Lending Book

Lending:

Products,

Operations and

Risk Management

Stage 2

Table of Contents

Parti:

Lending - A core banking practice/function 1

Part 2:

Lending Products 6

Part 3:

Lending Risk Assessment and Management 35

a. Overview and Sources of Lending Risks 37

b. Risk Assessment & Risk Management 47

c. Ratio Analysis & Assessing Customer Needs 71

d. Credit Risk Practice for Business and Commercial Banks 117

e. Credit Risk Practice for Retail Banking 185

f. Business Lending - When Things Go Wrong 208

Part 4:

Collateral and Documentation 214 Part 5:

Management of Credit -1 289

Management of Credit - II 293

Part 6:

Past Due Accounts/Over Due Accounts - Business Lending 303

Past Due Accounts/Over Due Accounts - Consumer Lending 310

Appendices/ Additional Reading Material

iftnq Products, Operations and Risk Management | Reference Book 1 1

Part One

Student Learning

Outcomes

Introduction

Lending - A core banking function

By the end of this chapter you should be able to:

State the role of bankers as lenders

State the importance of building a disciplined lending culture

State the importance of cash flow lending as opposed to security-based lending

Lending: Products, Operations and Risk Management | Reference Book 1

Lending in Perspective Historical sources reveal that existence of bank predates the use of money. The nature of deposits and loans were therefore in form of goods and commodities but the essence and principle was the same. The first record of such activity dates back to 2000 BC in Babylonia.

1

The modern day definition of a bank as per Britannica is:

An institution that deals in money and its substitutes and provides other financial services. Banks accept deposits and make loans and derive a profit from the difference in the interest rates paid and charged, respectively.

A difference in modern day banking from the ancient banking practices is that the sequence of the basic functions of the banks today is to take deposits and give out loans. This sequence was not necessarily followed in ancient times. Most importantly in earlier times loans were based out of savings.

2

Some differences between ancient and modern-day banking which have an impact on lending

The modem day banking has undergone massive changes in its basis of operations over the last 7 centuries to arrive at the structure and form that we see today. Lending remains a core function of banks as well as its most profitable product. Product types and variations have, however come into existence and most importantly the basis of the credit creation, as it is termed today, is vastly different.

Banks Create Money

Todays banks create money in the economy by making loans and investments. The amount of money that banks can lend is directly affected by the reserve requirement

1 of the Central Bank. In this way, money that

grows and flows throughout the economy in a much greater amount than it physically exists. For example a bank gets a deposit of PKR 1 million from Customer X. If the reserve requirement is 20% the bank is able to make a loan out of PKR 800,000. The bank lends the PKR 800,000 to Customer Y who uses the loan to buy a car and gives the money to Company A as payment. Company A in turn deposits the money in the bank and the bank based on Company As deposit can make out a loan of PKR 640,000 to its customer. This is an over-simplified example of how the banks create money and the money multiplier effect. You are encouraged to independently read more about this topic as it is of utmost importance in todays banking world. This ability to create money and thus be responsible for the increased money supply through creation of credit in the economy to the extent that the banks are able to do today is something that ancient bankers did not have to fret about. Banks today are able to lend several times its total capitalization which puts on them a much greater responsibility of understanding the credit they are creating and its recovery cycle.

1 Source: Davies, G. (1994) A History of Money from Ancient Times to the Present

Day, Cardiff, UK, University of Wales Press

2 Source: Dr. Frank Shostak (2011), The Importance of Real Lending, Cobden

Center-http://www.cobdencentre.org/

1 Reserve Requirement-This is imposed by the Central Bank of the country on all

banks in terms of what percentage of the deposits can the bank lend out as loans. In Pakistan the State Bank has a Cash Reserve Requirement (CRR) which ha s in the past varied between 4% to 7% and i Statutory Liquidity Requirement (SLR) which in the past has varied between 10% to 15%.

Lending: Products, Operations and Risk Management | Reference Book 1 3

Banks act as intermediary between depositors and borrowers

Banks facilitate the flow of funding by acting as an intermediary between

depositors and loan-seekers. Earlier the function was to act as an

intermediary between savers and borrowers. The difference is that when a

saver lends money, what he in fact is lending to the borrower are the

goods/services that he has not consumed. Credit then becomes a chain of

unconsumed goods/services lent to the borrower to be repaid out of future

production of the borrower. However, today the banks deposits do not necessarily consists of savers and lending decisions are thus more critical

because if the banks create credit without understanding how the credit will

generate the goods/services for the repayment of the credit, it will be creating

loss-making loans which may default either immediately or with a time-lag.

This time-lag has been also referred to as the credit bubble, in recent times.

Banks today thus play a much wider and a very critical role as they provide

liquidity and steady flow of credit in the economy which fuels growth and

stability.

Role of Banks as Lenders

Lending is a primary business function of banks. The banks make a profit by

accepting deposits at a rate of return and making out loans at a higher rate of

return than the deposits. The difference in the rate covers the administrative

cost as well as compensates them for the risk associated with lending.

Lending is a risky and perhaps the most profitable product of the banking

business and banks have over time tuned and fine-tuned lending policies,

practices and procedures to minimize risks and employ the principle of

prudence in lending decisions.

As lenders, banks have a very important role to play in the economic growth

of the country. Loans made to support activities which will generate income

above and beyond the amount to repay and service that loan are generally

viewed as loans which are beneficial for the economy and the country. The

banks over the past century however have developed a narrower view. Their

agenda is limited to making loans which will be serviced and repaid. Banks

have due to this been subject to criticisms from many who blame it for giving

rise to the increased consumerism.

Banks lending decisions have a far-reaching and a deep impact on the

economy. Any single loan that is made by the bank has a multiplier effect

thus banks need to be adequately aware of who they are lending to and what

the borrowers purpose for the loan is. An inadequate or irrelevant purpose

can channel funding in a direction that may be detrimental to economic

growth. Similarly the inability of the borrower to repay the loan either due to

lack of funds or intent can also cause a series of negative effects which will

have consequences that impact more than just the lending bank.


Banks role of financial intermediary in the economy is critical. Financial

intermediation takes place when banks as licensed deposit-takers take

deposits from public i.e. individuals, businesses and institutions and lend to

borrowers in the system. In most emerging economies, commercial banks

remain the major lenders to individuals, businesses and government. The

banks motive for financial intermediation is the margin between the cost of

funds and the markup for loans. For this return banks incur risk of the credit

they extend to the borrower. Given that the major source of funds are public

money, banks need to ensure that extreme discipline and caution are

exercised when lending money and taking other credit- related exposure.

Importance of Building a Disciplined Lending Culture

The effects and impact of lending have been briefly touched upon earlier.

The gravity is nonetheless not lessened by the limited attention that we have

paid to it in this chapter. Banks lending decisions are revered in the

economy as bank lending is a key economic indicator for a specific sector or

industry. If banks are willing to lend their money to a person or a company

or a sector/industry, it reflects the banks confidence in the borrowers

purpose of loan, ability to repay and intent to repay. Lending decisions are

thus of paramount importance as they are used as key market signals by

other players in the economy such as investors, suppliers, customers etc.

Moreover as banks deal with public monies, the effects of incorrect lending

decisions are far-reaching and can be devastating as witnessed in the recent

global financial crisis of 2007/8.

It is thus imperative to build a lending culture which is prudent and cautious.

Lending cultures driven by unrealistic or aggressive sales targets have

known to fail in the recent past with degenerating effects to the banks in

question.

Importance of Cash Flow- based and Security- based Lending

Each loan that a bank makes creates a ripple of liquidity. Each loan requires

scrutiny and consideration. The fundamental principle to be followed should

be that the loan be employed in a manner that it will generate an income

above and beyond the level which is required to service the loan and repay

the principal. Lenders thus need to assess the purpose of the loan, its

repayment capacity, character and reputation or name of the borrower and

in the instance the borrower is unable to pay the loan, how can the lenders

safeguard their interest.

