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CREDIT RISK ANALYSIS AT KOTAK MAHINDRA BANK
LTD.
SIP project report submitted in partial fulfilment of the requirements for the
PGDM Programme
By Nimisha Agarwal
2013173
Supervisors: 1. Mr. Ranjan Guglani
2. Prof. Sayan Banarjee
Institute of Management Technology, Nagpur
2013-15
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ACKNOWLEDGEMENTS
This project bears imprint of all those who have directly or indirectly helped and extended
their kind support in completing this project. I find no words to express my gratitude towards
those who are constantly involved with me throughout my project at KOTAK MAHINDRA
BANK LIMITED.
I would like to thank company guide Mr. Ranjan Guglani, Associate Vice President- Large
Corporates, Corporate Banking, New Delhi for guiding me throughout the duration I was
doing my internship. He has been a central guiding force giving me all the information and
imparting his knowledge on the entire process and activities.
I would like to thank my faculty guide Professor Sayan Banerjee, who has given me the
adequate freedom and has allowed me to conduct my work and research in the field of my
interest.
I am grateful to the Wholesale Banking team in New Delhi, headed by Mr. Rajan Nanoo,
Executive Vice President, Regional Credit head, Corporate Banking, Kotak Mahindra Bank
Ltd.
And finally I would like to acknowledge the entire department and employees of Kotak
Mahindra Bank Ltd, New Delhi, for taking out time from their busy schedules to answer all
my queries and give me time for interviews and ensuring that I have all the adequate
information to complete my report.
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CERTIFICATE
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TABLE OF CONTENTS
S.No. Particulars Page No.
1 Acknowledgements 2
2 Certificate 3
3 Objectives of the study 5
4 Introduction 6-8
5 Concepts used in the study 9-54
a. Credit Appraisal 10
b. Process of credit appraisal 11
c. Assessment of Product Structure 13
d. Risk Assessment 14
e. Layman's guide to detecting financial stress 23
f. Evaluation of security 25
g. Importance of a plant visit/ management meeting 28
h. Reference checks 29
i. Assessment of limits 30
j. Credit monitoring 37
k. Review/ Renewal 38
l. Basel II & Credit risk rating 39
m. Internal guidelines 42
n. Multiple Banking/ Consortium Banking Arrangement 45
o. Loan Review Mechanism 46
p. NPA Management & Recovery 47
q. Legal documents & Procedures 51
6 Case Study Analysis 55
7 Limitations of the study 65
8 Scope for future improvements 65
9 Sources of information 66
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OBJECTIVES OF STUDY
The Summer Internship program (SIP) at IMT, Nagpur is a crucial part of the Post Graduate
Diploma in Management (PGDM) curriculum. It gives students the opportunity to observe
the professional arena and execute all the theory they have learnt in classes and put that to
practical use. I have been fortunate enough to have had the opportunity to work in the
Corporate Credit Banking department at Kotak Mahindra Bank Ltd.
The credit division of any financial institution revolves around certain key traits that the
company must evaluate. The way there are 4 P’s in Marketing, there are 4 P’s in credit as
well. They are (i) Purpose, (ii) Promoter, (iii) Pricing & (iv) Property. They can easily be
explained as firstly the Purpose being the reason why the customer wants a loan.
Understanding the requirement that borrower has. The second is evaluating the Promoter. Is
the borrower credit worthy? Does he have the intent and the ability to repay back the facility
he has taken. Thirdly involves Pricing of the facility. What amount should the bank charge
for offering the facility and fourth can be explained by the Collateral or security being offered
against the facility such as property or any other form of security or guarantee.
It is essential that the funds which are sanctioned to the customer is given on time, correctly
and efficiently. In many cases the customer may have a requirement of funds as per his
financial management plan to operate his business. It is the duty of the lender to disburse the
funds as per the requirement of the borrower.
In this report, I will be explaining the Credit procedures which are a crucial function of a
bank. The economic and environmental influences that affect credit decisions. This report
will also cover the importance of understanding risk, risk mitigation, the character of the
borrower, the government and economic environment existing and the documents and legal
implications in offering loans
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INTRODUCTION
India is one of the top 10 economies globally, with vast potential for the banking sector to
grow. The last decade witnessed a tremendous upsurge in transactions through ATMs, and
internet and mobile banking. In 2014, the country’s Rs 81 trillion (US$ 1.34 trillion) banking
industry is set for a greater change. Two new banks have already received licences from the
government. Furthermore, the Reserve Bank of India’s (RBI) new norms will provide
incentives to banks to spot potential bad loans and take corrective steps that will curb the
practices of rogue borrowers.
The Indian government’s role in expanding the banking industry has been significant.
Through the Financial Inclusion Plan (FY 10-13), banking connectivity in the country
increased more than three-fold to 211.234 villages in 2013 from 67,694 at the beginning of
the plan.
India’s banking sector has the potential to become the fifth largest banking sector globally by
2020 and the third largest by 2025. The industry has witnessed discernible development, with
deposits growing at a CAGR of 21.2 per cent (in terms of INR) in the period FY 06-13; in
FY13 total deposits stood at US$ 1,274.3 billion.
Today, banks are turning their focus to servicing clients. Banks in the country, including
those in the public sector, are emphasising on enhancing their technology infrastructure, in
order to improve customer experience and gain a competitive edge. The popularity of internet
and mobile banking is higher than ever before, with Customer Relationship Management
(CRM) and data warehousing expected to drive the next wave of technology in banks. Indian
banks are also progressively adopting an integrated approach to risk management. Most
banks already have in place the framework for asset-liability match, credit and derivatives
risk management.
Source: http://www.ibef.org/industry/banking-india.aspx
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Kotak Mahindra Bank ltd. is an Indian bank and financial service firm established in 1985.
It was previously known as Kotak Mahindra Finance Limited, a non-banking financial
company. In February 2003, Kotak Mahindra Finance Ltd., the group’s flagship company
was given the license to carry on banking business by the Reserve Bank of India (RBI).
Kotak Mahindra Finance Ltd. is the first company in the Indian banking history to convert to
bank. As of 2011 to October 2013, it has more than 500 branches, over 1,000 ATMs and a
consolidated balance sheet of approx. US$ 2.9 billion.
Kotak Mahindra Bank Limited offers transaction banking, operates lending verticals,
manages initial public offerings (IPOs) and provides working capital loans. The bank
operates in four segments: Treasury and BMU, Corporate/ Wholesale Banking, Retail
Banking and other banking business. Treasury and BMU segment includes money market,
forex market, derivatives, investments and primary dealership of government securities and
balance sheet management unit (BMU) responsible for asset liability management.
Corporate/ Wholesale Banking segment includes wholesale borrowings and lendings and
other related services to the corporate sector, which are not included under retail banking.
Retail banking includes lending, branch banking and credit cards. Lending includes
commercial vehicle finance, personal loans, home loans, agriculture finance, other loans/
services and exposures. Other banking business segment includes any other business.
Corporate banking services from Kotak Mahindra Bank include the following:
 Product Suite:
This has a whole gamut of products including:
o Funded products that meet the working capital needs of the company along with other
structured products.
Source: http://www.ibef.org/industry/banking-india.aspx
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o Treasury products to mitigate risks that occur in business with products for foreign
exchange, money market and benchmark PLR.
o Amongst investment products, corporate bankers can choose term deposit, mutual
funds and bank assurance.
o Fixed income products offers highly qualified products from experienced
professionals providing plain vanilla debt issuance to Asset Backed Securities (ABS),
Mortgage Backed Securities (MBS), structured products and loan syndication.
 Trade Finance: Companies that are involved in import and export have sought the expertise
of our unique trade finance solutions. These include tailor made solutions created to meet the
needs of export and import services. Apart from this, corporate are provided bank guarantees
and other unique domestic services.
 Commercial Banking: This is the one stop shop for meeting the needs of corporate when it
comes to transportation, logistics and infrastructure and tractor industries.
 Transactions Banking: Kotak Mahindra Bank simplifies the complex financial clearing
system in India for corporate by offering receivables and payables services while ensuring
predictability of cash flows.
 Current Account: Quick and timely access to funds is provided to all corporate to meet the
demanding business environment by giving a 2 Way Sweep feature for giving liquidity and
higher returns.
 Convenience Banking: To complete the gamut of services, Kotak Mahindra Bank has
ensured that all corporates have access to net banking, Kotak Payment Gateway, mobile
banking, SMS banking alerts, phone banking and wide ATM network.
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CONCEPTS USED IN THE STUDY
Credit risk arises from the inability or unwillingness of a borrower to repay his liability on
due date. The liability may be in the form of an instalment of a term loan, bullet repayment of
a short term loan or timely servicing of interest on a loan. Credit risk may also arise from lack
of churn in the working capital account for a period of more than 90 days or shortfall in
drawing power or breach of financial covenants specified or occurrence of events of default
as per contractual terms.
The credit process is designed to evaluate the borrower for standard credit risks. However, no
two borrowers are alike and therefore one needs to identify the unique risks and mitigations
of each case. While appraising a borrower, the following questions need to be answered:
1. Is the borrower credit worthy?
2. What should be the overall exposure to the borrower?
3. Whether the borrower should be extended short term facilities or long term facilities
based on his requirement?
4. What security or other credit enhancement measures should be stipulated to safeguard
our facilities in case of default?
5. What should be the key monitor able parameters to identify any deterioration in credit
profile of the borrower subsequent to our disbursement?
The relationship between a bank and a borrower is typically built over a long term although
such a relationship may have been built over a number of transactions of shorter duration.
These transactions may take place across multiple products and with multiple entities of the
borrower. Default in any one of these transactions can lead to the entire exposure being
classified as a Non performing asset. Similarly, credit risk in one entity/ product can be
mitigated by building recourse to all other related entities that have active exposures by virtue
of a cross default clause that is normally inserted in all contracts. Therefore the credit
enhancement available in one facility can also be used to improve the credit risk of another
facility to the same borrower/group.
Thus the procedure to be followed while assessing the credit risk of the borrower is to
evaluate the historic track record of the borrower and all his related entities. The regulator
provides default data across banking system which can be used as the first step for such a
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credit check. Independent credit information bureaus such as CIBIL also make default data
available across the banking system. The background check of the borrower need not be
restricted to the official data on defaulters. Informal channels need to be created to have a
regular flow of information on defaulters.
There is also a need to keep track of recent occurrences of default in the environment as well.
Given the deep linkages between various players of an industry, starting from supplier to end
user, a default event in one part of a chain can also impact a company in another part of the
chain. The credit analyst is therefore required to stay abreast of all the developments in the
economy and industry including international developments such as movement in commodity
prices, volatile exchange rates, change in monetary policy, and bankruptcies in other
countries that may have an impact on the performance of the borrower.
The company may also make new plans that may change its financial projections. Lack of
key data on such specific developments with the borrower is one of the major reasons why
credit risk may not have been evaluated correctly in the first place. One of the major reasons
for incorrect assessment of credit risk is the fraudulent intentions of the borrower who has
submitted false data. It is therefore necessary to follow a strict discipline while evaluating
credit risk in order to isolate misleading and false information.
CREDIT APPRAISAL
Before any credit appraisal we may ensure that the basic information is considered as a pre
requisite for doing a credit appraisal, is made available and this data is most recent. The
information required would include the following:
i. Latest audited financials of the borrower and his group companies and provisional
financials of past performance
ii. Background information such as date of incorporation, nature of the entity, details on
shareholders, directors, their educational and professional background
iii. Details of location of registered office, factories and corporate office
iv. Capacity and production data of the borrower’s business
v. Revenue model of the company including segmental information on his customers
vi. Key raw materials and their sources
vii. Details of existing bankers, their loan amounts and their repayment terms
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viii. Future plans of the borrower for expansion of capacity, launching new products,
making acquisitions and means of financing of the same
ix. Statement of foreign exchange/ derivative exposure outstanding with details of MTM
losses/ gains.
In addition to the above, we may require knowledge about the industry in which the borrower
operates, their direct and indirect competitors, their respective market shares etc.
The information required would also depend on the following:
1. Nature of the transaction proposed- long term or short term, secured or unsecured,
working capital or term loan
2. Size of the loan
3. Credit rating of the borrower
4. Rating outlook of the industry
5. Background of the promoters
In general more in depth information is requires if the proposal is in the nature of a term loan,
unsecured loan, emanating from a new promoter, proposal has low credit rating and there is a
rating watch on the industry.
PROCESS OF CREDIT APPRAISAL
1. Obtain all the basic information as stated in above question
2. Visit the website of the company to know more about their company and product
details
3. Check whether the borrower or its directors/ shareholders appear in the NCIF of the
bank or are classified as wilful defaulters by RBI. Also check whether the customer
appears in the CIBIL list of suit filed/ wilful defaulters
4. Check applicability for any section 20 or any statutory restrictions for the borrower
5. Check that no credit facilities are extended to promoter related entities
6. Check if the sector exposure norms, individual and group exposure norms, substantial
exposure norms are being met.
7. Check if real estate exposure, capital exposure limits are being breached, if considered
8. Do a search on capital line and obtain information on peers in the same industry
9. Compare the performance of borrower with the performance of peers and determine
whether the borrower is a market leader, major player or only a minor player
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10. Where the companies have been rated by external agencies, their rating rationale
should also be considered while appraising the company
11. In case information is not available on a company especially while evaluating risk
limits obtain the financial information from ROC
12. Evaluate the security offered by conducting an ROC search, title search, valuation
report and calculating the security cover available for the proposed transaction
13. Collect references from suppliers, customers, bankers, competitors etc.
14. Assess the information gaps and list critical queries based in the information available
above
15. Visit the plant and meet the management of the company to bridge the information
gaps
16. Prepare the financial spreadsheet based on the estimates and projections submitted by
the borrower. Adjust the assumptions underlying the projections based on your critical
assessment
17. Financial analysis must be done on standalone as well as consolidated basis. Analysis
of YTD financials may also be presented on a quarter on quarter basis
18. In case of new borrower, evaluate the borrower vis a vis the BCAC specified in the
Credit origination policy
19. In case of large investments in subsidiaries, analyse the subsidiaries
20. In case of renewal obtain the detailed account performance report from the credit
monitoring division. Obtain copies of recent stock audit reports of the company and
also check the pending documents in the account as per the latest report
21. While doing a renewal, it is a good practice to compare the stock/ book debts as
appearing in the year end stock statement with the audited annual report of the
previous year
22. Complete the rating. Go ahead with the proposal only if the rating meets the minimum
requirement based on the expected loss indicated for the proposed transaction and the
pricing being obtained vis a vis the expected loss. ROE may be computed both on risk
adjusted basis or otherwise. If it does not meet minimum requirement in both cases,
obtain Business Head approval before going ahead.
23. While preparing the credit appraisal, ensure that all relevant risks have been
highlighted along with their mitigants, wherever possible
24. Assess individual facilities that have been proposed by the borrower
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25. Prepare a draft term sheet based on the facilities being proposed for sanction. Specify
detailed terms and conditions in the term sheet by selecting the appropriate term sheet
from the term sheet bank. Care should be taken to cancel all variable conditions that
are not applicable and specify additional variable conditions if any
26. Stipulate PDC and PG if the combined rating is below BB+. Check whether facilities
recommended are in line with portfolio norms specified
27. If the proposed transaction is in the nature of a take over ensure that take over
conditions have been specified
28. The proposal may be sent for sanction to the appropriate approving authority based on
the total exposure of the bank to the borrower/ group. While determining total group
exposure we are required to obtain information from other departments of the bank
such as home loans, consumer loans, commercial vehicles, ARD, etc.
29. Prepare the final term sheet based on the specific terms of the final approval and
forward the same to CAD, Legal, Credit monitoring and operations
30. Prepare the sanction reporting document and submit it to the credit committee
secretariat.
ASSESSMENT OF PRODUCT STRUCTURE
The type of loan sanctioned to a borrower and its terms of approval should naturally meet the
requirements of the borrower. It is therefore necessary to ensure that working capital needs
are met with working capital products and long term needs are met by long term products
specific to the end use. It therefore implies that the repayment terms of the loan should be
within the actual cash flows of the borrower.
While disbursing the loan, where the security build up is in stages, care should be taken to
ensure that the disbursement of the loan should be appropriately structured in line with the
delivery of security. Thus instead of releasing the total facility at one go, the disbursement
may be in stages in line with the build up of security. It is therefore essential to understand all
aspects of how the security will be created while sanctioning the loan. Where the product
structure relies on cash flows, it is necessary to monitor these cash flows on a periodic basis
and appropriate events of default (EODs) need to built into the terms of sanction.
While structuring limits, care should be taken to design the interchangeable limits as sublimit
to the main limit. Some of the details that need to be understood while specifying the detailed
conditions of disbursement include the following:
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 Mode of disbursement which involves:
1. How to pay?
2. Whom to pay- payment to vendor or borrower or a takeover?
3. On what basis to pay?(transactional documents)
4. How much to pay?- what is the margin, interest rate, processing fee?
 Repayment of the loan
1. What chain of events (cycle) will lead to eventual repayment?
2. What is the source of funds for repayment?
 Monitoring of the entire cycle which involves:
1. What are the transaction specific monitoring conditions?
2. What are the covenants/ events of default, if any?
RISK ASSESSMENT
I. Business risk
Business risk is unique to the customer’s specific business and depends on the product he
manufactures, technology he uses, his geographical location, key inputs/ raw material, access
to raw material and his cost structure. In a stable business model, the company has developed
barriers of entry either in the form of superior product quality as reflected by its brand equity,
its distribution network, low manufacturing cost, etc.
In order to evaluate the business model of the company, we need to understand the
composition of sales, the dependence on key raw materials, the availability of utilities such as
electricity, water, labour, etc. The value addition made by the business may be different for
different players. Business risk in service industry is different from that in a manufacturing
industry.
Business risk parameters can be broadly classified into market position factors and operating
efficiency factors. Market position implies the ranking or position of a brand, product, or
firm, in terms of its sales volume relative to the sales volume of its competitors in the same
market or industry. Operating efficiency is a measure of a management’s ability to generate
sales revenue and to control costs.
Market position factors:
1. Product quality
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2. Product range/ mix
3. Brand equity
4. Customisation of products
5. Project management skills
6. Diversity of markets
7. Long term contracts/ assured offtake
8. Distribution set up
9. Financial ability to withstand price competition
10. Composition of customer base
Operating efficiency factors:
1. Capacity utilisation
2. Availability of raw materials
3. Energy cost
4. Cost effective technology
5. Selling costs
6. Employee cost
7. Management of price volatility
8. Adherence to environmental regulation
9. R&D activities
10. Synergies with group companies
II. Industry risk
Credit risk is also a function of the industry in which the company operates. Industry risk
refers to the risk that uniformly impacts all players of an industry segment. Thus it is not
specific to a company but involves the entire industry that the company belongs to. Industry
risk encompasses all those risk factors that are external to the company but have a common
bearing on all its players.
