lending book
DESCRIPTION
ljkjkkTRANSCRIPT
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Lending:
Products,
Operations and
Risk Management
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Stage 2
Table of Contents
Parti:
Lending - A core banking practice/function 1
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Part 2:
Lending Products 6
Part 3:
Lending Risk Assessment and Management 35
a. Overview and Sources of Lending Risks 37
b. Risk Assessment & Risk Management 47
c. Ratio Analysis & Assessing Customer Needs 71
d. Credit Risk Practice for Business and Commercial Banks 117
e. Credit Risk Practice for Retail Banking 185
f. Business Lending - When Things Go Wrong 208
Part 4:
Collateral and Documentation 214 Part 5:
Management of Credit -1 289
Management of Credit - II 293
Part 6:
Past Due Accounts/Over Due Accounts - Business Lending 303
Past Due Accounts/Over Due Accounts - Consumer Lending 310
Appendices/ Additional Reading Material
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iftnq Products, Operations and Risk Management | Reference Book 1 1
Part One
Student Learning
Outcomes
Introduction
Lending - A core banking function
By the end of this chapter you should be able to:
State the role of bankers as lenders
State the importance of building a disciplined lending culture
State the importance of cash flow lending as opposed to security-based lending
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Lending: Products, Operations and Risk Management | Reference Book 1
Lending in Perspective Historical sources reveal that existence of bank predates the use of money. The nature of deposits and loans were therefore in form of goods and commodities but the essence and principle was the same. The first record of such activity dates back to 2000 BC in Babylonia.
1
The modern day definition of a bank as per Britannica is:
An institution that deals in money and its substitutes and provides other financial services. Banks accept deposits and make loans and derive a profit from the difference in the interest rates paid and charged, respectively.
A difference in modern day banking from the ancient banking practices is that the sequence of the basic functions of the banks today is to take deposits and give out loans. This sequence was not necessarily followed in ancient times. Most importantly in earlier times loans were based out of savings.
2
Some differences between ancient and modern-day banking which have an impact on lending
The modem day banking has undergone massive changes in its basis of operations over the last 7 centuries to arrive at the structure and form that we see today. Lending remains a core function of banks as well as its most profitable product. Product types and variations have, however come into existence and most importantly the basis of the credit creation, as it is termed today, is vastly different.
Banks Create Money
Todays banks create money in the economy by making loans and investments. The amount of money that banks can lend is directly affected by the reserve requirement
1 of the Central Bank. In this way, money that
grows and flows throughout the economy in a much greater amount than it physically exists. For example a bank gets a deposit of PKR 1 million from Customer X. If the reserve requirement is 20% the bank is able to make a loan out of PKR 800,000. The bank lends the PKR 800,000 to Customer Y who uses the loan to buy a car and gives the money to Company A as payment. Company A in turn deposits the money in the bank and the bank based on Company As deposit can make out a loan of PKR 640,000 to its customer. This is an over-simplified example of how the banks create money and the money multiplier effect. You are encouraged to independently read more about this topic as it is of utmost importance in todays banking world. This ability to create money and thus be responsible for the increased money supply through creation of credit in the economy to the extent that the banks are able to do today is something that ancient bankers did not have to fret about. Banks today are able to lend several times its total capitalization which puts on them a much greater responsibility of understanding the credit they are creating and its recovery cycle.
1 Source: Davies, G. (1994) A History of Money from Ancient Times to the Present
Day, Cardiff, UK, University of Wales Press
2 Source: Dr. Frank Shostak (2011), The Importance of Real Lending, Cobden
Center-http://www.cobdencentre.org/
1 Reserve Requirement-This is imposed by the Central Bank of the country on all
banks in terms of what percentage of the deposits can the bank lend out as loans. In Pakistan the State Bank has a Cash Reserve Requirement (CRR) which ha s in the past varied between 4% to 7% and i Statutory Liquidity Requirement (SLR) which in the past has varied between 10% to 15%.
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Lending: Products, Operations and Risk Management | Reference Book 1 3
Banks act as intermediary between depositors and borrowers
Banks facilitate the flow of funding by acting as an intermediary between
depositors and loan-seekers. Earlier the function was to act as an
intermediary between savers and borrowers. The difference is that when a
saver lends money, what he in fact is lending to the borrower are the
goods/services that he has not consumed. Credit then becomes a chain of
unconsumed goods/services lent to the borrower to be repaid out of future
production of the borrower. However, today the banks deposits do not necessarily consists of savers and lending decisions are thus more critical
because if the banks create credit without understanding how the credit will
generate the goods/services for the repayment of the credit, it will be creating
loss-making loans which may default either immediately or with a time-lag.
This time-lag has been also referred to as the credit bubble, in recent times.
Banks today thus play a much wider and a very critical role as they provide
liquidity and steady flow of credit in the economy which fuels growth and
stability.
Role of Banks as Lenders
Lending is a primary business function of banks. The banks make a profit by
accepting deposits at a rate of return and making out loans at a higher rate of
return than the deposits. The difference in the rate covers the administrative
cost as well as compensates them for the risk associated with lending.
Lending is a risky and perhaps the most profitable product of the banking
business and banks have over time tuned and fine-tuned lending policies,
practices and procedures to minimize risks and employ the principle of
prudence in lending decisions.
As lenders, banks have a very important role to play in the economic growth
of the country. Loans made to support activities which will generate income
above and beyond the amount to repay and service that loan are generally
viewed as loans which are beneficial for the economy and the country. The
banks over the past century however have developed a narrower view. Their
agenda is limited to making loans which will be serviced and repaid. Banks
have due to this been subject to criticisms from many who blame it for giving
rise to the increased consumerism.
Banks lending decisions have a far-reaching and a deep impact on the
economy. Any single loan that is made by the bank has a multiplier effect
thus banks need to be adequately aware of who they are lending to and what
the borrowers purpose for the loan is. An inadequate or irrelevant purpose
can channel funding in a direction that may be detrimental to economic
growth. Similarly the inability of the borrower to repay the loan either due to
lack of funds or intent can also cause a series of negative effects which will
have consequences that impact more than just the lending bank.
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Lending: Products, Operations and Risk Management | Reference Book 1
Banks role of financial intermediary in the economy is critical. Financial
intermediation takes place when banks as licensed deposit-takers take
deposits from public i.e. individuals, businesses and institutions and lend to
borrowers in the system. In most emerging economies, commercial banks
remain the major lenders to individuals, businesses and government. The
banks motive for financial intermediation is the margin between the cost of
funds and the markup for loans. For this return banks incur risk of the credit
they extend to the borrower. Given that the major source of funds are public
money, banks need to ensure that extreme discipline and caution are
exercised when lending money and taking other credit- related exposure.
Importance of Building a Disciplined Lending Culture
The effects and impact of lending have been briefly touched upon earlier.
The gravity is nonetheless not lessened by the limited attention that we have
paid to it in this chapter. Banks lending decisions are revered in the
economy as bank lending is a key economic indicator for a specific sector or
industry. If banks are willing to lend their money to a person or a company
or a sector/industry, it reflects the banks confidence in the borrowers
purpose of loan, ability to repay and intent to repay. Lending decisions are
thus of paramount importance as they are used as key market signals by
other players in the economy such as investors, suppliers, customers etc.
Moreover as banks deal with public monies, the effects of incorrect lending
decisions are far-reaching and can be devastating as witnessed in the recent
global financial crisis of 2007/8.
It is thus imperative to build a lending culture which is prudent and cautious.
Lending cultures driven by unrealistic or aggressive sales targets have
known to fail in the recent past with degenerating effects to the banks in
question.
Importance of Cash Flow- based and Security- based Lending
Each loan that a bank makes creates a ripple of liquidity. Each loan requires
scrutiny and consideration. The fundamental principle to be followed should
be that the loan be employed in a manner that it will generate an income
above and beyond the level which is required to service the loan and repay
the principal. Lenders thus need to assess the purpose of the loan, its
repayment capacity, character and reputation or name of the borrower and
in the instance the borrower is unable to pay the loan, how can the lenders
safeguard their interest.
