banking session 1

8/11/2019 Banking Session 1

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Agenda

Role of Asymmetric Information in Lending Adverse Selection

Moral Hazard

Indian Banking structure & Regulatoryframework / functions of RBI

Banking concepts/ Types of Financial facilities Cardinal Principles for Lending (SSLP)

Five Good Cs - Preliminary scrutiny of creditapplications

RBI/ GOI /Institutions

Internal Guidelines Types of Borrowers

Thursday, August 21, 2014 MBA Banking by Dinesh Mahabal 2


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Banking Indian perspective..

Banking is defined in Sec 5 (1) (b) of BankingRegulation Act 1949 as

Accepting for the purpose of lending orinvestment; of deposits from the public,repayable on demand or otherwise and

withdrawable by cheque, draft, order orotherwise. Many other financial activities were added over

time such as mobilisation of funds (MerchantBanking/ Shares issue management), Managementof Teasury/ Investment funds / Insuranceproducts etc.


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Banking Business A Bridge between Savers& Consumers

Banks / FIs act as Intermediaries betweenSavers & Consumers

There are two mechanisms for mobilisingsavings and channeling them into investments,

viz. 1.Bank-based and 2. Market-based Saversusually have incomplete information on

the affairs of companies and economy at large,which makes it more difficult for companies to

obtain direct financing from the market.Intermediation by banks mitigates such agencyproblems.



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Banking Business A Bridge betweenSavers & Consumers

There are -3- types of economic efficiencies viz. 1.Allocational, 2. Operational and 3. Informational

Financial market intermediaries such as Banksperform the critical function of dispensation of fundsbetween savers and investors/ users and improve allthe -3- types of efficiency

Allocational efficiency refers to the allocation offunds to most needy sector of the economy.

Operational efficiency considers how efficient aninstitution is so as to be optimally cost effective

Informational efficiency takes in to account theavailability of market knowledge base with anInstitution so as to perform the lending functionoptimally.


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Banking Business A Bridge betweenSavers & Consumers

The need for financial intermediation isjustified on the grounds of informationgathering and company (consumer) - monitoringfunctions performed by banks

By optimising the costs of acquiring andprocessing information, financial institutionsencourage mobilisation of savings and improveresource allocation.

Banks can also diversify risk among a largenumber of companies


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Asymmetric information

Can be defined as the information thoughavailable on public domain; is known to somepeople but not known to many other people.Thus of the two parties in the contract, one

has more or better information. Information asymmetries can lead totransaction occuring with clear benefit to thebetter informed partyor may also lead tofailure of transaction.

Some sellers with inside information about thequality of an asset will be unwilling to acceptthe terms offered by a less informed buyer


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This phenomenon may cause a party indistress to sale an asset at a price lowerthan it would command if all buyers andsellers had full information or otherwise if

the party is not distressed This leads to the introduction of price

discovery mechanism in case of genuinesales transactions.

This idea has been applied to both equityand debt finance


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Asymmetric information For equity market, shareholders demand a

premium to offload shares of relatively goodfirms This premium raises the cost of new equity

finance faced by managers of relativelyhigh-quality firms above the opportunity

cost of internal finance faced by existingshareholders The debt market, a borrower who takes out

a loan generally has better informationabout the potential returns and riskassociated with the investment for whichthe funds are requested (therefore, it is theduty of a lender to get all relatedinformation ton take informeddecision.)


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The lender on the other side does not havesufficient information concerning theborrower. Lack of adequate informationcreates problems before and after the

transaction of Lending is entered into The presence of asymmetric information

normally leads to two problematic issues viz.

1. Adverse selection (Credit Appraisal

Lacuna) and2. Moral hazards problems (Lax Monitoring

aspects)


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Adverse Selection

This refers to a situation in which sellers have relevantinformation that buyers lack (or vice versa) about some aspectof product quality. The ignorant party lacks information whilenegotiating an agreed understanding of or contract to thetransaction. This is the problem created by asymmetricinformation before the transaction occurs.

