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What Is Credit?

The word "credit" has many meanings in the financial world, but it most commonly refers to a
contractual agreement in which a borrower receives a sum of money or something else of value and
commits to repaying the lender at a later date, typically with interest.

Credit can also refer to the creditworthiness or credit history of an individual or a company—as in
"she has good credit." In the world of accounting, it refers to a specific type of bookkeeping entry.

Credit in Lending and Borrowing

Credit represents an agreement between a creditor (lender) and a borrower (debtor). The debtor
promises to repay the lender, often with interest, or risk financial or legal penalties. Extending credit
is a practice that goes back thousands of years, to the dawn of human civilization, according to the
anthropologist David Graeber in his book Debt: The First 5000 Years.

There are many different forms of credit. Common examples include car loans, mortgages, personal
loans, and lines of credit. Essentially, when the bank or other financial institution makes a loan, it
"credits" money to the borrower, who must pay it back at a future date.

Credit cards may be the most ubiquitous example of credit today, allowing consumers to purchase
just about anything on credit. The card-issuing bank serves as an intermediary between buyer and
seller, paying the seller in full while extending credit to the buyer, who may repay the debt over time
while incurring interest charges until it is fully paid off.

Similarly, if buyers receive products or services from a seller who doesn't require payment until later,
that is a form of credit. For example, when a restaurant receives a truckload of produce from a
wholesaler who will bill the restaurant for it a month later, the wholesaler is providing the restaurant
owner with a form of credit.

Other Definitions of Credit

"Credit" is also used as shorthand to describe the financial soundness of businesses or individuals.
Someone who has good or excellent credit is considered less of a risk to lenders than someone with
bad or poor credit.

Credit scores are one way that individuals are classified in terms of risk, not only by prospective
lenders but also by insurance companies and, in some cases, landlords and employers. For example,
the commonly used FICO score ranges from 300 to 850. Anyone with a score of 800 or higher is
considered to have exceptional credit, 740 to 799 represents very good credit, 670 to 739 is good
credit, 580 to 669 is fair, and a score of 579 or less is poor.1

Companies are also judged by credit rating agencies, such as Moody's and Standard and Poor's, and
given letter-grade scores, representing the agency's assessment of their financial strength. Those
scores are closely watched by bond investors and can affect how much interest companies will have
to offer in order to borrow money. Similarly, government securities are graded based on whether the
issuing government or government agency is considered to have solid credit. U.S. Treasuries, for
example, are backed by "full faith and credit of the United States."

In the world of accounting, "credit" has a more specialized meaning. It refers to a bookkeeping entry
that records a decrease in assets or an increase in liabilities (as opposed to a debit, which does the
opposite). For example, suppose that a retailer buys merchandise on credit. After the purchase, the
company's inventory account increases by the amount of the purchase (via a debit), adding an asset
to the company's balance sheet. However, its accounts payable field also increases by the amount of
the purchase (via a credit), adding a liability.

What Is a Letter of Credit?

Often used in international trade, a letter of credit is a letter from a bank guaranteeing that a seller
will receive the full amount that it is due from a buyer by a certain agreed-upon date. If the buyer
fails to do so, the bank is on the hook for the money.

What Is a Credit Limit?

A credit limit represents the maximum amount of credit that a lender (such as a credit card
company) will extend (such as to a credit card holder). Once the borrower reaches the limit they are
unable to make further purchases until they repay some portion of their balance. The term is also
used in connection with lines of credit and buy now, pay later loans.

What Is a Line of Credit?

A line of credit refers to a loan from a bank or other financial institution that makes a certain amount
of credit available to the borrower for them to draw on as needed, rather than taking all at once. One
type is the home equity line of credit (HELOC), which allows owners to borrow against the value of
their home for renovations or other purposes.

What Is Revolving Credit?

Revolving credit involves a loan with no fixed end date—a credit card account being a good example.
As long as the account is in good standing, the borrower can continue to borrow against it, up to
whatever credit limit has been established. As the borrower makes payments toward the balance,
the account is replenished. These kinds of loans are often referred to open-end credit. Mortgages
and car loans, by contrast, are considered closed-end credit because they come to an end on a
certain date.

The Bottom Line

The word "credit" has multiple meanings in personal and business finance. Most often it refers to the
ability to buy a good or service and pay for it at some future point. Credit may be arranged directly
between a buyer and seller or with the assistance of an intermediary, such as a bank or other
financial institution. Credit serves a vital purpose in making the world of commerce run smoothly.
Credit Risk:
Credit risk is the probability of a financial loss resulting from a borrower's failure to repay a
loan. Essentially, credit risk refers to the risk that a lender may not receive the owed
principal and interest, which results in an interruption of cash flows and increased costs for
collection. Lenders can mitigate credit risk by analyzing factors about a borrower's
creditworthiness, such as their current debt load and income.
Although it's impossible to know exactly who will default on obligations, properly assessing
and managing credit risk can lessen the severity of a loss. Interest payments from the
borrower or issuer of a debt obligation are a lender's or investor's reward for assuming
credit risk.
Understanding Credit Risk

When lenders offer mortgages, credit cards, or other types of loans, there is a risk that the borrower
may not repay the loan. Similarly, if a company offers credit to a customer, there is a risk that the
customer may not pay their invoices.

Credit risk can describe the risk that a bond issuer may fail to make payment when requested or that
an insurance company will be unable to pay a claim.

Credit risks are calculated based on the borrower's overall ability to repay a loan according to its
original terms. To assess credit risk on a consumer loan, lenders often look at the five Cs of
credit: credit history, capacity to repay, capital, the loan's conditions, and associated collateral.1

Some companies have established departments responsible for assessing the credit risks of their
current and potential customers. Technology has afforded businesses the ability to quickly analyze
data used to assess a customer's risk profile.

Bond credit-rating agencies, such as Moody's Investors Services and Fitch Ratings, evaluate the credit
risks of corporate bond issuers and municipalities and then rate them. If an investor considers buying
a bond, they will often review the credit rating of the bond. If a bond has a low rating (< BBB), the
issuer has a relatively high risk of default. Conversely, if it has a stronger rating (BBB, A, AA, or AAA),
the risk of default is lower.

Credit Analysis

What Is Credit Analysis?

Credit analysis is a type of financial analysis that an investor or bond portfolio manager performs on
companies, governments, municipalities, or any other debt-issuing entities to measure the issuer's
ability to meet its debt obligations. Credit analysis seeks to identify the appropriate level of default
risk associated with investing in that particular entity's debt instruments.

How Credit Analysis Works

To judge a company’s ability to pay its debt, banks, bond investors, and analysts conduct credit
analysis on the company. Using financial ratios, cash flow analysis, trend analysis, and financial
projections, an analyst can evaluate a firm’s ability to pay its obligations. A review of credit scores
and any collateral is also used to calculate the creditworthiness of a business.

Not only is the credit analysis used to predict the probability of a borrower defaulting on its debt, but
it's also used to assess how severe the losses will be in the event of default.

The outcome of the credit analysis will determine what risk rating to assign the debt issuer or
borrower. The risk rating, in turn, determines whether to extend credit or loan money to the
borrowing entity and, if so, the amount to lend.

Credit Analysis Example

An example of a financial ratio used in credit analysis is the debt service coverage ratio (DSCR). The
DSCR is a measure of the level of cash flow available to pay current debt obligations, such as interest,
principal, and lease payments. A debt service coverage ratio below 1 indicates a negative cash flow.

For example, a debt service coverage ratio of 0.89 indicates that the company’s net operating income
is enough to cover only 89% of its annual debt payments. In addition to fundamental factors used in
credit analysis, environmental factors such as regulatory climate, competition, taxation, and
globalization can also be used in combination with the fundamentals to reflect a borrower's ability to
repay its debts relative to other borrowers in its industry.

Special Considerations

Credit analysis is also used to estimate whether the credit rating of a bond issuer is about to change.
By identifying companies that are about to experience a change in debt rating, an investor or
manager can speculate on that change and possibly make a profit.

For example, assume a manager is considering buying junk bonds in a company. If the manager
believes that the company's debt rating is about to improve, which is a signal of relatively lower
default risk, then the manager can purchase the bond before the rating change takes place, and then
sell the bond after the change in rating at a higher price. On the other side, an equity investor can
buy the stock since the bond rating change might have a positive impact on the stock price.

7Cs of Creditworthiness
Creditworthiness measures how deserving an applicant is to get a loan sanctioned in his favor. In
other words, it assesses the likelihood that a borrower will default on their debt obligations. It is
based upon factors such as their repayment history and credit score.

Lending Institutions also consider the availability of assets and the extent of liabilities to determine
the probability of default. The 7’Cs of creditworthiness indicate the characteristics or features of
creditworthiness.

7C of creditworthiness are;

1. Character

2. Capacity

3. Cash

4. Capital

5. Collateral

6. Conditions

7. Control

Character

Responsibility, truthfulness, serious purpose, and serious intention to repay all monies owed make
up what is called character.

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The loan officer must be convinced that the customer has a well-defined purpose for requesting
credit and a serious intention to repay. The loan officer must determine if the purpose is consistent
with the bank’s loan policy, even with a good purpose.

However, the loan officer must determine that the borrower is responsible for using borrowed funds,
is truthful in answering questions, and will make every effort to repay what is owed.

Capacity

The loan officer must be sure that the customer has the authority to request a loan and the legal
standing to sign a binding loan agreement; this customer characteristic is known as the capacity to
borrow money.
For example, in most areas, a minor cannot legally be held responsible for a credit agreement; thus,
the lender would have difficulty collecting on such a loan.

Similarly, the loan officer must be sure that the representative from a corporation asking for credit
has proper authority from the company’s board of directors to negotiate a loan and sign a credit
agreement binding the company.

Cash

This feature of any loan application centers on the question.

Does the borrower have the ability to generate enough cash to repay the loan in the form of flow?
In an accounting sense, cash flow is defined as:

 Cash flow = Net profits + Noncash expenses.

 This is often called traditional cash flow and can be further broken down into Cash flow =
Sales revenues – Cost of goods sold – Selling, general, and administrative expenses- Taxes
paid in cash + Non-cash expenses.

The lender must determine if this volume of the annual cash flow will be sufficient to comfortably
cover the repayment of the loan and deal with any unexpected expenses.

Loan officers should carefully examine five areas when lending money to business firms or other
institutions. These are:

1. The level of and recent trends in sales revenue.

2. The level of and recent changes in the cost of goods sold.

3. The level of and recent trends in selling, general, and administrative expenses.

4. Any tax payments made in cash.

5. The level of and recent trends in noncash expenses.

Capital

Capital represents the potential borrower’s general financial position, emphasizing tangible net
worth and profitability, which indicates the ability to generate funds continuously over time.

The net worth figure in the business enterprise is the key factor that governs the amount of credit
made available to the borrower.

Collateral

In assessing the collateral aspect of a loan request, the loan officer must ask, Does the borrower
possess adequate net worth or owns enough quality assets to provide adequate support for the
loan?

The loan officer is particularly sensitive to such features as the borrower’s assets’ age, condition, and
degree of specialization.

Technology plays an important role here as well. If the borrower’s assets are technologically
obsolete, they will have limited value as collateral because of the difficulty of finding a buyer for
those assets should the borrower’s income falter.
Conditions

The loan officer and credit analyst must be aware of recent trends in the borrower’s work or industry
and how changing economic conditions might affect the loan.

A loan looks very good on paper, only to have its value eroded by declining sales or income in a
recession or by high-interest rates occasioned by inflation.

Control

The last factor in assessing a borrower’s creditworthiness status is control.

This factor centers on such questions as whether changes in law and regulation could adversely
affect the borrower and whether the loan request meets the lender’s and the regulatory authorities’
standards for loan quality.

Creditworthiness Examples: Acceptable and Unacceptable Loan requests of Commercial Banks

Examples

After assessing the borrower’s creditworthiness for the loan, banks make the final decision of
accepting or discarding loan requests.

The regulatory agencies restrict some types of loans while others are logically unacceptable from a
recovery point of view.

In the following section, we will see some acceptable and unacceptable loan requests:

Acceptable Loan Request Unacceptable Loan Request

Short-term working capital loan of the self-liquidating Loans to change the ownership structure of
feature. the firm.

Construction loans without making clear the

Loans are based on unmarketable securities.
source and schedule for repayment.

Loans to finance the carrying of commodities where Loans secured by the second mortgage on
the collateral is the negotiable warehouse receipts. real estate.

Construction loans on condominiums

Non-spec relative construction loans with
(ownership of more than one person) unless
commitments from reliable long-term lenders.
they are pre-sold.

Immovable property developments/expansion loan Loans to a new business without a track

with a clear repayment schedule record unless it is with adequate collateral.

So-called “bullet” loans or non-amortizing

Various kinds of permissible consumers loan
term loans
Acceptable Loan Request Unacceptable Loan Request

Loans where the source of payments is solely

Exceptionally long-term and revolving nature of
public or private financing, not firmly
credits to very reliable parties.
committed.

Construction loans for housing/real estate of which

Unsecured loans for real estate purposes.
the ownership is indisputable.

Loan (without collateral) to a successful businessman

Loans based on unmarketable securities.
with a very high reputation.

This list is far from complete, including only some types more or less generally regarded as desirable/
undesirable for commercial banks.

