Principles of lendingPrinciples of lending

It should cover following aspects It should cover following aspects 1. Regulatory – RBI/BASEL1. Regulatory – RBI/BASEL 2. Internal – Loan Policy2. Internal – Loan Policy 3. Managerial/Financial/Commercial/3. Managerial/Financial/Commercial/

MarketMarket 4. Types of customer – 4. Types of customer –

Individual/Partnership/CorporateIndividual/Partnership/Corporate 5. Types of loans – Corporate 5. Types of loans – Corporate

loans/SME/Rural/Trade/Export/Import/Project/Retloans/SME/Rural/Trade/Export/Import/Project/Retail etcail etc

Government/PSU/Quasi/PrivateGovernment/PSU/Quasi/Private 6. Gut feeling6. Gut feeling

General Lending General Lending principlesprinciples A lender does lend money and does A lender does lend money and does

not give it away.not give it away. Lenders must seek to arrive at an Lenders must seek to arrive at an

objective decision.objective decision. The approach of the true professional The approach of the true professional

is to resist outside pressures and to is to resist outside pressures and to insist on sufficient time and insist on sufficient time and information to understand and information to understand and evaluate the proposition. evaluate the proposition.

Professional lending Professional lending principlesprinciples Take time to reach a decision-detailed Take time to reach a decision-detailed

financial information takes time to financial information takes time to absorb. absorb.

If possible, it is preferable to get the If possible, it is preferable to get the paperwork before the interview, so that it paperwork before the interview, so that it can be assessed and any queries can be assessed and any queries identified.identified.

Do not be too proud to ask for a second Do not be too proud to ask for a second opinion-some of the smallest lending opinion-some of the smallest lending decisions can be the hardest. decisions can be the hardest.

Professional lending Professional lending principles principles Get full information from the customer and Get full information from the customer and

not make unnecessary assumptions or ‘fill not make unnecessary assumptions or ‘fill in’ missing details.in’ missing details.

Do not take a customer’s statements at Do not take a customer’s statements at face value and ask for evidence that will face value and ask for evidence that will provide independent corroboration. E.. provide independent corroboration. E.. Sathyam episodeSathyam episode

Distinguish between facts, estimates and Distinguish between facts, estimates and opinions when forming a judgement. opinions when forming a judgement.

Think again when the ‘gut reaction’ Think again when the ‘gut reaction’ suggests caution, even though the factual suggests caution, even though the factual assessment looks satisfactory. assessment looks satisfactory.

TRADITIONAL TRADITIONAL METHODS OF CREDIT METHODS OF CREDIT ANALYSISANALYSIS Anyone can lend, but lending Anyone can lend, but lending

money and ensuring it repayment money and ensuring it repayment distinguishes between a good distinguishes between a good banker and a bad banker. banker and a bad banker.

When you are dealing with When you are dealing with people, it is almost impossible to people, it is almost impossible to predict how someone will behave in predict how someone will behave in the future. It is important therefore the future. It is important therefore that lenders exercise sound that lenders exercise sound judgement while granting loan.judgement while granting loan.

Cond…Cond…

Lending principles help a banker to Lending principles help a banker to make sound judgement. make sound judgement.

Note however that principles are not Note however that principles are not laws of physical science that must hold laws of physical science that must hold whatever be the case; rather, the whatever be the case; rather, the principles serve as a framework within principles serve as a framework within which to make a decision. This is why which to make a decision. This is why lending is more akin to art than to lending is more akin to art than to science. science.

Cond..Cond..

The purpose of any credit The purpose of any credit assessment or analysis is the assessment or analysis is the measurement of credit risk.measurement of credit risk.

Borrowers’ credit assessment is Borrowers’ credit assessment is done using the following criteria, done using the following criteria, popularly known as the five Cs of popularly known as the five Cs of lending.lending.

FIVE Cs of LendingFIVE Cs of Lending

Character Character CapacityCapacity CapitalCapital CollateralCollateral ConditionsConditions

CHARACTERCHARACTER

Character is the sum total of human Character is the sum total of human qualities of honesty, integrity,morality qualities of honesty, integrity,morality and so on. and so on.

Character is perhaps the most Character is perhaps the most important and at time the most important and at time the most difficult criterion to assess. difficult criterion to assess.

