Lending Book.pdf

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Stage 2

Introduction

Lending - A core banking function

By the end of this chapter you should be able to:

■ State the role of bankers as lenders

■ State the importance of building a disciplined lending culture

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Lending: Products, Operations and Risk Management | Reference Book 1

Lending in Perspective

Historical sources reveal that existence of bank predates the use of money. The nature of deposits and loans were therefore in form of goods and commodities but the essence and principle was the same. The first record of such activity dates back to 2000 BC in Babylonia.1

The modern day definition of a bank as per Britannica is:

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

A difference in modern day banking from the ancient banking practices is that the sequence of the basic functions of the banks today is to take deposits and give out loans. This sequence was not necessarily followed in ancient times. Most importantly in earlier times loans were based out of savings.2

Some differences between ancient and modern-day banking which have an impact on lending

The modem day banking has undergone massive changes in its basis of operations over the last 7 centuries to arrive at the structure and form that we see today. Lending remains a core function of banks as well as its most profitable product. Product types and variations have, however come into existence and most importantly the basis of the credit creation, as it is termed today, is vastly different.

Banks Create Money

Today’s banks create money in the economy by making loans and investments. The amount of money that banks can lend is directly affected by the reserve requirement1 of the Central Bank. In this way, money that grows and flows throughout the economy in a much greater amount than it physically exists. For example a bank gets a deposit of PKR 1 million from Customer X. If the reserve requirement is 20% the bank is able to make a loan out of PKR 800,000. The bank lends the PKR 800,000 to Customer Y who uses the loan to buy a car and gives the money to Company A as payment. Company A in turn deposits the money in the bank and the bank based on Company A’s deposit can make out a loan of PKR 640,000 to its customer. This is an over-simplified example of how the banks create money and the money multiplier effect. You are encouraged to independently read more about this topic as it is of utmost importance in today’s banking world. This ability to create money and thus be responsible for the increased money supply through creation of credit in the economy to the extent that the banks are able to do today is something that ancient bankers did not have to fret about. Banks today are able to lend several times its total capitalization which puts on them a much greater responsibility of understanding the credit they are creating and its recovery cycle.

1

Source: Davies, G. (1994) A History of Money from Ancient Times to the Present Day, Cardiff, UK, University of Wales Press

2

Source: Dr. Frank Shostak (2011), The Importance of Real Lending, Cobden Center-http://www.cobdencentre.org/

1

Reserve Requirement-This is imposed by the Central Bank of the country on all banks in terms of what percentage of the deposits can the bank lend out as loans. In Pakistan the State Bank has a Cash

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Lending: Products, Operations and Risk Management | Reference Book 1 3

Banks act as intermediary between depositors and borrowers

Banks facilitate the flow of funding by acting as an intermediary between depositors and loan-seekers. Earlier the function was to act as an intermediary between savers and borrowers. The difference is that when a saver lends money, what he in fact is lending to the borrower are the goods/services that he has not consumed. Credit then becomes a chain of unconsumed goods/services lent to the borrower to be repaid out of future production of the borrower. However, today the banks’ deposits do not necessarily consists of savers and lending decisions are thus more critical because if the banks create credit without understanding how the credit will generate the goods/services for the repayment of the credit, it will be creating loss-making loans which may default either immediately or with a time-lag. This time-lag has been also referred to as the credit bubble, in recent times.

Banks today thus play a much wider and a very critical role as they provide liquidity and steady flow of credit in the economy which fuels growth and stability.

Role of Banks as Lenders

Lending is a primary business function of banks. The banks make a profit by accepting deposits at a rate of return and making out loans at a higher rate of return than the deposits. The difference in the rate covers the administrative cost as well as compensates them for the risk associated with lending. Lending is a risky and perhaps the most profitable product of the banking business and banks have over time tuned and fine-tuned lending policies, practices and procedures to minimize risks and employ the principle of prudence in lending decisions.

As lenders, banks have a very important role to play in the economic growth of the country. Loans made to support activities which will generate income above and beyond the amount to repay and service that loan are generally viewed as loans which are beneficial for the economy and the country. The banks over the past century however have developed a narrower view. Their agenda is limited to making loans which will be serviced and repaid. Banks have due to this been subject to criticisms from many who blame it for giving rise to the increased consumerism.

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Bank’s role of financial intermediary in the economy is critical. Financial intermediation takes place when banks as licensed deposit-takers take deposits from public i.e. individuals, businesses and institutions and lend to borrowers in the system. In most emerging economies, commercial banks remain the major lenders to individuals, businesses and government. The bank’s motive for financial intermediation is the margin between the cost of funds and the markup for loans. For this return banks incur risk of the credit they extend to the borrower. Given that the major source of funds are public money, banks need to ensure that extreme discipline and caution are exercised when lending money and taking other credit- related exposure.

Importance of Building a Disciplined Lending Culture

The effects and impact of lending have been briefly touched upon earlier. The gravity is nonetheless not lessened by the limited attention that we have paid to it in this chapter. Banks lending decisions are revered in the economy as bank lending is a key economic indicator for a specific sector or industry. If banks are willing to lend their money to a person or a company or a sector/industry, it reflects the banks confidence in the borrower’s purpose of loan, ability to repay and intent to repay. Lending decisions are thus of paramount importance as they are used as key market signals by other players in the economy such as investors, suppliers, customers etc. Moreover as banks deal with public monies, the effects of incorrect lending decisions are far-reaching and can be devastating as witnessed in the recent global financial crisis of 2007/8.

It is thus imperative to build a lending culture which is prudent and cautious. Lending cultures driven by unrealistic or aggressive sales targets have known to fail in the recent past with degenerating effects to the banks in question.

Importance of Cash Flow- based and Security- based Lending

Each loan that a bank makes creates a ripple of liquidity. Each loan requires scrutiny and consideration. The fundamental principle to be followed should be that the loan be employed in a manner that it will generate an income above and beyond the level which is required to service the loan and repay the principal. Lenders thus need to assess the purpose of the loan, its repayment capacity, character and reputation or ‘name’ of the borrower and in the instance the borrower is unable to pay the loan, how can the lenders safeguard their interest.

