Principles of Lending, Working Capital Assessment and Credit Monitoring

Principles of Lending, Working Capital Assessment and Credit Monitoring: Jaiib Paper 1 (Module B) Unit- 9

Dear bankers,

As we all know that  is Principles of Lending, Working Capital Assessment and Credit Monitoring for JAIIB Exam. JAIIB exam conducted twice in a year. So, here we are providing the Principles of Lending, Working Capital Assessment and Credit Monitoring (Unit-9), FUNCTIONS OF BANKS (Module B), Principle & Practice of Banking JAIIB Paper-1.

 

♦Principles of Lending

The Business of lending is not without certain risks, especially when the lending banks depend largely on the on the borrowed funds. The cardinal principles of lending are, therefore, as follows:

  • Safety
  • Liquidity
  • Diversity
  • Purpose
  • Stability
  • Profitability

Liquidity: Liquidity is an important principle of bank lending. Bank lend for short periods only because they lend public money which can be withdrawn at any time by depositors. They, therefore, advance loans on the security of such assets which are easily marketable and convertible into cash at a short notice.

Safety: The safety of funds lent is another principle of lending. Safety means that the borrower should be able to repay the loan and interest in time at regular intervals without default. The repayment of the loan depends upon the nature of security, the character of the borrower, his capacity to repay and his financial standing.

Diversity: In choosing its investment portfolio, a commercial bank should follow the principle of diversity. It should not invest its surplus funds in a particular type of security but in different types of securities. It should choose the shares and debentures of different types of industries situated in different regions of the country. The same principle should be followed in the case of state governments and local bodies. Diversification aims at minimising risk of the investment portfolio of a bank.

Purpose: Loans for undersirable and speculative purposes cannot be granted. Although the earnings on such business activities may be higher, ever then a bank cannot resort to these loans.

Stability: Another important principle of a bank’s investment policy should be to invest in those stocks and securities which possess a high degree of stability in their prices. The bank cannot afford any loss on the value of its securities. It should, therefore, invest it funds in the shares of reputed companies where the possibility of decline in their prices is remote.

Profitability: This is the cardinal principle for making investment by a bank. It must earn sufficient profits. It should, therefore, invest in such securities which was sure a fair and stable return on the funds invested. The earning capacity of securities and shares depends upon the interest rate and the dividend rate and the tax benefits they carry.

♦Non- Fund Based Limits

While ascertaining the credit needs of the borrowers, the bankers should assess both the fund based and non fund based limits required by him together and sanction them as a package. The Non-fund based limits are normally of two types:

  • Bank Guarantees
  • Letters of Credit

Bank Guarantees: A bank guarantee refers to a promise provided by a bank or any other financial institution that if a certain borrower fails to pay a loan, then the bank or the financial institution will take care of the losses. The bank will assure the original creditor through this bank guarantee that if the borrower does not meet his or her liabilities, then the bank will take care of them.

While issuing the bank guarantee, the banker has to keep in mind the instructions of RBI with regard to certain purposes that prohibit the issue of bank guarantee and also the extended liability period that has been occasioned consequent to amendment of Section 128 of Indian Contract act with respect of Guarantees issue in favour of the government departments.

A bank guarantee is a contract between 3 different parties and they include:

  • The applicant (the party that requests a bank guarantee from the bank and borrows from a creditor)
  • The beneficiary (the party that receives a partial guarantee)
  • The bank (the party that agrees to sign and assures payment in case the applicant fails to repay the loan)

Letter of Credit (L/C): A letter of credit is a document that guarantees the buyer’s payment to the sellers. It is Issued by a bank and ensures the timely and full payment to the seller. If the buyer is unable to make such a payment, the bank covers the full or the remaining amount on behalf of the buyer.

While sanctioning the letter of credit limits for the purchase of raw materials, the banker has to collect the following particulars:

  • Value of raw materials consumed in the ensuring year as projected
  • Value of raw materials that are purchased on credit out of the above
  • Time taken for advising the letter of credit to the beneficiary
  • Time for shipment and the consignment to reach the customer’s destination
  • Credit period (usance period) agreed between the beneficiary and the customer
  • Credit period projected and reckoned for calculation of the maximum permissible bank finance (MPBF) while sanctioning the funded limits to the borrower customer

Example:

  • Value of raw material consumption projected: Rs 3600 lakhs
  • Value of raw material (to be) bought on credit: Rs 2400 lakhs
  • Time for advising L/C: 10 days
  • Shipment time: 20 days
  • Credit period agreed upon between the seller and the customer OR the credit period projected as available in CMA format considered for calculation of MPBF while sanctioning funded limits, whichever is less: 30 days
  • Time required for one cycle of operation of L/C will be 10+20+30= 60 days
  • Assuming 360 days in a year, there could be 6 rotations/ cycles in a year. If the raw material consumed, to be bought on credit is Rs 2400 lakh in a year, the limit of L/C per rotation/cycle will work out to.
  • 2400lakhs/6=400 lakh

♦Term Loan and Working Capital Loan

Term Loan: A term loan is a loan that is repaid in regular intervals over a pre-agreed period of time. The time period of a term loan can last between one to ten years; however certain term loans may last as long as 30 years. Term loans are divided into two main categories.

  • Fixed Rate Term Loan: A fixed interest rate loan is a loan where the interest rate does not vary during the term of the loan.
  • Floating Rate Term Loan: In a floating interest rate loan, interest rate fluctuates during the term of the loan.

Working Capital Loan: A working capital loan is a short term loan with the aim of financing the day to day business operations of a company. Working capital loans are not used to inject capital into the business or to purchase long-term assets or investments.  Instead, it is used for aspects such as to settle accounts payables, pay monthly interest or with regard to any aspect that is involved with current assets and current liabilities.

Working Capital Requirement = Inventory+ Accounts Receivables – Accounts payable

Difference between Term Loan and Working Capital Loan

Term Loan Working Capital Loan
Term loan is a form of borrowing where the payments can be made over a predetermined period of time in regular intervals. Working capital loan is a loan taken out to finance routine business operations to minimize shortfalls in working capital.
Term loans may be short, medium or long term. Working capital loans are short term loans. (Quarterly and Half Yearly)
Repayment of a term loan is done by many installments. Repayment of a working capital loan is done by a limited number of installments.
The amount of the loan is based on the cost of running the business, since such loans are customized in accordance with the regular expenses incurred to run a business. Covers high-cost investments like business expansion, purchase of expensive plant and machinery, etc.

♦Estimation of working Capital Needs

The Conditions of commercial banks for lending on a short term basis are rigorous. A customer has to satisfy his bank about his character, capacity, capital and collateral, in brief he has to establish his creditworthiness. If the overall appraisal is satisfactory, the bank will finance only the residual gap in the customers resources, after taking into consideration the expected availability from all other sources of funds.

There are four methods of estimating the working capital requirement of a borrower:

  • The Operating cycle method
  • The Projected net working capital method
  • The Projected turnover method
  • The cash budget

There methods required the preparation of:

  • Projected financial statements
  • Projected fund flow statements
  • Projected cash flow statements/cash budgets

♦Operating cycle method

Operating cycle method for estimating working capital is based on the duration of the operating cycle. Longer the period of the cycle, bigger will be the working capital requirements. Operating cycle means the cycle of raw material to work in progress to finished goods to accounts payable and finally to cash. Operating cycle time is the time taken starting from raw material purchases to its conversion into cash.

In order to provide a relief to borrowers who face such a situation, the banks as part of their loan policy, decided as follows:

  • While assessing working capital requirement, creditors will not be set off against stock.
  • The borrowers will submit detail age-wise list of sundry creditors and sundry debtors as well as the stock statement.
  • Only those debtors will be considered who are outstanding for less than the period specified (up to 180 days maximum) from a case to case basis.
  • The borrower will have to hypothecate his entire book debts to the bank
  • The bank will not finance the borrower’s book debts if creditors exceed debtors.

Example of Operating cycle:

  • Procurement of raw material: 30 days
  • Conversion/process time: 15 days
  • Average time of holding of finished goods: 15 days
  • Average collection period: 30days
  • Total operating cycle: 90days
  • Operating cycle in a year: 4
  • Total operating expenses per annum: 60 lakhs
  • Total turnover per annum: 70 lakhs
  • Working capital requirement: 16/4=15lakhs

♦The Projected net working capital method

The Margin requirements have to be met by the borrower fro, the accruals during the course of the year and other long term funds, in the form of net working capital. The projected net working capital, of higher than the current level maintained by the borrower, would be built up progressively with the growth in production, sales and profits.

