CAIIB Paper 1 Module C ABM Credit Management PDF by Ambitious Baba
CAIIB Paper 1 Module C ABM Credit Management PDF by Ambitious Baba
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Credit
Credit is the trust which allows one party to provide money or resources to another
party wherein the second party does not reimburse the first party immediately, but
promises either to repay or return those resources at a later date.
Principles of Credit
Over a period of time, bankers have evolved certain basic principles for their lending
operations. Bank's loan policies, and other aspects of credit management, are influenced
to a great extent by these unwritten principles, which are as under:
• Safety of funds
• Purpose
• Profitability
• liquidity
• Security
• Risk spread
Types of Borrowers
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• Fund Based: In fund-based credit, there is actual transfer of money from the
bank to the borrower.
• Non-Fund Based: In non fund based credit, there is no transfer of money, but the
commitment by the bank on behalf of the client, may result in future transfer of
money to the beneficiary of such a commitment. Example of this is a bank
guarantee issued in favour of government departments (or any other
beneficiary) on behalf of a contractor, who is bank's customer.
• Credit can also be classified based on purpose, like working capital finance,
project finance, export finance, crop loan, etc. Banks often classify their credit
portfolio based on the type of the customers like, Corporate, retail, agriculture,
international, institutional credit, etc.
The laws applicable to all these different kinds of borrowers are different.
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The targets and sub-targets set under priority sector lending for domestic and foreign
banks operating in India are furnished here: (Figures are given as per cent of Adjusted
Net Bank Credit (ANBC) or credit equivalent amount of Off-Balance Sheet Exposure,
whichever is higher)
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Domestic
commercial banks
(excl. RRBs & Foreign banks
Regional Rural
Categories SFBs) & foreign with less than 20 Small Finance Banks
Banks
banks with 20 branches
branches and
above
Total Priority 40 per cent of ANBC 40 per cent of 75 per cent of ANBC 75 per cent of ANBC as
Sector as computed in para ANBC as computed as computed in para computed in para 6
6 below or CEOBE in para 6 below or 6 below or CEOBE below or CEOBE
whichever is higher CEOBE whichever whichever is higher; whichever is higher.
is higher; out of However, lending to
which up to 32% Medium Enterprises,
can be in the form Social Infrastructure
of lending to and Renewable
Exports and not Energy shall be
less than 8% can be reckoned for priority
to any other priority sector achievement
sector only up to 15 per
cent of ANBC.
Agriculture 18 per cent of ANBC Not applicable 18 per cent ANBC or 18 per cent of ANBC or
or CEOBE, CEOBE, whichever CEOBE, whichever is
whichever is higher; is higher; out of higher; out of which a
out of which a target which a target of 10 target of 10 percent# is
of 10 percent# is percent# is prescribed for SMFs
prescribed for Small prescribed for SMFs
and Marginal
Farmers (SMFs)
Micro 7.5 per cent of ANBC Not applicable 7.5 per cent of ANBC 7.5 per cent of ANBC or
Enterprises or CEOBE, or CEOBE, CEOBE, whichever is
whichever is higher whichever is higher higher
Advances to 12 percent# of ANBC Not applicable 15 per cent of ANBC 12 percent# of ANBC or
Weaker or CEOBE, or CEOBE, CEOBE, whichever is
Sections whichever is higher whichever is higher higher
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Banks should comply with the following common guidelines for all categories of
advances under the priority sector.
• Rate of interest: The rates of interest on bank loans will be as per directives
issued by Department of Regulation (DoR), RBI from time to time.
• Service charges: No loan related and ad hoc service charges/inspection charges
should be levied on priority sector loans up to ₹25,000. In the case of eligible
priority sector loans to SHGs/ JLGs, this limit will be applicable per member and
not to the group as a whole.
• Receipt Sanction/Rejection/Disbursement Register: A register/ electronic
record should be maintained by the bank wherein the date of receipt,
sanction/rejection/disbursement with reasons thereof, etc. should be recorded.
The register/electronic record should be made available to all inspecting
agencies.
• Issue of acknowledgement of loan applications: Banks should provide
acknowledgement for loan applications received under priority sector loans.
Bank Boards should prescribe a time limit within which the bank communicates
its decision in writing to the applicants.
The following credit restrictions have been placed on the banks:
(Details as per RBI circular No. Dir. BC. 13113.03.00/2009-10 dated 1, July 2009)
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• Advances against Bank's own shares: In terms of Section 20(1) of the Banking
Regulation Act, 1949, a bank cannot grant any loans and advances on the security
of its own shares.
• Restrictions on granting loans and advances to relatives of Directors
• Restrictions on Grant of Loans & Advances to Officers and Relatives of Senior
Officers of Banks
Asset Classification
In terms of Reserve Bank of India guidelines, all advances are required to be reviewed
and classified into two principal categories at regular intervals as follows:
(a) Performing Assets or Standard Assets, i.e., where the advances are earning
interest income on an actual realisation basis. This includes regular and temporarily
irregular accounts, as specified from time to time by the RBI.
(b) Non-Performing Assets (NPA), i.e., where advances are not earning interest on an
actual realisation basis. An asset, including a leased asset, is considered as non-
performing when it ceases to generate income for the bank. This includes irregular
accounts and sticky accounts with deep-seated irregularities. A loan or an advance
accounts will be considered as NPA where:
• Interest and/or installment of principal remain overdue for a period of more
than 90 days in respect of a term loan.
• The account remains ‘out of order’ in respect of an Overdraft/Cash Credit
(OD/CC).
• The bill remains overdue for a period of more than 90 days in the case of bills
purchased and discounted,
• The installment of principal or interest thereon remains overdue for two crop
seasons for short duration crops in respect of agriculture loan and advances,
• The installment of principal or interest thereon remains overdue for one crop
season for long duration crops in respect of agriculture loan and advances,
• In respect of derivative transactions, the overdue receivables representing
positive mark-to market value of a derivative contract, if these remain unpaid
for a period of 90 days from the specified due date for payment.