Security Based Lending: Name Lending and Collateral-based Lending

Banks driven by self-interest also exercise a great deal of caution and scrutiny before advancing a loan. There are different types of loan products that are available and different methods of scrutiny and risk assessment employed which will be discussed in the articles that follow.

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times lenders would limit their operations to people they knew either personally or within their own wider network (also known as name lending in recent times). However, as economies have expanded and enterprises have sprung which are diverse in industry and geography, lenders have had to expand operations beyond their limited circle. At this stage the lenders started employing a structured due diligence process and getting to know about the customer and its business operations and/or sources of funding and for additional comfort and security demanded collateral. Strong collateral (high in value and easy to liquidate) meant that even if the borrower’s ability to repay was questionable, the loan would still be good as funds could be recovered from the sale of the collateral. This phenomenon brought with it a new set of concerns relating to the title of the collateral and in case of default by the borrower, would the lender have the legal right to dispose of the asset that the borrower has given to the lender as collateral. Different countries have different legal systems and practices. The article on Collateral will discuss the different types of collateral and the rights of lenders and borrowers in detail; suffice to mention here that taking collateral against a loan advanced has been a practice for centuries.

Cash Flow Based Lending: Purpose and Capacity-based Lending

Lenders in the recent times have however expanded their focus on the purpose of the loan and the repayment capacity with reference to the purpose of the loan. While having good quality collateral is highly recommended, banks are in the business of borrowing and lending money and not liquidating collateral. Liquidating collateral is a lengthy and cumbersome exercise and not the bank’s core business function. Banks have thus realized that lending decisions which are transaction- specific and evaluate the capacity of the borrower based on the cashflow from the transaction/project/activity that is being financed are sounder than the ones which only consider the collateral and the borrower ‘name.’ This in no way stops the lender from requiring good quality collateral or considering the borrower ‘name.’ Analyzing the cash-flow and repayment capacity however is being given as much consideration when making the lending decision.

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Part Two

Lending Products

Student Learning By the end of this chapter you should be able to: Outcomes

1. Categories of Borrowers

*Describe the types of lending products available to business borrowers

■Differentiate between short term and long term lending

■Differentiate between funded and non-funded facilities

*Describe various types of long term lending facilities available to business borrowers

■Describe the characteristics of an individual borrower and explain how they differ from business borrowers

■ Describe the types of products available to individual customers

■Explain the purpose of individual/consumer borrowing and classify loans under^onsumer lending

2. Regulations and Practices

■Recall the SBP laws relevant to decide the lending limits for both business and consumer borrowers

*State the lending exposure limits as per SBP regulations

■State regulations concerning lending disclosure and reporting requirements for consumer lending

■State regulations concerning lending disclosure and reporting requirements for business lending

■Define credit policy, target markets and risk assessment criteria and discuss their importance in lending decisions

■State prudential regulations concerning the business /commercial lending operations

■State the minimum requirements for consumer financing as per the prudential regulations

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3. Pricing

* Recall the various types of pricing mechanisms available across the industry

■ Explain the industry-wide methodology used for calculation of pool rates

■ Explain internal cost of funds and discuss how it is determined

■ Explain the process of developing a pricing model based on floating mark up rate

■ Discuss the pros and cons of using a floating mark up rate as compared to using fixed rate

■ Explain 'risk based' and 'relationship yield' pricing models

■ Explain the concept of opportunity cost, risk reward pricing and re-pricing intervals

Categories of Borrowers

As discussed in the previous chapter, banks as lenders need to inculcate a disciplined lending environment to avoid making lending mistakes. Before a loan is made the lending bank should ask the following questions:

a. Who is the potential borrower?

b. Does the potential borrower meet bank’s target market definition and risk acceptance terms?

c. What is the purpose of borrowing/borrowing cause?

d. Does the borrower’s business/income generate sufficient cash within a reasonable time period to repay interest and principal? e. What would be my way out if the cash flows are not sufficient to

ensure repayments of loan?

The list above is not exhaustive and in the next few chapters we will address these issues in detail. It is important to have awareness of these fundamental questions as they are key to determining the credit requirement of the businesses and the repayment capacity.

A bank’s credit customers can be divided in to two broad categories:

a. Business Borrowers

b. Individual/Consumer Borrowers

The purpose of borrowing and source of repayment is distinct for each category and based on this the lending products offered by the bank to each segment are different. The State Bank of Pakistan does not allow banks to offer any lending product without collateral or security to business borrowers above PKR 2 million and up to a certain amount for individual borrowers. The clean lending limit for individual borrowers is PKR 2 million at present, but is subject to change. Please refer to the SBP website for up-to-date information.

A. Business Borrowers

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financing needs for capital expenditures. Some businesses also take on debt which could be in the form of credit from banks to manage their balance sheets more objectively. Businesses also seek bank support to meet their non-cash needs such as opening Letters of Credit, and extending financial or other form of guarantees on their behalf.

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Non- Funded Facilities

Lending Products for Business Borrowers:

Lending products for business borrowers can be mainly divided by the nature of the facility i.e. is it fund-based; this would entail the bank providing the customer with access to the funds; or non-fund based in which case the bank would assume the liability of payment on account of the customer to a 3rd party. Within each category there are several different sub-divisions based on the tenor and terms. Diagram 2.1 below is a good illustration of the lending products available for business borrowers, at a glance.

Diagram 2.1

Lending Products for Business Borrowers

Demand I Discounting I Export I Import

Finance I I Finance I Finance

Details of lending products available for businesses in Pakistan within each sub-heading and their brief description are as follows:

1. FUNDED FACILITIES:

a. SHORT TERM FINANCING PRODUCTS

i. Running Finance/Overdraft

An overdraft generally known as RF in Pakistan is a type of lending which offers a high degree of flexibility. For a bank, the overdraft is a staple product by means of which the customer may overdraw their current account balance, that is, draw out more from the account than the total amount of money standing in the account. The customer is permitted to overdraw the account up to an agreed limit (the overdraft limit). When an account is overdrawn, the customer is borrowing and owes the bank money. An overdraft is normally shown on the customer’s bank statement by the abbreviation DR (meaning debtor) after the balance on the account.

