Credit Management

Credit management is the process of monitoring and collecting payments from customers. A
good credit management system minimizes the amount of capital tied up with debtors. It is very
important to have good credit management for efficient cash flow. There are instances when a
plan seems to be profitable when assumed theoretically but practical execution is not possible
due to insufficient funds. In order to avoid such situations, the best alternative is to limit the
likelihood of bad debts. This can only be achieved through good credit management practices.

Credit management is the process of granting credit, setting the terms on which it is granted,
recovering this credit when it is due, and ensuring compliance with company credit policy,
among other credit related functions. The goal within a bank or company, in controlling credit, is
to improve revenues and profit by facilitating sales and reducing financial risks. A structured
credit policy ensures that the credit team uses a standardized method for managing a customer’s
credit risk. This leads to consistent credit decisions and eliminating compliance issues because
there is an audit trail.

A credit manager is a person employed by an organization to manage the credit department and
make decisions concerning credit limits, acceptable levels of risk, terms of payment and
enforcement actions with their customers. This function is often combined with Accounts
Receivable and Collections into one department of a company. The role of credit manager is
variable in its scope and Credit Managers are responsible for:

1. Controlling bad debt exposure and expenses, through the direct management of credit
terms on the company's ledgers.

2. Maintaining strong cash flows through efficient collections. The efficiency of cash flow
is measured using various methods, the most common of which is Days Sales
Outstanding (DSO).

3. Ensuring an adequate Allowance for Doubtful Accounts is kept by the company.

4. Monitoring the Accounts Receivable portfolio for trends and warning signs.

5. Hiring and firing credit analysts, accounts receivable and collections personnel.

6. Enforcing the "stop list" of supply of goods and services to customers.

7. Removing bad debts from the ledger (Bad Debt Write-Offs).

8. Setting credit limits.

9. Setting credit terms beyond those within credit analysts' authority.

10. Setting credit rating criteria.

 11. Setting and ensuring compliance with a corporate credit policy.

12. Pursuing legal remedies for non-payers.

13. Obtaining security interests where necessary. Common examples of this could be PPSAs,
letters of credit or personal guarantees.

14. Initiating legal or other recovery actions against customers who are delinquent.

Credit managers tend to fall into one of three groups depending on the specific legal and
jurisdictional knowledge required:

1. Commercial Credit Manager

2. Consumer Credit Managers

3. Construction Credit Managers

Credit Management

For running a profitable business in an enterprise, the entrepreneur needs to prepare and design
new policies and procedures for credit management. For example, the terms and conditions,
invoicing promptly and controlling debts.

Principles of Credit Management

Credit management plays a vital role in the banking sector. As we all know, banks are one of the
major sources of lending capital. So, Banks follow the following principles for lending capital −

Liquidity

Liquidity plays a major role when a bank is into lending money. Usually, banks give money for a
short duration of time. This is because the money they lend is public money. This money can be
withdrawn by the depositor at any point in time.

So, to avoid this chaos, banks lend loans after the loan seeker produces enough security of assets
which can be easily marketable and transformable to cash in a short period of time. A bank is in
possession to take over these produced assets if the borrower fails to repay the loan amount after
some interval of time as decided.

A bank has its own selection criteria for choosing security. Only those securities which acquire
enough liquidity are added to the bank’s investment portfolio. This is important as the bank
requires funds to meet the urgent needs of its customers or depositors. The bank should be in a
condition to sell some of the securities at very short notice without having any impact on their
market rates much. There are particular securities such as the central, state, and local government
agreements which are easily saleable without having any impact on their market rates.
Shares and debentures of large industries are also addressed under this category. But the shares
and debentures of ordinary industries are not easily marketable without having a fall in their
market rates. Therefore, banks should always make investments in government securities and
shares and debentures of reputed industrial houses.

Safety

The second most important function of lending is safety, safety of funds lent. Safety means that
the borrower should be in a position to repay the loan and interest at regular durations of time
without any fail. The repayment of the loan relies on the nature of security and the potential of
the borrower to repay the loan.

Unlike all other investments, bank investments are risk prone. The intensity of risk differs
according to the type of security. Securities of the central government are safer when compared
to the securities of the state governments and local bodies. Similarly, the securities of state
government and local bodies are much safer when compared to the securities of industrial
concerns.

This variation is due to the fact that the resources acquired by the central government are much
higher as compared to resources held by the state and local governments. It is also higher than
the industrial concerns.

Also, the share and debentures of industrial concerns are bound to their earnings. Income varies
according to the business activities held in a country. The bank should also consider the ability of
the debtor to repay the debt of the governments while investing in their securities. The
prerequisites for this are political stability and peace and security within the country.

Securities of a government acquiring large tax revenue and high borrowing capacity are
considered as safe investments. The same goes with the securities of a rich municipality or local
body and state government of a flourishing area. Thus, while making any sort of investments,
banks should decide securities, shares and debentures of such governments, local bodies and
industrial concerns which meets the principle of safety.

Therefore, from the bank’s way of perceiving, the nature of security is very essential while
lending a loan. Even after considering the securities, the bank needs to check the
creditworthiness of the borrower which is monitored by his character, capacity to repay, and his
financial standing. Above all, the safety of bank funds relies on the technical feasibility and
economic viability of the project for which the loan is to be given.

Diversity

When selecting an investment portfolio, a commercial bank should abide by the principle of
diversity. It should never invest its total funds in a specific type of securities, it should prefer
investing in different types of securities.
It should select the shares and debentures of various industries located in different parts of the
country. In the case of state governments and local governing bodies, the same principle should
be abided by. Diversification basically targets reducing risk of the investment portfolio of a bank.

The principle of diversity is applicable to the advancing of loans to different types of firms,
industries, factories, businesses, and markets. A bank should abide by the maxim that is “Do not
keep all eggs in one basket.” It should distribute its risks by lending loans to different trades and
companies in different parts of the country.

Stability

Another essential principle of a bank’s investment policy is stability. A bank should prefer
investing in those stocks and securities which hold a high degree of stability in their costs. Any
bank cannot incur any loss on the rate of its securities. So, it should always invest funds in the
shares of branded companies where the probability of decline in their rate is less.

