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Principles of Sound Lending, Credit Policy,

Planning and Lending Criteria.

Presented by:
Sk Nazibul Islam
Faculty Member, BIBM

Like every other business activity, banks are profit


oriented.
A bank invests its funds in many ways to earn
income.
The bulk of its income is derived from loans and
advances.

The business of lending is not without certain


inherent risks largely depending on the borrowed
funds.
A banker cannot afford to take undue risk in
lending.

- Banks lend mostly depositors money


- Credit / Loanable funds having cost
implications and repayment obligations to
the depositors have to be managed
efficiently with minimum possible credit risk.
- Prudent management of this risk is
fundamental to the sustainability of a bank.

- Credit Risk is the possibility that a borrower or


counter party will fail to pay interest or repay the
principal according to the terms specified in a credit
agreement .
- Credit risk means that payments may be delayed or
ultimately not paid at all, which can in turn cause cash
flow problems and affect a banks liquidity.

Banks make loans and advances to traders,


businessmen, agriculturists and industrialists. In
either case, the banks run the risk of default in
repayment.
Therefore, banks have to follow a cautious policy
and sound lending principles in the matter of
lending.

Traditionally, banks have been following


three cardinal principles of lending viz.
safety, liquidity and profitability and certain
other principles.

Safety: Safety first is the most important principle of good


lending. When a banker lends certain money he has to see that the
loan or advance is safe and the money lent will comeback. A bank
lends what it receives from the public as deposits. Safety depends
upon (i) the security offered by the borrower,
(ii) the repaying capacity and willingness of the debtor to repay
the loan with interest.
(iii) income generation
So the banker should ensure that the security offered is adequate
and readily realizable and the borrower is a person of integrity,
good character and reputation.

Liquidity:
- It is to be seen that money lent is not going to be locked up for a long
time. The money should return to bank as per repayment schedule.
-Liquidity refers to the ability of an asset to convert into cash without
loss within short time.
-The liabilities of a bank are repayable on demand or at a short notice.
-To meet the demand of the depositors in time, the bank should keep its
funds in liquid state.
-As such a bank should confine its lending to short term against
marketable securities.

Profitability:
-Banks earn profit to pay interest to depositors, declare
dividend to shareholders, and meet establishment charges
and other expenses.
-So profit is an essential consideration. The main source of
profit comes from the difference between the interest
received on loans and those paid on deposit.
-A bank must employ its funds in such a way that they will
bring adequate return for the bank.

Purpose of the loan:


Before sanctioning loans a banker should enquire
about the purpose for which it is needed. Loans for
non-productive and speculative purposes cannot
be granted Although the earnings on nonproductive business may be higher even then bank
can not resort to non-productive loans being
contrary to the national interests.

Sources of repayment: Before giving


financial accommodation, a banker should
consider the source from which repayment
is promised.

Diversification of Risks:
The banker should not lend a major portion of his loanable
funds to any single borrower or to an industry or to one
particular region.
An adverse change in the economy of these may affect the
entire business.
The bank must advance moderate sums to a large number
of customers spread over a wide area and belonging to
different industries.

A sound credit is one where timely repayment is


assured.
In the changing concept of banking, factors such
as purpose of the advance, viability of the
proposal and national interest are assuming a
greater importance than security, especially in
advances to agriculture, small industries, small
borrowers, and export oriented industries.

Banking is termed as business of


confidence.
Credit is the confidence of the lender on the
ability and willingness of the borrower to
repay the debt as per schedule of
repayment.

Before allowing credit facility a banker should be


satisfied that the applicant qualifies the following
five essentials which may be termed as 5 Cs.
namely1. Character Borrowers Integrity, honesty,
intention to repay the loan money, commitment,
credit record, dependability etc.

Capacity- Identity of Customer and Guarantor,


Corporate charters, Resolutions, Partnership
agreement, and other documents. Description of
history, legal structure, owners, nature of
operations, products and principal customers and
suppliers for a business borrower, Borrowers
business ability, Business experience, Technical
knowledge, Age etc.