Depending on the type, location, and size of the bank, others that might be included are;

 Term loans to more than a certain maturity: non-residential,

 The long-term real estate loans: revolving credits, floor plan lines;

 Loans to second mortgage companies;

 Construction loans, unsecured loans to individuals, etc.

This list could be further broadened, but some or all of these types may be highly acceptable to some
banks, although inappropriate for others.

Steps of Credit Analysis –

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

1. Collecting loan information of the applicant,

2. Collecting business information for which loan is sought,

3. Collecting the risk related information,

4. Assembling all credit information together,

5. Analyzing sensitive risky credit information,

6. Analyzing refined & very essential risk information,

7. Making a decision on the basis of loan analysis,

8. Design the appropriate loan structure according to a positive decision.

The above steps are discussed below –

(1) Collecting loan information of the applicant:

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

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

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

(3) Collecting the primary risk related information:

 Assessing the overall political and economic risks.

 Identification and give explanations to the positive and negative factors in conducting the
business.

 Evaluation of the positive sides of cash inflow and its possible stability in the light of the historical
demand of the business.

 Consideration of the future consequences and need for investment in light of the applied loan
proposal and repayment assurance of the loan.

 Evaluation of the impact on the balance sheet of the borrowers after using the loan.

 Assessing the possibility and the extent to which change is occurred in the risk level previously
measured.

(4) Assembling all credit information together:

 Collection of detailed descriptions about the proposed loan

 Collection of detailed information about the loan applicant

 A detailed description of the general financial objectives and plans of the business.

(5) Analyzing sensitive risky credit information:

 Inspection of the proposed business location,

 Collection of detailed information regarding profit earnings from the existing bank-clients
and other parties related to the business,

 Inspection of the internal working environment of the business,

Analysis of the Information regarding trading (selling/purchasing) and the availability of getting credit
opportunity from the suppliers (Trade Credit) and the relationship with the suppliers.
(6) Analyzing refined and very essential risk information:

Analysis of the honesty, integrity sincerity in individual and overall sense towards the proposed
business on the part of the owners, employees, staffs and laborers of the company.

 Analysis of the possible political and economic risk.

 Evaluation of the operational possibility in consideration of the proposed loan.

 Identification of the sources and uses of future cash inflow and outflow of the proposed loan
project.

 Assessment of the secondary safety of the collateral and surety.

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

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

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

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

 Determination of the types of loan, duration of loan and amount of interest in light of risks
associated with the loan.

 Loan analysis process should be here if the terms and conditions for applied loan are not
acceptable.

 Get approvals from the appropriate loan sanctioning authority.

 Sit for discussion with the borrowers about the acceptable conditions of the loan Preparation
& Maintenance of necessary documents of the permitted loan.

At last, it can be said that credit analysis is very much important for a bank for its loan sanctioning
activity and by following the above steps a bank does its credit analyzation.

What is the Credit Process?

The credit process is undertaken to review credit applications and determine whether a loan will be
granted to the applicant. The process seeks to determine the borrower’s ability and willingness to
honor payment obligations (including interest and principal) on time and in full. The process also
investigates the source(s) of funds from which the borrower will make to make an informed decision.
The institution must also understand the borrower’s industry and may undertake a detailed analysis
of how the business generates cash from its operating activities.
The lending institution applies credit analysis, which includes an analysis of both business risk and
financial risk to assess the probability of default. The process also allows the lender to make
informed decisions about structuring and pricing a loan.

Credit Process – Steps Involved

A bank’s loan department manages the process of granting loans to corporates, ensures regulatory
compliance, and undertakes all other related functions. This is an important corporate banking
function, as any type of lending is accompanied by the risk that a borrower will default.

The credit process evaluates the ability and willingness of a borrower to repay the debt, underwrites
the risk, prices the loan, and determines whether the loan fits the bank’s portfolio. An integral part of
the credit process is analysis of the borrower’s cash flows and financial statements.

What Type of Debt – Short-Term or Long-Term?

Borrowers may seek short-term debt (to fund short-term needs such as working capital) or long-
term debt (to support longer-term assets). The most common loans are term loans. Given their
longer duration, they carry higher risk and consequently charge a higher interest rate.

The credit process involves several steps that can be broken down into initial and later stages.

1. Generating a Loan Opportunity

In the initial stage, the product team generates the loan opportunity. Thereafter, the credit team
undertakes a risk assessment that involves an initial analysis of the potential borrower’s business.
Credit analysis covers business risk and financial risk as part of the initial risk assessment.

2. Reviewing the Five Cs of Credit

It might be noted that in credit analysis, financial institutions attempt to mitigate risk by reviewing
the five Cs of credit – capacity, capital, conditions, character, and collateral. These five Cs provide
lenders a framework for identifying and mitigating risk.

3. Structuring the Loan

If the credit analysis yields a positive initial risk assessment, the bank must structure the loan. The
point of structuring a loan is to mitigate risk and includes details such as the identity of the borrower,
any complexities in the borrower’s corporate structure, and a payment schedule that matches the
borrower’s future cash flows.

4. Preparing a Credit Memo

Once the loan is structured, a credit memo is prepared. The memo includes details such as the
borrower’s debt capacity, clarification of risks involved, and how those risks will be mitigated. The
memo is presented to the bank’s credit committee, which decides whether to put the bank’s capital
at risk. At this stage, an application can be rejected even if it passed the initial risk assessment.

5. Loan Syndication

Should the credit committee approve the loan application, the loan will be disbursed, or in the case
of a larger loan, a syndicate team will price the loan and distribute exposure to a group of banks
called a syndicate. The final terms between the banks are negotiated and then the funds are
disbursed. Thereafter, the loan will be monitored to ensure terms are met.
In loan syndication, a group of lenders collaborate to provide credit to a single large borrower, which
could be a conglomerate, multinational corporation, or government. The collaboration usually takes
place through an intermediary, the lead bank, that organizes and administers the syndicated loan. In
loan syndication, the risk is shared by the group of lenders and each lender contributes a portion of
the principal. Syndication typically occurs when the requested loan amount is beyond the capacity of
a single lender.

To develop an even more comprehensive understanding of the process undertaken by lenders, enroll
in the Credit Analyst online course. The course is designed to develop knowledge and skills that can
be applied directly to any credit analyst role.

Submission of Documents for Proving Your Bankability

Bankability is a very important aspect that is a part of credit appraisal. Bankability refers to what will
be accepted by a particular bank. A lender will assess if a loan given to a particular person will result
in future cash flow and profitability.

When you apply for a personal loan or any other loan from a bank or an NBFC, you will be required
to mandatorily furnish certain government-approved documents, reports, and other documents in
order to prove your income, age, and other aspects. These norms will vary from lender to lender.
While applying for your loan, your lender will specify the norms and you will be required to follow
them so that they can decide if the loan can be approved or not. Let us take a look at some of the
common norms that are set by lenders for the credit appraisal process:

Proof of income

In order to prove your monthly income, you will be required to submit certain documents and they
include:

 Most recent bank statements for 3 to 6 months

 Most recent salary slips

 Most recent Income Tax Return (for self-employed individuals)

 Audited financials for the previous 2 years

Proof of address

To prove your residential address, you will have to furnish any one of the following documents:

 Leave and license agreement

 Latest electricity bills or utility bills

 Aadhaar card

 Driving license

 Passport

Proof of identity

To prove your identity and date of birth, you will be required to submit any one of the following
documents:

 Aadhaar
  PAN card

 Voter ID

 Driving license

 Passport-size photographs

Proof of employment

To prove your employment information, you will be required to give certain documents regarding
your employer or your own company (if you are self-employed):

 Letter from your employer

 Offer letter or appointment letter provided by your employer

 Office address proof

 Employment certificate from your present employer

 Certificate of experience or relieving letter from your previous employer(s) to show your
overall work experience

Proof of creditworthiness

To prove your creditworthiness, you can show your credit score to your new lender. This can be done
by submitting your CIBIL report. When you are furnishing your CIBIL report, you should be sure about
the details of your credit score. You should also ensure that your credit score is 750 and above.

With the help of your CIBIL report, your lender will check if you have been prompt while making your
repayments and while clearing your credit card bills. Your lender will also be able to see if you have
defaulted any loan during your entire credit history and if you have made many enquiries. Hence,
you need to be very particular about how your credit report looks.

Proof of investment

If you have made any investment, you will be required to provide proofs. This can be done by giving
documents of your investments such as fixed deposits, shares, mutual funds, fixed assets, gold, etc.

When the lender takes a look at your income proof, age proof, and employment proof, the lender
gets an idea about your overall profile and the bank can determine if you will be able to repay your
loan promptly without any financial struggles.

What is loan pricing?

Loan pricing is the process of determining the interest rate for granting a loan, typically as an interest
spread (margin) over the base rate, conducted by the bookrunners. The pricing
of syndicated loans requires arrangers to evaluate the credit risk inherent in the loans and to
gauge lender appetite for that risk.

For market-based loan pricing, banks incorporate credit default spreads as a measure
of borrowers’ credit risks. It is standard procedure in loan pricing to benchmark a loan against recent
comparable transactions (“comps”) and select the base rate on which the financing costs are pegged.
A comparable deal is one with a borrower in the same industry, country and of the same size with
the same credit rating, for which a certain market rate of return is required.
A bank’s credit rating has a direct impact on its cost of funding and, thus, the pricing of its loans.
Banks with a high credit rating generally have access to lower cost funds in debt markets and low
counterparty margins in swap and foreign exchange markets. The lower cost of funds can be passed
on to borrowers in the form of lower loan pricing.

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

In conclusion, there needs to be a balance between the company’s debt structure, equity
capital, business risk, and future growth prospects. Several credit facilities aim to tie these aspects
together for a company to function well.

Cash Credit

Introduction to Cash Credit

Cash Credit is a short term loan approved by banks for businesses, financial institutions and
companies to meet their working capital requirements. The borrowing company can take money,
even without a credit balance, upto whatever borrowing limit exists.

Understanding Cash Credit

Cash Credit (CC) is a source of short term finance for businesses and companies. Cash credits are also
called working capital loans as they fund the instant cash requirements of the organizations, or to
purchase current assets. Borrowing limits on the amount of cash available for credit for the company
varies between commercial banks. The interest charged is on the daily closing balance instead of the
upper borrowing limit, so the repayment is only on the amount spent from the available limit.
Because it is taken for a short term, the repayment of the amount taken on credit is also set at 12 or
less months. Cash credit is a loan and banks demand collateral to approve it. Cash credits are similar
to overdraft facilities, though there are significant differences between them. Cash credit is available
for a shorter period of time and at a significantly less interest rate than overdrafts. Cash credit is used
by financial institutions and businesses and with a collateral, which thus becomes a loan, overdraft is
approved on the basis of the relationship that the bank and customer share.

Overdraft

An overdraft occurs when there isn't enough money in an account to cover a transaction or
withdrawal, but the bank allows the transaction anyway. Essentially, it's an extension of credit from
the financial institution that is granted when an account reaches zero. The overdraft allows the
account holder to continue withdrawing money even when the account has no funds in it or has
insufficient funds to cover the amount of the withdrawal.

Basically, an overdraft means that the bank allows customers to borrow a set amount of money.
There is interest on the loan, and there is typically a fee per overdraft. At many banks, an overdraft
fee can run upwards of $35.

Understanding Overdrafts

With an overdraft account, a bank is covering payments a customer has made that would otherwise
be rejected, or in the case of actual physical checks, would bounce and be returned without
payment.
As with any loan, the borrower pays interest on the outstanding balance of an overdraft loan. Often,
the interest on the loan is lower than the interest on credit cards, making the overdraft a better
short-term option in an emergency. In many cases, there are additional fees for using overdraft
protection that reduce the amount available to cover your checks, such as insufficient funds fees per
check or withdrawal.

While banks can charge overdraft fees, they cannot change the order of a customer's transactions in
order to collect more overdraft fees. In 2010, Wells Fargo was fined $203 million for the predatory
practice of structuring customer withdrawals in a way that maximized overdraft fees.1

In 2023, the Consumer Financial Protection Bureau (CFPB) found some financial institutions charged
unfair overdraft fees by authorizing an ATM or debit transaction made when the customer had a
positive balance, but later charging an overdraft fee because intervening transactions went through
before the debit settled. The CFPB found customers could not reasonably avoid these surprise fees. It
told the banks and credit unions to stop charging overdraft fees in these situations and a number of
them have come up with plans to refund customers who were charged them in the past.2

Special Considerations

Your bank can opt to use its own funds to cover your overdraft. Another option is to link the
overdraft to a credit card. If the bank uses its own funds to cover your overdraft, it typically won't
affect your credit score. When a credit card is used for overdraft protection, it's possible that you can
increase your debt to the point where it could affect your credit score. However, this won't show up
as a problem with overdrafts on your checking accounts.

If you don't pay your overdrafts back in a predetermined amount of time, your bank can turn over
your account to a collection agency. This collection action can affect your credit score and get
reported to the three main credit agencies: Equifax, Experian, and TransUnion. It depends on how
the account is reported to the agencies as to whether it shows up as a problem with an overdraft on
a checking account.

If an overdrawn account is not paid off in time, the bank may turn the debt over to a collections
agency.

