Basic Principles of Sound Lending

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Basic Principles of Sound Lending

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Introduction

•

• Credit is the key contributor to a bank’s profitability.Credit is the key contributor to a bank’s profitability. •

• The major portion of The major portion of the bank’s funds is employed by wathe bank’s funds is employed by way of loans y of loans and advances,and advances, which is the most p

which is the most profitrofitable employment of its funds.able employment of its funds. •

• Thus lending is a crucial acThus lending is a crucial activity for a bank enabling it to generate incometivity for a bank enabling it to generate income.. •

• The business of lending The business of lending is subject to certain is subject to certain inherent risks.inherent risks. •

• To sustain income generation while mitigating such risks, prudent decisions need toTo sustain income generation while mitigating such risks, prudent decisions need to be taken prior to and after sanctioning the c

be taken prior to and after sanctioning the credit.redit. •

• These decisions generally relatThese decisions generally relate to the e to the size, security and repayment of credit to besize, security and repayment of credit to be exte

extended during a nded during a financial yearfinancial year, the , the industries to focus on industries to focus on , the , the geographicalgeographical spread, type of credit to offer, type of proposals to finance, disbursal mechanism, spread, type of credit to offer, type of proposals to finance, disbursal mechanism, collater

collateral al value, pricing value, pricing method, repaymenmethod, repayment schedule, t schedule, monitoring process etc.monitoring process etc. •

• The macro and micro level policies of the The macro and micro level policies of the lending activity contribute to thelending activity contribute to the achieveme

achievement of nt of the bank’s financial objectives.the bank’s financial objectives. •

• The bank’s managemenThe bank’s management ensures that t ensures that the lending the lending decisions are within decisions are within bank’bank’ss overall objectives of growth and stability.

overall objectives of growth and stability. •

• The bank’The bank’s s Loan Policy is guided by the RBI’Loan Policy is guided by the RBI’s policies, which seeks to integras policies, which seeks to integrate thete the credit policy of the banking

credit policy of the banking syssystem as a tem as a whole within its framework of growth withwhole within its framework of growth with stability.

stability. •

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Introduction

•

• Thus, the role of field Thus, the role of field functionaries is very important as a functionaries is very important as a proper delivery channel.proper delivery channel. •

• Banking operations have two critical aspects.Banking operations have two critical aspects. •

• At the macro level, the credit operations of the banks lead At the macro level, the credit operations of the banks lead to a surplus position to a surplus position or aor a shortfall in the same.

shortfall in the same. •

• While the surplus position While the surplus position may lead to a decline omay lead to a decline on the interest ratn the interest rates, a tightes, a tight money position will result

money position will result in a in a rising interest ratrising interest rate scenario e scenario thereby affthereby affecting theecting the cost of credit and

cost of credit and the overall performance of various industries.the overall performance of various industries. •

• At the micro level, the At the micro level, the bank’bank’s operations should also s operations should also ensure profitability andensure profitability and adequate liquidity.

adequate liquidity. •

• To attain this, the operations of the bank should set a trade-off between theTo attain this, the operations of the bank should set a trade-off between the profitability and liquidity.

profitability and liquidity. •

• Excess profExcess profitability at the cost of itability at the cost of liquidity will lead to an liquidity will lead to an enhanced level of liquidityenhanced level of liquidity risk, which may be detrimental for the long term viability of the

risk, which may be detrimental for the long term viability of the bank.bank. •

• Similarly, excess liquidity may affect the profitability of the bank since the cost of Similarly, excess liquidity may affect the profitability of the bank since the cost of idle funds may eat into the profits.

idle funds may eat into the profits. •

• Thus, while lending, the bank should essentially try Thus, while lending, the bank should essentially try to balance its spreads, liquidityto balance its spreads, liquidity and risk

and risk levels.levels. •

• The bank will have to take calculated risks and arrive at an The bank will have to take calculated risks and arrive at an ideal credit portfolio. Inideal credit portfolio. In the forthcoming pages we wi

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Principles of sound lending

•

• The lending activity The lending activity of of the bank is subjecthe bank is subject to certt to certain sound principles.ain sound principles. •

• Because the business of Because the business of lending is subject to inherent risks especially lending is subject to inherent risks especially when the lending banks dependwhen the lending banks depend

largely on the borrowed funds. As such credit management is based on principles of sound lending. largely on the borrowed funds. As such credit management is based on principles of sound lending. a) Safety

a) Safety

•

• Banks are trustee of public money. Bank’s deposits are always payable on demand. Bank has to maintainBanks are trustee of public money. Bank’s deposits are always payable on demand. Bank has to maintain

trust of depositor

trust of depositor for everfor ever. As such the first . As such the first and foremost principle of lending is to ensure safety of and foremost principle of lending is to ensure safety of funds lent.

funds lent.