Security Based Lending: Name Lending and Collateral-based Lending

Banks driven by self-interest also exercise a great deal of caution and

scrutiny before advancing a loan. There are different types of loan products

that are available and different methods of scrutiny and risk assessment

employed which will be discussed in the articles that follow.

What is of importance here is how lenders risk management and

containment methods have evolved over time. Mutual trust has been one of

the basic and fundamental variables. The trust between the borrower and the

lender reflects the lenders comfort that the borrower will timely repay and

service the loan and the borrowers comfort that the lender will not

overcharge him on the interest rate. In previous


times lenders would limit their operations to people they knew either

personally or within their own wider network (also known as name lending

in recent times). However, as economies have expanded and enterprises

have sprung which are diverse in industry and geography, lenders have had

to expand operations beyond their limited circle. At this stage the lenders

started employing a structured due diligence process and getting to know

about the customer and its business operations and/or sources of funding and

for additional comfort and security demanded collateral. Strong collateral

(high in value and easy to liquidate) meant that even if the borrowers ability

to repay was questionable, the loan would still be good as funds could be

recovered from the sale of the collateral. This phenomenon brought with it a

new set of concerns relating to the title of the collateral and in case of

default by the borrower, would the lender have the legal right to dispose of

the asset that the borrower has given to the lender as collateral. Different

countries have different legal systems and practices. The article on

Collateral will discuss the different types of collateral and the rights of

lenders and borrowers in detail; suffice to mention here that taking collateral

against a loan advanced has been a practice for centuries.

Cash Flow Based Lending: Purpose and Capacity-based Lending

Lenders in the recent times have however expanded their focus on the

purpose of the loan and the repayment capacity with reference to the purpose

of the loan. While having good quality collateral is highly recommended,

banks are in the business of borrowing and lending money and not

liquidating collateral. Liquidating collateral is a lengthy and cumbersome

exercise and not the banks core business function. Banks have thus realized

that lending decisions which are transaction- specific and evaluate the

capacity of the borrower based on the cashflow from the

transaction/project/activity that is being financed are sounder than the ones

which only consider the collateral and the borrower name. This in no way

stops the lender from requiring good quality collateral or considering the

borrower name. Analyzing the cash-flow and repayment capacity however

is being given as much consideration when making the lending decision.

Authored By: Shahnoor Meghani


Part Two Lending Products

Student Learning By the end of this chapter you should be able to: Outcomes

1. Categories of Borrowers

* Describe the types of lending products available to business

borrowers

Differentiate between short term and long term lending

Differentiate between funded and non-funded facilities

* Describe various types of long term lending facilities available

to business borrowers

Describe the characteristics of an individual borrower and explain how they differ from business borrowers

Describe the types of products available to individual customers

Explain the purpose of individual/consumer borrowing and classify loans under^onsumer lending

2. Regulations and Practices

Recall the SBP laws relevant to decide the lending limits for both business and consumer borrowers

* State the lending exposure limits as per SBP regulations

State regulations concerning lending disclosure and reporting requirements for consumer lending

State regulations concerning lending disclosure and reporting requirements for business lending

Define credit policy, target markets and risk assessment criteria and discuss their importance in lending decisions

State prudential regulations concerning the business /commercial lending operations

State the minimum requirements for consumer financing as per the prudential regulations

State the general SBP Prudential regulations concerning consumer lending


3. Pricing

* Recall the various types of pricing mechanisms available across the industry

Explain the industry-wide methodology used for calculation of pool rates

Explain internal cost of funds and discuss how it is determined

Explain the process of developing a pricing model based on floating mark up rate

Discuss the pros and cons of using a floating mark up rate as compared to using fixed rate

Explain 'risk based' and 'relationship yield' pricing models

Explain the concept of opportunity cost, risk reward pricing and re-pricing intervals

Categories of Borrowers

As discussed in the previous chapter, banks as lenders need to inculcate a

disciplined lending environment to avoid making lending mistakes. Before a

loan is made the lending bank should ask the following questions:

a. Who is the potential borrower?

b. Does the potential borrower meet banks target market

definition and risk acceptance terms?

c. What is the purpose of borrowing/borrowing cause?

d. Does the borrowers business/income generate sufficient cash

within a reasonable time period to repay interest and principal?

e. What would be my way out if the cash flows are not sufficient to

ensure repayments of loan?

The list above is not exhaustive and in the next few chapters we will address

these issues in detail. It is important to have awareness of these fundamental

questions as they are key to determining the credit requirement of the

businesses and the repayment capacity. A banks credit customers can be divided in to two broad categories:

a. Business Borrowers b. Individual/Consumer Borrowers

The purpose of borrowing and source of repayment is distinct for each

category and based on this the lending products offered by the bank to each

segment are different. The State Bank of Pakistan does not allow banks to

offer any lending product without collateral or security to business borrowers

above PKR 2 million and up to a certain amount for individual borrowers.

The clean lending limit for individual borrowers is PKR 2 million at present,

but is subject to change. Please refer to the SBP website for up-to-date

information.

A. Business Borrowers

Businesses frequently are in need of funds to either bridge the temporary

liquidity gaps in the operating cycle or to supplement their long-term


financing needs for capital expenditures. Some businesses also take on debt

which could be in the form of credit from banks to manage their balance

sheets more objectively. Businesses also seek bank support to meet their

non-cash needs such as opening Letters of Credit, and extending financial or

other form of guarantees on their behalf.

Business borrowers repay the principal and interest from cash flows

generated through business operations. Banks generally look at the historic

trend of the businesss financial statements to gauge the sales growth, cash

cycle, stability of orders, productivity of assets, leverage etc to forecast the

future trends for the business based on which a part of the lending decision

relies upon.


Non-

Funded

Facilities

Lending Products for Business Borrowers:

Lending products for business borrowers can be mainly divided by the nature of

the facility i.e. is it fund-based; this would entail the bank providing the

customer with access to the funds; or non-fund based in which case the bank

would assume the liability of payment on account of the customer to a 3rd party.

Within each category there are several different sub-divisions based on the tenor

and terms. Diagram 2.1 below is a good illustration of the lending products

available for business borrowers, at a glance. Diagram 2.1

Lending Products for Business Borrowers

Demand I Discounting I Export I Import

Finance I I Finance I Finance

Details of lending products available for businesses in Pakistan

within each sub-heading and their brief description are as follows:

1. FUNDED FACILITIES:

a. SHORT TERM FINANCING PRODUCTS

i. Running Finance/Overdraft An overdraft generally known as RF in Pakistan is a type of lending

which offers a high degree of flexibility. For a bank, the overdraft is a

staple product by means of which the customer may overdraw their

current account balance, that is, draw out more from the account than

the total amount of money standing in the account. The customer is

permitted to overdraw the account up to an agreed limit (the overdraft

limit). When an account is overdrawn, the customer is borrowing and

owes the bank money. An overdraft is normally shown on the

customers bank statement by the abbreviation DR (meaning debtor) after the balance on the account.

Overdrafts are only available on current accounts, the accounts through

which businesses pass their income and expenditure. Although

overdrafts are repayable to the bank on demand, they are normally

agreed subject to annual review.

Funded Facilities

Short-term Facilities-Payable

within 1 year ej Long-term S

Facilities $ Payable

after 1

1 vear


Interest/mark-up on an overdraft is only charged on the day-to-day balance

outstanding on the account. Thus, if the current account fluctuates from a

credit balance (funds in the account) to a borrowing position (using the

overdraft), the customer only pays interest when the account is in the red/debit - what the customer is actually borrowing on that day.

The overdraft is a convenient way of borrowing to cover a businesss short term requirements. It is only appropriate for short term temporary borrowing

which is drawn down and then repaid and drawn and repaid again during the

working capital (or trading) cycle.