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• In case of interest payments, banks should, classify an account as NPA only if the
interest due and charged during any quarter is not serviced fully within 90 days
from the end of the quarter.
Categories of NPAs
Banks are required to classify non performing assets further into the following three
categories based on the period for which the asset has remained non performing and
the reliability of the dues:
• Substandard Assets: A substandard asset would be one, which has remained
NPA for a period less than or equal to 12 months. Such an asset will have well
defined credit weaknesses that jeopardise the liquidation of the debt and are
characterised by the distinct possibility that the banks will sustain some loss, if
deficiencies are not corrected.
• Doubtful Assets: An asset would be classified as doubtful if it has remained in
the substandard category for a period of 12 months. A loan classified as
doubtful has all the weaknesses inherent in assets that were classified as sub-
standard, with the added characteristic that the weaknesses make collection or
liquidation in full, on the basis of currently known facts, conditions and values,
highly questionable and improbable. When the realizable value of the security is
less than 50 per cent of the value assessed by the bank or accepted by RBI at the
time of last inspection, as the case may be, such NPAs may be straightaway
classified under doubtful category.
• Loss Assets: A loss asset is one where loss has been identified by the bank or
internal or external auditors or the RBI inspection, but the amount has not been
written off wholly. In other words, such an asset is considered uncollectible and
of such little value that its continuance as a bankable asset is not warranted
although there may be some salvage or recovery value. If the realizable value of
the security, as assessed by the bank/approved valuers/RBI is less than 10 per
cent of the outstanding in the borrowal accounts, the existence of security
should be ignored and the asset should be straightaway classified as loss asset.
Provisioning Norms
The Banks are required to make certain amount of provision on standard assets on fund
based outstanding as follows:
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In order to enhance the effectiveness of the Credit Guarantee Scheme for Financial
inclusion programme and create greater support to underserved/weaker segments, the
extent of guarantee cover for credit facility has been increased to 85% for ZED certified
MSEs, units under Aspirational District, Women & SC/ST Entrepreneur.
The trust shall provide guarantee coverage as under:
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There are basically two financial statements which every business enterprise is
required to prepare. These are:
• Balance sheet
• Profit & Loss account (Income & Expenditure statement in case of non-profit
organizations)
Apart from these, the auditors' report, explanatory schedules and notes on
accounts, if applicable, provide useful information to the bankers.
A funds flow statement also provides useful information but, this is only a mathematical
analysis of changes in the structure of two consecutive balance sheets and can be easily
prepared by the banker/ analyst himself if the basic statements, i.e. the balance sheets,
are available. Accounting Standard-3 makes it mandatory for some enterprises to
prepare Cash Flow statement for the accounting period (these enterprises are those
whose equity or debt is listed or is in the process of being listed on a recognized stock
exchange and also all other commercial, industrial and business enterprises whose
turnover for the accounting period exceeds Rs.50 crore. These enterprises are also
required to do segment-wise reporting as per A S -1 7.
Users of Financial Statements
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• General public
• Analysts
• Entity Concept
• Money Measurement Concept
• Stable Monetary Unit Concept
• Going Concern Concept
• Cost Concept
• Conservatism Concept
• Dual Aspect Concept
• Accounting Period Concept
• Accrual Concept
• Realization Concept
• Matching Concept
The format of balance sheet can be either Vertical or Horizontal as illustrated below
(activities like banking, insurance, electricity generation etc, which are governed by
acts other than Companies Act, need not follow these formats)
Horizontal Form: Horizontal form is maintained in two columns. The first column
shows the Liabilities and the second one shows the Assets.
The items shown in the first column against Liabilities are:
• Fixed assets
• Investments
• Current assets
• Loans and advances
• Miscellaneous expenditure
Vertical Form: In the Vertical Form, the different items are shown one below the other.
(A)Sources of funds
1. Shareholders’ funds
(a)Share capital
(b)Reserves and surplus
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2. Loan funds
(a)Secured loans
(b)Unsecured loans
(B)Application of funds
1.Fixed assets
2.Investments
3.Current assets, loans and advances
Less: Current liabilities and provisions Net current assets
4.Miscellaneous expenditures
Shareholder’s funds
• Share capital
• Reserve and Surplus
• Money received against share warrants
• Long-term borrowings
• Deferred tax liabilities (Net)
• Other long term liabilities
• Long term provisions
Current liabilities
• Short-term borrowings
• Trade payables
• Other current liabilities
• Short-term provisions
Total-
II. Assets
Non-current assets
• Fixed assets
(i)Tangible assets
(ii)Intangible assets
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(iii)Capital work-in-progress
(iv)Intangible assets under development
• Non-current investments
• Deferred tax assets (net)
• Long-term loans and advances
• Other non-current assets
Current Assets
• Current investments
• Inventories
• Trade receivables
• Cash and cash equivalents
• Short-term loans and advances
• Other current assets
Total-
Accounting
As per Income Tax rules, April to March is considered as the financial year for tax
purposes. However, as per Companies Act, this can be different. Only restriction, as per
Companies Act, is that the maximum duration of the financial year can be 15 months,
and can be extended up to 18 months with the permission of Registrar of Companies
(ROC).
Profit And Loss Account
It is a statement of income and expenditure of an entity for the accounting period. Every
P and L account must indicate the accounting period for which it is prepared The items
of a P & L account are:
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context that a need has been felt to reiterate the insights which can be derived
from proper analysis of Cash Flow Statement (CFS) in understanding the
financial capability of an enterprise.
