirement will be funded may create problem for itself as well as the customer. 3. Margin Contribution: In project lending secured by fixe3d asset a cash contribution from the company itself acts as evidence of commitment and cushion to the lenders against failure of the project or failure of the secrete asset to generate repayment. In unsecured transactions the focus shifts to the financing mix of debt and equity. 26
Credit Policies By Banks 4. Portfolio Consideration: Bank proposed exposure to the relevant corporate group, industry, 5. Credit Risk and Term: Banks will wish to limit their exposure to individual high risk and long-term advances more tightly then to lower risk and short-term advances. 6. Yield: Increasingly banks are concerned to maximize yield from the use of their balance sheet and the amount lent can be a significant determinant of the overall return from the deal. 7. Legal consideration:
Whether the company has borrowing powers to borrow the amount and the bank to lend it. 8. Repayment: The key issue is how the bank is to be repaid and what is the margin of error if operations deteriorate. The following factors will be looked into in this regard: a) The type of repayment source b) The quality of repayment source c) The currency of income from the repayment source d) Cash Flow protection (i.e. the margin of error); e) Financial flexibility (i.e. alternative sources of cash to cover shortages); f) Asset Protection to cover the bank if cash flow is inadequate; g) The need for good documentation.
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Credit Policies By Banks 9. Security and quasi-security: Security whether main or collateral in the bankers protection against non-payment from the primary repayment source-it is the insurance against failure and take the form of a legally in forcible claim on tangible assets or a third party guarantee. Quasi-security attempts to fulfill the same role either indirectly or by means of morale not a legal claim. Such additional protection is not necessary in all cases. Unsecured transactions are quite acceptable where cash flow protection is generous and reliable and adequate asset cover is available through the resources available for the general creditors of the company. 10. Control and Monitoring: The ability to take control of lending situation before a deterioration in the borrowers condition becomes terminal is crucial. It is achieved by insertion in the documentation of provisions, which if breached, will enable the switch over from term faculty to one immediately repayable on demand. 11. Designing Credit Facilities: Designing the details of credit facilities within the broad parameters of benefits to the borrower and protection and remuneration for the bank broadly involves: a) Fixing up Cash Credit and Working Capital Demand Loans Limit. b) Bill purchase and/or discounting facilities c) Term loan/deferred payment facilities d) Contingent liabilities limits for L/Cs and guarantees. 12. Pricing: Pricing is a very important aspect of lending especially in a competitive environment for achieving satisfactory remuneration for the bank. It will consider: a) The risk-reward ratio. b) The cost of administration and overheads. c) Capital adequsi costs and cost of statutory reserves and
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Credit Policies By Banks d) The need to optimize yields on advances 13. Conclusion on Structuring a Proposal: At first sight, preparation of a proposal may appear to involve a formidable list of considerations. In any situation, however, not all of the issues will require detailed considerations. It is the cases, which involve: a) Previously unknown customers b) Marginal propositions c) Complex commercial or legal issues, which will absorb the greatest time and effort. Efficient credit assessment and credit facilities structure will require to apply judgment and common sense. The following fundamental question if addressed will lead to proper conclusion. 1. If I lend this money, how and when will I be repaid? 2. What can go wrong and what protections do I have if it does? 3. What advantages are in the advances for the bank and how can they be safely maximized? This focus should prevent any tendency to go off unproductively at a tangent. Some of the tips for making credit decisions in the form of summarization of credit principles are given in the.
The 5cs Of Credit Appraisal Populrly Known Are

1. CHARACTER (good citizen) 2. CAPACITY (cash flow) 3. CAPITAL (wealth) 4. COLLATERAL (security) 5. CONDITIONS (economic, especially downside vulnerability)
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Credit Policies By Banks The bankers problem is to attempt to quantify these 5Cs, so that meaningful and consistent decision can be made regarding borrowers, creditworthiness. This procedure is known as Credit Analyses. Its purpose is to determine a borrowers credit risk. How do you make credit decisions? You can never known everything about a borrower, but even if you could, their would still be unknown since repayment of loans depend on what will happen in the future, not what has happened in the past. Credit Decisions are a Metter of personal judgment taken within the context of lending organizations overall policy towards the balance between profitability and liquidity. Liquidity will decrease as loans become longer term and more risky in character, but at the same time, profitability should increase as liquidity decreases. All lending officers must be aware of what is or is not an acceptable degree of risk for there institutions. Remember that no loan is a free of risk, and no bank would be able to continue in business if it never made risky loan. Offcourse at the time of the decisions if you decide not to approve a loan, be sure that the reasons are clear in your mind. Following are some of the point to be kept in view while making credit decisions: 1. Quality of credit is more important than exploiting new opportunities. Put simply by a wise old banker, Any fool can lend money, but it takes a lot of skill to get it back. Banks are not in the business of providing risk capital, because to do so they would have to pay depositors much higher rates to compensate for potential losses of their deposits. Remember that the bulk of the banks resources are short-term deposits from people who trust the bank to keep their money safe. This kind of money is not the banks for risky lending or even for equity type investment. In analyzing the degree of risk which a bank will assume in credit,
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Credit Policies By Banks careful consideration should be given to borrowers management experiences, capabilities, policies, profitabilitys, cash flow, and net wroth. As lending officers, you must decide your self how much money the borrower should borrow, how long it will take before repayment, and the true purpose of the loan. 2. Every loan should three ways out that are not related and exists from the beginning. Obviously, the first way out will be successful completion of the transition-for example, the sale of goods whose purchase has been financed by the bank. In a term loan, it will be the successful achievement of cash flows sufficient to repay the bank from the companys operations. The second way, in the event of failure of the project, will be action by the borrower in realizing from the liquidation if his assets and the third way is drawing on his resources, which would include raising debt by other means of financing. Lenders sometimes require borrowers to accept unrealistic constraints so that the loan does not break any of the lenders normal rules. If you need to do this in order to feel comfortable, you should question weather to make the loan at all. 3. The character of the borrower-or in the case of corporations, the principle management and shareholders-must be free of any doubt as to their integrity. If you have any questions as to the integrity, or honesty, or good intentions of the borrower, you should not approve the loan. You must, therefore, check on the moral standing and style of business before beginning negotiations. 4. If you do not understand the business, do not lend to it. Successful banks take pains to understand the market sectors in which they engage. After all, if you do not understand the industry or the sector, how can you evaluate the risks? 5. It is your decision, and you must fell comfortable with it according to your own judgment. Credit decisions are personal. They cannot be made solely on the basis of
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Credit Policies By Banks guidelines or analytic techniques. Each lending officer must exercise common sense and good judgment. You must also be sure that it is your own independent judgment on each transition and that you are not unduly influenced by your associates. However, nevertheless formalized analyses do take place to arrive at the decision. 6. The purpose of a loan should contain basis of its repayment. Short-term finance is typically oh seasonal nature cover seasonal asset expiation where repayment arises from subsequent assets contraction. Loans to fund other assets of a non-current nature carry greater risk. For both lender and borrower, it is desirable to have a realistically defined program of repayment agreed on in writing at the time the loan is made. 7. If you have all the facts, you do not need to be a genius to make the right decision. It pays to know. The more questions you ask, the more you understand the case. Also, the more respect you will gain in the end from borrowers who prefer to deal with a lender who understand their industry. Facts are helpful and if properly organized, will often make the decision easy. 8. The business cycle is inevitable. As lender, you must always be conscious of the current point in the business cycle so that you can evaluate the risks likely to arise with economic conditions change in the future. It has been well said that bad loans are made in good times. Similarly, lending becomes more apparently dangerous in very bad economic condition. In, fact banks that lend in bad times will, provided they have made a wise credit decision, gain permanent friends. 9. Although it is harder than evaluating financial statements, assessing a companys management quality it vital. There are, of course, many in which it shows: Do senior executives have a flamboyant life-style? Are employees encouraged to own part of the company? What are the feelings of fort line management? Asking questions of others in the industry will also help you assess a companys management quality.
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Credit Policies By Banks 10. Collateral security is not a substitute for payment. 11. Where security is taken, a professional and impartial view of its value and marketability must be obtained. Repayment, as said before, comes from realization of security. Security is taken partly to prevent these assets from being available to other lenders and partly to place the lender is a stronger negotiating position because the assets are usually necessary to operate a business. Security should be value correctly. You must also be conscious of differences in the market value, liquidation value and forced sale value. Such difference can sometimes be recognizing by insisting on margins. 12. Lending to smaller borrowers is riskier than lending to larger once. Although the same credit principles apply to small firms as to large once. In a small firm managerial resource are fewer. In a small firm managerial resource are fewer. In a large firm, there can be many decisions makers, all there running their own division or subsidiaries. In this way, there can be more jobs for good managers- and thus greater depth of management than in a small firm, where there is greater dependence of the chief executive and his or her immediate subordinates. 13. Do not let poor attention to detail and credit administration spoil and otherwise sound loan. A high proportion of write-offs are associated with sloppy administration or documentation. Never assume that loan agreements will not be relied upon. As rate has it, it is just those that are prepared in a hurry that are most likely to be tasted in court. 14. Local banks should be participants in lending to local borrowers. It is often a danger sign if local banks are not lender to local firm. They may already know too much about the risk of such a credit. In the same way, be cautious with those who seek to change to a new bank because they are dissatisfied with their present bank. New accounts, it has been said, go bad more often than old once.