Government contracts and debentures of industries carry fixed costs of interest. Their cost varies
with variation in the market rate of interest. But the bank is bound to liquidate a part of it to
satisfy its needs of cash whenever stuck by a financial crisis.

Else, they follow their full term of 10 years or more and variations in the market rate of interest
do not disturb them. So, bank investments in debentures and contracts are more stable when
compared to the shares of industries.

Profitability

This should be the chief principle of investment. A bank should only invest if it earns sufficient
profits from it. Thus, it should invest in securities that have a fair and stable return on the funds
invested. The procuring capacity of securities and shares relies on the interest rate and the
dividend rate and the tax benefits they hold.

Broadly, it is the securities of government branches like the government at the center, state and
local bodies that hugely carry the exception of their interest from taxes. A bank should prefer
investing in these types of securities instead of investing in the shares of new companies which
also carry tax exception. This is due to the fact that shares of new companies are not considered
as safe investments.

Now lending money to someone is accompanied by some risks mainly. As we know that bank
lends the money of its depositors as loans. To put it simply, the main job of a bank is to borrow
money from depositors and give money to the borrowers. As the primary source of funds for a
bank is the money deposited by its customers which are repayable as and when required by the
depositors, the bank needs to be very careful while lending money to customers.
Banks make money by lending money to borrowers and charging some interest rates. So, it is
essential on the bank’s part to follow the cardinal principles of lending. When these principles
are abided, they assure the safety of banks’ funds and in response to that they assure its
depositors and shareholders. In this whole process, banks earn good profits and grow as financial
institutions. Sound lending principles by banks also help the economy of a nation to prosper and
also advertise expansion of banks in rural areas.

What is a credit policy?

A credit policy is a set of guidelines and rules that guide credit management operations. It lists
rules around payment terms, late fees, credit limits, payment terms, interest rates, and more.

A good credit policy should do the following:

1. Define customer’s credit limits (this is maximum amount they can borrow)

2. Define credit terms (when payments, discounts, and late fees are due)

3. Where to record transactions

4. What actions to take collections and for non-payment

A good credit policy should be kept up to date and reviewed frequently as per the business
requirements.

The creation processes

In principle, solid credit management can involve two key steps. First you determine your
strategy and then you specify the appropriate procedures.

Step 1: Determine the strategy.

1. Which customers do you accept and under which conditions?

2. Which customers do you monitor?

3. Which of them should no longer be accepted, and when is the exit period?

Step 2: Prepare appropriate procedures.

1. What is your invoicing process like?

2. What is your invoice like?

3. When do you conduct a reminder by telephone?

4. When do you send a reminder in writing?

 5. What does the reminder look like?

6. When do you engage a debt collection agency?

7. When will you start legal proceedings?

8. What is the role of your employees in this issue?

9. Will you choose outsourcing or in-house management?

10. Which systems will you require?

Companies work with different applications and systems to limit the risks and to update the data.

1. Acceptance system: Based on credit information, you determine whether a new

customer is accepted or not. This can be a manual or automated process.

2. Monitoring system: This system checks the entire portfolio for continuous insight into
existing customers and suppliers. Certainly, relating to chain parties, the latter is essential.

3. Invoicing system: Invoices may be sent manually or automated (sometimes as a digital

invoice) and reminders must be logically aligned.

4. Bookkeeping system: All receivables and payables are booked in this system, which is
the basis for insight into the cash flow and receivables risk.

5. CRM system: The Customer Relationship Management (CRM) system lists information
relating to agreements, contact and contracts with customers. Complaints can also be
processed in this system, for better insight into the background of non-payment.

6. Automating receivables management: By automating your credit management, all

previously mentioned systems can be interlinked. This leads to a more efficient work
flow and to greater insight as it allows for easily generating cash flow and customer
reports. Automatically linking credit information decreases the percentage of non-paying
new customers. By automatically integrating the debt collections in the process, the
percentage of non-paying existing customers also decreases.
What is a credit manager?

A credit manager is someone responsible for overseeing the credit management process. Credit
managers usually have backgrounds in finance and/or business administration. They manage the
assessment of multiple potential and existing customers simultaneously. The role requires good
analytical and communication skills. These abilities are essential to a company’s economic
performance.

What is good credit management?

Simply put, good credit management involves ensuring all customers pay their invoices on time,
within the terms and conditions. That’s the ideal. In reality, it’s very unlikely all customers will
pay all outstanding invoices in full and on time. This is why you need a good credit management
program and team. Credit managers should have oversight over the credit management process
and best practices. They should also be responsible for keeping your credit policy up to date.

The benefits of good credit management

Credit management is important because it reinforces a company’s liquidity. If done correctly it

will improve cash flow and lower the rate of late payments. It’s the difference between a high or
low DSO, the amount of bad debt a financial portfolio presents and even negative or positive
customer relations.

Role of Credit in the Economy

Today, our economy thrives on the existence of credit. Cole and Mishler in 1995 write: “The use
of credit has become an important part of any economy. It is the oil that lubricates economic
machinery.” Jurinski adds: “The availability of credit is the lifeblood of any nation economy….
(And) it is hard to imagine an economy without the availability of credit. Credit grows the
economy, cash retards. However, misuse, abuse or mismanagement of credit seriously debilitates
the economy. Therefore, the one to whom credit is to be extended should have the ability,
character, and willingness to comply with the terms of the credit.

According to Summers and Wilson: “Credit is pervasive in all the economies of the world
affecting financial transactions at all levels from individual consumer to multinational company.

What is Credit Analysis?

It’s the method by which one calculates the creditworthiness of a business organization or
individual. In other words, it is the evaluation of the ability of a company or individual to honor
financial obligations.

To achieve this definition, searchlights are beamed on:

1. Analyzing the audited account of a company: The objective is to determine how prudent or
otherwise the company spends, saves, or invests the money it made during the immediate past
three years. The mindset for this is to know whether or not the company is capable of honoring
its payment obligations in the event of any credit line extended to it.

