WORKING CAPITAL MANAGEMENT

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 TABLE OF CONTENT

Contents Page Numbers

Introduction to Indian bank 6

Organizational structure of Indian bank 9

Objective of the study 10

Methodology 11

Working capital finance 12

Tandoon committee report 23

Overdraft 30
Cash credit 31
Short-term loans 31
Term loans 32
Bill financing 34
Bank guarantee 34
Pre-shipment finance 35
Letter of credit 38
Credit risk management 43
Industry rating 55
Project appraisal 59
Bibliography 62
Glossary 63

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 Introduction to Indian Bank

A premier bank owned by the Government of India

• Established on 15th August 1907 as part of the Swadeshi movement

• Serving the nation with a team of over 22000 dedicated staff

• Total Business crossed Rs.1,24,413 Crores as on 31.03.2009

• Operating Profit increased to Rs. 2228.83 Crores as on 31.03.2009

• Net Profit increased to Rs.1245.32 Crores as on 31.03.2009

• 1642 Branches spread all over India

International Presence

• Overseas branches in Singapore and Colombo including a Foreign Currency Banking

Unit at Colombo

• 240 Overseas Correspondent banks in 70 countries

Diversified banking activities - 3 Subsidiary companies

• Indbank Merchant Banking Services Ltd

• IndBank Housing Ltd.

• IndFund Management Ltd

A front runner in specialized banking

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• 90 Forex Authorised branches inclusive of 1 Specialised Overseas Branch at Chennai

exclusively for handling forex transactions arising out of Export, Import, Remittances and Non

Resident Indian business

• 1 Small Scale Industries Branch extending finance exclusively to SSI units

Leadership in Rural Development

• Pioneer in introducing Self Help Groups and Financial Inclusion Project in the country

• Award winner for Excellence in Agricultural Lending from Honourable Union Minister

for Finance

• Best Performer Award for Micro-Finance activities in Tamil Nadu and Union Territory

of Puducherry from NABARD

• Established 7 specialized exclusive Microfinance branches called "Microsate" across the

country to cater the needs of Urban poor through SHG (Self Help Group)/JLG (Joint Liability

Group) concepts

• A special window for Micro finance viz., Micro Credit Kendras are functioning in 44

Rural/Semi Urban branches

• Harnessing ICT (Information and Communication Technology) for Rural Development

and Inclusive Banking

• Provision of technical assistance and project reports in Agriculture to entrepreneurs

through Agricultural Consultancy & Technical Services (ACTS)

A pioneer in introducing the latest technology in Banking

• 100% Business Computerisation

• 168 Centres throughout the country covered under 'Anywhere Banking'

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• Core Banking Solution(CBS) in 1642 branches and 66 extension counters.

• 755 connected Automated Teller Machines(ATM) in 225 cities/towns

• 24 x 7 Service through 32000 ATMs under shared network

• Internet and Tele Banking services to all Core Banking customers

• E-payment facility for Corporate customers

• Cash Management Services

• Depository Services

• Reuter Screen, Telerate, Reuter Monitors, Dealing System provided at Overseas Branch,

Chennai

• I B Credit Card Launched

• I B Gold Coin

Vision of Indian Bank

"to become the bank of choice for corporates, medium businesses and upmarket retail customers

and to provide cost effective developmental banking for small business, mass market and rural

markets"

Mission of Indian Bank

"to provide superior, proactive banking services to niche markets globally, while providing cost-

effective, responsive services to others in our role as a development bank, and in so doing, meet

the requirements of our stakeholders".

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 Organizational Structure

The bank has a four tier structure comprising of Head Office and Branch Office.

Head Office

Zonal Offices

Regional Offices

Branches

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 Objective

The objective of the study is to know what working capital is and analyze the sanction of

working capital loan by Indian bank. The aim of the whole study would be to know how the loan

are given and sanctioned, the term and condition on which these are provided. In simple words

we can say that to know about the followings:

1) Working capital management

2) Working capital financing

3) Credit risk management of Indian bank.

4) Explaining of factors considered while assessing risk rating

5) Industry rating.

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 Methodology

Research in this project will be conducted with the help of the following:

1) Primary Data:

Primary data will be collected from the documents, Circular and the files of l corporate borrowal

accounts.

2) Secondary Data:

Secondary data will be taken from the books from the library, Indian Bank website and data

from the relevant websites.

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 Working capital finance

Working capital is the lifeblood of a business. Its effective provision can do much to ensure the

success of a business. Apart from financing for investing in fixed assets, every business also

requires funds on a continual basis for carrying on its operations. these include amounts or

expenses incurred for the purchase of raw material, manufacturing, selling, and administration

until such goods are sold and money realized. Working capital refers to the source of financing

required to by businesses on a continual basis for meeting these needs.

Commercial banks are the principal source of the working capital. They provide working capital

in the form of overdrafts, cash credit, short-term loans, financing of bills, bank guarantee, etc.

The banks provide working capital at the stage of manufacturing level (pre-sale stage for

acquisition/holding the required level of inventory). The inventory finance remained unsecured

with current asset primarily and repaid out of the sales process of manufactured goods. It is

generally extended by way of cash credit either against hypothecation or pledge or both.

The RBI has withdrawn its entire prescription relating to the maximum permissible bank finance

(MPBF) system of assessment of working capital requirement of any pursuing the policy of

deregulation of the banking sector. Except in few cases, the bank are free to evolve theor own

policy in the matter of working capital assessment of their borrowers and have such policies

approved by their Board of Directors.

