Bk Lecture 4 Types of Credit

8/4/2019 Bk Lecture 4 Types of Credit

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Types of credit

Credit refers toShort Term Loans & Advances repayable within 3 yearsMEDIUM TERM LOAN Repayable in more than 3 years and lessthan 6 yearsLONG TERM LOAN Repayable in more than 6 yearsOff-Balance Sheet TransactionsRevolving Credit

Loans can be of two typesfund base & non-fund base:

FUND BASE includes:Working Capital

Term Loan NON-FUND BASE includes:Letter of CreditBank GuaranteeBill Discounting

Section 5 of B. R. Act defines secured and unsecured loansSecured Loans and advances made on security of assets

the market value of which is not at any time less than theamount of the loan or advancesUnsecured Means a loans or advance not so secured

Security taken as an insurance against unwarranted situations

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Securities for lending

Two types: Primary and CollateralPrimary Security Generally from a viable andprofessionally managed enterprise

Personal

Created by a duly executed promissory note,acceptance or endorsement of bill of exchange etc.

Gives bank the right of action to proceedagainst the borrower personally in the eventof default

Impersonal

Created by way of a charge (pledge,hypothecation, mortgage, assignment etc.)Collateral Security Meaning running parallel ortogether

Taken as additional and separate security Could be secured / unsecured guarantees, pledge

of shares and other securities, deposits of title

deeds etc. Used to reinforce the primary security (for e.g.

plantation advances are not considered fullysecured until crop is harvested)

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Difference between Loans

and Advances

Loans A loan is granted for a specific time period. Generally

commercial banks grant short-term loans. But term loans, thatis, loan for more than a year, may also be granted. The

borrower may withdraw the entire amount in lumpsum or ininstalments. However, interest is charged on the full amount ofloan. Loans are generally granted against the security ofcertain assets. A loan may be repaid either in lumpsum or ininstalments

Advances An advance is a credit facility provided by the bank to its

customers. It differs from loan in the sense that loans may be granted for

longer period, but advances are normally granted for a shortperiod of time.

Further the purpose of granting advances is to meet the dayto day requirements of business.

The rate of interest charged on advances varies from bank tobank.

Interest is charged only on the amount withdrawn and not onthe sanctioned amount

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Difference between Loansand Advances contd

Loans are extended in accounts in which nodrawings are permitted to the borrowers

Generally there is one debit to principal amountto loan account though disbursal in stages ispossible depending on the need of the borrower

For operational purposes loan can be credited toa special account where withdrawal from time totime can be done by the party depending uponhis requirements

In case of advances, the sanctioned limit isplaced at the disposal of the borrower, subjectto terms of sanction, in running accounts whichcan be drawn upon by cheques by the borrower

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Modes of short-term financialassistance

Cash Credit Cash credit is an arrangement whereby the bank allows the

borrower to draw amounts upto a specified limit. The amount is credited to the account of the customer.

The customer can withdraw this amount as and when he requires. Interest is charged on the amount actually withdrawn. Cash Credit is granted as per agreed terms and conditions with

the customers. Overdraft Overdraft is also a credit facility granted by bank. A customer who

has a current account with the bank is allowed to withdraw more

than the amount of credit balance in his account. It is a temporary arrangement. Overdraft facility with a specified

limit is allowed either on the security of assets, or on personalsecurity, or both.

Discounting of Bills Banks provide short-term finance by discounting bills, that is,

making payment of the amount before the due date of the billsafter deducting a certain rate of discount.

The party gets the funds without waiting for the date of maturity ofthe bills. In case any bill is dishonoured on the due date, the bankcan recover the amount from the customer.

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Working capital finance

A firm's working capital is the money it has available to meetcurrent obligations (those due in less than a year) and toacquire earning assets.

Banks offer corporations Working Capital Finance to meet

their operating expenses, purchasing inventory, receivablesfinancing, either by direct funding or by issuing letter of credit. Key Benefits Funded facilities, i.e. the bank provides funding and assistance

to actually purchase business assets or to meet businessexpenses.

Non-Funded facilities, i.e. the bank can issue letters of creditor can give a guarantee on behalf of the customer to thesuppliers, Government Departments for the procurement ofgoods and services on credit.

Available in both Indian as well as Foreign currency.

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Term loans

TERM LOANSAlso referred as Term Finance , represents a source ofdebt finance, which is generally repayable in more thanone year and less than ten years.

