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Acknowledgement

Let me begin my acknowledgement by thanking God who bestowed me the courage and
wisdom to complete this report.

I am thankful to the entire faculty member for providing the suggestion on how the
research could be done and improved. I am fortunate to have the opportunity to develop
this report under kind supervision of my teacher.

I am grateful to my fellow’s for putting their heart and soul into this project and for
tolerating my continual barrage of phone calls and e-mails.

And a very loving thank you goes to my parents, whose guidance and prayers brought the
project into this form
Executive summary

Banks are financial intermediaries that supply financial services to surplus and deficit
units of the economy. In other words a bank uses the deposits of the bank to issue loans
to households; businesses etc and earn a return on them. Are banks special
intermediaries? Most bankers believe that the defining business of banking is lending.
Inattention to loan policies. Disregard of the banks own policies, unsafe concentration of
credit, Poor control over loan personnel, Loan growth over the bank’s ability to control
quality, poor systems for detecting loan problems.

To overcome their deficiencies in systems and procedures that spawn poor loans, banks
must develop a credit culture supported by well conceived management strategies for
controlling credit risk. For a bank to set a correct credit culture a bank must establish its
priorities with respect to the market place. An important feature reflected in credit data is
the expansion of bank credit for non-seasonal purposes. The rate of absorption of bank
credit in the economy has consequently increased manifold. The increase flow of bank
credit in recent year has been widely disturbed among different sectors of the economy.
However, a significant development is the comparatively flow of bank credit to certain
sector, which had a lesser claim on bank resources before 1959. Financial health of the
banking system has improved in recent year as a result of the measures taken to enhance
bank’s commercial orientation and upgrade the banking supervision system.

The objective of the Council is to achieve a more purposeful and equitable distribution
of bank credit and to bring credit, housing finance and credit to small borrowers in trade
and industry.

In order to ensure that the aggregate credit expansion by commercial does not exceed the
overall limit determined in the Credit Plan, the State Bank prescribes credit ceiling for
individual banks, if it consider it necessary. In case the ceiling is violated by banks they
become liable to penalty by the State bank.
Table of contents

INTRODUCTION AND BACKGROUND....................................................................... 6


CREDIT CULTURE........................................................................................................... 8
LENDING IN PAKISTAN................................................................................................. 9
FINANCING FACILITIES OFFERED BY PAKISTANI BANKS.................................11
NON-FUND BASED FACILITIES................................................................................. 11
RUNNING FINANCE (OVER DRAFT)......................................................................... 12
CASH FINANCE............................................................................................................. 12
DEMAND FINANCE....................................................................................................... 12
BILLS PURCHASED AND DISCOUNTED................................................................. 12
LITERATURE REVIEW................................................................................................ 14
THE CREDIT FUNCTION............................................................................................. 15
CREDIT PLANING IN PAKISTAN................................................................................
18 FACTORS DETERMINING THE GROWTH AND MIX OF BANK
LOANS............. 24 CREDIT ANALYSIS: WHAT MAKES A GOOD
LOAN?........................................... 25 SOURCES OF INFORMATION ABOUT LOAN
CUSTOMERS................................. 25 CONSUMER
INFORMATION....................................................................................... 26 BUSINESS
INFORMATION........................................................................................... 26
GOVERNMENT INFORMATION................................................................................. 26
GENERAL ECONOMIC INFORMATION.................................................................... 26
CONTROLLING LOAN LOSSES...................................................................................
29 THE LOAN REVIEW FUNCTION................................................................................
29 CORRECTING PROBLEM LOANS...............................................................................
30 BORROWER’S FINANCIAL STATEMENTS...............................................................
30 INTEREST RATE POLICY............................................................................................
30 FINANCIAL ASSESSMENTS........................................................................................
34 LENDING OF
BANKS.................................................................................................... 36
PERFORMANCE OF BANKS....................................................................................... 41
RECOMMENDATIONS.................................................................................................. 44

INTRODUCTION AND BACKGROUND

The role of commercial banking is to fill the diverse desires of both the borrowers and
lenders in our economy. Banks are financial intermediaries that supply financial services
to surplus and deficit units of the economy. Most of bank’s assets are financial in nature
such as the amount borrowed by households, businesses, government agencies etc. Banks
liabilities are also financial in nature primarily being the deposits kept by households,
businesses, government agencies etc. The assets and liabilities of a bank are channeled
i.e. the liabilities (major deposits) are used to enhance the bank’s assets. In other words a
bank uses the deposits of the bank to issue loans to households; businesses etc and earn a
return on them. Bank’s also raise capital from the sale of stock or the accumulation of
retained earnings but generally represent a relatively minor source of funds. (rumelt, 1977
and Anderson and paine, 1975).

Are banks special intermediaries? Do they play any unique role in the economy? And if
so, will they retain their specialty in the ever faster changing world of finance? The rapid
evolution of finance over the last two decades and the breathtaking ‘e-age’ revolution
have persuaded many that, eventually banks will be indistinguishable from other financial
intermediaries since all their functions can at least be efficiently be carried out by non-
banks. (Bossone, 2001).