Security Based Lending: Name Lending and Collateral-based Lending
Banks driven by self-interest also exercise a great deal of caution and
scrutiny before advancing a loan. There are different types of loan products
that are available and different methods of scrutiny and risk assessment
employed which will be discussed in the articles that follow.
What is of importance here is how lenders risk management and
containment methods have evolved over time. Mutual trust has been one of
the basic and fundamental variables. The trust between the borrower and the
lender reflects the lenders comfort that the borrower will timely repay and
service the loan and the borrowers comfort that the lender will not
overcharge him on the interest rate. In previous
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Lending: Products, Operations and Risk Management | Reference Book 1 5
times lenders would limit their operations to people they knew either
personally or within their own wider network (also known as name lending
in recent times). However, as economies have expanded and enterprises
have sprung which are diverse in industry and geography, lenders have had
to expand operations beyond their limited circle. At this stage the lenders
started employing a structured due diligence process and getting to know
about the customer and its business operations and/or sources of funding and
for additional comfort and security demanded collateral. Strong collateral
(high in value and easy to liquidate) meant that even if the borrowers ability
to repay was questionable, the loan would still be good as funds could be
recovered from the sale of the collateral. This phenomenon brought with it a
new set of concerns relating to the title of the collateral and in case of
default by the borrower, would the lender have the legal right to dispose of
the asset that the borrower has given to the lender as collateral. Different
countries have different legal systems and practices. The article on
Collateral will discuss the different types of collateral and the rights of
lenders and borrowers in detail; suffice to mention here that taking collateral
against a loan advanced has been a practice for centuries.
Cash Flow Based Lending: Purpose and Capacity-based Lending
Lenders in the recent times have however expanded their focus on the
purpose of the loan and the repayment capacity with reference to the purpose
of the loan. While having good quality collateral is highly recommended,
banks are in the business of borrowing and lending money and not
liquidating collateral. Liquidating collateral is a lengthy and cumbersome
exercise and not the banks core business function. Banks have thus realized
that lending decisions which are transaction- specific and evaluate the
capacity of the borrower based on the cashflow from the
transaction/project/activity that is being financed are sounder than the ones
which only consider the collateral and the borrower name. This in no way
stops the lender from requiring good quality collateral or considering the
borrower name. Analyzing the cash-flow and repayment capacity however
is being given as much consideration when making the lending decision.
Authored By: Shahnoor Meghani
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Lending: Products, Operations and Risk Management | Reference Book 1 6
Part Two Lending Products
Student Learning By the end of this chapter you should be able to: Outcomes
1. Categories of Borrowers
* Describe the types of lending products available to business
borrowers
Differentiate between short term and long term lending
Differentiate between funded and non-funded facilities
* Describe various types of long term lending facilities available
to business borrowers
Describe the characteristics of an individual borrower and explain how they differ from business borrowers
Describe the types of products available to individual customers
Explain the purpose of individual/consumer borrowing and classify loans under^onsumer lending
2. Regulations and Practices
Recall the SBP laws relevant to decide the lending limits for both business and consumer borrowers
* State the lending exposure limits as per SBP regulations
State regulations concerning lending disclosure and reporting requirements for consumer lending
State regulations concerning lending disclosure and reporting requirements for business lending
Define credit policy, target markets and risk assessment criteria and discuss their importance in lending decisions
State prudential regulations concerning the business /commercial lending operations
State the minimum requirements for consumer financing as per the prudential regulations
State the general SBP Prudential regulations concerning consumer lending
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Lending: Products, Operations and Risk Management | Reference Book 1 7
3. Pricing
* Recall the various types of pricing mechanisms available across the industry
Explain the industry-wide methodology used for calculation of pool rates
Explain internal cost of funds and discuss how it is determined
Explain the process of developing a pricing model based on floating mark up rate
Discuss the pros and cons of using a floating mark up rate as compared to using fixed rate
Explain 'risk based' and 'relationship yield' pricing models
Explain the concept of opportunity cost, risk reward pricing and re-pricing intervals
Categories of Borrowers
As discussed in the previous chapter, banks as lenders need to inculcate a
disciplined lending environment to avoid making lending mistakes. Before a
loan is made the lending bank should ask the following questions:
a. Who is the potential borrower?
b. Does the potential borrower meet banks target market
definition and risk acceptance terms?
c. What is the purpose of borrowing/borrowing cause?
d. Does the borrowers business/income generate sufficient cash
within a reasonable time period to repay interest and principal?
e. What would be my way out if the cash flows are not sufficient to
ensure repayments of loan?
The list above is not exhaustive and in the next few chapters we will address
these issues in detail. It is important to have awareness of these fundamental
questions as they are key to determining the credit requirement of the
businesses and the repayment capacity. A banks credit customers can be divided in to two broad categories:
a. Business Borrowers b. Individual/Consumer Borrowers
The purpose of borrowing and source of repayment is distinct for each
category and based on this the lending products offered by the bank to each
segment are different. The State Bank of Pakistan does not allow banks to
offer any lending product without collateral or security to business borrowers
above PKR 2 million and up to a certain amount for individual borrowers.
The clean lending limit for individual borrowers is PKR 2 million at present,
but is subject to change. Please refer to the SBP website for up-to-date
information.
A. Business Borrowers
Businesses frequently are in need of funds to either bridge the temporary
liquidity gaps in the operating cycle or to supplement their long-term
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Lending: Products, Operations and Risk Management | Reference Book 1
financing needs for capital expenditures. Some businesses also take on debt
which could be in the form of credit from banks to manage their balance
sheets more objectively. Businesses also seek bank support to meet their
non-cash needs such as opening Letters of Credit, and extending financial or
other form of guarantees on their behalf.
Business borrowers repay the principal and interest from cash flows
generated through business operations. Banks generally look at the historic
trend of the businesss financial statements to gauge the sales growth, cash
cycle, stability of orders, productivity of assets, leverage etc to forecast the
future trends for the business based on which a part of the lending decision
relies upon.
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Lending: Products, Operations and Risk Management | Reference Book 1 9
Non-
Funded
Facilities
Lending Products for Business Borrowers:
Lending products for business borrowers can be mainly divided by the nature of
the facility i.e. is it fund-based; this would entail the bank providing the
customer with access to the funds; or non-fund based in which case the bank
would assume the liability of payment on account of the customer to a 3rd party.
Within each category there are several different sub-divisions based on the tenor
and terms. Diagram 2.1 below is a good illustration of the lending products
available for business borrowers, at a glance. Diagram 2.1
Lending Products for Business Borrowers
Demand I Discounting I Export I Import
Finance I I Finance I Finance
Details of lending products available for businesses in Pakistan
within each sub-heading and their brief description are as follows:
1. FUNDED FACILITIES:
a. SHORT TERM FINANCING PRODUCTS
i. Running Finance/Overdraft An overdraft generally known as RF in Pakistan is a type of lending
which offers a high degree of flexibility. For a bank, the overdraft is a
staple product by means of which the customer may overdraw their
current account balance, that is, draw out more from the account than
the total amount of money standing in the account. The customer is
permitted to overdraw the account up to an agreed limit (the overdraft
limit). When an account is overdrawn, the customer is borrowing and
owes the bank money. An overdraft is normally shown on the
customers bank statement by the abbreviation DR (meaning debtor) after the balance on the account.
Overdrafts are only available on current accounts, the accounts through
which businesses pass their income and expenditure. Although
overdrafts are repayable to the bank on demand, they are normally
agreed subject to annual review.
Funded Facilities
Short-term Facilities-Payable
within 1 year ej Long-term S
Facilities $ Payable
after 1
1 vear
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Lending: Products, Operations and Risk Management | Reference Book 1
Interest/mark-up on an overdraft is only charged on the day-to-day balance
outstanding on the account. Thus, if the current account fluctuates from a
credit balance (funds in the account) to a borrowing position (using the
overdraft), the customer only pays interest when the account is in the red/debit - what the customer is actually borrowing on that day.
