Statutory & Regulatory restrictions on Advances :-

The Reserve Bank of India recently revamped the regulatory restrictions on

loans and advances by banks to directors of other banks and related entities.
The notification in this regard was released by the RBI on 23rd July 2021,
which provides for increased limits in loans & advances to be given by banks.

To whom this notification was issued?

The RBI sought to address all scheduled commercial banks excluding RRBs,
all small finance banks and all local area banks.

Statutory Restrictions

As per Section 20 of the Banking Regulation Act 1949[1], there is a

complete prohibition on banks to enter into any commitment for granting loan
to or on behalf of any of its directors and specified other parties wherein the
director is interested. The master circular on loans and advances- statutory
and other restrictions lays down the limits and prohibitions.

Amendment notification: Regulatory restrictions on

loans and advances

The master circular on loans and advances- statutory and other restrictions
specifies persons/entities to whom loans and advances can be extended up to
a specified limit with the prior approval from board. Now the amendment
notification introduced by the RBI vide notification dated 23rd July 2021 has
revised (enhanced) the limits for some classes of persons.
In the table made below, we have explained the existing limits and the
amended enhanced limits.

CATEGORY EXISTING AMENDED/REVISED LIMIT

LIMITS (RBI NOTIFICATION DATED
(MASTER 23RD JULY 2021)
CIRCULAR RBI)

Other banks’ Directors Up to 25 lakh Up to 5 crore rupees for personal

rupees loans (this amendment shall apply
only in case of personal loans).

Firms where directors of other Up to 25 lakh No Revision/Amendment

banks are interested as rupees
partner/guarantor

Companies wherein other banks’ Up to 25 lakh No Revision/Amendment

directors hold substantial interest/ rupees
is a guarantor/director

Relative (other than the spouse) Up to 25 lakh Up to 5 crore rupees

and minor/ dependent children of rupees
Chairman/MD or other directors

Relative (other than the spouse) Up to 25 lakh Up to 5 crore rupees

and minor/ dependent children of rupees
Chairman/MD or other directors
of other banks

Firm wherein relatives mentioned Up to 25 lakh Up to 5 crore rupees

above are partners/guarantors rupees

Companies where relatives are Up to 25 lakh Up to 5 crore rupees

interested as director or guarantor, rupees
if he/she is a major shareholder

The Central Bank also notified that the proposals for credit facilities of an
amount less than 25 lakh rupees or 5 crore rupees (as per the case) to these
borrowers could be sanctioned by the appropriate authority in financing bank
under the powers vested in such authority, however, the matter should be
reported to the board.

Explanation of certain terms

The RBI, in its notification, also explained certain terms which can be helpful
for better understanding. These terms are as follows:

 Major shareholder-
As per the notification, major shareholder refers to a person holding 10% or
more of paid up share capital of 5 crores rupees in paid up shares, whichever
is less.

 Control-

This term shall include the right to appoint a majority of directors or to control
the management or policy decisions exercisable by a person/persons acting
individually or in concert, directly, or indirectly including by virtue of their
shareholding or management rights or shareholders agreements or voting
agreements or in other manner.

 Personal loan-

The meaning of this term is taken from the RBI circular on harmonization of
banking statistics. As per this circular, the meaning of personal loans is loans
provided to individuals and consist of consumer credit, education loan, loans
provided for creation/enhancement of immovable assets and loans extended
for investment in financial assets.

What was the need for revision in regulatory

restrictions in loans and advances?

The master circular on loans and advances- statutory and other restrictions
was issued more than 5 years ago. Owing to the rising inflation, these limits
became vague and ambiguous and hence required revision. Further, due to
the impact of Covid-19 pandemic in the nation, such relaxation was forecasted.

Conclusion
So with the RBI’s notification on amendment to the regulatory restrictions on
loans and advances, the limits have been raised in the loans and advances to
be given by banks. We have attached the RBI’s notification in this regard with
this article for better understanding.