Character assessment involves Character assessment involves collecting information about the collecting information about the borrower’s track record of integrity, borrower’s track record of integrity, repayment ability and spending habits.repayment ability and spending habits.

Means of gathering Means of gathering informationinformation Credit check of internal bank records Credit check of internal bank records

or other financial institution.or other financial institution. Contact of applicant’s employers and Contact of applicant’s employers and

seek confidential information about seek confidential information about the employee***the employee***

Documentary evidence such as salary Documentary evidence such as salary statements, drivers license, utility billstatements, drivers license, utility bill

Confidential reports from credit rating Confidential reports from credit rating agencies are another source.agencies are another source.

CIBIL data/ECGC/Dun & Brad StreetCIBIL data/ECGC/Dun & Brad Street

Character assessment in Character assessment in relation to business relation to business borrowersborrowers

For business borrowers, For business borrowers, character assessment involves character assessment involves assessing the character of the assessing the character of the business owners or, in the case of business owners or, in the case of companies, the members of the companies, the members of the board.board.

Corporate governanceCorporate governance

CAPACITYCAPACITY

Capacity is the ability to repay the loan Capacity is the ability to repay the loan together with interest as per the pre-together with interest as per the pre-determined schedule.determined schedule.

A borrower’s capacity depends on two A borrower’s capacity depends on two factors: first, the borrower’s financial factors: first, the borrower’s financial position should be sound; and second, position should be sound; and second, the borrower must be able to generate the borrower must be able to generate sufficient net income to service the sufficient net income to service the loan repayment.loan repayment.

CapacityCapacity

To assess whether the borrower’s To assess whether the borrower’s financial position is sound, lenders, in financial position is sound, lenders, in the case of personal loans often the case of personal loans often examine details of assets and examine details of assets and liabilities. liabilities.

Also borrowers are required to give Also borrowers are required to give details of income and expenditure, and details of income and expenditure, and the net surplus available for the net surplus available for repayment.repayment.

CapacityCapacity In the case of businesses, In the case of businesses,

lenders usually ask for audited lenders usually ask for audited financial statements and financial statements and projected cash flow to determine projected cash flow to determine the financial soundness or the financial soundness or creditworthiness of the business creditworthiness of the business borrower. borrower.

CAPACITYCAPACITY

Capacity is about the primary Capacity is about the primary source from which repayment is source from which repayment is expected to take place. It is expected to take place. It is important to assess the primary important to assess the primary source from the outsetsource from the outset

Capacity to pay but willingness to Capacity to pay but willingness to pay. Main cause of NPA in bankspay. Main cause of NPA in banks

CAPITALCAPITAL

Capital refers to the capital contribution that Capital refers to the capital contribution that the borrower proposes to make in the total the borrower proposes to make in the total investment. investment.

An investment is usually financed partly by An investment is usually financed partly by bank loan and partly by the capital bank loan and partly by the capital contribution of the owner. contribution of the owner.

The owner’s contribution is called the The owner’s contribution is called the owner’s margin. owner’s margin.

The greater the owners contribution to a The greater the owners contribution to a project the greater is the lenders confidence project the greater is the lenders confidence in the venture. Banks usually expect at least in the venture. Banks usually expect at least a 20 – 25% percent input from the borrower. a 20 – 25% percent input from the borrower.

COLLATERALCOLLATERAL

Collateral is also known as secondary Collateral is also known as secondary source of repayment. When a loan source of repayment. When a loan cannot be paid out of primary source, cannot be paid out of primary source, lenders usually take possession of lenders usually take possession of collateral and dispose of it and use the collateral and dispose of it and use the proceeds to set off the outstanding loan proceeds to set off the outstanding loan amount.amount.

Type of collateral – Type of collateral – house/factory/machinery/ bank house/factory/machinery/ bank deposits/shares & debenturesdeposits/shares & debentures

Guarantee Guarantee

QUALITIES OF GOOD QUALITIES OF GOOD SECURITYSECURITY

TitleTitle The price of the security should be stable, or not The price of the security should be stable, or not

subject to wide fluctuations. subject to wide fluctuations. The marketability of the security should be rated The marketability of the security should be rated

good. good. The security should be easily valued.The security should be easily valued. The security should not deteriorate rapidly over time. The security should not deteriorate rapidly over time. If security is quickly transportable or portable, then If security is quickly transportable or portable, then

the lender can sell it in another market. If the security the lender can sell it in another market. If the security is not portable then, the lender may find it hard to sell is not portable then, the lender may find it hard to sell that security in the local market.that security in the local market.

