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Module I: Overview of Credit Analysis Credit Process, Credit Analysis, Credit Analysis Process, Lending Process and Documentation. Study Material Part 1

This chapter is devoted to a description of the main components of the credit process for a company or a project. This chapter describes the basic elements of a quality credit process. and importance of each component of the credit process. It also explains the critical importance of the identification, measurement and evaluation of risk in the credit process. Finally we discuss how to evaluate the quality of the credit process.

The Credit Process

The credit process begins with a thorough analysis of the borrowers creditworthiness, or capacity and willingness to repay the loan. The examiner should find an assessment by the credit officer of: The borrowers current and expected financial condition. The borrowers ability to withstand adverse conditions or stress. The borrowers credit history and a positive correlation between historical and projected repayment capacity. The optimal loan structure, including loan amortization, covenants, reporting requirements the underwriting elements. Collateral pledged by the borrower amount, quality and liquidity; bank ability to realize the collateral under the worst case scenario. And, Qualitative factors, such as management, the industry and the state of the economy.

This process begins with the collection, analysis and evaluation of information required to determine the creditworthiness of the borrower seeking credit from the bank. After the credit analysis is completed and borrower has been determined to be an acceptable risk, the credit

officer proposes a loan structure for approval that preserves the strengths and protects against identified weaknesses of the borrower. The process ends with determination of a risk rating for the credit and loan approval (or rejection). The banks credit policy, lending standards and procedures create the parameters for this process, thereby establishing the banks appetite for risk, conservative or aggressive. The credit policy and standards should define acceptable loan purposes, types of loans and loan structures, and industries to which the bank is willing to lend, as well as the types of information the lender is required to obtain and analyze. The policy and standards help to create the framework, requirements and tolerance limits for lending in which all bank credit personnel will engage. The lender must understand the banks credit risk management system and his/her role in it, as s/he engages in lending activities analysis, underwriting and monitoring.

The Credit Initiation and Analysis Process

The objective of the credit initiation and analysis process is to ensure that loans extended by the bank meet credit policy guidelines and that credit standards and procedures established in the credit policy are observed in all geographic areas where the bank is active. The credit policy, updated periodically as necessary, should clarify what types of loans are acceptable to the bank, what loan purposes, tenor, collateral, structure, and guarantees the bank will accept in its lending activities. In other words, the credit policy establishes threshold requirements that any prospective borrower must meet. The credit initiation and analysis process should follow a typical diagnostic process flow, beginning with screening of potential customers and data collection, followed by identification, analysis and measurement of risks, and then moving to a series of specific risk evaluation and risk mitigation actions in preparing for a credit decision, as shown on the following page.

Analysis of risks associated with any borrower should focus on the four foundations of creditworthiness, shown below: Industry involves the industry dynamics and the companys position within the industry. Weakness in the industry itself can significantly impact loan repayment ability and the companys position within the industry is an important issue. Financial Condition focuses on the borrowers ability to generate sufficient cash, the first source of loan repayment, or to draw on existing resources, e.g., capital or assets, to repay bank borrowings. The credit analyst examines the income statement, the balance sheet and the cash

flow statement to evaluate this foundation of creditworthiness, focusing on profitability, efficiency, liquidity, and leverage, in particular. Management Quality entails the competence, integrity and alliances of the key individuals running the company. Management weakness or dishonesty can have an impact on both repayment capacity and security realization. Depth of management is always a concern, especially in smaller, family run organizations. Security Realization determines the level of the banks control over collateral and the likely liquidation value, factoring in time, i.e., net present value. Weakness in security realization threatens the second source of loan repayment. As a potential lender in India the financial institutions are facing difficult times in evaluating following sectors of the economy today: Oil Retail Information Technology Civil Aviation & Telecommunications

The lender must understand the strength and weakness of each industry and the credit officer must have strong knowledge of the industry in which the borrower operates, in order to assess the key industry factors that impact the borrower today and may influence the borrower tomorrow. Key factors may include the level of competition, domestic and foreign, barriers to entry, government regulation, labor relations in the industry, cyclicality of the industry, and others. Analysis of the financial condition of the borrower may require an extensive effort, depending on the size and complexity of the borrowers business. The more complex the borrower, the more difficult it will be to analyze the financial statements and understand the interrelationship among the balance sheet, income statement and cash flow statement. If the borrower is part of a larger corporate structure, it will require an experienced lender, perhaps even a team of lenders, to fully understand the borrowers financial condition. Evaluation of the competence, capability and honesty of management requires serious due diligence on the part of the lender. This evaluation requires an experienced lender who is capable

of probing into the borrowers relationships with customers, suppliers and other creditors in order to understand the borrowers business relationships. Does the borrower enjoy a good reputation in its industry? Does it have longstanding customer relationships? At the same time, the lender must evaluate the skill and competence of management. Has management experienced several business cycles? Is management respected in its industry? Does the borrower have longstanding supplier and customer relationships? What is the history of the borrowers banking relationships? Does the owner hire competent managers and other pesonnel around him/her? Has the owner planned for succession? Is personnel turnover high? In the end, the management factor is the most important of the four credit foundations. In the absence of competent, skilled, honest management (or an owner), in whom the bank has confidence, the loan should not be approved, even if all other factors are rated excellent. Management/the owner is in control and decides if and when to repay loans. The credit analyst or officer must investigate the security or collateral that the borrower proposes to provide as support for the extension of credit and assure himself/herself of the value of the collateral in a liquidation scenario. In the worst case, what can the lender realistically expect to realize from sale of the collateral? The time value of money should also be factored in, especially if the collateral is real estate or a fixed asset whose sale is time consuming. There should be evidence in the credit file of each borrower that the credit analyst and/or officer has thoroughly analyzed the four credit foundations and identified the strengths and weaknesses of each foundation in relation to the borrower. Once the analysis is complete, the internal credit risk rating should be assigned as the culmination of the analysis. The banks credit policy should provide detailed guidance on assigning borrower risk ratings, including both quantitative and qualitative factors.