Industry risk may be measured by certain industry characteristics such as demand supply gap,
government policies, input related risks and the extent of competition in the market. They are
explained in detail as follows:
1. Demand supply gap would critically determine the volumes, realizations and
consequently the profitability of companies operating in an industry. The
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attractiveness of an industry for fresh capital investments would depend upon the
anticipated demand supply gap. The outlook on demand-supply position would
largely be a function of:
 Expected demand growth
 Shifts in consumption pattern resulting in replacement demand and product
substitution
 Present installed capacities and commissioning of new capacities, which would
determine the supply pattern in an industry.
2. Government policy determines the outlook of the policies and government
regulations on the industry. The impact of govt policies with respect to tariff barriers
such as import duties, quotas, sanctions, excise duty, taxes, domestic price control,
incentives for new investments, incentives for exports, legislations for pollution
control measures, laws with respect to foreign exchange on various industries need to
be examined.
3. Input related risks would involve taking a view on availability of raw material and
volatility in the prices of raw material. The volatility in prices would affect the
earnings stability, depending upon the ability of the industry to pass on increase in
raw material prices to the end users. The industries characterized by high value
addition would be less susceptible to the volatility in raw material prices. The extent
of value addition is reflected by the percentage of raw material cost in the overall cost
structure of the product.
4. Extent of competition measures the number and intensity of competition among
incumbents in the industry. The level of competition in an industry has implications
on future profitability of players in an industry. The number of players operating in an
industry would in turn depend on entry barriers in an industry. Existence of
government regulations regarding licensing requirements, levels of returns, heavy
capital investment requirements, distribution network, technology, patents and brand
equity could be significant entry barriers for prospective entrants to an industry. The
industry could be exposed to competition from the unorganised sector, as well as
imports. The increasing linkage with the global economy in a declining import duty
regime exposes domestic companies to competition from imports. The unorganised
sector also poses significant competition in industries with low entry barriers.
The following industry financials are to be measured while analysing the industry:
 Growth in operating margin (%)- industry
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 Operating margin(%)- industry
 Return on capital employed(%)- industry
 Variability of operating margins(ratio)- industry
The other factors to be analysed are the impact of change in technology, the company’s
performance relative to other players, the length of operating cycle in that industry and the
stage in life cycle of the industry. The availability of human resource is an important factor to
be analysed for service industry. While analysing the broker business, the cyclicality of the
industry and the regulatory measures should be looked into.
III. Management Risk
Management risk is the risk associated with ineffective or underperforming management
which hurts performance of the company being managed and therefore the returns generated
by the shareholders. The parameters to assess management risk are as follows:
1. Quality of information submitted by the company- Integrity
The timeliness, accuracy, adequacy of information and willingness to give
information depicts the professional quality of the management. This factor also
assesses the company’s promptness in furnishing regular information required by the
bank, such as quarterly performance data, stock statements, sales statements etc.
2. Working capital management- The lower the working capital cycle, the more
competitive the company will be. Financing requirements closely follow the actual
business cycle of the industry.
3. Corporate governance- The capability of the firm with respect to wealth creation for
all stakeholders while adopting sound corporate governance practices is judged while
analysing management risk.
4. Experience in the industry- A management with greater experience provides
comfort with respect to stability of the business model.
5. Managerial competence- Assessment of management’s competence would be based
on the quality of past decision making, as well as the general impression of the
efficiency of the company’s systems and procedures. While educational qualifications
could provide a base for good management, formal education in itself would not
guarantee exceptional management. The other dimension to be evaluated upon would
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be the track record of managing Joint Venture in the past, if joint venture is essential
for continued successful running of the business.
6. Business and Financial Policy- The management’s conservatism is judged based on
past business and financial policies relating to its leverage and would have a bearing
on future debt bearing levels. A track record characterized by large expansions in
relation to existing size or in unrelated areas is indicative of a relatively high appetite
for risk.
7. Ability to meet projections and maintain market share- This factor assesses the
management’s competence as well as its integrity in projecting performance.
Management’s competence is assessed in maintaining the market share while trying to
achieve the sales/ profit projections.
8. Management succession- This factor examines the extent of preparedness of the
company’s leadership for the future. A company with a well-groomed second line of
leadership would score highly on this parameter. Alternately a professionally
managed company would also score higher. On the other hand, a company highly
dependent on the existing leadership, and having uncertainties with respect to future
management would be placed at the lower end of the scale particularly if the existing
leadership is old.
9. Labour relations- This factor assesses the quality of industrial relations prevailing
within the company. A company characterized by peaceful labour relations is
expected to show greater stability in operations. Frequent industrial strike affects the
continuity of operations and could have implications on the debt servicing ability of
the company. Conversely a company with highly motivated labour force would be
ideally prepared to face competitive pressures.
10. Strategic initiatives- This factor assesses the company’s ability to successfully
implement its strategies. Companies, which have successfully executed major/
complex projects, or demonstrated an ability to manage strategic alliances, etc., would
score highly on this factor.
While analysing SMEs, along with the above mentioned factors the parameters to be
assessed are the Group support available to the company, the number of years of
experience the management has in the same line of business and the credentials of the
family running/ owning the business.
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While analysing stock brokers, along with the above mentioned factors the parameters to
be assessed are the legal ownership of the business and the personal net worth of the
promoter.
IV. Financial Risk
Financial risk is the risk arising from the financial profile of the borrower. It is measured by
calculating the free cash flow generation taking into account operating activities, investment
activities and financial activities including additional borrowing or repayments.
The objective of any financial analysis should therefore include the following:
1. Understand the product wise segmentation of income of the borrower’s business
2. Means of financing in the balance sheet and any mismatch between long term
liabilities and long term assets of the borrower
3. Operating profitability and cash flows of the company as distinct from the income
which is one time in nature.
4. Performance of the borrower entity on a consolidated basis
5. Working capital cycle of the borrower
6. Trend in unit sales realization, unit cost
7. Free cash flow analysis
Analysis of income statements
Analysis of profitability
Ratio Nomenclature Remarks
PBDIT/ Net Sales Operating profit margin Higher the ratio, higher is the
operational efficiency of the
company. This may be
compared with the industry
average/ other peer companies
Net Profit/ Net Sales Net profit margin Profit margin available for
shareholders of the company
for distribution. Higher the
ratio, higher is the growth
potential for the company.
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However, this should be
supported by the projected
future cash flows
PBIT/ Net Sales This is the profit margin
prior to meeting the interest
obligation
Higher the ratio, higher is the
comfort level for the lenders.
However, this should be
supported by the projected
future cash flows to ensure
that the company sustains the
level of profitability.
Cash Profit/ Net Sales Cash profit margin This is the profit available for
servicing the loan and meeting
the working capital/ capital
expenditure requirements of
the company. Higher the ratio,
higher is the comfort level for
the lenders.
Dividend/ Net profit Dividend distribution ratio Reflects the management’s
policy of profit retention and
increasing company’s net
worth
PBIT/ (Equity+ Debt) Return on capital employed Reflects the company’s overall
efficiency in utilization of total
capital employed. Higher the
ratio, higher is the comfort
level for the lenders
PBDIT/( interest on term
loan+ principal repayments)
Debt Service Coverage
Ratio(DSCR)
It indicates a company’s
ability to service its debt
obligation from earnings
generated from its operations
PBDIT/ Interest Interest Coverage ratio Interest cover is defined as the
extent of cushion or comfort
that a company has in meeting
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its interest obligations from
any surplus generated from its
operations.
Analysis of Cost Structure: The major cost components are:
- Material cost
- Labour cost
- Manufacturing overheads/ expenses
The following should be looked into while analysing the cost structure of a company:
- The behaviour of various cost components and cost composition in the overall product
cost over previous years
- How the company deals with cost increases may be studied- what kind of cost
increase can be passed to the customers, to what extent and whether the same is built
in the contract with the clients may be ascertained
- Whether the company has any supply side constraints or its raw material is subject to
price volatility and whether the company is facing any labour problems may also be
enquired.
Analysis of balance sheet ratios
The ratios generally considered as relevant for conducting credit analysis are:
1. Liquidity ratios
2. Gearing/ capitalisation ratios
3. Turnover ratios
Liquidity ratios
Current ratio: current asset/ current liabilities
The higher the ratio, the better it is for the company thereby indicating company’s strength in
meeting its short term obligations. In India, the Tandon committee had suggested that the
minimum acceptable current ratio should be 1.33. The movement of current ratio should be
read in conjuction with the movement of Net Working Capital (NWC) in order to arrive at a
proper and meaningful conclusion.
Acid test ratio/ Quick ratio= (current assets- inventory)/ current liabilities
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The rationale for computing the ratio in this manner is that inventory is the least liquid of all
the individual components of current assets.
Net Working Capital (NWC)= Total current assets- ( total current liabilities including bank
borrowing+ total repayments due within 1 year)
Net working capital indicates the company’s contribution towards its working capital gap
from its long term sources. As per the second method of lending suggested by Tandon
Committee, the ideal contribution by the promoter should be 25% of the current assets.
NWC can be negative in cases where the credit period received by the company by its
suppliers is better than the credit period it extends to its customers. In such cases, there is no
need for bank finance.
Gearing/ Capitalization ratios
1. Total Outside Liabilities (TOL)/ Tangible Net Worth (TNW) = (Long term debt+
Short term debt + other current liabilities)/ TNW
2. Total Outside Liabilities (TOL)/ Adjusted Tangible Net worth (ATNW)
ATNW= TNW- Investment in associates and subsidiaries + Borrowings from
subsidiaries (quasi equity)
3. Long term debt/ TNW
4. Long term debt/ ATNW
5. Term debt (including debentures)/ Cash profits (years)
Tangible Net Worth (TNW) = Equity Capital+ Preference Capital> 12 years+ Share premium
+ General Reserves+ other reserves &surplus – Intangible assets – Revaluation reserves
Short term credit and long term credit facilities are external sources of funding and are
therefore classified as Total Outside Liabilities (TOL). Gearing/ capitalization ratios provide
information on the position of owned funds compared to long term debts or total outside
liabilities of the enterprise.
Turnover ratios
These ratios are of great importance from a banker’s point of view as they determine the
working capital cycle and help in fixing the operating cycle of the enterprise.
 Receivables Turnover (domestic)
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 Receivables turnover (export)
 Inventory turnover
 Creditors turnover
 Fixed assets turnover
Fund flow analysis
A fund flow statement provides details concerned with the change in balance sheet position
by showing the summary of changes in financial position from one period to another. The
following questions may be answered with the funds flow statement:
1. Have working capital funds been diverted into creation of fixed assets/ long term
investments?
2. Has the company funded its fixed assets/ working capital from its own internal
generation or borrowed funds?
3. Is there a mismatch between generation of long term funds and long term assets?
4. What are the sources of repayment for loans?
LAYMAN’S GUIDE TO DETECTING FINANCIAL STRESS
The problems faced by businesses get reflected in their financial statements despite the
attempts of such potential customers to mask their non-performance through creative
accounting. It is possible to see early warning signs of financial stress or even the fact that the
business is already in deep waters by following good analytical discipline. Given below are a
few of these ailments that can be detected:
1. Insolvency: A company is insolvent if its liabilities are more than its assets. Accumulated
losses, deferred expenditure, intangible assets, unquoted investments, non-moving stock/
debtors, deferred tax assets are all signs of over stated assets. Insolvency of a business is a
matter of concern to its creditors. Thus, it is important to understand the ranking of creditors
based on underlying security to evaluate the impact of such insolvency. In such businesses it
is important that there is equity infusion from the promoters since further debt will only
increase the burden of the business through interest cost.
2. Illiquidity: A business is considered illiquid if it is unable to generate sufficient cash from
its operations, raise credit against its assets and the promoters are unable to infuse cash into
the business. Signs of illiquidity can be detected if the collection period of receivables is
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high, the level of stock is non-moving or rising, the cash balances are low, sudden sharp fall
in level of creditors and debt equity ratio is high. An illiquid business may have long term
and marketable assets in the form of land and building or unquoted investments.
3. Diversion: A business may be under financial stress if it has diverted its equity/ loans into
other businesses. Diversion of funds from a performing unit to a non-performing unit within
the same entity may also lead to such stress. Diversions out of the business can be detected by
analysing the nature of investments and loans and advances made by the business. If these
diversions exceed the cash accruals generated by the business it can lead to a financial stress.
In order to detect signs of such stress it is always essential to analyse the financials of group
companies and the segmental performance within the business.
4. Working Capital mismatch: This situation arises from diversion of short term liabilities
to finance long term assets within the business. If the long term loans and net worth of the
business are less than the net fixed assets it is evident that there is a working capital
mismatch.
5. Valuation of assets: Companies tend to capitalize various types of expenses in order to
avoid a hit on their profitability. Certain one time expenditures in the nature of goodwill,
brand building expenses may also be capitalized as fixed assets. It is also possible that by a
change in accounting policy on depreciation or inventory valuation, value of fixed assets/
current assets are overstated. The only way to detect capitalization of expenses is to compare
the capital cost with those of other competitors. Amounts reflected in goodwill and in the
nature of intangibles such as brand values are always shown separately in the schedules. The
impact of change in accounting policy can be found in the notes to accounts.
6. Quality of profits: It is important to understand whether a business is generating its profits
from its core operations or through its other income. Therefore, profitability ratios are best
analysed by comparing at the operating level across accounting periods. Some businesses
have a diversified stream of operations that may provide protection from seasonalities,
business cycles etc. The quality of profits in such businesses is higher. The trend in
profitability such as rising operating margins, rising net profit margins can also indicate the
quality of profits.
7. Hidden debt: It is essential to understand the leverage of the company on a consolidated
basis. Thus, it is possible that debt in group companies or subsidiaries have been guaranteed
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by the borrower. This needs to be added to the total debt of the borrower. Mark to market
(MTM) losses on foreign currency/ commodity value fluctuations can also impact the
leverage of the company. Look for disclosures on the same in the notes to accounts.
8. Under capitalization: A company is said to be undercapitalized if its equity base is too
small in relation to its sales turnover. Typically such companies have a high level of gearing
and low profitability. A business is also under capitalized if it is unable to generate sufficient
cash accruals to meet the operational requirements as dictated by increasing sales. The
contribution of equity in expansion/ acquisition plans of the company can indicate its
changing level of capitalization.
9. High dividend: A company normally invests its cash accruals back in business and
typically allocates a percentage of profits as dividend. An aggressive dividend policy is one
which puts a company under pressure to borrow in order to meet its dividend payments.
Typically dividend rates that consume more than 50% of annual profits may be considered as
high.
EVALUATION OF SECURITY
Evaluation of security structure
Security offered in the proposal is a key determinant of the credit risk of the transaction.
Security offered may be tangible such as current assets, fixed assets, cash flows, etc or
intangible such as post dated cheques, personal guarantee, negative lien, etc. While analysing
the security offered, it is required to calculate the security cover in percentage terms of the
transaction amount. This can only be done if detailed information is provided on the nature of
security held by all lenders. Ultimately the actual security that has been created represents the
real credit risk. An incomplete security is as good as no security.
Security may be offered as specific charge or floating charge. Specific charge is created when
banks choose to lend for specific projects of the borrower against security that is created out
of their funds. For example: specific receivables discounted, machinery for a specific product
line, exclusive mortgage of immovable property etc. When a bank chooses to fund projects or
working capital requirements by taking charge on current assets as a whole or movable fixed
assets as a whole, a floating charge is created. Any asset added to this pool stands
automatically charged to the bank. Any bank willing to extend facilities on specific charge
must necessarily seek a no objection certificate (NOC) from all existing floating charge
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holders. Once such NOC request is granted the charge of floating charge holders will stand
modified to charge on current assets or fixed assets excluding those charged to specific
charge holders.
Charge on assets signifies sequence in which the realizations from liquidation will be used to
pay off creditors. Thus, we have:
 Statutory dues
 Exclusive charge- exclusive first right over realizations at the time of liquidation
 First charge- first right over realizations at the time of liquidation
 Second charge- second right over realizations at the time of liquidation
 Subservient charge- right over realizations at the time of liquidation after first and
second charge but before unsecured creditors
 Unsecured
It should be noted that Sales tax authority will have the first right over sales proceeds if they
have made a claim on the company before the security was created by the bank.
Security may be offered on an exclusive basis (exclusive first charge) or on a non- exclusive
basis. The sharing pattern in non- exclusive cases could either be first pari passu, second pari
passu, subservient charge, etc. where the assets may be shared by multiple creditors in the
proportions of their outstanding. It is important to understand the process of creation of
security to ensure that the security as intended in the credit appraisal has actually been
created.
The procedure for creation of security offered by a borrower is dependent on nature of entity
of the borrower. A company incorporated under the Companies Act, 1956 is safest from the
point of view of the lender/ bank. This is because the claims against a security held by the
company are verifiable with the Registrar of Companies (ROC). Thus, in the case of
company, it is possible to determine whether there are any claimants to the security and the
status of the bank’s claim with respect to seniority over other creditors. In all other cases, one
has to rely on the disclosures made by the borrower in his balance sheet as there are no
regulatory authorities for verification of partnership firms unless they are registered,
proprietorship firms, HUFs, associations, etc.
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Tangible security may also be graded into hard collateral that is more realizable against its
book value while soft collateral may not be equally realizable. In terms of gradation of
preferred security an indicative list would be as follows:
1. Property with clear marketable title
2. Legitimate control over cash flows of the borrower
3. Post dated cheque of the borrower, post dated cheque of promoter/ guarantor
4. Personal guarantee
5. Charge on the moveable fixed assets of the borrower
6. Charge over current assets
7. Negative lien
8. Other securities like listed equity shares
The 4Cs of credit- Character, Collateral, Cheque, Cash flow control
The decision to approve a loan must also be based on a qualitative assessment of the
borrower. While this is highly subjective, it can give us proper direction in structuring the
terms of the loan. The credit decision usually involves finalizing the terms of the security.
The nature of security may be tangible or intangible. Tangible security is of varying grades as
defined in the section on “Evaluation of Security”. As seen there, collateral in the form of
land and building provides the highest comfort. This may be reinforced with security of cash
flow or an intangible security such as post dated cheque. The decision to combine or drop any
of these could be aided by qualitative assessment of the borrower.
Character of the borrower is an important element of his qualitative assessment. Character is
determined by his educational background, social life, his vision/ commitment for the
business, respect for regulations, business practices as revealed by the past. The character is
also analysed based on the intention to repay. The assessment of the character has important
fallouts in terms of the decision to sanction the loan and the specific terms under which they
would be sanctioned.
Where the character profile is not strong, comfort needs to be built upon the above security
parameters. On the other hand, where the evaluation on the character is comfortable, we may
allow greater flexibility with respect to the above security parameters.
