Principles of Sound Lending, Credit Policy, Planning and Lending Criteria.

Presented by:Sk Nazibul IslamFaculty Member, BIBM

Like every other business activity, banks are profit oriented.A bank invests its funds in many ways to earn income.The bulk of its income is derived from loans and advances.

The business of lending is not without certain inherent risks largely depending on the borrowed funds. A banker cannot afford to take undue risk in lending.

-Banks lend mostly depositors money - Credit / Loanable funds having cost implications and repayment obligations to the depositors have to be managed efficiently with minimum possible credit risk. - Prudent management of this risk is fundamental to the sustainability of a bank.

- Credit Risk is the possibility that a borrower or counter party will fail to pay interest or repay the principal according to the terms specified in a credit agreement .- Credit risk means that payments may be delayed or ultimately not paid at all, which can in turn cause cash flow problems and affect a banks liquidity.

Banks make loans and advances to traders, businessmen, agriculturists and industrialists. In either case, the banks run the risk of default in repayment. Therefore, banks have to follow a cautious policy and sound lending principles in the matter of lending.

Traditionally, banks have been following three cardinal principles of lending viz. safety, liquidity and profitability and certain other principles.

Safety: Safety first is the most important principle of good lending. When a banker lends certain money he has to see that the loan or advance is safe and the money lent will comeback. A bank lends what it receives from the public as deposits. Safety depends upon - (i) the security offered by the borrower, (ii) the repaying capacity and willingness of the debtor to repay the loan with interest.(iii) income generation So the banker should ensure that the security offered is adequate and readily realizable and the borrower is a person of integrity, good character and reputation.

Liquidity:- It is to be seen that money lent is not going to be locked up for a long time. The money should return to bank as per repayment schedule. -Liquidity refers to the ability of an asset to convert into cash without loss within short time. -The liabilities of a bank are repayable on demand or at a short notice. -To meet the demand of the depositors in time, the bank should keep its funds in liquid state. -As such a bank should confine its lending to short term against marketable securities.

Profitability: -Banks earn profit to pay interest to depositors, declare dividend to shareholders, and meet establishment charges and other expenses. -So profit is an essential consideration. The main source of profit comes from the difference between the interest received on loans and those paid on deposit. -A bank must employ its funds in such a way that they will bring adequate return for the bank.

Purpose of the loan: Before sanctioning loans a banker should enquire about the purpose for which it is needed. Loans for non-productive and speculative purposes cannot be granted Although the earnings on non-productive business may be higher even then bank can not resort to non-productive loans being contrary to the national interests.

Sources of repayment: Before giving financial accommodation, a banker should consider the source from which repayment is promised.

Diversification of Risks: The banker should not lend a major portion of his loanable funds to any single borrower or to an industry or to one particular region. An adverse change in the economy of these may affect the entire business. The bank must advance moderate sums to a large number of customers spread over a wide area and belonging to different industries.

A sound credit is one where timely repayment is assured. In the changing concept of banking, factors such as purpose of the advance, viability of the proposal and national interest are assuming a greater importance than security, especially in advances to agriculture, small industries, small borrowers, and export oriented industries.

Banking is termed as business of confidence.Credit is the confidence of the lender on the ability and willingness of the borrower to repay the debt as per schedule of repayment.

Before allowing credit facility a banker should be satisfied that the applicant qualifies the following five essentials which may be termed as 5 Cs. namely- 1. Character Borrowers Integrity, honesty, intention to repay the loan money, commitment, credit record, dependability etc.

Capacity- Identity of Customer and Guarantor, Corporate charters, Resolutions, Partnership agreement, and other documents. Description of history, legal structure, owners, nature of operations, products and principal customers and suppliers for a business borrower, Borrowers business ability, Business experience, Technical knowledge, Age etc.

Capital- Financial strength to cover a business risk, Stake in business, Solvency, retention of earning, ability to infuse more money, Take home pay for an individual, turnover of payables receivables, and inventory etc.

Condition- It is general business condition. Customers in industry and expected market share, Customers performance vis-a-vis comparable firms in the same industry, competitive climate Economic trends, Industry Growth, competitive & regulatory environments, Working conditions etc.

Collateral- Borrowers ability to produce additional securities i.e, ownership of assets, Asset quality, type, Location, Title,Liens encumbrances and restrictions, insurance coverage, Guarantees warranties issued Forced sales value etc.

Credit policyAll banks should have established credit policies that clearly outline the senor management's view of business development priorities and the terms and conditions that should be adhered to in order for loans to be approved.

The credit policy of any banking institution is a combination of certain accepted, time tested standards and other dynamic factors dictated by the realities of changing situations in different market places.

The accepted standards relate to safety , liquidity and profitability of the advance whereas the dynamic factors relate to aspects such as the nature and extent of risk, interest or margin, credit spread and credit dispersal.

General guidelines about the conduct of advances are issued by Head Office. In all business dealings, officers and employees must be guided by the principles of honesty, integrity and safeguard the interest of the depositors and shareholders of the bank.

They should strictly adhere to the Banking Laws, rules and Regulations of the government, the instructions issued by the Central Bank/Head Office from time to time which affect the business practices of the bank.However, the key to safe, liquid, healthy and profitable credit operation lies in the quality of judgment used by the officers making lending decisions and their knowledge of the borrowers and the market place.

The credit Policy /Guidelines should be updated at least annually to reflect changes in the economic outlook and the evolution of the banks loan portfolio, and be distributed to all lending /marketing officers.

The lending guidelines should be approved by the Managing Director/CEO & Board of Directors of the bank based on the endorsement of the banks Head of CRM and the Head of Corporate/ Commercial Banking.

