Statutory and Other Restrictions on Some CreditsThe following credit restrictions have been placed on the banks:(details as per RBI circular No. Dir. BC. 13113.03.00/2009-10 dated 1, July 2009)1. Advances against bank's own shares: In terms of Section 20(1) of the Banking Regulation Act, 1949, a bank cannot grant any loans and advances on the security of its own shares. 2. Restrictions on granting loans and advances to relatives of Directors3. Restrictions on Grant of Loans & Advances to Officers and Relatives of Senior Officers of Banks4. Restrictions on Grant of Financial Assistance to Industries Producing or Consuming Ozone Depicting Substances (ODS)5. Restrictions on Advances against Sensitive Commodities under Selective Credit Control (SCC)6. Advances against Fixed Deposit Receipts (FDRs) Issued by Other Banks7. Loans against Certificate of Deposits (CDs)8. Restrictions on Credit to Companies for Buy-back of their SecuritiesMethods of Credit AssessmentFor quite a long time, credit was considered to be a scarce commodity and RBI had a tight control over the methods of credit assessment by the banks. The guidelines on MPBF first or second or third method of lending, permissible inventory levels, etc. originated in this period. RBI has since relaxed the rules in this area and the banks are now free to adopt their own method of credit assessment. However, for loans and advances to Small Scale Industries, RBI guidelines are as under:'SS1 units having working capital limits of up to Rs. 5 crore from the banking system are to be provided working capital finance computed on the basis of 20 per cent of their projected annual turnover. The banks should adopt the simplified procedure in respect of all SSI units (new as well as existing).'Delivery of CreditRBI has advised the banks to follow, as far as feasible, the loan system, for delivery of bank credit. RBI guidelines in this respect are as under:1. In the case of borrowers enjoying working capital credit limits of Rs. 10 crore and above from the banking system, the loan component should normally be 80 per cent. Banks, however, have the freedom to change the composition of working capital by increasing the cash credit component beyond 20 per cent or to increase the 'Loan Component' beyond 80 per cent, as the case may be, if they so desire. Banks are expected to appropriately price each of the two components of working capital finance, taking into account the impact of such decisions on their cash and liquidity management.2. In the case of borrowers enjoying working capital credit limit of less than Rs. 10 crore, banks may persuade them to go in for the 'Loan System' by offering an incentive in the form of lower rate of interest on the loan component. as compared to the cash credit component. The actual percentage of 'loan component' in these cases may be settled by the bank with its borrower clients.

3. In respect of certain business activities, which are cyclical and seasonal in nature or have inherent volatility, the strict application of loan system may create difficulties for the borrowers. Banks may, with the approval of their respective Boards, identify such business activities which may be exempted from the loan system of delivery.Income Recognition and Asset ClassificationOne of the important functions of RBI is to ensure the stability of financial sector and thus ensuring the interests of the depositors. Banks are required to present their financial position in a fair and transparent manner. A crucial factor, affecting the health of a bank, is the quality of its assets. As these assets are formed mainly with depositors' money( bank's capital in formation of these assets can be as low as 9 per cent, which is the mandatory CAR), even a small deterioration in the quality of these assets can affect the interests of the depositors very badly. RBI has, therefore, prescribed guidelines for the banks to classify their assets depending on the conduct of each account. A provision, out of bank's profit, has to be made to provide for the possibility of default The amount of provision depends on the classification of the asset. Similarly, there are norms prescribed for not recognizing some of the perceived incomes so that the profit of the bank is not inflated unduly. For example, in an account where the principal itself is doubtful of recovery, there is no point in considering the interest receivable as part of the accrued income. There are elaborate RBI guidelines on these matters and all the banks have to compulsorily follow them. (consolidated guidelines are contained In RBI NI aster circular No. DBOD.'s o).BI-BC.I 7/ 21.04.04S/2009-10 dated July 1. 2009. Fide 01 [1112 circular is 'Master Circular � Prudential norms on Income Recognition� Asset Classification and Provisioning pertaining to Advance)Fair Practices Code(Details in RBI circulars dated 5/5/03 and 6/3/07)RBI has issued guidelines on fair practices code for lending. These are to be compulsorily followed by all banks in India. These guidelines pertain to:(1) application for loans and their processing(2) loan appraisal and terms and conditions(3) disbursements of loans(4) post disbursement supervision(5) general guidelines relating to discrimination based on sex, caste and religion. harassment in recovery, transfer/takeover of accounts, etc.SummaryIn banking business, the main source of income is still the income on advances given by the bank and, therefore, efficient credit management is very important in achieving the financial objectives of any bank. But, it is also a fact that credit involves some peculiar inherent risks which should be understood, measured and managed. Each bank formulates its own elaborate loan policy detailing the organizational set up

for credit administration, and prudential norms for single/group borrowers, as also for specific activities. The policy also lays down the appraisal standards, delegation of sanctioning powers, credit risk parameters and guidelines for delivery and monitoring . Appraisal of a credit proposal plays a major role in ensuring timely repayment of money lent by the bank and interest on it. Analysis of financial statements, both past and the projected, help the bank in appraisal of the viability of the proposal as also the amount needed by the borrower. The main methods used for this analysis are trend and ratio analysis. Banks also provide non fund based credit like guarantees, Letters of credit, co- acceptance of bills, etc. The fund based credit is mainly in the form of working capital finance or term loans, which include project and infrastructure finance. Despite all precautions taken in appraisal, delivery, monitoring and various other risk management measures, sometimes, there is default in timely repayment of principal and interest. Management of these problematic assets is also an important part of credit management. RBI, being the regulator of financial system in India, still has great influence on credit management of any bank despite relaxation of controls over the period of time. Knowledge and compliance of relevant RBI guidelines is essential for credit management department of any bank.KeywordsPrudential norms; Asset classification; Provisioning; Collateral security; Priority sector; MSM enterprises; Rehabilitation; Regulated interest rates; Principles of credit; types of borrowers; Appraisal; Delivery; Monitoring and supervision; Credit Risk Management.Check your progressFill in the blanks with correct choice:1. As per RBI guidelines, the turnover method of assessment should be applied for working capital limit of up to Rs �..in case of SSI units.(a) One Crore (b) Two Crores (c ) Five Crores (d) Ten Crores2. Interest rates, regulated by RBI, are applicable for credit limit up to Rs �.. lakh. (a) One (b) Two (c ) Five (d) Ten3. The total priority sector target fore foreign banks, operating in India, is �..(a) 20% (b) 32% (c ) 40% (d) 18%State True or False:4. As per RBI guidelines, the assets should be classified as Standard, Non-standard and doubtful. �. False.5. As per RBI guidelines, no provision is required for Standard Assets. �. False.6. As per MSMED Act 2006, small manufacturing enterprise is an enterprise where the investment in plant and machineryis more than Rs 25 lakh but dos not exceed Rs 5 crore. �. True.7. Fair practices code provides guidance and is not compulsory for the banks in

India. �. False.Answer to Check Your Progress1. (c); 2. (b); 3. (b); 4. False; 5. False; 6. True; 7. FalseThis is the end of chapter 26, of ADVANCED BANK ANAGEMENT- C A I I B PAPER 1 - Overview of Credit Management. ADVANCED BANK MANAGEMENTUNIT 27 � Analysis of Financial StatementsPart 1 of 2STRUCTURE27.0 Objectives27.1 Introduction27.2 Which are the Financial Statements?27.3 Users of Financial Statements27.4 Basic Concepts Used in Preparation of Financial Statements27.5 Legal Position Regarding Financial Statements27.6 Balance Sheet27.7 Profit and Loss Account27.8 Funds Flow and Cash Flow Statements27.9 Projected Financial Statements27.10 Purpose of Analysis of Financial Statements by Bankers77.11 Rearranging the Financial Statements for Analysis27.12 Techniques used in Analysis of Financial Statements27.0 OBJECTIVESAfter reading this chapter, you will have better understanding of:1. Types of financial statements2. Funds flow /Cash flow statement3. The importance and uses of financial statements in credit appraisal4. Projected financial statements5. Analysis of financial statements6. Relationship between items in balance sheet and P & L account7. Trend analysis8. Ratio analysis27.1 INTRODUCTIONWhenever a bank considers a loan proposal, apart from the integrity and K Y C aspects, it has a keen interest in knowing the financial details of the prospective borrower. The extent of these details depends upon the type of loan, type of borrower, purpose of the loan etc. In case of security based lending like loans against fixed deposits, shares etc, these financial details may be few or may not be required at all. But, in all other cases, such details are invariably collected with a view to assessing the following:1. The Net Worth of the Application: For an individual, the excess of his assets over his liabilities is his net worth. The same thing applies to any business entity as well but, prima facie, its financial statement shows assets and liability to be equal as business is considered to be separate legal entity and its net worth is added to liabilities considering that this is the amount payable to the promoters by the business entity. The net worth of an applicant helps the bank in deciding the level of activity which may be desirable by that applicant and the amount of money which can be lent to him.2. Repayment Captivity: In case of an individual, the bank collects information like his

income (salary, interest, dividend etc.) as also his expenditure, including repayments of existing borrowings, if any, to assess the surplus available for repayment of installments and interest on bank's loan. In case of a business enterprise, this information is available from its financial statements.3. Viability: Bank loan mayor may not result in increased earnings for a borrower. For example, a loan for consumer durables will not increase the income while a home loan may result in increased income from rent or reduced expenditure by way of savings on rent. In case of a business enterprise, bank loan is normally intended to increase the income level. A scrutiny of the financial records of the existing activity helps bank in assessing whether the proposed bank loan will result in a viable increase in operations.4. Availability of Unencumbered Securities: In case of individuals, where normally no formal statements of their financial position are available, the bank asks questions to find out about their assets, liabilities, sources of income, expenditure, terms of repayment of existing loans, need for the loan, use of the loan, etc., to address the above mentioned questions. In case of other applicants, such information is normally available from the financial statements, which they are required to prepare as per the law.The statutory provisions ions regarding preparation and audit of financial statements are mostly applicable to corporate entities but these provide the directions to the non-corporate entities as well, and most of such entities, having substantial business volume, follow these guidelines, prescribed for the corporate entities.27.2 WHICH ARE THE FINANCIAL STATEMENTSThere are basically two financial statements which every business enterprise is required to prepare. These are:1. Balance sheet2. Profit & Loss account (Income & Expenditure statement in case of non-profit organizations)Apart from these, the auditors' report, explanatory schedules and notes on accounts, if applicable, provide useful information to the bankers.A funds flow statement also provides useful information but, this is only a mathematical analysis of changes in the structure of two consecutive balance sheets and can be easily prepared by the banker/ analyst himself if the basic statements, i.e. the balance sheets, are available. Accounting Standard-3 makes it mandatory for some enterprises to prepare Cash Flow statement for the accounting period (these enterprises are those whose equity or debt is listed or is in the process of being listed on a recognized stock exchange and also all other commercial, industrial and business enterprises whose turnover for the accounting period exceeds Rs.50 crore. These enterprises are also required to do segment-wise reporting as per A S -1 7.

27.3 USERS OF FINANCIAL STATEMENTSApart from bankers, the other users of financial statements are:1. Other creditors and lenders2. Investors3. Government agencies4. Rating agencies5. Customers6. Employees7. General public8. Analysts27.4 BASIC CONCEPTS USED IN PREPARATION OF FINANCIAL STATEMENTSThe important concepts are as under:1. Entity Concept2. Money Measurement Concept3. Stable Monetary Unit Concept4. Going Concern Concept5. Cost Concept6. Conservatism Concept7. Dual Aspect Concept8. Accounting Period Concept9. Accrual Concept10. Realization Concept11. Matching Concept27.5 LEGAL POSITION REGARDING FINANCIAL STATEMENTS1. Format:In case of banking companies, the formats of both balance sheet and P&L account are prescribed by the Banking Regulation Act. In case of other companies, while the format of balance sheet is prescribed by the Companies Act, no format for Profit and Loss account is prescribed. However, Schedule VI of Companies Act requires that the statements should present a true and fair view of the state of affairs. The Companies Act has also specified that the profit and loss account must show specific information as required by Schedule-IV.The format of balance sheet can be either Vertical or Horizontal as illustrated below (activities like banking, insurance, electricity generation etc, which are governed by acts other than Companies Act, need not follow these formats)Horizontal Form: Horizontal form is maintained in two columns. The first column shows the Liabilities and the second one shows the Assets.The items shown in the first column against Liabilities are:Share CapitalReserves and surplusSecured loansUnsecured loansCurrent liabilitiesProvisionsThe items shown in the second column against Assets are:Fixed assetsInvestmentsCurrent assetsLoans and advancesMiscellaneous expenditureVertical Form: In the Vertical Form, the different items are shown one below the other.

(A) Sources of funds1. Shareholders� funds(a) Share capital(b) Reserves and surplus2. Loan funds(a) Secured loans(b) Unsecured loans(B) Application of funds1. Fixed assets2. Investments3. Current assets, loans and advances Less: Current liabilities and provisions Net current assets4. Miscellaneous expenditures2. AccountingAs per Income Tax rules, April to March is considered as the financial year for tax purposes. However, as per Companies Act, this can be different. Only restriction, as per Companies Act, is that the maximum duration of the financial year can be 15 months, and can be extended up to 18 months with the permission of Registrar of Companies (ROC).3. For incomplete Projects and no ActivityEvery company has to prepare the financial statements even if there is no activity during the accounting period or the project is not completed.27.6 BALANCE SHEETIt is a statement of assets (what is owned) and liabilities (what is owed to others) of an entity at a particular moment. It is like a snapshot of assets and liabilities and just as one picture may be different from another taken anytime earlier, the balance sheet may also be different at different moments of the same day. Therefore, every balance sheet must indicate the date at the end of which it is prepared. Normally, the balance sheet is prepared at the end of the accounting period for which the Profit & Loss account is prepared.LiabilitiesThe Companies Act classifies liabilities as follows:1. Share capital2. Reserve and surplus3. Secured loans4. Unsecured loans5. Current liabilities and provisions.Share CapitalThis is divided into two categories: equity capital and preference capital. The first represents the contribution of equity shareholders who are the owners of the firm. Equity capital carries no fixed rate of return by way of dividend. However, on the preference capital, the dividend rate may be fixed and cumulative.Reserve and SurplusReserves and surplus are profits which have been retained in the firm. There are two types of reserves: revenue reserves and capital reserves. Revenue reserves represent accumulated retained earnings from the profits of normal business operations. These are held in various forms: general reserve, investment allowan

ce reserve, capital redemption reserve, dividend equalization reserve, etc. Capital reserves arise out of gains which are not related to normal business operations. Examples of such gains are the premium on issue of shares or gain on revaluation of assets.Surplus is the balance in the profit and loss account which has not been appropriated to any particular reserve.Secured LoansThese denote borrowings of the firm against which specific securities have been provided. The important examples of secured loans are: debentures, loans from financial institutions and banks.Unsecured LoansThese are the borrowings of the firm against which no specific security has been provided. The examples of unsecured loans are: fixed deposits, loans and advances from promoters, inter-corporate borrowings, and unsecured loans from banks.Current Liabilities and ProvisionsCurrent liabilities and provisions, as per the classification under the Companies Act, consist of the following: amounts due to the suppliers of goods and services bought on credit; advance payments received; accrued expenses; unclaimed dividend; provisions for taxes, dividends, gratuity, pensions, etc.Current liabilities for managerial purposes (as distinct from their definition in the Companies Act) are obligations which are expected to mature in the next twelve months. So defined, they include the following:(1) loans which are payable within one year from the date of balance sheet, (2) accounts payable (creditors) on account of goods and services purchased on credit for which payment has to be made within one year, (3) Provision for taxation, (4) accruals for wages, salaries, rentals, interest, and other expenses (these are expenses for services that have been received by the company but for which the payment has not fallen due), and (5) advance payment received for goods or services to be supplied in the future.AssetsBroadly speaking, assets represent resources which are of some value to the firm. They have been acquired at a specific monetary cost by the firm for the conduct of its operations. Assets are classified as follows under the Companies Act:1. Fixed assets2. Investments3. Current assets, loans and advances4. Miscellaneous expenditures and lossesFixed AssetsThese assets have two characteristics: they are acquired for use over relatively long periods for carrying on the operations of the firm and they are ordinarily not meant for resale.Examples of fixed assets are land, buildings, plant and machinery, office furniture, computer systems etc.InvestmentsThese are financial securities owned by the firm. Some investments represent

long term commitment of funds. (these may be equity shares of other firms held for investment or control purposes.) Other investments are of short-term nature and may be classified undercurrent assets for the purpose of financial analysis. (As per Companies Act, short-term holding of financial securities also has to be shown under investments).Current Assets, Loans, and AdvancesThis category consists of cash and other resources which get converted into cash during the operating cycle of the firm. Current assets are held for a short period of time as against fixed assets which are held for relatively longer periods. The major components of current assets are: cash, debtors, inventories, loans and advances, and pre-paid expenses. Cash includes credit balances in the bank accounts. Debtors (also called receivables or sundry debtors) represent the amount owed to the firm by its customers who have bought goods, services on credit. Debtors are shown in the balance sheet at the amount owed, less provision for bad debts. Inventories/ stocks consists of-raw materials, work-in-process, finished goods, and stores and spares. They are accounted at the lower side of the cost or market value as per the accounting concept of conservatism.Loans and AdvancesThese are loans to employees, advances to suppliers and contractors, and deposits made with governmental and other agencies. They are shown at the actual amount. Pre-paid expenses are expenditure incurred for services to be rendered in the future,Miscellaneous Expenditures and LossesThis category consists of two items: (1) miscellaneous expenditures and (2) losses. Miscellaneous expenditures represent certain outlays such as preliminary expenses and pre-operative expenses which have not been written off. From the accounting point of view, a loss represents a decrease in owners' equity. Hence, when a loss occurs, the owners' equity should be reduced by that 'amount. However, as per company law requirements, the share capital (representing. equity) cannot be reduced when a loss occurs. So, the share capital is kept intact on the liabilities side of the balance sheet and the loss is shown on the assets side of the balance sheet.27.7 PROFIT AND LOSS ACCOUNTIt is a statement of income and expenditure of an entity for the accounting period. Every P and L account must indicate the accounting period for which it is prepared The items of a P & L account are:1. Gross and Net sales2. Cost of goods sold3. Gross profit4. Operating expenses5. Operating profit6. Non-operating surplus/deficit

7. Profit before interest and tax8. Interest9. Profit before tax10. Tax11. Profit after tax (Net Profit)Gross and Net SalesThe total price of goods sold and services rendered by an enterprise, including excise duty paid on the goods sold, is called Gross sales. Net sales are gross sales minus excise duties.Cost of Goods SoldThis is the sum of costs incurred for manufacturing the goods sold during the accounting period. It consists of direct material cost, direct ]about cost, and factory overheads. It is different from the cost of production, which represents the cost of goods produced in the accounting year, not the cost of goods sold during the same period.Gross ProfitThis is the difference between net sales and cost of goods sold. Most companies show this amount as a separate item. Some companies, however, show all expenses at one place without making gross profit a separate item.Operating ExpensesThese consist of general administrative expenses, selling and distribution expenses, and depreciation. Some companies include depreciation under cost of goods sold as a manufacturing overhead rather than under operating expenses.Operating ProfitThis is the difference between gross profit and operating expenses. As a measure of profit, it reflects operating performance and is not affected by non-operating gains/losses, financial leverage, and tax factor.Non-operating SurplusThis represents gains arising from sources other than normal operations of the business. Its major components are income from investments and gains from disposal of assets. Likewise, non-operating deficit represents losses from activities unrelated to the normal operations of the firm.Profit before, Interest and TaxesThis is the sum of operating profit and non-operating surplus/deficit. Referred to also as earnings before interest and taxes (EBIT), this represents a measure of profit which is not influenced by financial leverage and the tax factor.InterestThis is the expenses incurred for borrowed funds, such as term loans, debentures, public deposits, and working capital advances.Profit before taxThis is obtained by deducting interest from profits before interest and taxes.TaxThis represents the income tax payable on the taxable profit of the year.Profit after taxThis is the difference between the profit before tax and tax for the year.This is the end of Part 1 of 2, of chapter 27, of ADVANCED BANK MANAGEMENT- C A I I B PAPER 1.ADVANCED BANK MANAGEMENTUNIT 27 � Analysis of Financial StatementsChapter 27, Part 2 of 227.8 FUNDS FLOW OR CASH FLOW STATEMENTSEach item in the balance sheet represents either source of funds or use of funds.

