Project Report on

Processing of Loans and Ways to

Minimize
Non Performing Assets

Submitted To:

By:
Rahul Singh (MMS)
2
 Acknowledgment

We wish to take this opportunity to

thank all those that have gone out of
their way and helped us in ways more
than we could have ever expected in
completing this project.

Though the list is endless, we

would particularly like to express our
gratitude towards our

Project guide Professor S. Ganga for

her critical but helpful comments and
suggestions that have gone long way
to make this study possible.

The errors, if any, are the sole

responsibility of mine.
 CERTIFICATE

THAKUR INSTITUTE OF
MANAGEMENT STUDIES AND
RESEARCH, MUMBAI

This is to certify that the study presented by Rahul

Singh to Thakur Institute of Management Studies

and Research, Mumbai, in part completion of

Masters in Management Studies under Processing

of Loans and Ways to Minimize Non Performing

Assets has been done under my guidance in the

year 2007-09.

4
The Project is in the nature of original work that

has not so far been submitted for any other course

in this institute or any other institute. Reference of

work and relative sources of information have been

given at the end of the project.

Signature of the Candidate

Signature of the Guide

Rahul Singh

Prof. S. Ganga

5
 Executive Summary

The history of Indian Banking Industry dates back to 1786, and

it has crossed several phases like Nationalization, formation of
RBI, acceptance and adherence to the Basel norms and so on. In
today’s competitive world, banks provide advances for various
purposes like Housing, Vehicle, Setting up of new business and
all those activities which are permitted under the law. Lending is
very crucial to increase the revenue of a bank, in fact banks are
not only lending at PLR (Prime Lending Rate) but also at Sub-
PLR (lower than PLR) to tap the customers and ensure the
survival.
Sanctioning of loan does not happen just by filling up
of the application of the form, it goes through various processes
like field verification, legal verification, valuation of property,
offer letter and so on and finally ends with the disbursement of
the final amount. But after the payment of advances, the most
daunting problem i.e. Credit Risk crops up in the picture. Banks
are using various measures such as Active usage of SARFEASI
Act, 2002, Negotiation in repayment of loan etc. to minimize the
Non Performing Asset figure in its record. But with the recent
Subprime Crisis in the US, followed by the worldwide
meltdown has resulted in increase in level of NPAs of all the
banks in the country and the situation is further expected to
worsen in coming one or two years. Hence with this study, some
important suggestions have been given, which may help banks
to keep a check on the increasing level of its NPAs.
 INDEX

Chapter 1 Overview of Banking Sector ……….…….

…………………2

Chapter 2 Basic Principles of Lending…….........…….

…………………8

Chapter 3 Lending Procedure……………….

…………………….……10

Chapter 4 Funding of Working Capital

Working Capital- Meaning.……...
…………………………..20
Management of Working
Capital……………………….....…23
Method of Assessment- Turnover & MPFB
System………...27
Appraisal of Credit
Proposal………………………………....32
Nature of Facilities and Fixing of Credit
Limit………………44
Chapter 5 Credit Risk in Bank…..
……………………………………….53

Chapter 6 Non Performing Assets-

Meaning…………………………….61
Factors Affecting NPA…………………...
…………………..63
Steps Taken to reduce
NPAs…………………………………63
SARFEASI
ACT…………………………………………......65
Suggestions for Reducing NPAs in
India………………...…..66

Bibliography………………………………………
.………….68
Overview of Indian Banking Sector:

The Indian banking industry is currently termed as strong,

having weathered the global economic slowdown and showing
good numbers with strong support flowing in from the Reserve
Bank of India (RBI) measures.

Furthermore, a report "Opportunities in Indian Banking

Sector", by market research company, RNCOS, forecasts that
the Indian banking sector will grow at a healthy compound
annual growth rate (CAGR) of around 23.3 per cent till 2011.

According to a study by Dun & Bradstreet (an international

research body)—"India's Top Banks 2008"—there has been a
significant growth in the banking infrastructure. Taking into
account all banks in India, there are overall 56,640 branches or
offices, 893,356 employees and 27,088 ATMs. Public sector
banks made up a large chunk of the infrastructure, with 87.7
per cent of all offices, 82 per cent of staff and 60.3 per cent of
all ATMs.

A Glance at Development of the Banking Industry:

History of Indian Banking

Phase I

The establishment of the General Bank of India in the year 1786

marked the development of a structured banking system in India.
It was set up as a joint stock company. Later the bank of
Hindustan and Bengal Bank came into existence. The East India
company established three banks. The Bank Of Bengal in the
year 1809, The Bank Of Bombay in 1840 and Bank Of Madras
in 1843. The three banks were amalgamated in the year 1920 to
form the New Imperial Bank of India. The Imperial bank was
nationalized and was renamed as State Bank of India with the
passing of the State Bank of India Act 1955. The Reserve Bank
of India was constituted as shareholder’s bank in 1935 and is
now the Central Bank of the country. After independence, the
RBI bill was introduced in the Parliament to give public
ownership to the bank. Since January 1, 1949, it has been
operating as a state owned bank and state managed central bank.
It exercises the power to control the Indian Banking Industry

Phase II

Nationalization:
The major aim for nationalization was to give priority to meet
the credit requirement of the neglected sectors. Further this
credit facility was supposed to be extended at subsidized rates
i.e rate of interest were to be lower than those charged to larger
business units. Wholesale Banking paved the way for retail
banking resulting in an all round growth in the branch network,
deposit mobilization, credit disbursals and employment. As a
result profitability and competition took a back seat.

Objectives of Nationalization:

• Class banking to Mass Banking

• Reach out to unbanked areas
• Growth in deposit mobilization, Credit disbursals
• Loan portfolio to sectors identified as priority sectors

Nationalization of 14 major banks in 1969:

1. The Allahabad Bank Ltd

2. The Bank of Baroda Ltd
3. United Commercial Bank Ltd
4. The Bank of India Ltd
5. Bank of Maharashtra Ltd
6. Canara Bank Ltd
7. Central Bank of India Ltd
8. Dena Bank Ltd
9. Indian Bank Ltd
10. Indian Overseas Bank Ltd
11. Punjab National Bank Ltd
12. Syndicate Bank Ltd
13. Union Bank of India Ltd
14. United Bank of India Ltd

The nationalization of six more banks took place in 1980

 1. The Andhra Bank Ltd
2. Corporation Bank Ltd
3. The new bank of India
4. The Oriental Bank of commerce Ltd
5. The Punjab & Sindh Bank Ltd
6. Vijaya Bank Ltd

Impact of Nationalization:

The aggregate deposits of the banks increased from Rs. 4,669

crores in 1969 to Rs.2,33,753 crores in 1992. Tremendous
growth in the agricultural loans took place. The quality of credit
assets deteriorated as the sanctioning process became more
mechanical instead of in-depth credit assessment.

Categorization of Banks

In India, banks are categorized in to 3 major types. One is

nationalized banks, second is private banks and third is foreign
banks.

Banks in India

Nationalized Banks Private Banks Foreign

Banks

Nationalized Banks:
There are in total 27 nationalized banks in the
country. State bank of India and associate banks – 08 .Other
Nationalized banks – 19
Private sector Banks:
There are in total 30 Private sector banks in
our country. Some of them are

ICICI Bank
HDFC Bank
Kotak Mahindra Bank
IDBI Bank
IndusInd Bank
ING Vysya Bank
Jammu & Kashmir Bank
Karnataka Bank
Kotak Mahindra Bank

Foreign Banks:
There are in total 40 foreign banks operating in
our country.
Few of them are…..

ABN AMRO Bank

American Express Bank
BNP Paribas
Citibank
DBS Bank
Deutsche Bank
HSBC Bank
Standard Chartered Bank
Abu Dhabi Commercial Bank
China Trust Commercial Bank
Scotia Bank and many more.

The foreign banks have brought with them the latest technology
and latest banking practices in India. They have made Indian
Banking system more competitive and efficient. Government
has come up with a road map for expansion of foreign banks in
India.
The latest banking reforms have got many things for the foreign
banks to establish themselves in the Indian banking sector and
become a major player and reap the benefits by capitalizing on
the opportunities lying in this sector.
Currently, banking in India is generally fairly mature in terms of
supply, product range and reach-even though reach in rural India
still remains a challenge for the private sector and foreign banks.
In terms of quality of assets and capital adequacy, Indian banks
are considered to have clean, strong and transparent balance
sheets relative to other banks in comparable economies in its
region. The Reserve Bank of India is an autonomous body, with
minimal pressure from the government. The stated policy of the
Bank on the Indian Rupee is to manage volatility but without
any fixed exchange rate-and this has mostly been true.
With the growth in the Indian economy expected to be strong
for quite some time-especially in its services sector-the demand
for banking services, especially retail banking, mortgages and
investment services are expected to be strong. One may also
expect M&As, takeovers, and asset sales.
In March 2006, the Reserve Bank of India allowed Warburg
Pincus to increase its stake in Kotak Mahindra Bank (a private
sector bank) to 10%. This is the first time an investor has been
allowed to hold more than 5% in a private sector bank since the
RBI announced norms in 2005 that any stake exceeding 5% in
the private sector banks would need to be vetted by them.
In recent years critics have charged that the non-government
owned banks are too aggressive in their loan recovery efforts in
connection with housing, vehicle and personal loans. There are
press reports that the banks' loan recovery efforts have driven
defaulting borrowers to suicide.

Functions Performed by Banks:

 Accepting Deposits
 Fund Based and Non Fund Based Activities
 Transaction Banking Services
 Investment Banking Advisory
 Authorized Dealers

Now we’ll be concentrating more on the Advance Part of Fund

based activities in detail.

Fund Based Products:

 Cash Credit

Bill Finance Overdraft

Loans/
Advances

Term Finance Retail Finance

Different Types of Loans Available:

Now a days, banks, in
order to enhance the topline of the business, are providing
financial support in almost all the areas possible ranging from
Housing Finance to crop finance. The most common advance
products available are

 Car Finance
 Two Wheeler Loan
 Housing Loan
 Personal Loan
 Commercial Vehicle Loan
 Loan against Property
  Commercial Loan
 Loan for Starting up of New Venture
 Farm Equipment and Many more

Lending is very important for bank in order to increase their

business but at the same time it is very crucial decision as it may
have adverse impact on the bank and lead to collapse due to the
growing concern of increase in NPAs as was witnessed in the
US- Subprime crisis, which impacted the whole world’s
economy.

BASIC PRINCIPLES OF LENDING

Objectives of Lending
The basic objectives of lending are to grant credit
facilities to the entities:
i. For a defined purpose.
ii. To deploy the Bank’s resources in a profitable manner
and to achieve the statutory and regulatory norms.

Basic Principles
To achieve these objectives, the Bank has to follow a
prudent policy and conduct the business on the basis of
sound principles of lending namely, Safety, Liquidity
and Profitability. These aspects are further elaborated
below.

