Banking Business and Functions-2

Credit Creation

Concept of credit creation

Credit is created by commercial banks in two ways- advancing loans and by purchasing securities.

• Banks maintain some part of deposits as liquid cash termed as cash reserve. This is in minimum requirement as specified by RBI. The excess or surplus is given out as loans and advances.
• When giving a loan, banks open deposit account in the name of the borrower. This is known as secondary or derivative deposit.
• The deposit left after giving out loans is known as credit multiplier. Thus, credit is created from secondary deposits.
• Credit multiplier indicates the number of times primary deposits are multiplies and is the inverse of CRR.
• Thus, the entire process of credit creation rests on the following assumptions:
• Banking system is fully developed
• Transactions are through cheques
• Excess of CRR is kept as cash
• Credit policy stays the same.

Merits and demerits of credit creation

Merits:

• Banks are able to diversify risks with the help of credit creation.
• The loans and advances are generally done from excess or surplus reserves.
• This money which is lying passive joins the active process of credit creation

Demerits

Banks have to face a lot of limitations for successful credit creation.

• It is directly dependent on the volume of excess reserves available with the banks.
• CRR-the minimum cash limit of the bank which varies from 3-15%. Any increase in CRR leads to less credit.
• Risk-averse nature of customers which makes them keep some cash with them for emergencies while banks prefer giving more loans to keep credit creation going.
• Periods of economic recessions call for less loan demands from the customers.

Different types of credits

The need for credit comes from demand and supply side of the economy. The consumers of demand side require credit to acquire simple assets like consumer durables. The demand for credit from supply side corporate houses arises due to their needs for long-term investments. Types of loans:

Commercial loans: Loans which are given to supply side. These are given for 2 purposes:

1. For acquiring fixed assets
2. For maintaining the business

Individual loans: Loans which are given to demand side. These are given for 3 broad purposes:

1. Consumption
2. Acquiring durables

• Housing finance

Installment credit: Credit amount is decided in advance and the amount is disbursed  either in stages or all at once. It is however, repaid in installments.

Operating credit: This is given to meet the daily credit requirements for operations. Banks decide the credit limit and provide a current account from which money can be withdrawn.

Receivable finance: Credit is in form of bills of finance.

Types of Loans

There are various types of loans or advances, which can be divided on the basis of different sets of criteria. They include non-fund based / fund based loans; secured / unsecured loans; term /  demand loans; personal / commercial loans; working capital / project finance; priority sector loans; MSME credit; rural / agricultural loans, retail loans etc.

Non-fund based lending and fund based lending

The Fund based lending is direct form of loans on which actual cash is given to the borrower by the bank. Such loan is backed by primary and / or a collateral security.

In Non-fund based lending, bank does not make any funds outlay but only gives assurance. The “letter of credit” and “bank guarantees” fall into the category of non-funding loans. The non-funding loan can be converted to a fund-based advance if the client fails to fulfill the term of contract with the counterparty. In banking language, the non-funding  advances are called Contingent Liability of the banks.

Secured loan and unsecured loan

In the secured loans, the borrower has to pledge some assets (such as property) as collateral. Most common secured loan is Mortgage loan in which people mortgage their property or asset to get loans. Other examples are Gold Loan, Car Loan, Housing loan etc. In unsecured loans, the borrowers assets are not pledged as collateral. Examples of such loans are personal loans, education loans, credit cards etc. They are given out on the basis of credit worthiness of the borrowers. We note here that the interest rates on unsecured loans is higher than the secured loans. This is mainly because the options for recourse for lender in case of unsecured loans are limited.

Term Loans and Demand Loans

The commercial banks provide loans of both short term (short term credit), Medium and long term. Short term loans are those loans whose tenure is less than one year. Medium term tenure is between 1 to 3 years and long term is above 3 years. However, In case of agriculture loans, there are three types of loans viz. Short term (tenure <15 months), medium term (tenure 15 months to 5 years) and long terms (tenure > 5 years). The demand loans are the loans which can be recalled by bank on demand at any time. The above info is presented in the below table:

Personal loans and Commercial loans

If the debtor is an individual person (consumer) or a business; it is called personal loan or consumer loan. Common examples of personal loans are mortgage loans, car loans, credit cards, educational loan etc. The credit worthiness (or credit score) of the debtor is major criteria for banks to impart such loan facility. Commercial loans include commercial mortgages and corporate bonds. The credit rating of commercial organizations is one criterion for availing such loans.

