Lending.doc

Chapter 01

Lending – A Core Banking Function

An institute that deals in money and its substitutes + provides other financial services. Banks accept deposits, make loans, and derive a profit from the difference in the interest rates paid & charged, respectively.

1.1 Main Functions of a Bank (Banks act as intermediary b/w depositors & borrowers)

 Deposits

 Advances

 Trade

1.2 Sources of Funds

 Long-term Bank’s Own (Paid-up-capital, Reserves, Retained Earnings)

 Funds available from customers (Deposits, Margins on L/C & L/G, A/Cs of other Banks,)  Float available on Banking Transactions

 Short-term Sources (Borrowing from SBP/other Banks, KIBOR)

1.3 Utilization of Funds

 Legal Requirements (Statutory Reserves, A/cs for Clearing, etc…)

 Current Utilization (Advances)

 Permanent Utilization (Fixed Assets)

 Temporary Utilization (Placement with other banks, e.g NOSTRO A/Cs, KIBOR, REPOS, etc…)

2 Role of a Bank as Lender

 Lending is a primary function of a bank.

 Bank makes loan to support activities which will generate income & give rise to economic growth.  Bank lending has a Multiplier Effect which is directly affected by SBP Reserve Requirement. 3 Importance of Building a Disciplined Lending Culture

4 Types of Lending

4.1 Security Based Lending (Name / Collateral Based Lending) 4.2 Cash Flow Based Lending (Business Capacity Based Lending)

Chapter 02

Lending Products

1.1 Business Borrowers

1.1.1 Funded Facilities (Loan provided directly to customer)

(a) Short-Term Financing

(i) Running Finance / OD (known as RF in Pakistan)

 Covers the Working Capital needs of a customer

 Provided on Current A/Cs

 The mark-up is changed on outstanding amount day-to-day.

(ii) Demand Finance (known as LM in Pakistan)

 Similar to Running Finance / OD

 Facility is for a specific period

 Mark-Up charged on a specific rate

 Mark-Up charged after the completion of the period

(iii) Export Finance (Similar to Demand Finance / OD)

Types:

 Pre-Shipment Financing Part I (Funded through SBP)  Pre-Shipment Financing Part I (Funded through Banks)  Pre-Shipment Financing Part II (Funded through SBP)  Pre-Shipment Financing Part II (Funded through Banks)  Post-Shipment / Discounting (Funded through SBP)  Post-Shipment / Discounting (Funded through Banks)  Bill Discounting / Receivable Financing

(iv) Import Finance (Provided in case of L/C based transaction)

Types:

 Finance Against Trust Receipt (FATR)

 FATRs in respect of L/C Documents

 FATRs in respect of Collection Documents

 Finance Against Imported Merchandise (Funded through Banks) (b) Long-Term Financing / Term Lending

The agreement contains:

 Tenure  Collateral (Security)

 Repayment Schedule  Loan Terms & Conditions

 Mark-up Rate  Event of Default

1.1.2 Non-Funded Facilities (Loan provided to 3rd _{party on behalf of customer)} (a) Letter of Credit (L/C) (Contingent Liability of a bank)

Types:

 Sight (Payment is made at once at the time of receiving of goods)  Usance (Payment is made after certain pre-agreed period)

(b) Guarantees / Stand by Letter of Credit (L/G)(Bank takes guarantee that if the customer does not pay for the imports, then it will)

Types:

 Shipping Guarantees (SG)

 Bid Bonds (BB) (In case of non performance of tender agreement)  Advance Payment Guarantee (APG) (In case of Civil Engg Contracts)

1.2 Individual Borrowers

1.2.1 Asset – Based / Secured

(a) Short-Term Facility (Under Hire Purchase Agreement e.g. Refrigerators, ACs, etc…)

(i) Finance for Customer Durables

(b) Long-Term Facility

(i) Auto – Vehicle Finance

 Hire Purchase

 Leasing (A legal agreement b/w a customer & the leasing company selected by the dealer for the rental of Asset)  Categories of Leasing:

 Direct Leasing (You identify the asset & arrange for the leasing company to buy it)

 Sale-and-leaseback (You sell an asset which was already on leas and then lease it back)

 Types of Leasing:

 Finance Leasing (For obtaining all the financial benefit of the asset)  Operating Leasing (--- do ---)

(ii) House Finance

 Mortgages (For Built Building, initially registered in the name of Bank)

 Self-Build Finance (For financing the customer to build his own house)

 Valuation (at the start of project & end of project)

 Stages (completion of foundation, ground level slab, 1st _{level slab, Finishing)}

 Certification (from a Qualified Architect, Development / Cantonment Authority Inspector, Structural Engineer)

1.2.2 Clean Lending / Unsecured (a) Short-Term Facility

(i) Personal Loan – Installment Based Finance

(ii) Running Finance

(iii) Credit Cards (Method of Usage, Issuance & Features)

2 Prudential Regulations

Set of a minimum lending principles designed by the SBP.

 Objective

 To bring consistency

 To maintain quality of Credit Portfolios

2.1 Corporate – PR

 Corporate Governance

 Anti Money Laundering

 Operations

 Risk Management

 Maximum Exposure

 Single Not exceed 30% of equity

 Group Not exceed 35% of equity

 Contingent Liability Not exceed 10% of equity

 Total Exposure Not exceed 10 times of equity

 Subordinated loan shall be counted as equity

 Bank / DFIs shall not own shares in excess of 5%

 Banks/DFIs should take copies of Financial Statements duly audited by CAs

 Unsecured Exposure Restricted to Rs.

