Financial and Credit Risk Analytics

UNIT – 1

Concept of Credit:-

How do you define credit? This term has many meanings in the financial world, but credit is
generally defined as a contract agreement in which a borrower receives a sum of money or
something of value and repays the lender at a later date, generally with interest.

Credit also may refer to the creditworthiness or credit history of an individual or a company. To
an accountant, it often refers to a bookkeeping entry that either decreases assets or increases
liabilities and equity on a company's balance sheet.

Bank Credit :-

Bank credit is usually referred to as a loan given for business requirements or personal needs to
its customers, with or without a guarantee or collateral, with an expectation of earning periodic
interest on the loan amount. The principal amount is refunded at the end of loan tenure, which is
duly agreed and mentioned in the loan covenant.

In today’s world, demands are continuously increasing, but means to fulfill those demands are
limited; hence borrowing money will enable as the source to finance varied needs of a business,
profession, and personal.

Bank credit is given to borrowers on the fulfillment of the necessary documentation required by
the bank. Interest rates, terms of repayment are duly mentioned in the loan covenant.
Documentation to bank includes financial statements, income tax returns, projected financial
statements for three to five years, and changes based on the type of loan and from person to
person.

What Is Credit Risk?

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet
contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed
principal and interest, which results in an interruption of cash flows and increased costs for
collection. Excess cash flows may be written to provide additional cover for credit risk. When a
lender faces heightened credit risk, it can be mitigated via a higher coupon rate, which provides
for greater cash flows.

Although it's impossible to know exactly who will default on obligations, properly assessing
and managing credit risk can lessen the severity of a loss. Interest payments from the borrower
or issuer of a debt obligation are a lender's or investor's reward for assuming credit risk.
Types of Credit Risk

Credit risks are the reason why lending institutions undergo a lot of creditability assessments
before providing credit. Credit risks can be considerably classified into three types.

 Credit Default Risk: Credit default risk includes those losses which are incurred by
the lender when the borrower is incapacitated from returning such amount in entire or
when the borrower has exceeded 90 days from the due date but hasn’t made any payment.

 Concentration Risk: Concentration risks are those risks that emerge as a result of

substantial exposure to any individual or group because any unfavorable incident will
have a probability to impose large losses. It is mainly concerned with any
individual industry, company.

 Country Risk: Country risks are such risks that are inferred when a sovereign state
halts the payment needs to be made for foreign currency commitments overnight which
lead to default. Country risks are primarily influenced by macroeconomic
accomplishment. It is also termed as sovereign 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.
To reduce the lender's credit risk, the lender may perform a credit check on the prospective
borrower, may require the borrower to take out appropriate insurance, such as mortgage
insurance, or seek security over some assets of the borrower or a guarantee from a third party.
The lender can also take out insurance against the risk or on-sell the debt to another company. In
general, the higher the risk, the higher will be the interest rate that the debtor will be asked to pay
on the debt. Credit risk mainly arises when borrowers are unable or unwilling to pay.

WHAT IS CREDIT ANALYSIS?

Credit analysis is the process of determining the ability of a company or person to repay their
debt obligations. In other words, it is a process that determines a potential borrower’s credit
risk or default risk. It incorporates both qualitative and quantitative factors. Credit analysis is
used for companies that issue bonds and stocks, as well as for individuals who take out loans. To
learn more, check out CFI’s Credit Analyst Certification

USES FOR CREDIT ANALYSIS

Credit analysis is important for banks, investors, and investment funds. As

a corporation tries to expand, they look for ways to raise capital. This is achieved by
issuing bonds, stocks, or taking out loans. When investing or lending money, deciding
whether the investment will pay off often depends on the credit of the company. For
example, in the case of bankruptcy, lenders need to assess whether they will be paid
back.

Similarly, bondholders who lend a company money are also assessing the chances they
will get their loan back. Lastly, stockholders who have the lowest claim priority access
the capital structure of a company to determine their chance of being paid. Of course,
credit analysis is also used on individuals looking to take out a loan or mortgage.

Creditworthiness is the pivots point of the loan from financial institutions. 

7C's is one of the tool used for analysis of creditworthiness.

The Oxford Dictionary defines the creditworthiness as "The extent to which a person or a
company is considered suitable to receive financial credit, often based on their reliability in
paying money back" 

Credit is the lifeline of both individuals and institutions. Creditworthiness is the strength of
individual or Institutions in order to make them eligible to receive credit. Creditworthiness is key
to access finance from banks or NBFC, subsequently growth and development. Many startup
businesses fall to obtain bank loan only because of their less creditworthiness. 

In the era of CIBIL and other credit score record keeping organization it's very much essential to
maintain creditworthiness to obtain bank loans. The process to know your CIBIL score online is
very easy and cost effective. Few website provide the CIBIL and other credit score free. Now a
days each and every transaction linked with your credit taking ability is recorded by rating
agencies. So it's very much essential to maintain better credit score to avail credit or loan from
financial institutions. 

7C'S OF CREDITWORTHINESS

1. Character

2. Capacity 

3. Cash

4. Capital

5. Collateral 

6. Condition 

7. Control

 All the above factors are fundamentally used for evaluation of creditworthiness but different
organizations like CIBIL, Equifax, Experian and CRIF Highmark slightly differ from each other in
evaluation of creditworthiness and calculation of credit score. Now let's discus the above 7C's in
brief. 

CHARACTER 
Character as tool for analysis of creditworthiness is most vital factors consider by the lenders
because character of the promoter of company or Individual is the most powerful motivation of
borrower to repay the money. Responsibility, truthfulness serious purpose and serious intention
of replaying the money is the character. The banks try to prevent the wilful defaulters from
accessing the loan.
Credit history, Education, Knowledge and skills are also part of character which evaluated by
the lenders. For example suppose a bank X received loan application from Vijay Malya, will he
get credit or loan?  No, because his character will sufficient for rejection of the
application. Better the character better the creditworthiness. 

CAPACITY 
The basic of finance or loan is to give to those people or company who can refund the same
and have capacity to replay the principal with interest. The capacity is determined by the Asset,
liability, Cash flow, Network, existing debit obligations, industry risk and credit and credit
utilization ratio. The cash flow statement of organization and the person is helpful in determining
it's capacity.  Next is alternative sources of repayment of the loan amount which is vital because
sometimes the serious person also fails to repay the loan because of genuine reason that time
this alternative sources helps. Suppose the company have also alternative business he may
repay from that source also. In case of Individual having earning spouse is added advantage in
repayment of loan. Higher the capacity higher the creditworthiness.

CAPITAL
Normally loans are sanctioned for a project or a reason, so applicant must have invested sizable
amount in the enterprise or project. The loan applicants percentage of ownership is used to build
confidence in the project.   A companies owner must have invested his own money before The
Financial Institutions sanction loan. The single biggest reason for failure of any company is under
capitalization. In individual case the same also applicable. Ideally the banks sanction up-to 75% of
the total project cost this is because they want to share the risk sharing technique. A well
capitalized project is better places in obtaining the loan. Higher the initial capita higher the
creditworthiness. 

CASH
Cash particularly the free cash generated in business or the monthly surplus cash in case of
individual case is key to repayment of advance. If someone is earning high but the expense to earn
that amount is also more than that then he becomes cash deficiency. Some one have expenses more
than income is cash negative so they are not creditworthy. We can use cash flow statement for
evaluation of the net cash available for repayment. If Mr X is sanctioned housing loan but his salary
is not enough for his existing expenses then they may find difficult to repay. One Company is unable
to pay salary to employees, how it will repay the loan to bank. More is the surplus cash higher is
there creditworthiness. 

COLLATERAL
This the asset which are pledged against the loan. Mean in case the company or the person fails to
repay the amount then those asset are auctioned and amount is recovered . Land, factory, shares,
bonds, buildings , Bank deposit, Bank guarantee, LIC Policies etc are treated as the collateral for
sanction of loan.  Lenders actually sanction the loan against the collateral. In case of gold loan
company like Manapuram Finance, Mutooth Finance they take gold as collateral. For sanction of
working capital the machine and factory is taken as collateral.  Higher the collateral higher the
creditworthiness. 

CONDITION
The condition is the overall economic and political environment and it's impact on the the business
and it's revenue. The purpose of the loan and it's value addition to the growth of business in current
environment is the measure factor for sanction of debit. The  company investing the loan amount in
accusation or expansion or purchase of asset then there is more chances for sanction of advance in
comparison to the amount used in  date today expenses. During the condition evaluation the
strength and number of competitors, size of market, correlation with existing rules and regulations,
change in consumption taste and relevant social, economic and political  influence on business.
More favorable the condition better is the creditworthiness. 

CONTROL
Last but not the least factor of creditworthiness is control. This factor check the consistency of the
business with the rules and regulations. This also check control on business in achieving its
corporate goals. 

