Chapter 1 - Introduction to Bank Lending.pdf

Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune Module I: Basics of Credit and Credit Process Chapter 1: Introduction to Bank Lending Dr. M. Manickaraj The objective of this chapter...

Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune Module I: Basics of Credit and Credit Process Chapter 1: Introduction to Bank Lending Dr. M. Manickaraj The objective of this chapter is to describe the basic principles to be followed in lending, to describe the types of borrowers and various loan products and to provide an introduction to credit policy, credit analysis and credit administration. Structure 1.1 Principles of Bank Lending 1.2 Types of Borrowers 1.3 Types of Credit Facilities 1.4 Credit Policy 1.5 Credit Analysis 1.6 Credit Administration 1.7 Summary and Conclusion 1.1 Basic Principles of Bank Lending Commercial banks play a pivotal role in the development of nations across the globe. They contribute to economic development by mobilisation of savings from the public and lending the same to those in need of funds. Mobilisation of savings enables formation of capital and allocating the capital to productive sectors in the economy particularly the industrial sectors. Of course, now a days banks do lend money to variety of customers including private business firms, public sector enterprises, infrastructure projects, farmers, service enterprises and so on. Banks provide credit to individuals also for purchase of house, vehicles, education and the like. Banks mobilise the savings of millions of people and lend the same to various types of borrowers. As they deal with public money banks have to necessarily follow certain principles while lending. The principles if followed will also ensure the sustainability of banks. The main principles to be followed are discussed hereunder. Safety: People deposit their savings with banks mainly because of the confidence they have that the money deposited will be safe. If the confidence of the public is lost no bank can survive. For this reason, unlike any other business banks are regulated most Page 1 of 10 Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune stringently. The most important principle, therefore, to be followed by banks is ensuring safety of depositors’ money. Safety means the borrowers repay the loan with interest as per repayment schedule. Banks’ most important consideration while giving a loan is security offered by borrowers. Even then, they need to take into consideration the creditworthiness of the borrower which depends on his character, capacity to repay, and his financial standing. Above all, the safety of bank funds depends upon the technical feasibility and economic viability of the project for which the loan is advanced. Another major activity of banks is investing in various financial securities. The degree of risk varies depending on the issuer’s risk. Securities issued by the central government is the least risky and securities issued by state governments are riskier than central government securities. Securities issued by corporates are riskier than government securities. As safety of funds is the primary concern banks invest mostly in government securities. Lending is a risk taking business and hence banks need to have robust risk management systems in place to ensure safety for themselves and their depositors. Of late, the sources of risk and quantum of risk have multiplied. Therefore, risk management has become a critical function in banks in order to ensure safety of funds and sustainability of banks. Liquidity: Maintaining sufficient liquidity is another necessary condition for banks to survive. Banks must keep sufficient cash and be able to meet the demand for withdrawal of money by depositors at all times. Thanks to the technological advancements depositors and borrowers do not visit bank branches to withdraw money. Rather, they use alternative channels like ATMs for withdrawal of money or internet banking and mobile banking for transfer of money. As such banks cannot ask any customer to wait to draw money from their account. Hence, maintaining adequate liquidity by banks is of paramount importance. To ensure liquidity central banks have made it mandatory for banks to maintain a certain amount of money deposited with the central bank and some amount invested in very safe and liquid securities. Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) are the tools used by the Reserve Bank of India to ensure liquidity in the banking system. CRR and SLR demand banks to keep certain percentage of their net demand and time liabilities as cash reserve with the RBI and as investment in government securities and other approved securities respectively. Asset Liability Management (ALM) is another mechanism used to ensure liquidity by managing the mismatch between the maturity profiles of assets and liabilities. Profitability: Sustainability of any business would depend largely on surplus (profit) it can generate and banks are no exception. Though banks service the society and promote economic development they are expected to generate satisfactory profits in order to sustain themselves in the long run. They need to price loans and other services such that they will be able to meet all costs including