Statutory restrictions
Section 20 of the Banking Regulation Act, 1949 (hereinafter called the “BR Act”) puts complete
prohibition on banks from entering into any commitment for granting of loan to or on behalf of
any of its directors and specified other parties in which the director is interested. The Master
Circular is in furtherance of the same and specifies restrictions and prohibitions as below –
 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.

Benefits of Credit Appraisal

The benefits of credit appraisal are as follows :

 Reduces risk involved in the loans provided for a project.
 Increase confidence among the corporate bankers and improved sales decision.
 Reduces NPA (Non-Performing Assets) and possibility of financial loss.
 Proper assessment is done with different options.
 Types of Credit
There are four basic types of credit :
1. Service credit is monthly payments for utilities such as telephone, gas, electricity, and
water. One has to pay a deposit and late charge if payment is not on time.
1. Loans can be for small or large amounts and for a few days or several years. Money can
be repaid in one lump sum or in several regular payments until the amount one borrowed
and the finance charges are paid in full. Loans can be secured or unsecured.
2. Installment credit may be described as buying on time, financing through the store or the
easy payment plan. The borrower takes the goods home in exchange for a promise to pay
later. Cars, major appliances, and furniture are often purchased this way. One usually
sign a contract, make a down payment, and agree to pay the balance with a specified
number of equal payments called installments. The finance charges are included in the
payments. The item one purchase may be used as security for the loan.
3. Credit cards are issued by individual retail stores, banks, or businesses. Using a credit
card can be the equivalent of an interest-free loan-if one pay for the use of it in full at the
end of each month.

Credit Appraisal Process / Dimensions of Credit Appraisal

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.

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.
Loans have made our life easier, providing us the financial leverage that extends beyond our
earnings. Be it Credit Card, Home Loan, Personal Loan or Auto Loan etc. loans are the credit
extended to us by lenders on fulfilling certain key parameters. However, getting a loan in India
can often be a tedious process for the un-initiated, but not for individuals with a good credit score.

Whenever you apply for a loan, banks check your CIBIL Score and Report to evaluate your
credit history and credit worthiness. The higher your score the better are the chances of your loan
application getting approved.

79% of loans or credit cards are approved for individuals with high CIBIL Score.

WHAT DO BANKS BROADLY CHECK?

1. CIBIL Score and Report: It is one of the most important factor that affects your loan
approval. A good credit score and report is a positive indicator of your credit health.
2. Employment Status: Apart from a good credit history, lenders also check for your steady
income and employment status.
3. Account Details: Credit Facility statuses and suit filed cases are carefully examined by
lenders.
4. Payment History: Lenders check for any default on payments or amount overdue cases,
which might project a negative overview of your overall report.
5. EMI to Income Ratio: Banks also consider the proportion of your existing loans when
compared to your salary at the time of loan application. Your chances of loan approval gets
reduced if your total EMI’s exceed your monthly salary by 50%.
 Apart from your CIBIL Score, loan eligibility criteria differs from lender to lender and across
loan types. However, some of the basic requirements in terms of documentation are:

 Identity Proof: Aadhar Card, Valid Passport, Driving License, Voters ID or PAN Card
 Address Proof: Aadhar Card, Valid Passport, Driving License, Voters ID or Utility Bills
 Proof of Employment: Salary slip, Official ID card or letter from company
 Income Proof: Latest 3 months Bank Statement, salary slip for last 3 months
 3 Passport size photographs
Loans are no longer considered a last resort to buy a sought-after smartphone or a dream house.
Over the last decade or so, people have become less hesitant in applying for a loan, whether it’s
personal, vehicle, education, business, or home – especially when they don’t have a lump sum at
their disposal. Besides, Home and Education Loans provide tax advantages that reduce tax
liability and increase the cash in hand from salary income.
It also helps that banks are making it easier for customers and prospective borrowers to get loans
with minimal paperwork, quick eligibility checks, and competitive interest rates. They have
opened an online channel to apply and submit documents for the approval process. If you still
find the loan application and review process intimidating, here’s a list of seven factors that would
determine the approval of your submission:

 Credit history: Your credit history is indicative of your future repayment behaviour, based on
your pattern in settling past loans. It helps the bank to know if you will be punctual and regular
with your payments. Any default or delay in the past is investigated – the longer the delay, the
lower your score is likely to be.