Capital- Financial strength to cover a business


risk, Stake in business, Solvency, retention of
earning, ability to infuse more money, Take home
pay for an individual, turnover of payables
receivables, and inventory etc.

Condition- It is general business condition.


Customers in industry and expected market share,
Customers performance vis-a-vis comparable
firms in the same industry, competitive climate
Economic trends, Industry Growth, competitive &
regulatory environments, Working conditions etc.

Collateral- Borrowers ability to produce


additional securities i.e, ownership of assets, Asset
quality, type, Location, Title,Liens encumbrances
and restrictions, insurance coverage, Guarantees
warranties issued Forced sales value etc.

Credit policy

All banks should have established credit


policies that clearly outline the senor
management's view of business
development priorities and the terms and
conditions that should be adhered to in
order for loans to be approved.

The credit policy of any banking institution


is a combination of certain accepted, time
tested standards and other dynamic factors
dictated by the realities of changing
situations in different market places.

The accepted standards relate to safety ,


liquidity and profitability of the advance
whereas the dynamic factors relate to
aspects such as the nature and extent of risk,
interest or margin, credit spread and credit
dispersal.

General guidelines about the conduct of


advances are issued by Head Office.
In all business dealings, officers and
employees must be guided by the principles
of honesty, integrity and safeguard the
interest of the depositors and shareholders
of the bank.

They should strictly adhere to the Banking Laws,


rules and Regulations of the government, the
instructions issued by the Central Bank/Head
Office from time to time which affect the business
practices of the bank.
However, the key to safe, liquid, healthy and
profitable credit operation lies in the quality of
judgment used by the officers making lending
decisions and their knowledge of the borrowers
and the market place.

The credit Policy /Guidelines should be


updated at least annually to reflect changes
in the economic outlook and the evolution
of the banks loan portfolio, and be
distributed to all lending /marketing
officers.

The lending guidelines should be approved


by the Managing Director/CEO & Board of
Directors of the bank based on the
endorsement of the banks Head of CRM
and the Head of Corporate/ Commercial
Banking.

Any departure or deviation from the


Lending Guidelines should be explicitly
identified in credit applications and a
justification for approval provided.
Approval of loans that do not comply with
lending guidelines should be restricted to
the banks Head of Credit or Managing
Director /CEO & Board of Directors.

The Lending guidelines provide the key


foundations for account officers / Relationship
managers (RM) to formulate their
recommendations for approval.
It should be remembered that selection of
appropriate borrowers, proper follow-up and enduse supervision through constant close contact
with the borrowers, are the cornerstones for timely
recovery of credit.

Credit planning
Eligibility of loans and advances
- be a citizen of the country
- an adult
- Credit worthy
- no defaulter of the bank or a defaulter of
other bank
- not an insolvent person
- not lunatic /idiot

Business powers
Entertainment and disposal of loan
applications
Scrutiny of loan
Loan portfolio briefs
Appraisal of loan applications
Security title verification

Loan security & Collaterals


Valuation of securities
Sanction procedure
Interest on loans and Advances
Loan repayments
Documentations
Disbursement of loan

Loan Recovery Non-legal and legal


measures
Record management and release of security
Loan re-scheduling
Loan supervision and monitoring
MIS
Duties of Manager and other supervising
authorities.

Lending criteria
Industry and Business Segment Focus
The Lending Guidelines should clearly identify
the business/industry sectors that should constitute
the majority of the banks loan portfolio. For each
sector, a clear indication of the banks appetite for
growth should be indicated (as an example,
Textiles: Grow, Cement: Maintain, Construction:
Shrink). This will provide necessary direction to
the banks marketing staff.

Types of Loan Facilities


The type of loans that are permitted should
be clearly indicated, such as Working
Capital, Trade Finance, Term Loan, etc.

Single Borrower/Group
Limits/Syndication
Details of the banks Single Borrower
/Group limits should be included as per
Central Bank guidelines. Banks may wish
to establish more conservative criteria in
this regard.

Lending Caps
Banks should establish a specific industry
sector exposure cap to avoid over
concentration in any one industry sector.

