Principles & Practice of Sound Lending

A. Decision Making

Appraisal of a proposal is basically a decision-making exercise. It is choosing one amongst the available possibilities. It is a brainy activity as one has to separate Grain out of Chaff.

Decision making is a function of Information, Intuition & Application thereof. D= f (I, I, A).

Information is gathered from various sources like Application or Project Report submitted by the borrower, Trade/ Industrial Associations, Suppliers, Buyers, competitors, several sites like- ICAI/ Income Tax/ GST, CERSAI etc., Rating Agencies, Market, Other Banks, FIs, Google etc.

Intuition: It is the experience which our brain has recorded from the past Data, Circumstances, Situations we had faced.                 

It is the perception one has derived out of past experiences.                                                                                          

It is the Gut feeling that one develops after years of experience.

Application of these two aspects of Information & Intuition is decision making.   

Of course, those are applied after weighing Pros and Cons of various situations.

Remember the past experiences of self & others (seniors) are extremely useful.    

“Decision making is an ART & SCIENCE which one has to develop by applying the above tricks of the Trade”.

B. Concept of Credit

It is believed that the word ‘Credit’ has been derived from the Latin word ‘Credo’ which means “I believe in you'' or ‘I have trust in you’. In other words Credit means a trust or confidence reposed in another person. The concept of credit can be put forth in different words. It is the ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future.

Whereas the commonly accepted definition in terms of commercial transaction or commercial credit is, “An agreement based largely on trust under which goods, services, or money is exchanged against a promise to pay later,” and is also called commercial credit.

In terms of Double entry Book keeping, “It is an entry on the right-hand side of an account record in & It has the effect of decreasing an asset or expense account, or of increasing a capital, liability, or revenue account.”

However, we are concerned with commercial definition that ‘Credit is a contractual agreement in which a borrower receives something of value now and agrees to repay the Creditor or Lender at some future date along with interest & charges’.

Some of the well-known definitions of credit are:-

1. Prof. Cole: “Credit is purchasing power not derived from income but created by financial institutions either as an offset to idle income held by depositors in the bank or as a net addition to the total amount or purchasing power.”

2. Prof. Kinley: “By credit, we mean the power which one person has to induce another to put economic goods at his disposal for a time on promise or future payment. Credit is thus an attribute of power of the borrower.” 

3. Prof. Thomas: “The term credit is now applied to that belief in a mean’s probability and solvency which will permit of his being entrusted with something of value belonging to another whether that something consists, of money, goods, services or even credit itself as and when one may entrust the use of his good name and reputation.”

4. Prof. Gide: “It is an exchange which is complete after the expiry of a certain period of time”.

 5. Shri Vasant Desai: “To give or allow the use of temporarily on the condition that some or its equivalent will be returned.”

The sum & substance after taking into consideration all the above definitions the synonym for Credit is Trust. 

Importance & Characteristics of Credit:      

Credit is the life blood of the modern economy. Credit fuels economic activity by allowing businesses to invest beyond their cash on hand, households to purchase homes without saving the entire cost in advance, and governments to smooth out their spending by mitigating the cyclical pattern of tax revenues and to invest in infrastructure projects. Banks directly provide a substantial amount of credit in any country, but, unlike in almost any other economy, financial markets are the ultimate providers of long term credit. Credit is the driver of growth in any economy.

Credit is needed by all the segments of economy i.e. Business, Industry, Agriculture, transport & House hold etc. for various purposes. The money lent must come back as such while granting Credit the Credit Institutions take into the considerations the following basic aspects of credit.

 1. Confidence: It is the very basis of any credit transaction. The Creditor must have full faith & confidence in the debtor.                                                                                

2. Capacity: It is the ability to repay the borrowed money and needs to be gauged before extending Credit or Loan or an Advance. It is de-facto understanding the future flow of money to be received by the borrower.

3. Security: It is the Insurance to fall back upon in case of emergency. As such it is a very crucial point while taking any credit decision.

4. Credit Worthiness or Goodwill:  It connotes the standing of the borrower in the social & commercial field.  It denotes repaying intentions & abilities reflected in the past.

 5. Volume of credit or size of credit: The volume decides the speed & ease of the dispensation of credit. 

6. Period of credit: Longer the period, longer the time and hence the risk to be taken by the creditor. As such long term credit cannot easily be obtained because more risk elements are involved in its security and repayments.