Working Capital Finance and Project finance

If the loan amount is used for operating purposes of the business, and its utilization results in the creation of the current assets; it is called Working Capital finance. To provide such loans, the lending banks carry out detailed analysis of the borrowers’ working capital requirements and then fix the credit limits. Normally, this loan is a secured loan and the working capital finance is primarily secured by the inventories and receivables of the business. The common examples of Working capital finance include Cash Credit Facility and Bill Discounting. On the other hand, project finance mainly refers to extending the medium-term and long-term rupee and foreign currency loans to the manufacturing and infrastructure sectors. Various tools of project finance include Share capital, Term loan, Debenture capital etc. Difference in Cash Credit and Overdraft

MSME Credit

Banks grant a substantial amount of loans to the micro, small and medium enterprises (SMEs) as a part of Priority sector. Banks usually follow the cluster based approach while sanctioning such loans. This sector plays very important role in the economy and given its importance, RBI has taken several measures to increase flow of institutional credit to this segment. The Small Industries Development Bank of India (SIDBI) also facilitates the flow of credit to MSME sector at reasonable rates.

Retail Loans

The banks offer an array of various retail loan products such as home loans, automobile loans, personal loans (such as loans for marriage, medical expenses etc. ), credit cards, consumer loans (for TV sets, personal computers etc) and loans against time deposits and loans against shares. All of them come under the umbrella of retail loans. The target market for retails loans are the consumers in the middle and high income segment, salaried or self employed. Banks participate in the credit scoring programme to judge the credit worthiness of individuals. While granting such loans, banks use reports from agencies such as the Credit Information Bureau (India) Limited (CIBIL).

Factors that should be considered before granting loans to corporate houses

Banks have to weigh many factors before extending credit to large corporate houses. These are involved in legal activity with the sole purpose of making profit. Various factors which banks consider are as follows:

• Banks extend loans to corporate houses based on their balance sheets, length of their cash cycle and the products available with the banks.
• Banks also study audited balance sheets to study the needs and capacity to absorb credit.
• The borrowers are required to provide their financial details in the form of CMA data to the bankers and file a formal loan application.
• The banks offer many types of loans to the corporate clients depending on their needs. They are of two types: Short-term finance (for daily, seasonal and temporary working capital needs) and Long-term finance (to meet costs of acquisition of fixed assets).

General modes for securing advances

Advances are secured by attaching a tangible security against which the loan is granted. These securities are of two types:

• Primary security: The one against which the loan is given.
• Collateral security: It is given in addition to the existing primary security.

The securities maybe movable or fixed and thus the charges on them also varies accordingly. The   charge on movable properties is levied in five different ways. They are:

• Pledge: It is a contract in which the possession of the goods goes to the lender for giving credit to the borrower.
• Hypothecation: It is another way of charging a security in which the possession of goods lies with the borrower. Hypothecation has to be registered under Section 125 of the Companies Act.
• Assignment: It is charge created on assets like receivables and debtors.
• Banker’s lien: It is a general lien under Section 171 of Contract Act, 1872.
• Mortgage: It is known as transfer of interest especially in a fixed asset to secure debt.

Precautions to be taken while granting advances against security of goods

Secured advances involve the security of a tangible asset against which the lender gives loans. The borrower deposits goods as security for a loan. As in a pledge, banks who are the lenders take the possession of the goods to extend the credit to the borrower.

• Banks should maintain a reasonable difference between the value of goods and the amount of credit permitted and the latter should be less than the former.
• Banks should ensure that the goods are withdrawn with its prior approval.
• Banks have to also ensure that any additions and withdrawals from the pledged security happens with the bank’s permission.
• In case of a mortgage, the banks should carefully spell out the conditions of the mortgage.

Procedure adopted by the bank for loan appraisal and disbursal

Banks have to analyze the loan profiles of the borrowers from many angles.

• Banks have to conduct an initial appraisal to approve the loan. It takes care of the technological, financial, managerial and market analysis of the borrower.
• Banks then have to take a call on the way of financing which will best suit the client.
• A bank is required to know the details of the cash requirements of the borrower and the type of advance will suit his requirement.
• Final decisions comprises the way the funds will be dispensed i.e. whether in a lump-sum amount or in instalments.

Loan administration and loan pricing

Loan administration and pricing is highly essential for effective lending.

• Loan officers should know their roles and powers. High sanctioning powers of loan officers generally leads to the increase in risk of the banks.
• Bank’s loan policy should clearly define the sanctioning powers of the loan officers regarding the credit limit.
• Loan pricing in turn should effectively utilise the surplus funds with the banks which both covers the costs of the bank and also leaves a margin for the bank.
• Banks should have three main objectives in loan pricing:

1. Maintain margins
2. Balance risk and rewards

• Ensure market rates

NPAs

The assets of the banks which don’t perform (that is – don’t bring any return) are called Non Performing Assets or bad loans. Bank’s assets are the loans and advances given to customers. If customers don’t pay either interest or part of principal or both, the loan turns into bad loan.

