1

CREDIT RISK MANAGEMENT IDENTIFYING AND REHABILITATING

PADMALATHA SURESH
Padmalatha Suresh

2
Padmalatha Suresh

THE CREDIT MANAGEMENT PROCESS

BEFORE SANCTION OF CREDIT LIMITS CREDIT APPRAISAL AFTER SANCTION OF CREDIT LIMITS CREDIT REVIEW

3
Padmalatha Suresh

WHY CREDIT REVIEW?

TO CHECK
IF LOAN POLICY BEING FOLLOWED METICULOUSLY IDENTIFY PROBLEM ACCOUNTS AT INCIPIENT STAGE ASSESS BANKS EXPOSURE TO CREDIT RISK ASSESS BANKS FUTURE CAPITAL REQUIREMENTS

4
Padmalatha Suresh

AN EFFECTIVE CREDIT REVIEW SYSTEM MEANS

THE BANK WILL PERIODICALLY CHECK
BORROWERS FINANCIAL HEALTH SECURITY COVERAGE VIOLATION IN COVENANTS PAYMENT DEFAULTS

AND INITIATE REMEDIAL ACTION AT THE FIRST SIGNS OF PROBLEMS ADDITIONALLY, THE OVERALL QUALITY OF CREDIT SHOULD BE MONITORED

5
Padmalatha Suresh

EXPECTED LOSSES
Cost of being in banking business Provisions are made for expected losses EL = PD X EAD X LGD EL can be estimated for entire portfolio or individual account Can EL be called credit risk?

6
Padmalatha Suresh

WHAT IS CREDIT RISK?

PROBABILITY THAT A BORROWER OR A COUNTERPARTY WILL FAIL TO MEET OBLIGATIONS IN ACCORDANCE WITH AGREED TERMS In other words. Variations is EL levels leading to Unexpected losses

7
Padmalatha Suresh

BASLE COMMITTEE PRINCIPLES FOR CREDIT RISK MANAGEMENT

17 Principles under the following broad heads:

Establishing an appropriate credit risk environment Operating under a sound credit granting process Maintaining an appropriate credit administration, measurement and monitoring process Ensuring adequate controls over credit risk The role of supervisors

8
Padmalatha Suresh

CREDIT RISK MANAGEMENT

MEANS..
Managing risks in individual credits or transactions Managing risks in the credit portfolio Managing the inter relationships between credit risk and other risks

9
Padmalatha Suresh

CREDIT RISK CAUSES

INTERNAL CAUSES
MANAGEMENT
Inefficient /lack of commitment Dishonest

TECHNICAL MARKETING FINANCIAL

EXTERNAL CAUSES
FORCE MAJEURE POLITICAL

10
Padmalatha Suresh

SYMPTOMS OF INCIPIENT CREDIT RISK

OBSERVABLE IN OPERATIONS WITH BANK FROM FINANCIAL STATEMENTS FROM EXTERNAL SOURCES suppliers, labor, customers of borrowing unit, statutory authorities, industry trends

11
Padmalatha Suresh

PREDICTING FINANCIAL DISTRESS OF BORROWER FIRMS

ALTMANS Z-SCORE MODEL PREVALENTLY USED Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 Where X1 = working capital / total assets [%] X2 = retained earnings / total assets [%] X3 = EBIT / total assets [%] X4 = market value of equity / book value of debt [%] X5 = sales to total assets [times] The firm is classified as financially sound if Z > 2.99, and financially distressed or bankrupt if Z < 1.81

12

Z-SCORE SIGNIFICANCE OF INDICATORS high operating leverage Assume a firm with

Padmalatha Suresh

1. When sales decline, sales /assets also declines. Due to the high operating leverage, EBIT falls, leading to a fall in the EBIT / assets ratio 2. When EBIT falls, it drives down the retained earnings, and thus the ratio of retained earning / total assets 3. A fall in retained earnings is linked to the working capital, and therefore the working capital / total assets falls. 4. The market does not perceive the declines in key ratios in a favorable light, and the market value of equity falls. The book value of debt remaining relatively unchanged, the ratio Market value of equity / Book value of debt decreases. 5. The decline in market value of equity causes a dip in the firm value and an increase in the financial leverage of the firm. This implies higher financial risk to the firm, and hence a higher probability of distress. 6. The above chain of events is encapsulated in a decline in the Z-score.

