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Statutory and Other Restrictions on Some Credits

The following credit restrictions have been placed on the banks:


(details as per RBI circular No. Dir. BC. 13113.03.00/2009-10 dated 1, July 2009
)
1. Advances against bank's own shares: In terms of Section 20(1) of the Banking
Regulation Act, 1949, a bank cannot grant any loans and advances on the security
of its
own shares.
2. Restrictions on granting loans and advances to relatives of Directors
3. Restrictions on Grant of Loans & Advances to Officers and Relatives of Senior
Officers of Banks
4. Restrictions on Grant of Financial Assistance to Industries Producing or Cons
uming
Ozone Depicting Substances (ODS)
5. Restrictions on Advances against Sensitive Commodities under Selective Credit
Control (SCC)
6. Advances against Fixed Deposit Receipts (FDRs) Issued by Other Banks
7. Loans against Certificate of Deposits (CDs)
8. Restrictions on Credit to Companies for Buy-back of their Securities
Methods of Credit AssessmentFor quite a long time, credit was considered to be a
scarce commodity and RBI
had a tight control over the methods of credit assessment by the banks. The guid
elines
on MPBF first or second or third method of lending, permissible inventory levels
, etc.
originated in this period. RBI has since relaxed the rules in this area and the
banks are
now free to adopt their own method of credit assessment. However, for loans and
advances to Small Scale Industries, RBI guidelines are as under:
'SS1 units having working capital limits of up to Rs. 5 crore from the banking
system are to be provided working capital finance computed on the basis of 20 pe
r cent
of their projected annual turnover. The banks should adopt the simplified proced
ure in
respect of all SSI units (new as well as existing).'
Delivery of Credit
RBI has advised the banks to follow, as far as feasible, the loan system, for
delivery of bank credit. RBI guidelines in this respect are as under:
1. In the case of borrowers enjoying working capital credit limits of Rs. 10 cro
re
and above from the banking system, the loan component should normally be 80 per
cent. Banks, however, have the freedom to change the composition of working capi
tal
by increasing the cash credit component beyond 20 per cent or to increase the 'L
oan
Component' beyond 80 per cent, as the case may be, if they so desire. Banks are
expected to appropriately price each of the two components of working capital fi
nance,
taking into account the impact of such decisions on their cash and liquidity
management.
2. In the case of borrowers enjoying working capital credit limit of less than R
s.
10 crore, banks may persuade them to go in for the 'Loan System' by offering an
incentive in the form of lower rate of interest on the loan component. as compar
ed to the
cash credit component. The actual percentage of 'loan component' in these cases
may
be settled by the bank with its borrower clients.

3. In respect of certain business activities, which are cyclical and seasonal in


nature or have inherent volatility, the strict application of loan system may cr
eate
difficulties for the borrowers. Banks may, with the approval of their respective
Boards,
identify such business activities which may be exempted from the loan system of
delivery.
Income Recognition and Asset Classification
One of the important functions of RBI is to ensure the stability of financial se
ctor
and thus ensuring the interests of the depositors. Banks are required to present
their
financial position in a fair and transparent manner. A crucial factor, affecting
the health
of a bank, is the quality of its assets. As these assets are formed mainly with
depositors'
money( bank's capital in formation of these assets can be as low as 9 per cent,
which is
the mandatory CAR), even a small deterioration in the quality of these assets ca
n affect
the interests of the depositors very badly. RBI has, therefore, prescribed guide
lines for
the banks to classify their assets depending on the conduct of each account. A
provision, out of bank's profit, has to be made to provide for the possibility o
f default The
amount of provision depends on the classification of the asset. Similarly, there
are norms prescribed for not recognizing some of the perceived incomes so that
the profit of
the bank is not inflated unduly. For example, in an account where the principal
itself is
doubtful of recovery, there is no point in considering the interest receivable a
s part of
the accrued income. There are elaborate RBI guidelines on these matters and all
the
banks have to compulsorily follow them. (consolidated guidelines are contained I
n
RBI NI aster circular No. DBOD.'s o).BI-BC.I 7/ 21.04.04S/2009-10 dated July 1.
2009. Fide 01 [1112 circular is 'Master Circular
Prudential norms on Income
Recognition Asset Classification and Provisioning pertaining to Advance)
Fair Practices Code
(Details in RBI circulars dated 5/5/03 and 6/3/07)
RBI has issued guidelines on fair practices code for lending. These are to be
compulsorily followed by all banks in India. These guidelines pertain to:
(1) application for loans and their processing
(2) loan appraisal and terms and conditions
(3) disbursements of loans
(4) post disbursement supervision
(5) general guidelines relating to discrimination based on sex, caste and religi
on.
harassment in recovery, transfer/takeover of accounts, etc.
Summary
In banking business, the main source of income is still the income on advances
given by the bank and, therefore, efficient credit management is very important
in
achieving the financial objectives of any bank. But, it is also a fact that cred
it involves
some peculiar inherent risks which should be understood, measured and managed.
Each bank formulates its own elaborate loan policy detailing the organizational
set up

for credit administration, and prudential norms for single/group borrowers, as a


lso for
specific activities. The policy also lays down the appraisal standards, delegati
on of
sanctioning powers, credit risk parameters and guidelines for delivery and monit
oring .
Appraisal of a credit proposal plays a major role in ensuring timely repayment o
f money
lent by the bank and interest on it. Analysis of financial statements, both past
and the
projected, help the bank in appraisal of the viability of the proposal as also t
he amount
needed by the borrower. The main methods used for this analysis are trend and ra
tio
analysis. Banks also provide non fund based credit like guarantees, Letters of c
redit, coacceptance of bills, etc. The fund based credit is mainly in the form of working
capital
finance or term loans, which include project and infrastructure finance. Despite
all
precautions taken in appraisal, delivery, monitoring and various other risk mana
gement
measures, sometimes, there is default in timely repayment of principal and inter
est.
Management of these problematic assets is also an important part of credit
management. RBI, being the regulator of financial system in India, still has gre
at influence on credit management of any bank despite relaxation of controls ove
r the
period of time. Knowledge and compliance of relevant RBI guidelines is essential
for
credit management department of any bank.
Keywords
Prudential norms; Asset classification; Provisioning; Collateral security; Prior
ity sector;
MSM enterprises; Rehabilitation; Regulated interest rates; Principles of credit;
types of
borrowers; Appraisal; Delivery; Monitoring and supervision; Credit Risk Manageme
nt.
Check your progress
Fill in the blanks with correct choice:
1. As per RBI guidelines, the turnover method of assessment should be applied fo
r
working capital limit of up to Rs ..in case of SSI units.
(a) One Crore (b) Two Crores (c ) Five Crores (d) Ten Crores
2. Interest rates, regulated by RBI, are applicable for credit limit up to Rs ..
lakh.
(a) One (b) Two (c ) Five (d) Ten
3. The total priority sector target fore foreign banks, operating in India, is ..
(a) 20% (b) 32% (c ) 40% (d) 18%
State True or False:
4. As per RBI guidelines, the assets should be classified as Standard, Non-stand
ard
and doubtful. . False.
5. As per RBI guidelines, no provision is required for Standard Assets. . False.
6. As per MSMED Act 2006, small manufacturing enterprise is an enterprise where
the
investment in plant and machineryis more than Rs 25 lakh but dos not exceed Rs 5
crore. . True.
7. Fair practices code provides guidance and is not compulsory for the banks in

India.
. False.
Answer to Check Your Progress
1. (c); 2. (b); 3. (b); 4. False; 5. False; 6. True; 7. False
This is the end of chapter 26, of ADVANCED BANK ANAGEMENT- C
A I I B PAPER 1 - Overview of Credit Management. ADVANCED BANK MANAGEMENT
UNIT 27
Analysis of Financial Statements
Part 1 of 2
STRUCTURE
27.0 Objectives
27.1 Introduction
27.2 Which are the Financial Statements?
27.3 Users of Financial Statements
27.4 Basic Concepts Used in Preparation of Financial Statements
27.5 Legal Position Regarding Financial Statements
27.6 Balance Sheet
27.7 Profit and Loss Account
27.8 Funds Flow and Cash Flow Statements
27.9 Projected Financial Statements
27.10 Purpose of Analysis of Financial Statements by Bankers
77.11 Rearranging the Financial Statements for Analysis
27.12 Techniques used in Analysis of Financial Statements
27.0 OBJECTIVES
After reading this chapter, you will have better understanding of:
1. Types of financial statements
2. Funds flow /Cash flow statement
3. The importance and uses of financial statements in credit appraisal
4. Projected financial statements
5. Analysis of financial statements
6. Relationship between items in balance sheet and P & L account
7. Trend analysis
8. Ratio analysis
27.1 INTRODUCTIONWhenever a bank considers a loan proposal, apart from the inte
grity and K Y C
aspects, it has a keen interest in knowing the financial details of the prospect
ive
borrower. The extent of these details depends upon the type of loan, type of bor
rower,
purpose of the loan etc. In case of security based lending like loans against fi
xed
deposits, shares etc, these financial details may be few or may not be required
at all.
But, in all other cases, such details are invariably collected with a view to as
sessing the
following:
1. The Net Worth of the Application: For an individual, the excess of his assets
over
his liabilities is his net worth. The same thing applies to any business entity
as well but,
prima facie, its financial statement shows assets and liability to be equal as b
usiness is
considered to be separate legal entity and its net worth is added to liabilities
considering
that this is the amount payable to the promoters by the business entity. The net
worth of
an applicant helps the bank in deciding the level of activity which may be desir
able by
that applicant and the amount of money which can be lent to him.
2. Repayment Captivity: In case of an individual, the bank collects information
like his

income (salary, interest, dividend etc.) as also his expenditure, including repa
yments of
existing borrowings, if any, to assess the surplus available for repayment of in
stallments
and interest on bank's loan. In case of a business enterprise, this information
is
available from its financial statements.
3. Viability: Bank loan mayor may not result in increased earnings for a borrowe
r. For
example, a loan for consumer durables will not increase the income while a home
loan
may result in increased income from rent or reduced expenditure by way of saving
s on
rent. In case of a business enterprise, bank loan is normally intended to increa
se the
income level. A scrutiny of the financial records of the existing activity helps
bank in
assessing whether the proposed bank loan will result in a viable increase in ope
rations.
4. Availability of Unencumbered Securities: In case of individuals, where normal
ly no
formal statements of their financial position are available, the bank asks quest
ions to
find out about their assets, liabilities, sources of income, expenditure, terms
of
repayment of existing loans, need for the loan, use of the loan, etc., to addres
s the
above mentioned questions. In case of other applicants, such information is norm
ally
available from the financial statements, which they are required to prepare as p
er the
law.
The statutory provisions ions regarding preparation and audit of financial
statements are mostly applicable to corporate entities but these provide the dir
ections to
the non-corporate entities as well, and most of such entities, having substantia
l
business volume, follow these guidelines, prescribed for the corporate entities.
27.2 WHICH ARE THE FINANCIAL STATEMENTS
There are basically two financial statements which every business enterprise is
required to prepare. These are:
1. Balance sheet2. Profit & Loss account (Income & Expenditure statement in case
of non-profit
organizations)
Apart from these, the auditors' report, explanatory schedules and notes on
accounts, if applicable, provide useful information to the bankers.
A funds flow statement also provides useful information but, this is only a
mathematical analysis of changes in the structure of two consecutive balance she
ets
and can be easily prepared by the banker/ analyst himself if the basic statement
s, i.e.
the balance sheets, are available. Accounting Standard-3 makes it mandatory for
some
enterprises to prepare Cash Flow statement for the accounting period (these
enterprises are those whose equity or debt is listed or is in the process of bei
ng listed
on a recognized stock exchange and also all other commercial, industrial and bus
iness
enterprises whose turnover for the accounting period exceeds Rs.50 crore. These
enterprises are also required to do segment-wise reporting as per A S -1 7.

27.3 USERS OF FINANCIAL STATEMENTS


Apart from bankers, the other users of financial statements are:
1. Other creditors and lenders
2. Investors
3. Government agencies
4. Rating agencies
5. Customers
6. Employees
7. General public
8. Analysts
27.4 BASIC CONCEPTS USED IN PREPARATION OF
FINANCIAL STATEMENTS
The important concepts are as under:
1. Entity Concept
2. Money Measurement Concept
3. Stable Monetary Unit Concept
4. Going Concern Concept
5. Cost Concept
6. Conservatism Concept
7. Dual Aspect Concept
8. Accounting Period Concept9. Accrual Concept
10. Realization Concept
11. Matching Concept
27.5 LEGAL POSITION REGARDING FINANCIAL
STATEMENTS
1. Format:
In case of banking companies, the formats of both balance sheet and P&L
account are prescribed by the Banking Regulation Act. In case of other companies
,
while the format of balance sheet is prescribed by the Companies Act, no format
for
Profit and Loss account is prescribed. However, Schedule VI of Companies Act req
uires
that the statements should present a true and fair view of the state of affairs.
The
Companies Act has also specified that the profit and loss account must show spec
ific
information as required by Schedule-IV.
The format of balance sheet can be either Vertical or Horizontal as illustrated
below (activities like banking, insurance, electricity generation etc, which are
governed
by acts other than Companies Act, need not follow these formats)
Horizontal Form: Horizontal form is maintained in two columns. The first column
shows
the Liabilities and the second one shows the Assets.
The items shown in the first column against Liabilities are:
Share Capital
Reserves and surplus
Secured loans
Unsecured loans
Current liabilities
Provisions
The items shown in the second column against Assets are:
Fixed assets
Investments
Current assets
Loans and advances
Miscellaneous expenditure
Vertical Form: In the Vertical Form, the different items are shown one below the
other.

(A) Sources of funds


1. Shareholders funds
(a) Share capital(b) Reserves and surplus
2. Loan funds
(a) Secured loans
(b) Unsecured loans
(B) Application of funds
1. Fixed assets
2. Investments
3. Current assets, loans and advances
Less: Current liabilities and provisions Net current assets
4. Miscellaneous expenditures
2. Accounting
As per Income Tax rules, April to March is considered as the financial year for
tax
purposes. However, as per Companies Act, this can be different. Only restriction
, as per
Companies Act, is that the maximum duration of the financial year can be 15 mont
hs,
and can be extended up to 18 months with the permission of Registrar of Companie
s
(ROC).
3. For incomplete Projects and no Activity
Every company has to prepare the financial statements even if there is no activi
ty
during the accounting period or the project is not completed.
27.6 BALANCE SHEET
It is a statement of assets (what is owned) and liabilities (what is owed to oth
ers)
of an entity at a particular moment. It is like a snapshot of assets and liabili
ties and just
as one picture may be different from another taken anytime earlier, the balance
sheet
may also be different at different moments of the same day. Therefore, every bal
ance
sheet must indicate the date at the end of which it is prepared. Normally, the b
alance
sheet is prepared at the end of the accounting period for which the Profit & Los
s
account is prepared.
Liabilities
The Companies Act classifies liabilities as follows:
1. Share capital
2. Reserve and surplus
3. Secured loans
4. Unsecured loans
5. Current liabilities and provisions.
Share CapitalThis is divided into two categories: equity capital and preference
capital. The first
represents the contribution of equity shareholders who are the owners of the fir
m.
Equity capital carries no fixed rate of return by way of dividend. However, on t
he
preference capital, the dividend rate may be fixed and cumulative.
Reserve and Surplus
Reserves and surplus are profits which have been retained in the firm. There are
two types of reserves: revenue reserves and capital reserves. Revenue reserves
represent accumulated retained earnings from the profits of normal business
operations. These are held in various forms: general reserve, investment allowan

ce
reserve, capital redemption reserve, dividend equalization reserve, etc. Capital
reserves
arise out of gains which are not related to normal business operations. Examples
of
such gains are the premium on issue of shares or gain on revaluation of assets.
Surplus is the balance in the profit and loss account which has not been
appropriated to any particular reserve.
Secured Loans
These denote borrowings of the firm against which specific securities have been
provided. The important examples of secured loans are: debentures, loans from
financial institutions and banks.
Unsecured Loans
These are the borrowings of the firm against which no specific security has been
provided. The examples of unsecured loans are: fixed deposits, loans and advance
s
from promoters, inter-corporate borrowings, and unsecured loans from banks.
Current Liabilities and Provisions
Current liabilities and provisions, as per the classification under the Companie
s
Act, consist of the following: amounts due to the suppliers of goods and service
s bought
on credit; advance payments received; accrued expenses; unclaimed dividend;
provisions for taxes, dividends, gratuity, pensions, etc.
Current liabilities for managerial purposes (as distinct from their definition i
n the
Companies Act) are obligations which are expected to mature in the next twelve
months. So defined, they include the following:
(1) loans which are payable within one year from the date of balance sheet, (2)
accounts payable (creditors) on account of goods and services purchased on credi
t for
which payment has to be made within one year, (3) Provision for taxation, (4) ac
cruals
for wages, salaries, rentals, interest, and other expenses (these are expenses f
or
services that have been received by the company but for which the payment has no
t
fallen due), and (5) advance payment received for goods or services to be suppli
ed in
the future.
AssetsBroadly speaking, assets represent resources which are of some value to th
e
firm. They have been acquired at a specific monetary cost by the firm for the co
nduct of
its operations. Assets are classified as follows under the Companies Act:
1. Fixed assets
2. Investments
3. Current assets, loans and advances
4. Miscellaneous expenditures and losses
Fixed Assets
These assets have two characteristics: they are acquired for use over relatively
long periods for carrying on the operations of the firm and they are ordinarily
not meant
for resale.
Examples of fixed assets are land, buildings, plant and machinery, office
furniture, computer systems etc.
Investments
These are financial securities owned by the firm. Some investments represent

long term commitment of funds. (these may be equity shares of other firms held f
or
investment or control purposes.) Other investments are of short-term nature and
may be
classified undercurrent assets for the purpose of financial analysis. (As per Co
mpanies
Act, short-term holding of financial securities also has to be shown under inves
tments).
Current Assets, Loans, and Advances
This category consists of cash and other resources which get converted into
cash during the operating cycle of the firm. Current assets are held for a short
period of
time as against fixed assets which are held for relatively longer periods. The m
ajor
components of current assets are: cash, debtors, inventories, loans and advances
, and
pre-paid expenses. Cash includes credit balances in the bank accounts. Debtors (
also
called receivables or sundry debtors) represent the amount owed to the firm by i
ts
customers who have bought goods, services on credit. Debtors are shown in the
balance sheet at the amount owed, less provision for bad debts. Inventories/ sto
cks
consists of-raw materials, work-in-process, finished goods, and stores and spare
s. They
are accounted at the lower side of the cost or market value as per the accountin
g
concept of conservatism.
Loans and Advances
These are loans to employees, advances to suppliers and contractors, and
deposits made with governmental and other agencies. They are shown at the actual
amount. Pre-paid expenses are expenditure incurred for services to be rendered i
n the
future,
Miscellaneous Expenditures and Losses
This category consists of two items: (1) miscellaneous expenditures and (2)
losses. Miscellaneous expenditures represent certain outlays such as preliminary
expenses and pre-operative expenses which have not been written off. From the
accounting point of view, a loss represents a decrease in owners' equity. Hence,
when a
loss occurs, the owners' equity should be reduced by that 'amount. However, as p
er
company law requirements, the share capital (representing. equity) cannot be red
uced
when a loss occurs. So, the share capital is kept intact on the liabilities side
of the
balance sheet and the loss is shown on the assets side of the balance sheet.
27.7 PROFIT AND LOSS ACCOUNT
It is a statement of income and expenditure of an entity for the accounting peri
od.
Every P and L account must indicate the accounting period for which it is prepar
ed The
items of a P & L account are:
1. Gross and Net sales
2. Cost of goods sold
3. Gross profit
4. Operating expenses
5. Operating profit
6. Non-operating surplus/deficit

7. Profit before interest and tax


8. Interest
9. Profit before tax
10. Tax
11. Profit after tax (Net Profit)Gross and Net Sales
The total price of goods sold and services rendered by an enterprise, including
excise duty paid on the goods sold, is called Gross sales. Net sales are gross s
ales
minus excise duties.
Cost of Goods Sold
This is the sum of costs incurred for manufacturing the goods sold during the
accounting period. It consists of direct material cost, direct ]about cost, and
factory
overheads. It is different from the cost of production, which represents the cos
t of goods
produced in the accounting year, not the cost of goods sold during the same peri
od.
Gross Profit
This is the difference between net sales and cost of goods sold. Most companies
show this amount as a separate item. Some companies, however, show all expenses
at
one place without making gross profit a separate item.
Operating Expenses
These consist of general administrative expenses, selling and distribution
expenses, and depreciation. Some companies include depreciation under cost of go
ods
sold as a manufacturing overhead rather than under operating expenses.
Operating Profit
This is the difference between gross profit and operating expenses. As a
measure of profit, it reflects operating performance and is not affected by nonoperating
gains/losses, financial leverage, and tax factor.
Non-operating Surplus
This represents gains arising from sources other than normal operations of the
business. Its major components are income from investments and gains from dispos
al
of assets. Likewise, non-operating deficit represents losses from activities unr
elated to
the normal operations of the firm.
Profit before, Interest and Taxes
This is the sum of operating profit and non-operating surplus/deficit. Referred
to
also as earnings before interest and taxes (EBIT), this represents a measure of
profit
which is not influenced by financial leverage and the tax factor.
Interest
This is the expenses incurred for borrowed funds, such as term loans,
debentures, public deposits, and working capital advances.
Profit before tax
This is obtained by deducting interest from profits before interest and taxes.
TaxThis represents the income tax payable on the taxable profit of the year.
Profit after tax
This is the difference between the profit before tax and tax for the year.
This is the end of Part 1 of 2, of chapter 27, of ADVANCED BANK
MANAGEMENT- C A I I B PAPER 1.ADVANCED BANK MANAGEMENT
Analysis of Financial Statements
UNIT 27
Chapter 27, Part 2 of 2
27.8 FUNDS FLOW OR CASH FLOW STATEMENTS
Each item in the balance sheet represents either source of funds or use of funds
.

