Credit Appraisal 

and  Non-Performing Assets

               *Dr.P.Shanmukha Rao  **Dr.N.V.S.Suryanarayana

Granting of advances is the primary function of a bank. A major portion of its funds is used
for this purpose and this is also the major source of bank's income. However, lending money
is not without risk and, therefore a banker must take proper precaution in this respect is
discussed below.

Different forms of advances:

The advances can broadly be classified into categories.                                            (i)  Loans,

cash credits and overdraft     

(ii) Bills discounted and purchased.

Loans:

A loan is kind of advances made with or without security. In the case of loan the bank makes
a lump sum payment to the borrower or credit his deposit with the money advanced. It is
given for a fixed period at an agreed rate of interest. Repayment may be made in installment
or at the expire of certain period. The customer has to pay interest on the total amount as
advanced. A loan once repaid in full or in part cannot be drawn again by the borrower unless
the banker sanctions a fresh loan.

The rate of interest charged by a bank in the case of loan is usually lower than in the case of
cash credit and overdraft on account of the following reasons:

 Ø It involves lower cost of maintenance on account of not frequent operation of the

account.
 Ø The bank gets interest on the total amount sanctioned whether the customer
withdraws the whole money or not.

Loan may be a term loan or a demand loan. Term loan's payment is spread over a long
period. It includes a medium term loan and long-term loans. Demand loan is payable on
demand. Thus it is for short period.

Advantages of Loan system:

1. Observation of the financial discipline by the borrower.  

2. Periodic review of Loan account.             

3. Simple and profitable.      

Limitations of the Loan system:

1. Inflexibility.      
2. More formalities.

 3. Frequent Renewals.

Cash credit:

A cash credit is an arrangement by which a banker allows his customer to barrow money up
to a certain limit. Cash credit arrangement are usually made against the security of
commodities Hypothecated or pledged with the bank.

Hypothecation:

In the case of hypothecation, possession of goods is not given to the bank. The goods remain
at the disposal and in the go down of the borrower. The bank is given access to goods
whenever it so desires. The borrower furnishes periodically return of stock with him to the
bank. Such as advances are by the bank only to a person in whose integrity it has full
confidence.

Pledge:

In the case of the pledge, the goods are placed in custody of the bank with its name on the go
down where they are stored. The borrower has no right to deal with them. Customer favors
hypothecation to pledge because the latter is considered to lower his prestige.

Overdrafts:

The customer may be allowed to overdraw his current account, with or without security if he
requires temporary accommodation. This arrangement, like the Cash credit, is advantageous
from the customer's point of view as he is required to pay interest on the actual amount used
by him. A cash credit differ from the overdraft in the that the former is used for long terms by
commercial, Industrial concerns doing regular business, while the latter is supposed to be a
form of bank credit to be made use of occasionally and for shorter durations.

Bills discounted and purchased:

The bank also gives advances to their customers by discounting their bills. The net amount
after deducting the amount of discount is credited to the account of the customer. The bank
may discount the bills with or without security from the debtor in addition to the personal
security of one or more parsons already liable on the bill.
 

Secured & Unsecured Advances:

Secured
Advances:                                                                                                              
                         1. An advance made on the security of tangible assets like goods, building,
stock-exchange securities etc.,
and                                                                                                                               2. The
market value of such security must not be less than the amount of loan at any time till the
loan is repaid.

Unsecured Advances: An unsecured loan or advance means a loan or advance not so

security.

In case of a secured loan, charge is created in favor of the bank in respect of certain
properties. In case of unsecured loan usually the banks obtain the guarantee of one or more
parties in addition to personal security of the debtor. Bank grants unsecured loans without
any guarantee i.e., clean advances to parties enjoying high reputation and sound financial
position. Through both in case of secured and unsecured advances, the bank emphasis on
credit worthiness of the borrower but in case of unsecured advances this is all the more. The
bank must carefully examine the three C's i.e, Character, Capacity & Capital.