The overdraft is a convenient way of borrowing to cover a businesss short term requirements. It is only appropriate for short term temporary borrowing
which is drawn down and then repaid and drawn and repaid again during the
working capital (or trading) cycle.
The overdraft provides finance to cover a businesss working capital needs (the finance needed through the operating cycle) and help iron out the
fluctuations in its cash flow as bills are paid before funds are received from
sales income. A large inflow of funds one week will reduce the interest
payable while the firm retains the ability to borrow again next week. For
business customers the overdraft is often the cheapest and most convenient
means of borrowing.
An account with an overdraft facility should show wide fluctuations. For
instance, when the customer buys stock, the balance of the account would
swing into overdraft and once the stock is sold and sales income received,
the account should swing back into credit. When an account remains in debit
permanently, with low turnover this is referred to as hard core borrowing. It
is best to identify the hard core borrowing element of a business and
understand the underlying reason to best meet the businesss credit requirement soundly. If the run of the account shows that the account is
perpetually in debt, the debt is becoming hard core. It may indicate that things are not going according to plan. This could be due to several reasons.
Perhaps the customer is not collecting cash from debtors quickly enough, or
the business may be making losses or the business is financing its long-term
needs with short-term financing.
ii. Demand Finance
Demand finance generally known as LM in Pakistan is similar to running
finance in many aspects except that the tenor of the demand finance is fixed.
For example a business may have a requirement for short-term financing for
PKR 500,000 and it may know that this requirement is for a specific period
e.g. 2 months. The business can then ask the bank for a loan of PKR 500,000
for 2 months. The interest rate for the loan will be booked on the date of the
booking of the loan for the period of the loan. The LM must be paid at the
expiration of the term. In rare cases it may be rolled-over or extended,
however it is generally preferred by banks not to have a rolling LM to
ensure that the business has access to funds to pay off the loan and the debt
is not becoming hard core.
iii. Export Finance
Export finance is similar to demand finance. In Pakistan, the State Bank of
Pakistan (SBP) to incentivize exporters has in place special financing
schemes whereby exporters can access pre- shipment financing facilities as
well as post-shipment financing facilities. These facilities are available
through the State Bank funded
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Undng: Products, Operations and Risk Management | Reference Book 1 11
schemes via the banks or through banks own sources. The facilities
available at present are:
1. Pre-Shipment Financing-Part l(Fundecf through banks own
sources).
2. Pre-Shipment Financing-Part 1 (Funded through SBP refinance scheme).
3. Pre-Shipment Finance-Part 2 (Funded through SBP refinance Scheme).
4. Post-Shipment: Discounting/ Purchase of export Bills (Funded through banks own sources).
5. Post-Shipment: Discounting / Purchase of Export Bills (Funded through SBP refinance Scheme).
6. Bill Discounting/Receivable Financing.
All these facilities are tenor-bound and generally do not allow roll -over.
Detailed information on this can be sought from the SBP website.
iv. Import Finance
Import finance is generally available in terms of import loans or
financing against trust receipts (FATR) generally in case of a Letter of
Credit based transaction. Under this facility, the Bank provides the
documents of title of goods imported under L/C, to the customer to
enable the customer to obtain goods prior to payment and to sell them to
generate funds to pay-off the bank. The goods represented thereby and
the sale proceeds thereof in trust for the bank. Since this is a fund-based
facility as opposed to a non-funded facility (as in the case of L/Cs), due
care and diligence needs to be exercised when extending this facility.
Import finance can be further classified into the following:
1. Finance Against Trust Receipt (FATR)
FATRs are related to import transactions. The bank may allow specific
customers FATR facility against collection documents as per the terms
set out from time to time, which are discussed as follows:
a. FATRs in respect of L/C documents -
Under this facility, the Bank delivers the documents of the title to
goods imported under L/C, to the customer. This enables the
customer to get the goods prior to payment. The customer
undertakes to hold the documents in lieu of a Trust Receipt. There
are very obvious risks in permitting a customer to deal with goods in
this way. A customer having in his custody, goods released to him
against a trust receipt can fraudulently sell them or pledge them to a
third party, leaving the holder of the trust receipt i.e. the bank only
the right to sue for breach of trust. FATR facilities should therefore
are granted to undoubted importers against established credit lines.
It is important to note that the goods released under a trust receipt
must be fully insured by the customer and the Bank reserves the
right to inspect, repossess and if necessary, dispose of the goods at
anytime.
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b. FATRs in respect of collection documents -
FATRs in respect of collection documents are only granted when routed
through the Bank's branches. This facility is restricted to selected customers
with satisfactory account relationship and is governed by the following
safeguards:
Facility to be allowed with prior clearance and only provided to
prime customers with low risk ratings.
Branches should be satisfied that the collection bills have genuine
underlying trade transactions.
Branches are also required to ensure that the facility is used for
the customer's regular line of business.
The facility should be given as a separate FATR line under the
import line (i.e. FATR for collection documents) distinct from
FATR sub-limit under import (L/C) line.
Finance Against Imported Merchandise (FIM)
This facility is allowed against the commodities imported from other
countries usually through letter of credit. At times the importer does not
have enough money to pay for the imported merchandise. He therefore
requests the bank to pay the dues to the exporter against the security of
imported merchandise. This facility is usually allowed against imported
goods but occasionally such financing may be allowed against locally
manufactured goods covered under L/Cs or received for collection.
b. LONG TERM FINANCING PRODUCTS / TERM LENDING
Term loans are usually granted over a period of years to assist business
customers in buying assets such as plant and equipment, and buildings. A
term loan spreads the cost of the asset over its expected life. The repayments
can be tailored to suit the cash flow of the business, usually either monthly,
quarterly, half-yearly or annually.
A term loan is a loan for a fixed amount, for an agreed period, and on
specific terms and conditions. Normally such loans are for terms of between
three and seven years, although they can range up to twenty years. Longer
periods depend on the nature of the proposal, the robustness of the
performance of the company and its projections, and the security to be
granted.
Term loans are generally used for longer term asset purchases as these are
not suitable for financing under an overdraft facility, which should be used
for working capital purposes. The terms and conditions under which they are
granted includes interest and other costs, repayment, security and the
covenants applicable. The terms and conditions of the loan are set out in a
loan agreement which includes:
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Lending: Products, Operations and Risk Management | Reference Book 1 13
Tenon the term over which the loan is to be repaid
Repayment Schedule: the intervals at which the principal and
interest are due for payment.
Pricing: the mark-up rate that will be charged.
Collateral: the security to be granted.
Loan Covenants: conditions to be complied with by the customer,
such as the timely provision of accounting information, stock
report, share price in case of a listed company, leverage ratio etc.
Event of Default: events which would render the loan immediately
due for repayment such as the customer failing to meet a repayment
installment on time or the loan being used for a different purpose
from than agreed.
Some banks ask for requirements like establishment of Sinking
Fund and utilization of working capital facilitated through its
counters.
Provided the customer complies with the conditions detailed in the loan
agreement, the bank generally cannot demand repayment of a term loan.
Generally, the longer a loan is outstanding, the greater is the risk of default.
2. NON-FUNDEO FACILITIES:
a. Letters of Credit (L/C) In trade transactions where buyers and sellers are geographically
separated, banks play a crucial role in managing the payments. A letter
of credit is generally established by a bank on behalf of its customer (the
buyer/importer) guaranteeing to the sellers (exporters) bank that the bank will make the payment to the seller on time if seller performs as
per terms and conditions of the letter of credit.
L/C can be irrevocable or revocable. An irrevocable L/C cannot be
changed unless both buyer and seller agree. With a revocable L/C,
changes can be made without the consent of the beneficiary. While
dealing in L/Cs, the bank in question does not lend funds directly but
may have to pay in the instance the customer is unable to pay. L/Cs are
thus called contingent liabilities for banks.
There are two type of L/Cs:
I. Sight: is where payment is due to the seller at the time of receipt of
goods by the buyer. Sight L/C requires the importer / importing
bank to pay as soon as it receives the clean documents from
exporter.
