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UNITED BANK OF AFRICA (UBA)

UNITED BANK OF AFRICA (UBA) November 2006

November 2006

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TABLE OF CONTENTS

INTRODUCTION

SECTION 1: GENERAL CREDIT POLICIES

Page

1.1 CREDIT POLICIES

5

1.2 GENERAL CREDIT PRINCIPLES

5

1.3 APPLICABLE ACTIVITIES

6 - 7

1.4 GENERAL CREDIT FACILITIES

7 - 9

1.5 CREDIT PROCESS

9 - 11

SECTION 2: ROLES AND RESPONSIBILITIES AND APPROVAL AUTHORITIES

12 - 13

SECTION 3: RULES GOVERNING EXTENSION OF CREDIT

 

3.1

SANCTIONING PROCEDURES

14

3.1.1

OVERVIEW

14

3.1.2

DISCRETIONS

14

3.1.3

OTHER APPROVAL REQUIREMENTS

15 - 17

3.1.4

CREDIT PROGRAMS

17 - 18

3.1.5

CLEARING RISK

18

3.2

CREDIT ANALYSIS STANDARDS

18

3.3

FINANCIAL APPRAISAL

19 - 21

3.4

OPERATING PERFORMANCE

21 - 22

3.5

LIQUIDITY

23 - 24

3.6

DEBT SERVICE

25 - 27

3.7

EXCESS POSITIONS

28

3.7.1

EXCESSES

28

3.7.2

UNCLEARED EFFECTS

28

3.7.3

EXCESS APPROVAL AND REPORTING

28 - 30

3.8

MONTHLY REPORTING OF SANCTIONED FACILITIES

30

3.9

CREDIT PROCESSING RESPONSIBILITIES

30 - 31

SECTION 4: RISK AWARENESS

4.1

MONITORING

32

4.1.1

INTRODUCTION

32

4.1.2

MONITORING INTERNAL BANK INFORMATION

32 - 36

4.1.3

MONITORING EXTERNAL INFORMATION

36 - 40

4.1.4

MONITORING RESPONSIBILITIES

40 - 41

SECTION 5: REMEDIAL MANAGEMENT

5.1

OVERVIEW AND OBJECTIVES

42

5.2

WATCHLIST

43

5.2.1

IDENTIFICATION OF WATCH LIST ACCOUNTS

44

5.2.2.

WATCHLIST RELATIONSHIP MANAGEMENT RESPONSIBILITY

44

5.2.3

STRATEGY SHEETS

44

5.2.4

QUARTERTLY RETURNS

45

5.2.5

SECURITY

45

5.3

NON-PERFORMING ADVANCES

45

5.3.1

ACCOUNT MANAGEMENT RESPONSIBILITY

45

5.3.2

DEFINITIONS

45

5.3.3

STRATEGY SHEETS

46

5.3.4

MONTHLY RETURNS TO RISK MANAGEMENT

46

5.3.5

PROVISIONING

47

5.3.6

WRITING OFF OF CLASSIFIED ADVANCES

47

5.3.7

RECOVERY AND RELEASE OF PROVISIONS

47

SECTION 6: CREDIT RISK MODEL

6.1 CREDIT RISK RATINGS

48

6.2 GRADING CHARACTERISTICS AND GUIDELINES FOR COMPLETION

48 - 50

SECTION 7: PORTFOLIO MANAGEMENT AND REPORTING

7.1 OVERVIEW AND OBJECTIVES

51

7.2 MANAGEMENT REPORTING

51

7.3

GUIDELINES

51 - 52

SECTION 8: SECURITY

8.1

BACKGROUND

53

8.2

TYPES OF SECURITY AND VALUATION

53 - 62

Appendices

63 - 91

Introduction

INTRODUCTION:

“Credit Risk is the current or prospective risk to earnings and capital arising from an obligor’s failure to meet the terms of any contract with the bank or to otherwise fail to perform as agreed.”

The Credit Risk Policies and Procedures document the core credit policies for identifying, measuring, approving and reporting credit risk in United Bank of Africa Limited (“UBA”). These policies ensure compliance with the Banking and Financial Institution Act (2006) and Bank of

Tanzania Regulations.

These policies are established by the Bank and have been approved by the Board of Directors of UBA. Any subsequent changes to these policies must be approved by the Board Executive Committee to whom the responsibility for Credit Risk management is delegated.

Any exception to the policies and procedures herein must be approved the Board Executive Committee through Head of Credit Risk Management. All exceptions, including rationale, must be documented, and must carry either an expiration date or review date.

These policies and procedures replace existing Credit policies and procedures. This document will be updated periodically, as necessary, and the relevant pages replaced.

This document is designed for easy use and reference by all members of UBA at all experience and responsibility levels who are directly and indirectly involved in the credit process. This includes senior management and internal auditors. These policies act as a cornerstone for credit training of all staff at all levels within UBA.

Policy Document Structure:

The document is in two broad parts as summarised herebelow:

Section 1 – The Policy Statements Section 2 – 7 Standards and Procedures

General Credit Policies

SECTION 1: GENERAL CREDIT POLICIES

1.1: CREDIT POLICIES

UBA has identified ten core credit policies that define the bank’s risk behaviour and that characterize its credit culture. The board of directors carry the ultimate responsibility of approving and reviewing the credit risk policies of the bank. These statements are summarised in this section:

a) Business will be accountable in conjunction with Credit Risk Management for establishing and maintaining appropriate risk limits and risk management procedures for their businesses.

b) There will be a single Responsible Officer for every obligor.

c) Credit Risk policies will be established by Credit Risk Management, approved by the Board of Directors through the Board’s Executive Committee (“EXCO”), and effectively communicated throughout the institution.

d) The authority granted to individual credit officers to approve credit will be based upon consistent set of standards of experience, judgement, and ability.

e) Credit Officers will be appointed by EXCO with delegated authority exercised through the Managing Director and Head of Credit Risk Management.

f) Every obligor must be assigned a risk rating, in accordance with an approved Risk Rating Process.

g) Consistent standards across UBA for origination, documentation and maintenance of extensions of credit are applied.

h) Consistent approaches within UBA toward problem recognition, classification of problem credits and remedial action are applied.

i) UBA will maintain a diversified portfolio of risk assets. Limits will be maintained, including concentration limits by industry, maturity, currency and other parameters from time to time identified as being relevant. The policy includes target markets, diversification and concentration of the credit portfolio.

j) A comprehensive set of credit risk data must be reported into the risk system, in an accurate, complete and timely fashion.

1.2: GENERAL CREDIT PRINCIPLES

All business, which UBA undertakes, must meet the following fundamental tests before taking other elements into consideration:

a) The Bank’s credit posture is inherently conservative and must adequately reflect the balance between risk and reward.

b) Credit should only be extended for known purposes which have been identified and agreed with the borrower.

c) Credit should never be extended where the borrower’s business or ethical record is doubtful or where illegalities are suspected.

General Credit Policies

d) Credit should not be extended where the known sources of repayment are unclear, unproven or open-ended.

e) Credit should not be extended in unfamiliar markets or industries.

f) Credit should not be extended where agreed repayments are totally reliant on all economic factors working in the borrower’s favour.

g) The primary source of repayment should be from identified flows of cash from normal business operations with security being regarded only as a secondary source of repayment.

h) Concentrations of risk and all exposure should be calibrated to risk.

i) Lending must closely reflect the Bank’s business strategy.

j) If at all possible, lending transactions should be priced, structured and secured in such a manner that they are capable of being sold down to a third party, should we so decide.

k) Foreign currency lending must have take-out clauses, which will enable the Bank to switch to domestic currency at short notice. Foreign currency lending will be undertaken only in instances where a borrower has identified foreign currency income streams or has foreign currency based repayment source.