BENEFITS OF CREDITWORTHINESS:

1. Higher credit limit of loan amount sanction.

2. Less interest rate compared to lesser creditworthy person or institutions.

3. Easy and hassle free sanction process.

4. Less credit risk hence liberal terms and conditions for loan sanction and repayment. 

The prime business of Banking and Non Banking Financial institution is to provide credit to the
institutions, companies and individual persons. So they minutely check the creditworthiness of
the persons or organization before they disburse amount. Depending on the working culture of
the organization the process of evaluation changes but this formula is basic Foundation to all
type analysis. Moneylenders generally break down the credit value of the borrower by utilizing
the seven C's: Capacity, Capital, Control, Collateral, Conditions, and Character and Cash. Every
one of these standards causes the moneylender to decide the general danger of the advance.
While every one of the C's is assessed, none of them on their own will forestall or guarantee
access to financing. There is no programmed equation or ensured rates that are utilized with the
seven C's. They are just an assortment of elements that loan specialists assess to decide the
amount of hazard the potential borrower is for the repayment of the amount. 
WHAT IS THE CREDIT ANALYSIS PROCESS?

The credit analysis process refers to evaluating a borrower’s loan application to determine the
financial health of an entity and its ability to generate sufficient cash flows to service the debt. In
simple terms, a lender conducts credit analysis on potential borrowers to determine their
creditworthiness and the level of credit risk associated with extending credit to them.

During the credit analysis process, a credit analyst may use a variety of techniques, such as cash
flow analysis, risk analysis, trend analysis, ratio analysis, and financial projections. The
techniques are used to analyze a borrower’s financial performance data to determine the level of
risk associated with the entity and the amount of losses that the lender will suffer in the event of
default.

 Credit analysis is the evaluation of a borrower’s loan application to determine if the

entity generates enough cash flows to settle its debt obligations.
 The credit analysis process involves collecting information from the borrower,
analyzing the information provided, and making a decision on whether or not to
approve the loan.
 A credit analyst uses various techniques, such as ratio analysis, trend analysis, cash
flow analysis, and projections to determine the creditworthiness of the borrower.

STAGES IN THE CREDIT ANALYSIS PROCESS

The credit analysis process is a lengthy one, lasting from a few weeks to months. It starts from
the information-collection stage up to the decision-making stage when the lender decides
whether to approve the loan application and, if approved, how much credit to extend to the
borrower.

The following are the key stages in the credit analysis process:

 1. Information collection

The first stage in the credit analysis process is to collect information about the applicant’s credit
history. Specifically, the lender is interested in the past repayment record of the customer,
organizational reputation, financial solvency, as well as their transaction records with the bank
and other financial institutions. The lender may also assess the ability of the borrower to generate
additional cash flows for the entity by looking at how effectively they utilized past credit to grow
its core business activities.

The lender also collects information about the purpose of the loan and its feasibility. The lender
is interested in knowing if the project to be funded is viable and its potential to generate
sufficient cash flows. The credit analyst assigned to the borrower is required to determine the
adequacy of the loan amount to implement the project to completion and the existence of a good
plan to undertake the project successfully. The bank also collects information about the collateral
of the loan, which acts as security for the loan in the event that the borrower defaults on its debt
obligations. Usually, lenders prefer getting the loan repaid from the proceeds of the project that
is being funded and only use the security as a fall back in the event that the borrower defaults.

 2. Information analysis

The information collected in the first stage is analyzed to determine if the information is accurate
and truthful. Personal and corporate documents, such as the passport, corporate charter, trade
licenses, corporate resolutions, agreements with customers and suppliers, and other legal
documents are scrutinized to determine if they are accurate and genuine.

The credit analyst also evaluates the financial statements, such as the income statement, balance
sheet, cash flow statement, and other related documents to assess the financial ability of the
borrower. The bank also considers the experience and qualifications of the borrower in the
project to determine their competence in implementing the project successfully.

Another aspect that the lender considers is the effectiveness of the project. The lender analyzes
the purpose and future prospects of the project being funded. The lender is interested in knowing
if the project is viable enough to produce adequate cash flows to service the debt and pay
operating expenses of the business. A profitable project will easily secure credit facilities from
the lender.

On the downside, if a project is facing stiff competition from other entities or is on a decline, the
bank may be reluctant to extend credit due to the high probability of incurring losses in the event
of default. However, if the bank is satisfied that the borrower’s level of risk is acceptable, it can
extend credit at a high interest rate to compensate for the high risk of default.

 3. Approval (or rejection) of the loan application

The final stage in the credit analysis process is the decision-making stage. After obtaining and
analyzing the appropriate financial data from the borrower, the lender makes a decision on
whether the assessed level of risk is acceptable or not.

If the credit analyst assigned to the specific borrower is convinced that the assessed level of risk
is acceptable and that the lender will not face any challenge servicing the credit, they will submit
a recommendation report to the credit committee on the findings of the review and the final
decision.

However, if the credit analyst finds that the borrower’s level of risk is too high for the lender to
accommodate, they are required to write a report to the credit committee detailing the findings on
the borrower’s creditworthiness. The committee or other appropriate approval body reserves the
final decision on whether to approve or reject the loan.
 Steps of Credit Analysis

Credit analysis covers the area of analyzing the character of the borrowers, capacity to use the
loan amount, condition of capital, objectives of taking a loan, planning for uses, probable
repayment schedule & so on.

Steps of Credit Analysis –

Credit proposals are needed to be analyzed by following some steps. Here, we will see the eight-
step analysis process:

1. Collecting loan information of the applicant,

2. Collecting business information for which loan is sought,
3. Collecting the risk related information,
4. Assembling all credit information together,
5. Analyzing sensitive risky credit information,
6. Analyzing refined & very essential risk information,
7. Making a decision on the basis of loan analysis,
8. Design the appropriate loan structure according to a positive decision.

The above steps are discussed below –

(1) Collecting loan information of the applicant:

It requires a collection of information from the past and present financial statements of the
business provided by the applicant. Analysis of the personal characteristics, that is, whether he is
involved in any forbidden activities such as gambling, drinking habit or any other unethical
affair’s is also focused on this step.

(2) Collecting business information for which loan is sought:

The bank should know the purpose of the loan, the amount of the loan and whether it is possible
to implement the project by that amount. It is essential to collect the information about the
sources from which repay the loan. The information of past loan of the borrower should also be
collected by the loan officer.

(3) Collecting the primary risk related information:

 Assessing the overall political and economic risks.

 Identification and give explanations to the positive and negative factors in conducting the
business.
 Evaluation of the positive sides of cash inflow and its possible stability in the light of the
historical demand of the business.
 Consideration of the future consequences and need for investment in light of the applied loan
proposal and repayment assurance of the loan.
 Evaluation of the impact on the balance sheet of the borrowers after using the loan.
 Assessing the possibility and the extent to which change is occurred in the risk level
previously measured.

(4) Assembling all credit information together:

 Collection of detailed descriptions about the proposed loan
 Collection of detailed information about the loan applicant
 A detailed description of the general financial objectives and plans of the business.

(5) Analyzing sensitive risky credit information:

 Inspection of the proposed business location,

 Collection of detailed information regarding profit earnings from the existing bank-clients and
other parties related to the business,
 Inspection of the internal working environment of the business,
Analysis of the Information regarding trading (selling/purchasing) and the availability of getting
credit opportunity from the suppliers (Trade Credit) and the relationship with the suppliers.

(6) Analyzing refined and very essential risk information:  

Analysis of the honesty, integrity sincerity in individual and overall sense towards the proposed
business on the part of the owners, employees, staffs and laborers of the company.
 Analysis of the possible political and economic risk.
 Evaluation of the operational possibility in consideration of the proposed loan.
 Identification of the sources and uses of future cash inflow and outflow of the proposed loan
project.
 Assessment of the secondary safety of the collateral and surety.

(7) Making a decision on the basis of loan analysis:

 Determination of the explicit or implicit risk level of the proposed loan.

 If the level of risk is beyond acceptable, then loan proposal should be closed with a negative
comment.

(8) Design the appropriate loan structure according to the positive decision:

 Determination of the types of loan, duration of loan and amount of interest in light of risks
associated with the loan.
 Loan analysis process should be here if the terms and conditions for applied loan are not
acceptable.
 Get approvals from the appropriate loan sanctioning authority.
 Sit for discussion with the borrowers about the acceptable conditions of the loan Preparation &
Maintenance of necessary documents of the permitted loan.
At last, it can be said that credit analysis is very much important for a bank for its loan
sanctioning activity and by following the above steps a bank does its credit analyzation.
 Factors Evaluated During a Credit Appraisal Process
A lender’s credit appraisal process will typically check and evaluate the following important
factors:
 Income
 Age
 Repayment ability
 Work experience
 Present and former loans
 Nature of employment
 Other monthly expenses
 Future liabilities
 Previous loan records
 Tax history
 Financing pattern
 Assets owned
How Does a Lender Evaluate the Eligibility of a Borrower Through Credit
Appraisal?
A lender typically compares your loan amount, income, EMIs, repayment capacity, and your
overall expenses in order to determine if you are eligible or not to get a personal loan or any
other loan. Generally, banks and NBFCs take a look at certain ratios in order to check your loan
eligibility. These are some of the ratios that are useful in the credit appraisal process:
 Fixed obligation to income ratio (FOIR): This ratio refers to how one deals with his or her
debts and how often they repay their debts. It refers to the ratio of the loan obligations and
other expenses to the income that they earn on a monthly basis. The bank will assess if a
certain portion of your income is sufficient to manage your EMIs for the loan that you have
applied for and for your other liabilities. If the ratio is higher than the benchmark fixed by the
lender, then the lender may not accept the application.

