Banks Lending Functions. Types of Loan Products.

Submitted By: Group 6 Apoorva Gupta Arjun Kakdiya Ashish Gupta Ashish Kumar Gupta Gaurav Malik 2012073 2012075 2012078 2012073 2012115

Learning Objectives
To Understand why banks Lend Learn how banks lend Principles of Lending Understand the process of making a loan from start to finish Learn the fundamentals of credit appraisal Understand how loans are priced Understand how banks choose profitable customers

Table of Contents
Basic Contents Credit Process Financial Appraisal For Credit Decisions Different Types of Loans Loan Pricing Analysis

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Introduction
A basic purpose of financial markets is to transfer capital from investors to firms and entrepreneurs with profitable investment opportunities and in turn distribute risk efficiently across investors. In the absence of market frictions, the structure of financial markets does not fundamentally change this process. The relevance of financial markets and financial institutions occurs when they arise to help solve some of the frictions that we find in real markets.

Banks role as a financial intermediary

Banks serve multiple purposes. They pool assets thus lowering transactions costs. They transform short term liquid investments such as deposits into long term illiquid assets such as loan.

Low information cost

They also economize on collecting and processing the information necessary to make investment and lending decisions. Information available about borrowers is limited and expensive to acquire. This is one place where the services of banks may be of great value. Banks may be more efficient at collecting information due to simple economies of scale. They can collect information once for hundreds of borrowers thus reducing the aggregate cost of collecting information. If this information is durable (can be used as an input to the lending decision over multiple periods) and not easily replicated by competitors, theory suggests that a firm with close ties to financial institutions should have a lower cost of capital and greater availability of funds relative to a firm without such ties.

Source of financing
In none of the countries are capital markets a significant source of financing. Equity markets are insignificant. As the main source of external funding, banks play important roles in corporate governance, especially during periods of firm distress and bankruptcy. The idea that banks monitor firms is one of the central explanations for the role of bank loans in corporate finance. Bank loan covenants can act as trip wires signalling to the bank that it can and should intervene into the affairs of the firm.

Providing liquidity
Banks are also important in producing liquidity by, for example, backing commercial paper with loan commitments or standby letters of credit. Consumers use bank demand deposits as a medium of exchange, which is, writing checks, using credit cards, holding savings accounts, visiting automatic teller machines, and so on. Demand deposits are securities with special features. They can be denominated in any amount; they can be put to the bank at par (i.e., redeemed at face value) in exchange for currency. These features allow demand deposits to act as a medium of exchange.

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Financial Intermediation
The relationship between bank health and business cycles is at the root of widespread government policies concerning bank regulation and supervision, deposit insurance, capital requirements, the lender-of-last-resort role of the central bank, and so on. Clearly, the design of public policies depends on our understanding of the problems with intermediaries. Even without a collapse of the banking system, a credit crunch has sometimes been alleged to occur when banks tighten lending, possible due to their own inability to obtain financing. Also, the transmission mechanism of monetary policy may be through the banking system. Basically, financial intermediation is the root institution in the savingsinvestment process. Ignoring it would seem to be done at the risk of irrelevance. So, the viewpoint of this paper is that financial intermediaries are not a veil, but rather the contrary. Income and risks for banks with regard to lending: The point of taking on risk in the first place is to get a chance for a greater return, and when banks make loans, they are undertaking several types of risk in the hope of making a return. Theoretically at least, banks make money when they combine small savings deposits of individuals and put those funds together into loans, which they loan out to creditworthy borrowers. These borrowers pay back more in interest than the bank pays the depositors, making the bank profitable. When a bank makes a loan, though, there are several ways in which the profit-making model could fall on its face. Income: Banks also frequently attach a host of fees and charges when they make loans. While banks gamely try to defend these fees as important to defraying the costs of paperwork and so forth, in practice they're a honey pot of profits for the bank. Congress and has moved aggressively, in the wake of the subprime crisis, to restrict some of the fees that banks can charge customers. In many cases these new rules simply mean that customers have to actively select and approve certain account features, like automatic "overdraft insurance," but there are increasing limitations on what services banks can charge for, and how much they can charge. Although making mortgage loans and collecting the interest is certainly part of everyday "interest income" operations at banks, there are aspects of lending that fall into the noninterest income bucket. In some cases, banks are willing and able to lend money, but not especially well-equipped to manage the back office tasks that go into servicing those loans. In situations like this, a bank can sell the rights to service that loan, collecting and forwarding payments, handling escrow accounts, responding to borrower questions, etc., to another financial institution. While this can be done for almost any kind of loan, it is most common with mortgages and student loans

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Risks When a banker makes a loan, he is taking a risk that the borrower will pay the loan back (credit risk), and also taking the risk that the funds loaned out won't be needed to pay out withdrawals or to take care of regular bank business, thereby preventing bank runs (liquidity risk). Further, the banker is undertaking "interest rate risk," which is more subtle but still present. Interest rate risk represents the possibility that the bank has somehow priced its loan and deposit interest rates incorrectly, be it the bank's fault or the fault of an ever-changing marketplace. If it turns out that the loan payments aren't high enough to cover deposit costs (or, if the bank's profit on loans is less than its losses on deposits), the bank will fail to be profitable.