13
Padmalatha Suresh

ASSUMPTIONS OF ALTMANS Z SCORE

Firms equity publicly traded It is engaged in manufacturing activities Hence it is necessary to look for alternate models for non manufacturing or emerging market settings

14
Padmalatha Suresh

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 This is a proprietary model available to subscribers The score is reported to provide warning signals 3 to 5 years prior to bankruptcy

15
Padmalatha Suresh

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

16
Padmalatha Suresh

RESTRUCTURING OF LOANS
Stages at which restructuring /rescheduling/renegotiation can take place
Before commencement of commercial production During commercial production but before asset classified as substandard During commercial production but after asset classified as sub standard

17
Padmalatha Suresh

RESTRUCTURING OF LOANS
TREATMENT OF RESTRUCTURED STANDARD ACCOUNTS
If credit fully secured, rescheduling of principal installments alone classified standard Rescheduling interest classified as standard if the present value of sacrifice amount is written off or provision made for the amount.
Compute PV of future interest as per original contract discounted at PLR+ appropriate credit risk premium] Compute PV of restructured dues under new package Compare the PVs If PV[restructured] is less than PV [original] sacrifice to be written off/ provision made

18
Padmalatha Suresh

RESTRUCTURING OF LOANS
TREATMENT OF RESTRUCTURED SUB STANDARD ACCOUNTS
If credit fully secured, rescheduling principal installments alone account continues as substandard If interest to be rescheduled follow procedure as for standard accounts Sacrifice to be written off / provision made Even if sacrifice = writing off of past interest due, asset still treated substandard

19
Padmalatha Suresh

RESTRUCTURING OF LOANS
WHEN CAN THESE ASSETS BE UPGRADED?
After satisfactory performance for one year after rescheduling Amount of provision made [ net of PV of sacrifice] can be reversed

20
Padmalatha Suresh

WHAT IS BEING SICK? [SSI - INDIA]

When any of the borrowal accounts of the unit [principal or interest] remain overdue for a period exceeding one year, and account is sub standard over 6 months When previous years net worth is eroded by 50% due to cash losses [ the unit should have been in commercial existence for at least two years]

21

WHAT IS BEING SICK? [ OTHER UNITS]

Padmalatha Suresh

Company not less than 5 years old Accumulated losses equal to or exceeding its entire net worth POTENTIALLY SICK
Accumulated losses eroded 50% or more of peak net worth during preceding 4 financial years

22
Padmalatha Suresh

TO NURSE OR NOT TO NURSE?

Only those sick units having a fair chance of turning round within reasonable period to be nursed
If rehabilitated
Will the unit be able to meet financial obligations [current and future] within a reasonable time? Will the debt/equity improve within 3 to 5 years?

23
Padmalatha Suresh

TO NURSE OR NOT TO NURSE?

Also look at following
Were factors causing sickness mostly environmental? Can the unit operate more profitably at higher capacity? Can the unit generate cash to pay interest on current borrowings and provide for depreciation? Can the unit generate cash to pay interest/ installments of term loans?

Banker should be satisfied with the financial viability/technical feasibility if project is restarted

24
Padmalatha Suresh

STEPS FOR REHAB

Satisfied with the financial viability/technical feasibility of rehabilitation? Determine need for additional funds Prepare cash flow estimates Seek co-operation of other creditors suppliers, labor, other lenders Gear up Marketing arrangements Help in collection of overdue debts Help in disposal of unwanted/unproductive assets Help in additional financing arrangements with other lenders/ equity holders Develop controls to monitor managerial performance

