1. Credit Management Chapter- 1 INTRODUCTION

2. Credit OpportunityCredit Creation Credit Management Credit Completion Credit Life Cycle Theory

3. 1.1 Introduction (Cancel) Credit is a double –edged sword. It can be helpful or harmful, depending on how it is used. Clients should consider how “planned” borrowing can enable them to achieve their prioritized financial objectives. They must weigh the benefits of acquiring the assets or item against the debt service costs and principal repayments. Once credit has been obtained, clients must managed credit effectively and ensure that the maintain their creditworthiness.

4. 1.2 Debt Capacity Debt capacity is the amount of debt that borrowers can reasonably repay under the terms of a loan agreement, given the their available cash flow. This capacity is based on the borrowers current financial situation and expected future earning potential. The borrowers obligation is to make future payment of both interest and principal to the lender. The lender is thus concerned with a borrowers ability to repay the loan over the full term. A borrowers' expected after tax income is the key determinant of debt capacity. After tax income must be sufficient to repay all loans after the accounting for the borrowers living cost and major capital expenses. A lender criteria for the debt capacity are effected by a borrower’s liquidity, solvency and risk of future income and asset value

5. 1.2.1.Borrower’s Liquidity and solvency Liquidity refers to a borrower’s ability to meet debt service payments in the short term. Solvency refers to a borrowers ability to pay all debts in the long term. Therefore lenders are concerned with a both a borrower’s liquidity and solvency. The borrowers has two sources of funds to pay off the loan-expected after tax income and current and future assets. All things being equal, the higher the borrowers expected after tax income and net worth, the higher his or her debt capacity.

6. 1.2.2.Variability of borrowers cash flow and asset values Lenders must assess the uncertainty of a borrower’s future income and asset values, since there is the risk that the borrower’s income will fail to provide for all debt payment. A borrowers cash inflow may vary due to changes in income sources, such as loss of employment, reduced pay, disability or failure of a small business. Future income may decrease due to the obsolescence of a borrower’s marketable scale. Further, variations in asset value may influence a borrowers ability to service the debt.

7. 1.2.3 Borrower’s Risk Tolerance As stated, a borrower’s debt capacity is effected by liquidity, solvency and the risk of variable income and asset value. However, these characteristics are difficult to assess and measure precisely. Therefore, there is no exact method to determine the optimal level of consumer debt. To a large extent, the amount of debt that clients will assume depends on their risk tolerance, net worth and budgeted spending. Clients should be comfortable with their level of debts, based on their liquidity, solvency, after-tax income, asset values and general financial situation.

8. 1.2.4 Projected Cash flow Statements One of most useful tools for the financial planner to assess a clients debt capacity is a projected cash flow statement for income and expenses. A project cash flow should include both a liquidity and solvency aspects of a clients debt for a entire period of the loan the clients must add the proposed debt payments to current expenses in order to determine if the projected cash flow is positive. The clients should also include all additional expenses and income received resulting from the use of the loan proceeds.

9. 1.2.5 Matching Assets and term of the loan “Matching” Involves selecting a loan term that corresponds to the underlying asset’s economic life. It is usually not advisable to take out a loan that is longer than the asset expected economic life. The decision to match the term of a loan with the asset depends on the clients projected cash flow, the outlook for the interest rates, the client’s risk tolerance for fluctuating rates and types of assets to be acquired. If the funds are borrowed on the short term basis, there is a risk that interest rate will increased and the loan may be more expensive.

10. 2. Obtaining credit Consumer credit is relatively easy to obtain in OMAN. Credit provides clients with assess to funds to purchase goods and service when their savings or cash flow are limited. Credit can also be used as a source of emergency funds to cover unforeseen expenses. However, obtaining credit is privilege extended by the lender – It is not the right of every client. Therefore client should used credit wisely and continue to demonstrate to potential lenders that they are creditworthy. Personal credit management includes obtaining credit, building and maintaining a sound credit record, managing credit effectively.

11. 3. Excessive Debt While credit is useful if managed effectively, it can a financial hazard if it is mismanaged. If borrowers have assumed more debt then they are able or willing to repay, it is based to voluntarily approach lenders. In many situations the borrowers can renegotiate the terms of the loan, since the lender want the borrowers to be in a position to repay the loan. A credit counselor can help an over indebted borrower set up a debt management plan and offer advice on strategies to reduce the borrower’s debt load. If borrowers are too heavily indebt and unable to work out a plan, there assets may be repossessed by creditors.

12. 4. Lender’s criteria “Five Cs of creditworthiness” (Cancel) Success is obtaining credit at a reasonable interest rate depends on how well borrowers present themselves financially to a lender. Clients are assessed on the information in a loan application as well as on their credit history. Following table -01 summarizes the “five Cs of creditworthiness” which lenders use for when assessing any credit application.

13. Character: Refers to the client’s intention to repay the loan Character is a key factor for lenders. The client’s honesty and reliability help the lender in determining trustworthiness and dependability. Factors contributing to the assessment of the client’s character include the existing level of debt, asset, employment record, residence stability, purpose of the loan, record of out standing judgments Capacity: Refers to the client’s ability to repay the loan Lender look at capacity to predict the clients ability to repay the loan, based on his/her current income, job stability, assets and future considerations. Credit : refers to client’s past credit history Lender take into account the client’s current use and availability to the existing credit. They also assess the client’s payment history delinquencies, etc. Lenders use this information to determine how debt may be handled in the future Collateral: Refers to the property that can be used to secure the loan Lenders may require collateral as security if the loan is substantial relative to the client’s net worth. If the loan is in default, the assets pledged as collateral are liquidated to provides for the repayment of the loan. Capital : Refers to the client’s net worth Lenders require assessment of the client’s total assets and general financial situation. Net worth is viewed as an extension of the client's character and as a source of collateral.