Overdraft Protection

Some but not all banks will pay overdrafts automatically, as a courtesy to the customer (while
charging fees, of course.) Overdraft protection provides the customer with a further tool to prevent
embarrassing shortfalls that reflect poorly on your ability to pay.

Usually, it works by linking your checking account to a savings account, other checking account, or a
line of credit. If there's a shortfall, this source gets tapped for the funds, ensuring that you won't
have a check returned or a transaction/transfer declined. It also avoids triggering a non-sufficient
funds (NSF) charge.

The dollar amount of overdraft protection varies by account and by bank. Often, the customer needs
to specifically request it. There are a variety of pros and cons to using overdraft protection, but one
thing to bear in mind is that banks aren't providing the service out of the goodness of their hearts.
They usually charge a fee for it.
As such, customers should be sure to rely on overdraft protection sparingly and only in an
emergency. If the overdraft protection is used excessively, the financial institution can remove the
protection from the account.

What Is an Overdraft Fee?

An overdraft is a loan provided by a bank that allows a customer to pay for bills and other expenses
when the account reaches zero. For a fee, the bank provides a loan to the client in the event of an
unexpected charge or insufficient account balance. Typically these accounts will charge a one-time
funds fee and interest on the outstanding balance.

How Does Overdraft Protection Work?

Under overdraft protection, if a client’s checking account enters a negative balance, they will be able
to access a predetermined loan provided by the bank and be charged a fee. In many cases, overdraft
protection is used to prevent a check from bouncing, and the embarrassment that this may cause.
Additionally, it may prevent a non-sufficient fund fee, but in many cases, each will type of fee will
charge roughly the same amount.

What Are the Pros and Cons of Overdrafts?

The pros of overdraft involve providing coverage when an account unexpectedly has insufficient
funds, avoiding embarrassment and "returned check" charges from merchants or creditors. But it's
important to weigh the costs. Overdraft protection often comes with a significant fee and interest
which, if not paid off in a timely manner, can add an additional burden to the account holder.
According to the Consumer Financial Protection Bureau, customers who had overdraft protection, in
fact, often paid more in fees than those without it.

Demand Loan

A demand loan (DL) is a secured loan that has to be repaid by the borrower upon the lender’s
demand. Usually, the tenure of these loans can range from a minimum of seven days to a maximum
of one year. Individuals and businesses mostly use these loans to meet their short-term financial
requirements.
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Typically, lenders grant demand loans to the borrowers against collateral at a floating interest rate.
Borrowers can use land, buildings, vehicles, or fixed deposits as collateral to secure these loans. They
can be closed at the discretion of the lender or the borrower or as per the terms of their
agreement. Call loan is the most common form of demand loan. Furthermore, this loan is also called
a working capital demand loan as it is taken to finance the short-term capital needs of businesses like
payroll, rent, purchases, etc.

Demand Loan Explained

The demand loan is a loan agreement between the lender and the borrower, which enables the
lender to demand the loan repayment at any time. For DL, collateral is a must. The lender and
borrower enter into an agreement specifying the amount and tenure of the debt, interest payable,
and call back option available to the lender.

Under this arrangement, the borrower can also settle the loan anytime. Unlike usual loans, there is
no fixed maturity date or repayment schedule. The lenders charge a floating interest rate on loans as
per the demand loan agreement. The interest rate is higher than the prime lending rates of the bank
and is payable according to the terms specified in the contract.

The loans are of shorter duration, starting from seven days to as much time agreed upon by both
parties. It involves the least documentation and takes lesser sanction time. The terms of the loan
depend on the credit rating or history of the borrower. Businesses or individuals with a weaker credit
score or a shoddy credit history can also utilize such loans. Thus, banks must practice due
diligence before sanctioning them.

Usually, banks find it safer to disburse this type of loan since it has collateral security. In case of
default, they can recover their loan by encashing the value of the collateral. Moreover, they also
benefit from a steady flow of interest income from them. Therefore, DL is an attractive source of
income and an important means to improve their asset quality.

Furthermore, it is the most convenient form of loan for businesses as the loan does not have
any prepayment penalty. The borrowers get the flexibility to either foreclose the loan or make part
repayment anytime. If they close the loan before time, they have to pay interest only for the period
borrowed. In such a scenario, the borrowers save the interest for the remaining period.

Examples

Let us understand the concept of DL using examples given below:

Example #1

A small American farmer, McMahan, setups a modern dairy plant in his village. To fund its short-term
operational needs, he plans to take a loan. But, with no credit history to flaunt, if the farmer goes to
the bank and asks for a working capital loan, the farmer is not likely to get it.

But if McMahan can provide collateral like a fixed deposit or insurance paper, the farmer can easily
avail the DL to fund his business activity. The collateral will cover the loan amount and fully secure
McMahan’s loan.

Hence, McMahan takes a demand loan against the fixed deposit he has with the bank and gets the
required funds to operate the dairy project. Bank will be willing to offer debt as it can request
repayment anytime and receive interest on the money lent. Also, the bank has the option to encash
the deposit in case of default.

Example #2

An individual, Martin, has some urgent medical needs and requires some loan for the same, but for a
shorter duration. As Martin’s loan needs are urgent, Martin may not like to undertake the lengthy
process of loan disbursement from the banks.

Therefore, Martin will hand over the life insurance policy as collateral and avail the DL to cover his
treatment. Moreover, Martin can close the loan as soon as he gets the money from his pension
fund and pay interest only for the period he borrowed the money. Therefore, he’ll have access to
instant funds and pay less interest.

Example #3

A big company, XYZ, urgently needs machinery to improve its production capacity to meet the
demands of its product, facemasks. Since the company has a good relationship with its bank, it will
opt for DL. In this case, XYZ will submit a DL application with the bank to get a working capital
demand loan for buying machinery for its urgent needs.
Therefore, XYZ will offer some collateral like stocks, against which XYZ will be availing of the DL loan
and buying the required machinery. By purchasing the machinery, the company can expand its
production. As soon as XYZ gets the payments from the buyers of its facemasks, XYZ will close the
bank’s DL.
If the bank fears that the company will not be in a position to fulfill its obligation, it can ask the
company to repay. As evident, both the bank as well as the company XYZ benefit from demand loans.
The company gets the funds, and the bank receives interest.

What Is a Drawee?
Drawee is a legal and banking term used to describe the party that has been directed by the
depositor to pay a certain sum of money to the person presenting the check or draft. A typical
example is if you are cashing a paycheck. The bank that cashes your check is the drawee, your
employer who wrote the check is the drawer, and you are the payee.

How a Drawee Works

The drawee most often performs the function of an intermediary for a financial transaction. Its
purpose is to redirect funds from the payer, or drawer, account to present the funds to the payee.
Often, the position of drawee is held by a financial institution that holds the payer funds within a
deposit account under its management. Consumer banks regularly perform this function, removing
funds from a depositor’s account to pay the obligation listed on a check.

Check-cashing services perform the duties of a drawee but often require a small fee to complete the
transaction. Additionally, money order and wire transfer companies that exist outside of the
traditional banking format also qualify. The money order functions as the bill of exchange that when
provided to the payee is honored by the company that received the funds from the payer.

Banks often act as the drawee in financial transactions, but check cashing businesses and even retail
companies may also serve as a drawee, depending on the situation.

Drawees in Other Industries

There are instances outside of financial institutions where a party may be considered a drawee, if
only in an informal sense. For example, when a customer uses a manufacturer’s coupon as part of a
sales transaction, the store accepting the coupon can be seen as the drawee in relation to the
customer. The customer has presented a document, created by a company, functioning as the drawer
or payer of the debt, that entitles him to a certain amount of money in return for buying the product,
causing the customer to perform the role of payee.

What Is Bill Discounting?

Bill discounting is a trade-related activity in which a company sells its outstanding invoices to a
financier (a bank or another financial institution) that agrees to pay the company for them at a
future date.

In bill discounting, the business discount the outstanding invoices to gain access to short-term
financial assistance and maintain the working capital. This process is also called “Invoice
Discounting”. This process is governed by the negotiable instrument act, 2010. Factoring & Reverse
Factoring are two methods a bill is discounted on TReDS platorm. Both the methods are designed to
speed up and increase cash flow without disturbing the balance sheet.

Factoring is a financial transaction and a type of debt or finance in which a business sell sits accounts
receivable (i.e., invoices) to a third party (called a factor) at a discount.Benefits of factoring is working
capital optimization, credit protection against bad debts, No collateral required, prompt payments
for your invoices.

Reverse factoring, also known as supply chain finance or supplier finance, is a financial technology
solution that mitigates the negative effects of longer payment terms to help buyers and suppliers
optimize working capital. Benefits of reverse factoring Improved cash flows, reduce dearly payment
requests, Low interest rate of interest, Develop long term relationships.

BILL DISCOUNTING

Suppose, a business man sold goods to Mr.X worth Rs 10,000 on credit but Mr.X does not have the
money to pay today, but he is certain to pay on a later date, afer two months, so the bill is raised
stating Mr.X to pay Rs 10,000 afer two months. But an urgent need for funds is required by
businessman, and he can’t wait for two months, there by he discounts this bill with his bank/Bill
discounting company two months before its due date @ 15% P.A rate of discount.Now the bank pays
the drawer an amount of Rs 9750 afer deducting an applicable commission of Rs 250.

Businessman (drawer) sold goods and also got paid without having to lose either his customer or the
business. Mr. X got the goods not having paid today, and the bank made a good commission.
Advantages of Bill Discounting

Bill discounting is advantageous to businesses, banks, finance companies, and investors. Businesses
benefit by rejuvenating their cash-flow in-turn helping them stabilize growth and fund business
expenditure.

 Cash flow: Businesses being dependent on the cash flow to sustain their business can
easily rely on this quick financial aid to access speedy funds and continue to flourish. This
process quickens money inflow— profiting the organization in expanding deals, seeking
after development, securing hardware, etc.

 Instant access to cash: Bill discounting is a more efficient, faster way of assessing working
capital as it is hassle-free and does not involve the lengthy documentation procedure. With
M1xchange, businesses can secure financial assistance in just 24 to 72* hours.

 No collateral involved on TReDS: here is no requirement to keep any asset as security as

the unpaid invoice is considered as the collateral itself.

 No debt incurred: Bill discounting helps in saving tax liability. The chances of a company
suffering any loss or damage are almost nonexistent when compared to conventional
financing frameworks.

 No impact on the balance sheet: Bill discounting service offered by M1xchange does not
impact the balance sheet of the business as it is an off-the-book process.
 UNIT – 2

MULTIPLE BANKING ARRANGEMENT

The multiple banking arrangements are similar to a consortium advance and loan syndication,
wherein several lenders finance a single borrower. However, there are many structural and
operational differences among them. In multiple banking arrangements, a borrower borrows
simultaneously from more than one bank independent of each other. Each lending bank takes
separate loan documents and securities offered to each bank are separately charged.

In terms of the Reserve Bank of India (RBI) guidelines, the banks in their knowledge that their
borrowers are availing credit facility from other bank, shall adhere to a system of exchange of
information with other banks. The lenders should exchange information about the conduct of the
borrower’s account with other banks in the prescribed format at least at quarterly intervals. This
would provide early warning to other lenders about irregularities in the accounts of their customer
with other bankers. However, system on sharing of the information had failed to bring desired
discipline in multiple banking arrangements as many bankers are not prompt in exchanging the
information. The main difficulties in multiple banking there is no coordination among banks
regarding appraisal, documentation, other terms and advances. The absence of security sharing,
monitoring of end-use of funds and coordination among the lenders under multiple banking allowed
borrowers to play with credit discipline. In such a situation borrowers got the upper hand by playing
one bank against the other.

Consortium Lending in Banking

The borrower’s company delegates authority to the bank, which is known as the Consortium’s Lead
(leader) Bank. As per the consortium, the consortium leader is responsible for keeping the joint
advance/loan documents issued by the borrower’s company.

 A “Pari-Passu” fee will be created from securities offered by the borrower company against
the total credit extended to the company by the consortium’s lending institutions.

 A “pari passu” fee occurs when the borrowing entity is dissolved, or the security is sold or
disposed of by the consortium; The assets created by the encumbrance will be given
proportionately to the lender concerned.

 Thus the syndicated lending system provides space and the possibility for risk sharing among
banks. This system is considered to be mutually beneficial for banks and customers.

 In Consortium Advance, the commitment fee levied is not mandatory and is left to the
discretion of the Financing Consortium/Banks/Syndicate. Banks may frame guidelines on
the basis of commitment fees to ensure credit discipline.

What Is a Syndicate?
A syndicate is a temporary alliance of businesses that joins together to manage a large transaction,
which would be difficult, or impossible, to effect individually. Syndication makes it easy for
companies to pool their resources and share risks, as when a group of investment banks works
together to bring a new issue of securities to the market. There are different types of syndicates,
such as underwriting syndicates, banking syndicates, and insurance syndicates.

Types of Syndicates

Syndicates are usually comprised of companies in the same industry. For example, two
pharmaceutical companies may combine their research and development (R&D) teams by creating a
syndicate to develop a new drug. Or several real estate companies may form a syndicate to manage a
large development. Sometimes banks will form a syndicate to loan a very large amount of money to a
single party. Companies also may form a syndicate to manage a specific business venture if the
opportunity promises an attractive rate of return (RoR).

