Types of Credit Instruments & Its Features
This document gives idea about the various credit instruments used by the individuals and firms. Each credit instrument is described in brief.
Content
TYPES OF CREDIT INSTRUMENTS AND ITS FEATURES
By students of Department of Management Sciences, University of Pune (PUMBA)
Credit or loan is the act of giving money, property or other material goods to another party in exchange for future repayment of the principal amount along with interest or other finance charges. A loan may be for a specific, one-time amount or can be available as openended credit up to a specified ceiling amount. “Credit instruments are items that are utilized in the place of currency.” Just about all individuals and businesses make use of some type of credit instrument on a daily basis. The ability to use a credit instrument instead of currency rests in the fact that debtor and the recipient agree upon the use of the instrument and there is a reasonable expectation that the alternate form of payment will be honored. The contractual amount of credit instruments represents the maximum undiscounted potential credit risk if the counterparty does not perform according to the terms of the contract, before possible recoveries under recourse and collateral provisions. A large majority of these commitments expire without being drawn upon. The credit instruments are issued by the lenders only to those parties that are creditworthy. Credit risk for other credit instruments using the same credit risk process that is applied to loans and other credit assets. The terms of a standardized loan are formally presented (usually in writing) to each party in the transaction before any money or property changes hands. If a lender requires any collateral, this will be stipulated in the loan documents as well. Most loans also have legal stipulations regarding the maximum amount of interest that can be charged, as well as other covenants such as the length of time before repayment is required. Some credit instruments like credit derivatives are used for the riskmitigation purposes. These instruments help the lending firm to manage the credit risk associated with borrower. Principles of Lending Lenders usually follow some principles before granting loan to the borrower. They appraise the borrower on certain criteria which are described as follows.
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Safety of the funds- This is most important criterion while granting a loan. The funds should go in the safe hands. Identification of borrowers (KYC) - Institutional lenders have to follow KYC norms, which help them in identifying the borrowers. Purpose- The purpose for which the loan is granted is important because on this criterion interest rate applicable to the borrower and availability of certain facilities is decided.
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Liquidity- The borrower should always have liquid money with him so that the chance of the borrower becoming NPA is less. Security- The security offered for the loan plays important role, because in future if the borrower could not repay, the security charged with the creditor can be sold to recover the dues. Profitability- Profitability of business to which the loan is granted is important because non-profitable businesses generally turn into a NPA for the bank. Risk Management- Managing the risk created due to granting of loan is important. Because if the bank fails to manage various types of risks associated with credit given, the recovery becomes impossible. National Interest- Certain credit is given for the national interest and in these cases profitability of the bank is not the primary issue. Priority sector lending is the best example of the credit given in the national interest.
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Types of Lending Lending by the banks or the financial institutions can be divided into 3 major types.
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Fund-based lending This is the most direct form of lending. It is granted as a loan or advance with an actual outflow of cash to the borrower. It is supported by prime or collateral securities.
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Non –fund based lending There is no funds outlay for the Bank. It may crystallise into fundbased advances, on account of the failure to fulfil the contract. Letters of credit and bank guarantees, fall under this category.
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Asset-based lending This is an emerging category of bank lending. The bank looks primarily to the earning capacity of the asset being financed. Mostly, the banks do not have any recourse to the borrower. Specialised lending practices such as securitisation, or project finance fall under this category.
Common types of credit instruments The vast majority of credit instruments involve a mixture of standard types. We can broadly classify the credit instruments used by the lender as follows-
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Credit instruments which are used for meeting working capital requirements Credit instruments used for meeting capital expenditure Negotiable instruments like bill of exchange Non-funded credit instruments like L/C and B.G. Credit derivatives for risk mitigation Other instruments
Working Capital
The credit for fulfilling working capital requirements is usually given by using following modes of credit like cash credit, WCDL, overdraft like bills of exchange and commercial paper. Bill of exchanges are discussed under negotiable instruments. The security offered for working capital finance is current assets like inventory, book debts and receivables. CASH CREDIT It is the most popular method to finance working capital requirements of a company in India. Under the cash credit facility, a borrower is allowed to withdraw funds from the bank up to the sanctioned credit limit. He is not required to borrow entire sanctioned credit once, rather, he can withdraw periodically to the extent of his requirements and repay by depositing surplus funds in his cash credit account. There is no commitment charge; therefore, interest is payable on the amount actually utilised by the borrower. Cash credit limits are sanctioned against the security of current assets such as inventory, receivables and debtors. Though funds borrowed are repayable on demand, banks usually do not recall such advances unless they are compelled by the adverse circumstances. Cash credit is the most flexible arrangement from the borrower’s point of view. WORKING CAPITAL DEMAND LOAN
A borrower may sometimes require ad hoc or temporary accommodation in excess of the sanctioned credit limit to meet unforeseen contingencies. Banks provide such accommodation through a demand loan account or a separate non-operable cash credit account. Such a loan is termed as working capital demand loan. The borrower is required to pay a higher rate of interest above the normal rate on such additional credit. OVERDRAFT It is similar to cash credit arrangement. Under the overdraft facility, the borrower is allowed to withdraw funds in excess of the balance in his current account up to a certain specified limit during a stipulated period. Though overdrawn amount is repayable on demand, they generally continue for a long period by annual renewals of the limit. It is very flexible arrangement from the borrower’s point of view sine he can withdraw and repay funds when ever he desires within the overall stipulations. Interest is charged on daily balances, on the amount actually withdrawn, subject to some minimum charges. The borrower operates this facility through cheques. COMMERCIAL PAPER Commercial paper (CP) is an important money market instrument to raise short term funds. CP is a form of unsecured promissory note issued by the firms to raise short term funds. Only financially sound and highest rated companies are able to issue commercial papers. The buyers of commercial paper includes banks, insurance companies, mutual funds, trusts and firms with short surplus funds to invest for a short period with minimum risk. Given this investment objective demand for CPs of highly creditworthy companies will always be there. In India, RBI regulates issue of CPs. Only those companies which have a net worth of minimum Rs. 10 crores, MPBF of not less than Rs. 25 crores and which are listed on stock exchange are allowed to issue CPs. The size of the issue should be at least Rs. 25 lacs and size of the each CP should not be less than Rs. 5 lacs. A company can issue CPs amounting up to 75% of the MPBF. The maturity of CPs in India usually runs between 91 to 180 days. Interest rate on commercial paper is generally less than bank borrowing rate. A firm does not pay interest on a CP but it sells it at a discounted value. The yield calculated o this basis is referred to as interest yield which can be calculated as,
Interest yield = (face value) – (sale price) * _____360_____ Sale price days of maturity Interest on CP is tax deductible. In India, cost of a CP usually includes discount, rating charges, stamp duty and issuing & paying agent (IPA) charges. REVOLVER A revolver (RV), or credit line or revolving line, is a credit agreement in which the borrower has the right to choose when to obtain funds and when to repay funds and how much to borrow, within limits set by the contract. These limits typically stipulate a maximum borrowing amount (commitment), the date by which all borrowed funds must be repaid, and the covenants that the borrower must satisfy to qualify for receiving funds. In some cases, the agreement requires that the borrower periodically “clean up” (pay down to a specified level) the facility before re-borrowing. The revolving line involves all of the complications of the term loan plus the added feature of granting the borrower the right to choose when to borrow and in what amounts. By providing funds virtually on demand, the revolver allows a business to meet its working capital needs and to manage the liquidity risk created by volatile cash flows. Different types of revolving lines account for the major share of bank lending to businesses. By pooling revolvers across many businesses, a bank eliminates through diversification most of the liquidity risk that it inherits from customers.
Credit instruments used to meet capital expenditure
TERM LOAN A loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate is called as term loan. A term loan (TL) is a credit contract in which the borrower receives funds from the creditor(s) at contract closing or usually over a short period following closing and, in return, agrees to make payments of interest, fees and principal based on formulas and schedules specified in the agreement. Often term loan is given to purchase fixed assets such as plant & machinery, consumer products and house. Term loans almost always mature between 1-10 years. But term loans like home loans may be of maturity up to 20 years.
