Of late, Banks have evolved as Financial Super-Houses and a variety of functionalities has been brought within the ambit

of banking. With shifting of transactions to Core Banking platform, a paradigm shift is noticeable in the way banking is being done today. However, the traditional definition of banks as an agency, which accepts deposit for the purpose of lending, still holds true. Lending continues to be the most important function of banks with ever increasing complexities and diversification. Though the volume of personal segment retail credit has increased manifold, corporate credit along with retail commercial credit continues to be the mainstay of lending activities. With allround growing technological advancement and increasing sophistication, Indian borrowers are also becoming more and more demanding and it is imperative for bankers to enhance their knowledge and skills to match expectations. The fundamentals of credit discipline continue to be the same for effective credit administration and management, inspite of complexities, diversification, globalization and product proliferation. Selection of good borrowers though proper appraisal, assessment of their needs by taking into account volume of finance and the best mix of products with respect to type and amount of loan, maturity terms, interest rates etc., administration and management of credit safeguarding bank's interest through continuous follow up, supervision and monitoring till maturity, so as to continuously mitigate risks require high degree of understanding and deep involvement. Needless to emphasize here is the fact, that Bank's credit portfolio is the single most important factor which has a direct impact on health and profitability of the Bank. The objective of this book on CREDIT MANAGEMENT is to enable the reader to understand the rationale behind the instructions of the Bank in addition to knowledge and comprehension of basic principles of credit, empowering credit managers to confidently take informed and timely decisions. The current edition captures changes upto August'2011. As the basic objective of the book is to help attain conceptual clarity, operational guidelines related to interest rates, service charges, discretionary powers etc. continue to be out of the purview of the book. SME and P-segment products have also not been covered in this edition as the College brings out separate publications for these areas. I place on record my appreciation of Sri Subodh Kumar, Faculty, for his effort to bring out the updated edition. I also appreciate the contributions made by Sr. faculty Sri G.S. Rawat and Sri C. Sankara Narayanan faculty at the college. I believe that the updated edition will be of immense help.
State Bank Staff College Hyderabad August 2011

USHA R. NAIR Principal

(For Internal Circulation Only)

CREDIT MANAGEMENT

Updated by SUBODH KUMAR AGM & Faculty (Credit & IB)

STATE BANK STAFF COLLEGE

HYDERABAD AUGUST 2011

This book has been updated by taking help from instructions issued by the Bank as well as various publications within and outside the bank, but readers are advised not to treat it as a substitute for the written instructions of the Bank.

CONTENTS
S.No. 1. Policy & Other Matters a) Loan Policy b) 2. 3. 4. 5. 6. 7. 8. 9. Fair Lending Practices Code (FLPC) TOPICS Page No. 1 54 57 111 132 137 153 161 202 236 249 270 297 315 351 362 370 410 436 440 454 462 478 484 488 492
491

Financial Statement Analysis Working Capital and its assessment Commercial Paper Financing Trade and Services Term Loans and DPGs Project Appraisal Credit Risk Assessment Non-fund based Business (A) Letters of Credit (B) Bank Guarantees

10. 11. 12. 13. 14.

Short Term Export Finance Types of Lending arrangements Legal issues in Documentation Security Documentation Loan Administration I. Pre sanction process II. Post sanction process III. Stressed Assets Management

15. 16. 17. 18. 19. 20. 21. 22.

Factoring Basics of Leasing Credit Derivatives Securitisation Accounting Standards Introduction to Basel II Risk Based Supervision Credit Audit

Credit Management

1. CREDIT MANAGEMENT POLICY & OTHER MATTERS 1(a) LOAN POLICY

INTRODUCTION 1.1. SBIs Loan Policy is directed towards fulfilling the Banks vision Customer first and first in customer satisfaction. Loan Policy is aimed at accomplishing Banks mission to create products and services that help our customers achieve their goals. It will, inter-alia, facilitate service excellence to customers across the country as well as to those residing abroad. 1.2. SBIs Loan Policy is reviewed once in a year and is aligned with the Chairmans Policy guidelines. 1.3. The Loan policy of the Bank, at a holistic level, is an embodiment of the Banks approach to sanctioning, managing and monitoring credit risk and aims at making the systems and control effective. It is guided by the best practices of commercial prudence, the highest standards of ethical norms and the requirement of national priorities. 1.4 At the same time, the Loan Policy also aims at striking measured balance between underwriting assets of high quality, and customer oriented selling. The overall objective is to maintain and improve upon SBIs undisputed leadership in the Indian Banking scene. 1.5. The basic tenets of SBIs Loan Policy are as under:(i) The Loan Policy applies to all domestic lending.

(ii) It aims at spotting and seizing opportunities, revamping our products and delivery mechanism, as well as innovating new products ahead of competition. (iii) The Policy establishes a commonality of approach regarding credit basics, appraisal skills, documentation standards and awareness of institutional concerns and strategies, while at the same time leaving enough room for flexibility and innovation. (iv) It envisages an effective training system in all areas of Credit Management which reflects SBIs commitment to the up gradation of skills of all members to staff on a continuous basis. (v) Computerisation, management information systems based on a reliable database and development of faster communication as tools for better overall credit risk management are accorded due priority in the Policy. (vi) Optimum / maximum exposure levels are set out in the Policy to different sectors, in order to ensure growth of assets in a balanced and orderly manner.
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(vii) It provides for a comprehensive Credit Risk Assessment system that rates each potential / existing assets above a cut off level, and which lays down maximum risks/ hurdle rates for new / additional exposures. (viii) Banks approach to Export Credit and Priority Sector Advances and to specific groups of advances covering emerging opportunities such as Mid-Corporates, Retail, etc are set out in the policy. (ix) The Policy lays down norms for take over of advances from other banks/Fls. (x) Banks approach in granting credit facilities to companies whose directors are in the defaulters list of RBI / CIBIL is covered in the Policy. (xi) The Policy aims at sustained growth of assets in quantitative terms and at ensuring that there is no undue deterioration of individual assets within the portfolio. It simultaneously also aims at continued improvement of the overall quality of assets at the portfolio level. (Xii) All loan products would be reviewed once in a year. 1.6 The Central Board of the Bank is the apex authority for formulating all matters of policy in the Bank. The Banks Board has authorized the setting up of a Credit Policy & Procedures Committee (CPPC) at the Corporate Centre for dealing with all issues relating to credit policy and procedures. the CPPC approves policies for managing credit risk covering credit risk assessment, loan appraisal, exposure limits for a balanced portfolio, loan management and for NPA management including industrial rehabilitation, compromises and write offs.

EXPOSURE LEVELS
2.1 The Loan Policy recognizes the need for measures aimed at better risk management and avoidance of concentration of credit risk. 2.2. The primary guiding factors for fixing ceiling on exposures are the prudential norms prescribed by RBI, which currently stands at 15 % of capital funds (Tier-I and Tier-II capital) for single borrower and 40% of capital funds for a group (up to 20% for single borrower and 50% for a group provided the additional exposure is on account of infrastructure projects in specified sectors). However, in respect of Oil Companies who have been issued Oil Bonds (which do not have SLR status) exposure ceiling of twenty five percent of the capital funds has been prescribed by RBI. Bank may also, in exceptional circumstances, with the approval of the Board, consider enhancement of the exposure to a borrower up to a maximum of further 5% of capital funds, subject to the borrower consenting to the Bank making appropriate disclosure in the Annual Report.
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2.3 As per revised instructions of RBI, exposure shall include Credit (Funded and Non Funded)/ Investments (including Underwriting and similar commitments) and Offbalance Sheet exposure Viz., Foreign Exchange Forward Contracts and other derivative products i.e., Interest Rate Contracts and Gold Contracts etc. 2.4 The sanctioned limits or outstanding, whichever are higher, shall be considered for arriving at the credit exposure limit. Non-fund based exposures should also be considered at 100% of limit or outstanding, except off balance sheet items where exposures should be considered on the basis of credit conversion factors advised by RBI from time to time. In respect of fully disbursed term loans (TLs) only outstanding are considered without any reference to the limit. 2.5. The ceilings on single / group exposure limits would not a be applicable to existing / additional credit facilities (including funding of interests and irregularities) granted to weak / sick industrial units under rehabilitation packages. 2.6 Loans and advances granted against the security of Banks own term deposits will be excluded from the purview of exposure ceiling. 2.7. Borrowers to whom food credit limits are allocated directly by RBI will be exempt form the ceiling to the extent of such allocation. 2.8 Forward contracts in foreign exchange and other derivative products like currency Swaps, options, etc. need to be included at their replacement cost value to arrive at borrowers exposure for which RBI prescribed that Current Exposure Method need to be followed. 2.9. The group to which a particular borrowing unit belongs will be decided on the basis of relevant information available to the Bank; the guiding principle being commonality of management and effective control. 2.10. Exposures between Bank and other banks that are outside the prudential exposure norms, would be determined, bank-wise, as per the Bank Exposure Risk Index (BERI) model. A review as per the Model would be undertaken at yearly intervals. 2.11. Exposures on Primary Dealers would be subject to single borrower exposure limits set within the prudential exposure norms as per Institutional Risk Assessment model. 2.12. Based on current perceptions, the following exposure levels are prescribed. Individuals as borrowers Maximum aggregate credit facilities (fund based and non-fund based) of Rs. 25 crores *(other than against specified securities for which there is no restriction)

Credit Management

Non - corporates $ (Partnerships@, Trusts, JHF, Associations)

Maximum aggregate credit facilities (fund based and non-fund based) of Rs.100 crores* (other than against specified securities for which there is no restriction) The above ceiling will also be applicable to the aggregate of all facilities sanctioned to partnership firms which have identical partners. Maximum aggregate credit facilities as per prudential norms of RBI on exposures.

Corporates #

$ Non-corporates will include Partnerships, Trust, JHF Associations. # Corporates will include Companies, Societies, Govt. Departments, Institutions and Statutory Corporations. * Aggregate of fund-based and non-fund based (excluding facilities against specified securities but including off-balance sheet derivative exposures) @ Partnerships when converted into Limited Liability Partnerships (LLP) may be included under Corporates. 2.13. Terms Loans (loans with residual maturity of over 3 years) at any point of time should not in aggregate exceed 35% of the total domestic advances of SBI. 2.14. The Bank shall at any point of time restrict its funded exposure by way of term loans to infrastructure projects to 15% of the Banks total domestic advances. 2.15. The Bank shall endeavour to restrict fund-based exposure to a particular industry to a maximum of 15% of the Banks total domestic fund based exposure. 2.16. The Banks exposure to real estate, including residential mortgages, commercial real estate and indirect finance etc., will not exceed 25% of the Banks total domestic advances. 2.17. The exposure to sensitive commodities listed by RBI will be restricted to 5% of the Banks net-worth as at the end of the previous year. Capital Market Exposure : 2.18. The Banks aggregate exposure to the capital markets shall not exceed 40% of its net-worth (as defined by RBI) as on March 31 of the previous year. 2.19. Within the overall ceiling of 40%, Banks investment in shares, convertible bonds / debentures, units of equity - oriented mutual funds and all exposures to Venture Capital
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Funds (VCFs) [both registered and unregistered] shall not exceed 20% of Banks networth as on March 31 of the previous year. Also within the overall ceiling of 40%, the Banks exposure to stockbrokers both fund based and non-fund based shall not exceed 10% of its net-worth as on March 31 of the previous year. 2.20 The Bank will formulate from time to time lending policies relating to Grant of advances to individuals against shares, debentures and bonds. Grant of advances to individuals for subscription to rights / new issues of shares, debentures and bonds. Grant of advances to individuals for subscription of right/ new issues of shares, debentures and bonds. Advances against shares to stockbrokers, market makers. Loans for financing promoters contribution. Bank finance to employees to buy shares of their own companies. Bridge loans and Financing acquisition of equity under Govt. of Indias disinvestment programme.

2.21. Loans to individual against the equity - oriented securities shall not exceed Rs. 10 lakhs if securities are held in physical form and Rs. 20 lakhs if held in demat form. 2.22. The exposure norms for investments in shares, bonds and debentures of a corporate, subordinated debt instruments, venture capital, underwriting of corporate shares and debentures, underwriting of bonds of PSUs etc. would be guided by the Banks investment policy. 2.23. Bank can also extend finance to Indian companies for acquisition of equity in Indian Joint Ventures / Wholly Owned Subsidiaries abroad or in other Overseas Companies, new or existing, under the policy approved by the Banks Board in this regard. Banks exposure to this activity will not exceed 10% of the Banks net-worth. Further, such advances will form part of the capital market exposure and will be considered for the overall ceiling of 40% of Banks net-worth prescribed for capital market exposure. Unsecured Exposure : 2.24. Advances to companies in which the members of the Banks Board are directors will be subject to the relevant provisions in Banking Regulations Act (BRA) , 1949 and State Bank of India Act, 1955.
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2.25. Aggregate exposure to connected companies of the Bank, i.e. associates and subsidiaries, would be restricted to 40% of the Banks capital funds (Tier-I & Tier - II capital). However, as per RBI guidelines as prudential exposure limits prescribed by them are not applicable to inter-bank exposures , we may exclude exposure on our Associate Banks and banking subsidiaries from the above. 2.26. While extending credit/ non -credit facilities (letters of credit and guarantees) to Indian joint ventures / wholly owned subsidiaries abroad or extending buyers credit / acceptance finance to overseas parties for facilitating export of goods and services form India, the bank will ensure that such exposure is restricted to 20% of the Banks unimpaired capital funds (Tier-I, Tier-II Capital). For higher limits, Bank would approach RBI on a case - to case basis. Bank would also, inter alia, comply with section 25 of the BRA 1949 (i.e.. the aggregate of such assets outside India not to exceed 25% of the Banks demand and time liabilities in India). The cap of 20% is not applicable to credit extended from overseas operations i.e. when the funding is out of resources raised abroad (such resources are mobilised by our foreign offices through their customers / brokered deposits or inter-bank reciprocal credit lines and borrowings etc.) However, the concentration risk exposure (single borrower and group borrower) would apply to the Bank as a whole. 2.27. At the whole-Bank level, the total non-fund based exposure will not exceed twice the level of the total fund-based exposure. 2.28. Annual review of implementation of exposure ceilings will be undertaken. ***********

SUBSTANTIAL EXPOSURES
3.1. While prudential norms would be the guiding factor for monitoring credit concentrations in terms of exposure as defined by RBI, the following levels of exposures will be deemed to be substantial exposures for triggering internal monitoring mechanism. Single borrower in excess of 7.5% of Banks capital funds - Tier I plus Tier II. Group in excess of 15% of Banks capital funds Tier I plus Tier II. 32. Aggregate substantial exposures to single borrowers should not exceed 300% of Banks capital funds (Tier I plus Tier II). 3.3. Aggregate substantial exposures to groups of borrowers and to single borrowers not included in exposure to groups of borrowers should not exceed 600% of Banks capital funds (Tier I Tier II). 3.4. Substantial exposure norms are in-house norms set within the prudential norms and
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are intended to help in monitoring credit concentrations. These norms should not be deemed as a cap on further exposures and should not come in the way of booking bankable business. *********

CREDIT APPRAISAL
4.1. A decision as to the credit worthiness of a proposal is arrived at after considering a combination of several factors including: an assessment of the promoter, covering their background and relevant experience in the area of the proposed entity. the previous experience of the bank with the promoters of their group. Complete information of Take Over / New Management including regulatory compliance and impact of Change in Management Control the perceived prospects of the industry or activity proposed. the already existing extent and quality of the exposure of the Bank to the industry or activity on the one hand and to the promoters / group on the other. policy relating to exposure levels and norms prescribed by the regulators and by the bank for the proposed activity / industry. the perceived financial strength and the risk rating of the promoters, the borrowing entity and / or the group. the extent and nature or credit risk mitigants proposed, etc.

4.2. Having decided that the proposal, as a reasonable and acceptable business risk, is a bankable proposition, the next step involves assessing the nature and extent of the proposed exposure. The Bank provides a range of debt instruments including all types of terms and working capital facilities, each of which can be structure either as fund based products or non-fund based products or a combination of both. It is our effort to combine these with a range of payment and collection platforms that are off the shelf or tailor-made to meet individual requirements and seek to provide our customers with a complete solution to all their financial requirements. Assessment 4.3 The assessment of working capital is done through the Projected Balance Sheet Method (PBS), Cash Budget method or Turnover Method. 4.4. Under the PBS method, the fund requirements computed on the basis of borrowers projected balance sheet, the funds flow planned for the current/ following year and examination of the profitability, financial parameters. etc. The key determinants for the limit
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can, inter-alia, be the extent of financing support required by the borrower and the acceptability of the borrowers overall financial position including the projected level of liquidity. The projected Bank borrowing thus arrived at, is termed as Assessed bank Finance (ABF). This method is applicable for borrowers who are engaged in manufacturing, services and trading activities and who require fund bases working capital (WC) finance of above Rs. 5 crores. 4.5. Cash budget method is used for assessing working capital finance for seasonal industries like sugar, tea and construction activity. This method is also used for sanction of ad-hoc WC limits. In these cases, the required finance is quantified from the projected cash flows and not from the projected values of current assets and current liabilities. Other aspects of assessment like examination of funds flow, profitability, financial parameters, etc, are also carried out. 4.6. Under the turnover method, working capital requirement is computed at a minimum 25% of output value, of which, at least four-fifths is provided by the Bank and balance onefifth represents the borrowers contribution towards margin for working capital. This method is applicable for sanction of fund based working capital limit of upto Rs. 5 crore. 4.7. In respect of term loans, the computation of cost estimates is scrutinised very carefully to ensure that the total project cost arrived at is accurate, comprehensive, reasonable and realistic. Then the proportion of debt and equity components i.e. the project debt / equity, envisaged in the tie up for the means of financing of the project is examined to ascertain whether it is reasonable and acceptable. There is no standard project debt / equity (D/E) ratio that can be prescribed for any project. The stipulation of this ratio for a particular project, will be based on a number of factors such as the nature and size of the project, location, capital intensity, gestation period, promoters capacity, state of the capital markets, importance to the national economy, government policies, etc. Though there are no rigid norms for the project debt/equity ratios, however, one of the deciding factors of the D/E ratio will be the debt servicing ability of the project. After taking into consideration the above mentioned factors and the suitability of the various sources of finance with due regard to the financial leverage envisaged for the project, the term finance arrived at is validated and accepted. 4.8. After due appraisal and assessment, the appropriate authority, as laid down in the Scheme of Delegation of Financial Powers for advances, sanctions the credit facilities. Such sanctions, if not availed within a period of three months in respect of working capital facilities and within six months in the case of term loans, from the date of sanction, would lapse and require revalidation. Use of provisional / un-audited data 4.9. Further, provisional/ un-audited data is made use of for taking credit decisions, in
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respect of existing borrowal accounts, where there is likely to be a delay in obtaining audited financial statements from them and the reasons adduced therein are acceptable to the Bank. In respect of such cases, a review of the accounts is undertaken on the basis of audited financial statements within a period of six months form the date of renewal / enhancement. In cases where deviations on the negative side are observed as compared to un-audited data submitted earlier, the Controllers, to whom the review is submitted, issue oppropriate directions where considered necessary. Such directions normally include specifying additional covenants, placing restrictions on the drawings etc. Collateral Security 4.10 For SSI loans no collateral security is to be obtained for loans upto Rs. 5 lacs and for loans upto Rs. 15 lacs the sanctioning authority may consider waiving colleterial security subject to compliance with certain conditions. Under SBF segment, this waiver is permitted for loans upto Rs. 25,000.As regards Agriculture segment, waiver is generally permitted for loans upto Rs. 50,000 by RBI, though there are scheme specific ceilings in this regard. In other cases, with exception of specified categories like trade advances where obtention of collateral security is prescribed as a part of the scheme, obtention / waiver of collateral security is a discretion to be exercised by the sanctioning authority. Quantitative Standards 4.11. The basic quantitative parameters underpinning the Banks credit appraisal and the levels that are desired are as under: Sector / parameters Liquidity Current Ratio (Min.) Mfg 1.33 Others WC limits upto Rs. 5.00 crs - 1.00 Above Rs. 5.00 crores 1.20 Financial Soundness TOL/TNW (max.) DSCR Net (min). Gross (min.) Gearing D/E (max)
Credit Management

3:1

5:1

2:1 1.75:1 2:1

2:1 1.75:1 2:1

Unsecured loans brought in by the promoters and their close friends and relatives may be treated, except in the case of noncorporates, as quasi equity, highly selectively, subject to fulfillment of certain conditions).

Promoters Contribution* (min)

30% of Equity

20% of Equity

4.12. While these are indicative level, there cannot be a definite benchmark, as acceptable levels are case specific, guided by the nature, size and scope of the project. The sanctioning authority will have the necessary discretion to permit deviations in this regard, based on the justifications placed before it. Letter of Credit, Bills Discounting It is necessary, while sanctioning a borrower the facility of letters of credit, that the aggregate of fund based working capital finance and the LC facility is commensurate with the projected build up of chargeable current assets. 4.13. It should be ensured that the Bank opens Letters of Credit (LCs), issue guarantees / accept and discount bills under LCs only is respect of genuine commercial and trade transactions of borrower constituents who have been sanctioned regular credit facilities by the Bank. The prescription would not, however, prohibit the Bank form accepting bankable business from non-borrower constituents such as Govt. / Research / Defence / Educational organizations and other statutory organisations who have no borrowing arrangements with any FI/bank. 4.14. It is also not the intention of the Bank to turn down acceptable bill discounting business against LCs of other first class banks from borrowers who may not be dealing with us for their other banking requirements. However, in the interest of fostering better lending discipline as also in the overall interest of our Bank, we need to ensure that:(i) The extent of requirement of additional working capital against such bill discounting is separately assessed and appropriate bill discounting limits against letter of credit, is sanctioned to such borrowers. The borrowers existing bankers are separately and duly advised of the Bank having sanctioned the facility to the borrower. All due formalities under the KYC guidelines are meticulously and fully complied with.

(ii)

(iii)

When the safeguards / requirements given above are complied with, these borrowers will be borrower constituents of our Bank, who have been sanctioned regular credit facility (ies) by the Bank. 4.15. Bank would not Open LCs and purchase / discount / negotiate bills bearing the without recourse clause. However, Operating Offices may discount bills under LCs with or without recourse in respect of LCs opened by First Class Banks only. Bank would not
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ordinarily discount bills drawn by front finance companies set up by large industrial groups on other group companies. While discounting bills of services sector, Bank would ensure that actual services are rendered and accommodation bills are not discounted. Bank Guarantees 4.16. Bank as a general rule, will limit itself to the provision of financial guarantees and exercise due caution with regard to issuing of performance guarantees, BGs will generally be issued / renewed valid for a period not exceeding 18 months at any one instance. If BGs are to be issued for a longer period, an authority structure for according administrative clearance for this is in place. BGs originally issued for period less than 18 months but that have been subsequently extended crossing in aggregate the 18 months cut off will also attract administrative clearance. No BG should normally have a maturity of more than ten years. Bank may consider issuing BGs beyond maturity of 10 years only against 100% cash margin and with prior approval of the competent authority specified in this regard. 4.17 While sanctioning limits for BGs, factors such as the need for and the nature of BG, Whether the requirement is one time or on a regular basis, constituents financial strength, past record, margin, etc. will be looked into. In view of BASLE II guidelines, operating offices will ensure proper classification of Guarantees into Financial or Performance to reap the benefit of lower capital charge on Performance Guarantees issued by the Bank. 4.18 Bank will issue BGs with an automatic renewal clause only to select beneficiaries such as customs authority, courts and overseas project owners in respect of project exports. 4.19 Normally all Bank guarantees will be secured by a charge on the assets (current and / or fixed) of the applicant. Unsecured Bank Guarantees, where considered exceptionally, will generally be for shorter period and for relatively small amounts. 4.20 Banks liability under BG is absolute, independent and exclusive of any other contract entered into with the constituent. Thus the Bank is obliged to pay to the beneficiary without delay and demur the amount of BG on its invocation in accordance with the terms and conditions of the guarantee deeds. Only when the Bank has received an order of restraint / injunction from a competent/ appropriate Court, will the bank withhold payment under the BG. In such cases, the liability of the bank under the BG will continue, till the court case is decided, not withstanding a shorter period of validity as may have been stipulated in the guarantee itself. 4.21 The bank will not execute guarantees covering inter-company deposits / loans. BGs will also not be issued for the purpose of indirectly enabling the placement of deposits with non-banking institutions.
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4.22 Banks performances in non-fund based business will be reviewed at quarterly intervals and submitted to the Board. Guarantees and co-acceptances favouring Fls / banks /other lending agencies as guaranteeing Bank. 4.23 As per RBI guidelines, banks may issue guarantees favouring Fls/ other banks/ other lending agencies for loans extended by them. However, given the funding capabilities of our Bank, such guarantees are not proposed to be issued for domestic operations. The Bank will also not undertake the business of co-acceptance of bills of its constituents. If required, the policy would be reviewed at the appropriate time. As Lending Bank 4.24 Bank may extend fund based and non-fund based credit facilities against guarantees issued by other Banks/ Fls. 4.25 The exposure assumed against such guarantees will be deemed as an exposure on the guaranteeing bank/Fls and would be subject to the permissible Global Exposure Limit (PGEL) on other Banks and Fls in place in the Bank. A sublimit for such exposures may be fixed within the PGEL as part of the half yearly review exercise being undertaken by Credit Risk Management Department. Lending to Non - Banking Financial Companies (NBFCs) 4.26 The Banks approach to financing NBFCs is as under: Bank will extend finance only to Asset Finance Companies (AFCs), which are either Deposit Taking NBFCs (LBFC-D) or systemically important Non-Deposit Taking NBFCs (NBFC-ND-SI) The company should have been in operation for at least there years on the date of application. Exception may be considered in this regard for those NBFCs that are sponsored by existing reputed customers of the Bank. The sponsoring company must have been rated at least SB5 under Banks CRA system. The extent of finance to a NBFC will not exceed 3 times the NOF of the company in the case of SB1 to SB5 rated companies and 2 times the NOF for others or 10% of the Banks capital funds, whichever is lower. The ceiling on overall limit of bank credit mentioned above would be within the overall ceiling of borrowings (including public deposits and all others borrowings) of up to. - 10 times the NOF of such companies in the case of SB1 to SB5 rated companies and
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- 8 times the NOF in the case of others. The company should follow ICAI guidelines on standard accounting procedure. The company should comply with the regulations prescribed by RBI. Current ratio should not be less than 1.33. The leasing / hire purchase / loan receivable over dues must not be more than 5%. In the case of existing companies, NPAs, must not be more than 5% of its leasing & Hire Purchase / loan assts. The company must have been prompt in repaying maturing deposits, where applicable. Only on-lending made for creation of physical assets supporting productive / economic activity will be considered for computation of MPBF, without adjusting the projected NWC, for supporting other activities of the NBFC. Credit facilities may be granted by way of cash credit and Term loan only. In respect of existing borrowers not complying with the above guidelines, enhancement in credit facilities will not be considered in general. The possibility of exiting such accounts in terms of the Banks extant exit policy on standard assets will be explored, where felt necessary and found feasible. As Govt. owned NBFCs are also being brought under the ambit of RBI regulations, Banks guidelines on NBFC will be made applicable to such entities also. Bank will continue to extend finance to NBFCs against the second hand assets financed by them subject to the stipulations laid down in the this regard. Deviations in the above guidelines, within the RBI prescriptions, may be considered for credit proposals requiring sanctions by CCC-I / MCCC and above. Such deviations will have to be permitted by CCCC for sanctions below CCCC. Since the exposure ceiling in respect of all other industries are expressed as a percentage of the Banks total Domestic Fund based exposure, the NBFC sector should also be related to banks total Domestics Fund based exposure instead or relating to the Banks capital funds to maintain uniformity. This ceiling will be reviewed by CRMD at half yearly intervals. Given the special features of NBFCs as different from manufacturing units, a separate Credit Risk Assessment (CRA) model has been put in place for assessment of NBFCs. Half-yearly reviews of CRA rating have been stipulated for units rated SB7 & below.
13

Credit Management

Some Public sector NBFCs are financing infrastructure in a big way. The exposure to NBFCs need to be segregated into two categories, i.e. Public sector NBFCs and others and fix suitable sub ceiling within the exposure cap.

Financing of Infrastructure Projects 4.27 Infrastructure would include sectors such as power, roads, highways, bridges, ports, airports, rail system, water supply, irrigation, sanitation and sewerage system, telecommunication, housing, industrial park or any other public facility of a similar nature, construction relating to projects involving agro processing, supply of agricultural inputs, preservation and storage of processed agro products, educational institutions, hospitals and such other activities as may be notified by RBI from time to time. 4.28 Financing of infrastructure projects is characterised by large capital costs, long gestation period and high leverage ratios. Bank can sanction term loans to infrastructure projects within the overall ceiling of the prudential exposure norms. Further, subject to certain safeguards, Bank is also permitted to exceed the single borrower / group exposure norm to the extent of 5% / 10% provided the additional exposure is for the purpose of financing infrastructure projects. Lease Finance Although a policy is in place, a decision was taken not to undertake any fresh lease finance due to taxation issues {(i) Assets under lease were not treated as fixed assets and therefore, depreciation benefit was not available, (ii) Lease rentals were treated as sales and thus were subject to sales tax}. Gold Metal Loan 4.29 Bank has in place a Gold Metal Loan Scheme for extending finance to domestic jewelry manufacturers. The maximum period of the loan in 180 days. Policy for financing Carbon credits 4.30 The Kyoto protocol which came into force on February 16, 2005 established a mechanism for companies and governments in developed countries to contribute towards their fight against global warming by purchasing Certified Emission Reductions (CERs), more commonly called as carbon credits, from developing countries. The Bank has sensed a business opportunity in this development and has approved a policy for financing carbon credits. An interest concession of 10 bps below the eligible/ sanctioned pricing will be extended to projects that contribute to sustainable development. 4.31 Finance to Clean Development Mechanism (CDM) projects, advisory services for implementing CDM projects, loan against carbon credit receivables, carbon delivery
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guarantee, escrowing of carbon credits, aggregating and/ or bundling the smaller projects to make the process of generating CERs viable through economies of scale, etc. are the carbon credit related services being considered by the Bank. 4.32 The policy provides for empanelment of CDM consultants to offer the entire range of services from project concept state to trading of CERs. A Carbon Finance Committee with MD &CCRO as the chairperson and DMD (CDO), DMD (MCG), CGM (SME), CGM (CAG) as members and CGM (CPPD) as member Secretary has been constituted to empanel outside consultants / finalise agreements with outside agencies and oversee the Banks growth in this segment. Syndication of loans 4.33 The Bank on its own or jointly with other State Bank Group companies would undertake the syndication. Given the syndication capability of the Bank and the related Group synergies, the Bank would also attempt to market syndication of loan / treasury products as a stand - alone product. Acquisition through assignment of debts 4.34 The market for assignment of debts is expected to grow rapidly in the years to come. This gives the Bank an added opportunity for acquiring good quality loan assets and optimizing the Loan portfolio. To facilitate identification of retail and corporate assets for the purpose, the Bank has laid down guidelines on required credit rating, loan tenor, loan size, acceptable yield sanction process, etc. Dealing in securitised assets 4.35 The market for securitised assets is expected to grow as various players in the Indian financial market look for higher liquidity and returns. This gives the Bank an opportunity to identify homogenous pool of income producing assets in the loan book and to repackage them into marketable securities. The Bank has laid down the approach to identification of retail and corporate assets for the purpose and various other operational aspects. Hedging of forex risks 4.36 As mandated by RBI, the Bank has a separate Board approved Hedging policy. The main features of the policy are as under. (i) All forex loans upto USD 5 Mio (other than those extended for meeting forex expenditure) should be covered by procured hedge unless such customers have uncovered forex receivables to cover the loan amount.

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(ii)

In respect of forex loans above USD 5 Mio and those extended for meeting forex expenditure, the approach would be as under : Size of Exposure Approach

Purpose of Forex Loan

Forex loans Exposure extended to finance UDS 5 Mio exports

above Detemine Coverage Adopt appropriate under natural hedge hedge technique(s) for the portion of component first loan in excess of natural hedge cover. Indian corporates should have well defined Corporate Hedging Policy or the Corporates should have been included in the Banks direct exposure list for foreign offices Ensure procured hedge for the portion of loan in excess of natural hedge cover, before draw down.

Forex extended meeting expenditure

loans Exposure of all sizes for forex

Forex loans Loans upto the Detemine coverage extended for ceiling under under natural hedge meeting Rupee Automatic Route component first. expenditure under Automatic Route Forex loans Exposure extended for all USD 5 Mio. other purposes. (iii)

above Adopt appropriate hedge techniques.

In respect of pubic sector corporates on the Banks direct exposure list for foreign offices which are predominantly importers, there would be no cap on unhedged exposure but it should be ensured that the said corporates have well laid down corporate policy for hedging.

(iv) In respect of blue chip private corporates that are in the Banks direct exposure list and have a well defined corporate hedging policy, as a prudent measure, it should be ensured that at least 50% of their total forex borrowings from the banking system are hedged though the techniques of natural hedge, pass through status and procured hedge. However, the unhedged exposure of their total forex borrowings from the banking system should not exceed USD 200 Mio. 4.37. Any waiver within the hedging policy either in respect of existing exposures or future exposures would be subject to approval by the credit sanctioning authority not below CCCI / MCCC. The policy is subject to review in the event of any changes proposed by RBI from time to time on an annual basis.
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Fair Practices Code (FPC) for lenders 4.38 The Bank would continuously attempt to introduce transparent and fair practices, as envisaged by RBI, in respect of acknowledging loan applications, their quick processing, appraisal and sanction, stipulation of terms and conditions, post disbursement supervision, changes in terms and conditions, recovery efforts etc. The Bank has also put in place a mechanism for redressal of grievances of borrowers. ************** DOCUMENTATIONS STANDARDS 5.1. Correctly compiled, executed and maintained documents ensure that the : Owing the debt to the Bank by the borrower / guarantor is clearly established. Charge created on the borrowers assets as security for the debt is maintained and enforceable, and Banks right to enforce the recovery of the debt through the process of law is not allowed to become time-barred under the Law of Limitation

5.2 Documentation is continuous and ongoing process covering the entire duration of an advances comprising of the following stages : (i) Pre - execution formalities : These cover mainly searches at the Office of Registrar of Companies and search of the Register of Charges (applicable to corporate borrowers), to ascertain the capacity of borrowers to borrow and formalities, if any, to be completed by the borrowers in this regard. Searches at the office of the sub- Registrar of Assurances of Land Registry to check the existence or otherwise of prior charge over the immovable property offered as security, etc., as also taking other necessary precautions before creating equitable / registered mortgage, including obtention of the lawyers opinion as to the clear, absolute and marketable title to the property based upon the genuineness, completeness and adequacy of the title deeds provided. (ii) Execution of Documents It covers obtention of proper documents, appropriate stamping and correct execution and recording thereof as per laid down instructions and as per terms of sanction of the advance. This also ensures compliance with requirements, if any, of corporate borrowers contained in the Memorandum and Articles of Association, relevant resolution of the Board, etc. A copy of the loan agreement along with its all enclosures will be delivered to the borrowers (s) at the time of sanction / disbursal of loans and acknowledgment of receipt thereof be obtained.

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(iii) Post-execution formalities This phase covers the completion of formalities in respect of mortgages, if any, registration with the Registrar of Assurances, wherever applicable, and the registration of charges with the Registrar of Companies within the stipulated period, etc. (iv) Protection from Limitation / Safeguarding Securities These measures aim at preventing documents from getting time-barred through limitation and at protecting these securities charged to the Bank from being diluted by any subsequent charges that might be created by the borrower to secure his other debts, if any. These objectives are sought to be achieved by : (a) revival letters being obtained within the stipulated period from borrower / guarantor Obtention of Balance Confirmation from the borrower / guarantor at lest at annual intervals making periodical searches at the Office of the Registrar of Companies / registrar of Assurances. insuring Assets charged - (unless specifically waived) to safeguard the Bank against the risk of fire, other hazards, etc., Carrying out periodical valuation of securities charged to the Bank.

(b)

(c)

(d)

(e)

5.3 Keeping the above broad objectives and the documentation process in view, the Bank has devised standard documents in most cases for various types of loans given to the borrowers either by the Bank alone or as part of a Multiple Banking arrangement. Wherever standard specimens have not been devised, these are suitably drafted on a case-by-case basis with the help of in-house legal experts and, on occasions, where warranted, through reputed outside solicitors. 5.4 In respect of consortium advances, the documents are generally executed in consultation with the other member banks in accordance with the guidelines laid down by RBI/ IBA in the matter. Similarly, where advances are extended jointly with the financial institutions, documents are specially drafted in consultation with the solicitors / in-house legal experts to ensure pari- passu charge and / or second charge, whichever is applicable, of the movable / immovable assets of the borrower to protect the Banks interest. 5.5 While it is the Banks endeavour to standardise documents for all types of facilities, in cases where documents have to be specially drafted, the Local Head Offices / CAG / MCG
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are authorised to vet and approve such documents of facilities sanctioned up to their level. For facilities requiring sanction of CCCC/ ECCB or for special schemes drawn up by SBUs under NBG, such specially drafted documents need to be cleared by the Corporate Centre. 5.6 Unconditional Cancellability Unconditional Cancellability clause which gives the Bank the right to cancel the sanctioned limit without reference to the borrower at any time, needs to be accepted by borrowers to give effect to the Internal Capital Adequacy Framework guidelines of the RBI. ******** CREDIT MONITORING & SUPERVISION 6.1 The Bank has in place an effective post - sanction process to facilitate efficient and effective credit management and to ensure a high percentage of standard assets. Broadly, the objectives of post-sanction follow up, supervision and monitoring are as under : (a) Follow up function : ensuring the end - use of funds relating the account outstanding to the assets level on a continuous basis co-relating the activity level to the projections made at the time of the sanction / renewal of the credit facilities. detecting deviation from terms of sanction. making periodic assessment of the health of the advances by noting some of the key indicators of performance like profitability, activity level, and management of the unit and ensuring that the assets created are effectively utilised for productive purpose and are well maintained. ensuring recovery of installments of the principal in case of term loans as per the scheduled repayment programme and overall interest. identifying early warning signals, if any, and initiate remedial measures thereby averting incipient sickness. ensuring compliance with all internal and external reporting requirements for credit discipline. Supervision function: ensuring effective follow up of advances to maintain good assets quality. looking for early warning signals, identify incipient sickness and initiate proactive
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(b)

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remedical measures. (c) If irregularity in an account persists for more than six months the limit should be re-assessed. Monitoring function : ensuring that effective supervision is maintained on loans / advances and appropriate responses are initiated wherever early warning signals are noticed. monitoring on an ongoing basis the asset portfolio by tracking changes from time to time. chalking out strategies and initiate specific action to ensure high percentage of Standard Assets.

In case of Consortium / Multiple Banking Arrangements, Banks to obtain and exchange information with the consortium members / lenders at quarterly intervals. Operating Offices are also required to obtain information from the borrowers duly certified by a professional, preferably a Company Secretary. 6.2 Detailed operational guidelines on the following aspects for effective credit monitoring are in place : Post - sanction responsibilities of different functionaries. Reporting for control Security documents, Statement of stocks and book debts. Computation of drawing power (DP) on eligible current assets and maintenance of DP Register. Verification of assets including out sourcing of the activity. Inspection by branch functionaries frequency, reporting, register etc. Stock Audit. Follow up based on information systems Close monitoring during project implementation stage and production . Allocation of limit Monitoring of large withdrawals.
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post-commercial

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Detection and prevention of diversion of working capital finance. Conduct of Special Audit in cases of default / diversion of funds. Review and Management of Stressed Assets. Submission of irregularity reports wherever applicable.

6.3 To ensure end-use of funds certification from Chartered Accountants, inter-alia, may be obtained. In case of short term corporate / clean loans, such an approach would be supplemented by due diligence on the part of the Bank. It should be ensured that such loan are limited to borrowers whose integrity and reliability are above board. The Bank shall also endeavour to comply with the illustrative measures advised by RBI for monitoring and ensuring end-use of funds. Bank will also retain the right to carry out investigative audit conducted whenever it is prima-facie satisfied that there is a case for such investigative audit, to detect, siphoning/ diversion of funds or other malfeasance. 6.4 A system of loan review styled Credit Audit which inter-alia covers audit of credit sanction decisions at various levels has been implemented. Presently, all accounts with total indebtedness of Rs. 5 cr. and above for off-site accounts and Rs. 10 crores and above for on-site accounts are subjected to credit audit. The Credit Audit system serve as an effective control on the system of sanction of loans in the bank through appropriately delegated powers. ***** CREDIT RISK MANAGEMENT Background 7.1 Revised Credit Risk Management Policy approved by the Board is in place since December 2008. Our policy and procedures have since been aligned to Standardises Approach under Basle II from 1.4.08 and the Bank is gearing itself to adopt Foundation Internal Rating Based Approach. 7.2 Credit risk management encompasses identification, assessment, measurement, monitoring and control of the credit exposures. The procedure adopted by the Bank in this regard is detailed under : Risk Identification and Assessment 7.3 The Bank undertakes the following functions in the process of identifying and assessing the credit risk underlying a proposal : Developing and refining the credit risk assessment models used for taking
21

Credit Management

Commercial Banking and Retail Banking exposures. Conducting industry research, which is integral to assessing the risk associated with any loan proposal of corporate.

Credit Risk Assessment Process Commercial advances 7.4 The new CRA models for trading (applicable for Services & Trading activities) & Nontrading sectors (applicable for manufacturing activities) were implemented from November 2007, which would facilitate Banks transition from Standardised to Internal rating Based (IRB) approaches. Periodical review of CRA Models, based on developments in Risk assessment, Capital calculation methods etc. will be undertaken by Risk Management Department. 7.5 For each credit proposal, a credit rating is assigned using the internal credit rating system. The Bank as of now has a unified Credit Risk Assessment (CRA) System, which is used for assessing the credit risk of borrowers as well as facilities viz., working capital, term loan and non-fund based exposures etc., to commercial and institutional borrowers, SSI, SBF and agriculture segments for exposure of Rs. 25 lacs and above. The rating requires to be reviewed periodically and updated, atleast annually or as specified in the loan policy. However, borrowal accounts rated SB 10 and below would be rated at half-yearly intervals considering the risk severity of the loan. 7.6 The credit risk rating will be worked out by the respective branch or the Credit Processing Cell, as applicable, as soon as the audited balance sheet of the Company is received. The internal credit risk rating thus arrived at will be independently validated and approved by a separate Committee, set up for this purpose. This process of validation and approval is made prior to sanction / renewal / enhancement of the credit facilities and separated from the loan sanction process. This facilitates an independent and objective risk rating without being influenced by operational / budgetary considerations. Credit Risk Assessment (CRA) - Minimum scores / hurdle rates. 7.7 The CRA models adopted by the Bank take into account the various risks categorised broadly into financial, business, industrial and management risks. These risks are rated separately. The minimum score under various parameters and hurdle rate below which increasing or taking on fresh exposures are normally not permitted, are specified. Currently, no enhancements in credit limits or new connections are to be considered in respect of accounts rated below SB 10 (Old rating SB5/ SBTL5 as against earlier hurdle rating SB4/. SBTL4), subject to exceptions like availability of Central Govt. guarantees and / or availability of a Corporate guarantee of parent / group company which should have a CRA rating of SB9 and above (Old rating SB4/ SBTL4 as against earlier hurdle rating of SB3/SBTL3 and above). The actual models used, the minimum scores under each head, the hurdle rates, etc. are reviewed at regular intervals.
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Credit Risk Assessment Process - Non Banking Financial Companies (NBFCs) 7.8. Given the special features of NBFCs, as different from manufacturing units, a separate credit risk assessment model has been put in place fro assessing the risk of exposure taken against NBFCs. Credit Risk Assessment Process - Inter Bank Exposures. 7.9 As per RBI guidelines, Bank uses a separate rating model to assess the credit risk associated with lending to Banks. Such a rating model, called Bank Exposure Risk Index (BERI) model has been developed and is operational in the Bank. The Bank has set Permissible Global Exposure Limits (PGEL) for Banks. Credit Risk on Banks Associates & Subsidiaries is also assessed as per this model to maintain arms length relationship with them as directed by RBI. Credit Risk Assessment Process - Primary Dealers 7.10. The Bank uses a separate rating model to assess the credit risk associated with lending to primary dealers, Such a rating model, called institutional Risk Assessment Or IRA model has been developed and is operational in the Bank. Industry Exposure settings : 7.11 CRMD undertakes reviews of Industry / Sector Exposure Setting exercises for select industries at periodical intervals, which give specific policy prescriptions and contain quantitative parameters for handling portfolio in large / important industries. CRMD issues advisories on the general outlook in the near term for the industry from time to time. Credit Risk Measurement - Risk Components 7.12 Credit Risk measurement involves estimation of risk components such as probability of Default (PD), Exposure at Default (EAD), Loss Given Default (LGD), Expected Loss (EL) Unexpected Loss (UL) as described in the Basle II document. 7.13 As the Bank moves towards advanced approaches under the Basle II document for credit risk, it is necessary for the Bank to estimate the above risk components based on historical records of the Bank, construction of transition matrix, application of appropriate conversion factors for unutilized portion of the fund based exposures and non fund based exposures for providing capital, etc.

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Credit Risk Measurement - Portfolio Exposure 7.14 The objective of credit portfolio risk management including setting up prudential exposure limits is to achieve a well -diversified portfolio across dimensions such as companies, group companies, industries, collaterals, geopraphy, etc. Credit Risk Controls and reporting. 7.15 the objective of setting risk-based exposure limits in the portfolio is to optimize the credit portfolio composition, after taking into account return estimates and risk appetite defined by the Board. Credit Risk in Off-balance sheet Exposures 7.16 Credit Risk in non- fund based business of banks need to be assessed in a manner similar to the assessment of fund based business since it has the potential to become a funded liability in case the customer does not meet his commitments. Off- Balances Sheet exposures now include Derivative Exposures Viz., Foreign Exchange, Interest Rate & Gold Contracts, and Credit Risk on such exposures is assessed as per RBI instructions in this regard. 7.17 The Bank is required to make provisions for country risk exposures as per RBI guidelines. The data on country exposures are collected and monitored with respect to the country exposure limits on a periodical interval by the International Banking Group (IBG). Fixing of the country exposure limits and adherence to the same are reviewed and reported to the Board at quarterly intervals. Credit Risk Mitigation 7.18 CRMD has framed a Credit Risk Mitigation and Collateral Management policy based on the RBI guidelines which addresses (i) classification of credit risk mitigant, (ii) acceptable credit risk mitigant (iii) documentation and legal process requirements for credit risk mitigant, (iv) custody of collateral, (v) insurance, etc. Miscellaneous 7.19 Other aspects of Credit Risk Management such as pricing of loans, credit approval authority, documentation, credit monitoring, verification of end - use of funds, review and renewal of credit facilities, managing of problem loans, credit monitoring etc., have been discussed in great detail elsewhere in the Loan Policy document. *********

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REVIEW / RENEWAL OF ADVANCES 8.1 a. Working capital facilities are granted by the bank for a period of one year from the date of sanction.

b. Regular and ad hoc-credit limits need to be reviewed/ regularized not later than months from the due date/date of ad hoc sanction. In case if constraints such ass non-availability of financial statement and other data from the borrowers, the branch should furnish evidence to show that renewal/ review exercise is in progress. However, where the regular/ad hoc credit limits have not been reviewed/ renewed within 180 days from the due date/ date of ad hoc sanction, it will render the account as NPA.

c. In cases where term loans as well as working credit facilities have been sanctioned to a borrower, review of TL should form a part of the review/ renewal of working capital facilities. d. Stand alone TLs also need to be reviewed annually. 8.2 As regards granting of ad-hoc limits, it is considered only in exceptional circumstances and for genuine short-term credit requirements arising out of unforeseen contingencies faced by the borrowing company. Detailed operative guidelines in this regard are in place. 8.3 Term loans, which are irregular, are required to be reviewed once in six months. Such review of irregular Term Loans is to be included in the periodical review of Special Mention Accounts. 8.4. Authority structure for review of irregular term loans at half early intervals is given below. Present outstanding Above Rs. 150 cr. Above Rs. 50 cr & upto Rs. 150 cr Above Rs. 20 cr & upto Rs. 50 Cr. Above Rs. 5 cr. and upto Rs. 20 Cr Above Rs. 1 cr and upto Rs. 5 cr
Credit Management

Reviewing Authority CCCC WBCC-I WBCC-II CCC-I/ MCCC/ CAG Committee NWCC
25

Upto to Rs. 1 cr.

Controlling Authority

8.5 In the case of all listed companies with credit rating of SB8 and below, a brief review is to be put up on the basis of half-yearly working results published by them, duly incorporating comments such as extent of exposure, conduct of the account etc. Such review is to be submitted to the respective GE in respect of ECCB sanctions, to the CGM (Circle)/ CGM (CAG-Cen) /CGM(MCG)/CGM (SAMG) in respect of WBCC & CCCC sanction and to the GM (Network/ MC Region/ SAMG) in all other cases. 8.6 In respect of new term loans and existing term loans, if and when they are rescheduled, the following of financial covenants are to be stipulated :: (i) (ii) (iii) Current Ratio TOL/TNW Interest Coverage Ratio.

(iv) Default in payment of interest / installment (v) Cross Default (default in payment of installment/ interest to other institutions/ banks)

8.7. Default of these covenants would attract penal interest of 1% as under:a. Any adverse deviation by more than 20% from the stipulated levels in respect of any two of the items (i) to (iii) above - penal interest to be levied for the period of non-adherence subject to a minimum period of 1 year. Default in payment of interest / installments to the Bank or to other FI/banks penal interest to be levied for the period of such defaults. ****** TAKE OVER OF ADVANCES (A) Norms for take over of advances under SSI or C&I segments (including T&S Sector) will be as under : (i) (ii) The advance to be taken over should be rated SB7 or above. The unit should score the minimum score as prescribed, under the various risk segments, in the revised model for Credit Risk Assessment. The account should have been a standard asset in the books of the other bank / Fl during the preceding 3 years. However, if a unit does not have a track record for 3 years, if it has been in existence for a shorter duration, takeover can be considered
26

b.

(iii)

Credit Management

based on the track record for the available period, which should normally be for at least one year. Where a minimum history of at-least 1 year is not available and where for specific reasons it is still considered appropriate to take over, the authority structure provided for permitting deviations will be used. (iv) The unit should have earned net profits (post tax) in each of the immediately preceding 3 years. However, if the unit has been in existence for a lesser period, it should have earned net profit (post tax) in the preceding year of operation. (v) The Term Loan proposed to the taken-over should not have been rephased, generally, by the existing FI/ Bank after commencement of commercial production. However, if a rephasement was necessitated due to external factors and viability of the unit is not in doubt, such proposals may also be considered for sanction on a case - to case basiss.

(vi) When only TLs are taken over, the remaining period of scheduled repayment of the term loan should be atleast 2 years. For takeover of existing TLs, while the original time frame for repayment will be generally adhered to, flexibility may be allowed in the quantum of periodical repayments. If sanction of fresh term loan is proposed along with the takeover, the schedule of repayment for the existing term loans, if necessary, may be permitted to extend up to 8 years. However, in such cases the viability of aggregate outstanding of takeover ;plus fresh term loan should be established. Further, takeover of term loans solely for the purpose of accommodating cost over-run should not be encouraged. (vii) Take over of units from Associate Banks is not permitted. Term loans from State Financial Corporations may be taken over selectively. (viii) increasing our share in either a consortium or as Multiple Banking Arrangement of which we are already a part, or where we join a consortium either as an additional member or when another Bank exits, such sanctions are not considered as takeover of advances from another Bank. However, when we join a Multiple Banking Arrangement in order to replace an existing members such an arrangement either in whole or in part, all the norms relating to take- over of advances as detailed in this chapter will apply. (ix) Administrative Clearance (AC) : Prior administrative approval is required proposals as under to be obtained in cases of take over

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i)

For takeover of units complying with all the norms prescribed

Sanction by AC by Officials in the grade of Scale IV AGM of the Region /AGM/ DGM of and below branch in case of branches with divisions Officials in the grade of Scale V DGM (Branch) / DGM - Operations & Credit / DGM (Sales Hub - Region) DGM & above No AC is required. ii) For take over of units not complying with any one or more of the norms prescribed. Sanction by AC by CCC-II & below CCC-I SMECC & below MCCC CCC-I / MCCC/WBCC-I/ WBCC-II WBCC-I CCCC / ECCB CCCC (B) Norms for take over of advances under Agriculture segment In respect of Agriculture segment, all agricultural Term loans and agricultural cash credits with other Banks and Agricultural Credit Societies, Co-operatives are eligible for take over, subject to the fulfillment of the following terms and conditions of take over. i) The minimum amount eligible for takeover would be as under : a. ACC b. ATL for Allied Activities : Rs. 1.00 lakh : Rs. 10.00 lakhs

c. ATL for other than allied activities : Rs. 2.00 lakhs (iii) Only Standard Assets and regular accounts are eligible for take over. The account should have been a standard account in the books of the other banks / Financial Institution (FI) during the preceding 2 years. (iv) The term loans of incomplete nature are not eligible for take over. (v) (v) ATLs with a minimum 2 years repayment programme left are only eligible. Advances to borrowers falling outside the Service Area of the branch are also permitted for takeover, subject to adherence of the other instructions

(vi) Crop loans converted to Term Loans and Term Loans, which are rephased, are
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not eligible for takeover irrespective of their quantum. (vii) Takeover from our Associate Bank is not permitted. (viii) No ditution in the security in takeover proposals is permitted. (ix) The maximum amount eligible for takeover would be Rs. 50.00 lakhs. However, administrative clearance should be obtained from the Local Head Office in case, loans above Rs. 50.00 lakhs are required to be taken over. x) Wherever prescribed norms for takeover are met, no administrative clearance is needed for takeover. Otherwise administrative clearance should be obtained as under Sanction by AC by Official in the grade of Scale IV One step higher than the loan and below sanctioning authority. Scale V- AGM (including AGM of DGM - Operations & Credit. a Region) DGM (Branch) / Network Credit CCC-II Committee (NWCC) CCC-II/CCC-1 CCC-I WBCCI / II WBCC II CCCC/ ECCB CCCC Additional norms for take over of Loans above Rs. 25 lacs The advances to be taken over should be rated SB7 or above ( the unit should score at least 60% in the financial parameters). The unit should have earned net profits post tax in each of the immediately preceding 2 years. Take over of P segment advances in permitted for cherry picking of good Home Loan proposals. Take over of housing loans is considered selectively after due diligence and precautions, in cases where possession of the house / flat has been taken, repayment of existing loan has already commenced and installments have been paid as per terms of sanction. Houses / Flats under construction can also be considered for takeover after ensuring that there is no undue delay in construction / completion of the project. Takeover of Home Loans of govt. employees from the concerned State/ Central Govt. is also permitted after due diligence. Prepayment penalty for takeover from other banks/ FIs has also been permitted. Takeover of car loans is also considered selectively. *********
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xi)

(c)

DELEGATION OF POWERS 10.1 The two significant principle around which the scheme of delegation of financial powers revolve are : a) powers are exercisable only in relation to the duties and responsibilities specially entrusted to functionary, b) all sanctions are subject to report to the next higher authority. 10.2 The executive committee of the Central Board (ECCB) has full powers for sanctioning credit facilities. 10.3 The powers for sanctioning credit facilities by various authorities have been vested with them in terms of total indebtedness of the borrower. Computation of indebtedness will include Off Balance Sheet exposures arising from Derivatives and Forward Exchange contracts in addition to Fund-based exposures and Non Fund - based exposures (i.e., LCs, Guarantee, etc) as were included hitherto. 10.4 Higher discretionary power have been made available in the case of top rated borrowers (usually SB1 to SB5) and functionaries across the hierarchy are vested with such dual powers depending on the rating of the borrowers. .

MATURITY OF BANKS ADVANCES 11.3 (i) The maturity of any term loan, including moratorium, should not normally exceed 8 years except cases under CDR mechanism / rehabilitation packages approved by the Bank, infrastructure loans, Housing Term Loan (HTLs) to individuals, education loans and agricultural term loans under approved schemes. In case there are area specific schemes proposed by NABARD and formulated by the LHO, the Circle Credit Committee may decide to add such schemes also to the list of exempted category of agricultural term loans advised by Agri Business Unit from time to time. The tenor is to be considered from the day of first drawdown. 11.3 (ii) - In cases where maturity exceeds 8 years (except in case of exempted categories mentioned above), the loans should be administratively cleared by competent authorities as prescribed in chapter on Major & Minor Deviations in the Loan Policy.

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PRICING (FACTORS DECIDING INTEREST RATES AND OTHER CHARGES) 12.1 Pricing of loans / services in the Bank cover interest income and fee income. In keeping with RBI guidelines , w.e.f. 01.07.2010, the Bank has decided to quoate a single base rate (i.e.BR) which is the reference rate below which the Bank will not undertake any lending activity except the following permitted categories of Advances: DRI Advances Staff Advances Crop Loans upto Rs.3.00 lacs Export Credit for which subvention is available Laons against Banks Term Deposits Restructured Loans, if some of the WCTL, FITL etc. need to be granted below the Base Rate for the purpose of viability and there are recompense clauses. vii. Metal Gold Loan Scheme viii. Scheme of financing of off grid and decentralised solar (Photovoltaic and Thermal) applications as part of Jawaharlal Nehru National Rural Solar Mission (JNNSM) of the Ministry of New and Renewable Energy (MNRE) for which refinance is available. The list is subject to review by the RBI from time to time. Borrowal accounts with pricing linked to SBAR will be allowed to continue till next Review / Renewal / Reset / Maturity. 12.2 Pricing of Banks funds and services while being basically market driven, is also determined by two important considerations, i.e., minimum desired profitability and risk inherent in the transaction. 12.3 The Base Rate will be reviewed by the Asset Liability Management Committee (ALCO) of the Bank with a periodicity of at least once in a quarter. The spread over Base Rate will be fixed taking into account factors like allocable expenses, credit risk premium and tenor premium where applicable. Tenor premium will be applicable for all loans with tenor above three years. Interest Rates for loans extended to individuals for consumer durables or other purposes will be determined by Personal Banking Business Unit (PBBU) and are based on market conditions. 12.4 The Bank can price loans at fixed or floating rate basis linked to the Base Rate. However, the effective rate to be charged should be equal to or above the Base Rate at the time of sanction / renewal. Bank may also price floating rate products by using market rate
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i. ii. iii. iv. v. vi.

in a transparent manner. The floating interest rate based on such external rate should however be equal to or greater than the Banks Base Rate at the time of sanction/ renewal. 12.5 Bank has put in place a policy for reset of interest rates of term loans extended both on floating and fixed interest rate basis, to factor in changes in the interest rate scenario. The periodicity of reset is currently two years ( in few cases reset period is one year) and renegotiation of interest rate is based on well-defined triggers.

12. 6 The Bank has also adopted an appropriate authority structure to facilitate competitive pricing of loan products. The authority concerned while exercising the discretion takes into consideration the risk rating of the loan asset, the trends in movement of interest rates, market competition and overall business considerations. Various credit committees / sanctioning authorities / DMD and GE / CGM0Circles / CGM-Bus and other officials have been vested with powers for approving competitive pricing within the respective areas of operation. The quantum of delegation depends on factors such as degree of competition, market developments, target groups, purpose etc. Authority structure for reporting of exercise of discretion vested with various authorities has also been put in place. The policy on competitive pricing is reviewed from time to time based on changes in market conditions. *********** NPA MANAGEMENT 13.1 The Banks NPA Management Policy seeks to lay down the Policy on management and recovery of NPA and proactive initiatives to contain Gross NPAs. 13.2 The Policy lays stress on a system of early identification and reporting of all existing and potential problem loans as a first step towards management of NPAs. Such an Early Alert System which captures early warning signals, is an integral part of the Banks Risk Management process and is followed by time bound corrective actions comprising rehabilitation / restructuring or an early exit. 13.3 In line with the RBI guidelines on preventing slippage of NPA accounts, Bank has introduced a new asset category between standard and sub-standard, i.e. Special Mention Accounts (SMAs) for internal monitoring and follow - up in line with international practice. 13. 4 The first focus in management of SMAs will be possible up gradation of the loan asset through re-pheasant, restructuring or rehabilitation of borrowerss business. If the branch level review indicates that the problems of the unit are not temporary, viability
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studies need to be undertaken on a case-to-case basis. Viability of the unit and the promoters interest (and stake) are the basic prerequisites for the Bank to undertake restructuring / rehabilitation. However, right of recompense will be incorporated in every rehabilitation proposal. Given the pressures of globalisation, industry outlook needs to be given adequate attention. 13.5 (a) The Bank has also put in place a mechanism for outsourcing of recovery efforts, to supplement the efforts of the Banks staff. Since the role of Resolution Agents & Enforcement Agents overlapped, two channels for outsourcing of recovery are merged. 13.5 (b) The detailed guidelines for appointment of Recovery Agents / Agencies and monitoring of their conduct included : (i) (ii) Model Code conduct to be adopted by RAs. Declaration -cum- undertaking to be obtained from RAs.

(iii) Model Policy & Operating Guidelines for Repossession of Security. (iv) Application Form for appointment of RAs. (v) Grievances Redressal Mechanism.

13.6 Rephasement of term loans, including as part of rehabilitation / restructuring exercise, where considered on more than two occasions during the currency of the term loan will require prior administrative clearances as under : Sanctioning Authority Below NWCC*/ SMECC Administrative Approval by One Step higher than the Sanctioning Authority CCC-I / MCCC CCC-I Not required

NWCC/ SMECC CCC-II Others

* NWCC - Network Credit committee However, restructuring done under Corporate debt restructuring mechanism, Debt. restructuring mechanism for SMEs, Borrowers affected by natural calamities, which are already covered by separate set of guidelines issued by RBI, would be excluded from the purview of the above requirement. 13.7. a. The Bank has laid down a policy on approach to sacrifices in case of transfer of financial assets to Securistisation Companies and Reconstruction
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Companies (SCs / RCs) as each asset is unique in the context of circumstances necessitating consideration of transfer to SC / RC as a recovery option. b. The Bank has also laid down a policy in accordance with the RBI guidelines, for sale of NPAs to Banks / FIs / NBFCs other than SCs / RCs. c. Policy for purchase of Non-performing Assets (NPAs) from other banks under consortium/ multiple banking has been put in place to facilitate timely restructuring / rehabilitation in high value and potentially viable accounts. d. The Bank has also laid down policy for sale of Non Performing Retail Assets of the SME sector to ARCs, Banks, FIs and NBFCs on portfolio basis. 13.8 Viable units and where promoters show genuine interest in reviving the unit will continue to be supported. In other cases, especially where promoters are not cooperating, options to exit or reducing exposure will be actively explored, where feasible. Where despite our best efforts in this regard, it is not possible to exit an account or at - least to reduce our exposure, a reassessment of the situation will be done and if necessary Bank will consider either an acceptable OTS or in its absence, even consider recalling the account. Bank will examine the various options and initiate measures as appropriate in a time- bound manner, as delays in such situations far from helping matters are likely to lead to erosion of security and increase far from helping matters are likely to lead to erosion of security and increase in the ultimate quantum of the NPA. 13.9 Settlements through compromises (i.e. one time settlement of dues) will be a negotiated settlement under which Bank endeavors to recover its dues to the maximum extent possible. Detailed guidelines for compromise settlements are part of the NPA Management Policy. Separate Board approved guidelines are available for compromises with State Govt. / Central Govt. guaranteed accounts. Compromise settlements are permitted where cases are pending before courts /DRTs/ BIFR subject to consent decree obtained from the concerned court / DRT/ BIFR. 13.10 If settlement of dues through compromise is being negotiated with one unit of a Group banking with us, it shall be the endeavour to minimise the sacrifices by seeking support from the parent company / other Group companies. Ordinarily, no fresh finance will be considered either to the existing unit or to any new unit being promoted by the same promoters / guarantors. However, exceptions may be made in respect of settlements under various One Time Settlement Schemes of RBI and similar Schemes of the Bank (e.g. SBI OTS), for which separate guidelines are in place. The Bank may also extend fresh finance / enhancement / renewal of credit limits to a unit where the Bank has entered into a compromise with the unit/another unit of the same promoter/ guarantor, under Board approved guidelines. Such proposals will require prior administrative approval by CCC-I
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MCCC for sanction by authorities below CCC-I/ MCCC. Pursuant to the directives of Govt of India, the provision for re-lending to farmers who have settled their dues under compromise / SBI OTS / RBI OTs/ write off is also in place 13.12 The Bank has laid down a policy on approach to sacrifices in case of transfer of financial assets to Securitisation Companies / Reconstruction Companies (SCs/ RCs) as each assets is unique in the context of circumstances necessitating consideration of transfer to SC / RC as a recovery option. The Bank has also laid down a policy in accordance with the RBI guidelines, for sale of NPAs to Banks / Fls / NBFCs other than SCs / RCs. 13.13 The Bank recognises that transfer of financial assets to third party entities such as SCs/ RCs, would in most cases, be at a substantial discount to the book value of the asset / ledger balance. The Banks endeavour would be to optimise recovery while taking into account not only the ledger balance but also other aspects such a costs associated with continuing the account in our books including cost of maintaining assets, loss on account of deterioration in the quality of securities charged, opportunity loss due to non redeployment of locked funds more profitably etc. 13.14 Granting of loans to our borrower/ non - borrowers to settle OTS entered into with other banks / Fls is generally not permitted. However, loans for such purposes may be granted by ECCB on a highly selective basis, with the prior administrative clearances of the CCCC. 13.15 The Bank would follow a policy of write off, including partial write offs, subject to review from time to time on the basis of experience gained. Written off accounts are to be parked in Advances Under Collection Account (AUCA) in accordance with laid down instructions. The structured mechanism prescribed for follow-up of accounts parked in AUCA will be followed meticulously. All internal reviews on NPAs will also include accounts transferred to AUCA. 13.16. Accounts sanctioned / disbursed and where repayment has been initiated during the financial year and slipped into NPA category within first two years of sanction / repayment fall in the category of quick mortality loans. Such loans will be monitored / reviewed. Appropriate steps to be initiated to bring them back to standard asset category. ** *

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CREDIT FACILITIES TO COMPANIES WHOSE DIRECTORS ARE IN THE DEFAULTERS LIST OF RBI 14.1 The Directors of any company may be classified as promoter / elected / professional / nominee / honorary directors. RBI has been collecting and circulating information on defaulting companies amongst banks / Fls, including names of directors of such companies. Where sanction / continuation of credit facilities to such companies whose directors are in the RBIs defaulters list needs to be done, the following approach is to be followed:

Director of applicant company if a. Promoter Director of a defaulting company Director of a defaulting company having a role in the day-to-day affairs of its management.

Approach No adhoc / enhancement / additional / new credit facilities to be sanctioned to the applicant company till the names are removed from the defaults list by RBI. In case the performance and conduct of the accounts of the applicant company are otherwise satisfactory, renewal / continuation of the limit at the existing levels may be considered. No adhoc / enhancement / additional / new credit facilities to be sanctioned to the applicant company till the names are removed from the defaulters list by RBI. In case the performance and conduct of accounts of the applicant company are otherwise satisfactory, renewal / continuation of the limit at the existing levels may be considered.

b.

c.

Promoter Director of a defaulting company or director of a defaulting company having a role in day-today affairs of its management, but who resigned from the Board of defaulting company, to circumvent any obstacle in getting credit.

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d.

Director in a defaulting company, Proposal relating to the applicant company but not connected in any way with to be considered on merits. If the defaulting its day-to-day management. company is an associate / subsidiary of the applicant company of a group company, approach mentioned in a & b above may be followed. Nominee / professional / honorary director of a defaulting company, (including associate / group / subsidiary company). Proposal relating to the applicant company to be considered on usual parameters as these directors are in their professional / honorary capacity.

e.

f.

Promoter / nominee / professional The above approach as applicable may be / honorary director as in a to d followed in such cases also, if information is above, but whose names are yet available. to be included in RBIs defaulters list (as the list is published by RBI only once in six months)

The above policy on defaulters will be a broad framework for sanction / continuation of credit facilities to companies whose directors are in the RBIs list of defaulting borrowers of banks / Fls with dues of Rs. 1 Cr. and above. When the list of such defaulters is circulated by CIBIL ( instead of RBI), the same Policy would continue to apply. 14.2 Wilful default & action there against - Bank will fully comply with RBI guidelines on willful defaulters and action thereagainst in terms RBIs definitions of willful default, diversion & siphoning of funds and end-use of funds. These instructions apply without any exception to all loan accounts where the outstandings are Rs. 25 lacs or more. The identification of willful default in the Bank will be done by the Committee prescribed for this purpose. The identified borrower will be given an opportunity to make a representation before a Grievance Redressal Committee. At the end of this process, the name of the borrower will be included in the list of willful defaulters to be advised to RBI, where a decision has been taken to that effect. 14.3 Where a Letter of Comfort or guarantee furnished by the companies within a Group in favour of a willfully defaulting unit is not paid when invoked by the Bank, such Group companies also may be considered as willful defaulters. 14.4 Where possible, Bank shall adopt a proactive approach for a change of management of the willfully defaulting borrowing unit.

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14.5 Where Fls have significant stake and where the Fls take effective steps for removal from the Board of a borrowing unit, a person identified as willful defaulter, the Bank shall also proactively support such steps. 14.6 No additional facilities shall be granted by the Bank to the listed willful defaulters. Further, entrepreneurs / promoters of companies where the Bank has identified siphoning / diversion of funds, misrepresentation, falsification of accounts and fraudulent transactions shall be debarred from Bank finance for floating new ventures for a period of 5 years from the date the name of the wilful defaulter is published by RBI/CIBIL. 14.7 The Bank may also initiate criminal action willful defaulters, based on the facts and circumstances of each case after careful consideration and due caution. 14.9 The Bank has also put in place a policy regarding extending finance to the willful defaulters, in compliance with the guidelines issued by RBI from time to time. Detailed operative guidelines in this regard are in place as under. Wilful defaulter unit as applicant. No fresh limit / enhancement may be sanctioned. However, an authority not below CCCC may approve renewal / continuation of earlier sanctioned limits.

Applicant company whose director is Fresh limits and renewal/ listed as director of a willful defaulter enhancement of limits may be company. considered. Proposals otherwise within the powers of CCC-II / SMECC and below to be sanctioned by CCC-I / MCCC. For others, it will be the sanctioning authority.

14.10 The Bank has put in place a procedure for deletion of the names of the borrowers from the list of willful defaulters through the mechanism of reference to the Committee constituted, for this purpose, at Circles/MCG/CAG. ****

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MAJOR & MINOR DEVIATIONS 15.1 Deviations from the Banks Loan Policy have been classified as major and minor based on Criticality of the norms from asset quality angle General compliance levels Need for flexibility 15.2 Proposals involving major deviations from the Banks laid down policies are required to be sanctioned by a higher authority, as given below. Norms Deviations to be approved by Fund based exposure to a particular ECCB industry not to exceed 15% of total fund based exposure. Non-fund based exposures at the ECCB whole-bank level not to exceed 2 times the fund based exposure. Maturity of terms loans, including Maturity of terms loans, including moratorium, generally not to exceed 8 moratorium, generally not to exceed 8 years. years Authority structure for permitting deviations is as under. Sanction by Deviations to be approved by Below NWCC NWCC NWCC/DGM Sanctioning Authority Headed Credit Committees. CCC II & above Sanctioning Authority If maturity exceeds 10 years, the deviation may be permitted only by CCCI/MCCC for sanctions by authorities below CCC-I/MCCC. In other cases, the sanctioning authority will approve the tenor as part of the proposal (After due diligence). General Exposure norms - individuals - Rs. 25 Cr. - Non - corporate - Rs. 100 cr. ECCB

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 CRA linked minimum Scores i. Financial Risk (FR)* ii. Business & Industry risk (B&IR) Business Risks (BR) for trade] ** iii. Management risk Note : * Earlier termed as General ** Earlier termed as Business Risk

Sanction by

Deviations to be approved by i. Financial Risk : Below CCCII/ CCC-II / MCCC MCCC CCCII/MCCC Sanctioning & above Authority (The above authority structure would apply to cases where deviations do not exceed 10% below the minimum prescribed score in case of Financial Risk. In case they exceed 10%, such deviations my be approved by CCC-I/ MCC in respect of sanctions by CCC-II & below. For sanctions by CCCI/MCCC & above, sanctioning authority may approve) ii. Management / Business & Industry Risk. Deviation from the minimum prescribed score will be permitted by CCCC only Hurdle rates - New connections and enhancements Sanctions by Deviations to be approved by CCC- II CCC-I / MCCC & below CCC-I / MCCC Sanctioning & above Authority As per new rating model, SB-10 is the hurdle rete for new enhancement. Though not normally envisaged, deviations may be permitted up to SB 10 and may be approved by an authority prescribed above. In respect of borrowers rated SB 11 and below, no deviation is to the considered for new connections

Hurdle rates - New connections and enhancement

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 Credit facilities to companies whose Sanctions by directors are in the defaulters list of RBI Below CCC-I/ MCCC CCC-I/MCCC & above

Deviations to be approved by CCC-I / MCCC

Sanctioning authority

Credit facilities to units in the willful No deviations from RBI Guidelines defaulters list of RBI Credit facilities to companies whose No deviations from RBI Guidelines directors are in the willful defaulter list of RBI Leasing exposure norms Sanctions by Deviations to be approved by Below CCCC CCCC CCCC/ECCB Sanctioning Authority 15.3 Deviations not specifically mentioned above are considered as minor. Such minor deviations may continue to be permitted selectively by the sanctioning authority except where a separate structure has been specifically laid down involving approval thereof by some other authority. 15.4 Further, in respect of specific products / schemes, deviations, other than major deviations, in general norms such as eligibility criteria, quantum of finance, tenor of the loan, etc., albeit within the provisions of loan policy guidelines are required to be permitted, at times for business or strategic consideration. In the absence of an in built authority structure for permitting such deviations, for sanctions by CCC-I / MCG / CAG Committee and below, approval of the CGM (Circle / MCG/CAG) is necessary . No such approval is required for sanctions by Corporate Centre. In case the deviation is sought on stand - alone basis, in respect of sanctions by WBCC/CCCC, the GE concerned will give necessary approval. In respect of sanctions by ECCB, approval will be accorded by CCCC. 15. 5 In respect of deviation in risks, i.e. financial, management, business etc. the deviation permitted in any one of the risks may be compensated by strengths (higher scores) in other areas. ****
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ADVANCES TO LARGE CORPORATES 16.1 The financial environment has changed rapidly since 1991, with liberalisation in the areas of trade, industry, services and exchange control, deregulation of interest rates, removal of entry barriers for new banks, widening and deepening of financial markets, entry of mutual funds, Fls, Flls and insurance companies. Further, significant changes have come about in the way, Corporates conceptualise business models and operating processes, to improve efficiency of their inventory / receivables management procedures resulting in reduced dependence on Bank borrowings. 16.2 The traditional role of CAG has undergone a metamorphosis from being a major provider of corporate credit to that of a provider of sophisticated products and solutions to seamlessly handle financial transactions. In line with this change, CAG, apart from continuing to other the traditional corporate credit products, focusses on development of new products to match the requirements of corporates from time to time. 16.3 With the interest margins on funded exposures of top corporates coming under pressure, the fee-based transactions provide the much needed alternative. Hence, concerted efforts and continuous exploration of emerging opportunities are made to increase income in fee-based business covering the areas of Trade Finance, Forex, and Risk Management products like derivatives etc. To capture the fee-based business, it is also considered essential to continue the credit exposures - especially the short term exposures - at very competitive rates. It is necessary to retain the relationship by leveraging it to capture the funds flow of the corporates and the related business opportunities, which feed the various business groups. 16.4 The advanced technology developed by Cash Management Products and corporate Internet Banking Departments are utilised to address the needs of the entire value chain such as handling payments and collections, products such as salary payments, vendor & other counter-party payments, dealer collection, vendor and dealer finance, Multi-City Cheques, Dividend & Interest Warrants business. 16.5 Discretionary Power Structure for permitting competitive pricing of products and services has been laid down to enable the operating functionaries to quickly respond to the corporates needs after taking into consideration the credit risk rating of the borrower as well as the market competion. 16.6 As the terms and conditions governing the advance may differ from customer to customer depending upon its requirements, Banks policy permits customer specific documentation specially drafted by the legal experts and duly vetted by the Banks legal cells (in corporate centre/CAG/LHO). *****
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ADVANCES TO MID-CORPORATES 17.1 Financing mid-corporates is a thrust area for the Bank. Mid-corporates comprise all business enterprises (both corporate and non-corporate) with annual trunover between Rs.50 crores or enjoying aggregate working capital limits (FB and NFB) of Rs.10 crores or more or Term Loan of Rs.10 crores or more. It straddles primarily the SIB and C&I market segments. These businesses exhibit fast rate of growth both in size and in numbers at specific centres /clusters across the country. To tap the potential, involvement of our Bank with such borrower entities through branches across the country need to be fostered and developed in a focussed manner. 17.2 Accordingly, Mid-Corporate Group (MCG) was set up with the following objectives: Providing exclusive focused attention on the banking requirements of the MidCorporates. Selling vigorously the various products to these units through Relationship Management Model. Improving turnaround time for credit delivery and ensuring consistency in credit appraisal / quality. Achieving the ultimate goal of increasing our income and market share in this segment. Improvement in service levels for Mid- Corporates. 17.3 Given the competition for Mid-Corporate business in metro and urban centers, the Bank has put in place a business model that addressed their special features, which is also periodically reviewed based on changing market conditions. The model incorporates well-defined Sales Hubs and Credit Committees positioned in this structure. Further, the model strives to increase credit off-take by cementing relationships and by focussing more on sales through the marketing teams at the Sales Hub and the Relationship Managers. It also endeavours to prevent any fall in credit quality through quality processing and meaningful monitoring by utilising the expertise built up internally and available externally. 17.4 As a strategic initiative, the Mid-Corporate Group identify select emerging industries that are likely to grow further in the near term. Such industries are given a sharper focus to enable it to scale up its exposure and garner a greater share of the bankable business. Depending upon the market size, opportunities and potential available in various geographical areas, the desired direction in lending to these identified industries at the several Sales Hub level are also spelt out. 17.5 The Mid-Corporate Group need to use the organizational synergy for developing relationship with Mid-Corporates so that all their bankable business accrues to the bank by drawing on the resources of its Relationship Managers and the product specialists of other BUs. **********

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Advances to MSME
18. MSME stands for Micro, Small & Medium Enterprises. This sector is globally accepted as an engine for economic growth. World over, MSME sector is focussed for economic acceleration, employments generation and poverty alleviation. MSME segment plays an important role in the Indian Economy in terms of their contributions to industrial production, trade and services, exports, employment creation and creation of entrepreneurial base. The Central and State Governments, RBI and various commercial banks, NGOs, consultants and other services providers etc., are evolving and implementing new schemes for promotion and development of MSME sector. MSME Act,2006 enacted by the Government of India in June 2006, lays down the definition of MSME for industrial and service enterprises as under: Business enterprises Classification Original Investment in plant and machinery Industrial Enterprises Micro Small Upto Rs 25 lacs >Rs 25 lacs & Upto Rs 5 Crores Medium > Rs 5 Crores & Upto Rs 10 Crores Original Investment in Equipment Services Enterprises Upto Rs 10.00 lacs > Rs 10 Lacs & Upto Rs 2 Crores > Rs 2 Crores & Upto Rs 5 Crores

ADVANCES TO SERVICES SECTOR 19.1 As the Indian economy gets integrated with the global economic order, the share of the services sector in the GDP and its contribution to future growth is outpacing that of the industrial and primary sectors. Already, the services sector accounts for a little more than 50% of the GDP. The pattern of development of this sector has been in line with that of other developed countries of the world and it is possible that by the end of this decade, this sector may constitute the most significant sub-segment of the countrys economy. 19.2 As per the World Trade Organisation (WTO), services can be divided into 12 different sectors: (a) Communication (b) Business Services, including Professional and Computer (c) Educational (d) Environmental
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(e) Health (f) Financial Services like Insurance and Banking (g) Tourism and Travel (h) Recreational and Cultural (i) Transport (j) Constructional and Engineering (k) Personal, Community and Social (l) Miscellaneous and others The inclusion of the last item is a recognition on the part of the WTO indication that the list cannot be exhaustive and new categories of services would emerge with the pace of economic growth and modernisation. 19.3 All the above service segments offer significant potential for Bank finance. Bank has been innovating new marketing and product strategies so as to realise the potential offered by this sector. Recognising the special nature of the asset and liability profile, output etc. of such units, guidelines on lending to various activities of services sector are in place. Liberalised norms in respect of credit appraisal standards, collateral security, rigour of assessment are permitted. The generally indicative norms, subject to suitable modifications for specific sub-segments within the services sector, are: (i) The current ratio and TOL/TNW ratio (as per audited balance sheet not older than 12 months) should be as per the indicative levels as given under: Current ratio not below 1 is acceptable for units with FBWC limit of upto Rs.5 Cr. Depending upon the activity, for units with FBWC limits of above Rs.5 Cr., a current ratio lower than 1.33 and upto 1.20 may be considered acceptable.

TOL/TNW ratio higher than the generally accepted ceiling of 3 and upto 5 would be permissible depending on the type of activity. (ii) The unit should have earned profits (post tax) in each of the immediate preceding 3 years. However, if the unit has been in existence for a lesser period, it should have earned net profit (post tax) in the preceding year of operation in which it has been in existence. 19.4 Detailed administrative instructions regarding lending to services sector are in place and are reviewed from time to time. Specific authority structures for deviations, where considered appropriate, from these indicative levels for select financial parameters indicated above have also been laid down. *********
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ADVANCES TO RURAL SECTOR

20.1 The Bank has been a pioneer in agricultural banking in the country. With large number of branches in rural and semi-urban areas, SBI has been the undisputed leader in disbursal of agricultural credit, The Agricultural Development Branches (ADBs) and Agricultural Banking Divisions {ABDs) specialise in agricultural finance. 20.2 However, with changing demography and lifestyles in rural India, a strong need for providing comprehensive financial services encompassing savings, credit, remittance, insurance and pension products to the rural populace, has been felt by the Bank. Accordingly, to drive and enlarge the Bank's business in rural and semi-urban areas, a new business group, viz. Rural Business Group has been set up. This new business group comprises two SBUs, viz. the Agriculture Business Unit and the Rural Non-Farm Business Unit. Among other things, the credit requirements for not only the farming activity but also for those relating to agro based industrial activity, trade and services and for personal consumptions of the target group are addressed by the group. Agriculture 20.3 Separate strategic business unit viz. Agriculture Business Unit (ABU), was created during 2004 to drive agriculture business across the Bank with the following objectives: Providing focused attention to the banking requirements of the segment. Achieving 18 % benchmark (lending target) set by RBI. Focussing on micro finance institutions and SHG opportunities. Focussing on key corporate and institutional relationships in emerging opportunities and special initiatives in agri related areas. Focussing on product development and marketing. Reduction of NPA levels in Agriculture. Making agri finance a commercial proposition than a directed lending.

