Lending Book

Lending:
Products,
Operations and
Risk Management
Stage 2
Table of Contents
Parti:
Lending - A core banking practice/function
Part 2:
Lending Products
Part 3:
Lending Risk Assessment and Management
35
a. Overview and Sources of Lending Risks
37
b. Risk Assessment & Risk Management
47
c. Ratio Analysis & Assessing Customer Needs
71
d. Credit Risk Practice for Business and Commercial Banks
117
e. Credit Risk Practice for Retail Banking
185
f. Business Lending - When Things Go Wrong
208
Part 4:
Collateral and Documentation
214 Part 5:
Management of Credit -1
289
Management of Credit - II
293
Part 6:
Past Due Accounts/Over Due Accounts - Business Lending
303
Past Due Accounts/Over Due Accounts - Consumer Lending
310
Appendices/ Additional Reading Material
Part One
Introduction
Lending - A core banking function
Student Learning
Outcomes
By the end of this chapter you should be able to:

State the role of bankers as lenders
State the importance of building a disciplined lending culture

State the importance of cash flow lending as opposed to security-based
lending
iftnq Products, Operations and Risk Management | Reference Book 1
Lending in Perspective
Historical sources reveal that existence of bank predates the use of money.
The nature of deposits and loans were therefore in form of goods and
commodities but the essence and principle was the same. The first record of
such activity dates back to 2000 BC in Babylonia.1
The modern day definition of a bank as per Britannica is:
An institution that deals in money and its substitutes and provides other
financial services. Banks accept deposits and make loans and derive a
profit from the difference in the interest rates paid and charged,
respectively.
A difference in modern day banking from the ancient banking practices is
that the sequence of the basic functions of the banks today is to take deposits
and give out loans. This sequence was not necessarily followed in ancient
times. Most importantly in earlier times loans were based out of savings.2
Some differences between ancient and modern-day banking which
have an impact on lending
The modem day banking has undergone massive changes in its basis of
operations over the last 7 centuries to arrive at the structure and form that we
see today. Lending remains a core function of banks as well as its most
profitable product. Product types and variations have, however come into
existence and most importantly the basis of the credit creation, as it is
termed today, is vastly different.
Banks Create Money
Todays banks create money in the economy by making loans and

investments. The amount of money that banks can lend is directly affected
by the reserve requirement1 of the Central Bank. In this way, money that
grows and flows throughout the economy in a much greater amount than it
physically exists. For example a bank gets a deposit of PKR 1 million from
Customer X. If the reserve requirement is 20% the bank is able to make a
loan out of PKR 800,000. The bank lends the PKR 800,000 to Customer Y
who uses the loan to buy a car and gives the money to Company A as
payment. Company A in turn deposits the money in the bank and the bank
based on Company As deposit can make out a loan of PKR 640,000 to its
customer. This is an over-simplified example of how the banks create money
and the money multiplier effect. You are encouraged to independently read
more about this topic as it is of utmost importance in todays banking world.
This ability to create money and thus be responsible for the increased money
supply through creation of credit in the economy to the extent that the banks
are able to do today is something that ancient bankers did not have to fret
about. Banks today are able to lend several times its total capitalization
which puts on them a much greater responsibility of understanding the credit
they are creating and its recovery cycle.
1
Source: Davies, G. (1994) A History of Money from Ancient Times to the Present
Day, Cardiff, UK, University of Wales Press
2
Source: Dr. Frank Shostak (2011), The Importance of Real Lending, Cobden
Center-http://www.cobdencentre.org/
Reserve Requirement-This is imposed by the Central Bank of the country on all

banks in terms of what percentage of the deposits can the bank lend out as loans.
In Pakistan the State Bank has a Cash
Reserve Requirement (CRR) which ha s in the past varied between 4% to 7% and i
Statutory Liquidity Requirement (SLR) which in the past has varied between 10%
to 15%.
Lending: Products, Operations and Risk Management | Reference Book 1
Banks act as intermediary between depositors and borrowers
Banks facilitate the flow of funding by acting as an intermediary between

depositors and loan-seekers. Earlier the function was to act as an
intermediary between savers and borrowers. The difference is that when a
saver lends money, what he in fact is lending to the borrower are the
goods/services that he has not consumed. Credit then becomes a chain of
unconsumed goods/services lent to the borrower to be repaid out of future
production of the borrower. However, today the banks deposits do not
necessarily consists of savers and lending decisions are thus more critical
because if the banks create credit without understanding how the credit will
generate the goods/services for the repayment of the credit, it will be creating
loss-making loans which may default either immediately or with a time-lag.
This time-lag has been also referred to as the credit bubble, in recent times.
Banks today thus play a much wider and a very critical role as they provide
liquidity and steady flow of credit in the economy which fuels growth and
stability.
Role of Banks as Lenders
Lending is a primary business function of banks. The banks make a profit by

accepting deposits at a rate of return and making out loans at a higher rate of
return than the deposits. The difference in the rate covers the administrative
cost as well as compensates them for the risk associated with lending.
Lending is a risky and perhaps the most profitable product of the banking
business and banks have over time tuned and fine-tuned lending policies,
practices and procedures to minimize risks and employ the principle of
prudence in lending decisions.
As lenders, banks have a very important role to play in the economic growth
of the country. Loans made to support activities which will generate income
above and beyond the amount to repay and service that loan are generally
viewed as loans which are beneficial for the economy and the country. The
banks over the past century however have developed a narrower view. Their
agenda is limited to making loans which will be serviced and repaid. Banks
have due to this been subject to criticisms from many who blame it for giving
rise to the increased consumerism.
Banks lending decisions have a far-reaching and a deep impact on the
economy. Any single loan that is made by the bank has a multiplier effect
thus banks need to be adequately aware of who they are lending to and what
the borrowers purpose for the loan is. An inadequate or irrelevant purpose
can channel funding in a direction that may be detrimental to economic
growth. Similarly the inability of the borrower to repay the loan either due to
lack of funds or intent can also cause a series of negative effects which will
have consequences that impact more than just the lending bank.
Banks role of financial intermediary in the economy is critical. Financial

intermediation takes place when banks as licensed deposit-takers take
deposits from public i.e. individuals, businesses and institutions and lend to
borrowers in the system. In most emerging economies, commercial banks
remain the major lenders to individuals, businesses and government. The
banks motive for financial intermediation is the margin between the cost of
funds and the markup for loans. For this return banks incur risk of the credit
they extend to the borrower. Given that the major source of funds are public
money, banks need to ensure that extreme discipline and caution are
exercised when lending money and taking other credit- related exposure.
Importance of Building a Disciplined Lending Culture
The effects and impact of lending have been briefly touched upon earlier.
The gravity is nonetheless not lessened by the limited attention that we have
paid to it in this chapter. Banks lending decisions are revered in the
economy as bank lending is a key economic indicator for a specific sector or
industry. If banks are willing to lend their money to a person or a company
or a sector/industry, it reflects the banks confidence in the borrowers
purpose of loan, ability to repay and intent to repay. Lending decisions are
thus of paramount importance as they are used as key market signals by
other players in the economy such as investors, suppliers, customers etc.
Moreover as banks deal with public monies, the effects of incorrect lending
decisions are far-reaching and can be devastating as witnessed in the recent
global financial crisis of 2007/8.
It is thus imperative to build a lending culture which is prudent and cautious.
Lending cultures driven by unrealistic or aggressive sales targets have
known to fail in the recent past with degenerating effects to the banks in
question.
Importance of Cash Flow- based and Security- based Lending
Each loan that a bank makes creates a ripple of liquidity. Each loan requires
scrutiny and consideration. The fundamental principle to be followed should
be that the loan be employed in a manner that it will generate an income
above and beyond the level which is required to service the loan and repay
the principal. Lenders thus need to assess the purpose of the loan, its
repayment capacity, character and reputation or name of the borrower and
in the instance the borrower is unable to pay the loan, how can the lenders
safeguard their interest.
Security Based Lending: Name Lending and Collateral-based Lending
Banks driven by self-interest also exercise a great deal of caution and

scrutiny before advancing a loan. There are different types of loan products
that are available and different methods of scrutiny and risk assessment
employed which will be discussed in the articles that follow.
What is of importance here is how lenders risk management and
containment methods have evolved over time. Mutual trust has been one of
the basic and fundamental variables. The trust between the borrower and the
lender reflects the lenders comfort that the borrower will timely repay and
service the loan and the borrowers comfort that the lender will not
overcharge him on the interest rate. In previous
times lenders would limit their operations to people they knew either
personally or within their own wider network (also known as name lending
in recent times). However, as economies have expanded and enterprises
have sprung which are diverse in industry and geography, lenders have had
to expand operations beyond their limited circle. At this stage the lenders
started employing a structured due diligence process and getting to know
about the customer and its business operations and/or sources of funding and
for additional comfort and security demanded collateral. Strong collateral
(high in value and easy to liquidate) meant that even if the borrowers ability
to repay was questionable, the loan would still be good as funds could be
recovered from the sale of the collateral. This phenomenon brought with it a
new set of concerns relating to the title of the collateral and in case of
default by the borrower, would the lender have the legal right to dispose of
the asset that the borrower has given to the lender as collateral. Different
countries have different legal systems and practices. The article on
Collateral will discuss the different types of collateral and the rights of
lenders and borrowers in detail; suffice to mention here that taking collateral
against a loan advanced has been a practice for centuries.
Cash Flow Based Lending: Purpose and Capacity-based Lending
Lenders in the recent times have however expanded their focus on the
purpose of the loan and the repayment capacity with reference to the purpose
of the loan. While having good quality collateral is highly recommended,
banks are in the business of borrowing and lending money and not
liquidating collateral. Liquidating collateral is a lengthy and cumbersome
exercise and not the banks core business function. Banks have thus realized
that lending decisions which are transaction- specific and evaluate the
capacity of the borrower based on the cashflow from the
transaction/project/activity that is being financed are sounder than the ones
which only consider the collateral and the borrower name. This in no way
stops the lender from requiring good quality collateral or considering the
borrower name. Analyzing the cash-flow and repayment capacity however
is being given as much consideration when making the lending decision.
Authored By:
Shahnoor Meghani
Part Two
Lending Products
Student Learning By the end of this chapter you should be able to:
Outcomes
1. Categories of Borrowers
* Describe the types of lending products available to business
borrowers
Differentiate between short term and long term lending

Differentiate between funded and non-funded facilities
* Describe various types of long term lending facilities available
to business borrowers
Describe the characteristics of an individual borrower and

explain how they differ from business borrowers
Describe the types of products available to individual customers

Explain the purpose of individual/consumer borrowing and
classify loans under^onsumer lending
2. Regulations and Practices
Recall the SBP laws relevant to decide the lending limits for
both business and consumer borrowers
* State the lending exposure limits as per SBP regulations
State regulations concerning lending disclosure and reporting

requirements for consumer lending
State regulations concerning lending disclosure and reporting

requirements for business lending
Define credit policy, target markets and risk assessment criteria

and discuss their importance in lending decisions
State prudential regulations concerning the business

/commercial lending operations
State the minimum requirements for consumer financing as per

the prudential regulations
State the general SBP Prudential regulations concerning

consumer lending
3. Pricing
* Recall the various types of pricing mechanisms available across the industry
Explain the industry-wide methodology used for calculation of pool rates

Explain internal cost of funds and discuss how it is determined
Explain the process of developing a pricing model based on floating mark up rate
Discuss the pros and cons of using a floating mark up rate as compared to using
fixed rate
Explain 'risk based' and 'relationship yield' pricing models

Explain the concept of opportunity cost, risk reward pricing and re-pricing intervals
Categories of Borrowers
As discussed in the previous chapter, banks as lenders need to inculcate a

disciplined lending environment to avoid making lending mistakes. Before a
loan is made the lending bank should ask the following questions:
a. Who is the potential borrower?
b. Does the potential borrower meet banks target market
definition and risk acceptance terms?
c. What is the purpose of borrowing/borrowing cause?
d. Does the borrowers business/income generate sufficient cash
within a reasonable time period to repay interest and principal?
e. What would be my way out if the cash flows are not sufficient to
ensure repayments of loan?
The list above is not exhaustive and in the next few chapters we will address
these issues in detail. It is important to have awareness of these fundamental
questions as they are key to determining the credit requirement of the
businesses and the repayment capacity.
A banks credit customers can be divided in to two broad categories:
a. Business Borrowers
b. Individual/Consumer Borrowers
The purpose of borrowing and source of repayment is distinct for each
category and based on this the lending products offered by the bank to each
segment are different. The State Bank of Pakistan does not allow banks to
offer any lending product without collateral or security to business borrowers
above PKR 2 million and up to a certain amount for individual borrowers.
The clean lending limit for individual borrowers is PKR 2 million at present,
but is subject to change. Please refer to the SBP website for up-to-date
information.
A.
Business Borrowers
Businesses frequently are in need of funds to either bridge the temporary

liquidity gaps in the operating cycle or to supplement their long-term
financing needs for capital expenditures. Some businesses also take on debt
which could be in the form of credit from banks to manage their balance
sheets more objectively. Businesses also seek bank support to meet their
non-cash needs such as opening Letters of Credit, and extending financial or
other form of guarantees on their behalf.
Business borrowers repay the principal and interest from cash flows
generated through business operations. Banks generally look at the historic
trend of the businesss financial statements to gauge the sales growth, cash
cycle, stability of orders, productivity of assets, leverage etc to forecast the
future trends for the business based on which a part of the lending decision
relies upon.
Lending Products for Business Borrowers:
Lending products for business borrowers can be mainly divided by the nature of
the facility i.e. is it fund-based; this would entail the bank providing the
customer with access to the funds; or non-fund based in which case the bank
would assume the liability of payment on account of the customer to a 3rd party.
Within each category there are several different sub-divisions based on the tenor
and terms. Diagram 2.1 below is a good illustration of the lending products
available for business borrowers, at a glance.
Diagram 2.1
Lending Products for Business Borrowers
Funded Facilities
Short-term Facilities-Payable
within 1 year
ej
Long-term
S
NonFacilities $ Payable Funded
after 1
Facilities
vear
Demand I Discounting I Export I Import

Finance I
I Finance I Finance
Details of lending products available for businesses in Pakistan

within each sub-heading and their brief description are as follows:
1. FUNDED FACILITIES:
a. SHORT TERM FINANCING PRODUCTS
i.
Running Finance/Overdraft
An overdraft generally known as RF in Pakistan is a type of lending

which offers a high degree of flexibility. For a bank, the overdraft is a
staple product by means of which the customer may overdraw their
current account balance, that is, draw out more from the account than
the total amount of money standing in the account. The customer is
permitted to overdraw the account up to an agreed limit (the overdraft
limit). When an account is overdrawn, the customer is borrowing and
owes the bank money. An overdraft is normally shown on the
customers bank statement by the abbreviation DR (meaning debtor)
after the balance on the account.
Overdrafts are only available on current accounts, the accounts through
which businesses pass their income and expenditure. Although
overdrafts are repayable to the bank on demand, they are normally
agreed subject to annual review.
Interest/mark-up on an overdraft is only charged on the day-to-day balance

outstanding on the account. Thus, if the current account fluctuates from a
credit balance (funds in the account) to a borrowing position (using the
overdraft), the customer only pays interest when the account is in the
red/debit - what the customer is actually borrowing on that day.
The overdraft is a convenient way of borrowing to cover a businesss short
term requirements. It is only appropriate for short term temporary borrowing
which is drawn down and then repaid and drawn and repaid again during the
working capital (or trading) cycle.
The overdraft provides finance to cover a businesss working capital needs
(the finance needed through the operating cycle) and help iron out the
fluctuations in its cash flow as bills are paid before funds are received from
sales income. A large inflow of funds one week will reduce the interest
payable while the firm retains the ability to borrow again next week. For
business customers the overdraft is often the cheapest and most convenient
means of borrowing.
An account with an overdraft facility should show wide fluctuations. For
instance, when the customer buys stock, the balance of the account would
swing into overdraft and once the stock is sold and sales income received,
the account should swing back into credit. When an account remains in debit
permanently, with low turnover this is referred to as hard core borrowing. It
is best to identify the hard core borrowing element of a business and
understand the underlying reason to best meet the businesss credit
requirement soundly. If the run of the account shows that the account is
perpetually in debt, the debt is becoming hard core. It may indicate that
things are not going according to plan. This could be due to several reasons.
Perhaps the customer is not collecting cash from debtors quickly enough, or
the business may be making losses or the business is financing its long-term
needs with short-term financing.
ii. Demand Finance
Demand finance generally known as LM in Pakistan is similar to running

finance in many aspects except that the tenor of the demand finance is fixed.
For example a business may have a requirement for short-term financing for
PKR 500,000 and it may know that this requirement is for a specific period
e.g. 2 months. The business can then ask the bank for a loan of PKR 500,000
for 2 months. The interest rate for the loan will be booked on the date of the
booking of the loan for the period of the loan. The LM must be paid at the
expiration of the term. In rare cases it may be rolled-over or extended,
however it is generally preferred by banks not to have a rolling LM to
ensure that the business has access to funds to pay off the loan and the debt
is not becoming hard core.
iii. Export Finance
Export finance is similar to demand finance. In Pakistan, the State Bank of

Pakistan (SBP) to incentivize exporters has in place special financing
schemes whereby exporters can access pre- shipment financing facilities as
well as post-shipment financing facilities. These facilities are available
through the State Bank funded
schemes via the banks or through banks own sources. The facilities
available at present are:
Pre-Shipment Financing-Part l(Fundecf through banks own
sources).
2. Pre-Shipment Financing-Part 1 (Funded through SBP refinance
scheme).
3. Pre-Shipment Finance-Part 2 (Funded through SBP refinance
Scheme).
4. Post-Shipment: Discounting/ Purchase of export Bills (Funded
through banks own sources).
5. Post-Shipment: Discounting / Purchase of Export Bills (Funded
through SBP refinance Scheme).
6.
Bill Discounting/Receivable Financing.
1.
All these facilities are tenor-bound and generally do not allow roll -over.
Detailed information on this can be sought from the SBP website.
iv.
Import Finance
Import finance is generally available in terms of import loans or

financing against trust receipts (FATR) generally in case of a Letter of
Credit based transaction. Under this facility, the Bank provides the
documents of title of goods imported under L/C, to the customer to
enable the customer to obtain goods prior to payment and to sell them to
generate funds to pay-off the bank. The goods represented thereby and
the sale proceeds thereof in trust for the bank. Since this is a fund-based
facility as opposed to a non-funded facility (as in the case of L/Cs), due
care and diligence needs to be exercised when extending this facility.
Import finance can be further classified into the following:
1. Finance Against Trust Receipt (FATR)
FATRs are related to import transactions. The bank may allow specific
customers FATR facility against collection documents as per the terms
set out from time to time, which are discussed as follows:
a. FATRs in respect of L/C documents Under this facility, the Bank delivers the documents of the title to
goods imported under L/C, to the customer. This enables the
customer to get the goods prior to payment. The customer
undertakes to hold the documents in lieu of a Trust Receipt. There
are very obvious risks in permitting a customer to deal with goods in
this way. A customer having in his custody, goods released to him
against a trust receipt can fraudulently sell them or pledge them to a
third party, leaving the holder of the trust receipt i.e. the bank only
the right to sue for breach of trust. FATR facilities should therefore
are granted to undoubted importers against established credit lines.
It is important to note that the goods released under a trust receipt
must be fully insured by the customer and the Bank reserves the
right to inspect, repossess and if necessary, dispose of the goods at
anytime.
Undng: Products, Operations and Risk Management | Reference Book 1
11
b.
FATRs in respect of collection documents -
FATRs in respect of collection documents are only granted when routed

through the Bank's branches. This facility is restricted to selected customers
with satisfactory account relationship and is governed by the following
safeguards:
Facility to be allowed with prior clearance and only provided to
prime customers with low risk ratings.
Branches should be satisfied that the collection bills have genuine
underlying trade transactions.
Branches are also required to ensure that the facility is used for
the customer's regular line of business.
The facility should be given as a separate FATR line under the
import line (i.e. FATR for collection documents) distinct from
FATR sub-limit under import (L/C) line.
Finance Against Imported Merchandise (FIM)
This facility is allowed against the commodities imported from other

countries usually through letter of credit. At times the importer does not
have enough money to pay for the imported merchandise. He therefore
requests the bank to pay the dues to the exporter against the security of
imported merchandise. This facility is usually allowed against imported
goods but occasionally such financing may be allowed against locally
manufactured goods covered under L/Cs or received for collection.
b. LONG TERM FINANCING PRODUCTS / TERM LENDING
Term loans are usually granted over a period of years to assist business
customers in buying assets such as plant and equipment, and buildings. A
term loan spreads the cost of the asset over its expected life. The repayments
can be tailored to suit the cash flow of the business, usually either monthly,
quarterly, half-yearly or annually.
A term loan is a loan for a fixed amount, for an agreed period, and on
specific terms and conditions. Normally such loans are for terms of between
three and seven years, although they can range up to twenty years. Longer
periods depend on the nature of the proposal, the robustness of the
performance of the company and its projections, and the security to be
granted.
Term loans are generally used for longer term asset purchases as these are
not suitable for financing under an overdraft facility, which should be used
for working capital purposes. The terms and conditions under which they are
granted includes interest and other costs, repayment, security and the
covenants applicable. The terms and conditions of the loan are set out in a
loan agreement which includes:
Tenon the term over which the loan is to be repaid
Repayment Schedule: the intervals at which the principal and

interest are due for payment.
Pricing: the mark-up rate that will be charged.
Collateral: the security to be granted.
Loan Covenants: conditions to be complied with by the customer,

such as the timely provision of accounting information, stock
report, share price in case of a listed company, leverage ratio etc.
Event of Default: events which would render the loan immediately

due for repayment such as the customer failing to meet a repayment
installment on time or the loan being used for a different purpose
from than agreed.
Some banks ask for requirements like establishment of Sinking

Fund and utilization of working capital facilitated through its
counters.
Provided the customer complies with the conditions detailed in the loan
agreement, the bank generally cannot demand repayment of a term loan.
Generally, the longer a loan is outstanding, the greater is the risk of default.
2.
a.
NON-FUNDEO FACILITIES:
Letters of Credit (L/C)
In trade transactions where buyers and sellers are geographically

separated, banks play a crucial role in managing the payments. A letter
of credit is generally established by a bank on behalf of its customer (the
buyer/importer) guaranteeing to the sellers (exporters) bank that the
bank will make the payment to the seller on time if seller performs as
per terms and conditions of the letter of credit.
L/C can be irrevocable or revocable. An irrevocable L/C cannot be
changed unless both buyer and seller agree. With a revocable L/C,
changes can be made without the consent of the beneficiary. While
dealing in L/Cs, the bank in question does not lend funds directly but
may have to pay in the instance the customer is unable to pay. L/Cs are
thus called contingent liabilities for banks.
There are two type of L/Cs:
I.
Sight: is where payment is due to the seller at the time of receipt of

goods by the buyer. Sight L/C requires the importer / importing
bank to pay as soon as it receives the clean documents from
exporter.
Sight L/Cs are letters of credit where the bank engages to honor the
beneficiary's sight draft upon presentation, provided that the
documents are in accordance with the
13
conditions of the L/C. Drafts drawn at sight simply serve as receipts

for payments and are of no value for any other purpose. In
establishing sight L/Cs branches should ensure that goods are duly
insured and that the Bank retains control over the goods at all times.
Documents of title to the goods is released only against payment,
either by cash or to the debit of the customer's current account /
FATR account / FIM account. L/C, generally as a practice, is not
opened for a period in excess of 180 days without prior approval
from the risk chain / competent authorities.
II.
b.
Usance: is where payment is due after certain, pre-agreed number

of days by the buyer. The seller in this instance is providing credit
to the buyer. Usance L/Cs are similar to sight L/Cs but call for a
time or usance draft payable after a specified period of time. The
normal usance period allowed for this facility is 90 days. However,
it can be a maximum of 180 days. Exceptionally for undoubted
customers, usance period exceeding 180 days may also be allowed
with specific approvals from the risk chain / competent authorities.
Guarantees/Stand-by Letters of Credit
Business customers sometimes require the bank to issue a letter of

guarantee on their behalf. This is generally required by the party that the
customer is entering into business with. It can be regarding delivery of
goods and services by the customer to the party i.e. the party requires a
guarantee that the customer will provide the goods or services agreed
failing which the party will call upon the letter of guarantee. It can also
be if the customer is the purchaser of goods or services from the party
and if the customer does not purchase the goods from the party based on
the terms and agreements or defaults on the payment, the party can call
upon the guarantee and demand the bank to pay.
The bank in this instance as well, does not lend funds directly but may
have to pay in the instance the customer does not perform his
obligations or defaults.
These facilities cover a number of specific types of guarantees that the Bank
may issue for its customers but in all cases the common factors are:
The Bank substitutes its own credit standing for that of its
customer.
No actual movement of funds takes place at the time of issuing the

guarantee, although there is a clear commitment by the Bank to
effect payment when called upon to do so under the terms of the
particular guarantee. Thus it is necessary to record these
commitments as contingent liabilities.
The Bank charges a commission for this service usually quoted on

a quarterly basis.
Guarantees fall into many different categories, each of which has its own
characteristics and related risks; some of the important characteristics and
the appropriate precautionary measures are enumerated in the following
relevant sections overleaf.
a.
Shipping Guarantees (SG)
Guarantees of this nature are required to enable customers to release

goods before the arrival of the documents of title; they therefore render
the Bank liable to the shipping company to whom the guarantee has
been issued. Shipping company is, in turn liable to the true owners of
the goods in the event the goods are released wrongfully. It follows
therefore that such guarantees should be issued to importers with a
credit line. Full cash margin is generally taken for shipping guarantees
issued against Shipping L/C, unless waived by appropriate credit/risk
authority.
b.
Bid Bonds (BB)
The purpose of a bid bond is to substantiate the ability of a person

submitting the tender to perform the contract when awarded. Such a
bond is issued in connection with a tender and its normal characteristic
is an undertaking by the Bank on behalf of the applicant to pay the
beneficiary a fixed amount within a stipulated period on his simple
written demand if the applicant withdraws his obligation after the
acceptance of his tender. A bid bond must not contain any conditions
linking it with performance of a contract if awarded and must contain a
definite expiry date. If branches are asked to give such undertakings the
guarantees must be treated as Performance Bonds. If there is any
ambiguity in the terms of a bid bond which a branch is asked to sign it
should study the basic "conditions of tender" to ascertain its precise
liability. Branches must insist on the return of the original bid bond after
its expiry.
c.
Advance Payment Guarantees (APG)
Civil engineering contracts, particularly those awarded by local

governments, sometimes provide for an advance payment to be made to
the contractor for purposes such as mobilizing site, plant and equipment.
In order to obtain this payment the contractor is required to produce an
Advance Payment Guarantee.
d.
Financial Guarantees (FG)
Financial Guarantee is a general description of various guarantees

whose main characteristic is an undertaking to meet any claim from the
beneficiary up to a fixed sum on simple demand. Claims under such
guarantees must not be made contingent on the non -fulfillment of the
terms of contracts, which are unknown to the issuer. Unless the
creditworthiness of the concerned customer is undoubted, such
guarantees are issued against full cash margin.
B. Individual Borrowers
Individuals also frequently are in need of funds to pay for expenses or
purchase of assets, which they cannot afford to pay for in cash at the present
time. Situations that typically require borrowing include buying a house or a
car or consumer durables such as refrigerator, television, computer etc or
paying for education or medical expenses or wedding expenses etc. The
individuals borrowing needs are driven by his/her discretionary spending,
lifestyle and stage of life cycle.
Individual borrowers primarily repay the principal and interest from
15
their income which could be self-generated. If the borrower owns a business

or in the form of salary, profit from business ventures, investment income,
pension, endowment/trust fund etc. Banks generally look at the historic trend
of the individuals income, stability of cash flows, expense burden on the
individuals income etc to gauge the individuals ability to sustain the loan
and its cost.
Lending Products for Individual Borrowers
Lending products for individual borrowers can be mainly divided by the
nature of the facility:
a. asset-based which would entail the bank providing the customer
with access to the funds for purchasing an asset- (long term or short term)
and the title of the assets generally resides with the bank or
b. clean lending where the bank lends to the individual without any
underlying asset.
Diagram 2.2 below provides a good illustration of the lending
products available for individual borrowers, at a glance.
Diagram 2.2
Lending Products for Individuals
Assets-based/secured
Clean/ Unsecured
Personal
Loan
Running
Finance
Credit '
Cards
Auto/Vehicle I House
Finance I Finance
Details of the products available for individuals in Pakistan within each subheading are as follows:
A. ASSET-BASED: 1. Long-term Facility
i.
Auto/Vehicle Finance
In Pakistan auto finance has been a popular product available for
individuals. This product is available through two different modes: Hire
Purchase and Leasing, which are discussed briefly as under. While in
this chapter we are discussing this mode under lending
products for individuals, hire purchase and leasing are applicable modes
of financing for businesses as well.
a.
Hire purchase
Hire purchase is an agreement to hire an asset with an option to

purchase. The legal title passes to the customer when final payment has
been made. The term of the finance is required to be shorter than the
expected life of the asset.
The bank actually buys the vehicle which then belongs to it, letting the
customer use the vehicle in return for a series of regular payments. The
vehicle can be of any form. The bank has the security of ownership of
the asset and can repossess it if the hire purchase terms are broken.
After all the payments have been made, the customer becomes the
owner, either automatically or on payment of a modest fee.
The main advantages for the customer of a hire purchase agreement
are:
b.
Small initial outlay.

Easy to arrange.
Certainty - the loan cannot be called in providing the terms are
kept.
Tax relief - interest payments are tax deductible and the asset
may also be subject to a write-down allowance for businesses.
The disadvantages are that it is more expensive than a cash
purchase and the fixed term means it may not be possible or
expensive to make early termination.
Leasing
Leasing is similar to hire purchase in that a vehicle or equipment owner

(the lessor) gives the right to use the equipment to the user (the lessee
i.e. the customer) over a period in return for rental payments. The
essential difference is that the lessee never becomes the owner unless
under capital lease.
For business borrowers, purchase of machinery and equipment can tie
up a lot of business finances, but leasing effectively provides access to
the asset without buying it up front.
an
for
The numerous types of leasing are fundamentally rental agreements

providing the business or individuals (the lessee) with the use of an
asset owned by the bank (the lessor) for a specified period of time
subject to agreed payments (rental payments). Almost any equipment
in any price range can be leased.
A direct lease is where the business or the individual advises the

leasing company of the asset which it wishes to acquire and the lessor
then buys it from the manufacturer (if new) or the previous owner (if
used) in order that it can be rented back.
mg
PsdKts, Operations and Risk Management | Reference Book 1
17
Sale and leaseback (sometimes referred to as purchase leaseback) is

where the business or individual sells an asset which they already own
to the finance company and then lease it back. (Sale and leaseback is
quite common with property - the property being sold to an investor
who leases it back.)
In both cases, the asset requires to be returned to the lessor at the end of
the agreed period. Many leases have an end-of -lease option providing
renewal at a minimal cost or sale to a third party.
Leasing can be useful when other sources of finance are not available.
There are also tax advantages; for example, rental payments under an
operating lease are tax deductible, as is interest under a finance lease.
The depreciation charge in the companys accounts for a finance lease is
tax allowable, dependent on the method of depreciation used
There are two main types of leases:
Operating lease
This type commits the lessee to only a short term contract that
can be terminated on notice. Usually the lessor pays for repairs,
maintenance and insurance. An operating lease is used for small
items like photocopiers and short term projects like building firms
hiring plant, vehicles etc.
Finance lease
The leasing company expects to recover the full cost of

equipment and interest over the period of the lease. Usually the
lessee has no right of cancellation or termination. Despite the
absence of legal ownership, the lessee bears the costs of
maintenance etc, and suffers if the equipment is under-utilised or
becomes obsolete. Finance leases offer less flexibility for the user
but this is reflected in the cheaper pricing.
The advantages of leasing are similar to those for hire purchase. An
additional advantage for operating leases is the transfer of the
obsolescence risk to the finance provider. The lessee can hand back the
equipment and take a fresh lease of more modem items.
Leasing is a highly specialized area and a customer will need advice to
assess whether to buy or lease, especially on the complicated tax issues
of finance leases. You may learn more about leasing from your own
organizations leasing department or subsidiary.
House Finance
House purchase loans (normally referred to as mortgages) are a big part of

retail banking business. In the past they were mainly the domain of building
societies. A mortgage loan is a loan to
finance the purchase of residential property, usually with specified payment

periods and interest rates.
The amount available to borrowers by banks will often be a stipulated
multiple of the customers salary/monthly income or a multiple of joint
borrowers combined salaries or monthly income (the earnings multiplier).
The basic lending criteria are based on the borrowers ability to meet the
repayments. The property will be mortgage to the bank as collateral till the
borrower makes all the payments and is then able to transfer the title of the
house to his/her name.
There is also another type of finance available which is self-build finance for
borrowers who would like to obtain finance to build their own house. Since
there is no one standard self-build project, set procedures should ideally be
followed during the life of the loan. Each project should be assessed on its
individual merits. As a result, the principles of lending should be carefully
considered when assessing a self-build application.
A self-build loan is an advance that will finance the building, converting or
renovating of a property as the customers principal residence. It is
important to be aware that the self-build facility is not a mortgage in the
traditional sense of the word - rather it is structured as an overdraft that is
secured over the plot of land on which the house is being built. Because selfbuild facilities require a mortgage to be granted in support of the borrowing,
this kind of facility falls under the auspices of mortgage regulations.
By the nature of the project, the funding for this type of borrowing must be
flexible.
Either of these potential options could be used:
Funding of the project in arrears on confirmation of stage completion this is the most common funding arrangement.
Funding of the project in advance may be considered depending upon

the individual proposition, such as low LTV (loan to value).
The expenditure involved in building the house is then drawn down against
this overdraft. In most instances, repayment of the overdraft will come from
the drawdown of a mortgage once the house has been completed. It is better
to set up the facility on a separate account for ease of monitoring.
The bank will expect the valuer to confirm that there are no restrictions
affecting the site, that outline planning consent is held and that there are no
anticipated problems with any potential development, such as access, supply
of services, etc.
Normally two valuations are required when dealing with a self build:
At the start of the project, a current and projected end valuation.
Products, Operations and Risk Management | Reference Book 1
19
At the end of the project, a revaluation prior to the mortgage

drawdown.
The normal stages of a self-build project are:

completion of the foundations/under buildings/plinth.
completion of ground level slab.
completion of first level slab (where applicable).
finishing (case-to-case basis).
It is normal practice to allow the customer to draw down on the self -build
loan at the end of each of these stages, formal certification being generally
required from:
a qualified architect.
development/cantonment authority inspector, a
structural engineer.
2. Short-term Facility i. Finance for

Consumer Durables
Financing of consumer durables such as refrigerators, air conditioners,
washing machines, computers, and other electrical appliances has
become popular since the last 2 decades or so. This financing is
available through the hire purchase mode as well as the clean lending
mode. In the hire purchase mode the bank purchases the good and gives
it to the customer for use and the customer pays back the bank in
monthly or quarterly installments.
B. CLEAN LENDING 1. Short-term Facility i.
Personal Loan- Installment-based finance
Personal loans are normally granted for the purpose of consumer
purchases such as: consumer durables (televisions, fridge-freezers,
etc), education and medical expenses and for home improvements
such as a new fitted kitchen, double glazing, the building of a
conservatory, etc. Personal loans are not restricted to these
purposes and may be granted for any purpose that is acceptable to
the bank.
Interest is charged on personal loans at a flat rate which means that
it is calculated on the total amount of the loan for the full term and
applied to the amount of the loan at the commencement of the
repayment term. This total amount is then divided by the number
of monthly installments to determine the amount of the repayment
installments.
Personal loans are not usually secured and the repayment period
can vary from a few months to several years.
When a personal loan application is received, it is usually credit
scored to determine whether or not the bank is willing
to grant the facility. Once a customers application has been processed

and shows an acceptable credit score, a pre-contract illustration is
provided prior to the customer and banker signing the loan agreement.
A formal letter setting out the terms and conditions of the loan is
normally given to the customer containing details of the interest
structure, total payable and the amount of the rebate should the loan be
repaid early.
The loan is created by a transfer of funds into the customers operative
account and a corresponding debit is made to a separate loan account.
The agreed repayments are credited to the loan account until it is
cleared off.
Some personal loans carry automatic life cover and there is also an
option for the customer to purchase accident, sickness and
unemployment insurance. These ensure protection for the customer and
the bank.
ii.
Running finance
A running finance account allows a customer to draw up to a set limit
which is related to a monthly fixed payment into the account. A
multiplier is related to this monthly payment; for example, if the
customer pays in Rs. 10,000 per month, the limit of borrowing may be
set at Rs. 300,000 (30 x Rs. 10,000).
The application form is similar to that for a personal loan and the
response data is credit scored. A credit limit is agreed but the bank does
not normally look for security. A separate account is maintained and it
is usual to arrange for the monthly payment to be transferred from an
operative account to the revolving credit account by standing order.
Interest is charged on a daily basis and normally applied monthly.
Should the account move into credit, interest on the credit balance may
be paid by the bank. Provided monthly payments are maintained and
interest is paid, the customer can sustain the borrowing at or near the
limit, subject to periodic review by the bank. Insurance may be offered
to pay off the debt in the event of the death of the customer or to meet
repayments if the borrower has a prolonged illness or is made
redundant.
Revolving credit accounts are intended primarily for the professional
type of customer with good income; being designed to allow the
customer to change a car, purchase electrical goods, etc without the
need to keep contacting the bank to enter into new personal loan
agreements for each purchase. Cashline by UBL is an example of
running finance facility under consumer finance.
iii.
Credit cards
Credit cards have increasingly become a part of everyday life. These

plastic cards can be used by the cardholder to purchase goods and
services which are paid for at a later date. They are
21
becoming a widely used method of making payments and for obtaining

credit facilities.
Credit cards are a method of money transmission where the customer has the
option of settling only part of the monthly bill, thereby borrowing the
amount of the unpaid balance. If the customer pays off the outstanding
balance in full prior to the repayment date, no interest is charged and
therefore this is a very cost-effective method of short term borrowing. By
careful timing of their purchases and then repaying the bill in full, the
customer may obtain approximately up to 50 days interest-free credit.
There are currently two dominant groups who operate international networks
- Visa and MasterCard. All the main banks, offer their own versions of either
or both of these cards. There are other companies such as Diners and
Maestro but the market share and reach of these companies is by far the
largest.
The essential features of a credit card are:
the purchase of goods and services on credit subject to an agreed overall

limit.
the issue of regular statements by the credit card issuing bank/company.

the option for the customer of either paying all of the sums due to the
bank or electing to pay off only a portion of the sums due (minimum
amount or 3 - 5%, whichever is the greater) and paying interest on the
remainder.
A credit card account operates independently of a customers other accounts
with the bank, and the relationship between the bank and the cardholder
differs from the traditional banker/customer relationship. In some cases
banks have issued credit cards which have been linked to their existing
deposit accounts with the banks and banks offer direct debit facility for the
payment. However, this is not general practice.
Each bank policy may differ, however as per popular practice locally it is not
necessary for a person to maintain an account with the bank before they can
be issued with a credit card. It is initiated by a separate agreement between
the bank and its customer regulating the issue of the credit card and the
debtor/creditor relationship that exists between the parties. In addition, due
to the element of credit involved, the bank will have to be satisfied that the
customer can be considered creditworthy for the amount of their limit. The
customer completes an application form as the basis of the agreement
between them and the bank. The application form also provides the bank
with a great deal of information about the customer, such as employer,
salary, house owner or tenant, marital status, number of children, etc.
Normally the creditworthiness of the applicant is screened by
the statistical method of credit scoring. The process determines the
statistical probability that the credit will be repaid.
Use of the credit card
Provided that the issuer is satisfied with the creditworthiness of the

customer, a card and personal identification number (PIN) will be issued
and the customer will be granted a credit limit. The customer can then
use the card to make purchases up to the amount of the limit on the
account. The cardholder presents the card to the retailer and the
transaction is completed by the card being swiped through the retailers
terminal. In many countries the customers are also required to input their
PIN number on a keypad. A credit card can also be used for postal,
internet and telephone transactions; the card number being quoted over
the phone together with the security code number quoted on the back of
the card. This information is input on to a computer or noted on an order
form sent in the post.
Cash can be withdrawn via ATMs using the credit card by the cardholder
inputting their PIN. This withdrawal will be treated by the credit card
company as a cash advance and so interest will accrue from the date of
the transaction.
Joint credit cards are not offered, but the customer has the option of
applying for supplementary cards to be issued on the account.
For example, a husband may choose to have a supplementary card for his
wife and children. The liability of repayment of debt of the
supplementary card will be on the husbands account.
Every month, the cardholder receives a statement showing: their
limit.
the transactions that have been made with the card(s). any
payments that have been received, any interest that has
been debited to the account, the current balance.
the amount of available credit remaining,
minimum payment required, payment due
date.
On receipt of a statement, a cardholder has the option of:
a. repaying the whole balance by the due date shown on the statement,
or
b. repaying the minimum amount required which is generally 3 - 5%
of the total outstanding amount.
Should the cardholder elect not to clear the balance due, interest will be
charged monthly from the statement date or the date of the transaction on any
outstanding balance not repaid.
24
Regulations and Practices

As discussed in chapterl, depending on the characteristics of different
lending products, they have different permissible limits, risk mitigation and
process requirements. To ensure transparency and coherence amongst the
lending practices, the SBP has provided a comprehensive list of Prudential
Regulations (PRs) to the banks and financial institutes catering to the
financing requirements of various types of customers.
Prudential Regulations (PRs)

Prudential Regulations are a set of minimum lending principles designed by
the SBP. The objective of these regulations is to bring consistency in lending
practices among banks and to maintain quality of credit portfolios across
banks.
To cater to the specialized and dynamic areas of lending the SBP has
following separate sets of PRs geared towards:
Corporate.
Commercial/SME and
Consumer business.
Agriculture
Some salient features of these regulations are discussed below. You are
encouraged to visit the SBP website and study the up-to-date regulations in
detail.
Prudential Regulations-Corporate
Corporate PRs contain a total of 27 regulations revolving around corporate
business and covering following aspects of credit quality:
Risk management
Corporate governance
Anti Money Laundering
13
Operations
5
Highlights of most important Risk Management related regulations (PRs)
are:
Maximum exposure (in outstanding terms) of a bank/DFI to a single

borrower shall not exceed 30% of its equity (fund-based 20%) and to
a group of borrowers 35% (fund-based 30%).
Contingent liabilities of a bank/DFI shall not exceed 10% of its

equity.
Banks/DFIs shall as a matter of rule, obtain copies of financial

statements duly audited by a chartered accountant relating to the
business of every borrower who is a limited liability company
Lending: Products, Operations and .Risk Management | Reference Book 1
Unsecured exposure is restricted to Rs.200,000.
Total exposure (fund based and/or non funds based) availed by any
borrower not to exceed 10 times of borrowers equity (fund based
exposure not to exceed 4 times of its equity).
Banks/DFIs to ensure that total exposure (fund based and/or nonfund

based) availed by any borrower from financial institutions does not
exceed 10 times of borrowers equity (fund based exposure not to
exceed 4 times). However, where equity of a borrower is negative and
the borrower has injected fresh equity during its current financial year,
it will be eligible to obtain finance up to 3 times of fresh injected
equity, provided the borrower shall plough back at least 80% of its net
profit each year until such time it is able to borrow without this
relaxation.
For the purpose of borrowing- subordinated loans shall be counted as

equity of the borrower.
Banks/DFIs shall not:

a) Take exposure against the security of shares/TFCs issued by them.
b) Provide unsecured credit to finance subscription towards
floatation of share capital and issue TFCs.
c) Take exposure against TFCs or shares not listed on stock
exchanges.
d) Take exposure against sponsor directors shares.
Banks/DFIs shall not own shares of any company in excess of 5% of

their own equity. Further, total investments of bank in shares should
not exceed 20% of their own equity (for DFIs the limit is 35% of their
equity).
Regulation (PR-8) relating to classification and provisioning of assets

is represented by an extra-ordinary lengthy reading. You are
encouraged to familiarize yourself with provisions of this regulation
along with regulation pertaining to governance (Gs) and operations
(Os).
Prudential Regulations-SME
Keeping in view the important role of Small and Medium Enterprises
(SMEs) in the economic development of Pakistan and to facilitate and
encourage the flow of bank credit to this sector, a separate set of Prudential
Regulations specifically for SME sector has been issued by State Bank of
Pakistan. This separate set of regulations, is aimed at encouraging
banks/DFIs to develop new financing techniques and innovative products
which can meet the financial requirements of SME sector and provides a
viable and growing lending outlet for banks/DFIs.
Banks/DFIs should recognize that success in SME lending requires much
more extensive involvement with the SMEs than the traditional lender-
25
borrower relationship envisages. The banks/DFIs are, thus, encouraged to

work in close association with SMEs. The banks/DFLs should assist and
guide the SMEs to develop appropriate systems and effectively manage their
resources and risks.
State Bank of Pakistan encourages banks/DFIs to lend to SMEs on the basis
of assets conversion cycle and future cash flows. A problem, which the
banks/DFIs may encounter in this respect, is the lack of adequate
information. In order to overcome this problem, banks/DFIs may also like to
prepare general industry cash flows and then adjust those cash flows for the
specific borrowers keeping in view their conditions and other factors
involved.
As mentioned above, presently most of the SMEs in Pakistan lack
sophistication to have reliable and sufficient data and financial information.
In order to capture this data and information, banks/DFIs will need to assist
and guide their SME customers. The banks/DFIs may come up with
minimum information requirements and standardized formats for this
purpose as per their own discretion. For better understanding and to facilitate
their SME customers, banks/DFIs are encouraged to translate their loan
application formats and brochures in Urdu and other regional languages.
In order to encourage close coordination of the officials of the banks/DFIs
and SMEs, the banks/DFIs may require the concerned dealing officer to
regularly visit the borrower. For this purpose, at a minimum, the dealing
officer may be required to pay at least one quarterly visit and document the
state of affairs of the SME. In addition, an officer senior to the ones
conducting these regular visits may also visit the SME at least once in a year.
The banks may, at their own discretion, correlate the frequency of visits with
their total exposure to the SME borrower.
A total of eleven (11) regulations govern banks SME business. Some of the
important ones are discussed as under:
Banks/DFIs shall specifically identify the sources of repayment and

assess the repayment capacity of the borrower on the basis of assets
conversion cycle and expected future cash flows.
All facilities; except those secured against liquid assets; extended to

SMEs shall be backed by the personal guarantees of the owners of
SME.
Banks/DFIs can take clean exposure on an SME to the maximum

extent of Rs.3 Million against personal guarantee of the owner
(funded exposure restricted to Rs.2 Million). All facilities over and
above Rs.3 Million shall be appropriately secured.
Maximum exposure of a Bank/DFI shall not exceed Rs 75 Million.

Total facilities availed by a single SME from financial institutions
should not exceed Rs 150 million.
Classification and provisioning requirements for SME borrowers are

the same as in case of corporate borrowers. Candidate should
familiarize themselves with these complex requirements.
Prudential Regulations - Consumer financing

Apart from the specific regulations for credit cards, auto loans, housing
finance and personal loans, minimum general requirements laid down by
SBP that govern the consumer business are as follows:
Bank/DFIs to establish separate risk management capacity for

consumer business.
Bank/DFIs to prepare comprehensive credit policy duly approved by

their BODs.
For every type of consumer financing facility bank/DFIs to develop a

specific program.
Bank/DFIs to have an efficient computer-based MIS system which

should efficiently cater the needs of consumer.
Bank/DFIs to develop comprehensive recovery procedures for

delinquent consumer loans.
For detailed study of these regulations you are encouraged to read and
assimilate various requirements of different type of consumer financing.
To ensure that bank/DFIs strictly follow the prudential regulations and for
their own regulatory purposes, SBP requires submission of /DFIs various
reports periodically, by the Banks.
Credit Policy
A credit policy is defined as a set of clear written guidelines of a bank that
address the following areas:
Credit terms and conditions - risk assessment criteria.

Customer eligibility criteria - target market.
Criteria for assigning risk ratings for obligors and facilities.
Treatment of obligors of different ratings.
Process and hierarchy for approving or rejecting a credit proposal.
Procedure for policy deviations.
Steps to be taken in case of customer delinquency.
Banks /DFIs must prepare a comprehensive credit policy keeping in view the
PRs set by the State Bank. This credit policy must be approved by the BOD.
There is no one-size-fits-all credit policy as each customer approaching the
bank has varying credit requirements, profiles, repayment capabilities etc.
Operations and Risk Management | Reference Book 1
27
Each Banks policy is to be based on their particular business strategy and

cash-flow circumstances, industry standards, current economic conditions,
and the risk culture of the bank. It is imperative for the banks to consider the
link between credit and sales at the time of policy creation. Easy credit terms
can be an excellent way to increase asset sales, but they can also result in
immense losses if customers default. A typical credit policy will address the
following points:
Processes: Details of acquisition, verification and rejection processes

are discussed in detail as an essential part of the credit policy manual.
Credit limits: Suggests the amount of money a bank is willing to

extend in credit form to a single customer and also defines the
corresponding parameters and circumstances.
Credit terms: Terms like payment due date, early-payment discounts

and late-payment penalties etc.
Deposits: If there are any requirements from customers to pay a

portion of the amount due in advance.
Customer Information: This section outlines the level of information

required by the bank about a customer before making a credit
decision. Parameters like years in business, length of time at present
location, bio data, financial data, credit rating with other vendors and
credit reporting agencies, information about the individual principals
of the company etc are all part of this information.
Customer Eligibility Criteria: This section describes factors on which

the decision to extend a credit line to any customer depends. All the
conditions that must be evaluated and analyzed are listed in this
section. All the terms and conditions must be in line with those
mentioned in SBPs PRs. By having a practical and realistic risk
based eligibility criteria banks are aiming to decrease the likelihood
of bad loans.
Documents Required: This section lists the documents mandatory to

processing any form of loan. Includes credit applications, sales
agreements, contracts, purchase orders, bills of lading, delivery
receipts, invoices, correspondence etc.
Other areas like income calculation methodology, credit initiation, rejection

conditions, credit deviation authorities and scenarios, fraud detection and
prevention, collection and recovery strategy and many other sections are part
of the credit policy. Each Bank/DFI develops policy manuals according to
their own standards with more or less all of the sections discussed earlier.
Importance of Credit Policy:
It is evident from the details listed above that a credit policy plays a very
important role in lending operations. Without a credit policy it would be
impossible to manage huge lending portfolios. Once a good credit
policy is in place, all cross functional departments have a clear

understanding of their role, resulting in quick and transparent credit
decisions. By defining the target market, risk assessment criteria and by
developing and listing down credit terms and conditions; a credit policy
ensures mitigation of lending risks arising from customers debt servicing
capacity, limit assignment and possible loopholes in collection and recovery
processes.
Pricing
Pricing Mechanisms
Simplistically speaking a loan is when you give someone money for a certain
period and charge them a certain amount (usually expressed as a percentage
and is called markup or interest) for the use of that money. The borrower is
expected to pay back the principal as well as the markup.
Pricing of the loan is the markup rate. This markup rate charged has two
components:
1. Base component, which can be derived from:
Internal cost of funds or
Market-based cost of funds.
2. Variable component.
1. Base component:
1.1.Internal cost of funds:
As a bank, the loan that you give out is against deposits. These deposits
generally have a cost associated to it. The cost can be in terms of:
a) the rate of return promised to the depositor,
b) the administrative cost of generating, processing and servicing the
deposit/depositor.
This method of calculating the cost of deposit is generally called the internal
cost of funds.
1.2.Market-based cost of funds:
In addition to the funds obtained from its depositors, the bank can also
borrow from other banks including the central bank and the money market.
This borrowing involves a cost which is termed as the Market- based cost of
funds. Market rate indicators such as KIBOR, T-bills, PIBs, REPO and
Reverse REPO rates are generally used as benchmark indicators in the
Pakistan market.
KIBOR stands for Karachi Inter Bank Open-market Rate. Its the rate of
interest at which banks in Karachi offer to lend money to one another in the
money markets. KIBOR is issued on daily, weekly, monthly and on 1,2 and
3 yearly basis by the State Bank of Pakistan.
Treasury bills (T-bills) are zero coupon instruments issued by the
Government of Pakistan and sold through the State Bank of Pakistan via
hwducts. Operations and Risk Management | Reference Book 1
29
fortnightly auctions. T-Bills are issued with maturities of 3-months, 6months and 1 Year and are priced at a discount. T-Bills are risk free, SLR
(Statutory Liquidity Requirement) eligible securities that are actively traded
in the secondary market and are therefore highly liquid. They are issued with
a minimum denomination of Rs.100,000.
Pakistan Investment Bonds (PIBS) are long term bonds issued by the
Government of Pakistan and sold through the State Bank of Pakistan via
periodic auctions. PIBs are issued with tenors of 3, 5, 7,10,15, 20 and 30
Years. Being backed by the Government of Pakistan, they present a low risk
long term investment option. The Pakistan Investment Bonds offer a fixed
semiannual coupon and repayment of principal at maturity. They are highly
liquid SLR (Statutory Liquidity Requirement) eligible securities that are
actively traded in the secondary market. The minimum denomination of PIBs
is Rs.100, 000.
REPO and Reverse REPO The discount rate at which a central bank
repurchases government securities from the commercial banks, depending on
the level of money supply it decides to maintain in the country's monetary
system. To temporarily expand the money supply, the central bank decreases
repo rates. To contract the money supply it increases the repo rates.
Alternatively, the central bank decides on a desired level of money supply
and lets the market determine the appropriate repo rate. Repo is short for
repossession.
A reverse repo is simply the same repurchase agreement from the buyer's
viewpoint, not the seller's. Hence, the seller executing the transaction would
describe it as a "repo", while the buyer in the same transaction would
describe it a "reverse repo". So "repo" and "reverse repo" are exactly the
same kind of transaction, just described from opposite viewpoints. The term
"reverse repo and sale" is commonly used to describe the creation of a short
position in a debt instrument where the buyer in the repo transaction
immediately sells the security provided by the seller on the open market. On
the settlement date of the repo, the buyer acquires the relevant security on the
open market and delivers it to the seller. In such a short transaction the seller
is wagering that the relevant security will decline in value between the date
of the repo and the settlement date.
2. Variable component:
The variable component of the markup rate is the spread that banks keep on
top of their base component or cost of funds when lending to customers. The
size of the spread generally depends on three factors:
1.
Type of the customer i.e. whether the customer is a corporate /

wholesale customer or a consumer / retail customer.
2.
Customers credit risk rating which is assigned based on the

customers profile.
3.
The banks balance sheet mix and its need for deposit or loans at a
given point in time.
For banks the cost of doing business with the corporate / wholesale customer
is lower compared to consumer / retail customer. For example handing out a
loan of 100 million to one corporate customer costs less in terms of
administrative, legal, processing and servicing cost then than handing out a
total loan of PKR 100 million but split between to 100 different retail
customers.
31
Similarly, for banks the cost of lending is higher for high risk customers.
Since for high risk customers the probability of default is higher, the bank
needs to charge a higher rate to keep a cushion in case the customer defaults.
Each bank has a strategic requirement of maintaining certain debt-equity
ratio in its balance sheet. These requirements are specific to each bank, but
must be in line with SBPs stipulated guidelines.
Fixed and Floating Rates
The markup rate given to a customer can be floating or fixed.
Floating rate also known as a variable or adjustable rate refers to a rate on
any type of credit that does not have a fixed rate of mark-up or interest over
the life of that credit. Floating rate changes on a periodic basis. The change
is usually tied to the movement of an outside indicator or the prime rate/
discount rate (an interest rate charged by the central bank from depository
institutions that borrow reserves from it, for example the interest rate
charged by the State Bank of Pakistan). One of the most common rates used
as the basis for applying interest rates is the Karachi Inter-bank Offered Rate
or KIBOR.
The rate for such a credit will usually be referred to as a spread or margin
over the base rate: for example, a five-year loan may be priced at six- month
KIBOR + 2.50%. At the end of each six-month period, the rate for the
following period will be based on the KIBOR at that point, plus the spread.
Re-pricing interval The re-pricing interval measures the period from the date
the loan is made until it first may be re-priced. For floating-rate loans that are
subject to re-pricing at any time the re-pricing interval is zero. For floating
rate loans that have a scheduled re-pricing interval, the interval measures the
number of days between the date the loan is made and the date on which it is
next scheduled to re-price. For loans, having rates that remain fixed until the
loan matures (fixed-rate loans) the interval measures the number of days
between the date the loan is made and the date on which it matures. Loans
that re-price daily are assumed to re-price on the business day after they are
made.
Fixed rate on the other hand does not fluctuate during the fixed rate period.
This allows the borrower to accurately predict their future payments.
For an individual or a company taking out a loan when rates are low, a fixed
rate loan would allow the borrower to "lock in" the low rates and not be
concerned with interest rate spikes. On the other hand, if interest rates are
high at the time of the loan, the borrower will benefit from a floating rate
loan, because if the prime rate falls, the rate on the loan would decrease. The
opposite is true for the lender. The lender would not like to be stuck in a low
fixed rate lending contract if interest rates are rising, as his cost of funds will
rise. Bankers thus keep a large margin when lending at a fixed rate and do a
thorough analysis of the interest rate behavior to ensure that they do not bind
themselves to a lending contract which may become unfavorable in the
future.
Risk-based pricing in the simplest terms, is alignment of loan pridag with the
expected loan risk. It is a manifestation of the risk reward concerc- higher
the risk, higher the reward; in this case higher the risk, higher the price of
credit i.e. mark-up. Typically, a borrowers credit risk is used tz> determine
if a loan application will be accepted or declined. That sane risk level is also
used to drive pricing. This means charging a higher interest rate for a higher
risk transaction or high risk rated customer and a lower rate for a lower risk
transaction or a lower risk rated customer.
A balanced pricing strategy comprises of three critical elements. First, the
bank must have solid credit quality. If the borrower defaults, the net result is
a charge-off that negatively impacts credit reserves and bank earnings. The
second important component is profitability. Pricing for loans must result in
the required rate of return on assets as determined by the bank. The final
component of a balanced pricing strategy is portfolio growth. A balanced
pricing strategy should support portfolio growth generated by profitable,
quality loans. The result is a balanced pricing strategy that can be best
summarized as the proverbial three-legged stool of quality, profitability, and
growth. Each is important, but if one is missing, the stool will tip over.
Risk reward pricing is the ratio used by lenders to compare the expected
returns of a loan to the amount of risk undertaken to capture these returns.
This ratio is calculated mathematically by dividing the amount of profit the
lender expects to have made when the position is closed (i.e. the reward) by
the amount he or she stands to lose if price moves in the unexpected
direction (i.e. the risk).
The higher the risk the greater is the reward. In consumer banking the spread
is very large, the pricing is based on the whole portfolio and the
administrative cost is very high therefore the risk is high. Whereas in
corporate banking, the individual loan is priced therefore the risk is low.
Relationship yield pricing is pricing the credit based on the overal customer
relationship rather than on a stand-alone product basis. Fo example if the
customer has taken a loan from the bank, chances are h would also route his
collections and payments through the bank as wel Sometimes a loan is an
initiator of a larger relationship with the customs therefore it is the
relationship managers responsibility to not just sell loan to the customer but
build further relationship with customer t cross-selling other products. Since
other products generally have a low risk involved as compared to loans,
profitability of the customer to t! bank on a holistic level compared to the
risk involved will be high when the customer is using other products of the
bank.
For example, Haji Kareem Bakhsh & Co banks with the National Bank of
Pakistan (NBP). They are in the business of plastic bottles manufacturing. At
the moment they have a long term loan of Rs. lOOMillion with the bank at 1
year KIBOR + 2.5% p.a. NBP hosts their 200 employee accounts and also
provides payroll management services. Similarly, their collections account is
also being maintained at NBP. Last month the company imported machinery
from Japan worth $50,000 for which an LC of the required amount was also
opened by NBP in their name. The LC pricing is 0.1% which the customer is
refusing to pay on the pretext that it has such extensive business with the
bank. Moreover, the customer has requested a short-term financing- FIM for
a period of 30 days for which the customer insists that it will only pay 1
month KIBOR +0.5% on this transaction. On a stand-alone basis this
transaction will not make any money for the bank and there is risk involved.
It is important to evaluate the revenue of the entire relationship as well as the
impact on the relationship before deciding to open the LC or decline it.
Taking another example, where Mr. Ahmed Saad has a HBL credit card with
limit of Rs.100,000. He is very apt in settling his outstanding balance. He

generally makes the payment within few days of making the transaction,
which ensures that he is never charged any markup on the utilized amount.
The only income HBL earns on this credit card is the annual fee and 1.25%
to 2% acquiring commission on each transaction. Mr. Saad also maintains a
current account with HBL with an average balance of Rs.300,000. Mr. Saad
has requested the bank for a waiver on the annual charges for the credit card
which are PKR 1500. In his request he has mentioned his long standing
relationship with HBL on the depository side and has said that he would be
obliged to move his balance to a different bank if HBL cannot make this
concession for him. If this matter on pricing was to be viewed only based on
the card revenue, the customers request would be rejected. However if you
take in account the revenue generated by the bank by reinvesting the average
balance of PKR 300,000 @ of 12% (current discount rate), you will
probably be inclined to accommodate the customers request. Moreover the
deposit allows the bank to generate more loans (the money multiplier effect)
which will also yield profit. Considered on a relationship basis, Mr. Saads
account is profitable and compromising pricing on one product maybe of
overall benefit to the bank.
Opportunity Cost is the cost of an alternative that must be forgone in order
to pursue a certain action. Put another way, the benefits you could have
received by taking an alternative action. For example the opportunity cost of
lending to a customer instead of lending in the money market is the cost of
risk free return that is now lost by lending the customer. Lending to the
customer should thus yield a significant benefit above the money market
lending to compensate for the loss of risk-free return. Simply put the loan
can never be priced below the market rate under normal circumstances. Even
if the internal cost of funds for the bank is low, lending below market rate
would have a significant opportunity cost loss - meaning the loss we have
incurred by lending at a rate lower than what the customer was willing to
pay.
Compiled from:
Credit Lending Module and
Specialized Lending Book-One of
Chartered Bankers Institute and
Contribution by: Mr. Akbar Chugtai
Part Three
Student Learning
Outcomes
Lending Risk Assessment and

Management
Explain the importance of evaluating the level of risk in lending
Differentiate between risk assessment and management
Discuss the risks posed by the economic environment in lending
operations
Explain the importance of diversified risk portfolio
B
Explain the role of corporate governance and organizational

structure in ensuring smooth running of lending operations and its
impact on the bank's assessment of lender's risk rating
Describe the various types of SBP reporting requirements to
ensure industry wide effective risk assessment and management
for business and consumer lending
State various types of risks that impact the lending decision

Define obligor risk rating (0RR) and facility risk rating (FRR)
Explain the obligor risks associated with lending to an individual
and a business client
Identify the different types of industry risks that must be

considered while making the lending decision
Explain the transaction failure risk and suggest ways to avoid it

Explain foreign exchange and interest rate risk
Present other factors which can be a source of risk to the bank's

lending portfolio
Identify the sources of risk and explain its impact on obligor risk
rating and pricing
Highlight the ways in which a market check can be conducted for
a consumer and business client

Identify various means of market research available for consumer
and business clients
Explain the role of data check, search report, eClB and SBP risk
rating requirements in the risk assessment process
> Explain the SBP's risk rating requirements and state the impact of
this step on overall industry risk assessment practices
State the SBP Prudential Regulations relating to risk management

for business clients
State the SBP Prudential Regulations relating to risk management

for consumer clients
Explain the eligibility criteria for consumer lending of various

products under consumer portfolio
Calculate relevant financial ratios for making business lending
decisions
35
*
*
*
Demonstrate the use of debt burden in making lending decisions

for consumer clients
State the salient parameters of credit policy
Differentiate between consumer and business parameters in the
credit policy
Explain the meaning of delinquent/remedial portfolio and the

manner in which banks manage these
Explain the methods of measuring delinquency within a consumer

and business portfolio and discuss the role of trend analysis
Discuss various delinquency control measures and comment on

their accuracy
Explain collection policy for consumer portfolio and remedial

management for business portfolio and recall its prominent
parameters
Explain recovery policy and recall its prominent parameters

Differentiate between collection and recovery policies
Appreciate few collection and recovery strategies being used
industry wide
Explain risk management strategies being used for un-secured

lending products under the consumer product umbrella
Explain the general reserves requirements as imposed by SBP on

banks dealing in consumer lending
State SBP regulations concerning collection methodology and

describe the strategies adopted by banks for both business and
consumer lending
36
Overview and Sources of Lending Risks

Introduction:
The State Bank of Pakistan defines financial risk in the following manner:
Financial risk in a banking organization is possibility that the outcome of
an action or event could bring up adverse impacts. Such outcomes could
either result in a direct loss of earnings / capital or may result in imposition
of constraints on banks ability to meet its business objectives. Such
constraints pose a risk as these could hinder a bank's ability to conduct its
ongoing business or to take benefit of opportunities to enhance its business.
Regardless of the sophistication of the measures, banks often distinguish
between expected and unexpected losses. Expected losses are those that the
bank knows with reasonable certainty will occur (e.g., the expected default
rate of corporate loan portfolio or credit card portfolio) and are typically
reserved for in some manner. Unexpected losses are those associated with
unforeseen events (e.g. losses experienced by banks in the aftermath of
nuclear tests, Losses due to a sudden down turn in economy or falling
interest rates). Banks rely on their capital as a buffer to absorb such losses.
Risks are usually defined by the adverse impact on profitability of several
distinct sources of uncertainty. While the types and degree of risks an
organization may be exposed to depend upon a number of factors such as its
size, complexity business activities, volume etc, it is believed that generally
the banks face Credit, Market, Liquidity, Operational, Compliance / legal
/regulatory and reputation risks.
Until and unless risks are not assessed and measured prudently it will not be
possible to control risks. Hence the process of risk evaluation, the need to
monitor effectively all the areas that may give rise to possible risky
situations, becomes extremely important. Further a true assessment of risk
gives management a clear view of institutions standing and helps in
deciding future action plan. To adequately capture institutions risk exposure,
risk measurement should represent aggregate exposure of institution both
risk type and business line and encompass short run as well as long run
impact on institution. To the maximum possible extent institutions should
establish systems / models that quantify their risk profile, however, in some
risk categories such as operational risk, quantification is quite difficult and
complex. Wherever it is not possible to quantify risks, qualitative measures
should be adopted to capture those risks. Whilst quantitative measurement
systems support effective decisionmaking, better measurement does not
obviate the need for well-informed, qualitative judgment.
The acceptance and management of financial risk is inherent to the business
of banking and banks roles as financial intermediaries. It is important for a
bank to be risk averse and all managers must be able to recognize, manage
and mitigate risk at all levels of operation.
In a depressed economic environment like ours, wherein power, gas and
water supplies are not assured, businesses whether big or small run the risk
of disintegration. Investors both international and domestic shy away in such
an unstable economic and political environment aided by acute
37
security concerns. Likewise, lenders to the businesses tend to stay away

leaving businesses dry for liquidity. Resultant reduction in margins,
lengthening of receivables and negative cash flows cause the businesses to
face delays in meeting their financial commitments. Such delay if remain
consistent cause defaults and result in loss for lenders. A myriad of
frameworks and statements pertaining to risk management essentially cover
the following elements:
What is at risk and why?
What and where are the risks?
What is known about them?
How important are they?
What should be done about them?
Risk Management
Risk management is rigorous and coordinated approach to assess and
respond to all risks that effect the achievement of an organizations strategic
and financial objectives; including both upside and downside risks. The
objective of risk management is thus, to prevent loss by continuous
monitoring an accounts activity. At the same time banks cannot become risk
averse and take no risk at all, as this would result in an inadequate return on
capital for the bank. A fine degree of judgment is needed.
The State Bank of Pakistan, in its document Risk Management guidelines
for commercial banks and DFIs (Appendix 3A), defines risk management
as:
A discipline at the core of every financial institution and encompasses all
the activities that affect its risk profile. It involves identification,
measurement, monitoring and controlling risks to ensure that
a) The individuals who take or manage risks clearly understand it.
b) The organizations Risk exposure is within the limits established by
Board of Directors.
c) Risk taking decisions are in line with the business strategy and objectives
set by BOD.
d) The expected payoffs compensate for the risks taken
e) Risk taking decisions are explicit and clear.
f) Sufficient capital as a buffer is available to take risk.
Risk management as commonly perceived does not mean minimizing risk;
rather the goal of risk management is to optimize risk-reward trade -off.
As a process, Risk management has the following five steps, which include:
1) Risk Identification.
2) Risk Measurement.
3) Monitoring and Reporting.
4) Mitigation and Control.
5) Optimization.
Risk management process initiates with the existence of well documented

credit policies and procedures developed in line with risk strategy by the risk
management department. These policy documents should identify, the who,
what and when aspect of risk management, while procedures answer the
how feature. These policies and procedures should be communicated to all
employees. Separate policy and procedure documents should be developed
for each risk type (credit risk, market risk, operational risk, liquidity risk etc)
these policies and procedures should be updated at least once every year
based on changing business requirements for effective and efficient risk
management at the enterprise level. Credit policy of a bank/DFI should
feature its risk appetite, risk strategy, risk management framework and risk
management infrastructure on enterprise level. Additionally it should
emphatically state the use of a well defined target market and risk
acceptance terms for business selectivity and acceptable returns. Following
elements should form part of credit policy:
1.
2.
3.
4.
5.
Standards for financial/business analysis.

