Principles of lending

 It should cover following aspects

 1. Regulatory – RBI/BASEL
 2. Internal – Loan Policy
 3. Managerial/Financial/Commercial/
Market
 4. Types of customer –
Individual/Partnership/Corporate
 5. Types of loans – Corporate
loans/SME/Rural/Trade/Export/Import/Project/Ret
ail etc
 Government/PSU/Quasi/Private
 6. Gut feeling
General Lending
principles
 A lender does lend money and does
not give it away.
 Lenders must seek to arrive at an
objective decision.
 The approach of the true professional
is to resist outside pressures and to
insist on sufficient time and
information to understand and
evaluate the proposition.
Professional lending
principles
 Take time to reach a decision-detailed
financial information takes time to
absorb.
 If possible, it is preferable to get the
paperwork before the interview, so
that it can be assessed and any
queries identified.
 Do not be too proud to ask for a
second opinion-some of the smallest
lending decisions can be the hardest.
Professional lending
principles
 Get full information from the customer and
not make unnecessary assumptions or ‘fill
in’ missing details.
 Do not take a customer’s statements at
face value and ask for evidence that will
provide independent corroboration. E..
Sathyam episode
 Distinguish between facts, estimates and
opinions when forming a judgement.
 Think again when the ‘gut reaction’
suggests caution, even though the factual
assessment looks satisfactory.
TRADITIONAL
METHODS OF CREDIT
ANALYSIS
 Anyone can lend, but lending
money and ensuring it repayment
distinguishes between a good
banker and a bad banker.
 When you are dealing with
people, it is almost impossible to
predict how someone will behave
in the future. It is important
therefore that lenders exercise
sound judgement while granting
loan.
Cond…
 Lending principles help a banker to
make sound judgement.
 Note however that principles are not
laws of physical science that must hold
whatever be the case; rather, the
principles serve as a framework within
which to make a decision. This is why
lending is more akin to art than to
science.
Cond..
The purpose of any credit
assessment or analysis is the
measurement of credit risk.
 Borrowers’ credit assessment is
done using the following criteria,
popularly known as the five Cs of
lending.
FIVE Cs of Lending
 Character
 Capacity
 Capital
 Collateral
 Conditions
CHARACTER
 Character is the sum total of human
qualities of honesty, integrity,morality
and so on.
 Character is perhaps the most
important and at time the most
difficult criterion to assess.
 Character assessment involves
collecting information about the
borrower’s track record of integrity,
repayment ability and spending habits.
Means of gathering
information
 Credit check of internal bank records
or other financial institution.
 Contact of applicant’s employers and
seek confidential information about
the employee***
 Documentary evidence such as salary
statements, drivers license, utility bill
 Confidential reports from credit rating
agencies are another source.
 CIBIL data/ECGC/Dun & Brad Street
Character assessment in
relation to business
borrowers

 For business borrowers,

character assessment involves
assessing the character of the
business owners or, in the case of
companies, the members of the
board.
 Corporate governance
CAPACITY
 Capacity is the ability to repay the loan
together with interest as per the pre-
determined schedule.
 A borrower’s capacity depends on two
factors: first, the borrower’s financial
position should be sound; and second,
the borrower must be able to generate
sufficient net income to service the
loan repayment.
Capacity
 To assess whether the borrower’s
financial position is sound, lenders, in
the case of personal loans often
examine details of assets and
liabilities.
 Also borrowers are required to give
details of income and expenditure, and
the net surplus available for
repayment.
Capacity
 In the case of businesses,
lenders usually ask for audited
financial statements and
projected cash flow to determine
the financial soundness or
creditworthiness of the business
borrower.
CAPACITY
 Capacity is about the primary
source from which repayment is
expected to take place. It is
important to assess the primary
source from the outset
 Capacity to pay but willingness to
pay. Main cause of NPA in banks
CAPITAL
 Capital refers to the capital contribution that
the borrower proposes to make in the total
investment.
 An investment is usually financed partly by
bank loan and partly by the capital
contribution of the owner.
 The owner’s contribution is called the
owner’s margin.
 The greater the owners contribution to a
project the greater is the lenders confidence
in the venture. Banks usually expect at least
a 20 – 25% percent input from the borrower.
COLLATERAL
 Collateral is also known as secondary
source of repayment. When a loan
cannot be paid out of primary source,
lenders usually take possession of
collateral and dispose of it and use the
proceeds to set off the outstanding
loan amount.
 Type of collateral –
house/factory/machinery/ bank
deposits/shares & debentures
 Guarantee
QUALITIES OF GOOD
SECURITY
 Title
 The price of the security should be stable, or not
subject to wide fluctuations.
 The marketability of the security should be rated
good.
 The security should be easily valued.
 The security should not deteriorate rapidly over time.
 If security is quickly transportable or portable, then
the lender can sell it in another market. If the security
is not portable then, the lender may find it hard to sell
that security in the local market.
 Bogus documents – title deeds
COLLATERAL
 It is hard to find a security that
possesses all the above qualities,
and a lender is often required to
judge an acceptable compromise.
 Land for example, may have
stable value over time but it lacks
the quality of portability.
CONDITION
 An analysis of conditions covers
external and internal factors.
 It also covers the conditions and
terms of the loan.
 The riskier the advance the
stricter are the terms and
conditions.
EXTERNAL
CONDITIONS
 Economy
 Industry
 Threat of war
 Political instability
 Crime
Cannons of good
lending
C.a.m.p.a.r.i
 Character
 Ability
 Margin
 Purpose
 Amount
 Repayment
 Insurance( security)
INTERNAL CONDITIONS
 Lending policies
 Lending budget
 Availability of expert staff to monitor
loan.