Sight L/Cs are letters of credit where the bank engages to honor the
beneficiary's sight draft upon presentation, provided that the
documents are in accordance with the
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conditions of the L/C. Drafts drawn at sight simply serve as receipts
for payments and are of no value for any other purpose. In
establishing sight L/Cs branches should ensure that goods are duly
insured and that the Bank retains control over the goods at all times.
Documents of title to the goods is released only against payment,
either by cash or to the debit of the customer's current account /
FATR account / FIM account. L/C, generally as a practice, is not
opened for a period in excess of 180 days without prior approval
from the risk chain / competent authorities.
II. Usance: is where payment is due after certain, pre-agreed number
of days by the buyer. The seller in this instance is providing credit
to the buyer. Usance L/Cs are similar to sight L/Cs but call for a
time or usance draft payable after a specified period of time. The
normal usance period allowed for this facility is 90 days. However,
it can be a maximum of 180 days. Exceptionally for undoubted
customers, usance period exceeding 180 days may also be allowed
with specific approvals from the risk chain / competent authorities.
b. Guarantees/Stand-by Letters of Credit
Business customers sometimes require the bank to issue a letter of guarantee on their behalf. This is generally required by the party that the customer is entering into business with. It can be regarding delivery of
goods and services by the customer to the party i.e. the party requires a guarantee that the customer will provide the goods or services agreed failing which the party will call upon the letter of guarantee. It can also be if the customer is the purchaser of goods or services from the party and if the customer does not purchase the goods from the party based on the terms and agreements or defaults on the payment, the party can call upon the guarantee and demand the bank to pay.
The bank in this instance as well, does not lend funds directly but may have to pay in the instance the customer does not perform his obligations or defaults.
These facilities cover a number of specific types of guarantees that the Bank may issue for its customers but in all cases the common factors are:
The Bank substitutes its own credit standing for that of its customer.
No actual movement of funds takes place at the time of issuing the guarantee, although there is a clear commitment by the Bank to effect payment when called upon to do so under the terms of the particular guarantee. Thus it is necessary to record these commitments as contingent liabilities.
The Bank charges a commission for this service usually quoted on a quarterly basis.
Guarantees fall into many different categories, each of which has its own characteristics and related risks; some of the important characteristics and the appropriate precautionary measures are enumerated in the following relevant sections overleaf.
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a. Shipping Guarantees (SG)
Guarantees of this nature are required to enable customers to release
goods before the arrival of the documents of title; they therefore render
the Bank liable to the shipping company to whom the guarantee has
been issued. Shipping company is, in turn liable to the true owners of
the goods in the event the goods are released wrongfully. It follows
therefore that such guarantees should be issued to importers with a
credit line. Full cash margin is generally taken for shipping guarantees
issued against Shipping L/C, unless waived by appropriate credit/risk
authority.
b. Bid Bonds (BB)
The purpose of a bid bond is to substantiate the ability of a person
submitting the tender to perform the contract when awarded. Such a
bond is issued in connection with a tender and its normal characteristic
is an undertaking by the Bank on behalf of the applicant to pay the
beneficiary a fixed amount within a stipulated period on his simple
written demand if the applicant withdraws his obligation after the
acceptance of his tender. A bid bond must not contain any conditions
linking it with performance of a contract if awarded and must contain a
definite expiry date. If branches are asked to give such undertakings the
guarantees must be treated as Performance Bonds. If there is any
ambiguity in the terms of a bid bond which a branch is asked to sign it
should study the basic "conditions of tender" to ascertain its precise
liability. Branches must insist on the return of the original bid bond after
its expiry.
c. Advance Payment Guarantees (APG)
Civil engineering contracts, particularly those awarded by local
governments, sometimes provide for an advance payment to be made to
the contractor for purposes such as mobilizing site, plant and equipment.
In order to obtain this payment the contractor is required to produce an
Advance Payment Guarantee.
d. Financial Guarantees (FG)
Financial Guarantee is a general description of various guarantees
whose main characteristic is an undertaking to meet any claim from the
beneficiary up to a fixed sum on simple demand. Claims under such
guarantees must not be made contingent on the non -fulfillment of the
terms of contracts, which are unknown to the issuer. Unless the
creditworthiness of the concerned customer is undoubted, such
guarantees are issued against full cash margin.
B. Individual Borrowers
Individuals also frequently are in need of funds to pay for expenses or
purchase of assets, which they cannot afford to pay for in cash at the present
time. Situations that typically require borrowing include buying a house or a
car or consumer durables such as refrigerator, television, computer etc or
paying for education or medical expenses or wedding expenses etc. The
individuals borrowing needs are driven by his/her discretionary spending,
lifestyle and stage of life cycle.
Individual borrowers primarily repay the principal and interest from
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Lending: Products, Operations and Risk Management | Reference Book 1
a.
b.
Assets-based/secured
Auto/Vehicle I House
Finance I Finance
their income which could be self-generated. If the borrower owns a business or in the form of salary, profit from business ventures, investment income, pension, endowment/trust fund etc. Banks generally look at the historic trend of the individuals income, stability of cash flows, expense burden on the individuals income etc to gauge the individuals ability to sustain the loan and its cost.
Lending Products for Individual Borrowers Lending products for individual borrowers can be mainly divided by the
nature of the facility:
asset-based which would entail the bank providing the customer
with access to the funds for purchasing an asset- (long term or short term)
and the title of the assets generally resides with the bank or
clean lending where the bank lends to the individual without any
underlying asset.
Diagram 2.2 below provides a good illustration of the lending
products available for individual borrowers, at a glance.
Diagram 2.2
Lending Products for Individuals
Details of the products available for individuals in Pakistan within each sub-
heading are as follows:
A. ASSET-BASED: 1. Long-term Facility
i. Auto/Vehicle Finance In Pakistan auto finance has been a popular product available for
individuals. This product is available through two different modes: Hire
Purchase and Leasing, which are discussed briefly as under. While in
this chapter we are discussing this mode under lending
Clean/ Unsecured
Personal Loan
Running Finance
Credit '
Cards
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PsdKts, Operations and Risk Management | Reference Book 1 17
an
for
mg
A direct lease is where the business or the individual advises the
leasing company of the asset which it wishes to acquire and the lessor
then buys it from the manufacturer (if new) or the previous owner (if
used) in order that it can be rented back.
products for individuals, hire purchase and leasing are applicable modes
of financing for businesses as well.
a. Hire purchase Hire purchase is an agreement to hire an asset with an option to
purchase. The legal title passes to the customer when final payment has
been made. The term of the finance is required to be shorter than the
expected life of the asset.
The bank actually buys the vehicle which then belongs to it, letting the
customer use the vehicle in return for a series of regular payments. The
vehicle can be of any form. The bank has the security of ownership of
the asset and can repossess it if the hire purchase terms are broken.
After all the payments have been made, the customer becomes the
owner, either automatically or on payment of a modest fee.
The main advantages for the customer of a hire purchase agreement
are:
Small initial outlay.
Easy to arrange.
Certainty - the loan cannot be called in providing the terms are
kept.
Tax relief - interest payments are tax deductible and the asset
may also be subject to a write-down allowance for businesses.
The disadvantages are that it is more expensive than a cash
purchase and the fixed term means it may not be possible or
expensive to make early termination.
b. Leasing Leasing is similar to hire purchase in that a vehicle or equipment owner
(the lessor) gives the right to use the equipment to the user (the lessee
i.e. the customer) over a period in return for rental payments. The
essential difference is that the lessee never becomes the owner unless
under capital lease.
For business borrowers, purchase of machinery and equipment can tie
up a lot of business finances, but leasing effectively provides access to
the asset without buying it up front.
The numerous types of leasing are fundamentally rental agreements
providing the business or individuals (the lessee) with the use of an
asset owned by the bank (the lessor) for a specified period of time
subject to agreed payments (rental payments). Almost any equipment
in any price range can be leased.