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The working capital can also be classified as:

a. Permanent working capital

Permanent working capital is the minimum amount of investment in current asset

necessary for carrying out operations for a period.

b. Fluctuating working capital

Fluctuating working capital represents additional assets required at different times during

the operating period due to cyclic factors.

c. Seasonal working capital

Seasonal working capital means requirement for additional current asset due to seasonal

nature of the industry say rice seller, fan manufacturing, etc.

d. Adhoc working capital

Adhoc working capital means requirement of additional fund for meeting the needs

arising out of special circumstances such as execution of special order, delay in receipt of

payment of receivables.

e. Working capital term loan

A long term loan given to meet the working capital margin needs of borrower. The

concept was introduced by Tandon Committee.

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 f. Working capital gap

Working capital gap = Total current asset less total current liabilities. It is financed by net

working capital and bank financed for working capital ( called MPBF ).

Working Capital

Particulars Classification
Working capital Current asset such as cash, stocks, book

debts ,other current assets.

Net working capital Current asset – Current liabilities OR

Long term sources – Long term uses

Working capital gap Current assets – Current liabilities

( other than bank borrowing )

Working capital limits Bank facilities needed to purchase current

assets. These facilities are cash credit,

overdraft, biils purchase/discounting, Pre-

shipment or post-shipment loans etc.

Factors determining working capital

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It is necessary for any organization to run successfully its affairs, to provide for adequate

working capital. Managing working capital requires more attention than managing plant and

equipment expenditure. Mismanagement of working capital can be costly. The exact forecast of

the working capital is important and is dependent on the following factors:

• Production Policies.

• Nature of the business.

• Length in the period of process.

• Credit policies.

• Working capital rotation.

• Seasonal fluctuation.

• Fluctuation of supply.

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Procedure for assessment of working capital requirements

Generally there are three methods followed by banks for assessing working capital of a firm i.e.

traditional method suggested under Tandon Committee and cash budget method followed in case

of seasonal industries and also in case of seasonal industries and also in large loan accounts in

few banks.

Turnover method

As per this method suggested by Nayak Committee, the working capital is assessed as minimum

25% of the sales turnover, which is financed by way of bank at minimum of 20% and borrower’s

contribution at 5% of the projected sales. The norms for inventory and receivables and method

of lending are not applicable in this method.

Calculation of limit

Estimated sale turnover ( projected sale ) Rs. 80 lac

Minimum working capital @ 25% of estimated sales ( which represents 3 Rs. 20 lac

months sale)
Contribution of borrower @ 5 % Rs. 4 lac
Minimum bank credit for working capital @ 20 % of the projected sales Rs. 16 lac

Traditional method

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As per traditional method, the level of working capital is determined by the length of the

operating cycle and the size of the sales, as prescribed by Tendon Committee.

The sum total of anticipated current assets and also reasonable level of other current assets

would be the level of working capital required. Thereafter the amount of bank credit can be

determined as under:

A: Assess the level of net working capital (surplus of long term sources over long term uses)

available, which normally should not be less than 25% of total current assets.

B: work out bank finance to be sanctioned being gap of total current assets less NWC and other

current liabilities.

Calculation of limit

Method of lending First Second

Total current asset 2000 2000
Less other current liabilities 200 200
Working capital gap 1800 1800
Minimum stipulated NWC 450 500
Permissible bank finance 1350 1300

Cash Budget method

Under this method, monthly cash inflow and out flow statement is prepared and the gap between

the two becomes the bases for sanction of credit limit. Banks may use of cash budget method in

case of :
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• Seasonal industries

• Software development

• Service sector activites including construction activity.

• Film production etc.

Component of working capital

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Conversion Period

1 Annual cost of production

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 = Opening stock of work-in process + Consumption of raw material, etc. + Other

manufacturing cost such as wages and salaries, power and fuel, etc. +Depreciation –

Closing work-in process.

2 Average daily cost of production = (1) / 360

3 Average stock of work-in process = Opening W.I.P + Closing stock / 2

4 Average conversion period = (3) / (2) = n2 days.

Finished Goods Storage Period

1 Annual cost of sales

= Opening stock of finished goods + cost of production + Excise duty + Selling and

distribution costs + General administrative costs + Financial costs – Closing stock of

finished goods.

2 Average daily cost of sale = (1) / 360

3 Average stock of finished goods = Opening stock + Closing stock / 2

4 Finished goods Storage period = (3) / (2) = n3 days.

Average Collection Period

1 Annual credit sales of the company.

2 Average daily credit sales = (1) / 360

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 3 Average balance of sundry debtors = Opening balance + Closing balance / 2

4 Average collection period = (3) / (2) = n 4 days

Average Payment Period

1 Annual credit purchase made by the company

2 Average daily credit purchase = (1) / 360

3 Average balance of sundry creditors = Opening balance + Closing balance / 2

4 Average payment period = (3) / (2) = n5 days.

From the above calculation, the gross operating cycle period is obtained as (n1 + n2 + n3 + n4 )

days where n1 denotes the raw material storage period, n2 denotes the finished period for

conversion of raw material into finished goods, n3 denotes the finished goods storage period and

n4, the average collection period; each of which is expressed in days. When the average payment

period of n5 days is subtracted from the gross operating cycle period , as calculated above, the

resultant figure provides the operating cycle period.

Working Capital Cycle

The working capital cycle can be defined as:

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The period of time that elapses between the point at which cash begins to be expended on

manufacturing of a product and collecting cash from a customer.