All items on the liabilities side represent the funds provided to the enterprise
and all
items on the assets side (except cash) represent use of these funds. Cash in the
balance sheet represents the unutilized portion of funds, available to the enter
prise. If
cash is also perceived as a use of funds then all the uses of funds are equal to
all the
sources of funds. This perception of available cash, as a use of funds, is what
causes
the wide spread confusion about difference in a Funds flow statement and a Cash
flow
statement. When we compare two balance sheets of different dates, change in each
item (or introduction of a new item) in the balance sheet of later date, as comp
ared to
that item in the balance sheet of earlier date, will represent either addition o
f funds or
additional use of funds in the intervening period. Any increase in any item on t
he
liabilities side means additional funds available. Please note that additional f
unds are
also available if there is decrease in any item on the assets side. Similarly, a
ny increase
in any item on the assets side or decrease in any item on the liabilities side m
eans
additional use of funds. A statement of these additional sources of funds and ad
ditional
uses of funds is called Funds flow statement for the intervening period. Normall
y, this
intervening period is the accounting year, as the balance sheets, which form the
basis
of this statement, are prepared as on the last day of each accounting period. If
we have
to prepare the cash flow statement, we start with the cash in the first balance
sheet as
opening balance, add all the additional sources, excluding cash (cash is also a
source
of funds if it is at a reduced level in the subsequent balance sheet), and deduc
t all
additional uses (excluding cash), thus arriving at, the closing balance, which w
ill be
equal to the cash shown in the second balance sheet. In practice, the statement
is
prepared perceiving cash as a use or source of funds and it is known as Funds fl
ow or
cash flow statement. This should not be confused with the cash budget (which als
o is
referred to as cash flow statement) prepared for the purpose of assessing the ne
ed for
working capital funds from the bank. In that statement, all cash flows during a
period,
excluding bank finance, are taken and the deficit shown forms the basis of bank
finance.
27.9 PROJECTED FINANCIAL STATEMENTS
Actual financial statements are for the past period and analysis of these gives
very useful financial information to the banker. But for assessing the need for
bank
credit and to examine the viability of the activity, it is necessary to anticipa
te the

financial position of the enterprise in future. For example, for assessing the w
orking
capital needs, the statement of assets and liabilities of the last year will not
be
adequate. We will have to anticipate the level of operations during the current
year and
accordingly project the level of assets and liabilities to arrive at the need fo
r bank's loan.
Of course, the financial statements for the past period serve as the most import
ant
guide for this estimate. Also, in case of a new enterprise, where no financial s
tatements
are available, it becomes necessary to decide on a level of activity and accordi
ngly prepare the projected financial statements. Generally, in case of smaller e
nterprises,
where adequate financial expertise may not be available, the projected financial
statements for the next year are prepared by the bank by interviewing the concer
ned
person . In case of term loans for new projects/expansion, the projected financi
al
statements are normally prepared for the entire duration of bank loan to establi
sh the
viability of operations as also to determine the disbursal and repayment schedul
e.
Whenever the projected financial statements are submitted by the borrower, these
are
critically examined for their reasonability and if projections are considered to
be
unreasonable, the matter is discussed with the borrower and suitable consensus a
rrived
at.27.10 PURPOSE OF ANALYSIS OF FINANCIAL STATEMENTS
BY BANKERS
Different users, interested in the financial statements of an entity, may analyz
e
these with focus on evaluation of different aspects. For example, a share market
investor may be more interested in Earning Per Share (E P S), while the statutor
y
authorities may be more interested in compliance and provisions. The banker's fo
cus is
normally on the following aspects:
(a) Assessment of Performance and Financial Position: An analysis of the financi
al
statements reveals the trend of growth of its business and its profitability. By
comparing
these to the industry trend, opinion about the management and efficiency of the
enterprise is formed. Also, the financial statements reveal the composition of a
ssets and
liabilities of the enterprise. By seeing the trend of leverage (Debt/equity), re
tention of
profits etc., the financial health of the enterprise is judged.
(b) Projection of Future Performance: Past performance is often a good indicator
of
future performance. The financial statement analysis helps in projecting the ear
ning
prospects and growth rates in the level of activity and earnings with a reasonab
le
degree of certainty.
(c) Detecting Danger Signals: Financial statement analysis is an important tool

in
knowing the direction of business of the enterprise as also to detect any deteri
oration of
its financial health. Being aware of any deterioration of the financial position
, the bank
can take preventive measures to avoid/ minimize losses. Important ratios, arrive
d at
from the financial analysis. also help the bank to achieve this goal.
(d) Assessment of Credit Requirements: One of the difficulties in credit is the
accurate assessment of the financial need of the applicant. Over-financing and u
nderfinancing both are risky for the borrower and the bank. Financial statement anal
ysis is
used by banks to assess the credit requirement more accurately. Banks are also
concerned with repayment of loan interest within a reasonable time. Analysis of
the
financial statements of the borrower helps in assessing the repayment schedule a
s also
to assess credit risk, decide the terms and conditions of loan.
(e) Examine Funds Flow: This is to ascertain that the bank's funds have been use
d for
the intended purposes and there is no diversion. Also, the use of short term sou
rces is
examined to find if there is any unacceptable mismatch created in the liquidity
position.
(f) Cross Checking: The statements of stocks and book debts. as on the date of t
he
balance sheet, submitted by the borrower. for calculation of drawing power in th
e cash
credit account, are cross checked with the figures given in the balance sheet .
If
statements of the balance sheet date are not available, the statements of neares
t date
are used, which give a fair idea if the correct statements are being submitted.
27.11 REARRANGING THE FINANCIAL STATEMENTS
In keeping with the above objectives, a banker rearranges the figures in the
financial statements under distinct groups for a meaningful analysis.Balance She
et
The assets and liabilities are normally regrouped as under:
In regrouping, the items shown under Liabilities are: (1) Net worth, (2) Long-te
rm
liabilities (3) Current liabilities and provisions.
In regrouping, the items shown under Assets are: (1) Fixed assets, (2) Current
assets
(3) Non-current assets (4) Intangible assets.
Profit and Loss Account
The format prescribed under erstwhile Credit Monitoring Arrangement (CMA)
under which banks used to report sanction of large credit proposals to RBI, stil
l serves
as a useful guide for rearranging the items in Profit and Loss account. The impo
rtant
groups of items are as under:
The format is in three columns. The first column shows different items. The
second and the third one show the values of these items in the last year and pre
sent
year respectively.
The different items shown in the first column are:
1. Gross sales
2. Cost of sales
(a) Raw materials

(b) Power and fuel


(c) Direct labour
(d) Other manufacturing expenses
(e) Depreciation
(f) Sub total
(g) Add opening stocks
(h) Less closing stocks
(i) Total cost of sales
3. Selling, general and administrative expenses
4. operating profit
5. Interest
6. operating profit after interest
7. add non operating income
8. less non operating expenditure
9. Profit before tax
10. tax
12. Profit after taxImportant Points for Rearranging Financial Statements
While rearranging the financial statements, the following points should be
examined by the banker and suitable changes made in different items:
(a) Instalment of term loans due within one year
(b) Advance tax and provision of tax
(c) Deferred tax assets and liabilities
(d) Non moving inventory
(e) Receivables more than 6 months old
(f) Revaluation of assets and Intangible assets
(g) Investments
(h) Bills purchased and discounted
(i) Contingent liabilities
(j) Provisioning
(k) Depreciation method
(l) Inventory valuation
(m) Expenses relating to earlier years
(n) Important events after account period.
27.12 TECHNIQUES USED IN ANALYSIS OF FINANCIAL
STATEMENTS
Bankers mostly use three methods for analysis of financial statements.
(a) Funds Flow Analysis
(b) Trend Analysis
(c) Ratio Analysis
Funds Flow Analysis: If the borrower has not submitted the funds flow statement,
bank prepares the same from the last two balance sheets. The total sources of fu
nds
are categorized as 'Long term' and 'Short term'. Similarly, the total uses are a
lso
categorized as 'Long term' and 'Short term'. If the short term sources are more
than the
short uses it indicates diversion of working capital funds and needs to be probe
d further.
Sometimes, it may be a desirable thing e.g., in case of companies with very high
current
ratio, it may be desirable to use the idle funds for creating additional capacit
y. The
guiding principle is that this diversion should not affect the liquidity positio
n of the
company to unacceptable level.
Trend Analysis: Under trend analysis, bankers adopt the following methodology:(a
) The items for which trend is required to be seen, are arranged in horizontal
form and percentage increase or decrease from the previous year's figures is ind
icated

below it. Generally, this is used to see the trends of sales, operating profit,
PBT, PAT
etc. from P and L account. Similarly, the balance sheets, arranged in horizontal
order,
give the trends of increase or decrease of various items.
(b) Common size statements are prepared to express the relationship of various
items to one item in percentage terms. For example, consumption of raw materials
is
expressed as a percentage of sales for different years and comparison of these f
igures
gives indication of trend of operating efficiency.
Common size financial statements contain the percentages of a key figure alone,
without the corresponding amount figures. The use of percentages is usually pref
erable
to the use of absolute figures.
The use of common size statements can make comparisons of business
enterprises of different sizes much more meaningful since the numbers are brough
t to
common base, i.e. per cent. Such statement allows an analyst to compare the oper
ating
and financing characteristics of two companies of different sizes in the same in
dustry.
Ratio Analysis: This is the most favourite method of bankers for analysis of fin
ancial
statements. A ratio is comparison of two figures and can be expressed as a perce
ntage
(e.g. profitability is 23.7 per cent), as a number (e.g. current ratio is 1.33)
or simply as a
proportion (e.g. debt equity is 1: 2).Both the figures,used in calculation of a
ratio, can be
from either P& L account, or balance sheet or one can be from P& L account and t
he
other from balance sheet. Ratios help in comparison of the financial performance
and
financial position of an entity with other entities, as also for comparison with
its own
status over the years. While different users of financial statements are interes
ted in
different ratios, the ratios which interests a banker most, are the following:
(a) Profitability Ratios: Operating Profit Margin (OPM) and Net Profit Margin
(NPM) are calculated by dividing the figures of operating profit (EBIT, which me
ans
earnings before interest and tax) and net profit respectively by the net sales.
OPM is an
indicator of the operating efficiency of the enterprise while NPM is an indicati
on of ability
to withstand the adverse business conditions.
(b) Liquidity Ratios: These are Current ratio (CR) and Acid test ratio or quick
ratio. While CR is a ratio of total current assets to total current liabilities,
quick ratio is
calculated by dividing current assets (excluding inventory) by total current lia
bilities.
These ratios indicate the capacity of an enterprise to meet its short term oblig
ations.
(c) Capital Structure Ratios: Debt Equity Ratio (DER) is a ratio of total outsi
de
long term liability to the Net worth of an enterprise. Bankers are averse to hig
h debt
equity ratios as it not only represents high borrowings in relation to the owned
funds but

also affects the viability of the operation of the enterprise, as higher borrowi
ngs mean
higher costs and lower operating margins. In case of those enterprises, which ar
e not
capital intensive (i.e. the requirement of fixed assets is low), this ratio may
not indicate
the correct picture as working capital borrowings, which are not indicated by DE
R, may be disproportionate to the capital. So, bankers use ratio of TOL (Total O
utside Liabilities
to TNW (Tangible Net Worth).
(d) Ratio Indicating Ability to Service Interest and Instalmemts: Interest
Coverage Ratio (ICR) and Debt Service Coverage Ratio (DSCR) are the important
ratios in this category. ICR is calculated by dividing EBIT (earnings before int
erest and
tax) by total interest on long term borrowings. DSCR is ratio of total cash flow
s before
interest (net profit plus depreciation plus interest on long term borrowings) to
total
repayment obligation (instalment plus interest on long term borrowings).
(e) Turnover Ratios:
(1) Inventory Turnover Ratio: This is an indicator of movement of inventory. It
is
calculated by dividing cost of goods sold by average inventory. A higher ratio i
ndicates
faster movement of inventory. This is also used for calculating average inventor
y
holding period.
(2) Debtors Turnover Ratio: It is an indicator of how fast the debtors are
realized. It is calculated by dividing the net credit sales by average debtors o
utstanding
during the year. A higher ratio indicates faster collection of debts. This is al
so used for
calculating average collection period.
Deficiency in Ratio Analysis Method
The profit and loss account covers the entire fiscal period, whereas the balance
sheet is on a particular date. To compare an income statement figure such as sal
es to a
balance sheet figure such as debtors, we need a reasonable measure of average
debtors for the year, which is normally arrived at by using an average of beginn
ing and
ending balance sheet figures. This approach does not eliminate problems due to
seasonal and cyclical changes or bunching of sales near the year end.
Summary
Financial statements are prepared on the basis of accounts of financial
transactions of an enterprise. The balance sheet depicts the position of its ass
ets and
liabilities as on a particular date, while P and L account is prepared for an ac
counting
period and states the position of income, expenses and the profit. By comparing
two
successive balance sheets, we can calculate the flow of funds in the intervening
period.
So, the financial statements are effective tools in monitoring of an account. As
the credit
decisions are applicable for future needs of an enterprise, usually projected fi
nancial
statements are also prepared, specially, in case of medium and large enterprises
.
These are based on actual statements for the past period and anticipated perform

ance
in the future. Analysis of financial statements helps banks in knowing the finan
cial
health and performance and viability of an enterprise and in assessing its credi
t
requirements. The main methods used for this analysis are trend and ratio analys
es.
The trend analysis shows how the business of an enterprise is growing while the
ratio
analysis depicts the most critical financial parameters at a glance. Thus, if th
e key ratios
like OPM, debt to equity ratio, current ratio, DSCR, debtors' turnover ratio are
seen by a banker, he can form a reasonably correct opinion about the enterprise
. However, for a
final decision, a more detailed analysis is necessary.
While the format for balance sheet is prescribed by law, the format for P&L
account is prescribed only for the banking companies. But all entities, includin
g non
corporates, usually follow the well established accounting principles and prepar
e their
accounts accordingly. For meaningful analysis, a banker has to rearrange these
statements into various groups.
Keywords
Balance Sheet; P and L Account; Funds flow statement: Cash flow statement; Sourc
es
and uses of funds; Common size statements; OPM, debt to equity ratio; current ra
tio:
DSCR, debtors' turnover ratio; Contingent liabilities; Intangible assets; Pre-op
erative
expenses: Short term liabilities: Long term liabilities: Net worth; TNW; TOLChec
k Your Progress State True or False:
State True or False:
1. Companies Act has prescribed the format of the balance sheet. . True.
2. Format for P & L account for banking companies is prescribed by the Banking
Regulation Act. . True.
3. As per Companies Act, short-term holding of financial securities has to be sh
own
Linder investments. . True.
4. The furniture available in a furniture shop is classified under Fixed Assets.
. False.
5. For the purpose of analysis, installments of term loan, due within one year,
is
classified under current assets. . True.
6. Banks reduce the amount of intangible assets from the Net Worth for the purpo
se of
analysis of financial statements. . True.
7. The change in the method of inventory valuation does not affect the profit in
an
accounting year. . False.
8. The method of ratio analysis is the best method of financial analysis, as it
does not
suffer from any deficiency. . False.
9. Debt: Equity ratio (D E R) is a ratio of total outside liability to the net w
orth of an
enterprise. . False.
10. Interest Coverage Ratio (I C R) is calculated by dividing E B I T(earnings b
efore
interest and tax) by total interest on long term borrowings . True.
11. D S C R indicates the ability of an enterprise to service interest and insta
llments. .

True.
12. Contingent liabilities of an enterprise do not affect the financial analysis
. . False.
13. Funds flow statement and the statement of Sources and Uses of funds are the
same. . True.
14. Liquidity ratios indicate the capacity of an enterprise to meet its short te
rm
obligations. . True.
Key to Check Your Progress
1. True; 2. True; 3. True; 4. False; 5. True; 6. True; 7. False; 8. False; 9. Fa
lse; 10.
True; 11. True; 12. False; 13. True; 14. TrueThis is the end of Part 2 of 2, of
chapter 27, of ADVANCED BANK
MANAGEMENT- C A I I B PAPER1, Analysis of Financial
Statements.ADVANCED BANK MANAGEMENT
Unit 28 - WORKING CAPITAL FINANCE
STRUCTURE
28.0 Objectives
28.1 Concept of Working Capital
28.2 Working Capital Cycle
28.3 Importance of Liquidity Ratios
28.4 Methods of Assessment of Bank Finance
28.5 Bills/Receivables Finance by the Banks
28.6 Guidelines of R B I for Discounting/Rediscounting of Bills by Banks
28.7 Non Fund Based Working Capital Limits
28.8 Other Issues Related to Working Capital Finance
28.0 OBJECTIVES
After reading this chapter, you will have better understanding of:
1. The concept of working capital, total/gross working capital, net working capi
tal
2. Working capital cycle
3. Components of current assets/current liabilities, liquidity, importance of li
quidity ratios
4. Various sources of meeting working capital requirements
5. Bank finance for working capital, methods of assessment
6. Financing of bills/receivables
7. Non fund based working capital limits
8. Commercial paper, factoring, forfeiting
28.1 CONCEPT OF WORKING CAPITAL
Whenever a business enterprise is started, some fixed assets like office,
furniture, machines/computers etc, depending upon the need, are acquired. But th
is
alone may not be sufficient for running the business of that enterprise, except
for a few
activities like broking/commission agent, etc. Most of the business enterprises,
in the
course of their business, have to carry some current assets like raw materials,
finished goods, receivables etc. The money blocked in these current assets is ca
lled working
capital.
Let us take example of an entrepreneur setting up a small manufacturing
enterprise for manufacture of polythene bags. He completes the construction of f
actory
shed and puts up all the plant and machinery. At this point, if he takes a snaps
hot of his
assets and liabilities, it will be as under:
Balance sheet of ABC Ltd as on 9 September, 2009
Liabilities (Capital) Rs. 25 lakh
Assets (
Fixed assets) Rs 100
lakh

Liabilities (Long term liabilities) Rs. 75 lakh


Liabilities Total Rs 100 lakh
Assets
Total Rs 100 lakh
For running the factory, he needs raw material, i.e. the polythene granules. He
goes to the dealer and finds out that the rate of granules is Rs 100 per kg and
credit of 3
months is available. His requirement is 1000 kg (1 ton) per day. He purchases 30
tons
of granules which is the minimum quantity which the dealer sells. He starts manu
facture
of the bags on 10 September 2009. The process takes very little time, and on the
evening of 10 September 2009 he has 1 ton of bags with him. He incurs a cost (po
wer,
labour, transport, miscellaneous expenses, but ignoring depreciation) of Rs10,00
0 for
converting 1 ton of granules into bags. He approaches the wholesale dealer of ba
gs for
selling the bags to him. The deal is struck at Rs 1,10,000 per ton, but a minimu
m of 10
tons of bags is to be supplied. Also, credit of one month is to be given to the
purchaser.
So, the entrepreneur continues to manufacture for 10 days and on 21 September, 2
009
supplies 10 tons of bags by raising an invoice of Rs 11 lakh, payable on 21/10/0
9. The
next supply will be made on 1 October, 2009. If he takes a snapshot of his asset
s and
liabilities on the evening of 30 September 2009, the picture will be as under;
Balance sheet of ABC Ltd as on 30 September, 2009
(Liabilities) Capital Rs 25 lakh
(Assets) Fixed assets Rs 100 lakh
(Liabilities) Long term liabilities Rs 75 lakh
(Assets)Raw material( 10tons)
Rs 10
lakh
(Liabilities) Amount payable to supplier Rs 30 lakh
(Assets) Work in process
(0)
(Liabilities) Expenses payable Rs 2 lakh
(Assets) Finished goods( 10 tons)
Rs 11
lakh
(Liabilities) Amount receivable Rs 11 lakh
(Liabilities) Total Rs 132 lakh.
(Assets) Total Rs 132 lakh
The amount of raw materials, work in progress, finished goods, receivables
totaling Rs 32 lakh, is called the working capital or the current assets require
d to run the
enterprise smoothly. In this example, the entrepreneur has not arranged for any
money
to run his factory as his entire requirement of working capital is met through t
he credit
provided by the supplier. But, life in business, often, is not as simple as show
n here. It is a fact that current assets are required by almost every enterprise
to run the business
smoothly. How much of current assets are required to be maintained depends on th
e
nature of activity and the market conditions. Working capital finance by the ban
ks is
nothing but assessment of total current assets needed and how this need is to be
met.
In the above example, what happens if the credit is not available from the
supplier or, the credit is available only for 10 days? The credit provided to pu
rchaser

may not be reduced if the market practice is like that. In such a case, he will
approach
the bank and request for a working capital loan of Rs 32 lakh. Assuming that ban
k is
convinced about K Y C norms, viability of the project etc, the bank will assess
the needs
and sanction an amount. How much will that amount be, we will discuss later in t
he
chapter. But, bank will definitely ask him to bring some of his own money either
by way
of capital or long term borrowings like fixed deposits, loans from friends and r
elatives.
This amount, which is intended to meet part of the working capital, is called Ne
t Working
Capital. The other part of the working capital will be met by credit provided by
the
supplier, other credit available, and the bank finance. In short, we can say tha
t the total
requirement of current assets of an enterprise, which is termed as Total or Gros
s
working capital is met by short term credit available (including bank finance) a
nd some
amount arranged by the enterprise through long term funds (either capital or
borrowings), called Net Working Capital.
28.2 WORKING CAPITAL CYCLE
The normal operations of a business enterprise consist of some or all of the
actions like, purchase of raw materials, processing and conversion of raw materi
als into
finished goods, selling these goods on cash/ credit basis, receive cash on sale
or end of
credit period and again purchase raw materials. This is called working capital c
ycle. The
length of this cycle depends on:
(a) the stocks of raw materials required to be held
(b) the work in process, which in turn depends on the process involved in manufa
cturing
and processing the raw materials.
(c) the credit required to be provided to the purchasers
The longer the working capital cycle, the more is working capital requirement,
i.e., the need for maintaining the current assets. The correct assessment of thi
s cycle is
the most important part in a bank's assessment of gross working capital, net wor
king
capital and the bank finance. The assessment of working capital finance by the b
ank
follows the assessment of working capital requirement of the enterprise.
28.3 IMPORTANCE of LIQUIDITY RATIOS
For a banker, providing working capital finance, the liquidity ratios, specially
the
current ratio, play a very important role in assessment, sanctioning decision, a
nd
monitoring. The assessment involves stipulation of a minimum Net Working Capital
(N
W C) to be brought in by the enterprise from its long term sources. This results
in a
minimum current ratio (more than one) which the bank wants the enterprise to mai
ntain
at all the times. This is, normally, mentioned in the terms and conditions of sa
nction and
becomes an important tool for the bank to monitor the use of funds by the enterp

rise.28.4 METHODS OF ASSESSMENT OF BANK FINANCE


Holding Norms Based Method of Assessment of Bank Finance:
(1) Deciding on the level of Turnover of the Enterprise: This is a very importan
t step
in any method of assessment of working capital limits. In case of existing enter
prises,
the past performance is used as a guide to make an assessment of this. In case o
f new
enterprises, this is based on the production capacity, proposed market share,
availability of raw materials, industry norm etc. Despite analysis of all the da
ta, accurate
estimate of future turnover is often an area of disagreement between the bank an
d the
borrower.
(2) Assessment of Gross or Total Working Capital: This is the sum total of the
assessment of various components of the working capital:
(a) Inventory: For assessing the stock levels of raw materials, work in process
and the finished goods, information like lead time, minimum order quantity, loca
tion and
number of suppliers, percentage of imported material, manufacturing process, etc
. are
taken into account. Tandon committee had prescribed inventory norms for various
industries but these are not mandatory now and banks can estimate the levels
applicable to each case based on its peculiarities. Industry norms, available in
the data
base, are also used as a guide for the estimate of inventory level.
(b) Receivables and Bills: This estimate is relatively simpler compared to that
of
the inventory. This is mostly governed by the market practice applicable to a pa
rticular
business or place.
(c) Other Current Assets: A reasonable estimate of other current assets like
cash level, advances to suppliers, advance tax payment etc is necessary to avoid
under-financing.
Sources for Meeting Working Capita Requirement:
(a) Own Sources (N W C): The balance sheet of the last accounting year, depicts
the
position of available N W C. Also, as the estimate of limits is based on the pro
jected
balance sheet at the end of the current accounting year, there are some internal
accruals which are also taken into account. Depending on the desired current rat
io to be
maintained, bank may stipulate additional N W C to be brought in if the availabl
e N W C
and anticipated internal accruals are not considered enough to maintain the desi
red
current ratio.
(b) Suppliers Credit: Estimate of this depends on the market practice.
(C) Other Current Liabilities like salaries payable, advances from customers, et
c.
(d) Bank Finance
Calculation of Bank Finance
Logically, the need for working capital finance from the bank is equal to the ga
p
between total working capital and the availability of funds from all the sources
, as
mentioned above (of course, excluding bank finance). The enterprise or the bank
may