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Credit Policies By Banks 15. If a borrower wants a quick answer, it is NO. Any one who rushes you in to in lending decision should be told this principle. On the other hand, it pays to be prepared for requests from borrowers. Indeed, the best approach is to be sure that officers seeking new business check out their target companys with their superior officers before visiting the companies. 16. If the loan is guaranteed be sure that the guarantors interest is served as well as the borrowers. When a guarantor sings a guarantee and you are likely to have to depend on the guarantor for repayment, you should be very careful. You must also see to it that the guarantor knows his or her obligations. Guarantor should not sing if they are not in principal willing to lend the money to the brrower themselves, since they one day in effect have to do just that. 17. See where the banks money is going to be spent. If you do not visit the company, you will not get a feel for the atmosphere, corporate style, and other intangible effects. It often pays, especially with smaller companies, to check out what the management tells you. 18. Think first for the bank. Risk increases when the credit principles are violated. Good judgment, experience, and common sense are the marks of the good banker. The principles set out here are not perfect but are broken at your peril. If in doubt, ask yourself: Would I lend my own money?
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CREDIT RATING
Introduction: The rating of public or private issue of debt instruments has acquired an established feature of the growing debt market in India. Investors have come to rely heavily on the independent commercial rating agencies to establish an assessment of the creditworthiness of the borrowers. The rating agencies continually assess the credit quality of the borrowers through financial and market information. This chapter would provide insights into the methodology followed by the rating agencies to establish credit worthiness of their customers. This perception would sharpen the credit assessment skills of the lending banker. Already bankers are using the rating models evolved by them for pricing their loans. With the gaining of experience suitable models can be evolved for credit decision making and monitoring of advances in the near future. Credit Rating Explained: Credit rating for Industrial Securities first originated in the United States of America. In recent years this services is available in India with the establishment of credit rating agencies like CRISIL, ICRA, CARE. Rating is an assessment of the credit-worthiness of an obligor with respect to specific obligation. A corporate credit rating provides lenders with a simple system of grading the capacities of the Companies to make timely repayment of interest and principal on a particular type of debt. The higher the credit rating, the greater the likelihood that the borrowers will fulfill his obligation to repay the principal and interest in time. The National Bureau of Economic Research undertook an exhaustive study of investor experience with corporate bonds sold during 1900-43 period. Though the study can be said to be an outdated one, yet the result may be far-reaching and indicative of future trends. The
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Credit Policies By Banks study showed the percentage of bonds in each category at the time of offering which subsequently defaulted. Rating Category (Composite rating of various agencies) 1 2 3 4 5.9 Default Rates (Percentage of par values) 6 6 13 19 42
Thus, during the more than 40 years covered, including the greatest depression in the economic history, only 6% of par value of bonds originally rated in the top two categories subsequently defaulted, twice as high a percentage of third category of bonds defaulted, and three times as high a percentage of fourth category bonds. Over 40% of the bonds classified as speculative subsequently defaulted. Ratings are general and not absolute standard of quality. Rating corporate bonds is an art and not a since and never will be a precise science. The rating provides the investment community with up-to-date records of their opinion on the quality of most large, publicly held corporate and governmental bond issues. The rating agency judges the securities on both an absolute and relative basis. Ratings are of value only as long as they are credible. Credibility arises primarily from objectivity, which result from being independent of the issuers business. Thus rating to sum up: 1. Performs isolated function of credit risk assessment. 2. Reflects borrowers accountability, expected capability and inclination to pay interest and principal on a timely manner. a) It is an issue specific evaluation
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Credit Policies By Banks b) It is useful in differentiating credit quality. However a rating does not: 1. Recommend to purchase, sell or hold a particular security. 2. State both that the agency has performed an extensive audit of the issuing company nor that it attests to the authenticity of the information provided by the issuer and upon which the rating is based. 3. Further give a general-purpose evaluation of the issuing organisation. For example an issuer with an AA rating on particular obligation is not necessarily better than an issuer with a BB rating. 4. Create a fiduciary relationship between the rating agency and the users of the rating. 5. Give a one-time assessment of credit worthiness, which can be regarded valid over the entire future life of the security.
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Objectives And Benefits Of Credit Rating
1. Superior Information: Credit Rating by an independent professional rating firm offers a more reliable source of information on credit-worthiness of the obligor for three inter-related reasons. a) An independent rating unlike brokers and underwriters, who have vested interest in an issue, is likely to provide an unbiased opinion. b) Owing to its professional resources, a rating firm has greater ability to assess risk and c) A rating firm has access to lot of information, which may not be publicly available. 2. Low Cost Information: Rating firm analysis complex information and present it in a very cost-effective arrangement and readily understood format. 3. Simplify decision-making process: Credit rating will help simplify the decision making process for the investor. Investors will be told the risk levels in order to take investment decision. 4. Formulation of guidelines for institutional investment: The institutional investor can formulate their investment policy based on the ratings.
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Credit Policies By Banks Credit Rating System of a Leading Bank of in India For pricing of loan and for creating an incentive for companies to improve their financial management to reduce the interest costs, a leading Indian Bank has worked out a scoring system which has a range upto 30 points. Six parameters are considered and the maximum score for each is five points. The parameters are: a) Current ratio b) Debt-equity ratio c) Companies with inventory norms set by RBI d) Submission of data under the Quarterly Information System (QIS) e) Repayment of term loan installments f) Companies with other terms and condition like dividend, covenants, etc. Companies which get an aggregate of 27 points or more on this scale are designated A plus in the credit rating and are eligible to get credit at the minimum interest rate of 16%. Companies with the credit rating of A 16.5%, B plus 17% and those with a lower score 17.5%. For leasing companies, which get a rating of AAA from CRISIL, will be eligible for credit from the Bank at 16%. At the other end of the scale the bank may charge a rate of 18% for support to low priority activities like construction of hotels, cinema houses, etc. Another leading nationalized bank has evolved a two-tier model for credit rating of their borrowers used mainly for pricing their credit facilities.
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RATING METHODOLOGY
Any debt obligation and the issuer is evaluated on the basis of: 1. Business Risk Analysis 2. Financial Risk Analysis In each of these groups there are total ten criteria under which various factors are grouped which are as follows: Business Risk Analysis: 1. Industry Risk 2. Market position of the Company 3. Operating efficiency of the Company 4. Management evaluation Financial Risk Analysis: 5. Earnings Protection 6. Leverage and assets protection 7. Cash flow adequacy 8. Financial Flexibility 9. Accounting quality 10. Indenture Briefly we will study each of these criteria categories and see what are the factors taken into accounts in each one of these.
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Business Risk Analysis:

1. Industry Risk Industry risk is defined as the strength of the industry within the economy and also viewed in the context of economic trends. The various factors that are assessed in this category include: 1. Is the industry in a growth, stable or declining phase? 2. Is the business cycle independent of the economy or it moves with the economy in general? Does it lead or lag economic trends or does it have contra cyclical tendencies? 3. What is the natural of competition? Is it regional, national or international? Is the competition based on price, quality of product, distribution capabilities, image or some other factor? The basis for competition determines which factors should be analysed for a given company? 4. What is the natural of government regulation and policies with respect to a particular industry? It can be an encouraging or discouraging factor for industrys growth. 5. Labour situation in the industry. Is the industry unionised? If so, are labour contracts negotiated on an industry-wise basis? What is the negotiating history? What are the vulnerabilities to strikes or other labour unrests in related industry? 6. Other factors such as-Does the industry has good control of key raw material, or is there a dependence pressure or energy related problems? 7. To what extent the industry is fixed capital or working capital intensive? Does the industry require a heavy investment in fixed plant and equipment in order to generate sales or is the emphasis primarily on receivable and inventories? The answer to this question would provide basic financial characteristics of an industry. 8. Ease of entry or exit. 9. Companys ability to manage diverse operations is an indicator of business risk as some companies have adopted a portfolio approach to offset business risk by diversifying into various business activities.