Discouraged Business Types


Banks should outline industries or lending activities
that are discouraged. As a minimum, the following
should be discouraged:
- Highly Leveraged Transactions
- Finance of Speculative Investments
- Lending to companies listed on CIB black list or
known defaulters.

Loan Facility Parameters


Facility parameters (e.g., maximum size, maximum tenor, and
covenant and security requirements) should be clearly stated.
As a minimum, the following parameters maybe adopted:
- Banks should not grant facilities where the security position
is inferior.
- Assets pledged as security should be properly insured.
- Valuations of property taken as security should be
performed prior to loans being granted.
- A recognized 3rd party professional valuation firm may be
appointed to conduct valuations.

Credit Assessment
A thorough credit and risk assessment should be
conducted prior to the granting of loans, and at
least annually thereafter for all facilities. The
results of this assessment should be presented in a
Credit Application that originates from the
relationship manager/account officer (RM), and
is approved by Credit Risk Management (CRM).

The RM should be the owner of the customer


relationship, and must be held responsible to
ensure the accuracy of the entire credit application
submitted for approval.
- RMs must be familiar with the banks Lending
Guidelines and should conduct due diligence on
new borrowers, principals, and guarantors.

It is essential that RMs know their customers and


conduct due diligence on new borrowers,
principals, and guarantors to ensure such parties
are in fact who they represent themselves to be.
All banks should have established Know Your
Customer (KYC) and Money Laundering
guidelines which should be adhered to at all times.

Borrower Analysis
- The majority shareholders, management team
and group or affiliate companies should be
assessed.
- Any issues regarding lack of management depth,
complicated ownership structures or inter-group
transactions should be addressed, and risks
mitigated.

Industry Analysis
- The key risk factors of the borrowers industry
should be assessed.
- Any issues regarding the borrowers position in
the industry, overall industry concerns or
competitive forces should be addressed and
- the strengths and weaknesses of the borrower
relative to its competition should be identified.

Supplier/Buyer Analysis
- Any customer or supplier concentration should
be addressed, as these could have a significant
impact on the future viability of the borrower.

Historical Financial Analysis


- An analysis of a minimum of 3 years historical financial
statements of the borrower should be presented.
- Where reliance is placed on a corporate guarantor,
guarantor financial statements should also be analyzed.
- The analysis should address the quality and sustainability
of earnings, cash flow and the strength of the borrowers
balance sheet.
- Specifically, cash flow, leverage and profitability must be
analyzed.

Projected Financial Performance


- Where term facilities (tenor > 1 year) are being
proposed, a projection of the borrowers future
financial performance should be provided,
indicating an analysis of the sufficiency of cash
flow to service debt repayments.
- Loans should not be granted if projected cash
flow is insufficient to repay debts.

Account Conduct
- For existing borrowers, the historic performance
in meeting repayment obligations (trade payments,
cheques, interest and principal payments, etc.)
should be assessed.

Loan Structure
- The amounts and tenors of financing proposed
should be justified based on the projected
repayment ability and loan purpose.
- Excessive tenor or amount relative to business
needs increases the risk of fund diversion and may
adversely impact the borrowers repayment ability.

Security
- A current valuation of collateral should be
obtained and the quality and priority of security
being proposed should be assessed.
-Loans should not be granted based solely on
security.
- Adequacy and the extent of the insurance
coverage should be assessed.

Name Lending
- Credit proposals should not be unduly influenced by an
over reliance on the applicants reputation, reported
independent means, or their perceived willingness to inject
funds into various business enterprises in case of need.
- These situations should be discouraged and treated with
great caution.
- Rather, credit proposals and the granting of loans should
be based on sound fundamentals, supported by a thorough
financial and risk analysis.

Credit Risk Management (Key Messages)


Credit risk management lies at the heart of survival
for the vast majority of banks.
The profile of customers(WHOM has been lent to)
must be transparent.
Risks associated with the key banking products
(WHAT has been lent) must be understood and
managed.
The maturity profile of loan products (for HOW
LONG the loans have been made) interacts strongly
with liquidity risk management.

Thank You