Availability of post dated cheque is important more as a deterrent rather than as a realizable
security. Cash flow control needs to be from a reliable, creditworthy counterparty with a track
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record of past performance. Availability of property is usually considered a strong comfort
provided there is adequate hair cut. The quality of property also needs to be assessed from the
point of view of its neighbourhood, ease of access, quality of construction etc.
IMPORTANCE OF A PLANT VISIT/ MANAGEMENT MEETING
The business model of the company may not be as easily apparent until one visits the factory
to understand the product mix, the technology being used, the skills of the employees and the
quality of infrastructure. In order to maximize the benefit from meeting the promoter or
visiting the plant, it is important that the basic information required for credit appraisal is
made available prior to this meeting. The analyst should go through this information and
make a note of specific points that will need to be check during the plant visit. The analyst
should understand the industry, the business cycle of the company before the plant visit. Once
in the plant or with the promoter, the analyst is suddenly exposed to a huge flow of
information on the company. It is advisable that the analyst prepare the visit report as close to
the date of meeting as possible so that he is able to capture most of the relevant information
in granular details.
A plant visit helps to understand the genuineness of the business and the pace of activity in
the company. It can also help in revealing an inventory pile up, inefficiencies in production
processes, quality of fixed assets etc. It is important to record the details of fixed assets,
utilities available at the unit, information pertaining to manpower etc which can help evaluate
requests for financing capital expenditure. One can also get a feel of whether the company
has sufficient land for its existing business or any extra land is required for capacity
expansion since land is generally not held in the books of the company but in the personal
books of the promoter.
Frequently during a plant visit it is possible to meet the factory manager/ quality manager/
research head who may talk about the strengths of the product and the company in detail.
Sometimes simple questions posed to workers on the shop floor can confirm or negate the
facts provided by the company. During a plant visit the analyst must ensure that the right
person is available to conduct the tour of the factory. Thus the CFO may not always be the
right person to explain the manufacturing process and it is necessary to get the factory
manager or the supervisor to explain the manufacturing process.
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While meeting a promoter some of the standard information collected should be the history of
the company such as reasons for entering the business, competitive position of the company,
the relationship of the company with its suppliers, customers etc, the future plans of the
company in terms of capex, sales, new products, new locations etc. The promoter may also be
the best person to seek clarification on the financials, pending litigation as mentioned in the
notes to accounts, likely movement of product prices and raw material prices, response to
changing market scenario etc.
REFERENCE CHECKS
Frauds are a major reason why credit risk cannot be taken at face value. Frequently doubts
arise when the business model appears too good to be true or the company would like to
create an impression of there being no risks. While a good credit appraisal can give us the
precise idea of the mix of various risk elements and a clear assessment of its strengths and
weaknesses, promoters routinely attempt to hide or mislead the analyst with respect to critical
information. The due diligence process is therefore not complete unless an attempt is made to
corroborate the given data through independent sources.
Some of the information that should be checked through references are the following:
1. Track record and business performance- to be checked with existing lenders
2. Business performance- to be checked with customers based on their reputation
3. Legal disputes- to be checked with trade partners such as suppliers and customers
4. Financial statements- to be based on reputation of auditors
5. Insider views- to be taken from ex-employees, other customers of the bank
The analyst needs to choose the entities from whom reference check is to be taken very
carefully. Care should be taken to ensure that the person giving reference is not too close to
the interested party. Besides, reference is usually taken from a person with whom we already
have a comfortable relationship. Reference should be taken based on materiality of the due
diligence being done. Thus, if the borrower claims a long term contract for raw material
supply, the supplier would be a key reference point. Similarly, if a large percentage of sales is
booked from a single customer, reference should be taken from this customer.
The process of taking references should be continuous rather than only at the time of credit
appraisal. Thus, an analyst should develop a network of bankers, auditors, lawyers,
government officials through whom such references can be taken.
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Sometimes, in a large transaction where the quality of information is relatively weak and the
perceived risk is relatively high it may be necessary to take more detailed references. Such
situations may also demand making discrete enquiries such as monitoring the activities of the
promoter, getting to know his regular social network, details of his personal assets, other
businesses, etc.
Tools such as Credit Information Bureau of India Limited (CIBIL) reports and Negative
Customer Information Form (NCIF) database should be used to check the customer’s past
record in defaults or if there are any suits filed against the company/ borrower while
appraising the loan.
ASSESSMENT OF LIMITS
The credit policy of the bank recommends the use of Turnover Methodology of assessment of
working capital. If the end use of a loan is for working capital purposes, then it is necessary
to conduct working capital assessment and track limits based on stock and book debts
statements. The bank recognises that Turnover method may not be suitable for all sectors like
industries of seasonal nature, manufacturing units dependent on agricultural commodities as
inputs, NBFC’s, capital market intermediaries, real estate developers etc. In case of sectors
where turnover method cannot be applied, the bank would adopt suitable method of assessing
the requirements for the sector and apply the same consistently across the portfolio.
The assessment of limits varies with each facility requested by the borrower. While assessing
the limits of a borrower, the various conditions that are considered are the nature of facility
(fund based or non-fund based), tenor of facility, other bank limits, projections of sales, cash
flows etc. Broadly we can divide assessment of limits into assessment for working capital
facilities and assessment for term loans. While assessing limits for working capital facilities
we may use the Turnover Method, Maximum permissible finance (MPBF) method or the
Cash budget Method as explained below:
Assessment for Working Capital Facilities
I. Turnover Method
Under Turnover method, working capital requirement is computed at a minimum 30% of
gross sales of which at least four-fifths should be provided by the bank and the balance one-
fifth representing the Borrowers contribution towards margin for the working capital.
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Particulars Amt (Rs. Crs)
A Projected Gross sales of borrower
B Working capital requirement (30%)
C Maximum possible working capital restricted to 4/5 of B
D Less: facilities with other working capital banks
E Maximum Permissible Bank finance from Kotak Bank
This method is applicable for clients whose working capital requirement is not subject to
seasonal fluctuations and the operating cycle remains stable throughout the year. Turnover
method would not be applicable to companies whose operating cycle is long (in excess of
100-120 days). For instance, companies with exports, sales to SEB’s, utility companies, etc.
Points to be noted under Turnover method:
 It is to be ensured that the projected annual gross sales are reasonable and achievable
by the unit and the estimated growth if any over the previous year is realistic.
 At the time of assessment, we may call for returns filed with statutory authorities as
useful guiding documents for verification of sales & assessment of reasonableness of
the projections.
 The entire sales proceeds should be routed through the cash credit account of the
borrower in case of sole banking.
 Data of actual sales pertaining to the last 2 years, estimates for the current year, and
projections for the next year, together with the trend analysis of the relative industry,
would also be useful while appraising the sales projections.
 Other information regarding modernization, working capital for expansion, changes in
government policies, increase/ decrease in taxation and other relevant internal and
external factors also need to be taken into account.
 Any unreasonable projected increase (say beyond 25%) of the previous year actual or
current year estimates would need a closer look.
II. Tandon Committee’s Second Method of Lending
The second method of lending constituted by the committee is used to compute the maximum
permissible finance that can be granted by a bank to a borrower.
The information system to be submitted by the borrower as suggested by the Tandon
committee consists of the following financial statements:
1. Operating statement
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2. Fund flow statement
3. Statement of current assets and current liabilities
4. Balance sheet and P&L account
These documents are collected by the bank on an annual basis.
Under this method, the borrower should provide for a minimum of 25% of total current
assets. A certain level of credit for purchases and other current liabilities will be available to
fund the build up of current assets and the bank will provide the balance (Maximum
Permissible Bank Finance). Consequently, total current liabilities inclusive of bank
borrowings should not exceed 75% of current assets.
The MPBF method is used for larger corporate and in specific cases with longer operating
cycle. The trend of current assets and current liabilities also remains similar through the
years.
III. Cash Budget Method
Cash budget method is generally used for assessing working capital finance for seasonal
industries like sugar, tea, etc, for construction activity and for service oriented concerns. In
these cases, the required finance is quantified from the projected cash flows and not from the
projected values of assets and liabilities. In this method of assessment, besides the cash
budget other aspects like the borrower’s projected profitability, liquidity, gearing, funds flow,
etc. , are also analysed. The projections drawn by the borrower may then be jointly discussed
with the bank as modified in light of the past performance and the bank’s opinions. The peak
cash deficit is ascertained from the cash budgets.
The promoter’s margin money for such requirement may be mutually arrived at by the banker
and the borrower with the balance requirement forming the bank financed part of working
capital. The cash budget analysis is also used for sanction of ad hoc working capital limits.
Thus in this method, the required finance is quantified by the bank after assessing fund flow,
profitability and other financial parameters.
In seasonal industries, the peak level requirements of the borrowers would be normally for
short periods and the borrower cannot be given peak level limits throughout the year. In such
cases, cash budget system will help the bank in funding only deficit of the cash flow budget.
While fixing the limit based on the cash budget, the following points should be considered:
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i) The cash budget is realistic and based on the operations in the business/ similar
business
ii) The cash budget statement tallies with the underlying financial statements viz.,
projected balance sheet and profit and loss account.
iii) Outstanding bank borrowings figures in the projected balance sheet tally with the
deficit as shown in the cash budget statement
iv) The closing balance of the debtors is correctly arrived at by summing up opening
balance of debtors and credit sales minus realisation of debtors.
v) The expenses as indicated in the cash budget tallies with the expenses as reflected in
the projected profit and loss account.
vi) The peak deficit level needs to be linked to the drawing power of the borrower.
Facility wise assessment: In addition to the assessment methods for working capital
facilities, it is necessary to conduct facility wise assessment for each borrower.
Assessments of limits for various products are dealt with in respective product notes.
Term loans are loans with a medium to long term repayment schedule that may be
structured with an initial moratorium period. Such requirements arise when companies
purchase fixed assets, make long term investments, or when they make a contribution to
core working capital. A term loan being long term debt signifies high risk and is generally
priced higher. Therefore it is important that the need for the term loan is understood
clearly and the viability for the underlying project is carried out. Net Present value (NPV)
and Internal rate of return (IRR) can be used to judge the viability of a project.
Features of the facility:
1. The basis of assessment of a term loan is the projections made by the company. The
company may submit this information as part of its CMA data (credit monitoring
arrangement) or as projections for a specific standalone project. It is important to
understand all the assumptions underlying these projections.
2. The basis of evaluation of a term loan could be the debt equity projections, DSCR
projections, the free cash flow projections and a sensitivity analysis of the key
assumptions. In case of an existing company undertaking capacity expansion, DSCR
for the project on a standalone basis also has to be comfortable/ acceptable to assess
whether the project on a standalone basis is viable.
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3. The fixed assets that are created in the project act as the primary security for the loan.
Banks may insist on additional collateral including existing fixed assets, other
investments of the company or in rare cases promoter’s equity shares in the company.
4. It is important that the promoter has invested adequate capital in the project to ensure
its stability. Typically the long term debt equity ratio of a company should not exceed
1. The debt equity ratio of the new project itself may be higher but not exceeding 2
times unless it is a very large infrastructure project.
5. The borrower has the option to draw down funds in a single tranche or in multiple
tranches during the implementation period.
6. The proceeds of the loan shall be credited to the current account of the borrower to be
opened with the bank or the proceeds can also be disbursed by a cheque/pay order/
DD/ RTGS to the vendor directly based on the invoices submitted. Term loan can also
be disbursed by way of reimbursement of expenditure already incurred against
production proof and other documents as stipulated.
7. The repayment of the loan may follow an approved repayment schedule. Typically the
bank restricts its term loan financing to a period of 3-5 years based on the credit rating
of the borrower.
8. A term loan sanction is typically valid for a period of 3 months unless a higher
validity has been specifically approved. However if the company has drawn down its
first tranche, the validity of further disbursements id dependent on the amount of loan
that remains to be drawn down and capitalized for the purpose of making the
repayment schedule. All such balance disbursements will be subjected to the same
repayment schedule as the first disbursement. Thus if the tenor of the loan is
beginning from the date of first disbursement, the tenor of subsequent disbursements
follow the same repayment schedule.
9. Normally a bank sanctions LC and Buyers credit limits as a sublimit to term loan to
enable procurement of the equipment and to get the benefit of suppliers credit. In such
cases the tenor of the term loan begins from the date of opening of the LC.
10. Term loans should be subjected to periodic credit reviews atleast annually. This
should initially capture the details of time overrun or cost overrun, if any. The reviews
should be based on actual inspection of the site based on the size/ risk of the loan.
11. It is essential for the schedule for implementation of the project and the date of
commencement of commercial production to be obtained from the borrower.
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Principles of assessment
The various parameters that need to be appraised for a term loan are the following:
1. Cost of the project
2. Means of financing
3. Promoters contribution
4. Nature of product and existing competition
5. Nature of industry and demand forecasts
6. Impact of technology
7. Management capabilities and track record
8. Geographical location and distribution strategy
9. Repayment terms
10. Security for the loan
Structuring of term loan can be done in following ways:
1. Buyers credit facility as sub-limit to the term loan facility
The borrower shall have an option of converting the buyer’s credit facility into a
rupee liability at an interval of every one year. Buyer’s credit against LCs is restricted
to 36 months. At the end of 36 months or as stipulated by credit, the outstanding
balance in the buyer’s credit shall be converted into a rupee term loan. The tenor of
the rupee term loan will be the balance tenor based on original approved tenor and
buyer’s credit facility already availed.
2. LC facility as sub-limit to the term loan facility
The LC is opened in favour of the supplier of machinery/ equipment etc. The LC is
paid by disbursing the term loan facility. The tenor of LC would be included in the
overall tenor of the loan. In general the total tenor of the LC and the term loan should
not exceed a period of 5 years.
3. LC facility as sub-limit to the term loan facility, buyers credit against FD
In this structure, the LC will be repaid by way of a Buyers Credit facility. Buyer’s
credit is backed by 100% cash margin and is simultaneously outstanding with the
term loan. Buyer’s credit is repaid by closure of fixed deposit and the term loan is
repaid in instalments. This structure is useful when the Buyer’s credit rates are low
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enough to justify the spread between the term loan rate and fixed deposit rate of
interest.
4. LC facility and Buyers credit facility as sub limit to the term loan
In this structure, the LC facility is repaid by way of disbursement of Buyer’s credit
facility. LC and Buyer’s credit facility are sanctioned as sub-limit to term loan. The
borrower repays by way of EMI on TL value and tenor. These EMIs are kept as fixed
deposits until the Buyer’s credit falls due for repayment. The Buyer’s credit is repaid
by fixed deposit proceeds and term loan for the shortfall. After the buyer’s credit is
repaid, the EMIs continue from the borrower till the term loan is fully repaid. As
compared to the previous structure, here only the buyer’s credit facility has been
utilised and once the buyer’s credit is repaid, the balance term loan remains
outstanding in rupee denomination.
While assessing the risk of term loans we may use techniques such as free cash flow
analysis, break even analysis, and scenario and sensitivity analysis for computing the
limits to be sanctioned to the borrower.
1. Sensitivity Analysis
Sensitivity tests are used to assess the impact of the change in one variable on another
variable. It is usually used to stress test the repayment capability on a loan as
indicated by DSCR by varying other parameters such as selling price, capacity
utilization, operating margin etc.
2. Scenario analysis
Scenario tests include simultaneous variation of a number of parameters based on an
event experienced in the past or plausible market event that has not yet happened and
assessment of their impact on the desired outcome typically repayment of a loan.
In sensitivity analysis, typically one variable is varied at a time. If variables are inter-
related it is helpful to look at some plausible scenarios, each scenario representing a
consistent combination of variables.
3. Break even Analysis
While analysing new projects the bank would be interested in knowing how many
units may be produced and sold at a minimum to ensure that the project does not lose
money. Such an exercise is called break even analysis and the minimum quantity at
which loss is avoided is known as break even point (BEP).
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CREDIT MONITORING
The objective of credit monitoring is to detect “early warning signals”, in order that necessary
corrective action could be taken before the account deteriorates.
The monitoring of credit risk would include:
 Periodic review of the borrower’s operating and financial performance
 Periodic review of the performance of the borrower’s account with the bank
Monitoring for early warning signals
In order to detect early warning signals in case of weak accounts and initiate remedial action
promptly some symptoms of sickness have been listed below:
 Frequent change in financial year and accounting policies
 Shortage in quantity of hypothecated goods
 Over valuation of hypothecated goods in stock statements
 Inferior quality of goods produced/ or unusually high frequency/ quantity of return of
goods
 Removal of plant and machinery charged as security without bank’s prior consent
 Value of hypothecated assets stated lower in insurance policies vis-à-vis values
reported in stock statements/ balance sheet
 High value of receivables and inventories
 Frequent return of cheques deposited for credit into the account and/ or cheques
drawn on the account
 Frequent return of bills discounted/ purchased on behalf of the borrower. Large and
longer outstanding in the bill accounts. Longer period of credit allowed (vis-à-vis
industry practice) on sale documents negotiated through the bank drawn
 Frequent requests for excess drawings, TODs/ Ad hocs by the borrower and/ or
outstanding balance in cash credit account remaining continuously at the maximum
 Reduction in the level of turnover in the account, reduction in credit summation in
cash credit account
 Elongation of working capital cycle
 Delay in submission of stock statement, financial statements and other control
statements, including review/ renewal data by the borrower
Page | 38
 Widening difference between outstanding and drawing power/ sanctioned limit and
continuous irregularity in cash credit account
 Attempt to divert sale proceeds through accounts with other banks
 Inability to maintain stipulated margin on continuous basis
 Periodical interest debited remaining un-serviced
 Low capacity utilization
 Profit fluctuation, downward trend in sales and stagnation or fall in profit as reflected
in the quarterly/ monthly data followed by contraction in the market share of the
borrower
 Excess leverage relative to past and industry average
 Failure to pay statutory dues
 Failure to pay timely instalments of principal and interest on term loans
 Financing capital expenditures out of funds for working capital purposes
 A general decline in the related industry combined with many failures
 Diversion of funds for purpose other than for running the unit
 Attrition in key management and labour problems
 Increasing number of law suits against the company
 Any major negative remarks by auditor impacting profitability or regarding internal
controls of the company
 Continuous change in auditors, accounting policy
 Drastic fall in share price of the company
 Drastic increase in raw material prices or fall in selling prices
REVIEW/ RENEWAL
It is necessary that all revolving/ non-revolving limits are renewed/ reviewed on a yearly
basis. If such renewals are not performed diligently within the expiry date of the limit, it may
lead to the facility becoming an NPA. It is possible that the review/ renewal may be delayed
due to non-submission of complete information or non-availability of latest financials or due
to pending limit enhancement requests from the borrower. In all such cases, it is necessary to
take approvals for extension of validity of limits from the appropriate authority. The
maximum extension that can be given is for a period of 180 days and the renewal not taking
place within this period will lead to classification as NPA.
