CREDIT Instruments

Types of Credit Instruments & Its Features Credit or loan is the act of giving money, property or other material goods to another party in exchange for future repayment of the principal amount along with interest or other finance charges. A loan may be for a specific, one-time amount or can be available as open-ended credit up to a specified ceiling amount. “ C r e d i t i n s t r u m e n t s a r e i t e m s t h a t a r e u t i l i z e d i n t h e p l a c e o f currency.” Just about all individuals and businesses make use of sometype of credit instrument on a daily basis. The ability to use a creditinstrument instead of currency rests in the fact that debtor and ther e c i p i e n t a g r e e u p o n t h e u s e o f t h e i n s t r u m e n t a n d t h e r e i s a r e a s o n a b l e e x p e c t a t i o n t h a t t h e a l t e r n a t e f o r m o f p a ym e n t w i l l b e honored.The contractual amount of credit instruments represents the maximumundiscounted potential credit risk if the counterparty does not performa c c o r d i n g t o t h e t e r m s o f t h e c o n t r a c t , b e f o r e p o s s i b l e r e c o v e r i e s u n d e r r e c o u r s e a n d c o l l a t e r a l p r o v i s i o n s . A l a r g e m a j o r i t y o f t h e s e commitment s expire without being drawn upon. The credit instrumentsare issued by the lenders only to those parties that are creditworthy.C r e d i t r i s k f o r o t h e r c r e d i t i n s t r u m e n t s u s i n g t h e s a m e c r e d i t r i s k process that is applied to loans and other credit assets.The terms of a standardized loan are formally presented (usually inwriting) to each party in the transaction before any money or propertyc h a n g e s h a n d s . I f a l e n d e r r e q u i r e s a n y c o l l a t e r a l , t h i s w i l l b e stipulated in the loan documents as well. Most loans also have legals t i p u l a t i o n s r e g a r d i n g t h e m a x i m u m a m o u n t o f i n t e r e s t t h a t c a n b e charged, as well as other covenants such as the length of time beforerepayment is required.Some credit instruments like credit derivatives are used for the riskm i t i g a t i o n p u r p o s e s . T h e s e i n s t r u m e n t s h e l p t h e l e n d i n g f i r m t o man age the credit risk associated with borrower.

Principles of Lending

Lenders usuall y follow some principles before granting loan to theborrow e r . T h e y a p p r a i s e t h e b o r r o w e r o n c e r t a i n c r i t e r i a w h i c h a r e described as follows. • Safety of the funds- This is most important criterion while grantinga loan. The funds should go in the safe hands. • I d e n t i f i c a t i o n o f b o r r o w e r s ( K Y C ) - I n s t i t u t i o n a l l e n d e r s h a v e t o follow KYC norms, which help them in identifying the borrowers. • P u r p o s e - T h e p u r p o s e f o r w h i c h t h e l o a n i s g r a n t e d i s i m p o r t a n t because on this criterion interest rate applicable to the borrower and availability of certain facilities is decided. Liquidity- The borrower should always have liquid money with him so that the chance of the borrower becoming NPA is less. • SecurityThe security offered for the loan plays important role,because in future if t h e b o r r o w e r c o u l d n o t r e p a y, t h e s e c u r i t y charged with the creditor can be sold to recover the dues. • Profitability- Profitability of business to which the loan is granted isimportant because nonprofitable businesses generally turn into a NPA for the bank. • R i s k M a n a g e m e n t - M a n a g i n g t h e r i s k c r e a t e d d u e t o g r a n t i n g o f loan is important. Because if the bank fails to manage various typeso f r i s k s a s s o c i a t e d w i t h c r e d i t g i v e n , t h e r e c o v e r y b e c o m e s impossible. • National Interest- Certain credit is given for the national interest and in these cases profitability of the bank is not the primary issue.Priority sector lending is the best example of the credit given in thenational interest. Types of Lending Lending by the banks or the financial institutions can be divided into 3major types. • Fund-based lendingT h i s i s t h e m o s t d i r e c t f o r m o f l e n d i n g . I t i s g r a n t e d a s a loan o r a d v a n c e w i t h a n a c t u a l o u t f l o w o f c a s h t o t h e b o r r o w e r . I t i s suppo rted by prime or collateral securities. • Non –fund based lendingThere is no funds outlay for the Bank. It may crystallise into fund-b a s e d a d v a n c e s , o n a c c o u n t o f t h e f a i l u r e t o f u l f i l t h e c o n t r a c t . Letters of credit and bank guarantees, fall under this category.

