Credit Appraisal for Term Loan and Working Capital Financing with special reference to Consortium Banking SIP project report submitted in partial fulfillment of the requirements for the PGDM Program By Saket Rathi 2010197 Under the Guidance of: Mr. P.C.Bansal, Chief Manager – CD (O), PNB, New Delhi Dr. Gajavelli V S / Prof Anant Ram, IMT - Nagpur Institute of Management Technology, Nagpur 2010 – 2012
Transcript
1. Credit Appraisal for Term Loan and Working Capital Financing
with special reference to Consortium BankingSIP project report
submitted in partial fulfillment of the requirements for the PGDM
Program By Saket Rathi 2010197 Under the Guidance of: Mr.
P.C.Bansal, Chief Manager CD (O), PNB, New Delhi Dr. Gajavelli V S
/ Prof Anant Ram, IMT - Nagpur Institute of Management Technology,
Nagpur 2010 2012
2. AcknowledgementI express my sincere gratitude to Mr. P.C.
Bansal, Chief Manager, CD (O), Punjab National Bank,for guiding me
through this project, sharing his knowledge and experience and
correcting mymistakes. Without his guidance and valuable insights,
this project would not have seen the light ofday.I also am very
thankful to Mr Somshekharan Nair, Assistant General Manager, CD
(O), PunjabNational Bank, for providing valuable insights on the
Top Bottom approach and Bottom Topapproach of fund disbursement.I
would also like to express my sincere thanks to the library staff
for extending their support andresources for completion of this
project.A special thanks to my faculty guide, Prof. Dr. Gajavelli
V.S. and Prof. Anant Ram who has beenthe chief facilitator of this
project and helped me enhance my knowledge in the field of
bankingsector.RegardsSaket Rathi2010197IMT - Nagpur 2|Page
3. Certificate of CompletionIt is to certify that Mr. Saket
Rathi (2010197) has successfully completed Summer Project
Studytitled Credit Appraisal for Term Loan and Working Capital
Financing with specialreference to Consortium Banking under my
guidance. It is his original work, and is fit forevaluation in
partial fulfillment for the requirement of the Two Year Post
Graduate Diploma inManagement (Full-time).P.C.BansalChief Manager,
CD (O)Punjab National Bank7, Bhikaji Cama Place, New Delhi.Date:
June 04, 2011 3|Page
4. 1 Table of Contents1 Executive Summary
.........................................................................................................................
62 Abbreviations
..................................................................................................................................
83 Introduction
..................................................................................................................................
104 Objectives of the study
.................................................................................................................
115 About Banking
industry.................................................................................................................
126 About Punjab National Bank
.........................................................................................................
13 6.1 Organizational Structure
.......................................................................................................
14 6.2 Delivery Channels in PNB:
.....................................................................................................
15 6.3 Working of the Credit Administration Department (CD) at PNB
.......................................... 157 Bank Lending An
Overview
........................................................................................................
168
Methodology.................................................................................................................................
209 Types of Lending
...........................................................................................................................
2110 Term Loan
.................................................................................................................................
23 10.1 Features of Term Loan
..........................................................................................................
23 10.2 Term Loan Sanction Procedure
.............................................................................................
24 10.3 Pre-Sanction Inspection
........................................................................................................
2411 Working
Capital.........................................................................................................................
26 11.1 Data required for assessment of working capital requirement
............................................ 27 11.1.1 Assessment
of Fund Based Working Capital
.................................................................
28 11.1.2 Assessment of Non-Fund Based Working Capital
Facility............................................. 3012 Types of
Financing.....................................................................................................................
3913 Case Study: Term Loan - XYZ Energy Pvt. Ltd.
...........................................................................
41 13.1. POWER SECTOR SCENARIO IN INDIA: A PERSPECTIVE
...................................................... 41 13.1.1.
Power Supply
................................................................................................................
41 13.1.2. Peak Demand & Deficit Position
...................................................................................
41 13.2. FUTURE OUTLOOK
............................................................................................................
44 13.3. POWER SCENARIO REGION WISE
...................................................................................
50 13.4. POWER SCENARIO IN UTTARAKHAND
..............................................................................
54 13.5. POWER TRADING IN
INDIA................................................................................................
5414 Conclusion and
Recommendations...........................................................................................
9415 Limitations of the study
............................................................................................................
9616 Scope for future improvements
................................................................................................
97 4|Page
5. 17 Glossary
...................................................................................................................................
10018 References
..............................................................................................................................
103List of FiguresFigure 1: Operating Cycle
......................................................................................................................
26Figure 2: Issuing of Credit
.....................................................................................................................
31Figure 3: Process of Negotiation
...........................................................................................................
32Figure 4: Process of Settlement under L/C
...........................................................................................
32Figure 6: Tier System of Approval of Loans at
PNB...............................................................................
99List of TablesTable 1: Exposure norms for Commercial Banks in
India
......................................................................
19Table 2: Operating Cycle
........................................................................................................................
27Table 3: Assessment of Limit of Letter of Credit
....................................................................................
33Table 4: Assessment of Limit of Letter of Guarantee
............................................................................
34Table 5: The rating and score matrix
.....................................................................................................
37Table 5-1: Region-wise power
situation...........................................................................................
42Table 5-2: Existing Installed Capacity (MW) as on 31st March,
2010 .......................................... 44Table 5-3:
Long-term Projected Energy Requirement
...................................................................
45Table 5-4: Total Energy & Peak Load Availability Vs Installed
Capacity ..................................... 47Table 5-5:
Projected Demand & Supply Position at the end of XI Five Year
Plan ..................... 48Table 5-6: Projected Demand &
Supply Position at the end of XI Five Year Plan
..................... 48Table 5-7: State-wise Demand-Supply
Position for the Period 2009-10
..................................... 52Table 5-8: State-wise
Demand Forecast for Northern India
......................................................... 52Table
5-9: Likely capacity Addition During the XI
Plan..................................................................
53Table 5-10: Demand-Supply Forecast for the Northern Region in
2011-12 ............................... 53Table 5-11: Installed
Capacity as on 31st March, 2010
.................................................................
