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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
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
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
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
by increasing the cash credit component beyond 20 per cent or to increase the 'L
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
taking into account the impact of such decisions on their cash and liquidity
2. In the case of borrowers enjoying working capital credit limit of less than R
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
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
difficulties for the borrowers. Banks may, with the approval of their respective
identify such business activities which may be exempted from the loan system of
Income Recognition and Asset Classification
One of the important functions of RBI is to ensure the stability of financial se
and thus ensuring the interests of the depositors. Banks are required to present
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
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
banks have to compulsorily follow them. (consolidated guidelines are contained I
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
harassment in recovery, transfer/takeover of accounts, etc.
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
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
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
finance or term loans, which include project and infrastructure finance. Despite
precautions taken in appraisal, delivery, monitoring and various other risk mana
measures, sometimes, there is default in timely repayment of principal and inter
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
credit management department of any bank.
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
Check your progress
Fill in the blanks with correct choice:
1. As per RBI guidelines, the turnover method of assessment should be applied fo
working capital limit of up to Rs 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 ..
(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
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
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

. 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
Analysis of Financial Statements
Part 1 of 2
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
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
borrower. The extent of these details depends upon the type of loan, type of bor
purpose of the loan etc. In case of security based lending like loans against fi
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
1. The Net Worth of the Application: For an individual, the excess of his assets
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
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
and interest on bank's loan. In case of a business enterprise, this information
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
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
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
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
available from the financial statements, which they are required to prepare as p
er the
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
business volume, follow these guidelines, prescribed for the corporate entities.
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
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
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
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
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.


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
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
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
Profit and Loss account is prescribed. However, Schedule VI of Companies Act req
that the statements should present a true and fair view of the state of affairs.
Companies Act has also specified that the profit and loss account must show spec
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
by acts other than Companies Act, need not follow these formats)
Horizontal Form: Horizontal form is maintained in two columns. The first column
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
The items shown in the second column against Assets are:
Fixed assets
Current assets
Loans and advances
Miscellaneous expenditure
Vertical Form: In the Vertical Form, the different items are shown one below the

(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
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
and can be extended up to 18 months with the permission of Registrar of Companie
3. For incomplete Projects and no Activity
Every company has to prepare the financial statements even if there is no activi
during the accounting period or the project is not completed.
It is a statement of assets (what is owned) and liabilities (what is owed to oth
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
may also be different at different moments of the same day. Therefore, every bal
sheet must indicate the date at the end of which it is prepared. Normally, the b
sheet is prepared at the end of the accounting period for which the Profit & Los
account is prepared.
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
Equity capital carries no fixed rate of return by way of dividend. However, on t
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

reserve, capital redemption reserve, dividend equalization reserve, etc. Capital
arise out of gains which are not related to normal business operations. Examples
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
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
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
for wages, salaries, rentals, interest, and other expenses (these are expenses f
services that have been received by the company but for which the payment has no
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
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.
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
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
Act, short-term holding of financial securities also has to be shown under inves
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
components of current assets are: cash, debtors, inventories, loans and advances
, and
pre-paid expenses. Cash includes credit balances in the bank accounts. Debtors (
called receivables or sundry debtors) represent the amount owed to the firm by i
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
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
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
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
company law requirements, the share capital (representing. equity) cannot be red
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.
It is a statement of income and expenditure of an entity for the accounting peri
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
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
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
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
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
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
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
also as earnings before interest and taxes (EBIT), this represents a measure of
which is not influenced by financial leverage and the tax factor.
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
Analysis of Financial Statements
Chapter 27, Part 2 of 2
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
the wide spread confusion about difference in a Funds flow statement and a Cash
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
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
additional use of funds. A statement of these additional sources of funds and ad
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
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
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
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
excluding bank finance, are taken and the deficit shown forms the basis of bank
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
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
capital needs, the statement of assets and liabilities of the last year will not
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
guide for this estimate. Also, in case of a new enterprise, where no financial s
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
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
person . In case of term loans for new projects/expansion, the projected financi
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
Whenever the projected financial statements are submitted by the borrower, these
critically examined for their reasonability and if projections are considered to
unreasonable, the matter is discussed with the borrower and suitable consensus a
Different users, interested in the financial statements of an entity, may analyz
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
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
statements reveals the trend of growth of its business and its profitability. By
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
future performance. The financial statement analysis helps in projecting the ear
prospects and growth rates in the level of activity and earnings with a reasonab
degree of certainty.
(c) Detecting Danger Signals: Financial statement analysis is an important tool