•

• By safety means that the borrower is By safety means that the borrower is in a position to in a position to repay the loan, along with repay the loan, along with interest.interest. •

• Further, it is just not the capacity of the borrower to repay but also his willingness to repay.Further, it is just not the capacity of the borrower to repay but also his willingness to repay. •

• The former depends on his tangible assets and the success of his business.The former depends on his tangible assets and the success of his business. •

• The latter depends on the borrower’s character.The latter depends on the borrower’s character. •

• The banker should lend to a The banker should lend to a reliable customer who can and will repay the reliable customer who can and will repay the loan within the prescribedloan within the prescribed

period of time

period of time after generatinafter generating surplus from business g surplus from business such that doubtful debts are avoided.such that doubtful debts are avoided.

•

• In practice, banks ensure that they adhere to this In practice, banks ensure that they adhere to this principle by taking collaterprinciple by taking collateral security that isal security that is

marke

marketable, apart from primary table, apart from primary securitysecurity, which the bank can , which the bank can dispose off in the dispose off in the event of default.event of default.

•

• In more recent times, bankers have begun to concentrate more on the business aspect of the borrower,In more recent times, bankers have begun to concentrate more on the business aspect of the borrower,

i.e., the purpose and viability of the business

i.e., the purpose and viability of the business rather than on the collaterrather than on the collaterals.als.

•

• Thus, bankerThus, bankers have begun to s have begun to treat the entire business as security and treat the entire business as security and in this manner moved in this manner moved away fromaway from

the traditional concept of

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Principles of sound lending

•

• b) Liquidityb) Liquidity •

• The term liquidity refers to the The term liquidity refers to the extent of availability of funds with the extent of availability of funds with the banker forbanker for

providing credit to

providing credit to borrowers.borrowers.

•

• It is to be seen that money It is to be seen that money lent is not going to be locked up for a long time.lent is not going to be locked up for a long time. •

• The money should return to the bank as The money should return to the bank as per the repayment schedule.per the repayment schedule. •

• This schedule that is drawn up by the banker has to adhere to the requirement that atThis schedule that is drawn up by the banker has to adhere to the requirement that at

any point of time the banker should possess

any point of time the banker should possess liquidity to meet the withdrawals of theliquidity to meet the withdrawals of the depositors.

depositors.

•

• It is to be kept in mind that various deposits It is to be kept in mind that various deposits have various maturities and some of ithave various maturities and some of it

would also be payable on demand. would also be payable on demand.

•

• A bank’A bank’s inability to meet ts inability to meet the demand of ihe demand of its depositors can lead to a run ts depositors can lead to a run on the bankon the bank

which is a threat to its basic surv

which is a threat to its basic survival.ival.

•

• Hence the banker has to always monitor the cash flows and carry out the exercise of Hence the banker has to always monitor the cash flows and carry out the exercise of

ensuring liquidity with t

ensuring liquidity with the borrower as this in turn means he borrower as this in turn means liquidity with the bankerliquidity with the banker..

•

• FurtherFurther, liquidity would also refer to the quality of assets, , liquidity would also refer to the quality of assets, which should be easilywhich should be easily

convertible into cash without any loss of value. convertible into cash without any loss of value.

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Principles of sound lending

c)

c) ProfitabiProfitabilitylity

•

• Bank are not charitable institutions. All Bank are not charitable institutions. All banks are profit-earning institutions.banks are profit-earning institutions.

•

• The ultimate objective of lending is to earn The ultimate objective of lending is to earn profits.profits.

•

• Banks receive interBanks receive interest on est on loans and loans and advances lent, and advances lent, and they pay interesthey pay interest to t to theirtheir depositors.

depositors. •

• This difference between the receipts and payments will be the bank’s gross profit.This difference between the receipts and payments will be the bank’s gross profit. •

• Banks further incur various expenses as any organisation does.Banks further incur various expenses as any organisation does.