1.3: APPLICABLE ACTIVITIES

United Bank of Africa shall extend facilities to reputable commercial customers on transactions related to domestic and foreign trade and commerce, but within laid down industry and individual exposure limits as may be agreed from time to time. This may include the financing of:

a) Wholesale and retail trade, including the export and import of goods and commodities.

b) Manufacturing, including the processing of commodities and raw materials and the manufacture of finished or semi finished goods.

c) Financial, insurance and other services.

d) Building, construction, electricity and water generally including construction and purchase of residential and commercial real estate.

e) Transport, communication, freight and the general storage and movement of goods. Aircraft finance may be considered with specialist input and approval at Board level.

f) Hotels, Tourism and Tour Operators.

g) Personal lending but mainly on a pre-agreed packaged product basis.

h) Agriculture.

i) Business and professional services

Specifically excluded from consideration are loans for:

a) Speculative or non-productive purposes

b) Arms and armaments

General Credit Policies

c) Gambling.

d) Shipping finance.

e) Pornography.

f) Illegal activities.

g) Other purposes as may be laid down from time to time.

1.4: GENERAL CREDIT FACILITIES

Within authorized lines of credit, the following may be made available:

A Short Term Commercial Credit

Priority will be given to short-term, self-liquidating lines of credit which may encompass

a)

The issuance of commercial letters of credit and guarantees, the discount of domestic and export two-name paper and the granting of domestic and foreign currency loans, overdrafts and advances for the purpose of:

Financing imports, exports and domestic trade

Working capital finance

Seasonal agricultural finance

b)

The purchase or discount of documentary or clean drafts on banks and firms outside Tanzania and similar instruments on banks or firms within Tanzania.

c)

The negotiation of sight or usance drafts under letters of credit established by other banks of suitable standing where limits are in place

B

Term Credit

Term Credit with tenors exceeding five years outside established product profiles must be approved by the Head, Credit Risk Management, who shall monitor that tenor exposure is within set limits. Term credit may be extended to finance the following:

a) The purchase of machinery and equipment for commercial, industrial and agricultural purposes

b) The purchase, expansion or long term increase in the working capital of a business

c) The purchase of real estate

d) The purchase of vehicles

N.B.

i)

Term Credits are to be secured by first legal charges on real estate and/or debentures and/or other fixed assets and/or working capital assets and/or chattel mortgages or other

General Credit Policies

acceptable collateral including guarantees. Collateral is subject to outside independent appraisal satisfactory to the Bank and is to be properly and adequately insured to the satisfaction of the Bank with the Bank’s interest noted thereon.

ii)

It is the policy of the Bank that no disbursements will be allowed prior to the perfection of all security documentation.

C

Credits to Individuals

Credit to individuals should be targeted at the middle to top end of the personal banking market especially executives and staff of our commercial clients. Notwithstanding this, short-term personal loans or temporary overdrafts, may be made to individuals on a secured or unsecured basis in accordance with normal banking practice. It is however the Bank’s preference that such lending should as far as possible be packaged lending undertaken by the use of a scoring approach. This is covered by the Personal Banking products profiles, which are attached to this Credit Policy Document.

D Credits to Local and Overseas Banks

The Bank may issue or confirm clean documentary letters of credit for banks for which an approved line of credit has been established. The Bank may also place short-term deposits with local or foreign banks within approved lines of credit.

E Foreign Exchange Dealing and Money Market Placements

The Bank may undertake foreign exchange and money market placements in foreign and local currency within authorised dealing and placement limits and under the overall control and responsibility of the Head of Treasury.

F Real Estate Loans

Subject to overall prudential limits that are set from time to time, it is the policy of the bank to make loans for the construction or purchase of residential or commercial real estate. Real estate, both commercial and residential, may be taken as collateral for credit facilities granted for other acceptable purposes. Bridging loans may also be considered with a defined take-out from an acceptable long-term lender or take out within the Bank’s mortgage lending programme.

G Syndicated or Club Credits

The Bank may lead or enter into syndicated credits with reputable local and foreign banks and other reputable institutional lenders (e.g. Insurance companies) but must carry out its own appraisal in a robust fashion as though it was in a sole lender situation

General Credit Policies

H Guarantees

The Bank may issue bid and performance bonds, customs bonds, shipment and other guarantees of a normal commercial nature. Extreme care should however be taken with such instruments to avoid open-ended exposures which do not have a defined maturity date. Such guarantees should have maturity not exceeding three years and be subject to normal collateral requirements and in some cases, preferably be cash covered

I Loans to Directors and Staff

These may be made but as laid down in the separately issued Employee Loan Policy Document and specific Bank of Tanzania Prudential Guidelines or as may be updated from time to time.

J Problem Credits

The Bank may enter into any type of legal credit arrangement deemed necessary to ensure better support for the collection of problem loans. Such action will normally be subject to report to the Board Executive Committee

K Lending to Governments

The Bank is permitted to invest in local and foreign currency, in Treasury Bills and other Government paper subject to separate approved credit lines. In general, the policy will be to maintain an adequate liquidity ratio as dictated by law and sound banking practice and to maintain an investment portfolio with adequate distributions of maturities to provide the necessary liquidity. This will be actively managed by the Bank’s Assets and Liabilities Committee (ALCO), which meets monthly and at other times as and when required.

1.5: CREDIT PROCESS

A Background / Purpose

The purpose of this section is:

To clearly lay down the principles governing lending decisions and credit approval authority.

To establish a mechanism of thresholds below which credit approval authority may be vested in managers within business units, and

To establish a procedural framework within which the credit approval process will operate, and in doing so, provide some necessary definitions.

Credit approval for all exposures should be separated from loan marketing, analysis and structuring. There is also a need for universal dedication to total quality management by all lending

General Credit Policies

and credit officers. Credit Risk Management’s ability to speedily turn round will be largely influenced by the quality and integrity of Credit Requests (CRs) submitted by the Business Units.

A primary objective will be to ensure that roles and accountabilities are clearly defined and that

respective business and credit management disciplines are complementary and supportive whilst ensuring that objectivity and independence of judgement are maintained. The overall aim must be

to manage the Bank's credit risk in a safe and professional manner and one that is consistent with

our stated business objectives. This can only be achieved through a structured and efficient process that is implicitly understood and respected by all involved in the management of credit risk.

B

Definitions

A

common credit language is essential if the credit process is to function efficiently, effectively and

without ambiguity. The key definitions to be used within UBA are as follows:

a) Credit Officer - Any officer who approves a Credit Request (CR) within delegated authority.

b) Credit Accountability - The holding to account of a Credit Officer or a Responsible Officer for management practice, judgement, negligence, professionalism or lack of integrity which places the Bank in an avoidable position of unacceptable credit risk.

c) Credit Analysis - A process of examination and assessment whereby risks in any credit situation are identified, measured and subjected to tests of acceptability. Credit Analysis is a pre-requisite to the approval of credit based products, is integral to any Credit Request and is the responsibility of business units.

d) Credit Approval - A properly sanctioned authority to incur Credit Risk exercised by a Credit Officer. Integral to Credit Approval is Credit Analysis that vets for accuracy, coverage, perceptiveness, reasonableness and soundness of judgement. Appraisal is a pre-requisite for a considered professional opinion leading to the final credit decision, is integral to Credit Approval and is the responsibility of Credit Officers whether domiciled in Business Units or Credit Risk Management.

e) Credit Authority - The properly delegated authority to approve Credit Risks exercised by an individual officer.

f) Credit Request (CR) - A request for a Credit Approval ordinarily incorporating a full Credit Analysis and submitted in a standard format as laid down by the Bank.

g) Credit Responsibility - The responsibility of all officers, but especially senior and business unit managers, to ensure that their respective operations and subordinates manage Credit Risk in a prudent and professional manner and in accordance with laid down principles, procedures and policies and with due regard for the need to avoid excessive customer, counterparty and sectoral concentrations.

General Credit Policies

h) Credit Risk - The probability of loss of income and principal arising from failure of a customer or counterparty to meet promptly and in full their obligations to the Bank.

i) Dual Control - The principle that requires all Credit Requests to involve more than one competent officer. The purpose of Dual Control is to ensure the accuracy and honesty of essential facts and opinions as represented.

j) Excesses - Credit Risks which exceed amounts specified in an approved Credit Request (CR), or which arise when no Credit Request has been authorised by a Credit Officer with sufficient Credit Authority.

k) Limit Breaches - Unauthorised departures from the terms and conditions under which a Credit Request has been approved, other than excesses, or where the facility has expired.

l) Responsible Officer - An officer from a business unit who recommends and accepts Credit Accountability for a given Credit Risk and signifies this by signing the Credit Request. The Responsible Officer must take full responsibility for the proposed credit and should not sign for the preparation of a credit request and on the basis of recommendation by another officer. The Responsible Officer is usually the Relationship Manager.