54 5|Page
6. 1 Executive SummaryBanks play a critical role in the
economic development of an economy. They are important notonly for
economic growth but also financial stability. In an economy banks
has three major rolesto play i.e. first, they fulfill the financing
needs of the corporate sector. Second, they cater to theneeds of
the vast number of household savers, providing assured returns on
their surplus fundswhile maintaining liquidity and safeguarding
them from financial risks. Third, they act as asupport for
development of financial markets and its participants.This project
titled Credit Appraisal for Term Loan and Working Capital Financing
with specialreference to Consortium Banking studies the credit
appraisal methodology at Punjab NationalBank for a proposal
received either for term loan or working capital financing or both
for Rs. 35crore or more and where the borrower wants to avail the
facility from a consortium of banks.Credit appraisal is the process
of evaluating a proposals worthiness of being provided with thetype
of credit facility the borrower has asked for. This includes the
evaluation of current financialstatus, appraisal of projected cash
flows, fund flows, P&L and Balance sheets, purpose for whichthe
facility is availed, technical and financial feasibility of the
project, credit history, managerialcompetence and past experience,
etc. in case for a term loan.As part of the appraisal process,
credit rating is done for the proposal and is conducted either
bythe bank itself or is get done by approves external agencies.The
purpose of this project is to explain, in a brief and general way,
the manner in which risks areapproached by financiers in a project
finance transaction. Such risk minimization lies at the heartof
project finance. Efficient management of credit portfolio is of
utmost importance as it has atremendous impact on the Banks assets
quality & profitability. The ongoing financial reformshave no
doubt provided unparallel opportunities to banks for growth, but
have simultaneouslyexposed them to various risks, which need to be
effectively managed.The concept of Credit Management is undergoing
radical changes. Credit Risk in all exposurescalls for precise
measuring and monitoring for taking considered credit decisions
with suitablerisk mitigants, risk premium, etc. Credit portfolio
should be well diversified in various promisingsectors with a
cautious approach to be adopted in risky segments.Also, lending
continues to be a primary function in banking. In the liberalized
Indian economy,clientele have a wide choice. External Commercial
Borrowings and the domestic capital markets 6|Page
7. compete with banks. In another dimension, retail lending-
both personal advances and SMEadvances- competes with corporate
lending for funds and for human resources. But lending bynature
cannot be an aggressive selling activity, disregarding the risks
involved. Bank has to becompetitive without compromising on the
basic integrity of lending. The quality of the Bankscredit
portfolio has a direct and deep impact on the Banks
profitability.The study has been conducted with the purpose of
getting in-depth knowledge about the creditappraisal and credit
risk management procedure in the organization for the above said
first twopurposes. 7|Page
8. 2 AbbreviationsAGM Assistant General ManagerBG Bank
GuaranteeCC Cash CreditCMD Chairman and Managing DirectorCO Circle
OfficeCRMD Circle Risk Management DepartmentCCA Core Current
AssetsCD Credit Administration DepartmentCARD Credit Audit Review
DivisionCASA Current Account/Savings AccountCRMC Credit Risk
Management CommitteeDSCR Debt Service Coverage RatioDER Debt-Equity
RatioDTL Deferred Tax LiabilityDPG Deferred Payment GuaranteeDTA
Deferred Tax LiabilityBD Discount of BillsED Executive DirectorFACR
Fixed Asset Coverage RatioFB Fund BasedGM General ManagerHO Head
OfficeIRMD Integrated Risk Management DivisionLCB Large Corporate
BranchLC Letter of Credit 8|Page
9. LOC Letter of CreditMC Management CommitteeMPBF Maximum
permissible Bank FinanceMCB Mid Corporate BranchNWC Net Working
CapitalNFB Non Fund BasedPMS Preventive Monitoring SystemPF
Provident FundPNB Punjab National BankRBI Reserve Bank of IndiaRMC
Risk Management CommitteeRMD Risk Management DivisionTEV
Techno-Economic ValuationTL Term LoanWC Working CapitalCO Circle
Office 9|Page
10. 3 IntroductionBanks are an important cog in the wheel of
economic development. One of their main functions isto make
available funds, to enterprises / persons which are short of funds,
at reasonable cost. Themajor source of income for banks is interest
earned on loans and advances disbursed. To disbursethese loans and
advances, funds are mobilized by bank through various sources like
small savingsfrom numerous account holders, capital contribution
etc. (stake holders) and credit creation.Banks stand in a very
delicate situation where it has to maximize returns on these funds
but at thesame time maintain quality of their advances. A bank is
approached by many for funds for varioususes and it may approach
many for availing funds from it. The bank ascertains credit
worthinessof project and borrower in order to find eligible
borrowers to whom it would like to disbursefunds.To ascertain
credit worthiness of project and borrower a comprehensive
evaluation is done onvarious parameters for example: past
financials, techno economic viability of the project,management
competence, future cash and fund flows, actual requirements, etc.
This evaluationprocess is known as credit appraisal. Credit
appraisal is one of the steps through which bankssafeguard interest
of its stake holders.Funds are required for various purposes, at
various intervals and thus there are different ways ofdisbursing
funds. The broad objective of credit appraisal is to ascertain the
worthiness of theborrower but various methodologies are used for
appraising different methods of funddisbursement.The current
project is divided in three parts. First part explains about the
credit appraisal processfor term loan requirements for setting up a
project. Second part deals with the credit requirementsarising
after completion of the project (working capital requirements). The
third part deals indifferent banking arrangements under which a
borrower can avail credit facilities and acomparative analysis of
the same is done. 10 | P a g e
11. 4 Objectives of the studyThe primary objective of this
study is to ascertain in depth, the process used by PNB for
appraisalof Term Loan and / or of Working capital requirements of
the borrowers and various criterias onwhich such appraisal is done
before sanctioning of loans. The study intends to look into
theintricacies of term loan including risk mitigation for different
inherent risks in extending workingcapital advances to diversified
industries.The study involves understanding of usage of various
projections and financial techniques forterm loan like fund flow /
cash flow, profitability schedules, DSCR, sensitivity analysis,
Break Even Analysis, rate of return on the basis of various
calculation techniques, etc., in arriving at adecision.The study
also looks into various ways of ascertaining Working Capital
Requirements of aborrower and various ways of disbursing it.Another
objective of this project is to study different arrangements under
which a borrower canavail funds from PNB and present a comparative
analysis of the same. 11 | P a g e
12. 5 About Banking industryThe roots of the modern banking
industry can be traced from the fourteenth century in
medievalEurope. Banking in India originated in the last deCDes of
the 18th century.Banks act as payment agents by conducting checking
or current accounts for customers, payingcheques drawn by customers
on the bank, and collecting cheques deposited to customers
currentaccounts. Banks also enable customer payments via other
payment methods such as telegraphictransfer, EFT, POS, and
automated teller machine (ATM).Banks borrow money by accepting
funds deposited on current accounts, by accepting termdeposits, and
by issuing debt securities such as banknotes and bonds. Banks lend
money bymaking advances to customers on current accounts, by making
installment loans, and by investingin marketable debt securities
and other forms of money lending.A bank can generate revenue in a
variety of different ways including interest, transaction fees
andfinancial advice. The main method is via charging interest on
the capital it lends out to customers.The bank profits from the
differential between the level of interest it pays for deposits and
othersources of funds, and the level of interest it charges in its
lending activities. Profitability fromlending activities has been
cyclical and dependent on the needs and strengths of loan
customersand the stage of the economic cycle. Fees and financial
advice constitute a more stable revenuestream and banks have
therefore placed more emphasis on these revenue lines to smooth
theirfinancial performance. Banks have expanded the use of
risk-based pricing from business lendingto consumer lending, which
means charging higher interest rates to those customers that
areconsidered to be a higher credit risk and thus increased chance
of default on loans. This helps tooffset the losses from bad loans,
lowers the price of loans to those who have better credit
histories,and offers credit products to high risk customers who
would otherwise be denied credit. 12 | P a g e
13. 6 About Punjab National BankThe idea of a swadeshi bank
with Indian capital and Indian management representing all
sectionsof the Indian community gave birth to Punjab National Bank
on May 23, 1894. It was formed withan authorized capital of Rs 2
Lac and started its commercial operations with working capital of
Rs20 thousand on April 12, 1895 in Lahore, Punjab province, now in
Pakistan.The bank withstood turbulent economic times of 1913, when
78 other banks failed. Due to itsgood governance it sailed through
various economic crisis during 1926 to 1936 and partition ofIndia
and Pakistan.The registered office of the bank was transferred from
Lahore to Delhi on June 20, 1947. Duringpartition The Bank was
forced to close 92 offices in West Pakistan constituting 33 percent
of thetotal number and having 40% of the total deposits. The Bank,
however, continued to maintain afew caretaker branches.The Bank
then embarked on its task of rehabilitating the displaced account
holders. The migrantsfrom Pakistan were repaid their deposits based
upon whatever evidence they could produce. Suchgestures cemented
their trusts in the bank and PNB became a symbol of Trust and a
name you canbank upon. It is ranked as one of Indias top service
brands. PNB has remained fully committed toits guiding principles
of sound and prudent banking. Apart from offering banking products,
thebank has also entered the credit card, debit card; bullion
business; life and non-life insurance;Gold coins & asset
management business, etc.Financial Performance (2010-2011)Total
business of the bank crossed Rs.5.55 lakh crore.Net Interest Income
(NII) increased by39.3% while Net Interest Margin (NIM) improved to
3.96%. Net Profit increased by 13.5% toreach Rs.4433 crore.