Page | 39
While evaluating a renewal request it is necessary to obtain the latest information on the
borrower and his group companies. It is also important to visit the factory and meet the
management to update the performance of the company during the review/ renewal period
and also the business plans for the immediate future. Based on these meeting and the
information submitted, the CMA may be revised and request for enhancement considered on
the basis of the required CMA. All review/ renewals must be backed by the performance of
the account as provided by the credit monitoring division.
It must be ensured that in case of all working capital limits above Rs.5 crores which are
secured by current assets, a stock audit is conducted on an annual basis and the stock audit
report is made available for the renewal of limits. Proper approvals need to be taken to ensure
that such deferrals remain valid. In case of a serious concern being observed in the account
by RBI/ internal auditor/ statutory auditor, the remark with details of corrective action may be
highlighted in the review/ renewal proposal.
The process of renewal must be diligently followed even for exit accounts. If the borrower is
unwilling or uncooperative, the renewal must be taken up with the information already
available.
BASEL II AND CREDIT RISK RATING
The past three decades witnessed increasing globalization of banking operations, with banks
across the world increasing their presence across countries. This led to the birth of Basel
accord, which was adopted in order to stipulate standard capital requirements for banks.
Banks need to maintain capital for meeting unexpected losses arising from their operations.
The expected losses need to be covered through risk based pricing. Basel-I stipulated a one
size fit all number of 8%, meaning thereby that banks were required to keep Rs.8 as capital
for every Rs. 100 of lending. However, the flaw of the accord was exposed as banks which
had engaged in riskier lending and those which were conservative were required to maintain
the same level of capital. This led to further refinements and Basel-II was unveiled with risk
sensitive capital requirements.
Basel-II uses a “three pillars” concept-
1. Minimum capital requirements (addressing risk)
2. Supervisory review and
Page | 40
3. Market discipline- to promote greater stability in the financial system
The first pillar-The first pillar deals with maintenance of regulatory capital calculated for
three major components of risk that a bank faces- credit risk, operational risk and market risk.
The losses on the lending portfolio are dependent on:
1. The likelihood that an obligor will not repay his commitment- Technically called the
Probability of Default (PD)
2. The likely loss that will result or the proportion of exposure that will not be recovered
when a default occurs- Loss given Default (LGD)
3. Likely drawdown in the facility, at the time of default- Exposure at Default (EAD)
Basel-II takes into account the creditworthiness of the borrower (PD), the bank’s recovery
experience (LGD) and the exposure (EAD) in order to determine the capital requirement.
Thus, it also recognises reduced capital requirement wherever adequate security (collateral) is
available as a risk mitigant. Further, the accord enforces risk capital on committed but
unutilized credit lines and even off- balance sheet items. The exact risk capital required is
subject to the various approaches allowed under the accord.
Standardized approach stipulates risk capital based on external ratings of the borrower.
Wherever it is expected that the borrower along with the security offered would earn a better
rating than BB the bank may opt for getting the client rated to conserve capital. The risk
weight stipulated for varying rating grades are stipulated below:
Rating Grade Risk weight
AAA 0%
AA 20%
A 50%
BBB to BB 100%
Below BB 150%
Unrated 100%
In order to adopt the advanced approaches viz. Foundation Internal Ratings Based (IRB)
Approach and Advanced IRB; the banks need to calculate their own PD, LGD and EAD
numbers over 5 to 7 years. Thus ratings need to be inculcated in the internal decision making
process.
Page | 41
The second pillar- The second pillar defines the process for supervisory review of a bank’s
risk management framework and ultimately its capital adequacy. It sets out specific oversight
responsibilities for the board and senior management, thus reinforcing principles of internal
control and other corporate governance practices established by regulatory bodies.
The third pillar- The third pillar aims to bolster market discipline through enhanced
disclosure by banks. It sets out disclosure requirements and recommendations in several
areas, including the way a bank calculates its capital adequacy and its risk assessment
methods.
KMBL has an internal credit rating model (Kotak Risk Assessment Model- KRAM) for the
comprehensive risk assessment of the wholesale banking credit exposures. All borrower
accounts (except individual borrowers) are rated on the K-RAM model at the time of
appraisal and thereafter on every renewal of the account. The rating system gives out two
levels of ratings- Obligor rating which determines the standalone rating of the borrower
(which corresponds with the PD) and the facility rating which determines the rating of the
security available for the loan (which corresponds with LGD& EAD).
The rating system has various models to rate companies of different types. Thus they have
separate rating models for large corporate (turnover> Rs. 100 crs), SMEs (turnover< Rs. 100
crs), stock brokers, traders, NBFC’s and companies providing services. The parameters to
evaluate ratings are business risk, industry risk, management risk and financial risk.
Appropriate weightage to these parameters have been decided based on past experience and
management judgement.
The rating system of the bank grades obligors into 18 categories. An indicative scale for
probability of default based on CRISIL’s experience of rating migration/ defaults has been
used to develop the rating system. The facility extended by the bank to the borrower is also
rated on a comprehensive scale of 30 categories of ratings. The obligor rating is calibrated to
indicate the probability of default over the tenor of the loan. The facility rating captures the
specific security available to that facility and therefore measures the likely loss given default.
The combination of obligor and facility rating provides combined rating which is divided into
18 categories.
Page | 42
K-RAM has a process for creating the Bank’s own database on defaults. This database would
help in estimating probabilities of default for each rating category based on the Bank’s
experience.
Portfolio Management is a management tool used to minimise concentration of credit risk at
the portfolio level. This is done to avoid concentration of risk in a particular industry segment
or in a particular region. Portfolio analysis can also be done based on various parameters to
manage the duration risk at the portfolio or the unsecured component of the portfolio or based
on its linkages either in the supply chain or customer segments. It is also important to analyse
whether the risk adjusted return being generated by the portfolio is satisfactory. In order to
regulate the portfolio using the ratings as a benchmark, the bank has devised a set of norms
for escalation of sanctioning matrix by putting caps on borrower group exposures.
INTERNAL GUIDELINES
Credit Origination Process
The credit origination process (COP) is the process manual for credit origination compiled
with a view to standardize the credit origination process. The objectives of COP are to:
a) Define the process to be adopted in the origination of credit proposals in the
wholesale banking sphere (Corporate Banking., SME, FIG, TF, Agriculture,
Treasury), which can be applied consistently; and
b) Defining the responsibilities of various functionaries involved in the credit chain
Board Customer Acceptance Criteria (BCAC)
It ensures that the relationship manager would be able to segregate doable credit cases from
the non doable ones.
BCAC for Manufacturing Entities (subject to product guidelines if any)
S. No. Criteria Applicable for
corporate
customers
Applicable for SME
customers
1 Net sales/ Net profit on the growth
path
For the last two years For the last two years
2 Profitability at operating profit Minimum 10% of net Minimum 10% of net
Page | 43
(PBDIT) (i.e. excluding non
operative income)
sales. No slippage in
the last two years
sales. No slippage in
the last two years
3 Total term borrowing/ Cash profit
(basis- as per last audited
financials)
Not exceeding 3 Not exceeding 4
4 Interest/ Net sales (basis- as per last
audited financials)
Not exceeding 5% Not exceeding 5%
5 TOL/ TNW ratio Not exceeding 2.00 Not exceeding 2.50
(treating unsecured
loans from promoters
clearly sub-ordinated
to the banks exposure
as part of TNW)
6 Current ratio Minimum 1.10 Minimum 1.15
7 Promoters reputation No negative reports
from the market
No negative reports
from the market
8 Industry outlook Positive Positive
9 Borrower rating Not below BBB Not below BBB
BCAC for Traders (including importers and exporters)
S. No. Criteria Applicable for
corporate
customers & SME
customers, subject
to limits being
considered is more
than Rs. 3 crs.
Applicable for SME
customers, subject
to limits being
considered is less
than Rs. 3 crs
1 Business vintage Minimum five years Minimum three years
2 Business being carried out from the
current location (to be evidenced
from electricity/ telephone bill etc.)
Minimum three years Minimum two years
3 Banking habit Should be enjoying Should be enjoying
Page | 44
limits from banking
system for the last
two years
limits from the
banking system for
the last two years
4 Profit making Minimum for the last
three years
Minimum for the last
two years
5 Interest coverage (as per the last
audited financial statement)
Minimum 2 Minimum 2
6 TOL/TNW ratio Maximum 5 Maximum 5
7 Investment in other connected
entities
Not to exceed 50% of
the Tangible Net
worth (treating
unsecured loans from
promoters clearly
sub-ordinated to the
banks exposure as
part of TNW)
Not to exceed 50% of
the Tangible Net
Worth (treating
unsecured loans from
promoters clearly
sub-ordinated to the
banks exposure as
part of TNW)
Classification and declaration of borrowers as wilful defaulters
The bank would check whether the borrower and/ or its Directors/ associates appear in the
wilful defaulters list as announced by RBI from time to time. The bank would on case to case
basis extend finance to companies where the name of any its directors is reported as an
independent/ professional/ nominee director of another company appearing in wilful
defaulters list provided such director no longer continues to hold directorship in the wilfully
defaulting company. The decision to finance such companies will be taken by the respective
approving authority. In all other cases, the bank would not grant any credit facility to the
listed wilful defaulters.
A Wilful Default Assessment Note (WDAN) will be prepared containing details of:
a. The borrowers account, facilities availed and outstanding balance
b. Latest financial details
c. Comments on operations in the account
d. Details of default and follow-up action taken by the bank
Page | 45
e. Reasons why the borrower is recommended for classification as wilful defaulter
f. Whether the borrower has defaulted with other banks and details thereof
g. Specific event under which the borrower should be classified as wilful defaulter
A borrower classified as ‘wilful defaulter’ would be given 15 days time after issue of the said
notice letter to make a representation against the classification.
MULTIPLE BANKING/ CONSORTIUM BANKING ARRANGEMENT
Multiple banking is a banking arrangement where a borrower avails finance independently
from more than one bank and where the rules of consortium do not apply. The borrower may
avail credit facilities from various banks providing different securities on different terms and
conditions. In such an arrangement each banker is free to do his own credit assessment and
hold security independent of other bankers. There is a regular exchange of information with
the other banks.
Consortium Banking is a banking arrangement where several banks finance a single borrower
following common appraisal, joint documentation, joint supervision and follow up exercises.
There is a lead bank known as the consortium leader that supervises this entire process. In
consortium lending, several banks pool banking resources and expertise in credit
management together and finance a single borrower. However, normally the lead bank’s
assessment and documentation is followed by member banks. Thus the borrower enjoys the
advantage of single window facility while availing credit facilities from several banks.
KMBL would take exposures under sole banking, multiple banking or becoming part of the
consortium. In all these cases the bank would appraise the credit worthiness of the business
and the support worthiness of the request and assess the requirements of facilities either itself
or would base its assessment on the assessment of any of the multiple banking members or
the leader or any member of the consortium.
In case of financing under multiple banking arrangements, the bank would be free to:
 Structure the facilities
 Charge interest rates/ commission based on its risk perception and the structure of the
facilities
 Stipulate security as well as other terms and conditions for the exposure as deemed
necessary by the approving authorities
Page | 46
 Obtain credit securing documents as deemed necessary by the bank and register
charges with the appropriate authorities
 Administer and monitor the credit exposure as in the case of sole banking exposures
and may share information with the other lenders as regards the facilities, conduct of
account etc on reciprocal basis.
LOAN REVIEW MECHANISM
Loan Review Mechanism (LRM) is an effective tool for monitoring borrower accounts at
regular pre-defined intervals and serves as an early warning system in identifying
potential weakness in the loan that might lead to an impact on asset quality. LRM
comprises of a periodic review of the loans and advances granted by the bank to ensure
that the advances granted are of the desired credit quality and no deterioration takes place
in them in due course of time.
The LRM procedures encompasses all areas of loans granted starting from credit
origination, credit risk assessment, credit administration, disbursement (limit
implementation) and credit monitoring. It assesses the adequacy of and adherence to
internal loan policies and procedures and helps identifying potential problem areas and
loans at an early stage.
Criteria for selection and Frequency of reviews:
Category Obligor rating Aggregate Exposure Amount Frequency of
reviews
1 K-AA- and above Rs. 50 crores and above Within 3 months of
sanction and once a
year thereafter
2 K-A and above Rs. 20 crores and above Within 3 months of
sanction and once a
year thereafter
3 K-BBB- and above Rs. 10 crores and above Within 2 months of
sanction and once in
6 months thereafter
4 K-BB+ and below Irrespective of exposure amount Within 1 month of
Page | 47
sanction and once in
6 months thereafter
NPA MANAGEMENT AND RECOVERY
An NPA is an asset including a leased asset that becomes non performing when it ceases to
generate income from the bank.
 A non performing asset (NPA) is a loan or an advance where;
i. Interest and/ or instalment of principal remain overdue for a period of more
than 90 days in respect of a term loan
ii. The account remains ‘out of order’ in respect of an overdraft/ cash credit
iii. The bill remains overdue for a period of more than 90 days in the case of bills
purchased and discounted
iv. The instalment of principal or interest thereon remains overdue for two crop
seasons for short duration crops
v. The instalment of principal or interest thereon remains overdue for one crop
season for long duration crops
vi. The amount of liquidity facility remains outstanding for more than 90 days, in
respect of a securitisation transaction undertaken
 Banks should, classify an account as NPA only if the interest charged during any
quarter is not serviced fully within 90 days from the end of the quarter.
NPA Identification
Accounts with temporary deficiencies: The accounts will be classified as NPA based on
the temporary deficiencies in nature such as non-availability of adequate drawing power
based on the latest available stock statement, balance outstanding exceeding the limit
temporarily, non-submission of stock statements and non-renewal of the limits on the due
date as per the principles given below:
 Stock statements relied upon for calculating drawing power in respect of drawing in
working capital account should not be older than three months. The outstanding in the
account based on drawing power calculated from stock statements older than three
months, would be deemed as irregular.
Page | 48
 A working capital borrowal account will become NPA if such irregular drawings are
permitted in the account for a continuous period of 90 days even though the unit may
be working or the borrower’s financial position is satisfactory.
 An account where the regular/ ad hoc credit limits have not been reviewed/ renewed
within 180 days from the due date/ date of adhoc sanction will be treated as NPA.
Asset classification to be borrower wise and not facility wise- In respect of a borrower having
more than one facility with a bank, all the facilities granted by the bank will have to be
treated as NPA and not the particular facility or part thereof which has become irregular.
NPA classification and provisioning
Substandard assets Assets which have remained
NPA for a period less than or
equal to 12 months.
20% Capital provision for
unsecured & 10% for secured
Doubtful assets An asset would be classified
as doubtful if it has remained
in the substandard category
for a period of more than 12
months
100% Capital provision for
unsecured, 20% on secured
portion if doubtful upto 1
year, 30% on secured portion
if doubtful from 1 to 3 years,
100% on secured portion if
doubtful for more than 3
years.
Loss assets A loss asset is one which is
considered uncollectible and
of such little value that its
continuance as a bankable
asset is not warranted
although there may be some
salvage or recovery value.
100% Capital provision
Income recognition:
o Income from NPA is not recognised on accrual basis but is booked as income only
when it is actually received
Page | 49
o Interest on advances against term deposits, NSCs, IVPs, KVPs and life policies may
be taken to income account on the due date, provided adequate margin is available in
the accounts.
o If any advance, including bills purchased and discounted, becomes NPA as at the
close of any year, the entire interest accrued and credited to income account in the
past periods, should be reversed or provided for if the same is not realised. This will
also apply to government guaranteed accounts.
Restructured accounts: A restructured account is one where the bank, for economic or legal
reasons relating to the borrower’s financial difficulty, grants to the borrower concessions that
the bank would not otherwise consider. Restructuring would normally involve modification
of terms of the advances/ securities, which would generally include, among others, alteration
of repayment period/ repayable amount/ the amount of instalments/ rate of interest.
Recovery policy- The bank has formulated a recovery policy with the following objectives:
 Monitor standard assets to avoid slippages
 To manage and control the bank’s absolute NPA by accelerating recoveries
 To encourage compromise settlements and accelerate recoveries
 To keep gross NPA percentage at the minimum level of gross advances excluding
ARD portfolio
The bank can take recourse in case of default through the following sources:
1. Debt Recovery Tribunals
2. SARFAESI Act,2002
3. Arbitration
4. Section 138 of Negotiable Instruments Act,1881
5. Winding up process through courts proceedings
Under all the above mentioned processes, the distribution of proceeds must follow the
guidelines given under section 539A of the Companies Act.
The bank takes advantage of the SARFAESI Act, 2002 that empowers banks/ financial
institutions to recover their non-performing assets without the intervention of the court. The
Act provides three alternative methods for recovery of non-performing assets, namely-
 Securitisation
Page | 50
 Asset reconstruction
 Enforcement of security without the intervention of the court
The provisions of this Act are applicable only for NPA loans with outstanding above Rs. 1
lakh. NPA loan accounts where the amount is less than 20% of the principal and interest are
not eligible to be dealt with under this Act.
Non-performing assets should be backed by securities charged to the bank by way of
hypothecation or mortgage or assignment. It is essential that approval is received from 75%
of all secured creditors in order to have a right over BIFR ruling in case of a BIFR company.
The bank follows the steps as given below as per the SARFAESI Act, 2002:
I. It is to be ensured that the account should be classified as NPA as per RBI guidelines
II. Demand notice should be issued by an Authorised officer of the bank calling upon the
borrower/ guarantor to pay dues within 60 days. The borrower/ guarantor is entitled to
make his representations/ objections to the bank and the bank is required to deal with
these objections and communicate the same within 7 days.
III. In case of non-compliance by borrower, the bank u/s 13(4) can take any of the
following steps:
 Take possession of the secured assets of the borrower
 Take over the management of the business
 Appoint any person to manage the secured assets taken over
 Give notice to third person who has acquired secured assets/ or from whom
money is due to borrower
IV. Gives notice to the borrower for taking possession/ affix the same on the property
V. Take possession of the properties and publish a notice in two leading newspapers of
which one should be in a vernacular language
VI. In case of refusal to hand over possession, file an application u/s 14 before the Chief
Metropolitan Magistrate/ District Magistrate for taking forcible possession.
VII. After taking possession of the assets, if they are movable assets then the bank will
make an inventory of the assets and obtain valuation through an approved valuer. The
bank will fix a reserve price and then serve a notice for sale of 30 days to the
borrower. After this notice period the bank can sell the assets by public auction or
private treaty.
Page | 51
VIII. After taking possession of the assets, if they are immovable assets then the bank will
obtain valuation and fix a reserve price for the property. The bank will then give a 30
day notice for sale to the borrower. After this notice period the bank can sell assets by
public auction or private treaty.
LEGAL DOCUMENTS AND PROCEDURES
A. Basic Documents for all facilities
1. Application/ request letter for the facility: An application, wherein the prospective
borrower/ customer is applying to the bank for seeking credit facilities is required in
order to verify the intention of the borrower to avail the facilities.
