Unit 2

trade credit risk

Sole Banking Arrangement, Multiple Banking
Arrangement, Consortium Lending,
Syndication
Sole banking is a lending by single bank to a large borrower, subject to the
resources available with it and limited to the exposure limits imposed by the Reserve
Bank of India. Many a times when you propose to approach to new bank for funding,
they propose for sole banking that their complete banking should be transferred to
their bank. This is done for two reasons one is to get complete business and second
is very important is having complete monitoring of fund flow and cash flow of the
firm.

Multiple Banking Arrangement

As looked into above example of sole banking, it is also happening that it continues
with existing bank facility and take additional from other (new) bank. When the credit
requirements of a borrower are beyond the capacity of a single bank or that the bank
does not want to take more exposure on a particular borrower, he may then resort to
multiple banking. It is an arrangement where a borrower borrows simultaneously
from more than one bank independent of each other, under separate loan
documents with each bank. Securities are charged to each bank separately.

There are various loopholes in multiple banking arrangements, and also it can lead
to frauds so consortium banking is better for economy. Each banker is free to do his
own credit assessment and old security independent of other bankers.

Consortium Lending

Consortium lending also called joint financing or participation financing. It is a system

of financial emerged due to consequential increase in demand for funds of
substantial magnitude and inability of individual banks to take care of the entire fund
requirement of large borrowers. The system of consortium lending provides scope
and opportunity to share risk amongst banks. The system is considered to be
mutually beneficial to the banks as well as customers. Under multiple banking, there
is no coordination among banks regarding appraisal, documentation, other terms
and advances. In such a situation borrowers got the upper hand by playing one bank
against the other. It was, therefore, necessary to formalize these credit
arrangements to safeguard the interest of the banks. It is mainly catered in case of
large corporate and certain mid-sized borrowers.
As per the consortium lending approach, the group of banks would have a common
agreement wherein the lead bank (the bank that bears major risk) would assess the
borrower’s fund requirements, set common terms and conditions and share
information about borrower’s performance to other lenders.

The bank which takes the higher risk (by giving the highest amount of loan) will act
as a leader and thus it acts as an intermediary between the consortium and the
borrower.

Syndication

Reserve Bank of India has permitted the banks to adopt syndication route to provide
credit in lieu of consortium advance. A syndication credit differs from consortium
advance. A syndicated credit differs from consortium advances in certain aspects.
The salient features of a syndicated credit are as follows:

 The prospective borrower gives a mandate to a bank, commonly referred as a

lead bank (lead manager), to arrange credit on his behalf. The mandate gives
the commercial terms of the credit and the prerogatives of the mandated bank
in resolving contentious issue in the course of the transaction of complete
syndication.
 It is an agreement between two or more banks to provide a borrower a credit
facility using common documents of the borrower.
 The mandated bank prepares an information Memorandum about the
borrower in consultation with the latter and distributes the same amongst the
prospective lenders, inviting them to participate in the credit proposal.
 On the basis of information Memorandum each bank makes its own
independent economy and financial evaluation of the borrower. It may collect
additional information from other sources also. Generally, lead banker plays
important role as rest just follows.
 Thereafter, a meeting of the particular banks is convened by the mandated
bank and discuss the syndication strategy relating to co-ordination
communication and control with the syndication process and to finalize the
deal timing, charges for management, cost of credit, share of each
participating bank in the credit etc.
 A loan agreement is signed by all the participating banks.
 The borrower is required to give prior notice to the Lead Banker (Lead
Manager) of his agent for drawing the loan amount so that the latter may tie
up disbursement with the other lending banks.
 Under the system, the borrower has the freedom in terms of competitive
pricing. Discipline is also imposed through a fixed repayment period under
syndicated credit.
Credit Appraisal: Validation of proposal,
Dimensions of Credit Appraisals, Structuring
of Loan documents
Credit Appraisal is the process by which a lender appraises the technical feasibility,
economic viability and bankability including creditworthiness of the prospective
borrower. Credit appraisal process of a customer lies in assessing if that customer is
liable to repay the loan amount in the stipulated time, or not. Here bank has their
own methodology to determine if a borrower is creditworthy or not. It is determined in
terms of the norms and standards set by the banks. Being a very crucial step in the
sanctioning of a loan, the borrower needs to be very careful in planning his financing
modes. However, the borrower alone doesn’t have to do all the hard work. The
banks need to be cautious, lest they end up increasing their risk exposure. All banks
employ their own unique objective, subjective, financial and non-financial techniques
to evaluate the creditworthiness of their customers.