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Credit Policies By Banks Industry risk assessment will enable one in setting an upper limit on the rating of an unit within a particular industry considering the overall industry risk. 2. Market position of the company The rating company would evaluate a companys sales position in terms of: Competitive position taking into account market share of the company, marketing, distribution, strengths and weaknesses, diversity of products and customer base. The demand for its products should be determined over time to measure the market for the product. While estimating the demand, product obsolescence and quality, marketing support service organization and long term sales contracts-order backlog, etc. will have to be taken into account. 3. Operating efficiency of the company This is assessed from the operating margins of the company and its ability to maintain or improve them based upon pricing or cost advantages. In those units in which production efficiency is a critical factor, the rating agency tries to determine whether a company is a low cost producer, whether its facilities are more or loss advanced than average units and whether it is more or less vertically integrated than competitors. The other factors considered are labour productivity, cost effectiveness of plant & equipment, technology, energy efficiency, pollution control facilities, etc. 4. Management Evaluation: Management is assessed for its role in determining operational success and also for its risk tolerance. A companys earning performance, financial structure and business mix are a function of management. Management also largely determines a companys future. Evaluation of management emphasiss past performance, fulfillment of earlier plans and
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Credit Policies By Banks debt usage policies. It is also concern with the philosophy, experience, maturity, capability and depth of management. Many other factors that are assessed in this category include: 1. What is the managements goals and philosophy? 2. How successful has the management been in implementing and accomplishing past plans? 5. Management Credibility: Financial strategies followed by the Management and Management Control. The negative considered in Management evaluations are: 1. Significant reliance on an individual chief executive who may be close to retirement. 2. Finance function not receiving high organisation recognition. 3. Non-transition of management from family bond to professionals. 4. Unclear relationship between organisational structure and management strategy.
Financial Risk Analysis:

1. Earning protection can be viewed from: 1. Profit potential angle 2. Break-even analysis The most significant measure of profitability is: 1. Return on capital (pre-tax) 2. Profit margin
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Credit Policies By Banks Finally, the aim is to find out the sources of future earnings growth. A firm without clear direction for earning growth is considered weak. 2. Financial Leverage and Asset Protection: Financial leverage is the extent to which a firm uses someone elses fund to finance its business. The ratios that indicate the degree of leverage are: 1. Long-term debt/total capitalisation 2. Total debt (long-term + short term)/Total capitalisation 3. Total debt + off balance sheet liability/total capitalisation + off balance sheet liability The concept of asset protection refers to measurement of the relative amount of equity supporting the assets base, but in this context the term asset protection is used to indicate relative amount of asset base to support the outstanding debt. Here the focus tends more towards viewing the company on a liquidating basis. The asset protection and leverage is inter-related in as much as the more asset protection, the more leverage that can be used, but at the same time, asset protection is not the only determinants of how much leverage can be used. While measuring asset protection, the rating agency do not make any attempt to restate asset to their market value but it looks for assets that may be significantly under valued or over valued. 3. Cash flow adequacy: Earnings may be the best long-term determinant of credit worthiness. However when an interest or principal payment date arrives, earnings are not what matters. The obligation cannot be serviced out of earnings, which is just an accounting concept. The payment has to be made on cash. Analysis of cash flow can reveal of debt-servicing capability and ability of cash flow to meet other business cash needs of the firm.
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The principal ratio computed is the debt service coverage ratio (DSCR) 4. Financial Flexibility: Financial flexibility is an evaluation of a companys financing needs, plans and alternatives and its flexibility to accomplish is financing program under adverse condition without damaging credit worthiness. Following are the main points to be considered to judge the financial flexibility: 1. Variability of future cash flows and flexibility in capital spending program. Generally variable cash flows and inflexible capital needs are viewed as negative. 2. Debt maturity schedule. The longer the debt maturity, the more flexibility the firm has. Reliance on short-term debt for long-term needs may cause financial distress to the firm in times of economic downswing. 5. Accounting quality: Review of accounting quality is designed to determine whether financial statements can be relied upon for performance evaluation of the Company. As the rating process is very much of comparisons, it is important to have a common frame of reference. The various aspects reviewed in this category would include. 1. Auditors qualification 2. Method of income recognition 3. Inventory valuation policies 4. Depreciation policies 5. Interconnection with subsidiaries 6. Under valuation/over valuation of fixed assets 7. Off-balance sheet liabilities, etc.
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6. Indenture: Covenants in the indenture and the remedies provided for non-compliance is generally looked into by the rating agency. The following conditions are generally considered. 1. Whether the provisions of the indenture deviate from standard practice? 2. Whether the indenture allow the company to issue other bonds with equal or greater claim on the assets of the company. 3. Whether creation of sinking fund for redemption of principal is stipulated 4. Are the bonds senior or subordinate to other bonds? 5. Is the indenture too restrictive in term of payment of dividends, further borrowings, etc? Role of subjective Judgment: Bond rating or general credit rating is a complex business. It is note number game alone. It is a comprehensive analysis of the position of a company in whatever industry it is. Availability and the nature of information required: Besides the subjective judgment, which is the prime consideration, the quantum, availability and the nature of information that is required in the exercise of rating is also important in the rating exercise. Addition of other variables: In addition to the factor already discussed which have a bearing on the rating of the firm, the following other variables will have to be also considered.
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Credit Policies By Banks A. Indirect Taxation System Today one of the major components of product cost is indirect tax like excise and sales tax. It is also the most volatile since it is subject to frequent changes by the Government. B. The Exim Ratio: This will indicate the dependence of a company on export sales and imported raw material. The ratio of raw material to sales will indicate the critically of international price movements as also currency rates. An appreciation of Japanese Yen almost wiped out the margin of TV and LCV manufacturers, both of whom were heavily dependent on imported raw material. C. Comparative costs: With the government liberalising imports of equipment, raw material and technology, it has become essential to compare domestic costs with international costs. A comparison of domestic cost with landed costs of imported substitutes will quantify the threat to domestic firms from foreign firms. D. Bandwagon Riders: There is usually a path-breaking venture that does well and once it catches the public eye, hordes of industrialists jump on the bandwagon. In the recent past such industries have been HDPE woven sacks, EPABX system, ceramic tiles and Soya products. After an initial phase of high profit, substantial over-capacity develops and many units turn sick. This factor of bandwagon industry should be properly taken into account.
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DOCUMETATION: INTRODUCTION: Bank lending depends upon the legal enforceability of its claims against the borrower. Documentation forms an important basis for enforcement of such claims. Documentation therefore needs to be understood as an integral part of bank lending. The baker is required to know the legal principles involved in obtaining the documents and keeps it subsisting and legally valid for enforcement. Over period of time bank documentation has been more or less standardized except in the case of syndicate or other type of special funding. The banks have evolved procedures and practices, which have stood the legal test. The aim of this chapter is to introduce the essential operational features of documentation. The readers are however, expected to know the various laws having bearing on documentation, such as a contact act, the sale of goods act, the mortgages act, the negotiable instrument act, the law of registration act, the companies act, the limitations act, and host of other acts. For this purpose readers are advised to supplement the reading form the materials for detailed account of documentation. DOCUMETATION: Documentations means obtaining and execution of documents in proper form in accordance with the requirements of law. The evidence Act in section 3 defines a document in these words. Document means any matter expressed or described upon any substance by means of letter, figures or marks, or by more than one of those means, intended to be used for the purpose of recording that matter.
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Credit Policies By Banks Section 3 of the Act also defines evidence and documentary evidence as below: Evidence means and includes a) All statements which the court permits or requires to be made before it by witness, in relation to matters of fact under inquiry; such statements are called oral evidence; b) All documents produced for the inspection of the court; such documents are called documentary evidence. Section 61 of the Act states that the contents of the documents may prove either by primary or secondary evidence. Primary evidence means the document itself. However, with the phenomenal growth of telecommunication documents are being transmitted by electronic process such a Fax, Swift, electronic mail etc. Also with the help of computers and other electronic equipments document are stored on floppies, microfilm and other magnetic media. In such circumstance what constitute original documents for the purpose of primary evidence is a matter of question. Section 63 defines secondary evidence. Section 65 provides cases when secondary evidence is admissible. A few of the secondary evidence are certified or photocopies of the original, debit entries in the books of bank, etc. in the absence of properly executed documents, the onerous burden of proof will be on the banker. However, in the case of proper documentation, the burden of proof gets shifted to the defaulting borrower. Section 34 implies that although in terms of section 4 of the bankers book evidence Act, 1891, certified copies of the entries in the bankers books of account are admissible in evidence, though such copies or records by themselves cannot charge any person with liability. Additional and corroborative evidence has to be produced by the bank to enable it to prove its case.
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Credit Policies By Banks Execution of document means signing of document. The document must be properly executed as per the specimen signature recorded with the banker. Executions of the documents also include proper stamping and registration and complying with other formalities connected with it. Importance of Documentation: The following reasons may emphasis the importance of documentation. i. ii. iii. iv. v. vi. vii. Documentation helps to identify/specify the borrowers. It also helps to identify the security. It is required for the purpose of recording the transaction as written evidence. It is a means of evidence acceptable to a court of law. It is an evidence of creating a charge over the security. In case of negotiable instruments, documentation gives bankers a right of filing a summary suit. Documentation defines rights and obligations of the parties thereto.