Operating Profit was Rs.9056 crore, 23.6% up from last year. PNB
continuesto be among leading banks amongst nationalized banks in
net profit, operating margins, totalbusiness, deposits, advances,
CASA deposits and customer base.PNB has always looked at technology
as a key facilitator to provide better customer service andensured
that its IT strategy follows the Business strategy so as to arrive
at Best Fit. The Bankhas made rapid strides in this direction. All
branches of the Bank are under Core Banking Solution(CBS) since
Dec08, thus covering 100% of its business and providing Anytime
Anywherebanking facility to all customers including customers of
more than 3000 rural & semi urban 13 | P a g e
14. branches. Towards developing a cost effective alternative
channels of delivery, the Bank withmore than 3700 ATMs has the
largest ATM network amongst Nationalized Banks. Bankcontinues its
selective foray in international markets with presence in 9
countries, with 2 branchesat Hongkong, 1 each at Kabul and Dubai;
representative offices at Almaty, Dubai, Shanghai andOslo; a wholly
owned subsidiary in UK; a joint venture with Everest Bank Ltd.
Nepal and a JVbanking subsidiary DRUK PNB Bank Ltd. in Bhutan. Bank
is pursuing upgradation of itsrepresentative offices in China &
Norway and is in the process of setting up a representativeoffice
in Sydney, Australia and taking controlling stake in JSC Dana Bank
in Kazakhastan.6.1 Organizational StructureThe bank has its
corporate office at New Delhi and 58 circle office and 4267
branches. Thedelegation of power is decentralized up to the branch
level for quick decision making. The top-down approach at PNB can
be classified as follows:- Board of directors CMD ED GM ( NPA GM GM
GM GM GM GM (Credit) & Weak (Retail & (Treasury (IRMD)
(Deposits) (Audit) ....... Account) lending) ) DGM DGM DGM ......
AGM AGM AGM ...... Funtional HeadFigure 1 Organizational Structure
at PNB 14 | P a g e
15. Delivery Channels in PNB: Corporate Office (HO) Circle
Office Circle Office Circle office (CO) (CO) (CO) Large Mid
Specialized Branch Corporate Corporate Retail Hub branches e.g.
Office (BO) Agriculture Branches BranchesFigure 2 Delivery channels
in PNB6.2 Working of the Credit Division (CD) at PNBCD looks after
all proposals for all types of loans which fall within the purview
of GMs-HO/ED/CMD/MC/Board. A credit appraisal goes through
different level of sanctioning to enforceinternal controls and
other practices to ensure that exceptions to policies, procedures
and limits arereported in a timely manner to the appropriate level
of management for action.The bank has introduced committee system
in credit sanction process where in every loanproposal falling
within vested power is discussed in credit sanction committee. Such
committeeshave been formed both at head office and Zonal levels.The
CD is assisted by the Risk Management Department (RMD), Technical
Department and theIndustry desk for risk analysis and technical
feasibility of credit proposals.Credit Risk Management structure at
PNB involves: Risk Management division Zonal Risk Management
department (ZRMD) Regional Risk Management Department (RRMD) Risk
Management committee (RMC) Credit risk management committee (CRMC)
Credit Audit Review Division (CARD) 15 | P a g e
16. 7 Bank Lending An OverviewBanks have different ways of
extending credit to different types of borrowers for a wide variety
ofpurposes. Lending can be for long term or short term. Long
termPrinciples of Lending and Loan PolicyPrinciples of LendingBanks
lend from the funds mobilized as deposits from public. A bank acts
in the capacity of acustodian of these funds and is responsible for
its safety, security but at the same time is alsorequired to
deliver justified and assured returns over these borrowings. A bank
looks intofollowing aspects before lending:Safety: the first rule
of lending is to ascertain the safety of the advances made. This
meansassessment of the repaying capacity of the borrower and
purpose of borrowing. It also includesassessment of contingencies
and a fallback plan for the same. This is ensured by taking
adequatesecurity (readily marketable and free of encumbrances) by
way of guarantee, collateral, chargeson property, etc.Liquidity:
The second rule of lending is to ascertain how and when the
repayment of theadvances made would happen and that the repayment
is timely. This is to ascertain availability offunds in future and
make sure that the funds are not locked up for a long period. This
helps inmaintaining balance between deposits and advances and to
meet depositors obligation.Profitability: The third rule of lending
is to lend at higher rate of interest than borrowing rate.This is
called as interest spread / margin. One has to strike a balance
between profitability andsafety of funds. Interest rates must be
charged competitively but at the same time spread should
beadequate.Risk diversion: An old saying says never put all your
eggs in one basket. A lender must lend toa diversified customer
base. Diversification must be made in terms of geographical
locations,borrowers, industry, sector etc. It is done so as to
mitigate adverse financial effects of a businesscycle, catastrophe,
chain effect etc.Loan Policy 16 | P a g e
17. Banks are basically a lending institution. Its major chunk
of revenue is earned from interest onadvances. Each bank has its
own credit policy, based on the principles of lending, which
outlineslending guidelines and establishes operating procedures in
all aspects of credit management. Thepolicy is drafted by the
Credit Policy Committee and is approved by the banks board of
directors.The credit policy sets standards for presentation of
credit proposals, financial covenants, ratingstandards and
benchmarks, delegation of credit approving powers, prudential
limits on large creditexposures, asset concentrations, portfolio
management, loan review mechanism, risk monitoringand evaluation,
pricing of loans, provisioning for bad debts, regulatory/ legal
compliance etc. Thelending guidelines reflect the specific banks
lending strategy (both at the macro level andindividual borrower
level) and have to be in conformity with RBI guidelines. The loan
policytypically lays down lending guidelines in the following
areas:Credit-deposit ratio: Banks are under an obligation to
maintain certain statutory reserves likecash reserve ratio (CRR to
be kept as cash or cash equivalents), statutory liquidity ratio
(SLR to be kept in cash or cash equivalents and prescribed
securities), etc. These reserves aremaintained for asset liability
management (ALM) and are calculated on the basis of demand andtime
liabilities (DTL). Banks may further invest in non prescribed
securities for the matter ofrisk diversion. Funds left after
providing for these reserves are available for lending. The
CPCdecides upon the quantum of credit that can be granted by the
bank as a percentage of deposits.Targeted portfolio mix: CPC has to
strike balance between risk and return. It sets the
guidingprinciples in choosing preferred areas of lending and
sectors to avoid. It also takes into accountgovernment policies of
lending to preferred / avoidable sectors. The bank assesses sectors
forfuture growth and profitability and accordingly decides its
exposure limits.Hurdle ratings: A borrower is assessed on various
risk aspects to find out its suitability forextending credit to it.