Interest terms:

The banks were not free to fix their rates of interest. They were determined by the Reserve
Bank of India. As a matter of fact the bank lending rates were "Over the Bank Rate" (OBR).
In all banking documentation, the rate of interest of interest was quoted a linkage to OBR.
However, as a result of deregulation of interest rates, the banks are now allowed to fix their
own interest structure. After RBI fixes the floor rate, the bank fixes their Prime Lending Rate.
PLR is the minimum rate at which the bank would be prepared to lend to first class and A-
rated borrowers.

Interest Variation Clause in loan agreement:

The interest on advances is charged by bankers as per the schedule of interest rates prescribed
by the Reserve Bank of India from time to time the rates of interest are subject to change. In
order to overcome the difficulty experienced by the banks in implementing such interests, the
banker usually gets the following provision inserted in the loan agreements as regards interest
rates:

Provided that the interest payable by the borrower shall be subject to the interest rates
made by Reserve Bank of India from time to time.

The effect of such clause is that whenever the RBI revises the interest rates they are
automatically applicable.

 
No diversion of loan funds:

The borrower not to use the loan funds for the purposes other than those for which they were
sanctioned. This clause, thus, gives right to the banker to recall the advances in case it
apprehends that the borrower has violated or is violating this condition.

Recalling of Advances:

Recalling of advances sanctioned is the remedy of last resort. This may be done by a bank
under the following circumstances:

1. If the borrower fails to renew the documents sufficiently before the expiry of period
of limitation expires. The barrower/guarantor must renew the document
acknowledging the debt before the expiry of the limitation period in respect of the
concerned document.                                                           
2. If there is a material deterioration in the value of the security or the quantum of
turnover.                                                                                   
3. If the barrower fails to maintain adequate margin with the bank in spite of persistent
requests.                                                                          
4. If the borrower refused to lodge with the banker additional security to cover the
amount withdrawn in excess of the limit.                          
5. If the borrower is guilty of misconduct or fraud causing serious damage to his
credibility.                                                                             
6. If there is a change in the policy of bank, Reserve Bank of Government making
necessary the recalling of advance.

Term loans:

Term loans are also known as term/ project financial the primary sources of such loans are
financial institutions. Commercial banks also provide term finance in a limited way. The
financial institutions provide term finance in limited way. The financial institutions provide
project finance for new projects as also for expansion /diversification and modernization
where as the bulk of term loans extended by banks is in the form of working capital term loan
to finance the working capital gap. Through they are permitted to finance infrastructure
projects on a long-term basis, the quantum of such financing is marginal.

Features of term loans:

Maturity: The maturity period of term loans is typically longer in case of sanctions by
financial institutions in the range of 6-10 years in comparisons to 3-5 years of bank advances.
However, they are rescheduled to enable corporate/borrowers tide over temporary financial
exigencies.

Negotiated: The term loans negotiated loans between the borrowers and the lenders. They are
kin to private placement of debentures in contrast to their public offering to investors.
Security: All term loans are secured. While the assets financed by term loans serve as
primary security, all the other present and as well as future immovable properties of the
borrower constituted a general mortgage, interest liquidated damages and so on. They are
additionally secured by hypothitication of all movable properties subject to prior change in
favor of banks in respect of working capital advances.

Covenants:

To protect their interest, the financial institution reinforce the asset security stipulation with a
number of restrict terms and conditions. These are known as Convents. They are both
positive /affirmative and negative

Negative Covenants In the sense of what the borrower should not in the conduct of its
operations and fall broadly into four sets as respectively related to assets liabilities, cash
flows and control.

Assets-Related Covenants are intend to ensure the maintenance of a minimum asset base by
the borrowers. Included in this set of covenants are:

 Ø Maintenance of working capital position in terms of minimum current ratio.

 Ø Restriction on creation of further charge on asset.
 Ø Ban on sale of fixed assets without the lenders concurrence/approval.
 Ø Cash flow Related Covenants Which are intended to restrain cash outflows of the
borrowers, may include:
 Ø Restrictions on new projects/expansions without prior approval of the financial
institution
 Ø Limited on dividend payment certain amount and prior approval of the financial
institutions for declaration of higher amount
 Ø Arrangement to bring additional funds as unsecured loans/deposits to meet
overrun/shortfall
 Ø Ceiling of managerial salary and perks.