 Installment to income ratio (IIR): This ratio considers the equated monthly installments
(EMIs) of your loan to the income that you earn. It will indicate the amount you will be
required to take from your income to pay your personal loan EMI.

 Loan to cost ratio: This ratio indicates the maximum amount that a particular borrower is
eligible to take. This will depend on the cost of the car if you are taking a car loan and on the
cost of the house if you are taking a home loan. For a personal loan, it will depend on your
personal requirement. Usually, the ratio will range from 70 to 90% of the cost of the car or
house.
Finding out the loan eligibility of a loan applicant will assist a lender in fixing the loan amount
that needs to be offered to the applicant.

Submission of Documents for Proving Your Bankability

 Bankability is a very important aspect that is a part of credit appraisal. Bankability refers to what
will be accepted by a particular bank. A lender will assess if a loan given to a particular person
will result in future cash flow and profitability.
When you apply for a personal loan or any other loan from a bank or an NBFC, you will be
required to mandatorily furnish certain government-approved documents, reports, and other
documents in order to prove your income, age, and other aspects. These norms will vary from
lender to lender. While applying for your loan, your lender will specify the norms and you will
be required to follow them so that they can decide if the loan can be approved or not. Let us take
a look at some of the common norms that are set by lenders for the credit appraisal process:
Proof of income
In order to prove your monthly income, you will be required to submit certain documents and
they include:
 Most recent bank statements for 3 to 6 months
 Most recent salary slips
 Most recent Income Tax Return (for self-employed individuals)
 Audited financials for the previous 2 years
Proof of address
To prove your residential address, you will have to furnish any one of the following documents:
 Leave and license agreement
 Latest electricity bills or utility bills
 Aadhaar card
 Driving license
 Passport
Proof of identity
To prove your identity and date of birth, you will be required to submit any one of the following
documents:
 Aadhaar
 PAN card
 Voter ID
 Driving license
 Passport-size photographs
Proof of employment
To prove your employment information, you will be required to give certain documents
regarding your employer or your own company (if you are self-employed):
 Letter from your employer
 Offer letter or appointment letter provided by your employer
 Office address proof
 Employment certificate from your present employer
 Certificate of experience or relieving letter from your previous employer(s) to show your
overall work experience
Proof of creditworthiness
To prove your creditworthiness, you can show your credit score to your new lender. This can be
done by submitting your CIBIL report. When you are furnishing your CIBIL report, you should
be sure about the details of your credit score. You should also ensure that your credit score is 750
and above.
With the help of your CIBIL report, your lender will check if you have been prompt while
making your repayments and while clearing your credit card bills. Your lender will also be able
to see if you have defaulted any loan during your entire credit history and if you have made
many enquiries. Hence, you need to be very particular about how your credit report looks.
Proof of investment
If you have made any investment, you will be required to provide proofs. This can be done by
giving documents of your investments such as fixed deposits, shares, mutual funds, fixed assets,
gold, etc.
When the lender takes a look at your income proof, age proof, and employment proof, the lender
gets an idea about your overall profile and the bank can determine if you will be able to repay
your loan promptly without any financial struggles.
Credit Appraisal for Project Financing for Organizations
If a lender is approached by a company for project financing or a loan, then the lender will need
to consider financial, technical, commercial, market, and managerial aspects of the organization.
 Under credit appraisal, to evaluate financial aspects, the bank will have to check the
organization’s costs, expenses, and estimated revenues in order to understand if the company
will be able to repay the loan without any trouble.
 To assess technical aspects of a company, the bank will have to evaluate the nature of the
business and the industry or sector of the borrower. The lender will have to observe the
company’s raw materials, capital, labour, transportation, selling plans, etc.
 To evaluate the market of the borrower, the bank will have to evaluate its demand and supply.
If the demand-supply gap is high, then it is great news for the lender. This is because it
indicates that the company will enjoy good sales and hence, can repay the loan efficiently.
 The bank also needs to assess the managerial aspects of an organization before giving a loan to
them. The bank should understand the goals, plans, and commitment of the company to the
particular project. The organization’s management style and ways of handling subordinates
should be observed by the lender.
Banks will assess both financial and non-financial aspects in order to determine the borrower’s
creditworthiness while conducting the credit appraisal process.
The intensity of the credit appraisal will depend on the loan quantum and the purpose of the loan.
According to these aspects, the appraisal process can be simple or complex for both individuals
and entities.
What is loan pricing?
Loan pricing is the process of determining the interest rate for granting a loan, typically as
an interest spread (margin) over the base rate, conducted by the bookrunners.  The pricing
of syndicated loans requires arrangers to evaluate the credit risk inherent in the loans and to
gauge lender appetite for that risk.

For market-based loan pricing, banks incorporate credit default spreads as a measure

of borrowers’ credit risks.  It is standard procedure in loan pricing to benchmark a loan against
recent comparable transactions (“comps”) and select the base rate on which the financing costs
are pegged.  A comparable deal is one with a borrower in the same industry, country and of the
same size with the same credit rating, for which a certain market rate of return is required.

A bank’s credit rating has a direct impact on its cost of funding and, thus, the pricing of its
loans.  Banks with a high credit rating generally have access to lower cost funds in debt markets
and low counterparty margins in swap and foreign exchange markets.  The lower cost of funds
can be passed on to borrowers in the form of lower loan pricing.

Banks compete for lead arranger mandates on syndication strategy and pricing.  Some banks are
very effective at pricing loans, while others have better bargaining power, are more effective in
borrower monitoring, or have better incentive-inducing scheme.

Benefits of Loan Pricing

This methodical approach can help ensure the best loan and terms are matched to the borrower so
that the financial institution makes the sale and keeps the customer. Loan pricing models or loan
profitability models can allow banks or credit unions to set prices based on other institution
goals, too, including goals related to profitability targets or loan portfolio composition. In talking
with banks, it has learned these institutions thought a conservative estimate was that they could
pick up an additional 5 to 10 basis points in interest if they had more structured pricing
methodologies in place.

One overall benefit of effective loan pricing is that it is one of the many ways a financial
institution can optimize capital. Optimizing capital is important because it provides institutions
with the ability and freedom to deploy capital for developing new products and new markets,
addressing regulatory issues or navigating shifts in the macroeconomic environment. 

Another benefit of having a loan-pricing policy or model is that it provides the institution with
defensible measures for justifying pricing changes and for avoiding charges of discriminatory
pricing, which some lenders have faced in recent years. Officials with the banking regulatory
agencies recently outlined best practices they encourage as they relate to evaluating an
institution’s fair lending risk, and one of those best practices was to document pricing and other
underwriting criteria, including exceptions.
Considerations of Loan-Pricing Models

What are some considerations related to loan-pricing models for an institution's loan origination
system (LOS)? According to James L. Adams, supervising examiner at the Federal Reserve
Bank of Philadelphia, pricing is a key underwriting factor that should be addressed as part of a
sound loan policy. A simple cost-plus loan pricing model is one method of pricing loans, he
wrote in a newsletter for community banks that cites the Fed's Commercial Bank Examination
Manual (CBEM).  A cost-plus pricing model requires that all related costs associated with
extending the credit be known before setting the interest rate and fees, and it typically considers
the following:

 Cost of funds
 Operating costs associated with servicing the loan or loans
 Risk premium for default risk and
 A reasonable profit margin on capital.

In terms of fair lending compliance, loan pricing should be one of the easiest aspects to
manage. Underwriting can be fairly complex with a degree of subjectivity due to the need to
qualify certain characteristics of a credit profile. Loan pricing, on the other hand, should be
very straightforward. While underwriting can involve a wide range of circumstances that
differ for individual loans, pricing considerations are finite. 

There are (3) broad considerations in formulating an appropriate loan pricing strategy. These
are costs, risk, and profit.

Costs

Cost of Funds – As with each attribute, there are different ways this can be measured. The
simplest is to consider the institution’s interest expense. 

Capital Costs – To the extent a loan may impair capital, and this should be a consideration.

Overhead – Overhead is the institution’s cost to operate. Again, with all of the elements, this
can be measured in different ways and can vary over time. 

Fixed Costs – Fixed costs are the fixed portion of the expense of origination, processing, and
servicing an additional loan.