Roles and Responsibilities and Approval Authorities

SECTION 2: ROLES AND RESPONSIBILITIES AND APPROVAL AUTHORITIES:

Roles and responsibilities are detailed throughout these policies. Below is a high level summary of significant roles and responsibilities for certain individuals or groups.

Board of Directors

a) Approving risk management policies.

b) Approving material policy exceptions.

c) Approving certain extensions of credit as required by these policies.

Head of Credit Risk Management

a) Establishing after consultation with business heads, UBA risk management policies, standards and practices for the approval, measurement, reporting, monitoring, limiting and analysis of risk.

b) Establishing a risk management culture that promotes good analysis, judgement, flexibility and balance between risk and reward.

c) Establishing UBA risk limits

d) Establish risk reporting requirements.

e) Approving certain extensions of credit as required by these policies.

f) Managing the portfolio on non performing loans.

Credit Risk Analysts

a) Support corporate side of business in writing credit requests and other kinds of requests.

b) Providing independent review and approval of certain extension of credit as required.

c) Performing proactive risk management of transactional and portfolio activities.

d) Ensuring risk management policies, standards and practices are adhered to by the businesses they support.

e) Assisting in identification, classification, and management of problem credits.

Head of Corporate Banking

a) Marketing new business and managing existing business to enable the bank realize the revenue targets which are prescribed.

b) Managing their portfolio in accordance with the set standards for portfolio quality.

c) Establishing a risk management culture that promotes good analysis, judgement, flexibility and balance between risk and reward.

d) Recommend the appointment of Credit Officers.

e) Ensuring that extensions of credit are within all applicable limits and within established risk and return criteria.

f) Ensuring that processes exist for the identification, classification and management of problem credits.

Roles and Responsibilities and Approval Authorities

Credit Officer

A Credit Officer is an individual who has been granted a specific level of authority to approve extensions of credit on the basis of experience, proven ability and specific duties and responsibilities.

Responsible Officer

The Responsible Officer is usually the Account Relationship Manager and is responsible for ensuring the coordination, execution and monitoring of extension of credit, from early consultation through approval to maturity, including:

a) Serving as primary interface with the client

b) Ensuring complete, accurate and balanced assessment of risk in the credit request.

c) Coordinating the approval process, managing information flow to/from the client.

d) Ensuring that clear communication between UBA and the client is maintained, and that internal approvals are consistent with client expectations.

e) Ensuring compliance with related policies, as referred to throughout these policies.

f) Ensuring that approval documentation is complete.

g) Ensuring that legal documentation is complete, consistent with internal approvals and properly executed.

h) Managing their portfolio in accordance with the set standards for portfolio quality.

Rules Governing Extension of Credit

SECTION 3: RULES GOVERNING EXTENSION OF CREDIT

3.1 SANCTIONING PROCEDURES

3.1.1 Overview.

Credit Approval is the documented acceptance by Credit Officers of the credit risks in a credit facility. Credit approval is primarily the responsibility of the Responsible Officer and is always required for the establishment of a credit facility. Due diligence requirements for approval of credit are enumerated later in this chapter.

a) Every extension of credit must be approved by at least two authorized Credit Officers, one of whom must have a covering limit, and one of whom must be from Credit Risk Management. Specific Product Programs may set a separate approval process.

b) Each credit officer has a credit approval limit associated with it that establishes the maximum amount for which that level of credit officer may give final approval. In some cases, credit officers may have no credit limit, but have some credit related responsibilities and authorities. Credit approval limits are shown in the Credit Facility Approval Grid below

c) All authorities granted must be in compliance with the various policies and guidelines as laid down. These will also be subject to change by the issue of updated notice of delegated discretionary powers.

d) To achieve the stated objective of calibrating authority to perceived risk, the credit authorities now granted are intrinsically linked to Credit Risk Ratings. (See Remedial

Management section).

3.1.2 Discretions

a) Single Borrower Limits UBA is restricted, by The Bank of Tanzania to lend to any one connection a maximum amount of 25% of core capital as per the Credit Concentration and other Exposure Limits Regulations, 2001. Exposure against Single Borrower Limit is measured as the outstanding amounts (including Funded and Non-funded exposure).

b) Discretionary Powers

Discretions are as laid out below. These discretions are personal to the credit officer and not the position. They will be reviewed against experience, ability, sound judgement, maturity and perceived expertise of the personnel concerned.

Rules Governing Extension of Credit

Credit Facility Approval Grid

Approval Level

Approval Limit

Board of Directors

>TZS 800m

EXCO/Credit Risk CBA

>TZS200m-800m

N.K. Mchechu

TZS 200m

B.E. Hamisi

TZS50m

Head of Corporate

Recommends

Head of Institutional Clients

Recommends

Relationship Manager

Recommends

Credit Analyst

Recommends

In addition the following requirements must be met:

1)

Every extension of credit must be approved by at least two authorised Credit Officers, one of whom must have a covering limit, and one of whom must be from Credit Risk Management. Each credit shall be managed by a Responsible Officer who is usually the Account Relationship Manager. Specific Product Programs may establish a separate approval process.

2)

Credit Officers may only approve credits for amounts that fall within their specific delegated authority.

PERSONAL AND INSTITUTIONAL BANKING CUSTOMERS.

Personal and Institutional Banking customers will be restricted to use of standard packaged products as approved in specific product programs. Any exceptions must be forwarded to the Heads Personal and Institutional Banking who will seek approval from Credit Risk Management in line with the existing credit approval grid. The guidelines for preparation and approval of credit programs are as enumerated herein.

3.1.3 Other approval requirements

Connected Accounts

Total facilities, for the sake of determining Approval Level, shall include facilities to all connected accounts. Connected accounts include related entities including the parent entity and its majority- owned or effectively-controlled entities. It should not include facilities to affiliates unless the borrower effectively controls or provides support (guarantee) to the affiliate, or there is a material economic relationship in either direction, as determined by credit approvers. Total facilities include facilities for which the borrower provides a guarantee that is one of the primary sources of repayment or one of the principal considerations in the approval of the facility. When submitting a Credit Request for approval it is essential that any facilities for connected parties are included to ensure that the ‘Approver’ of facilities is aware of full exposure of the Bank to a particular Group or connection.

Rules Governing Extension of Credit

The following are examples of ‘connected accounts’:-

When facilities are extended in a parent/subsidiary relationship.

Customer has facilities in his sole name and also in a business where he is sole proprietor.

Majority shareholder of a company has facilities in his private name at the same time facilities marked for the company.

A number of individual companies with facilities where there are common directors or shareholders or their associates.

Where accounts are cross-guaranteed.

Where a common guarantor guarantees accounts.

Where a customer with facilities also guarantees another customer with facilities.

Where there is common security between accounts.

There may be other possibilities and in the case of uncertainty reference should be made to Head

of Credit Risk Management for guidance.

New or Increased facilities

Any increase to total facilities must be approved based on the new total facilities amount as per the credit facility approval grid.

Annual Reviews

All credits relationships are subject to periodic reviews. In most cases a full credit review is performed annually. In certain circumstances it may be performed less frequently. A full credit review must include the credit memorandum standards as described below. Approving credit officers may determine that it is not necessary or not applicable to the borrower and/or nature of the transaction to write a full credit review, and that determination is documented.

If an interim review is required, approving credit officers may determine that the interim qualifies as

the full credit review to run for a full year.

Approval Expiration

The approval of a credit facility for a specific transaction is valid for 90 days, unless specifically approved otherwise. A credit officer from Credit Risk Management can approve extension for up to an additional 90 days. If the transaction has not been booked during that time frame, the transaction must be re-approved at the requisite level.

Temporary Extensions

A periodic review cycle may be extended for up to 90 days.

