Five Pillars of Credit analysis used at Himalayan Bank ltd

Credit Appraisal is a process to ascertain the risks associated with the extension of the credit facility. It is generally carried by the financial institutions which are involved in providing financial funding to its customers. Credit risk is a risk related to non repayment of the credit obtained by the customer of a bank. Thus it is necessary to appraise the credibility of the customer in order to mitigate the credit risk. Proper evaluation of the customer is performed to measure the financial condition and the ability of the customer to repay back the loan in future. Generally the credit facilities are extended against the security know as collateral. But even though the loans are backed by the collateral, banks are normally interested in the actual loan amount to be repaid along with the interest. Thus, the customer's cash flows are ascertained to ensure the timely payment of the principal and the interest.

Credit Analysis at Himalayan Bank was done on the basis of Critical Five pillars of risk which are:

1. Industry Analysis 2. Technical Risk Analysis 3. Management Risk Analysis 4. Financial Risk Analysis 5. Security Analysis

Figure 7: Five Pillar Credit Risk Analysis

Industry Analysis

Overall situation of the industry is studied which includes the demand and the supply and the competition faced by particular client. The key risk areas that are examined are:

Figure 8: Industry Analysis Industry Attractiveness:

Industry attractiveness includes the industry structure, market structure and the regulatory environment in which the client operates.

Industry Structure:

Porter's five forces analysis is a framework for the industry analysis and business strategy development developed by Michael E. Porter of Harvard Business School in 1979. It uses concepts developed in Industrial Organization (IO) economics to derive five forces which determine the competitive intensity and therefore attractiveness of a market.

This model is based on evaluation of the following 5 forces.

1. The threat of substitute products

2. The threat of the entry of new competitors 3. The intensity of competitive rivalry 4. The bargaining power of customers 5. The bargaining power of suppliers

Figure 9: Porter Five Force Industry Analysis Market Structure

In-Depth Analysis of the market structure comprising of data related with a. Market size & growth during past 3-5 years

b. Reasons for market growth or decline

c. Market segmentation (Customers/Geography) d. Market share

e. Seasonality of the business

The potential risks areas under the market structure are related with shrinking market, volatile market and dominant competitors forcing out smaller players.

Regulatory Environment

Industry attractiveness also depends largely on the regulatory environment. No business can operate independently without any regulatory body behind it. The various aspects to be considered are

a. Review regulations which govern industry

b. Review recent changes & determine nature of future changes c. Evaluate impact of recent & political future changes

Potential Risks areas are low entry barrier which means new players are allowed to enter market, elimination of price controls leading to competition, risk exposure of foreign markets, price controls on key inputs lifted, and International Competition.

Company within the industry

The bank also needs to understand the competitive position of the client in the industry which includes areas such as:

a) Competitive position: the market share of the company b) Company strategy: strategy the company has utilized, and

c) Alliances: alliances with various institutions Technical Risk Analysis

The strength and quality of the technical support required for sustainability operation of the company in terms of manpower and the technology used should also be given due care. Appropriate technical competence of the manpower, availability of such manpower, the capability of the technology used, availability of after sales service, cost of maintenance and replacement, etc need to be evaluated.

Management Risk Analysis

The integrity, competence and nature of alliances of the borrower’s management team should be assessed. Management risks relates with the overall skills required to carry out the project by the client and his management. These skills may be:

a) Integrity :

The honesty, Quality/ Reliability of information, Character & Track record, Cooperativeness, Consistency & Quality of communication with bank, Supportiveness, etc of the management.

b) Competence

The requirements related with the ability, experience, skills and competence to carry out the business.

c) Alliances

The alliances of management with various individuals and institutions such as group exposure, political affiliations, private sector affiliation, etc that may affect the overall performance of the business needs to be evaluated as well.

Financial Risk Analysis

One of the most important pillars is the financial risk analysis which related to the overall performance in monetary terms. The borrower’s capacity to repay through cash flow is the “first way out” for all the banks. The strength of securities is the

“second way out” i.e. through collateral liquidation is also assessed.

Analysis of the financial performance of the company is very important as the client is served with money with the main aim of recovering with the cash flow of the client and not by sale of collateral or exercising other means. Financial risk analysis is done on the following aspects:

Figure 10: Financial Risk Analysis a) Performance

Evaluation of the performance of the company is done on the financial ratios calculated on the past income statement and balance sheet or expected statements.

Also the cash flows of the project is evaluated. Other aspects to be considered are the inventory quality, the asset quality etc.

b) Liquidity

The Liquidity of the firm needs to be assessed to check the client’s ability to sustain in difficult times.

c) Leverage

The leverage of the firm needs to be addressed as well so make sure the firm is maintaining.

Security Analysis

The control over various securities obtained by the bank to secure the loan, execution of the security documents and present value of the properties proposed for mortgage

to the bank. The FAC (Fixed Asset Collateral) Security does not completely cover the risks as the fixed assets may not fetch adequate return under circumstances of bad loan. The project is built in such areas where the land value is very low and the proposed site may not be useful for other purposes. Under the case of bad loan, where the bank might have to sell off the property to recover the loan, the fixed assets may not recover anything. Hence for this, bank needs to consider various other factors as security and finance the project only if the bank thinks it’s worth the investment considering the project will be a success for sure.

A bank provides credit which is very risky and it should be backed by certain security that can be exercised under extreme conditions where the project cannot pay back the loan amount. This security can be in terms of control or mitigation measures.

a) Control

Control by the bank of the project can be in terms of legal rights, documentation, exercise against fraud, insurance etc.

b) Other security:

Often various other securities such as land, building, machinery etc are placed as security whose distressed value is taken as a backup. The various aspects that should be considered are liquidation value, quality, quantity, market demand, time of scale, opportunity cost, technology replacement, legal process, etc.