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Part 5

Management of Credit

Part Five: Management of Credit Facility account monitoring Account Monitoring is an integral part of overall account management. It helps ensure maximization of return to the bank Various methods such as; Periodic review of account Interaction with Customer (meetings) Setting of covenant (agreement) agreed by customer Financial: Total equity not fall below certain level Non-Financial: Routing of trade volume Setting of Internal Risk Triggers Financial: Drop in sales by more than 10% Non-Financial: change in management Importance of Credit Management Growth and profitability largely depend on the quality of its risk asset portfolio Can be stressed by recalling the that accrue as a result. Essence of credit management is how effectively it is being monitored. Important ingredients such as; Being cognizant with the client need Observing micro and macro environmental factors Detail oriented approach Understanding of the process itself. Different ways of FAM Facilities allowed for Various Business: Can be categorized into short term and long term loans; These facilities can be further bifurcation into Funded : financing of A/R and Inventories; trade loan; long term loan for capital expenditure Non-Funded: Letter of Credit / Letter of Guarantees; Derivate Derivatives: include SWAPS; forward agreements etc and used as a hedging mechanism against fluctuation in IR or ER. Further bifurcation based on type of collateralization Secured: backed up by underlying collateral Unsecured: or clean loan does not have any collateral behind it. Types of Loans Long Term: more than 1 year Funded: loans for capital expenditure Non Funded: LG ,L/Cs Short Term: less than 1 year Funded: loans for working capital; inventory/receivables 2

Non Funded: L/Cs, LG etc Facility Utilization Excess: excess over approved limit Low: lower utilization of approved facility in a given time Peak: High utilization of approved facility in a given time Different ways of facility account monitoring Periodic analysis of financial statements Reveals sign of distress; anomalies in financial figures Monitoring of loan covenants assets in the loan agreement Breach of financial covenants act as a warning signals such as Current ratio: 1.0 throughout tenors Debt Service coverage ratio: at least 1.50 over loan tenor Activities in the facility account Include total debit and credit provide an idea about the health of the borrower. Cleanup of running finance account for a certain number of days; sometimes based on business dynamics partial cleanups is also considered sufficient. Limit Utilization and frequency of excess over limit Constant excess suggest inappropriate facility structuring or distressed situation faced by a borrower. Monitoring of security Primary source of repayment is business cash flow; in cases where operating cash flows have dried up and entity ability to remain as a going concern is in doubt. Stock reports Reviewing the reports of the level of stock that might be held as security by the institution. Market checks/CIB Checks Information about business performance from the market provides a good understanding of the borrowers reputation. CIB Checks reveals any overdue positions from other financial institution. Furthermore, details of litigation and write-offs availed are also a part of this report. CIB is basic requirement prior to taking any exposure beyond Rs 0.5 Million. Repayment Behaviors Delays in payment of interest and/or principal can be construed (seen) as warning signals. Business Reciprocity and account profitability report Reports for trade related facilities, import and export Maturity dates for LC Payments and their timely requirements Due date diaries indicate upcoming maturities. 3

Contract upgrades (Guarantees issued) Types: Performance guarantee Advance Payment guarantee Bid Bonds Retention Guarantees Any delays in projects completion should be known. Contract Maturities (Derivatives and Swaps) Although, its an off balance sheet items but any losses in this aspect can have negative impact on business profitability. SBP Prudential Regulation Bank cannot extend clean financing more than 500,000 to an obligor Secured Financing can be availed against various type of collateral Collateral can be in the form of current or fixed assets Short term funded facilities can be either pledge of stock or hypothecation. Pledge based should finance inventory holding Hypothecation based bridges the gap between receivable and payables Export Refinance Facility a product of SBP at concessional rates can be further divided; Part I ;based on export contracts in hand Part 2: based on previous years export performance Banks can also provide export loans: Pre shipment loans: from own sources to support export based customers Post shipment loans: allowed either against LG/LC; FIM, FATR etc Difficulties in operating the facility within present limits Based on different types of facilities, mechanism of monitoring also varies Pledge Based Facilities: Ensuring adequate quantity of pledged stock is available, Price of pledge stock is determine through reliable market sources The goods are pledge under supervision of Mucaddam who acts as custodian on banks behalf. Hypothecation Based Facilities: Are monitor through monthly stock reports Stock inspection by independent or bank personnel is also carried out. Export Based Loan: Adequate export volume and effective shipment are considered. FIM and FATR have specific tenor; non adjustment on due date signals warning. Disbursements of funded facilities are tagged and monitored. Project Financing: Seen on ground and timeline within which it was to be achieved as 4

