You are on page 1of 120

A PROJECT REPORT ON RISK MANAGEMENT IN INTERNATIONAL TRADE FINANCE

AT UNION BANK OF INDIA (OVERSEAS BRANCH, NARIMAN POINT, MUMBAI)

BY CHIRAG SHAH ISFS/MSF/07/M/0024

ICFAI SCHOOL OF FINANCIAL STUDIES MUMBAI


1

RISK MANAGEMENT IN INTERNATIONAL TRADE FINANCE

BY CHIRAG SHAH ISFS/MSF/07/M/0024

CHHAYA DANGDA (Faculty Guide)

A Report Submitted in Partial Fulfillment of the Requirement of MS (Finance) Program of ISFS 2007-09
2

DECLARATION

The project work carried out by me and presented through this report under the title RISK MANAGEMENT IN INTERNATIONAL TRADE FINANCE is an original one and has not been copied from elsewhere and has not been submitted elsewhere.

Date:

Signature Roll no. ISFS 0024

ACKNOWLEDGEMENT
On the onset I take the privilege to convey my gratitude to those who have cooperated, supported, helped and suggested me to accomplish my project work. This project work bears imprint, of many persons who are either directly or indirectly involved in the completion of it. I am grateful to Mr. R. Rengarajan, Center Head, ISFS Mumbai who has given me an opportunity to pursue my Summer Internship project in Union bank of India. I am also desirous of placing a record profound indebtness to my Faculty guide Prof. Chhaya Dangda, ISFS, Mumbai and my Company guide Mr. P Y Kotkar for his valuable advice, inputs, guidance, precious time and support they offered. I would also like to thank: Mr. Ajit Kulkarni (CGM, Overseas Branch, UBI) Mr. Girish Dave (Asst. Manager, Overseas Branch, UBI) Mr. Kiran Shah (Asst. Manager, Overseas Branch, UBI) Mr. P.D.Talekar (Senior Manager, Dept. of Agri Business, UBI) for explaining various intricacies related to International Trade Finance. Lastly, I convey my heartfelt thanks to the entire staff of UBI, Overseas Branch, Nariman Point, for their co-operation during my project work. I want to also thank my friends, colleagues and parents who have directly or indirectly helped me out in the completion of my project.

CHIRAG SHAH ISFS 0024

Executive summary

Risk management in banking designates the entire set of risk management processes and models allowing banks to implement risk-based policies and practices. They cover all techniques and management tools required for measuring, monitoring and controlling risks. The spectrum of models and processes extends to all risks: credit risk, market risk, interest rate risk, liquidity risk and operational risk, to mention only major areas. Broadly speaking, risk designates any uncertainty that might trigger losses. Risk-based policies and practices have a common goal: enhancing the riskreturn profile of the bank portfolio. The innovation in this area is the gradual extension of new quantified risk measures to all categories of risks, providing new views on risks, in addition to qualitative indicators of risks. Current risks are tomorrows potential losses. Still, they are not as visible as tangible revenues and costs are. Risk measurement is a conceptual and a practical challenge, which probably explains why risk management suffered from a lack of credible measures. The recent period has seen the emergence of a number of models and of risk management tools for quantifying and monitoring risks. Such tools enhance considerably the views on risks and provide the ability to control them.

Now, talking about Risk management in International Trade Finance, it has got considerable importance these days because of the following reasons: Sub prime crisis in USA leading to extreme exchange rate fluctuations: 01/08/2006 Rs. 46.65/$ 07/11/2007 Rs. 39.27/$ 16/07/2008 Rs. 43.17/$

Oil Price Shock: Feb 2008 $135.55/bbl July 2006 - $ 95.15/bbl

11.91% inflation for the week ended 05/07/2008

Sometimes it is very tough for RBI to control inflation because the cause of it is not in its hands i.e. oil price shock (reaching $145.17/bbl). It is evident from the steps that are not materializing taken by RBI such as increasing the MSS slab, raising CRR to 8.75%, raising Repo rate to 8.50% and other special market operations due to which it had to encourage fiscal steps such as free import custom duties, ban on certain export products, ban on certain export future contracts, etc. This leads trouble for both the Indian Banks and the exporters. The banks raise rates of advances due to the above steps taken by the RBI and the exporters have to suffer losses due to the exchange rate appreciation (volatility has increased a lot).

So, to study the above risks in international trade finance plus how it is controlled is my objective of doing this project. This project considers and includes various departments like Export, Import, Advances, and Guarantees and the risk management tools used for hedging its exposure.

Due to RBIs steps, interest rates have become very volatile, so a study is included about the interest rate volatility and its impact on profitability of the bank through a GAP analysis.

As any bank in this world faces default risk, a study is included about how the banks quantify and reduce such credit risk (a credit rating model is used in this chapter to find out its effectiveness).

In addition an effort is made to find out can ALTMANs Z SCORE MODEL for public listed companies can be INDIANSED or not? For which a sample of 30 companies have been considered which have already defaulted and their financial results of past years have been used to find out whether it can be known that the company is going to default or not?

Another characteristic of this project report is that after every chapter it concludes with a Value Added Note (VAN) which explains various basic terms included in the chapter and current scenario changes that have taken place and its implications on Indian Banks Trade finance department.

RISK MANAGEMENT IN INTERNATIONAL TRADE FINANCE

INDEX Sr. no. 1. Risk & its types


Introduction Types of Risks Value Added Notes (VAN) Types of Exposure in Forex

Chapters

Page no.
13 13 14 22

2.

Risk Management in Banking


Risk Management RBI guidelines Need of Risk Management in Banks Risk Control Measures VAN FEDAI Guidelines for Foreign Exchange

24 24 26 28 30 31

3.

International Trade Finance


Introduction to International Trade Current Scenario of Indias International Trade Indias BoP position UBI & its Overseas Branch Incoterms 2000 International Trade Documents involved VAN LERMS

33 34 35 38 39 41 44 52

4.

Risk Management in Import Advances


Introduction Letter of Credit (L/C) How the L/C operates? Parties to an L/C Types of L/C Risk associated with opening Import L/Cs Risk Management Tools used Documents involved Forward Contracts UBIs Export Import Performance VAN Capital Account Convertibility of Indian Rupee

53 53 54 54 55 56 57 58 62 66 67

5.

Risk Management in Export Finance


Pre shipment Finance Features of Pre shipment finance Types of Pre shipment finance Post shipment finance Features of Post shipment finance Types of Post shipment Finance Risk Management tools used WTPCG scheme Forward Purchase Contract SWAPs VAN Relief to Exporters for a while?

68 68 68 69 71 71 72 74 76 77 82

10

6.

Risk Management in issuing Guarantees


Introduction Benefits of Bank Guarantees Types of Bank Guarantees How to apply for Bank Guarantees Bank Guarantee V/s. L/C UBI An overview of issued L/C & L/G Risk Management Tools used VAN How the Importers use Buyers Credit for their own Advantage?

83 83 84 84 86 87 87 88 90

7.

Risk Management in Granting Advances


Introduction Credit Rating Model Calculating Loan Amount VAN Format of evaluation of Companies followed before granting a loan

92 92 94 101 101

8.

Interest Rate volatility and its impact on Profitability GAP Analysis


Why interest rates are so volatile in India? GAP analysis Observations Generalizations Suggestions Outcome VAN Deposit rates of Indian banks a comparative study

102 102 103 105 105 106 106 107

11

9.

Indianising Altmans Z score Model A study


Introduction A short Z score History Z score Ingredients Z score Original Model Objective of the study Study Method Data Source Analysis of the study Findings Problem faced Criticisms Outcome

108 108 109 110 111 112 112 113 113 114 114 115 116

Conclusion

117

References

119

12

Chapter 1 Risk & its Types

Risk is the only constant, Uncertainty is the only certainty.

Risk is a concept that denotes a potential negative impact to some characteristic of value that may arise from a future event. Exposure to the consequences of uncertainty constitutes a risk. In everyday usage, risk is often used synonymously with the probability of a known loss. (Definition from dictionary: The possibility of suffering harm or loss; danger.) Risk can be explained as an uncertainty and is usually associated with the unpredictability of an investment performance. All investments are subject to risk, but some have a greater degree of risk than others. Risk is often viewed as the potential for an investment to decrease in value. Though quantitative analysis plays a significant role, experience, market knowledge and judgment play a key role in proper risk management. As complexity of Financial Products increased, so do the sophistication of the Risk Managers tools. We understand risk as a potential future loss. When we take an insurance cover, what we are hedging is the uncertainty associated with the future events. Financial risk can be easily stated as the potential for future cash flows (returns) to deviate from expected cash flows (returns).

13

TYPES OF RISKS: Identifying and classifying risk types are critical components of a fully functional risk and capital management framework. Board and senior management may not be able to efficiently perform risk management activities without clearly defined risk categories that are aligned with business needs. In parallel, certain bottom-up risk management analytical activities require guidance to appropriately identify measure, monitor and report key individual risks.

Liquidity

Interest rate

Foreign Exchange

Banking Risks

Operations

Credit

Market

Other risks: Country Risk, Settlement Risk, Performance Risk, etc.

14

Risks borne by banks:

Liquidity Risk

Liquidity risk is the potential inability of a bank to generate sufficient cash to meet its normal operating requirements (cash expenses and repayment of short term liabilities). A mismatch in the assets and liabilities causes a bank to have a liquidity risk. A bank often promises greater liquidity in its liabilities than its assets can provide directly. To deal with such contingencies, a bank must have sources of liquidity ways it can lay its hands on cash whenever it needs it. However, excess liquidity is also costly for the bank because idle cash carries a cost as the bank pays interest on its deposits. So, banks seek to achieve reasonable trade-off between overt liquidity and relatively illiquidity.

Interest Rate Risk

Interest rate risk is the risk of an adverse effect of interest rate movements on a bank's profits or balance sheet. Interest rates affect a bank in two ways - by affecting the profits and by affecting the value of its assets or liabilities. If the money borrowed is on floating rate basis the bank faces the risk of lower profits in an increasing interest rate scenario. Similarly fixed rate assets face the risk of lower value of investments in an increasing interest rate scenario. Interest rate risk becomes prominent when the assets and liabilities of the bank do not match in their exposure to interest rate movements. In general, IRR has the potential to reduce a bank's earnings and lower its net worth. IRR manifests in several different ways but a simplified example can be taken to illustrate the general issue. The most common manifestation of IRR occurs because the assets of the banks, such as the loans it holds, gets due or matures at a different time than the liabilities of the bank, such as deposits.

15

Take, for example, a bank that funds itself only with certificates of deposit that have a maturity of two years. This bank supposes grants only mortgage loans with a maturity of 15 years. If the interest rates rise in the future, the bank would face a decline in its expected income. Why? The monthly inflow of cash to the bank from the mortgages is fixed for 15 years. When the certificates of deposit are due before the mortgages, the bank will have to pay more to receive funding so cash flows out of the bank will increase. Clearly IRR holds the potential to have a negative impact on earnings and net worth of a bank. So why don't banks try to eliminate it by ensuring that all of its assets and liabilities have exactly the same maturities? Banks would earn less money without taking on this risk. By earning the difference between long-term and short-term rates, for example, banks are getting paid to assume IRR and meet the demands of customers for deposits and loans. The challenge for banks is to measure IRR and manage it such that the compensation they receive is adequate for the risks they incur. Regulators and banks employ a variety of different techniques to measure IRR. A relatively simple method used by many community banks is gap analysis, which involves grouping assets and liabilities by their maturity period, or the time period over which the interest rate will change (the "repricing period"), such as less than three months, three months to one year, etc. The "gap" for each category is then expressed as the dollar value of assets minus liabilities. A large, negative gap would indicate that the bank has a greater amount of liabilities that are repricing during that time than assets, and therefore would be exposed to an increase in rates. A negative gap would suggest an exposure to a decline in rates. Regulatory agencies often employ a slightly more complex version of gap analysis to estimate the level of IRR for a bank and for the entire banking industry. This technique involves estimating the change in the value of assets and liabilities within each time band at a given institution for a change in interest rate (for example, up 2 percentage points) and then calculating the aggregate difference between the two. This amount roughly represents the loss in net worth a bank would suffer if interest rates moved unexpectedly.

16

Consider a hypothetical bank with Rs.80 Crore in assets, Rs.60 Crore of it in liabilities and Rs.20 Crore in equity capital. Following a 2 percentage point increase in interest rates, the asset value of the bank drops to RS.70 Crore while the value of liabilities falls to Rs.55 Crore. The change in net worth for this bank would be negative Rs.5 Crore, implying that equity capital is worth only Rs.15 Crore. Typically, the net change in economic value is expressed as a percentage of assets. Foreign Exchange Risk

Foreign Exchange Risk is the chance that a fluctuation in the exchange rate will change the profitability of a transaction from its expected value. It is the risk that arises due to unanticipated changes in exchange rates, which arises due to the presence of multi-currency assets and liabilities in a banks balance sheet. Fluctuations occur over the medium and long-term and also during a dealing session on a moment-to-moment basis. Foreign exchange exposure in a bank might arise due to the operations of the treasury (the dealing room) or due to unmatched assets and liabilities (in terms of currency and maturity) on the balance sheet. In addition, banks making markets and dealing in currency forwards, swaps and options take on foreign exchange exposure and relevant risks. Foreign exchange operations of a bank can function properly only if the risks associated with such operations are correctly identified and measures are taken to manage / limit those risks.

Operational Risk:

Operations Risk encompasses the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Operational risk, which can have more far-reaching effects on a company than other risks, includes the following: Business risk Legal risk Compliance risk Tax risk Fraud risk Processing and administrative risk

17

Physical asset risk Human Resource risk Facility risk Mis-selling risk.

Operational risk is especially difficult to quantify because robust and objective quantitative data is neither readily nor consistently available in many organizations. Operations risk is the risk that deficiencies in information systems or internal controls will result in unexpected loss. This risk is associated with human error, system failures and inadequate procedures and controls. Operations Risk exists for any organization arising out of day-to-day business activities. The operations risk that a bank faces includes the risk of fraud, theft, etc. To counter these risks, the banks have to maintain strict vigil and have to have tight control systems. This becomes very important due to the fact that the bank is basically investing somebody else's money. The banks typically operate by having employee specific exposure limits to ensure that the risk taken by the bank is not too much. There exists a risk of the mismatch in the risk taking ability of the organization as a whole (as decided by the top management) and that of the employee who is actually handling operations, which can lead to problems.

Credit Risk

Credit risk or default risk involves inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, hedging, settlement and other financial transactions. The credit risk of a banks portfolio depends on both external and internal factors. The external factors are the state of the economy, wide swings in commodity/equity prices, foreign exchange rates and interest rates, trade restrictions, economic sanctions, Government policies, etc. The internal factors are deficiencies in loan policies/administration, absence of prudential credit concentration limits, inadequately defined lending limits for Loan Officers/Credit Committees, deficiencies in appraisal of borrowers financial position, excessive dependence on collaterals and inadequate risk pricing, absence of loan review mechanism and post sanction surveillance, etc.

18

As per the RBI Guidance Note, October 2002 Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counter parties. In a banks portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality. Credit risk emanates from a banks dealings with an individual, corporate, bank, financial institution or a sovereign.

Credit risk may take the following forms: 1. In the case of direct lending: principal/and or interest amount may not be repaid; 2. In the case of guarantees or letters of credit: funds may not be forthcoming from the constituents upon crystallization of the liability; 3. In the case of treasury operations: the payment or series of payments due from the counter parties under the respective contracts may not be forthcoming or ceases; 4. In the case of securities trading businesses: funds/ securities settlement may not be effected; 5. In the case of cross-border exposure: the availability and free transfer of foreign currency funds may either cease or restrictions may be imposed by the sovereign. In this backdrop, it is imperative that banks have a robust credit risk management system, which is sensitive and responsive to these factors. The effective management of credit risk is a critical component of comprehensive risk management and is essential for the long-term success of any banking organization.