All items on the liabilities side represent the funds provided to the enterprise and all items on the assets side (except cash) represent use of these funds. Cash in the balance sheet represents the unutilized portion of funds, available to the enterprise. If cash is also perceived as a use of funds then all the uses of funds are equal to all the sources of funds. This perception of available cash, as a use of funds, is what causes the wide spread confusion about difference in a Funds flow statement and a Cash flow statement. When we compare two balance sheets of different dates, change in each item (or introduction of a new item) in the balance sheet of later date, as compared to that item in the balance sheet of earlier date, will represent either addition of funds or additional use of funds in the intervening period. Any increase in any item on the liabilities side means additional funds available. Please note that additional funds are also available if there is decrease in any item on the assets side. Similarly, any increase in any item on the assets side or decrease in any item on the liabilities side means additional use of funds. A statement of these additional sources of funds and additional uses of funds is called Funds flow statement for the intervening period. Normally, this intervening period is the accounting year, as the balance sheets, which form the basis of this statement, are prepared as on the last day of each accounting period. If we have to prepare the cash flow statement, we start with the cash in the first balance sheet as opening balance, add all the additional sources, excluding cash (cash is also a source of funds if it is at a reduced level in the subsequent balance sheet), and deduct all additional uses (excluding cash), thus arriving at, the closing balance, which will be equal to the cash shown in the second balance sheet. In practice, the statement is prepared perceiving cash as a use or source of funds and it is known as Funds flow or cash flow statement. This should not be confused with the cash budget (which also is referred to as cash flow statement) prepared for the purpose of assessing the need for working capital funds from the bank. In that statement, all cash flows during a period, excluding bank finance, are taken and the deficit shown forms the basis of bank finance.27.9 PROJECTED FINANCIAL STATEMENTSActual financial statements are for the past period and analysis of these gives very useful financial information to the banker. But for assessing the need for bank credit and to examine the viability of the activity, it is necessary to anticipate the

financial position of the enterprise in future. For example, for assessing the working capital needs, the statement of assets and liabilities of the last year will not be adequate. We will have to anticipate the level of operations during the current year and accordingly project the level of assets and liabilities to arrive at the need for bank's loan. Of course, the financial statements for the past period serve as the most important guide for this estimate. Also, in case of a new enterprise, where no financial statements are available, it becomes necessary to decide on a level of activity and accordingly prepare the projected financial statements. Generally, in case of smaller enterprises, where adequate financial expertise may not be available, the projected financial statements for the next year are prepared by the bank by interviewing the concerned person . In case of term loans for new projects/expansion, the projected financial statements are normally prepared for the entire duration of bank loan to establish the viability of operations as also to determine the disbursal and repayment schedule. Whenever the projected financial statements are submitted by the borrower, these are critically examined for their reasonability and if projections are considered to be unreasonable, the matter is discussed with the borrower and suitable consensus arrived at.27.10 PURPOSE OF ANALYSIS OF FINANCIAL STATEMENTS BY BANKERSDifferent users, interested in the financial statements of an entity, may analyze these with focus on evaluation of different aspects. For example, a share market investor may be more interested in Earning Per Share (E P S), while the statutory authorities may be more interested in compliance and provisions. The banker's focus is normally on the following aspects:(a) Assessment of Performance and Financial Position: An analysis of the financial statements reveals the trend of growth of its business and its profitability. By comparing these to the industry trend, opinion about the management and efficiency of the enterprise is formed. Also, the financial statements reveal the composition of assets and liabilities of the enterprise. By seeing the trend of leverage (Debt/equity), retention of profits etc., the financial health of the enterprise is judged.(b) Projection of Future Performance: Past performance is often a good indicator of future performance. The financial statement analysis helps in projecting the earning prospects and growth rates in the level of activity and earnings with a reasonable degree of certainty.(c) Detecting Danger Signals: Financial statement analysis is an important tool

in knowing the direction of business of the enterprise as also to detect any deterioration of its financial health. Being aware of any deterioration of the financial position, the bank can take preventive measures to avoid/ minimize losses. Important ratios, arrived at from the financial analysis. also help the bank to achieve this goal.(d) Assessment of Credit Requirements: One of the difficulties in credit is the accurate assessment of the financial need of the applicant. Over-financing and under-financing both are risky for the borrower and the bank. Financial statement analysis is used by banks to assess the credit requirement more accurately. Banks are also concerned with repayment of loan interest within a reasonable time. Analysis of the financial statements of the borrower helps in assessing the repayment schedule as also to assess credit risk, decide the terms and conditions of loan.(e) Examine Funds Flow: This is to ascertain that the bank's funds have been used for the intended purposes and there is no diversion. Also, the use of short term sources is examined to find if there is any unacceptable mismatch created in the liquidity position.(f) Cross Checking: The statements of stocks and book debts. as on the date of the balance sheet, submitted by the borrower. for calculation of drawing power in the cash credit account, are cross checked with the figures given in the balance sheet . If statements of the balance sheet date are not available, the statements of nearest date are used, which give a fair idea if the correct statements are being submitted.27.11 REARRANGING THE FINANCIAL STATEMENTSIn keeping with the above objectives, a banker rearranges the figures in the financial statements under distinct groups for a meaningful analysis.Balance SheetThe assets and liabilities are normally regrouped as under:In regrouping, the items shown under Liabilities are: (1) Net worth, (2) Long-term liabilities (3) Current liabilities and provisions. In regrouping, the items shown under Assets are: (1) Fixed assets, (2) Current assets (3) Non-current assets (4) Intangible assets.Profit and Loss AccountThe format prescribed under erstwhile Credit Monitoring Arrangement (CMA) under which banks used to report sanction of large credit proposals to RBI, still serves as a useful guide for rearranging the items in Profit and Loss account. The important groups of items are as under:The format is in three columns. The first column shows different items. The second and the third one show the values of these items in the last year and present year respectively.The different items shown in the first column are:1. Gross sales2. Cost of sales(a) Raw materials

(b) Power and fuel(c) Direct labour(d) Other manufacturing expenses(e) Depreciation(f) Sub total(g) Add opening stocks(h) Less closing stocks(i) Total cost of sales3. Selling, general and administrative expenses4. operating profit5. Interest6. operating profit after interest7. add non operating income8. less non operating expenditure9. Profit before tax10. tax12. Profit after taxImportant Points for Rearranging Financial StatementsWhile rearranging the financial statements, the following points should be examined by the banker and suitable changes made in different items:(a) Instalment of term loans due within one year(b) Advance tax and provision of tax(c) Deferred tax assets and liabilities(d) Non moving inventory(e) Receivables more than 6 months old(f) Revaluation of assets and Intangible assets(g) Investments(h) Bills purchased and discounted(i) Contingent liabilities(j) Provisioning(k) Depreciation method(l) Inventory valuation(m) Expenses relating to earlier years(n) Important events after account period.27.12 TECHNIQUES USED IN ANALYSIS OF FINANCIAL STATEMENTSBankers mostly use three methods for analysis of financial statements.(a) Funds Flow Analysis(b) Trend Analysis(c) Ratio AnalysisFunds Flow Analysis: If the borrower has not submitted the funds flow statement, bank prepares the same from the last two balance sheets. The total sources of funds are categorized as 'Long term' and 'Short term'. Similarly, the total uses are also categorized as 'Long term' and 'Short term'. If the short term sources are more than the short uses it indicates diversion of working capital funds and needs to be probed further. Sometimes, it may be a desirable thing e.g., in case of companies with very high current ratio, it may be desirable to use the idle funds for creating additional capacity. The guiding principle is that this diversion should not affect the liquidity position of the company to unacceptable level.Trend Analysis: Under trend analysis, bankers adopt the following methodology:(a) The items for which trend is required to be seen, are arranged in horizontal form and percentage increase or decrease from the previous year's figures is indicated

below it. Generally, this is used to see the trends of sales, operating profit, PBT, PAT etc. from P and L account. Similarly, the balance sheets, arranged in horizontal order, give the trends of increase or decrease of various items.(b) Common size statements are prepared to express the relationship of various items to one item in percentage terms. For example, consumption of raw materials is expressed as a percentage of sales for different years and comparison of these figures gives indication of trend of operating efficiency.Common size financial statements contain the percentages of a key figure alone, without the corresponding amount figures. The use of percentages is usually preferable to the use of absolute figures.The use of common size statements can make comparisons of business enterprises of different sizes much more meaningful since the numbers are brought to common base, i.e. per cent. Such statement allows an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry.Ratio Analysis: This is the most favourite method of bankers for analysis of financial statements. A ratio is comparison of two figures and can be expressed as a percentage (e.g. profitability is 23.7 per cent), as a number (e.g. current ratio is 1.33) or simply as a proportion (e.g. debt equity is 1: 2).Both the figures,used in calculation of a ratio, can be from either P& L account, or balance sheet or one can be from P& L account and the other from balance sheet. Ratios help in comparison of the financial performance and financial position of an entity with other entities, as also for comparison with its own status over the years. While different users of financial statements are interested in different ratios, the ratios which interests a banker most, are the following:(a) Profitability Ratios: Operating Profit Margin (OPM) and Net Profit Margin (NPM) are calculated by dividing the figures of operating profit (EBIT, which means earnings before interest and tax) and net profit respectively by the net sales. OPM is an indicator of the operating efficiency of the enterprise while NPM is an indication of ability to withstand the adverse business conditions.(b) Liquidity Ratios: These are Current ratio (CR) and Acid test ratio or quick ratio. While CR is a ratio of total current assets to total current liabilities, quick ratio is calculated by dividing current assets (excluding inventory) by total current liabilities. These ratios indicate the capacity of an enterprise to meet its short term obligations.(c) Capital Structure Ratios: Debt Equity Ratio (DER) is a ratio of total outside long term liability to the Net worth of an enterprise. Bankers are averse to high debt equity ratios as it not only represents high borrowings in relation to the owned funds but

also affects the viability of the operation of the enterprise, as higher borrowings mean higher costs and lower operating margins. In case of those enterprises, which are not capital intensive (i.e. the requirement of fixed assets is low), this ratio may not indicate the correct picture as working capital borrowings, which are not indicated by DER, may be disproportionate to the capital. So, bankers use ratio of TOL (Total Outside Liabilities to TNW (Tangible Net Worth).(d) Ratio Indicating Ability to Service Interest and Instalmemts: Interest Coverage Ratio (ICR) and Debt Service Coverage Ratio (DSCR) are the important ratios in this category. ICR is calculated by dividing EBIT (earnings before interest and tax) by total interest on long term borrowings. DSCR is ratio of total cash flows before interest (net profit plus depreciation plus interest on long term borrowings) to total repayment obligation (instalment plus interest on long term borrowings).(e) Turnover Ratios:(1) Inventory Turnover Ratio: This is an indicator of movement of inventory. It is calculated by dividing cost of goods sold by average inventory. A higher ratio indicates faster movement of inventory. This is also used for calculating average inventory holding period.(2) Debtors� Turnover Ratio: It is an indicator of how fast the debtors are realized. It is calculated by dividing the net credit sales by average debtors outstanding during the year. A higher ratio indicates faster collection of debts. This is also used for calculating average collection period.Deficiency in Ratio Analysis MethodThe profit and loss account covers the entire fiscal period, whereas the balance sheet is on a particular date. To compare an income statement figure such as sales to a balance sheet figure such as debtors, we need a reasonable measure of average debtors for the year, which is normally arrived at by using an average of beginning and ending balance sheet figures. This approach does not eliminate problems due to seasonal and cyclical changes or bunching of sales near the year end.SummaryFinancial statements are prepared on the basis of accounts of financial transactions of an enterprise. The balance sheet depicts the position of its assets and liabilities as on a particular date, while P and L account is prepared for an accounting period and states the position of income, expenses and the profit. By comparing two successive balance sheets, we can calculate the flow of funds in the intervening period. So, the financial statements are effective tools in monitoring of an account. As the credit decisions are applicable for future needs of an enterprise, usually projected financial statements are also prepared, specially, in case of medium and large enterprises. These are based on actual statements for the past period and anticipated perform

ance in the future. Analysis of financial statements helps banks in knowing the financial health and performance and viability of an enterprise and in assessing its credit requirements. The main methods used for this analysis are trend and ratio analyses. The trend analysis shows how the business of an enterprise is growing while the ratio analysis depicts the most critical financial parameters at a glance. Thus, if the key ratios like OPM, debt to equity ratio, current ratio, DSCR, debtors' turnover ratio are seen by a banker, he can form a reasonably correct opinion about the enterprise. However, for a final decision, a more detailed analysis is necessary.While the format for balance sheet is prescribed by law, the format for P&L account is prescribed only for the banking companies. But all entities, including non corporates, usually follow the well established accounting principles and prepare their accounts accordingly. For meaningful analysis, a banker has to rearrange these statements into various groups.KeywordsBalance Sheet; P and L Account; Funds flow statement: Cash flow statement; Sources and uses of funds; Common size statements; OPM, debt to equity ratio; current ratio: DSCR, debtors' turnover ratio; Contingent liabilities; Intangible assets; Pre-operative expenses: Short term liabilities: Long term liabilities: Net worth; TNW; TOLCheck Your Progress State True or False:State True or False:1. Companies Act has prescribed the format of the balance sheet. �. True.2. Format for P & L account for banking companies is prescribed by the Banking Regulation Act. �. True.3. As per Companies Act, short-term holding of financial securities has to be shown Linder investments. �. True.4. The furniture available in a furniture shop is classified under Fixed Assets. �. False.5. For the purpose of analysis, installments of term loan, due within one year, is classified under current assets. �. True.6. Banks reduce the amount of intangible assets from the Net Worth for the purpose of analysis of financial statements. �. True.7. The change in the method of inventory valuation does not affect the profit in an accounting year. �. False.8. The method of ratio analysis is the best method of financial analysis, as it does not suffer from any deficiency. �. False.9. Debt: Equity ratio (D E R) is a ratio of total outside liability to the net worth of an enterprise. �. False.10. Interest Coverage Ratio (I C R) is calculated by dividing E B I T(earnings before interest and tax) by total interest on long term borrowings �. True.11. D S C R indicates the ability of an enterprise to service interest and installments. �.

True.12. Contingent liabilities of an enterprise do not affect the financial analysis. �. False.13. Funds flow statement and the statement of Sources and Uses of funds are the same. �. True.14. Liquidity ratios indicate the capacity of an enterprise to meet its short term obligations. �. True.Key to Check Your Progress1. True; 2. True; 3. True; 4. False; 5. True; 6. True; 7. False; 8. False; 9. False; 10. True; 11. True; 12. False; 13. True; 14. TrueThis is the end of Part 2 of 2, of chapter 27, of ADVANCED BANK MANAGEMENT- C A I I B PAPER1, Analysis of Financial Statements.ADVANCED BANK MANAGEMENTUnit 28 - WORKING CAPITAL FINANCESTRUCTURE28.0 Objectives28.1 Concept of Working Capital28.2 Working Capital Cycle28.3 Importance of Liquidity Ratios28.4 Methods of Assessment of Bank Finance28.5 Bills/Receivables Finance by the Banks28.6 Guidelines of R B I for Discounting/Rediscounting of Bills by Banks28.7 Non Fund Based Working Capital Limits28.8 Other Issues Related to Working Capital Finance28.0 OBJECTIVESAfter reading this chapter, you will have better understanding of:1. The concept of working capital, total/gross working capital, net working capital2. Working capital cycle3. Components of current assets/current liabilities, liquidity, importance of liquidity ratios4. Various sources of meeting working capital requirements5. Bank finance for working capital, methods of assessment6. Financing of bills/receivables7. Non fund based working capital limits8. Commercial paper, factoring, forfeiting28.1 CONCEPT OF WORKING CAPITALWhenever a business enterprise is started, some fixed assets like office, furniture, machines/computers etc, depending upon the need, are acquired. But this alone may not be sufficient for running the business of that enterprise, except for a few activities like broking/commission agent, etc. Most of the business enterprises, in the course of their business, have to carry some current assets like raw materials, finished goods, receivables etc. The money blocked in these current assets is called working capital.Let us take example of an entrepreneur setting up a small manufacturing enterprise for manufacture of polythene bags. He completes the construction of factory shed and puts up all the plant and machinery. At this point, if he takes a snapshot of his assets and liabilities, it will be as under:Balance sheet of ABC Ltd as on 9 September, 2009Liabilities (Capital) Rs. 25 lakh Assets (Fixed assets) Rs 100 lakh

Liabilities (Long term liabilities) Rs. 75 lakhLiabilities Total Rs 100 lakh Assets Total Rs 100 lakhFor running the factory, he needs raw material, i.e. the polythene granules. He goes to the dealer and finds out that the rate of granules is Rs 100 per kg and credit of 3 months is available. His requirement is 1000 kg (1 ton) per day. He purchases 30 tons of granules which is the minimum quantity which the dealer sells. He starts manufacture of the bags on 10 September 2009. The process takes very little time, and on the evening of 10 September 2009 he has 1 ton of bags with him. He incurs a cost (power, labour, transport, miscellaneous expenses, but ignoring depreciation) of Rs10,000 for converting 1 ton of granules into bags. He approaches the wholesale dealer of bags for selling the bags to him. The deal is struck at Rs 1,10,000 per ton, but a minimum of 10 tons of bags is to be supplied. Also, credit of one month is to be given to the purchaser. So, the entrepreneur continues to manufacture for 10 days and on 21 September, 2009 supplies 10 tons of bags by raising an invoice of Rs 11 lakh, payable on 21/10/09. The next supply will be made on 1 October, 2009. If he takes a snapshot of his assets and liabilities on the evening of 30 September 2009, the picture will be as under;Balance sheet of ABC Ltd as on 30 September, 2009(Liabilities) Capital Rs 25 lakh (Assets) Fixed assets Rs 100 lakh(Liabilities) Long term liabilities Rs 75 lakh (Assets)Raw material( 10tons) Rs 10 lakh(Liabilities) Amount payable to supplier Rs 30 lakh (Assets) Work in process (0)(Liabilities) Expenses payable Rs 2 lakh (Assets) Finished goods( 10 tons) Rs 11 lakh(Liabilities) Amount receivable Rs 11 lakh(Liabilities) Total Rs 132 lakh. (Assets) Total Rs 132 lakhThe amount of raw materials, work in progress, finished goods, receivables totaling Rs 32 lakh, is called the working capital or the current assets required to run the enterprise smoothly. In this example, the entrepreneur has not arranged for any money to run his factory as his entire requirement of working capital is met through the credit provided by the supplier. But, life in business, often, is not as simple as shown here. It is a fact that current assets are required by almost every enterprise to run the business smoothly. How much of current assets are required to be maintained depends on the nature of activity and the market conditions. Working capital finance by the banks is nothing but assessment of total current assets needed and how this need is to be met.In the above example, what happens if the credit is not available from the supplier or, the credit is available only for 10 days? The credit provided to purchaser

may not be reduced if the market practice is like that. In such a case, he will approach the bank and request for a working capital loan of Rs 32 lakh. Assuming that bank is convinced about K Y C norms, viability of the project etc, the bank will assess the needs and sanction an amount. How much will that amount be, we will discuss later in the chapter. But, bank will definitely ask him to bring some of his own money either by way of capital or long term borrowings like fixed deposits, loans from friends and relatives. This amount, which is intended to meet part of the working capital, is called Net Working Capital. The other part of the working capital will be met by credit provided by the supplier, other credit available, and the bank finance. In short, we can say that the total requirement of current assets of an enterprise, which is termed as Total or Gross working capital is met by short term credit available (including bank finance) and some amount arranged by the enterprise through long term funds (either capital or borrowings), called Net Working Capital.28.2 WORKING CAPITAL CYCLEThe normal operations of a business enterprise consist of some or all of the actions like, purchase of raw materials, processing and conversion of raw materials into finished goods, selling these goods on cash/ credit basis, receive cash on sale or end of credit period and again purchase raw materials. This is called working capital cycle. The length of this cycle depends on:(a) the stocks of raw materials required to be held(b) the work in process, which in turn depends on the process involved in manufacturing and processing the raw materials.(c) the credit required to be provided to the purchasersThe longer the working capital cycle, the more is working capital requirement, i.e., the need for maintaining the current assets. The correct assessment of this cycle is the most important part in a bank's assessment of gross working capital, net working capital and the bank finance. The assessment of working capital finance by the bank follows the assessment of working capital requirement of the enterprise.28.3 IMPORTANCE of LIQUIDITY RATIOSFor a banker, providing working capital finance, the liquidity ratios, specially the current ratio, play a very important role in assessment, sanctioning decision, and monitoring. The assessment involves stipulation of a minimum Net Working Capital (N W C) to be brought in by the enterprise from its long term sources. This results in a minimum current ratio (more than one) which the bank wants the enterprise to maintain at all the times. This is, normally, mentioned in the terms and conditions of sanction and becomes an important tool for the bank to monitor the use of funds by the enterp

rise.28.4 METHODS OF ASSESSMENT OF BANK FINANCEHolding Norms Based Method of Assessment of Bank Finance:(1) Deciding on the level of Turnover of the Enterprise: This is a very important step in any method of assessment of working capital limits. In case of existing enterprises, the past performance is used as a guide to make an assessment of this. In case of new enterprises, this is based on the production capacity, proposed market share, availability of raw materials, industry norm etc. Despite analysis of all the data, accurate estimate of future turnover is often an area of disagreement between the bank and the borrower.(2) Assessment of Gross or Total Working Capital: This is the sum total of the assessment of various components of the working capital:(a) Inventory: For assessing the stock levels of raw materials, work in process and the finished goods, information like lead time, minimum order quantity, location and number of suppliers, percentage of imported material, manufacturing process, etc. are taken into account. Tandon committee had prescribed inventory norms for various industries but these are not mandatory now and banks can estimate the levels applicable to each case based on its peculiarities. Industry norms, available in the data base, are also used as a guide for the estimate of inventory level.(b) Receivables and Bills: This estimate is relatively simpler compared to that of the inventory. This is mostly governed by the market practice applicable to a particular business or place.(c) Other Current Assets: A reasonable estimate of other current assets like cash level, advances to suppliers, advance tax payment etc is necessary to avoid under-financing.Sources for Meeting Working Capita Requirement:(a) Own Sources (N W C): The balance sheet of the last accounting year, depicts the position of available N W C. Also, as the estimate of limits is based on the projected balance sheet at the end of the current accounting year, there are some internal accruals which are also taken into account. Depending on the desired current ratio to be maintained, bank may stipulate additional N W C to be brought in if the available N W C and anticipated internal accruals are not considered enough to maintain the desired current ratio.(b) Suppliers� Credit: Estimate of this depends on the market practice.(C) Other Current Liabilities like salaries payable, advances from customers, etc.(d) Bank FinanceCalculation of Bank FinanceLogically, the need for working capital finance from the bank is equal to the gap between total working capital and the availability of funds from all the sources, as mentioned above (of course, excluding bank finance). The enterprise or the bank may