Banks uses a comprehensive risk rating system on which each
borrower getsa score depending upon its strength and weaknesses.
This acts as a single point reference and usesa standardized
approach for variety of borrowers. Ratings reveal the overall risk
of lending. Fornew borrowers, a bank usually lays down guidelines
regarding minimum rating to be achieved bythe borrower to become
eligible for the loan. This is also known as the hurdle rating
criterion tobe achieved by a new borrower.Loan pricing: Risk-return
trade-off is a fundamental aspect of risk management. Borrowers
withweak financial position and, hence, placed in higher risk
category are provided credit facilities at a 17 | P a g e
18. higher price (that is, at higher interest). The higher the
credit risk of a borrower the higher wouldbe his cost of borrowing.
To price credit risks, bank devises appropriate systems, which
usuallyallow flexibility for revising the price (risk premium) due
to changes in rating. In other words, ifthe risk rating of a
borrower deteriorates, his cost of borrowing should rise and vice
versa.At the macro level, loan pricing for a bank is dependent upon
a number of its cost factors such ascost of raising resources, cost
of administration and overheads, cost of reserve assets like CRRand
SLR, cost of maintaining capital, percentage of bad debt, etc. Loan
pricing is also dependentupon competition.Collateral security: As
part of a prudent lending policy, bank usually advances loans
againstsome security. The loan policy provides guidelines for this.
In the case of term loans and workingcapital assets, bank takes as
primary security the property or goods against which loans
aregranted. In addition to this, banks often ask for additional
security or collateral security in theform of both physical and
financial assets to further bind the borrower. This reduces the
risk forthe bank. Sometimes, loans are extended as clean loans for
which only personal guarantee of theborrower is takenRole of RBIThe
credit policy of a bank should be conformant with RBI guidelines;
some of the importantguidelines of the RBI relating to bank credit
are discussed below.Directed credit stipulationsThe RBI lays down
guidelines regarding minimum advances to be made for priority
sectoradvances, export credit finance, etc. These guidelines need
to be kept in mind while formulatingcredit policies for the
Bank.Capital adequacyIf a bank creates assets-loans or
investment-they are required to be backed up by bank capital;
theamount of capital they have to be backed up by depends on the
risk of individual assets that thebank acquires. The riskier the
asset, the larger would be the capital it has to be backed up by.
Thisis so, because bank capital provides a cushion against
unexpected losses of banks and riskierassets would require larger
amounts of capital to act as cushion.Credit Exposure Limits 18 | P
a g e
19. As a prudential measure aimed at better risk management and
avoidance of concentration of creditrisks, the Reserve Bank has
fixed limits on bank exposure to the capital market as well as
toindividual and group borrowers with reference to a banks capital.
Limits on inter-bank exposureshave also been placed. Banks are
further encouraged to place internal caps on their
sectoralexposures, their exposure to commercial real estate and to
unsecured exposures.Table 1: Exposure norms for Commercial Banks in
IndiaExposure to Limit 1. Single Borrower 15% of capital fund
(Additional 5% on infrastructure exposure) 2. Group Borrower 40% of
capital fund (Additional 10% on infrastructure exposure) 3. NBFC
10% of capital fund 4. NBFC AFC 15% of capital fund 5. Indian Joint
Venture/ Wholly owned 20% of capital fund subsidiaries abroad/
Overseas step down subsidiaries of Indian corporate 6. Capital
Market Exposure (a) Banks holding of shares in any company The
lesser of 30% of paid-up share capital of the company or 30% of the
paid-up capital of the banks (b) Banks aggregate exposure to
capital market 40% of its net worth (solo basis) (c) Banks
aggregate exposure to capital market 40% of its consolidated net
worth (group basis) (d) Banks direct exposure to capital market
(solo 20% of its net worth basis) (e) Banks direct exposure to
capital market (group 20% of its consolidated net worth basis) 7.
Gross holding of capital among banks/ FIs 10% of capital
fundSource: Financial Stability Report, RBI, March 2010Review of
OperationsRBI has a policy of reviewing operations of the bank. It
conducts inspection every 3 years inBranch Offices and every year
at Head office of a Bank.Credit controlRBI through its various
mechanisms like policy rates, etc. controls the availability of
credit in theeconomy. It intervenes in the market by changing key
policy rates when it finds that there is shortage /excess credit
availability. 19 | P a g e
20. 8 MethodologyIn order to learn and observe the practical
applicability and feasibility of various theories andconcepts, the
following sources are being used: Discussions with the project
guide and staff members. Research papers and documents prepared by
the bank and its related officials. Banks Credit policy and related
circulars and guidelines issued by the bank. Study of proposals and
manuals. Website of Punjab national bank and other net sources. 20
| P a g e
21. 9 Types of LendingLending is broadly classified into two
broad categories: fund based lending and non-fund basedlending.
Fund Based Lending: This is a direct form of lending in which a
loan with an actual cash outflow is given to the borrower by the
Bank. In most cases, such a loan is backed by primary and/or
collateral security. The loan can be to provide for financing
capital goods and/or working capital requirements. Non-fund Based
Lending: In this type of facility, the Bank makes no funds outlay.
However, such arrangements may be converted to fund-based advances
if the client fails to fulfill the terms of his contract with the
counterparty. Such facilities are known as contingent liabilities
of the bank. Facilities such as letters of credit and guarantees
fall under the category of non- fund based credit. Let us explain
with an example how guarantees work. A company takes a term loan
from Bank A and obtains a guarantee from Bank B for its loan from
Bank A, for which he pays a fee. By issuing a bank guarantee, the
guarantor bank (Bank B) undertakes to repay Bank A, if the company
fails to meet its primary responsibility of repaying Bank A.Banks
carry out a detailed analysis of borrowers working capital
requirements. Credit limits areestablished in accordance with the
process approved by the board of directors. The limits onworking
capital facilities are primarily secured by inventories and
receivables (chargeable currentassets).Working capital finance
consists mainly of cash credit facilities, short term loan and
billdiscounting. Under the cash credit facility, a line of credit
is provided up to a pre-establishedamount based on the borrowers
projected level of sales inventories, receivables and cash
deficits.Up to this pre-established amount, disbursements are made
based on the actual level of inventoriesand receivables. Here the
borrower is expected to buy inventory on payments and, thereafter,
seekreimbursement from the Bank. In reality, this may not happen.
The facility is generally given for aperiod of up to 12 months and
is extended after a review of the credit limit. For clients
facingdifficulties, the review may be made after a shorter
period.One problem faced by banks while extending cash credit
facilities, is that customers can draw upto a maximum level or the
approved credit limit, but may decide not to. Because of this,
liquiditymanagement becomes difficult for a bank in the case of
cash credit facility. RBI has been trying tomitigate this problem
by encouraging the Indian corporate sector to avail of working
capitalfinance in two ways: a short-term loan component and a cash
credit component. The loancomponent would be fully drawn, while the
cash credit component would vary depending uponthe borrowers
requirements.According to RBI guidelines, in the case of borrowers
enjoying working capital credit limits ofRs. 10 crores and above
from the banking system, the loan component should normally be 80%
21 | P a g e
22. and cash credit component 20 %. Banks, however, have the
freedom to change the composition ofworking capital finance by
increasing the cash credit component beyond 20% or reducing it
below20 %, as the case may be, if they so desire.Bill discounting
facility involves the financing of short-term trade receivables
through negotiableinstruments. These negotiable instruments can
then be discounted with other banks, if required,providing
financing banks with liquidity. 22 | P a g e
23. 10 Term LoanTerm loans also referred as term finance;
represent a source of debt finance which is utilized
forestablishing or expanding a manufacturing unit by the
acquisition of fixed assets. These aregenerally repayable in more
than one year but less than 10 years. Such loans are raised
forexpansion, diversification and modernization of the enterprise.
