Professional Documents
Culture Documents
Products,
Operations and
Risk Management
Stage 2
Table of Contents
Parti:
Lending Products 6
Part 3:
Part 4:
Part 6:
Student Learning By the end of this chapter you should be able to:
Outcomes ■ State the role of bankers as lenders
■ State the importance of building a disciplined lending culture
■ State the importance of cash flow lending as opposed to security-based
lending
The modem day banking has undergone massive changes in its basis of
operations over the last 7 centuries to arrive at the structure and form that we
see today. Lending remains a core function of banks as well as its most
profitable product. Product types and variations have, however come into
existence and most importantly the basis of the credit creation, as it is
termed today, is vastly different.
Banks Create Money
Today’s banks create money in the economy by making loans and
investments. The amount of money that banks can lend is directly affected
by the reserve requirement1 of the Central Bank. In this way, money that
grows and flows throughout the economy in a much greater amount than it
physically exists. For example a bank gets a deposit of PKR 1 million from
Customer X. If the reserve requirement is 20% the bank is able to make a
loan out of PKR 800,000. The bank lends the PKR 800,000 to Customer Y
who uses the loan to buy a car and gives the money to Company A as
payment. Company A in turn deposits the money in the bank and the bank
based on Company A’s deposit can make out a loan of PKR 640,000 to its
customer. This is an over-simplified example of how the banks create money
and the money multiplier effect. You are encouraged to independently read
more about this topic as it is of utmost importance in today’s banking world.
This ability to create money and thus be responsible for the increased money
supply through creation of credit in the economy to the extent that the banks
are able to do today is something that ancient bankers did not have to fret
about. Banks today are able to lend several times its total capitalization
which puts on them a much greater responsibility of understanding the credit
they are creating and its recovery cycle.
1
Source: Davies, G. (1994) A History of Money from Ancient Times to the Present
Day, Cardiff, UK, University of Wales Press
2
Source: Dr. Frank Shostak (2011), The Importance of Real Lending, Cobden
Center-http://www.cobdencentre.org/
1
Reserve Requirement-This is imposed by the Central Bank of the country on all
banks in terms of what percentage of the deposits can the bank lend out as loans.
In Pakistan the State Bank has a Cash
Reserve Requirement (CRR) which ha s in the past varied between 4% to 7% and i
Statutory Liquidity Requirement (SLR) which in the past has varied between 10%
to 15%.
Banks today thus play a much wider and a very critical role as they provide
liquidity and steady flow of credit in the economy which fuels growth and
stability.
As lenders, banks have a very important role to play in the economic growth
of the country. Loans made to support activities which will generate income
above and beyond the amount to repay and service that loan are generally
viewed as loans which are beneficial for the economy and the country. The
banks over the past century however have developed a narrower view. Their
agenda is limited to making loans which will be serviced and repaid. Banks
have due to this been subject to criticisms from many who blame it for giving
rise to the increased consumerism.
The effects and impact of lending have been briefly touched upon earlier.
The gravity is nonetheless not lessened by the limited attention that we have
paid to it in this chapter. Banks lending decisions are revered in the
economy as bank lending is a key economic indicator for a specific sector or
industry. If banks are willing to lend their money to a person or a company
or a sector/industry, it reflects the banks confidence in the borrower’s
purpose of loan, ability to repay and intent to repay. Lending decisions are
thus of paramount importance as they are used as key market signals by
other players in the economy such as investors, suppliers, customers etc.
Moreover as banks deal with public monies, the effects of incorrect lending
decisions are far-reaching and can be devastating as witnessed in the recent
global financial crisis of 2007/8.
Each loan that a bank makes creates a ripple of liquidity. Each loan requires
scrutiny and consideration. The fundamental principle to be followed should
be that the loan be employed in a manner that it will generate an income
above and beyond the level which is required to service the loan and repay
the principal. Lenders thus need to assess the purpose of the loan, its
repayment capacity, character and reputation or ‘name’ of the borrower and
in the instance the borrower is unable to pay the loan, how can the lenders
safeguard their interest.
Lenders in the recent times have however expanded their focus on the
purpose of the loan and the repayment capacity with reference to the purpose
of the loan. While having good quality collateral is highly recommended,
banks are in the business of borrowing and lending money and not
liquidating collateral. Liquidating collateral is a lengthy and cumbersome
exercise and not the bank’s core business function. Banks have thus realized
that lending decisions which are transaction- specific and evaluate the
capacity of the borrower based on the cashflow from the
transaction/project/activity that is being financed are sounder than the ones
which only consider the collateral and the borrower ‘name.’ This in no way
stops the lender from requiring good quality collateral or considering the
borrower ‘name.’ Analyzing the cash-flow and repayment capacity however
is being given as much consideration when making the lending decision.
Authored By:
Shahnoor Meghani
Student Learning By the end of this chapter you should be able to:
Outcomes
1. Categories of Borrowers
■Recall the SBP laws relevant to decide the lending limits for
both business and consumer borrowers
* Recall the various types of pricing mechanisms available across the industry
■ Explain the process of developing a pricing model based on floating mark up rate
■ Discuss the pros and cons of using a floating mark up rate as compared to using
fixed rate
■ Explain the concept of opportunity cost, risk reward pricing and re-pricing intervals
Categories of Borrowers
As discussed in the previous chapter, banks as lenders need to inculcate a
disciplined lending environment to avoid making lending mistakes. Before a
loan is made the lending bank should ask the following questions:
a. Who is the potential borrower?
b. Does the potential borrower meet bank’s target market
definition and risk acceptance terms?
c. What is the purpose of borrowing/borrowing cause?
d. Does the borrower’s business/income generate sufficient cash
within a reasonable time period to repay interest and principal?
e. What would be my way out if the cash flows are not sufficient to
ensure repayments of loan?
The list above is not exhaustive and in the next few chapters we will address
these issues in detail. It is important to have awareness of these fundamental
questions as they are key to determining the credit requirement of the
businesses and the repayment capacity.
A bank’s credit customers can be divided in to two broad categories:
a. Business Borrowers
b. Individual/Consumer Borrowers
A. Business Borrowers
Business borrowers repay the principal and interest from cash flows
generated through business operations. Banks generally look at the historic
trend of the business’s financial statements to gauge the sales growth, cash
cycle, stability of orders, productivity of assets, leverage etc to forecast the
future trends for the business based on which a part of the lending decision
relies upon.
Funded Facilities
1. FUNDED FACILITIES:
i. Running Finance/Overdraft
An overdraft generally known as RF in Pakistan is a type of lending
which offers a high degree of flexibility. For a bank, the overdraft is a
staple product by means of which the customer may overdraw their
current account balance, that is, draw out more from the account than
the total amount of money standing in the account. The customer is
permitted to overdraw the account up to an agreed limit (the overdraft
limit). When an account is overdrawn, the customer is borrowing and
owes the bank money. An overdraft is normally shown on the
customer’s bank statement by the abbreviation DR (meaning debtor)
after the balance on the account.
All these facilities are tenor-bound and generally do not allow roll -over.
Detailed information on this can be sought from the SBP website.
Term loans are usually granted over a period of years to assist business
customers in buying assets such as plant and equipment, and buildings. A
term loan spreads the cost of the asset over its expected life. The repayments
can be tailored to suit the cash flow of the business, usually either monthly,
quarterly, half-yearly or annually.
A term loan is a loan for a fixed amount, for an agreed period, and on
specific terms and conditions. Normally such loans are for terms of between
three and seven years, although they can range up to twenty years. Longer
periods depend on the nature of the proposal, the robustness of the
performance of the company and its projections, and the security to be
granted.
Term loans are generally used for longer term asset purchases as these are
not suitable for financing under an overdraft facility, which should be used
for working capital purposes. The terms and conditions under which they are
granted includes interest and other costs, repayment, security and the
covenants applicable. The terms and conditions of the loan are set out in a
loan agreement which includes:
Provided the customer complies with the conditions detailed in the loan
agreement, the bank generally cannot demand repayment of a term loan.
Generally, the longer a loan is outstanding, the greater is the risk of default.
2. NON-FUNDEO FACILITIES:
Sight L/Cs are letters of credit where the bank engages to honor the
beneficiary's sight draft upon presentation, provided that the
documents are in accordance with the
B. Individual Borrowers
Individuals also frequently are in need of funds to pay for expenses or
purchase of assets, which they cannot afford to pay for in cash at the present
time. Situations that typically require borrowing include buying a house or a
car or consumer durables such as refrigerator, television, computer etc or
paying for education or medical expenses or wedding expenses etc. The
individual’s borrowing needs are driven by his/her discretionary spending,
lifestyle and stage of life cycle.
Auto/Vehicle I House
Finance I Finance
Details of the products available for individuals in Pakistan within each sub-
heading are as follows:
i. Auto/Vehicle Finance
In Pakistan auto finance has been a popular product available for
individuals. This product is available through two different modes: Hire
Purchase and Leasing, which are discussed briefly as under. While in
this chapter we are discussing this mode under lending
a. Hire purchase
Hire purchase is an agreement to hire an asset with an option to
purchase. The legal title passes to the customer when final payment has
been made. The term of the finance is required to be shorter than the
expected life of the asset.
The bank actually buys the vehicle which then belongs to it, letting the
customer use the vehicle in return for a series of regular payments. The
vehicle can be of any form. The bank has the security of ownership of
the asset and can repossess it if the hire purchase terms are broken.
After all the payments have been made, the customer becomes the
owner, either automatically or on payment of a modest fee.
b. Leasing
Leasing is similar to hire purchase in that a vehicle or equipment owner
(the lessor) gives the right to use the equipment to the user (the lessee
i.e. the customer) over a period in return for rental payments. The
essential difference is that the lessee never becomes the owner unless
under capital lease.
In both cases, the asset requires to be returned to the lessor at the end of
the agreed period. Many leases have an end-of -lease option providing
renewal at a minimal cost or sale to a third party.
Leasing can be useful when other sources of finance are not available.
There are also tax advantages; for example, rental payments under an
operating lease are tax deductible, as is interest under a finance lease.
The depreciation charge in the company’s accounts for a finance lease is
tax allowable, dependent on the method of depreciation used
• Finance lease
The leasing company expects to recover the full cost of
equipment and interest over the period of the lease. Usually the
lessee has no right of cancellation or termination. Despite the
absence of legal ownership, the lessee bears the costs of
maintenance etc, and suffers if the equipment is under-utilised or
becomes obsolete. Finance leases offer less flexibility for the user
but this is reflected in the cheaper pricing.
House Finance
House purchase loans (normally referred to as mortgages) are a big part of
retail banking business. In the past they were mainly the domain of building
societies. A mortgage loan is a loan to
There is also another type of finance available which is self-build finance for
borrowers who would like to obtain finance to build their own house. Since
there is no one “standard” self-build project, set procedures should ideally be
followed during the life of the loan. Each project should be assessed on its
individual merits. As a result, the principles of lending should be carefully
considered when assessing a self-build application.
By the nature of the project, the funding for this type of borrowing must be
flexible.
The expenditure involved in building the house is then drawn down against
this overdraft. In most instances, repayment of the overdraft will come from
the drawdown of a mortgage once the house has been completed. It is better
to set up the facility on a separate account for ease of monitoring.
The bank will expect the valuer to confirm that there are no restrictions
affecting the site, that outline planning consent is held and that there are no
anticipated problems with any potential development, such as access, supply
of services, etc.
Normally two valuations are required when dealing with a self build:
It is normal practice to allow the customer to draw down on the self -build
loan at the end of each of these stages, formal certification being generally
required from:
• a qualified architect.
• development/cantonment authority inspector, a
structural engineer.
Personal loans are not usually secured and the repayment period
can vary from a few months to several years.
Some personal loans carry automatic life cover and there is also an
option for the customer to purchase accident, sickness and
unemployment insurance. These ensure protection for the customer and
the bank.
The application form is similar to that for a personal loan and the
response data is credit scored. A credit limit is agreed but the bank does
not normally look for security. A separate account is maintained and it
is usual to arrange for the monthly payment to be transferred from an
operative account to the revolving credit account by standing order.
Credit cards are a method of money transmission where the customer has the
option of settling only part of the monthly bill, thereby borrowing the
amount of the unpaid balance. If the customer pays off the outstanding
balance in full prior to the repayment date, no interest is charged and
therefore this is a very cost-effective method of short term borrowing. By
careful timing of their purchases and then repaying the bill in full, the
customer may obtain approximately up to 50 days interest-free credit.
There are currently two dominant groups who operate international networks
- Visa and MasterCard. All the main banks, offer their own versions of either
or both of these cards. There are other companies such as Diners and
Maestro but the market share and reach of these companies is by far the
largest.
Each bank policy may differ, however as per popular practice locally it is not
necessary for a person to maintain an account with the bank before they can
be issued with a credit card. It is initiated by a separate agreement between
the bank and its customer regulating the issue of the credit card and the
debtor/creditor relationship that exists between the parties. In addition, due
to the element of credit involved, the bank will have to be satisfied that the
customer can be considered creditworthy for the amount of their limit. The
customer completes an application form as the basis of the agreement
between them and the bank. The application form also provides the bank
with a great deal of information about the customer, such as employer,
salary, house owner or tenant, marital status, number of children, etc.
To cater to the specialized and dynamic areas of lending the SBP has
following separate sets of PRs geared towards:
• Corporate.
• Commercial/SME and
• Consumer business.
• Agriculture
Some salient features of these regulations are discussed below. You are
encouraged to visit the SBP website and study the up-to-date regulations in
detail.
Prudential Regulations-Corporate
Corporate PRs contain a total of 27 regulations revolving around corporate
business and covering following aspects of credit quality:
• Risk management 13
• Corporate governance 4
• Operations 5
Highlights of most important Risk Management related regulations (PRs)
are:
• Maximum exposure (in outstanding terms) of a bank/DFI to a single
borrower shall not exceed 30% of its equity (fund-based 20%) and to
a group of borrowers 35% (fund-based 30%).
• Total exposure (fund based and/or non funds based) availed by any
borrower not to exceed 10 times of borrower’s equity (fund based
exposure not to exceed 4 times of its equity).
Prudential Regulations-SME
Keeping in view the important role of Small and Medium Enterprises
(SMEs) in the economic development of Pakistan and to facilitate and
encourage the flow of bank credit to this sector, a separate set of Prudential
Regulations specifically for SME sector has been issued by State Bank of
Pakistan. This separate set of regulations, is aimed at encouraging
banks/DFIs to develop new financing techniques and innovative products
which can meet the financial requirements of SME sector and provides a
viable and growing lending outlet for banks/DFIs.
A total of eleven (11) regulations govern banks SME business. Some of the
important ones are discussed as under:
For detailed study of these regulations you are encouraged to read and
assimilate various requirements of different type of consumer financing.
To ensure that bank/DFIs strictly follow the prudential regulations and for
their own regulatory purposes, SBP requires submission of /DFIs various
reports periodically, by the Banks.
Credit Policy
Banks /DFIs must prepare a comprehensive credit policy keeping in view the
PRs set by the State Bank. This credit policy must be approved by the BOD.
It is evident from the details listed above that a credit policy plays a very
important role in lending operations. Without a credit policy it would be
impossible to manage huge lending portfolios. Once a good credit
Pricing of the loan is the markup rate. This markup rate charged has two
components:
2. Variable component.
1. Base component:
This method of calculating the cost of deposit is generally called the internal
cost of funds.
In addition to the funds obtained from its depositors, the bank can also
borrow from other banks including the central bank and the money market.
This borrowing involves a cost which is termed as the Market- based cost of
funds. Market rate indicators such as KIBOR, T-bills, PIBs, REPO and
Reverse REPO rates are generally used as benchmark indicators in the
Pakistan market.
KIBOR stands for Karachi Inter Bank Open-market Rate. It’s the rate of
interest at which banks in Karachi offer to lend money to one another in the
money markets. KIBOR is issued on daily, weekly, monthly and on 1,2 and
3 yearly basis by the State Bank of Pakistan.
REPO and Reverse REPO The discount rate at which a central bank
repurchases government securities from the commercial banks, depending on
the level of money supply it decides to maintain in the country's monetary
system. To temporarily expand the money supply, the central bank decreases
repo rates. To contract the money supply it increases the repo rates.
Alternatively, the central bank decides on a desired level of money supply
and lets the market determine the appropriate repo rate. Repo is short for
repossession.
A reverse repo is simply the same repurchase agreement from the buyer's
viewpoint, not the seller's. Hence, the seller executing the transaction would
describe it as a "repo", while the buyer in the same transaction would
describe it a "reverse repo". So "repo" and "reverse repo" are exactly the
same kind of transaction, just described from opposite viewpoints. The term
"reverse repo and sale" is commonly used to describe the creation of a short
position in a debt instrument where the buyer in the repo transaction
immediately sells the security provided by the seller on the open market. On
the settlement date of the repo, the buyer acquires the relevant security on the
open market and delivers it to the seller. In such a short transaction the seller
is wagering that the relevant security will decline in value between the date
of the repo and the settlement date.
2. Variable component:
The variable component of the markup rate is the spread that banks keep on
top of their base component or cost of funds when lending to customers. The
size of the spread generally depends on three factors:
3. The bank’s balance sheet mix and its need for deposit or loans at a
given point in time.
For banks the cost of doing business with the corporate / wholesale customer
is lower compared to consumer / retail customer. For example handing out a
loan of 100 million to one corporate customer costs less in terms of
administrative, legal, processing and servicing cost then than handing out a
total loan of PKR 100 million but split between to 100 different retail
customers.
The rate for such a credit will usually be referred to as a spread or margin
over the base rate: for example, a five-year loan may be priced at six- month
KIBOR + 2.50%. At the end of each six-month period, the rate for the
following period will be based on the KIBOR at that point, plus the spread.
Re-pricing interval The re-pricing interval measures the period from the date
the loan is made until it first may be re-priced. For floating-rate loans that are
subject to re-pricing at any time the re-pricing interval is zero. For floating
rate loans that have a scheduled re-pricing interval, the interval measures the
number of days between the date the loan is made and the date on which it is
next scheduled to re-price. For loans, having rates that remain fixed until the
loan matures (fixed-rate loans) the interval measures the number of days
between the date the loan is made and the date on which it matures. Loans
that re-price daily are assumed to re-price on the business day after they are
made.
Fixed rate on the other hand does not fluctuate during the fixed rate period.
This allows the borrower to accurately predict their future payments.
For an individual or a company taking out a loan when rates are low, a fixed
rate loan would allow the borrower to "lock in" the low rates and not be
concerned with interest rate spikes. On the other hand, if interest rates are
high at the time of the loan, the borrower will benefit from a floating rate
loan, because if the prime rate falls, the rate on the loan would decrease. The
opposite is true for the lender. The lender would not like to be stuck in a low
fixed rate lending contract if interest rates are rising, as his cost of funds will
rise. Bankers thus keep a large margin when lending at a fixed rate and do a
thorough analysis of the interest rate behavior to ensure that they do not bind
themselves to a lending contract which may become unfavorable in the
future.
Risk-based pricing in the simplest terms, is alignment of loan pridag with the
expected loan risk. It is a manifestation of the risk reward concerc- higher
the risk, higher the reward; in this case higher the risk, higher the price of
credit i.e. mark-up. Typically, a borrower’s credit risk is used tz> determine
Risk reward pricing is the ratio used by lenders to compare the expected
returns of a loan to the amount of risk undertaken to capture these returns.
This ratio is calculated mathematically by dividing the amount of profit the
lender expects to have made when the position is closed (i.e. the reward) by
the amount he or she stands to lose if price moves in the unexpected
direction (i.e. the risk).
The higher the risk the greater is the reward. In consumer banking the spread
is very large, the pricing is based on the whole portfolio and the
administrative cost is very high therefore the risk is high. Whereas in
corporate banking, the individual loan is priced therefore the risk is low.
Relationship yield pricing is pricing the credit based on the overal customer
relationship rather than on a stand-alone product basis. Fo example if the
customer has taken a loan from the bank, chances are h would also route his
collections and payments through the bank as wel Sometimes a loan is an
initiator of a larger relationship with the customs therefore it is the
relationship manager’s responsibility to not just sell loan to the customer but
build further relationship with customer t cross-selling other products. Since
other products generally have a low risk involved as compared to loans,
profitability of the customer to t! bank on a holistic level compared to the
risk involved will be high when the customer is using other products of the
bank.
For example, Haji Kareem Bakhsh & Co banks with the National Bank of
Pakistan (NBP). They are in the business of plastic bottles manufacturing. At
the moment they have a long term loan of Rs. lOOMillion with the bank at 1
year KIBOR + 2.5% p.a. NBP hosts their 200 employee accounts and also
provides payroll management services. Similarly, their collections account is
also being maintained at NBP. Last month the company imported machinery
from Japan worth $50,000 for which an LC of the required amount was also
opened by NBP in their name. The LC pricing is 0.1% which the customer is
refusing to pay on the pretext that it has such extensive business with the
bank. Moreover, the customer has requested a short-term financing- FIM for
a period of 30 days for which the customer insists that it will only pay 1
month KIBOR +0.5% on this transaction. On a stand-alone basis this
transaction will not make any money for the bank and there is risk involved.
It is important to evaluate the revenue of the entire relationship as well as the
impact on the relationship before deciding to open the LC or decline it.
Taking another example, where Mr. Ahmed Saad has a HBL credit card with
Compiled from:
Credit Lending Module and
Specialized Lending Book-One of
Chartered Bankers Institute and
Contribution by: Mr. Akbar Chugtai
Introduction: The State Bank of Pakistan defines financial risk in the following manner:
“Financial risk in a banking organization is possibility that the outcome of
an action or event could bring up adverse impacts. Such outcomes could
either result in a direct loss of earnings / capital or may result in imposition
of constraints on bank’s ability to meet its business objectives. Such
constraints pose a risk as these could hinder a bank's ability to conduct its
ongoing business or to take benefit of opportunities to enhance its business.”
Until and unless risks are not assessed and measured prudently it will not be
possible to control risks. Hence the process of risk evaluation, the need to
monitor effectively all the areas that may give rise to possible risky
situations, becomes extremely important. Further a true assessment of risk
gives management a clear view of institution’s standing and helps in
deciding future action plan. To adequately capture institutions risk exposure,
risk measurement should represent aggregate exposure of institution both
risk type and business line and encompass short run as well as long run
impact on institution. To the maximum possible extent institutions should
establish systems / models that quantify their risk profile, however, in some
risk categories such as operational risk, quantification is quite difficult and
complex. Wherever it is not possible to quantify risks, qualitative measures
should be adopted to capture those risks. Whilst quantitative measurement
systems support effective decisionmaking, better measurement does not
obviate the need for well-informed, qualitative judgment.
Risk Management
As a process, Risk management has the following five steps, which include:
1) Risk Identification.
2) Risk Measurement.
3) Monitoring and Reporting.
4) Mitigation and Control.
5) Optimization.
Risk Assessment
Risk assessment process goes further deep to analyze the causes of risks,
their identification, description, estimation, evaluation and their relevant
mitigation strategies.
Corporate Governance:
In every financial institution, risk management activities broadly take place
simultaneously at following different hierarchy levels:
To be effective, the concern and tone for risk management must start at the
top. While the overall responsibility of risk management rests with the BOD,
it is the duty of senior management to transform strategic direction set by
board in the shape of policies and procedures and to institute an effective
hierarchy to execute and implement those policies. To ensure that the
policies are consistent with the risk tolerances of shareholders the same
should be approved from board.
Senior management has to ensure that these policies are embedded in the
culture of organization. Only the formulation of policies would not solve the
purpose unless these are clear and communicated down the line. Risk
tolerances relating to quantifiable risks are generally communicated as limits
or sub-limits to those who accept risks on behalf of organization. However
not all risks are quantifiable. Qualitative risk measures could be
communicated as guidelines and inferred from management business
decisions.
Risks must not be viewed and assessed in isolation, not only because a single
transaction might have a number of risks but also one type of risk can trigger
other risks. Since interaction of various risks could result in diminution or
enhancement, the risk management process should recognize and reflect risk
interactions in all business activities as appropriate. While assessing and
managing risk, the management should have an overall view of risks the
institution is exposed to. This requires having a structure in place to look at
risk interrelationships across the organization.
In every banking organization there are people who are dedicated to risk
management activities, such as risk review, internal audit etc. It must not be
construed that risk management is something to be performed by a few
individuals or a department. Business lines are equally responsible for the
risks they are taking. Because line personnel, more than anyone else,
understand the risks of the business, such a lack of accountability can lead to
problems.
Risk Evaluation/Measurement
Independent review
Contingency planning
There are various types/ sources of risks that impact the lending decisions.
Under Basel II these risks have been categorized into the below mentioned
categories. Basel II, is the second Basel Accord and represents
recommendations by bank supervisors and central bankers from the 13
countries making up the Basel Committee on Banking Supervision to revise
the international standards for measuring the adequacy of a bank's capital. It
was created to promote greater consistency in the way banks and banking
regulators approach risk management across national borders.(For details on
Basel II and its application in Pakistan please refer to Appendix 3).
1. Credit Risk
Credit risk is considered as the highest form of risk; it includes default risk
and multi-faceted liquidity risk. It is defined as a risk that borrowers may not
be able to fulfill their obligations (whether funded or non- funded) towards
the bank/DFI on time in full or contracted, resulting in a financial loss to the
lender. Credit exposure risk also incorporates in itself‘rating migration risk’
caused by the change in credit quality (rating) of the borrower and
consequently affecting default probability.
2. Liquidity risk
Liquidity risk is the risk that a bank/DFI may not be able to meet its financial
commitments to customers (depositors) and market (interbank market).
Liquidity risk may emerge as a result of the mismatch of assets and liabilities
or structured products. Another facet of liquidity risk is contingency liquidity
risk i.e. risk of not being able to meet contractual obligations due to
insufficient funds.
3. Market Risk
Market risk is defined as the risk that an asset cannot be sold at a (near) fair
value due to market disruption or impaired market access. Market risk
highlights the risk of losses on and off balance sheet positions arising from
(adverse) movements in the market prices or in other words exposure to
potential loss that would result from changes in the market price. Market risk
measurement is carried out by considering the underlying factors that
determine the price of market sensitive instruments. Such factors could be:
a. Equity Risk
A bank/DFI investments in stock market (shares) may become
vulnerable to losses if share prices and dividend yields there on
plunge due to market fluctuations.
4. Operational risk
Counter party risk is the risk that counterparty fails to honor its part of
contractual obligation while a bank/DFI has already met its commitment
e. g. a bank/DFI sold dollars forward to a counter party for a period of say
90 days. On 89th day (one day before maturity of the contract as that the
counterparty gets dollars on 90th day) Bank/DFI issues instructions to its
foreign depository bank to credit/Counter party account with dollars. On
90th day the counterparty is unable to deliver agreed amount of Pak Rupees
to the Bank/DFI.
Risk Rating
The obligor rating must be oriented to the risk of borrower default. Separate
exposures to the same borrower must be assigned to the same borrower
grade, irrespective of any differences in the nature of each specific
transaction. There are two exceptions to this. Firstly, in the case of country
transfer risk, where a bank may assign different borrower grades depending
on whether the facility is denominated in local or foreign currency.
Secondly, when the treatment of associated guarantees to a facility may be
reflected in an adjusted borrower grade. In either case, separate exposures
may result in multiple grades for the same borrower. Guarantor’s rating may
also be assigned to the borrower if there is an absolute guarantee and in case
of default the bank has 100% recourse on the guarantor.
Basel II requires the risk ratings to be carried out at an obligor level, spread
over a scale of one (1) to twelve (12), one (1) rating being the highest
quality risk and twelve (12) being the best equivalent to adversely classify as
loss. (Refer Appendix 3).
1. Price each obligor- higher the risk rating of an obligor, steeper the
risk will be.
The facility rating must be oriented to the loss severity of principal and/or
interest on any exposure. A Bank/DFI may have extended to a single counter
party a number of credit facilities against different collaterals, having
different priority rules and legal recourse to the recovery in case of default.
The Banks should consider relevant transactions specific facts, based on the
type of facility and collateral, while assigning the facility rating. This process
may result in different facility ratings to the same entity. The banks are
required to calculate and report loss severity of each facility provided to the
borrowers.
(Refer Appendix 3B).