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
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
(f) Cross Checking: The statements of stocks and book debts. as on the date of t
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 .
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.
In keeping with the above objectives, a banker rearranges the figures in the
financial statements under distinct groups for a meaningful analysis.Balance She
The assets and liabilities are normally regrouped as under:
In regrouping, the items shown under Liabilities are: (1) Net worth, (2) Long-te
liabilities (3) Current liabilities and provisions.
In regrouping, the items shown under Assets are: (1) Fixed assets, (2) Current
(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
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
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.
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
are categorized as 'Long term' and 'Short term'. Similarly, the total uses are a
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
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

below it. Generally, this is used to see the trends of sales, operating profit,
etc. from P and L account. Similarly, the balance sheets, arranged in horizontal
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
expressed as a percentage of sales for different years and comparison of these f
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
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
and financing characteristics of two companies of different sizes in the same in
Ratio Analysis: This is the most favourite method of bankers for analysis of fin
statements. A ratio is comparison of two figures and can be expressed as a perce
(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
other from balance sheet. Ratios help in comparison of the financial performance
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
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
These ratios indicate the capacity of an enterprise to meet its short term oblig
(c) Capital Structure Ratios: Debt Equity Ratio (DER) is a ratio of total outsi
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
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
calculated by dividing cost of goods sold by average inventory. A higher ratio i
faster movement of inventory. This is also used for calculating average inventor
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
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.
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
period and states the position of income, expenses and the profit. By comparing
successive balance sheets, we can calculate the flow of funds in the intervening
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
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

in the future. Analysis of financial statements helps banks in knowing the finan
health and performance and viability of an enterprise and in assessing its credi
requirements. The main methods used for this analysis are trend and ratio analys
The trend analysis shows how the business of an enterprise is growing while the
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.
Balance Sheet; P and L Account; Funds flow statement: Cash flow statement; Sourc
and uses of funds; Common size statements; OPM, debt to equity ratio; current ra
DSCR, debtors' turnover ratio; Contingent liabilities; Intangible assets; Pre-op
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
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,
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
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
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. .

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
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
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
After reading this chapter, you will have better understanding of:
1. The concept of working capital, total/gross working capital, net working capi
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
Whenever a business enterprise is started, some fixed assets like office,
furniture, machines/computers etc, depending upon the need, are acquired. But th
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
Let us take example of an entrepreneur setting up a small manufacturing
enterprise for manufacture of polythene bags. He completes the construction of f
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

Liabilities (Long term liabilities) Rs. 75 lakh

Liabilities Total Rs 100 lakh
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
of granules which is the minimum quantity which the dealer sells. He starts manu
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
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
So, the entrepreneur continues to manufacture for 10 days and on 21 September, 2
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
(Liabilities) Amount payable to supplier Rs 30 lakh
(Assets) Work in process
(Liabilities) Expenses payable Rs 2 lakh
(Assets) Finished goods( 10 tons)
Rs 11
(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
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
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
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

may not be reduced if the market practice is like that. In such a case, he will
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
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
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
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
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.
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
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
capital and the bank finance. The assessment of working capital finance by the b
follows the assessment of working capital requirement of the enterprise.
For a banker, providing working capital finance, the liquidity ratios, specially
current ratio, play a very important role in assessment, sanctioning decision, a
monitoring. The assessment involves stipulation of a minimum Net Working Capital
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
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


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
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
(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
the inventory. This is mostly governed by the market practice applicable to a pa
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
Sources for Meeting Working Capita Requirement:
(a) Own Sources (N W C): The balance sheet of the last accounting year, depicts
position of available N W C. Also, as the estimate of limits is based on the pro
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
current ratio.
(b) Suppliers Credit: Estimate of this depends on the market practice.
(C) Other Current Liabilities like salaries payable, advances from customers, et
(d) Bank Finance
Calculation of Bank Finance
Logically, the need for working capital finance from the bank is equal to the ga
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