Credit Underwriting
Credit underwriting is the process that banks undertake to structure a credit facility to minimize risks and generate the best return, given the risks that the banks assume. The credit structure includes the term of the loan, collateral required, amortization requirement, timing of interest payments, and reporting requirements.

Best underwriting practices include protections for the bank to mitigate the risks and increase the likelihood of loan repayment. Such protections include verification of cash flow to meet loan servicing requirements, proper loan covenants to preserve borrower strengths and limit weaknesses, and the requirement for sufficient, verified collateral and/or guarantees to provide a secondary or even tertiary repayment source. Underwriting also includes the reporting required of the borrower during the life of the loan. The higher the risk identified in the credit, the more information will be required and the greater the frequency of the information. This reporting forms the basis of post-disbursement loan monitoring. The structure of the loan is based on the analysis of the four credit foundations and should be approved in accordance with the credit authorities and approval procedures established in the credit policy. The credit approval should also include confirmation of the borrowers credit risk rating and requirements for monitoring proposed by the credit officer. The higher the risk, the more stringent the monitoring requirements should be. For example, monthly rather than quarterly financial statements might be required. Loan disbursement should occur once all required documents have been signed and delivered to the bank. The loan documents comprise the banks primary protection once the loan has been disbursed. If they are not in perfect order, there is potential for problems until the loan is repaid.

The loan agreement, a legal document binding both parties, is the key document for the lender. It should be designed to control the borrower and contain protections for the bank. These protections include such items as conditions under which the bank will make funds available and covenants to ensure that borrower strengths are preserved and weaknesses are contained. The strengths and weaknesses should have been clearly identified earlier in the credit process, quantified and then reflected in the loan agreement to mitigate the lenders risk and exercise control.

The loan agreement becomes the primary monitoring tool for the lender, as it contains all of the requirements that the borrower must fulfill until the loan has been repaid in full. Generally, each bank will have its own loan template that is modified to fit the particular borrower

circumstances. In the case of large, complex credits, the lender may work with the banks internal legal department or even outside counsel, in order to ensure that the loan agreement contains all possible protections for the bank.

Breach of Loan Covenants

A breach of a loan covenant usually triggers a default of the loan. However, most banks prefer to negotiate a fee-based waiver of the default so long as the ultimate repayment of the loan is relatively assured. Some common loan covenants are: Cash flow (earnings before interest, taxes, depreciation and amortization, and capital expenditures so called EBITDA) must cover debt service by 1.2x or more. Leverage as measured by debt/equity cannot exceed a pre-set number, such as 100%. In addition, some banks require their pre-approval before the borrower can incur additional debt of any kind. Maintenance of minimum current or quick asset ratios at no less than 1.00 and 0.70 respectively. Minimum sales or net income. Maintenance of an external credit rating above a set level, typically investment grade.

Loan Monitoring
Once loans are disbursed, the monitoring process begins. The purpose of loan monitoring is to identify as soon as possible any changes in the borrowers financial condition or performance that impact, or may impact, the borrowers capacity to repay the outstanding loan(s) to the bank as agreed. As noted above, the primary monitoring tool is the loan agreement. The monitoring process is based on the weaknesses identified during the credit initiation and analysis phase. These may be weaknesses in the borrowers industry, financial condition or performance, changes in which could impact the borrowers capacity to repay the loan in accordance with the credit agreement. The lender should actively monitor the borrowers strengths and, particularly, the weaknesses identified during the underwriting process on a

regular basis. The greater the weaknesses identified, the more frequent the monitoring. And, if new or worsening weaknesses are identified, the monitoring should be more frequent. Typically, the credit agreement requires the borrower to submit financial and other information on a regular basis. Generally, the higher the credit risk, the more often information is required by the bank. In addition to this regular flow of information, the lender contacts the borrower by phone, in person or today by email to track how the borrower is performing. The credit file should contain evidence of monitoring by the credit officer: site visits, phone calls, interim financial reporting, and annual financial statements. Of course, the best indicator of performance are loan and interest payments in accordance with the credit agreement, although on-time payments are NOT a guarantee that there are no credit problems. The key to effective monitoring is regular, close customer contact and receipt of financial statements to ensure that the bank has current knowledge of borrower activities. Based on direct customer information, the analytical framework developed during the credit initiation and analysis phase should be used to track borrower performance. The credit officer should monitor any previously identified weaknesses closely and track identified strengths for deterioration. The bank/lender should pay particularly close attention to preserving the two sources of loan repayment cash flow and security realization. The primary monitoring tool, the loan agreement, should stipulate the requirements for information that the borrower must provide: types of information and frequency of submission. The loan agreement should also contain covenants that the borrower must observe during the life of the loan. Such covenants may include requirements to observe certain ratios, such as leverage and liquidity, at all times. They may also include certain prohibitions, such as loans to company owners or officers, owner salaries or purchase of equipment without the written consent of the lender. Once deterioration or negative changes are identified, the bank/lender must determine whether or not the changes are material enough to affect repayment capacity and, therefore, effect a change in the risk rating. A truly material change may even represent a loan default, a violation of the credit agreement (the so-called MAC or Material Adverse Change clause), which would give the bank an opportunity to restructure the credit.