not have much control on the 'suppliers' credit' or 'other current liabilities',
as these are driven by market conditions or business needs. But banks can presc
ribe the amount to
be brought in by the enterprise through its own long term sources i.e. the N W C
. This
was at the core of the recommendations of the erstwhile Tandon committee, which
dominated the psyche of the bankers for a long time. Though banks are now free t
o
formulate their own policies in this regard, the methods of lending, mentioned t
here, still
find place in the calculations followed by the banks. The methods are;
(a) First Method of Lending: Under this, the enterprise was required to bring in
at least
25 per cent of the working capital gap (total current assets minus total current
liabilities
excluding bank finance)
(b) Second Method of Lending: Under this, the enterprise was required to bring i
n at
least 25 per cent of the total current assets
(b) Third Method of Lending: Under this, the enterprise was required to bring in
100
per cent of those current assets which are considered 'core assets' and at least
25 per
cent of the remaining current assets.
It may be noted that while the second method of lending results in current ratio
of
at least 1.33, in case of first method, it could be less and in the third method
it is likely to
be more than this.
Depending upon the loan policy of the bank, the working capital limit can be
arrived at by deducting from the total projected current assets, the stipulated
NWC and
the projected short term liabilities.
Cash Budget Method of Assessment
Any economic activity, however small it may be, involves outflows ( expenditure)
of money for procurement of inputs and inflows of money (income) from the sale o
f
output The nature, amount and periodicity of outflows and inflows is peculiar to
the type
of activity, level of operations, market conditions and the policies adopted by
the
owners/managers etc. The genesis of an enterprise's requirement for the working
capital funds, from the bank, lies in the fact that during a particular day, its
opening cash
balance and cash inflows are not sufficient to meet its normal cash outflows. Sh
ort term
bank finance, called working capital finance, fulfils this requirement of excess
cash
outflows. Therefore, an ideal way to assess the need for bank finance is to prec
isely
project the cash inflows and outflows for each day and provide finance to meet t
he cash
deficit. But, projection of daily cash flows is not a feasible option because ma
rket
conditions are not perfect. Therefore, the periodicity of estimating cash flows
is
increased to a more feasible level of a month or a quarter. A statement of estim
ated
cash inflows and outflows is prepared for this period and bank finance equal to

the cash
deficit, if any, is sanctioned.
A normal statement / budget, will look as under;
1 2 3 5
Inflows
1. Opening balance
2. Term loan from Bank3. Sales (Total sales-credit sales + realization for ealie
r sales)
4. Other cash inflows
Total inflows
Outflows
1. Capital expenditure
2. R. M. Purchase
3. Labor
4. Power and fuel
5. Payment of Interest
6. Repayment of Term loan installment
7. Other cash outflows
Total outflows
Cash surplus or (deficit)
Bank finance needed
Closing balance
Turnover Method of Assessment
The assessment of working capital limit by the banks, in some cases, is
influenced by the guidelines of R B I.
For working capital advances to Small Scale Industries. R B I guidelines are as
under:
`SSI units having working capital limits of up to Rs.5 crore from the banking
system are to be provided working capital finance computed on the basis of 20 pe
r cent
of their projected annual turnover. The banks should adopt the simplified proced
ure in
respect of all S S I units (new as well as existing).'
The R B I guidelines may result in under-financing for those S S I units where t
he
working capital cycle is more than 3 months. Therefore, the banks, normally, als
o
assess the requirement on the basis of holding norms also and sanction the limit
whichever is higher.
Comparison of the Three Methods of Assessment
It is easy to infer from the above that there is no basic difference between the
holding method and the cash budget method of assessment of bank finance. Both
involve the essential steps of projecting the level of activity, credit provided
to
customers, credit received from suppliers, requirement of other current assets a
nd
liabilities. The preciseness of the assessment in both the methods depends on ho
w precisely the credit officer estimates these parameters. However, the holding
method is
based on the estimate of average of all these parameters over next one year, whi
ch
may be too long a period for correct assessment, specially, for seasonal industr
ies.
Therefore, this method is more suitable for those activities which have relative
ly uniform
operations and for which the market conditions are not very volatile. The cash b
udget
method may be more suitable for activities which have wide fluctuation from mont

h to
month in the level of activities or market conditions, like seasonal industries
or execution
of project contracts.
The turnover method is more suitable for Small enterprises where detailed
financial records may not be available.
28.5 BILLS / RECEIVABLES FINANCE BY THE BANKS
Receivables are part of the current assets of a business enterprise. These arise
due to sales on credit basis to the customers. If the credit sales are based on
invoices
alone, the amount receivable from the customers is represented in the accounts a
s
'book debts' or 'sundry debtors'. The bank provides finance against these in a f
ashion
similar to that for inventory. The borrower submits a statement of book debts an
d bank
calculates the drawing power by deducting the applicable margin.
Another method of sales is through Bills of exchange drawn by the seller on the
purchaser in the following manner;
(a) If no credit is to be provided to the customer, a demand bill is drawn. This
,
along with the transport document like MR, RR etc, is given to bank either for c
ollection
or purchase. If bank purchases the bill, it provides immediate credit to the sel
ler (drawer
of bill), which may be even 100 per cent of the bill amount, after collecting th
e usual
charges. In case of either purchase or collection, the bank's branch at the purc
haser's
place presents the bill to him and delivers the transport documents to him again
st
payment of the bill. In case of collection, till the payment is credited to the
seller's
account, the amount is shown as book debt in his books. In case of purchase of t
he bill
by the bank, the amount of bill is not represented in the books.
(b) If the credit is to be provided on the sales, a bill of exchange, called usa
nce
bill, mentioning the period of payment, is drawn on the purchaser and is accepte
d by
him The outstanding amount is shown in the accounts as 'bills receivables'. The
advantage of sales under bills of exchange, which are governed by the NI Act, is
the
increased legal protection in case of default by the customer. For bank finance,
either
the accepted bill is given to the bank or the documents are sent through bank wh
ich
delivers the same to the purchaser against his acceptance of usance bill. Bank p
rovides
finance to the seller by discounting the usance bill after deducting the usual c
harges
and interest for the usance period.
The terms used in bills finance are purchase, discount and negotiation. Normally
,
'purchase' is used in case of demand bills, 'discount' in case of usance bills a
nd
'negotiation' in case of bills which are drawn under letters of credit opened by
the
purchaser's bank.

In case of purchase/discount/negotiation of the bill by the bank, the outstandin


g
amount of bills is not represented in the assets in the accounting books of the
drawer (i.e., the seller, who is customer of the financing bank). It may be repr
esented in his
contingent liabilities if the bills are not 'without recourse to drawer'. To get
a realistic
picture, at the time of assessment of working capital finance, the amount of bil
ls
purchased/discounted is added to both current assets and liabilities, depending
on the
bank's loan policy. However, the bills negotiated are normally not added as the
counterparty is another bank and the probability of recourse to drawer will be e
xtremely
low.
28.6 GUIDELINES OF RBI FOR DISCOUNTING /
REDISCOUNTING OF BILLS BY BANKS
The gist of R B I guidelines to banks, while purchasing / discounting /
negotiating / rediscounting of genuine commercial / trade bills, are as under:
(a) Banks may sanction working capital limits, as also bills limit, to borrowers
after proper appraisal of their credit needs and in accordance with the loan pol
icy as
approved by their Board of Directors. Banks should clearly lay down a bills disc
ounting
policy approved by their Board of Directors, which should be consistent with the
ir policy
of sanctioning of working capital limits. In this case the procedure for Board a
pproval
should include banks' core operating process from the time the bills are tendere
d till
these are realized. Banks may review their core operating processes and simplify
the
procedure in respect of bills financing. In order to address the often-cited pro
blem of
delay in realization of bills, banks may take advantage of improved
computer/communication networks like the Structured Financial Messaging System (
S F
M S) and adopt the system of 'value dating' of their clients' accounts.
(b) Banks should open letters of credit (L Cs) and purchase / discount / negotia
te
bills under L Cs only in respect of genuine commercial and trade transactions of
their
borrower constituents who have been sanctioned regular credit facilities by the
banks.
Banks should not, therefore, extend fund-based (including bills financing) or no
n-fund
based facilities like opening of L Cs. providing guarantees and acceptances to n
onconstituent borrower or/and non-constituent member of a consortium / multiple ba
nking
arrangement. However, in cases where negotiation of bills drawn under L C is res
tricted
to a particular bank and the beneficiary of the L C is not a constituent of that
bank, the
bank concerned may negotiate such an L C, subject to the condition that the proc
eeds
will be remitted to the regular banker of the beneficiary. However, the prohibit
ion
regarding negotiation of unrestricted L Cs of non-constituents will continue to

be in
force.
(c) Sometimes, a beneficiary of the LC may want to discount the bills with the L
C
issuing bank itself. In such cases, banks may discount bills drawn by beneficiar
y only if
the bank has sanctioned regular fund-based credit facilities to the beneficiary.
With a
view to ensuring that the beneficiary's bank is not deprived of cash flows into
its
account, the beneficiary should get the bills discounted/ negotiated through the
bank
with which he is enjoying sanctioned credit facilities.
(d) Bills purchased/discounted/negotiated under L C (where the payment to the
beneficiary is not made 'under reserve') will be treated as an exposure on the L
C
issuing bank and not on the borrower. All clean negotiations as indicated above
will be assigned the risk weight as is normally applicable to inter-bank exposur
es, for capital
adequacy purposes. In the case of negotiations 'under reserve', the exposure sho
uld be
treated as on the borrower and risk weight assigned accordingly.
(e) While purchasing / discounting / negotiating bills under L Cs or otherwise,
banks should establish genuineness of underlying transactions/documents.
(f) The practice of drawing bills of exchange claused 'without recourse' and
issuing letters of credit bearing the legend 'without recourse' should be discou
raged
because such notations deprive the negotiating bank of the right of recourse it
has
against the drawer under the Negotiable Instruments Act. Banks should not theref
ore
open L Cs and purchase/discount/negotiate bills bearing the 'without recourse' c
lause.
On a review it has been decided that banks may negotiate bills drawn under L Cs,
on
'with recourse' or 'without recourse' basis, as per their discretion and based o
n their
perception about the credit worthiness of the L C issuing bank. However, the res
triction
on purchase/discount of other bills (the bills drawn otherwise than under L C) o
n 'without
recourse' basis will continue to be in force.
(g) Accommodation bills should not be purchased/discounted/negotiated by
banks. The underlying trade transactions should be clearly identified and a prop
er
record thereof maintained at the branches conducting the bills business.
(h) Banks should be circumspect while discounting bills drawn by front finance
companies set up by large industrial groups on other group companies.
(i) Bills rediscounts should be restricted to usance bills held by other banks.
Banks should not rediscount bills earlier discounted by non-bank financial compa
nies (N
B F Cs) except in respect of bills arising from sale of light commercial vehicle
s and
two/three wheelers.
(j) Banks may exercise their commercial judgment in discounting of bills of the
services sector. However, while discounting such bills, banks should ensure that
actual
services are rendered and accommodation bills are not discounted. Services secto
r bills
should not be eligible for rediscounting. Further, providing finance against dis

counting of
services sector bills may be treated as unsecured advance and, therefore, should
be
within the norm prescribed by the Board of the bank for unsecured exposure limit
.
28.7 NON-FUND-BASED WORKING CAPITAL LIMITS
In the course of its business, an enterprise may sometimes need bank
guarantees or letters of credit or bank's co-acceptance of bills drawn on the en
terprise.
In providing such facilities, there is no outlay of funds by the banks. Therefor
e, in the
balance sheet, these do not appear in the assets of the bank or the liabilities
of the
enterprise. However, these appear in the contingent liabilities of both bank and
the
enterprise because in case of any liability arising on account of these items, t
he bank
has to fulfill its obligation and get the reimbursement from the enterprise on w
hose
behalf this obligation was taken.
Guarantees
Banks issue guarantees on behalf of their customers for various purposes. The
guarantees executed by banks comprise both performance guarantees and financial
guarantees. The guarantees are structured according to the terms of agreement, v
iz.,
security, maturity and purpose. Sometimes, it becomes difficult to distinguish b
etween
performance and financial guarantees but broadly, the difference between the two
is as
under;
The performance guarantee guarantees, to the beneficiary, reimbursement of
monetary loss arising due to non performance or under performance of a contract
by
the customer( applicant). Examples of performance guarantees are guarantees issu
ed
towards completion of a contract within a time limit, or with certain quality or
for the
satisfactory performance of any equipment, project etc. The financial guarantee,
on the
other hand, is for meeting certain financial obligations or dues of the customer
(applicant) to the beneficiary. Examples of financial guarantees are guarantees
issued
in lieu of security deposits, earnest money or payment of dues in case of defaul
t by the
client.
Co-acceptance of Bills
A supplier of goods will be more willing to provide credit to the purchaser (ban
k's
customer), if the bill of exchange drawn by him on purchaser and accepted by him
is
also accepted by the bank. Bank's co-acceptance acts like a guarantee for him ag
ainst
non payment by the purchaser. By providing this facility to the customer, the ne
ed for
working capital finance from the bank is reduced due to credit provided by the s
upplier.
RBI Guidelines on Guarantees and Co-acceptances
(Details available in Master circular no. DBOD. No. Dir. BC. 18/13.03.00/2008-09

dated 1, JuIy 2008)


A gist of the guidelines, which banks should comply with, in the conduct of thei
r
guarantee business is given below:
General Guidelines
As regards the purpose of the guarantee, as a general rule, the banks should
confine themselves to the provision of financial guarantees and exercise due cau
tion
with regard to performance guarantee business.
No bank guarantee should normally have a maturity of more than 10 years.
Precautions for Issuing Guarantees
Banks should adopt the following precautions while issuing guarantees on behalf
of their customers.
(a) As a rule, banks should avoid giving unsecured guarantees in large amounts
and for medium and long-term periods. They should avoid undue concentration of s
uch
unsecured guarantee commitments to particular groups of customers and / or trade
s.
(b) Unsecured guarantees on account of any individual constituent should he
limited to a reasonable proportion of the bank's total unsecured guarantees. Gua
rantees
on behalf of an individual should also bear a reasonable proportion to the const
ituent's
equity.(c) In exceptional cases, banks may give deferred payment guarantees on a
n
unsecured basis for modest amounts to first class customers who have entered int
o
deferred payment arrangements in consonance with Government policy.
(d) Guarantees executed on behalf of any individual constituent, or a group of
constituents, should be subject to the prescribed exposure norms.
While issuing guarantees on behalf of customers, the following safeguards
should be observed by banks:
(1) At the time of issuing financial guarantees, banks should be satisfied that
the
customer would be in a position to reimburse the bank in case the bank is requir
ed to
make payment under the guarantee.
(2) In the case of performance guarantee, banks should exercise due caution
and have sufficient experience with the customer to satisfy themselves that the
customer has the necessary experience, capacity and means to perform the obligat
ions
under the contract, and is not likely to commit any default.
(3) Banks should, normally, refrain from issuing guarantees on behalf of
customers who do not enjoy credit facilities with them.
Bank Guarantee Scheme of Government of India
Banks should adopt the Model Form of Bank Guarantee Bond given in Annexure
1 (Please refer R B I circular mentioned above). The Government of India have ad
vised
all the Government departments/ Public Sector Undertakings, etc. to accept bank
guarantees in the Model Bond and to ensure that alterations/additions to the cla
uses
whenever considered necessary are not one-sided and are made in agreement with t
he
guaranteeing bank. Banks should mention in the guarantee bonds and their
correspondence with the various State Governments, the names of the beneficiary
departments and the purposes for which the guarantees are executed. In regard to
the
guarantees furnished by the banks in favour of Government Departments in the nam
e of
the President of India, any correspondence thereon should be exchanged with the

concerned ministries/ departments and not with the President of India. In respec
t of
guarantees issued in favour of Directorate General of Supplies and Disposal, the
following aspects should be kept in view:
(1) In order to speed up the process of verification of the genuineness of the
bank guarantee, the name, designation and code numbers of the officer/officers s
igning
the guarantees should be incorporated under the signature(s) of officials signin
g the
bank guarantee.
(2) The beneficiary of the bank guarantee should also be advised to invariably
obtain the confirmation of the concerned banks about the genuineness of the guar
antee
issued by them as a measure of safety.
(3) The initial period of the bank guarantee issued by banks as a means of
security in Directorate General of Supplies and Disposal contract administration
would
be for a period of six months beyond the original delivery period. Banks may inc
orporate
a suitable clause in their bank guarantee, providing automatic extension of the
validity
period of the guarantee by 6 months, and also obtain suitable undertaking from t
he customer at the time of establishing the guarantee to avoid any possible comp
lication
later.
(4) A clause would be incorporated by Directorate General of Supplies and
Disposal in the tender forms of Directorate General of Supplies and Disposal
(Instruction to the tenderers) to the effect that whenever a firm fails to supp
ly the stores
within the delivery period of the contract wherein bank guarantee has been furni
shed,
the request for extension for delivery period will automatically be taken as an
agreement
for getting the bank guarantee extended. Banks should make similar provisions in
the
bank guarantees for automatic extension of the guarantee period.
Guarantee on Behalf of Share and Stock Brokers / Commodity
Brokers
Banks may issue guarantees on behalf of share and stock brokers in favour of
stock exchanges in lieu of security deposit to the extent it is acceptable in th
e form of
bank guarantee as laid down by stock exchanges. Banks may also issue guarantees
in
lieu of margin requirements as per stock exchange regulations. Banks have furthe
r
been advised that they should obtain a minimum margin of 50 per cent while issui
ng
such guarantees. A minimum cash margin of 25 per cent (within the above margin o
f 50
per cent) should be maintained in respect of such guarantees issued by banks. Th
e
above minimum margin of 50 per cent and minimum cash margin requirement of 25 pe
r
cent (within the margin of 50 per cent) will also apply to guarantees issued by
banks on
behalf of commodity brokers in favour of the national level commodity exchanges,
viz.,
National Commodity Derivatives Exchange (N C D E X), Multi Commodity Exchange of

India Limited (M C X) and National Multi-Commodity Exchange of India Limited (N


M C
E I L) in lieu of margin requirements as per the commodity exchange regulations.
Appraisal of Guarantee / Co-acceptance Limit
The bank guarantees may be required by the enterprise either on regular basis
or ad-hoc basis. For example, a normal manufacturing enterprise may require
guarantee in favour of Customs department for release of imported good, for whic
h no
regular assessment can be made. The sanction of regular B G limit is required fo
r some
businesses like contractors, who have to provide the guarantees on a regular bas
is for
security deposits of tenders, receipt of advance payment or return of retention
money,
as also performance guarantees for execution of projects. The assessment in such
cases depends on the nature of business and the terms of contracts. The bank has
to
examine the impact of sanction of guarantee limit on the fund based requirements
of the
borrower. For example, a guarantee issued in respect of receipt-of advance payme
nt
will reduce the fund based need of the enterprise. So, a part of the B G limit m
ay be
carved out of its total fund based W C limits.
The co-acceptance limit helps the borrower to get more credit from the supplier
and, therefore, is carved out of the fund based W C limit, if this credit was no
t taken into
account at the time of assessment.Letters of Credit
The genesis a letter of credit lies in the fact that a seller of good is worried
about
receipt of money from the buyer if he supplies the goods first, and the buyer is
worried
about non receipt of contracted goods if he makes the payment first. The bank ac
ts as
an intermediary between the two by using its credibility, as it is acceptable to
both buyer
and the seller. Letter of Credit (L C) is an undertaking by the bank, at the req
uest of the
buyer( applicant, who is customer of the bank), to the seller, to pay him the co
ntracted
amount if he supplies the goods as per the terms specified and submits the requi
red
documents, including the documents of the title of the goods. The conduct of LC
business is governed by the publication no.600 of the International Chamber of
Commerce (I C C), commonly known as U C P D C 600.
Appraisal of LC Limit
An L C is used for purchase of goods either through imports or local purchase.
For assessing the L C requirement of an enterprise, we have to know the followin
g;
(1) Average Amount of Each L C: This is dependent on the monthly consumption of
goods and the economic order quantity. Economic order quantity (E O Q) is estima
ted
by examining the sources of supply, means of transport, discount etc. In case of
imports, the E O Q is often larger in comparison to indigenous purchases.
(2) Frequency of L C Opening: Once E O Q is estimated, the number of I-Cs to be
opened in a year can be calculated by dividing annual consumption by E O Q.
Frequency of opening L Cs will be 12 divided by the number of I-Cs to be opened

in a
year.
(3) How many L Cs will be outstanding at a particular time: The time taken for o
ne L
C to remain in force depends upon the lead time (time taken from the date of ope
ning L
C to shipment of goods), the transit time and the usance available to purchaser
from the
date of receipt of goods. If the frequency of opening L C is less than this, ban
k will have
more than one L C outstanding at any point of time.
Example: If lead time is 10 days, transit is 20 days and usance period is six mo
nths, the
total time for which an L C will remain outstanding is seven months. If consumpt
ion of
goods is Rs 6 crore per year and E O Q is Rs one crore, the frequency of opening
L C is
every 2 months. It means that at any point of time, there will be four L Cs outs
tanding
( 7divided by 2 and rounded off to next figure). As the amount of each L C is Rs
one
crore, the total L C limit will be Rs 4 crore.
While sanctioning L C limit, its impact on the fund based requirements of the
borrower should be examined. In view of the increased credit available to him th
rough L
C, normally, an L C limit is carved out of the total fund based W C limit sancti
oned.28.8 OTHER ISSUES RELATED TO WORKING CAPITAL
FINANCE
Commercial Paper
Commercial Paper (C P), an unsecured money market instrument issued in the
form of a promissory note, was introduced in India in 1990 with a view to enabli
ng highly
rated corporate borrowers to diversify their sources of short-term borrowings. T
he cost
of borrowing through C P is normally lower compared to other sources of short te
rm
finance and therefore, it serves as a useful tool in working capital management
of the
corporate. Guidelines for issue of C P are governed by directives issued by the
R B I. A
master circular of all these guidelines issued up to 30/6/09, has been issued by
RBI on
1 July, 2009 and is posted on their website www.mastercirculars.rbi.org.in
Factoring
This is a method of financing the receivables of a business enterprise. The
financier is called 'Factor' and can be a financial institution. Banks are not p
ermitted to
do this business themselves but they can promote subsidiaries to do this. Under
factoring, the factor not only purchases the book debts/receivables of the clien
t, but may
also control the credit given to the buyers and administer the sales ledger. The
purchase of book debts/receivables can be with recourse or without recourse to t
he
client. If it is without recourse, the client is not liable to pay to the factor
in case of failure
of the buyer to pay.
Forfaiting
This is similar to factoring but is used only in case of exports and where the s
ale

is supported by bills of exchange/promissory notes. The financier discounts the


bills and
collects the amount of the bill from the buyer on due dates. Forfaiting is alway
s without
recourse to the client. Therefore, the exporter does not carry the risk of defau
lt by the
buyer.
Summary
Most of the business enterprises need to maintain some current assets like,
cash, raw materials, work-in-process, finished goods and receivables for smooth
functioning of their business. The cycle starting from purchase of raw material
and
culminating in receipt of sales proceeds from the customer, is called working ca
pital
cycle. The longer this cycle, larger is the amount of money blocked in the curre
nt
assets, and vice versa. The amount of money blocked in the current assets is cal
led
total or gross working capital. A part of this money may come from credit provid
ed by
suppliers, advances from customers and any other short term liability. Also, the
enterprise is also required to arrange for some long term funds (called N W C) t
o meet
part of this requirement. The gap, if any, is provided by the banks as working c
apital
finance. In the past, when credit was scarce, R B I provided elaborate guideline
s for
calculation of bank finance for W C. This has been relaxed substantially over a
period of
time but the guiding principles are still used by many banks for the assessment.
Banks also provide non-fund-based working capital limits. These are mainly, gua
rantees, L Cs
and co-acceptance of bills. The appraisal of these limits is also done by detail
ed
analysis as these carry risks similar to fund based limits. Some of the instrume
nts/
methods used in working capital finance are bills financing, factoring, forfaiti
ng and
commercial paper. R B I has issued guidelines in respect of all of these.
Keywords
Working capital cycle; N W C; Gross W C; Working capital gap; M P B F; First, se
cond
and third methods; Turnover method; Cash budget; Guarantees; Letters of credit;
Coacceptance of bills; Liquidity, Current ratio
Check Your Progress
1. Net Working Capital (N W C) means
The choices are:
(a) Total current assets minus bank finance
(b) Total current assets minus credit from suppliers
(c) Total current assets minus total current liabilities
(d) Short term sources brought in by the promoters
The correct choice is: (c) Total current assets minus total current liabilities
2. Which of the following statements is not true for efficient inventory managem
ent?
The choices are:
(a) It results in reduction in inventory
(b) It reduces the working capital requirements of the enterprise
(c) It reduces the N W C available with the enterprise