• It states the movement of cash and cash equivalents, into or out of, a business
during a given period of time. It narrates the travelogue of opening cash balance
at the beginning of the period in its journey to reach the closing cash balance at
the end. Cash comprises cash on hand and demand deposits with the Banks,
while cash equivalents are short-term and highly liquid instruments readily
convertible into cash at any time, without any significant erosion in value.
• CFS speaks about the alignment between profitability and net cash flow.
• CFS speaks about the deepness of the pocket the business has.
• CFS speaks about the accuracy of past assessment of future cash flows in terms
of the amount, timing and certainty of future cash flows and, thereby, provides
insights into operational efficiency of the business during given period against
the corresponding past period;
• CFS speaks about the acceptability of income accounted as per accrual concept.
• CFS speaks about the ability of the business to meet in time a specific and sure
cash out flows like repayment of an ad-hoc loan or retirement of a usance LC, etc.
• Each item in the balance sheet represents either source of funds or use of funds.
All items on the liabilities side represent the funds provided to the enterprise
and all items on the assets side (except cash) represent use of these funds.
• Cash in the balance sheet represents the unutilised portion of funds, available to
the enterprise. If cash is also perceived as a use of funds then all the uses of funds
are equal to all the sources of funds.
• This perception of available cash, as a use of funds, is what causes the wide
spread confusion about difference in a Funds flow statement and a Cash flow
statement. When we compare two balance sheets of different dates, change in
each item (or introduction of a new item) in the balance sheet of later date, as
compared to that item in the balance sheet of earlier date, will represent either
addition of funds or additional use of funds in the intervening period.
• Any increase in any item on the liabilities side means additional funds available.
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• Actual financial statements are for the past period and analysis of these gives
very useful financial information to the banker. But for assessing the need for
bank credit and to examine the viability of the activity, it is necessary to
anticipate the financial position of the enterprise in future.
• For example, for assessing the working capital needs, the statement of assets and
liabilities of the last year will not be adequate. We will have to anticipate the
level of operations during the current year and accordingly project the level of
assets and liabilities to arrive at the need for bank’s loan.
• Of course, the financial statements for the past period serve as the most
important guide for this estimate. Also, in case of a new enterprise, where no
financial statements are available, it becomes necessary to decide on a level of
activity and accordingly prepare the projected financial statements.
• Generally, in case of smaller enterprises, where adequate financial expertise may
not be available, the projected financial statements for the next year are
prepared by the bank by interviewing the concerned person.
• In case of term loans for new projects/ expansion, the projected financial
statements are normally prepared for the entire duration of bank loan to
establish the viability of operations as also to determine the disbursal and
repayment schedule.
• Whenever the projected financial statements are submitted by the borrower,
these are critically examined for their reasonability and if projections are
considered to be unreasonable, the matter is discussed with the borrower and
suitable consensus arrived at.
In keeping with the above objectives, a banker rearranges the figures in the financial
statements under distinct groups for a meaningful analysis.
Balance Sheet
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P&L Account
The format prescribed under erstwhile Credit Monitoring Arrangement (CMA), under
which banks used to report sanction of large credit proposals to RBI, still serves as a
useful guide for rearranging the items in P&L account. The important groups of items
are as follows:
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While rearranging the financial statements, the following points should be examined by
the banker and suitable changes made in different items:
• Funds Flow statement is not part of Financial Statements nor a return certified
by auditor. It is a requirement of the lenders to trace diversions, if any. However,
while submitting the estimates for current year and projections for next year,
most companies use the model of CMA format, which contains Funds Flow
statement also.
• If the borrower has not submitted the funds flow statement, bank prepares the
same from the last two balance sheets. The total sources of funds are categorised
as ‘Long term’ and ‘Short term’. Similarly, the total uses are also categorised as
‘Long term’ and ‘Short term’. If the short-term sources are more than the short-
term uses, (correspondingly long-term uses are more than long-term sources), it
indicates diversion of working capital funds and needs to be probed further.
Trend Analysis
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balance sheet items, arranged in vertical order give the trends of increase or
decrease of various items.
• Common Size Statements are prepared to express the relationship of various
items to one item in percentage terms. For example, consumption of raw
materials is expressed as a percentage of sales for different years and
comparison of these figures gives indication of trend of operating efficiency.
Ratio Analysis
• This is the most favourite method of bankers for analysis of financial statements.
A ratio is comparison of two figures and can be expressed as a percentage (e.g.,
profitability is 23.7 per cent), as a number (e.g., current ratio is 1.33) or simply as
a proportion (e.g., debt equity is 1:2).
• Both the figures, used in calculation of a ratio, can be from either P&L account, or
balance sheet or one can be from P&L account and the other from balance sheet.
Ratios help in comparison of the financial performance and financial position of
an entity with other entities, as also for comparison with its own status over the
years. While different users of financial statements are interested in different
ratios, the ratios which interest a banker most, are the following:
Liquidity Ratios
• Current Ratio is the indicator of liquidity, that is the ability to meet commitments
in time. It is expressed as simple ratio by dividing Total Current Assets by Total
Current Liabilities and is benchmarked normally to 1.33: 1, where the 0.33 over
1 is the surplus of Long Term Sources over Long Term Uses, technically called
the Net Working Capital [NWC]
• NWC Ratio gives the long term support available to build-up on current assets,
indicating margin available over CL to finance current assets. Expressed in per
cent, the formula is NWC/TCA × 100.
Profitability Ratios
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Coverage Ratios
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Whenever a business enterprise is started, some fixed assets like office, furniture,
machines/computers etc, depending upon the need, are acquired. But this alone may
not be sufficient for running the business of that enterprise, except for a few
activities like broking/commission agent, etc. Most of the business enterprises, in the
course of their business, have to carry some current assets like raw materials, finished
goods, receivables etc. The money blocked in these current assets is called working
capital.