The overdraft provides finance to cover a businesss working capital needs (the finance needed through the operating cycle) and help iron out the

fluctuations in its cash flow as bills are paid before funds are received from

sales income. A large inflow of funds one week will reduce the interest

payable while the firm retains the ability to borrow again next week. For

business customers the overdraft is often the cheapest and most convenient

means of borrowing.

An account with an overdraft facility should show wide fluctuations. For

instance, when the customer buys stock, the balance of the account would

swing into overdraft and once the stock is sold and sales income received,

the account should swing back into credit. When an account remains in debit

permanently, with low turnover this is referred to as hard core borrowing. It

is best to identify the hard core borrowing element of a business and

understand the underlying reason to best meet the businesss credit requirement soundly. If the run of the account shows that the account is

perpetually in debt, the debt is becoming hard core. It may indicate that things are not going according to plan. This could be due to several reasons.

Perhaps the customer is not collecting cash from debtors quickly enough, or

the business may be making losses or the business is financing its long-term

needs with short-term financing.

ii. Demand Finance

Demand finance generally known as LM in Pakistan is similar to running

finance in many aspects except that the tenor of the demand finance is fixed.

For example a business may have a requirement for short-term financing for

PKR 500,000 and it may know that this requirement is for a specific period

e.g. 2 months. The business can then ask the bank for a loan of PKR 500,000

for 2 months. The interest rate for the loan will be booked on the date of the

booking of the loan for the period of the loan. The LM must be paid at the

expiration of the term. In rare cases it may be rolled-over or extended,

however it is generally preferred by banks not to have a rolling LM to

ensure that the business has access to funds to pay off the loan and the debt

is not becoming hard core.

iii. Export Finance

Export finance is similar to demand finance. In Pakistan, the State Bank of

Pakistan (SBP) to incentivize exporters has in place special financing

schemes whereby exporters can access pre- shipment financing facilities as

well as post-shipment financing facilities. These facilities are available

through the State Bank funded

Undng: Products, Operations and Risk Management | Reference Book 1 11

schemes via the banks or through banks own sources. The facilities

available at present are:

1. Pre-Shipment Financing-Part l(Fundecf through banks own

sources).

2. Pre-Shipment Financing-Part 1 (Funded through SBP refinance scheme).

3. Pre-Shipment Finance-Part 2 (Funded through SBP refinance Scheme).

4. Post-Shipment: Discounting/ Purchase of export Bills (Funded through banks own sources).

5. Post-Shipment: Discounting / Purchase of Export Bills (Funded through SBP refinance Scheme).

6. Bill Discounting/Receivable Financing.

All these facilities are tenor-bound and generally do not allow roll -over.

Detailed information on this can be sought from the SBP website.

iv. Import Finance

Import finance is generally available in terms of import loans or

financing against trust receipts (FATR) generally in case of a Letter of

Credit based transaction. Under this facility, the Bank provides the

documents of title of goods imported under L/C, to the customer to

enable the customer to obtain goods prior to payment and to sell them to

generate funds to pay-off the bank. The goods represented thereby and

the sale proceeds thereof in trust for the bank. Since this is a fund-based

facility as opposed to a non-funded facility (as in the case of L/Cs), due

care and diligence needs to be exercised when extending this facility.

Import finance can be further classified into the following:

1. Finance Against Trust Receipt (FATR)

FATRs are related to import transactions. The bank may allow specific

customers FATR facility against collection documents as per the terms

set out from time to time, which are discussed as follows:

a. FATRs in respect of L/C documents -

Under this facility, the Bank delivers the documents of the title to

goods imported under L/C, to the customer. This enables the

customer to get the goods prior to payment. The customer

undertakes to hold the documents in lieu of a Trust Receipt. There

are very obvious risks in permitting a customer to deal with goods in

this way. A customer having in his custody, goods released to him

against a trust receipt can fraudulently sell them or pledge them to a

third party, leaving the holder of the trust receipt i.e. the bank only

the right to sue for breach of trust. FATR facilities should therefore

are granted to undoubted importers against established credit lines.

It is important to note that the goods released under a trust receipt

must be fully insured by the customer and the Bank reserves the

right to inspect, repossess and if necessary, dispose of the goods at

anytime.


b. FATRs in respect of collection documents -

FATRs in respect of collection documents are only granted when routed

through the Bank's branches. This facility is restricted to selected customers

with satisfactory account relationship and is governed by the following

safeguards:

Facility to be allowed with prior clearance and only provided to

prime customers with low risk ratings.

Branches should be satisfied that the collection bills have genuine

underlying trade transactions.

Branches are also required to ensure that the facility is used for

the customer's regular line of business.

The facility should be given as a separate FATR line under the

import line (i.e. FATR for collection documents) distinct from

FATR sub-limit under import (L/C) line.

Finance Against Imported Merchandise (FIM)

This facility is allowed against the commodities imported from other

countries usually through letter of credit. At times the importer does not

have enough money to pay for the imported merchandise. He therefore

requests the bank to pay the dues to the exporter against the security of

imported merchandise. This facility is usually allowed against imported

goods but occasionally such financing may be allowed against locally

manufactured goods covered under L/Cs or received for collection.

b. LONG TERM FINANCING PRODUCTS / TERM LENDING

Term loans are usually granted over a period of years to assist business

customers in buying assets such as plant and equipment, and buildings. A

term loan spreads the cost of the asset over its expected life. The repayments

can be tailored to suit the cash flow of the business, usually either monthly,

quarterly, half-yearly or annually.

A term loan is a loan for a fixed amount, for an agreed period, and on

specific terms and conditions. Normally such loans are for terms of between

three and seven years, although they can range up to twenty years. Longer

periods depend on the nature of the proposal, the robustness of the

performance of the company and its projections, and the security to be

granted.

Term loans are generally used for longer term asset purchases as these are

not suitable for financing under an overdraft facility, which should be used

for working capital purposes. The terms and conditions under which they are

granted includes interest and other costs, repayment, security and the

covenants applicable. The terms and conditions of the loan are set out in a

loan agreement which includes:


Tenon the term over which the loan is to be repaid

Repayment Schedule: the intervals at which the principal and

interest are due for payment.

Pricing: the mark-up rate that will be charged.

Collateral: the security to be granted.

Loan Covenants: conditions to be complied with by the customer,

such as the timely provision of accounting information, stock

report, share price in case of a listed company, leverage ratio etc.

Event of Default: events which would render the loan immediately

due for repayment such as the customer failing to meet a repayment

installment on time or the loan being used for a different purpose

from than agreed.

Some banks ask for requirements like establishment of Sinking

Fund and utilization of working capital facilitated through its

counters.

Provided the customer complies with the conditions detailed in the loan

agreement, the bank generally cannot demand repayment of a term loan.

Generally, the longer a loan is outstanding, the greater is the risk of default.

2. NON-FUNDEO FACILITIES:

a. Letters of Credit (L/C) In trade transactions where buyers and sellers are geographically

separated, banks play a crucial role in managing the payments. A letter

of credit is generally established by a bank on behalf of its customer (the

buyer/importer) guaranteeing to the sellers (exporters) bank that the bank will make the payment to the seller on time if seller performs as

per terms and conditions of the letter of credit.

L/C can be irrevocable or revocable. An irrevocable L/C cannot be

changed unless both buyer and seller agree. With a revocable L/C,

changes can be made without the consent of the beneficiary. While

dealing in L/Cs, the bank in question does not lend funds directly but

may have to pay in the instance the customer is unable to pay. L/Cs are

thus called contingent liabilities for banks.

There are two type of L/Cs:

I. Sight: is where payment is due to the seller at the time of receipt of

goods by the buyer. Sight L/C requires the importer / importing

bank to pay as soon as it receives the clean documents from

exporter.