Credit administration roles and responsibilities.
Compliances problem recognition (early warning signals).
Remedial management, and
Organization and deployment.
Risk Assessment
Risk assessment process goes further deep to analyze the causes of risks,
their identification, description, estimation, evaluation and their relevant
mitigation strategies.
Credit assessment is a process which guides a lending officer to determine
whether a credit is worthy of undertaking or not. Knowledge of the customer
is critical to making a sound credit judgment. Credit pundits have capsule
assessment ingredients, six in number; known as 6Cs i.e. character, cash
flow, collateral, capital, capacity and concentration. This means before we
attempt to assess worthiness of a credit, we must look at all these areas very
carefully. If a potential borrower enjoys a good market reputation vis-a-vis
his financial obligations towards its suppliers and customers, has not been
defaulted intentionally or benefited from a bank loan write-off and if market
check proves that banks, CIB and the suppliers/customers on a potential
customer are positive, first litmus test has been passed. The lending officer
may now proceed further to launch a full length credit assessment both
quantitative and qualitative. Quantitative assessment is relatively easy
(access to historical financial statements, financial projections and their
analysis) but for qualitative assessment one would like to know; what is the
financial character of the borrower i.e. is it a public limited company or a
private limited company, a partnership or a sole proprietorship and for what
purpose financing is being obtained? Further to it, one would like to ensure
that structure of the facility is appropriate and it commensurate with the
purpose of the facility. It is also equally important to know and assess
borrowers management competence, market and technical know-how,
products he manufactures/sells, his market share, years in business,
operations, and most importantly his business strategy. Risk identification,
risk understanding (including risks involved in realizing security/ collateral
39
interests) and identification of mitigating factors are the broader areas one
should focus on while assessing a credit. To sum up, one must look beyond
the financials to determine if the customer is an economically viable entity.
Corporate Governance:
In every financial institution, risk management activities broadly take place
simultaneously at following different hierarchy levels:
a) Strategic level: It encompasses risk management functions performed by
senior management and BOD. For instance definition of risks,
ascertaining institutions risk appetite, formulating strategy and policies
for managing risks and establish adequate systems and controls to ensure
that overall risk remain within acceptable level and the reward
compensate for the risk taken.
b) Macro Level: It encompasses risk management within a business area or
across business lines. Generally the risk management activities
performed by middle management or units devoted to risk reviews fall
into this category.
c) Micro Level: It involves On-the-line risk management where risks are
actually created. These are the risk management activities performed by
individuals who take risks on organizations behalf such as front office
and loan origination functions. The risk management in those areas is
confined to following operational procedures and guidelines set by
management.
Board and Senior Management oversight
To be effective, the concern and tone for risk management must start at the
top. While the overall responsibility of risk management rests with the BOD,
it is the duty of senior management to transform strategic direction set by
board in the shape of policies and procedures and to institute an effective
hierarchy to execute and implement those policies. To ensure that the
policies are consistent with the risk tolerances of shareholders the same
should be approved from board.
Senior management has to ensure that these policies are embedded in the
culture of organization. Only the formulation of policies would not solve the
purpose unless these are clear and communicated down the line. Risk
tolerances relating to quantifiable risks are generally communicated as limits
or sub-limits to those who accept risks on behalf of organization. However
not all risks are quantifiable. Qualitative risk measures could be
communicated as guidelines and inferred from management business
decisions.
To ensure that risk taking remains within limits set by senior
management/BOD, any material exception to the risk management policies
and tolerances should be reported to the senior management/board that in
turn must trigger appropriate corrective measures. These exceptions also
serve as an input to judge the appropriateness of systems and procedures
relating to risk management.
To keep these policies in line with significant changes in internal and

external environment, BOD is expected to review and make appropriate
changes as and when deemed necessary.
Risk Management framework
A risk management framework encompasses the scope of risks to be

managed, the process/systems and procedures to manage risk and the roles
and responsibilities of individuals involved in risk management. The
framework should be comprehensive enough to capture all risks a bank is
exposed to and have flexibility to accommodate any change in business
activities. An effective risk management framework includes:
a) Clearly defined risk management policies and procedures covering risk
identification, acceptance, measurement, monitoring, reporting and
control.
b) A well constituted organizational structure defining clearly roles and
responsibilities of individuals involved in risk taking as well as
managing it.
c) Banks, in addition to risk management functions for various risk
categories may institute a setup that supervises overall risk management
at the bank. Such a setup could be in the form of a separate department
or banks Risk Management Committee (RMC) could perform such
function. The structure should be such that ensures effective monitoring
and control over risks being taken. The individuals responsible for
review function (Risk review, internal audit, compliance etc) should be
independent from risk taking units and report directly to board or senior
management who are also not involved in risk taking.
d) There should be an effective management information system that
ensures flow of information from operational level to top management
and a system to address any exceptions observed. There should be an
explicit procedure regarding measures to be taken to address such
deviations.
e) The framework should have a mechanism to ensure an ongoing review of
systems, policies and procedures for risk management and procedure to
adopt changes.
Integration of Risk Management
Risks must not be viewed and assessed in isolation, not only because a single
transaction might have a number of risks but also one type of risk can trigger
other risks. Since interaction of various risks could result in diminution or
enhancement, the risk management process should recognize and reflect risk
interactions in all business activities as appropriate. While assessing and
managing risk, the management should have an overall view of risks the
institution is exposed to. This requires having a structure in place to look at
risk interrelationships across the organization.
41
Business Line Accountability
In every banking organization there are people who are dedicated to risk
management activities, such as risk review, internal audit etc. It must not be
construed that risk management is something to be performed by a few
individuals or a department. Business lines are equally responsible for the
risks they are taking. Because line personnel, more than anyone else,
understand the risks of the business, such a lack of accountability can lead to
problems.
Risk Evaluation/Measurement
Risk evaluation is essential to effectively monitor the level of risk present.

Until and unless risks are not assessed and measured, controlling will be
impossible. Hence the process of risk evaluation, the need to monitor
effectively all the areas that may give rise to possible risky situations,
becomes extremely important. Wherever it is not possible to quantify risks,
qualitative measures should be adopted to capture those risks. While
quantitative measurement systems support effective decision-making, better
measurement does not obviate the need for well-informed, qualitative
judgment. Consequently the importance of staff having relevant knowledge
and expertise cannot be undermined. Finally any risk measurement
framework, especially those employing quantitative techniques/model, is
only as good as its underlying assumptions, the rigor and robustness of its
analytical methodologies, the controls surrounding data inputs and its
appropriate application.
Independent review
One of the most important aspects in risk management philosophy is to

make sure that those who take or accept risks on behalf of the institution are
not the ones who measure, monitor and evaluate them. Again the managerial
structure and hierarchy of risk review function may vary across banks
depending upon their size and nature of the business, the key is
independence.
To be effective the review functions should have sufficient authority,
expertise and corporate stature so that the identification and reporting of
their findings could be accomplished without any hindrance. The findings of
their reviews should be reported to business units, Senior Management and,
where appropriate, the Board.
Contingency planning
Institutions should have a mechanism to identify stress situations ahead of

time and plans to deal with such unusual situations in a timely and effective
manner. Stress situations to which this principle applies include all types of
risks. For instance contingency planning activities include disaster recovery
planning, public relations damage control, litigation strategy, responding to
regulatory criticism etc. Contingency plans should be reviewed regularly to
ensure they encompass reasonably probable events that could impact the
organization. Plans should be tested as to the appropriateness of responses,
escalation and communication channels and the impact on other parts of the
institution.
Risk Spectrum
There are various types/ sources of risks that impact the lending decisions.
Under Basel II these risks have been categorized into the below mentioned
categories. Basel II, is the second Basel Accord and represents
recommendations by bank supervisors and central bankers from the 13
countries making up the Basel Committee on Banking Supervision to revise
the international standards for measuring the adequacy of a bank's capital. It
was created to promote greater consistency in the way banks and banking
regulators approach risk management across national borders.(For details on
Basel II and its application in Pakistan please refer to Appendix 3).
1. Credit Risk
Credit risk is considered as the highest form of risk; it includes default risk
and multi-faceted liquidity risk. It is defined as a risk that borrowers may not
be able to fulfill their obligations (whether funded or non- funded) towards
the bank/DFI on time in full or contracted, resulting in a financial loss to the
lender. Credit exposure risk also incorporates in itselfrating migration risk
caused by the change in credit quality (rating) of the borrower and
consequently affecting default probability.
2. Liquidity risk
Liquidity risk is the risk that a bank/DFI may not be able to meet its financial
commitments to customers (depositors) and market (interbank market).
Liquidity risk may emerge as a result of the mismatch of assets and liabilities
or structured products. Another facet of liquidity risk is contingency liquidity
risk i.e. risk of not being able to meet contractual obligations due to
insufficient funds.
3. Market Risk
Market risk is defined as the risk that an asset cannot be sold at a (near) fair
value due to market disruption or impaired market access. Market risk
highlights the risk of losses on and off balance sheet positions arising from
(adverse) movements in the market prices or in other words exposure to
potential loss that would result from changes in the market price. Market risk
measurement is carried out by considering the underlying factors that
determine the price of market sensitive instruments. Such factors could be:
a. Equity Risk
A bank/DFI investments in stock market (shares) may become
vulnerable to losses if share prices and dividend yields there on
plunge due to market fluctuations.
b. Interest rate risk
A bank/DFI may have to face loss situations due to change in bond
prices and yield curves (if discount rate increases, bond prices and
yields there on plunge). Increase in interest rates may also square
general credit spreads and negatively effect liquidity element.
43
c. Commodity Price risk

Prices of oils, metals etc may go down as a result of decreased
interest. Thus investments made in high interest rates regime may
adversely affect and may cause losses.
d. Currency or Foreign exchange risk
The risk that an investor will have to close out a long or short
position in a foreign currency at a loss due to an adverse movement
in exchange rates. This is also known as "currency risk" or
"exchange-rate risk".
4. Operational risk
Operational risk is defined as the risk of loss resulting from inadequate or

failed internal processes, people and systems or from external factors. It is
the risk associated with operating a business. Every Bank/DFI should have
an operational risk Management (ORM) framework to contain operational
risk to an acceptable level, as determined by senior management. It is
important to ensure that the bank has sufficient information to make
informed decisions about additional controls, adjustment to existing controls
or other risk integration efforts. Operational risk may pose serious threats of
losses both externally and internally. On the external front a bank/DFI may
have to digest gross cost of compensation and/or penalty payments made to
third parties, regulatory/tax fines, loss of resource(s) and legal/consultancy
cost incurred to fix operational anomalies. Internal losses may involve writeoffs, or impairment in the value of any financial asset owned by the bank,
restitution payments to third parties and out of packed costs.
5. Counter Party Risk
Counter party risk is the risk that counterparty fails to honor its part of
contractual obligation while a bank/DFI has already met its commitment
e. g. a bank/DFI sold dollars forward to a counter party for a period of say
90 days. On 89th day (one day before maturity of the contract as that the
counterparty gets dollars on 90th day) Bank/DFI issues instructions to its
foreign depository bank to credit/Counter party account with dollars. On
90th day the counterparty is unable to deliver agreed amount of Pak Rupees
to the Bank/DFI.
6. Industry Risk / Economic environment Risk
Industry risk can be multilateral in nature, usually spearheaded by economic

environment of the country in which it operates. Unstable political
environment can adversely affect economic growth. This at times compels
investors to shy away leaving industry performance in jeopardy. Unstable
political/economic factors thus make an industry highly vulnerable to
financial losses. Industry structure (size, products, markets, competition,
profit dynamics, growth profile, demand/supply forces, and cost structure),
its attractiveness now and in future, and success factors should be thoroughly
analyzed to determine the real risks an industry may face.
Risk Rating
The degree of risk inherent to each lending product must be gauged to
some extent of accuracy. The primary objective is to assess, at any given point of
time, realistically recoverable value of an underlined asset. Risk ratings is a
unique system designed to weigh and compare all risk assets regardless of
type, nature or location of the borrowers.
All banks/DFIs are required to assign internal risk ratings across all their
credit activities including consumer portfolio. The internal risk ratings
should be based on a two tier rating system:
1. An obligor rating, based on the risk of borrower default and
representing the probability of default by a borrower or group in
repaying its obligation in the normal course of business and that can
be easily mapped to a default probability bucket.
A facility 'eating, taking into account transaction specific factors,
and determining the loss parameters in case of default and
representing loss severity of principal and/or interest on any business
credit facility.
In practice facility rating is calculated on the basis of a) the type and
nature of facility and b) the type, quality, amount and recoverability
of the collateral secured against that particular facility.
The obligor rating must be oriented to the risk of borrower default. Separate
exposures to the same borrower must be assigned to the same borrower
grade, irrespective of any differences in the nature of each specific
transaction. There are two exceptions to this. Firstly, in the case of country
transfer risk, where a bank may assign different borrower grades depending
on whether the facility is denominated in local or foreign currency.
Secondly, when the treatment of associated guarantees to a facility may be
reflected in an adjusted borrower grade. In either case, separate exposures
may result in multiple grades for the same borrower. Guarantors rating may
also be assigned to the borrower if there is an absolute guarantee and in case
of default the bank has 100% recourse on the guarantor.
Basel II requires the risk ratings to be carried out at an obligor level, spread
over a scale of one (1) to twelve (12), one (1) rating being the highest
quality risk and twelve (12) being the best equivalent to adversely classify as
loss. (Refer Appendix 3).
Risk ratings are determined to:
1. Price each obligor- higher the risk rating of an obligor, steeper the
risk will be.
2. Calculation of the loss a credit carries based on its Corporate Branch
mark Loss Norm (CBLN) is not a prediction that there will be actual
loss on a particular credit, it is rather a statement that a particular
obligor displays characteristics similar to other obligors which over
an average period of time, produced a present value loss equal to
certain loss norm or written a range of loss norm.
45
The Chief Risk Officer (CRO) is responsible for advising loss norms to the
line management. Obligor Risk Rating (ORRs) may be assigned systemically
through the use of a debt rating models (DRM). DRMs perform complex
analysis of both qualitative and quantitative factors pertaining to a borrower
e.g. reliability of financial information, industry risk competitive conditions
in terms of economic environment, quality of obligors management and
compliance of PRs etc. ORRs must be assigned and approved for individual
credits when initially extended and must be reviewed at least annually if
otherwise warranted earlier due to any significant development. Also, must
be reviewed immediately after a credit is adversely classified.
The facility rating must be oriented to the loss severity of principal and/or
interest on any exposure. A Bank/DFI may have extended to a single counter
party a number of credit facilities against different collaterals, having
different priority rules and legal recourse to the recovery in case of default.
The Banks should consider relevant transactions specific facts, based on the
type of facility and collateral, while assigning the facility rating. This process
may result in different facility ratings to the same entity. The banks are
required to calculate and report loss severity of each facility provided to the
borrowers.
(Refer Appendix 3B).
Compiled from:
Specialized Lending Book-One of
Chartered Bankers Institute and
Contribution by: Mr. Akbar Chugtai
Risk Assessment fir Risk Management

Introduction:
In this chapter we are going to learn the basic principles of lending - a key
skill area for people working in financial services. All professions have some
core skills or competences. How to lend money safely and profitably is
certainly a key skill for bankers. By lending money safely we mean making
credit and lending decisions that are soundly based, and which result in the
interest being paid as it falls due and the loan repaid as arranged.
We shall see how to consider the character and capability of the person being
lent to and how a business proposal is analyzed - the important point being
the ability, or otherwise, of the borrower to repay. The reasons why a
business wants to borrow is an important part of the analysis of any lending
proposal from a customer.
If you were to look at a banks balance sheet you would see that the amount
of share capital, or shareholders funds, is quite small in relation to the loans
granted to customers (assets in a banks balance sheet). It is the share capital
in the balance sheet which is the buffer, or safety cushion, that protects the
creditors of the business, including the bank. All this capital must have been
lost before the creditors suffer through not being paid in full.
A banks main creditors are the people who deposit their money with it. If
these depositors are to be assured of getting their money back, the banks
assets, which mainly include loans to customers, need to be worth their full
balance sheet value. Thus banks need to ensure that the loans they grant are
safe and can be repaid by customers, otherwise the safety buffer of capital
will be quickly eroded. Hence it is important for a banker to possess sound
lending judgement.
At the outset it has to be said that a structured approach to the lending of
money is by far the best practice to adopt. There are many facets to a lending
proposal; going through them methodically allows fewer chances for
something important to be missed. Another point is that the same rules apply
for a small loan as for a large one. We ask, is the business capable of
repaying its loan out of income and on the terms arranged?
We start by considering the principles of lending, or canons of lending, as
they are sometimes called.
The canons of lending

Why lend?
As we all know, banks accept money on deposit from customers and pay
them interest on the sums deposited. In order to find the money to pay the
depositors interest as well as to meet the demands of shareholders and staff,
the bank must generate revenue and make a profit.
Lending out deposited funds remains core to the banking industry. The rate
of interest charged to borrowers is always greater than that paid to
depositors. The difference is the banks margin. However, if the borrower is
unable to repay the advance, the bank will not only lose
47
the interest it requires in order to pay the depositors interest, but may also
lose the capital sum which it needs to repay the depositor. Therefore lending
skills and judgement are critically important to the banker if the depositors
money is to be lent out safely and profitably, and repaid on time as agreed.
Banks need to minimise their bad debts.
The lending of money is not an exact science; it is not possible to work out
some formula or apply a certain theory to guarantee that the amount lent to
the customer will be repaid with interest. For lending to businesses, except
the smallest ones, there is no computer program that will accept business data
at one end and produce the correct lending decision at the other. The spectrum
of lending situations is too varied to accommodate a straightforward
numerical solution. After gathering the information, you require to analyze
your findings and make a sound lending decision. The general principles of
good lending, or canons of lending, if consistently applied with a structured
analytical approach and sound judgement, will reduce the risk involved in
lending to the customer.
To help remember the fundamental principles, mnemonics can be used to
ensure a uniform and consistent approach. Here are a few common examples:
CAMPARI=
Character Ability Margin Purpose

Repayment Insurance (Security)
Amount
PARSERS
= Person (Character,Capacity,
Commitment)
Amount
Repayment
Security
Expediency
Remuneration
Services
PARTS
= Purpose Amount Repayment Term

Security
5 Cs
= Character Capacity Capital Conditions

Collateral (Security)
CAMELS = Capital
Asset Quality
Management
Earnings
Liquidity
System
Your organisation may employ one of the above but from the list you will
see that they are all effectively variations on a theme. From the above
examples you can extract the key components:
People/Character.
Purpose/Amount.
Repayment capability/Terms.
Security.
Remuneration/Margin.
We shall examine each of these elements in turn and in some detail, but
before we start, here are three brief case studies; a more complex one is
included at the end of the chapter.
The following customers would like the bank to lend them money for
business purposes.
Case study
Mr Ahsan
Aged 44, he has been running his own engineering business for the last
10 years. He has banked with you since his business started and is
seeking an extension to his overdraft facility.
Mrs Khan
Aged 38, she is a housewife who is starting a new business in catering.
She has been a customer of the bank for the last 15 years.
Mr Asad
Aged 18, he has recently left college and wants a loan to
start a business washing cars. No previous bank account.
These customers, or potential customers, are all seeking loans, but will you
agree to lend to them?
On the limited information available, it is unlikely that you could make a
rational decision on whether to lend or not, but as we go through the factors
to be considered you will see how easy it is to build up a much clearer
picture of the customer. The information will come from a variety of sources,
some of which will be readily available, others may require you to dig
deeper.
People/Character
It is, of course, people who make things happen. While all of the above key
components are critical in assessing the viability of a proposal, if the
individuals involved are found wanting in major aspects, then there is little
scope for manoeuvre and to carry the proposition forward.
A deal making approach can help you to negotiate a mutually acceptable
compromise in the proposal when areas of deficiency are identified.
However, if you have doubts about the people with whom you are dealing
there is little you can do to gain enough confidence to
49
progress the proposal further.

Banks compete vigorously for business they see as attractive. There is a
limited amount of good business available. To be successful, bankers must
have the skills and judgment to assess a lending proposal thoroughly,
structure an acceptable proposition and then obtain approval for the loan.
You need to be able to identify an attractive opportunity. You also need to
show the professionalism and skill that the customer is entitled to expect
from their banker.
Remember too that banking relationships are based on mutual trust and
respect, both of which have to be earned. Openness, cooperation and honesty
are important. It is in this climate that the customer should be willing to
provide all the information that the bank reasonably requests in order to
assess the safety of the proposed lending and the customers ability to repay.
Some potential customers will make a direct approach to you but more
usually you will require a level of proactivity, which will not be achieved
from sitting behind a desk. Your job as a business banker or credit analyst
includes much more than just making credit decisions. You need to identify
and contact customers whom you wish to add to your portfolio. The quicker
you can assess the customer and their needs, structure a proposal that is
appropriate to both your customer and the bank, the greater the level of
success you will enjoy.
Preparation for meeting with a lending prospect
Imagine you have an appointment in your diary to go and see an existing

customer. You will want to be fully prepared for the meeting. There will
already be a great deal of information in the banks files and the typical
questions you should be asking as you prepare are:
How long have they been a customer of the bank? If less than say
six months, you may wish to find out their prior history. What is
their reputation and track record?
Have accounts been maintained in a satisfactory manner with
previous borrowing repaid on time? (The pattern of lodgements into
the account will give you more information.) Are there regular
lodgements to the account?
Are there any charges applied in respect of unauthorized
overdrafts?
Is there any evidence of items having to be returned unpaid for lack
of funds?
What are the figures for turnover (the businesss sales), the
maximum balance on the account, and the minimum and average
balance figures over the last three years?
Your computer records will provide this valuable information.

Let us now suppose that the meeting is with someone who does not at
present do business with you. You may have asked for the meeting to try to
gain their business, or they may have requested the meeting, having heard
positive comments about your efficient, friendly and
flexible service. Your reputation in the market is also important as you seek
to grow your business.
If an account is being transferred from another bank, you will want to know
why this is happening. It could be that the customer is unhappy about poor
service, high charges or the location of their current bank, providing you
with an opportunity to promote what your bank can offer. Equally, you must
be aware that the proposition being put to you may have already been
declined by their existing bank or that they are seeking an alternative
quotation for comparison purposes regarding pricing, etc. You would not
want to step lightly into another banks shoes and then find that there are
serious financial and management problems with the business.
Meeting the customer
Information gathering meetings should be held at your customers business

premises where possible; otherwise at least followed up with visits.
Customers tend to be far more comfortable and forthcoming in their own
environment. They take pride in showing you what they have achieved or
are looking to do. The visit also demonstrates that you are keen to work
closely with them and can relate to their situation and get a clear
understanding of their current and future needs.
Xo\x
atv expert \n e^erj WsYt\es& secXo^WtVj
looking while visiting their premises you will learn a lot about the
individuals and their business. You will not be surprised to learn that in
many cases the initial impression you form looking round the premises, its
overall organization, the quality of employees, stock levels/controls, etc,
very much aligns with your subsequent analysis of the performance figures.
So what should you be looking for in assessing the people? Initially, it is
important to obtain a profile of the individuals. While this can be compiled
from discussion, obtaining CVs from the management team can be helpful.
You should be looking for evidence of the following:
age.
qualifications and experience.
financial acumen.
integrity and reliability, organizational
ability and efficiency.
Qualifications and experience
You want to know whether the borrower has thought out their business
proposition fully and whether they have the drive and ability to see it
through to a successful conclusion. Many people in business have no formal
qualifications, but unless such qualifications are essential to the successful
operation of the business, relevant experience is often more important.
Essential question: Has the borrower the experience and qualifications to
make a success of the business?
51
Financial acumen
Another important demonstrable skill is good financial judgment and the

ability to keep proper records and accounts.
Essential questions:
Can the customer keep within any borrowing limit agreed?

Does the customer know quantity of sales to make a profit?
If goods are sold at a certain price, do they know how much it has
cost to produce them and does this price also cover all the
overheads and result in a profit?
The business and management team
Having acquired the basic information on the people involved in running the
business and formed an opinion on their abilities; you now need to think
about the business itself. From your existing knowledge of different business
structures, you will establish quickly whether the business is a sole trader, a
partnership or a limited company. The success of a business is inextricably
bound up with the drive and ability of the people running it.
Essential questions:
Do they relate well to each other?
Can they identify and agree common goals and objectives?
Can they work together as a team to achieve those goals?

Obviously, you only wish to deal with people who are respectable and
trustworthy. After all, there are many ways in which a borrower can take
unfair advantage of a bank once they have the money. We want our
customers to be honest, dependable and people of high integrity. Whether
your proposed borrower meets these criteria is a key judgment area.
Other issues as regards management are:
What ages are the members of the management team?

Are any of the management team close to retirement?
What abilities and qualifications do the management team have?
Have they distinguished themselves in previous business dealings?
Do they have previous experience in the business they are running?
What is their commitment to the business and how enthusiastic are
they about its success?
Are they risk takers or conservative, change-orientated or
conventional?
Drive - are they plodding along or are they looking to the future?
Are they looking at developments by their competitors and making
changes to existing practices to ensure that their business stays
competitive?
Are they leaders or followers in the market place?
Do they show strength and depth in the key areas of business,
such as production, marketing, finance, administration and human

resources?
Do they have a track record of coming through tough trading cycles

and conditions?
For the majority of small to medium sized businesses it is not practical or
realistic to have managers employed who are fully qualified in every critical
area. Usually there are one or two key individuals, expert in their own
specialism, but who know when to consult others, such as the accountant or
banker, for example.
As business grows it is important to review the key areas to ensure that there
is the appropriate knowledge and ability for the business to prosper. It is
especially important for you to keep informed of the customers overall
business strategy:
Is the customer involved in a highly competitive business where

competitors are always trying to undercut each other?
If so, how will price reductions affect the figures on which you will
base your decision on whether or not to lend?
What are the risks this business faces, how is management
minimizing these risks and are the projected figures robust enough to
show the loan can be repaid?
Is the business subject to seasonal fluctuations? (For example, a
seaside hotel or a farmer.).
What is the character of a business?
The character of a business, whether it is a sole trader, partnership or limited

company, not surprisingly, is shaped by the personal character of the
individual(s) who run the business. The sole trader apart, the other business
structures are heavily influenced by the ability of the individuals to interact
with each other and identify and agree common goals and objectives. Once
this is achieved, the real test is their capability to work as a team to proceed
in the chosen direction, respond constructively when things go wrong, and
ultimately meet desired targets.
This may seem like stating the obvious, but some businesses have been
known to founder due to personality clashes or individuals being unable to
agree on the way ahead. Provided you are satisfied that there is commonality
amongst the individuals in question, you should be in a position to determine
which of the above characteristics apply to the business. However, this is
only a part of the total picture.
Here is a checklist to prompt you to think through the key issues:
o Capacity
o Management
o Premises
o Plant and equipment
o Seasonality
o Social issues
o Succession planning
o Technology
o Profitability
o Staff
o Competition
o Legal issues
o Product
o Industry
o Political issues
o Service
o Cost structure
o Expediency
o Market
o Economic conditions
53
The areas to consider here are:
Capacity
the capacity of the management.

the capacity of the business.
the capacity of the industry and how the business compares with the
industry norms.
the overall effects of the economy on the business.
Management
This topic has already been covered above, but as a business grows it is
important to review the key areas to ensure that there is the appropriate
knowledge and ability for the business to prosper.
Succession planning
Succession planning ensures that a business can continue successfully after

the loss (whether planned or unexpected) of any individual manager or
member of staff, so it is vital to identify and plan for key positions in the
future.
There is another dimension to this which is particularly prevalent in familyrun businesses where they may have started as a sole trader or partnership
between, say husband and wife. If their sons or daughters indicate a desire to
join the business it can provoke issues in the following areas:
Can the business support the drawings of the additional individuals
and possibly their families? A business that once supported one
family may be stretched to support a number of families.
The personal problems that can arise in the above scenario. How do
you choose which one of your family is to succeed you when it is
obvious that the business cannot support everyone but they have all
indicated a desire to become involved? An example of this could be
a farming business where expansion could present a potential
solution but the cost implications present questionable viability.
Staff
When considering the quality and ability of the human resources available,
the following checklist will help:
Recognition/reward schemes.
Staff morale/turnover.
Commitment.
Under-/over-staffed.
Labour relations.
Dependency on specialist skills - easily recruited/replaced
Training issues.
Product
The product or service which the business sells/provides require

investigation. If the business produces only one product, it has all it eggs in
one basket, that is, it is relying totally on one product or on< service. This
could make the business more vulnerable. Also, if anothei company invents
a more advanced version of a similar product, youi customer could suffer
badly from the competition and perhaps go oul of business altogether.
Is this business involved in product development? It is always better foi a
business to diversify and have a range of products or services. It is equally
important that they keep abreast of technological developments, market
trends, etc to ensure that their products remain competitive.
Service
How aware is the business of its standing in the market place and
what does it do to sustain/improve its position?
How does it handle/research the following areas?
- Track service performance: assess gaps between
customer expectations and perception.
- Do they have an understanding of customer expectations
both current and future, within their industry?
- Gauge effectiveness to any changes that are introduced to
the manner in which they deliver their service.
- Identify high performing staff members/teams - reward and
recognition.
- Complaints: do they try to recover the situation?
Market
Does the business rely on one supplier or obtain raw materials from
a range of suppliers?
Who are the customers and what is the potential for
expansion?
Where is the business placed in the supply chain?
Relying on one major customer is risky; what happens if the customer

becomes unhappy about quality or delivery, or they encounter financial
difficulties? Relying on one customer also places that customer in a strong
position for specifying pricing, delivery schedules, etc.
Premises
Does the business own or lease its premises?

If the premises are owned, is there borrowing?
If there is borrowing outstanding, is the business generating
sufficient profit to make capital reductions and meet interest
payments?
If the premises are leased, what are the terms of the lease?
55
What is the rent and when are the rent reviews scheduled?
Is there sufficient space for the business to expand?
Are there special conditions in the lease?
Are these conditions acceptable to the bank?
Plant and equipment
Is the machinery owned, leased or under hire purchase

contract?
How old is the machinery?
Will it need to be replaced?
Does it work at full capacity?
Is there any machinery that is obsolete?
Is the machinery critical?
Alternative means of manufacture.
Technology
Is there a technological awareness to ensure that they are not

competitively disadvantaged by failing to keep up to date?
Need for new hardware/software?
Licensing agreements?
Training issues?
Competition
Who are the competitors of the business?

What size is the business in relation to its competitors?
Can the business allow a reduction in its sales prices to maintain its
customer base or attract new customers and at the same time
continue to be profitable? In many industries there is no longer
room for everybody; one businesss increase in customers represents
another businesss loss.
Industry/business sector
It is important to understand the industry in which a business operates and in

particular to compare the industry norms and averages. Published industry
studies will provide you with background information on various industries
and business sectors.
Is the customers sector growing (emerging), at a mature phase, or declining?
For each of these phases, the business may have to confront different risk
factors. Forming a view of the industrys maturity will assist in your
assessment as your customer will be presented with both opportunities and
problems at each stage:
Emerging industries tend to grow very fast. They are either new to
the market or have been revitalized by customer demand,
technology or changes to the cost base that have reestablished
viability. Growth is usually in excess of 20 per cent per annum and
can be as high as 100 per cent. But these can also be higher risk (for
example, the dot.com boom and bust in the technology industry
around 2000).
Mature industries can usually expect an annual growth of up to 20

per cent. Areas such as product development tend to be less
frequent in this category and businesses may remain in this stage for
many years. They can of course also become revitalized or decline.
Declining industries usually experience a steady decline over a
period of time and are higher risk as future income streams are
uncertain.
Cost structure
It is important to establish the operational gearing - the relationship between

fixed costs and variable costs.
A fixed cost is one that will remain constant whether or not the sales in a
business are rising or falling, for example repayments on a loan.
A variable cost normally fluctuates or can be controlled in proportion to
the level of sales, for example the cost of raw materials.
If a business shows a high level of variable to fixed costs it is in a better
position to be able to control its costs if sales drop - costs will decrease as the
sales turnover declines. If there is a high level of fixed to variable costs, the
business will be less able to reduce its costs and may thus incur losses.
You should also be aware of factors which may be applicable to the business
but are outside their control such as changes in taxation, interest rates and
exchange rates.
Economic conditions
How is the business affected by economic conditions? To what extent is the

trading cycle impacted by rises or falls in the economy? Do sales and profits
within the sector tend to rise and fall as the economic cycle expands and
contracts, or are the swings more severe in recessionary conditions, making
the business more risky?
Cyclical businesses tend to mirror trends in the economy. The building
industry is usually the first to suffer in a recession and amongst the last to
recover when the economy improves. In the retail business, sales of luxury
goods drop when there is an economic downturn.
Countercyclical businesses tend to perform better in recessionary conditions;
for example, a business which repairs goods may find that more customers
employ their services rather than buying new items.
Non-cyclical industries tend to trade in goods which are regarded as
necessities such as food, or a utility, such as a water company.
Where a business is prone to cyclicality, you are looking for evidence of
forward planning, primarily through retention of profits, to equip themselves
for periods of economic downturn.
How is the business affected by the seasons of the year? Does the
business require seasonal borrowing for peak sales periods?
Is this changing as a result of imported goods such as fruit,

vegetables, flowers, etc?
Can the impact be reduced by diversification into say,tourism, for

57
Seasonality
example, by provision of activities and attractions other than what

was previously accepted as the traditional season?
Social issues
Social issues includes such things as demographics, in the local market,

nationally and perhaps even internationally. Is unemployment an issue in the
market the business serves? Is management aware of financial pressures
affecting customers and suppliers? Does management know how their record
on social awareness is regarded by customers and potential customers? Do
they have a clear idea of the socio-economic groups they serve? Do they
support local initiatives and are they aware of local attitudes?
Profitability
What is the industrys record of profit and how does this compare
with the business you are assessing?
How are profits generated used? Are they reinvested in the business
or are they paid out as dividends or bonuses to directors?
Legal issues
Is the operation of the business affected by particular contract?

How quickly does the business respond to regulatory changes?
What about green issues, such as environmental protection?
Planning/consent issues.
Political issues
How would the business be affected by political issues, such as the

following?
Change of Government/Government policy.
International tensions, particularly where the customer is involved
in the export or import of goods.
Local government policy.
Local business rates.
Expediency
You may already have come across situations where the lending manager
has granted loan facilities in other than normal cirunnstances. This is often
done for reasons of expediency, because it is
the decision has been influenced by factors that would not normally form
part of lending criteria.
Case study
Say the son or daughter of a prominent businessman wants to borrow money

to start up in business. A refusal could mean their father transferring his
business account to another bank. If the financial information provided
suggests that serviceability is marginal but the borrowing requirement is
relatively modest, you may be prepared to assist against the fathers personal
guarantee. If things do not work out as expected, the father will be liable for
repayment of the borrowing. This may be a better option than declining the
son or daughter and risking the loss of the fathers business. While the loan
is not granted using the normal credit decision process, the risk to the bank
has been minimized and you have cemented your relationship with your new
customers father.
This is a judgment call that very much carries a health warning. If the
business proposal in the above scenario was seen to be completely unviable
and you were considering lending solely against security, then you may be
faced with some difficult decisions. Ever conscious of not breaching
confidentiality, you would certainly need to ensure that the father sought
appropriate legal advice and was fully aware of his liability. The father may
be guiding and assisting in the background and, through his own business
acumen, is well aware of the deficiencies and risks. However, if this is not
the case, you may wish to highlight diplomatically your areas of concern to
the son or daughter and actively encourage them to seek their fathers input,
together with agreement (if appropriate) to an open meeting with all parties.
Fundamentally you want to convey that you are not only acting in their best
interests, but also their fathers as guarantor, as well as the banks.
This is a difficult type of proposition. It may prove prudent and beneficial to
get a second opinion through discussion with the next level of the banks
sanctioning authority.
Purpose and amount
Do the proposals meet lending criteria? Obviously, the purpose of the loan
has to be legal and within the lending criteria, or guidelines, set out by your
bank. It is unlikely that any customer is going to be so blatant as to tell you
that they want the money for an illegal or unsuitable purpose, but you must
be aware that such things can happen and that it is the banks reputation
which is at risk should you lend money to a customer liable to participate in
such activities. However, even if the purpose of the loan is legal, you may
not be in a position to lend if the proposals do not meet the following
criteria:
1.
Your banks own policy on lending to particular types of customer.

All banks place restrictions on the total amount they are prepared
to lend both to any one customer and to any particular sector, such
as property development or farming. It may be that you have to
turn down an application
59
for a loan because the bank has limited the amount which it is
prepared to lend to that sector.
2. There are some credit controls imposed by government or financial
services regulators. These regulations may restrict your ability to
lend, and may apply to particular sectors of the economy.
Any significant changes to the above criteria will generally be highlighted in
communications from your banks head office. Your role is to gather the
information, ensure the criteria are met and then assess the viability of each
proposal.
Seven basic reasons why businesses borrow
The starting point to any lending decision is: why does the customer require
to borrow? This is the first specific assessment you need to make after
considering whether the request is legal and within your banks own policy.
All requests from customers for credit fall into any one or more of the
following seven borrowing requirements:
1.
To finance operating costs, or variable costs, and fixed costs (such

as wages, salaries, heat and light, etc) until trade debtors are
converted into cash.
2.
To finance stocks until they are converted to finished goods, sold,

and the debtors turned into cash.
3.
To finance the purchase or refurbishment of property, plant and

equipment until they are used up over many trading cycles in
producing output which is converted to sales and then to cash.
4.
To finance the whole range of assets, such as stock, debtors, and

fixed assets, and pay additional operating costs, etc, required to
support rapid growth.
5.
To finance a change in the companys ownership, such as a

management buyout.
6.
To finance one-off projects, such as property development.
7.
To finance survival until the company can be turned around. The

business may be leaking cash, making insufficient profits, or
incurring losses.
Remember, customers may require borrowing for more than one purpose; for
example, to finance both debtors and stock. It is up to you to differentiate
and account for how much requires to be financed for each component.
Knowing what you are financing brings you closer to understanding your
customers business and its needs. This is fundamental to good relationship
management.
Linked to borrowing requirements is the trading cycle, which in any business

starts
with cash
and ends with cash. What goes on within a business between
The trading
cycle
the start and finish of the cycle is important for bankers to understand. The
length of the cycle will depend on the industry. For example, a business that
sells fresh fish daily has a very short trading cycle, whereas a company
building a ship has a long trading cycle. It is cash generated through this
cycle that repays loans and services interest payments.
The management of working capital in the trade cycle is a key element in
financial management, not least because, for most firms, current assets
represent a major proportion of their total assets.
Working capital is the difference between current assets and current
liabilities. Working capital is also called net current assets.
Current assets are:
stock (inventory).
debtors (receivables).
short term marketable investments,
cash.
Current liabilities are:
creditors (payables) due within a year.
short term borrowings.

Some examples of trading cycles are the following.
Trading cycle 1
Simple trading cycle of a newspaper street vendor, who operates totally in

cash:
CASH
STOCK
lending: Products, Operations and Risk Management | Reference Book 1
61
Trading cycle 2
The trading cycle would look like the following:
Business plans
Broadly, any business plan should set out:
where you are now?

where you want to get to? how
you are going to get there?
The preparation of a business plan should be seen as an important

management tool by all businesses irrespective of size and not as a document
that they have to produce in support of a lending request. It should provide
four key functions:
assist in clarifying, focusing and researching the development of the

business.
provide a structure for the business strategy and development plans
over the short, medium and long term, can be used as the basis for
discussion or support with third parties such as bankers, shareholders
or other investors.
sets goals and objectives and enables monitoring and review against
actual performance.
Content of a good business plan
While reading this section, you must always keep in mind the size of the
business and the borrowing requirements. For example, it would be
unrealistic, as well as damaging to your relationship with your customer, to
expect that every time a longstanding, established sole trader seeks a modest
short term facility, they will produce a sizeable document detailing all of the
undernoted points. In other words you need to align your expectations with
your existing knowledge, the circumstances and your banks lending criteria.
However, this does serve to provide you with the type of plan that should be
produced where applicable.
Contact details
Business name, registered and trading address, contact name(s),

telephone/fax numbers and e-mail address, website details where
applicable.
Synopsis/executive summary
A few paragraphs briefly outlining the plan, detailing why it is being written
and what the business is seeking to achieve. Any borrowing requirements
should be detailed: how much, for what, and the length of time to repay.
Business background and history
This should include when the business commenced trading, its performance
and development since that time, notable achievements and milestones, and
any industry recognition such as quality awards. If it is a new business with
no history, detail should be provided of why the business is starting up and
the owners background and experience.
Products or services
What the business does, with details of their range of products and/or
services. This should then be expanded to demonstrate what differentiates
them from what is available elsewhere in the market.
Process
This is only applicable where the business is manufacturing a product. An

outline should be provided and illustrated where appropriate.
Market analysis
This is one of the key areas of the plan and can be wide ranging. It is heavily
influenced by the businesss industry sector and how your customer operates
within that market. An example of the type of areas you should expect to see
the results of research are:
market size, market
trends.
competitors - who, what they do and how they compare? market
segmentation, including different delivery channels such as retail
outlets or internet based, service quality, pricing.
potential
customers,
environmental
issues,
legislative issues.
Marketing strategy
The strategy is formulated on the back of the above research and is often
enhanced by the inclusion of a SWOT (Strengths, Weaknesses,
Opportunities, Threats) analysis. The content of the strategy is usually built
around:
customers and markets - what potential exists and specifically to whom

are they going to sell?
premises - where and the impact on distribution and sales? product or
service - already covered but needs to be briefly revisited in this section
to provide a complete view of the strategy; what and how does it
compare with the rest of the market?
promotion - how will the business advertise and what are the costs?
price - charging policy, including details of the margins involved and
comparison with competitors.
The proposal
This covers the reasons for undertaking the borrowing and what benefits it
will bring to the business, such as increased sales, cost savings, job creation,
etc. The financial requirements should be detailed illustrating the capital
expenditure and working capital needs.
63
Management/staff
Profiles of the management team supported by a structure chart (if

appropriate) illustrating how the business will operate in going forward.
Details should be provided of any additional staffing requirements and
the impact on the wages bill.
Property
Details of existing premises including ownership, value, terms of lease,

etc; in the case of a new business, details of proposed location and
inherent costs.
Equipment/capital expenditure
Details of necessary expenditure during the period of the plan (not

normally exceeding three years).
Financial information
Ideally presented in a tabular format to aid comparisons and to include:

the last three years profit and loss accounts and balance sheets.
projected performance figures for the profit and loss account and
balance sheet.
cash flow projections.
funding requirements - bank loan/increased overdraft, hire
purchase, leasing, equity.
Risk assessment
Demonstration that a sensitivity analysis has been completed considering

the impact of any variances from the forecast performance and what
actions could be taken to minimize the risk to the customer and those
who are funding the business. Examples could include contingency
strategies for failure to achieve projected turnover, reduced profit margin
or increased costs.
There are many sources that your customer can draw upon to assist in
compilation of their business plan, including websites. The sample format
shows the importance of a business plan, not only to support a borrowing
request but also a tool for the management, leading to a disciplined and
focused approach to the business.
Cash flow projections and monitoring are key components and they will be
covered in greater depth later in the course.
When examining a business plan you are assessing the risk attached to the
loan. Lending to a new business may appear more risky than lending to an
existing one, but, on the other hand, over-lending to an existing customer
brings its own risks. Unless you are quite sure the business is viable at the
new levels of debt, the risk may be increased and the bank merely throwing
good money after bad.
How much does the customer want?
How much does the customer need?
When considering borrowing proposals it is worth remembering that there is
almost as much risk of a loan not being repaid because the borrower has
requested too small a loan as there is when the borrower asks for too much
money. Therefore you need to assess how much the business actually needs
as opposed to what the customer thinks they need. In many cases this will be
the same amount, but sometimes the amounts do not align.
Example
hart (if
going
affing
The customer could ask for a loan to purchase a piece of equipment,

but forgets that running the plant may bring extra fixed costs, such
as wages and electricity. Also, the aim of the new plant may be to
increase production and therefore sales. But you will recall that
increasing sales means more money locked in stock and debtors and
these additional assets need to be financed until they are converted
into cash in the working capital/trading cycle.
rms of
>cation
If the customer has not borrowed enough and cannot finance the
extra costs involved, a situation could arise where a piece of
equipment lies idle and is not earning its keep and producing the
cash to repay the bank.
in (not
and to
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To ensure that the correct level of advance has been requested, the customer
is asked to produce a cash flow projection which can take the form of a
simple statement showing how much cash the business presently has, what
its projected income and expenditure will be and therefore how much cash
there will be at the end of the period. You will want to make your own
independent view of how much the business requires to finance its plans.
Customer's stake
When considering the amount of the loan requested, you should also take
into account how much the proprietor is investing in the business. If the
customer has capital of Rs. 100,000 in the business and requests a loan of Rs.
150,000, then they are asking the bank to invest more in the business than
they have invested. In other words, the bank is asked to take a bigger risk
than the proprietor is prepared to take.
As for the level of the customers stake in the business, generally speaking
the customer should have more, or at least as much invested in the business
as they are asking for in the loan, but this is not always the case. When the
amounts are small, you may not be too concerned about this rule, especially
when the customer can offer adequate security against the loan. But when the
amounts are larger you need to look carefully at the customers stake in the
business.
Repayment capability /Terms
In any loan agreement the customer must be able to repay the loan in the
agreed time span. The customer must therefore be able to show, based on
historical information and, more importantly, with projected figures, that the
business can meet interest payments and repay the loan, with an adequate
margin in case of the unexpected. There is no point in too much optimism; the
schedule of loan repayments must be realistic and achievable.
We have seen how important it is for the strength of the banks balance sheet
that its loans (assets) realize their full value - that is, the loans are repaid
according to their terms. It is these repayments and the interest earned that
creates the banks profit.
Obviously the term of the advance is crucial; the longer the loan term, the
smaller the capital repayments need to be each year. If a term loan is being
negotiated for the purchase of a fixed asset, it is prudent to make sure that the
loan is paid off during the life of the asset. It is also a sound principle to
remember that the longer the period of the loan, the greater the risk of
something happening that will increase the risk of it not being repaid.
Standing: Products, Operations and Risk Management | Reference Book 1
65
In the case of an overdraft facility agreed to provide working capital, however,

you will expect to see healthy fluctuations in the borrowing as the cash flows
through the trading (or working capital) cycle from the purchase of raw
materials to the collection of cash from debtors. With this type of lending, the
amount borrowed should fluctuate up and down as the cash flows through the
business.
Projected, or budgeted, figures for income and expenditure and profit
projections will form the basis of your assessment. Only once you have gone
through each of these, and considered all the principles of lending, will you be
able to give an answer to the customer.
Cash flow analysis
From what you have read so far you will have realized that cash flow analysis
and the ongoing monitoring of cash flow are key elements in credit and
lending. You should bear in mind that cash flow is crucial when discussing the
repayment of bank facilities and the period over which the loan is repaid, its
term.
Type/period of the loan
When you have established that the proposals are viable - that the business
can make the proposed interest and loan repayments - then you work with
your customer to determine the loan facility that best matches their needs.
For capital expenditure, we have seen that term of the loan facility should
normally tie in with the expected life of the asset being purchased. You will
also need to take into account any extra finance needed for working capital to
support the higher levels of debtors and stock during the working capital
cycle. Often the purpose of new investment in fixed assets is to increase
production and hence sales. These additional sales require to be financed in
order to cover the increased level of stock and debtors. Thus it may be
appropriate to divide the total facility you provide into an overdraft for
working capital which will fluctuate, and a term loan on which there is the
discipline of fixed repayments.
Each bank has its own range of lending products (including lternatives such as
asset finance through for example, hire purchase) and you should research this
in your own business unit.
Security
Although it is true that any proposition should be able to stand on its own
without the need for security, the bank will most likely wish to safeguard itself
against unforeseen circumstances or risk by seeking acceptable security.
Running a business is full of risks. Nobody can guarantee that the business
will be a success. Taking security not only protects the bank but also the
customer. Remember also that the bank is lending out its depositors money
and needs to get it back in order to repay those depositors when they want
their money.
Taking security over business premises, for instance, provides protection for
the customer if they have personal liability as a sole trader, partner or if there
is a guarantor for the loan. Security arrangements are included in the loan
agreement between the bank and the customer. Should the terms of the
agreement be breached, the loan usually becomes repayable on demand,
giving the bank the power to seek repayment and look to its security, although
more usually the bank will renegotiate the terms of the loan. Provided the
customer
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keeps to the terms and conditions, the bank cannot demand repayment.
Security is the insurance in case things go wrong or do not work out as
originally planned.
Typical items which can be used as security include:
legal mortgages over property.
floating charges (only from companies).
guarantees.
life policies.
stocks and shares.
It is always prudent to allow a margin for cover with the security taken (this
means obtaining more security than the amount of the loan). The reason for
seeking a margin of cover is a very prudent one; should the borrower fail to
keep up with repayments and the security needs to be sold, then it may not
fetch the value attached to it when the loan was granted. For example, the
value of stocks and shares can fluctuate markedly and we have seen how the
value of property can also fall in times of recession.
It is important to emphasize that we should never lend purely because we are
fully secured. Unless viability can be established in the business (it can
comfortably service and repay its debts from cash flow and profits) it is in
neither the customers nor the banks best interests to lend. In isolation, the
fact that the bank will not lose money is insufficient reason to agree to the
loan.
Sometimes customers may demur about providing security. They may feel
that the bank cannot lose out and is charging a lot for its facilities through
interest and charges. There are good arguments against this line of thought.
The banks return is fixed whereas the proprietors return is based on profit.
The potential is there for the business to generate profits which are not shared
with the bank; in other words, the investors in the business are risking their
capital with a view to making a sizeable return from its profits. The bank, on
the other hand, is taking the same financial risks but for a defined return
through the interest. The bank is not taking an equity risk; it is lending out
depositors funds which have to be repaid.
On the subject of security, there should also be a reference to covenants.
These are formal agreements made at the time of the loan. The bank has
agreed to the loan on the basis of its assessment of risk and wishes to ensure
that that risk does not increase during the term of the loan. The loan
agreement will contain obligations on the borrower such as provision of
information to the bank and adherence by the customer to financial covenants,
such as interest cover maintenance, gearing levels and liquidity ratios.
Remuneration/Margin
Like any other business, a bank needs to make profits to survive.

Profits for the bank come from a number of sources:
67
the difference between the interest rates charged to borrowers and

that paid to depositors.
loan arrangement fees.
charges for the services provided by the bank, such as night safe
facilities, etc.
Commission and payments received from outside agencies for
referring clients, such as insurance commission.
It is crucial that the pricing of a loan facility reflects the risk being taken by
the bank. This is a key principle - the higher the risk, the greater must be the
reward. This link between risk and reward is fundamental in finance. It is not
unreasonable for the bank to charge a higher rate of interest when it considers
that the risks are higher with a particular loan. Similarly, a lower rate of
interest may be applied to a fully secured loan to a customer with a strong
performance track record.
Many banks now adopt a matrix-type system to reflect the above scenario and
either guide or determine the pricing of a loan proposal. A simple example
might be a chart where the security value is given a rating and then cross
referenced against an appropriate interest charge.
Each bank has its own pricing policies and you should research what is the
practice in your own organization.
At the time of writing, financial services regulators are examining the level of
capital that a bank requires to hold to cover its credit and market risks. Higher
levels of capital are sure to be required and this will bring increased pressure
for adequate remuneration from bank lending and other services.
Well now go back to the three original applicants and apply the principles
weve just discussed to their individual circumstances.
Case study
Mr Ahsan
He wants a Rs. 2,000,000 extension to his overdraft for a period of six

months because he has won a lucrative contract with a large company to
supply parts for one of their products. The money is required to meet
additional material costs, overtime payments for labor and other costs. Mr
Ahsan presents you with his cash flow projection over that period of time
as well as his profit projection for the contract. You know him to be an
astute businessman and so have no hesitation in granting his request.
Mrs Khan
She is looking for a loan to improve her kitchen to the standard required
by environmental health so that she can prepare food for resale at home.
She does not want a home improvement loan as she does not want to
offer her home as security, but she can offer stocks and shares to the
value of Rs. 1,000,000 as security against
the loan of Rs. 500,000. You have confidence in her ability to make a
succes of her new catering business. She seems to have the drive and
ability to succeed. The conduct of her account over the past 15 years has
been exemplary. Because of this, you are willing to lend her the sum
asked for once the shares have been deposited with the bank and the
necessary paperwork signed.
Mr-Asad
He is relatively easy to deal withi He wants to start up a car cleaning

business in a densely populated area of town which has little or no
competition. He has purchased all the equipment he needs from his own
resources and has a license. He has presented fairly basic financial
projections, which indicate that the venture is viable and he is looking for
a business credit card with a limit of Rs. 100,000 to enable him to buy
petrol and materials. His father, who is already a well- respected customer
of the bank, is prepared to provide an unsupported personal guarantee and
Mr Asad agrees to clear the credit card balance monthly. There is little
risk to the bank and you agree to assist.
Conclusion
Remember, in instances where you are approached by customers of another
bank, it is important to be cautious. However, the proposal should still be
assessed objectively to ensure that good business is not turned away.
The constructive "No"
It is important to remember that, when assessing proposals, you will come to

the conclusion with some that you are unable to support the customers
request. In doing this it is essential that you convey your decision to the
customer as soon as possible, rather than continuing to hold out the
expectation of a loan facility being made available. You need to convey your
decline decision in as constructive a manner as possible.
The key issue is how you communicate this to the customer. Done properly it
can sometimes strengthen your relationship with customers, demonstrating an
appreciation that you have saved them from digging a financial hole that
they would struggle to climb out of.
Equally there will be those who will steadfastly refuse to see where you are
coming from, even when their accountant supports your view. In such cases,
all you can do is thank them for the opportunity to support their business, pass
on your regrets and recommend that they make alternative arrangements.
Approval processes for loans
All banks have their own method of having loans approved and you should
become thoroughly familiar with how this is done in your own organization.
Even if you are not at present an account manager
69
lending money, this is a key piece of vnormaUcm my

xmdeTsXandmg of corporate operations.
out
genera
Most banks arrange for a group of customers - a portfolio of accounts to

be managed by a manager who may be called a Business Bankinj Manager
or a Relationship Manager or an Account Manager. Thi manager will be
responsible for the banks relationship with thei group of customers.
Lending proposals from within the portfolio will require a forma application
form to be completed by the manager with a signec recommendation that the
loan be granted. This proposal will normall) be passed to the account
managers line manager for approval.
For larger loans the banks rules may require two managers to give approval,
in addition to the account managers recommendation, and may also be
passed to a specialist department, such as the Credit and Risk Department,
for approval. The largest loan applications may be presented for approval
formally to a Credit Control Committee comprising several senior managers.
For lending agreed within the retail banking branch network, credit scoring
is most commonly used.
Monitoring the bank's exposure to different industry sectors and to
customers' credit risk
Monitoring the banks exposure as a whole is the job of senior executives.

They must make sure that the bank's risks are well spread. This means not
having too great a liability to any one industry sector, or to any one customer
or group of customers. Carrying out this function is a key responsibility of
senior management.
Another key responsibility of management is to ensure that the bank has
adequate capital and a stable deposit base to support its lending. This
involves the careful risk assessment of their asset portfolios and stability of
their deposit bases, both from the markets and from businesses and
individuals. Hard lessons are being learned. Some of the traditional banking
principles will no longer be ignored. We have to spread and manage risk
carefully and ensure that we have a stable base of capital and deposits to
finance the banks business.
Some banks use a rating system to allocate a risk rating to each lending
proposal and through this to each portfolio of accounts. This is a way of
managing risk and avoiding undue concentration of low quality lending
business. It also helps portfolio analysis and the pricing being achieved.
Adapted from:
Specialized Lending BookOne of Chartered Banker
Institute.
Ratio Analysis
Needs
introduction
&
Assessing
Customer
Profit and Loss accounts, Balance sheets and Cash Flow Statements are at the
heart of business lending. These are the financial base documents that
bankers analyse and from which a ratio analysis can be derived in order to
establish trends within the business and highlight significant features. Ratios
are also useful in comparisons with past results, peer performance, and
industry norms. These financial statements and their analysis and
comparisons enable in assessing the customers needs and creditworthiness.
The essential question to be answered is: can this business and its
management make the interest and loan repayments within the agreed
timescale?
Once an advance has been made, strict monitoring and control are required to
ensure that the business is performing as planned and that the level of risk
stays the same as was originally accepted. Prompt action will be needed to
understand any deviation from the budgets agreed at the outset, and the
appropriate action taken.
It is the cash flowing through the business which generates the profit that
increases the net current assets and so builds up the capital, or shareholders
funds, in the balance sheet (unless these profits are drawn out by the
proprietors/shareholders). Hence the key importance of the cash flow
statement, profit and loss account and balance sheet in financial analysis.
Cash flow reporting will be examined later in this chapter.
The financial accounts are the language of the business in which the results
are communicated to the management, owners and those who lend money, as
well as those whom the management choose to inform. With public limited
companies the information is in the public domain, but is not publicly
available for private limited companies unless a search is made at Companies
House for a small fee.
In this chapter we shall examine these three financial statements and some of
the ratios used in their analysis. This work builds on what you have already
learned about the principles of lending. As you go through this chapter you
should refer to the procedures adopted by your own organization for business
lending. This will enhance your knowledge and understanding of the subject.
Financial Statements
You will most likely have studied accounting earlier in your career and feel
comfortable with its concepts and the contents of the financial statements. To
refresh your memory of the format and layout of accounts, however, set out
below are the accounts of Khan Ltd, an electrical retailer.
Khan Ltd.
Trading, Profit and Loss Account for the year
ended 31 December 2009
Rs.
Turnover
Less Cost of Sales
Stock at 1 Jan 2009
Add Purchases Less Stock at
31 Dec 2009 GROSS PROFIT
210,000
920,000
Rs,
1,130,000
252,000
Rs.
1,530,000
878.000
652.000
Administration Expenses
ent
| Reference Book 1
71
Directors Remuneration
Auditors Remuneration
Salaries and Wages
Expenses
Motor Vehicle Costs:
Admin
Depreciation:
Motor Vehicles
Machinery
Distribution Expenses
Salaries
Expenses
Motor Vehicle costs:
Distribution
Depreciation:
Motor Vehicles
Machinery
60,000
8,000
110,000
66,000
270,000
16,000
6,000
4,000
236,000 506,000
146,000
120,000
60,000
24,000
42,000
8,000
6,000
Other Operating Income

Rent Receivable
170,000
Interest Payable
Loans repayable within 5 years
Loans repayable after 5 years
Profit on Ordinary Activities before Tax
Taxation
Profit on Ordinary Activities after tax
Unappropriated profit b/f
Ordinary Dividend
Unappropriated profit c/f
1,000
3,000 4,000
166,000
50,000
116,000
110,000
226,000
60,000
Rs. 166,000
This account is produced for the companys own uses. The main object of a
trading account is to calculate the gross profit. To remind you of the
definitions:
Sales is the turnover, or revenue (the total value of goods sold) by the
business.
Cost of Sales = Opening Stock plus Purchases, less Closing Stock
Gross profit is simply the profit the business has made on buying and then
selling goods, i.e. on trading.
Gross profit = Sales less Cost of Sales
Administration expenses cover the day-to-day running expenses of the

business such as heating, lighting, rent, wages and salaries, and depreciation.
Distribution expenses are costs incurred in either selling the goods or
transporting them to the customer, for example, salespersons salaries and
expenses, and advertising costs.
Companies have more information than they are required to put into the
documents that they file with the Registrar of Companies. Our second
example is in the published format.
Khan Ltd.
Profit and Loss Account for the year ended
31 December 2009
Published Format
Turnover Cost of
Sales
sOOO
Rs.
1,530,000
878,000
GROSS PROFIT
652.000
Net Operating Expenses

Profit on Ordinary Activities
before Interest
Interest Payable
Profit on Ordinary Activities
before taxation
Tax on Profit on Ordinary Activities
Profit for the financial year Dividends
482.000
170.0
4,000
166.000
50.0
116,00
0
60.000
Retained Profit for the financial year
sOOO
1,000
Rs.
Rs. 56,000
>,000
),000
A Note to the Financial Statements gives the cost of sales, and breaks down net
operating expenses into distribution costs and administrative expenses. It also
snows other operating income (for example, rent received) which has been
netted with the above costs and expenses to give the net operating expense
shown in the filed profit and loss account. Other Notes to the accounts show a
statement which reconciles movements of reserves and the movement of
shareholders funds. You will recall that retained profits are classed as reserves.
>,000
To complete the set, here is the Balance Sheet.
>,000
1,000
),000
>,000
Khan Ltd.
Balance Sheet as at 31 December 2009
6,000
n object
i you of
I) by the
ck
fing and
Rs. Depn
Cost
40.000
200,000
30.0
Rs. 70,000
70.000
45.0 Rs.
315,000
58.0
102,000
11.0
8,000
Current Assets Stock
179,000
Trade Debtors
Creditors:
Amounts falling due within one year Trade
Prepayments
Creditors
18,000
Bank and Cash
Other Creditors
60,000
Accruals
20,000 98,000
Published Format
Fixed Assets
Premises
Plant and Machinery
Motor Vehicles
Rs.
Rs.
NBV
200,00
0
30.000
15.0
245,0
00
Net Current Assets

TOTAL ASSETS less CURRENT LIABILITIES
es of the
Creditors: Amounts falling due after more than one year

Bank Loans
40,000
Debentures
20,000
goods or
salaries
Ordinary Shares of 1 each

Reserves
Profit and Loss
rence Book 1
326,000
60,000 Rs. 266,000

Share Capital
put into
lies. Our
81,000
Authorised Issued
200,000
100,000
166,000 Rs.
266,000
73
This is a fair view of the companys business within the reporting period. It
must be a balanced and comprehensive analysis of the development and
performance of the company with a description of the principal risks. This
applies to all companies, except those that file small company accounts.
Balance Sheet
The first thing to say about a balance sheet is that it is produced as at a

specific date. It is a summary, or snapshot, of the businesss financial
position on that date.
Balance sheets can be categorized into those which are audited and those
which are unaudited. Not all companies have to have their accounts audited,
that is, verified for accuracy by someone outside the business. The
requirement is determined by the level of the sales turnover in the financial
year which is determined by the government.
Where a company does have to be audited or chooses to be audited, the
auditors confirm in their report that they have carried out an audit and are
satisfied that the final accounts provide a fair representation of the financial
position of the business (if indeed this is the case). If they are not satisfied,
they can qualify their report with the appropriate statement.
This report from the auditors, commonly referred to as the auditor's
certificate, is a crucial part of any financial report on a business and must be
read carefully.
From a lending managers point of view, audited accounts are better than
unaudited, but even here two questions can be raised:
When were the accounts last audited?
Who are the auditors?
A balance sheet is only correct on the day it is drawn up; it is a summary of
the assets and liabilities of the business at that particular date. For the
lending organization it is vital to see the most up-to-date position - a balance
sheet a year out of date is insufficient.
Do you know the auditor or the accountancy firm by reputation? Although
there is no requirement in law for sole traders, partnerships or small
companies to have their accounts audited, the accounts should be certified
by a qualified accountant. From a practical point of view, you may have to
accept accounts which are several months old and in these circumstances
you must obtain previous years accounts to compare one year with the next.
If the borrower is already a customer, these should already be on file. If not,
you should ask for accounts for at least the last three years, assuming the
customer has been in business that long. This will allow you to establish
trends and to understand how the business is performing.
rting
if the
on of
at file
If the proposal is from a new business, then projected figures should be

produced. These can be compared with the balance sheets of similar firms
whose accounts are held either by the branch or by making enquiries of
colleagues or at head office.
Even when it comes to company accounts, which by law must be audited
(other than for small companies), what is disclosed by the accounts depends
on the size of the company, and in many cases the reliability of company
accounts also depends on the individuals involved.
as at
nesss
ed and
e their
ide the
e sales
ament.
udited,
m audit
ation of
L If they
opriate
uditors
aess and
re better
if the accounts have been audited by a qualified auditor, you may still feel
that they are not necessarily the best set of accounts you have looked at.
Again, the best example of this could come from a set of audited accounts
produced for a very small company. Such a company might only have two
shareholders with one of them having 99% of the ordinary shares; it need
only have one director and a part-time company secretary. Any information
required by the auditor would come from the one director who might also be
the one who owns 99% of the shares. If the auditor was unsure of something,
there is nobody to turn to for clarification other than the director or
shareholder. Even if the auditor made some unkind remarks about the way
the company was being run, nobody is there to do anything about it. You
must sometimes rely, therefore, on the reputation of the companys officers
as to how well the accounts have been kept for the auditor.
Styles of balance sheets
You are likely to be presented with many types of balance sheets produced in
a variety of styles. The layout of the balance sheet may vary, but the
classification of assets and liabilities should not. Most banks re-input the
information on to a standard form to provide a uniform approach and make a
year-on-year trend analysis easier.
A specimen analysis form is shown below. This includes the various
categories of assets and liabilities. Following that is a sample balance sheet
ofLucky Cement.
Yearly Analysis of Business Accounts
ip; it is a
particular
ip-to-date
Branch:
................................................... Cus
tomers Name: ...........................
As at As at
Balance Sheet Date
Rs 000s Rs 000s Rs 000s
putation?
rtnerships
accounts al
point
of
lonths old
iccounts to
Current Assets Cash

& Bank
Debtors
Stock - Raw Materials
Finished Goods
Current Liabilities
Bank Overdraft
Creditors Provision for
Tax Provision for
Dividend
customer,
xounts for
as been in
rends and
As at
Net Current Assets

leference Book 1
75
Fixed Assets
Land & Buildings
Machinery Other
Plant
&
Total Net Current and Fixed Assets

Medium & Long term Liabilities
Debentures Preference Shares
Unsecured Loans Directors
Loans
Net Tangible Assets
.......... .................
Proprietors Funds
Capital
......... ..................
Reserves
......... ..................
P & L Account
......... ..................
(Less) Intangible Assets
(........ ) ( ............... )
( ....... )
Yearly Analysis of Business Accounts

Branch: ...................................... Customers Name: ............
Trading Results
For period to
Sales
Purchases
Other Cost of Sales
Overheads
Interest Charges
Total
Net Profit before tax
.........
..........
Rs 000s
.........
..........
.........
..........
.........
..........
.........
..........
.........
..........
........
..........
.........
...........
Rs 000s
Rs 000s
Ratios
As at As at
As at
Date
Capital Adequacy Leverage =
Interest
Coverage
Working
Capital Liquid Ratio
Operating Ratio
Stock Turnover Raw Materials
Stock Turnover Finished Goods
Credit Allowed
Credit Received
Gross Profit %
Net Profit %
ROCE %
The ratios mentioned below along with gearing ratio are considered most
important in Credit Analysis:
1.
DSCR = EBITDA / (Interest Expense + CPLTD)
2.
Debt/EBITDA
3.
Current Ratio
Calculation of Total Debt (Only banks interest bearing)

4.
Days Inventory
5.
Days Receivables
Balance Sheet as at June 30, 2010
Note |
2010
2009
- ----- (Rupees in 000) ----ASSETS
NON-CURRENT ASSETS
Property, plant and equipment
Intangible assets
Long term advance
Long term deposits
5
6
7
31,378,255
2,977
55,373
2,175
31,438,780
30,476,87
2
55,373
2,175
30,534,42
0
8
9
10
11
12
13
14
4,008,288
608,813
779,307
105,915
48,807
184,805
538,812
145,151
117,939
333,629
6,871,468
38,310,244
3,411,549
1,196,608
1,267,248
108,876
9,761
59,251
538,812
176,584
40,162
1,049,091
7,857,942
38,392,36
2
CURRENT ASSETS
Stores and spares
Stock-in-trade
Trade debts - considered good
Loans and advances
Trade deposits and short term
prepayments
Other receivables
Tax refunds due from the government
Taxation-net
Sales tax refundable
Cash and bank balances
15
16
TOTAL ASSETS
EQUITY AND LIABILITIES
SHARE CAPITAL AND
RESERVES
Share capital Reserves
17
18
1,658,600
31,957
319,217
1,562,850
3,572,624
NON- CURRENT LIABILITIES

Long term finance
Long term deposits
Deferred
liabilities
Deferred taxation
19
19
21
22
CURRENT LIABILITIES
Trade and other payables Accrued mark-up
Short term borrowings Current
23
portion of long term finance
24
23
CONTINGENCIES AND
1
9
COMMITMENTS 26 TOTAL
3,043,32
0 155,50
6,267,11
0
2 17JL75
9,641,691
9
4,300,000
28,589
234,633
3,233,750
1,478,490
20,018,22
6,041,712
2
23,251,97
2
2,677,356
233,381
6,187,941
-
9,098,678
38,310,244 39,392,362
EQUITY AND LIABILIIES

3,233,750
21,862,179
25,095,929
77
Ratio Analysis
Given any two figures you can make a ratio out of them. If you can make a
comparison with just two figures, think of how many ratios you could make
up from a full set of final accounts - hundreds. Therefore we need to focus
on calculating ratios that are both meaningful and add value to the overall
analysis. While the results of ratio calculations will provide isolated
indicators on the businesss performance, the real value is in a comparison
with previous figures and thus being able to complete a trend analysis. This
helps to find the reasons for movement or variance from historical
performance or what was forecast to happen. Ratio analysis facilitates
determining whether the performance of the business is improving or
deteriorating, and this will influence your decision on the lending proposal.
There are no ideal ratios and not all ratios are relevant to a particular
industry. You will hopefully have access to information on industry
averages which tend to include all businesses producing accounts, ranging
from sole proprietors to public limited companies. Your own organizations
standard form for financial analysis will show the set of ratios being used.
Types of ratios
We shall calculate and examine ratios under the following headings:
Financial ratios based on the capital structure of the business and its
liquidity ratios.
Profitability ratios.
Operating and activity ratios for the business.
Financial ratios: capital structure and liquidity ratios
Financial ratios are designed to show both the long term and the short term
financial position of a business. The main ratios are for capital adequacy and
working capital, or the current ratio (as it is also known). If either of these
ratios produces an unsatisfactory result, it may be necessary to produce
further ratios to delve more deeply.
Capital adequacy ratio / Equity ratio Proprietors'
funds less intangibles
---------------------------------------Total assets less intangibles
100
x
Intangibles are those assets in the balance sheet which only have a value if
the business can be sold as a going concern. Goodwill is an example. As a
prudent assessment of risk, therefore, it is better to exclude such items from
calculations. If the firm fails, there is no goodwill.
Proprietors funds are usually called Capital & Reserves,
Shareholders Funds, or Shareholders Equity in the balance sheet.
or
The capital adequacy ratio is calculated to show how much money the
owners have in the business. Although there is no one percentage figure
which suits all businesses, the higher this figure, the more protection there is
for lenders should things go wrong.
can
itios
eds.
ioth
ts of
css
s
ures
I the
wha
t
ther
ing,
mlar
istry
uits,
own
iet
of
The capital and reserves in the balance sheet is the safety buffer for the
creditors of a business. The capital will have to be totally lost before any
creditors, including the bank, lose money. As a general rule, the bank may
not want to lend more than the proprietors have in the business (it will not
want to have a greater stake in the business than the owners).
Example
Given the following summarised balance sheet:

Fixed assets
Current assets
Total assets
Capital & Reserves
Long term liabilities
Current liabilities
Total liabilities
300,000
500,000
800,000
300,000
100,000
400,000
800,000
So long as the total assets realise at least 500,000 (62.5% of their book
value) the creditors (long term liabilities and current liabilities) will be paid
in full.
Case study
ings:
iness
short
ipital
Dwn)
. lit, it
:eply.
M Khan pic
The directors of M Khan pic, manufacturers of knitting wools, are due to
meet you to discuss their financial requirements for the coming year. The
following figures have been extracted from their accounts for the last three
years.
20X1
Rs.00,000s
20X2
20X3
Rs.00,000s Rs.00,000s
85
625
530
1,240
65
625
615
1,305
45
625
700
1,370
Stock (or Inventories)

Debtors (or Receivables)
Cash
Total Current Assets
330
375
705
360
405
765
380
420
800
Total Assets
1,945
2,070
2,170
50
50
50
Fixed (or Non-current) assets

Goodwill
Premises
Plant
Total Fixed Assets
lave a
I is an
ter to :
is no
:s, or
leet.
iey
the
:ntage
more
nee Book 1
Current assets
Current Liabilities
Bank borrowing (or Borrowings)
79
Creditors (or Payables)

Current tax payable
Proposed dividend (Provisions)
60
150
60
100
185
70
140
210
85
Total Current Liabilities
320
405
485
Borrowings:
7% Debentures
10% Unsecured Loan Stock
200
400
200
400
200
400
Bank Term Loan

Total Non-Current Liabilities
Total Liabilities
350
950
1,270
350
950
1,355
350
950
1,435
Net Assets
675
715
735
Share capital
Reserves (or Retained earnings)
375
300
375
340
375
360
Total Equity
675
715
735
20X1
20X2
20X3
Rs.00,000s
Rs.00,000s Rs.00,000s
Sales
1,800
2,160
2,520
Net purchases (or Cost of Sales)

(1)
Gross Profit
720
920
1,150
1,080
1,240
1,370
Distribution costs &

administration expenses
Operating Profit
540
610
650
540
630
720
Interest payable
180
200
270
Profit before tax
360
430
450
Creditors: amounts falling due

after more than one year (or
Non-Current Liabilities)
Shareholders
Equity
(or
Shareholders Funds, or Capital &
Reserves)
Profit and Loss Account (or income Statement)
Tax [Not given in this example]

Profit after tax
Dividends [not given in this
example]
Retained profit
Cost of Sales = Opening Stock plus Purchases, less Closing Stock

Well examine the appropriate ratios as we work through this section. Capital
adequacy
To calculate the capital adequacy ratios for M Khan pic, we take the balance
sheet figures for Shareholder Equity (also called Proprietors Funds, or
Capital & Reserves) and deduct goodwill, which is also deducted from the
total assets denominator of the calculation.
Thus, taking Year 20X1, Proprietors funds = Capital & Reserves
(Rs.67,500,000) less Goodwill (Rs.850,000,000) = Rs. 59,000,000. Likewise,
Total assets less Goodwill = Rs. 194,500,000 less goodwill = Rs.
186,000,000.
59.0.
000
x
186.0.
100
= 31.72%
000
1
Ideally you are looking for a figure in excess of 50%, but this is not always
possible, and where the figure is below 50%, it is essential to calculate:
Gearing ratio Proprietors' stake Medium and long term borrowings
including preference shares
The gearing is fundamentally the relationship between debt and capital. Debt
in a balance sheet has to be repaid; capital does not, it is permanent.
It is important to remember that a business which is highly geared has to
maintain its profits in order to ensure that it can meet its commitments to its
outside lenders. Interest is a fixed cost which needs to be met despite any
drop that may occur in sales, and thus the profit available to meet the interest
payments. Any problems with profit forecasts should be regarded as being
potentially serious and may affect your decision to lend. We like to see the
proprietors stake in the business, also called Capital & Reserves or
Shareholders Funds, at least covering the medium and long term borrowings
including preferenc eshares. Thus you should be looking for a 1:1 ratio at
least, if not 1+: 1.
Some banks calculate this ratio using total debt, instead of medium and longterm borrowings. You should enquire about your own banks practice.
Interest cover ratio
This is calculated as follows:

Net profit before interest and tax Interest paid
This shows the number of times the interest payments can be met out of
current profits. Again, any changes to this ratio should be investigated before
loan agreements are renewed. A deterioration in
81
this ratio means the business has a reducing capacity to meet the interest it
has to pay. The trigger for a debt crisis within a business is often an inability
to make interest payments when due. While cash flow is a critical factor, an
early warning of problems can be determined from the interest cover ratio
which measures the ability of the company to meet its interest obligations.
Preference shares are usually included in this ratio as they receive an interest
payment, and it may be appropriate to include any other borrowings where
interest is payable, including short term borrowing where this has come from
a source other than the bank.
Liquidity
Liquidity means the availability of cash to meet the needs of the business.
This involves managing the firms trading cycle through the conversion of
sales to the collection of cash for those sales. Liquidity covers the prudent
management of the flow of funds through the business. One analogy is to say
that if the wheels of business are oiled by cash flow, then the cash budget
gauges how much oil is left in the can at any time. In any lending situation it
is very useful to understand the importance of liquidity and how it is
controlled.
A key measure of liquidity is the:
Working capital ratio or current ratio
Current Assets Current Liabilities
This ratio tells us how much current asset cover there is for each Rs. 1 of
liabilities. It gives an indication of the ability of a business to pay its short
term debts (the creditors, bank overdraft, etc) as they fall due without having
to resort to selling any fixed assets. You would expect to see a higher ratio in
a manufacturing business than in a retail business to reflect the length of time
it takes for cash to flow into the business.
However, this is not a ratio which you should view in isolation. Included
within the ratio, in the current assets, could be a great deal of stock and so
you might want to check how the stock was valued at the year end. One way
round this is to look at how this ratio changes over a period of years. If the
pattern is consistent and stock is valued on the same basis each year, there is
unlikely to be anything untoward; the trend is more important than one years
ratio as it highlights the need to further investigate variances in performance.
Even if you are happy with the current ratio (and in M Khans case it is
falling), it is prudent to take your examination of liquidity a stage further and
calculate another ratio that strips out the stock. This ratio is known by several
names: the liquid ratio, the quick ratio, the liquid asset ratio, or the acid test
ratio. This further ratio may reveal that an apparently comfortable current
ratio is misleading in terms of extinguishing current liabilities because of the
high proportion of stock in the current assets. Stock is the current asset least
easily turned into cash - the least liquid current asset.
Liquid ratio (or quick ratio/liquid asset ratio/acid test ratio)

Current Assets excluding Stock Current Liabilities
Stock will of course include the figures for raw materials, work-in- progress,
and finished goods which are sometimes shown separately in the balance
sheet.
The usefulness of this ratio may depend on the proportion of stock in the
current assets.
It is worth restating the importance of trend analysis and also how to interpret
the results. A current ratio of 2.0 may look satisfactory, but we need to
consider the industry norm within that sector, that is, consider the figure for
the business against its peer group in the same industry.
Case study
Suppose the 2006 current ratio of a business was 0.45 and for
2007 it was 0.56.
Is this good or bad, strong or weak? Does it make you feel relaxed or
uncomfortable?
On the surface it appears that there is insufficient coverage, but a study
of the trend analysis reveals an improvement year on year. You may be
interested to know that the business in question is one of the Pakistans
most successful retailers!
The case study illustrates how easy it is to form the wrong impression by
purely viewing the ratio in isolation without taking account of the trends or
the industry sector. A retailer, of course, usually receives cash for its sales
before having to pay its suppliers, and can therefore safely operate with a
lower current ratio due to its strong cash generation.
We have learned that different industries require different levels of working
capital or current ratio. The ratio measures liquidity. When it is rising, the
business may be making profits. When falling, there could be losses or the
management could be financing fixed assets on short term debt.
When we look at the current ratio for M Khan, we see that this ratio too is
falling. Without selling all their stock, M Khan pic cannot pay off all their
debts. They may well need to seek an increase in their overdraft facilities, and
at that point you would have to decide whether or not to do so and increase
the risk to the bank. However, as we have seen, the current ratio is only one
of a number of ratios to calculate and it requires to be viewed in the broader
context.
Profitability ratios
When examining the profitability of the business there are three ratios to
consider:
Gross profit ratio
Gross profit 100 x

Sales
1
83
This is the most basic measure of profitability. It measures the relationship

between gross profit (sales less the cost of making these sales) to sales. It is a
very important measure of profitability because it tells us whether the
business is making a profit on its main area of activity - the buying and
selling of product.
It is not easy for a business to significantly increase this gross profit margin
and a declining margin would be a concern. Most business people keep a
very close watch on this margin and you should too.
Net profit ratio
Net Profit
Sales
100
1
Net profit on trading is also an important measure of efficiency.