It doesn’t help if you don’t have a credit history as there is no premise to assess, such as no
Credit Card or Loan availed in the last two years. However, you can address this by maintaining
a Credit Card with no default in repayment.

Generally, a credit score between 700 and 800 is positive. That means you are likely to be
favoured as a safe applicant with a clean history devoid of any repayment defaults. On the other
hand, credit score of less than 300 will increase the likelihood of your application being rejected.
Specialised bureaus such as CIBIL are a source of credit scores that banks seek information from
to assess your creditworthiness.
 Work experience: Banks weigh your employment history and current engagement to ensure that
your source of income is reliable. A bank wants to be certain that your employer is financially
sound, with no history of outstanding or delay in paying employees their salaries. Stability of
your job matters too. Therefore, government jobs have the added advantage of being perceived
as safe compared to lesser known private companies or self-employment.

If you’re working with an eminent institution such as a blue-chip company, your chances are
equally good. Professionals such as doctors, CAs, engineers, and lawyers are also considered
safe. The idea is that your capacity for repaying the loan depends on your income, so its source
 needs to be reliable and consistent. Banks prefer applicants who have worked longer in their
present employment, as it also establishes stability.
 Age: Your age matters because it is indicative of your financially stability. You start working in
your 20s and by the time you turn 30 you would have five or six years of work experience. So
you are financially stable and moving up the proverbial corporate ladder with a better salary. As
you progress further in the next 20 or 30-odd years you will have fewer earning years to repay
your loans. Therefore, a loan application in your retirement years is likely to be rejected.
 Income: As already mentioned, your income represents your repayment capacity. Banks assess
your income capacity in the backdrop of existing debt obligations, dependents, source, and
duration. In this context, one of the many things the bank checks is sufficient surplus after EMI
payments. If this is found wanting, the bank infers that you’re spread far too thin and likely to
default. However, if the ratio is five times and above, the bank will consider you financially
healthy.

Similarly, many banks prefer applicants who have filed their IT returns and paid tax rather than
those who may have filed returns with no tax liability as their income wasn’t taxable.

Your eligibility gets better if you can show additional sources of income, such as your spouse’s
salary. This indicates better repayment capacity as you have more than one source of income to
tap into. Joint loans are offered for the same reason – combining the applicant and co-applicant’s
monthly salaries present more income to afford a higher loan.
 Repayment: If you choose a shorter repayment period, you have a better chance of getting the
loan approved. Several banks favour applications for a repayment period of up to five years. As
the repayment period increases in five-year slabs – 10, 15, 20, and 25 years – the score reduces.
So, keeping it short is the mantra in seeking that approval from a bank for a loan.
 Collateral: The collateral you provide to the bank while applying could help you secure the loan
easier and sooner. As the loan amount is a percentage of the assessed value of the collateral, a
high-value asset could mean more credit sanctioned for your use. The asset could be immovable
(land or house) or movable (vehicle, inventory, equipment, investments, insurance policies, gold
jewellery, art, and other such valuables). While Personal Loans (including credit card
outstanding balance) are unsecured loans, approval for loan to purchase a car or a home, run a
business, or study will not come through unless there is adequate collateral.

 Margin money: Generally, banks are willing to fund up to 80% of the cost of purpose of the
loan and expect the borrower to arrange for the balance. However, if you can put in more than
10-20%, the bank will not stop you. Rather, it will recognise that you are willing to reduce the
bank’s exposure to the default risk and approve your application sooner. The down payment you
are able to make will have a huge impact on your home, education, car, or business loan
eligibility.

