Notes on Credit Management in Banks

Credit management by commercial banks is a part of banking activities of normal course where banks constitute as a largest group of financial intermediaries. There are two core activities of commercial banks one to accept deposits and second to give loans and advances. The deposits are liabilities for any bank as these are required to be paid back to customers either on demand or on completion of a term.

Where as credit and advances made by banks are their financial Assets. But banks’ credit has to be productive and must contribute to the generation of the borrower’s income and also towards increasing the rate of growth of the economy as a whole.

Banks mobilize deposits to contribute to gross national product through their different kind of deposit schemes. About 60% of these funds are deployed as bank credit in various sectors of economy.

Thus deposit mobilisation and credit dispensation are the two most important functions of commercial banks. In a way, these banks are the trustees of the savings and idle funds of the society. How efficiently they are able to discharge this responsibility depends largely upon the quality of their credit portfolio.

Bank’s Sources and Uses of Funds:

The selection of uses and sources of funds is not applicable to banks only but to all organizations engaged in business activities to earn profit.

In case of banks, the main source of funds (liabilities) comes from:

Deposits:

1. Current Deposits,

2. Saving Deposits,

3. Fixed Deposits, and 

4. Certificate of deposits.

Borrowed Funds:

1. Borrowing from other banking companies etc.

2. Borrowing from Reserve Bank of India.

3. Borrowing from financial institutions.

Owned Funds:

1. Paid-up Capital.

2. Reserve funds.

3. Balance of Profit and Loss Account.

Uses of Funds by Banks:

The main source of assets comes from:

1. Cash (cash in hand or with RBI in the form of CRR or SLR).

2. Balance with other banks.

3. Money at call and short notice.

4. Investment.

5. Loans and Advances.

6. Fixed Assets.

Credit management of banks is confined to the Loans and Advances:

Functions of Banking Industry:

These functions are co-related with the credit policies of banks which are subject to a great extend, by the national policies. Keeping in view of the security of depositors (whose funds are used by banks for lending) certain restriction on lending functions are imposed by the regulations. Also the lending operations of banks are subject to restrictions imposed by the Reserve Bank of India from time to time in the interest of monetary stability.

Indian banks operate under several restrictions of credit policy like social lending, DRI lending, SSI lending, Priority sector lending, agriculture sector lending, Micro and SME lending etc. and in addition to all the reserve requirements and socio-economic objectives. In fact a sizable portion of banks resources is virtually taken out of bank’s discretion by pre-emption of funds reserve requirements and other Government sponsored schemes.

Banks in India cannot give out their entire deposit amount in loans. The regulatory authorities issue necessary guideline in this regard based on the monitory and financial policy of the government. The banks in India chalk out their own credit policies in view of the guide lines issued by the regulatory authorities.

In broad prospective banks deploy their funds into three main uses Cash, Investments, Loan and advances. But the cash and investments are determined largely by the RBI according the which it is mandatory for banks to maintain liquidity level to protect the banks and customers by way of Cash Reserve Ratio and Statutory Liquidity Ratio at present the cash reserve ratio is 6% (with effect from 24.4.2010) of total time and demand liabilities. This ratio is subject to changes depending upon the monetary policy.

The statutory Liquidity Ratio comprises:

1) Cash in hand and with other banks.

2) Investment in government and other approved securities.

All the above combined together take out sizable portion of bank resources and for the purpose of lending bank has to depend what is left out after meeting these constraints.

Importance of Credit, Loan & Advances Portfolio in Banks:

For each bank efficient management of credit portfolio is of utmost importance as it has tremendous impact on the banks’ profitability. The ongoing financial reforms have no doubt provided various opportunities to the banks for growth, but have exposed them to various risk, which need to be effectively managed.

With financial reforms and liberlisation policies of the government such new venues have come where credit exposure of banks has increased with the inherent risks. The situation became aggressive with increase of sick loan accounts. In order to arrest the situations RBI made credit norms more strict.

In the wake of continued tightening of norms of income recognition, asset classification and provisioning, increased competition and emergence of new types of risk in the financial sector, it has become imperative that the credit functions are strengthened by each bank.