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Credit Delivery System Introduction:Once the bank sanctions the proposal, the next important step is to disburse the loan to the customer. Here, the bank is called upon the decide the manner in which it will allow the customer to utilize the loan facility. While deciding on the appropriate credit delivery system the bank will take into account convenience, cost and competition into account. This chapter discusses about the various credit products matching the needs of the borrowers. It also discuss in detail the two board segments of the credit namely personal loan segment and the commercial segment, the method followed in assessment of and delivery of credit to these segment. In the process the major loan delivery system in the form of consortium, multiple and syndicated banking arrangements are discussed. Detailed accounts of working capital and term loan financing are also given.\
Form Of Advances: Banks make advances in the following forms: i) Overdrafts ii) Demand loans iii) Cash Credit iv) Term Loans v) Bills Purchases and Discounted i) Overdrafts: Bank grant overdraft facilities to individuals and commercial firms. The facility could be for a fixed duration usually for one year or it could be for a temporary period say three to
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Credit Policies By Banks six months. The facility is usually secured by readily realizable securities such as banks term deposits, quoted securities, etc. at times it is granted clean that is without any security for high worth borrowers. ii) Demand loan: This is an advance for a fixed amount repayable on demand. But generally the period of credit may extend from one year to three years. The facility can be repaid by regular installments like a term loan. However, unlike term loan this facility is secured by demand promissory note along with an installment letter from the borrower. In this type of advance no debits are raised further once the advance is fully disbursed. The credit in the account has the effect of parliamentary reducing the original advance. This type of advance can be granted to individuals as well as to business firms. This advance is usually secured by tangible assets. iii) Cash credit: This is the most common form of advance granted to business firms for meeting their capital needs. This advance is usually secured by hypothecation of stocks and or book debts of the firm. The account is freely operative. Both debits and credits in the account are freely allowed. The borrower enjoys drawing power calculated on the bases value of security charged in the account reduced by the stipulated margin, which generally varies from 25 to 50 per cent depending upon the nature of the security. The credit limit in the account is fixed at the time of sanction but the actual drawing is allowed as per the drawing limit. Banks generally stipulate commitment charges against non-utilization of limit under this advance. iv) Term Loans: Term loans are granted for fixed periods say for three to five years, which can further extend to 7 to 10 years in the case of project tied loans. The loans are generally granted for financing purchase of machinery, equipments or setting up of production facilities.
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Credit Policies By Banks This type of advances are generally secured by fixed or immovable assets while cash credit facility and demand loan facility is granted for working capital financing, the term loans are granted for financing capital expenditure of business firms. v) Bills purchase and discounted: Banks grant temporary accommodation say for 15 days to 90 days against trade transactions of his customers supported by relevant documents of trade bills. Bill purchase facilities are granted against demand bills, chques are promissory notes whether clean or documentary. In the case of bills discounting banks recover the discount or interest for the full period of usance in advance.
TYPES OF BORROWERS: Borrowers can be classified basically into two segments: Personal Loan Segment and Business Loan Segment. In each of these broad segments various loan schemes or the banks make facilities available. Based on the legal constitution of the borrowers we can have the following accounts: 1. Joint account holders 2. Partnership firms 3. Limited Companies 4. Clubs and Associations 5. Trustees 6. Receivers and Liquidators 7. Recognized Brokers 8. Non-Residents 9. Mercantile agents 10. Staff Members
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Credit Policies By Banks 11. Other Banks 12. Hindu Undivided Family It is important for the lending banker to know the legal constitution of the borrower to enter into a meaningful contract of lending. This will also give him the idea of resources he can have against the borrower and his assets for recovery of his dues. The constitution of the borrower will also help the banker to understand the credit worthiness namely the ability to pay and willingness to pay. Advances to the borrower can also be grouped based on the security charged in the accounts. They can be broadly divided into the following categories. a) Advance against pledge b) Advance against hypothecation c) Advance against mortgage d) Clean or unsecured advance
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Personal Loan Segment

A personal loan is granted for meeting the personal needs of the borrower- mostly for purchase of consumer durables and for meeting personal expenses. In this segment banks generally grant loan for acquiring white goods (such as freezers and washing machines) and brown goods (such as television and audio equipment). Finance is also granted for other purposes such as purchase of vehicles (two wheelers or four wheelers, furniture, cooking range, repairs renovation of houses, etc. All persons who are in service, business or profession are eligible for loans. Even partners or proprietors of firms are also eligible with personal guarantees of the other partners or the firm. One of the important segments of personal loans is loan against shares. Bank should take into account the purpose of such advance to ensure that the finance is not utilized for speculative purposes. The maximum limit per individual has been raised Rs. 10 lacs by RBI. However, shares pledged should be on the approved list of the bank. Banks do not generally finance against partly paid shares except in the case of registered stockbrokers. For advance above Rs. 5 lacs banks generally have the shares transferred in their name exception being to the accounts of stockbrokers. Under section 19(2) of the Banking Companies Act 1949, a bank cannot hold shares in any one company as a pledges or absolute owner for an amount exceeding 30% of the companys paid up capital or 30% of the companys paid up capital or 30% of the Banks paid up capital and reserves, whichever is less. Further, from banks point of view it is desirable to have shares in different companies well distributed in different lines of activities. Concentration of risk in shares of any one company should be avoided. Consumer credit is one of the major growth areas of modern day by retail banking. There are two types of credit granting decisions: i) Granting credit to new customers ii) Extending further credit to the existing customer
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Credit Policies By Banks The difference between the two is that in the second case one usually has extra information available- the repayment and other credit history of the borrower. Each bank follows its own procedure in deciding on the personal loan application. The emphasis is generally on questionnaire application form and personal interview. The process of credit decision can also be automated by the use of computer system where answers to various questions can be keyed in the customer or bank staff. In that case that bank should decided on: a) Setting up the credit scoring system b) Deciding which questions are the significant ones to ask c) Allocating scores to different answers d) Determining the level of score at which a loan is agreed/rejected. In the non-automated system, the credit decision is arrived at after evaluating the following factors- what is knows as CAMPARI lending considerations. They are briefly stated as follows: a) Character: Integrity and honesty b) Personal stability- age and health c) Connection d) Ability: e) Can the customer manage his financial affairs, personal resources., personal liabilities? f) Margin: g) Interest margin, amount margin. Commission and fees and scope for cross selling. h) Purpose: i) Why the loan needed? j) Is it customers and banks interest? k) Amount: l) Customer stake. Is the amount correct? Is it within the managers discretion?
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Credit Policies By Banks m) Repayment: n) Source other than earnings. Can the repayment be met without strain in the stipulated amount and in stipulated time? o) Insurance: p) Is the security necessary? The majority of personal lending nowadays is done on a credit scored basis especially in foreign banks abroad. A numerical score is calculated by allocating points of various characteristics of the borrower. Points are awarded on the basis of the type of job, address, frequency of income, age, marital status and several other factors. This system is used in conjunction with credit reference agencies. This system is used in conjunction with credit reference agencies. However, this system of credit scoring is yet to catch up popularity with Indian banks.
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Credit Policies By Banks COMMERCIAL SEGEMENT: BASICALLY COMMERCIAL SEGEMENTS ARE SERVED BY 1) Working capital Sub-divided into: a) Capital expenditure or equipments a) Production finance b) Contingency cover b) Project finance c) Acquisition finance I. Working Capital: Most industrial companies will have a requirement to fund a portion of their stock and trade debtors, which is not funded by trade creditors. The extent of this requirement will usually vary according to production and seasonal cycles or in other words operating cycles, the stock position will be high when stocks are being built up for sale and at its lowest when actually sold. Most companies will have more or less permanent need to have finance for working capital, as it is unusual for industrial companies to meet the working capital needs for production and also extend credit to buyers without recourse to bank finance. Companies, which are expanding their sales and production quickly, will find the most pressing need for working capital. a) Production and Trade Finance: Closely related to production credit is trade finance to facilitate domestic or a cross-border trade. While working capital is simply the funding of general excess of current assets over current liabilities whereas trade finance products are usually tailored for specific sales or set of sales. Examples of the latter includes letter of credit, bills of exchange, forfeiting, etc. 2) term loans sub divided into:
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Credit Policies By Banks Forfeiting has been defined as a fixed-rate deferred trade finance, which involves discounting without recourse of an exporters trade debt. Total risk lies with the forfeiter. This credit is generally available for a period of 1to 5 years. EXIM bank renders this facility. b) Contingency Cover: Companies will often seek a committed source of bank finance at a pre-arranged pricing which they can use at their option at any time, when either additional fund are required over and above those currently in use. In this way, a company can be certain of having financial recourses available to it should an investment opportunity arise (in the nature of a standby arrangement) for e.g. back-up commitment for a redemption of commercial paper. This type of facility may usually be available only to the higher quality borrowers. Term Loans: a) Capital Expenditure: Companies besides working capital will usually require funds to invest in production facilities (machine and equipments) with repayment tailored to some extent to the working lives of the capital assets built or acquired b) Project Finance: Certain type of companies will require finance tailored to suit the cash flow requirements of specific projects. Such finance is common in the case of oil industry, chemical, steel, power, property/real state, infrastructure development, project exports, etc.