Variable Costs – Variable costs are the variable portion of the expense of origination,
processing, and servicing an additional loan.
 Risk

Loan products carry varying degrees of risk, as do the credit characteristics to which they are
underwritten. Higher risk loans are more costly because of the higher probability of default but
they also have more carrying costs due to servicing. Loans should have a risk premium assigned
as part of the pricing structure. 

Profit

Finally, loans should have a margin above the aforementioned factors. This represents the actual
profit to the institution above its cost and taking into account risk. 

METHODS OF LOAN PRICING FOLLOWED BY COMMERCIAL BANKS

Banks are the major financial institutions, which intermediate between actual lenders and actual
borrowers. For the inter-mediation, banks are to pay the fund providers as ultimate lenders and
charge actual borrowers. A bank acquires funds through deposits, borrowings, and antiquity,
recognizing each source’s costs and the resulting average cost of funds to the bank.

The funds are allocated to assets, creating an asset mix of earning assets such as loans and non-
earning assets such as banks’ premises. The price that customers are charged for using an earning
asset represents the sum of the costs of the banks’ funds, the administrative costs, e.g., salaries,
compensation for non-earning assets, and other costs.

If pricing adequately compensates for these costs and customer to be fair .based on the funds and
service received. The loan price is the interest rate the borrowers must pay to the bank and the
amount borrowed (principal).

The price/interest rate is determined by the true cost of the loan to the bank(base rate)plus
profit/risk premium for the bank’s services and acceptance of risk. The components of the true
cost of a loan are:

1. Interest expense,
2. Administrative cost, and
3. Cost of capital

These three components add up to the bank’s base rate. The risk is the measurable possibility of
losing or not gaining the value. The primary risk of making a loan is repayment risk, which is the
measurable possibility that a borrower will not repay the obligation as agreed.

A good lending decision minimizes repayment risk. The prices a borrower must pay to the bank
for assessing and accepting this risk is called the risk premium.
Since the past performance of a sector, industry, or company is a strong indicator of future
performance, risk premiums are generally based on the historical quantifiable amount of losses in
that category.

Price of the loan(Interest Rate Charge) = Base Rate + Risk Premium.

Loan pricing is not an exact science- it gets adjusted by various qualitative and qualitative
variables affecting demand for and supply of funds. These are several methods of calculating
loan prices.

A. Interest-Based Loans by traditional banks

Pricing method Characteristics

Fixed-rate The loan is written at a fixed interest rate which is negotiated at an

origination. The rate remains fixed until maturity.

Variable-rate The rate of interest changes based on the minimum rate from time to time,
depending on the demand for and supply of funds.

Prime rate Usually, a relatively low rate is offered to highly honored clients for a track
record.

The rate for general This rate is applied to general borrowers’. This rate is usually higher than the
customer prime rate.

Caps and Floors For loans extended at variable rates, limits are placed on the extent to which
the rate may vary. A cap is an upper limit, and a floor is the lower limit.

Prime times This special rate is a number of times greater than the prime rate. If the
loan’s maturity is increased or decreased, this rate will also be increased or
decreased in a multiple.

Rates on another basis The interest rate can also be determined based on the current interest rate of
debt instruments or the regional index of change of interest/price.

This rate is similar to the prime rate except that the base is different. A rate
can be a bit lower or higher than the prime rate. Examples include the
regional index or other market interest rates such as the CD rate.
B. Determining loan price without interest

Pricing method Characteristics

Compensating balances Deposit balances that a lender may require to be maintained throughout
the period of the loan.

Balances are typically required to be maintained on average rather than at

a strict minimum.

Fees, charges, etc. A charge is taken for this interim period after sanctioning credit but before
disbursing the amount to the borrower. This charge helps to prevent the
loan taker from making unnecessary delays in taking a loan.

Apart from special/priority cases, no interest but 3% – 5% service is

charged on small loans.

For many borrowers, the factors that determine a bank's interest rate are a mystery. How does a
bank decide what rate of interest to charge? Why does it charge different interest rates to
different customers? And why does the bank charge higher rates for some types of loans, like
credit card loans, than for car loans or home mortgage loans?

Following is a discussion of the concepts lenders use to determine interest rates. It is important to
note that many banks charge fees as well as interest to raise revenue, but for the purpose of our
discussion, we will focus solely on interest and assume that the principles of pricing remain the
same if the bank also charges fees.

Cost-plus loan-pricing model

A very simple loan-pricing model assumes that the rate of interest charged on any loan includes
four components:

 the funding cost incurred by the bank to raise funds to lend, whether such funds are
obtained through customer deposits or through various money markets;
 the operating costs of servicing the loan, which include application and payment
processing, and the bank's wages, salaries and occupancy expense;
 a risk premium to compensate the bank for the degree of default risk inherent in the loan
request; and
 a profit margin on each loan that provides the bank with an adequate return on its capital.

Let's consider a practical example: how this loan-pricing model arrives at an interest rate on a
loan request of Rs.10,000. The bank must obtain funds to lend at a cost of 5 percent. Overhead
costs for servicing the loan are estimated at 2 percent of the requested loan amount and a
premium of 2 percent is added to compensate the bank for default risk, or the risk that the loan
will not be paid on time or in full. The bank has determined that all loans will be assessed a 1
percent profit margin over and above the financial, operating and risk-related costs. Adding these
four components, the loan request can be extended at a rate of 10 percent (10% loan interest rate
= 5% cost of funds + 2% operating costs + 2% premium for default risk + bank's targeted profit
margin). As long as losses do not exceed the risk premium, the bank can make more money
simply by increasing the amount of loans on its books.

Price-leadership model

The problem with the simple cost-plus approach to loan pricing is that it implies a bank can price
a loan with little regard to competition from other lenders. Competition affects a bank's targeted
profit margin on loans. In today's environment of bank deregulation, intense competition for both
loans and deposits from other financial service institutions has significantly narrowed the profit
margins for all banks. This has resulted in more banks using a form of price leadership in
establishing the cost of credit. A prime or base rate is established by major banks and is the rate
of interest charged to a bank's most creditworthy customers on short-term working capital loans.

This "price leadership" rate is important because it establishes a benchmark for many other types
of loans. To maintain an adequate business return in the price-leadership model, a banker must
keep the funding and operating costs and the risk premium as competitive as possible. Banks
have devised many ways to decrease funding and operating costs, and those strategies are
beyond the scope of this article. But determining the risk premium, which depends on the
characteristics of the individual borrower and the loan, is a different process.

Credit-scoring systems and risk-based pricing

Because a loan's risk varies according to its characteristics and its borrower, the assignment of a
risk or default premium is one of the most problematic aspects of loan pricing.

A wide variety of risk-adjustment methods are currently in use. Credit-scoring systems, which
were first developed more than 50 years ago, are sophisticated computer programs used to
evaluate potential borrowers and to underwrite all forms of consumer credit, including credit
cards, installment loans, residential mortgages, home equity loans and even small business lines
of credit. These programs can be developed in-house or purchased from vendors.

Credit scoring is a useful tool in setting an appropriate default premium when determining the
rate of interest charged to a potential borrower. Setting this default premium and finding optimal
rates and cutoff points results in what is commonly referred to as risk-based pricing. Banks that
use risk-based pricing can offer competitive prices on the best loans across all borrower groups
and reject or price at a premium those loans that represent the highest risks.

So, how do credit-scoring models and risk-based pricing benefit the borrower who only wants a
loan with reasonable repayment terms and an appropriate interest rate charge? Since a bank is
determining a reasonable default premium based on past credit history, borrowers with good
credit histories are rewarded for their responsible financial behavior. Using risk-based pricing,
the borrower with better credit will get a reduced price on a loan as a reflection of the expected
lower losses the bank will incur. As a result, less risky borrowers do not subsidize the cost of
credit for more risky borrowers.

Other risk-based pricing factors

Two other factors also affect the risk premium charged by a bank: the collateral required and the
term, or length, of the loan. Generally, when a loan is secured by collateral, the risk of default by
the borrower decreases. For example, a loan secured by a car typically has a lower interest rate
than an unsecured loan, such as credit card debt. Also, the more valuable the collateral, the lower
the risk. So it follows that a loan secured by the borrower's home typically has a lower interest
rate than a loan secured by a car.

However, there may be other factors to consider. First, the car may be easier to sell, or more
liquid, making the risk of the loan lower. Second, the term, or length of a car loan is usually short
—three to five years—as compared to the 15- to 30-year term of a home loan. As a general rule,
the shorter the term, the lower the risk, since the ability of the borrower to repay the loan is less
likely to change.

Assessing the interplay of credit score, collateral and term to determine the risk premium is one
of a lender's most challenging tasks. Whether loan-pricing models are based on a simple cost-
plus approach or price leadership, use credit-scoring or other risk-based factors, they are valuable
tools that allow financial institutions to offer interest rates in a consistent manner. Knowledge of
these models can benefit customers as well as banks. Although it cannot help customers make
their payments, an awareness of loan-pricing processes can ease the uncertainty that may be
involved in applying for a loan.