Quick Review
Ques1 - What are banks sources of financing? Ques2 - What is Financial Intermediation?

Types of lending:
There are three types of lending by banks i.e. fund based lending, non fund based lending and asset based lending. Non-fund based lending In case of non fund based lending; the lending bank does not commit any physical outflow of funds. As such, the funds position of the lending bank remains intact. The non fund based lending can be made by the banks in two forms. a) Bank guarantee. b) Letter of credit. Fund based lending In case of fund based lending bank commits the physical outflow of funds. As such, the funds position of the lending bank gets affected. The fund based lending can be made by the banks in the following forms(a)loan. (b)overdraft. (c)cash credit. (d)bills purchased/discounted. (e)working capital term loans. (f)packing credit. Asset based lending

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Simply put, asset-based loans are based on assets, generally accounts receivable and inventory, that are used as collateral. You're putting your future revenue on the line to gain access to money right now. Asset-based lenders will advance funds based on an agreed percentage of the secured assets' value. The percentage is generally 70 percent to 80 percent of eligible receivables and 50 percent of finished inventory.

Financial Appraisal for Credit Decisions

One of the foremost considerations for granting of credit facilities for any project is the financial position of a concern. Banks employ various techniques for financial appraisal. However, there is neither any uniformity in appraisal nor any standard norms are fixed for such appraisal. The position may be different from bank to bank and from project to project within the same bank depending upon the nature and the size of the project. There are, however, some important common features of financial appraisal, which will be discussed in this chapter. Financial appraisal revolves round two important financial statements, which are required to be submitted to the bank with the loan application. These financial statements are: Balance Sheet. Profit & Loss A/c. Balance sheet reveals the financial position of a concern at a particular point of time (usually the closing date of the operating year) while profit and loss a/c is the summary of operations during the operating year. Balance sheet gives particulars of assets and liabilities of a concern as on the date of closing and must also reveal the manner in which these are distributed. Total assets of any concern will be matched by its total liabilities at all the times. Profit and loss a/c is the statement of working results of the concern for its operations during the year and is an important indicator of the way the business is being conducted by the concern and its financial results. Financial appraisal is an important tool in the hands of bankers and forms the very basis of the credit decision to be taken by them. The credibility of the financial statements submitted to the banks is thus very important. It is preferable that audited balance sheet and profit and loss a/c are submitted as these are generally considered more reliable. Another important point to be noted here is that financial statements of a single year may not be considered sufficient to form any opinion about the financial position of a concern as the banks are interested to establish the trend in which the business is being conducted from year

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to year. The financial statements of at least last three years are analysed simultaneously to draw comparisons on year to year basis of the important financial indicators of a concern. The financial analysis is thus followed with 'trend analysis' which assumes more significance in as much as the concern with comparative weak financial base but improving trend may get favourable response from banks.

Financial Ratio Analysis:

Most large bank begins financial analysis with a standardised spread sheet or format, where the balance sheet and income statement data, past and future are rearranged in a consistent format to facilitate comparison overtime and benchmark with industry standards. Major ratios that are very important for the credit appraisal are as follow: Current Ratio A minimum current ratio of 1: 1 indicates that current liabilities are just matched by current assets. As per recent Reserve Bank of India's guidelines a minimum current ratio of 1.33:1 is to be ensured for large borrowers. Current Ratio = Current Assets /Current Liability Standard ratio is 2 : 1 Current Assets include: all current assets + receivables + cash in hand + bank balance + stock Current Liabilities include: all current liabilities + payables to creditors + working capital loans from banks + taxes payable + dividend payable Acid Test Ratio While calculating current ratio, we have presumed that all current assets can be realised to meet the current liabilities of a concern. But in practice all current assets are not so realisable.For example, inventory of finished goods etc. and stock in process may take a long time before these can be converted to cash and may thus not be available to meet the current dues of the firm. This may sometimes lead to erroneous conclusion regarding the real liquidity of the concern. Assets of such nature are thus excluded to find out the real liquidity position of the concern on a very short term basis. The relationship of such assets to current liabilities is termed as 'Quick or Acid test ratio' and is determined as under: Acid Test Ratio = Quick moving current assets / Quick moving current liabilities Standard ration is 1 : 1 Indications are as per current ratio but for immediate moving components.