Different Types of Credit Facilities

There are different ways of classifying the Credit Facilities. From a very broad perspective it includes institutional credits such as  

A] Types of Credit  

1. Bank Credit: It includes the credit facilities generally extended by banks. The main heads are Fund based & others are Non fund-based facilities. The fund based can be facilities like Loans/ Overdrafts/Bills purchased discounted. The common NFB facilities are Bank Guarantees & Letter of credit.                                                                                                                                                                       

 2. Commercial Credit: Loans to business ventures for economic activities carried out with an intention to earn profits. 

3. Industrial Credit: Credit for ventures undertaking manufacturing of goods.  

4. Trade Credit: Ventures undertaking the job of buying Goods / Providing Services for which Payments are to be done after a certain period.

5. Consumer credit:  Debt as “Money, Goods or Services provided to Individuals.

6. Investment Credit: Is the money provided as Tax incentives to enterprises from government authorities on certain investments made by them. This reduces their tax liabilities.                                                                                                  

 7. International Credit: Movement of Loan Capital from one nation to other or from organizations such as World Bank or Asian development bank. The trade between two countries or between an organization in one country to the other nation results in Bilateral Trade or Multilateral Trade.  

8. Public Credit: Is the debt raised by Government and is also known as National Debt, Public-Interest, Sovereign debt. It may be raised by the Central / State Govt. / Provincial, Municipal or Local government through various debt instruments like bonds.         

9. Real Estate/ Lease:  A credit tenant lease is a method of financing Real estate through transfer of property by a lease agreement. Such leases are for a certain period & at the end the lease hold property may vest back to the lease. The lease can be for Plant & Machinery or Vehicles also. 

B] Banks: Banks are one of the largest providers of Credit money. As such it is imperative to understand various Types of Credit as provided by banks.

Bankers traditionally extend the following two types of Credit:  

1. Fund Based Credit: The credit facilities where the bankers place the money in the hands of the borrower or honour cheques or instruments issued by him. 

2. Non Fund Based Credit: Banks accept certain kinds of the liabilities or performances on behalf of his client at a future date on happening or non happening of an event. Thus it is in a way lending his Words. These assurances may or may not be converted into the actual money as such called as NFB credit facilities. The facilities that come under the headings are Bank Guarantees & Letters of Credit. The details are given in the relevant chapter.

Fund Based: Traditional Products 

1. Overdrafts. 2 Cash Credit 3. Short Term Loans/ Demand Loans. 4 Bills Purchased &  Bills Discount facilities. 5 Term Loans

1. Overdraft:  Facility to allow drawl   more than available credit balance in the Current Account.  Generally it is allowed against certain types of the Financial Security such as a Fixed Deposit or a NSC or Shares or an Insurance policy. The account is a revolving type & drawls allowed to the extent of Limit or drawing power (D.P.) allowed against the security. The facility being a revolving type the customer can withdraw from his account when he needs it and to repay it by the means of deposits in account as and when it is convenient. Customers of good standing are allowed this facility even without security to a certain amount. The borrower has to pay the agreed interest on the amount used by him that is called as on daily product basis. 

2. Cash credit: It is a revolving credit facility wherein the underlying security is goods otherwise it is exactly similar to Overdraft facility. It is the most convenient facility extended by the bankers to carry out Trade, Business, Commerce, Industry & even to Agriculture. The facility is against the hypothecation of goods/ book debts & personal security, depending upon the nature of requirement of a borrower. The drawls are permitted by the bank to the extent of sanctioned Limit/ DP based on the value of Stock/Debtors less prescribed margin & other terms and conditions The borrowing limit is allowed to continue for years if there is a good turnover in account as well as goods. In this account deposits and withdrawals may be affected frequently. In India, cash credit is the most popular mode of advance for businesses. 

3. Demand loans: A demand loan is one which is also given against the Financial or Personal Security and has no stated maturity period and may be asked to be paid on demand. Its salient feature is, the entire amount of the sanctioned loan is paid to the debtor at one or few instalments. Interest is charged on the daily debit balance. 

4. Term loans: Generally sanctioned against security of a Fixed Asset. It is an advance for a fixed period repayable generally in instalments spread over a time. The maturity period depends upon the borrower’s future earnings.

5. Bill Purchased: It is financed against the Sales on Credit. The bills for recovery are raised by the Seller on the Buyer. The Bankers furnish Credit against such bills called as the Bills Purchased. The bills are accompanied with documents such as Railway Receipt or a Bill of Lading or a Lorry or Motor Transport Receipt. When such bills are payable on Demand the advance against the Demand Bills is called as Bills Purchased. The bills are presented for payment to the Buyer of goods at the Goods destination Branch. Bankers collect commission & interest for a number of days for which the bill remains outstanding. 

 6. Bill Discounted: Sometimes these bills are Time bills (or in the form of Promissory Notes) i.e. maturing after a certain fixed period say 90 days. These bills are accepted for payment by the Buyer of Goods. Bankers extend the funds by receiving an Accepted Promissory note or Bill payable at a future date and deducting that from the interest on the amount of the instrument. The main feature of this lending is that the interest is received by the banker in advance. This form of lending is more or less a clean advance and banks rely mainly on the creditworthiness of the parties. 

