Mod2 - MBO-5 Uses of Bank Funds

MANAGEMENT OF BANKING
OPERATIONS
CHAPTER 5-
USES OF BANK FUNDS –
THE LENDING FUNCTION
ROLE OF BANK AS AN INTERMEDIARY
IN THE FINANCIAL SYSTEM
They mitigate the default risk
They ensure liquidity of savings and

availability of funds to the required
They lower information costs
Copyright © 2018 Pearson India Education Services Pvt. Ltd Management of Banking and Financial services, 4/e 2
Checklist for Lending
3
Checks his previous track record
Transaction history
Nature and scope of business
Nature of industry
Market scenario
Technology
Proposed suppliers & buyers
Promoter’s investment
Promoter’s background and

qualification
Management of Banking and Financial services,
4/e
RISKS IN LENDING
● Profitable lending is dependent on the bank’s ability:
To take on and manage credit risk that arises

from the quality of the borrower and his business
To deal with the impact of fluctuations in interest

and exchange rates on profits, and
To manage the liquidity risk posed by mismatch

in the maturities of its liabilities and assets
WHO NEEDS CREDIT?
Both ‘demand’ and ‘supply’ sides of the economy need credit
Bank credit is one of the cheapest source of funding
On the demand side, consumers need bank finance for basic

needs – housing, consumption, purchase of durables, etc
On the supply side, corporates and the government require

funds for manufacturing, trading, services – for day to day
operations, or long term capital investment
CORPORATE AND RETAIL BANKING
Bank finance to the demand side is

typically called ‘Retail banking’, or
‘mass banking’
Bank finance to the supply side is

typically called ‘wholesale banking’,
‘corporate banking’, or ‘class banking’
TYPES OF LENDING
FUND BASED LENDING

• Direct lending to borrowers in the form of loans
/advances, based on prime or collateral security
NON FUND BASED LENDING
• No funds outlay at the time of entering into an agreement
with third party on behalf of customer. May crystallize
into fund based advance if customer does not fulfill terms
of contract with third party. Eg. LCs / Bank Guarantees
ASSET BASED LENDING
• Based on earning capacity of asset – eg. project finance
TYPES OF FUND BASED LENDING
SHORT TERM LOANS

• Working capital loans / seasonal lines of credit,
temporary special purpose loans
MEDIUM / LONG TERM LOANS
• Maximum tenure for terms loans is 10 years, usually
primary security is the asset financed
REVOLVING CREDITS
• Usually secured, granted based on assessed needs,
underlying securities and credit worthiness
THE NATURE OF CREDIT DECISIONS
Money should not be lent unless there is good

probability that money will be repaid – default risk
Collateral [security] is only a control measure
Borrowing proposition and repayment to be

considered in isolation of security
The experience and role of credit officers are critical

factors
THE CREDIT PROCESS
The Loan policy
Business development
Credit analysis / appraisal
The initial recommendations based on analysis
Credit delivery and administration
Credit review and monitoring

ASPECTS OF CREDIT APPRAISAL
The credit officer should be able to identify the risks

and opportunities in terms of
The borrower’s market
The technology used by the borrower
The management capability of the borrower
The economic aspects of the borrower’s business
The financial aspects of the borrower’s business

CIBIL (Credit Information Bureau (India) Limited)
is a Credit Bureau or Credit Information
Company. This company is engaged in
maintaining the records of all the credit-related
activities of companies as well as individuals
including credit cards and loans.
FINANCIAL APPRAISAL FOR CREDIT
DECISIONS
● Techniques prevalently used are
Financial ratio analysis
Cash flow analysis

Sensitivity analysis
● Financial ratios are grouped to indicate important

aspects of borrowing firm’s performance
Liquidity ratios
Profitability ratios
Leverage ratios
Operating ratios
Valuation ratios
RATING OF CUSTOMERS
Credit rating – assessing the ‘credit risk’ of a

customer – can be done internally by banks or
externally by credit rating agencies
They rate long term and short term

instruments
They also rate bank loans in terms of the Basel

requirements
Authorized CRAs India
CRISIL Ltd - www.crisil.com
India Ratings and Research P Ltd ( formerly Fitch ratings India P Ltd, and a 100% subsidiary
of Fitch ratings ) – www.indiaratings.co.in
ICRA Ltd (promoted by IFCI and now controlled by Moody’s) – www.icra.in
CARE Ltd (Credit Analysis and Research Ltd, promoted by IDBI) – www.careratings.com
Brickworks India P Ltd ( the most recent) – www.brickworkratings.in
SME rating agency of India Ltd (SMERA – joint venture between SIDBI( www.sidbi.com
),
Dun and Bradstreet Information Services India P Ltd (www.dnb.co.in ) and leading banks in
India – www.smera.in
How is CIBIL TransUnion Score calculated?
15
30%
• Past Performance: Individuals past
performance on their debt obligations is the
most important criterion
25%
• Credit Type & Duration: Type of loan
availed whether secured or unsecured loan, and
the duration of credit history established
25% • Credit Exposure: The total amount of credit

exposure
20% • Other factors: Other factors such as credit

utilization, recent credit behavior

4/e
https://www.cibil.com/credit-connect/how-read-and-interpret-your-credit-information
-report-cir-i
COMMON LOAN TYPES
● Based on purpose, some commonly known loan

types are
Working capital loans
Term loans for capital expenditure / Industrial credit
Syndicated loans
Agriculture loans
Project finance
Retail loans
Non fund based

credit facilities
LOAN PRICING
● The loan should be priced with the following

objectives
Maintain ‘spreads’ between cost of funds

and yield on advances to ensure profitability
Balance ‘risk-reward’ profile to ensure

sustainability
Ensure market rates to be competitive in

the market and maintain relationships
A BASIC MODEL FOR LOAN PRICING
A. COST PLUS LOAN PRICING MODEL