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Sale and leaseback (sometimes referred to as purchase leaseback) is
where the business or individual sells an asset which they already own
to the finance company and then lease it back. (Sale and leaseback is
quite common with property - the property being sold to an investor
who leases it back.)
In both cases, the asset requires to be returned to the lessor at the end of
the agreed period. Many leases have an end-of -lease option providing
renewal at a minimal cost or sale to a third party.
Leasing can be useful when other sources of finance are not available.
There are also tax advantages; for example, rental payments under an
operating lease are tax deductible, as is interest under a finance lease.
The depreciation charge in the companys accounts for a finance lease is
tax allowable, dependent on the method of depreciation used
There are two main types of leases:
Operating lease
This type commits the lessee to only a short term contract that
can be terminated on notice. Usually the lessor pays for repairs,
maintenance and insurance. An operating lease is used for small
items like photocopiers and short term projects like building firms
hiring plant, vehicles etc.
Finance lease
The leasing company expects to recover the full cost of
equipment and interest over the period of the lease. Usually the
lessee has no right of cancellation or termination. Despite the
absence of legal ownership, the lessee bears the costs of
maintenance etc, and suffers if the equipment is under-utilised or
becomes obsolete. Finance leases offer less flexibility for the user
but this is reflected in the cheaper pricing.
The advantages of leasing are similar to those for hire purchase. An
additional advantage for operating leases is the transfer of the
obsolescence risk to the finance provider. The lessee can hand back the
equipment and take a fresh lease of more modem items.
Leasing is a highly specialized area and a customer will need advice to
assess whether to buy or lease, especially on the complicated tax issues
of finance leases. You may learn more about leasing from your own
organizations leasing department or subsidiary.
House Finance
House purchase loans (normally referred to as mortgages) are a big part of
retail banking business. In the past they were mainly the domain of building
societies. A mortgage loan is a loan to
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Products, Operations and Risk Management | Reference Book 1 19
finance the purchase of residential property, usually with specified payment
periods and interest rates.
The amount available to borrowers by banks will often be a stipulated
multiple of the customers salary/monthly income or a multiple of joint
borrowers combined salaries or monthly income (the earnings multiplier).
The basic lending criteria are based on the borrowers ability to meet the
repayments. The property will be mortgage to the bank as collateral till the
borrower makes all the payments and is then able to transfer the title of the
house to his/her name.
There is also another type of finance available which is self-build finance for
borrowers who would like to obtain finance to build their own house. Since
there is no one standard self-build project, set procedures should ideally be followed during the life of the loan. Each project should be assessed on its
individual merits. As a result, the principles of lending should be carefully
considered when assessing a self-build application.
A self-build loan is an advance that will finance the building, converting or
renovating of a property as the customers principal residence. It is important to be aware that the self-build facility is not a mortgage in the traditional sense of the word - rather it is structured as an overdraft that is
secured over the plot of land on which the house is being built. Because self-
build facilities require a mortgage to be granted in support of the borrowing,
this kind of facility falls under the auspices of mortgage regulations.
By the nature of the project, the funding for this type of borrowing must be
flexible.
Either of these potential options could be used:
Funding of the project in arrears on confirmation of stage completion -
this is the most common funding arrangement.
Funding of the project in advance may be considered depending upon
the individual proposition, such as low LTV (loan to value).
The expenditure involved in building the house is then drawn down against
this overdraft. In most instances, repayment of the overdraft will come from
the drawdown of a mortgage once the house has been completed. It is better
to set up the facility on a separate account for ease of monitoring.
The bank will expect the valuer to confirm that there are no restrictions
affecting the site, that outline planning consent is held and that there are no
anticipated problems with any potential development, such as access, supply
of services, etc.
Normally two valuations are required when dealing with a self build:
At the start of the project, a current and projected end valuation.
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At the end of the project, a revaluation prior to the mortgage
drawdown.
The normal stages of a self-build project are:
completion of the foundations/under buildings/plinth.
completion of ground level slab.
completion of first level slab (where applicable).
finishing (case-to-case basis).
It is normal practice to allow the customer to draw down on the self -build
loan at the end of each of these stages, formal certification being generally
required from:
a qualified architect.
development/cantonment authority inspector, a
structural engineer.
2. Short-term Facility i. Finance for Consumer Durables
Financing of consumer durables such as refrigerators, air conditioners,
washing machines, computers, and other electrical appliances has
become popular since the last 2 decades or so. This financing is
available through the hire purchase mode as well as the clean lending
mode. In the hire purchase mode the bank purchases the good and gives
it to the customer for use and the customer pays back the bank in
monthly or quarterly installments.
B. CLEAN LENDING 1. Short-term Facility i.
Personal Loan- Installment-based finance
Personal loans are normally granted for the purpose of consumer
purchases such as: consumer durables (televisions, fridge-freezers,
etc), education and medical expenses and for home improvements
such as a new fitted kitchen, double glazing, the building of a
conservatory, etc. Personal loans are not restricted to these
purposes and may be granted for any purpose that is acceptable to
the bank.
Interest is charged on personal loans at a flat rate which means that
it is calculated on the total amount of the loan for the full term and
applied to the amount of the loan at the commencement of the
repayment term. This total amount is then divided by the number
of monthly installments to determine the amount of the repayment
installments.
Personal loans are not usually secured and the repayment period
can vary from a few months to several years.
When a personal loan application is received, it is usually credit
scored to determine whether or not the bank is willing
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Products, Operations and Risk Management | Reference Book 1 21
to grant the facility. Once a customers application has been processed
and shows an acceptable credit score, a pre-contract illustration is
provided prior to the customer and banker signing the loan agreement.
A formal letter setting out the terms and conditions of the loan is
normally given to the customer containing details of the interest
structure, total payable and the amount of the rebate should the loan be
repaid early.
The loan is created by a transfer of funds into the customers operative
account and a corresponding debit is made to a separate loan account.
The agreed repayments are credited to the loan account until it is
cleared off.
Some personal loans carry automatic life cover and there is also an
option for the customer to purchase accident, sickness and
unemployment insurance. These ensure protection for the customer and
the bank.
ii. Running finance A running finance account allows a customer to draw up to a set limit
which is related to a monthly fixed payment into the account. A
multiplier is related to this monthly payment; for example, if the
customer pays in Rs. 10,000 per month, the limit of borrowing may be
set at Rs. 300,000 (30 x Rs. 10,000).
The application form is similar to that for a personal loan and the
response data is credit scored. A credit limit is agreed but the bank does
not normally look for security. A separate account is maintained and it
is usual to arrange for the monthly payment to be transferred from an
operative account to the revolving credit account by standing order.
Interest is charged on a daily basis and normally applied monthly.
Should the account move into credit, interest on the credit balance may
be paid by the bank. Provided monthly payments are maintained and
interest is paid, the customer can sustain the borrowing at or near the
limit, subject to periodic review by the bank. Insurance may be offered
to pay off the debt in the event of the death of the customer or to meet
repayments if the borrower has a prolonged illness or is made
redundant.
Revolving credit accounts are intended primarily for the professional
type of customer with good income; being designed to allow the
customer to change a car, purchase electrical goods, etc without the
need to keep contacting the bank to enter into new personal loan
agreements for each purchase. Cashline by UBL is an example of
running finance facility under consumer finance.
iii. Credit cards
Credit cards have increasingly become a part of everyday life. These
plastic cards can be used by the cardholder to purchase goods and
services which are paid for at a later date. They are
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Lending: Products, Operations and Risk Management | Reference Book 1
becoming a widely used method of making payments and for obtaining
credit facilities.
Credit cards are a method of money transmission where the customer has the
option of settling only part of the monthly bill, thereby borrowing the
amount of the unpaid balance. If the customer pays off the outstanding
balance in full prior to the repayment date, no interest is charged and
therefore this is a very cost-effective method of short term borrowing. By
careful timing of their purchases and then repaying the bill in full, the
customer may obtain approximately up to 50 days interest-free credit.