Any departure or deviation from the Lending Guidelines should be explicitly identified in credit applications and a justification for approval provided.Approval of loans that do not comply with lending guidelines should be restricted to the banks Head of Credit or Managing Director /CEO & Board of Directors.

The Lending guidelines provide the key foundations for account officers / Relationship managers (RM) to formulate their recommendations for approval.It should be remembered that selection of appropriate borrowers, proper follow-up and end-use supervision through constant close contact with the borrowers, are the cornerstones for timely recovery of credit.

Credit planningEligibility of loans and advances- be a citizen of the country- an adult- Credit worthy- no defaulter of the bank or a defaulter of other bank- not an insolvent person- not lunatic /idiot

Business powersEntertainment and disposal of loan applicationsScrutiny of loanLoan portfolio briefsAppraisal of loan applicationsSecurity title verification

Loan security & CollateralsValuation of securitiesSanction procedureInterest on loans and AdvancesLoan repaymentsDocumentationsDisbursement of loan

Loan Recovery Non-legal and legal measuresRecord management and release of securityLoan re-schedulingLoan supervision and monitoringMISDuties of Manager and other supervising authorities.

Lending criteriaIndustry and Business Segment Focus The Lending Guidelines should clearly identify the business/industry sectors that should constitute the majority of the banks loan portfolio. For each sector, a clear indication of the banks appetite for growth should be indicated (as an example, Textiles: Grow, Cement: Maintain, Construction: Shrink). This will provide necessary direction to the banks marketing staff.

Types of Loan Facilities The type of loans that are permitted should be clearly indicated, such as Working Capital, Trade Finance, Term Loan, etc.

Single Borrower/Group Limits/Syndication Details of the banks Single Borrower /Group limits should be included as per Central Bank guidelines. Banks may wish to establish more conservative criteria in this regard.

Lending Caps Banks should establish a specific industry sector exposure cap to avoid over concentration in any one industry sector.

Discouraged Business Types Banks should outline industries or lending activities that are discouraged. As a minimum, the following should be discouraged: - Highly Leveraged Transactions - Finance of Speculative Investments - Lending to companies listed on CIB black list or known defaulters.

Loan Facility Parameters Facility parameters (e.g., maximum size, maximum tenor, and covenant and security requirements) should be clearly stated. As a minimum, the following parameters maybe adopted: - Banks should not grant facilities where the security position is inferior. - Assets pledged as security should be properly insured. - Valuations of property taken as security should be performed prior to loans being granted. - A recognized 3rd party professional valuation firm may be appointed to conduct valuations.

Credit Assessment A thorough credit and risk assessment should be conducted prior to the granting of loans, and at least annually thereafter for all facilities. The results of this assessment should be presented in a Credit Application that originates from the relationship manager/account officer (RM), and is approved by Credit Risk Management (CRM).

The RM should be the owner of the customer relationship, and must be held responsible to ensure the accuracy of the entire credit application submitted for approval. - RMs must be familiar with the banks Lending Guidelines and should conduct due diligence on new borrowers, principals, and guarantors.

It is essential that RMs know their customers and conduct due diligence on new borrowers, principals, and guarantors to ensure such parties are in fact who they represent themselves to be. All banks should have established Know Your Customer (KYC) and Money Laundering guidelines which should be adhered to at all times.

Borrower Analysis - The majority shareholders, management team and group or affiliate companies should be assessed. - Any issues regarding lack of management depth, complicated ownership structures or inter-group transactions should be addressed, and risks mitigated.

Industry Analysis - The key risk factors of the borrowers industry should be assessed. - Any issues regarding the borrowers position in the industry, overall industry concerns or competitive forces should be addressed and - the strengths and weaknesses of the borrower relative to its competition should be identified.

Supplier/Buyer Analysis - Any customer or supplier concentration should be addressed, as these could have a significant impact on the future viability of the borrower.

Historical Financial Analysis - An analysis of a minimum of 3 years historical financial statements of the borrower should be presented. - Where reliance is placed on a corporate guarantor, guarantor financial statements should also be analyzed. - The analysis should address the quality and sustainability of earnings, cash flow and the strength of the borrowers balance sheet. - Specifically, cash flow, leverage and profitability must be analyzed.

Projected Financial Performance - Where term facilities (tenor > 1 year) are being proposed, a projection of the borrowers future financial performance should be provided, indicating an analysis of the sufficiency of cash flow to service debt repayments. - Loans should not be granted if projected cash flow is insufficient to repay debts.

Account Conduct - For existing borrowers, the historic performance in meeting repayment obligations (trade payments, cheques, interest and principal payments, etc.) should be assessed.

Loan Structure - The amounts and tenors of financing proposed should be justified based on the projected repayment ability and loan purpose. - Excessive tenor or amount relative to business needs increases the risk of fund diversion and may adversely impact the borrowers repayment ability.

Security - A current valuation of collateral should be obtained and the quality and priority of security being proposed should be assessed. -Loans should not be granted based solely on security. - Adequacy and the extent of the insurance coverage should be assessed.

Name Lending - Credit proposals should not be unduly influenced by an over reliance on the applicants reputation, reported independent means, or their perceived willingness to inject funds into various business enterprises in case of need. - These situations should be discouraged and treated with great caution. - Rather, credit proposals and the granting of loans should be based on sound fundamentals, supported by a thorough financial and risk analysis.

Credit Risk Management (Key Messages)Credit risk management lies at the heart of survival for the vast majority of banks.The profile of customers(WHOM has been lent to) must be transparent.Risks associated with the key banking products (WHAT has been lent) must be understood and managed.The maturity profile of loan products (for HOW LONG the loans have been made) interacts strongly with liquidity risk management.

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