 INNOVATIVE CREDIT PRODUCTS:  TWO GAME CHANGERS

The bankers have to shift their focus area from loans to business activities to the Retail Customers as a fall out of the Liberalization, Privatization & Globalisation. The reasons were multiple: from falling margins, rise in level of Non-Performing Assets, demographic effects, rising GDP, rising numbers & incomes of Neo rich, Higher income & Middle class The second aspect was the Advent of Technology. It was essential for bankers to attune their Products to enable customers to perform banking transactions at their convenience. This has become the order for survival and improving the profitability of banks

Innovative Credit Products

1. Credit Cards:  Alternative to Cash, in fact is Credit/ Plastic Money.
2. Debit Cards: Alternative to Cash & affords Purchasing Power 
3. ATM.
4. Several products based on mobile phones.
5. Online facilities such as NEFT/RTGS etc. Now these products/ facilities have become the drivers of Retail Banking Products.
6. Housing Loans: Variety of products. 
7. Auto Loans. 
8. Personal Loans. 
9. Education Loans – pursuing the higher education.
10. Loans against Securities: Financial/ Gold & Jewellery/ Immovable.
11. Consumption loans for White Goods. 
12. Hybrid Products: Housing with Auto; At Variable rates of Interest 

The speed of reaching the Customer or Customer logging in for online sanction; verifying their own credentials, getting approval & money in Bank account is happening in Microseconds. It is absolutely essential for banks or any other financers to innovate & adapt to technological changes. Thus the need of the hour is that the bank staff should strive continuously to learn & sharpen the new skills such as Credit Management.

Importance of credit to Economy: 

Commercial banks with their abilities to create Credit Money help the entrepreneur/ businessmen/ industrialists & even the common man to acquire assets. This helps in carrying out the wheels of economy & has a great impact on the economic development of the country. Credit enables the business enterprise to acquire goods or services even before payments are made by them. The individuals can also acquire various assets through loans or use money for personal expenses. The basic function of credit provided by banks is to enable an individual and. The great benefit of credit with a bank is very low/ competitive interest rates & ease of doing business.. Majority people feel comfortable with banks because of familiarity with their products.

1. Exchange of ownership: Through Credit a Businessman (debtor) is facilitated to use something which he does not own completely. This way, the debtor is provided with control as distinct from ownership of certain goods and services. 

2. Employment generation: Credit enables people to carry out economic activities increasing the volume of employment.  

3. Increase consumption: Credit increases the consumption of all types of goods. By that, large scale production may stimulate which leads to decreased cost of production which in turn also lowers the price of product which in result rising standard of living.

4. Encourage Savings: Credit gives a boost to the saving habit of the people because of the attraction of interest and dividend from the commercial activities.   

5. Capital formation: Credit helps in capital formation by way that it makes available huge funds from able people to unable people to use some things. Credit makes possible the balanced development of different regions. 

6. Development of entrepreneurs: Credit helps in developing large scale enterprises and corporate business. It has also helped the different entrepreneurs to fight with difficult periods of financial crisis. Credit also helps the ordinary consumers to meet requirements even in the inability of payment. One can borrow money and grow business at a greater return on investment than the interest rates of loan. 

7. Ease of payment: Various credit instruments such as cheques/Drafts/Bills/LCs/BGs people can pay without much difficulty and botheration. Even the international payments have been facilitated very much. 

8. Help to Monetary System: By manipulating the volume & Interest on Credit by the monetary authorities like RBI can provide correct dose of Money in the systeem 

9. Achieving National Goals: Directing credit to particular sectors or geography helps in developing many priority sectors including agriculture. This has an impact on rising agricultural productivity and income of the farmers. Banks in developing countries are helping Nation building by extending credit to MSME/ Export/ Rural & such other sectors called as Priority Sector.

Some Disadvantages of credit:

There are certain disadvantages of Credit also. They are enumerated below 

1. Encourage expenditure:  Credit encourages wasteful expenses by the individuals as well as commercial institutions by overtrading. 

2. Encourage weakness:  Credit encourages entrepreneurs to continue to hide their weakness/shortcomings /inefficiencies/Losses in the hope to survive. NPA Menace 

3. Create Economic crisis:  Easy Money may lead to recession & depression in an economy as the boom of credit facilities has its  evil effect on the economy. Credit expanded beyond certain limits results in over investment, overproduction and rise of prices.           

4. Encourage inefficient: Credit gives encouragement to certain inefficient and worthless producers & may lead to Hoardings.  