Bogus documents – title deedsBogus documents – title deeds

COLLATERALCOLLATERAL

It is hard to find a security that It is hard to find a security that possesses all the above qualities, possesses all the above qualities, and a lender is often required to and a lender is often required to judge an acceptable compromise. judge an acceptable compromise.

Land for example, may have Land for example, may have stable value over time but it lacks stable value over time but it lacks the quality of portability.the quality of portability.

CONDITIONCONDITION

An analysis of conditions covers An analysis of conditions covers external and internal factors. external and internal factors.

It also covers the conditions and It also covers the conditions and terms of the loan. terms of the loan.

The riskier the advance the The riskier the advance the stricter are the terms and stricter are the terms and conditions. conditions.

EXTERNAL EXTERNAL CONDITIONSCONDITIONS EconomyEconomy IndustryIndustry Threat of warThreat of war Political instabilityPolitical instability CrimeCrime

Cannons of good Cannons of good lendinglendingC.a.m.p.a.r.iC.a.m.p.a.r.i CCharacterharacter AAbilitybility MMarginargin PPurposeurpose AAmount mount RRepayment epayment IInsurance( security)nsurance( security)

INTERNAL CONDITIONSINTERNAL CONDITIONS Lending policiesLending policies Lending budgetLending budget Availability of expert staff to monitor loan.Availability of expert staff to monitor loan.

A financial institution may decide to follow A financial institution may decide to follow restrictive lending policies, the lending restrictive lending policies, the lending budget and the availability of a funds budget and the availability of a funds constraint, or to expand lending business constraint, or to expand lending business in particular segments of the market. in particular segments of the market.

Credit analysis should take such aspects Credit analysis should take such aspects into account. into account.

Character Character It is virtually impossible to assess an It is virtually impossible to assess an

individual’s character just after one individual’s character just after one meeting. It is an extremely difficult area meeting. It is an extremely difficult area but vital to get right. Very sujectivebut vital to get right. Very sujective

How reliable is the customer’s word as How reliable is the customer’s word as regards the details of the proposition and regards the details of the proposition and the promise repayment.the promise repayment.

Does the customer make exaggerated Does the customer make exaggerated claims that are far too optimistic.claims that are far too optimistic.

If the customer is new, why are we being If the customer is new, why are we being approached? Can bank statements be approached? Can bank statements be seen to assess the conduct of the account. seen to assess the conduct of the account.

Ability Ability This aspect relates to the borrower’s ability in This aspect relates to the borrower’s ability in

managing financial affairs and is similar to managing financial affairs and is similar to character as far as personal customers are character as far as personal customers are concerned. concerned.

Is there a good spread of skill and experience Is there a good spread of skill and experience among the management team in, for among the management team in, for example,production,marketing and finance.example,production,marketing and finance.

Does the management team hold relevant Does the management team hold relevant professional qualifications?professional qualifications?

Are they committed to making the company Are they committed to making the company successful?successful?

Where the finance is earmarked for a specific area Where the finance is earmarked for a specific area of activity, do they have the necessary experience of activity, do they have the necessary experience in that area.in that area.

MarginMargin

Agreement should be reached at Agreement should be reached at the outset with the borrower in the outset with the borrower in respect of interest margin. The respect of interest margin. The interest margin will be a reflection interest margin will be a reflection of the risk involved in the lending, of the risk involved in the lending, while commission and other fees while commission and other fees will be determined by the amount will be determined by the amount and complexity of the work and complexity of the work involved.involved.

PurposePurpose

The lender will want to verify the The lender will want to verify the purpose is acceptable. purpose is acceptable.

Customers sometimes overlook Customers sometimes overlook problems in their optimism and if the problems in their optimism and if the bank can bring a degree of realism bank can bring a degree of realism to the proposition at the outset, it to the proposition at the outset, it maybe more beneficial to the maybe more beneficial to the customer than agreeing to the customer than agreeing to the requested advance.requested advance.

