Financial Credit Risk & Analytics KMBN FM 05 Unit -1 Notes
Financial Credit
It means a
letter of credit used directly or indirectly to cover a default in payment of
any financial contractual obligation of the Company and its Subsidiaries, including
insurance-related obligations and payment obligations under specific contracts
in respect of Indebtedness undertaken by the Company or any Subsidiary, and any
letter of credit issued in favor of a bank or other surety who in connection
therewith issues a guarantee or similar undertaking, performance bond, surety
bond or another similar instrument that covers a default in payment of any such
financial contractual obligations, that is classified as a financial standby
letter of credit by the FRB or by the OCC
Objectives:
1-This service
is provided by the financial institutions to fulfill the needs of the weaker sections of society.
2- It focuses
to help people to buy financial products at affordable prices. Like deposits,
loans, insurance, payment services, etc.
3- It supports building and maintaining financial
sustainability for poor individuals.
4-It promotes mobile banking.
5- It provides
facilities to a financial institution for providing financial services at an affordable price.
6- It helps to
improve financial awareness and financial literacy all over the Nation.
Credit Risk
Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection. Excess cash flows may be written to provide additional cover for credit risk. When a lender faces heightened credit risk, it can be mitigated via a higher coupon rate, which provides for greater cash flows.
Credit risk is the risk of loss that may occur from the
failure of any party to abide by the terms and conditions of any financial
contract, principally, the failure to make required payments on loans due to an entity.
Factors are Used to Assess
Credit Risk?
In order to assess the credit
risk associated with any financial proposal, the project finance division of
the firm first assesses a variety of risks relating to the borrower and the
relevant industry.
The borrower credit risk is
evaluated by considering:
The financial position of
the borrower, by analyzing the quality of its financial statements, its
past financial performance,
its financial flexibility in terms of the ability to raise capital, and its
capital adequacy
The borrower’s relative market
position and operating efficiency
The quality of management, by
analyzing its track record, payment record, and financial conservatism
Industry-specific credit risk is
evaluated by considering:
Certain industry
characteristics, such as the importance of the industry to the economic growth
of the economy and government policies relating to the industry
The competitiveness of the
industry
Certain industry financials,
including return on capital employed, operating margins, and
earnings stability
What is Credit Risk Analysis?
Credit risk analysis can be
thought of as an extension of the credit allocation process. After an
individual or business applies to a bank or financial institution for a loan, the lending
institution analyzes the potential benefits and costs associated with the loan.
Credit risk analysis is used to estimate the costs associated with the loan. To
learn more, check out CFI’s Credit Analyst Certification program.
Credit risk
or credit default risk is a type of risk faced by lenders. Credit risk arises
because a debtor can always renege on their debt payments. Commercial
banks, investment banks, asset management companies, private equity funds, venture capital funds, and insurance
companies all need to analyze the credit risks they are exposed to in order to
profitably operate in the market.
Credit
Risk = Default Probability x Exposure x
Loss Rate
Where:
Default Probability is the probability of a debtor reneging on his debt
payments.
Exposure is the total amount the lender is supposed to get
paid. In most cases, it is simply the amount borrowed by the debtor plus
interest payments.
Loss Rate = 1 – Recovery
Rate, where Recovery Rate is the
proportion of the total amount that can be recovered if the debtor defaults.
Credit risk analysts analyze each of the determinants of credit risk and try to
minimize the aggregate risk faced by an organization.
Credit Analysis Process?
The credit analysis process
refers to evaluating a borrower’s loan application to determine the financial
health of an entity and its ability to generate sufficient cash flows to
service the debt. In simple terms, a lender conducts credit analysis on
potential borrowers to determine their creditworthiness and the level of credit risk associated
with extending credit to them.
During the
credit analysis process, a credit analyst may use a variety of techniques, such
as cash flow analysis, risk analysis, trend analysis, ratio analysis, and financial projections. The
techniques are used to analyze a borrower’s financial performance data to
determine the level of risk associated with the entity and the number of losses
that the lender will suffer in the event of default.