♦Projected Turnover method

  • Banks, as a matter of policy and based in RBI guidelines, assess the working capital requirements including those of village industries, tiny industries (SSI units and traders) with a fund based working capital limit of up to Rs 5cr. by the turnover method.
  • Turnover Method is used to assess the working capital requirement of any borrower based on the turnover of the business. This method was originally suggested by the P.J. Nayak Committee for the Small Scale Industries in India in need of working capital from banks.

RBI has given following instructions:

  • 20% of their projected annual gross sales turnover may be considered as minimum working capital finance by banks.
  • In order to ensure that a minimum margin supports the working capital needs of a borrower, a 5% contribution is given promoters.
  • Guideline for the turnover method is framed, assuming an average operating cycle of 3 months. If the cycle is more than 3 months, the borrower should bring in a proportionately higher stake in relation to his requirement of the bank finance.
  • Drawing power is calculated through stock statement. Unpaid stacks are not to be financed, as it would result in double financing.

Example of calculating working capital requirement under projected annual turnover method:

  • Projected sales: Rs.1000000
  • Working capital requirements: 25% of projected sales= Rs250000
  • Margin (Contribution of Owner): 5% of projected sales =Rs 50000
  • Working capital to be funded by bank: Rs200000

♦Cash Budget System

The current loan policies of most banks state that, for an assessment of the working capital needs of a borrower who enjoys or requires fund based limits in excess of Rs 10crs. The cash budget system should be used.

Cash budget has to have the following steps in sequence when prepared for a quarter.

  • Actual receipts and payments during the first, the second and the third month.
  • The Position of the cash surplus/deficit is computed at monthly intervals. A surplus is generated of the receipts exceed the payment and a cash deficit occurs if payments are more than the receipts during the month.
  • The opening cash balance for the first month is adjusted against the cash surplus/ deficit that is generated during the month. The adjusted figure is the closing balance at the end of the first month, which becomes the opening balance for the next month viz… the second month.
  • A cash surplus generated during a month results in a higher closing cash balance via- to vis opening balance of the month, Conversely, a cash deficit during the month would cause a lower level of the closing cash balance as compared to the opening balance.
  • If the enterprise has a net position on borrowed funds (The company maintain cash credit/ overdraft account), a cash surplus generated during a month brings down the level of the borrowed funds at the end of the month.

♦Base Rate system

The concept of base rate was introduced on July 1, 2010, at all banks across India. Before the base rate system, BPLR (Benchmark Prime Lending Rate), (Chairman: Shri Deepak Mohanty) was employed. However, with the implementation of base rate system, the credit pricing became more transparent. Here is an article that explains in-depth about the base rate and other related information, which you might require for assistance to comprehend better.

The base rate is the minimum rate of interest that is set by a country’s central bank for lending a loan. This rate is usually taken as the standard interest rate by all the banks functioning in that country. Once the base rate is announced by the central bank, no bank is permitted to offer any type of loan to its customers at a rate that is lower than the base rate that has been set by the central bank of a nation.

As per RBI guidelines (as in July 2012), the following categories of loans could be priced without reference to Base Rate :-

  • DRI Advances;
  • Loans to banks’ own employees including retired employees;
  • Loans to banks’ depositors against their own deposits

Difference between Benchmark Prime Lending Rate (BPLR) and Base Rate

  • Benchmark Prime Lending Rate (BPLR) is the rate at which commercial banks charge their customers who are most credit worthy. According to the Reserve Bank of India (RBI), banks can fix the BPLR with the approval of their Boards. However, the RBI stipulates the interest rates as BPLR is influenced by the Repo rate and Cash Reserve Ratio (CRR) apart from individual bank’s policy.
  • However, the BPLR system failed to bring transparency in the lending rates of the banks. The calculations of BPLR is not that transparent and sometimes the banks under this system could lend to customers below the BPLR. So, Base Rate was introduced subsequently.
  • Base rate is the minimum interest rate of a bank, below which it cannot lend, except for DRI allowances, loans to bank’s own employees and loans to bank’s depositors against their own deposits. The base rate system has replaced the BPLR from July 1, 2010. Since then the BPLR is gradually losing its importance except for the loans taken before July 1, 2010. In such cases, RBI has allowed to continue with BPLR at which the loans were approved. They were, however, given the option of switching to the base rate before the expiry of their loans. RBI does not fix the base rate. Individual banks fix their own base rates and so each bank has its own base rate.

Who Calculates The Base Rate In India?