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
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
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
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
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
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
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
outflows. Therefore, an ideal way to assess the need for bank finance is to prec
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
conditions are not perfect. Therefore, the periodicity of estimating cash flows
increased to a more feasible level of a month or a quarter. A statement of estim
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
1. Opening balance
2. Term loan from Bank3. Sales (Total sales-credit sales + realization for ealie
r sales)
4. Other cash inflows
Total inflows
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
`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
working capital cycle is more than 3 months. Therefore, the banks, normally, als
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
customers, credit received from suppliers, requirement of other current assets a
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
may be too long a period for correct assessment, specially, for seasonal industr
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
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.
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
alone, the amount receivable from the customers is represented in the accounts a
'book debts' or 'sundry debtors'. The bank provides finance against these in a f
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
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
place presents the bill to him and delivers the transport documents to him again
payment of the bill. In case of collection, till the payment is credited to the
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
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
increased legal protection in case of default by the customer. For bank finance,
the accepted bill is given to the bank or the documents are sent through bank wh
delivers the same to the purchaser against his acceptance of usance bill. Bank p
finance to the seller by discounting the usance bill after deducting the usual c
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
'negotiation' in case of bills which are drawn under letters of credit opened by
purchaser's bank.

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

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
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
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
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
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
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 (
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
bills under L Cs only in respect of genuine commercial and trade transactions of
borrower constituents who have been sanctioned regular credit facilities by the
Banks should not, therefore, extend fund-based (including bills financing) or no
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
arrangement. However, in cases where negotiation of bills drawn under L C is res
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
will be remitted to the regular banker of the beneficiary. However, the prohibit
regarding negotiation of unrestricted L Cs of non-constituents will continue to

be in
(c) Sometimes, a beneficiary of the LC may want to discount the bills with the L
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
account, the beneficiary should get the bills discounted/ negotiated through the
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
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
because such notations deprive the negotiating bank of the right of recourse it
against the drawer under the Negotiable Instruments Act. Banks should not theref
open L Cs and purchase/discount/negotiate bills bearing the 'without recourse' c
On a review it has been decided that banks may negotiate bills drawn under L Cs,
'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
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
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
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
within the norm prescribed by the Board of the bank for unsecured exposure limit
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
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
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
behalf this obligation was taken.
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
security, maturity and purpose. Sometimes, it becomes difficult to distinguish b
performance and financial guarantees but broadly, the difference between the two
is as
The performance guarantee guarantees, to the beneficiary, reimbursement of
monetary loss arising due to non performance or under performance of a contract
the customer( applicant). Examples of performance guarantees are guarantees issu
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
in lieu of security deposits, earnest money or payment of dues in case of defaul
t by the
Co-acceptance of Bills
A supplier of goods will be more willing to provide credit to the purchaser (ban
customer), if the bill of exchange drawn by him on purchaser and accepted by him
also accepted by the bank. Bank's co-acceptance acts like a guarantee for him ag
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
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
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
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
unsecured guarantee commitments to particular groups of customers and / or trade
(b) Unsecured guarantees on account of any individual constituent should he
limited to a reasonable proportion of the bank's total unsecured guarantees. Gua
on behalf of an individual should also bear a reasonable proportion to the const
equity.(c) In exceptional cases, banks may give deferred payment guarantees on a
unsecured basis for modest amounts to first class customers who have entered int
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
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
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
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
whenever considered necessary are not one-sided and are made in agreement with t
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
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
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
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
be for a period of six months beyond the original delivery period. Banks may inc
a suitable clause in their bank guarantee, providing automatic extension of the
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
(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
the request for extension for delivery period will automatically be taken as an
for getting the bank guarantee extended. Banks should make similar provisions in
bank guarantees for automatic extension of the guarantee period.
Guarantee on Behalf of Share and Stock Brokers / Commodity
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
lieu of margin requirements as per stock exchange regulations. Banks have furthe
been advised that they should obtain a minimum margin of 50 per cent while issui
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
above minimum margin of 50 per cent and minimum cash margin requirement of 25 pe
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,
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

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
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
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
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
receipt of money from the buyer if he supplies the goods first, and the buyer is
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
amount if he supplies the goods as per the terms specified and submits the requi
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
(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
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
(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
( 7divided by 2 and rounded off to next figure). As the amount of each L C is Rs
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
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
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
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
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.
This is similar to factoring but is used only in case of exports and where the s

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
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
culminating in receipt of sales proceeds from the customer, is called working ca
cycle. The longer this cycle, larger is the amount of money blocked in the curre
assets, and vice versa. The amount of money blocked in the current assets is cal
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
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
analysis as these carry risks similar to fund based limits. Some of the instrume
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.
Working capital cycle; N W C; Gross W C; Working capital gap; M P B F; First, se
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
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
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
(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
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
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)
UNIT 29 Term Loans
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
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
1. Banks provide term loans normally for acquiring the fixed assets like land,
building, plant and machinery, infrastructure etc., (personal loans, consumption
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
called Working Capital Term Loan(W C T L) As we are aware, the business enterpri
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
and liabilities of the bank, term loans are considered long term assets while wo
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
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