Compiled from:
Credit Lending Module and
Specialized Lending Book-One of
Chartered Bankers Institute and
Contribution by: Mr. Akbar Chugtai
We shall see how to consider the character and capability of the person being
lent to and how a business proposal is analyzed - the important point being
the ability, or otherwise, of the borrower to repay. The reasons why a
business wants to borrow is an important part of the analysis of any lending
proposal from a customer.
If you were to look at a bank’s balance sheet you would see that the amount
of share capital, or shareholders’ funds, is quite small in relation to the loans
granted to customers (assets in a bank’s balance sheet). It is the share capital
in the balance sheet which is the buffer, or safety cushion, that protects the
creditors of the business, including the bank. All this capital must have been
lost before the creditors suffer through not being paid in full.
A bank’s main creditors are the people who deposit their money with it. If
these depositors are to be assured of getting their money back, the bank’s
assets, which mainly include loans to customers, need to be worth their full
balance sheet value. Thus banks need to ensure that the loans they grant are
safe and can be repaid by customers, otherwise the safety buffer of capital
will be quickly eroded. Hence it is important for a banker to possess sound
lending judgement.
Lending out deposited funds remains core to the banking industry. The rate
of interest charged to borrowers is always greater than that paid to
depositors. The difference is the bank’s margin. However, if the borrower is
unable to repay the advance, the bank will not only lose
The lending of money is not an exact science; it is not possible to work out
some formula or apply a certain theory to guarantee that the amount lent to
the customer will be repaid with interest. For lending to businesses, except
the smallest ones, there is no computer program that will accept business data
at one end and produce the correct lending decision at the other. The spectrum
of lending situations is too varied to accommodate a straightforward
numerical solution. After gathering the information, you require to analyze
your findings and make a sound lending decision. The general principles of
good lending, or canons of lending, if consistently applied with a structured
analytical approach and sound judgement, will reduce the risk involved in
lending to the customer.
To help remember the fundamental principles, mnemonics can be used to
ensure a uniform and consistent approach. Here are a few common examples:
CAMPARI= Character Ability Margin Purpose Amount
Repayment Insurance (Security)
CAMELS = Capital
Asset Quality
Management
Earnings
Liquidity
System
• People/Character.
• Purpose/Amount.
• Repayment capability/Terms.
• Security.
• Remuneration/Margin.
We shall examine each of these elements in turn and in some detail, but
before we start, here are three brief case studies; a more complex one is
included at the end of the chapter.
The following customers would like the bank to lend them money for
business purposes.
Case study
Mr Ahsan
Aged 44, he has been running his own engineering business for the last
10 years. He has banked with you since his business started and is
seeking an extension to his overdraft facility.
Mrs Khan
Aged 38, she is a housewife who is starting a new business in catering.
She has been a customer of the bank for the last 15 years.
Mr Asad
Aged 18, he has recently left college and wants a loan to
start a business washing cars. No previous bank account.
These customers, or potential customers, are all seeking loans, but will you
agree to lend to them?
People/Character
It is, of course, people who make things happen. While all of the above key
components are critical in assessing the viability of a proposal, if the
individuals involved are found wanting in major aspects, then there is little
scope for manoeuvre and to carry the proposition forward.
Remember too that banking relationships are based on mutual trust and
respect, both of which have to be earned. Openness, cooperation and honesty
are important. It is in this climate that the customer should be willing to
provide all the information that the bank reasonably requests in order to
assess the safety of the proposed lending and the customer’s ability to repay.
Some potential customers will make a direct approach to you but more
usually you will require a level of proactivity, which will not be achieved
from sitting behind a desk. Your job as a business banker or credit analyst
includes much more than just making credit decisions. You need to identify
and contact customers whom you wish to add to your portfolio. The quicker
you can assess the customer and their needs, structure a proposal that is
appropriate to both your customer and the bank, the greater the level of
success you will enjoy.
How long have they been a customer of the bank? If less than say
six months, you may wish to find out their prior history. What is
their reputation and track record?
Have accounts been maintained in a satisfactory manner with
previous borrowing repaid on time? (The pattern of lodgements into
the account will give you more information.) Are there regular
lodgements to the account?
Are there any charges applied in respect of unauthorized
overdrafts?
• Is there any evidence of items having to be returned unpaid for lack
of funds?
• What are the figures for turnover (the business’s sales), the
maximum balance on the account, and the minimum and average
balance figures over the last three years?
Let us now suppose that the meeting is with someone who does not at
present do business with you. You may have asked for the meeting to try to
gain their business, or they may have requested the meeting, having heard
positive comments about your efficient, friendly and
If an account is being transferred from another bank, you will want to know
why this is happening. It could be that the customer is unhappy about poor
service, high charges or the location of their current bank, providing you
with an opportunity to promote what your bank can offer. Equally, you must
be aware that the proposition being put to you may have already been
declined by their existing bank or that they are seeking an alternative
quotation for comparison purposes regarding pricing, etc. You would not
want to step lightly into another bank’s shoes and then find that there are
serious financial and management problems with the business.
• age.
• qualifications and experience.
• financial acumen.
• integrity and reliability, organizational
ability and efficiency.
You want to know whether the borrower has thought out their business
proposition fully and whether they have the drive and ability to see it
through to a successful conclusion. Many people in business have no formal
qualifications, but unless such qualifications are essential to the successful
operation of the business, relevant experience is often more important.
Essential questions:
• Can the customer keep within any borrowing limit agreed?
• Does the customer know quantity of sales to make a profit?
• If goods are sold at a certain price, do they know how much it has
cost to produce them and does this price also cover all the
overheads and result in a profit?
Having acquired the basic information on the people involved in running the
business and formed an opinion on their abilities; you now need to think
about the business itself. From your existing knowledge of different business
structures, you will establish quickly whether the business is a sole trader, a
partnership or a limited company. The success of a business is inextricably
bound up with the drive and ability of the people running it.
Essential questions:
• Do they relate well to each other?
• Can they identify and agree common goals and objectives?
• Can they work together as a team to achieve those goals?
Obviously, you only wish to deal with people who are respectable and
trustworthy. After all, there are many ways in which a borrower can take
unfair advantage of a bank once they have the money. We want our
customers to be honest, dependable and people of high integrity. Whether
your proposed borrower meets these criteria is a key judgment area.
As business grows it is important to review the key areas to ensure that there
is the appropriate knowledge and ability for the business to prosper. It is
especially important for you to keep informed of the customer’s overall
business strategy:
This may seem like stating the obvious, but some businesses have been
known to founder due to personality clashes or individuals being unable to
agree on the way ahead. Provided you are satisfied that there is commonality
amongst the individuals in question, you should be in a position to determine
which of the above characteristics apply to the business. However, this is
only a part of the total picture.
Management
This topic has already been covered above, but as a business grows it is
important to review the key areas to ensure that there is the appropriate
knowledge and ability for the business to prosper.
Succession planning
The personal problems that can arise in the above scenario. How do
you choose which one of your family is to succeed you when it is
obvious that the business cannot support everyone but they have all
indicated a desire to become involved? An example of this could be
a farming business where expansion could present a potential
solution but the cost implications present questionable viability.
Staff
When considering the quality and ability of the human resources available,
the following checklist will help:
• Recognition/reward schemes.
• Staff morale/turnover.
• Commitment.
• Under-/over-staffed.
Labour relations.
Dependency on specialist skills - easily recruited/replaced
• Training issues.
Service
How aware is the business of its standing in the market place and
what does it do to sustain/improve its position?
• How does it handle/research the following areas?
- Track service performance: assess gaps between
customer expectations and perception.
- Do they have an understanding of customer expectations
both current and future, within their industry?
- Gauge effectiveness to any changes that are introduced to
the manner in which they deliver their service.
- Identify high performing staff members/teams - reward and
recognition.
- Complaints: do they try to recover the situation?
Market
• Does the business rely on one supplier or obtain raw materials from
a range of suppliers?
Who are the customers and what is the potential for
expansion?
Where is the business placed in the supply chain?
Premises
Technology
Competition
Industry/business sector
Emerging industries tend to grow very fast. They are either new to
the market or have been revitalized by customer demand,
technology or changes to the cost base that have reestablished
viability. Growth is usually in excess of 20 per cent per annum and
can be as high as 100 per cent. But these can also be higher risk (for
example, the “dot.com” boom and bust in the technology industry
around 2000).
Cost structure
A fixed cost is one that will remain constant whether or not the sales in a
business are rising or falling, for example repayments on a loan.
You should also be aware of factors which may be applicable to the business
but are outside their control such as changes in taxation, interest rates and
exchange rates.
Economic conditions
Social issues
Profitability
• What is the industry’s record of profit and how does this compare
with the business you are assessing?
• How are profits generated used? Are they reinvested in the business
or are they paid out as dividends or bonuses to directors?
Legal issues
Political issues
Expediency
You may already have come across situations where the lending manager
has granted loan facilities in other than normal cirunnstances. This is often
done for reasons of expediency, because it is
Case study
This is a judgment call that very much carries a “health warning”. If the
business proposal in the above scenario was seen to be completely unviable
and you were considering lending solely against security, then you may be
faced with some difficult decisions. Ever conscious of not breaching
confidentiality, you would certainly need to ensure that the father sought
appropriate legal advice and was fully aware of his liability. The father may
be guiding and assisting in the background and, through his own business
acumen, is well aware of the deficiencies and risks. However, if this is not
the case, you may wish to highlight diplomatically your areas of concern to
the son or daughter and actively encourage them to seek their father’s input,
together with agreement (if appropriate) to an open meeting with all parties.
Fundamentally you want to convey that you are not only acting in their best
interests, but also their father’s as guarantor, as well as the bank’s.
Do the proposals meet lending criteria? Obviously, the purpose of the loan
has to be legal and within the lending criteria, or guidelines, set out by your
bank. It is unlikely that any customer is going to be so blatant as to tell you
that they want the money for an illegal or unsuitable purpose, but you must
be aware that such things can happen and that it is the bank’s reputation
which is at risk should you lend money to a customer liable to participate in
such activities. However, even if the purpose of the loan is legal, you may
not be in a position to lend if the proposals do not meet the following
criteria:
The starting point to any lending decision is: why does the customer require
to borrow? This is the first specific assessment you need to make after
considering whether the request is legal and within your bank’s own policy.
All requests from customers for credit fall into any one or more of the
following seven borrowing requirements:
Remember, customers may require borrowing for more than one purpose; for
example, to finance both debtors and stock. It is up to you to differentiate
and account for how much requires to be financed for each component.
Knowing what you are financing brings you closer to understanding your
customer’s business and its needs. This is fundamental to good relationship
management.
Trading cycle 1
CASH
STOCK
Business plans
issist in
sample Repayment capability /Terms
pport a
ing to a In any loan agreement the customer must be able to repay the loan in the
agreed time span. The customer must therefore be able to show, based on
historical information and, more importantly, with projected figures, that the
business can meet interest payments and repay the loan, with an adequate
ad they margin in case of the unexpected. There is no point in too much optimism; the
schedule of loan repayments must be realistic and achievable.
ched to We have seen how important it is for the strength of the bank’s balance sheet
ty than that its loans (assets) realize their full value - that is, the loans are repaid
ig to an according to their terms. It is these repayments and the interest earned that
ure the creates the bank’s profit.
creased
Obviously the term of the advance is crucial; the longer the loan term, the
smaller the capital repayments need to be each year. If a term loan is being
negotiated for the purchase of a fixed asset, it is prudent to make sure that the
loan is paid off during the life of the asset. It is also a sound principle to
remember that the longer the period of the loan, the greater the risk of
something happening that will increase the risk of it not being repaid.
ing that
luse the
orrower
iuch the
iks they
mes the
•nee Book 1 Standing: Products, Operations and Risk Management | Reference Book 1 65
In the case of an overdraft facility agreed to provide working capital, however,
you will expect to see healthy fluctuations in the borrowing as the cash flows
through the trading (or working capital) cycle from the purchase of raw
materials to the collection of cash from debtors. With this type of lending, the
amount borrowed should fluctuate up and down as the cash flows through the
business.
Projected, or budgeted, figures for income and expenditure and profit
projections will form the basis of your assessment. Only once you have gone
through each of these, and considered all the principles of lending, will you be
able to give an answer to the customer.
Cash flow analysis
From what you have read so far you will have realized that cash flow analysis
and the ongoing monitoring of cash flow are key elements in credit and
lending. You should bear in mind that cash flow is crucial when discussing the
repayment of bank facilities and the period over which the loan is repaid, its
term.
Type/period of the loan
When you have established that the proposals are viable - that the business
can make the proposed interest and loan repayments - then you work with
your customer to determine the loan facility that best matches their needs.
For capital expenditure, we have seen that term of the loan facility should
normally tie in with the expected life of the asset being purchased. You will
also need to take into account any extra finance needed for working capital to
support the higher levels of debtors and stock during the working capital
cycle. Often the purpose of new investment in fixed assets is to increase
production and hence sales. These additional sales require to be financed in
order to cover the increased level of stock and debtors. Thus it may be
appropriate to divide the total facility you provide into an overdraft for
working capital which will fluctuate, and a term loan on which there is the
discipline of fixed repayments.
Each bank has its own range of lending products (including lternatives such as
asset finance through for example, hire purchase) and you should research this
in your own business unit.
Security
Although it is true that any proposition should be able to stand on its own
without the need for security, the bank will most likely wish to safeguard itself
against unforeseen circumstances or risk by seeking acceptable security.
Running a business is full of risks. Nobody can guarantee that the business
will be a success. Taking security not only protects the bank but also the
customer. Remember also that the bank is lending out its depositors’ money
and needs to get it back in order to repay those depositors when they want
their money.
Taking security over business premises, for instance, provides protection for
the customer if they have personal liability as a sole trader, partner or if there
is a guarantor for the loan. Security arrangements are included in the loan
agreement between the bank and the customer. Should the terms of the
agreement be breached, the loan usually becomes repayable on demand,
giving the bank the power to seek repayment and look to its security, although
more usually the bank will renegotiate the terms of the loan. Provided the
customer
It is always prudent to allow a margin for cover with the security taken (this
means obtaining more security than the amount of the loan). The reason for
ow seeking a margin of cover is a very prudent one; should the borrower fail to
► keep up with repayments and the security needs to be sold, then it may not
in fetch the value attached to it when the loan was granted. For example, the
:ial
value of stocks and shares can fluctuate markedly and we have seen how the
ver
value of property can also fall in times of recession.
vide
s a
sole
urit
y•nee Book 1 Standing: Products, Operations and Risk Management | Reference Book 1 67
:ban
k :d,
the
pow
er
lly
the
tom
er
• the difference between the interest rates charged to borrowers and
that paid to depositors.
• loan arrangement fees.
• charges for the services provided by the bank, such as night safe
facilities, etc.
• Commission and payments received from outside agencies for
referring clients, such as insurance commission.
It is crucial that the pricing of a loan facility reflects the risk being taken by
the bank. This is a key principle - the higher the risk, the greater must be the
reward. This link between risk and reward is fundamental in finance. It is not
unreasonable for the bank to charge a higher rate of interest when it considers
that the risks are higher with a particular loan. Similarly, a lower rate of
interest may be applied to a fully secured loan to a customer with a strong
performance track record.
Many banks now adopt a matrix-type system to reflect the above scenario and
either guide or determine the pricing of a loan proposal. A simple example
might be a chart where the security value is given a rating and then cross
referenced against an appropriate interest charge.
Each bank has its own pricing policies and you should research what is the
practice in your own organization.
At the time of writing, financial services regulators are examining the level of
capital that a bank requires to hold to cover its credit and market risks. Higher
levels of capital are sure to be required and this will bring increased pressure
for adequate remuneration from bank lending and other services.
We’ll now go back to the three original applicants and apply the principles
we’ve just discussed to their individual circumstances.
Case study
Mr Ahsan
Mrs Khan
She is looking for a loan to improve her kitchen to the standard required
by environmental health so that she can prepare food for resale at home.
She does not want a home improvement loan as she does not want to
offer her home as security, but she can offer stocks and shares to the
value of Rs. 1,000,000 as security against
Mr-Asad
Conclusion
The key issue is how you communicate this to the customer. Done properly it
can sometimes strengthen your relationship with customers, demonstrating an
appreciation that you have saved them from “digging a financial hole” that
they would struggle to climb out of.
Equally there will be those who will steadfastly refuse to see where you are
coming from, even when their accountant supports your view. In such cases,
all you can do is thank them for the opportunity to support their business, pass
on your regrets and recommend that they make alternative arrangements.
All banks have their own method of having loans approved and you should
become thoroughly familiar with how this is done in your own organization.
Even if you are not at present an account manager
Adapted from:
Credit Lending Module and
Specialized Lending Book-
One of Chartered Banker
Institute.
You will most likely have studied accounting earlier in your career and feel
comfortable with its concepts and the contents of the financial statements. To
refresh your memory of the format and layout of accounts, however, set out
below are the accounts of Khan Ltd, an electrical retailer.
Khan Ltd.
Trading, Profit and Loss Account for the year
ended 31 December 2009
Rs. Rs, Rs.
Turnover 1,530,000
Less Cost of Sales
Stock at 1 Jan 2009 210,000
Add Purchases Less Stock at 920,000 1,130,000
31 Dec 2009 GROSS PROFIT 252,000 878.000
652.000
Administration Expenses
ent | Reference Book 1 Products, Operations and Risk Management | Reference Book 1 71
Directors’ Remuneration 60,000 270,000
Auditors’ Remuneration 8,000
Salaries and Wages 110,000
Expenses 66,000
Motor Vehicle Costs:
Admin 16,000
Depreciation:
Motor Vehicles 6,000
Machinery 4,000 236,000 506,000
Distribution Expenses 146,000
Salaries 120,000
Expenses 60,000 24,000
Motor Vehicle costs:
Distribution 42,000
Depreciation:
Motor Vehicles 8,000
Machinery 6,000
Other Operating Income
Rent Receivable
170,000
Interest Payable
Loans repayable within 5 years 1,000
Loans repayable after 5 years 3,000 4,000
Profit on Ordinary Activities before Tax 166,000
Taxation 50,000
Profit on Ordinary Activities after tax 116,000
Unappropriated profit b/f 110,000
226,000
Ordinary Dividend 60,000
Unappropriated profit c/f Rs. 166,000
This account is produced for the company’s own uses. The main object of a
trading account is to calculate the gross profit. To remind you of the
definitions:
Sales is the turnover, or revenue (the total value of goods sold) by the
business.
Gross profit is simply the profit the business has made on buying and then
selling goods, i.e. on trading.
Companies have more information than they are required to put into the
documents that they file with the Registrar of Companies. Our second
example is in the “published” format.
1,000 A Note to the Financial Statements gives the cost of sales, and breaks down net
>,000 operating expenses into distribution costs and administrative expenses. It also
snows other operating income (for example, rent received) which has been
netted with the above costs and expenses to give the net operating expense
1,000 shown in the filed profit and loss account. Other Notes to the accounts show a
>,000 statement which reconciles movements of reserves and the movement of
),000 shareholders’ funds. You will recall that retained profits are classed as reserves.
>,000 To complete the set, here is the Balance Sheet.
),000
Khan Ltd.
>,000 Balance Sheet as at 31 December 2009
6,000
goods or
’ salaries 60,000 Rs. 266,000
rence Book 1 Lending: Products, Operations and Risk Management | Reference Book 1 73
This is a fair view of the company’s business within the reporting period. It
must be a balanced and comprehensive analysis of the development and
performance of the company with a description of the principal risks. This
applies to all companies, except those that file small company accounts.
Balance Sheet
The first thing to say about a balance sheet is that it is produced “as at” a
specific date. It is a summary, or “snapshot”, of the business’s financial
position on that date.
Balance sheets can be categorized into those which are audited and those
which are unaudited. Not all companies have to have their accounts audited,
that is, verified for accuracy by someone outside the business. The
requirement is determined by the level of the sales turnover in the financial
year which is determined by the government.
From a lending manager’s point of view, audited accounts are better than
unaudited, but even here two questions can be raised:
ip; it is a Branch:
particular ................................................... Cus
ip-to-date tomer’s Name: ........................... As at As at As at
Proprietors’ Funds
Capital ......... ..................
Reserves ......... ..................
P & L Account ......... ..................
(Less) Intangible Assets (........ ) ( ............... ) ( ....... )
Trading Results
For period to ......... ..........
Rs 000s Rs 000s Rs 000s
Sales ......... ..........
Purchases ......... ..........
Other Cost of Sales ......... ..........
Overheads ......... ..........
Interest Charges ......... ..........
Total ........ ..........
Net Profit before tax ......... ...........
Ratios
As at As at As at
Date
Capital Adequacy Leverage =
Interest Coverage Working
Capital Liquid Ratio
Operating Ratio
Stock Turnover Raw Materials
Stock Turnover Finished Goods
Credit Allowed
Credit Received
Gross Profit %
Net Profit %
ROCE %
3,233,750
21,862,179
25,095,929
There are no ideal ratios and not all ratios are relevant to a particular
industry. You will hopefully have access to information on industry
averages which tend to include all businesses producing accounts, ranging
from sole proprietors to public limited companies. Your own organization’s
standard form for financial analysis will show the set of ratios being used.
Types of ratios
• Profitability ratios.
Financial ratios are designed to show both the long term and the short term
financial position of a business. The main ratios are for capital adequacy and
working capital, or the current ratio (as it is also known). If either of these
ratios produces an unsatisfactory result, it may be necessary to produce
further ratios to delve more deeply.
Intangibles are those assets in the balance sheet which only have a value if
the business can be sold as a going concern. Goodwill is an example. As a
prudent assessment of risk, therefore, it is better to exclude such items from
calculations. If the firm fails, there is no goodwill.
The capital adequacy ratio is calculated to show how much money the
owners have in the business. Although there is no one percentage figure
which suits all businesses, the higher this figure, the more protection there is
for lenders should things go wrong.
Case study
ings:
M Khan pic
iness The directors of M Khan pic, manufacturers of knitting wools, are due to
meet you to discuss their financial requirements for the coming year. The
following figures have been extracted from their accounts for the last three
years.
short 20X1 20X2 20X3
ipital Rs.00,000s Rs.00,000s Rs.00,000s
Dwn)
. lit, it
Fixed (or Non-current) assets
:eply.
Goodwill 85 65 45
Premises 625 625 625
Plant 530 615 700
Total Fixed Assets 1,240 1,305 1,370
Current assets
lave a
I is an
ter to : Stock (or Inventories) 330 360 380
is no Debtors (or Receivables) 375 405 420
Cash - - -
Total Current Assets 705 765 800
:s”, or
leet. Total Assets 1,945 2,070 2,170
iey
the Current Liabilities
:ntage
more Bank borrowing (or Borrowings) 50 50 50
•nee Book 1 Standing: Products, Operations and Risk Management | Reference Book 1 79
Creditors (or Payables) 60 100 140
Current tax payable 150 185 210
Proposed dividend (Provisions) 60 70 85
Borrowings:
7% Debentures 200 200 200
10% Unsecured Loan Stock 400 400 400
adequacy
To calculate the capital adequacy ratios for M Khan pic, we take the balance
sheet figures for Shareholder Equity (also called Proprietors’ Funds, or
Capital & Reserves) and deduct goodwill, which is also deducted from the
total assets denominator of the calculation.
Ideally you are looking for a figure in excess of 50%, but this is not always
possible, and where the figure is below 50%, it is essential to calculate:
Some banks calculate this ratio using total debt, instead of medium and long-
term borrowings. You should enquire about your own bank’s practice.
This shows the number of times the interest payments can be met out of
current profits. Again, any changes to this ratio should be investigated before
loan agreements are renewed. A deterioration in
Liquidity
Liquidity means the availability of cash to meet the needs of the business.
This involves managing the firm’s trading cycle through the conversion of
sales to the collection of cash for those sales. Liquidity covers the prudent
management of the flow of funds through the business. One analogy is to say
that if the wheels of business are oiled by cash flow, then the cash budget
gauges how much oil is left in the can at any time. In any lending situation it
is very useful to understand the importance of liquidity and how it is
controlled.
A key measure of liquidity is the:
This ratio tells us how much current asset cover there is for each Rs. 1 of
liabilities. It gives an indication of the ability of a business to pay its short
term debts (the creditors, bank overdraft, etc) as they fall due without having
to resort to selling any fixed assets. You would expect to see a higher ratio in
a manufacturing business than in a retail business to reflect the length of time
it takes for cash to flow into the business.
However, this is not a ratio which you should view in isolation. Included
within the ratio, in the current assets, could be a great deal of stock and so
you might want to check how the stock was valued at the year end. One way
round this is to look at how this ratio changes over a period of years. If the
pattern is consistent and stock is valued on the same basis each year, there is
unlikely to be anything untoward; the trend is more important than one year’s
ratio as it highlights the need to further investigate variances in performance.
Even if you are happy with the current ratio (and in M Khan‘s case it is
falling), it is prudent to take your examination of liquidity a stage further and
calculate another ratio that strips out the stock. This ratio is known by several
names: the liquid ratio, the quick ratio, the liquid asset ratio, or the acid test
ratio. This further ratio may reveal that an apparently comfortable current
ratio is misleading in terms of extinguishing current liabilities because of the
high proportion of stock in the current assets. Stock is the current asset least
easily turned into cash - the least liquid current asset.
Stock will of course include the figures for raw materials, work-in- progress,
and finished goods which are sometimes shown separately in the balance
sheet.
The usefulness of this ratio may depend on the proportion of stock in the
current assets.
It is worth restating the importance of trend analysis and also how to interpret
the results. A current ratio of 2.0 may look satisfactory, but we need to
consider the industry norm within that sector, that is, consider the figure for
the business against its peer group in the same industry.
Case study
Suppose the 2006 current ratio of a business was 0.45 and for
2007 it was 0.56.
Is this good or bad, strong or weak? Does it make you feel relaxed or
uncomfortable?
The case study illustrates how easy it is to form the wrong impression by
purely viewing the ratio in isolation without taking account of the trends or
the industry sector. A retailer, of course, usually receives cash for its sales
before having to pay its suppliers, and can therefore safely operate with a
lower current ratio due to its strong cash generation.
When we look at the current ratio for M Khan, we see that this ratio too is
falling. Without selling all their stock, M Khan pic cannot pay off all their
debts. They may well need to seek an increase in their overdraft facilities, and
at that point you would have to decide whether or not to do so and increase
the risk to the bank. However, as we have seen, the current ratio is only one
of a number of ratios to calculate and it requires to be viewed in the broader
context.
Profitability ratios
When examining the profitability of the business there are three ratios to
consider:
It is not easy for a business to significantly increase this gross profit margin
and a declining margin would be a concern. Most business people keep a
very close watch on this margin and you should too.
Example
The return on the share capital here is 50%. However, the true
return on capital invested by the shareholders and directors is in fact
20%, adding the directors’ loans to the ordinary share capital figure.
(Note: The return would be slightly higher than this assuming that
the loan carried a fixed rate of return but, even so, the difference is
too great to be ignored.)
In the profitability ratios we use Net Profit before Tax figures. This means
that we are using the same basis each year for calculations. If we use the after
tax profit this would involve having to make adjustments for changes in tax
rates in order to make the proper comparisons.
It cannot be emphasized enough that you can only compare ratios if they are
all calculated on the same basis. Consistent methodology of calculation is
essential - you need to compare “apples with apples”.
We now turn to the operating and activity ratios which measure how
efficiently a business is being run - how well it has used its resources.
Operating/activity ratios
For the most part, the method of calculating these ratios is:
It is not always possible to obtain figures for all the fixed costs of the
business. In these circumstances the ratios used can be the expenses to sales.
For example, add together the Distribution Costs and the Administration
Expenses shown in the Income Statement (Profit & Loss Account) and
express them as a percentage of Sales. These two costs can also be expressed
as a percentage of sales individually.
Breakeven ratio
Fixed costs
Gross margin %
Before completing this calculation, the fixed costs and gross margin figures
need to be examined to find out what has been included. The results can be
distorted if certain figures have been wrongly designated. For example, in an
industry such as clothing manufacture where there is a high level of
piecework (work paid for according to the quantity produced) this should be
included in the calculation of the gross margin but can often be added to
employees’ wages which are a fixed cost. You may be left with little
alternative but to make an estimate, particularly when dealing with a sales
force who earn a basic salary (fixed cost) plus a bonus or commission based
on volume sales (gross margin). To produce as robust and meaningful figure
as possible from this calculation, you must try to identify all costs which
relate directly to production. Gross Margin is Gross Profit divided by Sales
and expressed as a percentage.