20.4 The credit policy and procedures for agricultural segment are by and large determined by RBI and NABARD and the State Level Bankers' Committee (SLBC). The policies and procedures substantially differ from those of other segments. Lending to this sector is characterised by the twin features of Service Area Approach (SAA) and scale of finance' 20.5. SAA is now applicable only to Govt. sponsored schemes. The Bank will leverage on this relaxation for new lending and also go for takeover of quality assets from other banks. The Bank has put in place separate guidelines for takeover of Agriculture Advances. 20.6. District Level Technical committee (DLTC) works out the scale of Finance (SoF) for various crops grown locally. Such scale of finance is uniformly adopted by all commercial banks. However, in order to extend the need based finance and to fix realistic scales of finance for different areas, depending on the level of technology adopted by the farmers, DGM (Rural Business) at LHO or DGM-Operations & Credit (where DGM is not posted as Rural Business Head) are empowered to approve SoF upto double the limit fixed by DLTC for various crops. 20.7. The Banks branches support agriculturists involved in a wide range of agricultural activities such as crop production, horticulture, plantation crops, floriculture, farm mechanisation, land development and reclamation, digging of wells, tube wells and irrigation projects, forestry, Credit Management
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construction of cold storages, storage godowns and processing of agricultural Products' The Bank also supports allied Agri activities such as dairy, fisheries, livestock, rearing of silk worms, poultry, piggery etc. 20.8. Waiver of collateral security in Agricultural segments is generally permitted upto Rs. 50,000/though scheme specific ceilings have been prescribed. The ceiling of Rs. 50,000/- has been revised to Rs. 1 lac for Crop Loans (ACC / KCC) sanctioned to farmers having legal ownership of agricultural land with good repayment track record for last 2 years. 20.9 Bank has recognized that setting up of high value / hi-tech agricultural projects have been engaging the attention of entrepreneurs and projects covering agro/food-processing, biotechnology etc. are now being set up in the country. With a view to respond eminently to these emerging opportunities, the Bank extends support in a planned way to these unfolding avenues. Further, bank has also identified following thrust areas for short-term business opportunities with low incidence of NPAs: Kisan Credit Cards (KCCs) Seed Growers and Processors Warehouse Receipts Gold Loans Pulses, Oilseeds & Spices

At agricultural intensive centres Bank has set up Agricultural Commercial Branches to capture high value Agri Business. These branches will focus on agri and agri related SME business which will be part of Agri Priority Sector lending. Primarily areas will include agricultural lending through corporate partnership, commodity financing, investment credit and other high value credit areas such as horticulture, floriculfure and food processing. 20.10 Marketing and Recovery teams are placed across important centres of the country to assist the branches in development of business and in recovery bf bad loans. Bank's role under Lead Bank Scheme 20.11 The Bank has lead bank responsibility in 168 districts spread across the country. The annual credit plans for these districts are prepared and launched at the beginning of a financial year. The progress of various State sponsored poverty alleviation / employment generation schemes is reviewed in DCC / DLRC meetings. In addition, the Bank has convenorship responsibility to hold State Level Bankers committee meetings in 12 States (Arunachal Pradesh, Assam, Bihar, Chattisgarh, Delhi, Goa, Manipur, Meghalaya, Mizoram, Nagaland, Sikkim and Uttaranchal) and 2 Union Territories (Andaman & Nicobar lslands and Daman & Diu). These meetings are extensively used to resolve the issues relating to the flow of credit to various sectors of the economy in the State(s) / UT(s). Employment Generation Programmes of GOI 20.12. Swarnajayanti Gram Swarozgar Yojana (SGSY), Swarna Jayanti Shahari Rozgar Yojana (SJSRY), Scheme for Rehabilitation of Manual Scavengers (SRMS) and Prime Ministers Employment Generation Programme (PMEGP) are the four important poverty alleviation and employment generation programmes launched by GOl. Of these Schemes, SGSY is operative Credit Management 47

exclusively in the rural areas for the rural poor, SJSRY is for the urban poor and SRMS & PMEGP schemes cover both urban and rural centres. The Bank is enthusiastically implementing all the Schemes. Micro Credit 20.13 Of late, provision of micro credit is acting as a catalyst for inclusive development primarily focussing on uplifting the poor and for the benefit of the low income people in the society. The term micro credit refers to the provision of thrift, credit and other financial services and products of very small amount to the poor in rural, semi-urban and urban areas for enabling them to raise their income levels and improve their living standards. Bank has been supporting many NGOs who are active in the formation and development of volunteer groups known as Self Help Groups' (SHGs). The bank is committed to timely and adequate credit to SHGs in order to ensure upliftment of the poor. Further, to increase its outreach to a large number of low-income people, Bank is also financing MFls/NGOs including NBFCs engaged in microfinance activities, for on-lending to SHGs/JLGs and Individuals. Financial Inclusion 20.14 Despite expansion of branch network by commercial banks in rural, semi-urban and urban areas and their concerted efforts to reach out to the people, large sections of the population still remain outside the coverage of the formal banking system. Therefore, the Bank has been channelising its focus and effort towards provision of affordable financial services to those who are excluded from the formal financial system. Bank, to realise this objective, is leveraging alternate delivery channels such as engaging Business Facilitators / Correspondents and through wider application of technology. 20.15 All outsourcing activities including appointment of Business Facilitators and Business Correspondents; Management & Collection Agents are being done in strict compliance with RBI's instructions and approved policy of the Bank approved by its Board

************* ADVANCES TO PERSONAL SEGMENT 21.1 PBBU asset products encompass product lines like (i) Home Loans (ii) Auto Loans (iii) Education Loans (iv) Personal Loans . The first three product lines are for acquisition /financing of a specific product. The fourth product line is general purpose or nor-specific, including loans like flood loans. Similarly Education Loans, Reverse Mortgage Loan, Loan against Pension etc. address the credit needs of different age groups of the population. However, the Bank does not give loans for speculative purposes. The Bank aims at being No.1 player in Retail Loan market by adopting the following strategies: Launching innovative and customer friendly products with value added features to improve our product profile and to suit the specific requirements of various target clientele.

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Ongoing review and modification of existing Schemes Periodic updation of instructions, scheme-wise, to improve awareness about the products at the branches Thrust on marketing High Value and Big Ticket Loans Special focus to establish tie-up with Central/ State Governments, reputed corporations and other important institutions for granting P- segment Loans to their employees Entering into tie-ups with various reputed builders, auto manufactures, auto dealers, etc. Schemes targeted at specific customer groups with concessional interest rates, processing fee and margin. Special delivery platforms like Personal Banking Branches, Specialized Housing Finance Branches, Home Loan Sales Team (HLST), Multi Product Sales Team (MPST) for aggressive marketing. centralized Processing Centres (RACPCs / RASECs) set up for quick processing and sanction of loan. Adequate discretionary powers with various functionaries for sanction as also for improvement in pricing to reduce the Turn Around Time. Effective media strategy to give wide publicity about the various products. Strengthening of business sourcing capabilities through development of new business sourcing channels, individuals and institutional marketing consultants, marketing associates, loan counsellors on fee payment basis. Leverage cross-marketing channels through CAG, MCG, SME and RB Group. 21.4 P-segment Loans have several distinct features vis-a-vis loans to other business segments as below: (i) Eligibility criteria applicable to borrowers under various P- segment Loan schemes vary from each other depending upon the nature of the loans and their purpose. Purpose of Loan: Varies from Scheme to Scheme. e.g. Housing and Car Loans etc. are meant for asset acquisition whereas Personal Loans are generally availed for consumption. Education loans are extended for pursuing studies in India and abroad. The Education Loan scheme has been formulated as per IBA/ RBI guidelines. Housing Loans schemes would aim at facilitating achievement of objectives spelt out in the National Housing and Habitat Policy of Govt. of India. Appraisal/ Assessment: Assessment is done primarily on the basis of repayment capacity of the borrower, the current verifiable income of the borrower (except in

(ii)

(iii)

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respect of Education Loans) and availability of required margin (except in respect of Personal Loans) etc. iv) Financial power are vested with various authorities for different schemes. Further, LHOs have been authorized to vest the discretionary powers, scheme-wise, for branches upto Scale IV incumbency, subject to overall guidelines issued by the Corporate Centre. Disbursing branches : Sanction and disbursal of loan under certain schemes is restricted to specialised/ identified branches. LHOs have been vested with the powers to identify suitable branches over and above those specified by the Corporate Centre. Nature of facility. The loans are made available by way of Overdraft, Demand Loan or Term Loan (medium of long term). These could be clean or secured, depending upon the scheme. Pricing : The loans are made available either on floating rate of fixed interest rate based on the customers option in this regard. A combination of fixed on floating interest rates is also offered. In respect of floating rate loans the Interest rate is linked to Base Rate. The spread above the Base Rate may vary depending upon scheme, tenure, amount and also market conditions. Discretionary powers are vested with various Circle functionaries to quote improvement in pricing on a selective basis having regard to tie-ups with corporates / builders, high Value/ big ticket loans, market compulsions, etc. Discretionary power are also vested with Circle functionaries to permit relaxations in margin and processing fee on Home Loans.

v)

vi)

vii)

viii) Fixed Interest Rates : Loans are granted on fixed interest rate basis upto certain ceilings only i.e. Housing Loans upto Rs. 1 Crore. Further, Housing Loans on fixed interest rate basis are granted subject to a force-majeure clause authorising the Bank to change the rates suitably and prospectively in case of any major volatility in interest rates. Housing loans on fixed interest rates are also subject to interest rate reset clause in terms of which fixed interest rates may be reset at the end of every two years on the basis of the ten prevailing interest rate scenario. ix) Maturity of Advances : While the maturity of term loans should not normally exceed 8 years, in respect of Housing Loans, the repayment period is now permitted upto 25 years. In respect of Educational Loans, the Loan is normally repayable in 5 to 8 years after commencement of repayment. As the repayment would commence after a moratorium period, which generally covers course period plus 6 months or 1 years after getting employment, whichever is earlier, the tenure of Education Loans may
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also extend beyond 8 years. Further extension of tenure can be permitted upto a maximum of 5 years if interest rates on the existing loans go up and the EMIs are left unaltered. x) Repayment: Repayment in P-segment Loans are generally on the basis of Equated Monthly Installments (EMIs) , which consist of principal and interest components. (a) The Bank may use repayment option through stepped-up/ stepped-down monthly installments, balloon repayments etc., in sync with anticipated income of the borrower during the loan tenor. (b) In case of Reverse Mortgage loan scheme, repayment of loan is not insisted upon during the lifetime of the borrower. The loan is recovered through sale of mortgage property if legal heirs do not come forward to repay the loan. (iii) Rephasement of instalment(s)/ interest is permitted in genuine cases of borrowers inability to adhere to repayment schedule. Prepayment: Prepayment is freely permitted in all schemes without penalty except in Housing and Car Loans. Prepayment penalty @ 2% of the outstanding loan amount will be levied in respect of Housing Loans and Car loans, if these loans are pre-closed within 3 years from start of repayment. Even within this specified period of 3 years, if the account is closed from out of the borrowers own resources, for which proof is made available to the Bank, pre-closure penalty is waived.) Addition: In car loans pre-payment fee of 2 % of the amount of loan is levied if before expiry of half the agreed repayment period or partial payment is made in the first year. However no pre-payment fee is levied if the loan is foreclosed for availing a fresh loan from the Bank. Security : Obtention of Security depends on the particular scheme and the purpose of the loan.

xi)

xi)

xiii) Take -over : Take -over of P-Segment Loans is permitted in respect of Housing Loans and Car Loans. xiv) Asset Quality : Bank will take appropriate initiatives within the scope of regulatory guidelines for keeping asset quality at acceptable levels. xvi) Outsourcing : Some of the processes viz., New Channels for loan collection and recovery and Processes like income verification etc., may be outsourced (KYC compliance would not be outsourced as it is a core banking function). xvi) Priority Sector Classification : As per RBI instructions from time to time xvii) Asset valuation / Revaluation: as per extant instructions

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EXPORT CREDIT 22.1 Export sector has been recognised as a thrust area considering its importance and contribution of this sector to the economy. Therefore, the sector is being presently extended finance at concessional rates, with flexibility in financing norms. 22.2 Export finance is by a large regulated through the directive / guidelines issued by the Reserve Bank of India (RBI), Director General of Foreign Trade (DGFT) and the Foreign Exchange Dealers Association of India (FEDAI). Export finance is broadly classified into two categories : (i) (ii) Pre-shipment finance and Post-shipment finance

22.3 Pre-shipment finance often referred to as Export Packing Credit (EPC) is extended as working capital for purchase of raw materials, processing, packing, transportation and warehousing of goods meant for export. Both manufacturers as well as merchant exporters are eligible to avail Rupee Packing Credit at concessional rate of interest. Pre-shipment credit is available in foreign currency also. It has two essential features, viz.,. existence of an export order and / or letter of credit and liquidation of the credit by submission of export documents within a stipulated period. In case of exporters of proven standing, the facility can also be extended on a running account basis provided the conduct of the account is satisfactory and orders are lodged subsequently within a reasonable time. Substitution of contracts / export orders are also permitted in case of running accounts. EPC can also be provided to units established in SEZ / EPZ/ AEPZ/ EOUs for supply to units in the same or another SEZ / EPZ/ AEPZ/ EOU although no movement of merchandise takes place across the borders of the country. 22.4 There is no fixed formula for determining the quantum of finance to be granted to an exporter against specific order / LCs. The guiding principle to the applied in all such cases is a concept of need-based finance. The period for which the Bank gives packing credit depends upon the manufacturing / trade cycle or specific requirements of the individual export, normally not exceeding 180 days. The percentage of margin is determined depending on the nature of order, commodity, capability of exporter, etc. keeping in view the spirit behind RBI guidelines for liberal finance to export sector. 22.5 Since packing credit loans are concessional and purpose oriented, it will be necessary to ensure proper end use of amounts disbursed to the exporters. 22.6. Post- shipment finance can be extended upto 100% of the invoice value of goods. It can be short term or long term finance depending upon the payment terms offered by
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Indian exporters to overseas buyers. The maximum period usually allowed for realisation of export proceeds is 180 days from the date of shipment, with certain exceptions. Postshipment finance is also available both in rupees and specified foreign currencies. Very often export business takes place without support of documentary Letters of Credit and the Bank normally extends finance to the exporters by purchasing the bills drawn by them of foreign buyers or granting advance against bills sent on collection basis. While purchasing the bill, the Bank takes into consideration the track record of the exporter, country risk, nature of merchandise, terms of payment, payment record of the drawee, etc. Advances against Duty Drawback receivable are also granted under Post-shipment Finance. 22.7 RBI has been traditionally pursuing a policy to make available export credit at reasonably low interest rate with a view to helping the exporters to be competitive vis-a-vis their competitors. RBI have rationalised the interest rates on export credit which are indicated by RBI, periodically, in their Monetary & Credit Policy as ceiling rate in respect of all categories of export credit so that interest rates charged by the banks can actually be lower than the prescribed rate. Such ceiling rates will be linked to PLRs of respective banks as applicable to other domestic borrowers. 22.8 As far as deferred exports are concerned, RBI has allowed banks to charge their normal term lending rate based on the credit rating of the borrower. In this connection, deferred exports are those where the realisation period exceeds 180 days, with certain exceptions. All deferred exports are subject or regulatory guidelines contained in Project Export Manual (PEM) published by RBI. 22.9 The Export Credit Guarantee Corporation of India Ltd. (ECGC) provides support to both exporters and financing banks through export credit insurance. The related guarantee / policies issue by ECGC cover individual Packing Credit Guarantee (IPCGO) cover from ECGC for pre-shipment credits on a case-to-case by authorities empowered by the Bank for the same. As regards post - shipment credit, Bank may stipulate Individual postshipment Guarantee (IPSG) on a case-to-case basis depending on the risk perception. ******

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1(b) FAIR LENDING PRACTICES CODE (FLPC)

1. FAIR LENDING PRACTICES CODE (FLPC for short) is a voluntary code adopted by our Bank, which aims to achieve synchronization of best practices while dealing with customers in India. The Bank declares and undertakes To provide in a professional manner, efficient, courteous, diligent and speedy services in the matter of retail lending. Not to discriminate on the basis of religion, caste, sex, descent or any of them. To be fair and honest in advertisement and marketing of Loan Products. To provide customers with accurate and timely disclosure of terms, costs, rights and liabilities as regards loan transactions. If sought, to provide such assistance or advice to customers in contracting loans. To attempt in good faith to resolve any disputes or differences with customers by setting up complaint redressal cells within the organization. To comply with all the regulatory requirements in good faith. To spread general awareness about potential risks in contracting loans and encourage customers to take independent financial advice and not act only on representations from banks.

2.

3. 3.1.

FAIR PRACTICES: Product Information: a) On exercise of his choice on the product offered, the customer would be given the relevant information about the loan product of choice. c) The Customer would be explained the processes involved till sanction and disbursement of loan and would be informed of timeframe within which all the processes will be completed ordinarily at our bank. d) The Customer would be informed of the names and phone numbers of branches and the persons whom he can contact for the purpose of loan to suit his needs. e) The Customer would be informed the procedure involved in servicing and closure of the loan taken. 3.2. Interest Rates 3.2.1. Interest Rates for different loan products would be made available through and in anyone or all of the following media, namely: a) In the Bank's Web site b) Over phone, if Tele Banking services are provided c) Through prominent display in the branches and at other delivery points d) Through other media from time to time 3.2.2 Customers would be entitled to receive periodic updates on the interest rates applicable to their accounts. 3.2.3 On demand, Customers can have full details of method of application of interest.

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3.3

Revision in Interest Rates: a) The Bank would notify immediately or as soon as possible any revision in the existing interest rates and make them available to the customers in the media listed in Para 3.2.1. b) Interest Rate revisions to the existing customers would be intimated within 7 working days from the date of change through notifications in the Banks Website / media/ notice board at branches. Default Interest/Penal Interest: The Bank would notify clearly about the default interest/penal interest rates to the prospective customers. Charges: a) The Bank would notify details of all charges payable by the customers in relation to their loan account. b) The Bank would make available for the benefit of prospective customers all the details relating to charges generally in respect of their retail products in the media specified in Para 3.2.1. c) Any revision in charges would be notified in advance and would also be made available in the media as listed in Para 3.2.1. Terms and Conditions for Lending: a) The Bank would ordinarily give an acknowledgement of receipt of loan request and if demanded by the customer, a copy of the application form duly acknowledged would also be given, as soon as the customer chooses to buy a product of or service of his choice. b) Immediately after the decision to sanction the loan, the Bank would show draft of the documents that the customer is required to execute and would explain, if demanded by the customer, the relevant terms and conditions for sanction and disbursement of loan. c) Loan Application forms, Draft documents or such other papers to be signed by a customer shall comprehensively contain all the terms and conditions relating to the product or service of his choice. d) e) Reasons for rejection of loan applications would be conveyed to small borrowers seeking loans up to Rs. 2 lacs. Before disbursement of loan and on immediate execution of the loan documents, the Bank shall deliver a copy of the documents to the customers.

3.4.

3.5.

3.6.

3.7.

Accounting Practices: a) The Bank would provide regular statement of accounts, unless not found necessary by the customers. b) The Bank would notify relevant due dates for application of agreed interest, penal interest, default interest, and charges if they are not mentioned in the Loan applications, documents or correspondence.
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c)

The Bank would notify in advance any change in accounting practices which would affect the customer before implementation

3.8.

Information Secrecy a) All personal information of the customer would be confidential and would not be disclosed to any third party unless agreed to by customer. The term 'Third party' excludes all Law enforcement agencies, Credit Information Bureaux, Reserve Bank of India, other banks/ financial and lending institutions. b) Subject to above, customer information would be revealed only under the following circumstances; > If our Bank is compelled by law > If it is in the Public Interest to reveal the information > If the interest of the Bank require disclosure. Financial Distress: a) The Bank would sympathetically reckon cases of customer's financial distress. b) Customers would be encouraged to inform about their financial distress as soon as possible. c) The Bank would adequately train the operational staff to give patient hearing to the Customers in financial distress and would try to render such help as may be possible in their view.

3.9.

3.10. Grievance Redressal a) The Bank would have a Grievance Redressal Cell/ Department/ Centre within the organization. (Generally the Controlling Authority of the Branch would be the Redressal Officer)

b)

c)

The Bank would make available all details, namely; o Where a complaint can be made o How a complaint should be made o When to expect a reply o Whom to approach for redressal of grievance etc., to the customers individually on demand and through the media listed in Para 3.2.1. Response to a complaint whether positive or negative or requiring more time for redressal would generally be given within a maximum period of four weeks from the date of receipt of complaint, unless the nature of complaint is such that requires verification of voluminous facts and figures

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2. FINANCIAL STATEMENT ANALYSIS

1. 1.1 INTRODUCTION It is a generally accepted dictum among the bankers and other credit institutions that Analysis of Financial Statement constitutes the back-bone of good lending. It follows that the parameters taken for this analysis must satisfy the criteria for good lending. What, then is good lending and how does one judge this? Basically, the funds used by a banker for his loaning operations are provided by depositors and consequently the interests of the latter should be the major factor to determine the criteria for good lending. The depositor or for that matter any investor looks primarily to two aspects, while taking an investment decision (i) Yield and (ii) Safety of funds. A secondary but none the less relevant aspect would be liquidity or the ease with which the deposit could be encashed in times of need. Based on these, the principles of good lending can be stated to be as follows i) ii) iii) iv) Yield Safety of Funds Liquidity and Purpose

1.2

Purpose has been added to the above criteria because the general purpose and content of a bankers loan portfolio would go a long way in ensuring depositors confidence, although the latter does not as such stipulate any conditions regarding purpose of loans at the time the deposit is made. Analysis of Financial Statements must, therefore, seek out answers for the above questions before a lending decision is made. The scope of Financial Statement Analysis boils down to finding answers to two questions basically i) ii) How is the liquidity of the enterprise to be measured? What financial and other criteria are to be used to judge the safety of loans?

These two issues are elaborated in the subsequent paragraphs.0 1.3 Analysis of Financial Statements is therefore important to the banker for two reasons : (a) to decide on whether or not to extend the advance; and (b) If the advance is to be extended, what the quantum of advance should be. To assess the working capital limits required, financial statement analysis is used in the Projected Balance Sheet method in large value advances, i.e. above Rs 25 lacs for industrial units in C&I segment and above Rs 5 cr in the SSI segment. Also, even where Projected Balance Sheet method is not used for assessing the credit requirements (as in the case of Nayak Committee method for SSI units ), analysis of financial statement is still necessary to determine the safety of advance. The Credit Risk Assessment(CRA) process requires an analysis of financial statements of the unit and calculation of various ratios, before scoring under the Banks CRA rating can be attempted. Even where CRA rating is not necessary - as in the case of loan products like SME Credit Card and SME Smart Score - weightage is still given for financial ratios representing liquidity and gearing such as the Current Ratio, Total Outside Liability to Tangible Networth Ratio which in turn

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requires a basic understanding of analysis of financial statements. Granting an advance for less than Rs 10 lacs using SME Credit Card requires the use of a simple balance sheet. 2. 2.1 Definition of Financial Statement: Every business enterprise needs money constantly for its operations and such money is provided by the owners themselves, the gap, if any, being bridged by outsiders, viz., creditors. These funds are constantly in movement, involved in various financial transactions, thus continuously altering their form and content. A periodical assurance about their safety is, therefore, required by both the owners and the creditors. Further, if the enterprise happens to be limited company-the owners are the shareholders who do not exercise any direct control over the day-to-day affairs or administration of the Company, this being entrusted to the Board of Directors or the Management team. The management is, therefore, bound by law as well as contractual obligations to use such funds in accordance with the mandate of the purveyors of funds and produce evidence of having done so at periodical intervals. Financial Accounting is the manner of recording all financial transactions so as to enable extraction of the evidence mentioned above. Financial Accounting is the art of recording, classifying and summarizing, in a significant manner and in terms of money, transactions and events, which are, in part at least, of a financial character and interpreting the results thereof. Financial Accounting, therefore produces a significant summary of all recorded financial operations for the purpose of interpreting the end-result of such operations. Such a summary is called the Financial Statements, which comprise the Balance Sheet and the Profit and Loss Statement. American Institute of Public Accounts describes Financial Statements as under: Financial Statements are prepared for the purpose of presenting a periodical review or report on the progress by the Management. They deal with the status of investment in the business as also with the results achieved during the period. They reflect a combination of recorded facts, accounting conventions and personal judgments. And, the judgments and conventions applied affect them materially. The soundness of judgment necessarily depends upon the competence and integrity of those who make them and on their adherence to generally accepted accounting principles and conventions. 2.4 This definition is very appropriate as it succinctly but nonetheless effectively brings out the characteristic features of Financial Statements, their strengths and weaknesses and their reliability and limitations. This understanding is very important to us since the reliability or authenticity of the Analysis of the Financial Statements would, it will be appreciated, be just as much as that of the Financial Statements themselves. This definition indicates the following characteristic features of the Financial Statements: I) ii) iii) They are periodical review of the status of investment and progress made by the Management They contain facts recorded on the basis of accounting conventions and exercise of personal judgments. Integrity and competence of accountants who prepare them have a vital bearing on the ultimate results furnished by them.

2.2

2.3

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2.5

A major weakness of Financial Statements is its lack of objectivity, being influenced largely by subjective exercise of judgments. For instance, in the hands of unscrupulous management with fraudulent intentions, manipulations are possible, which could distort, to a large extent, the ultimate results, thus camouflaging the real picture. Nevertheless, if the accountant compiles the statements diligently and without personal bias and on the basis of established and generally accepted accounting conventions, the Financial Statements do reflect the financial conditions of the limited companies to examine, among others, the accounting practices, and procedures and comment on whether the Financial Statements give a true and fair view of the state of affairs and the net result. The Auditors Report is, therefore, an independent professional guarantee for compliance with the generally accepted accounting principles and to that extent, takes care of lack of objectivity, and an intelligent scrutiny of the Annual Report is bound to bring out Auditors reservations, if any, on this subject. To ensure the genuineness of the financial statements and that of the signatures of the chartered accountants therein, in case of large borrowers, viz. borrowers whose fund based limits are Rs.1 cr and above, a confirmation is to be obtained by sending a letter by Post/ e-mail regarding certification of financial statements from the Chartered Accountant who has signed the balance sheet / financial statements of the borrowers and this confirmation will be kept with the files of correspondence pertaining to the borrower.

3. 3.1

Criteria for Analysis As mentioned earlier, the outsiders or creditors who provide funds to the enterprise, do so on certain conditions to be fulfilled by the latter, the most important being the payment of interest and repayment of principal in time. Liquidity, therefore, connotes the availability of cash resources with the enterprise to liquidate such dues to the creditors and other pressing liabilities. The analysis of the Financial Statements should be such as to indicate or forecast the above performance capabilities on the part of the enterprise. Safety of funds lent was, till recently, considered to be synonymous with security by way of physical or tangible assets. But the events occurring not only in India but elsewhere have conclusively proved that the banker can no longer look to encashment of the assets through sale for liquidation of his dues and such repayment can be expected only from out of the surpluses generated by the enterprise in its operations. It will, therefore, be noted that viability of the enterprises is the primary and real security for the lender. Like the proverbial blind men trying to describe an elephant, viability is such a general term, lending itself to many different interpretations according to the perceptions and even predilections of the persons. For the purpose of this discussion, it can broadly be stated that viability connotes the ability of the enterprise basically to produce a product and market it at a profit or carry on an activity with a profit which is sufficient to meet the following charges or claims against it. i) ii) Service and repay the external indebtedness incurred for setting up the factory as well as carrying on its operations. Service the paid-up share capital at a reasonable rate or yield, considered good on market comparisons.

3.2

3.3

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iii)

Leave a surplus, adequate to meet its own growth needs.

Accomplishment of the above objectives is the broad or the ultimate goal of the enterprise but it involves a lot many management policies and decision-factors as under: i) Selection of the sources of funds or in other words the distribution of the requirements of funds between share-holders and creditors in such a manner as to (a) satisfy the various purveyors of funds on their expectation of return on their investment (b) satisfy the norms on the desirable mix between owned funds and borrowed funds. The funds provided, by the share-holders/creditors must be judiciously used to create certain assets. Judicious use of funds denotes a careful evaluation of various options available to it before an investment decision is taken. The assets so created ought to generate a net surplus, through their use, which is the highest or optimum return on investment after meeting all expenses and charges.

ii)

iii)

3.4

In order to understand these issues better, let us look at a typical Balance Sheet of a manufacturing enterprise. The monies it needs for initially setting up its factory and later on carrying on its operations in the factory and the sources providing such funds can be illustrated as under

Sources of Funds (Liabilities) Share-holders Funds (Paid-up capital and Reserves) (1) Term Liabilities(Debentures Term Loan etc.) (2) Bank Loans and other short-term creditors (3)

Uses of Funds (Assets) Factory assets (Land, Building, Plant and Machinery etc.) (4) Investments, Other loans loans and advances (5) Operating assets (Cash, inventory accounts receivables etc.) (6)

The aggregate requirement of funds (4+5+6) is met from the total sources (1+2+3). The relative proportion of the funds deployed in various assets depends on the Managements discretion. For instance, how much to invest in the factory assets would be governed by (i) capacity to be installed, (ii) whether to acquire own land and building or acquire it on lease, (iii) whether to install all the machineries or decide to outsource some components from subcontractors, (iv) whether to construct a housing colony for employees or not. Employment of funds in operating results would be determined, inter alia, by level of activity proposed while use of funds in trade investments or in giving out loans and

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advances to others would depend upon surplus cash available after use in the factory and operating assets. 3.5 Basically, an enterprise looks to the ultimate return on investment concept while deciding about deployment of funds in various assets; ,of course it is also true that availability of funds and the conditions attached to such availability would also be other determining factors in this exercise of discretion by the Management. While deciding upon the several sources of funds, the Management, takes into consideration factors like i) ii) iii) iv) v) vi) 3.7 Promoters capacity to bring in contribution) capital (otherwise known as promoters

3.6

Availability of capital resource in the country & state of capital market for a public issue. Repaying capacity of the enterprise. Norms on Debt Equity gearing stipulated by Term Lenders. Nature of the project and Life of the project.

In summary, it may be stated that the Analysis of Financial Statements indicates three broad decision factors, viz., I) ii) iii) checking the investment (or deployment) of funds decision of the enterprise, verifying the financing (funding) pattern proposed/in use by the enterprise and examining its operating efficiency.

BALANCE SHEET - ANALYSIS & INTERPRETATION 4. 4.1 What is a Balance Sheet? Balance Sheet, as the name indicates, is a statement of balances, depicting the state of affairs or position of a business enterprise. Since it is an aggregation of balances, it pertains obviously to a particular date. As on the date of reckoning, it discloses to the user of the statement of the investment of funds made by the enterprise on various classes or categories of assets and the various sources from which funds have been drawn to enable such investment. It would be useful to visualise a Balance Sheet essentially in terms of the resources of an enterprise and claims held against such resources provided to it. Clearly every person or organisation providing funds to the enterprise (either directly as investors and lenders or indirectly by providing credit or deferring payments due to them) will have claims against the assets or resources of the enterprise and will expect such claims to be met at appropriate times, inevitably there is a cost attached to claims, which needs to be reimbursed to all outsiders either in a Iumpsum at the time of repayment of the principal amount of the claim or in installments at the option of the providers of funds. Thus, it behoves of the manager of the enterprise to conduct the affairs of the business in such a way that the following objectives are met

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i) ii)

the funds provided to the manager by the owners/shareholders and lenders/other creditors are judiciously invested to create certain assets, the assets so created should be capable, through their operation and use by the manager, of yielding the highest return in terms of the net income after meeting all expenses and charges incurred in earning that income. the net income so earned should be adequate to service the cost of funds, viz, interest on loans and dividend on capital, in addition to redemption of the capital funds (principal) where stipulated, and to leave a surplus for future growth. the surplus funds should be so invested as to enable their prompt and ready encashment to meet maturing claims against the enterprise.

iii)

iv) 4.2

The Balance Sheet of an enterprise is basically analysed to test the above hypotheses and can, therefore, be deemed to reflect the financial condition of the enterprise. It was for this reason that some of the U.S. accountants and business organisations refer to Balance Sheet as A Statement of Financial Condition. While this is so, the Balance Sheet has certain limitations and cannot be treated as the sole indicator of financial position of a unit. Format of Balance Sheet: The Balance Sheet can be presented either in a T form or in a vertical order, beginning with assets. While the Companies Act, 1956, prescribes the form in which the Balance Sheet has to be presented by the limited liability corporations, there is no such standard form for non-corporate organisations. Schedule VI Companies Act, 1956 contains the format in which limited companies should present the Balance Sheet to the shareholders. The format has been devised by the framers of the Act, keeping essentially the interests of the shareholders in view, though there are provisions in the Act to protect the interests of all classes of persons or organisations who transact business with the Company. The grouping of the various assets and liabilities in Schedule VI follows the familiar dictum that assets and liabilities should be detailed in their order of permanence. For instance, assets start from fixed assets-the near permanent assets - and go down to current assets, loans and advances which are regarded as being closest to cash in terms of their convertibility to cash within a short period. Similarly, the liabilities start with share capital - the near permanent source of funds to an enterprise - and travel through long term loans down to current liabilities and provisions, the last-mentioned items requiring layout of funds by the enterprises at short notice. In accountants parlance, current assets, could, therefore, be converted into cash within a period of 12 months and current liabilities are those liabilities that mature for payment within 12 months. Thus advances to staff and group companies for instance can be a current asset, if they satisfy the test of conversion to cash within one year. Assets Assets can be described as economic sources, owned by an enterprise, whose cost at the time of their acquisition can be objectively measured. Thus, any item to be called an

5.0 5.1

5.2

5.3

5.4

6.0 6.1

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asset should satisfy three attributes, viz., (i) capacity to generate an economic benefit; (ii) ownership and (iii) measurement of cost. Thus, skilled labour and managerial personnel, though a very powerful asset, doubtless, is not regarded as such by the accountant for the Balance Sheet purposes, since they do not satisfy the third criterion of measurement of acquisition cost.. However, concept of ownership for the accountant is not the legal ownership but connotes eligibility of the enterprise to possess it and derive an economic benefit there from thus, materials and machinery, although not paid for, either in cash or otherwise, will become assets, nevertheless. 6.2 Fixed Assets

6.2.1 Fixed Assets are those assets which are operated by the enterprise to produce certain goods for sale at a profit. This would mean that fixed assets are something of a permanent nature, acquired by an enterprise to help generation of a certain productive activity and not held by it for the purpose of resale. Thus they are often referred to as productive assets. Obviously, the various components of a factory, when initially set up, would constitute fixed assets. They are land, building, plant and machinery furniture and fittings, transport vehicles etc. 6.2.2. As an analyst examining the Balance Sheet, one should look into the intrinsic worth of the assets rather than their rupee value. Thus, our examination should cover the qualitative aspects of these assets. For instance, land and buildings should be examined from the angle of their adequacy for current needs and scope for future expansion. Plant and machinery needs to be looked at from the points of view of (i) the nature of machinery, whether special purpose or standard, (ii) their productivity or machine efficiency, (iii) their age and future useful life and (iv) the policy of the enterprise for their modernisation and/or replacement. One cardinal principle is that since investment in fixed asset is irrevocable and represents money sunk irretrievably, the enterprise should evaluate all alternatives viz., leasing or hiring or sub-contracting, before deciding upon acquiring any fixed asset. The same concern which he displays while considering a request for a term loan viz., Is the administrative block necessary? should guide the analysts examination of all fixed assets. 6.2.3 One important feature of fixed assets accounting is depreciation. Many persons entertain wrong notions about depreciation. i) ii) II) Does it provide funds for replacement? Does the depreciated block denote its current worth? What, then, is depreciation?

Depreciation is nothing but a deferred amortisation of the cost of fixed assets on a notional wear and tear of the asset. Every asset has a limited time span of usefulness and every time it is operated there is a usage of its life. Therefore, to the extent of such usage, a reduction in value should be accounted. Two methods of depreciation are in use in India. i) ii) Straight line method Written Down Value method :
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Under the first method, a fixed amount is written off every year while under the second method, depreciation is provided at a fixed percentage of the outstanding net block each year. Suppose that under both methods, the asset is required to be depreciated upto 95% of its original cost and the time taken to reach this point under either method is the same based on the useful life of the machinery. Such being the case, it will be appreciated that the aggregate depreciation provisions, being restricted to 95% of original cost, cannot provide funds for replacement, under inflationary conditions nor does the depreciated value of the asset have any correlation with its current market value. Depreciation thus, is a non cash charge on the profit, being yearwise allocation of expenditure on fixed assets already incurred at the time of acquisition of such fixed assets. 6.3 Investments:

6.3.1 A company, not being an investment company, takes an investment decision in the following circumstances i) To promote a subsidiary or other company either for the purpose of creating an outlet for sale of its products or for manufacture of materials required by it for its own production. Such investments are called trade investments, i.e., those made to promote its own business. To acquire substantially or otherwise shares of another company, with a view to exercise control over the latter. To invest purely as a yielding proposition, idle cash for which it has no other productive use.

ii) iii)

6.3.2 Since all such investments excepting, perhaps, item (iii) result in contraction of resources available for productive use to carry on the activity for which the company was set up, the analyst will do well to verify that such investments would not curtail the level of productive activities. Thus the banker should examine the genuine need for investments and ask the question, Is the investment necessary? 6.4 Current Assets, loans and advances:

6.4.1 As per the Companies Act, the above category of assets would comprise the following items: I) ii) iii) iv) v) vi) Interest accrued on investments; Spares and spare-parts; Loose-tools; Stock-in-trade; Work-in-progress; Sundry Debtors; (a) Outstanding for a period exceeding 6 months; (b) Other debts

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Less: Provision for bad debts. vii) viii) Cash and bank balances. a) Loans and advances to subsidiaries; b) Loans and advances to partnership firms where the company or any of its directors is a partner. ix) x) xi) Bills of Exchange Advances recoverable in cash or kind or for value to be received. Balance with customs, port trusts, etc.

6.4.2 As stated earlier, while for the purpose of other users of Balance Sheet, all the above assets may be called current assets, the restrictive connotation adopted by the bankers in India for current assets makes use of the concept known as operating cycle or cash cycle. Operating cycle is simply the cyclical process of use of cash to purchase materials, their subsequent processing into finished products and sale and realisation of sale proceeds in cash. The time taken for this cycle to complete depends on various factors, some controllable and many uncontrollable in Indian conditions, and varies from industry to industry, why, even from unit to unit, within the same industry, say engineering or textiles. Thus, our definition of a current asset is that any asset that gets converted into cash within the operating cycle and forms an integral part of the cycle will be a current asset. The definition stems from our anxiety that short term bank finance should be utilised only for meeting working capital needs and not diverted for acquiring other assets or frittered away in outlays, not related to the business of the unit. Thus investments in group companies and advances to group companies will not qualify for a current asset. Similarly, deposits made with public utility bodies like Electricity Board etc., which are non-returnable during the pendancy of service of the utility to the enterprise and other advances to staff, officers etc., would not be regarded as current assets. Again the bankers look askance at any unduly large advances to employees, unrelated to the companys operations or objects. 6.4.3 Cash / bank balance (credit) cannot co-exist in any large bulk with bank borrowings. Further, any unduly large amount of cash and current account credit balance held by any enterprise would mean, unless there are good reasons for it, that its cash managements is poor as it is sacrificing opportunities for expansion of its trade, for idle cash is a dead investment. Thus, it should be at the irreducible minimum, just adequate to meet its dayto-day needs. 6.4.4 Receivables: 6.4.4.1 Receivables represent claims against customers to receive cash at a certain point of time in future. For our analysis, only claims arising out of sale of products manufactured/ traded or rendering of services by the enterprise would be classified as current assets. Receivables arising out of any other transaction will not be current assets. For instance, dues on account of sale of fixed assets will not be a current asset. Further, credit sales to its own staff or officers or group companies do not generally come under current assets unless the analyst can be certain that the terms of credit would be on par with sales to general public or that the enterprise would not show some indulgence in collection of debt.
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6.4.4.2 Invariably, a break-up of the receivables customer-wise would be useful. An examination of the customer-profile would disclose undue favours, if any, shown to any particular customer: in particular, whether the enterprise siphons away funds to group companies under some pretext or other or through what is known as benami transactions. Similarly an ageing analysis of debts would indicate whether the debts are current or overdue, considered in conjunction with terms of credit offered. This might mean one of two things, viz., either tardy and lax debt collection or inability of customers (retailers) to push the products due to stiff competition or inferior quality. 6.4.4.3 A useful test for examining receivables would be Receivables X 365 Annual Credit Sales This denotes the number of days for which credit sales are outstanding. For the numerator one could take either the year-end receivables or monthly average, if available. In any case, it is a reflection of the enterprises credit policy or experience in recovery of receivables, in relation to market terms: a higher ratio being generally indicative of unsatisfactory conditions unless there are genuine reasons for it, on account of customer mix - i.e., more sales to Government parties who may take longer time to pay for their purchases. Although receivables are nearer to cash than inventory and hence more liquid, they entail more risk to the financing banker especially if customers are restricted to very few numbers. 6.4.5. Non Current Assets: Following items are examples of non current assets: i) ii) iii) iv) Deferred Receivables (maturity exceeding one year) Security Deposits (kept with Electricity Boards, Telephone Dept, others..) Advances to group companies as also to capital equipment suppliers. Investments in subsidiaries/group companies.

It will bear repetition that lock-up of monies in non-current assets restricts their availability for productive operations and hence this locking up of funds has to be at the minimum level, consistent with corporate needs and policy. 6.5 Intangible Assets These include intangible assets like goodwill, patent, trade mark, franchise, etc., as well as expenditure like preliminary and pre-operative expenses (to the extent not written off), etc. In certain cases, even the accumulated losses, will appear under this head. The total of intangible assets should be subtracted from the enterprises net worth, to arrive at its Tangible Net Worth. 7. 7.1 Liabilities: The liabilities are the sources from which funds were drawn by the enterprise to acquire the various assets. Thus, liabilities represent claims against the enterprise, requiring

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payment at a point in future by converting the assets into cash. The three sources from which funds are drawn are i) ii) iii) 7.2 Proprietor or owners or share-holders who contribute the risk capital. The lenders-banks and others who grant the debt capital; and The outsiders (creditors) who defer payments due to them for materials delivered or services rendered to the enterprise.

Share-holders Contribution

7.2.1 The funds contributed by the share-holders constitute the capital of the enterprise. It denotes the stake of the owners in the enterprise and serves as the basis or leverage to negotiate loan funds from the lender. For a corporate unit, its Memorandum fixes the ceiling upto which capital can be raised, which is called the authorised capital. The memorandum also stipulates the class, number and face value of shares that can be issued. The capital structure is as under: i) Authorised Capital Divided into ....................................................................... equity and ........................................................................... preference shares of Rs. .................................................................. (face value). ............................. shares..................................... equity and .preference.......... issued for subscription either by prospectus or otherwise. ............................... shares..................................... equity and preference....................... subscribed to by the public and others

ii) Issued Capital

iii) Subscribed Capital

iv) Paid-up-capital:

............................. shares..................................... equity and preference..................... paid-up (fully or partly).

For the enterprise, the last-mentioned item represents the funds made available through share capital, while the others indicate cushion for further raising of capital in future. 7.2.2 It will be well-worth noting that raising of capital is time-consuming and calls for knowledge, on the part of the management, of the environment, the Govt. policies, investment climate in the country, other capital issues on the anvil etc. It does not happen that all issues are subscribed in full and in some cases, a portion devolves on the underwriters. Any capital issue to be successful would generally require the following conditions to be satisfied. i) Basically, the industrial unit should belong to a growth-oriented industry, preferably free of undue government controls or to a core sector, enjoying Govt. patronage.

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ii) iii) iv) v) vi) 7.3

The promoters or the management should have a good track record of having successfully managed other companies. The gestation period should not be unduly long. The timing of the issue should be such that it does not clash with other betterknown issues The investment climate should be conducive and there should not be discouraging threats. Above all, the issue should be appropriately timed, when the investors do not have to meet other statutory commitments like advance tax etc.

Reserves and Surplus

7.3.1 The reserves are of two kinds : Capital and Revenue. Capital reserves arise in the following cases i) ii) iii) iv) v) Surplus due to revaluation of fixed assets. Issue of shares at a premium. Capital profits on sale of assets (fixed assets and investments). Redemption of shares or bonds or debentures at a discount. Capital subsidy by the Govt. (State or Central).

7.3.2 Generally, capital reserves are not available for dividend distribution and they are perpetual reserves. Revenue reserves represent the profits earned from operations, after meeting all expenses and retained in business. In other words, the revenue reserves are accumulated past profits, not drawn by the shareholders as dividends. Some of the wellknown reserves are as follows: i) ii) iii) iv) v) General Reserve. Dividend equalisation reserve. Plant rehabilitation reserve. Reserve for contingencies like future loss, fall in value of investments held etc. Capital reserve or debenture redemptions reserve.

Some of the reserves are specific reserves, created in terms of external stipulations while others are free reserves, arising basically at the managements discretion. For instance, the capital or debenture redemption reserve arises in terms of stipulations by the debenture-holders or in terms of the statute (for capital redemption). These reserves are for specific purpose and cannot be utilised by the company for declaring dividends. All the same, all the reserves whether specific or free, whether capital or revenue, belong to the holders in the final analysis and hence, the entire reserves together with the paid-up capital constitute the net worth. In other words, net worth reflects theoretically, the surplus that might remain at the time of companys liquidation after paying off all outside

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liabilities (lenders and creditors) from the proceeds of sale of all assets of the company. For instance, if net worth accounts for 40% of the total assets, it would mean that at the time of reckoning, in case every asset realises at least 60 paise of each rupee invested in it, then the creditors and lenders would not come to grief. The surplus of net worth over paid up capital depends on the policy of plough-back of profits followed by the management. 7.4 Term liabilities

7.4.1 These, together with net worth, constitute the long-term or semi permanent source for the enterprise with which the initial cost of factory as well as subsequent additions are to be financed. The term liabilities comprise all debt contracted by the enterprise, not requiring to be liquidated within 12 months. Following items are examples of term liabilities. i) ii) iii) iv) v) vi) Debentures. Redeemable preference shares (whose redemption falls within 12 years from date). Term loans, Deferred credit from suppliers of capital equipments/materials Deposits from the public (payable beyond one year). Other term liabilities such as provision for gratuity liabilities.

7.4.2 A salient feature of term liabilities excepting items (ii) (v) and (vi) is that they are usually secured debt, covered by a charge over the under-takings fixed assets. While debentures are transferable securities, with a secondary market for trading and are repayable either in a lump-sum or instalments after a lapse of certain period, term loans and deferred credit are held by lending institutions throughout its currency-but requiring to be liquidated in certain stipulated instalments as per repayment schedule. Another feature of term liabilities, particularly term loans, is that the lenders as part of their loan arrangement prescribe a number of positive and negative covenants, the non-compliance of which may result in penal action, including takeover of management. This aspect needs to be studied by the analyst to foresee contingencies and eventualities, affecting the interests of short term lenders. 7.4.3 While the debentures and term loans are raised from the public or term lending institutions (including banks), as the case may be and hence subject to such stipulations as Debt: Equity gearing, necessity to create a redemption reserve, necessity to create a charge over assets etc. the other two long-term sources viz., deferred suppliers credit and public deposits are virtually without any strings or onerous conditions. 7.4.4 Suppliers credit is of two kinds, foreign currency or rupee, depending on whether the item purchased under the credit is imported or local purchase. Suppliers credit is generally available in a competitive free market where either due to competition or otherwise, inducements like longer payment terms are necessary to promote sales of capital equipment. Branches should familiarise themselves with the RBI regulations regarding sellers credit for imports from abroad. 7.4.5 Companies are permitted to collect deposits from public and from shareholders for maturity periods ranging from 6 months to 3 years. There is a ceiling on rates of interest
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payable on such public deposits. This is an easy and comfortable source of finance for well-run companies. 7.5 Current Liabilities and Provisions

7.5.1 These are liabilities either payable on demand or within a maximum period of 12 months. They are: i) ii) iii) iv) v) vi) vii) viii) ix) x) xi) Short-term bank borrowings Unsecured loans. Sundry creditors (Trade) Deposits from the public maturing within 1 year. Advances and deposits from dealers/customers. Accrued interest and other charges. Provision for taxation. Dividend payable. Statutory liabilities. Instalments of term loans etc. payable within 12 months. Other liabilities and provisions.

Of these current liabilities, we take the following two items for further discussion: i) ii) Trade creditors and Statutory liabilities.

7.5.2 Trade creditors are unpaid purchases outstanding on Balance Sheet date. This represents the credit enjoyed by the company on its purchases of raw materials and stores. The relevant test for this will be: Trade Creditors Total annual Credit Purchases

X 365

This figure reflects the no. of days the purchases remain unpaid. This, when compared with the normal trade credit period offered by market, could be interpreted in different ways. A much higher period than normal market credit could mean either of the following i) The companys liquidity is under pressure and it is unable to meet its creditors within normal credit due to cash flow problems: or ii) The company being a dominant unit dictates terms to its suppliers, by extending the period of credit allowed by the market.

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Similarly a lower ratio may indicate one of the two: a) The units liquidity is so comfortable that it does not require the normal period of market credit or the companys cash management is rather poor since it does not avail of the normal market credit available to it. b) Reluctance of suppliers to grant the normal credit due to the companys past track record of poor payments. In any case, trade creditors is very important to the Analyst as it is a barometer of the companys liquidity. The first casualty under any liquidity strain is only the trade creditors, which get extended. It is noteworthy that one of the signals of industrial sickness is an unduly extended trade creditors portfolio. 7.5.3 Similarly, statutory liabilities is another sure index of units liquidity. Generally no credit is available in respect of statutory liabilities like EPF and ESI dues (employers and employees contributions) and the units venture to defer their payments only braving penal action by the government. Hence, unless the liquidity position becomes one of extreme strain, these liabilities are not normally postponed. 7.5.4 In respect of other current liabilities, a general examination of their nature, repayment terms etc., will have to be conducted to understand the overall position. One may also mention the difference between provisions and reserves. While the former is a current liability, created mostly for meeting a specific and known obligation by charging it to the profit & loss account, as an expense incurred for earning the revenue, the latter is simply an appropriation from the after tax profit. It represents basically the monies belonging to the shareholders which by common consent are retained in business for meeting future needs. Thus, reserves form part of the units net worth. 8. Contingent Liabilities Another feature of Balance Sheet to be closely analysed by the credit analyst is the contingent liabilities. It often happens that at the time the Balance Sheet is drawn up, the accountant is not fully aware of some obligations of the enterprise : they may or may not accrue as a liability, because of dispute regarding their tenability as a claim against the enterprise or if they do arise, he is not certain about their quantum. For instance, quality disputes, tax appeals, etc. are obligations of this nature. These obligations are termed contingent liabilities and must be detailed as a footnote. A few examples of these contingent liabilities are : i) Pending law-suits. ii) Claims against the company not acknowledged as debts. iii) Guarantees issued by the company iv) Unexpired portion of Letters of Credit established by the Bank on behalf of the unit. v) Taxes and duties under dispute with authorities. vi) Bills/Cheques discounted with bankers. The relevance of these to the credit analyst lies in the likelihood of their occurrence. He will have to examine each of these and judge for himself to what extent chances exist for

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their materialising into real liabilities. If, in his judgment they are more likely to materialize, he must make a suitable provision in his own analysis, by setting it off against the net worth, even though the enterprise itself had not done so. 9. Limitations of a Balance Sheet While the above analysis of the Units Balance Sheet does disclose certain important indicators to the analyst, he will do well to remember that conclusions based purely on the Balance Sheet may quite be misleading, due to its inherent limitations. The Balance Sheet is often likened to a snapshot of a moving train and hence reveals just as much about the financial condition as the photograph does of the moving train, capturing only a particular position. Hence, any undue reliance on Balance Sheet is fraught with risks. The limitations of balance sheets are four-fold. i) ii) iii) iv) Inexactness owing to personal bias of the accountant in exercise of his judgment: e.g. valuation of stocks, provision for bad debts etc. Non-recognition of diminishing value of rupee and treating all assets only in terms of their recorded rupee value: inflation accounting is the answer Exclusion of all non-monetary transactions and factors, howsoever important they may be. Pertains to a date and hence liable to abuse like window-dressing.

In order to eliminate at least some of these limitations, the analyst could examine a series of balance sheets and discern a trend of the various financial and performance indicators. Such a comparison could be internal i.e. with past performance or external i.e., with those of similar units. A Balance Sheet analysis, it will be appreciated, is only the first step in the whole analysis, an indicator ordering a further probe, but definitely not the final conclusion. 10. 11. CLASSIFICATION OF CURRENT ASSETS AND CURRENT LIABILITIES CURRENT LIABILITIES: i) Short term borrowings ( including bills purchased and discounted not drawn under LCs opened by first class banks / correspondent banks) from a) Banks b) Others Unsecured loans Public deposits maturing within one year. Sundry creditors (trade) for raw materials and consumable stores and spares. Interest and other charges accrued but not due for payment. Advance/progress payments from customers. Instalments of term loan, deferred payment credits, debentures, redeemable preference shares and long term deposits, payable within one year Statutory Liabilities a) Provident fund dues b) Provision for taxation (see Note(2) below)
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ii) iii) iv) v) vi) vii) ix)

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c) d) e) x) a) b) c) d) e) 12.

Sales Tax, excise duty etc. Obligations towards workers considered as statutory Others (to be specified) Dividends (see Note (2) below) Liabilities for Expenses Gratuity payable within one year Other provisions Any other payments due within 12 months

Miscellaneous Current Liabilities

CURRENT ASSETS: i) ii) Cash and Bank Balances. Investment (see Note (3) below) a) b) iii) iv) v) vi) vii) viii) ix) x) xi) xii) Government and other Trustee Securities (Other than for long term purposes e.g. sinking fund, gratuity fund etc.) Fixed deposits with banks & margin money deposits (margin for LC/ BG established by the banker for working capital purposes).

Receivables arising out of sales other than deferred receivables, (including bills purchased and discounted by bankers). Instalments of deferred receivables due within one year. Raw materials and components used in the process of manufacture including those in transit (see Note(4) below). Stocks-in-process including goods in transit. Finished goods including goods in transit. Other consumable spares (see Note (4) below). Advance payment of tax. (see Note (5) below). Pre-paid expenses. Advances for purchase of raw materials, components and consumable stores. Deposits kept with public bodies etc., for the normal business operations e.g. earnest deposits kept by construction companies etc., maturing within the normal operation cycle. Monies receivable from contracted sale of fixed assets during the next 12 months. The concept of current liabilities would include estimated accrued amounts which are anticipated to cover expenditure within the year for known obligations, viz., the amount of which can be determined only approximately, as for example, provisions for accrued bonus payments, taxes, etc. In cases where specific provisions have not been made for those liabilities and the liabilities will be eventually paid out of general reserves, estimated amounts.
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xiii)

Notes (1)

(2)

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(3)

Investments in shares and advances to other firms/companies, not connected with the business of the borrowing firm, should be excluded from current assets. Dead inventory i.e. slow moving or obsolete items should not be classified as current assets. Provision for taxes and advance payment of tax can be netted out. Amount representing inter-connected company transactions should be treated as current only after examining the nature of transactions and merits of the case. For example advance paid for supplies for a period more than the normal trade practice, out of any considerations other than regular and assured supply, should not be considered as current. The above list of current liabilities and current assets is only illustrative and not exhaustive.

(4) (5) (6)

(7)

13. 13. 13.1

PROFIT AND LOSS STATEMENT ANALYSIS Importance of the Profit and Loss Statement The profit and loss statement summarises the transactions which together result in a profit (or loss) for a specific period of time. This profit or loss is shown on the balance sheet as an increase or decrease in owners equity. People who invest in securities believe that a study of the profit and loss statement of a business enterprise will give them information regarding future expectations of profits and dividends. It is in this context that the profit and loss statement has gained importance. The profit and loss statement reports the results of operations and indicates areas contributing to profitability or otherwise of the business enterprise. Analysis of profit and loss statements for several years may reveal desirable or undesirable trends in the profit earning capacity of a business enterprise. Revenues, Expenses and Changes in Owners Equity Defined more precisely, revenues are increases in owners equity that result from operations of a business enterprise while decreases in owners equity are expenses. Revenues take the form of an inflow of assets like cash and sundry debtors from customers or clients to whom products have been sold or services rendered. Revenues might also be earned from investments, for instance, interest on Govt. securities or dividends. It should be noted that revenues are not the only source for increase in owners equity. An inflow of capital funds invested by owners increases owners equity but it is not revenue.

13.2

13.3

13.4

Expenses connote sacrifice made, cost of services or benefits received, or resources consumed during a specified period. Expenses are costs incurred for generating revenue and are therefore related to the operations of a business enterprise. As stated earlier, expenses decrease owners equity, however they are incurred in the expectation that the revenues generated will more than offset the decrease in owners equity. The excess of earned revenues over the incurred expenses in a specific period is called profit or income. If expenses exceed revenues the difference is called a loss resulting in net decrease in owners equity.

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13.5

The Format of the Profit and Loss Statement can be seen from the Exhibit A furnished below: Exhibit A DHRUPAD COMPANY Profit and Loss Statement for the year ended March 31, 2010 Sales of goods and service Cost of goods sold Gross Profit Operating Expenses Staff Expenses Sales and Administration Expenses Depreciation Managerial remuneration Operating Profit Other Income Net Profit before taxes Provision for Taxes Net Profit after Taxes General Reserves taken to Rs. 1,44,73,526 79,88,956 64,84,570 31,64,830 18,64,390 3,56,971 80,169 10,18,210 4,35,326 14,53,536 7,90,000 6,63.536

Exhibit A is a profit and loss statement for Dhrupad Company. The statement shows the results (in Rupees) of operations of this company for the year ended March 31,2010. 13.6 As seen from the exhibit A, Dhrupad Company made a profit of Rs.6,63,536. This profit will be included as a net increase under general reserve in owners equity section of the balance sheet of Dhrupad Company. Instead of the format outlined in Exhibit A, some published annual statements in India follow the practice of listing revenues on the right hand and expenses on the left hand side of the profit and loss statement. This format is an outcome of the practice to represent the profit and loss account as it appears in the detailed accounting records (ledgers). Generally, additional schedules giving details of cost of goods sold and operating expenses are appended to a published profit and loss statement. Generally the format given in the exhibit facilitates easy analysis of the profit and loss statement. Comparison of results of operations for several years and calculation of ratios and percentages is easily done if the vertical format is followed. The first item on the profit and loss statement in Exhibit A is sales of goods and services. This item represents the revenues from operations for Dhrupad Company. Revenue might also be derived from exchange or sale of assets, interest on dividends from other investments. The usual practice however is to distinguish the two kinds of

13.7

13.8

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revenues. Revenue arising out of normal operations is designated as sales revenue whereas revenue arising out of investments and sale or exchange of assets is called other income 13.9 The second item of the profit and loss statement is cost of goods sold. Cost of goods sold is an item of expense and results in a decrease in owners equity. The difference between sales and cost of goods sold is called gross profit which in our case amounts to Rs.64,84,570. From gross profit several other items of expenses called operating expenses are deducted, the difference between gross profit and operating expenses is called operating profit. The operating profit figure is very important since it discloses the profitability and operating efficiencies of Dhrupad Company.

13.10 The next item on the profit and loss statement is other income. Other income is a net figure and includes interest on investment and securities paid or received, and profit or loss on sale and exchange of assets, etc. The total of operating profit plus other income gives the figure of net profit before taxes. Provision for taxes calculated according to income tax rules is deducted leaving a figure for net profit after taxes. Net profit after taxes represents the net increase in owners equity for Dhrupad Company during the year ended March 31, 2010. 13.11 The accounting period: The profit and loss statement illustrated in Exhibit A pertains to one years operations of Dhrupad Company. Ideally, an exact measurement of the net profit or loss of a business enterprise can only be made after the enterprise has ceased doing business and sold all its assets and paid off its liabilities. Management however cannot wait until the business operations have ended to determine the profit or loss from operations. In practice, therefore, accountants attempt to determine profits or losses for intervals of time shorter than the total life of a business entity. Accounting transactions that have occurred during a specified period of time are collected, summarised and a report is made of all the material changes in owners equity during this specific period. This specific period which is chosen to report profits or losses is called the Accounting period. 13.12 Although published statements for reporting to owners and outside agencies are prepared at annual intervals (quarterly performance reports should be furnished to stock exchange by the listed companies), management often needs interim profit and loss statements prepared for shorter intervals of time. This interval might be a quarter, a month, a week or even daily. Over the life of a business enterprise, a profit and loss statement and balance sheet are prepared at the end of each accounting period. The profit and loss statement presents the results of operations during an accounting period. It might also be said that a profit and loss statement covers the period between two balance sheet dates and explains the changes in owners equity during the accounting period. 13.13 Sales 13.14 Cost of Goods Sold and Operation Expenses: Profit and loss statement will give the figure of gross sales. Net sales is arrived at by deducting from gross sales, sale returns and allowances and sales discounts, excise duly and Sales tax.

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13.15 Gross Sales Gross Sales is total sales revenue measured by multiplying goods delivered into unit price per item. State and local sales taxes and octroi and excise duties charged to a consumer are to be excluded from net sales as they are not revenue for the unit but are collected by a business enterprise on behalf of the Central, State and Local authorities. Until such time as they are passed on to the government, they represent a liability of the business enterprise to Government. 13.16 Sales returns are part of goods sold to customers but returned by them to the business because the goods are not of a kind of quality ordered by a customer. Goods returned are called sales returns. Instead of returning the goods customers may sometimes claim an allowance on the price. In such a case, the allowance on price is called sales allowance. 13.17 Sales discounts are deductions from sale price allowed to customers to induce them to pay promptly. For example, a business may sell goods on terms 2/15, n/45 which means that customer will get a 2 percent deduction from the billed amount if payment is made within 15 days, after 15 days no discount will be given but the customer will be required to pay the billed amount within 45 days. Since sales discounts reduce the revenues received from sales it is deducted directly from gross sales instead of being shown as an expense item. Another kind of discount, trade discount does not appear on the profit and loss statement at all, trade discount is the amount deductible from published or catalogue price in order to arrive at actual sales price. 13.18 Sales Revenue and the Realisation concept The realisation concept is one of the most important concepts influencing modern day accounting practices. This concept states that as a general rule, sales revenue is recognised in the accounting period in which revenue is realised. Realisation occurs when goods are shipped or delivered to the customers. For services, revenue is recognised in the period in which services are rendered. It is important to emphasise that revenue recognition occurs not when a sales order is received, not when a contract is signed but when the goods are shipped or delivered. Payment for goods shipped or services rendered may be made immediately or after a period of time, the timing of payment is quite immaterial to the realisation concept. The crux of revenue recognition is performance of the contractual obligation through shipment or delivery of goods or rendering of services. 13.19 Cost of Goods Sold and Operating Expenses At the same time as owners equity is increased by the sales value of goods shipped or delivered or services rendered it is also reduced by the cost of goods sold and operating expenses. In this section we shall explain how cost of goods sold and operating expenses are measured but before we do so it should be emphasised that cost of goods and operating expenses are both expenses and have the same effect on owners equity, a decrease. But a distinction is made between these two items since gross profit (difference between sales revenue and cost of goods sold or services rendered) constitutes very important and useful information to management and other users of financial statements. Published statements are required to state all three items, that is, sales revenue, cost of goods sold and gross profit.

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13.20 Measuring Cost of Goods Sold The problem of measuring cost of goods sold arises because a business does not sell all the goods that it purchases during an accounting period. For example, a business may purchase 10,000 units of a product at Rs.5 per unit during an accounting period. If 5,000 units are sold during the accounting period at Rs.6 per unit, what is the cost of goods sold? The problem can be explained as follows: The purchase of 10,000 units can be regarded as inventory of Rs.50,000, an asset available for sale during the accounting period. Since only 5,000 units were sold, the cost of goods sold is Rs.25.000 (5,000 units x Rs.5 per unit), the balance of 5,000 is inventory available for sale during the next accounting period. If during the next accounting period another 3,000 units were purchased at Rs.5 per unit and 7,000 units were sold at Rs. 6 per unit partial profit and loss statements and balance sheets for operations for the two accounting periods would be Profit and Loss statement for Account Period 1 Sales Cost of Goods sold Gross Profit 30,000 25,000 5,000 Balance Sheet at the end of Accounting Period 1 Assets Current Assets Inventories 25,000

Profit and Loss Statement for Accounting Period 2 Sales Cost of Goods sold Opening Inventory Purchases Goods available for sales Less Closing Inventory Goods sold Gross Profit * 42,000 25,000 15,000 40,000 5,000 35.000 7,000

Balance Sheet at the end of Accounting Period 2 Assets Current Assets Inventories

5,000

During the two accounting periods, a total of 13,000 units were purchased at Rs.5 per unit of which 12,000 units were sold leaving a balance of 1,000 units at the end of the second accounting period. The cost of this inventory which is the closing inventory is Rs.5,000.

13.21 In the above example, we were concerned with measuring cost of goods sold in a business which was primarily engaged in buying and selling goods without any processing. In manufacturing businesses, where materials are processed and converted into finished goods before sale, the measurement of cost of goods sold is slightly more complicated.

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13.22 There are two distinct methods of calculating cost of goods sold. The first method called the perpetual inventory method is commonly used by businesses which are buying and selling high unit price, low volume items (like refrigerators and air conditioners.) In such businesses, a record is kept of the cost of each item sold, and cost of goods sold is determined by simply adding up the cost associated with individual items sold. The total cost of goods sold is subtracted from the asset inventory so that at all times the asset inventory represents cost of goods still available for sale. 13.23 The other method called the physical inventory method is generally used by businesses engaged in buying and selling high volume low unit price items (like provision stores). In this case, no track is kept of costs associated with each item that has been sold, but a physical inventory of goods remaining unsold is taken at the end of each accounting period. Costs are associated with the physical inventory on hand which results in the value of inventory not yet sold. The cost of goods sold is then determined through a process of deduction. To the inventory available for sale at the beginning of an accounting period (or remaining unsold at the end of the previous accounting period) is added the value of purchases made during the accounting period for which the profit and loss statement is being prepared. From this, the value of physical inventory not yet sold is deducted, giving the cost of goods sold during the current accounting period. 13.24 Until now the figure used for purchases represented the gross value of purchases. To determine the net purchases during an accounting period certain adjustments to gross purchases are necessary. A part of the purchase may be returned to the supplier because the goods supplied were not of the kind or quality ordered. Purchases returns will thus be deducted from gross purchases. Similarly, where an allowance on purchase price is claimed for non-standard goods, purchase allowance is also deducted from gross purchases. Purchase discount is next deducted from gross purchases. If any freight charges are incurred on the purchases of goods, this is added to gross purchases. To summarise by using an example, cost of goods sold for an accounting period will be calculated thus Opening Inventory Purchases Add : Less : Less : Add : Freight in Purchases Return and allowances. Purchase Discounts Net purchases Rs. Rs. 50 20 As. 260 Rs. 760 Rs. 250 Rs. 510 Rs. 300 Rs. 30 Rs. 330 Rs. 500

Rs. 260

Goods available for Sales Less : Closing Inventory Cost of goods sold

13.25 It should be noted that under the physical inventory method, we are assuming that if goods are not found in physical inventory at the end of an accounting period, they must

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have been sold. This is perhaps an erroneous assumption, since goods might have been pilfered or lost instead of being sold. Unless steps are taken to determine such shrinkages in physical inventory, the cost of goods sold calculation might be misleading. On the other hand, in the perpetual inventory method an actual count of inventory on hand can be made to check the accuracy of perpetual inventory records. 13.26 Measuring Operating Expenses Earlier in this note, we defined expenses as sacrifice made, cost of services or benefits received, or resources consumed during a specific accounting period. It might now be useful to distinguish between expenditures and expenses. An expenditure takes place when an asset, resource or service is acquired in exchange for cash, another asset or by incurring a liability. Expense is incurred only when the asset, resource or reserves is used or consumed. During the total life of a business all expenditures must become expenses. Within a single accounting period however, there is no necessary correspondence between expenditures and expenses. The relationship between expenditures and expenses is illustrated with examples in the next few paragraphs. 13.27 Expenditure incurred during an accounting period which become expenses in the same accounting period. If a resource, service or asset is acquired and consumed during the same accounting period, it is both an expenditure and expenses for that accounting period. There is an exact correspondence between expenditure and expense in the current accounting period in so far such items are concerned. Illustration: In Dec 2009, goods worth Rs.5,000 were purchased for cash. There was thus an expenditure of Rs. 5,000. One asset inventory or stocks being acquired in exchange for another asset cash. Out of this amount of Rs 5,000, how would be accounted for as expense for the year ended 31 March 2010? If all these goods were sold before 31 Mar 2010, there was an expense of Rs.5,000 in the year 2009-10. If none of the goods were sold in 2009-10, there was no expense in 2009-10. If the goods were sold subsequently in April 2010, there was an expense of Rs.5,000 in the year ending 31 March 2011. If only Rs,3,000 worth of goods were sold in 2009-10, there was an expense of only Rs.3,000 in 2009-10. 13.28 Expenditure incurred during an accounting period that become expenses in that same accounting period are the simplest types of accounting transactions. However, as can be seen from the next three sections, not all expenditures become expenses in the same accounting period in which they are incurred, 13.29 Expenditures incurred in previous accounting periods that will become expenses in current accounting period. In the last part of the previous illustration we saw that out of an expenditure of Rs.5,000 in 2009-10 only Rs.3,000 became an expense during the same year. What happened to the difference of Rs. 2,000? The expenditure of Rs.2,000 would have been shown as an asset on the balance sheet as on March 31, 2010 and may be used up and transformed into expenses in 2010-11 in or future years. Three major types of such assets are described below:

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13.30 Current assets include inventories of products which have not been sold at the end of the previous accounting period- these will become expenses in the current accounting period if the products are sold in this period. 13.31 Another kind of asset is prepaid expenses and deferred charges. These assets represent cost of services purchased in previous accounting periods but not used up until the commencement of the current accounting period. Such assets become expenses in the period in which they are used up or consumed. Insurance premium provides an example of prepaid expense. Premiums on most insurance policies are payable in advance and the amount paid as premium remain as assets until the accounting period in which the protection becomes effective at which time the proportionate premium is treated as expense. Illustration: - A company paid Ps,3,000 for rent in advance for 3 years on March 31, 2010. The balance sheet prepared on March 31, 2010 should show an asset prepaid rent. However, in the next three years, one-third of the prepaid rent, that is, Rs.1,000 would be regarded as an expense each year.. 13.32 The third type of assets that become expenses are Long-lived assets. Fixed assets are acquired by a business enterprise in the expectation that they would be used in generating revenue over a period of time. Fixed assets would therefore, become expenses in future accounting periods when the assets are used. The conversion of fixed assets into expenses parallels the examples of insurance premium. One important difference is that in case of insurance premium the life of the policy is definite whereas in case of fixed assets, like plant and machinery, the asset life has to be estimated. Because of the estimation involved, the process of determining the portion of the plant and machinery cost that will be regarded as an expense for the current accounting period is quite a difficult task. Although difficult, the concept of depreciation has been devised to estimate the expense for each accounting period. 13.33 Expenditure incurred in current accounting period that are not yet expenses In the preceding section, we described how assets become expenses in the current accounting period. Using the current accounting period as our reference point, there are some expenditures incurred in the current accounting period which are not expenses in the current accounting period but will become so in future accounting periods when the assets or resources are consumed or used up. Such expenditures include not only assets that are purchased for future use but also expenditures on the manufacture or purchase of products that are to be sold in future accounting periods. Thus using the illustration from the preceding section, the expenditure of Rs.3,000 in March 2010 on insurance premium, is an expenditure that is not yet an expense in the accounting period for the year ended March 2010 13.34 Expense for current accounting period that will be paid for in subsequent accounting periods: This category of operating expense is called accrued expense. The characteristic of accrued expense is that although services might have been used or benefits received in the current accounting period, payment for these services or benefits will be made in future accounting period. Owners equity is reduced when these expenses are incurred. Subsequent payment of the liability does not affect owners equity

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13.35 An example, of this type of expense is wages and salaries that are earned by employees but have not yet been paid. Some firms follow the practice of paying wages and salaries for a month in the first week of the following month, that is, wages and salaries for March 2010 are paid by the first week of April 2010. So far as the accounting period for the year ending March 2010 is concerned, wages and salaries for March 2010 are expenses for the period, although they will be paid only in April 2010. 13.36 Another example of accrued expense is interest expense. Interest is the cost of borrowed money and is an expense for the accounting period in which borrowed money is used. Quite often, interest is payable quarterly. If the annual accounting period ends on March 31, interest for the period Jan to March 31 has been incurred, although the obligations to pay will arise only in April. The obligation to pay interest is shown as a liability in the balance sheet prepared on March 31. 13.37 For all expenses of this type, transactions involved are essentially the same, the expense is shown as operating expense in the accounting period in which the services were used or benefits received. The obligation which results from this expense is shown as a liability in the balance sheet at the end of the current accounting period. 13.38 The Accrual concept - Cash Versus Accrual Accounting The essence of the accrual concept is that net profit (or net loss) arises from revenue and expenses transactions during an accounting period and that net profit (or net loss) is not synonymous with cash increase or cash decrease. 13.39 Earlier we have seen that the process of revenue recognition is not necessarily associated with the collection of cash. For example when products or services are sold on credit the increase in revenue leads to a corresponding increase in the asset, sundry debtors. At a later date when cash is collected from customers, increase in asset cash is offset by decrease in the asset sundry debtors, revenue is not increased at the time of collection but rather at the time when the products or services were delivered and billed on credit terms. 13.40 Occasionally, customers make advance payments for products or services to be delivered or sold in future years. Revenue is not recognised at the time of receipt of advance payment, although a liability to sell products or render services in future periods has been created at the time of advance payment. Revenue will be recognised only when products or services are actually delivered and billed. The liability would be removed at the time when revenue is recognised. 13.41 In a like manner, expenses are not necessarily represented by cash transactions. Expenses occur when benefit is received from or use is made of an expenditure or asset. The payment for the expenditure or asset may be in quite a different period than the one in which the expense is recognised. For example when supplies are purchased on credit, an asset account is created and liability to the creditor is recorded. Expense is recognised in the accounting period in which these supplies are used or consumed. When payment is made to the creditor, the liability is reduced but it does not affect expense recognition. 13.42 It is extremely important to recognise that net profit or loss is associated with changes in owners equity through revenue and expense transactions and that net profit or loss is not necessarily synonymous with cash increase or decrease. Generally speaking, the
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larger the net profit, the better off are the owners. An increase in cash, however, is no indication that the owners are better off. The increase in cash may merely be offset by a decrease in another asset or by an increase in a liability, with no effect on equity at all. Net profit will exactly correspond with net cash increase only if the following four conditions are met a) b) c) d) All sales are made for cash during the current accounting period. Any sales made on credit terms during the current accounting period are realised in cash in the current accounting period itself. All cash expenditures become expenses during the current accounting period, and All expenditures made on credit terms are paid off during the current accounting period, such expenditures being transformed into expenses during the current accounting period.

In short, for net profit to be synonymous with net cash increase, there must be complete correspondence between sales revenue and cash receipts, between cash payments and expenditures and between expenditures and expenses. 13.43 It is rare indeed for all the four conditions to be fulfilled in any business enterprise. Accrual accounting based on the accrual concept ignores the timing of cash receipts and payments in determining net income for an accounting period, the timing of revenue realisation and expense incurrence is the fundamental basis of accrual accounting. 13.44 Matching Expenses with Revenues An accurate measurement of net profit or net loss during an accounting period depends considerably on the proper matching of expenses with revenues. The matching concept means that in determining net profit for an accounting period, all expenses associated with revenue generation should properly be regarded as expenses for that period. If revenue is recognised on the billing and delivery of a particular product, then the cost of products sold should include all expenses associated with the sale of that product. 13.45 Similarly costs incurred for manufacturing a product that has not been sold but remains as closing stock at the end of the accounting period should not be included in operating expenses. 13.46 Quite often the expenses to be matched with revenues need to be estimated. For example, products are sometime sold under a repair and service guarantee scheme. The concept of matching expenses with revenues gives rise to the problem of estimating the portion of the future repair and service guarantee costs. 13.47 Sometimes the expenses needed to earn revenues are quite certain, but the likely revenues are uncertain. Taking another example, a company might spend a considerable sum of money on development of a new product to be launched. Over how many years should the cost of development be spread? This would depend amongst other factors on product life and its ability to generate revenues over a number of years.

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13.48 For practical reasons, accountants are sometimes forced to relax the concept of matching expenses with revenues. One reason is that a very exact matching of revenues and expenses may not be significantly useful and also the work and cost involved in achieving accuracy may not justify the results achieved. 13.49 The profit and loss appropriation statement The profit and loss appropriation account shows how the net profit for the current accounting period has been disposed of. The statement starts with the balance in the P&L appropriation account at the end of the previous period, to which is added the net profit of the current accounting period. From this sum any dividends that might have been declared or any specific appropriations from the P&L appropriation account are deducted and any excess left over is added to the general reserves. 13.50 Sometimes the net profit in an accounting period might be less than the profits required for declaration of dividends. In such a case the general reserve available at the end of the previous accounting period is used to cover the deficit between declared dividends and net profit. The profit and loss appropriation statement would then show general reserve available at the end of the previous accounting period., to which is added the net profit for the current accounting period. In other words there would be a reduction in the general reserves by an amount equal to the deficit between dividends and net profit. 13.51 The profit and loss appropriation statement forms the link between the profit and loss statement and the balance sheet. This is done through the process of additions to and subtractions from general reserves. 13.52 The profit and loss statement and the accounting equation It must be emphasized that all transactions shown on the profit and loss statement can be represented in terms of the accounting equation. When revenue from sales is received, owners equity increases by the amount of revenue from sales, this increase is offset by an increase either in cash or sundry debtors or some other asset. Similarly when an expenditure is incurred on purchase of products for sale and asset stock increases this increase is offset either by a decrease in cash or by an increase in liability to a creditor. When the products are sold owners equity decreases to the extent of the use of products for sale and stock of products for sale decreases correspondingly. 13.53. You will therefore see that revenues and expenses result in increase and decrease in owners equity and that such increase and decrease is accompanied by a corresponding change in another asset or liability item. So far as the balance sheet is concerned one could directly record the revenue and expense transactions in terms of their effect on owners equity, however, for management information purpose it is quite useful to separate the increases and decreases in the owners equity in the form of revenues and expenses. 13.54 In some cases business enterprises report to owners a net profit figure which is quite different from the one reported for tax purposes. There is nothing unethical about this practice since income tax regulations might in some cases prescribe a treatment for certain revenues and expenses which is quite different from that justified by sound business management policies. For example, income-tax regulations require companies to use the Written Down method of depreciation for tax reporting purposes. However, the Companies Act and Accounting Standards permit companies to choose either the written

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down method or the straight line method of depreciation for purposes of reporting to owners. In fact, some companies do follow straight line method of depreciation resulting in different net profit figures for tax returns and reporting to owners. 13.55 Almost every business enterprise attempts to pay the least amount of tax on its taxable profit both in the short and long runs. A company will hire experts to advise management in how best to comply with tax laws, and pay the least amount of tax. This aspect of management policy may be more properly designated as tax avoidance rather than tax evasion. Tax avoidance is perfectly legal and ethical provided it is done in compliance with tax laws. 13.56 In actual practice, several companies pattern their accounting policies for reporting to owners on the same line as the tax provisions. This is a very convenient procedure since it obviates the necessity of having separate accounting records for the two purposes. However, complete dependence on tax regulations for reporting to owners might result in serious distortion of financial reports presented to them. Tax regulations should not be substituted for clear and sound thinking on profit reporting practices. 14. 14.1 LIMITATIONS OF BALANCE SHEET Balance Sheet is as on a date - a snap shot - not always representative in character - it can be window-dressed to achieve certain purposes. However, properly read with the Auditors notes, reports and annexures it can lead to a number of inferences including latent problems. Facts 14.2 Balance Sheet Based on Accounting conventions Opinions (of the Auditor/Accountant/Management) It is designed to give a fair view. (e.g. Accounting period, money measurement, cost, stable monetary unit, assumed consistency etc.) 14.3 Often Balance Sheet can be more useful when analysed in relative terms than when the figures are looked at in absolute terms. Therefore, a careful, patient, systematic and informed analysis is a must. Conclusions must be tempered with other information about qualitative aspects. 14.4 15. 15.1 15.2 Unless audited it cannot be relied upon. But auditing too has its limitations, COMMON WINDOW DRESSING PRACTICES Date of Balance Sheet - If coinciding with end of season, the balance sheet size and liabilities may be smaller than during peak season. Indicating Current expenses as Capital in Balance Sheet.

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15.3 15.4 15.5

Resorting to heavy billing of sales on date of Balance Sheet leading to increased sales & increased profit. Preparing Balance Sheet on different dates for associate concerns. (making it difficult to ascertain the extent of interlocking of funds/stocks) Temporary reduction in CL (for a day or so) Setting off CL against CA, Issuing cheques in payment of CL but not despatching them (reduces S.Crs. and shows a better current ratio) Maximising collection of receivables on Balance Sheet date thus showing a large cash balance (including cheques yet to be realised) Resorting to heavy billing of sales on the date of Balance Sheet, leading to increased sales and profits Changing the method of Valuation of Stocks (In an inflationary situation change from weighted average cost of current assets to First in First out method (FIFO) leads to increase in profit)

15.6 15.7 15.8

15.9

Changing the method of Depreciation - particularly with retrospective effect

15.10 Booking unrealised income as revenue. BEYOND THE BALANCE SHEET PERSPECTIVES 16.1 Financial statements provide quantitative data which by themselves may not present a full picture of the company, owing to the existing accounting practices and conventions. Besides there are a number of qualitative aspects of a business which never get quantified and reflected even in a Balance Sheet compiled with utmost care and healthiest of accounting conventions and practices. Therefore, a banker should go beyond the Balance Sheet and examine the strengths and weaknesses of the enterprise and the business it is in. The major areas, a Banker should examine are: Quality of Management Managerial Efficiency Technology Marketing Stock Market Perceptions Growth Perspectives

Under each of these areas, a banker would need to probe and analyse the state obtaining in the company.

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17. Quality of Management Partners of the firm/ Directors of the Company. Are they Family Members? Are they experienced? Are they competent? Professionals - Are they Qualified/ Competent/ Experienced? On whom does the management of the firm/ Company rest? Are all the partners/ directors involved in the management or are only one or two involved? How responsive are the partners/ directors to environment changes? Are they receptive to innovations/ modern management techniques or are they treading the beaten path? What is the management team like and how is the responsibility shared in different functional areas such as * Finance and Accounting * Purchase and Materials Management * Production * Marketing * Internal control and administration What is the authority structure like? Unitary command? Is there proper delegation? What is the state of Labour Relations?

18. Managerial Efficiency Existence of a system for Management Control in the areas of * Budgeting financial forecasting. * Variance analysis, Control and directions. Cost Accounting Systems in use. * Are they suitable to the line the Company is engaged in? * Has the company developed standards for control? Financial management. * What is the quality of financial projects? * Cash management. Does the company go in frequently for unplanned overdrafts/excess drawings? Ability to generate information for control. Track record of the company in terms of conduct of account, complying with the covenants and ancillary business entrusted to the Bank.

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Inventory Management - What are the systems for control? * The reconciliation position recording perpetual inventory record. * Valuation methods used and consistency thereof.

19. Efficiency of the Fixed Assets * * * Capacity utilisation. Productivity. Age of the Plant - Are periodical repairs done?

20. Production Management * * * Production Planning Scheduling Control and quality control

21. Technology What is the state of technology used by the company / is it obsolete? Programmes for technology up gradation. Awareness of the competitors technology, its effect on the companys marketing and profitability. What are the companys plans for new product development and diversification? State of Research and Development.