Some requirements for credit appraisal are as follows:

 Wherever financing of infrastructure project is taken up under a

consortium/syndication arrangement – bank’s exposure shall not exceed 23%.
 The credit requirement must be assessed by all Indian financial institutions or
specialized institution set-up for this purpose.
 In such cases/due diligence on the inability of the projects are well defined
and assessed. State Government guarantee may not be taken as a substitute
for satisfactory credit appraisal.
 Bank may also take up financing infrastructure project independently
exclusively in respect of borrower’s promoters of repute with excellent past
record in project implementation.

Validation of proposal

The quality of every proposal should be explicitly validated. This means that you
should confirm that the key aspects of the proposal are what the company wants
them to be. It is nearly impossible to do this in one sitting with everything considered
all at once. Proposal Quality Validation explicitly identifies what should be validated,
allows for flexibility in how individual items get validated, and provides a mechanism
to ensure that the items chosen and methods for validation are sufficient to achieve
the quality desired.

Proposal Quality Validation ensures that your company confirms that key aspects of
your proposal are what the company wants them to be prior to submission. It is an
approach that confirms that what you have in the proposal meets your needs and
expectations. It avoids disasters that result from teams that work in isolation, creating
a proposal that is not what the company wants to submit and is only discovered too
late to do anything about it.
In developing your proposal, you will:

 Make decisions
 Invent approaches
 Incorporate information
 Address requirements
 Deliver a message
 Seek a superior score

Dimensions of Credit Appraisals

Service credit is monthly payments for utilities such as telephone, gas, electricity,
and water. One has to pay a deposit and late charge if payment is not on time.

Loans can be for small or large amounts and for a few days or several years. Money
can be repaid in one lump sum or in several regular payments until the amount one
borrowed and the finance charges are paid in full. Loans can be secured or
unsecured.

Installment credit may be described as buying on time, financing through the store or
the easy payment plan. The borrower takes the goods home in exchange for a
promise to pay later. Cars, major appliances, and furniture are often purchased this
way. One usually sign a contract, make a down payment, and agree to pay the
balance with a specified number of equal payments called installments. The finance
charges are included in the payments. The item one purchase may be used as
security for the loan.

Credit cards are issued by individual retail stores, banks, or businesses. Using a
credit card can be the equivalent of an interest-free loan-if one pay for the use of it in
full at the end of each month.

Credit Appraisal Process:

The process of credit appraisal is as follows:

1) Credit Processing:

Credit processing is the stage where all required information on credit is gathered
and applications are screened. Credit application forms should be sufficiently
detailed to permit gathering of all information needed for credit assessment at the
outset. In this connection, financial institutions should have a checklist to ensure that
all required information is, in fact, collected.
2) Credit-Approval/Sanction:

A financial institution must have in place written guidelines on the credit approval
process and the approval authorities of individuals or committees as well as the
basis of those decisions. Approval authorities should be sanctioned by the board of
directors. Approval authorities will cover new credit approvals, renewals of existing
credits, and changes in terms and conditions of previously approved credits,
particularly credit restructuring, all of which should be fully documented and
recorded. Prudent credit practice requires that persons empowered with thee credit
approval authority should not also have the customer relationship responsibility.

3) Credit Documentation:

Documentation is an essential part of the credit process and is required for each
phase of the credit cycle, including credit application, credit analysis, credit approval,
credit monitoring, collateral valuation, and impairment recognition, foreclosure of
impaired loan and realization of security. The format of credit files must be
standardized and files neatly maintained with an appropriate system of cross-
indexing to facilitate review and follow-up. The Bank of Mauritius will pay particular
attention to the quality of files and the systems in place for their maintenance.