An example of adverse selection is when people who are highrisk are more likely to buy Insurance, because the insurancecompany cannot effectively discriminate against them, usuallydue to lack of information about the particular individual's riskbut also sometimes by force of law or other constraints

Adverse Selection occurs when the potential borrowers - whoare most likely to produce an undesirable (adverse) outcome sayCredit default risks, are the ones who most actively seek outa loan and are thus most likely to be selected

That is why many a times walk-in businessis not preferred


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Disadvantages of Adverse Selection

When a Lender is not able to pricediscriminate (i.e. stipulate different interestrates) between good and bad borrowers in loancontracts, because the riskiness of projectscould not be observed

Thus, when interest rates increase, relatively

good borrowers drop out of the market,increasing the probability of default andpossibly decreasing lendersexpected profits

In equilibrium, lenders may set an interestrate that leaves an excess demand for loans(which is undesirable). Some borrowersreceive loans, while other observationallyequivalent or better borrowers are rationedout.


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Moral Hazard

Moral hazard is the consequence of asymmetric information afterthe transaction occurs. The ignorant party lacks information aboutperformance of the agreed-upon transaction or lacks the ability toretaliate for a breach of the agreement.

The lender runs the risk that the borrower will engage in activitiesthat are undesirable from the lenders point of view because they

are not intended or make it less likely that the loan will be paid back The debt contract is a contractual agreement by the borrower topay the lender a fixed amount of money at periodic intervals. Whenthe firm has reasonable profits, the lender receives the contractualpayments

Another example of moral hazard is when people are more likely to

behave recklessly after becoming insured, either because theinsurer cannot observe this behaviour or cannot effectively retaliateagainst it, for example by failing to renew the insurance


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Moral Hazard Problem origination

Adverse selection leads to entry of wrongborrower.

Lender not bothering to know about the exactsource of profits of the borrower.

The borrower is pursuing activities notenvisaged earlier & not contributing to theprofitability of the firm.

The lender not caring as long as the activities donot interfere with the ability of the firm to

make its debt payments on time


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Adverse Selection (AS) & Moral Hazard(MH)

Only when the firm cannot meet its debtobligation, thereby being in a state of default,the lender feels a need to verify the state ofthe firmsprofitability.

Thus, AS & MH are two aspects concerning theCredit Appraisal (Proper Selection of aBorrower) and Credit Monitoring (Vigil on theBorrower / user-Consumer of Money) so as to

ensure the interest of all stakeholders



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Indian Banking Structure

RBI

Commercial Banks Co-operative BanksFinancial/ Banking

InstitutionsNBFIs

Public SectorBanks

Private SectorBanks

Foreign Banks

Regional RuralBanks

Primary urbancoop

State andcentral coopbanks

PrimaryAgriculturalCredit Societies

LandDevelopmentBanks

All IndiaDevelopmentBanks

State FinanceCompanies

NABARD /NHB /EXIM

SpecializedInstitutions

Housing FinanceCompanies

Non - BankFinanceCompanies


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Indian Banking Structure

Multi Layered Structure

Future expected scenario:

Alliances (Corporation / OBC/ Indian Bank) Consolidation Evolving Foreign Ownership / FDI Norms No geographic, INR restrictions, Foreign Banks

(WOS/ branch structure)


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Functions of RBI

Three Basic Functions of RBI are:-

1. Supervisory and Regulatory

2. Promotional and Developmentaland3. Refinance Operations


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Functions of RBI - 1. Supervisory &Regulatory

a) Monopoly for Issue of notes: other thanRe.1 Notes & Coins & subsidiary coinsb) Exchange Control: Through Authorised

dealers / Commercial Banks, control of Fgn.

exchange & reserve, FERA / FEMAc) Statutory Regulations: SLR / CRR,collection of Economic information

d) Bank of Central Clearance: Act as clearinghouse for member Banks

e) Settlement & Transfer: performances thefunction of clearing & settlement (throughNEFT/ RTGS)