19

Other Risks

Country Risk Country risk is, loosely speaking, the risk of a crisis in a country. There are many risks related to local crises, including: Sovereign risk, which is the risk of default of sovereign issuers, such as central

banks or government sponsored banks. The risk of default often refers to that of debt restructuring for countries. A deterioration of the economic conditions - This might lead to a deterioration of

the credit standing of local obligors, beyond what it should be under normal conditions. Indeed, firms default frequencies increase when economic conditions deteriorate. A deterioration of the value of the local foreign currency in terms of the banks

base currency The impossibility of transferring funds from the country, either because there are legal restrictions imposed locally or because the currency is not convertible any more. Convertibility or transfer risks are common and restrictive definitions of country risks. A market crisis triggering large losses for those holding exposures in the local markets. A common practice stipulates that country risk is a floor for the risk of a local borrower, or equivalently, that the country rating caps local borrowers rating. In general, country ratings serve as benchmarks for corporate and banking entities. The rationale is that, if transfers become impossible, the risk materializes for all corporates in the country. There are debates around such rules, since the intrinsic credit standing of a borrower is not necessarily lower than on that of the country.

20

Performance Risk Performance risk exists when the transaction risk depends more on how the borrower performs for specific projects or operations than on its overall credit standing. Performance risk appears notably when dealing with commodities. As long as delivery of commodities occurs, what the borrower does has little importance. Performance risk is transactional because it relates to a specific transaction. Moreover, commodities shift from one owner to another during transportation. The lender is at risk with each one of them sequentially. Risk remains more transactionrelated than related to the various owners because the commodity value backs the transaction. Sometimes, oil is a major export, which becomes even more strategic in the event of an economic crisis, making the financing of the commodity immune to country risk. In fact, a country risk increase has the paradoxical effect of decreasing the risk of the transaction because exports improve the country credit standing.

21

Value Added Notes

Types of Exposure in Forex Exposures may be broadly classified into 3 groups: Transaction Exposure: It is the exposure due to the trade (Current Account) transactions. Main factor is the volatility of exchange rates. It can be covered through forward contracts or futures or options. The value of a firms cash inflows received in various currencies will be affected by respective exchange rates of these currencies when converted into the currency desired. Similarly, value of a firms cash outflows in various currencies will be dependent on the respective exchange rates of these currencies. The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure. Illustration: An Indian Exporter exports to the US and agrees to invoice in USD, say $1 million. At the time of receipt of order the exchange rate was Rs. 46.50 $. Then he expects Rupee value of this order at Rs. 4, 65, 00,000. If the Rupee is likely to strengthen during the period of completion of order, say Rs. 45.30 $, then the exporter is exposed to forex risk because of this transaction. The Rupee value of the order would be Rs. 4, 53, 00,000, thus a potential loss of Rs. 12 lakh. If he had agreed to invoice in Rupees then he would not have any forex exposure. However, the US importer would have to pay more than 1 million dollars in dollar terms. Thus now the US importer would face the exposure, instead of the Indian exporter.

Economic Exposure: It is the exposure due to setting up a factory or such long term investment, FDI. It is an exposure in Capital Account. It cannot be covered fully. The degree to which a firms present value of future cash flows can be influenced by exchange rate fluctuations is referred to as economic exposure to exchange rates. It thus is a comprehensive effect of potential transaction exposures on the project investment of an MNC.

22

Illustration: If an Australian MNC would setup a manufacturing facility in India as a subsidiary, then there will be regular transactions between the parent company and the subsidiary. There will be a series of transaction exposures on either account, each time they transact. As a result of such potential exposures, the entire investment proposal, the project, itself is vulnerable to investments risk. This is an exposure related to future cash flows, called as Economic Exposure.

Translation Exposure: It is an Accounting exposure. While MNCs consolidate their balance sheets, this exposure is noticed. Its a notional exposure. The exposure of MNCs consolidated financial statements to exchange rate fluctuations is known as Translation exposure. Foreign currency assets, liabilities, revenues and expenses that are consolidated at current exchange rates into parent-currency-denominated group financial statements. Thus in accounting terms, at the time of finalization of accounts, value considered is at prevailing exchange rates. However, these values in accounts would change over the period because of changes in exchange rates. These changes would happen without any trading or speculative action whatsoever. Hence it is an exposure related to translation of one currency value to another in accounting process.

23

Chapter 2 Risk Management in Banking

"If you can't afford to take a risk, then you can't afford to compete." - former Chrysler chairman Lee Iacocca

Risk Management

Risk is anything that threatens the ability of a nonprofit to accomplish its mission. Risk management is a discipline that enables people and organizations to cope with uncertainty by taking steps to protect its vital assets and resources. But not all risks are created equal. Risk management is not just about identifying risks; it is about learning to weigh various risks and making decisions about which risks deserve immediate attention. Risk management is a process that, once understood, should be integrated into all aspects of your organization's management. Risk management is an essential component in the successful management of any project, whatever its size. It is a process that must start from the inception of the project, and continue until the project is completed and its expected benefits realized. Risk management is a process that is used throughout a project and its products' life cycles. It is useable by all activities in a project. Risk management must be focused on the areas of highest risk within the project, with continual monitoring of other areas of the project to identify any new or changing risks. Risk Management is the process of measuring risk and then developing and implementing strategies to manage that risk. Financial risk management focuses on risks that can be managed ("hedged") using traded financial instruments (typically changes in commodity prices, interest rates, foreign exchange rates and stock prices). All large corporations have risk management teams, and small firms practice informal, if not formal, risk management.

24

Two distinct view points emerge - one which is about managing risks, maximizing profitability and creating opportunity out of risks and the other which is about minimizing risks/loss and protecting corporate assets. The management of an organization needs to consciously decide on whether they want their risk management function to 'manage' or 'mitigate' risks. Managing risks essentially is about striking the right balance between different risks and its efficient control and taking informed management decisions on opportunities and threats facing an organization. Both situations, i.e. over or under controlling risks are highly undesirable as the former means higher costs and the latter means possible exposure to risk. Derivatives are the instruments most commonly used in Financial Risk Management. Because unique derivative contracts tend to be costly to create and monitor, the most cost-effective financial risk management methods usually involve derivatives that trade on well-established Financial Markets. These standard derivative instruments include options, futures contracts, forward contracts, and swaps. The most important element of managing risk is keeping losses small, which is already part of your trading plan. Risk can be explained as uncertainty and is usually associated with the unpredictability of an investment performance. All investments are subject to risk, but some have a greater degree of risk than others. Risk is often viewed as the potential for an investment to decrease in value.

Managing risk: There are four ways of dealing with, or managing, each risk that you have identified. You can:

Accept it Transfer it Reduce it Eliminate it

25

For example, you may decide to accept a risk because the cost of eliminating it completely is too high. You might decide to transfer the risk, which is typically done with insurance. Or you may be able to reduce the risk by introducing new safety measures or eliminate it completely by changing the way you produce your product. When you have evaluated and agreed on the actions and procedures to reduce the risk, these measures need to be put in place. Risk management is not a one-off exercise. Continuous monitoring and reviewing is crucial for the success of risk management process. Such monitoring ensures that risks have been correctly identified and assessed, and appropriate controls are put in place. It is also a way to learn from experience and make improvements to your risk management approach. All of this can be formalized in a risk management policy, setting out your business' approach to and appetite for risk and its approach to risk management. Risk management will be even more effective if you clearly assign responsibility for it to selected employees. It is also a good idea to get commitment for risk management at the board level. Contrary to conventional wisdom, risk management is not just a matter of running through numbers. Though quantitative analysis plays a significant role, experience, market knowledge and judgment play a key role in proper risk management. As complexity of financial products increase, so do the sophistication of the risk manager's tools. RBI guidelines Banks in the process of financial intermediation are confronted with various kinds of financial and non-financial risks viz., credit, interest rate, foreign exchange rate, liquidity, equity price, commodity price, legal, regulatory, reputational, operational, etc. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. It therefore becomes very essential for top management of banks to attach considerable importance to improve the ability to identify measure, monitor and control the overall level of risks undertaken. This is a new development in Indian Banking. All these decades before the advent of Reforms the exercise of risk assessment and risk management were never seriously considered or attempted, as the banks were operating in a captive economy.

26

With liberalization in Indian financial markets over the last few years and growing integration of domestic markets and with external markets, the risks associated with banks' operations have become complex and large, requiring strategic management. Banks are now operating in a fairly deregulated environment and are required to determine on their own, interest rates on deposits and advance in both domestic and foreign currencies on a dynamic basis. The interest rates on banks' investments in government and other securities are also now market related. Intense competition for business involving both the assets and liabilities, together with increasing volatility in the domestic interest rates as well as foreign exchange rates, has brought pressure on the management of banks to maintain a good balance among spreads, profitability and long-term viability. Imprudent liquidity management can put banks' earnings and reputation at great risk. These pressures call for structured and comprehensive measures and not just ad hoc action. The Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. Banks are exposed to several major risks in the course of their business - credit risk, interest rate risk, foreign exchange risk, equity / commodity price risk, liquidity risk and operational risk. It is, therefore, important that banks introduce effective risk management systems that address the issues related to interest rate, currency and liquidity risks. Since the year 1998 RBI has been giving serious efforts and attention towards evolving suitable and comprehensive models for Risk-management by the Banks and to integrate this new discipline in the working systems of the Banks. RBI has defined that the broad parameters of risk management function should encompass: 1. organizational structure; 2. comprehensive risk measurement approach; 3. risk management policies approved by the Board which should be consistent with the broader business strategies, capital strength, management expertise and overall willingness to assume risk; 4. guidelines and other parameters used to govern risk taking including detailed structure of prudential limits; 5. strong MIS for reporting, monitoring and controlling risks; 6. well laid out procedures, effective control and comprehensive risk reporting framework;

27

7. separate

risk

management

framework

independent

of

operational

Departments and with clear delineation of levels of responsibility for management of risk; and 8. periodical review and evaluation In terms of this objective to provide risk-management tools and strategies to the commercial banks, RBI has been formulating a number of guidelines since 1998, to cover each type of risk, like Asset Liability Risk, Credit Risk, Market Risk, Country Risk etc.

NEED OF RISK MANAGEMENT IN BANKS Assumption and management of risk is the very essence of Banking and any other financial institutions business. Risk here refers to the sensitivity of a Bank's or the Institutions profitability to spatial and temporal dispersion of market parameters (e.g. interest rates, exchange rates, loan default, etc.) around their expected values. Globalization, liberalization and deregulation of financial markets have resulted in enhanced volatility in interest and exchange rates, rapid growth of innovations and a reduction in barriers relating to business diversification. All of this has been aided by rapid technological development. Consequently, the risks in financial markets and availability of instruments to analyze / manage them have multiplied. A typical Bank accepts large number of short-term deposits and tries to lend medium to long-term. The leftover money is used for investment purposes. Thus, a bank has deposits and equity on liability side and loans and investments on assets side of its balance sheet. The value of each of these components is subject to uncertainties. For Financial Institutions and Corporations, asset and liability management includes those activities that attempt to control exposure to financial and other price risks. The main purpose of asset and liability management is to make the consideration of risk explicit in the planning process and to enable decision makers to control risk exposure.

28

Any entity or investment project is bound to be exposed to price risks, and investment planning always involves assumptions about the movements of these prices. It aims at controlling the variability of future cash flows. Banks examine the risk exposure of their assets and liabilities to borrowers' default rates and future asset price movements to obtain a summary of their risk exposure profile. By entering into a set of financial transactions, they attempt to minimize any unexpected decline in profits. While importance of these activities has been broadly recognized in the developed countries, applications to the banks in countries like India have been limited. As part of the primary activity of financial intermediation, banks borrow and lend money. The price at which these funds are made available depends essentially on two parameters the time for which the funds are made available and the creditworthiness of the person to whom the funds are made available. Considering that the long-term funds are priced higher than short-term funds and a high-risk borrower pays high interest rate, banks will have to take liquidity risk or credit risk to earn the spreads. However, in the process of earning spreads, banks cannot enhance their risks beyond a certain manageable level. Risk manifest themselves in many ways and the risks in banking are a result of many diverse activities, executed from many locations, and by numerous people. The volatile nature of the banks operating environment will aggravate the effect of these risks.

29

Risk Control Measures Risk management identifies future risks in order to plan control measures to prevent its occurrence, or to control the extent of damage, if it were to occur. Obtaining insurance cover is a generally followed risk covering method against all known and identifiable risks, like loss in transit of goods in domestic trade, political and commercial risks in export business, fire-risks etc. Financial risks are covered by a process known as hedging. Hedging helps to reduce risks associated with market exposure by taking a counter position in the futures market, i.e. buy stock, sell Nifty futures etc. The development of derivatives market is a device for hedging different kinds of financial risks. Another innovative tool for hedging financial risks is called "Interest-rate-swaps". This is explained as under. The Corporations in which individual investors place their money have exposure to fluctuations in all kinds of financial prices, as a natural consequence of their operations. Financial prices include foreign exchange rates, interest rates, commodity prices and injustice prices. The changes in the financial prices cause uncertainty in the projected revenues to the corporate sector. And the companies often attribute the cause in decline in incomes to falling commodity prices, raising interest rates, declining home currency value. Necessity is the mother of invention. Human quest to find the solution continues. In this process various financial instruments were invented. Interest rate swap is one of the risk tools that helps the corporate to hedge from uncertainties of the interest rate fluctuations. The Reserve Bank of India has taken a bold step towards rupee derivative trading allowing banks/financial institutions to hedge against interest rate risks through the use of interest rate swaps and forward rate agreements. Similarly the risk of exchange-rate fluctuations can be covered by entering into forward contract for buying/selling the foreign currency.

30

Value Added Notes

FEDAI Guidelines for Foreign Exchange


Established in 1958, FEDAI (Foreign Exchange Dealers' Association of India) is a group of banks that deals in foreign exchange in India as a self regulatory body under the Section 25 of the Indian Company Act (1956). The role and responsibilities of FEDAI are as follows: 1. Formulations of FEDAI guidelines and FEDAI rules for Forex business. 2. Training of bank personnel in the areas of Foreign Exchange Business. 3. Accreditation of Forex Brokers. 4. Advising/Assisting member banks in settling issues/matters in their dealings. 5. Represent member banks on Government/Reserve Bank of India and other bodies. 6. Rules of FEDAI also include announcement of daily and periodical rates to its member banks. FEDAI guidelines play an important role in the functioning of the markets and work in close coordination with Reserve Bank of India (RBI), other organizations like Fixed Income Money Market and Derivatives Association (FIMMDA), the Forex Association of India and various other market participants.

31

Chapter 3 International Trade Finance ...the only means to well-being is to increase the quantity of products. This is what business aims at. - Ludvig von mises
Lets first understand International trade. International Trade is the exchange of capital, goods and services across international boundaries or territories. In most countries, it represents a significant share of GDP. While international trade has been present throughout much of history, its economic, social, and political importance has been on the rise in recent centuries. Industrialization, advanced transportation, globalization, multinational corporations, and outsourcing are all having a major impact on the international trade system. Increasing international trade is crucial to the continuance of globalization. International trade is a major source of economic revenue for any nation that is considered a world power. Without international trade, nations would be limited to the goods and services produced within their own borders. International trade is in principle not different from domestic trade as the motivation and the behavior of parties involved in a trade does not change fundamentally depending on whether trade is across a border or not. The main difference is that international trade is typically more costly than domestic trade. The reason is that a border typically imposes additional costs such as tariffs, time costs due to border delays and costs associated with country differences such as language, the legal system or a different culture. Another difference between domestic and international trade is that factors of production such as capital and labor are typically more mobile within a country than across countries. Thus international trade is mostly restricted to trade in goods and services, and only to a lesser extent to trade in capital, labor or other factors of production. Then trade in good and services can serve as a substitute for trade in factors of production. Instead of importing the factor of production a country can import goods that make intensive use of the factor of production and are thus embodying the respective factor. An example is the import of labor-intensive goods

32

by the United States from China. Instead of importing Chinese labor the United States is importing goods from China that were produced with Chinese labor. International trade is also a branch of economics, which, together with international finance, forms the larger branch of international economics. Current Scenario of Indias International Trade Lets now understand the exchange rate scenario of INR/USD and its relationship with and impact on Indias international trade As you can observe below from the chart, INR was appreciating against USD and reached a record level of 39.27 on 07/11/2007. It is because at that time US was feeling the pinch of sub prime crisis and was facing recession while India on the other hand was having a growing GDP, booming markets and inflation below the tolerance level of 5%.