2. Analyzing the board of directors of a company: You analyze the make-up of the board with
a view to determining their individual stake and commitment to the company, discovering their
individual advantage or disadvantage in terms of contacts that he or she have in the industry,
market or government places that the director is most likely going to bring to the company, if
need be, as well as the overall reputation of each board member for the purpose of safeguarding
the future of the company, or if a board member has a history of being critical of government
(federal, state, local) policies and the likelihood that such posture may attract attack on the
company directly or indirectly, among others.

3. Analyzing the management of a company: This is to determine their fitness to manage the
company for profit, their ability to manage the company with all sense of ethicality and
professionalism, their previous track records of a successful management of an enterprise, their
individual qualifications, and experiences. The analysis shows either the management of the
company is good enough to deliver to the expectation of the owners of the company, so that it
can honor its obligations to its suppliers or those with whom it does business.

4. Analyzing political environment of the country: This is to determine how susceptible or

vulnerable the company’s business might be, to determine if the line of business of the company
may expose the company to certain political attack, or the company is located in a place or
certain community where the possibility of political attack is high against the company, or in the
sudden event of government’s shift in policies, among others.
5. Analyzing the industry and market: This is where the company does its business with a
view to determining the leading and weak competitors, strong and weak products in the market
and the top five in the industry, as well as how others are doing, among others.

6. Analyzing the banking transaction: Records of the company’s banking transactions have to
be analyzed to see if the company have a case or unfulfilled credit obligations with any bank or
its name has been reported to credit bureau in relation to credit abuse or credit default.
Classification of Credit
What is credit?

Credit is defined in a couple of ways. One is the amount of money you are approved to borrow
from a lending institution. With this approval comes an agreement to repay the charges, any
additional fees that can or will be applied, and to abide by time restrictions.

Credit can also be classified as your borrowing reputation. It paints a picture of your payment
history and provides the lender with information regarding the likelihood of your repayment, in
other words, your risk factor.

Use of Credit

When used responsibly, credit can be a convenient and effective financial tool. From a simple
credit card to an auto or home loan, credit is the American way of life. Cashless transactions are
soon becoming the way of the future, and credit cards are among the most prevalent.
Understanding credit is important in order to use credit to your advantage and to prevent the
common financial pitfall – debt.

Bank credit is the total amount of funds a person or business can borrow from a financial
institution. Credit approval is determined by a borrower's credit rating, income, collateral, assets,
and pre-existing debt.

Bank credit is usually referred to as a loan given for business requirements or personal needs to
its customers, with or without a guarantee or collateral, with an expectation of earning periodic
interest on the loan amount. The principal amount is refunded at the end of loan tenure, duly
agreed upon, and mentioned in the loan covenant.
In today’s world, demands are continuously increasing, but the means to fulfill those demands
are limited; hence borrowing money will enable financing the varied needs of a business,
profession, and personal. Depending on the type of loan and the agreement on the bank credit
letter, these loans are either instalment-based, open credit, or revolving credit.

Bank credit typically refers to loans provided to customers for personal or business purposes,
with or without collateral, intending to regularly earn interest on the principal.

Secured loans are backed by collateral, which serves as a guarantee to the bank. Collateral can
include property, debtors, stock, fixed deposits, or any other asset the bank can sell or liquidate if
the borrower fails to make installment payments.

Working capital loans are obtained when businesses struggle to manage their working capital
effectively.

Bank Credit Explained

Bank credit refers to the loan extended to fulfil business needs without any collateral or security
being provided. Similar loans are extended to individuals through bank credit cards, however, for
business, loans are provided at a particular interest rate that is repaid through instalments,
through open or revolving credit.

Bank credit helps an organization meet business needs; however, there should be the right mix of
debt and equity components to have healthy financial statements.

This credit is given to borrowers to fulfill the necessary documentation required by the Bank.
Interest rates and repayment terms are duly mentioned in the loan covenant. Documentation to
the Bank includes:

 Financial statements.

 Income tax returns.

 Projected financial statements for three to five years.

 Changes are based on the type of loan and from person to person.

 Characteristics

Multiple individuals and organizations come together before a bank credit letter is issued. Let us
understand the parties involved and their characteristics through the discussion below.

1. Borrower: A person who borrows money.

2. Lender: The person who lends money is usually the bank.

 3. Rate of Interest: The interest rate can be a fixed or floating rate of interest. The floating
interest rate is based on benchmark rates like LIBOR [ LIBOR Rate (London Interbank
Offer) is an estimated rate which is calculated by averaging out the current rate of interest
being charged by major prominent banks in London which serves as a benchmark rate for
the financial markets domestically as well as internationally, where it can change on day-
to-day basis given the changes in certain market conditions.] or MIBOR [The Mumbai
Interbank Offer Rate (MIBOR) is one iteration of India's interbank rate, which is the rate
of interest charged by a bank on a short-term loan to another bank. As India's financial
markets have continued to develop, India felt it needed a reference rate for its debt
market, which led to the development and introduction of the MIBOR. MIBOR is used in
conjunction with the Mumbai interbank bid and forward rates (MIBID and MIFOR) by
the central bank of India to set short-term monetary policy. ].

4. Terms of Repayment: These are mentioned in the loan covenant and strictly adhere to
avoid the prepayment penalty.

5. Mode of Loan: Normally given in cash but sometimes will be given in the form of raw
material or fixed assets.

#1 – Classification Based on Borrower

#1 – Loan for Personal Purpose : Personal loans are given to meet the particular needs of the
group and individual. For example, personal loans are taken to purchase consumer goods,
electronics, houses, vehicles, etc.

#2 – Loan for Business or Profession Purposes : These loans are offered to meet the needs of
the business. It can be a working capital loan or cash credit facility to meet a short-term liquidity
crunch. Companies borrow money for major fixed asset expansion, business diversification into
different product portfolios, and varied customer segments. The purpose of lending money will
be different for different businesses based on circumstances, needs, and environments in which
the company operates.

#2 – Classification Based on Security

#1 – Secured Loans : Secured loans are secured against collateral, a guarantee given to the
Bank by the third party. Loans can be secured against property, plant and machinery and
equipment , debtors, stock, fixed deposits, and any other asset which can be sold or liquidated by
the Bank in case of nonpayment of installment on the part of the borrower.