Working Capital Cycle
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• For a banker, providing working capital finance, the liquidity ratios, specially
the current ratio, play a very important role in assessment, sanctioning decision,
and monitoring.
• The assessment involves stipulation of a minimum Net Working Capital (N W C)
to be brought in by the enterprise from its long term sources. This results in a
minimum current ratio (more than one) which the bank wants the enterprise to
maintain at all the times. This is, normally, mentioned in the terms and
conditions of sanction and becomes an important tool for the bank to monitor
the use of funds by the enterprise.
Deciding on the level of Turnover of the Enterprise: This is a very important step in
any method of assessment of working capital limits. In case of existing enterprises, the
past performance is used as a guide to make an assessment of this. In case of new
enterprises, this is based on the production capacity, proposed market share, availability
of raw materials, industry norm etc.
Assessment of Gross or Total Working Capital: This is the sum total of the
assessment of various components of the working capital.
• Inventory
• Receivables and Bills
• Other Current Assets
Sources for Meeting Working Capital Requirement:
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• Own Sources (N W C)
• Suppliers’ Credit
• Other Current Liabilities like salaries payable, advances from customers, etc.
• Bank Finance
Calculation of Bank Finance
Though banks are now free to formulate their own policies, the methods of
lending, mentioned there, still find place in the calculations followed by the banks. The
methods are;
• First Method of Lending: Under this, the enterprise was required to bring in at
least 25 per cent of the working capital gap (total current assets minus total
current liabilities excluding bank finance).
• Second Method of Lending: Under this, the enterprise was required to bring in
at least 25 per cent of the total current assets.
• Third Method of Lending: Under this, the enterprise was required to bring in
100 per cent of those current assets which are considered 'core assets' and at
least 25 per cent of the remaining current assets.
Cash Budget Method of Assessment
Any economic activity, however small it may be, involves outflows ( expenditure)
of money for procurement of inputs and inflows of money (income) from the sale
of output The nature, amount and periodicity of outflows and inflows is peculiar to the
type of activity, level of operations, market conditions and the policies adopted by the
owners/managers etc.
A normal statement / budget, will look as under:
Inflows
1. Opening balance
2. Term loan from Bank
3. Sales (Total sales-credit sales + realization for ealier sales)
4. Other cash inflows
Total inflows
Outflows
1. Capital expenditure
2. R. M. Purchase
3. Labor
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Receivables are part of the current assets of a business enterprise. These arise due
to sales on credit basis to the customers. The bank provides finance against these in a
fashion similar to that for inventory.
Another method of sales is through Bills of exchange drawn by the seller on the
purchaser in the following manner;
• If no credit is to be provided to the customer, a demand bill is drawn.
• If the credit is to be provided on the sales, a bill of exchange, called usance bill,
mentioning the period of payment, is drawn on the purchaser and is accepted by
him The outstanding amount is shown in the accounts as 'bills receivables'.
The terms used in bills finance are purchase, discount and negotiation. Normally,
'purchase' is used in case of demand bills, 'discount' in case of usance bills and
'negotiation' in case of bills which are drawn under letters of credit opened by the
purchaser's bank.
• Guarantees
• Co-acceptance of Bills
• Letters of Credit
• Commercial Paper (CP)
• Unsecured money market instrument
• Issued in the form of a promissory note
• Introduced in India in
• Cost of borrowing through CP is normally lower compared to other sources of
short term finances
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• Banks may sanction working capital limits, as also bills limit, to borrowers after
proper appraisal of their credit needs and in accordance with the loan policy as
approved by their Board of Directors.
• Banks should open letters of credit (L Cs) and purchase / discount / negotiate
bills under L Cs only in respect of genuine commercial and trade transactions of
their borrower constituents who have been sanctioned regular credit facilities by
the banks.
• If a beneficiary of the LC wants to discount the bills with the LC issuing bank
itself, banks may discount bills drawn by beneficiary only if the bank has
sanctioned regular fund-based credit facilities to the beneficiary.
Letters of Credit
The genesis a letter of credit lies in the fact that a seller of good is worried about receipt
of money from the buyer if she supplies the goods first, and the buyer is worried about
non receipt of contracted goods if she makes the payment first. The bank acts as an
intermediary between the two by using its credibility, as it is acceptable to both buyer
and the seller. Letter of Credit (LC) is an undertaking by the bank, at the request of the
buyer (applicant, who is customer of the bank), to the seller, to pay her the contracted
amount if she supplies the goods as per the terms specified and submits the required
documents, including the documents of the title of the goods. The conduct of LC
business is governed by the publication no. 600 of the International Chamber of
Commerce (ICC), commonly known as UCPDC 600.
Appraisal of LC Limit
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An LC is used for purchase of goods either through imports or local purchase. For
assessing the LC requirement of an enterprise, we have to know the following:
• Average Amount of Each LC: This is dependent on the monthly consumption of
goods and the economic order quantity. Economic order quantity (EOQ) is
estimated by examining the sources of supply, means of transport, discount, etc.
In case of imports, the EOQ is often larger in comparison to indigenous
purchases.
• Frequency of LC Opening: Once EOQ is estimated, the number of LCs to be
opened in a year can be calculated by dividing annual consumption by EOQ.
Frequency of opening LCs will be 12 divided by the number of LCs to be opened
in a year.
• How many LCs will be outstanding at a particular time: The time taken for one LC
to remain in force depends upon the lead time (time taken from the date of
opening LC to shipment of goods), the transit time and the usance available to
purchaser from the date of receipt of goods. If the frequency of opening LC is less
than this, bank will have more than one LC outstanding at any point of time.
Commercial Paper
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• This is similar to factoring but is used only in case of exports and where the sale
is supported by bills of exchange/promissory notes.
• The financier discounts the bills and collects the amount of the bill from the
buyer on due dates. Forfaiting is always without recourse to the client.
Therefore, the exporter does not carry the risk of default by the buyer.