Working Capital Cycle

Tandon committee report-concept of working capital

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Like many other activities of the banks, method and quantum of short-term finance

that can be granted to a corporate was mandated by the Reserve Bank of India till

1994. This control was exercised on the lines suggested by the recommendations of

a study group headed by Shri Prakash Tandon.

The study group headed by Shri Prakash Tandon, the then Chairman of Punjab

National Bank, was constituted by the RBI in July 1974 with eminent personalities

drawn from leading banks, financial institutions and a wide cross-section of the

Industry with a view to study the entire gamut of Bank's finance for working

capital and suggest ways for optimum utilisation of Bank credit. This was the first

elaborate attempt by the central bank to organise the Bank credit. The report of this

group is widely known as Tandon Committee report. As per the recommendations

of Tandon Committee, the corporates should be discouraged from accumulating

too much of stocks of current assets and should move towards very lean inventories

and receivable levels. The committee even suggested the maximum levels of Raw

Material, Stock-in-process and Finished Goods which a corporate operating in an

industry should be allowed to accumulate These levels were termed as inventory

and receivable norms. Depending on the size of credit required, the funding of

these current assets (working capital needs) of the corporates could be met by one

of the following methods:

• First Method Of Lending:

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Banks can work out the working capital gap, i.e. total current assets less

current liabilities other than bank borrowings (called Maximum Permissible

Bank Finance or MPBF) and finance a maximum of 75 per cent of the gap;

the balance to come out of long-term funds, i.e., owned funds and term

borrowings. This approach was considered suitable only for very small

borrowers i.e. where the requirements of credit were less than Rs.10 lacs

• Second Method of Lending

Under this method, it was thought that the borrower should provide for a

minimum of 25% of total current assets out of long-term funds i.e., owned

funds plus term borrowings. A certain level of credit for purchases and

other current liabilities will be available to fund the build up of current

assets and the bank will provide the balance (MPBF). Consequently, total

current liabilities inclusive of bank borrowings could not exceed 75% of

current assets. RBI stipulated that the working capital needs of all

borrowers enjoying fund based credit facilities of more than Rs. 10 lacs

should be appraised (calculated) under this method.

• Third Method of Lending:

Under this method, the borrower's contribution from long term funds will

be to the extent of the entire CORE CURRENT ASSETS, which has been

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 defined by the Study Group as representing the absolute minimum level of

raw materials, process stock, finished goods and stores which are in the

pipeline to ensure continuity of production and a minimum of 25% of the

balance current assets should be financed out of the long term funds plus

term borrowings.

(This method was not accepted for implementation and hence is of only

academic interest).

The three alternatives may be understood by taking the following example of a borrower’s

financial position, projected at the end of the next year:

Current Liabilities

Creditors for purchase 100

Other current liabilities 50

-------

150

Bank borrowing, including

Bill discounted with bankers 200

-------

350

------

Current Asset

Raw materials 200

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Stock-in process 20

Finished goods 90

Receivables including bills

discounted with bankers 50

Other current assets 10

-------

370

-------

The first method would mean the banker financing up to a maximum of 75% of the working

capital gap of 220, i.e.., 165 and the borrower providing at least 55 out of his long-term fund,

i.e.., owned funds plus long- term borrowings. This method will give a minimum current ratio of

1:1.

The second method would mean the borrower financing a minimum of 25 % of total current

assets (92) through long term funds and the gap i.e., maximum of 128 (278 – 150), will be

provided by the bank. This will give a current ratio of at least 1.3:1.

The third method would mean a further reduction in bank borrowing and strengthening of the

current ratio.

Permissible Levels of bank Finance

Ist Method

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Total current assets 370

Less: Current Liabilities

other bank borrowings 150

------

Working capital gap 220

Less: 25% of above from

long term sources 55

-------

Maximum bank borrowing

Permissible 165

Excess borrowings 35

Current ratio 1.17:1

2nd Method

Total current assets 370

Less: 25% above from long-term

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Sources 92

------

278

Less:Current liabilities other

Than bank borrowings 150

-------

128

-------

Working capital gap 220

Maximum bank borrowings

Permissible 128

Excess borrowings 72

Current ratio 1.33:1

3rd Method

Total current assets 370

Less: Core current assets

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From long term sources 95

----

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Real current assets

275

Less: 25% of above from long-term sources 69

----

206

----

Less: Current liabilities other

Than bank borrowings 150

-----

56

-----

Working capital gap 220

Maximum bank borrowings

Permissible 56

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Excess borrowings 144

Current ratio 1.79: 1

RBI Note:

Working capital may henceforth be determined by banks according to their perception of the

borrower and the credit needs. Banks should lay down, through their boards, transparent policy

and guidelines credit dispensation in respect of each board category of economic activity.

Indian bank provide working capital loan in the form of followings:

• Overdrafts.

• Cash Credit.

• Short-term loans.

• Term Loan.

• Bill financing.

• Bank guarantee.

• Pre-shipment Finance.

• Letter of credit.

Overdrafts

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The word overdraft means the act of overdrawing from a Bank account. In other

words, the account holder withdraws more money from a Bank Account than has been

deposited in it. All overdraft account is treated as current account.

Cash Credit

This account is the primary method in which Banks lend money against the security of

commodities and debt. It runs like a current account except that the money that can be

withdrawn from this account is not restricted to the amount deposited in the account. Instead, the

account holder is permitted to withdraw a certain sum called "limit" or "credit facility" in excess

of the amount deposited in the account.

Cash Credits are, in theory, payable on demand. These are, therefore, counter part of demand

deposits of the Bank.