not have much control on the 'suppliers' credit' or 'other current liabilities', as these are driven by market conditions or business needs. But banks can prescribe the amount to be brought in by the enterprise through its own long term sources i.e. the N W C. This was at the core of the recommendations of the erstwhile Tandon committee, which dominated the psyche of the bankers for a long time. Though banks are now free to formulate their own policies in this regard, the methods of lending, mentioned there, still find place in the calculations followed by the banks. The methods are;(a) First Method of Lending: Under this, the enterprise was required to bring in at least 25 per cent of the working capital gap (total current assets minus total current liabilities excluding bank finance)(b) Second Method of Lending: Under this, the enterprise was required to bring in at least 25 per cent of the total current assets(b) Third Method of Lending: Under this, the enterprise was required to bring in 100 per cent of those current assets which are considered 'core assets' and at least 25 per cent of the remaining current assets.It may be noted that while the second method of lending results in current ratio of at least 1.33, in case of first method, it could be less and in the third method it is likely to be more than this.Depending upon the loan policy of the bank, the working capital limit can be arrived at by deducting from the total projected current assets, the stipulated NWC and the projected short term liabilities.Cash Budget Method of AssessmentAny economic activity, however small it may be, involves outflows ( expenditure) of money for procurement of inputs and inflows of money (income) from the sale of output The nature, amount and periodicity of outflows and inflows is peculiar to the type of activity, level of operations, market conditions and the policies adopted by the owners/managers etc. The genesis of an enterprise's requirement for the working capital funds, from the bank, lies in the fact that during a particular day, its opening cash balance and cash inflows are not sufficient to meet its normal cash outflows. Short term bank finance, called working capital finance, fulfils this requirement of excess cash outflows. Therefore, an ideal way to assess the need for bank finance is to precisely project the cash inflows and outflows for each day and provide finance to meet the cash deficit. But, projection of daily cash flows is not a feasible option because market conditions are not perfect. Therefore, the periodicity of estimating cash flows is increased to a more feasible level of a month or a quarter. A statement of estimated cash inflows and outflows is prepared for this period and bank finance equal to

the cash deficit, if any, is sanctioned.A normal statement / budget, will look as under;1 2 3 5Inflows1. Opening balance2. Term loan from Bank3. Sales (Total sales-credit sales + realization for ealier sales)4. Other cash inflowsTotal inflowsOutflows1. Capital expenditure2. R. M. Purchase3. Labor4. Power and fuel5. Payment of Interest6. Repayment of Term loan installment7. Other cash outflowsTotal outflowsCash surplus or (deficit)Bank finance neededClosing balanceTurnover Method of AssessmentThe assessment of working capital limit by the banks, in some cases, is influenced by the guidelines of R B I.For working capital advances to Small Scale Industries. R B I guidelines are as under:`SSI units having working capital limits of up to Rs.5 crore from the banking system are to be provided working capital finance computed on the basis of 20 per cent of their projected annual turnover. The banks should adopt the simplified procedure in respect of all S S I units (new as well as existing).'The R B I guidelines may result in under-financing for those S S I units where the working capital cycle is more than 3 months. Therefore, the banks, normally, also assess the requirement on the basis of holding norms also and sanction the limit whichever is higher.Comparison of the Three Methods of AssessmentIt is easy to infer from the above that there is no basic difference between the holding method and the cash budget method of assessment of bank finance. Both involve the essential steps of projecting the level of activity, credit provided to customers, credit received from suppliers, requirement of other current assets and liabilities. The preciseness of the assessment in both the methods depends on how precisely the credit officer estimates these parameters. However, the holding method is based on the estimate of average of all these parameters over next one year, which may be too long a period for correct assessment, specially, for seasonal industries. Therefore, this method is more suitable for those activities which have relatively uniform operations and for which the market conditions are not very volatile. The cash budget method may be more suitable for activities which have wide fluctuation from mont

h to month in the level of activities or market conditions, like seasonal industries or execution of project contracts.The turnover method is more suitable for Small enterprises where detailed financial records may not be available.28.5 BILLS / RECEIVABLES FINANCE BY THE BANKSReceivables are part of the current assets of a business enterprise. These arise due to sales on credit basis to the customers. If the credit sales are based on invoices alone, the amount receivable from the customers is represented in the accounts as 'book debts' or 'sundry debtors'. The bank provides finance against these in a fashion similar to that for inventory. The borrower submits a statement of book debts and bank calculates the drawing power by deducting the applicable margin.Another method of sales is through Bills of exchange drawn by the seller on the purchaser in the following manner;(a) If no credit is to be provided to the customer, a demand bill is drawn. This, along with the transport document like MR, RR etc, is given to bank either for collection or purchase. If bank purchases the bill, it provides immediate credit to the seller (drawer of bill), which may be even 100 per cent of the bill amount, after collecting the usual charges. In case of either purchase or collection, the bank's branch at the purchaser's place presents the bill to him and delivers the transport documents to him against payment of the bill. In case of collection, till the payment is credited to the seller's account, the amount is shown as book debt in his books. In case of purchase of the bill by the bank, the amount of bill is not represented in the books.(b) If the credit is to be provided on the sales, a bill of exchange, called usance bill, mentioning the period of payment, is drawn on the purchaser and is accepted by him The outstanding amount is shown in the accounts as 'bills receivables'. The advantage of sales under bills of exchange, which are governed by the NI Act, is the increased legal protection in case of default by the customer. For bank finance, either the accepted bill is given to the bank or the documents are sent through bank which delivers the same to the purchaser against his acceptance of usance bill. Bank provides finance to the seller by discounting the usance bill after deducting the usual charges and interest for the usance period.The terms used in bills finance are purchase, discount and negotiation. Normally, 'purchase' is used in case of demand bills, 'discount' in case of usance bills and 'negotiation' in case of bills which are drawn under letters of credit opened by the purchaser's bank.

In case of purchase/discount/negotiation of the bill by the bank, the outstanding amount of bills is not represented in the assets in the accounting books of the drawer (i.e., the seller, who is customer of the financing bank). It may be represented in his contingent liabilities if the bills are not 'without recourse to drawer'. To get a realistic picture, at the time of assessment of working capital finance, the amount of bills purchased/discounted is added to both current assets and liabilities, depending on the bank's loan policy. However, the bills negotiated are normally not added as the counterparty is another bank and the probability of recourse to drawer will be extremely low.28.6 GUIDELINES OF RBI FOR DISCOUNTING / REDISCOUNTING OF BILLS BY BANKSThe gist of R B I guidelines to banks, while purchasing / discounting / negotiating / rediscounting of genuine commercial / trade bills, are as under:(a) Banks may sanction working capital limits, as also bills limit, to borrowers after proper appraisal of their credit needs and in accordance with the loan policy as approved by their Board of Directors. Banks should clearly lay down a bills discounting policy approved by their Board of Directors, which should be consistent with their policy of sanctioning of working capital limits. In this case the procedure for Board approval should include banks' core operating process from the time the bills are tendered till these are realized. Banks may review their core operating processes and simplify the procedure in respect of bills financing. In order to address the often-cited problem of delay in realization of bills, banks may take advantage of improved computer/communication networks like the Structured Financial Messaging System (S F M S) and adopt the system of 'value dating' of their clients' accounts.(b) Banks should open letters of credit (L Cs) and purchase / discount / negotiate bills under L Cs only in respect of genuine commercial and trade transactions of their borrower constituents who have been sanctioned regular credit facilities by the banks. Banks should not, therefore, extend fund-based (including bills financing) or non-fund based facilities like opening of L Cs. providing guarantees and acceptances to non-constituent borrower or/and non-constituent member of a consortium / multiple banking arrangement. However, in cases where negotiation of bills drawn under L C is restricted to a particular bank and the beneficiary of the L C is not a constituent of that bank, the bank concerned may negotiate such an L C, subject to the condition that the proceeds will be remitted to the regular banker of the beneficiary. However, the prohibition regarding negotiation of unrestricted L Cs of non-constituents will continue to

be in force.(c) Sometimes, a beneficiary of the LC may want to discount the bills with the LC issuing bank itself. In such cases, banks may discount bills drawn by beneficiary only if the bank has sanctioned regular fund-based credit facilities to the beneficiary. With a view to ensuring that the beneficiary's bank is not deprived of cash flows into its account, the beneficiary should get the bills discounted/ negotiated through the bank with which he is enjoying sanctioned credit facilities.(d) Bills purchased/discounted/negotiated under L C (where the payment to the beneficiary is not made 'under reserve') will be treated as an exposure on the L C issuing bank and not on the borrower. All clean negotiations as indicated above will be assigned the risk weight as is normally applicable to inter-bank exposures, for capital adequacy purposes. In the case of negotiations 'under reserve', the exposure should be treated as on the borrower and risk weight assigned accordingly.(e) While purchasing / discounting / negotiating bills under L Cs or otherwise, banks should establish genuineness of underlying transactions/documents.(f) The practice of drawing bills of exchange claused 'without recourse' and issuing letters of credit bearing the legend 'without recourse' should be discouraged because such notations deprive the negotiating bank of the right of recourse it has against the drawer under the Negotiable Instruments Act. Banks should not therefore open L Cs and purchase/discount/negotiate bills bearing the 'without recourse' clause. On a review it has been decided that banks may negotiate bills drawn under L Cs, on 'with recourse' or 'without recourse' basis, as per their discretion and based on their perception about the credit worthiness of the L C issuing bank. However, the restriction on purchase/discount of other bills (the bills drawn otherwise than under L C) on 'without recourse' basis will continue to be in force.(g) Accommodation bills should not be purchased/discounted/negotiated by banks. The underlying trade transactions should be clearly identified and a proper record thereof maintained at the branches conducting the bills business.(h) Banks should be circumspect while discounting bills drawn by front finance companies set up by large industrial groups on other group companies.(i) Bills rediscounts should be restricted to usance bills held by other banks. Banks should not rediscount bills earlier discounted by non-bank financial companies (N B F Cs) except in respect of bills arising from sale of light commercial vehicles and two/three wheelers.(j) Banks may exercise their commercial judgment in discounting of bills of the services sector. However, while discounting such bills, banks should ensure that actual services are rendered and accommodation bills are not discounted. Services sector bills should not be eligible for rediscounting. Further, providing finance against dis

counting of services sector bills may be treated as unsecured advance and, therefore, should be within the norm prescribed by the Board of the bank for unsecured exposure limit.28.7 NON-FUND-BASED WORKING CAPITAL LIMITSIn the course of its business, an enterprise may sometimes need bank guarantees or letters of credit or bank's co-acceptance of bills drawn on the enterprise. In providing such facilities, there is no outlay of funds by the banks. Therefore, in the balance sheet, these do not appear in the assets of the bank or the liabilities of the enterprise. However, these appear in the contingent liabilities of both bank and the enterprise because in case of any liability arising on account of these items, the bank has to fulfill its obligation and get the reimbursement from the enterprise on whose behalf this obligation was taken.GuaranteesBanks issue guarantees on behalf of their customers for various purposes. The guarantees executed by banks comprise both performance guarantees and financial guarantees. The guarantees are structured according to the terms of agreement, viz., security, maturity and purpose. Sometimes, it becomes difficult to distinguish between performance and financial guarantees but broadly, the difference between the two is as under;The performance guarantee guarantees, to the beneficiary, reimbursement of monetary loss arising due to non performance or under performance of a contract by the customer( applicant). Examples of performance guarantees are guarantees issued towards completion of a contract within a time limit, or with certain quality or for the satisfactory performance of any equipment, project etc. The financial guarantee, on the other hand, is for meeting certain financial obligations or dues of the customer (applicant) to the beneficiary. Examples of financial guarantees are guarantees issued in lieu of security deposits, earnest money or payment of dues in case of default by the client.Co-acceptance of BillsA supplier of goods will be more willing to provide credit to the purchaser (bank's customer), if the bill of exchange drawn by him on purchaser and accepted by him is also accepted by the bank. Bank's co-acceptance acts like a guarantee for him against non payment by the purchaser. By providing this facility to the customer, the need for working capital finance from the bank is reduced due to credit provided by the supplier.RBI Guidelines on Guarantees and Co-acceptances(Details available in Master circular no. DBOD. No. Dir. BC. 18/13.03.00/2008-09

dated 1, JuIy 2008)A gist of the guidelines, which banks should comply with, in the conduct of their guarantee business is given below:General GuidelinesAs regards the purpose of the guarantee, as a general rule, the banks should confine themselves to the provision of financial guarantees and exercise due caution with regard to performance guarantee business.No bank guarantee should normally have a maturity of more than 10 years.Precautions for Issuing GuaranteesBanks should adopt the following precautions while issuing guarantees on behalf of their customers.(a) As a rule, banks should avoid giving unsecured guarantees in large amounts and for medium and long-term periods. They should avoid undue concentration of such unsecured guarantee commitments to particular groups of customers and / or trades.(b) Unsecured guarantees on account of any individual constituent should he limited to a reasonable proportion of the bank's total unsecured guarantees. Guarantees on behalf of an individual should also bear a reasonable proportion to the constituent's equity.(c) In exceptional cases, banks may give deferred payment guarantees on an unsecured basis for modest amounts to first class customers who have entered into deferred payment arrangements in consonance with Government policy.(d) Guarantees executed on behalf of any individual constituent, or a group of constituents, should be subject to the prescribed exposure norms.While issuing guarantees on behalf of customers, the following safeguards should be observed by banks:(1) At the time of issuing financial guarantees, banks should be satisfied that the customer would be in a position to reimburse the bank in case the bank is required to make payment under the guarantee.(2) In the case of performance guarantee, banks should exercise due caution and have sufficient experience with the customer to satisfy themselves that the customer has the necessary experience, capacity and means to perform the obligations under the contract, and is not likely to commit any default.(3) Banks should, normally, refrain from issuing guarantees on behalf of customers who do not enjoy credit facilities with them.Bank Guarantee Scheme of Government of IndiaBanks should adopt the Model Form of Bank Guarantee Bond given in Annexure 1 (Please refer R B I circular mentioned above). The Government of India have advised all the Government departments/ Public Sector Undertakings, etc. to accept bank guarantees in the Model Bond and to ensure that alterations/additions to the clauses whenever considered necessary are not one-sided and are made in agreement with the guaranteeing bank. Banks should mention in the guarantee bonds and their correspondence with the various State Governments, the names of the beneficiary departments and the purposes for which the guarantees are executed. In regard to the guarantees furnished by the banks in favour of Government Departments in the name of the President of India, any correspondence thereon should be exchanged with the

concerned ministries/ departments and not with the President of India. In respect of guarantees issued in favour of Directorate General of Supplies and Disposal, the following aspects should be kept in view:(1) In order to speed up the process of verification of the genuineness of the bank guarantee, the name, designation and code numbers of the officer/officers signing the guarantees should be incorporated under the signature(s) of officials signing the bank guarantee.(2) The beneficiary of the bank guarantee should also be advised to invariably obtain the confirmation of the concerned banks about the genuineness of the guarantee issued by them as a measure of safety.(3) The initial period of the bank guarantee issued by banks as a means of security in Directorate General of Supplies and Disposal contract administration would be for a period of six months beyond the original delivery period. Banks may incorporate a suitable clause in their bank guarantee, providing automatic extension of the validity period of the guarantee by 6 months, and also obtain suitable undertaking from the customer at the time of establishing the guarantee to avoid any possible complication later.(4) A clause would be incorporated by Directorate General of Supplies and Disposal in the tender forms of Directorate General of Supplies and Disposal (Instruction to the tenderers) to the effect that whenever a firm fails to supply the stores within the delivery period of the contract wherein bank guarantee has been furnished, the request for extension for delivery period will automatically be taken as an agreement for getting the bank guarantee extended. Banks should make similar provisions in the bank guarantees for automatic extension of the guarantee period.Guarantee on Behalf of Share and Stock Brokers / Commodity BrokersBanks may issue guarantees on behalf of share and stock brokers in favour of stock exchanges in lieu of security deposit to the extent it is acceptable in the form of bank guarantee as laid down by stock exchanges. Banks may also issue guarantees in lieu of margin requirements as per stock exchange regulations. Banks have further been advised that they should obtain a minimum margin of 50 per cent while issuing such guarantees. A minimum cash margin of 25 per cent (within the above margin of 50 per cent) should be maintained in respect of such guarantees issued by banks. The above minimum margin of 50 per cent and minimum cash margin requirement of 25 per cent (within the margin of 50 per cent) will also apply to guarantees issued by banks on behalf of commodity brokers in favour of the national level commodity exchanges, viz., National Commodity Derivatives Exchange (N C D E X), Multi Commodity Exchange of

India Limited (M C X) and National Multi-Commodity Exchange of India Limited (N M C E I L) in lieu of margin requirements as per the commodity exchange regulations.Appraisal of Guarantee / Co-acceptance LimitThe bank guarantees may be required by the enterprise either on regular basis or ad-hoc basis. For example, a normal manufacturing enterprise may require guarantee in favour of Customs department for release of imported good, for which no regular assessment can be made. The sanction of regular B G limit is required for some businesses like contractors, who have to provide the guarantees on a regular basis for security deposits of tenders, receipt of advance payment or return of retention money, as also performance guarantees for execution of projects. The assessment in such cases depends on the nature of business and the terms of contracts. The bank has to examine the impact of sanction of guarantee limit on the fund based requirements of the borrower. For example, a guarantee issued in respect of receipt-of advance payment will reduce the fund based need of the enterprise. So, a part of the B G limit may be carved out of its total fund based W C limits.The co-acceptance limit helps the borrower to get more credit from the supplier and, therefore, is carved out of the fund based W C limit, if this credit was not taken into account at the time of assessment.Letters of CreditThe genesis a letter of credit lies in the fact that a seller of good is worried about receipt of money from the buyer if he supplies the goods first, and the buyer is worried about non receipt of contracted goods if he makes the payment first. The bank acts as an intermediary between the two by using its credibility, as it is acceptable to both buyer and the seller. Letter of Credit (L C) is an undertaking by the bank, at the request of the buyer( applicant, who is customer of the bank), to the seller, to pay him the contracted amount if he supplies the goods as per the terms specified and submits the required documents, including the documents of the title of the goods. The conduct of LC business is governed by the publication no.600 of the International Chamber of Commerce (I C C), commonly known as U C P D C 600.Appraisal of LC LimitAn L C is used for purchase of goods either through imports or local purchase. For assessing the L C requirement of an enterprise, we have to know the following;(1) Average Amount of Each L C: This is dependent on the monthly consumption of goods and the economic order quantity. Economic order quantity (E O Q) is estimated by examining the sources of supply, means of transport, discount etc. In case of imports, the E O Q is often larger in comparison to indigenous purchases.(2) Frequency of L C Opening: Once E O Q is estimated, the number of I-Cs to be opened in a year can be calculated by dividing annual consumption by E O Q. Frequency of opening L Cs will be 12 divided by the number of I-Cs to be opened

in a year.(3) How many L Cs will be outstanding at a particular time: The time taken for one L C to remain in force depends upon the lead time (time taken from the date of opening L C to shipment of goods), the transit time and the usance available to purchaser from the date of receipt of goods. If the frequency of opening L C is less than this, bank will have more than one L C outstanding at any point of time.Example: If lead time is 10 days, transit is 20 days and usance period is six months, the total time for which an L C will remain outstanding is seven months. If consumption of goods is Rs 6 crore per year and E O Q is Rs one crore, the frequency of opening L C is every 2 months. It means that at any point of time, there will be four L Cs outstanding ( 7divided by 2 and rounded off to next figure). As the amount of each L C is Rs one crore, the total L C limit will be Rs 4 crore.While sanctioning L C limit, its impact on the fund based requirements of the borrower should be examined. In view of the increased credit available to him through L C, normally, an L C limit is carved out of the total fund based W C limit sanctioned.28.8 OTHER ISSUES RELATED TO WORKING CAPITAL FINANCECommercial PaperCommercial Paper (C P), an unsecured money market instrument issued in the form of a promissory note, was introduced in India in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings. The cost of borrowing through C P is normally lower compared to other sources of short term finance and therefore, it serves as a useful tool in working capital management of the corporate. Guidelines for issue of C P are governed by directives issued by the R B I. A master circular of all these guidelines issued up to 30/6/09, has been issued by RBI on 1 July, 2009 and is posted on their website www.mastercirculars.rbi.org.inFactoringThis is a method of financing the receivables of a business enterprise. The financier is called 'Factor' and can be a financial institution. Banks are not permitted to do this business themselves but they can promote subsidiaries to do this. Under factoring, the factor not only purchases the book debts/receivables of the client, but may also control the credit given to the buyers and administer the sales ledger. The purchase of book debts/receivables can be with recourse or without recourse to the client. If it is without recourse, the client is not liable to pay to the factor in case of failure of the buyer to pay.ForfaitingThis is similar to factoring but is used only in case of exports and where the sale

is supported by bills of exchange/promissory notes. The financier discounts the bills and collects the amount of the bill from the buyer on due dates. Forfaiting is always without recourse to the client. Therefore, the exporter does not carry the risk of default by the buyer.SummaryMost of the business enterprises need to maintain some current assets like, cash, raw materials, work-in-process, finished goods and receivables for smooth functioning of their business. The cycle starting from purchase of raw material and culminating in receipt of sales proceeds from the customer, is called working capital cycle. The longer this cycle, larger is the amount of money blocked in the current assets, and vice versa. The amount of money blocked in the current assets is called total or gross working capital. A part of this money may come from credit provided by suppliers, advances from customers and any other short term liability. Also, the enterprise is also required to arrange for some long term funds (called N W C) to meet part of this requirement. The gap, if any, is provided by the banks as working capital finance. In the past, when credit was scarce, R B I provided elaborate guidelines for calculation of bank finance for W C. This has been relaxed substantially over a period of time but the guiding principles are still used by many banks for the assessment. Banks also provide non-fund-based working capital limits. These are mainly, guarantees, L Cs and co-acceptance of bills. The appraisal of these limits is also done by detailed analysis as these carry risks similar to fund based limits. Some of the instruments/ methods used in working capital finance are bills financing, factoring, forfaiting and commercial paper. R B I has issued guidelines in respect of all of these.KeywordsWorking capital cycle; N W C; Gross W C; Working capital gap; M P B F; First, second and third methods; Turnover method; Cash budget; Guarantees; Letters of credit; Co-acceptance of bills; Liquidity, Current ratioCheck Your Progress1. Net Working Capital (N W C) means �The choices are: (a) Total current assets minus bank finance(b) Total current assets minus credit from suppliers(c) Total current assets minus total current liabilities(d) Short term sources brought in by the promotersThe correct choice is: (c) Total current assets minus total current liabilities2. Which of the following statements is not true for efficient inventory management? The choices are: (a) It results in reduction in inventory(b) It reduces the working capital requirements of the enterprise(c) It reduces the N W C available with the enterprise