Initially commercial banks were viewed as a totally separate entity as compared to other
financial and non-financial organizations like investment banks but times have changed
and now commercial banks most obviously have to compete with other types of banks,
financial intermediaries, and with any organization that wishes to perform the task of
filling the diverse desires of surplus and deficit units in the economy. (Maier, 1963 and
Nutt, 1976).
Most bankers believe that the defining business of banking is lending. Recent history has
shown how critical it is for banks to control their risks of lending. Poor loan quality was
the main factor in the growing number of bank failures in our economy. The most basic
faults in lending procedures are

1. Inattention to loan policies


2. Overly generous loan terms and lack of clear standards
3. Disregard of the banks own policies
4. Unsafe concentration of credit
5. Poor control over loan personnel
6. Loan growth over the bank’s ability to control quality
7. Poor systems for detecting loan problems
8. Lack of understanding of borrower’s cash needs
9. Out of market lending

Credit Culture

To overcome their deficiencies in systems and procedures that spawn poor loans, banks
must develop a credit culture supported by well conceived management strategies for
controlling credit risk. The first step is to determine an appropriate credit culture that is
consistent with the business values of the management team. For a bank to set a correct
credit culture a bank must establish its priorities with respect to the market place.
(Brunner et al, 2000) Priorities may range from long term consistent performance of the
loan portfolio to emphasizing on aggressive loan growth and market share with highly
flexible standards. The first priority is the lower risk one and suggests goals of superior
loan quality with stable earnings and the second set is high risk and suggests acceptable
loan quality with superior earnings. (Wolfgang Hammes, 2000)
LENDING IN PAKISTAN

There has been a phenomenal growth in the level of bank credit over the year. Bank
credit in Pakistan increased rather slowly in the first decade after the establishment of the
state bank.

The primary reason for this was the private sector activity remained rather limited. While
there was undoubtedly considerable potential demand for bank credit, which the bank did
not need in view of their traditional criteria for credit worthiness, excess liquidity in the
economy coupled with various direct controls and the general economic climate tended to
inhibit the demand for bank credit. However, the situations changed critically in 1959 and
bank credit continued to rise sharply during the third and fourth plan periods.

An important feature reflected in credit data is the expansion of bank credit for non-
seasonal purposes. The general pattern of economic activities in the earlier years was
markedly seasonal with bank credit registering a notable expansion in the busy season
and a subsequent retirement of the same magnitude in the slack season. The seasonal
pattern has now lost its sharp edge owing to the structure changes in the economy. With
the growth of the industrial sector and the diversification of economic activity, bank
credit for non-seasonal purposes has raised sharply in recent year. The rate of absorption
of bank credit in the economy has consequently increased manifold. Though the seasonal
fluctuations have not disappeared, the fact that a sizeable non- seasonal demand is
superimposed on the seasonal demand has blunted the edge of seasonal fluctuation. They
no longer have the same significance for the banking system and money market. The
busy season extend roughly from September and April each year.

The increase flow of bank credit in recent year has been widely disturbed among different
sectors of the economy. However, a significant development is the comparatively flow of
bank credit to certain sector, which had a lesser claim on bank resources before 1959. In
line with the structural changes in the economy, the pattern of bank advance has
undergone a significant change over the year and commercial bank have rapidly adapted
themselves to the changing credit requirement of different sector of the economy
(Meenai, 1984, p.43)

The comprehensive financial sector reform program introduced in the 1990’s has largely
transformed Pakistan’s financial sector from a inward looking, narrow based and
government controlled regime to an outward looking, market based an dynamic system.
After passing through initial stage of trial and error in earlier year the market oriented
financial system has now achieved considerable sophistication. Some major objectives to
reforms has been achieved whilst others are being pursued. The financial sector reform
program envisages harnessing the private sector as the engine of growth. Hence, the
credit plan allocated more resources to the private sector then to the government sector
for budgetary support through bank borrowing . Annual average credit to the private
sector therefore, increased by RS. 53.3 billion in the 1990’s, which constituted 52% of
M2.

Substantial progress has been made in implementing banking sector reforms in 1990’s.
This includes: (I) conduct monitory policy through market based instrument (2) Interest
rate liberalizing and restoration of financial discipline through prudent lending (3)
enhancing the SBP’s authority in banking regulation and supervision. (4) improving the
capital base and management of nationalized commercial banks (5) Stemming the
hemorrhage caused by political motivated lending (6) curtailing operating losses by
reducing over staffing and excessive number of branches in the nationalized commercial
bank (NCBs) and development finance institutions (DFIs) through staff separation and
branch closure policy and (7) improving transparency through better prudential regulation
and financial disclosure standards. Financial health of the banking system has improved
in recent year as a result of the measures taken to enhance bank’s commercial orientation
and upgrade the banking supervision system. The cleaning up of the bank balance sheet
will be further augmented by the newly established Corporate and Industrial
Restructuring Corporation (CIRC), whose principal objective is to dispose of the
nationalized commercial bank (NCBs) a non-performing assets through industrial
restructuring, mergers and if necessary liquidation. A plan to restructure and consolidate
DFIs has also been formulated with the view to improving their financial health,
rationalizing commercializing their operations and paving their way for eventual
privatization.