Overdrafts are only available on current accounts, the accounts through which businesses pass their income and expenditure. Although overdrafts are repayable to the bank on demand, they are normally agreed subject to annual review.

Funded Facilities

Short-term Facilities-Payable within 1 year

ej Long-term S

Facilities $ Payable after 1

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Interest/mark-up on an overdraft is only charged on the day-to-day balance outstanding on the account. Thus, if the current account fluctuates from a credit balance (funds in the account) to a borrowing position (using the overdraft), the customer only pays interest when the account is “in the red”/debit - what the customer is actually borrowing on that day.

The overdraft is a convenient way of borrowing to cover a business’s short term requirements. It is only appropriate for short term temporary borrowing which is drawn down and then repaid and drawn and repaid again during the working capital (or trading) cycle.

The overdraft provides finance to cover a business’s working capital needs (the finance needed through the operating cycle) and help iron out the fluctuations in its cash flow as bills are paid before funds are received from sales income. A large inflow of funds one week will reduce the interest payable while the firm retains the ability to borrow again next week. For business customers the overdraft is often the cheapest and most convenient means of borrowing.

An account with an overdraft facility should show wide fluctuations. For instance, when the customer buys stock, the balance of the account would swing into overdraft and once the stock is sold and sales income received, the account should swing back into credit. When an account remains in debit permanently, with low turnover this is referred to as hard core borrowing. It is best to identify the hard core borrowing element of a business and understand the underlying reason to best meet the business’s credit requirement soundly. If the run of the account shows that the account is perpetually in debt, the debt is becoming “hard core”. It may indicate that things are not going according to plan. This could be due to several reasons. Perhaps the customer is not collecting cash from debtors quickly enough, or the business may be making losses or the business is financing its long-term needs with short-term financing.

ii. Demand Finance

Demand finance generally known as LM in Pakistan is similar to running finance in many aspects except that the tenor of the demand finance is fixed. For example a business may have a requirement for short-term financing for PKR 500,000 and it may know that this requirement is for a specific period e.g. 2 months. The business can then ask the bank for a loan of PKR 500,000 for 2 months. The interest rate for the loan will be booked on the date of the booking of the loan for the period of the loan. The LM must be paid at the expiration of the term. In rare cases it may be rolled-over or extended, however it is generally preferred by banks not to have a rolling LM to ensure that the business has access to funds to pay off the loan and the debt is not becoming hard core.

iii. Export Finance

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Undng: Products, Operations and Risk Management | Reference Book 1 11

schemes via the banks or through banks own sources. The facilities available at present are:

1. Pre-Shipment Financing-Part l(Fundecf through bank’s own sources).

2. Pre-Shipment Financing-Part 1 (Funded through SBP refinance scheme).

3. Pre-Shipment Finance-Part 2 (Funded through SBP refinance Scheme).

4. Post-Shipment: Discounting/ Purchase of export Bills (Funded through bank’s own sources).

5. Post-Shipment: Discounting / Purchase of Export Bills (Funded through SBP refinance Scheme).

6. Bill Discounting/Receivable Financing.

All these facilities are tenor-bound and generally do not allow roll -over. Detailed information on this can be sought from the SBP website.

iv. Import Finance

Import finance is generally available in terms of import loans or financing against trust receipts (FATR) generally in case of a Letter of Credit based transaction. Under this facility, the Bank provides the documents of title of goods imported under L/C, to the customer to enable the customer to obtain goods prior to payment and to sell them to generate funds to pay-off the bank. The goods represented thereby and the sale proceeds thereof in trust for the bank. Since this is a fund-based facility as opposed to a non-funded facility (as in the case of L/Cs), due care and diligence needs to be exercised when extending this facility.

Import finance can be further classified into the following:

1. Finance Against Trust Receipt (FATR)

FATRs are related to import transactions. The bank may allow specific customers FATR facility against collection documents as per the terms set out from time to time, which are discussed as follows:

a. FATRs in respect of L/C documents -

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b. FATRs in respect of collection documents -

FATRs in respect of collection documents are only granted when routed through the Bank's branches. This facility is restricted to selected customers with satisfactory account relationship and is governed by the following safeguards:

• Facility to be allowed with prior clearance and only provided to prime customers with low risk ratings.

• Branches should be satisfied that the collection bills have genuine underlying trade transactions.

• Branches are also required to ensure that the facility is used for the customer's regular line of business.

• The facility should be given as a separate FATR line under the import line (i.e. FATR for collection documents) distinct from FATR sub-limit under import (L/C) line.

Finance Against Imported Merchandise (FIM)

This facility is allowed against the commodities imported from other countries usually through letter of credit. At times the importer does not have enough money to pay for the imported merchandise. He therefore requests the bank to pay the dues to the exporter against the security of imported merchandise. This facility is usually allowed against imported goods but occasionally such financing may be allowed against locally manufactured goods covered under L/Cs or received for collection.

b. LONG TERM FINANCING PRODUCTS / TERM LENDING

Term loans are usually granted over a period of years to assist business customers in buying assets such as plant and equipment, and buildings. A term loan spreads the cost of the asset over its expected life. The repayments can be tailored to suit the cash flow of the business, usually either monthly, quarterly, half-yearly or annually.

A term loan is a loan for a fixed amount, for an agreed period, and on specific terms and conditions. Normally such loans are for terms of between three and seven years, although they can range up to twenty years. Longer periods depend on the nature of the proposal, the robustness of the performance of the company and its projections, and the security to be granted.

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• Tenon the term over which the loan is to be repaid

• Repayment Schedule: the intervals at which the principal and interest are due for payment.

• Pricing: the mark-up rate that will be charged.

• Collateral: the security to be granted.

• Loan Covenants: conditions to be complied with by the customer, such as the timely provision of accounting information, stock report, share price in case of a listed company, leverage ratio etc.

• Event of Default: events which would render the loan immediately due for repayment such as the customer failing to meet a repayment installment on time or the loan being used for a different purpose from than agreed.

• Some banks ask for requirements like establishment of Sinking Fund and utilization of working capital facilitated through its counters.

