Business Credit Essentials PDF

Learning Objectives: Upon completion of this chapter, students should be able to: 1. Apply key lending principle in credit risk assessment 2. Use 5Cs and CAMPARI framework in credit...

Learning Objectives: Upon completion of this chapter, students should be able to: 1. Apply key lending principle in credit risk assessment 2. Use 5Cs and CAMPARI framework in credit risk assessment 3. Understand the credit information acquisition and verification 4. Describe the loan agreement and security documentations Read More... Principles of Lending Sub-topic 2.1 Next Slide  RECAP: Bank Process Insights By Department By Process Marketing/Sales Marketing/Sales leads Department Head Office Origination Submission of application Credit Credit Risk Management information and In the bank process, the form and other required Department documents verification credit analysis, the Credit Analysis principles of lending, Credit Committee Credit Analysis Principles of Assessment and approval of  5Cs Approval and verification of Approval Department Lending facilities requested  CAMPARI information are occurring in the approval Issuance of letter of offer/ Compliance to rejection to borrower process. rules and regulations Borrower declines Borrower accepts offer Loan and (internal and offer or appeal against securities external) facilities Borrower comply to legal documentation Loan and securities requirement and pre- Administration documentations are Appointed disbursement conditions occurring in the Solicitor administration process. Credit Administration (perfection of legal Disbursement of credit Department documentations) facilities Panel Solicitor Credit facilities Monitoring monitoring Credit Rehabilitation & Recovery Credit facilities recovery Department Recovery Business Banking / Business Center Principles of Lending Every extension of credit facilities involves risk. It is important for Credit Officer to understand and apply the fundamental credit principles in their credit evaluation in order to make a sound credit judgement, and manage the credit risk effectively. Principle of Risk Taking Principle of Control Principle of Prioritizing Principle of Risk the Quality of Credit Diversification Principle of Proportionate Principle of Appropriate Stake Tenure of Financing Principle of Pari-PASSU Principle of Purposeful Principle of Protection and Productive Lending In the process of assessment and approval, credit officer need to ensure that al3 of these lending principles are complied. nafel Principles of Lending (Cont.) manage risk ~ 1. Principle of Risk Taking in Credit and Lending An effective risk management involves: Identify risks that can cause the credit to be vulnerable Mitigate risks with lending covenants, terms and conditions, control measures and / or appropriate structuring of credit facilities Under this principle, the bank is required to adopt a credit culture that guides the Bank’s Management and its officers to [practice effective risk management and quality( first policies in all Ccredit decisionsS with little exception Principles of Lending (Cont.) 1. Principle of Risk Taking in Credit and Lending (Cont.) A strong credit culture: Promotes good corporate governance that govern the business strategies and administrative actions of the bank management and its officers. Discourage irresponsible lending practice pinjaman bertanggungjawab Minimize Fraud ~ Develop positive recognition from the market Promote confidence among depositors, investors, and shareholders. orgyg -bagipinjam ambil Kira risk return concept Lender must also be mindful or risk return concept. pembiayaan hutang The Bank provides & debts financing must at a fixed capital by borrowing money that be repaid 2 return therefore Cshould not take on excessive raise equity risk( like business owners which have the potential of unlimited return. jgn amik equity risk berlebihan  Principles of Lending (Cont.) 2. Principle of Prioritizing the Quality of Credit - In the course of pursuing Illustration of the impact of Loan - loan growth and account Loss profitability, tak Sengaja the lender may If a loan of RM1 million earns an inadvertently compromise interest 10% p.a. defaulted with no the loan assets quality chance of recovery, total loss for the without realizing the material lender would be: financial implication caused RM1 million (loan principle) + ~ bila ada bukti loss has occurred by loan impairment. RM100,000 (interest lossess p.a.) = , It is imperative to note that RM1.1 million (total loan loss) for every one ringgit of loan If average loan size for the bank is losses, lender may need to RM1 million with an interest spread extend 50 to 100 times of new Next Slide of 2% p.a., the bank must get 55 new credit in order to loans totaling up to RM55 million to mengimbangi compensate the loan losses. cover the loss from this bad loan. ↳ tak Sengaja compromise loan New loan to cover loss = RM1.1 asset quality without realise Implikasi Kewangan disebabkan penurunan nilai pinjaman. Principles of Lending (Cont.) well spread portfolio - 3. Principle of Risk Diversification Lender is required to have a well spread /diversified lending portfolio to mitigate the concentration risk. Over concentration in any particular borrower group, industry sector or market segment may adversely be affecting the Bank’s financial condition in the event of downturn of any particular single counterparty, industry, or market segment. Bank Negara Malaysia had imposed the