But when INR appreciated at such levels exporters were adversely affected and importers were enjoying such appreciation of INR because importers were now able to get USD at a much lower rate which meant cheap imports but at the cost of domestic manufacturers. On the other hand exporters who had booked the contracts in terms of USD (when USD/INR was at Rs. 44-45 levels) they got the contract amount in USD but got lesser INR because of such appreciation and exporters who had huge forex exposure were badly affected.

33

RBI was also feeling the pinch as it was holding huge forex reserves. So to control the situation it was: Indulging in purchasing more and more forex reserves, so that the demand for USD increases and it starts appreciating again;

Extending the DEPB scheme so that exporters capital is not locked up; Reducing interest rate for exporters up to 2%; Open Market operations.

34

But now the situation is totally reversed. Inflation is at record highs. It has crossed the double digit figure and stands at 11.63% for the week ended 21st June, 2008.

It can be observed that when INR was appreciating (against USD); inflation was under the tolerance level of 5%. But when the INR started depreciating inflation rate increased drastically. Another reason for increasing inflation is the surging oil prices posing a threat to break the psychological barrier of $150/barrel (currently above $140/barrel).

35

Due to which oil marketing companies like Indian Oil Corporation Ltd., Bharat Petroleum and Hindustan Petroleum are feeling the heat and are facing trouble. For this purpose, petrol price were increased by Rs. 4, diesel by Rs. 2 and LPG cylinder by Rs. 50. It has also been announced to issue more oil bonds for oil marketing companies. RBI has also increased the repo rate to 9% and CRR to 9% in addition to the steps mentioned earlier. RBI states that it will be able to bring inflation down to 7% by the end of March, 2009. Despite, it is predicted that inflation will remain in 2 digits at the end of of March, 2009.

36

Indias BoP position Now having understood the impact of exchange rates on international trade and the economy at large lets look at the BoP (Balance of Payment) position of India.

Major Items of India's Balance of Payments (US $ million) Item 1. Exports 2. Imports 3. Trade Balance (1-2) 4. Invisibles, net 5. Current Account Balance (3+4) 6. Capital Account* 7. Change in Reserves# (- Indicates increase) *: Including errors and omissions. #: On BoP basis excluding valuation. P: Preliminary. PR: Partially Revised. R: Revised 2007-08P 2006-07PR 2005-06R 158,461 248,521 -90,060 72,657 -17,403 109,567 -92,164 128,083 191,254 -63,171 53,405 -9,766 46,372 -36,606 105,152 157,056 -51,904 42,002 -9,902 24,954 -15,052

There is a sharp rise in trade deficit (7.7% of GDP in 2007-08 from 6.9% in 2006-07). Also there has been a significant increase in invisible surplus led by remittances from overseas Indians and software services. As you can observe current account deficit has almost doubled showing the signs of increasing imports at a much higher rate than that of exports. (yoy)

37

38

Union Bank of India & its Overseas Department UNION BANK OF INDIA was inaugurated by none other than the Father of the Nation, Mahatma Gandhi. Since that the golden moment, Union Bank of India has this far unflinchingly traveled the arduous road to successful banking . a journey that spans 88 years. Union Bank of India is firmly committed to consolidating and maintaining its identity as a leading, innovative commercial Bank, with a proactive approach to the changing needs of the society. This has resulted in a wide gamut of products and services, made available to its valuable clientele in catering to the smallest of their needs. Today, with its efficient, value-added services, sustained growth, consistent profitability and development of new technologies, Union Bank has ensured complete customer delight, living up to its image of, GOOD PEOPLE TO BANK WITH. Anticipative banking- the ability to gauge the customer's needs well ahead of realtime - forms the vital ingredient in value-based services to effectively reduce the gap between expectations and deliverables. The key to the success of any organization lies with its people. Union Bank's family comprises of about 26,000 qualified / skilled employees. Union Bank is a Public Sector Unit with 55.43% Share Capital held by the Government of India. The Bank came out with its Initial Public Offer (IPO) in August 20, 2002 and Follow on Public Offer in February 2006. Presently 44.57 % of Share Capital is presently held by Institutions, Individuals and Others.

Over the years, the Bank has earned the reputation of being a techno-savvy and is a front runner among public sector banks in modern-day banking trends. It is one of the pioneer public sector banks, which launched Core Banking Solution in 2002. And now it has succeeded in becoming a 100% CBS networking Bank. Under this solution umbrella, All Branches of the Bank have been 1135 networked ATMs, with online Telebanking facility made available to all its Core Banking Customers individual as well as corporate. In addition to this, the versatile Internet Banking provides extensive information pertaining to accounts and facets of banking. Regular banking services apart, the customer can also avail of a variety of other value-added services like Cash Management Service, Insurance, Mutual Funds and Demat.

39

The Bank will ever strive in its endeavor to provide services to its customer and enhance its businesses thereby fulfilling its vision of becoming THE BANK OF FIRST CHOICE IN OUR CHOSEN AREA BY BUILDING BENEFICIAL AND LASTING RELATIONSHIP WITH CUSTOMERS THROUGH A PROCESS OF CONTINUOUS IMPROVEMENT. The overseas department of UBI consists of the following departments: 1. Exports 2. Imports 3. Guarantees 4. Remittances 5. Advances There are more than 90 clients in the overseas department of UBI. It consist both domestic trade finance and international trade finance. There are around 20 employees working in the different departments mentioned above. The entire branch mainly is in performing day to day operational work. Its client base includes many jewellery/diamond export/import firms. Later we will learn more about the above fields and how they handle the risks involved in it. In short we will learn about the risk management techniques used in these different departments.

40

Inco terms 2000 - International Commercial Terms used in Export Import Objectives Incoterms are internationally accepted commercial terms, developed in 1936 by the International Chamber of Commerce (ICC) in Paris. Incoterms 2000 define the respective roles of the buyer and seller in the agreement of transportation and other responsibilities and clarify when the ownership of the merchandise takes place. These terms are incorporated into export-import sales agreements and contracts worldwide and are a necessary part of foreign trade. Incoterms are used in union with a sales agreement or other methods of sales transactions and define the responsibilities and obligations of both, the exporter and importer in Foreign Trade Transactions. The main objectives of Incoterms 2000 revolve around the contract of Foreign Trade concerned with the loading, transport, insurance and delivery transactions. Its main function is the distribution of goods and regulation of transport charges. Another significant role played by Incoterms is to identify and define the place of transfer and the transport risks involved in order to justify the ownership for support and damage of goods by shipments sent by the seller or the buyer in an event of execution of transport. Incoterms make international trade easier and help traders in different countries to understand one another. These International Commercial Terms are the most widely used international contracts protected by the ICC copyright.

Incoterms safeguard the following issues in the Foreign Trade contract or International Trade Contract: 1. To determine the critical point of the transfer of the risks of the seller to the buyer in the process forwarding of the goods (risks of loss, deterioration, robbery of the goods) allow the person who supports these risks to make arrangements in particular in term of insurance. 2. To specify who is going to subscribe the contract of carriage that is to say the seller (exporter) or the buyer (importer).

41

3. To distribute between the seller and the buyer the logistic and administrative expenses at the various stages of the process. 4. It is important to define who is responsible for packaging, marking, operations of handling, loading and unloading, inspection of the goods. 5. Need To confirm and fix respective obligations for the achievement of the formalities of exportation and importation, the payment of the rights and taxes of importation as well as the sending of the documents. In dealing Foreign Trade there are 13 Incoterms globally adopted by the International Chamber of Commerce.

INTERNATIONAL INCOTERMS Incoterms or International commercial terms make trade between different countries easier. International Commercial Terms are a series of international trade terms that are used are used worldwide to divide he transaction costs and responsibilities between the seller and the buyer and reflect state-of-the-art transportation practices. Incoterms directly deal with the questions related to the delivery of the products from the seller to the buyer. This includes the carriage of products, export and import responsibilities, who pays for what and who has the risk for the condition of the products at different locations within the transport process.

Incoterms and world customs Incoterms deal with the various trade transactions all over the world and clearly distinguish between the respective responsibilities of the seller and the buyers.

42

The 13 International Incoterms are:


EXW FCA FAS Free FOB Free CFR Cost CIF Cost Insura nce CPT Carri age CIP Carria ge Insura nce Paid To Seller DAF Deliver ed At DES DEQ Deliver Deliver ed ed Ship Ex Deliver Deliver ed Duty ed Duty Unpaid Paid DDU DDP

SERVICE S

Ex

Free

Work Carri s er

Along Onbo & side Ship ard Freig

& Paid

Frontie r

Ex Quay Duty Unpaid

Vessel ht

Freight To

Warehouse Storage Warehouse Labor Export Packing Loading Charges

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Buyer Seller Buyer/

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Inland Freight

Buyer Seller *

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Terminal Charges Forwarder's Fees Loading On Vessel Ocean/Air Freight Charges On Arrival

Buyer Buyer Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Buyer Buyer Buyer Buyer Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Buyer Buyer Buyer Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Buyer Buyer Buyer Buyer Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

Seller

At Buyer

Buyer Buyer Buyer Buyer Buyer

Seller

Seller

Buyer

Buyer

Seller

Seller

Seller

Destination Duty, Taxes & Customs Buyer Clearance Delivery To Destination

Buyer Buyer Buyer Buyer Buyer

Buyer Buyer

Buyer

Buyer

Buyer

Buyer

Seller

Buyer Buyer Buyer Buyer Buyer Buyer

Buyer Buyer

Buyer

Buyer

Buyer

Seller

Seller

Source: www.i-b-t.net * There are actually two FCA terms: FCA Seller's Premises where the seller is responsible only for loading the goods and not responsible for inland freight; and FCA Named Place (International Carrier) where the seller is responsible for inland freight.

43

Having gone through the International trade scenario of India and the international commercial terms used in international trade lets understand the important risk

management documents involved in international trade finance.

Introduction to International Trade Documents


International market involves various types of trade documents that need to be produced while making transactions. Each trade document is differ from other and present the various aspects of the trade like description, quality, number, transportation medium, indemnity, inspection and so on. So, it becomes important for the importers and exporters to make sure that their documents support the guidelines as per international trade transactions. A small mistake could prove costly for any of the parties. For example, a trade document about the bill of lading is a proof that goods have been shipped on board, while Inspection Certificate certifies that the goods have been inspected and meet quality standards. So, depending on these necessary documents, a seller can assure a buyer that he has fulfilled his responsibility whilst the buyer is assured of his request being carried out by the seller. The following is a list of documents often used in international trade:

Air Waybill Bill of Lading Certificate of Origin Combined Transport Document Draft (or Bill of Exchange) Insurance Policy (or Certificate) Packing List/Specification Inspection Certificate

44

Air Waybills Air Waybills make sure that goods have been received for shipment by air. A typical air waybill sample consists of three originals and nine copies. The first original is for the carrier and is signed by a export agent; the second original, the consignee's copy, is signed by an export agent; the third original is signed by the carrier and is handed to the export agent as a receipt for the goods.

Air Waybills serves as: Proof of receipt of the goods for shipment. An invoice for the freight. A certificate of insurance. A guide to airline staff for the handling, dispatch and delivery of the consignment. The principal requirements for an air waybill are:

The proper shipper and consignee must be mention. The airport of departure and destination must be mention. The goods description must be consistent with that shown on other documents. Any weight, measure or shipping marks must agree with those shown on other documents. It must be signed and dated by the actual carrier or by the named agent of a named carrier. It must mention whether freight has been paid or will be paid at the destination point.

Bill of Lading (B/L) Bill of Lading is a document given by the shipping agency for the goods shipped for transportation form one destination to another and is signed by the representatives of the carrying vessel.

45

Bill of lading is issued in the set of two, three or more. The number in the set will be indicated on each bill of lading and all must be accounted for. This is done due to the safety reasons which ensure that the document never comes into the hands of an

unauthorized person. Only one original is sufficient to take possession of goods at


port of discharge so, a bank which finances a trade transaction will need to control the complete set. The bill of lading must be signed by the shipping company or its agent, and must show how many signed originals were issued. It will indicate whether cost of freight/ carriage has been paid or not: "Freight Prepaid: Paid by shipper "Freight collect: To be paid by the buyer at the port of discharge

The bill of lading also forms the contract of carriage.


To be acceptable to the buyer, the B/L should:

Carry an "On Board" notation to showing the actual date of shipment, (Sometimes however, the "on board" wording is in small print at the bottom of the B/L, in which cases there is no need for a dated "on board" notation to be shown separately with date and signature.)

Be "clean" having no notation by the shipping company to the effect that goods/ packaging are damaged.

The main parties involve in a bill of lading are:

Shipper
o

The person who send the goods. The person who take delivery of the goods. The person, usually the importer, to whom the shipping company or its agent gives notice of arrival of the goods.

Consignee
o

Notify Party
o

Carrier
o

The person or company who has concluded a contract with the shipper for conveyance of goods

46

The bill of lading must meet all the requirements of the credit as well as complying with UCP 600. These are as follows:

The correct shipper, consignee and notifying party must be shown. The carrying vessel and ports of the loading and discharge must be stated. The place of receipt and place of delivery must be stated, if different from port of loading or port of discharge. The goods description must be consistent with that shown on other documents. Any weight or measures must agree with those shown on other documents. Shipping marks and numbers and /or container number must agree with those shown on other documents. It must state whether freight has been paid or is payable at destination. It must be dated on or before the latest date for shipment specified in the credit. It must state the actual name of the carrier or be signed as agent for a named carrier.

Certificate of Origin The Certificate of Origin is required by the custom authority of the importing country for the purpose of imposing import duty. It is usually issued by the Chamber of Commerce and contains information like seal of the chamber, details of the good to be transported and so on. The certificate must provide that the information required by the credit and be consistent with all other document, It would normally include:

The name of the company and address as exporter. The name of the importer. Package numbers, shipping marks and description of goods to agree with that on other documents. Any weight or measurements must agree with those shown on other documents. It should be signed and stamped by the Chamber of Commerce.

47

Combined Transport Document Combined Transport Document is also known as Multimodal Transport Document, and is used when goods are transported using more than one mode of transportation. In the case of multimodal transport document, the contract of carriage is meant for a combined transport from the place of shipping to the place of delivery. It also evidence receipt of goods but it does not evidence on board shipment, if it complies with ICC 500, Art. 26 (a). The liability of the combined transport operator starts from the place of shipment and ends at the place of delivery. This documents need to be signed with appropriate number of originals in the full set and proper evidence which indicates that transport charges have been paid or will be paid at destination port. Multimodal transport document would normally show:

That the consignee and notify parties are as the credit. The place goods are received, or taken in charges, and place of final destination. Whether freight is prepaid or to be collected. The date of dispatch or taking in charge, and the "On Board" notation, if any must be dated and signed. Total number of originals. Signature of the carrier, multimodal transport operator or their agents.

Commercial Invoice Commercial Invoice document is provided by the seller to the buyer. Also known as export invoice or import invoice, commercial invoice is finally used by the custom authorities of the importer's country to evaluate the good for the purpose of taxation. The invoice must:

Be issued by the beneficiary named in the credit (the seller). Be address to the applicant of the credit (the buyer). Be signed by the beneficiary (if required). Include the description of the goods exactly as detailed in the credit. Be issued in the stated number of originals (which must be marked "Original) and copies.

48

Include the price and unit prices if appropriate. State the price amount payable which must not exceed that stated in the credit

Include the shipping terms.

Bill of exchange A Bill of Exchange is a special type of written document under which an exporter ask importer a certain amount of money in future and the importer also agrees to pay the importer that amount of money on or before the future date. This document has special importance in wholesale trade where large amount of money involved. Following persons are involved in a bill of exchange:

Drawer: The person who writes or prepares the bill. Drawee: The person who pays the bill. Payee: The person to whom the payment is to be made. Holder of the Bill: The person who is in possession of the bill.

