Commercial Banking

Module – 7

Dr. Gagandeep Sharma, SJIM

Dr. Gagandeep Sharma, SJIM

The Credit Management Process
 Two distinct processes
• Before sanction of credit limits – credit appraisal
• After sanction of credit limits – credit review
 A sound credit review process is necessary for the long term sustenance of the bank
 Makes sure: principal and interest are recovered
 Why credit review?
 To check
• If loan policy being followed meticulously
• Identify problem accounts at incipient stage
• Assess bank’s exposure to credit risk
• Assess bank’s future capital requirements

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An Effective Credit Review System Means
 The bank will periodically check
• Borrower’s financial health – financial statements
• Security coverage
• Violation in covenants
• Payment defaults
• And initiate remedial action at the first signs of problems!
 Additionally, the bank will monitor the overall composition and quality of credit portfolio
 Uniformity in credit monitoring – riskier clients?
 Monitoring of information regarding:
• Developments in the economy
• Borrower’s industry
• Borrower’s financial health
• Payment record
• Primary and collateral – quality, condition and value
• Loan documentation and developments in law
• Adherence of loan covenants

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Borrower Sickness
 Borrower sickness is a situation when financial health of the borrower begins to decline,
thereby increasing the chances of loan default and bankruptcy
 Three types of sickness:
 Sickness at birth – infeasible projects due to change in environment
 Induced sickness – management incompetence and willful default
 Genuine sickness – circumstances beyond borrower’s control
 When a borrower turns ‘sick’, the bank will have to investigate
 The reasons for sickness, and whether remedial measures can revive the ailing firm,
 The rationale for categorizing the borrower as ‘sick’,
 The risks involved in rehabilitating the borrowing firm, and
 In case the bank decides to rehabilitate, the requirements for such revival in the form of additional
financing, government support, management inputs, or upgraded technology.
 It is crucial for lending banks to be able to identify the signals of financial distress, detect them
early enough , and initiate remedial action, so that bank funds do not turn irrecoverable

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Triggers of Financial Distress
 Financial failure – prolonged period of lack of profitability, indicated by poor cash flows
• E.g. unrealizable receivables; poor quality inventories (obsolete, non-moving); inadequate
depreciation;
• Cost of capital > Return on investments
• MV of liabilities > MV of assets
• Leading to insolvency
 Lending banks are concerned with:
• Signals of financial distress
• Detection of these signals early so that account doesn’t turn irrecoverable
• Prediction of financial failure

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 Altman’s Z Score model
 Developed by Edward Altman in 1968 and improved in 19951
Working
 Developed using multiple discriminant analysis of 33 US Capital/To
companies – bankruptcy and non bankruptcy (each) tal Assets
(X1)
 Experimented with 22 accounting ratios and found 5 were
significant predictors of default Retained
 Model: Sales/Tota Earnings/
l Assets Total
• Z score = 1.2X1 + 1.4X2 +3.3X3 + 0.6X4 + 0.999X5 (X5) Assets
(X2)
 Interpretation: Good/bad
Value Interpretation
Less than 1.81 Failure
1.8-2.7 Good chance of default
BV
2.7—3.00 Alert needed Equity/BV EBIT/Total
Total Assets
Greater than 3.0 Default unlikely
Liabilities (X3)
 Prediction power: (X4)
• One year - 94% (failure) 97% (non failure)
• Two Years – 72% (failure) 94% (non failure)
1. E. I. Altman, “Financial Ratios, Discriminant Analysis, and the Prediction of Corporate Bankruptcy,” Journal of Finance 23, no. 4 (September 1968): 589–609

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Altman’s Z Score Model
 Model uses two important assumptions of corporate finance:
• Operating leverage:
 High operating leverage means larger proportion of fixed costs relative to variable costs
 Any change in sales affects profits significantly i.e. small changes in revenue leas to high changes in EBIT
• Asset utilization
 Proportion of assets to operational requirements and sales
 Model is for:
• Publicly traded firms and
• Manufacturing firms