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Functions of RBI - 2. Promotional &Developmental

a. Banker to Government: transacts bankingbusiness on behalf of Central Govt. Accept& pay out money, manage public debt /Treasury bills and issue new loans

b. Banker to Banks: Banks keep account withRBI (SGL)c. Agricultural Finance:NABARD, RRBsd. Industrial / Export Finance: IDBI, IFCI,

State FCs, DICGC, EXIM Bank, UTI etc


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Functions of RBI - 2. Promotional &Developmental

a. Strengthening of co-op Structure: Supervision /capitalisation of co-op sector

b. Collection of data and publications:Annual Reporton Trends in Banking, Report on Currency & finance,

RBI bulletin, Credit Information Review, AnnualReport of RBI on Countrysposition, first FinancialStability Report in March 2010

c. Promotion & Development of Institutions:sponsored NIBM, STCI for Govt securities market

etcd. Training Institutions: BTC (now closed), Collage ofAgri Banking, Pune, RBI Staff college, Chennai



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Functions of RBI - 3. RefinanceOperations

a. Refinance: To control the liquidity inthe market and directed lending, BankRate As a reference rate at which

RBI lends moneyb. Lender of last Resort(Repo / Reverse

Repo): Lending against eligible bills/

securities


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Retail Financial Services CorporateFinancial Services

Term Loans/ WC Loans

Project Finance

Trade Finance/Commercial Banking

Investment Bank

Venture Capital

Genl. Insurance

IT Services

Car Loans

Mortgages

Credit Cards

Personal loans

Deposits

Life Insurance

Mutual funds

A universal banking powerhouse...

Fee Based Servicescredit cardsDebit Cards

DepositoriesPortfolio management servicesInvestment bankingAsset management

Safe deposit lockersCash managementLetter of credit

Guarantees


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LOANSFund Based

SHORT TERM

CASH CREDIT

OVER DRAFT

BILLS

EXPORT

FC

HOUSINGAUTO

CONSUMER DURABLESPERSONAL

LOANS AGIANSTDEPOSITS / NSC

CLEAN loansMORTAGE BASED

RETAILOTHERSSHORT TERM

CASH CREDITOVER DRAFT

BILLSEXPORT

FCLBRIDGE LOAN

LONG TERM

TERM LOANPROJECT FINANCE

TRADE


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WHAT IS LENDING / Types of Lending

When a bank agrees to place funds at the

disposal of a borrower, either against atangible security or not, but against apromise from the intended borrower offunds to repay the amount at a future datewith interest for the amount used for the

period bank is said to have lent the money. Fund Based Lending The lending or placement of funds can be by

way of 'Demand Loan repayable on demand(max tenure 36 months) or 'Term Loan',repayable over a period of time (above 36months) at agreed intervals.


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It can also be by way of an overdraft where a'credit limit up to the amount to be lent is set inthe current account or a 'cash credit account',where against security of stocks or receivables'limit' up to sanctioned level of lending is madeavailable to the borrower in the form of running

accountallowing withdrawals up to the limit as perthe borowersrequirements. Lending can also take form of 'bill discounting'

when a bank lends against a bill of exchange drawnin favour of the borrower, but payable at a futuredate by immediately placing the amount of bill less

discount charges, at the disposal of the borrowerby 'discounting'the bill.


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All the lending transactions narrated asabove involve fund based creditdeployed since the funds actually flow

out of the Banking system


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NON FUND BASED

Current AssetsFinanced by

LETTER OF CREDIT

Fixed AssetsFinanced by

Deferred Payment Guarantee


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Non Fund Based type of LendingThere are certain types of advances

which do not involve deployment of

funds at least in the initial stage. Theseare called 'Non-Fund Based Credit'

A 'Performance Guarantee' issued by

the bank on behalf of a customer tothird party for fulfillment of terms ofcontract


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'Letter of Credit' issued by the Bank onbehalf of its customer favoring the thirdparty in India or abroad are some of theexamples of this type of finance

Even though funds are not involved at the

initial stage, bank is required to take risk, andon failure of its client to fulfill terms ofguarantee or letter of credit, banks will haveto pay out the funds to the beneficiary onbehalf of the customer and recover it laterfrom him. Thus the NFB becomes FB.