On the basis of the due date there are two types of bill of exchange:

Bill of exchange after Date: In this case the due date is counted from the date of drawing and is also called bill after date. Bill of exchange after Sight: In this case the due date is counted from the date of acceptance of the bill and is also called bill of exchange after sight.

Insurance Certificate Also known as Insurance Policy, it certifies that goods transported have been insured under an open policy and is not actionable with little details about the risk covered. It is necessary that the date on which the insurance becomes effective is same or earlier than the date of issuance of the transport documents.

49

Also, if submitted under a LC, the insured amount must be in the same currency as the credit and usually for the bill amount plus 10 per cent. The requirements for completion of an insurance policy are as follow:

The name of the party in the favor which the documents have been issued. The name of the vessel or flight details. The place from where insurance is to commerce typically the sellers warehouse or the port of loading and the place where insurance cases usually the buyer's warehouse or the port of destination.

Insurance value that specified in the credit. Marks and numbers to agree with those on other documents. The description of the goods, which must be consistent with that in the credit and on the invoice. The name and address of the claims settling agent together with the place where claims are payable. Countersigned where necessary. Date of issue to be no later than the date of transport documents unless cover is shown to be effective prior to that date.

Packing List Also known as packing specification, it contains details about the packing materials used in the shipping of goods. It also includes details like measurement and weight of goods. The packing List must:

Have a description of the goods ("A") consistent with the other documents. Have details of shipping marks ("B") and numbers consistent with other documents

50

Inspection Certificate Certificate of Inspection is a document prepared on the request of seller when he wants the consignment to be checked by a third party at the port of shipment before the goods are sealed for final transportation.

In this process seller submit a valid Inspection Certificate along with the other trade documents like invoice, packing list, shipping bill, bill of lading etc to the bank for negotiation. On demand, inspection can be done by various world renowned inspection agencies on nominal charges.

51

Value Added Notes

LERMS LERMS (Liberalized Exchange Rate Management System) was introduced in March 1992. It is a dual exchange rate system in the place of a single official rate. It consisted of one official rate for select government and private transactions and the market determined rate for the others. It treated current and capital transactions in the different ways. There were requirements of surrender of foreign exchange by the public to banks with some exceptions. Under the LERMS exports of goods and services who are in receipt of bulk of foreign exchange will have to sell their foreign exchange at the market rate in the foreign exchange market except 40% of their foreign exchange earnings which will have to be surrendered to the monetary authority of India i.e. RBI at an official rate. (i.e. the balance 60% of their foreign exchange earnings will have to be sold in the free market at the marked rate.) The RBI will sell foreign exchange at the official rate to authorized dealers only for: 1. Imports of specified goods covering governmental needs, 2. Imports under EXIM scraps unutilized as on February 29, 1992, and 3. Imports of life saving drugs and equipments under licenses. For Import under advance licenses and special impress licenses and imports for replenishment of raw materials for gem and jewelers exports foreign exchange will be available at official rate for 40% of the value. The remaining requirements will be met through purchases in the free market.

52

Chapter 4 Risk Management in Import Advances

"The policy of being too cautious is the greatest risk of all." - Jawaharlal Nehru

International Trade involves various complexities and problems. This may be due to various reasons. The parties to a sale contract are located in different countries and are governed by different legal systems. Also, the currencies of the two countries are different. Further, the trade and exchange regulations applicable to both the parties may differ. In such a situation, a seller who ships goods will be apprehensive whether he will receive payment from the buyer. The buyer, on the other hand, will be concerned whether the seller will ship the goods ordered for and deliver them in time. Given these complexities, a need for an ideal method of settling international trade payments was felt and so came the usage of documentary credits, commonly known as LC into vogue. Even this arrangement, initially created discomfiture as parties involved in the transaction have been using different terminologies, interpreting the arrangement in different ways. Subsequently, ICC came up with a set of guidelines in the name of Uniform Customs and Practice for Documentary Credits (UCPDC) to facilitate uniform interpretation of terminology used under documentary credit by all the concerned. The UCPDC first appeared in 1933 and since then is getting refined with the experiences gained from time to time. The latest revision under this, took place during 1993 and the document issued under publication no. 500 is currently in force. The UCPDC has thus attained universal acceptance and the local courts too are referring to these articles while settling trade disputes.

53

Introduction to L/C Letter of Credit L/C also known as Documentary Credit is a widely used term to make payment secure in domestic and international trade. The document is issued by a financial organization at the buyer request. Buyer also provides the necessary instructions in preparing the document. The International Chamber of Commerce (ICC) in the Uniform Custom and Practice for Documentary Credit (UCPDC) defines L/C as: "An arrangement, however named or described, whereby bank (the Issuing bank) acting at the request and on the instructions of a customer (the Applicant) or on its own behalf: 1. Is to make a payment to or to the order third party (the beneficiary) or is to accept bills of exchange (drafts) drawn by the beneficiary. 2. Authorized another bank to effect such payments or to accept and pay such bills of exchange (draft). 3. Authorized another bank to negotiate against stipulated documents provided that the terms are complied with. A key principle underlying letter of credit (L/C) is that banks deal only in documents and not in goods.

How the L/C operates?

54

Parties to Letters of Credit

Applicant (Opener): Applicant which is also referred to as account party is normally a buyer or customer of the goods, who has to make payment to beneficiary. LC is initiated and issued at his request and on the basis of his instructions.

Issuing Bank (Opening Bank): The issuing bank is the one which create a letter of credit and takes the responsibility to make the payments on receipt of the documents from the beneficiary or through their banker.

Beneficiary: Beneficiary is normally stands for a seller of the goods, who has to receive payment from the applicant.

Advising Bank: An Advising Bank provides advice to the beneficiary and takes the responsibility for sending the documents to the issuing bank and is normally located in the country of the beneficiary.

Confirming Bank: Confirming bank adds its guarantee to the credit opened by another bank, thereby undertaking the responsibility of payment/negotiation acceptance under the credit, in additional to that of the issuing bank. Confirming bank play an important role where the exporter is not satisfied with the undertaking of only the issuing bank.

Negotiating Bank: The Negotiating Bank is the bank who negotiates the documents submitted to them by the beneficiary under the credit either advised through them or restricted to them for negotiation. On negotiation of the documents they will claim the reimbursement under the credit and makes the payment to the beneficiary provided the documents submitted are in accordance with the terms and conditions of the letters of credit.

Reimbursing Bank: Reimbursing Bank is the bank authorized to honor the reimbursement claim in settlement of negotiation/acceptance/payment lodged with it by the negotiating bank. It is normally the bank with which issuing bank has an account from which payment has to be made.

Second Beneficiary: Second Beneficiary is the person who represents the first or original Beneficiary of credit in his absence.

55

Types of Letter of Credit 1. Revocable Letter of Credit L/C A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification. 2. Irrevocable Letter of Credit L/C In this case it is not possible to revoke or amended a credit without the agreement of the issuing bank, the confirming bank, and the beneficiary. 3. Confirmed Letter of Credit L/C Confirmed Letter of Credit is a special type of L/C in which another bank apart from the issuing bank has added its guarantee. 4. Sight Credit and Usance Credit L/C Sight credit states that the payments would be made by the issuing bank at sight, on demand or on presentation. In case of usance credit, draft is drawn on the issuing bank or the correspondent bank at specified usance period. 5. Back to Back Letter of Credit L/C Back to Back Letter of Credit is also termed as Countervailing Credit. A credit is known as back-to-back credit when a L/C is opened with security of another L/C. 6. Transferable Letter of Credit L/C It is a type of credit under which the first beneficiary which is usually a middleman may request the nominated bank to transfer credit to the second beneficiary. 7. Standby Letter of Credit L/C Initially used by the banks in the U.S, the standby letter of credit is very much similar in nature to a bank guarantee. The main objective of issuing such a credit is to secure bank loans. It is usually issued by the applicants bank in the applicants country and advised to the beneficiary by a bank in the beneficiarys country.

56

Risk Associated with Opening Imports L/Cs The basic risk associated with an issuing bank while opening an import L/C is: 1. The financial standing of the importer: As the bank is responsible to pay the money on the behalf of the importer, thereby the bank should make sure that it has the proper funds to pay. 2. The goods Bankers need to do a detail analysis against the risks associated with perishability of the goods, possible obsolescence, import regulations packing and storage, etc. Price risk is another crucial factor associated with all modes of international trade. 3. Exporter Risk There is always the risk of exporting inferior quality goods. Banks need to be protective by finding out as much possible about the exporter using status report and other confidential information. 4. Country Risk These types of risks are mainly associated with the political and economic scenario of a country. To solve this issue, most banks have specialized unit which control the level of exposure that that the bank will assumes for each country. 5. Foreign exchange risk Foreign exchange risk is another most sensitive risk associated with the banks. As the transaction is done in foreign currency, the traders depend a lot on exchange rate fluctuations.

57

Risk Management tools used

Scrutiny of documents This is a very important function and this should be done with great care. After receiving the document from the overseas supplier's bank the importer's bank will scrutinize them to verify the extent of correctness as per the terms of the L/C. For discrepancies in the documents following principles are adopted: If discrepancies are such which violates any of exchange control or import control regulations, the documents should straightaway be rejected. If the discrepancies are of trivial nature not affecting the character of the transactions the documents may be accepted on merits. If the documents are rejected, immediate notice to that effect should be given to the bank to safeguard the importer's interests. The documents prescribed by the beneficiary are carefully scrutinized by the issuing banker. The importer should also scrutinize the documents to ensure that: 1. They were presented when the credit was in force and had not expired. 2. The amendments and special instructions have been taken care of. 3. The amount of bill does not exceed the value of L/C. 4. All documents required in the L/C have been made available. 5. Documents carry required endorsements. 6. The documents do not contain discrepancies which violate any exchange control/import control regulations. 7. The invoice is duly signed; tallies with amount of draft, exact quantities are shown and are drawn in appropriate currency of the origin of goods. 8. Bill of lading is presented in full set of negotiable copies and is on board bill of lading and duly signed.

58

In case the goods are imported on cash against documents (CAD), documents against payment (D/P) or documents against acceptance (D/A) basis, the importer needs to take delivery of documents from the banker before completion of the customs formalities. This process, known as retirement of documents, needs the importer to apply to authorized dealer/banker who is in possession of documents. This can be done by tendering the funds equivalent to the value of documents and the bank charges exchange control copy of import license, where applicable, Form A1 duly completed for remittance of foreign exchange. The documents are released to the importers against payment in case of DP bills and against acceptance in case of DA bills. The payment in either case is accepted only from the bank account of importer. If the bank is out of funds the interest is charged to the importer's account. For any overdue period a penal interest will be charged.

Checklist for Document (received under L/C) scrutiny: 1. General-check whether all documents in full sets as per L/C terms have been received. 2. 3. Documents had been presented before the expiry date. All the documents are dated subsequent to the date of issue of the L/C.

4. Cancellation/overwriting in all documents are authenticated. 5. Bills of Exchange-check whether: Drawn on the person indicated in the L/C and duly signed up by the beneficiary of the credit. Drawing is within L/C amount and in the same currency as per the L/C. The amounts in words and figures are the same and identical with the amount stated in the invoice. 6. Superscription, regarding drawing under L/C has been made and the Bill must have been issued stamped.

59

7. Invoice- check, whether invoice: Is made out in the name of the person who had opened the L/C. Quantity, unit price and value are quoted as per L/C. Whether unit price and value are quoted as per L/C. The description of the merchandise corresponds to the description in the L/C. The arithmetical calculations are correct. Import license/OGL/Contract No./Order No./Indent No. mentioned as per L/C. No charge other than stipulated in L/C in included. Additional copy for Exchange Control purposes is submitted. The date and no. of the License/OGL indicated.

8. Bill of lading is submitted within 21days from the date of shipment, if no specific time is between the date of issue and expiry of L/C. 9. The date of shipment is between the date of issue and expiry of L/C. 10. Full quantity of goods is shipped, if part shipment is not allowed. 11. Full set is submitted. 12. Freight is shown as prepaid/payable at destination, as per L/C. 13. Bill of lading shows 'on board shipment'. 14. Parties are notified as per L/C terms. 15. Carrying vessel's name has been mentioned in Bill of Lading. 16. The beneficiary's name is shown as consignor, unless L/C terms permits third party bill of lading. 17. The consignee's name is as per L/C. 18. The B/L is manually signed. 19. The description of goods is consistent with L/C. 20. The ports of loading/destination are mentioned as per L/C. 21. Marks, numbers, quantity and weight agree with the invoice. 22. The carrying vessel belongs to any particular line as per L/C. 23. Adequately stamped. 24. Properly endorsed.

60

Scrutiny for Insurance documents-check whether the policy is taken out in the name of the shipper Certificate/policy is according to Letter of Credit terms Risk commences w.e.f. date of B/L Amount of insurance as per L/C terms Whether drawn in the same currency as the L/C Description of goods agree with B/L Risks as per L/C are covered The place where claims are payable is as per L/C terms Adequately stamped Details such as name of carrying vessel, ports of loading/destination, marks, agree with the B/L Certificate of analysis, weighment,etc. The certificates are issued by the authority stipulated in L/C Name of the shipper is properly shown The samples drawn relate to the goods actually shipped Date of sample verification is within the date of shipment Certificate of origin It is issued by the authority stipulated in the L/C and the description of goods agrees with that in the invoice Checking other documents All other documents stipulated in the L/C are verified They are issued by the authorities specified in the L/C They contain the details as required by the L/C For matter relating to Documentary Collections and Commercial terms, the importers are likely to be conversant with the brochures issued by the International Chamber of Commerce (ICC), Paris.

61

Forward Contracts
Forward Contract can be defined as a contract deliverable on a future date, duration of the contract being computed from spot value date at the time of transaction. Forward contract is an agreement to exchange one currency for another currency on a specific date in future at a predetermined exchange rate, set at the time the contract is made. A forward contract is traded in the over-the-counter marketusually between two financial institutions or between a financial institution and one of its clients. One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Forward contracts on foreign exchange are very popular. Most large banks have a "forward desk" within their foreign exchange trading room that is devoted to the trading of forward. Forward contracts are used to hedge foreign currency risk.

One of the factors influencing a currencys forward exchange rate is the level of interest rates for that currency relative to interest rates in the other currency. There are many theories on how a forward exchange rate can be calculated, but market participants adopt the interest rate differential between two currencies and the current market spot rate as the basis of their calculations. The forward price is often referred to as forward points, forward pips or swap points (pips). For example, assume that the spot and forward rates between dollars and sterling are the same, but the interest rates in sterling are 4% per annum for a 3-month deposit, while in dollars they are 2%. Investors would sell their dollars and buy sterling spot for the higher yield. They would simultaneously sell sterling and buy dollars forward for delivery at the end of the investment period. In this way, the investor would end up with more dollars than if the investment had been kept in dollars.

62

Forward contract prices are determined by two main factors: the current spot price between the two currencies and the interest rate prevailing in each of the two currencies. The forward price is calculated as follows:

Forward Rate = Spot Rate + Premium / - Discount

To decide whether to add or subtract the forward pips, firstly determine whether the currency to be bought or sold is trading at a premium or is trading at a discount. As all exchange rates have a fixed and a variable component, if the interest rates in the variable currency are greater than those of the fixed currency, the variable currency is trading at a discount relative to the fixed currency and forward pips are added to the spot rate to obtain the forward rate. If the interest rates in the variable currency are less than those of the fixed currency, the variable currency is trading at a premium and forward pips are subtracted from the spot rate to obtain the forward rate.

