Project-3

Chapter-1
INTRODUCTION :

Banks makes loans and advance to traders,

business and industrialists against the
security of some assets or on the basis of the
personal security of the borrower . Lending
money to different kinds of borrowers is one
of the most important functions of a
bank.lending is a risky business. To do this
business of lending successfully and
profitably a banker has to follow certain
principles.
MEANING:
Lending is the process by which a financial
institution provides funds to a borrower.
Often called a lender, the institution typically
receives interest in return for the loan.
Lending in banking benefits lenders and
borrowers alike by increasing liquidity within
the marketplaces where loans are originated
and used.
Chapter-2
Principles of lending:
The business of lending.which is main
business of the banks.it carries certain
inherant risks and bank cannot take more
than calculated risk.
Whenever it wants to lend.hence, lending
activity has to necessarily adhere to certain
principles.
The “Five Cs of Lending “ are a set of
criteria that lenders use to evaluate
borrowers and determine their
creditworthiness.

The Five C s of Lending:

1) Character
2) Capacity
3) Capital
4) Collateral
5) Conditions

The main principle behind the five Cs is to

gauge the risk of extending credit to a
borrower. A lender needs to evaluate who
they are lending money to, why the
borrower is asking for money, and the
likelihood of recovering loan proceeds.

Another principle of the five Cs is to

determine how credit is priced. Borrowers
with more favorable five Cs may get better
terms, lower rates, and lower payments.
Borrowers who are riskier with poorer five
Cs may face unfavorable terms.

A lender also relies on the five Cs to

determine whether they want to conduct
business with a borrower. If a borrower’s
five Cs are poor, then the lender may
decline to extend credit.The five-Cs-of-
credit method of evaluating a borrower
incorporates both qualitative and
quantitative measures. Lenders may look at
a borrower’s credit reports, credit scores,
income statements, and other documents
relevant to the borrower’s financial
situation. They also consider information
about the loan itself.Each lender has its own
method for analyzing a borrower’s
creditworthiness. Most lenders use the five
Cs—character, capacity, capital, collateral,
and conditions—when analyzing individual
or businetss credit applications.
Key Highlights:
•The 5 Cs are factored into most lenders’
risk rating and pricing models to support
effective loan structures and mitigate credit
risk.
•The 5 Cs must be taken collectively; no
single C in isolation can provide sufficient
insight to approve or decline a transaction.
•Strength in one C can help to offset
weakness in another.
 1) Character :

Character tends to be a very comprehensive, though sometimes subjective, aspect

of the evaluation of creditworthiness. The premise is that a borrower’s historical
track record of managing credit and making payments should serve as a proxy for
future creditworthiness, too. This information appears on the borrower’s credit
reports, which are generated by the three major credit bureaus: Equifax, Experian,
and TransUnion.

For individual borrowers: the assessment seeks to assess what kind of “person”
they are by understanding their credit history, often using a credit score (such
as FICO). For example, FICO uses the information found on a consumer’s credit
report to create a credit score, a tool that lenders use for a quick snapshot of
creditworthiness before looking at credit reports.

A corporate borrower: it is a little more complicated, particularly if it’s a private

company that’s new to a lending institution. Loan officers will want to try and
understand the character of the business by unpacking the management’s (and
ownership’s) reputation and credibility.

2)Capacity :
Capacity really speaks to a borrower’s ability to service debt obligations into the future. A borrower’s
capacity, whether personal or corporate, is typically measured using a variety of financial ratios like total
debt service (TDS) or debt service coverage (DSC).

Evaluating capacity requires a lender to look at a borrower’s ability to generate cash flow relative to their
total obligations, not just the borrowing request at hand. For commercial lenders, seeking to understand a
borrower’s sources of competitive advantage is also extremely important since this will impact the borrower’s
ability to maintain pricing power, margins, and cash flow.Sometimes, credit teams also follow the news alerts
to understand the customer’s financial position, acquisitions, employee stability, etcFor example, qualifying
for a new mortgage typically requires a borrower have a DTI of 43% or lower to ensure that the borrower
can comfortably afford the monthly payments for the new loan, according to the Consumer Financial
Protection Bureau (CFPB).

3)Capital :

Capital can be thought of as a borrower’s overall financial strength, but in particular, what other
unencumbered assets (or sources of cash) may be available to support debt repayment if cash flows were to
dry up?Capital refers to the assets owned and the amount of equity a customer has. Capital includes financial
and non-financial assets, and the credit teams get this information through public financial statements. These
teams will look at the value of the assets to assess the customers’ net worth. They’ll also take into account any
investments that could be used as collateral for the loan.

For a personal borrower, are there marketable securities or real estate assets that could be sold to free up
cash in the event the borrower needed it?

For business and commercial borrowers, an important thing to understand is the company’s capital structure
– meaning what proportion of funding comes from debt vs. equity. If a company is generally under-leveraged,
then a lender is likely more willing to extend credit than if that company were already over-leveraged.Also, is
there an opportunity to take a personal guarantee from the owner (or a corporate guarantee from a related
company) to backstop the proposed exposure?

4) Collateral:
Collateral is when an asset is pledged to a lender as security against credit exposure. Understanding what (if
any) collateral is available, particularly for senior secured lenders, is absolutely essential.

When structuring credit, collateral security plays a really important role in mitigating credit risk. After all, if
a borrower triggered an event of default and the lender were required to take enforcement action against
their security, the quality of the collateral would dictate the likelihood of full repayment.

The nature, condition, and overall desirability of an asset will influence the loan-to-value (LTV) that a lender
is willing to extend, as well as the terms under which the loan will be structured.

Collaterals’ are similar to the concept of a mortgage. If a customer can provide a ‘collateral,’ such as a fixed
asset, it increases the possibility of getting a higher credit line as it acts as a parameter of assurance to the
credit management teams. Most credit teams demand ‘collaterals’ from high-risk customers to avoid
incurring bad debts for their business

5)Conditions:

Conditions are a broad umbrella, but an important one. They, at least in part, refer to the purpose of the
credit that’s being requested. It also includes forces in the external environment (such as macroeconomic
factors) as well as industry-specific risks and opportunities.

Factors like where we are in the economic cycle, what (if any) political or technological risks may exist that
could impact the borrower’s cash flow, and other similar questions should be asked when seeking to
understand the strengths and weaknesses of a borrowing request.

Conditions encompass the current financial condition of the customer, which can be measured by analyzing
the company’s financial statements, cash flow, balance sheet, and income statement.

Additionally, credit teams review macroeconomic conditions, scrutinizing the country’s geopolitical situation,
economic conditions, and the customer’s industry.Conditions play a crucial role as they impact the overall
cost of credit.