The primary sources of such loansare financial institutions. These
are repayable in fixed monthly, quarterly or half
yearlyinstallments and secured by term loan agreements between the
borrower and the bank.Term loans are generally granted to finance
capital expenditure, i.e. acquisition of land, buildingand plant
& machinery, required for setting up a new industrial
undertaking or expansion/diversification of an existing one and
also for acquisition of movable fixed assets. Term loans arealso
given for modernization, renovation etc. to improve the product
quality or increase theproductivity and profitability.Term loans
are normally granted for periods varying from 3-7 years and in
exceptional casesbeyond 7 years. The exact period for which
particular loan is sanctioned depends on thecircumstances of the
case.The basic difference between short term facilities and tem
loans is that short term facilities aregranted to meet the gap in
the working capital and are intended to be liquidated by
realization ofassets, whereas term loans are given for acquisition
of fixed assets and have to be liquidated fromthe surplus cash
generated out of earning. There are not intended to be paid out of
the sale of thefixed assets given as security for the loan. This
makes it necessary to adopt a different approach inexamining the
application of the borrowers for term credit.10.1 Features of Term
LoanFollowing are the different features of term loans: Currency:
Financial institutions give rupee term loans as well as foreign
currency term loans. Security: All loans provided by financial
institutions, along with interest, liquidated damages, commitment
charges, expenses etc. are secured by way of: (a) First equitable
mortgage of all immovable properties of the borrower, both present
and future; and (b) Hypothecation of all movable properties of the
borrower , both present and future, subject to prior charges in
favor of commercial banks for obtaining working capital advance in
the normal course of business 23 | P a g e
24. Interest payment and principal repayment: These are
definite obligations which are payable irrespective of the
financial situation of the firm. Restrictive Covenants: FIs impose
restrictive conditions on the borrowers depending upon the nature
of the project and financial situation of the borrower.10.2 Term
Loan Sanction ProcedureThe procedure associated with a term loan
sanction involves the following steps: Submission of loan
application: The borrower submits an application form which seeks
comprehensive information about the project such as: (a) Promoters
background (b) Particulars of industrial concern (c) Cost of
project (d) Means of financing (e) Marketing and selling
arrangements (f) Economic considerations Initial processing of loan
application: The loan application is reviewed to ascertain whether
it is complete for processing, if it is incomplete then it is sent
back to the borrower for resubmission with all relevant
information. Appraisal of the proposed project: The detailed
appraisal of the project covers the marketing, technical,
managerial, and economic aspects. Issue of letter of sanction: If
the project is accepted, a financial letter of sanction is approved
to the borrower. Acceptance of terms and conditions by the
borrowing unit: On receiving the letter of sanction the borrowing
unit convenes its board meeting at which the terms and conditions
associated with the letter of sanction are accepted and appropriate
resolution is passed to the effect. Execution of loan Agreement:
After receiving the letter of acceptance from the borrowers. The FI
sends the draft of the agreement to the borrower to be executed by
the authorized person Creation of Security: The term loans and the
DPG assistance provided by the financial institutions are secured
through the first mortgage, by way of deposit of title deeds, of
immovable properties and hypothecation of movable properties.
Disbursement of loan: Periodically, the borrower is required to
submit the information on the physical progress of the projects,
financial status of the projects, arrangements made for financing
the projects, contribution made by the promoters, projected fund
flow statement, compliance with various statutory requirements and
fulfillment of disbursement conditions. Monitoring: Monitoring of
the project is done at the implementation stage as well at the
operational stage.10.3 Pre-Sanction Inspection Once the incumbent
is satisfied with the information furnished by the borrower that
the proposal for the term loan is worth consideration, he should
inspect the factory or place of business to check the authenticity
of the information supplied. Inspection can bring into 24 | P a g
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25. light certain factors which are not revealed by mere study
of financial statements. Even in case of new unit, inspection of
factory site is necessary. The assets of the concern which are
proposed to be charged should be verified physically and the title
of the borrowers on the same should be examined. The books of the
accounts and other relevant papers should be verified to see if all
liabilities, claims, contingencies, disputes have been admitted by
the concern. Such an inspection can focus on the unfavorable
aspects or weaknesses of the unit and can help to a large extent in
making an assessment of the proposal. 25 | P a g e
26. 11 Working CapitalWorking capital is defined as the total
amount of funds required for day to day operation of aunit. It can
also be referred as the current asset holding of an enterprise. It
is often classified asgross working capital (GWC) and net working
capital (NWC). Working capital finance is utilizedfor operating
purposes, resulting in creation of current assets (such as
inventories and receivables).This is in contrast to term loans
which are utilized for establishing or expanding a
manufacturingunit by the acquisition of fixed assets.Gross Working
Capital refers to the fund required for financing total current
assets of a businessunit. Net working capital no other hand is the
difference between current assets and currentliabilities (including
bank borrowings) that is nothing but the surplus of long term
sources overlong term uses as such it is known as the liquid
surplus available in a unit that can be eitherpositive or negative.
A positive NWC is always desirable because of the fact that it
provides notonly margin for the working capital requirement but
also improves ability of the borrower to meetits short term
liabilities.Operating Cycle MethodEvery business unit has an
operating cycle which indicates that a unit procures raw
materialfrom its funds, convert into stock in process which again
is converted into finished goodswhich can be sold for cash and thus
transformed into fund. Alternatively it can be sold on creditand on
realization thereof gets converted into fund.Thus every rupee
invested in current assets at the beginning of the cycle comes back
to thepromoter with the profit element added, after the lapse of a
specific period of time. This length oftime is known as operating
cycle or working capital cycle.Figure 3: Operating Cycle AR
converted Cash to cash Cash Account Sales Recievabl Order e Cash
Goods and Services convertedconverted to Account Deliver Produce to
Prepaid Receivables Goods Goods Expenses or or nd Service Service
Inventory 26 | P a g e
27. In order to keep the operating cycle going on, certain
level of current assets are always required,the total of which
gives the amount of total working capital required. Thus total
working capitalcan be obtained by assessing the level of various
components of current assets.The operating cycle is therefore
measured in terms of days of average inventory held for everymajor
category of working capital components.Table 2: Operating Cycle
Stages Time Value I Raw Material Holding Period Value of RM
consumed during the period II Stock in Process Time taken in RM +
Manufacturing converting RM into expenses during the FG period
(cost of production) III Finished Goods Holding period of FG RM +
mfg. exp. + before being sold adm. Overheads for the period (cost
of sales) IV Receivables Credit allowed to RM + mfg. exp .+ buyer
adm. Exp. + profit for the period (Sales)11.1 Data required for
assessment of working capital requirementFor assessing the working
capital needs of an organization, bank follows CMA
(CreditMonitoring Arrangement). It is required by banks and other
financial institutions, to introspect orstudy the minutes of
balance sheet and other financial statements of a body corporate
for financingtheir projects. In other words it is the detailed
explanation of the balance sheet and other financialratios of the
firm or any other corporate.The CMA includes analysis of following
six documents: i) Existing and proposed banking arrangements ii)
Operating statement iii) Analysis of Balance Sheet iv) Buildup of
current assets and current liabilities v) Calculation of MPBF
(Maximum Permissible Bank Finance) vi) Fund Flow Statement 27 | P a
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28. 11.1.1 Assessment of Fund Based Working CapitalWhile public
sector banks in India are nominally independent entities they are
subject to intenseregulation by the Reserve Bank of India (RBI).
