CREDIT MANAGEMENTOVERVIEW AND PRINCIPLES OF LENDING
• What is Credit – Credit is defined as confidence in borrower’s ability & intentions to repay r epay the loan extended to him by the creditor. Credit has become an integral part of modern industrialization economies. It has been considered as oil of the commerce. It contributes to the industrial growth and economic development. • What is Credit Management – Credit Management usually deals with the credit vetting of the customers, allocation of available funds to different sectors/segments of the economy, diversifying the applicable risk in extending credit, internal funds movements & reconciliation, as also maintaining relations with
• What are goals of Credit Management in Banks - Optimize the mix of Bank’s assets - Minimize ba bad de debt lo loss - Anal Analyz yze e cust custom omer er cred credit it risk risk - Main Mainta tain in fina financ ncia iall fle flexi xibi bilility ty - Be respo respons nsiv ive e to to ind indiv ivid idua uall cus custo tome mer r - Respec Respectt overal overalll corpor corporate ate financ financial ial constr constrain aints ts - Cred Credit it Mana Manage gers rs must must beco become me stra strate tegi gic c partners in business operations - Cred Credit it Man Manag ager ers s shou should ld lea learn rn how how to mana manage ge people of different culture - A Cred Credit it sys syste tem m is a fou found ndat atio ion n ston stone e of mod moder ern n economy
• Credit Management has two facets : -Credit Appraisal & Credit Monitoring. Credit Appraisal deals with the evaluation evaluation of credit needs of the borrower, his worthiness, his ability, his risk, policy regarding extension of credit to the borrowers, terms and conditions of the credit, sanctioning process of the Bank and involves a decision whether to extend the credit or not to the customer- pre sanction stage. Once a decision to extend the credit is taken, the borrower is asked to complete all the formalities of the terms and conditions, signing of the documents etc.(Pre disbursal stage). After which the credit is disbursed to the borrower.
• Credit Monitoring – This is a post disbursal period and is very important for the banker since the health of the unit is determined during this phase. Banks are required to keep constant watch on the unit vis-à-vis the loan account after disbursal of the loan, to ensure that the amount disbursed to the unit is safe, is being utilised for the purpose extended (ensuring end use of funds), generates income and does not turn out to be sick. There are three types types of follow up up that constitutes credit monitoring – monitoring – (a) Financial follow up (b) Physical follow up (c) Legal follow up
• Warning Signals – The loan account by itself would indicate explicitly the quality of the loan. There are bound to be warning signals before an account goes bad viz., (i) Reductions in credits (deposit entries) in the loan account if it is a working capital account (ii) issuing cheques to the creditors by the borrower in excess of the limit/Drawing Power (DP) available in the account, thereby frequent returning of these cheques (iii) Delays and defaults in repaying the interest/ instalments (iv) Non-submission/Delay in submission of the stock statements and/or financial data to the Bank. There is a need to identify these signals emanating from a loan
account. If the Bank does not take prompt follow up action, it could result in further defaults, thereby leading to a further degeneration in the quality of the loan and create problem loans. -Documentation – The Banker grants financial facility to its customer under a valid contract, the terms and conditions of the financial assistance are enumerated. Further, the terms of repayment as well as the consequences in the event of breach of conditions are enumerated. As a part of initial exercise, during the post sanction phase, the bank obtains certain documents from the borrower/competent authority of the borrowing Company duly signed so as to bind the borrower legally and enforce
charge. The importance of the documents lies in the fact that with proper documentation in force, there will not be any problem in enforcing a claim by the bank in case of a default by the borrower. LEGAL REMEDY In case of persistent default by the customer, where all other measures taken by the banker including reviving of the unit are not successful, the recourse open to the bank is (i) Enforce the repayment or enforce the security available through the Court of Law. A common complaint of the banks and financial institutions had been that they were facing enormous bottlenecks in the recovery of loans through the Civil Courts. In view of this the Government took initiative and established Debt Recovery Tribunals (DRTs). However, even after establishment of DRTs, enforcing security is still a time consuming process.
