FIN 6002 – Session 30

Pradeepta Sethi
TAPMI
 Bank credit
• Bank credit is the primary source of debt financing.

• For commercial banks, good loans are the most profitable

assets.

• Loans are typically less liquid than other assets, because

they cannot be turned into cash until the loan matures.

• Largest categories of loans are commercial and industrial

loans made to business.

• Extending loans to businesses and individuals involves

taking risks to earn high returns.

• Returns come in the form of loan interest, fee income, and

investment income from new deposits.

• Banks also use loans to cross-sell other fee-generating

services.

• The most prominent assumed risk is credit risk.

 Bank credit

• There are two important parts to good lending:

• assessing the borrower’s commitment to repay the loan.

• evaluating the borrower’s ability to pay the loan.

• Assessing the borrower’s commitment to pay is most

critical.

• When measuring a borrower’s commitment or desire to pay

the loan, the lender attempts to measure the borrowers’
character, the viability or quality of what the loan proceeds
will be used for, as well as the borrower’s history in paying
prior debts.

• The borrower’s ability to pay can be assessed by factors

such as total income, total debt, total assets and the value
of the collateral relative to the risk of what the loan will be
used for.
 Fundamental credit issues

• Bankers can make two types of errors in judgment.

• Extending credit to a customer who ultimately

defaults.

• Denying a loan to a customer who ultimately would

repay the debt.

• Many bankers focus on eliminating the first type of error,

applying rigid credit evaluation criteria and rejecting
applicants who do not fit the mold of the ideal borrower.

• The purpose of credit analysis is to identify the

meaningful, probable circumstances under which the
bank might lose.

• Cardinal principles of lending – Safety, Liquidity &

Profitability
 Fundamental credit issues

• Adverse selection in loan markets occurs because bad

credit risks (those most likely to default on their loans) are
the ones who usually line up for loans.

• In other words, those who are most likely to produce an

adverse outcome are the most likely to be selected.

• Borrowers with very risky investment projects have much

to gain if their projects are successful, so they are the
most eager to obtain loans. Clearly, however, they are the
least desirable borrowers because of the greater
possibility that they will be unable to pay back their loans.
 Fundamental credit issues

• Moral hazard exists in loan markets because borrowers

may have incentives to engage in activities that are
undesirable from the lender’s point of view. In such
situations, it is more likely that the lender will be
subjected to the hazard of default.

• Once borrowers have obtained a loan, they are more

likely to invest in high-risk investment projects—projects
that pay high returns to the borrowers if successful.

• The high risk, however, makes it less likely that they will
be able to pay the loan back.

• To be profitable, financial institutions must overcome the

adverse selection and moral hazard problems that make
loan defaults more likely.
 Managing credit risk
• Screening and Monitoring

• Collecting information, Credit score (CIBIL Score),

• Specialized lending,

• Restrictive covenants

• Establishment of long-term customer relationships

• Reduce the costs of information collection

• Collateral

• Secured loans – Property or other asset promised to

lender as compensation if the borrower defaults

• Margin requirements

• Firm receiving a loan must keep a required minimum

amount of funds in a current account at the bank
 Managing credit risk
• Credit rationing - refusing to make loans even though
borrowers are willing to pay the stated interest rate or even
a higher rate.
• Credit rationing takes two forms -
• The first occurs when a lender refuses to make a loan of
any amount to a borrower, even if the borrower is willing to
pay a higher interest rate.
• Guard against adverse selection: Charging a higher interest
rate just makes adverse selection worse for the lender - it
increases the likelihood that the lender is lending to a bad
credit risk
• The second occurs when a lender is willing to make a loan
but restricts the size of the loan to less than the borrower
would like.
• Guard against moral hazard: They grant loans to borrowers,
but not loans as large as the borrowers want. Such credit
rationing is necessary because the larger the loan, the
greater the benefits from moral hazard.
 Credit appraisal

Viability of the
business (Macro &
The Promoters
Micro Business
Environment)

Business financials Risk Mitigation

 Promoter evaluation

Track record Net Management Experience of Ownership

worth/availabil management pattern
ity of funds
 Maximum Permissible Bank
Finance (MPBF) method –
Tandon committee (1974), 3
methods