Stages in the Credit Analysis
Process
The credit analysis process is a
lengthy one, lasting from a few weeks to months. It starts from the
information-collection stage up to the decision-making stage when the lender
decides whether to approve the loan application and, if approved, how much
credit to extend to the borrower.
The following are the key stages
in the credit analysis process:
1. Information collection
The first stage in the credit
analysis process is to collect information about the applicant’s credit
history. Specifically, the lender is interested in the past repayment record of
the customer, organizational reputation, financial solvency, as well as their transaction
records with the bank and other financial institutions. The lender may also
assess the ability of the borrower to generate additional cash flows for the
entity by looking at how effectively it utilized past credit to grow its core
business activities.
The lender also collects
information about the purpose of the loan and its feasibility. The lender is
interested in knowing if the project to be funded is viable and its potential
to generate sufficient cash flows. The credit analyst assigned
to the borrower is required to determine the adequacy of the loan amount to
implement the project to completion and the existence of a good plan to
undertake the project successfully.
The bank also collects
information about the collateral of the loan, which acts as security for the
loan in the event that the borrower defaults on its debt obligations. Usually,
lenders prefer getting the loan repaid from the proceeds of the project that is
being funded, and only use the security as a fall back in the event that the
borrower defaults.
2. Information analysis
The information collected in the
first stage is analyzed to determine if the information is accurate and truthful.
Personal and corporate documents, such as the passport, corporate charter,
trade licenses, corporate resolutions, agreements with customers and suppliers,
and other legal documents are scrutinized to determine if they are accurate and
genuine.
The credit analyst also
evaluates the financial statements, such as the income statement, balance
sheet, cash flow statement, and
other related documents to assess the financial ability of the borrower. The
bank also considers the experience and qualifications of the borrower in the
project to determine their competence in implementing the project successfully.
Another aspect that the lender
considers is the effectiveness of the project. The lender analyzes the purpose
and future prospects of the project being funded. The lender is interested in
knowing if the project is viable enough to produce adequate cash flows to
service the debt and pay the operating expenses of the business. A profitable
project will easily secure credit facilities from the lender.
On the downside, if a project is
facing stiff competition from other entities or is on a decline, the bank may
be reluctant to extend credit due to the high probability of incurring losses
in the event of default. However, if the bank is satisfied that the borrower’s
level of risk is acceptable, it can extend credit at a high-interest rate to
compensate for the high risk of default.
3. Approval (or rejection) of
the loan application
The final stage in the credit
analysis process is the decision-making stage. After obtaining and analyzing
the appropriate financial data from the borrower, the lender makes a decision
on whether the assessed level of risk is acceptable or not.
If the credit analyst assigned
to the specific borrower is convinced that the assessed level of risk is
acceptable and that the lender will not face any challenge servicing the
credit, they will submit a recommendation report to the credit committee on the
findings of the review and the final decision.
However, if the credit analyst
finds that the borrower’s level of risk is too high for the lender to accommodate,
they are required to write a report to the credit committee detailing the
findings on the borrower’s creditworthiness. The committee or other appropriate
approval body reserves the final decision on whether to approve or reject the
loan.
Types of Credit Risk
1. Concentration risk
Concentration risk, also known
as industry risk, is the risk arising from gaining too much exposure to any one
industry or sector. For example, an investor who lent money to battery
manufacturers, tire manufacturers, and oil companies is extremely vulnerable to
shocks affecting the automobile sector.
2. Institutional risk
Institutional risk is the risk
associated with the breakdown of the legal structure or of the entity that
supervises the contract between the lender and the debtor. For example, a
lender who gave money to a property developer operating in a politically
unstable country needs to account for the fact that a change in the political
regime could drastically increase the default probability and the loss rate.
7 C’s Credit Analysis
7 C’s of Credit: Condition
Is there a logical need for
the funds? Does it make business sense? Are the funds to be used to
grow an existing and proven business product or
service business or to be
used for an unproven one?
7 C’s of Credit: Collateral
Is the proposed collateral sufficient? What type of value does it have?