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• Working capital loans are normally sanctioned for one year but are payable
on demand. Term loans are payable as per the agreed repayment schedule,
which is stipulated in the terms of the sanction. Therefore, for the purpose of
matching assets and liabilities of the bank, term loans are considered long
term assets while working capital loans are considered as short term assets.
• Banks provide term loans normally for acquiring the fixed assets like land,
building, plant and machinery, infrastructure etc., (personal loans,
consumption loans, educational loans etc. being exceptions)
• As a term loan is expected to be repaid out of the future cash flows of the
borrower, the D S C R assumes great importance while considering term
loans, while for working capital loans, the liquidity ratios assume greater
importance.
• In exceptional cases, banks provide term loans for current assets This is called
Working Capital Term Loan (WCTL)
• There is no uniform repayment schedule for all term loans. Each term loan has
its own peculiar repayment schedule depending upon the cash surplus of
the borrower.
Deferred Payment Guarantees (DPGs)
• When the purchaser of a fixed asset does not pay to the supplier
immediately, but pays according to an agreed repayment schedule, and the
bank guarantees this repayment, the guarantee is called DPG. This is a Non-
fund based method for financing purchase of fixed assets.
Difference Between Term Loan Appraisal And Project Appraisal
• In project finance all the financial needs of the enterprise, including working
capital requirements, are appraised. This is because the total requirement of long
term funds includes margin money for working capital. After assessing the total
requirement of long term funds, the banks decide upon the amount of term loan
to be sanctioned and the contribution of the promoters.
• If an existing enterprise wants to purchase a few machineries, which are not
going to have a major impact on the volume or composition of the business, it
will serve little purpose to have a detailed examination of techno- economic
feasibility, managerial competence, I R R etc. It may be enough for the bank to
examine the projections for next 2 to 3 years to find out that D S C R is at
satisfactory level. In case of loans to individuals also, like housing loans,
educational loans etc., it may be enough to examine the projected D S C R to judge
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Project appraisal
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• Transport
• Energy
• Water & Sanitation
• Communication
• Social and Commercial Infrastructure
Types of Financing by Banks
• Take-out Financing
• Inter-institutional
• Financing Promoter’s Equity
Appraisal
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Documentation
• While the enterprise or individual, who has taken the loan from the bank is
legally bound to repay the principal and the interest, in some cases, banks
stipulate guarantees of third parties, as an additional safety against default.
• These third parties can be individuals or any other legal entity. In case of
finance to firms, the personal guarantee of proprietor or partners is not
stipulated as they have unlimited liability and their personal assets can be
attached for recovery of bank loans.
• Mortgage
• Hypothecation Pledge
• Lien
• Assignment
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• Pledge
Disbursal of Loans
• In the case of borrowers enjoying working capital credit limits of Rs 10 crore and
above from the banking system, the loan component should normally be 80 percent.
Banks, however, have the freedom to change the composition of working capital
by increasing the cash credit component beyond 20 percent or to increase the
'Loan Component' beyond 80 percent, as the case may be, if they so desire. Banks
are expected to appropriately price each of the two components of working capital
finance, taking into account the impact of such decisions on their cash and liquidity
management.
• In the case of borrowers enjoying working capital credit limit of less than Rs. 10
crone, banks may persuade them to go in for the 'Loan System' by offering an
incentive in the form of lower rate of interest on the loan component, as compared to
the cash credit component. The actual percentage of 'loan component' in these cases
may be settled by the bank with its borrower clients.
• In respect of certain business activities, which are cyclical and seasonal in nature or
have inherent volatility, the strict application of loan system may create difficulties
for the borrowers. Banks may, with the approval of their respective Boards, identify
such business activities, which may be exempted from the loan system of delivery.
Term loans
• Promoters bring their entire contribution upfront before the bank starts
disbursing its commitment.
• Promoters bring certain percentage of their equity (40% — 50%) upfront and
balance is brought in stages.
• Promoters agree, ab initio, that they will bring in equity funds proportionately as
the banks finance the debt portion.
Syndication of Loans
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Credit control and monitoring, often referred as Loan Review Mechanism (L R M),
plays an important role in the following aspects:
• To ensure that the funds provided by the bank are put to the intended use and
continue to be used properly.
• To ascertain that the business continues to run on the projected lines.
• If the deterioration of the business continues despite appropriate action, the
bank should decide if any harsh action like, recalling the advance or seizing the
security, etc. is necessary.
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The risks faced by the business of banking can be classified into three broad
categories;
• Operational Risks: The examples of such risks are losses due to frauds,
disruption of business due to natural calamities like floods etc.
• Market Risks: These are the risks resulting from adverse market movements of
interest rates, exchange rate etc.
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• Credit Risks: The credit risk can be defined as the unwillingness or inability of a
customer or counterparty (e.g. the L C opening bank in a bills negotiation
transaction under that L C) to meet his commitment relating to a financial
transaction with the bank.
• External Factors: These factors affect the business of a customer and reduce his
capability to honor the terms of financial transaction with the bank. The main
external factors affecting the overall quality of the credit portfolio of a bank are
exchange rate and interest rate fluctuations, Government policies, protectionist
policies of other countries, political risks, etc.
• Internal Factors: These mainly relate to overexposure (concentration) of credit
to a particular segment or geographical region, excessive lending to cyclical
industries, ignoring purpose of loan, faulty loan and repayment structuring,
deficiencies in the loan policy of the bank, low quality of credit appraisal and
monitoring, and lack of an efficient recovery machinery.
