05 – Uses of Bank Funds—The Lending Function – Management of Banking and Financial Services, 2nd Edition

CHAPTER FIVE

Uses of Bank Funds—The Lending Function

CHAPTER STRUCTURE
KEY TAKEA WAYS FROM THE CHAPTER
  • Understand why banks lend

  • Learn how banks lend—Principles of lending

  • Understand the process of making a loan from start to finish

  • Learn the fundamentals of credit appraisal

  • Understand how loans are priced

  • Understand how banks choose profitable customers

SECTION I
BASIC CONCEPTS

Introduction

Assume that you have Rs. 10 lakh with you and that a dear friend approaches you with a request to lend him Rs. 10 lakh for a business he wishes to start. You need the money for buying a house in a year's time, and your friend agrees that he will return the money at the time you require it, out of the profits he generates from the business. A year goes by. You have negotiated the price of the house you want to buy, and ask your dear friend to repay the Rs. 10 lakh he took from you. You remind him of his assurance that he would repay you out of the profits from his business. Listed below are a few possible scenarios.

  • Your friend repays the loan in full and thanks you profusely for your timely help.
  • Your friend regrets that the business did not generate the expected profit, and he will be able to repay only Rs. 5 lakh immediately. He assures you that he would repay the remaining amount within another year if the business improves as expected.
  • Your friend gives you the story of how the project did not take off, and therefore he would be unable to repay even a small part of the total amount borrowed.

In the first case, you are happy that you could help your friend in need and do not envisage the other two possible outcomes. However, what if any of the latter two events happened? You would have lost your savings as well as the dream house. You regret having trusted your friend and his judgment about the prospects of his business. You regret not having had asked for more information about the project and its likelihood of success. You regret not having called your friend periodically to find out how the business venture was progressing.

In short, you could probably have avoided the unpleasant situation of your friend having to renege on his promise to you if you had had more information on the project, its risks and prospects; written a formal contract, enforceable in a court of law; instituted safeguards by way of terms and conditions and monitored the project cash flows periodically.

Let us consider another scenario. You have now invested your hard-earned savings of Rs. 10 lakh in a bank. Your dear friend approaches the same bank and requests a loan of Rs. 10 lakh for his business venture. What does the bank do? It calls for ‘information’—about your friend, his antecedents, his previous track record in business and honouring commitments, the nature and scope of his new venture, the nature of the industry, the market, the technology, proposed suppliers and buyers and how much he is willing to invest in the business if the bank were to grant him his request. The bank compares the information he gives with that available with it in respect of similar business ventures, and determines the probability of success. The bank lends your friend the money if it is satisfied that the Rs. 10 lakh will be repaid on the contracted date. At the end of 1 year, with your dream house almost finalized, you go to the bank and ask for your money back. The bank repays you without demur and with interest for the period for which your money had been lent to the bank. At the end of the same year, your friend would have repaid the bank in full; or repaid only a part of the amount borrowed since the business did not yield the expected returns or repaid nothing, since the project had not taken off as expected. However, unlike in the first scenario, where you were likely to be put to partial or total loss, you have not been affected by your friend's business success or failure.

Why is this so? The bank, as the financial intermediary, has assumed the risks you would have faced had you lent to your friend directly. Not only that, the risks in lending to your friend has not deterred the bank from assuring you of liquidity for your deposits—you could get back your Rs. 10 lakh when you demanded it back, irrespective of whether your friend had repaid the bank at that time.

Banks’ Role as Financial Intermediaries

Banks have a crucial role to play in the financial system of any country. The prime objective of the financial system is to channel surpluses arising in the economy through the activities of households, corporate houses and the government, into deficit units in the economy, again in the form of households, corporate houses and the government.

The financial system comprises ‘financial markets’ and ‘financial intermediaries’.

The financial markets function as ‘brokers’ that bring the surplus and deficit units together for mutual benefit. However, the risk of lending to deficit units is borne largely by the surplus units themselves.1

The financial intermediaries, on the other hand, create ‘assets’ out of the surpluses of the economy. In doing so, they assume the risk of lending to the deficit sectors. Not only that, they assure liquidity to the surplus units who have entrusted their savings to them. Last but not least, they reduce risk with low information costs. To illustrate this aspect, let us go back to scenario two in the above example of lending to a friend. If you had to gather all the information before deciding to lend to your friend, it would have been a costly exercise. But banks can gather the information at much lower costs because (1) they have the expertise; (2) they have the experience to back their decision of lending to a similar or the same industry; (3) they have ready access to current information on the borrowers’ cash flows through observing transactions in the accounts; (4) various deposit resources are pooled to form large loans, making which are relatively cheaper for banks; (5) borrowers value their ongoing relationship with the banks and hence part with information more readily and on a regular basis and (6) diversification of deposits over many independent assets is possible for banks.

Hence, financial intermediaries serve three useful purposes.

  • They mitigate the default risk of deficit units when surplus units lend to them.
  • They ensure liquidity of savings by surplus units.
  • They lower information costs.

Figure 5.1 illustrates the flow of funds through the financial system.

 

FIGURE 5.1 FLOW OF FUNDS THROUGH THE FINANCIAL SYSTEM.

Gains from Lending

Let us assume that your friend's project, if a success, could generate Rs. 1 crore of annual net profit. Your deposit with the bank earns an interest of Rs. 1 lakh at 10 per cent interest per annum. What has the bank done? Your investment, currently earning Rs. 1 lakh, has been converted into an asset that has the potential of earning Rs. 1 crore per year! Thus, there is a net addition to the total income of the economy by Rs. 90 lakh per annum. The bank has also saved you substantial transaction costs—information, contracting, monitoring—if you had invested directly in the project as in scenario above, thus maximizing the net income addition to the economy. However, net addition to national income can be maximized only if bank lending is ‘efficient’—lending should be at competitive prices, at minimum transaction costs, and the financial system should be ‘integrated’2A financial system is said to be integrated if similar loans can be made on similar terms everywhere in the economy.

Apart from adding to the entire economy's income, lending also adds profits to individual banks. A bank can lend profitably only if it is able to take on and manage credit risk that arises from the quality of the borrower and his business. The bank also has to contend with the impact of fluctuations in interest and exchange rates on profits, as well as the liquidity risk posed by mismatch in the maturities of its liabilities and assets.3

Who Needs Credit?

Banks extend credit to different categories of borrowers for different purposes. For most of these borrowers, bank credit is the primary and cheapest source of debt financing. Both the demand and supply sides of the economy need bank credit. Consumers of goods and services constitute the demand side of the economy, and they require bank credit to enable them acquire assets such as consumer durables, housing or for plain consumption. On the supply side, the need for credit arises from the corporate and government sectors engaged in manufacturing, trading and services. These sectors require bank credit for capital investment in long-term projects and for day-to-day operations.

In more common terms, financing the demand side of the economy, the large class of consumers, is called retail banking (also termed mass banking). Financing the supply side of the economy, which is more customized in nature and calls for specialized skills, is called wholesale banking or corporate banking or class banking.

In this chapter, we will look primarily at wholesale banking or corporate banking concepts, features and practices, since these are one of the most specialized in any banking organization.

Features of Bank Credit

For a bank, good loans are its most profitable assets. And any loan is ‘good’ till the borrower defaults in repayment. In its role as a financial intermediary, the direct assumption of financial risk is the bank's defining characteristic.

Consequently, banks have to look for higher returns. Returns come in the direct form of loan interest, or in the indirect form of fee-based ancillary services. Further, the borrowers may also contribute to generation of deposits, which, in turn, can be invested by the bank. The most prominent risk in lending is default risk (known as credit risk), which can arise due to several factors. Borrowers may default due to industry downturns and business cycles (such as in real estate) or due to specific problems related to the borrowers’ firms or activities, such as mismanagement, problems with labour, technological obsolescence and change in consumer preferences. Banks, therefore, make it a practice to set aside substantial reserves (called ‘provisions’) to compensate for anticipated losses due to credit risk.4

There can be another kind of risk associated with credit decisions-interest rate risk.5 Fluctuations in interest rates give rise to earnings volatility. Loan maturities, pricing and the methods of principal repayments all impact the timing and magnitude of banks’ cash inflows.

Keeping these prominent risks in view, risk-based capital standards require that banks maintain a stipulated amount of capital for every loan created in their books.6 This implies that banks choosing to lend to a specific borrower, group or sector must mobilize additional capital to keep growing. Banks have sought to circumvent these requirements by resorting to ‘securitization’7 or ‘off-balance sheet lending arrangements’. Under ‘off-balance sheet lending’, the bank does not directly extend credit but involves itself with the borrower either as an underwriter for arranging financing (as in ‘Loan syndications’8), or by issuing a letter of credit to import inventory rather than finance acquisition of inventory. In both cases, the bank earns a ‘fee-based income’ for its services, but creates a ‘contingent liability’ in its books.9 A contingent liability is, however, not free of risks. If the borrower defaults, the bank becomes liable, i.e., the bank's obligation to make payment under the contract arises from the happening of a contingent event.

Types of Lending

Broadly, three types of lending can be identified:

  • Fund-based lending: This is the most direct form of lending. It is granted as a loan or advance with an actual outflow of cash to the borrower by the bank. In most cases, such lending is supported by prime and/or collateral securities.10
  • Non-fund-based lending: There are no funds outlays for the bank at the time of entering into an agreement with a counterparty on behalf of the bank's customer. However, such arrangements may crystallize into fund-based advances for the bank if the customer fails to fulfil the terms of his contract with the counterparty. Most ‘contingent liabilities’ of the bank, more prominently, letters of credit (LCs) and bank guarantees (BGs), fall under this category.
  • Asset-based lending: This is an emerging category of bank lending. In this type of lending, the bank looks primarily or solely to the earning capacity of the asset being financed, for servicing its debt. In most cases, the bank will have limited or no recourse to the borrower. Specialized lending practices, such as securitization or project finance fall under this category.

Fund-based advances can be further classified based on the tenure of the loans.11 The traditional approach is to make the following distinction: short-term loans, long-term loans and revolving credits. We will examine the basic features of these loans in the following paragraphs.

Short-Term Loans Typically, these are loans with maturities of 1 year or less. Most of these loans are granted with the primary purpose of financing working capital needs of the borrower, resulting from temporary build up of inventories and receivables. In the case of such loans, repayments would flow out of conversion of current assets to cash.

Sometimes, seasonal lines of credit are granted to borrowers whose businesses are subjected to seasonal sales cycles, and hence, periodic peaking of inventory and other current assets. The amount of credit is made available based on the estimated peak and non-peak funding requirements of the borrowers. The borrowers draw upon the seasonal lines of credit during periods of peak production to meet seasonal demand, and repay the loans as inventories are liquidated and cash flows from sales come in. Interest accrues only on the amounts drawn down from the line of credit.

Both the above types of loans are generally made as ‘secured loans’. This implies that the banks make the loans based on the strength of underlying securities, such as inventories, receivables and other current assets. Such securities, the values of which directly affect the amount that can be granted as loan, are called ‘prime securities’. The other type of securities backing the loan repayments is ‘collateral securities’. Such securities are not directly linked to the operations of the borrower, but are offered either in lieu of or along with prime securities, as a cushion against probable default by the borrower. The idea is that banks can liquidate these securities in the event of default and realize the amount due under the loan agreement.

A third category of short-term loans, granted for ‘special purposes’, may or may not be secured. Such loans are called ‘unsecured loans’. They may arise due to a host of reasons, including temporary but unexpected or unusual increases in current assets, or a temporary cash crunch in the borrower's firm. Such requests are considered as falling outside the borrower's estimated needs for short-term working capital financing, and, depending on the borrower's creditworthiness, may be granted as ‘temporary’ or ‘ad hoc’ loans. These loans are often granted with terms and conditions different from those applicable to the assessed working capital needs of the borrower. Such loans may require full payment of interest and principal at maturity, i.e., a ‘bullet’. The term for such loans is determined by estimating the time at which the borrower can generate cash flows to make the repayment. The risk in these loans arises from a change in the assumed circumstances on which the decision to grant the loans were based.

Long-Term Loans Bank lending, which used to traditionally focus on ‘short-term’ loans, started looking at lending for periods longer than a year only from the 1930s onwards. These are called ‘term loans’ and have the following characteristics:

  • Original maturities of more than 1 year.
  • Repayments are structured based on future cash flows rather than on liquidation of short-term assets.
  • The primary purpose of these loans could be acquisition of fixed assets (versus current assets in the case of short-term loans), or funding expansion/modernization/diversification plans of the borrower's firm.
  • The term loans may be used as substitutes for equity or for financing permanent working capital needs.
  • Typically, these loans are fully disbursed at inception, and principal and interest are repaid depending on the borrower's capacity to generate operating cash flows.
  • The amount and structure of these loans will closely match the transaction being financed.
  • Mostly, the securities for the term loans will be the bank's claims on assets purchased from the term loan proceeds.
  • Though banks do not customarily lend for very long periods,12 the maximum tenure (maturity) of term loans is 10 years, the average ranging between 3 and 5 years.

Thus, long-term loans are generally structured to be more adaptable to borrowers’ specific requirements.

Revolving Credits Revolving credits offer the most flexibility to borrowers. Assessed to meet the borrowers’ requirements over a period of 1 year or more, revolving credits permit drawings from the line of credit at any time, and similarly, repay the whole or part of the outstanding loans as and when cash inflows happen in the borrowers’ firms. The revolving credit is usually a secured loan, with terms and conditions as applicable to other types of loans. The amount of revolving facility granted will be based on the assessed need of borrowers, underlying securities and borrowers’ creditworthiness.

