ALLAMA IQBAL OPEN UNIVERSITY ISLAMABAD

COURSE CODE 8593

SAMESTER AUTUM

2023

ASSIGNMENT NO.2

NAME AAAA

ID 0000

PROGRAME BS
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Q.1 Distinguish among the bank loans, bank draft and cash
credit. (20)
Ans.
Distinguishing Among Bank Loans, Bank Drafts, and Cash Credit:

1. Bank Loans:

- Nature:

- A bank loan is a financial arrangement where a borrower

receives a lump sum amount from a bank, and the borrower
agrees to repay the amount over a specified period with interest.

- Purpose:

- Bank loans can be used for various purposes such as

business expansion, capital investment, home purchase, or
personal needs.

- Repayment Structure:

- Borrowers repay the loan in fixed installments over the agreed

loan tenure. The interest rate may be fixed or variable, depending
on the terms of the loan agreement.

- Security:

- Loans may be secured or unsecured. Secured loans require

collateral, while unsecured loans do not have specific assets tied
to them.

- Usage Limitations:
 - Borrowers receive the entire loan amount upfront, and the
usage is not restricted to specific transactions.

2. Bank Drafts:

- Nature:

- A bank draft is a payment instrument issued by a bank on

behalf of a customer, providing a secure and guaranteed method
of making payments.

- Purpose:

- Bank drafts are often used for making payments in situations

where a check may not be accepted or when the payee demands
a guaranteed form of payment.

- Repayment Structure:

- Bank drafts do not involve repayment structures, as they

represent a form of payment rather than a credit arrangement.

- Security:

- Bank drafts are considered secure as they are typically drawn

against the funds in the payer's account, ensuring that the
payment is guaranteed.

- Usage Limitations:

- Bank drafts are used for specific payment transactions and

are not a revolving credit facility. They are often used in
international trade for secure cross-border transactions.

3. Cash Credit:

- Nature:

- Cash credit is a type of short-term credit facility extended by

banks to businesses. It allows borrowers to withdraw funds up to
a specified credit limit as needed.

- Purpose:

- Cash credit is primarily used by businesses to manage

working capital needs, such as purchasing inventory, managing
operational expenses, or meeting short-term cash flow
requirements.

- Repayment Structure:

- Unlike traditional loans, cash credit does not have fixed

installment repayments. Borrowers can withdraw and repay funds
within the credit limit as per their operational needs.

- Security:

- Cash credit may be secured by assets or receivables. It is a

form of revolving credit where the credit limit is periodically
reviewed based on the borrower's creditworthiness.

- Usage Limitations:

- Cash credit provides flexibility as businesses can draw and

repay funds within the approved credit limit. It is a continuous and
revolving form of credit.

Summary:

- Bank Loans:

- Nature: Lump sum credit with fixed repayments.

- Purpose: Varied, such as business expansion or personal needs.

- Repayment Structure: Fixed installments over a specified

period.

- Security: Can be secured or unsecured.

- Usage Limitations: Borrowers receive the full amount upfront.

- Bank Drafts:

- Nature: Payment instrument issued by a bank.

- Purpose: Secure payments, especially in international

transactions.

- Repayment Structure: Not applicable; used for payments.

- Security: Considered secure, drawn against payer's funds.

- Usage Limitations: Specific to payment transactions.

- Cash Credit:

- Nature: Short-term revolving credit facility.

- Purpose: Working capital needs for businesses.

- Repayment Structure: No fixed installments; revolving credit.

- Security: Secured by assets or receivables.

- Usage Limitations: Continuous, with withdrawals and

repayments within an approved credit limit.

Q.2 What precautions are usually undertaken by banks before

sanctioning such loans?
(20)
Ans.
Before sanctioning loans, banks typically undertake a series of
precautions and due diligence measures to assess the
creditworthiness of the borrower and to mitigate the risks
associated with lending. Here are some common precautions
taken by banks:

1. Credit Assessment:
- Banks conduct a thorough credit assessment to evaluate the
borrower's creditworthiness. This involves reviewing the
borrower's credit history, repayment behavior, and credit score.