Provided the customer complies with the conditions detailed in the loan agreement, the bank generally cannot demand repayment of a term loan. Generally, the longer a loan is outstanding, the greater is the risk of default.

2. NON-FUNDEO FACILITIES:

a. Letters of Credit (L/C)

In trade transactions where buyers and sellers are geographically separated, banks play a crucial role in managing the payments. A letter of credit is generally established by a bank on behalf of its customer (the buyer/importer) guaranteeing to the seller’s (exporter’s) bank that the bank will make the payment to the seller on time if seller performs as per terms and conditions of the letter of credit.

L/C can be irrevocable or revocable. An irrevocable L/C cannot be changed unless both buyer and seller agree. With a revocable L/C, changes can be made without the consent of the beneficiary. While dealing in L/Cs, the bank in question does not lend funds directly but may have to pay in the instance the customer is unable to pay. L/Cs are thus called contingent liabilities for banks.

There are two type of L/Cs:

I. Sight: is where payment is due to the seller at the time of receipt of goods by the buyer. Sight L/C requires the importer / importing bank to pay as soon as it receives the clean documents from exporter.

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conditions of the L/C. Drafts drawn at sight simply serve as receipts for payments and are of no value for any other purpose. In establishing sight L/Cs branches should ensure that goods are duly insured and that the Bank retains control over the goods at all times.

Documents of title to the goods is released only against payment, either by cash or to the debit of the customer's current account / FATR account / FIM account. L/C, generally as a practice, is not opened for a period in excess of 180 days without prior approval from the risk chain / competent authorities.

II. Usance: is where payment is due after certain, pre-agreed number of days by the buyer. The seller in this instance is providing credit to the buyer. Usance L/Cs are similar to sight L/Cs but call for a time or usance draft payable after a specified period of time. The normal usance period allowed for this facility is 90 days. However, it can be a maximum of 180 days. Exceptionally for undoubted customers, usance period exceeding 180 days may also be allowed with specific approvals from the risk chain / competent authorities.

b. Guarantees/Stand-by Letters of Credit

Business customers sometimes require the bank to issue a letter of guarantee on their behalf. This is generally required by the party that the customer is entering into business with. It can be regarding delivery of goods and services by the customer to the party i.e. the party requires a guarantee that the customer will provide the goods or services agreed failing which the party will call upon the letter of guarantee. It can also be if the customer is the purchaser of goods or services from the party and if the customer does not purchase the goods from the party based on the terms and agreements or defaults on the payment, the party can call upon the guarantee and demand the bank to pay.

The bank in this instance as well, does not lend funds directly but may have to pay in the instance the customer does not perform his obligations or defaults.

These facilities cover a number of specific types of guarantees that the Bank may issue for its customers but in all cases the common factors are:

• The Bank substitutes its own credit standing for that of its customer.

• No actual movement of funds takes place at the time of issuing the guarantee, although there is a clear commitment by the Bank to effect payment when called upon to do so under the terms of the particular guarantee. Thus it is necessary to record these commitments as contingent liabilities.

• The Bank charges a commission for this service usually quoted on a quarterly basis.

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a. Shipping Guarantees (SG)

Guarantees of this nature are required to enable customers to release goods before the arrival of the documents of title; they therefore render the Bank liable to the shipping company to whom the guarantee has been issued. Shipping company is, in turn liable to the true owners of the goods in the event the goods are released wrongfully. It follows therefore that such guarantees should be issued to importers with a credit line. Full cash margin is generally taken for shipping guarantees issued against Shipping L/C, unless waived by appropriate credit/risk authority.

b. Bid Bonds (BB)

The purpose of a bid bond is to substantiate the ability of a person submitting the tender to perform the contract when awarded. Such a bond is issued in connection with a tender and its normal characteristic is an undertaking by the Bank on behalf of the applicant to pay the beneficiary a fixed amount within a stipulated period on his simple written demand if the applicant withdraws his obligation after the acceptance of his tender. A bid bond must not contain any conditions linking it with performance of a contract if awarded and must contain a definite expiry date. If branches are asked to give such undertakings the guarantees must be treated as ‘Performance Bonds’. If there is any ambiguity in the terms of a bid bond which a branch is asked to sign it should study the basic "conditions of tender" to ascertain its precise liability. Branches must insist on the return of the original bid bond after its expiry.

c. Advance Payment Guarantees (APG)

Civil engineering contracts, particularly those awarded by local governments, sometimes provide for an advance payment to be made to the contractor for purposes such as mobilizing site, plant and equipment. In order to obtain this payment the contractor is required to produce an Advance Payment Guarantee.

d. Financial Guarantees (FG)

Financial Guarantee is a general description of various guarantees whose main characteristic is an undertaking to meet any claim from the beneficiary up to a fixed sum on simple demand. Claims under such guarantees must not be made contingent on the non -fulfillment of the terms of contracts, which are unknown to the issuer. Unless the creditworthiness of the concerned customer is undoubted, such guarantees are issued against full cash margin.

B. Individual Borrowers

Individuals also frequently are in need of funds to pay for expenses or purchase of assets, which they cannot afford to pay for in cash at the present time. Situations that typically require borrowing include buying a house or a car or consumer durables such as refrigerator, television, computer etc or paying for education or medical expenses or wedding expenses etc. The individual’s borrowing needs are driven by his/her discretionary spending, lifestyle and stage of life cycle.

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a.

b.

Assets-based/secured

Auto/Vehicle I House Finance I Finance

their income which could be self-generated. If the borrower owns a business or in the form of salary, profit from business ventures, investment income, pension, endowment/trust fund etc. Banks generally look at the historic trend of the individual’s income, stability of cash flows, expense burden on the individual’s income etc to gauge the individual’s ability to sustain the loan and its cost.

Lending Products for Individual Borrowers

Lending products for individual borrowers can be mainly divided by the nature of the facility:

asset-based which would entail the bank providing the customer with access to the funds for purchasing an asset- (long term or short term) and the title of the assets generally resides with the bank or

clean lending where the bank lends to the individual without any underlying asset.

Diagram 2.2 below provides a good illustration of the lending products available for individual borrowers, at a glance.