 A financial institution may decide to

follow restrictive lending policies, the
lending budget and the availability of a
funds constraint, or to expand lending
business in particular segments of the
market.
 Credit analysis should take such
 Character
 It is virtually impossible to assess an
individual’s character just after one
meeting. It is an extremely difficult area
but vital to get right. Very sujective
 How reliable is the customer’s word as
regards the details of the proposition
and the promise repayment.
 Does the customer make exaggerated
claims that are far too optimistic.
 If the customer is new, why are we
being approached? Can bank
statements be seen to assess the
conduct of the account.
 Ability
 This aspect relates to the borrower’s ability in
managing financial affairs and is similar to
character as far as personal customers are
concerned.
 Is there a good spread of skill and experience
among the management team in, for
example,production,marketing and finance.
 Does the management team hold relevant
professional qualifications?
 Are they committed to making the company
successful?
 Where the finance is earmarked for a specific
area of activity, do they have the necessary
experience in that area.
Margin
 Agreement should be reached at
the outset with the borrower in
respect of interest margin. The
interest margin will be a reflection
of the risk involved in the lending,
while commission and other fees
will be determined by the amount
and complexity of the work
involved.
Purpose
 The lender will want to verify the
purpose is acceptable.
 Customers sometimes overlook
problems in their optimism and if
the bank can bring a degree of
realism to the proposition at the
outset, it maybe more beneficial
to the customer than agreeing to
the requested advance.
Amount
 Is the customer asking for either
too much or too little?.
 There are dangers in both and it
is important therefore to establish
that the amount requested is
correct and that all incidental
expenses have been considered.
The good borrower will have
allowed for contingencies.
Repayment
 The real risk in lending is to be found
in the assessment of the repayment
proposals. It is important that the
source of repayment is made quite
clear at the outset and the lender must
establish the degree of certainty that
the promised funds will be received.
 Where the source of repayment is
income/cashflow, the lender will need
projections to ensure that there are
surplus funds to cover repayment after
meeting other commitments.
Insurance/Security
 Ideally the canons of good lending
should be satisfied irrespective of
available security, but security is
considered necessary in case the
repayment proposals fail to
materialise.
 It is important that no advance is
made until security procedures have
been completed,or are at least at a
stage where completion can take place
without the need to involve the
Evaluation
A two stage approach
 An assessment of the feasibility of the
borrower’s plan for repayment.
 If the proposal in not viable, it is pointless to
continue.
 A critical appraisal of what might realistically
go wrong-the likelihood of such events
occurring and the effect on the bank’s
position.
 the aim of this evaluation is to establish the
risk involved. List the pros and cons of a
proposition is often helpful. More reliance
should be placed on facts and evidence than
on estimates and opinions.
Modern approaches to
Credit risk
measurement.
 The measurement and management of
credit risk have undergone a
revolution in recent years.
 The advances in technology have
enabled financial engineers to try new
methods of model building and
analysis for credit risk measurement.
 Several factors have contributed to
this recent surge in technology-based
analysis methods.
Cond..
 Increased competition in the loan
market necessitated the development
of methods that are quicker more
accurate and more cost effective.
 Consumer expectations have
increased and most consumers now
expect efficient loan approval from
financial institutions.
 Response Time - Where lending
institutions have been found to be a
bit tardy, consumers have shifted to
other institutions.
Cond..
 Loyalty is less and less evident among
consumers. Banks now need methods
of credit assessment that cater to the
changed customer needs.
 Also in recent years, bankruptcies and
global competition have increased, so
accurate credit analysis has become
more important.
 The traditional system was based on
expert knowledge only, requiring
expensive and extensive staff training.
Risk Measurement
 Systematic/Non Systematic risk
 Credit rating – project/retail/SME
etc
 Pricing
 Monitoring