Some projects are so large that no single company can have all of the expertise needed to do the job
efficiently. This is often the case with large construction projects such as building a stadium, highway,
bridge, or railroad. In these situations, companies may form a syndicate so that each firm may apply
their specific expertise to the project. For tax purposes, syndicates are generally considered as
partnerships or corporations.

In financial services, the underwriting syndicate plays a critically important role in bringing new
securities to the market.

Managing Risk

The amount of risk assumed by each syndicate member can vary. For instance, in an undivided
account of an underwriting syndicate, each member is responsible for selling an allotted amount of
stock along with any excess shares not sold by the syndicate as a whole.

In this way, an individual syndicate member may need to sell far more securities than they are
allotted; other types of syndicates, however, may limit the degree of risk for each member.

Underwriting Syndicates

In an initial public offering (IPO), a number of investment banks and broker-dealers form a syndicate
to sell new offerings of stock or debt securities to investors. The underwriting group shares the risk
and aids in the successful distribution of the new securities issue.

The lead underwriter for the new issue initiates and manages the underwriting syndicate. The
syndicate is compensated by the underwriting spread—which is the difference between the price
paid to the issuer and the price received from investors and other broker-dealers. An underwriting
syndicate usually breaks up 30 days after the sale is complete, or if the securities cannot be sold at
the offering price. There are other types of syndicates, however, that function jointly, but which are
not temporary.

For example, an underwriter in the corporate health insurance field may evaluate the potential
health risks of a company's employees. The underwriter’s actuary would then use statistics to assess
the risk of illness for each employee in the company’s workforce. If the potential risk of providing
health insurance is too great for a single insurance firm, that company may form a syndicate to share
the insurance risk.
Introduction to Priority Sector Lending (PSL)

The Reserve Bank of India decides to allot funds to predetermined priority sectors of
the economy that may require credit and financial assistance, especially in cases where the lack of
PSL will lead to the heavy losses to the participants of that sector in some cases. Priority Sectors
Lending is the role exercised by the RBI to banks, imploring them to dedicate funds for specific
sectors of the economy like agriculture and allied activities, education and housing and food for the
poorer population.

Understanding Priority Sector Lending (PSL)

 The goal of a PSL initiative is to provide credit to the weaker sections of the society, as
opposed to funding only profitable sectors or spaces that are solely important to economic
growth. All sectors considered as a priority are able to easily access financial support like
apply for loans that the banks are required to allot at a lower interest rate.

 The following fall into the priority sectors under the policy: agriculture (including micro
financing groups like SHGs, JLGs, individual farmers, and other institutions dedicated to
individuals working in the sector), micro, small and medium scale enterprises (MSMEs) and
SSIs, Educational and Small Scale Industrial loans, Housing loans and other micro credit
finances.

 When banks overreach their PSL targets and need additional funding to raise funds for the
priority sectors, they are able to issue PSL certificates (PSLCs) only to the extent of the
amount banks are allowed to lend in that specific sector. These certificates can be traded on
RBI’s e-Kuber platform.

Highlights of Priority Sector Lending (PSL)

 For 2020, the RBI sought channeling funds for the startup sector.

 When introduced, only public sector banks were required to focus on the development of
the predetermined priority sectors; though now private and foreign banks are also required
to provide adequate care and credit.

 The way PSLCs are traded is similar to the workings of the money market, where issuing
these certificates will help banks raise money. Surplus banks may be incentivized in the
process, and banks facing cash shortfall may finance their short term needs.

What Is Acquisition Financing?

Acquisition financing is the capital that is obtained for the purpose of buying another business.
Acquisition financing allows users to meet their current acquisition aspirations by providing
immediate resources that can be applied to the transaction.

How Acquisition Financing Works

There are several different choices for a company that is looking for acquisition financing. The most
common choices are a line of credit or a traditional loan. Favorable rates for acquisition financing can
help smaller companies reach economies of scale, which is generally viewed as an effective method
for increasing the size of the company's operations.

A company seeking acquisition financing can apply for loans available through traditional banks as
well as from lending services that specialize in serving this market. Private lenders may offer loans to
those companies that do not meet a bank's requirements. However, a company may find that
funding from private lenders includes higher interest rates and fees compared to bank financing.

A bank might be more inclined to approve financing if the company to be acquired has a steady
stream of revenues, steady or growing EBITDA, which is a cash metrics that would help the acquirer
to pay back the debt obligations from the loan on the acquisition, substantial or sustained profits, as
well as valuable assets for collateral.

By comparison, securing bank approval can be problematic when attempting to finance the
acquisition of a company that largely has receivables rather than cash flow.

Other Types of Acquisition Financing

Small Business Administration Loans

Depending on the size of the businesses involved and the nature of the acquisition, there may be
financing options through the Small Business Administration (SBA). The SBA 7(a) loan program, for
example, may suit these needs for borrowers who qualify. The down payment may be as low as 10%
for acquisitions when using this program.

The borrower must, however, meet the SBA’s requirements on the size of the business, which
includes limits on net worth, average net income, and overall loan size. There may also be extensive
paperwork for the applicant that includes submitting details on accounts receivable, personal as well
as business tax information, and personal and business financial statements. The applicant for SBA
7(a) financing for an acquisition may also need to supply their corporate charter.

Debt Security

A company may use debt security, such as issuing bonds, as a means of financing an acquisition. In
many cases, a company may find that selling bonds on the open market offers advantages over
seeking funding from a bank or private lender. Banks generally have covenants or rules regarding
their funding that companies find restrictive and expensive. Because of this, companies turn to the
bond markets as an alternative source for financing mergers and acquisitions.

Other means of financing an acquisition include debt that is paid back as shares and interest in the
company making the acquisition. This may come into play if the buyer turns to close associates, such
as friends and family, to provide financing to secure the acquisition.

Owner Financing

Owner financing is another way for a business to fund an acquisition deal. It's often referred to as
"seller financing" or "creative financing." This usually entails the buyer making a down payment to
the seller. The seller agrees to finance the rest of the transaction or a portion of it. The buyer will
then make installment payments to the seller over an agreed-upon period.

In a buyer's market, a seller may find owner financing a good way to expedite the sale of a business.
It also allows the seller to receive a steady stream of regular payments from the buyer, which if
structured correctly could provide more income than traditional fixed-income investments. The
buyer, on the other hand, can benefit from reduced costs and more flexible terms when dealing
directly with the seller, as opposed to funding the acquisition through a bank or private lender.

What is Credit Appraisal ?

Credit appraisal means an investigation/assessment done by the bank prior before providing any
loans and advances/project finance and also cheeks the commercial, financial and technical viability
of the project proposed its funding pattern and further checks the primary and collateral security
cover available for recovery of such funds. Credit appraisal is a process to ascertain the risks
associated with the extension of the credit facility. It is generally carried by the financial institutions
which are involved in providing financial funding to its customers.

The process by which a leader appraises the creditworthiness of the prospective borrower is known
as Credit Appraisal. This normally involves appraising the borrower's payment history and
establishing the quality and sustainability of his income. The lender satisfies himself of the good
intentions of the borrower, usually through an interview. Some requirements for credit appraisal are
as follows :

 The credit requirement must be assessed by all Indian financial

institutions or specialized institution set-up for this purpose.

 Wherever financing of infrastructure project is taken up under a consortium/syndication

arrangement - bank's exposure shall not exceed 23%.

 Bank may also take up financing infrastructure project independently exclusively in respect
of borrowers promoters of repute with excellent past record in project implementation.

 In such cases/due diligence on the inability of the projects are well defined and
assessed. State Government guarantee may not be taken as a substitute for satisfactory
credit appraisal.

The important thing to remember is not to be overwhelmed by marketing or profit centre reasons to
book a loan but to take a balanced view when booking a loan, taking into account the risk reward
aspects. Generally everyone becomes optimistic during the upswing of the business cycle, but tend
to forget to see how the borrower will be during the downturn, which is a shortsighted approach.
Furthermore greater emphasis is given on financials, which are usually outdated; this is further
exacerbated by the fact that a descriptive approach is usually taken, rather than an analytical
approach, to the credit. Thus a forward looking approach should also be adopted, since the loan will
be re-paid primarily from future cash flows, not historic performance; however both can be used as
good repayment indicators.

Credit appraisal is done to evaluate the creditworthiness of a borrower. The credit appraisals for any
organisation basically follow these steps - assessment of credit need, financial statement analysis,
and financial ratios of the company, credit rating, working capital requirement, term loan analysis,
submission of documents, NPA classification and recovery.

Credit Appraisal Process

The process of credit appraisal is as follows:

1) Credit Processing:

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

2) Credit-Approval/Sanction :

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

3) Credit Documentation :

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

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

4) Credit Administration :

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

A financial institution's credit administration function should, as a minimum, ensure that :

i) Credit files are neatly organized, cross-indexed, and their removal from the premises is not
permitted.

ii) The borrower has registered the required insurance policy in favor of the bank and is regularly
paying the premiums.

iii) The borrower is making timely repayments of lease rents in respect of charged leasehold
properties.

iv) Credit facilities are disbursed only after all the contractual terms and conditions have been met
and all the required documents have been received;
v) Collateral value is regularly monitored.

vi) The borrower is making timely repayments on interest, principal and any agreed to fees and
commissions.

5) Disbursement :

Once the credit is approved, the customer should be advised of the terms and conditions of the
credit by way of a letter of offer. The duplicate of this letter should be duly signed and returned to
the institution by the customer. The facility disbursement process should start only upon receipt of
this letter and should involve, inter alia, the completion of formalities regarding documentation, the
registration of collateral, insurance cover in the institution's favor and the vetting of documents by a
legal expert. Under no circumstances shall funds be released prior to compliance with pre-
disbursement conditions and approval by the relevant authorities in the financial institution.

6) Monitoring and Control of Individual Credits :

To safeguard financial institutions against potential losses, problem facilities need to be identified
early. A proper credit monitoring system will provide the basis for taking prompt corrective actions
when warming signs point to deterioration in the financial health of the borrower. Examples of such
waning signs include unauthorized drawings, arrears in capital and interest and deterioration in the
borrower's operating environment. Financial institutions must have a system in place to formally
review the status of the credit and the financial health of the borrower at least once a year. More
frequent reviews (e.g at least quarterly) should be carried out of large credits, problem credits or
when the operating environment of the customer is undergoing significant changes.

Credit Rating

The term credit rating refers to a quantified assessment of a borrower's creditworthiness in general
terms or with respect to a particular debt or financial obligation. A credit rating can be assigned to
any entity that seeks to borrow money—an individual, a corporation, a state or provincial authority,
or a sovereign government.

Individual credit scores are calculated by credit bureaus such as Experian, Equifax, and TransUnion on
a three-digit numerical scale using a form of Fair Isaac Corporation (FICO) credit scoring. Credit
ratings for companies and governments are calculated by a credit rating agency such as S&P
Global, Moody’s, or Fitch Ratings. These rating agencies are paid by the entity seeking a credit rating
for itself or one of its debt issues.

Understanding Credit Ratings

A loan is a debt—essentially a promise, often contractual. A credit rating determines the likelihood
that the borrower will be willing and able to pay back a loan within the confines of the agreement
without defaulting.

A high credit rating indicates that a borrower is likely to repay the loan in its entirety without any
issues, while a poor credit rating suggests that the borrower might struggle to make their payments.
Just as an individual credit score is used to evaluate the creditworthiness of a single person,
businesses also use credit ratings to demonstrate their creditworthiness to prospective lenders.

Credit Ratings vs. Credit Scores

Credit ratings apply to businesses and governments as well as individuals. For example, sovereign
credit ratings apply to national governments while corporate credit ratings apply solely to
corporations. Credit scores, on the other hand, apply only to individuals.

Credit scores are derived from the credit history maintained by credit-reporting agencies such as
Equifax, Experian, and TransUnion. An individual’s credit score is reported as a number, generally
ranging from 300 to 850.2

A short-term credit rating reflects the likelihood that a borrower will default within the year. This
type of credit rating has become the norm in recent years, whereas in the past, long-term credit
ratings were more heavily considered. Long-term credit ratings predict the borrower’s likelihood of
defaulting at any given time in the extended future.3

Credit rating agencies typically assign letter grades to indicate ratings. S&P Global, for instance, has a
credit rating scale ranging from AAA (excellent) to C and D. A debt instrument with a rating below BB
is considered to be a speculative-grade or junk bond, which means it is more likely to default on
loans.3

A Brief History of Credit Ratings

Moody’s issued publicly available credit ratings for bonds in 1909, and other agencies followed suit in
the decades after.4 These ratings didn’t have a profound effect on the market until 1936 when a new
rule was passed that prohibited banks from investing in speculative bonds—that is, bonds with low
credit ratings.

The aim was to avoid the risk of default, which could lead to financial losses. This practice was
quickly adopted by other companies and financial institutions. Soon enough, relying on credit ratings
became the norm.5

The global credit rating industry is highly concentrated, with three agencies controlling nearly the
entire market: Moody’s, S&P Global, and Fitch Ratings.