interest and operating expenses and also will make profit. Banks in India have to determine rate of interest on loans using their Page 2 of 10 Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune respective Marginal Cost based Lending Rate (MCLR) which would cover the cost of funds, operating costs, risk costs and also profit margin. Recovery of loans with interest as per repayment schedule is another important function that will determine profitability of banks. Basel accords and the regulations by central banks have elaborate guidelines for determining unexpected losses due to credit default and allocation of capital for the same. Purpose of Loan: As discussed earlier banks need to ensure safety of deposits. Besides, banks play the role of enabling economic development by allocating the capital mobilised through deposits to various sectors in the economy. Banks hence provide credit to productive activities only and not for speculative and non-productive activities. Economic development can be achieved by producing goods and services and selling them to consumers or by boosting the demand for goods and services leading to greater economic development. Diversification of Risk: While providing credit for productive purposes it is important for banks to spread the credit portfolio such that the risks are fairly diversified. Diversification can be achieved by providing credit to many sectors and to large number of customers in various sections of the society. Exposure norms prescribed by the RBI are meant for ensuring diversification of risk and to see that the bank credit reaches all deserving sectors, regions and sections of the society. 1.2 Types of Borrowers Banks provide loans to variety of customers who differ significantly in terms of characteristics, loan requirements, frequency and volume of transactions, etc. Nature of relationship in each type of account or borrower calls for differing degree of care on the part of the banker. For example, the legal requirements in establishing a contractual relationship and in transactions for an individual borrower are vastly different from a corporate customer. In dealing with loan accounts, the banker should additionally be conversant with the legal provisions of various Acts as applicable to different classes of borrowers. Major types of borrowers and a brief description of them are as follows: Individual: An individual is a major who has attained 18 years of age, mentally sound, not an insolvent and is able to enter into a contract. However, in special circumstances guardians can borrow on behalf of minors. A married woman can borrow provided she has independent means. Else she can be a co-borrower. Purdahnashin women are also eligible to borrow, but bank must take the required precautions. Level of education is not a deterrent and illiterate persons can also borrow from banks. Agent: An agent is a person employed by another to act on behalf of the latter. Agent can do all such acts for the purpose of protection of the property of the principal as a man of ordinary prudence will do under such similar circumstances. Lending banker should take precautions such as scrutiny of the deed of agency and verify the extent of the agent’s authority. Page 3 of 10 Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune Attorney: A person may appoint an attorney to deal with any specific or general work on his/her behalf through a Power of Attorney. Business firms such as companies and limited liability partnerships too can appoint an attorney. Power vested with the attorney is restricted to the activities mentioned in that document only not beyond that. Bankers must carefully scrutinise the Power of Attorney and seek clear instructions from the principal where needed. Joint Borrowers: Two or more persons or a group of individuals who do not constitute a registered body or association can be treated as joint borrowers. Banks must obtain the signature of all the joint borrowers on loan documents or the signature of the attorney if power of attorney had been given to any one of the joint borrowers. Hindu Undivided Family: HUF is composed of all the members of the family and the senior most male member of the family who gets the right by birth in the ancestral property of the family is called the Kartha. Male major members of the HUF are called as Coparceners. Kartha has the authority to borrow and coparceners’ liability for the loan is limited to the extent of their share in the property. However, if they join the contract with Kartha or ratify the contract entered by Kartha, they become personally liable for the loan. Proprietary Firms: Business concerns owned by individuals are called proprietary forms. Liability of the sole proprietor is unlimited and hence in case of loans given to proprietary firms lenders will have recourse not only to the assets employed in business but also the private assets of the proprietor. Partnership Firms: Partnership is a relationship that subsists between persons in a business in common with a view to profit. The conditions to be met for entertaining a partnership firm by banks are as follows: It must be an association of two or more persons There must be an agreement among partners The agreement should be to carry on a business Profit earned by the firm