Short-term Loan

These loans can have a maturity date as early as 60 to 120 days from the date of inception of the

loan. Bank short term loans can also mature up to one to three years after the inception of the

loan. The terms depend on the bank and the amount of money borrowed.

Many banks may also require collateral, depending again, on the amount borrowed. The smaller

the loan, the less apt the lender or bank is to ask for collateral. The application process is a bit

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longer in that the bank will check the borrower’s credit to be sure the borrower has the ability to

pay the loan back. In the case of a small business borrowing money, the lender will review cash

flow history and in the case of an individual borrowing money, the lender may require paystubs.

They may also look at a borrower’s personal

credit score – or in the case of a business, business credit score – to determine whether to grant a

short term loan.

Term Loan

A bank loan to a company, with a fixed maturity and often featuring amortization of principal. If

this loan is in the form of a line of credit, the funds are drawn down shortly after the agreement

is signed. Otherwise, the borrower usually uses the funds from the loan soon after they become

available. Bank term loans are very a common kind of lending.

Working capital term loan:

Objective:

This scheme is aimed for those units currently facing problem due to lack of working capital

support from commercial banks, but can be made viable with the infusion of fresh funds by way

of one time core working capital assistance.

Eligibility:

1. The scheme is meant for limited companies which are industrial concerns as defined in IDBI

Act.

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2. Those limited companies which have not got any working capital:

a. They are defaulter in banks, but not willful defaulter.

b. They were under financed & hence running in lower capacity.

c. There is market for the product.

d. The promoters are competent and persons of integrity.

e. Technology is not outdated.

3. The Company and the unit must be potentially viable.

Quantum of Assistance:

75% of the working capital requirement of business for one cycle of operation.

Promoters’ Contribution: 25%

Interest rate: PLR + weight age of risk.

Repayment Period: Maximum 3 years

The borrower shall approach commercial banks for meeting its normal working capital

requirement at any time during currency of the loan. As and when the assistance is sanctioned by

the bank, the working capital loan from NEDFi should be repaid out of the proceeds of the loan

sanctioned by the bank. NEDFi in turn shall release its charge on current assets and also concede

second charge on fixed assets if so insisted by the bank.

Security:

i. First charge by way of hypothecation of current assets.

ii. Charge on fixed assets of the unit.

iii. Personal Guarantee of Promoter Director/Corporate Guarantee

iv. First pari-passu charge on the fixed assets of the unit, if the assets are mortgaged to other

institutions/ Bank

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 v. Adequate collateral security

Upfront fee: 1.00% of the loan amount

Bill Financing

A "bill of exchange" is a kind of legal negotiable instrument used to settle a payment at a future

date. It is drawn by a drawer on a drawee wherein drawee accepts the payment liability at a date

stated in the instrument. The Drawer of the bill of exchange draw the bill on the drawee and send

it to him for his acceptance. Once accepted by the drawee, it

becomes a legitimate negotiable instrument in the financial market and a debt against the

drawee. The drawer may, on acceptance, have the bill of exchange discounted from his bank for

immediate payment to have his working capital funds. On due date, the bill is again presented to

the drawee for the payment accepted by him, as stated therein the bill.

Bank Guarantee

Bank Guarantees is a financial instruments often used in inland or international trade when

suppliers or vendors do not have established business relationships with their counterparts. “a

guarantee is a written contract stating that IN THE EVENT the primary party (the buyer) is

unable or unwilling to pay its dues to the supplier the bank, as guarantor to the transaction the

BG issuer would pay (the client's debt) to the supplier”

In other words, a bank guarantee is an undertaking of a bank on behalf of its customer. But this

comes into play ONLY WHEN the principal party (the buyer) has failed to pay its supplier.

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Essentially, the bank becomes a co-signer for its customer's purchases.

Hence, in a BG the initial claim is still settled primarily (i.e., first) against the bank's client, and

not the bank itself. Should the client default, ONLY THEN would the bank (which has issued

the

BG) agree to pay for it's client's debts on behalf of its client. This is a type of contingent

guarantee.

A bank guarantee, therefore, is more risky for the merchant and less risky for the bank.

Pre-shipment Finance

• Pre-shipment finance is credit granted to the Exporters by a financial institution.

• Pre-shipment finance is part of working capital finance.

• The main objective is to enable the exporter to:

a) Procure raw material.

b) Carry out manufacturing process.

c) Provide a secured warehouse for goods & raw material.

d) Process and pack the goods.

e) Meet other financial costs, if any, of the business.

Types of pre-shipment finance

A) Packing credit.

B) Advance against cheques/drafts etc – representing advance payments.

Pre-shipment advance is extended in the following forms:

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 1) Packing credit in Indian Rupee (PCL)

2) Packing credit in Foreign Currency (PCFC)

REQUIREMENT FOR GETTING PACKING CREDIT

The facility is provided to the exporter who satisfies the following conditions:

a) Exporter should have a ten digit importer-exporter code number allotted by DGFT (Director

General of Foreign Trade).

Eligibility for packing credit

• Pre-shipment credit is granted to an exporter who has the export order or LC in his

own name.

• The exporter is the person or company who actually delivers the goods to the

importer/buyer.

• However, as an exception, Financial Institutions can also grant credit to a third-party

manufacturer or supplier of goods who does not have export orders or LCs in their name.

• But some of the responsibilities of meeting the export requirement have been outsourced

to them, by the main exporter.

Quantum of finance

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• There is no fixed formula to determine the quantum of finance that is granted to an

exporter against a specific order/LC.