A change in the risk rating sets in motion a series of other actions, including an increase in the loan loss reserve, as stipulated by the credit policy and central bank regulations. Other actions may include the demand for additional collateral, an increase in the interest rate, even demand for immediate loan repayment, calling the loan. Depending on the severity of the changes identified and the subsequent change in the risk rating, an action plan for the restoration of the credit risk rating should be developed, approved and executed. When a company publishes financial information infrequently, or when the reliability of the information is in doubt, banks turn to alternative sources of information. For example: VAT tax remittances as a measure of turn-over Monthly listing of accounts receivable to measure turn-over and cash generated from sales Rent rolls and copies of leases to monitor the performance of commercial real estate Court records to identify delinquent payments of taxes or payables to trade creditors

Credit Workout (Problem Loans)

Credit workout, or working with problem loans, should be covered in detail in the banks credit policy. The process for dealing with borrowers whose capacity to repay is in doubt or has become impaired is the subject. Banks have different methods for managing problem loans. Sometimes the responsibility lies with the originating loan unit, sometimes it lies with a special workout unit. The more complex the problem credit and the more bank departments that service the borrower, the greater the likelihood that a special workout unit will be charged with the responsibility of handling the loan. The banks credit policy will dictate the methodology for working with problem loans. There must be a mechanism for formal identification of a problem loan, such as a watch list and a watch list committee of problem credits. This mechanism is part of the process of informing senior management of the problem, so that a decision can be made about bank action as soon as possible. Generally, when a credit is placed on the watch list, it receives a risk

rating downgrade and a higher reserve because the capacity to repay has been, or is on the verge of becoming, impaired. A watch list committee meets on a regular basis to monitor progress in managing the watch list loans. When a loan is placed on the watch list, an action plan should be agreed internally and with the borrower as soon as possible. The action plan should include specific actions or goals to be achieved by the borrower and a specific time frame for their achievement. Depending on the severity of the credit impairment, this plan will include either a rehabilitation strategy or an exit strategy, based on the banks determination of several factors: The probability of success of the strategy chosen, The level of cooperation expected from the borrower, Expenses likely to be incurred in implementing the strategy, and The present value of the recovery expected (if the recovery will require a significant amount of time).

Once the plan is agreed, plan implementation begins. However, unexpected events may cause modification of the plan over time. The key elements are an agreed plan and effective implementation, with constant monitoring of the situation. If it appears the borrower cannot meet the terms of a reasonable and realistic workout plan, foreclosure proceedings should be commenced. The bank should have a methodology for making either the rehabilitation or exit strategy decision. This methodology should be communicated to all lending units throughout the bank so that a uniform approach to managing problem loans can be adopted. Of course, each problem loan is unique in its own way, but a uniform initial approach is essential. Problem loans develop when credit weaknesses appear that impair, or will soon impair, the capacity of the borrower to repay. Successful loan workouts depend on early identification of credit weaknesses and adverse credit trends. This requires consistent loan monitoring to identify any deterioration in the borrowers creditworthiness that may cause a downgrade of the risk rating. Then, senior management must be informed promptly of the deterioration. Examiners should be alert to delays in reporting of problem credits to senior management because prompt action is crucial to successful management and recovery. Typically, the more time that elapses before action is taken, the greater the loss.

Examples of credit deterioration include a new import regulation that will impact an entire industry, fraud, loss of key management, loss of a critical contract or supplier, or a warehouse fire in which inventory was destroyed. There are a number of indicators of emerging or potential credit quality problems, such as: Entry of low-cost competitors An increase in the cost of production inputs and a limited ability to raise prices Labor disputes Changes in the tax or tariff structure Implementation of international agreements that change the fundamentals of the business, such as WTO Launch of substitute technology A fraud at the company, which may indicate weak internal controls and an increased risk that the financial results have been mis-represented A loss of key management, which may indicate internal political problems

Evaluation of the credit process

In order to evaluate the banks credit process, the examiner will first need to ascertain what kinds of lending activities the bank participates in. What the bank chooses to do sets the requirements for the specific types of risk management systems used. After determining the credit areas that will be the focus of the examination, the examiner will begin by reviewing the banks credit policy, standards and procedures. The policy, standards and procedures establish the banks credit risk management system, from the general to the specific. The examiner must determine whether or not the policy and credit risk management system it sets forth is adequate for the types of loans the bank extends to its customers, the banks credit risk profile. Further, the examiner must assess whether or not the credit process is adequate. Adequacy means that all of the necessary components of the credit process have been fully implemented, are routinely executed and verified independently. If the process includes a sound credit risk evaluation process that leads to justifiable internal credit risk ratings, then the examiner should do limited testing or validation of that process. If gaps or weak points in the process are evident, then the examiner should focus on those areas in the examination, discuss them with bank management and detail them in the examination report. The credit risk

management section of the supervisory plan should then focus on these areas and the examiner should monitor them, or perhaps even follow up with a targeted exam, until the bank has made the necessary improvements. This is the essence of risk-based supervision, focusing on weak points or gaps in the risk management system and monitoring them continuously until the examiner is satisfied that they have been corrected and the system as a whole is adequate and operating as it should. The goal is for the risk management system to be operating as intended by management, so that examiners need only validate during the examination that the process remains adequate to the risk profile of the bank and no serious weaknesses are evident. One of the primary validation actions is to test a sample of new loans to ensure that the current process remains adequate, that the loans are in compliance with the banks credit policy and procedures, and that the internal credit risk ratings are appropriate.

Chapter Summary
This chapter contained a description of the main components of the credit risk evaluation process. We discussed the basic elements of a quality credit risk evaluation process and explained the importance of each component of the credit risk evaluation process. We also discussed the critical importance of the identification, measurement and evaluation of risk in the credit risk evaluation process. We finally evaluated the quality of the credit risk evaluation process. Credit means an investigation/assessment done by the banks before providing any Loans & advances/project finance & also checks the commercial, financial & technical viability of the project proposed, its funding pattern & further checks the primary & collateral security cover available for recovery of such funds.



Credit Appraisal is a process to ascertain the risks associated with the extension of the credit facility. It is generally carried by the financial institutions, which are involved in providing financial funding to its customers. Credit risk is a risk related to non-repayment of the credit obtained by purchaser of a loan of a bank. Thus it is necessary to appraise the credibility of the customer in order to mitigate the credit risk. Proper evaluation of the customer is performed this measures the financial condition and the ability of the customer to repay back the Loan in future. Generally the credits facilities are extended against the security know as collateral. But even though the Loans are backed by the collateral, banks are normally interested in the actual Loan amount to be repaid along with the interest. Thus, the customer's cash flows are ascertained to ensure the timely payment of principal and the interest.