Rules Governing Extension of Credit

Material Change

When an established credit facility undergoes a material change in terms or conditions, e.g. increasing facility amount, lengthening of tenor, material relaxation of collateral structure (materiality to be established by Credit Risk Management), total facilities must be re-approved in accordance with the Credit Facility Approval Grid.

Re-allocation of Facilities

Two Credit Officers may approve any reallocation from an approved facility where the borrower, exposure type (funded and non-funded), and tenor are pre-established in order to establish or increase another facility. One of the Credit Officer’s must have a covering limit for the amount of re- allocation.

Release of collateral

The release of collateral before the corresponding commitment is cancelled or repaid requires the approval based on the Credit Facility Approval Grid. After the corresponding commitment or exposure is cancelled or repaid, approval must be obtained from Credit Risk Management.

Waivers or amendments to existing legal documentation

Requests to waive or amend the provisions contained in existing credit agreements must be considered carefully. Such requests must obtain an approval as per Credit Approval grid.

3.1.4. Credit Programs

Where a product has unique and / or unusual risk characteristics (Dealer Finance, Supplier Finance, Collateral Management Structures, Asset Backed Finance, Leasing, Cash Covered Facilities etc), a Credit Program that documents product-specific credit approval requirements is required.

The Credit Program must;

Articulate how the proposed program fits into the Bank’s business strategy and specify the target market or customer segment the program will support.

Highlight and justify any deviations or exceptions from Credit Policies.

Define major risks and mitigants of the business activity.

Identify the acceptable risk taking criteria.

Include limits on the size of the Program as well as any other appropriate parameters.

Define a Process to ensure compliance with any applicable Program Limits.

Establish Risk Reporting requirements.

Include Risk/Return criteria

Establish rules for approving transactions or lines of credit, including roles and responsibilities and approval rules.

Rules Governing Extension of Credit

Describe any specific documentation standards.

Include the Risk Rating Process applicable to obligors covered under the Credit Program.

Extensions of credit under the program must be reported as specific exposures in the credit systems.

Consultation may be required to ensure a good understanding of legal, accounting, taxation and operations issues which would impact on the proposed program. Approval of the Credit Program should follow Credit Approval Limits as per the grid above.

3.1.5. CLEARING RISK

Clearing risk arises when UBA makes cash payment to a customer before it can confirm that reimbursement has taken place, as in the case of an uncleared cheque. It is possible to reduce clearing risk by not making a payment until receipt of reimbursement is confirmed.

Eligible customers

This service should only be given to first class customers in response to competitive pressures. It is not to be generally offered as a ‘product’ and must not be extended to classified accounts.

Annual review

For customers where we have agreed clearing risk limits, an annual review should be undertaken to ensure that the service is still appropriate. A brief report should be submitted to Credit Risk Management confirming that account operation of these accounts remains satisfactory and seeking confirmation that the service may continue. This should avoid individual credit appraisals or lengthy reporting.

3.2: CREDIT ANALYSIS STANDARDS

It is to be stressed that the Credit Request plus supporting documentation should include short, concise remarks preferable in ‘bullet’ form. It is important that all relevant factors are included. However, details not related to the application and repetition should be avoided. The use of the Credit Request (CR) format - Appendix IV should enable this to be achieved.

Preparation of the CR Package is the responsibility of the Responsible Officer. When there are multiple Responsible Officers for a credit relationship, it is the responsibility of each officer to prepare a CR for their clients and then forward a completed package to the Control Unit for consolidation. The Control Unit is usually the domicile of the client relationship.

The CR must be signed by the Responsible Officer and address all the issues indicated in the format in appendix IV.

Rules Governing Extension of Credit

3.3 FINANCIAL APPRAISAL

Financial appraisal forms one of the pillars in the assessment of credit risk. This section dwells in the various aspects of financial analysis standards and the various ratios one may look out for.

3.3.1: CAPITAL STRUCTURE

33 33 22

Gearing is the relationship between the Tangible Net Worth of the business, and its liabilities. As gearing increases, the shareholders cushion reduces and there is a higher risk of failure. This is mainly because of higher debt servicing costs and an increase on the reliance on external influences (i.e. banks and creditors).

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For a Bank, a higher gearing figure also represents higher risk as, in the event of a business failing, it is less likely to cover the debt purely from the assets of the business. This is because asset book values are unlikely to be achieved on a forced sale basis, and the margin afforded by the Tangible Net Assets is small.

It is also an indicator of a business’s capacity to grow and fund expansion. Low gearing gives a business greater flexibility than high gearing.

33

33

33 CCoommmmoonn GGeeaarriinngg RRaattiiooss

Net Gearing

Borrowed Money less Cash/Tangible Net Worth

Gross Gearing

Borrowed money/Tangible Net Worth

Total Liabilities Gearing

All Liabilities/Tangible Net Worth

Adjusted Gearing

All Liabilities less Subordinated Debt/Tangible Net Worth plus Subordinated Debt

Net and Gross Gearing have limited value. They are mainly used for Covenant setting, thus ensuring that a business does not enter into other significant borrowing arrangements without the existing lender knowing about it, and to try and maintain an acceptable margin between the debt and Tangible Net Assets in case the business fails.

Total Liabilities Gearing is a much better indicator of how much “external capital” a business relies on to trade. It also ensures that “window dressing” the Balance Sheet does not impact the Gearing ratio.

Adjusted Gearing discounts any liabilities that could be considered quasi-capital – such as Directors Loans or any other loans where the lender has formerly agreed to keep the liability within the business. Under these circumstances, it is probably more realistic to include these loans as capital as opposed to a liability.

Rules Governing Extension of Credit

3.3.4 Benchmarking

If data is available about other businesses in the industry, then this is a useful source of information. If a business is highly geared compared with the industry, then it is in a weaker position to respond to things like a price war, altered terms of trade or capital innovation. A lower geared business would be able to respond more positively and absorb any structural changes.

Another way to benchmark is to consider what is good, bad or average across all businesses regardless of the industry that they are in. Broadly, the following “rule of thumb” applies for Total Liabilities Gearing:

Very Poor

400%

Poor

300%

Average

150%

Good

70%

Very Good

50%

In addition to these benchmarking indicators, the trend is also likely to raise many questions.

3.3.5 Factors Influencing Gearing

In addition to subordinated debt, there may be other adjustments that should be made to the elements within the Balance Sheet, ensuring that a more representative Gearing figure is calculated.

A hidden Reserve or Deficit. This is as a result of asset value movements from the initial date of purchase. The most common example is property where it may have a book value that is 10 years out of date. The up to date value could significantly impact our view of the Gearing figure.

Goodwill. This represents an “Intangible” asset that is unlikely to be realised on the break-up of the business. It appears when another business has been bought for a price above its asset value, in consideration for things like the trading name, or the customer base. Commonly, this is taken out of the Balance Sheet and deducted from the Tangible Net Assets before Gearing is calculated.

Potential Gearing. If a business has substantial unused facilities, the un-drawn element could be added to the liabilities to show the potential Gearing position.

3.3.6 The Structure of the Balance Sheet

So far we have looked at liabilities as a whole, but businesses also get into trouble because the structure of the liabilities within the Balance Sheet is incorrect.

The most common example of this is where a business purchases a long-term fixed asset from cash flow. This could result in a shortage of cash with which to continue trading, possibly putting

Rules Governing Extension of Credit

the business at great risk. Broadly, if long-term assets require funding then this should be on a long-term basis, with repayments linked in some way to the life of the asset.

Similarly, stock is an asset that should be traded relatively quickly, so you would not expect a purchase of stock to be funded on a 10-year loan!

3.4: OPERATING PERFORMANCE

3.4.1 Sales

An analysis of the sales position should not only consider the “real” position, but should also be considered in relation to the industry within which the business operates. A 20% rise in sales looks good in isolation, but against a 35% rise across the industry it looks poor.

By considering the sales trend over a number of years can reveal a lot about the management, and can be used to start assessing whether many other movements within the Profit & Loss account and Balance Sheet appear reasonable. It is the base prompt for many questions.

3.4.2 Gross Profit Margin

This is fundamental to the profitable operations of the business and it is crucial to look at the trend as opposed to one year in isolation.