Documentation establishes the relationship between the financial institution and the
borrower and forms the basis for any legal action in a court of law. Institutions must
ensure that contractual agreements with their borrowers are vetted by their legal
advisers. Credit applications must be documented regardless of their approval or
rejection. All documentation should be available for examination by the Bank of
Mauritius.

4) Credit Administration:

Financial institutions must ensure that their credit portfolio is properly administered,
that is, loan agreements are duly prepared, renewal notices are sent systematically
and credit files are regularly updated. An institution may allocate its credit
administration function to a separate department or to designated individuals in
credit operations, depending on the size and complexity of its credit portfolio.

Structuring of Loan documents

Loan structure is the terms of a loan with respect to the various aspects the make up
a loan, including the maturity or tenor, repayment, and risk.

The loan structure is arrived at by taking into consideration several factors, such as
the purpose, the timeline, and the risk profile of the borrower. In the following
sections, we will discuss different structures that exist based on the above factors.
Documents to Apply for a Personal Loan

When applying for a personal loan, you will need to submit the following documents:

 PAN Card
 Identity proof (Aadhaar Card, Driving licence, Passport, Voter ID, etc.)
 Signature Proof (Passport, PAN card, etc.)
 Address proof (Passport copy, Aadhaar card, driving licence, utility bill; Gas or
electricity bill, Voter ID, ration card, rent agreement, etc.)
 Bank statements of the past 6 months

As a salaried individual, you additionally need to submit the following:

 Salary slips for the last three months

 Income tax returns OR form 16

As a self-employed individual, you additionally need to submit the following (for self /
business entity as applicable):

 Balance sheet and profit and loss account, income computation for the last 2
years
 Income Tax Returns for the last 2 years
 Business proof (License, registration certificate, GST number)
 IT Assessment OR Clearance Certificate
 Income Tax Challans OR TDS Certificate (Form 16A) OR Form 26 AS for
income declared in ITR
Credit Risk, Credit Risk Rating, Credit
Worthiness of Borrower
Credit Risk

A credit risk is risk of default on a debt that may arise from a borrower failing to make
required payments. In the first resort, the risk is that of the lender and includes lost
principal and interest, disruption to cash flows, and increased collection costs. The
loss may be complete or partial. In an efficient market, higher levels of credit risk will
be associated with higher borrowing costs. Because of this, measures of borrowing
costs such as yield spreads can be used to infer credit risk levels based on
assessments by market participants.

Losses can arise in a number of circumstances, for example:

 A consumer may fail to make a payment due on a mortgage loan, credit card,
line of credit, or other loan.
 A company is unable to repay asset-secured fixed or floating charge debt.
 A business or consumer does not pay a trade invoice when due.
 A business does not pay an employee’s earned wages when due.
 A business or government bond issuer does not make a payment on a
coupon or principal payment when due.
 An insolvent insurance company does not pay a policy obligation.
 An insolvent bank won’t return funds to a depositor.
 A government grants bankruptcy protection to an insolvent consumer or
business.

Credit Risk Rating

The term credit rating refers to a quantified assessment of a borrower’s

creditworthiness in general terms or with respect to a particular debt or financial
obligation. A credit rating can be assigned to any entity that seeks to borrow money
an individual, a corporation, a state or provincial authority, or a sovereign
government.

Types of Credit Ratings

All credit agency agencies use various terminology for determine credit ratings.
However, the notations are very similar. Ratings are always grouped into two: an
‘investment grade’ and also a ‘speculative grade’.

Investment grade:

These ratings mean that the investment is a solid one and the issuer will most likely
meet the repayment terms. These investments are priced less as compared to
speculative grade investments.
Speculative grade:

These investments are known to be high risk. So, they come with higher interest
rates.

Importance of Credit Rating

When a credit rating agency upgrades a company’s rating, it suggests that the
company has a high chance of repaying the credit. On the other hand, when the
credit rating gets downgraded, it suggests the company’s ability to repay has
reduced.

Once the company’s credit rating has been downgraded, it becomes difficult for the
company to borrow money. Lenders will consider such companies as high-risk
borrowers as they have a higher probability of turning into a defaulter. Financial
institutions will hesitate to lend money to the companies with low credit rating.