should be shared by the partners Business could be carried out either by all or by any of the partners of the firm Though partnership firm need not be registered, from bankers’ point of view it is necessary. Limited Company: Company incorporated under and regulated by the Companies Act. It could be a public company, private company or a government company. A company is a legal person and has perpetual entity. The liability of shareholders of companies is limited to the paid up capital. However, there could be companies where the liability of shareholders is limited by a guarantee and in such cases the shareholders agree pay a certain sum over and above the paid up Page 4 of 10 Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune capital in the event of losses or liquidation of the company. The nature and the status of a company, its objectives, right to borrow in its name, etc can found in its Memorandum of Association (MOA) and Articles of Association (AOA). A company can do only such businesses mentioned in the MOA. Banks providing credit to companies must necessarily collect the copies of these and other relevant documents and scrutinise the same before getting into any loan agreement. Limited Liability Partnerships (LLP): Partnership firms have unlimited liability. This unlimited liability restricts their ability to do business. In view of this Government of India has recently allowed the establishment of Limited Liability Partnerships (LLPs). These are business firms established under the Limited Liability Partnership Act 2008. LLP is a corporate business vehicle that enables professional expertise and entrepreneurial initiative to combine and operate in a flexible, innovative and efficient manner. It also provides the benefits of limited liability while allowing its members the flexibility for organizing their internal structure as a partnership. 1.3 Types of Credit Facilities Banks and other lending institutions offer a variety of loan products. Credit products can broadly be divided into five categories – credit products for business firms (companies, partnership firms, proprietorship firms and LLPs); project and infrastructure finance; export credit; credit products for retail customers; and credit products for agriculture. Credit products for business firms: The various credit products that would meet the requirements of business firms are as follows: · Term loans – Loans for a specified period of time and to be repaid within the specified period may be called term loans. These loans are offered generally for creating fixed assets that would be used for producing goods and services. Term loans are provided normally for medium term or long term. · Bridge loan: Offered for a short period of time until the borrower is able raise permanent finance. It is also referred to as interim financing, gap financing or swing loans. · Working capital loan: Working capital loan is meant for financing day to day operations of a business firm. It is used for purchase of raw material, payment of wages and salaries, electricity bill, etc. It is required because business firms in order to fill the gap in the cash flow of a firm between purchases of raw material till the time cash is collected from customers. Working capital loan is not meant for investing nor for purchase of fixed assets. To many banks working capital loans is the largest source of income. The following are the commonly offered working capital loan products: o Cash Credit: It is a secured working capital loan offered against tangible security. It is offered as a limit and the borrowing firms are free to draw funds from the loan account but within the limit. This provides flexibility Page 5 of 10 Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune to the firms to draw funds from the cash credit account depending on their working capital requirement and they need to pay interest only on the amount of loan utilized. o Overdraft: It is very similar to cash credit. However, as the name suggests the banks allow depositors to draw more funds than their deposit from the account and interest is charged on the amount of overdraft. o Working capital demand loan (WCDL) – It is a short term loan. It can be used by customers for meeting seasonal working capital requirements. o Discounting/Purchase of bills – Lending institutions provide credit by discounting or purchasing the receivables (bills) of business firms. Business firms sell goods and services on credit. However, they may need money immediately in order to finance their operations. To raise funds, they may discount the bills with a bank. On the due date of the bill the amount will be realised from the drawee (buyer) of the bill. The banks will charge commission and interest for the service. Demand bills are those bills or cheques which are payable on demand by the drawee. Banks may purchase such bills and make immediate payment to the drawer (seller). For this service banks will charge commission and no interest is charged. Composite loan – As the name suggests composite loan is a combination of both term loan and working capital loan. This loan is offered banks and financial institutions in India to MSMEs. The purpose of this loan is to ensure that the MSMEs are provided with both term loan and working capital