Chapter 1

Introduction

Credit rating:

A credit rating is an assessment of the creditworthiness of a borrower in general

terms or with respect to a particular debt or financial obligation. A credit rating can be assigned
to any entity that seeks to borrow money — an individual, corporation, state or provincial
authority, or sovereign government. Credit assessment and evaluation for companies and
governments is generally done by a credit rating agency such as Standard & Poor’s (S&P),
Moody’s, or Fitch. These rating agencies are paid by the entity that is seeking a credit rating for
itself or for one of its debt issues.

Bank Loan Rating:

Bank loan rating from external agencies are used by Banks, Vendors, Financial
Institutions, Investors and others to gauge the financial health of an Enterprise and its ability to
make timely payment of its bank loan, including principal and interest payment. Various external
credit rating agencies like CRISIL, ICRA, CARE, Brickworks and others have been authorized
by the Government to rate the bank loan facilities enjoyed by businesses in India. Further, to
improve awareness about credit rating and its benefit, the Government of India also provides a
subsidy for MSME businesses to obtain SME credit rating.

Funded facilities:

Working Capital Loans

– They are generally of short duration (< 1 year). The duration may be longer if the
working capital gestation period is longer e.g. Boeing.

Overdraft Facility

- Revolving loans against current account are called overdrafts or ODs which are
unsecured in nature. The borrower can overdraw funds beyond available balance upto an agreed
limit. Interest is payable only on the money used for the duration of withdrawal compounded
daily. In some countries, a commitment fee is levied on the unutilized limits. ODs are not good
for the banker since it is difficult to control the end use of funds, ensure repayment & there are
high administrative costs. ODs affect the bank's liquidity.

Cash Credit (CC) Facility

– A bank assesses the average value of inventory & receivables of a business.

Based on these assets as security, a bank issues 60-70% of asset value as limit on cash credit
facility. Just like an OD, borrower can draw on this limit. The buffer of 30-40% which is kept by
the bank is called Margin. The riskier the asset, the higher the margin. The interest on CC is
usually linked to a benchmark rate & decided periodically. CC is secured in nature unlike OD
which is unsecured in nature.

Working Capital Demand Loans (WCDL)

– This is a short term revolving loan facility given for the working capital
requirement of the company. A bank will quote a rate on WCDL depending on its current cost of
funds to which the customer must agree. WCDL limit is fixed but the borrower must negotiate
the rate with bank every time he borrows. WCDL is more common with medium & large
companies which have large working capital requirements unlike CC which is common with
small companies. Banks prefer WCDL more than CC since they have more control over the
terms & interest rates which is useful in an environment where interest rates are fluctuating. A
working capital loan is a loan that has the purpose of financing the everyday operations of a
company. Working capital loans are not used to buy long-term assets or investments and are
instead used to cover accounts payable, wages, etc. Companies that have high seasonality or
cyclical sales cycles usually rely on working capital loans to help with periods of reduced
business activity. Working capital is the cash available to finance a company's short-term
operational needs. However, sometimes a company does not have the adequate cash on hand or
asset liquidity to cover daily operational expenses. Therefore, working capital loans are simple
corporate debt borrowings that are used by a company to finance its daily operations.

Term Loan:

A term loan is a monetary loan that is repaid in regular payments over a set period of
time. Term loans usually last between one and ten years, but may last as long as 30 years in some
cases. A term loan usually involves an unfixed interest rate that will add additional balance to be
repaid.

Long term loans

– Banks provide these long term loans to finance expansions, buy real estate or
machinery.

Trade Finance

- Corporate banking facilitates international trade. Banks provide loans to the

seller to bridge his funding requirements till he gets paid. This is similar to a working capital
loan.

Pre-shipment loans

– This is working capital for purchasing raw materials, processing & packaging of
export commodities. Most common form is packing credit where the exporter gets concessional
interest rates.

Post-shipment loans

– These loans help exporters bridge their funding requirements when they export
on deferred payment basis i.e. credit.

Bill Discounting is an example. It provides liquidity to the exporter. The bank will discount the
trade bill which is accepted & endorsed to the bank by the buyer. The bank will advance the
exporter a portion of the face value of trade bill.

Forfaiting is the process when exporter has an agreement with the bank to discount his entire
medium term receivables (not a single bill but all his bills).

Factoring is the process when exporter has an agreement with the bank to discount his entire
short term receivables (not a single bill but all his bills).Bill discounting & factoring can also
happen for domestic transactions. Bank has recourse to the seller since in case of non-payment
by the buyer after credit period expiration; the seller must compensate the bank. Bill discounting
is always with recourse. In factoring, a bank can discount bills with/without recourse & even
with partial recourse. This is called Assignment of Receivables.
Non-Funded Facilities:

Trade Finance

Intermediaries

– Banks can act as intermediaries for documents & funds flow in international
transactions as transfer through banks is more secure. International trade payment mechanisms.

Letter of credit

– It is also called Documentary Credit (DC). The bank lends its guarantee of
payment to the buyer. The bank also guarantees payment to the seller provided he ships the
goods & complies with the terms of agreement. Here seller takes credit risk on the bank instead
of buyer. The importer gets credit from the bank & doesn’t have to make advance payment.