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Credit Policies By Banks c) Acquisition Finance: This is not generally given by the Indian banks except where it becomes necessary for the purpose of rehabilitation of the sick units. Repayment will usually be tailored to the cash flow surpluses expected to be generated by the combined entity. With this category of financial requirement comes the Leverage Buy Out. d) Deferred Payment Guarantee (DPG): The manufacturer of indigenous machinery/capital equipment can push up the sales of their products by offering deferred payment facilities to the prospective purchaser-user. The manufacturer gets the value of the machinery by discounting with his banker, the bills of exchange/promissory notes arising out of sale of the machinery. The scheme is also extended to cover transactions involving acquisitions imported equipments purchased by an industrial concern. The scheme has wide extending to all manufacturing industries, non-industrial and commercial users, public sector companies, and electricity undertakings, transport corporations, pollution control equipments manufacturers, etc. The bills or the promissory notes are generally accepted/guaranteed by the banker on behalf of the purchaser-user. The manufacturer-seller gets the bills discounted with his banker or directly get discounted with IDBI under the IDBI Bill Rediscounting Scheme. Banks take the same care while grating DPG facility as in the case of granting term loan for acquisition of fixed assets like plant and machinery. The bank will satisfy itself whether the borrower has enough cash flows to honor his commitment his under DPG on its due dates.
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Credit Policies By Banks Duration of Facilities: Bank facilities can be broadly divided into three categories short-term, medium term and long-term based on duration. Short-Term: Short-term facilities are those with maturity under one year. They may extend up to 2 to 3 years on annual renewal basis: Short-Term facilities are appropriate for: 1. Working Capital Finance: where stocks and debtors finance will be converted into cash for repayment within one year. 2. Trade Finance: where transaction finance will generate cash for repayment within one year. 3. Bridging Finance: where temporary funding is required pending the draw down of long-term finance-bridging finance is only effective if there is an assured source of defrayment. Where a company has been sanctioned a term loan facility by a financial institution it would take considerable time to complete documentation and comply with all the terms and conditions of loan before the loan is disbursed. The company has two options to raise funds immediately. a) It may obtain bridge loan from the financial institution by producing a bank guarantee for the amount or else, b) It may obtain bridge loan from the bank by producing a commitment letter from the financial institution which has agreed In principle to make a term loan to the company.
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Credit Policies By Banks The bank will generally obtain a floating charge on the current assets of the company along with an undertaking to create a mortgage of all its fixed assets if the term loan does not materialize. The bridge loan may be for no more then two or three months. Banks also gives bridge loan pending completion of a fresh issue of capital or debenture stock by the company. They are also granted for urgent completion of projects to avoid cost overruns. The other type of bridge loans can also be granted in the personal segments against shortly maturing insurance policy or debentures or for buying a new house pending disposal of existing house. Medium Term: Generally maturity for medium term is 3 to 5 years; some banks categorize medium term as 3 to 7 years. Such periods are suitable for: 1. Working Capital term loan over an extended period during the project life. 2. Capital expenditure where finance is required for the purchase of equipments with an estimated useful life, and direct or indirect cash flow generating of several years. Long-Term: Any facility with the term in excess of 5 years. Common uses for such funding are: 1. Acquisitions 2. Capital expenditure/Project finance/Rescheduling/Development finance, etc.
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Customising Credit Facilities

i. Regular or Committed Credit Facility: A committed credit facility is one where a bank has an obligation to lend for a predetermined period of time. Equally the borrower has to comply with his obligations under the loan agreement. Cash credit facility; project loans are examples of committed facility. Banks generally charge commitment charges if the borrowers do not draw the facility. ii. Casual or Uncommitted Credit Facility: Borrowers are also granted casual limits for a temporary period or for a specific trade transaction. The lender may refuse to lend if he considers a) b) c) Borrowers credit worthiness has deteriorated or Liquidity position is trend or He considers further lending unattractive. The borrower thus does not have a guaranteed source of funds. iii. On Demand Facility: Money lent on demand is repayable by the borrower as soon as the lender requests repayment. Temporary overdraft, demand loan, bills, etc., are in the nature of on demand facilities. The advantage to the borrower is that he does not have to pay any commitment charges however he has to face the uncertainty over the continuance of the facility.
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Credit Policies By Banks Offering Repayment and Prepayment Flexibility: Within the Regular or Committed Facilities there are two basic types of repayment profile revolving and non-revolving. 1. Non-Revolving: This is the term loan with the fixed repayment schedule. Any amount voluntarily repaid by a borrower (a pre-payment) will be set against future installments. Non-revolving term loans are, for many banks attractive assets to hold because, in the absence of credit problems, they can be expected to produce a steady stream of income at predetermined levels. The lender, therefore, will some times seek, to impose the penalty fees for early repayment. 2. Revolving: Revolving loans are those where, during the term, the borrower has the ability to repay amounts borrowed and subsequently to re-borrow them. A commitment fee is usually payable by the borrower on the un-drawn amounts. For major borrowers of high quality, banks are often prepared to grant revolving credit facilities for periods of 5 to 10 years for General corporate purposes. The, general corporate purposes may include stand by and backup under the contingency cover facility. The revolving credit facility will be used by the borrower when cheaper money is unavailable conventionally else where. Banks can provide permanent working capital to the borrowers in the form of short-term revolving loans. Main features of this system may be as follows:
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Credit Policies By Banks A borrowing base is normally stipulated under which the outstanding at any time should not exceed 75% to 80% of the inventory and receivables. The level will be monitored on post-fact basis with the help of financial statements. Each loan is made for 90 or 180 days. At maturity of each loan, bank is obliged to roll over/renew the loan only if all interest and principle payments have come in and the borrower is in compliance with all the covenants and conditions in the loan agreements. Revolving loan commitments usually are for 1 year but it can be for 2 to 3 years. The main loan delivery systems in place in the present day context are: a) Consortium b) Multiple banking arrangement and c) To a very insignificant extent syndication
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Consortium Arrangement With Banks Inter-Se

Consortium advance has now come to stay for large advances from banks particularly to corporate sector. Consortium takes place when two or more banks jointly participate in financing a borrower. It helps the banks to pool their resources and share the credit risk and at the same time fund large scale financial needs of the borrower. There can be different types of consortia, such as . 1. Consortium of banks for financing working capital 2. Consortium between banks and financial institutions in financing fixed assets. 3. In case of a borrower with different units (each one engaged in separate line of production) it can be that each unit is financed by a separate bank or by a subconsortium of banks under the overall consortium of banks for the borrower as a whole.
MULTIPLE BANKING ARRANGEMENTS:

Where the credit requirements of a borrower are met by more then one bank and each bank lends independently on its own terms and conditions namely security, rate of interest, margin, etc., the system of financing may be called Multiple Banking Arrangements. However, in order that this system operates smoothly and meets the cannons of lending two vital aspects are require to be fulfilled. 1. Exchange of free and frank information by the bank of borrowers account. The financing banks should have a regular exchange of information in order to protect their interest and insuring safety of funds. The banks may for this purpose establish Credit Information Bureau as in the case of advanced countries. The Kannan Committee also suggests this arrangement. 66
Credit Policies By Banks 2. The financing must adhere to the prudential exposure limits of the borrower. The exposure would take into account: a) Size of the bank b) Exposure to the industry c) Banks own prudential norms d) Security offered e) Quality of management and ongoing information provided by them. f) Banks profitability Subject to the fulfillment of above two conditions. The banks can finance either singly or in association with other banks. As per existing RBI guidelines, Multiple Banking Arrangements ahs been given equal importance like consortium. However, it has been suggested by RBI that the banks should take to syndication system gradually instead of other forms of Credit Delivery System.
SYNDICATION OF CREDIT: A syndicated credit is an arrangement between two or more lending institutions to provide a borrower credit facility, utilizing common loan document. A prospective borrower intending to raise resources through this method awards a mandate to a bank commonly referred to as Lead Manager to arrange credit on his behalf. The mandate spells out the commercial terms of credit and the prerogatives of the mandated bank in resolving contentious issues in the course of the transactions. The mandated bank is required to prepare an information memorandum about the borrower in consultation with the borrower and distribute the same against the prospective lenders soliciting their participation in the credit to be extended to the borrower. The mandated bank does not sell the credit risk but presents an opportunity to lend by extending an offer containing terms agreed between the mandated bank and the borrower.