200,000/- Banks/DFIs shall not:

 Take exposure against security of shares / TFCs issued by them

 Provide unsecured credit for floatation of shares capital & TCs

2.2 Short & Medium Enterprise (SME) – PR

 Banks / DFIs shall specifically identify the source of repayment of loan.

 All products except secured against liquid assets will require personal guarantees of the owners.

 Banks / DFIs can take maximum clean exposure up to Rs. 3 Million to an SME & above Rs. 3 Million will be treated as secured.

 Maximum exposure on an SME shall not exceed Rs. 75 Million.

 Classification & provisioning requirement for SME borrowers are the same as in case of corporate borrowers.

2.3 Consumer Financing – PR

 Banks / DFIs to establish separate risk management capacity for consumer business.

 Banks / DFIs to prepare comprehensive credit policy duly approved by their BODs.

 Banks / DFIs to develop a specific programme for each type of product.

 Banks / DFIs should have an efficient computer / MIS system to serve the customer in more proficient way.

 Banks / DFIs to form comprehensive recovery procedures.

3 Pricing

3.1 Price Mechanism

The amount of markup which is charged by the lender on any loan of a certain amount is known as Pricing of the loan.

3.2 Components of Price of Loan

(a) Base Components

 Internal Cost of Funds

 The rate of return promised to the depositor

 The administrative cost attached to its generation, processing & servicing  Market – Based Cost of Funds

 e.g. KIBOR, T-Bills, PIBs, REPOs & Reverse REPOs

(b) Variable Components

 Type of the Customer (Corporate, Wholesaler, Retailer, etc…)  Customer’s Credit Rating

 Financial Analysis of the Business 3.3 Components of Price of Loan

3.3.1 Risk-Based Pricing (e.g. Sub-ordinate Loan)

Alignment of loan pricing with the expected loan risk 3.3.2 Risk Reward Pricing

Ratio used by lenders to compare the expected returns of a loan to the amount of risk undertaken to capture these returns.

Risk Reward Pricing Ratio = The amount of markup to be charged by lender (i.e. Reward) The amount which can be lost in case of any unexpected activity (i.e. the Risk)

3.4 Types of Rates

3.4.1 Floating Rate (Variable / Adjustable Rate)

This rate is charged on periodical basis, which is usually tied to the movement of an outside indicator (SBP rate, KIBOR rate, etc…)

3.4.2 Fixed Rate 3.5 Re – Pricing Interval

3.5.1 For Floating Rate

The No. of days b/w the date the loan is made & the date on which it is next scheduled to re-price.

3.5.2 For Fixed Rate

Chapter 03

Lending Risk Assessment & Management

1.1 Introduction

1.1.1 Financial Risk

The possibility that the outcome of an action / event could bring up adverse impacts such as loss of earnings / capital, etc…

1.1.2 Expected Losses

The bank knows that there is a reasonable certainty of occurrence of any loss.

1.1.3 Unexpected Losses

These losses which are associated with unforeseen events.

1.2 Corporate Governance

(a) Strategic Level (Pertains to BODs)

(b) Macro Level (Pertains to Middle Management)

(c) Micro Level (Pertains to Low / On–the-line Management)

1.3 Risk Management Framework

 Clearly defined policies & procedures

 Organizational structure defining each person’s roles & responsibilities

 Formation of specialized departments such as Risk Management Committee (RMC)  Existence of an effective Management Information System (MIS)

 Review of compliance procedure & policies such as through Internal Auditors 1.3.1 Integration of Risk Management

 A single risk can trigger other many risk 1.3.2 Business Line Accountability

 Accountability of all the management hierarchy, which true compliance can mitigate risk

1.3.3 Risk Evaluation / Measurement  Essential for controlling

 Evaluated through quantitative measures, if quantitative are not possible than qualitative measures

1.3.4 Independent View

 Risk evaluation, controlling & acceptance must be done by separate independent individuals

1.3.5 Contingency Planning

Planning, Assessment & controlling of risks rising from unusual circumstances such as disaster recovery planning, public relations damage control, litigation strategy, responding to regulatory criticism, etc…

1.4 Risk Spectrum

Under Basel-II (An international standard for measuring the adequacy of a bank’s capital,

recommended by bank supervisors & the central bankers from 13 countries) following are various types / sources of risks that impact lending.

1.4.1 Credit Risk (The highest form of risk that includes default risk & multi-faceted liquidity risk.)

1.4.2 Liquidity Risk (The risk of a bank of not fulfilling its short-term debt obligations due to shortage or absence of liquid assets.)

1.4.3 Market Risk (The risk that an asset cannot be sold at or near to its fair value.)

(a) Equity Risk (Loss in share value in Stock Market)

(b) Interest Rate Risk (Decline in govt. bonds & securities rate will decrease the rate of interest, the bank pay to its depositors.)

(c) Commodity Price Risk

(d) Currency or Foreign Exchange Risk

1.4.4 Operational Risk (This can result difference losses such Gross Cost of Compensation, penalty payments to 3rd

1.4.5 Counter Party Risk

The risk that counterparty fails to fulfill its part of obligation while a bank / DFI has already met its commitment.

1.4.6 Industry Risk / Economic Environment Risk

 Unstable political / economic factor can adversely affect the industry & its structure (size, products, market competition, profit dynamics, growth profits, demand / supply forces & cost structure.)

1.5 Risk Rating

Can be done by Risk Management System through qualitative & quantitative measures or referred to credit rating agencies.