Is there a secondary market for
it? The lender wants to
know, in the event of a default, that it will be likely to recoup a significant
portion of the amount lent.
7 C’s of Credit: Credit
For smaller enterprises, the
personal credit score of the
individual owner(s) will be reviewed. As with personal loans, such as an auto or
mortgage loan, the bank is looking for
evidence of a history of you paying your lenders on time. For
larger companies, the bank will consult
Dun & Bradstreet reports for evidence of the timely payment of vendors and other
creditors.
7 C’s of Credit: Character
What do those who have
done business with the
prospective borrower have to say about its business practices?
A bank will typically
ask the applicant for a list of references, such as three customers and
three vendors to contact.
7 C’s of Credit: Capacity
Does the borrower have the
wherewithal to pay the debt service? Is it
generating enough free cash flow to
reasonably assure timely interest payments and
ultimately the repayment of the principal balance?
Due to the expanding levels of transnational business and
cross-border lending over the
last few decades, you need to discuss the two new C’s.
7 C’s of Credit: Currency
What is the recent history and
outlook of the primary currency in which the company will conduct
its operations? Does
the currency exhibit a
history or likelihood of losing its value? The more stable the currency, the more attractive the loan request will be to a lender.
7 C’s of Credit: Country
Does the borrower conduct a
significant portion of its operations in a country with a history of political
instability? Is there the possibility of an expropriation of the
borrower’s assets due to a
change in the country’s government? Is the
country’s current political and legal system hostile
to the interests of foreign countries? There are two factors that would make
the bank more likely to
be willing to make the loan, including the
following:
Documentation a Key Element of Credit Risk Management
Credit risk management
begins with a loan file well documented. It is expected that all credit
processes go to the credit committee with all documents to be analyzed and take a decision on the following steps.
Generally, after the disbursement, the Bank just needs to monitor and control the delinquency. However, these steps should be preceded by a loan file well document as this is a key element of Risk Management. Perhaps, you may ask why? Let´s analyze some key points.
1. Decision was taken to Approve - The credit committee to approve a loan also (not only) analyzes the documentation presented by the client to assess the viability of the business and the purpose of the loan. The elements that make those members of the credit committee take whether a positive or negative decision must be supported by appropriate documentation. On the other hand, it will show if the decisions taken are in compliance with the credit policy (requirements, the limit of decision, etc) as well it will provide an audit trail on how this decision was taken.
2. Loan Monitoring - The loan monitoring comes after the disbursement when it is important to check the amortization schedule and the application of the funds. In regards to the purpose of the loan, usually, the client provides the supportive documents of what he pretends to do with the loan which will allow the bank in this phase to monitor if that was done successfully.
3. Follow up on Problems – If there is a problem that arises it is very easy to follow up on the origin of it when the loan file is well documented. During my career, I have been confronted with some situations in which the key point to solve or track was a well-documented loan file. On the other hand, if the client is in default, documents regarding the business and purpose of the loan will give the bank an idea if the problem is related to the application or the market. Additionally, documents regarding the collateral, as the last stage, will help the bank in regard to loan recovery.
4. Credit History – A loan file well documented provides information about the client for future lending decisions.
Ideally, it is recommended that security documentation be maintained physically separated from the loan application and credit investigation information. Alternatively, credit and security files should be stored together in a fire-proof environment.
In some banks the collateral documents used to be filed by the branch manager in a separate file where only authorized people have access and in others, this task is assigned to the legal department and in both cases, the loan file has just kept a copy of the original documents.
It is recommended that in each credit file, a loan checklist be included, summarizing the various steps that have been taken to properly establish a new loan. This loan checklist should be completed by the lending officer responsible for the loan or by a designated credit committee member, where applicable. It should be reviewed and initialed by the loans supervisor/manager to ensure the credit and security files are in order before these files are stored and above all before this loan is discussed in the credit committee.
All these aspects should be taken care of by the credit department and also by the risk department. Remember, if we follow these steps it becomes easier to monitor and control the delinquency, and also, we will be in compliance with the credit policy requirements and even with standard steps that the regulator tells us to follow.