The best way to calculate average stock if you don’t have the figures for the
cost of goods sold and purchases is:
Opening stock + Closing stock 2
This calculates the number of times stock turns over. To calculate the number
of days’ stock on hand, divide stock by the cost of goods sold and multiply by
365.
As long as there has been no change to the accounting policies for
stockholding, then the figure should be consistent from one year to the next,
allowing us to make some comments on the efficiency of the business. An
increased stock turnover figure shows stock is being turned over more
quickly and indicates greater efficiency.
Generally, an increasing stock turnover shows that sales are rising, which
should be reflected in increased profits, but it could also be caused by a
change in stockholding policy. For example, if a firm in the past always held
two months’ stock in hand, we would expect to find a stock turnover for the
year of approximately 6. Change the stockholding to one month and stock
turnover rises to 12. Such a decision would be beneficial to the firm in one
major respect - less money tied up in stocks would lower costs and increase
liquidity. This would have to be balanced against the risk of running out of
stock more frequently which could result in loss of sales greater than the cost
savings made by reducing stock levels.
The debtors and creditors ratios
These two ratios go together. In the first, we are looking at how long a period
of credit is given to customers of the business (its debtors). In the second, we
are looking to see how much time is given to the business by its suppliers
(creditors) before their bills need to be paid. Ideally, both ratios should work
out at the same figure, but very often this is not the case. The formula for
calculating each is similar:
Debtors 365 Creditors 365
x x
Credit sales 1 Credit purchases 1
If sales are not split into credit and cash sales, then the credit sales figure is
not given separately. In these circumstances, it is common to use the total
sales figure, if possible applying your knowledge or research of the type of
business you are dealing with to make some assessment of the likely amount
dealt with on credit. In the case of purchases (in the creditors ratio), it is
common to use the cost of goods sold or the total purchases figure in the
calculation.
The starting point for compiling the cash flow report is the earnings of the
business. Earnings are profits. The accounts for a business are compiled
using accrual accounting principles. This means that cash for the income and
the expenditure may not actually have been received or paid out during the
financial period of the accounts.
A number of accounting practices allow businesses to decide when income
and expenses can be recognized; for example, sales in a business in one
sector may be booked in the profit and loss account when the goods are
delivered, or in another industry it might be more appropriate to book the sale
when the invoice is issued.
To understand how the income and expenditure are completed and applied
you need to read the notes to the accounts. Remember that “accrual
profits/earnings” can fluctuate; for example, sales may go up or down
because of the economy or as a result of demand for the product or service,
costs may rise or fall, etc. These fluctuations affect the firm’s ability to
service (meet the interest payments) and reduce its loans.
Carrying out any type of financial analysis is usually done over a minimum
of three years’ figures and noting the trends.
Measurements commonly used by banks and the wider financial market to
assess the ability of customers to service and repay debt include:
Earnings before Interest and Tax (EBIT).
Earnings before Interest, Tax and Amortization (EBITA).
• Earnings before Interest, Tax, Amortization and Depreciation
(EBITDA).
Operating cash flow.
Here is the profit and loss account we will use to compile the first part of the
cash flow report:
We shall complete the figures for 2009 and then later you will
• add Depreciation
• add Amortization (but remember the caveat mentioned above
and also how it applies to depreciation - if you look at the
balance sheet following you will see it is amortization of
patents - so it is acceptable to add this back).
Net Assets:
vidends
deed in (Total Assets - Total Liabilities) 65,700 75,500 88,000
Shareholders’ Funds 10,000 10,000 10,000
on and Share capital Profit and loss 55,700 65,500 78,000
account
•nee Book 1 Standing: Products, Operations and Risk Management | Reference Book 1 91
How to calculate cash from operations:
To calculate the 2009 values for Stock, Debtors and Creditors, we take their
2008 balance sheet values less their 2009 balance sheet values. You will
need to remember that:
This can be summarized as follows and you should refer to this throughout
this and future exercises until you completely understand the concept:
Let us test this concept before we proceed with the 2009 cash flow by taking
the balance sheet per month of a newspaper vendor. It is quite a simple
example as there are no previous values and these are expressed as a nil
value.
Assets Liabilities
Debtors 50,000 Opening Capital Cash 24,500
34,500 Net profit 60,000
Less Drawings ( 0)
Closing Capital 84.500
Total Assets 84,500 84.500
Total Liabilities
Month 0 Debtors Less Month 1 Debtors Changes
0 in
Debtors are a “use” of funds (50,000) 50,000
At the end of the first month’s trading, Rs. 50,000 of profits had been tied up
to fund new debtors.
We now return to the changes in the 2008 and 2009 balance sheets in the
example above in this chapter. Here are the figures we are going to use and
they have been extracted to make the calculation easier. First we establish if
the change is a source or a (use) of funds:
Now it is the simple matter of inserting the figures into the cash flow report,
adding down from EBITDA and taking into account all the changes in
Stock, Debtors and Creditors to arrive at a figure for “Cash from
Operations”.
dividends.
capital expenditure.
You may be wondering why we bother to add back these figures (tax,
interest, dividends, etc) only to deduct them later in the calculation.
The reasons are:
• It is easier to analyze the figures this way to show how much is
available to fund debt repayment.
Year-on-year trends can be detected much more quickly.
The figures added back are calculated using accrual accounting
principles and we need to convert them to a cash basis.
• Any surplus (i.e. a positive figure) will go into cash. If the resultant
figure is negative, this means the business has had to borrow funds
(invariably from you as the banker, generally on overdraft) or the
shareholders may decide to inject more cash as capital into the
business to fund the shortfall or deficit.
This part of the explanation is to set the scene for other calculations that we
are going to perform, but before leaving cash from operations it is useful to
carry out an analysis which, after all, is one of the reasons you do the
calculation.
We can see that:
EBITDA is positive - always a good sign; if year on year it is
negative, the business, if not already in trouble, it soon will be.
• Stock and Debtors are using up (Rs. 30,700,000) of the EBITDA -
you should check that the trend in the Stock or Trade Debtors Days
On Hand ratios is not moving adversely (i.e. increasing) This may
indicate that the business is carrying too much stock for its own
customers’ requirements, or obsolete stock, or that there may be
slow -paying debtors, or a significant bad debt.
It is only because of the trade creditors’ support (providing an
extra Rs. 34,800,000) that cash from operations is positive. You
need to be sure that the customer is not taking longer to pay their
creditors than the agreed period. You can detect this by referring to
Trade Creditor Days On Hand ratio.
At this stage you will begin to see the overlap with ratio analysis and some
of the reasons for favorable or adverse movements in these critical ratios.
Die to pay; The next important figure to be established is how much tax was paid in
cash. While a business may declare in the income statement the amount of
corporation tax due on the profits for that year, it is only by including the
balance sheet current liability figure that we can see how much cash tax has
been-paid.
The way in which this is calculated is straightforward. We start with the
these figures opening current liability value for the corporation tax due. In our customer’s
i later in the case the cash flow we are calculating is for the period to 31 March 2009,
thus we need the opening value as at 1 April 2008. The closing balances at
31 March 2008 will be the opening balance on 1 April 2008, so the figures
are:
Rs. 000s
) show how Opening corporation tax at 1 April 2008 Rs. 13,000
add corporation tax declared per the profit and loss account 2009 Rs. 6,700
less closing corporation tax at 31 March 2009 (Rs. 17,100)
tickly. Cash corporation tax paid Rs. 2,600
ng accrual t Before inserting this figure into the cash flow report and moving on to the
them to a next calculation, there is a question to be asked: why if the customer has
declared Rs. 6,700,000 of tax due have they paid Rs.
2,600,0 tax in cash? The simple explanation is that they should have paid
cash. If the at least the previous tax on profits declared of Rs. 100,000 as shown in the
less has had 2008 profit and loss account. We insert the tax paid in cash.
he banker, ly
decide to to Cash Flow Report for the year ending 31 March:
fund the Rs.
000s
2009
alculations 1
operations Retained Earnings add back:
‘the reasons
Interest Expenses Depreciation Amortization Tax
EBITDA
Changes in:
Stock
Trade Debtors Trade Creditors Cash from Operations
Taxation Paid
Cash from Operations and after tax
9,800
6,000
1,500
an year it is
it soon will 600
6,700
>00) of the 24,600
le Stock or g
adversely (25,500)
msiness is (5,200)
stomers’ tay
be slow 34,800
28,700
(2,600)
(providing
rations is 26,100
ner is not
:ed period,
irference
DaysBook
On 1 Products, Operations and Risk Management | Reference Book 1 95
aalysis and
ts in these
Rs. 000s
(6,000)
(2,000)
(8,000)
Now we are going to calculate the cash values for the following lines in the
cash flow report to arrive at a figure for cash after finance, tax and capital
expenditure. This involves calculating figures for:
1. Dividend paid
2. Capital Expenditure
Dividend paid in cash
Dividends are calculated using the same formula we used for taxation paid:
The conclusion is that no dividends have been paid in terms of cash during
2009. This is proved by:
the profit and loss account for 2009 showing zero for Dividends
Declared.
Thus thinking about capital expenditure in this way when carrying out an
analysis of the cash flow will allow you to distinguish between what has
been “maintenance” and what has been “discretionary” capital expenditure.
You should note that depreciation is often shown as net of gains or losses
on the sale of fixed assets. Think of:
The easiest way to think about this calculation for 2009 is:
Take the opening Net Tangible Fixed Assets (i.e. last year’s closing, 2008)
If depreciation for this year (2009) was deducted per the profit and loss account Rs. 60,200,000
o the net tangible Fixed Assets for the
Rs. (1,500,000)
end of 2009 should be Rs. 58,700,000
But the Net Tangible Fixed Assets for the
So why is there the difference? The answer has to be that the bus' has
bought more fixed assets during the year and the capi expenditure has been
(Rs. 3,300,000) during 2009.
This is simply the change between 2008 and 2009 of the long term debt:
ti the CPLTD and change in long term debt are part of the normal debt
IT repayment schedule; this should not change significantly unless the
agreed term of repayment was varied at the customer’s request.
f'
In conclusion, when you have compiled the cash flow report, you then need
to tie in your assessment of these financials to the ratio analysis. What you
need to assess is the sustainability of any year-on- year deficits and the overall
m impact on your customer’s ability to continue to trade.
Lending covenants
Now that term loans are commonly being written for periods of up to 10 years
- for some customers there are longer periods - lending covenants are
commonly used by banks at most levels of this lending. There is a “time risk”
for banks - the term loan is committing the bank to continue lending over many
years, albeit on a reducing balance basis. The increased risk comes from the
fact that repayment of the loan is being spread over a number of trading and
economic cycles. No one can predict the future - the further time goes on, the
less accurate the projections are likely to be and therefore the harder it is for
the lender to maintain the level of risk at what it was at the outset.
Covenants are formal agreements made at the time the loan is negotiated. The
bank has agreed to the loan on the basis of its assessment of risk and wishes to
ensure that that risk does not increase during the period of the loan. It thus
negotiates with the customer to abide by certain financial measures (for
example, ratios covering capital adequacy, gearing and interest cover) and
provide information (for example, management accounts). The covenants may
impose restrictions on the business, like not allowing it to grant security to any
other party.
- Audited accounts.
•nee Book 1 Standing: Products, Operations and Risk Management | Reference Book 1 101
- Management accounts.
- Aged lists of debtors and creditors.
- Professional valuations of security.
Lending covenants are thus a means of seeking a review of the facility where
conditions which were an integral part of the original credit decision have
changed. The bank has agreed to accept a certain level of risk when it granted
the loan, and negotiated an appropriate rate of interest. The covenants are
designed to keep the risk at the same level during the currency of the loan.
The review following a breach of covenants could lead to any one of the
following:
It is important that you do not try to cover every risk - there are some risks you
cannot assess or foresee, so you need to concentrate on the known and crucial
risks in the loan. Risk can be managed, but it can rarely be eliminated
completely.
Lending covenants have to be negotiated with the customer and you may not
be able to get all the covenants you wish, but this may be compensated for by a
higher rate of interest or additional security or asset cover. A small number of
focused and specific risk-based covenants is what is required. Lending
covenants need to be tailored and structured to meet the needs and risks of the
individual proposal from the customer.
Part of the skill of being a banker is to work out with the customer the
appropriate financing to meet their needs. How do we assess these needs? This
skill, when applied properly, will not only help the customer, it will also ensure
that the correct bank product is used, and a satisfied customer is the best
advertisement for your ability. You are more likely to attract new business if
you have satisfied customers. We want existing customers to continue to do
business with us and to do more of their business with us. We want potential
customers to wish to do business with us.
Case study
M. Abdullah
After introductions and the usual pleasantries, the situation at the meeting
develops as follows:
M Abdullah: I’ve come in this morning to ask you for some money - in fact
I’m looking for one of your overdrafts.
M Abdullah: You bankers hand out overdrafts, don’t you? I’ve never had
one before but I would like one now! Lots of my business
friends have got overdrafts so how about it! What do I
have to sign?
Already you will have gathered that we have here a highly successful
business customer who knows the business of the meat trade from A-Z, but
has never had reason to borrow to,support his previous expansion.
M Abdullah: Well, Mr Khan, what I’m looking for is one of your overdrafts
for Rs. 80,000. You know my shops alone are worth over
Rs. 500,000 so that should be no bother for you, should it?
Oh, by the way, please call me Muhammad.
M Abdullah: I really have little idea, Asad! But I promise you I will clear
the overdraft as soon as possible. I don’t want to pay
overdraft interest for one day longer than necessary.
You’ll have to explain. Do you provide other kinds of loans apart from
overdrafts?
We’ll have to discuss this further and have a review of your last
A Khan: three years’ audited accounts. Apart from our normal lending
assessment, this will also help us to work with you in determining
the loan facility that best meets your needs. However, at this stage,
based on the information I already have, I am sure you could cope
comfortably with a term loan of Rs. 80,000 repayable over, say, 8
years.
No problems, I’m sure, but why are you suggesting a term loan
rather than an overdraft?
M Abdullah:
Various reasons, Muhammad. For a start, if I provided you with an
overdraft facility of Rs. 80,000, this would be operated through
your ordinary business current account. As you know, all your
A Khan:
normal bank transactions are dealt with through that account -
lodgments from your daily shop sales and the many cheques you have to issue
each month. The level of the overdraft therefore would fluctuate all the time,
and although there might be some benefit gained on the amount of interest
payable, it is really quite difficult to monitor the systematic repayment of the
borrowing.
With a term loan, this is taken on a separate account and the only transactions
through the account, once the initial advance has been taken, are quarterly
interest charges and the repayments which will be
M Abdullah: Given that I bank my takings every day, monthly sounds fine.
A Khan: I would agree with you. The rate we would propose to charge you
will be fixed at the outset and will not alter during the
period of the loan. Again this is useful to you when working
on your outgoings over the next few years.
M Abdullah: One of my business pals told me that if a bank sees fit, it can
call on a customer who has an overdraft, to repay it on
demand. Is this correct, and if so, does it also apply to a
term loan?
At this stage you can’t progress matters further. Your customer hasn’t
brought any audited accounts with him and you should advise him of what
you need in support.
leasing/asset finance.
• invoice discounting/factoring.
We studied cash flow reports earlier. Now we are going to see how we use
them. You may already have studied the concept of cash flow forecasting
where a cash budget or cash flow forecast is a projection of receipts and
payments of liquid funds. When a customer asks for facilities for a new
business we usually seek a cash flow projection over the first twelve months
of the business’s life. However, it is useful to assess how the budgeted
receipts and payments will look over a longer period. In most new
businesses the first twelve months are a growth period. It is possible that in
this period the income and expenditure may not be representative of what
could become a more normal pattern of trade. Looking at the second twelve
months will give you a better picture of the business’s prospects. It is normal
for the figures to be given on a month-to-month basis.
You may often be asked to agree overdraft facilities for customers based on
their cash flow projections. If you do not know how cash budgets are
prepared, you will not be able to make a sound judgment based on the
projections. You may also be faced with customers who have little idea of
what you mean by a cash budget, let alone how they go about putting one
together, and they will look to you for advice. This could give you a
problem, at least in the first few years of your account manager role.
You can only offer limited advice and suggestions on how they might go
about completing a cash flow. Customers can of course seek the input of
their accountant, and this is desirable. Although this will incur a cost to the
business, it is worth highlighting that the preparation of cash flow
projections is not just to “ keep the bank happy”; used properly, it is a key
management technique for monitoring and controlling the business. If the
cash flow is already
We are now going to look at a case study to make it easier for you to
understand what cash flow forecasts are all about. We have already seen
earlier what a cash flow report looks like. In this case study we shall see
detailed cash flow forecasts.
Case study
"Underground"
A new customer has brought you a business plan for a sports club called
“Underground”. Here is the cash flow and some details of the story behind it.
Business Details
The club has a capacity of 400 and it is anticipated that it will attract around
300 paying clubbers on a Friday and Saturday and also around 200 on an
average Sunday. Admission charges for each evening will be Rs.300. On the
other evenings the club will be available for private hire at a cost of Rs.
15,000 per evening. It is anticipated that two evenings per week will be
taken up this way. The average attendance at private functions is anticipated
at 200.
As regards expenditure, the normal gross profit margin expected from bar
sales is 50%, with a 40% margin on sales of food. The bulk of staff involved
will be employed on a part-time basis except for:
Canteen Manager.
Office Secretary.
Resident DJs (2).
Cleaners (2).
There will be 10 part-time staff employed each evening the club is open.
*The wage bill for part-time staff has been calculated on 10 staff @ Rs. 3000
per night x 5 nights x 52 weeks.
Other costs are based on experience in operating a bar and from information
supplied from other clubs operating in other towns.
The ratable value of the club is Rs. 1,500,000 giving a present rates bill of
Rs.1,620,000.
All the revenue figures have been calculated on a conservative basis,
whereas costs have been estimated on a high basis in order to show how
secure the venture is. It is anticipated that profit margins on bar/canteen sales
You have not been given details of the actual loan proposal. The interest rate
used here is considerably higher than we now have and some of the income
and many of the costs will now appear low. However, this does not really
matter for the purpose of this exercise, which is to illustrate cash flow
monitoring.
Cash Flow Forecast - January December '00s
Month/ No. Jan Feb Mar Apr May Jun Jul Aug Oct Nov Dec Total
of wks
Income
(4) (4) (5) (4) (5) (4) (4) (5)
$ (4) (4) (5)
Bar Sale 24000 24000 30000 24000 3000 24000 24000 30000 24000 24000 24000 30000 312000
Food Sale 4800 4800 6000 4800 0
6000 4800 4800 6000 4800 4800 4800 6000 62400
Entrance Free 9600 9600 12000 9600 1200 9600 9600 12000 9600 9600 9600 12000 124800
Private Hires 1200 1200 1500 1200 0
1500 1200 1200 1500 1200 1200 1200 1500 15600
Total 39600 39600 49500 39600 4950 39600 39600 49500 39600 39600 39600 49500 514800
0
Bar Sale 12000 12000 1500 1200 1500 1200 12000 15000 12000 1200 12000 15000 156000
0 0 0 0 0
Food Sale 2880 2880 3600 2880 3600 2880 2880 3600 2880 2880 2880 3600 37440
Salaries 10625 10625 1062 1062 1062 1062 1062 1062 10625 1062 1062 10625 127500
5 5 5 5 5 5 5 5
Rates 1350 1350 1350 1350 1350 1350 1350 1350 1350 1350 1350 1350 16200
Insurances 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 12000
Heat & Light 500 500 500 500 500 500 500 500 500 500 500 500 6000
Repairs &
Maintenance 300 300 300 300 300 300 300 300 300 300 300 300 3600
Postage &
Stationery 100 100 100 100 100 100 100 100 100 100 100 100 1200
Telephone 200 200 200 200 200 200 200 200 200 200 200 200 2400
Travel & Motor
Expenses 150 150 150 150 150 150 150 150 150 150 150 150 1800
Advertising 750 750 750 750 750 750 750 750 750 750 750 750 9000
Professional Fee 200 200 200 200 200 200 200 200 200 200 200 200 2400
Licences 200 200 200 200 200 200 200 200 200 200 200 200 2400
CDs/ Records 200 200 200 200 200 200 200 200 200 200 200 200 2400
Security 200 200 200 200 200 200 200 200 200 200 200 200 2400
Cleaning 500 500 500 500 500 500 500 500 500 500 500 500 6000
Bank Charges 100 100 100 100 100 100 100 100 100 100 100 100 1200
Ln Repayment3000 3000 3000 3000 3000 3000 3000 3000 3000 3000 3000 3000 36000
Loan Interest 3400 3400 3400 3400 3400 3400 3400 3400 3400 3400 3400 3400 40800
VAT 9351 9351 9351 9351 37404
Total 37655 3765 50726 3765 41375 47006 37655 41375 47006 37655 37655 50726 504144 1
5 5
Monthy/ Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total
No. of Wks (4) (4) (5) (4) (5) (4) (4) (5) (4) (4) (4) (5)
Income less
Expenditure 1945 1945 -1126 1945 8125 - 1945 8125 -7406 1945 1945 - 10656
7406 1226
Opening Bank Balance
1945 3890 2664 4609 12734 5328 7273 15398 7992 9937 11882
Closing Bank
Balance 1945 3890 2664 4609 12734 5328 7273 15398 7992 9937 11882 10656
Taking the amounts given we can examine the cash flow in detail to see how
the figures have been arrived at. On the income side we can double check the
entries from the figures that came from the business plan and are quoted
above.
For example, bar sales are estimated at Rs. 500 per person. With attendances
of 800 customers at the weekend and 400 during the week, this comes to:
Rs. 120,000 x Rs. 500 x 4 weeks = Rs. 2,400,000 per month
11400 12000
Bar Sales
11400
12000 15000
Food
14250 39000 37050
2822 2880
Sales 28802822 3600
Salaries 10625 3528 9360 9173
10891 10625
Rates 10891 10625
1350 10891 31875 32672
1384 1350
Insurances1384
1000 Heat1350& 1384 4050 4151
1025 1000
light 500 Repairs & 1000
1025 1025 3000 3075
513 500
Maintenance513300 Postage
500 513 1500 1538
308 &300 308 300 308 900 923
Stationery 100
103 Telephone
100 200 Travel 100
103 & 103 300 308
Motor Expenses 150
205 200
Advertising205 200
750 205 600 615
154 Professional
150 154 Fees 150200 154 450 461
Licences 200
769 750
CDs/ 769
Records 750
200 769 2250 2306
205 200
Security 205 200
200 205 600 615
205 200
Cleaning 205 200
500 205 600 615
205 200 Charges
Bank 205 100 200 Ln 205 600 615
205 200
Repayment 2053000 Loan
200 205 600 615
513 500 3400
Interest 513 500 513 1500 1538
103 100 103 100 103 300 308
3000 3000 3000 3000 3000 9000 9000
3485 3400 3485 3400 3485 10200 10455
Closing Bank
Balance 1945 293 3890 586 2664 -2381
The first thing you might have looked at is the figures at the bottom of the
page - the closing bank balance at the end of each month compared to the
budgeted figures. You immediately see that the cash flows are not as good as
predicted and that by the end of the third month when VAT has to be paid
there is a negative balance of Rs. 238,100 compared with a budgeted surplus
of Rs. 266,400 - the pendulum seems to have swung completely the other
way. It is necessary therefore to examine the cash flows more closely in an
attempt to identify the reason for this variance.
The initial cash flow showed no requirement for overdraft facilities - this is a
cash business. Now an overdraft is required, if only to allow the VAT bill to
be paid. Is there security available to cover this? If the loan to buy the
business was a large one, it is unlikely that there is any available security
cover for overdraft facilities as well.
There are other concerns. If it looks as if the club is not going to pay its way,
there is no point in lending more money to it. This might only give the bank
a greater debt to try to collect in the future - if it can be collected at all.
What we need to do here is closely examine the actual figures in the cash
flow both on the income and expenditure side to see if we can identify any
particular area where either income or costs have been well out of line with
the budget. This being the case, it may be possible to discuss how to bring
them back into line.
The income side
There is no significant difference here. We can see that all areas are not quite
up to budget. Remembering that the figures were based on forecast
attendances, they are in fact out by less than 5%. This is not a great deal and,
in most circumstances, if a business could produce a cash flow at the start of
an enterprise with this degree of accuracy, you would be quite pleased with
it. However, the signs are there to be watched - income is not as good as
planned. Will it get better or will it get worse?
The expenditure side
Again there is nothing on the expenditure side which stands out as being
well outside what was planned. The total is in fact down by Rs. 16,000.
However, this hides a number of cost increases and, in reality, if all costs had
been controlled to their predicted amounts, then total expenditure in January
and February should have been lower by Rs. 65,800 and by Rs. 82,200 in
March. This is because bar and food costs are related to their sales figures. If
these sales change on the income side, there should also be a change on the
expenditure side
This is a point worth remembering and when presented with a cash flow
which has this type of relationship. You should always ensure
Adapted from:
Credit Lending Module and
Specialized Lending Book-
One of Chartered Banker
Institute.
All lending involves risk. It is the banker’s duty to assess and manage these
risks, deciding which risks to accept and which to reject. Management of
risk is at the core of banking. All bankers need to be risk aware and have
sound skills in risk management.
Risk analysis and You will recall that we have already defined risk as: “the possibility of
assessment incurring a misfortune or a loss”. The risks are the same in
business/commercial units of banks as we explored in relation to retail units,
only at a higher level, with a slightly different focus. We are still seeking to
assess the likelihood of the identified risk happening, its impact on the
customer and thus trying to prevent or reduce a bad debt provision, loss and
write off. As you will recall, losses and write -offs are a charge against the
bank’s profits and thus reduce shareholder value.
• Past due 90 days - where loan payments are in arrears for more than
90 days or where the account has been in excess of its limit for more
than 90 days.
If you have not properly identified the risks in a credit, or recognised the
warning signs as you monitor the loan, then it could move directly to the
third or fourth category above. Normally, this would prompt some sort of
internal investigation. Bankers generally do not like surprises, which is why
it is important to watch out for deteriorating trends and other warning signs.
To see the effect of bad debt we can use the following example: a Rs.
100,000 provision or write off, for a bank with a 3% profit margin before
loan provisions, means that new “good high quality” lending of Rs. 3.3m has
to be written to replace the loss. Hence the reason for careful risk
management.
Credit risk management covers a very wide range of topics and you need to
undertake it logically and conscientiously, breaking it down into its
constituent parts in order to be effective.
You could also visualise this output as the reading of a temperature gauge -
low, medium and high. If the temperature is low you should not get burnt. If
the temperature is high, you have to be very careful how you deal with this
high risk, otherwise you could suffer a very painful experience. When the
pain starts, no one else will want to take on the risk - the only way would be
if they receive something else in return, such as you sell your debt to them at
a discount.
Once this initial appraisal has been completed, you need to consider your
customer’s position relative to the industry of which it is part. This should
The first area we are going to look at is the condition of the economy in
which our customer operates and sells its products. There are various
economic measures that you will already be familiar with; for example,
employment rates, inflation levels (as measured by the Consumer Price
Index or the Retail Price Index), cost of raw materials used in the
production process (as measured by industry indices such as
manufacturing output statistics, retail sales, energy prices, industry
surveys, etc.
Your own bank’s economic department will provide updates regularly on not
just Pakistan’s economy, but other major countries, and this assistance can be
invaluable.
To help you arrive at your assessment of the economy, the following matrix
has been developed. You can use a circle or a highlighter pen to show
whether the risk is low, moderate or high.
The term “economic condition” relates to both the foreign and domestic
markets in which the business is active.
Low risk
This applies where there is stable or slow growth in the economy. The
business conditions show little or only slight changes in employment rates or
selling prices or the costs of production.
Moderate risk
This applies where there is rapid growth or moderate levels of inflation in the
economy. Economic upturn is evidenced by swift improvement in
employment rates, selling prices, wages or the other costs of production, or
all spending increases relative to the available supply of goods and services.
High risk
■ Scale of seasonality
Some industries have equal levels of sales and production and some do
Some industries will have stable levels of production for most of the year and
then will experience a surge in activity to meet a seasonal demand. For
example, a chocolate manufacturer will have level sales throughout the year,
apart from in the run up to Christmas when they produce say, selection
boxes, Valentine’s Day when boxes of chocolate are in demand, and then
prior to Eid, when Eidi baskets are in demand. The rest of the year from May
to October, demand will be stable.