Sight L/Cs are letters of credit where the bank engages to honor the

beneficiary's sight draft upon presentation, provided that the

documents are in accordance with the


conditions of the L/C. Drafts drawn at sight simply serve as receipts

for payments and are of no value for any other purpose. In

establishing sight L/Cs branches should ensure that goods are duly

insured and that the Bank retains control over the goods at all times.

Documents of title to the goods is released only against payment,

either by cash or to the debit of the customer's current account /

FATR account / FIM account. L/C, generally as a practice, is not

opened for a period in excess of 180 days without prior approval

from the risk chain / competent authorities.

II. Usance: is where payment is due after certain, pre-agreed number

of days by the buyer. The seller in this instance is providing credit

to the buyer. Usance L/Cs are similar to sight L/Cs but call for a

time or usance draft payable after a specified period of time. The

normal usance period allowed for this facility is 90 days. However,

it can be a maximum of 180 days. Exceptionally for undoubted

customers, usance period exceeding 180 days may also be allowed

with specific approvals from the risk chain / competent authorities.

b. Guarantees/Stand-by Letters of Credit

Business customers sometimes require the bank to issue a letter of guarantee on their behalf. This is generally required by the party that the customer is entering into business with. It can be regarding delivery of

goods and services by the customer to the party i.e. the party requires a guarantee that the customer will provide the goods or services agreed failing which the party will call upon the letter of guarantee. It can also be if the customer is the purchaser of goods or services from the party and if the customer does not purchase the goods from the party based on the terms and agreements or defaults on the payment, the party can call upon the guarantee and demand the bank to pay.

The bank in this instance as well, does not lend funds directly but may have to pay in the instance the customer does not perform his obligations or defaults.

These facilities cover a number of specific types of guarantees that the Bank may issue for its customers but in all cases the common factors are:

The Bank substitutes its own credit standing for that of its customer.

No actual movement of funds takes place at the time of issuing the guarantee, although there is a clear commitment by the Bank to effect payment when called upon to do so under the terms of the particular guarantee. Thus it is necessary to record these commitments as contingent liabilities.

The Bank charges a commission for this service usually quoted on a quarterly basis.

Guarantees fall into many different categories, each of which has its own characteristics and related risks; some of the important characteristics and the appropriate precautionary measures are enumerated in the following relevant sections overleaf.


a. Shipping Guarantees (SG)

Guarantees of this nature are required to enable customers to release

goods before the arrival of the documents of title; they therefore render

the Bank liable to the shipping company to whom the guarantee has

been issued. Shipping company is, in turn liable to the true owners of

the goods in the event the goods are released wrongfully. It follows

therefore that such guarantees should be issued to importers with a

credit line. Full cash margin is generally taken for shipping guarantees

issued against Shipping L/C, unless waived by appropriate credit/risk

authority.

b. Bid Bonds (BB)

The purpose of a bid bond is to substantiate the ability of a person

submitting the tender to perform the contract when awarded. Such a

bond is issued in connection with a tender and its normal characteristic

is an undertaking by the Bank on behalf of the applicant to pay the

beneficiary a fixed amount within a stipulated period on his simple

written demand if the applicant withdraws his obligation after the

acceptance of his tender. A bid bond must not contain any conditions

linking it with performance of a contract if awarded and must contain a

definite expiry date. If branches are asked to give such undertakings the

guarantees must be treated as Performance Bonds. If there is any

ambiguity in the terms of a bid bond which a branch is asked to sign it

should study the basic "conditions of tender" to ascertain its precise

liability. Branches must insist on the return of the original bid bond after

its expiry.

c. Advance Payment Guarantees (APG)

Civil engineering contracts, particularly those awarded by local

governments, sometimes provide for an advance payment to be made to

the contractor for purposes such as mobilizing site, plant and equipment.

In order to obtain this payment the contractor is required to produce an

Advance Payment Guarantee.

d. Financial Guarantees (FG)

Financial Guarantee is a general description of various guarantees

whose main characteristic is an undertaking to meet any claim from the

beneficiary up to a fixed sum on simple demand. Claims under such

guarantees must not be made contingent on the non -fulfillment of the

terms of contracts, which are unknown to the issuer. Unless the

creditworthiness of the concerned customer is undoubted, such

guarantees are issued against full cash margin.

B. Individual Borrowers

Individuals also frequently are in need of funds to pay for expenses or

purchase of assets, which they cannot afford to pay for in cash at the present

time. Situations that typically require borrowing include buying a house or a

car or consumer durables such as refrigerator, television, computer etc or

paying for education or medical expenses or wedding expenses etc. The

individuals borrowing needs are driven by his/her discretionary spending,

lifestyle and stage of life cycle.

Individual borrowers primarily repay the principal and interest from


a.

b.

Assets-based/secured

Auto/Vehicle I House

Finance I Finance

their income which could be self-generated. If the borrower owns a business or in the form of salary, profit from business ventures, investment income, pension, endowment/trust fund etc. Banks generally look at the historic trend of the individuals income, stability of cash flows, expense burden on the individuals income etc to gauge the individuals ability to sustain the loan and its cost.

Lending Products for Individual Borrowers Lending products for individual borrowers can be mainly divided by the

nature of the facility:

asset-based which would entail the bank providing the customer

with access to the funds for purchasing an asset- (long term or short term)

and the title of the assets generally resides with the bank or

clean lending where the bank lends to the individual without any

underlying asset.

Diagram 2.2 below provides a good illustration of the lending

products available for individual borrowers, at a glance.

Diagram 2.2

Lending Products for Individuals

Details of the products available for individuals in Pakistan within each sub-

heading are as follows:

A. ASSET-BASED: 1. Long-term Facility

i. Auto/Vehicle Finance In Pakistan auto finance has been a popular product available for

individuals. This product is available through two different modes: Hire

Purchase and Leasing, which are discussed briefly as under. While in

this chapter we are discussing this mode under lending

Clean/ Unsecured

Personal Loan

Running Finance

Credit '

Cards

PsdKts, Operations and Risk Management | Reference Book 1 17

an

for

mg

A direct lease is where the business or the individual advises the

leasing company of the asset which it wishes to acquire and the lessor

then buys it from the manufacturer (if new) or the previous owner (if

used) in order that it can be rented back.

products for individuals, hire purchase and leasing are applicable modes

of financing for businesses as well.

a. Hire purchase Hire purchase is an agreement to hire an asset with an option to

purchase. The legal title passes to the customer when final payment has

been made. The term of the finance is required to be shorter than the

expected life of the asset.

The bank actually buys the vehicle which then belongs to it, letting the

customer use the vehicle in return for a series of regular payments. The

vehicle can be of any form. The bank has the security of ownership of

the asset and can repossess it if the hire purchase terms are broken.

After all the payments have been made, the customer becomes the

owner, either automatically or on payment of a modest fee.

The main advantages for the customer of a hire purchase agreement

are:

Small initial outlay.

Easy to arrange.

Certainty - the loan cannot be called in providing the terms are

kept.

Tax relief - interest payments are tax deductible and the asset

may also be subject to a write-down allowance for businesses.

The disadvantages are that it is more expensive than a cash

purchase and the fixed term means it may not be possible or

expensive to make early termination.

b. Leasing Leasing is similar to hire purchase in that a vehicle or equipment owner

(the lessor) gives the right to use the equipment to the user (the lessee

i.e. the customer) over a period in return for rental payments. The

essential difference is that the lessee never becomes the owner unless

under capital lease.

For business borrowers, purchase of machinery and equipment can tie

up a lot of business finances, but leasing effectively provides access to

the asset without buying it up front.

The numerous types of leasing are fundamentally rental agreements

providing the business or individuals (the lessee) with the use of an

asset owned by the bank (the lessor) for a specified period of time

subject to agreed payments (rental payments). Almost any equipment

in any price range can be leased.