The bank will also lend money against the guarantee given by the third party on behalf of the
borrower. In the case of a guarantee, the guarantor will be liable to pay a balanced amount if the
borrower fails to do so.
#2 – Unsecured Loan : Unsecured loans are neither secured against any asset nor any guarantee
is provided to the Bank. A borrower with a great history of the settlement of dues, good credit
rating, and sound financial records will generally get an unsecured loan. Unsecured loans are
usually provided by small banks, Fincare Small Finance Bank Limited , United Community
Bank , ANZ Bank (UK) Limited etc. and relatives.

#3 – Classification Based on Duration

#1- Short Term Loans : These loans are given for a shorter duration, say one month to one year.

Credit Card Loans: These usually are given for one month. The Bank issues credit cards to
borrowers to facilitate the day-to-day needs of businesses and individuals. Credit cards are issued
to sales managers with a specific limit to spend expenditure on travel and sales-related expenses.
Individuals use credit cards for day-to-day requirements.

Cash Credit Facility or Bank Overdraft Facility: This is extended to current account holders
to withdraw more than the debit balance of the bank account. CC or bank OD facility is mainly
used when a business has a cash crunch and must settle sudden liabilities.

Working Capital Loans: These can be short-term or long-term in nature. It depends on the
working capital cycle of the company. The working capital cycle may be more than twelve
months in an industry that sells seasonal goods. A working capital loan is required when
companies cannot manage working capital effectively. The credit period allowed by vendors is
lower than the credit period allowed to debtors , and the stock turnover ratio is higher when the
need for working capital loans arises. The Stock turnover ratio means how quickly businesses
can convert stock into sales.

#2 – Long Term Loans : These loans are given for longer, say three to five years or more than
that. These loans are provided for the expansion of business, diversification of product portfolio
or business, substantial investment in fixed assets, and real estate where the cost to buy such
assets or investments is so vast that repayment of the same within a year is not possible.

Purpose

Despite the wide array of loans provided by banks which include conventional mortgages or
loans, and bank credit cards, these loans are attractive for businesses for more than one reason.
Let us understand the purpose of banks issuing these loans and businesses preferring them over
other possible options through the explanation below.

Educational Loans: These are given for pursuing higher education, repayment of which is due
after completing education. Interest gets accumulated for the loan.
Housing Loans: These are given to buy a home. The repayment of principal and interest is based
on the EMI principal. House is collateral for such loans, and excessive documentation is
required.

Vehicle Loans: These are given to purchase vehicles like cars, tempo, two-wheeler, autos, and
trucks. Normally assets are hypothecated to the Bank unless and until the final installment is
paid. You often see “hypothecated to / we banked …. Bank” written on the backside of cars. This
indicates a loan is taken from “… Bank”.

Vendor Financing: This is an arrangement provided by the Bank to pay to vendors as per agreed
credit terms, and in turn, the borrower will pay to the Bank after, say, 60 days or 90 days. The
Bank charges an interest rate to the borrower for paying in advance to suppliers. The advantage
of this is the minimal documentation required by the Bank.

Letter of Credit Facility: Like vendor financing [Vendor Financing, also known as trade credit,
is the lending of money by the vendor to its customers, who use the money to buy
products/services from the same vendor. Customers need not pay for the products upfront when
buying the goods but after the product’s sale. The vendor gives a line of credit to its customer
based on their goodwill and rapport to pay for the products after a certain period or over a while.]
but predominantly used while importing goods or making payments to overseas vendors. Terms
of repayment and interest rate are mutually agreed upon between the parties.

Advantages

 The loan is not repayable on demand. Terms of repayment and interest rate are pre-
decided; hence, cashflows can be managed better.

 It helps businesses and individuals when there is a need for funds.

 Interest payments can be negotiated and paid only for a certain period, and during the
balance, the borrower will pay only the principal.

 The cost of debt is lower than the cost of equity; hence the appropriate proportion of debt
in the portfolio enhances returns to equity shareholders by leveraging the cost of debt.

Disadvantages

Despite the various advantages mentioned above, there are a few factors that prove to be a hassle
or hurdle in securing the finance required. Let us understand why in some cases a bank credit
card a better option might be than this form of a loan through the discussion below.

 A borrower may have to surrender ownership of an asset if installments are not paid in
time.

 Bank charges one-time processing fees that need to be paid upfront.

  There is a prepayment penalty if the borrower pays the loan in advance.

 Companies should maintain the right debt-equity ratio. If there is a significant reliance on
loans by the Companies, it will be difficult to pay interest in the event of a crisis.

Types of Bank Credit

Bank credit comes in two different forms—secured and unsecured. Secured credit or debt is
backed by a form of collateral, either in the form of cash or another tangible asset. In the case of
a home loan, the property itself acts as collateral. Banks may also require certain borrowers to
deposit cash security in order to get a secured credit card.

Secured credit reduces the amount of risk a bank takes in case the borrower defaults on the loan.
Banks can seize the collateral, sell it, and use the proceeds to pay off part or all of the loan.
Because it is secured with collateral, this kind of credit tends to have a lower interest rate and
more reasonable terms and conditions.

Banks normally charge lower interest rates on secured credit because there's a higher risk of
default on unsecured credit vehicles.

Unsecured credit, on the other hand, is not backed by collateral. These kinds of credit vehicles
are riskier than secured debt because the chance of default is higher. As such, banks generally
charge higher interest rates to lenders for unsecured credit.

Examples of Bank Credit

The most common form of bank credit is a credit card. A credit card approval comes with a
specific credit limit and annual percentage rate (APR) based on the borrower's credit history. The
borrower is allowed to use the card to make purchases. They must pay either the balance in full
or the monthly minimum in order to continue borrowing until the credit limit is reached.

Banks also offer mortgage and auto loans to borrowers. These are secured forms of credit that
use the asset—the home or the vehicle—as collateral. Borrowers are required to make fixed
payments at regular intervals, usually monthly, bi-weekly, or monthly, using a fixed or variable
interest rate.

One example of business credit is a business line of credit (LOC). These credit facilities are
revolving loans granted to a company. They may be either secured or unsecured and give
corporations access to short-term capital.