This kind of loan is preferred by many bankers because usually an asset is created through this type of credit. Such asset provides security to the banker. Term loans are always secured in nature. The assets created from the term loan, are charged to the bank and are a primary security. In case of loans where no asset is created like in case of personal loan; collateral is required. Borrowers also prefer term loans for capital expenditure as they are less costly than other sources of finance like equity and interest on the term loans is tax deductible. Term loans can be quite complicated, involving amortization of principal, differing levels of seniority, posting of collateral, detailed covenant restrictions, prepayment penalties and interest and fees that may vary with the borrower’s risk rating or financial performance. LOAN SYNDICATION/ CONSORTIUM ADVANCE/ MULTIPLE BANKING ARRANGEMENT Loan syndication is the process of involving several different lenders in providing various portions of a loan. It is mainly used in extremely large loan situations; syndication allows any one lender to provide a large loan while maintaining a more prudent and manageable credit exposure because the lender isn't the only creditor. A syndicated loan (or consortium advance or multiple banking arrangements) is a large loan in which a group of banks provide funds for a borrower, usually several but without joint liability. There is usually a lead bank or group of banks (the "Arranger/s" or "Agent/s") that takes a percentage of the loan and syndicates or sells the rest to other banks. In contrast, a bilateral loan, only involves one borrower and one lender (often a bank or financial institution.) A syndicated loan is a much larger and more complicated version of a participation loan. There are typically more than two banks involved in syndication. Syndicated loans can be underwritten or arranged on a best endeavors basis. Where a loan is underwritten the Arrangers or Agents guarantee the terms and conditions and costs of the loan before it is sold to other banks, essentially removing the market risk for the Borrower. BOND/ DEBENTURE A corporate bond or a debenture is a credit instrument in which the issuer obtains cash from the initial investors at origination and, in return, agrees to make payments of interest and, at maturity, of principal to holders of the securities. A bond or debenture is a long-
term, fixed-income, financial security. Debenture holders are creditors or lenders to the firm. Bonds are less costly to the firm than equity because investors consider them a less risky alternative and interest payments on bonds are tax deductible. There is no ownership dilution as bond holders do not voting rights. Bond holders receive interest at a predetermined rate. Also during high inflation period bond issue benefits the borrowing firm. From the creditors point of view it is a secure credit as bonds are usually secured in nature i.e. they can take control over the assets of the company in case of default. Also when the borrowing firm is liquidated bondholders have preference over shareholders of the borrowing firm. Some bonds include sinking fund or redemption provisions basically equivalent to amortization of principal. Most allow prepayment after a period of call protection. The bond’s comparative simplicity makes it more readily marketable than other credit agreements that, in contrast, often include clauses proscribing or limiting assignments. But issuing firm has the legal obligation of paying interest & principal on due date. Also it increases financial leverage of the firm and disadvantageous to the firms with fluctuating sales and earnings.
Modes of Charge
Most credit facilities are secured in nature i.e. some assets of the borrowing firm are charged to the lender/ bank. So it will be important to know various types of charges that can be laid on the assets by the lenders while granting the credit to the borrower.
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Lien Lien is the right to retain securities/goods belonging to another, until a debt due from the latter is paid. Set off It is in effect the combining of the accounts of the debtor and creditor, so as to arrive at the net balance payable to one or the other. Pledge Pledge is bailment or delivery of goods as security for payment of a debt or performance of a promise, as per section 172 of Indian Contract Act, 1872. Goods are in the possession of the Bank. It is not a popular form of security.
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Hypothecation
When the possession of the property in the goods and other movables offered as security remains with the borrower and only an equitable charge is created in favour of the lender, the transaction is called a hypothecation. This is the most popular method of creating security for banks.
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Mortgage Mortgage is the transfer of an interest in specific immovable property for the purpose of securing the payment of money advanced by way of loan, an existing or future debt or performance of an engagement, which may give rise to a pecuniary liability. As per sec 58 of transfer of property act 1882 the important types of mortgage are: Equitable mortgage Registered mortgage or English mortgage
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Assignment Actionable claims are assigned by the borrowers to the bank. A borrower can assign Book debts Life Insurance Policies Money due from Govt departments or Semi-govt organisations.
Negotiable instruments
PROMISSORY NOTE A promissory note, also referred to as a note payable in accounting, is a contract where one party (the maker or issuer) makes an unconditional promise in writing to pay a sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms. They differ from IOUs (I owe unto) in that they contain a specific promise to pay, rather than simply acknowledging that a debt exists. The terms of a note typically include the principal amount, the interest rate if any, and the maturity date. Sometimes there will be provisions concerning the payee's rights in the event of a default, which may include foreclosure of the maker's assets. Demand promissory notes are notes that do not carry a specific maturity date, but are due on demand of the lender. Usually the lender will only give the borrower a few days notice before the payment is due. For loans between individuals, writing and signing a promissory note is often considered a good idea for tax and recordkeeping reasons. In the United States, a promissory note that meets certain conditions is a
negotiable instrument Commercial Code.
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Negotiable promissory notes are used extensively in combination with mortgages in the financing of real estate transactions. Other uses of promissory notes include the capitalization of corporate finances through the issuance and transfer of commercial paper. At various times in history, promissory notes have acted as a form of privately issued currency. In many jurisdictions today, bearer negotiable promissory notes are illegal precisely because they can act as an alternative currency. All Scottish and Northern Irish banknotes are effectively standardized demand promissory notes. BILL OF EXCHANGE A bill of exchange or "Draft" is a written order by the drawer to the drawee to pay money to the payee. The most common type of bill of exchange is the cheque, which is defined as a bill of exchange drawn on a banker and payable on demand. Bill of exchange is most popular instrument of payment in financing the internal and foreign trade in India. Funds lent under BP/BD are recoverable/ receivable after short period of time. Banks provide credit facilities against such bills of exchange in following ways, when banks,
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Negotiate such bills payable on demand/ against acceptance Purchases bills payable on demand Discount bills drawn on DA basis Grant advances against supply bills under collection
In the first 3 cases Bank becomes holder in due course for full value of bills and in the fourth case it is holder in due course for value up to the advances granted against such bills. Bills of exchange are written orders by one person to his bank to pay the bearer a specific sum on a specific date sometime in the future. When bills are ‘purchased’, such bills are payable on demand. When bills are ‘discounted’, such bills are payable after some usance period. Banks collect commission and interest on the day of purchase/discount, the advance sanctioned results into higher yield. The effective rate of interest is more than what bank earns under Cash Credit or Term Loan. Types of bills: Bills to be purchased/ discounted could be documentary or clean and demand or usance. When the instrument (bill) is accompanied by document of title of goods (such as bill of lading, railway receipt, motor receipt etc.) it is documentary bill and when no such documents of title to the goods accompany the bill, it is a clean bill. However when documents of title to goods are delivered against acceptance of a bill, the documentary usance bill gets converted into a clean bill. An example of bill of exchange
Transaction Process
CHEQUE A cheque is an unconditional order, drawn on a specified banker and is payable on demand. Cheque is one of the earliest forms of a credit instrument. It is utilized by consumers as a legitimate means of paying for goods and services received; the value of the cheque is underwritten by funds that are placed in a bank account. Upon the presentation by the recipient of the credit instrument, the bank deducts the specified amount as recorded on the cheque by the debtor. While the cheque is no longer the main credit instrument employed in many financial transactions, it remains in use by many businesses and individuals. General crossing - Sec 123 of Negotiable Instrument Act. Where a cheque bears across its face an addition of the words ‘and co’ or any abbreviation thereof, between two parallel transverse lines simply, either with or without the words‘ not negotiable’, that addition shall be deemed a crossing and the cheque shall be deemed to be crossed generally. Special crossing - Section 124 of Negotiable Instrument Act. Where a cheque bears across its face an addition of the name of a banker, either with or without the words ‘not negotiable’, that addition shall be deemed a crossing and the cheque shall be deemed to be crossed specially and to be crossed to that banker. Not negotiable crossing - Section 130 of Negotiable Instrument Act. A person taking a cheque crossed generally or specially, bearing in either case the words ‘not negotiable’ shall not have and shall not be capable of giving a better title to the cheque than that which the person from whom he took it had. Payment of cheques Section 126 of Negotiable Instrument Act Where a cheque is crossed generally, the banker on whom it is drawn shall not pay it otherwise than to a banker and where a cheque is crossed specially, the banker on whom it is drawn shall not pay it otherwise than to the banker to whom it is crossed or his agent for collection. Different types of Payment of Cheques Following are the various types of payment of cheques.