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Debt Equity Ratio It is a measurement of long-term solvency of concern and is calculated by comparing term liabilities with the net worth of the concern as under: Debt Equity Ratio = Total Long Term Loans / Net Assets Debt equity ratio of 2: 1 is generally acceptable. In highly capital intensive units it may even go upto 3:1. For small projects under priority sector, the promoter may not bring any equity/capital from his own source and the debt equity ratio may be infinity. The ratio gives an indication of the dependence of the concern on borrowed funds. A lower ratio means high financial stake of the concern in the business whereas a higher ratio would mean that the firm is working with a thin equity. A low debt equity ratio will, therefore, be preferable. However, the level of acceptance of debt equity ratio by the bank also depends upon the nature of project and sometimes comparisons may have to be drawn with projects of similar nature to arrive at a conclusion. The change in debt equity ratio over a number of years is also to be watched carefully and it should gradually reduce. Any increase in debt equity ratio over successive years would mean erosion in the net worth either due to losses or withdrawals from capital or reserve. The other reason for such reduction maybe due to heavy borrowings without corresponding additions to capital. Debt equity ratio may also be affected by diversification/modernisation etc. programme involving capital expenditure being undertaken by the unit where matching funds by the unit from its own sources in relation to borrowed funds for implementation of such programmes are not arranged. The change in debt ratio also throws light on the policy of management for distribution/retention of profits. Units; with good profitability not showing improvement in debt equity ratio over a period of time would reveal that most of the profits are being distributed to shareholders. However, any intervening capital expenditure for modernisation/diversification programme necessitating additional borrowings may alter the situation in this regard. All these aspects need to be probed and suitable explanatory notes would be necessary if there is any adverse movement in debt equity ratio as compare to earlier years. Standard is 2 : 1 Fixed Asset Coverage Ratio It shows if the loans given by bank against fixed assets are safe or not. It is calculated by following formula: Fixed Asset Coverage Ratio = Net Fixed Assets (after depreciation) /Long Term Loans Against Fixed Assets Standard is 2 : 1

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Gross Profit RatioandNet Profit Ratio: An increasing gross profit ratio would mean stabilisation of production, effective management of inventory besides marketing efficiency and better production management. The lower gross profit ratio on the other hand may mean a strain on the margins due to increase in the cost of raw materials and other production costs without a corresponding increase in sales realisation. This may also require an in depth study of all other aspects resulting increased cost of production to establish the real cause of such a decrease so that necessary adjustment in policy, if necessary, can be made to show better results in future. Gross Profit Ratio = (Gross Profit / Net Sales) X100 Net Profit Ratio = (Net Profit / Net Sales) X100 Higher the answer profitability is good. However, this ratio in isolation for any one year is of no use. It needs comparison with the previous years ratio to see if there is rise in profit or otherwise. Debtors Turnover Ratio: Debtor Turnover ratio will give the result in number of days that are taken on the average to realise the sale proceeds. Where figures of credit sales are not separately available, the figures of total sales may be taken in the denominator. Longer period in realisation of sales proceeds points towards the incapacity if the unit to realise its dues in time. The trend in the ratio on year to year basis is also required to be studied. The increasing ratio would indicate that the concern is having difficulty in sales due to sluggishness in demand or has ended up with some bad debts which cannot be realised promptly. Sometimes, the ratio may deteriorate due to the lack of efforts by the management to realise its dues promptly. This situation, therefore, needs very close examination and corrective measures are to be initiated immediately. Debtor Turnover ratio gives average days required for receiving the book debts Debtors Turnover Ratio = (Total Book Debts / Sale Made on Credit) X 365 Lower figure is a good indication Gives position about how many days average credit is given, efficiency of recover y of dues and control on credit sale. Debt Service Coverage Ratio (DSCR): DSCR is the ratio of cash available for debtservicing to interest, principal and lease payments. It is a popular benchmark used in the measurementof an entity's (person or corporation) ability toproduce enough cash to cover its debt (includinglease) payments. The higher this

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ratio is, theeasierit is to obtain a loan. A very high ratio mayindicate the need for lower moratoriumperiod/repayment of loan in a shorter schedule. DSCR = (Net Profit + Depreciation + Interest Paid On Long Term Loans) /(Total amount of EMIs paid and payable in the year + Interest Paid On Long Term Loans)