Financing facilities offered by Pakistani Banks

Pakistani bank offer following financing facilities to its customers:

1. Fund based Facilities


2. Working Capital Finance
3. Trade Finance
4. Agricultural Finance
5. Financing of small Business &Industry
6. Financing of Commodity Operations
7. Housing Finance
8. Consumer Finance
9. Musharika Financing
10. Employment Finance

Non-Fund based Facilities


1. Letter of credit
2. Guarantees
Forms of bank advances

The main types of bank advances are as follows

Running Finance (Over Draft)

Running finance is a cheque fluctuating account, where in the balance some times may be
in credit and at other times in debit within the currency of limit. It can be pre arranged for
a year or so as well as purely temporary when it is repaid in the shortest period not
exceeding a maximum of six weeks. As per terms agreed, it is repayable in installments
or in lump sum on expiry of limit the mark-up is chargeable on outstanding balance.
Account opening formalities are required to be completed.

Cash Finance

Cash Finance is a drawing account against credit granted by Bank and is operated in
exactly the same way as a current does on which a running finance has been sanctioned.
It is cheque account usual account formalities.

Demand Finance

Demand Finance account is an advance for fixed amount and no debit to the account may
be made subsequent to the initial advance except for mark-up, insurance premia godown
and other sundry charges. As an account credited to loan account is in reducing the
original advance, and further drawing are not allowed.

This is a single transaction, non-chequing account. It ranges for short period to medium
term and long term.
Bills Purchased and Discounted

Discounted and purchasing of bills is another form of finance in which the negotiable
installments supported by document of title are given value and fund are provided to the
seller, exporter consignor. This, a single transaction or clean and can be demand. The
banks give value numerous competitive advantages result from a sound forecasting
system. Most important among them are the ability to forecast changes in relevant
environmental condition that affect profitability (e.g. changes in consumer preferences,
uncertainty in investment markets and increased loan competition) and to construct goals
and plans accordingly. Forecasting systems are essential when the environment is
undergoing rapid changes, a situation that is descriptive of today’s banking community
(rumelt, 1977 and Anderson and paine, 1975).

The development-forecasting model relies on combining historical and future data in a


logical sequence. As a first step, it is necessary to identify those factors that influence the
forecast. In most bank situation, these factors can be subdivided into two categories,
environmental (external) factors and management policies (internal) factors.

Second, it is necessary to determine the relative important of these variables. The third
step in the forecasting is to determine which of these factors will change in the times
horizon of the forecasting. The fourth step of the sequence is to determine the impact of
the changes, positive, negative or zero. Finally, this information is combined and a
forecast is generated based on current position, forecast changes and their associated
impact (Maier, 1963 and Nutt, 1976).

In addition to the generated model with five steps that require determination of the
importance and impact of factor influencing the forecast. This determination is made
through a structured group process for eliciting and evaluating ideas (Janis, 1972) to such
document and receives the amount, when the bills mature from the drawer

LITERATURE REVIEW

The specialty of banks has traditionally been traced to the monetary nature of their
(demand) liabilities and to their running the economy’s payment system. Since the early
experience of the deposit-taking institutions of the 19th century, banks have issued debt
instruments that are accepted as means of exchange and payment on the basis of a
fiduciary relationship among the agents using them, and between the agents and the
issuing banks.

Supplying transaction and portfolio management services is what defines banking


according to (Fama, 1980), while (Kareken, 1985) emphasizes the central role of banks in
managing the payment system. . (Corrigan, 1982) adds to these functions the banks two
fold role of back up sources of liquidity for all enterprises in the economy and of
transmission belt for monetary policy. Others have objected that, with the evolution of
financial markets and institutions, none of the above functions is compellingly and
exclusively pertinent to banks as such. In advanced economies, transaction account
facilities are supplied by non-depository (and even non-financial) institutions with access
to payment clearing and settlement systems. Likewise, various other financial and non-
financial entities can provide credit to business, while the backup-source of liquidity
function in times of economic distress is in principle inconsistent with bank regulations
aimed to prevent or forestall bank failures. Finally, where monetary policy is mainly
conducted via open market operations, government security dealers (even more than
banks) may act as transmission belts of monetary policy signals to the economy.

Research has thus looked for other features that may more specifically characterize banks
as special financial intermediaries
THE CREDIT FUNCTION

Diamond (1984) finds a special feature in banks acting as delegated monitors of


borrowers, on behalf of the ultimate lenders (depositors), in the presence of costly
monitoring. Essentially, banks produce a net social benefit by exploiting scale economies
in processing the information involved in monitoring and enforcing contracts with
borrowers. Banks reduce the delegation costs through a sufficient diversification of their
loan portfolio. Even if diamond’s results shows that bank’s specialization in monitoring
credit improves social welfare, it does not prove to hold for banks exclusively, since any
kind of intermediary equally benefits from portfolio diversification. Also, it does not
explain why loan contracts are not replaced by more efficient risk sharing, more complete
state-contingent contracts that reduce asymmetric information (such as equities). What is
characteristic of banks loans is that their value is fixed in nominal terms and includes
collateral requirement clauses as well as costly bankruptcy provisions. By factoring ex-
post information asymmetries and agency costs in the credit-making process. Gale and
Hellwig (1985) show that such contract types, which they call standard debt contracts
(SDCs) are optimal financial agreements. These, on the one hand, save on the creditor’s
cost of monitoring states of nature throughout the life of the loan and, on the other, give
borrowers an incentive to minimize the risk of default and discourage them from hiding
their true business performance.