22. Marketing What is the nature of industry? * Present state and future prospects. * Status vis-a-vis Government priorities. Special features of the Industry * Government control on price/ distribution. * Government policy on import/ export. * Availability of raw materials. Market Share * Nature and extent of competition. * Growth vs. market share growth. 23. Growth Prospects What are the companys objectives?

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* Is it growth oriented or stagnant? * Diversification plans. Same industry. Other pursuits. Does the company plan for growth? * Its plan for conservation of resources consistent with liquidity/ capital base? 24. Market Perception It would be necessary to ascertain how the buyers of the Companys products, its competitors and stock market investors view the Companys status. All these aspects would need thorough examination along with the Balance Sheet analysis to obtain a clear picture of the state of affairs of the company, its strengths and weaknesses. 25.1 An important part of balance sheet analysis, is to draw conclusions from, or in other words, interpret the data presented for analysis. As has been seen above, a meaningful interpretation needs comparison. It may be between a) Two sets of figures in the balance sheet. b) Set of figures, like long-term loans, sundry creditors etc., in the balance sheets of the company for three or more consecutive years. c) A set of figures, like level of inventories in the balance sheet for a particular year or two or more companies in the same line of business and operating in the same area.

It is easier to compare ratios than the actual figures, which may at time be unwieldy and are not readily susceptible to interpretation. A ratio may be a figure or a percentage representing comparison of a rupee amount with some other rupee amount as a base. 25.2 With a sound knowledge of typical financial ratios, one may determine whether a particular item is relatively large, typical, or relatively small. 25.3 Comparative financial statements/ balance sheets exhibit trends, a clear understanding of which is based upon sound ratio studies, may convey some premonition regarding the immediate future of a particular business enterprise of course, provided management policies do not radically change. The great unknown is always the management, which has the power to improve the conditions or hasten the ruin. Some of the common useful ratios, together with brief comments are detailed below. RATIO ANALYSIS 26 Basically, the balance sheet and profit and loss account provide information which helps us to assess three main aspects of an organisations position viz., its solvency, liquidity and profitability. Instead of studying an item in isolation, it should be studied in comparison with industry average or with a similar type of unit in the same areas and/or the trend for the same enterprise for a period of 3 to 4 years. Such a study will show whether the operations of the enterprise are in step or out of step with the trends in the business and whether its

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position is improving or deteriorating. Studying a particular item as such may not reveal the correct position prevailing as evidenced by the following two examples i) An enterprises tangible net worth as on two different dates viz., A & B was Date A Total tangible assets Outside liabilities Tangible net worth Rs.1,10,000 Rs. 1,00,000 Rs. 10,000 Date B Rs. 20,000 Rs. 10,000 Rs. 10,000

The tangible net worth of the enterprise as on the two dates was the same. Imagine a situation where, for some reason, the outside liabilities have increased by say 10 percent on the two respective dates without a corresponding increase in the assets. The position would then be as follows: Date A Total tangible assets Outside liabilities (Increased by 10 percent) Tangible net worth Rs. 1,10,000 Rs. 1,10,000 Rs. NIL Date B Rs. 20,000 Rs. 11,000 Rs. 9,000

Therefore in order to get a clear idea of the degree of solvency (i.e. its liabilities), we cannot solely rely on the Tangible net worth of the enterprise to indicate its ability to meet outside liabilities. STUDY OF BALANCE SHEET - SOME COMMON RATIOS

26.1 Return on capital employed (ROCE) or ROA Return -------------------------------------------- X 100 Return = Profit before Depreciation, Interest and Tax Total Capital Employed i) ii) Total capital employed = Total Assets High ratio indicates that the business is run on profitable lines. It is a relationship between the profits made during the year and the finance employed to make that profit i.e.. it shows the earning power of the business. It is a measure of the managements skill in profitably employing the funds in the company. It should not only compare favorably with the rate of interest on loanable funds in the market but also compensate for the risk involved in running the business.

iii) iv)

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Operating Profit 26.2 X 100 Net Sales iii)

i) ii)

Indicates operating efficiency. Should be comparable with similar industries. Trend for the company over a period should be encouraging

Expenses 26.3 Sales X 100

i) ii)

Indicates efficiency. Trend for the company over a period is to be examined. As years go by sales should increase without a corresponding increase in expenses. Indicates profit earning capacity. If the ratio is high it means that the owners funds have been invested profitably. To be compared with the ratio in similar units. Trend for the company over a period is to be examined to find out whether the position is improving or deteriorating.

26.4

Net Profit after taxation i) X 100 ii) Tangible net worth iii) iv)

27. LIQUIDITY RATIOS

Current Assets
27.1 -------------------------------

i) ii)

Helps to measure liquidity and financial strength. Care should be taken in interpreting this ratio as: a) It is applied at a single point in time, implying a liquidation approach, rather a judgment on the going concern, for it does not explicitly take into account the revolving nature of current assets and current liabilities.

Current Liabilities CA - Inventory

27.2 ---------------------------------

CL - Bank Borrowing
iii) iv)

The seasonal character of the business resulting in a fluctuating current ratio, is a disturbing factor. Liquidity could be severely affected if current liabilities exceed current assets. The higher the ratio the better the liquidity position.

b)

28. 28.1

SOLVENCY RATIOS Total outside liabilities Tangible net worth i) ii) iii) iv) v) Indicates size of stake, stability and degree of solvency. Indicates how high is the stake of the creditors. Indicates what proportion of the companys finance is represented by the tangible net worth. The lower the ratio the greater the solvency. The ratio is usually higher in case of SMEs, particularly Trade Advances. Still anything over 3 or 4 should be viewed with concern. The ratio should be studied at the peak level of operations.

vi)

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Total term liabilities 28.2 Tangible net worth (Equity to Debt)

i) ii)

Indicates the proportion of owners stake to that of the outsiders, in the long term sources of the company. Anything over 2 is not normally considered good.

MISCELLANCEOUS RATIOS Retained profit X 100 29.1 Net Profit (after tax) Dividend 29.2 Net Profit (after tax) X 100

29.

Indicates prudence of the managers in conserving financial resources and long term strategies of the unit.

i) Annual sales 29.3 Closing stock iii) iv) v) ii)

Indicates the number of times stocks has turned over. A high ratio (good turnover) indicates a good financial management. If the ratio is low, may be a part of the stock is unusable/ unsaleable. To be compared with similar industries Trend for the company over a period should be examined

Trade creditors 29.4 Average monthly credit purchases

i) ii)

Indicates number of months credit received by the company, as on the date of the balance sheet. If the ratio is high, among other things, it may mean a) the company is short of funds b) creditors are allowing more time due to its good financial reputation.

iii)

Trend for the company over a period should be examined. If the company is taking a longer time than it used to do for paying off its dues, it is a warning signal. To be compared with the ratio in similar units.

iv)

Sundry Debtors 29.5 Average monthly credit sales

i) ii) iii)

indicates the number of months credit given by the company as on the date of the balance sheet. A high figure indicates sales on easy terms A low figure indicates, among other things. a) The company is short of funds.

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b) c) d) iv)

Prompt payment by customers The company is able to dictate terms due to exceptionally good quality of its product. The company has an efficient collection mechanism.

Trend for the company over a period should be examined. If the company is allowing less time than it used to do, it may be a warning signal.

i) Raw material stock 29.6 Average monthly consumption

High ratio indicates a) b) c) indiscreet buying presence of unsaleable stocks seasonal stocking

ii) iii) iv)

The nature and availability of raw materials should be examined to correctly interpret the ratio. To be compared with ratio in similar units. Trend for the company over a period should be examined.

Stocks-in process 29.7 Average monthly cost of production Finished goods stock 29.8 Average monthly cost of sales

The carry over should not normally exceed the cost for number of days/weeks corresponding to the duration of the production process.

If it is more than the figure for similar units, the reason for the overstocking should be looked into, as it may be an indicator to non-saleability of the product.

Percentage of Sales increase ADDITIONAL POINT FOR EXAMINATION Trend of sales : The trend of the companys sales for the last 3-5 years will indicate whether the sales have moved forward or backward. Any decline must be enquired into to satisfy that it is purely fortuitous and does not indicate an unhealthy trend.

30. 30.1

STOCK EXCHANGE RATIOS Net Profit (after tax) = No. of shares Indicates to what extent income is available per share, to pay dividend. Earnings per Share : EPS

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Payout Ratio Net Profit (after tax) 30.2 Total Dividend paid (Earnings - cover Ratio) Assesses annual income accruing from the share investment. Earning per share EPS 30.3 Market price of share (Earning -Yield Rate) Enables comparison of Dividend policy and yield. 30.4 Dividend per share X 100 Market price of shares (Dividend-Yield Rate) = = = Indicates the dividend paid to the net income.

FINANCIAL RATIOS USED FOR CREDIT RISK ASSESSMENT 31 Under the CRA system, financial risks in a proposal are sought to be captured through some relevant ratios. Since it is essential for the analysts to understand the significance of these ratios, it is dealt with separately in this chapter. Different ratios are used for assessing risks for extending working capital finance and term loans under CRA system. Also, the ratios used for assessing risk for financing NBFCs are different. Hence, these are discussed under the appropriate headings to facilitate easy understanding. 31.1 Working Capital Finance (All market segments except NBFCs) The following ratios are used for working capital finance: 1. 2. 3. 4. 5. 6. Current Ratio TOL/TNW PBDIT/Interest (times) PAT/Net sales (%) ROCE or ROA (%) (Inventory/ Net Sales + Receivables / Gross Sales) X 365 (Days)

Among the six ratios listed above, the following ratios have not been discussed earlier and hence are discussed below: 31.1.1 PBDIT/ Interest (Times) This is called Interest Coverage ratio. In the current context, the servicing capability of loan obligations is very crucial. This ratio, which indicates the number of times the gross

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earnings cover the interest payable is an indicator of the measure of comfort that profitability provides. * * * Higher Ratio indicates comfortable debt servicing capability from the cash accruals of the company. A ratio of more than 3 is considered comfortable, whereas a ratio of 4 will fetch maximum scores. A ratio of 2 and below is considered risky.

31.1.2 Inventory / Net Sales + Receivables / Gross Sales Expressed in days, this ratio captures the turnaround period of major items of the current asset. * * * * * 31.2 Higher the figure, the slower is the turnaround of current asset and in general higher the risk. This ratio will vary across industries. For assessment of risk, a shorter working capital cycle can be regarded less risky. Specific industry parameters should also be kept in mind while assessing the risk under this ratio. In general, it is expected that the working capital should be turned over at least twice.

For NBFCs, the ratios are 1. 2. 3. 4. 5. 6. 7. 8. Current Ratio TOL/NOF (Total outside Liabilities/Net owned funds) PBDT/Total Assets (%) PAT/Total Income (%) (Total income- Other Non-recurring income)/Interest Expenses (Interest Coverage Ratio) Expenses/ TTA ratio(%) Overdues/Demand Raised Ratio NPA/Total Working Assets Ratio(%)

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31.2.1 TOL / NOF This ratio represents the extent to which the company is leveraged, Net owned funds is used as a reference by RBI for registration and acceptance of deposits from public. NOF represents TNW, less Investment in excess of 10% of owned funds as stipulated by RBI. * * Higher ratio indicates increased dependence on borrowings and other liabilities. A ratio of 3 and below is considered very healthy, while a ratio above 7 is considered risky.

31.2.2 PBDT / Total Assets This ratio is a measure of gross profitability or gross return from the activity of the company. In the CRA models, for manufacturing company, the numerator is PBDIT but in NBFCs interest payment is a major component of cost and is equal to the cost of raw materials in a manufacturing company. So, it is more relevant to take PBDT for NBFCs. * A percentage of more than 10 is considered healthy whereas below 2 is considered risky.

31.2.3 PAT/ Total Income Total Income = Income minus other Non-recurring income. This ratio represents the profitability of operations. Total income from operations may be considered as equal to total sales of a manufacturing company. * A percentage of 11 and above is considered healthy and below 3 is considered risky.

31.2.4 (Total Income- other non-recurring income)/interest expenses The interest coverage ratio in respect of NBFCs is calculated by dividing total income less non-recurring income with interest expenses. This ratio measures the cushion available for meeting interest liability. * A ratio of 3 or more is considered healthy while less than 1 is considered highly risky.

31.2.5 Expenses/TTA ratio This is another efficiency ratio, which measures the efficiency of operations. * A percentage of 8 and below is considered efficient, while 16 and above is very unhealthy.

31.2.6 Overdue/Demand raised ratio This ratio measures collection efficiency. The term overdues represents claim amounts which have not been received till due date.

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A ratio of 1 and below is considered very healthy and more than 5 is considered very risky.

31.2.7 NPA/Total Working Assets Ratio NPAs in this context refer to lease rentals and hire purchase instalments overdue for more than 12 months. 31.3 TERM FINANCE (ALL MARKET SEGMENTS) The following ratios are used for assessing the financial risk in a term loan. For working capital facility the ratios may be actuals or projected depending on whether the companies are existing or new one. For term loans, the ratios are based on projections. Unlike the working capital facilities, all the relevant ratios carry equal weight for risk assessment. 1. 2. 3. 4. Project Debt/Equity Ratio TOL/TNW Gross Average DSCR (Project) Gross Average DSCR (For the whole company for all loans)

Besides the above, terms of repayment are also considered for assessing the risk in a term loan proposal, the longer the period greater the risk. 31.3.1 Project Debt/Equity In general Project Debt/Equity is the most important indicator for assessing risk in term exposure. In case of high gearing, any change in the environment, which affects the viability of the project, will seriously hamper the ability of the Company to service its debt. Hence, this ratio is considered important. o o For high value loans, i.e. for C&I and high value SSI and Agri accounts, the conventional gearing ratio upto 1.5 has been taken as the lowest risk level. The gearing above 2 has been regarded as critical risk area.

31.3.2 Gross Average DSCR (Project) Gross Average DSCR for the project = (PAT + Depreciation and other non-cash expenses + interest on term loan for the project) (Annual term loan instalments for the project + interest on term loans for the project) This ratio analyses the debt servicing capacity of the unit for the particular project. It is important to note that for calculating the average DSCR, the analyst is required to add all the cash accruals over the period of the project and divide them by the repayment obligations over the same period.

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o o

A ratio of 2 and above is considered safe. A ratio below 1.25 is considered risky.

31.3.3 Gross Average DSCR for all the Loans of the Company : This ratio is similar to the Gross Average DSCR for the project, except that it takes into account the cash accruals and repayment obligations for all term loans. When an existing company goes for expansion, the analyst would like to study the impact of the additional cash accruals and repayment obligations arising out of the new project on the Company as a whole. o o A ratio of more than 2 is considered healthy. A ratio below 1.25 is considered risky.

FUNDS FLOW ANALYSIS

32. HISTORICAL PERSPECTIVE 32.1 According to Roy A. Foulka, Funds Flow Statement is a statement of the sources and application of funds, is a technical device designed to highlight the changes in the financial condition of a business enterprise between two dates. In India, the funds flow analysis, in its present form, was not extensively used by the commercial banks for their working capital appraisal, until late sixties, when the National Credit Council Study Group No.11, popularly known as Dehejia Committee came out with its report.. This committee, asked to determine to what extent credit needs of the industry are likely to be inflated, pointed out that the banks did not seek to link credit with industrial output, with the result that end-use of bank credit was not property followed up. As a sequel to this the commercial banks and RBI started looking into their appraisal procedures and thus the funds flow statement came to be regarded as an important component of appraisal for working capital advances. Stated simply, a funds flow statement captures movement of funds to and from the companys coffers. Thus, sources include cash generated by the business after meeting the expenses, increase in owners equity, contracting of additional debt, sale of assets or reduction thereof. Increase in assets, liquidation of loans/other liabilities and reduction in owners equity denote uses. As a management tool for decision making, it discloses to the management, at a glance, as to what its committed outlays are in a given period of time and what the funds availability is for meeting such outlays. It is quite essential for the management to have an idea of the funds flow as, without which, management of capital expenditure and operational expenditure will become a haphazard exercise, leading to defaults in payment obligations of the business or sub optimal utilisation of funds. It is pertinent to mention here about the confusion that may arise about profit and liquidity. Many presume that adequacy of profit is tantamount to an automatic liquidity and vice versa. Nothing can be farther from reality.

32.2

32.3

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32.4

If maximisation of profit is the corporate goal or objective, the consistency of flow of funds into the system can be regarded as a precondition for reaching the goal. While profit generates additional funds, optimum deployment of funds forms the nucleus of the operating cycle in a business which generates additional profits. Despite good amount of profits, a situation of disequilibria can still arise due to wrong financial management decisions affecting the inflow and outflow of funds. A surfeit of this liquidity (funds) affects also the profitability, no doubt, due to non-utilisation, but if the funds tank gets dry, it leads to potential dangers, which, in turn, are capable of forcing the business eventually to insolvency. Thus, sound or prudent management principles dictate measures aimed at optimising profit, but simultaneously, they also enjoin upon the management to properly use the funds such that sufficient liquidity is available to the unit to meet its creditors in time, with neither an overdose of liquidity nor a depletion thereof with all the attendant difficulties. FUNDS FLOW STATEMENT The foregoing paragraphs indicate that the funds flow statement is not simply a fad in which banks indulge so as to satisfy an academic objective, but it is an important tool, in the hands of all users, be it the credit analyst or the corporate management. The basic consideration in the computation of the cash flow or funds flow statement is that some of the expenses reflected in the profit and loss statement do not lead to cash disbursements. It follows, therefore, that the actual cash generated from operations is not just the profit that is disclosed in the income statement but a sum which is an aggregate of profit after tax plus all other non-cash expenses like depreciation, provision for bad debts, amortisation of deferred revenue expenditures etc. FUNDS FLOW ANALYSIS As mentioned in an earlier paragraph, the funds flow analysis depicts the movements in the relative positions of various items of assets and liabilities between two dates. Based on this concept, we may outline the following steps in casting a funds flow statement.

33. 33.1

34. 34.1

Step 1: Add all non-cash outlays or expenses (like provisions for depreciation and bad debts, write-offs of miscellaneous/deferred revenue expenditure and good will/other intangibles, amortisation of leases, etc.) to the net profit after tax, to arrive at cash throw-off from operations. Step 2: Identify all sources of funds which include i) ii) iii) iv) v) vi) Issue of capital stock, Disbursement of term loans, Receipts by issue of debentures and public deposits. Increase in other liabilities (current and deferred), Sale of fixed assets and investments, Reduction in other assets (current and non-current).

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Step 3 :

Identify all uses of funds which include i) ii) iii) iv) v) vi) vii) Cash loss i.e. a loss before providing for non-cash expenses, Capital expenditure, Investment in other companies, etc.. Dividends paid/payable, Redemption of Term Loans and repayments under other liabilities Liquidation of other liabilities (current and deferred) Acquisition of other assets (current and non-current)

Step 4: Separately list the sources and uses and arrive at the net result. A proforma of funds flow statement appears as Annexure-1. 34.2 Basically, as a credit-analyst. we are interested in the following aspect of the financial position of the units financed by us i) ii) Where did the profits go? Was the funds generated (cash accruals) adequate to meet the Companys responsibility to shareholders for declaring appropriate dividends? If the funds were inadequate, how the situation was handled?

iii) When the net income is up, did the net current assets or net working capital go up proportionately? If not, what are the reasons? iv) v) vi) How was the capital expenditure financed? What became of the proceeds of sale of fixed assets and investments? How was the retirement of debt accomplished?

vii) How was the additional capital raised, used? viii) What became of the proceeds of the debenture issue or fixed deposits raised from public? The answers to the above questions are furnished by the funds flow analysis. As purveyors of working capital credit, these aspects are of vital interest to us, since commercial banks have to ensure proper end-use of bank credit towards the purpose for which it was granted and ensure against diversion of bank credit to unapproved purposes. 34.3 In order that we are able to analyse the position from the above angles, the funds flow statement is divided into two portions. While one portion discloses the movement of funds known as long-term account, (comprising long term sources and long term uses), the other reflects the fund flow amongst the current assets and liabilities in the short

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term account. Long term sources are indicated by changes in capital, term liabilities, fixed assets, investments, non current assets and intangible assets between two balance sheet dates. Similarly, short term sources and uses are denoted by the changes in current assets and current liabilities. Surplus of the tong term sources over long term uses results in increase in net working capital equal to the surplus, whereas a deficit of long term sources over long term uses will result in decrease in net working capital by amount of deficit. In case of deficit in long term account, the deficit is, in turn, met by a diversion of short-term funds to long term uses If there is increase in activity level in a unit during a year, it is likely to result in increased holding of current assets as at the end of the year compared to the position in the beginning of the year. In the face of such increases in current assets if the current ratio has to be maintained at the same level as in the beginning of the year, then the net working capital should increase in proportion to the increase in current assets. . Financial propriety dictates that the units management should, in the event of any inadequacy in cash generation, raise adequate long term funds in the shape of share capital, long term loans, etc. to meet fully the long term outlays like capital expenditure, retirement of loans, dividend payment, investment in other companies, acquisition of other non-current assets, etc. In as much as the net working capital is fed by the long term surplus generated in the funds flow, the banker is very particular to see that this surplus is adequate. The adequacy is, of course, determined by factors like the projected build-up of current assets (incremental), bankers conception of the acceptable current ratio and the bankers ability and willingness to provide additional credit to the borrower. 34.4 Thus, funds flow analysis is an integral part of the working capital appraisal, performing a very important task in the gamut of credit assessment. It is a composite and integrated statement that gives, at a glance, the salient features of funds flow and depicts the directional flow of working capital. Used for a retrospective analysis, it feeds us with valuable data about the managements style of functioning, its strengths and weaknesses from which we are enabled to form judgements on the corporate financial policy, financial prudence in planning of funds and overall financial management. On a prospective analysis, it tells us about the managements intention regarding use of funds. Significant and important facets of management functioning, like dividend policy, ploughback policy, growth objectives (expansion or diversification), optimum use of fixed assets through timely capital expenditure programmes for renovation/modernisation of plant and machinery etc. are revealed to us by the funds flow analysis. CASH BUDGET Contrasted with the broad level analysis of a funds flow statement, the cash budget is basically a functional statement, concerning itself with the pure cash management aspect. It is designed to throw light on i) what cash commitments are likely to arise within a short span of time and ii) what cash resources will be available to meet them. For instance, if the Finance Manager has to pay an installment of a term loan to a financial institution within a period of three months, he needs to visualise a cash budget to decide whether he can meet his commitment without any additional bank overdraft. Similarly, the cash budget would be a very useful and handy tool if the banker examining
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35. 35.1

a request from the borrower for opening a Letter of Credit for import of materials, has to decide whether the borrower would be able to meet the usance bill under the letter of credit without any increase in the sanctioned cash credit limit. A cash budget is a simple projection of cash account - usually month-wise indicating cash receipts and cash disbursement. 35.2 For the preparation of a cash budget, we need some information on the units corporate policy in terms of sales, purchases and other payables, other discretionary outlays like capital expenditures, dividends, retirement of debts etc. Following are the parameters for the purpose. i) Terms of sales-cash and credit, with respective ratios, ii) Period of credit allowed and Period of realisation of sundry debtors, iii) Period of credit available on purchases of raw materials, stores and spares, iv) Terms of payment for other expenses/payables. v) Production and sales budget. From these basic parameters and other data on miscellaneous receipts and payments, a cash budget can be drawn up. Proforma of a cash budget appears as Annexure-2. 35.3 As will be readily appreciated, a cash budget can be only as authentic and genuine as the underlying assumptions on which it is based are. Hence, the credit analyst will have to validate the assumptions by relating them to the units past experience and data for their relevance, reasonableness and practicality. However, more than any examination of the figures, the banker has to draw upon his knowledge of borrowers behavioural tendencies for meeting his commitments and experience of past dealings.

CONTRIBUTION AND BREAK EVEN ANALYSIS 36. 36.1 Profit Business organisations have profit as their primary goal and various management decisions (such as product pricing, production levels, expansion, diversification, etc.) are aimed at subserving this goal. Profit, simplistically stated, is the difference between sales realisations and the costs incurred. The profit and loss statements of organisations give details of sales realisations as well as costs. In other words, one could say, Profit = Sales - Costs Profit could, therefore, be increased by increasing sales and by taking steps to see that costs do not increase, at least correspondingly.

36.2

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37. 37.1

Profit and Loss Account: Profit, however, is not directly related to the level of activity or volume of sales of an organisation. Stated differently, profit does not necessarily increase or decrease directly in proportion to the volume of sales. This is because costs consist of various components, all of which do not vary proportionately with sales. There are some components of costs, which vary proportionately, but there are others, which are not dependent on the volume. Types of costs Broadly speaking, costs could be divided into two categories -fixed costs arid variable costs. Fixed Costs Fixed Costs are those costs which tend to remain the same irrespective of the volume of output. In other words, they do not vary when output changes. Factory rent, Managing Directors salary etc. are all examples of Fixed Costs. Fixed Costs are, however, not truly fixed at all times but only over a comparatively shorter time period e.g. a quarter or even over a year. Over a very long period, fixed costs may undergo some changes. Similarly fixed costs remain the same within a well defined range of output, but once a new range is reached the costs change. For example one foreman may be adequate for one shift, but once the organisation decides to operate two shifts, one more foreman may have to be employed and the fixed costs, representing the salary of foremen, would double. Fixed costs are, therefore, referred to as stepped costs also in such cases. Variable casts Variable costs are those costs which do vary in relation to the output. As a result, when output increases, variable costs go up proportionately. Raw materials consumed, stores and spares consumed etc., are examples of variable costs. Semi-variable Casts: There are some costs which are called semi-variable costs or semi-fixed costs. These are hybrid costs made up of a fixed element and a fully variable element. There is a tendency for the costs to vary with output, but the variation is irregular. If costs could be segregated into fixed and variable costs, it becomes easier to study the behaviour of profit in relation to volume. For a very broad understanding and use of contribution analysis, one could divide all costs into two categories only viz, fixed costs and variable costs. In other words, semi-fixed/semi variable costs could be treated as fixed. If such broad analysis should indicate the need for deeper probe into the profitplans, an in-depth study could be made by breaking up such semi-fixed/semi-variable costs into fixed and variable components.

38. 38.1 39. 39.1

39.2

39.3

40. 40.1

41. 41 .1

41 .2

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42. 42.1

Contribution The difference between the sales price and the variable costs is called Contribution. The contribution is the term used to describe this relationship between variable costs and selling price. Contribution = Sales - Variable Costs In view of the fact that variable costs by definition are directly related to sales, the contribution will increase when sales increase and contribution will go down, when sales go down. The two important features of contribution are: a) b) Contribution increases directly in proportion to the volume i.e., there is a linear relationship between the two and if nothing is produced and sold, the variable cost is nil and the loss incurred is equal to fixed costs.

43. 43.1

Importance of contribution in profit planning: As stated earlier, Profit = Sales - Costs In view of the fact that we have now been able to identify that costs consist of two components viz., fixed and variable, the above statement could be restated as under: Profit = Sales - (Variable Costs + Fixed Costs) or Profit =(Sales - Variable Costs)- Fixed Costs Where,

sales variable costs = contribution. or Profit = Contribution - Fixed Costs

In view of the fact that contribution increases directly in relation to sales and as fixed costs by definition remain the same, profit could be maximised by increasing contribution. In other words, organisations should have maximisation of contribution as one of their major goals and various management decisions must subserve this goal. 44. 44.1 Profit Volume Ratio The ratio of contribution to sales turnover is called profit volume ratio (or P/ V ratio). The P/ V ratio is a measure of the rate of contribution made by each rupee of sale out of which fixed expenses must be met. The profit volume ratio thus becomes an important factor in taking various management decisions. If there are two alternatives open to the management as a result of which two profit/volume ratios would emerge, the management would prima facie choose the alternative which gives a higher profit volume ratio.

44.2

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45. 45.1

Profit Projection: Contribution is an important tool in projecting Profits at different levels of activity. Consider the following data :No. of units sold Sales Variable Costs Contribution Fixed Costs Profit Contribution per unit : : : : : : : 100 Rs. 1,000 Rs. Rs. Rs. Rs. Rs. 600 --------400 300 --------100 --------4/If the unit increases sales by 20%, the profit would be as under No.of units sold Sales Variable Costs Contribution Fixed Costs Profit : : : : : : 120 Rs.1,200/Rs. 720/--------Rs. 480/Rs. 300/--------Rs. 180/---------

46. 46.1

Product Pricing Since variable costs of product are directly identifiable with it and would not be incurred without the order, these constitute the floor price beneath which no businessman would be willing to go. The contribution analysis thus helps in pricing decisions and enables the management to sell even below full costs by compensating it with increased volume. Consider the following data where two companies are competing for sale of the same product Company A Fixed Costs Variable Costs Full Cost. 4.00 6.00 10.00 Company B 2.00 8.00 10.00

46.2

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The contribution would vary depending upon the price quoted. Take the following price range Contribution Company A At selling price Rs.10 At selling price Rs. 9 At selling price Rs.7 Ps. 4.00 Ps. 3.00 Ps. 1.00 Company B Ps. 2.00 Ps. 1.00 Negative.

Thus both the companies can afford to sell at Rs.10.00 or Rs.9.00 because such sales still generate contribution towards meeting the fixed cost. At selling price of Rs.7.00,, the company B is priced out of competition in that its contribution becomes negative. If company B accepts the order at Rs.7.00, it will sell itself into liquidation by incurring cash losses-the higher the sales at this price, the higher would be the cash losses too. BREAK-EVEN ANALYSIS 47. Break-even analysis is very much an extension of the contribution analysis. Basically break-even analysis concerns itself in finding the point at which sales realisations and costs agree. The break-even point is, therefore, the volume of output at which neither profit is made nor a loss is incurred. Example Consider the example of a housewife wishing to start a cottage industry of manufacturing jams. The following data is available. Selling price per bottle Variable cost per bottle (i.e. cost of fruits, sugar, flavour, bottle etc.) Contribution per bottle : Rs. 40 : Rs. 24 : Rs. 16

47.1

Assuming that the housewife employs a sales-girl to sell the jam on a salary of Rs.80 per day, it would be necessary for the house-wife to produce and sell at least 5 bottles per day to cover the fixed costs (salary of sales-girl). This, therefore, is the break-even point for the unit. Break-even point can be expressed as a) b) c) Sales revenue-(Rs.200/- per day in the above example) Number of units-(5 bottles) Capacity utilization-(50% assuming 10 bottles of Jam can be produced every day).

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Algebraic formulae: 48. If V S F BE = = = = Variable Cost per unit Sales Price per unit Total Fixed Cost The break-even point (in terms of number of units) then F B E would be S-V (or contribution) The sales turnover at break-even point would be S x B E = S x [ F/(S-V)] Because B E = F/(S-V)

F = -----------(S-V)/S = F/C

(divide numerator & denominator by S) (Where C is the PV ratio)

F --------------------------S-V (or contribution) X Sales

49. Margin of Safety 49.1 Margin of safety is the percentage drop in sales that can occur before a loss starts. This formula is a dramatic way of calling to managements attention how close their sales level is to break-even point. Sales B E sales Margin of Safety =--------------------------------- X 100 Sales The answer is expressed as a percentage Example 49.2. Consider the following data : Sales (S) Variable Costs (r) Contribution (c) Fixed Costs(f) Profit :1000 : 600 --------: 400 : 300 ------: 100 -------

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BE Sales

F ----------------S-V

Sales =

300 -----------------1000 - 600

1000 =

750

Margin of Safety = (Sales - BE Sales )/ Sales = [ (1000 - 750 )/ 1000 ]* 100 = 25% That is, the unit would start incurring losses if sales were to drop by more than 25% compared to present operating level. Contribution Analysis Contribution analysis helps the management in taking decision which would lead to improvement in the profit-structure. In more specific terms, the analysis helps in answering questions like :a) b) c) d) e) f) g) h) i) j) k) How much of product-mix change will lead to increase in profits? What is the most profitable product-line? Which product in each product-line is most profitable? How much should the sales volume increase to offset the cost of additional capital expenditure? What additional volume office/representative? of sales is necessary to justify a new sales

Should the unit manufacture a product or buy it in the market? What savings in direct cost/material cost will justify buying a machine? How should product mix change and/or sales increase to offset a wage increase? How should products be priced for optimum profit - even below full cost? How much must prices be increased to compensate for cost increase? At what additional level of sales a given return on capital could be expected.

50. Conclusion : These and various decisions could be taken with the aid of contribution analysis as a tool. Without proper analysis, profit would not be planned but would only be a hope and may occur by accident. Note : In very exceptional case, items which are normally fixed costs may vary directly in proportion to the volume of sales e.g. in Aluminium industry power is akin to raw material. In such cases, it might be in order to classify these items as variable costs for determining contribution.

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Annexure 1

FUNDS FLOW STATEMENT

(Amount Rs.in lacs) As per balance sheet as at 20x1 Last Yr Aud B.S. 1. SOURCES a) Net Profit (after tax) b) Depreciation c) Increase in capital d) Increase in Term Liabilities(including Public deposits) e) Decrease in i) Fixed Assets ii) Other non-current assets f) Others g) 2. TOTAL 20x2 Current Yr Estimates 20x3 FollowingYr. Projections

USES a) Net loss b) Decrease in Term Liabilities (including Public deposits) c) Increase in : (i) Fixed Assets (ii) Other non-current assets d) Dividend payments e) Others f) T O T A L Long Term Surplus (+) Deficit (-) (1-2) Increase/decrease in current assets* (as per details given below) Increase/decrease in current liabilities other than Bank borrowings Increase/decrease in working capital gap Net surplus (+)/deficit (-) (difference of 3&6) Increase/decrease in Bank borrowings

3. 4. 5. 6. 7. 8.

INCREASE/DECREASE IN NET SALES * Break up of (4) i) Increase/Decrease in Raw Materials ii)Increase/Decrease in Stocks-in-process iii) Increase/Decrease in Finished Goods iv) Increase/decrease in Receivables a) Domestic b) Export v) Increase/Decrease in stores & spares vi) Increase/Decrease in other current assets Note:- Increase/decrease under items 4 to 8, as also under break-up of (4) should be indicated by (+) or (-)

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Annexure 2

PROFORMA OF CASH BUDGET

CASH RECEIPTS
1 I. ii. iii. Cash Sales Realisation of credit sales Other receipts (share capital monies, loan proceeds, fixed deposit receipts, etc.) -----------------------------------------------------------TOTAL RECEIPTS -----------------------------------------------------------2

MONTHS
3 4 5 6

CASH DISBURSEMENT
i. ii. iii. Payments to creditors towards supplies of materials/stores Salaries & Wage payments Other routine production expenses in cash (energy bill, water bill, rent, taxes, duties, Insurance, other payables) Payment to capital creditors (supply of machinery, civil construction, etc.) Advance Income-tax Others (Dividend, Redemption of term debt, repayment of deposits, Investment in other companies, etc.) -----------------------------------------------------------Total disbursements -----------------------------------------------------------Surplus /Deficit Add : Opening cash credit balance closing cash credit balance (cumulative position).

iv.

v. vi.

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3.
GENERAL 1.

WORKING CAPITAL AND ITS ASSESSSMENT

The objective of running any industry is earning profits. An industry will require funds to acquire fixed assets like land, building, plant, machinery, equipments, vehicles, tools etc., and also to run the business i.e. its day to day operations. Funds required for day to-day working will be to finance production and sales. For production, funds are needed for purchase of raw materials/stores/fuel, for employment of labour, for power charges etc., for storing finished goods till they are sold out and for financing the sales by way of sundry debtors/ receivables. Capital or funds required for an industry can therefore be bifurcated as fixed capital and working capital. Working capital in this context is the excess of current assets over current liabilities. Current assets are those assets that in the ordinary course of business will be converted into cash within a brief period (during the operating cycle of the industry and normally not exceeding one year) without undergoing diminution in value and without disrupting the operation. Current liabilities are those liabilities intended at their inception, to be paid in the ordinary course of business within a reasonably short time (normally within a year) out of the current assets or the income of the business. The above definition of working capital, however, takes into account only the funds available to the industry from long term sources like capital and long term borrowings, after meeting the expenses towards fixed and other non-current assets. It does not represent the total funds required by the industry for working capital to sustain its level of operations. The excess of current assets over current liabilities is treated as net working capital or liquid surplus and represents that portion of the working capital which has been provided from the long term source. This can be explained by the following diagram.

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2.

Definition: Working Capital is defined as the funds required to carry the required levels of current assets to enable the unit to carry on its operations at the expected levels uninterruptedly. Thus Working Capital Required (WCR) is dependent on a) The volume of activity (viz. level of operations i.e. Production & Sales) b) The activity carried on viz. mfg process, product, production programme, the materials and marketing mix.

3.

Though there are various methods used for assessing the quantum of Working Capital Requirement for an industry, the following are commonly used.

Methods and Application

SEGMENT

LIMITS

METHOD

SSI

Upto Rs 5 cr Above Rs 5 cr

Traditional Method & Nayak Committee Method Projected Balance Sheet Method

SBF

All loans

Traditional / Projected Annual Turnover Method

C&I Trade & Services

Upto Rs 1 cr

Traditional Method for Trade & Projected Annual

Above Rs 1 cr & upto Rs 5 cr Above Rs 5 cr

Projected Balance Sheet Method & Projected Annual Turnover Method Projected Balance Sheet Method

C&I Industrial Units

Below Rs 25 lacs Rs 25 lacs & over but upto Rs 5 cr Above Rs 5 cr

Traditional Method

Projected Balance Sheet Method & Projected Annual Turnover Method Projected Balance Sheet Method

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Various methods indicated above are discussed in detail. 4. Operating Cycle method 4.l Any manufacturing activity is characterized by a cycle of operations consisting of purchase of raw materials for cash, converting these into finished goods and realising cash by sale of these finished goods.

4.2 Diagrammatically, the operating cycle is represented as under'

4.3 The time that lapses between cash outlay and cash realisation by sale of finished goods and realisation of sundry debtors is known as the length of the operating cycle. 4.4 That is, the operating cycle consists of: a. Time taken to acquire raw materials and average period for which they are in store. b. Conversion process time c. Average period for which finished goods are in store and d. Average collection period of receivables (Sundry Debtors) 4.5 Operating Cycle is also called the cash-to-cash cycle and indicates how cash is converted into raw materials, stocks in process, finished goods, bills(receivables) and finally back to cash. Working capital is the total cash that is circulating in this cycle. Therefore, working capital can be turned over or redeployed after completing the cycle. 4.6 The length of the operating cycle = a+b+c+d ( as in 4.4) If a b c d = = = = 60 days 10 days 20 days 30 days

The operating cycle is 120 days (nearly 4 months). This means that there are 365/120 = 3 cycles of operations in a year. Let us consider a case where, the length of the operating cycle is 4 months, (i.e. 3 cycles in a year).
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Sales Operating expenses

= =

Rs.1,00,000 per annum Rs. 72,000 per annum

But the working capital requirement, as you know, is not Rs.72,000. In this case, there are 3 operating cycles in a year. That means each rupee of Working Capital deployed in the unit is turned over 3 times in a year. (This is also known as working capital turnover ratio). Operating Expenses Rs.72,000/therefore WCR = = = No. of cycles per annum 3 WCR is therefore not Rs. 72000/- but only Rs.24,000/4.7 Factors, which influence Working Capital Requirement, are: a. Level of operating expenses & b. Length of operating cycle. any reduction in either (a) or (b) will mean reduction in working capital requirement and indicate an efficient working capital management. In the aforesaid example, suppose the length of the operating cycle is reduced as under : a = 30 days b c d = = = 10 days 20 days 30 days Rs. 24,000/-

Total length of operating cycle = 90 days This is the Working capital turnover ratio (No. of operating cycles per year is 365/90 =4.) So, WCR = Rs. 72000/4 = Rs. 18000/-. 4.8 It can thus be concluded that by improving the Working Capital Turnover Ratio (i.e. by reducing the length of operating cycle) a better management (utilisation) of Working Capital results. It is obvious that any reduction in the length of the operating cycle can be achieved only by better management of one or more of the individual phases of the operating cycle period for which raw materials are in store, conversion process time, period for which finished goods are in store and collection period of receivables, Looking at the whole problem from another angle, we find that we can set up extremely clear guidelines for working capital management viz. examining the length of each of the phases of the operating cycle to assess the scope for reduction in one or more of these phases. This, in turn, would lead to improved productivity and better management in a wide variety of operational activities ranging from inventory control and production planning to marketing and credit management. The length of the operating cycle is different from industry to industry and from one firm to
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another within the same industry. For instance, the operating cycle of a pharmaceutical unit would be quite different from one engaged in the manufacture of machine tools. The operating cycle concept enables us to assess the working capital need of each enterprise keeping in view the peculiarities of the industry it is engaged in and its scale of operations. Operating cycle is an important management tool in decision-making. 4.9 Assessment of Working Capital Requirement and Permissible Bank Finance using Operating Cycle Concept Let us consider a case of a unit where: Sales = Raw Materials Wages Other manufacturing Expenses Total expenses Profit The operating cycle is Raw Materials Stock in process FG Sundry Debtors The total length of Operating cycle BxD WCR = = 30 = 35 days (D) 19,000 x 35 = 30 = = = = = = = Rs. 3,000 p.m. Rs. 19,000 p.m. (B) Rs. 1,000 p.m. (C) 15 days 2 days 3 days 15 days = = Rs. 20,000 p.m. (A) Rs. 14,000 p.m. Rs. 2,000 p.m.

Rs. 22,166/- (approx.)

Where B=Operating Expenses; and D= Length of Operating Cycle Traditional Method of Assessment of Working Capital Requirement The operating cycle concept serves to identify the areas requiring improvement for the purpose of control and performance review. But, as bankers, we require a more detailed analysis to assess the various components of working capital requirement viz., finance for stocks, bills etc. Bankers provide working capital finance for holding an acceptable level of current assets, viz. raw materials, stocks-in-process, finished goods and sundry debtors for achieving a predetermined level of production and sales. Quantification of these funds required to be blocked in each of these items of current assets at any time will, therefore provide a measure of the working capital requirement (WCR) of an industry. 5.1 Raw Materials: Any industrial unit has to necessarily stock a minimum quantum of materials used in its production to ensure uninterrupted production. Factors which affect or influence the funds requirement for holding raw materials are :
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i. ii.

Average consumption of raw materials. Their availability - locally or from places outside, easy availability / scarcity, number of sources of supply. iii. Time taken to procure raw materials (procurement time or lead time) iv. Imported or indigenous. v. Minimum quantity supplied by the market (Minimum Order Quantity (MOQ)). vi. Cost of holding stocks (e.g. insurance, storage, interest) vii. Criticality of the item. viii. Transport and other charges (Economic Order Quantity (EOQ)). ix. Availability on credit or against advance payment in cash x. Seasonality of the materials. This raw material requirement is generally expressed as so many months requirement (consumption). 5.2 Stocks-in-process : Barring a few exceptional types of industries, when the raw materials get converted into finished products within a few hours, there is normally a time lag or delay or period of processing only after which the raw materials get converted into finished product. During this period of processing, the raw materials are being processed and expenses are being incurred. The period of processing may vary from a few hours to a number of months and unit will be blocking working funds in the stocks-in-process during this period. Such funds blocked in SIP depend on: i. ii. iii. iv. v. The processing time Number of products handled at a time in the process Average quantities of each product, processed at each time. (batch quantity) The process technology adopted Number of shifts

A rough and ready formula for computing the requirement of funds is to find out the cost of production for the period of processing. viz. (raw materials consumed per month + expenses per month) x period of processing in months. 5.3 Finished goods: All products manufactured by an industry are not sold immediately. It will be necessary to stock certain amount of goods pending sale. This stocking depends on: i. ii. iii. iv. v. vi. vii. viii. ix. Whether the manufacture is against firm order or against anticipated order Supply terms Minimum quantity that can be despatched Transport availability and transport cost Pre-despatch Inspection Seasonality of goods Variation in demand Peak level/ low level of operations Marketing arrangement (wholesalers). e.g. direct sale to consumers or through dealers

The requirement of funds against finished goods is expressed as so many months cost of production.
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5.4. Sundry Debtors (Receivables) : Sales may be effected under three different methods: a. Against Advance Payment b. Against Cash c. On Credit In the case of (a) no funds are blocked up. Instead it helps in meeting the working capital needs. In case of Cash Sales (b) no funds are blocked up and hence there is no need for additional working capital requirement. It is in the case of (c) credit sales that working funds are required to meet delays in sales realisation. The entire sales of the industry will not be on cash basis. In fact a major portion will be on credit. A unit grants trade credit because it expects this investment to be profitable. It would be in the form of sales expansion and fresh customers or it could be in the form of retention of existing customers. The extent of credit given by the industry normally depends upon: i. Trade Practices ii. Market conditions iii. Whether it is a bulk purchase by the buyer. iv. Seasonality (e.g. rain coats, woolen products). v. Price advantage. Even in cases where no credit is extended to buyers, the transit time for the goods to reach the buyer may take some time and till the cash is received back, the unit will have to be out of funds. The period from the time of sale to the receipt of funds will have to be reckoned for the purpose of quantifying the funds blocked in Sundry Debtors. Even through the amount of Sundry Debtors according to the units books will be on the basis of Sale price, the actual amount blocked will be only the cost of production of the materials against which credit has been extended - the difference being the units profit margin - (which the unit does not obviously have to spend). The working capital requirement against Sundry Debtors will therefore be computed on the basis of cost of production (whereas the permissible Bank Finance will be computed on the basis of sale value since profit margin varies from product to product and buyer to buyer and cannot be uniformly segregated from the sale value). The working capital requirement is normally expressed as so many months cost of production. 5.5 Expenses : It is customary in assessing the working capital requirement of industries, to provide for one months expenses also. A question might be raised as to why expenses should be taken separately, whereas at every stage the funds required to be blocked had been taken into account. This amount is provided merely as a cushion, to take care of temporary bottlenecks and to enable the unit to meet expenses when they fall due. Normally one month total expenses, direct and indirect, salaries etc. are taken into account. In cases where the operating cycle is very short say one month or 2 months the provision for expenses can be reduced. Similarly, where the operating cycle is very long, say 12 months or more, the provision for expenses may have to be increased, to take care of contingencies. While computing the working capital requirements of a unit, it will be necessary to take into account two other factors, one is the credit received on purchases. Trade Credit is a normal practice in trading circles. The period of such credit will vary from place to place, material to material and person to person. The amount of credit received on purchases reduces the working capital funds required by the unit. Secondly, industries often receive advance against orders placed for their products. The buyers, in certain cases, have to
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necessarily give advance to producers e.g. Custom-made machinery. Such funds are used for the working capital of an industry. It can thus be summarised as follows: 1. Raw Materials Months requirements Rs. A 2. 3. Stocks-in- Process Months (Cost of (for Period of Processing) Production) Finished Goods Months cost of production required to be stocked Months cost of production (outstanding credits) One month(say) Rs. B Rs. C

4. 5.

Sundry Debtors Expenses

Rs. D Rs. E -----------------A+B+C+D+E -------------------

Less: Credit received on purchases (Months Purchases value) Advance payment on order received Working Capital Required (H)

Rs. F Rs.G

= (A+B+C+D+E) - (F+G)

The purpose of assessing the W/C requirement of the industry is to determine how the total requirements of funds will be met. The two sources for meeting these requirements are the units long term sources (like capital and long term borrowings) and the short term borrowings from banks. The long term resources available to the unit is called the liquid surplus or Net Working Capital (NWC). To explain its term, let us visualise the process of setting up of industry. The unit starts with a certain amount of capital which will not normally be sufficient even to meet the cost of fixed assets. The unit, therefore, arranges for a long term loan from a financial institution or a bank towards a part of the cost of fixed assets. From these two sources after meeting the cost of fixed assets some funds remain to be used for working capital. This amount is the Net Working Capital or Liquid Surplus and will be one of the sources of meeting the working capital requirements. The remaining funds for working capital have to be raised from banks. Banks normally provide working capital finance by way of advances against stocks and sundry debtors. Banks, however, do not finance the full amount of funds required for carrying inventories and receivables; and normally insist on the stake of the enterprise at every stage, by way of margins. Bank finance is normally restricted to the amount of funds locked up less a certain percentage of margin. Margins are imposed with a view to have adequate stake of the promoter in the business both to ensure his adequate interest in the business and to act as a bulwark against any shocks that the business may sustain. The margins stipulated will depend on various factors like saleability, quality, durability, price fluctuations in the market for the commodity etc. Taking into account the total working capital requirement as assessed earlier, the permissible limit, up to which the bank finance can be granted is arrived at as shown below:

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Permissible Limit Raw Materials Less: % margin Stocks-in-process Less:% Margin Finished goods Less:% Margin Sundry Debtors (at sale value) Less: % margin Total Permissible limit Rs. Rs. P Rs. Rs. Q Rs. Rs. R Rs. Rs. S (P+Q+R+S) T

P+Q+R will indicate the total limit against stocks and S the limit against sundry debtors or receivables in the form of bills, the difference between the working capital requirement (H) and the total permissible bank borrowing (T) should be met from the liquid surplus or NWC. When the liquid surplus is not sufficient to meet the long term working capital requirements, there will be a deficit in meeting the units working capital requirements. It will be necessary for the unit to either arrange to meet the funds from borrowings or arrange for more short term funds from bank, by reduction in margins temporarily or availing separate advances to be repaid out of the units future profits. Let us take a look at the working capital funds required by a unit and the source from which these are met. Working Capital Requirements 1. 2. 3. 4. Raw materials and stores Stock-in-process Finished Goods (Inventories) Sundry Debtors Sources Sundry creditors for purchase Advance payments received Liquid surplus or net working capital Short term bank borrowings against stocks and receivables 5. Cash for expenses

While granting working capital advances to a unit, it will be necessary to ensure that a reasonable proportion of the working capital is met from the long term sources viz. liquidsurplus. Normally, the liquid surplus or net working capital should be at least 25% of the working capital requirement (corresponding to the benchmark current ratio of 1.33), though this may vary depending on the nature of industry/ trade and business conditions. The format in which the Bank assesses the working capital requirement and the permissible limit of Bank finance under Traditional Method is shown below:
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Assessment of Working Capital Requirements Name of the Unit: M/s ABC Limited @ Anticipated monthly sales @@ Cost of production per month Cost of raw materials per month Item i) ii) iii) iv) v) vi) vii) Imported raw material Indigenous raw material Work in process Finished goods Receivables (at sale value) Expenses Total Less : Advance Payment recd Credit on purchase Working capital required Sources Liquid surplus in Balance Sheet as at the end of last year Limits from Bank Total Net deficit (C D) 20 195 215 (D) 5 Stocking / Payment Period ----1 month 2 weeks 2 weeks 1 month 1 months (Rs in 000s) Rs.100 Rs. 90 Rs. 80 Working Capital Required ----80 45 45 90 10 270 (A) (A - B) Margin % ----25 25 25 33 100 10.00 40.00 270-50 Amt. ----20.00 11.00 11.00 23.00 10.00 75.00 50.00 220.00 Permissible Limit ----60.00 34.00 34.00 67.00 --195.00 (B) ( C)

How the deficit will be met: Deficit will have to be met by plough back of profits or unsecured loans. Deficit should be reasonably small when compared to the working capital requirements/ bank finance/ profitability of the unit. Note: @ Sales to be computed at the maximum level of anticipated production during the next 12 months. @@ Cost of production includes cost of raw materials plus all expenses. Receivables under Working Capital Required is stated at cost, and, under Permissible Limit value thereof is at sale value less margin. For items (iii), and (iv), the basis of calculation would be the cost of production. Net Working Capital Deficit, if any, in the balance sheet, is to be added to working capital requirement. Since the limits will be arrived on the projections given by the unit, the assumptions and presumptions made by the unit should be properly analysed before sanction of the limit.

6.1 Projected Annual Turnover Method for SSI units (Nayak Committee) For SSI units which enjoy fund based working capital limits up to Rs.5 cr, the minimum working capital limit should be fixed on the basis of projected annual turnover. 25% of the output or annual turnover value should be computed as the quantum of working capital required by such unit .The unit should be required to bring in 5% of their annual turnover as margin money and the Bank shall provide 20% of the turnover as working capital finance. Nayak committee Guidelines correspond to working capital limits as per the Operating Cycle method

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where the average production / processing cycle is taken to be 3 months (i.e. working capital would be turned over 4 times in a year). Example : Anticipated annual output Working capital requirement @ 25% of A (Rs. in 000s) : : 1200 300 A B

Less: Liquid surplus or 5% of A whichever is higher (Liquid Surplus, say, is Rs. 20,000) : Minimum Permissible Bank Finance (B-C) :

60 240

IMPORTANT CLARIFICATIONS : i. The assessment of WC limits should be done both as per projected turnover method and the Traditional Method, wherever applicable as given in the Table on Methods and Application; and the higher of the two is to be sanctioned as credit limit. If the credit requirement based on production/processing cycle or Projected Balance Sheet Method is higher than the one assessed under Nayak Committee Method, the same (meaning that the limit arrived as per Traditional/PBS method) may be sanctioned, as Nayak Committee guidelines stipulate bank finance at a minimum of 20% of the projected turnover. On the other hand, if the assessed credit requirement is lower than the one assessed under Nayak Committee method, while the credit limit can be sanctioned at 20% of the turnover, actual drawals may be allowed on the basis of drawing power to be determined by the banks after excluding unpaid stocks. If the operating cycle is more than three months, there is no restriction on extending finance at more than 20% of the turnover provided that the borrower should bring in proportionally higher stake in relation to his requirement of bank finance. The projected turnover/output value may be interpreted as projected gross sales which will include excise duty also. While the approach of extending need based credit will be kept in mind, the financial strengths of the unit is also important, the later aspect assumes greater significance so as to take care of the quality of banks assets. The margin requirement, as a general rule, should not be diluted.

ii.

iii. iv.

6.2. Appraisal i. It is to be ensured that the projected annual turnover is reasonable and achievable by the unit and further, the estimated growth if any over the previous year is realistic.

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ii.

The returns filed with statutory authorities may be useful guiding documents for verification of sales & assessment of reasonableness of the projections. The entire sale proceeds should be routed through the Cash Credit account of the bank. Date of actual sales pertaining to the last five years, estimated for the current year, and projected for the next year, together with the trend analysis of the industry to which the unit belongs, would also be useful while appraising the sales projections. Other information regarding modernisation, expansion of the existing manufacturing capacity, government policies, taxation and other relevant internal and external factors also need to be taken into account. Any projection say beyond 15% of the previous year actuals or current year estimates would need closer look. SUBLIMITS The fixing of the limits against the stocks receivables etc will be decided as warranted. MARGINS

iii. iv.

v.

vi.

i.

The SSI units, would be required to bring in 5% of their annual turnover as their margin money for meeting the working capital. The margin will be 1/5th of the working capital required, except in cases of units financed under Entrepreneur scheme and sick units. If however, excess liquid surplus is available, the proportion of the borrowers margins to the bank finance may be higher than the 1:4 ratio stipulated. Besides the liquid surplus as above, the units debt-equity ratio should be within the acceptable range. Sundry creditors, and advance payments received will not be reckoned towards margin of 5%. mentioned above. DRAWING POWER

ii. iii. iv.

i.

Drawings in the account will be regulated as per drawing power arrived at, after providing for the security margin. However sales data should be obtained every month and compared with the projections. The data on actual turnover is for follow up only and not for regulating the drawings.

ii.

Sundry Creditors These will be treated as among the sources of funds required for building up the current assets. Seasonal Industries The peculiarity of the particular industry has to be taken into account. In case of seasonal industries, the peak season, and off-season turnover instead of annual turnover can be separately considered for determining the respective 20% turnover level.
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6.3

Projected Annual Turnover Method for C & I industrial units (limits upto Rs 5 cr)

Bank has decided to extend Nayak Committee approach for assessment of limits to C&I industrial units requiring credit limits upto Rs.5 cr. That is, credit requirement up to Rs.5 crores of C&I borrowers (industrial units) may be assessed at a minimum of 20% of projected annual turnover. In other words, the working capital requirement will be assessed at 25% of projected annual turnover, of which 5% should be borne by entrepreneur as margin and 20% would be allowed as Bank Drawings. While accepting projected annual sales turnover, a cap of 25% over actual annual sales turnover in the immediately preceding year should be set, except where production capacity has been substantially increased. 6.4 Projected Annual Turnover Method for Business Enterprises in Trade & Services Sector : i) For working Capital limits up to Rs. 5 cr to C&I(Trade) sector, the assessment of credit limit is to be based upon annual turnover. Thus, an across the board credit limit equal to 15% of projected annual turnover be offered to business enterprises in the T&S sector. It would be available for utilization generally as a cash credit limit. However, where needed an LC limit (as a sub-limit of total), may also be allowed. ii) The credit limit would be secured by hypothecation charge on the current assets of the enterprise. Periodical stock statements are to be obtained and margin of 25% be retained. iii) Credit limits under this assessment method may be offered to established (at least 3 years old) profit making business enterprises, eligible for credit rating of SB-4 and above. Mortgage of property valued at least at 33% of the limit is to be prescribed. Further, an interest rebate of 0.50% p.a. may be given to borrowers who offer mortgage of property valued at over 75% of the credit limit. iv) While accepting projected annual sales turnover, a cap of 25% over actual annual sales turnover in the immediately preceding year should be set. When circumstances warrant its breach, reasons therefor should be recorded. v) Where borrowers indicate need for credit limits which are higher than the amount indicated above, assessment under the traditional PBS method may be resorted to. TANDON AND CHORE COMMITTEE RECOMMENDATIONS

7.

Till the year 1996-97, banks in India were following the concept of Maximum Permissible Bank Finance (MPBF) for working capital limits, as enunciated in Tandon Committee and Chore Committee Reports. In the monetary and credit policy for the first half of 97-98, RBI announced withdrawal of their guidelines on assessment of working capital finance based on the MPBF concept. State Bank of India felt that many aspects of the CMA (Credit Monitoring Arrangement) followed till then, were based on sound principles of lending. Hence, while there was a need to continue to adopt these, certain flexibility was required to be brought into the method to avoid any rigid approach to fixing the quantum of finance. In the area of supervision, there was a need to rationalize the existing financial follows up procedure. As a consequence, the bank adopted the Projected Balance Sheet method in the second half of the year 1997-98 onwards. Before we discuss this method, it would be useful to understand the earlier concept of MPBF.
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7.1 MPBF METHOD The Tandon Committee was appointed to suggest a method for assessing the working capital requirements and the quantum of bank finance. Since at that time, there was scarcity of banks resources, the Committee was also asked to suggest norms for carrying current assets in different industries so that bank finance was not drawn more than the minimum required level. The Committee was also asked to devise an information system that would provide, periodically, operational data, business forecasts, production plan and the resultant credit needs of units. Chore Committee, which was appointed later, further refined the approach to working capital assessment. The MPBF method is the fall out of the recommendations made by Tandon and Chore Committees. Tandon Committee also recommended inventory/ receivable norms for 22 major industries. 7.2 Approach to lending Regarding approach to lending, the Committee suggested three methods for assessment of working capital requirements. FIRST METHOD The quantum of banks short-term advances will be restricted to 75% of working capital gap where working capital gap is equal to Current Assets minus Current Liabilities Other Than Bank Borrowings. Remaining 25% is to be met from long-term sources (Net Working Capital) SECOND METHOD Net Working Capital should at least be equal to 25% of total value of acceptable level of current assets. The remaining 75% should first be financed by Other Current Liabilities (OCL) and the bank may finance balance of the requirements. THIRD METHOD The borrower should provide for entire core current assets and 25% balance current assets from the Net Working Capital. To compute the level of working capital requirement of the unit, the analyst has to assess the level of current assets it has to carry, consistent with its projected level of production and sales. Inventory and receivables constitute most of the current assets. On the basis of the Committee report, RBI gave inventory norms and advised the banks to decide the levels of inventory and receivables taking into account, production, processing cycles and other relevant factors.

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Sources financing the acceptable level of Current Assets Credit on purchases & Other Current Liabilities (Excluding Bank Borrowing) Net Working Capital (NWC) Bank Borrowing (BB)

Net Working Capital= Long term sources- Long term uses. NWC= (TNW+TL) - (FA+Non-current Assets), which is equal to CA-CL. Working Capital Gap (WCG)= CA (OCL + Sundry Creditors).
Example: Method I Method II Method III ------------------------------------------------------------------------------------------------------------------------------------------200 Current Assets 200 Current Assets 200 Current Assets Other Current Liabilities Working capital gap 25% of this from long-term sources of the borrower 40 160 40 25% of this from long-term sources Difference Other Current Liabilities 50 150 40 Core current assets (say) Real current assets 25% of this from long-term sources of the borrower Difference Other Current Liabilities Maximum Permissible Maximum Permissible Bank Finance Minimum net w.c. Current Assets Current Liabilities Current Ratio (min) 110 50 200 150 1.33 Maximum Permissible Bank Finance Minimum net w.c. Current Assets Current Liabilities Current Ratio 68 92 200 108 1.85 108 40 56 144 36

Bank Finance 120 Minimum net w.c. (CA-CL) 40 Current Assets Current Liabilities Current Ratio (min) 200 160 1.25

Where in the case of a unit, Bank borrowings exceeded the maximum MPBF, the difference was treated as Excess Borrowings. Excess borrowings can be of two types: (a) those arising from a build-up of excess inventory/ receivables over the stipulated norms; and (b) those arising from a shortfall in the NWC of the unit. While type (a) can be adjusted by a liquidation of the excess Current Assets, type (b) can be adjusted by fresh capital/ future cash accrual/ long term borrowings. Till such adjustment took place, the Excess Drawings were converted into a Working Capital Term Loan repayable over a period of, say, three years.
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The computation of Bank finance is facilitated by CMA forms prescribed by RBI .The format provides, a fund of information/ data to the banker in respect of the past, present and future financial position of borrower. CMA formats are used in the Projected Balance Sheet method also. 8. Projected Balance Sheet Method (PBS)

The PBS method of assessment will be applicable to all C& I borrowers who are engaged in manufacturing, services, and trading activities, including merchant exports and who require fund based working capital finance of Rs. 25 lacs and above. In the case of SSI borrowers, who require working capital credit limit up to Rs.5 cr, the limit shall be computed on the basis of Nayak Committee formula as well as that based on production and operating cycle of the unit and the higher of the two may be sanctioned. Fund based working capital credit limits beyond Rs 5 cr for SSI units shall be computed in the same way as for C&I units. For business enterprises in Trade and Services Sector, where the projected turnover method as mentioned in paragraph 6.4 above is not applicable, PBS method shall be followed. 8.1 In the Projected Balance Sheet (PBS) method, the borrowers total business operations, financial position, management capabilities etc. are analysed in detail to assess the working capital finance required and to evaluate the overall risk of the exposure. The following financial analysis is also to be carried out: (a) Analysis of the borrowers Profit and Loss account, Balance Sheet, Funds Flow etc. for the past periods is done to examine the profitability, financial position, financial management, etc. in the business. Detailed scrutiny and validation of the projected income and expense in the business, and projected changes in the financial position (sources and uses of funds) are carried out to examine if these are acceptable from the angle of liquidity, overall gearing, efficiency of operations etc..

(b)

8.2 There will not be a prescription like mandatory minimum current ratio or maximum level of a current asset (inventory and receivables holding level norms) under PBS method. Under the PBS method, assessment of WC requirement will be carried out in respect of each borrower with proper examination of all parameters relevant to the borrower and their acceptability. The assessment procedure is as follows: Collection of financial information from the borrower Classification of current assets(CA) / current liabilities (CL) Verification of projected levels of inventory / receivables / sundry creditors Evaluation of liquidity in the business operation Validation of bank finance sought Assessment of limits for purchase of bills drawn under Letters of Credit (LCs) Fixing of sub limits,

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8.3 Collection of financial data For working capital assessment, the required financial data are obtained from the borrower in the following forms: Form I : Particulars of existing / proposed limits from the banking system Form II : Operating statement Form Ill : Analysis of balance sheet Form IV : Comparative Statement of CA / CL, Form VI: Funds flows statement. Information provided in the Forms II, III. IV, and VI serves the detailed financial analysis. In Form I, in addition to information relating to working capital and term loan borrowings (existing and proposed) information regarding borrowings from NBFCs, borrowings from term leading institutions for WC purposes, Inter Corporate Deposits taken, lease finance availed will also be collected. In addition a borrower also has to provide balance sheet projections as on an intermediate date for fixing limits needed at the peak level of operations. In respect of traders and merchant exporter who required bank finance of Rs. 100 lacs and above, data will be collected in the CMA forms applicable to them.. 8.4 CLASSIFICATION OF CURRENT ASSETS AND CURRENT LIABILITIES ( Form Ill Analysis of Balance Sheet) : From the data presented in published balance sheet of a borrower, their Current Assets and Current Liabilities are analysed as per the classification given in Form III. The classification is done to arrive at the current ratio and net working capital of the borrowers to evaluate their liquidity. Broadly speaking, current liabilities would include items payable or expected to be turned over within one year from the date of balance sheet and the term is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing resources properly classified as current assets or the creation of other current liabilities. The term current assets is used to designate cash and other assets or resources commonly identified as those which are reasonably expected to be realised in cash or sold or consumed or turned over during the operating cycle of the business usually not exceeding one year. 1). Current Liabilities would include estimated or accrued amounts which are anticipated to cover expenditure within the year. Known obligations, the amount of which can he determined only approximately, as for example, provisions, accrued bonus payment, taxes etc., are also classified as current liabilities. In cases where specific provisions have not been made for these liabilities and will be eventually paid out of general reserves, estimated amounts should be shown as current liabilities.

2).

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3). 4). 5).

Investments in shares and advances to the firms/companies, not connected with the business of the borrowing firm should be excluded from current assets. Dead Inventory i.e. slow moving or obsolete items should not be classified as current assets. Amounts representing inter-connected company transactions should be treated as current only after examining the nature of transactions and merits of the case. For example, advance paid for suppliers for a period more than the normal trade practice, in spite of any other considerations such as regular and assured supply should not be considered as current. Advance/ progress payments from customers Where on account of different accounting procedure progress payments received are shown on the liabilities side without deduction from work in progress, the progress payments may be set off against work-in-process. Outstanding advance payments received are to be reckoned as current liabilities or otherwise, depending upon whether they are adjustable within a year, or later.

6).

7).

Deposits from dealers selling agents etc. These deposits may be treated as term liabilities irrespective of their tenure if such deposits are accepted to be repayable only when the dealership/ agency is terminated. The deposits which do not satisfy the above condition should continue to be classified as current liabilities. Security deposits/ Tender deposits made by the unit may be classified as non-current assets.

8).

Provision for taxation Netting of tax provision and advance tax paid may be effected for all the years uniformly and, as such, for the current year also the advances tax paid can be set off against the provision, if any made for that year

9).

Sales-tax, excise etc. Provision for disputed excise duty, for example, should be classified as current liability, unless the amount is payable in installments spread over a period exceeding one year as per the orders of competent authority like the Excise Department or in terms of the directions of a competent court. In such cases, if the installments payable after one year are classified as long-term liability, no objection may be taken to such classification. Where the provision made for disputed excise duty is invested separately say in fixed deposits with banks, such provision may be set off against the relative investment.

10).

Other consumable spares Projected levels of spares on the basis of past experience but not exceeding 12 months consumption of imported items and 9 months consumption for indigenous items may be treated as current assets for the purpose of assessment of working capital requirements. Bills negotiated under L/Cs : The facility for purchase of demand and usance bills drawn under LCs will be computed outside the main assessment of working capital finance. Therefore, receivables in the form of sale bills (inland / export) drawn under LCs need not be included in Current Assets in Form III. Correspondingly, bank borrowings in the form of LC bill purchase limits will not be included in the projected bank finance under Current
128

11)

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Liabilities. Bank finance through LC bill purchased will, however, be shown separately as contingent liability (item B iv) under the additional information in Form Ill. 12) 13) Cash margin for LCs and Guarantees: Margins deposited for LCs and Guarantees relating to working capital will be included in the Current Assets. Investments: Fixed deposits with banks and trustee securities are to be classified as Current Assets. In addition, temporary investments of a borrower in SBIMF, and money market instruments like MMME, CP, CD etc. which are for the purpose of parking short term surplus will also be classified as current assets. All other investments like lnter Corporate Deposits, investments in shares and debentures (including investments in subsidiaries and associates) will be classified as non current assets. (ICDs placed with others should also be shown separately as item C under additional information in Form Ill). ICD taken : This will be part of current liabilities classified under item 2 (short term borrowings from others) in Form III. It should also be shown separately as item D under additional information in Form III.

14)

8.5 Verification of levels of Inventory/ Receivables/ Sundry Creditors: Projected levels of inventory and receivables are to be examined in the assessment exercise in relation to the trend of past levels, and inter firm comparison of the level & industry average. In the case of creditors, past trend and inter firm comparison serve as the basis for the verification. Under the PBS method, the projected levels of inventory, receivables and creditors for purchases will be examined with reference to the borrowers specific operational strengths and weaknesses, their need to hold the Current Assets at the levels projected, and their ability to absorb cost of carrying inventory / receivables at the levels proposed. In the cases where the projections of Current Assets reflect excessive and inefficient levels of inventory and receivables, or where the projected level of creditors is low and does not bear adequate explanation, the question of revising the projected values of Current Assets and Current Liabilities will arise and will have to be discussed with the borrower thoroughly. 8.6 Evaluation of Liquidity 1). In the assessment of working capital finance, the projected level of liquidity in a borrowers business is accepted usually if the Current Ratio(CR) projected is 1.33 or more. The Current Ratio of 1.33 will, however, be considered as a bench mark level of liquidity instead of as the minimum acceptable level. In cases where the CR is projected at a level lower than the bench mark or a slippage in the CR is proposed, this alone will not be a reason for rejection of the loan proposal or for sanction of the loan at a lower level. In each such case, the reasons for low CR or slippage should be carefully examined and in deserving cases the CR as projected may be accepted. For this, among others, the following aspects of the business should be examined to see whether or not the projected CR is acceptable:

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(i)

The size of the operations, the nature of the working capital cycle, and the overall financial position of the borrower : Normally the liquidity to be maintained in large scale operations involving longer and multistage working capital cycles will be higher than the liquidity required for smaller operations with shorter working capital cycles. Term Loan Installments falling due for payment in the next 12 months: In some cases the lower level CR may be due to large amount of term loan installments falling due next year being classified as Current Liabilities. In such cases the low CR need not be seen as a problem, if the borrowers cash accruals are adequate to service the installments due next year.

(ii)

(iii) Export oriented units: For predominantly export oriented units, the projected low CR may be accepted provided the profitability and cash flow are satisfactory. 2). For an existing borrower, where a lower CR is projected, there is a need to examine further, the overall quality of management of liquidity in the business in the past, before a final view is taken regarding the projected liquidity. For such examination a number of aspects of management of liquidity in the borrowers business should be looked into. After such an examination a view should be taken as to whether or not the liquidity management is of a good order and whether the projected CR is acceptable. An illustrative list of the various aspects of liquidity management in a borrowers business is given below: (i) Whether cheques drawn on the cash credit/ current accounts were referred due to insufficiency of Drawing Power/ funds: if so, how frequently and for what reasons this happened. Extent of devolvement of bills drawn under LC s opened by the borrower.

(ii)

(iii) Frequency and nature of irregularities in the accounts and how these were set right. (iv) Payment record in respect of inward bills (like Local Short Credits). (v) Running up of current Liabilities, especially statutory dues (to be seen from Monthly Select Operational Data, Financial Follow-up Reports and Balance Sheet)

(vi) Signs of lengthening working capital cycle (to be seen from stock statements) (vii) Resort to outside borrowings (to be seen from Financial Follow-up Reports and Balance Sheet) (viii) Adverse changes in the terms of purchases (reduction in credit period, switch from credit terms to cash on delivery [COD], denial of credit, etc.) (ix) Status of the term obligations (extent of overdues, reschedulement requests made) (x) Cost or time overrun in projects undertaken by the borrower : whether these had occurred, and if so, how these are managed.

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(xi) Market reports, if any, on the borrowers payment record. (xii) Any other transaction/ financial information indicative of the liquidity status of the borrower. 3). In the cases where projected Current Ratio is found acceptable, working capital finance as requested may be sanctioned. In specific cases where warranted, such sanction can be with a condition that the borrower should bring in additional long term funds to a specified extent by a given future date. Where it is felt that the projected Current Ratio is not acceptable but the borrower deserves assistance subject to certain conditions, suitable written commitment should be obtained from the borrower. Alternatively, where necessary, a lower amount may be sanctioned in these cases subject to revision of the business and financial plans.

8.7 Validation of bank finance sought : The projected bank borrowing shown in form Ill (item 1 under current liabilities) which reflects the finance sought by the borrower, will be validated with reference to the operating cycle of the borrower, projected level of operations, nature of projected build up of CA / CL, profitability, liquidity etc. Where these parameters are acceptable, the projected bank borrowing will stand validated for sanction. This amount will be termed as Assessed Bank Finance (ABF). The assessment exercise should be carried out with due focus on the specific nature and needs of each borrower. In certain cases it may become necessary to revise the business / financial plan of the borrower, if in the opinion of the Bank these require changes, e.g. planned levels of CA or CL are not realistic, a higher level of NWC is necessary, etc.. In these cases, the operating officials should discuss in detail these aspects with the borrower to facilitate revision of the business plan and financial projections.

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4. COMMERCIAL PAPER
1. Introduction Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. CP, as a privately placed instrument, was introduced in India in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors. Subsequently, primary dealers (PDs) and all-India financial institutions (FIs) have also been permitted to issue CP to enable them to meet their short-term funding requirements for their operations. To keep pace with several developments in the financial market, and in the light or recommendations made by an Internal Group, Reserve Bank of India has issued guidelines for issue of CPs. 2. Who can issue Commercial Paper (CP) Corporates, primary dealers (PDs) and the all-India financial institutions (FIs) that have been permitted to raise short-term resources under the umbrella limit fixed by Reserve Bank of India are eligible to issue CP. 2.1 A corporate would be eligible to issue CP provided: (a) the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crores; (b) company has been sanctioned working capital limit by banks or all-India financial institutions; and (c) 3. the borrowal account of the company is classified as a Standard Asset by the financing banks/ institutions.

Rating Requirement All eligible participants shall obtain the credit rating for issuance of Commercial Paper from either the Credit Rating Information Services of India Ltd. (CRISIL) or the Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt.Ltd or such other credit rating agency (CRA) as may be specified by the Reserve Bank of India from time to time, for the purpose. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies. The issuers shall ensure at the time of issuance of CP that the rating so obtained is current and has not fallen due for review.

4.

Maturity CP can be issued for maturities between a minimum of 7 days and a maximum upto one year from the date of issue. The maturity date of the CP should not go beyond the date up to which the credit rating of the issuer is valid.

5.

Denominations CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by single investor should not be less than Rs. 5 lakh (face value).

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6.

Limits and the Amount of Issue of CP CP can be issued as a stand alone product. The aggregate amount of CP from an issuer shall be within the limit as approved by its Board of Directors or the quantum indicated by the Credit Rating Agency for the specified rating, whichever is lower. Banks and Fls will, however, have the flexibility to fix working capital limits duly taking into account the resource pattern of companies financing including CPs.

6.1

An FI can issue CP within the overall umbrella limit fixed by the RBI i.e., issued of CP together with other instruments viz., term money borrowings, term deposits, certificates of deposit and inter-corporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet. The total amount of CP proposed to be issued should be raised within a period of two weeks from the date on which the issuer opens the issue for subscription. CP may be issued on a single date or in parts on different dates provided that in the latter case, each CP shall have the same maturity date. Every CP issue should be reported to the Chief General Manager, Industrial and Financial Markets Dept. (FMD), Reserve Bank of India, Central Office, Mumbai through the Issuing and Paying Agent (IPA) within three days from the date of completion of the issue. The IPA would also report issuance of CP on the negotiated dealing system (NDS) by the end of the day of issue. Every issue of CP, including renewal, should be treated as a fresh issue. Who can act as Issuing and Paying Agent (IPA) Only a scheduled bank can act as an IPA for issuance of CP.

6.2

7.

8.

Investment in CP CP may be issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by FIIs would be within the limits set for their investments by Securities and Exchange Board of India (SEBI).

9.

Mode of Issuance CP can be issued either in the form of promissory note or in a dematerialised from through any of the depositories approved by and registered with SEBI. CP will be issued at a discount to face value as may be determined by the issuer. No issuer shall have the issue of Commercial Paper underwritten or co-accepted.

10.

Payment of CP The initial investor in CP shall pay the discounted value of the CP by means of a crossed account payee cheque to the account of the issuer through IPA. On maturity of CP the holder will have to get it redeemed through the depository and receive payment from the IPA.

11.

Stand-by Facility (SF) In view of CP being a stand alone product, it would not be obligatory for the banks and FIs to provide stand-by facility to the issuers of CP. Banks and FIs would, however, have

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the flexibility to provide for a CP issue, credit enhancement by way of stand-by assistance/credit backstop facility, etc., based on their commercial judgement. 11.1 Non-bank entities including corporates may also provide unconditional and irrevocable guarantee for credit enhancement for CP issue provided : (i) (ii) the issuer fulfils the eligibility criteria prescribed for issuance of CP; the guarantor has a credit rating one notch higher than the issuer given by an approved credit rating agency; and

(iii) the offer document for the CP properly discloses the net worth of the guarantor company, the names of the companies to which the guarantor has issued similar guarantees, the extent of the guarantees offered by the guarantor company and the conditions under which the guarantee will be invoked. 11.2 CPs can be issued against the sanctioned fund-based working capital limits or on a stand-alone basis without linkage to the working capital limits. In case stand-by facility (SF) is sought for such CPs, extension of SF under each of these circumstances are governed by the following terms:

11.2.1 SF for CPs issued against fund-based working capital limits: SF to be carved out from the existing fund-based limits so that even in cases where liquidity support becomes necessary, the existing credit limits should not be breached. SF to be extended to the extent of a) 20% of FBWCL to borrowers rated SB1 to SB5 and b) 15% of FBWCL to borrowers rated SB6 to SB7 Rating should not be more than 12 months old and should be based on the balance sheet which is not more than 6 months old SF to be extended after a separate appraisal and sanction, the powers being as applicable to Non Fund Based business. SF can be extended to SB1 and SB 5 customers only. Rating should not be more than 12 months old and should be based on the balance sheet which is not more them 6 months old SF to be restricted to 20% of fund based limits over and above the sanctioned working capital limits. SF to be extended only after a separate appraisal and sanction Sanction of SF to be as per delegation of financial powers as applicable to nonbased business. Existing security for working capital to be extended. In case of consortium paripassu charge to be extended. Where considered necessary, the sanctioning authority can waive this. In case of devolvement 2% penal interest to be charged on the amount of devolvement on the first occasion and on the entire outstanding for the second occasion beyond which no fresh SF to be extended.

11.2.2 SF for CPs issued on stand alone basis.

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11.3

Since SF is in the nature of contingent liability suitable liability entries will have to be passed and reversed at the time of issue and payment.

12

Procedure for Issuance Every issuer must appoint an IPA for issuance of CP. The issuer should disclose to the potential investors its financial position as per the standard market practice. After the exchange of deal confirmation between the investor and the issuer, issuing company shall issue physical certificates to the investor or arrange for crediting the CP to the investors account with a depository. Investors shall be given a copy of IPA certificate to the effect that the issuer has a valid agreement with the IPA and documents are in order.

13

Role and Responsibilities The role and responsibilities of issuer, IPA and CRA are sent out below:

13.1

Issuer Issuers have to ensure that the guidelines and procedures laid down for CP issuance are strictly adhered to.

13.2

Issuing and Paying Agent (IPA) (i) IPA would ensure that issuer has the minimum credit rating as stipulated by the RBI and amount mobilised through issuance of CP is within the quantum indicated by CRA for the specified rating or as approved by its Board of Directors whichever is lower. IPA has to verify all the documents submitted by the issuer viz., copy of board resolution, signatures of authorized executants (when CP in physical form) and issue a certificate that documents are in order. It should also certify that it has a valid agreement with the issuer.

(ii)

(iii) Certified copies of original documents verified by the IPA should be held in the custody of IPA. 13.3 (i) (ii) Credit Rating Agency (CRA) Code of Conduct prescribed by the SEBI for CRAs for undertaking rating of capital market instruments shall be applicable to them (CRAs) for rating CP. Further, the credit rating agency should determine the validity period of the rating depending upon its perception about the strength of the issuer. Accordingly, CRA shall at the time of rating, clearly indicate the date when the rating is due for review. While the CRAs can decide the validity period of credit rating. CRAs would have to closely monitor the rating assigned to issuers vis-a-vis their track record at regular intervals and would be required to make its revision in the ratings public through its publications and website.

(iii)

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13.4 Documentation and Procedures

(i)

(ii)

Fixed Income Money Market and Derivatives Association of India (FIMMDA), as a self regulatory organisation (SRO) for the fixed income money market securities, may prescribe, in consultation with the RBI, for operational flexibility and smooth functioning of CP market, any standardised procedure and documentation that are to be followed by the participants, in consonance with the international best practices. Violation of these guidelines will attract penalties and may also include debarring of the entity from the CP market

13.5 Default in CP market

(i) On occurrence of default in redemption of CP,IPAs will have to immediately report full particulars to Financial Market Department, Reserve Bank of India, Mumbai

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5. FINANCING TRADE AND SERVICES

Trade is a significant component of tertiary sector and offers immense potential for growth. While primary sector supplies raw material, manufacturing sector converts them into finished goods. The question then is who would deliver them to the consumers. It is here that trade plays a dominant role in providing the link between the producer and the consumer. The consumer here includes manufacturing units also. Finished product of one manufacturing unit may be the raw material to be consumed by another manufacturing unit. Traders act as links between such producers and consumers also. The economic activity would remain incomplete without trade. Trade provides place utility by bringing products at the doorsteps of the consumers. Similarly services play a significant role in facilitating commerce in the economy. Education, healthcare, tourism, transportation, and information technology, not to speak of banking and insurance, are some of the examples in services industry. Services sector contributes about 50% of our GDP, relegating the manufacturing and primary sector to the background. The trend is no different elsewhere in the world. Banks, with vast resources at their command, should tap the opportunities presented by Trade and Services. Though we finance trade and services under SBF also, trade advance usually refers to advances in C & I segment. The principles involved in lending are the same for both the segments. 1) ADVANTAGES OF FINANCING TRADE & SERVICES 1.1. Economic sense Trade and services are basically channels of distribution providing a vital link between producers of merchandise and that of its consumers. Without Trade, there would be a gap in the Economy between production and consumption. Flow of credit to the distribution channel would narrow this gap. Further, consumption activates production which in turn accelerates employment, income generation, purchasing power and demand. The demand gives a push to further production and this chain kick-starts the whole economy . Opportunity for self-employment and wealth creation are plenty in the Trade and Services (T & S) sectors. 1.2. Business sense The administered interest regime has given way to the deregulated interest rate regime and freedom has been given to the individual banks to fix suitable rate of interest for working capital limits over Rs. 2 lacs for the trade segment based on commercial considerations. Hence, financing of trade offers scope for higher interest band which will ensure higher spread for banks. It makes commercial sense in the present context of thinning of spreads. 1.3. Other Distinct Advantages i) Banks are largely insulated from dis-intermediation in the case of trade advances. Traders prefer to be with commercial banks for their financing requirements. Their surplus funds also find their way back as bank deposits in their names/ names of relatives in view of safety and liquidity factors. Hence a better appreciation of trade advances would increase the market share in Advances and Deposits as well.

