LENDING ACTIVITIES OF COMMERCIALS BANKS Samir K Mahajan

LENDING ACTIVITIES OF COMMERCIALS BANKS Samir K Mahajan

WHO NEEDS CREDIT ? q Industries and Business /Corporates q Agriculture Sector q Government Sector q Consumers of Goods And Services SOURCES OF CREDIT q Institutional Sources say commercial banks, financial institutions and others q Non-Institutional/ Traditional say money landers, land lords, relatives and others Samir K Mahajan

TYPE OF BANK LENDING q Fund Based Lending q Non-fund Based Lending q Asset Based Lending Samir K Mahajan

FUND-BASED LENDING Fund based lending results in physical outflow of funds (cash ) from bank to borrower. As such, the funds position of the lending bank gets affected. The fund based lending can be classified on tenure of loans. Fund-Based Lending and Tenure of Loans: The traditional distinction is q Short term loan q Long term loan/Term Loan Samir K Mahajan

SHORT TERM LOAN FUND-BASED LENDING contd Short-term loans are credits which mature within one year. Most of these loans are granted with the primary purpose of financing working capital need of the borrowers resulting from temporary build-up of inventories and receivables. In such case, repayment of loan would flow in out of conversion of current asset (inventories and receivables) to cash. Sometime seasonal loans are granted to borrower whose business is subject to sale cycles, and periodic peaking of inventories and other current assets. The amount of credit made available is based on the estimate of peak and non-peak asset funding requirements of the borrower. The borrowers draw upon the seasonal funds during the peak period of production to meet the seasonal demand repay the loan when inventories are liquidated and cash flow from sales starts. Samir K Mahajan

FUND-BASED LENDING contd SHORT TERM LOAN contd. Both working capital and seasonal loans are made as secured loans. The short term secured loans are based on the underlying (existing) strength of prime securities such as: inventories, receivables or book debts, and other current assets. Size of prime securities directly affect the amount that can be granted as loans. The other type of loans backing the loan payments are collateral securities. Further, there may be unsecured loans granted for ‘special purposes’ such as : unexpected/unusual increase in current assets or a temporary cash crunch in the borrowers funds. They fall outside the short-term working capital requirement of business. Such loans may be granted as ‘temporary ‘or ‘ad hoc’ loans. E. g. overdraft Short term loans also can be linked to short term consumer loans, working capital loans of agriculture ( i. e. Credit for purchase of inventories such as: seeds, fertiliser, pesticides etc). Samir K Mahajan

TERM LOAN FUND-BASED LENDING contd Term loans are those maturity period is more than one year. Term loans are standard commercial loan, often offered for major capital investment in business such as: o acquiring long term/fixed assets (i. e. assets which will benefit the borrower over a long period exceeding at least one year) such as: purchase of plants and machineries o construction of building for factory o funding of business expansion or setting of new projects o modernisation and diversification plan of the borrower o purchase of new business q Term loans can be provided for financing permanent working capital too. q Term loans also includes financing for purchase of automobiles, consumer durables, real estate, and creation of infrastructure, investment in land, purchase of agricultural equipment and machineries, and livestock etc. Samir K Mahajan

FUND-BASED LENDING contd TERM LOAN contd. ü Typically, loans are fully disbursed at inception, and principals and interests are repaid depending on the borrower’s capacity to generate cash flow. ü These loans often have fixed interest rates , and are sought to be repaid in fixed and pre-determined instalments say quarterly or monthly basis. ü Security for the term loans are banks’ claim on the assets purchased from the term loans. ü Bankers tend to classify term loans into two categories: intermediate and long-term loans. ü Intermediate-term loans usually run more than one years but less than five years, and are generally repaid in monthly instalments from a business's cash flow. ü Long-term loans have period of 5 years and more , and can run for as long as 10 or 20 years. Samir K Mahajan

NON-FUND BASED LENDING ü Most contingent liabilities of the banks such as: letters of credit and bank guarantee , more predominantly, fall under the category of non-fund based lending. ü There are no funds outflows for the banks at the time of entering into an agreement with a counterparty/third party on behalf of the bank’s customer. ü However such arrangements may crystallise into a fund-based advances for the bank if the customer fails to fulfil the terms of his contact with the counterparty. Samir K Mahajan

ASSET BASED LENDING Asset based lending is an emerging category of bank lending. Here, the banks look primarily to the earning capacity of the asset being financed, for serving its debt. In most cases, the bank will have little or no recourse to the borrowers. E. g. consortium advance, multiple banking arrangement, loan syndication ü Specialised lending practices such as: project finance fall under this category. Project finance is financing of long-term infrastructure, industrial project/asset, public services etc. ü Project finance comes from equity/funds from one or more sponsoring firms/companies, or issues of bonds by the project companies, and from bank in the form of no or limited recourse debt, syndicated loans. ü Project debt and equity used to finance the project are paid back from the cash flow generated by the project. Note: Non-recourse debt or a non-recourse loan is a secured loan (debt) backed by a pledge of collateral, typically real property say the asset of the project, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the collateral. Samir K Mahajan