The optimality of SDCs suggests a powerful argument to explain why banks have
historically emerged as the first form of financial intermediation virtually everywhere in
the world whenever capitalistic production had taken place. However, SDC optimality is
not robust against changes in the universal risk neutrality assumption used by Gale and
Hellwig in their model, and does not hold in the case of ex-ante information asymmetries,
where SDCs become exposed to exposed to adverse selection and moral hazard risks.
Besides, as information and contract performance are crucial to the SDC optimality
result, one would expect bank special ness to fade with the development of financial
infrastructure, since this provides agents with better information and more efficient
contract enforcement technologies leading investors to prefer non- SDC contract types
(e.g. equity0 Bank special ness is therefore a product of history, much like its own
disappearance at some point.

Terlizzese (1988) uses the presence of ex-ante asymmetric information as a rationale for
the depositor’s preference to lend indirectly (writing a SDC with a bank) over direct
financing of individual entrepreneurs. As depositors are faced with a ‘lemon’ problem,
they generate a demand for delegated screening which banks have a comparative
advantage to perform. In a repeated game situation, the related agency problem is solved
through reputation incentives. Interestingly, due to the ex-ante information asymmetry,
banks should not find it possible to have depositors agree on deposit contracts
contingents on states of nature. This provides an enlightening explanation for why bank
commonly use SDC’s to finance their assets.

Though the credit function and the associated access to private information, banks tend to
establish long term relationships with fund users, based on mutual trust and mutually
beneficial incentives. Relationships ensure borrowers with a steady and reliable supply of
funding. Even at times of adverse contingencies, while they generate for the banks safe
sources of (quasi-monopolistic) rents. As relationships consolidate over time, it becomes
costly for both parties to exit and replace them with different counterparties. (Corrigan,
1982) Relationships, however, are not necessarily a unique feature of banks and can be
replicated by other types of non-bank financial intermediaries; especially those
specialized in term lending.

Evaluation of bank loan applications/ extensions normally revolves


around an 8-phase cycle.

I. Evaluation of the status of the firm’s customer relationship


II. Evaluation of a new customer relationship
III. Credit evaluation
IV. Check on legal and policy restrictions
V. Appraisal of the loan’s purpose, amount, maturity, payback and security
VI. Detailed recommendation
VII. Record analysis and recommendation, and
VIII. Follow-up review

I want to focus on credit evaluation. Credit investigation is undertaken in


varying degrees depending upon the client’s general reputation, the
amount and purpose of the loan, the repayment schedule, and the security
offered. The main concern of the loan officer is to access a loan
applicant’s ability to repay loans in the normal course of business. The
ability to repay is a function of net cash flows. The banker requires
information to assist him in predicting the potential cash flows of the
applicant, his ability to comply with the terms of loan and the risk
associated with the loan. In this research, I want to identify the types of
information required for this purpose.
Factors determining the growth and mix of bank Loans

The mix of loans held by any particular bank usually differs quite markedly from
institution to institution, based upon several critical factors. One of the key factors in
shaping an individual bank’s loan portfolio is the profile of characteristics of the market
area it serves. Each bank must respond to the particular demands for credit arising from
customers in its own market. A bank serving a suburban community with large number of
single-family homes and small retail stores will normally have mainly residential real
estate loans, automobile loans, credit for the purchase of home appliances and for
meeting household expenses, and other personal loans in its portfolio. In contrast, a bank
situated in a central city surrounded by office building, department stores, and
manufacturing establishment will typically have the bulk of its loan portfolio devoted to
business loans designed to stock shelves with inventories, purchased computer and other
equipment, and meet payrolls, as well as loans granted to business manager, lawyer and
other professional businessmen and women.

Of course, banks are not totally dependent on the local areas they serve for all the loans
they acquire. They can purchase whole loans or pieces of loans from other banks---
participation—a practice that helps reduce the risk of loss if the local areas served by the
bank incur severe economic problem. However, as we noted at the outset, a bank is
chartered by government authorities primarily to service selected markets and, as a
practical matter, most of its loans application will come from these areas.

Bank size is also a key factor shaping loan portfolio mix, especially the size of the bank’s
capital, which determines its legal lending limit to a single borrowing customer. Larger
banks typically are wholesale lender, devoting the bulk of their credit portfolio to large-
denomination loans to corporation and other business firms and to household situated in
urban areas. Smaller banks tend to emphasize retail credit in the form of smaller-
denomination home mortgage loans extended to individual and families, as well as
smaller business extend to individuals and families, as well smaller business loans to
farms and ranches.
The experience of management in making different types of loans also shapes a bank’s
loan mix, as does the bank’s official loans policy which prohibits its loan officers from
making certain kinds of loans.

CREDIT ANALYSIS: WHAT MAKES A GOOD LOAN?