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ii)

Apart from flow of income and commission from fund based/non-fund based limits, sizeable float funds and exchange income also accrue to banks in view of the fact that the traders would be utilising the remittances facility to a great extent. State Bank Group is in an enviable position in issuance of DDs/TTs/RTGS throughout the length and breadth of the country through its wide network of branches. Some of the other services being utilised by traders are inward bills business, locker facility and Forex business. The financing bank is generally better placed in tapping this potential to a greater extent.

iii) Financing traders does not warrant sophisticated appraisal techniques like in project/infrastructure financing. The assessment of credit requirements is relatively less complicated. iv) Verification of assets financed and their valuation could be more accurate as compared to a manufacturing concern. v) As the limits sanctioned may be better utilised, the business levels of the bank would be fairly stable and the bank can ensure steady flow of income including fee based income. vi) Where the business is conducted as family concerns and the owners are highly motivated to run the business on profitable lines, any business loss would affect the family reputation. This may act as a deterrent to renege on their commitments. vii) Collateral security by way of landed property or other forms may be forthcoming from the borrowers of this segment. viii) The incidence of sickness among the trading units is generally less than that of manufacturing units. The reason for this is that trader can respond to market changes faster than the manufacturing companies. Many a times, in the case of industrial credit, the NPA status becomes irretrievable. This may not be the case with trade advances. ix) Financing Trade and Services (T & S) Sector is a good avenue for credit deployment since risks are spread across a wider pool of assets. x) With a good network of traders in our books, the Bank will have more opportunity for cross selling other products. xi) Trade advances are short term in nature. In India, most commercial banks are comfortable in lending short as they have gained some expertise in short term working capital lending. 2. Illustrative list of Trade & Services

2.1. Retail and wholesale trading activities involve dealing in industrial products and agricultural produce -wholesale dealers/retail dealers/stockists, dealers of consumer durables, electronic goods, construction materials such as cement, steel, timber and hardware, fertilizers, grain merchants and other commodities. 2.2. Business enterprises who offer services could be covered under the umbrella of trade in services. The following are some of the major service segments which would be eligible for finance under services sector: i) Medicare - setting up of nursing homes, hospitals and clinics to run on commercial basis by professionals and others.

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ii)

Hospitality - Tourism and related services, construction of hotels, private airlines, and travel agents.

iii) Software - Software service providers and software training institutes. iv) Transport - Large transport operators of passenger buses, trucks, taxis (other than under the purview of priority sectors) v) Construction - Owners of marriage halls, cinema theatres, godowns, warehouses and markets. vi) Hire- purchase finance companies /firms vii) Consulting firms/Chartered Accountants/Agencies engaged in Advertisement and publicity services viii) Publishers ix) Construction, transport, supply and maintenance contractors x) Commercially run educational institutions xi) Architects xii) Lodging Houses xiii) Auditors xiv) Large housing corporates, industrial estates, real estate firms, commercial /residential property developers. xv) Professionals and self employed persons falling outside the SBF scheme. 3. FINANCIAL NEEDS OF TRADE & SERVICES

3.1. Working Capital A traders need for working capital mainly arises in the following areas: for purchase of stocks & advance payment for holding stock in trade for extending credit on sales a) Purchase of stocks : Traders dealing in certain commodities like fertilisers, steel and timber etc. are required to tender Bank Guarantees or open Letters of Credit in favour of the supplier. In such cases, they could be sanctioned Inland LC ( Demand / Usance) and Bank Guarantee facilities stipulating suitable margins. It should, however, be borne in mind that the liabilities under such limits may devolve upon the bank and hence should be reckoned on par with the fund based limits for assessing the credit risk. Care should also be taken to look into the levels of stocks financed by way of BG/LC facility while assessing further fund based limits viz., cash credit facility against such stocks to the firm. Cash Credit (Clean) or Overdraft (Clean) facility can be considered for wholesale traders dealing in perishable goods such as vegetables etc., and for making advance payments subject to banks usual terms and conditions governing such advances.

b) Stock holding: Most of the trading concerns dealing in Fast Moving Consumer Goods (FMCGs) and white goods such as refrigerators, washing machines or television sets,

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and textile goods etc., perforce hold a high level of stocks of varying designs, colours and sizes. This is warranted to cater to the customer preferences with reference to quality, price and models of these goods. The preferred mode of financing the requirement for stock holding would be by sanctioning Cash Credit facility against hypothecation of stocks. While assessing the need for financing the stock holding level, it is essential to look into the market credit enjoyed by the firm as traders generally enjoy considerable amount of credit on their purchases. c) Receivables : The sales of the trader and that of the services provider fall into three major categories. i) sales on credit terms Book Debts ii) sales on cash against delivery on collection basis iii) sales against documents of title to goods Activities falling under the services sector e.g., advertising agencies generally do not have the necessity to hold high levels of stocks/consumables. However, to a large extent, their funds would be blocked in the receivables. Hence, it is essential that the receivables be financed by way of cash credit against Book Debts. Traders of stationery articles or medical supplies may be despatching goods to the upcountry firms through usance bills sent on collection basis. Supplies to Government and QuasiGovernment agencies also are made through supply bills on collection basis. In these types of cases, overdraft against Trade Bills or Supply Bills would be an appropriate mode of finance. Since the supplies are already made, there would be no documents of title to goods other than the delivery challans duly acknowledging the receipt of goods/ invoices. Further, there are chances that the buyer may despatch the DD representing the proceeds of the bill directly to the borrower and in case the borrower does not use these funds for liquidating the borrowings, the financing bank will be left high and dry under these circumstances. Hence, it will be prudent for the banks to sanction this facility to borrowers whose integrity is beyond question. Generally, a trader from a metropolitan/urban centre where the products are in large supply, sells them to traders in other centres where demand for those products is high. For example, supplies of cashew nuts are in plenty in the state of Kerala. The traders sell them to all centres where they are in demand. Similarly, textile goods, especially saree materials, move from Surat to other parts of the country. These transactions are normally effected by the trader drawing usance bills on the buyer. For discounting such bills, parties approach the banks and sanctioning of Bill Discounting facility would meet their requirements. It is also possible that the seller insists on opening of L/Cs in their favour. The bills drawn by the seller in accordance with the terms of such Letter of Credits can be negotiated by the banks. If necessary, separate limits may be fixed for negotiating such LC backed inland bills. This is a lucrative business proposition. Due caution should be exercised as to the genuineness of the LC and the standing of the LC opening bank before entertaining the proposal. Demand Drafts purchased limit may be the usual method of lending for those who effect sales against obtention of post-dated cheques drawn on upcountry branches. Receivable related finance takes the form of discounting of bills of exchange, supply bill finance, overdraft against book debts.

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Term Loan The wholesale traders may approach banks for financing the construction of godowns and stockists for building their own godowns/premises. Most of the services sectors would require term finance for their purchase of equipments. With the opening of the economy, multinational companies have come to India and are setting up plants in the consumer goods and the automobile sectors. As they push their products through their dealer network, the dealers of these goods go in for posh showrooms for sales and display. Since many dealers would approach banks for financing this requirement as Term Loan, this is a good business opportunity for the Bank to take advantage of. As it might be difficult to attribute incremental cash flows to acquisition of certain assets e.g., doing up show room interiors DSCR could be considered on existing cash flows. 4. GUIDELINES FOR FINANCING OF T&S SECTOR

Lines of Activities Eligible for Finance All lines of lawful trading activity -trading in goods and services will be eligible for bank finance. While the general guidelines given for trade & services will be applicable to all eligible activities, financing of activities like Non-Banking Financial services, construction and service activity in the nature of development and export of software will be subject to separate guidelines. Application and Appraisal Forms: The following application and appraisal forms shall be used for financing T&S sector in C&I segment.
FBWC Limits Below Rs. 1 cr Form Formats applicable for Trade Advances (vide Chapter 30-8 , Manual on Loans and Advances) / Format given in Annexure of Process Manual of SMECCC Formats prescribed under PBS method (with modifications for Trade Advances).

Rs. 1 cr and above

In the case of service units in C&l sector, the general application/appraisal forms are to be used with appropriate modifications. Norms for Assessment of Limits i) Current ratio: For FBWC limits of Rs.1 cr and above, the bench mark level of 1.33 shall be observed. For FBWC limits below Rs. 1 cr, the net working capital in the business shall not be negative (i.e.,) the CR should be 1.0 and above. Debt-Equity Ratio: Though TOL/TNW ratio of 3 is a reasonable level for industrial ventures, the bench mark can be different for trading and other activities. For trade limits, TOL/TNW ratio at a higher level would be permissible because a higher gearing is a normal feature in trade activity. In the case of service units, the position of outside liabilities should be examined and accepted on a case to case basis.

ii)

iii) Profitability Ratios: New exposures to T & S units will be permissible as long as the units are earning profits. In cases of term loans, or clean cash credit limit subject to repayment, the profit earnings of the unit should be adequate to service the debt.
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Post Sale Financing : The following types of facilities can be given to trade and service units for financing their post sale requirements i.e. for carrying receivables. i) ii) iii) iv) Cash Credit / Overdraft against book debts. DD bill purchase (clean / documentary ) ( demand /usance) Overdraft /CC against bills under collection DD Cheque purchase facility

From the borrowers perspective, a large number of them look to the banks for bill finance by way of purchase /discount limits. This type of financing, if properly carried out, shall provide a good opportunity for increasing the bank credit to the trade sector with attendant interest, discount, and other income flows. Special attention should be given to this aspect of financing the trade units Term Loan Facility: As a general rule, concurrent borrowing is not allowed in the case of a trade or service unit financed by us. However, if there is an opportunity to extend Term Loan finance to a well established trade or service unit without taking part in the working capital finance, it is permissible in selected cases where the unit is well reputed and financially strong. Appraisal: In all cases, where a Term Loan is proposed to a trade or service unit for acquisition of fixed assets, the detailed appraisal prescribed for Term Loan shall be followed. However, in the cases where only a single item of equipment, car or a transport vehicle is to be financed, it shall be adequate if a simplified assessment is carried out. Accordingly, in such cases, it shall not be necessary to examine in detail the projected debt service cover, if the current level of profits is adequate to service the proposed repayment obligation. Also in this case, the projected cash flow statement need not be compiled. Clean Advances: In the cases where T&S units seek clean financing, such assistance can be extended on the following terms to the full extent of the requirement Clean Cash Credit (Clean CC): A clean CC facility repayable in a period upto three years and fully secured by tangible collateral security in the form of immovable property can be sanctioned as under. Clean Cash Credit to: Wholesale dealer / retailer A trade or service unit Purpose Long term deposit with and advance given to supplier, shortfall in long term funds or margins required for working capital purposes. Outlay in working capital, other than in inventory and receivables (e.g. advance payments for purchases, Advance tax paid). In this case, the clean CC facility shall normally be repayable within a period of one year. In exceptional cases, for long term Revenue expenditure like Advertisement, Cost of franchisee, Licenses etc.

A trade or service unit

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Clean Term Loan (Clean TL): A clean Term Loan facility repayable in a period upto five years and fully secured by tangible collateral security in the form of immovable property can be sanctioned to T&S units towards cost of setting up show room, office space or similar expenditure. The need for finance as a clean Term Loan shall arise when the cash outlay is for the purposes like rental deposit, cost of interior decorations ,etc., which does not result in acquisition of a tangible asset. Terms and Conditions of Advances i) Collateral Security: Clean cash credit and clean term loan facilities shall be fully secured by tangible collateral security in the form of immovable property. In case of secured advances, as a general rule collateral security of immovable property should be obtained and normally this should be at least 50% of the total exposure (both fund based and non-fund based) to a trade or service unit. Based on credit risk assessment, antecedents and market reputation of borrowers, if the Branch is of the view that it is in order to reduce the extent of collateral security of immovable properties, the same may be reduced up to 25% of the total exposure (fund and nonfund) to a trade or service unit, subject to Administrative Clearance of CCC-II if the credit facilities are required to be sanctioned by authorities below CCC-II. No Administrative Clearance will be required if sanction of credit facilities is by CCC-II and above. ii) Valuation of Security: Primary security in the form of inventory, book debts etc., shall be valued as per norms in force. As regards valuation of collateral in the form of immovable property, a conservative estimate of the value shall be made at the branch on the basis of all relevant information. Such a valuation may be based on enquiries regarding transfer of property in the neighbouring locations, and enquiries with the local office of Registrar of Assurances, estate agents, construction engineers etc. A rough estimate of the value may be obtained from one or more of these sources, for a small fee. The estimate and the information on the basis of which the value is arrived at shall be placed on record. In order to ensure that there are no delays in the disbursement of sanctioned facilities and also to avoid any need to change the collateral security after obtaining sanction, a preliminary scrutiny of the documents relating to the property should be carried out at the branch level to establish that prima facie, the title rests with the owner who is offering the security. This should be done prior to submitting the proposal to the sanctioning authority. iii) Stock Statement : It is not necessary to obtain from trade units, stock statements in the same format prescribed for industrial units. Branches may obtain from the trade units statements in a simplified format suitable for the business involved and to meet the banks requirements. The statement should, however, include the certificates regarding inventory / book debts usually obtained from a borrower. iv) Inspection: Inspection of borrowal units is to be carried out at monthly intervals. In the case of select borrowers of good business repute such inspection procedures can be carried out at quarterly intervals with the approval of the sanctioning authority; this shall, however, be subject to the designated branch officials visiting the borrower each month during the quarter and discussing the following aspects Sales Purchases

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Price fluctuations, if any Sales collections Movement of goods Liquidity in the business

A brief note of about one page on the above should be recorded and kept in the unit file. Also, in case of SB1, SB2 and SB3 rated borrowers enjoying credit facilities over Rs 50 lacs, the Bank officials will carry out inspections at quarterly intervals as against monthly. Security Margins : Asset Stock-in-trade Book Debts Letters of Credit Term Loans Margin 20 to 25 % 40 to 50 % 10% 30 to 50 %

Margins stated above are indicative in nature. In specific cases, suitable margins even lower than the indicative levels can be fixed. In all such cases, the collateral available, standing of the borrower, nature of the inventory, price fluctuations, standing of debtors etc. are to be taken into consideration Opinion / Credit Reports: Besides recording the opinion / credit report on the borrower / guarantor at the time of sanction, the reports should be updated each year at the time of renewal of the limits. 5. I. APPROACH TO ANALYSING TRADE ADVANCES PROPOSALS Understanding the Balance Sheet The financial statements namely, Trading and Profit and loss account and the Balance sheet of trading firms and that of manufacturing firms differ in many ways. Hence it is essential that when analysing the financial statements of trading firms, one should look from a different angle so as to adopt a different approach while vetting the proposal. Some of the special features are as under: a) * Gross Profit Ratio: Gross Profit ---------------------X 100 Net Sales

In the case of a trading company, a lower gross profit ratio may be acceptable since the margin on trade sales is generally low. A trading company can do with a lower ratio because investment per rupee of sales is also low - indicating a fast turnover of Current Assets manifested in a large volume of sales. * Gross Profit = Sales - (Op. Stock + Purchases - CI. Stock)

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b) Capital - turnover ratio:

Net Sales -----------------------Capital employed

In the case of trading firms, the above ratio will be high due to low level of capital employed. c) Capital : In some cases, it would be seen that loans appear in the names of friends and relatives. This may to be treated as quasi-capital for our purpose of analysis. Banks concern is also to ensure that these loans remain in the business. Normally, written undertakings are obtained addressed to the bank from these relatives to the effect that they would not withdraw their funds from the business during the currency of Banks advance. Such undertakings are generally honoured. d) Outside Liability / Equity Ratio: (TOL / TNW) Though a ratio of 3 is reasonable for industrial ventures, this ratio would be high for the trading firms. While the numerator would be high due to high level of trade credits available on purchases, the denominator would be low due to low level of capital base. As this is a normal feature of any trading activity, a higher ratio has been permitted in Banks guidelines on financing T&S Sector. e) In trading concerns, depreciation is charged not to the Trading account but to the profit and loss account because this depreciation is not on plant and machinery but on furniture and fixtures and office equipment. f) Although trading concerns vary from one to another because of the various types of goods in which they deal, a relationship can be established between the Gross profit and Selling & Administration expenses. As a thumb rule it is said that the selling and administrative expenses should not be more than one-third of the gross profit for a trading unit. If the ratio is high, the reasons may be enquired into.

II.

Take-Over of Advances:

The following Norms for take over of advances under SSI or C&I segments (including T&S Sector) have been put in place: (i) (ii) (iii) The advance to be taken over should be rated SB7 or above. The unit should score the minimum scores as prescribed, under the various risk segments, in the revised model for Credit Risk Assessment. The account should have been a standard asset in the books of the other bank/FI during the preceding 3 years. However, if a unit is not having a track record for 3 years, because it has been in existence for a shorter duration, takeover can be considered based on the track record for the available period, which should normally be for at least one year. Where a minimum history of at least 1 year is not available and where for specific reasons it is still considered appropriate to take over, the authority structure provided for permitting deviations would be used.
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(iv)

The unit should have earned net profits (post tax) in each of the immediately preceding 3 years. operation. However, if the unit has been in existence for a lesser period, it should have earned net profit (post tax) in the preceding year of

(v)

The Term Loan proposed to be taken-over should not have been rephased, generally, by the existing FI / Bank after commencement of production. However, if a rephasement commercial was necessitated due to external

factors and viability of the unit is not in doubt, such proposals may also be considered for sanction on a case-to-case basis. (vi) When only TLs are taken over, the remaining period of scheduled repayment of the term loan should be atleast 2 years. For takeover of existing TLs, while the original time frame for repayment will be generally adhered to, flexibility may be allowed in the quantum of periodical repayments. If sanction of fresh term loan is proposed along with the takeover, the schedule of repayment for the existing term loans, if necessary, may be permitted to extend up to 8 years. However, in such cases the viability of aggregate outstanding of takeover plus fresh term loan should be established. Further, takeover of term loans solely for the purpose of accommodating cost over-run should not be encouraged. (vii) (viii) Take over of units from Associate Banks is not permitted. State Financial Corporations may be taken over selectively. Increasing our share in either a consortium or as Multiple Banking Arrangement of which we are already a part, or where we join a consortium either as an additional member or when another Banks exits, such sanctions are not considered as take over of advances from another Bank. However, when we join a Multiple Banking Arrangement in order to replace an existing member of such an arrangement either in whole or in part all the norms relating to take over of advances as detailed in this chapter will apply. (ix) Administrative Clearance (AC) : Prior administrative approval is required to be obtained in cases of take over proposals as under: i) For takeover of units complying with all the norms prescribed Sanctions by and below AC by branch in case of branches with divisions Officials in the grade of Scale IV AGM of the Region / AGM / DGM of Term loans from

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Officials in the grade of Scale V DGM & above

DGM (Branch) / DGM(NCM) / DGM (Sales Hub - Region) No AC is required

(ii)

For take over of units not complying with any one or more of the norms prescribed. Sanctions by CCC-II & below SMECC & below CCC-I / MCCC / WBCC-I/WBCC-II CCCC / ECCB CCC-I MCCC WBCC-I CCCC AC by

7.

SERVICES SECTOR A direct relationship exists between the socio economic development and the services sector in India. This sector accounts for approximately 50% of Indias total GDP and has great potential for growth. The role of trade in the services sector in Indias balance of payments is invaluable. It has been estimated that of Indias total exports (both merchandise as well as invisibles) almost 40% is made up by trade in services. As a result of the net positive balance on services trade net invisibles financed a substantial portion of Indias total deficit on trade account. The high potential of the services sector to earn foreign exchange has been widely recognised. Being labour intensive, the services sector is of crucial importance to the Indian economy. Studies have shown that the employment elasticity to GDP growth in the services sector is higher than the case of both agricultural and manufacturing. Therefore, growth of the services sector will help in generating employment opportunities in the country. It is also important in accelerating the growth process in the economy as it provides services which are complementary to agriculture and industry. For instance, an agriculturist or industrialist requires financial services to provide capital for his production facilities, communication and transport services to reach the market and distribution and retail networks to reach the consumers.

7.1. Financing Software Activities The Scheme for financing of software activities will be implemented in the select Branches in Circles, Mid Corporate Group, and Corporate Accounts Group. These branches will have a separate cell called Software Cell to handle the loan accounts. 7.1.1 Administrative Clearance : Administrative clearance will have to be obtained from the authorities as under, for all the proposals relating to financing of software activities:
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Sanction by a) b)

Authority for AC

NWCC/DGM (MCG)/DGM(Branch) & GM Network / GM, MCG below CCC II and above No AC required

Administrative clearance would, however, not be required in the following cases: a) For renewal of working capital limits at existing levels b) For enhancement of working capital limits provided enhancement in fund based limits is less than Rs.3 crores 7.1.2 Eligible Activities: The Bank would undertake financing of the following four types of software activities: (i) (ii) (iii) (iv) Programming Services/ Man Power Exports Software Projects Software Products Miscellaneous IT Services

(a) Programming Services/ Man Power Exports: The activity covers programming work carried out by units promoted by qualified/ experienced software professionals at the customers site abroad or in India for an overseas customer. (b) Software Projects:

The activity covers customized software development, system solution and integration and maintenance of software. The profile, critical factors, problem areas and fund requirements of Programming Services/ Man Power Exports and Software Projects are detailed in Chapter 30-1, Manual on Loans and Advances Part -II (as at 31.12.2002) (c) Software Products: The development of products (e.g. application software required by Financial Institutions, Insurance Companies, etc.) involve large scale investment, the return on which can be realised only after the product is fully developed and sufficient demand is generated. Considering the nature of risk, this is generally funded through equity, venture capital etc. Therefore financing for this activity will be restricted to working capital requirements, after the software product has been developed and accepted by the market. (d) Miscellaneous IT Services:

Call centres, teleconferencing, telemedicine and other similar IT services result from the use of IT software over a system of IT products for realising value additions. Working capital requirements may arise for meeting the expenditure incurred in providing these services. 7.1.3. Eligibility Norms:

Software units eligible for Bank finance can belong to SSI or C&I market segments and should satisfy the following:
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(a) In case of take over of existing units, norms for take over prescribed should be complied with. The approval of appropriate authority should be obtained wherever there is a deviation from the norms. (b) In case of a new unit, (i) It should be a corporate body promoted by an existing company ( which should be eligible for a minimum credit rating of SB7) or a group of not less than 2 software technocrats/ professionals with at least 3 years of relevant industry experience. (No minimum experience is prescribed for software products, as units engaged in this activity will normally be large corporates). (ii) Minimum Tangible Networth of Rs 15 lacs for units engaged in programming services/ man power exports and software projects. ( In respect of the other two activities, namely software products and miscellaneous IT services, while no minimum TNW is prescribed, it should be ensured that the TNW bears a reasonable relationship to the nature and level of activity). 7.1.4. Appraisal and Assessment of Bank Finance :

A. Term Loans : Sanction of term loans (TLs) may be considered for part financing the cost of fixed assets. Term Loans can be sanctioned for purchase of office premises by companies eligible for credit rating of SB 3 and above, including those who have no prior borrowing arrangements with us. Term loans for acquisition of premises and computer hardware for setting up overseas offices in USA, UK and Germany may also be considered subject to relevant exchange control regulations. However, such term loans should be restricted to companies who have earned profits in each of the preceding 3 years and who qualify for credit rating of SB 3 and above. The quantum of term loan is also to be restricted to 50% of the tangible networth of the company. (a) Margin: 25 % minimum (b) Repayment: About 4 years (including moratorium where necessary). However, higher repayment period, depending on the repayment capacity, may be considered where term loans for acquisition of office furniture in India are granted. The repayment period for TL has been kept shorter than the normal keeping in view the rapid changes in technology and high degree of obsolescence. B. Working Capital (WC) (a) If a unit undertakes different types of software functions, WC limits will be assessed separately for each of the eligible activities. (b) The WC requirement will be assessed on the basis of cash budget method. The cash deficit on revenue account will be the basis for arriving at the Banks WC finance. (c) Sanction of WC limits will be subject to the following: (i) WC finance shall not exceed 75% of the amount of work in progress and receivables as projected in the Balance Sheet. (ii) As on the projected date, Total Outside Liabilities shall not be more than 3 times the Tangible Networth.
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(d) The limit assessed as above can be granted by way of domestic as well as export finance. (e) The sanctioned limits will be made available on a quarter to quarter basis. The Drawing Power will be the lowest of the following: (i) Peak Cash deficit for the ensuing quarter. (ii) (iii) 75% of the projected work in progress plus receivables 60% of the value of firm orders in hand.

(f) The guidelines laid down by the Bank, RBI and FEDAI for grant and conduct of export finance should be adhered to. Detailed instructions on documents to be collected from the applicant units, validation of projected cash budget, assessment of bank finance required, release and monitoring of bank limit are given in Chapter 30-1, Manual on Loans and Advances Part II ( as at 31 Decr 2002) 7.1.5 Security:

Primary: For Term Loans First charge over the assets financed. In respect of term loans for acquisition of premises and hardware for setting up overseas offices, help of our overseas offices may be taken for creation of charge. In cases where creation of charge is not considered feasible, waiver may be approved by the sanctioning authority. For Working Capital Limits As no tangible goods are created during the process of executing the contract and as the bills will not be backed by documents of title to goods, the advances will be treated as clean advances. Collateral: (i) For limits up to Rs 50 lacs collaterals may be taken, if available. For limits above Rs 50 lacs, the norms for obtention of collateral security for C&I units will be followed. (ii) Guarantee of all the promoters/ directors. However, guarantee of directors who have individual shareholding up to 5% may be waived if they are not promoter directors.

(iii) Necessary ECGC cover should be obtained. 7.2 Financing Construction Activities Financing of Construction Activities (Other than Housing Finance) i) Branches may entertain on a selective basis, economically viable proposals relating to: (a) Buildings which do not form a part of housing projects like hospitals, clinics, schools, colleges, markets, shopping centres and cinema houses, subject to the condition that cinemas and other places of entertainment should be given a low priority. (b) Construction of hotels and accommodation for tourists and commercial offices. ii) Such activities should be financed strictly on commercial principles. Branches should carefully scrutinise, while dealing with applications for such finance, cost of the project, sources of finance, income generated, cash flow, sources of repayment and other relevant data to ensure that the project is commercially viable and that the additional cash income generated will be adequate to meet the instalments due under such loans.
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While the finance for these construction activities (other than housing finance) may be granted to public as well as private sector undertakings, it should be ensured that in the case of public sector units, bank finance is not being substituted for usual budgetary allocations for construction of infrastructural facilities, e.g., construction of public roads, bridges, harbour, dams, etc. iii) Following guidelines have to be followed while financing the above activities: The activity should not be treated as developmental activity, but as a tool to attract more C&l business or for retaining existing valuable connection. Margin should be minimum 50% of the total cost of the project. The advances should be covered by equitable mortgage of land and building to be constructed out of the bank finance. The repayment period should be maximum of 5 years including the period of moratorium. However, in the case of shopping complexes, where the shops would be sold outright, and also in the case of builders where sales take place immediately after the construction is completed or where the sale prices are received in advance, either piecemeal or whole, the repayment period should be suitably reduced (the period of repayment should not exceed 2 years).

The obtention of third party guarantee may also be considered, wherever warranted. IV) The debt service coverage should be minimum 2. A new rating model has been designed for Infrastructure Projects for rating project finance exposure in Infrastructure Sector. 7.3 Financing Private Builders for Construction of Residential Flats i) We may finance private builders (who develop property within a period of 18/24 months and sell the same on outright basis to prospective buyers) for meeting the resources gap, on commercial considerations. Following aspects have to be kept in mind while financing private builders of residential complexes: Branch should be satisfied about the borrowers reputation as regards construction, adherence to delivery schedule, ability to execute the contract, present financial position, etc. The builder should have completed a few projects of similar size satisfactorily. All clearances from Govt/ Town Planning and Municipal Authorities for taking up the work on the project should be obtained and thoroughly checked before release of finance. The builders title to the property should be clear. As most of the ultimate buyers of the flats would be from the middle income group (salaried class), they would be raising loans from their employers against the security of the flats. Hence mortgage of the land may be waived depending upon the status and financial standing of the builders. However, personal guarantees of directors/ partners and corporate guarantee of associate companies acceptable to the Bank in addition to a Negative Lien should be obtained.
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For arriving at the cost of the project only the costs recorded in the various agreements between builders and property owner and the builder and flat owner should be considered. Reasonableness of the cost may be ascertained from specialised agencies like HUDCO, etc. The Bank finance will be assessed on the basis of cash budgets. The borrowers will be required to submit, on stage wise basis, the cash budget indicating the total requirements of funds for completing that particular stage of construction. Bank finance will be restricted to 50% of the gap left after reducing from the total requirements of funds, the advance received from the buyers of flats, credit from suppliers, statutory dues, etc. The statement should be certified by the borrowers auditors as also by architects/civil engineers. Initially an exposure limit of Rs 5 cr per builder or five times his Net Owned Funds may be fixed. (NOF would mean paid up capital plus free reserves less accumulated losses and other intangible assets). Initial exposure limit of up to Rs.25 cr. per builder subject to five times the builders NOF may be considered in case of top rated builders. In respect of projects financed by the Bank, payment should be received by the builders by cheque drawn jointly in favour of Bank and the builder. Monthly progress report indicating number of flats sold, payment received and deposited in the Bank should be obtained. Interest will be as applicable to working capital facilities. The advance should be liquidated within a period of 24 months from the date of first disbursement irrespective of whether the flats have been sold or not. The builder is expected to liquidate the advance from his own sources if the flats are not fully sold out. During the currency of the advance the builder should confine his entire borrowings with us relating to the particular project financed by the Bank. Administrative clearance of CCC-II is required to be obtained for proposals to be sanctioned by an authority below CCC-II. For sanctions by CCC-II and above no administrative clearance is necessary. Regular follow-up should be made to ensure that the funds are not diverted. The advances should be treated as working capital finance on the same basis as is done for financing industrial contractors.

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6. TERM LOANS AND DEFERRED PAYMENT GUARANTEES

1. A term loan is granted for a fixed term of not less than three years intended normally for financing fixed assets acquired/ to be acquired with a repayment schedule normally not exceeding 8 years. A term loan is a loan granted for the purpose of acquisition of capital assets, such as purchase of land, construction of, buildings, purchase of machinery, modernisation, renovation or rationalization of plant, and repayable from out of the future earnings of the enterprise, in instalments, as per a prearranged schedule. From the above definition, the following differences between a term loan and the working capital credit afforded by the Bank are apparent: i. ii. The purpose of the term loan is for acquisition of capital assets. The term loan is an advance not repayable on demand but only in instalments ranging over a period of years.

2.

iii. The repayment of the term loan is not out of the sale proceeds of the goods and commodities per se, whether given as security or not. The repayment should come out of the future cash accruals from the activity of the unit. iv. The security is not the readily saleable goods and commodities but the fixed assets of the units. 3. It may thus be observed that the scope and operation of the term loans are entirely different from those of the conventional working capital advances. The Banks commitment is for a long period and the risk involved is greater. An element of risk is inherent in any type of loan because of the uncertainty of the repayment. Longer the duration of the credit, greater is the attendant uncertainty of repayment and consequently the risk involved also becomes greater. However, it may be observed that term loans are not so lacking in liquidity as they appear to be. These loans are subject to a definite repayment programme unlike short term loans for working capital (especially the cash credits) which are being renewed year after year. Term loans would be repaid in a regular way from the anticipated income of the industry/ trade. These distinctive characteristics of term loans distinguish them from the short term credit granted by banks and it becomes necessary therefore, to adopt a different approach in examining the applications of borrowers for such credit and for appraising such proposals. The repayment of a term loan depends on the future income of the borrowing unit. Hence, the primary task of the Bank before granting term loans is to assure itself that the anticipated income from the unit would provide the necessary amount for the repayment of the loan. This will involve a detailed scrutiny of the scheme, its financial aspects, economic aspects, technical aspects, a projection of future trends of outputs and sales and estimates of cost, returns, flow of funds and profits.

4.

5.

6.

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7.

Appraisal of Term Loans Appraisal of term loan for, say, an industrial unit is a process comprising several steps. There are four broad aspects of appraisal, namely a. b. c. d. Technical feasibility, Economic feasibility, Financial feasibility, and Managerial competence. The purpose of appraisal is to ascertain whether the project will be sound technically , economically, financially and managerially and ultimately viable as a commercial proposition. The appraisal will involve the examination of: (i) Technical Feasibility To determine the suitability of the technology selected and the adequacy of the technical investigation and design; (ii) Economic Feasibility - To ascertain the extent of profitability of the project and its sufficiency in relation to the repayment obligations pertaining to term assistance; (iii) Financial Feasibility To determine the accuracy of cost estimates, suitability of the envisaged pattern of financing and general soundness of the capital structure; and (v) Managerial Competency To ascertain that competent men are behind the project to ensure its successful implementation and efficient management after commencement of commercial production. 7.1. Technical feasibility The examination of this item consists of an assessment of the various requirements of the actual production process. It is in short a study of the availability, costs, quality and accessibility of all the goods and services needed. i) The location of a project is highly relevant to its technical feasibility and hence special attention will have to be paid to this feature. Projects whose technical requirements could have been well taken care of in one location sometimes fail because they are established in another place where conditions are less favourable. One project was located near a river to facilitate easy transportation by barge but lower water level in certain seasons made essential transportation almost impossible. Too many projects have become uneconomical because sufficient care had not been taken in the location of the project, e.g. a woollen scouring and spinning mill needed large quantities of good water but was located in a place which lacked ordinary supplies of water and the limited water supply available also required expensive softening treatment. The accessibility to the various resources has meaning only with reference to location. Inadequate transport facilities or lack of sufficient power or water for instance, can adversely affect an otherwise sound industrial project. Size of the Plant- One of the most important considerations affecting the feasibility of a new industrial enterprise is the right size of the plant. The size of the plant must be such that it will give an economic product which will be competitive when compared to the alternative product available in the market. A smaller plant than
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the optimum size may result in increased production costs and may not able to sell its products at competitive prices. iii) Type of Technology - An important feature of the feasibility relates to the type of technology to be adopted for the project. A new technology will have to be fully examined and tried before it is adopted. It is equally important to avoid adopting equipment or processes which are obsolete or likely to become outdated soon. The principle underlying the technological selection is that a developing country cannot afford to be the first to adopt the new nor yet the last to cast the old aside. iv) Labour - The labour requirements of a project, need to be assessed with special care. Though labour in terms of unemployed persons is abundant in the country, there is shortage of trained personnel. The quality of labour required and the training facilities made available to the unit will have to be taken into account v) Technical Report - A technical report using the Banks Consultancy Cell, external consultants, etc., should be obtained with specific comments on the feasibility of the scheme, its profitability, whether machinery proposed to be acquired by the unit under the scheme will be sufficient for all stages of production, the extent of competition prevailing, marketability of the products etc., wherever necessary.

7.2. Economic feasibility An economic feasibility appraisal has reference to the earning capacity of the project. Since earnings depend on the volume of sales, it is necessary to determine how much output of the unit or the additional production from an established unit the market is likely to absorb at given prices. i) A thorough market analysis is one of the most essential parts of project investigation. This involves getting answers to three questions. a) b) c) How big is the market? How much is it likely to grow? How much of it can the project capture?

The first step in this direction is to consider the current situation, taking account of the total output of the product concerned and the existing demand for it with a view to establishing whether there is an unsatisfied demand for the product. Care should be taken to see that there is no idle capacity in the existing industries. ii) Future - possible future changes in the volume and patterns of supply and demand will have to be estimated in order to assess the long term prospects of the industry. Forecasting of demand is a complicated matter but one of vital importance. It is complicated because a variety of factors affect the demand for a product e.g. technological advances could bring substitutes into market while changes in tastes and consumer preference might cause sizable shifts in demand.

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Generally, demand for any product is fairly responsive to changes in price and income. People will reduce their consumption of a commodity which has risen in price. The degree of response in demand to changes in price cannot be the same for all commodities e.g. the demand for basic necessities might continue to remain the same irrespective of an increase in price. On the other hand, demand for luxury articles might go up sharply with a rise in income of all. iii) Intermediate product - The demand for an intermediate product (goods used as inputs for further production) will depend upon the demand and supply of the ultimate product (e.g. jute bags, paper for printing, parts for machines, tyres for automobiles). The market analysis in this case should cover the market for the ultimate product. An example is the spinning industry which produces yarn and sells it to weaving and knitting industry in the country. The growth prospects of the weaving and knitting business are dependent on the market for finished woven or knitted goods. It is the ultimate demand which really determines the long term market potential for spinning industry. iv) Ancillary Industry - In the case of ancillary industries producing parts for a larger industry e.g. machine tools etc., the capacity of the unit to diversify its activities is also important. In certain cases industries set up dependent on one big industry have often floundered for lack of demand for their product (intermediate) to work to full capacity. Then it becomes necessary to diversify its activities to include others also in order to utilise the idle capacity. How much of the potential market can the project capture? This depends mostly on the cost of production of the unit, its proximity to the major markets to its products and its sales organisation. The most important is the price. If the production cost is low, the unit will be sure of a market, domestic or foreign. There need be little fear of competition, for its cost advantage will enable the project to be well established before competition becomes a danger. The cost of the product to the ultimate consumer depends on the distances of the market from the industry. If the market is close by, the unit will have the advantage of less transportation charges. In this connection, the existence of similar industries in the area assumes importance and their cost of production will have to be ascertained to the extent of threat. An efficient sales organisation can be the touchstone of success especially in the case of small industries without much bargaining power. v) Export Oriented Units - In the case of export oriented industries catering to foreign markets, market analysis should be made separately and thoroughly. An underdeveloped country rarely has much chance of competing successfully with developed countries in an industry unless it possesses an advantage like low cost of raw material, cheap labour, etc. Another exception exists in cases where an undeveloped country has a marked transportation or tariff advantage in supplying certain products to a particular market. Conditions in the foreign market, price, terms of sales, incentives, etc. will have to be analysed carefully to ensure that the unit will be able to sell in the foreign market, economically.

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7.3. Financial feasibility Data from the borrower should be analysed to ensure that the project meets the following minimum financial criteria i) The estimated cost of the project is reasonable and complete and has reasonable chance of materialising as per anticipations. ii) The financial arrangement is comprehensive without leaving any gaps and ensures cash availabilities as and when needed. iii) The estimates of earnings and operating costs are as realistic as circumstances permit. iv) The borrowers repaying ability as judged from the project operation is demonstrable with a reasonable margin of safety The basic data required for the financial feasibility appraisal can be broadly grouped under the following heads i) Cost of the project including working capital. ii) Cost of production and estimates of profitability iii) Cash flow estimates and sources of finance. The cash flow estimates will help to decide the disbursal of the term loan. The estimate of profitability and the break even point will enable the banker to draw up the repayment programme, start-up time etc. The profitability estimates will also give the estimate of the Debt Service Coverage which is the most important single factor in all the term credit analysis. A study of the projected balance sheet of the concern is essential as it is necessary for the appraisal of a term loan to ensure that the concern will continue to have a sound financial position even after the implementation of the proposed scheme. Break-even point: In a manufacturing unit, if at a particular level of production, the total manufacturing cost equals the sales revenue, this point of no profit/ no loss is known as the break-even point. Break-even point is expressed as a percentage of full capacity. A good project will have reasonably low break- even point which would not be difficult to reach even providing for the uncertainties that may be encountered in the projections of future profitability of the unit. Debt/ Service Coverage The debt service coverage ratio serves as a guide to determining the period of repayment of a loan. This is calculated by dividing cash accruals in a year by amount of annual obligations towards term debt. The cash accruals for this purpose should comprise net profit after taxes with interest, depreciation provision and other non cash expenses added back to it.

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Debt Service Coverage Ratio

Cash accruals = ---------------------------------------Maturing annual obligations

This ratio is valuable, in that it serves as a measure of the repayment capacity of the project/ unit and is, therefore, appropriately included in the cash flow statements. The ratio may vary from industry to industry but one has to view it with circumspection when it is lower than the benchmark of 1.75. The repayment programme should be so stipulated that the ratio is comfortable. 7.4. Managerial Competence In a dynamic environment, the capacity of an enterprise to forge ahead of its competitors depends to a large extent, on the relative strength of its management. Hence, an appraisal of management is the touchstone of term credit analysis. If there is a change in the administration and managerial set up, the success of the project may be put to test. The integrity and credit worthiness of the personnel in charge of the management of the industry as well as their experience in management of industrial concerns should be examined. In high cost schemes, an idea of the units key personnel may also be necessary. 8. i) Deferred Payment Guarantees : A deferred payment guarantee (DPG) is a contract to pay to the supplier the price of machinery supplied by him on deferred terms, in agreed instalments with stipulated interest on the respective due dates in case of default in payment thereof by the buyer. A DPG is, in many respects a substitute for a term loan and, as far as the buyer of plant and machinery is concerned, it serves the same purpose as a term loan. An industrial undertaking desirous of acquiring plant and machinery can purchase them by making full payment, at the time of delivery itself, either from its own resources or by availing of a suitable term loan from a commercial bank/ financial institution. Alternatively, it can obtain credit from the suppliers on deferred payment basis and pay for the plant and machinery in agreed instalments over a period of time. In view of the extended period of repayment involved under the deferred payment arrangement, the supplier insists on the purchasers obligations being guaranteed by an acceptable financial institution. By this process, the supplier ensures elimination of the possible risk of loss arising out of the buyer defaulting in repayment of the instalments.

ii)

iii) In the case of a term loan, the amount is disbursed by the bank (as buyers banker) to the buyer who makes payment to the seller (or the bank may also make payment direct to the seller in some cases to ensure end-use of funds) for the plant and machinery supplied by him; and the buyer repays his obligation in instalments to the bank on the scheduled due dates. Whereas, in the case of a DPG, the buyers bank executes a guarantee on behalf of the buyer to the sellers banker who, on the strength thereof, discounts the sellers bills drawn on the buyer. Under this arrangement, the seller receives payment for the plant and machinery by his bills being discounted by his banker, and the buyer repays his obligation in instalments to the sellers banker by retiring those bills on the respective maturity dates.

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iv) The only difference between the two modes of term assistance is that, unlike in the case of a term loan where the bank lay down funds to the extent of the loan granted, under a DPG the bank does not lay down any funds. However, this difference is of no significance in so far as the element of risk to be assumed by the bank is concerned. While granting a term loan, it has to be ensured that the buyer of plant and machinery will be in a position to generate enough cash accruals to retire the bills (discounted on the sellers behalf by his banker on the strength of the guarantee of the buyers bank) on the respective maturity dates. Thus, the risk to be assumed by the bank under a DPG is identical with and the same as that to be assumed under a term loan. v) In view of the foregoing, and as servicing of deferred payment obligations can be done only out of future cash accruals, the economics of the project, its technical feasibility and economic viability will have to be assessed in detail, exactly as in the case of a term loan, and the standards of appraisal are, therefore, the same as those applicable to term loans. When the Branch is approached for financing a project, it should find out whether the project is prima facie acceptable by examining salient features such as the background and experience of the applicants, particularly in the proposed line of activity, the potential demand for the product, the availability of required inputs/utilities and other infrastructural facilities. 9. Financing Infrastructure Projects : Definition of infrastructure lending : Any credit facility in whatever form extended by lenders (i.e. Banks, FIs or NBFCs) to and infrastructure facility as specified below falls within the definition of infrastructure lending. In other words, a credit facility provided to a borrower company engaged in : developing or operating and maintaining, or developing, operating, and maintaining any infrastructure facility that is a project in any of the following sectors, or any infrastructure facility of a similar nature; i) a road, including toll road, a bridge or a rail system, ii) a highway project including other activities being an integral part of the highway project, iii) a port, airport, inland waterway or Inland port, iv) a water supply project, irrigation project, water treatment system sanitation and sewerage system or solid waste management system, v) telecommunication services whether basic or cellular, including radio raging, domestic satellite service (i.e. a satellite owned and operated by an Indian company for providing telecommunication service), network of trunking, broadband network and internet services, vi) an industrial park or special economic zone, vii) generation or generation and distribution of power, viii) transmission or distribution of power by laying a network of new transmission or distribution lines, ix) construction relating to projects involving agro-processing land supply of inputs to agriculture,

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x) xi)

construction for preservation and storage of processed agro-products, perishable goods such as fruits, vegetables and flowers including testing facilities for quality, construction of educational institutions and hospitals.

RBIs guidelines on infrastructure lending by banks are available in their web-site. Project Finance Strategic Business Unit of our Bank (PF-SBU) extends finance to Infrastructure Projects. As regards commercial projects, projects with cost in excess of Rs.200 cr. (Rs.100 cr. for projects engaged in service sectors) and having term loan component of Rs.50 cr. from SBI will be considered for appraisal at PF SBU.

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7. PROJECT APPRAISAL
After satisfying itself about the prima facie acceptability of the project, the Branch should call for from the applicant, an Application, covering full particulars. The Application should contain the following essential data/ information: (a) Particulars of the project along with a copy of the project report furnishing details of the technology, manufacturing process, availability of production facilities etc. (b) Estimates of costs of the project detailing the itemized assets acquired to be acquired, inclusive of preliminary preoperative expenses and working capital margin requirement. (c) Details of the proposed means of financing indicating the extent of promoters contribution, the quantum of share capital to be raised by public issue (if envisaged), the composition of the borrowed capital portion with particulars of term loans, deferred payment guarantees, foreign currency loans (if proposed to be availed of) etc. (d) Working capital requirements at the peak level (i.e., when the level of total current assets is at the peak) during the first year of operations after commencement of commercial production and the banking arrangements to be made for financing the working capital requirements. (e) Project implementation schedule. (f) Organizational set up with a list of Board of Directors and indicating the qualifications, experience and competence of (i) the key personnel to be in charge of implementation of the project during the construction period and (ii) the executives to be in charge of the functional areas of purchase, production, marketing and finance after commencement of commercial production. (g) Demand projection based on the overall market prospects together with a copy of the market survey report if any. (h) Estimates of sales, cost of production and profitability. (i) Projected profit and loss account and balance sheet for the operating years during the currency of the Banks term assistance with a copy of the market survey report if any. (j) Proposed amortisation schedule for the term debt i.e., repayment programme. (k) Projected funds flow statement covering both the construction period and the subsequent operating years during the currency of the term loan (l) Details of the nature and value of the securities offered. (m) Consents from authorities like the pollution control board and any other relevant information.

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In respect of existing concerns, in addition to the above, particulars regarding the history of the concern, its past performance, present financial position etc., should also be called for. These data/ information should be supplemented by the supporting statements (such as profit and loss account and balance sheet for the past years) wherever necessary. The Application completed in all respects and signed by the authorized signatories of the company will form the basis for the detailed appraisal. The branch may take up the appraisal exercise after a through examination of the various aspects (by undertaking an inspection of the project site or the factory in the case of existing units, if necessary). Although the basic techniques employed for appraising the viability of various projects are more or less the same, there could be no standard or uniform approach for appraising all projects. Each project has to be examined in proper perspective having due regard to its nature, size and scope. For instance, no uniform approach can be adopted while appraising proposals in respect of the following three projects: (i) An existing concern going in for expansion or modernization of its units. (ii) An existing concern setting up a new project (iii) A new concern venturing to set up a new project. In the case of (i) above, data regarding past performance, present financial position, quality of management etc. will be already available. These data will provide an insight into the background of the concern and thus serve as a guide to assess is future capability. Still in appraising a project of this nature, the degree of risk involved cannot be assessed with relative ease. In respect of (ii) above, the product proposed to be manufactured may be new and, therefore, may warrant a study of the technology, the manufacturing process involved, the availability of critical raw materials, the demand for the product etc. However, the already available knowledge of the background of the concern and the trend of its past working will render the task of appraisal less difficult as compared to that of (iii) above, where both the concern (i.e., the promoters) and the project will be new. The ultimate objective of the appraisal exercise is to ascertain the viability of a project with a view to ensuring the repayment of the borrowers obligations under the banks term assistance. Therefore, it is not so much the quantum of the proposed term assistance as the prospects of its repayment that should be considered while appraising a project. It should also be noted that while appraising a project, nothing should be taken for granted; all the data/ information should be checked and, wherever possible, counter-checked through interfirm and inter-industry comparisons. Healthy skepticism is a cardinal virtue in project appraisal. 1. PROPOSAL Under this head, the discussion should cover (i) the nature of the proposal, i.e., whether it is for grant of loan, issue of deferred payment guarantee and or extending underwriting support, mentioning also the respective quantum of assistance sought for under each mode; and (ii) the purpose for which the term assistance is required, that is whether it is for financing the part cost of a new project, expansion, modernization, diversification or for any other approved purpose.

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2.

BRIEF HISTORY In the case of an already existing company, (a) the essential particulars about its promoters, their background and standing, (b) its incorporation (and commencement of commercial production, in the case of a public limited company), (c) its subsequent corporate growth to date, and (d) major developments/ changes in its management. If the borrowing unit is new to Banks books, a credit report from its existing bankers should be obtained, to ascertain the credit worthiness of the company and the directors. A careful scrutiny of the Companys Memorandum and Articles of Association should be made to (i) ensure that there are no clauses prejudicial to the banks interests and (ii) ascertain whether any limitations have been placed on the Companys borrowing powers and operations. The registered address of the Company and the particulars regarding the location of its factories/ divisions, important activities of the Company and its lines of manufacture (division-wise details are to be given if there are more that one division) should also be ascertained. The present organizational/ management set up giving a list of the Board of Directors with their address, qualifications, experience and background should be on record. The line of activities, financial position etc., of the associate/ subsidiary concerns indicating the applicant companys financial involvement in them and the overall structure of inter-corporate investments should be ascertained to have an idea about the financial position/ activities of the group companies and to guard against possible diversion of funds, from the applicant company to the associate/ subsidiary concerns, at the cost of its own financial position. If such a diversion is apprehended, suitable covenant can be stipulated restricting the applicant companys further investments in (or assumption of liabilities on behalf of) the associate/ subsidiary concerns.

3.

PAST PERFORMANCE (FOR EXISTING UNITS) A summary of the companys past performance in terms of licensed/ installed/ operating capacities, sales, operating profit and net profit for the past 3 years should be analysed. The figures relating to sales and profitability should be analysed to ascertain the trend during the 3 years. If the trend has been steady and improving, the past performance of the company can be considered as satisfactory. If sales or operating profit/ net profit show an erratic or a declining trend, the factors that have led to such a trend should be analysed, if necessary, by comparing with the sales/ profitability trend of similar units in the industry. Capacity utilisation: If actual production is less than rated capacity, the reasons for the under-utilisation of the capacity should be examined. The steps taken/ to be taken by the company to improve the capacity utilisation should also be found out. The dividend policy followed by the units in case of private & public limited companies indicating the pay-out ratio (ratio of dividends paid to net distributable profits) maintained over the years should be studied to verify if the company aims at ploughing back adequate portion of the net profit in the business as retained earnings to strengthen the

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equity base, subject, of course, to occasional deviations to maintain consistency. (The drawals from the Capital Account in case of partnership concerns) The capital expenditure programmes undertaken by the unit over the period of, say, last three years and how they were financed have to be studied with a view to ascertaining whether they have been financed from appropriate long term sources, and whether the companys financial planning can be considered satisfactory. One more aspect of special importance to be examined relates to the companys management-labour relations (i.e. industrial relations). Whether there was any strike, lock-out or shut-down during the past 3 years and how the labour disputes, if any, were settled and the steps taken by the company to maintain cordial management-labour relations. In sum, the companys past performance has to be assessed to study if there has been a steady improvement and the growth record has been satisfactory. 4. PRESENT FINANCIAL POSITION (FOR EXISTING COMPANIES). The companys audited balance sheets and profit and loss accounts for the last 3 years have to be analysed. If the latest audited balance sheet is more than 6 months old, a pro-forma balance sheet as on a recent date should be obtained and analysed. Analysis of the companys capital would involve looking into the Position regarding authorized, issued and paid-up capital. Terms of the preference shares that is, whether they are redeemable or irredeemable, cumulative or non-cumulative and whether they carry any special rights. If the preference shares are redeemable, the terms of redemption and whether the company has made adequate provision for their redemption on the maturity date. Particulars regarding large shareholders (with holdings of 10% and above in the total capital) and details of shareholdings of groups/ families in the case of closely held companies.

A careful analysis and interpretation of the financial statements would provide a reasonably clear picture of the companys financial history and present position, indicating at the same time the likely future prospects. The lower the debt/ equity ratio, the better is the financial strength of the company. The current ratio (current assets divided by current liabilities) will reveal the liquidity position i.e. the measure of the companys liquidity. The overall financial soundness of the company would depend, among other things, on satisfactory debt/ equity and current ratio. The other aspects to be examined and commented upon under this head are the following (i) The method of depreciation followed by the company whether the company is following straight line method or written down value method and whether the company has changed the method of depreciation in the past and, if so, the reason therefor;

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(ii) Whether the company has revalued any of its fixed assets any time in the past and the present status of the revaluation reserve, if any, created for the purpose; (iii) Record of major defaults, if any, in repayment in the past and history of past sickness, if any; (iv) The position regarding the companys tax assessment whether the provisions made in the balance sheets are adequate to take care of the companys tax liabilities; (v) The nature and purpose of the contingent liabilities, together with comments thereon; (vi) Pending suits by or against the company and their financial implications; and (vii) Qualifications/ adverse remarks, if any, made by the statutory auditors on the companys accounts. 5. PROJECT: The nature of the project (i.e. whether it relates to modernisation, expansion, diversification or a new venture), the details of the product to be manufactured, the licensed capacity, the proposed installed capacity and the estimated capacity utilisation have to be studied carefully. If a detailed project report has been prepared by an outside agency, comment on their standing and experience and the reliability of the project report has to be recorded. If the project involves any collaboration arrangement, for technical or financial collaboration, the standing and experience of the collaborators and whether they are associated with any other project in the company has to be ascertained along with the terms of the collaboration agreement, the period of collaboration, the royalty payable, and the conditions if any stipulated by the Government while approving the collaboration arrangement. The collaboration agreement has to be examined to see whether it contains any clause prejudicial to the Banks interests and whether there are any restrictions in regard to patents, expansion etc, or any conditionalities for exports. In such a collaboration arrangement, specific guarantees in regard to input/ output ratios and wherever necessary/ feasible appropriate assurance for updating of technology within a broad spectrum of product specifications should be endeavoured to be obtained. If no collaboration arrangement is envisaged, the arrangements made by the company for technical advice/ services required for the project may have to be examined. Technical feasibility: If the project involves a new process or new technology, a technical feasibility report by a competent agency well experienced in the line will be essential. In the case of a project involving only expansion or modernisation, a technical feasibility report may not be insisted upon, provided the technical expertise available within the company is considered adequate for the purpose. The technical feasibility of a new project should be examined from the following angles;

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(i) The suitability of the technology; It has to be examined whether the proposed technology can be successfully employed in local conditions having regard to the available resources, men and materials. If, along with the import of technical know how, certain key / critical raw materials are also envisaged to be imported, whether arrangements made for the purpose are satisfactory and, if so, for how long these arrangements will hold good. (ii) The size of the plant: The proposed size of the plant has to be examined in relation to the optimum size warranted by technical factors, economy of scale, existing/ potential market (both inland and foreign) and production cost factors. If the proposed size of the plant is quite below the optimum size having regard to the above factors, the reasons for going in for sub-optimum size plant should be thoroughly examined, if necessary, by referring to outside technical consultants. (iii) The location of the plant: A particular location will be of strategic advantage if it has ready accessibility to critical inputs and utilities like raw materials, supplies, fuel, water etc. suitable to the technology chosen, the process to be adopted and the product to be manufactured. (iv) Technical arrangements: The arrangements made for obtaining the technical know-how, design and detailed engineering of plant, and selection of suppliers of machinery/ equipments should be examined. In addition, the adequacy of arrangements made for supervision of construction of buildings/ erection of plant and machinery, undertaking trial run of the plant, training of staff etc. should also be examined. (v) Manufacturing process is also one of the important aspects to be examined in connection with the evaluation of technical feasibility. (vi) Financing of Second Hand Machinery

The machinery proposed to be acquired should have been manufactured by firms of repute, preferably with established brand name. The repayment period should be fixed keeping in view the residual life of the machinery. The machinery should be got technically evaluated by a Chartered Engineer drawn from the panel maintained by our LHOs / IDBI. The Engineers Certificate, interalia, should clearly cover: The vintage of the machinery The minimum residual life The present market value The degree of obsolescence to which the machinery is likely to be exposed.

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No Objection Certificate (NOC) from the sellers bankers/ Financial Institution/ Non Banking Financial Company, in case the machinery is already pledged/ hypothecated, is to be obtained. Otherwise an affidavit by the seller be obtained stating that he is the true owner of the assets and that no other entity has any charge or interest over these assets. Machinery which has changed hands more than once will not be financed. The machinery proposed to be purchased should, prima facie, be of good quality and the technology relatively current. The vintage can also be ascertained after verifying the original sale documents of the machine / equipment proposed to be acquired. The unit should have suitable arrangements for after-sales service of the machine. Relaxation from above stipulations in respect of financing second hand machines may be considered on a case to case basis for genuine and acceptable reasons and with prior approval of appropriate authority. Financial feasibility: I. Cost of the project: Correct estimation of the total cost of the project is an important part of appraisal as it has a bearing on the means of financing and profitability. The cost estimates should be scrutinised item by item (wherever possible, by a comparative analysis of the cost estimates of similar projects in the same industry) with a view to ensuring that they have been arrived at realistically after taking into account all relevant cost optimisation factors. The break-up of the total cost of the project- expressed in rupees after converting the foreign exchange costs into their respective rupee equipments (wherever applicable) broadly under the following main heads has to be furnished in the proposal:
Particulars of items Rupee cost Rupee equivalent of foreign exchange cost Total

(i) (ii) (iii)

Land (including site development) Buildings Plant and machinery: (a) Imported items CIF Price Import duty Other duties, it any Clearing and forwarding charges. (b) Indigenous items Invoice price (inclusive of sales tax) Octroi levy Transportation charge Other charges, of any (c) Erection/installation charges

(iv) (v)

Technical know-how, engineering and consultancy fees. Expenses on foreign technicians and training of Indian technicians abroad.
167

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Miscellaneous fixed assets (steam generation/power distribution system, electrical installations, furnitures, etc.) Preliminary, capital issue and pre-operative expenses.

(viii) Provision for contingencies. (ix) Working capital margin Total cost of the project The various components of the total cost under the individual main heads as given below have to be studied and commented upon: (i) Land (including the development):

Examine the suitability of the site selected with reference to the surrounding topographical features, availability of transport facilities, nearness to railhead/ port and proximity to sources of water, power, labour, raw materials and markets for finished goods. Soil testing may also become necessary to confirm the suitability of land for the project especially when it involves the installation of heavy machinery. Furnish details regarding the location and extent of land acquired/ to be acquired and state whether the extent of land will be sufficient to take care of the present needs of the project and future expansion needs especially in the case of projects where the additional land is envisaged to be acquired in future. If the land covers agricultural or mining areas, mention the details and state whether they will have any impact on the project. Examine the borrowers title to the land and state whether it is freehold or leasehold. If there are any legal disputes about the title to the land, furnish the details. In the case of leasehold land, examine the lease deed to ascertain (a) whether the terms of the lease provide for the lease rights being assigned/ mortgaged to the Bank, (b) whether the lease period is sufficiently long (i.e. at least longer than the proposed repayment period of the Banks term loan) and (c) whether there are any clauses prejudicial to the Banks interests. The various items of cost estimates under this head should be scrutinized as under :Items to be included (a) (b) (c) Cost of land Registration of land Cost of levelling the land Documents/Particulars to be cross-checked Agreement for sale of land (i.e. Sale Deed). Legal charges for registering land. Total area of the land to be levelled and the cost of levelling per square metre. In this connection, it may also be necessary to examine the relative contour map. Total length of fencing/compound wall requirement and the cost of the fencing/ construction per meter thereof. The size of the gates and the type of materials used.

(d) Cost of fencing/compound wall (e) Cost of gates

State whether the price paid/ payable for the land is comparable to and in line with the prevailing prices for similar land in the area. In the case of leasehold land, state whether the premium (if any) paid and the lease rent payable are reasonable. In the case of other items, state how you are satisfied that the cost estimates are reasonable and acceptable
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(ii)

Buildings:

The items to be included under this head will be broadly the following categories: (a) main factory buildings, (b) ancillary factory/ office buildings, (c) godowns/ warehouses, (d) canteen, guest house etc., (h) garages, van/ truck sheds etc., (i) sewers and drainages, and (j) architects fees. Furnish a list of buildings contemplated for the project indicating the floor space and nature of construction. Examine whether the buildings will be sufficient having regard to the nature/ lay out, size of the plant and the proposed scale of operations and will permit further additions if needed in future. Office buildings envisaged should be restricted to essential/ functional requirements and all non-essential building plans should be discouraged, especially in the early stages of the project. Indicate whether the buildings will be acquired/ constructed or obtained on lease. If the buildings are to be acquired on lease, examine the terms of the lease and comment whether the lease arrangement is satisfactory. Where all the buildings are to be constructed, indicate the arrangements made by the company for the purpose. If the construction work is to be entrusted to outside agencies, comment on the standing and experience of the architects/ contractors. In case the company themselves are to undertake the construction work, state whether they have the requisite organisation and the necessary expertise for the purpose. Examine the cost estimates for the various items under this head with reference to (i) the envisaged designs of the buildings, (ii) the contemplated types of construction and (iii) the rate per square foot in respect of each type of construction. State whether the cost of construction assumed is reasonable and the rate per square foot is comparable to the prevailing trend. Where the entire construction work is to be entrusted to outside agencies, peruse the competitive quotations obtained by the company and comment on the basis adopted for selecting the approved quotations. In case any Government grant or subsidies will be available to the company for setting up housing colonies, examine whether the cost estimates have been drawn up accordingly taking them into account. (iii) Plant and machinery:

Furnish a list of the items of plant and machinery, classified in broad groups under two heads viz. (a) imported items and (b) indigenous items, together with the names of the suppliers. Examine these items in relation to the requirements of plant and machinery recommended in the technical feasibility report or indicated in the process chart in the project report and state how they will be suitable and adequate for the envisaged production programme. Comment on the status of the machinery suppliers and their reputation for proven quality of the machinery supplied by them. If they have supplied plant and machinery for similar projects financed by the Bank, obtain a report on the functioning of such plant and machinery and state whether it is satisfactory. In the case of imported items of plant and machinery, status reports on all the suppliers should be obtained and their experience and expertise in the manufacture of the respective items should be commented upon. Examine the supply contracts entered into with the company by the suppliers of plant and machinery and comment briefly on (a) the performance guarantees (if any) obtained from them by the company, and the nature of the penalty clauses incorporated therein for non adherence
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to the specifications/ performance standards and (b) the arrangements proposed for servicing the plant and machinery, affording technical assistance etc. State whether the prices quoted are on firm basis or subject to cost escalation. If the supply contracts contain price escalation clause, check whether sufficient contingency provision has been made to take care of the possible price escalation. Comment on the arrangements made for erection/ installation of the plant and machinery. If the contract for supply of plant and machinery is on turn-key basis, comment on the suppliers experience in this line and whether they have executed similar turn-key contracts in India or abroad. If the erection/ installation work is to be entrusted separately to outside agencies, comment on their competence. In case it is to be undertaken by the company themselves, state whether they have the necessary experience and expertise. The cost estimates of the various items of plant and machinery should be examined carefully with a view to establishing their reasonableness by cross-checking with the competitive quotations obtained by the company and by making independent references to reputed machinery manufacturers. In respect of imported items, comment whether the estimates include landed cost (CIF price + import duty + clearing, loading, forwarding and unloading charges) and erection/ installation charges. As for indigenous items, state whether the estimates include provisions for transit insurance, freight, local taxes, octroi levy and erection/ installation charges. The total cost estimates in respect of plant and machinery spares/ stores and essential tools shall also be examined. Comment whether firm arrangements have been made by the company with the suppliers (both indigenous and foreign) for effecting the deliveries in a phased manner in accordance with the project implementation schedule. In respect of imported items, state whether the company hold valid import licences or have made the necessary arrangements to obtain them. (iv) Technical know-how, engineering and consultancy fees:

Examine the basis of selection of the technical consultants for providing technical know-how/ design engineering. It should be ensured that there will be no diversion of funds from the company to the promoters indirectly through selection of an associate/ subsidiary concern of the promoters as technical consultants The fees payable under this head should be checked up with the terms of (a) the relative contract entered into by the company with the technical consultants or (b) the supply contracts if the suppliers themselves are to provide the technical now-how/ detailed design engineering. Comment whether the estimates of technical know-how/ engineering fees are reasonable in relation to the services contracted for the project and comparable to the scale of fees paid in respect of similar projects in the same industry. (v) Expenses on foreign technicians and training of Indian technicians abroad:

The expenses under this head will include (a) salary and allowances, boarding, lodging and other expenses payable in respect of foreign technicians required to be present in India during project implementation and trail runs and (b) expenses incurred on Indian technicians sent abroad for training. Comment whether the estimate of all the expenses under this head are reasonable. (vi) Miscellaneous fixed assets:

These will include items such as steam generation system, power generation-cum-distribution
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system/ electrical installations, laboratory equipments, workshop equipments, fire-fighting equipments, fixtures and fittings, furnitures and office equipments, effluent disposal plant, vehicles, railway siding and other assets nor directly involved in the manufacturing process. General guidelines applicable to verification of cost estimates under Plant and Machinery should be applied to verify the cost estimate under this head also. (vii) Preliminary, capital issue and pre-operative expenses:

Preliminary expenses will include expenses on floatation of the company such as cost of printing the Memorandum and Articles of Association, registration charges, legal fees, traveling expenses and other miscellaneous expenses incurred before the incorporation of the company, expenditure incurred on feasibility project reports, market/ other surveys, and engineering services relating to the project at the initial stages. Capital issue expenses will include brokerage, underwriting commission, fees of managers to public issue and other expenses such as legal, advertising, etc. relating to raising of capital. Pre-operative expenses are expenses incurred during the period between incorporation of the company and commencement of commercial production and will include the following: (a) (b) (c) (d) Establishment expenses, rent, rates and taxes; Interest and other financial charges on borrowings accrued and payable during the construction period; Mortgage expenses (like legal fees, stamp duty, registration charges etc.); Miscellaneous expenses incurred on insurance, stationery, travelling, publicity etc

Examine the assumptions underlying the cost estimates of the various items as detailed above and comment whether they are reasonable having regard to the nature of the organization, the size of the public issue and the project implementation schedule. (viii) Provision for contingencies: This provision is to take care of the following contingencies: (a) (b) (c) (d) Escalation in the cost of the items because of increase in prices, import duty, excise duty, sales tax, transportation charges, fluctuations in foreign exchange rates etc.; Delay in the implementation of the project owing to technical or other factors, in turn leading to increased interest and other costs; Unforeseen expenses cropping up during project implementation; and Sundry items/ expenses initially omitted, as they could not be envisaged at the time of project formulation.

The cushion built into the cost of the project by way of contingency provision will range from 5% (minimum) to 15% of the cost of non-firm items in the project cost. Examine the basis on which the contingency provision has been estimated and comment
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whether it is reasonable and adequate having regard to the proportion of firm costs and non-firm costs in the cost estimates and the project implementation schedule. (ix) Working capital margin:

This represents the provision required to be built into the cost of a project for meeting the working capital margin requirements at the peak level (i.e. when the level of current assets is at the peak) during the first year of operation after commencement of commercial production, additional margin money required during the subsequent years being met out of internal cash generation. While examining the working capital margin built into the cost of a project, it should be ensured that the provision is adequate to take care of the requirements of the project. General Comments: Inaccurate estimation of the total project cost - leading either to underestimation or overestimation will have an adverse impact on the ultimate course of the project. Underestimation will inevitably lead to a cost overrun i.e. increase in the project cost over the earlier estimates and hamper the project implementation because of the likely delay in obtention of additional funds at a later stage for matching the overrun. Overestimation, on the other hand, will inflate the total project cost giving scope for diversion of the excess funds for purposes other than financing the project (an undesirable feature) and thus affecting its financial strength. The computation of cost estimates should, therefore, be scrutinized carefully to ensure that the total project cost arrived at is accurate and comprehensive. A test of this factor is to express the total cost of the project per unit of the installed capacity (e.g. per tonne) and compare it with per unit cost of similar projects in the same industry. The appraising official should, after due scrutiny and cross-checking, satisfy himself that the cost estimates are reasonable and realistic. II Means of financing:

Examine the proportion of debt and equity components envisaged in the tie-up of the means of financing of the project which is technically called the project debt/ equity gearing. In this connection, there is no standard project debt/ equity ratio which can be applied to all term loan proposals. For a particular project, the ratio will be based on a number of factors such as the nature and size of the project, location, capital intensity, gestation period & promoters capacity. Where a project is being financed by a consortium of term lending institutions & banks, the project debt/ equity gearing is stipulated by the lead institution in consultation with the other lenders. Banks loan policy prescriptions on debt equity gearing (2:1 at present) should be kept in mind while appraising term loans. Furnish a break-up of the means of financing tied up for the project, grouped under the following main heads:

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Details of Source

Rupee

Rupee equivalent of Foreign exchange amount

Total

A Equity Components (i) Share Capital (a) Equity Shares (b) Preference Shares (ii) Internal Cash Accruals

(iii) Any Others (like central/ state subsidies etc.

B Debt Components (i) (ii) Debentures Term Loans

(iii) Deferred Payment Facilities (iv) Unsecured Loans/ Deposits (v) Any Others (like central/ state sales tax loans, development loans etc. Total Examine the suitability of the various sources of finance with due regard to the financial leverage envisaged for the project and furnish your comments on the following lines. A. (i) Equity Component: Share Capital: Indicate the composition of the share capital i.e. the proportion of equity shares and preference shares in the total share capital. In respect of the equity shares, furnish the break-up of the extent of subscription by the promoters and the public. In the case of preference shares, comment on the nature and type of the shares and the special rights, if any, carried by them. Just as a minimum level of equity is stipulated for a given level of debt, a minimum contribution is stipulated to be brought in by the promoters as their stake in the project,
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depending upon the nature and size of the project. (Banks loan policy stipulates a promoters stake of 20%). Such contribution to be brought in by the promoters will be by way of share capital; a portion of it may also be brought in by way of unsecured loans/deposits as stated above. State whether the stipulation regarding the minimum contribution to be brought in by the promoters is complied with by them. (ii) Internal Cash Accruals: The scope for utilizing internal cash accruals as one of the sources of finance for a project undertaken by any existing company is limited (a) as there is uncertainty involved in the cash generation by the existing units upto the expected level during the construction period of the proposed project and (b) the pre-empting demands thereon viz., payment of dividends to shareholders, repayment of maturing term obligations and plough back to meet the increased margin requirements arising from the enlarged scale of operations of the existing units. Further, the net working capital (long term sources minus long term uses) of a borrower in relation to the working capital requirements (being total of current assets) should not be allowed to deteriorate but should usually improve over a period. Accordingly, borrowers who have built up their net working capital by plough back of profits or by infusion of long term funds should not ordinarily by allowed to dilute the position unless the current ratio after the project implementation would still be satisfactory (the benchmark for the current ratio is 1.33 as per the loan policy). Keeping in mind the foregoing criteria, examine the companys audited balance sheet for the last year and the estimated/ projected balance sheets covering the entire period of implementation of the proposed project. Comment whether the company will comply with all the requirements in this regard as stated above and whether the level of internal cash accruals envisaged to be utilised for part-financing the proposed project is acceptable. State whether the companys proposed arrangement is satisfactory indicating the resultant financial parameters (iii) Any others (like central/state subsidies etc.): Indicate the exact source of finance under this head i.e. whether it is central subsidy or state subsidy. Examine the requirements, if any, stipulated by the Central government or the concerned State Government and state whether the company will have any difficulty in complying with any of those requirements. B. (i) Debt Component: Debentures: Examine the terms of the proposed issue of debentures such as the nature of debentures, the rate of interest, the date of redemption, the security offered etc. State whether the debenture holders will be entitled to any special rights. Comment on the arrangement made for the debenture issue and the underwriting support, if any, tied up therefor.

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In case any Debenture Trust is to be created, furnish brief comments on the details thereof such as the nature of the Trust, the names of the trustees and their duties and responsibilities. (ii) Term Loans Under section 293(1)(d) of the Companies Act, there is an upper ceiling on the powers of a public company (or a private company subsidiary to a public company) to borrow by way of term loans and any borrowings in excess of this amount is subject to the consent of its shareholders in general body meeting. It should, therefore, be ensured that the companys total borrowings raised/to be raised from all sources for part-financing the project, including the term loan applied for from the Bank, would not exceed the prescribed limit. Where, the total borrowings exceed the prescribed limit, it should be ensured that the requirements of Section 293(i)(d) of the Companies Act as above are complied with by the company. Where the Bank is not the sole lender for the proposed project, comment briefly on the consortium arrangement indicating the amount of individual term loans extended by the participating lenders. Obtain, in due course, copies of arrangement/ sanction letters issued by all the participating lenders and scrutinize them with a view to ensuring that the company will have no difficulty in complying with the terms of sanction and that they are also in line with the terms and conditions stipulated by us. If foreign currency loans are envisaged as part of the term loans tied up for part-financing a project, state whether the company have obtained the approval, if necessary, from the Government of India/Reserve Bank of India and comment whether the company will be in a position to comply with all the relevant Import trade control/ Exchange Control requirements. (iii) Deferred Payment Facilities: Furnish details of the deferred payment guarantees to be executed by the Bank. In case deferred payment guarantees are envisaged to be executed by other banks or financial institutions in the consortium, furnish the particulars thereof indicting the details of the firm arrangements made by the company for the obtention of all such deferred payment guarantees. In respect of the deferred payment guarantees to be executed by the Bank, scrutinize the terms of the contract entered into by the company with the suppliers of machinery/ equipments on deferred payment basis. Examine the drafts of the guarantees with a view to ensuring that they do not contain any clause prejudicial to the interests of the Bank. If the deferred payment guarantee is required under the IDBI/SIDBI Bills Rediscounting Schemes, it should be ensured that all the requirements of the respective scheme in regard to the draft format of the guarantee, the period of deferred payment, interest on deferred principal etc. are duly complied with. In the case of deferred payment guarantees in favour of foreign suppliers, required for import of capital goods, examine the terms of the contract entered into by the company with the foreign suppliers with a view to ensuring that they are in keeping with the terms and conditions stipulated in the relative import licence and that there are no clauses prejudicial to the Banks interests. Further, as in the case of foreign currency loans, it should be ensured that all the relevant Import Trade Control/ Exchange Control

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requirements are duly complied with in the case of foreign deferred payment guarantees also. (iv) Unsecured loans/deposits: Verify the sources of the unsecured loans/ deposits, the rate of interest payable, the terms of repayment and the firm arrangement made for obtaining these funds. In respect of deposits, examine the position relating to the companys compliance with the directives of Reserve Bank of India/ stipulations of the Government of India, in force from time to time, regarding (a) the quantum of deposits that can be accepted by non-banking nonfinancial companies (b) the minimum and maximum period permissible for such deposits and (c) the percentage of every years maturities required to be deposited with scheduled commercial banks or invested in Government or other approved securities., Where the unsecured loans/deposits are to be treated as part of the equity, state whether the requirements stipulated by the Bank-especially in regard to non-withdrawal of these funds during the currency of the term loans and the rate of interest payable-will be duly complied with. It should be borne in mind that all unsecured loans/ deposits raised by the company for financing a project should always be subordinate to the term loans of the banks/ financial institutions and should be permitted to be repaid only with the prior approval of all the banks and the financial institutions concerned. (v) Any others (like Central/State sales tax loans, development loans, etc.) Indicate the exact source of finance under this head i.e. whether it is central or state sales tax loan. Furnish brief details of the terms and conditions governing the loan like the rate of interest (if applicable), the manner of payment etc. General Comments: (a) Debt/equity gearing: State whether the pattern of the means of financing is in order. Comment whether the project debt/equity ratio is satisfactory and acceptable. (b) Promoters contribution to meet overrun: Comment whether the promoters have the capacity to bring in proportionate additional contribution to meet any possible overrun in the cost of the project. An undertaking to that effect should also be obtained from the promoters and kept along with the application. 6. PROJECT IMPLEMENTATION SCHEDULE Examine the project implementation schedule with reference to Bar Chart or PERT/CPM Chart (if proposed to be used by the company for monitoring the implementation of the project) and in the light of actual implementation schedules of similar projects. Furnish details of the main stages in project implementation and state whether the time schedule for construction of buildings, erection/ installation of plant and machinery, startup/ trial runs and commencement of commercial production is reasonable and acceptable.

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7. (i)

PRODUCTION FACTORS Manufacturing Process: Describe briefly the manufacturing process to be adopted by the company and enclose a simplified process flow chart wherever considered necessary. Examine the basis of selection of the proposed process and comment on the justification for its selection in relation to alternative process that have proved commercially successful. If the technology involved is new to the country, comment on the suitability of the manufacturing process indicating whether a similar process has been adopted successfully either locally or abroad. Where the manufacturing process is based on improved technology involving import of plant and machinery, comment on the training needs of the companys technical staff and how they will be met. In the case of patented processes, comment on the terms of the arrangements for adoption of the process by the company indicating the details of assignment of patents, transfer of technical know-how/ formula etc.

(ii)

Raw materials: Comment on the major raw materials required for the companys production programme indicating the sources of their supplies in respect of imported and indigenous items. Examine the pattern of unit prices of the major raw materials with a view to ascertaining whether there have been large fluctuations in the recent past and, if so, whether the company have taken this factor into account while projecting the cost of production and profitability estimates.

(iii)

Utilities and Essential Services: Examine the requirements of power, fuel, water (indicating the extent of treatment if necessary), transport (own/hired) and railway siding and comment on the adequacy of the arrangements made by the company to meet such requirements. Documentary evidence, wherever applicable, should be called for and scrutinized. Comment on the arrangements made for treatment and disposal of effluents and state whether they are adequate having regard to the manufacturing process involved, especially in respect of chemical units. Note: The aspects covered under items (ii) and (iii) above will from part of economic feasibility investigation.

(iv)

Operating Organisation: State whether the operating organisation to be in charge of operation of the plant is adequate, indicating whether the managerial/ technical personnel proposed by the company have the necessary expertise and experience. Indicate the requirements of other staff and skilled/ unskilled labour and comment whether the arrangements made by the company for recruitment and training of these personnel are adequate

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8.

WORKING CAPITAL REQUIREMENTS. Examine the basis on which the company have assessed the total working capital requirements at the peak level (i.e. when the level of current assets is at the peak) during the first year of operations after commencement of commercial production. Comment whether the contemplated levels of inventory/ receivables are in conformity with (a) the trend obtaining in similar units in the same industry or (b) the inventory/ receivables levels of the same company in the previous years if applicable. Generally, the company should confine their entire banking business (including foreign exchange/ ancillary business) exclusively to our Bank. However, where the total term loan requirements of a project are met by a consortium of term lending Institutions/ participating banks, the working capital finance may be shared by the participating banks in the same ratio in which the quantum of term loans allotted to the participating banks has been shared. Comment on the arrangements made by the company for obtaining such share of bank finance from the respective participating banks. In the case of an existing company, their total working capital requirements (including the working capital requirements of the proposed project) should be assessed on the same lines as above and the arrangements made by the company for financing the additional working capital requirements should be commented upon

9.

MARKET This constitutes a crucial aspect of project appraisal (under the head of economic feasibility) as the basic viability of the project and consequently the repayment of the Banks term loan depends up on the marketability of its products. This aspect should, therefore, be studied in depth and comments furnished under the following heads.

(i)

Sales prospects: The companys sales projections and the underlying assumptions should be thoroughly examined with reference to the demand forecasts made in the publications of the Planning Commission, Chambers of Commerce & Industry, State Directorates of Industries and industry information sources like CMIE, CRISINFAC etc. If the company have carried out a market survey through an outside agency, comment on the latters competence and experience on the field. Examine the companys demand projection on the basis of past consumption from indigenous/ imported sources and the likely future trend. Furnish a list of principal buyers indicating the quantities required by them. In the case of intermediary products i.e. those used as raw materials by another industry, discuss the products of the industry manufacturing the final end-product indicating the impact of the demand for the intermediary product. In the proposed product is intended to be a substitute of any existing product, the special features/ qualities of the proposed product vis--vis the existing product will need to be examined while assessing the future demand. Examine the total supply position in relation to the projected demand for the product. Discuss the nature and extent of competition likely to be faced by the project from the principal competitors in the industry indicating their installed/ operating capacities and likely future expansion. Comment on the competitive ability of the project to penetrate the market and to command the envisaged market share based on price, quality or other advantages over the competing products. State whether the extent of sales/ share of the market assumed by the company is reasonable and acceptable.