It is the process of appraising the credit worthiness of a Loan applicant. Factors like age, income, number of dependents, nature of employment, continuity of employment, repayment capacity, previous Loans, credit cards, etc. are taken into account while appraising the credit worthiness of a person. Every bank or lending institution has its own panel of officials for this purpose. However the 7 C of credit are crucial & relevant to all borrowers/ lending, which must be kept in mind, at all times:

1. Capacity Do I have experience running a business? Have I had this business for more than one year? Do I know this industry well? Do I have a good team working for me? Is the business operating well? 2. Cash Flow Is my business profitable? Do I have a bookkeeping system that will allow me to demonstrate this to the bank? Can I produce financial statements from this data? Is my cash flow sufficient to make the loan payments? 3. Capital Do I have sufficient reserves, or other people who could invest in the business, should unexpected problems or hard times arise?

4. Collateral Do I have collateral (business and/or personal) which I can offer? Is the property I own mine, or do I share it with my husband or family? 5. Character Can I show the bank that I am honest, and keep my promises? If I've had a loan or supplier credit before, did I always pay on time? Have I always paid my personal bills on time? Can I prove this to the bank? Do I have good references? 6. Conditions Is the industry that I am in a good one? Do I have a unique product or service which makes me different from my competitors? Is there growing demand for my products? Does a loan make sense for my business? 7. Commitment Am I committed to working hard so that my business will succeed? Do I really want it to grow? Have I put my own money into the business? If any one of these are missing in the equation then the lending officer must question the viability of credit. There is no guarantee to ensure a Loan does not run into problems; however if proper credit evaluation techniques and monitoring are implemented then naturally the Loan loss probability / problems will be minimized, which should be the objective of every lending Officer. Credit is the provision of resources (such as granting a Loan) by one party to another party where that second party does not reimburse the first party immediately, thereby generating a debt, and instead arranges either to repay or return those resources (or material(s) of equal value) at a later date. The first party is called a creditor, also known as a lender, while the second party is called a debtor, also known as a borrower.

Credit allows you to buy goods or commodities now, and pay for them later. We use credit to buy things with an agreement to repay the Loans over a period of time. The most common way to avail credit is by the use of credit cards. Other credit plans include personal Loans, home

Loans, vehicle Loans, student Loans, small business Loans, trade. A credit is a legal contract where one party receives resource or wealth from another party and promises to repay him on a future date along with interest. In simple Terms, a credit is an agreement of postponed payments of goods bought or Loan. With the issuance of a credit, a debt is formed.

Basic types of credit

There are four basic types of credit. By understanding how each works, you will be able to get the most for your money and avoid paying unnecessary charges.

Service credit is monthly payments for utilities such as telephone, gas, electricity, and water. You often have to pay a deposit, and you may pay a late charge if your payment is not on time.

Loans let you borrow cash. Loans can be for small or large amounts and for a few days or several years. Money can be repaid in one lump sum or in several regular payments until the amount you borrowed and the finance charges are paid in full. Loans can be secured or unsecured.

Installment credit may be described as buying on time, financing through the store or the easy payment plan. The borrower takes the goods home in exchange for a promise to pay later. Cars, major appliances, and furniture are often purchased this way. You usually sign a contract, make a down payment, and agree to pay the balance with a specified number of equal payments called installments. The finance charges are included in the payments. The item you purchase may be used as security for the Loan.

Credit cards are issued by individual retail stores, banks, or businesses. Using a credit card can be the equivalent of an interest-free Loan- end of each month.-if you pay for the use of it in full at the


Brief overview of Loans

Loans can be of two types fund base & non-fund base:

Fund Base includes: Working Capital Term Loan Non-fund Base includes:

Letter of Credit Bank Guarantee Bill Discounting

Fund Base:

Working capital

The objective of running any industry is earning profits. An industry will require funds to acquire fixed assets like land, building, plant, machinery, equipments, vehicles, tools etc., & also to run the business i.e. its day-to-day operations.

Funds required for day to-day working will be to finance production & sales. For production, funds are needed for purchase of raw materials/ stores/ fuel, for employment of labor, for power charges etc. financing the sales by way of sundry debtors/ receivables.

Capital or funds required for an industry can therefore be bifurcated as fixed capital & working capital. Working capital in this context is the excess of current assets over current liabilities. The

excess of current assets over current liabilities is treated as net, for storing finishing goods till they are sold out & for working capital or liquid surplus & represents that portion of the working capital, which has been provided from the long-Term source.

Term Loan A Term Loan is granted for a fixed Term of not less than 3 years intended normally for financing fixed assets acquired with a repayment schedule normally not exceeding 8 years.

A Term Loan is a Loan granted for the purpose of capital assets, such as purchase of land, construction of, buildings, purchase of machinery, modernization, renovation or rationalization of plant, & repayable from out of the future earning of the enterprise, in installments, as per a prearranged schedule. From the above definition, the following differences between a Term Loan & the working capital credit afforded by the Bank are apparent: o The purpose of the Term Loan is for acquisition of capital assets. o The Term Loan is an advance not repayable on demand but only in installments ranging over a period of years. o The repayment of Term Loan is not out of sale proceeds of the goods & commodities per se, whether given as security or not. The repayment should come out of the future cash accruals from the activity of the unit. o The security is not the readily saleable goods & commodities but the fixed assets of the units.

It may thus be observed that the scope & operation of the Term Loans are entirely different from those of the conventional working capital advances. The Banks commitment is for a long period & the risk involved is greater. An element of risk is inherent in any type of Loan because of the uncertainty of the repayment. Longer the duration of the credit, greater is the attendant uncertainty of repayment & consequently the risk involved also becomes greater.