•

• After accounting for all such expenses and provisions, banks have to earn aAfter accounting for all such expenses and provisions, banks have to earn a reasonable amount as net profit (NIM) so that dividends can be paid to its reasonable amount as net profit (NIM) so that dividends can be paid to its shareholders.

shareholders. •

• The trust and confidence level of the cuThe trust and confidence level of the customer and invesstomer and investor will be high tor will be high with awith a bank that has

bank that has a good track record of profits and dividend rates.a good track record of profits and dividend rates. •

• Hence it is Hence it is important that whatevimportant that whatever the business er the business the bank engages itself with, the bank engages itself with, thethe business be profitable enough not just to cover its

business be profitable enough not just to cover its costs but to ensure generationcosts but to ensure generation of surplus funds or

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Principles of sound lending

c)

c) ProfitabiProfitabilitylity

•

• It is also It is also a recent practice to analyse the pa recent practice to analyse the profitabirofitability of operations vis-à-vislity of operations vis-à-vis particular

particular customercustomers.s. •

• This approach, known This approach, known as the as the Customer ProfitCustomer Profitability Analysis (CPA), enables theability Analysis (CPA), enables the banker to decide the exten

banker to decide the extent to which t to which he can compromise on the profitability aspecthe can compromise on the profitability aspect so that a competitive rate can be offered to customer.

so that a competitive rate can be offered to customer. •

• This analysis is dThis analysis is done when more than one service one when more than one service is offereis offered by the bank d by the bank and toand to attract more customers.

attract more customers. •

• In the current context of the availability of freedom to a banker in the matter of In the current context of the availability of freedom to a banker in the matter of pricing credit and services,

pricing credit and services, a very conscious and careful exera very conscious and careful exercise is called cise is called for on hisfor on his part in order to strike a proper balance between the twin

part in order to strike a proper balance between the twin aims of making aaims of making a desirable leve

desirable level of profit and l of profit and at the same time at the same time offeoffering a competitive price for thering a competitive price for the product/service.

product/service. •

• This is the This is the kind of approach that is kind of approach that is required of a banker in order to entice newrequired of a banker in order to entice new customers to his fold while retaining the existing customers. There is a direct customers to his fold while retaining the existing customers. There is a direct relationship between profit and pricing of service offered by the banker.

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Principles of sound lending

•

• d) Purposed) Purpose •

• While lending the funds, the While lending the funds, the banker enquirebanker enquires from the borrower the purpose fors from the borrower the purpose for which he seeks the loan.

which he seeks the loan. •

• Banks do not grant loans for each and Banks do not grant loans for each and every purpose.every purpose.

•

• They ensure the safety and liquidity of their funds by gThey ensure the safety and liquidity of their funds by granting loans only forranting loans only for productive purposes.

productive purposes. •

• The funds lent should be put to optimum use.The funds lent should be put to optimum use.

•

• Loans are not Loans are not to be granted for speculative and unproductive purposes liketo be granted for speculative and unproductive purposes like hoarding stock or for anti-social activities, since a

hoarding stock or for anti-social activities, since apart from the morality of suchpart from the morality of such activities, there are also inherent risks involved with regard to the repayment of activities, there are also inherent risks involved with regard to the repayment of such loans.

such loans. •

• Loans that are Loans that are meant for personal expenditure likmeant for personal expenditure like marriage cane e marriage cane be refused.be refused.

•

• In some cases, the In some cases, the banks grant loans for personal expenditurbanks grant loans for personal expenditure and fore and for short/medium term like for education etc.

short/medium term like for education etc. •

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Principles of sound lending

•

• e) Securitye) Security

•

• The security offered against the loans The security offered against the loans may consist of a may consist of a large variety of items.large variety of items.

•

• It may be a plot of land, building, flat, gold ornaments, insurance policies, termIt may be a plot of land, building, flat, gold ornaments, insurance policies, term deposits etc.

deposits etc. •

• There may evThere may even be cases en be cases where there is no security at all.where there is no security at all.

•

• The banker must reThe banker must realise that is it only a alise that is it only a cushion to fall back upon in case of need.cushion to fall back upon in case of need. •

• The security and its The security and its adequacy alone should not adequacy alone should not form the sole consideration forform the sole consideration for judging the viability of a loan proposal.

judging the viability of a loan proposal. •

• NevertheleNevertheless, the ss, the security if asecurity if accepted must be adequate and ccepted must be adequate and readily markereadily marketable,table, easy to handle and

easy to handle and free from encumbrances.free from encumbrances. •

• It is the duty of the banker to check the nature of the security and assess whetherIt is the duty of the banker to check the nature of the security and assess whether it is adequate for the loan

it is adequate for the loan granted.granted. •

• Apart from the collateral, the banker has also to consider other Apart from the collateral, the banker has also to consider other factorfactors such ass such as capital of the borrower, his character and capacity.