Sale and leaseback (sometimes referred to as purchase leaseback) is

where the business or individual sells an asset which they already own

to the finance company and then lease it back. (Sale and leaseback is

quite common with property - the property being sold to an investor

who leases it back.)

In both cases, the asset requires to be returned to the lessor at the end of

the agreed period. Many leases have an end-of -lease option providing

renewal at a minimal cost or sale to a third party.

Leasing can be useful when other sources of finance are not available.

There are also tax advantages; for example, rental payments under an

operating lease are tax deductible, as is interest under a finance lease.

The depreciation charge in the companys accounts for a finance lease is

tax allowable, dependent on the method of depreciation used

There are two main types of leases:

Operating lease

This type commits the lessee to only a short term contract that

can be terminated on notice. Usually the lessor pays for repairs,

maintenance and insurance. An operating lease is used for small

items like photocopiers and short term projects like building firms

hiring plant, vehicles etc.

Finance lease

The leasing company expects to recover the full cost of

equipment and interest over the period of the lease. Usually the

lessee has no right of cancellation or termination. Despite the

absence of legal ownership, the lessee bears the costs of

maintenance etc, and suffers if the equipment is under-utilised or

becomes obsolete. Finance leases offer less flexibility for the user

but this is reflected in the cheaper pricing.

The advantages of leasing are similar to those for hire purchase. An

additional advantage for operating leases is the transfer of the

obsolescence risk to the finance provider. The lessee can hand back the

equipment and take a fresh lease of more modem items.

Leasing is a highly specialized area and a customer will need advice to

assess whether to buy or lease, especially on the complicated tax issues

of finance leases. You may learn more about leasing from your own

organizations leasing department or subsidiary.

House Finance

House purchase loans (normally referred to as mortgages) are a big part of

retail banking business. In the past they were mainly the domain of building

societies. A mortgage loan is a loan to

Products, Operations and Risk Management | Reference Book 1 19

finance the purchase of residential property, usually with specified payment

periods and interest rates.

The amount available to borrowers by banks will often be a stipulated

multiple of the customers salary/monthly income or a multiple of joint

borrowers combined salaries or monthly income (the earnings multiplier).

The basic lending criteria are based on the borrowers ability to meet the

repayments. The property will be mortgage to the bank as collateral till the

borrower makes all the payments and is then able to transfer the title of the

house to his/her name.

There is also another type of finance available which is self-build finance for

borrowers who would like to obtain finance to build their own house. Since

there is no one standard self-build project, set procedures should ideally be followed during the life of the loan. Each project should be assessed on its

individual merits. As a result, the principles of lending should be carefully

considered when assessing a self-build application.

A self-build loan is an advance that will finance the building, converting or

renovating of a property as the customers principal residence. It is important to be aware that the self-build facility is not a mortgage in the traditional sense of the word - rather it is structured as an overdraft that is

secured over the plot of land on which the house is being built. Because self-

build facilities require a mortgage to be granted in support of the borrowing,

this kind of facility falls under the auspices of mortgage regulations.

By the nature of the project, the funding for this type of borrowing must be

flexible.

Either of these potential options could be used:

Funding of the project in arrears on confirmation of stage completion -

this is the most common funding arrangement.

Funding of the project in advance may be considered depending upon

the individual proposition, such as low LTV (loan to value).

The expenditure involved in building the house is then drawn down against

this overdraft. In most instances, repayment of the overdraft will come from

the drawdown of a mortgage once the house has been completed. It is better

to set up the facility on a separate account for ease of monitoring.

The bank will expect the valuer to confirm that there are no restrictions

affecting the site, that outline planning consent is held and that there are no

anticipated problems with any potential development, such as access, supply

of services, etc.

Normally two valuations are required when dealing with a self build:

At the start of the project, a current and projected end valuation.


At the end of the project, a revaluation prior to the mortgage

drawdown.

The normal stages of a self-build project are:

completion of the foundations/under buildings/plinth.

completion of ground level slab.

completion of first level slab (where applicable).

finishing (case-to-case basis).

It is normal practice to allow the customer to draw down on the self -build

loan at the end of each of these stages, formal certification being generally

required from:

a qualified architect.

development/cantonment authority inspector, a

structural engineer.

2. Short-term Facility i. Finance for Consumer Durables

Financing of consumer durables such as refrigerators, air conditioners,

washing machines, computers, and other electrical appliances has

become popular since the last 2 decades or so. This financing is

available through the hire purchase mode as well as the clean lending

mode. In the hire purchase mode the bank purchases the good and gives

it to the customer for use and the customer pays back the bank in

monthly or quarterly installments.

B. CLEAN LENDING 1. Short-term Facility i.

Personal Loan- Installment-based finance

Personal loans are normally granted for the purpose of consumer

purchases such as: consumer durables (televisions, fridge-freezers,

etc), education and medical expenses and for home improvements

such as a new fitted kitchen, double glazing, the building of a

conservatory, etc. Personal loans are not restricted to these

purposes and may be granted for any purpose that is acceptable to

the bank.

Interest is charged on personal loans at a flat rate which means that

it is calculated on the total amount of the loan for the full term and

applied to the amount of the loan at the commencement of the

repayment term. This total amount is then divided by the number

of monthly installments to determine the amount of the repayment

installments.

Personal loans are not usually secured and the repayment period

can vary from a few months to several years.

When a personal loan application is received, it is usually credit

scored to determine whether or not the bank is willing


to grant the facility. Once a customers application has been processed

and shows an acceptable credit score, a pre-contract illustration is

provided prior to the customer and banker signing the loan agreement.

A formal letter setting out the terms and conditions of the loan is

normally given to the customer containing details of the interest

structure, total payable and the amount of the rebate should the loan be

repaid early.

The loan is created by a transfer of funds into the customers operative

account and a corresponding debit is made to a separate loan account.

The agreed repayments are credited to the loan account until it is

cleared off.

Some personal loans carry automatic life cover and there is also an

option for the customer to purchase accident, sickness and

unemployment insurance. These ensure protection for the customer and

the bank.

ii. Running finance A running finance account allows a customer to draw up to a set limit

which is related to a monthly fixed payment into the account. A

multiplier is related to this monthly payment; for example, if the

customer pays in Rs. 10,000 per month, the limit of borrowing may be

set at Rs. 300,000 (30 x Rs. 10,000).

The application form is similar to that for a personal loan and the

response data is credit scored. A credit limit is agreed but the bank does

not normally look for security. A separate account is maintained and it

is usual to arrange for the monthly payment to be transferred from an

operative account to the revolving credit account by standing order.

Interest is charged on a daily basis and normally applied monthly.

Should the account move into credit, interest on the credit balance may

be paid by the bank. Provided monthly payments are maintained and

interest is paid, the customer can sustain the borrowing at or near the

limit, subject to periodic review by the bank. Insurance may be offered

to pay off the debt in the event of the death of the customer or to meet

repayments if the borrower has a prolonged illness or is made

redundant.

Revolving credit accounts are intended primarily for the professional

type of customer with good income; being designed to allow the

customer to change a car, purchase electrical goods, etc without the

need to keep contacting the bank to enter into new personal loan

agreements for each purchase. Cashline by UBL is an example of

running finance facility under consumer finance.

iii. Credit cards

Credit cards have increasingly become a part of everyday life. These

plastic cards can be used by the cardholder to purchase goods and

services which are paid for at a later date. They are


becoming a widely used method of making payments and for obtaining

credit facilities.

Credit cards are a method of money transmission where the customer has the

option of settling only part of the monthly bill, thereby borrowing the

amount of the unpaid balance. If the customer pays off the outstanding

balance in full prior to the repayment date, no interest is charged and

therefore this is a very cost-effective method of short term borrowing. By

careful timing of their purchases and then repaying the bill in full, the

customer may obtain approximately up to 50 days interest-free credit.