25
Padmalatha Suresh

REHAB PACKAGE INTEREST DUES ON CC AND TL

Penal interest charged waived from accounting year in which cash losses started Unpaid interest CC+ TL segregated and funded Interest funded as above treated as funded term loan
at 0% interest [ for MLI units PLR less 2%] To be repaid within 3 years of rehab commencement [MLI 3-5 years/ 6-7 years in exceptional cases]

26
Padmalatha Suresh

REHAB PACKAGE INTEREST DUES ON CC AND TL

Unadjusted interest [between preparation of rehab package and implementation] funded as above Interest on term loans can be reduced by NOT MORE than 2% over contracted rate

27
Padmalatha Suresh

REHAB PACKAGE WORKING CAPITAL TERM LOAN

After segregating interest as above, balance would be dues of principal amount Principal considered irregular where not backed by Drawing Power [ in case of CC floating assets, TL- actual DP] This is funded as WCTL repayment in NOT MORE than 5 years [ MLI- 5-7 years] Interest on WCTL @ 1.5-3% LESS than contracted rate / PLR

28

REHAB PACKAGE CASH LOSSES

Padmalatha Suresh

Cash losses during rehab, till unit reaches Break Even funded by bank/ FI if both Bank/FI involved in rehab, only FI should finance cash losses Interest on funded cash losses @ rate charged by SIDBI /IDBI on rehab scheme Future cash losses [before interest payable to bank on Working capital] to be funded by FI Interest due to bank funded separately by bank If bank the only lender, both the above funded by bank interest as prescribed by SIDBI/IDBI rehab assistance scheme

29
Padmalatha Suresh

REHAB PACKAGE WORKING CAPITAL

Working capital in package - @ 1.5% below contracted rate / PLR Additional working capital @ 1.5% below PLR

30
Padmalatha Suresh

REHAB PACKAGE-CONTINGENCY LOAN [ONLY SSI]

For meeting additions to Capex up to 15% of estimated cost of rehab Interest @ concessional rate applicable to working capital assistance

31
Padmalatha Suresh

REHAB PACKAGE- START UP EXPENSES/ MARGIN FOR W/C

Start up expenses- includes payments for pressing creditors given as LONG TERM loans @ 1.5% less than contracted rate/PLR Margin money for working capital from SIDBI [refinance scheme] or Government [ margin money assistance scheme]

32

REHAB PACKAGE- PROMOTERS CONTRIBUTION

Padmalatha Suresh

OF ADDITIONAL REQUESTS UNDER REHAB PACKAGE

20% as promoters contribution by SSI 30% as promoters contribution by MLI Of the above at least 50% to be brought in immediately Remaining 50% within 6 months

Banks/ FI can insist for more promoters contribution Promoters contribution to include monetary value of sacrifice by banks/ FI/ government + long term requirement of funds under rehab

33
Padmalatha Suresh

IMPORTANT RIGHTS OF LENDER UNDER REHAB

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

34
Padmalatha Suresh

OTHER RELIEF SOURCES

STATE GOVERNMENT
IFST, guarantees, preferential treatment for power supply, etc

CENTRAL GOVERNMENT- excise exemptions, interest free loans, market/price support Company management Labor force of sick company

35
Padmalatha Suresh

CORPORATE DEBT RESTRUCTURING

OBJECTIVE
Timely and transparent mechanism for restructuring corporate debts of viable corporates Out of purview of legal proceedings

THREE TIER STRUCTURE

CDR STANDING FORUM CDR EMPOWERED GROUP CDR CELL

36
Padmalatha Suresh

CORPORATE DEBT RESTRUCTURING

CDR STANDING FORUM
All FI/banks Self empowered body Official platform for both creditors and borrowers to amicably evolve restructuring plans Will be assisted by CDR core group Will meet at least once every six months to review and monitor progress of corporate debt restructuring

37
Padmalatha Suresh

CORPORATE DEBT RESTRUCTURING

CDR EMPOWERED GROUP AND CDR CELL
Examine viability and rehabilitation potential of company Approve restructuring package within 90 days

OTHER TERMS OF RESTRUCTURING AS PER EARLIER NORMS

38
Padmalatha Suresh

QUESTIONS???