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
may coincide with the cropping pattern. In case of industrial enterprises, norma
banks stipulate monthly/quarterly repayment of principal along with all the accu
interest. In some cases, the entire repayment may be stipulated in one installme
nt only,
called the bullet repayment.
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
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
for a term loan.
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
(a) In project finance all the financial needs of the enterprise, including work
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
of long term funds, the banks decide upon the amount of term loan to be sanction
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
competence, I R R etc. It may be enough for the bank to examine the projections
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.

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
funds in case of contingencies arising out of delay in project implementation an
changes in market conditions?
(c) What is the form of business organization? Who are the key persons to be app
to run the business?
Technical Appraisal: The technical feasibility of a project involves the followi
(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
following aspects:
(a) Return on Investment: The usual methods used are the NPV, IRR, payback perio
cost benefit ratio, accounting rate of return etc.
(b) Break-even Analysis: A project with a high break-even point is considered mo
risky compared to the one with lower break-even point.
(c) Sensitivity Analysis: As market conditions are uncertain, a small change in
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
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
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
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
form of funded or non-funded facility.
(a) Take-out Financing: Banks may enter into take-out financing arrangement with
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 Banks may also be guided by the instructions regarding tak
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
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
(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
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
engaged in implementing or operating an infrastructure project in India. The con
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.
acquisition of such shares should be in respect of companies where the existing
promoters (and/ or domestic joint promoters) voluntarily propose to disinvest th
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
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
of that company or the company being acquired. The shares of the borrower compan
or company being acquired may be accepted as additional security and not as prim
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
financial viability of the project.
(8) This financing would be subject to compliance with the statutory requirement
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
and returns on the project are well defined and assessed. State government guara
may not be taken as a substitute for satisfactory credit appraisal and such appr
requirements should not be diluted on the basis of any reported arrangement with
Reserve Bank of India or any bank for regular standing instructions or periodic
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
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
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
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
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
exposure permitted above, banks may, in exceptional circumstances, with the appr
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 '
on account' to the annual financial statements in respect of the exposures where
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
Discipline- Implementation of the New Capital Adequacy Framework, as amended fro
time to time in the matter of capital adequacy.
(3) Asset Liability Management: The long-term financing of infrastructure projec
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
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
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
parameters laid down by leading public financial institutions. Also, setting up
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
mismatches that may arise out of extending long tenor loans to infrastructure pr
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

different take-out financing structures to suit the requirements of various bank
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
loan documents. The agreement between S B I and I D F C could provide a referenc
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
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
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
which have the requisite appraisal skills and the initial liquidity to fund the
Term loans are normally provided by the banks for the acquisition of fixed asset
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
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
exceptionally long implementation, gestation and pay back periods, high debt equ
ratio, etc. R B I has issued elaborate guidelines to banks on infrastructure fin

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
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
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
(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
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,
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)
UNIT 30 Credit Delivery
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
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
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
(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
(2) Whether any charge is to be created on the primary and collateral security?
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?
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
should sign the relevant documents. It should be ensured that if the owner of th
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
department prescribes the standard documents to be taken depending on the type o
the loan. In case of a structured loan, the legal department drafts the document
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
(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
be done within the prescribed time limit.
While the enterprise or individual, who has taken the loan from the bank is lega
bound to repay the principal and the interest, in some cases, banks stipulate gu
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
of proprietor or partners is not stipulated as they have unlimited liability and
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
unlimited/ any liability towards bank's dues. Therefore, in many cases banks sti
their personal guarantees. R B I suggestions to the banks in this respect are as
(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
persons or a group (that being professionals or Government), irrespective of oth
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
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
principal members of the group holding shares in the borrowing company rather th
that of the director or managerial personnel functioning as director or in any m
(2) Even if a company is not closely held, there may be justification for a pers
guarantee of directors to ensure continuity of management. Thus, a lending insti
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
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
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
guarantees to ensure continuity of management.
(3) Personal guarantees of directors may be helpful with regard to public limite
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
(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
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

