Credit Appraisal and Non-Performing Assets
*Dr.P.Shanmukha Rao **Dr.N.V.S.Suryanarayana
Granting of advances is the primary function of a bank. A significant portion of its funds is employed for this purpose and this is also the main source of bank’s income. Nonetheless, lending funds is not with out risk and, therefore a banker should take correct precaution in this respect is discussed below.
Various forms of advances:
The advances can broadly be classified into categories. (i) Loans, cash credits and overdraft
(ii) Bills discounted and purchased.
Loans:
A loan is kind of advances made with or without security. In the case of loan the bank makes a lump sum payment to the borrower or credit his deposit with the money advanced. It is given for a fixed period at an agreed rate of interest. Repayment may possibly be made in installment or at the expire of particular period. The customer has to pay interest on the total quantity as advanced. A loan once repaid in full or in part cannot be drawn again by the borrower unless the banker sanctions a fresh loan.
The rate of interest charged by a bank in the case of loan is normally lower than in the case of cash credit and overdraft on account of the following reasons:
Ø It entails lower price of maintenance on account of not frequent operation of the account.
Ø The bank gets interest on the total quantity sanctioned whether or not the customer withdraws the entire cash or not.
Loan may possibly be a term loan or a demand loan. Term loan’s payment is spread over a lengthy period. It includes a medium term loan and long-term loans. Demand loan is payable on demand. Thus it is for short period.
Advantages of Loan system:
1. Observation of the financial discipline by the borrower.
2. Periodic review of Loan account.
three. Straightforward and profitable.
Limitations of the Loan system:
1. Inflexibility.
2. Far more formalities.
3. Frequent Renewals.
Cash credit:
A cash credit is an arrangement by which a banker allows his customer to barrow money up to a specific limit. Cash credit arrangement are normally made against the security of commodities Hypothecated or pledged with the bank.
Hypothecation:
In the case of hypothecation, possession of goods is not given to the bank. The goods remain at the disposal and in the go down of the borrower. The bank is given access to goods whenever it so desires. The borrower furnishes periodically return of stock with him to the bank. Such as advances are by the bank only to a individual in whose integrity it has full confidence.
Pledge:
In the case of the pledge, the goods are placed in custody of the bank with its name on the go down where they are stored. The borrower has no right to deal with them. Customer favors hypothecation to pledge since the latter is considered to lower his prestige.
Overdrafts:
The customer may be allowed to overdraw his present account, with or with out security if he demands temporary accommodation. This arrangement, like the Cash credit, is advantageous from the customer’s point of view as he is needed to pay interest on the actual quantity utilized by him. A cash credit differ from the overdraft in the that the former is used for long terms by commercial, Industrial concerns performing regular company, whilst the latter is supposed to be a form of bank credit to be made use of occasionally and for shorter durations.
Bills discounted and bought:
The bank also gives advances to their customers by discounting their bills. The net quantity after deducting the amount of discount is credited to the account of the customer. The bank may discount the bills with or without security from the debtor in addition to the personal security of one or more parsons already liable on the bill.
Secured & Unsecured Advances:
Secured Advances: 1. An advance made on the security of tangible assets like goods, building, stock-exchange securities etc., and 2. The market value of such security should not be less than the amount of loan at any time till the loan is repaid.
Unsecured Advances: An unsecured loan or advance means a loan or advance not so security.
In case of a secured loan, charge is created in favor of the bank in respect of certain properties. In case of unsecured loan usually the banks obtain the guarantee of one or much more parties in addition to personal security of the debtor. Bank grants unsecured loans with out any guarantee i.e., clean advances to parties enjoying high reputation and sound financial position. By way of both in case of secured and unsecured advances, the bank emphasis on credit worthiness of the borrower but in case of unsecured advances this is all the more. The bank must carefully examine the 3 C’s i.e, Character, Capacity & Capital.