MODE OF CREDIT DELIVERY/METHODS OF LENDING Purpose Security Mode of Credit Delivery Working Capital Inventory Cash Credit, Working Capital demand loan, overdraft, commercial paper, letter of credit Book Debt /sundry debtor Cash Credits Receivables Bills purchased/discounted – inland foreign Capital Requirement Capital Assets Term loans, Consortium advance, multiple banking arrangement, loan syndication Consumer loans Assets Purchased under loans, Short-term consumer loans, mortgage loans in case of housing , consumer durable loans Samir K Mahajan

MODE OF CREDIT DELIVERY/METHODS OF LENDING contd. OVERDRAFT Overdraft occurs when the customer / borrower is allowed to withdraw funds in excess of the balance standing in his bank account, or even when the available balance becomes nil or goes below zero. In all of these cases, the balance of the bank account enters the negative, and the account is said to be overdrawn. However, bank fixes a limit beyond which the borrower is not be able to overdraw the account. It is not purpose oriented as in case of cash credit where in loans is advanced for operating expenses. Legally, overdraft is a demand assistance given by the bank, and is given for a very short period of time at the end of which the borrower is liable to repay the excess amount withdrawn and interest there in. The bank may allow overdraft in case of urgent credit need or cash crunch of the borrower against a collateral (say, pledging of Mutual Fund, KVP and other paper securities) or personal guarantee. Samir K Mahajan

CASH CREDIT MODE OF CREDIT DELIVERY/METHODS OF LENDING contd. A cash credit is a short-term cash loan to businesses to finance their "working capital" requirements. Under this, the bank guarantees a maximum amount that can be loaned on demand from the borrower. The borrower need not withdraw full cash credit limit in one instalment. The borrower is also under no obligation to actually take out a loan at any particular time. He can avail the facility according to his requirement subject to the condition that the total amount availed does not exceed the maximum credit limit. Interest is charged only on the amount utilised by the borrower. The bank also levies a minimum interest charge/ commitment charge on the amount not withdrawn. Cash credit is backed by prime securities and other current assets such as book debts and account receivables. The borrower can draw from the cash credit account on for operating expenses, and deposits the cash inflow when sales occur. The cash credit account is similar to current accounts as it is a running account (i. e. , payable on demand) with cheque book facility. But unlike ordinary current accounts, which are supposed to be overdrawn only occasionally, the cash credit account is supposed to be overdrawn almost continuously. The extent of overdrawing is limited to the cash credit limit that the bank sanctioned. Samir K Mahajan

BILLS PURCHASED/DISCOUNTED Bill discount is a short term credit facilities intended to provide current working capital to business. Under this method, the bank advances the loans on the security of bill of exchange after deducting a certain percentage technically known as discount from the true value of the bill concerned. In addition to advancing cash loans by discounting bill of exchange, a banker can purchase the bill outright and pay face value less bank charge. Purchase of bill are normally confined to bills payable on demand. A genuine commercial bill of exchange is self-liquating paper since it liquidates automatically out of the sale of goods covered by such bills. Samir K Mahajan

MODE OF CREDIT DELIVERY/METHODS OF LENDING contd. LOAN SYNDICATION AND CONSORTIUM Loan Syndication and Consortium finance are resorted to when a client/borrower needs a huge sum of capital that may either be too large for a single lender to provide for, or may be outside the scope of a lender’s risk exposure levels. In such situation, multiple lenders will work together to provide the borrower with the capital needed at appropriate rates agreed upon by the lenders. Such loans are common in mergers, acquisitions and buyouts where borrowers often need very large sums of capital to complete a transaction and often more than a single lender is able or willing to provide. Loan syndication and consortium finance spread the risk of a borrower’s default across multiple lenders. However, both these mode of lending have slight different approaches. Samir K Mahajan

MODE OF CREDIT DELIVERY/METHODS OF LENDING contd. Loan Syndication: Mainly used in extremely large loan situations, loan syndication is arranged by a lead bank or underwriter called agent or arranger which finalises terms, conditions of a loan with the corporate borrower. Thereafter, the bank approaches other banks and financial institutions for "selling" of this loan. The other banks, if agree, "purchase" a part of the loan on the same or different terms and conditions. Thus a group of lenders/banks (called a syndicate) jointly make a loan to a single borrower such that every syndicate member has a separate claim on the debtor (the borrower). Thus, risk of loan default is shared among the lenders. However, loan syndication allows any one lender to provide a large loan while maintaining maintain more prudent and manageable credit exposure. Samir K Mahajan

MODE OF CREDIT DELIVERY/METHODS OF LENDING contd. Consortium Finance: Under consortium financing, a single borrower approaches different lenders to finance a project and in response to that several banks (or financial institutions) come forward to finance the single borrower with common appraisal, common documentation, joint supervision, and follow-up exercises. Among the group of banks, one bank may act leader (called lead bank) which processes the loan application and gets concurrence or consent of other member banks and financial institutions. Usually, the bank or financing institution that sanctions maximum share of loan takes up the role of lead institution/bank. Such consortium/groups finance enables participating bank to experience and expertise but follow uniform approach in lending. share risk in lending, share the Samir K Mahajan