In rare cases, revolving loans are structured to convert to term loans or automatically renew on maturity. The automatic renewal facility, termed the ‘evergreen’ facility, continues till the borrower gives notice of termination. Such arrangements, needless to say, will put the banks more at risk of default than the other two types of lending.

SECTION II
THE CREDIT PROCESS

The risks involved in lending render it imperative that banks should have systems and controls that enable bank managers to take credit decisions after objectively evaluating risk-return trade offs. Whether it is consumer or commercial lending, credit decisions impact the profitability of banks, and ultimately their competitiveness and survival in the industry.

Credit decisions are by no means easy. The credit officer has to deal with conflicting objectives of increasing the loan portfolio (his targets) while maintaining loan quality (the risks inherent in the loan portfolio as well as in individual loans). He also has to balance these objectives with the bank's profitability and market value objectives, liquidity requirements and constraints of capital. He should be able to investigate and appraise the risks inherent in every opportunity to lend, and take decisions that will fit in with the overall strategy of the bank. Above all, he should not take or lead the bank to a wrong credit decision.

Despite the availability of tools and techniques and a huge body of knowledge to support decision-making, credit decisions are largely judgmental. However well versed the credit officer is in appraising and lending to risky projects, his contribution may not suit the bank if his decisions do not fall in line with the overall strategy of the bank. Therefore, apart from their expertise in credit appraisal, the strategic role of credit officers assumes utmost importance.

Constituents of the Credit Process13

The Loan Policy To ensure alignment of individual goals of credit officers to the bank's overall goals, banks formulate ‘loan policies’. These are written documents, authorized by individual bank's Board of Directors, that formalize and set guidelines for lending to be followed by decision-makers in the bank.

The loan policy specifies the bank's overall strategy for lending, identifies loan qualities and parameters, and lays down procedures for appraising, sanctioning, granting, documenting and reviewing loans. Loan policies emerge from and are fine-tuned by past experience of individual banks in extending credit, and the best practices followed in the industry. While supervising bank operations, regulators examine banks’ documented loan policies to ensure that existing lending practices conform to the organization's objectives and acceptable guidelines. The stance taken by individual bank managements determines the extent and form of risk that the bank would be willing to take.

Box 5.1 outlines the major components of a typical loan policy.

BOX 5.1 MAJOR COMPONENTS OF A TYPICAL LOAN POLICY DOCUMENT

Loan objectives

Within the regulatory prescriptions, the loan objectives will communicate to credit officers and other decision-makers, the bank's priorities among the conflicting objectives of liquidity, profitability, increasing business volumes, and risk and asset quality.

Volume and mix of loans

How much of the loan portfolio is to be channelled into specific industries, sectors or geographical areas, will be communicated in this section. It may also specify composition of the loan portfolio by size of loans, pricing of loans or securities. In many countries, especially developing economies, regulators stipulate targets for directed lending to certain critical sectors.

Loan evaluation procedures

Generally, uniform credit appraisal procedures are prescribed throughout the bank. The procedures would deal with all issues ranging from establishing suitability of the loan to the bank's overall strategy and risk taking ability, to selection of borrowers, market and project risk appraisal criteria, financial statement analysis, structuring of loan agreements, documentation and post-sanction monitoring.

Credit administration

Lending involves more risks than any other banking activity. Hence, banks are careful to ensure that credit decisions are taken by experienced and knowledgeable officers, with decision-making authority as decided by the top management or the board from time to time. The loan policy should indicate the credit sanctioning powers of the officers at various hierarchical levels of the bank. Due diligence should also ensure that officers do not overstep limits fixed for their levels. Similarly, if limits fixed for decision-making are too low and conservative, the top management may have to spend more time on decision-making. If limits are too high at every level, the bank may expose itself to heightened risks.

Credit files

Credit files are important documented and updated material used for both decision-making and continuous evaluation. Sometimes, the loan policy specifically mentions the mandatory format in which information in the credit files is to be maintained.

Lending rates

The interest charged should reflect the credit risk in a loan. The policy may also state the returns expected for each risk group of borrowers in the bank, and specifies risk limits up to which the bank can lend. It can also specify the credit scoring system to be adopted to fix the lending rates, and circumstances under which fixed and floating rates of interest can be charged to the borrower.

The other parameters that a loan policy may specify are (1) type of collateral the bank can accept as security for the loans; (2) the extent to which the security should cover the advances made; (3) nature of margins/compensating balances 14 to be maintained by various classes of borrowers; (4) limits up to which the bank can expose itself to certain sectors and borrower groups; (5) credit monitoring system that would be operative after the loan is disbursed; (6) credit to deposit ratios that the bank needs to maintain; (7) incentive schemes for loan officers; (8) loan agreement and other communication practices; (9) procedure for rescheduling/restructuring loans; (10) role of credit department in the bank; (11) role of recovery department in the bank and (12) role of legal department in the bank.

The loan policy establishes the ‘credit culture’ that is unique to each bank. Adherence to the guidelines of the loan policy is reviewed by credit monitoring committees, and the need for periodic revision is also suggested, in keeping with the dynamic environment.

Business Development and Initial Recommendations Within the broad framework of the loan policy of the bank, and based on the bank's goals in building its loan asset portfolio, credit officers seek to reinforce the relationship with existing customers, build new clientele and cross sell non-credit services. Though every employee of the bank, from the front office personnel to the top management, is responsible for overall business development, credit development requires a more focused approach. For one, not every prospective customer can be invited to be a borrower. There are enormous risks attached to making a bad loan than bypassing an opportunity for making a good loan.

Therefore, business development efforts for credit expansion should preferably begin with market research and detailed credit investigation. The outcome of this research will be reflected in the annual business plan of the bank, which would specify the broad industries, or areas where the bank would like to expand, and the extent to which the bank would like exposure to each industry or area.

Based on the plan, the bank embarks upon publicity for its proposed credit products in the case of retail lending, or special campaigns for attracting target customers. In the case of corporate borrowers, the credit officers formulate call programs. Once prospective credit customers are identified, credit officers try to obtain formal loan requests from these customers. The loan requests, once found acceptable in principle, would be processed further based on various documents called for, such as the prospective borrower's financial statements, credit reports, the relevant project report and the legal resolution to borrow.

Sufficient information is sought from the prospective borrower to analyse creditworthiness. Credit appraisal is essentially an analysis of the risks or vulnerabilities in respect of the borrower and his business. The risks are analysed with a view to determining how each of them, individually or in combination, can affect the debt servicing capacity of the borrower. A typical credit appraisal would deal with the following issues.

  • What are the risks inherent in the borrower's business? These risks are classified into market-related risks, technology-related risks, environment-related risks and so on.
  • What are the antecedents of the borrower? What is his reputation and integrity? How is his track record?
  • What are the financial risks inherent in the borrower's business? Is the project economically viable? Is the project financially feasible?
  • What risks are inherent in the operations of the business?
  • What have the managers of the borrower firm done to mitigate these risks?
  • Does the bank want to lend to this borrower in spite of the risks? If so, what steps should the bank take to ensure that debt repayments are not hampered?
  • What risks will the bank have to take if it decides to fund the borrower? How does the bank propose to mitigate these risks?

The first three questions focus on appraisal of the borrower, his firm, the project for which he has sought funds and his capacity to repay. The next two questions enable the credit analyst to examine the internal management and operations of the firm. The analysis leads to a decision–to lend or not to lend? Once the analyst decides to recommend lending, the safeguards in and structure of the loan agreement has to be put in place.

Traditionally, key risk factors were analysed using pragmatic considerations, such as creditworthiness of the borrower, security offered, prospects of the firm and longevity of the relationship. These were considered the ‘canons of lending’, and were addressed as the ‘five Cs’, (capacity, capital, collateral, conditions, character) or remembered through mnemonics such as ‘CCC'15 (capital, character, capability) or ‘PARTS’16 (purpose, amount, repayment, terms, security), or ‘CAMPARI’17 (character, ability, means, purpose, amount, repayment, insurance).

In all these models, the inherent assumption was that the borrower's past would be indicative of the future, an assumption that may not hold well in a highly dynamic or volatile environment.

Modern credit analysis uses the traditional concepts in making subjective evaluation, along with wide use of financial ratios and risk evaluation models to determine if a borrower is creditworthy. The accent on risk evaluation implies that the banker lends only if he is satisfied that risks are mitigated to ensure that the borrower's future cash flows (and hence debt service) will not be affected.

Broad Steps to Credit Analysis

Step 1—Building the ‘credit file’: The first step to effective credit analysis is gathering information to build the ‘credit file’. The preliminary information so obtained would throw light on the borrower's antecedents, his credit history and track record. If the project is a Greenfield project, the credit officer will have to do a thorough research into various aspects of the project, as well as into the borrower's financial and managerial capacity to make the project a success. If the borrower is an existing one, seeking additional credit, the information would be readily available with the credit officer. The credit file is an important tool box for the credit officer. It should contain all pertinent information on the borrower, including call report summaries, past and present financial statements, cash flow projections and plans for the future, relevant credit reports, details of insurance coverage, fixed and other assets, collateral values and security documents. The file for an existing borrower should also contain copies of past loan agreements, comments by prior loan officers and all correspondence with the customer. In the case of long standing borrowers, such credit files may run into several volumes. It is advisable for the credit officer to peruse all the volumes of the credit file before embarking on credit analysis.

Why is this step so important? One of the most vital factors in lending is assessing the borrower's willingness and desire to repay the loan. The most sophisticated credit analysis cannot measure and, therefore, cannot establish beyond doubt the borrower's intention to repay. The extensive information in the credit file will enable the credit officer to examine the borrower's track record in repayment, and help in forming an opinion about the borrower's future repayment intention and potential.

Step 2—Project and financial appraisal: Once the preliminary investigation is done, the internal and external factors, such as management integrity and capability, the company's performance and market value and the industry characteristics are evaluated.

One of the important activities at this stage is financial analysis. An illustrative list of inputs and activities is as follows:

  • Past financial statements. While the borrower's audited financial statements are typically the starting point/ many banks additionally ask for financial statements presented in the bank's own format. Typically, past financial statements pertain to the last 2–3 years, along with estimates for the current year.
  • Cash flow statements. This statement would reveal the usage of own and borrowed funds by the borrower.
  • The above data from the borrower enables the credit officer to analyse the liquidity position of the borrower/ his firm. Adequate liquidity is a vital indicator of the borrower's financial health to the bank, as loss of liquidity through delayed cash flows or diversion of short-term funds or leakage in cash, is bound to adversely affect the borrower's repayment capacity. Liquidity is assessed through a set of financial ratios. Most banks recast the financial statements of the borrower to reveal the true picture—for example, banks remove ageing receivables or slow moving/obsolete inventory from current assets. Hence, more detailed information is sought from the borrower before the financial statements are analysed.
  • The financial risk of an entity is measured by the debt it has incurred in the course of business compared with the owner's stake. Banks generally stipulate maximum debt to value ratios for various categories of borrowers, beyond which the borrowers will have to increase their stake in the business to avail more bank credit. Credit officers look more to the ‘tangible net worth’ on the borrower's books as the measure of owner's stake in the business. ‘Tangible net worth’ represents the net worth less intangible assets, such as losses or goodwill.
  • Once the borrower's current financial health is gauged, the projections are examined. The borrower's debt servicing capacity is determined by assessing the quality of cash flow projections given by the borrower. The experienced credit analyst questions the borrower's projections, especially the sales projections, till he satisfies himself that they are indeed realistic, achievable, and more importantly, the cash flows are Sufficient to service the debt (principal + interest). Further, sensitivity analyses are carried out on the projections to test the strength of the underlying assumptions and assess the impact on debt service capacity under various stress conditions. While every scenario cannot be adequately tested, the worst case scenario will indicate the most pessimistic outcome for the bank and it is then for the bank to decide whether it wants to undertake the risk.
  • Even the most scientifically done projections cannot predict the onslaught of future uncertainties. Hence, the lender looks for a secondary source of repayment, which is provided by the collateral securities. The credit officer evaluates the strength of the collateral securities to determine the amount that can be recovered by liquidating these securities in the worst possible scenario. It is to be noted that loans should not be made based on the strength of the collateral securities alone. The securities should be treated as the second line of defence and not the raison-d’ etre of the loan itself.

Step 3—Qualitative analysis: Integrity is the most important quality that the banker looks for in a borrower, and the most difficult to measure. So is assessment of the quality of the management team. However, lenders will have to make qualitative assessment of the borrower on most of the criteria mentioned in Annexure I, by evolving suitable measures. Many poor credit decisions have been the result of not knowing enough about the customer.

Step 4—Due diligence: Bypassing due diligence can be very costly for a bank. Many loans have run into problems since bankers did not take this step seriously. This is a time-consuming activity but well worth the effort. Due diligence can include checking on the borrower's address (if a new borrower), pre-approval inspections of the borrower's workplace, and interviews with the borrower's competitors, suppliers, customers and employees. A comprehensive due diligence can also include reviews of technology used by the borrower, planned capital expenditures, other obligations to outsiders, credit reports from other debtors, the internal management control and information system, industrial relations, employee compensation and benefits, and environmental audit. Disclosure of contingent liabilities by the borrower is an essential part of due diligence, since any such contingent claim on the borrower would directly impact the assessed debt service capacity.

Step 5—Risk assessment: A key function of the credit officer is to identify and analyse the key risks associated with the proposed credit. All potential internal and external risks are to be identified and their severity assessed in terms of how these risks would impact the borrower's future cash flows and hence the debt service capacity. The risk assessment would form an important input for structuring the credit facility and the terms of the loan agreement.