Fitch Ratings

John Knowles Fitch founded the Fitch Publishing Company in 1913, providing financial statistics for
use in the investment industry via "The Fitch Stock and Bond Manual" and "The Fitch Bond Book." In
1924, Fitch developed and introduced the AAA through D rating system that has become the basis
for ratings throughout the industry.6

In the late 1990s, with plans to become a full-service global rating agency, Fitch Ratings merged with
IBCA of London, a subsidiary of Fimalac, S.A., a French holding company. Fitch also acquired market
competitors Thomson BankWatch and Duff & Phelps Credit Rating Co.7

Beginning in 2004, Fitch started to develop operating subsidiaries specializing in enterprise risk
management, data services, and finance-industry training with the acquisition of a Canadian
company, Algorithmics, and the creation of Fitch Solutions and Fitch Learning.8

Moody’s Investors Service

John Moody and Company first published Moody’s Manual of Industrial and Miscellaneous
Securities in 1900. The manual published basic statistics and general information about stocks and
bonds of various industries.4
From 1903 until the stock market crash of 1907, Moody’s Manual was a national publication. In 1909,
Moody began publishing Moody’s Analyses of Railroad Investments, which added analytical
information about the value of securities.4

Expanding this idea led to the 1914 creation of Moody’s Investors Service, which in the following 10
years would provide ratings for nearly all of the government bond markets at the time. By the 1970s,
Moody’s began rating commercial paper and bank deposits, becoming the full-scale rating agency
that it is today.4

S&P Global

In 1860, Henry Varnum Poor first published the History of Railroads and Canals in the United States,
the forerunner of securities analysis and reporting that developed over the next century. The
Standard Statistics Bureau, formed in 1906, published corporate bond, sovereign debt, and municipal
bond ratings.9 Standard Statistics merged with Poor’s Publishing in 1941 to form Standard & Poor’s
Corporation.10

Standard & Poor’s Corporation was acquired by the McGraw-Hill Companies in 1966, and in 2016,
the company rebranded as S&P Global. It has become best known for indexes such as the S&P 500,
introduced in 1957, a stock market index that is both a tool for investor analysis and decision-making
and a U.S. economic indicator.10

Importance of Credit Ratings

Credit ratings for borrowers are based on substantial due diligence conducted by the rating agencies.
Though a borrowing entity will strive to have the highest possible credit rating because it has a major
impact on interest rates charged by lenders, the rating agencies must take a balanced and objective
view of the borrower’s financial situation and capacity to service and repay the debt.

A credit rating determines not only whether or not a borrower will be approved for a loan but also
the interest rate at which the loan will need to be repaid. As companies depend on loans for many
startup and other expenses, being denied a loan could spell disaster, and a high-interest-rate loan is
much more difficult to pay back. A borrower's credit rating should play a role in determining which
lenders to apply to for a loan. The right lender for someone with great credit likely will be different
than for someone with good or even poor credit.

Credit ratings also play a large role in a potential investor’s decision as to whether or not to purchase
bonds. A poor credit rating is a risky investment. That's because it indicates a larger probability that
the company will be unable to make its bond payments.

Credit ratings are never static, which means borrowers must remain diligent in maintaining a high
credit rating. They change all the time based on the newest data, and one negative debt will bring
down even the best score.

Credit also takes time to build up. An entity with good credit but a short credit history is not viewed
as positively as another entity with equally good credit but a longer credit history. Debtors want to
know if a borrower can maintain good credit consistently over time.

Considering how important it is to maintain a good credit rating, it's worth looking into the best
credit monitoring services and perhaps choosing one as a means of ensuring your information
remains safe.

AA+
The credit rating of the U.S. government by Standard & Poor’s, reduced the country’s rating
from AAA (outstanding) to AA+ (excellent) on Aug. 5, 2011.11 Global equity markets plunged for
weeks following the downgrade.12

Credit Ratings Scale

While each rating agency uses a slightly different scale, they each assign ratings as a letter grade for
long-term debts. A rating of AAA is the highest possible credit rating, while a rating in the D's or C's is
the lowest.

The rating scales for long-term debt at the three leading agencies are illustrated below:

Credit Ratings Scale: Highest to Lowest

Standard & Poors Moody's FitchRatings

AAA Aaa AAA

AA Aa AA

A A A

BBB Baa BBB

BB Ba BB

B B B

CCC Caa CCC

CC Ca CC

C C C

D RD

Note that there are further divisions in each letter rating. For example, S&P assigns a + or - for ratings
between CCC and AA, indicating a slightly higher or lower level of creditworthiness. For Moody's, the
distinction is made by adding a number between 1 and 3: A Baa2 issuance is slightly more
creditworthy than a Baa3 issuance, and slightly less so than one rated Baa1.131415

Investment Grade vs. Speculative Ratings

The range of possible credit ratings is divided into two categories: investment and non-investment-
grade debt.

Investment-Grade Ratings

Government or corporate borrowers with a rating between BBB and AAA are considered to have
investment-grade credit. These are extremely low-risk borrowers, who are considered very likely to
meet all of their payment obligations. Because there is high demand for their debt, these companies
or governments can usually borrow money at extremely low interest rates.

Non-Investment Ratings
A credit rating of BB or lower indicates non-investment or speculative-grade debt. The derisive term
"junk bonds" is also used for these borrowers, indicating the perceived likelihood that they are at risk
of default, or have already done so. However, there is one advantage to these types of bonds: they
typically pay out higher interest to the bondholder.

Factors That Affect Credit Ratings

Credit agencies consider several factors when rating a potential borrower. First, an agency considers
the entity’s past history of borrowing and paying off debts. A history of missed payments, defaults, or
bankruptcies can negatively impact the rating.

The agency also looks at the borrower's cash flows and current debt levels. If the organization has
steady income and the future looks bright, the credit rating will be higher. If there are any doubts
about the borrower's economic outlook, their credit rating will fall.

These are some of the factors that can influence the credit rating of a company or government
borrower:

 The organization's payment history, including any missed payments or defaults.

 The amount they currently owe, and the types of debt they have.

 Current cash flows and income.

 The market outlook for the company or organization.

 Any organizational issues that might prevent timely repayment of debts.

Note that credit ratings involve some subjective judgments, and even an organization with a spotless
payment history can be downgraded if the rating agency believes that its ability to make repayments
has changed.

For example, in 2011, Standard and Poor's reduced the credit rating of United States sovereign bonds
from AAA to AA+, in response to Congressional roadblocks that could have caused a default. Even
though the government ultimately made all of its payments on time, even the mere discussion of
non-payment was enough to cause a more negative outlook on U.S. government debt.

Creditworthiness:

Creditworthiness is a measure of how likely you will default on your debt obligations according to a
lender's assessment, or how worthy you are to receive new credit. Your creditworthiness is what
creditors consider before they approve any new credit.

Understanding Creditworthiness

Your creditworthiness tells a creditor just how suitable you are for that loan or credit card application
you filled out. The decision the lender makes is based on how you've dealt with credit in the past. so,
lenders look at several different factors: your overall credit report, credit score, and payment history.

Your credit report outlines how much debt you carry, the high balances, the credit limits, and the
current balance of each account. It will also flag any important information for the potential lender
including whether you've had any past due amounts, any defaults, bankruptcies, and collection
items.
 Creditworthiness is determined by several factors including your repayment history and credit score.
Some lending institutions also consider available assets and the number of liabilities you have when
they determine the probability of default.

Your creditworthiness is also measured by your credit score, which is a three-digit number based on
factors in your credit report. A high credit score means your creditworthiness is high and a lower
credit score indicates lower creditworthiness.

Payment history also plays a key role in determining your creditworthiness. Lenders don't generally
extend credit to someone whose history demonstrates late payments, missed payments, and overall
financial irresponsibility.

If you've been up-to-date with all your payments, the payment history on your credit report should
reflect that. Payment history counts for 35% of your FICO credit score, so it's a good idea to stay in
check, even if you have to just make the minimum payment.1

Your creditworthiness is important because it will determine whether you get approved for a new
loan, like car loan or credit card. The more creditworthy you are, the more likely you will be approved
for better interest rates, which can save you significant money. It can also affect employment
eligibility, insurance premiums, business funding, and professional certifications or licenses.

Checking Your Creditworthiness

The three prominent credit reporting agencies that measure creditworthiness are Experian,
TransUnion, and Equifax. Lenders pay the credit reporting agencies to access credit data on potential
or existing customers in addition to using their own credit scoring systems to grant approval for
credit.

Every consumer should keep track of their credit score because it is the factor financial institutions
use to decide if an applicant is eligible for credit, preferred interest rates, and specific credit limits.

You can request a free copy of your credit report once each year, or you can join a free credit
monitoring site like Credit Karma, Credit Sesame or another credit monitoring services.

How to Improve Your Creditworthiness

There are several ways you can improve your credit score to establish creditworthiness. First, you can
pay your bills on time. Then, you can pay more than the minimum monthly payment to pay down
debt faster and improve your credit utilization ratio. Some financial experts suggest keeping credit
card utilization rates below 30%, although 10% is ideal.2

You should understand your debt-to-income (DTI) ratio. An acceptable DTI is 35% but 28% is ideal.
DTI can be calculated by dividing your total monthly debt by your total gross monthly income.
Lenders use DTI when assessing an individual’s creditworthiness.

You can also order a free copy of your TransUnion, Experian, and Equifax credit reports. Review all
the information for accuracy and dispute any errors. Provide supporting documentation to
substantiate your dispute claim. In addition, you can dispute inaccurate information with the
company reporting the error.

Sources of Repayment
The main concern that a banker has when facilities are extended is on the repayment of the monies
advanced. This is the question that he will invariably zero in on and it would be prudent for the
prospective borrower to advise him upfront on how he intends to repay the facility.

In ideal circumstances there should be more than one source of repayment so that should there be,
for some reason, a delay or a problem, the repayment commitment can still be honored. Bankers
too, if presented with a well structured plan/ plans of repayment would be more willing to listen and
even advance facilities.

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

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

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

Refinancing

Another method of repaying a loan is by refinancing – procuring a second loan out of which the
existing loan is repaid. This may be either by:

1. Taking another loan.

2. Accepting fixed deposits. This is not particularly easy presently owing to the credit/ liquidity
crunch and the fact that several good companies have defaulted on the payment of principal
and/or interest.

3. Issuing debentures. Debentures are an acknowledgment of debt and this is a very popular
form of raising funds to repay existing loans. The convenience of a debenture is that it is
 usually repayable only after a minimum of three years. It gives the borrower some time to
arrange his finances.

The banker will seek to ensure that the charge is properly registered so that should the need arise,
the banker can take possession of the asset. There are two kinds of charges – specific and floating. A
specific charge is a charge on a specific asset. A floating charge, on the other hand, is a charge on all
the assets both present and future of the company. A specific charge has a prior charge however and
a banker would always prefer a specific charge.

There are times when the asset to be charged is already hypothecated. In such instances the bank
can only get a second charge for the facility given. This means that the banker’s rights are
subordinate to the entity that holds the first charge. In other occasions where there are a number of
lending banks as in a consortium, the borrower would be able to give the bank only a “pari passu”
charge. In this instance the bank’s rights are on the same footing as the other lending banks.

No banker will issue facilities unless it knows and checks the sources of repayment because he is in
the business of lending, and not in the business of giving away.

What Is Collateral?

Collateral in the financial world is a valuable asset that a borrower pledges as security for a loan.

When a homebuyer obtains a mortgage, the home serves as the collateral for the loan. For a car
loan, the vehicle is the collateral. A business that obtains financing from a bank may pledge valuable
equipment or real estate owned by the business as collateral for the loan.

A loan that is secured by collateral comes with a lower interest rate than an unsecured loan. In the
event of a default, the lender can seize the collateral and sell it to recoup the loss.

How Collateral Works

Before a lender issues you a loan, it wants to know that you have the ability to repay it. That's why
many of them require some form of security. This security is called collateral which minimizes
the risk for lenders. It helps to ensure that the borrower keeps up with their financial obligation. In
the event that the borrower does default, the lender can seize the collateral and sell it, applying the
money it gets to the unpaid portion of the loan. The lender can choose to pursue legal action against
the borrower to recoup any balance remaining.

As mentioned above, collateral can take many forms. It normally relates to the nature of the loan, so
a mortgage is collateralized by the home, while the collateral for a car loan is the vehicle in question.
Other nonspecific, personal loans can be collateralized by other assets. For instance, a secured credit
card may be secured by a cash deposit for the same amount of the credit limit—$500 for a $500
credit limit.

Loans secured by collateral are typically available at substantially lower interest rates than unsecured
loans. A lender's claim to a borrower's collateral is called a lien—a legal right or claim against an
asset to satisfy a debt. The borrower has a compelling reason to repay the loan on time because if
they default, they stand to lose their home or other assets pledged as collateral.

Types of Collateral
The nature of the collateral is often predetermined by the loan type. When you take out a mortgage,
your home becomes the collateral. If you take out a car loan, then the car is the collateral for the
loan. The types of collateral that lenders commonly accept include cars—only if they are paid off in
full—bank savings deposits, and investment accounts. Retirement accounts are not usually accepted
as collateral.

You also may use future paychecks as collateral for very short-term loans, and not just from payday
lenders. Traditional banks offer such loans, usually for terms no longer than a couple of weeks. These
short-term loans are an option in a genuine emergency, but even then, you should read the fine
print carefully and compare rates.