Cash in advance

– Buyer pays seller before shipment of goods. This is most advantageous to the
seller & least advantageous to the buyer.

Open account or credit

– This means that payment is made on an agreed upon future date. This is very
risky for a seller unless he has very strong relationship with the buyer or the buyer has excellent
credit rating. There are no guarantees & collecting payment often becomes a tedious affair.

Cash Management Services (CMS)

– It has no credit risk for the bank. It is a pure administrative service for the
corporate. The client maintains only one account with the bank. Cash management encompasses
receivables management, payables management & liquidity management. Banks are using better
technologies for cash management by connecting to ERP systems.

Bank Guarantee:

A bank guarantee is a guarantee from a lending institution ensuring the liabilities

of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank covers it. A
bank guarantee enables the customer, or debtor, to acquire goods, buy equipment or draw down
loans, and thereby expand business activity. A bank guarantee is a lending institution’s promise
to cover a loss if a borrower defaults on a loan. The guarantee lets a company buy what it
otherwise could not, helping business growth and promoting entrepreneurial activity. For
example, Company A is a new restaurant wanting to buy $3 million in kitchen equipment. The
equipment vendor requires Company A to provide a bank guarantee to cover payments before
shipping the equipment. Company A requests a guarantee from the lending institution keeping its
cash accounts. The bank essentially cosigns the purchase contract with the vendor.

Short Term Loans:

Short term loans are generally up to about three years. A popular short term loan
is a payday loan. Someone may take a payday loan out in the event of an emergency such as car
repairs, taking a vacation, or other unexpected bills. Payday loans are like a cash advance in
which the payment comes from your bank account on your next pay date. These are very popular
because of the few requirements needed to be approved for the loan. Unlike a long term loan,
you can get cash within 48 hours from companies like Online Payday Loans.net and there are no
credit checks. These loans are generally up to $2000.

Another popular short term loan is a flexible loan. This is generally a credit based loan, but up to
$25,000. The term is generally 12 months. Short term loans are at a higher interest rate than a
long term loan, capitalizing on the length of your loan. A lender will use the situation that you do
not have credit in order to offer the higher interest rate.

Long Term Loans:

Long term loans can be taken over an extended amount of time. Most common
long term loans are mortgages, student loans, wedding loans, start-up business loans, and home
improvement loans. A long term loan is credit based. The better your credit score the better your
interest rates will be. A long term loan can be in the form of a secure or an unsecured loan. A
secure loan requires a form of collateral or asset, such as a title to your car or your home. An
unsecured loan does not require any assets and has a higher interest rate as the lender has more at
stake. You can think of this as a line of credit with your bank or a credit card.

Taking a long term loan is generally through a bank or credit union, unlike a short
term loan. The amount of the loan will be based on your credit history and current income. With
long term loans, you have greater flexibility with payment options. For instance, mortgage loans
offer a fixed interest mortgage loan, in which the rate is the same over the term of the loan and
the payments are split equally. An adjustable rate mortgage loan’s rate can adjust every year.
There is also an interest only loan, of which a person can pay only the interest of the loan for a
set amount of years, and then start paying on the principal. Unlike short term loans, long term
loans can help establish credit.

When making the decision to take a loan, it’s important to think about a few
things. Think if you really need the loan and weigh other options. Shop around for the best
interest rates. Consider the consequences. Make sure you are able to afford paying the loan back.
For instance, a payday loan will take so much of your next paycheck. Make sure it doesn’t dig
you further into debt on other bills.

Credit rating agency:

A credit rating agency (CRA, also called a ratings service) is a company that
assigns credit ratings, which rate a debtor's ability to pay back debt by making timely interest
payments and the likelihood of default. An agency may rate the creditworthiness of issuers of
debt obligations, of debt instruments, and in some cases, of the servicers of the underlying debt,
but not of individual consumers.

The debt instruments rated by CRAs include government bonds, corporate bonds,
CDs, municipal bonds, preferred stock, and collateralized securities, such as mortgage-backed
securities and collateralized debt obligations.

The issuers of the obligations or securities may be companies, special purpose

entities, state or local governments, non-profit organizations, or sovereign nations. A credit
rating facilitates the trading of securities on a secondary market. It affects the interest rate that a
security pays out, with higher ratings leading to lower interest rates. Individual consumers are
rated for creditworthiness not by credit rating agencies but by credit bureaus (also called
consumer reporting agencies or credit reference agencies), which issue credit scores.

The value of credit ratings for securities has been widely questioned. Hundreds of
billions of securities that were given the agencies' highest ratings were downgraded to junk
during the financial crisis of 2007–08. Rating downgrades during the European sovereign debt
crisis of 2010–12 were blamed by EU officials for accelerating the crisis.Credit rating is a highly
concentrated industry, with the "Big Three" credit rating agencies controlling approximately
95% of the ratings business. Moody's Investors Service and Standard & Poor's (S&P) together
control 80% of the global market, and Fitch Ratings controls a further 15%.