Arrive at cost of funds
Assess servicing
costs
Base premium on credit risk [quantify]
Assess profit margin that ensures target ROE
Relate rate to benchmark rate
Ensure market presence by ‘relationship

pricing’ if necessary
● Loan price
Copyright © 2018 = cost
Pearson of funds
India Education +cost of servicing + risk
Services Pvt. Ltd
Management of Banking and Financial services, 4/e 18
premium + profit margin

Step 1:Arrive at Cost of Funds
19
● The maturity profile of Bank A is as under. The bank has a net

profit margin of 3%. The bank’s premium customer wants
additional loan of Rs50 crore for 3 years. What interest rate
should be proposed?
Maturity of Liability Liabililty Amount (crores) Rate (%)
Nil 10 0
6 months 25 5
1 year 25 9
2 years 10 11
3 years 20 12
Over 3 years 10 13
Total 100

4/e
Calculation of Average Cost of funds
20
Weighted
Maturity of Liabililty Amount Average
Liability (crores) Weights Rate (%) Rate
Nil 10 0.1 0 0
6 months 25 0.25 5 1.25
1 year 25 0.25 9 2.25
2 years 10 0.1 11 1.1
3 years 20 0.2 12 2.4
Over 3 years 10 0.1 13 1.3
Total 100 8.3
Loan Price = Average cost of funds + Servicing cost + Risk Premium + Profit
margin
Hence: 8.3 (Cost of funds) + 3 (profit margin) = 11.3%
Note – Bank may be ready to forego their servicing cost and risk premium for their
premium customers
4/e
FIXED VS FLOATING RATES
For pricing floating loans, banks fix a mark

up based on the risk and other factors
over the benchmark rate like LIBOR or
Prime rate. Indian benchmark rate –
MIBOR (Mumbai Interbank Offered Rate)
Two basic methods: Prime plus and Prime

Times
https://
www.bankbazaar.com/finance-tools/emi-calculator/fixed-vs-floating-interest-rate.html
https://www.hdfcbank.com/personal/resources/learning-centre/borrow/fixed-vs-floati
ng-interest-rate
Example
22
● The bank wants to charge floating rates to its

borrowers since it expects volatility. The present
prime rate is 10%. Bank wants to charge a premium
of 400 bps over the prime rate. Which method is
beneficial when prime rate:
● Moves up by 100 bps
● Falls by 100 bps

4/e
23
● Base case: Additive method: 10+4 = 14%

● Multiplicative method: adjustment factor is 14/10 = 1.4
● Therefore rate is 10 x 1.4 = 14%
● Case 1: If Prime rate moves up by 100 bps i.e. 11%

● Case 2: If Prime rate goes down by 100 bps i.e. 9%
● Interpretation???

4/e
CUSTOMER PROFITABILITY
ANALYSIS
Periodically, or every time a borrower approaches the bank

with a request for modifications in loan terms, a customer
profitability analysis should be carried out by the bank.
The analysis is used to evaluate whether the net gains from a

borrower’s transactions with the bank are in line with the
bank’s profit expectations.
The procedure involves comparing revenues generated by

the borrower with the associated costs, and ultimately with
the bank’s profit goal.
25
Now you are fit to become a credit officer!

4/e

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MANAGEMENT OF BANKING

They mitigate the default risk

They ensure liquidity of savings and

They lower information costs

Checks his previous track record

Nature and scope of business

Proposed suppliers & buyers

Promoter’s background and

● Profitable lending is dependent on the bank’s ability:

To take on and manage credit risk that arises

To deal with the impact of fluctuations in interest

To manage the liquidity risk posed by mismatch

Both ‘demand’ and ‘supply’ sides of the economy need credit

Bank credit is one of the cheapest source of funding

On the demand side, consumers need bank finance for basic

On the supply side, corporates and the government require

Bank finance to the demand side is

Bank finance to the supply side is

FUND BASED LENDING

SHORT TERM LOANS

Money should not be lent unless there is good

Collateral [security] is only a control measure

Borrowing proposition and repayment to be

The experience and role of credit officers are critical

The Loan policy

The initial recommendations based on analysis

Credit delivery and administration

Credit review and monitoring

The credit officer should be able to identify the risks

The technology used by the borrower

The management capability of the borrower

The economic aspects of the borrower’s business

The financial aspects of the borrower’s business

Financial ratio analysis

Cash flow analysis

● Financial ratios are grouped to indicate important

Credit rating – assessing the ‘credit risk’ of a

They rate long term and short term

They also rate bank loans in terms of the Basel

CRISIL Ltd - www.crisil.com

ICRA Ltd (promoted by IFCI and now controlled by Moody’s) – www.icra.in

Brickworks India P Ltd ( the most recent) – www.brickworkratings.in

25% • Credit Exposure: The total amount of credit

20% • Other factors: Other factors such as credit

Management of Banking and Financial services,

● Based on purpose, some commonly known loan

Term loans for capital expenditure / Industrial credit

Non fund based

● The loan should be priced with the following

Maintain ‘spreads’ between cost of funds

Balance ‘risk-reward’ profile to ensure

Ensure market rates to be competitive in

A. COST PLUS LOAN PRICING MODEL

Base premium on credit risk [quantify]

Assess profit margin that ensures target ROE

Relate rate to benchmark rate

Ensure market presence by ‘relationship

premium + profit margin

● The maturity profile of Bank A is as under. The bank has a net