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
longer connected with the management but continuance of their guarantees is
considered essential because the new management's guarantee is either not availa
or is found inadequate and payment of remuneration to guarantors by way of guara
commission is allowed.
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
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
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
goods as an agent of the bank.
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
through this account. Without bank's permission, no account can be opened with a
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
(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
the sundry creditors (account payable). These three items form major portion of
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
suitable margins (depending on method of assessment) on stocks and book debts an
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
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
be debit in the loan account (fixed amount) while the cash credit account may ha
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
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
'Loan Component' beyond 80 percent, as the case may be, if they so desire. Banks
expected to appropriately price each of the two components of working capital fi
taking into account the impact of such decisions on their cash and liquidity

(2) In the case of borrowers enjoying working capital credit limit of less than
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
be settled by the bank with its borrower clients.
(3) In respect of certain business activities, which are cyclical and seasonal i
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
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,
remitted to him by the bank. If any amount has already been paid to the buyer by
customer, satisfactory proof, like details of bank account etc, of this payment
obtained, and this is considered to be a part of his contribution (margin). In e
cases, like personal loans or consumption loans, the amount may be credited to t
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
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
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
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
at all times. Further they may adopt funding sequences so that possibility of eq
funding by banks is obviated'

The sole banking is suitable for financing working capital needs of an enterpris
only if the requirement is within the policy framework of the financing bank. If
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
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
etc. In case of multiple banking there is no formal arrangement between the bank
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
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
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
borrowers enjoying credit facilities from multiple banks as follows:
(1) 'At the time of granting fresh facilities, banks may obtain declaration from
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
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
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

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
statutory prescriptions that are in vogue, as per specimen given in Annex III of
circulars referred to in (i) above and DBOD. No. BP.BC. 110/ 08.12.001/2008-09 d
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.
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
lending to that borrower, by the banks and is generally used for large loans. Th
borrower, intending to avail the desired amount of loan, gives a mandate to one
(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
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.
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
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
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
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
the requirements. This is done under consortium arrangement or under multiple
banking. To prevent the misutilisation of banking system, RBI has issued guideli
regarding both consortium and multiple banking. RBI has also issued guidelines f
syndication of loans for both working capital and term loans. But, banks are usi
syndication only for term loans.
Personal guarantee; Third party guarantee; Assignment; Lien; Hypothecation; Pled
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
(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
from the date of execution of the documents. .False.
(7) Some documents may be required to be registered with the sub-registrar. . Tru
(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
guarantor. .False.
(10) Under 'Hypothecation', the possession of goods remains with the borrower. .
(11) Under 'Pledge', the possession of goods may remain with the borrower depend
on bank's decision. . True.
(12) As per RBI guidelines, in the case of borrowers enjoying working capital cr
limits of Rs. 10 crore and above from the banking system, the loan component sho
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


Credit Control and Monitoring
31.0 Objectives
31.1 Importance and Purpose
31.2 Available Tools for Credit Monitoring/Loan Review Mechanism
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
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
dynamic nature of business environment. Credit control and monitoring, often ref
as Loan Review Mechanism (L R M), plays an important role in the following aspec
(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
is any deterioration from what was projected at the time of appraisal, the same
be noticed and appropriate action initiated by the bank, in consultation with th
borrower, to ensure that the business continues to run on viable lines.
(3) If the deterioration of the business continues despite appropriate action, t
bank should decide if any harsh action like, recalling the advance or seizing th
security, etc. is necessary. In such cases, an early detection of the problem is
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.
The following records/information /methods are used by the bankers to monitor th
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
Frequent over-drawings, return of cheques and bills, delays in submission of sta
of stock and receivables, low turnover, routing of transactions with some other
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
strengthen their monitoring system by resorting to more frequent inspections of
borrowers' go downs, ensuring that sale proceeds are routed through the borrower
accounts maintained with the bank and insisting on pledge of the stock in place

(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
intervals (normally, monthly) and the bank calculates the Drawing Power (D P) on
basis of these. A thorough scrutiny of these is necessary to verify their correc
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
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
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
stocks during normal inspection is not feasible or where the stocks are located
various locations. Similarly, audit of receivables may also be conducted in some
The purpose of these audits is to cross check the reliability of the statements
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
about the use and diversion of funds, financial health, realization of debts, pr
etc. In case of working capital limits, this analysis is a part of the renewal e
(5) Periodic Visits and Inspection: The purpose of periodic visits is manifold.
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
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