Return on capital employed
Net profit
Owners' stake
100
1
Owners stake is synonymous with Capital & Reserves.

With the Return on Capital Employed (ROCE) ratio, it is important to assess
the total capital of the business including any long term loans put into the
business by the owners and to deduct from this figure the intangible assets
such as goodwill. If this is not done, we may get a very high return on
owners capital which would not be a true reflection of the actual return.
There are several methods of calculating ROCE but the one given above is
consistent with the approach being used in all the examples.
Example
A business has the following:

Ordinary shares
Loans from directors
Total capital
Net profit
Rs.
10,000
15,000
25,000
5,000
The return on the share capital here is 50%. However, the true
return on capital invested by the shareholders and directors is in fact
20%, adding the directors loans to the ordinary share capital figure.
(Note: The return would be slightly higher than this assuming that
the loan carried a fixed rate of return but, even so, the difference is
too great to be ignored.)
In the profitability ratios we use Net Profit before Tax figures. This means
that we are using the same basis each year for calculations. If we use the after
tax profit this would involve having to make adjustments for changes in tax
rates in order to make the proper comparisons.
With all these ratios you are asking whether profitability is increasing or
declining. You then try to find the reasons for any significant changes.
It cannot be emphasized enough that you can only compare ratios if they are
all calculated on the same basis. Consistent methodology of calculation is
essential - you need to compare apples with apples.
We now turn to the operating and activity ratios which measure how
efficiently a business is being run - how well it has used its resources.
Operating/activity ratios
For the most part, the method of calculating these ratios is:
Operating expenses 100
x
Sales
Operating expenses are equal to all fixed costs.

Sales, net of returns, are used as most of the businesss expenses can be
related to sales. Perhaps the best example from any set of accounts would be
cost of materials related to sales. One would expect material costs to rise in
proportion to any increase in sales. If the computed figure is lower on
increased sales, this would imply that the business was getting the benefits of
increased size. If material costs rise faster than sales, an explanation should be
sought.
It is not always possible to obtain figures for all the fixed costs of the
business. In these circumstances the ratios used can be the expenses to sales.
For example, add together the Distribution Costs and the Administration
Expenses shown in the Income Statement (Profit & Loss Account) and
express them as a percentage of Sales. These two costs can also be expressed
as a percentage of sales individually.
Breakeven ratio
A breakeven analysis is significant in that it enables you to identify the sales

volume necessary to cover all costs of the business and start to make a profit.
When the profit contribution matches the total fixed costs, the business has
reached its breakeven point, thereafter it is making profits. The figure is
calculated:
Fixed costs
Gross margin %
Before completing this calculation, the fixed costs and gross margin figures
need to be examined to find out what has been included. The results can be
distorted if certain figures have been wrongly designated. For example, in an
industry such as clothing manufacture where there is a high level of
piecework (work paid for according to the quantity produced) this should be
included in the calculation of the gross margin but can often be added to
employees wages which are a fixed cost. You may be left with little
alternative but to make an estimate, particularly when dealing with a sales
force who earn a basic salary (fixed cost) plus a bonus or commission based
on volume sales (gross margin). To produce as robust and meaningful figure
as possible from this calculation, you must try to identify all costs which
relate directly to production. Gross Margin is Gross Profit divided by Sales
and expressed as a percentage.
Although these two operating ratios are important, there are important
activity ratios which are not based on an operating expense. The most
important as far as a lending organization is concerned are stock turnover,
credit allowed (debtors ratio) and credit received (creditors ratio).
Stock turnover ratio
Cost of goods sold Average stock
As a reminder:
Cost of Goods Sold = Opening Stock + Net Purchases - Closing Stock
The best way to calculate average stock if you dont have the figures for the
cost of goods sold and purchases is:
Opening stock + Closing stock 2
This calculates the number of times stock turns over. To calculate the number
of days stock on hand, divide stock by the cost of goods sold and multiply by
365.
As long as there has been no change to the accounting policies for
stockholding, then the figure should be consistent from one year to the next,
allowing us to make some comments on the efficiency of the business. An
increased stock turnover figure shows stock is being turned over more
quickly and indicates greater efficiency.
Generally, an increasing stock turnover shows that sales are rising, which
should be reflected in increased profits, but it could also be caused by a
change in stockholding policy. For example, if a firm in the past always held
two months stock in hand, we would expect to find a stock turnover for the
year of approximately 6. Change the stockholding to one month and stock
turnover rises to 12. Such a decision would be beneficial to the firm in one
major respect - less money tied up in stocks would lower costs and increase
liquidity. This would have to be balanced against the risk of running out of
stock more frequently which could result in loss of sales greater than the cost
savings made by reducing stock levels.
The debtors and creditors ratios
These two ratios go together. In the first, we are looking at how long a period
of credit is given to customers of the business (its debtors). In the second, we
are looking to see how much time is given to the business by its suppliers
(creditors) before their bills need to be paid. Ideally, both ratios should work
out at the same figure, but very often this is not the case. The formula for
calculating each is similar:
Debtors 365
x
Credit sales 1
Creditors
x
Credit purchases 1
365
If sales are not split into credit and cash sales, then the credit sales figure is
not given separately. In these circumstances, it is common to use the total
sales figure, if possible applying your knowledge or research of the type of
business you are dealing with to make some assessment of the likely amount
dealt with on credit. In the case of purchases (in the creditors ratio), it is
common to use the cost of goods sold or the total purchases figure in the
calculation.
These two ratios are quite easy to calculate, and they can tell you a lot about
the way the business is being operated. By looking at changes in the debtors
ratio, you can be put on your guard if a sudden increase in the ratio takes
place. The explanation might be simple - increased sales may all have been
credit sales rather than some for credit and some for cash. This would
obviously push the ratio up, but equally so would a situation where the
business is not keeping up to date with the invoicing and collecting payment
from customers. This might provoke you to ask questions about its credit
control procedures and indeed the possibility that some of the debtors may be
bad debts.
In fact, along with the accounts, you should often ask for an up-to-date
debtors analysis sheet which will immediately highlight any debtors which
are outstanding for a long period - say, three months or more, which could
become bad debts.
A decrease in the time granted for credit could be a simple matter of more
cash sales or better credit control, or the owner might be pressing customers
to pay more quickly. Such a policy might lead to decreased sales in the future.
Changes in the creditor ratio might have a simple explanation. Debtors paying
more quickly may be allowing the business to pay its creditors more quickly,
or the business may not have been taking the full credit period to which it was
entitled. It could also imply, however, that the business has cash flow
problems and cannot pay creditors as quickly as in the past.
Changes in these ratios should be investigated either by looking more closely
at the accounts or through discussion with your customer.
Cash flow reporting

We have already identified the importance of cash flow and of ratio analysis.
We now take this a stage further by looking at the cash flow report.
One of the key areas that banks always focus on is the ability of customers to
repay their borrowings. There is little point in granting credit to someone who
is unable to pay it back because it places them under excessive financial
strain. We have already identified that having to rely totally on security
pledged as a primary source of repayment is never a good principle of
lending. Whenever you think about cash flow, please remember that cash is
the lifeblood of the business. Without cash a business cannot pay its bills,
wages and taxes, nor buy goods and services from suppliers, nor purchase
assets, and still have enough liquid resources to meet unexpected demands for
money. Any interruption in the flow of cash through the business can be like
a blood clot, potentially very dangerous.
It is important at this point to make the distinction between cash flow and
accounting profits. Cash flow is the simplest possible concept: it is the
difference between money received and money paid out. In order to obtain
accounting income, however, the figures are adjusted in two important ways:
to show income and profit as it is earned (at the time of sale) rather
than when the cash is actually received; a companys debtors will
usually pay the company after an agreed period of credit - say two
or three months.
87
to categorize cash outflows into current expenses and capital

expenses.
A business must be able to turn profits into cash.
Assessing the ability of a business customer to repay loans is fundamentally
not very different from assessing your own personal ability to borrow - you
assess the adequacy of your income against the amount of your expenditure.
The one major difference is the earnings of a business require to be adjusted
back to cash basis because of what is called accrual accounting, as we saw
above.
You will have an income and you will spend this on rent, loans, mortgage
payments, telephone, electricity, etc. You receive a cash income each month
and make cash payments each month by direct debit or card transactions. If
you have a surplus you may open a savings account; if you have a deficit
then you will borrow either on overdraft or credit card.
A business customer has income, but it is derived from sales which are
reduced by the cost of sales and fixed costs to give a profit. Businesses,
however, have balances to be collected from trade debtors, stock to be held
for future sales and trade creditors wishing to be paid when these are due.
Producing cash flow reports
The starting point for compiling the cash flow report is the earnings of the
business. Earnings are profits. The accounts for a business are compiled
using accrual accounting principles. This means that cash for the income and
the expenditure may not actually have been received or paid out during the
financial period of the accounts.
A number of accounting practices allow businesses to decide when income
and expenses can be recognized; for example, sales in a business in one
sector may be booked in the profit and loss account when the goods are
delivered, or in another industry it might be more appropriate to book the sale
when the invoice is issued.
To understand how the income and expenditure are completed and applied
you need to read the notes to the accounts. Remember that accrual
profits/earnings can fluctuate; for example, sales may go up or down
because of the economy or as a result of demand for the product or service,
costs may rise or fall, etc. These fluctuations affect the firms ability to
service (meet the interest payments) and reduce its loans.
Carrying out any type of financial analysis is usually done over a minimum
of three years figures and noting the trends.
Measurements commonly used by banks and the wider financial market to
assess the ability of customers to service and repay debt include:
Earnings before Interest and Tax (EBIT).

Earnings before Interest, Tax and Amortization (EBITA).
Earnings before Interest, Tax, Amortization and Depreciation
(EBITDA).
Operating cash flow.
Here are some definitions:

Earnings are profits.
Amortization is used to describe the accounting practice of writing down the

value of intangible assets over a number of years. Intangible assets, for
example, are goodwill, trade marks, patents, research and development costs
and intellectual property rights.
Depreciation is the accountants method of spreading the cost of an asset over
a number of years, usually its useful life. Different assets have different
levels of depreciation charge; for example, land is not generally depreciated,
buildings may be depreciated over 50 years, motor vehicles over five years
and computers over two years. Depreciation is a non-cash item. The cash
went out as capital expenditure when the asset was first purchased and the
depreciation charge is the method employed to recognise this cost over a
number of trading cycles.
All the measurements to assess ability to repay have their uses, each has its
own strengths and weaknesses and they are applicable in some situations and
not in others. For example, pure earnings measurement (such as EBIT) could
be used for a property investment company which lets out the property it
owns and where operating cash flow would not add any significant value to
the repayment risk assessment. For a manufacturing company, operating cash
flow will be the most reliable way to assess the repayment risk because an
earnings measurement would exclude the important variables of how much
additional stock or debtors are being tied up in earnings/profits.
Having seen the meaning of amortization and depreciation, we now come to
the adjustments to the income statement earnings needed to start compiling
the cash flow report. We add back to the earnings figure interest, tax, and the
non-cash items of depreciation and amortization.
The interest expense from the profit and loss account is added back to find
out if operating cash covers both the interest and capital repayments on debt.
Tax from the profit and loss account is also added back as this is a pure
accrual accounting figure - it does not tell you how much tax was paid in
cash. To find the actual tax paid out in cash we need to use both the taxation
figures in the P & L account and in. the balance sheet.
As we have seen, depreciation is a non-cash item. If it is added back to
earnings you need then to account for capital expenditure. It can be left out of
the calculation if the depreciation charge equates to the annual replacement
figure for capital expenditure. We shall add back the depreciation and then
calculate what is the actual annual capital expenditure. Later we can
determine if the business is spending sufficient to maintain its core assets.
In deciding whether or not to add back amortization, caution needs to be
exercised. Amortization of goodwill, trade marks, patents, R & D is normally
acceptable - the cost was incurred in cash a number of years ago and its
expense is now being recognized over a number of trading cycles.
Profit and loss account and balance sheet
Lets take a profit and loss account and balance sheet back to their cash
components.
The starting point is retained earnings and we will add back various items to
arrive at a figure for Earnings before Interest, Tax, Depreciation and
Amortization (EBITDA).
Here is the profit and loss account we will use to compile the first part of the
cash flow report:
Profit and Loss Account for the years ended 31 March:
Rs. 000s
Sales
Cost of Sales
Gross Profit
Administration Expenses
2008
2009
2010
651,500
547,300
104,200
27,000
750,600
645,500
105,100
32,300
801,000
632,800
168,200
55,100
42,100
7,200
1,000
500
26,400
10,000
16,400
0
16,400
48,200
6,000
1,500
600
16,500
6,700
9,800
0
9,800
85,000
4,900
1,700
700
20,800
8,300
12,500
0
12,500
Selling Expenses
Interest Expenses
Depreciation
Amortization
Profit before Tax
Tax
Profit after Tax
Dividends declared
Retained Earnings
We shall complete the figures for 2009 and then later you will
do the same for 2010.
Here is how you arrive at EBITDA for 2009:
Start with Retained Earnings
add Interest Expenses
add Depreciation
add Amortization (but remember the caveat mentioned above
and also how it applies to depreciation - if you look at the
balance sheet following you will see it is amortization of
patents - so it is acceptable to add this back).
add Dividends declared (but in our example no dividends were

deducted from the profits in 2008 or indeed in 2009).
= Earnings before Interest, Tax, Depreciation and Amortization

(EBITDA).
Here is how the figures for 2009 look:
Cash Flow Report for the year ending 31 March:
Rs. 000s
rious
Tax.
t part
)10
)00
J00
200
LOO
D00
900
700
2009
Retained Earnings
Interest Expenses
Depreciation
Amortization
Tax
= EBITDA
9,800 add back:

6,000
1,500
600
6,700
24,600
You will be able to see how the figure for Earnings before Interest and Tax
(EBIT) is calculated from the above figures. It is Rs. 22,500,000 - made up of
9,800,000 + 6,000,000 +6,700,000 = 22,500,000.
Now we need to extract some figures from the following balance sheets
(remember, there are various different layouts for balance sheets, but the
asset/liability classification will be the same):
Balance Sheets as at 31 March:
700
800
300
500
0
Rs. 000s
2008
2009
2010
Current Assets Stock

Trade Debtors Cash
87,100
79,400
2,300
112,600
84,600
4,100
108,900
114,400
3,600
Total Current Assets
168,800
201,300
226,900
Fixed Assets
60,200
62,000
65,600
Total Tangible Assets

Goodwill
Patents
229,000
3,400
1,000
263,300
2,800
1,000
292,500
2,100
1,000
Total Assets
233,400
267,100
295,600
Trade Creditors Taxation

Dividends Overdraft
Current portion of bank term loans
68,800
13,000
3.0
63,200
2.000
103,600
17.100
3,000
50.100
2,500
120,200
10,300
2,000
59,200
3,000
Total Current Liabilities Bank term

loans
150,000
17,700
176,300
15,300
194,700
12,900
Total Liabilities
167,700
191,600
207,600
(Total Assets - Total Liabilities)
65,700
75,500
88,000
Shareholders Funds
Share capital Profit and loss
account
10,000
55,700
10,000
65,500
10,000
78,000
Total Shareholders Funds
65,700
75,500
88,000
500
a will
Current Liabilities
itioned if you
iee it is
idd this
vidends
deed in
on and
nee Book 1
Net Assets:
91
How to calculate cash from operations:

We need to make adjustments to account for funds that are tied up in or
released from Stock, Debtors and Creditors and we do this by taking the
change in these balance sheet values.
To calculate the 2009 values for Stock, Debtors and Creditors, we take their
2008 balance sheet values less their 2009 balance sheet values. You will
need to remember that:
increases in Assets are a (use) of funds, i.e. a negative figure,

shown in brackets - profits are being tied up in stock or debtors.
decreases in Assets are a source, i.e. a positive figure - funds are

being released that were previously tied up.
increases in Liabilities are a source of funds, i.e. a positive
figure.
decreases in Liabilities are a (use) of funds, i.e. a negative

figure.
This can be summarized as follows and you should refer to this throughout
this and future exercises until you completely understand the concept:
Asset
Liability
Increase (>)
Decrease (<)
(Use of Funds)
Source of Funds
Source of Funds (Use of Funds)
Let us test this concept before we proceed with the 2009 cash flow by taking
the balance sheet per month of a newspaper vendor. It is quite a simple
example as there are no previous values and these are expressed as a nil
value.
Liabilities
Assets
Debtors
50,000 Opening Capital Cash

34,500 Net profit
Less Drawings
Closing Capital
Total Assets 84,500
Total Liabilities
24,500
60,000
( 0)
84.500
84.500
Month 0 Debtors Less Month 1 Debtors Changes

0 in
Debtors are a use of funds (50,000)
50,000
At the end of the first months trading, Rs. 50,000 of profits had been tied up
to fund new debtors.
We now return to the changes in the 2008 and 2009 balance sheets in the
example above in this chapter. Here are the figures we are going to use and
they have been extracted to make the calculation easier. First we establish if
the change is a source or a (use) of funds:
Balance Sheets as at 31 March: Rs. 000s
2008
2009 Change Source/(Use)
Current Assets
Stock
87,100 112,600
(Use)
Trade Debtors 79,400 84,600
(Use)
Current Liabilities
Trade Creditors 68,800 103,600
Source
The second stage is to calculate the amounts. As you become experienced
with this concept, you can combine the two steps.
Balance Sheets as at 31 March: Rs. 000s
Current Assets
2008
2009
Stock
Trade Debtors
87,100
79,400
112,600
84,600
(Use)
(Use)
-25,500
-5,200
Current Liabilities
Trade Creditors
68,800
103,600
Source 34,800
Now it is the simple matter of inserting the figures into the cash flow report,
adding down from EBITDA and taking into account all the changes in
Stock, Debtors and Creditors to arrive at a figure for Cash from
Operations.
Rs. 000s
2009
Retained Earnings 9,800 add back:

Interest Expenses
6,000
Depreciation
1,500
Amortization
600
Tax
6,700
EBITDA
24,600 Changes in:
Stock
(-25,500)
Trade Debtors
(-5,200)
Trade Creditors34,800 Cash from Operations 28,700
When you have added EBITDA to the changes in Stock, Trade Debtors and
Trade Creditors, the figure you will arrive at is the cash earnings from the
businesss trading activities, otherwise known as Cash from Operations.
Effectively this figure allows for the payment:
in the first instance of tax, which has to be paid.

of profits adjusted for interest paid on debt and non-cash items, and
93
thereafter of the cash earnings which allow the business to pay for
the servicing (interest) and debt.
What is left over after the above, if a positive, is available to pay:

dividends.
capital expenditure.
You may be wondering why we bother to add back these figures (tax,
interest, dividends, etc) only to deduct them later in the calculation.
The reasons are:
It is easier to analyze the figures this way to show how much is

available to fund debt repayment.
Year-on-year trends can be detected much more quickly.
The figures added back are calculated using accrual accounting
principles and we need to convert them to a cash basis.
Any surplus (i.e. a positive figure) will go into cash. If the resultant
figure is negative, this means the business has had to borrow funds
(invariably from you as the banker, generally on overdraft) or the
shareholders may decide to inject more cash as capital into the
business to fund the shortfall or deficit.
This part of the explanation is to set the scene for other calculations that we
are going to perform, but before leaving cash from operations it is useful to
carry out an analysis which, after all, is one of the reasons you do the
calculation.
We can see that:
EBITDA is positive - always a good sign; if year on year it is
negative, the business, if not already in trouble, it soon will be.
Stock and Debtors are using up (Rs. 30,700,000) of the EBITDA you should check that the trend in the Stock or Trade Debtors Days
On Hand ratios is not moving adversely (i.e. increasing) This may
indicate that the business is carrying too much stock for its own
customers requirements, or obsolete stock, or that there may be
slow -paying debtors, or a significant bad debt.
It is only because of the trade creditors support (providing an
extra Rs. 34,800,000) that cash from operations is positive. You
need to be sure that the customer is not taking longer to pay their
creditors than the agreed period. You can detect this by referring to
Trade Creditor Days On Hand ratio.
At this stage you will begin to see the overlap with ratio analysis and some
of the reasons for favorable or adverse movements in these critical ratios.
How to calculate the amount of corporation tax (or simply tax) paid
in cash
The next important figure to be established is how much tax was paid in
cash. While a business may declare in the income statement the amount of
corporation tax due on the profits for that year, it is only by including the
balance sheet current liability figure that we can see how much cash tax has
been-paid.
Die to pay;
these figures
i later in the
) show how
tickly.
ng accrual t
them to a
cash. If the
less has had
he banker, ly
decide to to
fund the
alculations
operations
the reasons
The way in which this is calculated is straightforward. We start with the

opening current liability value for the corporation tax due. In our customers
case the cash flow we are calculating is for the period to 31 March 2009,
thus we need the opening value as at 1 April 2008. The closing balances at
31 March 2008 will be the opening balance on 1 April 2008, so the figures
are:
Rs. 000s
Opening corporation tax at 1 April 2008
Rs. 13,000
add corporation tax declared per the profit and loss account 2009 Rs. 6,700
less closing corporation tax at 31 March 2009
(Rs. 17,100)
Cash corporation tax paid
Rs. 2,600
Before inserting this figure into the cash flow report and moving on to the
next calculation, there is a question to be asked: why if the customer has
declared Rs. 6,700,000 of tax due have they paid Rs.
2,600,0 tax in cash? The simple explanation is that they should have paid
at least the previous tax on profits declared of Rs. 100,000 as shown in the
2008 profit and loss account. We insert the tax paid in cash.
Rs.
000s
2009
Retained Earnings add back:

Interest Expenses Depreciation Amortization Tax
EBITDA
Changes in:
Stock
Trade Debtors Trade Creditors Cash from Operations
Taxation Paid
Cash from Operations and after tax
9,800
6,000
1,500
an year it is
it soon will
600
6,700
24,600
>00) of the
le Stock or g
adversely
msiness is
stomers tay
be slow
(providing
rations
is
ner is not
:ed period,
irference
DaysBook
On 1
(25,500)
(5,200)
34,800
28,700
(2,600)
26,100
95
aalysis and
ts in these
ference Book 1
96
How to calculate total cash finance costs
Now we are going to establish if the business generated sufficient cash to

repay its interest-bearing debt. Typically, this will be bank loans and term
loans. We leave the capital amount of the overdraft to the end of the
calculation - effectively it can be seen as a balancing item. The figures we
need to extract are:
1.
Interest expenses (from the profit and loss account) - the figure you
added back - will contain interest on short term facilities (for
example overdraft or other short and long term loans). This will
hopefully provide us with some comfort to show the interest on the
overdraft is being serviced. If a customer cannot pay the interest on
its loans, then the account will be classed as non-accrual (or non performing) and is thus a problem loan and potential bad
debt.
2 The current portion of long term debt (CPLTD) (for the prior year)
(from the balance sheet, the prior year is used here - 2008) remember current liabilities are creditors repayable in the
following 12 months; thus CPLTD for 2008 will be repaid out of
2009 cash flow.
Looking at the figures (balance sheet and profit and loss account) we see:
1
2
Interest Expenses 2009

CPLTD (prior year, 2008)
Rs. 6,000,000
Rs. 2,000,000
Returning to our partially completed cash flow report, we now have to slot
these figures in and calculate a sub-total for Total Cash Finance Costs.
Rs. 000s
Retained Earnings add

back:
Interest Expenses
Depreciation Amortization
Tax
EBITDA
Changes in:
Stock
Trade Debtors Trade
Creditors Cash from
Operations Taxation Paid
Finance Costs:
Interest Expenses CPLTD
(prior year)
Total Cash Finance Costs
2009
9,800
6,000
1,500
600
6,700
24,600
(25,500)
(5,200)
34,800
28,700
(2,600)
26,100
(6,000)
(2,000)
(8,000)
An analytical insight here shows a strong ability to service and repay interest
and loan installments. Cash coverage is a measure that is used in lending
covenants, similar to interest cover. In this case, cash cover is a healthy 3.27
times, i.e. the Rs. 8,000,000 that has to be paid out is covered by more than
three times from the 2009 earnings/cash from operations and after tax. Debt
repayment in 2009 is met comfortably.
Dividends paid in cash and capital expenditure
Now we are going to calculate the cash values for the following lines in the
cash flow report to arrive at a figure for cash after finance, tax and capital
expenditure. This involves calculating figures for:
1.
2.
Dividend paid
Capital Expenditure
Dividend paid in cash
Dividends are calculated using the same formula we used for taxation paid:
Dividends outstanding in current liabilities at the start of the year
plus Dividends declared in the profit and loss account for the current year
less Dividends outstanding in current liabilities at the end of the year
The calculation is:
Dividends - current liabilities end of 2008 Rs. 3,000,000
plus Dividends declared in the 2008 profit and
loss account
( 0)
less Dividends - current liabilities end of 2009 (Rs.3,000,000)
Dividends paid in cash in 2009
0
The conclusion is that no dividends have been paid in terms of cash during
2009. This is proved by:
the profit and loss account for 2009 showing zero for Dividends
Declared.
the change in the current liabilities for 2008/09 is zero.
Capital expenditure
Capital expenditure can be separated into two components following

discussion with your customer:
The first component can be described as essential or maintenance
capital expenditure - this is what a business requires to pay out in
replacing its fixed assets in order to keep the business running
smoothly without having to spend sizeable amounts in repairs or
maintenance costs. Most assets have a definitive life span: think about
a car, as it gets older the cost of repairs increases. That is why
businesses require a regular schedule of replacing fixed assets to
prevent the increasing cost of maintenance getting out of hand
economically and reducing the profitability of the business. This
applies just as equally to plant and machinery. The depreciation
charge in a customers accounts can be used as a proxy/estimate/rule
of thumb
97
amount for maintenance capital expenditure. In a particularly lean

year when their industry is in recession, maintenance capital
expenditure can be halted, but it is generally unwise to do this over a
period.
The second component is described as discretionary capital

expenditure. It is discretionary in as much as the management of the
business have decided to do something that they can directly influence
or wish to happen as part of a strategic plan, for example they wish to
open another outlet, they propose increasing their sales by 50%, etc.
These events not only increase the amount of stock and debtors which
require to be funded, but they will also need fixed assets to support
their plans.
Thus thinking about capital expenditure in this way when carrying out an
analysis of the cash flow will allow you to distinguish between what has
been maintenance and what has been discretionary capital expenditure.
You should note that depreciation is often shown as net of gains or losses
on the sale of fixed assets. Think of:
gains on sales of fixed assets as being an overestimation of
depreciation applied in previous years
losses on sales of fixed assets as being an underestimation of

depreciation applied in previous years.
Like depreciation, gains/losses on fixed asset sales are regarded as non-cash

items - the cash left or was used by the business the year in which the asset
was purchased. That may have been last year or five years ago or twenty
years ago.
The easiest way to think about this calculation for 2009 is:
Take the opening Net Tangible Fixed Assets (i.e. last years closing, 2008)
If depreciation for this year (2009) was deducted per the profit and loss account
o the net tangible Fixed Assets for the
Rs. 60,200,000
Rs. (1,500,000)
end of 2009 should be

But the Net Tangible Fixed Assets for the
Rs. 58,700,000
end of 2009 are actually
Rs. 62,000,000
So why is there the difference? The answer has to be that the bus' has
bought more fixed assets during the year and the capi expenditure has been
(Rs. 3,300,000) during 2009.
Now it is only a matter of putting these two items (Dividends Capital
expenditure) into the cash flow report and obtaining a for cash after finance,
tax and capital expenditure.
Rs. 000s
2009
Retained Earnings
add back:
Interest Expenses
Depreciation
Amortization
Tax
EBITDA
Changes in:
Stock
Trade Debtors
Trade Creditors
9,800
6,000
1,500
600
6,700
24,600
(25,500)
(5,200)
34,800
Cash from Operations
28,700
Taxation Paid
(2,600)
26,100
Finance Costs:
(6,000)
Interest Expenses
CPLTD (prior year)
Dividends Paid
Capital Expenditure
Cash after finance, tax and capital
expenditure
(2,000)
(8,000)
0
(3,300)
14,800
The observations we can make at this stage are:

The business has paid for all its capital expenditure from internally
generated earnings of one year.
The business appears to have spent around Rs. 1,800,000 in discretionary
capital expenditure (i.e. depreciation for the year is Rs. 1,500,000 and
using that as a proxy for maintenance capital expenditure gives Rs.
1,800,000 of discretionary) and is catching up on an under spend that
had occurred in the previous year; without the 2007 balance sheet, you
cannot tell.
Our previous observation on the apparent underpayment of tax is still
appropriate here. You will recall that they paid Rs. 2,600,000; the amount
they should have paid equal to the figure from the previous years profit
and loss account is Rs. 10,000,000, thus they appear to have the ability to
pay out Rs.6,400,000 (Rs.10,000,000 - Rs.2,600,000) from cash earnings
which should not have put a strain on their cash flow. We need to look
elsewhere for the answer - why did they feel they needed more cash on
hand or were you applying pressure to bring the overdraft balance down
to below its limit? Only by referring to the customers lending file and
asking them the reasons for this strategy will you find an answer.
Balancing and reconciling the cash flow report
The change in overdraft

2008 Overdraft is
Rs. 63,200,000
2009 Overdraft is
Rs. 50,100,000
The change is (Rs. 13,100,000)
The CPLTD (current year)
99
The CPLTD for the current year (i.e. 2009) will be used out of cash next
year, thus it is included here as a source of funds for this year (reducing a
liability). The figure inserted is Rs. 2,500,000.
Change in long term debt
This is simply the change between 2008 and 2009 of the long term debt:
2008 Long Term Debt Rs. 17,700,000
2009 Long Term Debt Rs. 15,300,000 A
(Use) of funds
(Rs. 2,400,000)
Now we continue to complete the cash flow report.
The full and completed cash flow report looks like this:
Rs. 000s
2009
Retained Earnings
9,800 add back:
Interest Expenses
6,000
Depreciation
1,500
Amortization
600
Tax
6,700
EBITDA
24,600 Changes in:
Stock
(25,500)
Trade Debtors
(5,200)
Trade Creditors
34,800
Cash from Operations
28,700
Taxation Paid
(2,600)
26,100 Finance Costs:
Interest Expenses
(6,000)
CPLTD (prior year)
(2,000)
(8,000)
Dividends Paid
0
Capital Expenditure(3,300) Cash after finance, tax and capital
expenditure 14,800 Short Term Debt
Cash
(1,800)
Overdraft
(13,100)
CPLTD (current year)
2,500
Change in Long Term Debt
(2,400)
(14,800)
100
The observations we make here are that the surplus of cash after finance, tax
and capital expenditure of Rs. 148,000 has given the business a cash surplus
which they have used to:
ti
IT
increase their cash on hand/at bank balance - the reason can be

established if you talk to the customer
reduce the overdraft - was this voluntary or as a result of pressure?

the CPLTD and change in long term debt are part of the normal debt
repayment schedule; this should not change significantly unless the
agreed term of repayment was varied at the customers request.
f'
In conclusion, when you have compiled the cash flow report, you then need
to tie in your assessment of these financials to the ratio analysis. What you
need to assess is the sustainability of any year-on- year deficits and the overall
impact on your customers ability to continue to trade.
Lending covenants
No analysis of a business lending proposal can be complete without
considering the security that may be required. In this section it is appropriate to
introduce lending covenants. Lending covenants form an integral part of term
loan lending and are included in the loan agreement document. It is important
for you to fully understand both their importance and their function.
Now that term loans are commonly being written for periods of up to 10 years
- for some customers there are longer periods - lending covenants are
commonly used by banks at most levels of this lending. There is a time risk
for banks - the term loan is committing the bank to continue lending over many
years, albeit on a reducing balance basis. The increased risk comes from the
fact that repayment of the loan is being spread over a number of trading and
economic cycles. No one can predict the future - the further time goes on, the
less accurate the projections are likely to be and therefore the harder it is for
the lender to maintain the level of risk at what it was at the outset.
Covenants are formal agreements made at the time the loan is negotiated. The
bank has agreed to the loan on the basis of its assessment of risk and wishes to
ensure that that risk does not increase during the period of the loan. It thus
negotiates with the customer to abide by certain financial measures (for
example, ratios covering capital adequacy, gearing and interest cover) and
provide information (for example, management accounts). The covenants may
impose restrictions on the business, like not allowing it to grant security to any
other party.
Covenants are often classified as affirmative or negative.
Affirmative covenants are actions the company agrees to comply with.
Examples are:
Provision of financial information:
-
nee Book 1
Audited accounts.
101
Management accounts.
Aged lists of debtors and creditors.
Professional valuations of security.
Payment of interest as it falls due.
Capital repayments to be made on the loan.
Adherence to certain ratios:

-
Shareholders funds Rs.
Capital adequacy %.
Gearing %.
Operating cash cover %.
Interest cover %.
Current or liquid ratio.
Loan to value %.
Negative covenants prohibit the borrower from doing something. Examples

are:
Limit the amount of debt the business can take on.
Restriction on dividends paid.
Limit/prohibition on asset disposals, or the granting of leases.
Restrictions on change of ownership.
Minimum levels of shareholdings for key people.

Covenants are established so as to force a review of the facilities if the
covenants are breached. Breach of covenant usually makes the loan repayable
on demand as a breach is an event of default. In effect, it brings about a
renegotiation of the loan. If a covenant is breached, things are obviously not
going according to plan and the bank will want to review its risk. It brings
early action; in the absence of covenants only non-payment of interest or a
loan installment would cause a renegotiation. And, of course, the longer rescue
is put off, the less likely there is to be satisfactory outcome. The breach will
trigger the negotiation of an action plan to heal the breach, or more likely,
renegotiate the terms. Often there is a clause in the loan agreement that states
that a default on one loan means a cross default with other loans which also
become repayable on demand.
Lending covenants are thus a means of seeking a review of the facility where
conditions which were an integral part of the original credit decision have
changed. The bank has agreed to accept a certain level of risk when it granted
the loan, and negotiated an appropriate rate of interest. The covenants are
designed to keep the risk at the same level during the currency of the loan.
The review following a breach of covenants could lead to any one of the
following:
negotiate a re-pricing of the loan.
seek additional security.
extend the repayment period.
102
renegotiate the whole credit facility.
It is important that you do not try to cover every risk - there are some risks you
cannot assess or foresee, so you need to concentrate on the known and crucial
risks in the loan. Risk can be managed, but it can rarely be eliminated
completely.
Lending covenants have to be negotiated with the customer and you may not
be able to get all the covenants you wish, but this may be compensated for by a
higher rate of interest or additional security or asset cover. A small number of
focused and specific risk-based covenants is what is required. Lending
covenants need to be tailored and structured to meet the needs and risks of the
individual proposal from the customer.
Assessing customer needs
Part of the skill of being a banker is to work out with the customer the
appropriate financing to meet their needs. How do we assess these needs? This
skill, when applied properly, will not only help the customer, it will also ensure
that the correct bank product is used, and a satisfied customer is the best
advertisement for your ability. You are more likely to attract new business if
you have satisfied customers. We want existing customers to continue to do
business with us and to do more of their business with us. We want potential
customers to wish to do business with us.
Case study
M. Abdullah
Purchase of a butchers shop
Put yourself in the position of a new bank relationship manager, Asad
Khan, who has as one of his customers a successful butcher, Muhammad
Abdullah, owner of five butcher shops in the city. In the past he has had
little contact with your business unit as the account runs substantially in
credit and is trouble free. Out of the blue, he telephones and advises that
he would like to see the manager the following morning to talk about
money.
After introductions and the usual pleasantries, the situation at the meeting
develops as follows:
M Abdullah: Ive come in this morning to ask you for some money - in fact
Im looking for one of your overdrafts.
103
A Khan:
I am pleased to see you - and I will certainly xlo my

best to help you. Can you give me some details of what
you are looking for?
M Abdullah: You bankers hand out overdrafts, dont you? Ive never had
one before but I would like one now! Lots of my business
friends have got overdrafts so how about it! What do I
have to sign?
Already you will have gathered that we have here a highly successful
business customer who knows the business of the meat trade from A-Z, but
has never had reason to borrow to,support his previous expansion.
A Khan:
Mr. Abdullah, I am pretty sure that we will be able to

assist you with your proposition, but before I can give you
any sort of answer, you will have to give me a fair bit of
information concerning this particular enterprise.
M Abdullah: Well, Mr Khan, what Im looking for is one of your overdrafts

for Rs. 80,000. You know my shops alone are worth over
Rs. 500,000 so that should be no bother for you, should it?
Oh, by the way, please call me Muhammad.
A Khan:
OK Muhammad, Im Asad. Now as far as this

proposed borrowing is concerned, youve told me how
much you are looking for. What is the money to be used
for?
M Abdullah: Right, Asad! No problem. My son is coming into the business

and I want to expand and buy another shop. Ive found
suitable premises which will cost Rs.
120,0. Ill pay the balance plus the cost of fitting and
equipping from the money I have on deposit with you.
A Khan:
That sounds fine, Muhammad. Your business has

demonstrated strong, steady growth over the last 15 years.
Given your track record with the other shops, what sort of
repayment period had you in mind if you were to borrow
Rs. 80,000?
M Abdullah: I really have little idea, Asad! But I promise you I will clear
the overdraft as soon as possible. I dont want to pay
overdraft interest for one day longer than necessary.
We are beginning to grasp the situation. Here we have a successful 1 butcher
who has had little need to become familiar with bank I procedures. The onus
is on the banker to obtain all the relevant information and to work with the
customer to identify which] particular method of borrowing might be most
suitable for him.
Muhammad, on the information you have given me so far, I am confident I

will be able to help you with the purchase of your new shop, but I would
suggest to you that an overdraft is perhaps not the best type of advance to suit
your particular requirements.
Youll have to explain. Do you provide other kinds of loans apart from
overdrafts?
We do indeed. The types of borrowing which would normally be provided to
assist with the purchase of a fixed asset such as a shop are a term loan or a
commercial mortgage. These types of loans are for a fixed amount and can be
geared to the projected performance of the business. Repayment would be
arranged over a fixed period of, say 10 or 15 years, with payments monthly,
quarterly, half yearly or annually. We can also look at repayment of interest
only or what we call a capital repayment holiday, at the early
stages. This enables you to get the business up and running before
you start to reduce the capital amount.
M Abdullah:
A Khan:
I would hope that I would be able to repay the loan long before the
end of 10 years, say within 7 or 8 years. Its my intention to further
expand well within that time.
Well have to discuss this further and have a review of your last
three years audited accounts. Apart from our normal lending
assessment, this will also help us to work with you in determining
the loan facility that best meets your needs. However, at this stage,
based on the information I already have, I am sure you could cope
comfortably with a term loan of Rs. 80,000 repayable over, say, 8
years.
No problems, Im sure, but why are you suggesting a term loan
rather than an overdraft?
M Abdullah:
Various reasons, Muhammad. For a start, if I provided you with an

overdraft facility of Rs. 80,000, this would be operated through
your ordinary business current account. As you know, all your
A Khan:
normal bank transactions are dealt with through that account lodgments from your daily shop sales and the many cheques you have to issue
each month. The level of the overdraft therefore would fluctuate all the time,
and although there might be some benefit gained on the amount of interest
payable, it is really quite difficult to monitor the systematic repayment of the
borrowing.
With a term loan, this is taken on a separate account and the only transactions
through the account, once the initial advance has been taken, are quarterly
interest charges and the repayments which will be
and Risk Management | Reference Book 1
105
taken on a regular basis from your operating current

account.
You therefore know exactly where you are as regards the
amount of loan outstanding at a given time, and it will help
you considerably when you are working on your cash flow
projections. How often would you wish your repayments to
be made?
M Abdullah: Given that I bank my takings every day, monthly sounds fine.
A Khan: I would agree with you. The rate we would propose to charge you
will be fixed at the outset and will not alter during the
period of the loan. Again this is useful to you when working
on your outgoings over the next few years.
M Abdullah: One of my business pals told me that if a bank sees fit, it can
call on a customer who has an overdraft, to repay it on
demand. Is this correct, and if so, does it also apply to a
term loan?
A Khan: Overdrafts were repayable on demand, but provided the customer
complies with the terms of the agreement, the overdraft
facility will be available until the agreed expiry date.
However, it does require to be reviewed, at least on an
annual basis. With a term loan, provided the customer
continues to repay the loan strictly in accordance with the
formal conditions laid down when the loan was granted, the
loan must be allowed to run its agreed course. No annual
renewal fee will be payable as is the case with overdrafts.
You will notice that the interview is proceeding in a satisfactory manner.
The customer would appear to be trustworthy with a fine track record; the
amount is acceptable although the period of repayment has yet to be firmly
decided.
M Abdullah: This idea of a loan taken on separate account over 8 years
appears to be right for me. Thanks for all your advice,
Asad. How do we move things forward?
At this stage you cant progress matters further. Your customer hasnt
brought any audited accounts with him and you should advise him of what
you need in support.
A key element in building on the relationship and progressing matters is to
arrange an early visit to the shop as well as your customers key business
premises. This demonstrates a genuine interest in the business as well as
providing you with an invaluable insight into the existing business and
proposed expansion. Your knowledge will be considerably enhanced by
expanding on this initial discussion when can combine this follow-up
meeting with collecting the financial information that you have advised that
you require in support. You can also use this meeting to begin to discuss
other areas in detail such as interest rate, fees, security, provision of other
services, etc as well as determining the period of the loan.
106
This case study reinforces the point that an important part of your job is to
tailor borrowing requirements to best suit your customers circumstances.
While we must at all times be conscious of our responsibilities in gaining
worthwhile and profitable business for the bank, we must also act in the best
interests of the customer.
In familiarizing yourself with your organizations range of lending products,
you will see that the bulk of the wide range of options now available to your
customers are derived from the basic products of:
overdraft, term loan.

leasing/asset finance.
invoice discounting/factoring.
Other alternative ways of borrowing could be as follows:
The borrowing simply taken on a separate account to keep it apart

from the ordinary operating account. If the operating account works
at all times in credit or moves into credit from time to time, then the
bank may be prepared to grant compensating interest on the credit
balances to be offset against the interest on the second account
which would run in debit during the period of the borrowing.
If the customer has business dealings abroad with clients or
suppliers, instead of a bank overdraft, it may be advantageous to:
-
borrow in an overseas currency
Arrange a facility (normally through the banks international department)

for advances to be made against bills for collection or advances against bills
negotiated.
Meeting all of your customers' needs - cross selling
It is important to keep being aware of all of your customers financial needs

and not just their borrowing requirements. Any loan facility in support of
capital expenditure will inevitably require insurance cover. Does your bank
currently provide insurance cover? Is this an opportunity to quote for all of
the business and not just the new acquisitions? Are the customers expanding
and looking to export abroad? This could be an opportunity to introduce
your international department.
Ultimately, every time you communicate with a customer you are gleaning
information of one form or another. It doesnt have to be a formal meeting
agreed for a specific purpose but an informal discussion at a chance meeting.
The key, as mentioned earlier, is to listen, and you will identify all types of
opportunities.
Cash flow monitoring
Cash flow monitoring is an essential part of controlling a business
customers account. Just to recap: cash is the lifeblood of a business, without
cash flow a business will be unable to pay its bills, including wages and
taxes; any blockage in the cash flow, like a clot in the blood flow, can have
serious consequences.'After all, the definition of insolvency is the inability
to pay the bills as they fall due. We are now going to look more closely at
cash flow projections and the importance of ongoing monitoring and
107
analysis of this information. As we have seen, it is part of your job to

monitor your customers accounts to ensure that they keep within the agreed
limits. By doing so you are also monitoring the banks risk. Cash flow
projections are a normal part of a business plan, as we have seen. We want
to see that the business, and particularly its cash flow, are progressing as
planned.
Cash flow projections
We studied cash flow reports earlier. Now we are going to see how we use
them. You may already have studied the concept of cash flow forecasting
where a cash budget or cash flow forecast is a projection of receipts and
payments of liquid funds. When a customer asks for facilities for a new
business we usually seek a cash flow projection over the first twelve months
of the businesss life. However, it is useful to assess how the budgeted
receipts and payments will look over a longer period. In most new
businesses the first twelve months are a growth period. It is possible that in
this period the income and expenditure may not be representative of what
could become a more normal pattern of trade. Looking at the second twelve
months will give you a better picture of the businesss prospects. It is normal
for the figures to be given on a month-to-month basis.
Preparing cash budgets
You may often be asked to agree overdraft facilities for customers based on
their cash flow projections. If you do not know how cash budgets are
prepared, you will not be able to make a sound judgment based on the
projections. You may also be faced with customers who have little idea of
what you mean by a cash budget, let alone how they go about putting one
together, and they will look to you for advice. This could give you a
problem, at least in the first few years of your account manager role.
You can only offer limited advice and suggestions on how they might go
about completing a cash flow. Customers can of course seek the input of
their accountant, and this is desirable. Although this will incur a cost to the
business, it is worth highlighting that the preparation of cash flow
projections is not just to keep the bank happy; used properly, it is a key
management technique for monitoring and controlling the business. If the
cash flow is already
108
completed, then you are will be asking the customer how he/she has arrived
at these figures. Can the customer convince you that the figures are not only
accurate but also realistic?
We are now going to look at a case study to make it easier for you to
understand what cash flow forecasts are all about. We have already seen
earlier what a cash flow report looks like. In this case study we shall see
detailed cash flow forecasts.
Case study
"Underground"
A new customer has brought you a business plan for a sports club called
Underground. Here is the cash flow and some details of the story behind it.
Business Details
The club has a capacity of 400 and it is anticipated that it will attract around
300 paying clubbers on a Friday and Saturday and also around 200 on an
average Sunday. Admission charges for each evening will be Rs.300. On the
other evenings the club will be available for private hire at a cost of Rs.
15,000 per evening. It is anticipated that two evenings per week will be
taken up this way. The average attendance at private functions is anticipated
at 200.
The proprietor estimates, from discussions with other people involved in
venues in other towns of a similar size, that bar/canteen sales will be Rs. 500
per person with Rs. 100 being spent on food.
As regards expenditure, the normal gross profit margin expected from bar
sales is 50%, with a 40% margin on sales of food. The bulk of staff involved
will be employed on a part-time basis except for:
Canteen Manager.
Office Secretary.
Resident DJs (2).
Cleaners (2).
There will be 10 part-time staff employed each evening the club is open.
Salaries are as follows:
Canteen Manager
Rs. 1,200,000
Office Secretary
Rs. 750,000
Disc Jockeys (Rs. 1,000,000 x 2)
Rs. 2,000,000
Cleaners (Rs. 500,000 x 2)
Rs. 1,000,000
Part-time staff*
Rs. 7,800,000
Total
Rs. 12,750,000
*The wage bill for part-time staff has been calculated on 10 staff @ Rs. 3000
per night x 5 nights x 52 weeks.
Other costs are based on experience in operating a bar and from information
supplied from other clubs operating in other towns.
The ratable value of the club is Rs. 1,500,000 giving a present rates bill of
Rs.1,620,000.
All the revenue figures have been calculated on a conservative basis,
whereas costs have been estimated on a high basis in order to show how
secure the venture is. It is anticipated that profit margins on bar/canteen sales
109
will be greater than stated.

Putting all the information into a cash flow you can see that, even after hefty
bank loan repayments, the business generates cash.
Note:
f
You have not been given details of the actual loan proposal. The interest rate
used here is considerably higher than we now have and some of the income
and many of the costs will now appear low. However, this does not really
matter for the purpose of this exercise, which is to illustrate cash flow
monitoring.
Cash Flow Forecast - January December
Month/
of wks
No. Jan
(4)
Income
Bar Sale
Food Sale
Entrance Free
Private Hires
Total
24000
4800
9600
1200
39600
Bar Sale 12000

Food Sale
2880
Salaries 10625
'00s
Feb
(4)
Mar
(5)
Apr
(4)
May
(5)
Jun
(4)
Jul
(4)
Aug
(5)
24000
4800
9600
1200
39600
30000
6000
12000
1500
49500
24000
4800
9600
1200
39600
3000
0
6000
1200
0
1500
24000
4800
9600
1200
39600
24000
4800
9600
1200
39600
30000
6000
12000
1500
49500
12000
1500
0
3600
1200
0
2880
1500
0
3600
1200 12000 15000

12000
0
2880
2880 3600 2880
1200 12000 15000 156000

0
2880 2880 3600
37440
2880
10625
4950
0
Oct
(4)
Nov
(4)
Dec
(5)
Total
24000
4800
9600
1200
39600
24000
4800
9600
1200
39600
24000 30000 312000

4800 6000 62400
9600 12000 124800
1200 1500 15600
39600 49500 514800
Rates
1350
1350
1062
5
1350
1062
5
1350
1062
5
1350
1062
5
1350
1062
5
1350
1062 10625
5
1350 1350
1062
5
1350
1062 10625 127500

5
1350 1350 16200
Insurances
1000
1000
1000
1000
1000
1000
1000
1000
1000
1000
1000
1000
12000
Heat & Light
500
500
500
500
500
500
500
500
500
500
500
500
6000
300
300
300
300
300
300
300
300
300
300
300
300
3600
Stationery
100
100
100
100
100
100
100
100
100
100
100
100
1200
Telephone
200
200
200
200
200
200
200
200
200
200
200
200
2400
Expenses
150
150
150
150
150
1800
Advertising
750
750
750
9000
Repairs &
Maintenance
Postage &
Travel & Motor
750
150
150
150
150
150
150
150
750
750
750
750
750
750
750
750
Professional Fee 200
200
200
200
200
200
200
200
200
200
200
200
2400
Licences
200
200
200
200
200
200
200
200
200
200
200
200
2400
CDs/ Records
200
200
200
200
200
200
200
200
200
200
200
2400
Security
200
200
200
200
200
200
200
200
200
200
200
200
2400
Cleaning
500
500
500
500
500
500
500
500
500
500
500
500
6000
Bank Charges
100
100
100
100
100
100
100
100
100
100
100
100
1200
Ln Repayment3000
3000
3000
3000
3000
3000
3000
3000
3000
3000
3000
3000
36000
Loan Interest
3400
3400
3400
3400
3400
3400
3400
3400
3400
3400
3400
40800
9351
37404
3400
VAT
200
9351
9351
9351
Total 37655
3765 50726
5
3765 41375 47006 37655 41375 47006

5
37655 37655 50726 504144
Monthy/
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
No. of Wks
(4)
(4)
(5)
(4)
(5)
(4)
(4)
(5)
(4)
(4)
(4)
(5)
-1126
1945
8125
7406
1945
8125 -7406
1945
1945
1226
1
Total
Income less
Expenditure
1945
1945
10656
Opening Bank Balance

1945 3890 2664 4609 12734 5328 7273 15398 7992 9937 11882
Closing Bank
Balance 1945 3890 2664 4609 12734 5328 7273 15398 7992 9937 11882 10656
Taking the amounts given we can examine the cash flow in detail to see how
the figures have been arrived at. On the income side we can double check the
entries from the figures that came from the business plan and are quoted
above.
For example, bar sales are estimated at Rs. 500 per person. With attendances
of 800 customers at the weekend and 400 during the week, this comes to:
Rs. 120,000 x Rs. 500 x 4 weeks = Rs. 2,400,000 per month
110
Other figures on the income side can be double checked this way as well.
The income side of this cash flow can therefore be said to be accurate at least
as far as the figures given are concerned. But how accurate are they?
Cash flow forecasts are based on certain assumptions, not least for the
income to be generated. This is the most sensitive figure and needs to be
tested strenuously. So much depends on the income forecast being
generated. Therefore, you must be satisfied that the basic assumptions of
income and expenditure are realistic. Can they be achieved? How does the
customer justify the assumptions?
One of the simplest ways of doing this is to ask how much you would spend
at a club or ask a junior member of your staff. This could either confirm or
cause a question to arise in your mind about the accuracy of the business
plan. Assuming, however, that you have to ask the customer, the questions
do not have to be complex. For example, asking how the attendance figures
were arrived at might produce a detailed answer demonstrating that both
marketing research for this club and knowledge of attendances at other clubs
have been taken into account. On the other hand, they could simply have
said that the figures were based on an average 75% attendance at the
weekend and 50% on private hires. This might be just as accurate, but
wouldnt you like to have the reassurance that some more work had gone
into the income figures?
On the expenditure side we can go through a similar process. The first step is
to check the arithmetic (as will have been done for the income side).
Assuming this to be accurate, we can then go on to examine individual
items.
Costs related to bar/canteen and food sales
The business plan suggested that these are related to income. For example,
bar sales costs are 50% of income while food sales costs are 60%. This is not
an unusual way of doing things and what you need to do here is to check
whether or not these are realistic. This can either come from experience,
perhaps with other customers, or from sector information maintained by your
own organization.
Salaries
More important than the total figures are the answers to two related
questions:
are the numbers of staff proposed sufficient for the likely numbers
attending?
are the salaries competitive?
Close questioning of the applicant will show how much research has been
done and to what extent you can rely upon it. Any changes brought about as
a result of this must be included in an amended cash flow to see if this
makes any significant difference to cash requirements.
From the salary and wages figures in the cash flow you can work out the
number of employees in a business. Since this should be related to sales, you
should be able to check that sales figures are consistent with the number of
staff proposed. By asking this type of question you are not only relating the
two figures but gaining confidence in the way the cash flow has been put
together.
Rates, insurances, advertising, licenses, bank charges, loan repayment and interest
All these figures can be confirmed either by having written confirmation, as

in the case of rates and insurance, or by agreement, as would be the case
with bank charges or loan repayment. Advertising is within the
managements control and questions related to where the business is going
to advertise should be confirmed by costs in writing from the various
111
advertising agencies, such as newspapers, Yellow Pages, etc.

Other expenses
For all the other expenses the same question keeps cropping up - are they
realistic in relation to the operation? In some instances, you can get reliable
information, such as past electricity bills, accounts or invoices; in others you
will be relying on the customers experience, for example on where money
for repairs and maintenance will be spent.
The overall picture
We are in some respects fortunate when it comes to cash flow analysis. Each
bank produces its own cash flow analysis sheet and you should always use
this as a check to ensure that all major expense items have been covered in
the cash flow in front of you. This is a valuable extra check.
The important point to remember when looking at cash flows is to question
the figures. You should ask the customer to explain how they arrived at the
figures they have put down. What are the underlying assumptions they have
made? Only by doing this can you feel confident that the numbers are
accurate and realistic.
You need to pay particular attention to the totals for each item in the cash
flow. Do these figures look realistic to you? Are they in line with what was
written in the business plan and stated by the customer at your meetings?
Another key set of assumptions in any cash flow is about the terms of trade
for the business. How long a period of credit will the business take from its
suppliers? Do the figures show payment being made within the timescale
agreed? Similarly, what collection period is used in the cash flow for the
businesss debtors? Are these terms of trade in line with the norms for this
industry?
As far as Underground is concerned, the figures supplied to you, if
accurate, show a very healthy position. Throughout the whole of the first
year there is a positive cash flow every month. This is not
112
unexpected; it is after all a cash business. In fact they are more likely to owe
people money than the other way about. But it is a new venture and all might
not go as well as this.
Having granted the loan, all you can do now is wait to see how the cash flow
turns out and ensure that you monitor it closely and keep a close eye on the
firms bank account. Any movement in the figures will have to be analyzed
to see what effect this will have on the business.
interpreting a cash budget
Now you are aware of how a cash flow fprecast is produced, but that is not
the end of the matter. It is all very well to ask a customer to give you
projections to illustrate how they expect the cash flow to run. This helps you
to decide whether or not to lend. However, the other main benefit comes
when you monitor the actual performance figures by inserting them
alongside the planned figures. This gives you a clear picture of how the
business is performing against the original plan.
In other words:
in the first instance the cash flow will let you know if the overdraft
facility being requested is reasonable, and
once the business starts operating you will find out how accurate it is
and how long it is likely that the overdraft will be needed in practice.
If variances from projected figures are identified at an early stage, this

enables you to work with your customer to address the situation and agree
and adopt appropriate remedial action to avoid it becoming a bigger
problem. A simple example could be where the overdraft is gradually
getting out of line with what was projected. The customer might agree to
tighten debt collection procedures, thereby reducing the dependency on
overdraft.
Interpretation of the cash budget leads us naturally to the key cash
generating areas of the balance sheet - the working capital. You will recall
the process by which cash circulates through the working capital cycle (for a
manufacturing business) as cash is used to buy supplies which are turned
into finished goods and then sold, with cash finally collected from debtors to
turn those sales into cash. This cash pays all the expenses of the business.
Working capital
Stock control
Money tied up in stock is not immediately generating cash and profit. It is

the least liquid of the current assets and can prove expensive to hold through
interest and holding costs, like insurance, and also obsolescence. If stock is
too low, it can prove costly in terms of lost orders or disrupted productivity.
The controls need to be set by management with a sound knowledge of the
business and its maximum/ minimum stock requirements. Security is
another important matter with stock and you will be keeping a close eye on
the stock turnover ratio.
Debtor control
The business needs to establish the period of credit it is prepared to
113
offer, together with the limit for each customer. Remember that debtors are
often the largest single asset in the business and therefore need careful
management. Although the terms should reflect the norm for the sector in
question, consideration needs to be given as to the amount of credit the
business can actually afford to give.
When looking closely at debtors you should request an aged list which will
illustrate whether debtors are being invoiced and collected promptly and so
avoid potential bad debts. The longer a debt is outstanding, the greater the
risk that it will not be paid. It is quite common for small businesses to be lax
about chasing up their debtors for payment.
Trade creditors
The buying policy in terms of raw materials must be efficient. This refers
not only to the period of credit which is negotiated, but also to the type and
quality of the materials which are bought. The quantity should mirror the
stock control procedures.
In terms of the negotiated period, full consideration should be given to any
discounts which may be available. However, once terms are negotiated with
the supplier, they should be respected. If payment is made too soon, the
businesss reputation will be enhanced but it will have a negative impact on
cash flow.
Alternatively, if it takes too long to pay, potentially aiding its own cash flow,
discounts will be lost and suppliers may become reluctant to continue to
deliver.
Lets look at the projected and actual cash flow for Underground after it
has been operating for three months.
Underground
Cash Flow Forecast - January March

Month/ Jan
No. of wks (4)
'00s
Feb
Mar
(4)
Total
(5)
Income Budget Acual
Budget Acual
Budget Acual
Budget Acual
Bar Sale 24000 22800

Food Sale 4800 4704
Entrance Fees 9600 9216
Private Hires 1200 1068
24000 22800
4800 4704
9600 9216
1200 1068
30000 28500
6000 5880
12000 11520
1500 1335
78000 74100
15600 15288
31200 29952
3900 3471
Total 39600 39600 39600 39600 49500 47235 128700122811
Expenditure Budget Actual Budget Actual Budget Actual Budget Actual

11400
2822
10891
1384
1025
513
12000
11400
Bar Sales
12000 15000
Food
2880
3600
Sales 28802822
Salaries 10625
10625
10891
10625
Rates
1350
1350
1384
1350&
Insurances
1000 Heat
1000
1025
light 500 Repairs & 1000
500
513300 Postage
500
Maintenance
14250
3528
10891
1384
1025
513
39000
9360
31875
4050
3000
1500
37050
9173
32672
4151
3075
1538
308
&300
308
300
Stationery
100
Telephone
200 Travel 100
&
100
103
Motor Expenses
150
200
205
200
Advertising
750
Professional
200
150
154 Fees 150
Licences
200
750
769
750
CDs/
Records
200
200
205
200
Security
200
200
205
200
Cleaning
500
200 Charges
205 100 200
Bank
Ln
200
2053000 Loan
200
Repayment
500 3400
513
500
Interest
308
900
923
103
300
308
205
600
615
103
205
154
769
205
205
205
205
513
103
3000
3485
114
100
3000
3400
103
3000
3485
100
3000
3400
154
450
461
769
205
205
205
205
513
103
3000
3485
2250
600
600
600
600
1500
300
9000
10200
2306
615
615
615
615
1538
308
9000
10455
115
37655 37495 37655

Income less
37495 50726 50202 126036 125192
VAT
Total
Expenditure 1945 293
Opening Bank Balace
1945 293 -1226 -2967 2664 -2381
0 1945 293 3890 586

Closing Bank
Balance
1945 293 3890 586 2664 -2381
The first thing you might have looked at is the figures at the bottom of the
page - the closing bank balance at the end of each month compared to the
budgeted figures. You immediately see that the cash flows are not as good as
predicted and that by the end of the third month when VAT has to be paid
there is a negative balance of Rs. 238,100 compared with a budgeted surplus
of Rs. 266,400 - the pendulum seems to have swung completely the other
way. It is necessary therefore to examine the cash flows more closely in an
attempt to identify the reason for this variance.
The initial cash flow showed no requirement for overdraft facilities - this is a
cash business. Now an overdraft is required, if only to allow the VAT bill to
be paid. Is there security available to cover this? If the loan to buy the
business was a large one, it is unlikely that there is any available security
cover for overdraft facilities as well.
There are other concerns. If it looks as if the club is not going to pay its way,
there is no point in lending more money to it. This might only give the bank
a greater debt to try to collect in the future - if it can be collected at all.
What we need to do here is closely examine the actual figures in the cash
flow both on the income and expenditure side to see if we can identify any
particular area where either income or costs have been well out of line with
the budget. This being the case, it may be possible to discuss how to bring
them back into line.
The income side
There is no significant difference here. We can see that all areas are not quite
up to budget. Remembering that the figures were based on forecast
attendances, they are in fact out by less than 5%. This is not a great deal and,
in most circumstances, if a business could produce a cash flow at the start of
an enterprise with this degree of accuracy, you would be quite pleased with
it. However, the signs are there to be watched - income is not as good as
planned. Will it get better or will it get worse?
The expenditure side
Again there is nothing on the expenditure side which stands out as being
well outside what was planned. The total is in fact down by Rs. 16,000.
However, this hides a number of cost increases and, in reality, if all costs had
been controlled to their predicted amounts, then total expenditure in January
and February should have been lower by Rs. 65,800 and by Rs. 82,200 in
March. This is because bar and food costs are related to their sales figures. If
these sales change on the income side, there should also be a change on the
expenditure side
This is a point worth remembering and when presented with a cash flow
which has this type of relationship. You should always ensure
116
that the actual figures relate in the same way as the figures presented in the
budget. In the case of Underground they do, considering the size of the
turnover and the fact that these two figures represent over 70% of income.
Apart from this, all the other figures are up, but again only by a small
amount. The net result is to turn what appeared to be a business with a
positive cash flow into one which is going to require overdraft facilities
possibly for some time to come.
Before granting any overdraft facility, you will want to ensure two things:
is security available to cover the overdraft and is this acceptable to

thebank?
what measures are being planned by the owner to try to improve the
situation in the coming months?
Assuming that you get satisfactory answers to these two questions, you may
be willing to grant overdraft facilities.
Summary
Cash flow projections are necessary to show how much cash will come into
and go out of a business over a period of time. This can be confirmed by
looking at the turnover figures in the bank account which also show how
well a business has done in the past and give an indication of its future
prospects, at least as far as cash flow is concerned. This is no small matter if a business has no cash, it cannot pay its bills and the creditors are just as
likely as the bank to want their money back. They can refuse to supply goods
on credit, and if the bank is refusing to meet any cheques, effectively the
business cannot operate and bankruptcy looms ahead.
By keeping a careful eye on a business you may not only prevent it going too
far down the road of having cash flow problems, but you may also prevent
your own bank from having to take the necessary legal action to recover a
debt - something which you, the customer and the bank do not want to
happen.
Adapted from:
Institute.
Introduction:
Credit Risk Practices for

Business and Commercial Banks
Banks use different titles in their organisation structures for the units that
deal with business customers, but usually they deal with the larger
commercial businesses in a unit separate from the retail banking arm. Some
banks use credit scorecards and behavioural credit scoring for credits at the
smaller end of the small and medium enterprise (SME) market. This does
not mean that a credit analysis is not being carried out; it is just a simpler
form of credit assessment.
Business and commercial banking includes any type of business - sole
trader, partnership, limited company,'public limited company or limited
liability partnership - and applies equally whether it is a trading entity or a
provider of services. The analytical techniques can be applied to credits of
any level, from the lower end of the SME market, all the way through to
large corporate.
It is important to remember that all businesses represent a credit risk; no
matter their size, legal structure, number of employees, whether in a
developing, mature or declining industry sector, high or low tech, growing
or downsizing, etc. For this reason, any business will be subjected to some
sort of credit risk analysis. The level and depth of the credit analysis will
depend on a number of factors, normally linked to the strategic direction and
objectives of the bank, and the size of the exposure.
All lending involves risk. It is the bankers duty to assess and manage these
risks, deciding which risks to accept and which to reject. Management of
risk is at the core of banking. All bankers need to be risk aware and have
sound skills in risk management.
In this section we move to more sophisticated analysis of how we assess
risk: market (or industry) risk, the risk attached to the business itself, and
then financial risk. In the financial risk assessment section we are building
on the study of principles of lending and business lending by applying this
knowledge in practice. Finally, we look at documentation and pricing, before
pulling the whole assessment together into a credit report.
Risk analysis and

assessment
You will recall that we have already defined risk as: the possibility of
incurring a misfortune or a loss. The risks are the same in
business/commercial units of banks as we explored in relation to retail units,
only at a higher level, with a slightly different focus. We are still seeking to
assess the likelihood of the identified risk happening, its impact on the
customer and thus trying to prevent or reduce a bad debt provision, loss and
write off. As you will recall, losses and write -offs are a charge against the
banks profits and thus reduce shareholder value.
117
The first step is to identify what the risk is, and then to assess the probability
of its occurrence. However, it is as well at the outset to be clear on the stages
that a loan usually goes through before it is written off:
Non-accrual loan status - where interest is neither taken into profit
nor applied to an account.
Past due 90 days - where loan payments are in arrears for more than
90 days or where the account has been in excess of its limit for more
than 90 days.
Troubled debt restructuring facilities - a distressed loan, one which
had a provision or was previously classed as past due 90 days.
Potential problem loans - where there is a possibility of a loss being
incurred and a provision has been raised, for example where
administration is likely, or there is difficulty in meeting loan or interest
payments. Normally values are quoted before any security is taken into
account.
If you have not properly identified the risks in a credit, or recognised the
warning signs as you monitor the loan, then it could move directly to the
third or fourth category above. Normally, this would prompt some sort of
internal investigation. Bankers generally do not like surprises, which is why
it is important to watch out for deteriorating trends and other warning signs.
The objective of risk management is to prevent losses happening, by
continually and regularly monitoring activity on the account. At the same
time we cannot become risk averse - take no risk at all - as this would result
in an inadequate return on capital for the bank. A fine degree of judgement is
needed.
To see the effect of bad debt we can use the following example: a Rs.
100,000 provision or write off, for a bank with a 3% profit margin before
loan provisions, means that new good high quality lending of Rs. 3.3m has
to be written to replace the loss. Hence the reason for careful risk
management.
Risk management strategy
Using a risk management strategy as a template to manage the credit risks,

we need to:
identify the issue(s) - understand what could happen.
identify the likelihood - probability.
put plans in place to solve or mitigate - plan.
make sure the outcome is dealt with quickly - action/monitor.
Remember there is residual risk - the risk that cannot be eliminated entirely
or insured against. This will be a key element in practice as it is the residual
risk that will normally create healthy profits or unhealthy losses. The trick is
to assess it accurately.
Credit risk management covers a very wide range of topics and you need to
undertake it logically and conscientiously, breaking it down into its
constituent parts in order to be effective.
118
Elements in the analysis and assessment process
To carry out an analysis and assessment, certain areas need to be examined.