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Comment briefly on the general conditions of the industry and its prospects. Indicate the extent of tariff protection, if any, available and the impact on the industrys prospects if it is withdrawn. If technology is the crucial factor in a particular industry, state whether any major technology changes are in the offing for the industry and how the company will cope with them. (ii) Selling Price: Trace the industrys general price trend to see whether its behaviour has been stable in the past and will continue to be so in the near future. Comment whether the companys pricing policy is in tune with the industrys trend and the prices assumed are realistic and sustainable in the face of current prices of competing products, both indigenous and imported. If there are Government price controls, quota system etc. in respect of the product, state whether the companys pricing mechanism has been formulated accordingly. (iii) Prospects for Exports: Comment on the companys prospects for exports. If there are export obligations as a condition for foreign collaboration or on account of any Government stipulation, state how the company would meet the export commitments. In case the export prices do not compare favourably with home market prices, state whether any subsidy/ cash incentive will be available to compensate for the loss, if any, to be sustained on the exports. (iv) Marketing Organisation: Give a brief description of the companys marketing organisation and discus about its adequacy for the purpose. Where the company propose to market their products through distributors or selling agents, comment on the terms of the arrangements entered into by the unit with them, remuneration payable and the competence of the distributors/ selling agents. It should be ensured that the selling agency arrangement is not used as a channel for siphoning away the profits. 10. COMMERCIAL VIABILITY COST OF PRODUCTION AND PROFITABILITY Appraising profitability is the most crucial exercise in project appraisal. Keeping this in view, the estimates of sales, cost of production and net profit furnished for the project should be subjected to a through and critical examination. A. Sales Volume/Value: (a) Volume: The volume of sales would depend upon how much the company can produce and how much they can sell. A detailed market study would have established as to how much the company can sell. How much the company can produce has to be established by examining the estimates in respect of (i) the number of working days in a year/number of shifts per day and (ii) the pattern of capacity utilization as under: (i) Number of working days in a year/number of shifts per day: As a general rule, an allowance of 60 to 70 days in a year should be made for Sundays and other declared holidays, plant shut-downs for repairing/ servicing and for unexpected occasional breakdowns. This should be adjusted upwards or
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downwards according to the nature of the industry to arrive at the number of working days for the particular project. For instance, the number of working days in a year could range from 320 to 340 days for chemical industry (with continuous process) and from 260 to 300 days for engineering industry. In the case of sugar industry, the number would vary from region to region. In the case of other agro based industries, it would depend upon the seasonal duration or the period of input availability. Hence estimated number of working days for each project should be checked carefully taking into account all the relevant factors. Likewise, the estimated number of shifts per day should also be checked taking into account the nature of the industry and the practice prevalent in the region. (ii) Capacity Utilisation: Generally, it will take about two years for a project to overcome the teething troubles, stabilize the production process and reach maximum capacity utilisation. It is, therefore, usual to assume a progressive increase in the capacity utilisation ranging from 45 to 55% in the first year, 65 to 75% in the second year and 85 to 95% in the third year and, thereafter, depending upon the nature of the industry. However, the pattern of capacity utilisation in respect of any project should be decided on the basis of the nature of the plant and machinery involved in the project and the environment of the region in which the project is to be located. The capacity utilization in the existing units in the industry/ sector will also be a guiding factor. (b) Value: Then quantum of annual production can be estimated on the basis of the capacity utilisation assumed as a percentage of installed capacity envisaged over the years. This should be refined for accuracy with reference to the number of shifts per day, the number of working days per year and the pattern of capacity utilisation assumed over the years. With the estimation of the quantum of goods to be produced and sold the gross sales value should be arrived at on the basis of the selling price per unit assumed realistically in terms of the prevailing market prices and the likely future trends. In the case of by-products, examine whether the estimated percentage of their quantum to total production is in accordance with the ratio envisaged in the technical process design and whether the selling price assumed is reasonable. If scraps/rejects are envisaged in the production process, the estimated percentage of their quantum to total production should be critically examined with a view to ensuring that it is not excessive. The selling prices of scraps/rejects should be assumed very conservatively. B. Cost of Production: (i) Materials consumed: The quantities of raw materials, components, packing materials and consumable stores required will depend upon the levels of production assumed over the years and the consumption factors programmed in the process formula as indicated by the technical collaborators or suppliers of plant and machinery. A countercheck would be to reduce the consumption factors as a proportion to a given unit of finished product
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and then work out the quantum of materials required in relation to the total levels of production assumed over the years, after allowing for wastage, rejection and process loss. The assumption in regard to the input costs of the materials should be crosschecked with reference to the quality required of the various materials, their prevailing price levels and the future price trend. The cost of materials consumed may be expressed as a percentage of production value and compared with the input cost structure of similar plants to see that it is in tune with the industry trend. (ii) Utilities (Power, water and fuel): Wages and salaries assumed should be realistic, having regard to the prevailing rates in the locality of the project and the qualification/ experience required of each category of personnel. It is normal to provide for a yearly increase to the extent of about 20% on wages, salaries and bonus, provident fund and ESI contributors and about 5% on annual increments. (iii) Factory overheads: The estimates in respect of repairs and maintenance charges should be crosschecked with reference to the basis indicated by the technical collaborators or the suppliers of plant and machinery and compared with the position obtaining in similar plants in the same industry. The estimates should provide for progressively increasing rates as the plant becomes older. The estimates in respect of rent, rates and taxes, insurance on factory assets and miscellaneous factory expenses should be examined item by item to see that they are accurate. (iv) Depreciation: In terms of the Companies Act, 1956 and the relevant accounting standards, companies in India have the freedom to choose either the written down value method or the straight line method for writing off depreciation in the profit and loss account. However, whichever method is chosen, it should be used consistently for appraisal purposes. Where a portion or whole of the preliminary/ pre-operative expenses/ interest is allowed to be apportioned over the fixed assets and capitalized, examine whether the relative depreciation/ amortisation provision is adequate. (v) Selling expenses: Selling expenses should be scrutinized under two heads, viz., sales expenses and distribution expenses. Sales expenses are the expenses incurred on sales promotion and after-sales service (if provided) and will include advertising costs, display costs, sales-mens salaries, commission and expenses, cost of administering the sales department, etc. Distribution expenses are expenses incurred, subsequent to the production of finished goods, in storing and sending them to the customers and wil include warehouse charges, dispatching expenses, wages and salaries, packing expenses, loading expenses, upkeep and running expenses of delivery vehicles etc. Examine the individual items under sales expenses and distribution expenses to ensure that the estimates are realistic, having regard to the nature of the products, the level of sales assumed and the market coverage envisaged. As a counter-check, the total of selling expenses as a percentage of sales should be compared with the trend obtaining in similar plants in the same industry in the region to see whether it is reasonable and acceptable.
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(vi) Financial expenses: Financial expenses, will consist of (a) interest payable on debentures, term loans and deferred payments and commission payable for the issue of the deferred payment guarantee (DPG) and (b) interest and other charges payable on working capital and other short term borrowings/ deposits etc. The estimates in respect of financial expenses should be cross-checked for accuracy with reference to the following (a) The rates of interest applicable to the different series of debentures (b) The rates of interest quoted by banks/ financial institutions for their respective term loans (interest calculations being made on the basis of outstanding under the term loans taking into account the envisaged repayment of instalments each year) (c) The interest component of instalments repayable over the years under deferred payment arrangement and the commission payable for the issue of the DPG (d) The rate of interest applicable to the working capital limits (interest calculation being made on the basis of the expected average level of utilisation over the years) and (e) The rates of interest applicable to the different types of short-term borrowings. (viii) Administrative expenses: The administrative expenses are those incurred in managing the business in all its aspects and will include directors salaries and fees, salaries of administrative staff, administrative office expenses, rent, rates and insurance, lighting, heating, airconditioning and cleaning of office premises, repairs and maintenance of office buildings, stationery, printing, postage and telephone charges, legal expenses, audit fees etc. Under this head, it should be ensured that management remuneration is not excessive. Administrative expenses as a percentage of net sales should reflect a smooth trend over the years (without showing large upward variation in any year). (viii) Royalty and know-how: If royalty/know-how fees are payable on a recurring basis, verify the relative provisions in the collaboration agreement or the technical consultancy agreement, as the case may be, to ensure that the amounts estimated as payable are according to the stipulated rates. (ix) Preliminary/pre-operative expenses: Preliminary/ pre-operative expenses upto a stipulated percentage of the cost of a project are usually amortised in equal yearly instalments over a period of 10 years.

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(x) Taxation: As taxation has an impact on the net profit, and through it on the cash accruals available for meeting the maturing term obligations, it is essential that tax liability is accurately forecast, after taking into account (a) the benefits, concession and investment allowance/ other allowances/ rebates (if any) available as per Income Tax Rules in force from time to time and (b) the tax holiday benefits, if applicable. C. Profitability: After a thorough scrutiny of the estimates of cost of production and profitability of the project as stated above, furnish the resultant projections on the lines of Annexure PA.I

1st Year (i) Cost of Production & Profitability : (a) Gross Sales (b) Net Sales (c) % increase over previous year (d) Production Value (e) Materials consumed (item 9(i) of Annexure PA-I ) (f) Other expenses (except depreciation) (g) Depreciation (h) Profit before Tax (i) Provision for Tax (j) Profit after Tax

2nd Year

3rd Year etc.

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1st Year 2nd Year 3rd Year etc.. (ii) Turnover / Profitability Parameters : (m) Gross Sales/ Total working funds (n) Materials consumed (as % of production value) (o) Other expenses (sum of f + g as percentage of production value) (p) Profit before Tax / production value (q) Profit before interest and tax / total working funds

Explanatory Notes: I. II. III. Production value = Net sales plus closing stocks-in process and finished goods minus opening stocks-in-process and finished goods. Profit before tax will include investment allowance/other allowances/rebates which, although charged to the profit and loss account, are in the nature of reserves. Total working funds = Average of the previous years and current years balance sheet totals The ratio of gross sales to total working funds will indicate the efficiency of operations in terms of the number of times the total working funds have been turned over during the year. The turnover would depend on the nature of the industry and the industry average could be the guiding factor for judging whether the turnover ratio in respect of a particular project is satisfactory. The percentages of (i) materials consumed and (ii) all other expenses respectively to production value should reflect a smooth trend over the years. Any abnormality observed in the trend of the percentage of materials consumed to production value should be examined carefully to ascertain the reasons therefor. Abnormal increases in the percentage of all other expenses to production value should be examined in detail by breaking down the expenses into utilities, factory overheads, selling expenses, financial expenses and other miscellaneous expenses and expressing them individually as a percentage to production value. By this process, the categories of expenses contributing to the abnormal increase in the percentage can be identified and the reasons therefore ascertained to ensure that they stem from genuine factors and are acceptable. The ratio of profit before tax to production value should be examined to see whether it is satisfactory in the light of the performance of similar units in the same industry. The purpose of the ratio of profit before interest and tax to total working funds is to ascertain the remuneration earned on the total funds. The level of this ratio could be deemed satisfactory where it gives a reasonable rate of return having regard to the prevailing pattern of yields on riskless investments (such as government bonds) plus an extra return commensurate with the nature of risk involved in the venture.

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Finally, whether the profit after tax as arrived at above is realistic should be examined from the angle of reasonableness. No standard norms can be laid down for judging the profitability of various projects. However, a reliable reference yardstick will be the general level of profitability and the experience of similar units in the same industry. The profitability of any particular project should, therefore, be judged accordingly. Inter-Firm comparison: The reasonableness of the financial projections should be cross-checked by comparing the key financial parameters of the project with those of a similar project or with the industry averages as under: Particulars Estimates for the proposed Actuals for Project for the first year existing similar of maximum capacity project or industry Utilisation average

Capital cost per unit of installed capacity Capacity utilisation as a percentage of installed capacity Gross sales/Total working funds Materials consumed as a percentage of production value All other expenses as a percentage of production value Profit before depreciation, interest and tax as a percentage of total working funds Net profit as a percentage of net sales In making inter-firm comparisons, the following two essential points should be born in mind: (i) the project taken for comparison should be similar in all respects; and (ii) due allowance should be given for special factors like locational advantage, superior technology, managerial competency etc., having a differing impact on either the proposed project or the project taken for comparison. 11. COMMERCIAL VIABILITY DEBT SERVICE COVERAGE AND REPAYMENT PROGRAMME

The ultimate purpose of project appraisal is to ascertain the viability of a project which has a direct bearing on the repayment of the instalments under the proposed term loan/ deferred payment guarantee. While the repayment programme will depend upon the profitability of a project, the quantum of annual instalments has to be related to the size of annual cash flows. The repayment schedule should, therefore, be fixed after ascertaining the annual servicing capacity of the project during the entire repayment period, which is indicated by the debt service coverage ratio. The debt service coverage ratio is the core test ratio in project financing. This ratio indicates the degree of viability of a project and influences in fixing the repayment period and the quantum of annual instalments. For the purpose of this ratio, debt means maturing term obligations viz. instalment and interest payable during a year under all the term loans/ deferred payment guarantees and servicing depends on cash accruals comprising net profit plus interest on term

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debt plus depreciation and non-cash write-off. The debt service coverage ratio measures the extent of cash accruals available to cover the maturing term debt obligations during each year. Debt service coverage ratio (Gross DSCR): Before comparing the debt service coverage ratio, the various items should be consolidated into aggregates as under:

Net Funds Generated (a) (b) (c) Net profit after Tax Interest on Term Loans Depreciation Charged Net Funds Generated (a+b+c)

1st Year

2nd Year

3rd Year etc.

Term Debt Obligations:

1st Year

2nd Year

3rd Year.. .. .. etc.

SBI Others Total SBI Others Total SBI Others Total (a) Term Loan Instalments (b) Instalments under DPGs (c) Interest on Term Loans/ DPGs Total Term Obligations (a+b+c)

I.

Debt Service Coverage Ratio (Gross DSCR):

1st Year A B Net Funds Generated Maturing term obligations Gross DSCR ( A divided by B )

2nd Year

3rd Year. etc.

A debt service coverage ratio (Gross DSCR) of 1.75 is taken as the bench mark.

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II.

Net Debt service coverage ratio (Net DSCR): 1st Year 2nd Year 3rd Year. etc.

A Net Funds Generated less Interest on term debt B Maturing term obligations Less interest on term debt Net DSCR ( A divided by B )

An ideal position would be a uniform pattern of the net debt service coverage ratio of 2 : 1 during the entire repayment period. A ratio more than 2 :1 will indicate surplus servicing cushion available. The level of the ratio between 1.7 5 : 1 to 2 : 1 will be the moderate risk range. The level of the ratio below 1.75 : 1 will indicate that the element of risk is on the high side. Finally, comment on the pattern of the debt service coverage ratios available during the repayment period as worked out above and state whether the margin of safety and the extent of risk coverage available in the debt servicing capacity of the project are satisfactory and acceptable. BREAK-EVEN ANALYSIS The next step in the scrutiny of the estimates of cost of profitability is the break-even analysis. The starting point for the break-even analysis is the classification of the expenses into fixed (and semi-fixed) expenses and variable expenses. Fixed expenses are those expenses which must be incurred irrespective of the level of production. Semi-fixed expenses are those expenses which remain fixed upto a certain level of production but become variable when the scale of operations crosses that level requiring more units of the input consistent with the increased level of production. Variable expenses are those expenses which vary directly in proportion to production. Furnish the break even analysis on the following lines for (i) the first full year of production: and (ii) the year of maximum capacity utilisation ( for a detailed illustration, please see Annexure PA. II).

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Installed capacity (per annum) Production per annum Amount Capacity utilisation (as a percentage of Installed capacity) A. B. Production value (as percentage of A) Variable Expenses (i) Raw materials (ii) Packing materials (iii) Consumable stores and spares (iv) Any others Contribution (A-B) Fixed and Semi-Fixed Expenses (i) Power and fuel (ii) Wages and salaries (iii) Repairs and maintenance (iv) Other factory overheads (v) Depreciation (vi) Sales expenses (vii) Distribution expenses (viii)Interest on debentures, term loans and deferred payments (ix) Interest on working capital and other short term bank borrowings (x) Administrative expenses (xi) Royalty and know-how E. Operating Profit (C-D) F. Break-even Sales: Fixed and semi-fixed expenses x Production value Contribution G. H. Break-even at installed capacity: Fixed and semi-fixed expenses x capacity utilisation % x 100 Contribution Cash break-even at installed capacity: Fixed and semi-fixed Expenses minus depreciation x capacity utilisation % x 100 Contribution ..................... ..................... ..................... ..................... ..................... ..................... ..................... ..................... ..................... ..................... ..................... (as percentage of A) (as percentage of A) (as percentage of A) Percentage 100

C. D.

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Explanatory Notes: Note I: Variable expenses are those expenses which, vary directly in proportion to production. Normally, such a linear relationship would exist only between raw materials/packing materials/consumable stores and spares, and production. Hence, in the format given above, only these items have been classified as variable expenses for arriving at contribution. However, where break-up of some of the other items like power and fuel, repairs and maintenance, distribution expenses and interest on working capital and other short term borrowings are available and consumption of these items varies directly in proportion to production, such items could also be classified as variable expenses. For example, in aluminium industry, power and fuel would be an item of variable cost as these are in the nature of raw materials for such an industry and could be classified accordingly. As a general rule, however, these items have been and, in fact, should be classified as fixed/semi-fixed expenses. Note - II: Expenses which do not vary directly in proportion to production have been classified as fixed and semi-fixed expenses. These expenses should be carefully scrutinised to ensure that they have been estimated for each year accurately and that they realistically represent the enhanced level of such expenses consistent with the envisaged enlargement in the scale of operations. For example, to meet the requirements of enlarged scale of operations, if a unit envisages stepping up of the employment of skilled/semi-skilled labour, the enhanced level of wages and salaries projected should be commensurate with the increase contemplated in such employment. Similarly, a second shift or additional shift contemplated by a unit would entail an increase in power and fuel expenses. The level of break-even point under all the above categories will depend upon many factors like plant efficiency, effective asset turnover, efficient management of operations, the forces affecting the price structure, optimisation in the cost structure etc. What is a satisfactory level of the break-even point should be decided case by case taking into account the parameters circumscribing each project. However, as a general rule, it can be said that the lower the breakeven level, better the chances of the unit operating at viable scale. Break-even sales level should be considerably low in relation to the projected sales as to leave a satisfactory margin of safety. Cost-Volume Price or Sensitivity Analysis: The last step in the scrutiny of the estimates of cost of production and profitability is the costvolume-price (CVP) or sensitivity analysis. The purpose of the CVP analysis is to study the cushion available in the profitability of a project to withstand shortfalls in the expected results owing to uncertainties. The uncertainties could have a threefold impact on the profitability of a project-by way of charges in the cost of production, volume of production or selling price. The CVP analysis will reveal the span of resilience of a project by testing the sensitivity of its profitability to a range of changes in cost, volume and price. Draw a summary of the CVP analysis on the following lines for the year with operating profit nearest to the average operating profit (total of the operating profits for all the years divided by the number of years)

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Average Year Level

10% increase in variable cost

(Amount in rupees) 10%decrease 10% decrease in volume of in selling sales price

1.

Sales (a) Units (b) Amount Variable Expenses Contribution (1(b)-2) Fixed Expenses Operating profit (3-4) Break-even sales

2. 3. 4. 5. 6.

If a project cannot stand even a 5% change in the above three variables, its span of resilience will be in such a narrow range that even minor uncertainties can throw the project out of gear. If a project can sustain changes in the three variables upto, say, 10%, its span of resilience will be in the medium range affording capacity to withstand the adverse impact stemming from minor uncertainties without severe setback in the profitability. Where a project can sustain changes in the three variables upto 15%, its span of resilience will be in such a wide range that even major uncertainties cannot throw the project out of gear. Comment on the conclusions arrived at from the above analysis about the sensitivity of the project and the degree of resiliency available to withstand the adverse impact arising from minor/major changes/ uncertainties in the profitability parameters. Repayment Programme: Furnish details of the repayment programme indicating due dates for repayment and amounts of instalments. In the light of the pattern of debt service coverage available throughout the repayment period, comment whether the company would be in a position to adhere to the repayment schedule without any difficulty. As regards initial moratorium (repayment holiday) period of the project, reasoned recommendations should be incorporated indicating the basis on which the period of moratorium has been determined. Where extended repayment programme is recommended for any particular project, the supporting reasons therefor indicating the basis on which such extended repayment period has been arrived at should be indicated. 12. FUNDS FLOW ANALYSIS The funds flows should be divided into long term funds flows and short term funds flows. On the long term side, the difference between long term sources and long term uses will indicate the long term surplus or deficit. The funds flow statement should be carefully examined and the reasonableness of the various assumptions underlying the projections should be ascertained. On the long term side, it should be ensured that fund outflows, inter alia, for essential expenditure on fixed assets, repayment obligations, taxes and dividends are fully provided for and that the cash generation would be adequate to meet all such essential commitments during the currency of the entire repayment period. Where large investment in fixed assets is

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contemplated subsequently, during any year after the project goes on stream, the need for such investment in fixed assets should be gone into thoroughly and comments should be furnished as to whether the pattern of the means of financing envisaged for the same is satisfactory. On the short term side, the projected increase in current liabilities/bank borrowings should be matched by appropriate increase in the contemplated inventory/receivables build-up and other current assets commensurate with the envisaged scale of operations. After a thorough scrutiny of the various items of inflows and outflows, enclose the detailed funds flow statement (covering the entire period of currency of the Banks term assistance) on the lines of Annexure PA.III. Following is a format for analysing the funds flow. 1st Year Long term sources Long term uses Long term surplus deficit (A) Increase in current assets Increase in current liabilities excluding Bank borrowings Increase/decrease in working capital gap (B) Net surplus/deficit (Net of A and B) Increase/decrease in bank borrowings The funds flow statement will highlight the projected course of the project and indicate the degree of financial discipline required to be imposed on the company with a view to ensuring proper end-use of the funds lent for the project and safeguarding the interests of the Bank. Depending on the degree of financial discipline desired in respect of any particular project, restrictions (in the form of special covenants) may be recommended to be placed on the Companys disposition of cash generation for payment of dividends, further expansion, investments in subsidiaries/ affiliate concerns, repayment of unsecured loans, etc., to ensure that commitments to the Bank are met without any difficulty as and when they fall due. 13. Projected balance sheets As in the case of cost of production and profitability estimates and funds flow projections, the projected balance sheets should also be furnished by the Company for the entire period covering the currency of the Banks term assistance. While scrutinizing the projected balance sheets, the following points can be crosschecked. The cost of the project, the means of financing, the profitability estimates, the funds flow projections and the projected balance sheets are all inter-related and any change in any one of them will necessitate consequent changes in others. Thus, if there is any overrun in the project cost, the means of financing would require to be revised for meeting the same, setting in train other consequential changes in interest charges, profitability estimates, cash accruals, loan repayments, funds flow projections and _ 2nd Year 3rd Year etc.

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projected balance sheets. Likewise, if there is a subsequent change in the assumed capacity utilisation, the working capital margin will require to be revised suitably necessitating a chain impact on the project and the means of financing with further consequential changes as above. Similarly, if there is a change in any of the components of the costs of production, it will have an immediate effect on the cash accruals and the debt servicing capacity warranting further consequential changes in the loan repayments, funds flow projections and projected balance sheets. The projected balance sheets should, therefore, be scrutinised analytically with reference to all the other related essential data so as to ensure that all the projections, made realistically and accurately, have been woven into well co-ordinated financial statements. 14. SECURITY AND MARGIN The details of the security to be offered for the Banks term loan/deferred payment guarantee together with full particulars of the assets to be secured, their value and the type of change to be created have to be furnished. Where guarantees of the Companys Directors or third parties are being stipulated as security, full particulars of such guarantees and their networth should also be furnished. While sanctioning term loans, stipulation of pledge of equity shares of the promoters should be considered as one of the items of collateral security and can be stipulated by the sanctioning authority where deemed necessary. In this connection, only fully paid up shares should be accepted as security. For companies which are listed and quoted, the lowest quote of the previous 52 weeks should be reckoned as the value of the security. For unlisted companies, 50% of the face value of the share may be considered as its value

Detailed opinion reports on the guarantors should be complied and kept on record. Furnish the details of the working of security margin available as under for the entire period of the currency of the Banks term assistance: Year-end outstandings under Term Loans/DPGs With SBI 1st Year 2nd Year 3rd Year And so on The percentage of margin available should be calculated by using the following formula: NFA OTL X100 Where NFA NFA = Net fixed assets i.e. written down value of fixed assets. OTL = Outstanding term liabilities . With Others Total Written down value of Security Percentage margin available

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As a general rule, the term lenders aim at restricting their advances to a maximum of 50% of the book value of fixed assets including those to be acquired. In new projects, however, the overall margin would depend on the project debt/equity ratio. For instance, where a project debt equity ratio of 2 : 1 has been accepted, the initial margin will at best be 33%. In fact, the margin may work out to even less than 33%, if we take into account the fact that some part of long term funds will go towards working capital margins. Since in the initial stages of production after completion of project, depreciation may be charged at a rate somewhat higher than the loan repayment programme, the margins available on year to year basis during the currency of the term loans may be less than the margin at the commencement of the loan. The position, however, would need to be examined in the overall context to determine the acceptability or otherwise of the margins over the life time of the loan. In case of projects involving expansion, in exceptional circumstances, the advance may be based on 33% of the market value of existing fixed assets, and 50% of cost of those to be acquired. In such cases it will be necessary to obtain an independent valuation report from expert valuers. The cost of such valuation and other out of pocket expenses shall be borne by the borrower. Expert valuation may also be called for when the condition and performance of the existing machinery tend to show that its market value is less than the book value. In reckoning the book value of the existing fixed assets, normal and extra-shift depreciation should be taken into account. Where fixed assets have been written up as a result of revaluation, the resultant increases should ordinarily be deducted from the latest book value. Having considered all the above aspects, it should be examined whether the security offered and the margin available are adequate and satisfactory. 15 SPECIAL TERMS AND CONDITIONS As a measure of effective follow-up, it is customary for the Bank to stipulate a number of standard covenants and special covenants in respect of all advances. The covenants, inter alia, to be stipulated in respect of all advances relate to: (i) The right of examination of borrowers books and inspection of borrowers factories either by the Banks officers or by auditors experts/ management consultants of the Banks choice; The restriction with regard to change in the capital structure, scheme of amalgamation/ reconstruction, scheme of expansion or addition to fixed assets, investment by way of share capital/ loans/ advances, deposits in other concerns, borrowing arrangements with other banks, financial institutions or otherwise, guarantee obligations and declaration of dividends; The restriction with regard to (a) repayment of deposits from friends and relatives of promoters/ directors without Banks prior permission and (b) payment of interest on those deposits the rate of interest payable thereon and payment of such interest being subject to regular repayment of instalments under Banks term loan a well as interest thereon; and The restriction with regard to transfer of controlling interest in the Company or drastic change in the Companys management set-up without Banks prior permission. The optional covenants relate to nomination of the Banks representatives on the Companys board, ceiling in regard to dividend declaration, withdrawal of moneys by
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(ii)

(iii)

(iv)

principal shareholders/ directors, changes in management set-up, insurance cover for standing charges and loss of profit arising from stoppage of production, informing the Bank of the happening of any significant event likely to have an effect on the working of the Company or its subsidiaries. The present position relating to the obtention of Pollution Control and other consents should be verified. Mention whether there are any consents, approvals and no objection certificates yet to be received and, if so, indicate the arrangements made by the company for obtaining them. The following details have to be examined and commented upon by the branch while preparing the project finance proposals. 16. GROUP COMPANIES Give brief resume of the group companies indicating the extent to which they depend on the parent company/ other companies in the Group for their managerial, financial and other resources. Comment on the liquidity and financial position of each of the group companies together with comments on their current working and outlook for the future. Furnish the details of borrowing arrangements of the group companies, if any, with the Bank and state whether their connections are satisfactory. 16.1 If the company happens to be the parent company, comment on the extent of the companys liability in respect of partly paid shares in the subsidiary companies and state whether it will have any difficulty in meeting the calls to be made in future. Furnish comments on the contingent liabilities if any, assumed by the company on behalf of the subsidiaries, having regard to the nature of the companys involvement in or assumption of liabilities on behalf of the subsidiaries or repayment of the loans, if any, raised from them. 17. MANAGERIAL COMPETENCY Discuss briefly about (a) the companys management set up, (b) the composition of the Board indicating whether it is broad based with experienced industrialists and professional executives and (c) the chief executive in charge of the day-to-day affairs of the company. Comment on the quality of the companys management and the level of the managerial experience built up within the Group which can be expected to percolate down to the company as well. State whether the company is well served in all areas of purchase, production, marketing, finance and personnel administration. If any deficiency is observed in the companys general management set up or in any of the important functional areas, suitable conditions would require to be imposed on the company for rectification thereof and the necessary recommendations for the purpose would require to be incorporated.

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Annexure PA.I COST OF PRODUCTION AND PROFITABILITY (Rs/ 000s omitted) Particulars of items 1. 2. 3. 4. 5. 6. 7. 8. 9. Installed capacity (Quantity per annum) No. of working days for the year No. of shifts per day (1 shift = 8 hours) Capacity utilisation (in percentage) Production per annum (in quantity) Gross sales Less: Excise duty Net sales Cost of sales (i) Materials consumed: (a) Raw materials (b) (c) Packing materials Consumable stores/spares 1st Year 2nd Year 3rd Year etc.

(ii) Utilities: Power, water and fuel (iii) Wages and salaries (iv) Factory overheads: (a) (b) (c) (d) (v) Repairs and maintenance Rent, rates and taxes Insurance on factory assets Miscellaneous factory expenses Depreciation

(vi) Sub-total (items I to v) (vii) Add: opening stocks-in process (viii) Sub-total (ix) Deduct: closing stocks-in-process (x) Sub-total (cost of production) (xi) Add: Opening stocks of finished goods (xii) Sub-total (xiii) Deduct: closing stocks of finished goods (xiv) Sub-total (total cost of sales) (Rs/ 000s omitted)
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Particulars of items 10. 11. Gross profit (item 8-item 9)

1st Year

2nd Year

3rd Year etc.

Selling, general and administrative expenses (i) Selling expenses: (a) Sales expenses (b) Distribution expenses (ii) Financial expenses: (a) Interest on debentures, term loans and deferred payments (b) Interest on working capital and other short term borrowings (iii) Administrative expenses (iv) Royalty and know-how (v) Sub-total Opening profit (Item 10-Item 11) Add: Other income (a) (b) (c) (d) sub-total Deduct: Other expenses (a) (b) (c) (d) Profit before a tax Provision for tax Net Profit

12. 13.

14.

15. 16. 17.

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BREAK- EVEN ANALYSIS

Annexure PA. II

NOTE: The break-even analysis should be made for (i) the first full year of production and (ii) the year of maximum capacity utilisation assumed. (Rupees in lacs) Installed capacity (per annum) Production for the year Capacity utilisation Weighted average capacity utilisation in sales realisation (calculated as under): [(450/500) x 80] + [(50/500) x 90] = 81 A. Sales: Product A 450 Product B 50 B. Variable Expenses (i) Raw Materials (ii) Packing materials (iii) Consumable stores and spares (iv) Power, water and fuel (v) Repairs & maintenance (vi) Distribution expenses (vii) Interest on working capital and other short term borrowings C. D. Contribution (A-B) Fixed and semi-fixed expenses (i) Wages and salaries (ii) Other factory overheads (iii) Depreciation (iv) Sales expenses (v) Interest on debentures, term loans and deferred payment credits (vi) Administrative expenses (vii) Royalty and know-how Opening Profit (C-D) Break-even sales: Fixed and semi-fixed expenses x Net Sales Contribution Break-even at installed capacity Fixed and semi-fixed expenses x capacity utilisation % x 100 Contribution Cash break-even at installed capacity Fixed and semi-fixed Expenses minus depreciation x capacity utilisation % x 100 Contribution = = 17 12 90 25 76 23 2 : : : Product A 3000 Nos. 2400 Nos. 80% 81% Amount 500 135 10 13 40 20 8 14 240 ---------260 ---------48% --------52% --------Product B 1500 Nos. 1350 Nos. 90%

Percentage 100%

E. F.

245 ---------15 ---------245 x 500 260

49% --------3% --------= 471.15

G.

245 x 0.81 x 100 = 76.32% 260 155 x 0.81 x 100 = 48.28% 260

G.

NOTE: In the above illustration, since break-up of items like power and fuel, repairs and maintenance, distribution expenses and interest on working capital and other short term borrowings was available and as these items were known to vary directly in proportion to production (in this particular case), they have been classified as variable expenses.

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Annexure PA. III FUNDS FLOW STATEMENT 1st year 2nd Year Long Term Sources (i) Profit before tax (ii) Depreciation (iii) Increase in share capital (iv) Increase in term loans/debentures/ deferred payment liabilities (v) Increase in other term liabilities (vi) Decrease in fixed assets (vii) Decrease in other non-current assets A. Sub-total 3rd Year etc.

Long Term Uses (i) Net Loss (ii) Decrease in share capital (iii) Decrease in term loans/debentures/deferred payment liabilities (iv) Decrease in other term liabilities (v) Increase in fixed assets (vi) Increase in other non-current assets (vii) Taxed payable (viii)Dividends payable B. Sub-total

C. Long term surplus/deficit (A-B) Working Capital Position D. Net Increase in current assets E. Net Increase in current liabilities F. Increase/decrease in net working capital (difference between D and E)

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Annexure PA.IV CALCULATION OF INTERNAL RATE OF RETURN (IRR) Internal Rate of Return is that rate at which the sum of discounted cash flows of the project is equal to the investment outlay. In other words, IRR is that rate which makes the present value of the benefits equal to the present value of costs or reduces the Net Present Value to zero. IRR gives a fair idea about the rate of return from the project. The following aspects may be considered while calculating the IRR of a project. I. Life of the Project:

The life of a project is the estimated duration of its economically productive life. For this purpose, (a) the physical life (determined by the physical factors of the plant and machinery) or (b) the technical life (determined by the technological obsolescence) or (c) the economic life (determined by the products market life), whichever is the shortest, is to be taken. II. Components of cash outflow:

The total funds invested in a project are used for acquisition of fixed assets as well as working capital assets. Cash outflow will, therefore, comprise the following: (a) Capital expenditure of the project (total cost of the project minus margin for working capital and interest during construction period), (b) yearly normal capital expenditure (expenditure on capital replacement and /or addition to fixed assets), and (c) working capital requirement (increase in inventory and receivables). III. Components of cash inflow:

All the benefits received during the life of a project will constitute the cash inflow. Cash inflow will comprise the following: (a) profit before tax with interest added back, (b) depreciation added back, and (c) add back the amount of preliminary and pre-operative expenses written off. The amount of interest and corporate income tax depend, inter alia, on the project debt equity gearing. If the debt/ equity ratio is high, the amount of interest will also be high and, consequently, as interest is a deductible item of expenditure for purpose of taxation, the corporate income tax will be low and vice versa. Thus, the amount of interest and income tax vary with the pattern of debt equity gearing. Therefore, while calculating IRR for purpose of comparative study of the income generating capacities of various projects, profit before tax with interest (on long term and short term borrowings) added back is taken into account. Similarly, as the amount of depreciation charged and preliminary/ pre-operative expenses written off remain within the unit, they are also added back to arrive at the total cash inflow. IV. Terminal value of the project:

The terminal value of a project is the residual or salvage value of the assets at the end of the estimated life of the project. This terminal value of the project is added to the cash inflow of the last year of the project life. For this purpose, the value of land may be taken at its input cost less amortisation, if any. The salvage value of the other assets may have to be estimated separately. V. Net cash inflow:

The net cash inflow will be the difference between cash outflow and cash inflow for each year. In some projects, the net cash inflow may be negative in the initial years owing to high cash

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outflow on investment in fixed assets and working capital assets. With increased level of production and profitability, the net cash inflow will become positive in the succeeding years. VI. Cut-off rate of return:

The cut-off rate of return is not required to calculate IRR. However, it is necessary for a different purpose-to compare the IRR with the cut-off rate of return to take decision regarding financing a project. The cut-off rate varies from time to time on the basis of the availability and cost of capital in the economy. Illustration on Calculation of Internal Rate of Return : A. Year CASH OUTFLOW Capital expenditure of the project 1950 Yearly normal capital expenditure 15.00 15.00 20.00 20.00 20.00 20.00 20.00 20.00 (Rs./ lacs) Increase in inventory/ receivable 50.00 245.50 45.50 60.00 40.00* Total

0 year 1st year 2nd year 3rd year 4th year 5th year 6th year 7th year 8th year 9th year 10th year

2000.00 245.50 45.50 75.00 55.00 20.00 20.00 20.00 20.00 20.00 20.00

*NOTE : The project is expected to reach the maximum level of capacity utilisation in the 4th year. As production will remain at this level during the subsequent years, no additional cash outflow is provided after the 4th year, the impact of inflation being ignored. B. CASH INFLOW Year Profit before tax with interest added back 416.20 542.10 687.90 803.84 807.92 814.16 Depreciation Preliminary/ pre-operative expenses written off 5.50 5.50 5.50 5.50 5.50 5.50 (Rs./ lacs) Total

0 year 1st year 2nd year 3rd year 4th year 5th year 6th year

185.95 185.95 187.55 187.55 191.20 193.30

607.65 733.55 880.95 996.89 1004.62 1012.96

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Year

Profit before tax with interest added back 868.25 874.68 881.30 1237.70*

Depreciation

Preliminary/ pre-operative expenses written off 5.50 5.50 5.50 5.50

Total

7th year 8th year 9th year 10th year

195.40 197.50 199.60 25.25

1069.15 1077.68 1086.40 1268.45

*NOTE: This includes the following: salvage value of land, other fixed assets and current assets. C. DISCOUNTED CASH FLOW USING INTERPOLATION FORMULA :

All spreadsheet software packages have a function to calculate the IRR of a given stream of cash flows. In the example given below the method of calculating IRR is illustrated. Example : Find out the two Net Present Values of the stream of cash flow during the life of the project, using two different rates of discount such that one NPV is positive and the other is negative. (Rs./ lacs) Discount Present Discount Present Cash Net Cash Cash Factor @ Value @ Factor @ Value @ Inflow Flow Outflow 34% p.a. 34 % p.a. 35%p.a. 35 % p.a. 2000.00 0.00 -2000.00 1.0000 -2000.0000 1.0000 -2000.0000 245.50 607.65 362.15 0.7463 270.2612 0.7407 268.2593 45.50 733.55 688.05 0.5569 383.1867 0.5487 377.5309 75.00 880.95 805.95 0.4156 334.9606 0.4064 327.5720 55.00 996.89 941.89 0.3102 292.1333 0.3011 283.5732 20.00 1004.62 984.62 0.2315 227.9002 0.2230 219.5836 20.00 1012.96 992.96 0.1727 171.5153 0.1652 164.0322 20.00 1069.15 1049.15 0.1289 135.2396 0.1224 128.3811 20.00 1077.68 1057.68 0.0962 101.7457 0.0906 95.8703 20.00 1086.40 1066.40 0.0718 76.5556 0.0671 71.6005 20.00 1268.45 1248.45 0.0536 66.8841 0.0497 62.0917 Sum of Positive Present Values (a) : 2060.3823 1998.4947 Sum of Negative Present Values (b): -2000.0000 -2000.0000 Net Present Value (NPV) = (a)-(b) : 60.3823 -1.5053 IRR = 34.98

Year 0 1 2 3 4 5 6 7 8 9 10

( Present discounted value of Re 1 in the nth year with r rate of discount can be given by the f ormula = 1/(1+r)n ) At a discount rate equal to IRR, the NPV will be zero. In the illustration above, at the discount rate of 34% the NPV is positive and it is negative when discount rate is 35%. The IRR is therefore between 34 % and 35%. Roughly, the formula for IRR = [ lower of the two discount rates + (difference between two discount rates X NPV at lower discount rate / absolute difference between the two NPVs) ] . In the illustration, IRR = 34 + (35-34) X [60.3823 / (60.3834 (-1.5053))] = 34.98 %.

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8. CREDIT RISK ASSESSMENT

IMPORTANCE OF CREDIT RISK ASSESSMENT Credit is a core activity of banks and an important source of their earnings, which go to pay interest to depositors, salaries to employees and dividend to shareholders In credit, it is not enough that we have sizable growth in quantity/ volume, it is also necessary to ensure that we have only good quality growth. To ensure asset quality, proper risk assessment right at the beginning, that is, at the time of taking an exposure, is extremely important. Moreover, with the implementation of Basle-II accord4, capital has to be allocated for loan assets depending on the risk perception/ rating of respective assets. It is, therefore, extremely important for every Bank to have a clear assessment of risks of the loan assets (or, asset pools) it creates, to become Basle-II compliant. That is why Credit Risk Assessment (CRA) system is an essential ingredient of the Credit Appraisal exercise. INDIAN SCENARIO : In Indian banks, there was no systematic method of Credit Risk Assessment till late 1980s/early 1990s. Health Code System (1985) / IRAC norms (1993) are Asset (loan) classification systems, not CRA systems. RBI came out with its guidelines on Risk Management Systems in Banks in 1999 and Guidance Note on Management of Credit in October, 2002. Reserve Bank has issued guidelines to banks in June 2004 on maintenance of capital charge for market risks on the lines of Amendment to the Capital Accord to incorporate market risks issued by the BCBS in 1996. The Revised Framework consists of three-mutually reinforcing Pillars, viz. minimum capital requirements, supervisory review of capital adequacy, and market discipline. Under Pillar 1, the Framework offers three distinct options for computing capital requirement for credit risk and three other options for computing capital requirement for operational risk. These options for credit and operational risks are based on increasing risk sensitivity and allow banks to select an approach that is most appropriate to the stage of development of bank's operations. The options available for computing capital for credit risk are Standardised Approach, Foundation Internal Rating Based Approach and Advanced Internal Rating

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Based Approach. The options available for computing capital for operational risk are Basic Indicator Approach, Standardised Approach and Advanced Measurement Approach. Keeping in view Reserve Banks goal to have consistency and harmony with international standards, it has been decided that all commercial banks in India (excluding Local Area Banks and Regional Rural Banks) shall adopt Standardised Approach (SA) for credit risk and Basic Indicator Approach (BIA) for operational risk. Banks shall continue to apply the Standardised Duration Approach (SDA) for computing capital requirement for market risks. Keeping in view the likely lead time that may be needed by the banks for creating the requisite technological and the risk management infrastructure, including the required databases, the MIS and the skill up-gradation, etc., the following time schedule has been laid down for implementation of the advanced approaches for the regulatory capital measurement : S. No. a. b. c. d. Approach The earliest date of making application by banks to the RBI April 1, 2010 April 1, 2010 April 1, 2012 April 1, 2012 Likely date of approval by the RBI March 31, 2011 September 30, 2010 March 31, 2014 March 31, 2014

Internal Models Approach (IMA) for Market Risk The Standardised Approach (TSA) for Operational Risk Advanced Measurement Approach (AMA) for Operational Risk Internal Ratings-Based (IRB) Approaches for Credit Risk (Foundationas well as Advanced IRB)

SBI SCENARIO : However, like in many other fields, in the field of Credit Risk Assessment too, our Bank played a proactive and pioneering role. We had our Credit Rating System (CRS) in 1988. Then, the CRA system was introduced in the Bank in 1996. The first CRA model was rolled out in 1996 to take care of exposures to the C & I (Manufacturing) segment. Thereafter, separate models for SSI & AGL segments were introduced in 1998, when the C&I (Mfg) CRA model was also modified. CRA for Trade was developed in the year 1999. In 2000, a separate CRA model was developed for Non Banking Finance Companies (NBFCs).

Thereafter, a pilot scheme for a unified Model for C&I/ SSI/ AGL was introduced in Chandigarh Circle in July 2003, which ran parallel to the existing Model. The unified model1 was later extended to other Circles w.e.f 1.4.2004. Thereafter, again a review of Credit Risk Assessment (CRA) Models for Non-Trading & Trading Sectors was undertaken with the objective of making them Basel-II compliant and meeting the requirements of Internal Ratings Based (IRB) Approach. Accordingly the new CRA Model (2007) was implemented on 19th October 2007, which was subsequently modified in January 2010. With increased liberalization and changes in the regulatory environment, Banks and NBFCs have started competing directly in many segments, which has also changed the business dynamics for NBFCs. Accordingly, new CRA Models for NBFCs/HFCs has been introduced for all
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exposures to NBFCs and HFCs of Rs.25 lacs and above. reading references at the end of this Chapter].

[The superscripts refer to the

As of now, in SBI, CRA is the most important component of the Credit Appraisal exercise for all exposures > 25 lacs and a very important tool in decision-making (a Decision Support System) as well as in pricing. INTER-RELATIONSHIP BETWEEN CREDIT & RISK CREDIT & RISK

Go hand in hand. They are like twin brothers. They can be compared to two sides of the same coin. All credit proposals have some inherent risks, excepting the almost negligible volume of lending against liquid collaterals with adequate margin.

LENDING DESPITE RISKS : So, risk should not deter a Banker from lending. A bankers task is to identify/ assess the risk factors/ parameters & manage / mitigate them on a continuous basis. But its always prudent to have some idea about the degree of risk associated with any credit proposal. The banker has to take a calculated risk, based on risk-absorption/ risk-hedging capacity & risk-mitigation techniques of the Bank. FOR A BANK, WHAT IS RISK?

Risk is inability or unwillingness of borrower-customer (s) or counter-party (ies) to meet their repayment obligations/ honour their commitments, as per the stipulated terms.

LENDERS TASK

Identify the risk factors, and Mitigate the risk

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HOW DOES RISK ARISE IN CREDIT? In the business world, Risk arises out of

Deficiencies / lapses on the part of the management (Internal factor) Uncertainties in the business environment (External factor) Uncertainties in the industrial environment (External factor)

Weaknesses in the financial position (Internal factor) To put it in another way, success factors behind a business are: Managerial ability Favourable business environment Favourable industrial environment Adequate financial strength

As such, these are the broad risk categories or risk factors built into our CRA models. CRA takes into account the above types of risks associated with a borrowal unit. The eventual CRA rating awarded to a unit (based on a score out of 100) is a single-point risk indicator of an individual credit exposure (please see Table-1 for details), and is used to identify, to measure and to monitor the credit risk of an individual proposal. At the corporate level, CRA is also used to track the quality of Banks credit portfolio. WHAT TYPE OF RATING IS AWARDED TO A LOAN PROPOSAL? The revised Credit Risk assessment (CRA) Models for Non-Trading & Trading Sectors, NBFCs and HFCs implemented in January 2010 was undertaken with the objective of making them Basel-II compliant and meeting the requirements of Internal Ratings Based (IRB) Approach. Salient Features of New CRA Models (a) Type of Models : S. Exposure Level No. (FB + NFB Limits ) (i) Over Rs. 5.00 crore (ii) Rs 0.25 crore to Rs. 5.00 crore (b) Type of Ratings : S. No. Model (i) Regular Model (ii) Simplified Model

Non Trading Sector (C&I , SSI , AGL) Regular Model Simplified Model

Trading Sector (Trade & Services) Regular Model Simplified Model

Type of Rating (i) Borrower Rating (ii) Facility Rating Borrower Rating
205

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(c) Type of Risks Covered : (i) S. No. Borrower Rating : Risk Category Maximum Score Regular Model Simplified Model Existing New Existing New Company Company Company Compan y 65 25 70 35 (65 x (70/2) 0.39) (-10) (-10) (-10) (-10) 20 30 20 40 (20 x 1.5) (20 x 2) 15 (+5) 45 ( 15 x 3) (+5) 10 (+5) 25 ( 10 x 2.5) (+ 5)

(i) (ii) (iii) (iv) (v)

Financial Risk (FR) Qualitative Factors (-ve) Business & Industry Risk (BR & IR) / Business Risk (for Trading Sector) Management Risk (MR) Qualitative Parameter (External Rating) Total

100

100

100

100

(vi) (vii) (viii) (ix) (x)

Borrower Rating based on the above Score Country Risk (CR) Final Borrower Rating after Country Risk Financial Statement Quality Risk Score / Rating Transition Matrix

Country Risk Assessment reworked Excellent / Good / Satisfactory / Poor Comments on Trend in Rating

(II) Financial Risk: Borrower Rating Regular Model (A) S. No. Financial Risk (FR) Parameter Marks Weight (b) (a) (i) TOL / TNW (a) Latest Ratio - 6 (b) Average of last 3 years-2 (c) Industry comparison - 2 Current Ratio (a) Latest Ratio-6 (b) Average of last 3 years-2 Maximum Wtd. Score Companys = (a) x (b) weighted (c) Score (d) 30

10

(ii)

10

1.5

15
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(c) Ind. comparison-2

(iii)

(iv)

(v)

(vi) (vii)

(viii)

(ix)

(x) (xi) (xii)

ROCE (PBDIT/ TA) (a) Latest Ratio-8 (b) Average of last 3 years-2 Retained Profit /TA (a) Latest Ratio-8 (b) Average of last 3 years-2 PBDIT/Interest (a) Latest Ratio-8 (b) Average of last 3 years-2 PAT/Net Sales (a) Latest Ratio - 8 (b) Average of last 3 years-2 Net Cash Accrual/Total Debt (a) Latest Ratio-8 (b) Average of last 3 years-2 Average Year to Year growth in Net Sales in last two quarters Financial Flexibility (a) Ability to raise funds through internal sources ( like internal accruals ,saleable assets); (b) Ability to raise resources through external sources (relationship with bankers, liquidity back-ups & the like); (c) Record in raising funds from capital markets; (d) Flexibility to defer its capital expenditure in case of weakening financial position. Group Risk Forex Risk Future Prospects (a) Gross Average DSCR (for all loans)

10

20

10

10

10

20

10

20

10

1.5

15

10

1.0

10

10

0.5

10 10 10

0.5 0.5 2

5 5 20

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(xiii)

(for a company availing TL facility only) or (b) (Inventory/Net Sales + Receivables/Gross Sales)x 365 (days) (for a company availing WC facility only) or (c ) [Sum of scores under {(a ) + (b)}]/2 (for a company availing both WC & TL facilities) Total Score ( FR) Total Score Normalized to 65 Qualitative Factors(ve) Total Score (FR)

10

2.0

20

195 195/3=65 (-10) 1 (-10) 65

Note on Scoring / Normalisation: (i) Calculation under Average of last 3 years includes latest year. (ii) In order to qualify for scoring under Average of Last 3 years sub-parameter , minimum data for last two years including the latest year would be required. (iii) In the event of non-availability of the minimum data as indicated in sub- para (ii) above, ratio-wise normalisation will be done. (iv) Gross Average DSCR (for all loans) : Gross Average DSCR for the entire residual period of the loan is to be reworked at the time of rating to ascertain the sufficiency of cash accrual or otherwise for continued repayability of the loan. (v) For existing units seeking additional Term Loan Facilities, Gross Average DSCR (for all loans) would be calculated taking into account the proposed TL Facilities.

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Business & Industry Risk (B & I R) Maximum Cos Parameters Score Score (i) Competition & Market Risk 2.5 (ii) Industry Outlook 2.5 (iii) Industry Cyclicality 1 (iv) Regulatory Risk 1.5 (v) Business Environment 0.5 (vi) Technology & Vulnerability to Technological 1.5 change (vii) Vulnerability to macro-economic 1 environment (viii) Access to Resources (Input profile) 2 (ix) User /product profile 2 (x)) Capacity utilisation & Flexibility in operation 1 (xi) Consistency in Quality 1 (xii) Research & Development / innovation 1 (xiii) Distribution Network 0.5 (xiv) Compliance of Environmental Regulations 2 Total Score (B & I R) 20 (C) Management Risk (MR) Parameters Maximum Cos Score Score (i) Integrity 2 (ii) Track Record / Conduct of Account / 2 Payment Record (iii) Managerial Competence / Commitment / 2 Expertise (iv) Structure & Systems 1 (v) Experience in the Industry 1 (vi) Strategic Initiatives 0.5 (vii) Length of relationship with the Bank 1.5 (viii) Credibility : Ability to achieve Sales /Profit 1 projections (ix) Ability to manage change 1 (x) Succession Plan / Key Person 1 (xi) Adherence to covenants of sanction 2 Total Score (MR) 15 (D) Qualitative Parameter (External Rating) (+5) (E) Aggregate Score under (FR + B & IR + MR) out of 100 ~ ( A +B+C+D) ~[ 65 + 20+ 100 15 + (+5)] (F) Borrower Rating based on the above score (G) Country Risk Assessment (H) Final Borrower Rating after Country Risk Assessment Excellent / Good (I) Financial Statement Quality /Satisfactory / Poor Qualitative comments on (J) Risk Score / Rating Transition Matrix trends
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(B )

(ii) Facility Rating (Regular Model): (A) Working Capital (WC) Facility / NFB Facilities (Except Capex) S.No Parameter Maximum Companys . Marks Score (A) (i) Risk Drivers for Loss Given Default (LGD) Industry (a) Industry Characteristics & Distance to Default - 3 Industry Recovery Score - 3 6 Geography 2 Unit Characteristics (a) Leverage / Enforcement of Collateral - 4 8 (b) Safety , Value & Existence of Assets- 4 Macro-Economic Conditions (a)

(ii) (iii)

(iv)

GDP Growth Rate : Impact of Business Cycle -1 4 (b) Insolvency Legislation in the Jurisdiction -1 (c) Impact of systemic / Legal factors on Recovery - 1 (d) Time Period for Recovery -1 (v) Total Security 70 (Primary + Collateral) (B) Risk Drivers for Exposure at Default (EAD) Credit Quality of the 10 Borrower # (C) Total Score [ (A) + (B) ] 100 (D) Borrower Rating Characteristics Current Ratio (-5) (E) Total Score (-ve) under Borrower Rating Characteristics (F) Total Facility Rating Score [100 + (-5) ] = [(C ) + (E)] (G) Facility Rating based on the Score in (F) above. (H) Assessment of Guarantees (I) Final Facility Rating after Assessment of Guarantees # Score of the unit under Borrower Rating to be divided by 10 to give Credit Quality of the Borrower.
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(B) Term Loan (TL) only / NFB Facilities for Capex S.No Parameter Maximum Companys . Marks Score (a) (b) (A) Risk Drivers for Loss Given Default (LGD) (i) Industry (b) Industry Characteristics & Distance to Default - 3 6 (c) Industry Recovery Score - 3 (ii) (iii) Geography Unit Characteristics (a) Leverage /Enforcement of Collateral - 4 (b) Safety , Value & Existence of Assets- 4 Macro-Economic Conditions (a) GDP Growth Rate : Impact of Business Cycle-1 (b) Insolvency Legislation in the Jurisdiction-1 (c) Impact of systemic /Legal factors on Recovery 1 (d) Time Period for Recovery 1 Total Security 2 8

(iv)

(v) (B)

70

Risk Drivers for Exposure at Default (EAD)

Credit Quality of the Borrower 10 # (C) Total Score [(A) + (B)] 100 (D) Borrower Rating Characteristics (i) Debt / Equity (-2) (ii) Gross Average DSCR (-2) (iii) Tenor of Facility (-1) (E) Total Score (-ve) under (-5) Borrower Rating Characteristics (i+ii+iii) (F) Total Facility Rating Score = [100 + (-5)] [( C ) + (E) ] (G) Facility Rating based on the Score in (F) above (H) Assessment of Guarantees (I) Final Facility Rating after Assessment of Guarantees # Score of the unit under Borrower Rating to be divided by 10 to give Credit Quality of the Borrower.
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NON-TRADING SECTOR : SIMPLIFIED MODEL BORROWER RATING SUMMARY Financial Risk (FR) (A) Parameters (a) (i) TOL/ TNW (a) Latest ratio -8 (b)Average of last 3 years-2 Current Ratio (a) Latest Ratio -8 (b)Average of last 3 years-2 Return on Capital Employed (ROCE) (%) (a) Latest ratio -8 (b)Average of last 3 years-2 PBDIT/Intt. (a) Latest ratio -8 (b)Average of last 3 years-2 PAT/Net Sales (a) Latest ratio -8 (b)Average of last 3 years-2 10 (b) 2.5 Mar ks Weig ht Maximum Weighted Score (a) x(b) (c) 25 Companys Weighted Score

(d)

(ii)

10

20

(iii)

10

20

(iv)

10

1.5

15

(v)

10

10

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(a)

Gross Average DSCR* (for All loans) (for TL only) or 10 2 20

(vi)

(b) Inventory / Net Sales + Receivables/Gross Sales (Days) (a) Latest ratio -8 (b)Average of last 3 years-2 (for WC only) or (c) [Sum of Scores under (A+B)]/2 (for a company enjoying both WC & TL facilities) Group Risk Forex Risk Future Prospects (FP) (Projected Ratios) Total Score Total Score normalised to 70 Qualitative Factors (-ve) Total Score (FR)

(vii) (viii) (ix)

10 10 10

0.5 0.5 2

5 5 20 140 140/2=70

(10)

(-10) 70

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NON-TRADING SECTOR : SIMPLIFIED MODEL BORROWER RATING SUMMARY *Note on Scoring: (i) Gross Average DSCR (for all loans) : Gross Average DSCR for the entire residual period of the loan is to be reworked at the time of rating to ascertain the sufficiency of cash accrual or otherwise for continued repayability of the loan. (ii) For existing units seeking additional Term Loan Facilities, Gross Average DSCR (for all loans) would be calculated taking into account the proposed TL Facilities. ( B) (i) (ii) (iii) (iv) (v) (vi) (vii) (C) (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) Business & Industry Risk(B & I R) Access to Resources (Input Profile) User / Product Profile Technology & Consistency in Quality Competition & Market Risk Industry outlook Regulatory, Labour & Environment Risk / Contemporary Issues Compliance of Environment Regulations Total (B & I R ) MANAGEMENT RISK (MR) Integrity Track Record / Conduct of account / Payment Record Managerial Competence / Commitment / Expertise Structure & Systems Experience in the Industry Length of Relationship with the Bank Succession Plan/Key Person Adherence to Covenants of Sanction Total Score under MR Qualitative Parameter (External Rating) Aggregate Risk Score : (A+B+C+D ) ~ [70 + 20 + 10 + (+5) ] CRA Rating based on the above score Country Risk (CR)Assessment Final Borrower Rating after CR Financial Statement Quality Risk Score/Rating Transition Matrix Maximum Score 3 3 2 4 4 2 2 20 2 2 2 0.5 0.5 1 0.5 1.5 10 (+5) Companys Score

(D) (E) (F) (G) (H) (I) (J)

100

Excellent/Good/Satisfactory/ Poor Qualitative comments on Trends

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TRADING SECTOR : REGULAR MODEL BORROWER RATING SUMMARY (A) Sl. No. (i) (ii) FINANCIAL RISK (FR) Parameter TOL / TNW (a) Latest Ratio - 8 (b)Average of last 3 years-2 Current Ratio (a)Latest Ratio - 8 (b) Average of last 3 years2 ROCE (PBDIT/ Total Assets) (a) Latest Ratio-8 (b) Average of last 3 years2 Retained Profit /TA (a) Latest Ratio-8 (b) Average of last 3 years2 PBDIT/Interest (a) Latest Ratio-8 (b) Average of last 3 years2 PAT/ Net Sales (a) Latest Ratio - 8 (b) Average of last 3 years2 Net Cash Accrual/Total Debt (TOL) (a) Latest Ratio-8 (b) Average of last 3 years2 Average Year to Year growth in Net Sales in last two quarters Financial Flexibility (a) Ability to raise funds through internal sources ( like internal accruals ,saleable assets); (b) Ability to raise resources through external sources (relationship with bankers, liquidity back-ups & the like); Mar ks (a) 10 10 Weig ht (b) 3 1.5 Maximum wtd. Score (a) x (b) (c) 30 15 Companys Weighted Score (d)

(iii)

10

20

(iv)

10

10

(v)

10

20

(vi)

10

20

(vii)

10

1.5

15

(viii)

10

1.0

10

10

0.5

(ix)

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215

(x) (xi) (xii)

(xiii)

(c) Record in raising funds from capital markets; (d) Flexibility to defer its capital expenditure in case of weakening financial position. Group Risk Forex Risk Future Prospects (Projected Ratios) (a) Gross Average DSCR (for all loans) (for a company availing TL facility only) or (b) (Inventory/Net Sales + Receivables/Gross Sales)x 365 (days) ( for a company availing WC facility only) or (c) [Sum of scores under {(a ) + (b)}]/2 (for a company availing both WC & TL facilities) Total Score Total Score Normalised to 65 Qualitative Factors (-ve) Total Score (FR)

10 10 10

0.5 0.5 2

5 5 20

10

2.0

20

195 195/3=65 (10) 1 (-10) 65

TRADING SECTOR : REGULAR MODEL BORROWER RATING SUMMARY Note on Scoring / Normalisation: (vi) Calculation under Average of last 3 years includes latest year. (vii) In order to qualify for scoring under Average of Last 3 years sub-parameter , minimum data for last two years including the latest year would be required. (viii) In the event of non-availability of the minimum data as indicated in sub- para (ii) above, ratio-wise normalisation will be done. (ix) Gross Average DSCR (for all loans) : Gross Average DSCR for the entire residual period of the loan is to be reworked at the time of rating to ascertain the sufficiency of cash accrual or otherwise for continued repayability of the loan.
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(x) For existing units seeking additional Term Loan Facilities, Gross Average DSCR (for all loans) would be calculated taking into account the proposed TL Facilities. (B ) (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (C) (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (D) (E) (F) (G) (H) (I) (J) Business Risk (BR) Parameters Competition Line of Activity & Market Risk Outlook/Cyclicality Regulatory Risk Technology Business Environment Vulnerability to macro-economic environment Distribution Network Maximu m Score 5 4 4 1.50 1.25 1.50 1.50 1.25 Companys Score

Total Score( BR) 20 Management Risk (MR) Parameters Integrity 2 Track Record / Conduct of Account/Payment Record 2 Managerial Competence / Commitment / Expertise 2 Structure & Systems 1 Experience in the Trade 1 Strategic Initiatives 0.5 Length of relationship with the Bank 1.5 Credibility: Ability to achieve Sales/Profit projections 1 Ability to manage change 1 Succession Plan/Key Person 1 Adherence to Covenants of Sanction 2 Total Score (MR) 15 Qualitative Parameter (External Rating) (+5) Aggregate Score under (FR+ BR +MR) out of 100 100 ~ ( A +B+C+D) ~ [ 65 + 20+ 15 + (+5)] Borrower Rating based on the above Score Country Risk (CR) Assessment Final Borrower Rating after Country Risk Assessment Excellent/Good/Satisfact Financial Statement Quality ory/Poor Qualitative Comments Risk Score / Rating Transition Matrix on Trends

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TRADING SECTOR : REGULAR MODEL : FACILITY RATING SUMMARY (A) Working Capital (WC) Facility / NFB Facilities (Except Capex) S.No Parameter Maximum Marks (A) (i) Risk Drivers for Loss Given Default (LGD) Trade @ (d) Trade Characteristics & Distance to Default - 3 Trade Recovery Score - 3 Geography Unit Characteristics (a) Leverage / Enforcement of Collateral - 4 (b) Safety , Value & Existence of Assets- 4 Macro-Economic Conditions (a) GDP Growth Rate : Impact of Business Cycle -1 (b) Insolvency Legislation in the Jurisdiction -1 (c) Impact of systemic / Legal factors on Recovery -1 (d) Time Period for Recovery - 1

Companys Score

6 2 8

(ii) (iii)

(iv)

Total Security (Primary + Collateral) 70 Risk Drivers for Exposure at Default (EAD) Credit Quality of the Borrower # 10 (C) Total Score [ (A) + (B) ] 100 (D) Borrower Rating Characteristics Current Ratio (-5) (E) Total Score (-ve) under Borrower Rating Characteristics (F) Total Facility Rating Score = [(C ) + (E)] [100 + (-5) ] (G) Facility Rating based on the Score in (F) above. (H) Assessment of Guarantees (I) Final Facility Rating after Assessment of Guarantees # Score of the unit under Borrower Rating to be divided by 10 to give Credit Quality of the Borrower. @ No Scoring under the parameters of Trade & Geography on account of non-availability of LGD / Growth data. Marks obtained out of 92 to be normalized to 100.

(v) (B)

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TRADING SECTOR :REGULAR MODEL FACILITY RATING SUMMARY (C) Term Loan (TL) only / NFB Facilities for Capex S.No . Parameter Maximum Marks (a) Companys Score (b)

(A) (i)

Risk Drivers for Loss Given Default (LGD) Trade @ (e) Trade Characteristics & Distance to Default 3 (f) Trade Recovery Score 3 Geography Unit Characteristics (a) Leverage /Enforcement of Collateral - 4 (b) Safety , Value & Existence of Assets- 4 Macro-Economic Conditions (a) GDP Growth Rate : Impact of Business Cycle-1 (b) Insolvency Legislation in the Jurisdiction-1 (c) Impact of systemic /Legal factors on Recovery 1 (d) Time Period for Recovery - 1

6 2 8

(ii) (iii)

(iv)

Total Security 70 Risk Drivers for Exposure at Default (EAD) Credit Quality of the Borrower # 10 (C) Total Score [(A) + (B)] 100 (D) Borrower Rating Characteristics (i) Debt / Equity (-2) (ii) Gross Average DSCR (-2) (iii) Tenor of Facility (-1) (E) Total Score (-ve) under Borrower Rating (-5) Characteristics (i+ii+iii) (F) Total Facility Rating Score = [( C ) + (E) ] [100 + (-5)] (G) Facility Rating based on the Score in (F) above (H) Assessment of Guarantees (I) Final Facility Rating after Assessment of Guarantees # Score of the unit under Borrower Rating to be divided by 10 to give Credit Quality of the Borrower. @ No Scoring under the parameters of Trade & Geography on account of non-availability of LGD / Growth data. Marks obtained out of 92 to be normalized to 100.

(v) (B)

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TRADING SECTOR : SIMPLIFIED MODEL BORROWER RATING SUMMARY

(A) S. No. Financial Risk (FR) Mar ks Weig ht Maximum Weighted Score = (a) x (b) (c) 25 20 20 15 10 Companys Weighted Score

Parameters (a) TOL/ TNW (a) Latest ratio -8 (b)Average of last 3 years-2 Current Ratio (ii) (a) Latest Ratio -8 (b)Average of last 3 years-2 Return on Capital Employed (ROCE) (%) (iii) (a) Latest ratio -8 (b)Average of last 3 years-2 PBDIT/Intt. (iv) (a) Latest ratio -8 (b)Average of last 3 years-2 PAT/Net Sales (v) (a) Latest ratio -8 (b)Average of last 3 years-2 (A) Gross Average DSCR* (for All loans) (for TL only) (B) Inventory / Net Sales + Receivables / Gross Sales (Days) (a) Latest ratio -8 (b)Average of last 3 years-2 (vi) (for WC only) or (C) Sum of Scores under (A+B)]/2 (for a company enjoying both WC & TL facilities) (vii) Group Risk (viii) Forex Risk (ix) Future Prospects (FP) (Projected Ratios) Total Score Total Score normalized to 70 (i) 10 10 10 10 10 (b) 2.5 2 2 1.5 1

(d)

10

20

10 10 10

0.5 0.5 2

5 5 20 140 140/2=70

Qualitative Factors (-ve) (-10) 1 (-10 ) Total Score (FR) 70 *Note on Scoring (i) Gross Average DSCR (for all loans) : Gross Average DSCR for the entire residual period of the loan is to be reworked at the time of rating to ascertain the sufficiency of cash accrual or otherwise for continued repayability of the loan.

(ii) For existing units seeking additional Term Loan Facilities, Gross Average DSCR (for all loans) would be calculated taking into account the proposed TL Facilities.
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(B) S. No. (i) (ii) (iii) (iv) (v) (C) (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (D) (E) (F) (G) (H) (I)

(J)

TRADING SECTOR : SIMPLIFIED MODEL BORROWER RATING SUMMARY Business Risk (BR) Parameters Maximum Companys Score Score Competition & Market Risk 8 Outlook / Cyclicality 6 Technology 2 Business Environment 2 Regulatory Risk 2 Total Score (BR) 20 Management Risk (MR) Integrity 2 Track Record / Conduct of Account / Payment Record 2 Expertise, Managerial Competence & Commitment 2 Structure & Systems 0.5 Experience in the Trade 0.5 Length of Relationship with the Bank 1 Succession Plan/Key Person 0.5 Adherence to Covenants of Sanction 1.5 Total Score (MR) 10 Qualitative Parameter (External Rating) (+5) Aggregate Risk Score :(FR + BR + MR) : 100 (A+B+C+D) ~ [70 + 20 + 10 + (+5)] CRA Rating Based on the above Score Country Risk (CR) Assessment Final Borrower Rating after CR Excellent / Good / Financial Statement Quality Satisfactory / Poor Qualitative Comments on Risk Score/Rating Transition Matrix Trends

(d) Rating Scales (Borrower Rating ): S. Borrower Range No. Rating of Scores 1 SB1 94-100 2 SB2 90-93 3 SB3 86-89 4 SB4 81-85 5 SB5 76-80 6 7 8 9 10 11 SB6 SB7 SB8 SB9 SB10 SB11 70-75 64-69 57-63 50-56 45-49 40-44 Risk Level Virtually Zero risk Lowest Risk Lower Risk Low Risk Moderate Risk with Adequate Cushion Moderate Risk Average Risk Acceptable Risk (Risk Tolerance Threshold) Borderline risk Comfort Level

Virtually Absolute safety Highest safety Higher safety High safety Adequate safety Moderate Safety Above Safety Threshold Safety Threshold Inadequate safety
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12 13 14 15 16 (e) S. N O

SB12 SB13 SB14 SB15 SB16

35-39 30-34 25-29 <=24 -

High Risk Higher Risk Substantial risk Pre-Default Risk (extremely vulnerable to default) Default Grade

Low safety Lower safety Lowest safety Nil

Rating Scales (Facility Rating) : FACILI TY GRAD ES FR1 FR2 FR3 FR4 FR5 RANGE OF SCORE LGD LEVEL (Recovery Level) RISK LEVEL COMFORT LEVEL

1 2 3 4 5

94-100 87-93 80-86 73-79 66-72

Virtually Zero LGD Lowest LGD (Highest Recovery) Lower LGD (Higher Recovery) Very Low LGD (High Recovery) Low LGD (Adequate Recovery) Moderate LGD (Moderate recovery) Average LGD (Average Recovery) LGD Tolerance Threshold (Recovery Tolerance Threshold) High LGD (Low recovery) Higher LGD (Lower Recovery) Substantial LGD (Small recovery) Highest LGD (Minimal/zero recovery

Virtually Zero Risk Lowest Risk Lower Risk Low Risk Moderate Risk with Adequate Cushion Moderate Risk Average Risk Acceptable Risk (Risk Tolerance Threshold) High Risk Higher Risk Substantial Risk Highest Risk

Virtually Absolute Safety Highest Safety Higher Safety High Safety Adequate Safety

6 7 8 9 10 11 12 13 14 15 16

FR6 FR7 FR8 FR9 FR10 FR11 FR12 FR13 FR14 FR15 FR16

59-65 52-58 45-51 38-44 31-37 24-30 17-23 11-16 5-10 1-4 0

Moderate Safety Above Safety Threshold Safety Threshold Low Safety Lower Safety Lowest Safety NIL

(f) Mapping to Old Borrower Rating Bands : New CRA Model S. No. 1 2 3 Score 94-100 90-93 86-89 Grade SB1 SB2 SB3 Existing CRA Model Grade SB1 Score >= 90

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SB2 4 81-85 SB4 5 76-80 SB5 6 70-75 SB6 SB3 7 64-69 SB7 8 57-63 SB8 SB4 9 50-56 SB9 10 45-49 SB10 SB5 11 40-44 SB11 SB6 12 35-39 SB12 13 30-34 SB13 SB7 14 25-29 SB14 15 < =24 SB15 SB8 16 SB16 (g) Qualitative Parameter (External Rating) :

>=75 >=65 >=50 >=45 >35 >=25 <25

Solicited Rating by a recognized External Credit Rating Agency (ECRA) translates to additional Score (Long Term Bank Loan Ratings given by the External Rating Agencies would qualify). Following ECRAs recognised by RBI are considered for this purpose:
S. No. 1 Type Domestic ECRA (a) Credit Analysis & Research Limited; (b) CRISIL Limited; (c) FITCH India; (d) ICRA Limited. (a) FITCH; (b) Moodys; (c) Standard & Poors

International 2

External Credit Rating Agencies (ECRAs) assign Bank Loan Ratings (BLRs) on long-term and short-term rating scales for various credit facilities. Cash Credit exposures should be reckoned as long term exposures and accordingly the long term rating awarded by ECRAs will be relevant. The BLR for Cash Credit facility should be reckoned for borrowers enjoying Cash Credit facility and other facilities such as Term Loan, Bank Guarantee, Letter of Credit facilities. If a borrower is enjoying long term facilities (other than Cash Credit) as well as short term facility, BLR for long term facility be considered. However, if a borrower has availed only a short term facility which has been rated by an ECRA, BLR for the same may be considered. The Scoring Bands for factoring Bank Loan Ratings of ECRAs (Long term/ Short Term) are as under: Long Term Rating AAA AA A BBB BB & below CAR E PR1+ PR1 PR2 PR3 PR4 & PR5 P1+ P1 P2 P3 P4 & P5 F1+ F1 F2 F3 B,C,D A1+ A1 A2 A3 A 4/ A5 20% 30% 50% 100% 150% Short Term Rating CRISIL FITCH ICRA Standardised Approach Risk Weight Additional Score Under New CRA Models 5 3.5 2 1 0

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Applicability of Issue Rating In circumstances where BLR in respect of a borrower is not available but a debt-issue of the borrower has been rated by an ECRA, such issue rating can be considered for awarding score if the Banks claim in respect of credit facilities ranks pari passu or senior to the rated debt issue. Multiple Ratings : In case of borrowers having multiple ratings from recognised ECRAs, following procedure is to be followed: (i) (ii) (iii) If there is only one ECRA rating for a particular claim, that rating would be used to determine scoring; If there are two ratings accorded by ECRAs which map into different risk weights, the rating corresponding to the higher risk weight would be taken cognisance of for scoring ; If there are three or more ratings accorded by ECRAs, with different risk weights, the ratings corresponding to the two lowest risk weights should be referred to and the rating corresponding to the higher of the two risk weights should be taken cognizance of for scoring.

(h) Financial Statement Quality: The credit analyst is to comment on the quality, adequacy and reliability of financial statements / information irrespective of the Risk Rating. This includes consideration of the size and capabilities of the accounting firm, compared to the complexities of the borrower and its financial statements. The comments on the quality of financial statements should include the quality of information provided to the Bank. The Quality is to be indicated as Excellent/Good/Satisfactory/Poor. This step is not instrumental in improvement of rating but is helpful in defining the best possible Borrower Rating. (i) Risk Score / Rating Transition Matrix: A major fluctuation in scores resulting in upgradation or deterioration in Rating by more than one stage is to be commented upon. Upgradation in Rating only on account of higher score in parameters other than Financial Risk , is to be examined and commented upon. This provides an additional risk awareness tool for the Credit Analyst. (j) Country Risk : Country risk is the risk that a borrower will not be able to service its obligations to pay because of cross - border restrictions on the convertibility or availability of a given currency. It is also an assessment of the political and economic risk of a country. Country Risk is assumed to exist when 25% or more of the borrowers cashflow or assets are located outside India. Country Risk Ratings are circulated by Foreign Department (FD). Country Risk Assessment Applicability: (i) (ii) Country Risk would be applicable to units having 25% or more of Cashflows / Assets to countries starting from Medium Risk. If entire such exports fall under single category from Medium Risk category to any of the Higher Risk Categories, Borrower Rating would undergo a downgrade as per the table below.
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(iii)

(iv)

In case of Unit having aggregate exports of 25% or more to various countries (under 5 categories of Medium to Higher Risk i.e. Medium Risk/ Medium Risk but under caution/ High Risk but not under Caution/ High Risk & under Caution/Very High Risk & under Caution), two categories would be identified which contribute maximum of such 25% or more of export and rating would be arrived for those two categories based on the table provided below. In such case the lower of the two ratings as arrived above would be the Final Borrower Rating of the Company. Exports against advance payment would not be taken into consideration for Country Risk Rating. Further, in cases where risk arising out of exports to Medium Risk to Higher Risk category countries is mitigated by a L/C from a first class Bank recognised by SBI or by ECGC cover, the Country Risk Rating would not be applicable. However, such details of exposure alongwith the type of risk mitigation available will have to be explicitly indicated in the CRA assessment sheet for validation by the CRA validation Committee or the equivalent authority as the case may be. Change in Rating based on Risk Category of Country* Country Ratings Change in Rating Insignificant Risk NIL Low Risk NIL Medium Risk NIL Medium Risk but under Caution Down by 1-stage High Risk but not under Caution Down by 2-stage High Risk & under Caution Down by 3 stage Very High Risk & under Caution Down by 4 stage Off Credit/ Restricted & under Caution Down by 5-stage * Country Ratings are circulated by Foreign Department (FD) from time to time.

(v)

If the borrower rating undergoes a downgrade of 3 or more stages on account of country risk, the sanction would be required to be obtained from a higher authority in the following manner: Sanctioning Authority Sanction Required from higher CCC-II & below CCC-I SMECC & below MCCC CCC-I/MCCC/WBCC WBCC CCCC/ECCB CCCC/ECCB

(k) Entry Barriers : (i) Non-Trading Sectors (Regular & Simplified Models)

All proposals are required to be rated first under two parameters of Compliance of Environmental Regulations and Integrity for which separate set of value statements have been given. A proposal getting zero (0) score in any of the two Entry Barriers would not be processed further and would be declined. No deviation is envisaged in the Entry Barrier. (ii) Trading (Regular & Simplified Models) All proposals are required to be rated on Integrity. A proposal getting zero (0) score would not be processed further and would be declined. No deviation is envisaged in the Entry Barrier.

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Frequency of Assessment Under Entry Barrier Existing Connections: (i) Annual Review or Renewal at Existing Level / Renewal with Enhancement; (ii) Any Facility being assessed for sanction subsequent to Annual Review / Renewal e.g., Working Capital / Term Loan / NFB Facilities. New Connections: (i) First Sanction / subsequent review;

(ii) Any Facility being assessed for sanction subsequent to First Sanction e.g., Working Capital /Term Loan/ NFB Facilities; Value Statements: Entry Barrier: Compliance of Environmental Regulations S. Value Statement No. (i) Full Compliance of Environmental Regulations as per the Central/State Laws. (ii) At present partial compliance but firm steps initiated for full compliance. Utter disregard of Environmental Regulations. (iii) Entry Barrier: Integrity (a) Integrity (Sole Proprietary Concern/ Partnership Firm/ Scor Unlisted Company) e The integrity and character of the Management is beyond (i) reproach. No fraudulent deals / transactions. On no occasion 2 any unsatisfactory feature of the unit has come to light. No adverse features revealed in any audit report. The management is reportedly reliable, has good reputation in (ii) the market and there are no adverse reports either on its 1.5 integrity. No adverse features to doubt the integrity of promoters. No adverse features revealed in any audit report. Rumours of adverse features not fully substantiated and hence (iii) may / may not be reckoned depending upon their seriousness. 1 Reports on conduct of account / stock audit / spot audit / periodic inspection reports comment against the integrity of the (iv) unit. The unit is a defaulter under RBIs wilful defaulters list. History indicates involvement in civil /criminal suits / questionable deals. (b) Integrity (for Listed Companies) : Corporate Governance (CG) CG systems are in place. The Company is not a defaulter or
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Score 2 1 0

Conclusion Proposal accepted for further processing No further processing of Proposal Remarks

Proposal accepted for further processing.

No further processing of Proposal Remarks

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wilful defaulter. The promoter Directors on the Board of the Company irrespective of their capacity, whether executive or non-executive are not defaulters / wilful defaulters. CG systems need fine tuning. The Company is aware of this task and is taking required steps in that direction. No adverse features on Companys Management reported in any of the (ii) Audit Reports .The company is not a defaulter / wilful defaulter. The promoter Directors on the Board of the Company irrespective of their capacity, whether executive or non-executive are not defaulters / wilful defaulters. Some complacency in implementation of CG Principles. The Company is not a defaulter / wilful defaulter / the promoter (iii) Directors on the Board of the Company irrespective of their capacity, whether executive or non-executive are not defaulters / wilful defaulters. Complacency in implementation of CG Principles evident. The (iv) Company is not a wilful defaulter / the promoter Directors on the Board of the Company are not wilful defaulters. (v) Disregard of the Corporate Governance systems. The company is defaulter/wilful defaulter. / The promoter directors of the applicant company are defaulters / wilful defaulters or are promoter directors of a company which is defaulter / wilful defaulter. (l) Hurdle Scores: Risk Types Financial Risk (FR) Business & Industry Risk (B&IR) [Business Risk (BR) for trade] Management Risk (MR) Aggregate hurdle Score Overall Hurdle Grade# Regular Model Existing New Company Company 25/65 10/25 12/20 8/15 45/100 SB10 16/30 22/45 48/100 SB10

(i)

1.5

Proposal accepted for further processing

0.5 0 No further processing of Proposal

Simplified Model Existing New Company Company 30/70 15/35 10/20 5/10 45/100 SB10 20/40 13/25 48/100 SB10

# Score Range 45-49 corresponds to SB10. Hence as per New CRA Models SB10 is the new Hurdle Grade. Under Facility Rating, if the score goes below the hurdle rate of FR10, the reasons for low score are to be given. (m) Factoring Decimal Scores while aggregating Score for Risk Grading (i) Score upto 0. 4 to be ignored; (ii) Score of 0.5 or more to be rounded off to the next number.

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(n) Reporting of Risk Score alongwith Rating: Aggregate Risk Score is to be shown in brackets alongwith Borrower Rating in internal reporting within the Bank. (o) Frequency of Rating: Annual. Borrowal Accounts, however, rated SB10 and below would be rated at half-yearly intervals due to the risk severity of the loan. (p) Risk Assessment for New Units Activity Status Basis of Risk Assessment Newly incorporated unit where the Projected Financials production/commercial production is yet to begin Newly incorporated unit where the audited Projected Financials financials relate to less than 12 months of commercial production. Newly incorporated unit where the audited financials reflect minimum 12 months of working Audited Financials after the start of commercial production. For Rating purpose, a new unit refers to a newly incorporated Firm / Company which may continue to be regarded as new for a period of three years after the start of commercial production. However, in the case of Companies / Firms promoted by an established Group, a view regarding their status as new or otherwise would be taken by the CGM of the Circle / CAG / Mid-Corporate after one years performance. (q) General (i) CRA Models models are applicable across the Bank for all exposures of Rs. 25 lacs and above. These models do not provide for any exemptions (including that for schematic lendings) unless the exemption is specifically approved by CPPC. (ii) For units engaged in both Industrial & Trading activities, the Risk Rating will be done based on the predominant activity financed by the Bank and the relevant model used. (iii) In a Multi Division Company, the thrust of scoring under Industry Outlook would be limited to the industry being financed by the Bank. (iv) Wherever a parameter is not applicable, the score would be normalised. (v) For a new unit, where value statements for some of the parameters appear to be out of place for scoring, the Credit Analyst would assess whether the unit has any plans to measure upto the levels indicated under those value statements and then score accordingly. (vi) While Borrower Rating of a unit will remain unchanged for a period upto one year, the different facilities would be rated simultaneously with Borrower Rating or as and when the facility is sanctioned / reappraised. A unit would carry several different Facility Ratings e.g. if a unit is enjoying one Working Capital facility & two (say) Term Loan facilities, it will have one Borrower Rating & 3 Facility Ratings. (vii) Borrower Rating would not be assessed each time a new facility is sanctioned to the unit within the year. (viii) While working out the Facility Rating, the share of total security against that facility will be worked out to score under Total Security (Primary + Collateral).

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3. Facility Rating (i) Facility Rating Design A Borrowing Company may be availing either one or more of Fund Based (FB) Facilities such as Working Capital (WC) /Term Loan (TL) or/and Non-Fund Based (NFB) Facilities like, Letters of Credit (L C) / Bank Guarantee (BG). All the facilities are to be rated separately viz., if a Borrowing Company has both WC & TL & two Bank Guarantee Facilities & three different L/C Facilities; in total, the Company would have one Borrower Rating & seven (i.e, 1+1+2 + 3 = 7) Facility Ratings. The pricing of loans, in future, will be linked to Facility Rating after building up adequate Loss Given Default (LGD) data base. For the present, pricing will continue to be linked to Borrower Rating only. (ii) Facility Hurdle Rate All facilities are expected to meet the Facility Hurdle Rate of FR10. Reasons for not crossing this Hurdle Rate would need to be commented upon by the Credit Analyst. (iii) Loss Given Default (LGD) Facility Rating would reflect the degree of severity of loss in the event of default on the obligation. Facility Rating Grade will thus translate to a LGD Scale, indicating loss percentage. The present Facility Rating Grades / Scales are empirically designed to reflect LGD levels. (iv) Collateral The Collaterals are an important ingredient of Facility Rating design; their quality and depth affects the severity of LGD for any facility and hence the Facility Rating itself. As an element of risk (uncertainty) is involved, prudence is required in assessing the value of the collateral offered for obtaining credit facility. The security is to be valued as per the extant instructions of the Bank. Basel-II does not differentiate between Primary & Collateral Securities and all securities charged for a loan are designated as Collaterals. Thus, while for monitoring of Drawing Power (DP) or DP related issues in borrowal accounts, the securities charged would continue to be segregated into Primary and Collateral securities, however, for the purpose of risk assessment, all securities will be treated as collateral securities. (v) Scoring under Facility Rating Scoring under Total Security Parameter under Facility Rating requires an in-depth look into types of Collaterals and their recognition and valuation as per Basel-II / RBI Document as discussed in Banks Collateral Management Policy (please see para 5 below). This would necessitate detailed analysis of Collaterals to facilitate scoring. In case of change in Facility Rating after Assessment of Guarantees, upper range of score corresponding to Final Facility Rating after taking Guarantees in consideration to be treated as units Score under Facility Rating. 4. IRB Requirements under Basel-II Guidelines Requirements for Risk Rating Design under Internal Ratings Based (IRB) Approach are detailed in Basel-II Document (International Convergence of Capital Measurement and Capital Standards) - A Revised Framework, published in June, 2006, available on the Bank for
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International Settlement website www.bis.org. Extracts from the Document are enclosed (for reference and detailed study, if desired). The following definitions are used in this context: S. No. Terminology Definition (i) (ii) (iii) (iv) (v) Probability of Default (PD) Loss Given Default (LGD) Exposure at Default (EAD) Expected Loss (EL) Unexpected (UL) The probability/risk/chance of a borrower defaulting on the payment of the credit obligations. The loss suffered in the event of a default of an exposure. The amount that is exposed to the default risk.