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Ante dated Post dated
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Stale cheques Amount in words and figures differs (sec 18 of N I Act) ) Authentication of alterations Forgery of drawer’s signature Payment during banking hours Protection to paying banker - 85(1) order cheques, 85(2) bearer cheques
Refusal of payment of cheques A banker can refuse to pay to the drawee against the cheque in following conditions-
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Payment countermanded by the drawer Death of the drawer Insolvency of the drawer Insanity of the drawer Garnishee order Breach of trust – trust accounts Defective title of the property Mutilated cheques
Non-funded credit instruments
LETTER OF CREDIT In a financial letter of credit (LC), the creditor guarantees the repayment of counterparty’s obligation and, in return, receives a onetime or periodic fee. Thus, a bank could issue a financial LC in support of a customer obtaining short-term cash from a money market fund that offers an attractive rate. In a financial LC, the bank essentially provides credit insurance. The instrument’s contingent pay-offs mirror those of a credit default swap. A Letter of Credit (LC) is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank is required to cover the full or remaining amount of the purchase. A letter of credit is often abbreviated as LOC or LC, and is also referred to as a documentary credit.
The parties to a letter of credit are usually an applicant who wants to send money, a beneficiary who will receive the money, the issuing bank and the advising bank. Letters of credit are often used for international transactions to ensure that payment will be received. They have become an important aspect of international trade, due to differing laws in each country and the difficulty of knowing each party personally. The bank also acts on behalf of the buyer, or holder of the letter of credit, by ensuring that the supplier will not be paid until the bank receives confirmation that the goods have been shipped. A letter of credit is often confused with a bank guarantee, which is similar in many ways but not the same thing. The main difference is the bank's position relative to the buyer and seller of a good or service in the event of the buyer's default of payment. With a letter of credit, a seller may request that a buyer provide them with a letter obtained from a bank which substitutes the bank's credit for their client's. In the event of the borrower defaulting, the seller can go to the buyer's bank for the payment. Instead of the risk that the buyer will not pay, the seller only faces the risk that the bank will be unable to pay, which is unlikely. This means that if the applicant obtaining the letter of credit fails to perform his or her obligations, the bank must pay. The letter of credit can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming the letter of credit. A letter of credit is less risky for the merchant, but even riskier for a bank. BANK GUARANTEE A bank guarantee is defined under Section 126 of the Indian Contracts Act 1872 as follows: “A contract to perform the promise or discharge the liability of a third person in case of his default.” The person who gives the guarantee is called the surety; the person in respect of whose default the guarantee is given is called the principal debtor and the person to whom the guarantee is given is called the creditor. A guarantee may be either oral or written. The liability of a guarantor comes into existence upon the failure of a debtor. If the guarantor extinguishes the liability of a debtor then the guarantor will acquire all the rights of the creditor, which is known as Right of Subrogation. Banks extend guarantees on behalf of their clients. These guarantees are classified as financial guarantees and performance guarantees. Financial Guarantees
The bank guarantees its customer’s credit-worthiness and his or her capacity to take up financial risks. Financial guarantees are typically issued for the following purposes:
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In lieu of Earnest Money/Tender deposit/Retention money.
Issued to Government departments for releasing disputed claim money like excise duty/customs duty etc. For example, if a contractor wants to bid for a tender, he or she needs to deposit a specified sum of money known as Earnest Money Deposit (EMD). This amount will be refunded to him or her if the work is not allotted to him or her. This involves blocking of funds for a specified period which varies depending on the nature of contract. This can be avoided by submitting a bank guarantee in the place of EMD. The bank undertakes to pay the money if the contractor is awarded the work but fails to pay the EMD. Performance Guarantees The bank guarantees obligations that relate to the technical, managerial, administrative experience and capacity of the customer. The liabilities under the performance guarantees are reduced to monetary terms. Performance guarantees typically cover the following areas:
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For performance of machinery/goods supplied deposit/Retention money
For satisfactory performance of Turnkey projects for a specific period for releasing disputed claim money like excise duty/customs duty, etc. In the above example, if the contract is awarded to the contractor, then the agency awarding the contract seeks an assurance that the contract completed is up to their satisfaction. Hence, they insist for a bank guarantee where a bank undertakes to compensate the agency for any loss suffered consequent to poor performance/nonperformance. Deferred Payment Guarantee This guarantee is issued for guaranteeing payment of specified amount over a period of time. The required margin, security and commission payable are determined on the basis of type of guarantee and creditworthiness of the customer. In cases of equipment financing by banks, the manufacturer by him or her or through a financing tie-up offers credit to the buyers at very attractive terms to generate additional demand for his or her products. However, the manufacturer may not be willing to assume the risk of default by the buyer and
consequently demand a guarantee from the buyer’s bankers that the terms of such financing would be met. Notwithstanding the classification of guarantees into financial and performance, the liability of a bank will always be determined in financial terms and banks are obliged to pay the amount demanded by the beneficiary subject to the limit up to which the bank agreed to make itself liable under a guarantee. While these guarantees do serve as non-fund based services serving the purpose of working capital management, there are also instances where banks may issue guarantees for financing capital equipment. The Deferred Payment Guarantee (DPG) is a bank facility where the bank does not directly extend a loan to a unit for acquiring equipment. Instead, it extends a guarantee to the equipment manufacturer on behalf of its client that the finance extended by the manufacturer (by himself or through its preferred financier) would be repaid as per the terms agreed upon. The advantage to the buyer here is that he or she benefits to the extent of savings in interest charges accruing on account of opting for equipment financing, minus the guarantee charges paid to the bank. In the normal course where the guarantee does not transfer onto the banker, the banker stands to earn fee-based income. Normally, such financing is done by extending a term loan. Suppose a supplier of capital equipment is willing to extend a long-term credit to the buyer. This will involve the supplier taking a credit risk and also blocking funds over the term of the credit. If the supplier is not willing to take the credit risk then he or she may insist a bank guaranteeing the credit extended to the buyer. In such circumstances, the bank can extend a deferred payment guarantee. The bank, under the deferred payment guarantee, undertakes to pay the installments if the buyer fails to pay the same. While these guarantees were in vogue earlier they have slowly disappeared from the scene with the entry of Bill Rediscounting Scheme introduced by IDBI/SIDBI. Under the scheme, the supplier draws different Bills of Exchange for each of the installment and have the same accepted by the buyer and the buyer’s banker as well. He or she will then have these bills discounted with his or her banker, which will eliminate the need for him or her to block the funds. The seller’s bank will in turn rediscount these bills with IDBI/SIDBI. Thus, the sale of capital equipment is effectively financed by IDBI/SIDBI. However, the credit risk is taken by the buyer’s banker since all others have a banker to fall back on. When the seller’s bank rediscounts these bills they appear as contingent items in the bank’s balance sheet even though credit has been initially extended to the seller. Hence, these items are added to the Net Bank Credit to obtain Gross Bank Credit.
