CORPORATE BANKING

FUNDED SERVICES Lending /Advances CB-CHPP07

Business of Lending/Advances
Banking is the acceptance for the purpose of lending or investment, of deposits from public, repayable on demand or otherwise, and withdrawal by cheque, draft, order or otherwise. Banking is accepting deposits to lend. Lending money can be profitable but is risky. As return on loans is usually better than the return banks receive on investments, a large portion of the deposits of a bank is given out as advances or loans to its customers. Credit risk is the risk of repayment and adversely affect earnings and capital. Credit risk applies to loans, derivatives, foreign exchange transactions, the investment portfolio and other financial activities. There is increasing competition in lending, due to expectation of high returns, also from non-bank financial firms.

Schedule Commercial Banks Portfolio

% share by credit-type
Credit Type Annual Average FY 1991-2001 For Year Annual Average FY 2002-2008 Yr. 2007-2008

Cash Credit
Overdraft Demand Loan Medium Term Loan Long Term Loan Inland Bills Others

35.07%
7.33% 8.99% 8.16% 22.13% 6.18% 12.14%

21.03%
5.25% 10.80% 12.00% 40.20% 2.98% 7.74%

16.80%
4.87% 10.06% 15.85% 44.40% 2.25% 5.77%

Corporate Credit Deleveraging

Heightened concern about default/delay by trade debtors and inordinately high cash discount rates bolster strong preference for B2B transactions and shorter credit period in recent years. These contributed to reduced level working capital requirement of corporate from banks, resulting into under utilization of bank credit. Further, the gap in level of credit limit utilization vis--vis credit limit available in respect of credit limits of Rs. 25 crores have widened considerably in recent years. There are structural changes of systemic importance in the fund flow matrix of large companies. Deposits/advances from customers and security/trade/dealer deposits have increased by 14.9 times and 8.2 times respectively, despite lower increase of 3.9 times in inventories. Small business liquidity is further strained as their purchases from large corporate are generally on cash/advance payment basis, where as their sales are generally on credit.

Ways to make Loans

Seven ways are:

Solicit Loans Buying Loans Commitments Customer -request Loan Loan Brokers Overdrafts Refinancing Collecting Loans

Principal Lending Activities

The principal lending activities include loans and leases. The types of loans are classified as; Line of Credit Revolving Loan Term Loan Bridge Loan Asset-Based Lending

Characteristics of Good Collateral (a secondary source of repayment) Durability, Identification, Marketability, Stability of value & Standardization determine the suitability for use as collateral.
Types of Collateral Accounts receivable (* Pledging * Factoring * Bankers acceptance) Inventory -Marketable Securities Real Property & Equipment -Guarantees

Lending Process
Evaluating a Loan request involves 6 Cs of credit:-

Character Capacity Capital Collateral Conditions Apply to borrower Compliance Applies to lender

Case relating to Compliance

A bank made a one-year $800,000 first mortgage loan to Panamanian corporation. The loan was collateralized with a $1.1 million home owned by the corporation. After the loan was made, the Government seized the property, on basis of a investigation discovery that the Corporation was owned by a drug trafficker, claiming that there is all probability that the house was purchased with the proceeds from illegal drug sales. Under Federal Laws, property that has been purchased with laundered money is subject to government seizure and forfeiture, even if it is collateral to a bank loan. In a reference to judiciary, the court ruled that that the bank was willfully blind to a number of obvious facts that should have been taken into account in making the loan. Sole asset of the corporation was the property, which was vacant and up for sale. Purpose of loan and how it was going to be repaid are not known. Bank lost the amount along with attorney fees.