Employed to finance acquisition of Fixed Assets and WCmargins .Carry fixed interest rates , monthly or quarterly repaymentschedules and a set maturity date

A term loan is granted for the purpose ofcapital assets, such as purchase of land, construction of,buildings, purchase of machinery,modernization, renovation or rationalization of plant, &repayable from out of the future earning of the enterprise,

in installments, as per a prearranged schedule. Thus the following differences between a term loan & the

working capital credit afforded by the Bank are apparent:The purpose of the term loan is for acquisition of capitalassets.The term loan is an advance not repayable on demandbut only in installments ranging over a period of years.

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ADVANTAGES & DISADVANTAGES

OF TERM LOAN

Advantages:Cost of capital lower than cost of private equityand preference capital.

TL do not result in dilution of control.TL are preferred since they are backed bysecurity.

Disadvantages :TL do not carry voting rights.Generally do not represent negotiablesecurities.

Upon failure to repay or delay in paymentbeyond 1 years entails serious

consequences

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BASIC FEATURES

Generally maturity period is 6 to 10 years. In some casesgrace period of 2 year may be granted.

Borrower company or any of Directors should not violate Sec274 (1) (g) of CA

It avoids underwriting commission and other flotation costs. Provided on the basis of general agreement (Term Loan)

containing terms and conditions. Granted after detailed Project appraisal of the. Secured, specifically by the assets acquired using the term

loan funds. This is called Primary Security .

Generally also secured by company

s other F/A and C/A. Thisis called Secondary security. Some times, Promoters` Guarantee/their shareholdings are

given; called Collateral security. Fixed or Floating charge on assets of borrower company. Restrictive Covenants : usually put for monitoring of

deployment of funds: Asset-related covenants : Capital employed, minimum asset base, provision in AOA for

Nominee Directors Minimum Current Ratio to be maintained Not to dispose off Assets without lender s permission

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Basic Features (Contd.)

b . Liability related covenants: Restrained from incurring additional debt Repay existing loan; Acceptable D/E Ratio c. Cash-outflow related covenants : Restricting dividends outflow Restricting capital expenditures. Restricting salaries and perks of managerial staff, etc. d. Positive covenants : Furnishing of periodical reports/statements Maintenance of a min. level of working capital. Creation to sinking fund, and Maintenance of certain Net Worth

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Appraisal of Term Loans

Appraisal of term loan for, say, an industrial unit is a processcomprising several steps. There are four broad aspects ofappraisal, namely

Technical Feasibility - To determine the suitability of the

technology selected & the adequacy of the technicalinvestigation & design; Economic Feasibility - To ascertain the extent of profitability of

the project & its sufficiency in relation to the repaymentobligations pertaining to term assistance;

Financial Feasibility - To determine the accuracy of costestimates, suitability of the envisaged pattern of financing &

general soundness of the capital structure; & Managerial Competency To ascertain that competent men

are behind the project to ensure its successful implementation& efficient management after commencement of commercialproductio n.

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What do banks look for when makingdecisions about term loans?

Credit capacity. The bank will conduct a full credit analysis,including a detailed review of financial statements andpersonal finances to assess ability to repay.

Collateral. This is the primary source of repayment. Expect

the bank to want this source to be larger than the amount thatis borrowed Capital. What assets are owned that can be quickly turned

into cash if necessary? The bank wants to know what isowned outside of the business-bonds, stocks, apartmentbuildings-that might be an alternate repayment source. If thereis a loss, the company s assets are tapped first, not the

bank's. Or, as one astute businessman puts it, "Banks like tolend to people who already have money." Banks also take apersonal guarantee.

Comfort/confidence with the business plan. How accurateare the revenue and expense projections? Expect the bank tomake a detailed judgment. What is the condition of theeconomy and the industry--hot, warm or cold?

This can be summarized as:Capacity (ability to pay);Character (willingness to pay);Capital (wealth of borrower);Collateral (security, if necessary);Conditions (external, economic).

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NON-FUND BASE

LETTER OF CREDIT A Letter of Credit (LC) is an arrangement whereby a bank (the

issuing bank) acting at the request & on the instructions of thecustomer (the applicant) or on its own behalf, is to make apayment to or to the order of a third party (the beneficiary), or is toaccept & pay bills of exchange (drafts drawn by the beneficiary);or authorizes another bank to effect such payment, or to accept &pay such bills of exchanges (drafts); or authorizes another bank tonegotiate against stipulated document(s), provided that the terms& conditions of the credit are complied with.