Collateralized Personal Loans

Another type of borrowing is the collateralized personal loan, in which the borrower offers an item of
value as security for a loan. The value of the collateral must meet or exceed the amount being
loaned. If you are considering a collateralized personal loan, your best choice for a lender is probably
a financial institution that you already do business with, especially if your collateral is your savings
account. If you already have a relationship with the bank, that bank would be more inclined to
approve the loan, and you are more apt to get a decent rate for it.

Use a financial institution with which you already have a relationship if you're considering a
collateralized personal loan.

Examples of Collateral Loans

Residential Mortgages

A mortgage is a loan in which the house is the collateral. If the homeowner stops paying the
mortgage for at least 120 days, the loan servicer can begin legal proceedings which can lead to the
lender eventually taking possession of the house through foreclosure.1 Once the property is
transferred to the lender, it can be sold to repay the remaining principal on the loan.

Home Equity Loans

A home may also function as collateral on a second mortgage or home equity line of credit (HELOC).
In this case, the amount of the loan will not exceed the available equity. For example, if a home is
valued at $200,000, and $125,000 remains on the primary mortgage, a second mortgage or HELOC
will be available only for as much as $75,000.

Margin Trading

Collateralized loans are also a factor in margin trading. An investor borrows money from a broker to
buy shares, using the balance in the investor's brokerage account as collateral. The loan increases the
number of shares the investor can buy, thus multiplying the potential gains if the shares increase in
value. But the risks are also multiplied. If the shares decrease in value, the broker demands payment
of the difference. In that case, the account serves as collateral if the borrower fails to cover the loss.
 UNIT – 3
Non-Fund Based Credit

On the Contrary, Non-Fund Based Credit is where the Fund is not transferred directly to the
borrower. It is offered to a third-party as agreed upon by the borrower, on behalf of the Borrower.

The bank usually acts as a guarantee provider to the seller on the behalf of the buyer. If the payment
is not received by the seller within pre-agreed time, The bank pays the amount to the seller. For e.g.
Bank Guarantee, Buyer Credit, Letter of Credit, Supplier Credit.

Following are the advantages of Non-Fund Based Credits:

1. It offers financial security to the seller if the buyer defaults due to any reason.

2. It offers Business expansion opportunities to the exporters.

The different types of non-fund based credit are

1. Letter Of Credit

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

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

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

A) Sight Credit

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

B) Revocable & Irrevocable Credit

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

Irrevocable Letter of Credit cannot be revoked or canceled by the issuing Bank. So once the LOC is
generated, Bank will have to honor the letter.

C) Confirmed Credit

In this type of Credit, a bank other than the issuing Bank confirms the Letter of Credit by adding its
confirmation. Only Irrevocable Letter of Credit is eligible for confirmation.

D) Back-to-Back Credit

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

The advantages of a letter of credit to the buyer is as follows

1. Allows the buyer to trade with the parties from any corner of the world

2. The buyer can edit the terms and conditions that fit him/her after consulting the seller.

3. It acts as a credit certificate for the buyer, and he/she can perform multiple trades as a major
financial institution like Bank backs him/her.

4. Letter of Credit offers better Cash flow to the buyer.

The advantages Of a Letter Of Credit To seller is as follows

1. The seller receives the money on fulfilling the terms mentioned In the Letter of Credit.

2. There is no risk of losing money for the seller if the buyer fails to pay the money. Seller gets
his/her dues from the Bank that has issued the Letter of Credit.

3. The letter of Credit is easy to quick to avail based on good credit.

4. If there is a dispute in trading, the seller can withdraw funds from the Bank even when the
case is pending.

2. Bank Guarantee

Under this type of Credit, Bank offers assurance that under any circumstances, the Guarantee issuing
Bank will fulfill any financial losses incurred by the protected party as mentioned in the Contract.

Let’s take a look at different guarantees

A) Financial Guarantee

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

B) Performance Guarantee

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

C) Deferred Payment Guarantee

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

3. Letters Of Comfort For Availing Buyers Credit

Letter of Comfort can be understood as the Guarantee offered by the Bank of Importer or buyer. The
Importer can use this Letter of Comfort to avail Buyer’s Credit from the Overseas banks. The Importer
or Buyer’s Bank charges certain fees for offering the Letter of Comfort.

4. Derivative Products

Derivatives are a type of financial security or financial contracts that are backed by some underlying
securities. These underlying securities can be anything, ranging from currencies, bonds, commodities
to stocks.

5. Buyer Credit

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

6. Supplier Credit

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

Types of Letters of credit

Due to frequent usage within the international collaboration, the names of LC types are given in
English as well

1. Irrevocable LC. This LC cannot be cancelled or modified without consent of the beneficiary (Seller).
This LC reflects absolute liability of the Bank (issuer) to the other party.

2. Revocable LC. This LC type can be cancelled or modified by the Bank (issuer) at the customer's
instructions without prior agreement of the beneficiary (Seller). The Bank will not have any liabilities
to the beneficiary after revocation of the LC.
3. Stand-by LC. This LC is closer to the bank guarantee and gives more flexible collaboration
opportunity to Seller and Buyer. The Bank will honour the LC when the Buyer fails to fulfill payment
liabilities to Seller.

4. Confirmed LC. In addition to the Bank guarantee of the LC issuer, this LC type is confirmed by the
Seller's bank or any other bank. Irrespective to the payment by the Bank issuing the LC (issuer), the
Bank confirming the LC is liable for performance of obligations.

5. Unconfirmed LC. Only the Bank issuing the LC will be liable for payment of this LC.

6. Transferable LC. This LC enables the Seller to assign part of the letter of credit to other party(ies).
This LC is especially beneficial in those cases when the Seller is not a sole manufacturer of the goods
and purchases some parts from other parties, as it eliminates the necessity of opening several LCs for
other parties.

7. Back-to-Back LC. This LC type considers issuing the second LC based on the first letter of credit. LC
is opened in favor of intermediary as per the Buyer's instructions and based on this LC and
instructions of the intermediary a new LC is opened in favor of Seller of the goods.

8. Payment at Sight LC. According to this LC, payment is made to the seller immediately (maximum
within 7 days) after the required documents have been submitted.

9. Deferred Payment LC. According to this LC the payment to the seller is not made when the
documents are submitted, but instead at a later period defined in the letter of credit. In most cases
the payment in favor of Seller under this LC is made upon receipt of goods by the Buyer.

10. Red Clause LC. The seller can request an advance for an agreed amount of the LC before
shipment of goods and submittal of required documents. This red clause is so termed because it is
usually printed in red on the document to draw attention to "advance payment" term of the credit.

LIMITS LIKE LETTERS OF CREDIT

The assessment Letter of Credit, Bank Guarantee (BG), or Letter of Guarantee (LG) limits are fixed by
banks based on the annual consumption of raw materials to be purchased against the Letter of Credit
or Letter of Guarantee (Bank Guarantee).

Ascertain from the customer the requirement of Consumption of Material (CM) per annum, which is
to be purchased under LC or LG.

Find out Procurement Time or lead time (PT) for importing the materials.

(Procurement Time or Lead time means the time taken in receiving the goods including the transit
period after the LC is opened)

If the material is purchased under credit, add the usance period or Credit Period (CP) to procurement
time.

We get Total Time (TT) when we add the credit period to the procurement period. TT=PT+CP

If CM is the Annual Consumption of Material to be purchased against LC or LG

We can compute the LG or LC limit required by the company by dividing the annual consumption of
raw material to be purchased against LC or LG and the same is divided by 12 and multiplied by total
time.(i.e.Monthly purchases ×total time). Note: Purchase value of goods for assessment of LC is done
on the basis of CIF (cost, insurance, and freight) of goodsWht is EOQ-economic order quantity which
is calculated by the source of supply, means of transport, and any discount.

Thus the formula for LC/LG Limit=CM×TT ÷ 12

However, if the minimum quantity (EOQ-economic order quantity) to be procured is more than the
limit arrived, such a request should be considered. This equation is to be adapted for LC under DA
terms as well as for inland LG. (The EOQ-economic order quantity is calculated taking into account
the source of supply, means of transport, and any discount for orders of a larger quantity, etc.).

Illustration 1: calculation of DP- LC limit:

(i)Total annual purchase: 120,00000

(ii) of which purchase under LC (50%):60,00000

(iii) Of import of RM under LC (50%): 30,00000

Assessment of Inland LC:

Lead time: 2 months

Monthly purchase for indigenous RM (6000000-3000000)/12 =2, 50,000

Therefore, Inland LC requirement (Monthly purchase x lead time i.e 250000×2 = 5, 00,000…… (A)

Assessment of import LC:

Monthly purchase of import RM (30,00000/12) = 2,50,000

Lead time: 4 months

Import LC requirement: 250000×4= 1000000 (B)

Total LC requirement (A+B) = 500000+1000000= 1500000 i.e. LC limit of Rs.15 lakh with the sub-limit
of Rs.10 lakh for import LC and Rs.5 lakh for domestic LC.

Illustration 2: Calculation of LC-DA limit

In the above example assume that there is a usance of 2 months available in both domestic and
import cases. While assessing the LC under Usance, the usance period is to be added to the lead
time.

 Inland LC requirement= (monthly purchase x (lead time+ usance period

= (250000 x (2.00+2.00) = 10, 00000

 Import LC requirement =(monthly purchase x (lead time+ usance period)

= (250000 x (4.00+2.00) = 15, 00000

Total LC requirement (i) +(ii)= 25 lakhs with the sub-limits of Rs.10 lakh for domestic LC and Rs.15
lakh for import LC.

Illustration 3: Calculation of (import) DA- LC limit with EOQ (Economic order quantity)

Total annual purchase of import RM = 30, 00000…………. (A)

Monthly requirement of import RM=2,50,000……………… (B)

Minimum order level (EOQ) = 10,00000……………………….. (C)

No. of LC required to be opened (A/B) 3000000/1000000=3……… (D)

Frequency of LCs: (12/ No. of LC required to be opened) =12/3 =4 months…………………… (E)

Therefore, Import orders will be placed under LC once in 4 months.

However, Credit (usance) is available for 6 months, and the lead time is 2 months

Total lead time is (2+6) = 8 months………………………………… (F)

Since the second order of RM under LC shall be placed by the customer before the retirement of the
first LC is for Rs.10lakh, therefore LC outstanding at any point in time shall be less than Rs.20 lakhs.

In the instant case Import LC requirement without EOQ:

LC limit without EOQ = (monthly purchase x (lead time+ Usance period)

= (250000x (2.00+6.00) = 2000000/- (Twenty Lakhs]

Assessment of DPG/APG: Assessment of DPG is done in the same method term loan is assessed, as it
is a substitution of the term loan. The assessment of the Advance Payment Guarantee (APG) is done
in the same way for fund-based limits. Since the borrower receives advance payment for the material
to be supplied by him at future date, the advance received should be reduced from the working
capital gap.

Effect on Working Capital limit:

Whenever LC/LG limits are sanctioned for the import of raw materials or goods imported for trading
purposes such limits shall normally help in reducing the working capital limit. Therefore, the
following points are to be noticed while sanctioning/opening LCs.

In the case of DA LCs, the customer gets sufficient time to process or sell the goods imported. Hence
the cash flow of the transaction must be studied for DA LCs.
The LC limit for working capital purposes shall be considered based on the annual consumption of
raw materials to be purchased. The limit sought after must be consistent with the known trade
practice of the borrower.
The LC limit sanctioned for working capital purposes cannot be used for the import of capital goods.
Bank has to check with the customer on how he would arrange funds for the retirement of LC
opened for the import of capital goods (either by term loan or from other sources for margin etc.).

RBI guidelines (Master circular dated April 1, 2022):

Guarantees executed on behalf of any individual constituent, or a group of constituents, should be

subject to the prescribed exposure norms.

As regards the purpose of the guarantee, as a general rule, the banks should confine themselves to
the provision of financial guarantees and exercise due caution with regard to performance guarantee
business.

As regards maturity, as a rule, banks should guarantee shorter maturities and leave longer maturities
to be guaranteed by other institutions.

The guarantees should not normally be allowed to customers who do not enjoy credit facilities with
the banks but only maintain current accounts. If any requests are received from such customers, the
banks should subject the proposals to thorough scrutiny and satisfy themselves about the genuine
need of the customers. The banks should be satisfied that the customers would be in a position to
meet the claims under the guarantees, when received, and not approach the bank for a credit facility
in this regard. For this purpose, the banks should enquire into the financial position of the customers,
the source of funds from which they would be in a position to meet the liability and prescribe a
suitable margin and obtain other security, as necessary. The banks may also call for the detailed
financial statements and Wealth-tax / Income-tax returns of the customer to satisfy themselves with
their financial status. The observations of the banks in respect of all these points should be recorded
in the banks’ books.

What is Letter Of Credit Discounting?

Letter of Credit discounting is a primary method of financing in international trade and is also known
as a documentary credit. Fundamentally, it is a guarantee provided by a financial institution to pay
sellers on behalf of buyers in case of default on their part. Letter of Credit discounting serves as
financial security for businesses involved in either export or import or both.

LC discounting is considered to be a typical funding option as financial institutions follow a

mandatory verification process to confirm the authenticity of both the parties. Also, the chance of
manipulating the discounting rate is minimal as only the prevailing rates apply to a Letter of Credit.

How Does The Letter of Credit Discounting Work?

The pointers mentioned below offer a fair idea about how an LC discounting works –

 On agreeing to the terms of trade, the seller requests a buyer to provide a Letter of Credit
before the goods are delivered to guarantee the financial security of the trade.