Seasonality applies to any business, especially those that are subject to trend,
the inconsistent demands of the consumer, or what was in fashion suddenly
becomes obsolete.
Again we use a template to asses and establish the level of the industry’s
exposure to seasonal sales.
Income in one quarter accounts for more than 50% of the total income for a
year during a trading year.
You are likely to lend mainly to businesses that are cyclical. There is
absolutely nothing wrong with that - you just need to understand the risk. For
example, if you have a customer that is part of an industry that is classed as
“leading or preceding cyclicality” and who requires to borrow more from
your bank at a time of rising interest rates and unemployment levels, you
need to consider whether the need to borrow more is due to the onset of an
economic recession rather than funding growth. As long as you understand
the risk and what is the underlying borrowing cause, you can proceed.
You may have experienced management who have successfully managed
previous economic recessions and a business that is well capitalised. It may
be a comfort that economists are predicting a “short” recession, but you do
not know if this will be correct. Economies can move swiftly from boom to
bust. You just have to be aware of your customer's particular kind of
cyclicality pattern.
The industry cycle moves in a converse pattern to that of the economy and
therefore is regarded as being counter-cyclical.
The industry cycle moves parallel with that of the economy and is regarded
as being concurrent; or the industry cycle precedes economic recovery or
slowdown and is regarded as leading the economy; or the industry cycle
follows with a time gap any economic recovery or slowdown and is regarded
as lagging.
■ Industry profitability
We will use the net margin % (NM%) to measure this risk. Net margin can be
calculated as net profit before tax (NPBT) to sales, or net profit after tax
(NPAT) to sales. Depending on the economic statistics available for an
industry, this will determine which version of the ratio you will use; both
have advantages and disadvantages.
• there are different tax rates applicable which depend on the size of
■ Industry profitability
Each of these five forces are broken down into specific elements; for
example, degree of rivalry includes industry product cycle, overcapacity in
the market, cost structure, etc.
The first area that Porter considers is the degree of rivalry in the industry. In
theory, intense competition amongst businesses operating in the same
industry should drive profits to zero as demand and supply meets
equilibrium. In practice, some businesses will perform better than rivals and
will earn profits above the average for the industry.
unng The logical conclusion is there may be some businesses that are incurring
losses. Part of this analysis is to identify the “good”, “the not so good” and
the “bad”. To do this there are a number areas to be considered under the
“degree of rivalry”.
Here you are analysing at what stage the industry’s products or services are
in their development:
• Mature products or services - they are fairly standard and have been
ods and established for some time with little in the way of technological
actuate innovation that will have an impact.
Maturing products or services - this is the pre-mature stage, where some
changes in design are still seen where demand continues to grow.
Emerging or declining demand in products or services - this type of
across all
product in an industry poses a risk higher than those that are considered
pposed to
to be mature or maturing. They are either yet to become established or
has been
well known in the market place (and subject generally to major design
•fits
innovations) or they are declining and have fallen or are falling out of
within
fashion.
looking at
imponent
s
rence Book 1 Lending: Products, Operations and Risk Management | Reference Book 1 125
For example, standard products, commodities such as coal or steel or basic
foodstuffs (milk, eggs, etc) will have greater rivalry in the market place, there
will be some oversupply, and profits will be low; whereas products that can
be differentiated will face less rivalry and generate potentially higher profits.
industry status
risk
Products or services are fairly standard, there is a degree of oversupply in the
market, real prices are falling, and lower profits are being seen. The industry
is generally considered to be mature.
Moderate risk
The market for the products or services continues to grow and improvements
to design are necessary, i.e. maturing.
High risk
Emerging businesses will have been recently established as a result of
demand changes for products and services in their markets. Declining
business is characterised by mass-produced products or services, lowering
prices and profitability.
High risk
There is significant overcapacity in the industry and demand from consumers
is not keeping up with what the industry is producing.
We have come across variable and fixed costs earlier when considering
a Profit and Loss Account as part of audited accounts. Here we add a
further dimension that incorporates the Balance Sheet.
We normally find that an industry which has a fixed cost structure in its
Profit and Loss Account will have a similar structure in its Balance
Sheet, that is, a greater proportion of Fixed Assets to Current Assets.
Thus a high proportion of fixed assets in the Balance Sheet indicates a
high fixed cost structure.
Variable costs
Variable costs are those costs of production that fluctuate directly in line
with the level of sales and consequently production, such as the costs of
raw materials. In essence, if production falls, the purchase of raw
materials also falls. This allows a business to reduce its costs quickly.
Where variable costs are high, the GM% (gross margin 96) will be low.
The balance sheet will have more current assets than fixed assets, as a
result of higher levels of debtors from sales and stock levels. This
industry can react quickly to slowdowns in the economy and
profitability will be lower. A retailer operating from short term
leasehold premises can react quickly to changes in economic activity,
for example.
• Fixed costs
Fixed costs are those costs that have to be paid whether or not the
business is making any sales. Typically these costs will be salaries and
costs of plant and machinery. Where variable costs are low, the GM%
will be high. The balance sheet will have more fixed assets than current
assets and the business can be described as being part of a “capital
intensive” industry. The industry will be unable to react quickly to
slowdowns in the economy and is likely to suffer losses as generally
production will have to be kept at a minimum level.
Low risk
More variable costs.
High risk
Where high exit costs exist, you will normally find that the industry will
have a very high proportion of fixed assets/costs and because of this a high
price will have to be paid if a business decides to abandon the manufacture
of its product.
Any specialist plant and machinery would have to be sold off at a knock-
down price either to a competitor or for scrap - which will depend on the
business’s depreciation policy - and this could be well below the balance
sheet book value.
The prospect of having to pursue this strategy often results in a business
remaining in the industry and being forced to compete. Often businesses
may require to restructure or downsize in some way. The alternative is the
sale of core plant and machinery (as the only buyers would likely be others
active in the industry) and this is often not feasible due to the probable loss
on a sale of fixed assets and the damage it will have on the shareholders’
funds.
The prospect of selling to a competitor who may have considered exiting the
industry themselves at some time in the recent past may be unpalatable and
might put them in a competitive position to gradually squeeze out the
businesses who sold out part of their production capacity. Highly specialised
investments in fixed assets often cannot be sold easily at balance sheet book
value and that alone can be a reason for remaining.
Barriers to exit LOW MODERATE HIGH Low risk
Assets can be easily liquidated or the business can be sold within a short
space of time.
Moderate risk
Due to the specialised nature of the business’s assets, a buyer of the assets or
the entire business would probably be a player already active in the industry;
or there could be political influences that restrict realisation of the
assets/business; or closing or selling the business would be costly and time
consuming, reducing the resultant cash inflow.
High risk
Significant high costs of realising the assets of the business exist; there could
be union agreements in place regarding redundancy or closure terms;
strategic alliances with other businesses may prevent exit due to the penalties
that would require to be paid, or simply because all the other players in the
market are in a similar situation and there is a lack of willing buyers.
Characteristics that dictate whether there is a low or a high level of risk from
domestic competition will depend on:
Low risk
Moderate risk
High risk
The business has a product that is standard, readily available elsewhere and
is subject to product substitution or the loss of market share is a constant
worry. Domestic competition is considered substantial.
Strength of foreign competition (Porter - degree of rivalry)
Generally where the product is extremely bulky and heavy, the competition
from foreign markets will be slight, unless an overseas competitor decides to
locate to your domestic market. The provision of services could quite easily
be affected if the barriers to entry required little in the way of investment in
fixed assets.
If the product or service is fairly standard, it could well be subject not just to
domestic but also to foreign competition.
As the industry or its products are new, foreign imports are not yet a danger.
Moderate risk
Due to customer demand, there is insufficient volume to keep pace with this
need domestically and this allows competitively priced foreign imports to
enter the home supply chain.
High risk
The business has a product that is standard and is readily available from
overseas competitors at a cheaper price.
However, if your customer sold 75% of their production to say, only one
High Street store, then the risk is extremely high if that one customer
cancelled its contract for one reason or another. For example, at renewal of
the contract it has found a cheaper supplier, or goes out of business and the
contract becomes void, or finds a justifiable reason for breaking the contract
(late delivery, quantity not met, inferior quality).
Moderate risk
High risk
Bargaining power of buyers (the price that has to be paid for supplies
of raw materials, services, etc) (Porter - buyer power)
This is straightforward and self explanatory. The risk to the industry is
high where the end-users of products or services can dictate the price
they pay. Can you go into a supermarket and tell the assistant that you
do not want to pay Rs. 400 for a tin of beans, but would rather pay Rs.
100? You will be shown the door (politely) and the supermarket can
dictate the price at which they sell to you, unless of course another
supermarket in the local area was selling at the price you wanted and
then that is another risk - competition. For this reason, bargaining power
of buyers visiting ii large supermarket or other major retailer is
generally seen as a low risk.
Where there are few buyers in a market place or where they purchase a
significant proportion of an industry’s output they will be influence prices
and will represent a high risk for those induscr.cs ntf manufacture the
products or services such as defence con:
Moderate risk
There are some substitutes available, but they have not made an impact on
demand for existing company products due to their superior quality or brand
loyalty or their reputation.
High risk
Where there are few buyers in a market place or where they purchase a
significant proportion of an industry’s output they will be able to influence
prices and will represent a high risk for those industries that manufacture the
products or services, such as defence contractors.
Moderate risk
High risk
This is the flip side of the previous risk item. Considering again a large High
Street supermarket, do you think they will be in a strong or a weak position
when negotiating with suppliers? You will no doubt have read widely
already about the influence that supermarkets or other major High Street
retailers can exert on their suppliers; thus in this case supermarkets will
again be assessed as low risk.
Competitive situation
Under this heading we are going to finalise the two remaining factors in
Michael Porter’s five forces - barriers to entry and degree of outside
regulation.
Moderate risk
Suppliers can have some influence on the prices they charge the business for
materials and supplies.
High risk
- universal technology.
- low brand recognition.
- ease of entry to distribution channels.
Moderate risk
High risk
Now that we have analysed all the risk factors, we can use our judgement to
arrive at an overall risk rating for the industry. This is what we have been
working up to in our analysis - an overall assessment of what the industry
risk is. We achieve this by completing the following.
This is based on the combined effect for each component of the individual
industry areas.
Both long and short term market disturbances are dealt with in an effective
and efficient manner. Management reacts quickly and appropriately to
adverse cyclical/seasonal trends and, as a result, maintains consistent
profitability and cash flow.
Moderate risk
The business has been able to absorb short term market disturbances
including economic or business savings. However, longer term disturbances
could adversely affect the business’s creditworthiness.
High risk
The business will be classed as mature where goods or services are provided
in a standard format and do not really change. Competition will be intense
and gaining market share can be difficult.
The business is growing, providing goods or services that are better than
those provided by their competitors. This allows them to charge a premium
which should result in a higher profit.
High risk
The next two categories are linked, but for simplicity are better considered
separately. We begin by defining the supply and distribution chain as a
pathway, map or linear chart.
At the centre of both chains is the product or service, and either side of the
product or service is the supply risk and the distribution risk. The supply risk
is affected by the ready accessibility of all those items that are required in
manufacturing, altering or providing the product or service and making sure
these are available to the business so that the distribution phase can begin.
One factor in the supply chain that you must always assess is the availability
of supplies. This includes the raw materials that are used in the
manufacturing process (which may be scarce or difficult to source) or the
The products will be regarded as staple items for survival such as food, heat,
water.
Moderate risk
Typically these will be purchases that can be deferred, if cash flow becomes
tight.
High risk
• Are the raw materials and resources required for the product or
service all readily available?
It is important in any business to have this clearly defined. The process starts
when the product is ready for delivery (when the manufacturing process is
complete) and the product or service is ready for sale.
There is no limitation of suppliers; the raw materials and other inputs can be
sourced locally; there is no perceived shortage in the next 12 months and
there is sufficient reliable transport readily available.
Moderate risk
High risk
Please note that we are not assessing in any part of this analysis the
business’s ability to take raw materials and convert them into finished goods.
It is presumed that, as you are considering a credit or borrowing request, the
customer has a marketable product which, as a minimum, is of similar and
acceptable standards to the rest of the industry.
Would it be acceptable to take on a credit risk where you knew that the
products, goods or services that were being marketed by your customer were
inferior to those of others in the industry, were unreliable, or were subject to
poor construction and having to be repaired or returned for correction or
replacement? It is presumed that you kaic considered this fully before even
commencing the analysis.
You may find that the products or services are inferior after conducting your
industry analysis, and then you need to decide if it is worthwhile continuing
with the remainder of the credit analysis.
For all your customers involved in manufacturing or retail industries, for
example, the organisation of transportation and delivery is critical, as they all
accept deliveries on a strict time frame. Manufacturing will require both
inward and outward specialism in logistics, which in effect describes the
whole process of dispatch and delivery. The retailer will only have inward
logistics and they will control deliveries strictly so that these are available to
Lending: Products, Operations and Risk Management | Reference Book 1
their customers when they need them, including time to unpack, label, price
and place them on the shelves during periods when their shop is closed or
quiet.
*
To understand the process better it is more efficient to concentrate on three
separate areas:
• distribution access.
• distribution influence.
• distribution elasticity.
The ability to access all customers who wish to buy the product or service is
easily achieved and without hindrance. Normally the manufacturing business
controls delivery by its own staff, rather than depending on customers
collecting from the factory gate. It will manufacture and deliver direct to the
consumer.
Moderate risk
The ability to access all customers who wish to buy the product or service is
mixed. Delivery standards are not entirely within the control of the business
which may use sub-contractors for delivery, over whom control is limited.
High risk
The business has complete control over its entire distribution network and
ensures there is consistent uniformity in the standard of its products or
services, permitting quality assurances to be provided to its customers. A
low risk will underpin brand loyalty and can reduce threats from substitutes.
High risk
Low risk
The links in the distribution chain are few and the business has a number of
years to plan ahead for any changes or has the ability to respond quickly to
changes in consumer habits.
Moderate risk
There are several links in the distribution chain and generally the business
has a limited amount of time to plan ahead for changes or the business may
be hampered economically if there is a sudden change in consumer habits.
High risk
There are many links in the distribution chain and at times these can be
complicated. Changes occur extremely quickly, consumer habits cannot be
forecasted or anticipated.
It is the people within a business that can make it operate at a higher level in
terms of earnings than that of its competitors. If there are two businesses of
similar size, operating in the same industry, in the same location, both having
started around the same time with the same levels of capital, producing
almost the same or nearly identical product or service and one produces more
profit per employee than the other. Why? You will invariably find it will be
due to the expertise of its management in running the business as a whole and
the efficiency of its workers.
We are going to analyse the efficiency of the five main areas of expertise in a
business:
• Production.
• Marketing.
• Finance.
• Human Resources.
• Information Technology.
In the case of service industries, “Production” is defined as the area in which
the sale is made by the sales staff, for example the Food Hall, the Ladies or
Gents or Children’s Clothing department, etc.
Unless you have another customer (or statistically better, more than one
customer) operating in the same industry from which you could make a
Lending: Products, Operations and Risk Management | Reference Book 1 141
direct comparison, the best (and probably the only way) is to visit the
customer in their own premises, during normal working hours, and walk
round the factory, office or shop and see for yourself what is happening.
Business owners generally will want to talk about their business and show
you how it operates so that you can better understand their needs. The ones
who don’t are a bit unusual and you need to try and establish why.
Understanding the business is essential.
Assess for yourself how each area operates. Ask the owner how efficiently
they see the different areas operating. Honest owners with whom you have
built up a relationship and trust will confide in you the areas that are causing
them concern.
This is the kernel of relationship management - to admit in confidence when
something is not going particularly well. By doing this they are seeking help
and advice or sometimes just want someone to listen to their problem.
As their lending banker you should not encounter too many surprises. Who
knows - you may know of another customer who applied a successful
strategy to solve a similar problem.
During your visit, establish precisely who is responsible for managing each
specialist area. Remember that no one area can survive without the other
areas. It would be prudent to establish how each interacts and how they deal
with resolving issues.
Case study
If the Production Manager is unable to hire new staff, you may find that
the Finance function has told Human Resources that there is a cash
shortage, recruitment of additional staff is suspended immediately and
only replacement staff are being hired. But when all Managers in charge
of the Divisions sit down and discuss the problem of cash shortage, you
may discover it is because:
• Marketing has boosted sales growth, raising the terms of trade for
debtors from 15 days to 60 days (without any prior warning to
anyone else).
• the change in the terms of trade has created a surge in demand for
the goods the Production Dept is producing.
• and the Finance Department finds that their overdraft is operating
at a level uncomfortably close to the limit.
Find out who precisely is responsible for each area listed below. Try and
meet them and get their opinion of what is going well and what is creating a
challenge.
Divisional Management performance
Production performance LOW MODERATE HIG
H
Marketing performance LOW MODERATE HIG
H
Finance performance LOW MODERATE HIG
H
HR performance LOW MODERATE HIG
H
IT performance LOW MODERATE HIG
H
Moderate risk
The division performs most of the time in an effective, satisfactory and fairly
efficient way. This also reflects the performance of the manager/director
responsible for this area.
High risk
Number of management/directors
For a sole trader with few employees you will often find that the
business owner is responsible for and controls all the following
functions: Production, Marketing, Finance, HR, IT, etc.
Number of management/directors
Yes, all are covered by full Key Person Insurance for all bank debt levels.
Two are covered by less that 50% Key Person Insurance for agreed bank debt
levels.
High risk
Here we are trying to establish the honesty and trustworthiness of the senior
leaders of the business and how they are perceived in the community. It is
common sense to say that if the owners and senior managers are rated as
“high risk”, then they could walk away when difficulties arise. This is
particularly so if they have no personal obligation to the business (like a
guarantee to the bank) and have put in minimal capital.
Moderate risk
The management team or directors are all principled individuals who are sound,
professional and respected by their workforce and the community. They could be
described as being principled.
Opinions have been expressed that the managers/directors do not always act in a
respectable and entirely honest manner. Should repayment become damaged, they
may not cooperate with the lender. We are uncertain regarding their character.
You may find that in your organization it is normal for applications to open a
business account to seek the authority of the customer(s) to carry out credit
checks much in the same way as is done for personal customers seeking a
personal loan, or a credit card. Sometimes where there are few
owner/managers in a business, their personal and commercial transactions can
become indistinguishable/ blurred.
Moderate risk
High risk
Succession plan
For all businesses you need to see that they have plans in place to cover their
senior positions. The presence of a robust succession plan could act to
mitigate for the loss of a key employee, manager, leader or one of the owners
(in a partnership or limited company) if they decide to resign or retire.
We have already looked at Key Person Insurance which normally onVy
COMICS \or\g te-im W\Yve.ss OT pe.'cmawe.nt. absence. because. of death.
This particular type of insurance will not cover resignations or dismissals,
whereas a robust succession plan will help mitigate the sudden or planned
departure of an employee, manager, or one of the owners (but not in all
circumstances).
Moderate risk
High risk
Employee relations
It is a fact of life that if employees are treated well, with respect and
and Risk Management | Reference Book 1
understanding, the pay back for
145a business is immeasurable. Treat employees
unfairly or harshly, and they will have no loyalty to the business or its
objectives. They will be constantly criticizing their employer and letting
anyone in the local community (who will listen to them) know exactly how
they feel about their employer. No doubt they will be looking for every
opportunity to secure employment with someone else even if they are going
to be paid slightly less.
“to give full consideration to the individual employee, spend a lot of time
making customers happy and go the last mile to do things right”.
There are leaders and managers responsible for each division, but they will only
be as good as the people who work in their division. The leader may be the most
highly qualified specialist in an industry, but if they have untrained and
discontented people working for them, their unit will not be maximising the
human resources it has available. This assessment also extends to trade unions or
employee associations.
• require a licence for emissions and discharges, without which they cannot
operate.
• may
Lending: Products, Operations and Risk Management | Reference Book 1need to remediate contaminated land or install 147
equipment to treat
waste.
As well as the industry itself, you also need to consider where the business is or
has been located. Environmentally sensitive sites are those:
In considering any of these matters you may require your customer to invest in an
environmental report or audit. Often it is only by looking at old Ordnance Survey
maps or local records can you establish if the site or an adjacent property was say,
an abattoir or garage fifty years ago. Remember that it is not just above ground
that you need to consider, but what lies below. You may immediately be thinking
of mine works, but less obvious structures are obsolete septic, petrol or oil storage
tanks.
You should check your own bank’s policy regarding taking any environmentally
contaminated (existing or former) land or property in security as this may affect:
• financial penalties.
Moderate risk
The business is in the process of conforming to the required environmental
compliance criteria.
High risk
The business has not fulfilled its obligations regarding the required
environmental compliance criteria.
Legal compliance
There are numerous laws and regulations that your customer requires to
comply with and you need to establish which ones may create the
largest risk for your customer. You need to stay alert to changes in
legislation.
compliance breach
• Prevention of particular events from taking place (for example, keeping all
insurances in force so that all property is adequately insured).
The first sign of a possible problem is where there are breaches in lending
covenants; for example, delay in providing information (holding back bad news)
or breach of a covenanted ratio (a deterioration in performance and credit risk).
Lending covenants can be varied or removed completely if the risks they were
measuring have reduced.
This template will crystallise the risk over a number of trading cycles/years for a
customer. If there are no covenants, then miss out the following two templates.
Compliance frequency - at this date, does the business consistently meet all the
terms and conditions of its credit agreements?
Financial
Low risk
Moderate risk
High risk
Payments to creditors are met before or within agreed terms, i.e. punctual.
Indications are that payments have extended beyond the agreed terms on an
infrequent basis.
High risk
Credit checks indicate the business is consistently late, without cause, in paying its
suppliers, i.e. delinquent.
The business plan will outline the vision the management have for the
business and will provide specific commentary on its strategic direction and
how this and their financial goals will be measured; in other words, what
success looks like.
Having this clearly and concisely laid out allows you to establish if you can
accept the likelihood of their vision occurring and how you would rate the
risk.
• Details of competitors.
• Details of customers.
• Future forecasts (which might be derived from past results with differences
- usually improvements - in sales levels and margins fully explained).
• Cash flow forecasts which have been built up from all income and
expenditure details on a month-by-month basis which reveal opening and
closing bank balance positions.
As you will know, predictions are seldom easy. The measurement of risk here is
how close their previous predictions have got to “actual”.
If the business plans continue to show sales growth of 20%, profitability growth
of 20% and operating cash growth of 15% when historical accounts show actual
sales growth of 5%, profitability growth of 2% and operating cash growth of
1%, then questions need to be asked. The assumptions behind the forecast will
require robust examination.
✓
What you are assessing is the capacity to deliver on forecast performance and
the template below assists in capturing these capabilities. A customer with a
good track record who can deliver on predictions can be a comfort to a lending
banker.
In the organisation where you work there will be such a plan which should be
fully documented. It may show such things as what procedures will be put in
place should the building be temporarily out of action. These plans do exist and
you should ask your line manager about them if you have not already seen a
copy.
Specialised companies exist who will reserve offices, fully equipped with
telephone and computer links, for businesses that require relocating temporarily
because of some incident. Immediately after “9/11”, US stockbrokers
transferred their operational business to London so that they could service their
customers until the US market reopened. This action went some way to
restoring financial confidence in the American economy.
When completing this template you need to assess both the business plan and
catastrophes section and you are required to make a balanced judgement when
assessing the overall risk rating.
Plan untested - Although a formal business plan is in place, it has not been
tested because the business has only been newly established with no track
record or because of a lack of cyclical/competitive experience.
Capital expenditure/technology
Capital expenditure relates here to maintenance capital expenditure, that is,
core capital expenditure (capex) that is sufficient to keep the production
facilities at a competent level. It is accepted that occasionally capex can be
delayed, but not indefinitely. The latter is different from discretionary capex
which is defined as expenditure that is a conscious decision of management
say, to expand or take over another business. Discretionary capex is not
assessed here.
Two useful ratios can assist in calculating fixed asset replacement cycles:
Accumulated depreciation
---------------------------------------------- x100 = x%
Gross depreciable fixed assets
As a rule of thumb, if this ratio exceeds 60%, this indicates that the fixed assets are
nearing the end of their useful life and replacement is becoming critical.
Life of fixed assets in years
- this ratio will give an indication on average of the life span in years of the
fixed assets being analysed. You will require to use some personal judgement
and common sense; for example, if motor cars are now 8 years old,
maintenance costs are likely to be high and that replacement is well overdue.
Some items of plant and machinery have a very short life cycle, others, such
as printing presses, can have long life spans (10/15 years). It is better to make
separate calculations for the core fixed assets. Again property can generally
be ignored because of its low depreciation charge.
When you are visiting the customer’s premises you can make an assessment of the
age of the equipment, remembering that some item; have a long life span and
others very short.
Case study
Have you ever gone into a hotel that has been poorly maintained? It appears tired
and shabby, in need of new tables, chairs, furniture or redecoration. Unless you
are buying on price or convenience alone, would you be encouraged to revisit it?
Possibly not, you will probably choose another venue the next time you are in the
area - as will a lot of other first-time customers - so the business is not going to
benefit from repeat business. At best they will only be marginally profitable, and
the lack of capital expenditure promotes a promiscuous spiral:
• because of the lack of earnings the business cannot replace the furnishings
or redecorate.
• this deterioration in amenities means that less customers come through the
door year on year.
Production assets, core fixed assets are ijiaintained in a good condition, are
regularly maintained, and there is a recognised cycle for replacement. Fixed
assets usage % under 60%.
Moderate risk
Production assets, core fixed assets are maintained in fairly good order,
maintenance is satisfactory, there have been a few breakdowns which have
disrupted production and the replacement cycle has not always been adhered to.
Fixed assets usage % approaching 60% or 66%.
High risk
Production assets, core fixed assets are poorly maintained, regular maintenance
schedules fall behind, breakdowns happen fairly often, disrupting production, and
the replacement cycle is behind schedule. Fixed assets usage % exceeds 66%, i.e.
core production assets have only about a third of their natural life left. Be careful
lending: Products, Operations and Risk Management | Reference Book 1 157
in the selection of figures that you choose re core production assets, excluding
assets that have long life cycles such as specialist plant or owned buildings. You
will need to be familiar with the assets from a site inspection, discussion with the
customer and by referring to specialist trade magazines.
Operational risk
Following completion of our analysis of the industry and business risks, we now
have a good overall view of the operational risks for the customer. This is where
the risk templates are really useful. You should list the high and moderate risks
you have already identified to ensure for the first few times of completion that
you capture them all. Remember that you have already completed an assessment
of industry risk and business risk using the template. This has shown how our
customer differs from the rest of the market in either a positive or negative way.
There is no need to include the individual components of these two assessments
into the completed final assessment.
In our final assessment here we will be looking at ratings which are moderate and
high risks and then differentiate these two risks on three levels:
• likely to happen.
Audit risk
Financial statements
Depending on the legal status and size of the business customer, you will have
different expectations of who has prepared the financial information and exactly
what type of information you will be given.
The first step is determining the source of the information and how accurate it has
been in the past. It would be pointless to base an analysis, and ultimately provide a
financial decision and credit funding, on inaccurate or unreliable data.
Management accounts
These are primarily prepared for the business’s own internal use and will be
produced either weekly, monthly or quarterly. Departmental heads of production,
finance, marketing and HR can make use of these accounts to:
The figures may not always be prepared in accordance with accepted accounting
standards and therefore the 12 months management accounts will not always
match the annual accounts. Thus the reliability of these figures requires to be kept
at the front of your mind, given that they are prepared internally and may not use
accepted accounting practices. As part of the interview with the customer it would
be sensible for you to discuss how the figures were arrived at and understand any
anomalies between the way in which the external accountant prepared the annual
accounts and those produced for the use and benefit of the internal management
team.
Auditors will generally give one of four opinions in their audit statement:
&
1 Unqualified - means that the certificate or report is being issued without
reservation; sometimes referred to as “clean”.
2 Qualified - means that the auditor has some reservations. Watch out for words
like “subject to” or “except”. Sometimes an amendment to the accounting
treatment has been implemented; for example, a change to the method in
which income is recognised or a change to depreciation policies or that stock
has been valued by the directors. Normally these can be accepted following
discussion with your customer and on receipt of satisfactory explanations.