Diagram 2.2

Lending Products for Individuals

Details of the products available for individuals in Pakistan within each sub-heading are as follows:

A. ASSET-BASED: 1. Long-term Facility

i. Auto/Vehicle Finance

In Pakistan auto finance has been a popular product available for individuals. This product is available through two different modes: Hire Purchase and Leasing, which are discussed briefly as under. While in this chapter we are discussing this mode under lending

Clean/ Unsecured

Personal Loan

Running

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PsdKts, Operations and Risk Management | Reference Book 1 17 an

for

mg

A direct lease is where the business or the individual advises the leasing company of the asset which it wishes to acquire and the lessor then buys it from the manufacturer (if new) or the previous owner (if used) in order that it can be rented back.

products for individuals, hire purchase and leasing are applicable modes of financing for businesses as well.

a. Hire purchase

Hire purchase is an agreement to hire an asset with an option to purchase. The legal title passes to the customer when final payment has been made. The term of the finance is required to be shorter than the expected life of the asset.

The bank actually buys the vehicle which then belongs to it, letting the customer use the vehicle in return for a series of regular payments. The vehicle can be of any form. The bank has the security of ownership of the asset and can repossess it if the hire purchase terms are broken. After all the payments have been made, the customer becomes the owner, either automatically or on payment of a modest fee.

The main advantages for the customer of a hire purchase agreement are:

• Small initial outlay. • Easy to arrange.

• Certainty - the loan cannot be called in providing the terms are kept.

• Tax relief - interest payments are tax deductible and the asset may also be subject to a write-down allowance for businesses. The disadvantages are that it is more expensive than a cash purchase and the fixed term means it may not be possible or expensive to make early termination.

b. Leasing

Leasing is similar to hire purchase in that a vehicle or equipment owner (the lessor) gives the right to use the equipment to the user (the lessee i.e. the customer) over a period in return for rental payments. The essential difference is that the lessee never becomes the owner unless under capital lease.

For business borrowers, purchase of machinery and equipment can tie up a lot of business finances, but leasing effectively provides access to the asset without buying it up front.

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Sale and leaseback (sometimes referred to as purchase leaseback) is where the business or individual sells an asset which they already own to the finance company and then lease it back. (Sale and leaseback is quite common with property - the property being sold to an investor who leases it back.)

In both cases, the asset requires to be returned to the lessor at the end of the agreed period. Many leases have an end-of -lease option providing renewal at a minimal cost or sale to a third party.

Leasing can be useful when other sources of finance are not available. There are also tax advantages; for example, rental payments under an operating lease are tax deductible, as is interest under a finance lease. The depreciation charge in the company’s accounts for a finance lease is tax allowable, dependent on the method of depreciation used

There are two main types of leases:

• Operating lease

This type commits the lessee to only a short term contract that can be terminated on notice. Usually the lessor pays for repairs, maintenance and insurance. An operating lease is used for small items like photocopiers and short term projects like building firms hiring plant, vehicles etc.

• Finance lease

The leasing company expects to recover the full cost of equipment and interest over the period of the lease. Usually the lessee has no right of cancellation or termination. Despite the absence of legal ownership, the lessee bears the costs of maintenance etc, and suffers if the equipment is under-utilised or becomes obsolete. Finance leases offer less flexibility for the user but this is reflected in the cheaper pricing.

The advantages of leasing are similar to those for hire purchase. An additional advantage for operating leases is the transfer of the obsolescence risk to the finance provider. The lessee can hand back the equipment and take a fresh lease of more modem items.

Leasing is a highly specialized area and a customer will need advice to assess whether to buy or lease, especially on the complicated tax issues of finance leases. You may learn more about leasing from your own organization’s leasing department or subsidiary.

House Finance

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Products, Operations and Risk Management | Reference Book 1 19

finance the purchase of residential property, usually with specified payment periods and interest rates.

The amount available to borrowers by banks will often be a stipulated multiple of the customer’s salary/monthly income or a multiple of joint borrowers’ combined salaries or monthly income (the earnings multiplier). The basic lending criteria are based on the borrower’s ability to meet the repayments. The property will be mortgage to the bank as collateral till the borrower makes all the payments and is then able to transfer the title of the house to his/her name.

There is also another type of finance available which is self-build finance for borrowers who would like to obtain finance to build their own house. Since there is no one “standard” self-build project, set procedures should ideally be followed during the life of the loan. Each project should be assessed on its individual merits. As a result, the principles of lending should be carefully considered when assessing a self-build application.

A self-build loan is an advance that will finance the building, converting or renovating of a property as the customer’s principal residence. It is important to be aware that the self-build facility is not a “mortgage” in the traditional sense of the word - rather it is structured as an overdraft that is secured over the plot of land on which the house is being built. Because self-build facilities require a mortgage to be granted in support of the borrowing, this kind of facility falls under the auspices of mortgage regulations.

By the nature of the project, the funding for this type of borrowing must be flexible.

Either of these potential options could be used:

• Funding of the project in arrears on confirmation of stage completion - this is the most common funding arrangement.

• Funding of the project in advance may be considered depending upon the individual proposition, such as low LTV (loan to value).

The expenditure involved in building the house is then drawn down against this overdraft. In most instances, repayment of the overdraft will come from the drawdown of a mortgage once the house has been completed. It is better to set up the facility on a separate account for ease of monitoring.

The bank will expect the valuer to confirm that there are no restrictions affecting the site, that outline planning consent is held and that there are no anticipated problems with any potential development, such as access, supply of services, etc.

Normally two valuations are required when dealing with a self build:

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• At the end of the project, a revaluation prior to the mortgage drawdown.

The normal stages of a self-build project are:

• completion of the foundations/under buildings/plinth. • completion of ground level slab.

• completion of first level slab (where applicable). • finishing (case-to-case basis).

It is normal practice to allow the customer to draw down on the self -build loan at the end of each of these stages, formal certification being generally required from:

• a qualified architect.

• development/cantonment authority inspector, a structural engineer.