Structuring
Loans that are made are either: # Secured # Unsecured # Partly Secured All commercial Loans have following elements: a) b) c) d) e) f) The type of credit facility and amount to be borrowed The term of the loan The method and timing of repayment Interest rates (fixed/floating) and fees Collateral if required Covenants or promises

Pricing
One key element in the process of commercial lending is loan pricing. There are nominal interest rates the interest rate that is stated in loan agreement. effective yield which takes into account the payment accrual basis and the payment frequency basis. Loan Pricing: When profit margins are wafer thin, precise estimates of cost are necessary to price loans correctly, taking into account risk, costs and returns. Return on net funds employed: Marginal cost of funds + Profit Goal = (Loan income Loan expense) / Net Bank Funds employed Required rate of return: Weighted average cost of capital of new funds = cost of interest bearing liabilities (1--corporate tax rate)x ratio of liabilities to assets + cost of equity (1ratio of liabilities to assets) Marginal cost of funds is the rate of return required by debt and equity investors on newly issued funds. Marginal cost of capital is WACC.

Profit Goal
The cost of capital takes into account the average risk of bank. The profit goal must consider the specific risk of each loan. Liquidity, measured in terms of years, must also be considered when evaluating the profit goal. Profit goal increases with the risk and the maturity of the loan. Loan Expense includes all direct and indirect costs associated with making, servicing, and collecting loan.(using cost accounting data) Net Bank Funds Employed is the average amount of the loan over its life, less funds provided by the borrower, net of Central Bank Reserve System reserve requirements. Relationship Pricing Under this, the rate charged on a loan may differ from rate indicated by loan pricing model, since the projected cash flow from each service, including loan, should be adjusted to take risks into account. Minimum Spread Some banks price loans by deterring the minimum spread they will accept between their lending rate and their cost plus profit margin.

Other Pricings
Average cost versus Marginal Cost The costs include the cost of funds and operating costs. As regards cost of funds, bank has to decide whether to use average cost of funds or marginal cost of funds. These two costs appear same but not necessarily. When market rates of interest are rising, the bank is better off using the marginal cost of funds, because it is higher than average cost of funds. When market rates of interest are falling, it is better using average cost of funds, which is higher than the marginal cost. If the bank views of the deposits as a pool of funds used to finance loans, the marginal cost of funds including cost of equity should be considered. * Performance Pricing: The price of the loan reflects the riskiness of the borrower. The price can be tied to specific financial ratios, the amount of the loan outstanding or other criteria.

Charge
It is a legal right on the assets that have been given by borrower as security for a loan/advance/facility. Kinds of Charge are: 1. Lien - a right to retain property pledged till payment is made. Banks also obtain a negative lien. 2. Pledge- bailment of goods (movable property) as security for payment of a debt or performance of a promise. Ownership continues with pledger. 3. Hypothecation is a charge against movable property for an amount of debt where neither ownership nor possession is passed on to creditor. Borrower executes a Letter of Hypothecation 4. Mortgage When a customer offers immovable property like land and building as security for a loan charge thereon is created by means of a mortgage. Ownership is not transferred. Types of mortgages are: Simple Mortgage, Mortgage by conditional sale , Usufructuary mortgage, English Mortgage, By deposit of title deeds or equitable mortgage, Anomalous mortgage, sub-mortgage.

Charge-2
Assignment transfer of a right, property or debt present or future. Borrowers normally assign [Book-debts ; Money due from Government or [semi-government organizations. Types of Assignments are: Legal or Equitable Trust Receipt Customer holds goods (separately) in trust for the bank. Charge is classified as {First Charge, Second Charge, {Pari-passu and Floating charge

Factors to be checked by banker while taking charge are: Ready conversion Return or Yield No Encumbrance Margin Stable Price Valuation Safety Other aspects

Funded Facilities/Services
Funded exposure relates to instances where bank actually lends money to purchase a factory, to purchase stocks/inventory, to provide working capital requirements, to buy a house, to augment infrastructure, etc. Funded facilities include: # Cash Credit & Packing Credit (Working capital finance) #Overdraft # Demand Loan # Term Loan # Inland/Foreign Bills purchase/discount # Export/Import credit # Other credit-type Non-funded services refer to facilities extended where no actual money is disbursed. They include: Guarantees Letters of Credit Foreign exchange facilities

Stipulations of RBI
There are certain stipulations of the Reserve Bank of India regarding lending, in respect of following: 1. 2. 3. 4. 5. Priority sector lending Export Credit Exposure norms Restrictions on advances Income recognition

These are extremely important for a banker.

