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Credit Analysis
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Prime Lending Rate and Bank
Credit What is the Benchmark Prime Lending Rate
(BPLR)? The benchmark lending rate of a bank to be followed
uniformly across all the branches
Can there be multiple PLRs? No. Since all lending rates can be determined with
reference to the Benchmark PLR by taking into
account term premia and/or risk premia, there is noneed for multiple BPLRs. These premia can befactored in to the spread over or below the BPLR.
Source: RBI
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Prime Lending Rate and Bank
Credit Can there be sub-PLR lending?
Yes. Banks are free to fix Benchmark Prime LendingRate (BPLR) for credit limits over Rs.2 lakhs with theapproval of their respective Boards.
Can the banks lend at fixed rate? Yes. Subject to the conformity with Asset Liability
guidelines
Can there be lending without any reference toPLR? Yes in specific cases loans for consumer durables,
loans against shares and debentures, billsdiscounting, finance granted to specifiedintermediary agencies etc.
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Core CreditProducts
Cash Credit A short term cash loan to a company to
meet the working capital requirement
How is it different from ordinary loan? From marketing point of view it is a joint
product: loan and current account bundled intoone product.
Customer is sanctioned a credit limit and he cankeep drawing and depositing cheques in cashcredit account.
It is more or less a permanent loan.
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Contd.. Legal enforcement is quite weak in case of
cash credit.
Pricing
Usually based on the credit rating of thecompany ranging from prime lending rateupwards.
Interest is charged on the consumedamount.
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Core Credit product Export Credit
Banks grant export credit on to meet all the financialrequirements of exporters
Pre-shipment/Packing credit, Post-shipment credit Exporters having firm export orders or confirmed
L/C from a recognized Bank can avail the exportcredit facilities provided they satisfy the requiredcredit norms.
Rupee export credit is usually available for amaximum period of 180- days from the date of firstdisbursement (can vary from bank to bank)
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Core Credit product Export Bill Rediscounting
Banks also offer financing of export by wayof discounting of export bills to provide post
shipment finance to the exporters atcompetitive international rate of interest.
The export bills can be purchased/discounted provided they comply with the
norms of the Bank/ RBI. Pricing of Export Credit
LIBOR linked and market determined.
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Core CreditProduct
Foreign Currency Loans
External commercial lending
LIBOR linked
Retail Lending Housing
Auto
Personal loan etc.
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Other CreditProducts
Letters of Credit
A payment undertaking given by a bank
(issuing bank) on behalf of a buyer(applicant) to pay a seller (beneficiary) for agiven amount of money on presentation ofspecified documents representing the supplyof goods within specified time limits.
How does it work?
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How does an LC work?
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Contd..
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Other CreditProducts
Bank Guarantees Bank provides a guarantee on behalf of the customer
that liabilities will be met
Primary liability lies with the customer. Advances against shares and debentures
Shares/ debentures/ bonds accepted by banks assecurity for loans/ advances should be valued at theprevailing market prices.
A uniform margin of50% has been stipulated for alladvances against shares/ debentures.
Others
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Credit AppraisalP
rocess Approaches to Credit Evaluation
Five C principle
Financial statements Scoring model
Altmans Z score model
Credit rating
J P Morgans CreditMetricsTM
Market models
Moodys-KMV model
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Five CP
rinciple Character
Reputation of the firm, repayment history - age ofthe firm a good proxy
Capital Leverage
Capacity Volatility of borrowers earnings
Collateral
Cycle or Economic conditions Cyclic vs. non-cyclic industries
A subjective model of credit analysis
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Credit ScoringM
odels Altmans Z score
Where, X1 = working capital/total asset ratio X2 = retained earnings/total assets ratio
X3 = EBIT/total assets ratio
X4 = market value of equity/book value of total
liabilities ratio X5 = sales/total assets ratio
543210.16.03.34.12.1 XXXXXZ !
1.81 2.81
Z Score
Bankrupt firm Stable firm
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Why do the Conventional
Techniques Fail? Not really! Rather they are increasingly getting
less relevant vis--vis Basel framework. Why? Basel regulations require the banks quantify the
credit risk/default risk which is not possible in any ofthese models.
Stability of Z-score model is doubtful (though it isstill used in banks as an Early Warning System,refer to ICICI Bank study)
Quantification of credit risk is only possible by somequantitative model of credit risk such as Creditrating.
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Credit Rating vis--vis Basel IIThe Transition Matrix
Transition matrix: probabilities of credit rating migrating from one
rating quality to another, within one year.