AmountAmount

Is the customer asking for either too Is the customer asking for either too much or too little?.much or too little?.

There are dangers in both and it is There are dangers in both and it is important therefore to establish that important therefore to establish that the amount requested is correct and the amount requested is correct and that all incidental expenses have that all incidental expenses have been considered. The good been considered. The good borrower will have allowed for borrower will have allowed for contingencies. contingencies.

RepaymentRepayment

The real risk in lending is to be found in the The real risk in lending is to be found in the assessment of the repayment proposals. It assessment of the repayment proposals. It is important that the source of repayment is is important that the source of repayment is made quite clear at the outset and the made quite clear at the outset and the lender must establish the degree of lender must establish the degree of certainty that the promised funds will be certainty that the promised funds will be received.received.

Where the source of repayment is Where the source of repayment is income/cashflow, the lender will need income/cashflow, the lender will need projections to ensure that there are surplus projections to ensure that there are surplus funds to cover repayment after meeting funds to cover repayment after meeting other commitments. other commitments.

Insurance/Security Insurance/Security

Ideally the canons of good lending should Ideally the canons of good lending should be satisfied irrespective of available be satisfied irrespective of available security, but security is considered security, but security is considered necessary in case the repayment necessary in case the repayment proposals fail to materialise.proposals fail to materialise.

It is important that no advance is made It is important that no advance is made until security procedures have been until security procedures have been completed,or are at least at a stage where completed,or are at least at a stage where completion can take place without the completion can take place without the need to involve the borrower any further.need to involve the borrower any further.

EvaluationEvaluationA two stage approachA two stage approach An assessment of the feasibility of the An assessment of the feasibility of the

borrower’s plan for repayment. borrower’s plan for repayment. If the proposal in not viable, it is pointless to If the proposal in not viable, it is pointless to

continue. continue. A critical appraisal of what might realistically A critical appraisal of what might realistically

go wrong-the likelihood of such events go wrong-the likelihood of such events occurring and the effect on the bank’s position. occurring and the effect on the bank’s position.

the aim of this evaluation is to establish the the aim of this evaluation is to establish the risk involved. List the pros and cons of a risk involved. List the pros and cons of a proposition is often helpful. More reliance proposition is often helpful. More reliance should be placed on facts and evidence than should be placed on facts and evidence than on estimates and opinions. on estimates and opinions.

Modern approaches to Modern approaches to Credit risk Credit risk measurement.measurement. The measurement and management of The measurement and management of

credit risk have undergone a credit risk have undergone a revolution in recent years. revolution in recent years.

The advances in technology have The advances in technology have enabled financial engineers to try new enabled financial engineers to try new methods of model building and methods of model building and analysis for credit risk measurement. analysis for credit risk measurement.

Several factors have contributed to Several factors have contributed to this recent surge in technology-based this recent surge in technology-based analysis methods.analysis methods.

Cond..Cond..

Increased competition in the loan Increased competition in the loan market necessitated the development market necessitated the development of methods that are quicker more of methods that are quicker more accurate and more cost effective. accurate and more cost effective.

Consumer expectations have increased Consumer expectations have increased and most consumers now expect and most consumers now expect efficient loan approval from financial efficient loan approval from financial institutions. institutions.

Response TimeResponse Time - Where lending - Where lending institutions have been found to be a bit institutions have been found to be a bit tardy, consumers have shifted to other tardy, consumers have shifted to other institutions. institutions.

Cond..Cond..

Loyalty is less and less evident among Loyalty is less and less evident among consumers. Banks now need methods consumers. Banks now need methods of credit assessment that cater to the of credit assessment that cater to the changed customer needs. changed customer needs.

Also in recent years, bankruptcies and Also in recent years, bankruptcies and global competition have increased, so global competition have increased, so accurate credit analysis has become accurate credit analysis has become more important. more important.

The traditional system was based on The traditional system was based on expert knowledge only, requiring expert knowledge only, requiring expensive and extensive staff training.expensive and extensive staff training.

Risk Measurement

Systematic/Non Systematic risk Credit rating – project/retail/SME

etc Pricing Monitoring