per agreed covenants between bank and the customers. Commercial operation date of the project in line with cash flow projection. Allowing disbursement of funded facilities usage by making payments directly to the suppliers. Contingent Facilities: Due date diaries are maintained to keep track on maturity profiles. Collaterals Regular updates on collateral provided to the bank. Monitoring various types of collateral depending on its reliability as: Liquid Securities: are easiest to liquidate Stock and Receivables: assets values are generally determine on the basis of the disclosure in the financial statement Any shortfall indicate inventory loss Account Receivable: aging of receivables is essential to ensure its collectability and adequate provisions for bad debt. Fixed Assets: valuation task is assigned to independent valuers, valuers must be listed in PBA (Pakistan Bank Association) Internal Risk Rating: Credit rating agencies or internal valuation on customers account on performance and its ability to pay loans on the back of its financial standing.

Requirement for meeting facility turnover Strict policy adherence where limit approved by the bank; and excess over limit are granted without breach of any covenant (agreement) set prior to it. A keen understanding of customers business cycle Staying abreast with changes in micro and macro external environments An irregularity in facility utilization refers to breach of any covenant set by the bank. Import based non funded lines are monitored through quantum (rise) of import volumes routed (channel) through the bank counter. Differentiate between monitoring frequency of peak/low facility utilization If facility utilization is stuck at the maximum level (Peak) for stagnant periods; it can lead to an overdue status and can further lead to delinquency In cases of import; LC transactions as a result of devaluation of a local currency against the currency in which LC is opened. Terminologies: Cash Flow from Operation (CFO): Derived after adding non-cash charges such as amortization/depreciation to net profit before taxes and subtracting working capital changes. 5

Represents cash flow available for investing in fixed assets and repaying financial dues Free Cash Flow to the Firm (FCFF): Represent free funds available for the distribution to the debt holders and equity holders of the firm. Bankers are concerned with cash flow figures because this is the primary source of repayment. Any abnormal activity should be investigated. Factors requires close attentions such as: Heavy intercompany loans Fluctuating revenues and profits High dividend payouts Tightening cash flows

Facility Monitoring System Significance and use of activity in facility account reports Account Activity Report: indicate max and min balance of an account Excess Report: excess over approved facility Covenant Report: compliance/non-compliance status of agreed covenants with the borrowers. Documentation/Document Deferral Report: assist account managers in following internal deferral expires: ex insurance policy Ways of Facility Account Monitoring Site Visit Stock Inspection Calls DP calculation based on stocks Utilization Reports Use of due date diaries for retrieval of due amounts Maturity Diaries: A diary for upcoming critical events ex: facility maturities/document expiry Setup an advance reminder which may facilitate issuance reminder letter to customers.

Part 6
Past Due Accounts

Part Six : Past Due Accounts BUSINESS LENDING - Classification Basis of classification of past due or delinquent accounts SBP Classifications in Pakistan Substandard: where markup or principal is overdue by 90 days Doubtful: where markup or principal is overdue by 180 days Loss: where markup or principal is overdue by one year or more Varies depending on nature of loan assets Term loan: if interest of loan installment in arrears; Cash Credit: if it remain stagnant or interest on credit account not serviced in due time Contingent commitment: if due and not paid on due date result in fraud overdue status. Action steps based on classification level of past due accounts Substandard: in such cases, customer needs to be thoroughly engaged by bank representative. Doubtful: in such cases, the bank should start looking at other options such as restructuring, litigation or out of court settlement. Loss: in such cases, out of court settlement, or litigation proceedings. Past due account management Business Lending Management techniques used in dealing with past due accounts Is all about making conscientious proactive effort in raising warning level right from the beginning rather than waiting for account actually going bad. In this effort, the role of account relationship manager to monitor the portfolio on day to day basis. Also relationship management system in place to have microscopic view at the relationship officer level And keeping updated to senior management on time Consistent engagement is prerequisite Annual renewal and interim account updates are tools to keep track of overall health of the account. Based on business condition and the nature of problem remedial strategies such as restructuring of loan facility, enhancement in credit limits, reduction in interest rates helps improves borrowers repayment capacity Customer contact modes used depending upon severity of failure in meeting commitments Once the account is in watch list status; immediately calls for follow up meeting with customers to help avert it from further downgrading. Also through internal discussions between the management and risk department help avert any further downgrading of the account to a substandard. 8