Shipping and Railway Guarantee A bank is requested to issue shipping and railway guarantee when the shipping documents are not received but the ship carrying the goods has arrived and the shipping company agrees to deliver the goods against the production of a bank guarantee. As this guarantee does not specify the amount of guarantee it is issued only on behalf of very respectable customers and usually against 100% margin. Normally, these guarantees are issued only when the bill is routed through the bank. Margin is fixed after determining the value covered by the bill. Full margin should be stipulated even when the bill is drawn against a letter of credit issued by the bank. However, where the borrower enjoys Trust Receipt Limit, the guarantee can be issued against the execution of TR without insisting on 100% margin. The features of Shipping and railway guarantee are that they-
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Enable immediate possession of the goods before payment. Avoid unnecessary delays to the day-to-day running of your business. Eliminate expensive demurrage/storage charges.
Defer payment until your supplier’s documents have been presented. Banks issue a shipping guarantee to the shipping company, undertaking to forward the title documents (e.g. Bills of Lading) when they are received. This allows the trader to take immediate control of the goods without the transport documents. Shipping guarantees are usually applicable under import Documentary Credit transactions, allowing prompt clearance of goods ahead of documents arrival. However, by taking the goods, protection against discrepant documents will be lost. Under normal circumstances, 100% cash margin against the value of the goods will be required if the trader does not have Trust Receipt facility. Shipping guarantees are only of value if they are issued immediately. In the case of usance bill with trust receipt facility, the usance should start to run from the date of issue of a guarantee and not from the date of acceptance of the bill. Before issuing the shipping guarantee the bank must obtain an undertaking to the effect that the borrower must honor the bill irrespective of discrepancy, if any, with the terms of the LC.
Credit Derivatives to mitigate the credit risk
Credit derivatives are effective tools to hedge credit risk. Credit risk can be defined as default risk arising on account of borrower’s inability to pay back loans. Any lending institution carries out credit analysis of a borrower and prepares his risk profile. But, as no risk can be completely mitigated, there is always a possibility of borrower default. Due to large amount of defaults that took place in the US housing loan markets in early 90’s, banks found out innovative ways to hedge risks, which led to expansion of derivative markets, where lenders could hedge against the risks. In 2000, the notional principal outstanding in these markets was $800 billion. Currently, this market stands somewhere around $600 trillion. This shows the stupendous turnover taking place in this market. Some of the commonly used credit derivatives are discussed as follows. CREDIT DEFAULT SWAPS (CDS) This is the most popular credit derivative. The popularity of this derivative can be seen from the fact that AIG, world’s largest insurer had worth $60 trillion outstanding positions in CDS at the time of its taking over by Federal Reserves. In a credit-default swap (DS) the buyer pays a one-time or periodic fee to the seller of protection for the right, in the case of default by a particular borrower, to receive cash compensation or to sell a credit instrument issued by the borrower at a specified price (near par). In contracts with extremely low-risk counterparties, this instrument offers basically the same state-contingent cash flows as a financial LC. Otherwise, the instrument involves counterparty risk as well as the risk of the underlying instrument. As with a financial LC and insurance contracts in general, the protection buyer in a DS typically has the right of canceling (prepaying) the agreement. This contract provides insurance against default by a particular company. The company is known as reference entity, and the default by the company is known as credit event. The buyer of the insurance obtains the rights to sell bonds issued by the defaulting company at their face value when a credit event occurs and the seller agrees to buy these bonds at face value when credit event occurs. The total face value of a bond is called the notional principle. The buyer of CDS makes periodic payments to the seller of CDS until default occurs. Once the default occurs, the seller buys the bonds issued by the defaulting company for its face value. The settlement in the event of a
default involves either physical delivery of the bonds or cash payments.
TOTAL RETURN SWAPS (TRS) In a total-return swap (TRS) the protection buyer exchanges the total returns on a specified underlying debt instrument for a set of stable cash flows. The protection seller receives cash flows that match the interest and principal payments plus the gains (minus the losses) of the underlying instrument. As in the CDS, the TRS can involve counterparty risk in addition to the risk of the underlying instrument. Also, as in the CDS, the TRS usually allows the protection buyer to cancel the agreement. A total return swap is a type of credit derivative. It is an agreement to exchange total return on a bond (or any asset) for LIBOR plus a spread. The total return includes coupons, interest, and the gain or loss on the asset over the life of the swap.
At the end of the life of the swap there is a payment reflecting the change in the value of the bond, and subsequent payments are made. This swap can be seen from 2 angles. For the payer of the bond, he gets a hedge against the uncertainties in bond value for paying a premium above LIBOR. For the receiver of the bond, this transaction is equivalent to invest in the reference bond by borrowing at the rate equal to LIBOR + premium. Collateralized Debt Obligations (CDOs) CDO is a way of creating securities with widely different risk characteristics from a portfolio of debt instruments. An example is shown below. In this, 4 types of securities are created from a portfolio of bonds. The first basket has 5% of total bond principle and absorbs all credit losses from the portfolio during the life of the CDO until they have reached 5% of total bond principle. The
second basket has 10% of total principal and absorbs all loses in excess of 5% up to maximum 15%. The third basket has principal up to 10% and absorbs all the losses in excess of 15% up to maximum 25%. The 4rth basket has 75% of the principal amount and absorbs the residual losses. The yields specified are the returns the investors are going to get in those specific baskets. For e.g. the investor in the first basket is going to get 35% on his initial investment. Once the value of total portfolio descends by 1%, his investment goes down by 20%, the next time he is going to get 35% on 80% of his investment.
Bond 1 Bond 2 Bond 3 . . . Bond n Average Yield 8%
1st 5%loss Yield 35% 2nd 10% loss, yield 15% 3rd 10%loss Yield 7.5% Residual loss, yield 6%
Trust
Other Instruments
CREDIT CARD The credit card is an example of a common credit instrument. Using a credit card to pay for a purchase creates a contract between the buyer and the seller. Essentially, the seller is extending credit to the buyer with the assumption that the company issuing the card will cover the amount of the purchase. In turn, the issuer of the credit card is anticipating that the cardholder will eventually pay off the amount of the debt along with applicable interest and finance charges. With this arrangement, credit card holders receive credit from the lenders with the understanding that the same will be repaid in full at a
future point in time. This type of obligation may carry a specific date for repayment and if the credit card holder is liable for a penalty. There are two main advantages to the use of a credit card. First, the consumer does not have to carry a great deal of currency in order to make purchases. Second, a credit card can usually be replaced with relative ease when damage, loss, or theft of the instrument takes place. This is in contrast to cash, which usually cannot be replaced when damaged, stolen, or lost. MULTI-OPTION CREDIT FACILITY (MOF) In a multi-option credit facility (MOF), the borrower has access to a range of instrument types within a single facility or contract. In this case, the creditor commits to provide credit up to a maximum amount, which can amortize over time, to be drawn on in various ways largely at the borrower’s discretion. In a more general case, the borrower can receive a term loan and then, as needed, obtain additional credit up to the remaining commitment amount. This additional credit can take the form of additional funded balances (revolvers), letters of credit, bankers’ acceptances, or some combination of these types. Of course, an MOF can offer less than the full menu of instrument types. BANKER’S ACCEPTANCE (BA) A banker’s acceptance (BA) is another type of payment guarantee. A short-term credit investment created by a non-financial firm and guaranteed by a bank. A banker's acceptance or BA is a time draft drawn on and accepted by a bank. In a BA, the bank certifies that it will stand behind time drafts (usually post-dated cheques) issued by a customer. The customer may then sell drafts endorsed as accepted by the bank at a discount to a funding source that does not want to bear the issuer’s credit risk. Before acceptance, the draft is not an obligation of the bank; it is merely an order by the drawer to the bank to pay a specified sum of money on a specified date to a named person or to the bearer of the draft. Upon acceptance, which occurs when an authorized bank accepts and signs it, the draft becomes a primary and unconditional liability of the bank. If the bank is well known and enjoys a good reputation, the accepted draft may be readily sold in an active market. Acceptances are traded at a discount from face value on the secondary market. Banker's acceptances are very similar to T-bills and are often used in money market funds.
