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CHAPTER 1 :NATURE OF CREDIT
LEARNING OUTCOMES
Basic concepts in credit Intermediation process Risk and return
Various instruments in government regulations affecting credit activity
Determine factors influencing credit activities Identify various stages in credit process
INTERMEDIATION PROCESS
Introduction The financial services industry touches the
lives of every individual, household and business within the economy.
Individuals and households provide savings to financial institutions which transform them into financial assets.
In this content, financial institutions act as financial intermediaries bridging the distance between depositors and borrowers.
Process of Intermediation
**The players in this Financial Services Industry are known as Financial Services Firms and they consists of the following: Commercial Banks; Merchant Banks; Finance Companies Scheduled Institutions
DEPOSITORS (with surplus units)
Financial Services Industry (FSI)**
BORROWERS (with deficit units)
INSTRUMENTS IN GOVERNMENT
In a conventional banking system, Central Banks usually employ six primary methods for implementing monetary policy : Statutory Reserve Requirement Minimum Liquidity Requirement Interest Rate Regulation Selective Credit Control Capital Adequacy Ratio Base Financing rate / Cost of Financing
These instruments have a similar effect on the quantity of money and credit in the economy.
STATUTORY RESERVE REQUIREMENT (SRR)
SRR is one of the oldest monetary instrument deployed by BNM to control the liquidity situation in the banking system.
SRR is a powerful instruments available to BNM because it affects the level of deposits and loans that a bank can legally support.
Any increment in the SRR ratio will: Reduce the level of reserve available to the banking
institutions Decrease the lending ability of the banking institutions
Any decrement in the SRR ratio will: Increase the level of reserves available to the banking
institutions. Increase the lending ability of the banking institutions.
MINIMUM LIQUIDITY REQUIREMENT (MLR) Under 38(1) of the BAFIA 1989, the banking
institutions are required to observe a minimum liquidity ratio.
The ratio is also expressed as a percentage of the EL based on the banking institutions.
The current definition of liquid assets are:- Cash - Cagamas Bond- Money at Call - Treasury Bills
It operates in the same manner as the SRR. Therefore when the liquidity ratio is raised, the amount of deposits and loans suppled by the reserves will decrease.
INTEREST RATE REGULATION An important instrument which BNM can
control including the bank’s liquidity and cost of bank credit through the interest rates charged on bank loans as well as the rates of interest offered for deposits.
Increment of the interest rate will : Increase the level of cost of funds for the banks
loans Decrease the demand for bank loans
Decrement of the interest rate will : Decrease the level of cost of funds for the banks
loans Increase the demand for bank loans
SELECTIVE CREDIT CONTROL Credit facility is important to all economic
sectors but due to certain consideration, some sectors need special protection.
Guideline on lending to these priority sectors are issued by central bank in order to achieve the target loans to these sectors.
This priority sectors comprise of small and medium industry, Bumiputra community, agricultural sector and low and medium house buyers.
CAPITAL ADEQUACY CONTROL (CAR) Capital Adequacy Ratio (CAR) is a ratio that
regulators in the banking system use to watch bank's health, specifically bank's capital to its risk. Regulators in the banking system track a bank's CAR to ensure that it can absorb a reasonable amount of loss.
Regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.
Capital adequacy ratio is the ratio which determines the capacity of a bank in terms of meeting the time liabilities and other risk such as credit risk, market risk, operational risk, and others. It is a measure of how much capital is used to support the banks' risk assets.
BASE FINANCING RATES (BFR) / COST OF FINANCING
is the cost and interest and other charges involved in the borrowing of money to purchase assets.
FACTORS INFLUENCING CREDIT ACTIVITIES
Credit activities will be affecting by several factors which will resulting the fluctuation based financing rate, demand for credit and profit rate. The several factors are known as:
1.Economics conditions During the economic growth, demand for
financing will be increase rather than during recession. Credit activities based on economic condition will be affected through investment spending and consumer spending which will increase growth domestic product (GDP).
2. Supply of money and interest rate Supply of money and interest rate also
affected the credit activities. But it depends on the economic situation. For example, during economic growth supply of money from depositors will increase. Many people will invest and saving to the financial institutions.
So, the supplies of money are increase resulting demand for financing increase. With the competitive profit rate offer by financial institution encouraged customer to demand for financing also. But, during the recession it will be supply of money decreased and profit rate for financing increased resulting decreased demand for financing.