We shall be looking at the following:
Market or industry risk assessment
- including cost structure, industry maturity, industry cyclicality,

profitability, dependence, substitutes, industry regulation, Porters five
strategic forces.
Business risk assessment
- including general characteristics and goals, product-market match,

supply and production analysis, distribution and sales, management
analysis, strategy risk.
Financial risk assessment
- Including operational risk, audit risk, asset and liability risk, borrowing
cause risk, financial repayment risk.
Documentation and pricing for risk
- including insurance/collateral.
Each area is subject to analysis. Within each area we shall examine different
elements to assess the level of credit risk. All of these elements are then
rolled up into whether the overall risk for that area is low risk, moderate risk
or high risk. Then various factors are brought together to provide an overall
view of the entire credit risk. The overall view of credit risk is the basis of a
credit report or credit memorandum. This requests the credit funding from a
customer and will be the banks record of the rationale why it lent the money.
Let us see what the three degrees of risk mean:
low risks which perhaps we do not require to mitigate.
moderate risks which should be mitigated.
high risks which really must be mitigated otherwise the
probability of loss is too great (remember these may be residual
risks).
You could also visualise this output as the reading of a temperature gauge low, medium and high. If the temperature is low you should not get burnt. If
the temperature is high, you have to be very careful how you deal with this
high risk, otherwise you could suffer a very painful experience. When the
pain starts, no one else will want to take on the risk - the only way would be
if they receive something else in return, such as you sell your debt to them at
a discount.
Market /industry risk assessment
Here we are investigating which industry the customer is part of.

A structure for market or industry risk analysis
As you have already discovered, any business - no matter its size or location
- is part of an industry. In completing this analysis we will break the process
into bite size chunks, that is, carry out a micro risk assessment and then
stand back and take a macro view of the industry as a whole.
Once this initial appraisal has been completed, you need to consider your
customers position relative to the industry of which it is part. This should
119
reveal if there are any positive or negative factors that may explain why your
customer performs at a level above or below the industry; in other words,
what differentiates it. This information may help to mitigate the risks that
you identify or it may reveal additional risks that may push the lending
assessment to a level that makes the risk/ reward unacceptable.
Economy and environment
Economic condition
The first area we are going to look at is the condition of the economy in
which our customer operates and sells its products. There are various
economic measures that you will already be familiar with; for example,
employment rates, inflation levels (as measured by the Consumer Price
Index or the Retail Price Index), cost of raw materials used in the
production process (as measured by industry indices such as
manufacturing output statistics, retail sales, energy prices, industry
surveys, etc.
Now back to assessing the condition of the economy in which the
industry of your customer is active. If the industry only sells in Pakistan,
then you need only assess Pakistans economy, but if there are major
exports (say more than 10% of sales) into other countries, you will need
to factor in the condition of that country or those countries into your
assessment.
Your own banks economic department will provide updates regularly on not
just Pakistans economy, but other major countries, and this assistance can be
invaluable.
To help you arrive at your assessment of the economy, the following matrix
has been developed. You can use a circle or a highlighter pen to show
whether the risk is low, moderate or high.
Economy and environment . Economic condition
LOW MODERATE HIGH
The term economic condition relates to both the foreign and domestic
markets in which the business is active.
Low risk
This applies where there is stable or slow growth in the economy. The
business conditions show little or only slight changes in employment rates or
selling prices or the costs of production.
Moderate risk
This applies where there is rapid growth or moderate levels of inflation in the
economy. Economic upturn is evidenced by swift improvement in
employment rates, selling prices, wages or the other costs of production, or
all spending increases relative to the available supply of goods and services.
High risk
A downturn in economic activity is evidenced by two or more consecutive

quarterly declines in Gross Domestic Product (GDP) or other key indicators
such as high unemployment rates or high rates of inflation. This
classification is normally used during an economic recession.
Scale of seasonality
Some industries have equal levels of sales and production and some do
120
not. Remember that it is both you need to measure. For example, bread
sales and production will match each other - you bake a loaf one day
and sell it either the same or next day. However, in the case of a
manufacturer of Christmas decorations, production will be constant
throughout the year to enable the industry to meet the sales demands of
retailers in the run up to Christmas.
Some industries will have stable levels of production for most of the year and
then will experience a surge in activity to meet a seasonal demand. For
example, a chocolate manufacturer will have level sales throughout the year,
apart from in the run up to Christmas when they produce say, selection
boxes, Valentines Day when boxes of chocolate are in demand, and then
prior to Eid, when Eidi baskets are in demand. The rest of the year from May
to October, demand will be stable.
Seasonality applies to any business, especially those that are subject to trend,
the inconsistent demands of the consumer, or what was in fashion suddenly
becomes obsolete.
Again we use a template to asses and establish the level of the industrys
exposure to seasonal sales.
Scale of seasonality LOW MODERATE HIGH Low risk
For the most part, the majority of earnings are generated evenly during a
twelve month trading period.
Moderate risk
Income in one quarter may be generally higher than in any of the three
remaining quarters in a twelve month trading period.
High risk
Income in one quarter accounts for more than 50% of the total income for a
year during a trading year.
Industry cycle comparative to economy
Unexpected events can suddenly impact on the economy - positively or

negatively. These are outside our control. They might be caused by any
political, economic, social or technological (PEST) factors, or by
something totally unanticipated that can trigger a downturn or an upturn
in economic activity. While we cannot predict when this will happen
with any degree of accuracy, we can predict what the outcome will be if
it does happen. This is known as cyclicality.
You are likely to lend mainly to businesses that are cyclical. There is
absolutely nothing wrong with that - you just need to understand the risk. For
example, if you have a customer that is part of an industry that is classed as
leading or preceding cyclicality and who requires to borrow more from
your bank at a time of rising interest rates and unemployment levels, you
need to consider whether the need to borrow more is due to the onset of an
economic recession rather than funding growth. As long as you understand
the risk and what is the underlying borrowing cause, you can proceed.
You may have experienced management who have successfully managed
previous economic recessions and a business that is well capitalised. It may
be a comfort that economists are predicting a short recession, but you do
not know if this will be correct. Economies can move swiftly from boom to
bust. You just have to be aware of your customer's particular kind of
cyclicality pattern.
121
Some industries will keep producing and selling goods or services no matter
the condition of the economy. For example, staple commodities such as
food, heat, light, public transport, etc will still be required by consumers no
matter the level of inflation, employment, interest rates, etc. These industries
are less affected by the economic cycle. They may also have lower levels of
profitability than more cyclical industries.
Activity in other industries will be affected by economic downturns with
business activity possibly running in the opposite direction of how the
economy is moving, that is, counter-cyclical. Industries which mirror the
direction of the economy are described as concurrent, and where activity
slows in anticipation of a recession, this is known as preceding the economy.
The final classification is lagging, where an industry continues to operate at
satisfactory levels for a time during a recession. The business then discovers
that, after a few months, activity starts to slow (falling sales, less demand for
its products, etc) until it grinds almost to a halt and does not recover until
some time after those industries which were classified as running concurrent
with the economy.
122
Here is the template that allows you to assess the cyclicality of the industry in
comparison to the economy in which the industry is active.
. Industry cycle comparative to economy LOW MODERATE HIGH
Low risk - independent
The industry cycle is unaffected by what is happening in the economy and

can therefore be regarded as independent.
Moderate risk - counter-cyclical
The industry cycle moves in a converse pattern to that of the economy and
therefore is regarded as being counter-cyclical.
High risk - concurrent/leading/lagging
The industry cycle moves parallel with that of the economy and is regarded
as being concurrent; or the industry cycle precedes economic recovery or
slowdown and is regarded as leading the economy; or the industry cycle
follows with a time gap any economic recovery or slowdown and is regarded
as lagging.
Industry profitability
During an economic cycle, industry profitability is measured from the

peak of one economic cycle to the peak of another - from high
economic activity to the low of recession and back to high economic
activity.
Different businesses maintain varying levels of profits and it is important to
recognise:
which industries will have stable levels of profitability oveT an
economic cycle.
those whose profitability only suffers a moderate reduction in profits.
those who will suffer losses.
Simply by their nature and reason for existence, some industries will make
profits year in, year out at fairly low levels, with the odd blip now and again.
At the other end of the spectrum some industries will fluctuate from fairly
high profits over a number of years to incurring losses over a period of time.
What is critical to the latters survival is whether they can sustain a period of
loss making by utilising their cash reserves or unused borrowing capacity
available due to prudent financial management during the good times.
Remember to link them to the economic cycle.
We will use the net margin % (NM%) to measure this risk. Net margin can be
calculated as net profit before tax (NPBT) to sales, or net profit after tax
(NPAT) to sales. Depending on the economic statistics available for an
industry, this will determine which version of the ratio you will use; both
have advantages and disadvantages.
NPBT can be useful as a measurement during time periods where: the
rates of tax fluctuate greatly, or

the industry participants operate in a number of tax jurisdictions, or
high interest rates are prevalent, or
there are different tax rates applicable which depend on the size of
123
the business, or
simply as a strength to gauge operational efficiency.
NPAT can be used as a proxy:
when measuring the shareholders return on capital, or
where taxation is not critical.
It will all depend on how the industry statistics are presented to you. The
major criterion is that you only use one of them in your calculations when
analysing trends to ensure that your analysis is accurate and consistent.
Here is the template and guidance for producing the risk assessment for this
area.
Industry profitability
LOW MODERATE
HIGH Low risk
Typically NM% will be low and profitability moves very little during
economic downturns.
Moderate risk
Typically NM% will be stable and will suffer a moderate reduction in

profitability during economic downturns.
High risk
Typically profitability will be high during expansionary periods and loss

making during economic downturns. NM% will fluctuate dramatically.
Industry status
In theory, the risk-adjusted rates of return should be constant across all

businesses operating in the same sector. Market forces are supposed to
ensure that this happens, most of the time. In practice, it has been found that
different businesses maintain varying levels of profits within the same
industry and the reason for this can be found by looking at how an industry is
constructed and managed and at the components which bring about or
explain the differences.
124
Professor Michael E Porter, in his Competitive Strategy. Techniques for

Analyzing Industries and Competitors, developed an industry standard
method of analysing industry risk. According to Porter, there are five forces
that can create an advantage (and by extension a disadvantage) for businesses
working in the same industry. If one business can develop an edge over its
competitors, it is generally believed that it will be more successful.
To commence our analysis, first of all we need to establish a view on the
industry in which the business operates. We will use the Porter format to
consider how different external influences affect the remainder of our
analysis of industry risk. We shall develop these theories and demonstrate
how they can be used in practice. If you have not already studied Porters
theory at this stage in your career, the five strategic forces are:
1. Degree of rivalry.
2. Threat of substitutes.
3. Buyer power.
4. Supplier power.
5. Barriers to entry.
Each of these five forces are broken down into specific elements; for
example, degree of rivalry includes industry product cycle, overcapacity in
the market, cost structure, etc.
The first area that Porter considers is the degree of rivalry in the industry. In
theory, intense competition amongst businesses operating in the same
industry should drive profits to zero as demand and supply meets
equilibrium. In practice, some businesses will perform better than rivals and
will earn profits above the average for the industry.
unng
The logical conclusion is there may be some businesses that are incurring
losses. Part of this analysis is to identify the good, the not so good and
the bad. To do this there are a number areas to be considered under the
degree of rivalry.
Industry product cycle (Porter - degree of rivalry)
tion in
Here you are analysing at what stage the industrys products or services are
in their development:
ods and
actuate
Mature products or services - they are fairly standard and have been
established for some time with little in the way of technological
innovation that will have an impact.
Maturing products or services - this is the pre-mature stage, where some
changes in design are still seen where demand continues to grow.
across all
pposed to
has been
fits
within
looking at
imponent
s
rence Book 1
Emerging or declining demand in products or services - this type of

product in an industry poses a risk higher than those that are considered
to be mature or maturing. They are either yet to become established or
well known in the market place (and subject generally to major design
innovations) or they are declining and have fallen or are falling out of
fashion.
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For example, standard products, commodities such as coal or steel or basic

foodstuffs (milk, eggs, etc) will have greater rivalry in the market place, there
will be some oversupply, and profits will be low; whereas products that can
be differentiated will face less rivalry and generate potentially higher profits.
industry status
Industry product cycle LOW MODERATE HIGH Low
risk
Products or services are fairly standard, there is a degree of oversupply in the

market, real prices are falling, and lower profits are being seen. The industry
is generally considered to be mature.
Moderate risk
The market for the products or services continues to grow and improvements
to design are necessary, i.e. maturing.
High risk
Emerging businesses will have been recently established as a result of

demand changes for products and services in their markets. Declining
business is characterised by mass-produced products or services, lowering
prices and profitability.
Degree of overcapacity in the market (Porter - degree of rivalry)
Overcapacity occurs when businesses are competing for the same

customers and refers to the excess capacity in products, quantity of
production facilities or service providers in the same industry. Put
simply, overcapacity is excess availability of a product (and as a
consequence too much production capacity) chasing too few buyers. It
is a not a new phenomenon and has been studied and opined on by
economists since Adam Smith. Overcapacity increases the risk that asset
values may fall and any collateral value reduces. In theory, where there
is overcapacity in an industry, selling prices will fall. Those businesses
within an industry that are inefficient or lack the financial strength to
survive or who are unable to restructure, will cease to exist.
To be able to understand the risks here, you need to carry out research based
on industry studies or trade magazines, the financial press or your own
knowledge.
Degree of overcapacity in the market LOW
MODERATE
HIGH Low risk
This is characterised by a minor overcapacity of demand in the market. It is

displaying demand that is exceeding the supplies available for the industrys
products.
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Moderate risk
Demand and supply and production are balanced.

High risk
There is significant overcapacity in the industry and demand from consumers

is not keeping up with what the industry is producing.
Cost structure (Porter - degree of rivalry)
We have come across variable and fixed costs earlier when considering
a Profit and Loss Account as part of audited accounts. Here we add a
further dimension that incorporates the Balance Sheet.
We normally find that an industry which has a fixed cost structure in its
Profit and Loss Account will have a similar structure in its Balance
Sheet, that is, a greater proportion of Fixed Assets to Current Assets.
Thus a high proportion of fixed assets in the Balance Sheet indicates a
high fixed cost structure.
A more in-depth explanation of this concept is as follows:
Variable costs
Variable costs are those costs of production that fluctuate directly in line
with the level of sales and consequently production, such as the costs of
raw materials. In essence, if production falls, the purchase of raw
materials also falls. This allows a business to reduce its costs quickly.
Where variable costs are high, the GM% (gross margin 96) will be low.
The balance sheet will have more current assets than fixed assets, as a
result of higher levels of debtors from sales and stock levels. This
industry can react quickly to slowdowns in the economy and
profitability will be lower. A retailer operating from short term
leasehold premises can react quickly to changes in economic activity,
for example.
Fixed costs
Fixed costs are those costs that have to be paid whether or not the
business is making any sales. Typically these costs will be salaries and
costs of plant and machinery. Where variable costs are low, the GM%
will be high. The balance sheet will have more fixed assets than current
assets and the business can be described as being part of a capital
intensive industry. The industry will be unable to react quickly to
slowdowns in the economy and is likely to suffer losses as generally
production will have to be kept at a minimum level.
Cost structure
LOW
Low risk
More variable costs.
MODERATE
HIGH
Moderate risk
Balanced variable and fixed costs.

High risk
More fixed costs than variable costs.

Barriers to exit (Porter - degree of rivalry).
This is the flip side to another element of Porters five forces - barriers to
entry (which we will look at shortly).
Where high exit costs exist, you will normally find that the industry will
have a very high proportion of fixed assets/costs and because of this a high
price will have to be paid if a business decides to abandon the manufacture
of its product.
Any specialist plant and machinery would have to be sold off at a knockdown price either to a competitor or for scrap - which will depend on the
businesss depreciation policy - and this could be well below the balance
sheet book value.
The prospect of having to pursue this strategy often results in a business
remaining in the industry and being forced to compete. Often businesses
may require to restructure or downsize in some way. The alternative is the
sale of core plant and machinery (as the only buyers would likely be others
active in the industry) and this is often not feasible due to the probable loss
on a sale of fixed assets and the damage it will have on the shareholders
funds.
The prospect of selling to a competitor who may have considered exiting the
industry themselves at some time in the recent past may be unpalatable and
might put them in a competitive position to gradually squeeze out the
businesses who sold out part of their production capacity. Highly specialised
investments in fixed assets often cannot be sold easily at balance sheet book
value and that alone can be a reason for remaining.
Barriers to exit LOW MODERATE HIGH Low risk
Assets can be easily liquidated or the business can be sold within a short
space of time.
Moderate risk
Due to the specialised nature of the businesss assets, a buyer of the assets or
the entire business would probably be a player already active in the industry;
or there could be political influences that restrict realisation of the
assets/business; or closing or selling the business would be costly and time
consuming, reducing the resultant cash inflow.
High risk
Significant high costs of realising the assets of the business exist; there could
be union agreements in place regarding redundancy or closure terms;
strategic alliances with other businesses may prevent exit due to the penalties
that would require to be paid, or simply because all the other players in the
market are in a similar situation and there is a lack of willing buyers.
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Strength of domestic competition (Porter - degree of rivalry)
Competition lies at the heart of all industries. At the heart of competition is

the relationship between the forces of supply and demand for products or
services. Within this area we are looking at the quantum of suppliers in an
industry operating out of the same country.
Characteristics that dictate whether there is a low or a high level of risk from
domestic competition will depend on:
what players in an industry have control over supply of the
products or services.
the extent of brand loyalty in existence.
whether the products or services are considered to be standard and

there is very little to distinguish between them from other similar
items.
Strength of domestic competition LOW MODERATE HIGH

Low risk
The business is part of an oligopoly or monopoly:

an oligopoly is a market where the control and supply of a commodity is
in the hands of a small number of producers and each one can influence
prices and affect competitors, for example petrol sales, telecoms, banks,
supermarkets.
a monopoly is a market in which one or two players have total control
over the entire market for a product due to some sort of barrier to entry
for other businesses, often a patent held by the controlling business with
little or no competition, such as car or computer manufacturers,
software houses, newspapers.
Moderate risk
As a result of brand loyalty, the business is minimally threatened by

competitors who produce similar products.
High risk
The business has a product that is standard, readily available elsewhere and
is subject to product substitution or the loss of market share is a constant
worry. Domestic competition is considered substantial.
Strength of foreign competition (Porter - degree of rivalry)
Generally where the product is extremely bulky and heavy, the competition
from foreign markets will be slight, unless an overseas competitor decides to
locate to your domestic market. The provision of services could quite easily
be affected if the barriers to entry required little in the way of investment in
fixed assets.
If the product or service is fairly standard, it could well be subject not just to
domestic but also to foreign competition.
Sometimes you may find that there is a cross-over or interdependency in
certain of these risk characteristics. You require using your judgement and,
where necessary, providing an explanation. What are examples of exceptions
129
or interdependencies?
Strength of foreign competition
Low risk
LOW MODERATE HIGH
As the industry or its products are new, foreign imports are not yet a danger.
Moderate risk
Due to customer demand, there is insufficient volume to keep pace with this
need domestically and this allows competitively priced foreign imports to
enter the home supply chain.
High risk
The business has a product that is standard and is readily available from
overseas competitors at a cheaper price.
Sales - customer/industry concentrated (Porter - degree of rivalry).
There are two elements to this that you require to assess:
sales being customer concentrated - if sales are well spread across a

market, with no one customer accounting for say, more than 25% of
total sales of a business, then the risk to exposure of one customer
withdrawing their business should not have a fatal effect on your
customer.
However, if your customer sold 75% of their production to say, only one
High Street store, then the risk is extremely high if that one customer
cancelled its contract for one reason or another. For example, at renewal of
the contract it has found a cheaper supplier, or goes out of business and the
contract becomes void, or finds a justifiable reason for breaking the contract
(late delivery, quantity not met, inferior quality).
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sales being industry concentrated - the industry has a product that is

only sellable into the one market, and then the risk is again high if that
industry suffers a reduction in the demand for its products.
Sales - customer/industry concentrated LOW MODERATE
HIGH Low risk
Sales are well spread to many customers across many markets or industries.
Moderate risk
There are pockets of concentration of sales to individual customers or

markets/industries that make up more than say, 25% of turnover.
High risk
Sales are concentrated on a few customers or markets/industries that make

up more than 50% of turnover.
Threat of substitutes (Porter - threat of substitutes)
Here the threat of substitutes refers to products available from other

industries and how the elasticity of the price is affected. As a result of
cheaper alternatives, demand in the original industry can become
flexible and the price charged can fall.
It is important to remember when dealing with the threat of substitutes
that in these circumstances it is the risk of alternatives coming from
another industry.
Bargaining power of buyers (the price that has to be paid for supplies
of raw materials, services, etc) (Porter - buyer power)

This is straightforward and self explanatory. The risk to the industry is
high where the end-users of products or services can dictate the price
they pay. Can you go into a supermarket and tell the assistant that you
do not want to pay Rs. 400 for a tin of beans, but would rather pay Rs.
100? You will be shown the door (politely) and the supermarket can
dictate the price at which they sell to you, unless of course another
supermarket in the local area was selling at the price you wanted and
then that is another risk - competition. For this reason, bargaining power
of buyers visiting ii large supermarket or other major retailer is
generally seen as a low risk.
Where there are few buyers in a market place or where they purchase a
significant proportion of an industrys output they will be influence prices
and will represent a high risk for those induscr.cs ntf manufacture the
products or services such as defence con:
Threat of substitutes
Low risk
LOW MODERATE HIGH
The threat from substitute products or services is insignificant, low or even

remote, due to strong customer brand loyalty or the patents or licences the
company holds for its products.
Moderate risk
There are some substitutes available, but they have not made an impact on
demand for existing company products due to their superior quality or brand
loyalty or their reputation.
High risk
Substitute products are widely available from different industries and

competition has created falling prices, or products of the same or better
quality can be obtained elsewhere and there is generally no brand loyalty.
Where there are few buyers in a market place or where they purchase a
significant proportion of an industrys output they will be able to influence
prices and will represent a high risk for those industries that manufacture the
products or services, such as defence contractors.
Bargaining power of buyers
LOW MODERATE HIGH
Low risk
Consumers cannot influence the price of goods or services due to limited

supply or the dearth of alternatives.
Moderate risk
Consumers may be able to influence selling price to a limited extent, but

generally the businesses within the industry can control prices.
High risk
Selling prices of products and services must be competitive due to their

general profile and availability of alternatives.
Bargaining power of suppliers (Porter - supplier power)
This is the flip side of the previous risk item. Considering again a large High
Street supermarket, do you think they will be in a strong or a weak position
when negotiating with suppliers? You will no doubt have read widely
already about the influence that supermarkets or other major High Street
retailers can exert on their suppliers; thus in this case supermarkets will
again be assessed as low risk.
Competitive situation
Under this heading we are going to finalise the two remaining factors in
Michael Porters five forces - barriers to entry and degree of outside
regulation.
Barriers to entry (Porter - barriers to entry)
Barriers for an industry to enter a competitors market can be significant

and unique to that industry. There are a number of factors that can create
these barriers:
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Assets owned by a business can be so specific to an industry that they

cannot be used to produce another product. Normally the costs of

obtaining this specialist equipment is expensive; for example, the
printing presses of a newspaper can only be used to produce tabloid or
broadsheet newspapers and would be totally useless to a small print
works that produced books. Specialised plant and machinery can deter
new entrants from entering the industry, because if the venture fails, the
plant cannot be used for an alternative use or to produce a different
product.
Bargaining power of suppliers
LOW MODERATE HIGH
Low risk
Suppliers have little or no ability to influence the price of goods or services

due to availability of alternatives.
Moderate risk
Suppliers can have some influence on the prices they charge the business for
materials and supplies.
High risk
Suppliers have considerable influence over the prices of their goods or

services due to limited supply or lack of alternatives.
Economies of scale can be a limiting factor for new entrants and
discourage competition. For example, if to break even an operator
requires to capture 20% market share, this may be considered too high a
price to pay for entering the industry. Often products in industries where
economies of scale operate are sold at a premium.
Industry know-how, specialist knowledge, intellectual property rights,
copyrights, licences and patents can all restrict entry into an industry
and its markets. Possession of these factors restricts new entrants to a
market. If a competitor starts to produce without permission a product
that has been patented by another business, they are in breach of the
rights of the business that owns the patent.
While being barriers to entry, all of these factors are also barriers to exit the
industry, as we discussed above. If the barriers to exit are a high risk, then it
is only but logical to surmise that the barriers to entry are likely to be a high
risk as well.
In summary, markets or industries are:
. easy to enter if there is:
- universal technology.
- low brand recognition.
- ease of entry to distribution channels.
. difficult to enter if there is:
- specialist knowledge, intellectual property rights, copyrights, licences and
patents.
- an established brand identity.
- distribution channels are restricted.
133
. easy to exit if there are:

- simple strategies to fixed asset disposal.
- costs of exit are low.
- businesses that are independent of the market and can compete in another
market.
. difficult to exit if there are:
- specialised plant and machinery or restricted alternatives of use
- high costs of quitting and these will have a significant adverse impact on
shareholder value
- forward or backward integration, as this will affect viability of other
businesses owned.
Competitive situation Barriers to entry LOW
MODERATE HIGH Low risk
Start-up costs are insignificant with merchandise not easily differentiated

and this allows ease of entry into the market.
Moderate risk
Some level of capital investment is needed and access to distribution

channels is necessary before new entrants may begin making sales.
High risk
Significant barriers exist because of brand name loyalty, high capital

investment requirements, or there is limited access to distribution channels
and any of these makes entry into the industry difficult.
Degree of outside regulation (Porter - barriers to entry)
Although we touched on regulation when exploring barriers to entry, it
is important that we make a distinction where there are elements of
voluntary (or self regulation) and where market forces continue to play
an influence on how much regulatory influence applies.
Regulators normally have statutory powers and licence the businesses which
operate in their sectors. Without a licence, it would be illegal to operate.
Announcements by governments which propose changes in legislation or
process requirements can wrong foot businesses.
Risks are often interdependent or one can impact on another area.
0
Degree of outside regulation LOW

There are few, if any, government laws/regulations affecting the industry.

The industry could be self regulating.
Moderate risk
There are some government laws/regulations affecting the industry. On the

whole the industry is self regulating.
High risk
The industry operates in an environment which is highly controlled by

134
government laws/ regulators.

Now that we have analysed all the risk factors, we can use our judgement to
arrive at an overall risk rating for the industry. This is what we have been
working up to in our analysis - an overall assessment of what the industry
risk is. We achieve this by completing the following.
Overall industry/ market rating
LOW MODERATE HIGH
This is based on the combined effect for each component of the individual
industry areas.
Risks related to market
Economic cycle success
We have already looked at the effects of economic cycles - cyclicality.

What we are assessing here is how management has coped with market
disturbances such as economic slumps and upturns.
Low risk (highly successful)
Both long and short term market disturbances are dealt with in an effective
and efficient manner. Management reacts quickly and appropriately to
adverse cyclical/seasonal trends and, as a result, maintains consistent
profitability and cash flow.
Moderate risk
The business has been able to absorb short term market disturbances
including economic or business savings. However, longer term disturbances
could adversely affect the businesss creditworthiness.
High risk
There is evident weakness in the manner in which management has

weathered market disturbances including industry, economic or other
problems that may affect financial performance. Unless there is an
immediate change in the way management responds to market conditions,
loan repayment could be jeopardised.
Business life cycle
We have already looked at the industry product cycle as part of industry

risk. This is one of the business risk factors that enable comparison of
your customer with their competitors as a whole in the same industry. If
you have decided that the industry is, for example, a moderate risk
and you have allocated a low risk assessment to the business life
cycle, you should list the differentiators. It is important to remember
that while declining or emerging businesses do carry a higher credit risk
than other businesses, they nonetheless provide higher risk/ reward
opportunities.
Business life cycle
Low risk
LOW MODERATE HIGH
The business will be classed as mature where goods or services are provided
in a standard format and do not really change. Competition will be intense
and gaining market share can be difficult.
135
Moderate risk
The business is growing, providing goods or services that are better than
those provided by their competitors. This allows them to charge a premium
which should result in a higher profit.
High risk
Declining businesses will be characterised generally by goods or services

which are nearly identical to those of their competitors and customer demand
is falling. The business is emerging where innovative goods and services are
the norm; however, buyers have yet to be convinced whether they should
purchase them. Prices and margins are high and profits are low.
Suitability of company product to market
In essence this classification is looking at how cyclicality can affect the

demand for the businesss products or services. Some items will always
be in demand as outlined in Maslows hierarchy of needs where there are
certain items that will always be required to sustain life. As Abraham
Maslow described it, survival is the primary demand for life, for
example air, food, drink, shelter, warmth, sleep, etc. When economic
times become tough, other items are not purchased including those that
are regarded as revenue and capital expenditure items.
Supply and distribution
The next two categories are linked, but for simplicity are better considered
separately. We begin by defining the supply and distribution chain as a
pathway, map or linear chart.
SUPPLY > PRODUCT or SERVICE > DISTRIBUTION
At the centre of both chains is the product or service, and either side of the
product or service is the supply risk and the distribution risk. The supply risk
is affected by the ready accessibility of all those items that are required in
manufacturing, altering or providing the product or service and making sure
these are available to the business so that the distribution phase can begin.
Remember that the business in manufacturing or, to a lesser extent in a
service industry, will have processes that allow it to transform the raw
product into a suitable format to be marketed. The final phase is how the
product or service is distributed to the customer.
Supply chain risk
One factor in the supply chain that you must always assess is the availability
of supplies. This includes the raw materials that are used in the
manufacturing process (which may be scarce or difficult to source) or the
136
cost becoming more expensive, or the semi-completed product that requires

some modification before being distributed via the availability of suitably
qualified labour.
Suitability of company product to market
LOW MODERATE HIGH
Low risk
The products will be regarded as staple items for survival such as food, heat,
water.
Moderate risk
Typically these will be purchases that can be deferred, if cash flow becomes
tight.
High risk
These products will be considered luxuries, there will often be cheaper

alternatives, but they will not have the same cachet of the real thing. The
purchase is often bought as a result of the brand name or due to the statement
the purchase makes.
On the supply side you need to consider:

Are the raw materials heavy and bulky? How will they be
transported? How easy is that to arrange? Are specialist transporters
required (air, sea or land)? What are the times and distances
involved? Are they subject to import taxes or levies? All these factors
need to be considered in assigning a risk factor.
Are any shortages of supplies anticipated due to demand from other
industries?
How are the raw materials purchased? Do they have to be paid in
advance of delivery? Is there a lead-in time to delivery? In planning
the future, what is the anticipated demand, and can this be quantified
or is it an educated guess?
Are the raw materials and resources required for the product or
service all readily available?
What steps should the business take to assure the continuity of
supply and maintain the spread between cost and selling prices?
Distribution access risks
At the beginning of the distribution chain is the product or service that is

being provided. The more steps in the distribution chain (which also applies
to the supply chain), the more complicated distribution is and the more
chances of something going wrong which will affect either the supply side or
the output side of the pathway. If you have been involved in any sort of
production or planning process, it often appears that Murphys Law comes
into play - if anything can go wrong, it will go wrong.
Manufacturing businesses will have different pressures from those operating
in a service industry. Good planning and defined processes and procedures
are essential.
137
Distribution chain
It is important in any business to have this clearly defined. The process starts
when the product is ready for delivery (when the manufacturing process is
complete) and the product or service is ready for sale.
The definition of a manufactured product is straightforward and apparent, but
services require some thought. The start of the distribution chain for service
industries will be having all the skilled employees in place with whatever
equipment they need, to be in a position to deliver the service. For example,
an accountancy firm would require qualified audit staff, computers and
transport, etc to be able to start a business audit.
The cycle ends when the product or service has been delivered and invoiced.
risk
Supply chain risks LOW MODERATE HIGH Low
There is no limitation of suppliers; the raw materials and other inputs can be
sourced locally; there is no perceived shortage in the next 12 months and
there is sufficient reliable transport readily available.
Moderate risk
There is some shortage of suppliers; raw materials, whilst having to be

imported from abroad, are still readily available; some planning is required
for the placement and fulfilment of orders; it is difficult to forecast
availability of supply and price beyond 6 months and transportation can take
just over 15 days.
High risk
Supplies of raw materials can be temporarily unavailable and have always to

be imported from abroad; a great deal of planning and timing of orders is
necessary; the price of supplies can fluctuate more than 10%; prices cannot
be forecast more than 3 months ahead; specialist or heavy transport facilities
are necessary and the time for delivery from one factory gate to another
exceeds 30 days.
Please note that we are not assessing in any part of this analysis the
businesss ability to take raw materials and convert them into finished goods.
It is presumed that, as you are considering a credit or borrowing request, the
customer has a marketable product which, as a minimum, is of similar and
acceptable standards to the rest of the industry.
Would it be acceptable to take on a credit risk where you knew that the
products, goods or services that were being marketed by your customer were
inferior to those of others in the industry, were unreliable, or were subject to
poor construction and having to be repaired or returned for correction or
replacement? It is presumed that you kaic considered this fully before even
commencing the analysis.
You may find that the products or services are inferior after conducting your
industry analysis, and then you need to decide if it is worthwhile continuing
with the remainder of the credit analysis.
For all your customers involved in manufacturing or retail industries, for
example, the organisation of transportation and delivery is critical, as they all
accept deliveries on a strict time frame. Manufacturing will require both
inward and outward specialism in logistics, which in effect describes the
whole process of dispatch and delivery. The retailer will only have inward
logistics and they will control deliveries strictly so that these are available to
their customers when they need them, including time to unpack, label, price
and place them on the shelves during periods when their shop is closed or
quiet.
*
To understand the process better it is more efficient to concentrate on three
separate areas:
distribution access.
distribution influence.
distribution elasticity.
Distribution access LOW MODERATE HIGH
Low risk
The ability to access all customers who wish to buy the product or service is
easily achieved and without hindrance. Normally the manufacturing business
controls delivery by its own staff, rather than depending on customers
collecting from the factory gate. It will manufacture and deliver direct to the
consumer.
Moderate risk
The ability to access all customers who wish to buy the product or service is
mixed. Delivery standards are not entirely within the control of the business
which may use sub-contractors for delivery, over whom control is limited.
High risk
There are issues regarding accessing all of its customers, delivery is

fragmented and the business has limited influence on delivery timescales and
schedules.
Distribution influence LOW MODERATE
HIGH Low risk
The business has complete control over its entire distribution network and
ensures there is consistent uniformity in the standard of its products or
services, permitting quality assurances to be provided to its customers. A
low risk will underpin brand loyalty and can reduce threats from substitutes.
Moderate
riskhas some control over its distribution network and can exert
The
business
some influence. It will normally have a mixed range of customers, both direct
consumers and wholesalers.
High risk
The business has no control over its distribution network, it is characterised

by many suppliers, competing with similar products. It will normally supply
products that are then reworked in some way or held by wholesalers who
stock many similar product lines.
Distribution elasticity
'
LOW MODERATE HIGH
Low risk
The links in the distribution chain are few and the business has a number of
years to plan ahead for any changes or has the ability to respond quickly to
changes in consumer habits.
Moderate risk
There are several links in the distribution chain and generally the business
has a limited amount of time to plan ahead for changes or the business may
be hampered economically if there is a sudden change in consumer habits.
High risk
There are many links in the distribution chain and at times these can be
complicated. Changes occur extremely quickly, consumer habits cannot be
forecasted or anticipated.
Management and personnel
It is the people within a business that can make it operate at a higher level in
terms of earnings than that of its competitors. If there are two businesses of
similar size, operating in the same industry, in the same location, both having
started around the same time with the same levels of capital, producing
almost the same or nearly identical product or service and one produces more
profit per employee than the other. Why? You will invariably find it will be
due to the expertise of its management in running the business as a whole and
the efficiency of its workers.
We are going to analyse the efficiency of the five main areas of expertise in a
business:
Production.
Marketing.
Finance.
Human Resources.
Information Technology.
In the case of service industries, Production is defined as the area in which
the sale is made by the sales staff, for example the Food Hall, the Ladies or
Gents or Childrens Clothing department, etc.
Unless you have another customer (or statistically better, more than one
customer) operating in the same industry from which you could make a
141
direct comparison, the best (and probably the only way) is to visit the
customer in their own premises, during normal working hours, and walk
round the factory, office or shop and see for yourself what is happening.
Business owners generally will want to talk about their business and show
you how it operates so that you can better understand their needs. The ones
who dont are a bit unusual and you need to try and establish why.
Understanding the business is essential.
Assess for yourself how each area operates. Ask the owner how efficiently
they see the different areas operating. Honest owners with whom you have
built up a relationship and trust will confide in you the areas that are causing
them concern.
This is the kernel of relationship management - to admit in confidence when
something is not going particularly well. By doing this they are seeking help
and advice or sometimes just want someone to listen to their problem.
As their lending banker you should not encounter too many surprises. Who
knows - you may know of another customer who applied a successful
strategy to solve a similar problem.
During your visit, establish precisely who is responsible for managing each
specialist area. Remember that no one area can survive without the other
areas. It would be prudent to establish how each interacts and how they deal
with resolving issues.
Case study
If the Production Manager is unable to hire new staff, you may find that
the Finance function has told Human Resources that there is a cash
shortage, recruitment of additional staff is suspended immediately and
only replacement staff are being hired. But when all Managers in charge
of the Divisions sit down and discuss the problem of cash shortage, you
may discover it is because:
Marketing has boosted sales growth, raising the terms of trade for
debtors from 15 days to 60 days (without any prior warning to
anyone else).
the change in the terms of trade has created a surge in demand for
the goods the Production Dept is producing.
and the Finance Department finds that their overdraft is operating
at a level uncomfortably close to the limit.
Find out who precisely is responsible for each area listed below. Try and
meet them and get their opinion of what is going well and what is creating a
challenge.
Divisional Management performance

Production performance
LOW
142
MODERATE HIG
H
MODERATE HIG
H
Marketing performance
LOW
Finance performance
LOW
MODERATE HIG
H
HR performance
LOW
MODERATE HIG
H
IT performance
LOW
MODERATE HIG
H
Low risk
The division operates consistently to a very high level of efficiency and is

held in high regard by its competitors. This also reflects the performance of
the manager/director responsible for this area.
Moderate risk
The division performs most of the time in an effective, satisfactory and fairly
efficient way. This also reflects the performance of the manager/director
responsible for this area.
High risk
The performance of the division is inconsistent, it is subject to continuous

improvement initiatives and its performance is seen as a drag on the overall
business. This also reflects the performance of the manager/director
responsible for this area.
Number of management/directors
For a sole trader with few employees you will often find that the
business owner is responsible for and controls all the following
functions: Production, Marketing, Finance, HR, IT, etc.
With partnerships and limited companies, the number of employees
begins to expand and you may find that the owners have specific
individuals in charge of various functions. You would think it highly
unusual for a quoted PLC to have only say, two individuals responsible
for all areas. As you will see, the credit risk is greatest when one
individual is responsible for all areas.
Number of management/directors
How many manager/ director positions in above divisions are
occupied by the same individual?
LOW MODERATE HIGH
Low risk
All are filled by different individuals.

One individual is responsible for two divisions.
High risk
One individual is responsible for three or more divisions.

There is a link between this last assessment and the next one which captures the
mitigation for situations where managers are looking after particular areas and key
person insurance is in place. You will see that this is extended to cover
percentages of bank debt levels.
Where managers/directors are responsible for two or more divisions, has Key
Person Insurance been provided?
LOW MODERATE HIGH Low
risk
Yes, all are covered by full Key Person Insurance for all bank debt levels.
143
Moderate risk
Two are covered by less that 50% Key Person Insurance for agreed bank debt
levels.
High risk
None are covered by Key Person Insurance.

Management /director character
Here we are trying to establish the honesty and trustworthiness of the senior
leaders of the business and how they are perceived in the community. It is
common sense to say that if the owners and senior managers are rated as
high risk, then they could walk away when difficulties arise. This is
particularly so if they have no personal obligation to the business (like a
guarantee to the bank) and have put in minimal capital.
risk
Management /director character

LOW MODERATE HIGH Low
All managers/directors are well-established members of the community whose

integrity is undoubted.
Moderate risk
The management team or directors are all principled individuals who are sound,
professional and respected by their workforce and the community. They could be
described as being principled.
Opinions have been expressed that the managers/directors do not always act in a
respectable and entirely honest manner. Should repayment become damaged, they
may not cooperate with the lender. We are uncertain regarding their character.
Management's/directors' personal credit record
You may find that in your organization it is normal for applications to open a
business account to seek the authority of the customer(s) to carry out credit
checks much in the same way as is done for personal customers seeking a
personal loan, or a credit card. Sometimes where there are few
owner/managers in a business, their personal and commercial transactions can
become indistinguishable/ blurred.
If a business operator pays little or no attention to their personal credit affairs,
it will conceivably be much worse for their commercial interests - even more
so if they have no personal liability for the business debts. This is a warning
to you of how to expect to see the business operating account working in
practice.
Management's/directors' personal credit record LOW
Management/directors are known to pay their personal debt punctually or in

advance of the due date.
Moderate risk
Management/directors are irregular in the payment of their personal debt

144
obligations. There have been one or two occasions over a period of time where
loan repayments have been late or cheques have been returned unpaid due to lack
of funds.
High risk
Management/directors are in default of their personal debt obligations. There have

been three or more occasions in the last ten years where loan repayments have
been late, cheques returned unpaid due to lack of funds or any loan accounts have
been 90 days in arrears, or the individual is currently in default with a credit
agreement.
Succession plan
For all businesses you need to see that they have plans in place to cover their
senior positions. The presence of a robust succession plan could act to
mitigate for the loss of a key employee, manager, leader or one of the owners
(in a partnership or limited company) if they decide to resign or retire.
We have already looked at Key Person Insurance which normally onVy
COMICS \or\g te-im W\Yve.ss OT pe.'cmawe.nt. absence. because. of death.
This particular type of insurance will not cover resignations or dismissals,
whereas a robust succession plan will help mitigate the sudden or planned
departure of an employee, manager, or one of the owners (but not in all
circumstances).
risk
Succession plan LOW MODERATE HIGH Low
(where the succession plan is well defined)

*
The succession plan has been formally prepared and is updated at least biennially.
It deals with all the major contingencies and transition issues to ensure the
continued smooth operation of the business in the event of the death or disability
of key managers/directors.
Moderate risk
(where the succession plan is partially defined)

The succession plan deals with some key issues. While it is more in depth than
poorly defined, succession is still not addressed adequately and as a result,
dealing with a change in the management team could adversely affect the
businesss performance.
High risk
(where the succession plan is poorly defined/none held/not up to date)

Some succession issues have been addressed but the plan is narrow in scope and
does not provide fully for major contingencies such as the incapacity of key
personnel. In the face of such adversity, the business would suffer financial
setbacks due to lack of strong and stable leadership. The plan is out of date or no
written plan is in place. While management may be strong, if any member of the
team were absent, loan repayment could be impaired.
Employee relations
It is a fact of life that if employees are treated well, with respect and
understanding, the pay back for
145a business is immeasurable. Treat employees
unfairly or harshly, and they will have no loyalty to the business or its
objectives. They will be constantly criticizing their employer and letting

anyone in the local community (who will listen to them) know exactly how
they feel about their employer. No doubt they will be looking for every
opportunity to secure employment with someone else even if they are going
to be paid slightly less.
You should establish what is the mission statement/core belief/reason for
existence of the business - this should be included in the business plan or the
annual accounts or stationery or advertising literature. This can be
illuminating and used to measure beliefs against reality.
146
Examples
IBM has three basic beliefs:
to give full consideration to the individual employee, spend a lot of time
making customers happy and go the last mile to do things right.
This sort of statement is a powerful commitment not just to this area of
consideration but also to market and operational risk.
There are leaders and managers responsible for each division, but they will only
be as good as the people who work in their division. The leader may be the most
highly qualified specialist in an industry, but if they have untrained and
discontented people working for them, their unit will not be maximising the
human resources it has available. This assessment also extends to trade unions or
employee associations.
Employee relations LOW MODERATE HIGH
The business has excellent relations with employees, trade unions, etc. Employee
opinion surveys reveal high satisfaction rates. Labour disputes/disruptions are
infrequent.
Moderate risk (moderately successful)
The business has fairly good relations with employees, trade unions, etc.
Employee opinion surveys reveal satisfactory satisfaction rates. Labour
disputes/disruptions are fairly infrequent.
High risk (unsuccessful)
The business has poor relations with employees, trade unions, etc. Employee
opinion surveys reveal dissatisfaction and employee turnover is higher than the
industry norm. Labour disputes/disruptions are fairly frequent.
Legal compliance Level of
environmental risk
Environmental risk has been becoming increasingly important to many

types of businesses. Immediately you begin to think of businesses that
pollute the atmosphere or the surrounding location as part of their
manufacturing or industrial process. Although the short term harm the
business may cause is immediately noticeable, it is the long term effect that
causes concerns.
Environmentally sensitive industries or activities are those that:
have capacity to contaminate land, water, air or other natural resources.
require a licence or permit to use natural resources, without which they
cannot operate.
require a licence for emissions and discharges, without which they cannot
operate.
may incur penalties for environmental breaches.
9
may
Lending: Products, Operations and Risk Management | Reference
Book 1need
waste.
to remediate contaminated land or install 147

equipment to treat
As well as the industry itself, you also need to consider where the business is or
has been located. Environmentally sensitive sites are those:
on which environmentally sensitive industries operate.
that are adjacent or in close proximity to sites on which environmentally
sensitive industries operate.
In considering any of these matters you may require your customer to invest in an
environmental report or audit. Often it is only by looking at old Ordnance Survey
maps or local records can you establish if the site or an adjacent property was say,
an abattoir or garage fifty years ago. Remember that it is not just above ground
that you need to consider, but what lies below. You may immediately be thinking
of mine works, but less obvious structures are obsolete septic, petrol or oil storage
tanks.
You should check your own banks policy regarding taking any environmentally
contaminated (existing or former) land or property in security as this may affect:
the value of securities held as these may be reduced because of adverse
environmental issues.
the ability to enforce securities because of possible environmental
liability.
collateral or security for loans - these may be postponed or set aside
under environmental laws or legislation.
A bank may be directly liable under environmental law or other legislation
because of its relationship with the customer or the security it holds. Where
environmental damage or breaches of legislation have occurred, this liability may
extend to:
financial penalties.
responsibility for undertaking rectification.
Level of environmental compliance
Once you have assessed the level of environmental risk applicable to

your customer, it is fairly simple to confirm their level of compliance.
You should obtain copies of any licences or permits that they have and
ensure these are updated as renewal falls due. You are preventing the
customer falling foul of any fines for non -compliance and at the same
time protecting their assets and shareholder value.
Level of environmental risk LOW MODERATE
HIGH
The business does not produce harmful contaminants in its operations

nor does it occupy a property that is situated on contaminated land.
Moderate risk (site contamination or processing contamination) During
the manufacturing or production processes, dangerous emissions are
released into the factory resulting in contamination or are released into
the atmosphere.
High risk (site and processing)
During the manufacturing or production processes, contamination of

both the factory and the environment is prevalent.
148
Level of environmental compliance LOW

The business fully conforms to all environmental compliance criteria.

Moderate risk
The business is in the process of conforming to the required environmental

compliance criteria.
High risk
The business has not fulfilled its obligations regarding the required
environmental compliance criteria.
Legal compliance
There are numerous laws and regulations that your customer requires to
comply with and you need to establish which ones may create the
largest risk for your customer. You need to stay alert to changes in
legislation.
149
Legal compliance
LOW
Low risk (compliant)
MODERATE HIGH
The business is fully compliant with all laws or regulations currently in force.
Moderate risk (in progress)
The business is taking the necessary steps to become compliant with laws that
are about to come on to the statute book and is in progress to become fully
compliant in the next few months with recent laws or regulations now on the
statute book.
High risk (not compliant)
The business is not compliant with material regulations or laws. Credit

compliance breach
Lending covenants cover the ongoing:

Provision of information (for example, audited accounts etc) within a
certain period of time. This is necessary to measure certain covenanted
ratios. Non-receipt of information constitutes an event of default.
Calculating some financial ratios (for example, minimum capital, operating
cash cover) that require to be maintained within specific tolerances
(breach of the ratio disciplines is considered to be an event of default)
during the life of the credit agreement.
Prevention of particular events from taking place (for example, keeping all
insurances in force so that all property is adequately insured).
The first sign of a possible problem is where there are breaches in lending
covenants; for example, delay in providing information (holding back bad news)
or breach of a covenanted ratio (a deterioration in performance and credit risk).
Lending covenants can be varied or removed completely if the risks they were
measuring have reduced.
This template will crystallise the risk over a number of trading cycles/years for a
customer. If there are no covenants, then miss out the following two templates.
Credit compliance breach
LOW MODERATE HIGH
Compliance frequency - at this date, does the business consistently meet all the
terms and conditions of its credit agreements?
Low risk (never)
Business consistently meets all the terms and conditions of its credit or loan
agreement.
Moderate risk (rarely)
Business meets all the major loan covenants but from time to time may fail to
comply with minor ones (for example, insurance cover has expired, but is being
renewed).
High risk (occasionally)
Now and then the business breaches a significant term or condition of the credit
or loan agreement.
Financial
This next section is the equivalent of an introduction to the financial

assessment you will be carrying out later. This deals with current information
(as opposed to historical data or information that will be as a minimum 6
months old).
Business credit reputation
You should be able to calculate from audited or management accounts the

number of days on average the business takes to pay its trade creditors.
Using your local market information you should hear if your customer is
riding the trade or, in other words, delaying payment to suppliers or
issuing cheques to a supplier for round amounts. This can indicate this is
an interim payment due to the absence of cash or headroom in the
overdraft limit. When examining the aged creditors list for another of your
customers, you may notice that one of your other customers appears in
their arrears section.
Credit covenant breach LOW MODERATE HIGH
At this date, the above represents the number of covenants breached.

Low risk
At this date, no covenants have been breached.

Moderate risk
At this date one covenant has been breached.

High risk
At this date two or more covenants have been breached.

Business credit reputation
LOW MODERATE HIGH Low risk
Payments to creditors are met before or within agreed terms, i.e. punctual.
Indications are that payments have extended beyond the agreed terms on an
infrequent basis.
High risk
Credit checks indicate the business is consistently late, without cause, in paying its
suppliers, i.e. delinquent.
Business plan success/dealing with catastrophes
A business plan will lay out the strategy for the business over the next year,
151
Moderate risk
two years or five years. It will then show what results or outcomes this
strategy will bring, by showing a forecast Profit and Loss Account, Balance
Sheet and Cash Flow which will detail what credit funding is required to
finance the strategies.
The business plan will outline the vision the management have for the
business and will provide specific commentary on its strategic direction and
how this and their financial goals will be measured; in other words, what
success looks like.
Having this clearly and concisely laid out allows you to establish if you can
accept the likelihood of their vision occurring and how you would rate the
risk.
A business plan should address the following:
The history and development of the business.
Management and responsibilities.
A description of the products, production process, plant and technology.
Details of component suppliers.
Details of competitors.
Details of customers.
Marketing and distribution capability.
Past results (a track record of at least three years would be helpful) and a
full analysis thereof.
Future forecasts (which might be derived from past results with differences
- usually improvements - in sales levels and margins fully explained).
An analysis of the latest balance sheet with comments on the realizable
value of assets and the status of liabilities.
Cash flow forecasts which have been built up from all income and
expenditure details on a month-by-month basis which reveal opening and
closing bank balance positions.
As you will know, predictions are seldom easy. The measurement of risk here is
how close their previous predictions have got to actual.
If the business plans continue to show sales growth of 20%, profitability growth
of 20% and operating cash growth of 15% when historical accounts show actual
sales growth of 5%, profitability growth of 2% and operating cash growth of
1%, then questions need to be asked. The assumptions behind the forecast will
require robust examination.
What you are assessing is the capacity to deliver on forecast performance and
the template below assists in capturing these capabilities. A customer with a
good track record who can deliver on predictions can be a comfort to a lending
banker.
Dealing with catastrophes will be detailed in a disaster recovery plan
(sometimes called a business continuity plan) and should form part of or be
prepared as an appendix to the business plan with all the accompanying
financial details. This is about ensuring a business can continue to operate
152
should the risk become a reality. All businesses need to learn how to prepare for
unexpected events and there should be a plan in place to deal with such events.
In the organisation where you work there will be such a plan which should be
fully documented. It may show such things as what procedures will be put in
place should the building be temporarily out of action. These plans do exist and
you should ask your line manager about them if you have not already seen a
copy.
Specialised companies exist who will reserve offices, fully equipped with
telephone and computer links, for businesses that require relocating temporarily
because of some incident. Immediately after 9/11, US stockbrokers
transferred their operational business to London so that they could service their
customers until the US market reopened. This action went some way to
restoring financial confidence in the American economy.
When completing this template you need to assess both the business plan and
catastrophes section and you are required to make a balanced judgement when
assessing the overall risk rating.
Business plan success/ dealing with catastrophes
LOW MODERATE HIGH
Both short and long term business plans have been very well executed, resulting
in strong business performance. Actual versus Plan are either within an
acceptable tolerance or plan is exceeded.
Moderate risk (moderately successful)
Implementation of the business plan is generally acceptable. While the business

plan addresses normal problems, there is no mention of specific issues. As a
result, sometimes the business is unable to achieve forecasted performance.
Actual versus Plan often fall short but still earning a lower level of profits.
153
High risk (no plan/untested/ unsuccessful)
No plan - Management has not prepared a formal business plan dealing with
the important business and competitive issues. As a result, if protracted
negative or adverse conditions arise and are not addressed, could weaken
future financial performance and place loan repayment at risk.
Plan untested - Although a formal business plan is in place, it has not been
tested because the business has only been newly established with no track
record or because of a lack of cyclical/competitive experience.
Unsuccessful - Implementation of a business plan has been ineffective causing
loss of market position, disruption within the business and financial
deterioration. Business survival is dependent on an immediate change in
strategy, otherwise repayment could be impaired.
Capital expenditure/technology
Capital expenditure relates here to maintenance capital expenditure, that is,

core capital expenditure (capex) that is sufficient to keep the production
facilities at a competent level. It is accepted that occasionally capex can be
delayed, but not indefinitely. The latter is different from discretionary capex
which is defined as expenditure that is a conscious decision of management
say, to expand or take over another business. Discretionary capex is not
assessed here.
Two useful ratios can assist in calculating fixed asset replacement cycles:
Fixed assets usage %
- this percentage indicates how much life is left in the assets. Calculations
should be made on separate core production assets such as vehicles, plant and
machinery, etc. Concentrate your assessment on those assets which you
consider are essential or fundamental to the business.
Normally, owned property can be ignored as it will be subject to a much lower
depreciation charge. Leased property should be included.
The ratio is calculated:
Accumulated depreciation
---------------------------------------------- x100 = x%
Gross depreciable fixed assets
As a rule of thumb, if this ratio exceeds 60%, this indicates that the fixed assets are
nearing the end of their useful life and replacement is becoming critical.
Life of fixed assets in years
- this ratio will give an indication on average of the life span in years of the
fixed assets being analysed. You will require to use some personal judgement
and common sense; for example, if motor cars are now 8 years old,
maintenance costs are likely to be high and that replacement is well overdue.
Some items of plant and machinery have a very short life cycle, others, such
as printing presses, can have long life spans (10/15 years). It is better to make
separate calculations for the core fixed assets. Again property can generally
be ignored because of its low depreciation charge.
The ratio is calculated:
Net fixed assets
x vears
Depreciation
charge
forOperations
year and Risk Management | Reference Book 1
Lending:
Products,
When considering the technology risk, you are assessing if the plant, machinery,
equipment, computers, etc are up to date. If the fixed assets usage ratio is more
than say, 70%, you should expect to find that the business is seeking to renew its
fixed assets with the latest equipment, unless of course they are buying old
technology because it is cheaper. This can be a reasonable reason if the
technology, such as new software, is largely untested.
When you are visiting the customers premises you can make an assessment of the
age of the equipment, remembering that some item; have a long life span and
others very short.
Case study
Have you ever gone into a hotel that has been poorly maintained? It appears tired
and shabby, in need of new tables, chairs, furniture or redecoration. Unless you
are buying on price or convenience alone, would you be encouraged to revisit it?
Possibly not, you will probably choose another venue the next time you are in the
area - as will a lot of other first-time customers - so the business is not going to
benefit from repeat business. At best they will only be marginally profitable, and
the lack of capital expenditure promotes a promiscuous spiral:
because of the lack of earnings the business cannot replace the furnishings
or redecorate.
this deterioration in amenities means that less customers come through the
door year on year.
visitors and earnings continue to fall until the business closes.
then it is sold off at a knock-down price.
Bearing all of the above in mind, you are now ready to assess whether the core
capital expenditure is being adequately replaced to ensure the medium to long
term survival of the business to match your medium to long term loan and
separate in your analysis what is considered discretionary capital expenditure.
Capital expenditure/ technology LOW MODERATE
HIGH Low risk
Production assets, core fixed assets are ijiaintained in a good condition, are
regularly maintained, and there is a recognised cycle for replacement. Fixed
assets usage % under 60%.
Moderate risk
Production assets, core fixed assets are maintained in fairly good order,
maintenance is satisfactory, there have been a few breakdowns which have
disrupted production and the replacement cycle has not always been adhered to.
Fixed assets usage % approaching 60% or 66%.
High risk
Production assets, core fixed assets are poorly maintained, regular maintenance
schedules fall behind, breakdowns happen fairly often, disrupting production, and
the replacement cycle is behind schedule. Fixed assets usage % exceeds 66%, i.e.
core production assets have only about a third of their natural life left. Be careful
in the selection of figures that you choose re core production assets, excluding
157
assets that have long life cycles such as specialist plant or owned buildings. You
will need to be familiar with the assets from a site inspection, discussion with the
customer and by referring to specialist trade magazines.
Financial risk assessment
Operational risk
Following completion of our analysis of the industry and business risks, we now
have a good overall view of the operational risks for the customer. This is where
the risk templates are really useful. You should list the high and moderate risks
you have already identified to ensure for the first few times of completion that
you capture them all. Remember that you have already completed an assessment
of industry risk and business risk using the template. This has shown how our
customer differs from the rest of the market in either a positive or negative way.
There is no need to include the individual components of these two assessments
into the completed final assessment.
In our final assessment here we will be looking at ratings which are moderate and
high risks and then differentiate these two risks on three levels:
unlikely to happen.
likely to happen.
very likely to happen.
Some of the risks you have identified may be mitigated by the factors that
differentiate your customer from their competitors; the ones that are not so
mitigated require you to consider what factors are likely to mitigate the risks.
Thereafter we can arrive at an overall balanced review, giving less emphasis to the
unlikely to happen and ensuring that you have factors to mitigate the very
likely to happen items. This process achieves the objective of providing a riskfocused assessment and conclusion.
Audit risk
It is natural that we should assess audit risk in a financial risk assessment.

Financial statements
It is important before reviewing and assessing the financial risks of a business to

determine the accuracy of the information you have been given. Depending on the
financial sophistication of your customer, the quality of the data will vary. You
may find that:
the owner of the business prepares their own accounts.
they are compiled by either an internal qualified or unqualified
bookkeeper.
an in-house accountant produces the accounts who may be CIMA,
ACCA or CA qualified.
an independent and external accountant produces the figures from the
information supplied and they may practice as a sole trader, partnership or
limited company or limited liability partnership.
Depending on the legal status and size of the business customer, you will have
different expectations of who has prepared the financial information and exactly
what type of information you will be given.
Annual financial statements are provided for the benefit of:
owners and managers of the business to gauge performance and reveal
the return on capital.
creditors - more often banks or large trade creditors.
157
You require to use your own judgment on how reliable the figures are and you can
form an opinion on this by discreet questioning of your customer.
The first step is determining the source of the information and how accurate it has
been in the past. It would be pointless to base an analysis, and ultimately provide a
financial decision and credit funding, on inaccurate or unreliable data.
Normally there are three types of financial statements:
compiled by the customer or their own staff or their own accountant typically management accounts primarily for internal use
certified by an external accountant or audit practice - typically these will
be the annual accounts of a sole trader or partnership.
audited accounts generally prepared by a registered and qualified auditor
who normally will be a chartered accountant.
Management accounts
These are primarily prepared for the businesss own internal use and will be
produced either weekly, monthly or quarterly. Departmental heads of production,
finance, marketing and HR can make use of these accounts to:
measure actual performance against projections.
decide what actions are necessary to deal with adverse variances, or
explore the reasons for positive variances to ensure that these
characteristics remain or are emulated elsewhere in the business.
The figures may not always be prepared in accordance with accepted accounting
standards and therefore the 12 months management accounts will not always
match the annual accounts. Thus the reliability of these figures requires to be kept
at the front of your mind, given that they are prepared internally and may not use
accepted accounting practices. As part of the interview with the customer it would
be sensible for you to discuss how the figures were arrived at and understand any
anomalies between the way in which the external accountant prepared the annual
accounts and those produced for the use and benefit of the internal management
team.
An auditors certificate should be read carefully to see if they wish to qualify

certain items, or even say that, the accounts do not represent a true and fair view
of the financial position of the company. The auditors will clearly define their
responsibilities of providing, audit services conducted in a professional manner,
preparing the accounts in accordance with accepted accounting practices and that
they present a true and fair view of the companys financial position. They will
make it clear that the directors are responsible for the contents of the Profit and
Loss Account, Balance Sheet Cash Flow Report, and the Notes to the accounts.
Auditors will generally give one of four opinions in their audit statement:
&
1
Unqualified - means that the certificate or report is being issued without

reservation; sometimes referred to as clean.
Qualified - means that the auditor has some reservations. Watch out for words
like subject to or except. Sometimes an amendment to the accounting
treatment has been implemented; for example, a change to the method in
which income is recognised or a change to depreciation policies or that stock
has been valued by the directors. Normally these can be accepted following
discussion with your customer and on receipt of satisfactory explanations.
However, if the company continually changes its depreciation year on year,
for example, this should give you cause for concern and a frank discussion
involving the auditor and the customer is necessary.
Adverse - here there has possibly been a disagreement between the auditor
and the client regarding the treatment of certain items within the Profit and
Loss Account or Balance Sheet. There may be a dispute regarding the
implementation of accounting policies. The auditor is clearly signaling that all
is not well.
Disclaimer - this is serious. The auditor has not been given sufficient access
to all records or systems to allow an opinion to be formed, despite trying to
gain the information from alternative sources. You need to seriously consider
the safety of the level of borrowings that is currently made available to the
customer.
It is not appropriate to provide templates for the risks covering the type of
financial statements received, who prepared them and the basis of preparation.
The risk has to be evaluated following discussion with your customer. Rarely
should you encounter the adverse and the disclaimer classifications and it is
entirely normal to see certified accounts covering sole traders and partnerships.
An important point to remember is that there is a time lag between the financial
year end of the customer and when the financial statements are delivered to the
bank - often anything between six to nine months.
The date of the certificate from the auditor will be a guide to when these figures
were finalized. There are various reasons for the delay, ranging from discussions
on tax planning, basis of asset valuations to the client actually paying for the audit
service.
As a provisional measure to satisfy a banks desire to see an up-to-date trading
statement, customers will often provide interim accounts, labeled first draft,
second draft, etc. These should give you some comfort on financial performance.
When carrying out any analysis of financial information, you should always
clearly state the basis on which the accounts have been prepared and when finals
are expected.
159
Asset and liability risk
Here we are going to briefly review the financial risk elements within the financial
statements which include the Profit and Loss Account and Balance Sheet.
The various ratios covered in the following will be familiar from your earlier
studies. We will not use the cash flow statement in our analysis as you will find
this only in the financial information produced by quoted PLCs or mid-range
corporates. However, we will use the operating cash flow calculation (earnings
before interest, tax, depreciation and amortisation adjusted for movements in
working capital) which provides a close enough comparison.
We are going to use the ratios we have seen before to assess the financial risk,
although absolute Rs figures are also useful (as you will see) and appropriate.
Ratios, as you know, provide you with a trend and that is the key to risk
identification.
We are going to analyse the financial risks by examining separate areas of the
Profit and Loss Account and Balance Sheet:
Growth.
Profitability.
Activity.
Gearing.
Cashflow.
Here are the specific items we are going to use and their definitions: Ratio
Definition
1. Growth - P & L
This Years Sales - Last Years Sales

Sales Growth % ------------------------------------------------- x 100
Last Years Sales
2. Profitability - P fir L
Gross Profit
Gross Margin % (GM%)
100
x
Sales
Operating Expenses %
All Fixed Costs
100
x
Sales
Net Margin % (NM%)
Profit After Tax 100

x
Sales
Some analysts prefer to use profit before tax, or profit before interest and tax
(PBIT).
3. Activity - Balance Sheet/P & L Account
Stock days on hand
Stock
365
x
Cost of Sales
160
Debtor days on hand
Trade Debtors
365
x
Sales
Creditor days on hand
Trade Creditors
365
x
Cost of Sales
NB
1. Cost of Sales is the same as Cost of Goods Sold (COS or COGS).
2. Stock turnover (number of times) would be COGS divided by average
stock.
4. Gearing - Balance Sheet
Capital Adequacy %
Shareholders Funds
100
x
Total Tangible Assets
161
Gearing %
Shareholders Funds
Interest Cover times
100
All Interest Bearing Debt

x
Earnings Before Profit and Tax

All Interest Payable
5. Operating Cash/ Balance Sheet/P & L Account
Cash Cover %
Capital Expenditure
Cash from Operations before tax 100

x
Cash Finance Costs
(Change in Fixed Assets)
+
(Current Years Depreciation Charge)
The following is provided to assist you to focus on how you actually

analyse the financial risks and reach a conclusion on the overall
financial risk.
1
You should look first at the ratios and develop some expectations based
on industry studies and your knowledge of what approximate range you
would expect to see.
Then, and only then, calculate the actual figures, or the ratios may
already be calculated for you, in which case do not look at the ratios
until you have developed your expectations.
Compare your expectations with the actual financial ratios you have
calculated/obtained.
Carry out an analysis on any divergence and adverse trend in the

historical figures (a movement of 10% or more would be described as
adverse).
One or two years of ratios and figures in isolation are meaningless; you
need as a minimum three years annual figures and even then the growth
ratios analysed will only represent two years.
Here is some guidance on each of the financial ratio risks selected.
162
Ratios
Growth - P & L
Sales Growth %
Primarily, if the businesss sales growth reflects what is happening
elsewhere in the economy and the customers industry for that time
period, you can surmise that they are performing on a par with their
peers. However, if performance on this measurement is above or below
peer group par, you need to make enquiries and seek the advice and
input of your customer. Remember that Porters five forces have a partto
play here and may provide an explanation regarding size, competition,
etc.
Sales drive the income generation of a business and are a fundamental
measurement of success. Sales growth is good, but too much can present
challenges or dangers to the business (and the lending banker).
Sales growth comes at a price for the business and that is the cost of the
additional trading capital that is required to fund the sales growth.
It can be a vicious circle, if sales are allowed to grow in an uncontrolled
way, without the provision of long term funding, then you have a situation
that is commonly referred to as over-trading or more precisely being
over-committed.
The operating profit which is thrown off by the increase in sales will help
fund some of the trading capital required by the expansion. We are using the
phrase trading capital to describe the main trading assets, rather than the
broader term working capital which includes all current assets and all
current liabilities. Trading capital reflects this narrower definition that we
need to apply.
Normally a business will have a trading capital requirement, that is, the
amount by which stock + trade debtors exceed trade creditors. If the sales
growth is so rapid, there could be insufficient internally generated income to
cover the trading capital required for the growth. Expanding sales turnover
requires more finance for stock and debtors. Survival is dependent on
someone financing the trading capital growth. Sometimes in these situations
where the expansion has not been discussed with their banker, we see
balances in excess of an agreed overdraft limit.
Long term sales growth needs to be funded either by:
additional equity injected by the owners.
borrowing via long term loans.
an invoice discounting or factoring facility for limited companies.
Thus sales growth has a limitation - how much the owners can inject in cash
or how much a bank will safely lend on a long term basis for businesses that
have this type of trading capital requirement.
The more permanent the sales growth, the more trading capital is required
and this is not just for one trading cycle, but many trading cycles. The
repayment of the finance (whoever injected the funding in the first place) for
permanent sales growth will either be by way of drawings/dividends for the
owners, or loan repayments to a bank. This happens gradually over many
trading cycles. To seek rapid repayment would only reduce the availability
of finance for trading capital growth.
That is why permanent sales growth requires long term funding and not
overdraft facilities. Long term sales growth funded on overdraft will only
create hard core or permanent borrowing and because it is required for some
time will not be reduced or repaid quickly. The discipline of a term loan with
fixed repayments is better.
In your analysis you need to appraise if sales growth is satisfactory. Industry
studies should be able to give you some idea of the sales growth for that
market. You may have to adjust this to take account of the local market
conditions in your region.
Profitability - P fir L
Gross Margin %
(GM%)
This is the initial and one of the major profit drivers for a business.
GM% will reflect the selling price of the businesss products. If GM%
is falling, this could be as a result of a price squeeze on their sales. As
we considered under Porters five forces, this could be because of
competitor pressure. Alternatively, suppliers may have increased the
cost of raw materials, and if this increase is not passed on to the
customer, this will create a fall in GM% (Porter - supplier power).
You may have encountered the term mark up. This is not the same as gross
margin, but the figures are used in a similar way. If a business knows it
wishes to achieve an average GM% of say, 20%, and it know? what its costs
are, then to achieve this it uses mark up to decide at whit price it must sell its
products. Let us review both GM% and mark up.
GM% =
100
Gross Profit
x
Sales
Or
100
Example: Sales Rs.lOOk

COGS Rs. 80k
Rs.lOOk
Rs.80k 100
= 20% GM%
GM%
Mark up =
x100 +100
Cost of Goods Sold
(If you used the figure for purchases this would be more accurate; for an
approximation COGS is sufficient.)
Example:
Desired GM% = 20%

COGS or Purchases Rs.80k 20%
x100 +100
Rs.80k
-125%
Mark up proof:
Rs.80k x 125% = Sales of Rs. 100k
Remember this is an average and will represent different

products. Businesses will calculate this on individual lines given the
different mix of margins achieved on their costs of production for a
manufacturer, or cost of purchases for a retailer.
Before leaving this topic, it is worthwhile exploring how Cost of Goods
Sold is calculated. It is generally:
Stock at start + Purchases + Other costs of production - Stock at end
As well as purchases and stock levels affecting the cost of goods sold,
accountants preparing annual accounts will sometimes include other items
which are regarded as costs of production, such as the costs to heat the
factory, power for the plant and machinery, carriage costs, transport,
depreciation on plant and machinery and labour costs. Generally, these costs
will vary with the level of production; for example, if the machinery is not
working, it is not using any power; if there is no production, there will be no
need for stock purchases. These are called variable costs.
Lending: Products,
Operations and Risk
Management |
Reference Book 1
165
The cost of goods sold reflects the cost of production which includes all the
costs that are necessary from taking raw materials and working them into a
finished product ready to be sold to a customer.
When conducting your analysis of cost of goods sold, you should establish if
there are any costs included that are in fact fixed costs. One possible item is
production wages - you need to establish on what basis the workforce are
paid. If they are paid on a piece work basis, the production wages are a true
variable cost, as the level of wages and bonuses will vary in direct proportion
with the level of factory production; whereas overtime payments would be a
variable cost.
However, if the wages are paid on a purely hourly rate and the workers are
paid whether there is production or not (which is the norm nowadays) then
the wages costs of these staff are a fixed cost. If the figures for wages,
overtime and bonuses were detailed separately, you could put the wages into
fixed costs and the overtime and bonuses into variable costs. Overtime
payments and bonuses will normally be dependent on the level of production.
The effort in doing this will not normally provide you with any more of an
insight into the financials or improve your risk assessment. Where you
discover production wages are indeed not a variable cost and have been
included as part of cost of goods sold, these can be stripped out and
incorporated within operating expenses (fixed costs).
This means that the GM% will be adjusted and may require some
clarification when making comparison with the rest of the players in the
industry. It is better leaving this adjustment until after you have assessed
your expectations for the industry versus the customer. This will become
clearer when we discuss break even point under the next heading.
For successful businesses, gross profit should always be a positive value and
the trend in the ratio should be fairly stable year on year with no major
fluctuations (movements greater than 10% require investigation and
discussion). If there are fluctuations that cause you concern, these need to be
discussed with the management and how it is to be addressed.
Operating Expenses %
Usually these are the fixed costs that require to be paid no matter the level of
production or regardless of what is happening in the business and they will
include the likes of rent, office expenses, marketing costs, charge for bad
debts, depreciation on office equipment and cars, salaries, directors
salaries/emoluments, pension costs, etc.
Remember that you may have to adjust this item upwards if there were nonvariable costs included in cost of goods sold, as previously mentioned. On
the other hand, you need to ensure that costs detailed under this item are not
really variable costs like transport or carriage expenses.
You need to carefully monitor the movement in the trend in the ratio, discuss
this with the management team and establish the reasons for the variance and
how it is to be addressed.
By interpreting operating expenses in this way, you have established the true
value of the fixed costs which can then be used to establish a break even
point (BEP). This is the level of sales at which neither a profit nor loss is
made. It can provide useful information and insight into your analysis for
sales as the difference between sales and BEP is the amount of sales that
actually provides the profit. The higher the figure in percentage terms will
give you more comfort as to the financial risk. But if the margin is thin, it
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alerts you to the fact that profitability could be marginal and a slip in sales
volumes for one month could mean the difference between profit and loss.
BEP is calculated:
Operating Costs GM%
If you calculate a BEP of Rs.lOOk for a set of annual accounts, its annual
sales are Rs.l20k, and the business earns for the year a profit before tax of
Rs.2.4k, what does that tell you?
It is not until months 11 and 12 that the business actually earns a profit. This
is calculated:
annual sales are Rs.l20k
which equates to Rs.lOk per month
BEP is achieved at Rs.lOOk, i.e. month 10 (Rs.lOOk^lOk per
month)
profit is therefore earned in months 11 and 12.
There is a presumption here (and it is only fair that you realise this now) that
the above analysis of calculating in which month profitability occurs will be
accurate where the customers trading (sales, GM%) is fairly level
throughout the financial year. If there are substantial lumps of seasonal
trading, the method will be inaccurate, but will provide you with a view of
the profitability situation. Care is necessary as it could be that these seasonal
lumps of income actually create the profits and therefore the profitability risk
level.
Net Margin %
This is the level of profitability that normally equates to operational profit.