(ii) To enter into a compromise proposal with the defaulting borrower. (iii) On recommendations of Narsimahan Committee for the purpose of examining Banking Sector reforms, the GOI promulgated Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Ordinance 2002 (SARFAESI) which was later on replaced by an Act . The provisions of this act will enable Banks and Financial Institutions to exercise power in taking over the possession of the securities, sell them and reduce their non-performing assets.
• Excel Bank Ltd. has sanctioned following credit limits to Andheri Enterprises Ltd.: • Cash- Credit • • • • •
Rs. 20 cr Bills Discounting Rs.5 cr Term Loan Rs. 10 cr L/C Rs. 5 cr The stock statement submitted by M/s.Andheri Enterprises as on 30/06/2010 is as follows : Raw Material : 8 cr WIP Rs.3 cr FG: Rs. 8 cr Receivables: Rs.8 cr (including receivables of Rs. 2 cr which are more than 6 months & excluding those included under Bills Discounting Limit). The present outstanding as on 15/10/2010 in CashCredit account are Rs.22 cr (including overdrawing) and the account has remained continuously irregular since 14/09/2010
• . First Term Loan installment of Rs. 2cr and quarterly interest amounting to Rs.0.60 cr has also remained unpaid till date. Further, Bills discounted limit is fully utilised, however, bills amounting to Rs.1.60 cr due for retirement till date also remained unpaid. • The margins applicable to RM, WIP, FG, Receivables are 30%, 40%, 30%& 40%. • 8 Cheques amounting to Rs.3.40 crs have been recently returned for want of required DP in the account.
Question: Calculate the amount of irregularity in the account as on date. What action should the bank take under the circumstances.
Risk Management : Banks Traditional role is to mobilize the funds from the household sector/surplus from the Corporates and deploy it with the household and Corporate Sector for consumption/productive purpose. Its role is that of intermidiary. As such Banks are exposed to various risks. The price at which the Banks mobilize and transfer funds depend on two parameters – the time for which the funds are made available and credit worthiness of the person to whom the funds are made available. Considering long term loans are priced higher than short term loans and a high risk borrower pays a higher price (interest),
credit risk to earn spreads. There is also a definite linkage between the various risks faced by the banks. For example, if the bank charges a client floating rate of interest, in case of increasing rate scenario, the bank’s interest rate risk will be lower. Consequently, the payment obligations of the borrower increases. Other things remaining constant, the default risk increases if the client is not able to bear the burden of the rising rates. There are many instances where the interest rate eventually leads to credit risk. A top priority of the banks is to improve their asset quality by minimizing and managing their credit risk. A robust credit risk management framework with a proper risk management model coupled with the sound/speedy legal framework improves the quality of the assets.
Another technique being employed by the Banks to reduce interest and liquidity risk is AssetLiability Management (ALM). ALM has both macro and micro level implications. At macro level it leads to the formulation of critical business policies, efficient allocation of capital and designing of products with appropriate pricing strategies. At micro level, the objective is two fold – it aims profitability through price-matching and ensuring liquidity by maturity matching. Price matching maintains spreads by ensuring deployments of liabilities is at a rate higher than the cost. Similarly, grouping the assets/liabilities based on their maturity profile ensures liquidity. The gap is
then assessed to identify the future financing requirements.
Credit Information: Banks and lending institutions have a traditional resistance, to share credit information because of confidential nature of banker-customer relationship. To serve this purpose and to make credit and other data available specialised institutions known as Credit information bureaus have been set up. They serve as repository of current & historical data of the existing and potential customers.
CREDIT INFORMATION BUREAU OF INDIA LTD.(CIBIL) CIBIL was promoted by SBI, HDFC, Dun & Bradstreet Information services (P) Ltd. to provide credit information of clients to its members. Presently, its shareholding pattern has been diversified to include number of banks and finance companies. CIBIL collects commercial and consumer creditdata and collates such data to create and distributes credit reports to its members. CIBIL primarily gets information from its members and at subsequent stage will supplement it with public domain information in order to create a
truly comprehensive snapshot of an entity’s financial track record. A Credit information report is a factual record of borrower’s credit payment history. Its purpose is to help credit grantors make informed lending decisions-quickly and objectively. CIBIL caters to both consumer and commercial sectors. Consumer Credit Bureau covers credit availed by individuals while the Commercial Credit Bureau covers credit availed by non-individuals e.g. partnership firms, proprietary concerns, Private and Public Ltd. companies etc.