A sample risk classification grid has been presented in Annexure I. Why do we need risk classification criteria? They are necessary to assist lending officers in assessing the degree of default risk in a proposed loan. They also set standards for arriving at loan pricing decisions and terms of the loan agreement commensurate with the risk of loss. Once constructed, the classification can be used for comparisons over time periods for the same borrower, or can be standardized for comparisons of different loans. It is, however, important to note that the most sophisticated risk classification criteria cannot substitute the experienced judgment of the credit officer. The risk classification criteria are to be used to determine the relevance and impact of identified factors and construct a framework to examine their applicability to specific loans.

Step 6—Making the recommendation: Finally, based on a thorough analysis of the project, the borrower and the market, and after examining the ‘fit’ of the credit with the ‘loan policy’, the credit officer makes his recommendations to consider the loan favourably or reject it outright. Sometimes, in the case of clients with a long history of relationship with the bank, even if the criteria for consideration of the current proposal fall short of expectations, the credit officer can suggest procedures to improve the borrower's financial condition and the repayment prospects. If warranted, the credit officer can also call for a revised credit proposal from the borrower. After a preliminary negotiation with the borrower, the credit officer's recommendations would specify the credit terms, including loan amount, maturity, pricing, repayment schedule, description of prime and collateral securities and the required terms and conditions for the borrower's compliance.

Credit Delivery and Administration Who takes the decision to lend? Depending on the size of the bank, the loan size and type of exposures planned, the final decision to lend may be taken by an authorized layer of the bank. Typically, banks fix ‘discretionary limits'—monetary ceilings up to which personnel at each level can take credit decisions—for each layer of authority starting from credit officers themselves to branch heads to senior and top management at the corporate office, including the Board of Directors. These ‘discretionary limits’ become larger as they move up the organizational hierarchy. For example, in some banks, the credit officer may have the least discretionary limit. Any request for a loan amount over and above this limit will have to be referred to the next higher layer, say the branch head, for his decision. Where the loan amount exceeds the branch head's or territorial head's discretion, the request is referred to the corporate office, where decision-makers can be individual senior or top management officials or a committee of such officials. Many times, large credit exposures are referred to a top management committee for a joint decision to be later ratified by the Board. Some critical exposures are referred to the Board for a decision.

For all decision-makers above the level of loan officers, the loan officer's appraisal forms the very basis of decision-making. Hence, the loan officer's role in the credit decision-making process is extremely critical. Many banks create a separate channel in the hierarchy for grooming and equipping credit officers with the essential attitude and skills for the lending function.

The hierarchical levels over and above the credit officer merely review the recommendations made by the credit officer, and add their insights and comments before making the decision. It is not necessary that a favourable recommendation from a credit officer after extensive research has to be approved by the ultimate decision-maker. Accountability demands at every level of the bank require that the decision-making authority forms an independent opinion of the borrower's creditworthiness and takes decisions accordingly in the best interests of the bank.

Some very large banks have a centralized ‘underwriting department’. This corporate service essentially sources new business for the bank and manages select existing relationships. For these select customers, this centralized department processes the credit request and conveys approval ‘in principle’, in order to cut the process and time required for a sanction through the regular process. Many large banks use customized software to evaluate credit requests. However, as already emphasized, sophisticated tools can be used as aids, and not as substitutes, for the credit officer's or the credit sanctioning authority's judgment.

Once a loan is approved, the officer communicates the sanction to the borrower through a formal ‘sanction letter’. The sanction letter is generally in the form of a ‘loan agreement’, to be signed by the borrower(s) and guarantors, if any. The loan agreement contains the following essential features.

  • Nature/type of credit facility.
  • Interest/discount/charges as applicable.
  • Repayment terms.
  • Stipulations regarding end use of each facility.
  • Additional fees applicable such as processing fees, closing fees or commitment fees.
  • Prime security for each credit facility.
  • Full description of the collateral securities.
  • Details of personal/third party guarantees.
  • Covenants—terms and conditions under which the loan facilities are being granted.
  • Events of default and penal provisions.

Loan Documentation Different types of borrowers and different types of security interests necessitate loan documentation procedures that would be valid in a court of law. Accordingly, once the loan agreement is signed, the borrowers and guarantors execute the loan documents. The security interest is said to be ‘perfected’ when the bank's claim on the borrower's assets forming the security is senior to that of any other creditor.

If the borrower defaults on a secured loan, the bank has the right to take possession of the assets and liquidate them to recover its dues. Proper loan documentation secures this right.

Terms and Conditions of Lending These are very important ingredients of any loan agreement. The bank derives control over the borrower's operations and also mitigates the risks of lending through this part of the loan agreement. The terms and conditions comprise of three distinct portions:

  • Conditions precedent : These are requirements that a borrower should satisfy before the bank acquires the legal obligation to disburse the loan amount. Some illustrative and commonly used conditions precedent are auditor's certificate for having brought in the committed capital amount, relevant legal opinions sought for and board resolution to borrow. An important condition precedent is a material adverse change clause that covers the financial statements and projections. The clause protects the bank in the event of a material change occurring after the loan is sanctioned but prior to disbursement, which may jeopardize the bank's chances of recovery of its dues from the borrower.
  • Representations and warranties: The assumptions based on which credit appraisal is done and the bank has agreed to lend money, emanate from the information the borrower himself provides to the bank. In executing the loan agreement, the borrower is assumed to confirm the truth and accuracy of the information provided to the bank. Any misrepresentation constitutes an event of default and renders the agreement invalid. The principal representations and warranties include the following.
    • All information provided, including financial statements, is true and correct.
    • The borrower is authorized by law to carry on the business.
    • The signatories to the loan agreement are authorized to do so, and their commitment is legal and binding.
    • All statutory obligations, such as payments of taxes, have been met.
    • There are no major legal proceedings pending or threatened against the borrower.
    • There are no factual omissions or misstatements in the information provided.
    • Collateral and prime securities are unencumbered.

    The third and most negotiated part of the loan agreement is the ‘covenants’ of the borrower.

    These are the operative part of the terms and conditions, and set standards and codes of conduct for the borrower's future business, as long as the borrower is indebted to the bank. The covenants are used by astute credit officers to mitigate the risks of the borrower's business, in order that credit risk is mitigated for the bank. Covenants are sacred, and any violation will be treated as an ‘event of default’. They normally take two distinct forms—'affirmative’ and ‘negative’.

  • Affirmative covenants are those actions the borrower should take to legally and ethically carry on the business. Illustrations of affirmative covenants include the following.
    • Ensuring that the funds are applied for the purpose for which they were intended.
    • The indicators ensuring financial health, such as a strong current ratio, a safe debt to equity ratio, appreciable sales growth and a healthy return on equity (ROE).
    • Ensuring that proper records and controls are maintained within the firm.
    • Ensuring compliance with the law, and reporting requirements required under statute.
    • Ensuring compliance with information requirements by the bank, and periodic reporting of financial and operating performance.
    • Ensuring that the prime and collateral securities are adequately insured.
    • Ensuring that property, fixed assets and other assets belonging to the borrower's firm are properly maintained.
    • The bank will retain its right of inspecting the assets offered as security at any time, without prior notice.
  • Negative covenants place clear and significant restrictions on the borrower's activities. Such covenants are intended to pre-empt managerial decisions that may adversely impact cash flows and hence jeopardize the borrower's debt service capacity. Borrowers would generally be more inclined to negotiate negative covenants, since they may be perceived as restricting operational autonomy. Some typical negative covenants are as follows.
    • Limiting further capital expenditure.
    • Limiting investment of funds.
    • Restricting additional outside liabilities.
    • Restricting investment in subsidiaries, other businesses.
    • Restricting sale of assets, subsidiaries.
    • Restricting dividend payouts.
    • Restricting prepayment of other debts.
    • Limits on debt in the capital structure.
    • Restrictions on mergers or share repurchase.
    • Restriction on starting or carrying on other business.
    • Restriction on encumbering assets (negative lien).

The last restriction, negative lien,18 is a covenant that is widely used by banks to prevent the borrower from creating encumbrances on assets, so as to benefit other creditors.

The bank may employ these restrictions and limitations selectively, to ensure that the risks in the borrower's business are mitigated. The ultimate objective of these restrictions is to ensure that the borrower's financial health is not impaired, and the bank's dues are paid on time.

Events of Default Such events, when they happen, may trigger the end of the banker–borrower relationship. An illustrative list of situations that may lead to an event of default include the following.

  • Failure to repay principal when due.
  • Failure to service interest payments on due dates.
  • Failure to honour a covenant.
  • Misrepresentation of facts.
  • Reneging on declarations made under representations and warranties.
  • Diversion of funds without bank's knowledge to other creditors or other accounts of the borrower.
  • Change in management or ownership structure.
  • Bankruptcy or liquidation proceedings.
  • Falsification or tampering with records.
  • Impairment of collateral, or entering into invalid agreements.
  • Material adverse changes that drastically change the assumptions under which the loan agreement was entered into.
  • All other force majeure events that imperil debt service.

The happening of which event of default may signify the end of the banker–borrower relationship is left for the banker to decide on the merits of each case. Under certain circumstances, where the risks of such events are considered less significant, the loan agreement can provide the borrower a grace period within which to rectify the breach of a covenant. In case the borrower is unable to rectify the breach within the grace period, the bank can downgrade or recall the advances made; agree for the take over of the borrowing account by another bank; or, if the borrower is not in a position to repay the bank's dues, enforce the securities and liquidate the outstanding advance.

In case of the third scenario given above, the bank will initially set off any unencumbered deposits of the borrower19 or cash margins20 against the advances outstanding. It will then sell off the securities to realize its dues or invoke the outside guarantees till the advance is completely liquidated.

Since the banker–borrower relationship is generally considered valuable by both parties, banks do not act in haste in the event of default.

Updating the Credit File and Periodic Follow-Up The credit file has to be continuously updated throughout the above process. Further, once the loan is disbursed, the following activities have to be carried out either by the credit officer himself or a team designated for the purpose.

  • Process loan payments and send reminders in case loan payments are received late. The simple practice of reminding the borrower for every payment not received on due date, would ensure that defaults are noticed on time by the bank and timely action taken in case defaults persist, ultimately preventing a credit risk to the bank.
  • The borrower will have to submit updates of financial performance periodically or as per the accounting practices in force. The bank can call for financial data at any point of time if it feels that the borrower's financial health deserves mid-course scrutiny.
  • The bank can call on the borrower at any time, even without prior intimation. When the bank's representative visits the borrower, the primary objective will be to ensure that the borrower's activities are in accordance with the bank's expectations.

Credit Review and Monitoring This is the most important step in credit management, and one that lends value to bank financing. Banks that have succeeded in credit management, and hence reduction of credit risk, are those that have separated credit review and monitoring from credit analysis, execution and administration.

The credit review and monitoring process is typically bifurcated into the distinct functions of monitoring the performance of existing loans and problem accounts.

Monitoring performance of existing loans is done in two ways. One is a continuous monitoring of the transactions in the accounts of the borrower. This is best done at the office from which the credit has been disbursed. The credit officers at the disbursing office have to be alert to symptoms exhibited by day-to-day operations in the borrower's loan account, and send warning signals to the borrower if they detect signs of incipient deterioration of financial health or misdemeanour.21 The second type of monitoring will be done through external or internal audit teams, and will be periodic or continuous, depending on the size of credit exposures or the importance of the credit disbursing office in the bank. The deficiencies in loan documentation or conduct uncovered by the audit team will have to be rectified by the credit team. The deficiency could be rectified simply by getting signatures on loan documents or filing the required statutory returns for perfecting the security. If the audit team points out violation of any loan covenant, then the credit team can persuade the borrower to fall in line.

However, what causes most concern would be deterioration in the financial condition of the borrower, which is manifested as the inability of the borrower to meet debt service requirements. Such accounts would be put on a ‘watch list’ and monitored closely, so that they do not turn ‘non-performing’.22 Sometimes, banks will have to modify the repayment terms in order to increase the probability of repayment. Such modified terms include restructuring interest and principal payments to suit the current cash flows of the borrower, or lengthening maturity of the loans. In such cases, the bank may also seek additional securities or additional capital from the borrower to compensate for the increased credit risk. It would be prudent to separate the loans under restructuring from the general credit stream, so that monitoring would be made more intense. Similarly, a separate set of specialists would man the credit monitoring or restructuring function.

In some cases, the borrower's financial condition deteriorates to such an extent that the loan will have to be ‘recalled’. In such cases, liquidation of assets or take over by another bank willing to take on the risk will be considered. It is more likely that the former action will have to be instituted. If all other avenues of restructuring and forbearance fail, the bank would resort to legal action. Once legal action is under way, the borrower loses the option to restructure the loans or be rehabilitated back to financial health. At this stage, many borrowers opt for ‘out of court settlement’, thus avoiding long and protracted legal hassles.

SECTION III
FINANCIAL APPRAISAL FOR CREDIT DECISIONS

Though several qualitative factors play a role in a credit decision, a major influencing factor is the financial health of the borrower as brought out by the financial appraisal. We have seen in the previous section that the credit officer uses techniques, such as financial ratio analysis, cash flow analysis and sensitivity analysis to assess the achievability of the projections. How these techniques are employed in appraising various categories of loans will be dealt with in this section.

Financial Ratio Analysis

Most large banks begin financial analysis with a standardized spreadsheet or format, where the balance sheet and income statement data, past and future, are rearranged in a consistent format to facilitate comparison over time and benchmark with industry standards. The rearrangement, and sometimes reclassification, is necessary not only for consistency but also for throwing up potential risks to the borrower's financial health.