2. Short-term Facility i. Finance for

Consumer Durables

Financing of consumer durables such as refrigerators, air conditioners, washing machines, computers, and other electrical appliances has become popular since the last 2 decades or so. This financing is available through the hire purchase mode as well as the clean lending mode. In the hire purchase mode the bank purchases the good and gives it to the customer for use and the customer pays back the bank in monthly or quarterly installments.

B. CLEAN LENDING 1. Short-term Facility i.

Personal Loan- Installment-based finance

Personal loans are normally granted for the purpose of consumer purchases such as: consumer durables (televisions, fridge-freezers, etc), education and medical expenses and for home improvements such as a new fitted kitchen, double glazing, the building of a conservatory, etc. Personal loans are not restricted to these purposes and may be granted for any purpose that is acceptable to the bank.

Interest is charged on personal loans at a flat rate which means that it is calculated on the total amount of the loan for the full term and applied to the amount of the loan at the commencement of the repayment term. This total amount is then divided by the number of monthly installments to determine the amount of the repayment installments.

Personal loans are not usually secured and the repayment period can vary from a few months to several years.

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to grant the facility. Once a customer’s application has been processed and shows an acceptable credit score, a pre-contract illustration is provided prior to the customer and banker signing the loan agreement. A formal letter setting out the terms and conditions of the loan is normally given to the customer containing details of the interest structure, total payable and the amount of the rebate should the loan be repaid early.

The loan is created by a transfer of funds into the customer’s operative account and a corresponding debit is made to a separate loan account. The agreed repayments are credited to the loan account until it is cleared off.

Some personal loans carry automatic life cover and there is also an option for the customer to purchase accident, sickness and unemployment insurance. These ensure protection for the customer and the bank.

ii. Running finance

A running finance account allows a customer to draw up to a set limit which is related to a monthly fixed payment into the account. A multiplier is related to this monthly payment; for example, if the customer pays in Rs. 10,000 per month, the limit of borrowing may be set at Rs. 300,000 (30 x Rs. 10,000).

The application form is similar to that for a personal loan and the response data is credit scored. A credit limit is agreed but the bank does not normally look for security. A separate account is maintained and it is usual to arrange for the monthly payment to be transferred from an operative account to the revolving credit account by standing order.

Interest is charged on a daily basis and normally applied monthly. Should the account move into credit, interest on the credit balance may be paid by the bank. Provided monthly payments are maintained and interest is paid, the customer can sustain the borrowing at or near the limit, subject to periodic review by the bank. Insurance may be offered to pay off the debt in the event of the death of the customer or to meet repayments if the borrower has a prolonged illness or is made redundant.

Revolving credit accounts are intended primarily for the professional type of customer with good income; being designed to allow the customer to change a car, purchase electrical goods, etc without the need to keep contacting the bank to enter into new personal loan agreements for each purchase. Cashline by UBL is an example of running finance facility under consumer finance.

iii. Credit cards

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becoming a widely used method of making payments and for obtaining credit facilities.

Credit cards are a method of money transmission where the customer has the option of settling only part of the monthly bill, thereby borrowing the amount of the unpaid balance. If the customer pays off the outstanding balance in full prior to the repayment date, no interest is charged and therefore this is a very cost-effective method of short term borrowing. By careful timing of their purchases and then repaying the bill in full, the customer may obtain approximately up to 50 days interest-free credit.

There are currently two dominant groups who operate international networks - Visa and MasterCard. All the main banks, offer their own versions of either or both of these cards. There are other companies such as Diners and Maestro but the market share and reach of these companies is by far the largest.

The essential features of a credit card are:

• the purchase of goods and services on credit subject to an agreed overall limit.

• the issue of regular statements by the credit card issuing bank/company. the option for the customer of either paying all of the sums due to the bank or electing to pay off only a portion of the sums due (minimum amount or 3 - 5%, whichever is the greater) and paying interest on the remainder.

A credit card account operates independently of a customer’s other accounts with the bank, and the relationship between the bank and the cardholder differs from the traditional banker/customer relationship. In some cases banks have issued credit cards which have been linked to their existing deposit accounts with the banks and banks offer direct debit facility for the payment. However, this is not general practice.

Each bank policy may differ, however as per popular practice locally it is not necessary for a person to maintain an account with the bank before they can be issued with a credit card. It is initiated by a separate agreement between the bank and its customer regulating the issue of the credit card and the debtor/creditor relationship that exists between the parties. In addition, due to the element of credit involved, the bank will have to be satisfied that the customer can be considered creditworthy for the amount of their limit. The customer completes an application form as the basis of the agreement between them and the bank. The application form also provides the bank with a great deal of information about the customer, such as employer, salary, house owner or tenant, marital status, number of children, etc.

Normally the creditworthiness of the applicant is screened by

the statistical method of credit scoring. The process determines the statistical probability that the credit will be repaid.

Use of the credit card

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terminal. In many countries the customers are also required to input their PIN number on a keypad. A credit card can also be used for postal, internet and telephone transactions; the card number being quoted over the phone together with the security code number quoted on the back of the card. This information is input on to a computer or noted on an order form sent in the post.

Cash can be withdrawn via ATMs using the credit card by the cardholder inputting their PIN. This withdrawal will be treated by the credit card company as a cash advance and so interest will accrue from the date of the transaction.

Joint credit cards are not offered, but the customer has the option of applying for supplementary cards to be issued on the account.

For example, a husband may choose to have a supplementary card for his wife and children. The liability of repayment of debt of the supplementary card will be on the husband’s account.

Every month, the cardholder receives a statement showing: their limit.

the transactions that have been made with the card(s). any payments that have been received, any interest that has been debited to the account, the current balance. the amount of available credit remaining, minimum payment required, payment due date.

On receipt of a statement, a cardholder has the option of:

a. repaying the whole balance by the due date shown on the statement, or

b. repaying the minimum amount required which is generally 3 - 5% of the total outstanding amount.

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Lending: Products, Operations and .Risk Management | Reference Book 1

Regulations and Practices

As discussed in chapterl, depending on the characteristics of different lending products, they have different permissible limits, risk mitigation and process requirements. To ensure transparency and coherence amongst the lending practices, the SBP has provided a comprehensive list of Prudential Regulations (PRs) to the banks and financial institutes catering to the financing requirements of various types of customers.