• Asset-based lendingT h i s i s a n e m e r g i n g c a t e g o r y o f b a n k l e n d i n g . T h e b a n k l o o k sprimarily to the earning capacity of the asset being financed.Mos tly, the banks do not have any recourse to the borrower.Specialise d l e n d i n g p r a c t i c e s s u c h a s s e c u r i t i s a t i o n , o r p r o j e c t finance fall under this category. Common types of credit instruments The vast majority of credit instruments involve a mixture of standard t y p e s . W e c a n b r o a d l y c l a s s i f y t h e c r e d i t i n s t r u m e n t s u s e d b y t h e lender as follows• Credit instruments which are used for meeting working capital requirements • Credit instruments used for meeting capital expenditure • Negotiable instruments like bill of exchange • Non-funded credit instruments like L/C and B.G. • Credit derivatives for risk mitigation • Other instruments Working Capital The credit for fulfilling working capital requirements is usually given byusing following modes of credit like cash credit, WCDL, overdraft likeb i l l s o f e x c h a n g e a n d c o m m e r c i a l p a p e r . B i l l o f e x c h a n g e s a r e discussed under negotiable instruments.The security offered for working capital finance is current assets likeinventory, book debts and receivables. CASH CREDIT It is the most popular method to finance working capital requirementso f a c o m p a n y i n I n d i a . U n d e r t h e c a s h c r e d i t f a c i l i t y, a b o r r o w e r i s allowed to withdraw funds from the bank up to the sanctioned creditl i m i t . H e i s n o t r e q u i r e d t o b o r r o w e n t i r e s a n c t i o n e d c r e d i t o n c e , rather, he can withdraw periodically to the extent of his requirementsand repay by depositing surplus funds in his cash credit account. Thereis no commitment charge; therefore, interest is payable on the amounta c t u a l l y u t i l i s e d b y t h e b o r r o w e r . C a s h c r e d i t l i m i t s a r e s a n c t i o n e d a gainst the security of current assets such as inventory, receivable sand debtors. Though funds borrowed are repayable on demand, banksusually do not recall such advances unless they are compelled by theadverse circumstances. Cash credit is the most flexible arrangementfrom the borrower’s point of view.

WORKING CAPITAL DEMAND LOAN A b o r r o w e r m a y s o m e t i m e s r e q u i r e a d h o c o r t e m p o r a r y accommodation in excess of the sanctioned credit limit t o m e e t unforeseen contingencies. Banks provide such accommodation througha d e m a n d l o a n a c c o u n t o r a s e p a r a t e n o n o p e r a b l e c a s h c r e d i t account. Such a loan is termed as working capital demand loan. Theborrower is required to pay a higher rate of interest above the normalrate on such additional credit. OVERDRAFT It is similar to cash credit arrangement. Under the overdraft facility,the borrower is allowed to withdraw funds in excess of the balance inhis current account up to a certain specified limit during a stipulatedp e r i o d . T h o u g h o v e r d r a w n a m o u n t i s r e p a y a b l e o n d e m a n d , t h e y generally continue for a long period by annual renewals of the limit. Itis very flexible arrangement from the borrower’s point of view sine hecan withdraw and repay funds when ever he desires within the overalls t i p u l a t i o n s . I n t e r e s t i s c h a r g e d o n d a i l y b a l a n c e s , o n t h e a m o u n t actu ally withdrawn, subject to some minimum charges. The borroweroperates this facility through cheques. COMMERCIAL PAPER Commercial paper (CP) is an important money market instrument to r a i s e s h o r t t e r m f u n d s . C P i s a f o r m o f u n s e c u r e d p r o m i s s o r y n o t e issued by the firms to raise short term funds. Only financially soundand highest rated companies are able to issue commercial papers. Theb u ye r s o f c o m m e r c i a l p a p e r i n c l u d e s b a n k s , i n s u r a n c e c o m p a n i e s , mutua l funds, trusts and firms with short surplus funds to invest for as h o r t p e r i o d w i t h m i n i m u m r i s k . G i v e n t h i s i n v e s t m e n t o b j e c t i v e d emand for CPs of highly creditworthy companies will always be there.In India, RBI regulates issue of CPs. Only those companies which havea net worth of minimum Rs. 10 crores, MPBF of not less than Rs. 25c r o r e s a n d w h i c h a r e l i s t e d o n s t o c k e x c h a n g e a r e a l l o w e d t o i s s u e CPs. The size of the issue should be at least Rs. 25 lacs and size of theeach CP should not be less than Rs. 5 lacs. A company can issue CPs amounting up to 75% of the MPBF. The maturity of CPs in India usuallyruns between 91 to 180 days.I n t e r e s t r a t e o n c o m m e r c i a l p a p e r i s g e n e r a l l y l e s s t h a n b a n k borrowing rate. A firm does not pay interest on a CP but it sells it at ad i s c o u n t e d v a l u e . T h e yi e l d c a l c u l a t e d o t h i s b a s i s i s r e f e r r e d t o a s interest yield which can be calculated as, Interest yield = (face value) – (sale price) * _____360 _____S a l e p r i c e d a y s o f m a t u r i y Interest on CP is tax deductible. In India, cost of a CP usually includesdiscount, rating charges, stamp duty and issuing & paying agent (IPA)charges.