(d) It increases the Inventory Turnover Ratio if the level of sales remains same.The correct choice is: (c) It reduces the N W C available with the enterprise3. Which of the following is not a source for meeting working capital requirements?The choices are: (a) Suppliers' credit(b) Bank finance(c) Other current liabilities(d) Advance payment to suppliersThe correct choice is: (d) Advance payment to suppliers(4) Which of the following is a liquidity ratio?The choices are: (a) Quick ratio(b) T O L / T N W(c) D S C R(d) Other current liabilitiesThe correct choice is: (a) Quick ratio(5) Which of the following is not correct regarding Current Ratio?The choices are: (a) For same level of current assets, increase in N W C results in increased current ratio.(b) The current ratio can be less than one(c) The current ratio can be negative(d) Current ratio is an indicator of liquidityThe correct choice is: (c) The current ratio can be negative(6) The commercial paper can be issued byThe choices are: (a) Corporates(b) Corporates and partnership firms(c) Any business entity(d) None of the aboveThe correct choice is: (a) Corporates(7) Which of the following is not correct regarding Forfaiting? The choices are: (a) It a form of working capital finance(b) It is used in export finance(c) It is with recourse to the drawer of the bill(d) Under this financier discounts the bills drawn on buyer.The correct choice is: (c) It is with recourse to the drawer of the bill.(8) Which of the following is correct regarding Letters of Credit. The choices are: (a) These are opened by a bank for export sales by the client(b) These are opened by a bank for local sales by the client(c) Letters of Credit do not carry much risk for the opening bank(d) Letters of Credit are opened by a bank for purchase of goods by the clientThe correct choice is: (d) Letters of Credit are opened by a bank for purchase of goods by the client.(9) Under Turnover method of assessment, the limit is sanctioned at per cent of the projected turnover. The choices are: (a) 25(b) 20(c) 30(d) 35The correct choice is: (b) 20(10) Cash budget method of assessment is more suitable for those business enterprises which have �. The choices are: (a) uniform level of operations(b) High level of operations

(c) Low level of operations(d) Seasonal operationsThe correct choice is: (d) Seasonal operations.Answer to Check Your Progress1. (c); 2. (c); 3. (d); 4. (a); 5. (c); 6. (a); 7. (c); 8. (d); 9. (b); 10. (d)END OF CHAPTER 28 � ADVANCED BANK MANAGEMENT- C A I I B PAPER 1ADVANCED BANK MANAGEMENTUNIT � 29 Term LoansSTRUCTURE29.0 Objectives29.1 Important Points about Term Loans29.2 Deferred Payment Guarantees (D P Gs)29.3 Difference between Term Loan Appraisal and Project Appraisal 29.4 Project Appraisal29.5 Appraisal and Financing of Infrastructure Projects29.0 OBJECTIVESAfter reading this chapter, you will have better understanding of:(1) The meaning of term finance(2) Deferred payment guarantees(3) Assessment of term/project finance(4) Techno-economic feasibility study(5) Infrastructure finance29.1 IMPORTANT POINTS ABOUT TERM LOANS1. Banks provide term loans normally for acquiring the fixed assets like land, building, plant and machinery, infrastructure etc., (personal loans, consumption loans, educational loans etc. being exceptions) while the working capital loans are provided for sustaining the working capital i.e. current assets level.2. In exceptional cases, banks provide term loans for current assets also. This is called Working Capital Term Loan(W C T L) As we are aware, the business enterprise is supposed to bring a part of its funds required to maintain the desired level of current assets from its long term sources (capital or term liabilities), called N W C, so that the stipulated current ratio can be maintained. If the enterprise is not able to bring in the required amount of N W C, it will feel liquidity crunch and business operations will be affected. In such cases, banks may provide W C T L.3. Working capital loans are normally sanctioned for one year but are payable on demand. Term loans are payable as per the agreed repayment schedule, which is stipulated in the terms of the sanction. Therefore, for the purpose of matching assets and liabilities of the bank, term loans are considered long term assets while working capital loans are considered as short term assets. Practically, however, an enterprise continues to enjoy the working capital loan till its working is satisfactory, while the term loan gets repaid over a period of time.4. As a term loan is expected to be repaid out of the future cash flows of the borrower, the D S C R assumes great importance while considering term loans, while for working capital loans, the liquidity ratios assume greater importance.5. There is no uniform repayment schedule for all term loans. Each term loan has its own peculiar repayment schedule depending upon the cash surplus of the borro

wer. Thus, in case of a salaried person, where income level is constant, the repayment can be through E M I system and in case of a farmer, the repayment of principal and interest may coincide with the cropping pattern. In case of industrial enterprises, normally, banks stipulate monthly/quarterly repayment of principal along with all the accumulated interest. In some cases, the entire repayment may be stipulated in one installment only, called the bullet repayment.29.2 DEFERRED PAYMENT GUARANTEES ( D P Gs)When the purchaser of a fixed asset does not pay to the supplier immediately, but pays according to an agreed repayment schedule, and the bank guarantees this repayment, the guarantee is called D P G. This is a Non-fund based method for financing purchase of fixed assets. However, if the purchaser defaults in payment of any amount, the bank has to pay the same to the supplier and the exposure becomes fund based till the amount is recovered from the client. The risks involved in a D P G are same as those in a term loan and therefore, the appraisal for a D P G is same as that for a term loan.29.3 DIFFERENCE BETWEEN TERM LOAN APPRAISAL AND PROJECT APPRAISALFor appraising a stand alone term loan proposal, all the concepts involved in a project appraisal may not be necessary to be applied though all concepts of a term loan appraisal are applicable to project finance also. The differences can be summarized as under:(a) In project finance all the financial needs of the enterprise, including working capital requirements, are appraised. This is because the total requirement of long term funds includes margin money for working capital. After assessing the total requirement of long term funds, the banks decide upon the amount of term loan to be sanctioned and the contribution of the promoters.(b) If an existing enterprise wants to purchase a few machineries, which are not going to have a major impact on the volume or composition of the business, it will serve little purpose to have a detailed examination of techno- economic feasibility, managerial competence, I R R etc. It may be enough for the bank to examine the projections for next 2 to 3 years to find out that D S C R is at satisfactory level. In case of loans to individuals also, like housing loans, educational loans etc., it may be enough to examine the projected D S C R to judge the viability. However, the basic principles of appraisal of a project or a standalone term loan are not different and if one is clear about project appraisal, the appraisal of a standalone term loan proposal is even simpler.20.4 PROJECT APPRAISAL

Project appraisal can be broadly taken in the following steps:(1) Appraisal of Managerial Aspects(2) Technical Appraisal(3) Economic AppraisalAppraisal of Managerial Aspects: The appraisal of managerial aspects involves seeking the answer to the following questions:(a) What are the credentials of the promoters'?(b) What is the financial stake of promoters in the project? Can they bring additional funds in case of contingencies arising out of delay in project implementation and changes in market conditions?(c) What is the form of business organization? Who are the key persons to be appointed to run the business?Technical Appraisal: The technical feasibility of a project involves the following aspects:(a) location(b) products to be manufactured, production process(c) availability of infrastructure(d) provider of technology(e) details of proposed construction(f) contractor for project execution(g) waste-disposal and pollution control(h) availability of raw materials(i) marketing arrangementsEconomic Appraisal: The economic or financial feasibility of a project involves the following aspects:(a) Return on Investment: The usual methods used are the NPV, IRR, payback period, cost benefit ratio, accounting rate of return etc.(b) Break-even Analysis: A project with a high break-even point is considered more risky compared to the one with lower break-even point.(c) Sensitivity Analysis: As market conditions are uncertain, a small change in the prices of raw materials or finished goods may have a drastic impact on the viability of a project. Sensitivity analysis examines such impact.29.5 APPRAISAL AND FINANCING OF INFRASTRUCTURE PROJECTSInfrastructure sector deals with roads, bridges, power, transport, telecommunication, etc. (This is defined in Section 10 of IT Act). Infrastructure projects involve some distinct features like exceptionally long implementation, gestation and pay back periods, high debt equity ratio etc. While the basic principles of appraisal of an infrastructure project are same as those involved in a normal project appraisal, there are some additional points to be considered, as highlighted in R B I guidelines R B I guidelines to the banks for financing infrastructure projects, are as follows:(A) Types of Financing by BanksIn order to meet financial requirements of infrastructure projects, banks may extend credit facility by way of working capital finance, term loan, project loan, subscription to bonds and debentures/ preference shares/ equity shares acquired

as a part of the project finance package which is treated as 'deemed advance' and any other form of funded or non-funded facility.(a) Take-out Financing: Banks may enter into take-out financing arrangement with I D F C & other financial institutions or avail of liquidity support from I D F C & other F Is. A brief write-up on some of the important features of the arrangement is given in paragraph 2.3.7.8(i). Banks may also be guided by the instructions regarding take-out finance contained in Circular No. DBOD. BP.BC. 144 / 21.04.048 / 2000 dated 29, February 2000.(b) Inter-institutional: Guarantees Banks are permitted to issue guarantees favouring other lending institutions in respect of infrastructure projects, provided the bank issuing the guarantee takes a funded share in the project at least to the extent of 5 per cent of the project cost and undertakes normal credit appraisal, monitoring and follow-up of the project.(c) Financing Promoter�s Equity: In terms of Circular No. DBOD. Dir. BC. 90/ 13.07.05/ 99 dated August 28, 1998, banks were advised that the promoter's contribution towards the equity capital of a company should come from their own resources and the bank should not normally grant advances to take up shares of other companies. In view of the importance attached to the infrastructure sector, it has been decided that, under certain circumstances, an exception may be made to this policy for financing the acquisition of the promoter's shares in an existing company, which is engaged in implementing or operating an infrastructure project in India. The conditions, subject to which an exception may be made, are as follows:(1) The bank finance would be only for acquisition of shares of existing companies providing infrastructure facilities as defined in paragraph (a) above. Further, acquisition of such shares should be in respect of companies where the existing foreign promoters (and/ or domestic joint promoters) voluntarily propose to disinvest their majority shares in compliance with SEBI guidelines, where applicable.(2) The companies to which loans are extended should, inter alia, have a satisfactory net worth.(3) The company financed and the promoters or directors of such companies should not be defaulters to banks or Financial Institutions.(4) In order to ensure that the borrower has a substantial stake in the infrastructure company, bank finance should be restricted to 50 per cent of the finance required for acquiring the promoter's stake in the company being acquired.(5) Finance extended should be against the security of the assets of the borrowing company or the assets of the company acquired and not against the shares of that company or the company being acquired. The shares of the borrower company or company being acquired may be accepted as additional security and not as primary security. The security charged to the banks should be marketable.

(6) Banks should ensure maintenance of stipulated margins at all times.(7) The tenor of the bank loans may not be longer than seven years. However, the Boards of banks can make an exception in specific cases, where necessary, for financial viability of the project.(8) This financing would be subject to compliance with the statutory requirements under Section 19(2) of the Banking Regulation Act, 1949.(9) The banks financing acquisition of equity shares by promoters should be within the regulatory ceiling of 40 per cent of their net worth as on 31 March of the previous year for the aggregate exposure of the banks to the capital markets in all forms (both fund based and non-fund based).(10) The proposal for bank finance should have the approval of the Board.(B) Appraisal(1) In respect of financing of infrastructure projects undertaken by Government owned entities, banks or Financial Institutions should undertake due diligence on the viability of the projects. Banks should ensure that the individual components of financing and returns on the project are well defined and assessed. State government guarantees may not be taken as a substitute for satisfactory credit appraisal and such appraisal requirements should not be diluted on the basis of any reported arrangement with the Reserve Bank of India or any bank for regular standing instructions or periodic payment instructions for servicing the loans or bonds.(2) Infrastructure projects are often financed through Special Purpose Vehicles. Financing of these projects would, therefore, call for special appraisal skills on the part of lending agencies. Identification of various project risks, evaluation of risk mitigation through appraisal of project contracts and evaluation of creditworthiness of the contracting entities and their abilities to fulfill contractual obligations will be an integral part of the appraisal exercise. In this connection, banks or Financial Institutions may consider constituting appropriate screening committees or special cells for appraisal of credit proposals and monitoring the progress or performance of the projects. Often, the size of the funding requirement would necessitate joint financing by banks or Financial Institutions or financing by more than one bank under consortium or syndication arrangements. In such cases, participating banks or Financial Institutions may, for the purpose of their own assessment, refer to the appraisal report prepared by the lead bank or Financial Institutions or have the project appraised jointly.(C) Prudential Requirements(1) Prudential Credit Exposure Limits: Credit exposure to borrowers belonging to a group may exceed the exposure norm of 40 per cent of the bank's capital funds by an additional 10 per cent (i.e. up to 50 per cent), provided the additional credit exposure

is on account of extension of credit to infrastructure projects. Credit exposure to single borrower may exceed the exposure norm of 15 per cent of the bank's capital funds by an additional 5 per cent (i.e. up to 20 per cent) provided the additional credit exposure is on account of infrastructure as defined in paragraph (a) above. In addition to the exposure permitted above, banks may, in exceptional circumstances, with the approval of their Boards, consider enhancement of the exposure to a borrower up to a further 5 per cent of capital funds. The bank should make appropriate disclosures in the 'Notes on account' to the annual financial statements in respect of the exposures where the bank had exceeded the prudential exposure limits during the year.(2) Assignment of Risk Weight for Capital Adequacy Purposes: Banks are required to be guided by the Prudential Guidelines on Capital Adequacy and Market Discipline- Implementation of the New Capital Adequacy Framework, as amended from time to time in the matter of capital adequacy.(3) Asset Liability Management: The long-term financing of infrastructure projects may lead to asset - liability mismatches, particularly when such financing is not in conformity with the maturity profile of a bank's liabilities. Banks would, therefore, need to exercise due vigil on their asset-liability position to ensure that they do not run into liquidity mismatches on account of lending to such projects.(4) Administrative arrangements: Timely and adequate availability of credit is the pre-requisite for successful implementation of infrastructure projects. Banks/ Fls should, therefore, clearly delineate the procedure for approval of loan proposals and institute a suitable monitoring mechanism for reviewing applications pending beyond the specified period. Multiplicity of appraisals by every institution involved in financing, leading to delays, has to be avoided and banks should be prepared to broadly accept technical parameters laid down by leading public financial institutions. Also, setting up a mechanism for an ongoing monitoring of the project implementation will ensure that the credit disbursed is utilized for the purpose for which it was sanctioned.(D) Take-out Financing or Liquidity Support(1) Take-out Financing or Liquidity Support: Take-out financing structure is essentially a mechanism designed to enable banks to avoid asset-liability maturity mismatches that may arise out of extending long tenor loans to infrastructure projects. Under the arrangements, banks financing the infrastructure projects will have an arrangement with I D F C or any other financial institution for transferring to the latter the out standings in their books on a pre-determined basis. I D F C and S B I have d

evised different take-out financing structures to suit the requirements of various banks, addressing issues such as liquidity, asset-liability mismatches, limited availability of project appraisal skills, etc. They have also developed a Model Agreement that can be considered for use as a document for specific projects in conjunction with other project loan documents. The agreement between S B I and I D F C could provide a reference point for other banks to enter into somewhat similar arrangements with I D F C or other financial institutions.(2) Liquidity support from I D F C: As an alternative to take-out financing structure, I D F C and S B I have devised a product, providing liquidity support to banks. Under the scheme, I D F C would commit, at the point of sanction, to refinance the entire outstanding loan (principal+ unrecovered interest) or part of the loan, to the bank after an agreed period, say, five years. The credit risk on the project will be taken by the bank concerned and not by I D F C. The bank would repay the amount to I D F C with interest as per the terms agreed upon. Since I D F C would be taking a credit risk on the bank, the interest rate to be charged by it on the amount refinanced would depend on the I D F C's risk perception of the bank (in most of the cases, it may be close to I D F C's P L R). The refinance support from I D F C would particularly benefit the banks which have the requisite appraisal skills and the initial liquidity to fund the project.SummaryTerm loans are normally provided by the banks for the acquisition of fixed assets or other long-term requirements (like for education or investments) of a customer. The terms of sanction invariably stipulate schedule of repayment of principal and interest. In appraisal of a term-loan proposal, D S C R is as important a ratio as current ratio is in appraisal of working capital limits. Sometimes, banks issue Deferred payment Guarantees (D P Gs) in favour of suppliers of capital equipments, if he is prepared to accept the sales price on deferred basis. However, the appraisal or a D P G is similar to that of a term-loan as the risks involved are similar. A project appraisal is similar to a term-loan appraisal with some additional points to consider. Project appraisal broadly involves appraisal of managerial aspects and examination of techno-economic feasibility. Infrastructure sector deals with roads, bridges, power, transport, telecommunication etc. Infrastructure projects involve some distinct features like exceptionally long implementation, gestation and pay back periods, high debt equity ratio, etc. R B I has issued elaborate guidelines to banks on infrastructure financing.