(d) It increases the Inventory Turnover Ratio if the level of sales remains same
.
The correct choice is: (c) It reduces the N W C available with the enterprise
3. Which of the following is not a source for meeting working capital requiremen
ts?
The choices are:
(a) Suppliers' credit
(b) Bank finance
(c) Other current liabilities
(d) Advance payment to suppliers
The correct choice is: (d) Advance payment to suppliers
(4) Which of the following is a liquidity ratio?
The choices are:
(a) Quick ratio(b) T O L / T N W
(c) D S C R
(d) Other current liabilities
The correct choice is: (a) Quick ratio
(5) Which of the following is not correct regarding Current Ratio?
The choices are:
(a) For same level of current assets, increase in N W C results in increased
current ratio.
(b) The current ratio can be less than one
(c) The current ratio can be negative
(d) Current ratio is an indicator of liquidity
The correct choice is: (c) The current ratio can be negative
(6) The commercial paper can be issued by
The choices are:
(a) Corporates
(b) Corporates and partnership firms
(c) Any business entity
(d) None of the above
The correct choice is: (a) Corporates
(7) Which of the following is not correct regarding Forfaiting? The choices are:
(a) It a form of working capital finance
(b) It is used in export finance
(c) It is with recourse to the drawer of the bill
(d) Under this financier discounts the bills drawn on buyer.
The correct choice is: (c) It is with recourse to the drawer of the bill.
(8) Which of the following is correct regarding Letters of Credit. The choices
are:
(a) These are opened by a bank for export sales by the client
(b) These are opened by a bank for local sales by the client
(c) Letters of Credit do not carry much risk for the opening bank
(d) Letters of Credit are opened by a bank for purchase of goods by the client
The correct choice is: (d) Letters of Credit are opened by a bank for purchase o
f
goods by the client.(9) Under Turnover method of assessment, the limit is sancti
oned at per cent of the
projected turnover. The choices are:
(a) 25
(b) 20
(c) 30
(d) 35
The correct choice is: (b) 20
(10) Cash budget method of assessment is more suitable for those business enterp
rises
which have . The choices are:
(a) uniform level of operations
(b) High level of operations

(c) Low level of operations


(d) Seasonal operations
The correct choice is: (d) Seasonal operations.
Answer to Check Your Progress
1. (c); 2. (c); 3. (d); 4. (a); 5. (c); 6. (a); 7. (c); 8. (d); 9. (b); 10. (d)
END OF CHAPTER 28
ADVANCED BANK MANAGEMENT- C A I I B
PAPER 1ADVANCED BANK MANAGEMENT
UNIT 29 Term Loans
STRUCTURE
29.0 Objectives
29.1 Important Points about Term Loans
29.2 Deferred Payment Guarantees (D P Gs)
29.3 Difference between Term Loan Appraisal and Project Appraisal
29.4 Project Appraisal
29.5 Appraisal and Financing of Infrastructure Projects
29.0 OBJECTIVES
After reading this chapter, you will have better understanding of:
(1) The meaning of term finance
(2) Deferred payment guarantees
(3) Assessment of term/project finance
(4) Techno-economic feasibility study
(5) Infrastructure finance
29.1 IMPORTANT POINTS ABOUT TERM LOANS
1. Banks provide term loans normally for acquiring the fixed assets like land,
building, plant and machinery, infrastructure etc., (personal loans, consumption
loans,
educational loans etc. being exceptions) while the working capital loans are pro
vided for
sustaining the working capital i.e. current assets level.
2. In exceptional cases, banks provide term loans for current assets also. This
is
called Working Capital Term Loan(W C T L) As we are aware, the business enterpri
se
is supposed to bring a part of its funds required to maintain the desired level
of current
assets from its long term sources (capital or term liabilities), called N W C, s
o that the
stipulated current ratio can be maintained. If the enterprise is not able to bri
ng in the
required amount of N W C, it will feel liquidity crunch and business operations
will be
affected. In such cases, banks may provide W C T L.
3. Working capital loans are normally sanctioned for one year but are payable on
demand. Term loans are payable as per the agreed repayment schedule, which is
stipulated in the terms of the sanction. Therefore, for the purpose of matching
assets
and liabilities of the bank, term loans are considered long term assets while wo
rking
capital loans are considered as short term assets. Practically, however, an ente
rprise continues to enjoy the working capital loan till its working is satisfact
ory, while the term
loan gets repaid over a period of time.
4. As a term loan is expected to be repaid out of the future cash flows of the
borrower, the D S C R assumes great importance while considering term loans, whi
le
for working capital loans, the liquidity ratios assume greater importance.
5. There is no uniform repayment schedule for all term loans. Each term loan has
its own peculiar repayment schedule depending upon the cash surplus of the borro

wer.
Thus, in case of a salaried person, where income level is constant, the repaymen
t can
be through E M I system and in case of a farmer, the repayment of principal and
interest
may coincide with the cropping pattern. In case of industrial enterprises, norma
lly,
banks stipulate monthly/quarterly repayment of principal along with all the accu
mulated
interest. In some cases, the entire repayment may be stipulated in one installme
nt only,
called the bullet repayment.
29.2 DEFERRED PAYMENT GUARANTEES ( D P Gs)
When the purchaser of a fixed asset does not pay to the supplier immediately,
but pays according to an agreed repayment schedule, and the bank guarantees this
repayment, the guarantee is called D P G. This is a Non-fund based method for
financing purchase of fixed assets. However, if the purchaser defaults in paymen
t of any
amount, the bank has to pay the same to the supplier and the exposure becomes fu
nd
based till the amount is recovered from the client. The risks involved in a D P
G are
same as those in a term loan and therefore, the appraisal for a D P G is same as
that
for a term loan.
29.3 DIFFERENCE BETWEEN TERM LOAN APPRAISAL AND
PROJECT APPRAISAL
For appraising a stand alone term loan proposal, all the concepts involved in a
project appraisal may not be necessary to be applied though all concepts of a te
rm loan
appraisal are applicable to project finance also. The differences can be summari
zed as
under:
(a) In project finance all the financial needs of the enterprise, including work
ing
capital requirements, are appraised. This is because the total requirement of lo
ng term
funds includes margin money for working capital. After assessing the total requi
rement
of long term funds, the banks decide upon the amount of term loan to be sanction
ed
and the contribution of the promoters.
(b) If an existing enterprise wants to purchase a few machineries, which are not
going to have a major impact on the volume or composition of the business, it wi
ll serve
little purpose to have a detailed examination of techno- economic feasibility, m
anagerial
competence, I R R etc. It may be enough for the bank to examine the projections
for
next 2 to 3 years to find out that D S C R is at satisfactory level. In case of
loans to
individuals also, like housing loans, educational loans etc., it may be enough t
o examine
the projected D S C R to judge the viability. However, the basic principles of a
ppraisal of a project or a standalone term loan are not different and if one is
clear about project
appraisal, the appraisal of a standalone term loan proposal is even simpler.
20.4 PROJECT APPRAISAL

Project appraisal can be broadly taken in the following steps:


(1) Appraisal of Managerial Aspects
(2) Technical Appraisal
(3) Economic Appraisal
Appraisal of Managerial Aspects: The appraisal of managerial aspects involves
seeking the answer to the following questions:
(a) What are the credentials of the promoters'?
(b) What is the financial stake of promoters in the project? Can they bring addi
tional
funds in case of contingencies arising out of delay in project implementation an
d
changes in market conditions?
(c) What is the form of business organization? Who are the key persons to be app
ointed
to run the business?
Technical Appraisal: The technical feasibility of a project involves the followi
ng
aspects:
(a) location
(b) products to be manufactured, production process
(c) availability of infrastructure
(d) provider of technology
(e) details of proposed construction
(f) contractor for project execution
(g) waste-disposal and pollution control
(h) availability of raw materials
(i) marketing arrangements
Economic Appraisal: The economic or financial feasibility of a project involves
the
following aspects:
(a) Return on Investment: The usual methods used are the NPV, IRR, payback perio
d,
cost benefit ratio, accounting rate of return etc.
(b) Break-even Analysis: A project with a high break-even point is considered mo
re
risky compared to the one with lower break-even point.
(c) Sensitivity Analysis: As market conditions are uncertain, a small change in
the
prices of raw materials or finished goods may have a drastic impact on the viabi
lity of a
project. Sensitivity analysis examines such impact.29.5 APPRAISAL AND FINANCING
OF INFRASTRUCTURE
PROJECTS
Infrastructure sector deals with roads, bridges, power, transport,
telecommunication, etc. (This is defined in Section 10 of IT Act). Infrastructur
e projects
involve some distinct features like exceptionally long implementation, gestation
and pay
back periods, high debt equity ratio etc. While the basic principles of appraisa
l of an
infrastructure project are same as those involved in a normal project appraisal,
there are
some additional points to be considered, as highlighted in R B I guidelines R B
I
guidelines to the banks for financing infrastructure projects, are as follows:
(A) Types of Financing by Banks
In order to meet financial requirements of infrastructure projects, banks may
extend credit facility by way of working capital finance, term loan, project loa
n,
subscription to bonds and debentures/ preference shares/ equity shares acquired

as a
part of the project finance package which is treated as 'deemed advance' and any
other
form of funded or non-funded facility.
(a) Take-out Financing: Banks may enter into take-out financing arrangement with
I D
F C & other financial institutions or avail of liquidity support from I D F C &
other F Is. A
brief write-up on some of the important features of the arrangement is given in
paragraph 2.3.7.8(i). Banks may also be guided by the instructions regarding tak
e-out
finance contained in Circular No. DBOD. BP.BC. 144 / 21.04.048 / 2000 dated 29,
February 2000.
(b) Inter-institutional: Guarantees Banks are permitted to issue guarantees favo
uring
other lending institutions in respect of infrastructure projects, provided the b
ank issuing
the guarantee takes a funded share in the project at least to the extent of 5 pe
r cent of
the project cost and undertakes normal credit appraisal, monitoring and follow-u
p of the
project.
(c) Financing Promoter s Equity: In terms of Circular No. DBOD. Dir. BC. 90/
13.07.05/ 99 dated August 28, 1998, banks were advised that the promoter's
contribution towards the equity capital of a company should come from their own
resources and the bank should not normally grant advances to take up shares of o
ther
companies. In view of the importance attached to the infrastructure sector, it h
as been
decided that, under certain circumstances, an exception may be made to this poli
cy for
financing the acquisition of the promoter's shares in an existing company, which
is
engaged in implementing or operating an infrastructure project in India. The con
ditions,
subject to which an exception may be made, are as follows:
(1) The bank finance would be only for acquisition of shares of existing
companies providing infrastructure facilities as defined in paragraph (a) above.
Further,
acquisition of such shares should be in respect of companies where the existing
foreign
promoters (and/ or domestic joint promoters) voluntarily propose to disinvest th
eir
majority shares in compliance with SEBI guidelines, where applicable.(2) The com
panies to which loans are extended should, inter alia, have a
satisfactory net worth.
(3) The company financed and the promoters or directors of such companies
should not be defaulters to banks or Financial Institutions.
(4) In order to ensure that the borrower has a substantial stake in the
infrastructure company, bank finance should be restricted to 50 per cent of the
finance
required for acquiring the promoter's stake in the company being acquired.
(5) Finance extended should be against the security of the assets of the
borrowing company or the assets of the company acquired and not against the shar
es
of that company or the company being acquired. The shares of the borrower compan
y
or company being acquired may be accepted as additional security and not as prim
ary
security. The security charged to the banks should be marketable.

(6) Banks should ensure maintenance of stipulated margins at all times.


(7) The tenor of the bank loans may not be longer than seven years. However,
the Boards of banks can make an exception in specific cases, where necessary, fo
r
financial viability of the project.
(8) This financing would be subject to compliance with the statutory requirement
s
under Section 19(2) of the Banking Regulation Act, 1949.
(9) The banks financing acquisition of equity shares by promoters should be
within the regulatory ceiling of 40 per cent of their net worth as on 31 March o
f the
previous year for the aggregate exposure of the banks to the capital markets in
all forms
(both fund based and non-fund based).
(10) The proposal for bank finance should have the approval of the Board.
(B) Appraisal
(1) In respect of financing of infrastructure projects undertaken by Government
owned entities, banks or Financial Institutions should undertake due diligence o
n the
viability of the projects. Banks should ensure that the individual components of
financing
and returns on the project are well defined and assessed. State government guara
ntees
may not be taken as a substitute for satisfactory credit appraisal and such appr
aisal
requirements should not be diluted on the basis of any reported arrangement with
the
Reserve Bank of India or any bank for regular standing instructions or periodic
payment
instructions for servicing the loans or bonds.
(2) Infrastructure projects are often financed through Special Purpose Vehicles.
Financing of these projects would, therefore, call for special appraisal skills
on the part
of lending agencies. Identification of various project risks, evaluation of risk
mitigation
through appraisal of project contracts and evaluation of creditworthiness of the
contracting entities and their abilities to fulfill contractual obligations will
be an integral
part of the appraisal exercise. In this connection, banks or Financial Instituti
ons may
consider constituting appropriate screening committees or special cells for appr
aisal of
credit proposals and monitoring the progress or performance of the projects. Oft
en, the
size of the funding requirement would necessitate joint financing by banks or Fi
nancial
Institutions or financing by more than one bank under consortium or syndication
arrangements. In such cases, participating banks or Financial Institutions may,
for the
purpose of their own assessment, refer to the appraisal report prepared by the l
ead
bank or Financial Institutions or have the project appraised jointly.
(C) Prudential Requirements
(1) Prudential Credit Exposure Limits: Credit exposure to borrowers belonging
to a group may exceed the exposure norm of 40 per cent of the bank's capital fun
ds by
an additional 10 per cent (i.e. up to 50 per cent), provided the additional cred
it exposure

is on account of extension of credit to infrastructure projects. Credit exposure


to single
borrower may exceed the exposure norm of 15 per cent of the bank's capital funds
by
an additional 5 per cent (i.e. up to 20 per cent) provided the additional credit
exposure is
on account of infrastructure as defined in paragraph (a) above. In addition to t
he
exposure permitted above, banks may, in exceptional circumstances, with the appr
oval
of their Boards, consider enhancement of the exposure to a borrower up to a furt
her 5
per cent of capital funds. The bank should make appropriate disclosures in the '
Notes
on account' to the annual financial statements in respect of the exposures where
the
bank had exceeded the prudential exposure limits during the year.
(2) Assignment of Risk Weight for Capital Adequacy Purposes: Banks are
required to be guided by the Prudential Guidelines on Capital Adequacy and Marke
t
Discipline- Implementation of the New Capital Adequacy Framework, as amended fro
m
time to time in the matter of capital adequacy.
(3) Asset Liability Management: The long-term financing of infrastructure projec
ts
may lead to asset - liability mismatches, particularly when such financing is no
t in
conformity with the maturity profile of a bank's liabilities. Banks would, there
fore, need to
exercise due vigil on their asset-liability position to ensure that they do not
run into
liquidity mismatches on account of lending to such projects.
(4) Administrative arrangements: Timely and adequate availability of credit is t
he
pre-requisite for successful implementation of infrastructure projects. Banks/ F
ls should,
therefore, clearly delineate the procedure for approval of loan proposals and in
stitute a
suitable monitoring mechanism for reviewing applications pending beyond the spec
ified
period. Multiplicity of appraisals by every institution involved in financing, l
eading to
delays, has to be avoided and banks should be prepared to broadly accept technic
al
parameters laid down by leading public financial institutions. Also, setting up
a
mechanism for an ongoing monitoring of the project implementation will ensure th
at the
credit disbursed is utilized for the purpose for which it was sanctioned.
(D) Take-out Financing or Liquidity Support
(1) Take-out Financing or Liquidity Support: Take-out financing structure is
essentially a mechanism designed to enable banks to avoid asset-liability maturi
ty
mismatches that may arise out of extending long tenor loans to infrastructure pr
ojects.
Under the arrangements, banks financing the infrastructure projects will have an
arrangement with I D F C or any other financial institution for transferring to
the latter the
out standings in their books on a pre-determined basis. I D F C and S B I have d

evised
different take-out financing structures to suit the requirements of various bank
s,
addressing issues such as liquidity, asset-liability mismatches, limited availab
ility of project appraisal skills, etc. They have also developed a Model Agreeme
nt that can be
considered for use as a document for specific projects in conjunction with other
project
loan documents. The agreement between S B I and I D F C could provide a referenc
e
point for other banks to enter into somewhat similar arrangements with I D F C o
r other
financial institutions.
(2) Liquidity support from I D F C: As an alternative to take-out financing
structure, I D F C and S B I have devised a product, providing liquidity support
to banks.
Under the scheme, I D F C would commit, at the point of sanction, to refinance t
he
entire outstanding loan (principal+ unrecovered interest) or part of the loan, t
o the bank
after an agreed period, say, five years. The credit risk on the project will be
taken by the
bank concerned and not by I D F C. The bank would repay the amount to I D F C wi
th
interest as per the terms agreed upon. Since I D F C would be taking a credit ri
sk on the
bank, the interest rate to be charged by it on the amount refinanced would depen
d on
the I D F C's risk perception of the bank (in most of the cases, it may be close
to I D F
C's P L R). The refinance support from I D F C would particularly benefit the ba
nks
which have the requisite appraisal skills and the initial liquidity to fund the
project.
Summary
Term loans are normally provided by the banks for the acquisition of fixed asset
s
or other long-term requirements (like for education or investments) of a custome
r. The
terms of sanction invariably stipulate schedule of repayment of principal and in
terest. In
appraisal of a term-loan proposal, D S C R is as important a ratio as current ra
tio is in
appraisal of working capital limits. Sometimes, banks issue Deferred payment
Guarantees (D P Gs) in favour of suppliers of capital equipments, if he is prepa
red to
accept the sales price on deferred basis. However, the appraisal or a D P G is s
imilar to
that of a term-loan as the risks involved are similar. A project appraisal is si
milar to a
term-loan appraisal with some additional points to consider. Project appraisal b
roadly
involves appraisal of managerial aspects and examination of techno-economic
feasibility. Infrastructure sector deals with roads, bridges, power, transport,
telecommunication etc. Infrastructure projects involve some distinct features li
ke
exceptionally long implementation, gestation and pay back periods, high debt equ
ity
ratio, etc. R B I has issued elaborate guidelines to banks on infrastructure fin
ancing.

