Basic Principles of Sound Lending
Introduction • •
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Credit is the key contributor to a bank’s profitability. The major portion of the bank’s funds is employed by way way of loans and advances, which is the most profit p rofitable able employment of its funds. Thus lending is a crucial activity ac tivity for a bank enabling it to generate income. income. The business of lending is subject to certain inherent risks. To sustain income generation while mitigating such risks, prudent decisions need to be taken prior to and after sanctioning the credit. c redit. These decisions generally relate relate to the size, security and repayment of credit to be extended extended during a financial year, year, the industries to focus on , the geographical spread, type of credit to offer, type of proposals to finance, disbursal mechanism, collateral collateral value, pricing method, repayment repayment schedule, monitoring process etc. The macro and micro level policies of the lending activity contribute to the achievement achievement of the bank’s financial objectives. The bank’s management management ensures that the lending decisions are within bank’s bank’s overall objectives of growth and stability. The bank’s bank’s Loan Policy is guided by the RBI’s RBI’s policies, which seeks to integrate integrate the credit policy of the banking system system as a whole within its framework of growth with stability. While formulating formulating the credit policy is a crucial step, delivering the credit to the
Introduction • • •
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Thus, the role of field functionaries is very important as a proper delivery channel. Banking operations have two critical aspects. At the macro level, the credit operations of the banks lead to a surplus position or a shortfall in the same. While the surplus position may lead to a decline on o n the interest rates, rates, a tight money position will result in a rising interest rate rate scenario thereby affecting affecting the cost of credit and the overall performance of various industries. At the micro level, the bank’s bank’s operations should also ensure profitability and adequate liquidity. To attain this, the operations of the bank should set a trade-off between the profitability and liquidity. Excess profitability profitability at the cost of liquidity will lead to an enhanced level of liquidity risk, which may be detrimental for the long term viability of the bank. Similarly, excess liquidity may affect the profitability of the bank since the cost of idle funds may eat into the profits. Thus, while lending, the bank should essentially try to balance its spreads, liquidity and risk levels. The bank will have to take calculated risks and arrive at an ideal credit portfolio. In the forthcoming pages we will will look at the basic principles of o f lending that help the
Principles of sound lending •
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The lending activity of the bank is subject subject to certain certain sound principles. Because the business of lending is subject to inherent risks especially when the lending banks depend largely on the borrowed funds. As such credit management is based on principles of sound lending.
a) Safety •
Banks are trustee of public money. Bank’s deposits are always payable on demand. Bank has to maintain trust of depositor for ever. ever. As such the first and foremost principle of lending is to ensure safety of funds lent.
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By safety means that the borrower is in a position to repay the loan, along with interest.
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Further, it is just not the capacity of the borrower to repay but also his willingness to repay.
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The former depends on his tangible assets and the success of his business.
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The latter depends on the borrower’s character.
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The banker should lend to a reliable customer who can and will repay the loan within the prescribed period of time after generating generating surplus from business such that doubtful debts are avoided. In practice, banks ensure that they adhere to this principle by taking collateral collateral security that is marketable, marketable, apart from primary security, security, which the bank can dispose off in the event of default. In more recent times, bankers have begun to concentrate more on the business aspect of the borrower, i.e., the purpose and viability of the business rather than on the collaterals. collaterals. Thus, bankers bankers have begun to treat the entire business as security and in this manner moved away from the traditional concept of collaterals. collaterals.
Principles of sound lending •
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b) Liquidity The term liquidity refers to the extent of availability of funds with the banker for providing credit to borrowers.
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It is to be seen that money lent is not going to be locked up for a long time.
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The money should return to the bank as per the repayment schedule.
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This schedule that is drawn up by the banker has to adhere to the requirement that at any point of time the banker should possess liquidity to meet the withdrawals of the depositors. It is to be kept in mind that various deposits have various maturities and some of it would also be payable on demand. A bank’s bank’s inability to meet the t he demand of its i ts depositors can lead to a run on the bank which is a threat to its basic survival. surv ival.