Credit Audit examines compliance with extant sanction and post-sanction processe
and procedures laid down by the bank from time to time. Each bank formulates its
policies, procedures, and organizational set up for credit audit. In some banks,
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
(C ) Functions of Credit Audit Department
(1) To process Credit Audit Reports
(2) To analyze Credit Audit findings and advise the departments/ functionaries
(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
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
from date of sanction)
(b) all existing accounts with sanction limits equal to or above a cut off depen
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
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

(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
(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
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
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
advance; (c) The statements of stock and receivables submitted by the borrower a
regular intervals (normally, monthly); (d) Stock/receivables audit conducted by
the bank;
(e) Financial statements of the business, auditors' report; (f) Periodic visits
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 (
Market reports about the borrower and the business segment. In rare cases, bank
also appoint its nominee on company's board. The credit audit is also a very eff
tool in supervision of credit.
Supervision; Monitoring; Control: Loan Review Mechanism(L R M); Stock statement;
Receivable statement; Deterioration of security; Inspection; Stock audit; Receiv
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
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
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
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

PAPER 1 - Credit Control and Monitoring.ADVANCED BANK MANAGEMENT

Risk Management and Credit Rating
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
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
The risks faced by the business of banking can be classified into three broad
(1) Operational Risks: The examples of such risks are losses due to frauds, disr
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
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
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.
(1) External Factors: These factors affect the business of a customer and reduce
capability to honor the terms of financial transaction with the bank. The main e
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
countries, political risks, etc. These factors look similar to what is mentioned
market risks above. But, whereas the market risks directly affect a bank, the fa
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
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.
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
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
through frequent reviews of norms and fixing internal limits for aggregate commi
to specific sectors of the industry or business so that the exposures are evenly
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
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
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
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
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
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
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
(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
requirements, as also a decision making tool, by the management of the bank, for
reviewing the loan policy of the bank.
Most of the banks in India have set up their own credit rating models as till re
past, the rating agencies were not equipped well enough to provide the ratings,
reliable as to banks depending on these for credit decisions. However, with expe
gained in last few years, these rating agencies have gained confidence of the ba
A few of such rating agencies are CARE, ICRA, CRISIL and SMERA.
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
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.
Credit derivatives are used to hedge the risks inherent in any credit asset with
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
have been prevalent in the Indian banking industry for long, the recent innovati
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
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
(International Swaps and Derivatives Association).The credit events defined by I

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

repudiation or moratorium etc. As per R B I guidelines, plain vanilla C D Ss onl
y are
(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
to the underlying credit. These notes are purchased by the general investors and
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
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
understand and sometimes the liability which arises is many times more than what
anticipated. Therefore, RBI is in favour of slow growth of these derivatives in
financial market. It is not out of place here to quote Warren Buffet, the famous
as saying, 'These are weapons of mass financial destruction'.
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
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
Framework, since March 31, 2009. Other commercial banks have also migrated to
these approaches from March 31, 2009. Thus, the Standardized Approach for credit
has been implemented for the banks in India.32.9 INTRODUCTION OF ADVANCED APPROA
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
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

plan and prepare for their migration to the advanced approaches for credit risk.
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
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
may approach R B I for necessary approvals, in due course, as per the stipulated
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
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
However, the banks should invariably obtain prior approval of the R B I for adop
ting any
of the advanced approaches.
The business of banking is prone to various risks like credit risks, market risk
and operational risk. The credit risks to the bank can arise due to internal of
causes. The internal risks are caused by banks own deficiencies like, overexposu
(concentration) of credit to a particular segment/geographical region, excessive
to cyclical industries, ignoring purpose of loan, faulty loan and repayment stru
deficiencies in the loan policy of the bank, low quality of credit appraisal and
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
countries and political risks. A bank takes various measures to mitigate these r
Some of these are; revision of prudential norms, upgrading the appraisal standar
tightening the monitoring mechanism and strengthening the recovery department .T
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

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
IRB approach will take some time for implementation.
Credit risk; internal risk; external risks; mitigation of risks; industry concen
tration; Credit
rating, internal rating; external rating; scoring; Credit derivatives; Basel 11;
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
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
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
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
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
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
END OF CHAPTER 32 - Risk Management and Credit Rating. ADVANCED BANK

UNIT 33 - Rehabilitation and Recovery

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)
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
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
defaulters, formation of CIBIL
Credit default means the inability or the unwillingness of a customer or
counterparty to meet commitments in relation to lending, trading, or any financi
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
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
(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
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
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
asset even though the repayment has not yet fallen due as per the repayment term
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
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

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
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
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
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
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
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
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
action and an appropriate strategy play very important role in achieving the bes
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