• TYPE OF INFORMATION AVAILABLE ON BORROWER: - Basic information like – Name, Address, ID No., Passport ID, Voters ID, Date of birth, Registration No., Date of incorporation, Legal Constitutions, Board of Directors etc. - Record of all the credit facilities availed by the borrower - Past Payment history - Amount overdue (if any) - Suit filed status - No. of enquiries made on that borrower by member
• INFORMATION NOT INCLUDED IN CIR - Income/Revenue details - Details of deposits with the banks - Details of the borrower’s assets - Value of assets mortgaged - Details of investments CIBIL itself does not classify any accounts as defaults account. It merely reflects the information of Asset Classification as per members record. LENDING DECISION: CIBIL CIR only provides available credit information and does not provide any opinion, indication or comment pertaining whether credit should or should not be granted.
The Credit grantors who have received an application for credit will make the credit decision. CIBIL does not own any responsibility merely on the basis of Credit information provided to the creditor. RIGHT TO INFORMATION ACT 2005 IS NOT APPLICABLE TO CIBIL – CIBIL is not a public authority. CREDIT FACILITIES EXTENDED BY THE BANKS: RETAIL : Risk Assessment on Scoring Model Personal Loans: Amount sanctioned: Multiple of Monthly Income/Annual Income, Repayment 5-7 years, Documentation- Loan Application, Loan Agreement, Demand Promissory Note (DP Note) Check-off facility (if available), PDCs for EMIs or
mandate to debit the account through ECS for monthly repayments. Consumer loans: To buy consumer goods, Margin Nil to 25%, Repayment 5-7 years, documents as in personal loan additionaly Hypothecation agreement Vehicle Loans: Cars/Scooters – Margin 5% to 25%, Period 5-7 years, Documents as above, Charge to be registered with RTO, Comprehensive Insurance to include Bank clause Home Loans: Home Loans against mortgage of property, Equitable Mortgage is preferred, Credit extended may be 60% to 85% of the cost of house/cost of construction, Period may range
from 10 to 30 years depending upon income and age of the borrower. Title Documents relating to property are called for verification of ownership. Photocopies of these documents are sent to Bank’s Legal Advisor to seek his opinion regarding ownership of the customer and also to know if the valid equitable mortgage can be created against the property. Sometimes, if necessary technical report from approved valuer to know the market value of the property is also called for. Documentation: Home Loan application, Loan agreement, personal guarantee agreements from the acceptable guarantors, Personal guarantee of the spouse/
legal heir, Deposit of titles of the property for equitable mortgage, independent letter to be sent by the customer to the bank detailing the details of the property and his independent acceptability to equitable mortgage the property, Recital to be prepared by the Banker, PDCs or ECS mandate for EMIs. Construction of house : Inspection, progressive payments on the basis of architects certificate, if title deed is not available, obtain any other acceptable security for the intervening period. Education Loan: Admission must be granted by a Recognised Institution, good academic track record of the student, Family financial position, scoring model
MARGIN : • Upto Rs 4 lacsNilAbove Rs. 4 lacs : Studies in India5%Studies Abroad15%- Scholarship/ assistantship to be included in margin. - Margin may be brought-in on year-to-year basis as and when disbursements are made on a pro-rata basis. • SECURITY : • Upto Rs 4 lacsCo-obligation of parents. No securityAbove Rs.4 lacs and upto Rs7.5 lakhsCoobligation of parents together with collateral security in the form of suitable third party guarantee. The bank may, at its discretion, in exceptional cases, waive third party guarantee if satisfied with the net-worth / means of parent/s who would be executing the document as “joint borrower”.Above Rs.7.5 lakhsCo-obligation of parents together with tangible collateral security of suitable value, along with the assignment of future income of the student for payment of instalments Loan application, Loan agreement to be signed by the student and parents, personal guarantee agreements (if applicable) •
Loan repayment to start as soon as the student gets employment or within 6 months of the completition of the course. LOAN AGAINST SHARES OF THE LISTED COMPANIES: Sanctioned both as demand loan or Limit/DP in Current Account. Facility should be extended only in case of listed companies. Amount sanctioned should not be more than 50% of the average market price of the share. Documents: Application form, DP Note, Transfer deed duly signed by the shareholder. If EMIPDCS/ECS, Bullet Payment. LOAN AGAINST BANKS OWN FDRS/NSCs etc. Sanctioned both as demand loan or Limit/DP in Current Account. Margin – 25% Lien of Bank is
noted (in case of NSCs/ KVPs with the issuing Post Office) Documents: FDR/NSCS/KVPs duly discharged by the customer, Application for loan, DP Note.