Safety
Safety of the funds lent has to be ensured with respect to:
i. Borrower
The Borrower should have the means, ability and
willingness to repay the advance along with interest as
per the terms of finance. These depend on factors like
tangible assets, income generating potential, operational
efficiency and integrity of the borrower. It is therefore
imperative to make a thorough investigation into the
means, character, antecedents, respectability and
capacity of the borrower before allowing them any credit
facilities and by keeping a close watch on their dealings
and on the operations in their accounts during the period
of advance. Character - Indicating the borrower’s
honesty, integrity, business ethics, regularity,
dependability, reputation and promptness to keep
promise.
ii. Profitability
Notwithstanding the socio-economic objectives of
lending, the fact remains that banks are profit making
institutions. They have to be run on commercial
 considerations to meet the expectations of the
shareholders and ensure their healthy growth. The Bank
should, therefore, have a proper mix of credit portfolio
which would earn sufficient income to enable it to defray
the cost of funds, meet establishment and other expenses,
provide for contingencies and risky assets, build reserves
and pay dividend to the shareholders.
iii. Liquidity
As the funds lent mostly belong to the depositors and as
the Bank should always be in a position to meet the
demands of the depositors, it is essential that the loans
and advances are recoverable in full on demand or within
a reasonable period. It is, therefore, necessary to ensure
that the funds lent are backed by securities that are easily
marketable and realisable. Matching of Assets and
Liabilities is very critical from this point of view.
iv. Security
Though repayment in the ordinary course must come out
of the surplus from business of the borrower, the security
aspect cannot be neglected. Security serves as a cushion
or comfort to fall back upon in the event on the
borrower’s failure or default in the repayment of
advance. Adequate tangible security ensures safety of
advance. The assets purchased out of the credit facilities
are obviously the first to be taken. It is a safeguard
against disposal/alienation of such securities. Wherever
necessary, the advances could also be secured by
obtaining collateral securities.
Procedure of Lending:
Hence, let’s have a look at the procedure involved in the
issuance of a loan by financial institutions.

Step 1: Application form

Step 2: Personal Discussion
Step 3: Bank's Field Investigation
Step 4: Credit appraisal by the bank and loan sanction
Step 6: Submission of legal documents & legal check
Step 7: Technical / Valuation check
Step 8: Valuation
Step 5: Offer Letter
Step 9: Registration of property documents
Step 10: Signing of agreements and submitting post-dated
cheques
Step 11: Disbursement

Step 1: Application form:

Filling up the application form is the
first step. The look of an application form may differ from bank
to bank, but nearly 80 per cent of the information they need is
similar. Most of this is basically your personal and professional
information, details of your financial assets and liabilities.

Documents to be Submitted :
 While submitting the application form, every bank asks for
several documents. And most banks these days provide doorstep
service, so that the customers don’t have to spend time visiting
their office to submit the documents. However, some banks still
insist on the customer visiting their offices at least once.

Proof of income:
This will need to be backed up by proof such as
copies of last three years Income Tax returns (along with copies
of Computation of Income/Annual accounts, if any), Form
16/Form 16A, last three months salary slips, copies of the last 6
months statements of all your active bank accounts in which the
salary/business income details are reflected, etc. Other
documents that needed to with the application form include age
proof, address proof and identification proof. Customers may
also be asked to give their employment details.

Age proof:
Copy of school leaving certificate/Driving
license/Passport/ration card/PAN card/Election Commission's
card/etc. are accepted as age proof.

Address proof:
Similar documents need to be provided to prove
that one is actually staying there currently.

Identification proof:
Same as above, but with photograph.
Sometimes, the same document if it contains a photograph, the
current residential address and the correct age can be the proof
for all 3 things.

Employment details:
If company, where the prospect is working
is not well-known, then a short summary about the nature of the
company, its business lines, its main customers, its competitors,
number of offices, number of employees, turnover, profit, etc
may be needed. Usually, the company profile that is available on
the standard website of the company is enough.

Financial check:
All the income-related documents one submits
like past Profit and Loss Account with the Balance Sheet and
expected/ forecasted cash flow statement with Profit and Loss
and Balance Sheet which serve a specific purpose. The lending
institution uses them to study the customer’s financial status.

The bank statements submitted are scrutinized for:

Level of activity in the case of self-employed persons, this gives

a very good clue about the extent of business activities.

Average bank balance a cursory glance at the average bank

balances maintained in a savings bank account speaks volumes
about the spending/saving habits of any individual.

Cheque returns a small charge debited by the bank in the

statement indicates that a cheque issued by the customer was
returned by the bank. Many such cheque returns can have a
negative impact in the process of loan sanction.

Cheque bounces if cheques deposited by customer are returned

by the issuer's bank, they will be visible in the bank statement
and again, banks have specific norms as to how many such
returns are acceptable in a period of one year.

Regular periodic payments the existence of periodic payments

to other finance companies/banks etc. indicate an existing
liability and you will need to provide full details to the lender.

Customer’s Investments also come under the scanner. This

helps the bank to estimate your ability to pay the down payment
as well as your savings habit.
Processing Fee

Along with the application form and the credit documents, banks
ask for a processing fee. This fee varies from bank to bank, but
is usually around 0.25% to 0.50% of the total loan amount. For
instance, if you take a loan of Rs 10 lakh, you will have to pay
around Rs 2,500 to Rs 5,000 as processing fee. The agent
dealing with you earns a commission from the bank, which to
some extent is also affected by the amount of fees paid by you.

Most banks have flexible fee structures, and it is advisable to

negotiate hard to find out the bank's 's minimum possible fees
though it is unlikely that a bank will agree to provide a loan
without any upfront fee at all. Some banks have zero upfront fee
loans, but that advantage may be negated as their other charges
such as legal charges and 'stamp duty are normally higher.
This fee is collected to maintain the loan account, and includes
work like sending Income Tax certificates every year,
maintaining post-dated cheques, etc.

Step 2: Personal Discussion

After formally and successfully
completing the application process, one has to wait till the home
finance institution evaluates the documents submitted. The wait
normally lasts only a day or two or sometimes even less.
However, some banks insist on meeting the applicant after
receiving the application form, and before the loan sanction.
This is to gather more details that may not be mentioned in the
application form and to reassure them of the applicant’s
repayment capacity.

Again, this stage is insisted upon only in very few cases these
days.

Step 3: Field Investigation:

Thousands of people apply for loans

everyday. And however eager a bank is to complete its targets,
every loan is a risk. So, it is only natural that it confirms or
validates the details you provide. The bank checks all your
information including existing residential address, place of
employment, employer credentials (if the applicant works for a
small organization), residence and work telephone numbers.
Representatives are sent to workplace or residence to verify the
details.
Even the references provided in the application form are
checked out. While this may sound irritating and an invasion of
your privacy, banks are forced to undertake validation in the
absence of any credit bureau. Once the credentials are
validated, it helps establish trust between the two.

Step 4 : Credit appraisal And Loan Sanction:

This is the
make-or-break stage. If the bank is not convinced about the
credentials, the application may get rejected. If it is satisfied, it
sanctions the loan. The bank or the home financier establishes
the applicant’s repayment capacity based on his/her income,
age, qualifications, experience, employer, nature of business (if
self employed), etc, and based on these, works out the
maximum loan eligibility, and the final loan amount is
communicated. The bank then issues a sanction letter. This
letter máy either be an unconditional letter, or may have certain
terms and conditions mentioned, which have to fulfill before
the loan disbursal.

Step 5: Submission of Legal Documents( Applicable for

Property Loans):

Now, the focus of the

bank's activities shifts from the applicant to the property he/she
intend to buy. Once the property is selected, one needs to hand
over the entire set of original documents pertaining to the
property to the bank so that it can keep them as security for the
loan amount given. These normally include:

The title documents of your seller, which prove the seller\'s title
including the chain of title documents if he is not the first owner
NOCs from the legal owners such as cooperative housing
societies, statutory development authorities, the lessor of the
land in the case of leasehold land, etc. NOCs are not required
where the property is situated on freehold land and the entire
land is being transferred along with the structure. These
documents remain in the bank's custody until the loan is fully
repaid.

Legal Check:

Every bank conducts a legal check on the

documents to validate their authenticity. Even the draft sale
documents that the applicant will be entering into with his/ her
seller will be scrutinized. The documents are sent to a lawyer in
their panel (either in-house or outsourced) for a thorough
scrutiny. The lawyer's report either gives a go-ahead if
documents are clear, or it may ask for a further set of
documents. In the latter case, you are expected to hand over the
additional documents to the bank for a clear title.

Step 6: Technical/ Valuation Check:

Banks are extremely careful

about the property they plan to finance. They send an expert to
visit the premises you intend to purchase. This expert could
either be a bank employee or he could belong to a firm of
architects or civil engineers.

Site Visit:

The site visits to your property are conducted to verify

the following:

In case of under construction property

• Stage of construction is the same as that mentioned in the

payment notice given to you by the builder.
• Quality of construction
• Satisfactory progress of work.
• Layout of flats and area of property is within permissions
granted by the governing authority.
• The builder has the requisite certificates to start
construction at the site.
• Valuation of the property in relation to other deals in the
surrounding areas.
In case of ready/resale :

• External / internal maintenance of the property.

• The age of the building.
• Will the building last the loan tenure? This has a direct
bearing on your loan eligibility, since the loan tenure will
be restricted to the maximum age of the property as
decided by the bank's engineer and this will impact your
loan eligibility.
• Quality of construction.
• Surrounding area (development).
• Whether the builder has received the requisite
certificates for handing over possession of the flat.
• There is no existing lien or mortgage on the property.
• Valuation of the property in relation to other deals in the
surrounding areas.

These inspections are carried out to

protect consumer interests in terms of construction quality,
adherence to local laws, approved building plans, etc. A
technical inspection also lets the bank understand the progress of
construction so as to release the staggered disbursements.

Step 7: Valuation:

Since housing loans are cheaper than other

loans, there have been cases where individuals have shown
purchase of properties from related entities at inflated prices to
obtain cheap loans. Since the risk associated with diversion of
funds is higher than if the loan was used for genuine purposes,
banks carry out an independent valuation to find out whether the
transaction is in line with the existing market price of the area.

Valuation has become a key parameter in determining the loan

amount that can be sanctioned by the bank. The valuation
process is quite subjective and depends on the quality and ability
of the person sent by the bank for valuation.

Valuation of real estate as a profession is still in its infancy in

India and is still non-standardized. In many cases, the valuer
determines the value of the property at an amount that is lower
than the documented cost of the property and this would result
in the loan amount being lower, since the bank funds a certain
percentage of the cost or valuation of the property, whichever is
lower.

This practice has led to severe consumer issues in an increasing

number of cases, as the valuation is normally done only after the
consumer takes a sanction (by paying a fee) and after identifying
and committing to buy the property.

The valuation issue rarely arises when a property is purchased

through a reputed builder directly or if the property is pre
approved. In both the cases, the banks would have already
completed the valuation and therefore, you can safely assume
that there is no difference between the documented cost of the
property and the bank's valuation amount.

Step 8: Offer Letter:

Once the loan is sanctioned, the banks sends
an offer letter mentioning the following details:

• Loan amount
• Rate of Interest
• Whether fixed or variable rate oæ interest linked to a
reference rate
• Tenure of the loan
• Mode of repayment
• If the loan is under some special scheme, then the details
of the scheme
• General terms and conditions of the loan
• Special conditions, if any

Acceptance Copy:

If the applicant agrees with what is mentioned

in the offer letter from the bank, he/she will have to sign a
duplicate letter of the same for the bank's records. Earlier, banks
used to charge administrative fees along with the offer letter.
However, with rising competition, administrative fees have
virtually disappeared from the home loan market.