Initial Rating at year-end (%)
Rating AAA AA A BBB BB B CCC Default
AAA 90.81 8.33 0.68 0.06 0.12 0 0 0
AA 0.70 90.65 7.79 0.64 0.06 0.14 0.02 0
A 0.09 2.27 91.05 5.52 0.74 0.26 0.01 0.06
BBB 0.02 0.33 5.95 86.93 5.30 1.17 1.12 0.18
BB 0.03 0.14 0.67 7.73 80.53 8.84 1.00 1.06
B 0 0.11 0.24 0.43 6.48 83.46 4.07 5.20
CCC 0.22 0 0.22 1.30 2.38 11.24 64.86 19.79
Source: Standard & Poor
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Prototype Risk RatingProcess
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P
rototype Risk RatingP
rocess Two-tier rating system:
Obligor rating
represents probability of default by a borrowerFacility rating
represents expected loss of principal and/orinterest
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Prototype System: 9 Step Process
5 steps associated with obligor rating Financial assessment
Quality of management
Borrowers absolute and relative position within theindustry
Quality of financial information
Country risk
4 steps associated with facility rating
Examining third party support Factoring in the maturity of the transaction
Review of the structure of the transaction
Assessment of the collateral
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P
rototype Risk RatingP
rocess
TransactionStructure
Collateral
Maturity of
Transaction
Third Party Support
Managerial Capability,Competitive Position
Quality of Financial Information, Country Risk
Financial Assessment
(Floor)
Obligor
Rating
Facility
Rating
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1.Financial Assessment Ratings reflect:
Financial position, performance and trends
Ability of borrower to withstand unexpectedfinancial setbacks
leverage
Access to the capital markets
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1.Financial AssessmentC
ontd.. Key financial ratios include three main
assessment areas: 1. Earnings /cash flows
2. Asset values/ Liquidity/Leverage
3. Financial size & Flexibility/Debt capacity
Need to: adjust key ratios for cyclical effect
weight current years performance relative to prioryears performance
benchmark results against other firms in the sameindustry group
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24The 3 componentsofthe financialassessmentindicate average performance with
riskratingsof6,3, and 5.5 foranaverage of5 (14.5/3 =4.83, roundedto 5)
Step
# RiskFactors
Adjusted
Obligor
Rating
Earnings/Cash Flow 6
Asset Values/Liquidity/Leverage 31.
Financial
Assessment
Financial Size & Flexibility/Debtcapacity
RiskRating
5.5 5.0
1.Financial AssessmentC
ontd..On a risk rating scale of say, 1 - 9, Rate theobligor for each of the 3 assessment areas:
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1.Financial Assessment Contd..
Validate against industry financial ratios
Example:
A. Earnings / Cash flow (solvency) EBIT / interest expense = 1.3 (interest coverage) (corresponds to a risk rating of B+/B, i.e. risk rating= 6)
B. Liquidity Current ratio = 2.4 (corresponds to a risk rating of say A, i.e. risk rating=3)
C. Leverage => Debt Capacity Total debt / capitalization = 60 (corresponds to a risk rating of BB-, i.e. risk rating=5.5)
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Riskrating Earnings (E)/Cashflow (CF)
Asset Values (AV)/
Liquidity (LIQ)/
Leverage (LEV)
Financial Size (FS) &
Flexibility (F)/
Debt Capacity (DC)
5 adequate earningsand
cashflow with additional
coverage
positive trends, butmaynot have been entirely
stable inthe past
assetsofaverage quality
with possible reliance on
intangibles
satisfactory workingcapitalwith adequate leeway
average leverage
tenorofliabilitiestoassets
maybe slightlymismatched
Marketaccesslimitedtoabilityto
attract high-yielddebt
approachinginvestmentgrade
(rated BB+) bankdebt easilyrefinancedby
otherFIs with agoodincrease
available
Implications for Risk rating 5 in the example:
1.Financial AssessmentC
ontd..
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2
. Quality ofM
anagement Factors (mostly subjective)
Experience
Succession planning
day-to-day account operation
environmental assessment
effect of contingencies
etc.
Note: use these factors to adjust obligor ratingdownwards:
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0.5
-
-
-
-
Day-to-DayAccountOperation
Management
Environmental
Contingencies
OtherFactors
Monthlyfinancialstatementinformationisconstantlylate andofpoorqualityanda 0.5
downgrade appliesto day-to-dayaccountoperation. The obligorratingisadjusted 5.5 from 5.