Interest terms:
The banks were not totally free to fix their rates of interest. They were determined by the Reserve Bank of India. As a matter of reality the bank lending rates had been “Over the Bank Rate” (OBR). In all banking documentation, the rate of interest of interest was quoted a linkage to OBR. Nevertheless, as a result of deregulation of interest rates, the banks are now allowed to fix their own interest structure. After RBI fixes the floor rate, the bank fixes their Prime Lending Rate. PLR is the minimum rate at which the bank would be ready to lend to very first class and A-rated borrowers.
Interest Variation Clause in loan agreement:
The interest on advances is charged by bankers as per the schedule of interest rates prescribed by the Reserve Bank of India from time to time the rates of interest are subject to change. In order to overcome the difficulty experienced by the banks in implementing such interests, the banker usually gets the following provision inserted in the loan agreements as regards interest rates:
Provided that the interest payable by the borrower shall be subject to the interest rates made by Reserve Bank of India from time to time.
The effect of such clause is that whenever the RBI revises the interest rates they are automatically applicable.
No diversion of loan funds:
The borrower not to use the loan funds for the purposes other than those for which they had been sanctioned. This clause, thus, gives right to the banker to recall the advances in case it apprehends that the borrower has violated or is violating this condition.
Recalling of Advances:
Recalling of advances sanctioned is the remedy of last resort. This might be performed by a bank under the following circumstances:
If the borrower fails to renew the documents sufficiently just before the expiry of period of limitation expires. The barrower/guarantor ought to renew the document acknowledging the debt before the expiry of the limitation period in respect of the concerned document.
If there is a material deterioration in the value of the security or the quantum of turnover.
If the barrower fails to maintain adequate margin with the bank in spite of persistent requests.
If the borrower refused to lodge with the banker additional security to cover the amount withdrawn in excess of the limit.
If the borrower is guilty of misconduct or fraud causing serious damage to his credibility.
If there is a change in the policy of bank, Reserve Bank of Government making required the recalling of advance.
Term loans:
Term loans are also known as term/ project financial the primary sources of such loans are financial institutions. Commercial banks also supply term finance in a limited way. The financial institutions supply term finance in limited way. The financial institutions offer project finance for new projects as also for expansion /diversification and modernization where as the bulk of term loans extended by banks is in the form of working capital term loan to finance the working capital gap. Via they are permitted to finance infrastructure projects on a lengthy-term basis, the quantum of such financing is marginal.
Features of term loans:
Maturity: The maturity period of term loans is generally longer in case of sanctions by financial institutions in the range of 6-10 years in comparisons to three-5 years of bank advances. Even so, they are rescheduled to allow corporate/borrowers tide over temporary financial exigencies.
Negotiated: The term loans negotiated loans between the borrowers and the lenders. They are kin to private placement of debentures in contrast to their public offering to investors.
Security: All term loans are secured. Whilst the assets financed by term loans serve as primary security, all the other present and as well as future immovable properties of the borrower constituted a general mortgage, interest liquidated damages and so on. They are additionally secured by hypothitication of all movable properties subject to prior change in favor of banks in respect of working capital advances.
Covenants:
To protect their interest, the financial institution reinforce the asset security stipulation with a number of restrict terms and conditions. These are known as Convents. They are both positive /affirmative and negative
Negative Covenants In the sense of what the borrower need to not in the conduct of its operations and fall broadly into four sets as respectively related to assets liabilities, cash flows and control.
Assets-Related Covenants are intend to make certain the maintenance of a minimum asset base by the borrowers. Included in this set of covenants are:
Ø Maintenance of working capital position in terms of minimum current ratio.
Ø Restriction on creation of further charge on asset.
Ø Ban on sale of fixed assets with out the lenders concurrence/approval.
Ø Cash flow Related Covenants Which are intended to restrain money outflows of the borrowers, could consist of:
Ø Restrictions on new projects/expansions with out prior approval of the financial institution
Ø Limited on dividend payment particular quantity and prior approval of the financial institutions for declaration of higher quantity
Ø Arrangement to bring additional funds as unsecured loans/deposits to meet overrun/shortfall
Ø Ceiling of managerial salary and perks.