KeywordsRepayments; D P G; W C T L; D S C R; E M I; Project; Infrastructure; I D F C; Take out financing; Inter-institutional guaranteesCheck Your Progress1. A D G P is issued by the bank for ----------, by its client.The choices are(a) Sale of goods(b) Purchase of goods(c) Sale of capital goods(d) Purchase of capital goodsThe correct choice is (d) Purchase of capital goods2. Which of the following statements is not true for an infrastructure project?The choices are(a) It has long gestation period(b) It reduces the risk for the lender as his funds get assured deployment for a long time.(c) The debt equity ratio is normally high for an infrastructure project(d) The implementation period is usually longThe correct choice is (b) It reduces the risk for the lender as his funds get assured deployment for a long time.3. Which of the following is not a source of funds for meeting the cost of fixed assets by an enterprise?The choices are(a) Credit by supplier of assets(b) Internal accruals(c) Debentures(d) D P GThe correct choice is (d) DPG4. Which of the following is ratio, indicative of the repaying capacity of a borrower?The choices are(a) Quick ratio(b) T O L/T N W(c) D S C R(d) D E RThe correct choice is (c) D S C R5. Which of the following is not correct regarding term loans by the banks?The choices are(a) Asset liability matching is an important consideration in term financing(b) Installment of term loan, payable within one year is considered as current liability(c) Repayment of a term loan can be in equated monthly instalments(d) Current ratio is the most important ratio in appraisal of a term loanThe correct choice is (d) Current ratio is the most important ratio in appraisal of a term loan6. Project loans can be given by the bank toThe choices are(a) Only corporates(b) Only corporates and partnership firms(c) Only corporate, partnership firms and societies(d) Any business entityThe correct choice is (d) Any business entity7. Which of the following is not correct regarding infrastructure project by the banks?The choices are(a) Banks are allowed to funds promoters' equity in certain circumstances(b) Exposure norms are relaxed by R B I

(c) Asset liability mismatch has been permitted by R B I(d) I D F C provides liquidity support to banksThe correct choice is (c) Asset liability mismatch has been permitted by R B I8. Which of the following statements is not correct for project appraisal?The choices are(a) Examination of technical feasibility is carried out(b) The contribution of promoters forms a part of economic appraisal(c) Promoters' background is part of the management appraisal(d) Capacity of promoters to arrange for additional funds, in case of contingencies, forms a part of economic appraisal.The correct choice is (d) Capacity of promoters to arrange for additional funds, in case of contingencies, forms a part of economic appraisal.Key to Check your Progress1. (d); 2. (b); I (d); 4. (c); 5. (d); 6. (d), 7. (c); 8. (d)END OF CHAPTER 29 � ADVANCED BANK MANAGEMENT- C A I I B PAPER 1ADVANCED BANK MANAGEMENTUNIT 30 � Credit DeliverySTRUCTURE30.0 Objectives30.1 Introduction30.2 Documentation30.3 Third Party Guarantees30.4 Charge over Securities30.5 Possession of Security30.6 Disbursal of Loans30.7 Lending under Consortium/Multiple Banking Arrangements30.8 Syndication of Loans30.0 OBJECTIVESAfter reading this chapter, you will have better understanding of:(1) Documentation(2) Third party guarantees(3) Various methods of creating charge over securities(4) Methods of delivery of bank loans(5) Consortium / multiple banking and syndication of loan30.1 INTRODUCTIONWhile, for the safety of an advance, the credit appraisal is critical for selecting the right borrower, assessing his credit needs and the viability of his operations appropriately and prescribing suitable terms and conditions for the credit, there are a few questions to be addressed before the bank parts with its money. These questions are:(1) What documents should be obtained from the borrower and the guarantor so that in the event of any default, the bank has the legal recourse to recover the money?(2) Whether any charge is to be created on the primary and collateral security? If yes, how it should be done?(3) Whether the charge of the bank on the securities is to registered with any authority prescribed by the law?(4) Whether the securities should be in possession of the borrower or the bank'?(5) How the loan should be disbursed'? Whether we issue a cheque for the loan amount in the name of the borrower or, should his account with the bank be credited or should some other method be adopted?(6) What are the R B I guidelines in this respect?30.2 DOCUMENTATIONDocuments are to be signed by the borrowers and guarantors so that the bank

can establish their liability in a court of law. In addition, the borrower has to sign the documents which create charge over the primary security, i.e. the security created out of the bank finance. For charge over collateral security, the owner of that security should sign the relevant documents. It should be ensured that if the owner of the collateral security is someone other than the borrower, he should first become a guarantor of the loan and then create charge over the security. Each bank's legal department prescribes the standard documents to be taken depending on the type of the loan. In case of a structured loan, the legal department drafts the documents applicable to that particular case. However, a few points, which must be ensured, by the credit officer. in connection with execution of the documents, are as under:(1) The documents should be properly stamped(2) The date of execution of documents should never be earlier than the date of stamping. Date and place of execution should be properly mentioned in the documents.(3) It should be ensured that the parties executing the documents have the necessary authority and the capacity to enter into a contract and executed the documents in that capacity. For example, a partner should sign on behalf of the firm and not in his individual capacity.(4) It should be ensured that the person signing the documents is doing so with his free will(5) The documents should be filled in before these are signed.(5) In case of companies, the charge should be registered with ROC. within 30 days from the date of execution of the documents.(6) If any document is required to be registered with the Sub-registrar, it should be done within the prescribed time limit.30.3 THIRD PARTY GUARANTEESWhile the enterprise or individual, who has taken the loan from the bank is legally bound to repay the principal and the interest, in some cases, banks stipulate guarantees of third parties, as an additional safety against default. These third parties can be individuals or any other legal entity. In case of finance to firms, the personal guarantee of proprietor or partners is not stipulated as they have unlimited liability and their personal assets can be attached for recovery of bank loans. However, in case of companies and other legal entities, the promoters/ directors/ trustees do not have unlimited/ any liability towards bank's dues. Therefore, in many cases banks stipulate their personal guarantees. R B I suggestions to the banks in this respect are as follows:(1) Personal guarantees of directors may be helpful in respect of companies, whether private or public, where shares are held closely by a person or connected persons or a group (that being professionals or Government), irrespective of other factors, such as financial condition, security available, etc., the exception be

ing in respect of companies where, by court or statutory order, the management of the company is vested in a person or persons, whether called directors or by any other name, who are not required to be elected by the shareholders. Where personal guarantee is considered necessary, the guarantee should preferably be that of the principal members of the group holding shares in the borrowing company rather than that of the director or managerial personnel functioning as director or in any managerial capacity.(2) Even if a company is not closely held, there may be justification for a personal guarantee of directors to ensure continuity of management. Thus, a lending institution could make a loan to a company whose management is considered good. Subsequently, a different group could acquire control of the company, which could lead the lending institution to have well-founded fears that the management has changed for the worse and that the funds lent to the company are in jeopardy. One way by which lending institutions could protect themselves in such circumstances is to obtain guarantees of the directors and thus ensure either the continuity of the management or that the changes in management take place with their knowledge. Even where personal guarantees are waived, it may be necessary to obtain an undertaking from the borrowing company that no change in the management would be made without the consent of the lending institution. Similarly, during the formative stages of a company, it may be in the interest of the company, as well as the lending institution, to obtain guarantees to ensure continuity of management.(3) Personal guarantees of directors may be helpful with regard to public limited companies other than those which may be rated as first class, where the advance is on an unsecured basis.(4) There may be public limited companies, whose financial position and/or capacity for cash generation is not satisfactory even though the relevant advances are secured. In such cases, personal guarantees are useful.(5) Cases where there is likely to be considerable delay in the creation of a charge on assets, guarantee may be taken, where deemed necessary, to cover the interim period between the disbursement of loan and the creation of the charge on assets.(6) The guarantee of parent companies may be obtained in the case of subsidiaries whose own financial condition is not considered satisfactory.(7) Personal guarantees are relevant where the balance sheet or financial statement of a company discloses interlocking of funds between the company and other concerns owned or managed by a group.R B I has also advised the banks to obtain an undertaking from the borrowing company as well as the guarantors that no consideration whether by way of commission, brokerage fees or any other form, would be paid by the former or received

by the latter, directly or indirectly. This requirement should be incorporated in the bank's terms and conditions for sanctioning of credit limits. During the periodic inspections, the bank's inspectors should verify that this stipulation has been complied with. There may, however, be an exceptional case where payment of remuneration may be permitted, e.g. where assisted concerns are not doing well and the existing guarantors are no longer connected with the management but continuance of their guarantees is considered essential because the new management's guarantee is either not available or is found inadequate and payment of remuneration to guarantors by way of guarantee commission is allowed.30.4 CHARGE OVER SECURITIESNature of security and the operational convenience often decide the type of charge to be created over a security. The procedure for creation of charge is same for both primary and collateral securities. The point to be kept in mind is that only the owner of an asset can create charge over it. The charge could be any of the following:(1) Mortgage(2) Hypothecation Pledge(3) Lien(4) Assignment30.5 POSESSION OF SECURITYAt the time of appraisal, banker has to decide about the possession of the security specially in case of inventory. With legal system in the country being still not perfect, this aspect has a bearing on the overall risk rating of the proposal. Till about a decade ago, a favoured method of finance of many banks used to be the, 'Lock and Key' advances in which the goods are kept in a godown and bank holds the keys of the locks of the godown. If any goods are to be delivered to the borrower, he has to deposit the money in his cash credit account (alternatively, provide a trust receipt) before bank's 'Godown Keeper' goes to the godown and delivers the goods. This system was very inconvenient not only for the borrower but for the bank also and slowly got changed to 'Hypothecation', where possession remained with the borrower. In case of 'Pledge' also, the borrower can have possession, called, 'Constructive Possession', and hold the goods as an agent of the bank.30.6 DISBURSAL OF LOANSWorking Capital Loans In case of sole banking, the bank providing working capital limits opens a cash credit account of the borrower and all his financial transactions should be routed through this account. Without bank's permission, no account can be opened with any other bank. Banks give permission to open current account with other bank only if they are convinced about its necessity. In such cases, periodic statements of that account are obtained to keep a tab on the transactions.The drawings in the cash credit account are regulated through the system of

'Drawing power' (D P) which is within the sanctioned cash credit limit. Ideally, the DP should be calculated by obtaining a statement of all the current assets and liabilities (excluding outstanding in cash credit account with the bank) and deducting from it the N W C stipulated at the time of assessment of the limit. However, this is not feasible as such a statement is normally available only after accounts are finalized. Even if bank insists for such statement, it will be available after much delay and may not serve the purpose. Therefore, banks obtain the statement of stocks, book-debts/receivables and the sundry creditors (account payable). These three items form major portion of current assets and liabilities in majority of the enterprises. Such statement is normally obtained on monthly basis but the periodicity can be reduced in exceptional cases. By stipulating suitable margins (depending on method of assessment) on stocks and book debts and reducing the amount of sundry creditors, the D P is calculated.Disbursal of entire W C limit by way of cash credit gives wide flexibility to the borrower in his working capital management. But, it creates the problem of fund management for the bank as there could be wide fluctuations in the utilization of limits. This also offers scope for diversion of funds by the borrower. If the liquidity in the market is tight and short-term interest on money market instruments is high, he may tend to utilize the limit fully In situations of abundant liquidity, the situation is reverse and the utilization of limit may tend to be low. The bank loses in such situations as it has to arrange for short term funds when interest rates are high and is left with surplus funds when rates are low. To meet this situation and to ensure that the utilization of limit is more stable, a portion of sanctioned limit is disbursed by way of 'Loan', which is a fixed component, and remaining amount is disbursed as cash credit. With this, if the borrower wants to draw very little amount or no amount, there will be debit in the loan account (fixed amount) while the cash credit account may have credit balance. R B I guidelines in this respect are as follows:(1) In the case of borrowers enjoying working capital credit limits of Rs 10 crore and above from the banking system, the loan component should normally be 80 percent. Banks, however, have the freedom to change the composition of working capital by increasing the cash credit component beyond 20 percent or to increase the 'Loan Component' beyond 80 percent, as the case may be, if they so desire. Banks are expected to appropriately price each of the two components of working capital finance, taking into account the impact of such decisions on their cash and liquidity management.

(2) In the case of borrowers enjoying working capital credit limit of less than Rs. 10 crone, banks may persuade them to go in for the 'Loan System' by offering an incentive in the form of lower rate of interest on the loan component, as compared to the cash credit component. The actual percentage of 'loan component' in these cases may be settled by the bank with its borrower clients.(3) In respect of certain business activities, which are cyclical and seasonal in nature or have inherent volatility, the strict application of loan system may create difficulties for the borrowers. Banks may, with the approval of their respective Boards, identify such business activities, which may be exempted from the loan system of delivery.Term loansIf the term loan is to be disbursed in one go, e.g. purchase of a machine/ ready house, the borrower is asked to deposit his margin with the bank, his loan account is debited by the amount of the loan and the entire amount to be paid to the buyer, is remitted to him by the bank. If any amount has already been paid to the buyer by the customer, satisfactory proof, like details of bank account etc, of this payment is obtained, and this is considered to be a part of his contribution (margin). In exceptional cases, like personal loans or consumption loans, the amount may be credited to the account of the customer with the bank.In cases where the execution of the project is spread over a period of time, the disbursement is normally related to the progress of the project. RBI guidelines in respect of disbursement of project loans are as under:'At the time of financing projects banks generally adopt one of the following methodologies as far as determining the level of promoters' equity is concerned.(1) Promoters bring their entire contribution upfront before the bank starts disbursing its commitment.(2) Promoters bring certain percentage of their equity (40% � 50%) upfront and balance is brought in stages.(3) Promoters agree, ab initio, that they will bring in equity funds proportionately as the banks finance the debt portion.While it is appreciated that such decisions are to be taken by the boards of the respective banks, it has been observed that the last method has greater equity funding risk. In order to contain this risk, banks are advised in their own interest to have a clear policy regarding the Debt Equity Ratio (DER) and to ensure that the infusion of equity/fund by promoters should be such that the stipulated level of DER is maintained at all times. Further they may adopt funding sequences so that possibility of equity funding by banks is obviated'30 .7 LENDING UNDER CONSORTIUM/MULTIPLE BANKING ARRANGEMENTS

The sole banking is suitable for financing working capital needs of an enterprise only if the requirement is within the policy framework of the financing bank. If the requirements grow beyond the comfort level of that bank due to prudential norms or risk perception for a particular segment [borrower, it would like another bank to finance a part of the requirements of that enterprise. Sometimes, even the borrowers may prefer not to depend on one bank and avail facilities from various banks. If two or more banks get into a formal arrangement to finance the working capital needs of a borrower, it is called consortium arrangement. The consortium banks decide on one of the members as 'Lead bank' who not only arranges periodic meetings of the member banks but also takes lead in assessment, documentation, charge creation, monitoring of the account, etc. In case of multiple banking there is no formal arrangement between the banks though they may share the information about the account in their mutual interest.RBI GuidelinesVarious regulatory prescriptions regarding conduct of consortium, multiple banking and syndicate arrangements were withdrawn by Reserve Bank of India in October 1996 with a view to introducing flexibility in the credit delivery system and to facilitate smooth flow of credit. However, Central Vigilance Commission, Government of India, in the light of frauds involving consortium/multiple banking arrangements, had expressed concerns on the working of Consortium Lending and Multiple Banking Arrangements in the banking system. The Commission had attributed the incidence of frauds mainly to the lack of effective sharing of information about the credit history and the conduct of the account of the borrowers among various banks. It was felt that there is need for improving the sharing/dissemination of information among the banks about the status of the borrowers enjoying credit facilities from more than one bank. Accordingly, RBI advised the banks to strengthen their information back-up about the borrowers enjoying credit facilities from multiple banks as follows:(1) 'At the time of granting fresh facilities, banks may obtain declaration from the borrowers about the credit facilities already enjoyed by them from other banks in the format prescribed (Ref RBI circular nos. DBOD No. BP.BC.46/08.12.001/2008-09 dated September 19, 2008 and DBOD. No. BP.BC.94/ 08.12.001/2009-09 dated December 8, 2008.). In the case of existing lenders, all the banks may seek a declaration from their existing borrowers, availing sanctioned limits of Rupees 5.00 crores and above or wherever, it is in their knowledge that their borrowers are availing credit facilities from other banks, and introduce a system of exchange of information with other banks as

indicated above.(2) Subsequently, banks should exchange information about the conduct of the borrowers' accounts with other banks in the format given in Annex 11 of RBI DBOD circulars referred to in (i) above at least at quarterly intervals.(3) Obtain regular certification by a professional, preferably a Company Secretary, Chartered Accountant or Cost Accountant, regarding compliance of various statutory prescriptions that are in vogue, as per specimen given in Annex III of RBI circulars referred to in (i) above and DBOD. No. BP.BC. 110/ 08.12.001/2008-09 dated February 10, 2009.(4) Make greater use of credit reports available from CIBIL.(5) The banks should incorporate suitable clauses in the loan agreements in future (at the time of next renewal in the case of existing facilities) regarding exchange of credit information so as to address confidentiality issues.'Vide circular RBI/2008-09/354[UBD.PCB.No.36/13.05.000/2008-09 dated January 21, 2009, in addition to Company Secretaries, banks were permitted to also accept the certification by Chartered Accountants & Cost Accountants. Further, Annex III � Part I and Part II has also been modified.30.8 SYNDICATION OF LOANSThe term 'Syndication' is normally used for sharing a long-term loan to a borrower by two or more banks. This is a way of sharing the risk, associated with lending to that borrower, by the banks and is generally used for large loans. The borrower, intending to avail the desired amount of loan, gives a mandate to one bank (called Lead bank) to arrange for sanctions for the total amount, on its behalf. The lead bank approaches various banks with the details These banks appraise the proposal as per their policies and risk appetite and take the decision. The lead bank does the liaison work and common terms and conditions of sanction may be agreed in a meeting of participating banks, arranged by the lead bank. Normally, the lead bank charges 'Syndication fee' from the borrower.SummaryIt is anticipated, at the time of sanctioning a loan, that the repayment of principal and interest will be as per the schedule and all other terms of sanction will also be abided by the borrower. However, in some cases, due to malafide intentions or due to business failure, the bank may have to fall back on the securities available and take other legal action depending upon the circumstances of each case. Therefore, before disbursing the money, the bank ensures that it creates appropriate charge over the securities and the documents are executed as per the legal requirement. Personal guarantee of the directors or third party guarantees can also be stipulated. The working capital limits are disbursed as cash credit or a combination of cash credit and loan. RBI guidelines for disbursal of both working capital and term loans should be followed. In case of

borrowers, whose working capital requirements are large, two or more banks can meet the requirements. This is done under consortium arrangement or under multiple banking. To prevent the misutilisation of banking system, RBI has issued guidelines regarding both consortium and multiple banking. RBI has also issued guidelines for syndication of loans for both working capital and term loans. But, banks are using syndication only for term loans.KeywordsPersonal guarantee; Third party guarantee; Assignment; Lien; Hypothecation; Pledge; Possession of security; Documents; Consortium arrangement; Multiple banking; Syndication of loans; Lead bank for syndication.Check Your ProgressState True or False:(1) The stamp duty on documents varies from State to State. �. True. (2) The date of execution of documents can be earlier than the date of stamping. �.False.(3) The parties executing the documents should have the necessary authority and the capacity to enter into a contract and execute the documents in that capacity. �. True.(4) Bank should ensure that the person signing the documents is doing so with his free will. �. True.(5) The documents can be filled in after these are signed. �.False.(6) In case of companies, the charge should be registered with ROC within 60 days from the date of execution of the documents. �.False.(7) Some documents may be required to be registered with the sub-registrar. �. True.(8) Third party guarantees can be taken from individuals only. Any other legal entity can not be third party guarantor. �.False.(9) Bank can create charge over security not belonging to either the borrower or the guarantor. �.False.(10) Under 'Hypothecation', the possession of goods remains with the borrower. �. True.(11) Under 'Pledge', the possession of goods may remain with the borrower depending on bank's decision. �. True.(12) As per RBI guidelines, in the case of borrowers enjoying working capital credit limits of Rs. 10 crore and above from the banking system, the loan component should normally be 80 per cent. �. True.(13) Under 'Loan system', the borrower has to maintain a minimum debit balance in his loan account, while the cash credit account may have a credit balance. �. True.(14) Banks disburse the term loans as per the progress of the project �. True.(15) Consortium banking and Multiple banking are same. �.False.(16) RBI encourages Multiple or Consortium banking for small loans. �. False.Key to Check Your Progress1. True; 2. False; 3. True; 4. True; 5. False; 6. False; 7. True; 8. False; 9. False; 10. True; 11. True; 12.True; 13. True; 14. True; 15. False; 16. FalseEND OF CHAPTER 30 � ADVANCED BANK MANAGEMENT- C A I I B

PAPER 1ADVANCED BANK MANAGEMENTUNIT 31 � Credit Control and MonitoringSTRUCTURE31.0 Objectives31.1 Importance and Purpose31.2 Available Tools for Credit Monitoring/Loan Review Mechanism31.0 OBJECTIVESAfter reading this chapter, you will have better understanding of:(1) Importance and purpose of credit control and monitoring(2) Various tools used by banks for credit control and monitoring.(3) Credit audit31.1 IMPORTANCE AND PURPOSEDespite an excellent credit appraisal, documentation and attention to security, the risk of default in an advance may go up as the time passes because the assumptions made at the time of appraisal may lose their sanctity, in view of the dynamic nature of business environment. Credit control and monitoring, often referred as Loan Review Mechanism (L R M), plays an important role in the following aspects:(1) To ensure that the funds provided by the bank are put to the intended use and continue to be used properly. Any diversion of bank's funds out of the business or for unauthorized use within the business should be detected and stopped.(2) To ascertain that the business continues to run on the projected lines. If there is any deterioration from what was projected at the time of appraisal, the same should be noticed and appropriate action initiated by the bank, in consultation with the borrower, to ensure that the business continues to run on viable lines.(3) If the deterioration of the business continues despite appropriate action, the bank should decide if any harsh action like, recalling the advance or seizing the security, etc. is necessary. In such cases, an early detection of the problem is very important as any delay in necessary action by the bank may result in deterioration of the available security and reduce the chances and amount of recovery.31.2 AVAILABLE TOOLS FOR CREDIT MONITORING / L R MThe following records/information /methods are used by the bankers to monitor the credit;(1) Conduct of the Accounts with the Bank: This gives very useful information about the financial health of the enterprise and use of the funds by it. Frequent over-drawings, return of cheques and bills, delays in submission of statements of stock and receivables, low turnover, routing of transactions with some other bank, delay in payment of interest and installments, devolvement of L Cs, invocation of Bank Guarantees, etc. are some of the unsatisfactory features. In such cases, banks may strengthen their monitoring system by resorting to more frequent inspections of borrowers' go downs, ensuring that sale proceeds are routed through the borrower's accounts maintained with the bank and insisting on pledge of the stock in place of hypothecation.