Besides these super seven factors, your existing relationship with the bank counts too. If you
have been a customer for a long time, your chance of getting a loan is better, especially if you
have a clean record. Familiarity with your financial past helps the bank determine your current
financial health.
 Structuring of Loan Documents
Documents Required for Loan against Property

For Salaried Individuals

 Proof of Residence - Any one of Ration Card / Telephone Bill / Electricity Bill / Voters Card.
 Proof of Identity - Any one of Voters Card / Aadhaar Card/ Driver’s License / Employers Card.
 Latest Bank Statement / Passbook (where salary / income is credited for past 6 months).
 Latest 6 Months Salary Slip with all deductions and last 2 years Form 16.
 Copies of all Property Documents.

For Self-Employed Individuals

 Certified Financial Statement for the last two years.

 Proof of Residence - Any one of Ration Card / Telephone Bill / Electricity Bill / Voters Card.
 Proof of Identity - Any one of Voters Card / Aadhaar Card/ Driver’s License / Employers Card.
 Latest Bank Statement / Passbook (where salary / income is credited for past 6 months).
 Copies of all Property Documents.

Documents Required for a Personal Loan

The following documents are required along with your Personal Loan application:

 Identity proof (copy of passport/voter ID card/driving license/Aadhaar)

 Address proof (copy of passport/voter ID card/driving license/Aadhaar)
 Bank statement of previous 3 months (Passbook of previous 6 months
 Latest salary slip/current dated salary certificate with the latest Form 16

Documents Required for a Business Loan

The following documents are required along with your Business Loan application:

 PAN Card - For Company/Firm/Individual

 A copy of any of the following documents as identity proof:
1. Aadhaar Card
2. Passport
3. Voter's ID Card
4. PAN Card
5. Driving License
 A copy of any of the following documents as address proof:

1. Aadhaar Card
2. Passport
3. Voter's ID Card
4. Driving License ..

* Bank statement of the previous 6 months

* Latest ITR along with computation of income, Balance Sheet, and Profit & Loss
account for the previous 2 years, after being CA Certified/Audited
* Proof of continuation (ITR/Trade license/Establishment/Sales Tax Certificate)
* Other Mandatory Documents [Sole Prop. Declaration Or Certified Copy of Partnership
Deed, Certified true copy of Memorandum & Articles of Association (certified by
Director) & Board resolution

Documents Required for Commercial Vehicle Loan

If you are running a small business, chances are you may need a loan to buy a vehicle to carry
out your work. The documents required to apply for a commercial vehicle loan are as follows:

 Age proof
 ID proof
 Application form
 Photograph
 Residence proof
 Income proof
 Current repayment track
 Work in hand/Contract copies
 Signature verification proof
 Existing vehicle ownership proof
 Pro forma invoice

What Is Credit Risk?

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet
contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed
principal and interest, which results in an interruption of cash flows and increased costs for
collection. Excess cash flows may be written to provide additional cover for credit risk. When a
lender faces heightened credit risk, it can be mitigated via a higher coupon rate, which provides
for greater cash flows.Although it's impossible to know exactly who will default on obligations,
properly assessing and managing credit risk can lessen the severity of a loss. Interest payments
from the borrower or issuer of a debt obligation are a lender's or investor's reward for assuming
credit risk.

Types of Credit Risk

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

 Credit Default Risk: Credit default risk includes those losses which are incurred by
the lender when the borrower is incapacitated from returning such amount in entire or
when the borrower has exceeded 90 days from the due date but hasn’t made any payment.
 Concentration Risk: Concentration risks are those risks that emerge as a result of
substantial exposure to any individual or group because any unfavorable incident will
have a probability to impose large losses. It is mainly concerned with any
individual industry, company.
 Country Risk: Country risks are such risks that are inferred when a sovereign state
halts the payment needs to be made for foreign currency commitments overnight which
lead to default. Country risks are primarily influenced by macroeconomic
accomplishment. It is also termed as sovereign risk.

