General Banking – Credit operations

T1GB - Credit

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without the express written permission of TEMENOS HEADQUARTERS SA.

COPYRIGHT 2007 - 2008 TEMENOS HEADQUARTERS SA. All rights reserved.

 General Banking – Credit Operations

Table of Contents

Document History..................................................................................................................... 3
Scope........................................................................................................................................ 4
Introduction............................................................................................................................... 4
What is Credit?...................................................................................................................... 4
Target Customers..................................................................................................................... 5
Credit Functions of Bank........................................................................................................... 5
Products.................................................................................................................................... 6
Product features........................................................................................................................ 6
Interest and charges.............................................................................................................. 6
Collateral............................................................................................................................... 7
Limit....................................................................................................................................... 7
Repayment of Loans............................................................................................................. 8
Overdue management............................................................................................................ 10
Associated Risks and mitigation............................................................................................. 10
Summary................................................................................................................................. 11
Common Terminologies...................................................................................................... 11

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 General Banking – Credit Operations

Document History

Author Version Date

M. Nagarajan R7.01.H1 November 30, 2007

[email protected]

Published By
Temenos Training Publications
Temenos Corporate Education Centre,
Temenos India Private Ltd,
No.146, Sterling Road, Nungambakkam, Chennai: 600 034, INDIA.
Ph: +91 44 2822 2001. E-mail: [email protected]

Thankful Acknowledgements
Temenos Corporate Training Team

Copyright © 2008 TEMENOS HEADQUARTERS SA

Warning: This document is protected by copyright law and international treaties. No part of
this document may be reproduced or transmitted in any form or by any means, electronic or
mechanical, for any purpose, without the express written permission of TEMENOS
HEADQUARTERS SA Unauthorized reproduction or distribution of this presentation or any
portion of it, may result in severe civil and criminal penalties, and will be prosecuted to the
maximum extent possible under applicable law.” Information in this document is subject to
change without notice.

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 General Banking – Credit Operations

Scope
In this document, we are going to see the basic features of Credit operations of Banks. This
covers different types of loans, their basic features, interest, charges and repayments, related
risks, mitigation of these risks and how Banks manage losses arising due to defaults by
Borrowers.

Introduction
What is Credit?
Credit is an arrangement for delayed payment for goods and services
For example, John buys grocery from a shop at the beginning of the month and the
shopkeeper agrees to receive the amount of the bill at the end of the month. In this instance,
we say that John has got the goods on Credit.
Finance is the backbone of business. Creation and maintenance of production capacity
needs money. Long term loans help acquiring fixed assets to create / add capacity. Short
term or working capital loans help to build up and maintain production capacity. Banks
provide long term loans and short term loans to their Borrowers.
 Paul wants to start a business at a cost of USD 300,000. He has USD 50,000 with
him. He approaches his Bank. Bank agrees to lend USD 250,000 with a condition that
the loan should be repaid over a period of 5 years. With this finance, Paul sets up his
business, buys machinery and sets up all related infrastructure.
 However, to run the business and achieve his budgeted turnover of USD 30,000
every month, Paul has to buy raw materials, pay wages, electricity bills and so on for
day-to-day activities of his business. Now he again approaches the Bank for working
capital assistance.
Besides such productive and business purposes, Banks also lend for consumption purposes
like purchase of house hold goods, vehicles, furniture etc.
 Jane wants to buy a car. Bank may finance part of the cost.
A loan is a contractual agreement between a Lender (Creditor) and a Borrower (Debtor).
Lender agrees to lend money to the Borrower on certain terms and conditions. Loan
agreement describes the terms and conditions legally binding both the parties
The borrowed money may be repayable in regular installments at predefined frequencies
during the life of loan or in one single payment at the end. The loan attracts a cost, referred as
interest. There may also be other associated charges such as processing fee, legal
expenses, insurance premium, etc.
When Banks lend money to Borrowers, it is called Fund based credit.
Banks are also involved in non fund based credit, where they do not part with money
immediately, but agree to pay under defined circumstances:
1. Letter of Credit, whereby a Bank assures timely payment to suppliers of its
customers.
2. Guarantee, whereby a Bank assures payment in case its Customer fails to pay or
perform.
We will see about fund based credit in this course.

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 General Banking – Credit Operations

Target Customers

Individuals: Salaried people may require Home Loans, Personal Loans, Car Loans, etc to
improve their standard of living. These loans are normally repaid in installments.
Students may require Educational Loans for paying College fees and hostel expenses, buying
books, etc. These loans are serviced after they complete studies and start earning.
Professional and Self Employed need finance for procuring equipments and meeting day to
day activities. For example, Car Loan to a Taxi Driver.
Corporates: Corporates engaged in manufacturing and service activities need assistance for
acquiring Fixed Assets and meeting Working Capital requirements.
Banks: Banks borrow from other Banks to meet shortfall in short term cash flows.