The division of the bank responsible for analyzing and making recommendation on the
fate of most application is the Credit Department. Experience has shown that this
department must ask and satisfactorily answer three major question regarding each loans
application:

1. Is the borrower creditworthy, and how do you know?


2. Can the loan agreement be properly structured and documented so that the bank
and its depositors are adequately protected and the customer has a high
probability of being able to service the loan without excessive strain?
3. Can the bank perfect its claim against the assets or earning of the customer such
that, in the event of default, recovery of funds can be made rapidly with low cost
and low risk?

SOURCES OF INFORMATION ABOUT LOAN CUSTOMERS

The bank relies principally on outside information to assess the character, financial
position, and collateral offered by a loan customer. Such an analysis begins by reviewing
information supplied by the borrower in the loan application. How much is being
requested? For what purpose? What other obligation does the customer have? What
assets might be used as collateral to back up the loan?

The bank will contact other lender to determine their experience with this customer. Was
all scheduled payment in previous loan agreements made on time? Were deposit balances
kept at sufficient levels? In the case of a household borrower the local or regional credit
bureau will be contacted to ascertain the customer’s credit history. How much was?
SOURCE OF INFORMATION ABOUT BUSINESS, CONSUMERS
AND GOVERNMENT BORROWING MONEY.

CONSUMER INFORMATION
Local bureau
Customer financial statement
Experience of other lender with this customer

BUSINESS INFORMATION
Customer financial statement
Customer annual reports
Experience of other lender
Securities and Exchange Commission
Moody’s industrial manual or banking and finance manual
Standard and Poor’s stock industry surveys
Standard and Poor’s stock market Encyclopedia
Business and industrial Ratios

GOVERNMENT INFORMATION
Government budget reports
Credit rating agencies

GENERAL ECONOMIC INFORMATION


Chamber of Commerce, Survey of current Business
International Economic Condition, and Monetary Trends
The wall street journal
Newsletters published by money center banks
Local newspapers
Local chamber of commerce
Borrowed previously and how well were those earlier loans handled? Is there any
evidence of slow or delinquent payment? Has the customer ever declared bankruptcy?

Most business borrowers of any size carry credit rating on their bonds and other debt
securities and on the firm’s overall credit record. Moody’s and Standard and Poor’s
Corporation assign rating reflecting the probability of default on bonds and shorter-term
notes. Dun and Bradstreet provides overall credit rating for several thousand
corporations. Other firms and organization, such as Robert Morris Associated, Leo Troy,
and Dun and Bradstreet, provide benchmark operating and financial ratios for whole
industries so that the borrower’s particular operating and financial ratios in any given
year can be compared to industry standards.

In the Robert Morris’ Annual Statement Studies, for example, data is submitted on
borrowing customers from loan officers who work in banks that are members of Robert
Morris Associated (RMA), the national association of loan officer. RMA group and
present average (median) values for each operating or financial ratio, as well as upper and
lower quartile values.

In the Almanac of Business and industrial Financial Ratios, prepared annually by Dr. Leo
Troy, Internal Revenue Service data is used to assemble average operating and financial
ratio for firms in different industries and asset-size group. Twenty two different ratios are
presented for each industry. A similar array of individual firm and industry data is
provided by Dun and Bradstreet Credit services, which maintains more then 1 million
financial statements from corporation, partnerships, and proprietorships in 800 different
businesses lines(indicated by Standard Industrial Calcification, or SIC, codes). An
industry Norm Book, containing data from the most recent year and the past three years,
is prepared by Dun and Bradstreet annually and contains 14 key ratio measuring
efficiency, profitability, and solvency.

In evaluating and credit application, the loan officer must look beyond the customer to
the economy of the local area for smaller loan requests and to the national or even
international economy for larger credit requests. Many loan customer are especially
sensitive to the fluctuation in economic activity known as the business cycle. For
example, auto dealers, producers of palm and other commodities, home builders, and
security dealers and brokers face cyclically sensitive markets for their goods and services.
The loan officer and credit analyst must determine whether the borrower is caught in an
economic downturn or enjoying a period of economic expansion. This does not mean that
banks should not lend to such firms. Rather, they must be aware of the vulnerability of
some of their borrower to cyclical changes is structure loans to take care of such
fluctuations and economic conditions. Moreover, for all business borrowers it is
important to develop a forecast of future industry condition. The loan officer must
determine if the customer’s projections for the future conform to the outlook for the
industry and a whole. Any differences in outlook need to be explained or accounted for
before a final decision is made about approving or denying a loan request.

Loan Function - Principles and Procedures

The technical requirements of a loan function are as follows.