DSCR what it indicates Important ratio for Term Loan assessment. As a standard DSCR should not be less than one. However, most of the banks prefer DSCR as 2 or more. DSCR 2 or more implies that even if the cash flow falls by 50%, the borrower would be able to pay the long term debt. Expenses Ratio: Expenses Ratio = (Total Expenditure / Total Sales) X 100 This ratio shows proportion of expenses to sales. If the ratio is high profitability is low. If the ratio is low profitability ishigh. For correct understanding comparison with previous years is necessary. The Return on Investment ratio (R0I): Investment for this purpose means the capital fund and also other term liabilities which are deployed for long term use to run the business. The return means net profit before tax plus interest paid on term liabilities. Interest on term liabilities is to be added as it is a direct charge on term liability which is counted as investment The ROI is calculated as under: Net Profit before tax + Int. on term liabilities x 100 Return on investment ratio = Net worth + Term liabilities The ratio indicates the earning power of any project in relation to the investment made and risks undertaken. It will also benefit to compare it with other projects to, find out the relative strength of any project in terms of profitability. This ratio is also found out for a number of successive years to establish the trend. Any deterioration would mean lower earning capacity of the project due to erosion in margins as a result of many factors which may include increase in cost of production, overheads and difficult competitive market. A careful study of these factors may help to plan suitable strategies for improvement in future. Cash Flow Statement Analysis: The statement of cash flows, as its name implies, summarizes a companys cash flows for aperiod of time. The statement of cash flows explains how a companys cash was generated

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during the period and how that cash was used. Even if the statement of cash flows seems to be a replacement for the income statement, the two statements have two different objectives. The income statement measures the results of operations for a period of time. Net income is the accountants best estimate at reflecting a companys economic performance for a period. The income statement provides details as to how the retained earnings account changes during a period and ties together, in part, the owners equity section of comparative balance sheets. The statement 2of cash flows provides details as to how the cash account changed during a period. The statement of cash flows reports the periods transactions and events in terms of their impact on cash. Also, this financial statement provides important information from a cash-basis perspective that complements the income statement and balance sheet, thus providing a more complete picture of a companys operations and financial position. It is important to note that the statement of cash flows does not include any transactions or accounts that are not already reflected in the balance sheet or the incomestatement. Rather, the statement of cash flows simply provides information relating to the cash flow effects of those transactions. Users of financial statements, particularly investors and creditors, need information about acompanys cash flows in order to evaluate the companys ability to generate positive net cash flows in the future to meet its obligations and to pay dividends. In some cases, careful analysis of cash flows can provide early warning of impending financial problems. Information Reported in the Statement of Cash Flows Accounting standards include specific requirements for the reporting of cash flows. The inflows and outflows of cash must be divided in three main categories, namely operating activities, investing activities and financing activities. Further, the statement of cash flows is presented in a manner that reconciles the beginning and ending balances of cash and cash equivalents. Cash equivalents are short-term, highly liquid investments that can easily be converted into cash. Generally, only investments with maturities of three months or less qualify as cash equivalents, such as: Treasury bills, money market funds or commercial paper. The general format for the statement of cash flows is presented in the table below:

Cash provided by (used in): Operating activities Investing activities Financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

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General Format for a Statement of Cash Flows The three categories of activities (operating activities, investing activities and financing activities) generating inflows and outflows of cash are very suggestively presented in the exhibit from below table:
Cash received from Operating activities Cash received from Investing activities Cash received from Financing activities

INFLOWS

Cash and cash equivalents

OUTFLOWS
Cash paid for Operating activities Cash paid OUTFLOWS for Investing activities Cash paid for Financing activities

Operating activities include those transactions and events that enter into the determination of net income. Cash receipts from the sale of goods or services are the major cash inflows for most businesses. Other inflows are cash receipts for interest revenue, dividend revenue and similar items.Major outflows of cash are for the purchase of inventory and for the payment of wages, taxes, interest, utilities, rent and similar expenses. Transactions and events that involve the purchase and sale of securities, property, buildings, equipment and other assets not generally held for resale and the making and collecting of loans areclassified as investing activities. These activities occur regularly and result in cash inflows and outflows. They are not classified under operating activities because they relate only indirectly to the entitys central, on-going operations, which usually involve the sale of goods and services. The analysis of investing activities involves identifying those accounts on the balance sheet relating to investments (typically long-term asset accounts) and then explaining how those accounts changed and how those changes affected the cash flows for the period. Financing activities include transactions and events whereby resources are obtained from or paid to owners (equity financing) and creditors (debt financing). Dividend payments, for example, fit this definition. The receipt of dividends and interest and the payment of interest
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are classified under operating activities simply because they are reported as a part of income on the income statement. The receipt or payment of the principal amount borrowed or repaid (but not the interest) is considered a financing activity.

