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It should cover following aspects 1. Regulatory – RBI/BASEL 2. Internal – Loan Policy 3. Managerial/Financial/Commercial/ Market 4. Types of customer – Individual/Partnership/Corporate 5. Types of loans – Corporate loans/SME/Rural/Trade/Export/Import/Project/Ret ail etc Government/PSU/Quasi/Private 6. Gut feeling
General Lending principles
A lender does lend money and does not give it away. Lenders must seek to arrive at an objective decision. The approach of the true professional is to resist outside pressures and to insist on sufficient time and information to understand and evaluate the proposition.
Professional lending principles
Take time to reach a decision-detailed financial information takes time to absorb. If possible, it is preferable to get the paperwork before the interview, so that it can be assessed and any queries identified. Do not be too proud to ask for a second opinion-some of the smallest lending decisions can be the hardest.
Professional lending principles
Get full information from the customer and not make unnecessary assumptions or ‘fill in’ missing details. Do not take a customer’s statements at face value and ask for evidence that will provide independent corroboration. E.. Sathyam episode Distinguish between facts, estimates and opinions when forming a judgement. Think again when the ‘gut reaction’ suggests caution, even though the factual assessment looks satisfactory.
TRADITIONAL METHODS OF CREDIT ANALYSIS
Anyone can lend, but lending money and ensuring it repayment distinguishes between a good banker and a bad banker. When you are dealing with people, it is almost impossible to predict how someone will behave in the future. It is important therefore that lenders exercise sound judgement while granting loan.
Lending principles help a banker to make sound judgement. Note however that principles are not laws of physical science that must hold whatever be the case; rather, the principles serve as a framework within which to make a decision. This is why lending is more akin to art than to science.
The purpose of any credit assessment or analysis is the measurement of credit risk. Borrowers’ credit assessment is done using the following criteria, popularly known as the five Cs of lending.
FIVE Cs of Lending
Character Capacity Capital Collateral Conditions
Character is the sum total of human qualities of honesty, integrity,morality and so on. Character is perhaps the most important and at time the most difficult criterion to assess. Character assessment involves collecting information about the borrower’s track record of integrity, repayment ability and spending habits.
Means of gathering information
Credit check of internal bank records or other financial institution. Contact of applicant’s employers and seek confidential information about the employee*** Documentary evidence such as salary statements, drivers license, utility bill Confidential reports from credit rating agencies are another source. CIBIL data/ECGC/Dun & Brad Street
Character assessment in relation to business borrowers
For business borrowers, character assessment involves assessing the character of the business owners or, in the case of companies, the members of the board. Corporate governance
Capacity is the ability to repay the loan together with interest as per the predetermined schedule. A borrower’s capacity depends on two factors: first, the borrower’s financial position should be sound; and second, the borrower must be able to generate sufficient net income to service the loan repayment.
To assess whether the borrower’s financial position is sound, lenders, in the case of personal loans often examine details of assets and liabilities. Also borrowers are required to give details of income and expenditure, and the net surplus available for repayment.
In the case of businesses, lenders usually ask for audited financial statements and projected cash flow to determine the financial soundness or creditworthiness of the business borrower.
Capacity is about the primary source from which repayment is expected to take place. It is important to assess the primary source from the outset Capacity to pay but willingness to pay. Main cause of NPA in banks
Capital refers to the capital contribution that the borrower proposes to make in the total investment. An investment is usually financed partly by bank loan and partly by the capital contribution of the owner. The owner’s contribution is called the owner’s margin. The greater the owners contribution to a project the greater is the lenders confidence in the venture. Banks usually expect at least a 20 – 25% percent input from the borrower.