• The only guiding principle is the concept of need-based finance.

• Banks determine the percentage of margin, depending upon factors such as:

a) The nature of order.

b) The nature of commodity.

c) The capability of exporter to bring in the requisite contribution in the shape of margin.

Appraisal and sanction of limit

• PCL is made available for the specific purpose of procuring / processing/manufacturing

of goods meant for export.

• PCL advance should be liquidated from export proceeds.

• While considering credit faculties for export, Banks look into the product/commodity

profile, country profile etc.

• Banks also look into the status report of the prospective buyer.

• For getting status report on foreign buyer, services of institutes like ECGC or

international consulting agencies like Dun and Brad Street etc may be utilized.

• Banks extend the PCL facilities after ensuring the following:

a) The exporter is a regular customer, bonafide exporter and has a good standing in the

market.

b) The country with which exporter wants to deal is under the list of Restricted Cover

Countries (RCC).

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DISBURSEMENT OF PCL

After sanctioning the limits, Banks disburse the loan.

Before disbursement, Banks checks the following particulars:

1) Name of the buyer.

2) Commodity to be exported, Quantity, Value (either CIF or FOB)

3) Last date of shipment / Negotiation.

4) Any other terms to be complied with

Letter of credit

A Letter of Credit is a payment term generally used for international sales transactions. It is

basically a mechanism, which allows importers/buyers to offer secure terms of payment to

exporters/sellers in which a bank (or more than one bank) gets involved. The technical term

for Letter of credit is 'Documentary Credit'. At the very outset one must understand is that

Letters of credit deal in documents, not goods. The idea in an international trade transaction

is to shift the risk. Thus a LC (as it is commonly referred to) is a payment undertaking given

by a bank to the seller and is issued on behalf of the applicant i.e. the buyer.

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 The Buyer is the Applicant and the Seller is the Beneficiary. The Bank that issues the LC is

referred to as the Issuing Bank which is generally in the country of the Buyer. The Bank that

Advises the LC to the Seller is called the Advising Bank which is generally in the country of

the Seller.

The specified bank makes the payment upon the successful presentation of the required

documents by the seller within the specified time frame. Note that the Bank scrutinizes the

'documents' and not the 'goods' for making payment. The process works in favor of both the

buyer and the seller.

Trade Finance by Indian Bank

Target Group Purpose

Wholesale and Retail Traders with 4 to 5 years Working capital needs of stock in trade,

of satisfactory track record receivables/infrastructure

Term Loan:

• Showcases, Basic Office amenities like

Computer Hardware

• Furniture layout for storage/display of

goods traded, cold storage facilities

• Neon Lighting, Hoarding, Display

panels

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 • Billing Equipment, Safety Equipment

etc.

• Front elevation and beautification of

layout

• Other facilities aimed at Customer

convenience like Air-conditioning,

purchase of Delivery Van, Trolley etc.

Eligible Amount Security

Scheme I Scheme I:

Secured OD upto Rs.10 lakh Against immovabale property, NSC, KVP, IVP

(The securities viz., immovabale property,

NSC, KVP, IVP

lodged for the full limit has to be retained with

the Bank till complete adjustment of the

facility)

Collateral : stocks in trade

Personal Guarantee of Directors for loans to

Private and Public Ltd. Companies

Scheme II Scheme II:

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OCC Above Rs.10 lakhs upto Rs.100 lakh Primary: Against Stocks and Book Debts

Collateral: 100% of OCC limit in terms of

value of Immovable property, NSC/ KVP/

IVP/Agricutural Land.

Personal Guarantee of Directors for loans to

Private and Public Ltd. Companies

Term Loan: Term Loan:

Max. upto Rs.10 lakh Hypothecation of items

purchased/infrastructure created, Collateral

100%

Personal Guarantee of Directors for loans to

Private and Public Ltd. Companies

Interest Rate Margin

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 Working capital Term Loan I Working Capital:

BPLR BPLR+TP For limits upto Rs.10 lakh:

Presently 12.50% Presently 13.30%

Immovable Property - 33%

NSC/KVP/IVP etc. - 10%

Agricultural Land - 50%

For limits above Rs.10 lakh and upto Rs.100

lakh:

Primary Security - 15% on paid stocks/book

debts (90 days)

Collateral Security - 100%

II Term Loan: 20%

Repayment Service Charge

Term Loan: Repayable in 48 equated monthly Rs.250/- per lakh or part thereof

instalments

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 CREDIT RISK MANAGEMENT

1.1 Risk is inherent in all aspects of a commercial operation and covers areas such as

customer services, reputation, technology, security, human resources, market price, funding,

legal, and regulatory, fraud and strategy. However, for banks and financial institutions, credit

risk is the most important factor to be managed. Credit risk is defined as the possibility that a

borrower or counterparty will fail to meet its obligations in accordance with agreed terms.

Credit risk, therefore, arises from the banks' dealings with or lending to a corporate, individual,

another bank, financial institution or a country. Credit risk may take various forms, such as:

• in the case of direct lending, that funds will not be repaid;

• in the case of guarantees or letters of credit, that funds will not be forthcoming from the

customer upon crystallization of the liability under the contract;

• In the case of treasury products, that the payment or series of payments due from the

counterparty under the respective contracts is not forthcoming or ceases;

• In the case of securities trading businesses, that settlement will not be effected;

• In the case of cross-border exposure, that the availability and free transfer of currency is

restricted or ceases.