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Altman’s Z Score Model

Firm value falls

but leverage
Retained earnings Market
Working capital increases 
EBIT & and Retained perception and
Sales decline and Working higher financial
EBIT/assets falls earnings/assets MV of equity / BV
capital/assets falls risk and
falls of debt falls
probability of
distress

High operational leverage consequences

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The ZETA score
 Appropriate for non manufacturing firms
 The model was built by Altman, Haldeman, and Narayanan in 1977 as a variation over the Z score
 Sample: 53 bankrupt and 58 non-bankrupt firms over 1969-1975
 The score is reported to provide warning signals 3 to 5 years prior to bankruptcy
 Zeta=1.2X1+1.4X2+3.3X3+0.6X4+1.0X5+0.999X6+0.3X7
• Where:
• X1 = Return on Assets = EBIT / Total Assets
• X2 = Stability of Earnings (standard deviation of ROA over time, inverted so higher stability → higher score)
• X3 = Debt Service Coverage = (EBIT + Depreciation) / Total Liabilities
• X4 = Cumulative Profitability = Retained Earnings / Total Assets
• X5 = Liquidity = Working Capital / Total Assets
• X6 = Capitalization = Equity / Total Capital (Equity + Debt)
• X7 = Size = log(Total Assets) Value Interpretation
 Interpretation: <1.23 High risk of bankruptcy
1.23-2.9 Moderate risk of bankruptcy
>2.9 Low risk of bankruptcy

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The Emerging Market Scoring [EMS] Model
 Modified version of the Z score to predict distress in emerging market firms – by Altman, Hertzell and Peck in 1995
 One version of EMS is the Emerging Market Corporate Bond scoring system
• Applicable to manufacturing and non manufacturing firms
• Applicable to privately and publicly held firms
 EM score = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4 + 3.25
 Where:
• X1 = working capital / total assets
• X2 = retained earnings / total assets
• X3 = operating income / total assets
• X4 = book value of equity / total liabilities

Value Interpretation
 Interpretation:
<1.1 High
1.1-2.6 Medium chance of
default
>2.6 Low