2. Accepted sanction letter: Sanction letter is a formal communication from the bank to
the borrower mentioning facilities offered by the bank to the borrower, its limit, type
of facility, purpose, validity, tenor, rate of interest, disbursement method, repayment
method, security, transactional documents, covenants/ conditions etc. It also mentions
the list of documents that need to be executed/ furnished/ submitted by the borrower
to the bank.
3. Constitutional documents: The constitutional documents required depending upon the
status of the borrower are:
 Sole Proprietorship: No constitutional document
 Partnership firms: Partnership deed
 Companies: - Memorandum and articles of association
- Certificate of incorporation
- Certificate of commencement of business in case of public
limited companies
- In case of a section 25 company, above documents and the IT
certificate confirming exemptions
 Trusts: Trust deed (if the trust is registered, the bye laws and certificate of
registration of trust are verified)
 Corporative societies: Bye laws (it is to be checked if the above mentioned
documents are rightly issued by the concerned registrar and duly certified)
 Limited Liability Partnerships (LLP): - Incorporation document - LLP
Agreement
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report
Nimisha Agarwal_SIP report

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Nimisha Agarwal_SIP report

  • 1. CREDIT RISK ANALYSIS AT KOTAK MAHINDRA BANK LTD. SIP project report submitted in partial fulfilment of the requirements for the PGDM Programme By Nimisha Agarwal 2013173 Supervisors: 1. Mr. Ranjan Guglani 2. Prof. Sayan Banarjee Institute of Management Technology, Nagpur 2013-15
  • 2. Page | 2 ACKNOWLEDGEMENTS This project bears imprint of all those who have directly or indirectly helped and extended their kind support in completing this project. I find no words to express my gratitude towards those who are constantly involved with me throughout my project at KOTAK MAHINDRA BANK LIMITED. I would like to thank company guide Mr. Ranjan Guglani, Associate Vice President- Large Corporates, Corporate Banking, New Delhi for guiding me throughout the duration I was doing my internship. He has been a central guiding force giving me all the information and imparting his knowledge on the entire process and activities. I would like to thank my faculty guide Professor Sayan Banerjee, who has given me the adequate freedom and has allowed me to conduct my work and research in the field of my interest. I am grateful to the Wholesale Banking team in New Delhi, headed by Mr. Rajan Nanoo, Executive Vice President, Regional Credit head, Corporate Banking, Kotak Mahindra Bank Ltd. And finally I would like to acknowledge the entire department and employees of Kotak Mahindra Bank Ltd, New Delhi, for taking out time from their busy schedules to answer all my queries and give me time for interviews and ensuring that I have all the adequate information to complete my report.
  • 4. Page | 4 TABLE OF CONTENTS S.No. Particulars Page No. 1 Acknowledgements 2 2 Certificate 3 3 Objectives of the study 5 4 Introduction 6-8 5 Concepts used in the study 9-54 a. Credit Appraisal 10 b. Process of credit appraisal 11 c. Assessment of Product Structure 13 d. Risk Assessment 14 e. Layman's guide to detecting financial stress 23 f. Evaluation of security 25 g. Importance of a plant visit/ management meeting 28 h. Reference checks 29 i. Assessment of limits 30 j. Credit monitoring 37 k. Review/ Renewal 38 l. Basel II & Credit risk rating 39 m. Internal guidelines 42 n. Multiple Banking/ Consortium Banking Arrangement 45 o. Loan Review Mechanism 46 p. NPA Management & Recovery 47 q. Legal documents & Procedures 51 6 Case Study Analysis 55 7 Limitations of the study 65 8 Scope for future improvements 65 9 Sources of information 66
  • 5. Page | 5 OBJECTIVES OF STUDY The Summer Internship program (SIP) at IMT, Nagpur is a crucial part of the Post Graduate Diploma in Management (PGDM) curriculum. It gives students the opportunity to observe the professional arena and execute all the theory they have learnt in classes and put that to practical use. I have been fortunate enough to have had the opportunity to work in the Corporate Credit Banking department at Kotak Mahindra Bank Ltd. The credit division of any financial institution revolves around certain key traits that the company must evaluate. The way there are 4 P’s in Marketing, there are 4 P’s in credit as well. They are (i) Purpose, (ii) Promoter, (iii) Pricing & (iv) Property. They can easily be explained as firstly the Purpose being the reason why the customer wants a loan. Understanding the requirement that borrower has. The second is evaluating the Promoter. Is the borrower credit worthy? Does he have the intent and the ability to repay back the facility he has taken. Thirdly involves Pricing of the facility. What amount should the bank charge for offering the facility and fourth can be explained by the Collateral or security being offered against the facility such as property or any other form of security or guarantee. It is essential that the funds which are sanctioned to the customer is given on time, correctly and efficiently. In many cases the customer may have a requirement of funds as per his financial management plan to operate his business. It is the duty of the lender to disburse the funds as per the requirement of the borrower. In this report, I will be explaining the Credit procedures which are a crucial function of a bank. The economic and environmental influences that affect credit decisions. This report will also cover the importance of understanding risk, risk mitigation, the character of the borrower, the government and economic environment existing and the documents and legal implications in offering loans
  • 6. Page | 6 INTRODUCTION India is one of the top 10 economies globally, with vast potential for the banking sector to grow. The last decade witnessed a tremendous upsurge in transactions through ATMs, and internet and mobile banking. In 2014, the country’s Rs 81 trillion (US$ 1.34 trillion) banking industry is set for a greater change. Two new banks have already received licences from the government. Furthermore, the Reserve Bank of India’s (RBI) new norms will provide incentives to banks to spot potential bad loans and take corrective steps that will curb the practices of rogue borrowers. The Indian government’s role in expanding the banking industry has been significant. Through the Financial Inclusion Plan (FY 10-13), banking connectivity in the country increased more than three-fold to 211.234 villages in 2013 from 67,694 at the beginning of the plan. India’s banking sector has the potential to become the fifth largest banking sector globally by 2020 and the third largest by 2025. The industry has witnessed discernible development, with deposits growing at a CAGR of 21.2 per cent (in terms of INR) in the period FY 06-13; in FY13 total deposits stood at US$ 1,274.3 billion. Today, banks are turning their focus to servicing clients. Banks in the country, including those in the public sector, are emphasising on enhancing their technology infrastructure, in order to improve customer experience and gain a competitive edge. The popularity of internet and mobile banking is higher than ever before, with Customer Relationship Management (CRM) and data warehousing expected to drive the next wave of technology in banks. Indian banks are also progressively adopting an integrated approach to risk management. Most banks already have in place the framework for asset-liability match, credit and derivatives risk management. Source: http://www.ibef.org/industry/banking-india.aspx
  • 7. Page | 7 Kotak Mahindra Bank ltd. is an Indian bank and financial service firm established in 1985. It was previously known as Kotak Mahindra Finance Limited, a non-banking financial company. In February 2003, Kotak Mahindra Finance Ltd., the group’s flagship company was given the license to carry on banking business by the Reserve Bank of India (RBI). Kotak Mahindra Finance Ltd. is the first company in the Indian banking history to convert to bank. As of 2011 to October 2013, it has more than 500 branches, over 1,000 ATMs and a consolidated balance sheet of approx. US$ 2.9 billion. Kotak Mahindra Bank Limited offers transaction banking, operates lending verticals, manages initial public offerings (IPOs) and provides working capital loans. The bank operates in four segments: Treasury and BMU, Corporate/ Wholesale Banking, Retail Banking and other banking business. Treasury and BMU segment includes money market, forex market, derivatives, investments and primary dealership of government securities and balance sheet management unit (BMU) responsible for asset liability management. Corporate/ Wholesale Banking segment includes wholesale borrowings and lendings and other related services to the corporate sector, which are not included under retail banking. Retail banking includes lending, branch banking and credit cards. Lending includes commercial vehicle finance, personal loans, home loans, agriculture finance, other loans/ services and exposures. Other banking business segment includes any other business. Corporate banking services from Kotak Mahindra Bank include the following:  Product Suite: This has a whole gamut of products including: o Funded products that meet the working capital needs of the company along with other structured products. Source: http://www.ibef.org/industry/banking-india.aspx
  • 8. Page | 8 o Treasury products to mitigate risks that occur in business with products for foreign exchange, money market and benchmark PLR. o Amongst investment products, corporate bankers can choose term deposit, mutual funds and bank assurance. o Fixed income products offers highly qualified products from experienced professionals providing plain vanilla debt issuance to Asset Backed Securities (ABS), Mortgage Backed Securities (MBS), structured products and loan syndication.  Trade Finance: Companies that are involved in import and export have sought the expertise of our unique trade finance solutions. These include tailor made solutions created to meet the needs of export and import services. Apart from this, corporate are provided bank guarantees and other unique domestic services.  Commercial Banking: This is the one stop shop for meeting the needs of corporate when it comes to transportation, logistics and infrastructure and tractor industries.  Transactions Banking: Kotak Mahindra Bank simplifies the complex financial clearing system in India for corporate by offering receivables and payables services while ensuring predictability of cash flows.  Current Account: Quick and timely access to funds is provided to all corporate to meet the demanding business environment by giving a 2 Way Sweep feature for giving liquidity and higher returns.  Convenience Banking: To complete the gamut of services, Kotak Mahindra Bank has ensured that all corporates have access to net banking, Kotak Payment Gateway, mobile banking, SMS banking alerts, phone banking and wide ATM network.
  • 9. Page | 9 CONCEPTS USED IN THE STUDY Credit risk arises from the inability or unwillingness of a borrower to repay his liability on due date. The liability may be in the form of an instalment of a term loan, bullet repayment of a short term loan or timely servicing of interest on a loan. Credit risk may also arise from lack of churn in the working capital account for a period of more than 90 days or shortfall in drawing power or breach of financial covenants specified or occurrence of events of default as per contractual terms. The credit process is designed to evaluate the borrower for standard credit risks. However, no two borrowers are alike and therefore one needs to identify the unique risks and mitigations of each case. While appraising a borrower, the following questions need to be answered: 1. Is the borrower credit worthy? 2. What should be the overall exposure to the borrower? 3. Whether the borrower should be extended short term facilities or long term facilities based on his requirement? 4. What security or other credit enhancement measures should be stipulated to safeguard our facilities in case of default? 5. What should be the key monitor able parameters to identify any deterioration in credit profile of the borrower subsequent to our disbursement? The relationship between a bank and a borrower is typically built over a long term although such a relationship may have been built over a number of transactions of shorter duration. These transactions may take place across multiple products and with multiple entities of the borrower. Default in any one of these transactions can lead to the entire exposure being classified as a Non performing asset. Similarly, credit risk in one entity/ product can be mitigated by building recourse to all other related entities that have active exposures by virtue of a cross default clause that is normally inserted in all contracts. Therefore the credit enhancement available in one facility can also be used to improve the credit risk of another facility to the same borrower/group. Thus the procedure to be followed while assessing the credit risk of the borrower is to evaluate the historic track record of the borrower and all his related entities. The regulator provides default data across banking system which can be used as the first step for such a
  • 10. Page | 10 credit check. Independent credit information bureaus such as CIBIL also make default data available across the banking system. The background check of the borrower need not be restricted to the official data on defaulters. Informal channels need to be created to have a regular flow of information on defaulters. There is also a need to keep track of recent occurrences of default in the environment as well. Given the deep linkages between various players of an industry, starting from supplier to end user, a default event in one part of a chain can also impact a company in another part of the chain. The credit analyst is therefore required to stay abreast of all the developments in the economy and industry including international developments such as movement in commodity prices, volatile exchange rates, change in monetary policy, and bankruptcies in other countries that may have an impact on the performance of the borrower. The company may also make new plans that may change its financial projections. Lack of key data on such specific developments with the borrower is one of the major reasons why credit risk may not have been evaluated correctly in the first place. One of the major reasons for incorrect assessment of credit risk is the fraudulent intentions of the borrower who has submitted false data. It is therefore necessary to follow a strict discipline while evaluating credit risk in order to isolate misleading and false information. CREDIT APPRAISAL Before any credit appraisal we may ensure that the basic information is considered as a pre requisite for doing a credit appraisal, is made available and this data is most recent. The information required would include the following: i. Latest audited financials of the borrower and his group companies and provisional financials of past performance ii. Background information such as date of incorporation, nature of the entity, details on shareholders, directors, their educational and professional background iii. Details of location of registered office, factories and corporate office iv. Capacity and production data of the borrower’s business v. Revenue model of the company including segmental information on his customers vi. Key raw materials and their sources vii. Details of existing bankers, their loan amounts and their repayment terms
  • 11. Page | 11 viii. Future plans of the borrower for expansion of capacity, launching new products, making acquisitions and means of financing of the same ix. Statement of foreign exchange/ derivative exposure outstanding with details of MTM losses/ gains. In addition to the above, we may require knowledge about the industry in which the borrower operates, their direct and indirect competitors, their respective market shares etc. The information required would also depend on the following: 1. Nature of the transaction proposed- long term or short term, secured or unsecured, working capital or term loan 2. Size of the loan 3. Credit rating of the borrower 4. Rating outlook of the industry 5. Background of the promoters In general more in depth information is requires if the proposal is in the nature of a term loan, unsecured loan, emanating from a new promoter, proposal has low credit rating and there is a rating watch on the industry. PROCESS OF CREDIT APPRAISAL 1. Obtain all the basic information as stated in above question 2. Visit the website of the company to know more about their company and product details 3. Check whether the borrower or its directors/ shareholders appear in the NCIF of the bank or are classified as wilful defaulters by RBI. Also check whether the customer appears in the CIBIL list of suit filed/ wilful defaulters 4. Check applicability for any section 20 or any statutory restrictions for the borrower 5. Check that no credit facilities are extended to promoter related entities 6. Check if the sector exposure norms, individual and group exposure norms, substantial exposure norms are being met. 7. Check if real estate exposure, capital exposure limits are being breached, if considered 8. Do a search on capital line and obtain information on peers in the same industry 9. Compare the performance of borrower with the performance of peers and determine whether the borrower is a market leader, major player or only a minor player
  • 12. Page | 12 10. Where the companies have been rated by external agencies, their rating rationale should also be considered while appraising the company 11. In case information is not available on a company especially while evaluating risk limits obtain the financial information from ROC 12. Evaluate the security offered by conducting an ROC search, title search, valuation report and calculating the security cover available for the proposed transaction 13. Collect references from suppliers, customers, bankers, competitors etc. 14. Assess the information gaps and list critical queries based in the information available above 15. Visit the plant and meet the management of the company to bridge the information gaps 16. Prepare the financial spreadsheet based on the estimates and projections submitted by the borrower. Adjust the assumptions underlying the projections based on your critical assessment 17. Financial analysis must be done on standalone as well as consolidated basis. Analysis of YTD financials may also be presented on a quarter on quarter basis 18. In case of new borrower, evaluate the borrower vis a vis the BCAC specified in the Credit origination policy 19. In case of large investments in subsidiaries, analyse the subsidiaries 20. In case of renewal obtain the detailed account performance report from the credit monitoring division. Obtain copies of recent stock audit reports of the company and also check the pending documents in the account as per the latest report 21. While doing a renewal, it is a good practice to compare the stock/ book debts as appearing in the year end stock statement with the audited annual report of the previous year 22. Complete the rating. Go ahead with the proposal only if the rating meets the minimum requirement based on the expected loss indicated for the proposed transaction and the pricing being obtained vis a vis the expected loss. ROE may be computed both on risk adjusted basis or otherwise. If it does not meet minimum requirement in both cases, obtain Business Head approval before going ahead. 23. While preparing the credit appraisal, ensure that all relevant risks have been highlighted along with their mitigants, wherever possible 24. Assess individual facilities that have been proposed by the borrower
  • 13. Page | 13 25. Prepare a draft term sheet based on the facilities being proposed for sanction. Specify detailed terms and conditions in the term sheet by selecting the appropriate term sheet from the term sheet bank. Care should be taken to cancel all variable conditions that are not applicable and specify additional variable conditions if any 26. Stipulate PDC and PG if the combined rating is below BB+. Check whether facilities recommended are in line with portfolio norms specified 27. If the proposed transaction is in the nature of a take over ensure that take over conditions have been specified 28. The proposal may be sent for sanction to the appropriate approving authority based on the total exposure of the bank to the borrower/ group. While determining total group exposure we are required to obtain information from other departments of the bank such as home loans, consumer loans, commercial vehicles, ARD, etc. 29. Prepare the final term sheet based on the specific terms of the final approval and forward the same to CAD, Legal, Credit monitoring and operations 30. Prepare the sanction reporting document and submit it to the credit committee secretariat. ASSESSMENT OF PRODUCT STRUCTURE The type of loan sanctioned to a borrower and its terms of approval should naturally meet the requirements of the borrower. It is therefore necessary to ensure that working capital needs are met with working capital products and long term needs are met by long term products specific to the end use. It therefore implies that the repayment terms of the loan should be within the actual cash flows of the borrower. While disbursing the loan, where the security build up is in stages, care should be taken to ensure that the disbursement of the loan should be appropriately structured in line with the delivery of security. Thus instead of releasing the total facility at one go, the disbursement may be in stages in line with the build up of security. It is therefore essential to understand all aspects of how the security will be created while sanctioning the loan. Where the product structure relies on cash flows, it is necessary to monitor these cash flows on a periodic basis and appropriate events of default (EODs) need to built into the terms of sanction. While structuring limits, care should be taken to design the interchangeable limits as sublimit to the main limit. Some of the details that need to be understood while specifying the detailed conditions of disbursement include the following:
  • 14. Page | 14  Mode of disbursement which involves: 1. How to pay? 2. Whom to pay- payment to vendor or borrower or a takeover? 3. On what basis to pay?(transactional documents) 4. How much to pay?- what is the margin, interest rate, processing fee?  Repayment of the loan 1. What chain of events (cycle) will lead to eventual repayment? 2. What is the source of funds for repayment?  Monitoring of the entire cycle which involves: 1. What are the transaction specific monitoring conditions? 2. What are the covenants/ events of default, if any? RISK ASSESSMENT I. Business risk Business risk is unique to the customer’s specific business and depends on the product he manufactures, technology he uses, his geographical location, key inputs/ raw material, access to raw material and his cost structure. In a stable business model, the company has developed barriers of entry either in the form of superior product quality as reflected by its brand equity, its distribution network, low manufacturing cost, etc. In order to evaluate the business model of the company, we need to understand the composition of sales, the dependence on key raw materials, the availability of utilities such as electricity, water, labour, etc. The value addition made by the business may be different for different players. Business risk in service industry is different from that in a manufacturing industry. Business risk parameters can be broadly classified into market position factors and operating efficiency factors. Market position implies the ranking or position of a brand, product, or firm, in terms of its sales volume relative to the sales volume of its competitors in the same market or industry. Operating efficiency is a measure of a management’s ability to generate sales revenue and to control costs. Market position factors: 1. Product quality