t

REVOLVER A revolver (RV), or credit line or revolving line, is a credit agreement inwhich the borrower has the right to choose when to obtain funds and when to repay funds and how much to borrow, within limits set by thecontract. These limits typically stipulate a maximum borrowing amount(commitment), the date by which all borrowed funds must be repaid,a n d t h e c o v e n a n t s t h a t t h e b o r r o w e r m u s t s a t i s f y t o q u a l i f y f orreceiving funds. In some cases, the agreement requires that theb o r r o w e r p e r i o d i c a l l y “ c l e a n u p ” ( p a y d o w n t o a s p e c i f i e d l e v e l ) t h e facility before re-borrowing.T h e r e v o l v i n g l i n e i n v o l v e s a l l o f t h e c o m p l i c a t i o n s o f t h e term loanplus the added feature of granting the borrower the right to c h o o s e when to borrow and in what amounts. By providing funds virtually ond e m a n d , t h e r e v o l v e r a l l o w s a b u s i n e s s t o m e e t i t s w o r k i n g c a p i t a l needs and to manage the liquidity risk created by volatile cash flows.Different types of revolving lines account for the major share of bank lending to businesses. By pooling revolvers across many businesses, abank eliminates through diversification most of the liquidity risk that itinherits from customers. Credit instruments used to meet capital expenditure TERM LOAN A loan from a bank for a specific amount that has a sp e c i f i e d repayment schedule and a floating interest rate is called as term loan.A t e r m l o a n ( T L ) i s a c r e d i t c o n t r a c t i n w h i c h t h e b o r r o w e r r e c e i v e s funds from the creditor(s) at contract closing or usually over a shortperiod following closing and, in return, agrees to make payments of interest, fees and principal based on formulas and schedules specifiedin the agreement.O f t e n t e r m l o a n i s g i v e n t o p u r c h a s e f i x e d a s s e t s s u c h a s p l a n t & machinery, consumer products and house.Term loans almost always mature between 1-10 years. But term loanslike home loans may be of maturity up to 20 years. This kind of loan is preferred by many bankers because usually ana s s e t i s c r e a t e d t h r o u g h t h i s t yp e o f c r e d i t . S u c h a s s e t p r o v i d e s s ecurity to the banker.Term loans are always secured in nature. The assets created from theterm loan, are charged to the bank and are a primary security. In caseo f l o a n s w h e r e n o a s s e t i s c r e a t e d l i k e i n c a s e o f p e r s o n a l l o a n ; collateral is required.Borrowers also prefer term loans for capital expenditure as they areless costly than other sources of finance like equity and interest on theterm loans is tax deductible.T e r m l o a n s c a n b e q u i t e c o m p l i c a t e d , i n v o l v i n g a m o r t i z a t i o n o f principal, differing levels of seniority, posting of collateral, detail e d covenant restrictions, prepayment penalties and interest and fees thatmay vary with the borrower’s risk rating or financial performance.

LOAN SYNDICATION/ CONSORTIUM ADVANCE/ MU L T I P L E BANKING ARRANGEMENT Loan syndication is the process of involving several different lenders inproviding various portions of a loan.It is mainly used in extremely large loan situations; syndication allowsa n y o n e l e n d e r t o p r o v i d e a l a r g e l o a n w h i l e m a i n t a i n i n g a m o r e prudent and manageable credit exposure because the lender isn't the only creditor.A syndicated loan (or consortium advance or multiple bankingarrangements) is a large loan in which a group of banks provide fundsfor a borrower, usually several but without joint liability. There isusually a lead bank or group of banks (the "Arranger/s" or "Agent/s")that takes a percentage of the loan and syndicates or sells the rest toother banks. In contrast, a bilateral loan, only involves one borrowerand one lender (often a bank or financial institution.) A syndicatedloan is a much larger and more complicated version of a participationloan. There are typically more than two banks involved in syndication.Syndicated loans can be underwritten or arranged on a best endeavorsbasis. Where a loan is underwritten the Arrangers or Agents guaranteethe terms and conditions and costs of the loan before it is sold to otherbanks, essentially removing the market risk for the Borrower.