However, if the company continually changes its depreciation year on year,
for example, this should give you cause for concern and a frank discussion
involving the auditor and the customer is necessary.
3 Adverse - here there has possibly been a disagreement between the auditor
and the client regarding the treatment of certain items within the Profit and
Loss Account or Balance Sheet. There may be a dispute regarding the
implementation of accounting policies. The auditor is clearly signaling that all
is not well.
4 Disclaimer - this is serious. The auditor has not been given sufficient access
to all records or systems to allow an opinion to be formed, despite trying to
gain the information from alternative sources. You need to seriously consider
the safety of the level of borrowings that is currently made available to the
customer.
It is not appropriate to provide templates for the risks covering the type of
financial statements received, who prepared them and the basis of preparation.
The risk has to be evaluated following discussion with your customer. Rarely
should you encounter the adverse and the disclaimer classifications and it is
entirely normal to see certified accounts covering sole traders and partnerships.
An important point to remember is that there is a time lag between the financial
year end of the customer and when the financial statements are delivered to the
bank - often anything between six to nine months.
The date of the certificate from the auditor will be a guide to when these figures
were finalized. There are various reasons for the delay, ranging from discussions
on tax planning, basis of asset valuations to the client actually paying for the audit
service.
As a provisional measure to satisfy a bank’s desire to see an up-to-date trading
statement, customers will often provide interim accounts, labeled first draft,
second draft, etc. These should give you some comfort on financial performance.
When carrying out any analysis of financial information, you should always
clearly state the basis on which the accounts have been prepared and when “finals”
are expected.
Here we are going to briefly review the financial risk elements within the financial
statements which include the Profit and Loss Account and Balance Sheet.
The various ratios covered in the following will be familiar from your earlier
studies. We will not use the cash flow statement in our analysis as you will find
this only in the financial information produced by quoted PLCs or mid-range
corporates. However, we will use the operating cash flow calculation (earnings
before interest, tax, depreciation and amortisation adjusted for movements in
working capital) which provides a close enough comparison.
We are going to use the ratios we have seen before to assess the financial risk,
although absolute Rs figures are also useful (as you will see) and appropriate.
Ratios, as you know, provide you with a trend and that is the key to risk
identification.
We are going to analyse the financial risks by examining separate areas of the
Profit and Loss Account and Balance Sheet:
• Growth.
• Profitability.
• Activity.
• Gearing.
• Cashflow.
Here are the specific items we are going to use and their definitions: Ratio
Definition
1. Growth - P & L
This Year’s Sales - Last Year’s Sales
Sales Growth % ------------------------------------------------- x 100
Last Year’s Sales
2. Profitability - P fir L
Sales
Some analysts prefer to use profit before tax, or profit before interest and tax
(PBIT).
NB
1. Cost of Sales is the same as Cost of Goods Sold (COS or COGS).
2. Stock turnover (number of times) would be COGS divided by average
stock.
Shareholders Funds x
1 You should look first at the ratios and develop some expectations based
on industry studies and your knowledge of what approximate range you
would expect to see.
2 Then, and only then, calculate the actual figures, or the ratios may
already be calculated for you, in which case do not look at the ratios
until you have developed your expectations.
3 Compare your expectations with the actual financial ratios you have
calculated/obtained.
5 One or two years of ratios and figures in isolation are meaningless; you
need as a minimum three years annual figures and even then the growth
ratios analysed will only represent two years.
Growth - P & L
Sales Growth %
Primarily, if the business’s sales growth reflects what is happening
elsewhere in the economy and the customer’s industry for that time
period, you can surmise that they are performing on a par with their
peers. However, if performance on this measurement is above or below
peer group par, you need to make enquiries and seek the advice and
input of your customer. Remember that Porter’s five forces have a partto
play here and may provide an explanation regarding size, competition,
etc.
Sales growth comes at a price for the business and that is the cost of the
additional trading capital that is required to fund the sales growth.
The operating profit which is thrown off by the increase in sales will help
fund some of the trading capital required by the expansion. We are using the
phrase “trading capital” to describe the main trading assets, rather than the
broader term “working capital” which includes all current assets and all
current liabilities. Trading capital reflects this narrower definition that we
need to apply.
Normally a business will have a trading capital requirement, that is, the
amount by which stock + trade debtors exceed trade creditors. If the sales
growth is so rapid, there could be insufficient internally generated income to
cover the trading capital required for the growth. Expanding sales turnover
requires more finance for stock and debtors. Survival is dependent on
someone financing the trading capital growth. Sometimes in these situations
where the expansion has not been discussed with their banker, we see
balances in excess of an agreed overdraft limit.
Long term sales growth needs to be funded either by:
That is why permanent sales growth requires long term funding and not
overdraft facilities. Long term sales growth funded on overdraft will only
create hard core or permanent borrowing and because it is required for some
time will not be reduced or repaid quickly. The discipline of a term loan with
fixed repayments is better.
Profitability - P fir L
Gross Margin %
(GM%)
This is the initial and one of the major profit drivers for a business.
GM% will reflect the selling price of the business’s products. If GM%
is falling, this could be as a result of a price squeeze on their sales. As
we considered under Porter’s five forces, this could be because of
competitor pressure. Alternatively, suppliers may have increased the
cost of raw materials, and if this increase is not passed on to the
customer, this will create a fall in GM% (Porter - supplier power).
You may have encountered the term “mark up”. This is not the same as gross
margin, but the figures are used in a similar way. If a business knows it
wishes to achieve an average GM% of say, 20%, and it know? what its costs
are, then to achieve this it uses mark up to decide at whit price it must sell its
products. Let us review both GM% and mark up.
x
Sales
Or 100
Rs.lOOk -
Rs.80k 100
= 20% GM%
Mark up = GM%
x100 +100
Cost of Goods Sold
(If you used the figure for purchases this would be more accurate; for an
approximation COGS is sufficient.)
Example:
-125%
As well as purchases and stock levels affecting the cost of goods sold,
accountants preparing annual accounts will sometimes include other items
which are regarded as costs of production, such as the costs to heat the
factory, power for the plant and machinery, carriage costs, transport,
depreciation on plant and machinery and labour costs. Generally, these costs
will vary with the level of production; for example, if the machinery is not
working, it is not using any power; if there is no production, there will be no
need for stock purchases. These are called variable costs.
Lending: Products,
Operations and Risk
Management |
Reference Book 1 165
The cost of goods sold reflects the cost of production which includes all the
costs that are necessary from taking raw materials and working them into a
finished product ready to be sold to a customer.
When conducting your analysis of cost of goods sold, you should establish if
there are any costs included that are in fact fixed costs. One possible item is
production wages - you need to establish on what basis the workforce are
paid. If they are paid on a piece work basis, the production wages are a true
variable cost, as the level of wages and bonuses will vary in direct proportion
with the level of factory production; whereas overtime payments would be a
variable cost.
However, if the wages are paid on a purely hourly rate and the workers are
paid whether there is production or not (which is the norm nowadays) then
the wages costs of these staff are a fixed cost. If the figures for wages,
overtime and bonuses were detailed separately, you could put the wages into
fixed costs and the overtime and bonuses into variable costs. Overtime
payments and bonuses will normally be dependent on the level of production.
The effort in doing this will not normally provide you with any more of an
insight into the financials or improve your risk assessment. Where you
discover production wages are indeed not a variable cost and have been
included as part of cost of goods sold, these can be stripped out and
incorporated within operating expenses (fixed costs).
This means that the GM% will be adjusted and may require some
clarification when making comparison with the rest of the players in the
industry. It is better leaving this adjustment until after you have assessed
“your expectations” for the industry versus the customer. This will become
clearer when we discuss break even point under the next heading.
For successful businesses, gross profit should always be a positive value and
the trend in the ratio should be fairly stable year on year with no major
fluctuations (movements greater than 10% require investigation and
discussion). If there are fluctuations that cause you concern, these need to be
discussed with the management and how it is to be addressed.
Operating Expenses %
Usually these are the fixed costs that require to be paid no matter the level of
production or regardless of what is happening in the business and they will
include the likes of rent, office expenses, marketing costs, charge for bad
debts, depreciation on office equipment and cars, salaries, directors’
salaries/emoluments, pension costs, etc.
Remember that you may have to adjust this item upwards if there were non-
variable costs included in cost of goods sold, as previously mentioned. On
the other hand, you need to ensure that costs detailed under this item are not
really variable costs like transport or carriage expenses.
You need to carefully monitor the movement in the trend in the ratio, discuss
this with the management team and establish the reasons for the variance and
how it is to be addressed.
By interpreting operating expenses in this way, you have established the true
value of the fixed costs which can then be used to establish a break even
point (BEP). This is the level of sales at which neither a profit nor loss is
made. It can provide useful information and insight into your analysis for
sales as the difference between sales and BEP is the amount of sales that
actually provides the profit. The higher the figure in percentage terms will
give you more comfort as to the financial risk. But if the margin is “thin”, it
BEP is calculated:
Operating Costs GM%
If you calculate a BEP of Rs.lOOk for a set of annual accounts, its annual
sales are Rs.l20k, and the business earns for the year a profit before tax of
Rs.2.4k, what does that tell you?
It is not until months 11 and 12 that the business actually earns a profit. This
is calculated:
month)
If you are an owner or a shareholder, PBT or EBT provides the gross return
on the capital invested which will allow comparisons to be made with rates
of return on risk-free investments such as bank deposits, or Treasury stock,
or of another business involved in the same sector; for example, the gross
In this section we will use profit before interest and tax, as this will allow
comparison with the interest cover ratio and the operating cash (cash from
operations). Both use earnings or profit before tax and interest; in financial
circles commonly referred to as EBIT.
These three ratios and the movement in their values are critical. Combining
the overall year-on-year changes in the Balance Sheet values will either
generate or absorb cash. That is why, when we considered sales growth, we
spent some time looking at the dynamic effect sales growth has on a
business through the overall change in the trading assets of stock, trade
debtors and trade creditors.
You should think of the combined effect (when the movements of these
three items are summed) as the “swing factors” of cash flow generation or
absorption as they can dramatically increase or reduce cash flow in any one
year. That can also mean implications for paying such things as interest, loan
repayments, wages or salaries, etc.
Levels of domestic or foreign competition will dictate the terms of trade, that
is, how long a customer has until they are required to pay for the finished
goods. This could be cash on delivery, cash with order, 15 days, 30 days, 45
days or 60 days credit terms.
You will find that businesses may offer their trade debtors 30 days credit as
standard terms of trade, but some large customers may be able to negotiate
longer terms of trade due to the substantial orders they place.
Despite the larger customer being say, a major company which appears to be
financially strong, this will give rise to another of Porter’s risks - customer
concentration.
To speed up cash flow, the business which offers 30 days credit may also
offer a discount if the invoice is settled within say, 7 days of delivery. The
business will be sacrificing some profit, but is accelerating operating cash
flow by the early collection of debtors which pays for such items as raw
material purchases, workers’ wages and salaries, electricity, gas, VAT, bank
interest, loan repayments, etc. It is sometimes prudent to lose 5% or 10% of
profit to receive a cash injection of 90% or 95%. Cash now is better than
cash in 30 days time and means less time spent on credit control and a lower
cost of borrowing.
Finally, let us look at the part trade creditors play in funding the trading
cycle. They are the flip side of all the characteristics we considered when
looking at debtors. Depending on the industry, suppliers may offer their
customers a period of time to pay for the goods they have supplied. Trade
creditors are a valuable source of credit and finance to a business.
To keep the trade cycle revolving, trade creditors will require payment on
time. There is a danger that if the customer (who as far as the supplier is
concerned is their debtor) does not pay on time, they may be refused future
supplies or be moved on to “cash with order” basis. This would deprive the
customer of a cheap source of finance.
To be able to obtain trade credit, the customer will need a track record, will
be subject to regular credit checks, and may be requested to provide a copy
of their annual accounts - very similar to the processes and information
requested by a bank.
These elements make up the trading asset cycle of a business. Let us now
consider the three elements individually in more detail.
While you can calculate this ratio on an overall stock holding basis, for a
manufacturer it can be illuminating to calculate how many days on average
each of the three different stock classifications is held.
The ratios are calculated in the same way as you have already done:
Raw materials
------------------------------- x 365
Cost of Goods Sold
Work in Progress
---------------------------- x 365
Cost of Goods Sold
Finished goods
---------------------------- x 365
Cost of Goods Sold
Before leaving the topic of stock, there is one final item that needs to be
considered and that is the topic of “window dressing” or audit risk. This
occurs where the business owners value the year end stocks themselves. This
was mentioned earlier when we looked at audit risk - the auditor qualifies the
audit certificate by stating that the stock has been valued by the directors or
owners. Stock should be valued at “the cost of purchase or market value,
whichever is lower.” What does this mean?
If the business purchases widgets for Rs. 3 and the market value is
Rs.5, then the stock valuation is based on Rs. 3. Later in the year, the
business purchases widgets for Rs. 3 and the market value is Rs. 2, then
the valuation is based on Rs. 2.
However, the business sells 100 widgets at Rs. 5 each and has:
3. What should have been the value of cost of goods sold if the
business had valued the closing stock correctly, using the accounting
principle for stock of First in First Out (FIFO) i.e. sales use up the
earliest amounts of stock first - in this case, the opening stock - the
1. Rs. 100.
2. Rs. 400.
3. Cost of goods sold is Rs. 200. Gross profit is Rs. 300.
As you can see, overvaluing stock inflates the gross profit. Why is this
important? An overvaluation of stock at end will overstate the gross profit.
To maintain the deception, the business would have to keep overvaluing
stock year in year out, or suddenly profitability would drop. How can you
spot this? The stock days on hand will keep increasing year on year. It can be
detected by obtaining an itemised list of stock numbers with individual
values for each amount. These can then be checked back to a selection of
invoices from creditors.
Normally you should find that the prudent approach is used with the same
basis, otherwise it should be highlighted by the auditor. It is perhaps better
for practical reasons to highlight this issue here rather than under audit risk to
allow you to see the practical implications.
If the customer were to supply a quarterly list of stock (that is, if they do not
supply management accounts containing a Balance Sheet) it can be a useful
source of information when monitoring some lending covenants.
Trade debtor days on hand
What will assist you here is an aged list of debtors, normally supplied as part
of the management accounts. Here each debtor is listed and classified into
the total amounts outstanding and then spread over a period of time (we will
assume 30 day terms of trade).
you would see that there is a clear deterioration in debtor collection and
customers are moving more and more into arrears. It can be interesting to
identify which customers are appearing in the 59/89/90+ day categories and
see if they are still being supplied with goods on credit - they will be if there
are amounts under “current”.
You can use the data received on aged lists to establish concentration risks.
In these circumstances the customer may find that credit dries up and they
have been suddenly moved to cash on delivery (COD) or even cash with
order (in advance of delivery).
As well as obtaining an aged list of debtors, when you suspect that there are
issues regarding the lengthening of creditor days you should seek an aged list
of trade creditors in exactly the same format as for trade debtors. Often an
aged list of creditors is supplied along with an aged list of debtors as part of
the standard management accounts pack.
For some industries you need to be alert to “contra entries”. This is where
your customer is showing one name as a debtor and the same name as a
creditor. In the event of insolvency the amount included as a debtor will be
offset under common law by the amount appearing as a creditor. For a
company, this could well reduce the value of the assets covered by your
floating charge.
Capital Adequacy %
This shows you how much the owners are contributing to the business by
way of equity or risk capital.
A higher net worth percentage will also indicate that levels of debt are low.
A low level of net worth percentage will mean there is a high level of
external liabilities. These have to be paid and interest bearing debt needs to
be service.
Gearing %
This is linked to gearing - the more debt there is, the more interest that has to
be serviced. High levels for interest cover are good; for example, for a
trading business with facilities that finance long term sales growth only (such
as stocks and debtors), this ratio should be around 7 or 1C times and would
be considered safe.
The ratio will reduce where borrowings finance fixed assets as well. Interest
in this case should include all the commitments of the customer in favor of
the bank and leasing companies.
A ratio of less than one times cover means that there was insufficient profit
(and remember that does not always equate to cash) to cover the interest
payments. The uncovered interest is then probably rolled up into existing
debt facilities such as overdraft, which may go unnoticed.
A ratio of 7 or 10 times may seem high to some people where only debtors
and stock are being funded or creditors are being paid early tc take advantage
of trade discounts for early invoice payment. It is really not where the ratio
was that is the issue - it is more where it is heading.
Example
Let us say you have a business customer who borrows short and long term to
fund debtors, stock and fixed assets. The trend in this ratio over the last four
years has been:
31/12/03 4.5 t
31/12/04 imes
31/12/05 3.0 t
31/12/06 imes
31/12/07 2.5 t
The 31/12/07 accounts are received in June 2008.
imes Six months age the ratio
was 1.5 times. Given the trend, where is the ratio
2.0 now? t
imes
1.5 t
imes
In June 2009 when you should be receiving the next set of accounts
(some customers, remember, may try and hold back bad news) it will
actually be less than 1.0 if the trend continues.
That is the whole point of ratios - where there is deterioration and no
action is taken, the erosion continues. From going from a fairly stable
position for 2003, there now appears to be a real problem. Who is more
worried - you or the business owners? Probably both of you will be
having some sleepless nights, now that you have detected the trend. '
Cash Cover %
This is very similar to interest cover, except that operating cash before
the payment of tax is divided by interest and capital repayments on
debts. You will recall that interest coverage is calculated before tax and
takes no account of the capital debt repayment. Also the accrual
accounting profit seldom equates to cash generation where a business
has a significant trading capital requirement.
We use the convention of before tax on the basis that interest charges are tax
deductible, but you should not lose sight of the fact that tax requires to be
paid one way or another.
The operating cash is the primary way in which the customer will fund:
• paying tax.
The starting point to any lending decision is: why does the customer require
to borrow? This is the first specific assessment you need to make after
considering whether the request is legal and within your bank’s own policy.
All requests from customers for credit fall into any one or more of the
following seven borrowing requirements:
1 To fund operating and fixed costs (such as wages, salaries, phone bills,
heat and light, etc) until trade debtors are converted to cash.
2 To fund stocks until they are converted to output, sales, debtor? and
then to cash.
3 To fund property, plant and equipment until they are used up over many
trading cycles in producing output which is converted to sales and then
to debtors and then to cash.
4 To fund the whole range of assets (stock, debtors, fixed assets,
additional operating costs, etc) required to support rapid growth.
5 To fund a change in the company’s ownership.
Trading cycle
Here is a simple trading cycle:
PAY BUY RAW
SUPPLIERS MATERIAL
AND EXPENSES
S
COLLECT
// CASH
W )
FROM START
w
CUST MANUFACTURE INTO
OMER WORK IN PROGRESS
S
(DEB
TORS
2. Stock then goes through the production process and is converted into
finished goods. In a retail business, after the goods are unpacked, a mark
up is calculated and they are placed on the shelves, ready for the consumer
to buy.
3. Where stock is sold on credit, it will appear as another asset - trade debtors
- and when the debtor pays the invoice, cash is generated and received. Of
course with the high street retailer, credit is not offered and when stock is
sold, the cash or Maestro or credit card slip goes straight into the till.
4. We are back to cash, when the business will purchase more stock out of a
mix of cash and trade credit and the whole trading cycle starts again.
The length of trading cycles will depend on the industry sector.
Example
The trading cycle of a fishmonger who only sells fresh fish has say, two or
three days maximum to complete any sales. Other factors come into play - the
time of year when the sale is made can be critical. During the summer, fresh
fish goes off more quickly than in winter and there are certain seasons when
only specific species are available.
Example
• less than 12 months, that is, a few weeks or a few months up to a maximum
of 12 months on overdraft for seasonal facilities or debtor finance facilities
Fixed assets need to be financed on debt that is repayable over many trading
cycles, such as a term loan, hire purchase or finance leasing.
Core stock requirements and long term sales growth calling for an increased
stock requirement need long term funding repayable over many trading
cycles, such as a term loan.
Long term sales growth calling for an increased debtor requirement needs
long term finance repayable over many trading cycles such as a term loan. A
limited company may also consider invoice discounting or debt factoring.
The purpose of the advance requires matching the period of time the debt
facility is required for. There needs to a logical match between purpose and
the repayment source. For example, you finance stock purchases but the
customer offers the primary repayment source as an insurance claim for fire
damage to their premises. Why? How are they to refurbish the premises after
the fire? How and when are they selling the stock? That is why there needs
to be a logical fit.
Financial repayment risk
Cash flow forecasts enable us to see where and when the cash to repay us is
coming from. We have seen how term loan repayments can be tailored to suit
the cash flow by deferring the start of repayments until the asset is generating
cash. Repayments may be rear-end \oaded by “balloon” repayments.
. The primary source of repayment for bank debt is the cash generated
over a number of trading cycles and this may last for a number of
years.
Think of those four points as “exit routes”: how likely is each of them to
happen? The lower down the list, the less chance there is of a successful
conclusion. Again Porter comes to mind and his wise counsel on barriers to
exit explains why the chances of success can be limited.
Legal risk
In lending money, there are always at least two parties - the customer and the
bank. The customer asks the bank for credit, the bank assesses the risk, and if
the risk is acceptable, agrees to the facilities. Thereafter the bank issues a
letter confirming the facilities or prepares a loan agreement which the
customer signs.
A request has been made, the request has been agreed (or modified) and
documents have been signed. This constitutes a contract at a basic level. The
contract will contain such items as:
• the amount.
• repayment terms.
• what the customer needs to do to prevent the facility being
withdrawn (in the event of default).
• security/collateral.
Your organization will have a set of standard agreements which cover nearly
all lending situations and the taking of security over assets, guarantees, etc.
These will cover many situations and will have been compiled by the bank’s
internal or external legal experts, scrutinised by the bank’s own solicitors
and, where the agreement is very complicated, subject to external legal
counsel opinion.
The aim is to make sure that these agreements are “watertight” - that they
cannot be challenged in court on a legal technicality or a poorly phrased
clause or term. They can sometimes stretch to twenty or thirty pages,
including explanations of terms, lending covenants, conditions precedent,
etc. While it may appear boring, all these documents prove the legal right to
seek loan repayment or enforcement of security.
Thus breaching one of the conditions of a term loan agreement could trigger
a cross default and give the bank the right to make all the customer’s
facilities repayable. This is only right as the risk has clearly increased. It is
likely that in these circumstances the bank will want to renegotiate all the
facilities.
There are similarities between lending covenants and condition? precedent,
but the two must not be confused. Conditions precedent are those items with
which a customer must comply or provide prior to the drawdown of (usually)
new and/or increased facilities. They are detailed in the credit write up as a
separate heading and along with the lending covenants as separate headings in
letters of offer.
Income is important to a bank. There will be charges for running the bank
current account (service charge) which will normally be a standard tariff based
on the type of debit and credit transactions passing though the account.
If the transaction is electronic, this will cost less than a manual entry. If
lodgements contain cheques to be processed from the business debtors, these
will be charged at a rate per item. If cash was lodged, this will be at a higher
cost than cheques.
The income elements that are really important for credit risk applications are
fees from arranging facilities and the rate of interest charged. Fees will
normally be x% of the facility being agreed, with minimum and maximum
amounts. You need to be aware what authority you have to modify fees.
Your organization will have its own policy on what it requires to be charged
to meet its own internal risk adjusted return on capital - the risk/reward ratio.
We explored earlier that banks require managing the amount of capital that
they have to set aside for each parcel of lending. Thus there is a requirement
when lending money that the return meets not just the risk/reward, but also
that the return on capital is adequate. This return on capital needs to meet the
bank’s risk-adjusted return on capital targets. Shareholders, investment
analysts, rating agencies and bank regulators pay attention to the return the
bank earns on its risk- adjusted assets (loans). They see this as a measure of
safety.
The principle of risk and reward will become more critical as bank regulators
raise the amount of capital the banks are required to hold.
For credit scored facilities, the scorecard will generate and continually
recommend facility levels and a risk rating for the account. For larger
commercial lending, there will be a computer programme that will model the
probability of default of similar loans based on the bank’s historical bad debt
experience.
You will want to find out what system your organization uses, and familiarize
yourself with it as well as establishing what a “good rating” looks like and
what a “poor rating” is likely to be and critically, what elements are likely to
bring this about.
The internal bank credit rating, non-interest income and the level of tangible
security cover are used to arrive at what minimum rate of interest requires to
be charged to meet the bank’s internal rate of return policy. Each time the
risk/reward model changes or the internal rating changes, you will need to run
the computer model to establish that the hurdle rate meets the bank’s internal
rate of return (risk adjusted return on capital). Again you will require to
establish if you have a level of discretion in deviating from the minimum
recommended rate.
To put legal, investment and regulatory risk into practice, you should, where
possible obtain the following relating to your bank:
• how much?
• how long?
•cost
Lending: Products, Operations and Risk Management | Reference Book 1
• security/collateral
The overdraft facility advice letter and term loan agreements will not provide
the rationale and reason why the credit facilities were granted.
It is best to tackle the credit write up in a structured and methodical manner and
the following is only a suggestion. Again, you should investigate your own
organization’s methodology.
One final thought: credit risk is, in some ways, as much of an art than as a
science. There may be “rules of thumb” and formulae that can provide
guidance, but it is the use of your skilled judgement that will show the quality
of your analysis and assessment.
Adapted from:
Credit Lending Module and
Specialized Lending Book-
One of Chartered Banker
Institute.
The first line of defense will typically be front line bankers, treasury
department, etc, made up of the bank’s own personnel.
• The second line of defense will be policies and procedures, internal audit,
credit approval, distressed lending units, group legal, operational risk,
executive committees, etc, again mainly staffed by the bank’s own
personnel.
The third line of defense will be the Board of Directors, the External
Auditor, the Financial Services Authority, Government legislation, etc,
this time with external personnel who will have contact with the bank’s
staff.
Banks often form a series of committees which can comprise both directors and
senior management. They meet regularly to review the risk policies they have set,
test their risk policies and review outcomes of actual losses. They will update
their strategies and mitigating factors so that these are aligned to current
circumstances. They will also convene if there is a major emergency.
A bank will typically have a set number of committees which will address the
following risk areas:
credit risk
• market risk
• operational risk
• strategy risk
• audit
The committees will normally report directly to the Board of Directors or
through an Executive Committee to the Board. Sometimes a Director will be a
member or chair of a committee; typically the makeup is of senior or executive
management, supported by Heads of Departments or Divisions from the bank.
Their function is to overview and test the risk strategies of the operational or
support units.
Credit risk
Credit risk is defined as the financial loss incurred due to the inability of a
customer to repay their loan, or overdraft, or other contractual obligations. The
use of the word “loan” from now on will encompass all credit facilities including
contingent liabilities.
The mandate of the Credit Risk Committee is delegated from the Board of
Directors, to whom it reports. Risk Committees may be formed at different
levels within an organization:
• Divisional level
quality
Credit scoring
Credit scoring is a statistical means of screening customers to determine their
creditworthiness. It is basically a system which allocates points according to the
data produced in answer to a credit application form; for example, people who
own their own home will score more points than those who rent. The process
determines the statistical probability that the credit will be repaid. There is no
universal system of credit scoring; nor is any system perfect.
Credit scoring is most often used in retail banking units where they are primarily
dealing with personal customers. However, you should bear in mind that the
smaller end of the Small and Medium Enterprise Businesses (SMEs) sector can
have credit risk assessed using the same techniques as fOT consumers. Later on we
shall come to high value lending.
As well as assessing credit risks, a form of credit scoring is used to determine the
suitability of the various accounts that could be offered to a customer wishing to
open an account that has “automatic” credit facilities. Credit scoring is used
extensively for mortgages, credit cards and other types of revolving credit.
Credit scoring is one of the most accurate, consistent and fair forms of credit
assessment. It uses information provided on an application form, external data
from eCIB and applies internal statistical information on the credit histories of
applicants who have previously repaid (or not) their credit on time.
When a customer wishes to borrow from the bank they generally have n
complete an application form which contains a great deal of information an data
about the customer. Certain aspects of the data are analyzed by awardn points
according to the answers given on the form. Usually, before the baaU will agree
to lend to the customer, a certain minimum score ha to be attained. The systems
are normally computer-based.