1.1.2 The more diversified a banking group is, the more intricate systems it would need, to

protect itself from a wide variety of risks. These include the routine operational risks applicable

to any commercial concern, the business risks to its commercial borrowers, the economic and

political risks associated with the countries in which it operates, and the commercial and the

reputational risks concomitant with a failure to comply with the increasingly stringent legislation

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and regulations surrounding financial services business in many territories. Comprehensive risk

identification and assessment are therefore very essential to establishing the health of any

counterparty.

1.1.3 Credit risk management enables banks to identify, assess, manage proactively, and

optimize their credit risk at an individual level or at an entity level or at the level of a country.

Given the fast changing, dynamic world scenario experiencing the pressures of globalisation,

liberalization, consolidation and disintermediation, it is important that banks have a robust credit

risk management policies and procedures which is sensitive and responsive to these changes.

1.1.4 The quality of the credit risk management function will be the key driver of the changes

to the level of shareholder return. Industry analysts have demonstrated that the average

shareholder return of the best credit performance US banks during 1989 - 1997 was 56%

higher than their peers. Low loan loss banks stage a quicker share price recovery than their

peers, and in a credit downturn, the market rewards the banks with the best credit performance

with a moderate price decline relative to their peers.

1.2 Building Blocks on Credit Risk

In any bank, the corporate goals and credit culture are closely linked, and an effective

credit risk management framework requires the following distinct building blocks: -

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1.2.1 Strategy and Policy

This covers issues such as the definition of the credit appetite, the development of credit

guidelines and the identification and the assessment of the credit risk.

1.2.2 Organization

This would entail the establishment of competencies and clear accountabilities for

managing the credit risk.

1.2.3 Operations/Systems

MIS requirements of the senior and middle management, and the development of tools and

techniques will come under this domain.

1.3 Strategy and Policy

1.3.1 It is essential that each bank develops its own credit risk strategy or enunciates a

plan that defines the objectives for the credit-granting function. This strategy should spell

out clearly the organization’s credit appetite and the acceptable level of risk - reward

trade-off at both the macro and the micro levels.

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1.3.2 The strategy would therefore, include a statement of the bank's willingness to

grant loans based on the type of economic activity, geographical location, currency,

market, maturity and anticipated profitability. This would necessarily translate into the

identification of target markets and business sectors, preferred levels of diversification and

concentration, the cost of capital in granting credit and the cost of bad debts.

1.3.3 The policy document should cover issues such as organizational responsibilities,

risk measurement and aggregation techniques, prudential requirements, risk assessment

and review, reporting requirements, risk grading, product guidelines, documentation, legal

issues and management of problem loans. Loan policies apart from ensuring consistency in

credit practices, should also provide a vital link to the other functions of the bank. It has

been empirically proved that organizations with sound and well-articulated loan policies

have been able to contain the loan losses arising from poor loan structuring and

perfunctory risk assessments.

1.3.4 The credit risk strategy should provide continuity in approach, and will need to take into

account the cyclical aspects of any economy and the resulting shifts in the composition and

quality of the overall credit portfolio. This strategy should be viable in the long run and through

various credit cycles.

1.3.5 An organization’s risk appetite depends on the level of capital and the quality of loan

book and the magnitude of other risks embedded in the balance sheet. Based on its capital

structure, a bank will be able to set its target returns to its shareholders and this will determine

the level of capital available to the various business lines.

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1.3.6 Keeping in view the foregoing, a bank should have the following in place: -

1. Dedicated policies and procedures to control exposures to designated higher risk sectors

such as capital markets, aviation, shipping, property development, defense equipment,

highly leveraged transactions, bullion etc.

2. Sound procedures to ensure that all risks associated with requested credit facilities are

promptly and fully evaluated by the relevant lending and credit officers.

3. Systems to assign a risk rating to each customer/borrower to whom credit facilities have

been sanctioned.

4. A mechanism to price facilities depending on the risk grading of the customer, and to

attribute accurately the associated risk weightings to the facilities.

5. Efficient and effective credit approval process operating within the approval limits

authorized by the Boards.

6. Procedures and systems which allow for monitoring financial performance of customers

and for controlling outstanding within limits.

7. Systems to manage problem loans to ensure appropriate restructuring schemes. A

conservative policy for the provisioning of non-performing advances should be followed.

8. A process to conduct regular analysis of the portfolio and to ensure on-going control of

risk concentrations.

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1.4 Credit Policies and Procedures

The credit policies and procedures should necessarily have the following elements: -

• Banks should have written credit policies that define target markets, risk acceptance

criteria, credit approval authority, credit origination and maintenance procedures and

guidelines for portfolio management and remedial management.

• Banks should establish proactive credit risk management practices like annual / half

yearly industry studies and individual obligor reviews, periodic credit calls that are

documented, periodic plant visits, and at least quarterly management reviews of troubled

exposures/weak credits.

• Business managers in banks will be accountable for managing risk and in conjunction

with credit risk management framework for establishing and maintaining appropriate risk

limits and risk management procedures for their businesses.

• Banks should have a system of checks and balances in place around the extension of

credit which are:

o An independent credit risk management function

o Multiple credit approvers

o An independent audit and risk review function

• The Credit Approving Authority to extend or approve credit will be granted to individual

credit officers based upon a consistent set of standards of experience, judgment and

ability.

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 • The level of authority required to approve credit will increase as amounts and transaction

risks increase and as risk ratings worsen.

• Every obligor and facility must be assigned a risk rating.

• Banks should ensure that there are consistent standards for the origination,

documentation and maintenance for extensions of credit.

• Banks should have a consistent approach toward early problem recognition, the

classification of problem exposures, and remedial action.