Credit Functions of Bank

Borrower seeking loan applies for Bank assistance. Details regarding Borrower, purpose,
amount etc. are furnished in that.
The Bank scrutinises the application and assess the following:
 Purpose of loan and its cost
 Promoter’s contribution
 Loan requirement
o Term Loan
o Working Capital
 Viability
 Profitability
 Collateral for assistance
 Cash Flow
 Credit Report
On satisfactory assessment, Bank sanctions limits for Long Term loan and / or Working
Capital assistance. Working Capital Limit is for future requirements and is based on the
estimated level of operation and sales.
Before release of funds or allowing use of credit facilities, Bank obtains various documents
like Demand Promissory Note, Loan Agreement and Security Documents.
Loan Agreement is executed between Bank and borrower. It sets the terms and conditions of
assistance. Money borrowed from Bank may be paid back in one shot at the end or in
installments. The installments may set at regular or irregular frequencies depending on cash
flow of borrower.
While financing projects, Bank will disburse the loan amount in one or more tranches
depending on the need and progress of project. Bank monitors end use of funds, periodically
reviews operations in the loan account, visits borrower premises, inspects production and
plant maintenance, ensures availability of insurance cover and checks sufficiency of
collateral.
Despite monitoring, Banks face delayed payment or even non-payment on due dates. They
meet the defaulting Borrowers and find out the reasons for over dues.
When the defaults are due to temporary setback and borrowers have genuine problems,
Banks tend to take a soft approach and help the Borrower in different ways to help them to
get over their problems.

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Banks fund their over dues and set revised schedules for repayments. If need be, Banks also
extend additional finance to Borrowers to enable them to revive their operations and enhance
repayment capacities.
Where some sacrifice is needed, Banks try to waive interest and charges partly or even fully.
Where revival of borrower is difficult, Banks negotiate for immediate settlement offering
further waivers.
Where all these efforts do not give desired result, Banks file recovery suits in Courts to bring
collateral for sale and / or to attach properties of Borrowers / Guarantors.
Banks also engage services of external agencies for collection of over dues.

Products
Overdraft: A facility whereby an account holder can withdraw more than what is available in
the account. The Banks decide the amount up to which the account can be overdrawn
depending on the account holder’s standing. Overdraft is usually allowed in current accounts.
Long Term Loans: These loans are repayable over a longer period and normally in
installments. These are usually sanctioned for purchase of Fixed Assets and hence charge is
created on the assets for which loans are availed. Banks may also require additional
collateral security.
Short Term Loans: These loans are repayable within a short time - days or months. Short
term loans are usually availed to overcome short term cash flow shortages. Such loans could
also be demand loans which are repayable as and demanded, with or without notice.

Product features
Interest and charges
Interest is the price for use of money. These rates are influenced by the cost of funds, further
profit margin, management overheads and Bank’s perception of risk involved.
The rate of interest may be fixed or floating. When the interest rate is agreed upon at the
outset and is kept the same throughout the loan period, it is called fixed interest rate.
Alternately, the interest rate may be revised from time to time during the tenor of the loan.
Here, a reference rate and the spread to be applied over the rate are agreed upon. While the
spread remains constant, the underlying reference rate may be undergoing changes from
time to time, which in turn will result in changes to the Loan rate. This is called floating rate.
Interest on loans may be calculated on daily balances or average / maximum balance of a
predefined period – average balance during a month or maximum balance any time during a
month.
Interest on loans can be Simple Interest or Compound Interest.
When Banks quote interest, it is generally on Simple Interest basis, unless otherwise stated
 Interest on a loan is payable once in 3 months. But a Bank may like to calculate how
much it is earning on a daily basis. If it calculates and does not charge it to Customer
daily (instead debit a receivable account and credit Profit), it is said to accrue interest
daily.
 At the end of the third month, the Customer is supposed to pay interest. This means
that the bank is Capitalising interest quarterly. (The Bank debits Customer account
and credits the receivable account)
 If the Customer does not pay this interest amount into his account, Interest gets
added to the Principal. Next monthly calculation of interest will be on the New
Principal (earlier Principal + Interest added previous month end).

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Interest can be collected in arrears or at the beginning.