  • 15. Page | 15 2. Product range/ mix 3. Brand equity 4. Customisation of products 5. Project management skills 6. Diversity of markets 7. Long term contracts/ assured offtake 8. Distribution set up 9. Financial ability to withstand price competition 10. Composition of customer base Operating efficiency factors: 1. Capacity utilisation 2. Availability of raw materials 3. Energy cost 4. Cost effective technology 5. Selling costs 6. Employee cost 7. Management of price volatility 8. Adherence to environmental regulation 9. R&D activities 10. Synergies with group companies II. Industry risk Credit risk is also a function of the industry in which the company operates. Industry risk refers to the risk that uniformly impacts all players of an industry segment. Thus it is not specific to a company but involves the entire industry that the company belongs to. Industry risk encompasses all those risk factors that are external to the company but have a common bearing on all its players. Industry risk may be measured by certain industry characteristics such as demand supply gap, government policies, input related risks and the extent of competition in the market. They are explained in detail as follows: 1. Demand supply gap would critically determine the volumes, realizations and consequently the profitability of companies operating in an industry. The
  • 16. Page | 16 attractiveness of an industry for fresh capital investments would depend upon the anticipated demand supply gap. The outlook on demand-supply position would largely be a function of:  Expected demand growth  Shifts in consumption pattern resulting in replacement demand and product substitution  Present installed capacities and commissioning of new capacities, which would determine the supply pattern in an industry. 2. Government policy determines the outlook of the policies and government regulations on the industry. The impact of govt policies with respect to tariff barriers such as import duties, quotas, sanctions, excise duty, taxes, domestic price control, incentives for new investments, incentives for exports, legislations for pollution control measures, laws with respect to foreign exchange on various industries need to be examined. 3. Input related risks would involve taking a view on availability of raw material and volatility in the prices of raw material. The volatility in prices would affect the earnings stability, depending upon the ability of the industry to pass on increase in raw material prices to the end users. The industries characterized by high value addition would be less susceptible to the volatility in raw material prices. The extent of value addition is reflected by the percentage of raw material cost in the overall cost structure of the product. 4. Extent of competition measures the number and intensity of competition among incumbents in the industry. The level of competition in an industry has implications on future profitability of players in an industry. The number of players operating in an industry would in turn depend on entry barriers in an industry. Existence of government regulations regarding licensing requirements, levels of returns, heavy capital investment requirements, distribution network, technology, patents and brand equity could be significant entry barriers for prospective entrants to an industry. The industry could be exposed to competition from the unorganised sector, as well as imports. The increasing linkage with the global economy in a declining import duty regime exposes domestic companies to competition from imports. The unorganised sector also poses significant competition in industries with low entry barriers. The following industry financials are to be measured while analysing the industry:  Growth in operating margin (%)- industry
  • 17. Page | 17  Operating margin(%)- industry  Return on capital employed(%)- industry  Variability of operating margins(ratio)- industry The other factors to be analysed are the impact of change in technology, the company’s performance relative to other players, the length of operating cycle in that industry and the stage in life cycle of the industry. The availability of human resource is an important factor to be analysed for service industry. While analysing the broker business, the cyclicality of the industry and the regulatory measures should be looked into. III. Management Risk Management risk is the risk associated with ineffective or underperforming management which hurts performance of the company being managed and therefore the returns generated by the shareholders. The parameters to assess management risk are as follows: 1. Quality of information submitted by the company- Integrity The timeliness, accuracy, adequacy of information and willingness to give information depicts the professional quality of the management. This factor also assesses the company’s promptness in furnishing regular information required by the bank, such as quarterly performance data, stock statements, sales statements etc. 2. Working capital management- The lower the working capital cycle, the more competitive the company will be. Financing requirements closely follow the actual business cycle of the industry. 3. Corporate governance- The capability of the firm with respect to wealth creation for all stakeholders while adopting sound corporate governance practices is judged while analysing management risk. 4. Experience in the industry- A management with greater experience provides comfort with respect to stability of the business model. 5. Managerial competence- Assessment of management’s competence would be based on the quality of past decision making, as well as the general impression of the efficiency of the company’s systems and procedures. While educational qualifications could provide a base for good management, formal education in itself would not guarantee exceptional management. The other dimension to be evaluated upon would
  • 18. Page | 18 be the track record of managing Joint Venture in the past, if joint venture is essential for continued successful running of the business. 6. Business and Financial Policy- The management’s conservatism is judged based on past business and financial policies relating to its leverage and would have a bearing on future debt bearing levels. A track record characterized by large expansions in relation to existing size or in unrelated areas is indicative of a relatively high appetite for risk. 7. Ability to meet projections and maintain market share- This factor assesses the management’s competence as well as its integrity in projecting performance. Management’s competence is assessed in maintaining the market share while trying to achieve the sales/ profit projections. 8. Management succession- This factor examines the extent of preparedness of the company’s leadership for the future. A company with a well-groomed second line of leadership would score highly on this parameter. Alternately a professionally managed company would also score higher. On the other hand, a company highly dependent on the existing leadership, and having uncertainties with respect to future management would be placed at the lower end of the scale particularly if the existing leadership is old. 9. Labour relations- This factor assesses the quality of industrial relations prevailing within the company. A company characterized by peaceful labour relations is expected to show greater stability in operations. Frequent industrial strike affects the continuity of operations and could have implications on the debt servicing ability of the company. Conversely a company with highly motivated labour force would be ideally prepared to face competitive pressures. 10. Strategic initiatives- This factor assesses the company’s ability to successfully implement its strategies. Companies, which have successfully executed major/ complex projects, or demonstrated an ability to manage strategic alliances, etc., would score highly on this factor. While analysing SMEs, along with the above mentioned factors the parameters to be assessed are the Group support available to the company, the number of years of experience the management has in the same line of business and the credentials of the family running/ owning the business.
  • 19. Page | 19 While analysing stock brokers, along with the above mentioned factors the parameters to be assessed are the legal ownership of the business and the personal net worth of the promoter. IV. Financial Risk Financial risk is the risk arising from the financial profile of the borrower. It is measured by calculating the free cash flow generation taking into account operating activities, investment activities and financial activities including additional borrowing or repayments. The objective of any financial analysis should therefore include the following: 1. Understand the product wise segmentation of income of the borrower’s business 2. Means of financing in the balance sheet and any mismatch between long term liabilities and long term assets of the borrower 3. Operating profitability and cash flows of the company as distinct from the income which is one time in nature. 4. Performance of the borrower entity on a consolidated basis 5. Working capital cycle of the borrower 6. Trend in unit sales realization, unit cost 7. Free cash flow analysis Analysis of income statements Analysis of profitability Ratio Nomenclature Remarks PBDIT/ Net Sales Operating profit margin Higher the ratio, higher is the operational efficiency of the company. This may be compared with the industry average/ other peer companies Net Profit/ Net Sales Net profit margin Profit margin available for shareholders of the company for distribution. Higher the ratio, higher is the growth potential for the company.
  • 20. Page | 20 However, this should be supported by the projected future cash flows PBIT/ Net Sales This is the profit margin prior to meeting the interest obligation Higher the ratio, higher is the comfort level for the lenders. However, this should be supported by the projected future cash flows to ensure that the company sustains the level of profitability. Cash Profit/ Net Sales Cash profit margin This is the profit available for servicing the loan and meeting the working capital/ capital expenditure requirements of the company. Higher the ratio, higher is the comfort level for the lenders. Dividend/ Net profit Dividend distribution ratio Reflects the management’s policy of profit retention and increasing company’s net worth PBIT/ (Equity+ Debt) Return on capital employed Reflects the company’s overall efficiency in utilization of total capital employed. Higher the ratio, higher is the comfort level for the lenders PBDIT/( interest on term loan+ principal repayments) Debt Service Coverage Ratio(DSCR) It indicates a company’s ability to service its debt obligation from earnings generated from its operations PBDIT/ Interest Interest Coverage ratio Interest cover is defined as the extent of cushion or comfort that a company has in meeting
  • 21. Page | 21 its interest obligations from any surplus generated from its operations. Analysis of Cost Structure: The major cost components are: - Material cost - Labour cost - Manufacturing overheads/ expenses The following should be looked into while analysing the cost structure of a company: - The behaviour of various cost components and cost composition in the overall product cost over previous years - How the company deals with cost increases may be studied- what kind of cost increase can be passed to the customers, to what extent and whether the same is built in the contract with the clients may be ascertained - Whether the company has any supply side constraints or its raw material is subject to price volatility and whether the company is facing any labour problems may also be enquired. Analysis of balance sheet ratios The ratios generally considered as relevant for conducting credit analysis are: 1. Liquidity ratios 2. Gearing/ capitalisation ratios 3. Turnover ratios Liquidity ratios Current ratio: current asset/ current liabilities The higher the ratio, the better it is for the company thereby indicating company’s strength in meeting its short term obligations. In India, the Tandon committee had suggested that the minimum acceptable current ratio should be 1.33. The movement of current ratio should be read in conjuction with the movement of Net Working Capital (NWC) in order to arrive at a proper and meaningful conclusion. Acid test ratio/ Quick ratio= (current assets- inventory)/ current liabilities
  • 22. Page | 22 The rationale for computing the ratio in this manner is that inventory is the least liquid of all the individual components of current assets. Net Working Capital (NWC)= Total current assets- ( total current liabilities including bank borrowing+ total repayments due within 1 year) Net working capital indicates the company’s contribution towards its working capital gap from its long term sources. As per the second method of lending suggested by Tandon Committee, the ideal contribution by the promoter should be 25% of the current assets. NWC can be negative in cases where the credit period received by the company by its suppliers is better than the credit period it extends to its customers. In such cases, there is no need for bank finance. Gearing/ Capitalization ratios 1. Total Outside Liabilities (TOL)/ Tangible Net Worth (TNW) = (Long term debt+ Short term debt + other current liabilities)/ TNW 2. Total Outside Liabilities (TOL)/ Adjusted Tangible Net worth (ATNW) ATNW= TNW- Investment in associates and subsidiaries + Borrowings from subsidiaries (quasi equity) 3. Long term debt/ TNW 4. Long term debt/ ATNW 5. Term debt (including debentures)/ Cash profits (years) Tangible Net Worth (TNW) = Equity Capital+ Preference Capital> 12 years+ Share premium + General Reserves+ other reserves &surplus – Intangible assets – Revaluation reserves Short term credit and long term credit facilities are external sources of funding and are therefore classified as Total Outside Liabilities (TOL). Gearing/ capitalization ratios provide information on the position of owned funds compared to long term debts or total outside liabilities of the enterprise. Turnover ratios These ratios are of great importance from a banker’s point of view as they determine the working capital cycle and help in fixing the operating cycle of the enterprise.  Receivables Turnover (domestic)
  • 23. Page | 23  Receivables turnover (export)  Inventory turnover  Creditors turnover  Fixed assets turnover Fund flow analysis A fund flow statement provides details concerned with the change in balance sheet position by showing the summary of changes in financial position from one period to another. The following questions may be answered with the funds flow statement: 1. Have working capital funds been diverted into creation of fixed assets/ long term investments? 2. Has the company funded its fixed assets/ working capital from its own internal generation or borrowed funds? 3. Is there a mismatch between generation of long term funds and long term assets? 4. What are the sources of repayment for loans? LAYMAN’S GUIDE TO DETECTING FINANCIAL STRESS The problems faced by businesses get reflected in their financial statements despite the attempts of such potential customers to mask their non-performance through creative accounting. It is possible to see early warning signs of financial stress or even the fact that the business is already in deep waters by following good analytical discipline. Given below are a few of these ailments that can be detected: 1. Insolvency: A company is insolvent if its liabilities are more than its assets. Accumulated losses, deferred expenditure, intangible assets, unquoted investments, non-moving stock/ debtors, deferred tax assets are all signs of over stated assets. Insolvency of a business is a matter of concern to its creditors. Thus, it is important to understand the ranking of creditors based on underlying security to evaluate the impact of such insolvency. In such businesses it is important that there is equity infusion from the promoters since further debt will only increase the burden of the business through interest cost. 2. Illiquidity: A business is considered illiquid if it is unable to generate sufficient cash from its operations, raise credit against its assets and the promoters are unable to infuse cash into the business. Signs of illiquidity can be detected if the collection period of receivables is
  • 24. Page | 24 high, the level of stock is non-moving or rising, the cash balances are low, sudden sharp fall in level of creditors and debt equity ratio is high. An illiquid business may have long term and marketable assets in the form of land and building or unquoted investments. 3. Diversion: A business may be under financial stress if it has diverted its equity/ loans into other businesses. Diversion of funds from a performing unit to a non-performing unit within the same entity may also lead to such stress. Diversions out of the business can be detected by analysing the nature of investments and loans and advances made by the business. If these diversions exceed the cash accruals generated by the business it can lead to a financial stress. In order to detect signs of such stress it is always essential to analyse the financials of group companies and the segmental performance within the business. 4. Working Capital mismatch: This situation arises from diversion of short term liabilities to finance long term assets within the business. If the long term loans and net worth of the business are less than the net fixed assets it is evident that there is a working capital mismatch. 5. Valuation of assets: Companies tend to capitalize various types of expenses in order to avoid a hit on their profitability. Certain one time expenditures in the nature of goodwill, brand building expenses may also be capitalized as fixed assets. It is also possible that by a change in accounting policy on depreciation or inventory valuation, value of fixed assets/ current assets are overstated. The only way to detect capitalization of expenses is to compare the capital cost with those of other competitors. Amounts reflected in goodwill and in the nature of intangibles such as brand values are always shown separately in the schedules. The impact of change in accounting policy can be found in the notes to accounts. 6. Quality of profits: It is important to understand whether a business is generating its profits from its core operations or through its other income. Therefore, profitability ratios are best analysed by comparing at the operating level across accounting periods. Some businesses have a diversified stream of operations that may provide protection from seasonalities, business cycles etc. The quality of profits in such businesses is higher. The trend in profitability such as rising operating margins, rising net profit margins can also indicate the quality of profits. 7. Hidden debt: It is essential to understand the leverage of the company on a consolidated basis. Thus, it is possible that debt in group companies or subsidiaries have been guaranteed
  • 25. Page | 25 by the borrower. This needs to be added to the total debt of the borrower. Mark to market (MTM) losses on foreign currency/ commodity value fluctuations can also impact the leverage of the company. Look for disclosures on the same in the notes to accounts. 8. Under capitalization: A company is said to be undercapitalized if its equity base is too small in relation to its sales turnover. Typically such companies have a high level of gearing and low profitability. A business is also under capitalized if it is unable to generate sufficient cash accruals to meet the operational requirements as dictated by increasing sales. The contribution of equity in expansion/ acquisition plans of the company can indicate its changing level of capitalization. 9. High dividend: A company normally invests its cash accruals back in business and typically allocates a percentage of profits as dividend. An aggressive dividend policy is one which puts a company under pressure to borrow in order to meet its dividend payments. Typically dividend rates that consume more than 50% of annual profits may be considered as high. EVALUATION OF SECURITY Evaluation of security structure Security offered in the proposal is a key determinant of the credit risk of the transaction. Security offered may be tangible such as current assets, fixed assets, cash flows, etc or intangible such as post dated cheques, personal guarantee, negative lien, etc. While analysing the security offered, it is required to calculate the security cover in percentage terms of the transaction amount. This can only be done if detailed information is provided on the nature of security held by all lenders. Ultimately the actual security that has been created represents the real credit risk. An incomplete security is as good as no security. Security may be offered as specific charge or floating charge. Specific charge is created when banks choose to lend for specific projects of the borrower against security that is created out of their funds. For example: specific receivables discounted, machinery for a specific product line, exclusive mortgage of immovable property etc. When a bank chooses to fund projects or working capital requirements by taking charge on current assets as a whole or movable fixed assets as a whole, a floating charge is created. Any asset added to this pool stands automatically charged to the bank. Any bank willing to extend facilities on specific charge must necessarily seek a no objection certificate (NOC) from all existing floating charge
  • 26. Page | 26 holders. Once such NOC request is granted the charge of floating charge holders will stand modified to charge on current assets or fixed assets excluding those charged to specific charge holders. Charge on assets signifies sequence in which the realizations from liquidation will be used to pay off creditors. Thus, we have:  Statutory dues  Exclusive charge- exclusive first right over realizations at the time of liquidation  First charge- first right over realizations at the time of liquidation  Second charge- second right over realizations at the time of liquidation  Subservient charge- right over realizations at the time of liquidation after first and second charge but before unsecured creditors  Unsecured It should be noted that Sales tax authority will have the first right over sales proceeds if they have made a claim on the company before the security was created by the bank. Security may be offered on an exclusive basis (exclusive first charge) or on a non- exclusive basis. The sharing pattern in non- exclusive cases could either be first pari passu, second pari passu, subservient charge, etc. where the assets may be shared by multiple creditors in the proportions of their outstanding. It is important to understand the process of creation of security to ensure that the security as intended in the credit appraisal has actually been created. The procedure for creation of security offered by a borrower is dependent on nature of entity of the borrower. A company incorporated under the Companies Act, 1956 is safest from the point of view of the lender/ bank. This is because the claims against a security held by the company are verifiable with the Registrar of Companies (ROC). Thus, in the case of company, it is possible to determine whether there are any claimants to the security and the status of the bank’s claim with respect to seniority over other creditors. In all other cases, one has to rely on the disclosures made by the borrower in his balance sheet as there are no regulatory authorities for verification of partnership firms unless they are registered, proprietorship firms, HUFs, associations, etc.