Chore committee (1979)

WC
assessment
methods Cash Budget method - Based
on procurement and cash
inflow) – Seasonal business

Turnover Method – Nayak

committee (1991)
 MPBF = 0.75 * (TCA – OCL)

MPBF = 0.75 * (TCA) – OCL

MPBF MPBF = 0.75 * (TCA – CCA) – OCL

TCA – Total Current Assets, OCL – Other

current liabilities, CCA – Core portion of
Current Assets
 Procurement of raw material : 30 days

Conversion/process time : 15 days

Average time of holding of finished goods: 15 days

Average collection period : 30 days

Operating Total operating cycle : 90 days

cycle method
Operating cycle in a year : 4

Total operating expenses per annum : ₹ 60 lacs

Total turnover per annum : ₹ 70 lacs

Working capital requirement : 60/4= ₹15 lacs

 Paid stock – 4 Margin 25% - DP = 3

Semi-finished goods – 4 Margin 50% - DP=2

Drawing Finished goods - 4 Margin 25% - DP = 3

power
method
Book Debts – 4 Margin 50% - DP = 2

Total DP= 10
 For SSI Units

Projected sales = ₹10,00,000

Nayak Working capital requirements: 25%

committee of projected sales i.e. ₹ 2,50,000

Margin (contribution of Owner) :

5% of projected sales i.e. ₹50,000

Working capital to be funded by

bank : ₹.2,00,000
 Loans & Advances

• Loans & advances – fund-based credit facilities

• Loan – capital expenditure / capital investments

• Advances – working capital financing

• Loans & advances form a major proportion of the asset

portfolio of a bank.

• After bank nationalization in 1969 – focus on credit

expansion in general and for priority sectors in particular.

• Banks were given targets to be achieved by extending

liberal credit – Asset performance could not be maintained
– bad debt, write-offs – Adverse impact on profitability

• Narasimham committee (1991) – performing assets

(standard) & nonperforming assets
 Non-performing assets
• An asset becomes non performing when it ceases to
generate income for the bank.

• Term loan - interest and/ or instalment of principal remain

overdue for a period of more than 90 days.

• Overdraft/cash Credit - the account remains ‘out of order’

(outstanding balance in excess of the sanctioned
limit/drawing power) for 90 days.

• Bills purchased and discounted - the bill remains overdue

for a period of more than 90 days.

• Agricultural loans - the instalment of principal or interest

thereon remains overdue for two crop seasons for short
duration crops, & for one crop season for long duration
crops
 COVID – 19 Impact

• Accounts classified as standard as on February 29,

2020, even if overdue, the moratorium period, wherever
granted, shall be excluded from the number of days past-
due for the purpose of asset classification under the
IRAC (Income Recognition, Asset Classification) norms.
 NPA Categories
which has remained NPA for a period less than or equal to 12
months.
Substandard Such an asset will have well defined credit weaknesses that
assets jeopardise the liquidation of the debt and are characterised by
the distinct possibility that the banks will sustain some loss, if
deficiencies are not corrected.
remained in the substandard category for a period of 12 months.
Doubtful It has all the weaknesses inherent in assets that were classified
assets as sub-standard with the added characteristic that the
weaknesses make collection or liquidation in full - highly
questionable and improbable.

where loss has been identified by the bank or internal or external

auditors or the RBI inspection, but the amount has not been
Loss assets written off wholly.
These assets are considered uncollectible and of little value.
 Signs of stress
• Delay in submission of stock statement/other stipulated
operating control statements or credit monitoring or
financial statements or non-renewal of facilities based on
audited financials

• Actual sales / operating profits falling short of projections

accepted for loan sanction by 40% or more; or

• a single event of non-cooperation / prevention from

conduct of stock audits by banks; or

• reduction of Drawing Power (DP) by 20% or more after a

stock audit; or

• evidence of diversion of funds for unapproved purpose

• Return of 3 or more cheques (or electronic debit

instructions) issued by borrowers in 30 days on grounds of
non-availability of balance/DP in the account or return of 3
or more bills / cheques discounted or sent under collection
by the borrower.
 Signs of stress

• Devolvement of Deferred Payment Guarantee (DPG)

instalments or Letters of Credit (LCs) or invocation of Bank
Guarantees (BGs) and its non-payment within 30 days.