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Credit Policies By Banks The information memorandum provides the basis for each lending banks making its own independent economic and financial evolution of the borrower, if necessary by seeking additional supporting information from other source as well. The mandate bank convenes a meeting to discuss the syndication strategy relating to coordination, communication and control within the syndication process and finalises deal timing, charges towards management expenses and cost of credit, share of each participating bank in the credit, etc. the loan agreement is signed by all the participating banks. The borrower is required to give a prior notice to the Lead Manager or his Agent for drawing the loan amount to enable the Agent to tie-up this disbursements with the other lending banks. While syndication is very similar to the system of consortium lending in terms funds of dispersal of risk, the freedom the borrower has in terms of competitive pricing and discipline that is sort to be achieved through a fixed repayment period under syndicated credit are absent in the present system of lending through consortium arrangement. The syndication of credit is a convenient mode of raising long-term funds by borrowers with high credit standing only and cannot supplant the system of consortium lending for meeting the fluctuating and current transaction needs of the borrowers in general. The J.V.Shetty committee has suggested introduction of syndication of credit on a selective basis. At the same time the committee has asked for enlarging the scope of inter-bank participation and commercial paper together with the system of consortium lending. These credit forms have intrinsic advantages making the credit delivery system more responsive need of borrower without diluting the financial discipline.
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POST SANCTION SUPERVISION, CONTROL AND MONITORING OF CREDIT

INTRODUCTION: With the present style of lending, where bankers approach is purpose oriented rather than security oriented, it becomes very important to keep a close watch on their borrowers operations. They have to play the role of a business partner rather than that of a conventional lender. A bank has to ensure that utilization of credit is in accordance with the purpose for which it is lent. The bank has also to monitor the performance of the unit to verify if the assumption on which the loan was sanctioned continues to hold good with regard to operations and environment. It is also to be seen whether the promoters are adhering to the terms and conditions of sanction. Evolving a system for obtaining information at regular intervals or making visits to the unit does this. The bank looking at the progress of a borrowers business can take a more detached view than that of the management of the unit. The bank can see the unit performance in total perspective and would be in a better position to give useful advice. GOALS OF MONITORING AND FOLLOW-UP: 1. To ensure that funds are utilized for the purpose for which they were sanctioned. 2. To see that the terms and conditions of sanction are complied with. 3. To monitor the project implementation to avoid time lag and cost over-runs 4. To evaluate the performance in term of production, sales, profit, etc., on a continues basis for ensuring that the borrower is keeping to the original plan and is having sufficient profits to service the debts, as also for normal business growth. 5. To assess the impact to changes in external environment on the performance of the company. 6. To detect early warning signals and symptoms of sickness for initiating timely action for recovery or rehabilitation. 69
Credit Policies By Banks 7. To keep check on the financial position.
Credit Monitoring Arrangements (CMA)

In October 1988, the Reserve Bank of India introduced the post-sanction scrutiny of large borrower limits-working capital limits of Rs. 10 crore and Term loan limits of Rs. 5 crore sanctioned by banks. RBI will subject such proposals sanctioned by the banks to close scrutiny and if they consider the limits sanctioned as unjustified they may reduce the limits. Under CMA, RBI gives various directions to banks and borrowers with a view to ensuring credit discipline. Some of the more important provision is indicated below: A) Borrower should maintain basic financial discipline as under: a) Estimates of current assets, current liabilities and working capital should be reasonable in the light of past trends. b) Classification of current assets and current liabilities should conform to RBI guidelines. (Now the classification is left to be each bank according to the manner in which they think fit). c) Minimum stipulated current ratio to be maintained (i.e. minimum stipulated NWC of 25% of current assets to be brought in by the borrower). Now this stipulated is waived for export industry and for new units. The banks are allowed to prescribe their own norms in this regard. d) QIS form should be submitted in time. e) Borrower should submit his annual accounts in time and banks should review them annually. B) Ad-hoc limits may be sanctioned for periods not exceeding 3 months subject to report to RBI.
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Credit Policies By Banks C) With a view to encouraging the bigger borrower to switch over from sales through book debts to sales through bills, RBI have advised that a) Banks will finance at least 75% of the credit sales by way of bills finance. b) Borrowers covered by CMA should achieve a level of 25% of total inland purchase by way of acceptances. (This condition for bill finance is also since relaxed by RBI and is left to the individual banks to decide upon the appropriate mix of book debt financing and bill finance and the borrowers preparedness to adhere to such limits). D) Bank should forward a copy of the Board Memo sanctioning the credit limit to RBI along with the balance sheet of the company and CMA data within 15 days of sanction. E) RBI in its circular dated 8/12/1997 has discontinued the system of Credit Monitoring Arrangement, as it existed till than. Now the banks are required to report to RBI on a monthly basis in the format enclosed with their circular. OFF-SITE SUPERVISION The technique of off-site supervision can be grouped into two heads: 1. Techniques and tools used at the instance of RBI 2. Techniques and tools evolved by bank themselves. Techniques/tools of monitoring used at the instance of RBI for large borrowal accounts (Limit Rs. 1 crore and above)
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Credit Policies By Banks The following are the returns submitted to Banks by the borrower their credit off-take. 1. QISI & ll incorporating the estimates and actual for each quarter respectively. 2. Half-yearly Funds Flow Statements and Operating Statement in Form lll. 3. Compulsory annual review of large borrower accounts. 4. Monthly statements of Select Operational Data. Techniques /Tools of Monitoring by Individual Banks: Besides the above procedures of monitoring based on RBI guidelines, banks have also additionally evolved credit monitoring Information System. Many of the leading banks have computerized credit Information database with the help of which, various field of information are monitored. Banks have also adopted the Assets Classification like standard, sub-standard, Doubtful and Loss Assets and monitor within the assets classification various performance parameters like interest payment, installment servicing, outstanding vis--vis limits, documentation, review and renewal of facilities, group liability and exposure, observance of prudential norms, action taken or contemplated to set right any irregularity in the accounts, etc. various special reports are generated from the data-base for management use and control. ON-SITE SUPERVISION Under on-site supervision stock inspection or physical verification of security is an important aspect. Before inspecting the unit, as a part as post-sanction follow-up certain information about the account needs to be kept ready for verification at the site of inspection. The following are some of the informations to be collected before carrying out actual inspection: 1. Verify the security documents especially the renewal document.
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Credit Policies By Banks 2. Verify the stock statements with reference to value, credit limit, drawing power, drawing limit, outstanding, margin, insurance, sub-limits, etc. 3. Scrutinizes the ledger accounts for noting the turnover, large withdrawals, excess drawings, if any, name of the payee and chques return if any. Actual Site Inspection Stock verification to be done by person who is familiar with the business, its products and process, method of accounting, etc. The value, quality and ownership of the stock should be verified. Books of accounts should be checked to compare with the figures given in the stock statement and also with the figures arrived on actual verification. Banks have devised their own formats of inspection suited to different industry and security. The information gathered through the inspection reports are quite valuable and if rightly processed and acted upon would help the bank to effectively monitor the accounts and credit available by them.
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CREDIT MONITORING (AS SUGGESTED IN KANNAN COMMITTEE) FOR LARGE BORROWAL ACCOUNTS
The committee has suggested that monitoring through periodical statements of stock, book debts coupled with physical verification of securities, business site of the borrower to be the basic credit-monitoring tool of the banks. The borrower should also give data relating to production, sales and other assumption on which working capital assessment is made by the financing bank. Periodical review of business performance data of the borrower should be made in conjunction with operations of the borrowers account, drawing power of securities, half yearly profitability statement, etc. Modality of such periodical review to be decided by each bank. Annual verification of current assets (including compliance of Pollution Control requirement wherever applicable) by borrowers auditor (in respect of borrowers with working capital limit over Rs. 5 crore) should be insisted. Alternatively, the company may also engage Chartered Accountant/Chartered Engineer/Architect, as may be deemed fit for this purpose. Borrower should obtain prior approval of the financing Bank for investment of funds outside business by way of ICD, investment in associate concern, etc., or in other outside investment. Violation of this condition by the borrower may invite penal interest or recall of the advance from the bank. Each Bank may maintain database of large borrowal accounts including Group Accounts at Central/Zonal Office for effective monitoring.