Most credit analysts use five broad categories of ratios—liquidity, profitability, leverage, operating and valuation. Liquidity ratios indicate the borrower's ability to meet short-term obligations, continue operations and remain solvent. profitability ratios indicate the earning potential and its impact on shareholders’ returns. Leverage ratios indicate the financial risk in the firm as evidenced by its capital structure and the consequent impact on earnings volatility. Operating ratios demonstrate how efficiently the assets are being utilized to generate revenue. Finally, valuation ratios extend beyond historical accounting measures to depict a realistic ‘value’ of the borrower. An illustrative list of commonly used financial ratios is presented in Annexure II.

Common Size Ratio Comparisons

Many banks may additionally use common size ratio comparisons. Such comparisons are valuable since they are independent of firm size, thus facilitating inter-firm comparisons in the same industry or line of business. However, the analysis should be able to spot the outliers, such as firms whose financial structure is vastly different from the typical firm in the industry. For example, a firm with leased assets would show a different asset ratio in an industry in which firms typically own substantial fixed assets. Hence, common size analysis is generally used along with ratio analysis as described above, to lead to better insights about the borrowing firm's financial strength.

Cash Flow Analysis

While the income statement of the borrower provides vital information, it also contains accounting adjustments and non-cash expenses. To get a clearer picture of the borrower's capacity to repay, the bank will have to convert the income statement into a cash flow statement, or call for a cash flow statement from the borrower.

Typically, the statement of cash flows is divided into four parts—cash from operating activities, cash from investing activities, cash from financing activities and cash. The intent is to distinguish between accounting profits as measured by net income in the income statement and the firm's various activities that affect cash flows, but are not reported in the income statement. Annexure III provides a methodology to reconcile the income statement to its cash equivalent. The vital analysis here is to determine how much cash is generated from the firm's activities, and whether it is Sufficient to cover loan repayments and interest payments. It is expected that a firm with prudent financial management would repay short-term loans from liquidating inventories and receivables, and long-term loans from surpluses after meeting financing costs, increase in net working capital (NWC) and capital expenditure.

SECTION IV
DIFFERENT TYPES OF LOANS AND THEIR FEATURES

Though classified under the single nomenclature—loan—on the bank's balance sheet, every loan or class of loans is unique. Each loan or type of loan has distinguishing features based on the purpose, the collateral, the repayment period and the borrower profile. We will examine the predominant characteristics of some popular loan types from the points of view of the borrower as well as the credit officer.

Loans for Working Capital

Banks are generally considered primary lenders to working capital requirements of firms, small and large. The rationale for banks having built up considerable expertise in funding short-term working capital is explained by the nature of bank liabilities, which are essentially short-term in nature.

A firm's Net Working Capital (NWC) is measured as the difference between its current assets and current liabilities. If a firm's working capital is positive, it implies that its current assets exceed its current liabilities, i.e., its current assets have been partly financed by ‘spontaneous liabilities’, such as trade creditors, and short-term bank debt and other current debt, and partly by long-term funds, including equity. A positive NWC is construed as a sign of healthy liquidity in the firm, since it is assumed that the liquidation of current assets at any point of time would enable the firm to pay off its current creditors fully.

Every firm begins by investing cash in current assets. Manufacturing firms invest in raw material that would be converted to finished goods to be sold in the market. Retail firms invest in merchandize for display at their showrooms. Service firms need cash for operations and office supplies. Almost all firms encourage credit sales to stimulate growth. Thus, there is a time lag between the investment of cash and the realization of cash from sales. The longer the firm takes to complete the cash-to-cash or ‘working capital’ cycle, the longer the firm has to wait to get back its cash investment. During this time lag, operations have to continue. The firm will have to continue investing in raw material or merchandize or day-to-day expenses. Where will the cash for this investment come from? As noted earlier, cash for operations will have to come from external creditors or internal generation. Working capital management is, therefore, a continuous process.

Each type of business depends on appropriate financing methods to stimulate investment and growth. Some firms depend on trade credit23 to finance the current assets—that is, they defer payment for inputs, in agreement with the supplier, for a specified number of days within which they hope to realize cash from sales. Some firms additionally defer expenses till the cash comes in from sales. However, the majority of firms depend on bank debt to manage the need for working capital. Thus, bank debt is a predominant source of funding working capital for all types of businesses and borrowers.

How much can a bank lend for working capital? The amount of loan will depend on the envisaged ‘working capital gap'(WCG), determined by the borrower's decision to take trade credit offered, or defer payment of certain accrued expenses. In balance sheet terms, this would represent the projected current assets less current liabilities, without bank borrowings being taken into account. The working capital gap represents the borrower's need for cash for uninterrupted operations, after taking into account sources of funds available in the natural course of business also called ‘spontaneous liabilities’. The bank, however, will not finance the entire working capital gap. It will expect that the borrower brings in his stake to fund the gap. This is called the ‘margin’. Bank debt will, therefore, typically amount to the working capital gap less the margin.

Many businesses find that their working capital fluctuates over time. The reasons could be unexpected fluctuations in demand, changes in market dynamics or seasonality. Of these, seasonal sales are the easiest to predict, and firms build up inventories temporarily and incur higher operating expenses in time for the peak sales season. During the off-season, working capital needs increase since the inventory has already been invested in, peak sales have not taken place and cash flow from receivables will happen only when the inventories are liquidated. If seasonal patterns are discernible, the bank assesses working capital needs as ‘peak level’ and ‘non-peak level’. Thus, two sets of working capital assessments would be required.

An important point to be noted here is that most firms have a stable level of working capital in the system, irrespective of seasonal and other fluctuations. In other words, just as fixed assets are at a predictable level, there are always some inventories, accounts receivable and other current assets that form a permanent part of the business. The only difference between the fixed assets and these ‘permanent’ current assets is that the latter changes its composition, as and when inventories are sold off and replaced, accounts receivable are realized and replaced with fresh ones, and so on. This ‘permanent’ working capital need, every year, is approximately equivalent to the minimum level of current assets minus the minimum level of current liabilities, without taking into consideration short-term bank debt and installments of long-term debt repayable in the short term (within the next 12 months). This difference reflects the requirement of long-term debt or equity financing for the ‘permanent’ current assets. It is important for borrowing firms and banks to be able to assess such ‘permanent’ working capital requirements and fund them with long-term investment. The increase over this ‘permanent’ working capital base due to sales growth would be financed through short-term credit from banks.

Working capital loans are structured as loans against the prime securities of inventories and/or book debts or as credit limits against bills raised on buyers of the goods and services of the borrowing firm. The price of the loan (the interest rate charged) depends on the additional securities available as collateral, and the credit score rating24 of the borrower. The repayment of the loan should closely match the working capital cycle, and the covenants should be able to mitigate the risks and vulnerabilities in the borrower's business and financials.

It is extremely important for the bank and the borrower to assess the working capital requirements accurately. A mistake often made by inexperienced credit officers is granting a loan for a larger amount or for a longer maturity than what is required, especially to ‘first class’ customers. In a purpose-oriented loan, such as for working capital, irrespective of the standing of or relationship with the borrower, it is imperative to estimate funding needs accurately in order to help the borrower's business and minimize the bank's risks. Both under- and overestimation have their pitfalls. If the working capital need is overestimated, the borrower may not use the additional money judiciously, or may purchase assets over which the bank does not have lien.25 If the working capital is underestimated, the borrower may face a liquidity crunch during the operational cycle and may have to re-approach the bank for additional loan or borrow from outside sources at exorbitant rates. In both cases, the bank faces default risk by the borrower.

Loans for Capital Expenditure and Industrial Credit

Firms need to invest periodically in capital assets to expand, modernize or diversify their business. In such cases, their credit needs will extend beyond a year. ‘Term loans’ are the preferred choice in such cases—with maturities of more than 1 year, repayment spread over the life of the asset or depending on the repaying capacity of the borrower. Most term loans are granted for purposes, such as a permanent increase in working capital (as discussed earlier) or for purchase of fixed assets or to finance start up costs for a new project. They generally carry maturities ranging from over 1–7 years. Though banks can, in theory, finance longer maturities, in practice they do not find it prudent to do so, because of the typically short- to medium-term maturity of bank liabilities. Lending for longer maturities may create a mismatch between asset and liability maturities and lead to a liquidity problem in banks.26

Since repayment runs into several years, the bank's decision to lend would be based more on the long-term cash generation capacity of the borrower firm or the assets being invested in. The benchmark ratio used predominantly is the debt service coverage ratio (DSCR),27 the minimum desirable level generally pegged at 2. The bank typically would require collateral for long-term lending, more as a secondary source for repayment in case of borrower default.

The characteristics of term loans are determined by the use of the loan amount. In the case of a term loan for purchase of a capital asset, the cost of the asset less a suitable margin is disbursed in full (in most cases direct to the supplier of the equipment) after the loan agreement is executed. The repayment terms are a function of the useful life of the asset, and the borrower's capacity to generate cash flows Sufficient to service the debt. The interest charged reflects the bank's perception of the default risk of the borrower and the collateral liquidation value over the duration of the loan. The covenants are more stringent than for working capital loans, since term loans extend over several years, and the borrowers may tend to dilute the negotiated terms. From the bank's side too, the credit officer who was instrumental in getting the loan sanctioned may no longer be available, and loan agreements may become unenforceable for lack of clarity.

Term loan repayments and interest payments could be structured in any of the following ways.

  • Repayments in fully amortized equal annual/half yearly/quarterly installment. Each periodic repayment will include interest and principal in varying amounts. The installment are treated as annuities and equated to the present value of principal plus interest to arrive at the installment. Interest is recovered in full in every instalment, and the remaining amount of the installment is taken towards principal repayment. As the principal gets repaid, the interest component, calculated on declining principal balances, decreases, and the principal component increases. Thus, in this method, the amount of payment per period remains constant, but the composition of the payment (principal and interest) varies from payment to payment.
  • Repayment of principal in equal installments over the designated period, with interest calculated separately on declining balances. In this case, the amount of debt service will vary from period to period. In contrast to the annualized method of repayment, each periodic payment in this mode will vary, but the amount of principal will remain constant.
  • Occasionally, the loan agreement may call for ‘balloon repayments’. In this case, the borrower is required to service only the periodic interest over the period of the loan. The entire principal amount becomes due only on maturity (also called a ‘bullet loan’). The difference between a ‘bullet’ and ‘balloon’ repayments is that in the case of ‘bullet repayment’ 100 per cent of the principal is due only at maturity while in the latter case, the credit (interest and principal) gets partially repaid during the term and presents lumpy repayment at maturity.
  • In rare cases, a variation of the above method is used. The principal and interest are amortized over a very long period, say 25 to 30 years. At the end of the period, the remaining principal amount is repaid in full.
  • For construction loans or project loans, the agreed amount is released in stages, as and when progress is shown in construction/the project.

Loan Syndication28

Large projects need enormous funding requirements. It may not be possible for one bank to finance the project requirements, from the viewpoint of both capital regulations and the risk of exposure. For the banks arranging the syndication and participating in it, syndication can be a source of substantial fee income as well. In essence, arranging a syndicated loan allows the lead bank to meet its borrower's demand for loan commitments without having to bear the market and credit risk alone, and also earn non-interest income in the process.

Syndicated loans are credits granted by a group of banks to a borrower. They are hybrid instruments combining features of relationship lending and publicly traded debt. They allow the sharing of credit risk between various financial institutions without the disclosure and marketing burden that bond issuers face.

Syndicated credits are a very significant source of international financing, with signings of international syndicated loan facilities accounting for no less than a third of all international financing, including bond, commercial paper and equity issues. Increasing trends of privatizations in emerging markets have enabled banks, utilities and transportation and mining companies from these regions to displace sovereigns as the major borrowers. However, and understandably so, the amount of international syndicated loan facilities, showed a decline since 2007. Quarters 2 and 3 of 2009 have shown a slight pick up, indicating confidence returning to the market (Source: BIS locational statistics, December 2009).

In a syndicated loan, two or more banks agree jointly to make a loan to a borrower. Every syndicate member has a separate claim on the debtor, although there is a single loan agreement contract. The creditors can be divided into two groups. The first group consists of senior syndicate members and is led by one or several lenders, typically acting as mandated arrangers, arrangers, lead managers or agents. These senior banks are appointed by the borrower to bring together the syndicate of banks prepared to lend money at the terms specified by the loan. The syndicate is formed around the arrangers—often the borrower's relationship banks—who retain a portion of the loan and look for junior participants. The junior banks, typically bearing manager or participant titles, form the second group of creditors. Their number and identity may vary according to the size, complexity and pricing of the loan as well as the willingness of the borrower to increase the range of its banking relationships. These bank roles have been enumerated above in decreasing order of ‘seniority’, and the hierarchy plays a decisive role in determining the syndicate composition, negotiating the pricing and administering the facility.

Junior banks typically earn just a margin and no fees. However, they may find it advantageous to participate in a syndicated loan—they may lack origination capability in certain types of transactions, geographical areas or industrial sectors, or a desire to cut down on origination costs. For these banks participation is also relationship building with the borrower who may reward them later with more profitable and prestigious business opportunities.

The Box 5.2 shows an illustrative structure of fees in a syndicated loan.

It is not mandatory that the lead arranger has to take a share in the credit exposure to the borrower. However, lead banks in practice do take a major share in credit exposures since their participation sends a strong signal to other participants that the borrower is creditworthy.