Loan pricing is the process of
determining the interest rate for
granting a loan, typically as an interest spread (margin) over the base rate, conducted by the book runners. The pricing of syndicated loans requires arrangers to evaluate the credit risk inherent in the loans and to
gauge lender appetite for that risk.
For market-based loan pricing, banks incorporate credit default spreads as a measure of borrowers’ credit risks. It is standard procedure in loan pricing to benchmark a loan against recent comparable transactions (“comps”) and select the base rate on which the financing costs are pegged. A comparable deal is one with a borrower in the same industry, country, and of the same size with the same credit rating, for which a certain market rate of return is required.
A bank’s credit rating has a direct impact on its cost of funding and, thus, the pricing of its loans. Banks with a high credit rating generally have access to lower-cost funds in debt markets and low counterparty margins in the swap and foreign exchange markets. The lower cost of funds can be passed on to borrowers in the form of lower loan pricing.
Banks compete for lead arranger mandates on syndication strategy and pricing. Some banks are very effective at pricing loans, while others have better bargaining power, are more effective in borrower monitoring, or have better incentive-inducing scheme
Benefits of loan
pricing
Here are some benefits
of the loan pricing.
Faster response
to policy-driven rate change
Banks are expected to respond faster to policy rate revisions as directed by
the Central Bank. While standing guided by the regulator’s formulae, lenders
will peg lending rates on the cost of acquiring funds. This is primarily the
interest paid for customer deposits and the costs incurred in administering
these deposits. For instance, the Reserve Bank of India (RBI) recently
announced a 25 point reduction in the repo rate. This is anticipated to
translate to a much faster lowering of borrowing rates for borrowers under the
MCLR regime.
Pay for Gain
Whereas new borrowers will have their rates calculated under the new regime
automatically, existing borrowers will have to part with a conversion fee of
0.5 percent to 1 percent of the loan amount. The choice of adopting the new
formulae on an existing loan will, therefore, be dependent on the outcome of a
cost versus benefit analysis, similar to one conducted when contemplating loan
refinancing options, on an individual’s loan. If the costs outweigh the benefits,
it is advisable to delay the conversion.
More transparency in
Loan Pricing
Though it is still possible for the lenders to fix margins between MCLR and
lending rates, the new methodology in the pricing of loans is better regulated
and more dynamic. Borrowers under the new regime will benefit from faster
transmission of changes made in the monetary policy. MCLR is also expected to
foster better compliance by banks.
Profitability
analysis
Analyzing
of the profits which is basically the money remaining from the capital after
subtracting all the overhead costs, will help you keep a track of your
business’ performance. Profitability analysis allows companies to maximize
their profit.
Importance
of profitability analysis
While
profitability analysis gives business owners a 360° view of your company’s
profits, different ratios that derive profitability ratios have different roles
to play. Let’s take a look at the importance of these ratios:
Gross
profit margin
It
is a measure of the profit earned on sales which denotes the profit part of the
total revenue earned, after deducting the costs
of goods sold (COGS). This report is extremely important as it
covers the admin and office costs and also includes the dividends which are to
be distributed to respective shareholders of the company. Higher the gross
profit, the company will be more profitable. Gross profit margin is also used
to assess the efficiency of cost management. So, if the ratio is low, the
business owner can then identify these pain points and improve purchasing and
production in terms of economy and effectiveness.
Net
profit margin
It
is the final ratio that validates the overall performance of a company. Any
disturbances in other ratios will impact the net profit margin ultimately, thus
this report is considered as one of the most important ratios. A low quick
ratio would mean that sales have been low in a particular period, eventually
impacting the net profit margin. This analysis will help investors to identify
the cracks in the way they operate and take timely decisions to improve the
company’s performance.
Returns
on equity
Returns
on equity are the percentage of the earnings, which shareholders get in return
for the investments made towards the company. The higher the ROE higher will be
the dividends shareholders will receive. This triggers more investors for your
company ultimately aiding in keeping your company afloat in the market.