Part of the credit loss that happens in the normal course of business due to default of exposures and the banks have to either make provisions for it or price it in the loans. Loss Part of credit loss that cannot be estimated or priced into the product and hence the banks have to provide capital for it by risk-weighting their assets.

Highlights of Basel requirements are as under: (i) The term rating system comprises all of the methods, processes, controls, and data collection and IT systems that support the assessment of credit risk, the assignment of internal risk ratings, and the quantification of default and loss estimates. A qualifying IRB rating system needs to have two separate and distinct dimensions: (a) the risk of borrower default i.e, Borrower Rating and (b) transaction-specific factors i.e., Facility Rating. A bank must articulate the relationship between borrower grades in terms of the level of risk each grade implies. Perceived and measured risk must increase as credit quality declines from one grade to the next. The second dimension must reflect transaction-specific factors, such as collateral, seniority, product type, etc. For banks using the advanced approach, facility ratings must reflect exclusively Loss Given Default (LGD). These ratings can reflect any and all factors that can influence LGD including, but not limited to, the type of collateral, product, industry, and purpose. Borrower characteristics may be included as LGD rating criteria only to the extent they are predictive of LGD. Banks may alter the factors that influence facility grades across segments of the portfolio as long as they can satisfy their supervisor that it improves the relevance and precision of their estimates. A bank must have a meaningful distribution of exposures across grades with no excessive concentrations, on both its borrower-rating and its facility-rating scales. To meet this objective, a bank must have a minimum of seven borrower grades for nondefaulted borrowers and one for those that have defaulted. Banks with lending activities focused on a particular market segment may satisfy this requirement with the minimum number of grades; supervisors may require banks, which lend to borrowers of diverse credit quality, to have a greater number of borrower grades.
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(ii)

(iii)

(iv)

(v)

(vi)

There is no specific minimum number of facility grades for banks using the advanced approach for estimating LGD. A bank must have a sufficient number of facility grades to avoid grouping facilities with widely varying LGDs into a single grade. The criteria used to define facility grades must be grounded in empirical evidence. A bank must have specific rating definitions, processes and criteria for assigning exposures to grades within a rating system. The rating definitions and criteria must be both plausible and intuitive and must result in a meaningful differentiation of risk. To ensure that banks are consistently taking into account available information, they must use all relevant and material information in assigning ratings to borrowers and facilities. Information must be current. The less information a bank has, the more conservative must be its assignments of exposures to borrower and facility grades or pools. An external rating can be the primary factor determining an internal rating assignment; however, the bank must ensure that it considers other relevant information. A borrower rating must represent the banks assessment of the borrowers ability and willingness to contractually perform despite adverse economic conditions or the occurrence of unexpected events. The range of economic conditions that are considered when making assessments must be consistent with current conditions and those that are likely to occur over a business cycle within the respective industry/geographic region. Given the difficulties in forecasting future events and the influence they will have on a particular borrowers financial condition, a bank must take a conservative view of projected information. Furthermore, where limited data are available, a bank must adopt a conservative bias to its analysis. A bank must have a credible track record in the use of internal ratings information. A bank using the advanced IRB approach must demonstrate that it has been estimating and employing LGDs and EADs in a manner that is broadly consistent with the minimum requirements for use of own estimates of LGDs and EADs for at least the three years prior to qualification. Improvements to a banks rating system will not render a bank noncompliant with the three-year requirement.

(vii)

(vii)

(viii)

(ix)

(x)

5. Collaterals & Guarantees Collateral Management Policy of the Bank has been put in place based on Basel-II / RBI Guidelines. This Policy is to be referred to for scoring under Total Security Parameter and Assessment of Guarantees under Facility Rating. Some features of the Policy are mentioned below: In addition to the general requirements for legal certainty, the legal mechanism by which the collateral is pledged or transferred must ensure that the Bank has the right to liquidate or take legal possession of the Collateral, in a timely manner, in the event of the default / insolvency /bankruptcy on the part of the counterparty or third party. Collaterals are broadly classified as Financial and Non-Financial A guarantee (counter-guarantee) must represent a direct claim on the protection provider and must be explicitly referenced to specific exposures or a pool of exposures, so that the extent of
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the cover is clearly defined and incontrovertible. The guarantee must be irrevocable. There must be no clause in the contract that would allow the protection provider unilaterally to cancel the cover or that would increase the effective cost of cover as a result of deteriorating credit quality in the guaranteed exposure. The guarantee must also be unconditional; there should be no clause in the guarantee outside the direct control of the Bank that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payment(s) due. 6. A Note on Guarantee Guarantees have remained an important driver for recovery. Guarantees would now be assessed separately for the additional comfort they provide for recovery. Rating arrived corresponding to total score under Facility Rating would move upward upto 2 stages based on the type of Guarantees as prescribed in the CRA Models. RISK ASSESSMENT - AN ESTIMATION, NOT A MATHEMATICAL CERTAINTY: However, we must appreciate that risk is not a mathematical concept. It cannot be measured accurately. It can only be assessed with some limitations. This is so because the components of risk (or, risk factors / categories) are partly quantifiable and partly non-quantifiable; some components are objective and some are subjective. It is easy to see that Financial Strength (which can be judged from widely accepted financial ratios and parameters) is a quantifiable and objective factor, while the others (Management, Business and Industry Risks) are not so. The latter three can be referred to as judgmental parameters, because the appraiser and the assessor have to apply their judgement about the unit and its promoters based on perceptions of different attributes which are neither measurable nor categorically objective. We should also remember that in risk assessment, we can only have a Model and go on refining it, based on our experiences, but never forget that a model is a model is a model

HOW ARE VARIOUS RISKS MEASURED/ ASSESSED? Financial risks are measured on the basis of a range of scores obtained in respect of the different financial / performance parameters under static ratios, moving average of companys last 3 years ratio, future prospects, group risk, forex risk and risk mitigation by accounting for the marks obtained under qualitative parameters. Again, the financial, management, industry and business risk factors carry different weights for existing and New units. [In this context, a new unit refers to a newly incorporated company/firm and should continue to be regarded as new for a period of three years. However, in the case of companies/firms promoted by an established group, the sanctioning authority may take a view on its status after one years performance].

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For assessment of the other types of risks, Business and Management, the scoring is on the basis of a subjective analysis, based on prescribed value statements. Appropriate weightages are accorded to the various types of risks (i.e. Financial, Business & Industry and Management). USE OF VALUE PARAMETERS : STATEMENTS (VS) TO ASSIGN SCORES TO JUDGEMENTAL

For each parameter under these risks, prescribed value statements (VS) convey different degrees of risk. The credit analyst/ Field Officer has to choose that VS which fits his perception about the unit to the closest extent & award the score prescribed for that VS. These scores are then added up, normalized (in Trade model) and weighted average taken to get the aggregate score. HOW ARE THE CREDIT RISK MANAGEMENT TOOLS USED TO MONITOR HEALTH OF THE BANKS LOAN PORTFOLIO? Periodical review of loan portfolio on risk rating basis is carried out to assess overall health of the Banks loan portfolio. Industry / geographical areas / groups are also reviewed periodically and appropriate ceilings set up to reduce concentration risks. CAN WE SHARE THE CRA DETAILS WITH THE BORROWERS? Yes, but to a limited extent, vide CC/CPP/AS/ CIR/14 DT. 04.06.2004. Items in CRA exercise that can be shared with the borrowers: -

CRA rating finally arrived at in a credit proposal can be informed to the borrower in writing
The following can be shared informally with the borrower (that is, across the table/ verbally) :

The four risk categories & the important parameters associated with each type of risk, viz,
CR, TOL/TNW, PAT/NS, Asset Turnover Ratio, Interest coverage Ratio, ROCE o Business : Technology, Consistency in Quality / Consistency in Cash Flow, Compliance of Environmental Regulations, etc. o Industry : Regulatory Risk, Competition, Industry Outlook etc. o Management : Expertise, Managerial Competence / Commitment, Track Record, Payment Record etc. [CARE: Marks/ Ratings on Integrity should not be discussed for obvious reasons]. And most importantly, the reasons for low rating, if any, should be shared with the borrower. o Financial :

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HOW IS CREDIT RATING LINKED TO LOAN PRICING? Pricing bands over Prime Lending Rate are linked to Credit Rating, with some flexibility for deviations delegated to different Sanctioning Authorities as per a prescribed structure. ACCOUNTS COVERED UNDER THE CREDIT RATING SYSTEM: - All large value Loans (Rs.25 lacs & above) for Commercial / AGL/ Trade/ NBFC Segments are covered under credit rating system. Table-3A : Authority for permitting deviations in minimum scores Sanctions by Deviations to be approved by Financial Risk * Below CCC-II / MCCC CCC-II/MCCC Business & Industry Risk Below CCC-II / MCCC CCC-II/MCCC Management Risk CCC-II/MCCC & Sanctioning Authority above Note: (The above authority structure Deviations under Financial would apply to cases where Risk reduced to 15%, so deviations do not exceed 10% that the rating do not slip below the minimum prescribed by more than one scale. score in case of Financial Risk. In case they exceed 10%, such deviations may be approved by CCC-I/MCCC in respect of sanctions by CCC-II & below. For sanctions by CCC-I/MCCC & above, sanctioning authority may approve). ii. Management /Business & Industry Risk: Deviation from the minimum prescribed scores will be permitted by CCCC only. Financing below the Hurdle Rate Sanctions by CCC-II & below CCC-I / MCCC & above New connections and enhancements Deviations to be approved by CCC-I /MCCC Sanctioning Authority As per new rating model, SB9 is the hurdle rate for new connections and enhancement. Though not normally envisaged, deviations may be permitted upto SB10 and may be approved by an authority prescribed above. In respect of borrowers rated SB 11 and below, no deviation is to be considered for new connections. Some Important Points to note: Only Standard Assets to be risk-rated. In case of a Consortium advance, only our share to be risk-rated.
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Rating is done at appraisal stage (CA/FO). Re-look to be given by assessor on judgmental scoring on I/M/B risk factors. Assessor should confirm the rating. At non-specified Branches, Bill Discounting limits under LCs form part of ABF/Total indebtedness. Hence should be included as part of WCL. If a Company is engaged in both manufacturing & trading activities, the Model should pertain to the predominant activity. Authority structure for CRA rating confirmation / approval : The internal credit risk rating will be independently validated and approved by a separate Committee. This process of validation and approval is made prior to sanction/renewal/enhancement of the credit facilities and separated from the loan sanction process. Further readings/ references: 1) The unified CRA Model modified vide CC letter NO: CRMD/BS/ dated 9th January 2010. 2) SME Smart Score - Corporate Centre letter nos. PDM/5/02-03 dt.21.09.02 & PDM/1 of 03-04 DT. 03.04.03. 3) Revised CRA Model for Non Banking Finance Companies (NBFCs) / Housing Finance Companies (HFCs) 4) Prudential Guidelines on Capital Adequacy - Implementation of the New Capital Adequacy Framework RBI letter no. DBOD.No.BP.BC.73/21.06.001/2009-10 dated 08.02.2010, addressed to the Chairmen of all Scheduled Commercial Banks.

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9.NON FUND BASED BUSINESS (A) LETTERS OF CREDIT Introduction The expectation of the seller of any goods and services is that he should get the payment immediately on delivery of the same. This may not materialise if the seller and the buyer are at different places (either within the same country or in different countries). The seller desires to have an assurance for payment by the purchaser. At the same time the purchaser desires that the amount should be paid only when the goods are actually received. Here arises the need for Letters of Credit (LCs). The objective of an LC is to provide a means of payment for goods and services supplied by a seller to buyer ensuring payment to the seller and the delivery of goods and services to the buyer at the same time. Definition 1. A Letter of Credit (LC) is means any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation. In other words, a documentary credit is an undertaking issued by a bank, on behalf of the buyer (the importer), to the seller (exporter) to pay for goods and services provided that the seller presents documents which comply with the terms and conditions of the documentary credit. Except as otherwise stated, documentary credits (LCs) are subject to the terms and conditions of UCPDC (Uniform Customs and Practices for Documentary Credits), ICC (International Chamber of Commerce) Publication 600 (2007). Basic Principle The basic principle behind an LC is to facilitate orderly movement of trade; it is therefore necessary that the evidence of movement of goods is present. Hence documentary LCs are those which contain documents of title to goods as part of the LC documents. Clean bills which do not have document of title to goods are not normally established by banks. Bankers and all concerned deal only in documents and not in goods. If documents form a complying presentation ( that means the documents comply with the LC as per UDPDC and International Standard Banking Practice) issuing bank will pay irrespective of whether the goods are of expected quality or not. Banks are also not responsible for the genuineness of the documents and quantity/quality of goods. If importer is our borrower, we have to advise him to specify proper documents to ensure quantity and quality of goods. Parties to the LC i). ii). iii) iv) v). vi). vii). viii). ApplicantBeneficiaryIssuing BankAdvising Bank Negotiating BankConfirming BankReimbursing BankSecond beneficiaryThe buyer who applies for opening LC The Seller who supplies goods The Bank which opens the LC The Bank which advises the LC after confirming authenticity The Bank which negotiates the documents The Bank which adds its confirmation to the LC The Bank which reimburses LC amount to negotiating bank The additional beneficiary in case of transferable LCs
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Confirming bank may not be there in a transaction unless the beneficiary demands confirmation by bankers of his choice normally his own bankers and such a request is made part of LC terms. A bank will confirm an LC for his beneficiary if opening bank requests this as part of LC terms. Reimbursing bank is used in an LC transaction by an opening bank when the negotiating bank is different from its correspondent or branch, who maintain the nostro account of the issuing bank. Here, the opening bank will direct the reimbursing bank to reimburse the negotiating bank for the payment made to the beneficiary. In the case of transferable LC, the LC may be transferred to a second beneficiary and if provided in the LC it can be transferred to more than one second baneficiary. Types of Letters of Credit a). Revocable and Irrevocable: As the name suggests, revocable LCs are those that can be revoked by the issuing bank and hence are not in commercial use. Irrevocable LCs cannot be revoked/ cancelled/ amended without the prior consent of all the parties to the LC. As per UCP 600, revocable LCs ca not be opened. Confirmed LC: The seller may ask for a confirmation of the LC by a bank in his own country if he is not satisfied about the issuing banks credentials. Sight/ Usance LCs: In case of sight LCs beneficiary gets immediate payment upon presentation of documents while in the case of usance, the payment is made after a certain period as per the LC terms. Sight LCs have to be paid by the drawee (buyer) immediately whereas he gets credit as per LC terms under Usance LCs. LCs with advance payment to the seller: The LC which authorises the nominated bank to advance a part of the LC amount to the seller to meet pre-shipment expenses is known as Red Clause Letter of credit. The seller gives a receipt and an undertaking to present the documents before the LC expires. Advance amount would be adjusted from the proceeds of the export documents. However, the risk is assumed by the buyer. When a Red Clause LC provides for the cost of storage facilities at the port of shipment in addition to the preshipment advance to the beneficiary it is called Green Clause LC. The goods are stored in the name of the issuing bank. Revolving LCs: Under this, the issuing bank undertakes to restore the credit to the original amount after it has been utilised. Number of such utilisation and the period of time by which these should take place are stipulated in the LC. On receipt of bill payment advice the LC amount gets reinstated. We generally issue, non-automatic and non-cumulative revolving credits only. Transferable LCs: Transferable LCs are transferable in whole or in part to one or more beneficiaries depending on the terms of the LC. As per UCPDC unless stipulated in the LC, all LCs are not transferable Back to Back LCs: When the bank opens new LCs against the backing of an LC received by a beneficiary having the first LC as security for the new LCs opened, the transaction is referred to as Back to Back. For example, let us assume a customer A, who exports marine products by buying them from a number of suppliers. If A receives an LC for USD100000 for shipment of marine products and he approaches the Bank for opening LCs in favour of his suppliers of marine products within the original value and in keeping with the terms of the original LC these new LCs are opened against the backing of the original LC. These LCs are called Back-to-Back LCs. However, it may be noted that this arrangement is not under the provisions of UCPDC though the individual LCs are governed by it.
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b). c).

d).

e).

f).

g).

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2.

Opening of Letters of Credit i) Ascertain the means, creditworthiness and standing of the applicant for LC who should normally be a constituent and whose account has been satisfactorily operated. LCs should be opened only after preparation of an appraisal memorandum which should cover 1. 2. Liabilities of the applicant to the Bank as also to third parties. Means by which the applicant is expected to meet his commitment after the bills under the LCs are received. LCs opened for purchase of machinery / capital goods should be backed by borrowers own funds or firm sanction of term loan. Margin the applicant is to deposit with the Bank and details of other securities he is offering to the Bank. Arrangement for payment of custom duties Forward cover if required ( for our borrowers)

2.1 Basic aspects to be observed for opening a One-time LC.

ii)

3. 4. 5.

Sanction of LC limits Assessment The assessment of LC limit depends on the following factors: A. Approximate value of purchases made under LC for the year. B. Maximum expected outstanding LCs at any one time C. Stocking Period and Usance Period D. Lead time including transit time For example, if a firm makes purchases under LCs of Rs.1200 lacs and the usance period enjoyed is 3 months and the unit stocks 2 months requirement and the lead time is one month, the LC limit is equal to 4 months requirement of purchases (i.e. 3+1)= (1200/12 )* 4 = Rs. 400 lacs Please note that the above calculation does not take into account special requirements on account of factors like seasonality, minimum order quantity, economic order quantity etc which have to be built in while arriving at the limits. For another example refer annexure LC-1 at the end of this chapter. Other Issues in appraisal and conduct of LC transactions. 1) The practice of drawing bills of exchange claused without recourse and issuing letters of credit bearing the legend without recourse should be discouraged because such notations deprive the negotiating bank of the right of recourse it has against the drawer under the Negotiable Instruments Act. Branches should not therefore open LCs and purchase / discount / negotiate bills bearing the without recourse clause Branches should open letters of credit (LCs) and purchase / discount / negotiate bills under LCs only in respect of genuine commercial and trade transactions of their borrower constituents who have been sanctioned regular credit facilities by the banks. Banks should not, therefore, extend fund based (including bills financing) or non-fund based facilities like opening of LCs, providing guarantees and acceptances
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2)

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to non-constituent borrower. The only exception to this is that the requests received from Govt./Research/Defence/Educational Organisations and other statutory organizations, who are not having any regular borrowing arrangements with any FI / other banks could be accepted and LCs opened on their behalf. 3) The LCs issued/ limits sanctioned should be commensurate with the borrowers turnover and cash credit limits and should be for genuine trade/ manufacturing activity. The level of sundry creditors in the CMA format has to be compared with the limits proposed. Usance period of the LC should ordinarily have relation to the working capital cycle. A suitable margin depending on the applicants means, creditworthiness, his other liabilities, etc. may be prescribed. Further, wherever warranted, a lien may be maintained on the unutilised portion of the cash credit account for the value of the bills to be received under the LC. Where the opener and the beneficiary are sister concerns or are otherwise linked, there should ordinarily be no need for LCs. Branches should ensure that LCs do not serve as a means of kite flying between the applicant and the beneficiary. Wherever warranted, branches may also ascertain the standing of the beneficiary. Delivery against acceptance (D/A) facilities should be granted only to applicants of undoubted standing and where the security available is much more than the value of the LC. LCs permitting payment against documents which do not confer on the Bank a full and undisputed title to the relative goods e.g., transport documents of an unapproved transport agency or incomplete set of documents of title to goods made out to the order of the applicant, should be treated as clean credits and should not ordinarily be issued.

4) 5) 6)

7)

8)

9)

10) Suitable insurance instructions safeguarding the Banks interest in the goods, on warehouse to warehouse basis, should be invariably incorporated. In cases where insurance is obtained by the applicant, suitable cover notes should be obtained at the time of opening of the LC in the joint names of the Bank and the applicant and the cover notes and the insurance policies thereafter should be deposited with the Bank. 11) Opening revolving letters of credit requires greater care. The validity of such LCs should not be for more than one year and the value of the LC should be based on the value of material the borrower needs for his genuine manufacturing/ trading requirements during this period. A special limit for the revolving amount should invariably be stipulated. For example, if the total LC is for Rs.10 lacs and it is expected to revolve 10 times, the outstanding liability at any one time should not be for more than, say, Rs.1 lac. The sub-limit of Rs.1 lac will be restored only after the beneficiarys bank receives the Banks advice that the earlier bill(s) for Rs.1 lac has been paid. 12) The application-cum-guarantee form should be adequately stamped as an agreement. It should be ensured that the application for LC does not contain any contradictory clause or any condition/ clause impossible to fulfill and one which violates the laws of the country. 13) The Omnibus Indemnity for Opening of LCs shall be obtained from all borrowers
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enjoying regular LC limits with the Bank. 14) The application-cum-guarantee form after issue of the LC should be kept in the strong room/ fire proof safe and in the custody of the authorised officials. 15) LCs should be serially numbered. 16) LCs (including amendments to LCs) should be signed by two authorised officials, when they are issued for amounts of Rs.50000/- and above. 17) Before despatching the LC, branches should ensure that the LC contains the following particulars: a) Particulars of Import Licence, if any; b) Full and correct address of the beneficiary; c) Precise/ brief description of goods; d) Price of goods in words and figures; e) Origin of goods; f) Mode of transport Sea/Air/Land/Rail;

g) Last date for shipment of goods/ negotiation of documents; h) Port of shipment/ destination; i) j) Whether part-shipment/ trans-shipment permitted; Value of goods CIF/CF/FOB basis; and its currency;

k) Payment terms D.P or D.A. tenor of bill; l) Expiry date of LC; m) Instructions regarding negotiation of documents and reimbursement; n) Documents to accompany and how many copies are required e.g. Draft, Invoice, B/L or AWB or R/R or L/R; Packing List, Weight List, Certificate of Origin, Insurance Policy/ Certificate, Quality Certificate, Consumer Invoice/ Certificate & Inspection Certificate. 2.2 Import Letters of Credit: Besides the guidelines enumerated above, the following additional instructions should be followed by branches for establishment of import LCs. a) Import Licenses: It should be ensured that the goods to be imported under the LC are covered by valid import licence, if required, issued either in the name of the customer or properly transferred in his favour. Branches should also satisfy themselves about the identity of the importer and that the person mentioned in the import licence/ transferee of the licence and the importer are one and the same. Among other things, the amount of the licence or the balance available thereunder, the type of goods permitted, the country of origin, the validity period, limiting factor for imports (quantity and/or value), any special conditions imposed, etc. should be scrutinised to ensure that the import is duly authorised. In particular, the following clause should be incorporated in all credits for import of goods under IBRD loans:Goods financed under this credit must not originate in or be shipped in a vessel flying
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the flag of any country which is not a member of the IBRD except Switzerland. Exchange Control: The terms of payment stipulated in the credit should fall within the permitted methods of payment as prescribed under FEMA. b) c) Forward Contract: In case of large value LCs forward contract has to be invariably arranged. When 100 per cent margin is recovered from the applicants, they should be informed that the margin represents a mere deposit against the proposed credit and that all bills negotiated thereunder will have to be retired at the rate of exchange ruling at that time, unless the rate has been fixed under a forward contract. Where LCs are to be opened for the import of machinery, the proposed means of financing the capital expenditure by the customer (term loans lined up etc.) should be verified with diligence. Further, the LC opening branch should ensure that (i) the beneficiaries of LCs are well reputed as revealed by the opinion reports on the beneficiaries; and (ii) the LCs are established in favour of only those beneficiaries who were indicated in the project report and/or financial institutions sanction endorsement where the term loan is sanctioned by them but LCs are established by the Bank. Branches should also obtain a letter from the concerned financial institution authorising the opening of the LC and undertaking to pay for the documents under the relative LC. This letter should preferably be obtained, unambiguously worded and without any conditions such as borrower fulfilling certain terms and conditions, etc.

d)

2.3 Onerous clauses in the letters of credit At the time of opening LCs, branches should incorporate the Banks standard clauses and avoid accepting onerous responsibility detrimental to the Banks interest. In case any special terms involving onerous responsibility on the Bank are proposed by the applicant or the beneficiary, the same would need to be cleared by the concerned controlling authority. 3. Negotiation of Bills under LCs Guidelines

3.1 The following approach should be adopted by branches while fixing limits for purchase of bills drawn under LCs of branches of SBI/ correspondent banks abroad/ first class banks in India, identified for the purpose by the Corporate Centre. a) Bill Limits for borrowers: Discounting of bills that fully conform to the terms of LCs opened by first class banks and other branches of SBI are treated on the same status as advances against specified security for the purpose of excluding them from the computation of total indebtedness so that Branch Managers can exercise full powers, unfettered by the limitations of Total Indebtedness of the drawer of the bills to the Bank. However, this exposure continues to be on the borrower only. Accordingly, for the Banks capital adequacy purposes, such outstandings are taken into consideration for arriving at the capital adequacy requirement, by allocating the risk weight as appropriate to the borrower constituent. b) Further, suitable bill limit for the purpose (outside the ABF) should be assessed and sanctioned separately by the authority concerned. Here it is reiterated that i.
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branches specifically authorised by the CGM are permitted to discount bills under LCs opened by first class banks without
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ii.

restrictions on power. No other Branches should be allowed to undertake this business. branches specifically authorised to discount bills under LCs of first class Banks be advised to the CGM (SME) as well as to the CPPD, Corporate Centre so that the matter could be taken up with IT Belapur for disabling branches not specifically authorised to discount bills.

c) Assessment of limit in such cases is essentially based on the volume of sales which is expected to be backed by LCs and the terms thereof. Fixing these limits should, as far as possible, coincide with the sanction / renewal of ABF. Units generally treat the sales arising out of bills backed by LCs as cash sales. Therefore, the receivables backed by LCs are not to be included in the book debts statement for the purpose of drawing power. In this connection it may be noted that while arriving at the ABF, only receivables arising out of credit sales will be taken into consideration. The total sales of the unit will thus comprise of the credit sales and sales backed by LCs. d) Stray Purchases: While no specific limit need be sanctioned for this purpose, the borrowers liability in such cases should be limited to one or two bills and the amount thereof should not exceed the capacity to meet the amount in the event of default RBIs Instructions: With regard to negotiation of bills under LC, RBI has instructed that (i) In cases where negotiation of bills drawn under LC is restricted to a particular bank, and the beneficiary of the LC is not a constituent of that bank, the bank concerned may negotiate such an LC, subject to the condition that the proceeds will be remitted to the regular banker of the beneficiary. However, the prohibition regarding negotiation of unrestricted LCs of nonconstituents will continue to be in force. The banks may negotiate bills drawn under LCs, on with recourse or without recourse basis, as per their discretion and based on their perception about the credit worthiness of the LC issuing bank. However, the restriction on purchase/discount of other bills (the bills drawn otherwise than under LC) on 'without recourse' basis will continue to be in force. Banks Operating Guidelines: (i) Operating offices may discount bills under LC if the negotiation is restricted to our Bank and the beneficiary is not a constituent of the LC opening Bank. The proceeds of negotiation will be remitted to beneficiarys banker. (ii) The operating offices may negotiate bills drawn under LCs with or without recourse clause in respect of LCs opened by First Class Banks only. The list of First Class Banks is revised by RMD on an ongoing basis. (iii) Other instructions: (a) Bank would discount bills under LCs only in respect of borrower constituents who have been sanctioned regular credit facilities by the Bank. Cases where only LC Bill Discounting limits are sanctioned after due appraisal & KYC, such parties will be treated as Bank's customers under Multiple Banking Arrangement (MBA) and the other Banks in the MBA will be advised of such LC Bill Discounting limits sanctioned by us. (b) The prescription would not prohibit the Bank from accepting such bankable business from non-borrower constituents such as Govt. / Research / Defence /
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(ii)

Educational organizations etc. and other statutory organisations etc. who have noborrowing arrangements with any FI/other banks. However, such business would be accepted from these non-borrower constituents only after guidelines on 'Know Your Customer (KYC)' norms are complied with. (c) Bank would not ordinarily discount bills drawn by front finance companies set up by large industrial groups on other group companies. (d) While discounting bills of services sector, bank would ensure that actual services are rendered and accommodation bills are not discounted. 3.2 Notwithstanding the availability of LCs, in all cases, the need to examine factors like the genuineness of the underlying transaction, past track record of payment of bills under LCs, nature of transaction particularly when these are covering sales within a city or locality or between group/ associate concerns, cannot be over-emphasised to avoid accommodation financing. Therefore, at the time of discount of bills, the usual precautions like ensuring genuine movement of goods etc. should be taken without fail. 3.3 Discrepant bills as also bills drawn under LCs opened by banks other than those mentioned in para 3.1 above, will be purchased only as part of the limits sanctioned for non-credit bills. That is, they will be handled for purchase only within the powers for advance against bills vested either with the branch officials or with a higher authority. Also financing of such bills will be within the ABF. The above procedure will be applicable for sanctioning limits to borrowers of the Bank and also non-borrowers including borrowers of other banks. 3.4 Precautions Notwithstanding the availability of LC, branches (both specified and non-specified) should ensure the following while negotiating bills. Genuineness of the LC to be verified; Genuineness of the underlying transaction to be verified by perusing the relative invoices, contracts or orders, etc.; Railway receipts/ truck receipts/ bills of lading tendered to be scrutinised carefully to verify their genuineness, quality and quantity of merchandise covered by them, the date of issue, etc. and to ensure that transport receipts are from approved carriers and not stale; Past track record of payment of bills under LCs by the customers to be taken note of; Due caution to be exercised regarding bills covering sales within a city or locality and between group/ associate concerns and those drawn by front companies of industrial groups; The standing and creditworthiness of the borrower as well as the drawee of the bills to be carefully looked into.

3.5 Obtention of documents of hypothecation/ pledge for the LC bill purchase facility As a general rule, a charge on current assets is not contemplated to be taken as security for this facility for the reason that bill purchases fully conforming to the terms of LCs opened by first class banks and other branches of SBI are treated on par with the advances against specified security. However, where the nature of the borrowers overall operations and his track record warrants strengthening of the security cover, these may be prescribed and appropriately covered as per the documentation procedure.
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3.6 CRA rating for LC bill discounting facility While CRA rating is not required for the limits under LCs sanctioned outside the total indebtedness at specified branches, such rating would be necessary for limits granted at non-specified branches inasmuch as these will be a part of the Assessed Bank Finance and within the Total Indebtedness ceiling. 3.7 Separate limits for export bills and inland bills Separate limits for purchase of bills under LCs will be sanctioned for export bills and inland bills. Treatment of Stocks covered by Usance Letters of Credit 4. Earmark lien for the outstanding usance LC bills against advance value of stocks. This provision ensures that the margin is available well before the CC a/c is debited for the matured LC bill. Where the unit is not in a position to provide the required margins as above, special sanction may be obtained for earmarking lien for the value of usance LC bills outstanding against the aggregate market value of all the securities (including the LC stocks).

4.1 In cases where the bills drawn under LC are received but the relative goods are not yet received, the sanction for cash credit limit may provide for facility of drawings against the documents of title to goods received under the Banks usance LCs and lien for the full amount of the outstanding bills may be earmarked against the advance value of the total stocks including the documents of title to goods received under the Banks LCs. 5. Restriction of negotiation of bills drawn under our LCs only to branches of SBI Restriction of such negotiations to the Banks branches is a desirable marketing strategy to the extent feasible. In cases where negotiation is not restricted, the Banks branch in the drawee centre should be alerted to attract the business of LC bill discounting. 6. Retirement of bills negotiated under LCs

6.1 Follow Up: a) Branches should scrutinise on receipt all documents negotiated under the Banks LC for any discrepancies and non-compliance of terms and conditions. If necessary, they should consult the applicant whether to retain the bills or return them in the event of discrepancies. Branches should take immediate steps to protect Banks interest in the goods in case payment is not made by the applicant on presentation of the bills. These steps will include advising the railway authorities or the transport company of the Banks interest in the goods and ensuring continuance of insurance covering the goods for the risks of fire, theft, etc. Bills drawn under letters of credit will be retired on receipt by debit to the applicants account. Only a reasonable period should be allowed to importers for retirement of bills drawn under letters of credit. A period of seven days is recommended for this purpose. This stipulation should be advised to the customers and tie up of funds looked into at the time of opening letters of credit.

b)

c)

Request for time for retirement of bills till the arrival of the goods can be entertained on being satisfied that the bills would be paid immediately on the arrival of goods. In the
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meantime, necessary confirmation of the drawees that the documents are in order and are acceptable to them should be obtained and recorded at the branch. In this connection, attention of the branches is invited to the following endorsement on import licenses:It is a condition of this license that when an irrevocable credit is opened by the holder of the license to finance the import of any goods covered thereby, then the authorised dealer in foreign exchange through whom the credit is opened shall be deemed to be a joint holder of this license to the extent of the goods covered by the credit. Thus, where letters of credit have been opened against a valid import license and on arrival of goods, the license holder does not honour the bills drawn against the letter of credit and does not produce the license for the clearance of the goods, the branch which has opened the LC will be able to clear the goods through the Customs and remit foreign exchange to the foreign suppliers in whose favour the credit was opened, by debit to the licensee in question. For the purpose of clearance of goods, the branch will provide the customs with certificates together with the exchange control copy of the licence to the effect that the import has been made and foreign currency has been remitted by the branch under the authority of a valid import license and a confirmed irrevocable letter of credit. 6.2 Devolvement of LC Bills The following approach should be adopted by branches to avoid problems arising from devolvement of LCs and the resultant excess drawings in the relative accounts. a) The limits for demand LCs and usance LCs should be assessed separately with ample justifications. The usance period should not, generally, exceed the production cycle. In case of bulk imports, establishment of LCs for longer usance period may be considered selectively. When liability under LC is met by creating an irregularity in the Cash Credit account, the relative LC limit should not be released for opening further LCs till the account is adjusted. In other words, the liability should not be marked off in LC liability register merely because of retirement of documents. The relative liability should be marked off only after the account is regularised. In case of devolvement, if the irregularity in the account is not adjusted within 15 days, or if the LC devolved earlier is not adjusted, no further LCs should be opened without adequate margin. A margin of 25% should be the minimum applicable in such cases. In cases where borrowers are found to have defaulted without sufficient reasons, margin should be stepped up to, say, 50% and above. In persistently defaulting cases, cancellation of LC limits should be considered. Excess liquidity available during the usance period of LCs enables the borrowers to divert short term funds which may lead to a situation where funds may not be available to meet the LC bills on due dates and ultimately lead to devolvement of the LCs. As per the extant instructions, lien has to be marked for the outstanding usance LC bills on the advance value of stocks. Where usance LC facilities are sanctioned, this should be borne out by the appraisal data relating to sundry creditors. As it would have a bearing on the level of sundry creditors, this aspect will have to be examined from that angle, while assessing the working capital facilities.
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b)

c)

d)

e)

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f) g)

The transactions in the account and the Financial Follow up Reports should be closely monitored to check diversions. Branches should not permit excess drawings in accounts which show persistent irregularity due to devolvement of LC bills. The practice of allowing excess drawings against the credits made in the account, leaving the existing irregularity unadjusted, should also not be permitted. In case of sick/ weak units, requests for usance LC facility should be examined with greater care. Implementation of the above mentioned control measures to check the incidence of LC devolvements should be monitored at periodic intervals, through the half-yearly reports by the branches on conduct of non-fund based business. The concurrent auditors at the branches are to scrutinise the half-yearly reports and confirm the genuineness of the reasons given for devolvement of Letters of Credit.

h) i)

7.

Crystallisation of Import Bills i) Sight bills under import LC and in conformity with the terms thereof shall be crystallised if not retired by the customer on the 10th day from the date of receipt thereof by converting the foreign currency amount in to rupees at the Banks Bill Selling rate prevailing on the date of conversion (crystallisation) or at the contracted rate, if a forward contract has been booked for the purpose. The crystallisation should be done by debit to a General Ledger account Advance made to customers against import bills in the books of the branches and the corresponding credit is to be put through and reported as sales to Foreign Department. Usance bills received under import LCs and in conformity with the terms thereof, may, on acceptance, be held in foreign currency up to the date of maturity. In the event of non-payment on the due date, the importers liability shall be crystallised by converting the foreign currency amount in to rupees at the Banks Bill Selling rate prevailing on the due date or at the contracted rate in case a forward contract has been booked. The crystallisation should be done by debiting straight away the Cash Credit accounts of the importer-applicants. If the importerapplicants do not have cash credit accounts, the relative debits should be raised to their current accounts. The transactions should be reported as sales to Foreign Department indicating that these relate to crystallisation of import bills.

ii)

8.

Interchangeability between Letter of Credit and Bank Guarantee Limits Generally, requests for interchangeability between the two facilities will be entertained only when the purposes for which the facilities have been sanctioned are similar. The extent to which such interchangeability can be permitted in case of borrowers with credit rating of SB10 and lower, is restricted as under: interchangeability from BG to LC may be permitted up to 50% of BG limit. interchangeability from LC to BG to be restricted to 25% of LC limit.

The interchangeability from LC to BG and vice versa need to be considered with due care as there would be change in quality of underlying exposure. Further, while considering requests for such interchangeability, the undernoted factors may be kept in mind:
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(i) (ii) (iii)

Time horizons of risk devolvement between the two facilities are different. Nature of risk is not the same i.e., the risk associated with a performance guarantee is different from that of a financial guarantee or an LC. While examination of cash flows is vital at the time of opening an LC, it is not generally considered as relevant in most cases of issues of BGs.

(iv) A usance LC limit has a bearing on the level of sundry creditors available and hence on the fund-based credit limit required. (v) The borrowing units track record in meeting the obligations under Letters of Credit. (vi) The authority for permitting such interchangeability will be as per the authority structure.

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Annexure-LC-1 Illustration for computation of LC limit. M/S XYZ Co Ltd Letter of Credit limit of Rs. 20 crores (Rs. in crores) Total purchase of raw materials Purchase of raw materials under LC Average monthly purchase of raw materials under LC Average holding of imported raw materials (2.2 months consumption) Average usance period Lead time and transit period Total of (B) and (C) The requirement of LC limit (A) X (D) Limit recommended say (A) 172.64 69.41 5.78 11.30 (B) (C) (D) 3 months 1 month 4 months 23.12 23.00

Explanatory notes: 1) While calculating the amount of raw materials purchases on LC basis, the following points need to be noted. (Amount in rupees) (a) (b) (c) (d) (e) (f) (g) (h) Raw material consumption Add : Closing stock of raw material Less: Opening stock of raw material Total Purchases during the period Purchases on LC basis as percentage of total purchases Purchases on LC basis in rupees Import duty payable, if any Purchases on LC basis net of import duty (CIF value) (f-g) 2) Transit time should be treated as nil if usance period starts from shipment date.

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(B). BANK GUARANTEES

A contract of guarantee is defined as a contract to perform the promise or discharge the liability of a third person in case of default. The parties to the contract of guarantee are: a) Applicant: The principal debtor person at whose request the guarantee is executed b) Beneficiary: Person to whom the guarantee is given and who can enforce it in case of default. c) Guarantor: The person who undertakes to discharge the obligations of the applicant in case of his default.

Thus, guarantee is a collateral contract, consequential to a main contract between the applicant and the beneficiary. Purpose of Bank Guarantees Bank Guarantees are used to for both preventive (- to prevent a party from reneging a contract) and remedial (- to redress the loss if a contract is reneged) purposes. The guarantees executed by banks comprise both performance guarantees and financial guarantees. The guarantees are structured according to the terms of agreement, viz., security, maturity and purpose. Branches may issue guarantees generally for the following purposes: a) In lieu of security deposit/earnest money deposits for participating in tenders; b) Mobilisation advance or advance money before commencement of the project by the contractor and for money to be received in various stages like plant layout, design/drawings in project finance; c) In respect of raw material supplies or for advances by the buyers; d) In respect of due performance of specific contracts by the borrowers and for obtaining full payment of the bills; e) Performance guarantee for warranty period on completion of contract which would enable the supplier to realise the proceeds without waiting for warranty period to be over; f) To allow units to draw funds from time to time from the concerned indenters against part execution of contracts, etc.

g) Bid bonds on behalf of exporters, h) Export performance guarantees on behalf of exporters favouring the Customs Department under EPCG scheme. Guidelines on conduct of Bank Guarantee business Classification of BG Based on the clarifications received from RBI, Bank Guarantees will now be classified as under: Financial Guarantees: a) Mobilisation advance or advance money before commencement of the project by the contractor and for money to be received in various stages like plant layout, design/drawings in project finance. b) In respect of raw material supplies or for advances by the buyers;
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Performance Guarantees: a) In-lieu of security deposits/earnest money deposits for participating in tenders . b) In respect of due performance of specific contracts by the borrowers and for obtaining full payment of the bills. c) Performance Guarantee for warranty period on completion of contract which would enable the supplier to realise the proceeds without waiting for the warranty period to be over. This includes Retention Money Guarantees. d) To allow units to draw funds from time to time form the concerned indentors against part execution of contracts, etc. e) Bid bonds on behalf of exporters. f) Export performance guarantees on behalf of exporters favouring the Customs Department under EPCG scheme. This includes Guarantees for subsidy entitlements on achieving minimum stipulated sales (domestic/exports) targets. g) Guarantees favouring Customs or Port Authorities for release of goods or for miscellaneous purposes like Demurrages etc. h) Guarantees for disputed liabilities like Revenue Dues, litigation pending at Courts etc., While all Financial Guarantees would attract 100% Credit Conversion Factor (CCF), Performance Guarantee would attract 50% CCF. Branches, as a general rule, should limit themselves to the provision of financial guarantees and exercise due caution with regard to performance guarantee business. The subtle difference between the two types of guarantees is that under a financial guarantee, a bank guarantees the customers (applicants) financial worth, creditworthiness and his capacity to take up financial risks. In a performance guarantee, the banks guarantee obligations relate to the performance related obligations of the applicant (customer). While issuing financial guarantees, it should be ensured that customers would be in a position to reimburse the Bank in case the Bank is required to make the payment under the guarantee. In case of performance guarantee, branches should exercise due caution and have sufficient experience with the customer to satisfy themselves that the customer has the necessary experience, capacity, expertise and means to perform the obligations under the contract and any default is not likely to occur. Branches should not issue guarantees for a period more than 18 months without prior reference to the controlling authority. Extant instructions stipulate an Administrative Clearance for issue of BGs for a period in excess of 18 months. However, in cases where requests are received for extension of the period of a BG, Administrative Clearance is not necessary for extension of the period of BGs as long as the fresh period of extension is within 18 months. No bank guarantee should, normally, have a maturity of more than ten years. Bank guarantee beyond maturity of 10 years may be considered against 100% cash margin with prior approval of the controlling authority. More than ordinary care is required to be exercised while issuing guarantees on behalf of customers who enjoy credit facilities with other banks. Unsecured guarantees, where furnished by exception, should be for a short period and for relatively small amounts. All deferred payment guarantees (DPGs) should ordinarily be secured. Appraisal of Bank Guarantee Limit Proposals for guarantees shall be appraised with the same diligence as in the case of fundbased limits. Branches may obtain adequate cover by way of margin and security so as to prevent default on payments when guarantees are invoked. Whenever an application for the issue of bank guarantee (or sanction of a regular bank guarantee limit as part of working capital
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limits) is received, branches should examine and satisfy themselves about the following aspects: a) The need for the bank guarantee and whether it is related to the applicants normal trade/business. b) Whether the requirement is one-time or on a regular basis. c) The nature of bank guarantee i.e., financial or performance. d) Applicants financial strength/ capacity (through an analysis of his financial statements, cash/ funds flow position and opinion reports) to meet the liability/ obligation under the bank guarantee in case of invocation. e) Past record of the applicant in respect of bank guarantees issued earlier; e.g., instances of invocation of bank guarantees, the reasons thereof, the customers response to the invocation, etc. f) Present outstanding on account of bank guarantees already issued. g) Margin. h) Collateral Security offered. An illustrative example of assessment is given at Annexure BG 1. Margins Following are some of the factors to be kept in view by the branches while determining the margins required: a) Cash margins provide a cushion against invocation. Margin money may be in the form of TDR with the Bank or a lien marked on the drawing power in the constituents cash credit account. However, where margin is sought to be taken in the form of a lien on the drawing power in the constituents cash credit account, specific approval from the sanctioning authority is necessary. b) The margin to be stipulated would depend on the borrowers means, resources, creditworthiness, security available, past experience with regard to issue of BGs, nature of guarantee and the nature of underlying transactions. If the applicant is an existing borrower, margin on bank guarantee may generally be the same as on stock, receivables, etc. Where reduced margins or no margins are stipulated, the reasons thereof must invariably be stated in the proposal. c) In case of Advance Payment Guarantees, lower margins may initially be stipulated. Once the advance is actually received, depending on the amount not likely to be immediately utilised, higher margins may be built up by impounding of cash advances.

d) In respect of non-borrower applicants, Banks approach should normally be to obtain full margins. However, a credit risk can be taken on the applicants based on the financial indicators, credit worthiness, security available etc. e) 100% margin should ordinarily be retained in respect of guarantees issued in connection with disputed customs/ central excise duties, unless otherwise specified in the sanction.

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Security Apart from the margin, bank guarantees are usually secured by an extension of the charge on current assets obtained to cover working capital facilities. Adequate collateral security by way of equitable mortgage/ extension of charge on current/ fixed assets or third party guarantee should be taken depending on the merits of each case. Commission Commission to be charged on the guarantees issued, service charges, authority for sanction of concession in service charges, refund of commission etc. shall be as per the instructions issued by the Bank from time to time. Documents Whenever a guarantee is issued and/or guarantee bond is countersigned by the Bank on behalf of a constituent, suitable Counter Guarantee (cf. Annexure BG 2) should be obtained from the constituent. . For each ad hoc bank guarantee issued, a separate Counter Guarantee is necessary. In the case of a regular bank guarantee limit duly sanctioned, a stamped omnibus Counter Guarantee (cf. Annexure BG 2A) for the bank guarantee limit will suffice. An omnibus Counter Guarantee, can be executed one time by the borrower to whom a limit for issuance of guarantees up to a specific amount is sanctioned. Where such a limit is sanctioned, guarantees can be issued within the limit favouring various beneficiaries. Guarantees issued should be recorded and a check kept so that the total amount of guarantees issued does not exceed the amount for which the omnibus Counter Guarantee has been taken. In case of a partnership firm, Counter Guarantees should be signed/executed by all the partners of the partnership firm. A partner of the firm is not competent to execute the Counter Guarantee for and on behalf of the firm unless he has been specifically authorised to do so by all the partners under the deed of partnership or otherwise. In case of a joint stock company, a board resolution should be got passed by the company before executing the Counter Guarantee or omnibus Counter Guarantee. The Banks charge in respect of the guarantees issued on behalf of the companies should also be filed for registration with the concerned Registrar within the stipulated period of 30 days. Both the bank guarantee (to be executed by the Bank) and the Counter Guarantee or Omnibus Counter Guarantee (to be executed by the applicant/borrower) are to be stamped as agreements as per Stamp Duty required at the place of execution. Format of Bank Guarantees Bank guarantees should normally be issued on the format standardised by Indian Banks Association (IBA) (Annexure BG-3). When it is required to be issued on a format different from the IBA format, as may be demanded by some of the beneficiary Government departments, it should be ensured that the bank guarantee is a) for a definite period, b) for a definite objective enforceable on the happening of a definite event, c) for a specific amount d) in respect of bona fide trade /commercial transactions, e) contains the Banks standard limitation clause f) not stipulating any onerous clause, and
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g) not containing any clause for automatic renewal of the bank guarantee on its expiry.
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Bank guarantees should be issued with a pre-printed and numbered standard first page of the guarantee form, which contains the limitation clause. The pre-printed form is to be used for all bank guarantees. However, in the case of a guarantee favouring a Government department if the concerned department objects to the use of the pre-printed form, branches may issue the guarantee on non-judicial stamp paper. The text of the guarantee will appear on the pages succeeding the printed first page. It should be ensured that while filling up the first page of the bank guarantee (the pre-printed and numbered standard first page), no separate claim period is provided i.e., the validity period of the guarantee will be stated inclusive of the claim period. Further, each page of the text of the guarantee enclosed with the pre-printed form should also find mention of pre-printed serial numbers of the prescribed security form, BG number, date of issue and amount, etc. In all the guarantees issued by the Bank, the limitation clause suggested by IBA, quoted below, should invariably be incorporated at the end of the text as concluding paragraph of the bank guarantee. (This clause should be included in addition to the text appearing on the printed page one.) Notwithstanding anything contained herein: a) our liability under this Bank Guarantee shall not exceed Rs._ _ _ _ _ _ _ (Rupees _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ only); b) this Bank Guarantee shall be valid up to _ _ _ _ _ _ _ _ _ _ _ ; and c) we are liable to pay the guaranteed amount or any part thereof under this Bank Guarantee only and only if you serve upon us a written claim or demand on or before _ _ _ _ _ _ _ _ _ _ _ (date of expiry of Guarantee).

In case of guarantees issued favouring Government departments, the above clause should be included in the Model Bank Guarantee (MBG) form(Annexure BG-5) prescribed for bank guarantees in favour of Government departments. If the Government departments/quasiGovernment institutions require guarantees as per their format, the controlling authorities may permit the branches to issue guarantees/extension guarantees as per their specimen forms, provided such forms generally conform to the model guarantee form, contain the usual standard limitation clauses and are free from any clause prejudicial to the Banks interest. In the case of bank guarantees favouring PSUs and autonomous bodies, where the beneficiaries so insist and a loss of business is perceived, branches can indicate a separate claim period. The period of the claim should, however, be kept at the minimum. It should generally not exceed three months. The guarantees/extension guarantees should be issued by signing in full on all pages with SS number. The guarantee may also be issued by the branches on a stamp paper on which the name of the customer (on whose behalf the guarantee is issued) appears as the purchaser thereof. It should be ensured that a) date of purchase of stamp paper is prior to the date of the bank guarantee, and b) the parties to bank guarantee are identical with those mentioned in the BG. The guarantees issued by the branches for Rs.50000/- and above should invariably be signed with their SS numbers by two officials jointly. Extension/Renewal of Bank Guarantee Branches may entertain requests from the applicants for extension/renewal of guarantee provided there is no change in the amount and other terms and conditions of the guarantee. The
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pre-printed forms prescribed for the purpose (Extension Guarantee) will be used. Expired bank guarantee may also be renewed with retrospective effect subject to the condition that the Bank remains indemnified as against the contingent liabilities etc. which may arise under the said guarantee i.e., the counter guarantee covers such liabilities retrospectively. Normally, requests for extension should emanate from the applicants. In case, however, the beneficiaries request the branches either to renew or pay the guarantee amount, the branches should acknowledge such letters to the beneficiaries and request the applicants to renew before the guarantees expire or deposit the guarantee amount for honouring the commitment. If no request for renewal is received by the branches in time, they should honour the guarantees invoked and recover the amount paid from the applicants in the usual manner. The stipulations pertaining to issue of guarantees apply equally to extension or renewal of guarantees. There is no provision for amendment of bank guarantees unlike in the case of Letters of Credit. Instead, fresh guarantees need to be issued, cancelling the earlier ones. Termination/Cancellation of Bank Guarantees After the expiry of each bank guarantee (including the time limit stipulated for preferring claim, if any), a registered letter with Acknowledgement Due should be sent to the beneficiary advising that the guarantee has expired and requesting the beneficiary to return the original guarantee document. It should be made clear in the letter that the beneficiary is no longer entitled to invoke the guarantee. The letter in the format is to be issued for all guarantees, including guarantees issued on behalf of a Foreign Bank/Foreign Office. If the guarantee is not returned within a period of one month, a reminder should be sent and thereafter liability in branch books reduced by the amount of expired guarantee. Margin money and the collateral, if any, taken exclusively for the relative guarantee may then be refunded. Branches should periodically verify the outstanding guarantees and take appropriate action for cancellation of outstanding guarantees beyond the respective dates of expiry/claims. Bank guarantee can be cancelled : a) prior to expiry of the period only with the written consent of the two parties to the contract i.e., the beneficiary and the applicant, or b) on the expiry of claim period Invocation of Bank Guarantee The beneficiary of the bank guarantee can invoke in writing, the guarantee any time before the expiry of the guarantee period. Invocation can be done by fax/hand delivery also followed by mail confirmation. Branches should ensure that all valid claims received under bank guarantees issued by them are settled promptly. In the case of any dispute, such honouring, on invocation, will be done under protest and the matters of dispute should be pursued separately. The Banks liability under bank guarantee is absolute and independent and exclusive of any other contract entered into by the applicant and beneficiary. It is, therefore, obligatory on the part of the Bank to pay to the beneficiary without delay and demur the amount of bank guarantee on its invocation in accordance with the terms and conditions of the guarantee deeds. It is not necessary for the beneficiary to satisfy the Bank about the default or the amount of actual loss suffered by him. In this connection, branch managers have been vested with necessary powers to honour the claims under the guarantees issued by the Bank provided the guarantee was executed under sanction from the competent authority and conditions stipulated for invocation of the guarantee have been fully complied with. Delay in honouring the claim
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immediately may unnecessarily put the Bank in problems pertaining to claim of interest, damages and at times injunction orders from court. Only when the Bank has received an order of restraint/ injunction from a competent/ appropriate court, the Bank can withhold payment under the bank guarantee. Till the court case is decided, the liability of the Bank under bank guarantee will continue. Guarantee commission for the period of pendency of court cases has to be recovered. In such cases, the beneficiary of the guarantee should be advised appropriately of the reason for non payment of amount due under invoked guarantee. In case of invocation of performance guarantees issued in favour of foreign beneficiaries, branches should note that the Bank is responsible for paying Indian income tax (withholding tax, where applicable) on the payments on account of such invoked guarantees. Hence the same may be deducted from the payments due to the beneficiary. Failure to deduct tax will make the Bank liable to pay the same. Banks obligation to deduct income tax from the claim amount in the event of invocation has to be specifically mentioned. If the transaction requires that the Indian company on whose behalf the guarantee is issued, should make good the tax liability, then a separate arrangement between the two parties can be entered into which would be outside the purview of the Bank guarantee. Interchangeability between Letter of Credit and Bank Guarantee limits On the issue of interchangeability between LC and BG limits please refer to the section on LCs. Advance Payment Guarantee (APG) Advance Payment Guarantees are ordinarily required by construction companies/ contractors. The following monitoring mechanism has been prescribed in respect of such guarantees for ensuring end use of funds. The under noted guidelines should be followed by the branches while executing and monitoring advance payment guarantees: a) Submission by the applicant of a flow chart indicating the expected progress of work in respect of each contract along with the application for issue of Advance Payment Guarantee (APG). b) A schedule of utilisation of the advance payment to be received, indicating the expected date/month of utilisation and its purpose. c) A periodical progress report should be submitted by the applicant of the guarantee to enable the branch to monitor the end use of funds/the progress of the work vis--vis the flow chart and the utilisation schedule. The periodicity of the report may be quarterly or half-yearly depending on the size of the contract and the period over which it is spread.

d) The progress of the work should be verified with the help of the flow chart and periodical progress reports and if there is deviation in the progress of work in excess of, say 15%, the matter may be reported to the controlling authority. The services of outside consultants/architects may also be enlisted in cases where contracts are of large value warranting vetting by such outside agency. This, however, would need to be approved by the appropriate authority and the cost recovered from the applicant. e) Where advance payments for purchase of material (or for meeting other expenses) are received by the customer against the Banks guarantee, the end use of these funds should be monitored to ensure that adequate stocks are actually held and these
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are not additionally financed by the branch under working capital facility. Stocks procured out of advance money may be knocked off from the value of security charged to the Bank mentioned in the stock statement. Alternatively, credit limit may be impounded during the execution period/cycle of operation during the currency of the guarantee. In respect of monitoring exposures under the APGs issued for construction companies and project/turnkey contractors, please refer to the instructions given in paragraph 3.2 0f Chapter 30-6 of volume - III Manual on loans and advances Deferred Payment Guarantee (DPG) A deferred payment guarantee (DPG) is a contract to pay to the supplier the price of machinery, supplied by him on deferred terms to the buyer, in agreed instalments with stipulated interest on the respective due dates in case of default in payment thereof by the buyer. Under the contract, the Bank executes a guarantee on behalf of the buyer to the sellers banker who, on the strength thereof, discounts the sellers bills drawn on the buyer. The seller receives payment for the plant and machinery by his bills being discounted by his banker, and the buyer repays his obligation in instalments to the sellers banker by retiring those bills on the respective maturity dates. DPG is also sanctioned in respect of deferred term commitments and obligations of financing institutions/ borrowers. A DPG is, in many respects, a substitute for a term loan with only the mode of term credit being different. The process of appraisal of a DPG proposal is, therefore, the same as is applicable to term loans. All the activities which are eligible for the purpose of granting term loans by the Bank will be eligible for the purpose of issuing deferred payment guarantees. The period of deferred payment guarantees should not ordinarily exceed 7 to 10 years, although it could be considered even beyond 10 years in exceptional cases depending upon merits. The standard covenants for DPGs are generally the same as those for term loans. Where both the buyer and the seller have common banking arrangements i.e., both are Banks constituents, the deferred payment guarantees as such will not be required to be executed. Instead the branch which handles the buyers account will issue a letter of commitment to the discounting branch (which handles the sellers account) authorising the discount of bills/notes without issuing a separate deferred payment guarantee. The issue of such a letter of commitment on behalf of the buyer, however, should be treated on par with a deferred payment guarantee. Instalments due under deferred payment guarantees are payable out of cash accruals generated by a unit. As cash accruals are part of the sales proceeds, which get routed through the units cash credit accounts, it is the usual practice to debit the cash credit account with the amount of the instalments under deferred payment guarantees, provided there is adequate drawing power. However, such debits should not be permitted, where these will result in over drawings in the cash credit account. Overdue instalments or instalments in default (where the DPG issued by the Bank has been invoked) should be debited to a separate account opened in the Term Loans Ledger styled as under:

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Name of the unit..(overdue instalments due under deferred guarantee No.. dated. for payment Rs..) account. The Banks commitments under a DPG facility should usually be secured by a charge (exclusive/pari-passu/second charge) over the capital equipments acquired/to be acquired by the buyer. The liability of the Bank under DPG will be the amount for which the guarantee is issued inclusive of interest. The liability should be reduced by the amount of instalments, inclusive of the interest component, as and when they are paid. Bank also executes foreign DPGs covering import of plant and machinery on deferred payment basis. A foreign DPG is in no way different from an inland DPG and, therefore, the proposal for a foreign DPG has to be processed, in the same way as the proposal for an inland DPG . Additionally, in the case of a foreign DPG it has to be ensured that all the relevant Import Trade Control/Exchange Control requirements in force from time to time are duly complied with before the DPG is executed. In the case of DPGs issued in foreign currencies, the conversion rate for control entries will be BC selling rate for the currency concerned ruling on the date the guarantee is issued. The entries will be reversed as and when the amounts are paid, at the same rate at which the original entry was passed as in the case of other bank guarantees. Export Performance Guarantees Favouring Customs These guarantees are those which are executed favouring the Customs Department for amounts linked to the customs duty relief availed by the exporter customers on imports of capital goods under the Export Promotion Capital Goods (EPCG) Scheme. The guarantees are for the due fulfillment of a specified level of export obligation undertaken by a customer to avail of the customs duty remission on the imports. In view of the nature of exposure involved in this type of guarantees, these guarantees stand on the footing of long term financing of a project, like a DPG commitment. In all cases of EPCG linked Bank Guarantees, branches should adopt the following approach: i) ii) Export Performance Guarantees given for availment of duty concessions on capital goods will be considered as part of the long term project finance. The assessment of the guarantee will be done by assessing the technical, financial and marketing ability of the project to achieve exports of the value within the time allowed under the duty concessions scheme, will be assessed.

iii) The guarantee should be supported by the same security which is available for the TL and DPG commitments for the project i.e. the Bank should have the first charge/pari passu first charge on the assets to be acquired. In addition, additional security as necessary should be obtained for the facility including the Export Performance Guarantee issued by ECGC. iv) Where the value of these guarantees is substantial in relation to the TL and DPG commitments from term lending institutions and banks, the risk under the guarantees should be shared with the term lending institutions through appropriate counter guarantees from them on the lines similar to issue of DPGs by the Bank on behalf of a consortium of term lenders.
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Comments on export performance are required to be given in the review/renewal proposals, for units availing bank guarantees under EPCG Scheme. In view of the above, it should be ensured that a suitable system is in place for monitoring the actual exports made by the customers vis-vis the commitments made with prescription to retain higher cash margins. Bid Bonds and Performance Guarantees on behalf of Exporters Bid bonds are issued in favour of overseas buyers in lieu of earnest money. Such guarantees have to be submitted by the exporters at the time they participate in tenders for the supply of goods/services abroad. While issuing bid bonds, branches may follow the undernoted guidelines: i) A flexible approach may be adopted in the matter of obtaining cover and earmarking of assets/credit limits/drawing powers, while issuing bid bonds and performance guarantees for export purposes. Branches may not ask for any cash margin in respect of bid bond and guarantees counter-guaranteed by ECGC. In other cases where such counter-guarantees of ECGC are not available, branches may stipulate a reasonable cash margin where it is considered necessary, as generally they are required to satisfy themselves about the capacity and financial position of the exporter while issuing such bid bonds/guarantees. Branches may consider sanctioning separate limit for issue of bid bonds and within the limits so sanctioned, bid bonds against individual contracts may be issued, subject to usual precautions.

ii)

iii) Issue of bid bonds for project exports is subject to compliance with the Exchange Control Regulations. Branches must comply with these regulations. For guidelines on project exports, please refer to the compendium of instructions brought out by the Project Exports Cell, Corporate Centre. Bank Guarantee Scheme of Government of India The Indian Banks Association (IBA) has, in consultation with the Reserve Bank of India, and Ministry of Finance, Government of India, evolved a Model Bank Guarantee Form in respect of guarantees to be issued in lieu of security deposit to departments of the State/Central Governments and Public Sector undertakings. While issuing such guarantees in lieu of security deposit, branches should adopt the aforementioned model guarantee form. It will also be in order for branches to consider issuing guarantees in any other suitable form, with the permission of the controlling authority provided the standard limitation clause is retained and also the spirit behind the model guarantee form is preserved and the Banks interests are not in any way jeopardised. However, if inclusion of any additional clause or alterations in the clauses of the model bank guarantee form are considered necessary owing to the peculiarities of certain contracts, it should be ensured that these additions/alterations are not one-sided and are not prejudicial to the interests of the Bank. Government of India has also clarified that (i) the bank guarantee would be invoked only where there is a specific breach on the part of the contractor of the terms and conditions of the relevant agreement and the bank guarantee bond, (ii) the decision to invoke the guarantee would be taken as far as possible, by an officer higher in rank than the officer who accepted the guarantee, and (iii) all claims under the guarantee bond should be made and lodged with the bank within the period specified in the relevant guarantee bond.
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Procedure to be followed when the judgements are delivered by Courts in favour of Government departments The following procedure should be adopted when the judgements are delivered by Courts in respect of guarantees issued in favour of Government Departments: a) Where the Bank was a party to the proceedings initiated by Government for enforcement of the bank guarantee and the case was decided in favour of the Government by the Court, branches need not insist on production of certified copy of the judgement as the judgement/order was pronounced in open Court in presence of the parties/their Counsels and the judgement would be known to the Bank. b) In case the Bank was not a party to the proceedings, a signed copy of the minutes of the order certified by the Registrar/Deputy or Assistant Registrar of the High Court or the ordinary copy of the judgement/order of the High Court, duly attested to be true copy by Government Counsel, would be sufficient for honouring the obligation under the guarantee unless the Bank decides to file any appeal against the order of the High Court. To facilitate prompt identification of the guarantees with the concerned departments, branches should mention in their correspondence with various State Governments, the names of the beneficiary departments and the purposes for which the guarantees were executed. Issue of Bank Guarantees in favour of other banks/financial institutions. Branches should not issue guarantees favouring financial institutions, other banks and/or other lending agencies for the loans extended by the latter, as it is intended that the primary lender should appraise and assume the risk associated with sanction of credit and not pass on the risk by securing itself with a guarantee. Branches may, however, issue guarantees to secure loans sanctioned by other lending institutions in respect of infrastructure projects subject to the condition that our Bank also takes a fund based exposure in the project at least to the extent of 5% of the project cost and the concerned branches undertake normal credit appraisal, monitoring and follow up of the project. Exceptions are permitted in the following cases by Reserve Bank of India. a) A bank can issue guarantee in favour of another bank in cases where it is unable to take its additional share in consortium account due to a liquidity strain and has temporarily transferred the share to another bank in the consortium along with issuing a guarantee in its favour. b) Banks can issue guarantee in favour of Industrial Development Bank of India (IDBI), in the case of import of technical know-how by way of drawings and designs under the Technical Development Scheme of IDBI under certain circumstances where no tangible security is available to IDBI. c) In the case of Sellers Line of Credit Scheme (SLCS) operated by financial institutions like IDBI, SIDBI, PFC etc. for sale of machinery, the primary credit is provided by the sellers bank to the seller through bills drawn on the buyer and sellers bank has no access to the security covered by the transaction which remains with the buyer. As such, buyers banks are permitted to extend guarantee/co-acceptance facility for the bills drawn under Sellers Line of Credit.

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However, such guarantee/co-acceptance facilities favouring financial institutions under their Buyers Line of Credit Scheme (BLCS) should not be granted for the reason that under the BLCS, the financial institutions assume the role of a primary lender by directly providing credit to the buyer to facilitate purchase of machinery, equipments etc. covered by the transaction. As the primary lender is required to make a proper assessment of the proposal and secure a charge of hypothecation on the assets, it would not be in order for the financial institutions to shift the risk of repayment by obtaining a bank guarantee. d) Banks can issue of guarantee in favour of different Development Agencies/Boards like Indian Renewable Energy Development Agency, National Horticulture Board, Sugar Development Fund, etc., on behalf of their clients/customers for obtaining soft loans and/or other forms of development assistance from such Agencies/Boards. However, such sanctions should be subject to the following conditions: i) Banks should satisfy themselves, on the basis of credit appraisal, regarding the technical feasibility, financial viability and bankability of individual projects and/or loan proposals i.e., the standard of such appraisal should be the same, as is done in the case of a loan proposal seeking sanction of term finance/ loan. ii) Banks should conform to the prudential exposure norms prescribed from time to time for an individual borrower/group of borrowers. iii) Banks should conform to the ceilings prescribed from time to time for sanction of term finance/loans from the banking system. iv) Banks should suitably secure themselves before extending such guarantees. Branches should not execute any guarantee in favour of HUDCO in respect of loans given to State sponsored bodies. Branches should not execute guarantees covering inter-company deposits/ loans. Guarantees should not also be issued for the purpose of indirectly enabling the placement of deposits with non-banking institutions. This stipulation will apply to all types of deposits/loans irrespective of their source, e.g. deposits/loans received by non-banking companies from trusts and other institutions. It is not the Banks normal practice to grant credit facilities on the strength of guarantees issued by other banks. But, in cases where branches entertain loan proposals on the strength of the guarantees issued by other banks/financial institutions, the under noted points should be kept in view:i) The credit proposals should be subjected to usual scrutiny by the branches ensuring that the proposals conform to the prescribed norms and guidelines and credit facilities allowed only if they are satisfied about the merits of the proposal. The availability of the other banks guarantee should not result in dilution of the standards of evaluation of the proposal and financial discipline in lending. ii) Branches should also enquire into the reasons as to why the other bank, instead of itself granting the credit facility, is guaranteeing it. This should be recorded in banks books. iii) It should also be ensured that the officials of the Bank issuing the guarantee are vested with the necessary powers and should insist on the relative powers being registered with it before releasing the credit facility.

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Annexure BG 1 Illustration showing the method of assessment of Bank Guarantee (BG) M/s. XYZ Co. Ltd. Bank Guarantee limit of Rs.15 crores Purpose : The company needs to furnish bank guarantees in favour of its clients for the following purposes: a. Earnest Deposits b. Security Deposits c. Advance Payments d. Retention money e. Sales tax, commercial tax and Excise Duty payments. Based on the past trends and projected performance, the limit requirement could be assessed as under: (Rs. in crores) Opening balance as on 1.4.20x0 (beginning of the year 20x0 x1) Guarantees Required : i) ii) iii) Earnest money deposits: 2% of additional tenders worth Rs.80 crores during 20x0 - 20x1 Security Deposits: 5% of tenders worth Rs.50 crores expected to be awarded during 20x0 - x1 Advance Payment Guarantees:10% of new orders worth Rs.50 crores expected during 20x0 - x1 Retention / Maintenance Guarantees : 10% of the jobs valued at Rs.60 crores expected to be completed during 20x0 - x1 Guarantees on account of Sales Tax, Commercial tax and excise duty payments Total: Less : Bank Guarantees to be cancelled during 20x0-x1 including those in (a) above Limit required Say, 1.60 9.50

2.50

5.00 6.00 1.00 25.60 10.00 15.60 16.00

iv) v) vi) vii) viii) ix)

A statement should be called for from the applicant (borrower) indicating the expected monthly position of bank guarantees for the next 12 months i.e. outstandings at the beginning of every month, guarantees likely to expire during the month, guarantees likely to be issued during the month and the outstandings at the end of every month to arrive at the assessment of the limit.

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Annexure BG 2 COUNTER GUARANTEE Place : Date : The Branch Manager, State Bank of India, . In consideration of your having at our request agreed to execute a Letter of Guarantee (as per copy annexed hereto) for Rs. (Rupees Only) in favour of the ....(hereinafter referred to as the beneficiary), we hereby agree and declare that: a) We will hold harmless and indemnify the Bank against and will pay to the Bank on demand at State Bank of India, . Branch, the amount of costs, claims, demands, damages, losses, expenses which may be made against or sustained by the Bank or for which the Bank may become liable by reason of the Bank having given and signed the said guarantee or otherwise in connection therewith AND we also agree to pay to the Bank at its branch forthwith on demand any amount which the Bank may be called upon to pay under the said guarantee (and whether the Bank shall have paid any such amount or not) plus all costs and charges which may be incurred by the Bank or become payable in connection with fulfillment of the terms of the said guarantee AND any payment made by the Bank on demand from the beneficiary shall be deemed to be an amount which the Bank has been called upon to pay under the said guarantee. b) The Bank shall be at liberty to debit the Current / Cash Credit Account maintained by us at the Banks .. Branch with any amount paid or payable by the Bank pursuant to clause(s) of this counter-guarantee. c) We further agree that this counter-guarantee will remain in force until the Bank is finally discharged of the liability under the said guarantee and has obtained confirmation in writing thereof from the beneficiary and received therefrom the said guarantee duly redeemed. d) Any notice by way of demand or the otherwise hereunder may be given by the Bank to the company by sending the same by post addressed to us at our registered office and the notice shall be deemed to have been given at the time when it would be delivered in the ordinary course of post and it will be sufficient in order to prove service of any such notice to prove that the envelope containing the same was posted and a certificate signed by the branch manager of the Banks branch that the envelope was posted shall constitute such proof. e) If for any reason or any action initiated by us, the Bank is prevented from making payment to the beneficiary of the guaranteed amount, we will be liable to pay the Bank guarantee commission for the period for which such action (i.e. the payment or discharge of the guarantee) is delayed, apart from being liable for other amounts payable to the Bank.

(Signature of the applicant of the BG)

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Annexure BG 2A Omnibus Counter Guarantee (To be stamped as an Indemnity) The Branch Manager, State Bank of India, (1) _____________ In consideration of your having at our request, executed and agreed in execute from time to time at the discretion of the Bank, various financial performance and other guarantees/ bonds whether already issued or to be issued in future (hereinafter referred at as Guarantees) in the form(s) as approved by the Bank subject to the outstanding Guarantees not exceeding (3) (2) Rs.. (Rupees _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ only) at any time in favour of our (4) Indian and foreign customers / suppliers, we _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ a Limited Company incorporated in India under the Companies Act 1956, and having our (5) Registered Office at _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ (hereinafter referred to as the Company which expression shall unless repugnant to the context or meaning thereof be deemed to include its successors-in-interest and permitted assigns) hereby irrevocably and unconditionally agree and undertake to indemnify you against all types of claims, losses, damages, actions and costs (as between Attorney and Client) charges and expenses whatsoever which may be brought or made against or sustained or incurred by you (and whether paid by you or not) or for which you may become liable under or in respect of these Guarantees and any subsequent renewal or renewals thereof the Company agrees that you may in your absolute and unqualified discretion and without you being required to ascertain whether or not there was in fact any breach on the part of the Company of the agreements with our customers/ suppliers and without you being required to go into the validity or otherwise of the demand for payment made by all or any one of them against you and notwithstanding any direction to the contrary given by the Company or any other person on the ground of a dispute as to the liability of the Company or otherwise admit or compromise and pay or submit to arbitration or dispute or resist any claim or demand made against you under or in respect of the guarantees already issued or to be issued and any subsequent renewal or renewals thereof, the counterindemnity hereof executed by the Company being available to you in respect of any action you may take or payment which you may make and the Company agree to pay you on demand at (6) all such moneys as the Company may be liable to pay under this Counter Indemnity including all claims, losses, damages, actions, costs, charge and expenses whatsoever which may be brought or made against you or sustained or incurred by you or for which you may become liable under or in respect of the Guarantees and any subsequent renewal or renewals thereof and that you may proceed against and recover from any property of the Company including any credit balance held by you and any security for the time being held by you on account of the Company by sale or otherwise and allocate and apply the net proceeds of sale and realization thereof and any other moneys in your hands standing to the credit of or belonging to the Company on any account whatsoever independently the one of the other in such order and in such manner as you may think fit in or towards payment of all amounts found payable by the Company to you hereunder and the Company agrees and undertakes forthwith on demand made by you to deposit with you such sum or security or further sum or security as you may from time to time specify as security for the due fulfillment of

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obligations of the Company hereunder and the securities so deposited with you may be sold by you after giving to the Company a weeks notice of sale and the said sum or the proceeds of the sale of the security(ies) may be appropriated by you in or towards satisfaction of the said obligations and any liability arising out of non-fulfilment thereof by the Company and the Company lastly agrees that this Counter Indemnity will be continuing one and will remain in force until you are finally discharged of all liabilities under all or any one of such Guarantees and all subsequent renewal or renewals thereof and have had the discharge confirmed in writing and received the Guarantees and any subsequent renewal or renewals thereof duly redeemed. Dated at _ _ _ _ _ _ _ _ _ _ __
(7)

this_ _ _ _ _ _ _ _ _ _

(8)

day of _ _ _ _ _ _ _ _ _ 20xx
(10)

(9)

The Common Seal of _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __ was hereunto __ ___ affixed, in pursuance of a Resolution of the Board of Directors of _ _ _ _ _ _ _ _ _ _ (11) (12) _______ __ day of _ _ _ _ _ passed in that behalf on the _ _ _ _ _ _ _ _ _ _ _ _ _ (13) _______________ 20xx in the present of
(14)

1. .. 2. ..

__________________ ______ (Signature(s) of the Director(s) authorised to sign documents) Note: Suitable modifications should be made in case of firms, proprietorship firms wherever warranted. In the case of Limited Liability Companies, it should be ensured that the Companys Common Seal is affixed on the counter-guarantee in accordance with the Articles of Association of the Company and a suitable resolution for affixing the Common Seal on the Counterguarantee is passed by the Company.

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Annexure BG-2AA

Instructions to fill in the Omnibus Counter-guarantee (vide Annexure BG-2A) I. Name of the document : Omnibus Counter-guarantee.

II. When to be obtained : When guarantees are issued on behalf of borrowers who have been granted a Guarantee limit, an omnibus counter guarantee is to be executed by them. This also is to be obtained from constituents on whose behalf guarantees are frequently issued although a regular guarantee limit has not been granted to them. III To be executed by : The borrowers.

IV Instructions regarding filling up of the document :-1. Name of the Branch. 2. Amount of guarantee limit, in figures. 3. Amount at No.2 in words. 4. Name of the Borrowers. 5. Address of the Registered Office of the Borrowers. 6. Name of the Branch and place. 7. Place of execution. 8 & 9. Date, Month and Year of execution. 10. Name of borrowing company. 11. As at No. 10 above. 12 & 13 Date, Month & Year on which the Resolution referred to was passed by the Board of Directors. 14. Name(s) of the Director(s) in whose presence the Common Seal of the company has been affixed, as per the authorisation specified in the Companys Resolution referred to at No. 12 above. CARE (A) In the case of Limited Liability companies, it should be ensured that the companys Common Seal is affixed on the counter-Guarantee in accordance with the Articles of Association of the Company and a suitable resolution for affixing the Common Seal on the counter-guarantee is passed by the Company. (B) Suitable modifications should be made in this document where warranted in case of firms/proprietorship firms.

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Annexure BG-3

Specimen of the First Page of Bank Guarantee (To be stamped as an agreement in accordance with the Stamp Act in force) STATE BANK OF INDIA Branch (Stamp) Form No. . .. .. .. .. Dear Sir, Guarantee No. Amount of Guarantee Rs.. Guarantee cover from 1.1.20x0 to 31.3.20x1 Last date for lodgement of claim 31.3.20x1 This Deed of guarantee executed by the State Bank of India constituted under the State Bank of India Act, 1955 having its Central Office at Nariman Point, Mumbai and amongst other places, a branch at (hereinafter referred to as the Bank) in favour of (hereinafter referred to as the Beneficiary) for an amount not exceeding Rs. .. (Rupees .. only) at the request of (hereinafter referred to as the Contractor /(s)). This Guarantee is issued subject to the condition that the liability of the bank under this Guarantee is limited to a maximum of Rs. .. (Rupees only) and the Guarantee shall remain in full force up to 31.3.20x1 (date of expiry) and can not be invoked otherwise than by a written demand or claim under this Guarantee served on the Bank on or before the 31.3.20x1, last date of claim). SUBJECT TO AS AFORESAID Date :dd.mm.yyyy

(Main Guarantee matter may be typed hereafter)

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Annexure BG-4 By Registered Post A/D To:

Dear Sir, Subject : Our Bank Guarantee No. dated We refer to our guarantee No. . Dated . executed by us for an amount of Rs. . for performance of / on account of .. in your favour. The validity period thereof expired on No claim has been received by us within the period mentioned therein i.e. on or before Please note that our obligations under the said guarantee have ceased to have any validity and legal force, as we have not received any claim under the guarantee within the validity period. While we are sure that you are aware of the position that retention of the document embodying the guarantee after the expiry of its validity period does not confer any right upon the beneficiary and you need not be reminded by us in this regard, we shall be glad it you will please return the obsolete document of guarantee duly cancelled to be kept by us for our record / audit purposes as the retention of the same by you would serve no purpose. Thanking you, Yours faithfully,

Branch Manager

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Annexure BG 5 MODEL FORM OF BANK GUARANTEE BOND 1. In consideration of the President of India (hereinafter called the Government) having agreed to exempt . (hereinafter called the said Contractor(s)) from the demand, under the terms and conditions of an Agreement dated . made between . and for .. (hereinafter called the said Agreement) of the security deposit for the due fulfillment by the said Contractor (s) of the terms and conditions contained in the said Agreement, on production of a Bank Guarantee for Rs. (Rupees .. only), we, (indicate the name of the bank) (hereinafter referred to as the Bank) at the request of .... [contractor(s)] do hereby undertake to pay to the Government an amount not exceeding Rs. . against any loss or damage caused to or suffered or would be caused to or suffered by the Government by reason of any breach by the said Contractor(s) of any of the terms or conditions contained in the said Agreement. 2. We (indicate the name of the bank) do hereby undertake to pay the amount due and payable under this guarantee without any demur, merely on a demand from the Government stating that the amount claimed is due by way of loss or damage caused to or would be caused to or suffered by the Government by reason of breach by the said contractor(s) of any of the terms or conditions contained in the said Agreement or by reason of the contractor(s) failure to perform the said Agreement. Any such demand made on the bank shall be conclusive as regards the amount due and payable by the Bank under this guarantee. However, our liability under this guarantee shall be restricted to an amount not exceeding Rs. . 3. We undertake to pay to the Government any money so demanded notwithstanding any dispute or disputes raised by the contractor(s) / supplier(s) in any suit or proceeding pending before any Court or Tribunal relating thereto our liability under this present being absolute and unequivocal. The payment so made by us under this bond shall be a valid discharge of our liability for payment thereunder and the contractor(s)/ supplier(s) shall have no claim against us for making such payment. 4. We . (indicate the name of bank) further agree that the guarantee herein contained shall remain in full force and effect during the period that would be taken for the performance of the said agreement and that it shall continue to be enforceable till all the dues of the Government under or by virtue of the said Agreement have been fully paid and its claims satisfied or discharged or till office/ department/Ministry of certifies that the terms and conditions of the said Agreement have been fully and properly carried out by the said contractor(s) and accordingly discharges this guarantee. Unless a demand or claim under this guarantee is made on us in writing on or before the .. we shall be discharged from all liabilities under this guarantee thereafter.