A declining margin must prompt questions as this may be a warning sign. Alternatively, it may be

due to a deliberate policy of reducing prices in order to undercut the opposition and increase sales.

If this works, evidenced by a higher Gross Profit figure, then there may be no need for concern

regarding the Gross Margin provided all other key ratios are satisfactory and as long as the

strategy is sustainable.

If however, sales remain static, a declining margin is an unhealthy sign and should prompt

investigation.

Another deliberate policy may be to increase prices and hope that sales do not fall by a disproportionate amount. Here, the Gross Margin would rise as the unit sale prices increased, and total sales possibly reduced. If the Gross Profit is maintained at or above previous levels then this could be seen as shrewd management, as long as the policy is sustainable.

A direct comparison with other businesses in the same industry could highlight a Gross Profit

Margin that is below/above that commonly seen. Any significant variance should be investigated.

Lastly, because stock is included within the Cost of Goods Sold calculation, the stock valuation will have a direct effect on the level of profit calculated. It is therefore important to understand the basis for the stock valuation, and its reliability.

Applicable Ratio:

Gross Profit / Sales

Rules Governing Extension of Credit

3.4.3 Operating Margin and Overhead Expenses

Calculating this margin allows a comparison year on year and against similar businesses within the industry, at an operating level. Basically, it is an indication of how much profit has been made purely from trading and before the cost of capital is considered.

This is another fundamental ratio as it informs whether any strategy surrounding sales and the Gross Profit Margin has worked. Have alterations to the elements at the top of the Profit and Loss Account been reflected in higher bottom line profits?

The analysis of the overhead expense in relation to sales helps us to establish whether overheads are being controlled in relation to how the business is progressing. We can look at regularly

increasing overheads and ask the question – are they really fixed? If overheads are increasing at

a high rate and analysis of where the costs are increasing and why needs to be undertaken. Managements’ ability to control the business adequately may also be questioned.

Applicable Ratios:

3.4.4 Net Profit Margin

Operating Profit/Sales Overhead Expenses/Sales

This margin evidences the extent to which the business can trade profitably on an on-going basis, after allowing for interest costs. Again, the year on year trend is important, as are industry comparisons.

Applicable Ratio:

3.4.5 Other Issues

Profit Before Tax/Sales

The above are the main ratios that can be used to analyse the operating performance of a business. However, throughout our analysis of the accounts, we must always remember to look behind the figures.

In particular, when assessing the Operating Performance, you should check that the profitability on

which you are basing your analysis is sustainable over a number of years, and excludes profits of a one-off nature (i.e. extraordinary profits and losses).

If you note any payments of a discretionary nature (such as directors pension contributions) you

may decide that these should be discounted for the purposes of your analysis at this level.

You should also check the performance of your company against its peers. It is also important to understand why the directors are managing the business in a given manner, particularly where discretionary payments are made. Is it sustainable from the business’ point of view?

Rules Governing Extension of Credit

3.5: LIQUIDITY

3.5.1 Current Ratio and Quick (Acid Test) Ratio

The Current Ratio gives an indication of a business’s ability to meet its current obligations, and therefore the higher the ratio, the better position the business is in, provided that the current assets can truly be considered “liquid” i.e. easily convertible into cash within a reasonable timescale.

Broadly, the following “rule of thumb” applies for the Current Ratio:

The Quick Ratio, whilst similar to the Current Ratio, considers only those assets that will soon turn into cash (commonly Cash and Debtors, but not stock). The Ratio expresses the degree to which a business’s most liquid assets cover their Current Liabilities.

Broadly, the following “rule of thumb” applies for the Quick Ratio:

Very High

3.0

Very High

1.3

High

2.5

High

1.0

Average

1.6

Average

0.7

Low

1.1

Low

0.5

Very Low

0.9

Very Low

0.3

Applicable Ratios:

Current Assets / Current Liabilities

3.5.2 Elements within the Working Capital Cycle

TTrraaddee DDeebbttoorrss

Liquid Current Assets / Current Liabilities

The control exercised by a business over the collection of its debts can be assessed using the Trade Debtor Turnover ratio. Analysis of this ratio can lead you to ask a number of important questions and assess how well the business manages its debtor book, and whether those debtors are likely to pay. Some common questions to ask when the ratio has deteriorated include:

Has the business changed its credit terms to some, or all, of its customers?

driven this?

If so, what has

Are there any bad debts distorting the overall figure?

Is debtor collection efficient? If slow payers are not chased for payment then the ratio will drift

How well are the debtors spread? Over reliance on a few customers can make a business particularly vulnerable to slow payers and/or the impact of bad debts

How does the trend compare with other businesses in the same industry?

Deterioration in the ratio is not necessarily a bad thing, but it does warrant further investigation and an explanation. Similarly, whilst an improvement in the ratio is generally seen as good, it may mask other issues like a cash flow problem; the business may be pressing its customers to pay

Rules Governing Extension of Credit

early so that it can satisfy pressing Creditors. If this is the case, then you are also likely to see a deterioration in both the Current and Quick ratios.

Applicable Ratio:

Trade Debtors/Sales X 365

TTrraaddee CCrreeddiittoorrss

An assessment of credit taken by the business is aided by calculating the Trade Creditor Turnover. Analysis of this ratio will help you to assess the business’s financial position with its suppliers.

As this relates to purchases of stock and/or raw materials, the calculation is based on the value of purchases during the year, adjusted for opening and closing stock. This is commonly referred to Cost of Goods Sold (COGS). If the Financial Statements of a business show direct labour in COGS, then this should be excluded from the calculation.

Any substantial increase should be discussed with the customer. Common questions include:

How well spread are the creditors? Dependence on one or two main suppliers can cause difficulties if they change their terms of trade.

If the Trade Creditor Turnover is increasing, why is this? It may be that the business has a liquidity problem and is delaying paying its creditors until the last minute.

Applicable Ratio:

Trade Creditors/Cost of Goods Sold X 365

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Effective stock management is important. Where as Trade Debtor Turnover and Trade Creditor Turnover are subject to external influences, stock control is very much down to management. There is little point in buying stock in January that will not be sold until December as this ties up valuable Working Capital.

Stock management can be assessed by calculating the Stock Turnover. This indicates the average number of days the stock is held. When assessing stock there are a number of issues to consider:

What does the business do? The type of business should determine how long stock is held for i.e. a fruit seller will not have stock outstanding for 3 months. Compare the Stock Turnover with similar businesses in the same industry

How much of the stock is saleable? Sometimes obsolete stock can inflate the stock figure when in fact this portion of the stock valuation is worthless. In this situation, obsolete stock should be written off

Seasonality should be taken into account. As the Financial Statements are a year end snapshot of the stock situation, the figure may be inflated/deflated if the business operates in a seasonal business i.e. toys where the bulk of the sales occur just before Christmas

Similarly one off contracts need to be taken into account if these cross the year end

Rules Governing Extension of Credit

If in doubt about the stock, a visit to the business premises will give you a feel for how much is

there, what is there?

Applicable Ratio:

Stock/Cost of Goods Sold X 365

3.6: DEBT SERVICE

3.6.1 Interest Cover Ratio

Interest Cover is a useful indicator of the business’ ability to meet its interest costs.

The higher this figure is the better. A low ratio makes the business vulnerable to rising interest rates or falling profits, as well as having implications about the sufficiency of retained profits to finance other areas of the business and debt repayment.

A high figure could suggest that the business has the capacity to take on additional indebtedness,

perhaps to fund fixed asset purchases or expansion.

Broadly, the following “rule of thumb” applies for the Interest Cover Ratio:

Very High

7.0

High

5.0

Average

3.5

Low

2.0

Very Low

0.75

Applicable Ratio:

Net Profit before Interest and Tax / Interest Paid

3.6.2 Long Term Debt (LTD) Coverage

Whilst the Interest Cover ratio is a good indicator, a business not only needs to cover interest costs but also debt repayments when they fall due. The Interest Cover ratio does not take this later requirement into consideration.

The LTD Coverage fulfils this function in a simple way. Whilst not perfect, it does provide a good indicator as to whether a business can meet both its debt repayment obligations. Another

advantage of this ratio is that it is forward looking; it looks to assess the debt coverage for the coming 12 months.