Credit limits are normally higher than those granted to individual consumers because of the
needs of businesses, their creditworthiness, and their ability to repay. Business LOCs are
normally subject to annual reviews.

What Is an Example of a Bank Credit?

Examples of bank credit include any money that a bank has loaned out to you. This includes
mortgages, auto loans, personal loans, and credit cards. Bank credit is a loan made by a bank to a
borrower that needs to be paid back.

What Credit Score Is Needed for a Bank Loan?

The credit score needed for a bank loan will depend on the individual's finances, the size of the
loan, and what the loan is being used for. Generally, a credit score of 640 is required or between
600 and 700.

Will a Bank Give a Loan with Bad Credit?

Usually, a bank will give a loan with bad credit. These may not be traditional banks but various
other banks or online lenders. When a person has bad credit, receiving a loan will be difficult and
costly. Banks will usually charge a higher interest rate, provide a smaller loan size, and may
include other stipulations.

The Bottom Line

Bank credit allows individuals to purchase high-priced items that would otherwise be difficult to
purchase just with cash, such as houses and cars. While some bank credit helps build assets, such
as mortgages, certain bank credit, such as credit cards, can be dangerous if not managed
correctly. Ensuring your debt-to-income ratio is at an acceptable level will help control any bank
credit and contribute to keeping your personal finances in good shape.

1. What is the function of bank credit?

The function of bank credit is to provide loans or credit to customers for various purposes, such
as personal expenses or business investments. Banks extend credit to individuals and businesses
to meet their financial needs and support economic growth. By granting loans, banks earn
interest income and facilitate economic activities by providing access to funds that individuals
and businesses may not have immediately available.

2. What is bank credit risk?

Bank credit risk refers to the potential for borrowers to default on their loan repayments, leading
to financial losses for the bank. It arises from the uncertainty of whether borrowers will fulfill
their contractual obligations, including paying interest and principal amounts on time.

3. Who is a bank credit analyst?

A bank credit analyst is a professional responsible for assessing the creditworthiness of

borrowers and analyzing the risks associated with extending credit. They evaluate loan
applications, review financial statements, analyze market trends, and assess various risk factors
to determine the probability of repayment. Bank credit analysts play a crucial role in making
informed lending decisions, managing credit portfolios, and ensuring the bank’s overall financial
health and stability.

Four Common Forms of Credit

Revolving Credit

This form of credit allows you to borrow money up to a certain amount. The lending institution
sets a credit limit, or the most you can borrow. In revolving credit, the borrower revolves the
balance by rolling from month to month until it is paid in full. Interest charges typically occur for
any revolving balance. As the money is paid back, the difference between the maximum credit
limit and the current balance is available to be borrowed. This is the most common form of credit
issued by credit cards, such as Visa, MasterCard, and store and gas cards. Credit cards are
considered unsecure credit because there is no collateral securing the amount borrowed.

Charge Cards

This form of credit is often mistaken to be the same as a revolving credit card. However, the
major difference between a credit card and a charge card is the credit card can carry a balance,
whereas the charge card must be paid in full each month. If the balance is not paid on time and in
full, penalty fees will be added. American Express is an example of a well-known charge card.
This form of credit is advantageous against accumulating credit card debt.

Installment Credit

Installment credit involves a set amount borrowed, a set monthly payment and a set timeframe of
repayment. Interest charges are pre-determined and calculated into the set monthly payments.
Common forms of installment credit agreements are home mortgages and auto loans.

Installment credit is also typically secure. Secure credit requires security for the lender. The
borrower must provide collateral, something of value pledge in order to guarantee loan
repayment. If the borrower fails to repay, or defaults on the loan, the lender may confiscate the
collateral. A home is an example of collateral on a mortgage, and a vehicle on an auto loan. If the
borrower were to default, the home or vehicle would be repossessed.

Non-Installment or Service Credit or Open Credit

This form of credit allows the borrower to pay for a service, membership, etc. at a later date.
Generally, payment is due the month following the service, and unpaid balances will incur a fee,
interest, and/or penalty charges. Continued non-payment will result in service cancellation and
can be reported to the credit bureau, affecting your credit score. Service or non-installment
agreements are very common in our everyday life. Cell phones, gas and electricity, water and
garbage are all examples of service credit.

Instruments of Credit
A credit instrument is a promissory note or other written evidence of a debt. Common examples
include bonds, loans, checks, or invoices. Credit instruments are used by governments,
companies, and individuals alike.

There are four basic types of credit market instruments, and the types of credit market
instruments are distinguished by the timing of cash flow payments of each instrument. The
different types of credit market instruments are simple loans, fixed-payment loans, coupon
bonds, and discount bonds.

Credit Instruments in Banks may be an order for payment of money to a specifies person or it
may be a promise to pay the loan. Credit Instruments generally in use are cheques, bank
overdraft, bills of exchanges, promissory notes, govt. bonds, T-bills, traveler’s cheque etc.

Kinds of Credit Instruments

(1) Negotiable Instruments: According to the negotiable instruments Act under Section 13-A,
A negotiable instrument means a cheque promissory note and a bill of exchange which are
payable to the bearer of the instrument or the person to be ordered.

Features of Negotiable Instruments:

 It must be conditional.

 It must be in writing.

 It is payable on demand or the period for the payment which is determined.

(2) Non-Negotiable Instruments: Non-Negotiable Instruments cannot be transferred or the

documents which are restricted to transfer by the issuer e.g., Money Order, Postal Order, Shares
Certificate etc. Such documents appear in the name of the beneficiary and the payments are made
only to those people to whom the instruments are made payable.

Credit Instrument # 1. Cheque:

According to Section 6 of the Negotiable Instrument Act, 1881, “A cheque is a bill of exchange
drawn upon a specified banker and payable on demand.”

From this definition, it is clear that a cheque is a bill of exchange, but it has the following two
additional qualifications:

(i) It is always drawn on a specified banker, and

(ii) It is always payable on demand.

In essence, a cheque may be defined as a written order, signed by a customer of a bank, directing
the bank to pay on demand out of his (the customer’s) account a stated sum of money to or to the
order of a specified person, or to bearer.