• Banks should maintain a diversified portfolio of risk assets in line with the capital desired

to support such a portfolio.

• Credit risk limits include, but are not limited to, obligor limits and concentration limits

by industry or geography.

• In order to ensure transparency of risks taken, it is the responsibility of banks to

accurately, completely and in a timely fashion, report the comprehensive set of credit risk

data into the independent risk system.

1.5 Organizational Structure

1.5.1 A common feature of most successful banks is to establish an independent group

responsible for credit risk management. This will ensure that decisions are made with sufficient

emphasis on asset quality and will deploy specialised skills effectively. In some organisations,

the credit risk management team is responsible for the management of problem accounts, and for

credit operations as well. The responsibilities of this team are the formulation of credit policies,

procedures and controls extending to all of its credit risks arising from corporate banking,

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treasury, credit cards, personal banking, trade finance, securities processing, payment and

settlement systems, etc. This team should also have an overview of the loan portfolio trends and

concentration risks across the bank and for individual lines of businesses, should provide input to

the Asset - Liability Management Committee of the bank, and conduct industry and sectoral

studies. Inputs should be provided for the strategic and annual operating plans. In addition, this

team should review credit related processes and operating procedures periodically.

1.5.2 It is imperative that the independence of the credit risk management team is preserved,

and it is the responsibility of the Board to ensure that this is not allowed to be compromised at

any time. Should the Board decide not to accept any recommendation of the credit risk

management team and then systems should be in place to have the rationale for such an action to

be properly documented. This document should be made available to both the internal and

external auditors for their scrutiny and comments.

1.5.3 The credit risk strategy and policies should be effectively communicated throughout the

organization. All lending officers should clearly understand the bank's approach to granting

credit and should be held accountable for complying with the policies and procedures.

1.5.4 Keeping in view the foregoing, each bank may, depending on the size of the

organization or loan book, constitute a high level Credit Policy Committee also called Credit

Risk Management Committee or Credit Control Committee, etc. to deal with issues relating to

credit policy and procedures and to analyze, manage and control credit risk on a bank wide basis.

The Committee should be headed by the Chairman/CEO/ED, and should comprise heads of

Credit Department, Treasury, Credit Risk Management Department (CRMD) and the Chief

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Economist. The Committee should, inter alia, formulate clear policies on standards for

presentation of credit proposals, financial covenants, rating standards and benchmarks,

delegation of credit approving powers, prudential limits on large credit exposures, asset

concentrations, standards for loan collateral, portfolio management, loan review mechanism, risk

concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal

compliance, etc. Concurrently, each bank may also set up Credit Risk Management Department

(CRMD), independent of the Credit Administration Department. The CRMD should enforce and

monitor compliance of the risk parameters and prudential limits set by the CPC. The CRMD

should also lay down risk assessment systems, monitor quality of loan portfolio, identify

problems and correct deficiencies, develop MIS and undertake loan review/audit. Large banks

may consider separate set up for loan review/audit. The CRMD should also be made accountable

for protecting the quality of the entire loan portfolio. The Department should undertake portfolio

evaluations and conduct comprehensive studies on the environment to test the resilience of the

loan portfolio.

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1.5.5 Typical Organizational Structure

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1.6 Operations / Systems

1.6.1 Banks should have in place an appropriate credit administration, measurement and

monitoring process. The credit process typically involves the following phases: -

1. Relationship management phase i.e. business development.

2. Transaction management phase: cover risk assessment, pricing, structuring of the

facilities, obtaining internal approvals, documentation, loan administration and routine

monitoring and measurement.

3. Portfolio management phase: entail the monitoring of the portfolio at a macro level and

the management of problem loans.

1.6.2 Successful credit management requires experience, judgement and a commitment to

technical development. Each bank should have a clear, well-documented scheme of delegation

of limits. Authorities should be delegated to executives depending on their skill and experience

levels. The banks should have systems in place for reporting and evaluating the quality of the

credit decisions taken by the various officers.

1.6.3 The credit approval process should aim at efficiency, responsiveness and accurate

measurement of the risk. This will be achieved through a comprehensive analysis of the

borrower's ability to repay, clear and consistent assessment systems, a process which ensures

that renewal requests are analyzed as carefully and stringently as new loans and constant

reinforcement of the credit culture by the top management team.

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1.6.4 Commitment to new systems and IT will also determine the quality of the analysis

being conducted. There is a range of tools available to support the decision making process.

These are:

• Traditional techniques such as financial analysis.

• Decision support tools such as credit scoring and risk grading.

• Portfolio techniques such as portfolio correlation analysis.

The key is to identify the tools that are appropriate to the bank.

Banks should develop and utilize internal risk rating systems in managing credit risk. The rating

system should be consistent with the nature, size and complexity of the bank's activities.

1.6.5 Banks must have a MIS, which will enable them to manage and measure the credit risk

inherent in all on- and off-balance sheet activities. The MIS should provide adequate information

on the composition of the credit portfolio, including identification of any concentration of risk.

Banks should price their loans according to the risk profile of the borrower and the risks

associated with the loans.

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 INDUSTRY RATING

Industry performance has direct affect on the performance of the companies belonging to that

industry. A company that operating in favorable industry would have more chance to perform

better and strengthen its business position rather than those industries which are operating under

unfavorable industry. Hence while assessing the credit rating of a company the prospect of

industry is an important factor that should be considered.