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

 A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit,
or other loan.
 A company is unable to repay asset-secured fixed or floating charge debt.
 A business or consumer does not pay a trade invoice when due.
 A business does not pay an employee's earned wages when due.
 A business or government bond issuer does not make a payment on a coupon or principal
payment when due.
 An insolvent insurance company does not pay a policy obligation.
 An insolvent bank won't return funds to a depositor.
 A government grants bankruptcy protection to an insolvent consumer or business.
To reduce the lender's credit risk, the lender may perform a credit check on the prospective
borrower, may require the borrower to take out appropriate insurance, such as mortgage
insurance, or seek security over some assets of the borrower or a guarantee from a third party.
The lender can also take out insurance against the risk or on-sell the debt to another company. In
general, the higher the risk, the higher will be the interest rate that the debtor will be asked to pay
on the debt. Credit risk mainly arises when borrowers are unable or unwilling to pay.
What is Creditworthiness?

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

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

Using Credit Ratings

Financial institutions use credit ratings to quantify and decide whether an applicant is eligible for
credit. Credit ratings are also used to fix the interest rates and credit limits for existing borrowers.
A higher credit rating signifies a lower risk premium for the lender, which then corresponds to
lower borrowing costs for the borrower. Across the board, the higher one’s credit rating, the
better.

A credit report provides a comprehensive account of the borrower’s total debt, current balances,
credit limits, and history of defaults and bankruptcies if any. Due to high levels of asymmetries
of information in the market, lenders rely on financial intermediaries to compile and assign credit
ratings to borrowers and help filter out bad debtors or “lemons.”

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

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

Outlook assessments are also provided to indicate future credit ratings, and they can be
“positive,” “stable”, or “negative.” A “positive” assessment means the agency is hopeful of
upgrading one’s rating, and vice-versa, while “stable” denotes no change.

Creditworthiness – Credit Scores for Individuals

An applicant for a credit card or housing loan may be required to present their credit score at
their bank. Credit scores express the same data as ratings, except numerically. A common
standard is the FICO score, which consolidates data from credit reporting bureaus – namely
Experian, Equifax, and TransUnion – and calculates an individual’s score.
Weights are assigned to key aspects of creditworthiness, which are then used to determine the
overall score. They include an individual’s default history, length of said history, total borrowed
amount, etc. FICO scores range from 300 – 850, which are grouped into blocks of “Excellent,”
“Good,” “Fair,” and “Poor.” Typically, scores above 650 symbolize a good credit history.
Borrowers with a score below 650 face a tough time accessing finance, and if they do, it’s
usually not at favorable interest rates.

Creditworthiness – Credit Ratings for Sovereign States

In cases of sovereign borrowers, i.e., national and state governments, ratings are assigned to
signify the strength of an economy. Institutional effectiveness, foreign reserves, economic
structures, fiscal flexibility, monetary policy, and growth prospects are some of the key factors
used to determine their rating. Sovereign ratings impact a country’s ability to borrow
internationally, as foreign investors get an idea of the risk associated with government-backed
securities.

A poorly rated, undeveloped country may face problems as they may need to pay a higher cost of
capital while borrowing for social expenditure. Moreover, poorly rated countries will need to
promise a higher rate of return on government bonds in order to convince investors to buy them.
Conversely, a higher rated country may be more attractive to foreign investors, which can lead to
a cycle of higher economic growth and a further increase in creditworthiness.

Sovereign ratings fluctuate due to political changes. For example, after the announcement of the
Brexit referendum in 2016, credit rating agency Moody’s changed the United Kingdom’s
outlook in preparation for a prolonged period of uncertainty. Agencies also act as warning
systems during a global economic downturn, as they may downgrade countries and deter
investors from undertaking risky ventures.

However, the efficiency of the Big Three was questioned following their failure to warn
investors in the lead-up to the Asian Financial Crisis in 1997. Moreover, a cautionary downgrade
may worsen the economic stability of a country. For example, during the 2010 European
Sovereign Debt Crisis, the S&P ratings for Greece and Portugal aggravated the crisis.

Creditworthiness – Credit Ratings for Securities

Ratings are issued not just to individual entities but also to short-term and long-term debt
obligations. The types of debts include asset- and mortgage-backed securities and collateralized
debt obligations.