Step 9: Registration of property documents:

 After the legal and
technical / valuation check, the draft documents as cleared by
the lawyer need to be finalised and signed and the stamping and
registration of the documents need to be done. Also, if any
NOCs are pending, these need to be obtained in the format
approved by the bank's lawyer.

Step 10: Signing of agreements and submitting post-dated

cheques:

All borrowers need to sign the home loan agreement and need to
submit post-dated cheques for the first 36 months (if that is the
agreed mode of repayment). The original property documents
have to be handed over to the bank at this stage. Some banks
also create a document recording the handing over of the
property documents to them as security for the due repayment of
the home loan.

This document is also called a memorandum of

entry and attracts significant stamp duty depending on the
amount of the loan in some states. The stamp duty payable on
such a memorandum is naturally recovered from

Not all banks create

this memorandum and hence the stamp duty may or may not be
payable, depending on the practice of the specific bank.
However, even where no such memorandum of entry is created,
the state government concerned may, in the future, demand a
stamp duty on the loan transaction, which naturally is
recoverable from the applicant as per the home loan agreement
signed by the parties involved.

Step 11: Disbursement:

After the bank has ensured that the

property is legally and technically clear, all the original
documents pertaining to transfer of ownership of property in
your favor have been submitted and all the necessary loan
agreements have been executed, finally, it is payment time! The
applicant will now actually receive the cheque and along with
that one also need to submit documents to prove that he/she has
paid his/her personal contribution towards the property, since
banks normally finance only up to 85-90 per cent of the total
cost of the house.

In case the applicant is expecting money from other sources to

fund his/ her contribution, he/she need to provide sufficient
evidence for the same. It is only after submitting this proof that
the bank will release part-disbursement of the loan.

The cheque will be in the name of the reseller (for resale flats),
builder, society or the development authority. It is only in
exceptional circumstances, that is, if the applicant provides
documents to support that he/she has made an excess payment
then only the cheque will be handed over to the applicant
directly by the bank.

Disbursement in Stages:

Usually, loans are disbursed on the basis

of the stage of construction of the property. So, in case of resale
or ready possession properties, the disbursement is full and final.
However, in case of under-construction properties, the payment
is made in parts, also known as part-disbursement.

Each option would have different disbursement processes.

Part disbursement: When a loan is partly disbursed, the bank

does not start EMIs immediately, since it is calculated on the
total loan amount at a particular rate of interest and for a given
tenure. Moreover, it normally does not start breaking up the
installments into its principal and interest components until the
entire loan amount is disbursed.

To overcome this difficulty, banks charge simple interest on the

partly disbursed loan amount. For instance, if you have a
sanctioned loan of Rs10 lakh, but the property is under
construction and the bank has disbursed only Rs4 lakh, you will
be charged a simple interest only on the disbursed amount. This
process continues until the final disbursement takes place. The
simple interest paid is called Pre-EMI interest or PEMI.

At this stage, banks may take only around three to six post-dated
cheques on account of PEMI.
Full and final disbursement: If it is a ready-possession
property, the bank disburses the entire loan amount in favor of
either the reseller or the builder.

Payment receipt: Once the bank hands over the pay order to the
borrower, he/she in turn is expected to hand it over to the
reseller or the builder and should get a receipt from them for the
payment and hand it back to the bank, as it will become part of
the borrower’s mortgage documentation.

Share certificates: In case the property is part of a society, the

customer will need to get the flat transferred in his/ her name by
asking the society to issue the share certificate in his/ her name
and recording the transfer of ownership in their books.

This normally happens at the first AGM/EGM after the sale

transaction. The transferred share certificate also happens to be a
part of the mortgage documentation and has, therefore, to be
handed over to the bank after the transfer takes place.

Repayment
The loan is generally repaid by equated monthly
installments, using post-dated cheques. Banks usually ask for
12, 24 or 36 PDCs (Post Dated Chques), after which the
customer need to repeat the process until the entire loan has
been repaid. Some banks may also insist on a cheque for an
amount equivalent to the loan outstanding at the end of PDC
period to ensure timely replenishment of PDCs for the next 12,
24 or 36 months as the case may be.
In case the installments are
to be deducted against the borrower’s salary, he/she need to
submit a letter letter from the employer accepting this
arrangement and directly remitting the amount to the bank
every month.
Some banks allow to give standing instructions to the bank to
deduct money each month crediting the borrower’s home loan
account.
Some banks allow the monthly installments to be paid by
convenient ECS facility.
Another possible mode of payment is by cash or demand draft
(not all banks offer this). One can also deposit the EMI every
month at the bank's office.

Prepayment

The borrowerr can prepay a loan either in part or in full at any

given point of time. It can also be prepaid, when it is only
partly disbursed. However, most banks have an upper limit on
the number of times a person can prepay his loan in a year as
well as on the minimum amount that can be prepaid each time.
Until recently, banks charged a penalty for part or full
prepayment. But increased competition has forced most banks
to allow partial prepayment at nil charge.
Most banks levy a prepayment charge if one makes the full
repayment and ask for release of the property documents.

Loan pre-closure/satisfaction

The customer also has the option of completely repaying the

loan at any time. Of course, each bank has its conditions for
preclosure. Also, the loan will get completely paid off on the
expiry of the tenure of the loan if one has paid all your
installments on time.

After one has completely repaid the entire loan, he/she must
ensure that the entire set of original property documents are
taken back. One should also ask the bank for a No-Objection
Certificate saying the account has been cleared. As an option,
the bank may issue a consent letter stating that the property is
now free from mortgage.

If the borrower has guarantors, the bank will issue a separate

letter for each of the guarantors stating that their liability has
come to an end.

At this stage, in some cases, you may discover that the original
documents have yet not been received by the bank from the
registrar. In such cases, the customer needs to follow up with
the registrar and get the documents from them directly by
showing them a copy of the bank's clearance certificate.

Sometimes (and we must stress only sometimes) the bank may

misplace the original property documents leading to avoidable
stress. In fact, the bank may claim that these documents were
never given to them at all. Hence the importance of insisting on
a proper receipt of title documents while handing them over to
the bank.

Remember that receipt will come in very useful when the loan
is fully paid off. Also, it is extremely useful when one wants to
shift the loan to a new lender.
After having seen, the steps involved in the processing of a loan,
let’s us understand the main issues involved in the issuance of
loan to meet the Working Capital Requirement.

What is Working Capital:

For running an industry or a Concern, two types of capital are
required viz., fixed capital and working capital. Fixed Capital is
utilized for acquiring the fixed assets such as land, building,
plant & machinery, etc., and to meet capital expenditure
connected with the setting to keep the wheels moving up of the
industry or Concern. But by themselves, these fixed assets
would not produce / earn anything. They have to be run /
worked for production. This requires enough liquid sources,
viz., working capital.
Working Capital represents
the money that is required for purchase / stocking of raw
materials, payment of salary, wages, power charges etc, and also
for financing the gap between the supply of goods and the
receipt of payment thereafter.

In other words, Working Capital Finance is the fund required to

meet the cost involved during the working capital cycle or
operating cycle.

Operating Cycle or Working Capital Cycle

Working capital cycle
of a manufacturing activity starts with the acquisition of the raw
materials / stores & spares and ends with realisation of cash for
finished goods. The cycle is long in some cases and short in
other cases depending upon the nature of business. In
manufacturing units, Working capital cycle comprises of
purchase of raw materials either in cash or credit basis,
converting raw materials into stock in process and then into
finished goods and transformation of finished goods into book
debts / cash.
In respect of trading concerns, operating
cycle represents the period involved from the time the goods and
services are procured and the same are sold and realized. The
working capital cycle is illustrated as follows:

Cash/Sundry
Creditors

Sundry Debtors

Raw Materials / Stores & Spares

Sales
Stock-in-Process

Finished Goods
The total working capital requirements for Industrial Units will
depend upon the holding period of assets and the operation of
the cycle. Thus, the stocking of raw materials may be
equivalent to one or three months’ raw materials consumption
for most industries, but say nil for a sugar mill.

As regards the operating cycle, the duration of each stage of

process cycle is first decided upon having regard to the function
it is supposed to perform. The conversion of raw materials into
finished goods depends upon the technical requirements and
manufacturing facilities available. Similarly, the turnover of
finished products and their transformation into book debts, bills
or cash could be related to factors like delivery schedule,
business customs and competition. Thus, the working capital
cycle of a manufacturing activity starts with the acquisition of
raw materials and ends with realization of cash for finished
goods.

The cycle is long in some cases and short in others, depending

upon the nature of business. Cycle is fast in consumer goods
industries and slow in capital goods industries. Cycle is short in
case of perishables such as food articles, beverages, fruits, fish,
eggs, etc. Cycle is long in the case of tobacco, distilling, timber,
steel, etc. Seasonal industries like manufacturers of umbrella,
woollen fabrics, fans, refrigerators, etc., require higher stocks in
some months and bare minimum in remaining months.

During the cycle, funds are blocked in various stages of current

assets, viz., cash itself, inventory (consisting of raw materials,
stock in process, finished goods) and receivables. These require
finance. Finance involves costs. Quicker the cycle more is the
turnover normally and longer the cycle, the less is the turnover.
Stagnation in any area effects turnover and profitability.

Working capital cycle vary from industry to industry depending

upon its nature of business. Factors which affect working capital
cycle are:
1) Policy of the management on production and sales
2) Inventory management/ Receivables management
3) Nature of manufacturing activity/process
4) Policy of extending credit for purchases as well as sales
5) Government policy
6) Type of product

The above factors are only illustrative and not exhaustive.

MANAGEMENT OF WORKING CAPITAL

Management of working capital

Management of working capital involves management of current
assets, current liabilities and Net working capital.

Current Assets
Current Assets are convertible assets, liquid assets or floating
assets. They change their form every now and then and
ultimately are converted into cash. Current assets are such assets
which are reasonably expected to be realised into cash within a
period of 12 months. They indicate short-term deployment of
funds and form Gross Working Capital.

Current Assets mainly consist of:

1) Cash and bank balance
2) Stock in trade consisting of raw materials, stock in process,
finished goods, stores, packing materials'
3) Book debts: including bills purchased & discounting (only
upto 180 days)
4) Investments (Short term)
5) Cash margin from non fund based limit (L/C / guarantee)
may be treated as a part of current assets. and
6) Other loans and advances, etc.

The quantum and period, for which each current asset is held,
should be reasonable and related to the requirement. Any asset
held in excess, burdens the business with unnecessary interest
and costs on such borrowings.

Cash and Bank Balance tied to or earmarked for long term use,
for example for a future expansion / diversification programme
or investment outside business, should be excluded from Current
Assets. Such part of the Cash and Bank Balances should be
shown under Other Non-Current Assets.

Holding of Cash or Bank Balances (or marketable securities /

investments) beyond the normal needs of business necessitates
critical evaluation. It is a common banking practice that a
business can not be granted bank credit, if it has surplus / idle
cash lying with it.
Book Debts, including Bills Purchased and Discounted
outstanding within the normal credit period allowed by the firm
or six months, whichever is lower, should be treated as Current
Assets – Receivables.

A break-up of the Receivables age-wise and party-wise may be

quite informative. Overdue debts, which are considered
realizable, should be classified into Other Non-Current Assets.
Debts which have doubtful realisability because of quality
control disputes, depressed market conditions, or because the
debtors are not financially sound and can not pay in the
foreseeable future etc. should be shown under Intangible Assets,
unless full provision has been made for them in the accounts.