Essentials/Characteristics of a Cheque:

1. A cheque must be in writing.

2. Cheque is an order on a specified bank to pay the amount.

3. The order to pay the amount must be an unconditional order.

4. A cheque is always drawn on a banker.

5. It must be signed by the drawer.

6. The amount ordered to be paid by the bank must be certain.

7. It is always payable on demand without any days of grace.

8. A cheque requires no acceptance.

9. A cheque to be valid must be made payable to, or to the order of a certain person or to the
bearer of the instrument.

10. A cheque may be crossed.

Parties to a Cheque:

There are three parties to every cheque: (i) drawer, (ii) drawee, and (iii) payee.

i. Drawer: The drawer is the person who signs the cheque ordering the bank to pay the amount.

ii. Drawee: The drawee is a bank on which cheque is drawn.

iii. Payee: The payee is a person to whom the sum of money expressed in the order is payable.
Sometimes the drawer and payee are the same person.

Dishonor of a Cheque: The banks may refuse payment or may dishonor a cheque in the
following cases:

1. When there are insufficient funds to the credit of the drawer.

2. When the cheque is post-dated and is presented before the date it bears.

3. When a cheque is not duly presented, e.g., presented after banking hours.

4. When the signatures of the drawer do not tally with the specimen signatures.
5. When the cheque is presented at a branch where the customer has no account.

6. When the amount in figures and in words does not tally.

7. When the cheque is mutilated, ambiguous, irregular, or otherwise materially altered.

8. When the cheque is not presented within 6 months of the issue of the cheque.

9. When some persons have joint account, and the cheque is not signed by all jointly or by the
survivors of them.

10. When a cheque is crossed and not presented through a bank.

Types of Cheque:

There are two types of cheques: (i) Open cheque, and (ii) Crossed cheque.

(i) Open Cheque: A cheque, which is payable in cash across the counter of the bank, is called an
open cheque. If its holder loses it, its finder may go to the bank and get the payment. In order to
avoid the losses incurred by open cheques getting into the hands of the wrong parties the custom
of crossing was introduced.

(ii) Crossed Cheque: A crossed cheque is one on which parallel transverse lines with or without
the words ‘& Co.’ are drawn. A crossing is a direction to the paying banker to pay the money
generally to a banker or a particular banker, as the case may be, and not to pay to holder across
the counter. The crossing provides protection and safeguards to the owner of the cheque.
Crossing does not affect the negotiability of a cheque, except where the words ‘not negotiable’
are added.

Types of Crossing:

There are two types of crossing:

(a) General Crossing, and (b) Special Crossing.

a. General Crossing: General crossing implies simply putting two parallel transverse lines on
the face of a cheque. Some words like ‘& Co.’, ‘Not Negotiable’ may be inserted in these lines.
If a cheque is crossed generally, the paying banker shall pay only to a banker.

b. Special Crossing: Where a cheque bears across its face an addition of the name of a banker,
either with or without the words ‘Not Negotiable’ the cheque is deemed to be crossed specially.
The payment of a specially crossed cheque can be obtained only through the particular banker
whose name appears between the lines. Transverse lines are not compulsory in case of a special
crossing.

Endorsement of a Cheque:

Endorsement means signing at the back of an instrument for the purpose of negotiation. The act
of signing a cheque, for the purpose of transferring it to someone else, is called the endorsement
of cheque. Under the Negotiable Instruments Act, the term endorsement means writing the name
of a person on the back of the instrument with the intention of transferring the rights therein.

The person who endorses the cheque is called the endorser. The person to whom the cheque is
endorsed is called the endorsee. The endorsement is usually made on the back of the cheque. If
no space is left on the cheque, the endorsement may be made on a separate slip attached to the
cheque.
Kinds of Endorsement:

1. General or Blank Endorsement: An endorsement is said to be general or blank if the

endorser simply puts his signature on the instrument without specifying the endorsee. For
example, if a cheque is payable to Ram Lai or order and Ram Lai endorses the cheque by simply
putting his signature, it is a general or blank endorsement, as:

2. Complete or Special Endorsement: When the endorser adds a direction to pay the amount
mentioned in the instrument to, or to the order of a specified person and signs it, the endorsement
is said to be ‘complete’ or ‘special’.

3. Restrictive Endorsement: A restrictive endorsement is one where the endorser restricts

further negotiation of the instrument.

4. Partial Endorsement: A partial endorsement is one where the endorsement is made for a part
of the amount of instrument.

5. Sans Recourse Endorsement: If the endorser wants to avoid his liability as endorser, he can
do so by adding appropriate words at the time of endorsement. [Sans recourse : This means that
even if the original agreement is not honored, the endorser cannot be held responsible. To enact a
sans recourse endorsement, the endorser includes a clause about this in the original document.]

(i) ‘Pay X or order sans recourse’, or (ii) ‘Pay X or order without recourse to me’, or

(iii) ‘Pay X or order at his own risk’.

6. Conditional or Qualified Endorsement: A conditional endorsement is one when the
endorser inserts some condition in his endorsement.

For example: ‘Pay A or order on his marriage’ is an example of conditional endorsement.

Bearer Cheque: A ‘bearer cheque’ is one which is payable to its bearer or holder who presents it
to the bank for the payment. In such cheques, the word ‘bearer’ is written after the name of the
payee. A bearer cheque is transferable merely by delivery. The drawee bank need not take any
pains to get the identification of the person to whom the payment is being made. It need not be
endorsed.

Order Cheque: An ‘order cheque’ is one which is payable to the person named in the cheque or
to his order. In such cheques, the word ‘order’ is written after the name of the payee. It is not
transferable merely by delivery.

Difference between Bearer Cheque and Order Cheque:

S.No. Basis of Bearer Cheque Order Cheque

Difference

1 Word On such cheques, the word In such cheques, the word order
bearer is written after the name is written after the name of the
of the payee. payee.

2 Payee One who presents it at the counter It is payable to the person named
of the bank can get the payment. in the cheque or to his order.

3 Transfer It can be transferred by mere It must be endorsed before it can

delivery. be transferred.