It is a contract between the Home owner and the financier/bank, which enables the Home owner to receive a stream of income (monthly/quarterly), from the future realizable value of home. It enables senior citizens/Old age (60 years & above) to get independent income and live honourably Normally banks will provide the stream of income to couple, till the last of two live but may put maximum tenure to 15 years The recovery of loan amount is effected through sale of house after the death of last of couple Even if maximum tenure of income stream is fixed for 15 years, couple can continue to live in the house till last of two is alive
heirs after death of couple can also pay the loan amount along with interest and can acquire the house
case if sale of house takes place, any surplus amount after clearing loan balance is passed on to the legal heirs
case if the sale amount falls short of the loan amount, loss is borne by the bank
of the property is got done and equity value on which annuity is paid to the couple may range from 60% to 90% of the property valuation
valuation is revisited periodically and if couple requires annuity value can be increased
of annuity paid to the couple is based on factors like current valuation, projected appreciation, age of applicant, current interest rates
the age, valuation, more is amount available
to the Bank: Bank will be able to get expected return on the principal invested No risk of account becoming NPA Provisioning and capital adequacy norms still not defined by RBI More profitable to offer mortgage to older people because of less life expectancy
• Risk factors for Bank: Life expectancy/mortality risk: May have to pay annuity for longer period, if borrower or spouse live longer. Risk is mitigated by fixing tenure to 15 years Interest rate risk: When interest rates move up: Can be mitigated by entering into floating rate contract Real Estate market risk: Depreciation in valuation: Real Estate values seldom depreciate in long run • Benefits to Borrower: Supplement retirement income Remain economical independent With real estate values increasing, better equity left over for heirs
upper age prescribed. In fact more the age, more easy to get loan
is a non recourse loan. Bank can recover the amount only when last of couple dies
• Disadvantage: Non
convential retirement tool
disturb emotional attachment
is complex; based on future value, life expectancy, interest rate risk
and servicing cost is high – upfront cost, servicing cost (Insurance etc), closure cost (Margins due to life expectancy& others) – Recommendations – go only for 15 years or fixed annuity period
borrower have two or more spouses, reverse mortgage agreement will include only one and bank will be entitled to sell property accordingly
COMMERCIAL CREDIT FACILITIES: Credit Facilities are extended to proprietary firms, partnership firms, SMES/SSIs, Private Ltd. and Public Limited Companies based on their CRA. The credit facility extended may be either Funded Facility or Non Funded Facility. FUNDED FACILITIES: (a) Working Capital: Cash-Credit Limit (CC Limit)
Temporary Overdraft Limit, Bill Discounting, CP Linked Working Capial loan Loan for Purchase of Fixed Assets : Term Loan, Corporate Loan NON FUNDED FACILITIES: Letter of Credits (L/Cs) and Bank Guarantees EXPORT FINANCE: PRESHIPMENT FINANCE: EXPORT Packing Credit (EPC) denominated in Rupees, Packing Credit in Foreign Currency (PCFC) denominated in Euro, Dollar, Pound, Yen Post Shipment Finance: Foreign Bill discounting Limit with or without L/C
IMPORT CREDIT: Letter of Credit (L/c) for import of machinery/material etc. PRINCIPLES OF LENDING: Credit Management is concerned with the sound principles of lending which are mainly concerned with the activity of the borrower and the profile of the borrower as individual. ACTIVITY: (a) Ensuring safety: Bank being a custodian of funds of the depositors must ensure safety of the funds deployed and lend the funds only to reliable borrowers, who after generating surplus
from their business can repay back the loan amount along with the interest. Banks traditionally create charge on collateral marketable securities of the borrower, in addition to the primary security. This enables them to dispose off the marketable securities in case of default by the borrower and recover the amount of defaulted loan. But with changing time and the banks having assumed the role of fore-runners in the socio-economic development with the extension of credit to the non-traditional and neglected sector, sufficient collaterals may not be available to the banks. Thus the viability of the business and its capacity to generate surplus
becomes best security for the Banks. To ensure safety of the funds this aspect has assumed more importance than the collaterals. (b) Ensuring Liquidity: The Banker mobilises funds from the depositors and lends the same to the borrowers on specified repayment terms. The borrower should be able to generate surplus funds to repay back to the banker, otherwise liquidity of the banker gets affected and in turn he may not be able to repay back the depositors funds on terms and conditions deposit is mobilised. A bank’s inability to meet the demand for withdrawals of the depositors can lead to a run on the bank, which can pose a