This risk assessment technique is neither a crystal ball nor a means of forecasting
whether an individually scored credit applicant will repay their debt as promised.
What it can do is assess the credit risk of the applicant using the historical
The term “scorecard” is often mentioned when credit scoring is discussed. This
refers to the set of points used in scoring an application. Points are allocated
according to the characteristics of various applicants whose accounts:
are then compared with the characteristics of those facilities that were
either slow to repay (required intervention of some kind) and
• are compared again, this time with those who did not repay their loan in
full.
For example, what you may discover is that applicants who had cheques or direct
debits dishonored in the last 12 months are more likely to default on loans x%
more than a customer who did not have debits returned unpaid.
Points are assigned to each characteristic that reflects the comparison between
“good”, and slow, and problem loans. The characteristics used may range from
post code to home ownership, length of time at address, to having a land line
telephone.
Credit scoring is the term used to describe systems within banks and financial
institutions which allow lenders to automate their credit decision making while
also managing the credit risk of those decisions. Credit scoring consists of a
statistically derived model (the credit scorecard) which is used to predict a
specific outcome and a set of strategies which drive the decisionmaking process.
Application scoring
In the credit risk arena, a number of different models can be used to predict
different outcomes. For example, a credit scoring model may be built to:
predict the credit risk of approving a new current account and providing
overdraft facilities.
Behavioral scoring
Allows management to control the “credit tap”, that is, increase or reduce
credit exposures, thus giving the bank control over approval volumes
/“bad” rates.
• With a standard and tested system, the quality of the credit portfolio will
be reliable during a stable economic cycle.
Is time sensitive - efficiency deteriorates over time. Very old data can
prove to be unreliable for making plans for tomorrow, so scoring systems
need to be replaced or updated over time.
How effective has the override performance been (where the lender has
not followed the course of action recommended by the scoring system) -
has there been stability in override decisions?
• Has the predictability of the level of defaults or approvals matched actual
results?
Historically, banks have built their credit scorecards using default or partial data
from the credit reference agencies. This has given the banks details of any credit
agreements which are in default. In recent years, the use of full data has become
The Electronic Credit Information Bureau (eCIB) was established by State Bank
of Pakistan (SBP) in December, 1992. The scope and activities of eCIB are
governed under the provisions of Banking Companies Ordinance (BCO), 1962.
Credit Information Bureau is an organization that collects and collates credit data
on borrowers from its member financial institutions. The financial data is then
aggregated in system and the resulting information (in the form of credit reports)
is made available on request to contributing member financial institutions for the
purposes of credit assessment, credit scoring and credit risk management. The
major purpose of this database is to enable the financial institutions to know the
credit history of their prospective customers thus enabling them to make a more
prudent decision.
In order to understand eCIB in detail, please see appendix 3A.
Mortgage lending
If the mortgage lender has the twin objectives of responding profitably to market
demand for mortgages and building a healthy mortgage portfolio, then marketing
and sales efforts need to be supported by a sound lending policy based on a
reliable credit assessment process. How can the risk inherent in mortgage lending
be managed effectively?
A banker wants to assist customers in fulfilling their desire to own their own
home, but also wants to be as sure as possible that they can meet the financial
commitments involved. The lender will not want to lose money - and so we have
to ensure that the loan will be serviced on a timely basis and repaid at the end of
the agreed term.
• property risk - value of the house itself and quality of the registered title.
- Repayment risk
- Property risk
The professional valuation should also provide some useful indicators of the
condition of the property as well as any repairs that need to be carried out
immediately or items that may create a need for future maintenance. The
latter may impact on the borrower’s ability to meet future mortgage
payments. Surveys fall into two categories:
The mortgage valuation brings some protection, as long as the surveyor did
not highlight a major defect. It is, however, a very brief report, normally only
providing a value. Whoever instructed the valuation can sue for recovery of
loss, either directly against the surveyor or via the surveyor’s personal
indemnity insurance. It is believed that, legally, the party instructing the
surveyor can make a claim for a defect discovered subsequently. The quality
of the legal title is important to both the borrower and the lender. It will be the
solicitor's responsibility to confirm precisely what is being purchased in terms
of land areas and if there are any changes documented by the local authority
planning department that may have a detrimental impact on the future value of
the property.
It is also crucial that any conditions or covenants applying to the title to the
property which restrict the borrower are highlighted. The solicitor acting in
the transaction, as well as having a duty of care to the borrower, is required to
ensure that all the lending documentation conforms to the standards agreed by
the lender and that any variation is agreed prior to its execution.
Other factors which come into the assessment of a mortgage application are:
- Conduct of accounts
Where the applicant is a customer of the bank already, the previous conduct of
the accounts can be checked to see if there is any evidence of unpaid items or
hard-core borrowing and it can also give a reasonable picture of the
applicant’s ability to budget effectively. If the applicant is not a customer,
references should be sought but, in addition and to provide as much useful
information as possible, most lenders will ask to have sight of the previous
three months’ bank statements.
■ Evidence of savings
In many cases this can be obtained from the account statements, but evidence
of savings elsewhere should also be obtained. This information can be used to
confirm the source of any contribution to the purchase price of the property. It
is also important that the lender confirms that the contribution is not being
borrowed from another source or, at the very least, where a proportion of the
funding is being obtained from elsewhere, details are available to the bank in
order that account can be taken of this when the security documentation is
drafted.
The bank will wish to ensure that its position is preserved and no other lender
has a prior claim over the proceeds of the house should the borrower default
on the loan. Any other loan will also require to be serviced and repaid and this
needs to be taken into account in assessing whether or not the applicant can
afford the overall commitment.
■ Income and expenditure profile
Has previous borrowing either with the bank which is assessing the mortgage
application, or with another bank or with a finance company, been serviced
and repaid satisfactorily?
References should be obtained from the current employer who will confirm
the level of salary and any other earnings such as overtime and commission.
Length of time with the current employer will be taken into account when
making a decision and many lenders prefer to see at least a year’s service
completed.
Finally under this heading, your bank will have a policy for dealing with
applications from the self employed. You may want to request previous sets
of accounts, probably for the last three years, in order to obtain some
indication of profitability and thus ability to service the mortgage.
A lot of information is required to assess ability to repay and to see that the risk
is acceptable:
Banks service this type of customer in different ways. High net worth customers
will probably have their own relationship manager and, depending on how the
bank organizes its distribution channels, it could be part either of a separate
division within the bank or a separate bank altogether.
This is a sector all on its own, and is segmented into high earning employees and
the seriously wealthy. We will limit our scope to considering the sector as a
whole - the same principles apply.
■ Financial analysis
A good place to start is the Statement of Net Worth. Completing this will assist
when assessing the income and expenditure of the customer and aid in
prompting questions at the interview when this area is being discussed. The
Statement of Net Worth is like a balance sheet. It is prudent to include only
tangible assets.
Gross asset values must be used. While net assets may be a short-cut method of
expressing property or asset values less mortgages/loans due, it will give a
false picture of the customer’s financial health and their net worth. In the
following example we will assume that the customer’s only asset is their home
and their only creditor their mortgage.
Example
Assets Rs
Liabilities
Property 300,000
Rs
Assets Liabilities
300,000
300,000
Personal loss of other assets can motivate the customer to ensure that the
project succeeds and the borrowing is repaid as agreed. The calculation of net
worth percentage is:
Thus if you look at the above example again, you can see that:
• Current assets are those assets that can be liquidated without penalty
within 12 months and will be close to or have the ability of conversion
into cash without penalty (short term investments).
Non-current assets (or fixed assets) are held for longer than 12 months or
those that are regarded as long term investments.
Current liabilities are those items that fall due for repayment within 12
months and will include overdrafts (repayable on demand) and the
current portion of any long term loans (e.g. a mortgage) due to be repaid
within the next 12 months.
Net worth is the customer’s stake and is Total Tangible Assets less Total
Liabilities.
• Current assets have the ability of being converted to cash easily within 12
months and without penalty or a forced sale. A forced sale can result
(because of time restrictions and availability of buyers) in a lower price
being achieved than had originally been estimated. The advertising
timeframe will have been reduced and may not reach all who are normally
active in the market. Buyers may also become aware of the situation and
reduce their bids accordingly.
Rs
Assets
Liabilities Current portion of
Cash 10,000
mortga 20,000 Long term portion of mortgag
Quoted shares 10,000
180,000 Net worth 120,000
Property 300,000
20,000
320,000
Assets Liabilities
Cash 10,000
Overdraft 200,000
Quoted shares 10,000
Property 300,000 Net worth 120,000
320,0 320,000
The current ratio is only 0.10 times (Cash + shares divided by overdraft) or
around 37 days of near-cash assets to cover the overdraft.
Current assets can be refined further into less than 90 days and 90 days to
365 days. This refinement of current assets into < 90 days allows an
assessment to be made of the absolute liquidity of the customer’s assets
or provides a quick ratio measurement.
Thus current assets less than 90 days, divided by the current liabilities,
gives you a measurement of how easily the customer can cope with
meeting their debts due, not just in the next three months but for the next
year. If this were say, 1.0 times, then you would be very relaxed about the
customer’s ability to meet a sudden demand from any of their other short
term creditors. This is why it is being described as a measurement of
refined liquidity which we will call absolute liquidity or the quick ratio.
Strong liquidity (a satisfactory current ratio, say 1.0 to 1.5 times) will
generally mean low credit risk and, if maintained when the new
borrowing is agreed, this will be a low credit risk.
Assets and liabilities require to be valued using market values - the value
that would be achieved between a willing buyer and seller.
• Property assets
These can be valued using the latest surveyor’s report and valuation, although
these will not be always up to date, unless the property was purchased
recently. You could seek a verbal desktop valuation from a bank-employed
surveyor. Other methods could be the valuation from an estate agent, and
although this may require to be adjusted slightly as the value will be based on
an expected selling price, it will still give you an approximate figure.
■ Other assets
• Currency accounts are valued at the spot rate in the financial press or from
your own bank’s daily currency circular or advice.
• Quoted shares are valued using the prices from the financial press.
• Life policy surrender values are per the letter issued by the life company.
These should be updated periodically say, every three or five years.
Remember that they will exclude any terminal bonuses which only become
known when the policy matures. Motor vehicles can be valued using the
internet.
• Shares in unquoted companies are normally valued by using the latest set of
audited accounts (total shareholders’ equity divided by number of shares
issued) or by the customer’s accountant where no balance sheet is available.
• Trusts set up in your customer’s favour can provide either an income stream
and/or eventual ownership of particular assets when a specific event takes
place, such as achieving a particular age, death of a parent or other relative.
You really need to see the trust deed to understand the stability of the income
or the terms of asset ownership. Do not confuse this with trusts created by a
customer. Although they may be trustees and can influence distributions to
the beneficiaries (who will not normally be themselves, otherwise there are
tax issues) ownership of the assets has been vested in the trust itself.
- Specialized assets
The assets will often be family heirlooms, paintings, ceramics, gold or silver
plate, antique furniture, bloodstock, etc, and you should seek independent
professional advice when relying on these values. While insurance values
may be a useful rule of thumb measurement, they will be approximately up to
50% higher than the value achieved at an auction where there is a willing
buyer and seller. In forced sale or adverse market conditions (say due to a
recession) the values achieved can fall dramatically.
■ Contingents
There is quite a degree of uncertainty here and the bequest may not actually come
into the customer’s possession.
In both cases, contingents are not included as values under assets or liabilities
within the Statement of Net Worth, but they still require to be assessed as how
likely they are to occur. If they crystallize, the liability becomes real.
assess the gearing of the customer - low gearing will generally indicate a
low risk, but watch for the impact on your analysis of any new debt and
assets purchased
Property asset details will allow you to establish income streams from
rented properties and allow you to check on the servicing costs to ensure
that they are included in the customer’s expenses.
• You will be able to establish if the customer is allowing for rental voids
Lending: Products, Operations and Risk Management | Reference Book 1 201
during the year; this is important where property is not let out on a long
term basis. If it is rented on a month-by-month basis, it may not be
prudent to expect the property to be let for a full twelve month period as
there will be times when the property will be empty, awaiting the arrival
of a new tenant. It is useful to establish the current rental amount for each
property, when the lease expires and how your customer establishes their
tenant’s financial reliability. From this you can assess rental voids and
assess income stability risks.
• Where the share or stock holdings are large, income from the dividends of
investments can contribute substantially to a high net worth individual’s
income. If this is 10% or more of earned income, it should be detailed
carefully and analyzed. Remember that dividends on ordinary shares will
be dependant on the underlying profitability of the company (dividends
are normally paid twice a year) and can fluctuate year on year. Be careful
when analyzing historical dividends that the analysis does not include
one-off or special dividends.
All of this will allow you to establish if there are any assets free of
mortgages which could be available as security if you feel it is needed.
Expiry of credit facilities of your bank or another competitor can alert you
to an imminent and potential new borrowing need of your customer,
especially where there is a need to replace assets such as cars, motor
homes, boats, etc.
• the exact living costs of the customer. Although you can obtain
information during the interview on how much they spend on food,
entertainment, travel etc, this may be seen as being invasive and you may
not enhance the relationship as a result of detailed questioning. It may be
simpler and quicker to establish this as a percentage of their net income -
generally a figure of 30% can be sufficient to cover “living expenses”.
You may discover that when the living expenses percentage is applied and you
establish the surplus of total net income, less total expenditure, that this figure is
not reflected in the operation of the bank account.
For example, if the surplus you calculate is equivalent to Rs. 100,000 per month,
but the overdraft is increasing at a rate of Rs. 100,000 per month, a reconciliation
of the Rs, 200,000 variance should be accounted for. You may have missed
something, or the customer may be spending more than 30% of their net income
on food, entertainment, etc. If you do not establish this now, there will be
potential for the overdraft limit to be exceeded part of the way through the next
12 months.
The surplus you calculate needs to have an approximate relationship with reality.
Again a variance of less than 10% is acceptable. For example, the surplus you
calculate is Rs. 900,000 and the customer’s current account on average during
the year increases (including transfers to savings accounts) by Rs. 800,000, then
this is more or less within 10% and can be accepted.
For these personal customers a mnemonic like the “5 Ps of credit” may help:
• Person
• Purpose
Payment
• Protection
Premium
Person
• Does the customer’s profile fit with your own bank's strategic and mark
objectives?
■ You will wish to review age (is customer nearing retirement?) or do 1 have
a young family which may explain the lack of elasticity in the! of income
less expenditure? No two customers are the same and personal
circumstances require to be taken into account in any ana
• What is the net worth surplus percentage? Do they have high or gearing or
leverage?
Purpose
■ Is the purpose for which the credit facilities are being granted legal, within
your bank’s credit policy?
■ Regarding legal risk, you need to ensure that the documentation for 1 credit
facilities and for any security provides a legal and binding cont
■ What precisely are you funding? If you are unsure, you must find to be
certain that the purpose is legal and within your bank’s pol
■ Is there a logical fit between the purpose for which the asset is financed
(investment property) and the source of repayment (which sh be rental
income)? For example, you may be asked to fund a rei property and are
granted security over it, but the loan repayment offered is solely from
dividend income. This is illogical - why are you not being offered the rental
income from the property? If you are being offereai both rental and
investment income, then accept it provided there is a sufficient margin
between income and debt costs.
At other times you may be asked to extend facilities for some expense (a
holiday, Eid, etc) and repayment is to come from a maturing life policy six
months later. This is acceptable on the basis that the proceeds of the life policy
cover both the principal and the roll up of interest. If you hold the life policy and
the life company’s cheque is sent direct to your bank this will reduce the risk of
payment being delayed.
Another common short term repayment source could be a regular annual bonus.
However, care and discretion needs to be exercised as this can vary substantially
from year to year and the actual sum payable will not be known until shortly
before payment. In these circumstances, an appropriate percentage could be
advanced; for example, depending on the track record of the customer, from
25% to 50% of the historical bonus sum. However, you need to be satisfied that
if a lower bonus is received that the customer can repay the shortfall within a
reasonable period.
■ Suppose you grant facilities and the customer accepts that they will need to
dispose of assets to repay you if debt reduction proves difficult from income.
Here you will want to document the agreement fully and have your facility
acknowledged before the borrowing is taken.
■ Use separate loan accounts where the lending is for a specific purpose. This
makes it easier to monitor the repayments.
Payment
■ A major part of credit risk assessment is making sure that the interest cost can
be met and repayments made as arranged.
■ The primary source for servicing the borrowing and meeting loan payments is
usually from the surplus of income over expenditure. You will need to make
sure there is enough surplus income and take into account:
Financing a new asset (like a holiday home) will bring increased running
and maintenance costs
■ Owning the asset may provide some income; if the asset is quoted shares
there will be dividend income, or if rental property, there will be rental
income.
■ Conditions can be put in the loan agreement to make sure that, for example,
investment income streams repay the debt.
■ This comes initially from the income and assets of the customer. If do not
repay you, then you may need to resort to the security held-
If you are financing a portfolio of investments, you may decide you debt to
market value ratio of no less than 75%. This is akin to the 1 value stipulation
in mortgage lending. Any rise in the ratio will alter risk/reward equation and
bring about a renegotiation.
■ Have you satisfactorily covered the external market risks? Fixed or rate
borrowing can help mitigate exposure to increases in interest Where a
substantial proportion of income or expenses is in a f_ currency, does the
customer require a foreign currency account foreign exchange contract
credit line?
life cover and/or critical health insurance, etc assist with repa or
servicing if an unexpected crisis occurs
Lending is not just a matter of writing up a credit facility and leaving it. need
to check regularly during the year that an overdraft facility is building up to
hard core or permanent debt. Remember that ove should normally swing into
credit from time to time, otherwise you non-amortizing loan.
« Are insurance policies still in place, adequate to cover the assets, and
premiums been paid?
Premium
■ What is the credit risk/reward ratio? Are you charging sufficient in' to
cover the credit risk your bank is being asked to take?
■ Your bank may have a pricing model that will assist you in estab the
hurdle interest rate and arrangement fee to be charged for the
■ You will recall that a bank must manage its return on capital em to ensure
that adequate returns are made to meet its costs and p the returns
shareholders expect.
Adapted from:
Credit Lending Module and
Specialized Lending Book-
One of Chartered Banker
Institute.
If the proposals have been properly analysed, and a fair decision made based on
known facts at the time, it would be unfair to level criticism at the lender.
Criticism would be justified, however, if warning signs had been evident and
little or no notice had been taken of them. The control of lending begins as soon
as a proposal is reviewed. There will also be occasions when borrowing is
declined because you are not satisfied that it meets the bank’s lending criteria.
When this happens, you are looking after your customer’s interests by not
lending money they are unable to repay. You are also protecting the bank’s
position.
In certain situations, a lending banker might feel that they have contributed to the
problem and in due course may well have to admit that their judgement has been
wrong. Once warning bells have begun to sound, it is essential that you instigate
remedial action which may well involve seeking guidance or instruction from
senior colleagues. It is absolutely wrong to just leave the problem and hope that
it will get better and the customer will work through the difficulties.
Types of Problems
The types of problems which may occur are many and varied. Here are some of
them:
• An event caused by the customer which might have been avoided if the
lender had been kept fully informed; for example, the customer with an
overdraft limit of Rs. 50,000 and an overdrawn balance of Rs. 49,250,
whose cheque for Rs.
15,0 in favour of HM Revenue and Customs is presented to you for
payment.
You will be able to identify for yourself other types of problems which may
occur.
Warning signs
Once an advance has been approved and taken by the customer, the banker must
remain on guard to ensure that everything goes according to plan
These are only two of the warning signs which are easily recognisable, but there
are many others and we will now look at some of these. We are going to list
some of the danger signs which might indicate that a customer is experiencing
problems. Taken individually, there might be little cause for concern but, where
a number of factors are evident, you should be on guard.
• cheques for round amounts are being issued by the customer - the regular
issue of cheques for round amounts might suggest that the customer is
unable to fully settle bills to creditors and is making payments on account
to appease them
Interviews/visits to customers
The message remains consistent - listen, look and visit. A great deal, can be
gleaned from asking the right questions during meetings with customers and
by listening to what the customer has, or has not, to say. When all is not
well, a visit to your customer’s business premises will provide some first
hand knowledge of warning signs such as:
If you have found it difficult to arrange an interview or visit, this may just be
because the customer is very busy at the time; but it may also indicate that they
are trying for some reason to avoid seeing you.
Financial information
Additional lending
As you might expect, the first reaction of many borrowers if they experience
financial difficulties is to approach the lender with a request for additional
finance. Reiterating earlier comments, unless viability can be established, it is
important that we don’t make the situation worse by assisting the customer to
dig an even deeper financial hole out of which they will find it impossible to
climb.
Example
“My company is in difficulty. If the bank were to increase the borrowing facility
by a modest 15% then this would allow us to clear some of the pressing
creditors, supplies of raw materials would be resumed and all will be well.”
Increasing the credit line available may be the correct solution but, on the other
hand, it may simply have the effect of adding 15% to the amount of bad debt
which the bank will ultimately have to face. Remember, it is from profitable
trading that the cash flow comes to repay the loans. Where a business is
prospering, with turnover and profit rising at a satisfactory rate, it may well be
entirely reasonable for borrowing to increase - possibly to match a growing
working capital requirement. However, if an enterprise is clearly suffering
financial difficulties, you will have to consider the possibility that this course of
action may simply postpone the day when more drastic decisions have to be
made, possibly at great cost to the borrower and the lender.
In other words, the bank does not want to be in the position of “throwing good
money after bad”. Ultimately, when you are considering whether or not it would
be prudent to increase a customer’s borrowing, you should revert to considering
the principles of lending.
Although many reasons can be put forward for businesses running into
difficulties, the main cause is usually a shortage of cash. If cash is not flowing
through the business at an acceptable rate, then the orderly operation of its
affairs becomes more and more difficult. Lack of profit is serious, lack of cash is
deadly! The reason for lack of cash can often be that certain assets are not being
fully utilised and when difficulties occur you need to see what improvements can
be made.
Stock is probably the first area to be examined. Stock lying for too long on the
shelf cannot improve cash flow. Amongst other things, consideration should be
given to:
Debtors
\
Are debtors being collected strictly in accordance with agreed terms and is a
review of these terms justified? You should examine an aged list to determine
the extent of the problem.
Are invoices being issued promptly? Factoring of debts might be considered as a
realistic option, although this will reduce the value of the bank’s security if you
are relying on a floating charge.
Creditors
In most cases you will find that this is a pressure point with suppliers pressing
for payment. However, you may find instances where the problems are not too
severe; where the cash flow difficulties are attributable to creditors being paid
prematurely and your customer is not taking full advantage of the terms available
to them. Equally they should ensure that they obtain any discounts that reflect
the prompt payment. Where the problems are more severe, can they renegotiate
their terms?
Other assets
The customer should also consider whether any assets are surplus to
requirements and could be sold. Sale and lease back of property is one possibility
and, for the future, the customer might consider leasing rather than purchasing
assets. You will need to consider whether this remedy would impair the value of
your security.
Other areas for review
Adapted from:
Credit Lending Module and
Specialized Lending Book-
One of Chartered Banker
Institute.
2. Types of collaterals
6. Monitoring of charge/margin
S. No List of Documents
1 Application Form
2 Copy of CNIC with orginal seen
3 Salary Slip/ Salary Certificate / Employer Letter / Income
Documents
4 Bank Statement
5 Bank Statement (External)
6 Proprietorship Certificate Copy or orignal
7 Registered Partnership Deed copy
8 Registered Memorandum & Article of Association with la^
issued Form 29 A Copy
9 Professional Degree Copy
10 All verfication reports
11 ECIB / Data Check / NADRA Verisys
»c.ng: Products,
Operations and Risk
Management |
Reference Book 1 221
PROCESS
Loans CHECKAgainst
- (Advances) LIST Collateral Securities
DESCRIPTION
Advances Against Imported STATUS
Merchandise (FIM) Sanctioned.
YES NO REMARKS
Documentation Required.
* Promissory Note-IB 12 duly stamped and signed.
* Customer's request for grant of facility.
* NIB forms as applicable in accordance with the
nature of facility with adhesive stamps.
Irrecoverable letter of lien/pledge of securities,
agreement etc.
YES NO
Documentation Required.
* Customer's request for grant of facility.
* Deposit receipt duly discharged.
* Promissory Note-IB 1 duly stamped and signed.
* NIB forms IB-6,6-A, 6B or 6C, 25A, with adhesive
stamps, signed by customers.
* Irrecoverable letter of lien/pledge of deposit
* agreement.
CIB report in case facility exceed Rs.0.500 million.
YES NO
Documentation Required.
* Customer's request for grant of facility.
* NDSCs, NDCs, FEBCs duly discharged.
* Promissory Note-IB 1 duly stamped and signed.
* NIB forms IB-6,6-A, 6B or 6C, 25A, with adhesive
stamps, signed by customers.
* Irrecoverable letter of lien/pledse of deposit asreeme it.
* Letters of arrangement / disbursement / instalment.
* CIB report in case facility exceeds Rs.0.500 million.
YES NO
Documentation Required.
**Finance made as registered/equitable mortgage
of land/building (Constructed OR to be constructed.)
YES NO
Documentation Required.
* Customer's request for grant of facility.
* Promissory Note IB-12.
> NIB forms noted below with appropriate adhesive
Stamps.
* IB-25 A Letter of Hypothecation.
* IB-26 Letter of Pledge.
* IB-29 Letter of Guarantee.
* Irrecoverable letter of hen.
* Agreement for financing on Mark up basis IB-6
* NOC from other banks holding charge on stocks
offered
for hypothecation if applicable.
* Insurance Policy from approved company covering
stocks under hypothecation with fire risks. Loss due to
theft, and bank mortgage/pledge/hypothecation clause,
alongwith premium paid receipt.
* In case of limited company
* Certified Memorandum of Article of Association.
* Certificate of Incorporation.
* Commencement of business (not required from
Private Limited Company).
* Board of Directors resolution authorizing to obtain
loan from the bank.
* An undertaking from directors committing to obtain
prior clearance from the bank before declaring an)
dividend (if part of the loan covenant).
* Letter of Guarantee from Directors.
* Letter of Partnership and personal guarantee
executed by all partners in case of Partnership
concern.
* Letters of arrangement, disbursement.
* Latest stock report indicating item quantity, quality,
rate and signed by borrowers.
* Favourable CIB report obtained.
DESCRIPTION STATUS
YES
1
NO REMARKS
Documentation Required.
* Customer's request for grant of facility.
* Promissory Note IB-12.
> IB forms noted below with appropriate adhesive
Stamps.
* IB-26 Letter of Pledge.
* IB-29 Letter of Guarantee.
* Irrecoverable Letter of Lien.
* Agreement for financing on Mark up basis IB-6
* NOC from other banks holding charge on stocks
offered
for hypothecation if applicable.
* Insurance Policy from approved company covering
stocks under pledge with fire risks. Loss due to
theft, and bank mortgage/pledge/hypothecation clause,
alongwith premium paid receipt obtained.
* In case of limited company :-
* Certified Memorandum of Article of Association.
* Certificate of Incorporation.
* Commencement of business (not required from
Private Limited Company).
* Board of Directors resolution authorizing to obtain
loan from the bank.
* An undertaking from directors committing to obtain
prior clearance from the bank before declaring an>
dividend in case of public limited company.
* Letter of Guarantee from Directors.
* Letter of Partnership and personal guarantee
executed by all partners in case of Partnership
concern.
* Letters of arrangement, disbursement.
* Latest stock report indicating item quantity, quality,
rate duly signed by borrowers.
Company
Types of Companies
Generally, companies can be categorized as follows:
Companies limited by Shares have further two types, (i) Private Limited
Companies and (ii) Public Limited Companies.
Documents Required
Generally, all the powers of a company are exercised by its dir except
as provided in the Ordinance or AOA of a comp However, as regards
the borrowing powers of a company, Ordinance specifically provides
vide Section 196 that the dir of a company shall exercise the said
powers on behalf of company by means of a Resolution passed at
their meeting. It therefore, necessary that whenever a Company
requests a fin facility, a copy of the Board Resolution be obtained in
this r duly attested by Company Secretary/Director(s). Similarly, on
renewal / enhancement of the facility (ies), a fresh Board Resolution
should be obtained to cover the aspect of renewal/enhancement. The
Board Resolution should preferably be specific as to bank name,
nature and amount of facility (ies), aspect of renewal / enhancement,
nature of securities; and should specify the company’s
representatives, who would sign / execute the documents. In
addition, a BR must confirm that the minutes of the relative meeting
A general and open ended Board Resolution may also be accepted, provided
the BR covers all the aspects mentioned above. In such a case, no fresh BR
is required on renewal/enhancements.