1.5.1 Concept of Credit Rating

 To participate in interbank deposit market

 The strengthen of FI is judged through credit rating

 To issue capital market instrument (Notes, Bonds & Sukuks)

1.5.2 Scope & Significance of Credit Rating

 Credit worthiness of FI can be measured

 The inverse relation b/w credit rating & rate of return

2 Risk Assessment & Risk Management The cannons of lending:

2.1 People / Character

(a) Preparation for meeting with a customer

(b) Meeting the customer

(c) Qualifications & Experience of the customer

(d) Financial expertise of the customer (Demonstrable skills of Financial Judgment) (e) The business & its management team

(f) The character of business

• Capacity • Premises • Seasonality

• Management • Plant & Equipment• Social issues

• Succession Planning • Technology • Profitability

• Staff • Competition • Legal issues

• Product • Industry • Political issues

• Service • Cost structure • Expediency

• Market • Economic conditions

2.2 Purpose / Amount

 Seven Basic reasons why Business Borrow:

(a) To finance Operating/Variable/Fixed Costs of business. (b) To finance Stock until they are converted into cash. (c) To finance the purchase of property, plant, etc…

(d) To finance the whole range of Assets (Stock, Fixed Assets).

(e) To finance the company’s ownership such as Mergers & Take-overs. (f) The business Projects.

(g) To finance the business for its recovery from going into losses.  The Trading Cycle of Business:

Cash Stock Sales

Debt  Contents of a good business:

• Contact Details • Market Analysis

• Executive Summary • Marketing Strategy

• Business Background & History • Management / Staff

• Product & Services • Property / Capital Expenditure

• Process • Financial Information

2.3 Repayment Capability  Cash Flow Analysis.  Type / Period of Loan.

2.4 Security (Works as an Insurance of Loan for Lender) Typical items which can be taken as security:

 Legal mortgages over property

 Floating Charges (only for companies)

 Guarantees

 Life Policies

 Stocks & Shares

2.5 Remuneration / Margin (More will be the risk, more will be the markup)

 The difference b/w the Markup charged to borrowers & the interest paid to depositors.

 Loan arrangement fees

 Charges for the services provided by bank, night safe facilities, etc…

 Commission & Payment received from outside agencies for referring clients, such as insurance commission.

3 Ratio Analysis & Assessing Customer Needs 3.1 Types of Ratios

3.1.1 Financial Ratios

(a) Capital Adequacy Ratio / Equity Ratio

Proprietors’ Funds – Intangibles x 100%

Total Assets – Intangibles

(b) Gearing Ratio _______Proprietors’ Stake________ x 100%

Med. & Long-Term Borrowing including Pref. Shares

(c) Interest Cover Ratio Net Profit before Interest & Tax x 100%

Interest Paid (d) Working Capital Ratio /

Current Ratio

__Current Assets_ x 100%

Current Liabilities (e) Liquid Ratio / Quick Ratio /

Acid Test Ratio

Current Assets excluding Stocks x 100%

Current Liabilities

3.1.2 Profitability Ratios

(a) Gross Profit Ratio Gross Profit x 100%

Sales

(b) Net Profit Ratio Net Profit x 100%

Sales

(c) Return on Capital ___Net Profit__ x 100%

Owner’s Equity

3.1.3 Operating / Activity Ratios

(a) Operating Expense Ratio Operating Expenses x 100%

Sales

(b) Breakeven Ratio ___Fixed Costs__ x 100%

Gross Margin %

(c) Stock Turnover Ratio Cost of Goods Sold x 100%

3.2 Cash Flow Reporting

Direct Method

Cash flows from operating activities

Cash receipts from customers Cash paid to suppliers and employees Cash generated from operations Interest paid

Income taxes paid

Net cash from operating activities

Cash flows from investing activities

Purchase of property, plant and equipment Proceeds from sale of equipment

Interest received Dividends received

Net cash used in investing activities

Cash flows from financing activities

Proceeds from issuance of share capital Proceeds from long-term borrowings Dividends paid *

Net cash used in financing activities Net increase in cash and cash equivalents

Cash and cash equivalents at beginning of period (Note) Cash and cash equivalents at end of period (Note)

* This could also be shown as an operating cash flow

Rs. xxx (xxx) xxx (xxx) (xxx) (xxx) xxx xxx xxx xxx xxx (xxx) Rs. xxx (xxx) (xxx) xxx xxx xxx Indirect Method

Cash flows from operating activities

Net profit before taxation Adjustment for:

Depreciation Investment income Interest expense

Operating profit before working capital changes Increase in trade and other receivables Decrease in inventories

Decrease in trade payables Cash generated from operations Interest paid

Income taxes paid

Net cash from operating activities

Cash flows from investing activities

Purchase of property, plant and equipment Proceeds from sale of equipment

Interest received Dividends received

Net cash used in investing activities

Cash flows from financing activities

Proceeds from issuance of share capital Proceeds from long-term borrowings Dividends paid *

Net cash used in financing activities Net increase in cash and cash equivalents

Cash and cash equivalents at beginning of period (Note) Cash and cash equivalents at end of period (Note)

* This could also be shown as an operating cash flow

3.3 Lending Covenants

Lending covenants form an integral part of term loan lending & are included in the loan agreement document, to keep the risk at the same level during the period of the loan, which the bank was agreed to accept when it granted the loan, & negotiated an appropriate rate of interest.

3.3.1 Affirmative Covenants

 Provision of financial information:

• Audited A/Cs • Aged lists of Debtors & Creditors

• Management A/Cs • Professional valuations of security

 Payment of Interest as it falls due.