The Big Three agencies were highly criticized in 2008 due to their failure to accurately evaluate
the exposure of subprime mortgages in the USA, which eventually triggered the 2008-2009
Global Financial Crisis. Due to the aforementioned reasons, agencies are held responsible for
losses accruing as a result of false or inaccurate ratings. There is also an emphasis on
transparency since individual agents may try to skew a credit report.

What Is Loan Purpose?

"Loan purpose" is a term used to describe the underlying reasons that the applicant is seeking
some type of loan financing. Defining the purpose for the loan often has an impact on the terms
and conditions that lenders will apply as part of the loan arrangement, and may even play a role
in determining the type of interest rates that the lender is willing to extend to the applicant. Loan
purpose is important to the process of obtaining mortgages or business loans that are connected
with specific types of business activities.
 One of the reasons that loan purpose is so important to lenders is that identifying the reason for
the financing helps to provide important information that aids in determining risk. Since the level
of risk has a direct impact on whether or not a loan is approved, and in the event of an approval
the interest rate that is extended, the lender is able to protect his or her interests with greater
efficiency. For example, when the purpose for the financing is to purchase a piece of real estate,
the lender can assess if there is reasonable grounds to believe that the debtor can repay the loan
according to terms.

Applicants also often benefit from loan purpose. This is because declaring the purpose can often
lead to enjoying a lower interest rate for the duration of the loan period, possibly obtaining more
advantageous repayment terms, and even trimming the fees and related charges that apply to the
granting of the loan itself. Assuming that the applicant can provide information that convinces
the lender that the financing is highly likely to be repaid in full, and that the value of
any collateral attached to the loan agreement will have sufficient worth to settle the outstanding
debt in the event the debtor becomes unable to service that debt, the opportunity to secure the
best possible terms is present.

Loan purpose is important for any type of lending situation, ranging from personal loans to
mortgages on property and even to business-related financing options. In each case, providing
details about the intended use of the proceeds from the loan can make an impact on the amount
that the lender is willing to extend, the interest rate that will apply, and even the terms that will
govern the loan for its duration. For this reason, taking the time to become acquainted with the
risk-based pricing factors that are relevant to the financing will aid in expediting consideration of
the loan and hopefully provide an outcome that is agreeable to both the loan applicant and the
lender.

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 Cash Flow?

The term cash flow refers to the net amount of cash and cash equivalents being transferred in
and out of a company. Cash received represents inflows, while money spent represents outflows.
A company’s ability to create value for shareholders is fundamentally determined by its ability
to generate positive cash flows or, more specifically, to maximize long-term free cash
flow (FCF). FCF is the cash generated by a company from its normal business operations after
subtracting any money spent on capital expenditures

 Cash flow is the movement of money in and out of a company.

 Cash received signifies inflows, and cash spent signifies outflows.
 The cash flow statement is a financial statement that reports on a company's sources and
usage of cash over some time.
 A company's cash flow is typically categorized as cash flows from operations, investing,
and financing.
 There are several methods used to analyze a company's cash flow, including the debt
service coverage ratio, free cash flow, and unlevered cash flow.

Understanding Cash Flow

Cash flow is the amount of cash that comes in and goes out of a company. Businesses take in
money from sales as revenues and spend money on expenses. They may also receive income
from interest, investments, royalties, and licensing agreements and sell products on credit,
expecting to actually receive the cash owed at a late date.

Assessing the amounts, timing, and uncertainty of cash flows, along with where they originate
and where they go, is one of the most important objectives of financial reporting. It is essential
for assessing a company’s liquidity, flexibility, and overall financial performance.

Positive cash flow indicates that a company's liquid assets are increasing, enabling it to cover
obligations, reinvest in its business, return money to shareholders, pay expenses, and provide a
buffer against future financial challenges. Companies with strong financial flexibility can take
advantage of profitable investments. They also fare better in downturns, by avoiding the costs
of financial distress.