By students of Department of Management Sciences, University of Pune (PUMBA)
Credit or loan is the act of giving money, property or other material goods to another party in exchange for future repayment of the principal amount along with interest or other finance charges. A loan may be for a specific, one-time amount or can be available as openended credit up to a specified ceiling amount. “Credit instruments are items that are utilized in the place of currency.” Just about all individuals and businesses make use of some type of credit instrument on a daily basis. The ability to use a credit instrument instead of currency rests in the fact that debtor and the recipient agree upon the use of the instrument and there is a reasonable expectation that the alternate form of payment will be honored. The contractual amount of credit instruments represents the maximum undiscounted potential credit risk if the counterparty does not perform according to the terms of the contract, before possible recoveries under recourse and collateral provisions. A large majority of these commitments expire without being drawn upon. The credit instruments are issued by the lenders only to those parties that are creditworthy. Credit risk for other credit instruments using the same credit risk process that is applied to loans and other credit assets. The terms of a standardized loan are formally presented (usually in writing) to each party in the transaction before any money or property changes hands. If a lender requires any collateral, this will be stipulated in the loan documents as well. Most loans also have legal stipulations regarding the maximum amount of interest that can be charged, as well as other covenants such as the length of time before repayment is required. Some credit instruments like credit derivatives are used for the riskmitigation purposes. These instruments help the lending firm to manage the credit risk associated with borrower. Principles of Lending Lenders usually follow some principles before granting loan to the borrower. They appraise the borrower on certain criteria which are described as follows.
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Safety of the funds- This is most important criterion while granting a loan. The funds should go in the safe hands. Identification of borrowers (KYC) - Institutional lenders have to follow KYC norms, which help them in identifying the borrowers. Purpose- The purpose for which the loan is granted is important because on this criterion interest rate applicable to the borrower and availability of certain facilities is decided.
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Liquidity- The borrower should always have liquid money with him so that the chance of the borrower becoming NPA is less. Security- The security offered for the loan plays important role, because in future if the borrower could not repay, the security charged with the creditor can be sold to recover the dues. Profitability- Profitability of business to which the loan is granted is important because non-profitable businesses generally turn into a NPA for the bank. Risk Management- Managing the risk created due to granting of loan is important. Because if the bank fails to manage various types of risks associated with credit given, the recovery becomes impossible. National Interest- Certain credit is given for the national interest and in these cases profitability of the bank is not the primary issue. Priority sector lending is the best example of the credit given in the national interest.
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Types of Lending Lending by the banks or the financial institutions can be divided into 3 major types.
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Fund-based lending This is the most direct form of lending. It is granted as a loan or advance with an actual outflow of cash to the borrower. It is supported by prime or collateral securities.
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Non –fund based lending There is no funds outlay for the Bank. It may crystallise into fundbased advances, on account of the failure to fulfil the contract. Letters of credit and bank guarantees, fall under this category.
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Asset-based lending This is an emerging category of bank lending. The bank looks primarily to the earning capacity of the asset being financed. Mostly, the banks do not have any recourse to the borrower. Specialised lending practices such as securitisation, or project finance fall under this category.
Common types of credit instruments The vast majority of credit instruments involve a mixture of standard types. We can broadly classify the credit instruments used by the lender as follows-
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Credit instruments which are used for meeting working capital requirements Credit instruments used for meeting capital expenditure Negotiable instruments like bill of exchange Non-funded credit instruments like L/C and B.G. Credit derivatives for risk mitigation Other instruments
Working Capital
The credit for fulfilling working capital requirements is usually given by using following modes of credit like cash credit, WCDL, overdraft like bills of exchange and commercial paper. Bill of exchanges are discussed under negotiable instruments. The security offered for working capital finance is current assets like inventory, book debts and receivables. CASH CREDIT It is the most popular method to finance working capital requirements of a company in India. Under the cash credit facility, a borrower is allowed to withdraw funds from the bank up to the sanctioned credit limit. He is not required to borrow entire sanctioned credit once, rather, he can withdraw periodically to the extent of his requirements and repay by depositing surplus funds in his cash credit account. There is no commitment charge; therefore, interest is payable on the amount actually utilised by the borrower. Cash credit limits are sanctioned against the security of current assets such as inventory, receivables and debtors. Though funds borrowed are repayable on demand, banks usually do not recall such advances unless they are compelled by the adverse circumstances. Cash credit is the most flexible arrangement from the borrower’s point of view. WORKING CAPITAL DEMAND LOAN
A borrower may sometimes require ad hoc or temporary accommodation in excess of the sanctioned credit limit to meet unforeseen contingencies. Banks provide such accommodation through a demand loan account or a separate non-operable cash credit account. Such a loan is termed as working capital demand loan. The borrower is required to pay a higher rate of interest above the normal rate on such additional credit. OVERDRAFT It is similar to cash credit arrangement. Under the overdraft facility, the borrower is allowed to withdraw funds in excess of the balance in his current account up to a certain specified limit during a stipulated period. Though overdrawn amount is repayable on demand, they generally continue for a long period by annual renewals of the limit. It is very flexible arrangement from the borrower’s point of view sine he can withdraw and repay funds when ever he desires within the overall stipulations. Interest is charged on daily balances, on the amount actually withdrawn, subject to some minimum charges. The borrower operates this facility through cheques. COMMERCIAL PAPER Commercial paper (CP) is an important money market instrument to raise short term funds. CP is a form of unsecured promissory note issued by the firms to raise short term funds. Only financially sound and highest rated companies are able to issue commercial papers. The buyers of commercial paper includes banks, insurance companies, mutual funds, trusts and firms with short surplus funds to invest for a short period with minimum risk. Given this investment objective demand for CPs of highly creditworthy companies will always be there. In India, RBI regulates issue of CPs. Only those companies which have a net worth of minimum Rs. 10 crores, MPBF of not less than Rs. 25 crores and which are listed on stock exchange are allowed to issue CPs. The size of the issue should be at least Rs. 25 lacs and size of the each CP should not be less than Rs. 5 lacs. A company can issue CPs amounting up to 75% of the MPBF. The maturity of CPs in India usually runs between 91 to 180 days. Interest rate on commercial paper is generally less than bank borrowing rate. A firm does not pay interest on a CP but it sells it at a discounted value. The yield calculated o this basis is referred to as interest yield which can be calculated as,
Interest yield = (face value) – (sale price) * _____360_____ Sale price days of maturity Interest on CP is tax deductible. In India, cost of a CP usually includes discount, rating charges, stamp duty and issuing & paying agent (IPA) charges. REVOLVER A revolver (RV), or credit line or revolving line, is a credit agreement in which the borrower has the right to choose when to obtain funds and when to repay funds and how much to borrow, within limits set by the contract. These limits typically stipulate a maximum borrowing amount (commitment), the date by which all borrowed funds must be repaid, and the covenants that the borrower must satisfy to qualify for receiving funds. In some cases, the agreement requires that the borrower periodically “clean up” (pay down to a specified level) the facility before re-borrowing. The revolving line involves all of the complications of the term loan plus the added feature of granting the borrower the right to choose when to borrow and in what amounts. By providing funds virtually on demand, the revolver allows a business to meet its working capital needs and to manage the liquidity risk created by volatile cash flows. Different types of revolving lines account for the major share of bank lending to businesses. By pooling revolvers across many businesses, a bank eliminates through diversification most of the liquidity risk that it inherits from customers.
Credit instruments used to meet capital expenditure
TERM LOAN A loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate is called as term loan. A term loan (TL) is a credit contract in which the borrower receives funds from the creditor(s) at contract closing or usually over a short period following closing and, in return, agrees to make payments of interest, fees and principal based on formulas and schedules specified in the agreement. Often term loan is given to purchase fixed assets such as plant & machinery, consumer products and house. Term loans almost always mature between 1-10 years. But term loans like home loans may be of maturity up to 20 years.