Loan Products:

Banks in ordinary course of business extend loan facilities by way of fund based facilities and/or non-fund based facilities. The fund based facilities are usually allowed by way of term loans, cash credit, bills discounted/purchased, demand loans, overdrafts etc.

In case of non-fund based facilities by way of issuance of inland and foreign letters of credit, issuance of bank guarantees, deferred payment guarantees, bills acceptance facilities etc. All these are usual type of loan facilities provided by banks. There are several other fields for which banks provide financial assistance.

A brief description of usual type of loans is given below:

1. Fund Bases Credit Facilities Overdrafts:

All overdrafts accounts are treated like current accounts where a cheque book is issued to the borrowers to withdraw the loan amount as per requirement. Normally overdrafts are allowed against the Bank’s own deposits, Government securities, approved shares and debentures of companies, life insurance policies, government supply bills, cash incentives and duty drawbacks, personal security etc.

2. Demand Loans:

A demand loan account is an advance for a fixed amount and no debits are made subsequent to the initial advance except for interest, insurance premia other sundry charges. Loan is secured by way of a promissory note and therefore subsequent drawing are not allowed. In fact it has the effect of permanently reducing the original advance.

Normally demand loans are allowed against bank’s own deposits, government securities, approved shares/debentures of companies, life insurance policies, pledge of gold/silver, mortgage of immoveable property, etc.

3. Term Loans:

Term loans are sanctioned normally for acquisition of fixed assets like land, building, plant/machinery, office equipments, furniture-fixture etc. for purchase of transport vehicles and other vehicles, agricultural equipments etc.

Term loans are granted for different periods, short term, medium term and long term and the duration varies normally 3-7 years but in exceptional cases banks do extend this period from case to case. Term loans for infrastructure Projects can be allowed even with longer repayment period which depends on the type of projects’ completion and commencement of the purpose be may production, service or any other field.

4. Cash Credit Advances:

Cash Credit account is drawing account against credit granted by the bank and is opened exactly the same way as a current account on which an overdraft has been sanctioned. These types of account are secured by way of pledge/hypothecation of goods or produce, mortgage of immoveable property, book-debts, trust securities etc.

A limit of particular amount depending on the need of the borrower and the securities available is fixed and the borrower can draw on account within the prescribed limit. Drawing more than fixed limit makes it an irregular account.

5. Bill Finance:

Advances against Indian bills are sanctioned in the form of limits (the amount fixed) for purchase of bills or discount of bills or bills sent for collection. Such limits are fixed for genuine trade transactions only. Bill are either payable on demand or at sight. In case of Usance bills which are payable on maturity after certain period of time nature of account mostly differs than that of bills payable on sight.

6. Packing Credit:

Packing credit is an advance given to an exporter who holds a Code Number assigned to him by the Directorate General of Foreign Trade, for financing the, purchase, processing, packing of goods against an export letter of credit or a firm export order, or evidence of an export order.

Non- Fund Based Credit Facilities:

(i) Letters of Credit:

Letter of credit is issued by the bank at the request of its customer in favour of a third party informing him that the bank undertakes to accept the bills drawn on its customers up to the amount stated in the letter of credit subject to the fulfillment of the conditions stipulated therein. This way, when a bank issues LC, it assumes responsibility to pay its beneficiary on production of bills drawn in accordance with the terms and conditions of the LC.

It is also known as “Documentary Credit” and is most popular method of payment/receipt in the international as well as domestic trade. Under documentary credit, the buyer’s promise to pay the seller on presentation of the documents, is Substituted by Banks’ undertaking to pay, on seller fulfilling the prescribed terms and conditions. Therefore the buyer’s liability to pay is to the credit issuing bank rather than to the seller.

There are several definitions of documentary credit but following definition appears to be more accurate.

“Documentary credit represents a commitment or undertaking of a bank to pay the seller of goods and services on behalf of its client on fulfillment of certain terms & conditions and presentation of stipulated documents as agreed upon by buyer & seller earlier.”

All documentary Credits are governed by the norms of International Chamber of Commerce known as Uniform customs and practice for documentary Credits.

Parties to Documentary Credit:

1. The Buyer:

The Buyer A person or entity willing to buy goods/services.