 The buyer approaches an issuing bank to obtain a Letter of Credit.

 To discount an LC, the seller submits required export documents to his/her bank.

 LC advice is issued to the exporter by his/her bank.

 The money availed is used to process the order and deliver goods or services as per the
terms.

 The collected export documents are forwarded to the LC issuing bank.

 On receiving the document, the issuing bank verifies them and notifies about the acceptance
of bills under LC.

 The institution disburses payment to the seller's account.

When Can A LC Be Discounted?

It must be noted that exporters can get the LC discounted in any of these situations –

 To fulfil financial requirements, an exporter may request for discounting of the bills backed
by a received Letter of Credit. The exporter's financial institution proceeds to discount the
bill and make a net payment after deducting applicable LC discounting charges.

1. When an importer wants to extend the payment term, but the exporter requires immediate
payment.
 2. In case an importer fails to pay the money on the due date.

Benefits Of LC Discounting:

LC discounting services in India provide quick and assured access to funding in times of need,
making it a preferred financial tool among business entities.

These are key benefits of LC discounting –

 It puts exporters at ease by eliminating credit risk and assuring payment.

 The advance payment helps to access working capital, which in turn results in seamless cash
flow and enhanced operations.

 On receiving the payment before a bill's maturity date, the beneficiary can pay off exporters,
use the money in the production process or meet other production-oriented requirements.

 It enables beneficiaries to provide extended repayment tenure to their trading partner,

which helps them to negotiate a better deal.

Though there are several benefits of LC discounting, exporters need to become familiar with its
limitations as well. If they do not find LC discounting a feasible option, they may consider alternative
funding options to keep their operations active until the importer pays off.

Loan Commitment
A loan commitment is an agreement by a commercial bank or other financial institution to lend a
business or individual a specified sum of money. A loan commitment is useful for consumers looking
to buy a home or a business planning to make a major purchase.

The loan can take the form of a single lump sum or—in the case of an open-end loan commitment—
a line of credit that the borrower can draw upon as needed (up to a predetermined limit).

Understanding a Loan Commitment

Financial institutions make loan commitments based on the borrower’s creditworthiness and—in if
it's a secured commitment—on the value of some form of collateral. In the case of individual
consumers, this collateral may be a home. Borrowers can then use the funds made available under
the loan commitment, up to the agreed-upon limit. An open-end loan commitment works like a
revolving line of credit: When the borrower pays back a portion of the loan's principal, the lender
adds that amount back to the available loan limit.

Interest rates when obtaining a secured loan commitment may be lower, but this type of loan
requires putting up collateral; if you can't repay the loan, you may risk losing the collateral.

Types of Loan Commitments

Loan commitments can be either secured or unsecured.

Secured Loan Commitment

A secured commitment is typically based on the borrower’s creditworthiness and it has some form of
collateral backing it. Two examples of open-end secured loan commitments for consumers are
a secured credit card–where money in a bank account serves as collateral–and a home equity line of
credit (HELOC)–in which the equity in a home is used as collateral.

Because the credit limit is typically based on the value of the secured asset, the credit limit is often
higher for a secured loan commitment than for an unsecured loan commitment. In addition, the
loan’s interest rate may be lower and the payback time may be longer for a secured loan
commitment than for an unsecured one. However, the approval process typically requires more
paperwork and takes longer than with an unsecured loan.

The lender holds the collateral’s deed or title–or places a lien on the asset–until the loan is
completely paid. Defaulting on a secured loan may result in the lender assuming ownership of and
selling the secured asset, at which point they would then be responsible for using the proceeds to
cover the loan.

Unsecured Loan Commitment

A loan that doesn't have any collateral backing it is primarily based on the borrower’s
creditworthiness. An unsecured credit card is one very basic example of an unsecured open-end loan
commitment. Typically, the higher the borrower’s credit score, the higher the credit limit.

However, the interest rate may be higher than on a secured loan commitment because no collateral
is backing the debt. Unsecured loans typically have a fixed minimum payment schedule and interest
rate. The process for acquiring this type of loan often takes less paperwork and approval time than a
secured loan commitment.

Advantages and Disadvantages of Loan Commitments

Open-end loan commitments are flexible and can be useful for paying unexpected short-term
debt obligations or covering financial emergencies. In addition, HELOCs typically have low interest
rates, which may make their payments more affordable. Secured credit cards can help consumers
establish or rebuild their credit; paying their bill on time and keeping total credit card debt low will
improve their credit scores, and in time they may be eligible for an unsecured credit card.

The downside of a secured loan commitment is that borrowers who take out too much money and
are unable to repay the loan may have to forfeit their collateral. For example, this could mean losing
their home. Unsecured commitments have a higher interest rate, which makes borrowing more
expensive.

Unfunded Line of Credit

An unfunded line of credit is one that a bank issues to a borrower, but is not borrowed upon at the
moment it is issued. The bank or lending institution will honor any future draws upon the unfunded
line of credit, but does not need to make any money available until the moment the customer
requests it.

How Is An Unfunded Line Of Credit Different Than A Traditional Loan?

If you take out a mortgage, the lender must immediately make the amount of the mortgage available
so you can buy that dream house. This is considered a traditional loan transaction. Other traditional
loan transactions include automobile loans, student loans and other consumer loans. An unfunded
line of credit is a line of credit which is reserved for future use and is not fully funded upon issue.
Borrowers Of Unfunded Lines Of Credit

Borrowers of unfunded lines of credit can be either individual retail customers or businesses.
Businesses such as hedge funds and insurance companies are customers of unfunded lines of credit,
and they most commonly use them as an emergency fund. Retail customers can also acquire
unfunded lines of credit in the form of home equity lines. Unfunded loan commitments, whether to
retail or corporate clients, represent liabilities to both borrowers and banks.

Risk Of Borrower Default

A borrower can default after drawing upon the line of credit, causing a major problem for the bank
which acted as a lender. For example, if a major catastrophe happens which requires an insurance
company to pay out claims for which it does not have sufficient cash reserves, that insurance
company may draw upon its unfunded line of credit. If the insurance company is unable to pay back
what it borrowed from the bank and files for bankruptcy, the bank must count the unrecovered
money as a loss.

Risk Of Bank Default

Unfunded lines of credit pose major risks for banks. Because the bank must honor the line of credit
at any given point in the future, it must have enough cash to do so. If a bank issues too many
unfunded loan commitments, and a high number of them are unexpectedly drawn upon, the bank
will be unable to honor the loan commitment. Banks are required to report unfunded lines of credit
quarterly to the United States government's Federal Deposit Insurance Corporation. Every bank limits
the number of unfunded credit lines it will issue to mitigate liability.

What Is a Line of Credit (LOC)?

A line of credit (LOC) is a preset borrowing limit that can be tapped into at any time. The borrower
can take money out as needed until the limit is reached. As money is repaid, it can be borrowed
again in the case of an open line of credit.

An LOC is an arrangement between a financial institution—usually a bank—and a customer that

establishes the maximum loan amount that the customer can borrow. The borrower can access
funds from the LOC at any time as long as they do not exceed the maximum amount (or credit limit)
set in the agreement.

How Line of Credit Works

Understanding Credit Lines

All LOCs consist of a set amount of money that can be borrowed as needed, paid back, and borrowed
again. The amount of interest, size of payments, and other rules are set by the lender. Some LOCs
allow you to write checks (drafts), while others include a type of credit or debit card. An LOC can
be secured (by collateral) or unsecured, with unsecured LOCs typically subject to higher interest
rates.

An LOC has built-in flexibility, which is its main advantage. Borrowers can request a certain amount,
but they do not have to use it all. Rather, they can tailor their spending from the LOC to their needs
and owe interest only on the amount that they draw, not on the entire credit line. In addition,
borrowers can adjust their repayment amounts as needed, based on their budget or cash flow. They
can repay, for example, the entire outstanding balance all at once or just make the minimum monthly
payments.

Unsecured vs. Secured LOCs

Most LOCs are unsecured loans. This means that the borrower does not promise the
lender any collateral to back the LOC. One notable exception is a home equity line of credit (HELOC),
which is secured by the equity in the borrower’s home. From the lender’s perspective, secured LOCs
are attractive because they provide a way to recoup the advanced funds in the event of
nonpayment.1

For individuals or business owners, secured LOCs are attractive because they typically come with a
higher maximum credit limit and significantly lower interest rates than unsecured LOCs. Unsecured
LOCs are also more difficult to obtain and often require a higher credit score or credit rating. Lenders
attempt to compensate for the increased risk by limiting the number of funds that can be borrowed
and by charging higher interest rates. That is one reason why the annual percentage rate (APR) on
credit cards is so high.

Credit cards are technically unsecured LOCs, with the credit limit—how much you can charge on the
card—representing its parameters. But you do not pledge any assets when you open the card
account. If you start missing payments, there’s nothing that the credit card issuer can seize in
compensation.

An LOC can have a major impact on your credit score. In general, if you use more than 30% of the
borrowing limit, your credit score will drop.2

Revolving vs. Non-Revolving Lines of Credit

An LOC is often considered to be a type of revolving account, also known as an open-end

credit account. This arrangement allows borrowers to spend the money, repay it, and spend it again
in a virtually never-ending, revolving cycle. Revolving accounts such as LOCs and credit cards are
different from installment loans such as mortgages and car loans.

With installment loans, consumers borrow a set amount of money and repay it in equal monthly
installments until the loan is paid off. Once an installment loan has been paid off, consumers cannot
spend the funds again unless they apply for a new loan.

Non-revolving LOCs have the same features as revolving credit (or a revolving LOC). A credit limit is
established, funds can be used for a variety of purposes, interest is charged normally, and payments
may be made at any time. There is one major exception: The pool of available credit does not
replenish after payments are made. Once you pay off the LOC in full, the account is closed and
cannot be used again.

As an example, personal LOCs are sometimes offered by banks in the form of an overdraft protection
plan. A banking customer can sign up to have an overdraft plan linked to their checking account. If
the customer goes over the amount available in checking, the overdraft keeps them from bouncing a
check or having a purchase denied. Like any LOC, an overdraft must be paid back, with interest.

Types of Lines of Credit

LOCs come in a variety of forms, with each falling into either the secured or unsecured category.
Beyond that, each type of LOC has its own characteristics.
Personal Line of Credit

This provides access to unsecured funds that can be borrowed, repaid, and borrowed again. Opening
a personal LOC usually requires a credit history of no defaults, a credit score of 670 or higher, and
reliable income. Having savings helps, as does collateral in the form of stocks or certificates of
deposit (CDs), though collateral is not required for a personal LOC. Personal LOCs are used for
emergencies, weddings and other events, overdraft protection, travel and entertainment, and to help
smooth out bumps for those with irregular income.

Home Equity Line of Credit (HELOC)

HELOCs are the most common type of secured LOC. A HELOC is secured by the market value of the
home minus the amount owed, which becomes the basis for determining the size of the LOC.
Typically, the credit limit is equal to 75% or 80% of the market value of the home, minus the balance
owed on the mortgage.

HELOCs often come with a draw period (usually 10 years) during which the borrower can access
available funds, repay them, and borrow again. After the draw period, the balance is due, or a loan is
extended to pay off the balance over time.3 HELOCs typically have closing costs, including the cost of
an appraisal on the property used as collateral.

Since the Tax Cuts and Jobs Act of 2017, interest paid on a HELOC is only deductible if the funds are
used to “buy, build or substantially improve” the property that serves as collateral for the HELOC.4

Business Line of Credit

Businesses use these to borrow on an as-needed basis instead of taking out a fixed loan. The
financial institution extending the LOC evaluates the market value, profitability, and risk taken on by
the business and extends an LOC based on that evaluation. The LOC may be unsecured or secured,
depending on the size of the LOC requested and the evaluation results. As with almost all LOCs, the
interest rate is variable.

Demand Line of Credit

This type can be either secured or unsecured but is rarely used. With a demand LOC, the lender can
call the amount borrowed due at any time. Payback (until the loan is called) can be interest only or
interest plus principal, depending on the terms of the LOC. The borrower can spend up to the credit
limit at any time.

Securities-Backed Line of Credit (SBLOC)

This is a special secured-demand LOC, in which collateral is provided by the borrower’s securities.
Typically, an SBLOC lets the investor borrow anywhere from 50% to 95% of the value of assets in their
account. SBLOCs are non-purpose loans, meaning that the borrower may not use the money to buy
or trade securities. Almost any other type of expenditure is allowed.

SBLOCs require the borrower to make monthly, interest-only payments until the loan is repaid in full
or the brokerage or bank demands payment, which can happen if the value of the
investor’s portfolio falls below the level of the LOC.

Limitations of Lines of Credit

The main advantage of an LOC is the ability to borrow only the amount needed and avoid paying
interest on a large loan. That said, borrowers need to be aware of potential problems when taking
out an LOC.

 Unsecured LOCs have higher interest rates and credit requirements than those secured by
collateral.

 Interest rates for LOCs are almost always variable and vary widely from one lender to
another.

 LOCs do not provide the same regulatory protection as credit cards. Penalties for late
payments and going over the LOC limit can be severe.

 An open LOC can invite overspending, leading to an inability to make payments.