threat to its basic survival. Thus the exercise of ensuring liquidity with the borrower also amounts to ensuing liquidity with the bank. Liquidity would also refer to the quality of assets which should be easily convertible into cash without any loss of value. Thus the concept of liquidity entails the banker to look for easy saleability and absence of risk of loss on sale of assets, which has been taken on collateral. (c) Generate Profits: Banks provide various credit facilities & other services to the customers and it is also prudent on the part of the banker to extend certain concessions to the customer on some of the services, in view of competition
amongst the banks. Thus the banks consider overall profitability of the business extended to the bank by the customer rather than profitability against each component of the business or service offered. Such an analysis of the business from the customer is known as customer profitability analysis or more often in the language of the bankers “Value of the account”. Thus there is a direct relationship between profit and pricing of services offered by the banker. Example: In case if a customer is availing of substantial credit limits in working capital/Term Loan and the amount of interest earned in the previous years is substantial,
concession may be given to the customer in rate of remittances / non-funded business or viceversa. (d) Purpose: Banks should lend the funds only for productive purposes and should also ensure End use of funds. Banks should not lend funds for unproductive purposes, speculative purposes, hoarding stocks or for anti-social activities, since apart from morality such activities have inherent risks involved with regard to repayment of loan. (e) Adequate security: Banks traditionally extend credit facility against collateral security.However,
bank before extending credit facility must ensure that collateral is sufficient to cover the loan amount, is easily marketable and is free of charges. (f) Risk Management through diversification: The principle of never keep all the eggs in the same basket applies to lending also. Banks should lend to a large number of industries and borrowers, so that risk gets diversified.
EVALUATION OF THE BORROWER-THE 6Cs INDIVIDUAL PROFILE ASSESSMENT (A) CHARACTER: Appraise personal characteristic of the borrower honesty, attitude,
willingness and commitment to repay debts. Banker needs to be careful and will have to use all his diligence and resources to find out the true character of the borrower. Banker should be familiar with the reputation of the borrower. Character also includes responsibility, integrity and consistency, which shall form the basis, on which borrower’s willingness to repay loans can be determined. (B) Capacity: An assessment of whether the borrower has the potential to repay the loan from his resources. Worth of the borrower and his competence-running business, managing cash flows, physical assets, plants, equipments, labor
and management skills. Banks generally insist upon their prospective borrowers to submit their financial statements in order to determine their credit worthiness. (C) Collateral: The prime principle of the banker in credit management is safety of funds. This can be achieved by obtaining proper security i.e., collateral should have adequate value, marketability so that in case it is required to be enforced the same can be sold with least effort, cost & sufficient to cover the defaulted amount. The bankers at the time of appraisal may require the valuation of collateral offered be valued by
an approved valuer. (D) Capital: The banker has to assess the financial strength of the borrower or his Tangible Net Worth (TNW). It represents the amount of equity capital that a firm can liquidate for payment of debt in the eventuality of all other means failing. The amount of borrower’s capital in relation to debt is relatively easy to compute. However, the valuation of underlying assets in which capital is invested is a complex and vital exercise. There could be substantial difference between the book value and the market value of the capital. (Monthly Stock verification, Stock Audits)
(E) Conditions: Banker needs to evaluate conditions in which the borrower is operating his business. STEP Analysis-Social, Technological, economic & Political conditions. These conditions affect the growth prospects of the firm and in eventuality affect the repaying capacity of the borrower. Incidentally, external conditions such as recession, interest rate shocks and asset price deflation can adversely affect the borrowers and contribute to their defaulting the loan. (F) Compliance: The banker needs to assess that loans granted are in conformity with the guidelines as specified from time to time by the
Government, other regulatory authorities and as per the Loan Policy of the Bank. In the absence of compliance , it will be difficult for the Banker to recover the loan in case of default.