This includes rules about how much the bankshould lend to
individual borrowersthe so-called maximum permissible bank finance.
Thereare multiple methods as suggested by different committees from
time to time. We have discussedfollowing recommendations by three
committees: 1. Simplified Turnover Method (Nayak Committee)This
method of assessing working capital requirement of a firm is given
by Nayak Committee.The committee headed by Mr. P.R. Nayak examined
the adequacy of institutional credit to SSIsector and gave its
recommendations which are as under: a. Under this method, bank
credit for working capital purposes for borrowers requiring fund
based limits up to Rs. 5 crore for SSI borrowers and Rs. 2 crore in
case of other borrowers, may be assessed at minimum of 25% of the
projected annual turnover of which should be provided by the
borrower (i.e. minimum margin of 5% of the annual turnover to be
provided by the borrower) and balance 4/5th (i.e. 20% of the annual
turnover) can be extended by way of working capital finance. b. The
projected turnover or output value may be interpreted as projected
gross sales which will include excise duty also. c. Since the bank
finance is only intended to support the need based requirement of a
borrower, if the available NWC (net long term surplus funds) is
more than 5%of the turnover the former should be reckoned for
assessing the extent of bank finance. 2. Maximum Permissible
Banking Finance Method (Tandon Committee )A committee headed by Mr.
P.L. Tandon, ex-chairman of PNB, was constituted with view
tosuggest improvement in the existing ash credit system. It
submitted its report on guidelines forfollow up of credit in August
1974, suggesting three methods of lending. These are as follows:
1st Method of Lending: 75% of the working capital gap (WCG = Total
current assets Total current liabilities other than bank
borrowings) is financed by the bank and the balance 25% of the WCG
considered as margin is to come out of long term source i.e. owned
funds and term borrowings. This will give rise to a minimum current
ratio of 1.17:1. The difference of 0.17 (= 1.17 1) represents the
borrowers margin which is known as Net Working Capital (NWC). 2nd
Method of Lending: Bank will finance maximum up to 75% of total
current assets (TCA) and borrower has to provide a minimum of 25%
of total current assets as the margin out of long term sources.
This will give a minimum current ratio of 1.33:1. 3rd Method of
Lending: This is same as 2nd method of lending, but excluding core
current assets from total assets and the core current assets are
financed out of long term funds of the company. The term core
current assets refers to the absolute minimum level of 28 | P a g
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29. investment in current assets, which is required at all
times to carry out minimum level of business activity. The current
ratio is further improved to 1.79:1.Examples: Current Liabilities
Current AssetsCreditors for purchase 100 Raw material 200Other
current liability 50 Stock in process 20Bank Borrowings 200
Finished Goods 90 Receivables 50 Other current assets 10 350 370
1st Method 2nd Method 3rd MethodTotal CA 370 Total CA 370 Total CA
370Less Total CL - Less Core CA from longBank Borrowing 150 Less
25% of CA 92 term sources 95WCG 220 278 27525% of WCG from Less
Total CL - Less 25% from longlong term sources 55 Bank Borrowings
150 term sources 69 Less Total CL - Bank Borrowings 150MPBF 165
MPBF 128 MPBF 56Current Ratio 1.17:1 Current Ratio 1.33:1 Current
Ratio 1.79:1 3. Chore CommitteeThe R.B.I constituted, in April
1979, a working group under the chairmanship of Sri K.B Chore,to
review the system of cash credit with the particular reference to
the gap between sanctionedlimit and the extent of their
utilization. It was also asked to suggest alternative type of
creditfacilities which would ensure greater credit discipline and
enable the banks to relate the creditlimits to increase in output
or other productive activities.The committee recommended assessment
of working capital requirements have to be mandatorilyassessed
based on 2nd method of lending suggested by Tandon Committee except
for sick/Unitsunder rehabilitation.As such, the banks are presently
assessing need based WC financing under 2nd Method of lending. 4.
CASH BUDGET SYSTEMIn case of tea, sugar, construction companies,
film industries and service sector requirement offinance may be at
the peak during certain months while the sale proceeds may be
realisedthroughout the year to repay the outstanding in the
account. Therefore, credit limits are fixed onthe basis of
projected monthly cash budgets to be received before beginning of
the season. 29 | P a g e
30. Branches should follow the procedure/guidelines issued from
time to time through variousCirculars for financing tea, sugar,
construction companies, film industries and service sector.11.1.2
Assessment of Non-Fund Based Working Capital FacilityThe credit
facilities given by the banks where actual bank funds are not
involved are termed asnon-fund based facilities. These facilities
are divided in three broad categories as under: Letters of credit
Guarantees Co-acceptance of-bills/deferred payment guarantees.Units
for the above facilities are also simultaneously sanctioned by
banks while sanctioning otherfund based credit limits.Facilities
for co-acceptance of bills/deferred payment guarantees are
generally required foracquiring plant and machinery and may,
technically be taken as a substitute for term loan whichwould
require detailed appraisal of the borrowers needs and financial
position in the same manneras in case of any other term loan
proposal. Letter of Credit: Letter of credit (LC) is a method of
settlement of payment of a trade transaction and is widely used to
finance purchase of raw material, machinery etc. It contains a
written undertaking by the bank on behalf of the purchaser to the
seller to make payment of a stated amount on presentation of
stipulated documents and fulfillment of all the terms and
conditions incorporated therein. Letters of credit thus offers both
parties to a trade transaction a degree of security. The seller can
look forward to the issuing bank for payment instead of relying on
the ability and willingness of the buyer to pay. Parties to a
Letter of Credit 1. Applicant/Opener: It is generally the buyer of
the goods who gets the letter of credit issued by his banker in
favour of the seller. The person on whose behalf and under whose
instructions the letter of credit is issued is known as applicant/
opener of the credit. 2. Opening bank/issuing bank: The bank
issuing the letter of credit. 3. Beneficiary: The seller of goods
in whose favour the letter of credit is issued. 4. Advising Bank:
Notification regarding issuing of letter of credit may be directly
sent to the beneficiary by the opening bank. It is, however,
customary to advise the letter of credit through sane other bank
operating at the place/country of seller. The bank which advises
the letter of credit to the beneficiary is known as advising bank.