Step
# RiskFactors
Adjusted
Obligor
Rating
2. Management/Qualitative
Down-
Grade by
5.5
2. Quality ofManagement Contd
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3.Industry Review Industry Rating (A)
Competitiveness
Trade environment
Regulatory framework
Restructuring
Technological change
Financial
Performance
Long term trends
Vulnerability to macroeconomic environment
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3.Industry Review
C
ontd Tier Assessment - Relative position within
industry (B)
relevant market sharecustomer base
cost structure
response to environmental changes
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Industryrating1 2 3 4 5
Tier
Assessment
Within
Industry
Tier1
Tier2
Tier3
Tier4
Bestpossible obligorrating(giveninitialindustryandtierratings)Example:
3.Industry Review
C
ontd
No
adjustment
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With Industryratinga 3, anda Tier2customerwith agoodshare ofthe relevant
marketshare, andanaverage coststructure, the bestpossible ratingisa 4. In
thiscase, there isno effectonthe obligorrating.
Step
# RiskFactors
Adjusted
Obligor
Rating
IndustryRating (1-5)
TierAssessment (1-4)
3. Industry/TierPosition
4 5.5
3
2
Best
Possible
3.Industry Review Contd
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4.Financial Statement
Quality
Factors
Auditors report
Accountants review
Internally prepared statements
etc.
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The annualstatementisauditedforabestpossible ratingof1
with nochange tothe ObligorRating
Step
# RiskFactors
Adjusted
Obligor
Rating
4. 1 5.5
Best
Possible
Financial Statement
Quality
Statement Type AUDIT
4.Financial Statement QualityContd
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5.Country Risk
Factors
Inability of a counterparty or obligor to payits obligations due to:
cross-border restrictions
convertibility and
availability of a given currency.
P
olitical and legal risk of a country
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Divisioncountryratings
Adjustmenttoobligorrating
(illustrative only)
Excellent, Very Good,
GoodorSatisfactoryNone
Fair Bestpossible obligorratingis 5
SelectivelyAcceptable
Marginal/Deteriorating
Bestpossible obligorratingis 6
Bestpossible obligorratingis 7
5.Country Risk Contd
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Asthe countryis India, there isno effectonthe ratingleavingthe final
obligorRatingat 5.5
Step
# RiskFactors
AdjustedObligor
Rating
5.
5.5
CountryRisk
(ifotherthan India)
Country
FIN
AL OBLIGORRATIN
G 5.5COMMENTS:
5.Country Risk Contd
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Facility Rating: Third Party Support(6)
Type of guarantee
Clean guarantee
Comfort letterCompletion guarantee
First Charge
Keepwell agreement
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A 100 % cleanguarantee isprovidedbyariskrated 4 client. The clientdoes
notprovide securitytootherlendersandthe positionisnotsubordinated.
Therefore the ratingisimprovedto 4.
FACILITY 1 TYPE: TERM AMOUNT: Final
Obligor
Rating
Adjusted
Facility
Rating
TypeThird Party
Support
5.5
46.
Facility Rating: Third Party Support(6) Contd
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Facility Rating: Term to Maturity(7)
Term to maturity of the facility
Increased risk in longer term facilities
Decreased risk for very short-term facilities
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The facilityisan 8-yeartermloanresultinginadowngrade froma 4 toa 5.
FACILITY 1 TYPE: TERM AMOUNT: FinalObligor
Rating
Adjusted
Facility
Rating
Term
5.5
5.07.
Facility Rating: Term to Maturity(7) Contd
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Facility Rating: Facility Structure(8)
Facility Structure
Covenants/Term
Repayment/AmortizationSeniority of loans
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Facility Rating: Facility Structure(8) Contd
Covenants: Covenants are in place whicheffectively mitigate all (or part) of any
increased risk due to term, by means ofdefault clauses that provide a fullopportunity to make demands, or bymeans of repayment arrangements that
ensure rapid pay-down ACTION: Upgrade only to offset (possibly
partially) any downgrade for term
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Facility Rating: Facility Structure(8) Contd
Subordinated/Loans security: The banks loan issubordinated, putting ones position and/or securitysignificantly behind other creditors
ACTION: Downgrade
Corporate organization: The borrower is highly cashflow dependent on related operating companiesthat have their own financing
ACTION: Downgrade
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Repaymentis wellaheadofschedule due toanunexpectedprincipal
reductionthatpartiallyoffsetsthe downgrade instep 7 resultinginan
upgrade of0.5 toaratingof4.5
FACILITY 1 TYPE: TERM AMOUNT: Final
ObligorRating
Adjusted
Facility
Rating
Structure
5.5
4.50.58. Upgrade
Facility Rating: Facility Structure(8) Contd
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Facility Rating: Collateral (9)
Collateral
Pledged assets are of very high caliber(generally no reliance on inventory) andprovide substantial over-coverage (usingconservative valuations, with liquidationappraisals held where warranted).