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5. We (indicate the name of bank) further agree with the Government that the Government shall have the fullest liberty without our consent and without affecting in any manner our obligations hereunder to vary any of the terms and conditions of the said Agreement or to extend time of performance by the said contractor(s) from time to time or to postpone for any time or from time to time any of the powers exercisable by the Government against the said Contractor(s), and to forbear or enforce any of the terms and conditions relating to the said agreement and we shall not be relieved from our liability by reason of any such variation, or extension being granted to the said Contractor(s) or for any forbearance act or omission on the part of the Government or any indulgence by the Government to the said Contractor(s) or by any such matter or thing whatsoever which under the law relating to sureties would, but for this provision, have effect of so relieving us. 6. This guarantee will not be discharged due to the change in the constitution of the Bank or the Contractor(s) / Supplier(s) 7. We . (indicate the name of the bank) lastly undertake not to revoke this guarantee during its currency except with the previous consent of the Government in writing. Dated the .. day of .. 20xx

For State Bank of India

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10. SHORT TERM EXPORT FINANCE

The World Trade Organisation is continually pushing for further liberalization of cross-border trade. Perceiving the advantages of an open trading system, and in response to the WTO initiatives, India has been progressively bringing down the barriers to the inflow of goods. The country has to gear up now, in terms of technology and efficiencies, to exploit emerging opportunities in the world markets which is implicitly available to a member nation like ours. There is therefore an urgent need to increase exports while maintaining imports at a healthy level. Also, as a long-term strategy, it is only through exports that a country can build a strong foundation for foreign exchange savings. Countries like Japan, Taiwan, have taken the route of export led growth and built significant reserves, bulk of which, therefore, is earned and not borrowed. Finally, given the countrys need to import oil and technology there is a need to build on the foreign exchange reserves more and more through earnings, while continuing to be an attractive destination for foreign investors and lenders. Promoting exports would also provide additional job opportunities to our qualified and skilled work force. Export efforts demand constant upgradation of technology for remaining competitive which also becomes available for the domestic markets. The efficiencies needed for an export led growth has a contagion effect on the local industries thus making investments more productive. Realising the need to make the countrys exports competitive, Government has put in place measures providing incentives, and subsidised finance. These are a means of compensation for the additional costs incurred on account of the countrys infrastructural deficiencies, as also to counter the competitive advantages enjoyed by overseas manufacturers on account of access to better technology, and work practices. It is a regulatory requirement that commercial banks must support export activity by providing subsidised finance to the deserving exporters. In turn, the RBI provides refinance to such banks at concessional rates (on certain terms and conditions and upto certain limits) to compensate for the losses suffered on account of the subsidised lending. Why should we finance exports? While financing exports, increased opportunities become available to the Bank for earning interest and other income through negotiation of bills, advising incoming Letters of Credit etc. There is some evidence to suggest that because of the inherent short term and time-bound nature of this portfolio one can learn of possible defaults earlier than is possible in the normal Cash Credit type of advances. In addition to the branch-level earnings, there is money to be made at the treasury where it is possible to set-off exports with imports of similar maturities and currencies. To the extent this is possible, it enables the Bank to retain the margins in both the transactions. Finally, if we do not meet our customers genuine requirements, our competitors will. Financing Exports Designed largely as per RBI guidelines, we have schemes to finance exports, both at the preshipment (Export Packing Credit) and post-shipment stages, in Rupee as well as in foreign currency (PCFC), i.e. in USD, GBP, EUR and JPY. In addition to Pre-shipment and Post-shipment credit facilities, the Bank offers the following facilities to exporters: a) Guarantees (bid bond, performance guarantees, Advance Payment guarantees, guarantees in lieu of customs duty etc.)
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b) Letters of Credit for import or purchase of raw materials etc. c) Derivative products to cover the exchange risk (Forward Contracts etc.) d) Exchange Earners Foreign Currency Account (EEFC) e) Fee-based services for accessing Forfait financing through our International Banking Group,, CC, Mumbai. Forfait finance is especially suitable for such export orders where the repatriation period is likely to exceed one year or the export is to a country on which the Bank may not wish to take exposure. In such cases we may recommend and assist the exporter to avail of finance through the Forfaiting mechanism. The brief details of the generic product are detailed in Annexure II to this chapter. This would help the operative functionaries to familiarize themselves with the features of the product. Detailed operational guidelines may, however, be had from International Banking Group, Corporate Centre. Exports are governed by various regulatory (RBI, Directorate General of Foreign Trade) and other provisions (Foreign Exchange Dealers Association of India, Uniform Customs and Procedures in Documentary Credits, Uniform Rules for Collections). Branches dealing in export credit should be conversant with the relevant provisions. 1. a) Pre-shipment Finance Purposes / Items eligible for Export Packing Credit (EPC): b) Export credit is available to all exporters, holding Import Export Code (IEC) number, and licenses as applicable, for exports backed by LCs or Firm Orders,

For export of consultancy services and computer software. Pre-shipment finance at Concessional rate of interest can be extended to exporters to enable them to undertake preliminary arrangements such as mobilising technical and other staff and training them or for purchase of any materials required for the purpose.

c)

Pre-shipment Credit to Floriculture, Grapes and Other Agro-based Products In the case of floriculture, pre-shipment credit is allowed to be extended by banks for purchase of cut-flowers, etc. and all post-harvest expenses incurred for making shipment. Pre Shipment Credit is also available in respect of export-related activities of all agro-based products including purchase of fertilisers, pesticides and other inputs for growing of flowers, grapes, etc. However the financing banks should be in a position to clearly identify such activities as export-related and satisfy themselves of the export potential thereof, and the activities are not covered by direct/indirect finance schemes of NABARD or any other agency. Such pre shipment credit would be subject to the normal terms & conditions relating to packing credit such as period, quantum, liquidation, etc.

d)

Export Credit to Processors/Exporters-Agri-Export Zones Government of India have set up Agri Export Zones in the country to promote agri exports and proposed that Agri Export Oriented Units (processing) would be set up in Agri Export Zones and to promote such units, production and processing have to be integrated. The producer has to enter into contract farming with the farmers around the unit and has to ensure supply of quality seeds, pesticides, micronutrients and other material to the group of farmers from whom the exporter would be purchasing their products as raw material for

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production of the final products for export. Such export processing units may be provided packing credit under the extant guidelines for the purpose of procuring and supplying inputs to the farmers so that quality inputs are available to them which in turn will ensure that only good quality crops are raised. The exporters will be able to purchase/import such inputs in bulk which will have the advantages of economies of scale. Inputs supplied to farmers by exporters may be treated as raw material for export and could be considered for sanctioning the lines of credit/export credit to processors/exporters to cover the cost of such inputs. As in the case of all finance, the end-use of funds will have to be verified. The end use criteria here would be met if the exporter distributes inputs to the farmers for raising the crops as per arrangements made by the exporter/main processor units, and further the final products are exported by the processors/exporters as per the terms and conditions of the sanction in order to liquidate the pre-shipment credit. Preshipment credit is also available for the following type of exporters and purposes. e) f) g) h) i) Finance against goods for exhibition and sale abroad Manufacturer Exporters Merchant Exporters / Traders Export Houses (Status Holders) Duty Drawback entitlements: Export credit can be given at pre-shipment stage for an amount in excess of export order; the excess representing the amount of duty drawback recoverable from appropriate authorities provided the transaction is covered by Export Production Finance Guarantee of Export Credit & Guarantee Corporation of India Ltd (ECGC). In such cases, excess advances should be liquidated from Duty Drawback received. Export documents are to be in the name of the exporter who alone would be entitled to duty drawbacks j) k) Advance Payment cheques sent for collection Deemed Exports Deemed exporters (recognised as such by Director General of Foreign Trade) are those who supply to units in Special Economic Zones, Export Oriented Units, United Nations-funded projects, Multilateral and bilateral agencies and funds, Export Promotion Capital Goods license holders etc. These exports can be financed in Rupee as well as in Foreign Currency against firm orders or LCs. The payments for such exports have to be realized in foreign currency or rupee remittances backed by inward remittance certificates. A post-shipment facility of 30 days is also made available to them. The Deemed exporters can claim incentives in their own right. l) Indirect exports ( Sub-Suppliers) Indirect exporters are those who may or may not be exporters in their own right. It is not necessary that they should hold an Importer Exporter Code. Export Order Holders (EOH), viz. Manufacturer exporters / Star Export Houses etc. place orders with indirect exporters for supply of goods. At times they may be asked to ship the consignment directly. Incentives, if any, shall be shared between the Export Order Holder and the indirect exporter as per mutual agreement. No post-shipment finance is envisaged for indirect exporters.
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The following conditions would need to be met for financing an indirect exporter: Inland LC in favour of the sub supplier of a manufacturer exporter A letter of undertaking from the EOH and his banker that EPC would not be enjoyed at their end for the same purpose during the course of the EPC being outstanding against the indirect exporter Where shipments are made to the EOH and not directly exported from the indirect exporters end (i.e. when such bills are not accompanied by Bill of Lading etc.) then a certificate from the EOH has to be obtained that exports have actually taken place. Such certificates should be submitted on a quarterly basis if it is an ongoing arrangement. Nature of EPC advances

2.

The basic premise behind Banks guidelines for advances to exporters is that no deserving exporter should be denied concessional finance. It only means that export proposals have to be appraised to ascertain that the exporter behind the enterprise is deserving of our encouragement. This issue is discussed later under Assessment of Export Packing Credits. 2.1 On line approach to credit: The credit facilities sanctioned to exporters should be renewed annually. In case of delay in renewal, the sanctioned limit may be allowed to continue uninterrupted and urgent requirement of the exporters should be met on ad hoc basis. In case of export of seasonal commodities, agro-based products, etc. sanction may be accorded for peak/non-peak credit facilities to exporters. In this connection, a Stand-by Line of Credit (SLC) for meeting genuine contingency needs of exporters may be sanctioned along with regular credit limits as a separate limit. The SLC limit should be got sanctioned (as a separate limit and not as a sub-limit) alongwith regular credit limits. If the unit enjoys a separate peak and non-peak limit, SLC should be arrived at separately as a percentage of peak and non peak limits. SLC limits, being contingent in nature, will be outside the consortium arrangement, if any. Being a general dispensation extended to all eligible units, no separate assessment / special justification is required for SLC.

2.2 Handling of Export Documents: While handling export documents, submission of original sales contract/ confirmed order/proforma invoice countersigned by overseas buyer/indent from authorised agent of overseas buyer need not be insisted upon, since the goods have already been valued and cleared by the customs authorities except in the case of transactions with Letters of Credit where the terms of LC require submission of the sale contract/other alternative documents. 2.3 Fast Track Clearance of Export Credit At special branches and branches having significant export business a facilitating mechanism for assisting export customers are in place for quick initial scrutiny of appraisal and for additional information/clarification. The prescribed time limit for disposal of proposals is as detailed below:

Type of proposal Sanction of fresh/enhanced credit limits

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Renewal of existing credit limits Sanction of adhoc credit facilities

2.4 Clean nature of export credit:

30 Days 15 Days

This advance granted to the exporter for procuring the goods from the market, though initially clean in nature, should be converted into secured advance as soon as the goods are procured by the exporter by charging/ hypothecating the goods in the name of the Bank. Packing Credit is normally granted to Manufacturer exporters, Merchant exporters. Besides these two categories, exporters who are sub-suppliers, known as indirect exporters and Deemed exporters are also offered the concessional finance. 3. Assessment of Export Packing Credit (EPC) EPC is a concessional working capital finance for exporters. The assessment of working capital limits are as per Projected Balance sheet Method, Cash Budget Method, Turn-over Method as applicable to the unit and is based on the projected build up of current assets/cash gaps/length of the working capital cycle etc. Besides the usual factors like capacity, viability, integrity, past performance, additional factors like the following need to be borne in mind: 1. The exporter should have registered with the Director General of Foreign Trade and obtained an Importer Exporter Code, and possess membership of the relevant Federation of Indian Export Organisations / Promotion council or any of its regional outfits. 2. The exporter should not figure in the ECGCs Specific Approval list. If so, their approval is required for fresh exposure 3. Should the exporter figure in RBIs caution list, their permission is a pre-requisite for fresh exposure. 4. While assessing the overall viability of the proposal, the quantum of incentives receivable should be looked into. A brief note on incentive schemes and their impact on export proposals is placed as Annexure I. 5. The capacity of the exporter to execute the orders as per time schedule is to be assessed having regard to installed capacity, raw material availability etc. 6. The exporters general level of preparedness for adhering to quality requirements could be crucial, as non-payments because of quality considerations are not insurable. 7. The country risk aspects have to be borne in mind as well. 8. Should the exporter deal in Quota items, then the necessary allotments would need to be verified. Wherever finance is extended under consortium arrangement, once the consortium has approved the assessment of the limits, necessary action should be initiated forthwith for completing the sanction process without waiting for sanction by the lead bank. As for quantum, the golden rule is need-based. The following aspects would, however, merit attention: 1. The period of credit would depend on the manufacturing / trade cycle, however, normally not exceeding 180 days, relaxable upto 360 days on merits. As part of a RBIs Special Financial Package, in vogue, pre-shipment credit could be extended upto 365 days for large value exports of products relating to Pharmaceuticals, Agro Chemicals, Transport equipment, Cement, Iron & Steel, Electrical machinery, Leather and Textiles. Preshiment credit in rupee at concessive rate of interest is available currently upto 270 days, including overdue EPCs
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2.

3.

4.

5.

EPC loans are usually restricted to the lower of 90% of FOB value of the contract, or the domestic cost of production. In the export of Hand Picked and Selected groundnut, deoiled and defatted cakes, the disbursements could go up to the value of raw material required. The excess amount disbursed should be liquidated by sale proceeds locally, within 30 days. Relaxations in respect of Current Ratio (compared to the benchmark current ratio) could be permitted if the unit is otherwise healthy with acceptable levels of profitability and cash flows. Inadequacy or non-availability of collateral cannot be a ground for rejecting a proposal for export finance. Interchangeability between domestic and export limits should be provided for, where the unit has both domestic and export operations. Similarly, interchangeability between pre-and postshipment could be provided for at the time of sanction itself. The term loan requirements for expansion of capacity, modernisation of machinery and upgradation of technology should be considered. Standby Lines of Credit for term loans are also extended by Mid Corporate Group & Corporate Accounts Group Branches.

4. Conduct and Supervision of EPC: Two types of accounting are in vogue when it comes to dispensing the credit under EPC(1) Order-by-order accounting and (2) Running account. While pre shipment credit is normally extended on order to order basis, running account facility is extended to those exporters with good track record and where the nature of activity demands such facility. Running account facility is automatically extended to Status Holder Exporters, 100% EOUs, Units in SEZ/FTZ/etc and also SBI Exporters Gold Card holders. For the sake of clarity, we shall examine the operational features of both separately: (1). Order-by-order facility: a. b. Drawing Power is linked to the lower of stock holding or orders in hand. Disbursement will be based on Firm orders / LCs produced and to be linked to production cycle, in order to preempt diversion of funds. The funds are to be released to the suppliers directly, where possible. Otherwise the borrowers current account could be credited. Cash disbursements, are to be made only with specific sanction and as required by industry practice. Inspection should be carried out with a view to ensure end-use, and adverse features should be acted upon quickly, as well as notified to Export Credit and Guarantee Corporation of India Ltd (ECGC). The physical inspection should also help spot the signs of slippages, if any, in time schedule. ECGC have to be kept informed of all material changes in respect of the accounts.

c.

The packing credit account has to be liquidated from the proceeds of bills offered for purchase / discount / negotiation. In such cases, where exports have taken place, the outstandings may also be liquidated by credits from exporters Exchange Earners Foreign Currency Account (EEFC). Where requested, substitution of orders may also be permitted depending on the merits of the case. It is to be ensured that the interest rates as per the applicable slab rates are applied on the outstandings. A daily list would need to be maintained to keep track of delay or non-submission of export bills. Where, bills are not submitted, and further extension is considered infructuous, the outstandings may be liquidated from sources other than bill proceeds, and interest should be charged as
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applicable to the Export Credit not Otherwise Specified (ECNOS), for the entire period of the advance. In the case of bills sent for collection for whatever reason, [viz. discrepant bills (under LCs), or the exporter does not want to avail post-shipment finance, or for whatever reason], either the borrower should be asked to repay the Export Packing Credit outstanding from his current account balances (ECNOS rate to be charged) or the branch should transfer the outstanding to Advances against Bills sent for Collection account. This enables two things: Once goods are shipped, cover under ECGC guarantee, if any, ceases; as such premium need not be remitted on this outstanding. However, if the outstanding continues to remain in the EPC there is the danger of account being debited with insurance premium for a nonexistent cover. Transferring to post-shipment phase enables us to monitor the bills realisation better, and ensure Exchange control compliances. Further, once the goods financed by EPC have been exported, the respective outstanding is rendered clean, as hypothecation of the goods no longer subsists. The proceeds should not be directly credited to the exporter if EPC availed earlier is outstanding. (2). Running Account facility: This facility is extended to exporters with good track record and Export Oriented Units (EOUs)/Units in Free Trade Zones/ Export Processing Zones (EPZs) and Special Economic Zones (SEZs). It offers operational freedom to the exporters who have a good track record i.e., overdue export bills not in excess of 5% of the last three years average export realization.. This aspect, however, has to be certified annually by a Chartered Accountant, to enable the exporter to continue to enjoy the Running account facility. Further, if misuse of the facility is observed, the bank can withdraw the facility and revert to the order-by-order basis of extending finance. Running account facility can be offered to all categories of eligible exporters excepting indirect exporters. Drawing Power in the account is linked to the lower of stock holding or orders in hand. Disbursement will be based on Firm orders / LCs produced, which need not be insisted upon and a statement of orders held would suffice. The orders / LC should however, be produced within a month. As far as possible the disbursements are to be linked to production cycle, in order to preempt diversion of funds. The funds are to be released to the suppliers directly, where possible. Otherwise the borrowers current account could be credited. Liquidation of packing credit in Running Account would be based on the principle first credit shall liquidate the first debit. As long as the credits to the account are from export bill proceeds, the end-use criteria would stand satisfied. Disbursements made in respect of an order may be liquidated by proceeds generated either, from servicing the particular order, or any other export order, irrespective of whether EPC had been drawn in respect of that order or not. The only complication in Running account is to keep track of the age of outstanding debits or its residual portions since the correctness of interest applied, which varies with period of outstanding, depends on this. To ensure that this is done and no income leakage occurs, it is necessary to have order-by-order back-up registers. As for the rest of the issues such as cash disbursements, inspections, non-submission of bills, or bills sent for collection etc. the observations made earlier under Order-by-order account would apply.
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One persisting irregularity observed at branches offering Running account is that, often bills are sent for collection without adjusting the EPC outstanding, as the overall outstandings are usually well covered by outstanding orders or stock as the case may be. This argument, if bought will throw the post-shipment monitoring mechanism out of gear. ECGC cover: Branches should obtain Individual Packing Credit Guarantee (IPCG) cover of ECGC for the PreShipment credits. Sanctioning authority can waive obtention of IPCGs in deserving cases, based on the risk perception, if the borrower is rated SB-4 or above and has a satisfactory track record for the last 18 months. In case of a new borrower, IPCG can be waived if he is rated SB-3 or above and offers valuable business potential. Reasoned deviations to this norm for waiver of IPCG may be permitted by the sanctioning authority on a case to case basis say, in case of top rated customers and/or availability of substantial collaterals, etc. The details in respect of various types of guarantees and policies being issued by ECGC in favour of banks and exporters are circulated by Foreign Department, Calcutta. Banks all other guidelines on monitoring of cash credit/WCDL are also applicable as such to EPC. 5. Security Export packing credit advances should be secured by pledge or hypothecation of stocks. Manufacturer-exporters having extensive domestic operations as well as export business, may not find it feasible to segregate stocks of goods meant for export and pledge/hypothecate them separately to the Bank. In such cases, it would suffice if it is ensured that the aggregate outstandings in all accounts (domestic cash credit account(s) as well as export packing credit account) are fully covered by the advance value of the stocks pledged/hypothecated to the Bank. In addition, where considered necessary, branches may obtain collateral security by way of third party guarantee /equitable mortgage of immovable property. However, the assessment of export credit (both pre and post- shipment) should be need-based and not directly linked to the availability of collateral security. 6. Pre-shipment Credit in Foreign Currency (PCFC)

The scheme of Pre-Shipment Credit in Foreign Currency (PCFC) enables the exporters to avail packing credit at international interest rates through Authorised Persons. The Scheme covers the cost of both domestic as well as imported inputs of exported goods. The scheme will be operated only at the designated branches as advised from time to time by the IBG Corporate Centre. Exporter-customers of non-designated branches (NDBs) can avail of the PCFC facility at the nearest designated branch (DB). All exporters, having firm export orders/irrevocable letters of credit are normally eligible for PCFC, subject to satisfying other credit norms. As regards existing customers, PCFC can be carved out of the EPC limits available to them subject to the outstandings under both the rupee and foreign currency facilities (converted at the prescribed notional rate) not exceeding the limits sanctioned. There is no need for sanction of a separate sub-limit for PCFC. Export Packing Credit (EPC) in Rupees in part and PCFC in part can be granted against the same export order. But the drawals already made under Rupee Running Account facility earlier should not be converted into PCFC advances. Before allowing this facility, it should be ensured that the exporter has not availed PCFC/EBR with any other bank in respect of the export bill in question. PCFC can be availed in USD, GBP, EUR and JPY for the time being.

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Exporters desirous of availing PCFC are obligated to discount the export bills under Export Bills Rediscounting Abroad Scheme (EBR) to enable them to repay the outstandings in foreign currency. Running Account facility is permitted in the case of exporters with good track record but not automatically to their/sister/associate/group concerns. For this purpose, exporters whose overdues do not exceed 5% of the average annual export realisations during the preceding three calendar years may be considered as exporters with good track record. The usual safeguards in this regard have to be followed. In case of non-utilisation of PCFC drawn for export purposes, besides levying the prescribed penalties, the running account facilities for the exporter concerned should be withdrawn with immediate effect. PCFC will be made available by way of cash credit account. Before any disbursal is made under PCFC, branches should ensure that the total of outstandings under EPC and the rupee equivalent of outstandings under PCFC (arrived at the fixed notional rate) are within the overall EPC limit of the exporter and the proposed disbursal falls within the limit. The drawing power register, therefore, should provide for columns to reflect PCFC and EPC outstandings and the total thereof, for monitoring the total outstandings at any point of time. Repayment of packing credit may be allowed with export documents relating to any other order covering the same or any other commodity exported by the exporter subject to the condition that there is no change in the terms and conditions as applicable for pre-shipment and post-shipment credit with reference to period, rate of interest, etc. The above relaxation is allowed subject to the following conditions: The facility of substitution of order / commodity is allowed when it is considered that the substitution is commercially necessary and unavoidable. The documents substituted should also pertain to shipment made by the exporting unit and not by its sister/associate/group concerns. while repayment of PCFC/Running Account facility is allowed from export proceeds of documents or advance remittances in respect of export orders against which such facility has not been availed, a declaration from the exporter may be obtained to the effect that he has not availed/will not avail PCFC from any bank against such orders/documents. The Bank may mark off the order representing the advance against PCFC drawals, if any left unmarked In case of liquidation of PCFC under Running Account facility by advance remittances, Branches should restrict such adjustments to PCFC drawals which are not outstanding for more than 360 days from the date of drawal.

PCFC will be available as in the case of rupee credit initially for a maximum period of 180 days from the date of first disbursement. Any extension of the credit will be subject to the same terms and conditions as applicable for extension of Rupee Packing Credit and it will entail an interest cost of 2% plus the original spread (charged initially) above 6 months LIBOR prevailing at the time of extension for the extended period. If no export takes place even within 360 days, PCFC will be adjusted at the ruling T.T. selling rate for the currency concerned. Interest right from the date of disbursement until the date of payment should be recovered at 2% over the interest rate applicable for the cash credit of the exporter and the interest earlier recovered at LIBOR related rates should be adjusted from that. Remittance of foreign exchange for repayment of principal with interest does not require RBIs prior approval in such cases. The rate of interest to be charged on PCFC accounts is linked to the 6 months LIBOR/ EUROLIBOR/EURIBOR rate as on the date of disbursement with a spread considered appropriate. 6 months LIBOR/EUROLIBOR/EURIBOR rate for USD, GBP, EUR and JPY will be
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indicated by SBI, New York in its special page on the Reuter Monitor used for EEFC Deposit rates, on a daily basis. For customers whose overall income from various types of business is substantial and their business relationship is very valuable concessions in pricing may be considered. Other than interest there are fixed transaction charges also to be recovered. Since the interest rates on the loans are linked to LIBOR rates prevailing at the time of PCFC disbursals, it is imperative to raise the foreign currency funds through the Banks foreign offices on the same day in respect of the disbursals made at the branches. The success and profitability of the scheme depends therefore largely on the prompt and accurate reporting of the disbursals and repayments to GMU Kolkata. In addition to the reporting of disbursals and repayments, maturity profile of PCFC disbursal, and repayment should be furnished. Before effecting each disbursal under PCFC, the approximate date of shipment should be ascertained from the exporter in order to compile the maturity profile of PCFC. If a branch fails to report the days disbursements to GMU Kolkata for the purpose of funding, GMU Kolkata will charge the differential between the LIBOR linked rate and average rate for rupee funds for the period involved to the branch concerned. PCFC is to be necessarily liquidated out of the proceeds of the related Export Bill under Export Bill Rediscounting Scheme (EBR). However, the following relaxations have been permitted. Advance remittances / separate inward remittances received in respect of orders against which PCFC has been availed can be used to liquidate the PCFC. Care should be taken to see that the remittances received are not converted into Indian Rupees but the relative cover funds should be arranged to be transferred to the respective main nostro account (i.e. India Dollar Account in the case of USD with SBI New York) and full particulars should be reported to GMU Kolkata. The proceeds of export bills sent on collection or otherwise against which no PCFC/Packing Credit had been availed of can also be applied to liquidate PCFC loan plus interest. The export bills tendered in respect of export orders against which PCFC has been availed cannot be sent on collection basis. The bills are to be necessarily discounted under EBR Scheme. Hence the availability of adequate non-credit bill discounting limit in the case of non-LC transactions and the possibility of negotiating the discrepant documents under indemnity etc. should be taken into account before grant of PCFC to the exporter. In case discrepant documents / non-LC bills are to be necessarily discounted while the non credit bill limit is fully utilised, it is suggested that the drawing power in EPC limit of the customer can be blocked to the extent of value of the documents discounted till the bill is realised. Individual Packing Credit Guarantee (IPCG) cover of ECGC is to be taken in respect of PCFC advances also. In terms of a clarification given by the Banks Law Department, no withholding tax is payable, if interest on the foreign currency line is remitted to the Banks own foreign office. As it is intended to avail lines of credit only from the Banks foreign offices, withholding tax may not be paid by the exporters. Forward Contracts can be booked in respect of future PCFC drawals. Cross currency forward contracts can also be availed in any of the permitted currencies against the invoiced currency in which PCFC is availed. PCFC drawals in cross currencies may be permitted subject to the exporter bearing the risk in fluctuation in currency rates. Any shortfall in the foreign currency proceeds of the bill to be applied for liquidation of PCFC can be met by sale of the foreign currency (of PCFC) against Rupees. In order to cover the shortfall, margins as considered necessary (say 10% minimum) may be retained on the drawal at the PCFC disbursement stage itself. This may not be necessary when the
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exporter enters into a cross currency forward contract, for matching PCFC amount while availing cross currency PCFC. The minimum amount of drawal for cross currency PCFC should be USD 250,000 or equivalent. The PCFC granted for deemed exports should be liquidated by EBR within a maximum period of 30 days or up to the date of payment by project authorities whichever is earlier, subject to compliance with other conditions relating to deemed exports PCFC can be granted to a manufacturer supplier against the LC or export order received by the export order holder on the basis of the disclaimer from the export order holder through his banker. PCFC granted to the manufacturer can be repaid by transfer of foreign currency from the export order holder by availing of PCFC or discounting of bills under EBR. It should be ensured that there is no double financing involved in the transaction and the total period of packing credit is limited to the actual cycle of production of the exported goods. PCFC can also be made available to both the supplier EOU/EPZ unit and the receiver EOU/EPZ unit as follows. PCFC for supplier EOU/EPZ unit will be for supply of raw material / components of goods which will be further processed and finally exported by receiver EOU/EPZ unit. The PCFC extended to supplier EOU/EPZ unit will have to be liquidated by receipt of foreign exchange from the receiver EOU/EPZ unit, for which purpose, the receiver EOU/EPZ unit can avail of PCFC. The stipulation regarding liquidation of PCFC by payment in foreign exchange will be met in such cases by transfer of foreign exchange from the banker of the receiver EOU/EPZ unit to the banker of supplier EOU/EPZ unit. Thus, there will not normally be any postshipment credit in the transaction from the supplier EOU/EPZ units point of view. In all these cases, it has to be ensured that there is no double financing for the same transaction. The PCFC granted to receiver EOU/EPZ unit will be liquidated by discounting of export bills. Existing EPC outstandings of the exporters in Rupees cannot be converted into PCFC advances. In case the Exporter avails Suppliers credit in respect of his imports, he will be eligible for PCFC only for purchase of domestic inputs. The PCFC amounts will be taken into account for the purpose of compliance with normal credit discipline like total assessed limits etc. PCFC can be granted in respect of exports under Asian Clearing Union mechanism. Before granting PCFC, it should be made clear to the exporters that the LCs should not be restricted to other banks and that the bills should be invariably discounted with the Bank under EBR scheme. Exporters availing PCFC at the Banks branches should not be allowed to book forward/cross currency forward contracts with any other bank in respect of the relative bills. Exporters who have not availed PCFC / EPC and exporters who availed EPC can avail the EBR scheme. Exporters who had availed PCFC have to necessarily avail EBR and cannot avail Rupee post shipment finance for discounting the relative bills.

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POST-SHIPMENT CREDIT Post-Shipment phase refers to the period when the goods have been shipped out and the credit to Banks Nostro account is awaited. The waiting time would depend on the tenor of the bill. Post-shipment credit means any loan or advance granted or any other credit provided by the Bank to an exporter of goods from India from the date of extending the credit after shipment of the goods to the date of realisation of the sale proceeds. Post-shipment finance can be classified as follows. Negotiation/Payment/Acceptance of export documents under Letters of Credit (LC). Purchase/Discount of export documents under confirmed orders/export contracts. Advances against bills sent on collection basis. Advances against exports on consignment basis. Advances against Duty Drawback entitlements. Advances against undrawn balances/retention money. Rediscounting of Export Bills Abroad (EBR).

Thus at the post-shipment stage, the Bank finances against (a) shipping documents and against (b) duty drawback entitlements. Post shipment finance can be extended up to 100% of the invoice value of goods. It can be short term or long-term finance depending upon the payment terms offered by Indian exporters to overseas buyers. The maximum period usually allowed for realisation of export proceeds is 6 months from the date of shipment. Often, export business may take place without the support of documentary letters of credit and we normally finance the exporters by purchasing the bills drawn by them on foreign buyers. While purchasing the bill, the bank takes into consideration the track record of the exporter, country risk, nature of merchandise, terms of payment, payment record of the drawee etc. Post shipment finance may be extended to the actual exporter who has exported the goods or to an exporter in whose name the export documents are transferred. In case of deemed exports, finance may be extended to the suppliers of goods who supply goods to the designated agencies. Finance should always be extended against evidence of shipment of export goods or supplies made to designated agencies (in the case of deemed exports). In case of discount/purchase of documentary bills, care should be taken in ascertaining the credit-worthiness of the drawees of the bills. Status reports on the overseas drawees should be obtained and carefully studied. The standing of LC opening bank should be verified before negotiating bills under LC (Letters of Credit). In case of documents against acceptance, it should be ensured that control over the goods is retained until the relevant export bills are accepted by the drawee. On acceptance of the claim by the drawee, the documents are released to the drawee and hence the advance becomes a clean one. It is therefore important to ascertain in these cases also the credit worthiness and integrity of the drawer and drawee of the bill. If the documents cover goods of perishable nature, the bills should preferably be drawn payable at sight, especially in the case of new exporter clients.
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The political and commercial risks are insurable with Export Credit and Guarantee Corporation of India Ltd. Where required, ECGC post shipment policy cover duly assigned to the Bank should be stipulated as a condition of sanction. It should also be stipulated that the exporter should authorise the branch to debit his account with the amount of premium payable under Individual Post Shipment Guarantee (INPSG) of ECGC. Depending upon the merits of each proposal and type of security (i.e., availability of Letter of Credit, firm order, or collateral & ECGC cover), suitable margin may be stipulated. Separate limits should preferably be sanctioned for bills drawn under letters of credit and bills drawn without letters of credit. Limits for negotiation of bills under letters of credit of foreign offices/ correspondents of the Bank can be fixed outside the Assessed Bank Finance and in such cases, branch managers of the specified branches have unlimited powers for fixing limits for negotiation of bills. Bank has the following system for certification of export receivables where post shipment credits are extended: a) All export units enjoying post-shipment credit above Rs.10 crs and with Credit Rating below SB4 (8&9)shall have their export receivables certified by a Chartered Accountant at half-yearly intervals. The Chartered Accountant shall certify about the actual level of receivables in the books of the borrower and age wise position. The authority to waive the certification, considering the attendant circumstances, shall be the CGM (CAG/MCG/Circles).

b) c)

Need-based inter-changeability between pre-shipment and post-shipment facilities may be permitted especially to take care of bunched export orders or physical exports. Branches should comply with the instructions in force in respect of (i) the authority for permitting such interchangeability; and (ii) the extent to which such interchangeability can be permitted. Documents must be scrutinised from the standpoint of their compliance of relevant exchange policy stipulations. Branches must be conversant with the relevant provisions of the FEMA. Documents under Letters of Credit The operations under Letters of Credit (LC) are governed by Uniform Customs & Practice for Documentary Credits (UCPDC) (2007 Revision - the International Chamber of Commerce Brochure No. 600). The cardinal principles of UCPDC are (a) the doctrine of strict compliance and (b) in LC operations, banks deal only in documents. It is, therefore, necessary for the exporter to submit documents for negotiation strictly in compliance with the terms and conditions of the LC and for the negotiating branch to check this compliance with reference to the documents submitted vis-a-vis the LC. It should be ensured that documents are 100% credit compliant. Govt of India has remitted stamp duty on export bills in terms their order dated 8th July 2004 Against non-credit bills In case of non credit bills, branches should be guided by factors such as the credit worthiness of the exporter, status report on the drawee (importer), past experience and whether ECGC guarantee cover is available. The following points will be considered relevant:
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A satisfactory status or opinion report on the importer is available, ECGC has fixed the credit limit on the buyer and the exposure is within the limit. The exporter should obtain the Contracts/Shipments (Comprehensive) Risks Policy of the ECGC. Where bills are not covered under LC, it should be ensured that the documents are in accordance with firm order/sales contract and shipping documents are drawn/endorsed/consigned to bank and are not allowing title to the goods to be passed on to the buyer directly. In case of bills drawn under contract or order, since the branch acts on behalf of the drawer of the bill as his agent, clear instructions must be obtained from the drawer of the bill regarding the course of action which the Bank should take with regard to all-important issues relating to the handling of the bill. The drawer should give definite instructions regarding protesting of the bill in case of dishonour by non-payment or non-acceptance. If the transaction is covered under ECGC policy, it is necessary that non-acceptance or non-payment shall be protested. Depending on the nature of bills, post shipment finance carries concessionary rates of interest for a period as detailed belowSight bills - Export finance against bills payable at sight (demand bills) is extended at concessionary rates of interest for a maximum period of Normal Transit Period (NTP) stipulated for the concerned bill as per FEDAI rules. Concessional rate of interest has to be charged up to the actual date of realisation of export proceeds or NTP stipulated for the bill, whichever is earlier. The date of realisation of demand bills for this purpose would be the date on which the proceeds get credited to the Banks Nostro Account abroad. Where interest for the entire NTP has been collected at the time of negotiation/purchase/discount of bills, the excess interest collected for the period from the date of realisation to the last date of the NTP should be refunded to the borrowers. Usance bills-Export bills payable within the period of usance are eligible for concessional rate of interest up to notional due date, which comprises NTP + usance period + plus grace period (if any). Total period in such cases is not to exceed 6 months from date of shipment. If the proceeds of export bills are not realised within the normal transit period in the case of demand bills and within due date in the case of usance bills, interest chargeable for the overdue period will be as applicable to Export Credit Not Otherwise Specified. Interest should be recovered at the time of giving advance by deducting the same from the amount to be disbursed. In case there is early realisation, proportionate interest should be refunded and in such cases, early delivery charges should be recovered. Overdue export bills (Crystallisation Procedure) FEDAI has liberalized the approach for crystallization of overdue export bills by banks, in light of which revised instructions as under are issued in our bank w.e.f 11.10.2006. (a) Banks Norms for the period for crystallistion : i) For units rated SB4 and below and non-borrowers, the crystallisation period would be 15 days from the due date/ notional due date (if 15th day falls on a holiday or Saturday the next working day). ii) For units rated SB 3 and above the crystallisation period would be 21 days from the due date/ notional due date (if 21st day falls on a holiday or Saturday the next working day).
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iii) While the above norms are considered as standard/ bench mark, it would be in order for the branches to extend the crystallization period, upon written request received before the prescribed benchmark / standard period suggested above as under :(A) In case units rated SB 4 and below and non-borrowers up to a maximum period of 30 days from the due date / notional due date. (B) In case of units rated SB 3 and above up to a maximum period of 45 days from the due date/ notional due date. While considering the request for extending the crystallisation period, the reason should be recorded in the application submitted by the customer to the appropriate authority as may be designated by the business groups. Undernoted factors, inter-alia, may be taken into consideration while considering the extension request : (a) The branch is satisfied that the exporter has not been able to realize export proceeds in spite of best efforts and for reasons beyond his control. (b) The exporter has submitted a declaration that he will realise the proceeds during the extended period. (c) The hedging practice (booking of forward contracts etc.) and the conduct of the account is satisfactory. (d) Crystallisation history of the exporter. (e) Percentage of overdue export bills. (f) The exporter has not been caution listed etc. (iv) Request for crystallisation before the standard / benchmark period will be acceded to by the branches. (b) Exchange Rate - For crystallisation into Rupee liability branches should apply the ready TT selling rate of exchange ruling on the date of crystallization. (c) Exchange difference - The exchange difference arising out of crystallisation to be recovered from or passed on to the customer, as the case may be. 5. In this connection, branches are advised to modify suitably the Letter of Undertaking to be obtained from the exporters at the time of export bills Advance against Bills sent on Collection Basis Branches may also sometimes grant advances against bills sent on collection basis. The need for resorting to this arrangement normally arises when the accommodation available under the Foreign Bills Purchased Limit is exhausted or when some export bills drawn under LC have discrepancies. Such facility may also be granted where it is the customary practice in the particular line of trade and in the case of exports to countries where there are problems of externalisation. Under such a situation, branches may send the export bill on collection basis and finance the exporter after retaining a suitable margin out of the total bill amount and debit such advances to an account styled Advances against bills sent on collection basis (rupee advance). The advance should be liquidated out of the realisation of export proceeds. The advances against bills sent on collection basis would attract interest rate as applicable for post-shipment credit i.e., according to the tenor of the bill. The EPC should not be continued until realisation of export proceeds. Advances against Goods sent on Consignment Basis When goods are exported on consignment basis at the risk of the exporter for sale and eventual remittance of sale proceeds to him by the agent / consignee, branches may finance against such transactions subject to the customer enjoying specific limit for that purpose. However, branches should ensure that while forwarding shipping documents to the Banks overseas
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branch/correspondent, they instruct them to deliver the documents only against Trust Receipt / Undertaking to deliver the sale proceeds by a specified date, which should be within the time prescribed for realisation of export proceeds. Branches should retain appropriate margin while granting advance against exports on consignment basis. Advances against Duty Drawback Entitlements Government of India has formulated a Duty Drawback Credit Scheme under which banks are allowed to grant advances to exporters against their entitlements of duty drawback on export of goods. The period of such advances will be up to a maximum of 90 days beyond which the Bank may not allow the advances or may charge normal interest applicable to export credit. Advance against duty drawback at post-shipment stage should be covered under Export Finance Guarantee of ECGC. The following are the other conditions to be fulfilled while granting loans against duty drawback entitlements. i) Declaration from the exporter to be obtained on the export promotion copy of the shipping bill containing the EGM number (Export General Manifest Number issued by customs department) mentioning the amount of duty drawback eligible. The amount of claim thus declared should be supported by a certificate from a Chartered Accountant authenticating the amount of claim on the basis of Exim Policy/Customs Rules. A lien for the amount of advance to be noted with the designated banks branch conducting the account of the custom department under EDI (Electronic Data Interchange) scheme. The financing branch should also make necessary arrangement with the designated banks branch for transfer of funds as and when duty drawback claim is credited by the customs through electronic fund transfer system. Branches may stipulate a margin between the amount of duty drawback provisionally certified and the advance to be granted.

ii) iii) iv)

v)

Advances against Undrawn Balances / Retention Money In certain lines of exports, it is the practice of exporters not to draw bills for the full invoice value of the goods but to leave a small part undrawn, for payment after adjustments due to differences in weight, quality, etc. ascertained after arrival and inspection of the goods. In such cases, branches may allow advance against the undrawn portion, provided: a) b) Undrawn balance is in conformity with the normal level of balance left undrawn in the particular line of export subject to a maximum of 10 percent of the full export value; and An undertaking obtained from the exporter that he will, within six months from the date of shipment of goods, repatriate balance proceeds of the shipment.

Branches are permitted to grant advances against undrawn balances at concessive rate of interest till the receipt of remittances from abroad, subject to a maximum of 90 days. Similarly under certain contracts, the foreign buyers retain a small portion of the bill amount up to an agreed period to enable themselves to be satisfied about the quality of the items supplied. Advance against such retention money can be allowed to the exporters if the retention money is repatriated to India within 360 days from the date of export. Such advance carries interest at concessive rate up to a maximum of 90 days.

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ECGC Cover As regards post-shipment credit not supported by letter of credit, post-shipment guarantee cover of ECGC is generally obtained against commercial and political risks. These guarantees provide credit enhancement to the Bank by insuring that a good portion of the Banks loss arising from the exporter not discharging his liabilities could be made good by ECGC. Rediscounting of Export Bills Abroad (EBR Scheme) The scheme of Rediscounting of Export Bills Abroad by authorised dealers was formulated by RBI in order to make available to the exporters post shipment finance at international rates of interest. Under the scheme, exporters bills are discounted at the post shipment stage and simultaneously rediscounted abroad by the Bank for raising foreign currency funds which are applied to liquidate the underlying PCFC loan. Both sight and usance bills are discounted under EBR scheme. The other features of the Scheme are advised from time to time by the International Division (Planning), IBG, Corporate Centre. The following are the extant instructions on the Scheme. i) Authorised Branches: The Scheme is operative at only the designated branches. Exporter customers of non-designated branches (NDBs) can avail the EBR facility at the nearest designated branch(DB) Eligibility: All exporters are eligible to cover their bills drawn under LCs, non-credit bills under sanctioned limits under the Scheme. Exporters availing PCFC should invariably avail EBR facility for discounting the relative export bills. But even if an exporter does not avail PCFC or rupee EPC, he can avail EBR facility. Also, exporters availing rupee EPC can avail EBR facility. Both demand and usance bills are eligible for coverage. EBR facility is normally available for a maximum period of 180 days i.e., export bills under EBR can be drawn for a maximum period of 180 days. In case borrower is eligible to draw usance bills for periods exceeding 180 days as per the extant instructions of FED, Post-shipment Credit under the EBR may be provided beyond 180 days. iii) Currency: EBR is restricted to four major currencies viz. USD, GBP, EUR and JPY. Cross currency availment is also permitted in the sense that exporters having LC or export order in other than these currencies can also avail PCFC and EBR in any of the above mentioned currencies. In case of cross currency disbursements, both PCFC and EBR should be availed in the same designated currency. The exchange risk in cross currency disbursements is to be borne by the exporters. iv) Rate of interest: Branches should ascertain interest rates from their LHOs. The rate of interest on demand bills and usance bills (with maximum usance of 180 days) is linked to six months LIBOR with a spread. SBI New York would advise the six month LIBOR rate for the designated currencies i.e. USD, GBP, EUR and JPY on a daily basis on the page showing EEFC and PCFC interest rates on Reuters Monitor Screen. Finer rates can be extended to high value customers from whom the overall income for the Bank is substantial. v) Forward Contracts: Forward contracts can be booked for the surplus portion of EBR bill, which is to be converted in to Indian rupees for credit to the exporters account after adjustment of its foreign currency portion to the PCFC.
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ii)

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vi) Return of export bills unpaid: The EBR advance which is a foreign currency loan will be closed when the overseas buyer pays the bill and the export proceeds are realised. But if any export bill discounted under EBR Scheme is returned unpaid, a sale entry is to be put through at the prevailing T.T. selling rate. vii) Direct discounting of bills by exporters: Exporters on their own can arrange for themselves, a line of credit with an overseas bank or any other agency (including a factoring agency) through a bank in India directly for discounting their export bills, subject to the condition that discounting of export bills will be routed through the designated bank/authorised dealers from whom the packing credit facility has been availed of. In case these are routed through any other bank/authorised dealer, the latter will first arrange to adjust the amount outstanding under packing credit with the concerned bank out of the proceeds of the rediscounted bills. When branches handle such bills under direct discounting, they should charge a discount of 0.75 % (present rate as specified by IBG, and Corporate Centre) for themselves apart from recovering the usual transaction charges commission etc. viii) Withholding Tax: In terms of a clarification received from the Banks Law Department, no withholding tax is payable, if interest on the foreign currency line is remitted to the Banks own foreign offices. As lines of credit will be availed of for this purpose only from the Banks foreign offices, withholding tax may not be paid by the exporters. ix) Crystallisation: Export bills under EBR which are not realised within 30 days from the expiry of the transit period (in case of sight bills) and due date (in case of usance bills), shall be crystallised as usual. Branches are required to advise GMU Kolkata the details of crystallised usance bills for cover purposes only. Based on this GMU Kolkata shall arrange to repay its own EBR loan, including the portion crystallised at branches.

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Annexure I EXPORT INCENTIVES The role of incentives in improving the viability of an export finance proposal is substantial, considering the wafer-thin margins which are on offer. As Bankers our role in this area is limited to providing the exporter with evidence of export bills negotiated or export proceeds received. Such evidence is needed by the exporter for onward submission to the appropriate authority for receiving the incentives due to him. The incentives are generally detailed in the current Foreign Trade Policy. As a financing banker one should be conversant with the nature of incentives the exporters are eligible for. This would help in our understanding the cash-flows better which enables more accurate assessment of financial needs of an exporter. I. Duty Exemption scheme Advance Licensing scheme II. Issued for duty free import of inputs Permits imports of items required for export production and that too without payment of customs duty. Export within 18 months. For physical exports including exports to Special Economic Zones, Deemed exports, Domestic suppliers to EPCG holder intermediate supplies made to a Manufacturer exporters to import inputs for manufacture of items for onward supply to the ultimate exporter/ or deemed exporter holding another Advance Licence. It is not transferable, subject to actual user condition.

Duty Remission schemes (A) Duty Free Replenishment Certificate (DFRC)

DFRC is issued to a merchant-exporter or manufacturer-exporter for the import of inputs used in the manufacture of goods without payment of basic customs duty and special additional duty. However, such inputs shall be subject to the payment of additional customs duty equal to the excise duty at the time of import. A minimum of 25% of value addition is a requirement, except for items in gems and jewellery sector. B. Duty Entitlement Pass Book (DEPB)

Gives duty entitlement at notified rates enabling duty-free imports of requirements for export production. It can be used for importing goods freely importable. It can be transferred within the same port. Both merchants and manufacturers are eligible. C. Export Promotion Capital Goods scheme:

Allows the exporter to import capital goods at a concessional duty of 5%, subject to an export obligation of 8 times the duty saved. Such export obligation should be fulfilled within 8 years. Import of second hand capital goods without any restriction on age is permitted under EPCG Scheme. Import of Capital Goods for export of agricultural products and their variants have been allowed at zero percent duty. EPCG licenses of Rs.100 crores and more to have 12 years export obligation with 5 yrs moratorium. Export obligation includes supplies made to EOUs etc as they are deemed exports.
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D.

Others a) Gem & Jewellery export promotion scheme b) 100% of Export Oriented units/ Free Trade/ Export Processing Zones/ STPs/ Special Economic Zones are being developed for intensive exports. Other incentives Deemed Exports: Eligible for Advance License for Intermediate supply/ deemed exports, Drawback and refund of terminal excise duty. Domestic Manufacturers supplies to EPCG license holders eligible for benefits as applicable to Deemed Exporters. Duty Drawback facility (Customs and Excise duty paid) Income tax exemptions (being phased out) Sales tax exemption & Central Sales tax exemption on supplies made to units in EPZ/FTZ. Status holders: have been exempted from compulsory negotiation through banks, Can retain 100% in EEFC as balance. Normal repatriation in 360 days

III. 1. 2. 3. 4. 5. 6.

7.

Advantages in a 100% EOU Can be located anywhere in the country Exempted from Customs/Excise Duty Raw material, machinery, components, consumables, spares, tooling and packaging materials- imported / procured locally.

100% FDI in manufacturing sector and unrestricted repatriation of profits SSI reservation policy not applicable Corporate tax holiday upto 2010 Reimbursement of Central Sales Tax paid on inter-state purchases Reduced export obligation over a 5 year period Domestic Tariff Area sales up to 50% of FOB value of exports are allowed and thus access to domestic market is also available

As the export incentives policy and details of the schemes change from time to time, one should be constantly in touch with latest developments.

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Annexure II Financing Exports through the Forfaiting mechanism Introduction Forfaiting is a mechanism of financing exports. by discounting export receivables evidenced by bills of exchange or promissory notes without recourse to the seller (viz. exporter) carrying medium to long term maturities on a fixed rate basis (discount) upto 100 percent of the contract value. The word forfait is derived from the French a forfait which means the surrender of rights. Simply put, forfaiting is the non-recourse discounting of export receivables. In a forfaiting transaction, the exporter surrenders, his rights to claim for payment on goods delivered to an importer, in return for immediate cash payment from a forfaiter. As a result, an exporter in India can convert a credit sale into cash, with no recourse to the exporter himself or his banker. The export contract can be executed in any of the major convertible currencies e.g. US Dollar, Deutsche Mark, Pound Sterling, Japanese Yen. Items / Countries eligible for forfait financing All exports of capital goods and other goods made on medium to long term credit ( 1 to 5 years) are eligible to be financed through forfaiting. Eligibility of an export transaction for forfaiting can be determined when the forfaiting agency is approached for a forfait quote. The availability of a forfaiting quote for a particular country will depend on the forfaiting agencys perception of risk quality of export receivables from that country. The forfaiting agency will indicate the maximum amount and the period of discount while giving quote for forfaiting. The basic mechanism Receivables under a deferred payment contract for export of goods, evidenced by bills of exchange or promissory notes, can be forfaited. Bills of exchange or promissory notes, backed by co-acceptance from a bank (which would generally be the buyers bank), are endorsed by the exporter, without recourse, in favour of the forfaiting agency in exchange for discounted cash proceeds. The bankers Co-acceptance is known as avalisation. The co-accepting bank must be acceptable to the forfaiting agency. The bills of exchange or promissory notes should be in the prescribed format. Basis of Quotation and Banks role: The role of Treasury Management Group in Corporate Centre will be that of a facilitator between the Indian exporter and the overseas forfaiting agency. The Exporter after finalising the terms of the contract with the buyer, arrives at a price to be realised in rupee terms which takes into account his costs and profits in cash terms. The final export, therefore is an offer to the buyer structured in a manner which ensures that the amount realised in foreign exchange by the exporter (after payment of forfaiting discount and other fees) is equivalent to the price which he would obtain if goods were sold on cash payment terms. For the purpose of invoicing, Forfaiting discount,
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commitment fees, etc. need not be shown separately; instead, these could be built into the FOB price. On a request from the exporter, for an export transaction which is eligible to be forfaited, branch through TMG, CC, Mumbai will obtain indicative forfaiting quotes - discount rate, commitment and other fees - from overseas agencies. If the quotes are acceptable to the exporter then quotes will be firmed up and further processing will be done. receive avalised bills of exchange or promissory notes, as the case may be, and send them to the forfaiter for discounting and will arrange for the discounted proceeds to be remitted to the Indian exporter. issue appropriate certificates to enable Indian exporters to remit commitment fees and other charges.

Cost Structure of a forfaiting transaction Typically a forfaiting transaction has three cost elements; Commitment fee, Discount fee, Documentation fee Commitment fee A commitment fee is payable by the exporter to the forfaiter for the latters commitment to execute a specific forfaiting transaction at a firm discount rate within a specific time (normally not more than one year). The commitment fee is charged as a percentage / annum of the unutilised amount to be forfaited and is charged for the period between the date the commitment is given by the forfaiter and the date of discounting takes place or until the validity of the forfait contract, whichever is earlier. The commitment fee is payable regardless of whether or not the export contract is ultimately executed. Discount fee Discount fee is the interest cost payable by the exporter for the entire period of credit involved and is deducted by the forfaiter from the amount paid to the exporter against the avalised promissory notes or bills of exchange. The discount fee is based on the relevant market interest rates as reflected by the prevailing London Inter-Bank Offered Rate (LIBOR) for the credit period and currency involved, plus a premium for the risks assumed by the forfaiter. The discount rate is applied to the aggregate principal and interest due on the debt instrument on its maturity, to arrive at the payout to the exporter. The discount rate is established at the time of executing a forfait contract between the exporter and the forfaiting agency. Documentation fee Generally, no documentation fee is incurred in straightforward forfait transactions. However, if extensive documentation and legal work is necessary, a documentation fee may be charged. As per RBI guidelines, discount fee, documentation fee and any other costs levied by a forfaiter must be transferred to the overseas buyer. Commitment fee should also be passed on to the overseas buyer to the extent possible. The exporter should finalise the export contract in a manner which ensures that the amount received in foreign exchange by the exporter after payment of forfaiting discount and other fees is equivalent to the price which he would obtain if goods were sold on cash payment terms.

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Our fee for facilitating the transaction Branch will charge a service fee for facilitating the forfaiting transaction which will be payable in Indian rupees. There may be additional costs levied by a forfaiter, such as handling charges, penalty etc. However, these costs are transaction-specific and will be specified, where applicable. Advantages to an exporter in using Forfaiting route 1. 2. 3. 4. 5. 6. 7. 8. 9. Converts a deferred payment export into a cash transaction, improving liquidity and cash flow Frees the exporter from cross-border political or commercial risks associated with export receivables Finance upto 100 percent of the export value is possible as compared to 80-85 percent financing available from conventional export credit programmes As forfaiting offers without recourse finance to an exporter, it does not impact the exporters borrowing limits. Thus, forfaiting represents an additional source of funding, contributing to improved liquidity and cash flow Provides fixed rate finance; hedges against interest and exchange risks arising from deferred export credit Exporter is freed from credit administration and collection problems Forfaiting is transaction specific. Consequently, a long term banking relationship with the forfaiter is not necessary to arrange a forfaiting transaction Exporter saves on insurance costs as forfaiting obviates the need for export credit insurance as the entire risk of non-payment is borne by the forfeiting agency in this transaction which is on a without recourse basis to the exporter. Simplicity of documentation enables rapid conclusion of the forfaiting arrangement.

Shipping Bill and GR form: Details of the forfaiting costs will be included along with the other details, such as FOB price, commission insurance, normally included in the Analysis of Export Value on the Shipping Bill. The claim for duty drawback, if any, will be certified only with reference to the FOB value of the exports stated on the shipping bill. In case of exports covered under the scheme of Forfaiting, the following procedure should be followed for filling up the various columns relating to the FOB value in the shipping Bill and the GR form :(i) (ii) The column Total f.o.b. value in words will reflect the total invoice value inclusive of the forfaiting discount charges. Under the column Analysis of export value, the actual f.o.b. value, exclusive of the forfaiting discount should be indicated against the sub-column F.O.B. value. The forfaiting discount will however, have to be shown separately under the sub-heading Other Deductions, on the basis of State Banks certificate which is to be submitted by exporters to the Customs Authorities. The column Full export value or where not ascertainable the value which exporter expects to receive on the sale of goods should indicate the total invoice value, inclusive of the forfaiting discount charges.

(iii)

(iv) Under the column Assessable Value under section 14 the actual f.o.b. value, net of the forfaiting discount will have to be shown.

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(v)

On the reverse of the Shipping Bill, the figures to be indicated against the column Value on which Drawback Claim should be the f.o.b. value after deduction of the forfaiting discount. This value should match with the value indicated in the column under (ii) above.

The export contract will provide for the overseas buyer to furnish avalised bills of exchange or avalised promissory notes. 1. If the contract provides for bills of exchange, the exporter will draw a series of bills of exchange and send them along with shipping documents to his banker for presentation to Buyer for acceptance through latters banker. Exporters banker will hand over shipping documents to Buyer against acceptance of bills of exchange by the importer and signature of aval. Avalised and accepted bills of exchange will be returned to exporter through his banker. Exporter will endorse avalised bills of exchange with the words Without Recourse and forward them through his banker to the forfaiting agency. 2. If promissory notes are provided for in the export contract, then the exporter will require the Buyer to prepare a series of avalised promissory notes, as agreed. On shipment, the exporters bank sends the shipping documents to the Buyers bank for transmission to the overseas buyer. Buyers banker will hand over shipping documents to Buyer against avalised promissory notes issued by the Buyer. Avalised and accepted promissory notes will be forwarded to the exporter through his banker. The Indian exporter endorses the avalised promissory notes with the words Without Recourse and forwards them through his bank to State Bank, which in turn will send them to the forfaiting agency. 3. The forfaiting agency effects the payment of the discounted value, in accordance with State Banks instructions, after verifying the avals signature, and other particulars. Normally, State Bank will direct the forfaiter to credit the payment to the nostro account of the exporters bank in the country where the forfaiter is based. The bank receiving the discounted proceeds will arrange to remit the funds to India. The exporter will be issued a Certificate for Foreign Inward Remittance. The GR form will also be released. 4. An export contract which provides for more than one shipment can also be forfaited under a single forfaiting contract. However, where the export is effected in more than one shipment, avalised promissory notes/bills of exchange in respect of each shipment could be forfaited, subject to the minimum value requirements laid down by the forfaiter. 5. On maturity of the bills of exchange/promissory notes, the forfaiting agency presents the instruments to the aval for payment. To summarise the steps involved in forfaiting are: i. ii. Commercial contract between the foreign buyer and the Indian exporter. Commitment to forfait bills of exchange/promissory notes (debt instruments).

iii. Delivery of goods by the Indian exporter to the foreign buyer. iv. Delivery of debt instruments. v. Endorsement of debt instruments without recourse in favour of the forfaiter. vi. Cash payment of discounted debt instruments. vii. Presentation of debt instruments on maturity. viii Payment of debt instruments on maturity.

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Annexure III SBI EXPORTERS GOLD CARD SCHEME Exim Policy 2003-2004 of the government proposed the introduction of a Gold Card Scheme for creditworthy exporters with good track record for hassle-free availability of export credit on best terms. Reserve Bank of India, have also released a model Scheme for implementation by the banks, after due customisation. The Bank has launched SBI EXPORTERS GOLD CARD SCHEME (hereinafter referred to as `Scheme), to meet working capital needs of exporters. 2. 2.1 (a) Certain features of the Scheme are detailed hereunder: Eligibility criteria: Our existing customers/new connections who fulfill the following criteria will be eligible for SBI Exporters Gold Cards: i. Accounts classified as Standard Asset continuously for a period of last three years. ii. No irregularities/ adverse features observed in the conduct of the accounts. However, occasional overdrawings should not be construed as an adverse feature. iii. The exporter has not been blacklisted by ECGC and/or included in RBI defaulters list/caution list. iv. The unit has not incurred losses during the past three years. v. Overdue export bills of the unit are not in excess of 10% of the previous years turnover. ( this requirement has been temporarily scrapped vide circular CCO/CPPDGOLD CARD S/49/2009 10 dt 22.09.2009 for the year 1.04.2009 to 31.03.2010 following the global financial crisis.) Greenfield projects may also be considered under the Scheme by the appropriate sanctioning authority on a case-to-case basis. In case of take-over of the account, the extant take over norms should be complied with, together with the other eligibility norms listed above. Assessment of Credit Limit: In case of units where projected export turnover, is up to Rs. 100 crore or below, assessment of credit limits, irrespective of the segment, will be done as per simplified turnover based assessment method (Nayak Committee method). Credit limits will be assessed at 20% of the turnover of the unit in case of manufacturer exporters and 15% of the turnover of the unit in case of trader exporters, provided the borrower contributes a margin of 5%. In case of borrowers whose requirement of credit limit is in excess of 20% or 15 % of their export turnover (which is permissible under turnover methods), assessment of credit facilities may be done as per Projected Balance Sheet / Cash Flow method etc. In case of units having both export and domestic sales components, the assessment of credit limit will be made as per turnover based assessment method for the unit as a whole, if credit facilities for both export and domestic business activities are required to be assessed as per this method in terms of extant instructions. In other words, as per existing dispensation for units with projected export turnover of up to Rs. 100 crore or below and domestic turnover of up to Rs. 25 crore or below, which satisfy the related criterion, simplified assessment as per turnover method will be applicable. In case of units, where the projected domestic turnover exceeds Rs 25 crore, combined limit or sub-limit for export
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(b) (c)

2.2 (a)

(b)

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(d)

activity will be assessed as per the Projected Balance Sheet/ Cash Budget method. However, the benefits under the scheme will be extended for the portion of Export Credit. Software Exporters will continue to be assessed as per cash budget method prescribed in respect of software finance, irrespective of quantum of turnover, and thus, turnover based method (Nayak Committee method) will not be applicable to this category of exporters. In respect of units with projected export turnover of above Rs.100 crore, the Projected Balance Sheet (PBS) method, or Cash Budget method of assessment, as applicable in respect of the business activity, will be followed. Non-fund based limits required by the exporters will be assessed as per existing norms. In case of consortium accounts, appraisal will be carried out as per the method applicable to the respective accounts and accepted by the consortium members. Stand-by limit: Under the Scheme, Standby limit of 20% will be sanctioned over and above the assessed fund based and non-fund based limits, to meet credit demands arising out of receipt of sudden orders etc. The Standby limit will be sanctioned to all Gold Card holders by the appropriate sanctioning authority along with sanction of assessed credit limits. Exporters will be entitled to avail stand-by limit for a maximum period of 180 days in one instance. However, there is no restriction as to the number of times stand-by limit is utilised by the exporter during the tenure of credit limits sanctioned under the Scheme. Sanction of Limits, Tenure and Empowerment of Branch Heads: Sanction of credit limits together with Standby limit will be granted in the usual manner by the sanctioning authority empowered to sanction the various types of credit facilities. Credit limits, as above, sanctioned under the Scheme will be valid for a period of three years. In cases where interchangeability is permitted between Export and Domestic credit limits, period of sanction of the components of the aggregate credit facilities will necessarily have to run concurrently. Accordingly, in such cases period of sanction of the export credit will be for 12 months in line with other credit facilities.

(e) (f)

2.3 (a) (b) (c)

2.4 (a) (b)

(c)

Under the Scheme, all Branch Heads are empowered to review the credit facilities at the end of 1st and 2nd year and accordingly to step up by up to 10%, both fund based and nonfund based as well as the stand-by credit facilities, without prior reference to the sanctioning authority, provided the various types and the combined credit facilities after step up, fall within the financial powers of the existing sanctioning authority which has sanctioned the credit limits for the period of three years, and on satisfactory fulfilment of the following parameters: i) Projected Sales turnover and order book position justifies increase in credit facilities. ii) The unit has earned net profit from export operations in the preceding financial year. iii) The unit has submitted its balance sheet (audited balance sheet where it is mandatory) within four months of close of financial year and no adverse movement has taken place both in Total Outside Liabilities (TOL) to Tangible Net Worth (TNW) and Current Ratio. iv) The unit continues to satisfy the other eligibility criterion prescribed under the Scheme. As no processing is involved in the dispensation provided for step up of credit facilities at the end of 1st and 2nd year, Branch Heads need not have to refer the proposals to the Centralised Processing Cells (CPC) of the Circle.
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The Branch Heads, however, at the end of 1st and 2nd year, will have to submit a review of the accounts in respect of which step-ups have been granted to the sanctioning authority in the nature of a Statement. The Statement will contain brief details of each of such accounts. The sanctioning authority will take on record the step ups granted by Branch Heads as per the Review Statement. (d) In case of requests from exporters for enhancements by over 10% of the credit limits originally sanctioned for the period of three years, and in cases where any type of credit facility or the combined credit facilities after step up, by up to 10% or less as may be needed for the unit, fall beyond the financial powers of the existing sanctioning authority which has sanctioned the credit limits for the period of three years, sanction of enhanced credit facilities will be granted by the appropriate sanctioning authority. However, the revised credit limit will be valid for a fresh period of three years from the date of sanction of enhanced credit facilities. Renewal of credit limits after period of three years:

2.5

The credit facilities sanctioned for the period of three years including standby limit and step ups, if any, granted by Branch Heads under the Scheme will get automatically rolled over for a further period of three years, subject to fulfilment of terms and conditions of sanction and the unit continuing to satisfy the eligibility criterion for grant of Exporters Gold Card. However, at the same time, Renewal Memorandum/ Note will have to be submitted to the existing sanctioning authority. 2.6 (a) (b) Credit facilities in Foreign Currency: Gold Cardholders will be given priority in sanction of PCFC advances. Accordingly, while seeking Funds Angle Clearance (FAC) from Foreign Department, Kolkata, the branches should clearly specify that the borrowing unit is a Gold Card holder. Normally, the foreign currency credit to Indian exporters is at rates of interest not exceeding LIBOR + mark up fixed by RBI ( 200 bp since 19.02.2010). In case of Gold Card holders, if PCFC is made available to them by making market borrowings, additional service charge at flat rate of 10 basis points (0.10 percent) will be charged, for which Foreign Department, Kolkata will advise separately. ECGC Cover : Exemptions from ECGC cover/guarantee may be considered by the sanctioning authority on case-to-case basis. Rate of Interest: Interest rate applicable to Gold card holders on pre-shipment and post shipment credits are lower than the rates presently applicable to other exporters. Security : The security norms for Gold Card holders will be the same as those for existing advances.

2.7

2.8

2.9

2.10 Service Charges : Banks existing schedule of charges, together with the discretion structure, will be applicable for accounts under the Scheme also. ======== =========== ========
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11. TYPES OF LENDING ARRANGEMENTS

INTRODUCTION Business entities can have various types of borrowing arrangements. They are One Borrower One Bank One Borrower- Several Banks (with consortium arrangement) One Borrower- Several Banks (without consortium arrangements- Multiple Banking) One Borrower Several Banks (Loan Syndication) The most familiar amongst the above for smaller loans is the One Borrower-One Bank arrangement where the borrower confines all his financial dealings with only one bank. Sometimes, units would prefer to have banking arrangements with more than one bank on account of the large financial requirement or the resource constraint of his own banker or due to varying terms and conditions offered by different banks or for sheer administrative convenience. The advantages to the bank in a multiple banking arrangement/ consortium arrangement are that the exposure to an individual customer is limited and risk is proportionate. The bank is also able to spread its portfolio. In the case of borrowing business entity, it is able to meet its funds requirement without being constrained by the limited resource of its own banker. Besides this, consortium arrangement enables participating banks to save man power and resources through common appraisal and inspection and sharing credit information. The various arrangements under borrowings from more than one bank will differ on account of terms and conditions, method of appraisal, coordination, documentation and supervision and control. A. Consortium Lending

When one borrower avails loans from several banks under an arrangement among all the lending bankers, this leads to a consortium lending arrangements. The concept of consortium arrangement among banks was introduced in 1973 for (i) sharing of advances to units in public and private sector wherever multiple banking existed, (ii) for revival of sick units and (iii) for better co-ordination among banks in multiple banking. In consortium lending, several banks pool banking resources and expertise in credit management together and finance a single borrower with a common appraisal, common documentation and joint supervision and follow up. The borrower enjoys the advantage similar to single window facility, while availing of credit facilities from several banks. The arrangement continues until any one of the bank moves out of the consortium. The bank taking the highest share of the credit will usually be the leader of consortium. There is no ceiling on the number of banks in a consortium. The consortium arrangement for extending working capital finance is only on a voluntary basis on the part of the financing banks. The participating banks would settle and frame the rules covering the consortium arrangement as among the member banks inter se as well as between the concerned banks and the borrower. Nevertheless, the level of a banks share in the finance extended to any borrower should be governed by the prudential exposure norms. Banks guidelines: Branches should keep in mind the following while participating in a consortium, whether as the leader of the consortium or as a participant: a) At the time of formation of a consortium, there is no specific ceiling prescribed for the number of banks in the consortium. However, for a meaningful participation, it should be

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b) c) d)

e) f)

preferable that each participating bank should share at least 5% of the total fund-based facilities. The borrower may also get a new bank added to a consortium with the consent of the existing member banks. Normally each member bank should take up a pro-rata share of any enhancement in the exposure. If any member is unable to do so, the other participants will be free to take up such members portion in a manner mutually agreed upon. When a member bank desires to leave a consortium, other participants may take up the members share. Where other participants do not wish to take up the share, the bank in question may leave the consortium only after a new bank agrees to become a member of the consortium, accepts the consortium terms in force and takes over the share of finance. The bank in question may also sell its debt to a third party, subject to such an undertaking being furnished by the buyer. It shall be a condition of sanction by the consortium that a borrower should not avail of any finance or facility (either fund-based or non-fund based) from a bank which is not a member of the consortium. Normally, as per the inter se arrangement of consortium banks, the lead bank is expected to fix drawing power (DP) for the consortium limit and advise the pro rata share of the DP to each member bank at stipulated intervals. Each member bank should regulate the drawings in their books within their share of the DP. Normally, in a consortium, a borrower will draw funds from the facilities with all the member banks and will not confine the drawings to the lead bank. If the lead bank does not allocate the proportionate DP to other member banks, it may have to extend excess drawings above its share inasmuch as the borrower will not be able to draw from the facilities with the member banks. Branches should, therefore, ensure that in the consortium where the Bank is the leader, the above type of situation is strictly avoided. APPRAISAL, ASSESSMENT AND FOLLOW-UP OF WC ADVANCES In case the leader of the consortium is different from SBI, we will persuade the consortium members to adopt the PBS method and FFR for follow up. If the banks follow a different method of appraisal we will follow the consortium leader. Inspection should be carried out by the lead bank and one or two other member banks jointly in such a manner that by rotation all the member banks are involved. The inspection note should be circulated to all member banks for the purpose. Whenever our Bank conducts the inspection either as the lead bank or as a member of a consortium, the Banks inspection report forms may be put into use. If any other bank in the consortium as the lead bank has devised its own format, we may not insist on our format also being filled up. However, branches may call for any additional information considered necessary. The Consortium Arrangement (CA) shall vest with the leader of a consortium, discretion to sanction and disburse additional finance up to 10% of the limits in emergencies and to transfer pro-rata shares of such additional financing to the participating banks explaining the reasons for the same. In such cases, the lead bank should preferably convene a consortium meeting immediately and inform other members about the reasons for such sanction indicating the pro-rata share in the additional limits to be met by each member. All the terms and conditions of sanction of various facilities by a consortium shall be uniform for all the member banks except pricing of fund-based and non-fund based facilities. The participating banks may each quote rates suitable to them, subject to such rates being disclosed to the consortium.

g)

h)

i)

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j) k)

l)

The consortium members should agree to execute the documents under the single window concept of lending approved by IBA, within a specific time frame, say 20 days, from the date of sanction by all the members. The leader of consortium should agree to carry out the following tasks in furtherance to Consortium Arrangement: Preparation of appraisal note and its circulation to the members. Convening consortium meetings at quarterly intervals or when required. Submission of prescribed data/information to RBI on behalf of consortium. Arrangements for completion of documentation formalities. Advising shares of member banks in the WC credit limits/drawing power allocated to each member. Any other task specific to a CA. Each consortium arrangement should include an agreement among the member banks that in the event of disagreement among the participants in regard to any issue concerning the financing arrangement (like terms of sanction, quantum of finance, additional finance requirement, etc.), the decision of the lead bank and the bank with the next highest share will be binding on all other member banks.

The approach detailed above should be adopted in all cases where our Bank participates in CA and these should be fixed as the ground rules for any CA. The ground rules should be recorded as minutes of the meeting of the consortium banks with the borrower. Copies of the minutes should be sent to each bank/borrower and their acknowledgement is obtained for record. It is possible that in some cases in settling the rules for CA, the other participants or the borrower may seek a different approach on any of the above aspect. The branches involved may on the merits of each case, accept a variation in the rule, keeping in view the status of the borrower i.e., value of account, the extent of our share in the consortium financing, and our Banks position as a leader/ participant and such deviations have to be approved by appropriate authority. Asset classification: In respect of consortium advances, each bank may classify the borrowal accounts according to its own record of recovery of interest and instalments and other aspects having a bearing on the recoverability of the advances, as in the case of multiple banking arrangement. In regard to stabilisation of commercial production and consequent classification of borrower accounts as standard/sub-standard assets in respect of term loans to units under consortium arrangement, the decision of the Bank, where the Bank is not the lead bank, as to whether the borrowing unit has achieved regular production and whether there is a need for rescheduling the repayment of term loan will be in line with the decision taken in this regard by the lead bank/institution. Documentation The procedure for documentation and specimen of the model documents evolved by the Legal Committee of the Indian Banks Association (IBA) and circulated to all banks for uniform adoption, are given in Chapter-4 of the Manual on Documentation. The important procedural features are as under: a) The borrower would be required to execute only one set of documents, which will be signed by the lead bank on its own behalf and on behalf of all other member banks. b) The lead bank shall complete the formalities connected with creation of charge etc. with the Registrar of Companies.

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c) d)

As soon as the documents are executed, the lead bank shall send a confirmation in this regard to other members by telex/telegram. The sharing of the security and the rights and responsibilities of the banks should be set out in an inter se agreement.

It would be the responsibility of the lead bank to initiate legal/ recovery proceedings, where necessary, and share the proceeds of realisation pro rata on the basis of the outstandings with different banks within the agreed sharing pattern. Any overdrawings allowed by a bank in excess of its agreed share will not be taken into account until the outstandings as stated above get adjusted. B. MULTIPLE BANKING ARRANGEMENT Multiple Banking Arrangement is one where the rules of consortium do not apply and no inter se agreement among banks exists. The borrower avails credit facility from various banks providing separate securities on different terms and conditions. There is no such arrangement called Multiple Banking Arrangement and the term is used only to denote the existence of banking arrangement with more than one bank. Multiple Banking Arrangement has come to stay as it has some advantages for the borrower and the banks have the freedom to price their credit products and non-fund based facility according to their commercial judgment. Consortium arrangement occasioned delays in credit decisions and the borrower has found his way around this difficulty by the multiple banking arrangement. Additionally, when units were not doing well, consensus was rarely prevalent among the consortium members. If one bank wanted to call up the advance and protect the security, another bank was interested in continuing the facility on account of group considerations. POINTS TO BE NOTED IN CASE OF MULTIPLE BANKING ARRANGEMENTS Though no formal arrangement exists among the financing banks, it is preferable to have informal exchange of information to ensure financial discipline Charges on the security given to the bank should be created with utmost care to guard against dilution in our security offered and to avoid double financing. Certificates on the outstandings with the other banks should be obtained on a periodical basis and also verified from the Balance sheet of the unit to avoid excess financing. C. CREDIT SYNDICATION A syndicated credit is an agreement between two or more lending institutions to provide a borrower a credit facility using common loan documentation. It is a convenient mode of raising long-term funds. The borrower mandates a lead manager of his choice to arrange a loan for him. The mandate spells out the terms of the loan and the mandated banks rights and responsibilities. The mandated banker- the lead manager- prepares an information memorandum and circulates among prospective lender banks soliciting their participation in the loan. On the basis of the memorandum and on their own independent economic and financial evaluation the lending banks take a view on the proposal. The mandated bank (Arranger) convenes the meeting to discuss the syndication strategy relating to coordination, communication and control within the

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syndication process and finalises deal timing, management fees, cost of credit etc. The loan agreement is signed by all the participating banks. The borrower is required to give prior notice to the lead manager about loan drawal to enable him to tie up disbursements with the other lending banks. Features of syndicated loans Arranger brings together group of banks Borrower is not required to have interface with participating banks, thus easy and hassle free Large loans can be raised through syndication by accessing global markets For the borrower, the competition among the lenders leads to finer terms Risk is shared Small banks can also have access to large ticket loans and top class credit appraisal and management Advantages Strict, time-bound delivery schedule and drawals. Streamlined process of documentation with clearly laid down roles and responsibilities Market driven pricing linked to the risk perception Competitive pricing but scope for fee-based income is also available Syndicated portions can be sold to another bank, if required Fixed repayment schedule and strict monitoring of default by markets which punish indiscipline.

Information Sharing in case of Consortium/Multiple Banking arrangements Reserve Bank of India vide circular no. RBI/2008-2009/183 (DBOD No. BP. BC.46/ 08.12.001/2008-09 dated September 19, 2008) has advised that in the light of frauds involving consortium/multiple banking arrangements which have taken place recently, Central Vigilance Commission, Government of India, has expressed concerns on the working of Consortium Lending and Multiple Banking Arrangements in the banking system. The Commission has attributed the incidence of frauds mainly to the lack of effective sharing of information about the credit history and the conduct of the account of the borrowers among various banks. Accordingly, RBI has decided to encourage the banks to strengthen their information back-up about the borrowers enjoying credit facilities from multiple banks as under: (i) At the time of granting fresh facilities, banks may obtain declaration from the borrowers about the credit facilities already enjoyed by them from other banks in Annex 1. In the case of existing lenders, all the banks may seek a declaration from their existing borrowers availing sanctioned limits of Rs.5.00 crore and above or wherever, it is in their knowledge that their borrowers are availing credit facilities from other banks, and introduce a system of exchange of information with other banks as indicated above.
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(ii)

Subsequently, banks should exchange information about the conduct of the borrowers' accounts with other banks in the format given in Annex II at least at quarterly intervals. (iii) Obtain regular certification by a professional, preferably a Company Secretary, Chartered Accountants & Cost Accountants, regarding compliance of various statutory prescriptions that are in vogue, as per specimen given in Annex III. (iv) Make greater use of credit reports available from CIBIL. (v) The banks should incorporate suitable clauses in the loan agreements in future (at the time of next renewal in the case of existing facilities) regarding exchange of credit information so as to address confidentiality issues. A summary of all the annexures is produced for easy comprehension and reference: Annexure -I Minimum Information to be Declared by Borrowing Entities to Banks while Approaching for Finance under Multiple Banking Arrangement Part- A Details of borrowing arrangements from other banks (institution-wise and facility-wise) Part- B Miscellaneous Details Annexure -II Credit Information Exchage among Banks Bio Data of the Company Part I Part II Major credit quality indicators Part III Exposure Details other than Derivatives Part -IV Exposure Details Derivatives Transactions Part - V Un-hedged foreign currency exposures of the borrowe with currency-wise details Part -VI Experience with the Borrower This section also contains Broad Guidelines for incorporating Comments under Part - VI (Experience) of the Credit Information Report Annexure-III Certification regarding compliance of various statutory Prescriptions Diligence Report Part-I Certifications of borrowal companies by Chartered Part-II Accountants / Company Secretaries/ Cost Accountants

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Annex - I Minimum Information to be Declared by Borrowing Entities to Banks while Approaching for Finance under Multiple Banking Arrangement A. Details of borrowing arrangements from other banks (institution-wise and facility-wise) I. Name and address of bank / institution

II. Facilities availed A. Fundbased credit facilities (Indicate the nature of facilities e.g. working capital / demand loan / term loan / short term loan) / foreign currency loan, corporate loan / line of bill discountingetc. credit / Channel financing, amount and the purpose) B. Non-fund-based facilities other than derivatives (Indicate the nature of facilities e.g. L/C, BG, DPG (I & F) etc. amount and the purpose)

C. Derivatives contracts entered into with the bank (Indicate the nature of the contract, maturity, amount and the purpose) III. Date of sanction IV. Present outstanding (In the case of derivatives contracts, negative MTM i.e which is not due for settlement may be indicated) V. Overdues position, if any (In the case of derivatives contracts, the negative MTM i.e. amount payable to the bank under the contract but not yet paid may be indicated)

VI. Repayment terms (for demand loans, term loans, corporate loans, project - wise finance)

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VII. Security offered (complete details of security both primary and collateral including specific cash flows assigned to project wise finance / loan raised & personal / corporate guarantee, to be furnished)

VIII. Requests for facilities which are under process [The information to be given for domestic and overseas borrowings from commercial banks, Financial Institutions and NBFCs] B. I. Miscellaneous Details (Rs. in crore) CPs raised during the year and current outstanding

II. Details of financing outside banking system e.g. L/C Bills discounting III Amount of un-hedged foreign currency exposures( please give currency-wise position in the format given below) (i) Short term exposures (less than one year) (a) Long positions (b) Short positions (c ) Net Short term Exposure (a-b) (ii) Long term exposures ( one year and beyond) (a) Long positions (b) Short positions (c) Net Long term exposure a-b) (iii) Overall Net Position (i-ii) for each currency (iv) Overall Net Position across all currencies III. Main and allied activities with locations IV. Territory of sales and market share V. Details of financial aspects incl. DSCR Projections wherever applicable as per requirement of bank - Imp. Financial covenants, if any, agreed to / accepted with other lenders. VI. CID A/Cs, within / outside financing Banks, being operated, if any VII. Demands by statutory authorities / current status thereof VIII. Pending litigations IX. A declaration authorizing the bank to share information with other financing banks

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Annex II (Part I to Part VI) Revised Format under Multiple Banking Arrangement CreditInformation Exchange Part I Bio Data of the Company I. Borrowing party's name and address II. Constitution III. Names of Directors / Partners IV. Business activity * Main * Allied V. Names of other financing Banks VI. Net worth of Directors / Partners VII. Group affiliation, if any VIII. Date on associate concerns, if banking with the same bank IX. Changes in shareholding and management from the previous report, if any

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Part - II Major credit quality indicators I. IRAC Classification II. Internal Credit rating with narration III. External Credit rating, if any IV. Latest available Annual Report of the borrower As on ---------------

Part III Exposure Details other than Derivatives (Rs. in crore) I. Type of credit facilities, e.g. working capital loan / demand loan / term loan / short term loan / foreign currency loan, corporate loan / line of credit / Channel financing, contingent facilities like LC, BG & DPG (I & F) etc. Also, state L/C bills discounting / project wise finance availed). II. Purpose of loan III. Date of loan facilities (including temporary facilities) IV. Amount sanctioned (facility wise) V. Balance outstanding (facility wise) VI. Repayment terms VII. Security offered * Primary * Collateral * Personal / Corporate Guarantees * Extent of control over cash flow VIII. Defaults in term commitments / lease rentals / others IX. Any other special information like court cases, statutory dues, major defaults, adverse internal / external audit observations

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Part - IV Exposure Details Derivatives Transactions Sr. No. Nature of the derivatives Transactions Notional Amount of contracts Weighted average maturity of contracts Amount of positive MTM for the bank (Not due for settlem ent) Amount of contract s classifie d as NPA (Rs. in crore) Notional Major Amount of reasons for outstanding restructuring contracts ( in brief) which have been restructured

A. 1. 2. 3.

4.

B.

1.

2.

Plain Vanilla Contracts Forex Forward contracts Interest rate Swaps Foreign Currency Options Any other contracts (Please specify) Complex derivatives including various types of option combinations designed as cost reduction/zero cost structures Contracts involving only interest rate derivatives. Other contracts including those involving foreign currency derivatives Any other contracts (Please specify)

3.