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
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
of the borrower.
Rehabilitation: Sometimes, the business enterprises face adverse internal or mar
conditions and incur losses for a long time, resulting in default in payment of
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
'Rehabilitation' in such cases after undertaking detailed viability study.
Compromise: If the restructuring or rescheduling or rehabilitation is not consid
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
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
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
insolvency systems are critical for strengthening market efficiency and integrat
ion and
for enhancing commercial confidence in contract enforcement. A quick resolution

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
Reserve Bank has consequently issued guidelines to commercial banks and financia
institutions to make increasing use of the forum of Lok Adalats. As per the earl
guidelines, banks could settle disputes involving amounts up to Rupees 5 lakh th
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
Adalats convened by various DRTs or DRATs for resolving cases involving Rupees 1
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
(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
Ordinance, i.e. 21, June 2002, has been extended to cover co-operative banks by
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
The Government has also notified the Security Interest (Enforcement) Rules, 2002
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
proceeds on sound lines. These guidelines, inter-alia, prescribe the financial a
which can be sold to S Cs or R Cs by banks or F Is, procedure for such sales (in
valuation and pricing aspects), prudential norms for the sale transactions (viz.
, provisioning or valuation norms, capital adequacy norms and exposure norms) an
related disclosures required to be made in the Notes on Accounts to balance shee

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
capital of Rupees 10 crore. Similar asset reconstruction or management companies
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,
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
creditor without depositing any portion of the money due; (b) provide that the d
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
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
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
legal right to appropriate that amount.
(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
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
However, the process of restructuring can be initiated by the bank in deserving

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
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
the recovery measures in respect of such accounts. Any restructuring done withou
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
credit facility and would invite supervisory concerns/action. BIER cases are not
for restructuring without their express approval.
The objective of the Corporate Debt Restructuring (CDR) framework is to ensure
timely and transparent mechanism for restructuring the corporate debts of viable
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
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
restructuring programme.
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
availing finance from more than one bank/Fl. This mechanism will be available to
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
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
and banks should participate in the system in their own interest. C D R Standing
will be a self-empowered body, which will lay down policies and guidelines, and

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
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
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
Life Insurance Corporation may have assumed exposures on certain borrowers, thes
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
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
would also lay down the policies and guidelines including those relating to the
parameters for restructuring (for example, maximum period for a unit to become v
under a restructuring package, minimum level of promoters' sacrifice etc.) to be
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
debt restructuring. It can also review any individual decisions of the C D R Emp
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
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

enforcement of the time frame. The CDR Core Group shall also lay down guidelines
ensure that over-optimistic projections are not assumed while preparing/approvin
restructuring proposals especially with regard to capacity utilization, price of
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
Bank of India Ltd., ICICI Bank Ltd. and State Bank of India as standing members,
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
conduct of the Group's meetings, voting will be in proportion to the exposure of
creditors only. In order to make the CDR Empowered Group effective and broad bas
and operate efficiently and smoothly, it would have to be ensured that participa
institutions/banks approve a panel of senior officers to represent them in the C
Empowered Group and ensure that they depute officials only from among the panel
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
by the necessary commitments including sacrifices, made towards debt restructuri
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
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
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
the Lead Institution. However, if the lead institution faces difficulties in wor
king out the
detailed restructuring package, the participating banks/financial institutions s
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
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
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
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
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
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
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
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
and if necessary, experts to be engaged from outside. If not found prima facie f
the creditors may start action for recovery of their dues.
All references for corporate debt restructuring by creditors or borrowers will b
made to the CDR Cell. It shall be the responsibility of the lead institution/maj
stakeholder to the corporate, to work out a preliminary restructuring plan in co
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

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
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
to another place if considered necessary, as may be decided by the Standing Foru
The administrative and other costs shall be shared by all financial institutions
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
financial institutions and banks in the Core Group at the rate of Rupees.50 lakh
and contribution from other institutions and banks at the rate of Rupees.5 lakh
Other Features
The scheme will not apply to accounts involving only one financial institution o
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
classified as standard'/ 'substandard' in the books of at least 90 per cent of cr
(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
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.
any milestone(s) may not be necessary, since the debt restructuring exercise is
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,
Core group may review the reasons for classification of the borrower as wilful d