2. Issuing Bank:

Issuing Bank is the Bank which issues or opens a letter of credit on the request of the buyer (in practice this bank is also the banker of the buyer).

3. The Seller:

The Seller is the one in whose favour the L/C is opened and to whom the L/C is addressed. He is also known as Beneficiary of L/C entitled to obtain payment under L/C.

4. Advising Bank:

Advising Bank is the intermediary bank which advises the L/C to the beneficiary. By advising it undertakes the responsibility of authenticity of the L/C.

5. Confirming Bank:

Confirming Bank is a bank who may be requested by the issuing bank to add its confirmation. If agreed to, the bank becomes a party to the L/C and undertakes the responsibility to honour the bills. In practice Advising bank is asked to add confirmation.

6. Negotiating Bank:

Negotiating Bank is bank to whom the seller is supposed to submit the documents for negotiation and get the payment as per the drawn bill.

7. Reimbursing Bank:

Reimbursing Bank is bank who is authorized by issuing bank to reimburse the paying or negotiating bank.

(ii) Guarantees:

Guarantee is a contract to perform the promise, or discharge the liability of a third person in case of his default. In the ordinary course of business, banks often issue guarantees on behalf of their customers in favour of third parties. When bank issues such a guarantee, it assumes a responsibility to pay the beneficiary, in the event of a default made by the customer.

Definition:

“Section 126 of Indian Contract Act defines guarantee as contract to perform the promise or discharge the liability of a third person in case of default, Guarantee is also known as LG.”

Contract of Indemnity:

As per section 124 of the Indian Contract Act an indemnity is defined as a contract by which one party promises to save the other from loss caused to him by the conduct of the promiser himself or by conduct of any other person.

Types of Guarantees:

A. Financial Guarantee:

In Financial guarantees, the guarantor is undertaking to pay damages in monetary terms on the happening of some default as specified in the Letter of Guarantee.

In these cases LGs are issued in lieu of financial transactions like:

i) LG for payment of determined liabilities towards tax, excise, duties, custom duties, octroi etc.

ii) LG issued towards disputed liabilities.

B. Performance Guarantee:

Under such LGs the letter of Guarantees are issued mostly to secure performance, of the contracts, the need to pay the LG amount will arise only in the event of non-performance of the contractual obligation.

C. Deferred Payment Guarantee:

It is popularly known as (DPG) The necessity to issue DPG arises in case of purchase of Capital goods like machinery. In such guarantees the banks are undertaking to pay the installments due under the deferred payment schedule. Unlike all other LGs here the payment will have to be made by the banks on the accepted due dates and thereafter the installment is recovered from the party.

Regulations relating to loans and advances:

Credit management or sanctioning of loans by banks in India is governed by the provisions of the Banking Regulation Act. Under these provisions the Reserve Bank of India issues directions covering the loan functions of the banks.

Although there is very large list of directions issued by the RBI in this regard and also it is an ongoing process as these directions are issued frequently but gist if provided below:

A. Reserve Bank of India has prescribed norms for bank lending to non-bank financial companies and financing of public sector disinvestments.

B. Banks are now free to determine their own lending rates but each bank needs to declare its Prime Lending Rate popularly known as PLR as approved by its board of directors. Each bank should also indicate the maximum spread over the PLR for all credit exposures other than retail loans. Banks are also given freedom to lend at a rate below the PLR in respect of creditworthy borrowers. However credit rates for certain categories of advances are regulated by the RBI.

(NOTE: The Prime lending rate is the minimum rate at which banks sanction loans. In most cases or say in majority of cases the bank charges higher than the PLR and in rare of rarest case interest rate is charged below PLR. The PLR system was recently changed and a new system know as BPLR (Basic Prime Lending Rate) was introduced. Lately this system has also been changed with BASE rate with provision not to lend blew Base rate.)

C. The banks are prohibited to grant any loan or make any commitment of granting loans or advances to or on behalf of any of its Directors, or any firm in which any of its Director is having any interest as a partner, manager, employee, or guarantor or any company.

Credit Exposure Limits:

The Reserve Bank of India has issued specific directions prescribing exposure limits for banks and long-term lending institutions in respect of their lending to individual borrowers and to all companies in a single group.