In calculating the forward points, users adopt a simple arithmetic formula which takes the interest rate differential per annum, converts it into a differential for the required period, and expresses the spot rate as a percentage of the differential for the period. However, it cannot be used entirely in isolation, for it assumes knowledge of relative interest rate levels by the interested party. It is, in essence, a variation on the old banking formula: Principle rate time = interest where the principle is the spot rate, the rate is the interest rate differential, and time is the maturity in days. Thus: Spot rate interest rate differential days/360 1 + (currency interest rate days/360) = Pips/points

In other words, the formula for dollars against currency forwards is: A D (B - C) (100 E) + (C - D) which equals the number of forward points of spot currency, with 360 day basis, where:

63

A = spot exchange rate B = currency interest rate C = dollar interest rate D = maturity in days E = day basis In foreign exchange market forward transaction are necessary for following reasons: One can hedge or cover an existing future financial, commercial or trade related exchange risk. These types of deals, in combination of spot deals, are used for money market operations through SWAP transactions. Taking a view of the market, these can be used for speculation

Forward Sale Contract


FSC is booked for imports into India, remittance of dividend, interest, etc. Underlying contract can be verified for compliance with exchange/trade control requirements. If import is under licence, Exchange Control copy is to be obtained and endorsed for having booked forward sale contract. Necessary approval from RBI for repayment of installments under foreign currency loan to be verified. The contract should not exceed the net amount payable overseas. Substitution of contract is permitted. Maturity period of FSC should normally be Approx. due date of the bill by taking into consideration date of shipment, postal transit, usance period etc. If usance bills under LC are already Due date of the bill received Import collection bill In line with the tenor of the bill. Maximum 6 months from the date of shipment.

In the case of import LC

64

Covering Exchange Risk in Forward Sale contract

Often, the enterprises that are exporting or importing take recourse to covering their operations in the Forward market. If an importer anticipates eventual appreciation of the currency in which imports are denominated, he can buy the foreign currency immediately and hold it up to the date of maturity. This means he has to block his rupee cash right away. Alternatively, the importer can buy the foreign currency forward at a rate known and fixed today. This will do away with the problem of blocking of funds/cash initially. In other words, Forward purchase of the currency eliminates the exchange risk of the importer as the debt in foreign currency is covered.

Example From the data given below calculate forward premium or discount, as the case may be, of the in relation to the rupee.

Spot Re/

1 month forward Rs 77.9542/78.1255

3 months forward Rs 78.2111/4000

6 months forward Rs 78.8550/9650

Solution Since 1 month forward rate and 6 months forward rate are higher than the spot rate, the British is at premium in these two periods, the premium amount is determined separately both for bid price and ask price. It may be recapitulated that the first quote is the bid price and the second quote (after the slash) is the ask/offer/sell price. It is the normal way of quotation in foreign exchange markets.

Premium with respect to bid price

1 month = Rs78.2111 -Rs 77.9542 x 12 x 100 = 3.95% P.a Rs 77.9542 1

6 months = Rs 78.8550 -Rs 77.9542 x 12 x 100 = 2.31% P.a Rs 77.9542 6 65

Premium with respect to ask price

1 month =

Rs 78.4000 -Rs 78.1255 x 12 x 100 = 4.21% P.a Rs 78.1255 1

6 months = Rs78.9650-Rs 78.1255 Rs 78.1255

x12 x 100 = 2.15% P.a 6

Risks involved in Forwards Because of the time span involved in forward contracts, there can be significant risks, just as on a spot deal. Credit risk, market/price risk and country risk are all potential problems. In fact, country risk is more significant than spot trades as unexpected events in a foreign country are more likely, given the longer period of exposure. Hence, mainly Banks and Financial Institutions indulge in booking Forward Contracts.

UBIs Export Import Performance


PARAMETERS MARCH 06 ACTUAL 5,189 41,285 19,458 11,328 10,499 4,130 MAR 07 ACTUAL 5769.65 52254 26938 12308 13008 4413 PROJECTION MARCH-08 7054 60000 30000 14000 16000 5750 GROWTH Am ount & % 1284 (22%) 7746 (14.82%) 3062 (11.37) 1692 (13.75%) 2992 (23%) 1337 (30%)

EXPORT CREDIT TERMINAL FOREX TURNOVER EXPORT IMPORT REMITTANCES NRI DEPOSITS

66

Value Added Notes

Capital Account Convertibility (CAC) of the Indian Rupee The Capital Account Convertibility refers to the freedom to convert local financial assets into foreign financial assets and vice versa at the market-determined rate of exchange. It is associated with changes of ownership in domestic/foreign financial assets and liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world. The currency convertibility on capital account is usually introduced only after the lapse of certain period of time after the introduction of partial currency convertibility on Current Account. The Capital Account convertibility can help to increase the inflow of foreign capital as it enables the foreign investors to repatriate their investments whenever they want. On the other hand it may also lead to flight of capital from the country if domestic conditions are unfavorable. Hence Capital Account Convertibility is usually introduced only after experimenting with the current account currency convertibility for a reasonable period of time. The country has to see to it that the stabilization programmers have been successfully carried out and a congenial, favorable atmosphere is ensured. The introduction of Capital Account Convertibility (even for certain types of capital assets) helps to attract resources from abroad. It enables the residents to hold internationally diversified portfolio investments. However, Capital Account Convertibility entails the risk of capital flight and greater fluctuations in foreign exchange rate, foreign exchange reserves and interest rate. Hence till the economy is well developed the country has to maintain various types of controls. Under free capital convertibility the residents of the country can sell their property abroad. Hence even if Capital Account Convertibility is introduced several restrictions have to be attacked.

67

Chapter 5 Risk management in Export finance

If you dont know for sure what will happen, but you know the odds, that is risk. If you dont even know the odds, that is uncertainty. - Frank Knight

PRE-SHIPMENTS FINANCE

Meaning Also popularly known as Packing Credit, pre shipment finance is advance credit facility obtained by an exporter from a bank or financial institution .It define as any loan to an exporter for financing the purchase, processing, manufacturing or packing of goods. Features of Pre-shipment Finance 1. Eligibility: As a rule, pre-shipment loan is granted only to those exporters who actually export and produce a confirmed export order and /or a letter of credit received in their own names. 2. Purpose: Packing credit is granted for the specific purpose of procuring/ purchasing/ manufacturing/ processing/ storing/ packing and shipping the goods. 3. Documentary Evidence: Pre-shipment finance is granted against the evidence of irrevocable L/C established through a reputed bank or against a confirmed order for export. The document of L/C or confirmed order must be deposited with the lending institution. 4. Security: The exporter is required to provide personal bond from sureties known to the bank. Also compulsorily, relevant policy issued by ECGC.

68

5. Form of Finance: Packing credit can be either in the form of funded or non-funded advance. Red Clause/Green Clause L/Cs is the forms of funded finance. Non-funded facilities include domestic L/Cs, back-to-back L/Cs and various guarantees. 6. Amount of Finance: There is no fixed limit for pre-shipment finance. It depends on the amount of export order, the credit-rating of the exporter done by the bank. 7. Term of Credit: Packing credit, being a working capital is basically short term finance. The maximum period is determined by the RBI. It is normally granted for a period of 180 days. It can be further extended up to 90 days with prior permission of the RBI. 8. Rate of Interest: The present rates of interest for packing credit are as under: Up to 180 days.13% per annum For additional 90 days.15% per annum 9. Loan Agreement: The exporter has to sign a loan agreement with the bank in order to get packing credit. 10. Monitoring the use of Loan: The lending bank monitors the use of finance by the exporter to ensure that the amount is used for export purpose only. The bank can impose penalty for misuse. 11. Repayment/ Liquidation of Loan: The exporter should repay the amount of packing credit out of the proceeds of export bill. METHODS/ TYPES/ FORMS OF PRE-SHIPMENT FINANCE Extended Packing Credit Loan: This facility, though for a short period, is granted to those exporters who are rated first class by the bank. Loan is granted for making advance payment to suppliers for acquiring exportable goods.

i.

69

ii.

Packing Credit Loan (Hypothecation): In this case packing credit is extended for obtaining raw materials, work-in-process and / or finished goods. The goods acquired are treated as security for the loan granted.

iii.

Packing Credit Loan (Pledge): This facility is available for seasonal goods or those acquired by the exporter under odd lots.

iv.

Security Shipping Loan: Once the raw material is converted in to finished goods, the same has to be handed over to transport operator or to the clearing and forwarding agent. The security loan can be obtained only after this.

v.

Advances against Back-to-Back Letter of Credit: An exporter, who has received original letter of credit from importer, requests his banker to open a letter of credit in favor of his supplier.

vi.

Advances against Red Clause L/C: When the exporter receives red clause L/C from the importer, it authorizes the exporters bank to provide advances to complete production.

vii.

Advances against Export Incentives: Advances against export incentives such as DBK is provided by the bank both at pre-shipment and post-shipment stage.

viii.

Packing Credit for Imports against Advance License Entitlement:

This

credit facility is available to manufacturer exporters who are not in receipt of letter of credit or confirmed export order. Finance is made available for imports against license for manufacture of export goods. ix. Advance against Cheques, Drafts etc.: Banks provide export credit at concessional rate against the proceeds of cheques, drafts etc. received directly towards advance payments for exports.

70

POST-SHIPMENT FINANCE The Reserve Bank of India defines post-shipment as any loan or advance granted or any credit provided by a bank to an exporter of goods from India from the date extending the credit after shipment of the goods to the date of realization of the export proceeds. FEATURES OF POST-SHIPMENT FINANCE: a) Forms of Post-shipment Finance: Banks provide post-shipment finance under different forms such as: Discounting of Export Bill Advance against goods sent on Consignment Basis. Advance against Retention Money etc.

b) Amount of Finance: The amount of post-shipment finance can be to the extent of 100% of invoice value of goods. It depends on short term, medium term and long term finance. It also depends on the value of capital goods and equipment or the value of turnkey projects. Any loan up to Rs. 10 crores for financing export of capital goods is decided by a commercial bank which can get refinanced itself by the EXIM Bank. In a contract above Rs. 10 crores but not more than Rs. 50 crores, the EXIM Bank decides whether the facility can be given. Contracts above Rs. 50 crores need clearance from the Working Group on Export Finance, consisting of the representatives of EXIM Bank, RBI ECGC and Exporters Bankers. In case of large contracts, representatives of the Ministries of Commerce and Finance are also members of the Working Group. c) Period of Finance: The period of loan depends on: Short-term: The loan is provided by commercial banks usually for 90 days. Medium-term: Commercial banks together with EXIM Bank provide medium term finance for a period between 90 days and 5 years.

71

Long-term: It is provided by EXIM Bank in case of export of capital goods and turnkey projects for a period exceeding 5 years.

d) Rate of Interest: Post-shipment finance facility is granted at a concessional rate of 13% p.a. for a period between 90 days. For medium term and long term loans the rates of interest are applicable as per the directives of RBI issued for time to time. e) Loan Agreement: The exporter is required to execute a formal loan agreement with the bank before the amount of loan is actually disbursed. f) Maintenance of Accounts: As per the RBI directives, banks must maintain a separate account in respect of each post-shipment advance. g) Disbursement of Loan Amount: Normally, post-shipment credit advances are not given in lump sums. It is disbursed in installments as and when required by the concerned exporter. h) Monitoring the use of Advances: The bank advancing post-shipment credit facility should monitor the use of finance to ensure that it is used for export purpose only. Penalty can be imposed for misuse. i) Repayment/Liquidation of Advances: The exporter is expected to repay the amount of loan to the bank as soon as he receives export proceeds. Generally, the lending bank itself realizes the export proceeds from the importers bank.

METHODS/ TYPES / FORMS OF POST-SHIPMENT FINANCE: I) Export Bills negotiated under L/C: An exporter can avail of post-shipment credit by drawing bills or drafts under the L/C. The bank insists on production of the necessary documents as stated in the L/C. If documents are in order, the bank negotiates the bill and advance is granted to the exporter.

72

II) Purchase/ Discounting of Export Bills under Confirmed Orders: If L/C is not available as security; bank financing depends upon the creditworthiness of the exporter. At the request of the exporter, the bank will purchase or discount the export bill and pay the equivalent rupees to the exporter. III) Advances against Bills sent for Collection: Advances against such bills that are sent for collection is granted under a separate account called post-shipment loan. This type advance is not very popular. IV) Advance against Goods sent on Consignment Basis: An exporter may send goods to his foreign agent on consignment basis. Post-shipment finance in this case is subject to the customer enjoying specific credit limit fixed by the bank. Advances are given against the documents of consignment. These documents are forwarded by the overseas bank to the importer only against a Trust Receipt. The Trust Receipt is the undertaking given by the agent abroad to send the amount of sale proceeds by a specified date. V) Advance against Duty Drawback Entitlement: DBK or drawback means refund of custom duties paid on the import of raw materials, components and packing material used for export products. Banks offer pre-shipment advances against DBK entitlements. VI) Advance against Undrawn Balance of Bills: In some cases bills are not drawn for the full invoice value of goods. Certain amount remains undrawn, which is due for payment after adjustments on account of differences in rates, weight, quality etc. to be ascertained after inspection and approval of the goods. Banks offer advances against such undrawn balances up to 5% of the value of export on an undertaking from the exporter to surrender the balance proceeds to the bank.

73

VII)Advances against Retention Money: In respect of certain exports of capital goods and project exports, the importer retains a part of the price towards guarantee of performance or completion of the project. Bank provide advance against such retention money. The advance is repayable within one year from the date of shipment or when the importer releases the payment of retention money, whichever is earlier. VIII) Advance against Deemed Exports: Certain specific sales or supplies made in India are considered as Deemed Exports although they are not exports in real sense, such as sales to foreign tourists during their stay in India and supplies made in India to IBRD/ IDA/ ADB aided projects. Credit is given for maximum of 30 days in case of such Deemed Exports. IX) Advances against Deferred Payments: In case of project exports or large-scale construction contracts, the exporter receives payment from the importer in statements spread over a period of time. Commercial banks together with the EXIM Bank offer advances against Deferred Payment at concessional rates of interest for 180 days.

Risk Management tools used The Whole Turnover Packing Credit Guarantee Scheme was introduced in the year 1969 with a view to providing guarantee cover on all India basis for shipment advances granted by banks. UBI entered into a contract with ECGC seeking cover against losses that may be sustainable granting pre-shipment advances to the exporters. This guarantee is issued for period of one year(commencing from the month of July to the month of June in the succeeding year.) ECGC while extending the guarantee fixes maximum liability i.e. the amount up to which the claims will be paid to the bank under this guarantee.

74

Types of Risks Covered


The following risks are covered under the guarantee in respect of losses, which may be incurred after granting Packing Credit Advances to exporter clients. a. b. Insolvency of the exporter Protracted default by the exporter to pay the amounts due to the Bank.

The Following advances are covered under this guarantee Packing Credit Advances granted for import of goods under a L/C in respect of export obligation. Packing Credit against LC/ orders Packing Credit to manufacturers for orders received from export Houses(EH) / Trading Houses(TH)/ Star Trading Houses (STH), Super Star Trading Houses Packing Credit to sub suppliers Packing Credit to deemed exports.

WTPCG does not cover advances granted: 1. To Public Sector Undertakings owned by the government of India minimum holding of the government should be to the extent of 51%. 2. 3. For exports made on deferred terms of payment, turnkey projects, construction works and service contracts. Against duty drawback:/cash assistance.

75

UBI & ECGC


Details of settlement of claims. Year 2003 - 04 2004 - 05 2005 06 2006- 07 Claims pending 31.03.07 WTPCG WTPSG 14 8 8.62 9.41 No. of cases 35 21 32 13 Amt. (Rs in crs.) 14.18 5.75 23.63 8.98

Forward Purchase Contract An exporter can eliminate the risk of currency fluctuation by selling his receivables forward. FPC is booked against export of goods and services/ receipt of foreign exchange by a forward remittance conversion of EEFC or FCNR deposits. Underlying contract to be verified for compliance with the exchange control/trade control regulations like for example delivery period of contract should not exceed 6 months from the date of shipment. A single contract can be booked for different export orders in the same currency and at appropriate tenor, if the payments are all being received by one bank. Substitution of export order can be allowed if shipment against the original order is not made.