 Capital repayments to be made on the loan

 Adherence to certain ratios:

• Shareholders’ Funds Ratio • Interest Cover Ratio

• Capital Adequacy Ratio • Current / Liquid Ratio

• Gearing Ratio • Loan to Value Ratio

• Operating Cash Cover Ratio

3.3.2 Negative Covenants

 Limit the amount of debt the business can take on.

 Restriction on dividends paid.

 Limit / prohibition on assets disposals, or the grating of leases.

 Restrictions on change of ownership.

 Minimum levels of shareholdings for key people.

3.3.3 Breach of Covenants

Breach of covenants can lead to the following:

 Negotiate a re-pricing of the loan.

 Seek additional security.

 Extend the repayment period.

 Renegotiate the whole credit facility.

3.4 Assessing Customer Needs

4 Credit Risk Practices for Business & Commercial Banks 4.1 Risk Analysis & Assessment

Step 1: Identification of the risk. Step 2: Assessment of the risk.

Stages Status Remarks

I Non-Accrual Loan Where the loan is at the stage of no applicability of loan.

II Past due 90 days Loan is due more than 90 days.

III Troubled Debt The recovered loan which has provision or was due for more than 90 days. IV Potential Problem Loans Where there is a possibility of a loss & the provision has been created.

4.2 Risk Management Strategy

Identification of the Issue

Identification of the probability

Mitigation of Risk

Quick Action / Monitoring 4.3 Elements in the Analysis & Assessment Process

4.3.1 Market / Industry Risk Assessment (Low, Moderate, High)

• Economic Conditions • Cost Structure

• Seasonality • Barriers to Entry

• Industry Cycle • Barriers to Exit

• Industry Profitability • Threats of Substitutes

• Industry Competitions (Domestic/Foreign) • Bargaining Power of Buyers

• Industry Regulations • Bargaining Power of Suppliers

4.3.2 Business Risk Assessment (Low, Moderate, High)

• Business Life Cycle • Legal Compliance

• Suitability of Product to Market • Recovery Plans

4.3.3 Financial Risk Assessment

• Operational Risk • Borrowing & Repayment (Ratios)

• Audit Risk (Internal/ External) • Asset & Liability Risk (Ratios)

4.3.4 Documentation & Pricing Risk 5 Credit Risk Practices for Retail Banking

5.1 The Risk Management Framework

Risk Management is a defensive proactive solution, under which the management reacts to foreseeable situations with a proper predetermined game plan.

5.1.1 Lines of Defense for a Bank

(a) Front Line Bankers, Treasury Department, etc…

(b) Policies & Procedures, Internal Audit, Credit Approval, Distressed Lending Units, Group Legal, Operational Risk, Executive Committee, etc…

(c) BODs, External Auditors, Financial Service Authorities, Govt. Legislation, etc…

5.1.2 How Risk is Manages & Overviewed

Through different following committees who directly report to BODs:

• Credit Risk (Business, Divisional, Group, Board Level) • Asset & Liability Risk

• Market Risk • Insurance & Investment Risk

• Operational Risk • Legal & Regulatory Risk

• Strategy Risk • Audit Risk

5.2 Credit Scoring

Statistical means of screening customers to determine their creditworthiness. A system that allocates points according to the data produced in answer to a credit application form. It determines the statistical probability that the credit will be repaid.

5.2.1 Types of Credit Scoring

(a) Application Scoring (Used for new customers)

 To predict the likelihood of the loan a/c going ‘Good’ or ‘Bad’.

 To determine the amount of credit limit.

 To provide overdraft facility based on a new a/c.

(b) Behavioral Scoring (Used for existing customers & is an ongoing, updateable assessment for credit)

 To increase a Credit Card limit

 To upgrade Debit / Credit Cards from Standard to Gold / Silver

 To decide whether to pay or return the transactions presented if the funds are insufficient in a/c.

5.2.2 Benefits of Credit Scoring

 All customers are treated same & fairly

 Allows the management to control the “Credit Tap” i.e. to increase / reduce credit exposure

 Standardized method of processing

 Considering volume credit approvals irrespective of value

 Improved Management Information System

 Efficient & Cost-effective method

 Reliable Credit Portfolios

5.2.3 Monitoring Credit Scoring

 The Credit Cards are regularly reviewed for:

 To find stability of current score with historical performance

 To find the changes of the makeup of the customer

 To find stability in override decisions

 Has the predictability of level of defaults match the actual

5.2.4 The Electronic Credit Information Bureau (ECIB) (Established by SBP in 1992)

5.3 Mortgage Lending

5.3.1 Risks involved in Mortgage Lending

(a) Repayment Risk (Ability of the customer to meet future payments). (b) Property Risk (Value of the house & quality of the registered title).

5.3.2 Other Factors

• Conduct of A/Cs • Conduct of previous Mortgage or Tenancy Agreements

• Evidence of Savings • Previous Credit History

• Income & Expenditure Profile • Employment & Salary

5.4 Credit Risk Analysis (5Ps)

5.4.1 Person (Trustworthiness, Risk Review, Age Review, Customer employed in which sector) 5.4.2 Purpose (Legal, Logic b/w the purpose of funding & repayment, Separate A/Cs where Lending is for a specific purpose)

5.4.3 Payment (The primary source of loan repayments which is usually the surplus Income over the expenditure of borrower)

5.4.4 Protection (Security, Mortgages)

5.4.5 Premium (Pricing of loan, Interest & other charges) 6 Business Lending – When Things Go Wrong

It happens when the lending being made, while neglecting the below warning signs:

6.1 Internal Bank Records (Bank A/Cs, Cheques issued, direct Debits, Standing orders, Correspondence, etc…)

Chapter 04

Collateral & Documentation

A Company Formed & Registered Under The Company Ordinance 1984.