  • The RBI (Reserve Bank of India) calculates the base rate in India. The RBI sets this to bring uniform rates to all banks in India.
  • A base rate comprises of all the elements of lending rates, which are common among the borrowers of various categories.
  • Note: Lending rate is the rate of interest that a bank lends to its customers. A lending rate includes the operating cost of a product, tenor premium, credit risk premium, and the borrower-specific cost. Therefore, it differs from one segment to the other.

How Is Base Rate Calculated?

The calculation of base rate is based on different factors. A few of them are:

  • Deposit cost
  • Administrative cost
  • Unallocated overhead cost
  • The amount of profit a bank earns in the last financial year

Applicability Of The Base Rate

  • Every loan category should be priced based on the base rate that has been set by the Reserve Bank of India. But a few loans can be priced without referring to the current base rate. These include the DRI advances, loans to a bank’s depositor on their deposits, and loans to a bank’s employees.
  • The base rate set by the central bank or the RBI also serves as a reference benchmark for the floating rate of a loan.
  • Any modifications in the base rate are applicable to all the existing loans that are associated with the current base rate.
  • The base rate set by the central bank is always minimum. Therefore, no bank is allowed to give a rate below than what is set to its customers.

It is mandatory for every bank to review its base rate on a quarterly basis. This action has to be taken only after the ALCOs (Asset Liability Management Committees) or the board approves it. Since the primary intention of implementing the base rate system is to sustain transparency in the prices of a lending product, every bank has to reveal its base rate details at all the branches and their official websites too.

Any modifications in the base rate have to be conveyed to the public frequently via appropriate channels. In addition, it is compulsory for all the banks to give proper details to the RBI regarding the minimum & maximum lending rates on a quarterly basis.

♦Credit Management

Credit management is the process of granting credit, setting the terms it’s granted on, recovering this credit when it’s due, and ensuring compliance with company credit policy, among other credit related functions. The goal within a bank or company in controlling credit is to improve revenues and profit by facilitating sales and reducing financial risks.

A credit manager is a person employed by an organization to manage the credit department and make decisions concerning credit limits, acceptable levels of risk, terms of payment and enforcement actions with their customers. This function is often combined with Accounts Receivable and Collections into one department of a company. The role of credit manager is variable in its scope and Credit managers are responsible for:

  • Controlling bad debt exposure and expenses, through the direct management of credit terms on the company’s ledgers.
  • Maintaining strong cash flows through efficient collections. The efficiency of cash flow is measured using various methods, most common of which is Days Sales Outstanding (DSO).
  • Ensuring an adequate Allowance for Doubtful Accounts is kept by the company.
  • Monitoring the Accounts Receivable portfolio for trends and warning signs.
  • Hiring and firing of credit analysts, accounts receivable and collections personnel.
  • Enforcing the “stop list” of supply of goods and services to customers.
  • Removing bad debts from the ledger (Bad Debt Write-Offs).
  • Setting credit limits.
  • Setting credit terms beyond those within credit analysts’ authority.
  • Setting credit rating criteria.
  • Setting and ensuring compliance with a corporate credit policy.
  • Pursuing legal remedies for non-payers.
  • Obtaining security interests where necessary. Common examples of this could be PPSA’s, letters of credit or personal guarantees.
  • Initiating legal or other recovery actions against customers who are delinquent.

♦Credit Monitoring

Credit Monitoring is the tacking of an individual’s credit history, for any changes or suspicious activities. A credit monitoring service is will show an individual’s credit report provide them with new information regarding new credit inquiries, accounts etc. The individual also can ensure if this information is actually genuine. Credit Monitoring can also be used by individuals to keep a check on their credit score, as well as keep track of them, giving them the option to be well of their credit history before applying for loans and mortgages. The process of monitoring takes many steps to ensure negligent loans in parameters of the credit policy followed when it comes to delinquency. The credit management section will ensure the collection of the loans.

Step Involved Credit Monitoring

  • Identify the potential NPAs when the loan default is for two months.
  • Study the causes- whether default is due to inherent weaknesses or due to temporary liquidity or cash flow problem.
  • Offer contingency help immediately in the form of ad-hoc limits if cash flow mismatches are genuine.
  • If limit are found to be inadequate lending to loan default during the year, ask the borrower to submit the renewal proposal and enhance suitably.
  • Visit the factory immediately, if the stock statement is not submitted and verify the securities.
  • Keep the documents live, scrutinize them periodically.
  • Implement the report of the concurrent auditor, statutory auditor, branch inspector, credit audit, regional manager’s report etc.

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