capital of the borrower, his character and capacity. •

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Principles of sound lending

•

• f) Risk f) Risk management through diversifmanagement through diversificationication

•

• A prudent banker always tries to select the borrower very carefully and takesA prudent banker always tries to select the borrower very carefully and takes tangible assets as security

tangible assets as security to safeguarto safeguard his interests. While this is d his interests. While this is no doubt anno doubt an adequate measure, there are other unforeseen contingencies against which the adequate measure, there are other unforeseen contingencies against which the banker has to guard himself

banker has to guard himself. Further if . Further if the bank lends the bank lends large amounts to a singlelarge amounts to a single industry or borrower, then the default by that customer can affect the banking industry or borrower, then the default by that customer can affect the banking industry as a whole

industry as a whole and will affect the basic survival of the and will affect the basic survival of the industryindustry.. •

• To safeguard his interest against all such risks, the banker follows the principle of To safeguard his interest against all such risks, the banker follows the principle of diver

diversification of risks based sification of risks based on the famous maxim ‘never keeon the famous maxim ‘never keep all the p all the eggs in oneeggs in one basket’. By lending funds to different sectors, a bank can save itself from the slump basket’. By lending funds to different sectors, a bank can save itself from the slump in some sectors by way of prosperity in the others. Banks have to lend to a large in some sectors by way of prosperity in the others. Banks have to lend to a large number of industries and

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E

Evaluation of

valuation of Borrower

Borrower

•

• It is of utmost importance that It is of utmost importance that the banker assesses his borrower well. As mentioned above, the borrower should notthe banker assesses his borrower well. As mentioned above, the borrower should not

only have the capacity

only have the capacity to repay as per bank’s requirements but should also to repay as per bank’s requirements but should also have the willingness have the willingness to repayto repay. There are. There are certain important checkpoints that the banker has to go

certain important checkpoints that the banker has to go through to ensure this. They may be referrthrough to ensure this. They may be referred to as the 6 Csed to as the 6 Cs and they are as follows:

and they are as follows:

•

• a) Charactera) Character – – The banker has to ensure that the person is of integrity. He should assess the personal characteristicsThe banker has to ensure that the person is of integrity. He should assess the personal characteristics

which include honesty, attitude, willingness and commitment to repay debts. There is however no set guidelines to which include honesty, attitude, willingness and commitment to repay debts. There is however no set guidelines to carry out such an assessment. The

carry out such an assessment. The characteristics are very personal in nature and in fact it may not be possible to carrycharacteristics are very personal in nature and in fact it may not be possible to carry out a fool-proof analysis. The banker should nevertheless carry out this

out a fool-proof analysis. The banker should nevertheless carry out this assessment with sincerity.assessment with sincerity.

•

• b) Capacityb) Capacity – – This includes the evaluation whether tThis includes the evaluation whether the borrower has the potential to repay the loan from his ownhe borrower has the potential to repay the loan from his own

resources. It includes the borrower’s success in running in business

resources. It includes the borrower’s success in running in business or managing his cash flows. Capacity oor managing his cash flows. Capacity of physicalf physical assets, plants and equipment,

assets, plants and equipment, cash flows etc are usually taken into account in this regard. Banks normally insist uponcash flows etc are usually taken into account in this regard. Banks normally insist upon their prospective borrowers to submit their financial statements in order to determine their creditworthiness. The their prospective borrowers to submit their financial statements in order to determine their creditworthiness. The importance of financial statements in this regard will be dealt with

importance of financial statements in this regard will be dealt with in the forthcoming units.in the forthcoming units.

•

• c) Capitalc) Capital – – The financial strength of The financial strength of the borrower or his net the borrower or his net worth is carefully studied by tworth is carefully studied by the bankerhe banker. It represents the. It represents the

amount of equity capital that a

amount of equity capital that a firm can liquidate for payment of debt n the eventuality of call other means firm can liquidate for payment of debt n the eventuality of call other means failing. Thefailing. The amount of the bo

amount of the borrower’s capital in relation to debt is rrower’s capital in relation to debt is relatively easy to compute. Howeverrelatively easy to compute. However, the valuation of , the valuation of underlyingunderlying assets in which capital is

assets in which capital is invested is a complex but vital exercise and has to be carried out.invested is a complex but vital exercise and has to be carried out.