List of documents required. Source for Certified Copy
Memorandum of Association Company Secretary
Articles of Association Company Secretary
Certificate of Incorporation Registrar Joint Stock of
Companies (SECP)
Certificate of Commencement of Business Registrar Joint Stock of)
(Only required for Public Limited Companies (SECP)
Companies)
Board Resolution to Borrow Company Secretary
Form 29 (List of Directors)/ Form A Registrar Joint Stock of
Companies (SECP)
Attested copies of CNIC’s of all directors NA
While the structure, pricing, repayment schedule and other terms of syndicated
loans can vary, the following common characteristics are usually present:
c. The arranger may underwrite (i.e. undertake to provide) all or part of the
facility amount.
Sole Proprietorship
A sole proprietorship is a business concern owned by a single his / her
own account with 100% control. There is no formal p to be followed in
setting up a sole proprietorship concern. H is necessary to establish that
the borrower is the sole owner of the whose name is being used; and
therefore, a declaration evide said position and the proprietor’s name etc.
should be obtained concern’s letterhead. Furthermore, such a concern
may be /registered with trade associations/bodies and may have NTN
which should also be obtained, if applicable.
The account opening and lending documents stipulated by the Bank should be
signed by the sole proprietor and the Proprietorship stamp should be affixed.
Nevertheless, it must be ensured that the documents of all types (especially DP
Note) should be signed in such a manner that the name of the proprietor appears
along with the name of the proprietorship concern, since proprietorship isn’t a
separate entity.
b. Partnership/ Firm
While extending loans to these bodies special care should be exercised. Charter
230 of incorporation, by-laws as Products,
Lending: well asOperations
proof andof Risk
their registration
Management | should be
carefully examined before granting any facility. Clear legal opinion from
bank’s internal legal department (Legal Affairs) should be obtained prior to
extending finance, regarding borrowing powers, charging of security and other
requirements.
Documentation Descriptions
The present mode of banking finance is structured on the pattern < Islamic
modes of financing, since interest based system of banli financing has been
banned in Pakistan, since 1982. The system and developed under guidelines
and parameters of a Board constit then by the Federal Government. The
Board not only developed structure of the system but also drafted standard
documentation in 1 context, including financing agreements. The said
standard docume /agreements are called IBsAB Forms.
Morabaha in its original terms provides that the purchase price may
include an amount of mark-up for some farther period (cushion period),
over and above the period of finance, so that if the purchase isn’t paid
on time, the lender may bring the matter to the court of law during the
said further period and no financial loss is caused to him for the said
period. However, if the borrower pays the purchase price in time, the
amount of mark-up for the further period is reversed. It is called rebate
or prompt payment bonus. Presently, it is taken as difference of mark-up
calculated @ Standard Markup Rate (SMR) and Timely Payment Mark
up Rate (TPMR).
ix. IB-31 (Agreement for Sale & Buy Back of Marketable Securities} is
obtained in the event where collateral is in the form of marketable |
securities, like shares. It also refers to sale price and purchase pr on the
pattern of IB-6, for the reasons that the securities are 1 to have been
purchased by the Bank and then sold back to customer.
i. Since sale price, purchase price and rebate are the main used in
the IBs, therefore, while executing IBs, principal emp should be
upon the amounts relating to the said terms. Accor the relevant
columns provided in the IBs for the said should be filled in
appropriately.
ii. The date of execution and the reference of IB-6 (where app should
be given therein.
iii. IB’s should be executed and witnessed appropriately. One witness
should be from borrower side and second witness should be from bank
side. Copy of CNIC of witnesses should also be kept.
iv. It must be ensured that the executants of the IBs are duly authorized to
execute the same (in case of companies and firms); and their
constitutions (MOA & AOA; and Partnership Deeds) allow execution of
the documents.
Retention of Legal documentation in safe mode is one of the important area that
can not be neglected. Since through these documents legal rights can be
enforced in the Court of Law. Inappropriate handling of these documents may
lead to invalidation of the rights or jeopordizing the interest of the Bank,
therefore, Bank should take all appropriate measures regarding safe custody of
legal documents.
IN HOUSE ARRANGEMENTS
Bank (depending on size and availability of resources) should keep all security
documentation in a room with fire proof arrangements under dual control after
lodgment in safe custody register. A separate register;/ similar arrangement
should also be maintained to keep track of movement of any document/
document folder. Bank should issue collateral lodgment receipt to the
concerned relationship manager which will serve as a proof that documents are
held in safe custody.
In cases where it seems that in house arrangements for safe custody of legal
documents are not appropriate, ex house arrangements may be considered.
These are more considerable in today’s world where uncertain events like
explosions/thefts have increased. However, one should have to understand the
cost and secrecy issues while making these decisions. However, where such
arrangements are deemed necessary by the Bank, all precautionary measures as
applicable for in house arrangements should be implemented.
Commercial credit involves lending to the various types of borrowers for the
purpose of meeting various business capital requirements. The commercial
credit facilities offered by the bank are mostly generic and are designed to
meet various types of requirements of the borrowers. Further, from time to
time, specialized products are offered by the bank which are based on these
facilities but have special features and terms that are designed to facilitate a
more specific type of borrower, business requirement or transactional
modalities.
Types of Collateral
The collateral / security could be in the form of First exclusive charge, senior
to all other lenders; First pari-passu charge; Pledge and exclusive charge;
Lending: Products, Operations and Risk Management |Equitable and
Reference Book 1 legal charge; Standby letter of credit / bank guarantee;
239 Corporate
or personal guarantee.
The collateral / security should ideally match the purpose, nature and structure
of the transaction; it should reflect the form and capacity of the obligor, its
operations and the business and economic environment.
The critical collateral / security related components with respect to the credit
process have been summarized in this section.
Following are the main reasons for a bank to take collateral / security:
• Lien on deposits.
• Pledge of Stocks / goods.
• Unregistered hypothecation charge on fixed assets and / or current assets
other than company (Sole Proprietorship and partnership) Registered
hypothecation charge on fixed assets and /or current assets for Private
and public limited companies.
Hypothecation of charge on Plant and Machinery and spare parts.
• Equitable / Token Register Mortgage of land and building. Personal
Guarantee of Directors / Proprietor / partners.
• Title of leased assets.
Assignment of Bank Guarantee.
• Guarantee, Cross Corporate Guarantee, Guarantees of Parent Co.. Lien
over Letter of Credits.
• Assignment of Receivables.
• Lien over import documents.
• Lien over export documents.
• Lien over bills.
• Post dated cheques/ Debit authority.
• Trust receipt.
• Assignment of Salary.
a) Marketability
As security is obtained for the purpose of meeting an emergency in the
event of default by the borrower, the main consideration should be its
ready reliability or marketability (including
Stability of Value
Security offered should provide reasonable stability in value and should not be
prone to violent fluctuation in prices (as discussed in (a) above). Although it is
the usual practice to maintain reasonable margin on security value to take care
of the volatility in prices, violent fluctuation will call for frequent adjustment of
margins and hence may not be cost effective.
Durability
A security should be reasonably durable. Easily perishable items like raw
foodstuff, spices etc. do not constitute good security and should be avoided.
Liability
The security should not involve the bank in any liability. A striking example is
the case of partly paid-up shares, which if transferred in the bank's name as
security, may involve the bank in the liability, for calls on the unpaid face
value. Another example is immoveable properly where taxes are heavily in
arrears.
The difference between the value of the security and the amount upto which the
borrower can draw is known as margin. Margin on securities is maintained as a
cushion against fluctuation in value of securities. This can occur due to a
shortage, which may not be discovered by inspection or shrinkage in value,
which may arise on account of the nature of goods charged or adverse shift in its
demand. Again, if a customer commits default in payment of the Bank's dues,
the Bank may have to take steps to sell the security after giving an appropriate
notice to him. In case of forced sale, the security is not likely to fetch its full
value. To provide for such eventualities, the Bank keeps a margin. The
percentage of margin depends upon a number of factors including the Bank's
perception of ready marketability and likely fluctuation in the value of the
security. The value of security less margin is known as Draw-able Limit or
Advance Value.
Hypothecation
Associated Risks
i. Low control over goods (possession with the borrower).
ii. Difficult to verify title to the property.
• Since real time check for amount of receivables and objective evidence of
the debtors is difficult to obtain. So such security should only be considered
for high value customers.
Documentation
Bank must ensure that appropriate security documents are arranged and must
also ensure that validity of these documents. In addition to finance agreements,
following document(s) should be obtained.
Charge Requirements
Debts due or accruing due to a person may be assigned by him to the creditor
and can thus be made security for an advance.
A charge on book debts taken by a banker as security should cover only those
debts due or accruing due from named debtors under specified contracts at the
time the charge was executed. For example in the event of insolvency, any
general assignment of existing or future book debts will be void against the
Official Assignee as regards to any debts not paid at the commencement of the
insolvency.
An assignee under a legal assignment can sue in his own name and can give a
good discharge for the debt without concurrence of the assignor.
B) Equitable Assignment:
Securities are classified according to the legal nature of the right or charge
created on the property/asset. Thus a security can be in the following forms:
A Charge: When an asset/property is identified as a security against a
facility in an agreement or document creating a borrowing relationship,
a charge is said to have been created. This charge can either be
registered formally or remain unregistered. A registered charge
obviously provides a higher degree of security.
There can also be General Lien, which arises out of general dealings between
two parties, e.g. the Banker's General Lien, which is an implied lien on all the
accounts/assets of the borrower that come into a banker's possession. The
Banker's General Lien is also subject to certain exceptions and conditions under
the law which will be discussed in relevant sections.
Collateral should match the purpose, nature and structure of the transaction it
should also reflect the form and capacity of the obligor, its operations, and the
business and economic environment. Collateral may include the assets acquired
through the funding provided, i.e. stock, receivables, or export bills, as well as
cash, government, securities, other marketable securities (such as shares),
current assets, fixed assets, specific equipment, and commercial and personal
real estate.
Charge refers to the security interest created on the property of the company. A
i. Fixed Charge:
Fixed Charge means a charge over assets of a company, which
attaches to the assets from the time of its creation.
The basic distinction between fixed and floating charges is that a fixed charge
attaches to the asset in question as soon as the charge is created, whereas a
floating charge attaches only when it crystallizes.
Registration of Charges
If a charge is not filed within 21 days, then SECP may be contacted for
extension of time; and if the commission is satisfied that it was accidental or
due to inadvertence or due to some other sufficient cause, or is not of a nature to
prejudice the position of creditors or shareholders of the company, or that on
other grounds it is just and equitable to grant relief, then the commission may
on such terms and conditions as seem just and expedient, order that the time for
registration be extended. In such an event, the mortgage or charge shall be filed
with registrar in the manner above referred, along with a certified copy of the
order of the commission.
Documents required for registration
Form X.
Instruments
. Make sure the creation date and description of the charge agree with the
instrument.
• Make sure that ranking of charge is properly mentioned on form X.
• Make sure the amount secured accurately reflects what is stated in the
Instrument.
• Make sure details of the property charged accurately reflect what is
stated in instrument.
• For mortgaged land it is desirable that you give the title number of the
Property.
• Ensure that charging clauses are always inserted, including reference to
fixed and floating charges.
Sign and date the form.
• Complete the forms legibly using black ink or, preferably, type the
form.
Certificate of Registration
If the Registrar is satisfied that the documents filed are acceptable, then he will
cause an entry in the register of charges and will issue certificate of registration
of mortgage or charge, which will be considered as evidence of the charge.
The following are some of the acceptable grounds for rectification of register of
mortgages or charges:
Ranking of Charges
Companies may create charge over their assets in favor of more than one
lender. However, the charge of each lender would not be equal. The law in such
a case gives priority to a charge created earlier in time. The priority as such is
termed as Ranking, which determines priority of right amongst company’s
secured creditors to enforce their charge, in case of liquidation. Ranking of a
charge is determined by time of filing of the particulars of the mortgage or
charge with the Registrar.
a. Terminologies
A Charge is called First Exclusive when it has been created over assets
of a company by a single creditor/lender; and there is no other charge
holder having claim over the said assets.
ii. Second/Inferior
b. Importance of Ranking
c. Procedure to be followed
The amount for which the bank creates a registered charge at the
Registrar of Joint Stock Companies is the secured amount. Several banks
may concurrently have charges registered against the assets of a
company. In this case, the charge holders may rank pari passu or may
hold ranking charges with varying priorities. In case of pari passu charge
holders, the proceeds of liquidation of a company will be shared in the
ratio of the outstanding of their respective secured amount to the
aggregate outstanding secured amounts of all the charge holders of the
company in the same ranking. Amount owed by a lender over and above
a charge / pari passu charge registered with the Registrar of Joint Stock
Companies, shall be an unsecured credit and will be satisfied after all the
secured creditors have been paid and all preferential payments to be
Lending: Products, Operations and Risk Management | Reference Book 1 251
made under the Companies Ordinance 1984 i.e. employee wages etc.
have been fulfilled.
Where property documents / security documents are released on full and final
adjustment of a limit, the Branch Manager should satisfy himself that the
property held is not a common security for any other unadjusted limits with the
branch or the branch has not issued any letter for joint charge or have received a
letter for joint charge from any of our other Branch / Bank.
Fraudulent Conveyance
Pledge
The person delivering the goods is called the pledgor or pawnor and the person
to whom the goods are delivered is called the pledgee or Pawnee. A pledge may
be in respect of goods, stocks, and shares, document of title to goods or any
other moveable property.
A charge by way of pledge of goods does not require registration under the
Companies Ordinance. The main advantage of a pledge is that the banker, as
lender, is in possession of the goods therefore in the event of default by the
borrower, the bank has the right, after giving reasonable notice to the pledgor, to
sell the goods and liquidate the advance.
1) Firstly, verify that the borrower has absolute title to the goods, by
sighting documentary evidence of his having paid the supplier.
3) The quality of the stocks particularly those which have a wide range of
quality and value e.g. rice, cotton, chemicals, and carpets must be
examined by a professionally competent person conversant with that
trade.
4) Where the goods are packed in containers such as drums, cases, and
bags, a test checking of the contents must be carried out by random
selection, in order to ensure the contents are indeed what they are
represented to be.
5) Ensure wherever possible that the Bank has exclusive possession and
control of the pledged goods and that Bank's guards are posted at the
Bank's warehouse, with signboards prominently displayed.
6) Ensure that where goods are in the custody of a third-party i.e. clearing
agents bonded warehouse etc. then such warehouse keeper has
acknowledged that the possession is and on behalf of the bank and that
the pledged goods will be released against the bank's delivery order.
Such clearing agent or warehouseman should be duly approved and the
limits observed.
7) The goods should be duly insured with an insurance Company on the
Bank's approved list and the original polices covering risks of theft, fire
riots & civil commotion etc., held by the Bank.
• The amount of the Policy should ,over the entire value of the goods
stored in the warehouse, irrespective of the amount advanced, to
avoid 'averaging' in the event of a loss claim.
9) It must be ensured that the premium has been paid and the premium
payment receipts are in records.
Types of Pledge
Pledge can be classified on the basis of godowns and storage conditions into
the following two categories:
(iii) . It should be mentioned in the notice that the bank has decided to
exercise its right of said pledge at "any time after the specified date for
redemption, in order to recover the advance.”
(viii) . The offer closest to the market value may be accepted. Full
documentation of bids and all correspondence regarding the sale
should be carefully preserved in safe custody for at least 4 years from
the date of sale as a precaution against any possible civil suit by the
pledgor that the goods were sold for less than their fair value.
The banker would do so against a Trust Receipt being duly signed by the
customer wherein he acknowledges that he holds the goods/sale proceeds
thereof in trust for the pledgee, that he would deposit sale proceeds in
repayment of advance and that he would keep the goods fully insured.
Earlier it was held that the pledgor does not lose his rights of property as pledge
by parting with the custody of the railway receipt or by entrusting them to their
customers for the special and limited purpose of clearing and realizing them, as
agents for the bank.
• The second possible source of risk to the banker is that I pledgor may
fraudulently pledge the same goods to anot bank. In the case of
Mercantile Bank of India the Central i Of India Ltd., (1938), the court
held that such a second pie was invalid on the basis of the old Sec 178
of the Contract. 1872 prevailing at the time the pledge was effected. The
Sec 178 regarding mercantile agents is identical to Sec 2 (Q| the Factor's
Act 1889 on which basis the case of Lloyds ]
Ltd., 1-1 Bank of America A7' el Xi (1938) was decidec i favour of
the validity of the second pledgee. The first plec The Lloyds Bank
thereby lost their rights in the proj originally pledged to them.
Since by extending this facility, the bank's rights as pledgee is prot only in
cases of insolvency of the customer/pledgor but not as fraud breach of trust
by him, such as by way of pledging the gc another bank or by
misappropriation of sale proceeds. It is of ut invariance that such facility
should be extended only to custom: undoubted financial standing and
whose business integrity is ofl highest order.
Hypothecation
1. To pay-in the proceeds of sales of such goods to his current ac with the
banker.
2. To have the stocks adequately insured (against theft, fire, i and civil
commotion etc.) with usual Bank clause incoi in the policy.
Mortgage
Types of Properties
a. Immovable Properties
The word “Immovable Property” has been defined in the registration Act
1908, section 2 (6) in detail. For the purpose of this document, it means -
land, buildings and things attached to the earth or permanently fastened to
anything attached to earth; and does not include:
Default by client
1. When exercising his power of sale, the mortgagee must act honestly and
equitably. He is under legal duty not only to act in good faith but also to
take reasonable care to obtain the true market price at the time he
chooses to sell.
2. The expenses of the sale are to be kept to the minimum and a full
account of the sale and expenses is to be submitted to the mortgagor and
surplus proceeds should be given to the second mortgagee, if any,
otherwise to the mortgagor.
Mortgage formalities
• Ideally a full first legal mortgage should be taken, stamped and registered
according to the requirements of local law.
• If the mortgage is being made by a limited company, it must be established
that the company is empowered by its Memoranda!® and Articles to
mortgage property up to the specified amount, ami a duly certified true copy
of the Board resolution authorizing the mortgage should be obtained. The
Lending: Products, Operationstitle deeds
and Risk and all |docume
Management relating
Reference Book 1 thereto, especially receipts on discharge
of possible pt mortgages, should be retained by the Bank at all times, andi
Bank should be satisfied that:
cciSrccmtpany ousiness.
The exemption of an "All Monies Mortgage" isup.considered by the Bank because
rt-uU.rafinniv:
mortgages or charges created in favor of the Bank as security for the advances
generally specify the amount of the advances and limit the security to that
amount plus mark-up. Accordingly, if and
possession of property because a Mortgagee in possession (the Bank) is
subject to burdensome liabilities in the management of property. However,
in certain situations such possessions may be taken, solely to protect the
Bank's interests with the prior approval of the Head Office.
The best and most preferable method of securing an advance against property is
a legal/registered mortgage but in view of the exorbitant court fee the
borrowers insist on equitable mortgages. It is convenient and expedient to
advance against an "Equitable Mortgage" which, in effect, is against a simple
deposit of the title deeds with a Memorandum of Deposit signed by the
Mortgagor (borrower) in which he states that the title deeds are to be held by
the Bank as security for the debt, agrees to execute a legal mortgage over the
property if called upon to do so by the Bank, and wherever possible gives an
irrevocable power of attorney to the Bank to enable it to realize the security
without application to the Court.
Business Lines should take extra care where properties offered to secure
exposure belong to third party. They should ensure that the owner/mortgagor is
close family member of the proprietor /partner/director. In case owner of
property has no direct interest in the business, consideration/reason of mortgage
of property should be examined. In case, any unusual case is detected in the
existing portfolio, it should be brought to the notice of competent authorities
and all efforts should be taken to either adjust the outstanding or replace the
property with any other acceptable property in the name of proprietor /partner or
close family member of sponsors.
i) The land should be in the name of the borrower, and all the necessary
documents should be completed and in order and approved as such by
bank's solicitors so that there will be no difficulty in creating a registered
mortgage.
ii) The application for advance should be supported by:
a) The original lease deed and, where applicable, the conveyance deed
establishing the applicant's complete title.
b) A "no objection certificate" for mortgaging the plot issued by the
leasing authority.
c) A search certificate issued by the appropriate district authorities
evidencing non-encumbrance of the plot.
d) An estimation of the construction cost from a qualified architect or
engineer indicating the area proposed to be constructed on the plot
and material required, its cost and labor charges.
e) The loan should be disbursed in phases, after the borrower has
268 Lending: Products, Operations and Risk Management | Reference
invested his part of the total cost. As each phase of the building is
completed the manager is required to visit the site to inspect the
progress to satisfy himself that the loan availed has been properly
utilized.
The following guidelines should be followed in case bank has charge over plant
& machinery of the borrower:
• Detailed list of plant and machinery that is being placed under bank’s
charge should be obtained from the client.
• Ensure that valuation of the asset is conducted through Bank’s approved
valuators and certificate to the effect is placed on file.
• Personally visit the asset and be satisfied with the evaluation before
allowing disbursement. A Visit Report should be placed on file accordingly.
In case the valuation is below the value assumed at the time of sanctioning
of facilities, the same should be immediately reported to the credit
sanctioning authority.
• Undertake fresh valuation of the plant and machinery once in every three
years.
The effect of the Limitation Act 1908 on a debt is to bar the enforcement of
recovery through the courts due to lapse of time in filing the suit for recovery
which is generally 3 years in the case of debts. But it does not discharge the
debt itself. Accordingly, a banker can exercise his right of lien over securities,
tive bills or cheques of the customer which may come into his hands in the ordinary
the course of business for the purposes of liquidating even a statute-barred debt of
'the that customer.
‘the
ised h Conditions necessary for exercising banker’s lien:
it.
1. The property must belong to the debtor.
2. It must come into the banker's possession lawfully.
3. It must come into the banker's possession in the ordinary course of business.
4. There should be no contract inconsistent with lien.
tion, Banker's Right of Set-off
lien
Set-off is the right of a debtor to satisfy a debt owing to him by his/her creditor
a the by taking into account all the debit and credit balances of the customer held by
him, in order to arrive at the net balance due between them. Conditions
necessary to exercise this right:
nthe
neral • The amounts to be set-off must be sums certain i.e. definitely ascertained
amounts and not contingent liabilities.
come • Due between the same parties.
plied • Due in the same rights i.e. debt due front a person in his private capacity
must cannot be set-off against a debt due to him as a trustee.
inary
• Not subject to contrary agreement.
er for
The banker's right of set-off is the right to combine two or more of the same
customer’s accounts in order to arrive at the net balance due between them, i.e.
[to be a right to set-off a credit balance in one account against a debit balance in
another account of the same customer in the same right. The right to combine
ind in
two or more current accounts without notice- whilst actively operated upon
name,
appears to have been the subject of controversial judicial decision.
a by a
inker.
It should be remembered that the bank would exercise its right of setoff without
lereas notice, only when it is essential to preserve its position, a position in which the
cer customer has placed him. The customer can avoid combinations, by discussing
has the matter with his banker and reaching an agreement with him.
ject to
It is the usual practice of bankers that where reliance is placed on the right of
set-off of a credit balance against a debit balance, an agreement called the letter
> of of set-off is taken from the customer confirming banker's right to combine
the I accounts at any time, without notices and to return cheques which would
these overdraw the combined balance.
sever
al !■
However, in case of death, bankruptcy, service of garnishee order, when banker
must stop the account, banker's right of set-off is undoubted. In order to
: to determine the net balance due to the executor of the deceased customer, official
the assignee of the bankrupt customer or to the court on service of garnishee order.
exten
ds ; to
the s
in his
ess.
•nee Book 1 Standing: Products, Operations and Risk Management | Reference Book 1 271
A banker cannot set off:
Shares in public limited companies quoted on the stock exchange are a common
form of security offered to bankers. Their value is easily ascertainable but they
are subject to fluctuations. Before accepting them as security we should be
mindful of the following points to assess the quality of the shares as security:
i) The age of the company, its reputation and that of its directors,
ii) Market value of the shares during recent years with special reference to the
stability of value.
iii) Liquidity/ turnover of the shares.
iv) The company's present financial position and dividend history during last
few years.
v) Prospects of the industry in general and the company in particular.
Advances are granted against the actively traded shares/TFCs of companies
listed on the Stock Exchange and which are the members of the Central
Depository Company. Since formation of Central Depository Company, the
issuance of material script of the member companies has been discontinued.
Considering this factor, it is to be ensured that all formalities of marking Bank’s
lien on shares as pledgee with the Central Depository Company are completed
to the entire satisfaction of the Branch Manager.
Bank’s standard documents mentioned in the applicable section of the Credit
Administration Manual shall be obtained. It is to be ensured that all State Bank
of Pakistan’s regulations in this regards are strictly complied with.
If advances are made against the security of shares/TFCs owned by the third
party, the owner of the share/TFCs shall execute Bank’s standard Personal
guarantee. Business Group will ensure that beneficiary of the facility against
shares has necessary mandate to pledge the shares as security for availing
financing facility from the bank/DFI.
In accordance with the State Bank of Pakistan’s requirements, amended from
time to time, the Bank shall not among others:
a) take exposure against the security of shares / TFCs issued by them,
d) take exposure on any person against the shares / TFCs issued by that person
or its subsidiary companies. For the purpose of this clause, person shall not
include individual.
DEFINITION:
At first sight the bank's form of guarantee may seem to be verbose and
an unduly lengthy document, but every phrase and condition is essential
and should never be tampered with or altered without the complete
approval of the bank's legal advisor,
vi) Signature of the guarantor: If the worth of the guarantor is undoubted
and he/she signs the guarantee in his/her own free will, knowing it to be
a guarantee and under no possible mistake or misapprehension, the bank
will have a satisfactory security.
PGs are not usually required for public limited companies (de{ on bank’s
policy) that are listed on the stock exchanges of] Lahore and Islamabad.
However, if a company falling in this cat has provided such guarantees to other
banks or NBFIs then should also seek the same.
For public limited companies not listed on the stock exchanges- iti be
mandatory to obtain PGs of all directors (excluding nor /government
employees/foreign nationals).
Exceptions
As a general guideline, PGs of all directors, partners and propr are required for
all customers as defined above. If, howevei exception has to be made for a
particular customer, then the , should be approved by the Competent Authority
for consideration.
There is a vast different between pledge of paper securities and j of stocks. Both
pledges have different risks and need to be cl comprehended. Pledge of paper
securities does not attract; significant risk about theft/stolen/robbery, as these
are nor retained under valt of a Bank, though there are some ris'tsi
fire/explosions etc against which proper insurance coverage shoi available.
Moreover, risk of market value is another concerned; particularly where value
of pledge depends on daily market price, the other hand pledge of stocks have
different areas of risks that: to be addressed appropriately. One of the key area
where Bank: focus is the appointment of Muccadam, as Bank's reliance in <
pledge of stocks merely depends on him. The other areas that ne be taken care
of in case of pledge of stocks are the nature* commodity, condition of godown,
and legal documentation in < third party godowns.
Legal Documentation
Documentation Categories
Normally there are three (3) categories of documents that are required to be
obtained from the customer:
retrieval.
Profit payment on security held as collateral should be the responsibility of business
units.
Some banks, depending on the size, resources and complexities of the systems have
different safe keeping arrangements. Some banks have centralized Credit
Administration departments performing the above function.
Insurance cover:
All assets charged to the bank are to be insured during the complete tenor of
outstanding liabilities. In case of equitable charge / mortgage on fixed assets, value of
land is excluded to calculate the value of insurance. Accordingly, all assets under
Bank’s lien are to be insured by an insurance company on the Banks approved panel.
1- It is in the interest of the Bank as well as clients that adequate insurance cover
is obtained for industries financed by us as well as for finance facilities
extended to our clients against machinery / stocks and hypothecation / pledge
of goods.
4- Insurance coverage should be obtained for all risks pertinent to the assets
being insured and keeping in view area / storage conditions where goods ate
stored.