2. Financial Statements Analysis:

 - Banks analyze the financial statements of the borrower,
including income statements, balance sheets, and cash flow
statements, to assess the financial health and stability of the
business or individual.

3. Business Plan Evaluation:

- For business loans, banks assess the borrower's business plan
to understand the purpose of the loan, projected cash flows,
market conditions, and the feasibility of the project.

4. Collateral Evaluation:
- Secured loans require collateral. Banks assess the value and
quality of the proposed collateral to determine its adequacy and
suitability as security for the loan.

5. Debt-Service Coverage Ratio (DSCR) Calculation:

- For commercial loans, banks calculate the debt-service
coverage ratio to evaluate the borrower's ability to cover debt
obligations with available cash flow.

6. Loan-to-Value (LTV) Ratio:

- In mortgage lending, banks calculate the loan-to-value ratio,
comparing the loan amount to the appraised value of the property.
This helps assess the risk associated with the loan.

7. Borrower's Capacity to Repay:

- Banks assess the borrower's capacity to repay the loan by
evaluating income stability, employment history, and other factors
affecting the ability to make timely payments.

8. Industry and Economic Analysis:

- Banks conduct industry and economic analyses to understand
the external factors that may impact the borrower's ability to
repay, especially in sectors sensitive to economic fluctuations.

9. Regulatory Compliance:
- Banks ensure that the loan proposal complies with regulatory
requirements, including interest rate regulations, legal restrictions,
and any specific guidelines set by regulatory authorities.

10. Documentation Verification:

- Banks verify the authenticity of the documents submitted by
the borrower, including identification, income proof, and business
registration documents.

11. Background Checks:

- For individual borrowers, banks may conduct background
checks to verify the borrower's identity, employment history, and
other relevant information.

12. Evaluation of Guarantors (if applicable):

- If there are guarantors for the loan, banks evaluate their
financial standing, creditworthiness, and capacity to fulfill the
guarantee commitment.

13. Assessment of Existing Debt:

 - Banks consider the borrower's existing debt obligations to
ensure that the additional loan is manageable and does not lead
to financial strain.

14. Interest Rate Risk Assessment:

- Banks assess interest rate risk by considering the potential
impact of interest rate fluctuations on both the borrower's ability
to repay and the bank's profitability.

15. Loan Covenants:

- Banks may include specific loan covenants that outline
conditions and restrictions on the borrower, ensuring compliance
with agreed-upon terms and protecting the bank's interests.

16. Environmental and Social Impact Assessment (for certain

projects):
- In cases of project financing, banks may conduct
environmental and social impact assessments to evaluate the
potential risks associated with the project.

By undertaking these precautions, banks aim to make informed

lending decisions, minimize risks, and ensure that loans are
extended to borrowers who are likely to meet their repayment
obligations. This comprehensive due diligence process helps
maintain the stability and integrity of the banking system.

Q.3 Define a letter of credit and describe the mechanism

involved in making payments for overseas business through a
letter of credit. (20)
Ans.
Letter of Credit (LC):

A Letter of Credit (LC) is a financial instrument widely used in

international trade transactions to facilitate secure and
guaranteed payments between a buyer and a seller, especially
when they are located in different countries. It is a written
commitment issued by a bank (known as the issuing bank) on
behalf of the buyer (importer) to pay a specified amount to the
seller (exporter) upon the presentation of compliant documents.
Letters of Credit provide assurance to both parties that the terms
of the trade deal will be honored.

Mechanism Involved in Making Payments for Overseas Business

Through a Letter of Credit:

1. Initiation of the Letter of Credit:

- The buyer and seller agree on the terms of the trade, including
the product or service, quantity, price, shipping terms, and the
necessary documents. The buyer decides to use a Letter of Credit
for the transaction.