Keywords
Repayments; D P G; W C T L; D S C R; E M I; Project; Infrastructure; I D F C; Ta
ke out
financing; Inter-institutional guarantees
Check Your Progress
1. A D G P is issued by the bank for ----------, by its client.
The choices are
(a) Sale of goods
(b) Purchase of goods
(c) Sale of capital goods(d) Purchase of capital goods
The correct choice is (d) Purchase of capital goods
2. Which of the following statements is not true for an infrastructure project?
The choices are
(a) It has long gestation period
(b) It reduces the risk for the lender as his funds get assured deployment for a
long time.
(c) The debt equity ratio is normally high for an infrastructure project
(d) The implementation period is usually long
The correct choice is (b) It reduces the risk for the lender as his funds get as
sured
deployment for a long time.
3. Which of the following is not a source of funds for meeting the cost of fixed
assets by
an enterprise?
The choices are
(a) Credit by supplier of assets
(b) Internal accruals
(c) Debentures
(d) D P G
The correct choice is (d) DPG
4. Which of the following is ratio, indicative of the repaying capacity of a bor
rower?
The choices are
(a) Quick ratio
(b) T O L/T N W
(c) D S C R
(d) D E R
The correct choice is (c) D S C R
5. Which of the following is not correct regarding term loans by the banks?
The choices are
(a) Asset liability matching is an important consideration in term financing
(b) Installment of term loan, payable within one year is considered as current
liability
(c) Repayment of a term loan can be in equated monthly instalments
(d) Current ratio is the most important ratio in appraisal of a term loanThe cor
rect choice is (d) Current ratio is the most important ratio in appraisal of a
term loan
6. Project loans can be given by the bank to
The choices are
(a) Only corporates
(b) Only corporates and partnership firms
(c) Only corporate, partnership firms and societies
(d) Any business entity
The correct choice is (d) Any business entity
7. Which of the following is not correct regarding infrastructure project by the
banks?
The choices are
(a) Banks are allowed to funds promoters' equity in certain circumstances
(b) Exposure norms are relaxed by R B I

(c) Asset liability mismatch has been permitted by R B I


(d) I D F C provides liquidity support to banks
The correct choice is (c) Asset liability mismatch has been permitted by R B I
8. Which of the following statements is not correct for project appraisal?
The choices are
(a) Examination of technical feasibility is carried out
(b) The contribution of promoters forms a part of economic appraisal
(c) Promoters' background is part of the management appraisal
(d) Capacity of promoters to arrange for additional funds, in case of
contingencies, forms a part of economic appraisal.
The correct choice is (d) Capacity of promoters to arrange for additional funds,
in
case of contingencies, forms a part of economic appraisal.
Key to Check your Progress
1. (d); 2. (b); I (d); 4. (c); 5. (d); 6. (d), 7. (c); 8. (d)
END OF CHAPTER 29
ADVANCED BANK MANAGEMENT- C A I I B
PAPER 1ADVANCED BANK MANAGEMENT
UNIT 30 Credit Delivery
STRUCTURE
30.0 Objectives
30.1 Introduction
30.2 Documentation
30.3 Third Party Guarantees
30.4 Charge over Securities
30.5 Possession of Security
30.6 Disbursal of Loans
30.7 Lending under Consortium/Multiple Banking Arrangements
30.8 Syndication of Loans
30.0 OBJECTIVES
After reading this chapter, you will have better understanding of:
(1) Documentation
(2) Third party guarantees
(3) Various methods of creating charge over securities
(4) Methods of delivery of bank loans
(5) Consortium / multiple banking and syndication of loan
30.1 INTRODUCTION
While, for the safety of an advance, the credit appraisal is critical for select
ing the
right borrower, assessing his credit needs and the viability of his operations
appropriately and prescribing suitable terms and conditions for the credit, ther
e are a
few questions to be addressed before the bank parts with its money. These questi
ons
are:
(1) What documents should be obtained from the borrower and the guarantor so
that in the event of any default, the bank has the legal recourse to recover the
money?
(2) Whether any charge is to be created on the primary and collateral security?
If
yes, how it should be done?(3) Whether the charge of the bank on the securities
is to registered with any
authority prescribed by the law?
(4) Whether the securities should be in possession of the borrower or the bank'?
(5) How the loan should be disbursed'? Whether we issue a cheque for the loan
amount in the name of the borrower or, should his account with the bank be credi
ted or
should some other method be adopted?
(6) What are the R B I guidelines in this respect?
30.2 DOCUMENTATION
Documents are to be signed by the borrowers and guarantors so that the bank

can establish their liability in a court of law. In addition, the borrower has t
o sign the
documents which create charge over the primary security, i.e. the security creat
ed out
of the bank finance. For charge over collateral security, the owner of that secu
rity
should sign the relevant documents. It should be ensured that if the owner of th
e
collateral security is someone other than the borrower, he should first become a
guarantor of the loan and then create charge over the security. Each bank's lega
l
department prescribes the standard documents to be taken depending on the type o
f
the loan. In case of a structured loan, the legal department drafts the document
s
applicable to that particular case. However, a few points, which must be ensured
, by the
credit officer. in connection with execution of the documents, are as under:
(1) The documents should be properly stamped
(2) The date of execution of documents should never be earlier than the date of
stamping. Date and place of execution should be properly mentioned in the docume
nts.
(3) It should be ensured that the parties executing the documents have the
necessary authority and the capacity to enter into a contract and executed the
documents in that capacity. For example, a partner should sign on behalf of the
firm and
not in his individual capacity.
(4) It should be ensured that the person signing the documents is doing so with
his free will
(5) The documents should be filled in before these are signed.
(5) In case of companies, the charge should be registered with ROC. within 30
days from the date of execution of the documents.
(6) If any document is required to be registered with the Sub-registrar, it shou
ld
be done within the prescribed time limit.
30.3 THIRD PARTY GUARANTEES
While the enterprise or individual, who has taken the loan from the bank is lega
lly
bound to repay the principal and the interest, in some cases, banks stipulate gu
arantees
of third parties, as an additional safety against default. These third parties c
an be
individuals or any other legal entity. In case of finance to firms, the personal
guarantee
of proprietor or partners is not stipulated as they have unlimited liability and
their
personal assets can be attached for recovery of bank loans. However, in case of
companies and other legal entities, the promoters/ directors/ trustees do not ha
ve
unlimited/ any liability towards bank's dues. Therefore, in many cases banks sti
pulate
their personal guarantees. R B I suggestions to the banks in this respect are as
follows:
(1) Personal guarantees of directors may be helpful in respect of companies,
whether private or public, where shares are held closely by a person or connecte
d
persons or a group (that being professionals or Government), irrespective of oth
er
factors, such as financial condition, security available, etc., the exception be

ing in
respect of companies where, by court or statutory order, the management of the
company is vested in a person or persons, whether called directors or by any oth
er
name, who are not required to be elected by the shareholders. Where personal
guarantee is considered necessary, the guarantee should preferably be that of th
e
principal members of the group holding shares in the borrowing company rather th
an
that of the director or managerial personnel functioning as director or in any m
anagerial
capacity.
(2) Even if a company is not closely held, there may be justification for a pers
onal
guarantee of directors to ensure continuity of management. Thus, a lending insti
tution
could make a loan to a company whose management is considered good.
Subsequently, a different group could acquire control of the company, which coul
d lead
the lending institution to have well-founded fears that the management has chang
ed for
the worse and that the funds lent to the company are in jeopardy. One way by whi
ch
lending institutions could protect themselves in such circumstances is to obtain
guarantees of the directors and thus ensure either the continuity of the managem
ent or
that the changes in management take place with their knowledge. Even where perso
nal
guarantees are waived, it may be necessary to obtain an undertaking from the
borrowing company that no change in the management would be made without the
consent of the lending institution. Similarly, during the formative stages of a
company, it
may be in the interest of the company, as well as the lending institution, to ob
tain
guarantees to ensure continuity of management.
(3) Personal guarantees of directors may be helpful with regard to public limite
d
companies other than those which may be rated as first class, where the advance
is on
an unsecured basis.
(4) There may be public limited companies, whose financial position and/or
capacity for cash generation is not satisfactory even though the relevant advanc
es are
secured. In such cases, personal guarantees are useful.
(5) Cases where there is likely to be considerable delay in the creation of a
charge on assets, guarantee may be taken, where deemed necessary, to cover the
interim period between the disbursement of loan and the creation of the charge o
n
assets.
(6) The guarantee of parent companies may be obtained in the case of
subsidiaries whose own financial condition is not considered satisfactory.
(7) Personal guarantees are relevant where the balance sheet or financial
statement of a company discloses interlocking of funds between the company and o
ther
concerns owned or managed by a group.R B I has also advised the banks to obtain
an undertaking from the borrowing
company as well as the guarantors that no consideration whether by way of
commission, brokerage fees or any other form, would be paid by the former or rec
eived

by the latter, directly or indirectly. This requirement should be incorporated i


n the bank's
terms and conditions for sanctioning of credit limits. During the periodic inspe
ctions, the
bank's inspectors should verify that this stipulation has been complied with. Th
ere may,
however, be an exceptional case where payment of remuneration may be permitted,
e.g. where assisted concerns are not doing well and the existing guarantors are
no
longer connected with the management but continuance of their guarantees is
considered essential because the new management's guarantee is either not availa
ble
or is found inadequate and payment of remuneration to guarantors by way of guara
ntee
commission is allowed.
30.4 CHARGE OVER SECURITIES
Nature of security and the operational convenience often decide the type of
charge to be created over a security. The procedure for creation of charge is sa
me for
both primary and collateral securities. The point to be kept in mind is that onl
y the owner
of an asset can create charge over it. The charge could be any of the following:
(1) Mortgage
(2) Hypothecation Pledge
(3) Lien
(4) Assignment
30.5 POSESSION OF SECURITY
At the time of appraisal, banker has to decide about the possession of the
security specially in case of inventory. With legal system in the country being
still not
perfect, this aspect has a bearing on the overall risk rating of the proposal. T
ill about a
decade ago, a favoured method of finance of many banks used to be the, 'Lock and
Key' advances in which the goods are kept in a godown and bank holds the keys of
the
locks of the godown. If any goods are to be delivered to the borrower, he has t
o deposit
the money in his cash credit account (alternatively, provide a trust receipt) be
fore bank's
'Godown Keeper' goes to the godown and delivers the goods. This system was very
inconvenient not only for the borrower but for the bank also and slowly got chan
ged to
'Hypothecation', where possession remained with the borrower. In case of 'Pledge
' also,
the borrower can have possession, called, 'Constructive Possession', and hold th
e
goods as an agent of the bank.
30.6 DISBURSAL OF LOANS
Working Capital Loans
In case of sole banking, the bank providing working capital limits opens a cash
credit account of the borrower and all his financial transactions should be rout
ed
through this account. Without bank's permission, no account can be opened with a
ny
other bank. Banks give permission to open current account with other bank only i
f they are convinced about its necessity. In such cases, periodic statements of
that account
are obtained to keep a tab on the transactions.
The drawings in the cash credit account are regulated through the system of

'Drawing power' (D P) which is within the sanctioned cash credit limit. Ideally,
the DP
should be calculated by obtaining a statement of all the current assets and liab
ilities
(excluding outstanding in cash credit account with the bank) and deducting from
it the N
W C stipulated at the time of assessment of the limit. However, this is not feas
ible as
such a statement is normally available only after accounts are finalized. Even i
f bank
insists for such statement, it will be available after much delay and may not se
rve the
purpose. Therefore, banks obtain the statement of stocks, book-debts/receivables
and
the sundry creditors (account payable). These three items form major portion of
current
assets and liabilities in majority of the enterprises. Such statement is normall
y obtained
on monthly basis but the periodicity can be reduced in exceptional cases. By sti
pulating
suitable margins (depending on method of assessment) on stocks and book debts an
d
reducing the amount of sundry creditors, the D P is calculated.
Disbursal of entire W C limit by way of cash credit gives wide flexibility to th
e
borrower in his working capital management. But, it creates the problem of fund
management for the bank as there could be wide fluctuations in the utilization o
f limits.
This also offers scope for diversion of funds by the borrower. If the liquidity
in the market
is tight and short-term interest on money market instruments is high, he may ten
d to
utilize the limit fully In situations of abundant liquidity, the situation is re
verse and the
utilization of limit may tend to be low. The bank loses in such situations as it
has to
arrange for short term funds when interest rates are high and is left with surpl
us funds
when rates are low. To meet this situation and to ensure that the utilization of
limit is
more stable, a portion of sanctioned limit is disbursed by way of 'Loan', which
is a fixed
component, and remaining amount is disbursed as cash credit.
With this, if the borrower wants to draw very little amount or no amount, there
will
be debit in the loan account (fixed amount) while the cash credit account may ha
ve
credit balance. R B I guidelines in this respect are as follows:
(1) In the case of borrowers enjoying working capital credit limits of Rs 10 cro
re
and above from the banking system, the loan component should normally be 80
percent. Banks, however, have the freedom to change the composition of working
capital by increasing the cash credit component beyond 20 percent or to increase
the
'Loan Component' beyond 80 percent, as the case may be, if they so desire. Banks
are
expected to appropriately price each of the two components of working capital fi
nance,
taking into account the impact of such decisions on their cash and liquidity
management.

(2) In the case of borrowers enjoying working capital credit limit of less than
Rs.
10 crone, banks may persuade them to go in for the 'Loan System' by offering an
incentive in the form of lower rate of interest on the loan component, as compar
ed to the
cash credit component. The actual percentage of 'loan component' in these cases
may
be settled by the bank with its borrower clients.
(3) In respect of certain business activities, which are cyclical and seasonal i
n
nature or have inherent volatility, the strict application of loan system may cr
eate difficulties for the borrowers. Banks may, with the approval of their respe
ctive Boards,
identify such business activities, which may be exempted from the loan system of
delivery.
Term loans
If the term loan is to be disbursed in one go, e.g. purchase of a machine/ ready
house, the borrower is asked to deposit his margin with the bank, his loan accou
nt is
debited by the amount of the loan and the entire amount to be paid to the buyer,
is
remitted to him by the bank. If any amount has already been paid to the buyer by
the
customer, satisfactory proof, like details of bank account etc, of this payment
is
obtained, and this is considered to be a part of his contribution (margin). In e
xceptional
cases, like personal loans or consumption loans, the amount may be credited to t
he
account of the customer with the bank.
In cases where the execution of the project is spread over a period of time, the
disbursement is normally related to the progress of the project. RBI guidelines
in
respect of disbursement of project loans are as under:
'At the time of financing projects banks generally adopt one of the following
methodologies as far as determining the level of promoters' equity is concerned.
(1) Promoters bring their entire contribution upfront before the bank starts
disbursing its commitment.
(2) Promoters bring certain percentage of their equity (40%
50%) upfront and
balance is brought in stages.
(3) Promoters agree, ab initio, that they will bring in equity funds proportiona
tely
as the banks finance the debt portion.
While it is appreciated that such decisions are to be taken by the boards of the
respective banks, it has been observed that the last method has greater equity f
unding
risk. In order to contain this risk, banks are advised in their own interest to
have a clear
policy regarding the Debt Equity Ratio (DER) and to ensure that the infusion of
equity/fund by promoters should be such that the stipulated level of DER is main
tained
at all times. Further they may adopt funding sequences so that possibility of eq
uity
funding by banks is obviated'
30 .7 LENDING UNDER CONSORTIUM/MULTIPLE BANKING
ARRANGEMENTS

The sole banking is suitable for financing working capital needs of an enterpris
e
only if the requirement is within the policy framework of the financing bank. If
the
requirements grow beyond the comfort level of that bank due to prudential norms
or risk
perception for a particular segment [borrower, it would like another bank to fin
ance a
part of the requirements of that enterprise. Sometimes, even the borrowers may p
refer
not to depend on one bank and avail facilities from various banks. If two or mor
e banks
get into a formal arrangement to finance the working capital needs of a borrower
, it is
called consortium arrangement. The consortium banks decide on one of the members
as 'Lead bank' who not only arranges periodic meetings of the member banks but a
lso takes lead in assessment, documentation, charge creation, monitoring of the
account,
etc. In case of multiple banking there is no formal arrangement between the bank
s
though they may share the information about the account in their mutual interest
.
RBI Guidelines
Various regulatory prescriptions regarding conduct of consortium, multiple
banking and syndicate arrangements were withdrawn by Reserve Bank of India in
October 1996 with a view to introducing flexibility in the credit delivery syste
m and to
facilitate smooth flow of credit. However, Central Vigilance Commission, Governm
ent of
India, in the light of frauds involving consortium/multiple banking arrangements
, had
expressed concerns on the working of Consortium Lending and Multiple Banking
Arrangements in the banking system. The Commission had attributed the incidence
of
frauds mainly to the lack of effective sharing of information about the credit h
istory and
the conduct of the account of the borrowers among various banks. It was felt tha
t there
is need for improving the sharing/dissemination of information among the banks a
bout
the status of the borrowers enjoying credit facilities from more than one bank.
Accordingly, RBI advised the banks to strengthen their information back-up about
the
borrowers enjoying credit facilities from multiple banks as follows:
(1) 'At the time of granting fresh facilities, banks may obtain declaration from
the
borrowers about the credit facilities already enjoyed by them from other banks i
n the
format prescribed (Ref RBI circular nos. DBOD No. BP.BC.46/08.12.001/2008-09 dat
ed
September 19, 2008 and DBOD. No. BP.BC.94/ 08.12.001/2009-09 dated December 8,
2008.). In the case of existing lenders, all the banks may seek a declaration fr
om their
existing borrowers, availing sanctioned limits of Rupees 5.00 crores and above o
r
wherever, it is in their knowledge that their borrowers are availing credit faci
lities from
other banks, and introduce a system of exchange of information with other banks
as

indicated above.
(2) Subsequently, banks should exchange information about the conduct of the
borrowers' accounts with other banks in the format given in Annex 11 of RBI DBOD
circulars referred to in (i) above at least at quarterly intervals.
(3) Obtain regular certification by a professional, preferably a Company
Secretary, Chartered Accountant or Cost Accountant, regarding compliance of vari
ous
statutory prescriptions that are in vogue, as per specimen given in Annex III of
RBI
circulars referred to in (i) above and DBOD. No. BP.BC. 110/ 08.12.001/2008-09 d
ated
February 10, 2009.
(4) Make greater use of credit reports available from CIBIL.
(5) The banks should incorporate suitable clauses in the loan agreements in
future (at the time of next renewal in the case of existing facilities) regardin
g exchange
of credit information so as to address confidentiality issues.'
Vide circular RBI/2008-09/354[UBD.PCB.No.36/13.05.000/2008-09 dated
January 21, 2009, in addition to Company Secretaries, banks were permitted to al
so accept the certification by Chartered Accountants & Cost Accountants. Further
, Annex
Part I and Part II has also been modified.
III
30.8 SYNDICATION OF LOANS
The term 'Syndication' is normally used for sharing a long-term loan to a
borrower by two or more banks. This is a way of sharing the risk, associated wit
h
lending to that borrower, by the banks and is generally used for large loans. Th
e
borrower, intending to avail the desired amount of loan, gives a mandate to one
bank
(called Lead bank) to arrange for sanctions for the total amount, on its behalf.
The lead
bank approaches various banks with the details These banks appraise the proposal
as
per their policies and risk appetite and take the decision. The lead bank does t
he liaison
work and common terms and conditions of sanction may be agreed in a meeting of
participating banks, arranged by the lead bank. Normally, the lead bank charges
'Syndication fee' from the borrower.
Summary
It is anticipated, at the time of sanctioning a loan, that the repayment of prin
cipal and
interest will be as per the schedule and all other terms of sanction will also b
e abided by
the borrower. However, in some cases, due to malafide intentions or due to busin
ess
failure, the bank may have to fall back on the securities available and take oth
er legal
action depending upon the circumstances of each case. Therefore, before disbursi
ng
the money, the bank ensures that it creates appropriate charge over the securiti
es and
the documents are executed as per the legal requirement. Personal guarantee of t
he
directors or third party guarantees can also be stipulated. The working capital
limits are
disbursed as cash credit or a combination of cash credit and loan. RBI guideline
s for
disbursal of both working capital and term loans should be followed. In case of

borrowers, whose working capital requirements are large, two or more banks can m
eet
the requirements. This is done under consortium arrangement or under multiple
banking. To prevent the misutilisation of banking system, RBI has issued guideli
nes
regarding both consortium and multiple banking. RBI has also issued guidelines f
or
syndication of loans for both working capital and term loans. But, banks are usi
ng
syndication only for term loans.
Keywords
Personal guarantee; Third party guarantee; Assignment; Lien; Hypothecation; Pled
ge;
Possession of security; Documents; Consortium arrangement; Multiple banking;
Syndication of loans; Lead bank for syndication.
Check Your Progress
State True or False:
(1) The stamp duty on documents varies from State to State. . True.
(2) The date of execution of documents can be earlier than the date of stamping.
.False.(3) The parties executing the documents should have the necessary authorit
y and the
capacity to enter into a contract and execute the documents in that capacity. . T
rue.
(4) Bank should ensure that the person signing the documents is doing so with hi
s free
will. . True.
(5) The documents can be filled in after these are signed. .False.
(6) In case of companies, the charge should be registered with ROC within 60 day
s
from the date of execution of the documents. .False.
(7) Some documents may be required to be registered with the sub-registrar. . Tru
e.
(8) Third party guarantees can be taken from individuals only. Any other legal e
ntity can
not be third party guarantor. .False.
(9) Bank can create charge over security not belonging to either the borrower or
the
guarantor. .False.
(10) Under 'Hypothecation', the possession of goods remains with the borrower. .
True.
(11) Under 'Pledge', the possession of goods may remain with the borrower depend
ing
on bank's decision. . True.
(12) As per RBI guidelines, in the case of borrowers enjoying working capital cr
edit
limits of Rs. 10 crore and above from the banking system, the loan component sho
uld
normally be 80 per cent. . True.
(13) Under 'Loan system', the borrower has to maintain a minimum debit balance i
n his
loan account, while the cash credit account may have a credit balance. . True.
(14) Banks disburse the term loans as per the progress of the project . True.
(15) Consortium banking and Multiple banking are same. .False.
(16) RBI encourages Multiple or Consortium banking for small loans. . False.
Key to Check Your Progress
1. True; 2. False; 3. True; 4. True; 5. False; 6. False; 7. True; 8. False; 9. F
alse; 10.
True; 11. True; 12.True; 13. True; 14. True; 15. False; 16. False
END OF CHAPTER 30 ADVANCED BANK MANAGEMENT- C A I I B

PAPER 1ADVANCED BANK MANAGEMENT


UNIT 31
Credit Control and Monitoring
STRUCTURE
31.0 Objectives
31.1 Importance and Purpose
31.2 Available Tools for Credit Monitoring/Loan Review Mechanism
31.0 OBJECTIVES
After reading this chapter, you will have better understanding of:
(1) Importance and purpose of credit control and monitoring
(2) Various tools used by banks for credit control and monitoring.
(3) Credit audit
31.1 IMPORTANCE AND PURPOSE
Despite an excellent credit appraisal, documentation and attention to security,
the risk of default in an advance may go up as the time passes because the
assumptions made at the time of appraisal may lose their sanctity, in view of th
e
dynamic nature of business environment. Credit control and monitoring, often ref
erred
as Loan Review Mechanism (L R M), plays an important role in the following aspec
ts:
(1) To ensure that the funds provided by the bank are put to the intended use
and continue to be used properly. Any diversion of bank's funds out of the busin
ess or
for unauthorized use within the business should be detected and stopped.
(2) To ascertain that the business continues to run on the projected lines. If t
here
is any deterioration from what was projected at the time of appraisal, the same
should
be noticed and appropriate action initiated by the bank, in consultation with th
e
borrower, to ensure that the business continues to run on viable lines.
(3) If the deterioration of the business continues despite appropriate action, t
he
bank should decide if any harsh action like, recalling the advance or seizing th
e
security, etc. is necessary. In such cases, an early detection of the problem is
very
important as any delay in necessary action by the bank may result in deteriorati
on of the
available security and reduce the chances and amount of recovery.
31.2 AVAILABLE TOOLS FOR CREDIT MONITORING / L R M
The following records/information /methods are used by the bankers to monitor th
e
credit;(1) Conduct of the Accounts with the Bank: This gives very useful
information about the financial health of the enterprise and use of the funds by
it.
Frequent over-drawings, return of cheques and bills, delays in submission of sta
tements
of stock and receivables, low turnover, routing of transactions with some other
bank,
delay in payment of interest and installments, devolvement of L Cs, invocation o
f Bank
Guarantees, etc. are some of the unsatisfactory features. In such cases, banks
may
strengthen their monitoring system by resorting to more frequent inspections of
borrowers' go downs, ensuring that sale proceeds are routed through the borrower
's
accounts maintained with the bank and insisting on pledge of the stock in place
of
hypothecation.