The mandated arrangers run two types of risks in syndication, assuming that the arrangers intend taking a major share in the syndicate's credit exposure. One is a ‘syndication risk’, arising out of under-subscription by participating banks in the syndicate. The credit requirements that have not been tied up will have to be entirely taken up by the lead bank/s. Once the syndicate is formed, the participating banks, including the arrangers, take on the credit risk—the risk that the borrower may default on debt service.

Therefore, before taking a decision to bid for the mandate, the relationship bank will have to do a thorough appraisal of the project and its prospects.

BOX 5.2 STRUCTURE OF FEES IN A SYNDICATED LOAN29

Fee

Type

Remarks

Arrangement fee

Front-end

Also called praecipium. Received and retained by the lead arrangers in return for putting the deal together.

Legal fee

Front-end

Remuneration of the legal adviser.

Underwriting fee

Front-end

Price of the commitment to obtain financing during the first level of syndication.

Participation fee

Front-end

Received by the senior participants.

Facility fee

Per annum

Payable to banks in return for providing the facility, whether it is used or not.

Commitment fee

Per annum charged on undrawn part

Paid as long as the facility is not used, to compensate the lender for tying up the capital corresponding to the commitment.

Utilization fee

Per annum charged on drawn part

Boosts the lender's yield: enables the borrower to announce a lower spread to the market than what is actually being paid, as the utilization fee does not always need to be publicized.

Agency fee

Per annum

Remuneration of the agent bank's services.

Conduct fee

Front-end

Remuneration of the conduct bank*

Prepayment fee

One-off if prepayment

Penalty for prepayment.

 

*The institution through which payments are channelled with a view to avoiding payment of withholding tax. One important consideration for borrowers consenting to their loans being traded on the secondary market is avoiding withholding tax in the country where the loan is deposited.

Source: BIS Quarterly Review, December 2004, p. 80.

Loans for Agriculture

Loans for agriculture are similar to other types of loans in the following respects.

  • Most of the loans for agriculture are short-term loans.
  • Agriculture being seasonal in nature, the norms for seasonal industries are applicable.
  • They can be likened to working capital loans, in that the loan is used for purchase of inventory, such as seeds, fertilizer and pesticides, and also to pay operating costs.
  • The sales are realized when the harvested crops are sold in the market.
  • Long-term loans for agriculture are given for investment in land, equipment or livestock.
  • Loans are paid out of cash flows arising from sale of crops harvested or produced from livestock.

The fundamental difference between loans for agriculture and other loans arises from the fact that agriculture is a vital national priority in many developed and developing countries. The governments and central banks of these countries have framed policies and institutional support systems to ensure that banks are involved in lending to this important sector, even when it appears that the sector may incur losses for a particular period.

Therefore, though loans for agriculture are to be assessed on similar lines as other loans, they are to be treated differently in terms of the outcome of such lending. Most countries have framed elaborate policies and institutional framework to ensure that agriculture and its allied activities are supported by banks.

Loans for Infrastructure—Project Finance

Project finance is a prominent form of ‘Asset-based lending’ (see Section I). Simply put, project finance involves the creation of a legally independent project company, with equity from one or more sponsoring firms, and non- or limited recourse debt, for the purpose of investing in a single purpose, industrial asset.30

Structuring a project finance deal entails substantial transaction costs in the nature of fees to lawyers, consultants and financial advisors, apart from obtaining necessary permits and environmental clearances. A deal could typically take 5–7 years to structure, since it also involves identifying and entering into suitable contracts with construction companies, suppliers of equipment and inputs, purchasers of output, operating companies and tying up the financing with various capital providers. Project companies are characterized by their highly leveraged structures with mean debts as high as 70 per cent, and the remaining equity contributed by the group of sponsoring firms in the form of either equity or quasi equity (subordinated debt), debt being non-recourse to the sponsors. The debt is also termed ‘project recourse’ since debt service depends exclusively on project cash flows.

A predominant share of project finance comes from banks in the form of debt, syndicated loans, or through subscription to bond issues of project companies. The risks for the lender are high, since the bank has limited or no recourse to the sponsor, unlike in conventional corporate financing. Thus, there are several supplementary credit arrangements that characterize project financing.

The primary mode of credit delivery is through term loans. The challenge in credit appraisal lies in the credit officer and the decision maker understanding the project and its risks in detail and instituting suitable risk mitigation measures for ensuring timely debt service.

Loans to Consumers or Retail Lending

Individual consumers generally seek bank finance to purchase durable goods, education, medical care, housing and other expenses. The average loan per borrower is small in relation to the bank's lending to corporate or business borrowers. Most loans have repayment periods ranging from 1–5 years, can be longer in the case of housing loans, carry fixed interest rates and are repaid in equal instellments. Individual consumers are generally seen as more prone to defaulting on loan repayment commitments than corporate borrowers. Interest rates on consumer loans are, thus, higher to compensate for the higher default risk. However, the loss to the bank when an individual customer defaults is not as great as when a corporate borrower does.

Consumer loans can also be classified based on repayment terms as instellments loans, credit cards and non-instellments loans. Instellments loans have a fixed periodic repayment schedule, which requires that a portion of both principal and interest are paid periodically. Payments on credit cards vary with the amount utilized. Non-instellments loans are special purpose loans, in which the individual expects a large cash inflow at a particular point of time that will enable him repay the debt entirely. An example of this would be a bridge loan for paying an advance for purchase of a new house, which will be repaid once the old house is sold off.

Banks are increasingly resorting to retail lending to take advantage of increased consumer spending and also because pools of such assets can be securitized thus leading to removal of default risk and greater liquidity for the banks, which, in turn, would lead to improved profitability.

The latter part of this book deals with retail lending while securitization is discussed in the chapters on ‘Credit Risk'

Non-Fund Based Credit

LCs and BGs (BGs or letters of guarantee—LGs) are the common forms of non-fund-based credit limits granted to borrowers to carry on their business. They are non-fund based since there is no outlay of funds for the bank at the time of granting the facility. The income earned from these services is classified under non-interest income.

The fact that this type of credit is granted with no funds disbursement at the outset, does not render it free of credit risk. LCs and BGs are off-balance sheet exposures for the bank, but they carry equal or more risks than on balance sheet credit exposures. Their risk arises from the fact that the bank is called upon to pay the counterparty or beneficiary, if the applicant or borrower fails to pay. The liability of the bank to the counterparty is determined by the relevant statute and the bank will have to pay the agreed amount to the counterparty without demur. It is then left to the bank to proceed legally or otherwise against the borrower or applicant to recover the loss.

It is, thus, evident that the bank will have to assess any request for non-fund based credit with the same rigour as it assesses the fund-based credit request. The default risk of the borrower remains, whether the bank has exposed itself to fund-based or non-fund-based credit.

The features of LCs and BGs are discussed in detail in subsequent chapters.

SECTION V
LOAN PRICING AND CUSTOMER PROFITABILITY ANALYSIS

Till about a decade ago, banks in many countries were regulated in respect of interest rates they could charge to borrowers. But in today's environment of deregulated interest rates and intense price competition for credit services to worthy customers, banks will have to price suitably not only to garner profit margins, but also to balance risk—return tradeoffs and ensure market presence. Declining interest spreads have forced banks to re-examine their revenue generation and cost control practices.

Let us link loan pricing to pricing of a product. How is the selling price of a tangible product determined? First, the selling price should cover variable costs. Then it should cover a portion of the fixed costs. Thereafter, it should yield a net positive return at a rate commensurate with the firm's policy and market expectation.

We have seen in the chapter on ‘Banks’ Financial Statements’ that the ‘interest earned by banks on loans, advances and investments’ is the equivalent of ‘revenues’ earned by a non-financial firm. The variable costs for our financial product—the loan—are the cost of the bank's liabilities. The fixed costs include the transaction servicing costs plus a portion of the overheads utilized for maintaining and monitoring the account. The bank's desired profit margin corresponds to the profit margin inbuilt into the selling price of a good or service.

However, there are two important points of difference between product pricing and loan pricing, especially for wholesale loans.

  • Every loan has a unique risk profile, which will have to be quantified and built into the price. This implies that, unlike non-financial firms, a single price cannot be fitted to a product line.
  • The price also depends on the profitability of the customer to the bank. Hence, loans to two borrowers with identical risk profiles may have to carry different prices. This is sometimes referred to as ‘relationship pricing’.

It is, therefore, evident that proper pricing of a loan is more complex and non-standardized than pricing of a product or service.

It also follows that, for every loan, at the minimum,

Loan price = cost of funds + servicing costs + risk premium + desired profit margin

Banks are confronted with several issues related to pricing. How should they rate the risk profile of customers for pricing? Should they make variable rate loans or fixed rate loans? What should be the prime rate quoted for good borrowers? Can they increase loan prices and still retain customers? How should fee income derived from the borrowers be adjusted in the loan price? Is the price being quoted on par with the market? If a customer's relationship with the bank undergoes a change, how should prices be adjusted, and with what repercussions?

Many banks use a generalized customer profitability analysis framework to resolve these issues. The vital question that arises here is: how do banks reconcile strategic decisions regarding deposit and loan mix and overall profitability with pricing decisions for individual customers, based on a framework?

We will build a step by step a basic loan pricing model in the following paragraphs and then refine it to take into account relationship pricing.

Step 1: Arrive at Cost of Funds

The objective here is to ensure that the loan price covers variable costs. This serves as the most basic model for pricing the loan.

 

Loan price = cost of funds + desired profit margin31

 

The issue here is: What is the cost of funds? Is it the average cost of the bank's sources of funds—deposits and borrowings, or is it the cost of funds that the bank requires to source to make the loan? The answer to this is a function of the investment policy the bank follows32, and is crucial in ensuring that the bank does not make a gross loss on the loan transaction.

We will define this with Illustration 5.1.

ILLUSTRATION 5.1

The maturity profile of Bank A is depicted in the Table 5.1. The bank's first class customer wants an additional loan of Rs. 50 crore to be repaid over the next 3 years. The bank seeks to have a net profit margin of 3 per cent on all its transactions. What should be the minimum interest rate ft proposes to the customer?

 

TABLE 5.1 THE MATURITY PROFILE OF BANK A

Maturity of liability Liability amount Rate (per cent)

Nil

10
0

6 months

25
5

1 year

25
9

2 years

10
11

3 years

20
12

Over 3 years

10
13

Total

100
 

Average cost of funds = 8.30 per cent

Case 1

Loan price = average cost of funds + profit margin
= 8.30 + 3.00
= 11.30 per cent

Case 2

Suppose the bank has invested its surplus funds in long-term investments, and has to borrow in the market to meet the request for the loan. Funds with a maturity of three years are available at 12 per cent. Therefore, the loan price will be,

 

Loan price = cost of funds with matching maturity + profit margin
= 12 + 3 = 15 per cent

Interpretation of the results in Case 1 and Case 2

The bank quotes 11.30 per cent or 15 per cent depending on its sources of funds for the loan. The questions here are: would the first class customer of the bank be willing to pay 15 per cent if the bank has to source funds with matching maturity from the market? How does this rate compare with that other banks quote for similar loans? If the bank wants to satisfy and retain its customer; it could end up making a loss or settling for less profit on the transaction.

Step 2: Determine Servicing Costs for the Customer

The following are typically assessed for each customer.

  • Identify the full list of services used by the customer. This list would include services related to the credit and non-credit facilities the customer avails from the bank. Examples of non-credit services would be the activity in the demand deposit accounts maintained by the customer (especially the zero cost deposits), usage of security/custodial services, or payment-related services such as transfers or LCs.
  • Assess the cost of providing each service. The bank's cost accounting system can be of help, but there can be wide variations in the way banks allocate overheads.
  • Multiply the unit cost with the extent to which such non-credit services are availed. For example, if it is assessed by a bank that it costs Rs. 10 to make a payment transfer, and the customer has used this service 500 times during the year; the cost for the customer works out to Rs. 5,000.
  • Cost of credit services depends on the loan size and forms a major portion of the servicing costs. They include loan administration expenses, of which a large share is contributed by personnel, processing or delivery costs.

Most banks calculate these costs as a percentage of the loan size.

Step 3: Assess Default Risk and Enforceability of Securities

One of the basic methods of assessing default risk is a credit scoring system. A typical credit scoring system includes many of the risk classification criteria listed in Annexure I. The borrower whose loan is being processed is rated on these criteria not only for deciding on sanction of the loan, but also with a view to assigning a value to the risk the bank would face if it lent to the borrower.

Based on the risk value assigned to the borrower, banks build models to assess the probability of default, arising out of the bank's prior experience with borrowers having similar risk profiles. Assessing probability of default (PD) is a rigorous exercise involving statistical techniques and is discussed in detail in the chapters on ‘Credit Risk’. The bank then puts a value to the enforceability and strength of the securities the bank holds or proposes to hold for the loan. Thus, the probable loss given default is also assessed.

Assigning these probabilities to the loan amount and interest recoverable, the bank computes the risk premium that will fit the borrower.

When there is no probability of default, the bank would receive the return it desires, or the rate contracted with the borrower. Let us assume that this rate is 15 per cent. Thus, at 100 per cent probability of repayment, the expected rate would be p ×r, where p is the probability of repayment and r the contracted rate.

When there is a probability of default, the expected rate would be the aggregate of the following.

  1. The probability of repayment × the contracted rate Plus
  2. The probability of default × the irrecoverable portion of the advance, expressed as a rate.

Expressed as an equation, the expected rate would be:

 

E(r) = P(R) + P(D) × ({R(P + Pr)/P}–1)

where  E(r) is the expected rate

     P(R) is the probability of recovery

     r is the contracted rate of interest

     P(D) is the probability of default P is the principal amount

     R is the recovery rate in the event of default

Illustration 5.2 gives one such simple methodology.