 It allows investors to make a sound investment decision after taking into

consideration the risk factor and past repayment behaviour. In other words, it
establishes a relationship between risk and return.
 Credit rating does a qualitative and quantitative assessment of a borrower’s
creditworthiness.
 In the case of the companies, credit ratings help them improve their corporate
image. It is useful especially for companies that are not popular.
 Lenders such as banks and financial institutions will offer loans at a lower
interest rate if the entity has a higher credit rating.
 The credit rating acts as a marketing tool for companies and also as a
resource that is helpful at the time of raising money. It reduces the cost of
borrowing and helps in the company’s expansion.
 Credit rating encourages better accounting standards, detailed information
disclosure, and improved financial information.

Credit Worthiness of Borrower

Creditworthiness, simply put, is how “worthy” or deserving one is of credit. If a

lender is confident that the borrower will honour her debt obligation in a timely
fashion, the borrower is deemed creditworthy. If a borrower were to evaluate their
creditworthiness on her own, it would result in a conflict of interest. Therefore,
sophisticated financial intermediaries perform assessments on individuals,
corporates, and sovereign governments to determine the associated risk and
probability of repayment.

Financial institutions use credit ratings to quantify and decide whether an applicant is
eligible for credit. Credit ratings are also used to fix the interest rates and credit limits
for existing borrowers. A higher credit rating signifies a lower risk premium for the
lender, which then corresponds to lower borrowing costs for the borrower. Across the
board, the higher one’s credit rating, the better.
A credit report provides a comprehensive account of the borrower’s total debt,
current balances, credit limits, and history of defaults and bankruptcies if any. Due to
high levels of asymmetries of information in the market, lenders rely on financial
intermediaries to compile and assign credit ratings to borrowers and help filter out
bad debtors or “lemons.”

The independent third parties are called credit rating agencies. The rating agencies
access potential customers’ credit data and use sophisticated credit scoring systems
to quantify a borrower’s likelihood of repaying debt. Lenders usually pay for the
services, but borrowers may also request their credit score to gauge their worthiness
in the market.

A limited set of credit raters are considered reliable, and it is due to the level of
expertise and data consolidation required, which is not publicly available. The so-
called “Big Three” rating agencies are and Fitch, Moody’s, and Standard & Poor’s.
These agencies rate corporates and sovereign governments on a range of “AAA” or
“prime” to “D” or “in default” in descending order of creditworthiness.
Purpose of Loan, Source of Repayment,
Collateral
Purpose of Loan

loan purpose is the underlying reason an applicant seeks a loan or mortgage.

Lenders use loan purpose to make decisions on the risk and what interest rate to
offer. For example, if an applicant is refinancing a mortgage after having taken cash
out, the lender might consider that an increase in risk and increase the interest rate
that is offered or add additional conditions. Loan purpose is important to the process
of obtaining mortgages or business loans that are connected with specific types of
business activities.

Pertaining to mortgages and their risk-based pricing factors, the loan purpose factor
is sub-categorized by purchase, rate and term refinance and cash-out refinance.
Lenders assess that a purchase loan contains the least amount of risk and thus
‘price’ purchase loans most favourably (i.e. no interest rate increase or a risk-based
pricing improvement in the order of .25%).

Rate and term refinances are priced similar to purchase loans, with no interest rate
increase. Cash received by the borrower at closing may not exceed $2000 to
maintain rate and term status. The purpose is, as the name implies, to reduce the
interest rate, payment, and/or overall term of the mortgage.

Cash-out refinances are deemed to have a higher risk factor than either rate & term
refinances or purchases due to the increase in loan amount relative to the value of
the property. Risk-based pricing typically mandates a .25% to .5% increase in
interest rate if a borrower needs to draw equity out of the subject property.

Uses:

Consolidate debt to pay off bills

Consolidating debt is one major reason to borrow a personal loan. This approach
can make sense if you’re able to secure a low interest rate. If you pay your other
debts with the money from a personal loan, you’ll only have one fixed monthly
payment, and you might be able to save money on interest.

Cover unplanned emergency expenses

While it’s best to build an emergency fund to cover unexpected expenses, an

emergency personal loan can help if you’re not yet prepared.
Make necessary home repairs

While you might have a wish list of home updates, you might only consider a
personal loan for emergency issues impacting your health and safety.