(2) Periodic Information Submitted as per the Terms of the Advance:


The statements of stock and receivables are to be submitted by the borrower at r
egular
intervals (normally, monthly) and the bank calculates the Drawing Power (D P) on
the
basis of these. A thorough scrutiny of these is necessary to verify their correc
tness,
accumulation of inventory (non-moving stocks) and old receivables (normally
receivables above six months are excluded for calculating D P). The detection of
nonmoving stocks and old receivables is not only necessary for correct calculation
of D P
but is also warranted to detect the danger signals in the business of the borrow
er.
During periodic inspection of the enterprise, by the bank officials, the latest
statement of
stocks and receivables are cross checked with the records. Stocks are also physi
cally
verified either fully or on random selection basis.
(3) Audit of Stocks and Receivables Conducted by the Bank: Stock audit
is used by the bank in case of medium and large size accounts where verifying th
e
stocks during normal inspection is not feasible or where the stocks are located
at
various locations. Similarly, audit of receivables may also be conducted in some
cases.
The purpose of these audits is to cross check the reliability of the statements
submitted
by the borrower.
(4) Financial Statements of the Business, Auditors Report: These are
normally available once a year. An analysis of these statements gives useful inf
ormation
about the use and diversion of funds, financial health, realization of debts, pr
ofitability,
etc. In case of working capital limits, this analysis is a part of the renewal e
xercise.
(5) Periodic Visits and Inspection: The purpose of periodic visits is manifold.
(a)
It gives an impression about the activity level. The assessment of limits is bas
ed on an
anticipated level of operations and field visit helps in ascertaining whether ac
tivities are
at that level or not. (b) It helps in finding out the position of stocks and oth
er assets
charged to the bank. (c) The fact of bank's charge over the assets should be
prominently displayed Yield visits help in finding out this.
(6) Interaction: Interaction with select creditors and debtors.
(7) Periodic Scrutiny: Periodic scrutiny of borrowers' books of accounts and the
accounts maintained with other banks
(8) Market Reports about the, Borrower and the Business Segment:
These reports are available from the industry associations and rating agencies.(
9) Appointing Bank s Nominee on Company s Board: In exceptional
cases, or in case of large limits, bank may opt to appoint nominee director on t
he board
to keep a tab on the important decisions.
(10) Credit Audit: (The details given here are based on R B I's 'Guidance note o
n
credit risk management') Credit audit is an examination of various credit functi
ons of the

bank. It is normally conducted by internal staff having adequate credit experien


ce.
Credit Audit examines compliance with extant sanction and post-sanction processe
s
and procedures laid down by the bank from time to time. Each bank formulates its
own
policies, procedures, and organizational set up for credit audit. In some banks,
credit
audit plays an important role in monitoring of large value accounts also.
R B I's suggestions in this respect, contained in their 'Guidance note on credit
risk management', are as under:
(A) Objectives of Credit Audit
(1) Improvement in the quality of credit portfolio
(2) Review sanction process and compliance status of large loans
(3) Feedback on regulatory compliance
(4) Independent review of Credit Risk Assessment
(5) Pick-up early warning signals and suggest remedial measures
(6) Recommend corrective action to improve credit quality, credit administration
and credit skills of staff, etc.
(B) Structure of Credit Audit Department: The credit audit and loan review
mechanism may be assigned to a specific Department or the Inspection and Audit
Department.
(C ) Functions of Credit Audit Department
(1) To process Credit Audit Reports
(2) To analyze Credit Audit findings and advise the departments/ functionaries
concerned
(3) To follow up with controlling authorities
(4) To apprise the Top Management
(5) To process the responses received and arrange for closure of the relative
Credit Audit Reports
(6) To maintain database of advances subjected to Credit Audit
(D) Scope and Coverage: The focus of credit audit needs to be broadened from
the account level to look at the overall portfolio and the credit process being
followed.
The important areas are:
(1) Portfolio Review: Examine the quality of Credit & Investment (Quasi Credit)
Portfolio and suggest measures for improvement, including reduction of concentra
tions in certain sectors to levels indicated in the Loan Policy and Prudential L
imits suggested
by RBI.
(2) Loan Review: Review of the sanction process and status of post sanction
processes and procedures (not just restricted to large accounts)
(a) all fresh proposals and proposals for renewal of limits (within 3 to 6 month
s
from date of sanction)
(b) all existing accounts with sanction limits equal to or above a cut off depen
ding
upon the size of activity
(c) randomly selected ( say 5-10%) proposals from the rest of the portfolio
(d) accounts of sister concerns/group/associate concerns of above accounts,
even if limit is less than the cut off
(3) Action Points for Review
(1) Verify compliance of bank's laid down policies and regulatory compliance wit
h
regard to sanction
(2) Examine adequacy of documentation
(3) Conduct the credit risk assessment
(4) Examine the conduct of account and follow up looked at by line functionaries

(5) Oversee action taken by line functionaries in respect of serious irregularit


ies
(6) Detect early warning signals and suggest remedial measures thereof
(4) Frequency of Review: The frequency of review should vary depending on
the magnitude of risk (say, for the high risk accounts - 3 months, for the avera
ge risk
accounts- 6 months, for the low risk accounts- I year).
(1) Feedback on general regulatory compliance
(2) Examine adequacy of policies, procedures and practices
(3) Review the Credit Risk Assessment methodology
(4) Examine reporting system and exceptions thereof
(5) Recommend corrective action for credit administration and credit skills of s
taff
(6) Forecast likely happenings in the near future
(5) Procedure to be followed for Credit Audit
(1) Credit Audit is conducted on site, i.e. at the branch which has appraised th
e
advance and where the main operative credit limits are made available.
(2) Report on conduct of accounts of allocated limits is to be called from the
corresponding branches.
(3) Credit auditors are not required to visit borrowers' factory or office premi
ses.Summary
Post-disbursal control, supervision and monitoring are very important for the
safety of bank's advance. The purpose is to ensure that the funds provided by th
e bank
are put to the intended use and continue to be used properly. This is also inten
ded to
ascertain that the business continues to run on the projected lines and continue
s to be
run on viable lines. The deterioration, if any, in the securities charged to the
bank can
also be detected by efficient monitoring This helps the bank in taking timely ac
tion for
taking the corrective measures or starting the recovery proceedings.
The tools available to the bank for effective monitoring are: (a) Conduct of the
accounts with the bank; (b) Periodic information submitted as per the terms of t
he
advance; (c) The statements of stock and receivables submitted by the borrower a
t
regular intervals (normally, monthly); (d) Stock/receivables audit conducted by
the bank;
(e) Financial statements of the business, auditors' report; (f) Periodic visits
and
inspections; (g) Interaction with select creditors and debtors; (h) Periodical s
crutiny of
borrowers' books of accounts and the accounts maintained with other banks; and (
i)
Market reports about the borrower and the business segment. In rare cases, bank
may
also appoint its nominee on company's board. The credit audit is also a very eff
ective
tool in supervision of credit.
Keywords
Supervision; Monitoring; Control: Loan Review Mechanism(L R M); Stock statement;
Receivable statement; Deterioration of security; Inspection; Stock audit; Receiv
ables
audit; Credit audit
Check Your Progress

1. Which of the following is not a purpose of credit monitoring? The choices are
:
(a) To ensure end use of the funds by the borrower
(b) To detect any deterioration in the security charged to the bank
(c) To comply with the guidelines of the RBI
(d) To ascertain that the business continues to run on the projected lines
The correct choice is.. (c) To comply with the guidelines of the RBI
2. Which of the following is not a tool available to check the bank for credit
monitoring?
The choices are:
(a) Sending regular reminders to the borrower
(b) Periodic visits to the business place for inspection
(c) Analysis of financial statements
(d) Examine conduct of borrower's account
The correct choice is.. (a) Sending regular reminders to the borrower3. Which o
f the following is not a method for detecting wrong mention of
inventory in a stock statement? The choices are:
(a) Stock audit
(b) Inspection of stocks
(c) Analysis of financial statements
(d) Cross-check from the balance sheet figure
The correct choice is (c) Analysis of financial statements
4. Which of the following is not a method for detecting wrong mention of
receivables in stock statement submitted by the borrower? The choices are:
(a) Analysis of financial statements
(b) Cross check from the balance sheet figure
(c) Receivables audit
(d) Inspection of books of account
The correct choice is.. (a) Analysis of financial statements
5. Which of the following is not a danger sign about the direction of business o
f
the borrower? The choices are:
(a) Devolvement of L Cs, invocation of Bank Guarantees
(b) Demand for higher limit
(c) Delays in submission of stock/receivables statements
(d) Return of cheques or bills
The correct choice is.. (d) Return of cheques or bills
6. Which of the following is not an unsatisfactory sign in conduct of the accoun
t
of the borrower? The choices are:
(a) Delay in payment of interest or instalments,
(b) routing of transactions with some other bank
(c) Frequent over drawings
(d) High turnover
The correct choice is (d) High turnover
7. Which of the following is not the purpose credit audit? The choices are:
(a) Improvement in the quality of credit portfolio
(b) Review sanction process and compliance status of large loans
(c) Feedback on regulatory compliance
(d) Stock inspection
The correct choice is (d) Stock inspection8. Purpose of appointing bank s nominee
on company s board of borrowing
company is:
The choices are:
(a) To keep a tab on the important decisions of the board
(b) To be a part of the management
(c) To guide the company for better working
(d) To safeguard the securities charged to the bank
The correct choice is (a) To keep a tab on the important decisions of the board
END OF CHAPTER 31
ADVANCED BANK MANAGEMENT- C A I I B

PAPER 1 - Credit Control and Monitoring.ADVANCED BANK MANAGEMENT


UNIT 32
Risk Management and Credit Rating
STRUCTURE
32.0 Objectives
32.1 Meaning of Credit Risk
32.3 Factors Affecting Credit Risk
32.4 Steps taken to Mitigate Credit Risks
32.5 Credit Ratings
32.6 Internal and External Ratings Methodology of Credit Rating
32.7 Use of Credit Derivatives for Risk Management
32.8 Basel 11 Accord
32.9 Introduction of Advanced Approaches of Basel II Framework in India
32.0 OBJECTIVES
After reading this chapter, you will have better understanding of:
(1) The various risks faced by the banks
(2) The meaning of credit risk
(3) Factors affecting credit risks
(4) Steps taken to mitigate credit risks
(5) The meaning of credit rating
(7) Objectives and importance of credit rating
(8) What is credit scoring
(9) Method of credit scoring
32.1 MEANING OF CREDIT RISK
The risks faced by the business of banking can be classified into three broad
categories;
(1) Operational Risks: The examples of such risks are losses due to frauds, disr
uption
of business due to natural calamities like floods etc.
(2) Market Risks: These are the risks resulting from adverse market movements of
interest rates, exchange rate etc.
(3) Credit Risks: The credit risk can be defined as the unwillingness or inabili
ty of a
customer or counterparty (e.g. the L C opening bank in a bills negotiation trans
action
under that L C) to meet his commitment relating to a financial transaction with
the bank. For example, in a fund based limit, the credit risk is the non payment
of principal and
interest by the borrower, as per the agreed terms of repayment. In case of a non
fund
based limit, the credit risk arises as the customer may not reimburse the bank f
ully in
case of invocation of a guarantee or devolvement of an L C.
32.2 FACTORS AFFECTING CREDIT RISK
(1) External Factors: These factors affect the business of a customer and reduce
his
capability to honor the terms of financial transaction with the bank. The main e
xternal
factors affecting the overall quality of the credit portfolio of a bank are exch
ange rate
and interest rate fluctuations, Government policies, protectionist policies of o
ther
countries, political risks, etc. These factors look similar to what is mentioned
under
market risks above. But, whereas the market risks directly affect a bank, the fa
ctors
mentioned here affect the businesses of the customers thus impairing the quality
of the
credit portfolio.
(2) Internal Factors: These mainly relate to overexposure (concentration) of cre

dit to a
particular segment or geographical region, excessive lending to cyclical industr
ies,
ignoring purpose of loan, faulty loan and repayment structuring, deficiencies in
the loan
policy of the bank, low quality of credit appraisal and monitoring, and lack of
an efficient
recovery machinery.
32.3 STEPS TAKEN TO MITIGATE CREDIT RISKS
The major objective of credit risk management is to limit the risk within
acceptable level and thus maximize the risk adjusted rate of return on the credi
t
portfolio. Following are the main steps taken by any bank in this direction;
(1) At Macro Level: The risks to the overall credit portfolio of the bank are mi
tigated
through frequent reviews of norms and fixing internal limits for aggregate commi
tments
to specific sectors of the industry or business so that the exposures are evenly
spread
over various sectors and the likely loss is retained within tolerable limits. Ba
nk also
periodically reviews the loan policies relating to exposure norms to single and
group
borrowers as also the structure of discretionary powers vested with various
functionaries. Many banks classify their credit portfolio based on some paramete
rs of
quality and periodically review this to avoid any rude shocks relating to credit
losses.
Earlier, RBI had made it mandatory to classify the portfolio by assigning health
codes to
each account. This is not mandatory now. Normally, banks also formulate policies
relating to rehabilitation, compromise, recovery and write off to get the best o
ut of a
worst case scenario.
(2) At Micro Level: This pertains to policies of the bank regarding appraisal st
andards,
sanctioning and delivering process, monitoring and review of individual
proposals/categories of proposals, obtention of collateral security etc. Credit
ratings and
credit scoring play important role in this area. For dispersion/transfer of risk
in large
value accounts, bank can resort to consortium/ multiple banking and use of deriv
atives
like credit default swaps.
32.4 CREDIT RATINGSThe level of credit risk involved in each loan proposal depen
ds on the unique
features of that proposal. Two similar projects, with different promoters, may b
e
appraised by a bank as having different credit risks. Similarly, two different p
rojects, with
same promoters, may also be appraised by the bank as having different credit ris
ks.
While appraising a credit proposal, the risk involved is also measured and often
quantified by way of a rating with the following objectives;
(1) To decide about accepting, rejecting or accepting with modifications/ specia
l
covenants
(2) To determine the pricing, i.e. the rate of interest to be charged

(3) To help in the macro evaluation of the total credit portfolio by classifying
it on the
ratings allotted to individual accounts. This is used for assessing the provisio
ning
requirements, as also a decision making tool, by the management of the bank, for
reviewing the loan policy of the bank.
32.5 INTERNAL AND EXTERNAL.
Most of the banks in India have set up their own credit rating models as till re
cent
past, the rating agencies were not equipped well enough to provide the ratings,
so
reliable as to banks depending on these for credit decisions. However, with expe
rience
gained in last few years, these rating agencies have gained confidence of the ba
nks.
A few of such rating agencies are CARE, ICRA, CRISIL and SMERA.
32.6 METHODOLOGY OF CREDIT RATING
Based on its loan policies and risk perceptions, each bank has its own rating
model. Common feature in all the risk models is that a score is given for differ
ent
perceived risks by allotting different weightages. The sum of all these scores f
orms the
basis for deciding on risk rating of a proposal. Normally, the broad categories
of risk
areas which are scored are:
(a) Promoters/Management aspects and the securities available
(b) Financial aspects based on analysis of financial statements
(c) Business/project risks
In view of the dynamic market scenario, there is need to review the ratings of a
borrower at regular intervals upgrade or downgrade or maintain it.
32.7 USE OF CREDIT DERIVATIVES FOR RISK
MANAGEMENT
Credit derivatives are used to hedge the risks inherent in any credit asset with
out
transferring the asset itself. The hedging is comparable to insurance and comes
at a
cost. Therefore, if the anticipated risk does not materialize, the return from t
he asset will
be less than what it would have been without the hedging. While simple technique
s for
transferring credit-risk, such as financial guarantees, collateral and credit in
surance
have been prevalent in the Indian banking industry for long, the recent innovati
ve
instruments in credit risk transfer (C R T) such as collateralized debt obligati
ons (C D O),), etc. are yet to gain significant currency. However, Credit Defaul
t Swaps (C D Ss)
finds use as the new hedging instrument. The brief description of two of these n
ew
generation credit risk hedging derivatives is given below:
(1) Credit Default Swaps (C D Ss): This is a bilateral contract in which the ris
k seller
(lending bank) pays a premium to the buyer for protection against credit default
or any
other specified credit event. Normally, C D S is a standardized instrument of I
S D A
(International Swaps and Derivatives Association).The credit events defined by I
SDA

are, bankruptcy, failure to pay, restructuring, obligation acceleration, obligat


ion
repudiation or moratorium etc. As per R B I guidelines, plain vanilla C D Ss onl
y are
allowed.
(2) Credit Linked Notes (C L N): In this, the risk seller gets risk protection b
y paying
regular premium to the risk buyer, which is normally a S P V which issued notes
linked
to the underlying credit. These notes are purchased by the general investors and
the
money received from them is used by the SPV to buy high quality securities. The
general investors get fixed or variable return on the note during its life. On m
aturity of
the underlying credit, the securities purchased by SPV are sold and money return
ed to
the investors. But, in case of default in the underlying credit, these securitie
s are used to
pay to the risk seller.
R B I's Worry on Derivatives
If the banks use these derivatives to hedge their credit risk by way of purchasi
ng
the risk protection, there is no apprehension. But, when the banks start selling
the credit
protection to other lenders, in respect of their credit risks, there is cause fo
r worry
because, often these instruments are so structured that they become very complex
to
understand and sometimes the liability which arises is many times more than what
was
anticipated. Therefore, RBI is in favour of slow growth of these derivatives in
Indian
financial market. It is not out of place here to quote Warren Buffet, the famous
investor,
as saying, 'These are weapons of mass financial destruction'.
32.8 BASEL 2 ACCORD
The new framework of Basel 2 accord is based on three pillars viz., 1) Minimum
capital requirements, 2) Supervisory review and iii) Market discipline. The mini
mum
capital requirement is based on market risk, operational risk and the credit ris
k. Basel 2
has laid down various approaches for assessment of credit risks. These are;
(a) Standardized Approach
(b) Foundation Internal Rating Based (I R B) Approach
(c) Advanced Internal Rating Based (I R B) Approach
Foreign banks, operating in India and Indian banks having operational presence
outside India have migrated to the simpler approaches available under the Basel
2
Framework, since March 31, 2009. Other commercial banks have also migrated to
these approaches from March 31, 2009. Thus, the Standardized Approach for credit
risk
has been implemented for the banks in India.32.9 INTRODUCTION OF ADVANCED APPROA
CHES OF
BASEL 2 FRAMEWORK IN INDIA
Having regard to the necessary up-gradation of risk management framework as
also capital efficiency likely to accrue to the banks by adoption of the advance
d
approaches envisaged under the Basel 2 Framework and the emerging international
trend in this regard, R B I considered it desirable to lay down a timeframe for
implementation of the advanced approaches in India. This would enable the banks

to
plan and prepare for their migration to the advanced approaches for credit risk.
R B I
has advised the following time schedule for implementation of the advanced
approaches (Foundation as well as Advanced IRB);
(1) The earliest date of making application by banks to R B I - April 1, 2012
(2) Likely date of approval by the R B I
March 31, 2014
The R B I has advised the banks to undertake an internal assessment of their
preparedness for migration to advanced approaches, in the light of the criteria
envisaged in the Basel 2 document, as per the aforesaid time schedule, and take
a
decision, with the approval of their Boards, whether they would like to migrate
to any of
the advanced approaches. The banks deciding to Migrate to the advanced approache
s
may approach R B I for necessary approvals, in due course, as per the stipulated
time
schedule. If, the result of a bank's internal assessment indicates that it is no
t in a
position to apply for implementation of advanced approach by the above mentioned
dates, it may choose a later date suitable to it based upon its preparation.
The banks, at their discretion, have the option of adopting the advanced
approaches for one or more of the risk categories, as per their preparedness, wh
ile
continuing with the simpler approaches for other risk categories, and it would n
ot be
necessary to adopt the advanced approaches for all the risk categories simultane
ously.
However, the banks should invariably obtain prior approval of the R B I for adop
ting any
of the advanced approaches.
Summary
The business of banking is prone to various risks like credit risks, market risk
s
and operational risk. The credit risks to the bank can arise due to internal of
external
causes. The internal risks are caused by banks own deficiencies like, overexposu
re
(concentration) of credit to a particular segment/geographical region, excessive
lending
to cyclical industries, ignoring purpose of loan, faulty loan and repayment stru
cturing,
deficiencies in the loan policy of the bank, low quality of credit appraisal and
monitoring,
and lack of an efficient recovery machinery. The main external risks are, exchan
ge rate
and interest rate fluctuations, Government policies, protectionist policies of o
ther
countries and political risks. A bank takes various measures to mitigate these r
isks.
Some of these are; revision of prudential norms, upgrading the appraisal standar
ds,
tightening the monitoring mechanism and strengthening the recovery department .T
he
rating system is introduced with the purpose of quantifying the risks involved i
n a
particular credit proposal. Normally, the scoring system is used for arriving at
the credit
rating. It gives the risk weightage based score to various risk parameters in a

proposal
and total of this score is used to award the credit rating. Each bank has its ow
n scale of rating. The derivatives are also used for risk hedging but their use
is, presently, limited.
Base II Accord prescribes Standardized as well as IRB approach for management of
credit risks. While the standardized approach has already been adopted by the ba
nks,
IRB approach will take some time for implementation.
Keywords
Credit risk; internal risk; external risks; mitigation of risks; industry concen
tration; Credit
rating, internal rating; external rating; scoring; Credit derivatives; Basel 11;
Standardized
approach; IRB (internal rating based) approach
Check Your Progress
1. Which of the Following k not a risk mentioned in the Basel II Accord
The choices are
(a) Operational risk
(b) Market risk
(c) Default risk
(d) Credit risk
(c) Default risk.
The correct choice is
2. Which of the following is not a credit risk? The choices are
(a) Unwillingness of a customer to meet his commitment relating to a financial
transaction with the bank
(b) Inability of the customer to reimburse the bank in case of invocation of a
guarantee or devolvement of an L.C
(c) Inability of a customer to meet his commitment relating to a financial
transaction with the bank
(d) Loss to the bank due to fraud
The correct choice is (d) Loss to the bank due to fraud
3. Which of the following is an external factor affecting credit risk?
The choices are
(a) Government policies
(b) Faulty loan and repayment structuring
(c) Overexposure (concentration) of credit to a particular segment
(d) Lack of an efficient recovery machinery
The correct choice is (a) Government policies
4. Which of the following is not an internal factor affecting credit risk?The ch
oices are
(a) Excessive lending to cyclical industries
(b) Low quality of credit appraisal and monitoring
(c) Deficiencies in the loan policy of the bank
(d) Protectionist policies of other countries
The correct choice is (d) Protectionist policies of other countries
5. Which of the following is not a macro level action for mitigation of credit r
isk?
The choices are
(a) Periodically reviews of the exposure norms for single and group borrowers
(b) Improving appraisal standards of credit proposals
(c) Frequent reviews of norms and fixing internal limits for aggregate
commitments to specific sectors of the industry or business
(d) Periodic review of total credit portfolio based on quality parameters
The correct choice is (b) Improving appraisal standards of credit proposals
6. Which of the following is not a micro level action for mitigation of credit r
isk?
The choices are
(a) Improving sanctioning and delivering process
(b) Obtention of collateral security