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WHAT IS Investments

Investments Banks are also permitted to invest in sharesof corporate up to a certain limit via primarymarket route i.e. by applying for new shares.This has opened up a new avenue, since a

judicious investment can earn the bank verygood returns on the funds deployed. Besides meeting the statutory requirements,

banks sometime invest in gilt edged or

government / government backed securitiesover and above minimum requirement, whenthe yield on such securities is attractive.


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Hire Purchase / Leasing

Leasing of assets is an activity which banksare allowed to undertake. In this case, bankearns lease rentals which are quite

attractive, besides getting tax incentives Thus it is very essential to understand and

appreciate the fact that in today's contextthe amount raised by the bank, could be

deployed in various ways and it need notdeploy its resources only by way of lending.


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Importance of Lending to Banks 2 fold

Social Significance Lending by banking sector, especially by publicsector/ nationalised bank assumes greaterimportance, because only these banks can make creditavailable to needy, small borrowers as also Very Big

Borrowers. Banks have to play an important role in employment

generation, poverty alleviation and nation building.Lending by the banks has helped many small scaleindustrialists, assisted farmers and encouraged smallborrowers / artisans to sustain and grow their smallbusinesses.


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Importance of Lending to Banks

Business Considerations: It constitutes major part of bank's assets. It earns substantial income to the bank by way of

interest, discount and commission. The borrowers to whom banks finance, generally give

deposit and other remunerative business to the bank,like remittances, collection, foreign exchange,merchant banking etc.

Banks also get non-fund based credit business from

these customers like guarantee, letters of credit etc.on which bank can earn handsome commission.


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Cardinal Principles of Lending (SSLP)

Safety & Security: Major portion ofdeposits mobilised are converted intoLoans & Advances to the customers

A banker lends depositorsmoney

Marketable security i.e. collateral basedlending

The concept of development bankingevolved post nationalisation


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Liquidity:Availability of funds at theright amount and time

Borrowers ability to generate adequate

surplus must be verifiedA strain on the cash flow of a borrower

puts strain on the Bankers cash flow

Easy marketability of the security


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Profitability

Default risk is to be evaluated and

Borrowersability and propensity to payto be verified

Asset Liability Management


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Criteria for Borrower Assessment -5- Cs

1. Character: To sort out scrupulousborrowers from Non-scrupulous one. Generalentrepreneurial behavior, habits,temperament, sincerity, honesty, integrityetc (KYC/ AML/ CFT)

2. Capacity: Ability to undertake and to runthe business


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Criteria for Borrower Assessment -5- Cs

3. Capital: Financial ability to raisecapital to show the level of confidence

4. Collateral: Additional security other

than primary5. Conditions: The overall assessment

leads to stipulations of conditions for

disbursal


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GUIDELINES ON LENDING FROM RBI AND GOI

Reserve Bank of India issuesguidelines from time to time relatingto flow of credit and variousdirectives about credit discipline bythe borrowers and banks

Government of India / Ministry ofFinance too issue directives to thebanks about credit, keeping in viewthe economic conditions, fiscaldeficit position of the country etc.


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Based on these guidelines / directives,

Banks issue instructions to thebranches/offices for their referenceand action.