76

SWAPs as a Risk Management tool


Swaps involve exchange of a series of payments between two parties. Normally, this exchange is effected through an intermediary financial institution. Though swaps are not financing instruments in themselves, yet they enable obtainment of desired form of financing in terms of currency and interest rate. Swaps are over-the-counter instruments. The market of currency swaps has been developing at a rapid pace for the last fifteen years. As a result, this is now the second most important market after the spot currency market. In fact, currency swaps have succeeded parallel loans, which had developed in countries where exchange control was in operation. In parallel loans, two parties situated in two different countries agreed to give each other loans of equal value and same maturity, each denominated in the currency of the lender. While initial loan was given at spot rate, reimbursement of principal as well as interest took into account forward rate. However, these parallel loans presented a number of difficulties. For instance, default of payment by one party did not free the other party of its obligations of payment. In contrast, in a swap deal, if one party defaults, the counterparty is automatically relived of its obligation. Currency swaps can be divided into 3 categories: (a) fixed-to-fixed currency swap, (b) floating-to-floating currency swap, (c) fixed-to-floating currency swap. A fixed-to-fixed currency swap is an agreement between two parties who exchange future financial flows denominated in two different currencies. A currency swap can be understood as a combination of simultaneous spot sale of a currency and a forward purchase of the same amounts of currency. This double operation does not involve currency risk. In the beginning of exchange contract, counterparties exchange specific amount of two currencies. Subsequently, they settle interest according to an agreed arrangement. During the life of swap contract, each party pays the other the interest streams and finally they reimburse each other the principal of the swap.

77

A simple currency swap enables the substitution of one debt denominated in one currency at a fixed rate to a debt denominated in another currency also at a fixed rate. It enables both parties to draw benefit from the differences of interest rates existing on segmented markets. A similar operation is done with regard to floating-tofloating rate swap. A fixed-to-floating currency coupon swap is an agreement between two parties by which they agree to exchange financial flows denominated in two different currencies with different type of interest rates, one fixed and other floating. Thus, a currency coupon swap enables borrowers (or lenders) to borrow (or lend) in one currency and exchange a structure of interest rate against another-fixed rate against variable rate and vice versa. The exchange can be either of interest coupons only or of interest coupons as well as principal. For example, one may exchange US dollars at fixed rate for French francs at variable rate. These types of swaps are used quite frequently. Important Features of Swap contracts Minimum size of a swap contract is of the order of 5 million US dollar or its equivalent in other currencies. But there are swaps of as large a size as 300 million US dollar, especially in the case of Eurobonds. The US dollar is the most sought after currencies in swap deals. The dollar-yen swaps represent 25 per cent of the total while dollar-deutschemark account for 20 per cent of the total. The swaps involving Euro are also likely to be widely- prevalent in European countries. Reasons for Currency Swap Contracts At any given point of time, there are investors and borrowers who would like to acquire new assets/liabilities to which they may not have direct access or to which their access may be costly. For example, a company may retire its foreign currency loan prematurely by swapping it with home currency loan. The same can also be achieved by direct access to market and by paying penalty for premature payment. A swap contract makes it possible at a lower cost. Some of the significant reasons for entering into swap contracts are given below.

78

Hedging Exchange Risk Swapping one currency liability with another is a way of eliminating exchange rate risk. For example, if a company (in UK) expects certain inflows of deutschemarks, it can swap a sterling liability into deutschemark liability.

Differing Financial Norms The norms for judging credit-worthiness of companies differ from country to country. For example, Germany or Japanese companies may have much higher debt-equity ratios than what may be acceptable to US lenders. As a result, a German or Japanese company may find it difficult to raise a dollar loan in USA. It would be much easier and cheaper for these companies to raise a home currency loan and then swap it with a dollar loan. Credit Rating Certain countries such as USA attach greater importance to credit rating than some others like those in continental Europe. The latter look, inter-alia, at company's reputation and other important aspects. Because of this difference in perception about rating, a well reputed company like IBM even-with lower rating may be able to raise loan in Europe at a lower cost than in USA. Then this loan can be swapped for a dollar loan. Market Saturation If an organization has borrowed a sizable sum in a particular currency, it may find it difficult to raise additional loans due to 'saturation' of its borrowing in that currency. The best way to tide over this difficulty is to borrow in some other 'unsaturated' currency and then swap. A well-known example of this kind of swap is World BankIBM swap. Having borrowed heavily in German and Swiss market, the WB had difficulty raising more funds in German and Swiss currencies. The problem was resolved by the WB making a dollar bond issue and swapping it with IBM's existing liabilities in deutschemark and Swiss franc. Parties involved Currency swaps involve two parties who agree to pay each other's debt obligations denominated in different currencies. The below example illustrates currency swaps:

79

Example Suppose Company B, a British firm, had issued 50 million pound-denominated bonds in the UK to fund an investment in France. Almost at the same time, Company F, a French firm, has issued 50 million of French franc-denominated bonds in France to make the investment in UK. Obviously, Company B earns in French franc (Ff) but is required to make payments in the British pound. Likewise, Company F earns in pound but is to make payments in French francs. As a result, both the companies are exposed to foreign exchange risk. Foreign exchange risk exposure is eliminated for both the companies if they swap payment obligations. Company B pays in pound and Company F pays in French francs. Like interest rate swaps, extra payment may be involved from one company to another, depending on the creditworthiness of the companies. It may be noted that the eventual risk of non-payment of bonds lies with the company that has initially issued the bonds. This apart, there may be differences in the interest rates attached to these bonds, requiring compensation from one company to another. Example 2 Consider an American-based company that has raised money by issuing a Swiss franc-denominated Eurobond with fixed semi-annual coupon payments of 6% on 100 million Swiss francs. Up front, the company receives 100 million Swiss francs from the proceeds of the Eurobond issue. In essence, they are using the Swiss francs to fund their American operations. Because this issue is funding American-based operations, the company is going to have to convert the 100 million Swiss francs into dollars. This can be done by entering into a currency swap whereby the Swiss franc debt can be converted into a dollar like debt. The American company can agree to exchange the 100 million Swiss francs at inception into dollars, receive the Swiss franc coupon payments on the same dates as the coupon payments are due to the companys Eurobond investors: pay dollar coupon payments tied to a preset index and re-exchange the dollar notional into Swiss francs at maturity.

80

The Stages in a Currency Swap

81

Value Added Notes


Relief to Exporters for a While

INR appreciating more than 10% was hurting exporters a lot. Because the exporters had contracts in USD while there operating expenses were in INR due to which expenses remained the same but when they earned and converted USD into INR they received much less due to which their margins got squeezed. But then steps were taken to relieve exporters. The DEPB (Duty Entitlement Pass Book) scheme which was going to be expiring on 31st march, 2007 has been extended till May, 2009. It is likely that the scheme would continue till the implementation of a uniform goods and services tax (GST). The GST is likely to be put in place by 2010. Some price sensitive products like Basmati rice, steel and cement would, however, not be entitled for the benefits under the scheme. Their exclusion is aimed towards curtailing inflation which has touched a year high of 11.91% for the week ended July 05, 2008.

DEPB is the most popular scheme among the exporters because of the fact that under the scheme traders can import the raw material and equipment at a reduced rate and show the obligatory export latter. The government wants the scheme to be replaced by the duty drawback scheme under which the traders would first pay all the required taxes and get the drawback after showing proof of mandatory exports. Denting margins of exporters because of sharp appreciation in rupee versus the greenback in the last 12 months coupled with political pressure and ensuing general election next year has led to the continuation of the scheme during the current fiscal. In addition, the Government has decided to pay 6% interest to exporters on delayed refund of terminal excise duty and CST as this would go a long way in getting timely refund to exporters. Besides this step, exchange rate is also now in a range of Rs.42.00-42.50/USD adding to the relief of the exporter.

82

Chapter 6 Risk Management in Issuing Guarantees

"To assure that you will never experience failure: don't take a risk, don't attempt anything new, don't expand on your ideas, don't set goals. Never to do any of these things actually guarantees you will fail. Catherine Pulsifer, from Failure Is A Golden Opportunity

Guarantees A bank guarantee is a written contract given by a bank on the behalf of a customer. By issuing this guarantee, a bank takes responsibility for payment of a sum of money in case, if it is not paid by the customer on whose behalf the guarantee has been issued. In return, a bank gets some commission for issuing the guarantee. Any one can apply for a bank guarantee, if his or her company has obligations towards a third party for which funds need to be blocked in order to guarantee that his or her company fulfils its obligations (for example carrying out certain works, payment of a debt, etc.). In case of any changes or cancellation during the transaction process, a bank guarantee remains valid until the customer dully releases the bank from its liability. In the situations, where a customer fails to pay the money, the bank must pay the amount within three working days. This payment can also be refused by the bank, if the claim is found to be unlawful.

83

Benefits of Bank Guarantees For Governments: 1. Increases the rate of private financing for key sectors such as infrastructure. 2. Provides access to capital markets as well as commercial banks. 3. Reduces cost of private financing to affordable levels. 4. Facilitates privatizations and public private partnerships. 5. Reduces government risk exposure by passing commercial risk to the private sector. For Private Sector: 1. Reduces risk of private transactions in emerging countries. 2. Mitigates risks that the private sector does not control. 3. Opens new markets. 4. Improves project sustainability.

Legal Requirements Bank guarantee is issued by the authorized dealers under their obligated authorities notified vide FEMA 8/ 2000 dt 3rd May 2000. Only in case of revocation of guarantee involving US $ 5000 or more need to be reported to Reserve Bank of India (RBI).

Types of Bank Guarantees 1. Direct or Indirect Bank Guarantee: A bank guarantee can be either direct or indirect. Direct Bank Guarantee: It is issued by the applicant's bank (issuing bank) directly to the guarantee's beneficiary without concerning a correspondent bank. This type of guarantee is less expensive and is also subject to the law of the country in which the guarantee is issued unless otherwise it is mentioned in the guarantee documents.

84

Indirect Bank Guarantee: With an indirect guarantee, a second bank is involved, which is basically a representative of the issuing bank in the country to which beneficiary belongs. This involvement of a second bank is done on the demand of the beneficiary. This type of bank guarantee is more time consuming and expensive too. 2. Confirmed Guarantee It is cross between direct and indirect types of bank guarantee. This type of bank guarantee is issued directly by a bank after which it is send to a foreign bank for confirmations. The foreign banks confirm the original documents and thereby assume the responsibility. 3. Tender Bond This is also called bid bonds and is normally issued in support of a tender in international trade. It provides the beneficiary with a financial remedy, if the applicant fails to fulfill any of the tender conditions. 4. Performance Bonds This is one of the most common types of bank guarantee which is used to secure the completion of the contractual responsibilities of delivery of goods and act as security of penalty payment by the Supplier in case of nondelivery of goods. 5. Advance Payment Guarantees This mode of guarantee is used where the applicant calls for the provision of a sum of money at an early stage of the contract and can recover the amount paid in advance, or a part thereof, if the applicant fails to fulfill the agreement. 6. Payment Guarantees This type of bank guarantee is used to secure the responsibilities to pay goods and services. If the beneficiary has fulfilled his contractual obligations after delivering the goods or services but the debtor fails to make the payment, then after written declaration the beneficiary can easily obtain his money form the guaranteeing bank.

85

7. Loan Repayment Guarantees This type of guarantee is given by a bank to the creditor to pay the amount of loan body and interests in case of non fulfillment by the borrower. 8. B/L Letter of Indemnity This is also called a letter of indemnity and is a type of guarantee from the bank making sure that any kind of loss of goods will not be suffered by the carrier. 9. Rental Guarantee This type of bank guarantee is given under a rental contract. Rental guarantee is either limited to rental payments only or includes all payments due under the rental contract including cost of repair on termination of the rental contract. 10. Credit Card Guarantee Credit card guarantee is issued by the credit card companies to its customer as a guarantee that the merchant will be paid on transactions regardless of whether the consumer pays their credit.

How to Apply for Bank Guarantee Procedure for Bank Guarantees is very simple and is not governed by any particular legal regulations. However, to obtained the bank guarantee one need to have a current account in the bank. Guarantees can be issued by a bank through its authorized dealers as per notifications mentioned in the FEMA 8/2000 date 3rd May 2000. Only in case of revocation of guarantee involving US $ 5000/ or more to be reported to Reserve Bank of India along with the details of the claim received.

86

Bank Guarantees vs. Letters of Credit: - A bank guarantee is frequently confused with letter of credit (LC), which is similar in many ways but not the same thing. The basic difference between the two is that of the parties involved. In a bank guarantee, three parties are involved; the bank, the person to whom the guarantee is given and the person on whose behalf the bank is giving guarantee. In case of a letter of credit, there are normally four parties involved; issuing bank, advising bank, the applicant (importer) and the beneficiary (exporter). Also, as a bank guarantee only becomes active when the customer fails to pay the necessary amount where as in case of letters of credit, the issuing bank does not wait for the buyer to default, and for the seller to invoke the undertaking.

UBI An overview of issued L/Cs and L/Gs

Sr 1. 2. 3. 4. 5.

Particulars

Letters of Guarantees 2007-08 2006-07 2005-06 Nos. issued 18915 22341 17585 Amount (Rs. 4452 4041 4195 In Crores) Nos. invoke/ 229 213 176 Devolved Amount (Rs. 59 237 35 In Crores) % invoked/ 1.33 5.86 0.83 devolved

Letters of Credits 2007-08 2006-07 15665 15962 12810 8508 1488 553 4.32 1883 663 7.79

2005-06 17277 8938 1466 705 7.89

87

Risk Management Tools used Export Performance Guarantee provides cover to the Bank against the risk of loss involved in issuing the below types of guarantees: 1. 2. 3. 4. 5. Bid Bond or Bid Guarantee which is required to be submitted along with the bids for export contracts; Performance Bond or Performance Guarantee which is issued favoring the foreign buyer for due performance of the contract; Advance Payment Guarantee which is issued favoring foreign buyer against advance payment received from the buyer; Retention Money Guarantee issued favoring the foreign buyer in lieu of his retaining a portion of each payment as Retention Money; Guarantee issued to an overseas bank for the purpose of enabling the foreign bank to extend foreign currency loan/OD to the Indian exporter for the purpose of executing an export contract; 6. Guarantee issued to customs authorities in India in lieu of customs duty payable on imported raw materials or components meant for manufacturing goods for export; 7. 8. 9. Guarantee issued to Import Control Authorities in India in support of export undertakings given by the exporter who gets advance import licence; Guarantee issued to Sales Tax Authorities in lieu of payment of sales tax on goods meant for export; Guarantee issued to Export Promotion Councils against allotment of export quota. For the purposes of EPG, a loss will be deemed to have arisen when the bank is unable to recover from the exporter the money that bank has paid to the beneficiary of the guarantee. In other words, the Bank will have to establish that: (a) The guarantee was invoked by the beneficiary (b) The amount demanded by the beneficiary was paid by it strictly in accordance with the guarantee; (c) The exporter was called upon to reimburse the bank with the said amount and (d) The exporter has failed to discharge the debt so created.

88

Risks Covered The risk insured under the EPG are (i) Insolvency of the exporter and (ii) His protracted default.

Buyers Credit In the usual practice, an importer requests his bank to open a Letter of Credit. When the L/C is honored i.e. when the importers bank makes payment on behalf of the importer, the importer reimburses the money so paid by the importers bank. However, in the case of Buyers Credit, the importer requests L/C opening bank to pay the dues on behalf of the importer. Thus this is a form of credit facility given to the importer.

Steps involved in Buyers Credit 1. Importer requests for arranging buyers credit. He will execute necessary documentation favoring the bank. 2. The bank arranges an External Commercial Borrowing with one of the banks abroad with whom the bank has tie up. For this, the bank will provide an undertaking to make payment on the new due date. Technically, the bank abroad treats this as a credit facility provided to the bank extending the credit facility. It is not concerned with the importer. 3. The Bank credits the funding Banks nostro account, and in turn, the bank pays off the exporter (or the negotiating bank). 4. For all practical purposes, the L/C gets extinguished. The books of the bank funding the Buyers credit should show this liability as a contingent liability on account of the buyers credit. 5. On the new due date, importer pays the funding bank. With this, the transaction gets closed.