Cash Credit
Finance given to purchase goods/manufacture goods for sale and finance debtors is known as cash credit. Banker fixes the cash credit limit after taking into account several features of working of borrowing concern such as: Production -- Sales -- Inventory -- past utilization etc. The limits are sanctioned on a year-to-year basis and reviewed periodically. Drawing power against inventory/ debtors, which are current , is fixed and customer is expected to finance remaining amount. There are three methods used. MPBF method --- Tandon Committee --- with three alternatives. Turnover method Nayak Committee recommendations. Client prepares a projected cash budget and bank assesses quantum of working capital required and monitors disbursements. Kannan Committee recommended this method for W.C. up to Rs.5 Crores

Cash Credit -2
Drawing Power : In order to ensure that clients have adequate finance, but not more than they need, banks call for statements periodically, giving position of stocks and debtors, on basis of which drawing power is arrived at, after providing for the stipulated margin. Interest is charged on actual amount utilized by the customer. The loan is technically repayable on demand and there is therefore no defined date of payment. Raneegunj Coal Association and another vs Union Bank of India and others. In this case, Supreme Court has described Cash Credit as Cash Credit is a drawing account against credit granted by a bank and is operated in exactly the same way as a current account on which an overdraft has been sanctioned. Since it is in the nature of a current account, no interest is payable in this account Such accounts are opened only by traders, industrial units and other business units.

Cash Credit -3
Hypothecation: As cash credit is financed against stocks and debtors, these are usually hypothecated to the bank. If the customer defaults, the bank can seize the assets hypothecated and sell them to third parties to realize the amounts due. The margin stipulated becomes cushion in case the bank does not realize real value due to distress sale. Commitment charge: This existed for two purposes: to encourage proper management of funds by banks and bring about better discipline in availing finance by borrowers. W.e.f. 01-07-1996, RBI has advised banks to evolve their own guidelines to ensure credit discipline. Levying of a commitment charge now depends on the individual banks. There are both Advantages & Disadvantages in extending/availing this facility.

Overdrafts
When a financial accommodation is extended to a customer and he is allowed to withdraw more than the balance in his current account, resulting in indebtedness to bank, such indebtedness or advance is known as Overdraft. Overdraft can be temporary or a regular arrangement and can be secured or unsecured. Customer is required to pay interest only on the amount actually overdrawn in the account and they are running accounts like cash-credit. Overdrafts are repayable on demand. Bank of Maharashtra vs. M/s United Construction Co. and others: Bombay High Court concluded in this case that there is an implied agreement by stating where a customer is having a current account in a bank, even without any express grant of overdraft facility, overdraws on his account and the cheques issued by him are honoured, without there being sufficient balance in the account, the transaction amounts to loan and the customer is bound to make good the loan to bank with reasonable interest.

Overdraft- 2
Indian Overseas Bank, Madras and Another vs. M/s Naranprasad Govindlal Patel It was held in this case that an overdraft arrangement between bank and its customer, although called facility, is nothing but a contract and cannot be terminated by the bank unilaterally even though it is temporary one. The court held that bank is liable for damages. Any cheque issued prior to receipt of information from bank must be honored. Interest Interest is charged on the amount overdrawn for the period overdraft exists. Interest is charged monthly. Bank can charge compound interest at a monthly rate on overdraft amount, even without an agreement. Security An overdraft facility is sanctioned against paper securities.( shares, l.I.C.policies, bonds and other government securities), whereas cash credit is sanctioned against stocks and debtors. Overdrafts may be Secured and Unsecured.

LOANS
For a specific period For a definite purpose Loans are advances Repayable in installments or balloon payments

purchase of premises, capital assets, setting expansion of factory etc.

