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Credit appraisal techniques

A forward looking approach should also be adopted

Nov ,12 - 18, 2001

The Banking sector in Pakistan continues to suffer from a loan problem portfolio, due to a variety
of reasons. While there is no guaranteed procedure for ensuring loans do not go bad (certain
circumstances can go against the best of borrowers), I have tried to develop a procedure for
analyzing credits, as outlined below. This is based primarily on personal experience of over 20
years as a lending offficer, sitting on the Board of Banks besides guidance from earlier
supervisors, and training programmes attended.

The important thing to remember is not to be overwhelmed by marketing or profit center reasons
to book a loan but to take a balanced view when booking a loan, taking into account the risk
reward aspects. Generally we remain optimistic during the upswing of the business cycle, but
tend to forget to see how the borrower will during the downturn, which is a shortsighted approach.
Furthermore we tend to place greater emphasis on financials, which are usually outdated; this is
further exacerbated by the fact that a descriptive approach is usually taken, rather than an
analytical approach, to the credit. Thus a forward looking approach should also be adopted, since
the loan will be repaid primarily from future cash flows, not historic performance; however both
can be used as good repayment indicators.

Having postulated above guidelines, following is a suggested general procedure for reviewing
short term lending proposals

Company Profile / Ownership: This should cover the legal structure of company, i.e. is it public /
private / listed. If listed then broker reports can be an additional source of information besides
share price. Sole proprietorships / partnerships tend to be higher risk. Potential support can be
provided by sister concerns, multinationals etc. While this can be a support it can also work as a
disadvantage with possible diversion of funds to sister concerns, transfer pricing etc. which
should thus be addressed.

When dealing with individual Group companies it is essential go review overall Group exposure to
ensure that the Group Risk is adequately analyzed and monitored, and Group limits also set.

Proposed Transaction: Following key items should be addressed:

Purpose of facility: This must be specific and general terms should be avoided, such as
"working capital facility." A specific need would be to "finance inventory" or "receivables" (or both).
These two assets generally constitute the rationale for short-term borrowings.

Source of repayment: The cash cycle including payment and selling terms must be reviewed,
which impact cash flow. Normally there should be reliance on identifiable cash flows for the first
way out to repay the loan rather than the security itself. The lending officer should understand the
cash production cycle and its tenor, and should question how the Bank will be repaid if things do
not work out as expected for the customer e.g. slow sales, increases in inventory costs, etc.

Credit Limits - Bank experience to date with borrower and use of facility should be reviewed.
Limits with other Banks should also be provided, besides ability to obtain additional debt i.e. Bank
should avoid being in a situation of lender of last resort. Sole Banking relationships are
undesirable as it shows too much reliance on one source. Proposed Limit will give the overall
exposure to the company, which should be reviewed to see if it is warranted, in relation to facility
purpose, size of sales, capital etc., besides the usual credit criteria.

Security: Full details should be provided, besides description of security as the alternative loan
repayment source and its realizable value, where possible. It should be properly insured by a
Bank approved Insurance Company and covered against various risks. Documentation must be
precise, while security evaluation should cover control, marketability and lending margin, to
protect against price fluctuations. Frequent independent verification of the security should take

If the security taken is not saleable, then this should be recognized and the risk addressed e.g. if
there is only a sole seller of the product, then there will be no other buyer for his assets, in event
of a forced sale. The Bank will thus be left with an unrealizable asset. Where receivables are
taken as security, then quality / ageing should be reviewed, which would enable the Bank to
assess the reliability of this asset as a loan repayment source.

Banks should not lend in an inferior position; all charges on security should be First Registered
and pari passu with other lenders, to ensure the Banks interests are properly covered. If the
Directors' guarantees are taken then separate individual Net worth statements or tax returns
should be provided to support these guarantees and judge their capacity to repay guaranteed

Financial Analysis: Normally a spread sheet should be used for analysis, which shows ratios,
trends etc. At minimum the last three years financials should be spread to analyze trends. Figures
should be updated and not more than six months old. Quality of auditors should be ascertained to
judge reliability of figures, and check if the accounts are qualified. The figures should be
analyzed, not described, in order to judge the financial position of the company.