Once the account reaches the zone beyond watch list than more microscopic view is applied by calling for account review from quarterly to monthly basis And in worst cases it is done on day to day basis also. Regulation imposed by SBP on collection and recovery process Recovery of due payment should be in accordance with financial institution (recovery of finance) ordinance of 2001. Ordinance laid down procedures to recover delinquent account Banks are required to make periodic reviews of the recovery procedures. Banks remain answerable to the SBP for compliance with these guidelines Global best practices Includes; a thorough due diligence on security coverage, understanding of local laws and An effective and efficient legal system to prevent frauds. Net exposure and status of financial assets Net Exposure: is defined as total exposure less liquid assets that are held at security by bank whether fund based or non fund based. SBP defined mechanism for calculation of net exposure; Cash and near cash securities are given 100% weight. Other current assets as hypothecation charge on inventories and receivables do not get accounted for any exposure benefits. If stocks are held at virtue of pledge arrangement, benefit of 40% is availed. Securities availed in the form of fixed assets such as land and building etc, allow use of benefit which may differ in value depending on nature of security. Condition for activating remedial actions Regularly ascertain the realistic loan recoverable amount by updating the values of available collateral with formal valuation and reviewing security documentation Reviews should update the status and development of loan account and progress of the remedial plans. Rescheduling and restructuring of Borrowers account Concept of RRBA Common terminologies used while managing a past due accounts. When account is showing weaknesses in its repayments a thorough analysis is done to understand the root cause and based on the findings through cash flows, financial statements RR comes into play The process refers to reinstituting of outstanding credit facilities with amendment in payments schedules, grace period, reduction in mark up rates, amendment in security package etc. It is done on the basis of ; actual needs of the customer industry cycles sponsors 9

cash flow at the time of rescheduling Need and benefits obtained from RRBA RR is not restricted to any classification or rating of the credit, it may be exercised at point in time even on excellent credit to synchronize with changing external and internal condition that may eventually impact the cash flow of the company. It is a process to recognize problem and facilitate in better management It entails following steps; Identify weaknesses in credit. If restructured credit still has the capacity to pay. Analysis of cash flows and financial statements. Projection are verified through other players Crystal clear understanding is developed with clients in credit parameters Security analysis Clubbing of all overdue facilities till cutoff date. Upfront payment of markup due till cutoff date. Reduction in markup rates on new reconstructed facility Before institute fresh visit to customer (mandatory) Monthly follow up on the account with mutual consent of the borrower. Time value of money (watchlist, substandard, doubtful or loss) Finally, if restructuring fails; such credit should be recovered through legal proceedings Special Asset Management Wing: specialize in recovering loans through litigation / court settlements in banks

Loss loan provisioning Concept of LLP LLP are main accrual expenses of the bank. They are set aside by bank manager to face future deterioration of credit portfolio quality. Its shows the basis for establishing banks capacity to absorb losses Importance of LLP LLP is a vital aspect of banks financial reporting to regulators and investors. It reflects the risk of losses inherent in underlying banks portfolio. Write off Concept of write off The process of recognizing an uncollectable loan is called write off Loan losses(LL) are written off against loan loss reserves (LLR) and are removed from outstanding portfolio Concept of FSV in case of write off FSV: stands for Force Sale Value; the value which fully reflects the price and can currently be obtained by selling the mortgage /pledge assets in forced sale conditions Substandard: 25% Provision of net exposure - FSV benefits. 10