Operating costs low

no cheque book issued Not a running account no debits allowed except interest, charges, insurance premium etc.
Interest charged on actual balance

Types of Loans
Loans can be classified as: Short Term Loan #Loans for a period of less than a year to meet working capital needs against tangible security goods, shares etc. Medium and Long Term Loan #For a period in excess of one year extended for purchase of capital goods/ for capital expenditure secured by asset purchased large amounts financed jointly with other financial institutions. Bridge Loan #Short term loans sanctioned to bridge cash flows granted to industrial undertakings to meet urgent & essential needs RBI stipulates certain conditions for these loans. Composite Loan #Granted for buying both for capital assets and for working capital purposes usually granted to small borrowers Consumption Loan #provided for personal needs such as medical expenses, marriage expenses, education loans, car loans, professional loans etc and also for consumer durable goods. Demand Loan #repayable on demand banks own time deposits, NSCs, and other securities. Bank has a right to recall loan any time and in case of default can dispose of securities pledged.

Other aspects of Loans

Interest: Interest is charged at monthly rests. Term Loans and working capital advances are to be clubbed to determine size of Loan and rate of interest. BPLR (benchmark prime lending rate) is determined by Actual cost of funds, Operating expenses & Minimum margin for provision/capital charge and profit margin. Banks are free to charge a rate of interest based on customers credit worthiness and BPLR, except in cases of loans up to Rs.2 lakhs (BPLR) and on export credit (not exceeding BPLR minus 2.5%). Advantages:- Periodical installments payable on Loans and yearly review of advance ensures a discipline on borrower, Easy to manage and documentation is comprehensive. Disadvantage:- Bank has no control on end use of Loans.

RBI notification on 15-11-2010

Banks are required to disclose all in cost involved in processing/sanction of loan application in a transparent manner. With a view to bring in fairness and transparency, banks have been told to disclose to borrowers all information about Fees/charges payable for processing the loan application The amount of fees refundable if loan amount is not sanctioned/disbursed Pre-payment options and charges, if any Penalty for delayed repayments, if any Conversion charges for switching loan from fixed to floating rates and vice-versa Existence of any interest reset clause and any other matter which affects the interest of the borrower. All information relating to processing fees/charges should also be displayed in the Web site of the Banks for all categories of LOANS.

Bill Discounting
This type of advances (discounting bills of exchange) are short-term and self liquidating by nature. A bill of exchange is: an instrument in writing containing an unconditional order, signed by the maker directing a certain person to pay a certain sum of money to or to the order of certain persons or to bearer of the instrument. Buyer gets some time to make payment. Seller can, if he requires, have bill discounted and obtain cash. Bank or any one who discounts the bill gets good title provided he discounts /buys the bill in good faith, for consideration and without being aware of any defect in the title of the person from whom the bill was purchased.

Types of Bills of Exchange Sight or Demand Bills Usance Bills

Classification of B. E. Documentary Bills Clean Bills

Purchase/discounting of Bills
When a seller (creditor) of the goods draws a bill on the buyer (debtor), the banker can purchase/discount the bill at the request of the drawer and lend its own funds before realization of the bill. Banker credits the account with the amount of the bill after deducting its charges or discount. In case of demand bills, that are payable on demand (presentation), discounting is known as purchase of bills. In case of usance bills (bill that matures after a specified period of time), where the banker has to hold the bill, after acceptance, until due date, the practice of funding is called discounting of the bill. The discount includes interest on the amount lent in addition to other charges/expenses. Bankers Position Keshari Chand vs. Shillong Banking Corporation Supreme Court held in the above case that: Under collection arrangement, the banker is bound to act according to directions given by the customer, since he acts as his agent. In absence of such directions, banker is bound to use reasonable skill and diligence in his work and acts in accordance with usage prevailing at the place of business.

Discounting of bills and advantages

Dena Bank vs. M.P. National Textiles Corporation Ltd. Madhya Pradesh High Court held in this case that: In case of the bills and the relevant documents purchased or discounted by banker, it is the responsibility of the bank to collect the amount of bills from the drawee and to reimburse itself. If payment is refused by the drawee banker can present the documents back to the drawer and collect the value thereof. Advantages of discounting of bills: Safety of funds of the bank bill being a negotiable legal instrument considered good. Certainty of Payment ideal self liquidating asset, i.e. semi-liquid assets. Facility of refinance In case of need for funds, bill can be discounted with Central Bank or any other bank. Stability in value Amount payable on bill is fixed and does not fluctuate in value like other tangible assets. Profitability Earns discounting interest and exchange/fees for transaction. Accommodation Bills: Not to be discounted, as there is no consideration.