However, it may be observed that Term Loans are not so lacking in liquidity as they appear to be. These Loans are subject to a definite repayment programme unlike short Term Loans for working capital (especially the cash credits) which are being renewed year after year. Term Loans would be repaid in a regular way from the anticipated income of the industry/ trade.

These distinctive characteristics of Term Loans distinguish them from the short Term credit granted by the banks & it becomes necessary therefore, to adopt a different approach in examining the applications of borrowers for such credit & for appraising such proposals.

The repayment of a Term Loan depends on the future income of the borrowing unit. Hence, the primary task of the bank before granting Term Loans is to assure itself that the anticipated income from the unit would provide the necessary amount for the repayment of the Loan. This will involve a detailed scrutiny of the scheme, its capital assets. Financial aspects, economic aspects, technical aspects, a projection of future trends of outputs & sales & estimates of cost, returns, flow of funds & profits.


Non-fund Base:
Letter of credit The expectation of the seller of any goods or services is that he should get the payment immediately on delivery of the same. This may not materialize if the seller & the buyer are at different places (either within the same country or in different countries). The seller desires to have an assurance for payment by the purchaser. At the same time the purchaser desires that the amount should be paid only when the goods are actually received. Here arises the need of Letter of Credit (LCs). The objective of LC is to provide a means of payment to the seller & the delivery of goods & services to the buyer at the same time.

Definition A Letter of Credit (LC) is an arrangement whereby a bank (the issuing bank) acting at the request & on the instructions of the customer (the applicant) or on its own behalf, o Is to make a payment to or to the order of a third party (the beneficiary), or is to accept & pay bills of exchange (drafts drawn by the beneficiary); or o Authorizes another bank to effect such payment, or to accept & pay such bills of exchanges (drafts); or o Authorizes another bank to negotiate the Terms & conditions of the credit are complied with. against stipulated document(s), provided that

Bank Guarantees: A contract of guarantee is defined as a contract to perform the promise or discharge the liability of the third person in case of the default. The parties to the contract of guarantees are: a) Applicant: The principal debtor person at whose request the guarantee is executed b) Beneficiary: Person to whom the guarantee is given & who can enforce it in case of default. c) Guarantee: The person who undertakes to discharge the obligations of the applicant in case of his default. Thus, guarantee is a collateral contract, consequential to a main co applicant & the beneficiary.

Purpose of Bank Guarantees Bank Guarantees are used to for both both preventive & remedial purposes. The guarantees executed by banks comprise both performance guarantees & financial guarantees. The guarantees are structured according to the Terms of agreement, viz., security, maturity & purpose.

Branches may issue guarantees generally for the following purposes: a) In lieu of security deposit/earnest money deposit for participating in tenders; b) Mobilization advance or advance money before commencement of the project by the contractor & for money to be received in various stages like plant layout, design/drawings in project finance; c) In respect of raw materials supplies or for advances by the buyers; d) In respect of due performance of specific contracts by the borrowers & for obtaining full payment of the bills; e) Performance guarantee for warranty period on completion of contract which would enable the suppliers to period to be over; realize the proceeds without waiting for warranty) To allow units to draw funds from time to time from the concerned indenters against part execution of contracts, etc. f) Bid bonds on behalf of exporters g) Export performance guarantees on behalf of exporters favoring the Customs Department under EPCG scheme.

Bill discounting:

Definition: As per Negotiable Instrument Act, The bill of exchange is an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of, a certain person, or to the bearer of that instrument.


Discounting of bill of exchange: A seller (Drawer) if need cash, may handover the B/E to the Bank, NBFC, a company or a high Net worth Individual and obtain ready cash this is known as discounting of bill. the practice in India is that, the financing organization holds the original B/E till the drawee pays on maturity. For discounting the bill, financiers charge an interest on the bill amount for the duration of the bill which is called discount charges.normal maturity periods are 30, 60, 90, 120 days.

Types of Bills 1. Demand Bill 2. Usance Bill 3. Documentary Bills a. Documents against acceptance (D/A) bills b. Documents against payment (D/P) bills 4. Clean Bills

Advantages o To Investors 1. Short Term source of finance 2. Outside the purview of Section 370 of Indian Companies Act 1956 3. No tax deducted at source 4. Flexibility o To Banks 1. Safety of funds 2. Certainty of payment 3. Profitability


Credit Appraisal Process

Receipt of application from applicant

Receipt of documents (Balance sheet, KYC papers, Different govt. registration no., MOA, AOA, and properties documents

Pre-sanction visit by bank officers

Check for RBI defaulters list, willful defaulters list, CIBIL data, ECGC, Caution list etc

Title clearance reports of the properties to be obtained from empanelled Advocates

Valuation reports of the properties to be obtained from empanelled valuer/engineers

Preparation of financial data

Proposal preparation

Assesborrowernt of proposal

23 Sanction/approval of proposal by appropriate sanctioning authority

Documentations, agreements, mortgages

Disbursement of Loan

Post sanction activities such as receiving stock statements, review of accounts, renew of accounts, etc (On regular basis)


Loan administration pre- sanction process

Appraisal, Assessment and Sanction functions

1. Appraisal

A. Preliminary appraisal Sound credit appraisal involves analysis of the viability of operations of a business and the capacity of the promoters to run it profitably and repay the bank the dues as and when they fall Towards this end the preliminary appraisal will examine the following aspects of a proposal. Banks lending policy and other relevant guidelines/RBI guidelines, Prudential Exposure norms, Industry Exposure restrictions, Group Exposure restrictions, Industry related risk factors, Credit risk rating, Profile of the promoters/senior management personnel of the project, List of defaulters, Caution lists, Acceptability of the promoters, Compliance regarding transfer of borrower accounts from one bank to another, if applicable; Government regulations/legislation impacting on the industry; e.g., ban on financing of industries producing/ consuming Ozone depleting substances; Applicants status vis--vis other units in the industry, Financial status in broad Terms and whether it is acceptable The Companys Memorandum and Articles of Association should be scrutinized carefully to ensure (i)

that there are no clauses prejudicial to the Banks interests, (ii) no limitations have been placed on the Companys borrowing powers and operations and (iii) the scope of activity of the company. Further, if the proposal is to finance a project, the following aspects have to be examined:

Whether project cost is prima facie acceptable Debt/equity gearing proposed and whether acceptable Promoters ability to access capital market for debt/equity support Whether critical aspects of project - demand, cost of production, profitability, etc. are prima facie in order Required Documents for Process of Loan a) Application for requirement of loan b) Copy of Memorandum & Article of Association c) Copy of incorporation of business d) Copy of commencement of business e) Copy of resolution regarding the requirement of credit facilities f) Brief history of company, its customers & supplies, previous track records, orders In hand. Also provide some information about the directors of the company g) Financial statements of last 3 years including the provisional financial statement for the year 2007-08 h) Copy of PAN/TAN number of company i) Copy of last Electricity bill of company j) Copy of GST/CST number k) Copy of Excise number l) Photo I.D. of all the directors m) Address proof of all the directors n) Copies related to the property such as 7/12 & 8A utara, lease/ sales deed, 2R Permission, Allotment letter, Possession o) Bio-data form of all the directors duly filled & notarized

p) Financial statements of associate concern for the last 3 years After undertaking the above preliminary examination of the proposal, the branch will arrive at a decision whether to support the request or not. If the branch (a reference to the branch includes a reference to SECC/CPC etc. as the case may be) finds the proposal acceptable, it will call for from the applicant(s), a comprehensive application in the prescribed proforma, along with a copy of the proposal/project report, covering specific credit requirement of the company and other essential data/ information. The information, among other things, should include:

Organizational set up with a list of Board of Directors and indicating the qualifications, experience and competence of the key personnel in charge of the main functional areas e.g., purchase, production, marketing and finance; in other words a brief on the managerial resources and whether these are compatible with the size and scope of the proposed activity. Demand and supply projections based on the overall market prospects together with a copy of the market survey report. The report may comment on the geographic spread of the market where the unit proposes to operate, demand and supply gap, the competitors share, competitive advantage of the applicant, proposed marketing arrangement, etc. Current practices for the particular product/service especially relating to Terms of credit sales, probability of bad debts, etc. Estimates of sales cost of production and profitability. Projected profit and loss account and balance sheet for the operating years during the Currency of the Bank assistance. If request includes financing of project(s), branch should obtain additionally a) Appraisal report from any other bank/financial institution in case appraisal has been done by them. b) No Objection Certificate from Term lenders if already financed by them and c) Report from Merchant bankers in case the company plans to access capital market, wherever necessary.


In respect of existing concerns, in addition to the above, particulars regarding the history of the concern, its past performance, present financial position, etc. should also be called for. This data/information should be supplemented by the supporting statements Such as: a) Audited profit loss account and balance sheet for the past three years (if the latest audited balance sheet is more than 6 months old, a pro-forma balance sheet as on a recent date should be obtained and analysed). For non-corporate borrowers, irrespective of market segment, enjoying credit limits of Rs.10 lacs and above from the banking system, audited balance sheet in the IBA approved formats should be submitted by the borrowers. b) Details of existing borrowing arrangements, if any, c) Credit information reports from the existing bankers on the applicant Company, and d) Financial statements and borrowing relationship of Associate firms/Group Companies.

B. Detailed Appraisal The viability of a project is examined to ascertain that the company would have the ability to service its Loan and interest obligations out of cash accruals from the business. While appraising a project or a Loan proposal, all the data/information furnished by the borrower should be counter checked and, wherever possible, inter-firm and inter-industry comparisons should be made to establish their veracity. The financial analysis carried out on the basis of the companys audited balance sheets and profit and loss accounts for the last three years should help to establish the current viability. In addition to the financials, the following aspects should also be examined:

The method of depreciation followed by the company-whether the company is following straight line method or written down value method and whether the company has changed the method of depreciation in the past and, if so, the reason therefore;


Whether the company has revalued any of its fixed assets any time in the past and the present status of the revaluation reserve, if any created for the purpose; Record of major defaults, if any, in repayment in the past and history of past sickness, If any; The position regarding the companys tax assessment - whether the provisions made in the balance sheets are adequate to take care of the companys tax liabilities; The nature and purpose of the contingent liabilities, together with comments thereon; Pending suits by or against the company and their financial implications (e.g. cases relating to customs and excise, sales tax, etc.); Qualifications/adverse remarks, if any, made by the statutory auditors on the companys accounts; Dividend policy; Apart from financial ratios, other ratios relevant to the project; Trends in sales and profitability, past deviations in sales and profit projections, and estimates/projections of sales values; Production capacity & use: past and projected; o Estimated requirement of working capital finance with reference to acceptable build up of inventory/ receivables/ other current assets; Projected levels: whether acceptable; and Compliance with lending norms and other mandatory guidelines as applicable Project financing: If the proposal involves financing a new project, the commercial, economic and Financial viability and other aspects are to be examined as indicated below:

Statutory clearances from various Government Depts. / Agencies Licenses/permits/approvals/clearances/NOCs/Collaboration agreements, as applicable Details of sourcing of energy requirements, power, fuel etc. Pollution control clearance Cost of project and source of finance