ILLUSTRATION 5.2

Bank A of Illustration 5.1 has made a risk assessment of the borrower and is confident that there is a 95 per cent probability of the borrower repaying the principal and interest as scheduled. It also makes a conservative estimate that in case of default, the bank can recover about 85 per cent of the principal and interest due. The bank feels that it cannot quote a rate lower than 14 per cent on the loan. What should be the rate it quotes to the borrower to include the default risk? Let us assume that the bank's cost of funds is 12 per cent and the servicing costs are at 0.25 per cent.

Solution

Though the bank intends quoting the rate of 14 per cent, it may not realize 14 per cent since there is a default risk attached to the borrower. The expected rate can be computed using the above equation:

 

E(r) = 0.95 × 0.14 + 0.053 ({5000 (l + 0.14) × 0.85}/5000} – 1)
E(r) = 13.3 + (– 0.031) 3 13.269

 

This implies that the bank will effectively obtain a return of 13.27 per cent from a loan contracted to yield 14 per cent. The difference between the contracted rate and the expected rate 0.731 can be taken as a measure of the risk premium.

Thus, the bank will have to price the loan to this borrower at a minimum of 12 (cost of funds) + 0.25 (servicing costs) 3 0.731 (risk premium) + 3 (desired profit), that is, at 15.98 per cent.

An alternate method of arriving at the risk premium would be to assume the expected rate as the sum of cost of funds, servicing cost and the desired profit, that is, 15.25 per cent and solve for r. The difference between 15.25 per cent and r can be taken as a measure of the risk premium. The results from the two methods may not be identical, but will be comparable. ‘Risk’ measures can at best be indicative, and the bank can take a decision on the interest rate to be charged based on its relationship with the customer and the market demand for funds.

Step 4: Fixing the Profit Margin

One approach that can be used to set the profit margin for loan transactions is to use the ROE as a determinant. The ROE is generally set based on market expectations and shareholders’ required returns.

We have already seen that ROE × ROA × EM

Therefore, ROA or net return on assets will be the product of ROE and the inverse of the equity multiplier (EM), which is represented by the term ‘equity/assets’, a measure of capital adequacy of the bank.

Illustration 5.3 will make the point clear.

ILLUSTRATION 5.3

If the bank in the Illustrations 5.1 and 5.2 desires to give its shareholders a return of 20 per cent, its assets amount to Rs. 10,000 crore, and its capital amounts to Rs. 1,000 crore, what should be the profit margin it should target for the borrower seeking Rs. 50 crore of credit, assuming that its cost of funds and servicing costs remain at the levels described above, and the risk premium is 0.731 as calculated above?

Desired return = 0.20 3 1000/10000 = 0.02

Therefore, the bank should target a minimum return or profit of 2 per cent on the transaction. The bank already has proposed a return of 3 per cent which is profitable for the bank.

The steps discussed above are the basics that the bank should grapple with while pricing its loans. While the bank may have little influence over the cost of funds and servicing costs, it can adjust the risk premium and desired profit depending on the relationship it has with the individual borrower, the industry in which the borrowing firm operates, and the market rates for comparable loans.

Some More Models of Loan Pricing

Fixed Versus Floating Rates When the interest rates are relatively stable and the yield curve slopes upward, banks would be willing to lend at fixed interest rates, above the rates they pay for shorter term liabilities. In an environment where rates are volatile, and banks have to source funds from the market at varying interest rates, they would prefer to lend on floating rates and for shorter maturities. In effect, floating rate loans transfer the interest rate risk from the bank to the borrower. Though this appears desirable, it may result in heightened credit risk for the bank. The rationale is as follows: rising interest rates increase the borrower's interest expense, which, if not met out of operating cash flows or the borrower's own funds, may lead to a shortfall in debt service.

It is evident that most borrowers would prefer fixed rate loans, due to the predictable cash flows for debt service, and allow the banks to bear the interest rate risk. If banks want to encourage borrowers to agree for floating rate pricing, they typically offer two alternatives.

  • In the first floating rate pricing alternative, banks may set the floating rate at a level below the corresponding fixed rate. The bank charges a ‘term premium’ to cover the risk on fixed rate loans. The size of the discount and the premium will have to depend on the bank's cost of funds and the required rate of return.
  • In the second pricing alternative, banks set an interest rate cap on the floating rate loans to limit the possible increase in interest payments. The cap may be applicable for any interval or for the entire maturity of the loan. The borrower pays the negotiated floating rate till the cap is reached. The inherent risk to banks lies in the market interest rates breaching this cap.

Typically, the floating rate structure works well when linked to a reliable benchmark reference rate, representing the rate structure in the economy. The most widely used reference rates are the London Inter Bank Offered Rate (LIBOR)33 and the prime rate (US markets).

Pricing Floating Loans Once the benchmark rate is determined, the bank can develop and use prime rate-based34 pricing models. Sub-prime lending is resorted to only in exceptional cases. In pricing most loans, a mark up over the prime rate is stipulated. As the market-determined or bank-determined prime moves up or down, the interest rates charged to the borrower also increase or decrease. The mark ups are based on a credit rating of the borrower, and are modelled to take care of the risks in lending to the particular borrower.

There are two basic methods for loading the mark ups on the prime rate—through an additive method and a multiplicative method-termed ‘prime plus’ and ‘prime times’, respectively. For instance, if the loan price is indicated as ‘prime + 3’, the borrower will have to pay interest at 300 basis points (bps) over the prime rate. As the prime rate changes, 300 bps (or 3 per cent) will be added on to the prime rate to arrive at the loan price for the borrower. The 300 bps reflect the bank's perception of the creditworthiness of the borrower. The more the default risk in a loan, the higher will be the additive factor over the prime rate.

The ‘prime-times’ method is a variation of the prime plus method, where the additive factor is replaced by a multiplicative factor. The extent to which this factor exceeds unity is a measure of the credit risk of the borrower. If the multiplicative factor is less than unity, the bank is pricing the loan sub-prime. For instance, if the bank wants to charge 300 bps above a prime rate of 10 per cent using the multiplicative model, the adjustment factor will be 1.3, i.e, 13/10.

In practice, banks fix a mark up based on the risk and other factors, and then arrive at the premium (in case of the additive model), or the adjustment factor (in case of the multiplicative model). Though both methods will have to lead to the same loan price at the time they are fixed, the impact of fluctuations in prime rate may lead to different loan prices as Illustration 5.4 demonstrates.

ILLUSTRATION 5.4

The bank cited in the foregoing illustrations wants to charge floating rates for its borrower since it expects interest rate volatility in the near future. The present prime rate is 10 per cent. The bank wants to charge a premium of 400 bps over the prime rate. Which method of arriving at the floating rate should it use—prime plus or prime times? Which pricing method would benefit the bank more when the prime rate

  1. moves up by 100 bps
  2. falls by 100 bps

Solution

Base Case

The prime rate is at 10 per cent

Since the premium desired is 400 bps, by the additive method, the loan price would be = 10 + 4 = 14 per cent
If the multiplicative method is used, the adjustment factor would be = l4/10 = 1.4

Therefore, by the multiplicative method, the loan price would be similar to the additive method, that is, 10 × 1.4 = 14 per cent

Case 1

The prime rate moves up by 100 bps, i.e., to 11 per cent

The loan price by the prime plus method would now be = 11 + 4 = 15 per cent

The loan price by the prime times method would now be = 11 × 1.4 = 15.4 per cent

Case 2

The prime rate falls by 100 bps, i.e., to 9 per cent

The loan price by the prime plus method would now be = 9 + 4 = 13 per cent

The loan price by the prime times method would now be = 9 × 1.4 = 12.6 per cent

Interpretation of the results

While the loan price is identical for a given prime rate under the two methods, when the prime rate increases, the prime times method is seen to yield a higher return for the bank. When the prime rate falls, the prime plus method is more beneficial to the bank.

Therefore, in a rising interest rate environment, banks may gain more returns by adopting the prime times method for arriving at floating rates. Conversely, in a falling interest rate regime, floating rates may be arrived at using the prime plus method.

Hedging and Matched Funding As described above, many borrowers prefer fixed rate loans. If banks have to make fixed rate loans in deference to borrower preferences, they attempt to control loss of profits due to interest rate volatility by using interest rate swaps or futures, or by matched funding.

In interest rate swaps, fixed rate payments are made in return for floating rate receipts. It is also possible to directly buy interest rate caps. With futures, it is possible to make fixed rate loans and hedge against potential losses from higher borrowing costs in future. This can be achieved by selling futures contracts or buying put options on futures.

In matched funding, loans are made with sources of funds with identical maturities. For example, the bank will source a deposit of 1 year maturity to fund a loan of identical maturity and amount. In the ideal situation, the bank can avoid interest rate risk on this transaction if there is a positive spread between the loan price and the cost of the deposit, and the interest payments also coincide. In large banks, the transfer pricing systems can be used flexibly for matched funding.

The Price Leadership Model The basic model described above makes the assumption that the bank knows its costs accurately, and can estimate probability of default and recovery rate for each borrower or class of borrowers. The basic model also fails to build in the effects of competition—the more intense the competition, the less the profit margin. These factors had led to the concept of ‘price leadership’ in banking, where a base or reference rate was established by banks. This rate was traditionally the lowest rate charged by banks to its most creditworthy customers on short-term or working capital loans. The actual loan rate charged to a borrower would be this base rate plus a suitable mark up, to compensate for the risk. Assigning the appropriate risk premium is one of the most difficult aspects of loan pricing, and many banks use a credit scoring system, basing their assessment on a grading of the risk factors.

Cost Benefit Loan Pricing It is a practice for many banks to base their loan rates on the base reference rate, the LIBOR or the prime rate. Some banks have also developed sophisticated loan pricing systems that determine whether their loan prices fully compensate for all the costs and risks involved in lending. One of these systems assesses the costs and benefits of the pricing model using the following steps.

Employ sensitivity analysis to estimate the total revenue that a loan would generate under different interest rates and charges.

Estimate the net loanable funds turnover.

Estimate the before tax yield from the loan by dividing the estimated revenue from the loans by the net amount loanable funds utilized by the borrowers.

This method is defined by the Illustration 5.5.

ILLUSTRATION 5.5

A borrower of a bank is sanctioned a Rs. 10 crore credit limit, but utilizes only Rs. 8 crore on an average at contracted rate of 20 per cent. The borrower will have to pay a commitment fee of 0.5 per cent on the unused portion of the credit limit. Additionally, the bank insists that the customer maintains a margin (a deposit or compensating balance) of 20 per cent for the utilized portion of the credit limit and 5 per cent for the unutilized portion. Reserve requirements imposed by the central bank stand at 10 per cent of the deposits.

  1. Estimated loan revenue = revenue from credit limit utilized + revenue from unutilized credit limit

    = Rs. 8 crore × 0.20 + Rs. 2 crore × 0.005

    = Rs. 1.6 crore + Rs. 1 lakh

    = Rs. 1.61 crore

  2. Estimated bank funds outlay for the borrower = utilized credit limit Less (i) compensating balance/margin requirement and (ii) reserve requirement.

    = Rs. 8 crore – (Rs. 8 crore × 0.2 + Rs. 2 crore × 0.05 + 0.10

    {Rs. 8 crore × 0.2 + Rs. 2 crore × 0.05})

    = Rs. 8 crore – (Rs. l.7 crore + Rs. l7 lakh)

    = Rs. 6.13 crore

  3. Estimated before tax yield to the bank from this loan

    = estimated loan revenue/estimated funds outlay

    = Rs. l.61 crore/Rs. 6.l3crore

    = 26.26 per cent

In this case, the bank should decide whether the before tax yield of 26.26 per cent is sufficient to cover its cost of funds, servicing costs, the risk inherent in the loan and the desired profit margin.

Customer Profitability Analysis Periodically, or every time a borrower approaches the bank with a request for modifications in loan terms, a customer profitability analysis should be carried out by the bank. The analysis is used to evaluate whether the net gains from a borrower's transactions with the bank are in line with the bank's profit expectations. The procedure involves comparing revenues generated by the borrower with the associated costs, and ultimately with the bank's profit goal. Although the analysis is discussed here in respect of borrowers, the procedure can be used to evaluate the efficacy of non-credit activities as well.

The steps in analysing customer profitability are typically as follows.

 

Step 1 Identify all the services used by the customer–deposit services, loans availed, payment services, services relating to transfer of funds, custodial services and other fee-based services.
Step 2 Identify the cost of providing each service. Generally, unit costs can be derived from the bank's cost accounting system. The bank's services can be bifurcated into credit-related and non-credit-related services.
Step 3 Cost estimates for non-credit-related services can be obtained by multiplying the unit cost of each service by the corresponding activity level.
Step 4 The major portion of costs is in respect of credit-related services. The bank incurs actual cash expenses in interest payment towards the source of funds for the loan, and the costs for credit analysis and execution. The latter includes personnel and overhead costs, including cash outgo for sending bills for collection, processing payments, maintaining collateral and updating documentation. It may be computed as a fixed percentage of the loan amount.
Step 5 The credit-related expenses has a non-cash component–the allocation of default risk expense. The bank's risk rating system is used in categorising loans in terms of their potential for default risk, and the likely magnitude of such default. Some banks build in the default risk into the loan price as we have seen earlier in the basic model.
Step 6 Assess the revenues generated by the relationship with the borrower. The borrower could have deposit balances with the bank, either as a depositor or by way of compensating balances. To estimate the income from interest-bearing deposits, the bank deducts the average transactions ‘f1oat’35 and the mandatory ‘reserve requirements’ from the average deposit balances held during the period of analysis. It then applies a ‘notional interest rate’ on the balances to estimate the earnings potential of the customer's deposit ba1ances. 36 The opportunity cost of compensating balances varies directly with the interest rate levels, and hence, corporate borrowers do not prefer this mode of cash retention by the bank.
Step 7 Assess the fee-based income generated. Fees are generally charged on a per service basis. In the case of credit relationships, banks charge upfront fees for processing the loan application and making funds available (regardless of whether the funds are utilized by the borrower); commitment fees for the unutilized portion of the credit limit; and conversion fee, in case there is a rescheduling of the loan repayment terms.
Step 8 Assess the revenue from loans.