(c) Monitoring and review of individual proposals/categories of proposals


(d) Periodical reviews of the exposure limits for business or industry segment
The correct choice is
(d) Periodical reviews of the exposure limits for business
or industry segment
7. Which of the following statements is not true regarding credit derivatives
products?
The choices are
(a) These are used to hedge credit risk to the bank
(b) The protection buyer is the lending bank
(c) The protection seller can be another bank or any other organization
(d) The credit asset is transferred in case of derivatives
The correct choice is (d) The credit asset is transferred in case of derivatives
.
8. Credit rating is a system of: The choices are(a) Measuring risk
(b) Mitigating risk
(c) Migrating risk
(d) Credit appraisal
The correct choice is (a) Measuring risk
9. Internal rating means: The choices are
(a) Rating the project
(b) Rating the promoters
(c) Rating the risk for internal use
(d) None of the above
The correct choice is (d) None of the above.
10. For external credit rating, banks depend on: The choices are
(a) Rating agencies
(b) Experienced staff of the bank
(c) Banking consultants
(d) None of the above
The correct choice is (a) Rating agencies
11. Which of the following is not an approach for assessment of credit risks, la
id
down under Basel 2 Accord? The choices are
(a) Standardized approach
(b) Foundation Internal Rating Based (I R B) approach
(c) Advanced Internal Rating Based (I R B) approach
(d) Simplified Internal Rating Based (I R B) approach
The correct choice is (d) Simplified Internal Rating Based (I R B) approach
12. Which of the following statements is true regarding Standardized approach?
The choices are: (a) It has already been adopted by all the banks
(b) It has been adopted only the foreign banks operating in India.
(c) It has been adopted by the foreign banks operating in India and some of the
Indian banks
(d) It has to be adopted by the all the banks by March 2010
The correct choice is (a) It has already been adopted by all the banks
13. R B I has suggested which of the following earliest date of making applicati
on
by banks to R B I regarding implementation of the advanced approaches
(Foundation as well as I R B) The choices are(a) 1, April 2012
(b) 1, April 2013
(c) 1, April 2014
(d) 1, April 2015
The correct choice is (a) 1, April 2012
Answer to Check Your Progress
1(c);
2.(d);
3.(a);
4.(d);
5.(b);
6.(d);
7.(d);
8.(a);
9
.(d);
10.(a);
11(d);
12.(a);
13.(a)
END OF CHAPTER 32 - Risk Management and Credit Rating. ADVANCED BANK
MANAGEMENT- C A I I B PAPER 1 ADVANCED BANK MANAGEMENT

UNIT 33 - Rehabilitation and Recovery


STRUCTURE
33.0 Objectives
33.1 Credit Default/Stressed Assets/N P As
33.2 Willful Defaulters
33.3 Options Available to Banks for Stressed Assets
33.4 R B I Guidelines on Restructuring of Advances by Banks
33.5 Corporate Debt Restructuring (C D R) Mechanism
33.6 S M E Debt Restructuring Mechanism
33.7 R B I Guidelines on Rehabilitation of Sick S S I Units
33.8 Credit Information System
33.9 Credit Information Bureau (India) Ltd., (CIBIL)
33.0 OBJECTIVES
After reading this chapter, you will have better understanding of:
(1) The meaning of credit default, stressed assets, non performing assets and
the options available to banks for dealing with them.
(2) Meaning of rehabilitation, rescheduling, compromise and write off.
(3) Meaning of Debt restructuring, institutional/organizational framework for de
bt
restructuring available for S M Es and Corporates
(4) The legal framework available for recovery.
(5) Credit information system, objectives and procedures for disclosure of list
of
defaulters, formation of CIBIL
33.1 CREDIT DEFAULT/STRESSED ASSETS/N P As
Credit default means the inability or the unwillingness of a customer or
counterparty to meet commitments in relation to lending, trading, or any financi
al
transactions. This may take the following forms;
(1) in the case of direct lending: principal and/or interest amount may not be r
epaid as
per the terms of repayment.
(2) in the case of guarantees or letters of credit: funds may not be forthcoming
from
the constituents upon crystallization of the liability;(3) in the case of treasu
ry operations: the payment or series of payments due from
the counter parties under the respective contracts may not be forthcoming or cea
ses;
(4) in the case of securities trading businesses: funds/securities settlement ma
y not
be effected;
(5) in the case of cross-border exposure: the availability and free transfer of
foreign
currency funds may either cease or restrictions may be imposed by the sovereign.
Stressed assets are those assets in which the default has either already occurre
d
or which are facing a reasonably certain prospect of default. For example, the t
erm loan
for an industrial project, implementation of which has been abandoned, is a stre
ssed
asset even though the repayment has not yet fallen due as per the repayment term
s.
Non Performing Assets (N P As)
As per R B I directives, banks in India have to classify their assets into
Performing or Standard assets or Non performing assets (N P As). N P As are furt
her
classified into (a) Sub-standard, (b) doubtful and (c) loss assets. The classifi
cation is
based on the period of default as also the availability of security. The amount
of

provision required to be made on the asset portfolio of a bank depends on its


classification into the four categories of standard, sub standard, doubtful and
loss. The
consolidated R B I guidelines on this are available in their Master circular Num
ber D B
O D.No.BP.BC.17/21.04.048/2009-10 dated 1, July 2009
33.2 WILLFUL DEFAULTERS
The default in payment as per agreed terms could be intentional or due to the
reasons beyond the control of the borrower. The intentional default is referred
to as
willful default. As per R B I guidelines, a 'willful default' would be deemed to
have
occurred if any of the following events is noted:
(1) The unit has defaulted in meeting its payment or repayment obligations to th
e lender
even when it has the capacity to honour the said obligations.
(2) The unit has defaulted in meeting its payment or repayment obligations to th
e lender
and has not utilized the finance, borrowed for the specific purposes for which
the
finance was availed of but has diverted the funds for other purposes.
(3) The unit has defaulted in meeting its payment or repayment obligations to th
e lender
and has siphoned off the funds so that the funds have not been utilized for the
specific
purpose for which finance was availed of, nor are the funds available with the u
nit in the
form of other assets.
(4) The unit has defaulted in meeting its payment or repayment obligations to th
e lender
and has also disposed off or removed the movable fixed assets or immovable prope
rty
given by him or it for the purpose of securing a term loan without the knowledge
of the
bank or lender.
(Details available in R B I circular D B O D No. DL.BC. 16/20.16.003/2009-10 dat
ed 1,
July 2009. The Master Circular has been placed on the R B I web-site
(http://www.rbi.org.in).33.3 OPTIONS AVAILABLE TO BANKS FOR STRESSED
ASSETS
Every credit default does not necessarily result in loss to the bank. In many
cases, bank may be able to recover its dues fully. In other cases, the recovery
may be
with some loss or, in the worst scenario there may be no recovery at all. The ti
mely
action and an appropriate strategy play very important role in achieving the bes
t
recovery for any stressed asset. While formulating the strategy, the bank has to
keep in
mind the legal system as also the social aspects prevailing in the country. Norm
ally, a
bank follows the following steps in case of a stressed asset:
(1) Exit from the account
(2) Rescheduling or Restructuring
(3) Rehabilitation
(4) Compromise
(5) Legal action
(6) Write off
Exit from the Account: Bank's first effort is to exit from the account which is
showing

signs of stress. This is possible only when the symptoms of stress are detected
at a
very early stage so that the borrower is able to shift his account to another ba
nk which
has a different credit appetite. Once the symptoms become more pronounced,
acceptance of account by another bank may not materialize. In case of
consortium/multiple banking, there is good possibility of other banks taking up
the share
of the bank wanting to exit but in case of sole banking, bank may find it very d
ifficult to
exit a problematic account and it has to consider other options for dealing with
such
accounts.
Rescheduling or Restructuring: If the default is not willful, the banks normally
reschedule or restructure the loans in accordance with the revised cash flow est
imates
of the borrower.
Rehabilitation: Sometimes, the business enterprises face adverse internal or mar
ket
conditions and incur losses for a long time, resulting in default in payment of
bank's
dues. This is, specially true of the manufacturing enterprises, which are consid
ered as
'sick' if there is erosion in the net worth due to accumulated cash losses to th
e extent of
50 per cent of its net worth during the previous accounting year and the unit ha
s been in
commercial production for at least two years. Banks may examine the possibility
of
'Rehabilitation' in such cases after undertaking detailed viability study.
Compromise: If the restructuring or rescheduling or rehabilitation is not consid
ered
viable or, does not yield the desired results, banks try to recover their dues b
y offering
some concessions to the borrower. Such decision is influenced by the availabilit
y or
realisability of the securities, enforceability of the documents etc.
Legal Action: In cases where even the compromise does not materialize, banks hav
e
to initiate recovery proceedings. The forums available to the banks are as under
;(1) Government Machinery: In case of finance under government sponsored
schemes, the recovery officers, appointed by the state governments, help in reco
very of
bank's dues
(2) Civil Courts: Banks can file the civil suits for recovery of their dues in t
he civil
courts. This option is used for dues up to Rupees ten lakhs only as Debt Recover
y
Tribunals (DRTs) are preferred for higher amount. However, the proceedings in th
e civil
courts are very slow. The Committee on Financial Sector Assessment (C F S A) has
observed that, 'the average time taken in India for winding-up proceedings is on
e of the
highest in the world. Improvements in effective enforcement of creditor rights a
nd
insolvency systems are critical for strengthening market efficiency and integrat
ion and
for enhancing commercial confidence in contract enforcement. A quick resolution

of
stressed assets of financial intermediaries is essential for the efficient funct
ioning of
credit and financial markets.'
(3) Lok Adalats: In the area of dispute settlement, the Legal Services Authority
Act, 1987 has conferred statutory basis on the Lok Adalats (people's courts). Th
e
Reserve Bank has consequently issued guidelines to commercial banks and financia
l
institutions to make increasing use of the forum of Lok Adalats. As per the earl
ier
guidelines, banks could settle disputes involving amounts up to Rupees 5 lakh th
rough
the forum of Lok Adalats. This was enhanced to Rupees 20 lakh in August 2004.
Further, banks have also been advised by the Reserve Bank to participate in the
Lok
Adalats convened by various DRTs or DRATs for resolving cases involving Rupees 1
0
lakh and above to reduce the stock of N P As.
(4) Debt Recovery Tribunals (DRTs): These are created specially for banks
and Financial Institutions (F Is) for expediting the recovery cases involving am
ounts in
excess of Rupees 10 lakh. The Debt Recovery Tribunal (Procedure) Rules 2003 were
amended substantially regarding application fee and plural remedies for better
administration of the Recovery of Debts due to Banks and Financial Institutions
Act,
2002.
(5) SARFAESI Act, 2002: The passage of the Securitization and Reconstruction
of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act
) has
provided the necessary impetus for banks and Financial Institutions (F I s) to h
asten the
recovery of their dues. This Act, effective from the date of promulgation of the
first
Ordinance, i.e. 21, June 2002, has been extended to cover co-operative banks by
a
notification dated January 28, 2003. The Act provides, inter alia, for enforceme
nt of
security interest for realization of dues without the intervention of courts or
tribunals.
The Government has also notified the Security Interest (Enforcement) Rules, 2002
to
enable secured creditors to authorize their officials to enforce the securities
and recover
the dues from the borrowers.
Since the Act provides for sale of financial assets by banks or Financial
Institutions (F ls) to Securitization Companies (S Cs) or Reconstruction Compani
es (R
Cs), guidelines have been issued to ensure that the process of asset reconstruct
ion
proceeds on sound lines. These guidelines, inter-alia, prescribe the financial a
ssets
which can be sold to S Cs or R Cs by banks or F Is, procedure for such sales (in
cluding
valuation and pricing aspects), prudential norms for the sale transactions (viz.
, provisioning or valuation norms, capital adequacy norms and exposure norms) an
d
related disclosures required to be made in the Notes on Accounts to balance shee

ts.
The I F C L along with other banking and F Is, incorporated an asset
reconstruction company called 'Asset Care Enterprise Ltd.' (ACE) in June 2002 wi
th an
authorized capital of Rupees 20 crore. More recently, the I D B I, the I C I C I
Bank, the
S B I and few other banks have jointly promoted the Asset Reconstruction Company
(India) Ltd. (ARCIL) with an initial authorized capital of Rupees 20 crore and p
aid-up
capital of Rupees 10 crore. Similar asset reconstruction or management companies
are
also being proposed by other institutions or banks.
The Enforcement of Security Interest and Recovery Debts Laws (Amendment)
Act, 2004 has amended the SARFAESI Act, Recovery of Debts due to banks and
financial institutions Act, 1993 and the Companies Act, 1956. By this amendment,
the
SARFAESI Act has been amended, inter alia, to (a) enable the borrower to make an
application before the debt recovery tribunal against the measures taken by the
secured
creditor without depositing any portion of the money due; (b) provide that the d
ebt
recovery tribunal shall dispose of the application as expeditiously as possible
within a
period of 60 days from the date of application and (c) enable any person aggriev
ed by
the order by the debt recovery tribunal to file an appeal before the debt recove
ry
appellate tribunal after depositing with the appellate tribunal 50 per cent of t
he amount
of debt due to him as claimed by the secured creditor or as determined by the de
bt
recovery tribunal, whichever is less.
(5) Write off: When all the efforts to recover the dues are exhausted or, the ba
nk is
convinced that further pursuit of the case will not result any worthwhile result
s, the
outstanding amount is written off by utilizing the provision made for that accou
nt in the
books. If the provision is not enough, the excess amount is debited to Profit an
d Loss
account (P & L account). The write off does not mean that the borrower's liabili
ty to the
bank has ended. If bank is able to recover any amount from him in future, it has
the
legal right to appropriate that amount.
33.4 R B I GUIDELINES ON RESTRUCTURING OF ADVANCES
BY BANKS
(Details contained in R B I circular D B O D.No.BP.BC.No.37 /21.04.132/2008-09
dated August 27, 2008)
Banks may restructure the accounts classified under 'standard', 'sub-standard'
and 'doubtful' categories. Banks can not reschedule/restructure/renegotiate borr
owal
accounts with retrospective effect.
Normally, restructuring can not take place unless alteration or changes in the
original loan agreement are made with the formal consent or application of the d
ebtor.
However, the process of restructuring can be initiated by the bank in deserving
cases

subject to customer agreeing to the terms and conditions.


No account will be taken up for restructuring by the banks unless the financial
viability is established and there is a reasonable certainty of repayment from t
he
borrower, as per the terms of restructuring package. The viability should be det
ermined by the banks based on the acceptable viability benchmarks determined by
them, which
may be applied on a case-by-case basis, depending on merits of each case. The
accounts not considered viable should not be restructured and banks should accel
erate
the recovery measures in respect of such accounts. Any restructuring done withou
t
looking into cash flows of the borrower and assessing the viability of the proje
cts or
activity financed by banks would be treated as an attempt at ever greening a wea
k
credit facility and would invite supervisory concerns/action. BIER cases are not
eligible
for restructuring without their express approval.
33.5 CORPORATE DEBT RESTRUCTURING (C D R)
MECHANISM
Objective
The objective of the Corporate Debt Restructuring (CDR) framework is to ensure
timely and transparent mechanism for restructuring the corporate debts of viable
entities
facing problems, outside the purview of BIER, DRT and other legal proceedings, f
or the
benefit of all concerned. In particular, the framework will aim at preserving vi
able
corporates that are affected by certain internal and external factors and minimi
ze the
losses to the creditors and other stakeholders through an orderly and coordinate
d
restructuring programme.
Scope
The CDR Mechanism has been designed to facilitate restructuring of advances of
borrowers enjoying credit facilities from more than one bank/Financial Instituti
on (F I) in
a coordinated manner. The CDR Mechanism is an organizational framework
institutionalized for speedy disposal of restructuring proposals of large borrow
ers
availing finance from more than one bank/Fl. This mechanism will be available to
all
borrowers engaged in any type of activity subject to the following conditions:
(1) The borrowers enjoy credit facilities from more than one bank or F l under m
ultiple
banking or syndication or consortium system of lending.
(2) The total outstanding (fund-based and non-fund based) exposure is Rupees 10
crores or above. C D R system in the country will have a three tier structure
(a) C D R Standing Forum and its Core Group.
(b) C D R Empowered Group.
(c) C D R Cell.
C D R Standing Forum
The C D R Standing Forum would be the representative general body of all
financial institutions and banks participating in C D R system. All financial in
stitutions
and banks should participate in the system in their own interest. C D R Standing
Forum
will be a self-empowered body, which will lay down policies and guidelines, and
monitor

the progress of corporate debt restructuring.The Forum will also provide an offi
cial platform for both the creditors and
borrowers (by consultation) to amicably and collectively evolve policies and gui
delines
for working out debt restructuring plans in the interests of all concerned.
Forum shall comprise of Chairman & Managing Director, Industrial Development
Bank of India Ltd; Chairman, State Bank of India; Managing Director & CEO, ICICI
Bank
Limited; Chairman, Indian Banks' Association as well as Chairmen and Managing
Directors of all banks and financial institutions participating as permanent mem
bers in
the system. Since institutions like Unit Trust of India, General Insurance Corpo
ration,
Life Insurance Corporation may have assumed exposures on certain borrowers, thes
e
institutions may participate in the C D R system. The Forum will elect its Chair
man for a
period of one year and the principle of rotation will be followed in the subsequ
ent years.
However, the Forum may decide to have a Working Chairman as a whole-time officer
to
guide and carry out the decisions of the C D R Standing Forum.
The R B I would not be a member of the C D R Standing Forum and Core Group.
Its role will be confined to providing broad guidelines.
The C D R Standing Forum shall meet at least once every six months and would
review and monitor the progress of corporate debt restructuring system. The Foru
m
would also lay down the policies and guidelines including those relating to the
critical
parameters for restructuring (for example, maximum period for a unit to become v
iable
under a restructuring package, minimum level of promoters' sacrifice etc.) to be
followed
by the C D R Empowered Group and C D R Cell for debt restructuring and would
ensure their smooth functioning and adherence to the prescribed time schedules f
or
debt restructuring. It can also review any individual decisions of the C D R Emp
owered
Group and C D R Cell. The CDR Standing Forum may also formulate guidelines for
dispensing special treatment to those cases, which are complicated and are likel
y to be
delayed beyond the time frame prescribed for processing.
A C D R Core Group will be carved out of the CDR Standing Forum to assist the
Standing Forum in convening the meetings and taking decisions relating to policy
, on
behalf of the Standing Forum. The Core Group will consist of Chief Executives of
Industrial Development Bank of India Ltd., State Bank of India, I C I C I Bank L
td, Bank
of Baroda, Bank of India, Punjab National Bank, Indian Banks' Association and De
puty
Chairman of Indian Banks' Association representing foreign banks in India.
The C D R Core Group would lay down the policies and guidelines to be followed
by the CDR Empowered Group and CDR Cell for debt restructuring. These guidelines
shall also suitably address the operational difficulties experienced in the func
tioning of
the CDR Empowered Group. The CDR Core Group shall also prescribe the PERT chart
for processing of cases referred to the CDR system and decide on the modalities
for

enforcement of the time frame. The CDR Core Group shall also lay down guidelines
to
ensure that over-optimistic projections are not assumed while preparing/approvin
g
restructuring proposals especially with regard to capacity utilization, price of
products,
profit margin, demand, availability of raw materials, input-output ratio and lik
ely impact
of imports/international cost competitiveness.
CDR Empowered GroupThe individual cases of corporate debt restructuring shall be
decided by the CDR
Empowered Group, consisting of E D level representatives of Industrial Developme
nt
Bank of India Ltd., ICICI Bank Ltd. and State Bank of India as standing members,
in
addition to E D level representatives of financial institutions and banks who ha
ve an
exposure to the concerned company. While the standing members will facilitate th
e
conduct of the Group's meetings, voting will be in proportion to the exposure of
the
creditors only. In order to make the CDR Empowered Group effective and broad bas
ed
and operate efficiently and smoothly, it would have to be ensured that participa
ting
institutions/banks approve a panel of senior officers to represent them in the C
DR
Empowered Group and ensure that they depute officials only from among the panel
to
attend the meetings of CDR Empowered Group. Further, nominees who attend the
meeting pertaining to one account should invariably attend all the meetings pert
aining to
that account instead of deputing their representatives.
The level of representation of banks/financial institutions on the CDR Empowered
Group should be at a sufficiently senior level to ensure that concerned bank/F I
abides
by the necessary commitments including sacrifices, made towards debt restructuri
ng.
There should be a general authorization by the respective Boards of the
participating institutions/banks in favour of their representatives on the CDR
Empowered Group, authorizing them to take decisions on behalf of their organizat
ion,
regarding restructuring of debts of individual corporates.
The CDR Empowered Group will consider the preliminary report of all cases of
requests of restructuring, submitted to it by the CDR Cell. After the Empowered
Group
decides that restructuring of the company is prima-facie feasible and the enterp
rise is
potentially viable in terms of the policies and guidelines evolved by Standing F
orum, the
detailed restructuring package will be worked out by the CDR Cell in conjunction
with
the Lead Institution. However, if the lead institution faces difficulties in wor
king out the
detailed restructuring package, the participating banks/financial institutions s
hould
decide upon the alternate institution/bank which would work out the detailed
restructuring package at the first meeting of the Empowered Group when the
preliminary report of the CDR Cell comes up for consideration.