While the guidelines from Reserve Bank

of India /government keep on changingdue to changes in Macro-Economiccircumstances, they could be classifiedinto

'Positive' and 'Restrictive The Relevant Circular is

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Positive directives: Reserve Bank of India has directed the bank about

sector-wise deployment of credit to ensure flow ofcredit to the needy and weaker section

Accordingly, 40% of the net bank credit should be tothe Priority sector of which, 18% of net bank creditshould go to agricultural sector, 10% of net bankcredit or 25% of priority sector advances should goto identified weaker sections of the society, 1% ofprevious years total advances should be by way of

advances under DRI scheme and balance to the SSI/ SB sector Export credit should constitute at least 10% of total

credit

GUIDELINE ON LENDING FROM RBI ND GOI


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Reserve Bank of India /State Governments also

monitor credit flow to the backward areas/States tohave better credit/ deposit ratio in these areas. Thisis done through Service Area Approach, Lead BankScheme and/or State Level BankersCommittee.

Government / Reserve Bank of India directs the

banks to extend credit to the borrowers identifiedunder its various programmes.

Reserve Bank of India /Government also issuesdirectives to banks for financing the sick but viableunits, in their efforts for revival under rehabilitationpackage.


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Restrictive directives Though considerable flexibility has been provided

to banks by Reserve Bank of India over the years,some restrictions/ regulatory guidelines continue tohold good even now. Some of these are:

(a) As a measure of price control of sensitivecommodities like Sugar / Edible Oil / Rice Wheat etc.

(b) Under the selective credit control, banks areadvised to stipulate margin requirements on finance

against the selected commodities besidesdifferential rates of interest are specified


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(c) To avoid excess speculation Reserve Bank of India

has put restrictions by way of stipulating maximumlimit and minimum margin on finance to brokers orindividuals against shares and securities.

(d) Certain restrictions are put by Reserve Bank ofIndia on banks while granting loans to its directors,

directors of other banks(e) There are other restrictions like group exposure

limits for lending to single borrower and one groupup to permissible percentage of the bank'scapital/net owned funds, necessity to follow capitaladequacy, norms for expansion of credit etc.


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Internal Lending Guidelines by IndividualBanks - Loan Policy

Exposure Ceilings

Guidelines for Unsecured - Guaranteesand Advances

Industry/Sectoral Limit - RegulatoryGuidelines

Internal caps


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Pre-sanction appraisal and evaluation

Documentation

Insurance Post Sanction Monitoring

Rejection of proposals


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Time Frame for disposal of proposals

Management of Assets

Retail Credit Project Finance

Line of Credit


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Financing disinvestments and mergers &acquisitions

Film Financing Real Estate Advances Short Term Corporate Loans etc


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Small & Medium Enterprise (SME) LoanProducts

Loan Take-over Priority Sector including bank specific

priority sector products


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TYPES OF BORROWERS

1. Individuals

There are various types of individuals to whom Bank grants various types ofcredit facilities. As per law every individual to whom a credit facility issanctioned must be competent to contract. Minors, persons of unsound mind andun-discharged insolvents are incompetent to enter into a valid contract.

2. Minors (i) According to Section 11 of Indian Contract Act, 1872, a minor is incompetent

to enter into a contract and any contract entered into by a minor is VOIDabinitio.

(ii) A minor's contract cannot be ratified even on his attaining majority. Furtherthe right to set off also cannot be exercised in such cases.

3. Lunatics As per the Indian Contract Act (Section 11) a person of unsound mind (insane) is

incompetent to enter into a contract. As such any contract entered into withsuch a person is void. The banker, however, should not rely merely on hearsayinformation.


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TYPES OF BORROWERS


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TYPES OF BORROWERS

C) Private limited company

In respect of conversion of partnership firm into a privatelimited company, following procedure is followed :

The firm furnishes the certificate of incorporation from theRegistrar of Companies (RoC) and Relevant Memorandum andArticles of association.

A letter of reconstitution letter whereby outgoing partners andthe private limited company confirm that the documents inrespect of various facilities executed by the partnership firmwould be binding and enforceable and also they confirm thebalance outstanding in various accounts of the partnership firmas of a particular date.