1.1 Characteristics of a Company

• Legal Entity • Privilege of limiting the liability

• Dual Entity • Perpetual Success (i.e. a company will remain unless wound up)

1.2 Laws Governing the Companies in Pakistan

(a) Companies Ordinance 1984

(b) Securities Exchange Commission of Pakistan Act 1997

1.3 Types of Companies

1.3.1 Company Limited by Guarantee (A person / group takes the guarantee to contribute a certain amount to meet companies credit obligations in case of winding up)

1.3.2 Company Limited by Shares (a) Public Limited Company.

• Announce the shares to General Public • No. of Directors (≥03)

• Transferability of Shares • The word “Public Ltd” in the end of the name • No. of shareholders can (≥50)

(b) Securities Exchange Commission of Pakistan Act 1997

• Cannot announce the shares to General Public • No. of Directors (≥02)

• No Transferability of Shares • The word “Pvt. Ltd” in the end of the name

• No. of shareholders can (≤50)

1.4 Extent of Liability of Directors

1.5 Documents Required for Lending the Company

List of Documents Requirement Source for Certified Copy

Memorandum of Association Company Secretary

Articles of Association

---do---Board Resolution to Borrow

---do---Certificate of Incorporation Company Registrar

Certificate of Commencement of Business ---do---Form 29 (List of Directors / ---do---Form A ---do---Attested copies of CNICs of all directors ---do---2 Other Types of Borrowers & Documents Requirement

S. No Account Nature Documents Required

1 Individuals / Sole Proprietorship a. Attested copy of CNIC.

b. Trade body Association Letter / NTN (if applicable).

2 Partnership Firm

a. Attested copies of CNICs of all partners. b. Attested copy of ‘Partnership Deed’. c. Attested copy of ‘Registration Certificate’.

d. Mandate of partners to borrow & sign the documents.

3 Societies, Associations, NGOs & Clubs

d. Attested copy of CNIC of authorized person(s) to operate the a/c. a. Certified copy of ‘Registration Certificate’.

b. Certified copy of ‘By-laws / Rules & Regulations’. c. Executive Committee Resolution for borrowing.

4 Trust

c. Attested copy of CNICs of all trustees. a. Attested copy of ‘Registration Certificate’. b. Certified copy of ‘Instrument of Trust’.

3 Documentation Description

3.1 Terminologies used in IBs

 Banking Finance (Running / Cash / Demand) is based upon “Murabaha”, which is basically a sale on credit, i.e. the bank purchases certain assets (Raw Material / Stocks / Machinery, etc…) from the borrower & pays the sale price (the amount of finance), which is then sold to the borrower at purchase price (Sale Price + Markup) after a certain period.

3.2 Description of commonly Used IBs

3.2.1 IB-6 (Agreement for Finance) (Used for Short / Medium / Long-term Financing other than Agricultural Finance)

IB-6A Single Transaction Finance, other than Running Finance

IB-6B Demand Finance

IB-6C Financing to Fixed Income Persons

IB-6K Linked Markup with KIBOR

3.2.2 IB-8 (Agreement for Issuance of L/C) (Agreement for Issuance of L/C) 3.2.3 IB-12 (D.P Note)

A written commitment by the borrower that on demand he shall pay a certain sum of money to bank. If the period is more than 03 years then a fresh D.P should be obtained before expiry of 03 years.

3.2.4 IB-20 (Agreement for Discount / Purchase of Bills)  An agreement whereby the customer agrees to:

(a) Honour the bills on maturity.

(b) Indemnify the bank in case of dishonor of bill 3.2.5 IB-28 (Letter of Lien on Marketable Securities) 3.2.6 IB-29 (Personal Guarantee)

3.2.7 IB-30 (Counter Guarantee)

 It is obtained in the event of extending Bank Guarantee (BG) facility to a customer. 3.2.8 IB-31 (Agreement of Sale & Buy of Marketable Securities)

3.3 Precautions in Filling the IB-Forms

• Emphasize on Main terms i.e. Price, Purchase Price & Rebate Dates • Verification of borrowers signs

• Dates • Stamp Duty

• 02Witnesses & CNICs • Borrower’s sign on each page of IB-Form

• Main Documents Attestation • Cutting / Overwriting be authenticated

3.4 Use of Standard Documentation (If not possible then the draft must be vetted from legal) 3.5 Inclusion of Standard Clauses

• Adverse Change Clause • Cross Default Clause

• Majority Ownership Clause

3.6 Review of Standard Documents (Banks all forms must be reviewed by legal dept. at least once in a year)

4 Collateral / Security

A very critical component of the credit process, which is primarily taken by banks against finances provided to borrowers to secure repayment (2nd _{way out), if the cash flows (1}st _{way out) of borrower becomes} short / unavailable.

4.1 Reasons for a Bank to take Security / Collateral

• To fund repayment • To fulfill SBP regulatory requirement of clean exposure

• To diversify means of repayment • To improve banks right

• To secure lending / financing

4.2 Approved Securities by Bank

• Lien on deposits • Lien over L/C

• Pledge of stocks / goods • Lien over Import Documents

• Hypothecation Charge • Lien over Export Documents

• Mortgage • Lien over Bills Documents

• Personal Guarantee • Trust Receipt

• Assignment of Bank Guarantee • Assignment of Receivables

4.3 Attributes of a Good Tangible Security

• Marketability • Liability

• Easy Valuation • Storability

• Stability of Value • Transportability

• Durability • Yield

• Easy Transferability of Title

4.4 Classification of Securities

• Charge • Mortgage

• Lien • Assignment

• Pledge • Hypothecation

4.5 Charge

A security by a company for payment of a debt or other obligation that does not pass “the title of the property”.