DIFFERENT TYPES OF CREDIT FACILITIES PROVIDED BY BANKS

At some stage, every Business needs funding for smooth operations. There are multiple funding
sources available in the market for business organizations. Credit Facility offered by Banks is
one such source. It can be understood as an agreement or arrangement between the borrower and
banks where the borrower can borrow money for an extended period. Credit Facilities are
utilized by the Companies, primarily to satiate the funding-needs for various business
Operations. Banks on the other hand earn profit from the interest incurred on the principal
amount lent to the borrower.

The different types of Credit Facilities can be broadly classified into two parts:

 Fund Based Credit

 Non-Fund Based Credit.
Let’s understand them in detail.
FUND BASED CREDIT
Fund Based Credit is the one where the Bank provides the Fund directly to the Borrower without
any third party involvement. It usually involves an immediate flow of funds to the borrower’s
account.  For e.g. Loans, Ods (Over Drafts), CCs (Cash Credit), PAD (Payment Against
Documents), Consortium loans, etc.

Fund-Based Credit comes with multiple advantages. Let’s take a look at them.

1. The fund-based Credit offers immediate funding to the borrower.

2. The fund-based Credit offers actual funding for business operations.
The different types of fund based credits are as follows

1. LOAN
A loan is a type of Fund-Based Credit where the Borrower has to repay the Credit within the pre-
agreed time & interest. Loans are given to the business to meet their various running expenses
such as production, distribution, expansion etc. A huge amount of loan can be given to the
companies depending on their requirements. Although, to ensure the safety of returning of the
funds, Credit Monitoring Arrangement Data reports are carefully monitored in funding cases
that involve a large amount of principal.

Let’s take a look at different types of loans.

A) Demand Loans & Term Loans
Demand loan:

Demand Loans, sometimes known as working capital loans, are offered by the lender to the
Borrower for the short-term.
As the name suggests, the Borrower has to repay the loan on the demand of the lender. There is
no fixed tenure for the repayment. The Borrower can repay the loan in advance without paying
any prepayment charges. These loans are generally offered against tangible assets or similar
securities.

Term Loan:
These loans come with a predefined repayment schedule and tenure. As the tenure is fixed, the
Borrower will have to pay some pre-payment charges in early payments. They are generally
offered for the large funding requirements.

B) Unsecured Loan & Secured Loan

Unsecured Loan
These loans are offered to the Borrower without any collateral but generally carry a high interest
rate. This means, if the Borrower defaults on the repayment of loan, there is no way for the
lenders to acquire any asset of the Borrower whether it is tangible or non-tangible. These loans
include Personal loans and student loans as well.

Secured Loan
The lenders offer these loans against any tangible or non-tangible asset like home, piece of land,
vehicle etc. If the Borrower defaults on the payment, his/her assets can be acquired by the lender.
Loans such as home loans and loans against property are a few types of secured loans.

2. CASH CREDIT
Cash credit is provided to the business owners to carry out their regular business expenses. In
Cash credit, the borrower is given access to a current account from which they can withdraw
money within a predefined limit for an agreed amount of time. The interest is charged on the
daily closing balance of the account rather than the borrowing limit.

3. OVERDRAFTS
This Credit Facility is offered to Current Account holders in a particular bank, to borrow the
fund more than their existing balance for a specific period. These credits are secured by the
physical assets, pledge of FDs, Securities or Mortgage of some immovable property in some
cases.

4. CREDIT CARD
Under this facility, a Credit Cardholder can spend a fixed amount of money using the card
offered to him/her by the Bank. The user has to pay the credits used within the stipulated time
regularly. Any failure to pay the outstanding bills on time attracts a penalty from the Bank.

5. EXPORT FINANCE
Export finance is the financing facility which is provided by the banks to fund exporters to meet
their production and export needs. The different type of export finance are

A) Packing Credit Advances

These types of credits are offered to exporters to meet the expenses for manufacturing and
packing the goods for export as per the buyer’s need. The credit is offered against hypothecation
of goods stock, and any other assets of the Borrower.

B) Post Shipment Finance

These type of credits are offered to the exporters once they export their product to the buyers.
These credits are offered to meet the interim cash requirement of the exporter. It is offered based
on the document and invoices suggesting that the export is made.
6. HIRE PURCHASE FINANCE
This type of finance is offered to the buyer when he/she is looking to buy some expensive
product. Under this Credit, it is agreed that the buyer will pay some down payment initially and
the rest of the amount will be paid in installments.

7. BILL FINANCE
In bill finance, a Bank draws a bill of exchange from another bank to transfer the funds due to
Credit offered to the Borrower.

The different types of bill finance are

A) Bill Discounted
This Credit allows the seller to borrow money from Bank in advance against the payment that
will be received by the seller in the future. The Bank deducts some charges as the fees from the
payment, once the buyer deposits it

B) Bill Purchased
This Credit allows the seller to borrow funding based on a sales document not drawn under the
Letter of Credit. The lending bank submits these documents to the buyer’s bank for the
payments.

8. LEASING FINANCE
Under this credit facility, the owner of an asset gives the right to use that asset to the Borrower
against the payment of a specific amount. It is one of the most important forms of medium and
long-term finance. As the owner leases his/her property, he/she is known as the lessor, and the
one who takes the property on lease is called the lessee.

9. RETAIL CREDIT
The banks offer Credit or loan to the Borrower to purchase certain moveable or immovable
properties, durables, vehicles or similar products. This Credit is offered to the Borrower based on
his/her credit history. This facility is offered on Business to Business transactions as well as
Business to Customer transactions.

NON-FUND BASED CREDIT

On the Contrary, Non-Fund Based Credit is where the Fund is not transferred directly to the
borrower. It is offered to a third-party as agreed upon by the borrower, on behalf of the
Borrower.
The bank usually acts as a guarantee provider to the seller on the behalf of the buyer. If the
payment is not received by the seller within pre-agreed time, The bank pays the amount to the
seller. For e.g. Bank Guarantee, Buyer Credit, Letter of Credit, Supplier Credit.

Following are the advantages of Non-Fund Based Credits:

1. It offers financial security to the seller if the buyer defaults due to any reason.
2. It offers Business expansion opportunities to the exporters.
The different types of non-fund based credit are

1. LETTER OF CREDIT
A letter of credit is an assurance provided by the Bank to the seller on behalf of the buyer that the
seller will receive the buyer’s payment at regular intervals. It also states that if the buyer fails to
pay the seller for any reason, the Bank will be responsible for the remaining or full payment.

Letter of Credit is offered based on the collateral of cash or certain securities. With the rising
international trading, Letter of Credit is becoming a crucial tool to manage the payments between
parties that hardly know each other and live in different countries with different laws. The bank
charges a certain percentage from the buyer as the fees for offering the Letter of Security.

The Letter of Credit can be divided into the following parts:

A) Sight Credit
This letter of Credit is quicker than others. Here the Borrower can take the lender’s funds by
showing a bill of exchange and sight letter of Credit.

B) Revocable & Irrevocable Credit

Revocable Letter of Credits is the one that can be revoked or canceled by the issuing bank
without prior notice to any party.

Irrevocable Letter of Credit cannot be revoked or canceled by the issuing Bank. So once the
LOC is generated, Bank will have to honor the letter.
C) Confirmed Credit
In this type of Credit, a bank other than the issuing Bank confirms the Letter of Credit by adding
its confirmation. Only Irrevocable Letter of Credit is eligible for confirmation.

D) Back-to-Back Credit
Under this type of Credit, the exporter requests the Bank to offer an LC to his/her local supplier.
The request is based on the export LC received by the exporter from an overseas buyer. Here, an
LC is issued based on an export LC and hence the name, Back-to-Back Credit.
The advantages of a letter of credit to the buyer is as follows

1. Allows the buyer to trade with the parties from any corner of the world
2. The buyer can edit the terms and conditions that fit him/her after consulting the seller.
3. It acts as a credit certificate for the buyer, and he/she can perform multiple trades as a major
financial institution like Bank backs him/her.
4. Letter of Credit offers better Cash flow to the buyer.
The advantages Of a  Letter Of Credit To seller is as follows

1. The seller receives the money on fulfilling the terms mentioned In the Letter of Credit.
2. There is no risk of losing money for the seller if the buyer fails to pay the money. Seller gets
his/her dues from the Bank that has issued the Letter of Credit.
3. The letter of Credit is easy to quick to avail based on good credit.
4. If there is a dispute in trading, the seller can withdraw funds from the Bank even when the
case is pending.
2. BANK GUARANTEE
Under this type of Credit, Bank offers assurance that under any circumstances, the Guarantee
issuing Bank will fulfill any financial losses incurred by the protected party as mentioned in the
Contract.