2. Application by the Buyer:

- The buyer applies for a Letter of Credit from their bank (issuing
bank). In the application, the buyer specifies the terms and
conditions of the LC, including the type of LC (sight or usance),
expiry date, and any special instructions.
3. Issuance by the Issuing Bank:
- Upon approval of the buyer's application, the issuing bank
issues the Letter of Credit, detailing the terms and conditions. The
LC is sent to the seller's bank (advising or confirming bank) if
necessary, and the seller is informed.

4. Confirmation (Optional):
- In some cases, especially when dealing with unfamiliar
overseas banks, the issuing bank may request a confirming bank
to add its confirmation to the LC. This provides an additional layer
of payment security for the seller.

5. Advising the Letter of Credit:

- The advising bank, located in the seller's country, receives the
Letter of Credit from the issuing bank and notifies the seller that
the LC has been opened in their favor. The advising bank ensures
that the LC is genuine and has been issued correctly.

6. Seller's Shipment and Documentation:

- The seller ships the goods or provides the services as per the
terms of the agreement. Simultaneously, the seller prepares the
required documents specified in the LC, such as the invoice, bill of
lading, packing list, certificate of origin, and any other documents
mentioned in the LC.

7. Document Presentation:
- The seller presents the compliant documents to the advising
bank, which checks whether they meet the terms outlined in the
LC. If the documents conform to the LC, the advising bank
forwards them to the issuing bank.

8. Payment or Acceptance by the Issuing Bank:

- The issuing bank reviews the documents. If everything is in
order, the bank makes the payment to the seller as per the terms
of the LC. In the case of a sight LC, payment is made immediately;
for a usance LC, payment is made at a later date upon maturity.

9. Delivery of Documents to the Buyer:

- The issuing bank releases the documents to the buyer upon
payment or acceptance. The buyer can use these documents to
claim the goods from the carrier and proceed with customs
clearance.

10. Payment by the Buyer:

- The buyer is obligated to make the payment to the issuing
bank according to the terms specified in the LC. If it is a sight LC,
payment is immediate; if it is a usance LC, payment is made at
the agreed-upon maturity date.

The use of Letters of Credit in international trade transactions

provides a secure and structured mechanism, ensuring that both
the buyer and the seller fulfill their respective obligations. The
involvement of banks adds a layer of trust and security, making it
a widely accepted method for mitigating payment and delivery
risks in cross-border trade.
Q.4 Describe very briefly the principles of note issue by the
central bank of a country. Discuss three most important
methods of note issue. (20)
Ans.
Principles of Note Issue by the Central Bank:

The principles of note issue by a central bank refer to the

guidelines and policies that govern the issuance and
management of the national currency. These principles aim to
ensure the stability and integrity of the monetary system. Key
principles include:

1. Monopoly of Note Issue:

- Typically, central banks have the sole authority to issue and
manage the national currency, ensuring a centralized and
controlled system to prevent excessive or unauthorized issuance.

2. Backed by Assets:
- Notes issued by the central bank are often backed by tangible
assets such as gold, foreign exchange reserves, or government
securities. This backing instills confidence in the value of the
currency.

3. Legal Tender:
- Central bank notes are designated as legal tender, meaning
they must be accepted for transactions within the country. This
legal status enhances the widespread use and acceptance of the
currency.

4. Convertibility:
- In some cases, central bank notes were historically directly
convertible into a specific quantity of a commodity like gold.
While direct convertibility is less common today, the stability of
the currency is maintained through other means.

5. Controlled Circulation:
- Central banks manage the circulation of currency to prevent
overissuance or shortages. This involves monitoring economic
conditions, adjusting interest rates, and implementing open
market operations.

Three Most Important Methods of Note Issue:

1. Minimum Reserve System:

- In this method, the central bank is required to hold a minimum
reserve of specified assets (such as gold or foreign exchange)
against the total value of banknotes issued. The reserve serves as
a guarantee for the convertibility and stability of the currency.