14. 5. Approach for safety of loans Safety of loans is directly related – To the basis on which decision to lend is taken – Type and quantum of credit to be provided – Terms and conditions of the loan Two-pronged approach – Pre-Sanction appraisal To determine the ‘bankability’ of each loan proposal – Post-Sanction control To ensure proper documentation, follow-up and supervision

15. 5.1 Pre-Sanction appraisal Concerned with measurement of risk of a loan proposal requirements are: Financial data of past and projected working results Detailed credit report is compiled on the borrower surety Market reports Final / audited accounts Income tax and other tax returns / assessments Confidential reports from other banks and financial institutions – Credit Report (CR) needs to be regularly updated Appraisal should reveal whether a loan proposal is a fair banking risk

16. 5.2 Post-Sanction appraisal Depends to large extent upon findings of pre-sanction appraisal – Requirements are: Documentation of the facility and ‘after care’ follow- up Supervision through monitoring of transactions in loan amount Scrutiny of periodical statements submitted by the borrower Physical inspection of securities and books of accounts of the borrower Periodical reviews etc.

17. 6. Loans and Advances Difference between Loans and Advances Loans are extended in accounts in which no drawings are permitted to the borrowers Generally there is one debit to principal amount to loan account – though disbursal in stages is possible depending on the need of the borrower For operational purposes loan can be credited to a special account where withdrawal from time to time can be done by the party depending upon his requirements In case of advances, the sanctioned limit is placed at the disposal of the borrower, subject to terms of sanction, in running accounts which can be drawn upon by cheques by the borrower

18. 7. Securities for lending 1.Primary Security: A. Personal : Created by a duly executed promissory note, acceptance or endorsement of bill of exchange etc. Gives bank the right of action to proceed against the borrower personally in the event of default B. Impersonal : Created by way of a charge (pledge, hypothecation, mortgage, assignment etc.) 2. Collateral Security : Meaning running parallel or together Taken as additional and separate security Could be secured / unsecured guarantees, pledge of shares and other securities, deposits of title deeds etc. Used to reinforce the primary security (for e.g. plantation advances are not considered fully secured until crop is harvested)

19. 8. Preconditions of loans Willingness or intention to repay as per agreement – Relatively easier to assess – Determined by good track record of payments and debt servicing – Uncertain / uncontrollable events could affect the judgment Purpose for which loan is sought – Should be documented carefully Type of loan applied for - Working capital loan, term loan, personal loan etc. Conditions which can set the trend of future

20. 9. Tools for determining future trends (Cancel) Financial Analysis – past and projected Credit rating Assessment of credit needs Terms of sanction Documentation and creation of security interest Post-lending supervision – 3 stages – Regular surprise verification of security – Stock audit – Obtaining and scrutiny of control statement (stock statements, financial statements) Repayment and / or rollover

21. 10. Credit Risk Defines credit risk as: – The possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality.

22. 11. Credit Risk Management The following are the forms of credit risk: Non-repayment of the principal of the loan and/or the interest on it. Contingent liabilities like letters of credit/guarantees issued by the bank on behalf of the client and upon crystallization amount not deposited by the customer In the case of treasury operations, default by the counter-parties in meeting the obligations. In the case of securities trading, settlement not taking place when it is due. In the case of cross-border obligations, any default arising from the flow of foreign exchange and/or due to restrictions imposed on remittances out of the country

23. 12. Policy Framework Strategy and Policy : Credit policies and procedures of banks should necessarily have the following elements: Written policies defining target markets, risk acceptance criteria, credit approval authority, credit origination and maintenance procedures and guidelines for portfolio management and remedial management Systems to manage problem loans to ensure appropriate restructuring schemes A conservative policy for the provisioning of non- performing advances should be followed Consistent approach towards early problem recognition, classification of problem exposures, and remedial action

24. Policy Framework (Cancel) Organizational Structure – Banks should have an independent group responsible for the CRM. Responsibilities to include formulation of credit policies, procedures and controls extending to all of its credit risk arising from corporate banking, treasury, credit cards, personal banking, trade finance, securities processing, payments and settlement systems. – Board of Directors should have the overall responsibility for management of risks. – The Board should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks – Risk Management Committee will be a Board level Sub committee including CEO and heads of Credit, Market and Operational Risk Management Committees. It will devise the policy and strategy for integrated risk management containing various risk exposures of the bank including the credit risk

25. 13. Loan Review Mechanism / Credit Audit Credit audit examines the compliance with extant sanction and post-sanction processes and procedures laid down by the bank from time to time The objectives of credit audit are: – Improvement in the quality of credit portfolio – Review of sanction process and compliance status of large loans – Feedback on regulatory compliance – Independent review of credit risk assessment – Pick-up of early warning signals and suggest remedial measures, and – Recommend corrective actions to improve credit quality, credit administration, and credit skills of staff

26. 14.Components of Credit Risk Default Risk – Risk that a borrower or counterparty is unable to meet its commitment Portfolio Risk – Risk which arises from the composition / concentration of bank’s exposure to various sectors Two factors affect credit risk – Internal Factors – Bank specific – External factors – State of economy, size of fiscal deficit etc.

27. Managing Internal Factors Adopting proactive loan policy Good quality credit analysis Loan monitoring Sound credit culture Managing External Factors Well diversified loan portfolio Scientific credit appraisal for assessing financial and commercial viability of loan proposal Norms for single and group borrowers Norms for sectoral deployment of funds Strong monitoring and internal control systems Delegation and accountability

28. Credit Risk Management as per RBI (cancel) Measurement of risk through credit scoring Quantifying risk through estimating loan losses Risk pricing – Prime lending rate which also accounts for risk Risk control through effective Loan Review Mechanism and Portfolio Management