89

Value Added Notes


How the importers use this tool for their own advantage? Suppose the maturity date of the contract in USD has arrived i.e. 180 days are over. Now the importer has to make payment to the exporter. He goes to his bank to avail of buyers credit facility. Bank will generally demand 100% margin for availing such facility. It means that the overseas bank will make the payment now at the guarantee of importers bank. So for the time being nostro a/c of importers bank will be credited and payment will be made to the exporter through exporters bank. So exporter will not know from where the funds are coming. So the transaction between exporter and importer is completed. But the transaction between the importer, his bank and the overseas bank is not yet completed.

So what this all means is that: Importer has borrowed money in terms of USD at Libor rates of interest which is currently 4-5% from the overseas bank for a period of 180 days. While the importer will get 8-9% interest on the margin which he has kept with his bank. So he will be making profit from such transaction. But the risk he faces is of exchange rate. So he will have to book forward and hedge his exposure.

90

On the Maturity Date (buyers credit)

Overseas Bank
Credits its nostro A/c After 180 days of maturity Loan amount payment with interest

Importers bank
Payment

Exporters bank

100% margin + interest on BF

Receives interest on margin amount

Payment

Importer

Exporter

91

Chapter 7

Risk Management in Granting Advances


Risk comes from not knowing what you`re doing. Warren Buffet

INTRODUCTION:

A banks job is to accept deposits and lend. It earns through the spread between the rate at which it lends and the rate at which it accepts deposits. So in granting advances the main risk that it faces is the Credit Risk. So, our main concern in this chapter, here, would be Credit risk itself and models used for quantifying it. Managing Credit Risk has always been the most risky business in the Financial Services Industry. If we look back into the past, we will find that poor management of Credit Risk was the root cause behind most of the major Banking disasters. Being the oldest risk in the market, it was not given much attention and almost remained aloof to the advent of technology until the late 1990s. With the introduction of banking regulations, there is awareness in the industry now to identify measure, monitor and control Credit Risk as well as to determine that they hold adequate capital against this risk. Credit risk not only affects the lenders but also any company that receives funds for products or services. As the market has turned increasingly competitive with the mushrooming of new players, it is quite evident that companies are taking on more credit risk. But for a more transparent market and healthy competition, the Financial Services Industry must turn Credit Risk into an opportunity. The Financial Services Industry must manage credit risk at both individual and portfolio levels. However, individual management of credit risk requires relevant and specific knowledge of the counterpart's business and financial status. The Financial Service Organizations have gained considerable experience in the evaluation of credit defaults by using models and the advanced risk management methods.

92

Over the years, these models have evolved significantly and today they are accepted by the industry as stable and accurate. The sad part of the story is that the operation of these models requires a huge amount of data.. Thus, it is likely that only large banks will be capable of using the advanced risk management practices laid down by Basel II. The internal ratings-based (IRB) requirements of Basel II are quite painstaking and once a bank elects to use the IRB approach in one portion of its loan book, it must do so for all of its loans. This universal application will challenge most banks because they typically run their lending businesses by department or branch. While the industry has made rapid progress in solving the individual aspects of the Credit Risk Management problem, a consistent strategy to manage all sources of credit risk has not been taken up. Even the biggest Financial Organizations are yet to integrate disparate components of credit risk for an enterprise-wide Credit Risk Framework.

The following is one of the models used to quantify the credit risk involved and provides a Credit rating for the client and the interest rate to be charged to the client is based on the rating outcome.

93

Rating Model

Applicable for sanctions above Rs. 10 crores (Fund based and non fund based) Investment grade
Credit quality Rating Numeric Aggregate Score Credit Quality

Non investment grade


Rating Numeric Aggregate Score

Lowest risk Low risk Medium risk Satisfactory risk Fair risk

CR 1 CR 2 CR 3 CR 4 CR 5

>90 86 90 81 85 76 80 71 75

High risk Higher risk Highest risk Default grade

CR 6 CR 7 CR8 CR 9

61 70 51 60 50 & below

Default grade means a stage once the account enters into a NPA category.

1. RATING OF THE BORROWER No. Parameter 1. Debt equity ratio 2. Ratio to total outside liability to tangible net worth 3. Current ratio Parameter criterion Score A. Financial risk Below 1 3 1 to 1.5 2 1.5 to 2.5 1 2.5 & above 0 1.5 & below 3 1.5 to 2.5 2 2.5 to 4 1 Above 4 0 1.5 & above 5 1.33 to 1.5 4 1.17 to 1.33 3 1 to 1.17 2 Less than 1 1 Above 15% 4 >12% to 15% 3 >10% to 12% 2 >8% to 10% 1 Less than 8% 0 100% & above 3 >80%<100% 2 >60%<80% 1 Below 50% 0 94 Max 3

4. ROCE NPAT/TNW + LT liabilities 5. Net sales Actual vis-vis Projections

6. Interest service coverage ratio 7. Debt service coverage ratio 8. Growth in net sales 9. Growth in net profit

More than 2.5 2 to 2.5 1.99 to 1.5 Less than 1.5 >2 >1.5 to 2 >1.1 to 1.5 <1.1 >20% >15%<20% >10%<15% Less than 10% >20% >15%<20% >10%<15% Less than 10%

3 2 1 0 3 2 1 0 3 2 1 0 3 2 1 0

Sub total

30

Additional 2 parameters based on Cash Flow Statement A Net cash from >5% 3 operations to >3% to 5% 2 sales 0 to 3% 1 Negative 0 B Net cash from Above 40% 3 operations to Between 25% to 2 long term 40% 1 debts Between 10% to 0 25% Below 10%

95

I.

II. III.

IV.

V. VI. VII. VIII. IX. X.

B. Management Risk Management Very high > 5 years Experience High ( 2 to 5 years ) Moderate (> 2 years) Absent ( 0 years ) Management High Initiatives Moderate Low Honoring Financial Honored on time Commitments Honored but delayed within acceptable period Honored but delayed beyond acceptable period Not honored Concentration of Team of qualified management professional Mgt. concentrated in few hands Business dependent on 1 or 2 individuals Labor management Very good in the past Cordial inadequate Affiliate Concerns Absent Performance Present Market reputation of the promoters/ management Ability of the promoters/ mgt. to bail out the company in case of crisis Succession planning in key business areas Balance sheet practices Excellent image No adverse factors Yes No Yes No Unqualified report for the past 3 yrs. Unqualified report for past 2 yrs. Other cases Complied with Not complied with

3 2 1 0 2 1 0 3 2 1 0 2 1 0

2 3

2 1 0 2 0 2 1 1 0 1 0 2 1 0 2 0

2 2 2 1 1 2

XI.

Statutory compliance
a) Pollution Board b) Environmental clearance c) Sales tax income tax no.

d) Export/import code
(list only illustrative)

Sub total 96

22

C. Industry risk 1. Market potential/ demand situation Diversification among different consumer segments Competitive situation Good Neutral Unfavorable High Moderate low 2 1 0 2 1 0 3 2 1 0 2 1 0 2 1 0 2 1 0 3 2 1 0 2 1 0 18 2 2

2.

3.

4.

5.

6.

7.

8.

Monopoly situation Favorable Neutral Unfavorable Inputs/ raw High material Moderate availability Low Locational issues Favorable Neutral Unfavorable Technology Superior Adequate Low Manufacturing Good efficiency/capacity Satisfactory utilization Average Below average Cyclicality/ Not affected by cyclical seasonality fluctuations Favorable industry cycle with long term prospects Susceptible to unfavorable changes in the markets/ industry cycle

2 2 2 3

Sub total

97

Summary

Borrower Rating A. Financial aspects B. Management risk C. Market/industry risk Sub total D. Cash flow related parameters Total No. of parameters 10 10 8 28 2 Marks 30 22 18 70 6

30

76

2. RATING OF THE FACILITY

A. Compliance of sanction terms


1. Compliance of sanction terms Submission of stock statements All sanction terms complied with Only 2nd charge not registered EM not completed Timely submission Submitted within 30 days from due date Belated submission beyond 30 days Submitted within 3 months Between 3 and 6 months from Delay > 6 months (From closure of the A/c) Up to 5 years More than 5 years Turnover commensurate with sales Turnover > 70% to < 90% Turnover > 60% to < 70% Turnover < 60 % Top class no occasion of excess and return of cheques Satisfactory rare occasions Average Occasional Below average - Frequent 2 1 0 2 1 0 2 1 0 2 1 3 2 1 0 3 2 1 0 2 2

2.

3.

Submission of audited balance sheet & profit & loss A/c Repayment schedule for term loans only Operations in the account

4.

2 3

5.

6.

Operations in the account

98

7.

Commitments under term loan and payment on interest on cash credit/ overdraft etc. Margin given on term loan

Timely payment Irregular up to 1 month from due date Irregular beyond 1 month up to 2 months Delayed beyond 2 months > 40% margin > 25% to < 40% margin 20% to < 25% < 20 %

3 2 1 0 3 2 1 0

8.

Sub total

20

III. BUSINESS CONSIDERATIONS Length of relationship > 5 years 1. 2.


Income value to the bank from the account as %age to total fund based limits

1 5 years < 1 year > 10% > 8% - 10% < 8%

2 1 0 2 1 0

2 2

Sub total

SUMMARY I. II. III. Rating of the Borrower Cash Flow related Parameters Rating of the facility Business Aspects TOTAL Marks 70 6 20 4 100

Note: The total score under the model is 100. When one or more parameters are not applicable, the score obtained under the applicable parameters should be converted into% terms and appropriate grade/ rating is assigned.

99

This is how the banks quantify the credit risk involved. The above model includes both qualitative and quantitative data and the financial data used is certified by a registered Chartered Accountant. This credit rating is generally done on a yearly basis. So every year the credit rating of a firm may improve or deteriorate. And on this credit rating interest rate to be charged, the limits for L/C, L/G, preshipment finance and post shipment finance is based. So as the credit rating goes down, the interest to be charged to the business increases. For the above credit rating model the financial indicators which come into picture are as follows: Year Ending Paid up Capital Reserves & Surplus Intangible Assets Tangible Net Worth Long Term Liabilities Capital Employed Net Block Investments Non Current Assets Net Working Capital Current Assets Current Liabilities Current Ratio Debt Equity Ratio DER (TOL/TNW) Net Sales Other Income Net Profit Before tax Net Profit After Tax Depreciation Cash Accruals 31.3.2006 (Aud.) 31.3.2007 (Aud.) 31.3.2008 (Aud/ Prov) 31.3.2009 (Est.)

100

The company may apply for a loan of any amount but one of the way through which bank fixes this loan amount is as follows:

Total Current Assets. Less: Current Liabilities (Other than Bank Borrowings) Working Capital Gap. NWC Flexible Bank Balance (FBF) Net Sales NWC to TCA % Flexible Bank Finance to TCA % Sundry Creditors to TCA %

The flexible bank finance (FBF) is the amount which gets sanction as a loan (WC term loan). If additional amount is required by the firm it will have to provide a security for it. Though looks simple, but it requires a lot of documentation and hard work to get the sanction of the loan from the bank.

Value Added Notes

The format for granting advances is available in the CD attached to this book. It will give the reader an idea what are the requirements that he/she will have to satisfy. After granting the loan too, the borrower will have to furnish all the data the lender (bank) requires.

101

Chapter 8 Interest Rate Volatility and its impact on Profitability a GAP Analysis

Even a correct decision is wrong when it was taken too late. Lee Iacocca

The acceptance and management of financial risk is inherent to the business of banking and banks roles as financial intermediaries. To meet the demands of their customers and communities and to execute business strategies, banks make loans, purchase securities, and take deposits with different maturities and interest rates. These activities may leave a banks earnings and capital exposed to movements in interest rates. This exposure is interest rate risk. Why are the interest rates so volatile in India? Inflation touching historical heights of 2 digits i.e. 11.42. This means that the real interest rate is negative in India. Real Interest rate = Nominal Interest rate Inflation rate That implies that though they may be keeping deposits with the banks and earning interest of 5-6% but their deposit is still getting eroded in terms of value making the banks think of increasing the deposit rates. RBI has a job to do i.e. to curb inflation for which it has taken broad steps of increasing the repo rate to 8.5% and the CRR ratio to 8.75% to suck the liquidity from the market through banks so that inflation can be controlled. Repo rate is the discount rate at which a central bank repurchases government securities from the commercial banks, depending on the level of money supply it decides to maintain in the country's monetary system. To temporarily expand the money supply, the central bank decreases repo rates (so that banks can swap their holdings of government securities for cash), to contract the money supply it increases the repo rates.

102

In terms of Section 42(1) of the RBI Act 1934, Scheduled Commercial Banks are required to maintain with RBI an average cash balance, the amount of which shall not be less than three per cent of the total of the Net Demand and Time Liabilities (NDTL) in India, on a fortnightly basis and RBI is empowered to increase the said rate of CRR to such higher rate not exceeding twenty percent of the Net Demand and Time Liabilities (NDTL) under the RBI Act, 1934.

So, now due to the increase in these rates the Scheduled Commercial Banks will face the problem of shortage and increase in the cost of funds due to which either it will have to increase its advances rate or decrease its deposit rates. Facing such a dual dilemma and in addition the competition between banks makes it even tougher to take a decision on either side. So is the subject of INTEREST RATE VOLATILITY RISK getting more and more encouragement and so is this study made.

GAP analysis Interest rate risk measurement can be done by inspecting assets and liabilities classified into maturity buckets, and computing the gap between assets and liabilities, in each time bucket. A bank can compute the gap statement where each component is classified into a time bucket based on time to repricing. In India, this interest rate risk statement is computed by banks and submitted to the regulator, the Reserve Bank of India. The statement is, however, not required to be made public. Public disclosure consists of what is called the liquidity statement, which shows the maturity distribution where each component is classified based on the time to maturity. If gap analysis had to be undertaken by independent analysts, then this would require imputation of the interest rate risk statement using public disclosures.

103

While gap analysis reveals mismatches at various maturities, it does not offer a mechanism for reducing them into a single scalar measure of the vulnerability of the bank, and in judging the economic significance of the vulnerability.

Rate Sensitive Assets (RSA) includes: Short term securities issued by the government and private borrowers Short term loans made by bank to borrowing customers Variable rate loans made by the bank to borrowing customers

Rate Sensitive Liabilities (RSL) includes: Borrowings from money market Short term savings A/c Money market deposits Variable rate deposits

UBI 1 - 14 days 15 28 days Deposits Loans & Advances Investment, 354 securities Borrowings 1568 28 387 397 759 1558 50 13 329 1058 697 1163 9827 5120 15266 6123 3932 1025 2018 29 days 3 8183 7960 3 6 9436 7080 6 12 13653 9483 1 yr 3 yrs. 5 yrs. 5987 7278 Over 5 yrs.

months months 3 yrs.

months months months 21194 29515 38256 7133

104

1 - 14 days

15 - 28 days

29 days 3 months

3 months 6 months 7777 9833 -2056

6 months 12 months 10646 14412 -3766

1 yr 3 yrs.

3 yrs. 5 yrs.

Over 5 yrs.

RSA RSL GAP

4286 7691 -3405

2347 1053 1294

9018 8570 448

39342 22752 16590

12398 6037 6361

22399 38269 -15870

Observations More amounts of borrowings are usually made in the short term maturity buckets than in above 1 year maturity buckets. Huge investments are made in the maturity bucket of over 5 years. The amount of deposits is highest in the maturity buckets of 1 3 years and above 5 years buckets. The amount of loans and advances is also more in the maturity bucket of 1 year 3 years.

Generalizations When the GAP position is positive and when interest rates rise, there will be increase in the Net Interest Income. When the GAP position is positive and interest rates fall, there will be decrease in Net Interest Income. When GAP position is negative and when interest rates rise, there will be decrease in Net Interest Income. When GAP position is negative and when interest rates fall, there will be increase in Net Interest Income.

105

Suggestions The interest rate risk measurement system employed by a bank should be sufficient to access the effect of interest rate changes on both earnings and economic value. The system should also provide a meaningful measure of the Banks interest rate exposure and should be capable of identifying any excessive exposures that may arise.