loan by the same bank/financial institution. Demand loan – This is a unique kind of loan which is offered with a condition that the loan can be called back by the lender anytime. Thus the demand loan is embedded with a call option that can be exercised by the lender. Demand loan is offered normally for meeting working capital requirements for a period up to three years. Drawing money from demand loan account using cheques is not allowed. Non-fund based credits: Letters of credit (LC) and bank guarantees (BG) are the most commonly used non-fund credit products. Other products include buyer’s credit, supplier’s credit, co-acceptance of bills and trade credit. Project Finance: Project finance was being offered by term lending institutions like Industrial Development Bank of India (IDBI) and Industrial Credit and Investment Corporation of India (ICICI). Of late, commercial banks too have started providing project finance for infrastructure and industrial projects. These loans are for a very long period of time and the risk is quite high. Export Credit: Credit extended to exporters by banks in exporters’ country is called export credit. In order to promote exports governments generally offer Page 6 of 10 Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune interest subsidy to exporters. Governments also provide guarantee for the loans to exporters. For instance the Government of India offers interest subsidy to exporters and also provides export credit guarantee through the Export Credit Guarantee Corporation of India (ECGC). Retail loans: Retail loans are nothing but the loans offered to individuals. Variety of retail loan products are offered by banks and financial institutions. Popular ones include housing loan, home improvement loan, vehicle loan, consumer/personal loan, gold loan, credit cards, etc. Credit Products for Agriculture: Loans extended to farmers and for purposes that will facilitate agriculture farming are called agriculture credit products. Agriculture also includes allied activities like dairy farming, poultry farming, animal husbandry, fish farming, etc. Broadly loans given for agriculture can be divided into investment credit and crop loan. Investment credit would include loans for development of land, irrigation system, purchase of equipment like tractors, tillers, harvesting machines, and so on. It will also include loans for construction of cold storages, transport equipment and the like. On the other hand, crop loans are short term loans given for the purpose of meeting crop production expenses and post-harvest expenses. 1.4 Credit Policy Prudent management of loan portfolio of a bank would depend to a great extent on its credit policy. Credit policies should be clearly defined and set forth in such a manner as to provide effective supervision by the board of directors and senior officers. The board of directors of every bank has the legal responsibility to formulate lending policies and to supervise their implementation. Credit Policy is a written document which contains specific guidelines for all types of credit decisions and determines the composition of credit portfolio. The main objective of credit policy is to provide direction and guidance within the framework of regulatory prescriptions, corporate goals and social responsibilities. Another objective of the credit policy is to achieve a healthy balance between volume of credit business, earnings and asset quality. Basic features of credit policy are: It is a document approved by the board of respective banks Credit policy must be comprehensive and provide guidance to credit function of the bank Credit policy must indicate authorities and responsibilities attached to each functionary in credit department/branches Credit policy must be explicit about risk management Credit policy must be updated periodically. Normally it is updated every year. Page 7 of 10 Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune Contents of Credit Policy: The following is a list of general guidelines to be included in the credit policy of banks1: · Sectors and general fields of lending in which the bank will engage and the kinds or types of loans within each general field; · Lending authority of each loan officer; · Lending authority of a loan or committee, if any; · Responsibility of the board of directors in reviewing, ratifying, or approving loans; · Guidelines under which loans will be granted; · Guidelines for rates of interest and the terms of repayment for loans; · Limitations on the amount advanced in relation to the value of the collateral; · Guidelines for documentation required by the bank for each type of secured loan; · Guidelines for obtaining and reviewing real estate appraisals; · Maintenance and review of credit files on each borrower; · Procedures for recovery including, but not limited to, actions to be taken against borrowers who fail to make timely payments; · Limitations on the maximum volume of loans in relation to total assets; · Method/s for assessment of credit to be sanctioned · Guidelines regarding target portfolio mix and risk diversification and the bank's plans for monitoring and taking appropriate corrective action, if deemed necessary, on any concentrations that may exist; · Guidelines for loan review and grading system; The above guidelines are only indicative and not exhaustive. In addition to the abovementioned general guidelines, banks develop specific policy guidelines for each credit department or function like corporate credit, project and infrastructure finance, lending to MSMEs, lending to agriculture and retail credit. 