Single Counter Party Exposure restriction on financial institutions to mitigate risk concentration. Next Slide Principles of Lending (Cont.) 3. Principle of Proportionate Stake In credit risk evaluation, it is important for Credit Officer to assess the financial and capital commitment of owner/shareholder of a company towards the company’s business and debts obligation. Reason - lenders are only debt creditors with fixed return for the lending risk they underwrite unlike the shareholders who participate in the unlimited growth potential of the company. A low capital commitment by business owner/ shareholder or borrower increase the risk of loan default in time of economy adverse as the Kemerosotan ekonomi potential losses suffered by borrower mendorong is relatively low as compared to lender prompting borrower to walk away from their debts obligation. Principles of Lending (Cont.) 3. Principle of Proportionate Stake (Cont.) For retail lending, a Higher Loan to Value (LTV) of assets financed, led to higher lending risk due to lower margin of contribution by borrower relative to lender in assets financing. For business lending, Debts to Shareholders Equity of amount on of exposure account for loan repayment and debts a fi can have to single borrower to mitigate concentrationIsexcessive reliance on one borrower Principles of Lending (Cont.) 8. Principle of Appropriate Tenure of Financing 9. Principle of Purposeful and Productive ~ lengthmed Lending The longer the tenure of the loan, the higher All business lending must be purposeful i.e. the risk of default to the lender. the purpose of the loan must beCconsistent The principle of tenor matching states, that with the nature of the business.) -Kalanbusinesan t the duration of the loan must match the In addition, the business lending must be dgn mengena · kena ada kena cafe. borrower’s needs based on theCpurpose of deemed productive where the(loan is · the loan.( This is to mitigate the risk of directed to finance assets(( that are able to funding mismatch and abuse of banking )( generate income/cash flow to meet the loan productive income repayment.) business generate Kena and facility. - to repay the loan. For financing of long term assets, the For retail lending (e.g. housing loan, personal proposed loan tenure must be in line with loan), loan is granted to a borrower who is economy life span of assets in order for economically productive that have the ability lender to (have control over cash flow( to generate recurring and reliable income to (generated from assets1C for loan repayment.( meet loan repayment. businesroductive For example, propertyNext hasSlide longer economy life span than motor vehicle, therefore, involvesClonger financing kaan once as busine tenure(C as compared to motor vehicle.C ↳ hauta jangka hay lagi at lama davi motor , so loan tenure dia lagi lama Sbb jangka hayatlama.  Credit Evaluation Framework Sub-topic 2.2 Next Slide Credit Evaluation Framework In credit risk assessment lender would identify potential borrowers who have positive attitude, responsibility and willingness to honour obligation before assessing other factors such as capacity to pay, financial commitment, and adequacy of collateral to cover loan exposure. There a few credit evaluation models available. We are going to cover the popular credit analysis approaches used for SME credit analysis: ↳ a way to evaluate borrower's creditworthiness OR financial ↳ to determine ntk approve loan analysis The 5Cs Model The CAMPARI Model In bank’s business lending practice, these two models are used as a complimentary.  The 5Cs Model Character Collateral Capacity 5Cs Model Condition Capital St The 5Cs Model (Cont.) 1. Character and creat men The most important and difficult factors to be assessed. It refers to the integrity, sense of responsibility, honesty, diligence, prudence, and reputation of an individual borrower or key management team or major shareholder of a borrowing company. In business lending, Credit Officer needs to assess the business corporate character which is Crepresented by the control - system of rules yg company -peneraju company’s corporate governance. A company with good corporate governance is spearhead by CEO and management team that demonstrated organizational discipline and trustworthiness in their conduct of business. Kecekapan A company that have the management expertise and competency and clear vision to anticipate and manage changes in industry tend and cycles are (criteria of positive corporate character1( that ensure sustainability of business.( In addition, the age, marital status, lifestyle and past track record of borrower or business owners also provide an insight to their character. The founding owners who adopted conservative management style with proven past records in C executing business planCC are perceived to be lesser risk(as compared to the new management team with (aggressive management styleCwhich poiseCuncertainty in execution of business plan.