Outcome To conclude, a positive GAP is beneficial when interest rates rise, as it will result in increase in Net Interest Income. A negative GAP will prove to be advantageous when interest rates fall, as it will also result in increase in Net Interest Income. Total elimination of interest rate risk may not be practical in Indian Banking scenario. However, being conscious of its existence, magnitude and impact and managing it well is the essence of risk management function.

106

Value Added Notes


A Comparison of Domestic Deposit Card Rates of different Indian Banks

Tenor

BOI 12/11/ 07

OBC ~ 01/01/ 08 3.50 3.50 4.75 5.50 6.50 8.00 6.50 7.75 7.75 8.75 8.75 8.75 8.75 9.00 9.00

SBI @ 04/01/ 08 <1 Cr 4.75 4.75 5.25 7.00 7.00 7.00 7.50 7.50 8.75 8.75 8.75 8.75 8.50 8.50 8.50 8.50 8.50 8.50

PNB 29/10/07 < 5Cr 4.25 5.25 5.25 6.25 6.25 6.25 6.25 7.50 7.50 8.50 8.50 8.50 8.50 8.50 8.50 8.50 8.50 8.50 8.50

Central 03/12/07 3.75 4.75 4.75 5.50 6.00 6.00 6.00 7.25 7.25 8.25 8.25 9.25 8.25 8.50 8.75 8.75 8.50 8.50 8.50

Canar a 10/08/0 7 Upto 2 Crs 4.00 4.75 4.75 5.50 6.00 6.00 6.00 7.25 7.25 8.50 8.50 8.50 8.50 8.75 8.75 8.75 8.50 8.50 8.50

BOB 15/11/0 7 <1 Cr 3.50 4.50 4.50 5.00 6.25 6.25 6.25 7.25 7.25 8.50 8.50 8.50 8.50 8.25 8.25 8.25 7.50 7.50 8.00

IOB $ 01/11/07 3.50 4.00 4.75 5.25 6.00 6.00 6.00 6.75 ++ 7.50 ^^ 8.25 8.25 8.25 8.25 8.50 8.75 8.75 8.50 8.50 8.50

Allaha bad ^^ 10/02/0 8 3.00 3.00 4.75 6.50 7.00 7.00 7.00 7.50 7.50 8.50 8.50 9.00 9.00 8.75 8.75 8.75 8.75 8.75 8.75

Min

Max

Union Bank 24/10/0 7 -

Max Limit 7-14 days 15-30 days 31-45 days 46-90 days 91-129 days 120 Days 121 - 179 days 180 days 270 days 271 days to <1 year 1 year > 1 years 554 days 555 Days 556 Days < 2 years 2 years < 3 years 3 years

< 5Cr 3.00 4.50 4.50 5.50 6.00 6.00 6.00 7.25 7.25 8.50 8.50 8.50 8.50 8.75 8.75

3.00 3.00 4.50 5.00 6.00 6.00 6.00 7.25 7.25 8.25 8.25 8.25 8.25 8.25 8.25 8.25 7.50 7.50 8.00

4.25 5.25 5.25 6.50 7.00 8.00 7.00 7.75 7.75 8.75 8.75 9.25 9.00 9.00 9.00 8.75 9.00 9.00 9.00

3.75 4.00 4.00 5.00 5.50 5.50 5.50 6.50 6.50 8.25 8.25 8.25 8.25 8.75 8.75 8.75 8.75 8.75 8.75

> 3 years < 8.75 8.75 5 years 5 years < 7 9.00 8.75 years 7 years < 8 9.00 8.75 years 8 years 9.00 8.75 and above @ 91-180 days -7% and 181 <1 Yr 7.50% ** Union 94 Months Scheme - 9%

$ IOB - For deposit above 25 lakhs

Lower than UBI rate

Higher than UBI rate

Equals UBI rate

107

Chapter 9 Indianising Altmans Z score Model


Well, when you're trying to create things that are new, you have to be prepared to be on the edge of risk. - Michael Eisner

20695 is the number of cases of businesses defaulting an amount of more than 100 lacs individually in the year 2007 which is an increase of nearly 17.5% over and above its previous year. It can be said that greatest of the risk that the bank faces is the credit risk. If the Bank knew that a bankruptcy might occur in the next year or two, it could better protect itself. But how can one predict which businesses are likely to go bankrupt and which are not? About 40 years ago, Edward I. Altman set out to answer this question. Altman, a financial economist at New York University's Graduate School of Business, developed a model for predicting the likelihood that a firm would go bankrupt. This model uses five financial ratios that combine in a specific way to produce a single number. This number, called the Z Score, is a general measure of corporate financial health. Later, Altman developed a modified version for private manufacturing firms and a second version for use by all businesses. But the study undertaken will consider only its main model i.e. mainly the public listed companies.

Before going on with Indianising Altman Z score model lets first understand the General Altman Z score model theoretically.

108

A Short Z-Score History In 1966 Altman selected a sample of 66 corporations, 33 of which had filed for bankruptcy in the past 20 years, and 33 of which were randomly selected from those that had not. The asset size of all corporations ranged from $1 million to $26 million...approximately $5 million to $130 million in 2005 dollars. Altman calculated 22 common financial ratios for all 66 corporations. (For the bankrupt firms, he used the financial statements issued one year prior to bankruptcy.) His goal was to choose a small number of those ratios that could best distinguish between a bankrupt firm and a healthy one. To make his selection Altman used the statistical technique of multiple discriminant analysis. This approach shows which characteristics in which proportions can best be used for determining to which of several categories a subject belongs: bankrupt versus nonbankrupt, rich versus poor, young versus old, and so on. The advantage to MDA is that many characteristics can be combined into a single score. A low score implies membership in one group, a high score implies membership in the other group, and a middling score causes uncertainty as to which group the subject belongs. Finally, to test the model, Altman calculated the Z Scores for new groups of bankrupt and nonbankrupt firms. For the nonbankrupt firms, however, he chose corporations that had reported deficits during earlier years. His goal was to discover how well the Z score model could distinguish between sick firms and the terminally ill. Altman found that about 95% of the bankrupt firms were correctly classified as bankrupt. And roughly 80% of the sick, nonbankrupt firms were correctly classified as nonbankrupt. Of the misclassified nonbankrupt firms, the scores of nearly three fourths of these fell into the gray area.

109

The Z score Ingredients

The Z score is calculated by multiplying each of several financial ratios by an appropriate coefficient and then summing the results. The ratios rely on these financial measures:

Working Capital is equal to Current Assets minus Current Liabilities. Total Assets is the total of the Assets section of the Balance Sheet. Retained Earnings is found in the Equity section of the Balance Sheet. EBIT (Earnings Before Interest and Taxes) includes the income or loss from operations and from any unusual or extraordinary items but not the tax effects of these items. It can be calculated as follows: Find Net Income; add back any income tax expenses and subtract any income tax benefits; then add back any interest expenses.

Market Value of Equity is the total value of all shares of common and preferred stock. The dates these values are chosen need not correspond exactly with the dates of the financial statements to which the market value is compared.

Net Worth is also known as Shareholders' Equity or, simply, Equity. It is equal to Total Assets minus Total Liabilities.

Book Value of Total Liabilities is the sum of all current and long-term liabilities from the Balance Sheet.

Sales include other income normally categorized as revenues in the firm's Income Statement.

110

The original model took the following form: Z = 0.012 X1 + 0.014 X2 + 0.033 X3 + 0.006 X4 + 0.999 X5 Where, X1 = Working Capital/total assets X2 = Retained Earnings/total assets X3 = EBIT/total assets X4 = Market value of equity/book value of total liabilities X5 = Sales/total assets (1)

In the original version, all ratios were stated as percentages, except X5, which was stated as an absolute value. For example, if EBIT/total assets ratio were 15%, or 0.15, X3 would be assumed to equal 15. Eventually, a more convenient specification was proposed:

Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5

(2)

In this specification, an EBIT/total assets ratio of 15% would result in X3 = 0.15. X5, as was the case in the original version, is stated as an absolute value. Altman himself used this version in Altman and Lafleur (1981). For public manufacturer if the score is 3.0 or above bankruptcy is not likely. If the score is 1.8 or less bankruptcy is likely. A score between 1.8 and 3.0 is the gray area.

111

Z score Less than 1.81 Between 1.81 and 3.00 More than 3.00

Groups Default group Gray zone Non default group

Objective of the study

The objective behind this study is to find out whether Altman Z score model can be implemented in India; whether it can predict before a year or two that this public listed company is going to default or not and if not why i.e. what are its criticisms and what steps should have to be taken to make it fit for public listed companies of India. As our purpose of the study is to find out that it can predict default or not we will be considering only the default companies.

Study method
In this study we will be considering 30 public listed companies of India which have already defaulted for amount of more than 100 lacs as on 31st march, 2008. So, now as we know these 30 companies have already defaulted in the year 2008, we will be using these companies balance sheet and profit and loss data for the years older than 2007. So if it can predict accurately with a good success rate in that respective year that the company is going to default with the bank than it will prove that Altman Z score can be indianised.

112

Source
The data of defaulted companies have been taken from www.cibil.com. The banks with whom the businesses have defaulted are as follows:

Financial Institutions Foreign bank Nationalized Banks Others

Global Trade Finance Ltd. JP Morgan Chase NA Andhra Bank, Central Bank of India SBI Orissa, EXIM Bank of India, SIDBI

Analysis of the study


Z Score of the 30 default companies considered are as follows: i. Z = 1.5421 ii. Z = -2.9567 iii. Z = -1.1275 iv. Z = -26.6512 v. Z = 2.6882 vi. Z = 4.0515 vii. Z = -0.728 viii. Z = -12.7313 ix. Z = -2.8853 x. Z = 4.1753 xi. Z = -1.7516 xii. Z = - 64.3325 xiii. Z = -16.8121 xiv. Z = -6.3888 xv. Z = 0.1384 xvi. Z = 0.4046 xvii. Z = -8.6366 xviii. Z = 2.4323

113

xix. Z = 5.1028 xx. Z = 0.7418 xxi. Z = -2.5588 xxii. Z = 1.3643 xxiii. Z = -70.9386 xxiv. Z = 4.6558 xxv. Z = 5.1679 xxvi. Z = -102.6486 xxvii. Z = -3.7374 xxviii. Z = -71.1534 xxix. Z = -69.753 xxx. Z = -6.5002

Default group Gray zone Non default group

23 2 5

If we consider default groups to total number of companies it gives us 76.67% success rate and if we consider both default group and gray zone to total no. of companies it comes to 83.33% success rate.

Findings
Altman Z score model can be Indianised for public sector companies as it has the capability to predict whether the company will default or not before a year or two. Problem faced Some companies taken above include balance sheet and Profit and loss data of even as old as years such as 2000, 2001 and 2002. So if the data was available for the past 1 year or 2 it may have given us a better success rate than it has given us above.

114

Before concluding I would like to throw light on some criticisms of the Altmans

Z score model:-

Market value of Equity (MVE) = no. of shares * share price/CL + LT liability As share prices change every day, MVE changes every day and as a result the Z score too. Hence proving to be very hectic for banks as a sudden volatility like going on now in the Indian Stock Markets can change Z score of businesses from very high to a low point or vice versa.

If Company is in gray zone it is not clear in which direction the company is and where it will go?

Qualitative factors such as Management team, innovative tools used, products, segments, marketing initiatives, future growth plans, SWOT analysis, industry in which business operates, competition, raw material availability and supply, demand of the products, labor union stability, etc are ignored. Stress is given only on the financial ratios.

If share prices are not available e.g. shares are not traded for last 2-3 months or a year what value to be taken?

Quarterly results of Profit & loss is available but of balance sheet it is not. So it is difficult to find quarterly Z scores.

Private sector companies data not easily available and if available question on its authenticity arrives.

115

Outcome
To conclude it can be said that Altmans Z score model can not only be used by banks but also the investors because many of the above companies were not traded after they defaulted. But it still cant be used as a single credit tool by banks to check the credibility of the businesses. So it may be preferable to include Altmans Z score model in the credit rating model of the bank in place of the financial ratios used by the banks.

116

Conclusion

Future remains uncertain. It has become more difficult now to predict what is going to happen and what is in store for an economy in the near future. The global factor which didnt affect much the economy earlier is now affecting it very badly. The factor to which I am pointing out is Crude oil which touched a record high of $147/barrel nearly an increase of 45% from the beginning of the year 2008. It is because of this reason that inflation peaked to a 13 year high of 12.01% for the week ended 26th july, 2008. BSE Sensex of 30 companies has weightage of around 20% for oil companies which fell due to surging oil prices making sensex also to dip. Due to rising inflation, RBI which has the responsibility to curb it took steps by using its tools

THE RISING COST OF MONEY


(Major banks lending rates) Bank ICICI Bank Consumer loans* Companies** HDFC Floating rate Fixed rate PLR INCREASES Central Bank IndusInd Bank Yes Bank Bank of Rajasthan DEPOSIT RATES Bank ICICI Bank Yes Bank Increase (bps) 75-100 25^ 75 75 50 100 13.75 17.00 17.00 16.00 75 NIL 11.75*** 14.00 75 75 14.25 17.25 Increase New rate (bps) (%)

* Floating reference rate; ** Benchmark advance rate *** Minimum rate on new loans ^ For deposits of one year and one day to 18 months (Source: Banks)

in the benefit of the economy. It raised the Repo rate to 9% (125bps increase) and the CRR to 9% (100bps increase). Due to this step Indian banks felt the pinch as the cost of funds increased. Due to which banks started to raise rates as you can observe in the table.

Another risk that the Indian Banks are now facing is the exchange rate volatility (table below) due to which hedging risk using various Derivative tools has become one of its important function which cannot be ignored.

117

Currency

04/08/08

05/08/08

06/08/08

07/08/08

GBP Euro USD

84.6335 66.911 42.545

82.4265 65.2860 42.245

81.929 64.75 42.085

81.755 64.665 42.075

Aus $

40.711

38.6765

38.2195

38.187

The above table gives us the exchange rate of just 4 days that how volatile the Forex market has been these days. Also it can be observed that when exchange rate was out of control of RBI i.e. it was appreciating, inflation was under control at around 5%. But when exchange rate came under control of RBI inflation got out of control. Both situation are not at all favorable for Indian Banks due to which it has become very important to have an active Risk Management department and an Asset Liability Management Department in a Bank. Another issue which needs to be seen is the credit rating model used by the banks. It is very difficult to quantify credit risk but as the rates tends to rise this factor gets more important from banks point of view. An effort is made in this project to use ALTMANs Z score model for Indian Public listed companies which can prove very effective at times as it will give an indication that the client may default in the near future making the bank more vigilant and help in taking steps for the same well in advance.

118

REFERENCES Books
Credit Derivatives (George Chacko, Anders Sjoman, Hideto Motohashi, Vincent Dessain) Total Quality Loan Management (S Wayne Linder) Treasury, Investment & Risk Management (The Indian Institute Of Bankers) Derivatives Simplified (Mahapatra, Bhaskar) International Trade & Finance (ICFAI Publications) Risk Management in Banking (Joel Bessis) Export Import and Logistics Management (Usha Kiran Rai) A Foreign Exchange Primer (Shani Shamah) International Finance (B.M.S. Semester VI, Dipak Abhyankar) Economics of Global Trade & Finance (M. Com Part I)

Magazine
Banking Finance Volume XXI No. 5 May 08

Websites
www.rbi.org.in www.dgft.delhi.nic.in personal website of R Kannan www.bis.org www.defaultrisk.com www.unionbankofindia.co.in www.infodriveindia.com www.i-b-t.net

119

www.ssrn.com www.eximin.net www.finmin.nic.in

www.business-standard.com www.bloomberg.com www.livecharts.co.uk www.advfn.com www.mospi.nic.in Indiabudget.nic.in Exim.indiamart.com www.oil-price.net

UBI Database:
Handbook of Imports Handbook of Exports Annual Report of UBI Credit Rating Model Private Companies financial results UBI website

120