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Financial System
Financial
Banks channel surplus money from the healthy sectors in the economy to weak sectors of the economy
Functions of Banks
Create assets out of surplus money Bears the risk of lending i.e. mitigates risk in the economy Ensures liquidity Lowers information cost
Get- Securities
Financial Intermediaries
Expertise of banks Comparison with similar or same industry is easier as banks have a store of information always Monitoring cash flow details by watching the account details Large loans at cheaper cost Diversification of assets over assets (loans)
Efficient lending practices development Results in good credit risk management Leads to minimum transaction cost Manage interest and exchange rate fluctuations Manage liquidity risk by managing mismatch in maturities of assets and liabilities
Demand side
Consumers
Supply side
Manufacturing,
Loan maturities, pricing, methods of principal payments etc. affects banks cash flows To keep up growth apart from credit growth additional funds are required which is obtained from securitization and offbalance lending arrangements off-balance lending arrangements include Underwriting services, letter of credit off-balance lending arrangements increases fee based income but also increases contingent liabilities
Types of lending
Mostly used for working capital needs Maturity 1 year or less WC needs arise from build up of inventories and other current assets Repayments occur when CA are converted to cash Seasonal lines of credit to seasonal businesses
a/c is maintained throughout year but amount is withdrawn during peak season Underlying assets are
Primary securities inventories, receivables and other CAs Collateral securities supports primary securities
for special purposes These are unsecured loans Loan amount is the amount in excess of WC needs of the firm Maturity of loan determined by bank repayment of principal and interest on maturity of loan The above is called bullet loan
Maturity of more than 1 year (3 to 5 yrs -10 yrs) Loan sanction is based on the firms future cash flows Loans are used for acquiring fixed assets, modernization of factory, diversification etc. Used as substitutes for equity and for permanent working capital needs Principal and interest payments term are based on companys cash flow status Collateral will be the assets for which fund is loaned
Revolving credits
Maturity of 1 year or more Its also is based on cash flow of the company Withdrawal from line of credit happens as and when requirement arise Its a secured loan based on future cash flow, current assets and credit worthiness of the borrower Its renewed automatically until the borrower closes down the account
Credit process
There should be optimum trade-off between loan portfolio target(of the bank) and loan quality
Constituents of the credit process Loan policy Aligns credit officers goal to the banks overall goal The document is approved by the board of directors Has procedures for appraising, sanctioning, granting, documenting and reviewing loans Business development and initial recommendations Happens through extensive market research and credit investigations Financial statements and credit reports of borrowers are extensively analysed
Credit Appraisal
Credit worthiness of borrower is checked Viability of the project is verified Risk mitigation plans of the company are analysed Bank analyses and measures the risks which it is exposed to plan accordingly the risk mitigation process Cannons of lending
5 Cs capacity, capital, collateral, conditions and character PARTS purpose, amount, repayment, terms, security CAMPARI character, ability, means, purpose, amount, repayment, insurance
Credit Analysis
Building the credit file Credit history of existing customers and building credit files for new customers Project finance appraisal Management/ operations of the company, market, industry activities are analysed and evaluated Financial Analysis Past financial statement and future projections Cash flow statements (shows liquidity state of the company through inventory and receivables position) Only tangible net worth is considered as owners equity Tangible Net worth = Net worth intangible assets
Credit Analysis
of the company is analysed by calculating the debt to equity ratio of the company. This differs for different industry. To apply for more debt, the owner must infuse more equity into the company to keep debt equity ration constant Cash flow projections are made to determine the debt servicing capacity of the borrower
Financial risk
Debt servicing capacity refers to repaying capacity of the borrower (both interest and principal)
Build scenarios to evaluate cash flow projections and calculate debt servicing capacity Ask for collateral if the risks are high
Credit Analysis
Qualitative Analysis
Due Diligence Check borrowers residence, work addresses, interview with people who knew the borrower, past credit history, contingent liabilities of borrower etc. Risk Assessment Identify internal/external risks that would affect companys cash flows, thereby affecting debt servicing capacity The above leads to loan pricing decisions Classification of risk helps to associate business with particular risk Making the recommendation Made by the credit officer (amount to disburse, interest, maturity etc.)
Representation
No
and warranties
misrepresentation of the above by the borrower. If o the loan agreement will become nullified and bank can take legal action
Affirmative covenants
Ensuring
fund usage Keeping financial ration healthy Proper record maintenance and reporting standards Right of inspection by the bank
Negative covenants
Limiting
capital expenditure, investments Restriction of additional liabilities, sale of assets, dividend pay outs, mergers etc.
Events of default Update of credit file and periodic follow up Credit review and monitoring
the transactions in the borrowers accounts External or internal audit teams (periodic/continuous)
Deficiencies uncovered
Repayment
cash flows Worst case scenario recalling the loans by liquidating assets
Loans for working capital Loans for capital expenditure and industrial credit Loan syndication Loans for agriculture Loans for infrastructure project finance Loans for consumers or retail lending Non-fund based credit