4 Safety Bearer cheques are not safe. Order cheques are comparatively
safer.

5 Bank’s Liability Bank is not liable if the payment Bank is liable if the payment is
 is made to any wrong person. made to any wrong person.

Credit Instrument # 2. Bank Draft: It is usually drawn by one branch of a bank upon its
another branch, instructing the latter to pay a specified amount to the payee named therein or to
his order. There cannot be any bearer draft. Bank drafts are always payable to a certain payee
named in the draft or to his order. They may be crossed like a cheque. Bank drafts are called
‘Demand Drafts’ as they are payable on demand without any days of grace.

Bank draft is the most convenient and economical method for sending money from one place to
another. A person who wants to send money obtains the draft from the bank by paying the
necessary amount and the bank commission. He sends the draft to the payee by post. He (payer)
presents the draft in the concerned branch and gets the payment.

Clearing House:

One great advantage that follows from the use of cheques is that we do not have to carry a
pocketful of notes or coins for our purchases. In countries where people have developed banking
habits, rarely is a purchase paid for in cash, unless it is a very small sum. The people who are
paid in cheques do not get them cashed but just pay them into their accounts at their bank. Thus,
if both the people have a common bank, a mere change in their bank balances completes the
transaction.

When there are several banks in a locality and the two people have accounts with different banks,
the process is not so simple. Every bank receives during the course of the day cheques on other
banks in favor of its customers. To send cash back and forth from one bank to another every day
would be very troublesome. To avoid this trouble, the device of a Clearing House is used.

The representatives of the local banks meet at a fixed place after working hours and balance their
claims against one another. When simple book entries have cancelled most of the obligations, a
small balance may be claimed by one bank from the other.

This is usually settled through a cheque on the Central bank (the Reserve Bank of India or the
State Bank of India) with which all commercial banks have to keep accounts. There are Clearing
Houses in important cities in India, the most important being those in Bombay, Calcutta, and
Delhi.

Credit Instrument # 3. Hundi:

A hundi is almost an Indian bill of exchange, which has been in use since time immemorial. It is
the oldest surviving form of credit instrument in India.

A hundi may be defined as “A written order, usually unconditional, drawn by one person on
another for payment on demand or after a specified time of a certain sum of money, to a person
named therein.”

A bill of exchange is always unconditional, but a hundi is sometimes conditional, e.g., Jokhami
Hundi.

Types of Hundis:

1. Namjog Hundi: A hundi payable to a specified person named in the hundi is known as Namjog
Hundi. It can be negotiated by endorsement and delivery.

2. Shahjog Hundi: A shahjog hundi is one which is payable to or through a Shah. Shah means a
respectable person in the market. It is like a crossed cheque.

3. Dhanijog Hundi: A dhanijog hundi is one which is payable to the person who holds or to the
bearer thereof. The word ‘Dhani’ means owner.

4. Firmanjog Hundi: A firmanjog hundi is one which is payable to order.

5. Darshanhar Hundi: A darshanhar hundi is one which is payable to bearer.

6. Darshani Hundi: A darshani hundi is one which is payable at sight or on demand. Darshani
hundi is similar to a demand bill.

7. Muddati Hundi: A muddati hundi is one payable after the expiry of a certain period. This is
also called ‘Miadi Hundi’ or ‘Thavani’.

8. Jawabi Hundi: A jawabi hundi is used for remittance of money from one place to another. It is
similar to a money order. The person receiving the money has to send a Jawab (answer) to the
remitter showing that he has received the money.

9. Jokhami Hundi: A jokhami hundi is one which is drawn against goods shipped on the vessel
named in the hundi.

According to Justice Baley, “A Jokhami Hundi is in the nature of a policy of insurance, with the
difference that the money is paid beforehand to be recovered if the ship is not lost.”

It is payable only when the goods reach the destination safely.

10. Nishanjog Hundi: This type of hundi is payable only to the person who presents it.

Specimens of the two types of hundis used in India (translated in English) are given below:

Credit Instrument # 4. Bill of Exchange:

It is an important part of negotiable instruments used both in inland and overseas trade. Its use
has increased manifold due to expansion of trade and commerce. According to Negotiable
Instruments Act, 1981, “A ‘bill of exchange’ is an instrument in writing and containing an
unconditional order signed by the maker, directing a certain person to pay a certain sum of
money only to or to the order of a certain person or to the bearer of the instrument.”

Characteristics/Essentials of a Bill of Exchange:

1. It should be in writing.

2. It should contain an order to pay.

3. It should have unconditional order.

4. It must be signed by the drawer.

5. It must contain an amount of money.

6. All the three parties-drawer, drawee and payee must be mentioned.

7. The bill may be made payable on demand or after a specified period of time.

8. It must bear the required revenue stamp.-

Parties to a Bill of Exchange:

There are three parties to a bill of exchange:

1. Drawer: The maker/writer of the bill is called Drawer. He is generally the creditor.

2. Drawee: The person on whom the bill is drawn is called Drawee. He is normally the debtor.

3. Payee: The person who is entitled to receive the amount of the bill on its maturity is called
Payee. The writer of the bill can be a drawer as well as payee of the bill.

Advantages of a Bill of Exchange:

The main advantages of a bill of exchange are:

1. Helps in Enhancing Business: Those persons who are not in a position to run their business
due to scarcity of funds, can run their business by obtaining credit through bills or by discounting
the bills from bank.

2. Legal Document: It is a legal document under the Negotiable Instrument Act. And if, after
accepting the bill, the drawee fails to pay the amount, the dishonored bill is sufficient proof for
the court to decide the liability of the drawee.

3. Negotiable Instrument: A bill of exchange is a negotiable instrument. So, it can be

transferred from one person to another in the settlement of debts.

4. Discounting: If the holder of the bill needs funds before the due date, he can get money
readily by discounting the bill with a bank.

5. Foreign Payments: The difficulties in payment of foreign debts are also removed by the bill
of exchange and now the trader of one country can very easily make payment to his foreign
counterpart.