The major objective of credit risk management is to limit the risk within acceptable level
and thus maximize the risk adjusted rate of return on the credit portfolio. Following are
the main steps taken by any bank in this direction;
• Macro Level: The risks to the overall credit portfolio of the bank are
mitigated through frequent reviews of norms and fixing internal limits for
aggregate commitments to specific sectors of the industry or business so that
the exposures are evenly spread over various sectors and the likely loss is
retained within tolerable limits. Bank also periodically reviews the loan policies
relating to exposure norms to single and group borrowers as also the structure of
discretionary powers vested with various functionaries.
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Credit Ratings
The level of credit risk involved in each loan proposal depends on the unique features of
that proposal. Two similar projects, with different promoters, may be appraised by a
bank as having different credit risks. Similarly, two different projects, with same
promoters, may also be appraised by the bank as having different credit risks. While
appraising a credit proposal, the risk involved is also measured and often quantified
by way of a rating with the following objectives;
• Most of the banks in India have set up their own credit rating models as till
recent past, the rating agencies were not equipped well enough to provide the
ratings, so reliable as to banks depending on these for credit decisions. However,
with experience gained in last few years, these rating agencies have gained
confidence of the banks.
The following are the CRAs accredited by
Based on its loan policies and risk perceptions, each bank has its own rating model.
Common feature in all the risk models is that a score is given for different perceived
risks by allotting different weightages. The sum of all these scores forms the basis for
deciding on risk rating of a proposal. Normally, the broad categories of risk areas
which are scored, are:
• Promoters/Management aspects and the securities available
• Financial aspects based on analysis of financial statements
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• Business/project risks
Credit derivatives are used to hedge the risks inherent in any credit asset without
transferring the asset itself. The hedging is comparable to insurance and comes at a
cost. Therefore, if the anticipated risk does not materialise, the return from the asset
will be less than what it would have been without the hedging.
While simple techniques for transferring credit-risk, such as financial guarantees,
collateral security and credit insurance have been prevalent in the Indian banking
industry for long, the recent innovative instruments in credit risk transfer (CRT) such as
collateralised debt obligations (CDO), etc.,
• Credit Default Swaps (CDSs): This is a bilateral contract in which the risk seller
(lending bank) pays a premium to the buyer for protection against credit default
or any other specified credit event. Normally, CDS is a standardized instrument
of ISDA (International Swaps and Derivatives Association).
• Credit Linked Notes (CLN): In this, the risk seller gets risk protection by paying
regular premium to the risk buyer, which is normally a SPV which issued notes
linked to the underlying credit. These notes are purchased by the general
investors and the money received from them is used by the SPV to buy high
quality securities.
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There are exactly four well known CICs in India as of now. Given below is a list of CICs in
India:
• CIBIL
• Equifax
• Experian
• In the case of direct lending: principal and/or interest amount may not be
repaid as per the terms of repayment.
• In the case of guarantees or letters of credit: funds may not be forthcoming
from the constituents upon crystallization of the liability;
• In the case of treasury operations: the payment or series of payments due
from the counter parties under the respective contracts may not be forthcoming
or ceases;
• In the case of securities trading businesses: funds/securities settlement may
not be effected;
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As per RBI directives, banks in India have to classify their assets into Performing or
Standard assets or Non performing assets (NPAs). NPAs are further classified into (a)
Sub-standard, (b) doubtful and (c) loss assets.
The classification is based on the period of default as also the availability of security. The
amount of provision required to be made on the asset portfolio of a bank depends on its
classification into the four categories of standard, sub standard, doubtful and loss.
Willful Defaulters
The default in payment as per agreed terms could be intentional or due to the reasons
beyond the control of the borrower. The intentional default is referred to as willful
default. As per RBI guidelines, a 'willful default' would be deemed to have occurred if
any of the following events is noted:
• The unit has defaulted in meeting its payment or repayment obligations to the
lender even when it has the capacity to honour the said obligations.
• The unit has defaulted in meeting its payment or repayment obligations to the
lender and has not utilized the finance, borrowed for the specific purposes for
which the finance was availed of but has diverted the funds for other purposes.
• The unit has defaulted in meeting its payment or repayment obligations to
the lender and has siphoned off the funds so that the funds have not been
utilized for the specific purpose for which finance was availed of, nor are the
funds available with the unit in the form of other assets.
• The unit has defaulted in meeting its payment or repayment obligations to
the lender and has also disposed off or removed the movable fixed assets or
immovable property given by him or it for the purpose of securing a term loan
without the knowledge of the bank or lender.
Every credit default does not necessarily result in loss to the bank. In many cases,
bank may be able to recover its dues fully. In other cases, the recovery may be with
some loss or, in the worst scenario there may be no recovery at all.
The timely action and an appropriate strategy play very important role in achieving the
best recovery for any stressed asset. While formulating the strategy, the bank has to
keep in mind the legal system as also the social aspects prevailing in the country.
Normally, a bank follows the following steps in case of a stressed asset:
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Legal Action: In cases where even the compromise does not materialize, banks have to
initiate recovery proceedings. The forums available to the banks are as under;
• Government Machinery
• Civil Courts
• Lok Adalats
• Debt Recovery Tribunals (DRTs)
• SARFAESI Act, 2002
Mechanism
i)The borrowers enjoy credit facilities from more than one bank or F l under multiple banking
or syndication or consortium system of lending.
ii)The total outstanding (fund-based and non-fund based) exposure is Rupees 10 crores or
above. C D R system in the country will have a three tier structure
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owed to the State or Central Government and unsecured creditors, if any. If the
borrower does not respond within the above period, the Committee may proceed
ex-parte (with respect to or in the interests of one side only).
• On receipt of information relating to the liabilities of the borrower, the
Committee may send notice to such statutory creditors as disclosed by the
borrower as it may deem fit, informing them about the application under the
framework and permit them to make a representation regarding their claims
before the Committee within 15 working days of receipt of such notice. It is
clarified here that these information are required for determining the total
liability of the unit in order to arrive at a suitable RP and not for payments of the
same by the lender.