(2) Periodic Information Submitted as per the Terms of the Advance: The statements of stock and receivables are to be submitted by the borrower at regular intervals (normally, monthly) and the bank calculates the Drawing Power (D P) on the basis of these. A thorough scrutiny of these is necessary to verify their correctness, accumulation of inventory (non-moving stocks) and old receivables (normally receivables above six months are excluded for calculating D P). The detection of non-moving stocks and old receivables is not only necessary for correct calculation of D P but is also warranted to detect the danger signals in the business of the borrower. During periodic inspection of the enterprise, by the bank officials, the latest statement of stocks and receivables are cross checked with the records. Stocks are also physically verified either fully or on random selection basis.(3) Audit of Stocks and Receivables Conducted by the Bank: Stock audit is used by the bank in case of medium and large size accounts where verifying the stocks during normal inspection is not feasible or where the stocks are located at various locations. Similarly, audit of receivables may also be conducted in some cases. The purpose of these audits is to cross check the reliability of the statements submitted by the borrower.(4) Financial Statements of the Business, Auditors� Report: These are normally available once a year. An analysis of these statements gives useful information about the use and diversion of funds, financial health, realization of debts, profitability, etc. In case of working capital limits, this analysis is a part of the renewal exercise.(5) Periodic Visits and Inspection: The purpose of periodic visits is manifold. (a) It gives an impression about the activity level. The assessment of limits is based on an anticipated level of operations and field visit helps in ascertaining whether activities are at that level or not. (b) It helps in finding out the position of stocks and other assets charged to the bank. (c) The fact of bank's charge over the assets should be prominently displayed Yield visits help in finding out this.(6) Interaction: Interaction with select creditors and debtors.(7) Periodic Scrutiny: Periodic scrutiny of borrowers' books of accounts and the accounts maintained with other banks(8) Market Reports about the, Borrower and the Business Segment: These reports are available from the industry associations and rating agencies.(9) Appointing Bank�s Nominee on Company�s Board: In exceptional cases, or in case of large limits, bank may opt to appoint nominee director on the board to keep a tab on the important decisions.(10) Credit Audit: (The details given here are based on R B I's 'Guidance note on credit risk management') Credit audit is an examination of various credit functions of the

bank. It is normally conducted by internal staff having adequate credit experience. Credit Audit examines compliance with extant sanction and post-sanction processes and procedures laid down by the bank from time to time. Each bank formulates its own policies, procedures, and organizational set up for credit audit. In some banks, credit audit plays an important role in monitoring of large value accounts also.R B I's suggestions in this respect, contained in their 'Guidance note on credit risk management', are as under:(A) Objectives of Credit Audit(1) Improvement in the quality of credit portfolio(2) Review sanction process and compliance status of large loans(3) Feedback on regulatory compliance(4) Independent review of Credit Risk Assessment(5) Pick-up early warning signals and suggest remedial measures(6) Recommend corrective action to improve credit quality, credit administration and credit skills of staff, etc.(B) Structure of Credit Audit Department: The credit audit and loan review mechanism may be assigned to a specific Department or the Inspection and Audit Department.(C ) Functions of Credit Audit Department(1) To process Credit Audit Reports(2) To analyze Credit Audit findings and advise the departments/ functionaries concerned(3) To follow up with controlling authorities(4) To apprise the Top Management(5) To process the responses received and arrange for closure of the relative Credit Audit Reports(6) To maintain database of advances subjected to Credit Audit(D) Scope and Coverage: The focus of credit audit needs to be broadened from the account level to look at the overall portfolio and the credit process being followed. The important areas are:(1) Portfolio Review: Examine the quality of Credit & Investment (Quasi Credit) Portfolio and suggest measures for improvement, including reduction of concentrations in certain sectors to levels indicated in the Loan Policy and Prudential Limits suggested by RBI. (2) Loan Review: Review of the sanction process and status of post sanction processes and procedures (not just restricted to large accounts)(a) all fresh proposals and proposals for renewal of limits (within 3 to 6 months from date of sanction)(b) all existing accounts with sanction limits equal to or above a cut off depending upon the size of activity(c) randomly selected ( say 5-10%) proposals from the rest of the portfolio(d) accounts of sister concerns/group/associate concerns of above accounts, even if limit is less than the cut off(3) Action Points for Review(1) Verify compliance of bank's laid down policies and regulatory compliance with regard to sanction(2) Examine adequacy of documentation(3) Conduct the credit risk assessment(4) Examine the conduct of account and follow up looked at by line functionaries

(5) Oversee action taken by line functionaries in respect of serious irregularities(6) Detect early warning signals and suggest remedial measures thereof(4) Frequency of Review: The frequency of review should vary depending on the magnitude of risk (say, for the high risk accounts - 3 months, for the average risk accounts- 6 months, for the low risk accounts- I year).(1) Feedback on general regulatory compliance(2) Examine adequacy of policies, procedures and practices(3) Review the Credit Risk Assessment methodology(4) Examine reporting system and exceptions thereof(5) Recommend corrective action for credit administration and credit skills of staff(6) Forecast likely happenings in the near future(5) Procedure to be followed for Credit Audit(1) Credit Audit is conducted on site, i.e. at the branch which has appraised the advance and where the main operative credit limits are made available.(2) Report on conduct of accounts of allocated limits is to be called from the corresponding branches.(3) Credit auditors are not required to visit borrowers' factory or office premises.SummaryPost-disbursal control, supervision and monitoring are very important for the safety of bank's advance. The purpose is to ensure that the funds provided by the bank are put to the intended use and continue to be used properly. This is also intended to ascertain that the business continues to run on the projected lines and continues to be run on viable lines. The deterioration, if any, in the securities charged to the bank can also be detected by efficient monitoring This helps the bank in taking timely action for taking the corrective measures or starting the recovery proceedings.The tools available to the bank for effective monitoring are: (a) Conduct of the accounts with the bank; (b) Periodic information submitted as per the terms of the advance; (c) The statements of stock and receivables submitted by the borrower at regular intervals (normally, monthly); (d) Stock/receivables audit conducted by the bank; (e) Financial statements of the business, auditors' report; (f) Periodic visits and inspections; (g) Interaction with select creditors and debtors; (h) Periodical scrutiny of borrowers' books of accounts and the accounts maintained with other banks; and (i) Market reports about the borrower and the business segment. In rare cases, bank may also appoint its nominee on company's board. The credit audit is also a very effective tool in supervision of credit.KeywordsSupervision; Monitoring; Control: Loan Review Mechanism(L R M); Stock statement; Receivable statement; Deterioration of security; Inspection; Stock audit; Receivables audit; Credit auditCheck Your Progress

1. Which of the following is not a purpose of credit monitoring? The choices are:(a) To ensure end use of the funds by the borrower(b) To detect any deterioration in the security charged to the bank(c) To comply with the guidelines of the RBI(d) To ascertain that the business continues to run on the projected linesThe correct choice is.. (c) To comply with the guidelines of the RBI2. Which of the following is not a tool available to check the bank for credit monitoring?The choices are:(a) Sending regular reminders to the borrower(b) Periodic visits to the business place for inspection(c) Analysis of financial statements(d) Examine conduct of borrower's accountThe correct choice is.. (a) Sending regular reminders to the borrower3. Which of the following is not a method for detecting wrong mention of inventory in a stock statement? The choices are:(a) Stock audit(b) Inspection of stocks(c) Analysis of financial statements(d) Cross-check from the balance sheet figureThe correct choice is (c) Analysis of financial statements4. Which of the following is not a method for detecting wrong mention of receivables in stock statement submitted by the borrower? The choices are:(a) Analysis of financial statements(b) Cross check from the balance sheet figure(c) Receivables audit(d) Inspection of books of accountThe correct choice is.. (a) Analysis of financial statements5. Which of the following is not a danger sign about the direction of business of the borrower? The choices are:(a) Devolvement of L Cs, invocation of Bank Guarantees(b) Demand for higher limit(c) Delays in submission of stock/receivables statements(d) Return of cheques or billsThe correct choice is.. (d) Return of cheques or bills6. Which of the following is not an unsatisfactory sign in conduct of the account of the borrower? The choices are:(a) Delay in payment of interest or instalments,(b) routing of transactions with some other bank(c) Frequent over drawings(d) High turnoverThe correct choice is (d) High turnover7. Which of the following is not the purpose credit audit? The choices are:(a) Improvement in the quality of credit portfolio(b) Review sanction process and compliance status of large loans(c) Feedback on regulatory compliance(d) Stock inspectionThe correct choice is (d) Stock inspection8. Purpose of appointing bank�s nominee on company�s board of borrowing company is:The choices are:(a) To keep a tab on the important decisions of the board(b) To be a part of the management(c) To guide the company for better working(d) To safeguard the securities charged to the bankThe correct choice is (a) To keep a tab on the important decisions of the boardEND OF CHAPTER 31 � ADVANCED BANK MANAGEMENT- C A I I B

PAPER 1 - Credit Control and Monitoring.ADVANCED BANK MANAGEMENTUNIT 32 � Risk Management and Credit RatingSTRUCTURE32.0 Objectives32.1 Meaning of Credit Risk32.3 Factors Affecting Credit Risk32.4 Steps taken to Mitigate Credit Risks32.5 Credit Ratings32.6 Internal and External Ratings Methodology of Credit Rating32.7 Use of Credit Derivatives for Risk Management32.8 Basel 11 Accord32.9 Introduction of Advanced Approaches of Basel II Framework in India32.0 OBJECTIVESAfter reading this chapter, you will have better understanding of:(1) The various risks faced by the banks(2) The meaning of credit risk(3) Factors affecting credit risks(4) Steps taken to mitigate credit risks(5) The meaning of credit rating(7) Objectives and importance of credit rating(8) What is credit scoring(9) Method of credit scoring32.1 MEANING OF CREDIT RISKThe risks faced by the business of banking can be classified into three broad categories;(1) Operational Risks: The examples of such risks are losses due to frauds, disruption of business due to natural calamities like floods etc.(2) Market Risks: These are the risks resulting from adverse market movements of interest rates, exchange rate etc.(3) Credit Risks: The credit risk can be defined as the unwillingness or inability of a customer or counterparty (e.g. the L C opening bank in a bills negotiation transaction under that L C) to meet his commitment relating to a financial transaction with the bank. For example, in a fund based limit, the credit risk is the non payment of principal and interest by the borrower, as per the agreed terms of repayment. In case of a non fund based limit, the credit risk arises as the customer may not reimburse the bank fully in case of invocation of a guarantee or devolvement of an L C.32.2 FACTORS AFFECTING CREDIT RISK(1) External Factors: These factors affect the business of a customer and reduce his capability to honor the terms of financial transaction with the bank. The main external factors affecting the overall quality of the credit portfolio of a bank are exchange rate and interest rate fluctuations, Government policies, protectionist policies of other countries, political risks, etc. These factors look similar to what is mentioned under market risks above. But, whereas the market risks directly affect a bank, the factors mentioned here affect the businesses of the customers thus impairing the quality of the credit portfolio.(2) Internal Factors: These mainly relate to overexposure (concentration) of cre

dit to a particular segment or geographical region, excessive lending to cyclical industries, ignoring purpose of loan, faulty loan and repayment structuring, deficiencies in the loan policy of the bank, low quality of credit appraisal and monitoring, and lack of an efficient recovery machinery.32.3 STEPS TAKEN TO MITIGATE CREDIT RISKSThe major objective of credit risk management is to limit the risk within acceptable level and thus maximize the risk adjusted rate of return on the credit portfolio. Following are the main steps taken by any bank in this direction;(1) At Macro Level: The risks to the overall credit portfolio of the bank are mitigated through frequent reviews of norms and fixing internal limits for aggregate commitments to specific sectors of the industry or business so that the exposures are evenly spread over various sectors and the likely loss is retained within tolerable limits. Bank also periodically reviews the loan policies relating to exposure norms to single and group borrowers as also the structure of discretionary powers vested with various functionaries. Many banks classify their credit portfolio based on some parameters of quality and periodically review this to avoid any rude shocks relating to credit losses. Earlier, RBI had made it mandatory to classify the portfolio by assigning health codes to each account. This is not mandatory now. Normally, banks also formulate policies relating to rehabilitation, compromise, recovery and write off to get the best out of a worst case scenario.(2) At Micro Level: This pertains to policies of the bank regarding appraisal standards, sanctioning and delivering process, monitoring and review of individual proposals/categories of proposals, obtention of collateral security etc. Credit ratings and credit scoring play important role in this area. For dispersion/transfer of risk in large value accounts, bank can resort to consortium/ multiple banking and use of derivatives like credit default swaps.32.4 CREDIT RATINGSThe level of credit risk involved in each loan proposal depends on the unique features of that proposal. Two similar projects, with different promoters, may be appraised by a bank as having different credit risks. Similarly, two different projects, with same promoters, may also be appraised by the bank as having different credit risks. While appraising a credit proposal, the risk involved is also measured and often quantified by way of a rating with the following objectives;(1) To decide about accepting, rejecting or accepting with modifications/ special covenants(2) To determine the pricing, i.e. the rate of interest to be charged

(3) To help in the macro evaluation of the total credit portfolio by classifying it on the ratings allotted to individual accounts. This is used for assessing the provisioning requirements, as also a decision making tool, by the management of the bank, for reviewing the loan policy of the bank.32.5 INTERNAL AND EXTERNAL.Most of the banks in India have set up their own credit rating models as till recent past, the rating agencies were not equipped well enough to provide the ratings, so reliable as to banks depending on these for credit decisions. However, with experience gained in last few years, these rating agencies have gained confidence of the banks.A few of such rating agencies are CARE, ICRA, CRISIL and SMERA.32.6 METHODOLOGY OF CREDIT RATINGBased on its loan policies and risk perceptions, each bank has its own rating model. Common feature in all the risk models is that a score is given for different perceived risks by allotting different weightages. The sum of all these scores forms the basis for deciding on risk rating of a proposal. Normally, the broad categories of risk areas which are scored are:(a) Promoters/Management aspects and the securities available(b) Financial aspects based on analysis of financial statements(c) Business/project risksIn view of the dynamic market scenario, there is need to review the ratings of a borrower at regular intervals upgrade or downgrade or maintain it.32.7 USE OF CREDIT DERIVATIVES FOR RISK MANAGEMENTCredit derivatives are used to hedge the risks inherent in any credit asset without transferring the asset itself. The hedging is comparable to insurance and comes at a cost. Therefore, if the anticipated risk does not materialize, the return from the asset will be less than what it would have been without the hedging. While simple techniques for transferring credit-risk, such as financial guarantees, collateral and credit insurance have been prevalent in the Indian banking industry for long, the recent innovative instruments in credit risk transfer (C R T) such as collateralized debt obligations (C D O),), etc. are yet to gain significant currency. However, Credit Default Swaps (C D Ss) finds use as the new hedging instrument. The brief description of two of these new generation credit risk hedging derivatives is given below:(1) Credit Default Swaps (C D Ss): This is a bilateral contract in which the risk seller (lending bank) pays a premium to the buyer for protection against credit default or any other specified credit event. Normally, C D S is a standardized instrument of I S D A (International Swaps and Derivatives Association).The credit events defined by ISDA

are, bankruptcy, failure to pay, restructuring, obligation acceleration, obligation repudiation or moratorium etc. As per R B I guidelines, plain vanilla C D Ss only are allowed.(2) Credit Linked Notes (C L N): In this, the risk seller gets risk protection by paying regular premium to the risk buyer, which is normally a S P V which issued notes linked to the underlying credit. These notes are purchased by the general investors and the money received from them is used by the SPV to buy high quality securities. The general investors get fixed or variable return on the note during its life. On maturity of the underlying credit, the securities purchased by SPV are sold and money returned to the investors. But, in case of default in the underlying credit, these securities are used to pay to the risk seller.R B I's Worry on DerivativesIf the banks use these derivatives to hedge their credit risk by way of purchasing the risk protection, there is no apprehension. But, when the banks start selling the credit protection to other lenders, in respect of their credit risks, there is cause for worry because, often these instruments are so structured that they become very complex to understand and sometimes the liability which arises is many times more than what was anticipated. Therefore, RBI is in favour of slow growth of these derivatives in Indian financial market. It is not out of place here to quote Warren Buffet, the famous investor, as saying, 'These are weapons of mass financial destruction'.32.8 BASEL 2 ACCORDThe new framework of Basel 2 accord is based on three pillars viz., 1) Minimum capital requirements, 2) Supervisory review and iii) Market discipline. The minimum capital requirement is based on market risk, operational risk and the credit risk. Basel 2 has laid down various approaches for assessment of credit risks. These are;(a) Standardized Approach(b) Foundation Internal Rating Based (I R B) Approach(c) Advanced Internal Rating Based (I R B) ApproachForeign banks, operating in India and Indian banks having operational presence outside India have migrated to the simpler approaches available under the Basel 2 Framework, since March 31, 2009. Other commercial banks have also migrated to these approaches from March 31, 2009. Thus, the Standardized Approach for credit risk has been implemented for the banks in India.32.9 INTRODUCTION OF ADVANCED APPROACHES OF BASEL 2 FRAMEWORK IN INDIAHaving regard to the necessary up-gradation of risk management framework as also capital efficiency likely to accrue to the banks by adoption of the advanced approaches envisaged under the Basel 2 Framework and the emerging international trend in this regard, R B I considered it desirable to lay down a timeframe for implementation of the advanced approaches in India. This would enable the banks

to plan and prepare for their migration to the advanced approaches for credit risk. R B I has advised the following time schedule for implementation of the advanced approaches (Foundation as well as Advanced IRB);(1) The earliest date of making application by banks to R B I - April 1, 2012(2) Likely date of approval by the R B I � March 31, 2014The R B I has advised the banks to undertake an internal assessment of their preparedness for migration to advanced approaches, in the light of the criteria envisaged in the Basel 2 document, as per the aforesaid time schedule, and take a decision, with the approval of their Boards, whether they would like to migrate to any of the advanced approaches. The banks deciding to Migrate to the advanced approaches may approach R B I for necessary approvals, in due course, as per the stipulated time schedule. If, the result of a bank's internal assessment indicates that it is not in a position to apply for implementation of advanced approach by the above mentioned dates, it may choose a later date suitable to it based upon its preparation.The banks, at their discretion, have the option of adopting the advanced approaches for one or more of the risk categories, as per their preparedness, while continuing with the simpler approaches for other risk categories, and it would not be necessary to adopt the advanced approaches for all the risk categories simultaneously. However, the banks should invariably obtain prior approval of the R B I for adopting any of the advanced approaches.SummaryThe business of banking is prone to various risks like credit risks, market risks and operational risk. The credit risks to the bank can arise due to internal of external causes. The internal risks are caused by banks own deficiencies like, overexposure (concentration) of credit to a particular segment/geographical region, excessive lending to cyclical industries, ignoring purpose of loan, faulty loan and repayment structuring, deficiencies in the loan policy of the bank, low quality of credit appraisal and monitoring, and lack of an efficient recovery machinery. The main external risks are, exchange rate and interest rate fluctuations, Government policies, protectionist policies of other countries and political risks. A bank takes various measures to mitigate these risks. Some of these are; revision of prudential norms, upgrading the appraisal standards, tightening the monitoring mechanism and strengthening the recovery department .The rating system is introduced with the purpose of quantifying the risks involved in a particular credit proposal. Normally, the scoring system is used for arriving at the credit rating. It gives the risk weightage based score to various risk parameters in a

proposal and total of this score is used to award the credit rating. Each bank has its own scale of rating. The derivatives are also used for risk hedging but their use is, presently, limited. Base II Accord prescribes Standardized as well as IRB approach for management of credit risks. While the standardized approach has already been adopted by the banks, IRB approach will take some time for implementation.KeywordsCredit risk; internal risk; external risks; mitigation of risks; industry concentration; Credit rating, internal rating; external rating; scoring; Credit derivatives; Basel 11; Standardized approach; IRB (internal rating based) approachCheck Your Progress1. Which of the Following k not a risk mentioned in the Basel II AccordThe choices are(a) Operational risk(b) Market risk(c) Default risk(d) Credit riskThe correct choice is � (c) Default risk.2. Which of the following is not a credit risk? The choices are(a) Unwillingness of a customer to meet his commitment relating to a financial transaction with the bank(b) Inability of the customer to reimburse the bank in case of invocation of a guarantee or devolvement of an L.C(c) Inability of a customer to meet his commitment relating to a financial transaction with the bank(d) Loss to the bank due to fraudThe correct choice is � (d) Loss to the bank due to fraud3. Which of the following is an external factor affecting credit risk?The choices are(a) Government policies(b) Faulty loan and repayment structuring(c) Overexposure (concentration) of credit to a particular segment(d) Lack of an efficient recovery machinery The correct choice is � (a) Government policies4. Which of the following is not an internal factor affecting credit risk?The choices are(a) Excessive lending to cyclical industries(b) Low quality of credit appraisal and monitoring(c) Deficiencies in the loan policy of the bank(d) Protectionist policies of other countriesThe correct choice is � (d) Protectionist policies of other countries5. Which of the following is not a macro level action for mitigation of credit risk?The choices are(a) Periodically reviews of the exposure norms for single and group borrowers(b) Improving appraisal standards of credit proposals(c) Frequent reviews of norms and fixing internal limits for aggregate commitments to specific sectors of the industry or business(d) Periodic review of total credit portfolio based on quality parametersThe correct choice is � (b) Improving appraisal standards of credit proposals6. Which of the following is not a micro level action for mitigation of credit risk?The choices are(a) Improving sanctioning and delivering process(b) Obtention of collateral security