5- Open Pledge: Some limits allowed against Phutti, Cotton, Rice, Paddy, Sugar
and like stocks are under open pledge arrangement, exposing the Bank to
high risks for Burglary, Fire, Riot, Strike, Damage/Malicious damage etc. As
such, it is necessary that appropriate insurance policy is obtained keeping in
view the fact that goods are kept under open pledge. The policy / policy
cover note should clearly mention that the insurance stocks/assets are stored
in open and there should be no restrictive clause regarding such storage
arrangement to avoid any dispute in the event of a claim.
6- Legal Cases: Regarding insurance cover on non-performing assets for which
Bank has filed recovery suit(s), insurance cost can be debited to outstanding
balances only after seeking permission from the Competent Court by filing an
urgent application through our counsel to this effect because the matter is sub-
judice. It is, therefore, recommended to consult the counsel, contesting the case
on Bank’s behalf, well in time to seek court’s permission in this respect.
7- The branches should invariably obtain insurance cover note in original and
10- In case the insured stocks/assets are stored in open or oj sided building/sheds or
where there is/are deviation(s) 1 policy or warranty conditions are not fulfilled,
the policy/] cover note should clearly mention the same and there she not be
restrictive clause regarding such storage arrangemer avoid any dispute in the
event of any claim. Branches she ensure that clause excluding the storage as
above is deleted i varied by the insurance company and duly authenticat bearing
signature & seal.
11- For coverage of risks other than Fire, Burglary, RSD and MD prior
approval of competent authorities is required subject to proper
justification. Where Burglary cover for full value of stocks are not
obtained (e.g.; 1st loss basis i.e. quantity of goods whose lifting is
possible within a night (12 hours) subject to the condition that same
is atleast 10% of goods under Bank’s Pledge / lien or higher), prior
permission of competent authority be obtained in writing.
13- In case of financing, where during Banks exposure (fund based &/or
non fund) transportation by sea vessel is involved, appropriate
marine insurance cover shall be obtained in all cases. Monitoring
methodology of guarantees and that of insurance policies for claims
secured against Bank guarantee or insurance policies it is essential
that the Bank monitors the following:
Vendor Management
Outsourcing is a cost effective alternative for the bank for activities that do
not constitute mainstream banking. However, outsourcing can amplify the
risk profile of a bank by exposing it to strategic, reputation, compliance and
operational risks arising from failure of a vendor in providing the service,
breaches in security, or inability to comply with legal and regulatory
requirements. The bank also needs to manage associated concentration risk
that may cause lack of control over a service provider who renders many
services for the bank, or Bank is excessively dependent on a vendor for a
specific service or due to dominant position in a specific region etc.
Management of concentration risk will be the responsibility of business
units.
third-party risks.
13- In case of financing, where during Banks exposure (fund based &/or non
fund) transportation by sea vessel is involved, appropriate marine
insurance cover shall be obtained in all cases. Monitoring methodology
of guarantees and that of insurance policies for claims secured against
Bank guarantee or insurance policies it is essential that the Bank
monitors the following:
Vendor Management
Outsourcing is a cost effective alternative for the bank for activities that do not
constitute mainstream banking. However, outsourcing can amplify the risk
profile of a bank by exposing it to strategic, reputation, compliance and
operational risks arising from failure of a vendor in providing the service,
breaches in security, or inability to comply with legal and regulatory
requirements. The bank also needs to manage associated concentration risk that
may cause lack of control over a service provider who renders many services for
the bank, or Bank is excessively dependent on a vendor for a specific service or
due to dominant position in a specific region etc. Management of concentration
risk will be the responsibility of business units.
fc
Ti<ajcts, Operations and Risk Management | Reference Book 1 283
Key factors involved in Risk Management Process are:
• Establishing senior management awareness of the risks with
outsourcing agreements in order to ensure effe management
practices.
• Ensuring that an outsourcing arrangement is prudent from
institution.
• Systematically assessing needs while establishing ‘ requirements.
• Implementing effective controls to address iden
• Performing ongoing monitoring to identify and evai in associated
risks.
• Documenting procedures, roles/ responsibilities. mechanisms, and
responsibility segregation amor.£ departments of the bank.
a. Concentrations to be avoided.
b. Technical expertise of the Valuer to be kept in view.
c. Fair distribution of business among all Valuers.
Performance Evaluation:
i. Periodic Evaluation:
appraisal of all enlisted Valuers on an annual basis to any change in
Valuer’s limit amount, scope regarding assets or geographical
allocation.
Clearing of goods imported under bank’s lien should be entrusted only to Bank’s
approved C&F Agents.
Stock reports:
When goods are to be pledged the relevant authority should prep letter
addressed to the Muccadum (warehouse agents) providing 1 the name of the
customer, the details of the goods to be pledged« requesting them to receive
the goods in good order and conc directly from the customers and
simultaneously, should also prep letter addressed to the customers providing
them the name ; address of the Muccadum and advising them to deliver the
goods to 1 pledged directly to the Muccadum. The concerned authority si
receive stock reports from the Muccadum in duplicate and, ensuring the
approximate value of goods stated in the stock rep in accordance with the
value of pledged goods shown in the! advice forward the original stock report
to the officer designs control of pledged goods advising him to inspect the
goods.
The stock register is supposed to include details of all goods < pledged or
hypothecated. Stock inspection of the pledged stock is 1 undertaken by the
bank at a frequency deemed appropriate I
bank and report thereof should be placed in file. Moreover, stock inspection is
supposed to be carried out by bank’s approved surveyor^ valuators and Stock
report also to be obtained after issuance of Delivery Order. Periodical reports of
value, quantity, quality, weight, and measurement of pledged goods are obtained
from the customer, and are duly verified by the Bank’s warehouse staff or
Muccadam.
Bank's Charge and Search Reports:
Facility Account Account monitoring is an integral part of overall account management. This,
Monitoring not only, helps in ensuring maximization of returns to the bank (e.g. setting
of min. business routing covenants), at times it may act as an early warning
signal i.e. when the account behavior is not in line with acceptable
parameters.
Ways of Facility The account manager may opt for various methods to ensure effective
Account Monitoring
management of a portfolio of accounts. These may include:
Challenges While the above covenants / triggers are helpful in ensuring appropriate
utilization of facilities, actual utilization is dependent on a number of factors
which may / may not be within the control of the borrower. Some of these
factors may be directly linked with the business cycle of the borrower while
others may be a result of changes in economic conditions.
Compliance to As highlighted above, the facility advising may contain certain covenants
Business Routing requiring the borrower to route a certain amount of business through the
Requirements bank.
In addition to the above, banks may require the borrower to award z ‘first
right of refusal’ on a lucrative one off deal e.g. a derivative / bocd mandate
as part of a competitively / below market priced deal.
Monitoring Facility In order to ensure that all facilities are being utilized for the agreei.
Utilization purposes, regular monitoring of the facility at relevant intervals JS
paramount.
• Client Calls.
• Stock inspection.
• Site Visits.
Account managers rely on a number of reports that help ensure utilization of
facilities in line with requirements and agreed covenants. Following are a
Facility Reports - few examples of facility reports;
Significance & Use Account Activity Report: These reports indicated the max. & min. balances
of an account during a specified period of time. These help identify trends
and may highlight risk areas if the activity in the account does not
correspond with the business.
Customer Name Jan Feb Mar Apr May jun Jul Aug Sept Oct Nov Dec
The above document may be reviewed on a monthly basis (at the start of the
relevant month) to ensure that the account manager has sufficient time to
follow up & arrange for settlements / revised documents.
Authored by:
Ali Saad Khan
The Importance of Growth and profitability of a financial institution largely depends on the
Management of Credit quality of its risk asset portfolio, which mostly comprises credit risk assets.
Credit risk assets mostly comprise of loans and advances to customers in the
form of Retail/ Consumer lending or Corporate/ institutional lending. As
banks are in the business of booking Credits, strong Credit management is
necessary. It will be fair to say that in the business of credits, the most
important task after booking of the asset is its management. Importance of
good credit management can be stressed by recalling the benefits that accrue
as a result. An account which is managed well reflects stability, healthy
account turnover, source of income for the bank and a strong asset base for
the bank. By staying closely in touch with the account and understanding the
business dynamics and account triggers, an account manager can effectively
manage an account. Essence of credit management revolves around how
effectively it is being monitored. A thorough understanding of the credit
process is imperative to evolve a monitoring process which has the ability to
not only manage the credit portfolio effectively but also avert any losses
which may arise due to inherent weaknesses of a credit, macro environment
or borrowers behavior in terms of utilization of the credit facilities allowed.
Important ingredients of a good credit management process include
understanding the business, staying in touch closely with the account,
observing macro and micro environmental factors that may impact the
business, being cognizant with the client’s needs etc. To effectively manage
any process, understanding of the processes is required. Same is the case
with credit management. A detail-oriented approach! works best for
effective credit management.
'I
■
In the financial world that we live in today and after having witnessed
global financial turmoil, it is a known fact that it originated not just because
of on-balance sheet items but it was also due to the closed eye on the off-
balance sheet items that created a ripple effect and led to distortions in the
entire fabric of the financial sector. Consistent watch is required to
guarantee a healthy portfolio not only of funded but also of contingent
commitments. Any misjudgments will have a domino effect creating severe
liquidity risk and will put the credit rating of financial institutions at peril.
The financial world has been in the evolution stage and continues to evolve.
Any money lent is evaluated on the basis of capital allocation for it. This
concept has been emphasized through various BASEL acts. As such, Basel I
Act has undergone constant changes brought in to better manage health of
credit portfolio and we have seen subsequent introductions of BASEL II and
BASEL III.
The credit manager of today realizes the fact that each facility extended to a
customer poses risks. These risks have been defined and dimensioned in
earlier sections. Facility account monitoring occupies great importance in
overall monitoring of asset portfolio after the bank has decided to take on
that risk, price it and extend the credit to the customer. Based on this notion,
this section attempts to provide its readers a holistic view of the importance
of facility monitoring and various avenues available for this purpose.
The role of a good credit manager is to endeavor in developing an effective monitoring system that
encompasses a consistent vigilance over the asset portfolio. Avenues available for such monitoring are
the following monitoring tools):
£ W)| ■ Periodic analysis of Financial
Statements
^ 2 ■ Monitoring pf loan covenenats
tLrB asset in the loan agreement
O ■ Activity in facility account
Different ways of ■ Limit utilization
facility account ■ Monitoring of Sexurity
monitoring in use:
ii ■
■
■
Stock Reports
Market Chechs
Repayment behaviour
Stock Reports - Reports the stock level at each location that might be
. Maturity date for LC payments and their timely retirements. Due date
diaries indicate upcoming maturities and act as flags for account
managers.
Other monitoring Facility account monitoring on financial performance and more importantly
mechanisms: the cash flow movements of an account is of utmost importance. It is
necessary to keep a record of all definite sources of repayment, sufficient
enough to extinguish the debt in the event of repayment failure. A detailed
analysis of the cash flow statement is imperative as cash flow statements
provide details of sources and uses of cash. Sources of cash represent an
inflow and uses of cash reflect a drag on the cash balance. Cash flow from
operations (CFO), which is derived after adding non cash charges such as
depreciation/ amortization etc to net profit before taxes and subtracting
working capital changes from this figure, is used as an indication of
repayment ability in most cases. This
For Export-based loans Adequate export volume and effective shipment of goods are considered
as monitoring techniques for export based loans. FIM and FATR have
specific tenors, non-adjustment on due date signals an early warning.
Ongoing site visits for customers is also a monitoring tool. Disbursement of
funded facilities can be tagged with specific usage or achieving of certain
milestones and this can be an effective monitoring tool as well.
Disbursement of export based loans against specific Export LCs or export
contracts also serves as a monitoring mechanism for intended usage.
For Project Financing Project Financing is gauged periodically through the amount of capital
expenditure seen on ground and the timeline within which it was to be
achieved as per agreed covenants between the bank and customer.
Commercial operation date in line with the cash flow projections forms the
premise of monitoring a long term loan and any delays provide early
warning signals with respect to project delays. Allowing disbursement of
funded facilities for specific usage by making payments directly to suppliers
etc. ensures proper utilization of both short and long term facilities.
For Contingent Facilities For monitoring of contingent commitments, due date diaries are
maintained to keep a track on maturity profiles and the client is informed
well before time to meet a payment requirement for L/C, Contract, and
Derivative etc. Whereas commitments against guarantees are monitored
Facility Monitoring Facility Monitoring Systems are tools and techniques that automa
Systems: analyze facility utilization behavior and trends that serves as early w«
signals to detect any anomalies. The systems could be in the for daily,
weekly, monthly or quarterly MIS reports, flash tickers, 01 access to
data through core banking systems etc. MIS reports are a i tool that
aids in assessment of many aspects regarding the overall i portfolio of
an organization. This may include composition of the i portfolio, credit
history of the borrowers, and financial performs borrowers.
Additionally a well functioning MIS system would ] credit exposures’
approaching risk limits to be identified and brov the timely attention of
the management and the board.
Due date diaries: Due date diaries are tools used to monitor payments falling due and a
used to aware the account manager of any delayed payments and 1 as a
reminder of the upcoming payments in order to attain timely ] of
payments. These diaries are circulated across the
Significance and use Reports on activity in facility accounts hold much significance for various
of reports on activity reasons. Firstly, once credit is extended to customers, continuous monitoring
in facility accounts
of loans, and hence reporting of any changes is vital. This is because if there
are any changes in the financial position of an account, or if there is a
possibility of slippage of an account from standard asset to substandard
asset, immediate warning to customers could be extended. Moreover, loan
officers would then be able to classify the borrowers with standard assets
and sub-standard assets. These steps act as a deterrent to weak asset quality
of the advances book of the bank. Such reports give controls to the account
manager who can be more aware of early warning signals and work towards
curative strategies at the very onset.
Authored by:
Zulfiqar Alavi
Accounts
By the end of this chapter you should be able to:
5. Write Off
■ Explain the concept of write off loans and state the conc
for write off
302
Past Due Accounts / Over Due Accounts -
Business Lending
Loan classification is a norm in the business of credits. Various
categorizations are used to reflect the health of a loan. In easiest terms, it is
actually the process of differentiating the good from the bad and bad from the
worse and so on, within the credit portfolio of a financial institution. To
achieve this differentiation, certain tools and techniques are applied right
from the time of booking of asset till its repayment and also during its
delinquency period. The rating assigned at the time of booking is attributed to
various factors related to quantitative and qualitative assumptions. Such
assumptions revolve around the financial capability of a customer/financial
statements, past business performance, positioning in industry, management
strength, market reputation and overall client’s capability of handling
business.
Once the asset is booked, specific rating assigned may undergo changes
depending on the performance of the loan. Default is a consequence of delays
in meeting financial commitments on due dates towards interest payments
and loan repayment. A default has distinct levels reflecting the deteriorating
degree and practices for categorization for such defaults during delinquency
is generally uniform across the globe. The default over a day and continuing
till 90 days is termed as Overdue, more than 90 days till 180 days is termed as
Substandard, and more than 180 days till a year is termed as Doubtful. If the
default exceeds one year then it equals a Loss. From the day loan becomes
overdue and enters varied degree of default stages, it results in an adverse
impact on the profitability of the institution as distinct level of provisions are
applied depending on the loan classification.
This article will help understand the rating of an asset/ lending portfolio and
its treatment while taking the readers through the cycle of a bad credit
resulting in a write off. Understanding this part of the credit management
process along with the importance of restructuring methodology is of utmost
significance to become effective credit managers, hence each part of this
process is discussed in detail in the following article.
Loss: Where mark-up or principal is overdue by one year or more from the
due date. Recovery method in such cases usually includes out of court
settlement or litigation proceedings. The loan is reported as a loss in the
financial statements and recovery by all legal means is commenced.
Global practices for management of past due credits include a thorough due
diligence on security coverage, understanding of the local laws and an
effective and efficient legal system to prevent fraud. The responsibility of
establishing a strong legal system lies with the state. Consistent engagement
is a prerequisite towards implementation of past due loan management
process. Based on the business conditions and the nature of problems being
faced by the borrower, appropriate remedial strategies such as restructuring
of loan facility, enhancement in credit limits or reduction in interest rates
help improves borrowers repayment capacity. Banks have to regularly
ascertain the realistic loan recoverable amount by updating the values of
available collateral with formal valuation and reviewing security documents
to ensure the enforceability of contracts and collateral. Finally, such credits
should be subject to more frequent review and monitoring. Review should
update the status and development of the loan accounts and progress of the
remedial plans. In the management of nonperforming assets, upgrading
assets to standard category by cash recoveries through constant follow-up is
the most viable option. Not only does it increase interest income, it also
helps reduce provisioning and capital adequacy requirement.
There is a likelihood that the classified loans may not be recoverable and the
bank might have to take adequate steps to collect them. In this regard, SBP
has provided guidelines that are applicable to various types of Consumer,
SME and Corporate financing facilities. Recovery of due payment to the
bank should be in accordance with the Financi Institutions (recovery of
finances) Ordinance of 2001. This ordinal has a laid down procedure to
recover delinquent loans and adherence to these principles is required by the
banks. Also, banks are required to make periodic reviews of the recovery
procedures and they remain answerable to the SBP for compliance with these
guidelines.
304 Lending: Products, Operations and Risk Management | Reference Book 1
Net Exposure is defined as total exposure less liquid assets that are held as
security by the bank. Exposure refers to any financing facilities whether fund
based and/or non-fund based. Liquid Assets are those which are readily
convertible into cash without recourse to a court of law. There is a defined
mechanism for calculation of net exposure for provisioning requirement as
laid down by SBP. Cash and near Cash Securities are given a 100% weight
to arrive at net exposure. For example, a facility of PKR 100 million that is
secured by PKR 40 Million in cash and near cash securities, the net exposure
on the borrower is calculated at PKR 60 Million. Other current assets such as
hypothecation charge on inventories and receivables do not get accounted
for any exposure benefits. However, if the stocks are held by virtue of a
pledge arrangement, benefit of 40% is availed. Similarly, securities held in
the form on a charge on Fixed Asset such as land and building, plant and
machinery etc. allow use of benefit which may differ in value depending on
the nature of the security.
Whole idea behind having an effective past due account management system
is the fact that in the business of credit and advances an asset of the bank
(lending) / portfolio is always exposed to inherent risks of the credit itself or
it is exposed to other risks originating from the industry to which it belongs .
There are instances when an account starts showing signs of weaknesses
such as recurrent overdue status in payment of its mark up or its repayment
towards installment and principal. An effective credit management process
assist in identifying such weaknesses at the very initial level by raising alarm
signals. Usually in such an instance when the account is showing persistent
delays in servicing of its payments, corrective measures should be adopted to
assist in maintaining a good health of the account before it is too late. An
effective credit management process for past due account management is all
about making a conscientious proactive effort in raising warning signals
right from the very beginning rather than waiting for the account actually
going bad. It is the role of the account relationship manager to monitor the
portfolio on day to day basis and keep good track on the health of his
accounts/ portfolio. As the concept of relationship management system is to
have a microscopic view at the relationship officers level, it helps in
implementation of a fruitful process whereby it is incumbent upon the
relationship manger to keep updating the senior management on his
accounts/ portfolio through call reports by regular visits to customer
including factory visits. Annual renewal and interim account updates are
tools to keep track of overall health of the account. In today’s complex
financial world, the main challenge for credit management is to be one step
ahead of the customer. Such an approach forms the linchpin of an efficient
credit process which has the ability to raise warning signs much before the
account actually becomes delinquent. Recognition of a deteriorating health
of an account is reflective by downgrading the status of the account from
regular to watch list. Once the account is in watchlist status it immediately
and Risk Management | Reference Book 1 305
calls for an incessant follow up meetings with the customer to help avert it
from further downgrading. It is here, when the business unit of the bank
usually decides to revisit the the credit and outstanding facilities, keeping
into account the reasons that led to slow down or a default status.
Understandings derived from such meetings with customer and also through
internal discussions between the management and risk department, often
leads to restructuring or rescheduling the account to avert any further
downgrading of the account to a substandard, doubtful or Loss status. Once
the account reaches the zone beyond watchlist then a more microscopic view
is applied by calling for account review from quarterly to monthly basis and
in worst cases it is done on day to day basis.
Clubbing of all overdue facilities till cut off date, into a restructured facility
on a medium to long term basis.
Upfront payment of mark up due till cut off date & or conversion of same
into a facility to be repaid separately, during the tenor of principal
restructured facility or may be at the tail end of the restructured principal
facility.
Before instituting the revised structured limits fresh visit to customers must
be mandatory.
Time Value of Money: This concept must be applied throughout the process
of restructuring a delinquent credit regardless of its category of classification
(watchlist, substandard, doubtful or loss). The Net Present value ‘NPV”
concept acts as a barometer for the bank to analyze the actual financial
impact on the banks balance sheet while undertaking restructuring of loans
with reduced mark up rate OR at times no mark up rate, extended longer
tenors at zeroised mark up rates etc. Such an instance may arise where a
credit is restructured on a long tenor with the objective of just recovering the
principal due. In such a scenario , the bank bears a cost on the liability side
of its balance sheet to fund an asset which is not yielding any interest value .
Hence, such restructuring proposals must be viewed with the help of NPV .
This often helps in taking a decision by taking a decision for a haircut
upfront and getting the customer pay residual amount in terms of NPV
upfront only if possible. Ideally, the NPV of the restructured loan should be
equal to or greater than the current loan outstanding. However, this might
rarely be the case. If the NPV is less than current value of the loan, the bank
essentially takes a hair cut on its outstanding
loan. This option might be viable in certain scenarios where the other
alternative might be the risk of total loss. Importantly, banks usually
provide a grace period in principal repayment so that the borrower is
able to consolidate its business and be able to make the repayments
once the grace period ceases. Care should be taken when an account is
restructured as an incorrect restructuring might result in the borrower
being unable to pay back the liability. Such an effort by the bank
would be futile in recovering the loan amount. Therefore,
Undng: Products, Operations and Risk Management | Reference Book 1 307
understanding of the borrower’s business together with its repayment
capability needs to be thoroughly analyzed. This is a normal practice
in restructuring of delinquent credits.
Finally, even if after the restructuring the credit fails to perform and
the management has exhausted all efforts towards recovery of a
delinquent loan through remedial process i.e restructuring, then such a
credit needs to be recovered through instituting legal proceedings, for
which the account is usually passed on to the Special Asset
Management wing of the bank, which specializes in recovery of
delinquent loans through litigations/ court settlements.
Loan loss provisioning together with general loss reserves forms the basis for
establishing a bank’s capacity to absorb losses. Loan-loss provisions are one
of the main accrual expenses for banks. They are set aside by bank managers
to face a future deterioration of credit portfolio quality. Hence, the role they
play within a bank’s financial statements is crucial, given the sensitive
information they are supposed to convey. It is contended that this provision
should be positively correlated to the lending cycle of the banks such that
loan loss reserves are built up during peak financial times so that they can be
utilized in a recession. Loan provisioning is a vital aspect of bank’s financial
reporting to regulators and investors as it is reflective of the risk of losses
inherent in the underlying loan portfolia This provides insight into the risk-
taking behavior of banks.
However, loan write off does not imply that loan recovery should stopped. It
should be continued until total outstanding balance ' recovered.
In case of write offs, SBP states that banks shall continue to write off bad
loans with the approval of banks’ Board of Directors under a well defined
and transparent write off policy. All liquid securities held as collateral
should be realized and sale proceeds to be used to adjust the outstanding
amount of principal. Importantly, no write offs will be allowed where
Forced Sale Value (FSV) is more than the recoverable outstanding amount,
exception being on cases settled under general incentive scheme of the SBP.
FSV refers to the value which fully reflects the possibility of price
fluctuations and can currently be obtained by selling the mortgaged/pledged
assets in forced/distressed sale conditions.
The regulatory requirements that govern FSV states that banks are allowed
to take the benefit of 40% of FSV of the pledged stocks and mortgaged
residential, commercial and industrial properties (where building is
constructed) held as collateral against non performing loans for 3 years, with
one year extension period if FSV valuation of land is not more than 4 years,
from the date of classification for calculating provisioning requirement.
Banks may avail the above benefit of FSV subject to compliance with the
SBP guidelines. If the additional impact on profitability arising from
availing the benefit of FSV is not available for payment of cash or stock
dividend, bank management ensures that FSV used for taking benefit of
provisioning is determined accurately and is reflective of market conditions
under forced sale situations and that the party-wise details of all such cases
where banks have availed the benefit of FSV shall be maintained for
verification by SBPs inspection teams during regular/special inspection.
(Please refer to SBP’s circular regarding FSV benefit issued in 2011)
Banks may add any other condition(s) as they deem fit and should report full
particulars of loans written off to Credit Information Bureau of SBP. Banks
are also allowed to consider cases for rescheduling and restructuring in
respect of sick industrial units and non performing loans under a well
defined and transparent policy. Rescheduling and restructuring done simply
to break time frame or allow un-warranted improvement in classified
category of loans is not permissible. These shall always be done under a
proper and appropriate agreement in writing by following the due course of
law.
Authored by.
Zulfiqar Alavi
Past due Accounts/Over Due Accounts -
Consumer Lending
Within Consumer Banking, an account is considered to be delinquent when
The grid below defines the triggers based on which the banks provision their
portfolios i.e. identify the bad debts, as stipulated by the State bank of
Pakistan in the Prudential Regulations for Consumer Finance. For each
trigger, set on the number of days past due, specific provision amount is
identified/declared by the banks as an indication of the portfolio that is likely
to be irrecoverable.
Consumer Products Specific Provisions Requirement*
Banks use a variety of debt collection practices for recovering the bad debts.
These include sending mail reminder notices, in order to bring a customer’s
loan up to date which are used early in the process in the crucial 30-60 day
window and are very tactful communications intended to get the account
holder re-connected with the bank and resolving their delinquencies.
The banks also sort out and segregate the "soft" delinquencies from the more
problematic accounts that should be immediately acted upon. The
segregation is done based on past due account status. Soft delinquencies are
generally referred to as the accounts between 30 to 60 days past due and
accounts greater than 90 days past due are categorized as problematic. When
identified early enough, the majority of these accounts can be restored,
preventing having to write them off.
A few Banks use debt scoring as a tool for both pre and post default, a
powerful mathematical probability tool that helps the banks greatly by
predicting the accounts more likely to pay, as well as the more difficult
accounts before these accounts depreciate even more in recovery likelihood.
The score thus generated is generally referred to as a “Behavior Score”
which is based on customer’s repayment behavior. All the accounts with a
low score are categorized as high risk customers and are dealt with a firm
hand, on the other hand, accounts with a high score are treated differently
where the contact (if made) is solely as a reminder because these accounts
tend to serve the debt efficiently and are low risk customers.
Post segregation of the accounts, the process of calling the customers begins.
More often than not, customers are aware that their accounts are delinquent
so they’re not surprised to hear from the bank. Though tactful, a collector
communicates the gravity and magnitude of rectifying the matter and that
failing to do so could result in a negative credit report, as well as limiting
one’s ability to avail additional facilities from the industry. The collection
unit contacts the customers on their provided numbers. The priority of which
is the mobile number, in the event of no contact office land line and
residence land line numbers are used. If the customer is still not contactable,
the field officers are sent to the customer’s provided addresses (office and
residence).
Ensuring smooth and regular collections of bad debts and complying with
the fair debt collection guidelines issued by the State Bank of Pakistan is a
continuing challenge to the banking industry. The essence of the guidelines
is to safe guard the interest of the customer and defining of standard
operating procedure for debt collection by the banks. The guidelines issued
in November 2008 were to address the grievances of customers/borrowers as
they had various complaints against the collectors of different banks which
ranged from the language used over the phone to untimely visits and the
attitude of the collectors. These guidelines include but are not limited to
serving a 14 day written notice to the customers prior to the visit by the
collectors or before repossessing of assets, phone calls to be made from the
recorded lines and contacting the customers at a convenient time.
To collect the bad debts, banks allow debt rescheduling and restructuring to
provide a borrower with relief when needed due to an economic downturn or
other unforeseen personal event (i.e. job loss, illness etc.). This is where the
debtor and the bank negotiate to defer payments of principal and/or interest
falling, due in a specified interval for repayment on a new schedule. In most
cases, these new terms are structured to make it easier for the borrower to
repay. The term of the loan is extended to make allowances for the lower
repayments and in some cases; simply repaying the outstanding amount with
certain waivers is also arranged.
Compiled by:
Farheen Ali