Source of Repayment

Primary Source: The primary source of repayment should be directly related to the
kind of loan given i.e. for facilities extended (overdraft) for working capital or to
finance trade the repayment should be from the proceeds of the goods sold. If a
bridge loan prior to the final allotment of a public issue has been given, the
repayment should be from the monies received after the allotment is made. On the
other hand if the bridge loan is given prior to the sale of an asset, the proceeds from
the sale of the asset should be used to extinguish the loan.

Secondary Source: Even though there may be a real and quantifiable first source of
repayment, there is always a possibility that on account of occurrences beyond the
borrower’s control, the loan cannot be repaid from the primary source. A classic
example is what is presently happening in India on account of the liquidity crunch
and the demand downswing. A well-known company purchased 41 windmills at a
cost of around Rs. 1 crore each and was confident of selling them quickly. Due to a
credit squeeze the windmills were unsold and the company could not repay the
borrowings from the proceeds of the sale. The company in order to meet its credit
commitments sold some property it owned. This was its secondary source of
repayment. When companies take working capital finance in the form of overdrafts,
they normally hypothecate debtors and stock. If repayments are not made, the
secondary source of repayment can be seized and sold and the proceeds can be
used to liquidate the loan.

Tertiary Source: The tertiary source is further security for a loan. This is in the form
of additional collateral that may be unconnected with the business. A director could
pledge the shares that he owns in certain blue-chip companies as additional security.
Alternatively, the principal shareholders could give their personal guarantees or a
well-wisher could give his guarantee. The comfort that a Bank would derive is that
should the primary and secondary source of repayment fail, they will have recourse
to yet another source of repayment. It is assurances such as these that help the
Banker in supporting and recommending a request for a credit facility.

Collateral

The term collateral refers to an asset that a lender accepts as security for a loan.
Collateral may take the form of real estate or other kinds of assets, depending on the
purpose of the loan. The collateral acts as a form of protection for the lender. That is,
if the borrower defaults on their loan payments, the lender can seize the collateral
and sell it to recoup some or all of its losses.
If a borrower defaults on a loan (due to insolvency or another event), that borrower
loses the property pledged as collateral, with the lender then becoming the owner of
the property. In a typical mortgage loan transaction, for instance, the real estate
being acquired with the help of the loan serves as collateral. If the buyer fails to
repay the loan according to the mortgage agreement, the lender can use the legal
process of foreclosure to obtain ownership of the real estate. If a second mortgage is
involved the primary mortgage loan is repaid first with the remaining funds used to
satisfy the second mortgage. A pawnbroker is a common example of a business that
may accept a wide range of items as collateral.

The type of the collateral may be restricted based on the type of the loan (as is the
case with auto loans and mortgages); it also can be flexible, such as in the case of
collateral-based personal loans.

Marketable collateral is the exchange of financial assets, such as stocks and bonds,
for a loan between a financial institution and borrower. To be deemed marketable,
assets must be capable of being sold under normal market conditions with
reasonable promptness at current fair market value. For national banks to accept a
borrower’s loan proposal, collateral must be equal to or greater than 100% of the
loan or credit extension amount. In the United States of America, the bank’s total
outstanding loans and credit extensions to one borrower may not exceed 15 percent
of the bank’s capital and surplus, plus an additional 10 percent of the bank’s capital
and surplus.

Reduction of collateral value is the primary risk when securing loans with marketable
collateral. Financial institutions closely monitor the market value of any financial
assets held as collateral and take appropriate action if the value subsequently
declines below the predetermined maximum loan-to-value ratio. The permitted
actions are generally specified in a loan agreement or margin agreement.

Types of collateral loans.

Vehicle Loans

No guarantor is required for such a loan since the car itself acts as a security with
the lender. A typical car financing arrangement is different from a loan against a
commercial vehicle. A car financing arrangement is executed at the time of purchase
of the vehicle; the proceeds are purely utilized for the purchase of the vehicle only.
The borrower is free to use the vehicle for any purpose. However, commercial
vehicles cannot be used for personal use by the borrower, who has to have an
existing business to be eligible for the loan.
Loan Against Securities

A loan against securities is an extension of an overdraft facility by the financial

institutions. The financial assets like shares, bonds etc. act as collateral with the
lender, against which the borrower is issued a limit. The borrower can then take
short term loans within this limit.