1. Exposure ceiling for a single borrower is 15% of capital funds effective from March 2002. Group exposure limit is 40% of capital funds effective from March, 2002. In case of financing for Infrastructure Projects, the single borrower exposure limit is extendable by another 5% i.e., up to 20% of capital funds and the group exposure limit is extendable by another 10% (i.e. up to 50 % of capital funds). Capital fund is the total capital as defined under capital adequacy norms (Tier I and Tier II capital).

2. Non-fund bases exposures are calculated at 100 % and in addition, banks include forward contracts in foreign exchange and other derivative products, like currency swap and options, at their positive market value (including potential future exposure) in determining individual or group borrower exposure ceilings, effective from April 1, 2003.

Credit exposure is aggregate of:

i) All types of funded and non-funded credit limits.

ii) Investment in shares, debentures, bonds and units of mutual funds.

iii) Facilities extended by way of equipment leasing, hire-purchase finance and factoring services.

iv) Advances against shares, debentures, bonds, and units of mutual funds to stock brokers and market makers.

v) Bank loan for financing promoters’ contributions.

vi) Bridge loan against equity flows/issues.

vii) Financing of IPO (Initial Public Offerings).

In order to ensure that exposures are evenly distributed the Reserve Bank of India requires banks to fix internal limits of exposure to specific sectors. These limits are subject to periodical review by the banks.

Directed lending: (Priority Sector):

In order to achieve the targets of monetary, economic and financial policies the government of India decides to elevate certain sections for extended bank facilities. Under such policies it remains the main objective to spread the economic growth even to lowest level of the society. As such different sectors are selected for such purposes which are given priority over other schemes of lending by banks.

In view of above the RBI requires commercial banks to lend a certain percentage of their net bank credit to specific sectors known as Priority Sector. Total priority sector advances should be 40% of net bank credit with agricultural advances required to be 18% of net bank credit and advances to the weaker sections required to be 10 % of net bank credit and 1% of the previous year’s net bank credit required to be lent under the Differential Rate of Interest scheme popularly known as DRI scheme.

Common Guidelines on financing of Priority sector loans:

While Priority sector has not been defined either by government or by RBI but categories of PS are set forth as follows:

Categories of Priority Sector:

1. Agriculture (Direct or Indirect Finance):

Direct finance to agriculture shall include short, medium and long term loans given for agriculture and allied activities (dairy, fishery, piggery, poultry, beekeeping etc.) directly to individual farmers, Self Help Group (SHGs) or joint liability groups (JLGs) of individual farmers without limit and to others (such as corporate, partnership firms and institutions) up to the limits prescribed for taking up agricultural/allied activities. Direct and indirect agriculture finance is defined in detail by the RBI.

2. Small Enterprises: (Direct and Indirect finance):

Direct finance to small enterprises shall include all loans given to micro and small (manufacturing) enterprises engaged in manufacturing/production, processing or preservation of goods, and micro and small (service) enterprises engaged in providing or rendering of services, and whose investment in plant and machinery and equipments respectively does not exceed the amounts of Rs. 5 crores.

3. Retail Trade:

Retail trade shall include traders/private retail traders dealing in essential commodities (fair price shops) and consumer co-operative stores with credit limits not exceeding Rs. 20 lacs.

4. Micro Credit:

Provision of credit and other financial services and products of very small amounts not exceeding Rs. 50000/- per borrower, either directly or indirectly through a SHG/JLG mechanism or to NBFC/MFI for on-lending up to Rs. 50000/- per borrower, will constitute micro credit.

5. Education Loan:

Education loans include loans and advances granted to only individuals for educational purposes up to Rs. 10 lacs for studies in India and Rs. 20 lacs for studies abroad, and do not include those granted to institutions.

6. Housing Loan:

Loans up to 20 lacs to individuals for purchase/construction of dwelling unit per family, (excluding loans granted by banks to their own employees) and loans given for repairs to the damaged dwelling units of families up to Rs. 1 lac in rural and semi-urban areas and up to Rs. 2 lacs in urban areas and metropolitan areas.