The basis of valuation of each item of inventory should be the

invoice value / cost or market value, whichever is lower. The
period of holding of each item should conform to its demand
and supply position in the market, production requirements and
ordering time. The quality of stocks should satisfy the
requirements of a good security. "Dead Inventory" i.e. slow
moving or obsolete items should be excluded. Only those stores
and spares, which are of consumable nature and are linked to the
operating cycle, should be considered as Current Assets.
Machinery stores (with exception of certain items like
consumable injection moulds etc. in some industries) should be
a part of Other Non-Current Assets, since these items are
included in the capital cost.

The following items should not be treated as Current Assets and

the same may be classified as Non-Current Assets.
1) Investments / loans to subsidiaries / associates (non-trade
investments)
2) Other Investments (not marketable)
3) Overdue book debts (generally those more than six months
old)
4) Deferred Receivables (maturity exceeding one year)
5) Others – fixed deposits with Government Departments, loans
to directors / employees / partners, advances (machinery
suppliers), machinery stores, tools etc.
6) Cash margin held for deferred payment guarantee

Current Liabilities
Current liabilities are short term liabilities which are repayable
within a year. They are normally raised for meeting the working
capital needs and to acquire current assets. Current liabilities
are the main source of finance for working capital and are
normally identified with the operating cycle of the business.
Current Liabilities normally consists of:
1) Bank Borrowings for working capital
2) Other short term borrowings like Unsecured Loans, Inter
Corporate Deposits etc.
3) Sundry Creditors (for goods, expenses and others including
advance payment against orders)
4) Term Loan / Debentures / Deferred Payments and Lease
Rental instalments repayable within a period of one year
5) Statutory Liabilities (due within one year)
6) Other current liabilities and provisions (accrued expenses of
wages, interest, unclaimed dividend and provision for
taxation etc.)

Working Capital Gap

This represents excess of current assets over current liabilities
excluding bank borrowings. A part of the Current Assets are
financed by Current Liabilities (other than bank borrowings).
The remaining portion of current assets which requires financing
is called as working capital gap. Banks do not grant advance to
the full extent of working capital gap. It is always desirable rule
that the borrower has to finance a part of working capital gap out
of either capital or long term sources which reflects his
continued commitment to the business that is necessary for the
survival of the unit.

Net Working Capital

This represents excess of current assets over current liabilities
(including bank finance). It indicates the margin or long term
sources provided by the borrower for financing a part of the
current assets. For successful operation of a business, Current
Assets should be more than the Current Liabilities. It ensures
continuous liquidity (current assets are prone to price
fluctuations and should, therefore, have an in-built margin to
absorb changes) and owner's stake in the current business
operations.

Current Ratio
The ratio of current assets to current liabilities is known as
Current Ratio. It indicates the liquidity position whereby the
capacity of unit to pay the creditors and short-term liabilities is
determined. It is generally expected that the customer should
meet about 25% of its Working Capital requirements or Current
Asset from long term sources. Thus, normally, the current ratio
should be minimum 1.33.
 The current ratio
indicates only the quantitative coverage and by itself does not
give any indication as to quality of current assets and current
liabilities. The adequacy of the ratio should, therefore be judged
by examining the quality of the components of current assets
and current liabilities.
Consideration of
factors such as valuation of stocks and guidelines on inventory,
sundry debtors, borrowing and marketability of investments
would substantially assist in determining the quality of the ratio.
If a scrutiny of current assets reveals that they contain slow
moving/non moving stock of raw materials, work in process,
finished goods and non recoverable debtors, and if there are
current liabilities requiring urgent attention/payment, even a
high current ratio cannot be deemed adequate as liquidity may
be affected. Similarly, a certain fall in the price of materials
would shrink the value of stocks thereby narrowing the margin
of safety to creditors/banks. It is therefore always necessary to
make an in depth study of the current ratio of the unit and not to
take it at is face value. It is also essential that proper
classification of current assets and current liabilities is ensured
to arrive at need based permissible bank finance.
METHODS OF ASSESMENT OF WORKING CAPITAL
NEEDS

Consistent with the policy of liberalization, in April 1997, RBI

withdrew the prescription in regard to assessment of working
capital needs, based on MPBF, enunciated by Tandon
Committee. Thus banks are given greater operational freedom
for dispensation of credit. Banks are also free to evolve their
own method of assessing working capital requirements of the
borrowers within the prudential guidelines and exposure norms
already prescribed. However the banks continue to adhere to
various guidelines under Credit Monitoring Arrangement
(CMA) for sanction of credit proposals and classification of
current assets and liabilities as they still hold good and valid.

Working capital to business/industry is what blood is to human

body. Short supply and excess supply will have adverse effects
on the business.

Effects of short supply: It shall bring crunch in the working of

the unit and thereby failure to utilize the created capacities
which result in short fall in production, short fall in sales,
business failure, under utilization of men, materials, machinery
and management, frustration of the objective of enterprise,
inability to accept attractive opportunities etc.

Effects of excess supply - Builds up huge inventory, book

debts, which is not required for their normal operations.
Complacency and deteriorating management efficiency,
extravagance, unhealthy speculation unwarranted expansion,
Liberal Dividend Policy, Diversion of funds, etc.

The level of investment in an operating cycle depends upon

changes in:
1) Terms of production and sales other factors remaining
constant
2) The price of raw materials
3) Lead time for producing raw materials
4) The pattern of manufacturing expenses
5) The process time
6) Policy of extending credit (both on purchase as well as sales)
etc.

Assessment of working capital shall normally based on the

following:
1) Production / Processing cycle of the industry
2) Size of the business and quantum of working capital
requirements
3) Financial and managerial capability of the borrower and the
various parameters relating to the borrower.
4) Prevailing mandatory instructions of RBI
5) The trade and industry practice prevailing and other
objective factors

Assessment of the Working Capital requirement of a borrower

shall generally be made under any one of the following three
methods:
1) Turnover method (P R Nayak Committee recommendation)
2) Maximum Permissible Bank Finance (MPBF) System
(Tandon/Chore Committee recommendation)

Turnover Method
Under this method working capital limit shall be computed at
20% of the projected gross sales turnover accepted by the bank.
This system is normally applicable to traders, merchants,
exporters who are not having a pre determined manufacturing /
trading cycle. Under the turnover method bank should ensure
that maintenance of minimum margin on the projected annual
sales turnover. Normally 25% of the estimated gross sales
turnover value shall be computed as working capital
requirements, of which 20% shall be provided by the bank and
the balance 5% by way of promoter contribution towards margin
money. However if the available net working capital (NWC) is
more, the same shall be reckoned for assessing the extent of
bank finance and lower limit/s can be considered. The turnover
method may be applied for sanction of fund based working
capital to the borrowers requiring working capital facility upto
Rs 500 lakhs from the banking system for SSI units. In case of a
traders, while bank finance could be assessed at 20% of the
projected turnover, the actual drawals should be allowed on the
basis of drawing power determined after deducting unpaid
stocks. Under this method current ratio would be 1.25.

Example
Projected accepted annual Gross Sales Turnover -
Rs.10.00 lacs
25% of the above - Rs.
2.50 lacs
Minimum margin to be provided by the borrower - Rs.
0.50 lacs
(or NWC, whichever is higher)
Bank finance - Rs.
2.00 lacs
(or lesser, in case NWC is higher)

As the working capital requirement are linked to projected

turnover, reasonableness of the projected annual turnover of the
applicant company should be analysed by keeping in view of
past performance of the unit, the orders on hand, installed
capacity of the units, power, availability of raw materials and
other infrastructural facilities . In respect of a new unit projected
turnover should be analysed with regard to installed capacity,
marketability of the products, performance of the similar unit in
the industry, background of the promoters etc.

The projected turnover / output value is the gross sales which

include excise duty. The assessment of working capital credit
limits should be done both as per projected turnover basis and
traditional methods based on production/processing cycle
(MPBF). If the credit requirement based on MPBF method is
higher than the one assessed on projected turnover basis, the
same may be sanctioned. On the other hand, if the assessed
credit requirement is lower than the one assessed on projected
turnover basis, while the credit limit can be sanctioned at 20% of
the projected turnover, drawals may be allowed basing on actual
drawing power after excluding unpaid stocks.

In addition to the above, any other short term / adhoc Working

Capital facilities to meet the emergent needs of the borrowers
and other seasonal imperfections can be considered by the
sanctioning authority, subject to the borrower submitting the
required details in support of the need/justification and the
sanctioning authority is convinced / satisfied with the borrower
requirements. Such short term finance / adhoc facilities shall be
permitted for short term, say upto 3-4 months.

MPBF System
Before the MPBF Method is explained, it is necessary to
understand the erstwhile Second Method of Lending under
Tandon Committee Recommendations. Under Method II, the
borrower should bring in a minimum margin of 25% of all
current assets from owned funds and long term liabilities, and
the balance i.e 75% be financed by the Bank.
The example given below will illustrate this:-
Current Liabilities Current Assets
Credit for purchase 100 Raw materials 200
Other current liabilities 50 Stock-in-process 20
150 Finished goods 90
Bank borrowings including bill 200 Receivables including bill 50
discounted discounted
350 Other current assets 10
Method II 370
a. Current Assets 370
Less:
b. Current Liabilities other than Bank 150
Borrowings
c. Working Capital Gap 220
d. Minimum stipulated net working 92
capital i.e 25% of Current Assets
e. Actual / projected net working capital 20
(total current assets – 370 minus total
current liabilities – 350 incl. Bank
Borrowings – 200)
f. Item c minus d 128
g. Item c minus e 200
h. Max. Permissible Bank Finance 128
(Item f or g whichever is lower)
i. Excess borrowings 72
(representing shortfall in net working
capital – item d minus e)
As per past practice, current assets and current liabilities for the
next year are reckoned in accordance with the usually accepted
approach of bank.

The borrower is required to bring 25% of current assets.

Against the MPBF of Rs. 128 lakhs the actual borrowing is Rs.
200 lakhs resulting in excess borrowing of Rs. 72 lakhs. This
excess borrowing is required to be brought from the long term
sources i.e. Equity, unsecured loans or long term borrowings. In
absence of any support from the borrower, the deficit in long
term sources may be treated as working capital Term Loan
repayable by the borrower by installments to be fixed while
sanctioning the next year's limits.

The assessment of credit requirement of the borrower shall be

made based on the total study of the borrower's business
operations vis-à-vis the production/processing cycle of the
industry, which shall represent a reasonable build up of current
assets for being supported by bank finance.

Based on Kannan Committee recommendations, RBI has

allowed freedom to the banks to decide the holding levels of
various components of current assets for financial support to
ensure efficient functioning of the unit.

The levels of inventory and receivables shall be based on

industry trend and closely related market developments.
Projected level of inventory and receivables shall be examined
in relation to the past trend and based on inter firm comparisons.
The existing norms are only indicative level of inventory and
borrower specific operational needs to hold projected level of
inventory and reasonable thereof, ability to absorb the cost of
carrying such inventory and comparison of the other similar
units in the industry shall be relied upon to decide the required
and acceptable level for being supported by the bank.
APPRAISAL OF CREDIT PROPOSAL

Proposals have to be examined from various angles of safety,

viability, feasibility, national priority and repaying capacity of
each borrower. A critical study of the financial statements,
project report and other information submitted by the borrower
is necessary.

