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Factors involved in consideration of credit proposals. Factors involved in consideration of credit proposals. Proper assessment of a credit proposal, taking into account all the relevant and important factors forms the basis of a banker’s sound financing decisions.
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Factors involved in consideration of credit proposals • Proper assessment of a credit proposal, taking into account all the relevant and important factors forms the basis of a banker’s sound financing decisions. • The following factors must be taken into consideration. • Diversification • Safety/security • Liquidity • Profitability • Desirability • Customer’s character • Customer’s management capability • Customer’s capital • Project viability • Credit risk and return
Diversification • The principle of diversification is the key method for managing credit risks. • Banks apply this concept by setting exposure limits on several criteria such as industry exposure limits, counter party limits and per party limits.
diversification • According to prudential regulation R1 • The total outstanding exposure (fund based and non-fund based) by a bank/DFI to any single person shall not at any point in time exceed 30% of the bank’s/DFI’s equity as disclosed in the latest audited financial statements, subject to the condition that the maximum outstanding against fund based exposure does not exceed 20% of the bank’s/DFI’s equity.
Diversification • The total outstanding exposure (fund based and non-fund based) by a bank/DFI to any group shall not exceed 50% of the bank’s/DFI’s equity as disclosed in the latest audited financial statements, subject to the condition that the maximum outstanding against fund based exposure does not exceed 35% of the bank’s/DFI’s equity.
Safety / Security • Safety of bank’s exposure is one of the most vital aspects of affording any credit facility. • The bank should be certain that the credit facilities allowed are well secured and can be recovered through realization of such securities. • Security held should be considered a second way out, as bank’s financing should normally be liquidated from customer’s business cash flows.
Safety / security • From a banker’s point of view prime / collateral securities should posses the following attributes before such securities could be termed as acceptable. • Readily realizable and of steady increasing value. • Marketability/ storability of the goods offered as security. • Durability of the assets charged to the bank. • Transportability / transferability (where applicable) of the nature of assets charged. • Bank has unhindered access to security. • Special care is required in case security is previously encumbered. • All security documentation should be perfect in all respects. • However security collateral offered should not be taken as sole justification for sanctioning of facilities and other factors such as viability of the project, etc should be given due consideration.
Liquidity • It would require the banker to ensure that the customer remains in a position to repay on demand, or at least within a reasonable time after the demand for payment is made. • The banker should also ensure that funds invested are not locked up for any unduly long or indefinite period. • The banker should ascertain whether the transactions of the project being financed would generate necessary cash to repay the finance and mark up, as per the agreed schedule. • In case of large projects feasibility study and cash generation statement should also be examined minutely. • Bankers usually prefer granting of short term finances. The longer the period of repayment, the greater the unforeseen risks in future, due to factors such as change in the global / national economic situation or changes in government policies.
Profitability • The major source of a bank’s income is through financing of viable projects generally on a short term basis and this important profitability factor should be kept in constant view. • However in the process of such profit making considerable risk is often involved as among several unforeseen factors the borrowing firm may at some point in time, not be able to operate successfully, thus risking the bank’s finances. • Hence the banker should avoid investment in such projects where although the profit is high, a much greater risk is involved. • to maintain a proper balance the bank should keep in its investment portfolio, three types of investments i-e liquid semi-liquid & income earning investments. • In a nut shell the bank while employing funds in the most profitable channels, should not ignore important aspects of safety and liquidity.
Desirability • While providing facilities to customers the banker must ensure that the funds are utilized for productive, bonafide business purpose and not for speculative undesirable activities such as hoarding, black marketing or for purposes other then the customer’s normal sphere of business. • It should be ensured that the purpose of borrowing is clearly spelt out indicating useful and productive application of funds for a specific purpose, which should be in line with the regulatory requirements.
Customer’s character • The customer’s previous records must be looked into to ascertain the degree of their honesty and integrity. • Information should be obtained as to whether they have been known to keep their commitments or have been defaulters in respect of any facility allowed in the past by any bank.
Customer’s management quality • It is important to gauge the customers’ ability to manage their business efficiently and in manner that they conserve their resources and meet their obligations on time. • This ability can be judged from their qualities of effective management and necessary experience in their particular line of trade . • The banker must have a clear picture of this aspect, as facilities allowed without carefully weighing these aspects may lead to partial or total loss of funds lent by the bank.
Customer’s capital • The customer should have sufficient funds as his own stake in the business. • Prudent bankers are reluctant to finance borrowers who do not invest enough funds of their own in the business. • It should be ensured that the customer has sufficient stake in the business to remain committed even in the difficult circumstances.
Project viability • An applicant having a viable project and possessing other favorable attributes may be financed. • A customer may have a well balanced proportions of character, capacity and capital, yet the credit proposal may still be lacking in the aspects of project viability, marketability of goods produced, conduct of the account and operation/ utilization of previous limits granted, the fulfillment of commitments etc. Thus all these factors must be kept in mind.
Credit risk and return • The reward that the bank receives for bearing the risks which are inherent in its customer base and the products which it offers are determined by a number of factors, the most powerful being the risk/ reward criteria and market competition. • The product offered by the banks in the same market generally posses similar characteristics. It is therefore difficult to demand a return which is substantially different from that prevailing in the market place. • The ultimate objective of the bank is to maximize the return, but this must be done with in acceptable risk parameters. • The principle risk parameters are the strength of the business, cash flows, and the ease with which the security can be realized. • However while deciding on the rate of return, both probability of default and that of loss, must be carefully analyzed.