Cash flows can be analyzed using the cash flow statement, a standard financial statement that
reports on a company's sources and usage of cash over a specified time period. Corporate
management, analysts, and investors are able to use it to determine how well a company can
earn cash to pay its debts and manage its operating expenses. The cash flow statement is one of
the most important financial statements issued by a company, along with the balance sheet and
income statement.
Types of Cash Flow

Cash Flows From Operations (CFO)

Cash flow from operations (CFO), or operating cash flow, describes money flows involved
directly with the production and sale of goods from ordinary operations. CFO indicates whether
or not a company has enough funds coming in to pay its bills or operating expenses. In other
words, there must be more operating cash inflows than cash outflows for a company to be
financially viable in the long term.

Operating cash flow is calculated by taking cash received from sales and subtracting operating
expenses that were paid in cash for the period. Operating cash flow is recorded on a company's
cash flow statement, which is reported both on a quarterly and annual basis. Operating cash
flow indicates whether a company can generate enough cash flow to maintain and expand
operations, but it can also indicate when a company may need external financing for capital
expansion.

Note that CFO is useful in segregating sales from cash received. If, for example, a company
generated a large sale from a client, it would boost revenue and earnings. However, the
additional revenue doesn't necessarily improve cash flow if there is difficulty collecting the
payment from the customer.

Cash Flows From Investing (CFI)

Cash flow from investing (CFI) or investing cash flow reports how much cash has been
generated or spent from various investment-related activities in a specific period. Investing
activities include purchases of speculative assets, investments in securities, or the sale of
securities or assets.

Negative cash flow from investing activities might be due to significant amounts of cash being
invested in the long-term health of the company, such as research and development (R&D), and
is not always a warning sign.

Cash Flows From Financing (CFF)

Cash flows from financing (CFF), or financing cash flow, shows the net flows of cash that are
used to fund the company and its capital. Financing activities include transactions involving
issuing debt, equity, and paying dividends. Cash flow from financing activities provide
investors with insight into a company’s financial strength and how well a company's capital
structure is managed.

What is Cash Flow?

Cash Flow (CF) is the increase or decrease in the amount of money a business, institution, or
individual has. In finance, the term is used to describe the amount of cash (currency) that is
generated or consumed in a given time period. There are many types of CF, with various
important uses for running a business and performing financial analysis. This guide will explore
all of them in detail.

Types of Cash Flow

There are several types of Cash Flow, so it’s important to have a solid understanding of what
each of them is. When someone refers to CF, they could mean any of the types listed below, so
be sure to clarify which cash flow term is being used.

Types of cash flow include:

1. Cash from Operating Activities – Cash that is generated by a company’s core business
activities – does not include CF from investing. This is found on the
company’s Statement of Cash Flows (the first section).
2. Free Cash Flow to Equity (FCFE) – FCFE represents the cash that’s available after
reinvestment back into the business (capital expenditures). Read more about FCFE.
3. Free Cash Flow to the Firm (FCFF) – This is a measure that assumes a company has
no leverage (debt). It is used in financial modeling and valuation. Read more about FCFF.
4. Net Change in Cash – The change in the amount of cash flow from one accounting
period to the next. This is found at the bottom of the Cash Flow Statement.

Uses of Cash Flow

Cash Flow has many uses in both operating a business and in performing financial analysis. In
fact, it’s one of the most important metrics in all of finance and accounting.

The most common cash metrics and uses of CF are the following:

 Net Present Value – calculating the value of a business by building a DCF Model and
calculating the net present value (NPV)
 Internal Rate of Return – determining the IRR an investor achieves for making an
investment
 Liquidity – assessing how well a company can meet its short-term financial obligations
 Cash Flow Yield – measuring how much cash a business generates per share, relative to
its share price, expressed as a percentage
 Cash Flow Per Share (CFPS) – cash from operating activities divided by the number of
shares outstanding
 P/CF Ratio – the price of a stock divided by the CFPS (see above), sometimes used as an
alternative to the Price-Earnings, or P/E, ratio
 Cash Conversion Ratio – the amount of time between when a business pays for its
inventory (cost of goods sold) and receives payment from its customers is the cash
conversion ratio
  Funding Gap – a measure of the shortfall a company has to overcome (how much more
cash it needs)
 Dividend Payments – CF can be used to fund dividend payments to investors
 Capital Expenditures – CF can also be used to fund reinvestment and growth in the
business

What is Collateral?