Every credit proposal shall be subjected to an objective appraisal

as per the policy and procedural guidelines laid down from time
to time to establish technical feasibility, economic viability and
bankability of the proposal.

Appraising officers should visit the factory, godowns and

business place/s and acquaint himself with the process of
production and infrastructure available to the industrial unit and
business condition of the borrower (in the case of traders) and
correctly assess the requirements and financial implications
involved, before the proposal is sanctioned / forwarded. If it is
an entirely new project, the Appraising officer should try to
understand the production process involved, the various stages
of production, the proposed installed capacity, number of shifts
to be worked, the raw materials required, easy availability or
otherwise of it, availability of other external economies etc., all
have to be taken into account.

Following factors need to be evaluated:

1. Goods / commodities offered as prime security to the
Bank should relate to the borrower’s line of business.
2. Commodities satisfying the following qualities are
generally acceptable for our advance:
a) absence of wide fluctuations in price
b) easy marketability
c) free from the risk of early deterioration
d) easy ascertainability of value
3. Wherever licence / permit is required to deal in certain
commodities, before accepting such commodities Branch
has to satisfy that borrower is having valid licence /
permit. Copies of licence / permit should be obtained.
4. Advances on commodities covered under RBI Selective
Credit Control should be governed by RBI directives
issued from time to time.
5. For Advances on commodities on which duty is not paid,
rules governing such good should be adhered strictly.

The proposed line of activity should be legal and not prohibited.

The Government policies relevant to the industry should be

found out. If it requires any licence / quota / permission, it
should be ensured that it has been obtained.
viii)If any clearance from the local government authority like
Factories Inspector, Corporation / Panchayat etc., Electricity
Board, Pollution Control Board, Sanitation Department etc., is
required the same should be got.

Following guidelines should also be adhered to:

v. The request of the borrower is assessed properly and the

Credit Proposal, including the terms and conditions
proposed, conform to the basic lending principles,
 Bank’s credit policy and norms & guidelines of Reserve
Bank of India / other regulatory authorities.
vi. Balance Sheet, Profit & Loss Account and other
financial statements are analysed properly. Items of
Assets and Liabilities are classified properly and
projections made are reasonable and realistic.
vii. Level of inventory holdings (past and projections)
viii. Trends in sales & Profitability
ix. Production capacity and use – past and projected
x. Estimated working capital gap with reference to
acceptable build-up of inventory/receivables/other
current assets
xi. All relevant ratios are calculated.
xii. Reasons for major variations in the Balance Sheet and
other relevant ratios have been ascertained and
commented upon.
xiii. Study the off balance sheet item, non credit items like
contingent liabilities, deferred payment liabilities,
pending claims, guarantees offered, forward contracts,
swaps etc and its impact in the case of crystallization.
xiv. Diversion of funds
xv. Auditors Comments on the balance sheet
xvi. Assessment of credit requirements is carried out by using
appropriate formats, methods and as per the applicable
norms and guidelines.
xvii. Limits proposed are within the borrowing powers of the
company.
xviii. The information / comments about the borrowers,
guarantors and the project given in the Proposal display a
fair, complete and correct picture.
xix. Appropriate and adequate primary security is available
for the advance.
xx. Adequate and suitable collateral security may be
obtained as warranted.
xxi. Norms and documents proposed are appropriate.

Computation of Net Worth

For computing the outside networth and means branches should
obtain the details of assets and liabilities of the proprietor /
partners / directors etc., as also those of the co-obligants /
guarantors at the time of sanction / renewal of limits. To ensure
that the particulars relating to the assets declared are genuine,
branches should obtain the tax paid receipt or such other
documentary evidence in the case of immoveable properties,
besides verifying the existence of such property, its market
value, etc.

Besides, for confirming the veracity of the declarations,

branches should also call for IT/WT assessment orders
wherever, such persons are assesses under IT/WT. However,
the networth under WT Act is restrictive in nature and will not
depict the correct picture of the value of the assets held by the
assessee. In such cases, the branch should make an independent
enquiry of the market value of the assets declared taking into
account the nature of property, location, market value of similar
properties etc. This is more relevant in the case of immovable
properties where the value of properties continue to appreciate
and declaring the original purchase value gives a distorted
picture.
Branches should verify and satisfy themselves every year, on an
ongoing basis, preferably at the time of renewal of the limits /
review of the accounts, the assets declared , so as to ensure that
there is no erosion or dilution in the outside networth / means of
the proprietor / partner / director / co-obligant / guarantor etc.
For this purpose, branches should compare the latest declaration
with the one earlier obtained form the borrower.
For computing the networth, the following guidelines should
also be adhered to:

A. Individuals and proprietory concerns

a) Moveable assets like Bank Deposits, Gold
ornaments, jewellery, investment in shares,
debentures, company deposits.
b) Personal unencumbered immovable properties like
self acquired property, share in the ancestral
property acquired on division of Joint Hindu
Family as per Hindu Succession Act / Indian
Succession Act.
c) Capital investment in the business including
Investment in partnership.
d) Out of the above properties / assets i.e. (a) to (c),
existing borrowings, if any, should be reduced to
arrive at the net value of assets. This net value of
the assets shall be the net estimated worth or
means of the borrower.

B. Partnership & Joint Hindu Family (HUF) concerns

a) Capital invested in the business by all the partners
b) Undivided profits
c) Total worth of individual partners i.e. total value of
liquid assets of the partners; total value of self
acquired immovable properties of each partner;
investment; stock; cash deposits, etc., stake in
sister concerns.
d) Out of the above items, i.e. (a) to (c) deduct
borrowings, accumulated losses, intangible
assets, if any
e) However, while computing the liquid assets of the
partner the value of shares in the Private / Public
Limited companies, held by partners, proprietor,
etc., of these firms should not be included at the
face value, if the scrip is not quoted in the stock
exchange and / or is not readily marketable. The
full face value of shares can be taken into account
in assessing the holders’ means only if the
companies whose capital these shares represent
are first rate running concerns, which have been
continuously making good profits in the past and
whose existing liabilities do not our-weigh their
easily realizable assets.
f) Further while assessing the worth of a partner, his
investments should be ignored, as the investment
in such firm is included in the firm.

C. Limited Companies
a) Apart from paid capital and free reserves as
appearing in the balance sheet, balance in the
share premium account, capital and debenture
redemption reserves, and any other reserves (not
being the reserve created for repayment of any
future liability for depreciation in assets, for bad
debts or reserves created by revaluation of assets)
shall also be taken into account.
b) Accumulated balance of loss, balance of deferred
revenue expenditure and other intangible assets
should be deducted from the capital as in (a)
above.
Obtention of Personal Guarantees of Directors
Wherever loans / advances are granted to corporate borrowers
the sanctioning authorities are required to obtain guarantees
from Directors (excluding nominee directors) and other
managerial personnel in their individual capacity, wherever felt
necessary. Managerial personnel are those who may not be
called as promoters / directors but who have otherwise, a stake
in the ownership / management of the company concerned.
However, obtention of personal guarantee from such managerial
personnel may be decided on case to case basis.

Apart from this, wherever the sanctioning authorities feel that

the guarantee from third parties is required (through such
persons are not directors in the company), they may stipulate the
guarantee of such persons, keeping in view the financial position
of the borrowing company, stake of the proposed guarantor in
the company, etc.

It should be ensured that the system of obtaining the guarantee is

not used by guarantors (not only by directors) as a source of
income from company. An undertaking from the borrower
company as also the guarantors should be obtained to the effect
that no consideration, whether by way of commission, brokerage
or fees or in any other form will be paid by the former or
received by the latter directly or indirectly.

The purpose of obtaining such guarantees is that the borrowers

are more amenable to financial discipline if the directors /
promoters or other persons interested in the borrowing concern
have given their personal guarantee. A suitable clause in the
sanction memorandum to the branches should be incorporate.

When a director whose personal guarantee has already been

obtained resigns from the directorship, the proposal should make
specific mention as to the continued availability or otherwise of
his personal guarantee. If the same is not available, the proposal
to relieve him from the personal guarantee should be specifically
mentioned in the proposal.

When credit facilities are extended to borrowing units in the

same group, guarantees of the parent / holding company may be
insisted.

Branches / offices, during their periodic inspection of the

borrower’s unit, should also verify their books of account /
financial statements to ensure that the borrowing company has
not paid any commission / brokerage / fees, etc., to the
guarantors for extending such guarantee.

This apart, the branches should also obtain from the borrowing
company, an auditor’s certificate annually, to the effect that no
commission, brokerage/fees, etc., has been paid to the
guarantors by the company.

Borrowers are required to furnish the documents indicated along

with the application for financial assistance.

A flash report on the proposal is prepared and submitted to

Zonal Committee / Credit Committee depending upon the
exposure. Flash report on the proposal is prepared basically to
consider eligibility of the proposal for assistance. Once the
committee decides that the proposal is "in principle" eligible for
financial assistance. Detailed appraisal is being undertaken.

Credit Rating
All proposals brought before the Zonal Committee/Credit
Committee for sanction to be assessed by Internal Rating
System.

Rating exercise to commence either outside or in house for new

companies after flash report. For other cases, as soon as the
request for assistance is received.

Proposal with a rating of atleast BBB are normally considered

for appropriate credit decision by the Sanctioning Authority.

It may be mentioned that credit rating is one of the critical inputs

considered for sanction of assistance.

The various risk relating to the project (sponsor risk, participant

risk, operating risk, engineering risk, supply risk, market risk,
funding risk etc. ) needs to examined. The risks and the
mitigation mechanism needs to be suitably highlighted.

Presently, our internal risk rating is being done on the RAM

(Risk Assessment Model) software, which has been devised by
CRISIL. It is a software designed to assess credit risk in
structured and comprehensive manner which ultimately helps in
assessing the credit quality of the borrowers. The credit risk of
the company is broken down into risk categories as under:
1. Business Risk
2. Management Risk
3. Financial Risk
4. Industry Risk

1. Business Risk
It mainly covers market position factors such as access to
patents, brand equity, consistency in quality,
customisation of product/product design, distribution set
up, diversity of markets, financial ability to withstand
price competition, long term contracts/assured offtake,
product range/mix, support service facilities/after sales
service, project management skills and size related
pricing advantages.
It also covers operating efficiency factors such as
availability of raw materials, Multi locational
advantages, adherence to environmental regulation,
capacity utilization, cost of effective technology,
employee cost, efficient raw material usage, energy cost,
extent of integration, management of input price
volatility, selling costs, vulnerability of event risks,
bargaining power with suppliers, proximity to customers
and employee attrition rate.

2. Management Risk
This risk mainly covers Track Record, credibility,
payment record and other factors like group support,
management proactiveness

3. Financial Risk
 This risk is evaluated through a combination of the
following ratios (both past and projected)
→ Interest Coverage
→ Return on capital employed
→ Operating Margins
→ Operating income/short term borrowings
→ Current Ratio
→ DSCR
→ Total Outside Liabilities/Total Networth
→ Free cash flow from operations/Total debt.

4. Industry Risk
The factors covered under industry risk are qualitative
factors such as demand supply gap, Government Policy,
Extent of competition, Input related risk and Quantitative
factors such as Return on capital employed, operating
margins, variability of operating margins, slope of
operating margin trendline.