4.5.1 Types of Charge

(a) Fixed Charge (The value of the asset at the time of creation of charge) (b) Floating Charge (The value of the asset when the charge is crystallized i.e. default / liquidation of Co.)

4.5.2 Registration of Charge

 Mandatory under provision of Company Ordinance 1984  Unregistered charge is not entertained by Official Liquidator

 Company cannot create more than one charge on any asset due to its registration

 The charge must be registered within 21 days after the creation of charge, if not then must be requested for extension of deadline to the SECP

 Document required for registration

 Form-10 containing particulars of mortgages / charges

 Certified copies of instrument creating the charge

 Affidavit which indemnifies the copies of instruments are true copies  Ranking of charges:

(a) Terminologies

 1st _{Exclusive Charge (One creditor as claimant)}

 2nd _{/ Inferior Charge (More than one creditors as claimant)}

 Pari Passu Charge (Various secured creditors as claimant) (b) Importance of Ranking.

Then Then

Pari Passu 1st _{Exclusive Charge 2}nd _{/ Inferior Charge}

(c) Procedure to be followed.

 Specifying the ranking of the charge on all documents & Form-10

 NOC, in case, if there is already a charge.

 Final legal opinion after registration from the legal department of bank (d) Approval for Issuance of NOCs

4.5.3 Releasing of Charge / Letter of Satisfaction of Charge 4.6 Pledge

Bailment (delivery) of goods from one person (Pledger / Pawnor) to another person (Pledgee / Pawnee) as security for payment of a debt or other obligation

4.6.1 Features of Pledge  Possession of goods

 Actual (Physical transfer of goods from one person to another)

 Constructive(The keys of warehouse of the goods is handed over from one person to another)

 Contract of Pledge can be oral as well as written.

 No requirement of registration under Company Ordinance 1984 4.6.2 Types of Pledge

(a) Pledge Under Lock / Key (Keeping the goods in covered godown under Lock / Key arrangement)

4.6.3 Categories of Legal Documentation

(a) Documents providing evident to legal claim:

 Board Resolution

 Markup / Finance Agreement

 Documents Creating Security Interest (e.g. Hypothecation, MODTD, SBLC, Bank Guarantee, et…) (b) Documents required by Regulatory Bodies (e.g. SBP)

(c) Support Documents.

4.6.4 Security Arrangements

 Legal document must be placed in security documentation folder in vault.

 Vault must be fire proof.

 There should be no electric wiring in the vault.

 Unauthorized persons should be strictly restricted inside the vault.

 Security Document Folder Movement Register should be maintained to record the movement.

 Obtaining of proper insurance cover.

4.6.5 Exercising Sale in Case of Default

While exercising the above, the banker must act in the best interest of Pledgor, & keep two points in mind:

(a) Proper notice must be served to the Pledgor.

(b) Reasonable steps should be taken to secure a fair price of goods:

 Goods should be examined by a qualified reputed surveyor to establish their market value.

 Written offer to purchase should be invited from several dealers.

 The advertisement of auction should be published in at least two prominent newspapers.

 The offer closest to market value may be accepted.

4.7 Hypothecation

A kind of mortgage, in which the Lender creates a charge against the property of the borrower, without getting the property into his (Lender’s) own custody.

 Stocks of goods in the possession of borrower may be hypothecated through the letter of hypothecation with following undertakings of borrower:

(a) To pay the bank through the sales proceed of such goods. (b) To insure all the stock adequately against fire, theft, etc…

4.8 Mortgage

Transfer of an interest in specific immovable property for the purpose of securing the payment of an existing / future debt or other obligation through delivery of title deeds of immovable property by the borrower.

4.8.1 Steps to Formalize the Mortgage Arrangement

 Examination of Title Deeds by bank’s Legal Department

 Valuation Certificate from reputed surveyors

 Search & Non-Encumbrance Certificate from Land Registry

 Property owner should come to the bank & int the presence of at least two witnesses he should hand over the Title deed

 Insurance Policy with bank Mortgage clause

 Memorandum of such deposit should be recorded in the mortgage register

 In case of Limited Company the charge must be registered

 Legal agreement of mortgage

 Drawing should remain within the DP after retaining 40% margin on properties

 Ensuring that the property is in safe custody & will not be rented without NOC / consent of bank.

4.8.2 Types of Properties

(a) Immovable Properties.

Land, Building & things, permanently attached with earth. Plant & Machinery attached to leasehold land for long-term period.

 Exceptions:

 Standing timber, growing crops or grass.

 Machinery attached to the land for short period.

4.8.3 Exercising Sale in Case of Default

 Bank can do the above on happening of following incidents: (a) If the advance is not paid on prescribed date.

(b) If installments of debt is not paid within 03 months.

(c) If the interest of 03 months aggregate of Rs. 1,000/- is not paid. (d) If the mortgaged property is damaged or its value diminishing.

 If selling is done by auction then:

 The advertisement should be published in at least 02 prominent newspapers.

 Mortgagee bank should not buy himself unless there is a clause mentioned in the mortgage agreement.