Background support also adds strength.
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Strongsecurity. Afirstcharge is heldoverallcompanyassetsincludingstate ofthe art
commercialbuildings. Upgrade by 0.5 toafinalfacilityratingof4
FACILITY 1 TYPE: TERM AMOUNT: Final
Obligor
Rating
Adjusted
Facility
Rating
Collateral Category
5.5
4.0.59. Upgrade
4.0FINAL FACILITY RATING
COMMENTS:
Facility Rating: Collateral (9)Contd
Back
ground
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Appendix
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Appendix
Letters of Credit
Bills discounting
Comfort letter Keep well agreement
Pre-shipment credit
Post-shipment credit
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Letters of Credit
Beneficiary The beneficiary is entitled to payment as long as he
can provide the documentary evidence required bythe letter of credit. The letter of credit is a distinct
and separate transaction from the contract on whichit is based. All parties deal in documents and not ingoods. The issuing bank's obligation to the buyer, isto examine all documents to insure that they meetall the terms and conditions of the credit. Uponrequesting demand for payment the beneficiarywarrants that all conditions of the agreement havebeen complied with. If the beneficiary (seller)conforms to the letter of credit, the seller must bepaid by the bank.
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Letters of Credit
Issuing bank The issuing bank's liability to pay and to be
reimbursed from its customer becomes absoluteupon the completion of the terms and conditions ofthe letter of credit.
The issuing banks' role is to provide a guarantee tothe seller that if compliant documents are presented,the bank will pay the seller the amount due and to
examine the documents, and only pay if thesedocuments comply with the terms and conditions setout in the letter of credit.
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Letters of Credit
Advising/Confirming bank An advising bank, usually a foreign correspondent
bank of the issuing bank will advise the beneficiary.
Generally, the beneficiary would want to use a localbank to insure that the letter of credit is valid. Inaddition, the advising bank would be responsible forsending the documents to the issuing bank. Theadvising bank has no other obligation under the
letter of credit. If the issuing bank does not pay thebeneficiary, the advising bank is not obligated topay.
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Letters of Credit
Negotiability
Letters of credit are usually negotiable. Theissuing bank is obligated to pay not only thebeneficiary, but also any bank nominated bythe beneficiary. Negotiable instruments arepassed freely from one party to anotheralmost in the same way as money. To be
negotiable, the letter of credit must includean unconditional promise to pay, on demandor at a definite time.
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Bills Discounting
Discounting with recourse
Discounting with recourse is the discountingof bills of exchange, when a risk of theissuer of the bill is run by the company: ifthe bill is not paid at maturity, the bankreceives the amount thereof from thecompany which had discounted the bill of
exchange.
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Bills Discounting
Discounting without recourse
Discounting without recourse is a straightsale of customer receivables, wherein thebank has no recourse to its customer if thebill remains unpaid at maturity.
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Comfort Letters
Usually, a letter issued to a lendinginstitution by a parent company/bankacknowledging the approval of asubsidiary company's attempt forfinancing.
See the sample comfort letter issued by a
bank.
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Keep well Agreements
Usually, a contract between a parentcompany and its subsidiary to maintainsolvency and financial backingthroughout the term set in theagreement.
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Pre-shipment Credit
Banks offer pre-shipment credit toexporters by way of packing credit,enabling them to finance operations likepurchase/import of raw materials orprocessing and packing of export goods.Exporters can avail of this pre-shipment
credit either in rupees or foreigncurrency.
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Post-Shipment Credit
Banks offer post-shipment credit to exporters,helping them finance export sales receivablefor the time lag between shipment of goodsand date of realization of export proceeds.
Exporters can avail of the following services: Negotiation/ payment/ acceptance of export
documents under letter of credit Purchase/ discount of export documents under
confirmed orders/export contracts etc.
Advances against export bills sent on collection Exporters can avail of this credit either in
rupees or in foreign currency.
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