It is basically asking the questions:

“If the trading performance remained constant over the next 12 months, would the business be able to repay its debts due within that period?” and

“What is the margin of safety between the cash generated and the debt to be repaid?”

As this ratio is primarily looking at how much cash has been generated solely from profit, depreciation and any amortisation are added back to the profit as they are non-cash items that

Rules Governing Extension of Credit

have deflated the profit figure. The Current Maturing Ltd figure is used, as this is the amount within the Creditors figure that is anticipated to be repaid over the coming 12 months.

Applicable Ratio:

Net Profit after Tax, plus Depreciation and Amortisation / Current Maturing Long Term Debt

This is a simple Ratio that assumes all other assets and liabilities will remain at a constant level. In reality this will not happen, so it would be best to use this ratio as an indicator in conjunction with the other Debt Service ratios, and to raise questions with the customer.

33

Having considered Debt Coverage in terms of Profit, or Cash generated from Profit, this element

looks at coverage from a cash viewpoint, taking into account asset and liability movements throughout the year.

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The information required to calculate the ratios is taken from a Cash Statement, or a Funds Flow Statement. Sometimes, these are in different formats, and sometimes a Statement is not available at all. Therefore, a simple structure is detailed below that could help you construct a cash flow statement, and provide consistency:

PBIT plus depreciation

Net Working Capital Movement

Net Movement in other non Cash Current Assets and non Debt Liabilities

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Less Interest Costs Less Dividends Paid Less Long Term Debt Repaid

Less Capital Expenditure

Net Cash Position before Finance Financed by:

From the P&L Account

(Increase)/Decrease in Trade Debtors and Stock Increase/Decrease in Trade Creditors (Increase)/Decrease in Other Debtors & Prepayments etc. Increase/(Decrease) in Other Creditors, Tax, & Accruals etc.

The sub total generated from above

From the P&L Account Care: has the dividend been paid or deferred? Last years Current Maturing LTD

From Fixed assets

Capital

Increase/(Decrease) in Capital

New Borrowings:

LTD

Increase/(Decrease) in Total of LTD and Current Maturing LTD.

STD

Increase/(Decrease) in the Overdraft

Directors

Increase/(Decrease) in Directors Loans

Cash Usage

(Increase)/Reduction in Cash Balances

NNeett FFiinnaannccee PPoossiittiioonn

Rules Governing Extension of Credit

The Net Finance Position (NFP) should be a complete opposite to the Net Cash Position before Finance (NCP). For example, if the NCP indicated a cash negative position of TZS.1m after trading, interest payments and capital expenditure etc., then the NFP should equal TZS.1m surplus as these elements would have brought cash into the Balance Sheet to finance the cash shortfall generated from trading.

3.6.4 Financial Charges Ratio

This ratio calculates the number of times the cash generated from the business’s operations covers Interest and Dividend payments.

The higher the figure, the better. Low coverage makes the business vulnerable to rising interest rates and drains on cash, as well as having implications about the sufficiency of cash for other purposes i.e. re-investment into fixed assets.

Broadly, the following “rule of thumb” applies for the Financial Charges Ratio:

Very High

3.0

High

2.2

Average

1.75

Low

1.3

Very Low

0.9

Applicable ratio: Net Cash after Operations / Interest and Dividends Paid

3.6.5 Cash Coverage Ratio

As with the profit ratios, whilst the Financial Charges ratio is a good indicator a business not only needs to cover interest costs but also debt repayments as well. The Financial Charges ratio does not take this later requirement into consideration.

The Cash Coverage ratio fulfils this function. Debt repayments are calculated as being last years Current Maturing LTD. This was to be repaid within 12 months so we should assume that it has been, unless we are told or know otherwise.

Broadly, the following “rule of thumb” applies for the Cash Coverage ratio:

Very High

2.5

High

1.7

Average

1.25

Low

0.8

Very Low

0.4

Applicable ratio: Net Cash after Operations / Interest, Dividends Paid and LTD Repaid.

Rules Governing Extension of Credit

3-7: EXCESS POSITIONS

INTRODUCTION

Accounts shown on the refer list as being in excess of agreed facilities, or overdrawn without prior arrangement should be regarded as a warning sign and must always be properly investigated by the Account Relationship Manager.

3.7.1 EXCESSES

Approval to establish credit lines should be given in accordance with the credit approval grids. Temporary excesses can also occur from time to time in the operating accounts of clients, usually caused by failure to receive anticipated incoming fund, by drawing against uncleared funds or by misposting of funds to the wrong account. In some cases the client simply overdraws in excess or in absence of approved limits. Excess positions vary in terms of risk characteristics.

TECHNICAL RISK ONLY EXCESSES

An excess which is corrected by the receipt of CLEARED funds (for fate) on the day following the date of the excess (i.e. on the date the refer list is usually received at the branch) can be regarded as “technical risk only”.

POTENTIAL RISK EXCESSES

Any excess that cannot be classified as “technical risk only” is to be regarded as “potential risk excess” which will either fall within the Account Relationship Manager’s discretion or will be reportable in line with risk approval limits as amended from time to time.

3.7.2 UNCLEARED EFFECTS

Paying against un-cleared effects carries the same risk as potential risk excesses and should be treated in the same manner

3.7.3 EXCESS APPROVAL AND REPORTING

Any excess over limit must be pre-approved. Excesses that may go over 14 days must be approved as per the Credit Approval Grid. These approvals must be documented and submitted to Credit Risk Management to update systems.

Other conditions for excesses;-

The account must not be in Watch list or classified.

The account must not be subject to legal action.

The discretion to pay excesses has not been withdrawn.

No more than two previous separate excesses have occurred within the last two calendar months.

Rules Governing Extension of Credit

The excess does not result in an exposure to the customer in excess of the Legal Lending Limit.

Account is not past due.

The Account Relationship Manager has been satisfied as to:

Reason for the excess.

Source of repayment

Ability to clear within 14 days.

A record must be maintained to ensure that excesses are cleared within the 14 days or a formal

report prepared.

Format: Excess Log: Appendix V

For any excesses agreement must be sought as follows:

Brief report to include:-

Customer name

Account Relationship Manager

Credit Officer

Total exposure

Balance – Cleared position

Terms & Conditions met?

Reasons for excess

Method of repayment

FORMAT: EXCESS REPORT: Appendix VI

URGENT REQUESTS

It is accepted that some excesses fall within the sanctioning authorities of EXCO/Credit Risk CBA

or the Board of Directors. In many cases to await the next EXCO CBA or Board meeting would

create a relationship problem with our customer (in theory cheques would have to be returned if in

excess) it is therefore suggested that excesses above EXCO CBA limit may be signed off by Managing Director and Credit Committee.

Those accounts reportable to the Board should be presented in a summarised form to the next appropriate Board meeting.

FORMAT: SUMMARY EXCESS REPORT: Appendix vi

TO REDUCE THE INCIDENCE OF EXCESS REPORTS

Consideration should be given to seeking excess limits at time of submission of credit applications.

Rules Governing Extension of Credit

If excesses are frequent, the level of facility should be reviewed. If we are happy to pay in excess of limit marked we should be prepared to formalise limit. If not we should not be entertaining excesses and the account controlled accordingly.

Consideration should be given to seeking 'uncleared' limits for those accounts where this is a regular feature – the level of credit appraisal will depend on the amount and spread of the uncleareds. E.g. A large cheque from a client of a building contractor undertaking a major contract should be appraised more thoroughly than a hotel which pays in 20 cheques a day from a spread of paying guests. In all cases however the risks involved should be fully considered. PAYMENT AGAINST UNCLEAREDS IS NO DIFFERENT IN RISK TERMS THAN MARKING AN OVERDRAFT LIMIT.

3.8: MONTHLY REPORTING OF SANCTIONED FACILITIES.

As an additional control, Credit Administration Unit will prepare a monthly report on all approvals given during the previous month.