You can measure this ratio as profit or earnings:
before interest and tax (abbreviated as PBIT, or EBIT).
after interest and before tax (PBT, or EBT).
after interest and after tax (shareholders earnings).
As long as you measure it consistently year in, year out, you will get an
accurate trend analysis of the risk. If the ratio is trending down by a
movement of 10%, then investigation and a discussion with the customer is
necessary.
There are various reasons why you might wish to analyse:
profit before paying interest and tax (EBIT), or
profit after paying interest but before paying tax (EBT).
These may allow you to compare businesses without the inclusion of gearing
(interest payments) or businesses that would have different taxation regimes
(for example, unincorporated against incorporated).
If you are an owner or a shareholder, PBT or EBT provides the gross return
on the capital invested which will allow comparisons to be made with rates
of return on risk-free investments such as bank deposits, or Treasury stock,
or of another business involved in the same sector; for example, the gross
167
dividend return from quoted PLCs who have a Stock Exchange listing.
In this section we will use profit before interest and tax, as this will allow
comparison with the interest cover ratio and the operating cash (cash from
operations). Both use earnings or profit before tax and interest; in financial
circles commonly referred to as EBIT.
Activity - Balance Sheet/P & L Account
Stock days on hand.
Trade debtor days on hand.
Trade creditor days on hand.
These three ratios and the movement in their values are critical. Combining
the overall year-on-year changes in the Balance Sheet values will either
generate or absorb cash. That is why, when we considered sales growth, we
spent some time looking at the dynamic effect sales growth has on a
business through the overall change in the trading assets of stock, trade
debtors and trade creditors.
You should think of the combined effect (when the movements of these
three items are summed) as the swing factors of cash flow generation or
absorption as they can dramatically increase or reduce cash flow in any one
year. That can also mean implications for paying such things as interest, loan
repayments, wages or salaries, etc.
Levels of domestic or foreign competition will dictate the terms of trade, that
is, how long a customer has until they are required to pay for the finished
goods. This could be cash on delivery, cash with order, 15 days, 30 days, 45
days or 60 days credit terms.
168
This will all depend on the industry norms. If the industry norm is 30 days
credit and suddenly a major manufacturer decides to steal market share
and to attract customers gives 45 days credit, the other manufacturers may
have to follow suit and offer 45 day terms to stay in business. Unless they
can differentiate themselves from the rogue manufacturer, for example by
better reliability or quality, shorter delivery dates, higher discounts for early
settlement etc, it can turn into a question of survival.
You will find that businesses may offer their trade debtors 30 days credit as
standard terms of trade, but some large customers may be able to negotiate
longer terms of trade due to the substantial orders they place.
Despite the larger customer being say, a major company which appears to be
financially strong, this will give rise to another of Porters risks - customer
concentration.
Customer concentration risk is not always about financial default - the
apparently financially strong company may not always be consistently so
over a time horizon. The risk may arise if the contract is not renewed or
cancelled for one reason or another, such as lack of demand, quality control
issues, a major transport strike, delivery schedules not met, etc and any of
these reasons may be break clauses that allow the contract to be cancelled.
This will leave the business with considerable unused capacity and could
lead to the disposal of specialised machinery and lay-offs in the workforce.
To speed up cash flow, the business which offers 30 days credit may also
offer a discount if the invoice is settled within say, 7 days of delivery. The
business will be sacrificing some profit, but is accelerating operating cash
flow by the early collection of debtors which pays for such items as raw
material purchases, workers wages and salaries, electricity, gas, VAT, bank
interest, loan repayments, etc. It is sometimes prudent to lose 5% or 10% of
profit to receive a cash injection of 90% or 95%. Cash now is better than
cash in 30 days time and means less time spent on credit control and a lower
cost of borrowing.
Finally, let us look at the part trade creditors play in funding the trading
cycle. They are the flip side of all the characteristics we considered when
looking at debtors. Depending on the industry, suppliers may offer their
customers a period of time to pay for the goods they have supplied. Trade
creditors are a valuable source of credit and finance to a business.
To keep the trade cycle revolving, trade creditors will require payment on
time. There is a danger that if the customer (who as far as the supplier is
concerned is their debtor) does not pay on time, they may be refused future
supplies or be moved on to cash with order basis. This would deprive the
customer of a cheap source of finance.
To be able to obtain trade credit, the customer will need a track record, will
be subject to regular credit checks, and may be requested to provide a copy
of their annual accounts - very similar to the processes and information
requested by a bank.
These elements make up the trading asset cycle of a business. Let us now
consider the three elements individually in more detail.
Stock days on hand
While you can calculate this ratio on an overall stock holding basis, for a
manufacturer it can be illuminating to calculate how many days on average
each of the three different stock classifications is held.
169
You would calculate:

Raw material days on hand.
Work in progress days on hand.
Finished goods days on hand.
The sum of these three ratios will give you the overall stock holding level
which can sometimes mask a problem or highlight an issue that needs to be
addressed by management.
The ratios are calculated in the same way as you have already done:
Raw materials
------------------------------- x 365
Cost of Goods Sold
Work in Progress
---------------------------- x 365
Cost of Goods Sold
Finished goods
---------------------------- x 365
Cost of Goods Sold
You are interested in the trend of the ratios.
Before leaving the topic of stock, there is one final item that needs to be
considered and that is the topic of window dressing or audit risk. This
occurs where the business owners value the year end stocks themselves. This
was mentioned earlier when we looked at audit risk - the auditor qualifies the
audit certificate by stating that the stock has been valued by the directors or
owners. Stock should be valued at the cost of purchase or market value,
whichever is lower. What does this mean?
If the business purchases widgets for Rs. 3 and the market value is
Rs.5, then the stock valuation is based on Rs. 3. Later in the year, the
business purchases widgets for Rs. 3 and the market value is Rs. 2, then
the valuation is based on Rs. 2.
However, the business sells 100 widgets at Rs. 5 each and has:
Opening stock of 100 widgets at Rs. 2.
Purchases of 100 widgets at Rs. 3.
but values the closing stock of 100 widgets at Rs. 4.
1. What will be the cost of goods sold?

2. What is the gross profit?
3. What should have been the value of cost of goods sold if the
business had valued the closing stock correctly, using the accounting
principle for stock of First in First Out (FIFO) i.e. sales use up the
earliest amounts of stock first - in this case, the opening stock - the
170
oldest first? What is the gross profit?

The answers are:
1. Rs. 100.
2. Rs. 400.
3. Cost of goods sold is Rs. 200. Gross profit is Rs. 300.
As you can see, overvaluing stock inflates the gross profit. Why is this
important? An overvaluation of stock at end will overstate the gross profit.
To maintain the deception, the business would have to keep overvaluing
stock year in year out, or suddenly profitability would drop. How can you
spot this? The stock days on hand will keep increasing year on year. It can be
detected by obtaining an itemised list of stock numbers with individual
values for each amount. These can then be checked back to a selection of
invoices from creditors.
The basis of valuation should remain consistent over many accounting
periods and businesses should not (without a detailed explanation and
normally discussed in advance) switch from one accounting method of stock
valuation of First in First Out (FIFO) to Last in First Out (LIFO) or even
Average Purchase Price (another method).
Normally you should find that the prudent approach is used with the same
basis, otherwise it should be highlighted by the auditor. It is perhaps better
for practical reasons to highlight this issue here rather than under audit risk to
allow you to see the practical implications.
If the customer were to supply a quarterly list of stock (that is, if they do not
supply management accounts containing a Balance Sheet) it can be a useful
source of information when monitoring some lending covenants.
Trade debtor days on hand
A falling ratio usually demonstrates efficiency, with the management paying

close attention to credit control and it may also indicate that production,
marketing and finance are all communicating well. An increasing ratio needs
to be investigated, as this may mean that one or two customers may be
struggling to settle their invoices on time.
What will assist you here is an aged list of debtors, normally supplied as part
of the management accounts. Here each debtor is listed and classified into
the total amounts outstanding and then spread over a period of time (we will
assume 30 day terms of trade).
The total outstanding for each trade debtor is split into:
Current and not overdue, i.e. < 30 days.
31 days to 59 days, i.e. 1 month overdue.
60 days to 89 days, i.e. 2 months overdue.
90 days plus, i.e. 3 months plus overdue.
You analyse the totals for each period by expressing these as a percentage of
total debtors outstanding. One period on its own will not reveal very much
other that the names of those customers that have not paid up on time. With
a series of aged list totals you can quickly detect potential issues. It is better
171
to try and compare the same period this year with the same period last year,
as this will allow for seasonal peaks where special terms of trade may apply.
If you discovered the following percentages:
Jan 06
Apr 06
July 06
Current < 30 days
80%
65%
50%
31 days to 59 days
60 days to 89 days
90 days plus
10%
7%
3%
15%
12%
8%
20%
18%
12%
you would see that there is a clear deterioration in debtor collection and
customers are moving more and more into arrears. It can be interesting to
identify which customers are appearing in the 59/89/90+ day categories and
see if they are still being supplied with goods on credit - they will be if there
are amounts under current.
You can use the data received on aged lists to establish concentration risks.
Trade creditor days on hand
These are analysed in a similar way to trade debtors. A lengthening of trade

creditor days on hand can give cause for concern - is the customer riding
the trade, that is, are they slow in settling their suppliers and taking longer
than the agreed credit terms to pay for the goods supplied?
Trade creditors will eventually tire of having to seek payment, you may see
the overdraft at its limit or unauthorised overdrafts appearing and cheques
made payable to suppliers for round amounts. The latter could indicate that
your customer is making interim payments instead of paying the full bill.
In these circumstances the customer may find that credit dries up and they
have been suddenly moved to cash on delivery (COD) or even cash with
order (in advance of delivery).
As well as obtaining an aged list of debtors, when you suspect that there are
issues regarding the lengthening of creditor days you should seek an aged list
of trade creditors in exactly the same format as for trade debtors. Often an
aged list of creditors is supplied along with an aged list of debtors as part of
the standard management accounts pack.
For some industries you need to be alert to contra entries. This is where
your customer is showing one name as a debtor and the same name as a
creditor. In the event of insolvency the amount included as a debtor will be
offset under common law by the amount appearing as a creditor. For a
company, this could well reduce the value of the assets covered by your
floating charge.
. Gearing - Balance Sheet
Capital Adequacy %
This shows you how much the owners are contributing to the business by
way of equity or risk capital.
Capital adequacy % is an indication of the customers stake in the
business. The lower the percentage the less the customer has of a personal
stake. The capital in a business if the buffer or cushion between the creditors
172
and their losing money. The bigger the capital adequacy %, the safer the
proposition is.
A higher net worth percentage will also indicate that levels of debt are low.
A low level of net worth percentage will mean there is a high level of
external liabilities. These have to be paid and interest bearing debt needs to
be service.
Gearing %
This is the amount of interest bearing debt to shareholder funds /equity/net

worth in the business. For unincorporated bodies this is simply the capital
account and for incorporated bodies this is capital plus all reserves plus
cumulative retained earnings.
173
A low ratio will normally mean a low financial credit risk and a high ratio
normally indicates a high financial risk. Low risk will normally be a ratio of
under say, 80%, a moderate financial risk could lie between 80% and 150%
and a high risk will be normally in excess of 150%. However, this is not the
whole story - shareholder value would probably be low if the gearing were
10%. This is because the business ii not benefiting from the additional assets
(resources) that the higher debt could provide, and so it is earning less profit.
On the other hand, debt levels of 200% are quite likely to make the business
ver y vulnerable. Debt interest is a fixed cost which has to be met regardless
of the level of sales. A drop in sales could expose the business to losses.
Each business has an optimum level of gearing; the safest level is where the
actual gearing is just below the optimum. The correct level of debt promotes
shareholder value and consequently return on equity. Shareholders equity
attracts a higher rate of return than bank debt, the difference in the two rates
being known as the equity risk premium. This is the premium shareholders
expect to earn because they are last in the queue to get their money back if
the business fails, and so bear the greatest risk.
Interest Cover times
This is linked to gearing - the more debt there is, the more interest that has to
be serviced. High levels for interest cover are good; for example, for a
trading business with facilities that finance long term sales growth only (such
as stocks and debtors), this ratio should be around 7 or 1C times and would
be considered safe.
The ratio will reduce where borrowings finance fixed assets as well. Interest
in this case should include all the commitments of the customer in favor of
the bank and leasing companies.
A ratio of less than one times cover means that there was insufficient profit
(and remember that does not always equate to cash) to cover the interest
payments. The uncovered interest is then probably rolled up into existing
debt facilities such as overdraft, which may go unnoticed.
A ratio of 7 or 10 times may seem high to some people where only debtors
and stock are being funded or creditors are being paid early tc take advantage
of trade discounts for early invoice payment. It is really not where the ratio
was that is the issue - it is more where it is heading.
Example
Let us say you have a business customer who borrows short and long term to
fund debtors, stock and fixed assets. The trend in this ratio over the last four
years has been:
31/12/03
4.5
t
31/12/04
imes
31/12/05
3.0
t
31/12/06
imes
31/12/07
2.5
t
The 31/12/07 accounts are received in June 2008.
imes Six months age the ratio
was 1.5 times. Given the trend, where is the ratio
2.0 now? t
imes
1.5
t
imes
174
Around 1.3 times? Where will it be on 31/12/08? Around 1.0 times.

In June 2009 when you should be receiving the next set of accounts
(some customers, remember, may try and hold back bad news) it will
actually be less than 1.0 if the trend continues.
That is the whole point of ratios - where there is deterioration and no
action is taken, the erosion continues. From going from a fairly stable
position for 2003, there now appears to be a real problem. Who is more
worried - you or the business owners? Probably both of you will be
having some sleepless nights, now that you have detected the trend. '
Operating Cash - Balance Sheet/P & L Account
Cash Cover %
This is very similar to interest cover, except that operating cash before
the payment of tax is divided by interest and capital repayments on
debts. You will recall that interest coverage is calculated before tax and
takes no account of the capital debt repayment. Also the accrual
accounting profit seldom equates to cash generation where a business
has a significant trading capital requirement.
We use the convention of before tax on the basis that interest charges are tax
deductible, but you should not lose sight of the fact that tax requires to be
paid one way or another.
The operating cash is the primary way in which the customer will fund:
servicing of overdraft interest.
repayment of the capital and interest payments on term loans,
HP, finance leasing agreements.
paying tax.
all or part of capital expenditure.
A ratio of greater than 1.1 to 1.5 times is satisfactory. 0.99 times or less will
mean that there is insufficient internally generated cash in the year to meet
debt payments, tax, and finance capital expenditure - all of which will then
have to be financed by a lender or the owners.
One year of a ratio of 0.99 times or less should not give you a real cause for
concern. Even in a further year, if the deficit is not too high (say a ratio of
0.90 times) you should generally not be too concerned. Why? Businesses
that can fund all their capital expenditure from internally generated cash do
not borrow - they have cash on deposit.
However, if you see year three being less than 1.0 times, action is required
as the safety of the borrowing is deteriorating. All depends on the particular
circumstances of the customer, the level of deficit and the risk appetite of
the bank. Follow the money (or in this case) the increasing borrowing
requirement or need for capital from the owners to see where it may end.
This is included as a reminder of how critical this item is. Although we have
covered this under the business risk assessment, we are now analysing the
financial strength and operational cash of the business and it is worthwhile
reaffirming that our risk assessment is still appropriate. Remember to
differentiate between core and discretionary capital expenditure - it helps to
identify those years where management have embarked on a strategy of
expansion or acquisition.
175
Capital Expenditure
Borrowing cause, structure and packaging of facilities

Borrowing cause
The starting point to any lending decision is: why does the customer require
to borrow? This is the first specific assessment you need to make after
considering whether the request is legal and within your banks own policy.
All requests from customers for credit fall into any one or more of the
following seven borrowing requirements:
1
To fund operating and fixed costs (such as wages, salaries, phone bills,
heat and light, etc) until trade debtors are converted to cash.
To fund stocks until they are converted to output, sales, debtor? and
then to cash.
To fund property, plant and equipment until they are used up over many
trading cycles in producing output which is converted to sales and then
to debtors and then to cash.
To fund the whole range of assets (stock, debtors, fixed assets,

additional operating costs, etc) required to support rapid growth.
To fund a change in the companys ownership.
To finance one-off projects, such as property development.
To fund survival (the business is either leaking cash or making

insufficient profits or is incurring losses) until the company can be
turned around.
The borrowing requests at the beginning of the list should be a low risk, but
as you will know, number 5 is starting to become a high risk and number 7
does not always have a successful or happy outcome and is for that reason a
very high risk.
Customers may require borrowing for more than one purpose; they may
require, for example, to finance both debtors and stock. It is up to you to
differentiate and account for how much requires to be funded for each
component. Knowing what you are funding brings you closer to
understanding your customers business needs. It is fundamental to good
relationship management.
Linked to the seven borrowing requirements is the trading cycle. The trading
cycle of any business starts with cash and ends with cash. It is what goes on
in the business between the start and finish of the cycle
176
that is important for lenders to understand. The length of the cycle will
depend on the industry. It is cash that repays loans and services interest
payments, as we will see when considering the financial repayment risk.
Trading cycle
Here is a simple trading cycle:

PAY
SUPPLIERS
AND EXPENSES
//
COLLECT
FROM
CUST
OMER
S
(DEB
TORS
CASH
w
SELL GOODS
TO
CUSTOMERS
BUY RAW
MATERIAL
S
)
START
MANUFACTURE INTO
WORK IN PROGRESS
Jl
COMPLETE
MANUFACTURE
INTO FINISHED
GOODS
1.
Cash will be used to buy stock or pay for stock purchases from a previous
trading cycle (some businesses will use both methods to buy stock).
Business will take the benefit of discounts where appropriate (and getting
their purchases cheaper and increasing their GM%) or taking the free
credit period from trade creditors who may not offer discounts.
2.
Stock then goes through the production process and is converted into
finished goods. In a retail business, after the goods are unpacked, a mark
up is calculated and they are placed on the shelves, ready for the consumer
to buy.
3.
Where stock is sold on credit, it will appear as another asset - trade debtors
- and when the debtor pays the invoice, cash is generated and received. Of
course with the high street retailer, credit is not offered and when stock is
sold, the cash or Maestro or credit card slip goes straight into the till.
4.
We are back to cash, when the business will purchase more stock out of a
mix of cash and trade credit and the whole trading cycle starts again.
The length of trading cycles will depend on the industry sector.
Example
The trading cycle of a fishmonger who only sells fresh fish has say, two or
three days maximum to complete any sales. Other factors come into play - the
time of year when the sale is made can be critical. During the summer, fresh
fish goes off more quickly than in winter and there are certain seasons when
only specific species are available.
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The trading cycle of all businesses who deal in perishable goods has to be
very short - perhaps 120 trading cycles in one year.
Example
A beef farmer may have a trading cycle of 18 months - financing the

calf from the day it is born, feeding the animal, looking after it and
eventually selling it at auction for slaughter when the animal has
matured.
Structure and packaging of facilities
Finance of customer requests should be scheduled so that the total borrowing

cause is repayable in:
less than 12 months, that is, a few weeks or a few months up to a maximum
of 12 months on overdraft for seasonal facilities or debtor finance facilities
more than 12 months, with regular weekly, monthly or quarterly
repayments with a term of say, 10 years on term loan, hire purchase or
finance leasing.
This is commonly known as structuring facilities. It is important to keep in
mind that what is being financed needs to match the length of time the asset
requires to be funded for.
Fixed assets need to be financed on debt that is repayable over many trading
cycles, such as a term loan, hire purchase or finance leasing.
Core stock requirements and long term sales growth calling for an increased
stock requirement need long term funding repayable over many trading
cycles, such as a term loan.
Long term sales growth calling for an increased debtor requirement needs
long term finance repayable over many trading cycles such as a term loan. A
limited company may also consider invoice discounting or debt factoring.
The purpose of the advance requires matching the period of time the debt
facility is required for. There needs to a logical match between purpose and
the repayment source. For example, you finance stock purchases but the
customer offers the primary repayment source as an insurance claim for fire
damage to their premises. Why? How are they to refurbish the premises after
the fire? How and when are they selling the stock? That is why there needs
to be a logical fit.
Financial repayment risk
We need to fit the financing we provide to what it is financing. Long term

assets need long term financing. Short term lending on overdraft is suitable for
the fluctuating requirements of the trading cycle.
Cash flow forecasts enable us to see where and when the cash to repay us is
coming from. We have seen how term loan repayments can be tailored to suit
the cash flow by deferring the start of repayments until the asset is generating
cash. Repayments may be rear-end \oaded by balloon repayments.
You should think of repayment risk as series of steps:
. The primary source of repayment for bank debt is the cash generated
over a number of trading cycles and this may last for a number of
years.
178
. The secondary source of repayment is the sale of surplus assets to

pay down the bank debt, sometimes known as downsizing or
restructuring.
. The tertiary source of repayment is realisation of security held by the
bank and may run alongside a restructuring exercise.
. The final repayment source is by seeking repayment from sources
outside the business which have granted guarantees or by a voluntary
sale of the business to a competitor or the liquidation of the business
to realise whatever funds can be raised.
Think of those four points as exit routes: how likely is each of them to
happen? The lower down the list, the less chance there is of a successful
conclusion. Again Porter comes to mind and his wise counsel on barriers to
exit explains why the chances of success can be limited.
Documentation and pricing risk
Legal risk
In lending money, there are always at least two parties - the customer and the
bank. The customer asks the bank for credit, the bank assesses the risk, and if
the risk is acceptable, agrees to the facilities. Thereafter the bank issues a
letter confirming the facilities or prepares a loan agreement which the
customer signs.
A request has been made, the request has been agreed (or modified) and
documents have been signed. This constitutes a contract at a basic level. The
contract will contain such items as:
the amount.
period of time covered by the agreement.
the cost of the borrowing.
repayment terms.
what the customer needs to do to prevent the facility being
withdrawn (in the event of default).
security/collateral.
Your organization will have a set of standard agreements which cover nearly
all lending situations and the taking of security over assets, guarantees, etc.
These will cover many situations and will have been compiled by the banks
internal or external legal experts, scrutinised by the banks own solicitors
and, where the agreement is very complicated, subject to external legal
counsel opinion.
The aim is to make sure that these agreements are watertight - that they
cannot be challenged in court on a legal technicality or a poorly phrased
clause or term. They can sometimes stretch to twenty or thirty pages,
including explanations of terms, lending covenants, conditions precedent,
etc. While it may appear boring, all these documents prove the legal right to
seek loan repayment or enforcement of security.
You should investigate and review copies of your organizations legal
agreements covering overdrafts, term loans, factoring/invoice discounting,
or finance leases.
179
We have already covered lending covenants when we considered credit

compliance breach. These clauses will be written into term loan agreements
or 364-day overdraft facilities. In essence, what the bank is saying to the
customer is:
If you maintain items a, b and c of this agreement, we will continue
to lend you Rs.x.
Breach these and we will consider this to be an event of default,
which allows us to ask for our loan to be repaid immediately or
within x days, or seek additional security to protect our increased
risk and/or increase the rate of interest.
Late or non-payment of a loan instalment, exceeding an agreed overdraft
facility or insolvency of a party to the agreements - these are the most
common ones. Death of a sole trader or a partner in a firm means that the
contract has been broken. Death of a shareholder or director in limited
companies or members of a limited liability partnership do not trigger
repayment as these are continuing entities. Others conditions could be
failing to maintain insurance on assets in which the bank has an interest or
has security over.
An event of default can be triggered by default on another bank facility. For
example, an on demand (365-day) overdraft facility will be cross
defaulted to say, term loan agreements or asset finance facilities or foreign
exchange contracts etc.
Thus breaching one of the conditions of a term loan agreement could trigger
a cross default and give the bank the right to make all the customers
facilities repayable. This is only right as the risk has clearly increased. It is
likely that in these circumstances the bank will want to renegotiate all the
facilities.
There are similarities between lending covenants and condition? precedent,
but the two must not be confused. Conditions precedent are those items with
which a customer must comply or provide prior to the drawdown of (usually)
new and/or increased facilities. They are detailed in the credit write up as a
separate heading and along with the lending covenants as separate headings in
letters of offer.
In the event of a request by a customer to waive or vary a condition precedent
(or lending covenant) prior to drawdown of the facilities, the written
permission of whoever approved the loan within your bank should be
obtained.
Examples of conditions precedent prior to drawdown of increased facilities
include:
interest rate protection taken out by the customer.
full planning consent to be in place and evidenced to the bank.
all security to be executed.
certified opening statement of affairs of the business.
satisfactory surveyors report and valuation showing a minimum
valuation of Rs.x.
There may be some conditions subsequent to the approval which, once
achieved, are regarded as closed. Lending covenants should not be regarded as
180
a condition subsequent - they are an ongoing condition of support.

Investment risk and regulatory risk
Income is important to a bank. There will be charges for running the bank
current account (service charge) which will normally be a standard tariff based
on the type of debit and credit transactions passing though the account.
If the transaction is electronic, this will cost less than a manual entry. If
lodgements contain cheques to be processed from the business debtors, these
will be charged at a rate per item. If cash was lodged, this will be at a higher
cost than cheques.
You should be aware of these costs as they are bound to be part of an
important discussion you have with a number of business customers. If
transactions on an account are exceptionally high - say, a large high street
retailer or a local authority - this is either negotiated or tendered for, normally
by a central unit in your bank who have expertise in providing the leanest
quote.
The income elements that are really important for credit risk applications are
fees from arranging facilities and the rate of interest charged. Fees will
normally be x% of the facility being agreed, with minimum and maximum
amounts. You need to be aware what authority you have to modify fees.
181
Interest rates will either be x% over base rate or the Karachi Inter Bank offer
Rate (KIBOR).
Your organization will have its own policy on what it requires to be charged
to meet its own internal risk adjusted return on capital - the risk/reward ratio.
We explored earlier that banks require managing the amount of capital that
they have to set aside for each parcel of lending. Thus there is a requirement
when lending money that the return meets not just the risk/reward, but also
that the return on capital is adequate. This return on capital needs to meet the
banks risk-adjusted return on capital targets. Shareholders, investment
analysts, rating agencies and bank regulators pay attention to the return the
bank earns on its risk- adjusted assets (loans). They see this as a measure of
safety.
The principle of risk and reward will become more critical as bank regulators
raise the amount of capital the banks are required to hold.
For credit scored facilities, the scorecard will generate and continually
recommend facility levels and a risk rating for the account. For larger
commercial lending, there will be a computer programme that will model the
probability of default of similar loans based on the banks historical bad debt
experience.
Market/industry, business risk and financial risks assessments will normally
be used to arrive at an overall value for the customer. The rating will have to
be updated at least once a year, or if there is a significant change positively or
negatively in the industry, business or financial health of the customer as soon
as it occurs. Thus the rating will be under constant review.
You will want to find out what system your organization uses, and familiarize
yourself with it as well as establishing what a good rating looks like and
what a poor rating is likely to be and critically, what elements are likely to
bring this about.
The internal bank credit rating, non-interest income and the level of tangible
security cover are used to arrive at what minimum rate of interest requires to
be charged to meet the banks internal rate of return policy. Each time the
risk/reward model changes or the internal rating changes, you will need to run
the computer model to establish that the hurdle rate meets the banks internal
rate of return (risk adjusted return on capital). Again you will require to
establish if you have a level of discretion in deviating from the minimum
recommended rate.
To put legal, investment and regulatory risk into practice, you should, where
possible obtain the following relating to your bank:
Legal risk - standard business overdraft letter and a busin term
loan agreement.
Investment risk - service charge, interest rate and arrangem fee
tariffs.
Regulatory risk - details of commercial rating model and the
regulatory capital requirements are being handled by y bank.
The purpose of credit write up is to pull all the information, risks and analysis
together into an internal document. The overdraft facility advice letter and term
loan agreements, etc will give you the basic information for the credit facilities:
how much?
how long?
cost
security/collateral
The overdraft facility advice letter and term loan agreements will not provide
the rationale and reason why the credit facilities were granted.
The credit write up document (often called a credit application, or a credit
memorandum) outlines the thinking, logic, risks identified and mitigating
circumstances used in arriving at a decision to lend. The credit write up is an
essential credit risk document and acts as a way of understanding the
customers business, their needs and some of their opinions. While the property
of the bank, these files can be sought by a court to understand the banks
rationale for granting a facility, especially if the customer is claiming unfair
treatment or is disputing something. It can be seen as a record of the decision at
the time it was taken and not influenced by later external events or
circumstances.
The credit write up is a valuable document because:
it allows cross-selling opportunities to be identified

on a change of relationship manager, allows the newly appointed
manager to become familiar with the customer prior to the first meeting
and allows empathy to be created through some prior knowledge.
It is best to tackle the credit write up in a structured and methodical manner and
the following is only a suggestion. Again, you should investigate your own
organizations methodology.
One final thought: credit risk is, in some ways, as much of an art than as a
science. There may be rules of thumb and formulae that can provide
guidance, but it is the use of your skilled judgement that will show the quality
of your analysis and assessment.
Pro forma credit risk write up
It is sometimes beneficial to provide a structured summary of the

request. An example is shown on the first page that follows.
thereafter the following pages provide the structure of the write up, with
headings and sub-headings.
Guidance is provided to help you to complete your assessment.
These are only suggestions.
You can use paragraphs to detail your assessment, or numbered bullet
points may be a better way. Use whichever method you feel is more
effective.
This is a focused risk assessment; do not try to oversell the proposal remember that someone else may have to analyse and review your risks to
provide a decision. It is important that you cover all the salient facts and not
presume knowledge.
Adapted from:
Institute.
184
Credit Risk Practices for Retail Banking

Introduction
Credit scoring is an important decision making tool in lending to individuals and

also with some SME lending. We consider credit scoring in detail in this chapter,
including the technique of behavioral scoring. Credit reference agencies are an
integral piece of the jigsaw that comes together to give a credit decision and we
will see how they operate and the information they supply.
A large part of bank lending is mortgages and there is a section on this important
topic. With higher value lending a profitable part of the retail banking scene, we
cover how this area of the business should be handled. Finally, credit risk
analysis pulls everything together and includes the assessment techniques used.
The risk management framework
Risk management is a defensive proactive solution. Management will sometimes

have to react to a situation. If the situation is foreseeable, there will already be a
game plan in place to deal with it. If it is something that no one can predict, then
some of the existing strategies can be modified and employed to deal with the
situation. In order to avoid sudden shocks, therefore, it is important that there are
well thought out structures, strategies and verification processes in place which
will lead to a high probability of success.
The typical risk management model will include three lines of defense for
a bank:
The first line of defense will typically be front line bankers, treasury
department, etc, made up of the banks own personnel.
The second line of defense will be policies and procedures, internal audit,
credit approval, distressed lending units, group legal, operational risk,
executive committees, etc, again mainly staffed by the banks own
personnel.
The third line of defense will be the Board of Directors, the External
Auditor, the Financial Services Authority, Government legislation, etc,
this time with external personnel who will have contact with the banks
staff.
Banks often form a series of committees which can comprise both directors and
senior management. They meet regularly to review the risk policies they have set,
test their risk policies and review outcomes of actual losses. They will update
their strategies and mitigating factors so that these are aligned to current
circumstances. They will also convene if there is a major emergency.
The primary function of risk management is to:
identify the issue(s) - understand what could happen
identify the likelihood - probability
put plans in place to solve or mitigate - plan
make sure the outcome is dealt with quickly - action/monitor.
185
How risk is managed and overviewed
A bank will typically have a set number of committees which will address the
following risk areas:
credit risk
asset and liability risk
market risk
insurance and investment risk
operational risk
legal and regulatory risk
strategy risk
audit
The committees will normally report directly to the Board of Directors or
through an Executive Committee to the Board. Sometimes a Director will be a
member or chair of a committee; typically the makeup is of senior or executive
management, supported by Heads of Departments or Divisions from the bank.
Their function is to overview and test the risk strategies of the operational or
support units.
Our main purpose here is to consider credit risk.
Credit risk
Credit risk is defined as the financial loss incurred due to the inability of a
customer to repay their loan, or overdraft, or other contractual obligations. The
use of the word loan from now on will encompass all credit facilities including
contingent liabilities.
The mandate of the Credit Risk Committee is delegated from the Board of
Directors, to whom it reports. Risk Committees may be formed at different
levels within an organization:
Business Unit level
Divisional level
Group level Board level

The influence of the committees will be in direct proportion to where they are in
the organizations hierarchy.
The main activities that a Credit Risk Committee undertakes are:
recommending the risk appetite and the direction
regulatory adherence maintaining and approving
credit policies portfolio management and credit
quality
186
agreeing and monitoring risk and pricing models

lending authority control.
Credit scoring
Credit scoring is a statistical means of screening customers to determine their

creditworthiness. It is basically a system which allocates points according to the
data produced in answer to a credit application form; for example, people who
own their own home will score more points than those who rent. The process
determines the statistical probability that the credit will be repaid. There is no
universal system of credit scoring; nor is any system perfect.
Before a bank can be in a position to agree to lend money to a customer, it must
have a certain amount of information about the customer so as to estimate their
likely ability to repay the loan. Credit scoring can be used, therefore, as part of a
standardized approach to determining creditworthiness.
Credit scoring is most often used in retail banking units where they are primarily
dealing with personal customers. However, you should bear in mind that the
smaller end of the Small and Medium Enterprise Businesses (SMEs) sector can
have credit risk assessed using the same techniques as fOT consumers. Later on we
shall come to high value lending.
Credit scoring is an ethical decision-making process and, if applied correctly, it
should reduce the number of instances where customers borrow more than they
can afford.
As well as assessing credit risks, a form of credit scoring is used to determine the
suitability of the various accounts that could be offered to a customer wishing to
open an account that has automatic credit facilities. Credit scoring is used
extensively for mortgages, credit cards and other types of revolving credit.
Credit scoring is one of the most accurate, consistent and fair forms of credit
assessment. It uses information provided on an application form, external data
from eCIB and applies internal statistical information on the credit histories of
applicants who have previously repaid (or not) their credit on time.
When a customer wishes to borrow from the bank they generally have n
complete an application form which contains a great deal of information an data
about the customer. Certain aspects of the data are analyzed by awardn points
according to the answers given on the form. Usually, before the baaU will agree
to lend to the customer, a certain minimum score ha to be attained. The systems
are normally computer-based.
Credit scoring is a statistical means of assessing the probability of repayment of
the loan by an individual or small business who supplies specific dza when
applying for credit. Behavioral scoring systems calculate credit risk levels on a
regular basis during the normal operation of the account using the transactions
flowing through the account. Credit scoring is all based am the fact that it is
possible, using statistics on past performance, to predict the- future credit
repayment pattern of customers with similar financi_ characteristics.
This risk assessment technique is neither a crystal ball nor a means of forecasting
whether an individually scored credit applicant will repay their debt as promised.
What it can do is assess the credit risk of the applicant using the historical
187
Introduction to the credit scoring system
repayment record of individuals with similar characteristics in their financial

profile. The bank uses its historical credit experience to estimate the degree of
risk - low, moderate or high. For example, the statistics may show that the
customer, when compared with similarly classed customers, behaved
satisfactorily at a rate of say 30:1.
In estimating the probability of non-repayment (default) in this way, those who
pass the score set by the bank are regarded as an acceptable default risk, and
applications for credit where the score falls below the accepted score are
rejected. Normally those with a low number value score are rejected. An
application with a high number score (and above the acceptable score) is agreed.
The term scorecard is often mentioned when credit scoring is discussed. This
refers to the set of points used in scoring an application. Points are allocated
according to the characteristics of various applicants whose accounts:
were fully repaid on time with no issues
are then compared with the characteristics of those facilities that were
either slow to repay (required intervention of some kind) and
are compared again, this time with those who did not repay their loan in
full.
For example, what you may discover is that applicants who had cheques or direct
debits dishonored in the last 12 months are more likely to default on loans x%
more than a customer who did not have debits returned unpaid.
Points are assigned to each characteristic that reflects the comparison between
good, and slow, and problem loans. The characteristics used may range from
post code to home ownership, length of time at address, to having a land line
telephone.
Lending: Products, Operations and Risk Management j Reference Book 1
Overview of credit scoring
Credit scoring is the term used to describe systems within banks and financial
institutions which allow lenders to automate their credit decision making while
also managing the credit risk of those decisions. Credit scoring consists of a
statistically derived model (the credit scorecard) which is used to predict a
specific outcome and a set of strategies which drive the decisionmaking process.
Application scoring
In the credit risk arena, a number of different models can be used to predict
different outcomes. For example, a credit scoring model may be built to:
predict the likelihood of a new loan account going bad or becoming
delinquent
determine the amount of credit limit to be allocated to a new credit card
predict the credit risk of approving a new current account and providing
overdraft facilities.
These types of credit scoring are generally referred to as application scoring.
Application scoring is used for new and existing customers and is a single point
in time assessment for credit. Typically, an application scorecard will use
application data and credit reference bureau data in the decisionmaking process.
If available, behavioral data may also be used.
Behavioral scoring
Additionally, credit scoring can be used to:

increase a credit card limit for an existing credit card customer
decide whether to pay or return transactions presented against an existing
current account if insufficient funds are available
upgrade credit or debit cards from standard to gold and beyond.
These types of credit scoring are generally referred to as behavioral scoring.
Behavioral scoring, unlike application scoring, is used for existing customers
only and is an ongoing, updateable assessment for credit. Typically, a behavioral
scorecard will use application data, credit information bureau data and
behavioral data in the decision-making process.
Behavioral scoring was a later development in credit scoring but is a more
powerful credit scoring tool than application scoring because we use actual
working knowledge of the transactions and activities that are running through an
operative account, such as a current account, a credit card account, etc.
Additionally, behavioral scores are normally calculated on a regular basis
(monthly) and give an up-to-date view of the credit risk of a customer.
A consistent and impartial assessment of customers - all customers are
treated the same and fairly.
Allows management to control the credit tap, that is, increase or reduce
credit exposures, thus giving the bank control over approval volumes
/bad rates.
189
Benefits of credit scoring
A uniform method of processing standard customer requests.
An increase in ability to consider volume credit approvals irrespective of

value.
Much improved management information systems - it is all electronic

based.
An efficient, cost-effective method of credit risk assessment.
With a standard and tested system, the quality of the credit portfolio will
be reliable during a stable economic cycle.
Boundaries of credit scoring solutions
A sizeable number of historical applicants and repayment patterns data are

normally required to build a credit scorecard
Can be expensive to build and put in place, although there is a choice
between in-house built systems and off-the-shelf purchased systems.
Is time sensitive - efficiency deteriorates over time. Very old data can
prove to be unreliable for making plans for tomorrow, so scoring systems
need to be replaced or updated over time.
Is not infallible and errors can occur.

Not all lending decisions are suitable for a scoring solution.
Will not solve all credit issues.

Obviously, a great deal of skill and time needs to go into the preparation of an
application scorecard - similarly, with the behavioral scorecard. This is a
specialized area of credit risk practice and we do not need to go further into the
mechanics of compiling these systems.
Scorecards are regularly reviewed to ensure that they are still appropriate to the
customer base of the financial organization. The review will normally measure
the following performance areas:
Stability of the current score in comparison with the historical
performance - has the level of declined applications increased, for
example?
Have there been changes of the makeup of the customer base?

How effective has the override performance been (where the lender has
not followed the course of action recommended by the scoring system) has there been stability in override decisions?
Has the predictability of the level of defaults or approvals matched actual
results?
Historically, banks have built their credit scorecards using default or partial data
from the credit reference agencies. This has given the banks details of any credit
agreements which are in default. In recent years, the use of full data has become
190
more common where banks can see details of all credit agreements with other
lenders, whether in default or not. Although strict rules apply around the use of
Monitoring
credit
full data, there
are scoring
clear benefits in preventing lending to customers who cannot
afford their total commitments.
The Electronic Credit Information Bureau (eClB)
The Electronic Credit Information Bureau (eCIB) was established by State Bank
of Pakistan (SBP) in December, 1992. The scope and activities of eCIB are
governed under the provisions of Banking Companies Ordinance (BCO), 1962.
Credit Information Bureau is an organization that collects and collates credit data
on borrowers from its member financial institutions. The financial data is then
aggregated in system and the resulting information (in the form of credit reports)
is made available on request to contributing member financial institutions for the
purposes of credit assessment, credit scoring and credit risk management. The
major purpose of this database is to enable the financial institutions to know the
credit history of their prospective customers thus enabling them to make a more
prudent decision.
In order to understand eCIB in detail, please see appendix 3A.
Mortgage lending
If the mortgage lender has the twin objectives of responding profitably to market
demand for mortgages and building a healthy mortgage portfolio, then marketing
and sales efforts need to be supported by a sound lending policy based on a
reliable credit assessment process. How can the risk inherent in mortgage lending
be managed effectively?
A banker wants to assist customers in fulfilling their desire to own their own
home, but also wants to be as sure as possible that they can meet the financial
commitments involved. The lender will not want to lose money - and so we have
to ensure that the loan will be serviced on a timely basis and repaid at the end of
the agreed term.
191
As with any other lending proposition, information is required about

prospective borrower and specifically about income and outgoings. You need
to bear in mind that the mortgage commitment is likely to be a 1 term one
and, consequently, some assessment has to be made on the li level of that
income and outgoings over an extended period of time.
There are two significant risks in relation to mortgage lending:
repayment risk - ability of the customer to meet future payme
property risk - value of the house itself and quality of the registered title.
Repayment risk
Credit scoring techniques can be used in assessing the repayment risk of a

mortgage. Information obtained from eCIB can be used.
The use of web-enabled technology allows some lenders to speed ur
application processing times for mortgage brokers and to offer on-line
agreements-in-principle or decisions-in-principle. Furthermore, technology is
being developed to offer particular products which conform to the banks risk
appetite. For example, rather than just reject a particular application for one
product because the applicant has moved home twice in the last five years, it
may be possible to provide an alternative mortgage with a slightly different
profile. This automatic matching of borrower profile against the product
criteria eliminates human error and allows the customer's needs to be met.
By utilizing the eCIBs vast database, the credit score generated can indicate
how well customers can handle their lending obligations. Accuracy of data is
critical in the whole process and as long as this accuracy is maintained, then
faster and more reliable credit risk decisions will be made. Credit scoring can
also be used in the process of pricing for risk with mortgages. This is
something that banks can use to differentiate themselves from their
competitors.
-
Property risk
The quality of the professional valuation is important when calculating the

loan to value ratio. Some lenders will use a yardstick for valuation based on
the lower of cost of purchase or professional valuation. The lower the level of
loan being sought in relation to the value of the property, the lower the risk of
loss to the lender.
The professional valuation should also provide some useful indicators of the
condition of the property as well as any repairs that need to be carried out
immediately or items that may create a need for future maintenance. The
latter may impact on the borrowers ability to meet future mortgage
payments. Surveys fall into two categories:
Mortgage valuation - a brief report normally only containing a valuation
Full survey report which includes a valuation.
A surveyor whose firm is one of a number on a panel approved by the lender

will carry out the survey. Lenders will insist that the survey repor. is
addressed to the bank and not to the customer. The report needs careful
perusal. You would not want to lend if there are structural problems.
The mortgage valuation brings some protection, as long as the surveyor did
not highlight a major defect. It is, however, a very brief report, normally only
providing a value. Whoever instructed the valuation can sue for recovery of
loss, either directly against the surveyor or via the surveyors personal
indemnity insurance. It is believed that, legally, the party instructing the
surveyor can make a claim for a defect discovered subsequently. The quality
of the legal title is important to both the borrower and the lender. It will be the
solicitor's responsibility to confirm precisely what is being purchased in terms
of land areas and if there are any changes documented by the local authority
planning department that may have a detrimental impact on the future value of
the property.
It is also crucial that any conditions or covenants applying to the title to the
property which restrict the borrower are highlighted. The solicitor acting in
the transaction, as well as having a duty of care to the borrower, is required to
ensure that all the lending documentation conforms to the standards agreed by
the lender and that any variation is agreed prior to its execution.
Other factors which come into the assessment of a mortgage application are:
-
Conduct of accounts
Where the applicant is a customer of the bank already, the previous conduct of
the accounts can be checked to see if there is any evidence of unpaid items or
hard-core borrowing and it can also give a reasonable picture of the
applicants ability to budget effectively. If the applicant is not a customer,
references should be sought but, in addition and to provide as much useful
information as possible, most lenders will ask to have sight of the previous
three months bank statements.
Evidence of savings
In many cases this can be obtained from the account statements, but evidence
of savings elsewhere should also be obtained. This information can be used to
confirm the source of any contribution to the purchase price of the property. It
is also important that the lender confirms that the contribution is not being
borrowed from another source or, at the very least, where a proportion of the
funding is being obtained from elsewhere, details are available to the bank in
order that account can be taken of this when the security documentation is
drafted.
The bank will wish to ensure that its position is preserved and no other lender
has a prior claim over the proceeds of the house should the borrower default
on the loan. Any other loan will also require to be serviced and repaid and this
needs to be taken into account in assessing whether or not the applicant can
afford the overall commitment.
Income and expenditure profile
This provides clear evidence of the applicants ability to budget finances on a

month-to-month basis and meet current monthly commitments without
difficulty. It also provides an indication of the amount of funds available to
service the mortgage on a regular basis. The lender is looking for evidence
that a free sum is currently left on a monthly basis.
193
Conduct of previous mortgage or tenancy agreement

If the applicant already has a mortgage elsewhere, the prospective lender
should seek a reference in order to confirm that it was serviced without
difficulty. Where this is a first-time purchase, an indication from a landlord
that rental payments were met on time is a good indicator of the applicants
ability to meet the mortgage payments.
Previous credit history
Has previous borrowing either with the bank which is assessing the mortgage
application, or with another bank or with a finance company, been serviced
and repaid satisfactorily?
Employment and salary
References should be obtained from the current employer who will confirm
the level of salary and any other earnings such as overtime and commission.
Length of time with the current employer will be taken into account when
making a decision and many lenders prefer to see at least a years service
completed.
Discretion and judgment are required to supplement credit policy in these
areas and different lenders will have different approaches. As with any other
area of the credit assessment process, the extent to which a lender is prepared
to exercise discretion in one area will be directly related to the level of
comfort which is being provided under the various headings.
Finally under this heading, your bank will have a policy for dealing with
applications from the self employed. You may want to request previous sets
of accounts, probably for the last three years, in order to obtain some
indication of profitability and thus ability to service the mortgage.
Assessing and deciding
A lot of information is required to assess ability to repay and to see that the risk
is acceptable:
the level of borrowing and loan-to-value

the level of contribution from the applicant and its availability
the term of the loan
the property and its condition (including any restrictions of title)
creditworthiness of the applicant.

All the information requires to be assessed and then a decision taken on whether
or not to grant the loan. It goes without saying that this process is facilitated by a
good, sound knowledge of the applicant. Often the lending banker is likely to find
it easier to assess an application from an existing customer.
High value lending High
net worth customers
Credit scoring or behavioral credit scoring may not entirely arrive at a

satisfactory credit risk assessment for this type of customer as their asset base and
income is higher than for the average bank customer. As a result, while credit
scoring may be used for this type of customer, very often a manual assessment
for lending purposes is required over and above the credit score assessment.
194
Income will probably be a mix of earned income (from employment) and/or

unearned income (from assets owned). Assets owned will include shares,
property or other investments. This fact does not prevent the use of the services
of a eCIB to establish public record data.
The industry sector
Banks service this type of customer in different ways. High net worth customers
will probably have their own relationship manager and, depending on how the
bank organizes its distribution channels, it could be part either of a separate
division within the bank or a separate bank altogether.
This is a sector all on its own, and is segmented into high earning employees and
the seriously wealthy. We will limit our scope to considering the sector as a
whole - the same principles apply.
Financial analysis
Financial information needed on the customer comes primarily from two
pieces of information:
Assets and liabilities - a Statement of Net Worth (tangible assets less
liabilities), with a note of any contingent liabilities.
Income and expenditure - normally stated annually, but it can be aligne to
the frequency of income (monthly or quarterly).
The above financial information will normally be contained in one document.
Your organization will have its own format. The information is obtained from
the present bank file and is updated when carrying out a review of the existing
credit file or from a request for additional support from the customer.
Depending on the customers needs, this could be completed annually.
195
What is important is the:
accuracy of the information

reliability of the information
ability to have the information verified or confirmed from independent
documents. This is particularly relevant for a new customer or if a
substantial uplift in the credit amount is being requested. It should still be
verified at least once a year as ownership and liability values may vary
and income and expenditure levels do fluctuate. Remember, you are
relying on this information to arrive at a sound or safe credit decision for
your bank.
Assets and liabilities

A good place to start is the Statement of Net Worth. Completing this will assist
when assessing the income and expenditure of the customer and aid in
prompting questions at the interview when this area is being discussed. The
Statement of Net Worth is like a balance sheet. It is prudent to include only
tangible assets.
Gross asset values must be used. While net assets may be a short-cut method of
expressing property or asset values less mortgages/loans due, it will give a
false picture of the customers financial health and their net worth. In the
following example we will assume that the customers only asset is their home
and their only creditor their mortgage.
Example
1. Using the net asset method

Assets
Rs
Liabilities
Property
300,000
Less mortgage
200,000
Net worth 100,000 100,000

Net Worth % = Net
Worth/Assets Total is 100%
2. Using the gross asset method

Rs
Liabilities
Assets
Property 300,000
Mortgage 200,000
Net worth 100,000
300,000
300,000
196
Net Worth % = Net Worth/Assets Total is 33%

While both methods arrive at the same figure for net worth (+Rs 100,000), the
net worth percentage in method 1 is 100% and in method 2 is 33%. Thus if
you were assessing the customers stake, the second method provides by far
the most accurate position. Method 1 gives a misleading picture.
The Net Worth % is an indication of the customers stake in a credit risk
proposal. The lower the percentage, this indicates that the customer has little
in the way of personal stake that may be lost if the credit facility goes wrong.
A high percentage indicates that the customer has more to lose personally than
the bank.
Personal loss of other assets can motivate the customer to ensure that the
project succeeds and the borrowing is repaid as agreed. The calculation of net
worth percentage is:
Net Worth divided by Total Tangible Assets = Net Worth %
The corollary of this equation is Liabilities to Total Tangible Assets.
Thus if you look at the above example again, you can see that:
Net Worth % is 33%
Liabilities to Total Tangible Assets is 67%.

A low level of net worth percentage will mean there is a high level of external
liabilities, most of which, for personal customers, will normally be debt.
How to categories assets and liabilities into time periods
Current assets are those assets that can be liquidated without penalty
within 12 months and will be close to or have the ability of conversion
into cash without penalty (short term investments).
Non-current assets (or fixed assets) are held for longer than 12 months or
those that are regarded as long term investments.
Current liabilities are those items that fall due for repayment within 12
months and will include overdrafts (repayable on demand) and the
current portion of any long term loans (e.g. a mortgage) due to be repaid
within the next 12 months.
Non-current liabilities are those classed as being the total portion of a

liability repayable in more than 12 months.
Net worth is the customers stake and is Total Tangible Assets less Total
Liabilities.
197
In this method of assessment:
Current assets have the ability of being converted to cash easily within 12
months and without penalty or a forced sale. A forced sale can result
(because of time restrictions and availability of buyers) in a lower price
being achieved than had originally been estimated. The advertising
timeframe will have been reduced and may not reach all who are normally
active in the market. Buyers may also become aware of the situation and
reduce their bids accordingly.
Current assets divided by current liabilities in effect will give a current

ratio. If it is more than 1.0 times (generally as a basic rule of thumb, 1.5
times could be considered as totally satisfactory) it means that, if current
assets were converted to cash, there is the ability for the customer to
comfortably repay all their current debts due within the next 12 months
from their current assets.
The current ratio is an indicator of whether there is a match or mismatch

between short term debt to long term debt plus net worth. If there is a
mismatch, the customer may wish to consider moving some short term
debt to long term debt. If they had come under short term financial
pressure they would not have to rely entirely on their bank increasing their
overdraft, which could carry with it additional conditions.
Examples Matched long term and short

term debt Mortgage over 20 years
Rs
Assets
Liabilities Current portion of

Cash
10,000
mortga 20,000 Long term portion of mortgag

Quoted
shares
10,000
180,000 Net worth

Property
300,000
20,000
320,000
120,000
The current ratio is 1 times (Cash + shares divided by current portion of

mortgage) that is, the customer has 365 days near-cash assets to cover current
portion of the mortgage repayment.
Mismatched long term and short term debt
Using an overdraft to fund a property which is to be held as a long term
investment
Rs
Assets
Liabilities
Cash
10,000
Overdraft
200,000
Quoted shares 10,000

Property
300,000
320,0
Net worth 120,000

320,000
The current ratio is only 0.10 times (Cash + shares divided by overdraft) or
around 37 days of near-cash assets to cover the overdraft.
Current assets can be refined further into less than 90 days and 90 days to
365 days. This refinement of current assets into < 90 days allows an
assessment to be made of the absolute liquidity of the customers assets
or provides a quick ratio measurement.
Thus current assets less than 90 days, divided by the current liabilities,
gives you a measurement of how easily the customer can cope with
meeting their debts due, not just in the next three months but for the next
year. If this were say, 1.0 times, then you would be very relaxed about the
customers ability to meet a sudden demand from any of their other short
term creditors. This is why it is being described as a measurement of
refined liquidity which we will call absolute liquidity or the quick ratio.
Strong liquidity (a satisfactory current ratio, say 1.0 to 1.5 times) will
generally mean low credit risk and, if maintained when the new
borrowing is agreed, this will be a low credit risk.
Assets and liabilities require to be valued using market values - the value
that would be achieved between a willing buyer and seller.
Property assets
These can be valued using the latest surveyors report and valuation, although
these will not be always up to date, unless the property was purchased
recently. You could seek a verbal desktop valuation from a bank-employed
surveyor. Other methods could be the valuation from an estate agent, and
although this may require to be adjusted slightly as the value will be based on
an expected selling price, it will still give you an approximate figure.
199
A number of websites using details from the Land Registry can give you details
of recent sale prices in a post code area. However, to be effective, you require to
know that the details of your customers property match those quoted in the
Registry. You really need to know the area very well; otherwise you may
compare the selling price of a detached house with a semi-detached house. Some
banks insist on visual inspection by account managers and this can be a useful
opportunity for relationship managers to obtain a better understanding and feel
for their district. The advice of local colleagues in your banks network is often a
valuable source of local knowledge and market conditions.
Other assets
Bank balances can be taken from the latest bank statements.
Currency accounts are valued at the spot rate in the financial press or from
your own banks daily currency circular or advice.
Quoted shares are valued using the prices from the financial press.
Life policy surrender values are per the letter issued by the life company.
These should be updated periodically say, every three or five years.
Remember that they will exclude any terminal bonuses which only become
known when the policy matures. Motor vehicles can be valued using the
internet.
Shares in unquoted companies are normally valued by using the latest set of
audited accounts (total shareholders equity divided by number of shares
issued) or by the customers accountant where no balance sheet is available.
Trusts set up in your customers favour can provide either an income stream
and/or eventual ownership of particular assets when a specific event takes
place, such as achieving a particular age, death of a parent or other relative.
You really need to see the trust deed to understand the stability of the income
or the terms of asset ownership. Do not confuse this with trusts created by a
customer. Although they may be trustees and can influence distributions to
the beneficiaries (who will not normally be themselves, otherwise there are
tax issues) ownership of the assets has been vested in the trust itself.
- Specialized assets
Specialized assets, require a great deal of professional judgment to be
exercised. A lot of care is required when depending on these values,
especially where they represent say, more than 10% of total assets. This 10%
rule of thumb can be applied to any asset when assessing values.
The assets will often be family heirlooms, paintings, ceramics, gold or silver
plate, antique furniture, bloodstock, etc, and you should seek independent
professional advice when relying on these values. While insurance values
may be a useful rule of thumb measurement, they will be approximately up to
50% higher than the value achieved at an auction where there is a willing
buyer and seller. In forced sale or adverse market conditions (say due to a
recession) the values achieved can fall dramatically.
Liabilities should be valued at the amount outstanding at the date of the

Statement of Net Worth. In cases of substantial fixed rate lending (say where the
debt represents more than 50% of the asset value of the assets it funds, or 50% of
the total interest-bearing debt), the amount used would be the amount that would
require to be repaid to clear off the borrowing. This should include early
repayment fees/breakage costs/ other charges levied by the lender.
Contingents
An intangible asset or contingent asset for a personal customer could be a
legacy due from the estate of someone who is still alive. In this example of a
will, it is contingent on the customer relying on:
the testator not changing their wishes, and
the beneficiary not predeceasing the testator.
There is quite a degree of uncertainty here and the bequest may not actually come
into the customers possession.
Intangible liabilities or contingent liabilities are the most common type of
contingents you will come across. Contingent liabilities arise where there is some
sort of potential legal liability due, for example as the result of granting a
guarantee for a third partys debt. Perhaps the customer is being sued in court for
a debt or other obligation due. You will also need to assess the liabilities that
could potentially arise where your customer is a sole trader or a partner in a
general partnership.
In both cases, contingents are not included as values under assets or liabilities
within the Statement of Net Worth, but they still require to be assessed as how
likely they are to occur. If they crystallize, the liability becomes real.
In summary, when analyzing the Statement of Net Worth, you should:
establish the assets and liabilities of the customer
confirm their accuracy in both value and ownership

assess the liquidity risk - the current ratio and quick ration (absolute
liquidity)
assess appropriateness of debt structure (is there sufficient balance

between short term and long term funding?)
assess the gearing of the customer - low gearing will generally indicate a
low risk, but watch for the impact on your analysis of any new debt and
assets purchased
assess the likelihood of contingents crystallizing.

Income and expenditure
Once completed, the Statement of Assets and Liabilities is a useful prompt
for further questions. For example:
Property asset details will allow you to establish income streams from
rented properties and allow you to check on the servicing costs to ensure
that they are included in the customers expenses.
Income from rented properties should be net of estate agents or letting
agents fees and tax.
You will be able to establish if the customer is allowing for rental voids
201
during the year; this is important where property is not let out on a long
term basis. If it is rented on a month-by-month basis, it may not be
prudent to expect the property to be let for a full twelve month period as
there will be times when the property will be empty, awaiting the arrival
of a new tenant. It is useful to establish the current rental amount for each
property, when the lease expires and how your customer establishes their
tenants financial reliability. From this you can assess rental voids and
assess income stability risks.
Where the share or stock holdings are large, income from the dividends of
investments can contribute substantially to a high net worth individuals
income. If this is 10% or more of earned income, it should be detailed
carefully and analyzed. Remember that dividends on ordinary shares will
be dependant on the underlying profitability of the company (dividends
are normally paid twice a year) and can fluctuate year on year. Be careful
when analyzing historical dividends that the analysis does not include
one-off or special dividends.
All of this will allow you to establish if there are any assets free of
mortgages which could be available as security if you feel it is needed.
The pricing of any competitors finance revealed in the Statement of Net

Worth can be estimated to assist you with gaining new business. A simple
way of doing this is by taking the annual interest costs for the year to date
from the Statement of Income and Expenditure and dividing this by the
average principal amount of debt in the Statement of Assets and
Liabilities.
Expiry of credit facilities of your bank or another competitor can alert you
to an imminent and potential new borrowing need of your customer,
especially where there is a need to replace assets such as cars, motor
homes, boats, etc.
Remember that income can be earned or unearned:
earned income is from employment

unearned income is from investments.
It is best if the customer supplies the information. You can verify net income
levels from the operative account via mandated salaries. You should establish
major items of other unearned income such as investment income.
202
Generally as a rule of thumb you should ignore small items of income (say the
dividend income on quoted shares) unless these exceed 10% of total earned
income.
Expenditure needs to be accurate and you will need to gather information
regarding:
mortgage and all loan commitments
tax and other statutory payments for utilities on all properties.
the exact living costs of the customer. Although you can obtain
information during the interview on how much they spend on food,
entertainment, travel etc, this may be seen as being invasive and you may
not enhance the relationship as a result of detailed questioning. It may be
simpler and quicker to establish this as a percentage of their net income generally a figure of 30% can be sufficient to cover living expenses.
You may discover that when the living expenses percentage is applied and you
establish the surplus of total net income, less total expenditure, that this figure is
not reflected in the operation of the bank account.
For example, if the surplus you calculate is equivalent to Rs. 100,000 per month,
but the overdraft is increasing at a rate of Rs. 100,000 per month, a reconciliation
of the Rs, 200,000 variance should be accounted for. You may have missed
something, or the customer may be spending more than 30% of their net income
on food, entertainment, etc. If you do not establish this now, there will be
potential for the overdraft limit to be exceeded part of the way through the next
12 months.
The surplus you calculate needs to have an approximate relationship with reality.
Again a variance of less than 10% is acceptable. For example, the surplus you
calculate is Rs. 900,000 and the customers current account on average during
the year increases (including transfers to savings accounts) by Rs. 800,000, then
this is more or less within 10% and can be accepted.
The surplus is an indicator of ability to:
take on more debt, assuming the asset being purchased is non-earning, or

maintain the margin by which they can continue to meet existing debt
payments to your and other banks.
Credit risk analysis
For these personal customers a mnemonic like the 5 Ps of credit may help:
Person
Purpose
Payment
Person
Protection
Premium
This is primarily about the trustworthiness of your customer. Banking i

based on trust. If your high net worth customer is unreliable in this ] stop
your analysis at this point and do not commit to lending. It she be unusual
Lending: Products, Operations and Risk Management to
| Reference
205
have toBook
do 1this.
The customers risk strategy requires to be reviewed. Does the credit: at the
macro and overall levels appear logical, reasonable and make i If it does,
continue with the assessment; if not, pause and reappraise i not, and be fully
reassured before continuing with the risk asses
Does the customers profile fit with your own bank's strategic and mark
objectives?
You will wish to review age (is customer nearing retirement?) or do 1 have
a young family which may explain the lack of elasticity in the! of income
less expenditure? No two customers are the same and personal
circumstances require to be taken into account in any ana
- What industry sector is the customer employed in? Is it stable or vulne to
economic downturns?
What is the net worth surplus percentage? Do they have high or gearing or
leverage?
Purpose
The legal and regulatory risks require to be assessed.