This kind of loan is preferred by many bankers because usually an asset is created through this type of credit. Such asset provides security to the banker. Term loans are always secured in nature. The assets created from the term loan, are charged to the bank and are a primary security. In case of loans where no asset is created like in case of personal loan; collateral is required. Borrowers also prefer term loans for capital expenditure as they are less costly than other sources of finance like equity and interest on the term loans is tax deductible. Term loans can be quite complicated, involving amortization of principal, differing levels of seniority, posting of collateral, detailed covenant restrictions, prepayment penalties and interest and fees that may vary with the borrower’s risk rating or financial performance. LOAN SYNDICATION/ CONSORTIUM ADVANCE/ MULTIPLE BANKING ARRANGEMENT Loan syndication is the process of involving several different lenders in providing various portions of a loan. It is mainly used in extremely large loan situations; syndication allows any one lender to provide a large loan while maintaining a more prudent and manageable credit exposure because the lender isn't the only creditor. A syndicated loan (or consortium advance or multiple banking arrangements) is a large loan in which a group of banks provide funds for a borrower, usually several but without joint liability. There is usually a lead bank or group of banks (the "Arranger/s" or "Agent/s") that takes a percentage of the loan and syndicates or sells the rest to other banks. In contrast, a bilateral loan, only involves one borrower and one lender (often a bank or financial institution.) A syndicated loan is a much larger and more complicated version of a participation loan. There are typically more than two banks involved in syndication. Syndicated loans can be underwritten or arranged on a best endeavors basis. Where a loan is underwritten the Arrangers or Agents guarantee the terms and conditions and costs of the loan before it is sold to other banks, essentially removing the market risk for the Borrower. BOND/ DEBENTURE A corporate bond or a debenture is a credit instrument in which the issuer obtains cash from the initial investors at origination and, in return, agrees to make payments of interest and, at maturity, of principal to holders of the securities. A bond or debenture is a long-
term, fixed-income, financial security. Debenture holders are creditors or lenders to the firm. Bonds are less costly to the firm than equity because investors consider them a less risky alternative and interest payments on bonds are tax deductible. There is no ownership dilution as bond holders do not voting rights. Bond holders receive interest at a predetermined rate. Also during high inflation period bond issue benefits the borrowing firm. From the creditors point of view it is a secure credit as bonds are usually secured in nature i.e. they can take control over the assets of the company in case of default. Also when the borrowing firm is liquidated bondholders have preference over shareholders of the borrowing firm. Some bonds include sinking fund or redemption provisions basically equivalent to amortization of principal. Most allow prepayment after a period of call protection. The bond’s comparative simplicity makes it more readily marketable than other credit agreements that, in contrast, often include clauses proscribing or limiting assignments. But issuing firm has the legal obligation of paying interest & principal on due date. Also it increases financial leverage of the firm and disadvantageous to the firms with fluctuating sales and earnings.
Modes of Charge
Most credit facilities are secured in nature i.e. some assets of the borrowing firm are charged to the lender/ bank. So it will be important to know various types of charges that can be laid on the assets by the lenders while granting the credit to the borrower.
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Lien Lien is the right to retain securities/goods belonging to another, until a debt due from the latter is paid. Set off It is in effect the combining of the accounts of the debtor and creditor, so as to arrive at the net balance payable to one or the other. Pledge Pledge is bailment or delivery of goods as security for payment of a debt or performance of a promise, as per section 172 of Indian Contract Act, 1872. Goods are in the possession of the Bank. It is not a popular form of security.
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Hypothecation
When the possession of the property in the goods and other movables offered as security remains with the borrower and only an equitable charge is created in favour of the lender, the transaction is called a hypothecation. This is the most popular method of creating security for banks.
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Mortgage Mortgage is the transfer of an interest in specific immovable property for the purpose of securing the payment of money advanced by way of loan, an existing or future debt or performance of an engagement, which may give rise to a pecuniary liability. As per sec 58 of transfer of property act 1882 the important types of mortgage are: Equitable mortgage Registered mortgage or English mortgage
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Assignment Actionable claims are assigned by the borrowers to the bank. A borrower can assign Book debts Life Insurance Policies Money due from Govt departments or Semi-govt organisations.
Negotiable instruments
PROMISSORY NOTE A promissory note, also referred to as a note payable in accounting, is a contract where one party (the maker or issuer) makes an unconditional promise in writing to pay a sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms. They differ from IOUs (I owe unto) in that they contain a specific promise to pay, rather than simply acknowledging that a debt exists. The terms of a note typically include the principal amount, the interest rate if any, and the maturity date. Sometimes there will be provisions concerning the payee's rights in the event of a default, which may include foreclosure of the maker's assets. Demand promissory notes are notes that do not carry a specific maturity date, but are due on demand of the lender. Usually the lender will only give the borrower a few days notice before the payment is due. For loans between individuals, writing and signing a promissory note is often considered a good idea for tax and recordkeeping reasons. In the United States, a promissory note that meets certain conditions is a
negotiable instrument Commercial Code.
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Negotiable promissory notes are used extensively in combination with mortgages in the financing of real estate transactions. Other uses of promissory notes include the capitalization of corporate finances through the issuance and transfer of commercial paper. At various times in history, promissory notes have acted as a form of privately issued currency. In many jurisdictions today, bearer negotiable promissory notes are illegal precisely because they can act as an alternative currency. All Scottish and Northern Irish banknotes are effectively standardized demand promissory notes. BILL OF EXCHANGE A bill of exchange or "Draft" is a written order by the drawer to the drawee to pay money to the payee. The most common type of bill of exchange is the cheque, which is defined as a bill of exchange drawn on a banker and payable on demand. Bill of exchange is most popular instrument of payment in financing the internal and foreign trade in India. Funds lent under BP/BD are recoverable/ receivable after short period of time. Banks provide credit facilities against such bills of exchange in following ways, when banks,
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Negotiate such bills payable on demand/ against acceptance Purchases bills payable on demand Discount bills drawn on DA basis Grant advances against supply bills under collection
In the first 3 cases Bank becomes holder in due course for full value of bills and in the fourth case it is holder in due course for value up to the advances granted against such bills. Bills of exchange are written orders by one person to his bank to pay the bearer a specific sum on a specific date sometime in the future. When bills are ‘purchased’, such bills are payable on demand. When bills are ‘discounted’, such bills are payable after some usance period. Banks collect commission and interest on the day of purchase/discount, the advance sanctioned results into higher yield. The effective rate of interest is more than what bank earns under Cash Credit or Term Loan. Types of bills: Bills to be purchased/ discounted could be documentary or clean and demand or usance. When the instrument (bill) is accompanied by document of title of goods (such as bill of lading, railway receipt, motor receipt etc.) it is documentary bill and when no such documents of title to the goods accompany the bill, it is a clean bill. However when documents of title to goods are delivered against acceptance of a bill, the documentary usance bill gets converted into a clean bill. An example of bill of exchange
Transaction Process
CHEQUE A cheque is an unconditional order, drawn on a specified banker and is payable on demand. Cheque is one of the earliest forms of a credit instrument. It is utilized by consumers as a legitimate means of paying for goods and services received; the value of the cheque is underwritten by funds that are placed in a bank account. Upon the presentation by the recipient of the credit instrument, the bank deducts the specified amount as recorded on the cheque by the debtor. While the cheque is no longer the main credit instrument employed in many financial transactions, it remains in use by many businesses and individuals. General crossing - Sec 123 of Negotiable Instrument Act. Where a cheque bears across its face an addition of the words ‘and co’ or any abbreviation thereof, between two parallel transverse lines simply, either with or without the words‘ not negotiable’, that addition shall be deemed a crossing and the cheque shall be deemed to be crossed generally. Special crossing - Section 124 of Negotiable Instrument Act. Where a cheque bears across its face an addition of the name of a banker, either with or without the words ‘not negotiable’, that addition shall be deemed a crossing and the cheque shall be deemed to be crossed specially and to be crossed to that banker. Not negotiable crossing - Section 130 of Negotiable Instrument Act. A person taking a cheque crossed generally or specially, bearing in either case the words ‘not negotiable’ shall not have and shall not be capable of giving a better title to the cheque than that which the person from whom he took it had. Payment of cheques Section 126 of Negotiable Instrument Act Where a cheque is crossed generally, the banker on whom it is drawn shall not pay it otherwise than to a banker and where a cheque is crossed specially, the banker on whom it is drawn shall not pay it otherwise than to the banker to whom it is crossed or his agent for collection. Different types of Payment of Cheques Following are the various types of payment of cheques.