 The mortgagee bank should exercise his power of sale in the best interest of mortgagor.

 The expanses of the sale should be kept to the minimum, which details should be submitted to the mortgager and also the surplus, if any.

4.8.4 Execution of Memorandum of Deposit of Title Deeds in Case the Property Owner is Female

 At the time of signing prior to execution the documents must be read & explained the female.

 Execution of the memorandum can be adequately done, if:

 She has understood the documents. This can be done by adding a clause in the memorandum.

 The signature of the attesting witness are also there on the memorandum.

 Proper attestation by 02 witnesses of the memorandum.

4.8.5 3rd _{Party Property}

 If the owner is other than the borrower, the bank should ensure that the owner should family

member / close relative & if not then must inquire the reason of his interest in the loan.

 NOC issued by the Leasing Authority.

 Non-Encumbrance Certificate issue by the District Authority.

 The land should be in the name of borrower, so necessary documents should be completed & at last legally vetted.

4.9 Lien

Right of a bank, who is possession of his borrower’s property, for retaining such property until the debt due to the borrower is paid back.

4.9.1 Types of Lien

(c) Particular Lien (Arises from a particular transaction, connected with the subjected property, e.g. Carrier’s Lien for his charges)

(d) General Lien (Arises from general dealing b/w two parties, e.g. Bank’s Lien)

4.9.2 Lien & Limitation Act 1908

A/c to the said law, a banker can exercise his right of lien over securities, bill or cheques of the customer which may come to his hands in the ordinary course of business.

 Necessary conditions for exercising such lien: (a) The property must belong to the borrower.

(b) Property must come into banker’s possession lawfully.

(c) Property must come into banker’s possession in the ordinary course of business. (d) No contract inconsistent with lien

4.9.3 Banker’s Right of Set-off

 Necessary condition to exercise the right:

 The amount to set-off must be certain i.e. not contingent liabilities

 Due b/w the same parties

 Due in same rights, i.e. debt due in personal capacity cannot be set-off with funds available in official capacity

 Limitations of Right of set-off:

 Credit Balance on trust a/c

 Credit Balance on customer a/c against contingent liability on Bills, L/C, L/G, etc…

4.10 Stock Exchange Securities (Shares / TFCs)

 Before accepting, the quality of securities must be assessed through:

 Age, Reputation & Directors of the company.

 Market value of securities during recent years.

 Liquidity / Turnover of shares.

 Company’s financial position & dividend history.

 Prospectus of the company.  Restrictions on banks by SBP:

 Taking exposure on their own issued shares / TFCs

 Providing unsecured credit to finance through TFCs

 Taking exposure against Non-listed securities

 Taking exposure against the securities issued by borrower’s won company or its subsidiary.

 Taking exposure against “Sponsor Director’s Shares”.

 Taking exposure against securities of listed companies that are not member of Central Depository System.

 Taking exposure against securities of company with low credit rating.

4.11 Guarantees (Secondary Liability)

A collateral security of secondary liability under which a person (guarantor / surety) gives the guarantee of the borrower for the payment of loan, & if the borrower is unable to pay, then he will pay back the amount of loan to the lender (Creditor).

4.11.1 Parties to Guarantees

(a) Guarantor / Surety (Who gives the guarantee)

(b) Principle Debtor (Whose default the guarantee is give)

(c) Creditor (When the guarantee is given)

4.11.2 Types of Guarantees

(a) Specific Guarantee (Executed in respect of a specific transaction & terminates when it is completed) (b) General Guarantee (Extends to series of transactions & can be revoked by the surety by a notice to creditor)

4.11.3 Essential Features

 May be oral or writing, written on stamp paper is preferred

 Opening phrase, defining the parties to the contract

 Opening clause explains the reason of the guarantee

 Liability of the guarantor

 Renunciation of common law rights

 Signature of the guarantor

4.11.4 Invalidation of the Contract (a) Signing is done under undue facts:

• By mistake • Under Coercion

• By misrepresentation • Under Undue Influence

• By Concealment of Facts

(b) Death of Guarantor (c) Insanity of Guarantor.

(d) Bankruptcy / Insolvency of the Guarantor. (e) Minor as Guarantor.

(f) In case of Partnership, the contract must be signed by all the partners.

(g) In case of Limited Company, the clause of such privilege must be mentioned in the Memorandum of Association.

4.11.5 Requirement of Personal Guarantees

 Bank can have different Personal Guarantees as security against the loan, which includes the following:

(a) Public Limited Company (Not usually required)

(b) Public Unlimited Company (Mandatory to obtain the PGs of Directors)

(c) Private Limited Company (Obtained the PGs of Directors)

Chapter 05

Management of Credit

Monitoring of facilities by setting up various triggers & periodic review to ensure that the facilities are being utilized as advised and in line with the original purpose of facility.