There are currently two dominant groups who operate international networks
- Visa and MasterCard. All the main banks, offer their own versions of either
or both of these cards. There are other companies such as Diners and
Maestro but the market share and reach of these companies is by far the
largest.
The essential features of a credit card are:
the purchase of goods and services on credit subject to an agreed overall
limit.
the issue of regular statements by the credit card issuing bank/company.
the option for the customer of either paying all of the sums due to the
bank or electing to pay off only a portion of the sums due (minimum
amount or 3 - 5%, whichever is the greater) and paying interest on the
remainder.
A credit card account operates independently of a customers other accounts
with the bank, and the relationship between the bank and the cardholder
differs from the traditional banker/customer relationship. In some cases
banks have issued credit cards which have been linked to their existing
deposit accounts with the banks and banks offer direct debit facility for the
payment. However, this is not general practice.
Each bank policy may differ, however as per popular practice locally it is not
necessary for a person to maintain an account with the bank before they can
be issued with a credit card. It is initiated by a separate agreement between
the bank and its customer regulating the issue of the credit card and the
debtor/creditor relationship that exists between the parties. In addition, due
to the element of credit involved, the bank will have to be satisfied that the
customer can be considered creditworthy for the amount of their limit. The
customer completes an application form as the basis of the agreement
between them and the bank. The application form also provides the bank
with a great deal of information about the customer, such as employer,
salary, house owner or tenant, marital status, number of children, etc.
Normally the creditworthiness of the applicant is screened bythe statistical method of credit scoring. The process determines the
statistical probability that the credit will be repaid.
Use of the credit card Provided that the issuer is satisfied with the creditworthiness of the
customer, a card and personal identification number (PIN) will be issued
and the customer will be granted a credit limit. The customer can then
use the card to make purchases up to the amount of the limit on the
account. The cardholder presents the card to the retailer and the
transaction is completed by the card being swiped through the retailers
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Products, Operations and Risk Management | Reference Book 1 24
terminal. In many countries the customers are also required to input their
PIN number on a keypad. A credit card can also be used for postal,
internet and telephone transactions; the card number being quoted over
the phone together with the security code number quoted on the back of
the card. This information is input on to a computer or noted on an order
form sent in the post.
Cash can be withdrawn via ATMs using the credit card by the cardholder
inputting their PIN. This withdrawal will be treated by the credit card
company as a cash advance and so interest will accrue from the date of
the transaction.
Joint credit cards are not offered, but the customer has the option of
applying for supplementary cards to be issued on the account.
For example, a husband may choose to have a supplementary card for his
wife and children. The liability of repayment of debt of the
supplementary card will be on the husbands account.
Every month, the cardholder receives a statement showing: their
limit.
the transactions that have been made with the card(s). any
payments that have been received, any interest that has
been debited to the account, the current balance.
the amount of available credit remaining,
minimum payment required, payment due
date.
On receipt of a statement, a cardholder has the option of: a. repaying the whole balance by the due date shown on the statement,
or
b. repaying the minimum amount required which is generally 3 - 5%
of the total outstanding amount.
Should the cardholder elect not to clear the balance due, interest will be
charged monthly from the statement date or the date of the transaction on any
outstanding balance not repaid.
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Lending: Products, Operations and .Risk Management | Reference Book 1
Regulations and Practices As discussed in chapterl, depending on the characteristics of different
lending products, they have different permissible limits, risk mitigation and
process requirements. To ensure transparency and coherence amongst the
lending practices, the SBP has provided a comprehensive list of Prudential
Regulations (PRs) to the banks and financial institutes catering to the
financing requirements of various types of customers.
Prudential Regulations (PRs)
Prudential Regulations are a set of minimum lending principles designed by
the SBP. The objective of these regulations is to bring consistency in lending
practices among banks and to maintain quality of credit portfolios across
banks.
To cater to the specialized and dynamic areas of lending the SBP has
following separate sets of PRs geared towards:
Corporate.
Commercial/SME and
Consumer business.
Agriculture
Some salient features of these regulations are discussed below. You are
encouraged to visit the SBP website and study the up-to-date regulations in
detail.
Prudential Regulations-Corporate
Corporate PRs contain a total of 27 regulations revolving around corporate
business and covering following aspects of credit quality:
Risk management 13
Corporate governance 4
Anti Money Laundering 5
Operations 5
Highlights of most important Risk Management related regulations (PRs)
are:
Maximum exposure (in outstanding terms) of a bank/DFI to a single borrower shall not exceed 30% of its equity (fund-based 20%) and to
a group of borrowers 35% (fund-based 30%).
Contingent liabilities of a bank/DFI shall not exceed 10% of its equity.
Banks/DFIs shall as a matter of rule, obtain copies of financial statements duly audited by a chartered accountant relating to the
business of every borrower who is a limited liability company
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Undng: Products, Operations and Risk Management | Reference Book 1 25
Unsecured exposure is restricted to Rs.200,000.
Total exposure (fund based and/or non funds based) availed by any
borrower not to exceed 10 times of borrowers equity (fund based
exposure not to exceed 4 times of its equity).
Banks/DFIs to ensure that total exposure (fund based and/or nonfund
based) availed by any borrower from financial institutions does not
exceed 10 times of borrowers equity (fund based exposure not to
exceed 4 times). However, where equity of a borrower is negative and
the borrower has injected fresh equity during its current financial year,
it will be eligible to obtain finance up to 3 times of fresh injected
equity, provided the borrower shall plough back at least 80% of its net
profit each year until such time it is able to borrow without this
relaxation.
For the purpose of borrowing- subordinated loans shall be counted as
equity of the borrower.
Banks/DFIs shall not:
a) Take exposure against the security of shares/TFCs issued by them.
b) Provide unsecured credit to finance subscription towards
floatation of share capital and issue TFCs.
c) Take exposure against TFCs or shares not listed on stock
exchanges.
d) Take exposure against sponsor directors shares.
Banks/DFIs shall not own shares of any company in excess of 5% of
their own equity. Further, total investments of bank in shares should
not exceed 20% of their own equity (for DFIs the limit is 35% of their
equity).
Regulation (PR-8) relating to classification and provisioning of assets
is represented by an extra-ordinary lengthy reading. You are
encouraged to familiarize yourself with provisions of this regulation
along with regulation pertaining to governance (Gs) and operations
(Os).
Prudential Regulations-SME
Keeping in view the important role of Small and Medium Enterprises
(SMEs) in the economic development of Pakistan and to facilitate and
encourage the flow of bank credit to this sector, a separate set of Prudential
Regulations specifically for SME sector has been issued by State Bank of
Pakistan. This separate set of regulations, is aimed at encouraging
banks/DFIs to develop new financing techniques and innovative products
which can meet the financial requirements of SME sector and provides a
viable and growing lending outlet for banks/DFIs.
Banks/DFIs should recognize that success in SME lending requires much
more extensive involvement with the SMEs than the traditional lender-
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Lending: Products, Operations and .Risk Management | Reference Book 1
borrower relationship envisages. The banks/DFIs are, thus, encouraged to
work in close association with SMEs. The banks/DFLs should assist and
guide the SMEs to develop appropriate systems and effectively manage their
resources and risks.
State Bank of Pakistan encourages banks/DFIs to lend to SMEs on the basis
of assets conversion cycle and future cash flows. A problem, which the
banks/DFIs may encounter in this respect, is the lack of adequate
information. In order to overcome this problem, banks/DFIs may also like to
prepare general industry cash flows and then adjust those cash flows for the
specific borrowers keeping in view their conditions and other factors
involved.
As mentioned above, presently most of the SMEs in Pakistan lack
sophistication to have reliable and sufficient data and financial information.
In order to capture this data and information, banks/DFIs will need to assist
and guide their SME customers. The banks/DFIs may come up with
minimum information requirements and standardized formats for this
purpose as per their own discretion. For better understanding and to facilitate
their SME customers, banks/DFIs are encouraged to translate their loan
application formats and brochures in Urdu and other regional languages.