Priority Sector Advances

The different segments of priority sectors are: Agriculture (direct and Indirect finance) :- Finance for agriculture and allied activities for short, medium or long term, directly to individual farmers, SHGs, JLGs, or to others (corporate, partnership firms or institutions.) Indirect finance for agricultural machinery, implements or for construction of cold storage, warehouse, tractors, well boring equipment etc. Small Enterprises (Direct & Indirect Finance) :- Finance to small enterprises i.e. loans to micro and small enterprises engaged in manufacture/production, processing or preservation and rendering of services. These include small road & water transport operators, small business, professional and self-employed persons etc. Indirect finance to any person providing inputs to or marketing the output of artisans etc.

Priority Sector Advances-2

Retail Trade: Traders dealing in essential commodities, and consumer co-operative stores. Micro Credit:-Lending small amounts, not exceeding Rs 50,000 per borrower either directly or indirectly, constitute micro credit. Education Loans: Granted for studies in India up to 10 lakhs and up to 20 lakhs for studies abroad. Housing Loans: Loans up to Rs 20 laks for a dwelling (purchase/ construction) and for repairs up to Rs 1 lakh in rural and semi urban areas and Rs.2 lakhs ( urban and metropolitan areas) Export Finance is not treated as priority sector, in case of Indian Banks.

Priority Sector Advances-3

Others: (i) Investments in securitized assets, representing loans to various categories of priority sector, (ii) Outright purchases of any loan asset eligible to be categorized under priority sector and (iii) Investments by banks in Inter Bank Participation Certificates, on a risk sharing basis, if underlying assets are eligible under priority sector are eligible to be classified under priority sector. * ANBC: Targets and sub-targets under priority sector are linked to Adjusted Net Bank Credit, which is arrived at as under: (a) Net Bank Credit plus Investments made by banks in non-SLR bonds held in held-to-maturity (HTM) category or (b) Credit equivalent amount of Off-Balance Sheet Exposures (OBE) which ever is higher as on March 31 of the previous year.

Priority Sector Advances-4

Targets fixed for all scheduled commercial banks, excluding foreign banks, in lending to priority sector is 40% of ANBC, with sub-targets as under: 18% of ANBC goes to agricultural of which indirect category not to exceed 4.5%. 10% of ANBC goes to weaker sections (or 25% of priority sector advances) 1% of previous years total advances are to given under DRI scheme (differential rate of interest) with sub-limit that 40% of DRI amount goes to SC/ST categories and 66- 2/3% through rural and semi-urban branches. 40% of total credit to SSI goes to cottage industries, tiny industries, artisans etc. with investment in plant & machinery not exceeding Rs.5 lakhs. 20% of SSI credit goes to SSI units with investment between Rs.5 lakhs to Rs. 25 lakhs. Remaining 40% goes to SSI units with investment exceeding Rs.25 lakhs. Targets for Foreign Banks is 32% of ANBC or credit equivalent of Off balance sheet exposure, whichever is higher. Advances to SSI should not be less than 10% of ANBC. and to Export Credit should not be less than 12% of ANBC.

Export Credit
Advances are made by banks both as pre-shipment export credit and post shipment export credit. These advances can be either in rupees or in foreign currency.

Export credit-2
Pre-shipment/packing credit means any loan or advance granted or any other credit provided by a bank to any exporter -- for financing the purchase, processing, manufacturing or packing of goods prior to shipment -- for working capital expenses towards rendering of services on the basis of L/C opened in his favour or some other person by an overseas buyer or on basis of confirmed and irrevocable order for export of goods/services. Post-shipment credit means any loan or advances granted or any other credit provided by a bank to an exporter of goods/services, after shipment of goods/services to date of realization of export proceeds and includes any loan or advance granted to exporter in consideration of or on security of any Duty Drawback allowed by the Government from time to time.