( Credit Officer can assess the character of borrower through personal interview with the decision maker; discreet market check with borrower’s supplier, customer or other lenders, or review of the company’s past track record and reputation in the industry. The 5Cs Model (Cont.) 2. Capacity The second most important factor to assess borrower’s ability to generate cash flow to repay the debts obligation. be -canrasted It is to identify the repayment source as the first way out – lender needs to assess the reliability of repayment source. For business lending, this can be measured by financial ratios like time interest earned (TIE) and debts servicing ratio (DSR). It is also referred to management’s capacity to operate the business. The ability of a company to generate cash flow in meeting loan repayment is largelyCdependent on the competency of management in operating the business.C The Credit Officer needs to assess the capacity of borrower’s management team through review of their Cprofessional qualification, industry hak ada burden experience and past track record. Borrowers must have the legal capacity to borrow and charge/encumber its assets as collateral for the loan. For limited liability company, this can be verified through memorandum and article of association, accompanied by board resolution passed by the BOD. (board of director The 5Cs Model (Cont.) 3. Capital It is a financial commitment by borrower in a business. It is also a display of borrower’s confidence in the business to the lending bank. capital sikit A borrower with little capital contribution would be less committed towards the business and might have a higher propensity to walk away from honouring its debts obligation in time of crisis. For business lending, direct financial commitment is reflected by shareholders funds in the business terdiri drpd profit other creditors' loar prioritize comprising paid up capital and earnings retained in the company. ~ over their own loan to company Indirect shareholders’ financial commitment is in the form of subordination of shareholders or directors advances, as well as third party collateral provided by the business owners. The direct and indirect financial commitment can be measured by financial ratio such as Debt to Equity Ratio (Known as Financial Gearing). The 5Cs Model (Cont.) 4. Condition It deals with external influences/ macro issues that can influence borrower’s ability in honouring their debts obligations. The macro issues – globalization, foreign exchange fluctuation, interest rate changes, economy conditions of major trading partners, and regulatory changes. Lender needs to assess the impact of changes in macro environment on the sustainability of borrower’s ukur Kecekapan business, and gauge the proactiveness and competency of the management in Cdentifying and managing these external condition changes.( In addition, lender needs to relate this factor with the economy cycle, industry trends, and product life cycle of business. A proactive lender would assess the vulnerability of borrower towards economy downturn and cap or gradually (reducing their credit exposure3 as borrowers moves towards a declining industry trendSand (product subset stage( – Products demands weaken at these stage that would erode borrower’s profits and cash flow generation towards loan repayment. pembangunan/kitavan hayat produk ↳ tawarkan wide range of product The 5Cs Model (Cont.) 5. Collateral It refers to both security and guarantee provided by borrower to function as protection for the loan. In order for collateral to serve its purpose: It must have sufficient value for lender to cover the loan exposure; berusaha It holds some value to the borrower, who will endeavor to prevent losing the collateral. For example, a strategic assets such as valuable family house and strategic block of voting shares in a family business. Although collateral serves as second way out, lender must ensure the quality of collateral remained in tact at all times in order to Y make sure quality of collateral effectively protect the loan. terjaga to protect loan merosof A deteriorated collateral such as drop in assets value or loss of guarantor’s income generating capacity will not have sufficient value to cover the loan when needs arise. A good collateral must have characteristic such as: Stability in value & Potential marketability in the near future I Clear title ownership / Ease of transfer of ownership Y Easy accessibility Low depreciation rate &  The CAMPARI Model Character Ability to repay Margin of finance Purpose Amount Repayment terms Insurance Character Willingness to pay versus ability to pay  Similar to ‘character’ in 5Cs Ability to repay Kecukupan Adequacy of cash to meet repayment  similar to ‘capacity’ in 5Cs Margin of finance The client must contribute a certain margin as member of commitee committeemen. The banker will not grants 100% financing to comply with principle of proportionate stake holding. For any asset financing the customer has to pay a certain percentage of the value of the asset that needs to be financed. Purpose The purpose of the loan must be defined. Speculative purposes are considered risky and will not be entertained. Amount The amount the financier is willing to contribute to the client. How much is too much for a clients? Any amount beyond the repayment of capacity of a client is too much. Repayment terms The structure and terms of repayment. The repayment can be evaluated in terms of the following:  Tenor of the proposed loan  Repayment amount for each installment  Frequency of installment  Insurance In worst case situation, the loan can be settled from insurance proceeds. Some business credit requires insurance coverage arrangement including the followings:  Property financing – will requires property insurance  Agriculture financing – will requires hazard/natural catastrophe (i.e. fire and flood) insurance.  