  • 27. Page | 27 Tangible security may also be graded into hard collateral that is more realizable against its book value while soft collateral may not be equally realizable. In terms of gradation of preferred security an indicative list would be as follows: 1. Property with clear marketable title 2. Legitimate control over cash flows of the borrower 3. Post dated cheque of the borrower, post dated cheque of promoter/ guarantor 4. Personal guarantee 5. Charge on the moveable fixed assets of the borrower 6. Charge over current assets 7. Negative lien 8. Other securities like listed equity shares The 4Cs of credit- Character, Collateral, Cheque, Cash flow control The decision to approve a loan must also be based on a qualitative assessment of the borrower. While this is highly subjective, it can give us proper direction in structuring the terms of the loan. The credit decision usually involves finalizing the terms of the security. The nature of security may be tangible or intangible. Tangible security is of varying grades as defined in the section on “Evaluation of Security”. As seen there, collateral in the form of land and building provides the highest comfort. This may be reinforced with security of cash flow or an intangible security such as post dated cheque. The decision to combine or drop any of these could be aided by qualitative assessment of the borrower. Character of the borrower is an important element of his qualitative assessment. Character is determined by his educational background, social life, his vision/ commitment for the business, respect for regulations, business practices as revealed by the past. The character is also analysed based on the intention to repay. The assessment of the character has important fallouts in terms of the decision to sanction the loan and the specific terms under which they would be sanctioned. Where the character profile is not strong, comfort needs to be built upon the above security parameters. On the other hand, where the evaluation on the character is comfortable, we may allow greater flexibility with respect to the above security parameters. Availability of post dated cheque is important more as a deterrent rather than as a realizable security. Cash flow control needs to be from a reliable, creditworthy counterparty with a track
  • 28. Page | 28 record of past performance. Availability of property is usually considered a strong comfort provided there is adequate hair cut. The quality of property also needs to be assessed from the point of view of its neighbourhood, ease of access, quality of construction etc. IMPORTANCE OF A PLANT VISIT/ MANAGEMENT MEETING The business model of the company may not be as easily apparent until one visits the factory to understand the product mix, the technology being used, the skills of the employees and the quality of infrastructure. In order to maximize the benefit from meeting the promoter or visiting the plant, it is important that the basic information required for credit appraisal is made available prior to this meeting. The analyst should go through this information and make a note of specific points that will need to be check during the plant visit. The analyst should understand the industry, the business cycle of the company before the plant visit. Once in the plant or with the promoter, the analyst is suddenly exposed to a huge flow of information on the company. It is advisable that the analyst prepare the visit report as close to the date of meeting as possible so that he is able to capture most of the relevant information in granular details. A plant visit helps to understand the genuineness of the business and the pace of activity in the company. It can also help in revealing an inventory pile up, inefficiencies in production processes, quality of fixed assets etc. It is important to record the details of fixed assets, utilities available at the unit, information pertaining to manpower etc which can help evaluate requests for financing capital expenditure. One can also get a feel of whether the company has sufficient land for its existing business or any extra land is required for capacity expansion since land is generally not held in the books of the company but in the personal books of the promoter. Frequently during a plant visit it is possible to meet the factory manager/ quality manager/ research head who may talk about the strengths of the product and the company in detail. Sometimes simple questions posed to workers on the shop floor can confirm or negate the facts provided by the company. During a plant visit the analyst must ensure that the right person is available to conduct the tour of the factory. Thus the CFO may not always be the right person to explain the manufacturing process and it is necessary to get the factory manager or the supervisor to explain the manufacturing process.
  • 29. Page | 29 While meeting a promoter some of the standard information collected should be the history of the company such as reasons for entering the business, competitive position of the company, the relationship of the company with its suppliers, customers etc, the future plans of the company in terms of capex, sales, new products, new locations etc. The promoter may also be the best person to seek clarification on the financials, pending litigation as mentioned in the notes to accounts, likely movement of product prices and raw material prices, response to changing market scenario etc. REFERENCE CHECKS Frauds are a major reason why credit risk cannot be taken at face value. Frequently doubts arise when the business model appears too good to be true or the company would like to create an impression of there being no risks. While a good credit appraisal can give us the precise idea of the mix of various risk elements and a clear assessment of its strengths and weaknesses, promoters routinely attempt to hide or mislead the analyst with respect to critical information. The due diligence process is therefore not complete unless an attempt is made to corroborate the given data through independent sources. Some of the information that should be checked through references are the following: 1. Track record and business performance- to be checked with existing lenders 2. Business performance- to be checked with customers based on their reputation 3. Legal disputes- to be checked with trade partners such as suppliers and customers 4. Financial statements- to be based on reputation of auditors 5. Insider views- to be taken from ex-employees, other customers of the bank The analyst needs to choose the entities from whom reference check is to be taken very carefully. Care should be taken to ensure that the person giving reference is not too close to the interested party. Besides, reference is usually taken from a person with whom we already have a comfortable relationship. Reference should be taken based on materiality of the due diligence being done. Thus, if the borrower claims a long term contract for raw material supply, the supplier would be a key reference point. Similarly, if a large percentage of sales is booked from a single customer, reference should be taken from this customer. The process of taking references should be continuous rather than only at the time of credit appraisal. Thus, an analyst should develop a network of bankers, auditors, lawyers, government officials through whom such references can be taken.
  • 30. Page | 30 Sometimes, in a large transaction where the quality of information is relatively weak and the perceived risk is relatively high it may be necessary to take more detailed references. Such situations may also demand making discrete enquiries such as monitoring the activities of the promoter, getting to know his regular social network, details of his personal assets, other businesses, etc. Tools such as Credit Information Bureau of India Limited (CIBIL) reports and Negative Customer Information Form (NCIF) database should be used to check the customer’s past record in defaults or if there are any suits filed against the company/ borrower while appraising the loan. ASSESSMENT OF LIMITS The credit policy of the bank recommends the use of Turnover Methodology of assessment of working capital. If the end use of a loan is for working capital purposes, then it is necessary to conduct working capital assessment and track limits based on stock and book debts statements. The bank recognises that Turnover method may not be suitable for all sectors like industries of seasonal nature, manufacturing units dependent on agricultural commodities as inputs, NBFC’s, capital market intermediaries, real estate developers etc. In case of sectors where turnover method cannot be applied, the bank would adopt suitable method of assessing the requirements for the sector and apply the same consistently across the portfolio. The assessment of limits varies with each facility requested by the borrower. While assessing the limits of a borrower, the various conditions that are considered are the nature of facility (fund based or non-fund based), tenor of facility, other bank limits, projections of sales, cash flows etc. Broadly we can divide assessment of limits into assessment for working capital facilities and assessment for term loans. While assessing limits for working capital facilities we may use the Turnover Method, Maximum permissible finance (MPBF) method or the Cash budget Method as explained below: Assessment for Working Capital Facilities I. Turnover Method Under Turnover method, working capital requirement is computed at a minimum 30% of gross sales of which at least four-fifths should be provided by the bank and the balance one- fifth representing the Borrowers contribution towards margin for the working capital.
  • 31. Page | 31 Particulars Amt (Rs. Crs) A Projected Gross sales of borrower B Working capital requirement (30%) C Maximum possible working capital restricted to 4/5 of B D Less: facilities with other working capital banks E Maximum Permissible Bank finance from Kotak Bank This method is applicable for clients whose working capital requirement is not subject to seasonal fluctuations and the operating cycle remains stable throughout the year. Turnover method would not be applicable to companies whose operating cycle is long (in excess of 100-120 days). For instance, companies with exports, sales to SEB’s, utility companies, etc. Points to be noted under Turnover method:  It is to be ensured that the projected annual gross sales are reasonable and achievable by the unit and the estimated growth if any over the previous year is realistic.  At the time of assessment, we may call for returns filed with statutory authorities as useful guiding documents for verification of sales & assessment of reasonableness of the projections.  The entire sales proceeds should be routed through the cash credit account of the borrower in case of sole banking.  Data of actual sales pertaining to the last 2 years, estimates for the current year, and projections for the next year, together with the trend analysis of the relative industry, would also be useful while appraising the sales projections.  Other information regarding modernization, working capital for expansion, changes in government policies, increase/ decrease in taxation and other relevant internal and external factors also need to be taken into account.  Any unreasonable projected increase (say beyond 25%) of the previous year actual or current year estimates would need a closer look. II. Tandon Committee’s Second Method of Lending The second method of lending constituted by the committee is used to compute the maximum permissible finance that can be granted by a bank to a borrower. The information system to be submitted by the borrower as suggested by the Tandon committee consists of the following financial statements: 1. Operating statement
  • 32. Page | 32 2. Fund flow statement 3. Statement of current assets and current liabilities 4. Balance sheet and P&L account These documents are collected by the bank on an annual basis. Under this method, the borrower should provide for a minimum of 25% of total current assets. A certain level of credit for purchases and other current liabilities will be available to fund the build up of current assets and the bank will provide the balance (Maximum Permissible Bank Finance). Consequently, total current liabilities inclusive of bank borrowings should not exceed 75% of current assets. The MPBF method is used for larger corporate and in specific cases with longer operating cycle. The trend of current assets and current liabilities also remains similar through the years. III. Cash Budget Method Cash budget method is generally used for assessing working capital finance for seasonal industries like sugar, tea, etc, for construction activity and for service oriented concerns. In these cases, the required finance is quantified from the projected cash flows and not from the projected values of assets and liabilities. In this method of assessment, besides the cash budget other aspects like the borrower’s projected profitability, liquidity, gearing, funds flow, etc. , are also analysed. The projections drawn by the borrower may then be jointly discussed with the bank as modified in light of the past performance and the bank’s opinions. The peak cash deficit is ascertained from the cash budgets. The promoter’s margin money for such requirement may be mutually arrived at by the banker and the borrower with the balance requirement forming the bank financed part of working capital. The cash budget analysis is also used for sanction of ad hoc working capital limits. Thus in this method, the required finance is quantified by the bank after assessing fund flow, profitability and other financial parameters. In seasonal industries, the peak level requirements of the borrowers would be normally for short periods and the borrower cannot be given peak level limits throughout the year. In such cases, cash budget system will help the bank in funding only deficit of the cash flow budget. While fixing the limit based on the cash budget, the following points should be considered:
  • 33. Page | 33 i) The cash budget is realistic and based on the operations in the business/ similar business ii) The cash budget statement tallies with the underlying financial statements viz., projected balance sheet and profit and loss account. iii) Outstanding bank borrowings figures in the projected balance sheet tally with the deficit as shown in the cash budget statement iv) The closing balance of the debtors is correctly arrived at by summing up opening balance of debtors and credit sales minus realisation of debtors. v) The expenses as indicated in the cash budget tallies with the expenses as reflected in the projected profit and loss account. vi) The peak deficit level needs to be linked to the drawing power of the borrower. Facility wise assessment: In addition to the assessment methods for working capital facilities, it is necessary to conduct facility wise assessment for each borrower. Assessments of limits for various products are dealt with in respective product notes. Term loans are loans with a medium to long term repayment schedule that may be structured with an initial moratorium period. Such requirements arise when companies purchase fixed assets, make long term investments, or when they make a contribution to core working capital. A term loan being long term debt signifies high risk and is generally priced higher. Therefore it is important that the need for the term loan is understood clearly and the viability for the underlying project is carried out. Net Present value (NPV) and Internal rate of return (IRR) can be used to judge the viability of a project. Features of the facility: 1. The basis of assessment of a term loan is the projections made by the company. The company may submit this information as part of its CMA data (credit monitoring arrangement) or as projections for a specific standalone project. It is important to understand all the assumptions underlying these projections. 2. The basis of evaluation of a term loan could be the debt equity projections, DSCR projections, the free cash flow projections and a sensitivity analysis of the key assumptions. In case of an existing company undertaking capacity expansion, DSCR for the project on a standalone basis also has to be comfortable/ acceptable to assess whether the project on a standalone basis is viable.
  • 34. Page | 34 3. The fixed assets that are created in the project act as the primary security for the loan. Banks may insist on additional collateral including existing fixed assets, other investments of the company or in rare cases promoter’s equity shares in the company. 4. It is important that the promoter has invested adequate capital in the project to ensure its stability. Typically the long term debt equity ratio of a company should not exceed 1. The debt equity ratio of the new project itself may be higher but not exceeding 2 times unless it is a very large infrastructure project. 5. The borrower has the option to draw down funds in a single tranche or in multiple tranches during the implementation period. 6. The proceeds of the loan shall be credited to the current account of the borrower to be opened with the bank or the proceeds can also be disbursed by a cheque/pay order/ DD/ RTGS to the vendor directly based on the invoices submitted. Term loan can also be disbursed by way of reimbursement of expenditure already incurred against production proof and other documents as stipulated. 7. The repayment of the loan may follow an approved repayment schedule. Typically the bank restricts its term loan financing to a period of 3-5 years based on the credit rating of the borrower. 8. A term loan sanction is typically valid for a period of 3 months unless a higher validity has been specifically approved. However if the company has drawn down its first tranche, the validity of further disbursements id dependent on the amount of loan that remains to be drawn down and capitalized for the purpose of making the repayment schedule. All such balance disbursements will be subjected to the same repayment schedule as the first disbursement. Thus if the tenor of the loan is beginning from the date of first disbursement, the tenor of subsequent disbursements follow the same repayment schedule. 9. Normally a bank sanctions LC and Buyers credit limits as a sublimit to term loan to enable procurement of the equipment and to get the benefit of suppliers credit. In such cases the tenor of the term loan begins from the date of opening of the LC. 10. Term loans should be subjected to periodic credit reviews atleast annually. This should initially capture the details of time overrun or cost overrun, if any. The reviews should be based on actual inspection of the site based on the size/ risk of the loan. 11. It is essential for the schedule for implementation of the project and the date of commencement of commercial production to be obtained from the borrower.
  • 35. Page | 35 Principles of assessment The various parameters that need to be appraised for a term loan are the following: 1. Cost of the project 2. Means of financing 3. Promoters contribution 4. Nature of product and existing competition 5. Nature of industry and demand forecasts 6. Impact of technology 7. Management capabilities and track record 8. Geographical location and distribution strategy 9. Repayment terms 10. Security for the loan Structuring of term loan can be done in following ways: 1. Buyers credit facility as sub-limit to the term loan facility The borrower shall have an option of converting the buyer’s credit facility into a rupee liability at an interval of every one year. Buyer’s credit against LCs is restricted to 36 months. At the end of 36 months or as stipulated by credit, the outstanding balance in the buyer’s credit shall be converted into a rupee term loan. The tenor of the rupee term loan will be the balance tenor based on original approved tenor and buyer’s credit facility already availed. 2. LC facility as sub-limit to the term loan facility The LC is opened in favour of the supplier of machinery/ equipment etc. The LC is paid by disbursing the term loan facility. The tenor of LC would be included in the overall tenor of the loan. In general the total tenor of the LC and the term loan should not exceed a period of 5 years. 3. LC facility as sub-limit to the term loan facility, buyers credit against FD In this structure, the LC will be repaid by way of a Buyers Credit facility. Buyer’s credit is backed by 100% cash margin and is simultaneously outstanding with the term loan. Buyer’s credit is repaid by closure of fixed deposit and the term loan is repaid in instalments. This structure is useful when the Buyer’s credit rates are low
  • 36. Page | 36 enough to justify the spread between the term loan rate and fixed deposit rate of interest. 4. LC facility and Buyers credit facility as sub limit to the term loan In this structure, the LC facility is repaid by way of disbursement of Buyer’s credit facility. LC and Buyer’s credit facility are sanctioned as sub-limit to term loan. The borrower repays by way of EMI on TL value and tenor. These EMIs are kept as fixed deposits until the Buyer’s credit falls due for repayment. The Buyer’s credit is repaid by fixed deposit proceeds and term loan for the shortfall. After the buyer’s credit is repaid, the EMIs continue from the borrower till the term loan is fully repaid. As compared to the previous structure, here only the buyer’s credit facility has been utilised and once the buyer’s credit is repaid, the balance term loan remains outstanding in rupee denomination. While assessing the risk of term loans we may use techniques such as free cash flow analysis, break even analysis, and scenario and sensitivity analysis for computing the limits to be sanctioned to the borrower. 1. Sensitivity Analysis Sensitivity tests are used to assess the impact of the change in one variable on another variable. It is usually used to stress test the repayment capability on a loan as indicated by DSCR by varying other parameters such as selling price, capacity utilization, operating margin etc. 2. Scenario analysis Scenario tests include simultaneous variation of a number of parameters based on an event experienced in the past or plausible market event that has not yet happened and assessment of their impact on the desired outcome typically repayment of a loan. In sensitivity analysis, typically one variable is varied at a time. If variables are inter- related it is helpful to look at some plausible scenarios, each scenario representing a consistent combination of variables. 3. Break even Analysis While analysing new projects the bank would be interested in knowing how many units may be produced and sold at a minimum to ensure that the project does not lose money. Such an exercise is called break even analysis and the minimum quantity at which loss is avoided is known as break even point (BEP).
  • 37. Page | 37 CREDIT MONITORING The objective of credit monitoring is to detect “early warning signals”, in order that necessary corrective action could be taken before the account deteriorates. The monitoring of credit risk would include:  Periodic review of the borrower’s operating and financial performance  Periodic review of the performance of the borrower’s account with the bank Monitoring for early warning signals In order to detect early warning signals in case of weak accounts and initiate remedial action promptly some symptoms of sickness have been listed below:  Frequent change in financial year and accounting policies  Shortage in quantity of hypothecated goods  Over valuation of hypothecated goods in stock statements  Inferior quality of goods produced/ or unusually high frequency/ quantity of return of goods  Removal of plant and machinery charged as security without bank’s prior consent  Value of hypothecated assets stated lower in insurance policies vis-à-vis values reported in stock statements/ balance sheet  High value of receivables and inventories  Frequent return of cheques deposited for credit into the account and/ or cheques drawn on the account  Frequent return of bills discounted/ purchased on behalf of the borrower. Large and longer outstanding in the bill accounts. Longer period of credit allowed (vis-à-vis industry practice) on sale documents negotiated through the bank drawn  Frequent requests for excess drawings, TODs/ Ad hocs by the borrower and/ or outstanding balance in cash credit account remaining continuously at the maximum  Reduction in the level of turnover in the account, reduction in credit summation in cash credit account  Elongation of working capital cycle  Delay in submission of stock statement, financial statements and other control statements, including review/ renewal data by the borrower
  • 38. Page | 38  Widening difference between outstanding and drawing power/ sanctioned limit and continuous irregularity in cash credit account  Attempt to divert sale proceeds through accounts with other banks  Inability to maintain stipulated margin on continuous basis  Periodical interest debited remaining un-serviced  Low capacity utilization  Profit fluctuation, downward trend in sales and stagnation or fall in profit as reflected in the quarterly/ monthly data followed by contraction in the market share of the borrower  Excess leverage relative to past and industry average  Failure to pay statutory dues  Failure to pay timely instalments of principal and interest on term loans  Financing capital expenditures out of funds for working capital purposes  A general decline in the related industry combined with many failures  Diversion of funds for purpose other than for running the unit  Attrition in key management and labour problems  Increasing number of law suits against the company  Any major negative remarks by auditor impacting profitability or regarding internal controls of the company  Continuous change in auditors, accounting policy  Drastic fall in share price of the company  Drastic increase in raw material prices or fall in selling prices REVIEW/ RENEWAL It is necessary that all revolving/ non-revolving limits are renewed/ reviewed on a yearly basis. If such renewals are not performed diligently within the expiry date of the limit, it may lead to the facility becoming an NPA. It is possible that the review/ renewal may be delayed due to non-submission of complete information or non-availability of latest financials or due to pending limit enhancement requests from the borrower. In all such cases, it is necessary to take approvals for extension of validity of limits from the appropriate authority. The maximum extension that can be given is for a period of 180 days and the renewal not taking place within this period will lead to classification as NPA.