5. Confirming Bank: A letter of credit substitutes the credit
worthiness of the buyer with that of the issuing bank. It may
sometimes happen especially in import trade that the issuing 30 | P
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31. bank itself is not widely known in the exporters country
and exporter is not prepared to rely on the L/C opened by that
bank. In such cases the opening bank may request other bank usually
in the country of exporter to add its confirmation which amounts to
an additional undertaking being given by that bank to the
beneficiary. The bank adding its confirmation is known as
confirming bank. The confirming bank has the same liabilities
towards the beneficiary as that of opening bank. 6. Negotiating
Bank: The bank that negotiates the documents drawn under letter of
credit and makes payment to beneficiary. The function of advising
bank, confirming bank and negotiating bank may be undertaken by a
single bank only. Letter of Credit Mechanism Any
business/industrial venture will involve purchase transactions
relating to machine/other capital goods and raw material etc., and
also sale transactions relating to its products. The customer may
be an applicant for a letter of credit for his purchases while be
the beneficiary under other letter of credit for his sale
transaction. The complete mechanism of a letter of credit may be
divided in three parts as under: 1. Issuing of Credit: Letter of
credit is always issued by the buyers bank (issuing bank) at the
request and on behalf and in accordance with the instructions of
the applicant. The letter of credit may either be advised directly
or through some other bank. The advising bank is responsible for
transmission of credit and verifying the authenticity of signature
of issuing bank and is under no commitment to pay the seller. The
advising bank may also be required to add confirmation and in that
case will assume all the liabilities of issuing bank in relation to
the beneficiary as stated already. Refer to diagram given below for
complete process of issuance of credit.Figure 4: Issuing of Credit
Buyer Seller Sales Contract Applicant Beneficiary (1) (2) (4)
Buyers Advising Issuance of Letter of Bank Bank Credit Issuing
Confirming (3) Bank Bank 31 | P a g e
32. 2. Negotiation of Documents by beneficiary: On receipt of
letter of credit, the beneficiary shall arrange to supply the goods
as per the terms of L/C and draw necessary documents as required
under L/C. The documents will then be presented to the negotiating
bank for payment/acceptance as the case may be. The negotiating
bank will make the payment to the beneficiary and obtain
reimbursement from the opening bank in terms of credit. The entire
process of negotiation is diagrammatically represented as under:
Buyer Supply of Goods (5) Seller Applicant BeneficiaryPayment to
Beneficiary (7) Documents for Negotiation (6) Buyers Documents (8)
Advising/ Confirming Bank Bank Issuing Reimbursement (9)
Negotiating Bank Bank Payment to Beneficiary (7) Figure 5: Process
of Negotiation 3. Settlement of Bills Drawn under Letter of Credit
by the opener: The last step involved in letter of credit mechanism
is retirement of documents received under L/C by the opener. On
receipt of documents drawn under L/C, the opening bank is required
to closely examine the documents to ensure compliance of the terms
and conditions of credit and present the same to the opener for his
scrutiny. The opener should then make payment to the opening bank
and take delivery of documents so that delivery of goods can be
obtained by him. This aspect of L/C transaction is represented as
under: Figure 6: Process of Settlement under L/C Buyer Delivery of
Goods (12) Applicant Payment (11) Documents (10) Buyers Bank 32 | P
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33. Issuing BankTypes of Letter of Credit: Letter of credit may
be divided in two broad categories as under: (i) Revocable letter
of credit. This may be amended or cancelled without prior warning
or notification to the beneficiary. Such letter of credit will not
offer any protection and should not be accepted as beneficiary of
credit. (ii) Irrevocable letter of credit. This cannot be amended
or cancelled without the agreement of all parties thereto. This
type of letter of credit is mainly in use and offers complete
protection to the seller against subsequent development against his
interest.Letter of credit may provide drawing of documents on
following two bases: (i) Delivery against payment (DP) Sight: In
this case documents are delivered against payment. The beneficiary
is paid as soon as the paying bank or borrowers bank has determined
that all necessary documents are in order. (ii) Delivery against
acceptance (DA) Usance (time): In this case documents are delivered
against acceptance. The borrower pays after certain due date of
payment specified.Assessment of Limit of Letter of Credit:Table 3:
Assessment of Limit of Letter of Credit Assessment of Limit of
Letter of CreditAnnual Raw Material Consumption AAnnual Raw
Material Procurement through ILC/ FLC BMonthly Consumption CUsance
DLead Time ETotal Time F=D+ELC Time Required G=F*C Bank Guarantee A
contract of guarantee can be defined as a contract to perform the
promise, or discharge the liability of a third person in case of
his default. The contract of guarantee has three principal parties
as under: o Principal debtor: The person who has to perform or
discharge the liability and for whose default the guarantee is
given. o Principal creditor: The person to whom the guarantee for
due fulfilment of contract by principal debtor. Principal creditor
is also sometimes referred to as beneficiary. 33 | P a g e
34. o Guarantor or Surety: The person who gives the
guarantee.Bank provides guarantee facilities to its customers who
may require these facilities for variouspurposes. The guarantees
may broadly be divided in two categories as under: o Financial
guarantees: Guarantees to discharge financial obligations to the
customers. o Performance guarantees: Guarantees for due performance
of a contract by customers.Table 4: Assessment of Limit of Letter
of Guarantee Assessment of Limit of Letter of GuaranteeOutstanding
Bank Guarantee as per audited balance sheet AAdd bank guarantee
required during the period BLess estimated maturity or cancellation
of bank guarantee Cduring the periodRequirement of bank guarantee
D=A+B-C Bills Co-Acceptance: It is same as letter of credit. The
difference is that the letter of credit is accepted by buyer as
well by co-accepting bank. Deferred Payment Guarantee (DPG): A
deferred payment guarantee is a contract under which a bank
promises to pay the supplier the price of machinery supplied by him
on deferred terms, in agreed installments with stipulated interest
in the respective due dates, in case of default in payment thereof
by the buyer. As far as the buyer of the plant and machinery is
concerned, it serves the same purpose as term loan. The advantage
to the buyer is that he is benefited to the extent of savings in
interest charges accruing on account of opting equipment financing
under installment payment system less the guarantee.Risk
ManagementRisk management is the identification, assessment and
prioritization of risks followed byco-ordinate and economical
application of resources to minimize, monitor and control
theprobability or impact of unfortunate events.The risk that a
borrower might fail to meet its obligations towards the bank in
accordance with theagreed terms and conditions, is the credit risk
contracted during sanctioning of loan. It is the riskof default of
on the part of borrower, which could be due to either inability or
unwillingness torepay his debts.Factors determining credit risk:
State of Economy Wide swing in commodity prices Trade restrictions
Fluctuations in foreign exchange rates and interest rates Economic
sanctions Government policiesSome company specific factors are: 34
| P a g e
35. Management Expertise Company Policies Labour RelationsThe
internal factors within the bank, influencing credit risk for a
bank are: Deficiencies in loan policies/ administration Absence of
prudential concentration limits Inadequate defined lending limits
for loan officers or credit committees Deficiencies and appraisal
of borrowers financial position Excessive dependence on collateral
without ascertaining its quality/ reliability Absence of loan
review mechanismThe risk management philosophy & policy of the
Bank is an embodiment of the Banks approachto understand measure
and manage risk and aims at ensuring sustained growth of healthy
assetportfolio. This would entail in reducing exposure in high risk
areas, emphasizing more on thepromising industries, optimizing the
return by striking a balance between the risk and the returnon
assets and striving towards improving market share to maximize
shareholders value.Following procedure is followed at PNB, HO for
risk rating: The head office of the bank at Bhikaiji Cama place
receives the proposals of various organizations demanding loans.
They receive a copy of the companys financial results. The branches
also send their rating after some initial screening to the head
office for vetting. These branches obtain the data from the
proposal and the discussions with other banks in the consortium.