MODE OF CREDIT DELIVERY/METHODS OF LENDING contd. MULTIPLE BANKING In multiple banking, borrower approaches multiple banks to finance the entire requirement of funds, and different banks provide finance and different banking facilities to the single borrower without having a common arrangement and understanding between the lenders. Each bank deals independently with borrower with respect to documentation, monitoring and supervision of each one’s loan. Thus, borrower deals with all financing banks individually. To avoid frauds and duplicate lending, at the time of granting fresh advance, banks must obtain declaration from the borrower about credit facility already enjoyed from other banks. Samir K Mahajan

LEGAL ASPECT OF LENDING On legal aspect, loans and advances may be categorised q Secured by collateral q Unsecured q Covered by bank guarantees Samir K Mahajan

LEGAL ASPECT OF LENDING contd. q Unsecured loans don’t have asset for collateral. These loans may be more difficult to get and have higher interest rates. Unsecured loans rely solely on your credit history and your income to qualify you for the loan. If you default on an unsecured loan, the lender has to exhaust collection options including debt collectors and lawsuit to recover the loan. q Guarantees of Government or Other Banks or Agencies A notable exception is those loans covered by guarantees of government, or other banks or agencies such as : ECGC (Export Credit Guarantee Corporation of India Limited), DICGC (Deposit Insurance and Credit Guarantee Corporation ). These loans are not considered unsecured after guarantee. q Secured Loans Secured loans are loans that rely on assets (current or fixed) of the enterprise, property of households as collateral for the loan. In the event of loan default, the lender can take possession of the asset and use it to cover the loan. Interest rates for secured loans may be lower than those for unsecured loans. The asset may need to be appraised before a can borrow a secured loan. Samir K Mahajan

Forms of Secured Loans Secured loan take the following forms: o Pledge o Hypothecation o Mortgage Samir K Mahajan

LEGAL ASPECT OF LENDING contd. Pledge: In other words, pledge is a contact in which the lender (pledgee) takes actual possession of assets (i. e. certificates, goods ) as security /collateral for a loan by borrower (pledger ) while advancing a loan. The lender retains the possession of pledged asset until the borrower repays the entire debt amount. A pledged asset is returned to the borrower when all conditions of the debt have be satisfied. ‘ The lender does not have ownership unless default occurs. In case there is default by the borrower, the lender has a right to sell the goods in his possession, and adjust its proceeds towards the amount due (i. e. principal and interest amount). Pledge assets may be are gold and jewellery, stock etc. Samir K Mahajan

LEGAL ASPECT OF LENDING contd. Hypothecation is used for creating charge against the security of movable assets but here the possession of the security remains with the borrower itself. Thus, in case of default by the borrower, the lender (i. e. to whom the goods / security has been hypothecated) will have to first take possession of the security , and then sell the same in order to adjust it to the amount due (principal and interests). Hypothecation is mortgage against movable property. In mortgage, there is transfer of interest of movable property from borrower (mortgagor) to lender( mortgagee). The best example of this type of arrangement are Car Loans. In this case Car / Vehicle remains with the borrower but the same is hypothecated to the bank / financer. In case the borrower, defaults, banks take possession of the vehicle after giving notice, and then sell the same and credit the proceeds to the loan account. Note: charge here is used to describe any form of security for debt of borrower. Charge gives right to the lender to sell asset and appropriate the sale value to amount due in case of any default. Samir K Mahajan

LEGAL ASPECT OF LENDING contd. Mortgage is used for creating charge against immovable property but here the possession of the security remains with the borrower itself. In mortgage, there is transfer of interest of immovable property from lender (mortgagor) to borrower ( mortgagee). Mortgage includes collaterals such as: land, buildings or anything that is attached to the earth or permanently fastened to anything attached to the earth (However, it does not include growing crops or grass as they can be easily detached from the earth). The best example when mortgage is created is when someone takes a housing loan / home loan. In this case house is mortgaged in favour of the bank / financer but remains in possession of the borrower which he uses for himself or even may give on rent. Note: Transfer of interest differ from sale where there is transfer of ownership. Transfer implies that only some rights of the owner of property is transferred to lender, and some rights are retained with the owners. Once the amount/debt due is cleared, the interest of the property is fully retained by the owners. Samir K Mahajan

LEGAL ASPECT OF LENDING contd. Difference Between Pledge, Hypothecation and Mortgage at a Glance Point of Difference Pledge Hypothecation Mortgage Type of Security Movable Immovable Possession of the security Remains with lender (pledgee) Remains with Borrower Usually Remains with Borrower Car / Vehicle Loans, Advance against stock and debtors Housing Loans Examples of Loan where used Gold Loan, Advance against NSCs, Advance against goods (also given under hypothecation) Samir K Mahajan