  • 39. Page | 39 While evaluating a renewal request it is necessary to obtain the latest information on the borrower and his group companies. It is also important to visit the factory and meet the management to update the performance of the company during the review/ renewal period and also the business plans for the immediate future. Based on these meeting and the information submitted, the CMA may be revised and request for enhancement considered on the basis of the required CMA. All review/ renewals must be backed by the performance of the account as provided by the credit monitoring division. It must be ensured that in case of all working capital limits above Rs.5 crores which are secured by current assets, a stock audit is conducted on an annual basis and the stock audit report is made available for the renewal of limits. Proper approvals need to be taken to ensure that such deferrals remain valid. In case of a serious concern being observed in the account by RBI/ internal auditor/ statutory auditor, the remark with details of corrective action may be highlighted in the review/ renewal proposal. The process of renewal must be diligently followed even for exit accounts. If the borrower is unwilling or uncooperative, the renewal must be taken up with the information already available. BASEL II AND CREDIT RISK RATING The past three decades witnessed increasing globalization of banking operations, with banks across the world increasing their presence across countries. This led to the birth of Basel accord, which was adopted in order to stipulate standard capital requirements for banks. Banks need to maintain capital for meeting unexpected losses arising from their operations. The expected losses need to be covered through risk based pricing. Basel-I stipulated a one size fit all number of 8%, meaning thereby that banks were required to keep Rs.8 as capital for every Rs. 100 of lending. However, the flaw of the accord was exposed as banks which had engaged in riskier lending and those which were conservative were required to maintain the same level of capital. This led to further refinements and Basel-II was unveiled with risk sensitive capital requirements. Basel-II uses a “three pillars” concept- 1. Minimum capital requirements (addressing risk) 2. Supervisory review and
  • 40. Page | 40 3. Market discipline- to promote greater stability in the financial system The first pillar-The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces- credit risk, operational risk and market risk. The losses on the lending portfolio are dependent on: 1. The likelihood that an obligor will not repay his commitment- Technically called the Probability of Default (PD) 2. The likely loss that will result or the proportion of exposure that will not be recovered when a default occurs- Loss given Default (LGD) 3. Likely drawdown in the facility, at the time of default- Exposure at Default (EAD) Basel-II takes into account the creditworthiness of the borrower (PD), the bank’s recovery experience (LGD) and the exposure (EAD) in order to determine the capital requirement. Thus, it also recognises reduced capital requirement wherever adequate security (collateral) is available as a risk mitigant. Further, the accord enforces risk capital on committed but unutilized credit lines and even off- balance sheet items. The exact risk capital required is subject to the various approaches allowed under the accord. Standardized approach stipulates risk capital based on external ratings of the borrower. Wherever it is expected that the borrower along with the security offered would earn a better rating than BB the bank may opt for getting the client rated to conserve capital. The risk weight stipulated for varying rating grades are stipulated below: Rating Grade Risk weight AAA 0% AA 20% A 50% BBB to BB 100% Below BB 150% Unrated 100% In order to adopt the advanced approaches viz. Foundation Internal Ratings Based (IRB) Approach and Advanced IRB; the banks need to calculate their own PD, LGD and EAD numbers over 5 to 7 years. Thus ratings need to be inculcated in the internal decision making process.
  • 41. Page | 41 The second pillar- The second pillar defines the process for supervisory review of a bank’s risk management framework and ultimately its capital adequacy. It sets out specific oversight responsibilities for the board and senior management, thus reinforcing principles of internal control and other corporate governance practices established by regulatory bodies. The third pillar- The third pillar aims to bolster market discipline through enhanced disclosure by banks. It sets out disclosure requirements and recommendations in several areas, including the way a bank calculates its capital adequacy and its risk assessment methods. KMBL has an internal credit rating model (Kotak Risk Assessment Model- KRAM) for the comprehensive risk assessment of the wholesale banking credit exposures. All borrower accounts (except individual borrowers) are rated on the K-RAM model at the time of appraisal and thereafter on every renewal of the account. The rating system gives out two levels of ratings- Obligor rating which determines the standalone rating of the borrower (which corresponds with the PD) and the facility rating which determines the rating of the security available for the loan (which corresponds with LGD& EAD). The rating system has various models to rate companies of different types. Thus they have separate rating models for large corporate (turnover> Rs. 100 crs), SMEs (turnover< Rs. 100 crs), stock brokers, traders, NBFC’s and companies providing services. The parameters to evaluate ratings are business risk, industry risk, management risk and financial risk. Appropriate weightage to these parameters have been decided based on past experience and management judgement. The rating system of the bank grades obligors into 18 categories. An indicative scale for probability of default based on CRISIL’s experience of rating migration/ defaults has been used to develop the rating system. The facility extended by the bank to the borrower is also rated on a comprehensive scale of 30 categories of ratings. The obligor rating is calibrated to indicate the probability of default over the tenor of the loan. The facility rating captures the specific security available to that facility and therefore measures the likely loss given default. The combination of obligor and facility rating provides combined rating which is divided into 18 categories.
  • 42. Page | 42 K-RAM has a process for creating the Bank’s own database on defaults. This database would help in estimating probabilities of default for each rating category based on the Bank’s experience. Portfolio Management is a management tool used to minimise concentration of credit risk at the portfolio level. This is done to avoid concentration of risk in a particular industry segment or in a particular region. Portfolio analysis can also be done based on various parameters to manage the duration risk at the portfolio or the unsecured component of the portfolio or based on its linkages either in the supply chain or customer segments. It is also important to analyse whether the risk adjusted return being generated by the portfolio is satisfactory. In order to regulate the portfolio using the ratings as a benchmark, the bank has devised a set of norms for escalation of sanctioning matrix by putting caps on borrower group exposures. INTERNAL GUIDELINES Credit Origination Process The credit origination process (COP) is the process manual for credit origination compiled with a view to standardize the credit origination process. The objectives of COP are to: a) Define the process to be adopted in the origination of credit proposals in the wholesale banking sphere (Corporate Banking., SME, FIG, TF, Agriculture, Treasury), which can be applied consistently; and b) Defining the responsibilities of various functionaries involved in the credit chain Board Customer Acceptance Criteria (BCAC) It ensures that the relationship manager would be able to segregate doable credit cases from the non doable ones. BCAC for Manufacturing Entities (subject to product guidelines if any) S. No. Criteria Applicable for corporate customers Applicable for SME customers 1 Net sales/ Net profit on the growth path For the last two years For the last two years 2 Profitability at operating profit Minimum 10% of net Minimum 10% of net
  • 43. Page | 43 (PBDIT) (i.e. excluding non operative income) sales. No slippage in the last two years sales. No slippage in the last two years 3 Total term borrowing/ Cash profit (basis- as per last audited financials) Not exceeding 3 Not exceeding 4 4 Interest/ Net sales (basis- as per last audited financials) Not exceeding 5% Not exceeding 5% 5 TOL/ TNW ratio Not exceeding 2.00 Not exceeding 2.50 (treating unsecured loans from promoters clearly sub-ordinated to the banks exposure as part of TNW) 6 Current ratio Minimum 1.10 Minimum 1.15 7 Promoters reputation No negative reports from the market No negative reports from the market 8 Industry outlook Positive Positive 9 Borrower rating Not below BBB Not below BBB BCAC for Traders (including importers and exporters) S. No. Criteria Applicable for corporate customers & SME customers, subject to limits being considered is more than Rs. 3 crs. Applicable for SME customers, subject to limits being considered is less than Rs. 3 crs 1 Business vintage Minimum five years Minimum three years 2 Business being carried out from the current location (to be evidenced from electricity/ telephone bill etc.) Minimum three years Minimum two years 3 Banking habit Should be enjoying Should be enjoying
  • 44. Page | 44 limits from banking system for the last two years limits from the banking system for the last two years 4 Profit making Minimum for the last three years Minimum for the last two years 5 Interest coverage (as per the last audited financial statement) Minimum 2 Minimum 2 6 TOL/TNW ratio Maximum 5 Maximum 5 7 Investment in other connected entities Not to exceed 50% of the Tangible Net worth (treating unsecured loans from promoters clearly sub-ordinated to the banks exposure as part of TNW) Not to exceed 50% of the Tangible Net Worth (treating unsecured loans from promoters clearly sub-ordinated to the banks exposure as part of TNW) Classification and declaration of borrowers as wilful defaulters The bank would check whether the borrower and/ or its Directors/ associates appear in the wilful defaulters list as announced by RBI from time to time. The bank would on case to case basis extend finance to companies where the name of any its directors is reported as an independent/ professional/ nominee director of another company appearing in wilful defaulters list provided such director no longer continues to hold directorship in the wilfully defaulting company. The decision to finance such companies will be taken by the respective approving authority. In all other cases, the bank would not grant any credit facility to the listed wilful defaulters. A Wilful Default Assessment Note (WDAN) will be prepared containing details of: a. The borrowers account, facilities availed and outstanding balance b. Latest financial details c. Comments on operations in the account d. Details of default and follow-up action taken by the bank
  • 45. Page | 45 e. Reasons why the borrower is recommended for classification as wilful defaulter f. Whether the borrower has defaulted with other banks and details thereof g. Specific event under which the borrower should be classified as wilful defaulter A borrower classified as ‘wilful defaulter’ would be given 15 days time after issue of the said notice letter to make a representation against the classification. MULTIPLE BANKING/ CONSORTIUM BANKING ARRANGEMENT Multiple banking is a banking arrangement where a borrower avails finance independently from more than one bank and where the rules of consortium do not apply. The borrower may avail credit facilities from various banks providing different securities on different terms and conditions. In such an arrangement each banker is free to do his own credit assessment and hold security independent of other bankers. There is a regular exchange of information with the other banks. Consortium Banking is a banking arrangement where several banks finance a single borrower following common appraisal, joint documentation, joint supervision and follow up exercises. There is a lead bank known as the consortium leader that supervises this entire process. In consortium lending, several banks pool banking resources and expertise in credit management together and finance a single borrower. However, normally the lead bank’s assessment and documentation is followed by member banks. Thus the borrower enjoys the advantage of single window facility while availing credit facilities from several banks. KMBL would take exposures under sole banking, multiple banking or becoming part of the consortium. In all these cases the bank would appraise the credit worthiness of the business and the support worthiness of the request and assess the requirements of facilities either itself or would base its assessment on the assessment of any of the multiple banking members or the leader or any member of the consortium. In case of financing under multiple banking arrangements, the bank would be free to:  Structure the facilities  Charge interest rates/ commission based on its risk perception and the structure of the facilities  Stipulate security as well as other terms and conditions for the exposure as deemed necessary by the approving authorities
  • 46. Page | 46  Obtain credit securing documents as deemed necessary by the bank and register charges with the appropriate authorities  Administer and monitor the credit exposure as in the case of sole banking exposures and may share information with the other lenders as regards the facilities, conduct of account etc on reciprocal basis. LOAN REVIEW MECHANISM Loan Review Mechanism (LRM) is an effective tool for monitoring borrower accounts at regular pre-defined intervals and serves as an early warning system in identifying potential weakness in the loan that might lead to an impact on asset quality. LRM comprises of a periodic review of the loans and advances granted by the bank to ensure that the advances granted are of the desired credit quality and no deterioration takes place in them in due course of time. The LRM procedures encompasses all areas of loans granted starting from credit origination, credit risk assessment, credit administration, disbursement (limit implementation) and credit monitoring. It assesses the adequacy of and adherence to internal loan policies and procedures and helps identifying potential problem areas and loans at an early stage. Criteria for selection and Frequency of reviews: Category Obligor rating Aggregate Exposure Amount Frequency of reviews 1 K-AA- and above Rs. 50 crores and above Within 3 months of sanction and once a year thereafter 2 K-A and above Rs. 20 crores and above Within 3 months of sanction and once a year thereafter 3 K-BBB- and above Rs. 10 crores and above Within 2 months of sanction and once in 6 months thereafter 4 K-BB+ and below Irrespective of exposure amount Within 1 month of
  • 47. Page | 47 sanction and once in 6 months thereafter NPA MANAGEMENT AND RECOVERY An NPA is an asset including a leased asset that becomes non performing when it ceases to generate income from the bank.  A non performing asset (NPA) is a loan or an advance where; i. Interest and/ or instalment of principal remain overdue for a period of more than 90 days in respect of a term loan ii. The account remains ‘out of order’ in respect of an overdraft/ cash credit iii. The bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted iv. The instalment of principal or interest thereon remains overdue for two crop seasons for short duration crops v. The instalment of principal or interest thereon remains overdue for one crop season for long duration crops vi. The amount of liquidity facility remains outstanding for more than 90 days, in respect of a securitisation transaction undertaken  Banks should, classify an account as NPA only if the interest charged during any quarter is not serviced fully within 90 days from the end of the quarter. NPA Identification Accounts with temporary deficiencies: The accounts will be classified as NPA based on the temporary deficiencies in nature such as non-availability of adequate drawing power based on the latest available stock statement, balance outstanding exceeding the limit temporarily, non-submission of stock statements and non-renewal of the limits on the due date as per the principles given below:  Stock statements relied upon for calculating drawing power in respect of drawing in working capital account should not be older than three months. The outstanding in the account based on drawing power calculated from stock statements older than three months, would be deemed as irregular.
  • 48. Page | 48  A working capital borrowal account will become NPA if such irregular drawings are permitted in the account for a continuous period of 90 days even though the unit may be working or the borrower’s financial position is satisfactory.  An account where the regular/ ad hoc credit limits have not been reviewed/ renewed within 180 days from the due date/ date of adhoc sanction will be treated as NPA. Asset classification to be borrower wise and not facility wise- In respect of a borrower having more than one facility with a bank, all the facilities granted by the bank will have to be treated as NPA and not the particular facility or part thereof which has become irregular. NPA classification and provisioning Substandard assets Assets which have remained NPA for a period less than or equal to 12 months. 20% Capital provision for unsecured & 10% for secured Doubtful assets An asset would be classified as doubtful if it has remained in the substandard category for a period of more than 12 months 100% Capital provision for unsecured, 20% on secured portion if doubtful upto 1 year, 30% on secured portion if doubtful from 1 to 3 years, 100% on secured portion if doubtful for more than 3 years. Loss assets A loss asset is one which is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted although there may be some salvage or recovery value. 100% Capital provision Income recognition: o Income from NPA is not recognised on accrual basis but is booked as income only when it is actually received
  • 49. Page | 49 o Interest on advances against term deposits, NSCs, IVPs, KVPs and life policies may be taken to income account on the due date, provided adequate margin is available in the accounts. o If any advance, including bills purchased and discounted, becomes NPA as at the close of any year, the entire interest accrued and credited to income account in the past periods, should be reversed or provided for if the same is not realised. This will also apply to government guaranteed accounts. Restructured accounts: A restructured account is one where the bank, for economic or legal reasons relating to the borrower’s financial difficulty, grants to the borrower concessions that the bank would not otherwise consider. Restructuring would normally involve modification of terms of the advances/ securities, which would generally include, among others, alteration of repayment period/ repayable amount/ the amount of instalments/ rate of interest. Recovery policy- The bank has formulated a recovery policy with the following objectives:  Monitor standard assets to avoid slippages  To manage and control the bank’s absolute NPA by accelerating recoveries  To encourage compromise settlements and accelerate recoveries  To keep gross NPA percentage at the minimum level of gross advances excluding ARD portfolio The bank can take recourse in case of default through the following sources: 1. Debt Recovery Tribunals 2. SARFAESI Act,2002 3. Arbitration 4. Section 138 of Negotiable Instruments Act,1881 5. Winding up process through courts proceedings Under all the above mentioned processes, the distribution of proceeds must follow the guidelines given under section 539A of the Companies Act. The bank takes advantage of the SARFAESI Act, 2002 that empowers banks/ financial institutions to recover their non-performing assets without the intervention of the court. The Act provides three alternative methods for recovery of non-performing assets, namely-  Securitisation
  • 50. Page | 50  Asset reconstruction  Enforcement of security without the intervention of the court The provisions of this Act are applicable only for NPA loans with outstanding above Rs. 1 lakh. NPA loan accounts where the amount is less than 20% of the principal and interest are not eligible to be dealt with under this Act. Non-performing assets should be backed by securities charged to the bank by way of hypothecation or mortgage or assignment. It is essential that approval is received from 75% of all secured creditors in order to have a right over BIFR ruling in case of a BIFR company. The bank follows the steps as given below as per the SARFAESI Act, 2002: I. It is to be ensured that the account should be classified as NPA as per RBI guidelines II. Demand notice should be issued by an Authorised officer of the bank calling upon the borrower/ guarantor to pay dues within 60 days. The borrower/ guarantor is entitled to make his representations/ objections to the bank and the bank is required to deal with these objections and communicate the same within 7 days. III. In case of non-compliance by borrower, the bank u/s 13(4) can take any of the following steps:  Take possession of the secured assets of the borrower  Take over the management of the business  Appoint any person to manage the secured assets taken over  Give notice to third person who has acquired secured assets/ or from whom money is due to borrower IV. Gives notice to the borrower for taking possession/ affix the same on the property V. Take possession of the properties and publish a notice in two leading newspapers of which one should be in a vernacular language VI. In case of refusal to hand over possession, file an application u/s 14 before the Chief Metropolitan Magistrate/ District Magistrate for taking forcible possession. VII. After taking possession of the assets, if they are movable assets then the bank will make an inventory of the assets and obtain valuation through an approved valuer. The bank will fix a reserve price and then serve a notice for sale of 30 days to the borrower. After this notice period the bank can sell the assets by public auction or private treaty.
  • 51. Page | 51 VIII. After taking possession of the assets, if they are immovable assets then the bank will obtain valuation and fix a reserve price for the property. The bank will then give a 30 day notice for sale to the borrower. After this notice period the bank can sell assets by public auction or private treaty. LEGAL DOCUMENTS AND PROCEDURES A. Basic Documents for all facilities 1. Application/ request letter for the facility: An application, wherein the prospective borrower/ customer is applying to the bank for seeking credit facilities is required in order to verify the intention of the borrower to avail the facilities. 2. Accepted sanction letter: Sanction letter is a formal communication from the bank to the borrower mentioning facilities offered by the bank to the borrower, its limit, type of facility, purpose, validity, tenor, rate of interest, disbursement method, repayment method, security, transactional documents, covenants/ conditions etc. It also mentions the list of documents that need to be executed/ furnished/ submitted by the borrower to the bank. 3. Constitutional documents: The constitutional documents required depending upon the status of the borrower are:  Sole Proprietorship: No constitutional document  Partnership firms: Partnership deed  Companies: - Memorandum and articles of association - Certificate of incorporation - Certificate of commencement of business in case of public limited companies - In case of a section 25 company, above documents and the IT certificate confirming exemptions  Trusts: Trust deed (if the trust is registered, the bye laws and certificate of registration of trust are verified)  Corporative societies: Bye laws (it is to be checked if the above mentioned documents are rightly issued by the concerned registrar and duly certified)  Limited Liability Partnerships (LLP): - Incorporation document - LLP Agreement