Is the purpose for which the credit facilities are being granted legal, within
your banks credit policy?
Regarding legal risk, you need to ensure that the documentation for 1 credit
facilities and for any security provides a legal and binding cont
What precisely are you funding? If you are unsure, you must find to be
certain that the purpose is legal and within your banks pol
Is the borrowing properly structured? Funding long term invest property on
overdraft is not in the customers or the banks best inter For example, with
finance for rental property it is difficult to see whe the agreed reductions are
being made when the overdraft also cc lending for other purposes.
Is there a logical fit between the purpose for which the asset is financed
(investment property) and the source of repayment (which sh be rental
income)? For example, you may be asked to fund a rei property and are
granted security over it, but the loan repayment offered is solely from
dividend income. This is illogical - why are you not being offered the rental
income from the property? If you are being offereai both rental and
investment income, then accept it provided there is a sufficient margin
between income and debt costs.
You may be asked to grant facilities for what appears to be a long term
investment, but the repayment is from a short term asset repayment source;
for example, a bridging loan where the new property being purchased before
the sale proceeds of the existing property are received. In these circumstances
a short term facility is appropriate.
At other times you may be asked to extend facilities for some expense (a
holiday, Eid, etc) and repayment is to come from a maturing life policy six
months later. This is acceptable on the basis that the proceeds of the life policy
cover both the principal and the roll up of interest. If you hold the life policy and
the life companys cheque is sent direct to your bank this will reduce the risk of
payment being delayed.
Another common short term repayment source could be a regular annual bonus.
However, care and discretion needs to be exercised as this can vary substantially
from year to year and the actual sum payable will not be known until shortly
before payment. In these circumstances, an appropriate percentage could be
advanced; for example, depending on the track record of the customer, from
25% to 50% of the historical bonus sum. However, you need to be satisfied that
if a lower bonus is received that the customer can repay the shortfall within a
reasonable period.
Suppose you grant facilities and the customer accepts that they will need to
dispose of assets to repay you if debt reduction proves difficult from income.
Here you will want to document the agreement fully and have your facility
acknowledged before the borrowing is taken.
Use separate loan accounts where the lending is for a specific purpose. This
makes it easier to monitor the repayments.
Payment
A major part of credit risk assessment is making sure that the interest cost can
be met and repayments made as arranged.
Having the income to repay you mandated to the bank is a comfort.
The primary source for servicing the borrowing and meeting loan payments is
usually from the surplus of income over expenditure. You will need to make
sure there is enough surplus income and take into account:
The impact on any increases in new debt

Financing a new asset (like a holiday home) will bring increased running
and maintenance costs
Owning the asset may provide some income; if the asset is quoted shares
there will be dividend income, or if rental property, there will be rental
income.
Conditions can be put in the loan agreement to make sure that, for example,
investment income streams repay the debt.
205
Protection
This comes initially from the income and assets of the customer. If do not
repay you, then you may need to resort to the security held The risk can be mitigated by setting formal triggers (covenants,
agreements) in the loan documentation.
If you are financing a portfolio of investments, you may decide you debt to
market value ratio of no less than 75%. This is akin to the 1 value stipulation
in mortgage lending. Any rise in the ratio will alter risk/reward equation and
bring about a renegotiation.
Have you satisfactorily covered the external market risks? Fixed or rate
borrowing can help mitigate exposure to increases in interest Where a
substantial proportion of income or expenses is in a f_ currency, does the
customer require a foreign currency account foreign exchange contract
credit line?
Insurance is used to mitigate an unforeseen event and the aim is to the
customer personally and their assets:
life cover and/or critical health insurance, etc assist with repa or
servicing if an unexpected crisis occurs
any asset held as security or which is owned by the customer m
adequately insured for fire, theft or loss.
Have arrangements been made to regularly review the facilities their
lifetime to meet audit risk requirements? There is no point in reactive to
situations - you need to monitor the facilities and an^ problems before
they happen.
Lending is not just a matter of writing up a credit facility and leaving it. need
to check regularly during the year that an overdraft facility is building up to
hard core or permanent debt. Remember that ove should normally swing into
credit from time to time, otherwise you non-amortizing loan.
Are insurance policies still in place, adequate to cover the assets, and
premiums been paid?
Premium
What is the credit risk/reward ratio? Are you charging sufficient in' to
cover the credit risk your bank is being asked to take?
Your bank may have a pricing model that will assist you in estab the
hurdle interest rate and arrangement fee to be charged for the
You will recall that a bank must manage its return on capital em to ensure
that adequate returns are made to meet its costs and p the returns
shareholders expect.
Any additional income should be taken into account when valuing the overall
connection with the customer. But the value of the connection should not be
used as a substitute for proper assessment of the credit risk.
In summary, the 5 Ps of credit are:
1. Person - strategy risk

2. Purpose - legal and regulatory risk
3. Payment - credit risk
4. Protection - insurance and investment risk and audit risk
5. Premium - asset and liability risk and market risk
Adapted from:
Institute.
207
Business Lending - When Things Go Wrong

introduction
In every lending proposal there is an element of risk. The degree of risk must be
carefully evaluated when the proposal is being considered and ultimately the risk
must be related to the remuneration (or reward) which the bank obtains.
However, in recognising that an element of risk is present, we must also accept
that things can sometimes go wrong and it is on this aspect of lending that we
will now focus our attention.
If the proposals have been properly analysed, and a fair decision made based on
known facts at the time, it would be unfair to level criticism at the lender.
Criticism would be justified, however, if warning signs had been evident and
little or no notice had been taken of them. The control of lending begins as soon
as a proposal is reviewed. There will also be occasions when borrowing is
declined because you are not satisfied that it meets the banks lending criteria.
When this happens, you are looking after your customers interests by not
lending money they are unable to repay. You are also protecting the banks
position.
In certain situations, a lending banker might feel that they have contributed to the
problem and in due course may well have to admit that their judgement has been
wrong. Once warning bells have begun to sound, it is essential that you instigate
remedial action which may well involve seeking guidance or instruction from
senior colleagues. It is absolutely wrong to just leave the problem and hope that
it will get better and the customer will work through the difficulties.
Types of Problems
The types of problems which may occur are many and varied. Here are some of
them:
An event which is unexpected and in many cases unavoidable; for

example the sudden death of the companys managing director or the
principal force within the organisation.
An event caused by the customer which might have been avoided if the
lender had been kept fully informed; for example, the customer with an
overdraft limit of Rs. 50,000 and an overdrawn balance of Rs. 49,250,
whose cheque for Rs.
15,0
in favour of HM Revenue and Customs is presented to you for
payment.
An event brought about by human error; for example a lender is forced
to realise a security when a customer defaults and then discovers that the
documents were wrongly prepared when the security was taken at the
outset.
You will be able to identify for yourself other types of problems which may
occur.
Warning signs
Once an advance has been approved and taken by the customer, the banker must
remain on guard to ensure that everything goes according to plan
208
with the conduct of the account and the orderly repayment of the borrowing.
This process comes under the heading of control of advances.. You will already
appreciate that the monitoring of accounts is crucial to effective control and that
the lending banker, or the advances team providing support, must allocate the
required amount of time to this task. This monitoring includes the following
checks:
if budgets/forecasts or cash flow projections have been supplied, these
must be checked regularly against what is actually happening and
explanations sought for variances which are other than minor
an ongoing daily awareness/review where a borrowing limit is
under strain or is regularly exceeded.
These are only two of the warning signs which are easily recognisable, but there
are many others and we will now look at some of these. We are going to list
some of the danger signs which might indicate that a customer is experiencing
problems. Taken individually, there might be little cause for concern but, where
a number of factors are evident, you should be on guard.
Internal bank records
Warning signs may be spotted from bank accounts, cheques issued,

direct debits, standing orders, correspondence, etc, such as:
the customer attempts to take unauthorised excess borrowing
the customer unexpectedly requests extra borrowing
the level of turnover (lodgements) through the account is falling
evidence of hard core borrowing is emerging - this can easily be seen
from the maximum/minimum (or account coursing) review, illustrating
the past years high, low and average balances on a month-by-month
basis
the customers cheques are having to be returned unpaid
cheques which are lodged by the customer are subsequently returned
unpaid
cheques for round amounts are being issued by the customer - the regular
issue of cheques for round amounts might suggest that the customer is
unable to fully settle bills to creditors and is making payments on account
to appease them
the customer regularly issues cheques against unclear effects
cheques issued by the customer are being presented specially for
payment
the customer regularly asks for cheques received to be specially
presented
numerous status enquiries (opinion requests) are received
concerning the customer
the customer hands to the bank a standing order in favour of finance

company
cheques originally lodged by the customer are returned paym
stopped
the customer makes regular significant withdrawals in cash
rumors regarding the financial standing/stability of the customer.
Interviews/visits to customers
The message remains consistent - listen, look and visit. A great deal, can be
gleaned from asking the right questions during meetings with customers and
by listening to what the customer has, or has not, to say. When all is not
well, a visit to your customers business premises will provide some first
hand knowledge of warning signs such as:
staff industry levels/attitudes
state of repair/age of buildings and machinery
machinery not being used to capacity or evidence that it is being sold
off
obsolete stock or overstocking, etc.
How have things changed since you were last there? What you might be looking
for could be:
heavy reliance is being placed by the business on one customer or

supplier
the business makes sudden changes into other areas of trade
income from sales is not being received as expected
requests for release of security, particularly guarantees, are received
assets are not being fully employed or stock is not being turned over
the business is under pressure from creditors
changes in the management team
no attention is being paid to management succession
the management team is not working together
the management is not reacting to changed circumstances.
If you have found it difficult to arrange an interview or visit, this may just be
because the customer is very busy at the time; but it may also indicate that they
are trying for some reason to avoid seeing you.
Financial information
We have already learned the importance of financial information and. its

analysis whenever we are assessing lending propositions. This assessment
includes a trend analysis of year-on-year performance and a comparison
with other businesses in the same sector. Along with the results of your
analysis, the identification of the following may give you cause for concern
and merit further investigation:
210
other borrowings may be revealed

the figures in the audited accounts may be markedly different from
those in the management accounts operating losses may be evident
production of financial information and accounts is late

a change of auditor or an unusually high audit fee
the auditors statement accompanying the accounts is qualified
management accounts are sketchy or non-existent
the business may be losing valued customers.
Additional lending
As you might expect, the first reaction of many borrowers if they experience
financial difficulties is to approach the lender with a request for additional
finance. Reiterating earlier comments, unless viability can be established, it is
important that we dont make the situation worse by assisting the customer to
dig an even deeper financial hole out of which they will find it impossible to
climb.
Example
Consider the following scenario:

My company is in difficulty. If the bank were to increase the borrowing facility
by a modest 15% then this would allow us to clear some of the pressing
creditors, supplies of raw materials would be resumed and all will be well.
Increasing the credit line available may be the correct solution but, on the other
hand, it may simply have the effect of adding 15% to the amount of bad debt
which the bank will ultimately have to face. Remember, it is from profitable
trading that the cash flow comes to repay the loans. Where a business is
prospering, with turnover and profit rising at a satisfactory rate, it may well be
entirely reasonable for borrowing to increase - possibly to match a growing
working capital requirement. However, if an enterprise is clearly suffering
financial difficulties, you will have to consider the possibility that this course of
action may simply postpone the day when more drastic decisions have to be
made, possibly at great cost to the borrower and the lender.
In other words, the bank does not want to be in the position of throwing good
money after bad. Ultimately, when you are considering whether or not it would
be prudent to increase a customers borrowing, you should revert to considering
the principles of lending.
Remedial action by the customer
Although many reasons can be put forward for businesses running into
difficulties, the main cause is usually a shortage of cash. If cash is not flowing
through the business at an acceptable rate, then the orderly operation of its
affairs becomes more and more difficult. Lack of profit is serious, lack of cash is
deadly! The reason for lack of cash can often be that certain assets are not being
fully utilised and when difficulties occur you need to see what improvements can
be made.
211
Stock
Stock is probably the first area to be examined. Stock lying for too long on the
shelf cannot improve cash flow. Amongst other things, consideration should be
given to:
reducing prices in order to sell off dead or obsolete stock
cutting down on reordering

concentrating on fewer items which are known to be saleable
considering alternative suppliers

just-in-time delivery (JIT).
Debtors
\
Are debtors being collected strictly in accordance with agreed terms and is a
review of these terms justified? You should examine an aged list to determine
the extent of the problem.
Are invoices being issued promptly? Factoring of debts might be considered as a
realistic option, although this will reduce the value of the banks security if you
are relying on a floating charge.
Creditors
In most cases you will find that this is a pressure point with suppliers pressing
for payment. However, you may find instances where the problems are not too
severe; where the cash flow difficulties are attributable to creditors being paid
prematurely and your customer is not taking full advantage of the terms available
to them. Equally they should ensure that they obtain any discounts that reflect
the prompt payment. Where the problems are more severe, can they renegotiate
their terms?
Other assets
The customer should also consider whether any assets are surplus to
requirements and could be sold. Sale and lease back of property is one possibility
and, for the future, the customer might consider leasing rather than purchasing
assets. You will need to consider whether this remedy would impair the value of
your security.
Other areas for review
These will include:

Staff costs - cutback through say, a reduction in working hours or a
recruitment embargo. If more immediate action is required it may
involve a reduction in the number of employees or redundancies
Capital expenditure - can planned expenditure be postponed or
altered?
Finally, going back to the first principle of lending (people character vnl the
directors or owners of the business be willing to take hard decisions about the
future running of the enterprise? They may well find it difncuit to dispense with
the services of long-serving employees. The enterprise may be a close family
business and they may resist change.
Firms of investigating accountants are increasingly being used to assist bank
customers who are experiencing difficulties and this course of action may well
212
have to be considered. The acceptance and cooperation of the customer is

essential. Resistance is sometimes encountered, not least because the
accountants fees are payable by the customer, not the bank. Investigating
accountants prefer to be consulted earlier rather than later, when the position may
well be beyond the point of no return.
Adapted from:
Institute.
213
Collateral and Documentation
Part four
Student
Outcomes
Learning
1. Different types of financing agreements

Recall different types of financing agreements ava" in
the industry
2. Types of collaterals
Describe different types of collaterals being used in
wide with respect to consumer and business lending
Describe various attributes of a collateral and explain of
enforcement, realization and marketability with re the type
of collateral
Differentiate between the pledge of paper securities and
of goods
Define 'hypothecation' and identify instances where
form of collateral is used
Explain how 'assignment of receivables' is used as coll
and recall instances where this form is used
Explain the use of 'mortgage of immovable assets' as
col and state its application
Explain stated and implied lien over customers assets
Explain the concept of charge, its types and ranking
Define 'guarantee' and provide examples of their use
3. Types of collateral documentation
Recall different types of collateral agreements

Differentiate amongst a hypothecation, mortgage, lien,
fl charge and a pledge agreement
4. Safe-keeping of borrower/customer documentation

Explain in-house safe keeping arrangements and explain
modus operandi
Explain the ex-house safe keeping arrangements and t!
modus operandi
214
Write the arrangements for storage of documents

* Explain the system of recording used for document storage
State the procedures to be followed for depositing and
retrieving documents and discuss the precautions that must be
exercised in the process
Recall SBP's guidelines concerning the handling of lending
documents
5. Bank's risk under various types of collateral

Explain the risks faced by banks when various types of
collaterals are used
Recall strategies adopted by banks and regulatory bodies to
mitigate this risk
Discuss the impact of a poorly managed collateral
6. Monitoring of charge/margin
Define the term Muccudum and describe its role
Describe the conditions and methodology used for appointment
and rotation of a Muccudum
State the obligations of the custodial services under the
monitoring arrangement
Explain the monitoring methodology of immovable assets and
that of stock reports and valuation
Differentiate between monitoring methodology of guarantees
and that of insurance policies
Explain the monitoring of guarantees in terms of issuer's status,
validity and conditions for claims
Explain the monitoring of insurance policies in terms of issuer's
status, validity and conditions for claims
Discuss the concept of a search report for charge monitoring
Describe the parameters and discuss the importance of a proper
and credible source for monitoring prices of financial assets and
collateral
215
ADVANCES
List of Demand Finance Covered Under This Write-Up.
1- Advance against Fixed/ short term/ deposit receipts issued

scheduled Bank (Local/Foreign Currency).
2- Advances against PLS saving /Current Accounts blocked / for
operation for operation of the amount pledged.
3- Advances against Share Certificates.
4- Advances against Government Securities DSCs, NIT Units, etc.
5- Advances against Pledge / hypothecation of Goods.
6- Advances against Regd. / Equitable Mortgage of Property,
Building.
7- Advances against Imported Merchandise (FIM).
8- Advances against Import LC PAD (forced)
9- Advances against Finance trust receipt (FATR).
10- Advances against Export refinance part I, part II
11- Advances against Machinery and equipment
12- Advances against Collateral Securities - General
List of Documents (All Consumer Finances)
S. No
1
2
3
4
5
6
7
8
9
10
11
12
13
List of Standard Documents (Personal Loans).

1- List of Standard Documents (Personal Loan).
2- List of Standard Documents (Auto Loan).
3- List of Standard Documents (Credit Card).
List of Standard Documents (Personal Loans) List of
Documents
Loan Application Form (LAF) with Credit Approval

Finance Legal Agreement
Copy of CNIC with Orignal Seen
CIU Approval Checklist
Deviation Sheet (if any)
Indeminity form in case of Salary transfer
Bank Statement
ECIB/Data Check / Verisys
Verfication Reports / RCE Recommendation
Customer's Employment Certificate
Customer Salary Slip
DBR Sheet
Letter of Awareness, Letter from Employer & Undertaking
Lending: Products, Operations and Risk Management | Ref
S. No List of Standard Documents (Auto Loans) List of Documents
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
Loan Application Form

Copy of CNIC with orignal seen
Two recent passport size photographs
Lastest salary slip or orignal attested lastest salary certificate
or attested Letter from Employer
Three or six months bank statements with reflecting salary
credited as per respective constitution
Proof of proprietorship / bank letter / pamership / directorship
verfied
NTN Certificate / Bank Certificate / Rent Agreement / MOA
Form 29 attached to verify length of SEB/SEP
DDA instruction attached in file (mandatory for liability and
legacy constitution
Verfication reports
ECIB/ Data Check / NADRA Verisys
Aggregate DBR Sheet
Legal Finance Agreement
Copv of Purchase Order
Copy of Pay order
Copy of Sale Invoice
Copv of Sale Certificate
Valid Insurance Cover Note
PSO
Copy of Registration Book
Delivery Order
Copv of Authority to Drive letter
Excise File
Running Page
218
List of Standard Documents (Credit Cards)

S. No
1
2
3
4
5
6
7
8
9
10
11
List of Documents
Application Form
Copy of CNIC with orginal seen
Salary Slip/ Salary Certificate / Employer Letter / Income
Documents
Bank Statement
Bank Statement (External)
Proprietorship Certificate Copy or orignal
Registered Partnership Deed copy
Registered Memorandum & Article of Association with la^
issued Form 29 A Copy
Professional Degree Copy
All verfication reports
ECIB / Data Check / NADRA Verisys
Cash / Finance Against Pledge of: Shares (Marketable Securities)
DESCRIPTION
STATUS
REMARKS
YES
NO
Documentation Requirements
1- Limit sanctions advice approved by

appropriate level of credit authority
of Head Office, Region, Zone, and
Chief Manager.
2- Officer Incharge Advances
confirmation in writing for receipt
of all charge / legal documents
received before disbursement of the
facility such as:a)
DP Note IB-1 stamped and
signed.
b)
NIB document duly signed
with adhesive stamps i.e. IB-31
agreement for sale and buy back
of marketable securities.
c)
IB-28 Letter of Lien
on marketable securities.
d)
IB-29 Letter of Letter of Guarantee.
e)
Mark up Agreement.
f)
Borrower's request for grant of
facility.
g)
Share Certificates of listed
companies transfer deeds signed
by registered holder of shares
and signatures verified by Co.
h)
Securities counted / verified and
kept in safe-custody
i)
Transfer deeds to be kept in
safe-custody separately
j)
Letter from the company for
having registered banks lien on
the shares.
PROCESS CHECK LIST
Advances Against Imported Merchandise (FIM) Sanctioned.
Note: These procedures depend on internal bank policies and many differ
from bank to bank. Automation of many processes may have also
effected the work flows.
220
Lending: Products, Operations and Risk Management |
PROCESS
CHECK LIST
DESCRIPTION
STATU
S
DRAFT
YES NO
Facility to be provided on
Pledged Basis (preferably)
Hypothecation Basis
Landed cost to include invoice value.
freight, custom & taxes, etc.
Customer's request for grant of facility against

merchandise imported under the L/C
Promissory note (IB-12) duov stamped and signed
> NIB forms noted below:-
IB-6 Buy Back Agreement

IB-22 Mortgage Deed
IB-24 Memorandum of Deposit of Title Deed
IB-25 A Letter of Hypothecation
IB-26 Letter of Pledge
IB-29 Letter of Guarantee
Letter of Arrangement/Disbursement/Instalment
CIB Report in case facility exceed Rs.0.500 Million
PROCESS CHECK LIST
Advances Against Imported Merchandise (FIM)

Forced.
DESCRIPTION
When import documents are not retired promptly anc

PAD lodged remain unsettled within reasonable time
FORCED FIM concept is practiced to ensure that :Goods are cleared and do not incur demurrage.
Bank's approved clearing agent used for clearance
Consignment after clearance stored in bank's
Godown and duly insured.
Delivery of consignment only against payment.
landed cost + Freight + Custom + Taxes +
Insurance + Godown rent + Clearance charges +
Octroi + handling charges.
STATU
S
nur
Customer's request for grant of facility against

merchandise imported under the L/C.
Promissory note (IB-12) duoy stamped and signed.
IB-6 Buy Back Agreement.

IB-22 Mortgage Deed.
IB-24 Memorandum of Deposit of title deed
IB-25 A Letter of Hypothecation.
IB-26 Letter of Pledge.
IB-29 Letter of Guarantee.
Letter of Arrangement/Disbursement/Instalment.
CIB Report in case facility exceeds Rs.0.500 Million
c.ng: Products,
Operations and Risk
Management |
Reference Book 1
221
PROCESS
CHECKAgainst
LIST Collateral Securities
Loans
- (Advances)
DESCRIPTION
STATUS
Advances Against Imported
Merchandise (FIM) Sanctioned.
Documentation Required.
*
*
*
a)
b)
c)
d)
YES
NO REMARKS
Promissory Note-IB 12 duly stamped and signed.

Customer's request for grant of facility.
NIB forms as applicable in accordance with the
nature of facility with adhesive stamps.
Irrecoverable letter of lien/pledge of securities,
agreement etc.
Following documents required in case of advances
made to a limited company. Certified copies of
Memorandum of Article & Association.
Certificate of Incorporation.
Certificate of Commencement of business (Not re
quired for Pvt. Co).
Bio data of management.
e)
Board Resolution authorizing management to

obtain loan.
f>
Where IB-6 (Buy Back Agreement) obtained, stock

report must be received.
PROCESS CHECK LIST
DRAFT
Advances Against Fixed / Call / Short Term Deposit Receipts

DESCRIPTION
STATUS
*
*
*
*
*
*
YES
NO

Deposit receipt duly discharged.
NIB forms IB-6,6-A, 6B or 6C, 25A, with adhesive
stamps, signed by customers.
Irrecoverable letter of lien/pledge of deposit
agreement.
CIB report in case facility exceed Rs.0.500 million.
PROCESS CHECK LIST
DRAFT
Advances Against Government Securities - DSCs, FEBCs fir NIT Units.

DESCRIPTION
STATUS
YES
*
*
*
*
222
REMARKS
*
*

NDSCs, NDCs, FEBCs duly discharged.
NIB forms IB-6,6-A, 6B or 6C, 25A, with adhesive
stamps, signed by customers.
Irrecoverable letter of lien/pledse of deposit asreeme
Letters of arrangement / disbursement / instalment.
CIB report in case facility exceeds Rs.0.500 million.
it.
Lending: Products, Operations and Risk Management |
NO
REMARKS
PROCESS CHECK LIST
DESCRIPTION
Advances Against Trust Receipts (FTR).

Documentation Requires
STATUS
YES
DRAFT
REMARKS
NO
> Customers request for grant of facility

> Promissory Note-IB 12 duly stamped and signed
IB-6 Buy Back Agreement.

IB-24 Memorandum of Deposit of Title Deed.
IB-25A Letter of Hypothecation.
IB-26 Letter of Pledge.
IB-29 Letter of Guarantee.
*
Letter of Arrangement/Disbursement/Instalment.
*
*
CIB Report in case facility exceeds Rs.0.500 Million

Insurance Policy for Fire, Theft with bank mortgagf
clause.
PROCESS CHECK LIST DRAFT Advances Against Demand Finance
Land fir Building.

DESCRIPTION
STATUS
YES
REMARK*
NO
**Finance made as registered/equitable mortgage

of land/building (Constructed OR to be constructed.)
*
*
*
*
*
*
*
*
*
*
*
*
*
223

Promissory Note-IB 12
IB-21/A Agreement for Financing on Mark up basis
for
purchasing / construction of building (house / flat)
IB-24 Memorandum of Deposit of title deed for
equitable mortgage.
IB-29 Letter of Guarantee (from partners/directors of
Company).
Sale deed/lease deed/sale agreement (title deed and
documents related to properly).
Non Encumbrance (Search) Certificate from district
and registration department.
Approved Building Plan (site plan) permission to
construct.
Incase building already constructed completion
certificate/ownership certificate issued by appropriate
authority (i-e. LDA/KDA/IDA)
Permission to mortgage existing in the (Sale/Lease
deed).
Extract from record of right showing mutation in
respect of the property.
Vauation report from approved surveyoi/bank's
engineer.
Copy
of property tax/wealth tax as applicable.
Letter of lien (if required).
Legal opinion, vetting by bank's legal counsel.
CNIC / Tax Number.
CIB positive Report for loans exceeding
Rs.0.500 Million.
Irrevocable undertaking from borrowers to maintain
possession/occupancy status of the property during
the tenor of loan.
PROCESS CHECK LIST

Advances Against DESCRIPTION
Hypothecation of Goods.
DRAFT
STATUS
YES
REMARKS
NO
* Customer's request for grant of facility.

* Promissory Note IB-12.
> NIB forms noted below with appropriate adhesive
Stamps.
* IB-25 A Letter of Hypothecation.

* IB-26 Letter of Pledge.
* IB-29 Letter of Guarantee.
* Irrecoverable letter of hen.
* Agreement for financing on Mark up basis IB-6
* NOC from other banks holding charge on stocks
offered
for hypothecation if applicable.
* Insurance Policy from approved company covering
stocks under hypothecation with fire risks. Loss due to
theft, and bank mortgage/pledge/hypothecation clause,
alongwith premium paid receipt.
* In case of limited company
* Certified Memorandum of Article of Association.
* Certificate of Incorporation.
* Commencement of business (not required from
Private Limited Company).
* Board of Directors resolution authorizing to obtain
loan from the bank.
* An undertaking from directors committing to obtain
prior clearance from the bank before declaring an)
dividend (if part of the loan covenant).
* Letter of Guarantee from Directors.
* Letter of Partnership and personal guarantee
executed by all partners in case of Partnership
concern.
* Letters of arrangement, disbursement.
* Latest stock report indicating item quantity, quality,
rate and signed by borrowers.
* Favourable CIB report obtained.
224
PROCESS CHECK LIST
DRAFT
Advances Against Pledge of Goods.

DESCRIPTION
* Customer's request for grant of facility.

> IB forms noted below with appropriate adhesive
Stamps.

* Irrecoverable Letter of Lien.
* Agreement for financing on Mark up basis IB-6
* NOC from other banks holding charge on stocks
offered
for hypothecation if applicable.
* Insurance Policy from approved company covering
stocks under pledge with fire risks. Loss due to
theft, and bank mortgage/pledge/hypothecation clause,
alongwith premium paid receipt obtained.
* In case of limited company :* Certified Memorandum of Article of Association.
* Certificate of Incorporation.
* Commencement of business (not required from
Private Limited Company).
* Board of Directors resolution authorizing to obtain
loan from the bank.
* An undertaking from directors committing to obtain
prior clearance from the bank before declaring an>
dividend in case of public limited company.
* Letter of Guarantee from Directors.
* Letter of Partnership and personal guarantee
executed by all partners in case of Partnership
concern.
* Letters of arrangement, disbursement.
* Latest stock report indicating item quantity, quality,
rate duly signed by borrowers.
Lending: Products, Operations and Risk Management | Reference I
STATUS
YES
NO REMARKS
DRAFT
PROCESS CHECK LIST

Advances Against Machinery fir Equipments..
DESCRIPTION
STATUS
YES
NO REMARKS

> IB forms noted below:
* IB-6 Buy Back Agreement.

* IB-25 A Letter of Hypothecation.
* IB-22 Mortgage Deed.
*
IB-24 Memorandum of Deposit of title deed (For Eq.
motgage).
* Marketable Securities IB-31.
* Letter of lien IB-28.
* Title deed and Documents related to property.
*
Non Encumbrance Certificate.

*
Approved building plan & Lay out of the industrial
unit.
* Permission for construction or completion Certificate.
* Permission to mortgage land/building.
*
Extract from record of right showing mutation in

respect
of property offered.
* CNICs of Directors.
* Legal opinion.
*
*
*
*
*
*
Vauation report from bank's Mechanical engineer/

reputable surveyors.
List of machinery and its present book value based on
original invoices/import documents showing.
Brand/Model/Year/Warranty Period.
Market price. Three quotations for similar
machinery.
Evidence of ownership & Certificate
of non
Encumbrance.
Government permission for establishment of industrial
unit and location et from
Promotion Bureau for (Provincial/Federal/Investment
industries).
* NOC from other banks and their

acceptance of Bank for :* First Charge.
* Second Charge.
* Pari Passu Charge.
*
Charges registered with the Registrar Joint Stock
Companies.
* Positive report from CIB.
LIMITATION FOR REGISTRATION OF CHARGE
* In case of limited company, charge on property to be
registered with Registrar Joint Stock Companies
within
21 days and certificate to be obtained.
*
In case equitable mortgage of property a letter on
undertaking preferably hand written to be
obtained from borrowers to the effect that the
borrower shall execute if and when required a
legal mortgage on the property duly registered.
7?^
Documentation and Collateral

Introduction:
While extending credit it is important that the corporate status / structure of

the customer should be clearly established. The corporate status / structure of
the borrower determine what security / collateral and documentation is
required to secure the finances.
A borrower can either be a Company, Firm, Sole Proprietorship, An
Individual, Partnership, Trust, Society, NGO, or Non-Profit Organization
etc. A brief discussion of these corporate forms is as follows:
Company
The Companies Ordinance, 1984 defines a Company as,a Company formed
and registered under this Ordinance or an existing Company (Existing
Company means a Company incorporated under the previous law on the
subject i.e. Companies Act, 1913).
A Company has a number of legal features and characteristics as defined in
the Ordinance. Some of the important characteristics relevant to the topic are
discussed below:
a.
A Company is a legal entity, which status it attains as soon it is

incorporated under the Ordinance. Following incorporation, it
becomes capable of purchasing and disposing of property, entering
into contracts, suing or being sued etc. in its own name; and capable
of performing all the functions which a Company is authorized to
perform, though the functions are performed through its
management.
b.
A Company has an existence which is separate, independent and

distinct from its shareholders / members, as well as from the
management.
c.
A Company has the privilege of limiting personal liability of its

shareholders / members for the business debts / obligations.
d.
A Company having a separate personality from its

shareholders/members is itself bound for its debts and obligations;
and the shareholders/members are liable for the Companys
debts/obligations only in case of a Companys winding up; and that
also to the extent of:
i. amount of value of the shares respectively held by the
shareholders, in case of a Company limited by shares; and
ii. to the extent of such amount as the members may respectively
undertake vide the Memorandum of Association to contribute to
the assets of the Company, in case of a Company limited by
guarantee.
e.
226
A Company has a perpetual succession. Its existence is independent

of existence of its members and directors i.e. the company shall
remain, unless wound up.
Laws Governing Companies In Pakistan

Companies Ordinance, 1984 and the Securities Exchange Commission of
Pakistan Act, 1997 are the basic laws governing companies in Pakistan. The
Ordinance provides basic principles and procedures of the Company law,
whereas, the Act provides regulatory and monitoring principles of the
Company law.
Types of Companies
Generally, companies can be categorized as follows:
a. Company limited by Guarantee
A Company limited by Guarantee means a Company the members whereof
undertake / guarantee vide the Memorandum of Association to contribute a
certain amount to the assets of the Company, in the event if its winding up, to
meet the Companys debts / obligations. Such a Company may or may not
have share capital.
b. Company limited by Shares
A Company limited by Shares means a Company the shareholders whereof
are liable for the Companys debts and obligations, in the event of its
winding up, however, to the extent of the amount of value of the shares
respectively held by them.
Companies limited by Shares have further two types, (i) Private Limited
Companies and (ii) Public Limited Companies.
(i) Public Limited Company
A Pubic Limited Company means a Company with limited liability (by
shares) that allows invitation to the public to subscribe for the shares of the
Company; and also allows transferability of its shares. The number of its
shareholders can be more than fifty. However, the minimum number of
members and directors of such a Company should be at least three (03). It is
required to use the word Public Limited with its name.
(ii) Private Limited Companies
A Private Limited Company means a Company with limited liability (by
shares) which prohibits invitation to the public to subscribe for the shares of
the Company; and restricts transferability of its shares. Additionally, it limits
the number of its shareholders to fifty. Furthermore, the minimum number of
members of such a Company should be at least two (02); and the minimum
number of its directors should also be at least two (02). It is required to use
the word Private Limited with its name.
A Private Limited Company may also be of another type of Company i.e.
Single Member Company (SMC) which has only one member. It is
required to use the word SMC Private Limited with its name. It is governed
by all the provisions applicable upon a Private Limited Company, except that
the number of its members and directors cannot exceed one (01). However, it
is required that the single member of every SMC shall nominate a nominee
director to act as director in case of his death; and shall nominate an
alternate nominee director to act as nominee director in case of nonavailability of nominee director.
Extent of Liability of Directors
Directors are shareholders representative and are not liable for the debts /
227
obligations of the company. Banks obtain personal guarantees of director of

companies for finances allowed to the companies, especially in case of
Private Limited Companies, so that if companies fail to repay the finances,
the same can be recovered from the personal assets of their directors. Please
refer to BANKs Policy on Personal guarantees.
Documents Required at the
Relationship with a Company.
time
of
Establishing
Borrowing
The validity of any act of a company is dependent upon firstly, whether it is

within the powers of the company, as provided in the Memorandum of
Association (MOA) thereof (or in the Ordinance); and secondly whether the
act has been performed by the management of the company in accordance
with the rules and regulations provided in the Articles uk Association (AOA)
(or in the Ordinance). Consequently, any act of a company contrary to the
said aspects would be invalid.
Documents Required
i.
Memorandum of Association (MOA)

MOA is the constitution of a company. It defines objectives
purposes for which the company has been formed. It also pro
basic information about the company i.e. Name, Registe
Office/Address etc; information as to liability of the members;
amount of share capital with which the company proposes to
registered, and the division thereof into shares of a fixed amo etc.
MOA should be carefully examined as to any restrictive cla
i. e. whether it places any restrictions on the actions of the com]
ii. Articles of Association (AOA)

AOA are by-laws for the working and general administration a
company. It provides the powers and duties of the Directors Officers
of a company. The AOA should be examined to estab" how, by
whom and to what extent the borrowing powers of company would
be exercised. Generally, AOA of companies the directors to exercise
borrowing powers. However, it must ensured that the directors may
exercise the powers without restriction.
iii. Board Resolution (BR)
Generally, all the powers of a company are exercised by its dir except
as provided in the Ordinance or AOA of a comp However, as regards
the borrowing powers of a company, Ordinance specifically provides
vide Section 196 that the dir of a company shall exercise the said
powers on behalf of company by means of a Resolution passed at
their meeting. It therefore, necessary that whenever a Company
requests a fin facility, a copy of the Board Resolution be obtained in
this r duly attested by Company Secretary/Director(s). Similarly, on
renewal / enhancement of the facility (ies), a fresh Board Resolution
should be obtained to cover the aspect of renewal/enhancement. The
Board Resolution should preferably be specific as to bank name,
nature and amount of facility (ies), aspect of renewal / enhancement,
nature of securities; and should specify the companys
representatives, who would sign / execute the documents. In
addition, a BR must confirm that the minutes of the relative meeting
228
of the Directors have been entered in the Minutes Book of the

Company.
A general and open ended Board Resolution may also be accepted, provided
the BR covers all the aspects mentioned above. In such a case, no fresh BR
is required on renewal/enhancements.
List of documents required.
Source for Certified Copy
Memorandum of Association
Articles of Association
Certificate of Incorporation
Company Secretary
Company Secretary
Registrar Joint Stock of
Companies (SECP)
Certificate of Commencement of Business Registrar Joint Stock of)
(Only required for Public Limited Companies (SECP)
Companies)
Board Resolution to Borrow
Company Secretary
Form 29 (List of Directors)/ Form A
Registrar Joint Stock of
Companies (SECP)
Attested copies of CNICs of all directors NA
Collateral In Case of Companies - Specific Features

There are specific features of collateral in Company category firstly in terms
of expressions used for collaterals; and secondly in terms of additional
requirement for perfecting the collaterals.
The expressions used for collateral in company category include Charge
over current/fixed assets, Floating Charge and Assignment etc., which
expressions are based upon nature of the assets under charge.
As regards the additional requirement for perfecting the collateral in
company category, the same are laid down in the Companies Ordinance,
including registration of the said Charges with the relevant office of SECP
i. e. Registrar of Companies.
Types of charges, importance and their [imitations are dealt in details
in the later part of this chapter.
Documentation Under Consortium Finance
The term "syndicated lending/ Consortium Lending" refers to the arrangements

whereby multiple lenders usually advance funds jointly to one/ single borrower.
While the structure, pricing, repayment schedule and other terms of syndicated
loans can vary, the following common characteristics are usually present:
a. Syndicated loans are normally governed by one set of documentation
describing the rights and obligations of the signatories - the borrower and all
the lenders (or syndicate members).
b. One or more lenders are mandated by the borrower to arrange credit
facilities on terms agreed between the arranger and the borrower.
c. The arranger may underwrite (i.e. undertake to provide) all or part of the
facility amount.
d. Typically, the total amount of a syndicated deal is relatively significant,
ioaduig: Products, Operations and Risk Management | Reference Book 1
229
even though the credit extended by each participant does not generally
exceed what it would be prepared to lend on a bilateral basis;
e. The tenor may well be medium- or long-term, although short-tenx (under
one year) facilities are also common, particularly for related transactions.
f. Syndicated lending involves multiple parties e.g. arrang underwriters, agents
(facility and security), legal counsel (transa lawyer) and participating
lenders.
g. The Banks internal guidelines should be followed for completion security
documentation in following two cases:
i. Where BANK is Lead Manager/ Security Trustee.
ii. Where BANK is not Lead Manager/ Security Trustee.
Other Types of Borrowers and Documentation Requirem a.
Sole Proprietorship
A sole proprietorship is a business concern owned by a single his / her
own account with 100% control. There is no formal p to be followed in
setting up a sole proprietorship concern. H is necessary to establish that
the borrower is the sole owner of the whose name is being used; and
therefore, a declaration evide said position and the proprietors name etc.
should be obtained concerns letterhead. Furthermore, such a concern
may be /registered with trade associations/bodies and may have NTN
which should also be obtained, if applicable.
The account opening and lending documents stipulated by the Bank should be
signed by the sole proprietor and the Proprietorship stamp should be affixed.
Nevertheless, it must be ensured that the documents of all types (especially DP
Note) should be signed in such a manner that the name of the proprietor appears
along with the name of the proprietorship concern, since proprietorship isnt a
separate entity.
b. Partnership/ Firm
Partnership is a business relationship entered into by a formal, written or oral
agreement between two or more persons carrying on a business in common.
The capital of a partnership is provided by the partners who are liable jointly
and seriely for the total debts/obligations of the firm; and share profit and loss
of the business according to the terms of the Partnership deed. In case
Partnership deed is unregistered, all partners of the firm should sign the
Account Opening Form. However, in case of registered partnership deed,
partners may authorize any one or more partners to do so (only if Partnership
deed specifically allows the same).
While extending loans, partnership deed should be carefully analyzed for
borrowing clause (mandate of partners for borrowing), signing / documentation
execution requirements or any restrictive clause therein. The Loan
documentation should preferably be signed by all the partners. However, they
may authorize one or more partners to do so as per the above mentioned
procedure. The firm stamp should be affixed on all the documents.
c. Other forms like Trusts, Societies, NGO's, Clubs etc
230
While extending loans to these bodies special care should be exercised. Charter
of incorporation, by-laws
as Products,
well asOperations
proof and
of Risk
their
registration
should be
Lending:
Management
|
carefully examined before granting any facility. Clear legal opinion from
banks internal legal department (Legal Affairs) should be obtained prior to
extending finance, regarding borrowing powers, charging of security and other

requirements.
d. Government Bodies etc.
Some government entities are borrowing against guarantees provided by the
Central or Provincial Government. Such type of advance is usually against the
ceiling / allocation advised by the Central Bank.
Banks must satisfy themselves that officials negotiating on behalf of
government should have necessary authority. The lending documents should be
signed by the Government officials authorized to sign such documents and the
document authorizing them to do so must be carefully checked. Legal
Clearance from banks internal law department (legal Affairs) should also be
obtained.
ioaduig: Products, Operations and Risk Management | Reference Book 1
231
List of Documents Required

Sr# Account Nature
Documents Required
01. Individuals / Sole
1. Attested photocopy of CNIC
Proprietor ship
2. Trade body Association Letter/NTN, if
applicable.(For Sole proprietorship only)
02 Partnership/ Firm
1. Attested photocopies of CNICs of all partnenJ
2. Attested copy of Partnership Deed duly
signed by all partners of the firm.
3. Attested copy of Registration Certificate with
Registrar of Firms. (In case partnership is
registered)
4. Mandate of partners to borrow & sign the
documents.
03. Societies/
1. Certified copy of Certificate of Registration.
NGOs Clubs etc.
Certified copy of Bye-laws/Rules & Regulations.
2. Resolution of the Governing Body/ Executrei
Committee for opening of account authorizing
the person(s) to operate the account and attested
copy of the identity caul of the authorized
person(s).
04. Trust
1. Attested copy of Certificate of Registration

Where applicable).
2. Attested copies of NIC of all the trustees.
3. Certified copies of Instrument of Trust
Documentation Descriptions
The present mode of banking finance is structured on the pattern < Islamic
modes of financing, since interest based system of banli financing has been
banned in Pakistan, since 1982. The system and developed under guidelines
and parameters of a Board constit then by the Federal Government. The
Board not only developed structure of the system but also drafted standard
documentation in 1 context, including financing agreements. The said
standard docume /agreements are called IBsAB Forms.
a. Terminologies used in IBs
The principal segment of banking finance (Running/Cash/De Finance) is based
upon Morabaha, one of the Islamic modes of finam Morabaha is basically a
sale on credit. However, in banking finance tei the Bank purchases certain
assets (raw material/stocks/machinery from the borrower and pays the price
thereof (sale price) to him, whkk is actually the amount of finance; and then
sells it to the borrower at 2 price (purchase price) which is to be paid by the
borrower after a ce: period, along with mark-up/profit for the period of finance.
i.
Sale Price
Amount of the facility.
ii.
Purchase Price
The sale price + the maximum allowable mark-up according to the
following formula:
Principal + Markup rate per annum * (No. of days of agreement)

365
Morabaha in its original terms provides that the purchase price may
include an amount of mark-up for some farther period (cushion period),
over and above the period of finance, so that if the purchase isnt paid
on time, the lender may bring the matter to the court of law during the
said further period and no financial loss is caused to him for the said
period. However, if the borrower pays the purchase price in time, the
amount of mark-up for the further period is reversed. It is called rebate
or prompt payment bonus. Presently, it is taken as difference of mark-up
calculated @ Standard Markup Rate (SMR) and Timely Payment Mark
up Rate (TPMR).
b. Description of Commonly used IBs
i. Agreement for Finance
Agreement for Financing or Mark-up Agreement is the basic and
fundamental document in Non Interest based financing system. It
provides basic terms and conditions of financing between the Bank and
the Customer. It provides the amount of finance and the mark- up
thereupon; and the terms and conditions for repayment thereof. It in fact
establishes the contract between the Bank and the Customer.
ii. IB-6 (Agreement for Finance) is used for Short/Medium/Long Term
Financing on mark-up, other than Agricultural farming finance. IB-6A is
used in case of single transaction finance, other than Running Finance.
IB-6B is used as mark-up agreement for Demand Finance. IB-6C is used
as mark-up agreement for financing to fixed income persons. IB-6K is
used where mark-up is linked with Kibor.
IB-6, in whatever form, is the most necessary document, without which
the bank's claim cannot be established. It must be obtained in case of all
types of financing (except Non Fund Based Financing). In addition, it
must be obtained on each renewal/enhancement.
iii. IB-8 (Application/Agreement for Issuance of LC) is an application
written by the customer and guaranteed by one guarantor, stating
particulars of its own, beneficiary, goods, amounts, shipment, payment
and voyage etc. The application in itself is an agreement; and upon
execution thereof by the parties, it attains the status of a contract.
iv. IB-12 (D. P. Note) is a written commitment by the borrower that on

demand he/she shall pay to the bank certain sum of money. It should
be obtained in case of all financings. It is obtained for the Purchase
Price. It must be obtained on each renewal /enhancement of the
facilities. However, in case of a facility for a period of more than three
years, a fresh DP Note should be obtained233
before expiry of three years.
v. IB-20 (Agreement for Discount/Purchase of Bills) is an agreement
whereby the customer agree to (i) honor the bills on maturity (ii)
indemnify the bank in case of dis-honor of any bill etc.
vi. IB-28 (Letter of Lien on Marketable Securities) is a letter by which the
customer or the owner (third party) agrees to pledge its marketable or
other securities e.g. Shares, Defense Saving Certificates DSCs etc.
with the Bank. It must be signed by pledgor/ owner of securities.
vii. IB-29 (Personal Guarantee) is an agreement/contract between the
guarantor/surety, the borrower and the Bank, whereby the
Guarantor/Surety undertakes to repay the outstanding liabilities of the
borrower in case of his default to the Bank. It may be given in person
or in a corporate capacity (by a company).
viii. IB-30 (Counter Guarantee) is obtained in the event of extending Bank
Guarantee (BG) facility to a customer, whereby it undertakes amongst
other covenants, to pay any and all amounts which bank may be
required to pay under the BG to the beneficiary of the BG.
ix. IB-31 (Agreement for Sale & Buy Back of Marketable Securities} is
obtained in the event where collateral is in the form of marketable |
securities, like shares. It also refers to sale price and purchase pr on the
pattern of IB-6, for the reasons that the securities are 1 to have been
purchased by the Bank and then sold back to customer.
c. Precautions in filling the IB Forms
i.
Since sale price, purchase price and rebate are the main used in
the IBs, therefore, while executing IBs, principal emp should be
upon the amounts relating to the said terms. Accor the relevant
columns provided in the IBs for the said should be filled in
appropriately.
ii. The date of execution and the reference of IB-6 (where app should
be given therein.
iii. IBs should be executed and witnessed appropriately. One witness
should be from borrower side and second witness should be from bank
side. Copy of CNIC of witnesses should also be kept.
iv. It must be ensured that the executants of the IBs are duly authorized to
execute the same (in case of companies and firms); and their
constitutions (MOA & AOA; and Partnership Deeds) allow execution of
the documents.
v.
Signatures of executants should be verified with lead pencil by

authorized signatory (AS/ IBS holder).
vi.
Provincial Governments levy stamp duty on agreements. It should be

ensured that proper stamp duty is paid as per requirement.
vii. Every Page of IB forms should be signed by the executant (s).

viii. There should be no cutting of text in IB forms, while executing IB forms
some customers delete standard clauses or alter the draft of IB forms. In
case of cutting of clause or any text in IB forms its approval should be
obtained from banks internal legal department (Legal Affairs). All
cuttings/ alterations must be duly authenticated.
234
d. Use of Non Standard Documentation

Bank should use standard formats of the bank. In case of specialized
transactions, where it is not possible to use standard formats, drafts should be
vetted from banks internal legal department prior to execution of
documents.
e. Inclusions of standard clauses
Following clauses should be present in all standard/ Non standard
documentation:
Adverse Change Clause.
. Majority Ownership Clause.
. Cross Default Clause.
Especially, in case of financing to Large Corporates/ Consortium Finance
it should be ensured that these clauses are covered in documentation.
f. Review of Standard Documents

Banks internal legal department should review all standard documentation /
IB forms at least once in a year (or any other frequency as deemed
appropriate) and all changes should be circulated to branches. Any change
made by legal department in standard documentation shall override the
existing documentation.
235
SAFE KEEPING OF BORROWER'S DOCUMENTATION
Retention of Legal documentation in safe mode is one of the important area that
can not be neglected. Since through these documents legal rights can be
enforced in the Court of Law. Inappropriate handling of these documents may
lead to invalidation of the rights or jeopordizing the interest of the Bank,
therefore, Bank should take all appropriate measures regarding safe custody of
legal documents.
IN HOUSE ARRANGEMENTS
In todays financial markets a number of arrangements are available for

retention of documents. These include archiving and digital copies of the
documents besides conventional retention in the vault. It is important that
measures should be taken to address unfortunate incidents like fire, explosion or
theft, to keep the in house arrangements more appropriate.
Bank (depending on size and availability of resources) should keep all security
documentation in a room with fire proof arrangements under dual control after
lodgment in safe custody register. A separate register;/ similar arrangement
should also be maintained to keep track of movement of any document/
document folder. Bank should issue collateral lodgment receipt to the
concerned relationship manager which will serve as a proof that documents are
held in safe custody.
Access to collateral should be by dual authorization. Receipt and release of
collateral should require authorization from at least two responsible officers of
the Bank.
At all times, security documentation should be available for physical checking
by internal and external audit.
Under no circumstances a security document, an insurance folder or any
contents of the same are to be removed from the Bank premises or as per the
arrangement of the Bank. These documents should NOT be kept outside the
vault area for an overnight period. Authorization and outward movement of any
such documentation should be noted in the Movement Register. In cases,
where an outward movement of any such security document from the custodial
area to another area is required then this too should be noted in the Movement
Register or any other arrangement for this purpose.
Collateral registers should be checked against physical holdings at least
annually by the Banks Officials from different regions (Cross regioo checking
should be implemented on a best effort and as-practical basis>.
EX-HOUSE ARRANGEMENTS
In cases where it seems that in house arrangements for safe custody of legal
documents are not appropriate, ex house arrangements may be considered.
These are more considerable in todays world where uncertain events like
explosions/thefts have increased. However, one should have to understand the
cost and secrecy issues while making these decisions. However, where such
arrangements are deemed necessary by the Bank, all precautionary measures as
applicable for in house arrangements should be implemented.
Different types of financing arrangements
Commercial credit involves lending to the various types of borrowers for the
purpose of meeting various business capital requirements. The commercial
credit facilities offered by the bank are mostly generic and are designed to
meet various types of requirements of the borrowers. Further, from time to
time, specialized products are offered by the bank which are based on these
facilities but have special features and terms that are designed to facilitate a
more specific type of borrower, business requirement or transactional
modalities.
The types of financing arrangements can be divided in funded and nonfunded
facilities.
Funded Facilities: Short-term /Working
Capital Facilities
These are facilities which are designed to meet the short-term or working
capital needs of the customer, i.e. for financing of various current assets,
primarily stocks & receivables. The tenure is usually less than one year and the
customer may roll over the liability several times within the approved limit
during that period, depending upon their cash conversion cycle.
The available short-term/working capital facilities are as follows:
Running Finance (Overdraft): Running Finance (RF) is a facility under

which the bank allows the customer to draw funds in excess of the
credit balance in their account up to a specific amount (limit) through
any number of transactions. The customer may avail this facility at any
time throughout its validity. The facility is a revolving advance, i.e. the
customer may borrow, repay and borrow again up to any amount
according to their working capital needs.
Banks also use this facility structure to finance local procurement of goods
and / or merchandise and secure the same through pledge of goods and / or
merchandise being procured.
Post-Import Finance Facilities: Post-import financing is a type of working
capital financing availed when the customer imports certain items, but does
not have sufficient cash to pay the exporter at that point in time. Therefore
the bank pays the exporter on behalf of the importer (customer) at that
point in time. The customer/importer then repays the bank according to the
terms of the facility, i.e. maximum tenure allowed to the customer, along
with pre-specified mark-up. There are a number of types of post import
facilities including:
(a)
(b)
(c)
(d)
Finance Against Trust Receipt (FATR).

Finance Against Imported Merchandise (FIM).
Payment Against Documents (PAD).
Acceptance.
Export Finance Facilities (including both SBP-ERF and banks own

financing takes place where the business
237of the customer
source):
Book 1Export
involves export and export-related transactions are financed. In such cases,

it is expected that the financing will be automatically-adjusted through
realization of the export proceeds within the stipulated time period, in
which regard the SBPs timelimit for realization of export proceeds serves
as the maximum that may be allowed. Export Finance Facilities may be
disbursed through the banks own funds (known as Own Source) or the
banks funding may be refinanced through the SBP by means of the SBPs
Export Refinance Facility. The two types of facilities are:
A. Banks Own Source.
(a) Finance Against Packing Credit (FAPC).
(b) Finance Against Foreign Bills (FAFB).
(c) Foreign Bill Purchased.
B. SBP Export Re-Finance Scheme.
(a) Export Finance Part -1.
(b) Export Finance Part - II.
(c) SBP-LTF-EOP.
Export Refinance Part-lAl: ERF is a special facility by SBP aimed at
encouraging exporters by offering them financing at low mark -up rates.
The ERF facility is disbursed through commercial banks, and each bank
must undertake its own risk analysis on the borrower and obtain sufficient
securities by its own stand because in case the customer defaults, the bank
has to re SBPs funds through its own source and then proceed for litiga
against the customer for recovery. For this scheme, the S periodically
announces an ERF rate, over which the bank charge a spread of up to but
not exceeding 1%. These rates typically very low. Guidelines are subject to
change from time time. You are advised to confirm the prevalent rates from
website.
FE25 Financing: FE 25 Financing uses the banks foreign currency
deposits held under the FE 25 account scheme. This facility is classified
as a working capital facility and is allowed to exporters and importers,
with a maximum tenor of 180 days from the date of shipment, or as
otherwise stipulated by State Bank of Pakistan. The USD amount is
converted into PKR at the rate prevailing on that day, and lent.
Negotiation/Discounting of Bills: Bill purchase/discounting takes place

when the borrower makes a shipment against an LC or contract, and
needs immediate cash realization of proceeds (i.e. the bills) for business
purposes. In such cases, after verifying that the shipment documents are
in accordance with the terms of the LC/contract, the bank deducts markup from the amount of the transaction (i.e. discounts the bills) and
advances the remaining amount to the borrower with the understanding
that when the bills are realized under the terms of the LC or contract,
they would be used to settle the liability. An undertaking obtained from
the borrower ensures that in case payment is not received from the LC
opening bank or purchaser of goods on time, the bank may obtain the
payment from the borrower. There are two types:
(a) Local Bill Purchase (LBP) / Inland Bill Purchased (IBP)
(b) Foreign Bill Purchase (FBP).
Long-term/Capital Expenditure Facilities
These facilities are designed to meet the long-term or capital expenditure

requirements of the customer, i.e. financing of various fixed assets. As such, the
repayment period is usually spread over several years depending on the amount
of the loan and the capacity of the borrower.
238
Term Finance (TF): Term Finance refers to funds made available to a

customer for a fixed period, usually more than 1 year, for the purpose of
investment in fixed assets/capital expenditure. TF is usually disbursed in

lump-sum, but disbursement may be divided into tranches scheduled
according to requirements of a project undertaken by the customer.
Repayment schedule is fixed prior to disbursement-taking the form of
either one single payment, or, more often, a schedule of installments
starting after a grace period. The repayment schedule is calculated on the
basis of cash flows and capacity of the customer.
NON-FUNOED FACILITIES
There are two basic types of non-funded facilities that may be availed by
customers:
Letter of Credit (LC): A Letter of Credit (LC) is a mode of payment for
imported goods, in which the bank acts as intermediary to ensure that
the transaction is carried out according to the terms of the contract
between the two parties. An LC is a conditional guarantee issued by the
bank in favour of a specified beneficiary (exporter), on behalf of the
banks customer (applicant/importer), which states that a certain sum
will be paid at a specified time against presentation of title documents of
goods in favor of the bank, subject to the condition that they are
compliant with all requirements stated in the LC.
Types of Documentary Credit:
Revocable Letter of Credit.
Irrevocable Letter of Credit.
Irrevocable Confirmed Letter of Credit.
Revolving Credit.
Transferable Credit.
Back to Back Credit.
Red Clause or Packing Credit.
Stand-by Credit.
Modes of Payment under LCs:
Available by Negotiation.
Available by Acceptance.
Available by Sight Payment.
Available by Deferred Payment.
Broadly, L/Cs may be classified as under Sight - Letters of Credit (L/C Sight) & Usance Letters of Credit (L/C - DA).
Letter of Guarantee (LG): A Letter of Guarantee (LG) is an irrevocable

written undertaking by the bank (issuer of the guarantee, guarantor or
surety) in favour of another party (the beneficiary) on behalf of its
customer (applicant) to the effect that in case a certain pre-defined
obligation is not met, the bank will pay a specified sum of money to the
beneficiary upon a simple written demand. Thus there is no immediate
disbursement of funds upon the issuance of the guarantee, and the
liability
of
the
bank
is
contingent
upon
defined
circumstances/conditions. The bank is substituting its own credit rating
for that of its customer.
Types of Collateral
Collateral / Security is a very critical component of the credit process. Banks

primarily take collateral / security against finances provided to borrowers to
secure repayment (second way out), should cash flows (first way out) becomes
short / unavailable.
The collateral / security could be in the form of First exclusive charge, senior
to all other lenders; First pari-passu charge; Pledge and exclusive charge;
and
Corporate
Lending: Products, Operations and Risk Management |Equitable
Reference Book
1 legal charge; Standby letter of credit / bank guarantee;
239
or personal guarantee.
The collateral / security should ideally match the purpose, nature and structure
of the transaction; it should reflect the form and capacity of the obligor, its
operations and the business and economic environment.
The critical collateral / security related components with respect to the credit
process have been summarized in this section.
Following are the main reasons for a bank to take collateral / security:
To fund repayment, should cash flows become short / unavailable To

diversify means of repayment in order to provide flexibility in disposal.
To prevent assets from being otherwise encumbered.
To improve the Banks rights with respect to lenders.
To allow the Banks financial or psychological leverage in negotiation.
To secure the financing / lending provided to customer.
For the repayment of Bank principal amount along with markup and
other handling charges in case of customer default.
To satisfy the regulatory requirement as clean exposure is not allowed
by SBP (requires that all exposures more than a predefined limit in SBP
PRs be backed by some tangible or intangible security with appropriate
margins.
Following is the list of accepted securities approved by the bank:
Lien on deposits.
Pledge of Stocks / goods.
Unregistered hypothecation charge on fixed assets and / or current assets
other than company (Sole Proprietorship and partnership) Registered
hypothecation charge on fixed assets and /or current assets for Private
and public limited companies.
Hypothecation of charge on Plant and Machinery and spare parts.
Equitable / Token Register Mortgage of land and building. Personal
Guarantee of Directors / Proprietor / partners.
Title of leased assets.
Assignment of Bank Guarantee.
Guarantee, Cross Corporate Guarantee, Guarantees of Parent Co.. Lien
over Letter of Credits.
Assignment of Receivables.
Lien over import documents.
Lien over export documents.
Lien over bills.
Post dated cheques/ Debit authority.
Trust receipt.
Assignment of Salary.
Attributes of a Good Tangible Security
There are certain qualities, which a good tangible security should possess. Some
of the important attributes are:
a)
Marketability
As security is obtained for the purpose of meeting an emergency in the

event of default by the borrower, the main consideration should be its
ready reliability or marketability (including
240
form of cash, term deposit, bank guarantees investments in Government

Schemes, (e.g. SSC/DSC etc.) are considered better forms of security in view of
their ready reliability as opposed to jewellery, precious stones owing to their
increased susceptibility to volatile market fluctuations. However, no general
rule can be laid down in this regard. Each case has to be decided by the
manager keeping in view the intrinsic worth of the business, reputation of the
customer etc., while determining the security that is acceptable.
Easy ascertainment of value
The value of the security should be easily ascertainable. Articles that are rarely
quoted or are so highly specialized that the value thereof cannot be ascertained
without referring to an expert should generally be avoided.
Stability of Value
Security offered should provide reasonable stability in value and should not be
prone to violent fluctuation in prices (as discussed in (a) above). Although it is
the usual practice to maintain reasonable margin on security value to take care
of the volatility in prices, violent fluctuation will call for frequent adjustment of
margins and hence may not be cost effective.
Durability
A security should be reasonably durable. Easily perishable items like raw

foodstuff, spices etc. do not constitute good security and should be avoided.
Ascertainment of Title/Easy Transferability of Title
The customer's title to the security should be easily ascertainable and

undisputed. It should be verified if there are any other interests in the security
such as prior charges or encumbrances. Particularly in respect of security by
way of properties, adequate care should be taken to establish clear title and it
should be ensured that the Bank can enforce its charge on the property e.g.
mortgage charge on a rented / self occupied residential property cannot be
easily enforced and therefore constitutes a weak security. Also, the transfer of
.title in Banks favour on a security should not be difficult if the occasion so
demands it. Security documentation obtained by the Bank should be adequate to
facilitate such transfer.
Liability
The security should not involve the bank in any liability. A striking example is
the case of partly paid-up shares, which if transferred in the bank's name as
security, may involve the bank in the liability, for calls on the unpaid face
value. Another example is immoveable properly where taxes are heavily in
arrears.
g)
Storability
Where the security is in the form of commodities these should be such as

do not present undue storage problems. Certain types of chemicals are
classified as hazardous goods and cannot be stored in the same godowns
as other non-hazardous goods. Certain types of commodities require
storage at definite temperatures otherwise they deteriorate.
h)
Transportability
Finally, the security should be in such form as to facilitate it's transport

to other centers, if necessary for sale purposes.
i)
Yield
If a security is a source of steady income, it is considered desirable as it

affords an automatic source of repayment of capital and mark-up either
wholly or in part. For example, if the security consists of highly
marketable shares on which regular dividend is received or a property
with steady rental income, the Bank can take a mandate to collect the
dividends/rentals and appropriate them in reduction from time to time of
the funded exposure.
In actual practice, hardly any security possesses all the desirable attributes
mentioned above and defects do exist in the securities which are sometimes
covered by taking a higher margin or insisting on other safeguards, such as
supplementary security.
Margin
The difference between the value of the security and the amount upto which the
borrower can draw is known as margin. Margin on securities is maintained as a
cushion against fluctuation in value of securities. This can occur due to a
shortage, which may not be discovered by inspection or shrinkage in value,
which may arise on account of the nature of goods charged or adverse shift in its
demand. Again, if a customer commits default in payment of the Bank's dues,
the Bank may have to take steps to sell the security after giving an appropriate
notice to him. In case of forced sale, the security is not likely to fetch its full
value. To provide for such eventualities, the Bank keeps a margin. The
percentage of margin depends upon a number of factors including the Bank's
perception of ready marketability and likely fluctuation in the value of the
security. The value of security less margin is known as Draw-able Limit or
Advance Value.
Hypothecation
Hypothecation is a legal transaction where borrowing is made against goods

which are charged in favor of the Bank as security; however, the ownership as
well as the possession of the goods remains with the borrower. If the borrower
fails to repay the loan, the Bank can set-off its obligation by liquidation of
hypothecated asset after obtaining court order.
The security in the form of hypothecation is normally used as an additional
comfort to the Banks. Since under hypothecation, the ownership and possession
of securities remains with the borrower, there are wide chances for
misappropriation of hypothecated assets. In view of the nature of security, the
hypothecation charge is only allowed either to very high
243
reputed customers or retained as an additional collateral.

Associated Risks
i. Low control over goods (possession with the borrower).

ii. Difficult to verify title to the property.
Following should be given due consideration in case of hypothecation of stocks:
Where finance is secured by inventory,
a. Ascertain that the goods are of stable value.
b. Readily marketable, and
c. Borrower has valid title to the assets.
The Bank should avoid financing against high-risk items, such as
perishable/hazardous and government banned commodities or goods whose
prices are usually subject to wide fluctuations.
Where security comprises of seasonal goods, repayment of finance should be
effected by customers before the end of season.
Where finances are extended to listed companies, hypothecated stock
statement would be verified with quarterly financials of company. For other
types of borrowers stock statement would be verified with annual financials.
This requirement is in addition to physical stock inspection.
The following should be given due consideration in case of hypothecation of
debtors/receivables:
Since real time check for amount of receivables and objective evidence of
the debtors is difficult to obtain. So such security should only be considered
for high value customers.
The age of the debt is an important aspect, where finance is secured by
Account Receivables. Three-month age period is considered acceptable.
However, on the basis of nature of the customers' business, collection period,
financial strength of debtors and normal credit period allowed in that
particular industry this may be waived.
Where finances are extended to listed companies, statement of book debts
would be verified with quarterly financials of company. However, in case of
financing to proprietorship, partnership & unlisted companies statement of
book debts should be verified with customers books of accounts on half
yearly basis.
Documentation
Bank must ensure that appropriate security documents are arranged and must
also ensure that validity of these documents. In addition to finance agreements,
following document(s) should be obtained.
Insurance
The hypothecated/pledged goods should be adequately & comprehensively

insured against all the usual hazard/ risk such as fire, riot, strikes, burglary, rain,
floods, atmospheric damages, malicious damages, terrorism (if applicable) etc.
If any of these risks is not covered, a waiver should be obtained from the
sanctioning authority. Banks interest should be clearly noted in the relevant
insurance policy and all guidelines prescribed be adhered in this regard.
Charge Requirements
In case of limited companies, Bank's first / or ranking charge over the

borrower's entire stocks/ book debts/receivables should be registered with the
Registrar, Joint Stock Companies.
Assignment of Book debts
Debts due or accruing due to a person may be assigned by him to the creditor
and can thus be made security for an advance.
A charge on book debts taken by a banker as security should cover only those
debts due or accruing due from named debtors under specified contracts at the
time the charge was executed. For example in the event of insolvency, any
general assignment of existing or future book debts will be void against the
Official Assignee as regards to any debts not paid at the commencement of the
insolvency.
A)
Legal Assignment Under Sec 130, of the Transfer of Property Act

i) An absolute assignment not by way of charge only preserving die
mortgagor's equity of redemption.
ii) In writing signed by the assignor.
iii) Notified in writing to the debtor.
An assignee under a legal assignment can sue in his own name and can give a
good discharge for the debt without concurrence of the assignor.
B)
Equitable Assignment:
i) Which may be created orally or in writing or in any other form.
ii) Notice need not be given to the debtor although it is clearly desirable.
iii) An equitable assignee cannot sue in his own name. Any action must be
brought in the name of the assignor. And if the customer will not assist,
it will be necessary for the banker to apply to the courts for power to
enforce the rights under an assignment. An equitable assignment of
book debts to a banker may be created in one of two ways:
a)
iv)
v)
By a specific undertaking from the customer to the banker agreeing

to pay over a particular debt owed to him.
b) By the customer giving to the banker a written order addressed to
his debtor requiring the debtor to hand over to the banker a certain
sum out of a specific debt.
Written notice of assignment should always be given promptly to the
debtor.
Priority as regards more than one assignment ranks according to the date
of notice to the debtor. If the banker fails to give notice and the
customer subsequently assigns the debt to another creditor who without
notice of prior assignment, gives notice to the debtor, the banker's claim
will be postponed to that party.
245
vi)
Notice is also necessary to prevent the official receiver in insolvency

from claiming the debt as property within the order and disposition of
the insolvent.
It will be seen that the benefit of a contract may be assigned by equitable or

legal assignment. An assignment which does not comply with all the legal
requirements of an assignment may still be valid as an equitable assignment.
The principal drawback to an assignment whether legal or equitable, is that an
assignee takes the assignment; subject to equities i.e. he has exactly the same
rights as the assignor had and no more. Thus if the debtor had a counter claim
against the assignor, the assignee will be entitled only to the balance due after
allowing for the counter claim e.g. Aftab has carried out work for Bashir for
which he is entitled to be paid Rs. 1000 Bashir has a counter claim against
Aftab for Rs.200 say in respect of some deviation from the work to be
performed in the agreed specification. Aftab assigns his rights under the
contract to Shamim. Although Shamim is ostensibly, the assignee of rights to
Rs. 1000 he can not claim more than the net amount i.e. Rs.800.
When taking an assignment of debts as security, we should
i) Ascertain the credit -worthiness of the debtor. Such an arrangement
should be agreed only for undoubted customers. Also, in such cases,
confirmations from the employer/purchaser acknowledging the
payments due should be obtained periodically and it should be ensured
that the Bank's advances are adequately covered by such receivables at
all times.
ii) Enquire of the debtor
Classification of Securities
Securities are classified according to the legal nature of the right or charge
created on the property/asset. Thus a security can be in the following forms:
A Charge: When an asset/property is identified as a security against a
facility in an agreement or document creating a borrowing relationship,
a charge is said to have been created. This charge can either be
registered formally or remain unregistered. A registered charge
obviously provides a higher degree of security.
A Lien: is a right or Charge on the asset arising out of mere possession

or custody of borrower's goods with the lender. A lien can be a Specific
Lien. i.e. a lien or charge given on a particular asset or a particular Lien
which arises from a particular transaction,
e. g. a carrier's lien on the goods carried by him against the freight
charges payable to him.
There can also be General Lien, which arises out of general dealings between
two parties, e.g. the Banker's General Lien, which is an implied lien on all the
accounts/assets of the borrower that come into a banker's possession. The
Banker's General Lien is also subject to certain exceptions and conditions under
the law which will be discussed in relevant sections.
246
A Pledge: is a bailment of goods as a security for credit facilities. In

case of Pledge of Goods, exclusive possession of goods passes to the
lender with the intention of placing them under pledge with the lender.
This possession could either be through ar3l delivery of goods or
3 The amount of debt.

Whether any prior charge exists.
Whether the debtor has any (counter-claim) against the debt.
iii) Obtain acknowledgement of the assignment and diarize due date.
Lending:
Operations a
and
Risk Management
| Reference
Book 1debts (to check
iv) Obtain
fromProducts,
the borrower
monthly
statement
of book
through delivery of the documents of title to the goods.
Hypothecation: In case of Hypothecation, the charged assets remain in

the custody and ownership of the borrower, while the bank holds a
charge on the assets and the borrower is accountable to the bank for the
sale proceeds of the goods on which a hypothecation charge is created.
A Mortgage: is a transfer of interest in a property, generally an
immoveable property, to constitute a security against credit facilities, e.
g. mortgage on real estate property.
A mortgage can be by actual transfer of interest by registration of a

mortgage in the lender's name or by registering an intention to create a
legal mortgage or what is called the Equitable Mortgage in which the
intention to create mortgage is established by deposit of original title
documents with the lender.
An Assignment: is the transfer of rights to a claim or dues in favour of

the lender as a security for credit facilities, e. g. Assignment of an
Insurance Policy or the Assignment of Debts.
Collateral may be taken in any of a number of forms, for instance:
1. first exclusive charge, senior to all other lenders.
2. first pari-passu charge (where the prior charge holders, by issuance of
No Objection Certificates (NOCs), agree to share pro-rata the collateral
under charge.
3. ranking charge.
4. inferior charge.
5. pledge and exclusive charge.
6. equitable or legal mortgage.
7. standby letter of credit / bank guarantee.
8. corporate or personal guarantees (supported by the statement of the
guarantor) of types of claims/ personal net worth.
Collateral should match the purpose, nature and structure of the transaction it
should also reflect the form and capacity of the obligor, its operations, and the
business and economic environment. Collateral may include the assets acquired
through the funding provided, i.e. stock, receivables, or export bills, as well as
cash, government, securities, other marketable securities (such as shares),
current assets, fixed assets, specific equipment, and commercial and personal
real estate.
Types of charges, importance and their limitations

a.
Charge:
Charge refers to the security interest created on the property of the company. A
whether any payment has been received directly by the assigner).

v) An assignment of book debts by a Limited Company by way of security
must be registered under sec 121 of companies Ord. 1984.
vi) Charge over book debts/receivables to be registered with SECP.
vii) Obtain Certificate of Registration of Charge from SECP.
viii)
Periodical age-wise list of receivables, as per Sanction
Advice, to be obtained.
ix) Ensure that book debt/receivables are routed through the account of
borrower.
Book 1 applicable charges and security documents.
247
x) Obtain
charge is security for the payment of a debt or other obligation that does not
pass title of the property or any right to its possession to the person to whom
the charge is given.
When an asset/property is identified as a security against a facility in an
agreement or document creating a borrowing relationship, a charge is said to
have been created. This charge can either be registered formally or remain
unregistered. A registered charge obviously provides a higher degree of
security. Charging a security means making it available as a cover for an
advance. The method of charging should therefore be legal and perfect. It is
important that the charge is completed and all the relevant formalities are
complied with so that in case of default by a borrower the security is available
to the Bank. It should, however be borne in mind that whatever form the charge
may take, the Bank does not become the absolute or exclusive owner of the
security, the Bank has only certain defined rights in it, until the debt is repaid. It
can also either be a Hypothecation charge, where possession of property/asset
remains with the borrower or a charge on pledged goods, in which case the
assets /goods are held with the lender/Bank.
b.
Types of Charge:
i.
Fixed Charge:
Fixed Charge means a charge over assets of a company, which
attaches to the assets from the time of its creation.
ii.
Floating Charge:
Floating Charge means a charge which floats over assets of a
company until an event of default occurs or until the company goes
into liquidation, at which time the floating charge crystallizes and
attaches to the assets intended to be covered by the charge.
Furthermore, its ranking shall be determined when crystallized.
A floating charge is not as effective as a fixed charge but is more flexible.