 

Illustration 5.6 describes the process.

ILLUSTRATION 5.6

Our bank in the examples given earlier has been requested by the customer to make the loan of Rs. 50 crore at the interest rate of 10 per cent. The borrower argues that the negotiated rate will be justified since compensating balances are being maintained with the bank in accordance with the loan agreement. The bank is looking for a target return of 14.4 per cent on the transaction, taking into account the risk factors in the loan and the ROE.

The terms of the proposed loan agreement (if the bank decides to lend) would be:

  • Amount of short-term loan: Rs. 50 crore.
  • Fees: 0.15 per cent processing fee: 1 per cent on unutilized loan amount as commitment fee.
  • Compensating balances: 3 per cent of loan + 2 per cent of actual borrowing.

The customer uses the following services during the year for which the transaction costs are given alongside.

Nature of service Number of transactions Cost per transaction (Rs.)

Items in transit

15,000
0.20

Demand deposit transactions

5,000
6.00

Payment transfers

500
2.00

 

Other information relating to the customer's loan and deposit transactions are as follows:

Average loan outstanding

Rs. 42 crore

Credit administration costs

1 per cent

Credit risk expenses

1 per cent

Cost of funds

6.5 per cent

Average yield on the short-term investment

7 per cent

Required reserve ratio

10 per cent

Average demand deposit balance

Rs. 1 crore

Average float in Rs.

Rs. 50 lakh

 

Would the bank meet its targeted profit if it were to lend to this borrower at 10 percent?

 

 

 

 

*Investment revenue calculated as follows:

Actual demand deposit balances

1,00,00,000

Less float

50,00,000

Collected balances

50,00,000

Less reserve requirement @ 10 per cent

5,00,000

Investible balance

45,00,000

Compare the profit generated by the customer with the target profit. The actual profit falls short by Rs. 3.84 crore. One reason is that the customer has not maintained compensating balances in accordance with the loan agreement. Against the stipulated compensating balances of Rs. 2.34 crore, the customer has maintained only Rs. 1 crore. However, even if the stipulated compensating balances had been maintained, the account would not have yielded the targeted profit for the bank. Hence, the bank has to rethink its relationship with the customer: Is it worth acceding to the customer's request and making less than targeted profit on the transaction? What should be the renegotiated interest rate if the bank wants to achieve targeted profit? If the customer does not agree to the renegotiated interest rate, what other compensating factors can be stipulated? Or can the relationship be terminated?

CHAPTER SUMMARY
  • Banks have a crucial role to play in the financial system of any country. The prime objective of the financial system is to channel surpluses arising in the economy, into deficit units. The financial system comprises of ‘financial markets’ and ‘financial intermediaries’. The financial markets function as ‘brokers’ that bring the surplus and deficit units together for mutual benefit. However, the risk of lending to deficit units is borne largely by the surplus units themselves. The financial intermediaries, on the other hand, create ‘assets’ out of the surpluses of the economy.
  • Financial intermediaries serve three useful purposes—they mitigate the default risk of deficit units when surplus units lend to them, they ensure liquidity of savings by surplus units and they lower information costs.
  • A bank can tend profitably only if it is able to take on and manage credit risk that arises from the quality of the borrower and his business. The bank also has to contend with the impact of fluctuations in interest and exchange rates on profits, as well as the liquidity risk posed by mismatch in the maturities of its liabilities and assets.
  • Banks extend credit to different categories of borrowers for different purposes. For most of these borrowers, bank credit is the primary and cheapest source of debt. Financing the demand side of the economy, the large class of consumers, is called retail banking (also termed mass banking). Financing the supply side of the economy, which is more customized in nature and calls for specialized skills, is called Wholesale banking or corporate banking or class banking.
  • For assuming financial risks, banks have to look for higher returns. Returns come in the direct form of loan interest, or in the indirect form of fee-based ancillary services. The most prominent risk in lending is default risk. There can be another kind of risk associated with credit decisions—interest rate risk.
  • Broadly, there are three types of lending—fund-based, non-fund-based and asset-based. Fund-based advances can be further classified based on the tenure of the loans into (1) short-term loans, (2) long-term loans and (3) revolving credits.
  • Credit decisions are by no means easy. Apart from their expertise in credit appraisal, the strategic role of credit officers assumes utmost importance.
  • The ‘credit process’ has the following constituents—(1) the loan policy; (2) business development; (3) credit analysis, which includes steps such as building the credit file, project appraisal, financial appraisal, qualitative analysis, due diligence and risk assessment; (4) the initial recommendation based on the analysis; (5) credit delivery and administration, which includes important steps, such as loan documentation, stipulating the terms and conditions of lending, framing the positive and negative covenants, specifying the events of default and finally updating the credit file and following up periodically and credit review and monitoring, which is typically bifurcated into monitoring performance of existing loans and problem accounts.
  • Though several qualitative factors play a role in a credit decision, a major influencing factor is the financial health of the borrower as brought out by the financial appraisal. The credit officer uses techniques, such as financial ratio analysis, cash flow analysis and sensitivity analysis to assess the achievability of the projections. Five broad categories of financial ratios are used—liquidity, profitability leverage, operating and valuation.
  • Though classified under the single nomenclature—loans—every loan or class of loans is unique. Each type of loan has distinguishing features-based factors, such as the purpose, the collateral, the repayment period and the borrower profile. Examples of popular loans are working capital loans, industrial credit, term loans for capital expenditure, syndicated loans, agriculture, loans, project finance, retail lending and non-fund based credit.
  • In the present environment of deregulated interest rates and intense price competition for credit services to worthy customers, banks will have to price suitably not only to garner profit margins, but also to balance risk—return tradeoffs and ensure market presence. Since every loan has a unique risk profile and every borrower enjoys a unique relationship with the bank, proper pricing of a loan is more complex and non-standardized than pricing of a product or service.
  • For ‘every loan’, at the minimum, Loan price = cost of funds + servicing costs + risk premium + desired profit margin.
  • For pricing floating loans, banks fix a mark up based on the risk and other factors, and then arrive at the premium (in case of the additive model) or the adjustment factor (in case of the multiplicative model).
  • Many borrowers prefer fixed rate loans. If banks have to make fixed rate loans in deference to borrower preferences, they attempt to control loss of profits due to interest rate volatility by using interest rate swaps or futures, or by matched funding.
  • Periodically, or every time a borrower approaches the bank with a request for modifications in loan terms, a customer profitability analysis should be carried out by the bank. The analysis is used to evaluate whether the net gains from a borrower's transactions with the bank are in line with the bank's profit expectations. The procedure involves comparing revenues generated by the borrower with the associated costs, and ultimately with the bank's profit goal.
TEST YOUR UNDERSTANDING
  1. Why can't banks lend without a written loan policy?
  2. How do banks frame covenants for lending? What factors do they base the covenants on?
  3. Why do banks need specialized schemes of lending for each sector of economic activity? What would happen if lending procedures were standardized and rigid?
  4. Why should credit needs of a borrower be assessed accurately? What would happen if the borrower's needs are (a) over-assessed (b) under-assessed?
  5. A firm ‘S’ started its relationship with Bank ‘B’ with a demand deposit of Rs. 2 lakh. At the end of the year, the deposit had been overdrawn by Rs. 1 lakh. From the financial statement given below, establish the reasons for this: (Rs. in lakh).
      Beginning of the year End of the year

    Fixed assets

    7.5
    12

    Inventories

    2
    3.5

    Receivables–book debts

    3.8
    3.5

    Bills receivable

    1.0
    1.3

    Trade creditors

    2.5
    3.3

    Share capital

    2.5
    3.0

    Share premium

    Nil
    0.25

    The profit before depreciation and tax was Rs. 2.5 lakh. Tax rate is at 40 per cent. Assume depreciation at 20 per cent on the outstanding fixed assets. The firm intends paying 15 per cent dividend on its year-end capital.

    Would you, as a bank manager, consider converting the overdraft into a working capital loan?

    What are some of the covenants you would stipulate?

  6. What is the effective annual interest rate on each of the following loans? The amount of loan, in all cases, is Rs. 5 lakh, and the interest rate is 12 per cent.
    1. The loan is repayable in 3 years, principal payable in 36 equal installments and interest on declining balances.
    2. The loan is repayable in 4 years, in equal monthly installments.
    3. The loan is repayable with simple interest every year, at the end of 2 years. The entire amount of principal is payable at the end of the second year.
  7. The promoters of a successful chain of restaurants approach you, the credit officer of a bank pursuing aggressive credit policies, for the following loans. Which of the loans would you consider favourably, and which would you reject? Give reasons for your decisions. What type of loan would you grant in each of the cases you have decided favourably upon? Also provide the risk mitigation measures you would put in place for each type of loan you are considering favourably. (Each situation is to be treated independently).
    1. The restaurant wants a working capital loan to finance its inventory predominantly consisting of vegetables, cheese and milk. The inventory may be transferred from the local sourcing headquarters (situated near your bank) to any of the restaurants in the city and suburbs.
    2. The restaurant wants to buy new cars for all the promoters.
    3. The restaurant wants to invest in the firm supplying cheese and vegetables and seeks bank finance for the investment.
    4. The restaurant wants bank finance to pay off the long-term mortgage loan used to buy the premises in which all the restaurants are located.
    5. The restaurant wants bank finance to buy new, state-of-the-art cooking equipment for all its restaurants.
    6. The restaurant has tied up for venture capital funding for its new posh up market chain and wants interim bank finance till the funding comes through.
    7. The restaurant has run into cash flow problems and wants bank finance to pay employee's salaries.
  8. From the following information relating to a bank, arrive at the prime rate (base rate) on which the bank would base the interest rates on loans.
    Details (per cent)  

    Capital adequacy Ratio

    10

    Reserve requirements

    15

    Cost of capital

    12

    Cost of deposits

     

    Demand deposits*

    3

    Term deposits

    6
    *Fifty per cent of demand deposits are interest-free deposits.

    Ratio of demand to term deposit is 1:2

    The bank has a credit scoring system to rate borrowers and uses the system to fix lending rates as given below.

    Category Rate Proportion

    A

    At prime

    0.40

    B

    At prime + 100 bps

    0.40

    C

    At prime + 200 bps

    0.20

    The bank also earns an interest of 3 per cent on 50 per cent of the reserves.

    The bank's total working funds consists of only capital and deposits. The management requires a net profit margin of 4 per cent.

  9. A borrower approaches you, the credit officer, to amend the agreement in respect of the loan of Rs. 10 lakh sanctioned to him. He prefers you to price the loan at 15 per cent and completely waive the requirement of compensating balances. The loan agreement stipulates an interest rate of 13 per cent with compensating balances of 20 per cent of the loan amount.
    1. What is the effective cost to the borrower of each alternative?
    2. What is the effective return to the bank of each alternative, if the bank has to maintain a 15 per cent reserve requirement on its liabilities?
    3. Which pricing scheme will be preferred by the bank and why?
TOPICS FOR FURTHER DISCUSSION
  • Why does collateral alone not justify credit extension?
  • What are the primary sources of income for a bank from a borrower? In today's changing scenarios which of these is more valuable and why?
  • During a credit crunch, would non-fund-based lending increase or decrease? Why?
  • What were the causes of the sub prime crisis that began in 2007? What kinds of banks were worst affected? What kinds of banks remained relatively unaffected? Why?
SELECT REFERENCES
  1. Federal Reserve Bank of New York, ‘The Credit Process: A Guide for Small Business Owners’, accessed at http://www.ny.frb.org/education/addpub/credit.html
  2. Harvard Business School. 1993 Note on Bank Loans. Boston: Harvard Business School Publishing.
  3. Kohn, Meir. 1999. Financial Institutions and Markets, Chapter 2, New Delhi: Tata McGraw Hill Publishing Company Ltd, 27–47.
ANNEXURE I
RISK CLASSIFICATION CRITERIA AND THE ROLE OF CREDIT RATING

For a corporate borrower or a large project, risks can be endogenous or exogenous to the firm. Endogenous risks arise due to factors internal to the firm and its operations, and exogenous risks arise due to macroeconomic and other factors outside the firm that nevertheless impact the firm's operations, existence and success.

A key skill required in credit appraisal is the ability to identify risks, assess their severity on the firm's value and ensure they are mitigated so that the lender is comfortable with the credit risk.37

Many banks rate customers for risk internally, either qualitatively or through internally developed models. However, with the advent of Basel 2 regulations38, banks feel the need to calibrate the credit risk in their books in a better manner. Hence, credit rating agencies such as CRISIL, ICRA and CARE have commenced rating bank loans. Credit risk in such cases would be measured by the ratings accorded to the proposed credit exposures by the rating agencies.

A Brief on the Three Major Rating Agencies in India

1. CRISIL.39  CRISIL, established in 1987, is one of India's leading ratings, research, risk and policy advisory companies. A majority shareholder from 1997 in CRISIL is Standard & Poor's, one of the world's leading providers of independent credit ratings. From 2007, CRISIL commenced rating of bank loans.