Returns
on capital employed (ROCE) and Return on assets (ROA)
These
returns measure the efficiency of a company in utilizing its assets. By
evaluating ROCE, the management can take decisions that’ll help them minimize
the inefficiencies. Higher the ROCE higher will be the efficiency in the
production process of the company.
ROA
is a measure of every penny of income earned on every penny of the asset owned
by the company. Similar to ROCE, ROA also helps the management manage the
utilization of assets, diligently.
Profitability
ratio analysis
Analysts
and investors use profitability ratios to measure and evaluate a company’s
ability to generate income (profit) relative to revenue, balance
sheet assets, operating costs, and shareholders’ equity during a
specific period of time. They show how well a company utilizes its assets to
produce profit and value for shareholders.
A
higher ratio establishes that the company is on the profitable side and is
generating enough revenue, profit, and cash
flow. This ratio analysis comes in handy while doing a comparative
analysis with your competitors in the market or even with previous periods, to
understand the current financial position of your firm.
Credit Facility Meaning
The credit facility is a preapproved loan facility provided
by the bank to the companies wherein they can borrow money as and when required
for their short term or long term needs without the need to reapply for a loan
each time
Types of Credit
Facilities
Credit facilities are broadly classified into two types, and
we will mainly focus on credit facilities meant for businesses or corporates.
The two types are i) Short term facilities as
working capital requirements ii) Long term facilities
required for capital expenditure or acquisition-related expenses.
1 –
Short Term Facilities
Short Term Loans
These are generally limited to up to a year and are mainly
borrowed by businesses for their working capital requirement. It may or may not
be a secured one, which also is dependent on the credit rating of the borrower.
At times the borrower may have to give its current
assets such as inventories or receivables as
collateral when the credit rating of the borrower is of non-investment grade.
Trade Finance
To facilitate structures cash conversion cycle
of business, this type of credit facility is very useful and can be of the
following types:
Export credit: This kind of loan is granted by government agencies to
export houses to enhance the growth of exports
Letter of credit: Generally, three parties are involved in such scenarios:
Bank, supplier, and company bank here guarantees the payment from the company
to the supplier, and this is a much more secure form of credit facility. The
bank issues the letter of credit based on the collateral from the company, and this type
of arrangement is more preferred by suppliers as it mitigates the risk of
default to a great extent.
Factoring: Factoring is a more advanced form of borrowing, where a
company would involve a third party (Factor) to sell its account receivables at
a discount to help them transfer the credit
risk from their books. It helps the company to remove the
receivables from its
balance sheet, which can further act as a source to fulfill its cash
requirements.
Credit from suppliers: This is more of a relationship-based where the supplier
who has a strong relationship with its customers will be in a better position
to provide credit after good negotiation of the payment terms to secure a
profitable transaction.
Cash credit and overdraft
It is a type of facility where a borrower can withdraw
money/funds more than what it has in its deposit. Interest rates apply to the
extra amount, which has been withdrawn apart from the amount in its deposit.
The borrower’s credit score plays a crucial role in the size of credit and
interest rate charged.
#2 – Long Term Facilities
Notes
These are generally unsecured and raised from capital
markets. They are generally costlier to compensate for the elevated credit risk
lenders are willing to take. It can be considered an option when banks are
in a denial state to provide any further credit line. They are generally meant
for large tenure like 7-10 years.
Bank Loans
It is one of the most common forms of credit facility where the amount, tenure, and repayment schedule are predefined. These loans can be secured (high-risk borrowers} or unsecured (investment grade Grade Investmentread more borrowers) and are usually given at floating interest rates. Before giving such loans, banks need to perform crucial checks or due diligence to mitigate credit risk.
A bridge loan is a short-term
financing option for homeowners looking to replace their current home and pay
off their mortgage either by paying interest on a regular basis or by paying a
lump sum interest when the loan is paid off.
Mezzanine debt
It is a blend of equity and debt. This type of capital is usually not guaranteed by assets and is lent solely based on a company’s ability to repay the debt from free cash flow mezzanine finance can be structured either as debt or preferred stock. It gives the lender the right to convert to an equity interest in the company in case of default, generally, after venture capital companies and other senior lenders are paid.