Contract financing – will requires general liability insurance Credit Information and Verification Sub-topic 2.3 Next Slide  Credit Information and Verification 1. Company documents (credit information) 2. Third Party record/opinions (verification) 3. Warning signals RECAP: Bank Process Insights Quality of credit Credit information Information verification Credit officer research: information are very  Industry reports critical for a quality credit Credit application form - Credit  Valid credit request  Economic reports assessment and yielding a purpose  Borrowing capacity quality credit portfolio Borrower/Firm key documents:  Character CIS Certificate of Business  Credit Banker’s opinion Economic Registration, Memorandum and history CCRIS Economic analysis Credit Officers Articles of Association, CTOS  Information Industry Directors’ NRIC, Form 9, Form asymmetry Industry analysis  Adverse Credit 24, Form 49, Income tax form selection Files SME  Moral Business profile/business plan  Proof of business prospects hazard Other project specific plan (i.e.  Proof of project to be undertaken Business Credit Managers property development plan,  Justification for new credit facility & plantation development plan, requirement Financial contract award) analysis  Proof of income/repayment capacity Analysis and Audited financial statements, recommendation  Accountant/auditor’s opinion on the latest management accounts business and financial prospects SME credit application Property valuation report  Valuer’s opinion – reasonable Credit decision in business banking (for property offered as a valuation? – to mitigate overvaluation collateral to the bank)  Collateral suitability and sufficiency Documents requested from the borrower/firm Credit officer verification  Key credit information Documents INFORMATION Certificate of Business Business registration for sole proprietor / partnership Registration Memorandum and Articles M&A are part of the registration documents in company incorporation (i.e. Sdn Bhd., Bhd) of Association (M&A) FORM 9 Certificate of incorporation of private company FORM 24 Returns of allotment of shares FORM 49 Return giving particulars in register of directors, managers, secretary and changes in particulars Directors’ NRIC NRIC of the directors will be used for credit history check on part of the directors. Director Income tax return Director income tax return from will be use to assess the directors financial capacity. This is known form as secondary source of income or repayment capacity to the borrowing firm. Business profile/business BP provides information related to the firm’s business profile, prospects, present project to be plan (BP) undertaken, and justification for new credit facility requirement. BP will also provide information on the existing banking and credit facilities with other financial institutions. Financial statements Financial statements provides proof of main income and repayment capacity of the borrowing firm. Qualified audit report? - a report issued by an auditor that reports certain discrepancies in the financial statements prepared by the entity. Property valuation report Current fair valuation of any property to be charged as a collateral to the bank loan. hafe Information verification Source/system record/opinion Customer information system CIS is a bank own customer database. (CIS) In CIS, credit officer can access the existing relationship and credit history of the borrower. Generally, existing and good customer of a bank are favourable. Central Credit Reference CCRIS is a centralised online Credit Bureau system provided by BNM. CCRIS collects credit-related information from Information System (CCRIS) financial institutions. Among the information that will be on the credit report from CCRIS are:  Outstanding credit  Special attention accounts, which are credit facilities under close supervision of financial institutions  Applications for credit in the previous 12 months that have been approved or are pending. Credit Tip-Off Service (CTOS) CTOS is a credit reference system own by CTOS Digital Berhad. CTOS collects credit-related information from a wider range of sources, including legal firms, government agencies, and telecommunications companies. The types of credit related information which will be included in the credit report from CTOS will include bankruptcy, legal action and even case statuses. It will also detail an individual’s business exposure, business ownerships and directorships, if any. Banker’s opinion Banker’s opinion is normally seeks for satisfactory conduct of credit facilities. Banker could provide opinion on the borrower character. Accountant/Auditor’s opinion The account of SMEs are normally prepared by the appointed accounting/auditing firm. The accountant/auditor could provide opinion on the owner character, business and financial performance of the firm. Valuer’s opinion Valuer’s opinion may be needed to ascertain the reasonable valuation for the property offered as a collateral to the bank. This could mitigate overvaluation tactic with the hope of getting higher financing from the bank.  borrowerae ? Identify a signate ↑ Warning signals In Business lending, the warning signs relevant to risk assessment include: ⑳ Qualified audit reports; no Recent change of the company’s auditors; Frequent change of offices and warehousing arrangements; Court notice of litigation against the loan applicant or borrowers; Non-filling of latest statutory records and annual audited financial statements with CCM. Warning indicators on credit reports (i.e. CTOS, CCRIS) Loan Securities and Documentation Sub-topic 2.4 Next Slide