Positive covenants:

In addition to the foregoing covenants, certain positive covenants starting what the borrowing
firm should do during the term of a loan included in a loan agreement. They provide, inter
alia, for 

1) Furnishing of periodical financial statements.     

2) Maintenance of a minimum level of working Capital.       

3) Creation of sinking fund for redemption of debt. 

4) Maintenance of certain net worth.

 

Repayment Schedule / Loan Amortization:

The term loan has to be amortized according to predetermined schedule. The payment/
repayment has two components:

(i)                Interest     

(ii)             (ii) Repayment of principal.

The interest components of loan amortization are a legally enforceable by contractual

obligation. The barrower has to pay a commitment charge on the utilization amount. The
interest on term loans by the financial institutions, subject to minimum prime lending rate, is
risk-related and varies with the credit risk of the borrower.

Typically, the principal is repayable over 6-10 years period after an initial grace period of 1-2
years. Where as the mode of payment of term loans is equal semi-annual installments in case
of institutional borrowings, the term loans from banks are repayable in equal quarterly
installments. With this type of loan amortization pattern, the total debt-servicing burden
declines over time, the interest burden declining and principal repayment remaining constant.
In other words, common practice to amortize loan is repayable in equal installments and
payment of interest on the unpaid loans.

Important Considerations

While lending money the banker has to take into account various consideration. These
considerations relate to the bank itself, the borrower, and the proposal.

Parameters for the bank:

The bank while advancing money should look to its position regarding liquidity, safety and
profitability.

(i) Liquidity: since banks themselves heavily depend on borrowed funds, they spread their
investments in such a way that they are in a position to acquire cash with in a short period of
time. Their borrowings also come from deposits, which are usually not for a long period. The
banks, therefore, prefer granting of short-term loans to their customers.

(ii) Safety: The capacity of the banker to repay to its deposits depends upon its borrower's
repaying capacity. The banker has, therefore, to see the safety of the advances made by it.

(iii) Profitability: The banker earns its profits through advances and, therefore it cannot
ignore the considerations of profitability while making advances. However, the bank cannot
ignore the other two aspects too it has to see that the funds remain fairly liquid, safe and give
a reasonable return. In order to have a proper balance, the bank keeps in its investments
portfolio three types of investments: liquid, semi liquid, and income earning investments. It
has to maintain them in optimum proportions.

Customer credibility:

The banker while selecting his borrower should have clear appraisal about the three C's:
Character, Capacity& Capital

Character:

Character denotes integrity of the borrower i.e., he should have willingness to repay the
money borrowed.

Capacity:

Capacity denotes his ability to manage his business. The bank can judge it on the basis of
education background and the experience of the entrepreneur.

Capital:

Capital denotes his financial soundness. The borrower should have his own funds also. No
banker will take to lend money to a person who does not put money from his own resources.
However the banker should see that he does not lack any of them in a significant way.

Evaluation of proposal:

The bank should look to the following aspects regarding the proposal.

Purpose:

The purpose for which the money is being borrowed is gaining more importance on account
of increasing realization on the part of the banks about their social responsibility. The project,
which will help rural upliftment, import substitutions or equitable distribution of income, has
to be preferred in comparison to other projects. Similarly loan for productive purposes should
be given in priority to loan for unproductive purposes, such as for marriage or other religious
ceremonies.

Security:

Security is now considered to be a secondary consideration while advancing loans. However

these aspects cannot be completely over looked since it is a safeguard for unexpected defaults
in repayments by the borrower.

Sources of repayment:
The banker has also to see whether the project for which it is advancing loan will generate
necessary cash to repay the loan and the interest as per the agreed program.

Term: 

The term or the period for which the loan is required is also important banks cannot afford to
lockup their funds for long periods. They, therefore, prefer granting of short-term loans to
long-term loans.

Factor Limiting The Level of Advances

(i)                The type of deposits.                                                                  

(ii)    Credit control by Reserve Bank of India.

(ii)             Seasonal variations

(iii)           General business conditions.

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