Let’s take a look at different guarantees

A) Financial Guarantee
In this type of Guarantee, the Guarantor takes responsibility for the Borrower. This means, if the
Borrower fails to repay the debt, Guarantor will be liable to pay the unpaid amount.

B) Performance Guarantee
The Guarantor issued a security bond that assures the lender that the Contractor will complete
the work satisfactorily in the stipulated time.

C) Deferred Payment Guarantee

This type of Guarantee is usually given on deferred or postponed payments. The banks generally
offer DPG on the purchase of certain machinery and goods.

3. LETTERS OF COMFORT FOR AVAILING BUYERS CREDIT

Letter of Comfort can be understood as the Guarantee offered by the Bank of Importer or buyer.
The Importer can use this Letter of Comfort to avail Buyer’s Credit from the Overseas banks.
The Importer or Buyer’s Bank charges certain fees for offering the Letter of Comfort.
4. DERIVATIVE PRODUCTS
Derivatives are a type of financial security or financial contracts that are backed by some
underlying securities. These underlying securities can be anything, ranging from currencies,
bonds, commodities to stocks.

5. BUYER CREDIT
It is a short-term funding option, offered to the Indian Buyers or Importers by the Bank to
manage their import Business. Using Buyer’s Credit, the Importers can avail loans from foreign
financial institutions which offer Credit at comparatively lower rates. Buyer’s Credit can be
availed for importing almost all types of capital and non-capital goods.

6. SUPPLIER CREDIT
This type of Credit is used to support the importers financially in India. Here any overseas
Financial Institute or Supplier offers the Credit to the Importer on the Libor rates, which are
comparatively low. Such Credit is backed by the Letter of Credit offered to the Importer via
Importer’s Bank.

BILL DISCOUNTING
 
1 INTRODUCTION:
Bills of exchange that are used in the course of normal trade and commercial activities are called
commercial bills‗. Bill financing, is an ideal mode of short-term financing available to business
concerns. It imparts flexibility to the money market, besides providing liquidity within the
banking system. It also contributes towards the effectiveness of the monetary policy of the
central bank of a country.
According to the Indian Negotiable Instruments Act 1881, ―Bill of Exchange is an instrument
in writing containing an unconditional order, signed by the marker, directing a certain person to
pay a certain sum of money only to, or to the order of, a certain person, or to the bearer of that
instrument.
The bill of exchange is essentially a trade-related instrument, and is used for financing
genuine transactions. Bill financing, is an ideal mode of short term financing available to
business concerns. It imparts flexibility to the money market, besides providing liquidity within
the banking system. It also contributes towards the effectiveness of the monetary policy of the
central bank of a country.
 
2 BILL DISCOUNTING
 
When the seller (drawer) deposits genuine commercial bills and obtains financial
accommodation from a bank or financial instit instead of discounting the bill immediately may
choose to wait till the date of maturity.
When the seller (drawer) deposits genuine commercial bills and obtains financial
accommodation from a bank or financial institution, it is known as 'bill discounting'. The seller,
instead of discounting the bill immediately may choose to wait till the date of maturity.
Commercial, the option of discounting will be advantageous because the seller obtains ready
cash, which can be used for meeting immediate business requirements. However, in the process,
the seller may lose a little by way of discount charged by the discounting banker.
 
3 Following are the salient features of bill discounting financing:
 
1. Discount charge:
 
The margin between advance granted by the bank and face value of the bill is called the
discount, and is calculated on the maturity value at rate a certain percentage per annum.
 
2. Maturity:
 
Maturity date of a bill is defined as the date on which payment will fall due. Normal
maturity periods are 30, 60, 90 or 120 days. However, bills maturing within 90 days are the most
popular.
 
3. Ready finance:
 
Banks discount and purchase the bills of their customers so that the customers get
immediate finance from the bank. They need not wait till the bank collects the payment of the
bill.
 
4. Discounting and purchasing:
 
The term discounting of bills is used for demand bills‗, where the term purchasing of
bills is used for usance bills‗. In both cases, the bank immediately credits the account of the
customer with the amount of the bill, less its charges. Charges are less in case of purchasing of
bill because the bank can collect the payment immediately by presenting the bill to the drawee
for payment. Charges are, however, higher in the case of discounting of bill‗ because the bank
charges include not only the charges for service rendered, but also the interest for the period
from the date of discounting the bill to the date of its maturity. In addition, there are also charges
when bills are dishonored. In such circumstances, the bank will debit the account of the customer
with the amount of the bill along with interest and other charges. Since the bank is granting
advance to the customers in both the discounting and purchasing of bills, bills discounted and
purchased are shown as advances (Schedule 9) by a bank in its balance sheet.
 
4 Steps In Discounting And Purchasing Following steps are involved in the discounting and
purchas8isng of commercial bills of exchange:
 
1. Examination of Bill: The banker verifies the nature of the bill and the transaction. The
banker then ensures that the customer has supplied all required documents along with the bill.
 
2. Crediting Customer Account after examining the genuineness of the bill, the banker grants a
 
credit limit, either on a regular or on an ad net amount of the bill i.e. value of bill minus
discount charges. The amount of discount is the income earned by the bank on discounting /
purchasing. The amount of the bill is taken as advance by the bank.
3. Control over Accounts: To ensure that no customer borrows more than the sanctioned
limit, a separate register is maintained for determining the amount availed by each customer.
Separate columns are allotted to show the names of customers, limits sanctioned, bills
discounted, bills collected, loans granted and loans repaid. Thus, at any given point in time the
extent of limit utilized by the customer can be readily known.
4. Sending Bill for collection: The bill, together with documents duly stamped by the banker, is
sent to the banker's branch (or some other bank‗s branch if the banker does not have a branch of 
its own) for presenting the bill for acceptance or payment, in accordance with the instructions
accompanying the bill.
 
5. Action by the Branch: On receipt of payment, the collecting bank remits the payment to
the banker which has sent the bill for collection.
 
6. Dishonor: In the event of dishonor, the dishonor advice is sent to the drawer of the bill.
It would be appropriate for the collecting banker to get the protested for dishonor. For this
purpose, the collecting banker or branch of the bank maintains a separate register in which
details such as date on which the bills are to be presented, the party to whom it is to be presented,
etc. are recorded. The banker then presents them for acceptance or payment, as required. The
banker debits the customers' (drawer / borrower) account with the amount of the bill and also all
charges incurred due to dishonor of the bill. Such a bill should not be purchased in the event of
its being presented again. However, the banker may agree to accept it for collection.
 
5 BILL SYSTEMS There are essentially two systems of bills, the drawer bill system and
the drawee bill system, which are explained blow:
 
Drawer Bills System
 1‘Drawer Bills System‘s characterize sellers of goods on the buyer of the goods
2. Bills being discounted or purchased at the instance of the drawer of the bills
3. The banker primarily taking into consideration the credit of the drawer of bill, while
discounting or purchasing these bills this system of financing goods is quite popular in our
country.
Drawee Bills System „Drawee Bills System‘s characterized by:
a. The banker accepting the bill drawn by the seller at the instance of the buyer (the drawee)
b. The banker providing assistance, primarily on the strength of the creditworthiness of the buyer
the two types of the drawee bills system are as follows:
1. Acceptance credit system: Under this system, the buyer’s banker accepts the bill of exchange
for the goods purchased by the drawee. Such a bill may either be drawn on the buyer or the
banker. The banker also requires the borrower to show separately, the goods purchased under
acceptance credit in periodical stock statements submitted to the banker.
2. Bills discounting system: Under this system, the seller directly draws the bill on the buyer’s
bank discounts the bill and sends the proceeds to the seller. The buyer's banker will show the bill
as bill discounted‗. Under both the systems, the banker keeps a record of the bills, both accepted
and still outstanding. This is to ensure that the advance sanctioned does not exceed the credit
limit. The main advantages of the Drawee bill scheme are as follows:  
 
1.  Assured payment: Since the banker has accepted the bill, the seller is assured
of payment. Moreover, if the seller decides to get it discounted, the discount rate will be lower
because the drawee is the banker itself.
 
2. Buying advantage: Due to the surety and standing of the banker, it is possible for
the buyer to obtain goods at competitive rates.
 
3. Safety of funds: There is hardly any risk for the buyer’s bank because the bill is accepted or
discounted against the security of the goods purchased by the buyer. Moreover, the goods are
under the control of the banker. It is equally advantageous for the seller's bank, since the
discounted bill may be rediscounted with any other financial institution. This is because; a
banker has accepted the bill.