Insurance Protection – to protect against destruction of collateral held against the loan
e.g. inventory.
Documentation Standards – A standard documentation checklist should be required for
each credit file. Standard loan documentation is
1.
The basic loan agreement
2. The credit application
3. The borrower’s financial statements
4. Credit reports
5. Evidence of perfection of security interest
6. Assignment of receivables
7. Insurance policies
8. Corporate borrowing resolution or partnership agreement
9. Continuing guarantee
10. Financial statements of the guarantor
11. Correspondence
12. Copies of existing and paid off promissory note

Controlling Loan Losses


The Loan Review Function

Banks find that invariably a small portion of their loans become delinquent and
eventually must be written off. This basic risk of lending is not necessarily bad because
when a bank does not experience at least a few such cases, this is likely to be a sign that
that bank is passing up profitable business. Most banks review loans to control losses and
monitor loan quality. Loan review consists of a periodic audit of the ongoing
performance of some or all of the active loans in the bank’s loan portfolio. Its essence is
credit analysis although unlike the credit analysis conducted by the credit department as
part of the loan approval process, credit analysis of loan review occurs after the loan is on
the books. The following points are emphasized in the loan review:

1. To detect actual or potential problem loans as soon as possible


2. To provide an incentive for loan officers to monitor loans and to report
deterioration in their own loans.
3. To enforce uniform documentation
4. To ensure that loan policies, banking laws and regulations are followed.
5. To inform the management and the board about the overall condition of the loan
portfolio.
6. To aid in establishing loan loss reserves.
7. Financial condition and repayment ability of the borrower
8. Completeness of documentation
9. Consistency with the loan policy
10. Perfection of the security interest
11. Apparent profitability correcting Problem Loans
Correcting Problem Loans
Indicator of trouble is as follows:

1. Disturbing trends in financial statements


2. Management turnover
3. Cancellation of Insurance
4. Security interest filed against borrower by other creditors
5. Notice of a lawsuit, tax liens and other action against the borrower
6. Deteriorating relations with trade suppliers
7. Death or illness of principals
8. Marital difficulties of principals
9. Loss of key source of revenue
10. Deterioration of labor relations
11. Natural disasters
12. Rapid growth

Borrower’s Financial Statements


Concrete financial statements studied and attested by professional analysts, CPAs and/or
attorneys, should support loans.

Interest Rate Policy


Interest rates charges on loans potentially depend in one or more of several
considerations such
• Other banking relationships with the borrower

Inventory Turnover:

Inventory turnover indicates the liquidity of the inventory. This computation is similar to
the receivables computation turnover. The inventory turnover formula follows:
Computing the average inventory based on the beginning of the year and the end of the
year inventories can be misleading if the company has seasonal fluctuations or if the
company uses natural business year. The solution to the problem is similar to that used
when computing the receivables turnover- that is, use the monthly balances of inventory.
Monthly estimates of inventory are available for internal analysis, but not for external
analysis. Quarterly figures may be available for external analysis. If adequate information
is not available, avoid comparing a company on natural business year with a company on
calendar year. The company with the natural business year tends to overstate inventory
turnover and therefore, the liquidity of its inventory.

Over time, the difference between the inventory turnover for a firm that uses LIFO and
one that uses a method that results in a higher inventory figure can become very material.
The LIFO firm will have a much lower inventory and therefore a much higher turnover.
Also, it may not be reasonable to compare firms in different industries.

When you suspect that the inventory turnover does not result in a reasonable answer
because of inventory and / or cost of goods sold dollar figures not being reasonable,
perform the computation using quantities rather than dollars. As with the day’s sales in
inventory, this alternative is feasible only when performing internal analysis.

Current Ratio:
Another indicator, the current ratio, determines short term debt paying ability and is
computed as follows:

For many years the guideline for minimum current ratio has been 2.00. Currently, many
firms are not successful in staying above a current ratio of 2.00. This indicates a decline
in liquidity of many firms

A comparison with industry average should be made to determine the typical current ratio
for similar firms. In some industries, a current ratio substantially below 2.00 is adequate,
while other industries require a much larger ratio. In general, the shorter the operating
cycle, the higher the current ratio.
A comparison of the firm’s current ratio with prior periods, and a comparison with
industry averages, will help to determine if the ratio is high or low. The current ratio is
considered to be more indicative of the short term debt paying ability than the working
capital. The current ratio shows the relationship between the size of the current assets and
the size of the current liabilities, making it feasible to compare the current ratio for
instance, between Motorola and Intel.

LIFI inventory can cause major problems with current ratio because of the
understatement of inventory. The result is an understated current ratio. Extreme caution
should be exercised when comparing a firm that uses LIFO and a firm that uses some
other costing method.

Acid Test Ratio (Quick Ratio):

The current ratio evaluates an enterprise’s overall liquidity position,


considering current assets and current liabilities. At times, it is desirable to
access a more immediate position than that indicated by the current ratio. The
acid test (or quick) ratio relates the most liquid assets to current liabilities.

Inventory is removed from current assets when computing the acid test ratio. Some of the
reasons for removing inventory are that inventory may be slow moving or possibly
obsolete, and parts of the inventory may have been

pledged for specific creditors. Compute the acid test ratio as follows:
Usually a very immaterial difference occurs between acid test ratios computed
under the first method and this second method. Frequently, the only difference
is the inclusion of prepayments in the first method.
The usual guideline for acid test ratio is 1.00.

PROTOTYPE RISK RATING SYSTEM


Rating systems are based on both quantitative and qualitative evaluation. The final
decision is based on different attributes, but usually it is not calculated. We show how an
internal rating system in a bank can be organized in order to rate creditors systematically.
Ratings generally apply to obligors and loans for which underwriting and structuring
require judgment. They are produced for business and institutional loans and
counterparties on derivatives transaction, not consumer loans. Credit decisions for small
lending exposures are primarily based on credit scoring techniques.