TYPE OF BORROWER


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TYPES OF BORROWERS

It is also advisable to take a fresh LAD /

confirmation letter from the company as well asguarantor/s in respect of out-standings. If the equitable mortgage by deposit of title deeds is

created in respect of the property belonging to thepartnership firm, the same will continue to hold good

so as to confirm and establish that the proposed Pvtlimited company has acquired the assets and liabilitiesattached to the partnership firm

In such case, a confirmation from the limitedcompany that the equitable mortgage created in

respect of the property belonging to the partnershipfirm shall continue to be the security for the limitspermitted to be utilised by the limited company and,therefore, need not be disturbed, should be obtained

TYPES OF BORROWERS


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TYPES OF BORROWERS

D) Limited companies

Memorandum and Articles of Associationshould specifically empower the company toborrow money and also charge its assets.There should not be restrictive clauses in thisregard

If a company borrows without a specificprovision in the Memorandum of Association,such borrowing cannot be ratified by thegeneral body nor can the bank utilise the

security held against such advance towardsits adjustment.

TYPES OF BORROWERS


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TYPES OF BORROWERS

In the case of a company engaged in trading,

powers to borrow are implied. Further, it must be ensured that the purpose for

which credit facility is sought is consistent with theobjects of the company

Under Section 293(1) of the Companies Act, 1956,the board of directors of a public limited companyand of a private limited company, which is a subsidiaryof a public limited company, cannot borrow in excessof the paid-up capital and free reserves without the

consent of the company in general meeting

TYPES OF BORROWERS


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TYPES OF BORROWERS

E) Clubs, Associations and Societies As unregistered societies cannot be sued in law, credit facilities

should be considered only to clubs, and societies which areregistered under the Societies Registration Act, 1860 or theCompanies Act, 1956 or the State Co-operatives Act.

The committee members, both existing and future, shouldguarantee the facility sanctioned in their personal capacity. Thisis to ensure that the committee members take personal interestin liquidating the advances granted.

The clubs and associations should pass a resolution and submit acertified true copy the borrowings and charging of securitiesshould be in conformity with the provisions contained in the bye-

laws


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TYPES OF BORROWERSF) Receivers and Liquidators Advances to receivers and liquidators can be considered

only after ensuring that they have the necessary powers toborrow by reference to the Court's order.

G) Executors and Administrators

An advance to an executor can be considered beforeobtaining the letter of probate from a competent court forpayment of estate duty etc. However, such facilities shouldbe granted on his personal security only, as an executordoes not acquire any power until and unless the probate isgranted in his favour. In case of joint executors, theyshould be made jointly and severally liable for such

advances.


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TYPES OF BORROWERS

H) Schools, Collages and Educational Institutions

Normally all such institutions would be incorporatedas a trust, society or associations.In such cases, allthe guidelines applicable to financing a trust, societyor Association as enumerated above are applicable.

The registration of the institution with the State /Central Education Department as a recognisedinstitution, must be a precondition for consideringsuch proposals.

Normally such facilities are granted for acquiring

fixed assets like building, buses etc.


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TYPES OF BORROWERS

I) Local Authorities Local authorities like municipal corporation etc. are

the corporate bodies constituted / created by specialstatute of the Parliament or the State legislation.

Their capital is wholly subscribed by the Central /State Government. These are artificial persons.While considering granting of credit facilities to such

bodies the relative statutes and borrowing powersetc. should be carefully studied and a resolution for

borrowings from the bank duly passed by the localbody in accordance with its constitution should beobtained


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TYPES OF BORROWERSJ) Public sector undertakings and corporations

Public sector undertakings and corporations arealso constituted /created by special acts of theParliament/State Legislatures. As such allguidelines applicable to local authorities areapplicable to them

Further, if they are incorporated as companiesunder Companies Act, all guidelines applicable togranting of credit facilities to companies are alsoto be made applicable

k) Staff members and Staff related advances


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Final Thoughts

Ships are safest when they are anchored atthe harbors

But that is NOT the place where they are

supposed to beSimilarly Banking is also NOT a no risk

business

But it is..Calculated Risk Taking


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Thank You

[email protected]

banking session 1

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