BILL FINANCE
There are several financial instruments that are engaged in the day-to-day activities of an
enterprise - from bills to tenders to commercial papers. These devices ease business transactions,
and are critical in the proper management of working capital.
Individuals come across various instruments like bill finance in due course of conducting
business, but no set manual arrives with them. That’s why it’s crucial to know about these in
detail.
With a comprehensive understanding of bill finance, business-owners can manage their
company’s transactions better and ensure fewer discrepancies and mistakes.
WHAT IS BILL FINANCE?
It is a binding short-term financial instrument that mandates one party to pay a specific sum of
money to another at a predetermined date or on-demand. Also known as a bill of exchange, it
essentially denotes, in writing, that one person (debtor) owes money to another (creditor). 
Businesses predominantly use bill finance during international trade, since the degree of
uncertainty concerning the payment is considerable in that regard. However, there’s no set law as
such, and companies can use a bill of exchange for intra-border trade as well. 
Usually, bill finance does not involve any interest payment. But, a creditor might charge a
penalty fee or interest if it does not receive the due amount by a predetermined date. In that case,
the issuer must mention these details in such a document. 
Businesses can also leverage their unpaid invoices to avail cash advance through KredX’s
invoice discounting service within 24 – 72 hours*. 

HOW DOES BILL FINANCE WORK?

The practice of bill of exchange issuance involves three parties primarily – 

 Drawee – This is the person or entity on which a bill of exchange is issued, also referred to
as the debtor. A drawee needs to accept the bill, which legally binds it to pay a specific sum. 

 Drawer – This person issues a bill of exchange, usually before undertaking credit sales. A
drawee is obliged to pay the due amount to a drawer. This entity must sign a bill of
exchange during issuance. 

 Payee – The payment ultimately goes to a payee. In most cases, a drawer, and payee are
the same entity. However, in some cases, a drawer can transfer bill finance to a third-
party, in which case that person becomes the payee. 

Usually, when a business sells its goods on credit, a bill of exchange is issued by the drawer to
the buyer (drawee). The buyer shall accept this document, assenting to stipulated terms like date
and mode of repayment. Thereafter, it becomes legally binding. 
In case, such a bill of exchange involves payment on demand clause, the drawer can ask for
settlement of dues any time before the specified date. If not, the buyer or drawee must pay the
stated amount by the due date, as mentioned in that bill finance. 
Typically, the payment date is set somewhere between 30 days and 90 days from the date of
sales. With premium clients, this period tends to be on the lengthier end. Enterprises, especially
small-scale ones, can be cash strapped if payments are late.
WHAT ARE THE TYPES OF BILL FINANCE?
The following table discusses the various types of bill finance that are mostly used.

Types Explanation 

Also known as sight draft, this type of bill finance comes with an on-
Demand bill
demand payment stipulation. 

Bills of exchange that feature the clause of payment by a specific date

Usance bill
and time. These are also known as time draft. 

A type of bill of exchange that requires the presentation of supporting

Documentary bill
documents attesting to the legitimacy of a transaction(s). 

It involves no supporting documents, and therefore, the interest that one

Clean bill
needs to pay, if any, is much higher. 

Inland bill This is issued for transactions within national borders. 

As opposed to the inland bill, a foreign bill of exchange is issued to

Foreign bill
debtors beyond national borders. 

When a bank issues a bill of exchange, it’s called a bank draft. In this
Bank draft
case, a bank enforces bill payment as per terms. 

Trade draft Bill finance issued by an individual is called a trade draft. 

Accommodation
It refers to the unconditional bill finances. 
bill

Bill finance is a crucial document for businesses that carry out trade on credit. It not only
substantiates a transaction, but also provides a legal avenue to creditors, if debtors fail to make
good on their debts.
 Cash Delivery: Types of facilities, Modes of Delivery

What is Cash Credit?

Cash Credit is short-term funding or loan for a company to meet its working capital
requirements. Bank offers loans to an enterprise depending on its credit history and financial
stability. Funding procured from cash credit loans can be used for various business purposes,
such as business expansion, buying plant and machinery, purchasing raw materials, enhancing
stocks, hiring staff, paying-off salaries, undertaking training, debt consolidation, etc. Cash credit
has a loan repayment tenure of a maximum of up to 12 months that can be renewed.

WHAT IS CASH CREDIT LOAN?

Cash credit loan is a type of working capital loan in which money can be withdrawn against the
hypothecation of stocks and receivables. Cash credit instantly helps businesses in overcoming
the cash crunch situation during business tenure. This working capital loan can be availed either
in form of a secured loan or an unsecured loan. The business is limited to borrow only up to the
sanctioned limit from the lender. Businesses need to submit collateral or security to avail cash
credit loan wherein the collateral to be submitted can be in the form of fixed assets, stock-in-
trade, raw materials, finished goods, equipment, property, etc.

CASH CREDIT LOAN INTEREST RATE

The interest rate for availing Cash Credit loan varies from bank to bank that shall change from
time to time and depends on the creditworthiness and financial history of the applicant.

Salient Features of Cash Credit

 Cash credit is a short-term loan with a repayment period of 12 months

 Interest rate charged by the lender is on the money withdrawn and not on the total
sanctioned limit
 Money can be withdrawn any number of times from the sanctioned limit
 Cash credit is always offered against collateral or security
 Higher limits can be availed by businesses with good credit scores and repayment history
 Credit limit is sanctioned considering the company’s turnover and volume
 Cash credit can be repaid in form of monthly, quarterly, or half-yearly repayments
 Individual borrowers can also avail cash credit against their Fixed Deposits
 Lender has an option of recalling sanctioned amount at short notice
 Interest rate paid on cash credit loan is tax-deductible
HOW CASH CREDIT WORKS?

Cash credit permits an enterprise to withdraw money from a bank account. The money can be
withdrawn a number of times until the total sanctioned limit is reached. The cash limit is defined
by the lender as per the applicant’s profile, CIBIL score, creditworthiness. These factors are
based on the borrower’s company structure and its assets and liabilities.

DOCUMENTS REQUIRED

 Duly filled application form with Passport-sized photographs

 Business PAN card
 KYC documents: Applicant’s Passport, Driving License, Voter’s ID card, PAN card,
Aadhar card, Utility Bills (Water/ Electricity Bills)
 Income Proof: Last 6 months’ bank statement
 Business Incorporation Certificate
 Business address proof
 Ownership proof: Company’s deed
 Details of collateral or security to be submitted
 Any other document required by the lender

CASH CREDIT LOAN PROCEDURE

The initial step is that bank or lender sanctions a limit to a business or enterprise and from the
assigned limit, businesses can withdraw money as per their requirements. However, the limit
sanctioned by the lender depends on the current assets and liabilities of the business. Strong and
financially sound establishments are sanctioned with higher limits, as compared to businesses
with lesser finance or lower credit score. The interest rate charged by the bank or lender depends
on the creditworthiness and submitted collateral by the company.

Also Read: How to Apply for Business Loan – Step by Step Procedure

WHO CAN AVAIL CASH CREDIT LOAN?

Cash Credit Facility can be availed by Individuals, Professionals, Business Owners,

Companies, Partnerships, Sole Proprietorships, Limited Liability Partnerships (LLPs), Co-
operative Societies, and Registered Trusts engaged in manufacturing, trading, and services
categorized under MSME.

ADVANTAGES AND DISADVANTAGES OF CASH CREDIT LOANS

Pros Cons

No collateral required Rate of Interest is High

Interest Rate on the withdrawn or utilized amount Short-term Loan

No CIBIL score check is required Lesser repayment period of 12 months

Interest paid is tax-deductible Difficult to avail by Startups

Quick and easily accessible with flexibility Used mainly to meet working capital requirements

FEATURES OF CASH CREDIT LOANS

The key features and benefits of cash credit loans are –
 Purpose of the loan :
Cash credit loans are availed by companies for working capital purposes. The day-to-day
operations of the company are critical for supply chain management and inventory
management. The funds so borrowed can be used for paying the supplier to procure raw
material or for paying the storage area rent which could be charged daily, the funds can also be
used to hire personnel on a temporary basis and are paid wages.
 Type of loan :
Cash credit loans are secured loans; the loan is provided against adequate security in the form
of assets or stock. The collateral can be stock, assets or financial instruments of cash value
higher than that of the loan. The loan quantum is generally a % of the cash value of the
collateral.
 Short-term loan with an EMI schedule :
These loans are used to meet short term requirement. Generally, these loans are used for
working capital management, primarily because they are extended as an overdraft facility.
Hence, the company can withdraw the funds as per requirement. The interest is chargeable for
the funds withdrawn and for the period withdrawn. The funds are repayable as per EMI
schedule can be monthly or quarterly. Irrespective of the financial situation of the company,
the repayment must happen as per schedule.
 Collateral :
There is a wide variety of instruments that qualify as collateral for these types of loans. Loan
applicant can provide raw materials, finished goods or any other inventory as hypothecation.
The loan value is always lower than the cash value of the collateral. In the event of default, the
collateral is sold at prevalent market price and the loan is closed in full. Incase, the cash value
 of collateral falls below the loan value, the borrower is required to bring in additional
collateral or sell off the underlying collateral and close the loan in full.
 Interest payment is flexible :
Interest is payable only on the amount utilized and not on the entire loan approved by the
bank. This is one of the key benefits derived under this loan. Cash credit loans are offered as
an overdraft. The funds are credited to the cash credit account, the borrower can withdraw
funds as per requirement.
 No restriction on number of withdrawals :
Any number of withdrawals is allowed against the cash credit account. The borrower may
choose to withdraw funds daily to cater to working capital requirement. Operational aspects of
the business require daily funding, cash credit loans align perfectly with this need. Fund
withdrawal can be made by cheque issuance; cheques are issued by lender with the business
entity’s name. Fund transfer can be conducted using internet and mobile banking facility.
 Other types of collateral :
Company and entity can also apply for cash credit against fixed deposits or any other financial
instruments. For companies which do not manufacture goods, the collateral can be in any other
form.
COLLATERAL FOR CASH CREDIT LOANS
Cash credit loans are secured loans, hence, there is a need for furnishing security to avail the
loan. The security can be submitted in the form of finished stock, work – in progress stock,
stock-in-trade, spare parts, storage products etc. The value of the stock is evaluated and a %
lower than the cash value of the products is extended as credit facility in the cash credit account.
The hypothecated products cannot fall in value against the loan value. In case the cash value of
the collateral inches closer to the loan value, the lender may request for additional collateral or
sell off the collateral and close the loan in full.