•

• d) Conditionsd) Conditions – – The banker has to assess the conditions The banker has to assess the conditions in which the borrower is operating his business. A STEP analysisin which the borrower is operating his business. A STEP analysis

may come in handy in

may come in handy in this regard. STEP stands for Social, Technological, Economic and Political conditions. this regard. STEP stands for Social, Technological, Economic and Political conditions. The marketThe market potential of the product, the competitiveness

potential of the product, the competitiveness of the firm in the market, the growth prospects and other such factorsof the firm in the market, the growth prospects and other such factors influence the borrower’s ability to

influence the borrower’s ability to repay the debt. The banker must also repay the debt. The banker must also consider external factors that maybe beyondconsider external factors that maybe beyond the control of the firm but may nevertheless affect the business.

the control of the firm but may nevertheless affect the business.

•

• e) Collaterale) Collateral – – Banker has to ensure safety of funds lent as seen in the portioBanker has to ensure safety of funds lent as seen in the portio n on principles of lending. One n on principles of lending. One of the waysof the ways

that the banker ensures this is by retaining collateral other than the

that the banker ensures this is by retaining collateral other than the primary securityprimary security. The possibility . The possibility that the borrowerthat the borrower may lose the collateral may in fact act as an incentive for him to repay his debt.

may lose the collateral may in fact act as an incentive for him to repay his debt.

•

• f) Compliancef) Compliance – – The loan, which is to be gThe loan, which is to be given to the borroweriven to the borrower, should be in accordance with the rules and , should be in accordance with the rules and regulationsregulations

as stipulated. Banker has to ensure that all the formalities are met as

as stipulated. Banker has to ensure that all the formalities are met as its absence may cause a concern for recovery of its absence may cause a concern for recovery of the loan. Hence to safeguard this interest banker has to conform to the guidelines issued by the

the loan. Hence to safeguard this interest banker has to conform to the guidelines issued by the government andgovernment and regulatory authorities.

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T

Types of

ypes of Securities

Securities

•

• As discussed As discussed earlierearlier, banks , banks are financial intermediaries whose resources areare financial intermediaries whose resources are mobilized from public and lent to various sectors of the economy. The money mobilized from public and lent to various sectors of the economy. The money mobiliz

mobilized from the ed from the public by way of deposits public by way of deposits is repayable on demand. Hence,is repayable on demand. Hence, bankers have to take utmost care to ensure that they are in a position to meet bankers have to take utmost care to ensure that they are in a position to meet such demand at any given point of time. For this,

such demand at any given point of time. For this, banks secure their advancesbanks secure their advances with appropriate securities.

with appropriate securities. •

• By practice, the securities offered by the borrowers are of different types. TheyBy practice, the securities offered by the borrowers are of different types. They may be immovable or movable security

may be immovable or movable security, debts , debts etc. The land etc. The land and buildings,and buildings, machineries embedded to earth

machineries embedded to earth etc. come under the etc. come under the category of immovable,category of immovable, whereas goods, vehicles, furniture, machineries, gold

whereas goods, vehicles, furniture, machineries, gold ornaments etc. comeornaments etc. come under the category of movable security. Accounts receiv

under the category of movable security. Accounts receivables also ables also known asknown as book debts are

book debts are classified as classified as intangible securityintangible security.. •

• Classification of security may also be as personal and tangible as well as primaryClassification of security may also be as personal and tangible as well as primary and collateral. Personal security refers to personal liability. The bank has a right and collateral. Personal security refers to personal liability. The bank has a right of action against the borrower, e.g. guarantee. Tangible security is something of action against the borrower, e.g. guarantee. Tangible security is something that can be realised by a sale or transfer, e.g. land, goods, stock etc.

that can be realised by a sale or transfer, e.g. land, goods, stock etc. •

• Primary security is one Primary security is one that is registered as the main cover for an advance;that is registered as the main cover for an advance; generally, assets against which advance is made. For example, stock for cash generally, assets against which advance is made. For example, stock for cash credit, machinery for term loans. Collater

credit, machinery for term loans. Collateral security is al security is security other than security other than thethe primary security lodged by

primary security lodged by the borrower or by a the borrower or by a third partythird party.. •

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•

a) Adequacy of margin: In banking terminology, ‘margin’ refers to

the difference between the market value of the security and the

amount of advance granted against it. Banker needs to keep

adequate margin because of the following reasons:

•

i) The market value of the securities is liable to fluctuations in the

future with the result that the banker’s secured loans may turn

into partly secured ones.

•

ii) The liability of the borrower towards the banker increases

gradually as interest accrues and other charges become payable by

him.