In order to encourage close coordination of the officials of the banks/DFIs
and SMEs, the banks/DFIs may require the concerned dealing officer to
regularly visit the borrower. For this purpose, at a minimum, the dealing
officer may be required to pay at least one quarterly visit and document the
state of affairs of the SME. In addition, an officer senior to the ones
conducting these regular visits may also visit the SME at least once in a year.
The banks may, at their own discretion, correlate the frequency of visits with
their total exposure to the SME borrower.
A total of eleven (11) regulations govern banks SME business. Some of the
important ones are discussed as under:
Banks/DFIs shall specifically identify the sources of repayment and
assess the repayment capacity of the borrower on the basis of assets
conversion cycle and expected future cash flows.
All facilities; except those secured against liquid assets; extended to
SMEs shall be backed by the personal guarantees of the owners of
SME.
Banks/DFIs can take clean exposure on an SME to the maximum
extent of Rs.3 Million against personal guarantee of the owner
(funded exposure restricted to Rs.2 Million). All facilities over and
above Rs.3 Million shall be appropriately secured.
Maximum exposure of a Bank/DFI shall not exceed Rs 75 Million.
Total facilities availed by a single SME from financial institutions
should not exceed Rs 150 million.
Classification and provisioning requirements for SME borrowers are
the same as in case of corporate borrowers. Candidate should
familiarize themselves with these complex requirements.
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Operations and Risk Management | Reference Book 1 27
Prudential Regulations - Consumer financing
Apart from the specific regulations for credit cards, auto loans, housing
finance and personal loans, minimum general requirements laid down by
SBP that govern the consumer business are as follows:
Bank/DFIs to establish separate risk management capacity for
consumer business.
Bank/DFIs to prepare comprehensive credit policy duly approved by
their BODs.
For every type of consumer financing facility bank/DFIs to develop a
specific program.
Bank/DFIs to have an efficient computer-based MIS system which
should efficiently cater the needs of consumer.
Bank/DFIs to develop comprehensive recovery procedures for
delinquent consumer loans.
For detailed study of these regulations you are encouraged to read and
assimilate various requirements of different type of consumer financing.
To ensure that bank/DFIs strictly follow the prudential regulations and for
their own regulatory purposes, SBP requires submission of /DFIs various
reports periodically, by the Banks.
Credit Policy
A credit policy is defined as a set of clear written guidelines of a bank that
address the following areas:
Credit terms and conditions - risk assessment criteria.
Customer eligibility criteria - target market.
Criteria for assigning risk ratings for obligors and facilities.
Treatment of obligors of different ratings.
Process and hierarchy for approving or rejecting a credit proposal.
Procedure for policy deviations.
Steps to be taken in case of customer delinquency.
Banks /DFIs must prepare a comprehensive credit policy keeping in view the
PRs set by the State Bank. This credit policy must be approved by the BOD.
There is no one-size-fits-all credit policy as each customer approaching the
bank has varying credit requirements, profiles, repayment capabilities etc.
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Each Banks policy is to be based on their particular business strategy and
cash-flow circumstances, industry standards, current economic conditions,
and the risk culture of the bank. It is imperative for the banks to consider the
link between credit and sales at the time of policy creation. Easy credit terms
can be an excellent way to increase asset sales, but they can also result in
immense losses if customers default. A typical credit policy will address the
following points:
Processes: Details of acquisition, verification and rejection processes
are discussed in detail as an essential part of the credit policy manual.
Credit limits: Suggests the amount of money a bank is willing to
extend in credit form to a single customer and also defines the
corresponding parameters and circumstances.
Credit terms: Terms like payment due date, early-payment discounts
and late-payment penalties etc.
Deposits: If there are any requirements from customers to pay a
portion of the amount due in advance.
Customer Information: This section outlines the level of information
required by the bank about a customer before making a credit
decision. Parameters like years in business, length of time at present
location, bio data, financial data, credit rating with other vendors and
credit reporting agencies, information about the individual principals
of the company etc are all part of this information.
Customer Eligibility Criteria: This section describes factors on which
the decision to extend a credit line to any customer depends. All the
conditions that must be evaluated and analyzed are listed in this
section. All the terms and conditions must be in line with those
mentioned in SBPs PRs. By having a practical and realistic risk
based eligibility criteria banks are aiming to decrease the likelihood
of bad loans.
Documents Required: This section lists the documents mandatory to
processing any form of loan. Includes credit applications, sales
agreements, contracts, purchase orders, bills of lading, delivery
receipts, invoices, correspondence etc.
Other areas like income calculation methodology, credit initiation, rejection
conditions, credit deviation authorities and scenarios, fraud detection and
prevention, collection and recovery strategy and many other sections are part
of the credit policy. Each Bank/DFI develops policy manuals according to
their own standards with more or less all of the sections discussed earlier.
Importance of Credit Policy:
It is evident from the details listed above that a credit policy plays a very
important role in lending operations. Without a credit policy it would be
impossible to manage huge lending portfolios. Once a good credit
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hwducts. Operations and Risk Management | Reference Book 1 29
policy is in place, all cross functional departments have a clear
understanding of their role, resulting in quick and transparent credit
decisions. By defining the target market, risk assessment criteria and by
developing and listing down credit terms and conditions; a credit policy
ensures mitigation of lending risks arising from customers debt servicing
capacity, limit assignment and possible loopholes in collection and recovery
processes.
Pricing
Pricing Mechanisms
Simplistically speaking a loan is when you give someone money for a certain
period and charge them a certain amount (usually expressed as a percentage
and is called markup or interest) for the use of that money. The borrower is
expected to pay back the principal as well as the markup.
Pricing of the loan is the markup rate. This markup rate charged has two
components:
1. Base component, which can be derived from:
Internal cost of funds or
Market-based cost of funds.
2. Variable component.
1. Base component:
1.1.Internal cost of funds:
As a bank, the loan that you give out is against deposits. These deposits
generally have a cost associated to it. The cost can be in terms of:
a) the rate of return promised to the depositor,
b) the administrative cost of generating, processing and servicing the
deposit/depositor.
This method of calculating the cost of deposit is generally called the internal
cost of funds.
1.2.Market-based cost of funds:
In addition to the funds obtained from its depositors, the bank can also
borrow from other banks including the central bank and the money market.
This borrowing involves a cost which is termed as the Market- based cost of
funds. Market rate indicators such as KIBOR, T-bills, PIBs, REPO and
Reverse REPO rates are generally used as benchmark indicators in the
Pakistan market.
KIBOR stands for Karachi Inter Bank Open-market Rate. Its the rate of
interest at which banks in Karachi offer to lend money to one another in the
money markets. KIBOR is issued on daily, weekly, monthly and on 1,2 and
3 yearly basis by the State Bank of Pakistan.
Treasury bills (T-bills) are zero coupon instruments issued by the
Government of Pakistan and sold through the State Bank of Pakistan via
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Lending: Products, Operations and .Risk Management | Reference Book 1
fortnightly auctions. T-Bills are issued with maturities of 3-months, 6-
months and 1 Year and are priced at a discount. T-Bills are risk free, SLR
(Statutory Liquidity Requirement) eligible securities that are actively traded
in the secondary market and are therefore highly liquid. They are issued with
a minimum denomination of Rs.100,000.
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Lending: Products, Operations and Risk Management | Reference Book 1 31
Pakistan Investment Bonds (PIBS) are long term bonds issued by the
Government of Pakistan and sold through the State Bank of Pakistan via
periodic auctions. PIBs are issued with tenors of 3, 5, 7,10,15, 20 and 30
Years. Being backed by the Government of Pakistan, they present a low risk
long term investment option. The Pakistan Investment Bonds offer a fixed
semiannual coupon and repayment of principal at maturity. They are highly
liquid SLR (Statutory Liquidity Requirement) eligible securities that are
actively traded in the secondary market. The minimum denomination of PIBs
is Rs.100, 000.