Prudential Regulations (PRs)

Prudential Regulations are a set of minimum lending principles designed by the SBP. The objective of these regulations is to bring consistency in lending practices among banks and to maintain quality of credit portfolios across banks.

To cater to the specialized and dynamic areas of lending the SBP has following separate sets of PRs geared towards:

• Corporate.

• Commercial/SME and

• Consumer business.

• Agriculture

Some salient features of these regulations are discussed below. You are encouraged to visit the SBP website and study the up-to-date regulations in detail.

Prudential Regulations-Corporate

Corporate PRs contain a total of 27 regulations revolving around corporate business and covering following aspects of credit quality:

• Risk management 13

• Corporate governance 4

• Anti Money Laundering 5

• Operations 5

Highlights of most important Risk Management related regulations (PRs) are:

• Maximum exposure (in outstanding terms) of a bank/DFI to a single borrower shall not exceed 30% of its equity (fund-based 20%) and to a group of borrowers 35% (fund-based 30%).

• Contingent liabilities of a bank/DFI shall not exceed 10% of its equity.

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Undng: Products, Operations and Risk Management | Reference Book 1 25

• Unsecured exposure is restricted to Rs.200,000.

• Total exposure (fund based and/or non funds based) availed by any borrower not to exceed 10 times of borrower’s equity (fund based exposure not to exceed 4 times of its equity).

• Banks/DFIs to ensure that total exposure (fund based and/or nonfund based) availed by any borrower from financial institutions does not exceed 10 times of borrower’s equity (fund based exposure not to exceed 4 times). However, where equity of a borrower is negative and the borrower has injected fresh equity during its current financial year, it will be eligible to obtain finance up to 3 times of fresh injected equity, provided the borrower shall plough back at least 80% of its net profit each year until such time it is able to borrow without this relaxation.

• For the purpose of borrowing- subordinated loans shall be counted as equity of the borrower.

• Banks/DFIs shall not:

a) Take exposure against the security of shares/TFCs issued by them.

b) Provide unsecured credit to finance subscription towards floatation of share capital and issue TFCs.

c) Take exposure against TFCs or shares not listed on stock exchanges.

d) Take exposure against ‘sponsor directors shares.

• Banks/DFIs shall not own shares of any company in excess of 5% of their own equity. Further, total investments of bank in shares should not exceed 20% of their own equity (for DFIs the limit is 35% of their equity).

• Regulation (PR-8) relating to classification and provisioning of assets is represented by an extra-ordinary lengthy reading. You are encouraged to familiarize yourself with provisions of this regulation along with regulation pertaining to governance (Gs) and operations (Os).

Prudential Regulations-SME

Keeping in view the important role of Small and Medium Enterprises (SMEs) in the economic development of Pakistan and to facilitate and encourage the flow of bank credit to this sector, a separate set of Prudential Regulations specifically for SME sector has been issued by State Bank of Pakistan. This separate set of regulations, is aimed at encouraging banks/DFIs to develop new financing techniques and innovative products which can meet the financial requirements of SME sector and provides a viable and growing lending outlet for banks/DFIs.

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borrower relationship envisages. The banks/DFIs are, thus, encouraged to work in close association with SMEs. The banks/DFLs should assist and guide the SMEs to develop appropriate systems and effectively manage their resources and risks.

State Bank of Pakistan encourages banks/DFIs to lend to SMEs on the basis of assets conversion cycle and future cash flows. A problem, which the banks/DFIs may encounter in this respect, is the lack of adequate information. In order to overcome this problem, banks/DFIs may also like to prepare general industry cash flows and then adjust those cash flows for the specific borrowers keeping in view their conditions and other factors involved.

As mentioned above, presently most of the SMEs in Pakistan lack sophistication to have reliable and sufficient data and financial information. In order to capture this data and information, banks/DFIs will need to assist and guide their SME customers. The banks/DFIs may come up with minimum information requirements and standardized formats for this purpose as per their own discretion. For better understanding and to facilitate their SME customers, banks/DFIs are encouraged to translate their loan application formats and brochures in Urdu and other regional languages.

In order to encourage close coordination of the officials of the banks/DFIs and SMEs, the banks/DFIs may require the concerned dealing officer to regularly visit the borrower. For this purpose, at a minimum, the dealing officer may be required to pay at least one quarterly visit and document the state of affairs of the SME. In addition, an officer senior to the ones conducting these regular visits may also visit the SME at least once in a year. The banks may, at their own discretion, correlate the frequency of visits with their total exposure to the SME borrower.

A total of eleven (11) regulations govern banks SME business. Some of the important ones are discussed as under:

• Banks/DFIs shall specifically identify the sources of repayment and assess the repayment capacity of the borrower on the basis of assets conversion cycle and expected future cash flows.

• All facilities; except those secured against liquid assets; extended to SMEs shall be backed by the personal guarantees of the owners of SME.

• Banks/DFIs can take clean exposure on an SME to the maximum extent of Rs.3 Million against personal guarantee of the owner (funded exposure restricted to Rs.2 Million). All facilities over and above Rs.3 Million shall be appropriately secured.

• Maximum exposure of a Bank/DFI shall not exceed Rs 75 Million. Total facilities availed by a single SME from financial institutions should not exceed Rs 150 million.

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Operations and Risk Management | Reference Book 1 27

Prudential Regulations - Consumer financing

Apart from the specific regulations for credit cards, auto loans, housing finance and personal loans, minimum general requirements laid down by SBP that govern the consumer business are as follows:

• Bank/DFIs to establish separate risk management capacity for consumer business.

• Bank/DFIs to prepare comprehensive credit policy duly approved by their BODs.

• For every type of consumer financing facility bank/DFIs to develop a specific program.

• Bank/DFIs to have an efficient computer-based MIS system which should efficiently cater the needs of consumer.

• Bank/DFIs to develop comprehensive recovery procedures for delinquent consumer loans.

For detailed study of these regulations you are encouraged to read and assimilate various requirements of different type of consumer financing.

To ensure that bank/DFIs strictly follow the prudential regulations and for their own regulatory purposes, SBP requires submission of /DFIs various reports periodically, by the Banks.