• Request for extension of time either for creation or

perfection of securities as against time specified in original
sanction terms or for compliance with any other terms and
conditions of sanction.

• Increase in frequency of overdrafts in current accounts.

• Promoter(s) pledging/selling their shares in the borrower

company due to financial stress.
 Special Mention Accounts (SMA)

• Timely and adequate interventions may prevent slippage of

NPAs.

• Special Mention Accounts (SMA) - a new asset category

between ‘Standard’ and ‘Sub-standard’.

• SMA-0 – Principal or interest payment overdue between 1

- 30 days, account showing signs of incipient stress

• SMA-1 – Principal or interest payment overdue between

31-60 days

• SMA-2 – Principal or interest payment overdue between

61-90 days

• For revolving credit facilities like cash credit the there are
two sub-categories - SMA -1 & 2
Loan disbursed on Jan 1, 2018, first default in payment happened on Mar 31, 2019.
Assuming the default continued there after; the period wise classification will be as
follows:
Classification Enters Continues till
Standard Jan 1, 2018 Mar 31, 2019
SMA-0 April 1, 2019 April 30, 2019
SMA-1 May 1, 2019 May 30, 2019
SMA-2 May 31, 2019 June 29, 2019
Sub standard June 30, 2019 June 30, 2020
Doubtful-1 July 1, 2020 July 1, 2021
Doubtful-2 July 2, 2021 July 2, 2022
Doubtful-3 July 3, 2022 Uncertain

Period wise classification

 Effect of NPA on bank’s performance

• Banks cannot account for interest income in their profit and

loss account as they cannot debit interest of the loan
account unless recovery is affected in the same year.
• Interest or other charges already debited but not recovered
have to be provided for and provision on the amount of
gross NPA is to be made.
• Asset Classification to be borrower-wise and not facility-
wise i.e. All accounts of the borrower would be treated as
NPA, one account is NPA.
• Risk-weights are higher for the assets where chances of
turning NPA are more.
• It also affects the credit-deposit ratio (CD ratio) of banks as
they are not able to extend fresh credits as the funds
remain blocked in NPAs.
• Provision made for NPA is not tax deductible.
 Situation 1
• Profit = 1000
• Provision for NPA = 400
• Profit before tax = 600
• Tax@35% = 350
• Profit after tax = 600-350=250

Situation 2
• Profit = 1000
• Provision for NPA = 200
• Write-off amount= 200
• Profit before tax = 600
• Tax@35% = 280
• Profit after tax = 600-280=320

Effect of NPA on bank’s performance

Particulars Amount
1 Standard Advances
2 Gross NPAs *
3 Gross Advances ** ( 1+2 )
4 Gross NPAs as a percentage of Gross Advances (2/3) (in %)
Deductions
Provisions held in the case of NPA Accounts as per asset classification (including
(i)
additional Provisions for NPAs at higher than prescribed rates).
(ii) DICGC / ECGC claims received and held pending adjustment
(iii) Part payment received and kept in Suspense Account or any other similar account
Balance in Sundries Account (Interest Capitalization - Restructured Accounts), in
5 (iv)
respect of NPA Accounts
(v) Floating Provisions***
Provisions in lieu of diminution in the fair value of restructured accounts classified
(vi)
as NPAs
Provisions in lieu of diminution in the fair value of restructured accounts classified
(vii)
as standard assets
6 Net Advances(3-5)
7 Net NPAs {2-5(i + ii + iii + iv + v + vi)}
8 Net NPAs as percentage of Net Advances (7/6) (in %)
Principal dues of NPAs plus Funded Interest Term Loan (FITL) where the corresponding contra credit is
*
parked in Sundries Account (Interest Capitalization - Restructured Accounts), in respect of NPA Accounts.
‘Gross Advances' mean all outstanding loans and advances including advances for which refinance has
** been received but excluding rediscounted bills, and advances written off at Head Office level (Technical
write off).
Floating Provisions would be deducted while calculating Net NPAs, to the extent, banks have exercised this
***
option, over utilising it towards Tier II capital.
 Provisioning norms