They can also contact the company for further clarifications The
auditors report and notes to accounts serve as a useful guide. The
past records of companys transactions with the bank (if any) are
also considered. The officials at the HO study and check the
financials and the subjective parameters. Then the final rating is
done after making suitable amendments.The credit risk rating tool
has been developed with a view to provide a standard system
forassigning a credit risk rating to the borrowers of the bank
according to their risk profile. Thisrating tool is applicable to
all large corporate borrower accounts availing total limits (fund
basedand non-fund based) of more than Rs. 12 crore or having total
sales/ income of more than Rs. 100crore.The Bank has robust credit
risk framework and has already placed credit risk rating models
oncentral server based system PNB TRAC, which provides a scientific
method for assessing creditrisk rating of a client. Taking a step
further during the year, the Bank has developed and placedon
central server score based rating models in respect of retail
banking. These processes havehelped the Bank to achieve fast &
accurate delivery of credit; bring uniformity in the system
andfacilitate storage of data & analysis thereof. The analysis
also involves analyzing the projectionsfor the future years.This
credit risk rating captures risk factors under four areas: 35 | P a
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36. 1. Financial evaluation (40%) 2. Business or industry
evaluation (30%) 3. Management evaluation (20%) 4. Conduct of
account (10%) Financial evaluation Under this, various parameters
are taken and based on the financial data scores are assigned
during the risk rating process. The financial evaluation involves
past financials classified based on industry comparison and
absolute comparison. Following are some of the parameters, which
have been explained in detail: A. Liquidity Parameter a. Current
Ratio b. Debt Service Coverage Ratio B. Profitability Parameter a.
Return on Investment C. Operating Efficiency Parameter D. Other
Parameters a. Future risk expectations b. Cash flow adequacy c.
Transparency in financial statements of the company d. Quality of
the inventory e. Reliability of the debtors f. Quality of
investment / loans and advances to other companies g. Trends in the
financial performance over the past few years Business evaluation
It involves the evaluation of the operating efficiency of the
concerned company under which various factors are considered which
is extremely important for risk rating purposes. These could be raw
material/ cost of production or it could be credit period availed
and allowed. All these factors help in judging the efficiency in
operating the business. Market Position Evaluating the market
position for the purpose of risk rating is extremely important to
judge the competitive position of the company and analyzing the
input related risk, product related risk, price competitiveness and
other market factors and then giving scores for the purpose of
calculating the aggregate market position. Management evaluation 36
| P a g e
37. It is done by comparing the targets set with the targets
achieved by the management during the year. Subjective assessment
is also done based on the factors risk like track record or
sincerity of the management. Conduct of Account Evaluation This
evaluation involves PMS rating. PMS is a macro level monitoring
tool. In other words, it is a close actions oriented follow up of
the health of borrower. It aims to minimize the loan losses by
capturing early warning signals of deterioration and taking
preventive action. It has a memory of one year and reporting
frequently is linked to credit rating.How to rateThe ratios of the
company are compared with the benchmark ratios and rating is given
to thecompany up to 2 decimal points based on its position within
the benchmark values.Procedure for evaluation at PNB is as follows:
1. Each industry has its own risk and depending on it, a suitable
risk factor is chosen and industry risk is adjusted into the score
of rating. 2. These areas cover different parameters based on which
the past and the future performance of the company are evaluated.
3. The combined scores of these areas are calculated. 4. Then based
on the weight age assigned (given in brackets above) the overall
score is calculated. 5. This overall score is used to determine the
ratings as illustrated in following table:Table 5: The rating and
score matrixRating Category Description Score obtained Grade AAA
Minimum risk Above 80.00 AAA Between 77.50 - 80.00 AA+ AA Marginal
risk Between 72.50 77.50 AA Between 70.00 72.50 AA- Between 67.50
70.00 A+ A Modest risk Between 62.50 67.50 A Between 60.00 62.50 A-
Between 57.50 60.00 BB+ BB Average risk Between 52.50 57.50 BB
Between 50.00 52.50 BB- Between 47.50 50.00 B+ Marginally B Between
42.50 47.50 B acceptable risk Between 40.00 42.50 B- 37 | P a g
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38. C High risk Between 30.00 40.00 C D Caution risk Below
30.00 DBased on the above table rating is done. Once the rating is
done, the rate of interest at which thebank will be lending the
money is determined. Normally, a company with higher rating is
givenloan at a lower interest as compared to company with lower
ratings. This is because the riskinvolved with higher rated company
is lower. 38 | P a g e
39. 12 Types of FinancingConsortium FinancingWhere the entire
credit needs of the borrower is financed by a group of banks by
forming aconsortium. It promotes collective application of banking
resources.Merits: To bank: 1. A single bank carries a
disproportionate credit risk when it finances single handedly a
huge sum to a large borrower. Consortium financing helps to spread
this risk among a number of banks who are members of the
consortium. 2. Consortium financing leads to a better credit
appraisal in as much as the expertise of all the member banks can
be contributed for appraising the proposal. 3. Smaller banks which
cannot alone finance huge limits to the large borrowers can still
join in financing by becoming the member of consortium. Financing
large borrowers being a profitable proposition helps in increasing
their profitability. 4. It stops unhealthy practices of snatching
good large borrowal accounts by one bank from other by offering
unwanted counter offers with respect to interest and service
charges. 5. All banks lend on same terms and conditions regarding
the security, rate on interest, margin, etc. i.ee no one has
superior rights or more favorable propositions.To borrower: 1. A
borrower availing credit from a consortium does not suffer from
scarcity of credit due to credit squeeze of its sole banker. 2.
Internal competition among the participating banks to have larger
share in the consortia enables a borrower having good fundamentals
to enjoy lower interest and service charges 3. Borrower enjoys same
interest and service charges from all the banks normally set at a
level below prevailing rates.Demerits: To Bank 1. Bank is under an
obligation to share information with other lending institutions. 2.
Bank does not have superior rights in case of a default. 3. Bank
has to fall in line w.r.t. terms and conditions set out by the lead
bank although adequate propositions are made for its reservations.
39 | P a g e
40. 4. Bank cannot move out of consortia within first 2 years
without approval of other members of the consortia and existing/new
member is willing to take its share. 5. In case of a dispute Lead
Bank or the bank having 2nd highest share in the consortium will be
the final authorities in cases of differences of opinion and their
views will prevail in all cases of disputes among the members
relating to terms and conditions.To Borrower 1. Borrower cannot
negotiate terms and conditions with individual banks depending upon
the size of business it is providing to them. 2. All members of the
consortium have superior rights than other lenders which affects it
borrowing capacity in the open market.Multiple BankingWhere the
credit requirements of a borrower are met by more than one bank and
each bank lendsindependently on its own terms and conditions,
regarding the security, rate of interest, margin etc.,this system
of financing is called Multiple Banking Arrangements.Advantages: To
bank: 1. Bank lends under its own terms and conditions regarding
the security, rate of interest, margin, etc. and may ask for
superior rights. 2. The bank is independent of other lending
institution. 3. The bank is under no obligation to share
proprietary data with other lending institution.To Borrower 1.
Borrower can decide the level of business it wants to give to a
particular bank depending upon the services provided. 2. Borrower
has the possibility of getting surplus credit facility from the
banks collectively. 3. Borrower can negotiate for terms and
condition.Demerits: To Bank 1. There is a possibility of over
financing to the borrower. 2. More vigilant and robust monitoring
mechanism has to be