There are currently two dominant groups who operate international networks

- Visa and MasterCard. All the main banks, offer their own versions of either

or both of these cards. There are other companies such as Diners and

Maestro but the market share and reach of these companies is by far the

largest.

The essential features of a credit card are:

the purchase of goods and services on credit subject to an agreed overall

limit.

the issue of regular statements by the credit card issuing bank/company.

the option for the customer of either paying all of the sums due to the

bank or electing to pay off only a portion of the sums due (minimum

amount or 3 - 5%, whichever is the greater) and paying interest on the

remainder.

A credit card account operates independently of a customers other accounts

with the bank, and the relationship between the bank and the cardholder

differs from the traditional banker/customer relationship. In some cases

banks have issued credit cards which have been linked to their existing

deposit accounts with the banks and banks offer direct debit facility for the

payment. However, this is not general practice.

Each bank policy may differ, however as per popular practice locally it is not

necessary for a person to maintain an account with the bank before they can

be issued with a credit card. It is initiated by a separate agreement between

the bank and its customer regulating the issue of the credit card and the

debtor/creditor relationship that exists between the parties. In addition, due

to the element of credit involved, the bank will have to be satisfied that the

customer can be considered creditworthy for the amount of their limit. The

customer completes an application form as the basis of the agreement

between them and the bank. The application form also provides the bank

with a great deal of information about the customer, such as employer,

salary, house owner or tenant, marital status, number of children, etc.

Normally the creditworthiness of the applicant is screened bythe statistical method of credit scoring. The process determines the

statistical probability that the credit will be repaid.

Use of the credit card Provided that the issuer is satisfied with the creditworthiness of the

customer, a card and personal identification number (PIN) will be issued

and the customer will be granted a credit limit. The customer can then

use the card to make purchases up to the amount of the limit on the

account. The cardholder presents the card to the retailer and the

transaction is completed by the card being swiped through the retailers


terminal. In many countries the customers are also required to input their

PIN number on a keypad. A credit card can also be used for postal,

internet and telephone transactions; the card number being quoted over

the phone together with the security code number quoted on the back of

the card. This information is input on to a computer or noted on an order

form sent in the post.

Cash can be withdrawn via ATMs using the credit card by the cardholder

inputting their PIN. This withdrawal will be treated by the credit card

company as a cash advance and so interest will accrue from the date of

the transaction.

Joint credit cards are not offered, but the customer has the option of

applying for supplementary cards to be issued on the account.

For example, a husband may choose to have a supplementary card for his

wife and children. The liability of repayment of debt of the

supplementary card will be on the husbands account.

Every month, the cardholder receives a statement showing: their

limit.

the transactions that have been made with the card(s). any

payments that have been received, any interest that has

been debited to the account, the current balance.

the amount of available credit remaining,

minimum payment required, payment due

date.

On receipt of a statement, a cardholder has the option of: a. repaying the whole balance by the due date shown on the statement,

or

b. repaying the minimum amount required which is generally 3 - 5%

of the total outstanding amount.

Should the cardholder elect not to clear the balance due, interest will be

charged monthly from the statement date or the date of the transaction on any

outstanding balance not repaid.

Lending: Products, Operations and .Risk Management | Reference Book 1

Regulations and Practices As discussed in chapterl, depending on the characteristics of different

lending products, they have different permissible limits, risk mitigation and

process requirements. To ensure transparency and coherence amongst the

lending practices, the SBP has provided a comprehensive list of Prudential

Regulations (PRs) to the banks and financial institutes catering to the

financing requirements of various types of customers.

Prudential Regulations (PRs)

Prudential Regulations are a set of minimum lending principles designed by

the SBP. The objective of these regulations is to bring consistency in lending

practices among banks and to maintain quality of credit portfolios across

banks.

To cater to the specialized and dynamic areas of lending the SBP has

following separate sets of PRs geared towards:

Corporate.

Commercial/SME and

Consumer business.

Agriculture

Some salient features of these regulations are discussed below. You are

encouraged to visit the SBP website and study the up-to-date regulations in

detail.

Prudential Regulations-Corporate

Corporate PRs contain a total of 27 regulations revolving around corporate

business and covering following aspects of credit quality:

Risk management 13

Corporate governance 4

Anti Money Laundering 5

Operations 5

Highlights of most important Risk Management related regulations (PRs)

are:

Maximum exposure (in outstanding terms) of a bank/DFI to a single borrower shall not exceed 30% of its equity (fund-based 20%) and to

a group of borrowers 35% (fund-based 30%).

Contingent liabilities of a bank/DFI shall not exceed 10% of its equity.

Banks/DFIs shall as a matter of rule, obtain copies of financial statements duly audited by a chartered accountant relating to the

business of every borrower who is a limited liability company

Undng: Products, Operations and Risk Management | Reference Book 1 25

Unsecured exposure is restricted to Rs.200,000.

Total exposure (fund based and/or non funds based) availed by any

borrower not to exceed 10 times of borrowers equity (fund based

exposure not to exceed 4 times of its equity).

Banks/DFIs to ensure that total exposure (fund based and/or nonfund

based) availed by any borrower from financial institutions does not

exceed 10 times of borrowers equity (fund based exposure not to

exceed 4 times). However, where equity of a borrower is negative and

the borrower has injected fresh equity during its current financial year,

it will be eligible to obtain finance up to 3 times of fresh injected

equity, provided the borrower shall plough back at least 80% of its net

profit each year until such time it is able to borrow without this

relaxation.

For the purpose of borrowing- subordinated loans shall be counted as

equity of the borrower.

Banks/DFIs shall not:

a) Take exposure against the security of shares/TFCs issued by them.

b) Provide unsecured credit to finance subscription towards

floatation of share capital and issue TFCs.

c) Take exposure against TFCs or shares not listed on stock

exchanges.

d) Take exposure against sponsor directors shares.

Banks/DFIs shall not own shares of any company in excess of 5% of

their own equity. Further, total investments of bank in shares should

not exceed 20% of their own equity (for DFIs the limit is 35% of their

equity).

Regulation (PR-8) relating to classification and provisioning of assets

is represented by an extra-ordinary lengthy reading. You are

encouraged to familiarize yourself with provisions of this regulation

along with regulation pertaining to governance (Gs) and operations

(Os).

Prudential Regulations-SME

Keeping in view the important role of Small and Medium Enterprises

(SMEs) in the economic development of Pakistan and to facilitate and

encourage the flow of bank credit to this sector, a separate set of Prudential

Regulations specifically for SME sector has been issued by State Bank of

Pakistan. This separate set of regulations, is aimed at encouraging

banks/DFIs to develop new financing techniques and innovative products

which can meet the financial requirements of SME sector and provides a

viable and growing lending outlet for banks/DFIs.

Banks/DFIs should recognize that success in SME lending requires much

more extensive involvement with the SMEs than the traditional lender-


borrower relationship envisages. The banks/DFIs are, thus, encouraged to

work in close association with SMEs. The banks/DFLs should assist and

guide the SMEs to develop appropriate systems and effectively manage their

resources and risks.

State Bank of Pakistan encourages banks/DFIs to lend to SMEs on the basis

of assets conversion cycle and future cash flows. A problem, which the

banks/DFIs may encounter in this respect, is the lack of adequate

information. In order to overcome this problem, banks/DFIs may also like to

prepare general industry cash flows and then adjust those cash flows for the

specific borrowers keeping in view their conditions and other factors

involved.

As mentioned above, presently most of the SMEs in Pakistan lack

sophistication to have reliable and sufficient data and financial information.

In order to capture this data and information, banks/DFIs will need to assist

and guide their SME customers. The banks/DFIs may come up with

minimum information requirements and standardized formats for this

purpose as per their own discretion. For better understanding and to facilitate

their SME customers, banks/DFIs are encouraged to translate their loan

application formats and brochures in Urdu and other regional languages.