How NPA is defined?

According to RBI, terms loans on which interest or installment of principal remain overdue for a period of more than 90 days from the end of a particular quarter is called a Non-performing Asset. However, in terms of Agriculture / Farm Loans; the NPA is defined as under:

• For short duration crop agriculture loans such as paddy, Jowar, Bajra etc. if the loan (installment / interest) is not paid for 2 crop seasons , it would be termed as a NPA.
• For Long Duration Crops, the above would be 1 Crop season from the due date.

Standard Asset

If the borrower regularly pays his dues regularly and on time; bank will call such loan as its “Standard Asset”. As per the norms, banks have to make a general provision of 0.40% for all loans and advances except that given towards agriculture and small and medium enterprise (SME) sector.

However, if things go wrong and loans turn into bad loans, the PCR (Provision Coverage Ratio[1]) would increase depending up the classification of the NPA.

Special Mention Account

Banks are required to classify nonperforming assets further into three main categories (Sub-standard, doubtful and loss) based on the period for which the asset has remained non performing. This is as per transition of a loan from standard loan to loss asset as follows:

• If the borrower does not pay dues for 90 days after end of a quarter; the loan becomes an NPA and it is termed as “Special Mention Account”.

Sub-standard Account

• If a loan remains Special Mention Account for a period less than or equal to 12 months; it is termed as Sub-standard Asset. In this case, bank has to make provisioning as follows:
  • 15% of outstanding amount in case of Secured loans
  • 25% of outstanding amount in case of Unsecured loans

Doubtful Asset

• If sub-standard asset remains so for a period of 12 more months; it would be termed as “Doubtful asset”. This remains so till end of 3rd year. In this case, the bank need to make provisioning as follows:
  • Up to one year: 25% of outstanding amount in case of Secured loans; 100% of outstanding amount in case of Unsecured loans
  • 1-3 years: 40% of outstanding amount in case of Secured loans; 100% of outstanding amount in case of Unsecured loans
  • more than 3 years: 100% of outstanding amount in case of Secured loans; 100% of outstanding amount in case of Unsecured loans

Loss Asset

• If the loan is not repaid even after it remains sub-standard asset for more than 3 years, it may be identified as unrecoverable by internal / external audit and it would be called loss asset. An NPA can declared loss only if it has been identified to be so by internal or external auditors.

Impact of Implications of the NPAs on Banks

The most important implication of the NPA is that a bank can neither credit the income nor debit to loss, unless either recovered or identified as loss. If a borrower has multiple accounts, all accounts would be considered NPA if one account becomes NPA.

Difference between Gross NPA and Net NPA

The NPA may be Gross NPA or Net NPA. In simple words, Gross NPA is the amount which is outstanding in the books, regardless of any interest recorded and debited. However, Net NPA is Gross NPA less interest debited to borrowal account and not recovered or recognized as income. RBI has prescribed a formula for deciding the Gross NPA and Net NPA.

How SARFAESI Act helps to recover NPAs?

The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act has provisions for the banks to take legal recourse to recover their dues. When a borrower makes any default in repayment and his account is classified as NPA; the secured creditor has to issue notice to the borrower giving him 60 days to pay his dues. If the dues are not paid, the bank can take possession of the assets and can also give it on lease or sell it; as per provisions of the SAFAESI Act.

Asset Reconstruction Companies

If a bad loan remains NPA for at least two years, the bank can also resale the same to the Asset Reconstruction Companies such as Asset Reconstruction Company (India) (ARCIL).  These sales are only on Cash Basis and the purchasing bank/ company would have to keep the accounts for at least 15 months before it sells to other bank. They purchase such loans on low amounts and try to recover as much as possible from the defaulters. Their revenue is difference between the purchased amount and recovered amount.

Wilful default

Willful default means that a party does not make loan repayment out of its will. There are four conditions when it is assumed that the default is a willful default:

• When a borrower defaults despite his capacity to repay
• When a borrower defaults but diverts finance away from the purpose it was availed for.
• The funds are available in the other form of assets but party does not make payment.
• Party disposed off the removable assets / immovable property which was used for thr purpose of secured loan, without knowledge of the bank.

The SS Kohli Committee had recommended some penal measures against the willful defaults. Some of them are as follows:

• The willful defaulters are not able to access the markets, so a copy of the list of the willful defaulters are shared by the RBI to SEBI.
• No facility is provided by a Bank / FI to a willful defaulter till 5 years from the date of publishing its name in the list of willful defaulters.
• Expeditious legal action is initiated against for the recovery of the amount.