Doubtful: 50% Provision of net exposure FSV benefits. Loss: 100% Provision of net exposure FSV benefits. SBP regulations concerning write off SBP states that bank continue to write off bad loans with the approval of Board of Directors under a well defined write off policy All liquid securities held as collateral should be realized and sale proceeds to be used to adjust the outstanding amount of principal. No write off allowed in cases where FSV is more than recoverable outstanding amount. Exception being on cases settled under general incentive scheme of SBP SBP Circular FSV Benefits 2011 states; Benefits of 40% of FSV of the pledged stocks and mortgaged residential , commercial and industrial policies held as collateral against non performing for years and one year extension period (not more than 4 years) Bank Management ensure FSV used for undertaking is determined accurately and reflects the market conditions All such cases where banks have availed the benefit of FSV shall be maintained for verification by SBPs inspection team during regular/special inspection Banks may add any condition and should report full particulars of loan write off to CIB of SBP.

Part Six CONSUMER LENDING- Classification Basis of classification of past due or delinquent accounts Repayment performance of individual borrowers is the best indicator Time Base Criteria: Overdue by more than 30 days are closely monitored. SBP Prudential Regulation for Consumer Finance. Credit Cards: 100% (180)* PIL and Cash line : 25% (90) and 100% (180) Autos and Mortgage/Baseline: 25%(90), 50%(180) and 100%(360) *(DPD) day past due Subjected Classification: Performing and Non performing (90 days) is also made for risk assessment. Such Classification for the cases involving bankruptcy, fraud, skip and death of the customer Requirement to be classified as subjected: proper evidence and documentation is required. Collection and Recovery Fraud Unit: plays vital role in bank in highlighting such overdue account based on which senior management decides on the classification category for subject classification. Action steps based on classification level of past due accounts Risk Management Unit: closely monitor such loan and making decision about loss provision. Therefore it divide portfolio into two categories Unsecured Lending: portfolio includes; credit card, running finance and PILs; exposure is total outstanding of the delinquent account. 11

Secured Lending: portfolio like mortgage, FSV benefits of collateral is subtracted from the total outstanding to determine net exposure at risk Past due account management Business Lending Management techniques used in dealing with past due accounts Sort out and segregation is done on past due account; Soft Delinquencies: are referred to as accounts between 60 to 90 days past due. Problematic: accounts greater than 90 days. Banks also use debt scoring tools for both pre and post default Behavior Score: is based on customer repayment behavior. All such accounts with a low score are categorized as high risk customers Customer contact modes used depending upon severity of failure in meeting commitments Post Segregation: the process of calling customer The Collection Unit: is responsible to contact customer on their provided number; priority mobile phone, in the event no contact; land line are used. If customer is still not contactable the field officer are send to the customers provided address. Dunning Letter: are collection letter; issued to customer to demand payment of the debt; failure to which leads to aggressive recovery through hiring of debt collection agencies. Regulation imposed by SBP on collection and recovery process The essence of guideline is to safeguard the interest of customer and defining SOPs Issued in November 2008; it comprises: Serving of 14 days written notice before visiting to customers Before visiting phone calls are made from the recorded line and contacting the customers at a convenient time Global best practices The dedicated Collection unit to monitor and recover past due accounts. Specialized collectors are hired to ensure unit provides efficient and dedicated service. Also including contracting people to inform them of an unpaid account, advising customer how to pay and arranging for legal action on unpaid account. Net exposure and status of financial assets Condition for activating remedial actions Provide borrower with relief when needed due to an economic downturn or other unforeseen personal event. The term of loan is extended to make allowance for lower repayments and certain waivers are also arranged. Rescheduling and restructuring of Borrowers account Concept of RRBA It improves the likelihood for the banks to receive full or negotiated payment of interest and principal to an outright default. Also directive of SBP for the banks to RR the non-performing loans for smooth 12

recovery. Need and benefits obtained from RRBA It relieves borrowers strain of heavy repayment amounts Loss loan provisioning Concept of LLP Importance of LLP Write off Concept of write off Is a a decision taken at the senior management level. Once declare as write off; the loans or assets account are closed and removed from the receivables in the balance sheet. Reasons include; identification of fraud; skip (where no contact can be established); death of the customer; inability to recover and pay. Concept of FSV in case of write off Where the loan amount exceeds 5 Million and customer has no means to repayment; the bank declare customer as write off No write off is allowed where FSV of securities held and is more than recoverable outstanding amount.

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