Parties to the LC Applicant The buyer who applies for opening LC Beneficiary The seller who supplies goods Issuing Bank The Bank which opens the LC Advising Bank The Bank which advises the LC after confirming

authenticity Negotiating Bank The Bank which negotiates the documents Confirming Bank The Bank which adds its confirmation to the LC Reimbursing Bank The Bank which reimburses the LC amount to

negotiating bank Second beneficiary The additional beneficiary in case of

transferable LCs

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BANK GUARANTEES

A contract of guarantee is defined as a contract toperform the promise or discharge the liability of the thirdperson in case of the default . The parties to thecontract of guarantees are:

Applicant: The principal debtor person at whoserequest the guarantee is executed

Beneficiary: Person to whom the guarantee is given &who can enforce it in case of default.

Guarantee: The person who undertakes to dischargethe obligations of the applicant in case of his default.

Thus, guarantee is a collateral contract, consequentialto a main contract between the applicant & thebeneficiary.

Purpose of Bank Guarantees Bank Guarantees are used to for both both preventive

& remedial purposes. The guarantees executed bybanks comprises both performance guarantees &financial guarantees. The guarantees are structuredaccording to the terms of agreement, viz., security,maturity & purpose.

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Revolving credit

A line of credit where the customer pays a commitment feeand is then allowed to use the funds when they are needed. Itis usually used for operating purposes, fluctuating each monthdepending on the customer's current cash flow needs.

Revolving credit is a type of credit that does not have a fixednumber of payments, in contrast to installment credit. Examples of revolving credits used by consumers

include credit cards. Corporate revolving credit facilities aretypically used to provide liquidity for a company's day-to-dayoperations.

Revolving lines of credit can be taken out by both corporations

and individuals. The bank that is in agreement with thecustomer guarantees a maximum amount that can be loanedto the customer. Along with the commitment fee there are alsointerest expenses for corporate borrowers and carry forwardcharges for consumer accounts.

A revolving credit arrangement allows you to borrow up to yourcredit limit without having to reapply each time you need cash.As you repay the money you have borrowed, it is available tobe borrowed again.

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Characteristics

The borrower may use or withdraw funds up to apre-approved credit limit.

The amount of available credit decreases and

increases as funds are borrowed and then repaid. The credit may be used repeatedly. The borrower makes payments based only on the

amount they've actually used or withdrawn, plusinterest.

The borrower may repay over time (subject to anyminimum payment requirement), or in full at anytime.

In some cases, the borrower is required to pay afee to the lender for any money that is undrawnon the revolver; this is especially true of corporatebank loan revolving credit facilities.

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Loan Syndication

Syndication is an arrangement where a group of banks, which may nothave any other business relationship with the borrower, participate for asingle loan

There has been a sharp rise in loan off-take recently, with the creditgrowth being 25% higher than the previous year. As India Inc. goes on

a capital expenditure and expansion spree, the financial system iswitnessing a subtle change in the way credit is mopped up. More andmore corporates are looking at loan syndications - a commonphenomenon in the West.

"Syndication is an arrangement where a group of banks, which may nothave any other business relationship with the borrower, participate for asingle loan.

"A syndicated facility is a lending facility, defined by a single loanarrangement, in which several or many banks participate.

The standard theory for why banks join forces in a syndicate is riskdiversification. The banks in the syndicate share the risk of large,indivisible investment projects.

Syndicates may also arise because additional syndicate membersprovide informative opinions of investment projects or additionalexpertise after the funding has been extended.

Most syndicated loans are floaters, paying a spread over Libor, butother structures abound. Fixed-rate term loans, revolving lines of creditand even letters of credit are syndicated. Loans may be structuredspecifically to appeal to institutional investors. These might have twotranches:

a Tranch A structured as a typical bank loan, such as a floater or revolver,and offered to bank lenders, anda Tranch B structured as a fixed-rate term loan and offered to non-bank

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Loan syndication contd.

Traditionally, loan syndication was practiced in Europe. Euro syndicated loan is usually a

floating rate loan with fixed maturity,a fixed draw down period and

a specified repayment schedule. One, two or even three banks may act as lead managers and

distribute the loan among themselves and other participatingbanks.

One of the lead banks acts as the agent bank and administers theloan after execution, disbursing funds to the borrower, collectingand distributing interest payments and principal repayments

among lead banks, etc. A typical Euro credit would have maturity between 5 to 10 years,

amortization in semi-annual installments, and interest rate resetevery three or six months with reference to LIBOR.

Syndicated loans can be structured to incorporate various options,e.g.,

a drop lock feature converts the floating rate loan into a fixed

rate loan if the benchmark index hits a specified floor.A multi-currency option allows the borrower to switch thecurrency of denomination on a roll-over date.Security in the form of government guarantee or mortgage on

assets is required for borrowers in developing countries likeIndia.