Positive covenants:
In addition to the foregoing covenants, certain positive covenants beginning what the borrowing firm need to do throughout the term of a loan included in a loan agreement. They offer, inter alia, for
1) Furnishing of periodical financial statements.
2) Maintenance of a minimum level of working Capital.
three) Creation of sinking fund for redemption of debt.
4) Maintenance of particular net worth.
Repayment Schedule / Loan Amortization:
The term loan has to be amortized according to predetermined schedule. The payment/ repayment has two components:
(i) Interest
(ii) (ii) Repayment of principal.
The interest components of loan amortization are a legally enforceable by contractual obligation. The barrower has to pay a commitment charge on the utilization amount. The interest on term loans by the financial institutions, subject to minimum prime lending rate, is risk-related and varies with the credit risk of the borrower.
Typically, the principal is repayable over 6-10 years period after an initial grace period of 1-2 years. Where as the mode of payment of term loans is equal semi-annual installments in case of institutional borrowings, the term loans from banks are repayable in equal quarterly installments. With this type of loan amortization pattern, the total debt-servicing burden declines over time, the interest burden declining and principal repayment remaining constant. In other words, widespread practice to amortize loan is repayable in equal installments and payment of interest on the unpaid loans.
Essential Considerations
Whilst lending dollars the banker has to take into account various consideration. These considerations relate to the bank itself, the borrower, and the proposal.
Parameters for the bank:
The bank while advancing dollars need to look to its position regarding liquidity, safety and profitability.
(i) Liquidity: since banks themselves heavily depend on borrowed funds, they spread their investments in such a way that they are in a position to acquire cash with in a short period of time. Their borrowings also come from deposits, which are generally not for a long period. The banks, as a result, prefer granting of short-term loans to their clients.
(ii) Safety: The capacity of the banker to repay to its deposits depends upon its borrower’s repaying capacity. The banker has, for that reason, to see the safety of the advances made by it.
(iii) Profitability: The banker earns its profits by means of advances and, therefore it can not ignore the considerations of profitability although making advances. Nevertheless, the bank cannot ignore the other two aspects too it has to see that the funds remain fairly liquid, safe and give a reasonable return. In order to have a correct balance, the bank keeps in its investments portfolio three sorts of investments: liquid, semi liquid, and income earning investments. It has to maintain them in optimum proportions.
Customer credibility:
The banker while choosing his borrower should have clear appraisal about the three C’s: Character, Capacity& Capital
Character:
Character denotes integrity of the borrower i.e., he ought to have willingness to repay the dollars borrowed.
Capacity:
Capacity denotes his ability to manage his organization. The bank can judge it on the basis of education background and the experience of the entrepreneur.
Capital:
Capital denotes his financial soundness. The borrower need to have his own funds also. No banker will take to lend money to a person who does not put dollars from his own resources. However the banker ought to see that he does not lack any of them in a significant way.
Evaluation of proposal:
The bank need to look to the following aspects regarding the proposal.
Purpose:
The purpose for which the money is being borrowed is gaining a lot more significance on account of increasing realization on the component of the banks about their social responsibility. The project, which will aid rural upliftment, import substitutions or equitable distribution of income, has to be preferred in comparison to other projects. Similarly loan for productive purposes ought to be given in priority to loan for unproductive purposes, such as for marriage or other religious ceremonies.
Security:
Security is now considered to be a secondary consideration although advancing loans. Nonetheless these aspects can not be entirely over looked since it is a safeguard for unexpected defaults in repayments by the borrower.
Sources of repayment:
The banker has also to see regardless of whether the project for which it is advancing loan will generate essential money to repay the loan and the interest as per the agreed program.
Term:
The term or the period for which the loan is required is also critical banks cannot afford to lockup their funds for lengthy periods. They, as a result, prefer granting of short-term loans to lengthy-term loans.
Factor Limiting The Level of Advances
(i) The kind of deposits.
(ii) Credit control by Reserve Bank of India.
(ii) Seasonal variations
(iii) General enterprise conditions.