3.Government regulations and policies Bank Negara Malaysia is a Central Bank of
Malaysia. Act as a protector of depositors and deposits almost to the safety. BNM also act as to maintain stability of financial system and to structures financial system with intention to avoid customer from the monopoly power of banks.
So, in order to resembling BNM roles, Bank Negara Malaysia has comes with the regulatory framework which is the BNM Garis Panduan GP5, BAFIA (Banking and Financial Institution Act 1989 and Capital Adequacy Guidelines 1989. In 2011 BNM has state the new pre-requirement to financial institution in Malaysia where is credit assessment must be done by evaluating customer’s net income.
This regulation and policies will change time to time depending on the economic situation. When the economic are stable, the regulation and policies would be more flexible to increase business activities but different in the recession.
4. Competition among banks Competition among financial institution
always happens in order to achieve higher market share in financial portfolios and all together affected credit activities. Hence, anywhere of financial institutions offers the best and better facilities to customer will get attentions form customers.
STAGES IN CREDIT PROCESS
Credit process is the basic concepts in the credit environment. There are four main stages of credit process. First, credit officer will market bank’s facilities to the potential customer (STAGE 1: BUSINESS DEVELOPMENT). After having a potential customer, he will ask for customer details (job, income, address, identity number and the others requirement) to do a credit analysis. Hence, credit officer must know the sound lending principle or known as a credit analysis (STAGE 2: CREDIT EVALUATION). Once the financing has approved, credit administration and monitoring will be required (STAGE 3: CREDIT MONITORING). If the borrower default or failed to fulfil the payment in the right time, credit officer must study the remedial actions suitable to the customer (STAGE 4: CREDIT RECOVERY).
STAGES IN CREDIT PROCESS
STAGE 1: BUSINESS DEVELOPMENT
BUSINESS DEVELOPMENT CAN BE DONE THROUGH THE SELLING CYCLE
PROSPECTING Involve the opportunities to find out the business
require financing. During this process, credit officer must identity and aware of the credit risk and business condition because different company has different business condition and credit risk towards financial institutions. If credit officer failure to identify the credit risk there will potentially negative impact to bank’s portfolio.
DATA COLLECTION Credit officer will collect preliminary information with
respect to the background and nature of the business and industry that it’s operates from, the pricing of the financing based on market conditions and the type and value of security offered.
ANALYSIS AND MEETING Credit officer should arrange to meet the prospective
customer for the purpose of making a site visit to the premises to gather more facts about the business. This site visit is normally recorded into a Call Report and submitted to the bank management for further comments.
SELLING AND NEGOTIATION During the meeting and if there is sufficient
information to make proposal, the credit officer may proceed to discuss the financing structure to ensure that the prospect is able to make repayments. This negotiation with the prospect involves bank’s willing to sell his financial products at the highest level of profit rate and the prospect hoping to gain the lowest possible profit rate.
CREDIT MEMORANDUM If the selling negotiations appear accommodative to
both parties, then the credit officer will proceed to prepare a credit memorandum or application for Accommodation (AA) to recommend the proposed financing to the finance committee for their approval.
APPROVAL OF OFFER Upon the approval of committee by endorsing the
Credit Memorandum, the officer will proceed to prepare a Letter of Offer and to forward to the prospect for his acceptance. In the event the offer is not accepted by the prospect, renegotiations will have to commence. Once the offer has met with acceptance, the officer will proceed to initiate the selling cycle with another new prospect.
STAGE 2: CREDIT EVALUATION
Credit analysis covers the following:
i. Quantitative aspectii. Qualitative aspectiii.Documentation processiv.Security and other legal aspectsv. Profitability and relationshipvi.Capital adequacy ratio compliance
STAGE 3: CREDIT MONITORING
Follow up aspects on the financing account includes:
i. Annual or interim reviewsii. Reassessment of existing terms and
conditionsiii.Renewal of financing facilityiv.Re-establishment of borrowing relationship
with issuance of a fresh Letter of Offer and Customer’s acceptance of the renewed facility
STAGE 4: CREDIT RECOVERY
Comprises the following actions:
i. Winding-up proceeding by means of legal action on the company
ii. Enforcement of guarantees against guarantors as individuals
iii.Receivership via appointment of Receivers and Managers (R&M)
iv.Foreclosure by way of auctioning a landed property
v. Turnaround of restructuring by salvaging the company to generate cash flow.