The banks and FIs are required to compile the list of the suit filed willful defaulters and submit the same to the Credit Information Bureau of India Ltd. every quarter, provided the outstanding amount is Rs. 25 Lakh or more.

NPA and Provision Coverage Ratio

For every loan given out, the banks to keep aside some extra funds to cover up losses if something goes wrong with those loans. This is called provisioning. Provisioning Coverage Ratio (PCR) refers to the funds to be set aside by the banks as fraction to the loans.

• PCR is the ratio of provision to gross non-performing assets (NPAs).
• A key relationship in analyzing asset quality of the bank.
• A measure that indicates the extent to which the bank has provided against the troubled part of its loan portfolio.
• A high ratio suggests that additional provisions to be made by the bank in the coming years would be relatively low (if gross NPAs do not rise at a faster clip).
• Thus, PCR refers to the percentage of the loan amount that the bank has set aside as provisions to meet an eventuality where the loan might have to be written off it becomes irrecoverable.
• It is a measure that indicates the extent to which the bank has provided (set aside money to bear the loss) against the troubled part of its loan portfolio.
• PCR  = Cumulative provisions / Gross NPAs

Thus, more the NPAs lesser will be the PCR. Kindly note that till 2011, the RBI had mandated the banks to keep a 70% PCR. This implied that more they had NPAs, more they needed to keep aside additional funds to cover up the losses. The requirement was withdrawn by RBI on the ground that such requirement would wipe out their quarterly profits.

Priority Sector Lending

Priority sector was first properly defined in 1972, after the National Credit Council emphasized that there should be a larger involvement of the commercial banks in the priority sector. The sector was then defined by Dr. K S Krishnaswamy Committee. The priority sectors include those sectors which may not get adequate institutional credit due to social, cultural and economic reasons.

Common priority sectors include Agriculture Finance, Small Enterprises, Retail Trade, Micro Credit, Education Loans and housing loans.

Sectors that come under Priority Sectors

As per Reserve Bank of India, Priority sector includes the following:

• Agriculture and Allied Activities viz. dairy, fishery, animal husbandry, poultry, bee-keeping and sericulture.
• Small scale industries (including setting up of industrial estates)
• Small road and water transport operators (owning up to 10 vehicles).
• Small business (Original cost of equipment used for business not to exceed  20 lakh)
• Retail trade (advances to private retail traders up to 10 lakh)
• Professional and self-employed persons (borrowing limit not exceeding 10 lakh of which not more than Rs.2 lakh for working capital; in the case of qualified medical practitioners setting up practice in rural areas, the limits are Rs.15 lakh and Rs.3 lakh respectively and purchase of one motor vehicle within these limits can be included under priority sector)
• State sponsored organizations for Scheduled Castes/Scheduled Tribes
• Education (educational loans granted to individuals by banks)
• Housing [both direct and indirect – loans up to 5 Lakhs (direct loans up to Rs 10 lakh in urban/ metropolitan areas), Loans up to Rs.1 lakh and Rs.2 lakh for repairing of houses in rural/ semi-urban and urban areas respectively].
• Consumption loans (under the consumption credit scheme for weaker sections)
• Micro-credit provided by banks either directly or through any intermediary; Loans to self help groups(SHGs) / Non Governmental Organizations (NGOs) for on lending to SHGs
• Loans to thesoftware industry (having credit limit not exceeding Rs 1 crore from the banking system)
• Loans to specified industries in the food and agro-processing sector having investment in plant and machinery up to Rs 5 crore.
• Investment by banks inventure capital (venture capital funds/ companies registered with SEBI)

Priority Sector Targets

In 1974, the banks were given a target of 33.33 % as share of the priority sector in the total bank credit. On the basis of Dr. K S Krishnaswamy committee, the target was raised to 40%. The current Priority sector targets are as follows:

Why RBI imposes the Priority Sector Targets?
The overall objective of priority sector lending program is to ensure that adequate institutional credit flows into some of the vulnerable sectors of the economy, which may not be attractive for the banks from the point of view of profitability.
Priority Sector lending in India has been made a salient feature of the banking in India mainly due to the social and economic objectives that underlie PSL. However, banks are also required to keep certain amount to maintain Statutory Liquidity Ratio ( SLR) and from the remaining disposable amount, 40 per cent is dedicated for the priority sector. Thus, large fraction of banks’ resources cause the so called “Double Repression” on the banking system. The economic survey has brought this issue to the forefront and has recommended the government to re-structure SLR and Priority Sector Lending.

[1] For every loan given out, the banks to keep aside some extra funds to cover up losses if something goes wrong with those loans. This is called provisioning.