Hence the banker has to always monitor the cash flows and carry out the exercise of ensuring liquidity with the t he borrower as this in turn means liquidity with the banker. banker. Further, Further, liquidity would also refer to the quality of assets, which should be easily convertible into cash without any loss of value.
Principles of sound lending c) Profitability Profitability •
Bank are not charitable institutions. All banks are profit-earning institutions.
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The ultimate objective of lending is to earn profits.
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Banks receive interest interest on loans and advances lent, and they pay interest interest to their depositors.
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This difference between the receipts and payments will be the bank’s gross profit.
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Banks further incur various expenses as any organisation does.
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After accounting for all such expenses and provisions, banks have to earn a reasonable amount as net profit (NIM) so that dividends can be paid to its shareholders. The trust and confidence level of the customer cu stomer and investor investor will be high with a bank that has a good track record of profits and dividend rates. Hence it is important that whatever whatever the business the bank engages itself with, the business be profitable enough not just to cover its costs but to ensure generation of surplus funds or margin.
Principles of sound lending c) Profitability Profitability •
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It is also a recent practice to analyse the profitabi p rofitability lity of operations vis-à-vis particular customers. customers. This approach, known as the Customer Profitability Profitability Analysis (CPA), enables the banker to decide the extent extent to which he can compromise on the profitability aspect so that a competitive rate can be offered to customer. This analysis is done d one when more than one service is offered offered by the bank and to attract more customers. In the current context of the availability of freedom to a banker in the matter of pricing credit and services, a very conscious and careful exercise exercise is called for on his part in order to strike a proper balance between the twin aims of making a desirable level level of profit and at the same time offering offering a competitive price for the product/service. This is the kind of approach that is required of a banker in order to entice new customers to his fold while retaining the existing customers. There is a direct relationship between profit and pricing of service offered by the banker.
Principles of sound lending •
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d) Purpose
While lending the funds, the banker enquires enquires from the borrower the purpose for which he seeks the loan. Banks do not grant loans for each and every purpose. They ensure the safety and liquidity of their funds by granting g ranting loans only for productive purposes. The funds lent should be put to optimum use. Loans are not to be granted for speculative and unproductive purposes like hoarding stock or for anti-social activities, since apart a part from the morality of such activities, there are also inherent risks involved with regard to the repayment of such loans. Loans that are meant for personal expenditure like like marriage cane be refused. In some cases, the banks grant loans for personal expenditure expenditure and for short/medium term like for education etc. Loans are now available for varied purposes these days.
Principles of sound lending •
e) Security
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The security offered against the loans may consist of a large variety of items.
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It may be a plot of land, building, flat, gold ornaments, insurance policies, term deposits etc.
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There may even even be cases where there is no security at all.
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The banker must realise realise that is it only a cushion to fall back upon in case of need.
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The security and its adequacy alone should not form the sole consideration for judging the viability of a loan proposal. Nevertheless, Nevertheless, the security if accepted a ccepted must be adequate and readily marketable, marketable, easy to handle and free from encumbrances. It is the duty of the banker to check the nature of the security and assess whether it is adequate for the loan granted. Apart from the collateral, the banker has also to consider other factors factors such as capital of the borrower, his character and capacity. The evaluation of the borrower is an important activity of the banker and this topic
Principles of sound lending •
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f) Risk management through diversification diversification A prudent banker always tries to select the borrower very carefully and takes tangible assets as security to safeguard safeguard his interests. While this is no doubt an adequate measure, there are other unforeseen contingencies against which the banker has to guard himself. himself. Further if the bank lends large amounts to a single industry or borrower, then the default by that customer can affect the banking industry as a whole and will affect the basic survival of the industry. industry. To safeguard his interest against all such risks, the banker follows the principle of diversification diversification of risks based on the famous maxim ‘never keep keep all the eggs in one basket’. By lending funds to different sectors, a bank can save itself from the slump in some sectors by way of prosperity in the others. Banks have to lend to a large number of industries and borrowers borrowers so that the risk gets diversified.
