UNIT 5 USES OF BANK FUNDS LENDING FUNCTION

Banks Role as Financial Intermediary

Financial System
Financial

Markets Financial Intermediaries

Banks channel surplus money from the healthy sectors in the economy to weak sectors of the economy

Functions of Banks

Create assets out of surplus money Bears the risk of lending i.e. mitigates risk in the economy Ensures liquidity Lowers information cost

Fund Flow through the Financial System

Surplus Sector of the Economy
Invest- Cash

The Financial System

Financial markets

Deficit Sectors of the Economy

Get- Cash
Give- Securities in return Get- Cash

Get- Securities

Invest- Cash Get- Securities

Financial Intermediaries

Give- Loan agreement in return

How credit process is made easier for banks?

Expertise of banks Comparison with similar or same industry is easier as banks have a store of information always Monitoring cash flow details by watching the account details Large loans at cheaper cost Diversification of assets over assets (loans)

Gains from lending function

Efficient lending practices development Results in good credit risk management Leads to minimum transaction cost Manage interest and exchange rate fluctuations Manage liquidity risk by managing mismatch in maturities of assets and liabilities

Who needs credit?

Demand side
Consumers

of goods and services Is also called retail banking

Supply side
Manufacturing,

trading and services Is also called wholesale banking

Features of bank credit

Prominent risk for banks default or credit risk

Provisions are created for anticipated default risk

Leads to earnings volatility

Secondary risk for banks interest rate risk

Loan maturities, pricing, methods of principal payments etc. affects banks cash flows To keep up growth apart from credit growth additional funds are required which is obtained from securitization and offbalance lending arrangements off-balance lending arrangements include Underwriting services, letter of credit off-balance lending arrangements increases fee based income but also increases contingent liabilities

Types of lending

Fund based lending

Loan

supported by collaterals and other assets

of credits and bank guarantees

Non-fund based lending

Letter

Asset based lending

Securitization

and project finance Classified into 3

Short

term loans Long term loans Revolving credits

Short term loans

Mostly used for working capital needs Maturity 1 year or less WC needs arise from build up of inventories and other current assets Repayments occur when CA are converted to cash Seasonal lines of credit to seasonal businesses

a/c is maintained throughout year but amount is withdrawn during peak season Underlying assets are
Primary securities inventories, receivables and other CAs Collateral securities supports primary securities

Both WC loans and seasonal LCs are secured loans

Short term loans

3rd type of short term loan

Loans

for special purposes These are unsecured loans Loan amount is the amount in excess of WC needs of the firm Maturity of loan determined by bank repayment of principal and interest on maturity of loan The above is called bullet loan

Long term loans/ term loans

Maturity of more than 1 year (3 to 5 yrs -10 yrs) Loan sanction is based on the firms future cash flows Loans are used for acquiring fixed assets, modernization of factory, diversification etc. Used as substitutes for equity and for permanent working capital needs Principal and interest payments term are based on companys cash flow status Collateral will be the assets for which fund is loaned

Revolving credits

Maturity of 1 year or more Its also is based on cash flow of the company Withdrawal from line of credit happens as and when requirement arise Its a secured loan based on future cash flow, current assets and credit worthiness of the borrower Its renewed automatically until the borrower closes down the account

Credit process

Credit process is based on the risk-return profile of the borrower

There should be optimum trade-off between loan portfolio target(of the bank) and loan quality
Constituents of the credit process Loan policy Aligns credit officers goal to the banks overall goal The document is approved by the board of directors Has procedures for appraising, sanctioning, granting, documenting and reviewing loans Business development and initial recommendations Happens through extensive market research and credit investigations Financial statements and credit reports of borrowers are extensively analysed

Credit Appraisal

Risks inherent in a business are classified as

Market related risk Technology related risk Environment related risk

Credit worthiness of borrower is checked Viability of the project is verified Risk mitigation plans of the company are analysed Bank analyses and measures the risks which it is exposed to plan accordingly the risk mitigation process Cannons of lending

5 Cs capacity, capital, collateral, conditions and character PARTS purpose, amount, repayment, terms, security CAMPARI character, ability, means, purpose, amount, repayment, insurance

Credit Analysis

Building the credit file Credit history of existing customers and building credit files for new customers Project finance appraisal Management/ operations of the company, market, industry activities are analysed and evaluated Financial Analysis Past financial statement and future projections Cash flow statements (shows liquidity state of the company through inventory and receivables position) Only tangible net worth is considered as owners equity Tangible Net worth = Net worth intangible assets

Credit Analysis
of the company is analysed by calculating the debt to equity ratio of the company. This differs for different industry. To apply for more debt, the owner must infuse more equity into the company to keep debt equity ration constant Cash flow projections are made to determine the debt servicing capacity of the borrower

Financial risk

Debt servicing capacity refers to repaying capacity of the borrower (both interest and principal)

Build scenarios to evaluate cash flow projections and calculate debt servicing capacity Ask for collateral if the risks are high

Credit Analysis

Qualitative Analysis

Due Diligence Check borrowers residence, work addresses, interview with people who knew the borrower, past credit history, contingent liabilities of borrower etc. Risk Assessment Identify internal/external risks that would affect companys cash flows, thereby affecting debt servicing capacity The above leads to loan pricing decisions Classification of risk helps to associate business with particular risk Making the recommendation Made by the credit officer (amount to disburse, interest, maturity etc.)

Credit delivery and administration

Lending decision is based on discretionary limits Loan documentations

Mitigates

risks posed to the bank precedent

Terms and conditions of lending

Conditions
Criteria

that a borrower should fulfil before bank sanctions the loan

Representation
No

and warranties

misrepresentation of the above by the borrower. If o the loan agreement will become nullified and bank can take legal action

Credit delivery and administration Loan agreement covenants

Affirmative covenants
Ensuring

fund usage Keeping financial ration healthy Proper record maintenance and reporting standards Right of inspection by the bank

Negative covenants
Limiting

capital expenditure, investments Restriction of additional liabilities, sale of assets, dividend pay outs, mergers etc.

Credit delivery and administration

Events of default Update of credit file and periodic follow up Credit review and monitoring

Credit Review and Monitoring

Monitoring the performance of existing loans

Monitoring

the transactions in the borrowers accounts External or internal audit teams (periodic/continuous)
Deficiencies uncovered

by the audit team will be rectified by

the credit team

Monitoring problem accounts

When

borrower fails to meet debt service requirements

schedule and terms changes to enable smooth

Repayment

cash flows Worst case scenario recalling the loans by liquidating assets

Different types of loans and their features

Loans for working capital Loans for capital expenditure and industrial credit Loan syndication Loans for agriculture Loans for infrastructure project finance Loans for consumers or retail lending Non-fund based credit