•

b) Marketability of security: If the borrower defaults in making

payment, the banker has to liquidate the security to make good his

funds. For this, the security has to be marketable. As discussed

earlier this is one of

earlier this is one of the basic principles of lending.

the basic principles of lending.

•

c) Documentation: Documents that are prepared and signed by

the borrower at the time of securing the loan is of much

significance as these documents contain all the terms and

conditions on which a loan is sanctioned by the banker. Hence, any

misunderstanding or dispute later on may easily be avoided or

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Credit Deployment

•

Deployment or disbursement or dispensation of credit is

Deployment or disbursement or dispensation of credit is the

the

key factor for a ban

key factor for a bank’

k’s profitabil

s profitability

ity. The

. There are different types

re are different types

of credit, and each type

of credit, and each type of credit is characterize

of credit is characterized by certain

d by certain

unique factor

unique factors. Loan is

s. Loan is a broad term used

a broad term used to explain the

to explain the

different types of credit facilities

different types of credit facilities –

– short/medium/long term

short/medium/long term

extended in the credit market. For the customer or borrower,

the selection of the type of

the selection of the type of credit will depend on three

credit will depend on three

factors namely, cost of credit, need for credit and cash flow

requir

requirements. Since a loan has a

ements. Since a loan has a demand and supply side as

demand and supply side as

well, they can be

well, they can be classified accordingly

classified accordingly. Demand

. Demand side loans

side loans

will be individual loans while the supply side loans would be

commercial loans. For the banks, the classification will

depend on three factor

depend on three factors, namely nature of

s, namely nature of credit, type of

credit, type of

security and purpose of loan. Loans

security and purpose of loan. Loans are also further classified

are also further classified

into secured and unsecured loans. Thus

into secured and unsecured loans. Thus there are numerous

there are numerous

consider

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Credit Management

•

Credit management applies to all types of credit and to

the entire gamut of related operations. It comprises of

activities under the four areas: Credit Allocation, Credit

evalua

evaluation, Credit Discipline

tion, Credit Discipline and

and Cred

Credit Monitoring.

it Monitoring.

•

Under credit allocation, the focus is on the exposure

limits of banks both in terms of the activities for which

the funds are being lent and

the funds are being lent and also the

also the sector

sectoral allocation

al allocation

of funds. Credit Evaluation should be based on Credit

Appraisal Standards. Credit Discipline is to explain the

importance of norms in giving fresh loans as well as for

takeover of advances. Credit monitoring refers to the

activity that a banker has to start immediately after the

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Credit Allocation

•

The basic objective of a credit policy aims at avoiding large concentration of

loans and looks for an optimal spread of the loan portfolio. In this regard,

the primary guiding factors for fixing a ceiling on the exposure are the

prudential exposure norms prescribed by RBI, which is firstly 15% of capital

funds (Tier I and Tier II capital) for individual exposures and secondly 40% of

capital funds (Tier I and Tier II capital) for group exposures.

•

While the prudential guidelines serve as a broad indicator for avoiding

concentration of assets, there are various other factors such as market

conditions, government policies, the legal framework, economic indicators,

stock market movements etc. Another factor that determines the exposure

limits to a

limits to a particular industry is the strength of management of the

particular industry is the strength of management of the

particular unit in the industry.

•

Thus, there are several factors that have to be taken into consideration at

the time of

the time of credit alloca

credit allocation. It is

tion. It is howev

however a

er a very significan

very significant activity as

t activity as it

it

effectively covers various aspects relating to the extent to which credit

portfolio can be quantitatively disbursed.

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Credit Evaluation

•

Over a period of time, banks have developed credit appraisal

methodology that is not only scientific but also practical. It is being

constantly improved in the light of new experiences gained in this

regard. Both fund based and non-fund based, and term credit

facilities have survived the test of time and are now well

comprehended. However certain Qualitative and quantitative

aspects are taken into account while evaluating a proposal.

•

Qualitative

: This parameter at the outset is examined from both

the angle of the borrower (as seen in the section on evaluation of

borrower) and also from the bank’s point of view based on its

prudential levels of exposure to the borrower, group and industry.