Interest in arrears: Generally interest is due at the end of “interest period” – monthly,
quarterly, annually etc. This is called interest in arrears.
 Lawrence borrowed $10,000 from Bank of America at 10% p.a. on January 1, 2008.
Principal payable at the end of 3 years and interest payable monthly on the last day. If
the first month’s interest ($82.20) is due on 31 st January 2008, the interest is said to
be payable in arrears.
Interest in advance: If the interest for “interest period” is payable at the beginning of interest
period, then the interest is said to be payable in advance
 In the above example, if Lawrence pays the first month’s interest ($82.20) on 1 st
January 2008, the interest is said to be payable in advance.
Bank, in addition to interest collects charges for services. Charges may be one time
collection or periodic collection.
One time charge – Loan agreement charges, Documentation charges, Legal fees, etc.
Periodic charges – Charges which are periodic in nature like statement charges, account
maintenance charges.

Collateral
Security for the loan is creation of charge on assets as a cover for the loan. Lender may also
insist on additional security.
Security for loan is also called as collateral.
Banks take security in various forms - goods, document of title to goods, shares, bonds, plant
and machinery, immovable property, life policies and book debts. Guarantees from reputed
individuals or institutions are also considered collateral. In the event of default by Borrower,
the Lender has the right to seize and realise collateral.
 Smith has taken housing loan from Bank and offered his house as collateral
Loans not backed up by any collateral are called Unsecured or Clean Loans.
 Mary is employed in a Bank and she has taken Festival loan from Bank without any
collateral.

Limit
Limit is the maximum exposure that a Bank is willing to take.
 A bank may set the overall Limit for a Borrower as $500,000. Then the borrower may
avail any assistance from Bank but within this overall amount of $500,000
 Alternately this Bank could also set overdraft limit of $300,000 and term loan limit of
$200,000. Then this borrower cannot borrow beyond $300,000 as overdraft even if he
has not taken any term loan.
Fixed Limit: Limit value is independent of any collateral. Collateral is treated as additional
security.
Variable Limit: Limit value is dependent on the underlying collateral. The limit available will
go up or come down depending on the value of collateral. However, the overall maximum
value of limit remains the same.
 Limit is for $5 million and Collateral provided for $5 million. If collateral value comes
down to $4 million, Limit will also be reduced. If collateral value goes up as $6 million,
Limit is pegged at $5 million.
The available limit is arrived based on the various drawings that are possible on the loan.

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Limit available may or may not be restored based on the repayment of the loan.

Revolving Limit: The available limit is replenished with every repayment in the loan account.
The amount of available Limit decreases when borrowed and increases when repaid. Fresh
loans are permitted against repayments of earlier loans.
Revolving Limits is useful for activities where receipts and payments are more frequent.
Hence working capital assistance is generally sanctioned revolving limits.
 A Company was sanctioned an overdraft limit of USD 3 million on 10th Feb in Current
Account. It availed USD 2.5 million on 11th.Available limit was reduced to USD 0.5
million. It deposited USD 1 million on 13th. The available limit was raised to 1.5
million on 13th. It again availed USD 1.25 million on 14th. Present available limit is
USD 0.25 million.
 Thus any number of drawals is permitted but the outstanding should not exceed the
sanctioned limit at any point of time.
Non-Revolving Limit: Drawals are permitted up to the sanctioned limit. Repayments will not
restore the available limit.
 Another Company was sanctioned a limit of USD 200,000 on 1st Jan. It drew its first
loan of USD 120,000 on 5th Jan. After this, available Limit was reduced to USD
80,000. It took another loan of USD 60,000 on 10th Jan. Now the available limit is
only USD 20,000. It repaid USD 40,000 on 15 th Jan and drawals beyond USD 20,000
will not be permitted even if it repays USD 40,000.

Repayment of Loans
The loans borrowed may be repaid in lump sum at the end of the loan period or may be
repaid over a period of time in installments.
Demand loans:

a. Call Loans: Loans repayable on demand without any prior notice.

b. Notice Loans: Loans repayable on demand with specified number of days’ notice. Usually
the notice period is agreed at the time of contracting the loan. In this case the loan can be
closed at any time but after serving the agreed period of notice.
Generally, such Demand loans are between Banks.
Term loans:

These loans are generally for a longer term than Demand Loans. They are broadly classified
as Short term, Medium Term and Long term loans.
Repayment could be as a single bullet payment at the end or periodical installments.
a. Annuity: Instalment amount is same throughout. In this case, the Principal and
Interest components vary in each instalment. Initial installments comprise more of
interest and less of principal, while later installments have lesser interest and more
principal. This type of repayment is more useful for Borrowers having even cash
flows.
 Judy has taken a mortgage loan of $10,000. She should repay this @$1,000
per quarter for the next 12 quarters.

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b. Linear: Principal Instalment is same throughout, but interest component will be

gradually coming down. Hence the total amount of repayment will be gradually
coming down.

c. Savings type: Only periodical interest is collected during the loan period. Instead of
repaying the principal, certain savings / investments will be made periodically and a
lien will be created on the savings / investment. On maturity, the savings / investment
will be transferred to discharge the loan.