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

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
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
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
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
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
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
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
Agreement (D C A) and the Inter-Creditor Agreement (I C A) shall provide the leg
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
through their membership of the Standing Forum shall have to enter into a legall
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
The Inter-Creditor Agreement would be a legally binding agreement amongst the
creditors with necessary enforcement and penal clauses, wherein the creditors wo
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.,
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
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
creditors (i.e., those outside the minimum 75 per cent by value and 60 per cent
number) would be willing to participate in the entire CDR package, including the
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
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
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
either by the borrower or any lender against the other party and will not cover
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
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
Sharing of Additional Finance
Additional finance, if any, is to be provided by all creditors of a 'standard' o
'substandard account' irrespective of whether they are working capital or term c
on a pro-rata basis. In case for any internal reason, any creditor (outside the
75 per cent and 60 per cent) does not wish to commit additional financing, that
will have an option in accordance with the provisions of exit option.
The providers of additional finance, whether existing or new creditors, shall ha
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.
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
of the principal due to the creditor.
In addition, the exit option will also be available to all lenders within the mi
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
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
The lenders who wish to exit from the package would have the option to sell thei
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
The new lenders shall rank on par with the existing lenders for repayment and se
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
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

before its reference to the CDR mechanism, any fulfilled commitments under such
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
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
system as they fell under 'doubtful' category. Hence, a second category of CDR i
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
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
would be up to the promoter to firm up additional financing arrangement with new
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
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
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.
Apart from CDR Mechanism, there exists a much simpler mechanism for restructurin
of loans availed by Small and Medium Enterprises (S M Es). Unlike in the case of
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
have funded and non-funded outstanding up to Rupees. 10 crores under
multiple/consortium banking arrangement. Major elements of this arrangement are

(1) Under this mechanism, banks may formulate, with the approval of their Board
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
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
(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
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
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
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
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,
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
account at least to the extent of deposit of sale proceeds
Following are broad parameters for grant of relief and Concessions for revival o
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
more than 3 % in the case of tiny or decentralized sector units) below the docum
(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

16, January 2002, and RPCD. SME&NFS. BC.No.102/06.04.01/2008-09 4, May 2009)
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
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
an efficient database system was keenly felt by the Reserve Bank/ Government as
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
Association and Reserve Bank was constituted by the Reserve Bank in the year 199
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
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
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
Information Companies (Regulation) Act, the Reserve Bank advised banks and finan
institutions on October 1, 2002 to obtain consent from all existing borrowers an
guarantors at the time of renewal of loans and consent of all the new borrowers
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
while some modalities like 'consent clause' could be adopted as a base to begin
for limited operations of a C I B, such modalities cannot be a substitute for a
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
Bureau to collect, process and share credit information on the borrowers of cred
institutions, the Credit Information Companies (Regulation) Act, 2005 was passed
May 2005 by Parliament and notified in the Gazette of India on 23, June 2005. Th

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
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
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
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
Credit Information Bureau (India) Ltd (CIBIL) was set up by State Bank of India
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
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
credit information by collecting, collating and disseminating credit information
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
the Principle of Reciprocity, which means that only Members who have submitted a
their credit data, may access Credit Information Reports from CIBIL. The relatio
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
respectively, as reported to them by the banks or F Is and responsibility for re

correct information and also accuracy of facts and figures rests with the concer
banks and financial institutions. Therefore, R B I has advised the banks and fin
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
it is necessary to furnish information about directors who were associated with
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
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
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
accounts of wilful defaulters with outstanding balance of Rupees 25 lakh and abo
based on information furnished by scheduled commercial banks and financial
institutions is available at
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
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
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
borrowers committing defaults with any of the banks. Under this system, CIBIL wa
formed in January 2001 with the purpose of information sharing on defaulters as
other borrowers by providing details pertaining to credit facilities already ava
iled of by a
borrower as well as his payment track record.
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
amount may not be repaid as per the terms of repayment.
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
( standard ) assets or Non performing assets(N P As). N P As are further classif
ied into
Sub-standard, doubtful and loss assets
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.
6. The default due to the reasons beyond the control of the borrower, is referre
d to as
wilful default.
7. The default in payment as per agreed terms could be intentional or due to the
reasons beyond the control of the borrower.
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
lies with the government.
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.
14. Banks can settle disputes involving amounts up to Rupees.20 latch through th
forum of Lok Adalats.
15. As per R B I directives, banks can reschedule/restructure/renegotiate borrow
accounts with retrospective effect.
16. For restructuring of SME loans, no forum like CDR is available.
17. Credit Information System was started with the objective of sharing informat
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
End of the book Advanced Bank Management, Paper 1.