Operating Activities Cash receipts from: Sales of goods and services Interest revenue Dividend revenue Sale of investments in trading securities Cash payments to: Suppliers for inventory purchases Employees for services Governments for taxes Lenders for interest expense Brokers for purchase of trading securities Others for other expenses (utilities, rent) Investing Activities Cash receipts from: Sale of property, plant and equipment Sale of a business segment Sale of investments in securities other than trading securities Collection of principal on loans made to other entities Cash payments to: Purchase property, plant and equipment Purchase debt or equity securities of other entities Make loans to other entities Financing Activities Cash receipts from: Issuance of own stock Borrowing (bonds, notes, mortgages) Cash payments to: Stockholders as dividends Repay principal amounts borrowed Repurchase an entitys own stock (treasury stock)

Analysing the cash flow effects of financing activities involves identifying those accounts relating to financing (typically long-term debt and common stock) and explaining how changes inthose accounts affected the companys cash flows. Some investing and financing activities do not affect cash. For example, equipment may be purchased with a note payable or land may be acquired by issuing stock. These non-cash transactions are not reported in the statement of cash flows. However, if a company has significant non cash financing and investing activities, they should bedisclosed in a separate schedule or in a narrative explanation. The disclosures may be presented below the statement of cash flows or in the notes to the financial statements.
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Quick Review
Ques1 Different types of Lending? Ques2 Explain different financial ratios? Ques3 Explain Cash flow statement in detail.

Different types of Loans

A loan is an arrangement in which a borrower takes money from a lender or a financial institution and promises to return it within a fixed period of time and at a fixed rate of interest, which is determined at the time the loan is granted. In most of the cases, a loan is returned in fixed instalments and each instalment is a fixed amount of money. There are various types of loans. Some of them can be classified as follows: Secured and Unsecured Loans

Secured Loan: A secured loan is one in which you get loan against an asset that you possess. For example, you can take a loan against your property, a vehicle that you own, your jewellery etc. If by any chance you are unable to pay back the money you have taken as loan, the financial institution will sell that asset and recover the amount. The interest rates may be lower for secured loans as compared to unsecured loans. The financial institution from which you take a secured loan usually estimates the market value of th e asset you keep as security. Unsecured: If you do not have an asset to keep as security, you can get an unsecured loan. However, in order to qualify for this loan you would have to have a good record of credit history and have a good income. The interest rates for unsecured loans are usually higher as compared to secured loans.

Subsidized and Unsubsidized loans It you are granted a loan as part of your financial aid, you might be eligible for subsidized or unsubsidized loans, or can avail both.

Subsidized loans are awarded to those who qualify for it and the borrowers are not charged any rate of interest. In India, the best example of subsidized loans are those given by rural banks or cooperative banks to the farmers, especially for the purchase of farm equipments like tractors, pumps etc, or to implement latest technology that would increase their produce. Some countries provide subsidized loans to students to pursue their studies.
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Unsubsidized loans are given to lenders at a fixed rate of interest till the time the full amount is repaid. The interest rates charged on this type of loan can be minimized by repaying the loan before the interest accumulates.

Open-Ended and Closed-Ended Loans

Open-Ended loans are loans in which you can take loans several times. You can pay the loan and take a loan again. You have a credit limit for these loans. This means that you cannot take loan against an amount fixed by your lender. You need to pay interest on these loans only if you exceed the credit limit or you pay after the date of maturity. The credit limit can be increased by the lender if you have a good record and do not default in payments. Credit cards and lines of credit are a good example of open-ended loans. Closed-Ended loans are loans that are fixed at the time you take them. This means that when you take this loan, the amount of instalments to be paid, whether it has to monthly or half yearly etc., the duration till when you have to repay the loans are fixed by the lender when you take this loan. These loans are given against an agreed rate of interest. If you want, you can repay the instalments before the term allotted for it. Some examples of open-ended loans are car loans, mortgage loans student loans.

Demand Loans: These are short term loans and have to be paid by the borrower at any time it is asked to be repaid to the lender. Unlike other types of loans, this loan does not have a date of maturity and at times may not have specific schedule for repaying the loan. These loans are at times said as 'call loan' and are given by lenders to borrowers with whom they have long standing business relationship. This loan is good for the borrowers as they can repay it it according to their convenience. Banks are the chief providers of loans in the country. But before you take a loan from a bank, make sure that you are aware of the various types of loans that you can avail and also know the rates of interest offered by various banks. Loans can be further categorized; however, this would depend on whether the borrower is an individual or an organization that wants to take loan for a business transaction.