5.  Evil of Monopoly:  Credit creates monopolies resulting in exploitation of both the consumers and the workers. 

In NutShell: 

‘Credit is a double-edged Sword’. 

Hence it must be made available to a requisite quantity by Monetary Authorities. 

Fundamentals of Credit Appraisal                                                                                            

Under this heading we will discuss the “Principles of Leading”.

Lending is an essential function of banking. Bank’s credit dispensation shall be based on sound tenets of prudence, asset quality, optimization of earnings, fair trade practice, good corporate governance and disclosure, transparency in lending decisions, pricing and other terms of sanction. Sustainable development, regulatory compliance, encouraging sectors like farm credit, exports etc in line with national priority, corporate social responsibility, inclusive growth are the heart of banking. Simultaneously the professional standards, best practices and integrity, adherence to Fair Practice Code and Lender’s liability guidelines, Lender’s leveraging business opportunities for credit growth and earnings to enhance shareholder value is equally important. Taking into consideration all these aspects the Bankers undertake the lending function by following these governing principles.

Safety: - First and foremost Principle of lending is to ensure the safety of funds lent, as these funds are from deposits entrusted to the bank by the public at large. The funds lent are safe when the borrower is in a position to repay the advance with interest, as per the terms of contract. So, safety of funds lent basically depends upon the borrower to whom the loan is granted. The safety of funds lent to the customer depends on the five C’s, purpose of loan, security offered for the loan are to be taken into consideration before a decision to lend is taken.   

The basics of lending are

a) Safety b) Liquidity c) Purpose d) Profitability e) Security f) National Goals  g) Spread/ Diversification of Risk h) Post sanction Supervision and follow up. 

It is aptly said in the words of a banker that, “An ideal advance is one which is granted to a reliable customer for an approved purpose in which the customer has adequate experience and knowledge, it is in safe hands and that the money will be used for the purpose for which it is sanctioned in order to generate the sufficient income to repay the loans on due dates as per schedule and will also generate enough surplus for him”. 

Credit Appraisal :   

Appraisal is the process of systematic review of all the related aspects of the project with a view to ascertain its viability.  It is the ability :  

i] To generate adequate cash to repay the principal & interest on the borrowed money in the predetermined time. 

ii] To provide appropriate return to the entrepreneur/s on their owned funds to keep their interest intact in the enterprise.     

5 C’s studied by a Banker to judge the Creditworthiness 

Character Business character                                                                                                                               Credit Capacity – To generate income to repay                                                           

Capital- The contribution/stake of borrower                                                                                                    

Collateral- The insurance to fall back upon                                                                                           

Comfort/confidence with the business plan: How accurate, reliable are the revenue and expense projections? Banks work out on these aspects and after considering the backward & forward linkages; economic considerations arrive at credit decisions.

The three fundamental pillars on which the credit appraisal is based are I) Integrity of the borrower now commonly referred as the due diligence. II) Financials of the borrower. III) Market Trends & guarantor. Bankers study these aspects by undertaking the following steps.                                                                                                              

I) Integrity of the Borrower / Due diligence.

@ It includes virtues like Honesty to carry out the proposed activity.
@ Studying the Social, Financial, Business status of the borrower.
@ Past performance of the borrower.
@ KYC compliances.
@ Credit worthiness.
@ Business experience.

Due Diligence process for borrowers

The process by which this initial study or assessment of the borrowing entity and its owner/ promoter is carried out has come to be known as “due diligence” or “pre-sanction due diligence” in banks. Generally speaking, due diligence is the detailed investigation of a person or a business entity, which is necessary to be carried out prior to signing of a contract. The investigation is to be carried out with the level of care that a reasonable person is expected to take considering the nature of the contract. In banks, it refers to a set of procedures which is carried out before opening of the account of a customer or before granting loan facilities to a borrower, since in both cases the bank enters into a contractual relationship with the customer/borrower. It will be obvious that the scope of due diligence will be much wider and deeper when considering sanction of a loan facility as compared to when opening a deposit account.

The basic objective of carrying out due diligence in the case of a prospective borrower (whether in the form of an individual, non-corporate or corporate entity) is to establish the borrower’s identity, good standing, means and credit-worthiness as well as to verify the borrower’s track record of past dealings and honouring financial commitments on time.

Interview of the borrower 

An important step in Credit appraisal involves Interview of the Borrower. It may be only of the "Key Person" of the Unit or of 2/3 persons associated with the firm. 

The meetings and interview techniques are to be leveraged for getting an insight into the various aspects such as 

Borrower’s interest in the venture, his vision, his plans, the study undertaken by him about the backward linkages (supply side) and forward linkages (marketing).

 By raising tactful questions the banker has to obtain the vital information beyond the documents or data submitted by the borrower.