The main problem faced by bank is obtaining information about companies that have not
issued traded debt instruments. The data about these companies are unproven quality and
are therefore less reliable, and it can be a challenge to extract to minimum required to
improve the allocation of credit.

The credit analysts in a bank or a rating agency must take into considerations many
attributes of a firm: financial as well as managerial, quantitative as well as qualitative.
The analysts must ascertain the financial health of the firm, and determine if earning and
cash flows are sufficient to cover the debt obligations. The analysts would also want to
analyze the quality of the assets of the firm and the liquidity of the firm.

In addition, the analysts must take into account the features of the industry to which the
potential clients belongs, and the status of the client within its industry. The effects of
macro-economic events on the firm and its industry should also be considered, as well as
the country risk of the borrower. Combined industry and country factors can by assessed
to calculate the correlation between assets for the purpose of calculating portfolio effects.

A major consideration is providing alone is the existence of a collateral, or otherwise of


alone guarantor, and the quality of the guarantee. This issue of guarantee is especially
important for banks providing loans to small and medium-sized companies that cannot
offer sufficient collateral.

When rating borrower one must decide whether to grade borrowers according to their
current condition (“point-in-time” rating assessment), or their expected creditworthiness
over the life of the loan or the entire cycle (“through-the-cycle” rating assessment). This
decision depends on the objective of the rating system. A long-horizon, through-the-cycle
approach is used when the purpose of the rating system is to assist lending or investment
decision. Loan officers generally consider potential stress conditions in the lending
decision and instructing a transaction (covenants, loans amount, term, collateral,
guarantee) over the life of the loan. This is the philosophy adopted by rating agencies. It
involves estimating the borrower’s conditions at the worst point in a credit cycle, and
grading according to the risk at that time. It is therefore expected that agencies’ ratings
stay stable over the credit cycle.

Financial assessment

If the earning and cash flows are sufficient cover the debt. The credit analyst will study
the degree to which the trends associated with these “financial” are stable and positive.
The credit analyst would also want to analyze the degree to which the assets are of high
quality, and make sure that the obligor has substantial cash reserve.

The analyst would also want to examine the firm’s leverage. Similarly, the credit analyst
would also want to analyze the degree to which the firm had access to the capital
markets, and whether it has an appropriate flexibility to borrower money.

The rating should reflect the financial position and performance of the company and its
ability to withstand possibly unexpected financial setbacks. This is a key step in the credit
assessment.

Industry benchmarks

The analysis of the competitive position and operating environment of a firm helps in
assessing its general business risk profile. This leads to the calibration of the quantitative
information drawn from the financial ratio from the firm, using industry benchmarks. The
ratios summarize information on the profitability and interest coverage of the issuer, on
its capital structure. (I.e. leverage), asset, protection, and cash flows adequacy. The major
ratios considered include:

1. EBIT interest coverage (x)


2. EBITDA interest coverage (x)
3. Funds from operation/total debt (%)
4. Free operating cash flows/total (%)
5. Pre-tax return on capital (%)
6. Operating income/sales (%)
7. LTD/capital (%)

8. Total debt/capitalization (%)

A company with an excellent business can assume more debt then a company with
average business possibilities. For example, a company with an excellent business
position will be able to take on a debt to total capitalization ratio (ratio 8 above) of 50%
in order to qualify for rating category A, whereas a company with only average business
possibilities will only be able to take on a debt to total capitalization ratio of 30% in order
to qualify for rating category A.

Table 11 provides data on average ratios for risk categories for three overlapping periods
(1992-94, 1993-95, 1994-96). The table indicates that the ordinal nature of the categories
corresponds well, on average, to the financial ratio. For example, if we examine the EBIT
interest coverage ratio (I.e. EBIT divided by interest expense) the we would observe that
the median for the AA credit class for the 1994 to 1996 period was 11.06 while for the
BB it was 2.27. The ratio for the AA credit class range from a low of 11.06 to a high of
9.67 over the three (1992-94, 1993-95, 1994-96) three-year overlapping sample periods,
while the ratio for the BB class ranged from 2.07 to 2.27.
LENDING OF BANKS

Followings are the advances of different banks which they advance to different sectors
that show the lending in Pakistan.

2006 2005 2004

MCB 198,239 180,323 137,318


NBP 294,336,000 268,839,000 220,794,000
PRIME BANK 21,264,000 25,523,000 32,124,000
SAUDI PAK BANK 25,487,000 19,513,000 29,022,000
STANDARD CHARTED BANK 51,508,000 50,215,000 29,438,000
PUNJAB BANK 39,439,000 63,624,000 10,132,000
Following is the deposit and lending rate for all banks under the regulation of State Bank
of Pakistan, which shows the upward movement in the interest rate
Performance of Banks

The financial sector in Pakistan comprises of commercial banks, foreign banks


development finance institutions (DFIs), micro finance companies (NBFCs) (leasing
companies, investment banks, discount houses, housing finance companies, venture
capital companies, mutual funds), modarabas, stock exchange and insurance companies.
As of 31st December 2005 there were 4 public sector banks, 4 specialized banks, 20 local
private commercial banks, 11foreign banks, 7 DFIs and 5 micro finance banks. Bank
wise data shows that the share of the large five banks in the incremental credit has
increased from 48.8 percent during July-February FY05 to 55.9 percent during FY06. As
a result, the institutional concentration in lending activities has increased.