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Ante dated Post dated
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Stale cheques Amount in words and figures differs (sec 18 of N I Act) ) Authentication of alterations Forgery of drawer’s signature Payment during banking hours Protection to paying banker - 85(1) order cheques, 85(2) bearer cheques
Refusal of payment of cheques A banker can refuse to pay to the drawee against the cheque in following conditions-
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Payment countermanded by the drawer Death of the drawer Insolvency of the drawer Insanity of the drawer Garnishee order Breach of trust – trust accounts Defective title of the property Mutilated cheques
Non-funded credit instruments
LETTER OF CREDIT In a financial letter of credit (LC), the creditor guarantees the repayment of counterparty’s obligation and, in return, receives a onetime or periodic fee. Thus, a bank could issue a financial LC in support of a customer obtaining short-term cash from a money market fund that offers an attractive rate. In a financial LC, the bank essentially provides credit insurance. The instrument’s contingent pay-offs mirror those of a credit default swap. A Letter of Credit (LC) is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank is required to cover the full or remaining amount of the purchase. A letter of credit is often abbreviated as LOC or LC, and is also referred to as a documentary credit.
The parties to a letter of credit are usually an applicant who wants to send money, a beneficiary who will receive the money, the issuing bank and the advising bank. Letters of credit are often used for international transactions to ensure that payment will be received. They have become an important aspect of international trade, due to differing laws in each country and the difficulty of knowing each party personally. The bank also acts on behalf of the buyer, or holder of the letter of credit, by ensuring that the supplier will not be paid until the bank receives confirmation that the goods have been shipped. A letter of credit is often confused with a bank guarantee, which is similar in many ways but not the same thing. The main difference is the bank's position relative to the buyer and seller of a good or service in the event of the buyer's default of payment. With a letter of credit, a seller may request that a buyer provide them with a letter obtained from a bank which substitutes the bank's credit for their client's. In the event of the borrower defaulting, the seller can go to the buyer's bank for the payment. Instead of the risk that the buyer will not pay, the seller only faces the risk that the bank will be unable to pay, which is unlikely. This means that if the applicant obtaining the letter of credit fails to perform his or her obligations, the bank must pay. The letter of credit can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming the letter of credit. A letter of credit is less risky for the merchant, but even riskier for a bank. BANK GUARANTEE A bank guarantee is defined under Section 126 of the Indian Contracts Act 1872 as follows: “A contract to perform the promise or discharge the liability of a third person in case of his default.” The person who gives the guarantee is called the surety; the person in respect of whose default the guarantee is given is called the principal debtor and the person to whom the guarantee is given is called the creditor. A guarantee may be either oral or written. The liability of a guarantor comes into existence upon the failure of a debtor. If the guarantor extinguishes the liability of a debtor then the guarantor will acquire all the rights of the creditor, which is known as Right of Subrogation. Banks extend guarantees on behalf of their clients. These guarantees are classified as financial guarantees and performance guarantees. Financial Guarantees
The bank guarantees its customer’s credit-worthiness and his or her capacity to take up financial risks. Financial guarantees are typically issued for the following purposes:
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In lieu of Earnest Money/Tender deposit/Retention money.
Issued to Government departments for releasing disputed claim money like excise duty/customs duty etc. For example, if a contractor wants to bid for a tender, he or she needs to deposit a specified sum of money known as Earnest Money Deposit (EMD). This amount will be refunded to him or her if the work is not allotted to him or her. This involves blocking of funds for a specified period which varies depending on the nature of contract. This can be avoided by submitting a bank guarantee in the place of EMD. The bank undertakes to pay the money if the contractor is awarded the work but fails to pay the EMD. Performance Guarantees The bank guarantees obligations that relate to the technical, managerial, administrative experience and capacity of the customer. The liabilities under the performance guarantees are reduced to monetary terms. Performance guarantees typically cover the following areas:
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For performance of machinery/goods supplied deposit/Retention money
For satisfactory performance of Turnkey projects for a specific period for releasing disputed claim money like excise duty/customs duty, etc. In the above example, if the contract is awarded to the contractor, then the agency awarding the contract seeks an assurance that the contract completed is up to their satisfaction. Hence, they insist for a bank guarantee where a bank undertakes to compensate the agency for any loss suffered consequent to poor performance/nonperformance. Deferred Payment Guarantee This guarantee is issued for guaranteeing payment of specified amount over a period of time. The required margin, security and commission payable are determined on the basis of type of guarantee and creditworthiness of the customer. In cases of equipment financing by banks, the manufacturer by him or her or through a financing tie-up offers credit to the buyers at very attractive terms to generate additional demand for his or her products. However, the manufacturer may not be willing to assume the risk of default by the buyer and
consequently demand a guarantee from the buyer’s bankers that the terms of such financing would be met. Notwithstanding the classification of guarantees into financial and performance, the liability of a bank will always be determined in financial terms and banks are obliged to pay the amount demanded by the beneficiary subject to the limit up to which the bank agreed to make itself liable under a guarantee. While these guarantees do serve as non-fund based services serving the purpose of working capital management, there are also instances where banks may issue guarantees for financing capital equipment. The Deferred Payment Guarantee (DPG) is a bank facility where the bank does not directly extend a loan to a unit for acquiring equipment. Instead, it extends a guarantee to the equipment manufacturer on behalf of its client that the finance extended by the manufacturer (by himself or through its preferred financier) would be repaid as per the terms agreed upon. The advantage to the buyer here is that he or she benefits to the extent of savings in interest charges accruing on account of opting for equipment financing, minus the guarantee charges paid to the bank. In the normal course where the guarantee does not transfer onto the banker, the banker stands to earn fee-based income. Normally, such financing is done by extending a term loan. Suppose a supplier of capital equipment is willing to extend a long-term credit to the buyer. This will involve the supplier taking a credit risk and also blocking funds over the term of the credit. If the supplier is not willing to take the credit risk then he or she may insist a bank guaranteeing the credit extended to the buyer. In such circumstances, the bank can extend a deferred payment guarantee. The bank, under the deferred payment guarantee, undertakes to pay the installments if the buyer fails to pay the same. While these guarantees were in vogue earlier they have slowly disappeared from the scene with the entry of Bill Rediscounting Scheme introduced by IDBI/SIDBI. Under the scheme, the supplier draws different Bills of Exchange for each of the installment and have the same accepted by the buyer and the buyer’s banker as well. He or she will then have these bills discounted with his or her banker, which will eliminate the need for him or her to block the funds. The seller’s bank will in turn rediscount these bills with IDBI/SIDBI. Thus, the sale of capital equipment is effectively financed by IDBI/SIDBI. However, the credit risk is taken by the buyer’s banker since all others have a banker to fall back on. When the seller’s bank rediscounts these bills they appear as contingent items in the bank’s balance sheet even though credit has been initially extended to the seller. Hence, these items are added to the Net Bank Credit to obtain Gross Bank Credit.