These risks are measured on a scale of 1-6 points, 6 being the

highest score and results in ten grades as under:

Grade Degree of safety Comments

with regard to
servicing debt
obligations
Grade I Very High The fundamentally strong debt servicing capacity of
(AAA) such companies is most unlikely to be adversely
affected by changes in circumstances.

Grade Degree of safety Comments

 with regard to
servicing debt
obligations
Grade – II High Adverse business conditions are unlikely to affect
(AA+) debt servicing capacity. Such companies differ in
safety from those in Grade only marginally.
Grade – III Adequate Changes in circumstances are more likely to affect
(AA) debt servicing capacity than for higher grades.
Grade – IV Average Debt servicing capacity could weaken in view of
(A) changing circumstances.
Grade – V Below Average While such companies are less susceptible to default
(BBB) than those in lower grades, uncertainties faced by
them could adversely affect debt servicing capacity.
Grade – VI Inadequate Uncertainty faced by issuer could lead to inadequate
(BB+) capacity to make timely debt repayments.
Grade – Low Debt servicing capacity is highly vulnerable to
VII (BB) adverse changes in circumstances.
Grade – High Risk Adverse business or economic conditions are likely
VIII (B) to lead to lack of ability or willingness to service
debt obligations.
Grade – IX Substantial Risk Timely payment of debt would continue only if
(CC) favourable circumstances continue.
Grade – X Default Debt servicing capacity in default and returns from
(C) this may be realized only on reorganization or
liquidation.

Pre-sanction Inspection and Credit Reports

Pre-sanction inspection should be conducted and credit reports
collected for considering the credit request.

The main objectives of conducting pre-sanction inspection are:

i. To establish the identity of the customer.
ii. To validate market information with regard to means,
standing, business integrity, experience and abilities of
the parties concerned.
iii. To verify the correctness of particulars given in the
Credit Application Form and its enclosures
iv. To verify / get information on the customer and their
business unit.
v. To understand the nature of activity.
vi. To evaluate standing (year of establishment, experience,
reputation).
vii. To judge Management / business abilities (availability of
technical / experienced staff, efficiency of operations).
viii. To ensure Proper maintenance of records / accounts.
ix. To verify adequacy of internal controls.
x. To ascertain working of the unit (installed capacity,
production, marketing facilities, targets, problems,
prospects).
xi. To inspect immovable property (location, area,
ownership, encumbrance, payment of taxes and dues,
approximate value etc.),
xii. To verify machinery (original purchase invoice, present
value).
xiii. To verify / ascertain from records, the
correctness of stocks, competitors, Working
Capital cycle, Manufacturing Process,
Suppliers, Buyers etc.
xiv. To verify meeting of statutory obligations
(income tax, excise, sales tax, licences etc.).
xv. To analyse conduct of business - sound or
over trading (low cu
xvi. Current ratio, creditors exceeding debtors,
frequent excess drawings etc.), under trading
(lower trading than the resources may
permit).

NATURE OF FACILITIES AND FIXING OF CREDIT

LIMITS

Credit facilities can be funded or Non-funded. The funded

limits are those where outlay of the Bank's funds is involved.
Non funded based limits are those where the Bank endorses the
commitment / promise made by the borrower and the Bank need
to meet only if the borrower fails to honour it. Main types of
facilities under fund based limits and non funded based limits
and the related guidelines for granting advances against them are
discussed below in brief.

Fund Based Limits

Fund Based limits are generally granted by way of Overdrafts,
Cash Credit and Bills Purchased / Discounted. Usually the
security offered, the purpose and size of advance, repayment
terms and requirements of a customer decide the type of facility
to be granted. Though there is no hard and fast rule to determine
this, there are well set practices.

Overdraft and Cash Credit

In Overdraft/Cash Credit, the borrower is allowed to carry out
debit and credit transactions upto a limit. These are more
operative accounts and have cheque book facility. The term
"Overdraft" is generally used for continuing limits granted
against the security of term deposits and other financial
securities, occasional overdrawings / debits in current accounts
and also for continuing limits granted for personal purposes.
"Cash Credit" is generally used for regular limits granted for
working capital requirements of commercial establishments.
Cash Credit (CC) is granted against hypothecation of stock such
as raw materials, work-in-process, finished goods and stock-in-
trade, including stores and spares.

CC is granted by way of a running account, drawings to be

regulated within the drawing limit permissible which is arrived
at on the basis of composition of current assets and current
liability based on the declaration in the stock statement in the
prescribed format submitted by the borrower.
Branch will obtain periodical stock statements at the stipulated
intervals from the borrower to have a watch over the stock
position and also will check the goods at irregular intervals to
satisfy about the correctness of the declaration of the stock by
the borrower.

Borrowers to whom CC limits have been extended should

maintain proper stock books. If proper books are not
maintained, it would be difficult to check the stock at any time
with reference to their books and stock statements.

Borrowers enjoying CC limits should route all purchase and sale

transactions through their CC accounts. In other words, these
parties have to remit the sale proceeds to their CC accounts and
payment for all purchases of stock are to be made by cheques
drawn on these accounts.
Branches are required to exercise utmost care while considering
for CC limits as possession of the goods will remain with the
borrower. Branches should bear in mind the following aspects
while fixing / recommending CC limits.
i. The borrower must be creditworthy
ii. The borrower’s dealings with the Bank should be
satisfactory
iii. The borrower must be prepared to submit the correct and
authenticated stock statement as per the format
prescribed by the Bank and at the periodicity stipulated
by the Bank
iv. The borrower must be agreeable to hypothecate the
entire stock belonging to him and to insure the stock for
its full value for fire and other risks at his own cost
v. The borrower must agree for the periodical inspection of
stock and the books of accounts maintained by him, by
the branch officials and / or by the Inspecting Officials of
the Bank as and when required.

The limit upto which the drawings are allowed in the cash Credit
/ Overdraft account is called Drawing Limit. It is the lower of
Sanctioned Limit and Drawing Power. Drawing Power is Value
of Security less Margin. An illustration for this is given below:

M/s. ABC is sanctioned a Cash credit limit of Rs. 500 lacs

against hypothecation of stocks. The margin stipulated is 25%.
The value of paid stocks as per the stock statement submitted by
the borrower and verified by the Bank Officials at the beginning
of three consecutive months were Rs. 600 lacs, Rs. 800 lacs and
Rs. 400 lacs. The Drawing Limits (i.e. the extent to which the
drawals can be allowed in the account would, thus be:
→ For the 1st month Rs. 450 lacs (Lower of
sanctioned limit Rs. 500 lacs and drawing power
Rs. 450 lacs (value of security – margin i.e 600-
150)
→ For the 2nd month Rs. 500 lacs (Lower of
sanctioned limit Rs. 500 lacs and drawing power
Rs. 600 lacs (800-200)
→ For the 3rd month Rs. 300 Lacs (Lower
of sanctioned limit Rs. 500 lacs and drawing
power Rs. 300 lacs (400-100)

Cash credit / overdraft limits are repayable on demand.

However, unless a decision is taken to recall the advance, and
subject to the stipulation of periodic (generally annual) review /
renewal, the limits are of continuous nature. No repayment is
generally stipulated for such limits. In certain cases, however,
the seasonal limits (higher limits during the peak period of the
activity / credit requirement of the borrower and lower limits
during the slack season ) are stipulated. There are also cases
when a phased reduction in limits is prescribed, based on the
realization/working capital cycle of borrower’s produce.

In other words, Working Capital Finance is extended in different

forms basing on the requirement as follows:
I. Inventory Limits (Pre-Sales)
i. Cash Credit (CC) including WCDL wherever
permitted
ii. Packing Credit (PC)
iii. Overdraft
iv. Vendor financing

II. Finance against Receivables (Post-Sales)

i. Book Debts
ii. Bills Purchased / Discounted/Negotiated

III. Non-Fund based limits

i. Letter of Credit (LC)
ii. Bank Guarantee (BG)

Working Capital finance is made available for financing Current

Assets which consist mainly of:
1) Inventory (Raw materials, stocks in process, finished
goods, stores & spares etc)
2) Receivables (Sundry Debtors)
After having assessed the Permissible Bank Finance (PBF) that
could be extended to a borrower as per the method as applicable,
the various types of limits that can be considered are arrived at
as follows:
The finance required would depend on the period between the
purchase of raw materials / goods till the finished goods are sold
and realized. Further, the holding levels for raw materials,
stock-in-process and finished goods depend on the lead periods
for which they remain in the working capital cycle.
Out of the Permissible Bank Finance (PBF) assessed, the
quantum pre-sales limits like CC, PC etc., are fixed basing upon
the levels of Inventory held and the period between the purchase
of raw materials and its sale as finished goods.
For fixing the post sales limit, the average time taken for
realization of sale proceeds be ascertained. The level of Sundry
Debtors in relation to sales will indicate the finance provided.

The following example will illustrate the above:

M/s ABC has projected a sales turnover of Rs.2.50 lakhs per

month. The following are the other financial parameters:

Current Assets Holding Levels (Assumption)

Raw Materials Rs. 3,00,000 2 months’ consumption
Work-in-process Rs. 1,50,000 1 month cost of production
Finished Goods Rs. 4,50,000 2 ½ months’ cost of sales
Sundry Debtors Rs. 5,00,000 2 months’ sales
Cash Rs. 1,00,000
Rs.15,00,000
Current Liabilities
Sundry Creditors Rs. 3,00,000 2 months’ purchases

Working Capital
Gap (CA-CL) Rs.12,00,000
Less 25% on CA Rs. 3,75,000
 PBF Rs. 8,25,000

In the above example, considering a margin of 25% on stocks, a

CC limit of Rs.4.50 lakhs could be considered. Similarly,
keeping a margin of 25% on receivables, bills limit of Rs.3.75
lakhs could be considered as follows:

Total Stocks (inventory) Rs.9,00,000 Sundry Debtors Rs.5,00,000

Less Sundry Creditors Rs.3,00,000 Less 25% margin Rs.1,25,000
Rs.6,00,000 Bills Limit Rs.3,75,000
Less 25% margin Rs.1,50,000
CC Limit Rs.4,50,000

Computation of Drawing Power

1. Inventories
Total inventory (excluding non usable non moving, slow moving A
stocks) (period to be specified)
LESS; Unpaid stocks (on account of sundry creditors for purchases, B
DALC, advance payment guarantees / suppliers credit etc.) and stock
hypothecated to any other facilities
Value of paid stock (A – B) C
LESS: Stipulated margin on stocks as per sanction D
DP / DL on stocks (C-D) E

2. Book Debts
Total amount of inland credit sales (debtors) not exceeding the period F
permitted by the sanctioning authority
LESS; Value of bills (Supply Bill, SDB, BE) discounted by the G
Bank/Factors duly adding back the margin (on the date of stock
statement) & advance received against suppliers
Net bills receivables / debtors unfinanced by the Bank / Factors (F-G) H
LESS: Stipulated margin on book debts as per sanction I
DP / DL on Book Debts (H-I) or stipulated sub limit under Book Debt J
whichever lower
The total drawing power / drawing limit against stocks and Book
Debts shall be E+J or sanctioned limit whichever is lower.