In order to encourage close coordination of the officials of the banks/DFIs

and SMEs, the banks/DFIs may require the concerned dealing officer to

regularly visit the borrower. For this purpose, at a minimum, the dealing

officer may be required to pay at least one quarterly visit and document the

state of affairs of the SME. In addition, an officer senior to the ones

conducting these regular visits may also visit the SME at least once in a year.

The banks may, at their own discretion, correlate the frequency of visits with

their total exposure to the SME borrower.

A total of eleven (11) regulations govern banks SME business. Some of the

important ones are discussed as under:

Banks/DFIs shall specifically identify the sources of repayment and

assess the repayment capacity of the borrower on the basis of assets

conversion cycle and expected future cash flows.

All facilities; except those secured against liquid assets; extended to

SMEs shall be backed by the personal guarantees of the owners of

SME.

Banks/DFIs can take clean exposure on an SME to the maximum

extent of Rs.3 Million against personal guarantee of the owner

(funded exposure restricted to Rs.2 Million). All facilities over and

above Rs.3 Million shall be appropriately secured.

Maximum exposure of a Bank/DFI shall not exceed Rs 75 Million.

Total facilities availed by a single SME from financial institutions

should not exceed Rs 150 million.

Classification and provisioning requirements for SME borrowers are

the same as in case of corporate borrowers. Candidate should

familiarize themselves with these complex requirements.

Operations and Risk Management | Reference Book 1 27

Prudential Regulations - Consumer financing

Apart from the specific regulations for credit cards, auto loans, housing

finance and personal loans, minimum general requirements laid down by

SBP that govern the consumer business are as follows:

Bank/DFIs to establish separate risk management capacity for

consumer business.

Bank/DFIs to prepare comprehensive credit policy duly approved by

their BODs.

For every type of consumer financing facility bank/DFIs to develop a

specific program.

Bank/DFIs to have an efficient computer-based MIS system which

should efficiently cater the needs of consumer.

Bank/DFIs to develop comprehensive recovery procedures for

delinquent consumer loans.

For detailed study of these regulations you are encouraged to read and

assimilate various requirements of different type of consumer financing.

To ensure that bank/DFIs strictly follow the prudential regulations and for

their own regulatory purposes, SBP requires submission of /DFIs various

reports periodically, by the Banks.

Credit Policy

A credit policy is defined as a set of clear written guidelines of a bank that

address the following areas:

Credit terms and conditions - risk assessment criteria.

Customer eligibility criteria - target market.

Criteria for assigning risk ratings for obligors and facilities.

Treatment of obligors of different ratings.

Process and hierarchy for approving or rejecting a credit proposal.

Procedure for policy deviations.

Steps to be taken in case of customer delinquency.

Banks /DFIs must prepare a comprehensive credit policy keeping in view the

PRs set by the State Bank. This credit policy must be approved by the BOD.

There is no one-size-fits-all credit policy as each customer approaching the

bank has varying credit requirements, profiles, repayment capabilities etc.


Each Banks policy is to be based on their particular business strategy and

cash-flow circumstances, industry standards, current economic conditions,

and the risk culture of the bank. It is imperative for the banks to consider the

link between credit and sales at the time of policy creation. Easy credit terms

can be an excellent way to increase asset sales, but they can also result in

immense losses if customers default. A typical credit policy will address the

following points:

Processes: Details of acquisition, verification and rejection processes

are discussed in detail as an essential part of the credit policy manual.

Credit limits: Suggests the amount of money a bank is willing to

extend in credit form to a single customer and also defines the

corresponding parameters and circumstances.

Credit terms: Terms like payment due date, early-payment discounts

and late-payment penalties etc.

Deposits: If there are any requirements from customers to pay a

portion of the amount due in advance.

Customer Information: This section outlines the level of information

required by the bank about a customer before making a credit

decision. Parameters like years in business, length of time at present

location, bio data, financial data, credit rating with other vendors and

credit reporting agencies, information about the individual principals

of the company etc are all part of this information.

Customer Eligibility Criteria: This section describes factors on which

the decision to extend a credit line to any customer depends. All the

conditions that must be evaluated and analyzed are listed in this

section. All the terms and conditions must be in line with those

mentioned in SBPs PRs. By having a practical and realistic risk

based eligibility criteria banks are aiming to decrease the likelihood

of bad loans.

Documents Required: This section lists the documents mandatory to

processing any form of loan. Includes credit applications, sales

agreements, contracts, purchase orders, bills of lading, delivery

receipts, invoices, correspondence etc.

Other areas like income calculation methodology, credit initiation, rejection

conditions, credit deviation authorities and scenarios, fraud detection and

prevention, collection and recovery strategy and many other sections are part

of the credit policy. Each Bank/DFI develops policy manuals according to

their own standards with more or less all of the sections discussed earlier.

Importance of Credit Policy:

It is evident from the details listed above that a credit policy plays a very

important role in lending operations. Without a credit policy it would be

impossible to manage huge lending portfolios. Once a good credit

hwducts. Operations and Risk Management | Reference Book 1 29

policy is in place, all cross functional departments have a clear

understanding of their role, resulting in quick and transparent credit

decisions. By defining the target market, risk assessment criteria and by

developing and listing down credit terms and conditions; a credit policy

ensures mitigation of lending risks arising from customers debt servicing

capacity, limit assignment and possible loopholes in collection and recovery

processes.

Pricing

Pricing Mechanisms

Simplistically speaking a loan is when you give someone money for a certain

period and charge them a certain amount (usually expressed as a percentage

and is called markup or interest) for the use of that money. The borrower is

expected to pay back the principal as well as the markup.

Pricing of the loan is the markup rate. This markup rate charged has two

components:

1. Base component, which can be derived from:

Internal cost of funds or

Market-based cost of funds.

2. Variable component.

1. Base component:

1.1.Internal cost of funds:

As a bank, the loan that you give out is against deposits. These deposits

generally have a cost associated to it. The cost can be in terms of:

a) the rate of return promised to the depositor,

b) the administrative cost of generating, processing and servicing the

deposit/depositor.

This method of calculating the cost of deposit is generally called the internal

cost of funds.

1.2.Market-based cost of funds:

In addition to the funds obtained from its depositors, the bank can also

borrow from other banks including the central bank and the money market.

This borrowing involves a cost which is termed as the Market- based cost of

funds. Market rate indicators such as KIBOR, T-bills, PIBs, REPO and

Reverse REPO rates are generally used as benchmark indicators in the

Pakistan market.

KIBOR stands for Karachi Inter Bank Open-market Rate. Its the rate of

interest at which banks in Karachi offer to lend money to one another in the

money markets. KIBOR is issued on daily, weekly, monthly and on 1,2 and

3 yearly basis by the State Bank of Pakistan.

Treasury bills (T-bills) are zero coupon instruments issued by the

Government of Pakistan and sold through the State Bank of Pakistan via


fortnightly auctions. T-Bills are issued with maturities of 3-months, 6-

months and 1 Year and are priced at a discount. T-Bills are risk free, SLR

(Statutory Liquidity Requirement) eligible securities that are actively traded

in the secondary market and are therefore highly liquid. They are issued with

a minimum denomination of Rs.100,000.


Pakistan Investment Bonds (PIBS) are long term bonds issued by the

Government of Pakistan and sold through the State Bank of Pakistan via

periodic auctions. PIBs are issued with tenors of 3, 5, 7,10,15, 20 and 30

Years. Being backed by the Government of Pakistan, they present a low risk

long term investment option. The Pakistan Investment Bonds offer a fixed

semiannual coupon and repayment of principal at maturity. They are highly

liquid SLR (Statutory Liquidity Requirement) eligible securities that are

actively traded in the secondary market. The minimum denomination of PIBs

is Rs.100, 000.

REPO and Reverse REPO The discount rate at which a central bank

repurchases government securities from the commercial banks, depending on

the level of money supply it decides to maintain in the country's monetary

system. To temporarily expand the money supply, the central bank decreases

repo rates. To contract the money supply it increases the repo rates.