2. Proportional Reserve System:

- Under this system, the central bank is required to hold reserves
in proportion to the total value of notes issued. The reserves may
include a combination of gold, foreign exchange, and other liquid
assets. This method allows for flexibility while ensuring a secure
backing for the currency.
3. Currency Board System:
- In a currency board system, the central bank fully backs the
national currency with foreign exchange reserves. The country
commits to maintaining a fixed exchange rate with a foreign
currency, and the central bank holds foreign reserves equal to the
entire domestic currency in circulation.

These methods aim to balance the need for flexibility in currency

issuance with the necessity of maintaining confidence in the
currency's value. They also play a crucial role in supporting
monetary policy and economic stability by providing a secure
foundation for the national currency. The choice of a specific
method depends on various economic factors and the monetary
policy objectives of the central bank.

Q.5 Define monetary policy. What are the instruments of credit

controls? (20)
Ans.
Monetary Policy:

Monetary policy refers to the set of measures and actions

implemented by a country's central bank to regulate and control
the money supply, interest rates, and credit conditions in the
economy. The primary objective of monetary policy is to achieve
specific macroeconomic goals, such as price stability, full
employment, and sustainable economic growth. Central banks
use various tools to influence the money supply, interest rates,
and overall economic activity.

Instruments of Credit Controls:

Credit controls are tools employed by central banks to manage

the availability, cost, and use of credit in the economy. These
controls help achieve the broader goals of monetary policy. The
main instruments of credit controls include:

1. Open Market Operations (OMO):

- Description: Central banks buy or sell government securities in
the open market to influence the money supply and interest rates.
- Effect: Buying securities injects money into the economy,
lowering interest rates and encouraging borrowing. Selling
securities removes money, raising interest rates and reducing
borrowing.

2. Bank Rate (Discount Rate):

- Description: The interest rate at which commercial banks can
borrow funds from the central bank.
- Effect: A change in the bank rate influences the cost of
borrowing for commercial banks. An increase discourages
borrowing, while a decrease encourages it.

3. Reserve Requirements:
- Description: Central banks set the minimum reserve that
commercial banks must hold in proportion to their deposits.
- Effect: Increasing reserve requirements reduces the funds
available for lending, curbing credit expansion. Decreasing
requirements has the opposite effect, encouraging lending.

4. Selective Credit Controls:

- Description: Central banks may impose specific controls on
lending to certain sectors or purposes.
- Effect: This approach targets credit to specific areas, such as
real estate or consumer credit, to manage potential risks or asset
bubbles.

5. Repo Rate (Repurchase Agreement Rate):

- Description: Central banks engage in repurchase agreements,
where they sell securities with an agreement to repurchase them
later.
- Effect: Adjusting the repo rate influences short-term interest
rates and helps manage liquidity in the financial system.

6. Liquidity Adjustment Facility (LAF):

- Description: LAF allows banks to borrow or lend money to the
central bank on a short-term basis to manage their liquidity needs.
- Effect: Banks use LAF to address temporary liquidity
imbalances, impacting short-term interest rates.

7. Credit Rationing:
- Description: Central banks may limit the amount of credit
banks can extend to borrowers or specific sectors.
- Effect: Credit rationing helps control excessive borrowing in
certain areas, preventing potential economic imbalances.
8. Margin Requirements:
- Description: Central banks may set minimum margin
requirements for loans, especially in financial markets.
- Effect: Increasing margin requirements reduces leverage,
reducing the risk of speculative bubbles in financial markets.

9. Guidance and Moral Suasion:

- Description: Central banks may provide guidance or use moral
suasion to influence banks' lending behavior without resorting to
formal regulations.
- Effect: Through persuasion and guidance, central banks aim to
align the behavior of financial institutions with broader monetary
policy objectives.

These instruments, used individually or in combination, allow

central banks to fine-tune the money supply, interest rates, and
credit conditions to achieve the desired economic outcomes. The
choice of instruments depends on the prevailing economic
conditions and the specific goals of monetary policy at any given
time.