Shipping and Railway Guarantee A bank is requested to issue shipping and railway guarantee when the shipping documents are not received but the ship carrying the goods has arrived and the shipping company agrees to deliver the goods against the production of a bank guarantee. As this guarantee does not specify the amount of guarantee it is issued only on behalf of very respectable customers and usually against 100% margin. Normally, these guarantees are issued only when the bill is routed through the bank. Margin is fixed after determining the value covered by the bill. Full margin should be stipulated even when the bill is drawn against a letter of credit issued by the bank. However, where the borrower enjoys Trust Receipt Limit, the guarantee can be issued against the execution of TR without insisting on 100% margin. The features of Shipping and railway guarantee are that they-
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Enable immediate possession of the goods before payment. Avoid unnecessary delays to the day-to-day running of your business. Eliminate expensive demurrage/storage charges.
Defer payment until your supplier’s documents have been presented. Banks issue a shipping guarantee to the shipping company, undertaking to forward the title documents (e.g. Bills of Lading) when they are received. This allows the trader to take immediate control of the goods without the transport documents. Shipping guarantees are usually applicable under import Documentary Credit transactions, allowing prompt clearance of goods ahead of documents arrival. However, by taking the goods, protection against discrepant documents will be lost. Under normal circumstances, 100% cash margin against the value of the goods will be required if the trader does not have Trust Receipt facility. Shipping guarantees are only of value if they are issued immediately. In the case of usance bill with trust receipt facility, the usance should start to run from the date of issue of a guarantee and not from the date of acceptance of the bill. Before issuing the shipping guarantee the bank must obtain an undertaking to the effect that the borrower must honor the bill irrespective of discrepancy, if any, with the terms of the LC.
Credit Derivatives to mitigate the credit risk
Credit derivatives are effective tools to hedge credit risk. Credit risk can be defined as default risk arising on account of borrower’s inability to pay back loans. Any lending institution carries out credit analysis of a borrower and prepares his risk profile. But, as no risk can be completely mitigated, there is always a possibility of borrower default. Due to large amount of defaults that took place in the US housing loan markets in early 90’s, banks found out innovative ways to hedge risks, which led to expansion of derivative markets, where lenders could hedge against the risks. In 2000, the notional principal outstanding in these markets was $800 billion. Currently, this market stands somewhere around $600 trillion. This shows the stupendous turnover taking place in this market. Some of the commonly used credit derivatives are discussed as follows. CREDIT DEFAULT SWAPS (CDS) This is the most popular credit derivative. The popularity of this derivative can be seen from the fact that AIG, world’s largest insurer had worth $60 trillion outstanding positions in CDS at the time of its taking over by Federal Reserves. In a credit-default swap (DS) the buyer pays a one-time or periodic fee to the seller of protection for the right, in the case of default by a particular borrower, to receive cash compensation or to sell a credit instrument issued by the borrower at a specified price (near par). In contracts with extremely low-risk counterparties, this instrument offers basically the same state-contingent cash flows as a financial LC. Otherwise, the instrument involves counterparty risk as well as the risk of the underlying instrument. As with a financial LC and insurance contracts in general, the protection buyer in a DS typically has the right of canceling (prepaying) the agreement. This contract provides insurance against default by a particular company. The company is known as reference entity, and the default by the company is known as credit event. The buyer of the insurance obtains the rights to sell bonds issued by the defaulting company at their face value when a credit event occurs and the seller agrees to buy these bonds at face value when credit event occurs. The total face value of a bond is called the notional principle. The buyer of CDS makes periodic payments to the seller of CDS until default occurs. Once the default occurs, the seller buys the bonds issued by the defaulting company for its face value. The settlement in the event of a
default involves either physical delivery of the bonds or cash payments.
TOTAL RETURN SWAPS (TRS) In a total-return swap (TRS) the protection buyer exchanges the total returns on a specified underlying debt instrument for a set of stable cash flows. The protection seller receives cash flows that match the interest and principal payments plus the gains (minus the losses) of the underlying instrument. As in the CDS, the TRS can involve counterparty risk in addition to the risk of the underlying instrument. Also, as in the CDS, the TRS usually allows the protection buyer to cancel the agreement. A total return swap is a type of credit derivative. It is an agreement to exchange total return on a bond (or any asset) for LIBOR plus a spread. The total return includes coupons, interest, and the gain or loss on the asset over the life of the swap.
At the end of the life of the swap there is a payment reflecting the change in the value of the bond, and subsequent payments are made. This swap can be seen from 2 angles. For the payer of the bond, he gets a hedge against the uncertainties in bond value for paying a premium above LIBOR. For the receiver of the bond, this transaction is equivalent to invest in the reference bond by borrowing at the rate equal to LIBOR + premium. Collateralized Debt Obligations (CDOs) CDO is a way of creating securities with widely different risk characteristics from a portfolio of debt instruments. An example is shown below. In this, 4 types of securities are created from a portfolio of bonds. The first basket has 5% of total bond principle and absorbs all credit losses from the portfolio during the life of the CDO until they have reached 5% of total bond principle. The
second basket has 10% of total principal and absorbs all loses in excess of 5% up to maximum 15%. The third basket has principal up to 10% and absorbs all the losses in excess of 15% up to maximum 25%. The 4rth basket has 75% of the principal amount and absorbs the residual losses. The yields specified are the returns the investors are going to get in those specific baskets. For e.g. the investor in the first basket is going to get 35% on his initial investment. Once the value of total portfolio descends by 1%, his investment goes down by 20%, the next time he is going to get 35% on 80% of his investment.
Bond 1 Bond 2 Bond 3 . . . Bond n Average Yield 8%
1st 5%loss Yield 35% 2nd 10% loss, yield 15% 3rd 10%loss Yield 7.5% Residual loss, yield 6%
Trust
Other Instruments
CREDIT CARD The credit card is an example of a common credit instrument. Using a credit card to pay for a purchase creates a contract between the buyer and the seller. Essentially, the seller is extending credit to the buyer with the assumption that the company issuing the card will cover the amount of the purchase. In turn, the issuer of the credit card is anticipating that the cardholder will eventually pay off the amount of the debt along with applicable interest and finance charges. With this arrangement, credit card holders receive credit from the lenders with the understanding that the same will be repaid in full at a
future point in time. This type of obligation may carry a specific date for repayment and if the credit card holder is liable for a penalty. There are two main advantages to the use of a credit card. First, the consumer does not have to carry a great deal of currency in order to make purchases. Second, a credit card can usually be replaced with relative ease when damage, loss, or theft of the instrument takes place. This is in contrast to cash, which usually cannot be replaced when damaged, stolen, or lost. MULTI-OPTION CREDIT FACILITY (MOF) In a multi-option credit facility (MOF), the borrower has access to a range of instrument types within a single facility or contract. In this case, the creditor commits to provide credit up to a maximum amount, which can amortize over time, to be drawn on in various ways largely at the borrower’s discretion. In a more general case, the borrower can receive a term loan and then, as needed, obtain additional credit up to the remaining commitment amount. This additional credit can take the form of additional funded balances (revolvers), letters of credit, bankers’ acceptances, or some combination of these types. Of course, an MOF can offer less than the full menu of instrument types. BANKER’S ACCEPTANCE (BA) A banker’s acceptance (BA) is another type of payment guarantee. A short-term credit investment created by a non-financial firm and guaranteed by a bank. A banker's acceptance or BA is a time draft drawn on and accepted by a bank. In a BA, the bank certifies that it will stand behind time drafts (usually post-dated cheques) issued by a customer. The customer may then sell drafts endorsed as accepted by the bank at a discount to a funding source that does not want to bear the issuer’s credit risk. Before acceptance, the draft is not an obligation of the bank; it is merely an order by the drawer to the bank to pay a specified sum of money on a specified date to a named person or to the bearer of the draft. Upon acceptance, which occurs when an authorized bank accepts and signs it, the draft becomes a primary and unconditional liability of the bank. If the bank is well known and enjoys a good reputation, the accepted draft may be readily sold in an active market. Acceptances are traded at a discount from face value on the secondary market. Banker's acceptances are very similar to T-bills and are often used in money market funds.