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d. Rollover of loan: On maturity, Short Term Loan may be renewed for a further period.
Such renewal is called Roll Over. While rolling over, interest could be settled and
principal could be rolled over or both could be rolled over. While renewing, the old
interest rate could be applied or a new rate quoted depending on the rollover period.

Overdue management
When principal or interest or charges or all of them are not paid on due date, they are called
over dues. To discourage over dues, Banks charge penalties in the form of Penal Interest
and Penal charges. Prolonged over dues are classified as Non Performing Assets and as per
the Central Bank Norms, adequate provision for such over dues are created against profits.
When the Bank finds that the over dues are not recoverable, they are written off against the
provision already created or against profits.
Banks take the following steps for management and recovery of over dues:
Negotiate with customers for early settlement
Engage services of collecting agents
Sell the loan asset to specialised agencies
Take legal action
Provisioning for bad and doubtful loans
Write off the loan when all other recovery efforts fail.

Associated Risks and mitigation

Credit risk: Credit Risk is the probability of loss arising due to failure of borrower to repay
principal and / or interest.
 Union Ltd has borrowed USD 1 million from FIN Bank. Union Ltd is not performing
well and hence FIN Bank faces credit risk in realising its money.
Country risk (political / legal problems): This is a risk a Bank faces when the counterparty
is in a foreign country. The politico-legal situation in that country could adversely affect the
Bank’s assets.
 Commercial Bank of Africa has given a loan to its Customer to set up an industrial
unit in a foreign country. Due to civil war, that country has freezed any outward
payment from the country. Though its customer is earning profits, CBA is now facing
Country risk in realising its money.
Commodity risk (loss in value or drop in demand of financed commodity): This is a risk
which a Bank faces when the industry/sector to which the Borrower belongs gets affected due
to various market factors. The Borrower may not be able to make payments on time or not at
all.
 State Bank of India has financed a five star winter resort. As snow fall has not been
good this year, tourist inflow has dropped and occupancy is very low in all hotels. SBI
is now facing commodity risk in realising its money this season.
Mitigation of risks: Risks cannot be eliminated but mitigation is essential and possible.
Banks manage risks through Credit Analysis, Credit Rating and Credit Administration.
Measurement of risk, monitoring process and provisioning ensures adequate control over
credit risk. Credit Risk Management practices differ amongst Banks depending on nature and
complexity of their activities.
Banks manage their risks by setting limits on exposure to counterparties, currencies, industry
segments and countries. The idea is not to put all eggs in one basket.
Banks invariably insist on different kinds of collateral and they also strive to maintain
adequate margins on the collaterals and thereby increasing their chances of recovery by
selling the collaterals.

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Managing credit exposure and understanding complex financial relationships is becoming

more and more challenging.
Increasing collateral such as cash deposits and surety, purchase of credit derivative or credit
insurance are some of the credit mitigation strategies. Credit Insurance enhances the strength
to pass on large adverse swings in bad debt write-offs and to support the insured’s credit
management.

Summary
We have so far seen the following:
 Meaning of Credit
 Types of customers
 Credit functions in Banks
 Products and their features
 Management of over dues
 Associated Risks and their Mitigation
Finally, to have a quick recap of what we have seen so far:

Common Terminologies
Accrual: Accrued expense is expense incurred but not yet paid. Accrued income is the
income earned but not yet received.
Annuity: Annuity contract provides for a fixed instalment amount throughout the term.
Asset: Assets generate income for business.
Borrower: One who is indebted for loan availed. The party who receives money, with an
obligation to pay it back in terms of a loan agreement.
Capitalisation: Capitalisation is applying interest and/or charges accrued to the loan principal
amount.
Collateral: Asset acceptable as security for a loan or other obligation.
Co-obligant / Guarantor: Person responsible for repaying a debt if the Borrower defaults.
Credit history: Record of payments made by the Borrower. Used as a guide to determine
whether the Borrower is likely to pay accounts on time in the future.
Credit Limit: It is the maximum amount that a Borrower can avail as assistance
Credit Report: Report to a prospective Lender on the credit standing of a Borrower. It is
useful to determine credit worthiness of the Borrower.
Discount: In a loan, discount is interest taken in advance.
Grace Period: Time allowed after deadline for fulfilling an obligation
Interest: Cost of amount borrowed. Simple Interest is calculated on the principal outstanding.
Compound Interest is calculated on Principal and interest outstanding
Lender: Person or business providing credit.
Lien: A legal hold or claim of one person on the property of another as security for a debt or
charge.
Linear repayment: Fixed amount of principal throughout and decreasing amounts of interest.
Maturity: The final date on which an obligation becomes due for discharge.
Mortgage: A lien or claim against property given by the borrower to the lender as security for
money borrowed.

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