6. Credit Facility: A bill of exchange enables a person to buy goods on credit.

7. Easy Transfer of Money: A bill of exchange provides an easy way of sending money from
one place to another.

8. Exact Date of Payment: By drawing a bill in the drawer, the drawer knows when he is going
to receive a certain payment. The drawee is also certain about the time of making the payment.

Difference between Hundi and Bill of Exchange:

S.No. Basis of Hundi Bill of Exchange

Difference

1 Language It is a negotiable instrument It is usually written in English.

written in an oriental
language.

2 Conditional Hundi may be both Bill of exchange is always

conditional and unconditional. unconditional.

3 Amount In hundi, the amount is In bill of exchange, the amount

written several times. appears twice (words and figures).

4 Use Hundis are used within the Bill of exchange is used both in
country. inland and in foreign trade.

5 Name of Drawer In hundi, the name of the In bill of exchange, the name of
drawer appears two times. the drawer appears only when he
 signs it.

Credit Instrument # 5. Promissory Note:

According to Negotiable Instrument Act, 1881, “A promissory note is an instrument in writing

(not being a bank note or a currency note) containing an unconditional undertaking signed by the
maker to pay a certain sum of money only to or to the order of a certain person or to the bearer of
the instrument.”

Essential Characteristics of a Promissory Note:

1. It should always be in writing.

2. It is always unconditional.

3. It is a promise by the debtor to pay.

4. The promise is always for payment of money.

5. It must be signed by the maker.

6. The maker must be a certain person.

7. The payee must be a certain person.

8. The amount of payment under the promissory note must be certain.

9. A promissory note must be stamped as prescribed by the Indian Stamp Act.

10. The place, time and date of payment are not essentials of a promissory note.

But usually these are also given in a promissory note.

Parties to a Promissory Note:

1. Drawer/Maker. Drawer is a person who promises to pay the amount stated in the promissory
note. He is the debtor.

2. Payee is the person to whom the promise is made for the payment. He is the creditor.

Kinds of Promissory Note:

A promissory note may be made or drawn by one or more than one person and thus it is
classified as given below:
1. Simple or Single Promissory Note: When a promissory note is made or drawn by one person,
it is called a simple/single promissory note. The maker of this promissory note is individually
liable for the amount.

2. Joint Promissory Note: When a promissory note is made or drawn by two or more people, it
is called a joint promissory note. The makers of this promissory note are jointly liable for the
payment.

3. Joint and Several Promissory Note: When a promissory note is made by two or more
persons and the makers of the promissory note are liable jointly and severally, it is called a joint
and several promissory note.

Credit Instrument # 6. Trade Bills:

Ordinarily bills are drawn and accepted for the purpose of receiving or making payments for
goods sold or purchased on credit. Such bills, which are drawn up for consideration, are known
as Trade Bills.

1. Purpose: It is drawn and accepted for any business transaction.

2. Proof: It is proof of debt. 3. Consideration: Trade bill is drawn up and accepted for some
consideration. 4. Dishonor: If this bill is dishonored, payment can be taken with the help of
court.5. Discounting of the Bill: If such a bill is discounted by the bank, the whole amount of
the bill remains in the drawer.

Credit Instrument # 7. Accommodation Bills:

Sometimes a bill is drawn and accepted without any consideration. It is drawn and accepted just
to help the drawer or both the drawer and the acceptor or raise funds temporarily by getting the
bill discounted. A bill drawn without any consideration is known as Accommodation Bill. It is
also termed as ‘Kite Bill’ or ‘Fictitious Bill’.

1. Purpose: It is drawn and accepted to raise funds temporarily.

2. Proof: It is drawn and accepted for financial help.

3. Consideration: Accommodation Bill is drawn up and accepted without any consideration.

4. Dishonor: If this bill is dishonored, payment cannot be taken with the help of the court.

5. Discounting of the Bill: If such a bill is discounted with the bank and the money received is
distributed between the drawer and drawee.

Advantages of Credit:

The services rendered by credit to society are undoubtedly very great.

(i) Credit instruments replace metallic money to some extent. This means a great economy.
Expenditure is avoided on precious metals for monetary purposes. Also, there is no loss arising
from the wear and tear of coins.

(ii) Trade and industry are financed mostly by the aid of credit. No industrial or commercial
progress would be possible if the business were to be conducted strictly on a cash basis. In the
absence of credit, trade would be on a very restricted scale.

(iii) Credit makes capital more productive. It is through credit that capital is transferred from
persons who cannot use it themselves to persons who are in a position to do so. Without credit
facilities, a good deal of capital would have remained unused.

(iv) Credit enables banks to lend far beyond their cash reserves. Thus, they are able to make
profits for themselves besides helping trade and industry. The banks can in this way ‘create
money’.

(v) Credit instruments like bills of exchange facilitate payments not only between people living
in the same country, but also between people belonging to different countries. This facilitates and
extends international trade.
(vi) Men of enterprise and business ability are enabled by credit to launch business undertakings,
even though their own financial resources may be meagre. In this way, credit helps the
development of trade and industry in the country. Without its aid, a good deal of business talent
would have been wasted.

Abuses of Credit: Credit is a very delicate instrument, and, as such, it has to be handled with
utmost care. Unless the use of credit is kept within sensible limits, it is/likely to prove very
dangerous.

The following possible evils-of credit’ may be mentioned:

(i) Reckless borrowing ruins both the borrower and the lender. The spirit of gambling is
introduced in business. This is against the spiritual healthy trade.

(ii) By making it easy for a person to get funds, credit may encourage extravagance and waste.
People start living beyond their means. This is indeed a very bad habit.

(iii) If the banks create credit beyond proper limits, it may encourage speculation. Over-
speculation may endanger the economic stability of the country. It stands in the way of healthy
development of trade and industry.

(iv) Free use of credit by the manufacturers may lead to over-production, causing depression in
the industry. Depression brings business to a standstill. It causes unemployment and brings
misery to the workers.

(v) Unsound businesses are kept alive by the artificial aid of credit. It is in the interest of the
community that such weak links should be removed. Credit may only conceal the financial
weakness of a concern.

(vi) Credit encourages the formation of monopolies by placing large funds at the disposal of a
few individuals or corporations. Monopolies exploit consumers and indulge in so many other
anti-social practices.