A process that analyses an industry from various angles to develop thorough understanding in

order to spot opportunities for lending/investment purposes based on the relative attractiveness

in terms of their ability to maintain growth and profitability in the long run is called industry

rating.

Thus to provide a common system for assigning a rating to different mfg. industries a tool has

been developed according to the risk profile.

Purpose of industry rating

The purpose of industry rating is to ascertain the credit risk involve in these industries while

sanctioning loans. It is very important for the banks to see industry rating while sanctioning loan

to the companies, that the company to whom they are giving loan comes under which industry

and what is the rating of that industry. So, by the industry rating it’s become easy for the banks

to decide which industry is best for investing or giving loans.

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Industry rating tools

The industry-rating tool incorporates and includes various factors for assessing the risks inherent

in an industry. These risks may arise due to various forces impacting the industry and it may be

shaped by internal structure/ competition or a result of macroeconomic forces acting on the

entire economy. Industry prospects-as reflected by the industry rating have profound influence

on the performance/repayment capacity of the companies in the industry. The rating process

involves evaluation of the above areas through various objective and subjective parameters. The

tool evaluates an Industry on a scale of 7 i.e., AAA to D with AAA indicating highly favorable

industry and D highly unfavorable industry.

Risk parameters or sources of risks considered in the tool and the methodology used in

aggregation of score:

1. The scores are assigned to each of the parameters in the different sections on a scale of 0 to 4

up to two decimal points, with 0 being very poor and 4 being excellent.

2. Indicative weights for the above areas have been prescribed as under:

S.No Risk parameter Weight

1 Future of the industry 20%
2 Stock market perception 10%
3 Impact of government polices 15%
4 Default experience 5%
5 Industry financials 10%
6 Structure of industry which influences the profit potential 40%

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3. However depending on the nature of industry the importance of various areas given above

may differ. Hence flexibility up to 5% against the weights assigned has been provided to enable

the user to change the weights depending on the industry rated if felt necessary.

4. The above areas have various parameters/sub parameters. Since the relative importance of this

parameter depends on the nature of industry no weights have been prescribed for these

parameters/sub parameters. User will have the freedom to award the weights depending upon the

relative importance of parameters/sub parameters.

5. Scores are awarded to different parameters. The weighted score of each parameter is arrived at

by multiplying the score by weight. These weighted scores are aggregated and a composite score

for the industry is arrived at in percentage terms. Higher the score obtained by an industry better

is its industry rating.

6. The overall percentage score obtained is then translated into a rating on a score of 7 from

AAA to D as under

Industry rating Risk profile

AAA Highly favorable
AA Favorable
A Marginal favorable
BB Neutral
B Marginal unfavorable
C Unfavorable
D Highly unfavorable

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 Project appraisal

Since every bank wants to minimize the number of non-performing assets and they want their

credit portfolio to be healthy, efficient project appraisal is very important as it can check and

prevent induction of weak accounts to the loan portfolio.

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Feasibility of the Projects

1. Management Appraisal

Management appraisal is related to the technical and managerial competence, integrity,

knowledge of the project, managerial competence of the promoters etc. The promoters should

have the knowledge and ability to plan, implement and operate the entire project effectively. The

past record of the promoters is to be appraised to clarify their ability in handling the projects.

2. Technical Feasibility

Technical feasibility analysis is the systematic gathering and analysis of the data pertaining to

the technical inputs required and formation of conclusion there from. The availability of the raw

materials, power, sanitary and sewerage services, transportation facility, skilled man power,

engineering facilities, maintenance, local people etc are coming under technical analysis. This

feasibility analysis is very important since its significance lies in planning the exercises,

documentation process, risk minimization process and to get approval.

3. Financial feasibility

One of the very important factors that a project team should meticulously prepare is the financial

viability of the entire project. This involves the preparation of cost estimates, means of

financing, financial institutions, financial projections, break-even point, ratio analysis etc. The

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cost of project includes the land and sight development, building, plant and machinery, technical

know-how fees, pre-operative expenses, contingency expenses etc. The means of finance

includes the share capital, term loan, special capital assistance, investment subsidy, margin

money loan etc. The financial projections include the profitability estimates, cash flow and

projected balance sheet. The ratio analysis will be made on debt equity ration and current ratio.

4. Commercial Appraisal

In the commercial appraisal many factors are coming. The scope of the project in market or the

beneficiaries, customer friendly process and preferences, future demand of the supply,

effectiveness of the selling arrangement, latest information availability an all areas, government

control measures, etc. The appraisal involves the assessment of the current market scenario,

which enables the project to get adequate demand. Estimation, distribution and advertisement

scenario also to be here considered into.

5. Economic Appraisal

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How far the project contributes to the development of the sector, industrial development, social

development, maximizing the growth of employment, etc. are kept in view while evaluating the

economic feasibility of the project.

6. Ecological Appraisal

Ecological analysis should be done particularly for major projects, which have significant

ecological imprecations like power plants, irrigation scheme environmental polluting industries

like bulk drugs, chemicals, etc. The key aspect of ecological analysis is:

• The likely damage to be caused to the environment.

• The cost of the required restoration measures, which ensure that the damages to the

environment is within the acceptable limits.

BIBLIOGRAPHY

1. Commercial Banking, ICFAI University.

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2. Working capital management, V.K. Bhalla.

3. Handbook of banking information, N.S.Toor.

4. Banking law and practices, P.N.Varshney.

5. Website of Indian Bank (www.indian-bank.com)

6. Website of RBI (www.rbi.com)

7. Documents and reference material of Indian Bank (for guidelines)

8. Financial management ( I.M.Pandey)

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