• Within 30 days of convening its first meeting for a specific borrower, the
Committee will take a decision on the option to be adopted under the RP and
notify the borrower about such a decision within 5 working days from the date of
such decision.
• If the RP decided by the Committee envisages restructuring of the debt of the
enterprise, the Committee will arrange for Techno-Economic Viability (TEV)
study and finalise the terms of the restructuring in accordance with the extant
prudential norms. Timelines for completion the same has to be as per individual
bank’s instructions from time to time.
• Upon finalisation of the terms of the RP, implementation of that plan has to be
completed by the bank within 30 days from the date of decision (if the RP is
Rectification) and within 90 days from the date of decision (if the RP is
restructuring). In case recovery is considered as RP, the recovery measures
should be initiated at the earliest but not later than 30 days from the date of
decision.
(RBI Circular titled Framework for Revitalising Distressed Assets in the Economy –
Refinancing of Project Loans, Sale of NPAs and Other Regulatory Measures dated 26-02-
2014) A financial asset may be sold to the Securitisation company (SC)/Reconstruction
company (RC) by any bank/FI where the asset is:
• A NPA, including a non-performing bond/debenture, and
• A Standard Asset where:
✓ The asset is under consortium/multiple banking arrangements,
✓ At least 75% by value of the asset is classified as non-performing asset in the
books of other banks/FIs, and
✓ At least 75% (by value) of the banks/FIs who are under the
consortium/multiple banking arrangements agree to the sale of the asset to
SC/RC.
• Where the financial asset is reported as SMA-2 by the bank/FI to Central
Repository for Information on Large Credit (CRILC). However, if restructuring
has been decided as the Resolution Plan, then banks will not be permitted to sell
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• The Insolvency and Bankruptcy Board of India is entrusted with the task of
regulating both the profession and process of IBC. Insolvency Professionals,
Insolvency Professional Agencies, Insolvency Professional Entities and
Information Utilities are under the regulatory supervision of IBBI.
• Apart from these four, IBBI is the ‘Authority’ under the Соmраnies (Registered
Vаluers аnd Vаluаtiоn) Rules, 2017 fоr regulаtiоn аnd develорment of the
рrоfessiоn of vаluers in the country.
Insolvency Professionals (IP)
• Insolvency Professionals (IPs) are the frontline warriors implementing IBC. They
are professionals licensed/registered by IBBI to undertake the role of the
Interim Resolution Professional (IRP), Resolution Professional (RP), liquidator
and/or bankruptcy trustee under any resolution process initiated under the
Code. The IP does the end-to-end job, depending upon her role, of IBC
• IPAs are bodies or entities registered with IBBI and are responsible for
promoting the best professional standards among Insolvency Professionals (IP).
Every IP must be a member of an IPA before seeking registration with IBBI.
• As of now there are three IPAs, namely, a) Institute of Company Secretaries of
India, b) Institute of Chartered Accountants of India and c) Institute of Cost
Accountants of India
• IUs are reservoirs of financial information of all entities under the Code. It is a
pooling centre of information from entities like banks, FIs, NBFCs, ARCs,
Corporates, firms, individuals, utilities on any financial or other credit
transaction with them. The information is then authenticated by IU with the
counterparties before documenting.
• The information available with the IUs are accessible through a Central
Application Programming Interface (CAPI). When a person or entity intends to
initiate a CIRP against a Corporate Debtor, it must attach a copy of certificate of
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default issued by IU with the CIRP application filed with the Adjudicating
Authority.
Creditors and Committee of Creditors (CoC)
• Financial Creditors are those who have lent money to the Corporate Debtor (CD),
meant for paying back, without any trade transaction. Operational creditors are
those who have supplied goods or services on credit or those who have made
advance payment of money to the CD in consideration of receiving back goods or
service.
• The Committee of Creditors is a committee of, normally, only financial creditors
and is formed by the Interim Resolution Professional based on the claims
received from the creditors. Each financial creditor will have a voting power
proportionate to the exposure to the corporate debtor. Operational creditors
have only observatory role in CoC except where there are no financial creditors.
Quorum of CoC is 33% by value.
• Critical matters are passed by the CoC with 66% majority and routine matters
with a 51% majority. Withdrawal of Application for Resolution under section
12A requires 90% majority of the Committee (all by value).
Adjudicating Authority
• The National Company Law Tribunal (NCLT) is the adjudicating authority for
insolvency resolution process of corporate entities, namely, Companies, LLPs or
other corporate entities incorporated under any law in force.
• The Debt Recovery Tribunal (DRT) is the adjudicating authority for non
Corporate entities (Individuals, Proprietors, Partners of a Partnership). Appellate
authorities are National Company Law Appellate Tribunal (NCLAT) and Debt
Recovery Appellate Tribunal (DRAT) for orders of NCLT and DRT respectively.
Paradigm Shift
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• The applicant (FC or CD as the case may be) shall propose name of an IP to act as
Interim Resolution Professional. In the case of application by OC, proposition of
IRP is optional.
• Why ‘interim’ is because only CoC, when formed later, can decide who is regular
Resolution Professional. Once appointed, all powers of the CEO and Board of
Directors of CD will vest with the IRP and it is her responsibility to run the CD as
a going concern.
Moratorium
Resolution Plan
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• As proposed by the CIRP Applicant, the NCLT, while admitting the CIRP, by virtue
of the same order, also appoints an Interim Resolution Professional (IRP),
provided there is no ongoing investigation or disciplinary action against the IP.
• As it is not mandatory for Operational Creditor to propose any IP for
appointment as IRP, in the absence of such proposed names, in consultation with
IBBI, NCLT appoints an IRP within 14 days of admission of CIRP.
• Immediately on her appointment, the IRP takes control of the entire assets and
affairs of the corporate debtor as an on-going concern. The powers of the board
of directors shall stand suspended from the date of initiation of CIRP.