Alternatively, the central bank decides on a desired level of money supply

and lets the market determine the appropriate repo rate. Repo is short for

repossession.

A reverse repo is simply the same repurchase agreement from the buyer's

viewpoint, not the seller's. Hence, the seller executing the transaction would

describe it as a "repo", while the buyer in the same transaction would

describe it a "reverse repo". So "repo" and "reverse repo" are exactly the

same kind of transaction, just described from opposite viewpoints. The term

"reverse repo and sale" is commonly used to describe the creation of a short

position in a debt instrument where the buyer in the repo transaction

immediately sells the security provided by the seller on the open market. On

the settlement date of the repo, the buyer acquires the relevant security on the

open market and delivers it to the seller. In such a short transaction the seller

is wagering that the relevant security will decline in value between the date

of the repo and the settlement date.

2. Variable component:

The variable component of the markup rate is the spread that banks keep on

top of their base component or cost of funds when lending to customers. The

size of the spread generally depends on three factors:

1. Type of the customer i.e. whether the customer is a corporate /

wholesale customer or a consumer / retail customer.

2. Customers credit risk rating which is assigned based on the

customers profile.

3. The banks balance sheet mix and its need for deposit or loans at a

given point in time.

For banks the cost of doing business with the corporate / wholesale customer

is lower compared to consumer / retail customer. For example handing out a

loan of 100 million to one corporate customer costs less in terms of

administrative, legal, processing and servicing cost then than handing out a

total loan of PKR 100 million but split between to 100 different retail

customers.


Similarly, for banks the cost of lending is higher for high risk customers.

Since for high risk customers the probability of default is higher, the bank

needs to charge a higher rate to keep a cushion in case the customer defaults.

Each bank has a strategic requirement of maintaining certain debt-equity

ratio in its balance sheet. These requirements are specific to each bank, but

must be in line with SBPs stipulated guidelines.

Fixed and Floating Rates

The markup rate given to a customer can be floating or fixed.

Floating rate also known as a variable or adjustable rate refers to a rate on

any type of credit that does not have a fixed rate of mark-up or interest over

the life of that credit. Floating rate changes on a periodic basis. The change

is usually tied to the movement of an outside indicator or the prime rate/

discount rate (an interest rate charged by the central bank from depository

institutions that borrow reserves from it, for example the interest rate

charged by the State Bank of Pakistan). One of the most common rates used

as the basis for applying interest rates is the Karachi Inter-bank Offered Rate

or KIBOR.

The rate for such a credit will usually be referred to as a spread or margin

over the base rate: for example, a five-year loan may be priced at six- month

KIBOR + 2.50%. At the end of each six-month period, the rate for the

following period will be based on the KIBOR at that point, plus the spread.

Re-pricing interval The re-pricing interval measures the period from the date

the loan is made until it first may be re-priced. For floating-rate loans that are

subject to re-pricing at any time the re-pricing interval is zero. For floating

rate loans that have a scheduled re-pricing interval, the interval measures the

number of days between the date the loan is made and the date on which it is

next scheduled to re-price. For loans, having rates that remain fixed until the

loan matures (fixed-rate loans) the interval measures the number of days

between the date the loan is made and the date on which it matures. Loans

that re-price daily are assumed to re-price on the business day after they are

made.

Fixed rate on the other hand does not fluctuate during the fixed rate period.

This allows the borrower to accurately predict their future payments.

For an individual or a company taking out a loan when rates are low, a fixed

rate loan would allow the borrower to "lock in" the low rates and not be

concerned with interest rate spikes. On the other hand, if interest rates are

high at the time of the loan, the borrower will benefit from a floating rate

loan, because if the prime rate falls, the rate on the loan would decrease. The

opposite is true for the lender. The lender would not like to be stuck in a low

fixed rate lending contract if interest rates are rising, as his cost of funds will

rise. Bankers thus keep a large margin when lending at a fixed rate and do a

thorough analysis of the interest rate behavior to ensure that they do not bind

themselves to a lending contract which may become unfavorable in the

future.

Risk-based pricing in the simplest terms, is alignment of loan pridag with the

expected loan risk. It is a manifestation of the risk reward concerc- higher

the risk, higher the reward; in this case higher the risk, higher the price of

credit i.e. mark-up. Typically, a borrowers credit risk is used tz> determine

Operations and Risk Management | Reference Book 1

if a loan application will be accepted or declined. That sane risk level is also

used to drive pricing. This means charging a higher interest rate for a higher

risk transaction or high risk rated customer and a lower rate for a lower risk

transaction or a lower risk rated customer.

A balanced pricing strategy comprises of three critical elements. First, the

bank must have solid credit quality. If the borrower defaults, the net result is

a charge-off that negatively impacts credit reserves and bank earnings. The

second important component is profitability. Pricing for loans must result in

the required rate of return on assets as determined by the bank. The final

component of a balanced pricing strategy is portfolio growth. A balanced

pricing strategy should support portfolio growth generated by profitable,

quality loans. The result is a balanced pricing strategy that can be best

summarized as the proverbial three-legged stool of quality, profitability, and

growth. Each is important, but if one is missing, the stool will tip over.

Risk reward pricing is the ratio used by lenders to compare the expected

returns of a loan to the amount of risk undertaken to capture these returns.

This ratio is calculated mathematically by dividing the amount of profit the

lender expects to have made when the position is closed (i.e. the reward) by

the amount he or she stands to lose if price moves in the unexpected

direction (i.e. the risk).

The higher the risk the greater is the reward. In consumer banking the spread

is very large, the pricing is based on the whole portfolio and the

administrative cost is very high therefore the risk is high. Whereas in

corporate banking, the individual loan is priced therefore the risk is low.

Relationship yield pricing is pricing the credit based on the overal customer

relationship rather than on a stand-alone product basis. Fo example if the

customer has taken a loan from the bank, chances are h would also route his

collections and payments through the bank as wel Sometimes a loan is an

initiator of a larger relationship with the customs therefore it is the

relationship managers responsibility to not just sell loan to the customer but

build further relationship with customer t cross-selling other products. Since

other products generally have a low risk involved as compared to loans,

profitability of the customer to t! bank on a holistic level compared to the

risk involved will be high when the customer is using other products of the

bank.

For example, Haji Kareem Bakhsh & Co banks with the National Bank of

Pakistan (NBP). They are in the business of plastic bottles manufacturing. At

the moment they have a long term loan of Rs. lOOMillion with the bank at 1

year KIBOR + 2.5% p.a. NBP hosts their 200 employee accounts and also

provides payroll management services. Similarly, their collections account is

also being maintained at NBP. Last month the company imported machinery

from Japan worth $50,000 for which an LC of the required amount was also

opened by NBP in their name. The LC pricing is 0.1% which the customer is

refusing to pay on the pretext that it has such extensive business with the

bank. Moreover, the customer has requested a short-term financing- FIM for

a period of 30 days for which the customer insists that it will only pay 1

month KIBOR +0.5% on this transaction. On a stand-alone basis this

transaction will not make any money for the bank and there is risk involved.

It is important to evaluate the revenue of the entire relationship as well as the

impact on the relationship before deciding to open the LC or decline it.

Taking another example, where Mr. Ahmed Saad has a HBL credit card with


limit of Rs.100,000. He is very apt in settling his outstanding balance. He

generally makes the payment within few days of making the transaction,

which ensures that he is never charged any markup on the utilized amount.

The only income HBL earns on this credit card is the annual fee and 1.25%

to 2% acquiring commission on each transaction. Mr. Saad also maintains a

current account with HBL with an average balance of Rs.300,000. Mr. Saad

has requested the bank for a waiver on the annual charges for the credit card

which are PKR 1500. In his request he has mentioned his long standing

relationship with HBL on the depository side and has said tha