Evaluation of Borrower •
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It is of utmost importance that the banker assesses his borrower well. As mentioned above, the borrower should not only have the capacity to repay as per bank’s requirements but should also have the willingness to repay. repay. There are certain important checkpoints that the banker has to go through to ensure this. They may be referred referred to as the 6 Cs and they are as follows: a) Character – Character – The banker has to ensure that the person is of integrity. He should assess the personal characteristics which include honesty, attitude, willingness and commitment to repay debts. There is however no set guidelines to carry out such an assessment. The characteristics are very personal in nature and in fact it may not be possible to carry out a fool-proof analysis. The banker should nevertheless carry out this assessment with sincerity. b) Capacity – Capacity – This includes the evaluation whether the t he borrower has the potential to repay the loan from his own resources. It includes the borrower’s success in running in business or managing his cash flows. Capacity of o f physical assets, plants and equipment, cash flows etc are usually taken into account in this regard. Banks normally insist upon their prospective borrowers to submit their financial statements in order to determine their creditworthiness. The importance of financial statements in this regard will be dealt with in the forthcoming units. c) Capital – Capital – The financial strength of the borrower or his net worth is carefully studied by the t he banker. banker. It represents the amount of equity capital that a firm can liquidate for payment of debt n the eventuality of call other means failing. The amount of the borrower’s bo rrower’s capital in relation to debt is relatively easy to compute. However, However, the valuation of underlying assets in which capital is invested is a complex but vital exercise and has to be carried out. d) Conditions – Conditions – The banker has to assess the conditions in which the borrower is operating his business. A STEP analysis may come in handy in this regard. STEP stands for Social, Technological, Economic and Political conditions. The market potential of the product, the competitiveness of the firm in the market, the growth prospects and other such factors influence the borrower’s ability to repay the debt. The banker must also consider external factors that maybe beyond the control of the firm but may nevertheless affect the business. e) Collateral – Collateral – Banker has to ensure safety of funds lent as seen in the portio n on principles of lending. One of the ways that the banker ensures this is by retaining collateral other than the primary security. security. The possibility that the borrower may lose the collateral may in fact act as an incentive for him to repay his debt. f) Compliance – Compliance – The loan, which is to be given g iven to the borrower, borrower, should be in accordance with the rules and regulations as stipulated. Banker has to ensure that all the formalities are met as its absence may cause a concern for recovery of the loan. Hence to safeguard this interest banker has to conform to the guidelines issued by the government and regulatory authorities.
Types of Securities •
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As discussed earlier, earlier, banks are financial intermediaries whose resources are mobilized from public and lent to various sectors of the economy. The money mobilized mobilized from the public by way of deposits is repayable on demand. Hence, bankers have to take utmost care to ensure that they are in a position to meet such demand at any given point of time. For this, banks secure their advances with appropriate securities. By practice, the securities offered by the borrowers are of different types. They may be immovable or movable security, security, debts etc. The land and buildings, machineries embedded to earth etc. come under the category of immovable, whereas goods, vehicles, furniture, machineries, gold ornaments etc. come under the category of movable security. Accounts receivables receivables also known as book debts are classified as intangible security. security. Classification of security may also be as personal and tangible as well as primary and collateral. Personal security refers to personal liability. The bank has a right of action against the borrower, e.g. guarantee. Tangible security is something that can be realised by a sale or transfer, e.g. land, goods, stock etc. Primary security is one that is registered as the main cover for an advance; generally, assets against which advance is made. For example, stock for cash credit, machinery for term loans. Collateral Collateral security is security other than the primary security lodged by the borrower or by a third party. party. While granting advances on the basis of any type of security as above, a banker
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a) Adequacy of margin: In banking terminology, ‘margin’ refers to the difference between the market value of the security and the amount of advance granted against it. Banker needs to keep adequate margin because of the following reasons: i) The market value of the securities is liable to fluctuations in the future with the result that the banker’s secured loans may turn into partly secured ones. ii) The liability of the borrower towards the banker increases gradually as interest accrues and other charges become payable by him. b) Marketability of security: If the borrower defaults in making payment, the banker has to liquidate the security to make good his funds. For this, the security has to be marketable. As discussed earlier this is one of the basic principles of lending. c) Documentation: Documents that are prepared and signed by the borrower at the time of securing the loan is of much significance as these documents contain all the terms and conditions on which a loan is sanctioned by the banker. Hence, any misunderstanding or dispute later on may easily be avoided or