•

Quantitative

: The parameters in this regard are based in financial

statements which are critical in understanding the financial

position of the business concern. They show whether the firm is

making a profit, how much debt the firm has relative to assets,

and how the cash in the business is being used. The analysis of

financial statements is carried out using several techniques which

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rre

e t

t rra

att n

ng

g o

o tt e

e o

orrrro

ow

we

er

r

•

The need to rate the borrower is basically a pre-sanction process to enable

the banker to take decision whether to grant loan to the borrower and if

yes, what should the price be. Financial parameters such as measurement

through ratios and compliance parameters that take into consideration

general information regarding the enterprise such as stock statements

being submitt

being submitted on time,

ed on time, and submission of periodical reports, are

and submission of periodical reports, are

analysed.

•

Credit propo

Credit proposals also pass

sals also pass through the credit risk assessment process and

through the credit risk assessment process and

then the computation of risk gradation is done. After determining the risks

involved in a credit proposal a decision with regard to the price to be

charged can be taken. All kinds of risks such as management risks, business

risks, financial risks and project risks are taken into view.

•

While financial risks are easily

While financial risks are easily quantifie

quantified, the

d, the quantific

quantification of non-financial

ation of non-financial

risks is quite subjective, to avoid much scope for subjectivity during credit

analysis, the parameters are broken down to their minute details.

•

Final grading is done after the individual sub parameters under the different

types of risks have been scored. The final score is then compared to the

benchmark score and the bank then decides about the spread to be

maintained on this basis.

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Credit Discipline

•

• Banks perform the basic functions of a financial intermediary by accepting deposits and issuing loans. Considering that theBanks perform the basic functions of a financial intermediary by accepting deposits and issuing loans. Considering that the

maturity periods of deposits and advances vary, successful credit management depends on the level of credit discipline that a maturity periods of deposits and advances vary, successful credit management depends on the level of credit discipline that a bank imposes. Strict discipline is not only required to overcome mismatches in maturity between deposits and advances but bank imposes. Strict discipline is not only required to overcome mismatches in maturity between deposits and advances but also other factors such as specific types of advances (as in takeover of advances) and specific types of borrowers (as in case of also other factors such as specific types of advances (as in takeover of advances) and specific types of borrowers (as in case of companies).

companies).

•

• The maturities of different components of a bank’s credit portfolio are determined based in the composition of its resourceThe maturities of different components of a bank’s credit portfolio are determined based in the composition of its resource

pool. The asset portfolio is concentrated around working capital financing which is essentially a type of revolving credit. The pool. The asset portfolio is concentrated around working capital financing which is essentially a type of revolving credit. The actual amount of credit to the customer is determined by the asset base of the borrower, which includes current assets. Any actual amount of credit to the customer is determined by the asset base of the borrower, which includes current assets. Any additional requirements or downward revisions in sanctioned limits are considered at the time of annual renewal of the additional requirements or downward revisions in sanctioned limits are considered at the time of annual renewal of the advance. Any excess liquidity during the short-term is generally deployed in loans maturing within a short period like bridge advance. Any excess liquidity during the short-term is generally deployed in loans maturing within a short period like bridge loans, bills financing etc.

loans, bills financing etc.

•

• Loan PricingLoan Pricing: this can be divided into Interest pricing and non-interest pricing. In cases where loans up to Rs.2 Lakhs, RBI: this can be divided into Interest pricing and non-interest pricing. In cases where loans up to Rs.2 Lakhs, RBI

regulations will be complied with and tenor linked to PLR is announced time to time. In cases of discounting of bills, lending to regulations will be complied with and tenor linked to PLR is announced time to time. In cases of discounting of bills, lending to intermediary agencies etc, interest rates that are not linked to PLR are charged.

intermediary agencies etc, interest rates that are not linked to PLR are charged.

•

• Banks also charge fixed interest rates in respect of certain loans in the personal segment. In the case of commercial loans alsoBanks also charge fixed interest rates in respect of certain loans in the personal segment. In the case of commercial loans also

fixed interest rates are extended, albeit

fixed interest rates are extended, albeit selectivelyselectively..

•

• Renewal of advancesRenewal of advances: generally, working capital facilities are sanctioned by the bank for a period of 1 year and thereafter the: generally, working capital facilities are sanctioned by the bank for a period of 1 year and thereafter the

limits are required to be renewed every year, i.e. fresh sanction is accorded each year for the existing limits. Where, however, limits are required to be renewed every year, i.e. fresh sanction is accorded each year for the existing limits. Where, however, renewal is not done for some reasons, sanction for the continuance of the existing limits is obtained in each case by reviewing renewal is not done for some reasons, sanction for the continuance of the existing limits is obtained in each case by reviewing the facilities.

the facilities.