The CDR Empowered Group would be mandated to look into each case of debt
restructuring, examine the viability and rehabilitation potential of the Company
and
approve the restructuring package within a specified time frame of 90 days, or,
at best
within 180 days of reference to the Empowered Group. The CDR Empowered Group
shall decide on the acceptable viability benchmark levels on the following illus
trative
parameters, which may be applied on a case-by-case basis, based on the merits of
each case:
(a) Return on Capital Employed (R O C E)
(b) Debt Service Coverage Ratio (D S C R)
(c) Gap between the Internal Rate of Return (I R R) and the Cost of Fund (C o F)
(d) Extent of sacrifice..
The Board of each bank/Fl should authorize its Chief Executive Officer (C E O)
and/or Executive Director (E D) to decide on the restructuring package in respec
t of cases referred to the CDR system, with the requisite requirements to meet t
he control
needs. CDR Empowered Group will meet on two or three occasions in respect of eac
h
borrowal account. This will provide an opportunity to the participating members
to seek
proper authorizations from their C E O or E D, in case of need, in respect of th
ose cases
where the critical parameters of restructuring are beyond the authority delegate
d to
him/her.
The decisions of the CDR Empowered Group shall be final. If restructuring of
debt is found to be viable and feasible and approved by the Empowered Group, the
company would be put on the restructuring mode. If restructuring is not found vi
able, the
creditors would then be free to take necessary steps for immediate recovery of d
ues
and, or liquidation or winding up of the company collectively or individually.
CDR Cell
The CDR Standing Forum and the CDR Empowered Group will be assisted by a
CDR Cell in all their functions. The CDR Cell will make the initial scrutiny of
the
proposals received from borrowers/creditors, by calling for proposed rehabilitat
ion plan
and other information and put up the matter before the CDR Empowered Group, with
in
one month to decide whether rehabilitation is prima facie feasible. If found fea
sible, the
CDR Cell will proceed to prepare detailed Rehabilitation Plan with the help of c
reditors
and if necessary, experts to be engaged from outside. If not found prima facie f
easible,
the creditors may start action for recovery of their dues.
All references for corporate debt restructuring by creditors or borrowers will b
e
made to the CDR Cell. It shall be the responsibility of the lead institution/maj
or
stakeholder to the corporate, to work out a preliminary restructuring plan in co
nsultation
with other stakeholders and submit to the CDR Cell within one month. The CDR Cel
l will
prepare the restructuring plan in terms of the general policies and guidelines a

pproved
by the CDR Standing Forum and place for consideration of the Empowered Group
within 30 days for decision. The Empowered Group can approve or suggest
modifications but ensure that a final decision is taken within a total period of
90 days.
However, for sufficient reasons the period can be extended up to a maximum of 18
0
days from the date of reference to the CDR Cell.
The CDR Standing Forum, the CDR Empowered Group and CDR Cell is at
present housed in Industrial Development Bank of India Ltd. However, it may be s
hifted
to another place if considered necessary, as may be decided by the Standing Foru
m.
The administrative and other costs shall be shared by all financial institutions
and
banks. The sharing pattern shall be as determined by the Standing Forum.
CDR Cell will have adequate members of staff deputed from banks and financial
institutions. The CDR Cell may also take outside professional help. The cost in
operating the CDR mechanism including CDR Cell will be met from contribution of
the
financial institutions and banks in the Core Group at the rate of Rupees.50 lakh
each
and contribution from other institutions and banks at the rate of Rupees.5 lakh
each.
Other Features
The scheme will not apply to accounts involving only one financial institution o
r
one bank. The CDR mechanism will cover only multiple banking accounts or syndica
tion or consortium accounts of corporate borrowers engaged in any type of activi
ty with
outstanding fund-based and non-fund based exposure of Rupees. 10 crore and above
by banks and institutions.
The Category 1 CDR system will be applicable only to accounts classified as
'standard' and 'substandard'. There may be a situation where a small portion of
debt by
a bank might be classified as doubtful. In that situation, if the account has be
en
classified as standard'/ 'substandard' in the books of at least 90 per cent of cr
editors
(by value), the same would be treated as standard/substandard, only lot the purp
ose of
judging the account as eligible for CDR, in the books of the remaining 10 per ce
nt of
creditors. There would be no requirement of the account/company being sick, N P
A or
being in default for a specified period before reference to the CDR system. Howe
ver,
potentially viable cases of N P As will get priority. This approach would provid
e the
necessary flexibility and facilitate timely intervention for debt restructuring.
Prescribing
any milestone(s) may not be necessary, since the debt restructuring exercise is
being
triggered by banks and financial institutions or with their consent.
While corporates indulging in frauds and malfeasance even in a single bank will
continue to remain ineligible for restructuring under CDR mechanism as hitherto,
the
Core group may review the reasons for classification of the borrower as wilful d
efaulter

specially in old cases where the manner of classification of a borrower as a wil


lful
defaulter was not transparent and satisfy itself that the borrower is in a posit
ion to rectify
the willful default provided he is granted an opportunity under the CDR mechanis
m.
Such exceptional cases may be admitted for restructuring with the approval of th
e Core
Group only. The Core Group may ensure that cases involving frauds or diversion o
f
funds with malafide intent are not covered.
The accounts where recovery suits have been filed by the creditors against the
company, may be eligible for consideration under the CDR system provided, the
initiative to resolve the case under the CDR system is taken by at least 75 per
cent of
the creditors (by value) and 60 per cent of creditors (by number).
BIER cases are not eligible for restructuring under the CDR system. However,
large value B I F R cases may be eligible for restructuring under the CDR system
if
specifically recommended by the CDR Core Group. The Core Group shall recommend
exceptional B I F R cases on a case-to-case basis for consideration under the CD
R
system. It should be ensured that the lending institutions complete all the form
alities in
seeking the approval from B I F R before implementing the package.
Reference to CDR System
Reference to Corporate Debt Restructuring System could be triggered by (1) any
or more of the creditor who have minimum 20 per cent share in either working cap
ital or
term finance, or (2) by the concerned corporate, if supported by a bank or finan
cial
institution having stake as in (1) above.
Though flexibility is available whereby the creditors could either consider
restructuring outside the purview of the CDR system or even initiate legal proce
edings
where warranted, banksor Fls should review all eligible cases where the exposure
of the
financial system is more than Rupees.100 crore and decide about referring the ca
se to CDR system or to proceed under the new Securitization and Reconstruction o
f Financial
Assets and Enforcement of Securities Interest Act, 2002 or to file a suit in D R
T etc.
Legal Basis
CDR is a non-statutory mechanism which is a voluntary system based on DebtorCreditor Agreement (D C A) and Inter-Creditor Agreement (I C A). The Debtor-Cred
itor
Agreement (D C A) and the Inter-Creditor Agreement (I C A) shall provide the leg
al
basis to the CDR mechanism. The debtors shall have to accede to the D C A, eithe
r at
the time of original loan documentation (for future cases) or at the time of ref
erence to
Corporate Debt Restructuring Cell. Similarly, all participants in the C D R mech
anism
through their membership of the Standing Forum shall have to enter into a legall
y
binding agreement, with necessary enforcement and penal clauses, to operate the
System through laid-down policies and guidelines. The I C A signed by the credit
ors will
be initially valid for a period of 3 years and subject to renewal for further pe

riods of 3
years thereafter. The lenders in foreign currency outside the country are not a
part of
CDR system. Such creditors and also creditors like G I C, L I C, U T I, etc., wh
o have
not joined the CDR system, could join CDR mechanism of a particular corporate by
signing transaction to transaction I C A, wherever they have exposure to such
corporate.
The Inter-Creditor Agreement would be a legally binding agreement amongst the
creditors with necessary enforcement and penal clauses, wherein the creditors wo
uld
commit themselves to abide by the various elements of CDR system. Further, the
creditors shall agree that if 75 per cent of creditors by value and 60 per cent
of the
creditors by number, agree to a restructuring package of an existing debt (i.e.,
debt
outstanding), the same would be binding on the remaining creditors. Since Catego
ry 1
CDR Scheme covers only standard and sub-standard accounts, which in the opinion
of
75 per cent of the creditors by value and 60 per cent of creditors by number, ar
e likely to
become performing after introduction of the CDR package, it is expected that all
other
creditors (i.e., those outside the minimum 75 per cent by value and 60 per cent
by
number) would be willing to participate in the entire CDR package, including the
agreed
additional financing.
In order to improve effectiveness of the CDR mechanism, a clause may be
incorporated in the loan agreements involving consortium or syndicate accounts
whereby all creditors, including those which are not members of the CDR mechanis
m,
agree to be bound by the terms of the restructuring package that may be approved
under the CDR mechanism, as and when restructuring may become necessary.
One of the most important elements of Debtor-Creditor Agreement would be
'stand still' agreement binding for 90 days, or 180 days by both sides. Under th
is clause,
both the debtor and creditor(s) shall agree to a legally binding 'stand-still' w
hereby both
the parties commit themselves not to take recourse to any other legal action dur
ing the
'stand-still' period, this would be necessary for enabling the CDR System to und
ertake
the necessary debt restructuring exercise without any outside intervention, judi
cial or
otherwise. However, the stand-still clause will be applicable only to any civil
action
either by the borrower or any lender against the other party and will not cover
any
criminal action. Further, during the stand-still period, outstanding foreign exc
hange forward contracts, derivative products, etc., can be crystallized, provide
d the borrower is
agreeable to such crystallization. The borrower will additionally undertake that
during
the stand-still period the documents will stand extended for the purpose of limi
tation and
also that he will not approach any other authority for any relief and the direct

ors of the
borrowing company will not resign from the Board of Directors during the stand-s
till
period.
Sharing of Additional Finance
Additional finance, if any, is to be provided by all creditors of a 'standard' o
r
'substandard account' irrespective of whether they are working capital or term c
reditors,
on a pro-rata basis. In case for any internal reason, any creditor (outside the
minimum
75 per cent and 60 per cent) does not wish to commit additional financing, that
creditor
will have an option in accordance with the provisions of exit option.
The providers of additional finance, whether existing or new creditors, shall ha
ve
a preferential claim, to be worked out under the restructuring package, over the
providers of existing finance with respect to the cash flows out of recoveries,
in respect
of the additional exposure
Exit Option
As stated in para above a creditor (outside the minimum 75 per cent and 60 per
cent) who for any internal reason does not wish to commit additional finance wil
l have
an exit option. At the same time, in order to avoid the 'free rider' problem, it
is necessary
to provide some disincentive to the creditor who wishes to exercise this option.
Such
creditors can either (a) arrange for its share of additional finance to be provi
ded by a
new or existing creditor, or (b) agree to the deferment of the first year's inte
rest due to it
after the CDR package becomes effective. The first year's deferred interest as
mentioned above, without compounding, will be payable along with the last instal
ment
of the principal due to the creditor.
In addition, the exit option will also be available to all lenders within the mi
nimum
75 per cent and 60 percent provided the purchaser (of their share) agrees to abi
de by
restructuring package approved by the Empowered Group. The exiting lenders may b
e
allowed to continue with their existing level of exposure to the borrower provid
ed they tie
up with either the existing lenders or fresh lenders taking up their share of ad
ditional
finance.
The lenders who wish to exit from the package would have the option to sell thei
r
existing share to either the existing lenders or fresh lenders, at an appropriat
e price,
which would be decided mutually between the exiting lender and the taking over l
ender.
The new lenders shall rank on par with the existing lenders for repayment and se
rvicing
of the dues since they have taken over the existing dues to the exiting lender.
In order to bring more flexibility in the exit option, One Time Settlement can a
lso
be considered, wherever necessary, as a part of the restructuring package. If an

account with any creditor is subjected to One Time Settlement (O T S) by a borro


wer
before its reference to the CDR mechanism, any fulfilled commitments under such
O T
S may not be reversed under the restructured package. Further payment commitment
s of the borrower arising out of such O T S may be factored into the restructuri
ng
package.
Category 2 CDR System
There have been instances where the projects have been found to be viable by
the creditors but the accounts could not be taken up for restructuring under the
C D R
system as they fell under 'doubtful' category. Hence, a second category of CDR i
s
introduced for cases where the accounts have been classified as 'doubtful' in th
e books
of creditors, and if a minimum of 75 per cent of creditors (by value) and 60 per
cent
creditors (by number) satisfy themselves of the viability of the account and con
sent for
such restructuring, subject to the following conditions:
(a) It will not be binding on the creditors to take up additional financing work
ed out under
the debt restructuring package and the decision to lend or not to lend will depe
nd on
each creditor bank or F I separately. In other words, under the proposed second
category of the CDR mechanism, the existing loans will only be restructured and
it
would be up to the promoter to firm up additional financing arrangement with new
or
existing creditors individually.
(b) All other norms under the CDR mechanism such as the standstill clause, asset
classification status during the pendency of restructuring under CDR, etc., will
continue
to be applicable to this category also.
No individual case should be referred to R B I. CDR Core Group may take a final
decision whether a particular case falls under the CDR guidelines or it does not
.
All the other features of the CDR system as applicable to the First Category wil
l
also be applicable to cases restructured under the Second Category.
Incorporation of 'Right to Recompense' Clause
All CDR approved packages must incorporate creditors' right to accelerate
repayment and borrowers' right to pre-pay. The right of recompense should be bas
ed on
certain performance criteria to be decided by the Standing Forum.
33.6 S M E DEBT RESTRUCTURING MECHANISM
Apart from CDR Mechanism, there exists a much simpler mechanism for restructurin
g
of loans availed by Small and Medium Enterprises (S M Es). Unlike in the case of
CDR
Mechanism, the operational rules of the mechanism have been left to be formulate
d by
the banks concerned. This mechanism will be applicable to all the borrowers whic
h
have funded and non-funded outstanding up to Rupees. 10 crores under
multiple/consortium banking arrangement. Major elements of this arrangement are
as

under:
(1) Under this mechanism, banks may formulate, with the approval of their Board
of
Directors, a debt restructuring scheme for S M Es within the prudential norms la
id down
by R B I. Banks may frame different sets of policies for borrowers belonging to
different
sectors within the S M E if they so desire.
(2) While framing the scheme, banks may ensure that the scheme is simple to
comprehend and will, at the minimum, include parameters indicated in these guide
lines.(3) The main plank of the scheme is that the bank with the maximum outstan
ding may
work out the restructuring package, along with the bank having the second larges
t
share.
(4) Banks should work out the restructuring package and implement the same withi
n a
maximum period of 90 days from date of receipt of requests.
(5) The S M E Debt Restructuring Mechanism will be available to all borrowers en
gaged
in any type of activity.
(6) Banks may review the progress in rehabilitation and restructuring of S M Es
accounts on a quarterly basis and keep the Board informed
33.7 R B I GUIDELINES ON REHABILITATION OF SICK SSI
UNITS
As per the definition, a unit is considered as sick when any of the borrowal
account of the unit remains substandard for more than 6 months or there is erosi
on in
the net worth due to accumulated cash losses to the extent of 50 per cent of its
net
worth during the previous accounting year and the unit has been in commercial
production for at least two years. The criteria will enable banks to detect sick
ness at an
early stage and facilitate corrective action for revival of the unit. As per the
guidelines,
the rehabilitation package should be fully implemented within six months from th
e date
the unit is declared as potentially unviable. During this period of six months,
of
identifying and implementing rehabilitation package, banks or F Is are required
to do
'holding operation' which will allow the sick unit to draw funds from the cash c
redit
account at least to the extent of deposit of sale proceeds
Following are broad parameters for grant of relief and Concessions for revival o
f
potentially viable sick S S I units:
(1) Interest on Working Capital - Interest 1.5 per cent below the prevailing fix
ed or
prime lending rate, wherever applicable
(2) Funded Interest Term Loan - Interest Free
(3) Working Capital Term Loan - Interest to be charged 1.5 per cent below the
prevailing fixed or prime lending rate, wherever applicable
(4) Term Loan - Concessions in the interest to be given not more than 2 per cent
(not
more than 3 % in the case of tiny or decentralized sector units) below the docum
ent
rate.
(5) Contingency Loan Assistance - The Concessional rate allowed for Working
Capital Assistance

(Details available in R B I circulars RPCD.No. PLNFS.BC.57/06.04.01/2001-02 date


d
16, January 2002, and RPCD. SME&NFS. BC.No.102/06.04.01/2008-09 4, May 2009)
33.8 CREDIT INFORMATION SYSTEM
The need of credit information system was felt in order to alert the banks and
financial institutions (F Is) and put them on guard against borrowers who have d
efaulted
in their dues to other lending institutions. It was also imperative to arrest ac
cretion of fresh N P As in the banking system through an efficient system of cre
dit information on
borrowers as a first step in credit risk management. In this context, the requir
ement of
an adequate, comprehensive and reliable information system on the borrowers thro
ugh
an efficient database system was keenly felt by the Reserve Bank/ Government as
well
as credit institutions. A Working Group (Chairman: Shri N.H. Siddiqui) with
representatives from select public sector banks, I D B I, I C I C I, Indian Bank
s'
Association and Reserve Bank was constituted by the Reserve Bank in the year 199
9,
to explore the possibilities of setting up a Credit Information Bureau (CIB). Th
e Working
Group had recommended to set up a C I B under the Companies Act, 1956 with equit
y
participation from commercial banks, F Is and NBFCs registered with the Reserve
Bank. As per the recommendations made by the Working Group, Credit Information
Bureau (India) Ltd., (CIBIL) was set up by State Bank of India in association wi
th HDFC
in January 2001.
In order to get over the legal constraints of customer confidentiality vis-a-vis
providing information on banks' customers to CIBIL, pending enactment on the Cre
dit
Information Companies (Regulation) Act, the Reserve Bank advised banks and finan
cial
institutions on October 1, 2002 to obtain consent from all existing borrowers an
d
guarantors at the time of renewal of loans and consent of all the new borrowers
and
guarantors for sharing the credit information in respect of non-suit filed accou
nts with
the CIBIL. A Working Group (Chairman: Shri S.R. Iyer) set up in 2002 observed th
at
while some modalities like 'consent clause' could be adopted as a base to begin
with,
for limited operations of a C I B, such modalities cannot be a substitute for a
special
legislation. The Working Group, therefore, recommended the enactment of an
appropriate legislation by the Government of India expeditiously, in consultatio
n with the
Reserve Bank. With a view to strengthening the legal mechanism and facilitating
the
Bureau to collect, process and share credit information on the borrowers of cred
it
institutions, the Credit Information Companies (Regulation) Act, 2005 was passed
in
May 2005 by Parliament and notified in the Gazette of India on 23, June 2005. Th
e

Government of India also notified the rules and regulations for the implementati
on of the
Credit Information Companies (Regulation) Act, 2005 on December 14, 2006 making
the Act operational. In terms of Section 15(1) of the Act, every credit institut
ion has to
become member of at least one credit information company within a period of thre
e
months from commencement of the Act or any extended time allowed by the Reserve
Bank on application As per R B I guidelines, each credit institution should prov
ide credit
data (positive as well as negative) to the credit information company in the for
mat
prescribed by the credit information company.
Sub section (1) of Section 21 of the Credit Information Companies (Regulation)
Act, 2005, which provides; ,any person, who applies for grant or sanction of cre
dit
facility, from any credit institution, may request such institution to furnish h
im a copy of
the credit information obtained by such institution from the credit information
company '.
Further, sub-section (2) of the said Section also specifies that every credit
institution shall on receipt of request, as indicated in sub-section (1), furnis
h to such
person a copy of the credit information subject to payment of charges specified
by the
Reserve Bank R B I has prescribed a maximum fee of Rupees. 501- (Rupees fifty on
ly)
for the purpose.33.9 CREDIT INFORMATION BUREAU (INDIA) LTD. (CIBIL)
Credit Information Bureau (India) Ltd (CIBIL) was set up by State Bank of India
in
association with HDFC in January 2001. Presently, Dun and Bradstreet Information
Services India (P) Ltd. is also their equity holder as well as technology partne
r. As,
presently, this is the only approved credit information company, all credit inst
itutions are
required to be its members. The purpose of setting up of CIBIL is information sh
aring on
defaulters as also other borrowers as comprehensive credit information, which pr
ovides
details pertaining to credit facilities already availed of by a borrower as well
as his
payment track record, has become the need of the hour.
CIBILs aim is to fulfill the need of credit granting institutions for comprehens
ive
credit information by collecting, collating and disseminating credit information
pertaining
to both commercial and consumer borrowers, to a closed user group of Members.
Banks, Financial Institutions, Non Banking Financial Companies, Housing Finance
Companies and Credit Card Companies use CIBIL:s services. Data sharing is based
on
the Principle of Reciprocity, which means that only Members who have submitted a
ll
their credit data, may access Credit Information Reports from CIBIL. The relatio
nship
between CIBIL and its Members is that of close interdependence.
R B I and CIBIL disseminate information on non-suit filed and suit filed account
s
respectively, as reported to them by the banks or F Is and responsibility for re
porting

correct information and also accuracy of facts and figures rests with the concer
ned
banks and financial institutions. Therefore, R B I has advised the banks and fin
ancial
institutions to take immediate steps to up-date their records and ensure that th
e names
of current directors are reported. In addition to reporting the names of current
directors,
it is necessary to furnish information about directors who were associated with
the
company at the time the account was classified as defaulter, to put the other ba
nks and
financial institutions on guard. Banks and F Is may also ensure the facts about
directors,
wherever possible, by cross-checking with Registrar of Companies.
As per R B I guidelines, bank and FIs are required to submit the list of suit-fi
led
accounts of willful defaulters of Rupees 25 lakh and above as at end-March, June
,
September and December every year to Credit Information Bureau (India) Ltd.
The data on borrowal accounts against which suits have been filed for recovery
of advances (outstanding aggregating Rupees. 1.00 crore and above) and suit file
d
accounts of wilful defaulters with outstanding balance of Rupees 25 lakh and abo
ve,
based on information furnished by scheduled commercial banks and financial
institutions is available at www.cibil.com
Summary
Even with best of loan policies adopted by a bank and with high standards of
appraisal, the quality of a few loan accounts may deteriorate as the time passes
. This
may give rise to actual default or possibility of default in repayment of princi
pal and
interest in some of the accounts. As per R B I directives, banks in India have t
o classify
their assets into Performing (standard) assets or Non performing assets (N P As)
. N P
As are further classified into Sub-standard, doubtful and loss assets. The optio
ns
available to banks in regard to the assets where the quality has deteriorated, a
re Rescheduling and Restructuring, Rehabilitaion, Compromise, Legal action or Wr
ite off.
As per R B I guidelines, forums are available for restructuring of debts of Corp
orates
and S M Es, in deserving cases. There are also guidelines on rehabilitation of s
ick S S I
units. Credit information system has also been introduced to share information a
bout
borrowers committing defaults with any of the banks. Under this system, CIBIL wa
s
formed in January 2001 with the purpose of information sharing on defaulters as
also
other borrowers by providing details pertaining to credit facilities already ava
iled of by a
borrower as well as his payment track record.
Keywords
Rescheduling; Restructuring; Rehabilitation; Compromise; Legal action; Write off
;
Corporate Debt Restructuring (CDR); S M E Debt Restructuring; CREDIT
INFORMATION SYSTEM; CIBIL; Performing (standard) assets; Non performing

assets(N P As); Sub-standard: Doubtful assets; Loss assets


Check Your Progress
State true or False:
1. In the case of fund based lending, credit default means that principal/and or
interest
amount may not be repaid as per the terms of repayment.
True.
2. In the case of guarantees or letters of credit, credit default means crystall
ization of
the liability. False.
3. As per R B I directives, banks in India have to classify their assets into Pe
rforming
( standard ) assets or Non performing assets(N P As). N P As are further classif
ied into
Sub-standard, doubtful and loss assets
True.
4. The amount of provision required to be made on the asset portfolio of a bank
depends on the classification of assets. True.
5. No provision is required to be made by a bank on its Standard Assets.
False.
6. The default due to the reasons beyond the control of the borrower, is referre
d to as
wilful default.
False.
7. The default in payment as per agreed terms could be intentional or due to the
reasons beyond the control of the borrower.
True.
8. Writing off a loan means that the borrower is no longer liable to pay the amo
unt to the
bank. False.
9. In case of finance under government sponsored schemes, responsibility for rec
overy
lies with the government.
False.
10..Banks reschedule or restructure the loans in accordance with the revised ca
sh flow
estimates of the borrower. True.
11. The Debt Recovery Tribunals are meant for recovery of dues of the banks and
financial institutions only. True.12. For filing cases in the Debt Recovery Trib
unals, the amount of claim must be more
than Rupees 10 lacs. True.
13. SARFAESI Act provides for enforcement of security interest for realization o
f dues
without the intervention of courts or tribunals.
True.
14. Banks can settle disputes involving amounts up to Rupees.20 latch through th
e
forum of Lok Adalats.
True.
15. As per R B I directives, banks can reschedule/restructure/renegotiate borrow
al
accounts with retrospective effect.
False.
16. For restructuring of SME loans, no forum like CDR is available.
False.
17. Credit Information System was started with the objective of sharing informat
ion
about borrowers committing defaults with any of the banks. True.
Select the Correct Answer:
18. The aim of a rehabilitation programme is: The choices are:
(a) To make the operations of the enterprise viable again
(b) To help in employment generation
(c) To comply with R B I guidelines
(d) To increase bank's advances
The correct answer is
(a) To make the operations of the enterprise viable again
19. Banks enter into compromise with borrowers in case of default, because:
The choices are:
(a) Recovery through legal action is time consuming
(b) Adequate security is not available

(c) Realization or security may be difficult


(d) All the above
The correct answer is
(d) All the above
END OF CHAPTER 33-Rehabilitation and Recovery, ADVANCED BANK
MANAGEMENT- C A I I B PAPER 1.
End of the book Advanced Bank Management, Paper 1.