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CREDIT RISK MANAGEMENT
How to define Credit Risk? Credit Risk is defined by the losses in the event of a default of the borrower to repay his obligations or in the event of a deterioration of the borrowers credit quality. This simple definition hides a couple of underlying risks. Virtually, the quality of the risk is outstanding balance loaned to the borrower and the quality of the risk reflects both the chances that the default occurs and from the guarantees that reduces the loss in the event of the default. The amount of the risk represented by the outstanding balance and the date of default may differ from the ultimate loss in the event of default because of potential recoveries. Recoveries would depend upon any credit risk mitigations, such as guarantees, either collateral or the third party guarantees, the capabilities of negotiating with the borrower and the funds available, if any, to repay the debt after repayment of other lenders who may have a priority claim over the borrowers assets/ funds either by virtue of legal rights, superior bargaining position, efficient debt collections strategies, etc. Introduction: Credit risk Management has been practiced since commencement of banking activity but the discussion of risk management, the tools used in different risk management areas and the resources deployed in terms of skills and technology have shown considerable sophistication in recent years. The tone has been set by increasing competition for loan business, declining spreads and the heightened risk surrounding industrial and commercial activity. The Basel Committee on banking Supervision set up by the Bank for International settlements (BIS) has issued some broad principles of management of credit risk by banks. These are: Establishing an appropriate credit risk environment Operating under a sound credit Granting Process. 75
Credit Policies By Banks Maintaining an appropriate credit administration, Risk measurement and monitoring process. Ensuring adequate controls over credit risk Role of bank supervisors (bank regulatory authorities) in ensuring that banks have an effective system in place to identify, measure, monitor and control credit. Credit risk management covers both the decision-making process, before the credit decision is made, the follow-up of credit facilities, plus all monitoring and reporting processes. The decision-making process covers all the steps associated with the clients credit application, from the original account officers proposal to all credit officers who examine the credit application, or to a credit committee which approves/ reviews the proposal. The decision is based on various credit evaluations parameters based on financial data, plus judgmental assessment of the market outlook, of the borrower, of the management and of the shareholders. Customer, industry and country do the follow-up through periodic reporting reviews of the bank commitments. In addition, warning systems are put in place to signal the deterioration of the situation of the borrower before defaulter whenever possible. A workout process, by which all actions to minimize possible losses are considered and taken, can be triggered if a default occurs. In the following few pages we shall have a look at the more important aspects relevant for credit risk management. We start with the limits system which sets the maximum amount of risk that the bank should take with borrowers, the ratings systems used to appraise the quality of the risk, and see few examples of the credit enhancement devices. Limits System and Credit Screening: Credit risk is sought to be limited by strict exposure limits aimed at limiting losses in the event of a default. Before any credit decision is made, an authorization has to be specified. The authorization sets the maximum amount at risk with any customer, or group of customers. Within the authorization, credit decisions can be made, provided that they meet the standards of credit risk acceptance laid down by the bank. The usage of credit lines
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Credit Policies By Banks should remain below the limit approved. The risk reporting system should be able to consolidate all he facilities that are made available to a customer in order to constantly check that the line usage remains within limits. The basic principles followed while setting up limits are simple to understand as under: (1) Avoid a situation in which any single loss endangers the bank; (2) To diversify and broad base the commitments across various dimensions such as customers, industries and geographical regions: (3) To avoid lending to any borrower an amount that would increase its debt beyond its debt servicing capacity. The equity of the borrower sets up some reasonable limit to its debt given acceptable levels of its debt/ equity ratio. The capital of the bank sets up another limit to lending given the diversification requirements and/ or the credit policy guidelines. The bank Regulatory authorities also often prescribe exposure limits in relation to banks capital and maximum credit exposure to an individual customer as also credit exposure in the aggregate. Ultimately, with a full-blown quantitative risk management system, the capital of the bank could be allocated to all credit lines. Such allocations of capital require special systems to measure risks at the level of transaction and the level of the bank portfolio, including diversification effects. Risks based capital allocation is a sophisticated system, which goes well beyond the recording of amounts at risk. This allocation can serve the purpose of limiting the consolidated risk according to actual available capital. It also makes explicit the capital usage of various credit lines. Limits can potentially be defines in terms of capital usage. Most practices, however, do not reach this stage, but the trend is to focus on the capital usage of credit lines because of regulation and its emphasis on risk based capital.
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Credit Policies By Banks Do you think that limits systems are widely used? To respond let it be added that sometimes it is not as relevant as it appears. When the bank is dealing with the limited number of big customers, it is difficult to set limits. First, lending is based on a continuous relationship. Setting limits and relationship banking are interacting processes. Second, big corporations with an excellent credit standing are less subject to limits given The high quality of their risk. In other words, relationship banking and name lending tend to reduce the importance of quantitative limits. However, bank regulators do prescribe that banks observe a system of lending limits while providing loans. For individuals, the credit application process can be considerably simplified, compared to what it is for corporate of financial sector borrowers. There are a large number of customers so that statistical methods rather than customized risk appraisal systems become relevant. Authorization results from the appraisal of the credit standing of borrowers based upon their observable characteristics such as yearly income, property, values, employment characteristics and so on. For individual the appraisal of the risk quality can often rely on credit scoring. Scoring so arrived at estimates the quality of the risk as a function of a limited number of selected characteristics/ parameters. The limits systems centralize the information about borrowers, in terms of both authorizations and usage of credit lines. In addition to limiting the amount at risk, the centralization is also the basis for monitoring portfolio orientations, such as increasing the portfolio diversification, or reducing concentration in particular industry or industrial group, or any other portfolio parameter.
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Credit Policies By Banks Risk Quality and Ratings: The amount of risk has to be paired with some information of risk quality to offer a complete of risk. The quality of risk covers both the default probabilities and the recoveries in the event of default. It is usually captured through risk rating systems. External Ratings: The best-known systems are those of specified credit rating agencies. For e.g. Moodys uses a simplified rating scale, plus a detailed rating scale. The simplified scale includes six levels. It is briefly described in the following module. Standards and Poor use similar scale. Such rating characteristics debt issues rather the issuers. The reason is that some debt issues, from the same borrower, could be less risky than others. Investors are more interested in the risk of an issue, given its specific protection, than in the issuer. Rating qualifies the risk of losses in the event of default, a combination of probabilities and recoveries. The rating signifies ranking, not quantitative measures of risk quality. Common rating systems include from six to ten different ranks, which are sufficient to discriminate among risk classes. For the internal use of banks, there are other occupations to be considered. First, ratings could qualify the credit standing of the borrower, instead of combining it with recovery risk. Ratings attached to facilities are useful whenever guarantees are attached to individual facilities. For transactions structured with guarantees and collaterals the quality of the protection becomes more important than the credit standing of the borrower. Whether it is necessary to have a dedicated rating system for facilities or not is a management decision. However, to have a fine pricing system for different facilities to meet the demand of competition, a bank would need for a dedicated rating system to ensure that its pricing system is risk-based.
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Credit Policies By Banks A rating system can also serve as a tool for credit policy. For instance, some minimum rating might be required to make a loan, or to delegate authority to credit officers. They can be allowed or not allowed to enter transactions based on the borrowers rating. A rating system requires robustness to be accepted as a reliable tool, for corporate borrowers, the criteria for assessing risk are well known: profitability, growth, industry outlook, competitive advantages, management and shareholders, in addition to the standard financial and operational performance ratios. Rating are required while lending to financial institution as well, however the rating criteria differ significantly from those applicable to corporate borrowers. Since the financial industry is highly regulated, the policy of regulating bodies, which can vary greatly between countries, is an important factor for those institutions that operate internationally. In addition, the rating system for individual borrowers is obviously different from that applicable to corporate borrowers as mentioned earlier. Internal Ratings: Internal Ratings system exits in many situations. As per the system the borrowers are ranked according to their credit quality. Sometimes, facilities are also rated, in order to capture the quality of the protection against the default of the borrower that is embedded with the facility. Such protection can be obtained through the status of privileged debt, or collateral, guarantees, or any other contractual agreement. Rating System: Design: Finally, the design of the rating system changes across institutions. While a few will prefer a fairly detailed rating system, while explicit rules for appraising criteria and weighting them, another may focus more on judgmental appraisal of risk quality, with guidelines specifying the criteria to be appraised before making a judgment.