Where possible projected financials should also be obtained as repayment will be from future
cash flows. Key items such as trends, market position, industry risk, industry status,
capitalization, liquidity, dependence on borrowings, leverage, profitability, inventory/receivables
position, besides capital/debt structure should be reviewed. Asset Turnover ratio is useful,
besides leverage which shows net worth coverage of liabilities.

Days Inventory and Days Receivable are crucial indicators of a Company's liquidity and show the
need for an amount of borrowed funds, which are repaid through the liquidation of these assets.
Earnings are key to a company's success. Therefore one should review long term earning power,
consistency and trend of core earnings, earnings mix, and dividend policy.

Balance sheet figures are at a point of time - therefore it is essential to analyze realistically e.g.
borrowings/inventory can be reduced for balance sheet date purposes. Thus average figures are
more reliable where available. Figures can also be inflated for seasonal factors e.g. inventory
build-up during the cotton-buying season, which should be recognized accordingly.

For Project Finance one should analyze both historic and projected figures, with full sensitivity
analysis, to ascertain repayment ability. The Bank should rank pari passu on cash flows with the
lenders i.e. for long-term loans the tenor should not exceed that of other lenders. Periodic project
monitoring is essential to check progress of the project both during implementation and after it is

Management Evaluation: This aspect is often not given the importance it warrants. It should not
be overlooked since the management impacts overall performance of the company and hence its
ability to repay loans.
Following items should be noted when assessing management:

• Quality and depth of management, particularly the CEO.

• Experience, qualifications, and capability.
• Succession and back up plans.
• Management style i.e. conservative, centralized/ decentralized approach,

Organization Culture, Corporate strategy.

• Career progression, training and development policies.

• Staffturnover/personnel policies.
• Training, motivation, morale, besides staff quality.

The CEO sets the pace for the Company and can determine its success with the necessary
teamwork e.g. Jack Welch of General Electric, who has been enormously successful as CEO.

People are the most important resource a Company has and are crucial for its successful
running. Those Companies are successful which treat and recognize its talent properly and have
a clear, careful and thought out business strategy, formalized in a Business Plan which is then
followed accordingly. Besides this they have a organized change culture, solid customer
relationships and a strategic brand management / differentiation.

Above items are not found in the Balance Sheet, and should be analyzed by the lending officer,
after careful scrutiny and discussion with management.

Risk Areas: The lending order should review all risks officer relating to the lending point wise
along with the mitigants and justified why lending is warranted, i.e. can the risks be covered or
are these acceptable risks. Each borrower will have different risk profiles and therefore it is
important to ensure there are adequately understood and addressed.

Checkings: Written checkings from other lenders should be obtained. Trade/market checkings
can be obtained from various sources e.g. suppliers, etc. Talking to suppliers and other market
information can give updated input on the company's financial position, e.g. if company is
delaying payment to suppliers this could indicate liquidity problems. Also checks should be made
from the market how the company's product is selling in the market or if it suffers from quality
problems - these items are important since they impact sales and ultimately cash flow.

Loan Profitability: Again this is an important area which helps evaluate the risk / reward aspects
of a transaction. It is important to earn an acceptable spread on a loan, and therefore to arrange
necessary funding, to compensate for the credit risk. Apart from this the Bank should make an
adequate return on the loan to help build the up net worth which is a cushion to absorb loan
losses. The Bank should maximize return on assets not only through spread income but other
non funds income such as commissions, exchange etc. which are generated from contingent risk
and do not involve the use of Bank funds.