Credit Deployment •
Deployment or disbursement or dispensation of credit is the key factor for a bank’ ban k’ss profitability profitabil ity.. There There are different types of credit, and each type of credit is characterized characterized by certain unique factors. factors. Loan is a broad term used to explain the different types of credit facilities – facilities – short/medium/long term extended in the credit market. For the customer or borrower, the selection of the type of credit will depend on three factors namely, cost of credit, need for credit and cash flow requirements. requirements. Since a loan has a demand and supply side as well, they can be classified accordingly. accordingly. Demand side loans will be individual loans while the supply side loans would be commercial loans. For the banks, the classification will depend on three factors, factors, namely nature of credit, type of security and purpose of loan. Loans are also further classified into secured and unsecured loans. Thus there are numerous considerations considerations that are of significance when it comes to credit
Credit Management •
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Credit management applies to all types of credit and to the entire gamut of related operations. It comprises of activities under the four areas: Credit Allocation, Credit evaluation, evaluation, Credit Discipline and Credit Credit Monitoring. Under credit allocation, the focus is on the exposure limits of banks both in terms of the activities for which the funds are being lent and also the sectoral sectoral allocation of funds. Credit Evaluation should be based on Credit Appraisal Standards. Credit Discipline is to explain the importance of norms in giving fresh loans as well as for takeover of advances. Credit monitoring refers to the activity that a banker has to start immediately after the
Credit Allocation •
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The basic objective of a credit policy aims at avoiding large concentration of loans and looks for an optimal spread of the loan portfolio. In this regard, the primary guiding factors for fixing a ceiling on the exposure are the prudential exposure norms prescribed by RBI, which is firstly 15% of capital funds (Tier I and Tier II capital) for individual exposures and secondly 40% of capital funds (Tier I and Tier II capital) for group exposures. While the prudential guidelines serve as a broad indicator for avoiding concentration of assets, there are various other factors such as market conditions, government policies, the legal framework, economic indicators, stock market movements etc. Another factor that determines the exposure limits to a particular industry is the strength of management of the particular unit in the industry. Thus, there are several factors that have to be taken into consideration at the time of credit allocation. allocation. It is however however a very significant significant activity as it effectively covers various aspects relating to the extent to which credit portfolio can be quantitatively disbursed.
Credit Evaluation •
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Over a period of time, banks have developed credit appraisal methodology that is not only scientific but also practical. It is being constantly improved in the light of new experiences gained in this regard. Both fund based and non-fund based, and term credit facilities have survived the test of time and are now well comprehended. However certain Qualitative and quantitative aspects are taken into account while evaluating a proposal. Qualitative: This parameter at the outset is examined from both the angle of the borrower (as seen in the section on evaluation of borrower) and also from the bank’s point of view based on its prudential levels of exposure to the borrower, group and industry. Quantitative: The parameters in this regard are based in financial statements which are critical in understanding the financial position of the business concern. They show whether the firm is making a profit, how much debt the firm has relative to assets, and how the cash in the business is being used. The analysis of financial statements is carried out using several techniques which
re t rat ng o t e orrower •
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The need to rate the borrower is basically a pre-sanction process to enable the banker to take decision whether to grant loan to the borrower and if yes, what should the price be. Financial parameters such as measurement through ratios and compliance parameters that take into consideration general information regarding the enterprise such as stock statements being submitted submitted on time, and submission of periodical reports, are analysed. Credit proposals proposals also pass through the credit risk assessment process and then the computation of risk gradation is done. After determining the risks involved in a credit proposal a decision with regard to the price to be charged can be taken. All kinds of risks such as management risks, business risks, financial risks and project risks are taken into view. While financial risks are easily quantified, quantified, the quantification quantification of non-financial risks is quite subjective, to avoid much scope for subjectivity during credit analysis, the parameters are broken down to their minute details. Final grading is done after the individual sub parameters under the different types of risks have been scored. The final score is then compared to the benchmark score and the bank then decides about the spread to be maintained on this basis.