Build-up of fixed assets (requirement of funds for investments in fixed assets to be critically examined with regard to production factors, improvement in quality of products, economies of scale etc.) Arrangements proposed for raising debt and equity Capital structure (position of Authorized, Issued/ Paid-up Capital, Redeemable Preference Shares, etc.) Debt component i.e., debentures, Term Loans, deferred payment facilities, unsecured Loans/ deposits. All unsecured Loans/ deposits raised by the company for financing a project should be subordinate to the Term Loans of the banks/ financial institutions and should be permitted to be repaid only with the prior approval of all the banks and the financial institutions concerned. Where central or state sales tax Loan or developmental Loan is taken as source of financing the project, furnish details of the Terms and conditions governing the Loan like the rate of interest (if applicable), the manner of repayment, etc. Feasibility of arrangements to access capital market Feasibility of the projections/ estimates of sales, cost of production and profits covering the period of repayment Break Even Point in Terms of sales value and percentage of installed capacity under a Normal production year Cash flows and fund flows Proposed amortization schedule Whether profitability is adequate to meet stipulated repayments with reference to Debt Service Coverage Ratio, Return on Investment Industry profile & prospects Critical factors of the industry and whether the assessment of these and management plans in this regard are acceptable Technical feasibility with reference to report of technical consultants, if available Management quality, competence, track record Companys structure & systems Applicants strength on inter-firm comparisons


For the purpose of inter-firm comparison and other information, where necessary, source data from Stock Exchange Directory, financial journals/ publications, professional entities like CRISINFAC, CMIE, etc. with emphasis on following aspects: o Market share of the units under comparison o Unique features o Profitability factors o Financing pattern of the business o Inventory/Receivable levels o Capacity utilization o Production efficiency and costs o Bank borrowings patterns o Financial ratios & other relevant ratios o Capital Market Perceptions o Current price o 52week high and low of the share price o P/E ratio or P/E Multiple o Yield (%)- half yearly and yearly

Also examine and comment on the status of approvals from other Term lenders, market view (if anything adverse), and project implementation schedule. A pre-sanction inspection of the project site or the factory should be carried out in the case of existing units. To ensure a higher degree of commitment from the promoters, the portion of the equity / Loans which is proposed to be brought in by the promoters, their family members, friends and relatives will have to be brought upfront. However, relaxation in this regard may be considered on a case to case basis for genuine and acceptable reasons. Under such circumstances, the promoter should furnish a definite plan indicating clearly the sources for meeting his contribution. The balance amount proposed to be raised from other sources, viz., debentures, public equity etc., should also be fully tied up.

C. Present relationship with Bank:


Compile for existing customers, profile of present exposures: Credit facilities now granted Conduct of the existing account Utilization of limits - FB & NFB Occurrence of irregularities, if any Frequency of irregularity i.e., number of times and total number of days the account was irregular during the last twelve months Repayment of Term commitments Compliance with requirements regarding submission of stock statements, Financial Follow-up Reports, renewal data, etc. Stock turnover, realization of book debts Value of account with break-up of income earned Pro-rata share of non-fund and foreign exchange business Concessions extended and value thereof Compliance with other Terms and conditions Action taken on Comments/observations contained in RBI Inspection Reports: CO Inspection & Audit Reports

D. Credit risk rating: Draw up rating for (i) Working Capital and (ii) Term Finance.

E. Opinion Reports: Compile opinion reports on the company, partners/ promoters and The proposed guarantors.

F. Existing charges on assets of the unit: If a company, report on search of charges with ROC. G. Structure of facilities and Terms of Sanction: Fix Terms and conditions for exposures proposed - facility wise and overall: Limit for each facility sub-limits Security - Primary & Collateral, Guarantee

Margins - For each facility as applicable Rate of interest Rate of commission/exchange/other fees Concessional facilities and value thereof Repayment Terms, where applicable ECGC cover where applicable Other standard covenants

H. Review of the proposal: Review of the proposal should be done covering (i) strengths and weaknesses of the exposure proposed (ii) risk factors and steps proposed to mitigate them (ii) Deviations, if any, proposed from usual norms of the Bank and the reasons therefore

I. Proposal for sanction: Prepare a draft proposal in prescribed format with required backup details and with recommendations for sanction.

J. Assistance to Assessment: Interact with the assessor, provide additional inputs arising from the assessment, incorporate these and required modifications in the draft proposal and generate an integrated final proposal for sanction.

2. Assessment: Indicative List of Activities Involved in Assessment Function is given below:

Review the draft proposal together with the back-up details/notes, and the borrowers application, financial statements and other reports/documents examined by the appraiser. Interact with the borrower and the appraiser. Carry out pre-sanction visit to the applicant company and their project/factory site. Peruse the financial analysis (Balance Sheet/ Operating Statement/ Ratio Analysis/

Fund Flow Statement/ Working Capital assessment/Project cost & sources/ Break Even analysis/Debt Service/Security Cover, etc.) to see if this is prima facie in order. If any deficiencies are seen, arrange with the appraiser for the analysis on the correct lines. Examine critically the following aspects of the proposed exposure. o Banks lending policy and other guidelines issued by the Bank from time to time o RBI guidelines o Background of promoters/ senior management o Inter-firm comparison o Technology in use in the company o Market conditions o Projected performance of the borrower vis--vis past estimates and performance o Viability of the project o Strengths and Weaknesses of the borrower entity. o Proposed structure of facilities. o Adequacy/ correctness of limits/ sub limits, margins, moratorium and repayment schedule o Adequacy of proposed security cover o Credit risk rating o Pricing and other charges and concessions, if any, proposed for the facilities o Risk factors of the proposal and steps proposed to mitigate the risk o Deviations proposed from the norms of the Bank and justifications therefor

To the extent the inputs/comments are inadequate or require modification, arrange for additional inputs/ modifications to be incorporated in the proposal, with any required modification to the initial recommendation by the Appraiser Arrange with the Appraiser to draw up the proposal in the final form. Recommendation for sanction: Recapitulate briefly the conclusions of the appraisal and state whether the proposal is economically viable. Recount briefly the value of the companys (and the Groups) connections. State whether, all considered, the proposal is a fair banking risk. Finally, give recommendations for grant of the requisite fund-based and non-fund based credit facilities.