There is no insurance against loan losses or problems, nor is lending a rocket science. The
lending officer must therefore exercise common sense and follow basic lending rules when
analyzing a credit. There is no short cut to this - after disbursement it is also essential to maintain
contact with the company and remain abreast of its financial position. A lending officer must not
only have requisite credit skills, but develop problem recognition abilities to enable him to take
necessary and timely action, as and when required.
The above is a basic guideline to reviewing short-term credits and is not all exhaustive. It should
thus be reviewed on a case by case basis. Each borrower has different circumstances and should
be reviewed as such. I have attempted to cover short-term borrowings only - project finance and
other form of lending have different risk criteria, which have not been addressed here. However 3
'C' s of a credit are crucial and relevant to all borrowers / lending which must be kept in mind at all

• Character
• Capacity
• Collateral

If any one of these are missing in the equation then the lending officer must question the viability
of the credit.

There is no guarantee to ensure a loan does not run into problems; however if proper credit
evaluation techniques and monitoring are implemented then naturally the loan loss probability /
problems will be minimized, which should be the objective of every lending officer.

About the Author

The author has a honors degree in Economics / Accounting and a MBA, both from British
Universities. Subsequently he has gained over 20 years lending experience with Citibank and
American Express Bank, in Pakistan and the Middle East. He has served on the Board of
Directors of NDFC and Orix Investment Bank besides other Companies and is presently working
as a Credit Advisor with Pakistan Kuwait Investment Company (Pvt.) Ltd.

The above article has been derived from presentations the author has made to Bankers on Credit
Analysis. It has been written in view of the positive responses obtained, recognizing the need to
reach a wider audience on this relevant subject.

The effect of credit growth on NPAs

A. S. Ramasastri
N. K.Unnikrishnan

FINANCIAL year 2004-05 has seen substantial growth in bank credit. As on

March 18, 2005, the annual credit growth was 26.2 per cent against a much
lower 16 per cent in the previous year. In this context, it is important to look at
the trend in non-performing assets (NPAs) of banks.

NPAs are largely a fallout of banks' activities with regard to advances, both at
the management and implementation levels (including overall controls by the top
management), the credit appraisal system, monitoring of end-usage of funds
and recovery procedures.
It also depends on the overall economic environment, the business cycle and the
legal environment for recovery of defaulted loans. Since the overall environment
is more or less same for all banks, non-performing loans of individual banks are
mainly a result of management controls and systems put in place by them.

A bank with an efficient credit appraisal and loan recovery system will grow
stronger over the years. Such banks have good management control and also
inherent strengths in terms of a highly motivated staff, good checks and
balances, which are further enhanced by a regulatory and supervisory system.

As the growth in advances is largely determined by the economic and business

environment, such banks will be able to push their credit portfolio aggressively,
especially when the economy is booming. Also, as such banks have a diversified
credit portfolio, it would act as a cushion during economic downturns. This will
result in lower NPAs, allowing them to grow stronger and even adopt a more
aggressive growth strategy and, thereby, withstand marginally higher incidences
of default.

However, a bank without inherent strengths will not be able to push their credit
portfolio the way they want to. They are characterised by poor management
control, inadequate credit appraisal and even low levels of motivation among the
staff. When such banks push their advances portfolio, chances of their asset
quality deteriorating are higher.

Since asset quality will be visible only after credit disbursal, which itself depends
on the regulatory definition of NPAs, any deterioration will be reflected after a
time lag.

Thus, banks without inherent strength will have higher NPA levels, especially
when the economy has seen above average credit growth.

Factors affecting NPAs

General environmental factors: These include business cycles, the legal
framework, ethical standards, the regulatory and supervisory system, and the
political environment.

Bank specific factors: The credit appraisal system; credit recovery procedures;
controls, checks and balances adopted by the top management; the risk
management system in place; and the motivation level of staff.

Thus, for both healthy and not-so-healthy banks, asset quality after an above
average credit growth has a major effect on NPAs. One way to capture the effect
of deterioration in the asset quality is to consider cumulative growth rates of
credit, which also captures the time-lag effect of credit migration.

A quick analysis (see Table 1) shows that high cumulative growth of advances
(2000-01 over 1997-98) was followed by a spurt in NPAs in later years for a
majority of the banks. Of the 18 banks with more than 80 per cent cumulative
growth, 12 witnessed increased NPA levels.