Asset class Provision requirement

Standard asset – Agricultural and Small and Micro Enterprises 0.25%
(SMEs) sectors
Standard asset –Commercial Real Estate (CRE) Sector 1.00%
Standard asset – Commercial Real Estate – Residential Housing 0.75%
Sector (CRE - RH)
Standard asset – Housing loans (extended at teaser rates) and 0.25% (2.00 - 0.40% after
1 year)
restructured advances 5.00%
All other Standard asset – loans and advances not included 0.40%
above
Doubtful asset – Up to one year 25%
Doubtful asset – One to three years 40%
Doubtful asset – More than three years 100%
Loss asset – Should be written off, if permitted to be in books 100%
 Provisioning norms

Asset classification Period as NPA Normal Provisioning (%) Accelerated Provisioning

(%)
Sub- standard Up to 6 months 15 15
(Secured)
6 months to 1 year 15 25
Sub- standard Up to 6 months 25 (other than 25
(Un-secured) infrastructure loans)
20 (infrastructure loans)
6 months to 1 year 25 (other than 40
infrastructure loans)
20 (infrastructure loans)
Doubtful I 2nd Year 25 (secured portion) 40 (secured portion)
100 (unsecured portion) 100 (unsecured portion)
Doubtful II 3rd & 4th Year 40 (secured portion) 100 for both secured and
100 (unsecured portion) unsecured portion

Doubtful III 5th year onwards 100 100

 Provisions
• Floating provisions are part of profits kept for contingencies
under extraordinary circumstances – Extra provision
cushion

• Extra-ordinary circumstances – General, Market and Credit

• Floating provisions can be netted off from gross NPAs to

arrive at disclosure of net NPAs.

• Can be treated as part of Tier II capital within the overall

ceiling of 1.25% of total risk weighted assets

• Provisioning Coverage Ratio (PCR) – ratio of provisioning

to gross non-performing assets

• Indicates the extent of funds a bank has kept aside to

cover loan losses.

• Provisioning coverage ratio, including floating provisions,

should not be less than 70 per cent.
• Master Circular - Prudential norms on Income
Recognition, Asset Classification and Provisioning
pertaining to Advances – July 1, 2015

• Prudential Framework for Resolution of Stressed

Assets – June 7, 2019

• Resolution Framework for COVID-19-related

Stress – August 6, 2020
 Withdrawal of extant instructions

• Corporate Debt Restructuring Scheme (CDR)

• Strategic Debt Restructuring Scheme (SDR)

• Scheme for Sustainable Structuring of Stressed Assets

(S4A)

• Flexible Structuring of Existing Long-Term Project Loans

(5/25)

• Joint Lenders’ Forum (JLF)

 Prudential Framework of Resolution of Stressed
Assets

• In force since June 7, 2019

• Early identification and reporting of stress

• Implementation of Resolution Plan

• Implementation Conditions for RP

• Delayed Implementation of Resolution Plan

• Prudential Norms
 Early identification and reporting of stress
• Classification of assets into SMA
• Reporting of SMAs to Central Repository of Information on
Large Credits – CRILC
• Banks shall report credit information, including
classification of an account as SMA to CRILC on all
borrower entities having aggregate exposure of ₹50 million
and above with them.
• CRILC-Main (Monthly Submission):
• Section 1 – Exposure to Large Borrowers
• Section 2 – Reporting of Technically/Prudentially
Written-off Accounts
• Section 3 – Reporting of Balance in Current Account
• Section 4 – Reporting of Non cooperative Borrowers
• Banks shall report to CRILC, all borrower entities in default
(with aggregate exposure of ₹ 50 million and above), on a
weekly basis.
 Implementation of Resolution Plan (RP)

• Default with any lender is a lagging indicator of financial stress

faced by the borrower.