Credit Discipline •
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Banks perform the basic functions of a financial intermediary by accepting deposits and issuing loans. Considering that the maturity periods of deposits and advances vary, successful credit management depends on the level of credit discipline that a bank imposes. Strict discipline is not only required to overcome mismatches in maturity between deposits and advances but also other factors such as specific types of advances (as in takeover of advances) and specific types of borrowers (as in case of companies). The maturities of different components of a bank’s credit portfolio are determined based in the composition of its resource pool. The asset portfolio is concentrated around working capital financing which is essentially a type of revolving credit. The actual amount of credit to the customer is determined by the asset base of the borrower, which includes current assets. Any additional requirements or downward revisions in sanctioned limits are considered at the time of annual renewal of the advance. Any excess liquidity during the short-term is generally deployed in loans maturing within a short period like bridge loans, bills financing etc. Loan Pricing : this can be divided into Interest pricing and non-interest pricing. In cases where loans up to Rs.2 Lakhs, RBI regulations will be complied with and tenor linked to PLR is announced time to time. In cases of discounting of bills, lending to intermediary agencies etc, interest rates that are not linked to PLR are charged. Banks also charge fixed interest rates in respect of certain loans in the personal segment. In the case of commercial loans also fixed interest rates are extended, albeit selectively. selectively. Renewal of advances : generally, working capital facilities are sanctioned by the bank for a period of 1 year and thereafter the limits are required to be renewed every year, i.e. fresh sanction is accorded each year for the existing limits. Where, however, renewal is not done for some reasons, sanction for the continuance of the existing limits is obtained in each case by reviewing the facilities. As regards term loans, these are required to be reviewed once in a year. For the purpose of this review, respective banks have devised a separate authority structure. today. One such strategy for Takeover of advances : Banks are required to aggressively market for good quality advances today. improving the quality of assets in a bank’s loan portfolio is to takeover advances outstanding in other banks/FIs. Advances t o be taken over should be rated ‘good’ or above and the asset should have remained a standard asset in the books for atleast preceding 3 months. Any term loan which is to be taken over should not have been rephrased earlier ear lier.. In case of all takeover proposals, generally banks insist for prior approval from the appropriate authority, which may be the Regional manager/ GM/ Board of the Bank. Generally, Generally, this strategy is not encouraged, except under exceptional circumstances circumstances in consideration of larger business intere st and valuable connections. RBI has also advised banks that any fresh limit/renewal/enhancement in the case of willful defaulters may be considered which
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Credit Monitoring
There are three types of follow-up that constitute Credit Monitoring: Financial follow-up, Physical follow-up and Legal follow-up. Following are the basic elements: To ensure that the post sanction review of the loan shall indicate the financial health code of the bank as good by virtue of the assets , which are kept as the securities, remaining good and not depreciating excessively. To ensure proper documentation docu mentation is maintained such that the securities are safe and protected especially in times of recovery. recovery. To verify whether all the terms and conditions of sanction are met with and in case of deviation report to the sanctioning authority so that needful steps can be taken by them. Thus, there will be no communication gap between the sanctioning authorities and the branches. To undertake periodic review of control returns such as stock statements, financial statements and any caution signals that are emanated are to be analysed in the early stages so that the health of the loan remains good. To undertake a constant review of the financial statements in order to ensure that the funds are utilised properly and there is no diversion of funds. To undertake periodical mid-term reviews to check the financial health of the th e unit and take timely steps to see that loans given do not deteriorate in quality. quality. Under the Credit Monitoring Arrangement, banks ensure the following: Borrower should maintain reasonable estimates of current cur rent assets, current liabilities and working capital. Should maintain classification of current assets and current liabilities as per bank’s guidelines. Should maintain a minimum current ratio of 1.33 except for export industry and for new units. Should submit annual audit accounts in time for annual review by banks. Ad hoc limits are sanctioned for periods not exceeding three months. As far as possible, post-sale limits are sanctioned in the form of Bill Finance.