The range of ratings for long-term loans are AAA (highest safety), AA (high safety), A (adequate safety), BBB (moderate safety). These ratings are termed ‘investment grade’, and help corporate and other borrowers in acquiring the right pricing for their loans from banks. ‘Sub investment grade’ or ‘speculative grade’ ratings are B (inadequate safety), B (high risk), C (substantial risk) and D (default). The NM (not meaningful) rating implies that the rating is meaningless since the firm is under liquidation or reorganization or is under unresolved legal dispute.

The range of ratings for short-term instruments, on similar lines as above, ranges from P-1 to P-5, with P-4 indicating low safety and P-5 indicating likely default.

In addition, the rating may be suffixed with ‘+’ or ‘–’ sign to reflect comparative standing within the category.

CRISIL's credit rating methodology follows the steps given in Table 5.2.

2. CARE.40   Credit analysis and Research Limited (CARE ratings) was promoted in 1993 by major banks and financial institutions in India. The three largest shareholders are IDBI Bank, Canara Bank and State Bank of India.

 

TABLE 5.2 STEPS FOLLOWED BY CRISIL RATING METHODOLOGY

Step

Analysis

Key factors analysed

1.

Business risk–Industry risk

Macroeconomic factors, Industry structure, demand-supply, growth prospects, profitability, market size, competition, cyclicality, regulatory environment

2.

Business risk–Market position

Competitive advantage, market share, distribution strengths, pricing power, brand strength, SWOT analysis, etc.

3.

Business risk–operating efficiency

Capacity utilization, cost structure, technological factors, labour relations, access to resources, flexible production and R&D capabilities, backward and forward integration

4.

Financial risk–accounting quality

Accounting policies, reporting and disclosures and adjustments

5.

Financial risk–existing and future financial position

Capital structure, profitability, debt protection ratios, off balance sheet obligations, liquidity, working capital management, sensitivities

6.

Financial risk–cash flow adequacy

Working capital needs, sources and uses of funds, cash accruals to service debt payments, capital expenditure plans and funding

7.

Financial risk–financial flexibility

Bank limits, utilization, access to capital markets, cash and marketable securities, relationship with bankers, contingency plans, etc.

8.

Management risk–integrity

Track record, reputation in markets, adherence to law and regulations, intra group transactions

9.

Management risk–risk appetite

Attitude to business risk, risk management practices, growth plans, unrelated diversification, etc.

10.

Management risk–competence

Consistency of performance, track record, success of past strategies, succession plans, senior management quality, ability to attract and retain talent, experience in managing downturns

11.

Management risk–governance practices

Board composition and oversight, transparency and disclosure, share-holder value creation and equitable treatment

12.

Project risk

If new project

13.

External support

Government, group, parent company

14.

Long-term rating

Based on steps 1 to 13 long-term rating and rating outlook-positive, stable or negative-awarded

15.

Short-term rating

Current liquidity position, size of short-term debt, maximum short-term debt capacity, mapping long-term rating to short-term rating

16.

Mapping long-term to short-term rating

1. AAA, AA+, AA, AA-, A+ all map to P1+
2. A+, A, A- map to P1
3. A, A-, BB+ map to P2+
4. BBB+, BBB map to P2
5. BBB, BBB– map to P3+/P3

 

 

The range of long-term ratings is similar to that of CRISIL. However, the ratings are called CARE AAA (highest safety), CARE AA (high safety), CARE A (adequate safety), CARE BBB (moderate safety), CARE BB (inadequate safety), CARE B (low safety), CARE C (high likelihood of default) and CARE D (default).

Similarly, short-term ratings are assigned the following ratings: PR 1+/1(lowest credit risk and highest capacity for timely loan repayment), PR 2 (adequate capacity for timely repayment) and PR3 (moderate capacity). PR 4 and PR 5 exhibit inadequate capacity to repay and characteristics of default. As done by CRISIL, affixing ‘+’ or ‘?’ sign after the assigned rating indicates the relative position within the band covered by the CARE rating symbol.

CARE's ratings are done with a methodology similar to that of CRISIL described in Table 5.2. The economy is analysed with specific reference to the business risks of the borrowing entity, followed by an assessment of financial risk factors and the quality of management. The degree of financial risk exposure of the company within the overall context of the business risk, taken together with the evaluation of the company management, forms the basis for arriving at the rating.

3. ICRA.41 ICRA Limited (formerly Investment Information and Credit Rating Agency of India Limited) was set up in 1991 by leading financial/investment institutions, commercial banks and financial services companies as an independent and professional Investment Information and Credit Rating Agency. The international Credit Rating Agency Moody's Investors Service is ICRA's largest shareholder. The participation of Moody's is aimed at Benefiting ICRA's in-house research capabilities, and providing it with access to Moody's global research base. Today, ICRA and its subsidiaries together form the ICRA Group of Companies (Group ICRA). ICRA is a Public Limited Company, with its shares listed on the Bombay Stock Exchange and the National Stock Exchange.

As done by CRISIL and CARE, ICRA assigns short-term and long-term ratings to bank loans. It assigns ratings A1 to A5 for short-term debt instruments, and long-term ratings ranging from LAAA to LD for long-term instruments. ICRA also uses the suffix ‘+’ or ‘−’ to denote the relative position of the borrower within the rating category. Figure 5.2 depicts how ICRA's short-term ratings are linked to its long-term ratings. Though the linkage is only indicative, it is noteworthy that a borrower with a sub investment grade long-term rating would typically be rated sub investment grade in the short term too.

 

FIGURE 5.242 ICRA'S RATING OF BANK LOANS—HOW LONG-TERM AND SHORT-TERM RATINGS ARE MAPPED INTO EACH OTHER

 

Source: ICRA Web site

 

Like the other rating agencies listed above, ICRA considers all relevant factors that have a bearing on the future cash generation and debt servicing ability of the borrower before finalizing its rating. These factors include: industry characteristics, competitive position of the issuer, operational efficiency, management quality, commitment to new projects and other associate companies, and funding policies of the issuer. A detailed analysis of the past financial statements is made to assess performance under ‘real world’ business dynamics. Estimates of future earnings under various sensitivity scenarios are evaluated to ensure that debt would be serviced over its tenure. Primarily, it is the relative comfort level on the issuers’ cash flows to service obligations that determines the Rating

What Does Credit Rating by the Agencies Really Convey?

Credit rating by an agency is merely an indicator of the credit risk that could arise if the bank lent to the borrower. It reflects the opinion of the agency and does not amount to a recommendation to lend. The rating confines itself to the debt repaying capacity of the borrower, and does not consider the interplay of other risks inherent in the external and internal environment of the borrower, such as interest rate risk, liquidity risk, exchange rate risk and so on. Further, the rating is specific to the loan being granted, and is not tantamount to a rating of the borrowing entity.

The Sub Prime Crisis—A Failure of the Rating Agencies?

All the top credit rating agencies of the world are under a cloud in the wake of the financial meltdown. They have been accused of being too slow in alerting investors of the risks of investments based on high risk subprime loans.

Most countries are now considering stricter regulation on the rating agencies and the way they do business.

The European commission has, in November 2008, published a series of proposals that include banning ratings agencies from doing consulting work for clients who they also rate, and calling for greater disclosure of how the ratings are arrived at. The Commission has also suggested that if the agency did not have Sufficient reliable information to rate, they should not be allowed to rate the security. Other proposals include having at least three independent directors on the boards of rating agencies, whose compensation was not linked to business performance, and publishing annual transparency reports.

Australia has proposed a ‘licensed self regulatory system’ for credit rating agencies, which would be required to adhere to the code of conduct developed by the International Organization of Securities Commissions (IOSCO). The code of conduct had been updated in 2008 to reflect the lessons from the sub prime crisis.

In spite of the role of external credit rating agencies, banks would have to develop internal risk rating systems to rate borrowers, since banks are in close proximity with the borrowers to collect more relevant information for decision making. The factors to be considered for such risk analysis can be synthesized from the rating agencies’ models, and customized for individual banks and borrowers.

A typical risk management system should therefore take into account the following factors.

Principal Factors

The Borrower/Management

The Firm/Project

General characteristics

  • Constitution-proprietary versus partnership versus limited liability companies
  • Product characteristics-differentiation, substitutes, patents, brand creation, technology (stable or fast changing) etc.
  • Vulnerability to uncontrollable/unpredictable events (acts of God)
  • Control over availability and prices of supplies and raw materials
  • Scope in terms of both markets and products
  • Availability of labour/power/other utilities
  • Is the product subject to selective credit control?

Management team

  • Industry experience
  • Managerial breadth and qualifications
  • Managerial depth and turnover rate
  • Calibre and structure of board
  • Management reputation
  • Management controls proposed
  • Forward planning and vision

Financial condition

  • Business plan projections and critical assumptions made
  • Borrower's/owner's stake
  • Cash flow projections
  • Leverage ratios
  • Quality of assets
  • Profitability ratios
  • Shareholder value added
  • DSCR over project/loan period
  • NPV/IRR over project period
  • Value of the firm as a going concern
  • Security provisions
  • Restrictive covenants
  • Repayment/amortization provisions
  • Quality and reputation of other lenders

Capital sources–Equity

  • Access to private/public markets
  • Borrower's/owner's personal equity
  • Breadth of ownership

Capital sources–Debt

  • Long-term/short-term
  • Ease of a[u16]ccess to private and public markets or just private markets

Commercial Bank Relationships

Financial reporting

  • Reputation/stature of audit firm
  • Accounting practices proposed/existing

Industry

Structure and economics

  • Competition
  • Government policy-regulation/legislation
  • Importance of industry to economy
  • Degree of control by industry participants over demand and selling prices
  • Industry's dependency on government/other industries
  • Is the industry on any reservation list?
  • Import substitute/export potential

Maturity

  • Stage in industry's life cycle
  • Ease of entry
  • First mover advantage
  • Rate of capacity additions
  • Technology
  • Rate of technological obsolescence
  • Does the market need the product in this form?
  • Are disruptive innovations likely?

Stability

  • Sensitivity to business cycles
  • Sensitivity to credit cycles
  • Supply/demand balance
  • Vulnerability to technological innovation
  • Vulnerability to production changes
  • Vulnerability to distribution changes
  • Vulnerability to changes in consumption patterns/customer preferences

Risk Modifiers

Types of agreements

  • Revolving credits
  • Term loans
  • Other loans
  • Security provisions
  • Restrictive covenants
  • Repayment/amortization provisions
  • Quality and reputation of other lenders

Types of collaterals

  • Floating and fixed assets-market value
  • Valuation considerations
  • Marketability of securities
  • Quality of floating and fixed assets

Guarantees

  • Collateralized
  • Enforceability
  • Status of guarantors
ANNEXURE II
CREDIT APPRAISAL—SOME COMMONLY USED FINANCIAL RATIOS

Liquidity Ratios

The liquidity ratios reflect the sufficiency of cash (liquid funds) in the firm to meet its liabilities. Those liabilities maturing for payment within the next 12 months are termed current liabilities. Such liabilities will be paid through generating cash and other liquid assets (called ‘current assets’) through the working capital operating cycle, typically within the next 12 months. The borrower with weak liquidity is generally not considered a good credit risk.

 

Leverage Ratios

These ratios reflect the financial risk inherent in the borrower firm. Higher debt probably implies higher profitability in some cases, but also implies higher potential earnings volatility and higher risk of insolvency. The bank needs to assess the These ratios reflect the financial risk inherent in the borrower leverage of the borrower from the viewpoint of debt service, firm. Higher debt probably implies higher profitability in some the firm size and industry practices. Some common ratios cases, but also implies higher potential earnings volatility employed in the analysis are as follows.

 

 

TABLE 5.3 ILLUSTRATION OF IMPLICATIONS OF A DEBT-EQUITY RATIO HIGHER THAN THE INDUSTRY AVERAGE

 

The simple example shows that

  1. if the profitability of the firm exceeds the interest cost in good times (in year 1, the EBIT/value for the firm is 20 per cent, while the interest cost is 14 per cent), the ROE of the firm will be higher than the industry average.
  2. In bad times, however, when the profitability of the firm plummets below the interest cost, the industry ends up making a small profit, while the firm makes a loss. Everything else being equal, it is the interest cost that is responsible for the loss of the highly levered firm.

Profitability Ratios

The bank expects the borrowing firm to conduct its business prudently, mitigate risks, be cost effective and thus generate enough profits to cover long-term debt obligations; taxes and other statutory payments; pay reasonable dividends to equity holders; and thereafter leave a surplus for plough back into reserves or invest in high yielding projects. The important profitability ratios for the bank as lender are as follows.

 

Operating or Activity Ratios

Activity or turnover ratios measure the operational efficiency and the liquidity of the current assets of the borrower firm.

 

Valuation Ratios

What is the real value of the borrower? The financial definition of ‘value’ is the ‘present value of future cash flows’. The future potential of the firm is a major determinant of the market perception of the firm, and hence its ‘market value’. This is particularly true of the value of publicly traded firms. The bank is interested in the value of a firm both in view of its ongoing relationship as well as the prospects of problem-free debt service.

 

ANNEXURE III
INCOME STATEMENT-BASED CASH FLOW ANALYSIS

Cash flow to firm = cash flow from operations + cash flow from investments + cash flow from financing

How do we arrive at the cash flow of a firm from its Income statement and balance sheet?

Table 5.4 demonstrates.

 

TABLE 5.4 CASH FLOW OF A FIRM CALCULATED FROM INCOME STATEMENT AND BALANCE SHEET