3.9: CREDIT PROCESSING RESPONSIBILITIES

PROCEDURE IN DEALING WITH APPROVED CREDIT APPLICATIONS:

Once the credit request has been approved, Credit Administration Unit (CAU) will:-

Ensure CR packages includes various materials that need to be reviewed by CAU with the documentation checklist (in appendix xv& xvi) duly updated and initialed by the Relationship Manager. Any exception in the checklist should be informed to the Relationship Manager immediately.

Check that proper approvals have been obtained as per UBA policies.

Prepare the Facility Letter, which will be signed by Head of Credit Administration Unit and Managing Director.

Diarise return of the Facility Letter together with documentation required therein. If Facility Letter is not returned within the stipulated period, limits will be cancelled and facility called up unless approved otherwise.

Ensure all security documentation is drawn up and executed in accordance with sanction, liaising with Banks legal advisors as appropriate.

Instruct property valuers, if appropriate, in line with established policy on property valuations.

Code the approval and amend as appropriate, the commitment and expiry date on Bank systems upon receipt of all necessary documentations and confirmation that they are in order

Collect agreed facility fees.

Maintain appropriate MIS to track receipt of financial information required as per approved CR i.e. Audited accounts, Borrowing Certificates, Debenture formula, Management accounts (Balance sheet/Profit & Loss), Personal Financial Statements etc.

Rules Governing Extension of Credit

Track any conditions that are mentioned by the Credit Officers that need tracking are placed in the relevant tickler.

Risk Awareness

SECTION 4: RISK AWARENESS

4.1

4.1.1 Introduction

MONITORING

Monitoring of information from both internal Bank sources and from external sources is necessary for effective control. This section covers:

Monitoring Internal Bank Information

Overdraft excesses

Account behaviour

Other Bank Account behaviour

Covenant Compliance

Security Monitoring

Monitoring External Information

Behavioural Customer Information

Plans, Budgets, and Forecasts

Management Accounts

Audited Accounts

Monitoring Responsibilities

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Overdraft Excesses

Excesses over an agreed limit should always be investigated. Inadequate assessment of excesses is often a major characteristic in cases where Banks lose money.

In some cases investigation may mean that a higher limit is agreed, but in other cases investigation may result in a full reappraisal of the lending.

Managers should be alert to the possibility of cross firing (see below) with overdraft excesses.

If a customer appears to be reliant on a large overdraft, despite being profitable, consideration should be given as to whether the customer is overtrading.

 

Overtrading

Overtrading occurs when a business expands its sales turnover and total assets by a large amount without providing extra capital (new capital or retained profits) to support the

Risk Awareness

expansion. Other causes are if a business reduces its quasi-capital base by repaying a loan without replacing it, or where inflationary pressures mean that retained profits are insufficient to pay for a replacement of fixed assets and stocks.

Whatever the reason, a consequence is that, in spite of earning profits, the business relies increasingly on short-term credit, including bank overdraft. Some overtrading can be allowed provided that it is kept under control. Loss of control is evident when the business has increasing difficulties in paying bills on time, because of its increasing reliance on short term credit and/or bank overdraft and is eventually unable to do so.

Uncontrolled overtrading does not happen overnight, but rather a business sinks gradually into ever-increasing liquidity problems, without the management realising that the problems are worsening. It can be difficult to persuade managers that their business is overtrading, and should not be allowed more credit by the Bank, so discussions with a customer must be handled tactfully.

Apart from often reaching or even exceeding credit limit originally agreed, symptoms of overtrading are:

A rapid increase in sales turnover

A rapid increase in the volume of current assets (and possibly fixed assets) – stock and debtor turnover periods may slow down, which means that the rate of increase stock and debtors will be even greater than the increase in sales turnover.

Only a small increase in capital e.g. retained profits – if any

Most of the increase in assets is financed by credit, especially working capital finance and trade creditors. The payment period to creditors is likely to become much slower.

The effects of overtrading including rising purchase costs (buying on best credit terms, not on price), lower gross profit margins (selling at a discount to win more sales), strained business relations with trade creditors, pressure on debtors, replacement of ageing fixed assets deferred and eventually difficulty in paying wages, salaries and taxes. At the time of collapse through overtrading, most businesses are still trading profitably.

Remedies for overtrading are:

Reduction in current assets – apply better management to stocks and debtors, perhaps using factoring.

Injections of fresh capital.

Leasing or renting (instead of purchasing) fixed assets.

Account Behaviour

This provides the best means for judging account liquidity trends, enabling consideration of the following areas:

What is the worst balance trend?

Risk Awareness

What is the best balance trend?

Is there any evidence of hardcore (see below) developing?

Is

the average balance worsening?

Is the account turnover out of line with the expected level of sales? If so, why? Is there a large and unexplained increase in turnover? Or is the account excessively active for the balances maintained and for the type of business? If so, this could indicate cross firing (see below)

Has there been a change in the run of the account compared with previous years?

Have seasonal swings vanished and/or is borrowing being taken earlier than previously?

 

Hard-core

Hard-core is evidenced when an account never fluctuates into credit and/or the average debit balance deteriorates over time (possibly, but not always becoming a greater percentage of turnover)

The account should be reviewed for signs of an imbalance between credit and debit turnover that may indicate deterioration in underlying terms of trade, or that the management of the business is not controlling working capital and cash is being tied up in current assets (refer Overtrading above).

Alternatively, hard-core may relate to historic or current losses, or an element of financing which does not relate to current assets (e.g. capital expenditure)

Where account behaviour shows turnover through the account running far ahead of an actual sales turnover of the business, this could be an indication of cross firing.

Cross Firing

While there are many thousands of quite genuine inter-account and inter-company transactions daily, unless the balances are all CLEARED then there is a risk of cross firing.

Cross firing is the creation of artificial credit on an account or series of accounts by taking advantage of un-cleared effects.

An example as to how this can be done using accounts of three different banks or branches of

a bank is set out below:

   

DR

CR

Balance

Bank or Branch X

       

Jan 1

Cheque from Z

 

1,000

1,000

CR

Jan 2

Cheque from Y

 

4,000

5,000

CR

Jan 3

Cheque to Y

1,000

 

4,000

CR

Jan 4

Cheque from Z

 

8,000

   

Jan 4

Cheque to Z

4,000

 

8,000

CR

Bank or Branch Y

       

Risk Awareness

Jan 1

Cheque from X

 

1,000

1,000

CR

Jan 2

Cheque from Z

 

4,000

5,000

CR

Jan 3

Cheque to Z

1,000

 

4,000

CR

Jan 4

Cheque from X

 

8,000

   

Jan 4

Cheque to X

4,000

 

8,000

CR

Bank or Branch Z

       

Jan 1

Cheque from Y

 

1,000

1,000

CR

Jan 2

Cheque from X

 

4,000

5,000

CR

Jan 3

Cheque to X

1,000

 

4,000

CR

Jan 4

Cheque from Y

 

8,000

   

Jan 4

Cheque to Y

4,000

 

8,000

CR

If we assume that cheques clear on day three, then the actual CLEARED balances on the above are all nil. However, they all show an apparent credit of 8,000 and any or all of the above branches or banks could fall victim to cross firing by making a payment outside the ring of accounts, against the apparent credit balance. They could be making the payment against an actual nil balance and so a loss will be incurred.

Cross firing can arise as a pure attempt to defraud the bank or as a despairing means whereby a business with liquidity problems can seek to stay within its limit. Once in operation, cross firing can expand rapidly.

Undetected cross firing can involve the Bank in far greater losses than those made by individual bad debts. Although it its simplest form it will involve only two accounts, several individuals may pass cheques in a ring and there may be great difficulty in relating the transactions. Monitoring cross firing in a multi-banked complex group can be extremely difficult.

Look out for chance revealing remarks or actions by the customer or for cheques payable to ‘Cash’ or to parties recognisable as the drawers of cheques paid in, even though the names may be different. The cheques may be for round amounts, although clever operators do not confine themselves to round amounts. Bankers’ crossings on customers’ paid cheques may help linking up connections with other parties and with drawee banks of cheques paid in.

If cross firing is suspected, each credit paid in and each cheque drawn should be referred, record drawers’ and payees’ names respectively, retain dishonoured cheques and advise the relevant department.

Other Bank Account Behaviour Information

You should make full and effective use of any reports that are available to monitor trends on the bank account. Care must be taken to:

Verify completion of security.