•

• As regards term loans, these are required to be reviewed once in a year. For the purpose of this review, respective banks haveAs regards term loans, these are required to be reviewed once in a year. For the purpose of this review, respective banks have

devised a separate authority structure. devised a separate authority structure.

•

• Takeover of advancesTakeover of advances: Banks are required to : Banks are required to aggressively market for good quality advances aggressively market for good quality advances todaytoday. One such . One such strategy forstrategy for

improving the quality of assets in a bank’s loan portfolio is to takeover advances outstanding in other banks/FIs. Advances t improving the quality of assets in a bank’s loan portfolio is to takeover advances outstanding in other banks/FIs. Advances t o beo be taken over should be rated ‘good’ or above and the asset should have remained a standard asset in the books for

taken over should be rated ‘good’ or above and the asset should have remained a standard asset in the books for atleastatleast preceding 3 months. Any term

preceding 3 months. Any term loan which is to loan which is to be taken over should not be taken over should not have been rephrased earhave been rephrased earlierlier. In case of all . In case of all takeovertakeover proposals, generally banks insist for prior

proposals, generally banks insist for prior approval from the appropriate authority, which may be the approval from the appropriate authority, which may be the Regional manager/ GM/Regional manager/ GM/ Board of the Bank.

Board of the Bank.

•

• GenerallyGenerally, this strategy is , this strategy is not encouraged, except under not encouraged, except under exceptional circumstanexceptional circumstances in consideration of ces in consideration of larger business interelarger business intere stst

and valuable connections. and valuable connections.

•

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•

• Credit MonitoringCredit Monitoring

•

• There are three types There are three types of follow-up that constitute Credit Monitoring: Financial follow-up, Physicalof follow-up that constitute Credit Monitoring: Financial follow-up, Physical

follow-up and Legal follow-up. Following are the basic elements: follow-up and Legal follow-up. Following are the basic elements:

•

• TTo ensure that the post o ensure that the post sanction review of the loan shall indicate the financial health code of sanction review of the loan shall indicate the financial health code of thethe

bank as good by

bank as good by virtue of the assets , virtue of the assets , which are kept as the securities, remaining good and notwhich are kept as the securities, remaining good and not depreciating excessively.

depreciating excessively.

•

• TTo ensure proper docuo ensure proper documentation is maintained such that the securities are safe and mentation is maintained such that the securities are safe and protectedprotected

especially in times of

especially in times of recoveryrecovery..

•

• TTo verify whether all the o verify whether all the terms and conditions of sanction are met with and in terms and conditions of sanction are met with and in case of deviationcase of deviation

report to the sanctioning

report to the sanctioning authority so that needful steps can be taken by them. Thus, there will beauthority so that needful steps can be taken by them. Thus, there will be no communication gap between the sanctioning authorities and the branches.

no communication gap between the sanctioning authorities and the branches.

•

• TTo undertake periodic review of o undertake periodic review of control returns such as control returns such as stock statements, financial statements andstock statements, financial statements and

any caution signals that are emanated are to be

any caution signals that are emanated are to be analysed in the early stages so that the analysed in the early stages so that the health of health of the loan remains good.

the loan remains good.

•

• TTo undertake a constant review of the o undertake a constant review of the financial statements in order to ensure that the financial statements in order to ensure that the funds arefunds are

utilised properly and there is no diversion of funds. utilised properly and there is no diversion of funds.

•

• TTo undertake periodical mid-term reviews to check the o undertake periodical mid-term reviews to check the financial health of thfinancial health of the unit and take timelye unit and take timely

steps to see that

steps to see that loans given do loans given do not deteriorate in qualitynot deteriorate in quality..

•

• Under the Credit Monitoring Arrangement, banks ensure the following:Under the Credit Monitoring Arrangement, banks ensure the following: •

• Borrower should maintain reasonable estimates of curBorrower should maintain reasonable estimates of current assets, current liabilities and workingrent assets, current liabilities and working

capital. capital.

•

• Should maintain classification of current assets Should maintain classification of current assets and current liabilities as and current liabilities as per bank’s guidelines.per bank’s guidelines. •

• Should maintain a minimum current ratio of 1.33 Should maintain a minimum current ratio of 1.33 except for export industry and for except for export industry and for new units.new units. •

• Should submit annual audit accounts in time Should submit annual audit accounts in time for annual review by banks.for annual review by banks. •

• Ad hoc limits are sanctioned Ad hoc limits are sanctioned for periods not exceeding three months.for periods not exceeding three months.

As far as possible, post-sale limits are sanctioned in the form of Bill

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