• SARAFESI ACT, 2002 • The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARAFESI) empowers banks /FIs to recover their non-performing assets, without the intervention of Court. The act provided three alternative methods of recovery of nonperforming assets: • Securitisation • Asset Reconstruction • Enforcement of Security without the intervention of Court • The provisions of this act are applicable to NPA loans with outstandings above Rs. 1 lac. NPA loan accounts where the amount is less than 20% of the principal and interes are not eligible
• To be dealt with under this Act. • Non performing assets should be backed by securities charged to the Bank by way of hypothecation or mortgage or assignment. Security interest by way of pledge, lien, hire purchase, lease are not liable for attachment under this act. • The act empowers the banks • To issue demand notice to the defaulting borrower and guarantor, calling upon them to discharge their dues in full within 60 days from the date of notice. • To give notice to any person who has acquired any of the secured assets from the borrower to surrender the same to the Bank.
• To ask any debtor of the borrower to pay any sum due or becoming due to the borrower. • CAUTION: ANY SECURITY INTEREST CREATED OVER AGRICULTURAL LAND CAN NOT BE PROCEEDED WITH. • If on receipt of demand notice, the borrower makes any representation or raises any objection, Authorised officer shall consider such representation or objection carefully and if he comes to the conclusion that such representation or objection is not acceptable or tenable, he shall communicate the reasons for non-acceptance within one week of receipt of such representation or objection. • A borrower/guarantor aggrieved by the action of the Bank can file an appeal with DRT and then
• With DRAT, but not with any Civil court. The borrower/guarantor is required to deposit 50% of the dues before filing the appeal. • If the borrower fails to comply with the notice, the Bank may take recourse to one or more of these measures: • Take possession of the security • Sale or lease the right over the security • Manage the same or appoint any person to manage the same.
• LETTER OF CREDIT: It is a financial instrument issued by the bank on application of its customer (importer/purchaser) in favour of exporter/seller, guaranteeing reimbursement of drafts (Bills of exchange) drawn by the exporter/seller for the supplies upto certain amount and within a specified period as per terms enumerated in the L/c. • Parties involved:
- Confirming Bank
• Applicant-Importer/Purchaser -Negotiating Bank • Opening Bank/Issuing Bank • Advising Bank • Beneficiary
- Reimbursing Bank
• Types of L/cs: • Revocable L/c, Irrevocable L/c, • Deferred Payment L/c: Allows Bank to make payment in predetermined instalments • Confirmed L/c ; Unconfirmed L/c • Revolving L/c • Transferable L/c • Back to back L/c • Anticipatory L/c – Red clause letter L/c, Green Letter clause L/c
• Guarantees: Sec.126 of the Contract Act. A contract of guarantee is a contract to perform the promise or discharge the liability of the third person in case of his default. The person who gives the guarantee is called surety; the person on whose behalf /default the guarantee is given is called principal debtor and the person to whom the guarantee is given is called creditor/beneficiary. The liability of a guarantor/ surety comes into existence upon the failure of a debtor. If the surety extinguishes the liability of a debtor, then the surety will acquire all the rights of the creditor, known as right of subrogation.
• Types of Guarantees: • Financial Guarantees: Bid/Tender Guarantee, Deferred Payment Guarantee • Performance Guarantees: APG, PG,RMG • A DPG is a Financial Guarantee and can be said to be a substitute of Term Loan. Difference between the two is that in case of Term Loan, the lender bank lays down funds to the extent loan extended for the purchase of FA. In case of DPG the bank does not lays down the funds for acquiring FA by the borrower but has to make sure that the borrower has sufficient cash flows at the time of retirement of bills drawn by the
Seller and got discounted by his bank on the strength of the purchaser/importers bank. It is therefore necessary that the various aspects of appraisal of the project viz. economics of the project, its technical feasibility and economic viability etc. are assessed in detail, as done in case of Term Loan.