Credit Policy

A credit policy is defined as a set of clear written guidelines of a bank that address the following areas:

• Credit terms and conditions - risk assessment criteria. • Customer eligibility criteria - target market.

• Criteria for assigning risk ratings for obligors and facilities. • Treatment of obligors of different ratings.

• Process and hierarchy for approving or rejecting a credit proposal. • Procedure for policy deviations.

• Steps to be taken in case of customer delinquency.

Banks /DFIs must prepare a comprehensive credit policy keeping in view the PRs set by the State Bank. This credit policy must be approved by the BOD.

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Each Bank’s policy is to be based on their particular business strategy and cash-flow circumstances, industry standards, current economic conditions, and the risk culture of the bank. It is imperative for the banks to consider the link between credit and sales at the time of policy creation. Easy credit terms can be an excellent way to increase asset sales, but they can also result in immense losses if customers default. A typical credit policy will address the following points:

• Processes: Details of acquisition, verification and rejection processes are discussed in detail as an essential part of the credit policy manual.

• Credit limits: Suggests the amount of money a bank is willing to extend in credit form to a single customer and also defines the corresponding parameters and circumstances.

• Credit terms: Terms like payment due date, early-payment discounts and late-payment penalties etc.

• Deposits: If there are any requirements from customers to pay a portion of the amount due in advance.

• Customer Information: This section outlines the level of information required by the bank about a customer before making a credit decision. Parameters like years in business, length of time at present location, bio data, financial data, credit rating with other vendors and credit reporting agencies, information about the individual principals of the company etc are all part of this information.

• Customer Eligibility Criteria: This section describes factors on which the decision to extend a credit line to any customer depends. All the conditions that must be evaluated and analyzed are listed in this section. All the terms and conditions must be in line with those mentioned in SBP’s PRs. By having a practical and realistic risk based eligibility criteria banks are aiming to decrease the likelihood of bad loans.

• Documents Required: This section lists the documents mandatory to processing any form of loan. Includes credit applications, sales agreements, contracts, purchase orders, bills of lading, delivery receipts, invoices, correspondence etc.

Other areas like income calculation methodology, credit initiation, rejection conditions, credit deviation authorities and scenarios, fraud detection and prevention, collection and recovery strategy and many other sections are part of the credit policy. Each Bank/DFI develops policy manuals according to their own standards with more or less all of the sections discussed earlier.

Importance of Credit Policy:

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hwducts. Operations and Risk Management | Reference Book 1 29

policy is in place, all cross functional departments have a clear understanding of their role, resulting in quick and transparent credit decisions. By defining the target market, risk assessment criteria and by developing and listing down credit terms and conditions; a credit policy ensures mitigation of lending risks arising from customer’s debt servicing capacity, limit assignment and possible loopholes in collection and recovery processes.

Pricing

Pricing Mechanisms

Simplistically speaking a loan is when you give someone money for a certain period and charge them a certain amount (usually expressed as a percentage and is called markup or interest) for the use of that money. The borrower is expected to pay back the principal as well as the markup.

Pricing of the loan is the markup rate. This markup rate charged has two components:

1. Base component, which can be derived from: • Internal cost of funds or

• Market-based cost of funds.

2. Variable component.

1.Base component:

1.1.Internal cost of funds:

As a bank, the loan that you give out is against deposits. These deposits generally have a cost associated to it. The cost can be in terms of:

a) the rate of return promised to the depositor,

b) the administrative cost of generating, processing and servicing the deposit/depositor.

This method of calculating the cost of deposit is generally called the internal cost of funds.

1.2.Market-based cost of funds:

In addition to the funds obtained from its depositors, the bank can also borrow from other banks including the central bank and the money market. This borrowing involves a cost which is termed as the Market- based cost of funds. Market rate indicators such as KIBOR, T-bills, PIBs, REPO and Reverse REPO rates are generally used as benchmark indicators in the Pakistan market.

KIBOR stands for Karachi Inter Bank Open-market Rate. It’s the rate of interest at which banks in Karachi offer to lend money to one another in the money markets. KIBOR is issued on daily, weekly, monthly and on 1,2 and 3 yearly basis by the State Bank of Pakistan.

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Pakistan Investment Bonds (PIBS) are long term bonds issued by the Government of Pakistan and sold through the State Bank of Pakistan via periodic auctions. PIBs are issued with tenors of 3, 5, 7,10,15, 20 and 30 Years. Being backed by the Government of Pakistan, they present a low risk long term investment option. The Pakistan Investment Bonds offer a fixed semiannual coupon and repayment of principal at maturity. They are highly liquid SLR (Statutory Liquidity Requirement) eligible securities that are actively traded in the secondary market. The minimum denomination of PIBs is Rs.100, 000.

REPO and Reverse REPO The discount rate at which a central bank repurchases government securities from the commercial banks, depending on the level of money supply it decides to maintain in the country's monetary system. To temporarily expand the money supply, the central bank decreases repo rates. To contract the money supply it increases the repo rates. Alternatively, the central bank decides on a desired level of money supply and lets the market determine the appropriate repo rate. Repo is short for repossession.

A reverse repo is simply the same repurchase agreement from the buyer's viewpoint, not the seller's. Hence, the seller executing the transaction would describe it as a "repo", while the buyer in the same transaction would describe it a "reverse repo". So "repo" and "reverse repo" are exactly the same kind of transaction, just described from opposite viewpoints. The term "reverse repo and sale" is commonly used to describe the creation of a short position in a debt instrument where the buyer in the repo transaction immediately sells the security provided by the seller on the open market. On the settlement date of the repo, the buyer acquires the relevant security on the open market and delivers it to the seller. In such a short transaction the seller is wagering that the relevant security will decline in value between the date of the repo and the settlement date.

2.Variable component:

The variable component of the markup rate is the spread that banks keep on top of their base component or cost of funds when lending to customers. The size of the spread generally depends on three factors:

1. Type of the customer i.e. whether the customer is a corporate / wholesale customer or a consumer / retail customer.

2. Customer’s credit risk rating which is assigned based on the customer’s profile.

3. The bank’s balance sheet mix and its need for deposit or loans at a given point in time.