Distinction between Fixed & Floating Charge
The basic distinction between fixed and floating charges is that a fixed charge
attaches to the asset in question as soon as the charge is created, whereas a
floating charge attaches only when it crystallizes.
Registration of Charges
It is mandatory under provisions of Section 121 of the Companies Ordinance,

1984 that every mortgage, charge or other interest created by a company over
its assets should be registered with Registrar of Companies, within 21 days after
the creation of the mortgage or charge.
Effects of Registration and Non Registration
Registration of a mortgage or charge ensures its security in the event of
liquidation or winding up of company. Registration of a charge, as such,
constitutes a notice to the public as to the creation of the mortgage or charge;
and if any person acquires such property, he will be deemed to have notice of
the said mortgage or charge from the date of such registration. If a mortgage or
charge is not registered in time, then it would become void against any other
secured creditor (holding registered charge over the companys assets). Such a
void charge would not be entertained by official liquidator, in case of winding
up of the company. Nevertheless, the charge in such a case will remain payable,
but it will be unsecured.
248
Remedy for registration of a charge out of time
If a charge is not filed within 21 days, then SECP may be contacted for
extension of time; and if the commission is satisfied that it was accidental or
due to inadvertence or due to some other sufficient cause, or is not of a nature to
prejudice the position of creditors or shareholders of the company, or that on
other grounds it is just and equitable to grant relief, then the commission may
on such terms and conditions as seem just and expedient, order that the time for
registration be extended. In such an event, the mortgage or charge shall be filed
with registrar in the manner above referred, along with a certified copy of the
order of the commission.
Documents required for registration
The following documents are required to be filed for registration of a mortgage

or charge with the Registrar:
Form 10 containing particulars of mortgages or charges etc.

Certified copies of instruments creating the mortgage or charge.
Affidavit that copies of the instruments are true copies.
Form X.
Form X should be properly filled-in, it must be signed and stamped by the
company's authorized signatory.
Instruments
Instruments creating the mortgage or charge include mortgage deed/

Memorandum of Deposit of Title Deeds (IB-24), Letter of Hypothecation (of
Stocks, Book Debts, Machinery/Plant/Equipment etc.). These would be filed in
the form of certified copies, attested by a Notary Public.
Precautions in filing of charges
. Make sure the creation date and description of the charge agree with the
instrument.
Make sure that ranking of charge is properly mentioned on form X.
Make sure the amount secured accurately reflects what is stated in the
Instrument.
Make sure details of the property charged accurately reflect what is
stated in instrument.
For mortgaged land it is desirable that you give the title number of the
Property.
Ensure that charging clauses are always inserted, including reference to
fixed and floating charges.
Sign and date the form.
Complete the forms legibly using black ink or, preferably, type the
form.
Certificate of Registration
If the Registrar is satisfied that the documents filed are acceptable, then he will
cause an entry in the register of charges and will issue certificate of registration
of mortgage or charge, which will be considered as evidence of the charge.
Modification of Mortgages and Charges
Whenever the terms or conditions or extent or operation of any mortgage or

charge registered as above are modified, it is mandatory that the particulars of
such a modification together with a copy of the instrument evidencing such
modification be filed / registered with the Registrar. The procedure for
Lending: Products, Operations and Risk Management |modification
Reference Book 1 of mortgage or charge is same as in case of
249 registration of
mortgage or charge, however, for the subject purpose Form XVI shall be used
instead of Form X; and the Registrar shall issue Acknowledgement of Filing
instead ofCertificate of Registration.
Modification is change in mortgage or charges i.e. change in:
Amount of mortgage / charge (enhancement or reduction in amount).

Change in particulars of property (excluding or including certain
property or asset).
Variation in the rate of markup or interest.
Extension of time for repayment on period of maturity (Rescheduling).
Change in other terms and conditions.
Rectification of charges, relevant provisions of law and procedure
The following are some of the acceptable grounds for rectification of register of
mortgages or charges:
Omission or mis-statement of particulars.

Failure to file modification of charge.
Omission to intimate payment or satisfaction.
Satisfaction of charges and related Forms
Satisfaction of mortgage or charge is also necessary to be filed with Registrar.

It is caused by way of memorandum of satisfaction of mortgage or charge on
Form 17 with or without NOC obtained from the mortgagee/chargee.
Ranking of Charges
Companies may create charge over their assets in favor of more than one
lender. However, the charge of each lender would not be equal. The law in such
a case gives priority to a charge created earlier in time. The priority as such is
termed as Ranking, which determines priority of right amongst companys
secured creditors to enforce their charge, in case of liquidation. Ranking of a
charge is determined by time of filing of the particulars of the mortgage or
charge with the Registrar.
In view of the aspect of ranking of charges, it is utmost necessary while
extending loan to a company that a Search Report is carried out from the
Company Registrars office to ascertain whether the company assets have
earlier charge in favor of some other lender. The search should be conducted by
the Banks approved agencies.
a.
Terminologies
i.
First Exclusive Charge
A Charge is called First Exclusive when it has been created over assets
of a company by a single creditor/lender; and there is no other charge
holder having claim over the said assets.
ii.
Second/Inferior
A Charge is called Second or Inferior when it is created over assets of a

company which are already under a prior charge.
iii. Pari Passu Charge
250
Pari Passu charge means a charge under an agreement between the

secured creditors of a company where all the creditors have equal rights
of payment; and have the same level of seniority/ranking, irrespective of
date and
time of creation of their respective charges. In case of Pari
Passu charge, every Pari Passu charge holder shall have a right over
respective assets of the company, in accordance with its proportionate
amount of charge/exposure.
Pari Passu charge may be arranged/created amongst creditors of a
company jointly at the time of creation thereof or even in case of
inferior ranking charges, by way of having NOC from the senior
creditor.
Under consortium finance usually lenders jointly enter into an
agreement with the borrower to create a Pari Passu charge on assets of
the company.
b.
Importance of Ranking
Ranking of charge determines secured creditors priority/ranking to

recover their outstanding from the assets of a company, in case of
liquidation or winding up thereof. In the event of liquidation/winding-up
of a company, though all the secured creditors have a right to enforce
their claims, however, the claims are entertained in accordance with the
ranking and there are chances that inferior charge holders may not have
any assets to enforce their claims.
c.
Procedure to be followed
All security documents and Form 10 should distinctly specify ranking of

BANKS charge. If prior charges exist over the assets of a customer,
then NOC for creation of pari passu charge in favor of BANK shall be
required. In such cases, reference number and date of NOC for creation
of pari passu charge should be given in the letter of hypothecation, deed
of floating charge or mortgage deed.
Prior to creation of charge, Search Report from office of Registrar of
Companies should invariably be obtained. Search Report should clearly
mention the ranking of existing charge(s) created on the assets intended
to be accepted by our Bank as security. This report would help in
ascertaining the total amount of charge / encumbrance created on the
assets and ranking of existing charge holders.
After registration of charge, final legal opinion on perfection and
ranking of charge should be held from banks internal legal department
(Legal Affairs)/ Legal Retainer.
d.
Satisfaction of Bank's registered charges with RJSC in

case of liquidation:
The amount for which the bank creates a registered charge at the
Registrar of Joint Stock Companies is the secured amount. Several banks
may concurrently have charges registered against the assets of a
company. In this case, the charge holders may rank pari passu or may
hold ranking charges with varying priorities. In case of pari passu charge
holders, the proceeds of liquidation of a company will be shared in the
ratio of the outstanding of their respective secured amount to the
aggregate outstanding secured amounts of all the charge holders of the
company in the same ranking. Amount owed by a lender over and above
a charge / pari passu charge registered with the Registrar of Joint Stock
Companies, shall be an unsecured credit and will be satisfied after all the
secured creditors have been paid and all preferential payments to be
251
made under the Companies Ordinance 1984 i.e. employee wages etc.
have been fulfilled.
e.
Approval for issuance of NOCs
While considering requests for issuance of NOCs, Bank should give

consideration to the fact that there should be no dilution in security i.e.
after issuance of NOC, Bank should not become inferior in respect of
ranking of charge or margin. Banks should be more cautious for issuance
of NOCs for delinquent accounts.
Release of Charge / Letter of Satisfaction of Charge
Before replacement or change of property / security documents / partial release
of property (this does not include exposure secured against 100 % cash/ Near
Cash Collateral), some banks require written approval from a Competent
Authority.
Where property documents / security documents are released on full and final
adjustment of a limit, the Branch Manager should satisfy himself that the
property held is not a common security for any other unadjusted limits with the
branch or the branch has not issued any letter for joint charge or have received a
letter for joint charge from any of our other Branch / Bank.
In case, the customer requests partial release of cash collateral security on
partial adjustment of limit, branch manager after satisfying that remaining
security will adequately cover the finance along with margin, can release cash
collateral securities. If cash collateral securities are held with CAD, request
letter from branch manager will be required to CAD confirming above.
252
In terms of SBP BPD/RU-20/121-04(Policy)/7868/02 dated 24th May 2002,

creating further encumbrance on the assets is not favored and this should be
communicated to the concerned bank/ NBFI / Customer within a period of 15
working days
Fraudulent Conveyance
Particular care must be exercised when the conversion of a customer's business

into a limited company is followed by a request for accommodation e.g. if a
trader transfers his assets and liabilities to a limited company without the
consent of each and every one of his creditors, the transaction may be
interpreted as a fraudulent conveyance. A fraudulent conveyance is not
necessarily a dishonest transaction, but one that defeats or delays a man's
creditors and does not imply a dishonest motive or a state of insolvency.
Such a conveyance is an act of bankruptcy, and if within 3 months of its date a
petition and a receiving order results, the trustee's title will relate back to the
time of the conveyance and invalidate the transaction. This will mean that the
sale of the assets by the trader to the company can be set aside and such assets
will revels to the official assignee, rendering void and valueless any debenture
or charge given by the newly constituted company to the bank.
Pledge
Pledge is a bailment of goods as security for payment of a debt or performance

of a promise. Bailment means delivery of goods by one person to another for
some purpose, under a contract that the goods shall, when the purpose is
accomplished, be returned or otherwise disposed off according to the directions
of the person delivering them.
The person delivering the goods is called the pledgor or pawnor and the person
to whom the goods are delivered is called the pledgee or Pawnee. A pledge may
be in respect of goods, stocks, and shares, document of title to goods or any
other moveable property.
The essential feature of a pledge is transfer of possession of the goods, either
actual or constructive.
1. When possession of the goods is physically transferred from the
borrower to the lender, possession is said to be actual.
2. When the keys of the warehouse in which the goods are stored are
handed over by the borrower to the lender or lien the documents of title
relating to the goods are delivered duly endorsed if necessary,
possession is then said to be symbolic or constructive.
The contract of a pledge need not be expressed in writing. It may be implied

from the nature of the transaction or the circumstances of the case. However, to
avoid any dispute, a suitable Letter of Pledge is taken by bankers duly signed by
the borrower, so that there is then, no doubt about the intention of the pledgor.
A charge by way of pledge of goods does not require registration under the
Companies Ordinance. The main advantage of a pledge is that the banker, as
lender, is in possession of the goods therefore in the event of default by the
borrower, the bank has the right, after giving reasonable notice to the pledgor, to
sell the goods and liquidate the advance.
Whereas pledge of goods/raw materials is considered a better type of security
than mere hypothecation, as the bank has physical possession and control over
the goods, yet we must not lose sight of the fact that the nature of the goods,
their quality and quantity combined make them of value. Accordingly, we
should not be misled by any illusion of security merely because the goods are in
our possession.
1) Firstly, verify that the borrower has absolute title to the goods, by
sighting documentary evidence of his having paid the supplier.
2) It is of utmost importance that due care is exercised at the time of taking
such goods into custody, to ensure that they do not consist of dead
stock, outdated items, perishable items or such stocks that would
deteriorate in value the longer they are stored.
3) The quality of the stocks particularly those which have a wide range of
quality and value e.g. rice, cotton, chemicals, and carpets must be
examined by a professionally competent person conversant with that
trade.
4) Where the goods are packed in containers such as drums, cases, and
bags, a test checking of the contents must be carried out by random
selection, in order to ensure the contents are indeed what they are
represented to be.
5) Ensure wherever possible that the Bank has exclusive possession and
control of the pledged goods and that Bank's guards are posted at the
Bank's warehouse, with signboards prominently displayed.
6) Ensure that where goods are in the custody of a third-party i.e. clearing
agents bonded warehouse etc. then such warehouse keeper has
acknowledged that the possession is and on behalf of the bank and that
the pledged goods will be released against the bank's delivery order.
Such clearing agent or warehouseman should be duly approved and the
limits observed.
7) The goods should be duly insured with an insurance Company on the
Bank's approved list and the original polices covering risks of theft, fire
riots & civil commotion etc., held by the Bank.
8) Policy should incorporate the "Bank mortgage clause". Expiry dates of
such policies should be diarized.
The place of storage and description of the goods should be

stated in the Insurance Policy.
255
Lending: Products, Operations and Risk Management | Reference Bookcorrectly

1
Any restrictive clauses in the Insurance Policy should be complied

with, such as no hazardous goods stored with nor- hazardous goods.
The amount of the Policy should ,over the entire value of the goods
stored in the warehouse, irrespective of the amount advanced, to
avoid 'averaging' in the event of a loss claim.
9) It must be ensured that the premium has been paid and the premium
payment receipts are in records.
Types of Pledge
Pledge can be classified on the basis of godowns and storage conditions into
the following two categories:
i.
Pledge under lock & key:

This means that the goods are kept in covered godov.TU under lock
and key arrangements.
ii.
Open Pledge:
Open pledge means that the goods are kept in an open p.irr and
control over the pledged goods is affected at the m=i* gate of the
factory/godown premises. Keeping in view tftd relatively high risk
involved in open pledge, this should orim be allowed to high value
customers.
Exercising right of sale in the event of default
Pledge is a popular method of charging securities as cover for advances, This

type of charge is preferred because it confers on the pledge, a rigjBB of sale in
the event of default by the pledgor, provided notice is given b* the pledgee of
his decision to recover the advance by sale of the goocsl However, when
exercising the right of sale of pledged goods, the baricsr must act in the interest
of the pledgor, and keep two points in TTIT-W|I firstly, proper notice must be
served on the pledgor and, secondM reasonable steps should be taken to secure
a fair price for the good otherwise the bank may be faced with claims by the
pledgor on eitbe or both grounds.
Accordingly, to safeguard its position, certain precautions should be taial when
exercising the statutory right of sale of pledged goods such asq
(i)
The terms of the notice to be carefully drafted to ensure that full
particulars of the loan and goods are specified to enable the borrower
to identify the transaction.
256
(ii)
.
Sufficient time is given to the pledgor to redeem the liabilities,
specific date being mentioned.
(iii)
.
It should be mentioned in the notice that the bank has decided to
exercise its right of said pledge at "any time after the specified date for
redemption, in order to recover the advance.
(iv)
.
Where the goods are of doubtful value, they should be
examined by a qualified reputed surveyor to establish their market
value.
(v)
.
Written offers to purchase should be invited from several
dealers, well established in that particular line of business after they
haveLending:
inspected
theOperations
goods. and Risk Management | Reference Book 1
Products,
(vi)
.
In case of sale by auction, the auction should be well advertised
in at least two prominent newspapers giving details to attract the right
type and number of bidders.
(vii) .
The advertisement should incorporate a clause reserving to the
bank the right to reject any bid without assigning any reason in order
to avoid any chances of collusion by parties interested in keeping the
bids unduly low for their own subsequent advantage.
(viii) .
The offer closest to the market value may be accepted. Full
documentation of bids and all correspondence regarding the sale
should be carefully preserved in safe custody for at least 4 years from
the date of sale as a precaution against any possible civil suit by the
pledgor that the goods were sold for less than their fair value.
Delivery of pledged goods under trust receipt arrangement
The question is sometimes raised as to what is the position when a banker to

whom documents of title to goods have been pledged as security for an advance,
releases the same to its customer when it thinks fit for the special and limited
purpose of clearing and selling the goods in repayment of the advance.
The banker would do so against a Trust Receipt being duly signed by the
customer wherein he acknowledges that he holds the goods/sale proceeds
thereof in trust for the pledgee, that he would deposit sale proceeds in
repayment of advance and that he would keep the goods fully insured.
Earlier it was held that the pledgor does not lose his rights of property as pledge
by parting with the custody of the railway receipt or by entrusting them to their
customers for the special and limited purpose of clearing and realizing them, as
agents for the bank.
257
Accordingly, it was held that goods so pledged are not in possession,

order or disposition of the pledgor within the meaning of Sec 52 (2) (c)
of the Insolvency Act 1920 even where the railway receipts had been
handed over to the pledgor for a special and limited purpose.
In other words, should the pledgor/customer be adjudicated insolvent
while the pledged goods or proceeds thereof are in his possession, the
bank's right to them would over-ride that of the Official Assignee or
Receiver, and accordingly the banks rights as pledgee would be
protected.
However, the weakness in this arrangement lies in the character of the
pledgor. In the event of the pledgor committing a breach of mistrust in
respect of the sale proceed*! a bona fide buyer without notice of the
trust would obtain a good title, under Sec 30(2) of the Sale of Goods
Act 1930. the bank's rights in respect of the goods would be lost and i
only remedy would be in proceeding against the pled: personally for
criminal breach of trust.
The second possible source of risk to the banker is that I pledgor may
fraudulently pledge the same goods to anot bank. In the case of
Mercantile Bank of India the Central i Of India Ltd., (1938), the court
held that such a second pie was invalid on the basis of the old Sec 178
of the Contract. 1872 prevailing at the time the pledge was effected. The
Sec 178 regarding mercantile agents is identical to Sec 2 (Q| the Factor's
Act 1889 on which basis the case of Lloyds ]
Ltd., 1-1 Bank of America A7' el Xi (1938) was decidec i favour of
the validity of the second pledgee. The first plec The Lloyds Bank
thereby lost their rights in the proj originally pledged to them.
Since by extending this facility, the bank's rights as pledgee is prot only in
cases of insolvency of the customer/pledgor but not as fraud breach of trust
by him, such as by way of pledging the gc another bank or by
misappropriation of sale proceeds. It is of ut invariance that such facility
should be extended only to custom: undoubted financial standing and
whose business integrity is ofl highest order.
Hypothecation
Hypothecation means the charging of property to a creditor wh property

itself remains in the possession of the debtor or at least t not pass into the
creditors possession.
It is a kind of mortgage. Stocks of goods in the possession of a i may be
hypothecated to the banker and in the Letter of Hypothc the debtor
undertakes:
1. To pay-in the proceeds of sales of such goods to his current ac with the
banker.
2. To have the stocks adequately insured (against theft, fire, i and civil
commotion etc.) with usual Bank clause incoi in the policy.
Lending: Products, Operations and Risk Management | Refe
Under the terms of the Letter of Hypothecation, the bank has the right at its
discretion, to take possession of goods and thereafter to treat it as a pledge. The
Bank may take over possession of the goods and after giving reasonable notice
to the borrower, may arrange to sell them without intervention of the court for
the purpose of recovering its dues.
There are, however, practical difficulties in obtaining possession of
hypothecated goods from a reluctant and uncooperative borrower. Further, by
the time the bank decides to exercise its right to take possession, the bulk of the
stock may already have been disposed off to meet the pressing demands of
other creditors.
In view of the fact that such facilities can be easily misused by the borrower
through pledge of the same goods to another bank or disposal of the goods
without accounting for the proceeds, such facilities are only to be granted to
borrowers of undoubted financial standing and integrity or otherwise
collaterally secured.
Steps taken to formalize the hypothecation arrangement:
1.
First, it is necessary to verify ownership. Verification and

valuation should be recorded.
2.
Letters of Hypothecation duly stamped signed and verified
should be kept on record.
3.
Where the borrower is a Joint Stock Company, registration of the
charge is required with SECP.
4.
Stock statements must be submitted monthly by the borrower and
kept on record.
5.
Adequate margin as stipulated in approval must be maintained.
6.
Comprehensive Insurance in favour of the Bank to be obtained.
7.
The branch manager should visit the borrower's premises at least
quarterly to inspect the hypothecated stocks and record the fact in
the Godown Inspection Register. A visit report of the same
narrating details facts of hypothecated goods should be kept in
customers file.
8.
Hypothecation is not considered a good mode of security.
However, branches may propose advance against this security
only for well established and reputed businesses.
9.
Branches will ensure that the stocks and other assets are fully
insured against normal risks and the policy does not contain lien
of other banks. A confirmation to this effect should be obtained
from the customers in periodical stock statements.
10. Check Memorandum and Articles of Association /Partnership
Deed if charge over company/firms assets can be created.
11. Obtain Board Resolution to create charge over stock and
authorizing directors/persons to sign documents on behalf of the
company.
12. Banks charge and security documents duly signed by the
authorized signatory (ies) mentioned in the Board Resolution/
Partnership Deed and sole proprietor certificate to be obtained.
13. Register ranking/pari passu/floating/fixed charge over stock as
per Sanction Advice, with SECP.
14. Obtain certificate of Registration of Charges. (For companies).
15. File with SECP Joint Letter of Hypothecation signed by all
consortium/participant banks for registration of Join: pari passu
charge. (For companies).
16. Alternatively, obtain NOCs from all consortium /participants
banks and submit along with Letter of Hypothecation to SECP
for registration of pari-pass. charge (For companies).
17. Personal guarantees of sole proprietor/partners/direct oa as per
State Bank of Pakistan circulars issued from time M time.
18. Periodical stock statements (as per Sanction Advicr|| should be
obtained.
259
19.
20.
21.
Periodical inspection of hypothecated stock (as Sanction

Advice) to be carried out.
Insurance policy in the joint names of the Bank and
borrower with mortgage and other risk coverage c
mentioned in the Sanctioned Advice should be ob
Obtain original premium payments receipts.
Mortgage
A Mortgage is the transfer of an interest in specific imm property for

the purpose of securing the payment of an exi. future debt or the
performance of an obligation which may give a financial liability.
An Equitable Mortgage or a Mortgage by Deposit of Title place when
a person delivers the title deeds of his immovable to a creditor with
the intention to create a security thereon existing or future debt or for
the performance of a financial such as a guarantee.
Steps to formalize the mortgage arrangement:
i)
Ensure that the Title Deeds are examined by tiie solicitors

and obtain their certificate to the effect prospective
mortgagor has title to the property capacity to mortgage, the
title deeds are authentic, complete and valid for creation of
ii)
Obtain valuation certificate from reputed
iii) Obtain search certificate & non-encumbrance from the land
registry.
iv) Ascertain by inquiry:
a. that the ownership of the property is not
b. who is in occupation of the property.
c. what are the rights of the occupier and
d. to what extent such occupation affects the of the
property.
e. that the property tax and dues have been
f. that the borrower mortgagor is not in income tax.
v)
Obtain insurance policy with Bank mortgs: incorporated.
vi) The property owner should call at the bank and in the presence of at
least 2 witnesses formally hand over to the manager the Title Deeds
making the appropriate oral declaration.
vii) The memorandum of such deposit should be recorded in the mortgage
register at the branch on a day subsequent to that on which the deposit
is made.
viii) In cases where the property owner is a limited company, the charge
created should be registered with the registrar of joint stock companies
within 21 days of creation of the equitable mortgage.
ix) Obtain an agreement form the owner to create a legal mortgage in the
Bank's favour as and when called upon to do so. Obtain an Irrevocable
Power of Attorney from the borrower authorizing the Execution of
legal mortgage on his behalf.
x)
Record a caveat with the land registry to give notice to any intending
purchasers of the Bank's interest in the property.
xi) Continued retention of the original title deeds in Bank's custody
throughout the tenure of the loan.
xii) It is to be ensured that drawing should remain within the DP after
retaining 40% margin on properties.
xiii) Ensure that commercial / residential properties are in self use &
properties will not be rented without NOC / consent of bank.
260
Products,
Operations and
Risk M
A Legal Mortgage or Lending:
Registered
Mortgaged
takes
place when the mortgagor by
an instrument signed by the borrower attested by at least two witnesses and

registered under the Registration Act, binds the borrower personally to pay the
loan and agrees expressly that in the event of his default, the mortgagee shall
have the right to cause the mortgaged property to be sold and the sale proceeds
to be applied in payment of the debt.
Types of Properties
a.
Immovable Properties
The word Immovable Property has been defined in the registration Act
1908, section 2 (6) in detail. For the purpose of this document, it means land, buildings and things attached to the earth or permanently fastened to
anything attached to earth; and does not include:
Standing timber, growing crops or grass.
Machinery imbedded in or attached to the earth, when dealt with
apart from the land.
The phrase attached to earth means something in the nature of
permanent fixture, for work, and not removable after a short
period / time. Accordingly, machinery of a factory would fall in
the definition of immovable property. However, if the machinery
is treated or dealt apart from the land, like in the case where it is
movable in
261
nature or where machinery is installed over land which is not owned

by the owner of the machinery, then it wouli be treated as movable
property. However, in cases where machinery is installed over
leasehold land and the lessor has specifically allowed the lessee to
mortgage the leasehold rights, then the machinery will be treated 2*
Immovable Property.
Whenever an immovable property is offered as sei against credit
/advances, it would be taken as security way of mortgage
whether registered or equitable anc other property, being
movable property would be taken security by way of
hypothecation, or specific charge.
From a financing perspective, only private dorc immovable
properties will be accepted as security, domain includes the
properties owned by private persons, singular or collective. State
and Public d properties will not be accepted as security.
b.
Movable Properties
Property of every description except immovable pro

called movable asset.
Default by client
1. In the case of an equitable mortgage i.e. mortg deposit of title

deeds, there is a presumption as to p liability and so the
mortgagee can file a suit a mortgagor for recovery of the loan
in the event of Secondly, he has the right to file a petition in
the sale of the mortgaged property. Whereas, in the registered
or simple mortgage, the mortgagor pe covenants to repay the
debt and therefore the mo has the right to sue him in the event
of default to e recovery of the loan.
2. Secondly, the mortgagee bank can appoint a receiver, a power of
sale is expressly conferred by the mortga^ to recover the income
of the property concerned and the same towards repayment of
the debt.
3. Thirdly, the mortgagee bank can, in the event of de the debtor,
effect sale of the mortgaged property reasonable notice, where
the power of sale withe intervention of the court is expressly
conferred by the of the mortgage deed, in terms of the Transfer
of act.
Circumstances in which a Bank as registered mortgagee has the to exercise
its power of sale on the mortgaged property wit intervention of the courts:
In terms of the Transfer of Property act as amended in 1966, scheduled Banks

have been granted the power of sale without the intervention of the court,
provided such power is expressly conferred on the mortgage bank in the
mortgage deed. However the following conditions have been prescribed by the
Ministry of Finance under its notification dated 30.10.1969 for sale of
mortgaged property by the scheduled Bank:
1.
The mortgagee bank may sell the mortgaged property by private

treaty or public auction on the happening of any of the following
events, namely:
a.
b.
c.
d.
If the advance is not repaid on the fixed date mentioned

in the mortgage deed.
If the mortgage debt is repayable by installments and if
any installment is not paid within 3 months of its
becoming due and payable.
If interest for 3 months or up to an aggregate of Rs.
1000/- (Rupees one thousand or as per prevailing rate)
has become payable on the mortgage debt and remain
unpaid in spite of notice being served on the mortgagor.
If the mortgaged property is damaged or diminishes in
value so as to impair the security.
2. In case the mortgaged property is sold by public auction the

mortgagee bank must give reasonable publicity of the auction.
3. The mortgagee bank should not buy the mortgaged property or sell it
to any of its officers or employees, except for cases where there is
consent in terms of settlement.
4. Where the mortgagor is prepared to redeem the mortgage before the
sale or auction, as the case be, he whould be allowed to do so.
5. In terms of the 1966 amendment to the Transfer of Property
ordinance, Banks are exempted from producing to the registrar for
the purpose of registering a sale deed, in respect of mortgaged
properly sold by the bank on default of the mortgagor, any clearance
certificate from the income tax authorities.
Mortgagee should have regard to interests of mortgagor when exercising his
power of sale.
1. When exercising his power of sale, the mortgagee must act honestly and
equitably. He is under legal duty not only to act in good faith but also to
take reasonable care to obtain the true market price at the time he
chooses to sell.
2. The expenses of the sale are to be kept to the minimum and a full
account of the sale and expenses is to be submitted to the mortgagor and
surplus proceeds should be given to the second mortgagee, if any,
otherwise to the mortgagor.
Mortgage formalities
Legal formalities in respect of mortgage properties should always be

completed prior to disbursement. Obtain original title deeds, with
additional documents, if any, mentioned in the legal opinion for registered
or equitable mortgage of property/fixed assets.
Bank should obtain an opinion from Bank's approved lawyer/in house
Legal Adviser to establish true ownership, validity of the documents and
that effective charge can be created. Various statutes e.g. Rent Act,
Municipal Planning Acts etc. must be taken into account before accepting
land as Security.
Officer/ Manager of the Business Group must personally visit the property
and be satisfied with the evaluation before allowing disbursement. A Visit
Report should be placed on file accordingly.
Valuation of property should be accepted from banks approved evaluator
withBook
due1 diligence. Forced Sale Value should be effectively
Undng: Products, Operations and Risk Management | Reference
263incorporated in
valuations.
In case the valuation is below the value assumed at the time of sanctioning
of facilities, the same should be immediately reported to the credit
The Business Group should undertake fresh valuation of the j property
once in three years or as per SBP instructions in this regard or as per
banks internal policy. Some banks as a prudent practice requires that the
subsequent valuation of an asset is not conduted by valuator that has
conducted a valuation before.
Business Units should establish genuineness of Title Documents and
ensure that the property offered as security should be free ] from all/any
encumbrances.
They should check whether the proposed mortgagor has already j created
any tenancy agreement. This right to create a legal tenancy on factory or
commercial properly under mortgage should be | restricted, and only
allowed with bank's prior permission. For 1 purpose a suitable undertaking
will be drafted by lawyer/in-hot legal advisor and should be included in the
facility offer letter.
It must be ensured that the property is not in any dispute ; there are no
dues outstanding against it. Evidence of latest payi of property dues at
the time of fresh and renewal of propos should be obtained.
If the property has been acquired on Lease the remaining 1< period
should not be less than 10 years as required by the St Bank of Pakistan.
Safe guarding the bank's interest to the maximum, it should 1 ensured that
the remaining lease period is greater than the run.
The charge should be registered, when required, with follow offices.
- Land and Revenue Record.

- Registrar (property).
- Registrar of the Joint Stock Companies( If Limited Compa
A.
Obtain relevant charge and security documents duly signsiJ| the
authorized personnel.
B.
In case of property/fixed assets belonging to limited cor obtain.
264
a) Board Resolution to Mortgage.

b) Register charge with SECP.
SECPs Certificate of Registration of Charge to be obtained.
d) For 3rd party limited companys property/ fixed assets, check
Memorandum and Articles of association which permits the company to
mortgage its assets to secure third partys debt. If so, Board Resolution to
be provided.
Obtain NOC(s) from the first and / or the subordinate charge holder(s) in
the following situation for creation of:
Ranking charge over a specific item of assets of the company (e.g.
plant, machinery, vehicles etc.) Supplemental charge, in addition to
the already existing charge, over entire assets of the company.
f) Verification from SECPs search report that Banks charge is registered.
Register/inform the relevant authorities about the banks charge
over property/fixed assets.
Mortgage property/fixed assets to be insured as per terms of
Sanctions Advice or waiver to be obtained from the competent
authority.
Care to be exercised where property belongs to a lady especially
parda nashin. To safeguard the banks interest, instructions
contained in various circulars issued by Credit Group, Head office
from time to time/or legal opinion in this respect are meticulously
followed.
It is to be ensured that the property is not in the name of a minor. In
case of individual joint owners, make sure that none of the owner is
a minor.
Managers or their subordinates should endeavor to familiarize themselves with
local real estate prices to enable them to make a rough check on any valuation
received. Urban property generally forms the most suitable security.
A substantial margin of security should be taken, as a property's value in a
forced sale situation, which may be less than its market value.
In order to avoid legal complications in mortgage property documentation,
signatures of the mortgagor(s) on the security documents should be taken in
his/her physical presence. Relationship Managers should fill the attach
confirmation letter and submit the same to CAD along with signed security
documents. Other points of importance are:
Great care must be taken in granting advances against short leased
property. If granted, limits must be on a declining scale in accordance
with the yearly reduction in the value of the lease.
Lawyers are not infallible. All documents must be carefully checked.
The local laws governing mortgages, foreclosure and the disposal of
property must be strictly adhered to.
o It is desirable to see property tax receipts etc. yearly to ensure that the
property does not become encumbered o Property must be adequately
insured with an approved insurance company with the Bank's interests
noted in the policy. The original policy and premium receipt and all
subsequent renewal endorsements and receipts must be deposited with
the Bank.
Registered mortgages of property
Ideally a full first legal mortgage should be taken, stamped and registered
according to the requirements of local law.
If the mortgage is being made by a limited company, it must be established
that the company is empowered by its Memoranda! and Articles to
mortgage property up to the specified amount, ami a duly certified true copy
of the Board resolution authorizing the mortgage should be obtained. The
deeds
and all |docume
relating
thereto, especially receipts on discharge
Lending: Products, Operationstitle
and Risk
Management
Reference Book
1
of possible pt mortgages, should be retained by the Bank at all times, andi

Bank should be satisfied that:
1. All the necessary inquiries have been made to confirm 1 borrower's
title to the property.
2. The land is freehold, or if it is leasehold there is a subst term to run.
3. The property is of a nature, which can be mortgaged under i local
laws, and that the Bank has the right to foreclose 1 mortgage, if so
required.
4. The identification, measurements and market valuation of! property
have been verified.
5. The customer, if an executor or trustee, has power to ere mortgage.
6. The property is not subject to any prior charge.
7. All the owners of the property concerned have executed^ mortgage. If
only one of the owners is the borrower 1 others must provide personal
guarantees and this mi incorporated within the mortgage
documentation.
The mortgage should provide for repayment on dema include a clause

giving the Bank the power of sale upon any i
Bank mortgages are usually drawn up as continuing sec fluctuating
advances. It is customary that, once a moi created in favor of the lender,
then the charge is not vac the Lands Dept, till they receive a Redemption
Deed lender and is valid for a specific period as agreed bet lender and the
borrower. The period has to be extended 1 expiry to keep the mortgage
charge valid. If the moi proposed to be made for a fixed sum, the advance:
preferably be granted in the form of a separate loan acc monthly or other
regular repayments stipulated to avoid l in Clayton's Case operating against
the Bank.
The mortgage should cover an amount, which the bank i agreeable to
provide to the customer over a period ofl that frequent change in mortgage
value can be avoided.
Of the remedies usually provided, a power of sale fori without
reference to the court is best. If there is a prc company mortgage
for the appointment of a Receiver by 1 the Bank's liability as agent
of the Mortgagor (the I should be expressly excluded. It is
advisable to avc
possession of property because a Mortgagee in possession (the Bank) is

subject to burdensome liabilities in the management of property.
However, in certain situations such possessions may be taken, solely to
protect the Bank's interests with the prior approval of the Head Office.
Equitable mortgages of property
The best and most preferable method of securing an advance against

property is a legal/registered mortgage but in view of the exorbitant court
fee the borrowers insist on equitable mortgages. It is convenient and
expedient to advance against an "Equitable Mortgage" which, in effect, is
against a simple deposit of the title deeds with a Memorandum of Deposit
signed by the Mortgagor (borrower) in which he states that the title deeds
are to be held by the Bank as security for the debt, agrees to execute a legal
mortgage over the property if called upon to do so by the Bank, and
wherever possible gives an irrevocable power of attorney to the Bank to
enable it to realize the security without application to the Court.
Some general considerations are:
1.
The Bank must retain possession of the title deeds, and all the
prescribed searches as to title must be made.
2.
Whenever possible the Memorandum of Deposit of Title Deeds
should be executed with a stamp duty according to local
requirements.
3.
No advance may be given if there is the slightest suspicion attaching
to the title deeds, e.g. Trust Property, etc.
4.
The charge must be registered with the registrar of joint stock
company, if given by a Limited Company.
All Monies Mortgage
Before accepting the usual equitable mortgage from customers as

security for advances, consideration should be given to the customer to
execute an All Monies Mortgage. This is a charge over property
whereby the property is made available as security for all indebtedness
of the borrower to the Bank without limit and as permitted by the local
laws,
The advantages to the Bank of All Monies Mortgage are:
(i)
(ii)
(iii)
(iv)
It protects the Bank on EOLs.

It permits the value of the security to fluctuate with market value
without incurring the legal expenses or delay of a further charge.
It eliminates the problem of persuading customers that a
further charge is necessary for increased facilities.
Registration of an "All Monies" charge with the Registrar of
cciSrccmtpany ousiness.
The exemption of an "All Monies Mortgage" isup.considered

by the Bank because
rt-uU.rafinniv:
mortgages or charges created in favor of the Bank as security for the advances
generally specify the amount of the advances and limit the security to that
amount plus mark-up. Accordingly, if and
possession of property because a Mortgagee in possession (the Bank) is

subject to burdensome liabilities in the management of property. However,
in certain situations such possessions may be taken, solely to protect the
Bank's interests with the prior approval of the Head Office.
Equitable mortgages of property
The best and most preferable method of securing an advance against property is
a legal/registered mortgage but in view of the exorbitant court fee the
borrowers insist on equitable mortgages. It is convenient and expedient to
advance against an "Equitable Mortgage" which, in effect, is against a simple
deposit of the title deeds with a Memorandum of Deposit signed by the
Mortgagor (borrower) in which he states that the title deeds are to be held by
the Bank as security for the debt, agrees to execute a legal mortgage over the
property if called upon to do so by the Bank, and wherever possible gives an
irrevocable power of attorney to the Bank to enable it to realize the security
without application to the Court.
Some general considerations are:
1.
The Bank must retain possession of the title deeds, and all the prescribed
searches as to title must be made.
2.
Whenever possible the Memorandum of Deposit of Title Deeds should
be executed with a stamp duty according to local requirements.
3.
No advance may be given if there is the slightest suspicion attaching to
the title deeds, e.g. Trust Property, etc.
4.
The charge must be registered with the registrar of joint stock company,
if given by a Limited Company.
All Monies Mortgage
Before accepting the usual equitable mortgage from customers as security

for advances, consideration should be given to the customer to execute an
All Monies Mortgage. This is a charge over property whereby the
property is made available as security for all indebtedness of the borrower
to the Bank without limit and as permitted by the local laws,
The advantages to the Bank of All Monies Mortgage are:
(i)
(ii)
(iii)
(iv)
It protects the Bank on EOLs.

It permits the value of the security to fluctuate with market value
without incurring the legal expenses or delay of a further charge.
It eliminates the problem of persuading customers that a further
charge is necessary for increased facilities.
Registration of an "All Monies" charge with the Registrar of
Companies might dissuade other lenders from competing for that
company business.
The exemption of an "All Monies Mortgage" is considered by the Bank

because mortgages or charges created in favor of the Bank as security for the
advances generally specify the amount of the advances and limit the security to
that amount plus mark-up. Accordingly, if and when a further advance is
required and the property already mortgaged or charged is considered to be of
sufficient value to support the increase, it is necessary for a further mortgage or
charge (in some cases, fresh mortgage on the entire property) to be executed in
order to render the property available as security up to the amount of the
increased advances plus mark-up. On each occasion, the lawyers would charge
a scale fee for preparation of the document, based on the
amount of the securi ty provided. Stamp duty is also payable, basei the same
amount.
On every renewal of the facility a Supplemental Memorandum Confirming
Deposit of Title Deeds, should invariably be taken.
General power of attorney
It is not a legal requirement to obtain a registered General P Attorney from

the owner of the property where the prope equitably mortgaged.
However, as
267
in the standard General P Attorney it is recited that the executants have

created an eq mortgage in favor of the bank, he cannot challenge the same. cases where the owner is not the borrower and he/she executes registers the
General Power of Attorney, he/she cannot challeni: equitable mortgage. For
these reasons, General Power of A should be obtained where an equitable
mortgage is created.
Execution of a Memorandum of Deposit of Title Deals (MOTD) the
property owner is a female
Instances have been reported that during the course of ex proceedings

the lady owner of the mortgaged property have execution of MOTD
and signatures on the documents. B should therefore avoid accepting
properties owned by la/ security.
In case, any such property is taken as security then procedure be done as
follows:
1.
At the time of execution of Memorandum of Deposit Deeds where

women and pardanashin women in p concerned, the document must be
read over and e them prior to executing the same.
2.
Execution of the Memorandum should be adequately there is evidence
that the lady admits that:i.
She has understood the documents. This may be way of
adding a clause at the end of the Memo she has fully
understood the contents of Memo its implications.
ii.
She is the executants and after it is signed, the si
attesting witnesses present there are made. Iden' the
party by a female bank officer may also help the
bank's position.
3.
Proper attestation by two witness, in this case the would be sufficient
evidence of execution of the M
Third Party Property
Business Lines should take extra care where properties offered to secure
exposure belong to third party. They should ensure that the owner/mortgagor is
close family member of the proprietor /partner/director. In case owner of
property has no direct interest in the business, consideration/reason of mortgage
of property should be examined. In case, any unusual case is detected in the
existing portfolio, it should be brought to the notice of competent authorities
and all efforts should be taken to either adjust the outstanding or replace the
property with any other acceptable property in the name of proprietor /partner or
close family member of sponsors.
Guidelines in case loan is for the construction of property are as follows:
i)
The land should be in the name of the borrower, and all the necessary
documents should be completed and in order and approved as such by
bank's solicitors so that there will be no difficulty in creating a registered
mortgage.
ii) The application for advance should be supported by:
a)
b)
c)
d)
268
e)
The original lease deed and, where applicable, the conveyance deed
establishing the applicant's complete title.
A "no objection certificate" for mortgaging the plot issued by the
leasing authority.
A search certificate issued by the appropriate district authorities
evidencing non-encumbrance of the plot.
An estimation of the construction cost from a qualified architect or
engineer indicating the area proposed to be constructed on the plot
and material required, its cost and labor charges.
The loan should be disbursed in phases, after the borrower has
invested his part of the total cost. As each phase of the building is
completed the manager is required to visit the site to inspect the

progress to satisfy himself that the loan availed has been properly
utilized.
iii)
The prescribed minimum margin should be maintained throughout the

period of construction and afterwards until the loan is repaid.
Charge over Plant and Machinery
The following guidelines should be followed in case bank has charge over plant
& machinery of the borrower:
Detailed list of plant and machinery that is being placed under banks
charge should be obtained from the client.
Ensure that valuation of the asset is conducted through Banks approved
valuators and certificate to the effect is placed on file.
Personally visit the asset and be satisfied with the evaluation before
allowing disbursement. A Visit Report should be placed on file accordingly.
In case the valuation is below the value assumed at the time of sanctioning
of facilities, the same should be immediately reported to the credit
Undertake fresh valuation of the plant and machinery once in every three
years.
269
Banker's Lien
Lien is the right of a creditor, who is in actual or constructive possession of his

debtor's property, to retain such property until the debt due to him has been
repaid. The borrower is still the owner of the property but the lender has
possession of the property. Sec 171 of the contract Act refers to banker's lien
but this right can only be exercised where there is no express or implied
contract inconsistent with it. Generally, a lien does not cover a right of sale.
A lien may be either:
a)
b)
A particular lien, which arises from the particular transaction, connected

with the property subject to lien e.g. a carrier's lien for his charges on
goods carried.
General lien, which arises out of general dealings between the two
parties e.g. Bank's Lien.
By virtue of Sec 171 of the Contract Act of 1872, bankers may in the absence of
a contract to the contrary, retain as security for the general balance of account,
any goods bailed to them.
A Banker's lien is a general lien on all goods and securities that come into his
possession as a banker, unless there is an express or implied contract
inconsistent to it. To be subject to lien the property must come into the hands of
the banker to be dealt with in his ordinary course of business as a banker.
Securities deposited with a banker for safe custody are not subject to lien.
Where the" holder of a bill 'has a lien on it. He/She is considered to be a holder
for value to the extent of the sum which he has lent and in such circumstances
the banker could sue on the bill in his own name. A banker has lien on all bills,
cheques and notes sent to him by a customer for collection, where the customer
is indebted to the banker.
A Banker's lien has been defined as an implied pledge, whereas ordinary lien
does not imply a power of sale. Accordingly, a banker has a power of sale over
such securities on which he has a lien, subject to reasonable notice to his
customer.
In one way a lien is equivalent to a set-off. Where credit balances of the
borrower in the hands of a banker are concerned, provided these are in the same
rights and due between the same parties and in several judicial decisions, the
two terms have been used interchangeably.
Whereas the banker's right of set-off is confined to debts due to the banker by
the customer on his/her other accounts, lien is not it extends to goods, securities
and negotiable instruments belonging to the customer which may come into the
hands of his/her bankers in his capacity as a banker i.e. in the ordinary course of
banking business.
270
Lien and the law of limitation
tive
the
'the
the
ised h
it.
The effect of the Limitation Act 1908 on a debt is to bar the enforcement of
recovery through the courts due to lapse of time in filing the suit for recovery
which is generally 3 years in the case of debts. But it does not discharge the
debt itself. Accordingly, a banker can exercise his right of lien over securities,
bills or cheques of the customer which may come into his hands in the ordinary
course of business for the purposes of liquidating even a statute-barred debt of
that customer.
Conditions necessary for exercising bankers lien:
1.
2.
3.
4.
tion,
lien
a the
nthe
neral
come
plied
must
inary
er for
[to be
ind in
name,
a by a
inker.
lereas
cer
has
ject to
> of
the I
these
sever
al !
: to
the
exten
ds ; to
the s
in his
ess.
nee Book 1
The property must belong to the debtor.

It must come into the banker's possession lawfully.
It must come into the banker's possession in the ordinary course of business.
There should be no contract inconsistent with lien.
Banker's Right of Set-off
Set-off is the right of a debtor to satisfy a debt owing to him by his/her creditor
by taking into account all the debit and credit balances of the customer held by
him, in order to arrive at the net balance due between them. Conditions
necessary to exercise this right:
The amounts to be set-off must be sums certain i.e. definitely ascertained

amounts and not contingent liabilities.
Due between the same parties.
Due in the same rights i.e. debt due front a person in his private capacity
cannot be set-off against a debt due to him as a trustee.
Not subject to contrary agreement.
The banker's right of set-off is the right to combine two or more of the same
customers accounts in order to arrive at the net balance due between them, i.e.
a right to set-off a credit balance in one account against a debit balance in
another account of the same customer in the same right. The right to combine
two or more current accounts without notice- whilst actively operated upon
appears to have been the subject of controversial judicial decision.
It should be remembered that the bank would exercise its right of setoff without
notice, only when it is essential to preserve its position, a position in which the
customer has placed him. The customer can avoid combinations, by discussing
the matter with his banker and reaching an agreement with him.
It is the usual practice of bankers that where reliance is placed on the right of
set-off of a credit balance against a debit balance, an agreement called the letter
of set-off is taken from the customer confirming banker's right to combine
accounts at any time, without notices and to return cheques which would
overdraw the combined balance.
However, in case of death, bankruptcy, service of garnishee order, when banker
must stop the account, banker's right of set-off is undoubted. In order to
determine the net balance due to the executor of the deceased customer, official
assignee of the bankrupt customer or to the court on service of garnishee order.
271
A banker cannot set off:

1.
2.
3.
4.
Credit balance on trust account.

Credit balance on current account against contingent liab; on bills
discounted unless customer is insolvent or the bill overdue.
Credit balance on joint or partnership account against de balance on
personal account or, joint party or partner.
A debit balance on a loan account and a credit balance current account
without reasonable notice to the customer.
Lien/blocking of deposit
SBP directives, in the instance of advances against foreign currency

local currency deposits should be followed in addition to the folio
guidelines:
i.
ii.
iii.
iv.
v.
Advances should only be made against the Bank's own de accounts /

deposit receipts, provided bank lien has been m in the account or the
original deposit receipt is duly disch in banks favour as the case
may be. A signed Letter of Lien Set-off1 and a letter of Authority to
mark lien on banks stan format, should be obtained.
For deposit receipts, it should be ensured that the receipt' the
notation, Under Banks Lien, on its face and the s should be
placed in banks Safe Custody along with o charge / security
documents.
All foreign currency deposits should be placed under banks by
necessary system input in the system and the confirma /advice
should cite the notation under banks lien in concerned account.
The signed Letter of Authority to mark and the Letter of Lien and
Set-off should necessarily be ob from the customer prior to
disbursement of the facilities.
In the instance of advances secured against local currency term
deposits, proper discharge should be obtained at the side of the
receipts and which after verification of the signa should be safedin with the lending branch/CAC.
Advances must not be made by one branch (Lending B against the
deposit held by another branch) without ob prior written
confirmation that:
vi.
the lending branch's lien over the deposit has registered

and appropriate charge documents are by the branch
holding the deposit.
The branch holding the deposit should also co~ that the
proceeds are freely transferable to the len branch.
Advances made against deposits held by other b would
require an irrevocable financial guarantee in favor of the
lending branch with the prior approval the appropriate credit
authority.
When a local currency advance is being made against a foi currency

deposit, provision should be made for fluctuations the exchange rate
between the two currencies i.e. the current deposit and the currency
of advance. The Head Office and/or State Bank of Pakistan will
advise margin requirements mark-up rates to be charged from time
to time.
Stock Exchange Securities
Shares in public limited companies quoted on the stock exchange are a common
form of security offered to bankers. Their value is easily ascertainable but they
are subject to fluctuations. Before accepting them as security we should be
mindful of the following points to assess the quality of the shares as security:
i)
ii)
The age of the company, its reputation and that of its directors,
Market value of the shares during recent years with special reference to the
stability of value.
iii) Liquidity/ turnover of the shares.
iv) The company's present financial position and dividend history during last
few years.
v) Prospects of the industry in general and the company in particular.
Advances are granted against the actively traded shares/TFCs of companies
listed on the Stock Exchange and which are the members of the Central
Depository Company. Since formation of Central Depository Company, the
issuance of material script of the member companies has been discontinued.
Considering this factor, it is to be ensured that all formalities of marking Banks
lien on shares as pledgee with the Central Depository Company are completed
to the entire satisfaction of the Branch Manager.
Banks standard documents mentioned in the applicable section of the Credit
Administration Manual shall be obtained. It is to be ensured that all State Bank
of Pakistans regulations in this regards are strictly complied with.
If advances are made against the security of shares/TFCs owned by the third
party, the owner of the share/TFCs shall execute Banks standard Personal
guarantee. Business Group will ensure that beneficiary of the facility against
shares has necessary mandate to pledge the shares as security for availing
financing facility from the bank/DFI.
In accordance with the State Bank of Pakistans requirements, amended from
time to time, the Bank shall not among others:
a) take exposure against the security of shares / TFCs issued by them,
b) provide unsecured credit to finance subscription towards floatation of share
capital and issue of TFCs.
c) take exposure against the non-listed TFCs or the shares.
d) take exposure on any person against the shares / TFCs issued by that person
or its subsidiary companies. For the purpose of this clause, person shall not
include individual.
273
e) take exposure against sponsor directors shares (issued: own name or

in the name of their family members) of 1 DFIs.
f) , take exposure on any one person (whether singly or toge other
family members or companies owned and controlled 1 or his family
members) against shares of any commercial 1 DFI in excess of 5% of
paid-up capital of the share issuing 1 DFI.
g) take exposure against the shares / TFCs of listed companies! not
members of the Central Depository System.
h) take exposure against unsecured TFCs or non-rated TFCs i rated below
BBB or equivalent. Exposure may, however. 1 against unsecured /
subordinated TFCs, which are issued I banks / DFIs for meeting their
minimum capital requirer per terms and conditions stipulated in BSD
Circular No- I August 25,2004.
Guarantees Covering Advances
DEFINITION:
A contract of guarantee is defined in sec 126 of the contract act, 1 follows: A

contract to discharge the liability or perform the pi another in case of his
default. The person who gives the guara called the "surety", the person in
respect of whose default I guarantee is given is called the "principal debtor"
and the perse* ij whom the guarantee is given is called the "creditor
A guarantee is a collateral security of secondary liability, the gua being liable
upon default of the principal debtor and when I guarantor meets his liability to
the creditor, he can sue the pi debtor for repayment. For banks it is essential
that before laying comfort on guarantee, it is necessary that necessary due
deliga guarantors networth is conducted. For this purpose statement* personal
networth should be obtained.
A guarantee may be for a specific period or continuing/general. I said to be
specific when it has been executed in respect of a sf transaction and it
terminates when the guaranteed advance is rep surety can revoke a specific
guarantee only in the case where lis has not been incurred namely, where the
amount has not yet: advanced to the principal debtor.
A continuing guarantee is one which extends to a series i transactions. A
continuing guarantee may at any time be revoked 1 the surety by notice to the
creditor, but the revocation affects I transactions only. The surety is liable for
the debt existing at the i notice was served to the creditor. Whether in a
particular i guarantee is a continuing guarantee or not is a question of I
intention of the parties as expressed by the language they ] employed
understanding it fairly in the sense in which it is used s this intention is best
ascertained by looking at the position of I parties at the time the instrument is
written.
Essential features:
i) A guarantee may be oral or in writing but according to English law it

must be evidenced by a memorandum. However, banks in Pakistan and
elsewhere always take a written guarantee as security
i. e. on a printed form duly stamped, (at the prevailing rates),
ii) The opening phrases name and describe the parties to the contract. The
guarantee will be addressed to the lending bank, followed by the name
and address of the customer described as the principal followed by the
name and address of the guarantor. Accordingly, the three parties to the
arrangement are clearly described and defined as the lender, the principal
debtor and the guarantor,
iii) The opening clause usually explains why the guarantor has undertaken
the liability i.e. the consideration for the guarantee. Legally it is not
essential to record in a guarantee the consideration for which it was
274
given but a bank guarantee refers suitably to the subject. The guarantee
may merely state that the guarantee is given in consideration of the bank
making or continuing of advances or otherwise granting credit for so
long as the bank may deem fit. The consideration should not however be
expressed as the lending of a stated amount as it frequently is in private
loan arrangements, because the bank would then have to lend precisely
the given amount to the customer,
iv) Liability of the guarantor: the guarantor accepts responsibility for every
possible amount which the principal may owe to the bank when the
demand is made subject to a limitation on his maximum liability which,
for reference should be inserted in the guarantee by the guarantor in his
own handwriting. The liabilities of the guarantor are expressed to be
payable on demand, thereby ensuring that the - guarantee cannot be
statute barred until three years from the date when demand is made upon
the guarantor,
vi) Renunciation of common law rights: The form of guarantee covers all
possibilities, limiting the common-law rights of the guarantor and
permitting freedom to the banker in dealing with the borrower.
At first sight the bank's form of guarantee may seem to be verbose and
an unduly lengthy document, but every phrase and condition is essential
and should never be tampered with or altered without the complete
approval of the bank's legal advisor,
vi) Signature of the guarantor: If the worth of the guarantor is undoubted
and he/she signs the guarantee in his/her own free will, knowing it to be
a guarantee and under no possible mistake or misapprehension, the bank
will have a satisfactory security.
invalidation of the Contract:
A contract of guarantee is rendered invalid and surety is discharged of his

obligations in case the guarantee was signed by him/her:
a) By mistake.
b) By misrepresentation.
c) By concealment of a material fact.
d) Under coercion.
c) Under undue influence.
The Bank's rights as creditor against a guarantor on determination of the
guarantee by:
275
i)
Death of a Guarantor:
In absence of express agreement to bind personal representatives , the

guarantor's death determines the guarantee.Accordingly, the bank must stop
all operations on the guaranteed account to prevent the operation of the rule
in Clayton's case and ascertain the liability of the personal representatives of
the deceased guarantor for the amount owing at the date of the guarantor's
death.
In case the deceased guarantor had pledged personal securities to bank in
support of his guarantee the banker has the right to release them after
reasonable notice to the guarantor's personal representatives and apply the
sale proceeds towards adjustment of the guarantee debt. In the event of any
shortfall in the sale proceeds, the banker has the right to claim the balance
of debt from the deceased guarantor's estate.
ii) Insanity of the Guarantor:
Immediately after hearing from a reliable source that a guarantor has

become mentally incapacitated, the principal debtor's account must be
stopped, for the mentally affected guarantor's estate will only be liable for
the balance then due to the bank on the guarantor's account.
The guarantee is terminated as to future advances and the validity of any
clause in the guarantee purporting to make it effective as a continuing
security pending notice from the manager of the insane's estate does not
appear to have been tested in the courts. A clause requiring notice of
determination by the personal representatives on the death of the guarantor
would not be applicable in the event of his lunacy.
iii) Adjudication of the Guarantor as Insolvent:
On notice that the guarantor has been adjudged insolvent, the banker must
stop the account of the principal debtor and demand repayment from him.
Assuming repayment is not forth-coming from the principal debtor, the
bank has the right to file a proof against the insolvent guarantor's estate with
the official assignee or receiver.
Any part-payment of the debt before proof must be deducted from the proof
but payments made after proof do not necessitate its amendment.
The banker has the right to realize those assets and file a proof for the
balance if any, still outstanding or he has the right to deduct the estimated
value of the securities and file a proof the balance debt, if any.
Value: The value of the guarantee depends entirely upon instant
ability of the guarantor to pay when called upon. A guarantee
unsupported by collateral security is in effect, an unsecured advance
to the guarantor and we should, accordingly, take every means to make
quite sure that the guarantor's financial strength is undoubted, to the extent
of his liability, not only now but throughout the period involved. Hence, the
credit-worthiness of the guarantor must be periodically reviewed to ensure
his continued good financial standing. Accordingly, diarize for periodic
renewal of inquiry.
276
Validity: Capacity to contract on the part of the guarantor is essential to the

validity of guarantees.
i) A guarantee from a minor, no matter how wealthy he may be, is not
acceptable as it will not be enforce-able against him.
ii) If a ,joint and several guarantee is taken, ensure that all the
intending guarantors have signed the form, failure of one to sign
would release the others.
iii) Where the guarantor is a limited company, the memorandum of
association should contain a clear power to engage in such
contracts for the benefit of third-parties, and a board resolution
obtained authorizing the official to sign and clearly identifying the
guarantee, where the directors passing the resolution are personally
interested in giving of the guarantee. Have the resolution passed by
the company in general meeting.
When mutual guarantees are given by companies in the same
group, it is essential that each company fulfils all necessary
formalities.
iv) Guarantees should be signed by all the partners_ unless specific
authority is given for one to sign on behalf of the others. The power
of one partner to bind his co-partners does not extend to giving
guarantees for the benefit of third parties.
Third Party Corporate Guarantee / Bank Guarantee
In case where a corporate guarantee is required from a third party as part of

the security to support the approved facilities, it must be ascertained and
ensured that the Corporate Guarantor in question (in case of a limited
company) has the legal power under its Memorandum of Association to
secure third party borrowings by creating a charge on its assets / issuing its
corporate guarantee. Necessary Board Resolution to be obtained duly vetted
by Banks Lawyer.
Text of the Corporate guarantee/Bank guarantee to be vetted by approved
Legal Advisor/Legal Affairs Division.
In case where a bank guarantee is required to secure the approved facilities,
authenticity and genuineness of such bank guarantee is to be verified with
the Head Office of the bank issuing that guarantee (in case of local
bank/Business Group of bank domiciled in Pakistan). In the case of a
guarantee received from an overseas bank, a tested message/SWIFT
message is to be obtained confirming the authenticity of that guarantee prior
to disbursement of facility.
Requirement of Personal Guarantees
SBP requires banks to formulate their own policy guidelines regarding

obtaining of Personal Guarantees. Following can serves as the criteria
in this respect, however banks own policies shall be followed:
277
Public Limited Companies (Limited)
PGs are not usually required for public limited companies (de{ on banks
policy) that are listed on the stock exchanges of] Lahore and Islamabad.
However, if a company falling in this cat has provided such guarantees to other
banks or NBFIs then should also seek the same.
Public Limited Companies (Unlimited)
For public limited companies not listed on the stock exchanges- iti be
mandatory to obtain PGs of all directors (excluding nor /government
employees/foreign nationals).
Private Limited Companies
PGs of all directors to be obtained (excluding nominees/govei

employees/foreign nationals) along with personal networth state
Partnerships and Proprietorships
For proprietorships and partnerships, PGs of owners or partneis j proprietors

must be obtained.
Exceptions
As a general guideline, PGs of all directors, partners and propr are required for
all customers as defined above. If, howevei exception has to be made for a
particular customer, then the , should be approved by the Competent Authority
for consideration.
However, in case personal assets/properties have been charged to 1 bank as
security, the waiver/release of personal guarantees of <
(shareholders/directors/third parties) of assets held as security may I allowed
only if it does not adversely affect the perfect the seci after seeking necessary
clearance from the Legal Division.
Pledge of paper securities and pledge of stocks
There is a vast different between pledge of paper securities and j of stocks. Both
pledges have different risks and need to be cl comprehended. Pledge of paper
securities does not attract; significant risk about theft/stolen/robbery, as these
are nor retained under valt of a Bank, though there are some ris'tsi
fire/explosions etc against which proper insurance coverage shoi available.
Moreover, risk of market value is another concerned; particularly where value
of pledge depends on daily market price, the other hand pledge of stocks have
different areas of risks that: to be addressed appropriately. One of the key area
where Bank: focus is the appointment of Muccadam, as Bank's reliance in <
pledge of stocks merely depends on him. The other areas that ne be taken care
of in case of pledge of stocks are the nature* commodity, condition of godown,
and legal documentation in < third party godowns.
Legal Documentation
While extending credit it is important that the corporate status / structure of

the customer should be clearly established. The corporate status / structure
of the borrower determine what security / collateral and documentation is
required to secure the finances.
A borrower can either be a Company, Firm, Sole Proprietorship,
individuals, Trust, Society, NGO, or Non-Profit Organization etc.
Documentation is an essential part of the credit process and is required for
each phase of the credit cycle. It establishes the relationship between the
bank and the borrower and forms the basis for any legal action in the event
of a default. It is the responsibility of the bank to ensure completeness of
278
documentation in accordance with approved terms and conditions.

Outstanding documents should be tracked and followed up with business to
ensure execution and receipt.
Documentation Categories
Normally there are three (3) categories of documents that are required to be
obtained from the customer:
2.
3.
1. Documents providing evidence to legal claim. For example:

Board Resolution.
Markup/ Finance Agreements (IB 06, 6A, 6B, 6C, STFA etc).
Documents creating security interest like hypothecation/ pledge
agreements, bill discounting agreements, Memorandum of Deposit
of title deeds (MODTD), SBLC, Bank Guarantee etc.
All documents that provide evidence to legal claim should not be
deferrable.
Documents required by regulatory bodies
All documents that are required to be obtained as per instructions
issued by SBP/ any other regulatory body are not deferrable.
Support documents
Documents that do not provide evidence to legal claim and are
obtained to further strengthen security interest or to monitor
performance of the borrower.
Maintenance of Collaterals / Security Documents
Collateral documentation, such as mortgage papers and title documents, are

assets of the Bank, which if lost or fraudulently given to other lenders may
cause loss to the Bank.
The Bank should keep all security documentation in Security
Documentation Folder in a room with fire proof arrangements under dual
control after lodgment in Safe Custody Register. A separate register should
also be maintained to keep track of movement of any document/document
folder. Relevant Bank departments should issue collateral lodgment receipt
to the concerned branch which will serve as a proof that documents are held
in safe custody.
retrieval.
Profit payment on security held as collateral should be the responsibility of business
units.
Access to collateral should be by dual authorization. Receipt and release of collateral
should require authorization from at least two responsible officers of the Bank.
At all times, security documentation should be available for physical checking by
internal and external audit.
Under no circumstances a security document, an insurance folder or any contents of
the same are to be removed from the Authorized Area. These documents should NOT
be kept outside the vault area for an overnight period. Exceptions to the above rule
need to be properly approved. Authorization and outward movement of any suer
documentation should be noted in the Movement Register. In cases where an
outward movement, of any such security document, from the custodial area to another
area is required then this too should be noted in the Movement Register.
279
When such a document is required by a branch then the request for its temporary
release / transfer should come from the branch. Such a request should clearly specify
the purpose & time of temporary movement, needs to be duly approved by relevant
authorities. After the authorization process, as detailed above, the branchs authorized
representative should take custody of the required document at the authorised
premises.
When files / documents are authorized to be removed temporarily outside the
custodial area, the responsibility of these files / documents also shift to the concerned
individual who has taken over temporary custody.
Documents placed in the branches:
In branches where legal documents are placed, it should be the responsibility of

Branch Manager to ensure that security documentation is placed in Security
Documentation Folder in roonr with fire proof arrangements under dual control after
lodgment in Safe Custody Register. A separate register will also be maintained to
keep track of movement of any document / document folder.
On receipt, collateral should be entered in register and placed in a clearly marked
folder/pouch for accurate identification and ready retrieval. Access to collateral
should be by dual authorization. Receipt and release of collateral should require
authorization of by least two responsible officers. At all times security documentation
should be available for physical checking by internal and external audit.
Under no circumstances the documentation, insurance folders and their contents
should be removed from the Credit Documentation area. Exceptions need to be
properly approved by Branch Manager and the outward movement of any such
documentation should be noted in the Checkout Card. When outside the Credit
Documentation Area, the responsibility of the files shifts to the Branch Manager.
Collateral registers should be checked against physical holdings at least annually.
280
Other arrangements:
Some banks, depending on the size, resources and complexities of the systems have
different safe keeping arrangements. Some banks have centralized Credit
Administration departments performing the above function.
Insurance cover:
All assets charged to the bank are to be insured during the complete tenor of
outstanding liabilities. In case of equitable charge / mortgage on fixed assets, value of
land is excluded to calculate the value of insurance. Accordingly, all assets under
Banks lien are to be insured by an insurance company on the Banks approved panel.
1- It is in the interest of the Bank as well as clients that adequate insurance cover
is obtained for industries financed by us as well as for finance facilities
extended to our clients against machinery / stocks and hypothecation / pledge
of goods.
It should be ensured that advances do not remain unsecured for lack of
adequate insurance cover and a proper policy of insurance is obtained. This
fact should also be reported in the proposals for renewal/enhancement of
existing facilities and/or for grant of fresh finances mentioning therein
validity date/risk covered/amount of insurance obtained.
2- It should be ensured that stocks/machineries providing cover to our facilities
must always be adequately covered, i.e. insurance must always provide cover
to the required stocks/assets declared from time to time for coverage/value
not less than outstanding loan or exposure / operative limit whichever is
higher plus 10%.
3- It may be suggested to customer to get insurance cover for remaining
stocks/assets also, so that in case of any mishap their loss may be minimized.
Where customers do not get the remaining assets/stocks insured, an
undertaking should be obtained from customers, to the effect, that insurance
claim received shall be first available towards adjustment of Banks
financing and balance if any shall be repaid / paid from their own sources. In
case where goods under banks lien have to be transported, the transit risk
coverage should also be obtained.
4- Insurance coverage should be obtained for all risks pertinent to the assets
being insured and keeping in view area / storage conditions where goods ate
stored.
5- Open Pledge: Some limits allowed against Phutti, Cotton, Rice, Paddy, Sugar
and like stocks are under open pledge arrangement, exposing the Bank to
high risks for Burglary, Fire, Riot, Strike, Damage/Malicious damage etc. As
such, it is necessary that appropriate insurance policy is obtained keeping in
view the fact that goods are kept under open pledge. The policy / policy
cover note should clearly mention that the insurance stocks/assets are stored
in open and there should be no restrictive clause regarding such storage
arrangement to avoid any dispute in the event of a claim.
6- Legal Cases: Regarding insurance cover on non-performing assets for which
Bank has filed recovery suit(s), insurance cost can be debited to outstanding
balances only after seeking permission from the Competent Court by filing an
urgent application through our counsel to this effect because the matter is subjudice. It is, therefore, recommended to consult the counsel, contesting the case
on Banks behalf, well in time to seek courts permission in this respect.
7- The branches should invariably obtain insurance cover note in original and
281
examine the same vis-a-vis appropriateness of the risks covered, with Bank
Clause, before allowing any disbursement/taking any exposure on such assets
under our lien. Please note that no risk extension is covered unless premium for
the extension(s) is/are received by the insurance company. They should diarize
the validity date of Insurance Cover Note and ensure that Premium Payment
Receipt in original / Policy is received before the expiry of validity of the; cover
note. During currency of cover note if any claim is lodged, the insurance
company is liable to pay claim only after receipt of premium.
8- In case of insurance of building, insurance cover is available for value above
plinth level and as such insurance coverage for. fixed property under our lien
may be obtained after deducting; value of land and below plinth civil works etc.,
for whichl necessary assistance of banks approved valuer may be obtained.
9- Normally Insurance polices expire at 4 Oclock in the aftemc of the policy
expiry date and as such branches should hold 1 documents confirming
renewal of policy before the afore time. However, as a matter of rule,
branches are advised 1 obtain renewal of the policy atleast one week before
its ex and should diarize the same. Where Night-work is applic the matter be
referred to insurance companies for cover &/or exclusion of Night-work
clause from warranties.
10- In case the insured stocks/assets are stored in open or oj sided building/sheds or
where there is/are deviation(s) 1 policy or warranty conditions are not fulfilled,
the policy/] cover note should clearly mention the same and there she not be
restrictive clause regarding such storage arrangemer avoid any dispute in the
event of any claim. Branches she ensure that clause excluding the storage as
above is deleted i varied by the insurance company and duly authenticat bearing
signature & seal.
11- For coverage of risks other than Fire, Burglary, RSD and MD prior
approval of competent authorities is required subject to proper
justification. Where Burglary cover for full value of stocks are not
obtained (e.g.; 1st loss basis i.e. quantity of goods whose lifting is
possible within a night (12 hours) subject to the condition that same
is atleast 10% of goods under Banks Pledge / lien or higher), prior
permission of competent authority be obtained in writing.
12- Insurance coverage to be obtained should not only be limited to
above guidelines, but be based on specific ground reality. To further
facilitate understanding of branches/field offices on the subject,
Appendix I to Chapter 5.4 provides details of perils for which
insurance cover (other than marine insurance) are generally
available for stocks/assets under banks lien and the risks usually not
covered in a standard policy. However, branches are advised to
study the specific original policy / policy cover note and ensure that
all pertinent risk for which cover is available & required has been
obtained/relevant exclusion have been deleted and duly stamped by
the insurer.
13- In case of financing, where during Banks exposure (fund based &/or
non fund) transportation by sea vessel is involved, appropriate
marine insurance cover shall be obtained in all cases. Monitoring
methodology of guarantees and that of insurance policies for claims
secured against Bank guarantee or insurance policies it is essential
that the Bank monitors the following:
The validity of insurance policy or guarnatee should not be less
than the expiry of claim.
. The rating of Bank or Insurance Company should always be
282
monitored on regular basis and it should remain within the

acceptable range of the Bank.
. If there is any difference in the currency of claim and curreny of
Insurance Policy or Bank guarantee than the movement of
currency should be monitored meticulously.
. If in case of Bank guarantee where Country Risk is involved then
rating of Country and any adverse scenario of that Country
should be monitored.
Vendor Management
Outsourcing is a cost effective alternative for the bank for activities that do
not constitute mainstream banking. However, outsourcing can amplify the
risk profile of a bank by exposing it to strategic, reputation, compliance and
operational risks arising from failure of a vendor in providing the service,
breaches in security, or inability to comply with legal and regulatory
requirements. The bank also needs to manage associated concentration risk
that may cause lack of control over a service provider who renders many
services for the bank, or Bank is excessively dependent on a vendor for a
specific service or due to dominant position in a specific region etc.
Management of concentration risk will be the responsibility of business
units.
In order to mitigate these risks, risk management technigues have
third-party risks.
283
11- For coverage of risks other than Fire, Burglary, RSD and MD prior
approval of competent authorities is required subject to proper
justification. Where Burglary cover for full value of stocks are not
obtained (e.g.; 1st loss basis i.e. quantity of goods whose lifting is
possible within a night (12 hours) subject to the condition that same is
atleast 10% of goods under Banks Pledge / lien or higher), prior
permission of competent authority be obtained in writing.
12- Insurance coverage to be obtained should not only be limited to above
guidelines, but be based on specific ground reality. To further facilitate
understanding of branches/field offices on the subject, Appendix I to
Chapter 5.4 provides details of perils for which insurance cover (other
than marine insurance) are generally available for stocks/assets under
banks lien and the risks usually not covered in a standard policy.
However, branches are advised to study the specific original policy/
policy cover note and ensure that all pertinent risk for which cover is
available & required has been obtained/relevant exclusion have been
deleted and duly stamped by the insurer.
13- In case of financing, where during Banks exposure (fund based &/or non
fund) transportation by sea vessel is involved, appropriate marine
insurance cover shall be obtained in all cases. Monitoring methodology
of guarantees and that of insurance policies for claims secured against
Bank guarantee or insurance policies it is essential that the Bank
monitors the following:
The validity of insurance policy or guarnatee should not be less than
the expiry of claim.
. The rating of Bank or Insurance Company should always be monitored
on regular basis and it should remain within the acceptable range of
the Bank.
. If there is any difference in the currency of claim and curreny of
Insurance Policy or Bank guarantee than the movement of currency
should be monitored meticulously.
. If in case of Bank guarantee where Country Risk is involved then rating
of Country and any adverse scenario of that Country should be
monitored.
Vendor Management
Outsourcing is a cost effective alternative for the bank for activities that do not
constitute mainstream banking. However, outsourcing can amplify the risk
profile of a bank by exposing it to strategic, reputation, compliance and
operational risks arising from failure of a vendor in providing the service,
breaches in security, or inability to comply with legal and regulatory
requirements. The bank also needs to manage associated concentration risk that
may cause lack of control over a service provider who renders many services for
the bank, or Bank is excessively dependent on a vendor for a specific service or
due to dominant position in a specific region etc. Management of concentration
risk will be the responsibility of business units.
In order to mitigate these risks, risk management techniques have been
developed for proper identification, assessment and mitigation of third-party
risks.
fc
Ti<ajcts, Operations and Risk Management | Reference Book 1
283
Key factors involved in Risk Management Process are:

Establishing senior management awareness of the risks with
outsourcing agreements in order to ensure effe management
practices.
Ensuring that an outsourcing arrangement is prudent from
institution.
Systematically assessing needs while establishing requirements.
Implementing effective controls to address iden
Performing ongoing monitoring to identify and evai in associated
risks.
Documenting procedures, roles/ responsibilities. mechanisms, and
responsibility segregation amor. departments of the bank.
Typically, this process incorporates the following activities:
Risk assessment and its requirements.
Due diligence in selecting a third-party service provider.
Adopting qualitative & quantitative criterion for e- allocation of
limit.
Contract negotiation and implementation; and
Ongoing monitoring.
valuation of FIXED ASSETS under banks lien And Valuers:
Professional Valuers are individuals or organizations that value of assets
and collateral provided to Banks and Institutions for the purpose of
securing loans, advances and facilities.
Section 5(m) of BCO 1962 states, Secured Loans and Ad a loan or
advance made on the security of assets, the m which is not at any time less
than the amount of such loan7. Accordingly, the market value is required to
be used as the valuation of assets offered as security at the time of extei
Keeping in view best practices a reasonable margin should to cover price
fluctuations. The following guidelines shouM mind while approving
valuators:
a. Concentrations to be avoided.
b. Technical expertise of the Valuer to be kept in view.
c. Fair distribution of business among all Valuers.
Performance Evaluation:
Performance Evaluation of all enlisted Valuers should be annually.