Ensure that all conditions relating to maintenance of security in good order are satisfied.

Risk Awareness

Ensure that advance is not diverted to purposes other than those for which granted. This may be revealed by inspection of vouchers, particularly cheques issued.

Monitor that all conditions of sanction are observed.

Discover and control any irregular practices e.g. issue of post-dated cheques, cross firing.

Covenant Compliance

The basic questions to answer are:

Are the covenants being met?

Is there a trend emerging in the margin of compliance?

Does this trend match the forecasts or projections?

Take care not to ignore potential problem warning signs and always re-appraise an account before permanently relaxing covenants or waiving compliance with some or all of them to fit the customer’s position – this should be regarded as tantamount to releasing security.

Monitoring of Current Assets held as Security

Key points to include:

What assets are charged by the Bank’s security documentation?

How significant are preferential creditors and other prior claims?

It is important to understand the underlying terms of trade e.g.

When does a debtor become collectable.

Is stock subject to retention of title clausing?

Asset value in a break-up situation can be significantly lower than going concern values.

Current Asset monitoring information can provide a good indication of current profitability and liquidity as well as confirming compliance with the security formulae.

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Behavioural Customer Information

Behavioural information about a customer will be available from interviews with the customer and visits to the premises. Visits are a particularly valuable way of getting to know the true business behind the figures on the Bank account and in financial statements. Visits also demonstrate an interest in a business and encourage customers to talk widely about their hopes and problems. They also give us the opportunity to gain a first hand impression of the physical organisation of the business and to meet all the members of a management team.

If there is an unexpected request for an increase in facilities within a period of sanction, this indicates a failure in management to predict and plan adequately. On the other hand,

Risk Awareness

if the Bank helps management to learn from their mistakes future request should be presented in advance.

Assessment of management quality is the key area of importance. management:

It is essential that

Consider the future role of their business

Understand the consequences of their decisions

Are customer focused

Are disciplined.

Have balanced judgement.

Identify any loss of market.

The frequency of the visits will vary. The visiting pattern should not be determined by the customer’s geographical location and unannounced visits may be appropriate if the business is giving cause for concern.

For medium sized businesses with more than one site, a visit to each of the major operating units is vital.

The key to a successful visit or interview is good preparation. There should be a clear agenda of items for discussion and this will usually include an assessment of financial performance to date compared to budget and any alterations of future plans which the company proposes to make.

Business Plans, Budgets and Forecasts

It is recommended that managers arrange for account reviews to take place when the customer’s forecasts for the next period are available. This is normally around six months before official publication of the year-end audited accounts, but the customer will nevertheless have a good view of what the year-end position is likely to be.

Progress against forecasts should be monitored using management accounts and audited accounts with the focus on trends.

In the initial lending appraisal the key underlying assumptions the company made in formulating its plans will have been identified. Management accounting information shows how these assumptions work out in practice. A failure, for example, to attain a planned level of gross margin or slower than anticipated collections from debtors can have fundamental implications for the company’s working capital and hence its ability to repay its borrowing.

Where key assumptions can no longer be regarded as valid, the management of the company should revise the plans. In light of the new forecasts, consider:

Is the plan still viable?

Have the assumptions in the new plan been sufficiently revised or do they still look optimistic?

Risk Awareness

Information on performance to date should be sufficiently detailed to be able to judge the direction in which the key elements of the business are moving i.e. what are the trends? If the indications are that performance is flat rather than improving then this must be reflected in the new forecasts. Be particularly sceptical if there is no concrete evidence that matters are getting better but updated projections assume this.

Management Accounts

Receipt of actual figures on a regular basis is an essential part of the monitoring process. By closely examining a customer’s performance it is possible to monitor the effects of non- attainment of forecasts and to take remedial action.

The best management accounts include:

Brief management comment (with reasons for variations from the forecasts and operating budgets).

Profit and loss account.

Balance sheet.

Working capital details (aged debtor analysis, aged creditor analysis and stock).

Additionally, the management accounts should enable the original cash flow forecasts to be updated and a rolling cash flow should be provided.

Much of the monitoring of management figures which we carry out is in relation to security over Current Assets and such monitoring can provide us with an early warning of potential difficulties.

Management accounts are a major source of information and means of monitoring probably the single most dangerous threat to the viability of a business i.e. cash shortages. They also allow comparisons of actual performance to be made against forecasts.

Note:

Lack of comparisons of actuals against forecasts is a major characteristic in cases where banks have lost money.

For most companies the level of sales will be the paramount key assumption. It is useful to monitor sales performance by making the following comparisons:

Monthly actuals against budgets.

Cumulative for the period to date for actuals and budgets.

With last year’s figures.

Where manufacturing to order is an important element of sales, similar analysis to the above, of the company’s future order book should be carried out as this will provide an even earlier indication of problems than sales figures.

Risk Awareness

Cumulative figures are generally much more significant than the results for any single month.

A

variance in one month may well adjust itself in the next.

It is the overall trends that are

important.

Any differences between management accounts and audited accounts should be explained. Management accounts can easily be adjusted to show a rosy picture simply by manipulation of

the value of the stock to improve apparent profitability. If there is any doubt about the reliability

of

the management accounts, then it may be appropriate to obtain auditor’s confirmation of the

figures on for example a quarterly basis.

 

Management accounts (or projects) may give us a clear indication that the security margin may be (about to be) eroded, especially where there is a request to increase facilities. More security may be offered but it may be of poorer quality.

Audited Accounts

 

The audited accounts should give an independently verified view of a business. However, the quality of audited accounts can be variable and they also only give a snapshot view of a business.

There may be a difference in practical application of the auditor’s role between businesses where there are substantial outside shareholders and those where the directors are the proprietors and the main concern may be the saving of tax. It may also be the case that auditors will be subject to pressure to comply with their clients’ wishes because they cannot afford to sacrifice the fees the relationship generates.

As well as comparing one set of audited figures with another they should always be analysed relative to any management accounts, to help form a view of the accuracy of management figures. Any major discrepancies should be clearly understood

Group Accounts

 

It

is essential to understand fully the Bank’s position when lending to a group of companies.

Which company/companies is the bank lending to and from which company/companies does

the Bank have security?

 

Particularly where a substantial foreign parent is involved, subsidiary companies may have weak balance sheets. A subsidiary may be valuable to the extent that it represents a core business of its parent.

The nature and extent of inter-company transactions/asset transfers, their rationale and what they mean in terms of the ownership of the assets must be clear.

Answering the following questions may help in establishing exactly the Bank’s position and its exposure:

Does the Bank hold cross guarantees, or cross guarantees and debentures from all the companies within the group?

Risk Awareness

Which companies own the assets? Where are these assets held?

To which companies is the Bank lending? Do these companies hold assets i.e. is the Bank lending to a subsidiary or to a holding company?

What is the extent of inter-company trading?

Which company has the greatest debt? Is this the company to which the bank is lending?

What is the financial position of the entire group? Are other banks lending to the same company or to other companies? How much? What for? What other facilities do the companies have? Does the Bank hold guarantees from other banks? Do other banks hold security?

What is the Bank’s total exposure to the group?

What is the exposure to the holding company?

What is the exposure to subsidiaries?

If a subsidiary of the group or holding company fails, what is the Bank’s position? What will other lenders receive?

Look for and understand substantial changes in the treatment of acquisitions, goodwill and depreciation.

Remember – if the Bank lends to a weak company without the benefit of guarantee support, in the event of insolvency the Bank would adopt the position of an unsecured creditor!

Industrial/ Sector information

Credit Risk Department will keep track and monitor the performance of individual sectors in the economy and any threats that may pose a great risk to the Bank’s lending portfolio. Industrial/sector information will also form part of the monitoring activity within the Bank and will contribute towards determining the proposed limit exposures in the loan portfolio.

4.1.4 MONITORING RESPONSIBILITIES

The Account Relationship Manager is principally responsible for all aspects of account monitoring. Credit Administration Unit, however will keep a log to track that the requisite information is received on a regular basis by way of an approved memorandum from Team Leaders.

Where customer fails to comply, Credit Admin will advise Account Rela