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Loan Workout Function
 Aims of credit review and monitoring:
• Watch out for warning signals
• Identify sick loans and record the findings
• Revise credit ratings
• Classify accounts for provisioning and expected losses (standard, sub-standard and NPAs)
 Loan workout (restructuring or remedial management) is the function of renegotiating or modifying the terms of a loan
when the borrower is facing financial distress and cannot meet original repayment terms, especially when a default event
has occurred
 Once the problem is identified, the bank has two options:
• Restructure the borrower’s debt, or
• Liquidate the loan
 In many banks, loan workout is a centralized function, handled by specialists
 Workout function activities:
• Setting rules for workout function
• Prioritize loan workout based on urgency of the situation
• Assembly of best teams and skillsets
• Assess available alternatives based on analytical rules – alternatives like restructuring, loan sales, foreclosures, do nothing etc.
Warning signals for sickness
 Continuous irregularities in cash credit / OD account: Outstanding balance at the maximum
 Failure to pay installments and/or interest in term loan accounts
 Complaints from input suppliers regarding non payments
 Delay in submission of control statements
 Diversion of sales, reduced credit summations
 Frequent return of cheques
 Decline in production, sales, profits etc.
 high inventories and debtors
 Failure to pay statuary liabilities
 Diversion of funds
 Crystallized liabilities under LC/BGs
RBI framework for distressed assets – February 2014
 Borrowers showing signs of ‘sickness’ to be classified
as ‘special mention accounts’ Period Framework / Event
• SMA-0 Principal or interest payment not overdue Multiple schemes: CDR,
Pre-2018
for more than 30 days but account showing signs SDR, S4A, JLF
of incipient stress . Revised Framework
2018
• SMA-1 Principal or interest payment overdue introduced (Feb 12)
between 31-60 days Supreme Court strikes
• SMA-2 Principal or interest payment overdue Apr 2019
down 2018 framework
between 61-90 days
New Prudential Framework
• Scheme contained detailed guidelines regarding: Jun 2019
issued
Corporate Debt Restructuring (CDR), Strategic
COVID-19 special
Debt Restructuring (SDR), Scheme for
2020–21 restructuring schemes
Sustainable Structuring of Stressed Assets (S4A),
(Resolution 1.0 & 2.0)
and Joint Lenders’ Forum (JLF)
Restructuring
 Restructuring of sick accounts involves modification in terms of advance/securities including:
• Alteration of repayment period
• Alteration of repayment amount
• Amount or number of instalments
• Changes in interest rate
 RBI restructuring guidelines for advances to:
• Industrial units
• For corporates under corporate debt restructuring (CDR) (exposures above Rs.10crores)
• Small and medium enterprises (SME) (exposures Rs.10crores or lower)
• All other accounts
 Criteria: all categories are allowed to be restructured!
• Financial viability
• No retrospective restructuring
• Fraudulent borrowers are not eligible
 For troubled loans banks grant concessions which are not given to normal credit facilities
• A part of the outstanding principal amount can be converted into debt at lower rates or equity instruments
• Unpaid interest can be converted into a ‘funded interest term loan’ (FITL) to be repaid in instalments under the package
• FITL can also be converted into other debt or equity instruments
• Other relief measures under special circumstances spelt out by RBI
 Joint Lender Forum (JLF) to decide on (a) Rectification, (b) restructuring, or (c) recovery, based on potential viability of borrower
Restructuring
 Restructuring of sick accounts involves modification in terms of advance/securities including:
• Alteration of repayment period
• Alteration of repayment amount
• Amount or number of instalments
• Changes in interest rate
 RBI restructuring guidelines for advances to:
• Industrial units
• For corporates under corporate debt restructuring (CDR) (exposures above Rs.10crores)
• Small and medium enterprises (SME) (exposures Rs.10crores or lower)
• All other accounts
 Criteria: all categories are allowed to be restructured!
• Financial viability (next slide)
• No retrospective restructuring
• Fraudulent borrowers are not eligible
Restructuring
 For troubled loans banks grant concessions which are not given to normal credit facilities
• A part of the outstanding principal amount can be converted into debt at lower rates or equity instruments
• Unpaid interest can be converted into a ‘funded interest term loan’ (FITL) to be repaid in instalments under the package
• FITL can also be converted into other debt or equity instruments
• Other relief measures under special circumstances spelt out by RBI

 Joint Lender Forum (JLF) to decide on (a) Rectification, (b) restructuring, or (c) recovery, based on potential viability of
borrower

 Viability parameters for nursing

• Return on capital employed should be at least equivalent to 5 year government security yield plus 2%.
• The debt service coverage ratio should be greater than 1.25 within the 5 years period in which the unit should become viable
and on year to year basis the ratio should be above 1. The normal debt service coverage ratio for 10 years repayment period
should be around 1.33.
• The benchmark gap between internal rate of return and cost of capital should be at least 1 per cent.
• Operating and cash break even points should be worked out and they should be comparable with the industry norms.
• Trends of the company based on historical data and future projections should be comparable with the industry. Thus
behaviour of past and future EBIDTA should be studied and compared with industry average.
• Loan Life Ratio (LLR), should be 1.4, which would give a cushion of 40 Per cent to the amount of loan to be serviced.
LLR =Present value of total available cash flow ACF during the loan life period (including interest and principal) /
Maximum amount of loan
Important Rights of Lender Under Rehab
 Loss on account of fair value diminution
• Economic loss in value of loan due to reduction in interest rate and/or rescheduling of repayment
of principal
PV of cash flows at existing rates – PV of cash flows at revised rates
• Requires provisioning for banks
1] RIGHT OF REVIEW
• Rehab package subject to review and interest rates could be increased if cash generation warrants
2] RIGHT OF RECOMPENSE
• After successful rehab, sacrifices by lenders to be recouped from future profits /cash accruals of rehabilitated
units