BENEFITS OF AVAILING CASH CREDIT LOANS

 Working capital requirements can be met conveniently
 Provides for bank guarantees to meet performance and financial obligations
 Interest has to be paid only on the funds withdrawn and for the period utilized
 Processing and sanction are convenient and easy, since, this is a secured loan
 Cash credit loans can be extended either as an overdraft facility or as a term loan
 Terms are negotiable between the lender and borrower
 Favorable interest rates can be negotiated if the credit history of the promoters or company
(applicant) is high
 Flexible repayment schedule can be either monthly or quarterly
 After assessment of the working capital finance to be provided by the bank, it is to be

decided – in consultation with the borrower – as to how the credit limit will be availed of

by the borrower.

 Depending upon the nature of the business activity and the operating cycle

prevalent in the particular industry, the following modes of delivery of credit are

seen in different countries:

 Overdraft/Cash Credit System:

 In this system, the borrowers are allowed to draw funds from the account to the extent of

the value of inventories and receivables less stipulated margin within the maximum

permissible credit limit granted by the bank. Here, the drawing power of the borrower is

computed by the banks by deducting the stipulated percentage of margin from the value

of the various items of inventory and receivables.

 Borrowers can draw cheques on their overdraft or cash credit account to the extent of the

drawing power so calculated, subject to the maximum credit limit granted by the bank.

Value of the inventory is taken at cost price or market price, whichever is lower. Any

withdrawal of funds beyond this limit renders the account irregular, serving as a warning

signal to the lending banker and also prompting him to monitor the account closely. The

borrower is required to submit a statement of stocks and receivables to the bank on a

monthly basis.

 It is necessary to understand the difference between ‘drawing power’ and ‘drawing limit’.

Drawing power is worked out by deducting the stipulated margin from the value of

inventory and receivables, as declared in the monthly statements. If the amount so

calculated is lower than the sanctioned limit, the drawing power becomes the drawing

limit.

 On the contrary, if the drawing power is above the sanctioned limit, the drawing limit is

restricted to the sanctioned limit only. Drawing power is helpful to the banker for taking a

decision on a request by the borrower for allowing ‘over limit’, i.e., drawing beyond the
 sanctioned limit. Drawings allowed beyond the sanctioned limit should also be

adequately secured by inventory and receivables after deduction of stipulated margins.

 The overdraft and cash credit system of credit delivery dominates the scenario of credit

dispensation by commercial banks all over the world. Despite several shortcomings, the

system finds favour with both the commercial banks and the borrowers, in the form of

short-term bank borrowings.

 All sale proceeds are deposited in this account by the borrower; as and when necessary,

the account is drawn up to the limit for making payments to the suppliers and other

creditors. The system has been in vogue for a long time, mainly because of its flexibility,

which can take care of temporary requirements of funds by the borrowers. The cash

credit system enables continuous recycling of funds into the bank.

 Loan System:

 In some countries, term loans for short periods are the main form of short- term finance.

Under this system, loans are sanctioned for definite purposes and periods. This is usually

accompanied by the maintenance of a current account for routing the day-to-day

transactions of the business enterprise. This system forces the borrower to plan his cash

budget in advance, thus ensuring a degree of self discipline.

 This system enables the bank to manage funds and the credit portfolio rationally. Unlike

the overdraft or cash credit account, the borrower cannot liquidate the outstanding by

deposit of sale proceeds on day-to-day basis and, therefore, the earnings of the banks get

a boost under the loan system. Automatic review is built into the loan system, as every

new loan has to be negotiated afresh.

 This gives an opportunity to the bank to deny a loan if the performance of the company is

not found to be satisfactory. The loan system is relatively simple to administer as there is

no need to calculate the drawing power and giving various sub-limits against each item of

inventory and receivables.

 However, under the loan system, although the purpose of a loan is determined at the time

of granting the loan, once the funds are disbursed, the bank has no further control over

the end use of the funds.

 Bill System:

 In bill system of financing, the borrower is financed against the bills of exchange drawn

by him on his buyers. Financing is also done under the drawee bill system, where the

borrower is a drawee of bill of exchange for his purchases. In case of sales bills, the

borrower submits the bill of exchange along with the shipping documents, and the bank

purchases or discounts the bill and credits the proceeds to the borrower’s current account

for his utilisation.

 Thereafter, the relative bill is presented to the drawee (buyer) for payment and, upon

receipt of the amount, the bill purchase/discounted account is squared off. Bill finance is

self-liquidating in nature.

 In case of drawee bills, the borrower is the buyer and the supplier draws the bill on him

and presents the bill to the borrower’s bank for payment. The bank discounts the bill and

remits the proceeds to the supplier’s bank and on due date of the bill, the borrower pays

the amount with interest and other charges towards liquidation of the outstanding in the

drawee bill discount account.

 The cost of operation for borrowers under the bill system and also the cost of

administering the system by banks are somewhat higher than other systems because of

stamp duties, detailed book-keeping, etc.

 Commercial Paper (CP):

 Commercial paper is a popular form of raising working capital at a low cost by the

corporate business houses. CP is a short-term money market instrument and the banks

find it a convenient route to park their excess liquidity for a short period, not exceeding

12 months. The subscribers are other corporate houses, commercial banks, etc.
 Commercial paper is a promissory note made by a highly rated corporate entity and is

offered to the prospective investors including the banks for subscription. The banks

invest in such commercial papers while discounting the promissory note at an underlying

rate of interest, which is generally lower than the market rate of interest, including that of

the prime lending rate of the commercial banks.

 Commercial papers provide the corporate houses with an additional avenue of raising

working capital, at a price substantially lower than the interest charged by the commercial

banks in their fund-based working capital limits of overdraft/cash credit granted to the

borrowers.

 In some countries, the money market regulatory authorities stipulate certain eligibility

criteria for the corporates desirous of issuing CP. The criteria generally include the

minimum tangible net worth of the issuer, availability of working capital facility from

commercial banks/financial institutions, classification of the borrowal account of the

corporate as a ‘standard asset’ by the financing bank, etc.

 However, in developed economies like the USA, the UK, Japan, etc., the commercial

paper may be issued as a stand-alone product and need not be tied up with the company’s

working capital limit from the bank. The mechanism of issuing a commercial paper calls

for appointing a commercial bank/financial institution to act as an issuing and paying

agent (IPA) for the issue.

 The bank makes its own assessment about the fund-based working capital requirement of

the company. After an agreement regarding the quantum of the issue, the rate of interest

is reached between the bank and the issuing company, the potential investors are given a

copy of the IPA certificate.

 The investor pays the discounted value of the CP to a designated account, and thereafter,

the issuing company makes arrangements for crediting the CP to the investor’s account

with a depository participant. Of course, the system of delivery of physical certificate of

 CP is also prevalent in many places. A commercial bank acting as IPA should make a

promise to redeem the amount of CP to the investor on due date.

Bridge Loan: Commercial banks often grant bridge loans to the business enterprises to

temporarily bridge the financial gap between granting of loans by other banks and financial

institutions and actual disbursement by them. The gap arises due to the time taken for completion

of documentation and other formalities between the borrower and the financial institution.

Bridge loans are also sanctioned by commercial banks to meet the time-gap between the closure

of a public issue of equity or other shares by a company and actual availability of funds after

completing all the formalities as required by the capital market regulatory authorities. Availing

of a bridge loan often becomes essential during the period of project implementation when the

delay in procuring the plant and machinery and incurring other capital expenditure will result in

time and cost overrun.

The bridge loan helps the project work to continue without any hindrance or stoppage for lack of

fund. After the funds are available to the business enterprise, the bridge loan is repaid. Banks

have to exercise caution in granting bridge loans as unless a proper tie-up with the incoming

funds is made, the repayment may pose a problem.