1.5 Credit Analysis Credit analysis is most critical function in banks. It is essential to evaluate a borrower’s credit worthiness before taking lending decisions. It involves the evaluation of a borrower’s ability to honour his/her financial obligations. Seven C’s of Credit: A customer’s ability to repay loans can be assessed by evaluating the customer on seven factors which can be referred to as the 7 C’s of Credit. They are briefly discussed hereunder. · Character: The first and most important factor that will determine a borrower’s repayment capacity is the integrity of the borrower. If a borrower is of decent 1 Source: Federal Deposit Insurance Corporation (FDIC), DSC Risk Management Manual of Examination Policies https://www.fdic.gov/regulations/safety/manual/section3-2.pdf, accessed on November 11, 2017. Page 8 of 10 Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune character and is a person of repute for his honesty and integrity then the probability of the borrower defaulting on repayment of loans will be lower. · Commitment: Another important factor is the commitment of the borrower. If the borrower is committed to his profession or business then he/she will do everything that may be necessary to run the profession/business in the best possible manner. This will enable overcoming any challenges and will make the business/profession a success. · Capacity: Though a customer may be committed to his/her business competency in the line of activity is equally important to be successful. Therefore, the customer’s technical qualification, knowledge, skills, and experience should be studied as part of credit analysis. · Cash flow: The customer or his business should generate adequate profit and cash flow to service the loans. If the business is incurring losses for a prolonged period then repayment of loan would not be possible. · Capital: While lending institutions may provide loans the borrowers should bring in their share of capital. It is generally referred to as margin money for loan or equity margin. Capital will indicate several things. It will ensure the commitment of the borrower in the business and also will act as a cushion to absorb losses of the business. If adequate capital is there then the risk of providing loans will be less. · Conditions: The performance of a borrower will depend on several factors which are external to his activity/business. Such factors would include macroeconomic conditions, industry scenario, changes in technology, competition and so on. Therefore, external factors that could determine a borrower’s performance should also be studied before sanctioning a loan. · Collateral: Security for loan is also important. As a last resort the lenders can recover loans by disposing of security provided by the borrowers for loans. The value of security will depend on enforceability and realisable value. Therefore, due care must be taken while accepting any asset as security for loans. Guarantees of individual persons and business entities too are considered as security for loans. 1.6. Credit Administration Credit administration involves organising and managing credit processes, and managing risks. As banks and financial institutions grow in terms of size, number of branches, number of employers, diversity and complexity, risks increase disproportionately and it becomes increasingly challenging to manage credit portfolios. At the same time, banks and financial institutions are often subject to increased regulatory, governance, and transparency requirements. One of the most effective ways to address all these is to have sound credit administration. Credit administration would involve making and implementing credit policy, maintaining files and databases, credit monitoring and supervision, internal audit, reporting, and credit risk management. Page 9 of 10 Course: Credit Management (Module I: Basics of Credit and Credit Process) NIBM, Pune 1.7 Summary and conclusion Banks and financial institutions play a pivotal role in development of economies through provision of loans for various productive sectors and activities. They offer variety of loan products to different customer segments. The customer segments can broadly be divided into three – individuals, business firms and agriculture farmers. The loan products offered can be classified into term loans and working capital loans. Non-fund credit facilities too are offered to business borrowers. Credit policy is the document that will provide direction and guidance for providing credit. Credit can be offered to any customer only after careful evaluation of his/her repayment capacity. 7 C’s of credit that capture all the factors that will determine a borrower’s repayment capacity should be studied before sanctioning loans. Banks and financial institutions today are very big and are subjected to stringent regulation. Therefore, there is a need to have a sound credit administration for managing credit portfolios efficiently. Page 10 of 10