Margin on raw materials, semi-finished goods, finished goods

and book-debts would vary depending upon nature of industry,
period of operating cycle and standing of the borrower in the
market. Normally margin on book-debts is kept higher than the
inventory.

Drawing should be within the permissible drawing limit as per

the latest stock statement. Borrower must be asked to regulate
drawings strictly within the limit available on the stock held
from day to day. If there is reduction in the stock, the borrower
should work within the reduced limit arrived at. However if
they want to draw beyond the drawing limit of the previous
statement before next statement falls due, they have to submit
fresh statement declaring sufficient additional stock to cover the
additional advance required. Such submission in between due
dates should be permitted only on very very exceptional basis
for meeting urgent business requirements as otherwise parties
would be submitting stock statements every alternate day / very
frequently which would result in difficulties in monitoring
movement of stocks.

Stock Statement is an important monitoring tool and non-

submission of Stock Statements for a period of one month from
the due date for submission are to be treated as irregularity and
are to be followed up with the company for early submission. In
case of persistent default, penal interest be charged and a
suitable letter be addressed to borrower to bring in borrowing
discipline.
 Assessing Letter of Credit (LC) Limit
A limit for a letter of credit facility for working capital purposes
enables an enterprise to procure raw materials and other
important ingredients for production on credit terms. An
alternative to the LC limit is to sanction a fund based credit
facility in favour of the enterprise. However a letter of credit
issued by the bank on behalf of its customer is an off balance
sheet item in the books of the client which enables the latter to
prepare a more appealing balance sheet. Further, the role of a
commercial bank as an intermediary considerably enhances the
level of comfort required for trading for buyer and seller.
Therefore, if the supplier of material does not insist on advance
payment, the customer (buyer of the material) would prefer an
LC limit. The process of assessing LC limits is intimately
related to the appraisal of other working capital facilities to the
customer.

There are always a number of factors at work which impact the

computation of the LC limit as a part of the overall working
capital credit requirements of an enterprise. It is therefore
difficult to prescribe a standard method to work out the exact
amount of LC limit to be provided to a manufacturing unit.
However, following major factors should be taken into account
in any quantitative method of assessment:
A Annual consumption of the material being purchased 120 (Rs lacs)
B Lead time from opening of credit to shipments ½ (months)
C Transit period for goods till it arrives at the factory ½ (months)
D Credit Period available 3 (months)

The sum of B, C and D can be called as purchase cycle. In the

above case purchase cycle would be 4 months. We denote the
purchase cycle by P (months). The cycle commences at the point
of placement of order whereas the final payment is made at the
end of the cycle.

The quantum of LC limit may now be worked out using the

expression (P X A/12), which would work out to Rs 40 lacs.
This represents the cost of the material that will be consumed in
one working cycle.

Assessing BG Limit
Banks usually issue guarantees in the following circumstances:
1) Enterprise participating in tenders, auctions etc are
generally required to submit bank guarantees for a
minimum stipulated amount in lieu of security
deposits/earnest money deposit etc.
2) It is common practice to provide mobilisation advance
by the principal to contractors/vendors executing turn-
key projects or civil projects which may take
considerable time for completion. Mobilisation advance
may be provided both before the commencement of the
project and at various stages of progress in respect of
plant layout design, drawings, construction etc. As a
security against funds provided in advance, the
contractors are often required to submit bank guarantees.
3) Sometimes raw material ar supplied by the buyer to the
manufacturing units with whom supply orders are placed
by the former. In these cases, the buyer of goods
(supplier of raw material) may require security in the
form of bank supplying products/services to a parent
company, where the latter suppliles raw material against
submission of bank guarantee.
4) Even after the goods have been supplied in terms of the
contract, the buyers may hold a portion of the supply
bills till they are finally satisfied about the quality of the
material supplied. The retained amount is released only
after a bank guarantee for an equivalent amount is
submitted by the supplier.
5) Supplier of goods and services often proved warranty
period to the buyers of such products. In these cases, the
suppliers may request the bank to issue performance
guarantees in favour of the buyers. On submission of
such performance guarantee, the suppliers receive the
proceeds without waiting for the expiry of the warranty
period.

It is generally observed that guarantees are mainly required by

the construction companies for the purpose of EMD, Bid Bond,
APG, Machinery Advance etc. An indicative way of assessing
the guarantee limits may be assumed as under:
Sr. No. Particulars Amount
A Value of contracts expected to be bid 1000.00
B EMD Guarantee (generally 3% to 5% of A), Here we will 50.00
assume 5%
C Expected value of the new contract (25% of A), It may vary 250.00
from company to company
D Performance Guarantee (Normally 10% of C) 25.00
E Advance Payment / Security Deposit Guarantee (5% of C), 12.50
This may vary from project to project.
F Fresh Guarantees required (B+C+D+E) 337.50
G Existing bank guarantees (Assumption) 100.00
H Guarantees expiring during the year 25.00
I Guarantees requirement (F+G-I) 412.50
J Total guarantees limits required 412.50
In other cases where guarantees are to be issued for the
procurement of raw materials, the assessment will be case
specific and no formal way of assessment can be applied.
Introduction to Credit Risk

3.1 Meaning of Credit Risk

Credit risk is defined as the possibility of losses
associated with diminution in the credit quality of
borrowers or counterparties. In a bank’s portfolio,
losses stem from outright default due to inability or
unwillingness of a customer or counterparty to
meet commitments in relation to lending, trading,
settlement and other financial transactions.
Alternatively, losses result from reduction in
portfolio value arising from actual or perceived
deterioration in credit quality.

3.2 Bifurcation of Credit Risk

The study of credit risk can be bifurcated to
facilitate better cognition of the concept.
 Overall Credit Risk

Firm Credit risk Portfolio Credit Risk

A single borrower/obligor exposure is generally

known as Firm Credit Risk while the credit
exposure to a group of similar borrowers , is called
portfolio Credit Risk This bifurcation is important
for the proper understanding and management of
credit risk as the ultimate reasons for failure to pay
can be traced to economic, industry, or customer –
specific factors. While risk decides the fate of
overall portfolio, portfolio risk in turn determines
the quantum of capital cushion required.

Both firm credit risk and portfolio credit risk are

impacted or triggered by systematic and
unsystematic risks.
 Firm Credit Risk Portfolio Credit Risk

Credit risk

Systematic Risk Unsystematic Risk

Socio-political
Risks
Business Risks

Economic Risks

Other Exogenous
Financial Risks
Risks

External forces that affect all business and

households in the country or economic system are
called systematic risks and are considered as
uncontrollable. The second type of credit risks is
unsystematic risks and is controllable risks. They
do not affect the entire economy or all business
enterprises/households. Such risks are largely
industry-specific and /or firm specific. A creditor
can diversify these risks by extending credit to a
range of customers.

3.3. Sources of Credit Risk

Credit risk emanates from a bank’s dealings with
an individual, corporate, bank, financial institution
or a sovereign.
Credit risk may take the following forms:
 in the case of direct lending: principal/and or
interest amount may not be repaid
 in the case of guarantees or letters of credit:
funds may not be forthcoming from the
constituents upon crystallization of the
liability
 in the case of treasury operations: the
payment or series of payments due from the
counter parties under the respective
contracts may not be forthcoming or ceases
 in the case of securities trading businesses:
funds/ securities settlement may not be
effected
 in the case of cross-border exposure: the
availability and free transfer of foreign
currency funds may either cease or
restrictions may be imposed by the
sovereign.

3.4 Components of credit risk:

The credit risk in a bank’s loan portfolio consists of
three components;
(1) Transaction Risk
(2) Intrinsic Risk
(3) Concentration Risk
(1) Transaction Risk: Transaction risk focuses on
the volatility in credit quality and earnings
resulting from how the bank underwrites individual
loan transactions. Transaction risk has three
dimensions: selection, underwriting and
operations.
(2) Intrinsic Risk: It focuses on the risk inherent
in certain lines of business and loans to certain
industries. Commercial real estate construction
loans are inherently more risky than consumer
loans. Intrinsic risk addresses the susceptibility to
historic, predictive, and lending risk factors that
characterize an industry or line of business.
Historic elements address prior performance and
stability of the industry or line of business.
Predictive elements focus on characteristics that
are subject to change and could positively or
negatively affect future performance. Lending
elements focus on how the collateral and terms
offered in the industry or line of business affect the
intrinsic risk.
(3) Concentration Risk: Concentration risk is the
aggregation of transaction and intrinsic risk within
the portfolio and may result from loans to one
borrower or one industry, geographic area, or lines
of business. Bank must define acceptable portfolio
concentrations for each of these aggregations.
Portfolio diversify achieves an important objective.
It allows a bank to avoid disaster. Concentrations
within a portfolio will determine the magnitude of
problems a bank will experience under adverse
conditions.

3.5 Selecting a Risk Strategy:

The bank does have an opportunity to reduce their
concentration in one line of business or industry.
Outstanding would have to be replaced with more
lending focused on lower risk lines of business and
borrowers. Banks must constantly monitor the risk
profile to determine its future lending practices are
consistent with the desired risk profile.
Using the risk profile as a frame of reference,
management should select a risk strategy that will
be consistent with long-term objectives for portfolio
quality and performance. The three variable risk
strategies in order of riskiness are: Conservative,
Managed and Aggressive. The selection of the
appropriate strategy depends on a bank’s priorities
and risk appetite. Most often, the choice is not
made as part of a formal process but evolves as
the bank seeks its desired risk posture through its
lending practices. Consequently, few banks have a
clear picture of the risk profile that will emerge. A
selection of risk strategy with specific
implementation plans provides a much better idea
of the future risk profile. The following guidance
should help in understanding, which strategy best
serves managements intent;
(i) Conservative: Accepts relatively low levels of
transaction, intrinsic and concentration risk. The
strategy normally supports a values-driven culture.

(ii) Managed: Accepts relatively low levels of risk

in two categories but high levels in one category.
For example: a bank that takes conservative levels
of concentration and transaction risk but is more
aggressive with intrinsic risk. The strategy normally
promotes the immediate performance culture.

(iii) Aggressive: Accepts relatively low levels of

risk in one category, more aggressive risk in two
categories. An example would be a bank that
closely manages transaction risk but accepts
higher levels of intrinsic and concentration risk.
This strategy is normally employed in a production
driven culture. Obviously, credit volatility rises as
the levels and categories of risk are increased. The
aggressive strategy requires more careful
management because it operates closer to the
danger zone.
If risk in all three categories reaches high levels,
the bank’s credit volatility becomes so great in a
downturn that capital adequacy and survival could
become real issues.