This can be attributed to: (1) rising credit to deposit ratio, especially of the private sector
banks and (2) the banks’ response to capital requirements. Specifically, due to strong
sustained credit growth, the average credit to deposit ratio of the banking industry has
increased substantially in the preceding three years. The number of domestic bank
branches, which was 6872 in June 2004, and 7089 in June 2005 further increased to 7301
in December 2005. The number of foreign bank branches also increased from 67 in June
2004, to 105 in December 2005 (Table-6.11 and Fig: 7). Due to liberalized branch
licensing policy, the branch network of banks has started increasing. The increase in
branch network is particularly skewed towards private banks. The banks have opened 304
offices during the period from 01- 04-2005 to 31-03-2006. Due to the instructions for
opening of 20 percent of their branch expansion outside the big cities/Tehsil
Headquarters by the large banks (with network of more than 100 branches) the reach of
the financial services is expanding further and the banking services will be available to
people living in rural/less developed areas. Due to the positive economic outlook the
foreign banks have also started expanding their branch network. As of 31-03- 2006, the
total number of banks/offices in Pakistan is 7501

During the first six months of the current fiscal year, total assets of all the scheduled
banks increased by Rs 299 billion (8.9%) from Rs 3350 billion in June 2005 to Rs 3649
billion in December 2005. During July-March 2005-06, there was also an increase of Rs
303.9 billion (17.3%) in the net advances of the scheduled banks, from Rs 1759.6 billion
in June 2005 to Rs 2063.5 billion in March 2006. Scheduled banks’ deposits have
increased by Rs 272.9 billion (11.5%) during July-March 2005-06 or from Rs 2377.5
billion in June 2005 to Rs 2650.4 billion in March 2006. Total investments of all the
scheduled banks have increased by Rs 77.1 billion during the first nine months of the
outgoing fiscal year. In 2005, the banking sector produced impressive results. The year
has been unprecedented in terms of profits. Higher lending rates and increased demand
for private sector credit contributed significantly to the profitability of banks. The
increase in profits has had a positive impact on return on assets and return on equity of
the sector.

As a result of on-going privatization and restructuring drive, majority of public sector


banks have been privatized. In 2005, from the remaining 49 percent shares of
Government in UBL, another 4.22 percent shares were offered to general public and
recently the Government has announced another 10 percent divestment of UBL shares.
IPO for shares of HBL owned by the Government is under consideration. Further, the
government is contemplating to offload its remaining share holding in public sector banks
through the local stock exchanges. Once this will happen, the percentage of banking
sector in the private hands will increase even further.
PRACTICAL CASE STUDY

HSBC
Recommendations
Based on the conclusions drawn form the findings of the study, the following are
recommended:

1. In implementing effective credit evaluation, it is necessary that everyone


understands the critical credit evaluation factors. Local banks should devise a
system like a management training program for the new employees which would
enable them to better understand the critical factors in credit evaluation.
2. Banks in general, local as well as foreign should develop or outsource financial
models which would help them to analyze the financial statements of companies
consistently. This would reduce the time factor and also increase the efficiency of
the whole process.
3. Banks in general, local as well as foreign banks should develop or outsource a
model that would determine the credit ratings of a company based on their
financial and subjective data.
4. Banks in general, local as well as foreign should develop or outsource a financial
model that would rate the company based on their financial and subjective data as
well as the fluctuation in the companies stock prices. The reason being that bank
officials should consider that the investors of the company also have a
considerable amount of information as their money is on stake, thus the stock
price movements should also be considered for ratings as well as future
projections.
5. The bank’s policy should emphasize on knowledge and information. The bank
officials in the required department should stay close to their customers in order
to anticipate any future requirements of the company resulting in efficient
servicing from the bank.
6. The bank officials should be abreast of the all the current developments in
financial statement analysis.
7. The bank officials should be abreast of all the current developments in the
financial sector and analyze the impact of any significant change.
REFFERENCES

• Elsas, R. Kraahnen, J.P. (1998) Is relationship lending special? Evidence from


credit-file data in Germany. Journal of Banking and Finance 22. 1283 – 1316
• Brunner A. Krahnen J.P Weber M (2000). Information production in lending
relationships: On the role of corporate ratings in commercial banking. Working
paper, CFS, Frankfurt/Main in progress,
• Petersen, M.A., Rajan, R.J., (1994). The benefits of lending relationships:
Evidence from small business data. Journal of finance 49, 3 – 37.
• Bossone Biagio (2001). Do banks have a future? A study on banking and finance
as we move into the third millennium. Journal of banking and finance, 2239 –
2276. Allied Publishers Pvt. Ltd.
• Hukku N.V. (1956). Analytical studies of bank deposits. New Delhi:
• Nigam, Lall M.B. (1953). Financial Analysis techniques for banking divisions.
Ahmedabad: Indian institute of Management.
• Meenai A.S. (1984). Money and Banking in Pakistan. Karachi: Oxford
• University Press.

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