(c) Monitoring and review of individual proposals/categories of proposals(d) Periodical reviews of the exposure limits for business or industry segmentThe correct choice is � (d) Periodical reviews of the exposure limits for business or industry segment7. Which of the following statements is not true regarding credit derivatives products?The choices are(a) These are used to hedge credit risk to the bank(b) The protection buyer is the lending bank(c) The protection seller can be another bank or any other organization(d) The credit asset is transferred in case of derivativesThe correct choice is � (d) The credit asset is transferred in case of derivatives.8. Credit rating is a system of: The choices are(a) Measuring risk(b) Mitigating risk(c) Migrating risk(d) Credit appraisalThe correct choice is � (a) Measuring risk9. Internal rating means: The choices are(a) Rating the project(b) Rating the promoters(c) Rating the risk for internal use(d) None of the aboveThe correct choice is � (d) None of the above.10. For external credit rating, banks depend on: The choices are(a) Rating agencies(b) Experienced staff of the bank(c) Banking consultants(d) None of the aboveThe correct choice is � (a) Rating agencies11. Which of the following is not an approach for assessment of credit risks, laid down under Basel 2 Accord? The choices are(a) Standardized approach(b) Foundation Internal Rating Based (I R B) approach(c) Advanced Internal Rating Based (I R B) approach(d) Simplified Internal Rating Based (I R B) approachThe correct choice is � (d) Simplified Internal Rating Based (I R B) approach12. Which of the following statements is true regarding Standardized approach?The choices are: (a) It has already been adopted by all the banks(b) It has been adopted only the foreign banks operating in India.(c) It has been adopted by the foreign banks operating in India and some of the Indian banks(d) It has to be adopted by the all the banks by March 2010The correct choice is � (a) It has already been adopted by all the banks13. R B I has suggested which of the following earliest date of making application by banks to R B I regarding implementation of the advanced approaches (Foundation as well as I R B) The choices are(a) 1, April 2012(b) 1, April 2013(c) 1, April 2014(d) 1, April 2015The correct choice is �(a) 1, April 2012Answer to Check Your Progress1(c); 2.(d); 3.(a); 4.(d); 5.(b); 6.(d); 7.(d); 8.(a); 9.(d); 10.(a); 11(d); 12.(a); 13.(a)END OF CHAPTER 32 - Risk Management and Credit Rating.� ADVANCED BANK MANAGEMENT- C A I I B PAPER 1 ADVANCED BANK MANAGEMENT

UNIT 33 - Rehabilitation and RecoverySTRUCTURE33.0 Objectives33.1 Credit Default/Stressed Assets/N P As33.2 Willful Defaulters33.3 Options Available to Banks for Stressed Assets33.4 R B I Guidelines on Restructuring of Advances by Banks33.5 Corporate Debt Restructuring (C D R) Mechanism33.6 S M E Debt Restructuring Mechanism33.7 R B I Guidelines on Rehabilitation of Sick S S I Units33.8 Credit Information System33.9 Credit Information Bureau (India) Ltd., (CIBIL)33.0 OBJECTIVESAfter reading this chapter, you will have better understanding of:(1) The meaning of credit default, stressed assets, non performing assets and the options available to banks for dealing with them.(2) Meaning of rehabilitation, rescheduling, compromise and write off.(3) Meaning of Debt restructuring, institutional/organizational framework for debt restructuring available for S M Es and Corporates(4) The legal framework available for recovery.(5) Credit information system, objectives and procedures for disclosure of list of defaulters, formation of CIBIL33.1 CREDIT DEFAULT/STRESSED ASSETS/N P AsCredit default means the inability or the unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, or any financial transactions. This may take the following forms;(1) in the case of direct lending: principal and/or interest amount may not be repaid as per the terms of repayment.(2) in the case of guarantees or letters of credit: funds may not be forthcoming from the constituents upon crystallization of the liability;(3) in the case of treasury operations: the payment or series of payments due from the counter parties under the respective contracts may not be forthcoming or ceases;(4) in the case of securities trading businesses: funds/securities settlement may not be effected;(5) in the case of cross-border exposure: the availability and free transfer of foreign currency funds may either cease or restrictions may be imposed by the sovereign.Stressed assets are those assets in which the default has either already occurred or which are facing a reasonably certain prospect of default. For example, the term loan for an industrial project, implementation of which has been abandoned, is a stressed asset even though the repayment has not yet fallen due as per the repayment terms.Non Performing Assets (N P As)As per R B I directives, banks in India have to classify their assets into Performing or Standard assets or Non performing assets (N P As). N P As are further classified into (a) Sub-standard, (b) doubtful and (c) loss assets. The classification is based on the period of default as also the availability of security. The amount of

provision required to be made on the asset portfolio of a bank depends on its classification into the four categories of standard, sub standard, doubtful and loss. The consolidated R B I guidelines on this are available in their Master circular Number D B O D.No.BP.BC.17/21.04.048/2009-10 dated 1, July 200933.2 WILLFUL DEFAULTERSThe default in payment as per agreed terms could be intentional or due to the reasons beyond the control of the borrower. The intentional default is referred to as willful default. As per R B I guidelines, a 'willful default' would be deemed to have occurred if any of the following events is noted:(1) The unit has defaulted in meeting its payment or repayment obligations to the lender even when it has the capacity to honour the said obligations.(2) The unit has defaulted in meeting its payment or repayment obligations to the lender and has not utilized the finance, borrowed for the specific purposes for which the finance was availed of but has diverted the funds for other purposes.(3) The unit has defaulted in meeting its payment or repayment obligations to the lender and has siphoned off the funds so that the funds have not been utilized for the specific purpose for which finance was availed of, nor are the funds available with the unit in the form of other assets.(4) The unit has defaulted in meeting its payment or repayment obligations to the lender and has also disposed off or removed the movable fixed assets or immovable property given by him or it for the purpose of securing a term loan without the knowledge of the bank or lender.(Details available in R B I circular D B O D No. DL.BC. 16/20.16.003/2009-10 dated 1, July 2009. The Master Circular has been placed on the R B I web-site (http://www.rbi.org.in).33.3 OPTIONS AVAILABLE TO BANKS FOR STRESSED ASSETSEvery credit default does not necessarily result in loss to the bank. In many cases, bank may be able to recover its dues fully. In other cases, the recovery may be with some loss or, in the worst scenario there may be no recovery at all. The timely action and an appropriate strategy play very important role in achieving the best recovery for any stressed asset. While formulating the strategy, the bank has to keep in mind the legal system as also the social aspects prevailing in the country. Normally, a bank follows the following steps in case of a stressed asset:(1) Exit from the account(2) Rescheduling or Restructuring(3) Rehabilitation(4) Compromise(5) Legal action(6) Write offExit from the Account: Bank's first effort is to exit from the account which is showing

signs of stress. This is possible only when the symptoms of stress are detected at a very early stage so that the borrower is able to shift his account to another bank which has a different credit appetite. Once the symptoms become more pronounced, acceptance of account by another bank may not materialize. In case of consortium/multiple banking, there is good possibility of other banks taking up the share of the bank wanting to exit but in case of sole banking, bank may find it very difficult to exit a problematic account and it has to consider other options for dealing with such accounts.Rescheduling or Restructuring: If the default is not willful, the banks normally reschedule or restructure the loans in accordance with the revised cash flow estimates of the borrower.Rehabilitation: Sometimes, the business enterprises face adverse internal or market conditions and incur losses for a long time, resulting in default in payment of bank's dues. This is, specially true of the manufacturing enterprises, which are considered as 'sick' if there is erosion in the net worth due to accumulated cash losses to the extent of 50 per cent of its net worth during the previous accounting year and the unit has been in commercial production for at least two years. Banks may examine the possibility of 'Rehabilitation' in such cases after undertaking detailed viability study.Compromise: If the restructuring or rescheduling or rehabilitation is not considered viable or, does not yield the desired results, banks try to recover their dues by offering some concessions to the borrower. Such decision is influenced by the availability or realisability of the securities, enforceability of the documents etc.Legal Action: In cases where even the compromise does not materialize, banks have to initiate recovery proceedings. The forums available to the banks are as under;(1) Government Machinery: In case of finance under government sponsored schemes, the recovery officers, appointed by the state governments, help in recovery of bank's dues(2) Civil Courts: Banks can file the civil suits for recovery of their dues in the civil courts. This option is used for dues up to Rupees ten lakhs only as Debt Recovery Tribunals (DRTs) are preferred for higher amount. However, the proceedings in the civil courts are very slow. The Committee on Financial Sector Assessment (C F S A) has observed that, 'the average time taken in India for winding-up proceedings is one of the highest in the world. Improvements in effective enforcement of creditor rights and insolvency systems are critical for strengthening market efficiency and integration and for enhancing commercial confidence in contract enforcement. A quick resolution

of stressed assets of financial intermediaries is essential for the efficient functioning of credit and financial markets.'(3) Lok Adalats: In the area of dispute settlement, the Legal Services Authority Act, 1987 has conferred statutory basis on the Lok Adalats (people's courts). The Reserve Bank has consequently issued guidelines to commercial banks and financial institutions to make increasing use of the forum of Lok Adalats. As per the earlier guidelines, banks could settle disputes involving amounts up to Rupees 5 lakh through the forum of Lok Adalats. This was enhanced to Rupees 20 lakh in August 2004. Further, banks have also been advised by the Reserve Bank to participate in the Lok Adalats convened by various DRTs or DRATs for resolving cases involving Rupees 10 lakh and above to reduce the stock of N P As.(4) Debt Recovery Tribunals (DRTs): These are created specially for banks and Financial Institutions (F Is) for expediting the recovery cases involving amounts in excess of Rupees 10 lakh. The Debt Recovery Tribunal (Procedure) Rules 2003 were amended substantially regarding application fee and plural remedies for better administration of the Recovery of Debts due to Banks and Financial Institutions Act, 2002.(5) SARFAESI Act, 2002: The passage of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act) has provided the necessary impetus for banks and Financial Institutions (F I s) to hasten the recovery of their dues. This Act, effective from the date of promulgation of the first Ordinance, i.e. 21, June 2002, has been extended to cover co-operative banks by a notification dated January 28, 2003. The Act provides, inter alia, for enforcement of security interest for realization of dues without the intervention of courts or tribunals. The Government has also notified the Security Interest (Enforcement) Rules, 2002 to enable secured creditors to authorize their officials to enforce the securities and recover the dues from the borrowers.Since the Act provides for sale of financial assets by banks or Financial Institutions (F ls) to Securitization Companies (S Cs) or Reconstruction Companies (R Cs), guidelines have been issued to ensure that the process of asset reconstruction proceeds on sound lines. These guidelines, inter-alia, prescribe the financial assets which can be sold to S Cs or R Cs by banks or F Is, procedure for such sales (including valuation and pricing aspects), prudential norms for the sale transactions (viz., provisioning or valuation norms, capital adequacy norms and exposure norms) and related disclosures required to be made in the Notes on Accounts to balance shee

ts.The I F C L along with other banking and F Is, incorporated an asset reconstruction company called 'Asset Care Enterprise Ltd.' (ACE) in June 2002 with an authorized capital of Rupees 20 crore. More recently, the I D B I, the I C I C I Bank, the S B I and few other banks have jointly promoted the Asset Reconstruction Company (India) Ltd. (ARCIL) with an initial authorized capital of Rupees 20 crore and paid-up capital of Rupees 10 crore. Similar asset reconstruction or management companies are also being proposed by other institutions or banks.The Enforcement of Security Interest and Recovery Debts Laws (Amendment) Act, 2004 has amended the SARFAESI Act, Recovery of Debts due to banks and financial institutions Act, 1993 and the Companies Act, 1956. By this amendment, the SARFAESI Act has been amended, inter alia, to (a) enable the borrower to make an application before the debt recovery tribunal against the measures taken by the secured creditor without depositing any portion of the money due; (b) provide that the debt recovery tribunal shall dispose of the application as expeditiously as possible within a period of 60 days from the date of application and (c) enable any person aggrieved by the order by the debt recovery tribunal to file an appeal before the debt recovery appellate tribunal after depositing with the appellate tribunal 50 per cent of the amount of debt due to him as claimed by the secured creditor or as determined by the debt recovery tribunal, whichever is less.(5) Write off: When all the efforts to recover the dues are exhausted or, the bank is convinced that further pursuit of the case will not result any worthwhile results, the outstanding amount is written off by utilizing the provision made for that account in the books. If the provision is not enough, the excess amount is debited to Profit and Loss account (P & L account). The write off does not mean that the borrower's liability to the bank has ended. If bank is able to recover any amount from him in future, it has the legal right to appropriate that amount.33.4 R B I GUIDELINES ON RESTRUCTURING OF ADVANCES BY BANKS(Details contained in R B I circular D B O D.No.BP.BC.No.37 /21.04.132/2008-09 dated August 27, 2008)Banks may restructure the accounts classified under 'standard', 'sub-standard' and 'doubtful' categories. Banks can not reschedule/restructure/renegotiate borrowal accounts with retrospective effect.Normally, restructuring can not take place unless alteration or changes in the original loan agreement are made with the formal consent or application of the debtor. However, the process of restructuring can be initiated by the bank in deserving cases

subject to customer agreeing to the terms and conditions.No account will be taken up for restructuring by the banks unless the financial viability is established and there is a reasonable certainty of repayment from the borrower, as per the terms of restructuring package. The viability should be determined by the banks based on the acceptable viability benchmarks determined by them, which may be applied on a case-by-case basis, depending on merits of each case. The accounts not considered viable should not be restructured and banks should accelerate the recovery measures in respect of such accounts. Any restructuring done without looking into cash flows of the borrower and assessing the viability of the projects or activity financed by banks would be treated as an attempt at ever greening a weak credit facility and would invite supervisory concerns/action. BIER cases are not eligible for restructuring without their express approval.33.5 CORPORATE DEBT RESTRUCTURING (C D R) MECHANISMObjectiveThe objective of the Corporate Debt Restructuring (CDR) framework is to ensure timely and transparent mechanism for restructuring the corporate debts of viable entities facing problems, outside the purview of BIER, DRT and other legal proceedings, for the benefit of all concerned. In particular, the framework will aim at preserving viable corporates that are affected by certain internal and external factors and minimize the losses to the creditors and other stakeholders through an orderly and coordinated restructuring programme.ScopeThe CDR Mechanism has been designed to facilitate restructuring of advances of borrowers enjoying credit facilities from more than one bank/Financial Institution (F I) in a coordinated manner. The CDR Mechanism is an organizational framework institutionalized for speedy disposal of restructuring proposals of large borrowers availing finance from more than one bank/Fl. This mechanism will be available to all borrowers engaged in any type of activity subject to the following conditions:(1) The borrowers enjoy credit facilities from more than one bank or F l under multiple banking or syndication or consortium system of lending.(2) The total outstanding (fund-based and non-fund based) exposure is Rupees 10 crores or above. C D R system in the country will have a three tier structure(a) C D R Standing Forum and its Core Group.(b) C D R Empowered Group.(c) C D R Cell.C D R Standing ForumThe C D R Standing Forum would be the representative general body of all financial institutions and banks participating in C D R system. All financial institutions and banks should participate in the system in their own interest. C D R Standing Forum will be a self-empowered body, which will lay down policies and guidelines, and monitor

the progress of corporate debt restructuring.The Forum will also provide an official platform for both the creditors and borrowers (by consultation) to amicably and collectively evolve policies and guidelines for working out debt restructuring plans in the interests of all concerned.Forum shall comprise of Chairman & Managing Director, Industrial Development Bank of India Ltd; Chairman, State Bank of India; Managing Director & CEO, ICICI Bank Limited; Chairman, Indian Banks' Association as well as Chairmen and Managing Directors of all banks and financial institutions participating as permanent members in the system. Since institutions like Unit Trust of India, General Insurance Corporation, Life Insurance Corporation may have assumed exposures on certain borrowers, these institutions may participate in the C D R system. The Forum will elect its Chairman for a period of one year and the principle of rotation will be followed in the subsequent years. However, the Forum may decide to have a Working Chairman as a whole-time officer to guide and carry out the decisions of the C D R Standing Forum.The R B I would not be a member of the C D R Standing Forum and Core Group. Its role will be confined to providing broad guidelines.The C D R Standing Forum shall meet at least once every six months and would review and monitor the progress of corporate debt restructuring system. The Forum would also lay down the policies and guidelines including those relating to the critical parameters for restructuring (for example, maximum period for a unit to become viable under a restructuring package, minimum level of promoters' sacrifice etc.) to be followed by the C D R Empowered Group and C D R Cell for debt restructuring and would ensure their smooth functioning and adherence to the prescribed time schedules for debt restructuring. It can also review any individual decisions of the C D R Empowered Group and C D R Cell. The CDR Standing Forum may also formulate guidelines for dispensing special treatment to those cases, which are complicated and are likely to be delayed beyond the time frame prescribed for processing.A C D R Core Group will be carved out of the CDR Standing Forum to assist the Standing Forum in convening the meetings and taking decisions relating to policy, on behalf of the Standing Forum. The Core Group will consist of Chief Executives of Industrial Development Bank of India Ltd., State Bank of India, I C I C I Bank Ltd, Bank of Baroda, Bank of India, Punjab National Bank, Indian Banks' Association and Deputy Chairman of Indian Banks' Association representing foreign banks in India.The C D R Core Group would lay down the policies and guidelines to be followed by the CDR Empowered Group and CDR Cell for debt restructuring. These guidelines shall also suitably address the operational difficulties experienced in the functioning of the CDR Empowered Group. The CDR Core Group shall also prescribe the PERT chart for processing of cases referred to the CDR system and decide on the modalities for

enforcement of the time frame. The CDR Core Group shall also lay down guidelines to ensure that over-optimistic projections are not assumed while preparing/approving restructuring proposals especially with regard to capacity utilization, price of products, profit margin, demand, availability of raw materials, input-output ratio and likely impact of imports/international cost competitiveness.CDR Empowered GroupThe individual cases of corporate debt restructuring shall be decided by the CDR Empowered Group, consisting of E D level representatives of Industrial Development Bank of India Ltd., ICICI Bank Ltd. and State Bank of India as standing members, in addition to E D level representatives of financial institutions and banks who have an exposure to the concerned company. While the standing members will facilitate the conduct of the Group's meetings, voting will be in proportion to the exposure of the creditors only. In order to make the CDR Empowered Group effective and broad based and operate efficiently and smoothly, it would have to be ensured that participating institutions/banks approve a panel of senior officers to represent them in the CDR Empowered Group and ensure that they depute officials only from among the panel to attend the meetings of CDR Empowered Group. Further, nominees who attend the meeting pertaining to one account should invariably attend all the meetings pertaining to that account instead of deputing their representatives.The level of representation of banks/financial institutions on the CDR Empowered Group should be at a sufficiently senior level to ensure that concerned bank/F I abides by the necessary commitments including sacrifices, made towards debt restructuring.There should be a general authorization by the respective Boards of the participating institutions/banks in favour of their representatives on the CDR Empowered Group, authorizing them to take decisions on behalf of their organization, regarding restructuring of debts of individual corporates.The CDR Empowered Group will consider the preliminary report of all cases of requests of restructuring, submitted to it by the CDR Cell. After the Empowered Group decides that restructuring of the company is prima-facie feasible and the enterprise is potentially viable in terms of the policies and guidelines evolved by Standing Forum, the detailed restructuring package will be worked out by the CDR Cell in conjunction with the Lead Institution. However, if the lead institution faces difficulties in working out the detailed restructuring package, the participating banks/financial institutions should decide upon the alternate institution/bank which would work out the detailed restructuring package at the first meeting of the Empowered Group when the preliminary report of the CDR Cell comes up for consideration.