Fund based and Non-Fund based loans

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. Different forms of fund based lending are:

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1. Overdrafts: These are treated as current accounts. Normally overdrafts are allowed against the Banks own deposits, government securities approved shares and/or debentures of companies, life insurance policies, government supply bills, cash incentive and duty drawbacks, personal security etc. Overdraft accounts are kept in the ordinary current account head at branches. 2. Demand Loans: A demand loan account is an advance for a fixed amount and no debits to the account are made subsequent to the initial advance except for interest, insurance premium and other sundry charges. As an amount credited to a demand loan account has the effect of permanently reducing the original advance, any further drawings permitted in the account will not be secured by the demand promissory note taken to cover the original loan. A fresh loan account must, therefore be opened for every new advance granted and a new demand promissory note taken as security. Demand loan would be a loan, which is payable on demand in one shot i.e. bullet repayment. Normally, demand loans are allowed against the Banks own deposits, government securities, approved shares and/or debentures of companies, life insurance policies, pledge of gold/silver ornaments, and mortgage of immovable property. 3. Cash credit Advances: A cash-credit is an arrangement to extend short term working capital facility under which the bank establishes a credit limit and allows the customers to borrow money upto a certain limit. Under the system, bank sanctions a limit called the cash-credit limit to each borrower upto which he is allowed to borrow against the security of stipulated tangible assets i.e. stocks, book debts etc. The customer need not draw at once the whole of the credit limit sanctioned but can withdraw from his cash-credit account as and when he needs the funds and deposit the surplus cash/funds proceeds of sale etc., into the account. 4. Bill Purchase/Discounting: These represent advances against bills of exchange drawn by the customers on their clients. Bills are either purchased or discounted by banks. Demand bills are purchased and usance bills are discounted. Bills may be either clean or documentary. Bills accompanied by title to goods i.e. R/R, MTR, etc. are called documentary bills. Bills without such documents are known as clean bills. Documents under bills are either deliverable against acceptance or against payment.

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

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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 are established in accordance with the process approved by the board of directors. The limits on working capital facilities are primarily secured by inventories and receivables (chargeable current assets). Working capital finance consists mainly of cash credit facilities, short term loan and bill discounting. Under the cash credit facility, a line of credit is provided up to a pre-established amount based on the borrower's projected level of sales inventories, receivables and cash deficits. Up to this pre-established amount, disbursements are made based on the actual level of inventories and receivables. Here the borrower is expected to buy inventory on payments and, thereafter, seek reimbursement from the Bank. In reality, this may not happen. The facility is generally given for a period of up to 12 months and is extended after a review of the credit limit. For clients facing difficulties, the review may be made after a shorter period. One problem faced by banks while extending cash credit facilities, is that customers can draw up to a maximum level or the approved credit limit, but may decide not to. Because of this, liquidity management becomes difficult for a bank in the case of cash credit facility. RBI has been trying to mitigate this problem by encouraging the Indian corporate sector to avail of working capital finance in two ways: a short-term loan component and a cash credit component. The loan component would be fully drawn, while the cash credit component would vary depending upon the borrower's requirements. According to RBI guidelines, in the case of borrowers enjoying working capital credit limits of Rs. 10 crores and above from the banking system, the loan component should normally be 80% and cash credit component 20 %. Banks, however, have the freedom to change the composition of working capital finance by increasing the cash credit component beyond 20% or reducing it below 20 %, as the case may be, if they so desire.

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Bill discounting facility involves the financing of short-term trade receivables through negotiable instruments. These negotiable instruments can then be discounted with other banks, if required, providing financing banks with liquidity.

The credit facilities given by the banks where actual bank funds are not involved are termed as 'non-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 other fund based credit limits. Facilities for co acceptance of bills/deferred payment guarantees are generally required for acquiring plant and machinery and may, technically be taken as a substitute for term loan which would require detailed appraisal of the borrower's needs and financial position in the same manner as 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.

Bank Guarantee

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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. o Guarantor or Surety: The person who gives the guarantee.

Bank provides guarantee facilities to its customers who may require these facilities for various purposes. 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 contract by customers.

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.

Loan for Working Capital: (i) Any business enterprise whether engaged in manufacturing or purely trading activity, has to have sufficient capital to finance both, its fixed and long term assets, viz. land, building, machineries, etc. and to maintain certain level of short term assets for smooth conduct of day

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to day business activities/ production schedule. Such short term assets which are required for day to day operation are called the current assets. (ii) The amount of current assets required for a smooth conduct of business is dependent on the nature of the activity, availability of the raw materials, level of production, storage capacity and funds available. So the funds/capital actually required to maintain this required level of current assets, is called the gross working capital. (iii) Out of the level of gross working capital, required as above, the borrower raises the necessary funds from many sources, viz.: (a) Share Capital (b) Retained Profits (c) Bank Borrowings (d) Trade Creditors (e) Advance from Purchasers (iii) Out of the above, credit available in the form of trade creditors and advance from purchasers etc., are sources of finance which are short term in nature and are available as per trade practices and market conditions. The remaining resources are, therefore, to be raised from own capital or through bank borrowing. Such short term credits available to the firm are called current liabilities and the difference of gross working capital and the current liabilities is called the 'Net Working Capital'.