Evaluation is initiated for two reasons:
i. Periodic Evaluation:
appraisal of all enlisted Valuers on an annual basis to any change in
Valuers limit amount, scope regarding assets or geographical
allocation.
ii. Event Driven Evaluation:

event driven evaluation upon receiving any material negative information
regarding creditworthiness, integrity, reputation and /or conduct of
approved Valuers. It is preferred that a property is evaluated by a
different valuator that has previously conducted valuation.
Muccadumage operations and muccadums Muccadumage services are
utilized for sites/customers with credit limits secured by pledge of goods
or where independent inspection of Pledged/ hypothecated stocks is
required. The job is assigned to only banks enlisted Muccadums.
The following criteria could be met with while selecting a mucaddam:
i.
Total number of sites under charge of requesting Muccadum is less than

Banks allocated limit on maximum number of sites to that particular
Muccadum.
ii. Not more than a reasonable percentage (as deemed appropriate) of total
sites of the circle are entrusted to the requesting Muccadum.
iii. Any area of specialization or geographic restriction of a mucaddum.
Before entrusting any fresh site to a Muccadum, relevant competent authorities
should undertake a site inspection and determine number of guards to be
appointed at the site. Discrepancies like non availability of firefighting
equipment, improper stacking, unacceptable stocks condition, non-standard
procedures being followed, details of multiple borrowings (if applicable) and
number of Godown keepers should be noted and communicated to the relevant
authorities.
C&F Agents and clearence of imported goods
Clearing Agents services are required, whenever some branch process

customers request for import of goods against banks financing from abroad
and needs to fulfill the port/custom requirements for taking up custody of goods.
Clearing & Forwarding (C&F) agents arrange clearance of shipment from the
vessel through customs gate and take control of goods for onward delivery as
per banks approved arrangements.
Clearing of goods imported under banks lien should be entrusted only to Banks
approved C&F Agents.
VENDORS PROVIDING SERVICES of CREDIT REPORTS, SEARCH REPORTS
AND LEGAL SERVICES
Knowledge of customers credit worthiness is vital for taking any lending

related decision as it helps in gauging of credit risk and supports in mitigation of
default risk. In addition, it also assists in analyzing industry and business risks
pertaining to individual clients and their respective industries.
Practically, there can be no one source that could provide conclusive information
about all such facets and process of obtaining such information is both
methodological and unstructured. In addition, market intelligence cannot
reasonably be obtained in one go, but is acquired through a process of gradual
analysis over a period of time from a host of various sources, such as other
customers, other bankers, competitors, newspapers, etc. Therefore, it is crucial
for a banker to have accurate knowledge about the developments in the
economy, and key industries being focused by the Bank.
Banks enlisted external vendors provide different reports/searches that provide
disclosure about customers financial strength, business/marketing strategy,
managements interests and competence, technology employed, competitors,
285
customers, suppliers, regulatory and economic environment. Different reports/

searches/ services providing support in risk management are as below:
Local Credit Report (direct interview with borrower).

Market Reputation Checks (without contacting borrower).
SME Credit Reports (direct interview with borrower).
Charges Search Reports.
Certified True Copies of Form29, Form-A, or any other
document from RJSC office.
Charge Registration.
Legal Service.
International/Cross-border Credit Report.
Stock reports:
When goods are to be pledged the relevant authority should prep letter
addressed to the Muccadum (warehouse agents) providing 1 the name of the
customer, the details of the goods to be pledged requesting them to receive
the goods in good order and conc directly from the customers and
simultaneously, should also prep letter addressed to the customers providing
them the name ; address of the Muccadum and advising them to deliver the
goods to 1 pledged directly to the Muccadum. The concerned authority si
receive stock reports from the Muccadum in duplicate and, ensuring the
approximate value of goods stated in the stock rep in accordance with the
value of pledged goods shown in the! advice forward the original stock report
to the officer designs control of pledged goods advising him to inspect the
goods.
In case of hypothecated goods the officer should scrutinize the! report to
ensure that the description and value of goods accordance with the description
and value of sanction advice and 1 the complete address of the place where the
goods have been: clearly mentioned. He should also check if the insurance
poi:ryi been taken from an approved company and is in banks favour. Ini of
any discrepancy, the officer should contact the customer to | same rectified.
The stock register is supposed to include details of all goods < pledged or
hypothecated. Stock inspection of the pledged stock is 1 undertaken by the
bank at a frequency deemed appropriate I
bank and report thereof should be placed in file. Moreover, stock inspection is
supposed to be carried out by banks approved surveyor^ valuators and Stock
report also to be obtained after issuance of Delivery Order. Periodical reports of
value, quantity, quality, weight, and measurement of pledged goods are obtained
from the customer, and are duly verified by the Banks warehouse staff or
Muccadam.
Bank's Charge and Search Reports:
In view of the aspect of ranking of charges, it is utmost necessary while

extending loan to a company that a Search Report is carried out from the
Company Registrars office to ascertain whether the company assets have earlier
charge in favor of some other lender. The search should be conducted by the
Banks approved agencies.
Search Report should clearly mention the ranking of existing charge(s) created
on the assets intended to be accepted by our Banks as security. This report
would help in ascertaining the total amount of charge/encumbrance created on
the assets and ranking of existing charge holders.
Authored
286
by:
Farhan Ali
student Learning i. Facility account monitoring Outcomes

Recall different ways of facility account monitoring in use
Discuss the difficulties that may be encountered in operating
the facility within present limits
Recall the requirements for meeting facility turnover and
quantum of business booked under the facility
Differentiate between monitoring frequency of peak/low
fadfity utilization and that of irregularities in the accounts
2. Facility monitoring systems

Discuss the significance and use of reports on activity in
facility accounts
Define facility monitoring systems
Explain the use of due date diaries for retrieval of due
amounts or settlement of facilities in a facility monitoring
systems
287
Management of credit refers to monitoring of facilities once these have been

advised to the customer. The scope may entail setting of various covenants /
triggers and their periodic review to ensure that the facilities are being
utilized as advised and are in line with the original purpose of the facility.
Facility Account
Monitoring
Ways of Facility
Account Monitoring
Account monitoring is an integral part of overall account management. This,

not only, helps in ensuring maximization of returns to the bank (e.g. setting
of min. business routing covenants), at times it may act as an early warning
signal i.e. when the account behavior is not in line with acceptable
parameters.
The account manager may opt for various methods to ensure effective
management of a portfolio of accounts. These may include:
Periodic review of the account.

Close interaction with customer i.e. regular meetings.
Setting of covenants agreed by the customer. These can be financial
and non-financial in nature as follows:
Financial - Total equity not to fall below PKR XXX,
Non Financial - Routing of trade volume = 2x of the facility
amount.
Setting of internal risk triggers. These include financial and
non-financial triggers.
Financial - Drop in sales by more than 10% when compared
with last quarter.
Non Financial - Chang in shareholding / management control
etc.
Challenges
While the above covenants / triggers are helpful in ensuring appropriate

utilization of facilities, actual utilization is dependent on a number of factors
which may / may not be within the control of the borrower. Some of these
factors may be directly linked with the business cycle of the borrower while
others may be a result of changes in economic conditions.
Following are a few examples of the above:
288
Rapid growth in sales requiring higher working capital facilities.
Increase in working capital requirements as a result of higher

commodity prices e.g. cotton.
Impact of higher oil prices on operating costs e.g. electricity /

transportation.
Devaluation of local currency (in case the borrower significantly
Management
of Credit -1
import oriented).
Compliance to
Business Routing
Requirements
Materialization of contingent liabilities i.e. insufficient cushion in

funded facilities to accommodate the same.
Any other unforeseen event e.g. temporary blocking of facilities by

other banks on companys panel.
As highlighted above, the facility advising may contain certain covenants

requiring the borrower to route a certain amount of business through the
bank.
These may include a threshold of minimum average utilization of i funded
facility or routing of a certain percentage of trade business through the bank.
Following are some common example of such z requirement:
Term Loans: It is a common practice by most banks to restrict

routing of all trade business and sometimes sales proceeds, m case
the subject term loan is being advised for import of machinery. The
borrower is restricted to establish LCs / open contracts through the
same bank for retirement of these documents through the said term
loan.
Trade Facilities: General trade facilities usually require routing of

trade business in multiples of the facility size e.g. annuil trade
business worth two times of the facility amount must be routed
through banks trade counters. The above is only applicable in case
the facility is provided for working capital requirements of the
company.
Funded Working Capital Facilities: A similar restriction i.e. routing

of trade business, may also be placed where the bank commits
balance sheet in the form of funded working capital lines e.g.
overdraft / short term loans etc.
In addition to the above, banks may require the borrower to award z first
right of refusal on a lucrative one off deal e.g. a derivative / bocd mandate
as part of a competitively / below market priced deal.
Monitoring
Utilization
Facility
In order to ensure that all facilities are being utilized for the agreei.
purposes, regular monitoring of the facility at relevant intervals JS
paramount.
Facility structuring i.e. selection of appropriate facility in line widi
borrowers requirements should help minimize the risk of routing of funds
away from the intend purposes. In this regard, recognition of the quantum
and purpose of requirement is the first step towards selection of a suitable
product for the borrower.
Selection of facility and utilization may be explained with the help
following examples (related to working capital facilities):
Permanent / Core Requirement: Permanent working capital
289
requirements may be financed through an overdraft or revolving short term

loan facility. Such facilities are suitable for businesses that have similar
levels of borrowing requirements throughout the year e.g. car dealers.
Facility utilization under such products is not likely to vary significantly
during the period.
Seasonal Requirement: Some borrowers requirement increase on account
of exposure to seasonal changes. This can be easily observed in industries
that are linked to / dependent upon natural commodities e.g. cotton, sugar,
wheat etc. It is common for sugar manufacturers to request their banks for
an increase in working capital facilities before the start of the crushing
season for procurement of sugarcane. Similarly, the requirements of textile
industry increase with the availability of cotton crop. These seasonal
requirements should start reducing in line with business cycle of the
borrower.
Utilization of facilities should be in line with the industry trends &
requirements of the business. A higher than anticipated requirement may
indicate diversion of funds outside the business which is likely to lead to an
increase overall risk profile of the customer. The bank may rely on various
facility monitoring systems to assist in achieving the above goal.
Facility
Monitoring
Systems
Most banks have in-house systems that generate various reports on regular
intervals to assist effective management of account. In addition to providing
data required to ensure that the facilities are being utilized within agreed
parameters, these also help identify risk areas and opportunities for the
bank.
An effective facility monitoring system should cover the following key
areas:
Activity Utilization Reports.
Monitoring of Covenants.
Drawing Power DP Calculation based on stock and receivable

statement.
Stock / receivable report.
Monitoring of Security / Collateral Documentation.
Review of Management Account.
Tracking of Document Deferral Deadlines.
Facility Reports Significance & Use
Client Calls.
Upcoming Maturities Report.
Stock inspection.
Site Visits.
Account managers rely on a number of reports that help ensure utilization of
facilities in line with requirements and agreed covenants. Following are a
few examples of facility reports;
Account Activity Report: These reports indicated the max. & min. balances
of an account during a specified period of time. These help identify trends
and may highlight risk areas if the activity in the account does not
correspond with the business.
Account Activity Report: These reports indicates the max. & min.
balances of an account during a specified period of time. These help
identify trends and may highlight risk areas if the activity in the
account does not correspond with the business.
Excess Report: These highlight excess over approved facility

amount / pre-defined threshold. Such reports are helpful in
identifying risk areas of a customer.
Covenant Report: These reports highlight compliance / non -
compliance status of agreed covenants with the borrower at a

particular date.
Maturity Diaries
Documentation / Document Deferral Report: These reports assist

account
managers
in
following
up
on
upcoming
documentation/internal deferral expiries e.g. insurance policies.
Maintaining a diary for upcoming critical events e.g. facility maturities and
document expiry is a useful tool for all account managers. It is advisable to
setup an advance reminder which may facilitate issuance of a reminder to
the customer as well.
The same may be maintained through a proprietary software or manually.
Following is a draft format of the same:
Customer Name Jan Feb Mar Apr May jun Jul Aug Sept Oct Nov Dec
[ Upcoming Loan Maturities
Customer ABC
15
Customer XYZ
Customer 123
15
15
15
31
31
30
30
30
31
Document Expiries - Insurance Policy

Customer ABC
Customer XYZ
30
31
Customer 123
31
Document Expiries - Banking Facility Letter

Customer ABC
31
Customer XYZ
Customer 123
31
30
The above document may be reviewed on a monthly basis (at the start of the
relevant month) to ensure that the account manager has sufficient time to
follow up & arrange for settlements / revised documents.
Authored by:
Ali Saad Khan
292
Management of Credit - II
The Importance of Growth and profitability of a financial institution largely depends on the
Management of Credit quality of its risk asset portfolio, which mostly comprises credit risk assets.
Credit risk assets mostly comprise of loans and advances to customers in the
form of Retail/ Consumer lending or Corporate/ institutional lending. As
banks are in the business of booking Credits, strong Credit management is
necessary. It will be fair to say that in the business of credits, the most
important task after booking of the asset is its management. Importance of
good credit management can be stressed by recalling the benefits that accrue
as a result. An account which is managed well reflects stability, healthy
account turnover, source of income for the bank and a strong asset base for
the bank. By staying closely in touch with the account and understanding the
business dynamics and account triggers, an account manager can effectively
manage an account. Essence of credit management revolves around how
effectively it is being monitored. A thorough understanding of the credit
process is imperative to evolve a monitoring process which has the ability to
not only manage the credit portfolio effectively but also avert any losses
which may arise due to inherent weaknesses of a credit, macro environment
or borrowers behavior in terms of utilization of the credit facilities allowed.
Important ingredients of a good credit management process include
understanding the business, staying in touch closely with the account,
observing macro and micro environmental factors that may impact the
business, being cognizant with the clients needs etc. To effectively manage
any process, understanding of the processes is required. Same is the case
with credit management. A detail-oriented approach! works best for
effective credit management.
'I
Credit portfolio of a financial institution has a clear segmentation between

its consumer assets and corporate assets. Each segment has a distinct credit
management and monitoring requirement. Retail and consumer credits are
basically straight lending to finance individual customers: ready cash needs
such as Personal Loans, Credit Cards, Mortgages, and Auto Loans. In such
credits, greater reliance is on customers debt capacity which is derived at
the initial stage of booking a consumer loan. These are basically derived
from customers monthly income and revenues, hence generally repayments
for the loan availed is on monthly basis. Additionally, such types of loans
are structured using Product Program Manual (PPM), which serve as a
guideline and specify criterion for allowing these loans. Monitoring of this
portion of banks asset bucket is done on a portfolio basis taking into
account payment behavior and past dues.
Corporate or wholesale credit generally drives the balance sheet of banks in
Pakistan, as it deals in extension of large ticket credit to various industries of
the economy. As such, each credit is exposed to risks emanating from
customers financial position/ cash flows, underlying asset held for the credit
transaction/ facility, ever changing macro level position which may affect
customers performance and security value held by the bank.
293
In this aspect, each customer is unique and each business model is distinct.
These differences exist right from the time of booking the loan throughout
the tenor of the loan. Varying credit management techniques are required to
be used that best suit each situation.
This section primarily deals with the importance of monitoring as a
mechanism to ensure consistency in the health of the asset portfolio. The job
of monitoring of an asset becomes lot easier if at the initiation level
i. e. booking of the asset, the structuring of the credit facility is dons
keeping in view the necessary considerations such as the purpose for which
the money is being lent, what asset creation is being done through the
utilization of the facility, how and when the repayment is to be made and
what macro/micro level factors may affect the transaction. Different facets
of structuring include purpose of the loan, tenor, amount, type- collateral,
pricing, repayment structure among other things.
In the financial world that we live in today and after having witnessed
global financial turmoil, it is a known fact that it originated not just because
of on-balance sheet items but it was also due to the closed eye on the offbalance sheet items that created a ripple effect and led to distortions in the
entire fabric of the financial sector. Consistent watch is required to
guarantee a healthy portfolio not only of funded but also of contingent
commitments. Any misjudgments will have a domino effect creating severe
liquidity risk and will put the credit rating of financial institutions at peril.
The financial world has been in the evolution stage and continues to evolve.
Any money lent is evaluated on the basis of capital allocation for it. This
concept has been emphasized through various BASEL acts. As such, Basel I
Act has undergone constant changes brought in to better manage health of
credit portfolio and we have seen subsequent introductions of BASEL II and
BASEL III.
The credit manager of today realizes the fact that each facility extended to a
customer poses risks. These risks have been defined and dimensioned in
earlier sections. Facility account monitoring occupies great importance in
overall monitoring of asset portfolio after the bank has decided to take on
that risk, price it and extend the credit to the customer. Based on this notion,
this section attempts to provide its readers a holistic view of the importance
of facility monitoring and various avenues available for this purpose.
294
Facility
Account
Monitoring:
In order to develop a better understanding of facility monitoring, it is better to

for various business
requirements. Such facilities can be segregated into short term working capital
facilities and long term loans. Within the sphere of these facilities, there is
further bifurcation into funded and non-funded facilities. Funded facilities
usually incorporate financing of account receivables and inventory, trade loans
and long term loans for capital expenditure, whereas non-funded facilities
consist largely of Letters of Credit (LC), Letters of Guarantee (LGs),
Derivatives etc that remain off-balance sheet. Loans are further bifurcated
based on type of collateralization. A loan can be secured or unsecured. Secured
loan is one which is backed by
recap the diverse set of

of credit
facilities
Management
Credit
- IIallowed
295
underlying collateral. Unsecured loan or clean loan does not have any collateral behind it. As per State
Bank of Pakistans Prudential Regulations, banks cannot extend clean financing more than Rs.
500,000 to an obligor. Secured financing can also be against varying types of collateral such as
hypothecation based or pledge based. Collateral can be in the form of current assets as well as in the
form of fixed assets. Further, short term funded facilities can be either against pledge of stock or
hypothecation of stock. Pledge based facilities should primarily finance inventory holding while
hypothecation based facilities primarily bridge the gap between an entitys receivables and payables.
To recap, pledge denotes holding of assets in banks control while hypothecation refers to holding a
claim on an asset which is in the control of the obligor. Short term trade loans are utilized to finance
obligors working capital. Export Refinance facility is a product offered by State Bank of Pakistan
(SBP) at concessional rates to incentivize exporters. This product is of two types: Part I and Part II.
Part I is allowed based on export contracts in hand while Part II is allowed based on previous years
export performance. Banks may also provide Export based pre-shipment loans from own sources to
support export based customers. Post-shipment export based loans are allowed either against export
LCs or export contracts. Banks may also provide short term funded facilities to customers for
retirement of LC; examples include products such as Finance against Imported Merchandise (FIM)
and Finance against Trust Receipt (FATR). Long term loans may be either in the form of term loans
for existing projects for Capex or project financing for new ventures. Derivatives include swaps,
forward agreements etc and are used as a hedging mechanism against fluctuations in interest rates or
exchange rates.
The role of a good credit manager is to endeavor in developing an effective monitoring system that
encompasses a consistent vigilance over the asset portfolio. Avenues available for such monitoring are
the following monitoring tools):
W)| Periodic analysis of Financial
Statements
Different ways of
facility account
monitoring in use:
^ 2
Monitoring pf
tLrB
asset in the loan agreement
ii
loan covenenats
Activity in facility account
Limit utilization
Monitoring of Sexurity
Stock Reports
Market Chechs
Repayment behaviour
Financial Statements - An analysis of the financial statements (balance

sheet, income statement, cash flow statement etc.) reveals signs of
distress. Anomalies in financial figures can raise early warning signals.
Glaring variations in revenue and profitability, shrinking cash fkn | from
operations, high other income, increasing cost structure, spiraling
leverage position, increased debt burden, low interest coverage and debt
service coverage ratios, variations between management .and audited
accounts, withdrawal of funds from owners equity, low current ratio,
inventory buildup, stuck up receivables, huge amours of inter-company
loans signify worsening financial conditions
Financial Covenants - Breach of financial covenants act as warning
signals. Adherence to financial covenants signifies commitment and
satisfactory business health of the customer. Covenants can be either
positive or negative. An example of a positive covenant is stipulation such
as Current Ratio to be maintained above l.Ox throughout tenor of facility
or a condition that Debt Service Coverage Ratio should be maintained at
atleast 1.50x over the loan tenor. While an example of a negative
covenant maybe a restriction on dividend payout during grace period or a
stipulation that borrower not to obtain further bank debt without prior
clearance of existing bankers.
Activity in the credit facility/ account statistics - Account turnover
including total debits and total credits also provide an idea about the
health of the borrower. This can be simply done by printing a statement of
account for the customer and looking at the various transactions and the
funds that have flowed in and out of the account. Cleanup of running
finance accounts for a certain number of days during a year is ideally
targeted. In case cleanup clause cannot be adhered to, a certain amount of
credit turnover in the account (twice of approved limit in instances) is
considered an effective monitoring tool. An account which shows no
credit transactions is considered hardcore in nature and denotes
weakening business health or perhaps mis- utilization of facilities in
certain instances. These need to be investigated. In some cases based on
business dynamics and level of funds required for operations, partial
cleanup is also considered sufficient.
Limit utilization and frequency of excess over limit - Constant excesses
might suggest inappropriate facility structuring or distressed situation
faced by the borrower. It may also signify that the account manager has
not fully understood the business cycle of the borrower and its financing
needs. Furthermore, it could also be indicative of mis- utilization of funds
for purposes other than originally approved.
Security position - An analysis of the security position is crucial in credit
managing as it acts as the last line of defense for the bank if the borrower
becomes delinquent. Although the primary source of repayment is the
companys operating cash flow, disposal of security may be looked into in
cases where operating cash flows have dried up and entitys ability to
remain as a going concern is in doubt. In certain cases, security provided
may have limited recourse. Nature of security, value of security and
realizability of security through sale in distressed situation are important
facets.
Stock Reports - Reports the stock level at each location that might be
held as a security by the institution. These reports depict available stock

position vis-a-vis limits outstanding and are obtained on a client- wide
basis each month to gauge the level of security coverage for facilities
secured against stocks. Obtaining stock reports is also a requirement of
SBP.
. Market Checks / CIB Checks - Information about business performance
from the market provides a good understanding of the borrowers
reputation. Outsourced agencies provide market checking reports to the
banks. However, informal market checks may also be carried out by the
account manager on an ongoing basis. Any negative comment in these
reports is investigated. Bank checkings are also obtained from the
customers other banks to ascertain customers repayment behavior at
their end. CIB checks reveal any overdue positions from other financial
institutions. CIB reports are generated online through SBP system and are
a basic requirement prior to taking any exposure beyond Rs. 0.5 Million
as per SBP Prudential Regulations. Format of CIB reports reflects total
funded exposure from all banks, total non- funded exposure from all
banks along with details of past dues at all banks and number of times
restructuring/ rescheduling has taken place in the industry for this
particular obligor. Furthermore, details of litigation and write-offs availed
are also a part of this report.
. Adherence to repayment schedule of interest and principal - Delays in
payment of interest and/or principal can also be construed as warning
signs. Payment lags put the customers intent and/ or ability to repay in
question. Delays in payment of principal or mark-up beyond 90 days
leads to adverse classification of the account and correspondingly loan
loss reserves have to be created.
. Business reciprocity and account profitability report. For trade related
facilities, import and export volume routed through banks counters and
banks share in customers trade wallet are reviewed. As a general rule of
thumb, import volume of atleast twice the LC limit should be routed
through banks counters in a year.
. Maturity date for LC payments and their timely retirements. Due date
diaries indicate upcoming maturities and act as flags for account
managers.
. Contract updates regarding Guarantees issued (Performance Guarantees,
Advance Payment Guarantees, Bid Bonds, Retention Guarantees). Delays
or untoward happenings in projects undertaken by an obligor can lead to
the Guarantees being called or project payments being delayed. Any
revision in timelines of project completion should be known to the
account manager.
. Contract maturities for Derivatives and Swaps. Although derivatives are
off-balance sheet items but any losses in this aspect can have an
impairing effect on the businesss profitability and thus need to be
monitored.
Details of these monitoring mechanisms are discussed in detail below.
297
Requirements for
Account monitoring should be performed systematically, consistently over

time, and in conformity with the objective criteria set by the bank. The
and quantum of business account manager should be cognizant with banks policies and should
booked under the
remain abreast with any subsequent changes. Policies on facility utilization
range from strict adherence to the limit approved by the bank to special
facility:
circumstances where one-off extensions or excess over limit approvals are
granted in accordance to the bank policies, without breach of any covenant
set prior to it. However, utilization of facility is solely based on business
needs and may vary during seasonal financing or instances when businesses
require considerable disbursement for peak requirements. A keen
understanding of the customers business cycle is imperative to gauge when
does the customers requirement peak or when should major adjustments be
expected. Staying abreast with changes in the macro and micro external
environment also adds value to this process. Irregularity in facility
utilization refers to breach of any covenant or regulation set by the bank.
Such a case could arise at instances where the assigning of limit does not
reflect the true needs of a business. For example, export based funding is
monitored through the quantum of export business routed and rollover of the
facilities upon shipment. Import based non funded lines are monitored
through quantum of import volumes routed through the bank counters.
There may be instances where peak/low utilization does not hold much
weight. Therefore, cleanup clause is mandatory for such short term funded
facilities. However, in cases where the borrower cannot commit complete
cleanup due to paucity of funds, a partial cleanup may suffice.
meeting facility turnover
Difficulties encountered
in operating the facility
within present limits:
It is effective monitoring of the account statistics that result in an

understanding that the existing allowed limits to a customer are not adequate
in terms of the size and the business requirements. If a credit facility is
utilized 100% at all times it shows that there is a definite requirement for
enhancement. On the contrary, if facility utilization is stuck at its maximum
level for stagnant periods it reflects problems that can lead to an overdue
status and if not cured will further lead to delinquency.
If an account consistently requires excess over its prescribed limits and is
regular in interest payments, there may be a need for enhancement. Facility
account monitoring would frequently encounter challenges when the
outcome of the analysis exhibits that the limits during the tenor of the
facility have been consistently breached and/or excesses allowed. Excesses
may also occur in LC transactions as a result of devaluation of the local
currency against the currency in which LC is opened.
Other
monitoring
mechanisms:
298
Facility account monitoring on financial performance and more importantly

the cash flow movements of an account is of utmost importance. It is
necessary to keep a record of all definite sources of repayment, sufficient
enough to extinguish the debt in the event of repayment failure. A detailed
analysis of the cash flow statement is imperative as cash flow statements
provide details of sources and uses of cash. Sources of cash represent an
inflow and uses of cash reflect a drag on the cash balance. Cash flow from
operations (CFO), which is derived after adding non cash charges such as
depreciation/ amortization etc to net profit before taxes and subtracting
working capital changes from this figure, is used as an indication of
repayment ability in most cases. This
is because CFO represents the cash flows available for investing in fixed
assets and repaying financial dues. Another proxy of repayment ability is
Free Cash Flow to the Firm (FCFF). FCFF uses EBITDA, subtracts working
capital changes and Capex and takes into account taxes paid before arriving
at a figure which represents free funds available for 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. In order to
corroborate cash flow assumptions, monitoring of debits and credits in the
account provides indication of any slow down in business activity. Any
abnormal activity should be investigated. Continuously declining
profitability, burgeoning costs, tightening cash flows, fluctuating revenue
and profitability, heavy inter-company loans or abnormally high dividend
payouts etc warrant account managers close attention.
Based on differing types of facilities, mechanism for monitoring also varies.
Cleanup conditions or account turnover requirements for running finance
facilities have been already discussed in detail. There are also differences in
monitoring of pledge-based and hypothecation-based facilities. Pledgebased facilities are monitored through ensuring that adequate quantity of
pledged stock is maintained. The price of pledged stock is determined
through reliable market sources and the goods are pledged under
supervision of Mucaddam who acts as a custodian on banks behalf.
Movement of pledged stock is monitored to ensure that the bank is not left
with old/ spoiled stock. Stock is released against commensurate adjustment
in outstanding.
Hypothecation-based facilities are additionally monitored through obtaining
monthly stock reports. Stock inspection by bank personnel or independent
appraisers is also carried out.
For Export-based loans Adequate export volume and effective shipment of goods are considered
as monitoring techniques for export based loans. FIM and FATR have
specific tenors, non-adjustment on due date signals an early warning.
Ongoing site visits for customers is also a monitoring tool. Disbursement of
funded facilities can be tagged with specific usage or achieving of certain
milestones and this can be an effective monitoring tool as well.
Disbursement of export based loans against specific Export LCs or export
contracts also serves as a monitoring mechanism for intended usage.
For Project Financing Project Financing is gauged periodically through the amount of capital
expenditure seen on ground and the timeline within which it was to be

achieved as per agreed covenants between the bank and customer.
Commercial operation date in line with the cash flow projections forms the
premise of monitoring a long term loan and any delays provide early
warning signals with respect to project delays. Allowing disbursement of
funded facilities for specific usage by making payments directly to suppliers
etc. ensures proper utilization of both short and long term facilities.
For Contingent Facilities For monitoring of contingent commitments, due date diaries are
maintained to keep a track on maturity profiles and the client is informed

well before time to meet a payment requirement for L/C, Contract, and
Derivative etc. Whereas commitments against guarantees are monitored
299
through understanding of performance contracts and whe banks

customer is adhering to the agreed parameters of the , under which
any guarantee is issued.
Collateral:
Monitoring also comprises of regular updates on collateral pr the

bank. In an ever growing volatile economic environment, it is
expected that banks will be repaid from proceeds gen; completion
of transaction, risk of failure cannot be fully el Banks should
continuously monitor the true realizable value of s along with
keeping an update on the extent to which coverage is |
In Pakistan, where collateral requirements exist as per reg has particular
significance. Various types of collateral depending I realizability into
cash will require varying degrees of monitoring.] liquid securities
including cash and near cash collateral are the < liquidate and most often
do not diminish in value. Other acquired in the form of current assets
(stocks and receivables) and I assets are more complex in terms of the
monitoring that the)' i Current assets values are generally determined on
the basis of the < in the financial statements or market valuations. Any
shortfall < is generally indicative of a decline in price (inventory losses)
or cl of funds for purposes other than the actual purpose of the loan, j
receivables monitoring, with specific reference to the aging of i is
essential to ensure its collectibility and adequate provisions for I debts.
Task of valuation of fixed assets is assigned to independent vs These
valuers are enlisted on panel of Pakistan Bank Association I as well as on
the panel of banks itself. Being enlisted on PBAs | gives further credence
to the integrity and fairness of the
Internal Risk Rating:
Facility
Monitoring
Systems:
Due date diaries:
300
Another value added mechanism is that of internal risk rating i include

analyzing micro and macro factors for determining the i profile of a
borrower. Credit rating process is to be separately supf by an appropriate
monitoring system, which features periodic ref on performance of
individual accounts and its ability to repay lc the back of its financial
standing. Any downturn in customers! profile or industry fundamentals
should translate into rating dow
Facility Monitoring Systems are tools and techniques that automa

analyze facility utilization behavior and trends that serves as early w
signals to detect any anomalies. The systems could be in the for daily,
weekly, monthly or quarterly MIS reports, flash tickers, 01 access to
data through core banking systems etc. MIS reports are a i tool that
aids in assessment of many aspects regarding the overall i portfolio of
an organization. This may include composition of the i portfolio, credit
history of the borrowers, and financial performs borrowers.
Additionally a well functioning MIS system would ] credit exposures
approaching risk limits to be identified and brov the timely attention of
the management and the board.
Due date diaries are tools used to monitor payments falling due and a
used to aware the account manager of any delayed payments and 1 as a
reminder of the upcoming payments in order to attain timely ] of
payments. These diaries are circulated across the
all concerned to alert them of any problem credits to avoid any defaults on
repayment. MIS systems are generally constant across a bank; however, an
account manager may devise specific MIS to be able to better monitor the
performance of the prevailing client mix.
Prerequisite for effective monitoring is an all encompassing management
information system (MIS) that provides real time information on the
borrower. The MIS should be able to highlight any breach of covenants or
regulations imposed by the bank and trigger remedial measures.
Significance and
use
of reports on activity
in facility accounts
Reports on activity in facility accounts hold much significance for various

reasons. Firstly, once credit is extended to customers, continuous monitoring
of loans, and hence reporting of any changes is vital. This is because if there
are any changes in the financial position of an account, or if there is a
possibility of slippage of an account from standard asset to substandard
asset, immediate warning to customers could be extended. Moreover, loan
officers would then be able to classify the borrowers with standard assets
and sub-standard assets. These steps act as a deterrent to weak asset quality
of the advances book of the bank. Such reports give controls to the account
manager who can be more aware of early warning signals and work towards
curative strategies at the very onset.
Given the above analysis on the importance of Monitoring activity in the
Credit Management Process, it may also be noted that in todays financial
world, the scrutiny done on health of assets of the financial institution by
external auditors, central bank and rating agencies revolves around
determining qualitative standards of monitoring techniques that an
institution uses to manage its overall credit portfolio. Thus an effective
monitoring mechanism is a prerequisite for not only attaining a good credit /
audit rating but maintaining it too. Monitoring is a constant process that will
always undergo improvements given the changing dynamics of the business
environment and policies laid down by regulators. An account managers
primary task is to understand the obligor and obligors business model. If a
strong credit management process and systems are in place, staying abreast
with developments in the account becomes easier leading to better account
management and resultantly healthier asset portfolio.
Authored by:
Zulfiqar Alavi
301
Part Six
Past Due Accounts/Over Due

Accounts
Student Learning
Outcomes
1. Classification
State the basis for classification of past due or delinquent
accounts
* Discuss the action steps based on classification level of past due
accounts
2. Past due account management
Discuss the management techniques used in dealing with past
due accounts
Comment on customer contact modes used depending on
severity of failure in meeting commitments in case of business and
consumer lending
Discuss the regulations as imposed by SBP concerning the
collection and recovery processes while dealing with consumer and
business clients
Discuss the global best practices and subjective classification
adopted by various banks as part of risk management stratc
Recall the process of determining net exposure and status
financial assets and collateral in case of delinquency
Discuss the conditions for activating remedial actions in case of
delinquency
3. Rescheduling and restructuring of borrower accounts
Explain the concept of rescheduling and restructuring
borrower accounts
Discuss the need and benefit obtained from reschedul
borrower accounts
4. Loan loss provisioning
Explain the concept of loss provisioning for lending por
State the importance of loan loss provisioning ar benefits
in financial reporting
5. Write Off
Explain the concept of write off loans and state the conc
for write off
Explain the concept of FSV in case of write off and stale t
regulatory requirements governing it
State SBP regulations concerning write off loans
302
Past Due Accounts / Over Due Accounts Business Lending

Loan classification is a norm in the business of credits. Various
categorizations are used to reflect the health of a loan. In easiest terms, it is
actually the process of differentiating the good from the bad and bad from the
worse and so on, within the credit portfolio of a financial institution. To
achieve this differentiation, certain tools and techniques are applied right
from the time of booking of asset till its repayment and also during its
delinquency period. The rating assigned at the time of booking is attributed to
various factors related to quantitative and qualitative assumptions. Such
assumptions revolve around the financial capability of a customer/financial
statements, past business performance, positioning in industry, management
strength, market reputation and overall clients capability of handling
business.
Once the asset is booked, specific rating assigned may undergo changes
depending on the performance of the loan. Default is a consequence of delays
in meeting financial commitments on due dates towards interest payments
and loan repayment. A default has distinct levels reflecting the deteriorating
degree and practices for categorization for such defaults during delinquency
is generally uniform across the globe. The default over a day and continuing
till 90 days is termed as Overdue, more than 90 days till 180 days is termed as
Substandard, and more than 180 days till a year is termed as Doubtful. If the
default exceeds one year then it equals a Loss. From the day loan becomes
overdue and enters varied degree of default stages, it results in an adverse
impact on the profitability of the institution as distinct level of provisions are
applied depending on the loan classification.
Provisions are applied on a net exposure basis and in Pakistan there is a
specific laid down principle by the central bank for adherence by Financial
Institutions. This will be discussed later on in the article. It is absolutely
important for an effective credit management process to be well equipped in
managing various degrees of default and to apply corrective measures.
Consistent monitoring of loan classification for further downgrade or an
upgrade is gaining greater importance especially in the aftermath of 2008
global financial turmoil. Learning from this, banks have further crystallized
the theoretical fact of the significance of loan classification process and
provisions. Importantly, deviation or non adherence to the loan classification
criteria at the individual institution level will have far reaching consequences
on the economic fabric of the financial system. A thorough understanding is
therefore required of this terrain of the financial world.
This article will help understand the rating of an asset/ lending portfolio and
its treatment while taking the readers through the cycle of a bad credit
resulting in a write off. Understanding this part of the credit management
process along with the importance of restructuring methodology is of utmost
significance to become effective credit managers, hence each part of this
process is discussed in detail in the following article.
303
The basis for classification of delinquent or past due account loans varies
depending on the nature of the loan asset. A term loan becomes past due if
interest or loan installment is in arrears while an overdraft/cash credit
account is treated as past due if it remains stagnant or the interest on it is not
serviced in due time. Contingent commitments, if due and not paid on due
date result in a funded overdue status.
Banks in Pakistan formulate their own system of classifying delinquent loans
and ensure timely recovery of outstanding debt, subject to complying with
the minimum categories of classification laid down by the State Bank of
Pakistan (SBP). These classifications are:
Substandard: Where mark-up or principal is overdue by 90 days or more
from the due date. In such cases, the customer needs to be thoroughly
engaged by the bank representatives and possible restructuring options
should be discussed.
Doubtful: Where mark-up or principal is overdue by 180 days or more from
the due date. In such cases, even though the customer is in constant contact
with the bank, the bank should start looking at other options such as
restructuring, litigation or out of court settlement in order to secure the
repayment of outstanding loan.
Loss: Where mark-up or principal is overdue by one year or more from the
due date. Recovery method in such cases usually includes out of court
settlement or litigation proceedings. The loan is reported as a loss in the
financial statements and recovery by all legal means is commenced.
Global practices for management of past due credits include a thorough due
diligence on security coverage, understanding of the local laws and an
effective and efficient legal system to prevent fraud. The responsibility of
establishing a strong legal system lies with the state. Consistent engagement
is a prerequisite towards implementation of past due loan management
process. Based on the business conditions and the nature of problems being
faced by the borrower, appropriate remedial strategies such as restructuring
of loan facility, enhancement in credit limits or reduction in interest rates
help improves borrowers repayment capacity. Banks have to regularly
ascertain the realistic loan recoverable amount by updating the values of
available collateral with formal valuation and reviewing security documents
to ensure the enforceability of contracts and collateral. Finally, such credits
should be subject to more frequent review and monitoring. Review should
update the status and development of the loan accounts and progress of the
remedial plans. In the management of nonperforming assets, upgrading
assets to standard category by cash recoveries through constant follow-up is
the most viable option. Not only does it increase interest income, it also
helps reduce provisioning and capital adequacy requirement.
There is a likelihood that the classified loans may not be recoverable and the
bank might have to take adequate steps to collect them. In this regard, SBP
has provided guidelines that are applicable to various types of Consumer,
SME and Corporate financing facilities. Recovery of due payment to the
bank should be in accordance with the Financi Institutions (recovery of
finances) Ordinance of 2001. This ordinal has a laid down procedure to
recover delinquent loans and adherence to these principles is required by the
banks. Also, banks are required to make periodic reviews of the recovery
procedures and they remain answerable to the SBP for compliance with these
guidelines.
304
Net Exposure is defined as total exposure less liquid assets that are held as
security by the bank. Exposure refers to any financing facilities whether fund
based and/or non-fund based. Liquid Assets are those which are readily
convertible into cash without recourse to a court of law. There is a defined
mechanism for calculation of net exposure for provisioning requirement as
laid down by SBP. Cash and near Cash Securities are given a 100% weight
to arrive at net exposure. For example, a facility of PKR 100 million that is
secured by PKR 40 Million in cash and near cash securities, the net exposure
on the borrower is calculated at PKR 60 Million. Other current assets such as
hypothecation charge on inventories and receivables do not get accounted
for any exposure benefits. However, if the stocks are held by virtue of a
pledge arrangement, benefit of 40% is availed. Similarly, securities held in
the form on a charge on Fixed Asset such as land and building, plant and
machinery etc. allow use of benefit which may differ in value depending on
the nature of the security.
Prior to instituting remedial management and considering loan write offs,
banks should make utmost efforts in recovering the outstanding balance.
Debt rescheduling and restructuring may be done where the bank deems fit
that the borrower would be able to repay the debt based on the respite
provided through longer tenor and/or decrease in interest rate. Such is a
common practice amongst banks while managing delinquent credit. Banks
should measure a restructured loan by reducing its recorded investment to a
net realizable value, taking into account the cost of all the concessions at the
date of restructuring.
Whole idea behind having an effective past due account management system
is the fact that in the business of credit and advances an asset of the bank
(lending) / portfolio is always exposed to inherent risks of the credit itself or
it is exposed to other risks originating from the industry to which it belongs .
There are instances when an account starts showing signs of weaknesses
such as recurrent overdue status in payment of its mark up or its repayment
towards installment and principal. An effective credit management process
assist in identifying such weaknesses at the very initial level by raising alarm
signals. Usually in such an instance when the account is showing persistent
delays in servicing of its payments, corrective measures should be adopted to
assist in maintaining a good health of the account before it is too late. An
effective credit management process for past due account management is all
about making a conscientious proactive effort in raising warning signals
right from the very beginning rather than waiting for the account actually
going bad. It is the role of the account relationship manager to monitor the
portfolio on day to day basis and keep good track on the health of his
accounts/ portfolio. As the concept of relationship management system is to
have a microscopic view at the relationship officers level, it helps in
implementation of a fruitful process whereby it is incumbent upon the
relationship manger to keep updating the senior management on his
accounts/ portfolio through call reports by regular visits to customer
including factory visits. Annual renewal and interim account updates are
tools to keep track of overall health of the account. In todays complex
financial world, the main challenge for credit management is to be one step
ahead of the customer. Such an approach forms the linchpin of an efficient
credit process which has the ability to raise warning signs much before the
account actually becomes delinquent. Recognition of a deteriorating health
of an account is reflective by downgrading the status of the account from
regular to watch list. Once the account is in watchlist status it immediately
305
calls for an incessant follow up meetings with the customer to help avert it
from further downgrading. It is here, when the business unit of the bank
usually decides to revisit the the credit and outstanding facilities, keeping
into account the reasons that led to slow down or a default status.
Understandings derived from such meetings with customer and also through
internal discussions between the management and risk department, often
leads to restructuring or rescheduling the account to avert any further
downgrading of the account to a substandard, doubtful or Loss status. Once
the account reaches the zone beyond watchlist then a 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.
Restructuring & Rescheduling are common terminologies used while
managing a past due account or the asset portfolio. As mentioned above when
the account is showing weaknesses in its repayments, a thorough analysis is
done to understand root cause. Based on the findings and depending of the
financial health of the company and a thorough analysis of the financial
statements and the projected cash flows , restructuring or rescheduling comes
into play. The process of restructuring or rescheduling refers to reinstituting
of outstanding credit facilities with amendments in payments schedules,
grace period, reduction in mark up rates, amendments in security package ,
etc . It is done on the basis of actual needs of the customer. Depending of the
nature of the credit, its sponsors, industry cycles, cash flow at the time of
rescheduling it is often that same is also supported by an enhancement in
overall facilities. Such enhancement may be a result of fresh working capital
lines to be allowed without which the process of restructuring may result in
vain. This restructuring/ rescheduling is not restricted to any classification or
rating of the credit. It may be exercised at any point in time even on an
excellent credit to synchronize with changing external and internal condition
that may eventually impact cash flow cycle of the company. Similarly,
restructuring may be carried out for any watchlist/ substandard, doubtful or
loss account. As it is a process to recognize problems and facilitate in better
management of credits by extending terms of repayment of dues to gel in
with the actual capacity of the borrower under the new conditions, it occupies
great important in the business of managing credits and especially that of
delinquent credits.
Usually a restructuring of delinquent credit entails following:
First and foremost weaknesses in the credit are recognized.
The credit still has the capacity to pay provided if restructured.
Thorough analysis of financial statements and Projected cash
statements.
306
Assumptions for projections are verified through other players and industry
sources. Crystal clear understanding is developed with the client on the credit
parameters of the restructuring process such as tenor, mark up rate, any
waivers, etc. Security analysis is done at this juncture to enhance and fortify
security. Clubbing of all overdue facilities till cut off date, into a restructured
facility on a medium to long term basis.
Crystal clear understanding is developed with the client on the credit
parameters of the restructuring process such as tenor, mark up rate, any
waivers, etc.
Security analysis is done at this juncture to enhance and fortify security.
Clubbing of all overdue facilities till cut off date, into a restructured facility
on a medium to long term basis.
Upfront payment of mark up due till cut off date & or conversion of same
into a facility to be repaid separately, during the tenor of principal
restructured facility or may be at the tail end of the restructured principal
facility.
Reduction in mark up rates on the new restructured facility by certain
percentage points . If the health or cash flows of the credit do not allow, then
the rate for cost of funds of the bank may be applied.
Before instituting the revised structured limits fresh visit to customers must
be mandatory.
Preferably a monthly mechanism for follow up on the account must be
devised with mutual consent of the borrower. This should form an important
tool to closely monitor the restructured performance.
Time Value of Money: This concept must be applied throughout the process
of restructuring a delinquent credit regardless of its category of classification

(watchlist, substandard, doubtful or loss). The Net Present value NPV
concept acts as a barometer for the bank to analyze the actual financial
impact on the banks balance sheet while undertaking restructuring of loans
with reduced mark up rate OR at times no mark up rate, extended longer
tenors at zeroised mark up rates etc. Such an instance may arise where a
credit is restructured on a long tenor with the objective of just recovering the
principal due. In such a scenario , the bank bears a cost on the liability side
of its balance sheet to fund an asset which is not yielding any interest value .
Hence, such restructuring proposals must be viewed with the help of NPV .
This often helps in taking a decision by taking a decision for a haircut
upfront and getting the customer pay residual amount in terms of NPV
upfront only if possible. Ideally, the NPV of the restructured loan should be
equal to or greater than the current loan outstanding. However, this might
rarely be the case. If the NPV is less than current value of the loan, the bank
essentially takes a hair cut on its outstanding
loan. This option might be viable in certain scenarios where the other
alternative might be the risk of total loss. Importantly, banks usually
provide a grace period in principal repayment so that the borrower is
able to consolidate its business and be able to make the repayments
once the grace period ceases. Care should be taken when an account is
restructured as an incorrect restructuring might result in the borrower
being unable to pay back the liability. Such an effort by the bank
would be futile in recovering the loan amount. Therefore,
307
understanding of the borrowers business together with its repayment

capability needs to be thoroughly analyzed. This is a normal practice
in restructuring of delinquent credits.
Finally, even if after the restructuring the credit fails to perform and
the management has exhausted all efforts towards recovery of a
delinquent loan through remedial process i.e restructuring, then such a
credit needs to be recovered through instituting legal proceedings, for
which the account is usually passed on to the Special Asset
Management wing of the bank, which specializes in recovery of
delinquent loans through litigations/ court settlements.
Loan loss provisioning together with general loss reserves forms the basis for
establishing a banks capacity to absorb losses. Loan-loss provisions are one
of the main accrual expenses for banks. They are set aside by bank managers
to face a future deterioration of credit portfolio quality. Hence, the role they
play within a banks financial statements is crucial, given the sensitive
information they are supposed to convey. It is contended that this provision
should be positively correlated to the lending cycle of the banks such that
loan loss reserves are built up during peak financial times so that they can be
utilized in a recession. Loan provisioning is a vital aspect of banks financial
reporting to regulators and investors as it is reflective of the risk of losses
inherent in the underlying loan portfolia This provides insight into the risktaking behavior of banks.
The process of recognizing an uncollectable loan is called a write off Loan
losses are written off against loan loss reserves and are removed from the
outstanding portfolio. The conditions for write offs include that the account
has been past due for more than 1 year, the probability of recovering the tied
up funds is negligible and that the security held bf the bank is inadequate to
cover the outstanding loan.
However, loan write off does not imply that loan recovery should stopped. It
should be continued until total outstanding balance ' recovered.
308
Past Due Classification
Provisioning Requirement
Substandard
Provision of 25% of net exposure (less

FSV benefit)
Doubtful

FSV benefit)
Loss

FSV benefit)
* FSV Benefit: Cash and Cash equivalents = 100%, pledged stocks and
mortgaged residential, commercial and industrial properties = 40% The
above mentioned provisions differ for differ customer types.
In case of write offs, SBP states that banks shall continue to write off bad
loans with the approval of banks Board of Directors under a well defined
and transparent 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. Importantly, no write offs will be allowed where
Forced Sale Value (FSV) is more than the recoverable outstanding amount,
exception being on cases settled under general incentive scheme of the SBP.
FSV refers to the value which fully reflects the possibility of price
fluctuations and can currently be obtained by selling the mortgaged/pledged
assets in forced/distressed sale conditions.
The regulatory requirements that govern FSV states that banks are allowed
to take the benefit of 40% of FSV of the pledged stocks and mortgaged
residential, commercial and industrial properties (where building is
constructed) held as collateral against non performing loans for 3 years, with
one year extension period if FSV valuation of land is not more than 4 years,
from the date of classification for calculating provisioning requirement.
Banks may avail the above benefit of FSV subject to compliance with the
SBP guidelines. If the additional impact on profitability arising from
availing the benefit of FSV is not available for payment of cash or stock
dividend, bank management ensures that FSV used for taking benefit of
provisioning is determined accurately and is reflective of market conditions
under forced sale situations and that the party-wise details of all such cases
where banks have availed the benefit of FSV shall be maintained for
verification by SBPs inspection teams during regular/special inspection.
(Please refer to SBPs circular regarding FSV benefit issued in 2011)
Banks may add any other condition(s) as they deem fit and should report full
particulars of loans written off to Credit Information Bureau of SBP. Banks
are also allowed to consider cases for rescheduling and restructuring in
respect of sick industrial units and non performing loans under a well
defined and transparent policy. Rescheduling and restructuring done simply
to break time frame or allow un-warranted improvement in classified
category of loans is not permissible. These shall always be done under a
proper and appropriate agreement in writing by following the due course of
law.
Authored by.
Zulfiqar Alavi
Past due Accounts/Over Due Accounts Consumer Lending

Within Consumer Banking, an account is considered to be delinquent when
Reference BDDX 1
309
the payment is not received on the due date; repayment performance of

individual borrowers traditionally is the best indicator of the lending quality.
For delinquency reporting purposes, the industry standards include
measuring delinquency as of 30, 60, 90,120, and 150 days past due. Accounts
that are overdue by more than 30 days are closely monitored and are subject
to specific collections processes.
The overdue accounts, at a minimum, are generally classified based on the
criteria defined by the State Bank of Pakistan in the Prudential Regulations
for Consumer Finance which broadly includes time based classification into
three categories, Substandard, Doubtful and Loss.
The grid below defines the triggers based on which the banks provision their
portfolios i.e. identify the bad debts, as stipulated by the State bank of
Pakistan in the Prudential Regulations for Consumer Finance. For each
trigger, set on the number of days past due, specific provision amount is
identified/declared by the banks as an indication of the portfolio that is likely
to be irrecoverable.
Consumer Products
Specific Provisions Requirement*
Credit Cards
Personal Installment Loans
Cashline
Autos
100% at 180 DPD (Charge off at 180 DPD)

25% at 90DPD & 100% at 180DPD
25% at 90DPD & 100% at 180DPD
25% at 90DPD, 50% at 180 DPD & 100% at
360 DPD
25% at 90DPD & 50% at 180DPD & 100%
at 360DPD (of the outstanding resulting
between the differences of Forced Sale
Value).
Mortgage/Businessline
* DPD= Days Past Due

In addition to the above time based criteria, subjective classification of
performing and non-performing (loans past due by more than 90 days) credit
portfolio is also made for risk assessment. In such scenario, the category of
classification determined on the basis of time based criteria is either further
downgraded or the loss recognition process is accelerated. Such classification
is carried out primarily for the cases involving bankruptcy, fraud, skip and
death of the customer along with the inadequacy of security inclusive of its
realizable value and credit worthiness of the borrower, etc. For any account
to be classified on a subjective grounds proper evidence and documentation
is required. The collections, recovery and fraud unit of the bank generally
play a vital role in highlighting such accounts based on which the senior
management decides on the classification category for subjective
classification. This helps the banks to make proper provisions and closely
monitor such loans in order to minimize risk and Non Performing Loans
(NPLs). The responsibility of monitoring these loans and making decisions
about loss provisions resides with the risk management unit of the bank.
However, the banks generally prefer to use objective (time based
classification) for all Consumer products due to the number of accounts
within each product.
Banks risk management strategy includes regular review of the performance
of the collections team along with the current portfolio movements in terms
of delinquency. For this purpose the total exposure of the banks portfolio at
risk is looked at closely. Therefore, the portfolio is broadly classified as
unsecured and secured lending. For the unsecured portfolio (clean lending)
including Credit Cards, Running finance and Personal Installment loans the
net exposure at risk is the total outstanding of the delinquent accounts.
However, for the Secured portfolio like Mortgages, Forced Sales Value
310
(FSV) benefit of the collateral is subtracted from the total outstanding to

determine the net exposure at risk. For example, in the grid below the
highlighted amount of Rs. 20,000 is the net exposure at risk for Credit Cards,
as out of the total of Rs. 100,000 utilized only Rs. 20,000 is delinquent.
Credit Cards
Total Accounts
Booked
10
Limits Assigned
0.25
(Rupees Million)
Outstanding (utilized
Delinquent Portfolio
amount)
0.10
Accounts
2
Amount
0.02
The overall banking practice in Pakistan and globally is to have a dedicated

Collections unit to monitor and recover the past due accounts. This unit is
responsible for collecting the payments for overdue accounts of the portfolio,
specialized collectors are hired to ensure that the unit provides efficient and
dedicated services which include contacting people to inform them of an
unpaid account, arranging payments, advising customers on how to pay the
overdue account, arranging for legal action on unpaid accounts, organising
the repossession of assets, keeping records of all the correspondence with the
customers and also providing credit reports for the performance of the
portfolio.
Banks use a variety of debt collection practices for recovering the bad debts.
These include sending mail reminder notices, in order to bring a customers
loan up to date which are used early in the process in the crucial 30-60 day
window and are very tactful communications intended to get the account
holder re-connected with the bank and resolving their delinquencies.
The banks also sort out and segregate the "soft" delinquencies from the more
problematic accounts that should be immediately acted upon. The
segregation is done based on past due account status. Soft delinquencies are
generally referred to as the accounts between 30 to 60 days past due and
accounts greater than 90 days past due are categorized as problematic. When
identified early enough, the majority of these accounts can be restored,
preventing having to write them off.
A few Banks use debt scoring as a tool for both pre and post default, a
powerful mathematical probability tool that helps the banks greatly by
predicting the accounts more likely to pay, as well as the more difficult
accounts before these accounts depreciate even more in recovery likelihood.
The score thus generated is generally referred to as a Behavior Score
which is based on customers repayment behavior. All the accounts with a
low score are categorized as high risk customers and are dealt with a firm
hand, on the other hand, accounts with a high score are treated differently
where the contact (if made) is solely as a reminder because these accounts
tend to serve the debt efficiently and are low risk customers.
Post segregation of the accounts, the process of calling the customers begins.
More often than not, customers are aware that their accounts are delinquent
so theyre not surprised to hear from the bank. Though tactful, a collector
communicates the gravity and magnitude of rectifying the matter and that
failing to do so could result in a negative credit report, as well as limiting
ones ability to avail additional facilities from the industry. The collection
unit contacts the customers on their provided numbers. The priority of which
is the mobile number, in the event of no contact office land line and
residence land line numbers are used. If the customer is still not contactable,
the field officers are sent to the customers provided addresses (office and
residence).
Collection strategies including issuance of collection letters more commonly
311
referred to as dunning-letters issued to demand payment of a debt, calls the

customers, field visits to collect are the remedial steps taken against the
delinquent loans, failure of which leads to aggressive recovery, hiring of a
debt collection agency, as they act as an effective and diplomatic
dispassionate third party which can encourage past due/written off customers
to get in touch with the bank and make the required arrangements to pay off
the debts, and litigation stage where the bank issues legal notices and files
litigation for the recovery of the loan.
Ensuring smooth and regular collections of bad debts and complying with
the fair debt collection guidelines issued by the State Bank of Pakistan is a
continuing challenge to the banking industry. The essence of the guidelines
is to safe guard the interest of the customer and defining of standard
operating procedure for debt collection by the banks. The guidelines issued
in November 2008 were to address the grievances of customers/borrowers as
they had various complaints against the collectors of different banks which
ranged from the language used over the phone to untimely visits and the
attitude of the collectors. These guidelines include but are not limited to
serving a 14 day written notice to the customers prior to the visit by the
collectors or before repossessing of assets, phone calls to be made from the
recorded lines and contacting the customers at a convenient time.
To collect the bad debts, banks allow debt rescheduling and restructuring to
provide a borrower with relief when needed due to an economic downturn or
other unforeseen personal event (i.e. job loss, illness etc.). This is where the
debtor and the bank negotiate to defer payments of principal and/or interest
falling, due in a specified interval for repayment on a new schedule. In most
cases, these new terms are structured to make it easier for the borrower to
repay. The term of the loan is extended to make allowances for the lower
repayments and in some cases; simply repaying the outstanding amount with
certain waivers is also arranged.
Rescheduling or restructuring of the loan improves the likelihood for the
banks to receive full or negotiated payment of its interest and principal as
opposed to an outright default. The central bank has also issued directives for
the banks to reschedule or restructure the non performing loans for smooth
recovery and relieving the borrowers strain of heavy repayment amounts.
312
Banks after exhausting all recovery efforts declare the loan as write of: and
the loans or assets account are closed and are removed from the receivables
in the balance sheet. Writing off of the loans or accounts is a decision taken
at the senior management level which includes the heads or Group Heads of
the departments such as Collections, Business, Risk management and
Finance, as it impacts the financial health of the business. Decision to book
write off can be based on varied reasons including identification of fraud,
skip (where no contact can be established) customer, death of the customer,
inability to recover or pay etc. The State Bank of Pakistan has issued specific
directives on the writing off of irrevocable loans and advances whereby the
loans can be written off given that the conditions laid down are met. These
include confirmation that borrower has no known means of repayment,
thorough review by the internal audit where the loan amount exceeds Rs. 5
Million etc. Banks define a detailed policy/ process to establish the fact that
the customer is to be written off, which includes extraction of bureau reports,
assessing repayment capacity of the borrower, discussion with the customer
about his financial health and the amount that can be recovered (if any). The
risk management department is responsible for reviewing and approving the
write off of such loans. However, for mortgages, no write off is allowed
where forced sale value of securities held, is more than the recoverable
outstanding amount.
In an environment where consumer debt is rising, it is imperative for the
banks to choose the right approach for debt collections management. In these
challenging times, a more consultative collection approach is needed and the
banking industry today is now reaching out to the distressed consumers and
structuring repayment schedules and devising ways to collect the past due
accounts in a way where the consumer plight is recognized without
compromising on the banks collection strategies.
Compiled by:
Farheen Ali
313
Important Terms:
Asset Buckets: Aggregation of consumer loans reported as a rolled-up

number since their size is too small to report it separately and then making
the buckets based on the behavior of these loans. BASEL III: A global
regulatory standard on bank capital adequacy and liquidity agreed by the
members of the BASEL Committee on Banking Supervision. BASEL I was
introduced in 1988 and published a minimum set of capital requirements
focusing primarily on Credit Risk. BASEL II was implemented in 2008 and
was based on a three pillar model and focuses on credit risk along with
operational risk, market risk and residual risk. BASEL III was developed in
response to the deficiencies in financial regulations revealed by the global
financial crisis and strengthens bank capital requirements and introduces
new regulatory requirements on bank liquidity and bank leverage.
Classification: Non-performing portfolio is adversely classified based on
objective time based criteria as well as subjective performance indicators.
Categories of Classification include: Substandard, Doubtful and Loss. For
agriculture financing, Other Assets Especially Mentioned (OAEM) category
also exists.
Cleanup: This refers to a periodic adjustment of a running finance loan
Contingent items: These are liabilities that may or may not be incurred by
an entity depending on the outcome of a future event such as a court case.
FATR: Finance Against Trust Receipt is a short term loan which is utilized
to retire LCs. The goods imported are released to the customer against a
signed trust receipt.
FIM: Finance against Imported Merchandise is a short term line utilized to
retire LCs. The goods imported are kept under banks pledge and are
released against commensurate cash payment.
Internal Risk Rating: A mechanism used to assign the borrower a score and
rating signifying the element of risk inherent. This is usually a combination
of qualitative and quantitative factors with scoring and weightage assigned.
Loan Covenants: Conditions imposed at the time of sanctioning a loan to
ensure certain minimum performance levels or to deter from undertaking
certain activities.
Off-balance sheet items: These are asset or debt items not reflected on the
balance sheet of an entity. Examples include contingent items,
commitments, derivatives etc
PPM: Product Program Manual is an end to end documentation which
defines a specific programmed credit along with its annexures, policies and
related forms. Programmed credit are a set of instructions applicable on a
set target market to enable booking of a credit through a structured program
with features that suit the target markets customers.
314
References
Books
Credit Risk Management - S.K. Baghci Credit Risk Management in Banks Arvind Tain
Bank Lending - Tne Institute of Bankers Pakistan (IBP) Managra Rjsk in
Financial Sector - The Institute of Bankers Pakistan (IBP
Articles
Management of Credit Related NPA - P. Jayaraman

Credit Risk Management: Guiding Principles for Implementation - IBP
Journal Oct-Dec 2007
Loan Loss Provision - Uplift India Association
Earnings and Capital Management and Signaling: The Use of Loan Loss
Provisioning by European Banks - Domenico Curcio
Risk Management - IBP Journal Jul-Sep06
Risk Based Auditing in Banking Industry - IBP Journal Jul-Sep10
Challenges in Credit Risk Management - IBP Journal Apr-Jun10
Guiding Principles of Credit Risk Management - IBP Journal
Oct-Dec07
State Bank of Pakistan
Prudential Regulations - Updated version January 31, 2011 Guidelines for

Commercial Banks and DFIs, Risk Management BPRD Circular No. 13 of
2008 BPRD Circular No. 06 of 2007
The Financial Institutions (Recovery of Finances) Ordinance, 2001
Appendices / Additional Reading Material

Following is the list of documents which have been referred to in this
315
reference book and candidates are urged to read these in detail for
clarification of concepts.
Appendix 3 - BASEL II - An overview by The Institute of Chartered
Accountants of Pakistan.
(www.icap.org.pk/mies/miesl .pdf)
Appendix 3A - Risk Management- Guidelines for Commercial Banks and
DFIs by State Bank of Pakistan.
(www.sbp.org.pk/riskmgm.pdf)
Appendix 3B -Guidelines on Internal Credit Risk Rating Systems by State
Bank of Pakistan
(www.sbp.org.pk/bsrvd/2007/Annex-C8.pdf)
Appendix 3C - Understanding Credit Information Bureau Consumer
Awareness Program by State Bank of Pakistan.
(www.sbp.org.pk/bsd/cib_awareness.pdf)
Short-term Term Finance (TF): An RF facility presents monitoring
issues, in certain cases it is more advisable to grant transaction
based working capital finance in the form of a revolving short term
TF (or in most banks Demand Finance) line. In this case, finance is
granted against documented transactions, such as invoices of credit
316
sales or work orders for consignments etc. which the customer has
to adjust within a certain fixed tenor. The limit itself is, however,
revolving, and the customer can again obtain financing against
amounts adjusted, up till the expiry of the limit.
Lease Finance: Lease Finance facility is offered to the customer in
cases where Plant & Machinery, Vehicles or other similar fixed
assets are to be financed. It is differentiated from TF (above) in that
the funds are disbursed directly to the vendor, and the title of the
leased asset remains in the name of the Bank till full adjustment of
the LF. Repayment schedule of the LF is predetermined, usually in
the form of periodic installments, and may include a prior grace
period. LF may be collateralized as well, depending upon the amount
of exposure and the riskiness of the borrower.
For hypothecation of stocks, standard letter of Hypothecation (IB 25-A).
For hypothecation of book debts/ Receivable and machinery, draft to be
obtained from Legal Affairs Department.
317

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Lending:

Lending - A core banking practice/function

a. Overview and Sources of Lending Risks

b. Risk Assessment & Risk Management

c. Ratio Analysis & Assessing Customer Needs

d. Credit Risk Practice for Business and Commercial Banks

e. Credit Risk Practice for Retail Banking

f. Business Lending - When Things Go Wrong

Collateral and Documentation

Past Due Accounts/Over Due Accounts - Consumer Lending

Appendices/ Additional Reading Material

By the end of this chapter you should be able to:

State the importance of building a disciplined lending culture

iftnq Products, Operations and Risk Management | Reference Book 1

Todays banks create money in the economy by making loans and

Reserve Requirement-This is imposed by the Central Bank of the country on all

Banks act as intermediary between depositors and borrowers

Banks facilitate the flow of funding by acting as an intermediary between

Lending is a primary business function of banks. The banks make a profit by

Lending: Products, Operations and Risk Management | Reference Book 1

Banks role of financial intermediary in the economy is critical. Financial

Banks driven by self-interest also exercise a great deal of caution and

Lending: Products, Operations and Risk Management | Reference Book 1

Lending: Products, Operations and Risk Management | Reference Book 1

Differentiate between short term and long term lending

Describe the characteristics of an individual borrower and

Describe the types of products available to individual customers

2. Regulations and Practices

* State the lending exposure limits as per SBP regulations

State regulations concerning lending disclosure and reporting

State regulations concerning lending disclosure and reporting

Define credit policy, target markets and risk assessment criteria

State prudential regulations concerning the business

State the minimum requirements for consumer financing as per

State the general SBP Prudential regulations concerning

Lending: Products, Operations and Risk Management | Reference Book 1

Explain the industry-wide methodology used for calculation of pool rates

Explain 'risk based' and 'relationship yield' pricing models

As discussed in the previous chapter, banks as lenders need to inculcate a

Businesses frequently are in need of funds to either bridge the temporary

Lending: Products, Operations and Risk Management | Reference Book 1

Lending: Products, Operations and Risk Management | Reference Book 1

Lending Products for Business Borrowers:

Demand I Discounting I Export I Import

Details of lending products available for businesses in Pakistan

An overdraft generally known as RF in Pakistan is a type of lending

Lending: Products, Operations and Risk Management | Reference Book 1

Interest/mark-up on an overdraft is only charged on the day-to-day balance

Demand finance generally known as LM in Pakistan is similar to running

Export finance is similar to demand finance. In Pakistan, the State Bank of

Lending: Products, Operations and Risk Management | Reference Book 1

Import finance is generally available in terms of import loans or

Undng: Products, Operations and Risk Management | Reference Book 1

FATRs in respect of collection documents -

FATRs in respect of collection documents are only granted when routed

This facility is allowed against the commodities imported from other

Lending: Products, Operations and Risk Management | Reference Book 1

Tenon the term over which the loan is to be repaid

Repayment Schedule: the intervals at which the principal and

Pricing: the mark-up rate that will be charged.

Collateral: the security to be granted.

Loan Covenants: conditions to be complied with by the customer,

Event of Default: events which would render the loan immediately

Some banks ask for requirements like establishment of Sinking