Securitization
This technique is pretty much similar to factoring. The only
distinction is the institution involved and the liquidity of the assets. In
factoring the financial institution is the factor that purchases the trade receivable of a business, whereas, in securitization, there
could be more than one party who will purchase its long-term receivables.
Securitized assets can be NAP mortgage receivables, and credit card receivables.
Example #1
Under credit facility, for example, suppose Customer X is
given a $50000 credit facility or LOC for investment in a new venture which is
secured against some collateral by a bank. The bank fixes a loan term of 10 years
for the repayment of the loan, and Customer X is permissible to utilize the
funds within the overall limit ($50000), and an interest rate of 20% is
charged.
Demand Loan.
As the name suggests, a demand loan is the type of loan in which the
lender can demand to be repaid at any time. This agreement is clear for both
the borrower as well as the lender at the time of processing. Often, in-demand
loans, lenders, or financiers can claim the lent money to be paid in
comparatively shorter periods of time compared to other loans such as term
loans. Because these loans are sanctioned without fixing the
duration of repayment, often, borrowers can enjoy the liberty of paying back
the amount without dealing with prepayment costs.
Features of Demand Loans
Mentioned below are the features of these types of loans;
Demand loans are secured loans that the lenders grant against tangible
assets owned and offered by the borrowers as collateral.
The tenure of the loan is negotiable and is decided by the lender.
The lender decides the term of the loan.
Demand loans are essentially approved to be able to meet short-term
business requirements.
The tenure of this loan can not be lesser than seven days.
Components of the loan can be divided by banks over different maturity
periods according to the requirement of the borrower.
Benefits of Demand Loans
Despite being an unconventional method such as availing a tenure loan,
there are several advantages associated with demand loans, some of which are
stated here:
Demand loans are apt for gaining quick capital for running businesses
and buying raw materials, paying salaries, rents, etc.
The interest amount to be paid by the borrower is only calculated on the
percentage of the said amount that is actually used.
The loan amount can be repaid to the lender by the borrower earlier than
the decided tenure without inculcating any additional penalties for
prepayments.
Borrowers can avail themselves of the loan without worrying about
long-term EMI (Equated monthly installments).
Borrowers can make small payments as per their liquidity until the time
they can pay back the entire amount.
Disadvantaged of Demand Loans
Now that we have had an in-depth understanding of demand loans and their
pros let us look at some disadvantages.
The lender or financer can demand the loan amount back at any time
as per his/her convenience, which could lead to unsavory circumstances for the
borrower.
The borrower could extend the loan tenure if he/she doesn’t have the
amount at the time of the finalized tenure date, lengthening the bargain’s
payment process.
Interest is only levied upon the amount used by the borrower and not the
entire loan amount, which could reduce the chances of earning money for the
financer in case a small amount is used.
Tangible assets work as collateral in case of a demand loan, so in case
some loophole is overlooked by the lender, the borrower could abscond with the
money, although this is highly unlikely.
Bill Finance
Bill financing is a term used when an
enterprise uses its invoices to obtain cash from a bank in order to purchase
supplies and goods for the business. Bill financing is also termed Bill discounting or Invoice discounting.
Drawee Bill Scheme:
1-Acceptance System The seller may draw a bill on the
bank of the buyer who shall accept it under an arrangement with the buyer. The
seller can discount the bill with his banker. The seller bank will get the
payment from the buyer's bank on the due date.
ii. Bill discounting System: Under this system, the buyer bank will itself discount the bills drawn by the seller and will the liability against the buyer.
Cash delivery
In the investment
world, cash delivery is a
settlement method when a futures or options contract expires or is exercised. Also known as cash settlement, it
requires the seller of the financial instrument to transfer the associated
monetary value of the asset to the buyer, rather than deliver the actual
physical underlying asset.