Loan for capital expenditure and industrial credit: Term Loan (i) Any credit facility which is stipulated to be repaid in fixed installments over a period of not less than 3 years is to be classified as Term Loans. (ii) Loans where the repayment period is less than 3 years are to be classified as Demand Loans. Purpose: (i) Term loans are usually granted to various types of borrowers for acquiring fixed assets like land, buildings, plant & machinery, equipments, vehicles etc. (ii) In the case of individuals and firms, term loans are granted usually for purchase of vehicles, construction of a house/flat, purchase of equipments, etc. (iii) In the case of industrial undertakings, term loans are granted to meet the capital expenditure in the form of acquiring land, building, plant & machinery etc. either for setting up a new unit, expansion or diversification of an existing unit. Such loans are also considered for modernization or renovation
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programmes of the existing industrial undertakings for improving the quality of the products manufactured, reducing the cost of production or otherwise improving the efficiency and profitability of the organization. Features: Following 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 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.

Loan syndication

Borrowing by way of a loan facility can provide a borrower with a flexible and efficient source of funding. If a borrower requires a large or sophisticated facility or multiple types of facility this is commonly provided by a group of lenders known as a syndicate under a syndicated loan agreement. A syndicated loan agreement simplifies the borrowing process as the borrower uses one agreement covering the whole group of banks and different types of facility rather than entering into a series of separate bilateral loans, each with different terms and conditions. The purpose of this note is to provide guidance on various aspects of a syndicated loan transaction, focusing on the following: the types of borrowing facilities commonly seen in a syndicated loan agreement;

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a description of the parties to a syndicated loan agreement and an explanation of their role a brief explanation of the documentation entered into by the parties; the time line for a typical syndicated loan transaction; an a description of the common methods used by lenders to transfer syndicated loan participations.

Quick review Ques1 Different types of loans? Ques2 what is a bank guarantee?

CUSTOMER PROFITABILITY ANALYSIS AND LOAN PRICING

The analysis procedure compels banks to be aware of the full range of services purchased by each customer and to generate meaningful cost estimates for providing each service. The applicability of customer profitability analysis has been questioned in recent years with the move toward unbundling services. Customer profitability analysis is used to evaluate whether net revenue from an account meets a banks profit objectives. We build a step by step a basic loan pricing model:

LOAN AND DEPOSIT PRICING MODELS vary in their methodology, but all attempt to quantify the various costs and risks of extending credit or rising funding in the current rate environment and generate projected rates of return. A conceptually sound and analytically robust pricing model can bring pricing errors to light. Most of these errors fall into one of several common categories:

- ONE SIZE FITS ALL PRICING Many of the costs of extending credit are proportional to a loans size. However, operating expenses are inelastic. While in many cases originating and servicing a $100 thousand loan is less than a $1 million loan, it is not 1/10 the cost. This leads to progressively higher required rates/fees to maintain a consistent rate of return on the portfolio. The mark-ups achieved on smaller versus larger loans vary widely by institution, but in most cases dont approach what is required for consistency in rates of return. This is unavoidable to some extent: relationship pricing is often used to justify sub-optimal pricing at the loan
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level to ensure the retention of valuable customer relationships. But while this may often be justifiable, the larger point here is that many institutions are largely ignoring this critical variable entirely. - PERSONALIZING ASSUMPTIONS When implementing a pricing model and quantifying the variables for the first time, the temptations are to think of these in terms of the institutions experience: its funding costs, its credit experience, and its operating costs. This is a mistake, as pricing assumptions should always reflect marketplace norms for competitors in the institutions footprint. To not do so would lead to systemic over- or under pricing based on whether the institution is worse, or better, than its competitors.

To illustrate, lets assume an institution suffers from unusually high operating expenses. The consequences of using these in their pricing model could only be that because of these higher costs, the institution will need to charge higher rates/fees than its competitors to recoup them. The likely result is getting out-bid on most deals. Customers cannot be expected to be sympathetic to the institutions cost problems, and be willing to pay more. Conversely, if the institution out-performs its peers by whatever metric, the result of embedding this experience as a pricing assumption will lead to overly aggressive bidding, ending in passing along the benefits of this out-performance to its customers rather than to its shareholders.

- UNDER-VALUING CUSTOMER OPTIONS Most financial products contain embedded customer options. Interest rate floors and caps, as well as the ability to prepay a loan or call a time deposit, are common examples. The value of these options are often either ignored or quantified in rudimentary ways, e.g., a 3%-2%-1% penalty structure for prepayment within one, two or three years. While any attempts at quantification are (usually) better than none, most institutions under-value the risk these options create for financial loss.

The problem with most customer options is that they are notoriously difficult to quantify. Most institutions dont have the resources to do such analyses in-house, nor do many pricing models perform this level of analysis. But since such valuations are being performed daily in the financial markets, an acceptable solution may be to receive indications on option valuation from the institutions securities dealer or other service providers.