Rupee Export Credit

Pre-shipment Credit/ Packing Credit Period of Advance -- The period should be sufficient to enable the exporter to ship the goods/render the services. -- If pre-shipment advance is not adjusted by submission of export documents within 360 days from date of advance, concessional rate of interest will cease ab initio. -- RBI would provide refinance only for a period not exceeding 180 days Disbursement -- A separate account is maintained to monitor period of sanction and end-use of funds. -- Funds are disbursed in one lump sum or in stages depending upon need and as per contract or L.C -- Banks may maintain different accounts at various stages. Banks should ensure that accounts are adjusted by transfer of funds from one account to other until exported. End-use should be for exports.

Pre-shipment Credit/ Packing Credit

Liquidation of Packing Credit The advance should be liquidated out of the proceeds of export bills of the product/services by purchase or discount. It can also be repaid/prepaid out of balances in EEFC account or from rupee resources of exporter to extent exports have actually taken place. If not so liquidated/repaid banks are free to decide the rate of interest. Value difference:If export bills are not of equivalent value for liquidating Packing Credit, excess packing credit can be adjusted by export of those bye-products. When larger quantity of raw materials (agro) are purchased for manufacture non-exportable produce can be sold locally. However, banks will charge commercial rate of interest on the shortfall. No refinance will be available from RBI. Banks can grant Packing Credit advance to exporters to extent of value of raw materials required, even if it exceeds value of export order. Excess is to be adjusted in 30 days, to become eligible for concession rate of interest.

Running account facility

Packing Credits are generally granted against L.Cs or firm export orders. In anticipation of receipt of LCs or firm export orders, banks have been authorised to extend pre-shipment credit running account facility in respect of any commodity. However, Running account facility should not be granted to granted Proceeds of cheques, drafts etc, representing advance payment for exports can also be utilized. Banks can extend credit to manufacturers of specific sectors/segments, who do not have any L.Cs/export orders, if goods are exported through STC/MMTC or other export houses. P.C. can be shared between Export Order Holder and sub-supplier of raw materials etc as in case of EOH and manufacturer supplier. P.Cs. May be given to construction contractors to meet initial working capital requirements, to meet preliminary expenses. Pre-shipment credit facilities are also granted against consultancy agreements for meeting expenses.

Pre-shipment & Post-shipment Export Credit

Both the types of finances can be provided to Exporters of IT service and software. Pre-shipment credit can be extended to floriculture, grapes and other agrobased products, subject to satisfying that they are export related and are not covered by NABARD. Export credit can also be given to processors/exporters-agri-export zones. Post-shipment Export Credit: Post-shipment advance can mainly take the form of : 1) Export bills purchased/discounted/negotiated 2) Advances against bills for collection 3) Advances against duty drawback receivable from Government. Liquidation of export credit is by i) proceeds of export bills received from abroad and ii) repaid or pre-paid out of balances in Exchange Earners Foreign Currency Account as also from other bills sent on collection basis. Such adjusted export bills should continue to be followed for realization of export proceeds.

Post-shipment Export Credit:

Period: Demand Bills period of advance shall be Normal Transit Period as specified by FEDAI. Usance Bills maximum duration of 180 days from date of shipment. Advances against undrawn balances on export bills maximum period of 90 days Other export finances: Advances against retention money Export on consignment basis Export of precious and semi-precious stones Consignment exports to East European Countries and Russian Federation Exports through ware-house-cum-display centres Export of goods for exhibition and sale Credit on differed payment terms and Advances against duty drawback.

Other Matters
ECGC post-shipment guarantee scheme Deemed Exports Gold Card Scheme Interest: A ceiling has been prescribed for rupee export credit linked to BPLRs and banks decide actual rates within this ceiling. In case of ECNOS, banks can decide rate of interest keeping in view BPLR and spread guidelines. Banks should charge interest on pre-shipment credit up to 270 days on basis of ceiling rate arrived at on basis of BPLR relevant for export credit. Advances cease to qualify for concession rate beyond 360 days. Export bills & Overdue Bills