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Some of the important roles inSyndicated Loans include

Arranger / Lead Manager : The lead manager is a bank that isawarded the mandate by the prospective borrower and isresponsible for placing the syndicated loan with the otherbanks and ensures that the syndication is fully subscribed.They are entitled to the arrangement fee and undergo areputation risk during this process.

Underwriting Bank : It is the bank that commits to supplyingthe funds to the borrower - if necessary from its own resourcesif the loan is not fully subscribed. The lead manager or anotherbank may play this role. Not all syndications are underwritten.The risk is that the loan may not be fully subscribed.

Participating Bank: This bank participates in the syndicationby lending a portion of the total amount required. It is entitledto receive the interest and the participation fee. But it,however, faces risks such as: -* Borrower credit risk* Passive approval and complacency

Facility Manager / Agent: This bank takes care of all the

administrative arrangements over the term of loan, e.g.,disbursements, repayments, compliance. This bank acts onbehalf of all the banks participating. This may be either thelead manger or the underwriting bank.

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Stages Involved in the Process

Premandate Phase : The prospective borrower mayliaise with a single bank or it may invite competitive bidsfrom a number of banks. The lead bank identifies theneeds of the borrower, designs an appropriate loan

structure, develops a persuasive credit proposal, andobtains internal approval. The mandate is created. Thedocumentation is created with the help of specialistlawyers.

Placing the Loan : The lead bank can start to sell theloan in the market place. The lead bank needs to

prepare an information memorandum, term sheet, andlegal documentation and approach selected banks andinvite participation. The lead manager carries out thenegotiations and controversies are ironed out. Thesyndication deal is closed, including signing of themandate.

Post Closure Phase : The agent now handles the day-to-day running of the loan facility.

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Advantages and disadvantages

Benefits of Loan Syndicatiors for Borrowers Syndicated loans provide borrowers with a more complete

menu of financing options. In effect, the syndication marketcompletes a continuum between traditional private bilateral

bank loans and publicly traded bond markets. This hasresulted in a more competitive corporate finance market,which has permitted issuers to achieve more market-orientedand cost-effective financing.

Disadvantages Managing multiple bank relationships is no small feat. Each

bank needs to come to an understanding of the business and

how its financial activities are conducted. A comfort level mustbe established on both sides of the transaction, which requirestime and effort. Negotiating a document with one bank cantake days. To negotiate documents with four to five banksseparately is a time-consuming, inefficient task. Staggeredmaturities must be monitored and orchestrated. Moreover,multiple lines require an inter-creditor agreement among the

banks, which takes additional time to negotiate.

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Indian transactions

A recent example has been the Rs. 1,300 crore loansyndication of Hutch done by ABN Amro, HSBC and StandardChartered for three years. The issue was underwritten by thethree banks equally and was thrown open for book building. Itwas pitched at a rate of 7.10%. However, on the back ofdemand from banks, the interest rate was brought down to7%. It was distributed among 10 banks.

Hindalco raised around Rs. 6,000 crores, which was lead-managed by IDBI Bank. The loan has tenure of 10 years witha reset after five years. It was priced at 5-year G Sec plus 65bps. Thirty banks participated in the issue.

The largest syndication deal in the market currently is ReliancePorts at around Rs. 4,200 crores. There are also two deals in the pharmaceutical sector for Rs.

1,000 crores each, and two in the telecom sector for aboveRs. 1,000 crores.

Also, Delhi-based DLF is looking at raising Rs. 1,000 croresfor 10 years. In India, most corporates in the market arelooking at raising money for Greenfield projects.

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Indian transactions contd.

The Housing Development Finance Corporation(HDFC) has signed a loan agreement for $200 millionwith International Finance Corporation (IFC), the privatesector development arm of the World Bank group. The

loan would be available to HDFC in two tranche - thefirst part of $100 million to be lent directly by IFC as amultilateral tranche, and the second part as asyndicated tranche, said a news release from thehousing finance company. The first tranche has bulletmaturity at the end of 8 years, the rate of interest being

six-month LIBOR plus 100 basis points. The secondtranche would be syndicated by IFC and would beplaced with leading international banks.

The main objective of the loan was broad-basing themedium-to-long-term funding sources for HDFC andalso to reduce the overall cost of funding. The proceeds

of the loan will be utilized for lending to individualsacross the country for residential housing. HDFC is inthe process of finalising suitable risk managementarrangements to hedge against foreign exchangefluctuations.

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Comparison

Bk Lecture 4 Types of Credit

Documents

Transcript of Bk Lecture 4 Types of Credit