REPO and Reverse REPO The discount rate at which a central bank
repurchases government securities from the commercial banks, depending on
the level of money supply it decides to maintain in the country's monetary
system. To temporarily expand the money supply, the central bank decreases
repo rates. To contract the money supply it increases the repo rates.
Alternatively, the central bank decides on a desired level of money supply
and lets the market determine the appropriate repo rate. Repo is short for
repossession.
A reverse repo is simply the same repurchase agreement from the buyer's
viewpoint, not the seller's. Hence, the seller executing the transaction would
describe it as a "repo", while the buyer in the same transaction would
describe it a "reverse repo". So "repo" and "reverse repo" are exactly the
same kind of transaction, just described from opposite viewpoints. The term
"reverse repo and sale" is commonly used to describe the creation of a short
position in a debt instrument where the buyer in the repo transaction
immediately sells the security provided by the seller on the open market. On
the settlement date of the repo, the buyer acquires the relevant security on the
open market and delivers it to the seller. In such a short transaction the seller
is wagering that the relevant security will decline in value between the date
of the repo and the settlement date.
2. Variable component:
The variable component of the markup rate is the spread that banks keep on
top of their base component or cost of funds when lending to customers. The
size of the spread generally depends on three factors:
1. Type of the customer i.e. whether the customer is a corporate /
wholesale customer or a consumer / retail customer.
2. Customers credit risk rating which is assigned based on the
customers profile.
3. The banks balance sheet mix and its need for deposit or loans at a
given point in time.
For banks the cost of doing business with the corporate / wholesale customer
is lower compared to consumer / retail customer. For example handing out a
loan of 100 million to one corporate customer costs less in terms of
administrative, legal, processing and servicing cost then than handing out a
total loan of PKR 100 million but split between to 100 different retail
customers.
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Similarly, for banks the cost of lending is higher for high risk customers.
Since for high risk customers the probability of default is higher, the bank
needs to charge a higher rate to keep a cushion in case the customer defaults.
Each bank has a strategic requirement of maintaining certain debt-equity
ratio in its balance sheet. These requirements are specific to each bank, but
must be in line with SBPs stipulated guidelines.
Fixed and Floating Rates
The markup rate given to a customer can be floating or fixed.
Floating rate also known as a variable or adjustable rate refers to a rate on
any type of credit that does not have a fixed rate of mark-up or interest over
the life of that credit. Floating rate changes on a periodic basis. The change
is usually tied to the movement of an outside indicator or the prime rate/
discount rate (an interest rate charged by the central bank from depository
institutions that borrow reserves from it, for example the interest rate
charged by the State Bank of Pakistan). One of the most common rates used
as the basis for applying interest rates is the Karachi Inter-bank Offered Rate
or KIBOR.
The rate for such a credit will usually be referred to as a spread or margin
over the base rate: for example, a five-year loan may be priced at six- month
KIBOR + 2.50%. At the end of each six-month period, the rate for the
following period will be based on the KIBOR at that point, plus the spread.
Re-pricing interval The re-pricing interval measures the period from the date
the loan is made until it first may be re-priced. For floating-rate loans that are
subject to re-pricing at any time the re-pricing interval is zero. For floating
rate loans that have a scheduled re-pricing interval, the interval measures the
number of days between the date the loan is made and the date on which it is
next scheduled to re-price. For loans, having rates that remain fixed until the
loan matures (fixed-rate loans) the interval measures the number of days
between the date the loan is made and the date on which it matures. Loans
that re-price daily are assumed to re-price on the business day after they are
made.
Fixed rate on the other hand does not fluctuate during the fixed rate period.
This allows the borrower to accurately predict their future payments.
For an individual or a company taking out a loan when rates are low, a fixed
rate loan would allow the borrower to "lock in" the low rates and not be
concerned with interest rate spikes. On the other hand, if interest rates are
high at the time of the loan, the borrower will benefit from a floating rate
loan, because if the prime rate falls, the rate on the loan would decrease. The
opposite is true for the lender. The lender would not like to be stuck in a low
fixed rate lending contract if interest rates are rising, as his cost of funds will
rise. Bankers thus keep a large margin when lending at a fixed rate and do a
thorough analysis of the interest rate behavior to ensure that they do not bind
themselves to a lending contract which may become unfavorable in the
future.
Risk-based pricing in the simplest terms, is alignment of loan pridag with the
expected loan risk. It is a manifestation of the risk reward concerc- higher
the risk, higher the reward; in this case higher the risk, higher the price of
credit i.e. mark-up. Typically, a borrowers credit risk is used tz> determine
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Operations and Risk Management | Reference Book 1
if a loan application will be accepted or declined. That sane risk level is also
used to drive pricing. This means charging a higher interest rate for a higher
risk transaction or high risk rated customer and a lower rate for a lower risk
transaction or a lower risk rated customer.
A balanced pricing strategy comprises of three critical elements. First, the
bank must have solid credit quality. If the borrower defaults, the net result is
a charge-off that negatively impacts credit reserves and bank earnings. The
second important component is profitability. Pricing for loans must result in
the required rate of return on assets as determined by the bank. The final
component of a balanced pricing strategy is portfolio growth. A balanced
pricing strategy should support portfolio growth generated by profitable,
quality loans. The result is a balanced pricing strategy that can be best
summarized as the proverbial three-legged stool of quality, profitability, and
growth. Each is important, but if one is missing, the stool will tip over.
Risk reward pricing is the ratio used by lenders to compare the expected
returns of a loan to the amount of risk undertaken to capture these returns.
This ratio is calculated mathematically by dividing the amount of profit the
lender expects to have made when the position is closed (i.e. the reward) by
the amount he or she stands to lose if price moves in the unexpected
direction (i.e. the risk).
The higher the risk the greater is the reward. In consumer banking the spread
is very large, the pricing is based on the whole portfolio and the
administrative cost is very high therefore the risk is high. Whereas in
corporate banking, the individual loan is priced therefore the risk is low.
Relationship yield pricing is pricing the credit based on the overal customer
relationship rather than on a stand-alone product basis. Fo example if the
customer has taken a loan from the bank, chances are h would also route his
collections and payments through the bank as wel Sometimes a loan is an
initiator of a larger relationship with the customs therefore it is the
relationship managers responsibility to not just sell loan to the customer but
build further relationship with customer t cross-selling other products. Since
other products generally have a low risk involved as compared to loans,
profitability of the customer to t! bank on a holistic level compared to the
risk involved will be high when the customer is using other products of the
bank.
For example, Haji Kareem Bakhsh & Co banks with the National Bank of
Pakistan (NBP). They are in the business of plastic bottles manufacturing. At
the moment they have a long term loan of Rs. lOOMillion with the bank at 1
year KIBOR + 2.5% p.a. NBP hosts their 200 employee accounts and also
provides payroll management services. Similarly, their collections account is
also being maintained at NBP. Last month the company imported machinery
from Japan worth $50,000 for which an LC of the required amount was also
opened by NBP in their name. The LC pricing is 0.1% which the customer is
refusing to pay on the pretext that it has such extensive business with the
bank. Moreover, the customer has requested a short-term financing- FIM for
a period of 30 days for which the customer insists that it will only pay 1
month KIBOR +0.5% on this transaction. On a stand-alone basis this
transaction will not make any money for the bank and there is risk involved.
It is important to evaluate the revenue of the entire relationship as well as the
impact on the relationship before deciding to open the LC or decline it.
Taking another example, where Mr. Ahmed Saad has a HBL credit card with
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Lending: Products, Operations and .Risk Management | Reference Book 1
limit of Rs.100,000. He is very apt in settling his outstanding balance. He
generally makes the payment within few days of making the transaction,
which ensures that he is never charged any markup on the utilized amount.
The only income HBL earns on this credit card is the annual fee and 1.25%
to 2% acquiring commission on each transaction. Mr. Saad also maintains a
current account with HBL with an average balance of Rs.300,000. Mr. Saad
has requested the bank for a waiver on the annual charges for the credit card
which are PKR 1500. In his request he has mentioned his long standing
relationship with HBL on the depository side and has said tha