Loan Against Property

A loan against property financing arrangement includes a loan taken from a financial
institution with no restriction on its use by the borrower. The existing house property
is kept as collateral with the lender as a security against a probable default by the
borrower. Whereas, A typical housing loan financing arrangement is to facilitate the
purchase or construction of a new home and the proceeds are to be used for that
purpose only.
Cash Flows as Profit and Components of Cash
Flows
Cash flow and profit are two different financial parameters, but when you’re running
a business, you need to keep track of both. Here’s how they’re different, why they’re
both important and how they intersect with other corporate issues, especially when a
company grows rapidly.

Cash Flow

Cash flow is the money that flows in and out of the firm from operations and
financing and investing activities. It’s the money you need to meet current and near-
term obligations. But there are two things to keep in mind about cash flow:

A Business Can Be Profitable and Still Not Have Adequate Cash Flow

In the worst case, insufficient cash flow in a profitable business can send it into
bankruptcy. For example, you’re making widgets and selling them at a profit. But
your product goes through a long sales chain and some of your biggest and most
important wholesale customers don’t pay on invoices for 120 days. This sounds
extreme, but many large US corporations in the 21st century don’t pay an account
payable for three or four months from the receipt of the invoice.

Since you’re the little guy, the suppliers of materials you need to make those widgets
often want to be paid either upon receipt or in 15 or 30 days. Ironically, if you’re
caught between suppliers who want their money now and buyers who’re slow to pay,
a successful product with increasing sales can create a real cashflow crisis. Even
though your unit sales are increasing and profitable, you won’t get paid in time to pay
your suppliers and meet payroll and other operational expenses. If you’re unable to
meet your financial obligations in a timely way, your creditors may force you into
bankruptcy at a period when sales are growing rapidly.

Your Sales May Be Growing and the Money Keeps Pouring In, but That Doesn’t
Mean You’re Making a Profit

If you borrow money to solve the cash flow problem, for instance, the rising debt
costs that result can raise your costs above the breakeven point. If so, eventually
your cash flow will dry up and eventually your business will fail.
Profit

Profit, also called net income, is what remains from sales revenue after all the firm’s
expenses are subtracted. It’s obvious in principle that a business cannot long survive
unless it is profitable, but sometimes, as with cash flow, the very success of a
product can raise expenses. It may not be immediately apparent that this is a
problem. In other cases, you may be aware of the problem, but believe that by
reducing production costs you can restore profitability in time to avoid a crisis.
Unfortunately, unless you have a clear understanding of all the relevant cost data,
you may not act effectively or promptly enough to make the firm profitable again
before it runs out of money.

Components of Cash Flows

(i) Cash Flow from Operating Activities

The net amount of cash coming in or leaving from the day to day business
operations of an entity is called Cash Flow from Operations. Basically it is the
operating income plus non-cash items such as depreciation added. Since accounting
profits are reduced by non-cash items (i.e. depreciation and amortization) they must
be added back to accounting profits to calculate cash flow.

Cash flow from operations is an important measurement because it tells the analyst
about the viability of an entities current business plan and operations. In the long run,
cash flow from operations must be cash inflows in order for an entity to be solvent
and provide for the normal outflows from investing and finance activities.

(ii) Cash Flow from Investing Activities

Cash flow from investing activities would include the outflow of cash for long term
assets such as land, buildings, equipment, etc., and the inflows from the sale of
assets, businesses, securities, etc. Most cash flow investing activities are cash out
flows because most entities make long term investments for operations and future
growth.

(iii) Cash Flow from Finance Activities

Cash flow from finance activities is the cash out flow to the entities investors (i.e.
interest to bondholders) and shareholders (i.e. dividends and stock buybacks) and
cash inflows from sales of bonds or issuance of stock equity. Most cash flow finance
activities are cash outflows since most entities only issue bonds and stocks
occasionally.