3. Sanction: Indicative list of activities involved in the sanction function is given below: Peruse the proposal to see if the report prima facie presents the proposal in a comprehensive manner as required. If any critical information is not provided in the proposal, remit it back to the Assessor for supply of the required data/clarifications. Examine critically the following aspects of the proposed exposure in the light of corresponding instructions in force: Banks lending policy and other relevant guidelines RBI guidelines Borrowers status in the industry Industry prospects Experience of the Bank with other units in similar industry Overall strength of the borrower Projected level of operations Risk factors critical to the exposure and adequacy of safeguards proposed There against Value of the existing connection with the borrower Credit risk rating Security, pricing, charges and concessions proposed for the exposure and covenants o Stipulated vis--vis the risk perception. Accord sanction of the proposal on the Terms proposed or by stipulating modified or additional conditions/ safeguards, or Defer decision on the proposal and return it for additional data/clarifications, or Reject the proposal, if it is not acceptable, setting out the reasons.


Loan administration - Post sanction credit appraisal process

. Need Lending decisions are made on sound appraisal and assessment of credit worthiness. Past record of satisfactory performance and integrity are no guarantee for future though they serve as a useful guide to project the trend in performance. Credit assessment is made based on promises and projections. A loan granted on the basis of sound appraisal may go bad because the borrower did not carry out his promises regarding performance. It is for this reason that proper follow up and supervision is essential. A banker cannot take solace in sufficiency of security for his loans. He has to a) Make a proper selection of borrower b) Ensure compliance with terms and conditions c) Monitor performance to check continued viability of operations d) Ensure end use of funds. e) Ultimately ensure safety of funds lent.

Stages of post sanction process

The post-sanction credit appraisal process can be broadly classified into three stages viz., follow-up, supervision and monitoring, which together facilitate efficient and effective credit management and maintaining high level of standard assets. The objectives of the three stages of post sanction process are detailed below.


Types of Lending Arrangements

Introduction Business entities can have various types of borrowing arrangements. They are One Borrower One Bank One Borrower Several Banks (with consortium arrangement) One Borrower Several Banks (without consortium arrangements Multiple Banking One Borrower Several Banks (Loan Syndication) One Bank The most familiar amongst the above for smaller loans is the One Borrower-One Bank arrangement where the borrower confines all his financial dealings with only one bank.

Sometimes, units would prefer to have banking arrangements with more than one bank on account of the large financial requirement or the resource constraint of his own banker or due to varying terms & conditions offered by different banks or for sheer administrative convenience. The advantages to the bank in a multiple banking arrangement/ consortium arrangement are that the exposure to an individual customer is limited & risk is proportionate. The bank is also able to spread its portfolio. In the case of borrowing business entity, it is able to meet its funds requirement without being constrained by the limited resource of its own banker. Besides this, consortium arrangement enables participating banks to save manpower & resources through common appraisal & inspection & sharing credit information. The various arrangements under borrowings from more than one bank will differ on account of terms & conditions, method of appraisal, coordination, documentation & supervision & control. Consortium Lending

When one borrower avails loans from several banks under an arrangement among all the lending bankers, this leads to a consortium lending arrangements. In consortium lending, several banks pool banking recourses & expertise in credit management together & finance a single borrower with a common appraisal, common documentation & joint supervision & follow up. The borrower enjoys the advantage similar to single window availing of credit facilities from several banks. The arrangement continues until any one of the bank moves out of the consortium. The bank taking the highest share of the credit will usually be the leader of consortium. There is no ceiling on the number of banks in a consortium. Multiple Banking Arrangement Multiple Banking Arrangement is one where the rules of consortium do not apply & no inter se agreement among banks exists. The borrower avails credit facility from various banks providing separate securities on different terms & conditions. There is no such arrangement called Multiple Banking Arrangement & the term is used only to denote the existence of banking arrangement with more than one bank. Banking Arrangement has come to stay as it has some advantages for the borrower & the banks have the freedom to price their credit products & nonfund based facility according to their commercial judgment. Consortium arrangement occasioned delays in credit decisions & the borrower has found his way around this difficulty by the multiple banking arrangement. Additionally, when units were not doing well, consensus was rarely prevalent among the consortium members. If one bank wanted to call up the advance & protect the security, another bank was interested in continuing the facility on account of group considerations.

Points to be noted in case of multiple banking arrangements Though no formal arrangement exists among the financing banks, it is preferable to have informal exchange of information to ensure financial discipline Charges on the security given to the bank should be created with utmost care to guard against dilution in our security offered & to avoid double financing Certificates on the outstanding with the other banks should be obtained on the periodical basis & also verified from the Balance sheet of the unit to avoid excess financing


Credit Syndication A syndicated credit is an agreement between two or more lending institutions to provide a borrower a credit facility using common loan documentation. It is a convenient mode of raising long-term funds.

The borrower mandates a lead manager of his choice to arrange a loan for him. The mandate spells out the terms of the loan & the mandated banks rights & responsibilities. The mandated banker the lead manger prepares an information memorandum & Circulates among prospective lender banks soliciting their participation in the loan. On the basis of the memorandum & on their own independent economic & financial evolution the leading banks take a view on the proposal. The mandated bank convenes the meeting to discuss the syndication strategy relating to coordination, communication & control within the syndication process & finalizes deal timing, management fees, cost of credit etc. The loan agreement is signed by all the participating banks. The borrower is required to give prior notice to the lead manger about loan drawal to enable him to tie up disbursements with the other lending banks.

Features of syndicated loans Arranger brings together group of banks Borrower is not required to have interface with participating banks, thus easy & hassle fee Large loans can be raised through syndication by accessing global markets For the borrower, the competition among the lenders leads to finer terms Risk is shared Small banks can also have access to large ticket loans & top class credit appraisal & management

Advantages Strict, time-bound delivery schedule & drawals Streamlined process of documentation with clearly laid down roles & responsibilities Market driven pricing linked to the risk perception Competitive pricing but scope for fee-based income is also available

Syndicated portions can be sold to another bank, if required Fixed repayment schedule & strict monitoring of default by markets which punish indiscipline