3.13 Tools of credit risk management

The instruments and tools, through which credit

risk management is carried out, are detailed below:

a. Exposure Ceilings:
Prudential Limit is linked to Capital Funds -say 20%
for individual borrower entity, 45% for a group with
additional 5%/10% for infrastructure projects,
subject to approval of the Board of Directors,
threshold limit is fixed at a level lower than
Prudential Exposure; Substantial Exposure, which is
the sum total of the exposures beyond threshold
limit should not exceed 600% to 800 % of the
Capital Funds of the bank (i.e. 6 to 8 times).

b. Review/Renewal:
Multi-tier Credit Approving Authority, constitution
wise delegation of powers, sanctioning authority’s
higher delegation of powers for better-rated
customers; discriminatory time schedule for review
/ renewal, Hurdle rates and Bench marks for fresh
exposures and periodicity for renewal based on risk
rating, etc

c. Risk Rating Model:

Set up comprehensive risk scoring system on a six
to nine point scale. Clearly define rating thresholds
and review the ratings periodically preferably at
half yearly intervals, to be graduated to quarterly
so as to capture risk without delay. Rating
migration is to be mapped to estimate the
expected loss.

d. Risk based scientific pricing:

Link loan pricing to expected loss. High-risk
category borrowers are to be priced high. Build
historical data on default losses. Allocate capital to
absorb the unexpected loss. Adopt the RAROC
framework.
e. Portfolio Management
The need for credit portfolio management
emanates from the necessity to optimize the
benefits associated with diversification and to
reduce the potential adverse impact of
concentration’ of exposures to a particular
borrower, sector or industry.
Portfolio management shall cover bank-wide
exposures on account of lending, investment, other
financial services activities spread over a wide
spectrum of region, industry, size of operation,
technology adoption, etc. There should be a
quantitative ceiling on aggregate exposure on
specific rating categories, distribution of borrowers
in various industries & business group. Rapid
portfolio reviews are to be carried on with proper &
regular on-going system for identification of credit
weaknesses well in advance. Steps are to be
initiated to preserve the desired portfolio quality
and portfolio reviews should be integrated with
credit decision-making process.

f. Credit Audit/Loan Review Mechanism

This should be done independent of credit
operations, covering review of sanction process,
compliance status, review of risk rating, pick up of
warning signals and recommendation for corrective
action with the objective of improving credit
quality.
It should target all loans above certain cut-off limit
ensuring that at least 30% to 40% of the portfolio is
subjected to LRM in a year so as to ensure that all
major credit risks embedded in the balance sheet
have been tracked and to bring about qualitative
improvement in credit administration as well as
Identify loans with credit weakness. Determine
adequacy of loan loss provisions. Ensure adherence
to lending policies and procedures. The focus of the
credit audit needs to be broadened from account
level to overall portfolio level. Regular, proper &
prompt reporting to Top Management should be
ensured. Credit Audit is conducted on site, i.e. at
the branch that has appraised the advance and
where the main operative limits are made
available.

Non Performing Asset- A cause of Worry for

Banks:

A non-performing asset can

be defined as a credit facility in respect of which the interest and
installment of principal has remained past due for a specified
period of time. An asset is classified s NPA if borrower does
not pay dues in the form of principal and interest for a period of
180 days.

Gross NPA:

In % FY 07 FY 08 Q1 FY09 Q2 FY09 Q3 FY09 FY09E FY 10E

SBI 2.90 3.00 2.54 2.51 2.60 3.10 4.68

PNB 3.30 2.60 2.82 2.37 2.30 2.65 4.10
BOI 2.43 1.68 1.64 1.53 1.60 1.95 4.10
UBI 2.90 2.20 2.08 1.93 1.70 2.15 3.60
HDFC Bank 1.10 1.10 1.50 1.57 1.90 2.00 2.57
ICICI Bank 2.15 3.70 3.07 4.20 4.10 4.91 6.70
Axis Bank 0.90 0.70 0.92 0.91 0.90 1.00 1.80
Source: Business Standard

Classification of NPAs:
Various assets can be classified as NPA,
if the assets satisfy the following conditions:

Term Loans:
A term loan is a loan repayable by installments. It
is treated as NPAs if interest/ installmeIt is nt. An amount
remains past due for a period of six months or two quarters or
more. An amount is considered as past due when it remains
outstanding for 90 for 90 days beyond the date of payment.

Cash Credit/ Overdraft:

It is treated as NPAs only if the account
remains out of the order for two quarter or more. An account
may belong out of order if the balance outstanding remains
continuously in excess of the sanctioned limit.

Bills Purchased/ Discounted:

A bill including chq/ Draft
purchased/ discounted is treated as NPA if it remains overdue
for two quarters as more as in the date of Balance Sheet.

Agricultural Advances:
In case of advance granted for
agricultural purposes including agricultural gold loan, the loan
will balance NPAs if interest/ installment as the case may be
remains unpaid after it has become due for two harvest season,
but for a period not exceeding two half years.

Provisioning:

For the purpose of provision, all the advance

accounts are classified into four categories i.e. Standard, Sub-
Standard and doubtful or loss Assets.

Standard Assets:
 Are those assets, which do not disclose any
problem and do not carry more than normal risk and are regular
in all respect.

Sub-Standard Assets:
These are those accounts which have been
classified as NPAs for a period not exceeding two years means
upto two years.

Doubtful Assets:
The assets which have remained NPAs for a
period of above two years.

Loss Assets:
Those NPA accounts where loss has been
identified by the bank/ internal inspector/ external auditor/ RBI
inspector or are those NPAs where there is no realizable value of
security.

Factors affecting the NPAs in India:

The principal challenge of
banking soundness emanates from the persistence of the
significant amount of non performing assets on bank’s balance
sheet. The origin of the problem of burgeoning NPAs in the
quality of management of credit risk by banks. The banking
sector has been facing the serious problem of non-performing
assets. But the problem of NPAs in more in Public Sector Banks
as compare to private sector and foreign banks. The Indian
economy has been much affected due to heavy fiscal deficit,
poor infrastructure facilities, sticky legal system, dislocation of
trade, commerce and industry in the wake of new economic
policies, mounting unemployment etc. under such situation, it
goes without telling that banks are no exemptions and they are
bound to bear the crisis. The main causes of increasing NPAs
are

Causes of increase in NPAs

Internal Factors External
Factors

Internal Factors:
The internal factors include

I. Poor Credit appraisal system by the banks

II. Improper SWOT analysis
III. Non-compliance with the norms of lending
IV. Stackness in post credit appraisal
V. Inefficient management of funds
VI. Absence of regular industry visits and monitoring
VII. Poor Delivery mechanism of banks

External Factors:
They are
I. Industrial stickiness
II. Non viability of unit/ project
III. Change in government policies
IV. Diversion of funds and willful defaults
V. Persistent losses due to shift in competition, lack of
demand, labor problems etc.
Steps taken to Reduce NPAs:
The financial institutions and
banks are coming up with the various innovative ways to
reduce the mounting level of NPAs , some of them are stated
below…

• Negotiated settlements are encouraged to ensure

recovery with minimum time delay and expenses.

Example: Syndicate Bank has Synd Adalat is a process wherein

the borrowers are given opportunity to settle their dues under
compromise. Such Adalats would be organized at General
Manager’s Office / Regional Office/cluster centres to enable the
borrowers to participate in person and put forth his views. The
date and place finalized for organizing such Adalats would be
made known in advance. The Regional Manager or the
Executives from Corporate Office would chair these Adalats. In
principle acceptance of the proposal would be considered
against the commitment by the borrower to settle the dues.
Later, such proposals are placed before the Competent Authority
for obtaining final sanction. The proceedings of the Adalat
would be drawn to firm up the discussion and for taking further
follow up action.

Other Measures are:

• Credit appraisal skills are being upgraded.

• Settlement Advisory committee are in operation.
• Publication of defaulters name as per the RBI’s
direction in line to change in Banking Secrecy Act
• Special onetime scheme for small and marginal
farmers as was put place.
• Setting up of Asset Reconstruction company limited
• RBI also introduced Corporate Debt Restructuring
schemes in a bid to avoid further accumulation of
NPAs in banks and financial institutions.
• Enforcement of SARFEASI ACT 2002.
A Brief About SARFEASI Act:

In the year 2002, the level of

Non- Performing Assets of banks and financial institutions was
estimated at Rs. 1,00,000 crores. To stop this burgeoning level
of NPAs, which has various negative impacts on the
performance of Banks, a new act, was needed to handle this
problem. This act is seen as most potent weapon being handled
by banks and financial institutions to manage the NPAs.

This act is seen as a landmark measure in the process of legal

reforms, which enable secured lenders to enforce their rights.
This act is a unique mechanism for settlement of dues, which is
at the discretion of secured tender and can be pursued without
the intervention of courts. The act provides the mechanism to
deal with defaulting enviable companies. It covers loan assets
wherein a default has occurred (i.e. interest remained due for
more than 180 days) and the assts have been classified as
nonperforming by the lenders.
Under this act, lender by giving a notice of 60 days can
take steps to recover their dues. This provides for:

I. Setting up and securitization of Asset Management

Companies.
II. Enforcement of Security interest created in favor of any
secured creditors without the intervention of the courts
provided 75% of the secured creditors are in agreement.
III. Takeover of the management of assets or their disposal
expeditiously.
• Transfer problem learn to asset management
companies.
• Change management or takeover business.
• Take possession of secured assets.
• Dispose off these assets by sale or lease etc.

Alternative Mechanism to deal with NPAs in India:

 One channel was referring problem of
companies to a semi judicial body i.e. the Board of Industrial
and Financial Reconstruction (BIFR). The criteria for doing so
were related to the unit registering lesser in successive year and
erosion of its Net Worth. Once a unit was referred to BIFR
lenders were required to bide by BIFR procedure. With a view
to speeding up the debt recovery process, Debt Recovery
tribunals were set up.

Suggestions for reducing NPAs in India:

Management
of NPA is a giant problem calling for multidimensional strategy.
Banks have to display professionalism and scientific
temperament in appraisal, monitoring and supervision of loans
account, system overload and fragmented nature of supervisory
functions in public sector banks really hamper the recovery
efforts.
Following are some of the important measures to reduce
the level of NPAs.

(1) Early Warning Signals:

It is essential to identify signs of distress or early
recognition of problem loans. The need for early
identification of problem loans has been
established as one of the principles of the Basel
Committee for the management of credit risk.
Problem
loans most commonly arise from a cash crisis
facing the borrower. As the crisis develops, internal
and external signs emerge, often subtly.
A typical Early Warning Signals process is listed
below:
a. Continuous Monitoring by Loan Officers
b. Scheduled Loan Reviews
c. External Examination
d. Loan Covenants
e. Warning Signs
f. Asset Classification and Downgrade Report

(2) Establishing Risk Management

Information System (RMIS):
The effectiveness of risk management depends on
efficient information system, computerization and
networking of the branch activities. An objective
and reliable database has to be built up for which
bank has to analyze its own past performance data
relating to loan defaults, operational losses etc.
(a) Added to IT expenditure is the cost and effort of
training and redeployment of manpower. Besides
training in the ‘hard’ aspects of understanding risk
and using software, there is also need for building
in a risk orientation in individual officers at the
operating level, to create awareness about credit
assessment skills and risk mitigation processes .

(3) Redesigning the Internal Rating System:

In order to ensure a systematic and consistent
credit assessment process within the bank, a
robust and auditable rating system must be in
place. A list of credit drivers or factors that
influence the creditworthiness of a borrower /
company with a weight assigned on measurable
element data like financial ratios and subjective
elements like management quality, industry
prospects etc., The Basel Committee set up by BIS
has been urging banks to set up internal systems
to measure and manage credit risk. It is important
that Indian banks use credit ratings available from
agencies in conjunction with their internal models
to measure credit risk.

Bibliography:

Websites:
www.buzinessstandard.com
www.apnaloan.com
www.economictimes.com
www.rbi.org
www.ibef.com
www.wikipedia.org
www.syndicatebank.in

Textbooks:
Management of Non Performing Assets in Banks
- By: Sugan C. Jain