Collateral is an asset or property that an individual or entity offers to a lender as security for a
loan. It is used as a way to obtain a loan, acting as a protection against potential loss for the
lender should the borrower default in his payments. In such an event, the collateral becomes the
property of the lender to compensate for the unreturned borrowed money.

For example, if a person wants to take out a loan from the bank, he may use his car or the title of
a piece of property as collateral. If he fails to repay the loan, the collateral may be seized by the
bank based on the two parties’ agreement. If the borrower has finished paying back his loan, then
the collateral is returned to his possession.

 Collateral is an item of value used to secure a loan.

 Collateral minimizes the risk for lenders.
 If a borrower defaults on the loan, the lender can seize the collateral and sell it to recoup
its losses.
 Mortgages and car loans are two types of collateralized loans.
 Other personal assets, such as a savings or investment account, can be used to secure a
collateralized personal loan.

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

In order to be able to take out a loan successfully, every business owner or individual should
know the different types of collateral that can be used when borrowing.

1. Real estate
The most common type of collateral used by borrowers is real estate, such as one’s home or a
parcel of land. Such properties come with a high value and low depreciation. However, it can
also be risky because if the property is sequestered due to a default, it cannot any longer be taken
back.

2. Cash secured loan

Cash is another common type of collateral because it works very simply. An individual can take
a loan from the bank where he maintains active accounts, and in the event of a default, the bank
can liquidate his accounts in order to recoup the borrowed money.

3. Inventory financing
This involves inventory that serves as the collateral for a loan. Should a default happen, the items
listed in the inventory can be sold by the lender to recoup its loss.

4. Invoice collateral
Invoices are one of the types of collateral used by small businesses, wherein invoices to
customers of the business that are still outstanding – unpaid – are used as collateral.

5. Blanket liens
This involves the use of a lien, which is a legal claim allowing a lender to dispose of the assets of
a business that is in default on a loan.

Borrowing without Collateral

Not all loans require collateral, especially if the borrower doesn’t have any property to offer. In
such a case, there are several ways to borrow money, including:

1. Unsecured loans
From the name itself, unsecured loans don’t give the lender any form of assurance or protection
that the money will be returned. However, they usually involve relatively smaller amounts than
what might be loaned against collateral. Examples of unsecured loans include credit card debts.

2. Online loans
With the advancement of technology, there are many more ways to get a loan. In fact, people can
now obtain online loans that don’t require collateral and are often approved quickly. After filling
out an application form, the lender will let the applicant know if he or she is approved, how
much the loan amount is, the interest rate, and how the payments are supposed to be made.

3. Using a co-maker or co-signer

These types of loans don’t require property for collateral. Instead, another individual besides the
borrower co-signs the loan. If the borrower defaults, the co-signer is obliged to pay the loan.
Lenders prefer co-signers with a higher credit rating than the borrower. A co-signed loan is often
one way an individual without established credit can begin to establish a credit history.

Collateral vs. Security

Collateral and security are two terms that often confuse people who think the terms are
completely synonymous. In fact, the two concepts are different. The differences are explained
below:

 Collateral is any property or asset that is given by a borrower to a lender in order to

secure a loan. It serves as an assurance that the lender will not suffer a significant loss.
Securities, on the other hand, refer specifically to financial assets (such as stock shares)
that are used as collateral. Using securities when taking out a loan is called securities-
based lending.
 Collateral can be the title of a parcel of land, a car, or a house and lot, while securities are
things such as bonds, futures, swaps, options, and stocks.
 Collateral, or at least the ownership title to it, stays with the lender throughout the time
the borrower is paying the loan. Securities, on the other hand, allow the borrower to
benefit from both the loan and the securities portfolio even while the loan is still being
paid back because the securities portfolio remains under the borrower’s control. However,
the lender assumes a greater risk because the value of the securities may fluctuate
substantially.