Mode of Delivery :
Depending upon the nature of the business
activity and the operating cycle prevalent in the particular industry, the
following modes of delivery of credit are seen in different countries:
Overdraft/Cash Credit System:
In this system, the borrowers are allowed to draw funds from
the account to the extent of the value of inventories and receivables less the stipulated margin within the maximum permissible credit limit granted by the
bank. Here, the drawing power of the borrower is computed by the banks by
deducting the stipulated percentage of margin from the value of the various
items of inventory and receivables.
Borrowers can draw cheques on their overdraft or cash credit account to the extent of the drawing power so calculated, subject to the maximum credit limit granted by the bank. The value of the inventory is taken at cost price or market price, whichever is lower. Any withdrawal of funds beyond this limit renders the account irregular, serving as a warning signal to the lending banker and also prompting him to monitor the account closely. The borrower is required to submit a statement of stocks and receivables to the bank on a monthly basis.
Loan System:
In some countries, term loans for short periods are the main
form of short-term finance. Under this system, loans are sanctioned for
definite purposes and periods. This is usually accompanied by the maintenance
of a current account for routing the day-to-day transactions of the business
enterprise. This system forces the borrower to plan his cash budget in advance,
thus ensuring a degree of self-discipline.
This system enables the bank to manage funds and the credit portfolio rationally. Unlike the overdraft or cash credit account, the borrower cannot liquidate the outstanding by deposit of sale proceeds on a day-to-day basis and, therefore, the earnings of the banks get a boost under the loan system. Automatic review is built into the loan system, as every new loan has to be negotiated afresh.
Bill System:
In the billing system of financing, the borrower is financed against the bills of exchange drawn by him on his buyers. Financing is also done under the drawee bill system, where the borrower is a drawee of a bill in exchange for his purchases. In the case of sales bills, the borrower submits the bill of exchange along with the shipping documents, and the bank purchases or discounts the bill and credits the proceeds to the borrower’s current account for his utilization.
Thereafter, the relative bill is presented to the drawee (buyer) for payment and, upon receipt of the amount, the bill purchase/discounted account is squared off. Bill finance is self-liquidating in nature.
In the case of drawee bills, the borrower is the buyer and the
supplier draws the bill on him and presents the bill to the borrower’s bank for
payment. The bank discounts the bill and remits the proceeds to the supplier’s
bank and on the due date of the bill, the borrower pays the amount with interest
and other charges towards the liquidation of the outstanding in the drawee bill
discount account.
Commercial Paper (CP):
Commercial paper is a popular form of raising working capital at a low cost by the corporate business houses. CP is a short-term money market instrument and the banks find it a convenient route to park their excess liquidity for a short period, not exceeding 12 months. The subscribers are other corporate houses, commercial banks, etc.
Commercial paper is a promissory note made by a highly rated corporate entity and is offered to prospective investors including the banks for a subscription. The banks invest in such commercial papers while discounting the promissory note at an underlying rate of interest, which is generally lower than the market rate of interest, including that of the prime lending rate of the commercial banks.
Commercial papers provide the corporate houses with an
additional avenue of raising working capital, at a price substantially lower
than the interest charged by the commercial banks in their fund-based working
capital limits of overdraft/cash credit granted to the borrowers.
Bridge Loan:
Commercial banks often grant bridge loans to the business
enterprises to temporarily bridge the financial gap between granting of loans
by other banks and financial institutions and actual disbursement by them. The
gap arises due to the time taken for the completion of documentation and other
formalities between the borrower and the financial institution.
Bridge loans are also sanctioned by commercial banks to meet the time gap between the closure of a public issue of equity or other shares by a
company and the actual availability of funds after completing all the formalities
as required by the capital market regulatory authorities. Availing of a bridge
loan often becomes essential during the period of project implementation when the
delay in procuring the plant and machinery and incurring other capital
expenditures will result in time and cost overrun.
The bridge loan helps the project work to continue without any
hindrance or stoppage for lack of funds. After the funds are available to the
business enterprise, the bridge loan is repaid. Banks have to exercise caution
in granting bridge loans as unless a proper tie-up with the incoming funds is
made, the repayment may pose a problem
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