The CDR Empowered Group would be mandated to look into each case of debt restructuring, examine the viability and rehabilitation potential of the Company and approve the restructuring package within a specified time frame of 90 days, or, at best within 180 days of reference to the Empowered Group. The CDR Empowered Group shall decide on the acceptable viability benchmark levels on the following illustrative parameters, which may be applied on a case-by-case basis, based on the merits of each case:(a) Return on Capital Employed (R O C E)(b) Debt Service Coverage Ratio (D S C R)(c) Gap between the Internal Rate of Return (I R R) and the Cost of Fund (C o F)(d) Extent of sacrifice..The Board of each bank/Fl should authorize its Chief Executive Officer (C E O) and/or Executive Director (E D) to decide on the restructuring package in respect of cases referred to the CDR system, with the requisite requirements to meet the control needs. CDR Empowered Group will meet on two or three occasions in respect of each borrowal account. This will provide an opportunity to the participating members to seek proper authorizations from their C E O or E D, in case of need, in respect of those cases where the critical parameters of restructuring are beyond the authority delegated to him/her.The decisions of the CDR Empowered Group shall be final. If restructuring of debt is found to be viable and feasible and approved by the Empowered Group, the company would be put on the restructuring mode. If restructuring is not found viable, the creditors would then be free to take necessary steps for immediate recovery of dues and, or liquidation or winding up of the company collectively or individually.CDR CellThe CDR Standing Forum and the CDR Empowered Group will be assisted by a CDR Cell in all their functions. The CDR Cell will make the initial scrutiny of the proposals received from borrowers/creditors, by calling for proposed rehabilitation plan and other information and put up the matter before the CDR Empowered Group, within one month to decide whether rehabilitation is prima facie feasible. If found feasible, the CDR Cell will proceed to prepare detailed Rehabilitation Plan with the help of creditors and if necessary, experts to be engaged from outside. If not found prima facie feasible, the creditors may start action for recovery of their dues.All references for corporate debt restructuring by creditors or borrowers will be made to the CDR Cell. It shall be the responsibility of the lead institution/major stakeholder to the corporate, to work out a preliminary restructuring plan in consultation with other stakeholders and submit to the CDR Cell within one month. The CDR Cell will prepare the restructuring plan in terms of the general policies and guidelines a

pproved by the CDR Standing Forum and place for consideration of the Empowered Group within 30 days for decision. The Empowered Group can approve or suggest modifications but ensure that a final decision is taken within a total period of 90 days. However, for sufficient reasons the period can be extended up to a maximum of 180 days from the date of reference to the CDR Cell.The CDR Standing Forum, the CDR Empowered Group and CDR Cell is at present housed in Industrial Development Bank of India Ltd. However, it may be shifted to another place if considered necessary, as may be decided by the Standing Forum. The administrative and other costs shall be shared by all financial institutions and banks. The sharing pattern shall be as determined by the Standing Forum.CDR Cell will have adequate members of staff deputed from banks and financial institutions. The CDR Cell may also take outside professional help. The cost in operating the CDR mechanism including CDR Cell will be met from contribution of the financial institutions and banks in the Core Group at the rate of Rupees.50 lakh each and contribution from other institutions and banks at the rate of Rupees.5 lakh each.Other Features The scheme will not apply to accounts involving only one financial institution or one bank. The CDR mechanism will cover only multiple banking accounts or syndication or consortium accounts of corporate borrowers engaged in any type of activity with outstanding fund-based and non-fund based exposure of Rupees. 10 crore and above by banks and institutions.The Category 1 CDR system will be applicable only to accounts classified as 'standard' and 'substandard'. There may be a situation where a small portion of debt by a bank might be classified as doubtful. In that situation, if the account has been classified as �standard'/ 'substandard' in the books of at least 90 per cent of creditors (by value), the same would be treated as standard/substandard, only lot the purpose of judging the account as eligible for CDR, in the books of the remaining 10 per cent of creditors. There would be no requirement of the account/company being sick, N P A or being in default for a specified period before reference to the CDR system. However, potentially viable cases of N P As will get priority. This approach would provide the necessary flexibility and facilitate timely intervention for debt restructuring. Prescribing any milestone(s) may not be necessary, since the debt restructuring exercise is being triggered by banks and financial institutions or with their consent.While corporates indulging in frauds and malfeasance even in a single bank will continue to remain ineligible for restructuring under CDR mechanism as hitherto, the Core group may review the reasons for classification of the borrower as wilful defaulter

specially in old cases where the manner of classification of a borrower as a willful defaulter was not transparent and satisfy itself that the borrower is in a position to rectify the willful default provided he is granted an opportunity under the CDR mechanism. Such exceptional cases may be admitted for restructuring with the approval of the Core Group only. The Core Group may ensure that cases involving frauds or diversion of funds with malafide intent are not covered.The accounts where recovery suits have been filed by the creditors against the company, may be eligible for consideration under the CDR system provided, the initiative to resolve the case under the CDR system is taken by at least 75 per cent of the creditors (by value) and 60 per cent of creditors (by number).BIER cases are not eligible for restructuring under the CDR system. However, large value B I F R cases may be eligible for restructuring under the CDR system if specifically recommended by the CDR Core Group. The Core Group shall recommend exceptional B I F R cases on a case-to-case basis for consideration under the CDR system. It should be ensured that the lending institutions complete all the formalities in seeking the approval from B I F R before implementing the package.Reference to CDR SystemReference to Corporate Debt Restructuring System could be triggered by (1) any or more of the creditor who have minimum 20 per cent share in either working capital or term finance, or (2) by the concerned corporate, if supported by a bank or financial institution having stake as in (1) above.Though flexibility is available whereby the creditors could either consider restructuring outside the purview of the CDR system or even initiate legal proceedings where warranted, banksor Fls should review all eligible cases where the exposure of the financial system is more than Rupees.100 crore and decide about referring the case to CDR system or to proceed under the new Securitization and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 or to file a suit in D R T etc.Legal BasisCDR is a non-statutory mechanism which is a voluntary system based on Debtor- Creditor Agreement (D C A) and Inter-Creditor Agreement (I C A). The Debtor-Creditor Agreement (D C A) and the Inter-Creditor Agreement (I C A) shall provide the legal basis to the CDR mechanism. The debtors shall have to accede to the D C A, either at the time of original loan documentation (for future cases) or at the time of reference to Corporate Debt Restructuring Cell. Similarly, all participants in the C D R mechanism through their membership of the Standing Forum shall have to enter into a legally binding agreement, with necessary enforcement and penal clauses, to operate the System through laid-down policies and guidelines. The I C A signed by the creditors will be initially valid for a period of 3 years and subject to renewal for further pe

riods of 3 years thereafter. The lenders in foreign currency outside the country are not a part of CDR system. Such creditors and also creditors like G I C, L I C, U T I, etc., who have not joined the CDR system, could join CDR mechanism of a particular corporate by signing transaction to transaction I C A, wherever they have exposure to such corporate.The Inter-Creditor Agreement would be a legally binding agreement amongst the creditors with necessary enforcement and penal clauses, wherein the creditors would commit themselves to abide by the various elements of CDR system. Further, the creditors shall agree that if 75 per cent of creditors by value and 60 per cent of the creditors by number, agree to a restructuring package of an existing debt (i.e., debt outstanding), the same would be binding on the remaining creditors. Since Category 1 CDR Scheme covers only standard and sub-standard accounts, which in the opinion of 75 per cent of the creditors by value and 60 per cent of creditors by number, are likely to become performing after introduction of the CDR package, it is expected that all other creditors (i.e., those outside the minimum 75 per cent by value and 60 per cent by number) would be willing to participate in the entire CDR package, including the agreed additional financing.In order to improve effectiveness of the CDR mechanism, a clause may be incorporated in the loan agreements involving consortium or syndicate accounts whereby all creditors, including those which are not members of the CDR mechanism, agree to be bound by the terms of the restructuring package that may be approved under the CDR mechanism, as and when restructuring may become necessary.One of the most important elements of Debtor-Creditor Agreement would be 'stand still' agreement binding for 90 days, or 180 days by both sides. Under this clause, both the debtor and creditor(s) shall agree to a legally binding 'stand-still' whereby both the parties commit themselves not to take recourse to any other legal action during the 'stand-still' period, this would be necessary for enabling the CDR System to undertake the necessary debt restructuring exercise without any outside intervention, judicial or otherwise. However, the stand-still clause will be applicable only to any civil action either by the borrower or any lender against the other party and will not cover any criminal action. Further, during the stand-still period, outstanding foreign exchange forward contracts, derivative products, etc., can be crystallized, provided the borrower is agreeable to such crystallization. The borrower will additionally undertake that during the stand-still period the documents will stand extended for the purpose of limitation and also that he will not approach any other authority for any relief and the direct

ors of the borrowing company will not resign from the Board of Directors during the stand-still period.Sharing of Additional FinanceAdditional finance, if any, is to be provided by all creditors of a 'standard' or 'substandard account' irrespective of whether they are working capital or term creditors, on a pro-rata basis. In case for any internal reason, any creditor (outside the minimum 75 per cent and 60 per cent) does not wish to commit additional financing, that creditor will have an option in accordance with the provisions of exit option.The providers of additional finance, whether existing or new creditors, shall have a preferential claim, to be worked out under the restructuring package, over the providers of existing finance with respect to the cash flows out of recoveries, in respect of the additional exposureExit OptionAs stated in para above a creditor (outside the minimum 75 per cent and 60 per cent) who for any internal reason does not wish to commit additional finance will have an exit option. At the same time, in order to avoid the 'free rider' problem, it is necessary to provide some disincentive to the creditor who wishes to exercise this option. Such creditors can either (a) arrange for its share of additional finance to be provided by a new or existing creditor, or (b) agree to the deferment of the first year's interest due to it after the CDR package becomes effective. The first year's deferred interest as mentioned above, without compounding, will be payable along with the last instalment of the principal due to the creditor.In addition, the exit option will also be available to all lenders within the minimum 75 per cent and 60 percent provided the purchaser (of their share) agrees to abide by restructuring package approved by the Empowered Group. The exiting lenders may be allowed to continue with their existing level of exposure to the borrower provided they tie up with either the existing lenders or fresh lenders taking up their share of additional finance.The lenders who wish to exit from the package would have the option to sell their existing share to either the existing lenders or fresh lenders, at an appropriate price, which would be decided mutually between the exiting lender and the taking over lender. The new lenders shall rank on par with the existing lenders for repayment and servicing of the dues since they have taken over the existing dues to the exiting lender.In order to bring more flexibility in the exit option, One Time Settlement can also be considered, wherever necessary, as a part of the restructuring package. If an

account with any creditor is subjected to One Time Settlement (O T S) by a borrower before its reference to the CDR mechanism, any fulfilled commitments under such O T S may not be reversed under the restructured package. Further payment commitments of the borrower arising out of such O T S may be factored into the restructuring package.Category 2 CDR SystemThere have been instances where the projects have been found to be viable by the creditors but the accounts could not be taken up for restructuring under the C D R system as they fell under 'doubtful' category. Hence, a second category of CDR is introduced for cases where the accounts have been classified as 'doubtful' in the books of creditors, and if a minimum of 75 per cent of creditors (by value) and 60 per cent creditors (by number) satisfy themselves of the viability of the account and consent for such restructuring, subject to the following conditions:(a) It will not be binding on the creditors to take up additional financing worked out under the debt restructuring package and the decision to lend or not to lend will depend on each creditor bank or F I separately. In other words, under the proposed second category of the CDR mechanism, the existing loans will only be restructured and it would be up to the promoter to firm up additional financing arrangement with new or existing creditors individually.(b) All other norms under the CDR mechanism such as the standstill clause, asset classification status during the pendency of restructuring under CDR, etc., will continue to be applicable to this category also.No individual case should be referred to R B I. CDR Core Group may take a final decision whether a particular case falls under the CDR guidelines or it does not.All the other features of the CDR system as applicable to the First Category will also be applicable to cases restructured under the Second Category.Incorporation of 'Right to Recompense' ClauseAll CDR approved packages must incorporate creditors' right to accelerate repayment and borrowers' right to pre-pay. The right of recompense should be based on certain performance criteria to be decided by the Standing Forum.33.6 S M E DEBT RESTRUCTURING MECHANISMApart from CDR Mechanism, there exists a much simpler mechanism for restructuring of loans availed by Small and Medium Enterprises (S M Es). Unlike in the case of CDR Mechanism, the operational rules of the mechanism have been left to be formulated by the banks concerned. This mechanism will be applicable to all the borrowers which have funded and non-funded outstanding up to Rupees. 10 crores under multiple/consortium banking arrangement. Major elements of this arrangement are as

under:(1) Under this mechanism, banks may formulate, with the approval of their Board of Directors, a debt restructuring scheme for S M Es within the prudential norms laid down by R B I. Banks may frame different sets of policies for borrowers belonging to different sectors within the S M E if they so desire.(2) While framing the scheme, banks may ensure that the scheme is simple to comprehend and will, at the minimum, include parameters indicated in these guidelines.(3) The main plank of the scheme is that the bank with the maximum outstanding may work out the restructuring package, along with the bank having the second largest share.(4) Banks should work out the restructuring package and implement the same within a maximum period of 90 days from date of receipt of requests.(5) The S M E Debt Restructuring Mechanism will be available to all borrowers engaged in any type of activity.(6) Banks may review the progress in rehabilitation and restructuring of S M Es accounts on a quarterly basis and keep the Board informed33.7 R B I GUIDELINES ON REHABILITATION OF SICK SSI UNITSAs per the definition, a unit is considered as sick when any of the borrowal account of the unit remains substandard for more than 6 months or there is erosion in the net worth due to accumulated cash losses to the extent of 50 per cent of its net worth during the previous accounting year and the unit has been in commercial production for at least two years. The criteria will enable banks to detect sickness at an early stage and facilitate corrective action for revival of the unit. As per the guidelines, the rehabilitation package should be fully implemented within six months from the date the unit is declared as potentially unviable. During this period of six months, of identifying and implementing rehabilitation package, banks or F Is are required to do 'holding operation' which will allow the sick unit to draw funds from the cash credit account at least to the extent of deposit of sale proceedsFollowing are broad parameters for grant of relief and Concessions for revival of potentially viable sick S S I units:(1) Interest on Working Capital - Interest 1.5 per cent below the prevailing fixed or prime lending rate, wherever applicable(2) Funded Interest Term Loan - Interest Free(3) Working Capital Term Loan - Interest to be charged 1.5 per cent below the prevailing fixed or prime lending rate, wherever applicable(4) Term Loan - Concessions in the interest to be given not more than 2 per cent (not more than 3 % in the case of tiny or decentralized sector units) below the document rate.(5) Contingency Loan Assistance - The Concessional rate allowed for Working Capital Assistance

(Details available in R B I circulars RPCD.No. PLNFS.BC.57/06.04.01/2001-02 dated 16, January 2002, and RPCD. SME&NFS. BC.No.102/06.04.01/2008-09 4, May 2009)33.8 CREDIT INFORMATION SYSTEMThe need of credit information system was felt in order to alert the banks and financial institutions (F Is) and put them on guard against borrowers who have defaulted in their dues to other lending institutions. It was also imperative to arrest accretion of fresh N P As in the banking system through an efficient system of credit information on borrowers as a first step in credit risk management. In this context, the requirement of an adequate, comprehensive and reliable information system on the borrowers through an efficient database system was keenly felt by the Reserve Bank/ Government as well as credit institutions. A Working Group (Chairman: Shri N.H. Siddiqui) with representatives from select public sector banks, I D B I, I C I C I, Indian Banks' Association and Reserve Bank was constituted by the Reserve Bank in the year 1999, to explore the possibilities of setting up a Credit Information Bureau (CIB). The Working Group had recommended to set up a C I B under the Companies Act, 1956 with equity participation from commercial banks, F Is and NBFCs registered with the Reserve Bank. As per the recommendations made by the Working Group, Credit Information Bureau (India) Ltd., (CIBIL) was set up by State Bank of India in association with HDFC in January 2001.In order to get over the legal constraints of customer confidentiality vis-a-vis providing information on banks' customers to CIBIL, pending enactment on the Credit Information Companies (Regulation) Act, the Reserve Bank advised banks and financial institutions on October 1, 2002 to obtain consent from all existing borrowers and guarantors at the time of renewal of loans and consent of all the new borrowers and guarantors for sharing the credit information in respect of non-suit filed accounts with the CIBIL. A Working Group (Chairman: Shri S.R. Iyer) set up in 2002 observed that while some modalities like 'consent clause' could be adopted as a base to begin with, for limited operations of a C I B, such modalities cannot be a substitute for a special legislation. The Working Group, therefore, recommended the enactment of an appropriate legislation by the Government of India expeditiously, in consultation with the Reserve Bank. With a view to strengthening the legal mechanism and facilitating the Bureau to collect, process and share credit information on the borrowers of credit institutions, the Credit Information Companies (Regulation) Act, 2005 was passed in May 2005 by Parliament and notified in the Gazette of India on 23, June 2005. The

Government of India also notified the rules and regulations for the implementation of the Credit Information Companies (Regulation) Act, 2005 on December 14, 2006 making the Act operational. In terms of Section 15(1) of the Act, every credit institution has to become member of at least one credit information company within a period of three months from commencement of the Act or any extended time allowed by the Reserve Bank on application As per R B I guidelines, each credit institution should provide credit data (positive as well as negative) to the credit information company in the format prescribed by the credit information company.Sub section (1) of Section 21 of the Credit Information Companies (Regulation) Act, 2005, which provides; ,any person, who applies for grant or sanction of credit facility, from any credit institution, may request such institution to furnish him a copy of the credit information obtained by such institution from the credit information company '.Further, sub-section (2) of the said Section also specifies that every credit institution shall on receipt of request, as indicated in sub-section (1), furnish to such person a copy of the credit information subject to payment of charges specified by the Reserve Bank R B I has prescribed a maximum fee of Rupees. 501- (Rupees fifty only) for the purpose.33.9 CREDIT INFORMATION BUREAU (INDIA) LTD. (CIBIL)Credit Information Bureau (India) Ltd (CIBIL) was set up by State Bank of India in association with HDFC in January 2001. Presently, Dun and Bradstreet Information Services India (P) Ltd. is also their equity holder as well as technology partner. As, presently, this is the only approved credit information company, all credit institutions are required to be its members. The purpose of setting up of CIBIL is information sharing on defaulters as also other borrowers as comprehensive credit information, which provides details pertaining to credit facilities already availed of by a borrower as well as his payment track record, has become the need of the hour.CIBILs aim is to fulfill the need of credit granting institutions for comprehensive credit information by collecting, collating and disseminating credit information pertaining to both commercial and consumer borrowers, to a closed user group of Members. Banks, Financial Institutions, Non Banking Financial Companies, Housing Finance Companies and Credit Card Companies use CIBIL:s services. Data sharing is based on the Principle of Reciprocity, which means that only Members who have submitted all their credit data, may access Credit Information Reports from CIBIL. The relationship between CIBIL and its Members is that of close interdependence.R B I and CIBIL disseminate information on non-suit filed and suit filed accounts respectively, as reported to them by the banks or F Is and responsibility for reporting

correct information and also accuracy of facts and figures rests with the concerned banks and financial institutions. Therefore, R B I has advised the banks and financial institutions to take immediate steps to up-date their records and ensure that the names of current directors are reported. In addition to reporting the names of current directors, it is necessary to furnish information about directors who were associated with the company at the time the account was classified as defaulter, to put the other banks and financial institutions on guard. Banks and F Is may also ensure the facts about directors, wherever possible, by cross-checking with Registrar of Companies.As per R B I guidelines, bank and FIs are required to submit the list of suit-filed accounts of willful defaulters of Rupees 25 lakh and above as at end-March, June, September and December every year to Credit Information Bureau (India) Ltd.The data on borrowal accounts against which suits have been filed for recovery of advances (outstanding aggregating Rupees. 1.00 crore and above) and suit filed accounts of wilful defaulters with outstanding balance of Rupees 25 lakh and above, based on information furnished by scheduled commercial banks and financial institutions is available at www.cibil.com SummaryEven with best of loan policies adopted by a bank and with high standards of appraisal, the quality of a few loan accounts may deteriorate as the time passes. This may give rise to actual default or possibility of default in repayment of principal and interest in some of the accounts. As per R B I directives, banks in India have to classify their assets into Performing (standard) assets or Non performing assets (N P As). N P As are further classified into Sub-standard, doubtful and loss assets. The options available to banks in regard to the assets where the quality has deteriorated, are Rescheduling and Restructuring, Rehabilitaion, Compromise, Legal action or Write off. As per R B I guidelines, forums are available for restructuring of debts of Corporates and S M Es, in deserving cases. There are also guidelines on rehabilitation of sick S S I units. Credit information system has also been introduced to share information about borrowers committing defaults with any of the banks. Under this system, CIBIL was formed in January 2001 with the purpose of information sharing on defaulters as also other borrowers by providing details pertaining to credit facilities already availed of by a borrower as well as his payment track record.KeywordsRescheduling; Restructuring; Rehabilitation; Compromise; Legal action; Write off; Corporate Debt Restructuring (CDR); S M E Debt Restructuring; CREDIT INFORMATION SYSTEM; CIBIL; Performing (standard) assets; Non performing

assets(N P As); Sub-standard: Doubtful assets; Loss assetsCheck Your ProgressState true or False:1. In the case of fund based lending, credit default means that principal/and or interest amount may not be repaid as per the terms of repayment. � True.2. In the case of guarantees or letters of credit, credit default means crystallization of the liability. � False.3. As per R B I directives, banks in India have to classify their assets into Performing ( standard ) assets or Non performing assets(N P As). N P As are further classified into Sub-standard, doubtful and loss assets � True.4. The amount of provision required to be made on the asset portfolio of a bank depends on the classification of assets. � True.5. No provision is required to be made by a bank on its Standard Assets. � False.6. The default due to the reasons beyond the control of the borrower, is referred to as wilful default. � False.7. The default in payment as per agreed terms could be intentional or due to the reasons beyond the control of the borrower. � True.8. Writing off a loan means that the borrower is no longer liable to pay the amount to the bank. � False.9. In case of finance under government sponsored schemes, responsibility for recovery lies with the government. � False.10..Banks reschedule or restructure the loans in accordance with the revised cash flow estimates of the borrower. � True.11. The Debt Recovery Tribunals are meant for recovery of dues of the banks and financial institutions only. � True.12. For filing cases in the Debt Recovery Tribunals, the amount of claim must be more than Rupees 10 lacs. � True.13. SARFAESI Act provides for enforcement of security interest for realization of dues without the intervention of courts or tribunals. � True.14. Banks can settle disputes involving amounts up to Rupees.20 latch through the forum of Lok Adalats. � True.15. As per R B I directives, banks can reschedule/restructure/renegotiate borrowal accounts with retrospective effect. � False.16. For restructuring of SME loans, no forum like CDR is available. � False.17. Credit Information System was started with the objective of sharing information about borrowers committing defaults with any of the banks. � True.Select the Correct Answer:18. The aim of a rehabilitation programme is: The choices are:(a) To make the operations of the enterprise viable again(b) To help in employment generation(c) To comply with R B I guidelines(d) To increase bank's advancesThe correct answer is � (a) To make the operations of the enterprise viable again19. Banks enter into compromise with borrowers in case of default, because:The choices are:(a) Recovery through legal action is time consuming(b) Adequate security is not available

(c) Realization or security may be difficult(d) All the aboveThe correct answer is � (d) All the aboveEND OF CHAPTER 33-Rehabilitation and Recovery, ADVANCED BANK MANAGEMENT- C A I I B PAPER 1. End of the book Advanced Bank Management, Paper 1.