1.1 Facility Account Monitoring

 Helps in maximization of returns to the bank

 It may act as an early warning signal, i.e. the derailed a/c behavior from acceptable parameters 1.2 Ways of Facility Account Monitoring

 Periodic Review of A/c

 Close Interaction with Customer

 Setting of covenants agreed by the customer (Financial & Non-Financial)

1.3 Challenges

 The above mentioned triggers are used to ensure appropriate utilization of facilities, although there are No. of factors which are not in the control of the borrower:

 Rapid growth in sales requiring higher working capital facility

 Higher commodity prices increase working capital requirements

 Higher energy prices increase operating costs

 Devaluation of local currency (if the borrower is involved in import / export business)

 Materialization of contingent liabilities

 Any other unforeseen event, e.g. temporary blocking of facilities by other banks on company panel

1.4 Compliance to Business Routing Requirements

 Term Loans (The customer is restricted to route trade business e.g. receiving

of sales proceeds, opening of L/Cs in such case)

 Trade Facilities (Limiting the trade business through bank’s trade counters)

 Funded Working Capital Facilities (Restriction on trade business in the form of funded working capital e.g. OD / Short-term Loans)

1.5 Monitoring Facility Utilization

 Permanent / Core Requirement (DD / Short-term Loan Facility, such types of borrowers have similar levels of borrowings throughout the year, e.g. Car Dealer)

 Seasonal Requirements (Industries such as textile & sugar, which depends upon cotton & sugarcane, respectively)

1.6 Facility Monitoring System Key Areas

• Activity Utilization Reports • Client Calls

• Monitoring of Covenants • Upcoming Maturities Report

• Drawing Power (DP) • Stock Inspection

• Stock / Receivable Reports • Site Visits

• Monitoring of Security Document • Review of Management A/Cs

• Tracking of Documents Deferral Deadlines

1.7 Facility Reports

 Account Activity Report (Indicate the max & min balances of an a/c during a specified period for highlighting & matching them with the actual correspondence of the business)

 Excess Report (Indicate the excess over the approved level / threshold of the facility)

 Covenant Report (Indicate compliance / Non Compliance with covenants at a particular date)

Chapter 06

Past Due Accounts / Overdue Accounts

 To reflect the health of loan, categorizations are used. It is done through different tools / techniques and attributed through factors like qualitative / quantitative. Such categorization includes:

 Substandard Loans (Where markup & principle is over due by 90 days from the due date)

 Doubtful Loans (Where markup & principle is over due by 180 days from the due date)

 Loss (Where markup & principle is over due by 01 year or more)  The loan provisioning is done as per the instructions / guidelines given by the SBP.

 The writing off of loans produce a very negative effect on the company’s profitability as well as market standing / credit rating.

 Management of past due credits, which include due diligence on security coverage, understanding of the local laws, appropriate remedial strategies, etc. cannot only increase the interest income but also reduce provisioning & Capital Adequacy Requirement.

 For the purpose of loan recovery SBP has provided guidelines pertaining to various type of consumers, SME & Corporate Financing Facilities.

 Restricting / rescheduling are common terminologies used while managing a past due account, which includes following contents:

 To identify the weaknesses & root cause of default.

 Whether the credit has still the capacity to pay off the loan, if it is restructured.

 Through analysis of financial statements & cash flows

 Assumptions for projections are verified

 Security analysis if restructured

 Developing of crystal clear understanding of credit parameters

 Reduction in markup rates

 Sharp & close monitoring after the restructuring process

 Applying the “Time Value of Money” Concept

 After the restructuring / rescheduling & all the possible efforts of management if the loan is still outstanding, then the remedial process should be proceeded, i.e. litigation

 Loan loss provisioning is one of the main accrual expenses of banks, which forms the basis for establishing a bank’s capacity to absorb losses

Past Due Classification Provisioning Requirement

Substandard 25% of Net Exposure (Less FSV benefit)

Doubtful 50% of Net Exposure (Less FSV benefit)

Loss 100% of Net Exposure (Less FSV benefit)

 SBP states that the bank should continue writing-off their loans after getting approved from the company’s BODs with a fully transparent method while adjusting with the sale proceeds of collaterals / securities, except where the Forced Sale Value (FSV) is more than the outstanding amount. FSV refers to the value which fully reflects the possibility of price fluctuations & can currently be obtained by selling the mortgaged / pledged assets in forced conditions.

2 Past Due A/Cs – Consumer Lending

 Delinquent A/Cs are the A/Cs when the payment is not received on the due date. The industry standards for delinquency reporting are 30, 60, 90, 120 & 150 days past due. The bank also make segregation of soft & problematic delinquencies, i.e. 30-60 days past due as soft & more than 90 days past dues as problematic.  The classification of past due A/Cs is done as per the criteria defined by SBP in PRs, i.e. Substandard, Doubtful

& Loss.

 The provisioning is done as per the SBP defined criteria in PRs for Consumer Finance, i.e.

Consumer Products Specific Provisions Requirement

Credit Cards 100% at 180 DPD (Charge off at 180 DPD)

Personal Installment Loans 25% at 90 DPD, 100% at 180 DPD Cash line

---do---Autos 25% at 90 DPD, 50% at 180 DPD, 100% at 360 DPD

Mortgage / Business line

25% at 90 DPD, 50% at 180 DPD, 100% at 360 DPD (of the outstanding resulting b/w the difference of FSV)

 Subjective Classification of Performing & Non-performing loans is carried out primarily for the cases involving bankruptcy, fraud, skip & death of the consumer, where the collections, recovery & fraud unit of the bank generally play a vital role.

 Objective Classification (Time Based Classification)

 The overall Credit Banking Practice in Pakistan & globally is to have a dedicated & effective “Collections” unit to monitor & recover the past due A/Cs. This unit is responsible for:

• Recovery of past due debts • Advising customers on how to pay the over due A/c

• Contacting People • Arranging for legal action

• Informing people about unpaid A/Cs • Organizing the repossession of Assets

• Arranging Payments • Keeping Records

• Providing Credit Reports for the performance of the portfolio

 Some banks use debt scoring as a tool for both pre & post defaults which consists of a powerful

mathematically probability tool that helps in assessing the repayment behavior of the customer & referred as “Behavior Score”.