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- ROSY SCENARIOS Calculating a projected return necessarily requires making numerous assumptions. Some of these require individual judgment calls: for example, how long will a commercial mortgage with a 20-year term really stay on the books, or how much will a line of credit be utilized? Human nature being what it is, there is usually a bias towards the optimistic when making these assumptions, leading to unrealistically high projected returns, and ultimately under pricing. There are two potential solutions to this problem. First, with some factors management can provide standardized guidance for how to handle subjective variables. The second is an audit process to provide assurance of the reasonableness of assumptions used in preparing proposals.

- STALE ASSUMPTIONS All of the assumptions going into a rate of return calculation are subject to changing conditions. Assumptions such as capital requirements, loss experience and operating expenses should be evaluated and adjusted at least annually. The trend for all of these assumptions has been upward (more capital, higher expenses) so the more stale these assumptions become the more of an upward bias they place on results, leading to under pricing. As rate of return goals are another important input in a pricing model, these should be revaluated along with the other inputs. Thus, evaluating pricing decisions in a financial model will always be an inherently subjective, and thus error-prone, process. The ultimate insurance against costly errors being made is the knowledge and objectivity of the practitioners building, calibrating and using it, as well as the reasonable and effective controls and guidelines put in place by the executives who will ultimately be held responsible for the results.

LOAN PRICING ANALYSIS OPTION A: Requires 4+4 investable balance or $490,000 net of account float and req. res. OPTION B: Assumes no compensating balances but pays a 0.025 facility fee.

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Expenses
Deposit activity Loan administration and risk Interest on borrowed funds $ 68,000 68,250 388,500 $524,750 66,150 $590,900 (0.013 x $5.25 million) (0.074 x $5.25 million) (0.18 x 0.07 x $5.25 million)

Target Prorit
Total Revenues

Option A: Compensating balances set at 4 + 4 investable balances

($490,000); earnings credit rate = 4%; 1/2 of 1% commitment fee Option B: 1/4 of 1% facility fee, no balances required

Option A Option B
Fee income $ 8,750 $ 17,500 Investment income from balances 19,600 0 Required loan interest 562,550 573,400 Total $590,900 $590,900 Required loan rate 10.72% 10.92% NOTE: Required loan rate is $562,550/5,250,000 = 10.72 percent; 573,400/5,250,000 = 10.92 percent.

CUSTOMER PROFITABILITY ANALYSIS

The two types of customer profitability common in retail banking include current customer profitability and lifetime value. Customer profitability analysis enhances a bank's ability to 1) Acquire new, profitable customers 2) cross-sell profitably to existing customers 3) Provide differentiated service to customers based on their profitability 4) Migrate customers to more profitable products and services 5) Make pricing determinations that will make products more profitable.

Before undertaking customer profitability analysis, banks must ensure that they are ready to calculate customer profitability. Banks must 1) establish buy-in from the various business units affected by customer profitability analysis, 2) develop consistent, accurate and fair cost and revenue allocations, 3) develop good specifications prior to implementation and 4) ensure that all necessary staff are ready to undertake customer profitability analysis. The largest banks were more likely to calculate current customer profitability than smaller banks. Current customer profitability was used primarily to support product development, pricing determinations, the identification of customers for migration to more profitable products and
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services and the establishment of customer segments. However, the resulting activities supported by customer profitability analysis were not very effective. Few of banks were calculating lifetime value, although many of the largest banks expected to be doing so by year-end 2000. Many smaller banks will be developing customer profitability analyses for the first time. Regardless of bank size, most banks that currently calculate customer profitability will need to increase the effectiveness of the support for the resulting applications. They will need to do this by incorporating more product information into the analysis and using actual costs and transaction- level behaviour in their analyses. There are several considerations for banks.

Summary:
Banks extend credit to different categories of borrowers for a wide variety of purposes. For many borrowers, bank credit is the easiest to access at reasonable interest rates. Bank credit is provided to households, retail traders, small and medium enterprises (SMEs), corporate, the Government undertakings etc. in the economy. Retail banking loans are accessed by consumers of goods and services for financing the purchase of consumer durables, housing or even for day-to-day consumption. In contrast, the need for capital investment, and day-to-day operations of private corporate and the Government undertakings are met through wholesale lending. Loans for capital expenditure are usually extended with medium and long-term maturities, while day-to-day finance requirements are provided through short-term credit (working capital loans). Meeting the financing needs of the agriculture sector is also an important role that Indian banks play.

Critical Questions
Why credit needs of a borrower should be assessed accurately? Which is the most important financial ratio for credit decisions? List down all important financial ratios How is effective pricing of loans undertaken by banks? Importance of cash flow analysis?

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