• Once a borrower is reported to be in default by any of the

lenders, lenders shall undertake a prima facie review of the
borrower account within thirty days from such default (“Review
Period”).

• During this Review Period of thirty days, lenders may decide

on the resolution strategy, including the nature of RP, the
approach for implementation of the RP, etc.

• Resolution plan broadly means regularization of the account

by payment of all over dues by the borrower entity, sale of the
exposures to other entities / investors, change in ownership
and restructuring etc.

• The lenders may also choose to initiate legal proceedings for

insolvency or recovery.

• Lenders should initiate the process of implementing a

resolution plan (RP) even before a default.
 Implementation of Resolution Plan (RP)

• If RP has to be implemented then during this review

period, all lenders shall enter into an inter-creditor
agreement (ICA).

• The ICA provides ground rules for finalization and

implementation of the RP.

• ICA stipulates that any decision agreed by lenders

representing 75 per cent by value of total outstanding
credit facilities and 60 per cent of lenders by number shall
be binding upon all the lenders.

• ICA provide for rights and duties of majority lenders, duties

and protection of rights of dissenting lenders, treatment of
lenders with priority in cash flows/differential security
interest, etc.

• RP shall be implemented within 180 days from the end of

Review Period.
Implementation conditions of Resolution Plan

• RPs involving restructuring / change in ownership in

respect of accounts where the aggregate exposure of
lenders is ₹ 1 billion and above, shall require independent
credit evaluation (ICE) of the residual debt by credit rating
agencies (CRAs).

• Accounts with aggregate exposure of ₹ 5 billion and above

shall require two such ICEs, others shall require one ICE.

• RPs which receive a credit opinion of RP4 (moderate

degree of safety regarding timely servicing of financial
obligations and carry moderate credit risk) or better for the
residual debt from one or two CRAs, as the case may be,
shall be considered for implementation.

• RP which does not involve restructuring/change in

ownership shall be deemed to be implemented only if the
borrower is not in default with any of the lenders as on
180th day from the end of the Review Period.
 COVID – 19 Framework
• Eligible accounts – Those accounts that were classified as
standard, but not in default for more than 30 days with the
lending institution as on March 1, 2020.

• Continue to remain standard till the invocation of RP.

• Resolution under this framework may be invoked not later

than December 31, 2020.

• RP must be implemented within 90 days and 180 days

from the date of invocation for personal and other
exposures, respectively.

• Under RP in both personal and other exposures a

maximum of two years moratorium can be granted.

• In case of other exposures the ICA has to be signed by all

lending institutions within 30 days from the date of
invocation.
 Restructured Accounts

• Restructured account is one where the bank, for

economic or legal reasons relating to the borrower's
financial difficulty, grants to the borrower
concessions that the bank would not otherwise
consider.
• Restructuring would normally involve modification
of terms of the advances / securities.
• alteration of repayment period
• alteration of repayable amount
• alteration of the amount of instalments
• alteration of rate of interest
 Restructured Accounts - Classification

• Restructuring of advances could take place in the following

stages:

• before date of commencement of commercial production /

operation (DCCO);

• after commencement of commercial production / operation

but before the asset has been classified as 'sub-standard';

• after commencement of commercial production / operation

and the asset has been classified as 'sub-standard' or
'doubtful

• Accounts classified as 'standard' shall be immediately

downgraded as non-performing assets (NPAs), i.e., ‘sub-
standard’ to begin with.
 Restructured Accounts - Classification
• Banks may restructure the accounts classified under
'standard', 'sub- standard' and 'doubtful' categories.

• The non-performing assets, upon restructuring, would

continue to have the same asset classification as prior to
restructuring.

• Banks cannot reschedule / restructure / renegotiate

borrowal accounts with retrospective effect.

• While a restructuring proposal is under consideration, the

usual asset classification norms would continue to apply.

• No account will be taken up for restructuring by the banks

unless the financial viability is established and there is a
reasonable certainty of repayment from the borrower, as
per the terms of restructuring package.

• While the borrowers indulging in frauds and malfeasance

will continue to remain ineligible for restructuring.