While State Bank of Indore, Jammu & Kashmir Bank, Andhra Bank and UTI Bank
reduced their NPAs in 2000-01 over 1999-00, United Western Bank, Global Trust
Bank and ICICI Bank, among others, saw substantially higher NPA levels.

Such comparison may not be fully relevant now. Banks have managed to reduce
their NPAs substantially over the years, thanks to higher provisions and an
improved legal framework for pursuing bad loans.

Thus, while comparison with the past may not be fair, lessons from the past may
not be inappropriate. Banks with an aggressive approach to credit growth may
have to handle their advances portfolio with care, especially after a spurt in
overall credit growth.

Given the cumulative growth in advances, which can be classified as low or high
credit growth compared to an average `middle' growth, it may be appropriate to
look at resulting NPAs, which can also classified as low or high, again as
compared to an average or middle level NPA.

In statistical jargon, this could be viewed as an attempt to create 2 x 2

contingency tables, with one variable as cumulative credit growth and the other
as NPAs. The classifications are based on average cumulative growth for each

To reduce the effect of outliers on classification, extreme observations are

excluded while averaging. Such classification is done for four years from 2000-01
to 2003-04 on the basis of three years' cumulative growth of advances (Table 2).

From Table 2 it can be seen that banks fall in four categories along with number
of years it appeared in the category. For instance, State Bank of India has low
cumulative credit growth followed by low NPAs for all the four years from 2000-
01 to 2003-04 and IndusInd Bank had high cumulative credit growth followed by
low NPAs for 2000-01 and 2003-04.

Some major observations can be made based on Table 2:

 Banks with high credit expansion followed by low NPAs are the ones with a
good credit appraisal system in place and with ability to recover it.

It may be possible for a bank to perform well in this sense for one year, but not
Only HDFC Bank was able to perform this way over four years, that is, from
2000-01 to 2003-04. Jammu & Kashmir Bank and IDBI Bank have been in this
category for three years.

 Banks with high credit expansion followed by high levels of NPAs cannot
perform consistently and they invariably fall behind; it is an unsustainable
approach. Banks such as Development Credit Bank fall in this category.

Aggressive credit expansion along with non-recovery till 2001-02, forced it to

substantially curtail its operations, ending up with low advance growth during
2003-04. Lord Krishna Bank has been in this category since 2001-02.

 Banks with low credit expansion and low NPAs adopt a cautious approach
towards credit expansion. And those that consistently belong to this category
have low growth in advances, despite low levels of NPAs.

As per Table 2, only State Bank of India has been in this category consistently.

Perhaps, the credit market in India does not have the capacity to absorb the
funds available. Sangli Bank, one of the old private sector banks, has been in
this category for three years. Banks with comparatively larger balance-sheets,
such as State Bank of Saurashtra and Bank of Baroda, were also members of
this group for two years.

 As mentioned, banks with low credit growth and high NPAs are the ones to be
monitored. These banks may have to review their credit assessment and
monitoring systems. Based on the four years, the banks commonly in this group
are Dena Bank, Ganesh Bank of Kurundwad and SBI Commercial & International.

Further, for the last three years, Punjab & Sind Bank has been in this category.
United Western Bank and erstwhile Global Trust Bank were in this category for
two years. It is worth mentioning that United Western Bank had extended high
credit despite having high NPAs during 1997-98 to 2000-01.

 The common perception that listing of a bank in the stock market improves
quality of management may not be always correct, as illustrated in the Dena
Bank, United Western Bank and Global Trust Bank cases.
 Also, ownership pattern does not necessarily have a bearing on performance
of banks. Both private and government entities have appeared in the important
categories discussed.

To conclude, higher than average credit expansion can further strengthen banks
if there is a good credit appraisal systems, strict recovery procedures and overall
checks and balances by the top management.

(The authors are in the Division of Banking Studies, RBI, Mumbai.)

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