Public announcement
• Within three days of appointment, the IRP, has to make a Public Announcement
of commencement of CIRP, published on the websites of IBBI as well as CD and
also in two newspapers including one in regional language to invite all creditors
for submission of claims and proof of claims (PoC) within 11 days from the
date of the announcement.
• Based on the claims received from Financial Creditors, the IRP shall constitute a
Committee of Creditors (CoC) consisting of all those financial creditors (who are
not a related party to the Corporate Debtor).
• The CoC has to meet within seven days of its constitution. In case there are no
financial creditors (other than related parties) at all, the CoC shall consist of only
operational creditors with
✓ 18 largest such creditors by value,
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✓ One representative elected by all workmen other than workmen included in top
18 operational creditors and
✓ One representative elected by all employees other than employees included in
the top 18 operational creditors
• The CoC, in its first meeting, will decide on either continuation of IRP as RP or
nomination of another IP as RP by a majority of 66% vote in favour. In case CoC
decides to replace IRP, the IRP will immediately fil the CoC resolution for
appointment of RP together with consent letter from the proposed RP with
NCLT.
• The RP, within 7 days of her appointment, must appoint two valuers, who are
registered with IBBI, to determine the fair value and liquidation value of the CD.
The valuation received from the valuers must be kept by RP in strict confidence
and it can be disclosed even to the members of CoC only against a Non-
Disclosure Agreement (NDA) individually from each member.
• Each CoC member has voting power proportionate to her share in the financial
debt of the Corporate Debtor (immaterial whether debt secured or unsecured, as,
both are treated as equal for voting).
Withdrawal of CIRP
Liquidation Process
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• The CIRP fails as no resolution plan is received or is not approved by the CoC;
• Any of the stakeholder’s defaults or deviates from terms of approved Resolution
Plan;
• Creditors representing 66% of the outstanding financial debt resolve to liquidate
the corporate debtor at any time before the preparation of the information
memorandum.
• The corporate debtor contravenes the CIRP and anyone prejudicially affected
applies for liquidation.
If otherwise not ineligible, the RP himself can be appointed as liquidator.
Public Announcement
The liquidator shall prepare a list of stakeholders, category-wise, on the basis of proofs
of claims submitted and accepted, with
• The amounts of claim admitted, if applicable,
• The extent to which the debts or dues are secured or unsecured, if applicable,
• The details of the stakeholders, and
• The proofs admitted or rejected in part, and the proofs wholly rejected.
The list of stakeholders is to be filed with the Adjudicating Authority within forty-five
days from the last date for receipt of the claims and, as modified from time to time, shall
be
• Available for inspection by the persons who submitted proofs of claim;
• Available for inspection by members, partners, directors and guarantors of the
corporate debtor;
• Displayed on the website, if any, of the corporate debtor.
• Filed on the electronic platform of the Board for dissemination on its website:
Stakeholders’ consultation committee
The liquidator has to constitute a consultation committee within sixty days from the
liquidation commencement date, based on the list of stakeholders prepared, to advise
her on matters relating to
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The decision(s), if any, taken by the liquidator prior to the constitution of consultation
committee shall be placed before the consultation committee for information in its first
meeting. The composition of the consultation committee shall be as
• For the purposes of liquidation, the liquidator shall form an estate of the assets,
which will be called the liquidation estate in relation to the CD and she shall hold
the liquidation estate as a fiduciary for the benefit of all the creditors.
• Liquidation estate shall comprise of all assets that may or may not be in
possession of the corporate debtor, whether tangible or intangible, whether
moveable or immovable; but shall exclude assets owned by a third party which
are in possession of the corporate debtor, assets in security collateral held by
financial services providers and are subject to netting and set-off in multi-lateral
trading or clearing transactions, personal assets of any shareholder or partner of
a corporate debtor as the case may be provided such assets are not held on
account of avoidance transactions, assets of any Indian or foreign subsidiary of
the corporate debtor; or any other assets as may be specified by the Board,
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Pre-packaged Insolvency Resolution Process for stressed micro, small and medium
enterprises (MSMEs) will allow the stressed debtor, ie, the MSMEs, and its creditors to
quickly work out a plan to turn around the MSME corporate entity without a bankruptcy
process, which would then be sanctioned by the Adjudicating Authority.
Applicability
• While the CIRP under IBC is creditor-in-control model, that is, the creditors take
over the management and find out course of resolution, the PIRP is on a reverse
framework of debtor-in-possession model, where the debtor has to approach
creditors for resolution with a base resolution plan in place.
• In case of a default by an MSME and if a minimum of 66 per cent creditors vote in
favour, the financial creditors can initiate the PIRP and file an application with
the adjudicating authority for the same. In case a corporate debtor does not have
any financial creditors, it may approve the application filing through a special
resolution with a 75 per cent majority and move the court to initiate PIRP. Then
the court will appoint an insolvency resolution professional as approved by
creditors.
Timelines
• 120 days from the date of commencement is the time frame given for
completion of the entire PIR process.
• Also, within 90 days of date of commencement, the Resolution Personal
has to submit the resolution plan to the adjudicating authority after the same
is approved by the committee of creditors. The PIRP will stand terminated in
case the plan is not approved by the committee of creditors (CoC) within the
time.
Resolution Plan
• Under PIRP also, the applicability of section 29A of IBC, which prohibits
defaulting promoters or wilful defaulters from participating in the resolution
process, has been extended.
• The MSME defaulter, who is under PIRP has to, within two days of PIRP
commencement, submit a base resolution plan to the resolution professional.
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Any changes thereon have to be done before its approval by the CoC.
Nevertheless, if the resolution plan does not envisage payment to the operational
creditors in full or in case the resolution plan is not approved by creditors, new
bids can be invited.
Comparison of PIRP with CIRP
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