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Credit Policies By Banks Credit Enhancement: Guarantees and loan covenants are the main vehicles of credit enhancement. Credit enhancements are sought when a bank does not feel comfortable about the decision on the basis of a borrowers rating alone. An enhancement helps a bank not only to take the credit decision but also to price the facility more competitively. The borrower may not object to the credit enhancement particularly if it helps him in obtaining a lower price from the bank. They aim at reducing the amount of loss in the event of default because they increase the recoveries. The covenants trigger preemptive actions whenever the credit standing deteriorates. Collaterals and third party guarantees serve as an insurance, whose value is uncertain, in the event of default. Covenants are virtually sort of an aid to active monitoring of risks. Covenants: Covenants create additional obligations for the borrower. For instance, if the borrower breaks the covenants, the lender can be entitled to a prompt repayment of its debt. This is a powerful incentive to comply with the covenants. In practice, some waivers can be accepted. The actual goal of covenants is to initiate negotiations with the borrower before default, not to trigger default as such. There are financial covenants based on usual financial ratios. For instance, the debt/ equity ratio can be specified to remain below a stated limit; if the actual ratio exceeds the limit the lender would be entitled to call off the credit facility. Legal covenants restrict the initiatives of the borrowers. Typically they seek to reduce diversification beyond the borrowers so that he repays the bank debt first, before anything else. But there are alternatives to design the set of covenants According to the specifics of a borrowers or a transaction. Structured transactions: Credit enhancing devices can be sophisticated, such as those in case of structured transactions. The structure of the transaction aims at isolating the risk of transaction from
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Credit Policies By Banks that of the borrowing entity. Guarantees and covenants are the basic ingredients of the transaction structure. The level of protection can also be improved with other specific features. For instance, reserve account can be set up and/or built up progressively with time whenever some target indicator hits a trigger value. The build-up of cash balances, or of collateral, serves as a first-level protection for the lender that has privileged access to them. Securitization: A good example of a structured transaction is Securitization. Whenever some assets are securities, they serve as collateral for debt issues sold to investors. The risk of those debt issues has to be limited and rated, so that investors know what they buy. Typically, the flows generated by collateral assets will be routed again to the low risks investors as a priority. The structures isolate investors from the original credit risk of the assets being Securitization. Credit enhancing vehicles are numerous and are been increasingly used. They range from stand by letters of credit, complex structures for Leveraged Buy Outs (LBO), project finance, assets acquisition or Securitization. The credit enhancement is obtained by the separation, partial or almost total, of the risk of the transaction from the risk of the borrower. Credit enhancing vehicles achieve this purpose through risk transformation as well as risk reduction. The collateral changes the credit risk into a recovery risk plus an asset value risk. Third- party guarantees transform the default risk of the debtor into a smaller joint default risk. Covenants, or other devices mitigating credit risk, are useful triggers for active risk monitoring whenever the credit standing of the borrowers deteriorates.
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Does Credit Risk Exits In Banking Transaction? How To Measure Credit Risk In Banking Transaction?
From a quantitative standpoint, credit risk is measured by the loss in the event of a default. Credit risk results from a combination of default risk, exposure risk and recovery risk. The resulting loss L is random and can be seen as the product of a random variable characterizing default D (a percentage), an uncertain exposure X (a value), and an uncertain recovery rate R (a percentage): Loss = D*X*(1-R) Let us summarize the issue of measuring risk. Although a symbolic formulation, it shows that upstream random factors that influence exposures and recoveries have to be investigated. It also suggests that the measure should, ideally cover all three components. Let us introduce common measures of the components of credit risk, from default risk to exposure risk and recovery risk. Default Risk: An adequate quantitative measure of default risk is the probability of default. The available measures are either rating or historical statistics on defaults, which can be used as proxies for default risk. Another method to quantify default risk is to derive an estimate of default probability based on a borrowing entitys characteristics. What is Exposure Risk? Exposure is the amount or risk in the event of default without considering recoveries. Since the default occurs at an unknown future date, the amounts at risk that count is future amount at risk. When they are known, they must be derived from the time profile of the exposure. 83
Credit Policies By Banks When they are unknown, they have to be estimated, based on assumptions, conventions, or modeling of future exposures. The type of commitment given by the banks to the borrowers is important since it sets up the upper limits of possible future exposures. What is Recovery Risk? Guarantees and Covenants diminish risk because they reduce the loss in the event of default. The loss in the event of default is the amount at risk at default time less recoveries. Normally, recoveries require legal procedure, expenses, and a significance lapse of time. Loss in the event of default can be estimated before of after the costs of waiting and workout costs. From a measurement standpoint, the valuation of suck guarantees is a Herculean task, if it is feasible at all. There are many uncertainties involved. Some historical recovery rates are available by ratings. They are statistical observation, but the observed recovery rates vary widely around the average. Going beyond some forfeit valuation is not an easy task given the uncertainty in recoveries from guarantees. The following is the list of some credit risk enhancing effects of guarantees along with some remarks relevant from a valuation standpoint. All guarantees are subject to legal risk, i.e. the risk that the guarantees may not be enforced if they happen to be used. Legal risk depends upon the type of guarantees. Some guarantees are more enforceable than others. Letters of intent, or letters of comfort have less force than legal commitments without recourse. The regal risk also depends upon the current environment at the time of default and after. Whenever legal procedures are activated, the protection of guarantees becomes subject to the outcomes of such procedures. Beyond legal risk, guarantees transform and reduce risks. Collateral can be seized and sold by the lender, there by reducing or even canceling the loss. The original credit risk turns into a recovery risk plus an asset value risk. Recovery depends upon the nature of assets, their location, their integrity, and the legal environment. The risk on the liquidation also varies according to the nature of collateralized assets. It is zero with cash. The mark-to-market value of securities held as collateral has a
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Credit Policies By Banks volatility that can be derived from market volatility combined with the sensitivity of the securities. The methodology developed for market risk also applies for any capital market collateral. The risk on the liquidation value of other types of collateral, such as real estate, aeroplanes, ships and fixed equipments, is less easy to capture. In some cases existing dates are relevant. The value of airplanes, for example can be tabulated according to their type, their age and their remaining life. But in this and other cases, the expected value of such collateral remains subject to judgment based on characteristics of the assets. Third Party Guarantees: Third party guarantees have two-fold risk. First, there is the legal risk of not being able to enforce the guarantee, which depends upon the nature of guarantee. Secondly, default risk is enhanced because third party guarantees transfer the credit risk from the borrower to the guarantor at the time of default. The effect on risk is that the default probability of the borrower is changed into a joint probability of default of both borrower and guarantor. Usually, a joint probability of default is much lower than a single probability. For instance, when the defaults of the borrower and the guarantor are actually interdependent, the joint probability of default is the product of probabilities of default of each one. If the borrower and the guarantor have a 1% & a 0.5% default probability, their joint default probability becomes 0.5% * 1% = 0.005% which is quite close to zero.
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Credit Risk Management An Indian perspective Banks & Risks Management System
Banks in the process of financial intermediation are confronted with various kinds of financial & non-financial risk viz. credit, interest rate, liquidity, equity price, legal, regulatory, reputation, operational, etc. these risk are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. Thus, top management of banks should attach considerable importance to improve the ability to identify, measure, monitor & control the overall level of risk undertaken. Risk Management System: RBI Guidelines: While managing credit risk the guidelines issued by the RBI to banks in India are clearly defined and exhaustive. Broad spectrum is as under: Credit policies that define target markets, risk acceptance criteria, credit approval authority, credit organization and maintenance procedure and guidelines for portfolio management & remedial management. Establish proactive credit risk management practices like annual/ half yearly industry studies & individual obligator reviews, periodic credit calls are documented, periodic plants visits, and at least quarterly management reviews of troubled exposures/weak credits. Business managers in banks to be accountable for managing risk and in conjunction with credit risk management framework for stabling & maintaining appropriate risk limits and risk management procedures for their businesses. Banks to have a system of checks & balances in place around the extension of credit viz. An independent credit risk management functions. Multiple credit approvers. An independent audit & risk review function.
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Credit Policies By Banks The Credit Approving Authority to extend or approve credit will be granted to individual credit officers based upon a consistent set of standards of experience judgment and ability. The level of authority required to approve credit will increase as amounts and transaction risk increase & risk rating worsen. Every obligor & facility must be assigned a risk rating. Banks to ensure that there are consistent standards for organization, documentation & maintenance for extension of credit. Banks to have a consistent approach towards early problem recognition, the classification of problem exposures, & remedial action. Banks to maintain a diversified portfolio of risk assets in line with capital desired to support such portfolio. Credit risk limits include, but are not limited to, obligor limits and concentration limits by industry or geography. In order to ensure transparency of risks taken, it is incumbents upon banks to accurately, completely & in a timely fashion, report the comprehensive set of credit risk data into the independent risk system. Organizational set up for Credit Risk Management: A common feature of most successful banks is to establish an interdependent group responsible for credit risk management. This will ensure that decisions are made with sufficient emphasis on asset quality will deploy specialized skills effectively. In some organization, the credit risk management team is responsible fro the management of problem accounts, & for credit operation as well it is imperative that the independence of the credit risk management team is preserved, & it is responsibility of the Board to ensure that this is not allowed to be compromised at any time. The credit risk strategy & policies should be effectively communicated throughout the organization. All lending officers should clearly understand the banks approach to granting credit & should be held accountable for complying with the policies & procedures.
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BIBLOGRAPHY
Following are the two important sources from where I have collected all the information regarding my project on CREDIT POLICIES BY BANKS THE PRIMARY DATA COLLECTION: Punjab National Bank, Ulhasnagar Branch, Camp no.-2. Punjab National Bank, Training Institute, Belapur. THE SECONDARY DATA COLLECTION: Books: 1. Banking Strategy- Vol. II By: Indian Banks Association 2. Laws And Practices Relating To Banking By: The Indian Institute Of Bankers Press Releases Of Banks: 1. IBA Bulletin 2. Banking outlook By Indian Banks Association Newspapers: The Times Of India The Economic Times Websites: www.credit policies by banks.com www.rbi.org.com
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