 Misuse of an LOC can hurt a borrower’s credit score. Depending on the severity, the services
of a top credit repair company might be worth considering.

What are common types of lines of credit (LOCs)?

The most common types of lines of credit (LOCs) are personal, business, and home equity (HELOCs).
In general, personal LOCs are typically unsecured, while business LOCs can be secured or unsecured.
HELOCs are secured and backed by the market value of your home.

How can I use an LOC?

You can use an LOC for many purposes. Examples include paying for a wedding, a vacation, or an
unexpected financial emergency.

How does an LOC affect my credit score?

Lenders conduct a credit check when you apply for an LOC. This results in a hard inquiry on your
credit report, which lowers your credit score in the short term. Your credit score will also drop if you
tap into more than 30% of the borrowing limit

Performance Guarantee

A Performance Guarantee is a contractors promise to complete the project undertaken. To further

elaborate, a Performance Guarantee is a document that legally confirms that you, the contractor will
complete the contract you have undertaken.

A Performance Guarantee is issued by an insurance company or bank to an employer on behalf of

the contractor to guarantee the full and due performance of the works by the contractor as set out in
the contract data.

Performance Guarantees give the contract employer confidence that they will meet their projected
deadlines and have their contracts completed.

In other words, should the contractor fail to construct the building according to the specifications
laid out by the contract, the client is guaranteed compensation for any monetary losses up to the
amount of the performance bond.
Financial Guarantee:

A financial guarantee is an agreement that guarantees a debt will be repaid to a lender by another
party if the borrower defaults. Essentially, a third party acting as a guarantor promises to assume
responsibility for a debt should the borrower be unable to keep up on its payments to the creditor.

Guarantees can also come in the form of a security deposit or collateral. The types vary, ranging from
corporate guarantees to personal ones.

Understanding Financial Guarantees

Some financial agreements may require the use of a financial guarantee before they can be
executed. In many cases, a guarantee is a legal contract that promises repayment of a debt to a
lender. This agreement takes place when a guarantor agrees to take on the financial responsibility if
the original debtor defaults on their financial obligation or goes insolvent. All three parties must sign
the agreement in order for it to go into effect.1

Guarantees may take on the form of a security deposit. Common in the banking and lending
industries, this is a form of collateral provided by the debtor that can be liquidated if the debtor
defaults.2 For instance, a secured credit card requires the borrower—usually someone with no credit
history—to put down a cash deposit for the amount of the credit line.

Financial guarantees act just like insurance and are very important in the financial industry. They
allow certain financial transactions, especially those that wouldn't normally take place, to go
through, permitting, for instance, high-risk borrowers to take out loans and other forms of credit. In
short, they mitigate the risk associated with lending to high-risk borrowers and extending credit
during times of financial uncertainty.

Guarantees are important because they make lending more affordable. Lenders can offer their
borrowers better interest rates and can get a better credit rating in the market. They also put
investors at ease, making them feel more comfortable because they know their investments and
returns are safe.1

Special Considerations

A financial guarantee doesn't always cover the entire liability. For instance, a guarantor may
only guarantee the repayment of interest or principal, but not both.

Sometimes, multiple companies sign on as a party to a financial guarantee. In these cases, each
guarantor is usually responsible for only a pro-rata portion of the issue. In other cases,
however, guarantors may be responsible for the other guarantors' portions if they default on
their responsibilities.

Financial guarantees may cut down the risk of default in most cases but that doesn't mean they're
fool-proof. We saw this during the fallout after the financial crisis of 2007-2008.

Most bonds are backed by a financial guarantee firm, also referred to as a monoline insurer, against
default. The global financial crisis hit financial guarantee firms particularly hard. It left numerous
financial guarantors with billions of dollars of obligations to repay on mortgage-backed
securities (MBSs) that defaulted, causing financial guarantee firms to have their credit ratings
slashed.

Types of Financial Guarantees

As noted above, guarantees may come in the form of a contract or may require the debtor to put up
some form of collateral in order to access credit. This acts as an insurance policy, which guarantees
payment for both corporations and personal lending. Here are some of the most common types of
both.

Corporate Financial Guarantees

A financial guarantee in the corporate world is a non-cancellable indemnity. This is a bond backed by
an insurer or other secure financial institution. It gives investors a guarantee that principal and
interest payments will be made.

Many insurance companies specialize in financial guarantees and similar products used by debt
issuers as a way of attracting investors. As noted above, the guarantee gives investors comfort that
the investment will be repaid if the securities issuer can't fulfill the contractual obligation to make
timely payments. It also can result in a better credit rating, due to the outside insurance, which
lowers the cost of financing for issuers.

A letter of intent (LOI) is also a financial guarantee. This is a commitment that states that one party
will do business with another. It clearly lays out the financial obligations of each party but may not
necessarily be a binding agreement.3

LOIs are commonly used in the shipping industry, where the recipient's bank provides a guarantee
that it will pay the shipping company once the goods are received.

Personal Financial Guarantees

Lenders may require financial guarantees from certain borrowers before they can access credit. For
example, lenders may require college students to get a guarantee from their parents or another
party before they issue student loans. Other banks require a cash security deposit or form of
collateral before they give out any credit.

Don't confuse a guarantor with a cosigner. A cosigner's responsibility for a debt occurs at the same
time as the original borrower, while the guarantor's obligation only kicks in when the borrower
defaults.

Example of a Financial Guarantee

Here's a hypothetical example to show how financial guarantees work. Let's assume that XYZ
Company has a subsidiary named ABC Company. ABC Company wants to build a
new manufacturing facility and needs to borrow $20 million to proceed.

If banks determine that company ABC has potential credit deficiencies, they may ask XYZ Company to
become a guarantor for the loan. That means that if ABC defaults, XYZ Company must repay the loan
using funds from other lines of business.

DEFERRED PAYMENT GUARANTEE

Deferred Payment Guarantee is a guarantee for a payment usually on installments which has been
deferred or postponed. Banks issue DPG in the cases of purchase of capital goods/machinery where
the seller offers credit to the buyer and buyer’s bank guarantees the due payments to the seller. Here
the seller draws drafts of different maturities on the buyer which are accepted by the buyer and co-
accepted by the Buyer’s bank. Thereby the buyer’s bank guarantees due payment of those drafts
drawn by the seller which represents the total consideration of the contract of sale/supply. The seller
avail the refinance from his bank against co-accepted bills. DPG involves substitution of the term
loan. Unlike all other Guarantees here the payment will have to be made by the bank on the
accepted due dates and thereafter the installment is recovered from the borrower on whose behalf
guarantee is issued. Hence procedure applicable for assessment of term loan must be followed for
DPG limit viz. projection under operating statement, Funds flow statement, DSCR, BEP etc. The
proposal is also examined having regard to the profitability / cash flows of the project to ensure that
sufficient surpluses are generated by the borrowing unit to meet the commitments as a bank has to
meet the liability on the accepted due dates at regular intervals.

As per Reserve Bank of India guidelines, Banks, which intend to issue deferred payment guarantees
on behalf of their borrowers for acquisition of capital assets should ensure that the total credit
facilities including the proposed deferred payment guarantees do not exceed the prescribed
exposure ceilings.

DIFFERENT TYPES OF BANK GUARANTEES

Various types of guarantees are issued by the banks on behalf of their customers. Bank Guarantees
(BG) is also known as Letter of Guarantees which can be broadly classified as (i) Financial Guarantees
and (ii) Performance guarantees. Earnest money Deposit guarantee or Bid Bond Guarantee,
Guarantee for Payment of Customs duty (specific or continuing), Advance Payment Guarantee (APG),
Deferred Payment Guarantee (DPG), Shipping Guarantee, Performance guarantee, Retention Money
guarantees etc are some of the prominent types of guarantees issued by the banks.

Bank Guarantee or letter of guarantee is a fee-based credit facility extended by the banks to their
customers. The non-fund based facilities are the letter of guarantee or letter of credit by the banks
wherein banks get fee income and Since there is no immediate outflow of funds from the banks they
are also known as the non-fund based facility. However in the case of non-fund based credit facility,
the bank has to discharge the financial liability of the contract agreed to the guarantee or
documentary credit, if the contract is partly or fully not performed by the customer.

Financial guarantees
Financial guarantees are issued by the banks whenever a contract is awarded to their customer, who
is generally a contractor of civil work or a supplier of goods, machinery, equipment by a Government
Department or a large industrial undertakings, the customer is under obligation to deposit cash
security or earnest money as a token of due compliance of the terms and conditions of the contract.
This cash security provided by the contractor or supplier is forfeited by the Government Department
or the company which awarded the contract, in the event the contractor or supplier fails to comply
with the terms stipulated in sanction. The customer normally will have an option to furnish a bank
guarantee in lieu of cash security, so that his working funds are not unnecessarily blocked. The
guarantees issued by banks for above purpose is called financial guarantee wherein the banks
undertake to pay the guaranteed amount during a specified period on demand from the beneficiary.
The examples of Financial Guarantee are as under.
Guarantee for Earnest money Deposit (Local Tender)/Bid Bond Guarantee (international tender):
[ A bid bond guarantee is a guarantee issued by the bank to the effect that bidder would not
withdraw the bid before the expiry of bid/tender period or in case the contract is awarded to the
bidder that he would comply with the terms of the tender and enter into the contract.].

Guarantee for Payment of Customs duty (specific or continuing):

a customer may require a guarantee favouring custom department for payment of customs duty
covering import of raw materials. It means that the guarantee covers custom duty in arrears to the
Customs Department by the customer up to a limit (stating maximum of amount) of guarantee
undertaken by the bank.

Advance Payment Guarantee (APG)

Although Advance Payment guarantee is associated with the financial guarantee it has the inherent
risk of performance guarantee Advance payment guarantees are issued on behalf of the (i) Supplier
of raw materials/finished goods or (ii) on behalf of a contractor for an execution of contract when he
receives the advance payment. Since supplier receives an advance from the purchaser for the supply
of raw material or finished goods on a future date, it is a substitution of working capital funds. In the
case of execution of the contract, if any one of the terms of the contract is not fulfilled, the
guarantee is likely to be invoked. While accepting the request from the customer for APG limit the
banker should thoroughly analyse all risk factors.

Deferred Payment Guarantee (DPG)

In the cases of purchase of capital goods/machinery where the seller offers credit to the buyer and
buyer’s bank guarantees the due payments to the seller. Here the seller draws drafts of different
maturities on the buyer which are accepted by the buyer and co-accepted by the Buyer’s bank.
Thereby the buyer’s bank guarantees due payment of those drafts drawn by the seller which
represents the total consideration of the contract of sale/supply. The seller avail the refinance from
his bank against co-accepted bills. DPG involves substitution of the term loan. Hence procedure
applicable for assessment of term loan must be followed for DPG limit viz. projection under
operating statement, Funds flow statement, DSCR, BEP etc.

Shipping Guarantee

Shipping guarantee is issued to the shipping company to release the goods by the shipping
companies on the basis of bank guarantee. Shipping guarantee is issued due to the arrival of the
consignment (Ship carrying the goods already arrived) but non-receipt of relative documents of title
to goods.

Performance Guarantee:

Performance guarantees are issued by the banks on behalf of a Service Contractor, who has to
effectually perform all the conditions of the contract between him and the department/company
that awarded the contract. The bank has to discharge the financial liability of the contract agreed in
the guarantee, if the contract is partly or fully not performed by the customer. Such type of
guarantees issued by the bank is called Performance Guarantee. Many a time the terms of the
contract may be of highly technical in nature and bank is generally not expected to know the
technical aspects of the contract. Therefore the bank assumes only the financial liability of the
contract. Since the issuance of performance guarantee is more complicated and risky, before issuing
performance guarantees, the bank has to ensure that the customer has sufficient experience in the
line of business and he has capacity and means to carry out the obligation under the contract.

Retention Money guarantees

Retention money is a part of the amount payable to the contractor, is retained and payable at the
end after successful completion of the contract. Retention Money guarantee is issued to ensure that
retention money withheld by the beneficiary is released to the applicant (contractor) so that he gets
sufficient working capital to complete the contract.

calculate bank guarantee limit

You can take the recently formed clothing manufacturer XX Company for example. It needs to buy
Rs.2 crore worth of cloth raw resources. Before shipping the raw resources to XX firm, the raw
material seller asks XX firm to offer a bank guarantee to fulfil payments. The mortgage company
handling the company’s cash accounts asks and grants a guarantee to XX company. In general, the
bank and the supplier consign the purchase agreement. The supplier can get their money back from
the bank if XX company does not pay. This is the process for the assessment of bank guarantee limit.

What are the rules of bank guarantee limits?

1) The authorities executing the guarantees must provide their names, titles, and employee codes in
addition to their signatures. This will speed up the process of checking the bank guarantees.

2) When you as a beneficiary obtain the bank guarantee, you are recommended to get in touch with
the approver’s bank to confirm its credibility.

3) The bank guarantee’s initial phase will last for 6 months after the original delivery time. If the
banks decide, they may include a language in the agreement that grants an additional extension of 6
months.

4) The bank guarantee will effectively be renewed according to the request for an extension of the
delivery time. It can be done if the candidate violates the agreement and does not provide the
products or services on schedule.

5) You must print the bank guarantees and renewal papers used in the Directorate General of
Supplies and Disposal contract management on non-judicial stamp paper.
UNIT – 4