Collateral is also known as secondary source of repayment. When a loan cannot be paid out of primary source, lenders usually take possession of collateral and dispose of it and use the proceeds to set off the outstanding loan amount. Type of collateral – house/factory/machinery/ bank deposits/shares & debentures Guarantee
QUALITIES OF GOOD SECURITY
Title The price of the security should be stable, or not subject to wide fluctuations. The marketability of the security should be rated good. The security should be easily valued. The security should not deteriorate rapidly over time. If security is quickly transportable or portable, then the lender can sell it in another market. If the security is not portable then, the lender may find it hard to sell that security in the local market. Bogus documents – title deeds
It is hard to find a security that possesses all the above qualities, and a lender is often required to judge an acceptable compromise. Land for example, may have stable value over time but it lacks the quality of portability.
An analysis of conditions covers external and internal factors. It also covers the conditions and terms of the loan. The riskier the advance the stricter are the terms and conditions.
Economy Industry Threat of war Political instability Crime
Cannons of good lending C.a.m.p.a.r.i
Character Ability Margin Purpose Amount Repayment Insurance( security)
Lending policies Lending budget Availability of expert staff to monitor loan. A financial institution may decide to follow restrictive lending policies, the lending budget and the availability of a funds constraint, or to expand lending business in particular segments of the market. Credit analysis should take such
It is virtually impossible to assess an individual’s character just after one meeting. It is an extremely difficult area but vital to get right. Very sujective How reliable is the customer’s word as regards the details of the proposition and the promise repayment. Does the customer make exaggerated claims that are far too optimistic. If the customer is new, why are we being approached? Can bank statements be seen to assess the conduct of the account.
This aspect relates to the borrower’s ability in managing financial affairs and is similar to character as far as personal customers are concerned. Is there a good spread of skill and experience among the management team in, for example,production,marketing and finance. Does the management team hold relevant professional qualifications? Are they committed to making the company successful? Where the finance is earmarked for a specific area of activity, do they have the necessary experience in that area.
Agreement should be reached at the outset with the borrower in respect of interest margin. The interest margin will be a reflection of the risk involved in the lending, while commission and other fees will be determined by the amount and complexity of the work involved.
The lender will want to verify the purpose is acceptable. Customers sometimes overlook problems in their optimism and if the bank can bring a degree of realism to the proposition at the outset, it maybe more beneficial to the customer than agreeing to the requested advance.
Is the customer asking for either too much or too little?. There are dangers in both and it is important therefore to establish that the amount requested is correct and that all incidental expenses have been considered. The good borrower will have allowed for contingencies.
The real risk in lending is to be found in the assessment of the repayment proposals. It is important that the source of repayment is made quite clear at the outset and the lender must establish the degree of certainty that the promised funds will be received. Where the source of repayment is income/cashflow, the lender will need projections to ensure that there are surplus funds to cover repayment after meeting other commitments.
Ideally the canons of good lending should be satisfied irrespective of available security, but security is considered necessary in case the repayment proposals fail to materialise. It is important that no advance is made until security procedures have been completed,or are at least at a stage where completion can take place without the need to involve the
Evaluation A two stage approach
An assessment of the feasibility of the borrower’s plan for repayment. If the proposal in not viable, it is pointless to continue. A critical appraisal of what might realistically go wrong-the likelihood of such events occurring and the effect on the bank’s position. the aim of this evaluation is to establish the risk involved. List the pros and cons of a proposition is often helpful. More reliance should be placed on facts and evidence than on estimates and opinions.
Modern approaches to Credit risk measurement.
The measurement and management of credit risk have undergone a revolution in recent years. The advances in technology have enabled financial engineers to try new methods of model building and analysis for credit risk measurement. Several factors have contributed to this recent surge in technology-based analysis methods.
Increased competition in the loan market necessitated the development of methods that are quicker more accurate and more cost effective. Consumer expectations have increased and most consumers now expect efficient loan approval from financial institutions. Response Time - Where lending institutions have been found to be a bit tardy, consumers have shifted to other institutions.
Loyalty is less and less evident among consumers. Banks now need methods of credit assessment that cater to the changed customer needs. Also in recent years, bankruptcies and global competition have increased, so accurate credit analysis has become more important. The traditional system was based on expert knowledge only, requiring expensive and extensive staff training.
Systematic/Non Systematic risk Credit rating – project/retail/SME etc Pricing Monitoring
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