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Part V Un-hedged foreign currency exposures of the borrowe with currency-wise details (Rs. in crore) I Short term exposures (less than one year)

(a) Long positions (b) Short positions (c ) Net short- term exposure (a-b) II Long term exposures ( one year and beyond)

(a) Long positions (b) Short positions (c) Net long-term exposure (a-b) III Overall Net Position (I II) for each currency ( Please give Overall Net Position in this format for each currency) IV Overall Net Position across all currencies Part VI Experience with the borrower I. Conduct of funded facilities (based on cash management / tendency to overdraw) II. Conduct of contingent facilities (based on payment history) III. Compliance with financial covenants IV. Company's internal systems & procedures V. Quality of management VI. Overall Assessment (The above to be rated as good, satisfactory or below par only) (*) Broad guidelines for incorporating comments under this head is furnished in the next page

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Broad Guidelines for Incorporating Comments under Part - VI (Experience) of the Credit Information Report Good I. Conduct of funded facilities * Over-drawings (No. of times) * Average period of adjustment * Extent of overdrawings (% of limit) * No. of Defaults * Average period of adjustment Upto 4 times Within 1 month Upto 10% 5 to 6 times Within 2 months 10 to 20% Above 6 times Beyond 2 months Above 20% Satisfactory Below Par

II. Conduct of contingent facilities (Other than Derivatives) Upto 2 times 3 to 4 times Above 4 times Beyond 2 weeks

Within 1 week Within 2 weeks

III

Conduct of Derivatives Transactions * No. of contracts where the <25% of total positive MTM value due to the number of bank remained overdue for contracts more than 30 days * No. of contracts where the <1% of total positive MTM value due to the number of bank remained overdue for contracts more than 90 days and the account had to be classified as NPA ( but later on regularized and is not NPA as on the date of exchange of information) Note: All cases where any of the contracts has been classified as NPA and continues to be NPA as on the date of the exchange of information should be shown as Below Par) * No. of contracts restructured during the relevant period <25% of total number of contracts 25-50% of total number of contracts > 50% of total number of contracts 25-50% of total number of contracts 1-5% of total number of contracts > 50% of total number of contracts > 5% of total number of contracts

IV. Compliance with financial covenants * Stock statement / Financial data Timely * Creation of charge Prompt Delay upto 15 Delay over 15 days days Delay upto 2 months Delay over 2 months

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V. Company's internal systems and procedures * Inventory Management Adequate systems are in place - do - do - do Adequate systems are in place but not adhered - do - do - do Adequate systems are not in place - do - do - do -

* Receivables Management * Resource Allocation * Control over Information VI. Quality of management * Integrity

Reliable

Nothing adverse

Cannot be categorized in previous columns -do-

Expertise Competence / Commitments

Professional & visionary Timely

Have necessary experience Executions /

* Tract Record

-do-

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Annexure-III (Part I and Part II)

Part : I

DILIGENCE REPORT To, The Manager, (Name of the Bank) I/We have examined the registers, records, books and papers of Limited having

its registered office at as required to be maintained under the Companies Act, 1956 (the Act) and the rules made thereunder , the provisions contained in the Memorandum and Articles of Association of the Company, the provisions of various statutes, wherever applicable, as well as the provisions contained in the Listing Agreement/s, if any, entered into by the Company with the recognized stock exchange/s for the half year ended on . In my/our opinion and to the best of my/our information and according to the examination carried out by me/us and explanations furnished to me/us by the Company, its officers and agents. I/We report that in respect of the aforesaid period: 1. The management of the Company is carried out by the Board of Directors comprising of as listed in Annexure ., and the Board was duly constituted. During the period under review the following changes that took place in the Board of Directors of the Company are listed in the Annexure ., and such changes were carried out in due compliance with the provisions of the Companies Act, 1956. 2. The shareholding pattern of the company as on ------- was as detailed in Annexure : During the period under review the changes that took place in the shareholding pattern of the Company are detailed in Annexure.: 3. The company has altered the following provisions of (i) (ii) The Memorandum of Association during the period under review and has complied with the provisions of the Companies Act, 1956 for this purpose. The Articles of Association during the period under review and has complied with the provisions of the Companies Act, 1956 for this purpose.

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4. The company has entered into transactions with business entities in which directors of the company were interested as detailed in Annexure.. . 5. The company has advanced loans, given guarantees and provided securities amounting to Rs. 295 of the Companies Act , 1956. 6. The Company has made loans and investments; or given guarantees or provided securities to other business entities as detailed in Annexure .and has complied with the provisions of the Companies Act, 1956. 7. The amount borrowed by the Company from its directors, members, financial institutions, banks and others were within the borrowing limits of the Company. Such borrowings were made by the Company in compliance with applicable laws. The break up of the Company's domestic borrowings were as detailed in Annexure .. : 8. The Company has not defaulted in the repayment of public deposits, unsecured loans, debentures, facilities granted by banks, financial institutions and nonbanking financial companies. 9. The Company has created, modified or satisfied charges on the assets of the company as detailed in Annexure. Investments in wholly owned Subsidiaries and/or Joint Ventures abroad made by the company are as detailed in Annexure 10. Principal value of the forex exposure and Overseas Borrowings of the company as on are as detailed in the Annexure under" 11. The Company has issued and allotted the securities to the persons-entitled thereto and has also issued letters, coupons, warrants and certificates thereof applicable to the concerned persons and also redeemed its as preference to its directors and/or persons or firms or companies in which directors were interested, and has complied with Section

shares/debentures and bought back its shares within the stipulated time in compliance with the provisions of the Companies Act,1956 and other relevant statutes. 12. The Company has insured all its secured assets. 13. The Company has complied with the terms and conditions, set forth by the lending bank/financial institution at the time of availing any facility and also during the currency of the facility

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14. The Company has declared and paid dividends to its shareholders as per the provisions of the Companies Act, 1956. 15. The Company has insured fully all its assets. 16. The name of the Company and or any of its Directors does not appear in the defaulters' list of Reserve Bank of India. 17. The name of the Company and or any of its Directors does not appear in the Specific Approval List of Export Credit Guarantee Corporation. 18. The Company has paid all its Statutory dues and satisfactory arrangements had been made for arrears of any such dues. 19. The funds borrowed from banks/financial institutions have been used by the company for the purpose for which they were borrowed. 20. The Company has complied with the provisions stipulated in Section 372 A of the Companies Act in respect of its Inter Corporate loans and investments. 21. It has been observed from the Reports of the Directors and the Auditors that the Company has complied with the applicable Accounting Standards issued by the Institute of Chartered Accountants in India. 22. The Company has credited and paid to the Investor Education and Protection Fund within the stipulated time, all the unpaid dividends and other amounts required to be so credited. 23. Prosecutions initiated against or show cause notices received by the Company for alleged defaults/offences under various statutory provisions and also fines and penalties imposed on the Company and or any other action initiated Company and /or its directors in such cases are detailed in Annexure.. . 24. The Company has (being a listed entity) complied with the provisions of the Listing Agreement. 25. The Company has deposited within the stipulated time both Employees' and Employer's contribution to Provident Fund with the prescribed authorities. Note : The qualification, reservation or adverse remarks, if any, are explicitly stated may be stated at the relevant paragraphs above place(s). Place: Date: Signature: Name of Company Secretary/Firm: C.P. No.: against the

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Part II CERTIFICATIONS OF BORROWAL COMPANIES BY CHARTERED ACCOUNTANTS / COMPANY SECRETARIES/ COST ACCOUNTANTS i. ii. Terms of reference for stock audit are to be spelt out clearly by the Banks, so End-use verification of funds lent, if certified by Statutory Auditors, will be a good

that the Chartered Accountants can give focused attention to such areas. comfort to the Banks. iii.As Banks quite often deal with unlisted companies, disclosure requirements for such companies above a specific turnover may be made akin to those for listed companies, viz. consolidated iv. balance sheet, segmental reporting etc. Information on large shareholding also will be useful. Further, the following additional certification either from Chartered Accountant or (a) Company Directors not figuring in defaulters list (RBI/ECGC)/willful defaulters list etc.) (b) Details of litigation above a specified cut off limit. (c) A specific certificate, probably from the Company Secretary, regarding compliance with Sec. 372 (a) of the Companies Act. (d) Details of creation/ modification/satisfaction of charges on the assets of the company, position regarding insurance, show cause notices received, finds and penalties awarded. v. vi. As regards rotation of Auditors, for the sake of operational convenience, it is In order to avoid concentration, group companies may have different Statutory/ suggested they may be changed once every 5 years instead of every 3 years. Internal Auditors in case group turnover exceeds Rs.100 crores. Company Secretary or Cost Accountants may also be thought of :-

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12. LEGAL ISSUES IN DOCUMENTATION

ESSENTIALS OF DOCUMENTATION 1. The main purpose of obtaining documents is to secure the advances and enable the Bank to recover the dues through legal means when all other recourses fail. Documentation process attempts to ensure the following: a) The owing of the debt to the Bank by the Borrower is clearly established by the documents. b) The charge created on the Borrowers assets as security for the debt is maintainable and enforceable. c) The Banks right to enforce the recovery of the debt through a court of law is not allowed to become time-barred under the law of limitation. 2. Documentation assumes special significance in the following instances: a) At times, the Bank has to prove its claim against the legal representatives, official receiver / liquidator, etc. b) The Bank may have to prove its prior charge in respect of assets charged to the Bank against the claims by Government Departments, other creditors, etc. c) It is not uncommon to observe that the Borrower, who is very co-operative at the time of availing the credit facilities and is ready to sign on dotted lines, ceases to cooperate once the account turns bad. 3 As documents form the primary evidence in any dispute between the Bank and the Borrower, it is imperative that they are correct and valid at all times. Documentation, therefore, is a continuous and on-going process covering the entire period of advance. DOCUMENTATION (Law and Procedure) 4 General The Loan / security documents are of crucial importance to the Bank in respect of all loans and advances as they constitute the primary evidence in any legal proceedings between the Bank and the Borrower(s) / Guarantor(s). They establish the precise jural relationship between the Bank and the Borrower(s) / Guarantor(s). In the absence of properly executed documents, it may be very difficult for the Bank to succeed in any suit filed in a Court of Law for enforcing its rights under the documents. The legal protection and judicial adjudication always requires and depends upon valid documents. 4.1 Object The object of documentation is to serve as primary evidence for enforcing the Banks right to recover the contracted debt through Court of Law in the event of all other recourses proving to be of no avail. Documentation will succeed in fulfilling this objective only when the following

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requirements are met; (1) the owing of the debt to the Bank by the Borrower is established by documents; (2) the charge created on the Borrower's assets as security for the debt is preserved, protected, perfected and maintained in accordance with the law; and (3) the Banks right to enforce the security for recovery of the debt through Court of Law is not barred by expiry of limitation under the Law of Limitation. 4.2 Purpose The purpose of the document is to help in identifying the parties, the nature and extent of security, for providing evidence of the transactions, for settling / crystallising the terms and conditions, for defining the rights and liabilities of parties or under the securities, for creating the charges / encumbrances, for protecting the priority of charges, for computing the period of limitation and lastly for enforcing the rights under the documents. 4.3 Requirements A document to serve the above purposes and objects must contain correct description of the parties, mention the actual place of execution, mention correct date of execution, contain accurate description of the properties / securities, contain proper recitals / covenants, provide for consideration for the transaction, stipulate the terms and conditions of repayment, contain all other essential terms and conditions, be duly stamped and must be registered and attested wherever the Law requires the document to be so registered and attested. The documents to be executed by the Borrower(s) / Guarantor(s) in favour of the Bank depends upon the type of charge (Hypothecation, Pledge, Mortgage, etc.), type of the advance (Demand Loan, Cash Credit, Term Loan, etc.), nature of the security (movable or immovable, actionable claims, etc.) and finally upon the constitution of the Borrower(s) / Guarantor(s) (Individual, Partnership Firm, Company, Association of Persons, Trust, HUF, etc.). While obtaining the security documents, regard must be had to the constitution of the Borrower(s) / Guarantor(s) and its / their authority and competence to execute the documents, the nature and type of securities being the charge, legal nature of the charges and applicable laws thereto. 4.4 Document A 'document' in common parlance is understood to mean any matter written upon a paper in some language known to and understood by the parties to such document. According to the definition given in Section 3 of the Evidence Act, it means any matter expressed or described, or described upon any substance whether paper, letter, stone, leather or leaves by means of letters, figures or marks or by more than one of those means which is intended to be used for the purpose of recording that matter. In other words, document is a written statement of facts declaring certain rights, obligations, responsibilities and liabilities relating to or concerning or in respect of the transactions or the parties or the ownership and / or possession of the property and for matters incidental thereto and which is admissible in law as a piece of evidence or a record of bargain / transaction. 4.5 Instrument Section 2 (14) of the Indian Stamp Act, 1899, defines instrument as "Instrument includes every document by which any right or liability is, or purports to be, created, transferred, limited, extended, extinguished or recorded". Instrument is a document which creates any right or liability. All instruments are documents but all documents need not necessarily be instruments. 4.6 The legality, validity and enforceability of any loan/ security depends upon the legal provisions contained in

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The Indian Contract Act, 1872 The Negotiable Instruments Act, 1881 The Transfer of Property Act, 1882 The Indian Stamp Act, 1899 The Evidence Act, 1872 The Indian Registration Act, 1908 The Sale of Goods Act, 1930 The Companies Act, 1956 The Limitation Act, 1963 & The Personal Laws of the parties, among others 5 Definition of Property The expression or word property is defined in different ways under different laws. The general principle of law is that the property not only covers the physical asset but even the owners rights or interests in such physical asset. The physical asset may be in the nature of movable or immovable / fixed asset such as land and building, factory shed, furniture and fixtures. The right or interest in relation to such property may represent the actionable claim like book debts, or bills of exchange or documents of title to goods / property, etc. Broadly stated, property is of two types: Movable and Immovable property. 5.1 Movable property According to Section 2 (9) of the Indian Registration Act, 1908, movable property includes standing timber, growing crops and grass, fruit upon and juice in trees and property of every other description, except immovable property. Movable property includes actionable claims, negotiable instruments, and documents of title to goods. 5.2 Immovable property Section 2 (6) of the Indian Registration Act, 1908, states that it includes land, buildings, hereditary allowances, rights to ways, lights, fisheries, or any other benefit to arise out of land and things attached to the earth, permanently fastened to anything which is attached to the earth. However, according to Section 3 of Transfer of Property Act, 1882immovable property does not include standing timber, growing crops or grass. According to the Section 3 (ibid), attached to the earth means a) rooted to the earth, as in the case of trees and shrubs, b) embedded in the earth, as in the case of walls or buildings; or, c) attached to what is so embedded for the permanent beneficial enjoyment of that to which it is attached, as in the case of doors, windows, etc. 5.3 Freehold property It means complete and total ownership of immovable property and the buildings or structures erected thereon or anything grown. Ownership from one person to another may pass voluntarily or involuntarily. If a person transfers the ownership (title) in a property to another by sale, it is a voluntary transfer of ownership. Where, however, it passes upon the death of a person, it is deemed as involuntary transfer owing to intervention laws of succession and inheritance. What is to be noted importantly is that in the case of title to freehold property, there are no restrictions on the owner to deal with the property in a particular manner. The title-holder can deal with it in the manner he desires and at the time convenient to him. No time schedule can be prescribed

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either for effecting any type of transfer by way of Sale, Lease, Pledge, Gift, Mortgage, Exchange, etc. The transfer can be at his terms. 5.4 Leasehold property A leaseholder of immovable property (Lessee) is required to deal with the leased property on the terms and conditions mentioned in the Lease Deed. A Lessee cannot travel beyond the terms of the lease, lest he be evicted by termination of the lease by the Lessor. The ownership rests with the Lessor while possession and enjoyment with the Lessee. Subject to the terms of the lease, a Lessee can transfer his leasehold interest / rights to another. A leasehold interest can also be heritable - when legal heirs occupy the leased house upon the death of the Lessee. The Lessor cannot evict them during the currency of the lease. In the case of Government Leases, ground rent payable on the leased property is a first charge on the property, being a Sovereign claim. 5.5 Ownership of property : Meaning and scope Ownership is a basket of rights which entitles a person to the exclusion of others to possess, enjoy (use), or to dispose of the property in accordance with the law. The property can be transferred by the owner to another person in the manner prescribed under law. It can also be effected through his agent or attorney. The ownership necessarily comprises the right of possession, the right of enjoyment and the right of disposition. They represent the general interest of the owner in the property. The owner or his duly authorized agent may, depending upon the type of transfer of property, viz., Pledge, Sale, Mortgage or Lease, transfer either whole or some of the above rights in favour of the transferee. In the case of Pledge, the Borrower only transfers the possession of his assets but not the right of enjoyment. It means that the Bank cannot use the pledged assets in any manner it likes as the owner can. The Bank can only possess the assets as a Pledgee and sell the assets in the event of default as per the provisions of the Indian Contract Act, 1872, by serving the mandatory notice, etc. In other words, the right of possession and the right of disposition is governed by the terms of Pledge Agreement / Indian Contract Act. Likewise, in the case of mortgage other than English Mortgage, what the Borrower conveys or transfers to the Bank is only right of disposition through the intervention of Court and not the right of possession or the right of enjoyment. In the case of Lease, the Lessor transfers his right of enjoyment and right of possession but not right of disposition. Whenever the owner transfers only some rights and not all the rights to the transferee, it is said that he has transferred only limited or special interest and not the whole or general interest in the property. Ownership does not necessarily mean that the owner always has actual possession of the property. The ownership remains with the owner while the possession, however, may remain with others as in the case of encumbrances. 5.6 Possession of property Conversely, possession sometimes may indicate strong presumption but not ownership. It does not always imply ownership. A Lessee or a Trustee or an English Mortgagee may have possession of the property transferred to them belonging to another person. But such transfer or encumbrance does not make him owner of the property so transferred. The possession again may be actual or symbolic or constructive as in the case of Pledge. The undisturbed possession with or by another for a continuously longtime sometimes may confer ownership rights as against the others under the principles of adverse possession under the Law of Limitation.

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5.7 Type of Transfers Property of any kind may be transferred in any of the following methods: Transfer by operation of law: The Civil Procedure Code, Debts Recovery Tribunal Act, Presidency Insolvency Act / Provincial Insolvency Act, Companies Act, Indian Succession Act, Hindu Succession Act or the Personal Laws of the parties contain elaborate provisions relating to transfer of property arising out of inheritance, succession, insolvency, court auctions / sales, i.e., by operation of law. Transfer by act of parties (Inter vivos): Provisions contained in the Indian Contract Act, Transfer of Property Act, and Sale of Goods Act govern transfers of both special interest and general interest in the movable or immovable property by one person to another by way of Sale of goods / property, Bailment, Pledge, Hypothecation, Mortgage, Charge, Lease, Transfer of actionable claims, etc. Transfer by way of forfeiture, confiscation and sale of property is governed by, Income Tax, Excise, Customs Acts, Revenue authorities, Enforcement Authorities, etc, The Principle of Adverse Possession as per the provisions of Limitation Act governs the transfers set up by the adverse possessor in favour of another. Transfer of Negotiable Instruments is covered by the principles contained in the Negotiable Instruments Act, 1881. 6 Title Deeds It is a legal instrument which indicates the evidence of a persons right to landed property. It shows in whom the legal estate is vested and how the property has been transferred from one person to another by the document till finally it was transferred to the present owner. A person's right to a piece of property is proved by the documents called title deeds. 6.1 'Executed or execution Section 2 (12) of the Indian Stamp Act, 1899, states that executed and execution used with reference to instruments means 'signed' and 'signature'. Signature includes a mark by an illiterate person. Signature must be the signatures of all the persons necessary to complete the transaction. If a document is required to be attested under any law, the signature of the attestor(s) must be affixed to complete the execution. The word execution means that the person by affixing his signature or mark has signified his assent to the contents of the document. However, the proof of the signature cannot always mean or be regarded as tantamount to proof of the execution. It is necessary for a document to be said to have been executed by a person that there should be not only physical contact of signing the document but a mental inclination of executing it. If a person of unsound mind signs a document, he cannot be said to have executed the document as mental act is silent in such case. Execution consists in signing a document written out, read over and understood. It does not merely consist of signing a name on a blank paper. The execution of a document means signing, sealing and delivering. To execute means to go through the formalities necessary for the validity of legal act. Execution implies conscious execution and knowledge of its contents. Mere admission of signature on document without admitting contents thereof does not amount to execution. The execution of a document is always a question of fact and it must be proved like any other fact. 6.2 Execution of a document : Burden of proof The responsibility or the burden to prove that a document has been executed by the Borrower(s) or the Guarantor(s) lies with the Bank. Mere admission of the signature or the thumb impression

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by the Borrower does not mean that he has admitted the execution of a document. As the documents do not prove themselves, it is essential for the Bank, before a document is relied upon as evidence, it must be filed in the Court and must be proved according to law. Bank witnesses must be examined to prove the document. The contents of a document may be proved either by primary or secondary evidence. It must be proved by the production of the original document itself for inspection and examination of the Court unless a secondary evidence of it is permitted under Section 65 of the Evidence Act. The law stipulates, as a first requirement, the production of the original document and as a second requirement proving the signature or the thumb impression or the handwriting of the Borrower. In proving a document or signature, two distinct kinds of evidence are produced. Firstly, the evidence of a witness who saw the act of writing; and, secondly, the testimony of a person as to the kind of writing or the signature. The first is a direct evidence and the second is an indirect evidence. In terms of Section 45 of the Evidence Act, the handwriting and signature of a person can be proved by an expert. Section 47 (ibid) permits the opinion of any other person acquainted with the handwriting of the person by whom it is alleged to have been written or signed, that it was or was not so written or signed by him. Section 73 (ibid) empowers the Court to compare the disputed document or the signature with the one undisputed for the purpose of deciding as to whether a particular document was written or signed by a person, by whom it is supposed to be written or signed. The disputed signature or the writing is compared with any admitted writing or signature or with the one already proved elsewhere. It may also be compared with a writing or signature which was written or signed in the Court room itself with the old handwriting or signature of the person whose handwriting or the signature is in question or the Court may make the person write or sign before it and then compare the disputed writing or signature with the said specimen. 6.3 Methods to prove a writing or signature A writing or signature may be proved by any of the following methods: a) b) c) d) e) f) g) h) By calling a person who has signed or written the document, or By calling a person in whose presence the document was written or signed, or By calling a handwriting expert or fingerprint expert, or By calling a person acquainted with the handwriting of the person by whom the document is supposed to have been signed or written, or By comparison by the Court of the disputed signature or the handwriting with some admitted signature or handwriting, or By proof of an admission by the person who is alleged to have signed or written the document that he has signed or written the document, or By the statement of a deceased professional scribe, made in his diary or in course of business, that the signature in the document is that of a particular person, or By other circumstantial evidence.

6.4 Blank document and admission of signature If the Borrower contends that the Bank obtained his signature or the thumb impression on blank papers and then it might have got prepared a document, it means that the Borrower does not admit his signature or the impression. In such cases, the burden lies on the Bank to prove the execution in the manner stated above. However, if the Borrower admits his signature or the thumb impression on a document but contends that it was on a blank paper (that is he disputes the contents of the document), then the burden lies on the Borrower to prove the said contention.

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6.5 Execution of a document in a language not known to the Borrower: Burden of proof When a document has been written in a language and signed by a person not knowing that language, the burden to prove that the contents of the document was read over and explained to such Borrower and that the Borrower has executed the document only after understanding the implications thereof, lies on the Bank who relies on the document for recovery of its dues. 6.6 Execution by Pardanashin woman or illiterate person A pardanashin woman observes total seclusion in accordance with the religious practices or the customs of her community. A pardanashin woman does not deal with any outsiders or third parties other than the members of her own family. The law enjoins certain presumptions in the case of a pardanashin woman. The principles of execution of documents obtained from a pardanashin woman are equally applicable to documents taken from an illiterate person, viz., a) That any contract entered into by her / him may be subject to undue influence, b) That the contract may not have been made with her / his own free will and consent and with the full understanding of the liability / obligation undertaken under such contract. Thus, any document executed and a contract entered into by her / him is not free from all infirmities. In the case of such execution by a pardanashin woman or illiterate person the burden is heavy on the Bank getting advantage under the document to establish and to prove that the contents of the document were read over and explained to her / him, that she / he understood the legal consequences of the execution of such document, that she / he had also independent advice at the relevant time and that the execution of the document was not only a physical exercise but also a mental act. The document should also be obtained in the presence of some other person. The document should also contain a certificate or an endorsement to that effect. In the absence of such certificate or endorsement, the burden will have to be discharged by some other evidence, direct or circumstantial. It is also advisable to obtain a separate declaration from some other persons known to her / him for confirming the execution of the document. A photograph bearing clear identification of such pardanashin woman or illiterate person should also be obtained and kept on record. 7 Attestation The Transfer of Property Act, 1882, defines the expression attestation as: Attested in relation to an instrument, means, and shall be deemed always to have meant, attested by two or more witnesses, each of whom has seen the executant sign or affix his mark to the instrument, or has seen some other person sign the instrument in the presence and by the direction of the executant or has received from the executant a personal acknowledgement of his signature or mark or of the signature of such other person, and each of whom has signed the instrument in the presence of the executant; but it shall not be necessary that more than one of such witnesses shall have been present at the same time, and no particular form of attestation shall be necessary. 7.1 Attestation is not necessary for the validity of documents which are not required by law to be attested. The person must sign as a witness and for the purpose of attesting the execution of a document. An executant (i.e., the Borrower himself) can not be an attesting witness. 7.2 It is not necessary that that the attesting witnesses should know or be made aware of the contents or the nature of the document. The attesting witness merely witnesses the execution of the document by the executant and is not concerned with anything relating to the document. Both the attesting witnesses need not be present at the same time. The essential requirement is

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that each of the attesting witnesses must sign in the presence of the executant. There is no prescribed format of attestation. Sections 68 to 72 of the Evidence Act, 1872, provide for the rules relating to proof of execution of documents by attesting witnesses. 7.3 The documents in the nature of Sale, Mortgage (other than Equitable Mortgage), Gift in respect of immovable property and Wills require compulsory attestation as per Sections 54, 59 and 123 of Transfer of Property Act and Section 63 of Indian Succession Act, 1925, respectively. 7.4 The credit facilities generally, are made available by the Bank in the form of loans and advances. A secured loan or advance is defined in Section 5 (n) of the Banking Regulation Act, 1949, as a loan or advance made on the security of assets, the market value of which is not at any time less than the amount of such loan or advance and an unsecured loan or advance means a loan or advance not so secured. 7.5 Loans are extended in accounts in which no series of drawings are permitted to the Borrower. Generally, there is only one debit of the principal amount to the loan account though disbursal of the loan in stages may be made as per the needs of the Borrower or such dispersal may also be in accordance with the terms of sanction depending upon the progress of the project for which the loan has been granted. Subsequent debits to the loan account normally will be by way of interest and other charges recoverable on the loan. In the case of advances accounts which are generally in the nature of running accounts, the sanctioned limit will be placed at the disposal of the Borrower subject to the terms of sanction. 7.6 Securities taken by Banks may be primary security and / or collateral security. The primary security signifies the security which has been furnished by the Borrower to the Bank on his own. The collateral security is a an additional and separate security taken to secure the due repayment of money borrowed; common forms of collateral security include additional security from the Borrower himself or from third party, secured or unsecured guarantees, pledge, deposit of title deeds, etc., taken in addition to the primary security for the loan. 7.7 Documentation process involves compliances with certain formalities by the Bank and Borrower before and after the execution of the documents. The pre-execution formalities basically relate to the conducting of searches at various offices of the statutory authorities. These are: a) The Register of Charges at the Registered Office of the Company b) Office of the Registrar of Companies c) Office of the Registrar of Assurances / Sub-Registrar of Assurances d) Office of the Collector or the Competent Authority under the Land Acquisition Act e) The State Industrial Development Corporations or Development Authorities or City Improvement Trusts f) Lis pendens registers of the subordinate courts g) Office of the Competent Authority under the Urban Land (Ceiling and Regulation) Act, 1976 h) Office of the Local Authority or the Municipal Corporation, and i) Office of the concerned Income Tax Department The first two types of searches will not be applicable to Borrower(s) / Guarantor(s) who are not corporate bodies.

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ADVANCES TO COMPANIES 8 A Company is a voluntary organisation of persons formed for certain specific purposes with some capital divisible into several parts, commonly known as shares, the liability thereunder being limited. A Company is always a creature of law and being a legal person, it is separate and distinct from the members constituting it. A Company has perpetual succession unless it is wound up. Two major classes of companies under the Companies Act, 1956 8.1 Private Company [Section 3 (iii)] "Private Company" means a Company which has a minimum paid-up capital of one lakh rupees or such higher paid-up capital as may be prescribed, and by its articles, a) Restricts the right to transfer its shares, if any; b) Limits the number of its members to fifty not including i) Persons who are in the employment of the Company; and ii) Persons who, having been formerly in the employment of the Company, were members of the Company while in that employment and have continued to be members after the employment ceased; and c) Prohibits any invitation to the public to subscribe for any shares in, or debentures of, the Company; d) Prohibits any invitation or acceptance of deposits from persons other than its members, directors or their relatives. 8.2 Public Company [Section 3 (iv)] "Public Company" means a Company which a) Is not a Private Company; b) Has a minimum paid-up capital of five lakh rupees or such higher paid-up capital, as may be prescribed; c) Is a Private Company which is a subsidiary of a Company which is not a Private Company 8.3 Whenever it is proposed to grant advances to a Limited Company, the documents enumerated below should be obtained from the Company and duly scrutinised and examined. Copies of all these documents certified to be true and correct under the signature of the Chairman or the Managing Director or the Secretary of the Company should be obtained and kept on record. a) Certificate of Incorporation A Company is deemed to have been registered only when it gets the Certificate of Incorporation from the Registrar of Companies (RoC) of the State where the Registered Office of the Company is located. The Company comes into existence only upon such incorporation. Branches must exercise adequate care in scrutinising the Certificate of Incorporation for ascertaining as to its incorporation, as different consequences follow in respect of contracts entered into by the Company before or after its incorporation. b) Certificate of Commencement of Business A Public Limited Company can commence its business only after it obtains from the RoC a Certificate of Commencement of Business. This will not apply to a Private Limited Company as it can commence business from the date of its incorporation itself.

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c) Memorandum of Association Memorandum of Association of a Company should be scrutinised to ascertain that the purpose and the amount of loan sought for are authorised by it. It must be ascertained that the Memorandum of Association contains particulars relating to the name of the Company, the place, district and the State in which its Registered Office is situated, the objects for which the Company is formed, the liability of its members, the extent of its operation and the authorised capital of the Company. At times, it also prescribes the area and the objects beyond which it cannot operate. The following aspects should be examined very carefully in the Memorandum of Association: a) The procedure for borrowing and the ceiling or prohibition on the borrowing. b) The powers of the Board of Directors to borrow money. c) The powers for creating mortgage on the assets of the Company. d) Articles of Association The Articles of Association contain rules relating to the management of the affairs of the Company. It also provides, inter alia, for the manner in which the power to borrow can be exercised, rules relating to Common Seal, resolutions, meetings, powers of directors, etc. The following aspects should be examined very carefully in the Articles of Association: a) The procedure and authority to draw and endorse cheques, Bills of Exchange on behalf of the Company, b) The powers of the directors in general in conducting the affairs of the Company, and the correct provisions relating to the manner of affixing the common seal. 8.4 Registered Office Every Company must have a Registered Office which determines the place at which correspondence and communication may be exchanged or sent. As per Section 53 of the Companies Act, 1956, a document to be properly served on a Company must be sent to the Company at its Registered Office by post either under Certificate of Posting or by Registered Post or by personal delivery at such office. The notices are deemed to have been served on the Company only when they are sent to the Registered Office. 8.5 Register of Charges A Register of Charges is compulsorily required to be maintained by the Company and the charges affecting the assets of the Company including the floating charges and Pledge should be entered in it. All the above documents should be scrutinised and examined from the original documents and certified copies thereof should be taken invariably. The Memorandum and Articles of Association with all its amendments made by the Company from time to time should be obtained and held on record. 8.6 Legality of contracts entered into before and / or after incorporation Before a Company comes into existence, it may be necessary for the members interested in promoting the Company to enter into certain contracts for the purpose of running the Company as and when it comes into such existence. These contracts are generally known as preincorporation contracts. For a contract to be valid, it must satisfy certain essential conditions stipulated in the Indian Contract Act. One such condition is that a contract must be entered into between two competent persons. The Company before its incorporation is not a legal person and in the eyes of law, is a non-entity for all purposes. The pre-incorporation contracts are generally entered into by the promoters as agents of the Company proposed to be constituted. No one can act as an agent of a person who is not in existence. For an agency to be legal and

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binding, the principal and the agent should not only be competent to enter into a contract between them but should also be living / legal persons. Since the promoters cannot act as agents of the Company which has not yet come into existence, the Company will not be liable for any of the acts of the promoters done before its incorporation. The Company after its incorporation is not bound by the pre-incorporation contracts entered into by its promoters even though it has received the benefits of the contract. The Company after its incorporation likewise cannot enforce the preincorporation contracts in the event of a breach of such contract. The Company cannot ratify a pre-incorporation contract entered into by its promoters. In case the Company desires to avail the benefit of such preincorporation contracts, it must enter into a new contract with the other party after the date of its incorporation and if the Company makes such a fresh contract in terms of the pre-incorporation contract, the liability of the promoters who personally remain liable in the event of any breach thereof till that date will come to an end from the said date. In case the Company after its incorporation does not enter into a fresh contract with the other party, then the pre-incorporation contract can be terminated by either the promoter or the other party. A suit for specific performance of such preincorporation contract cannot lie by and against the Company so long as the Company has not accepted the same by a fresh contract and communicated such acceptance to the other party. BORROWING POWERS OF A COMPANY 8.7 A Limited Company can exercise its power of borrowing subject to the provisions contained in the Memorandum of Association and the Companies Act, 1956. Any borrowing made in violation thereof will be treated as ultra vires borrowing and the same can not be ratified subsequently even by the whole body of the shareholders of the Company. If the borrowing is ultra vires the Company, it is not enforceable at law and the Bank will not be able to recover the monies lent and advanced to the Company. 8.8 Borrowing powers in the Memorandum of Association The Memorandum of Association of the Company should be examined to ascertain that the purpose, the object and the amount of loan sought for are authorised by the Memorandum of Association. If there is any restriction on the borrowing and the Company borrows in excess of such restriction, such borrowing would be ultra vires the Company. It cannot be subsequently rectified under any circumstances. Likewise, the Company also cannot enter into a contract beyond the scope of the object for which it is formed. Any borrowing for carrying out an object other than those mentioned in the Memorandum of Association cannot be enforced. 8.9 Borrowing powers under the Companies Act, 1956 Every borrowing of a Company is also subject to the provisions contained in Section 292 and 293 (1) (d) of the Companies Act, 1956. The Board of Directors of a Limited Company must pass a resolution under Section 292 of the Companies Act to exercise the powers specified therein including the power to borrow. Such a resolution can be passed only at a duly convened meeting of the Board. Borrowing power cannot be exercised by the Board of Directors by means of a Circular resolution passed without convening a meeting of a Board of Directors. 8.10 Every resolution passed for exercising the borrowing powers must contain specific sanctions resolving power (i) to borrow, (ii) to create security, (iii) the nature and extent of the security to be charged, (iv) the nature and extent of the loan required, (v) to execute loan documents, (vi) the names of the Directors and other persons authorised to execute the documents with or without the authority of Common Seal, (vii) names of the Directors authorised

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to operate the accounts and the names of the Directors authorised to sign and execute Balance Confirmation Letter and Revival Letter on behalf of the Company in favour of the Bank, and (viii) the names of the Directors who are authorised to create mortgage and to deposit the title deeds in the case of Equitable Mortgage. The Resolution should also state that a copy of the resolution certified to be correct and true by the Chairman of Meeting should be sent to the Bank in the manner mentioned therein. 8.11 A copy of the resolution passed by the Board of Directors at a meeting duly convened and at which proper quorum was present must be certified by the Chairman or (if so permitted) by the Secretary of the Company and the same should be obtained and held on record. 8.12 Another statutory restriction on the borrowing powers of a Company is contained in Section 293 (1) (d) of the Companies Act, 1956. According to this Section, the Board of Directors of a Limited Company cannot borrow in excess of the aggregate of the paid-up capital and its free reserves (i.e., to say the reserves not set apart for any specific purpose) without the consent of the shareholders in its General Meeting. This restriction is not applicable to a Private Limited Company except where it is a subsidiary of a Public Limited Company. A specific resolution that the total borrowings of the Company together with the loans and advances sought for from the Bank are not in excess of the limits or the ceilings prescribed under Section 293 (1) (d) of the Companies Act for borrowings by the Directors should be incorporated in the Board Resolution passed for borrowing monies from the Bank. 8.13 Power to furnish / execute Corporate Guarantees and Inter-Corporate Loans As per recent amendments to Companies Act, 1956, (as per Sec. 372 A), a Limited Company can make a loan to any other body corporate and give a guarantee upto 60% of its paid-up share capital and free reserves, or 100% of its free reserves, whichever is more. However, giving Corporate Guarantee itself should be permitted under the Objects Clause of the Company's Memorandum of Association. 8.14 In case the aggregate of loans and the guarantees already made / provided by the Company exceeds the aforesaid maximum limits, no further loan shall be made or guarantee given without the authority of a special resolution previously passed in a General Meeting. 8.15 However, Section 372A of the Companies Act, 1956, also provides that the Board of Directors may give guarantee without the authority of a special resolution in an Annual General Meeting if a) A resolution is passed in the meeting of the Board authorising to give guarantee in accordance with the provisions of this Section. b) Exceptional circumstances which prevent the Company from obtaining previous authorisation by a special resolution passed in a General Meeting for giving the guarantee. c) The resolution under clause (a) above is confirmed within 12 months, in a General Meeting of the Company or the Annual General Meeting held immediately after passing of the Board's resolution, whichever is earlier. It is also a requirement of the Company Law that the notice of such resolution shall indicate clearly the specific limits, the particulars of the body corporate in / to which the loan or guarantee to be given, the purpose of the loan or guarantee and the specific sources of funding and such other details.

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8.16 Section 372A also stipulates that no loan shall be made or guarantee given by the Company, unless the resolution sanctioning it is passed at a meeting of the Board with the consent of all the Directors present at the meeting and the prior approval of the Public Financial Institutions (as per Section 4A), if any Term Loan has been availed from them and there is a default in respect thereof. It is not sufficient that the resolution passed is merely a majority resolution, but it should be a resolution passed by all the directors who attend the Board Meeting convened in this connection. All Directors will have to give their respective assent to the resolution. However, such prior approval of Public Financial Institutions shall not be required where the aggregate of loans and guarantees provided so far does not exceed the limit of 60% referred to in Para 1.11.13, and also if there is no default in repayment of loan instalments or payment of interest thereon as per the terms and conditions of such loans to the Public Financial Institutions. Public Financial Institutions are those which are notified as such by the Central Government by a Gazette notification under Section 4 A of the Companies Act, 1956. The expression does not include banks. 8.17 Section 58 A deals with invitation by a Company to the public for subscription towards Public Deposit. It is also one mode of borrowing available to Companies to raise short term funds other than borrowing from banks. If a Company has defaulted in complying with the provision of Section 58 A, it cannot either directly or indirectly a) Make any loan to any body corporate; b) Give any guarantee or provide security; so long as such default subsists in payment of any one Public Deposit to any person. 8.18 Every Company shall maintain a register showing the following particulars in respect of every loan made, guarantee given by it in relation to any body corporate: a) The name of the body corporate for whose benefit loan is made or guarantee is given b) The amount, terms and purpose of the loan or guarantee c) The date on which the loan has been made; and d) The date on which the guarantee has been given or in connection with a loan of a Third Party (Bank). 8.19 These particulars shall be entered chronologically in a register called as 'Register of Guarantees' within 7 days of the making of such loan or the giving of such guarantee. This register shall be kept at the Registered Office of the Company and shall be open for inspection and extracts may be taken therefrom. 8.20 Companies giving Corporate Guarantees need not file any particulars with RoC if it does not create any charge on the property. It only fastens corporate liability to pay the guaranteed money like personal liability in the case of an individual. If the Company, however, creates a charge on its movable and / or immovable properties by way of a Hypothecation and / or Mortgage, as security for the performance of the guarantee obligations under Corporate Guarantee, it should file Form 8 and Form 13 for registering the said charge. 8.21 If there is a default in complying with these provisions, the Company and every officer of the Company who is in default shall be punishable with imprisonment which may extend to 2 years or with fine which may extend to Rs. 50,000/-.

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8.22 As per explanation provided under Section 372 A, the expressions 'Loan' and 'Free Reserves' shall mean 'Loan' includes debentures or any deposit of money made by one Company with another Company, not being a Banking Company 'Free Reserves' means those reserves which, as per the latest audited Balance Sheet of the Company, are free for distribution as dividend and shall include balance to the credit of the Securities Premium Account, but shall not include Share Application money. EXECUTION OF DOCUMENTS 9 Documents can be executed by a Limited Company in the following manner: (1) By affixing Common Seal under a Resolution of the Board of Directors and in accordance with the Articles of Association of the Company. The Common Seal is the official signature of the Company. (OR) (2) Under the signature(s) of a person(s) duly authorised by a Resolution if the Articles of Association so provide. (OR) (3) By a Power of Attorney holder under the power granted by the Company. Such power is by necessity required to be executed under the Common Seal of the Company pursuant to a Board Resolution. 9.1 The documents must be executed by the Directors who are duly authorised by the Board Resolutions for and on behalf of the Company and always in a representative capacity in the following manner: Common Seal FOR and ON BEHALF OF M/s. ABC Company Ltd., Sd/- Mr. A Sd/- Mr. B DIRECTORS 9.2 Where however, as per the Articles of Association, Common Seal is affixed, the endorsement to that effect is a must in the following manner: IN WITNESS WHEREOF, the Common Seal of the Company is hereunto affixed and the respective parties have subscribed their hands in the manner and on the day, month and year hereinbefore mentioned" The COMMON SEAL of M/s. ABC Company Ltd. COMMON SEAL has been affixed pursuant to a Board Resolution passed by the Board of Directors at their meeting in the presence of Mr. A and Mr. B, Mr. A held on the two Directors of the Company, who have Mr. B affixed their signatures hereto in token thereof. Directors 9.3 Common Seal of the Company In terms of Section 147 (1) (b) of the Companies Act, 1956, every Company should have its name engraved in legible characters on its Seal. 9.4 The expression engrave signifies that the material used for making the seal should be a hard material such as brass, copper or steel or such other metallic substance or object. In other words, a Company cannot have a rubber stamp as its Common Seal. Such a rubber stamp is against or in violation of the mandate of Section 147. A document which is affixed with a rubber

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stamp as Common Seal of the Company is invalid and accordingly cannot be enforced in a Court of Law. Way back in 1964, the Department of Company Affairs, Govt. of India, have clarified that only a metallic seal can be a Common Seal of the Company. 9.5 The Common Seal must contain the name of the Company in legible characters. It can be engraved in English or in any of the vernacular languages specified in Schedule 8 of the Constitution. In addition to the name of the Company, the fact that it is a Common Seal should also be engraved on it. 9.6 Since Common Seal is the official signature of the Company, whenever it is affixed on a document it signifies that the document has been executed by / under proper authority and accordingly it authenticates the due execution. The Articles of Association of a Company contain elaborate and specific provisions for the use of the Common Seal. If a Common Seal is affixed without the authority of the Board of Directors, such affixation by itself is invalid and the document will be treated as a forged document. Even a subsequent resolution of the Board will not validate such documents. The only remedy is to obtain fresh set of documents under fresh resolution. 9.7 In addition to certain documents specified in the Companies Act itself, the Articles of Association should be perused for ascertaining as to the class of documents which are required to be affixed with Common Seal. 9.8 There can be only one Common Seal for a Company. In case the letters engraved on the Common Seal has defaced, a new seal must be adopted by the Company by passing a suitable resolution before using the new seal. The Common Seal can be taken to any place in India where the documents are required to be executed by the Company. However only facsimile of the Common Seal (and not the original Common Seal) can be taken to a foreign country for execution of a document thereat. 9.9 No person whether a Managing Director or Director or Company Secretary can use the Common Seal without the authority of a validly passed Board Resolution as required by the Articles of Association of the Company. The Official Liquidator of a Company upon its winding up shall have all the powers to use the Common Seal in the name and on behalf of the Company {Section 457 (2)(1) of the Companies Act}. Whenever the Common Seal is used, it is necessary to mention that the Common Seal has been affixed by the named person/s under the authority of valid Board Resolution and that he executed the document accordingly. REGISTRATION OF CHARGES 10 Search of records A search of records touching the title of the Company to the assets should invariably be made whenever a financial assistance to a Limited Company, whether Public or Private is under consideration or when the assets (fixed, movable or floating) are to be taken as security. A search in the books or Registers kept both in the Office of the Registrar of Companies (of the State where Registered Office of the Company is situated) and in the Register of Charges maintained by the Company at its Registered Office will have to be conducted to ensure that there are no outstanding or intervening charges on the assets which are proposed to be charged to the Bank and the search should cover the period upto the date of creation of the charge since incorporation of the Company. Existence of any outstanding or intervening charge would adversely affect the priority of the proposed charge in favour of the Bank. It should also

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be ensured that if any earlier loan in respect of which the charge is outstanding but which loan has been already liquidated, the Company should be advised to satisfy such outstanding charge in the records of the RoC and obtain Certificate of Satisfaction for the purpose. In case an earlier charge is outstanding and is not properly satisfied or remains to be satisfied, the Company should be asked to give satisfactory reasons for the same and such cases should be scrutinised with care and caution. 10.1 A search at the Registered Office of the Company as well at the Office of the Registrar of Companies should include the following: a) Register of Charges b) Register of Guarantees c) Register of Resolutions d) Register of Directors Such searches should be made at least at these stages in view of the time limit of 30 days provided for compliance under Company Law: a) Pre-sanction stage b) Post-sanction and at the time of obtaining documentation c) At the time of filing Bank's charge with RoC, after documentation / disbursement d) Before 6 months from the date of filing Bank's charge with RoC e) At least once a year, thereafter 10.2 A charge by way of pledge does not require any registration with the RoC. However, it is necessary to conduct search in respect thereof also so as to ensure that the assets are free from any encumbrance. This precaution is necessary to rule out the possibility of any pledge in favour of third parties. For pledge, search should be done at the Registered office of the company in the Register of Charges maintained by it. 10.3 Search is a continuing process and will have to be made in the records of the RoC not only at the time of initial advance to the Company but on every occasion when any additional limit or a new facility is considered or a new charge on security is created or existing security is extended to cover additional limits or new facilities. A modification of the charge or an amalgamation or merger also should be preceded by a search in the office of the RoC. It should, however, be ensured that at least one search is conducted during a year invariably. 10.4 In case a charge is required to be created on an immovable property or on the fixed assets of the Company, a search of files of the Company respecting such property should also be made in the office of Sub- Registrar of Assurances, Municipal, Panchayat and other revenue offices in addition to the search in the Office of the RoC. Generally, in the case of an immovable property, a search should be conducted for a period of 30 years to the date of creation of charge in favour of the Bank for reasons of certain provisions contained in the Limitation Act. 10.5 In case any advance or loan for acquiring any ship or an inland vessel or a coasting vessel or a boat of certain DWT (Dead Weight Tonnage) or such other ship building advances are to be considered, a search of similar nature in the Office of the Registrar of Ports or the Port Registry is a condition precedent for considering such proposal. The provisions of Merchant Shipping Act should also be borne in mind for granting any advance to the shipping Company.

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10.6 Charges which require registration The Companies Act, 1956, contains extensive provisions dealing with the subject of registration of charges by a Company. It also enumerates a comprehensive and exclusive list of assets, a charge in respect of which is required to be registered. A registration of a charge not only makes such charge effective and enforceable against every person including the Official Liquidator, it further provides a source of knowledge and information to every person interested or affected thereby operating as a constructive notice thereto. The charges which are required to be registered under Section 125 of the Companies Act, 1956, are as under: (a) A charge for the purpose of securing any issue of debentures. (b) A charge on uncalled share capital of the Company. (c) A charge on any immovable property, wherever situated, or any interest therein. (d) A charge on any Book Debts of the Company. (e) A charge, not being a pledge, on any movable property of the Company. (f) A floating charge on the undertaking or any property of the Company including Stockin-Trade. (g) A charge on calls made but not paid. (h) A charge on a ship or any share in a ship. (i) A charge on goodwill, on a patent or a licence under a patent, on a trade mark, or on a copyright, or a licence under a copyright. The aforesaid enumerated charges, the particulars in respect of which will have to be filed and registered with the Registrar of Companies within a period of 30 days from the date of creation of charge and any failure to do so makes the charge void as against the Official Liquidator and other Creditors. Another consequence of non-registration is that the money secured by the charge immediately becomes payable. It is pertinent to note that as against the Company, so long as it is a going concern, the charge is effective and enforceable but not when the Company goes into liquidation. The particulars of charge in the prescribed Form 8 and Form 13 will have to be filed within 30 days from the date of creation of the charge. The 30 days will have to be reckoned from the date when the instrument of charge (Hypothecation, Mortgage, etc.) is executed. 10.7 Floating and Fixed Charges A charge created on the assets of the Company may be a fixed charge or a floating charge depending upon the security stipulations of the Bank. A charge includes a lien and an equitable charge whether created or evidenced by an instrument in writing or by deposit of title deeds or by agreement to deposit. A fixed charge is a charge which is created on certain and definite property of the Company and when the charge is a fixed charge, the Company which has created such a charge can only deal with the property subject to the terms and conditions of such fixed charge. For example, a charge on the land and building and other immovable assets of the Company is in the nature of a fixed charge. 10.8 A floating charge is an equitable charge which is created on some class of property. For example, a charge in the nature of hypothecation of Stocks, Book Debts, uncalled capital, etc. The Company can, however, deal in such property in the ordinary course of business until the charge becomes crystallised upon the happening of certain events set out in the Deed of Floating Charge. A floating charge has the effect of creating an immediate charge on the property charged with the exception that it enables the Company to deal with such property in the normal course of business and subject to the limitations as may be imposed in the instrument creating the charge itself. A floating charge need not be on all the assets of the Company. It may be created with regard to a particular class of the assets of the Company,

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such as Book Debts, Stock-in-Trade or uncalled capital, etc. It is the essence of a floating charge that it is not to be put into immediate operation but is only to float so that the Company is allowed to carry on its business as though the charge does not exist. A floating charge will remain dormant until the Company ceases to be a going concern or the person in whose favour the charge is created intervenes. Under Section 434 of the Companies Act, 1956, any floating charge created within 12 months prior to the commencement of the winding up is invalid unless it is established that the Company immediately after the creation of such charge was in fact solvent. 10.9 Crystallisation of Floating Charge A floating charge becomes fixed or crystallised when a) The debtor Company ceases to carry on business, or b) The Company goes into liquidation, or c) A Receiver is appointed at the instance of the creditor or the debenture holder of the Company, or d) A default is made in paying the principal or interest and the holder of the charge enforces the floating charge by institution of suit. A floating charge may also crystallise on the happening of any of the events specified in any document which created such charge in favour of the creditor. 10.10 Effect of crystallisation of the floating charge a) When a floating charge upon any or all the assets of the Company becomes crystallised, it constitutes a fixed charge on such assets then belonging to the Company. b) It will have priority over any subsequent floating charges and also over Unsecured Creditors. It should, however, be noted that crystallisation of a subsequent floating charge does not have the effect of crystallising a prior floating charge in the absence of stipulation to that effect in the agreement which created such prior charge. When a floating charge becomes crystallised, the Company cannot deal with the charged property without the consent of the holder of the charge, i.e., the Bank. 10.11 Registration of charges with Registrar of Companies (ROC) Electronic filing (e-filing) of forms for creation / modification / satisfaction of charges The Ministry of Company Affairs (MCA) is implementing a major e-Governance initiative known as MCA 21 to improve and refine the process of registration of charge with Registrar of Companies (RoC). All the subsisting charges has been digitized by the RoC and the charges are now filed using e-forms and documents in physical form will not be accepted for registration of charges. Authenticating these e-forms can be done using digital signatures in accordance with the information Technology Act, 2000. The website of MCA www.mca.gov.in gives the detailed procedure for e-filing. The authorized officers at the Branches and other authorized officers as decided by the Circle, need to obtain Digital Signature Certificates (DSC) from Institute for Development and Research in Banking Technology, Hyderabad (IDRBT) or any other authorized agent , for authenticating where necessary, all relevant e-forms for the purposes of registration of a charge with the ROC. The Branches may note the following :i. The concerned person of the Company i.e. Managing Director or Director or Manager or Secretary (In the case of an Indian Company) or an authorized

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ii. iii. iv.

representative (in the case of foreign company) obtains the Digital Signature Certificate (DSC) from the appropriate authority to affix digital signature on the eforms. Further, the Director signing the form on behalf of the Company will also be required to have Director Identification Number (DIN) over and above the DSC. Digital signature is to be obtained by the Chartered Accountant or Cost Accountant or Company Secretary (in whole-time practice) for the purpose of certification of the e-form by signing digitally. At the time of e-filing, documents executed by the company for sanction and disbursement of loans should be scanned and provided along with the digitally signed forms 8, 10, 17 for registration of charges with ROC. Branches should review the existing charges and highlight the discrepancies / errors, if any, to the concerned RoC.

ADVANCES TO PARTNERSHIP FIRM 11 Partnership involves a contract between two or more persons to carry on a business with the object of sharing the profits. Section 4 of the Indian Partnership Act, 1932, defines the expression Partnership as the relationship between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. It means that there must be an agreement between the persons concerned to share the profits of the business which has been agreed to be carried on by all or any of the persons concerned acting for all. Partnership is merely an association of persons for carrying on the business of such partnership and the persons involved thereunder are individually referred to as Partners and collectively as Partnership or 'Firm and the name in which the business is carried on is called the Firm name. The Firm is not a distinct and separate legal entity from that of the partners. 11.1 Partnership is always created by an agreement and not by status. The agreement executed between the partners for defining the terms and conditions of the partnership and the respective rights and liabilities is known as Partnership Agreement or Partnership Deed. The Partnership Agreement should be examined and scrutinised to ascertain the persons who have entered into such partnership, the object or the purposes for which it is formed, the restrictions imposed on the rights of the partners to borrow or to operate the bank accounts and also to examine the conditions relating to retirement, death or insolvency of partners on the status or continuance of the partnership in such events. 11.2 Law has prescribed ceiling on the number of persons in a Firm. Section 11 of the Companies Act, 1956, prohibits a Company, an Association or Partnership to have more than ten persons for the purpose of carrying on banking business and in case of non-banking business to have more than twenty persons. To arrive at the total number of partners in a Partnership Firm, the nature and status of the partner is to be ascertained. In the case of a Partnership Firm in which a Company is one of the partners, it is treated as a single entity and counted as one member. Where partnership includes one or more Hindu Undivided Family (ies), all the major co-parceners of such Hindu Undivided Family (ies) should be individually counted to arrive at the total number. If a Partnership Firm consists of one or more Firms as its partner, each partner of such Firm should be individually counted for determining the total figure. A Firm which violates the above legal stipulation is an illegal association.

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WHO CAN BE PARTNERS 11.3 Since partnership is created by an agreement, it must satisfy all the requirements of the Indian Contract Act, 1872. In other words, the persons must be competent to enter into a contract and they must not be of unsound mind, insane, lunatic and undischarged insolvents. Since a Minor is not competent to enter into a contract, he cannot become a partner in a Firm. However, a Minor can be admitted to the benefits of the partnership with the consent of all partners (Section 30 of the Indian Partnership Act, 1932). A Minor is not liable personally for any debts of the Firm nor his private property can be made liable. However, Minors share in the Firm is liable for all acts of the Firm. Section 30 (ibid) contains detailed provisions relating to the rights and liabilities of a minor partner. It is always advisable to note the date of birth of the Minor whenever a Partnership Firm contains such a partner. A Minor within six months of his attaining majority or attaining the knowledge that he had been admitted to the benefits of the partnership, should by way of public notice, elect to become or not to become a partner in the Firm and such notice determines the position of the Minor as regards the Firm. In case a Minor fails to give such notice, he shall automatically become a partner on the expiry of six months. When a Minor elects to become a partner on attaining majority, he becomes personally liable to third parties for all acts of the Firm done since he was admitted to the benefits of the partnership. In case a Minor elects not to become a partner, his rights and liabilities continue upto the date of public notice and he will not be liable for any acts of the Firm done after the date of the public notice. 11.4 Trust as a partner A Trust is created by an Instrument of Trust for the benefit of the persons named therein, who are called The Beneficiaries by a person called The Settlor and the Trust is administered by a person designated by the Settlor and such person is called The Trustee. The Trust is governed by the law laid down in the Indian Trusts Act. The Trust Deed and the Partnership Deed must be examined and verified to ensure that the Trust Deed empowers the Trustee(s) to enter into a partnership, to carry on the business, to borrow money by itself or as a partner of Firm and authorises the Trustee the power of delegation to represent the Trust in a Firm and that the Trustees have passed a resolution authorising any one or more of them to act as partner in the Firm on behalf of such Trust. Advances to a Firm having a Trust as one of the partners is always risky in view of the possibility of an allegation of breach of trust against the Bank by the beneficiaries of the Trust and such cases need the approval of Controllers. 11.5 Hindu Undivided Family (HUF) as a partner A Hindu Undivided Family is created by status and not by an agreement unlike the Partnership Firm. A Hindu Undivided Family does not have a separate legal entity from that of its members and, therefore, cannot as such enter into a partnership. However, a Karta of a Hindu Undivided Family can enter into a partnership and can become partner in the Firm in a representative capacity on behalf of the family. Although Karta is a partner in representative capacity, however, for arriving at the total number of partners in a Partnership Firm, all major co-parceners of such Hindu Undivided Family (ies) will be individually counted to determine the maximum ceiling which is twenty in the case of a non-banking partnership Firm. The legal complications which are applicable to a Partnership Firm with a Trust as its partner applies equally to a Firm consisting of Hindu Undivided Family as one of its partners.

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11.6 Limited Company as a partner A Limited Company being a distinct legal entity under the Companies Act, it can become a partner of a Firm. It will be counted as one member only. The Directors or the Shareholders of the Company are not liable for the dues of the Firm although the assets of the Company can he made answerable for the Firms debt. The Memorandum and Articles of Association and the restrictions contained herein for exercising the borrowing powers should be examined to ascertain that the borrowing is within its powers. The Company should pass necessary resolutions for exercising the borrowing powers, for executing the documents by its Directors and for affixing its Common Seal on the loan documents. Registration of Charge under Section 125 of the Companies Act is also essential. AUTHORITY OF A PARTNER TO BIND THE FIRM 12 Section 18 of the Indian Partnership Act, 1932, says that subject to the provisions of the Act, a partner is the agent of the Firm for the purpose of the business of the Firm. Section 22 of the Act further says that in order to bind the Firm, any act done or any instrument executed by a partner should be so done or executed in the Firm name and not otherwise. It means that the Firm is bound only by such acts of a partner which are done by him as such partner relating to the business of the Firm. The act of a partner which is done in the usual way to carry on the business of the Firm in the name of the Firm binds the Firm and this authority of the partner to bind the Firm is called Implied Authority. However, in the absence of an agreement to the contrary, the implied authority of a partner does not empower the partner to do the following: a) Submit a dispute relating to the business of the Firm to arbitration b) Open a Bank account on behalf of the Firm in his own name c) Compromise or relinquish any claim by the Firm d) Withdraw a suit or proceeding filed on behalf of the Firm e) Admit any liability in any suit or proceeding against the Firm f) Acquire any immovable property on behalf of the Firm g) Transfer any immovable property belonging to the Firm, or h) Enter into partnership on behalf of the Firm 12.1 The implied authority of a partner so far as the dealing with the Bank is concerned, therefore, does not extend to opening a Bank account on behalf of the Firm in his name or to enter into any compromise by the Firm or to transfer any immovable property whether by way of mortgage, lease etc. or execute a guarantee on behalf of the Firm as these are not the acts which are done in the usual way for carrying on the business of the Firm. Express authority for doing so is required to be given to a partner by all the remaining partners of the Firm. To ascertain the authority of a partner in a Partnership Firm, the Bank generally takes what is known as Partnership Letter or Partnership Mandate. Partnership Letter contains various disclosures by the Firm and creates sufficient authority for the Bank to ensure whether the transactions carried in the account of the Firm are valid and in order. 12.2 The Partnership Letter, inter alia, should state that i) The partners signing the documents are the only and all the partners of the Firm and they are duly authorised to sign the documents ii) Their signatures and execution will be binding on the Firm and each partner iii) If there is any change in the constitution of the Firm, they will undertake to notify the Bank. Branches should ensure that this Letter or Mandate is signed by all the partners.

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12.3 Power to borrow on behalf of the Firm While in the case of a Trading Firm, a partner can borrow money on behalf of the Firm as a matter of course. In the case of a non-trading Firm, however, a partner cannot borrow money or give security over the Firms property unless such powers are expressly given to him by the Partnership Deed or all the partners have expressly consented to exercising such powers by any such partner. 12.4 Partnership Firm as a Guarantor In this case, Guarantee Agreement must be signed either by all the partners or by a partner holding specific authority from the other partners for executing the Guarantee Agreement. This is because the implied authority does not extend to guaranteeing obligation of another. In the absence of such clause in the Partnership Deed, the remaining partners of the Firm should execute a General Power of Attorney in favour of a Managing Partner. 12.5 Partnership Firm as Mortgagor No partner has implied authority to bind the Firm by a transaction involving immovable property. In case of mortgage, either all the partners or partner having specific authority from the other partners should sign the document. 12.6 Partners Individual Guarantee In order to ensure that Bank would rank as first creditor even in respect of assets of the partner in the event of insolvency of the Firm or partners, the Personal Guarantee of all the individual partners in respect of aggregate advance to Partnership Firm should be obtained on stamp paper. Every partner is liable jointly with all the other partners and severally also, for all acts of the Firm while he is a partner. The principle of joint and several liability is that for every act of the Firm, a partner can be sued individually and also jointly with all other partners. CHANGE IN THE CONSTITUTION OR RECONSTITUTION OF A FIRM 13 Sections 29 to 35 of the Indian Partnership Act, 1932, deal with rights and liabilities of partners whenever there is a reconstitution and the Firm continues even after such reconstitution. A Partnership Firm will undergo a change in its constitution if any of the following events take place in its structure: a) Transfer of a partners share b) Introduction of a new partner c) Retirement of a partner d) Expulsion of a partner e) Insolvency of a partner f) Death of a partner So far as the Bank is concerned, generally it comes across cases mentioned in (b) to (f). 13.1 Admission / Introduction of a new partner A person can be admitted or introduced as a partner in a Partnership Firm either with the consent of all the existing partners or in accordance with the agreement already entered into between the partners in that behalf (Section 31). 13.2 Liability of a new partner A new partner does not become liable for any act of the Firm done prior to his admission or introduction as such partner. A new partner is liable for the acts of or the debts incurred by the

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old Firm only if he expressly agrees to be liable for such acts or debts of the old Firm before he becomes a partner and enters into an agreement with the creditor and the creditor accepts the new Firm as its debtor and the new Firm assumes liabilities of the old Firm. The Bank should not close the existing account of the old Firm and all the documents executed by the old Firm should be kept without any change and they should not be cancelled. Wherever there is a mortgage by the Firm, it should not be disturbed but a specific declaration confirming the continuance of the existing mortgage should be obtained from all the partners including the new partner. 13.3 Retirement of a partner A partner may retire from a Firm with the consent of all the other partners or in accordance with an express agreement by the partners or where the partnership is at will by giving notice in writing to all other partners of his intention to retire. 13.4 Liability of a retiring partner Different consequences follow as to the liability of a retiring partner for the acts done before his retirement and after such retirement. 13.5 Before retirement A retired partner continues to be liable for all the acts of the Firm done before his retirement or pending at the time of his retirement, unless he is relieved from liability by an agreement between him, the Bank and the remaining partners of the Firm. 13.6 After retirement A retiring partner along with other partners at the time of his retirement continues to be liable to the Bank for any act done by any of them after the retirement of the partner till public notice is given of his retirement. Whenever a partner retires from the Partnership Firm, the accounts of the old Firm should be broken and stopped. It should not, however, be closed. This is necessary in order to keep the liability of the retiring partner alive for the debts due to the Bank as at the date of his retirement in view of the principle laid down in Claytons Rule' and Sections 59 to 61 of the Indian Contract Act, 1872. Moreover, the Bank should serve notice immediately on the retiring partner advising him that his liability to the Bank for the debts of the Firm continues to subsist and that he is not discharged of his liability towards the Bank. Branches should note that no fresh documents should be obtained from the reconstituted Firm as it will amount to discharge of the retiring partner unless the Bank decides to renew and continue the advances to the new Firm. 13.7 Expulsion of a partner A partner may be expelled by the decision of the majority partners exercised in good faith under the authority given under the agreement between the partners. The liability of an expelled partner stands on the same footing as that of a retired partner. 13.8 Insolvency of a partner Where a partner is adjudicated as insolvent or bankrupt, he ceases to be such partner from the date of Order of Adjudication whether or not the Firm is dissolved. The estate of an insolvent partner is not liable for the acts of the Firm after the date of the Order of Adjudication and the Partnership Firm is also equally not liable for any act of the insolvent partner after date of such Order.

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13.9 Death of a partner Subject to the contract between the parties, a Firm is dissolved by the death of a partner. However, if it is not dissolved by virtue of a contract between the partners, then the estate of a deceased partner is not liable for any acts of the Firm done after his death. Same rules as applicable to retiring partners also apply in the case of a deceased partner. 13.10 Payment of Partnership Firm dues and of separate debts As regards the settlement of debts due from the Firm and also separate and personal debts due from any partner to the Bank, the respective assets of the Firm and the personal property of the partner will be applied as follows: The property of the Firm shall be applied a) First in payment of the debts of the Firm b) And if there is any surplus, then the share of each partner shall be applied in payment of his separate debts Likewise, separate and personal property of any partner will be applied a) First in payment of the separate debts b) And any surplus remaining will be applied in payment of the Firms debts The above rule equally applies in the case of insolvency of any or all of the partners of the Partnership Firm. In order to have recourse to the properties of the Firm and the personal properties of the partners, it is necessary to insist on execution of the document by the partners in their representative capacity and also in their personal capacity. The Bank can claim priority for the dues of the Firm and private debts of the partners only if the execution is done in the above manner and not otherwise. Reconstitution of Partnership Firm 13.11 Whenever the Partnership Firm is reconstituted on account of death, retirement, expulsion / admission, etc., pending sanction of limits to the reconstituted Firm, obtention of fresh documents and transfer of outstanding balances to new account(s), a stamped letter of continuity should be obtained from all the incoming and outgoing partners as an interim measure. Where advances to dissolved Firm are secured by Third Party Guarantee, a stamped letter of confirmation should be obtained from the Guarantors. Even in cases where Proprietorship Firm changes into a Partnership Firm, the letter of continuing guarantee with suitable modification should be obtained. 13.12 In respect of Term Loans, there is no need to obtain a fresh set of documents consequent to reconstitution of a firm. A stamped letter should be obtained. It should be executed by the continuing partners, incoming partners and Guarantor(s), if any, at the time of obtaining fresh documents for Working Capital Limits to the reconstituted Firm. 13.13 In case of reconstitution, the mortgage created over the partnership property will not be affected. In order to make incoming partner(s) liable for the past liabilities (normally not liable for past debts), stamped agreement confirming that the mortgage created by the Firm to secure the said advances, shall be binding on them also would be necessary. Existing mortgage should not be disturbed.

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13.14 When a Borrower carrying on a business in his individual capacity desires to manufacture / trade in the name of Sole Proprietary Firm as a Sole Proprietor, no additional / new documents should be obtained except a letter that he would hereafter do manufacturing / trading in the name of Firm as its Sole Proprietor and loans earlier availed of by him and documents executed by him in favour of Bank shall cover the business so carried under the trade name.

13.15 Limited Liability Partnership Firms

Summary of Limited Liability Partnerships Act, 2009 Section 2 of the Act defines Body Corporate means a company as defined in Section 3 of the Companies Act, 1956 and includes: (i) (ii) (iii) A limited liability partnership registered under this act; A limited liability partnership incorporated outside India; and A company incorporated outside India.

It does not include: (i) a Corporation sole; (ii) a cooperative society registered under any law for the time being in force; and (iii) any other body corporate which the Central Government may by notification in the Official Gazette, specify. If a limited liability partnership incorporated outside India establishes a place of business within India, it will be called as Foreign Limited Liability Partnership. Limited Liability Partnership (LLP) Agreement means agreement: (i) (ii) between the partners; between the LLP and its partners

and would determine the mutual rights and duties of the partners and their rights and duties in relation to LLP. LLP as Body Corporate: As per the Act LLP is a Body Corporate incorporated under the Act and (i) is legal entity separate from its partners (ii) has perpetual succession For the purpose of incorporation of LLP two or more persons associated for carrying on a lawful business with a view to profit shall subscribe their names to incorporation document. Incorporation document shall contain; (i) Name of the LLP; (ii) Proposed business; (iii) Address of the Registered Office;
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(iv) (v) (vi)

Names and addresses of each of the partners; Names and addresses of each of the designated partners. Any other relevant information concerning LLP as may be prescribed.

The incorporation document has to be filed with the Registrar of the State in which the office of the LLP is to be situated. Incorporation document is to be certified by either an Advocate or Chartered Accountant or Company Secretary or a Cost Accountant that all the provisions of the LLP Act have been complied with. After completion of all requirements, Registrar will issue a certificate to the effect that LLP is incorporated by the name given in the certificate. LLP would not be registered by a name, which, in the opinion of the Central Government is undesirable or identical to that of any other LLP or Corpoprate body. (This is identical to Section 20 of the Companies Act). Government may direct LLP to change its name, which LLP has to comply within three months from the date of the direction. LLP may also apply to the Registrar to give direction to such subsequent LLP to change its name. Such an application should be submitted within 24 months from the date of incorporation of subsequent LLP. Registered Office: All communications and notices to LLP shall be served/received at its registered office and/or at any other place specifically declared by the LLP for the purpose in the form and manner prescribed. Change of Registration office may be changed by LLP after filing notice of change with the Registrar. On registration, LLP by its name can sue and can be sued. LLP can acquire ,own, hold and develop or dispose of movable/immovable property. Partners in LLP: Individual or body corporate may be a partner in a LLP. Accordingly, other than Cooperative society and corporation sole (specifically excluded) the following can be partners in an LLP: (i) (ii) (iii) (iv) (v) (vi) Individuals; Limited Liability Partnerships; Companies; Foreign Limited Liability Partnerships. Limited liability Partnerships incorporated outside India. Foreign Companies.

but excludes individuals of (i) unsound mind; (ii) un-discharged insolvent; or (iii) has applied to be as insolvent and the application is pending. LLP shall have minimum of two partners
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If the number of partners is reduced below 2 and it carries business for more than 6 months, then, the continuing partner shall be personally liable for the affairs of the LLP for the period of such continuance. Designated Partners (DPs): In terms of Section 7 of LLP Act, every LLP should have at least two Designated Partners (DPs), one of whom should be resident in India. If all partners are bodies corporate, then the bodies corporate should nominate individuals to become DPs. If incorporation document specifies Designated Partners (DPs), they will be DPs on incorporation. Any partner may become a designated partner. An individual shall give consent to LLP to become designated partner. LLP has to file with the Registrar the particulars of individuals appointed as designated partners within 30 days of their appointment. The designated partner shall obtain a Designated Partner Identification Number (DPIN) from the Central Government. Liabilities of Designated Partners: DPS shall be responsible for compliance of the provisions of the Act including(i) filing any document (ii) return (iii) statement, etc. and any other requirement as specified in the LLP agreement. Provisions for Vacancy/vacuum of DPs: (i) LLP may appoint a designated partner within 30 days of a vacancy (ii) If no DP is appointed or if at any time there is only one DP, all partners shall be deemed as DPs. (iii) If DPs are not appointed as required under Section 7 of LLP Act, then the LLP and all partners are liable to penalty which shall be not less than Rs. 10000/ and not exceeding Rs. 5,00,000/=. The penalty shall also be imposed for (a) not filing the particulars of individuals within 30 days of his appointment as DPs or (b) appointed DPs have not carried out their responsibilities under the Act viz., filing of returns etc., Partners and their Relations: Mutual rights and duties of the partners shall be in accordance with the LLP agreement. Any change in the LLP agreement has to be filed with the Registrar. In the absence of LLP agreement, rights and duties shall be determined by the provisions set out in the First Schedule of the LLP Act. Every partner shall inform the LLP of any change in his name or address within a period of 15 days of the change. LLP is liable to file notice with the Registrar for informing any change in
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the partners or their name or address within 30 days of the change. A partner may lend money to LLP and may transact other business with LLP. He has the same right and obligations with respect of such loan or other transaction like any other person who is not a partner. Any person may cease to be a partner: (i) In accordance with an agreement with other partners or by giving notice in writing of not less than 30 days to the other partners of his intention to resign as partner. (ii) On his death or dissolution of the LLP; If he is declared to be of unsound mind (iii) (iv) If he is adjudged as an insolvent. Even after a person ceases to be partner of an LLP, he shall be treated as a partner in relation to any third person having dealings with LLP, unless the third person has notice to the effect that he has ceased to be a partner or notice regarding ceasing to be partner is given to the Registrar. Whatever obligation incurred while a person was a partner shall not be discharged when he ceases to be a partner. Extent and Limitation of Liability of LLP and its Partners: Every partner of the LLP is the agent of LLP but is not an agent of other partners. An LLP is not bound by anything done by a partner in dealing with a person if (i) the partner has no authority to act for the LLP in doing a particular act and (ii) the other person knows that he has no authority or does not know or believe him to be a partner of the LLP. Partners are not personally liable for the obligations of LLP. However, he shall be personally liable for his own wrongful acts or omissions. Property(ies) of partners is/are not liable to the liabilities of the LLP. If any person represents himself as a partner in LLP, he is liable to any person who has given credit on the basis of such representation. If LLP has received credit on the basis of such representation, it shall be liable to the extent of credit received by it or any financial benefit derived thereon. If a partner has expired and the business of the LLP are carried with the continued use of that name or of the deceased partners name as a part thereof, the legal heirs of the deceased or his estate shall not be liable for any act of the LLP done after his death. If the LLP or its partners carry out any act with the intent to defraud creditors, then the liability of LLP and partners who acted with the intent to defraud shall be unlimited.

Contributions of the Partners: Obligation of a partner to contribute to LLP shall be as per the LLP agreement.

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Partner can contribute by way of tangible, movable or immovable or intangible property. A creditor of an LLP can enforce the original obligation against any partner of LLP without notice of any subsequent compromise between partners.

Financial Disclosures: LLP has the option to maintain the accounts on the basis of cash or accrual basis as against in case of Companies, accounts are required to be maintained only on accrual basis (i.e., mercantile system of accounting) LLP has to prepare Statement of Account and Solvency within 6 months from the end of the financial year (i.e., 1st April to 31st March every year). Every year, LLP has to file the Statement of Account and Solvency with the Registrar within the prescribed time (60 days) for the purpose. Accounts are to be audited. However, Central Government may exempt any class of LLPs from mandatory audit by issuing notification to this effect.

Inspection of Document kept by Registrar: Incorporation document, name & address changes in the partners, Statement of Account (including Profit and Loss account) and Solvency and Annual Return filed by LLP with the Registrar shall be available for inspection by any person on payment of prescribed fee. By Statute, Registrar is vested with the powers to seek any information from any person (including present or former partner/employee/designated partner) connected with LLP. The information is required to be submitted within a reasonable time. Registrar may destroy any documents filed in physical form or electronic form in accordance with the rules as may be prescribed.

Assignment and Transfer of Partnership Rights: The rights of a partner to a share of the profit and losses of the LLP and to receive distribution shall be transferable in accordance with the LLP Agreement. Transfer of rights by the partner does not by itself cause the dissociation of the partner or a dissolution and winding up of the LLP. Transfer of rights does not entitle the transferee to participate in the management or conduct of the activities of the LLP or access to information concerning the transactions of the LLP. Investigation: Central Government, Tribunal, Courts have been empowered to investigate the affairs of the LLP either suo moto or on an application received from partners/creditors/others. Central Govt. may also appoint inspectors for investigations. Inspectors, so appointed, will only be individuals and not body corporate, firm or association. Inspectors with the prior approval of the Govt. can keep the books and papers of LLP in his custody for a maximum of 30 days. Inspectors, however, may seize the documents from LLP after obtaining approval from Judicial Magistrate of the first class or Metropolitan Magistrate. In such cases also inspector cannot keep the books for more than 6 months.
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Inspectors shall submit report after investigation to Government. The copy of the report may be obtained by any person or entity related to or affected by the report on their request. The authenticated copy of this report shall be admissible as evidence in any legal proceedings. Govt may prosecute such persons, if found guilty, for the offence. Further, Govt. may also cause to be presented to the Tribunal a petition for winding up of the LLP, if the investigation establishes that The affairs of the LLP are not being conducted in accordance with the provisions of the Act. LLP was formed for any fraudulent or unlawful purpose. The business of the LLP is being conducted with an intent to defraud its creditors, partners or any other person. The affairs of the LLP are in a manner oppressive or unfairly prejudicial to some or any of its partners.

Winding up and Dissolution: Besides reason stated above, the LLP may be wound up voluntarily or by the Company Law Board Tribunal for following reasons; LLP wants that it should be wound up For a period of more than 6 months, the number of partners is reduced below 2. LLP is not in a position to pay its debts. LLP has acted against the interests of the sovereignity and integrity of India, the Security of the State or public order. LLP has not filed with the Registrar the Statement of Accounts and Solvency or annual returns for any five consecutive financial years. Tribunal is of the opinion that it is just and equitable the LLP should be wound up. Conversion to Limited Liability Partnership: A partnership firm may convert into a LLP A private limited company may convert into a LLP. Unlisted public limited company may convert into a LLP.

Foreign Limited Liability Partnerships: Central Government has the power to make rules in relation to establishment of place of business by foreign limited liability partnerships within India and carrying on their business by taking into consideration of the provisions of the Companies Act, 1956 or any other regulatory mechanism. Compromise, Arrangement or Reconstruction: If compromise between an LLP and creditors or LLP and its partners is proposed, the Tribunal (or the liquidator in case of LLP being wound up) may order a meeting of the creditors or partners. If the majority representing 3/4th in value of the creditors or partners at the meeting agrees to compromise, then the compromise if sanctioned by the Tribunal is binding on all creditors or partners and also LLP. If LLP is being wound up, it is binding on the liquidator. Within 30 days from the date of the Tribunal order, the LLP has to file the order with the
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Registrar. Only after filing the order with the Registrar, the order shall have effect. The Tribunal has power to supervise the carrying out of the compromise. The Tribunal also has the powers to facilitate reconstruction or amalgamation of LLP. The Tribunal may make provisions for transfer whole or part of LLP undertaking, property or liabilities to transferee entity. Make provision for dissolution without winding up of transferor LLP. Impact of extant instructions (Partnership firms) Impact of Provisions of Limited Liability Partnership (LLP) Act, 2008 Unlimited personal liability No personal liability of of each partner for dues of partner except in case of partnership firm. Personal fraud. property of partners is also liable for partnership dues. Partnership is registered under Partnership Act and registration is not mandatory. Partnership is not a legal entity separate from its partners. Action to be taken

Partnership documents are required to be filed with Registrar of Firms of respective states In the absence of agreement to the contrary, death of partner dissolves firm Minimum two and maximum twenty partners All partners are liable for statutory compliance as required under the Law

Due diligence at the time of processing of proposals will be more intensive as is being carried out in cases of sanction of facilities to companies. Personal guarantee of partners on a case-to-case basis will be stipulated. LLP would be Scrutiny of LLP document will be more incorporated under LLP inclusive as the firms operations would Act and incorporation is be governed by LLP agreement. mandatory. LLP is a legal entity Viability of LLP will be the prime concern. separate from its The LLP agreement would provide extent partners having of equity. Additional funds brought in by perpetual succession the partners will not be treated as equity or quasi-equity. Funds already inducted, as loans from friends and relatives, if treated as quasi-equity, should be retained till the ratio meets the benchmark prescribed by the Bank. In case of LLP, Registrar After finalisation of appropriate rules by of Companies (ROC) is the Govt. prescription for registration of the administrative charge with ROC and periodicity for its authority regular verification will be stipulated. Death of partner does LLP agreement would provide the not dissolve LLP. continuity process, which is to be examined in detail along with its applicability. Minimum two but no limit It appears LLP would be abridged to maximum number of version of Pvt. Companies. Accordingly partners. all Precautions for financing Pvt. Companies need to be taken. Only designated Statutory liabilities and its impact on LLP partners are liable for to be examined in detail. statutory compliance as required under the Law

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Partner cannot enter into business with firm, though he can give loan to the firm

Partner can enter into business with LLP. He can also give loan to LLP.

Every partner of firm is agent of firm and also of other partners. He can bind partnership firm as well as other partners by his act. Partnership firm can be LLP can be wound up. dissolved

Provisions of companies Act as applicable to transactions with the interconnected parties viz., companies/ firms where directors are interested, will apply mutatis-mutandis to partners under LLP. Every partner is agent of LLP agreement would be scrutinized for LLP but not of other examining duties and responsibilities of partners. He can bind partners in LLP. LLP but not other partners by his act.

After receipt of procedure for winding up as are being framed by the Ministry of Law Affairs, it would be examined in detail and impact thereof would be examined. Partner is entitled for Partner is entitled for Details of remuneration will be examined remuneration, if it is remuneration, if it is and impact thereof on LLP would be provided in the partnership provided in the LLP examined. agreement agreement RULES OF STAMPING OF DOCUMENTS 14 The law relating to stamping of documents is governed by the Indian Stamp Act, 1899. Certain types of instruments like Bills of exchange, Cheques, Promissory Notes, Bills of Lading, Letters of Credit, Policies of Insurance, Transfer of Shares Debentures, Proxies and Receipts are exclusively governed by the Indian Stamp Act, 1899, while other documents are governed by the local stamp law. In order to be enforceable, the documents / instruments are required to be stamped in accordance with the stamp law. In other words, they should be 'duly stamped'. Instruments / documents which are unstamped or insufficiently or inadequately stamped or affixed with a stamp of improper description will be inadmissible in evidence for any purpose. An instrument other than Bill of Exchange and Promissory Note can be validated by payment of the deficit stamp duty and penalty which may extend to 10 times of the duty, provided sufficient reasons are shown. The stamp duty under the stamp law is determined with reference to the nature of the instrument / document and not to the nature of the transaction. 14.1 Kinds of Stamps There are different kinds of stamps which should be used in accordance with the provisions contained in the local Stamp Act. Normally, the stamps are either general stamp papers or adhesive / special adhesive stamps. The stamp papers which are called non-judicial stamp papers in common parlance are those on which stamps of the required value are embossed or engraved. This type of stamp paper should not be used on the printed documents. However, the Banks printed documents can be typed on these non-judicial stamp papers or the printed documents should be got stamped by adhesive stamps by the stamp office / authority, and in no circumstances the stamp paper should be pasted to the printed document. 14.2 Time of stamping Every document executed in India should be stamped at the prescribed rate of duty and with the kind of stamp either before or at the time of the execution of such document. Any stamp affixed
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after the date of execution of the document will not make it a valid document. The date of execution should always be subsequent to the date of stamping and under no circumstances the document should be antedated. Where a document which is liable for stamp duty in India (except Bill of Exchange and Promissory Note) is executed outside India, it must be stamped within 3 months of its arrival in India with the amount of applicable stamp duty when such document relates to property or anything to be done in India. Such documents should be submitted to the local stamp office with an application for getting endorsement on the document as to the stamping within 3 months of its first arrival in India. 14.3 Place of stamping A document should bear the stamp of that State where it is first executed and the stamp duty should be paid in accordance with local stamp law of that State in which it is first executed. Where a document is executed in one State and relates to anything to be done or any matter to be acted upon in another State or where any of the executants are in another State, then such document must be first stamped in accordance with the stamp law of the first State in which it is first executed and the excess or difference in stamp duty, if any, in the second State is to be paid. The document should be taken to the stamp office in the other State and should be got endorsed by them to avoid any objections on this count at a later date. 14.4 Writing on stamp paper If general stamp paper (non-judicial stamp paper) is used for a document, then each paper should have some substantial part of the document handwritten or typed on it. The practice of affixing general stamp papers on a printed document is unlawful. No part of the printed document should be written or typed on the embossed or engraved portion of the stamp. While there is no prohibition in using the general stamp paper on both the sides, the proper procedure should, however, be that reverse side of the stamp paper be kept blank for the use of the SubRegistrar of Assurances. Where more than one general stamp paper is used for a document, each stamp paper should have some substantial part of the document and it should be serially connected in a running fashion so as to indicate that each subsequent general stamp paper is a part and parcel of the previous stamp paper. 14.5 In the case of a Hundi, each part of the Hundi with its distinctive number should he handwritten or typed and where more stamp papers are used for the purpose, they should be serially connected to each other. The practice of attaching stamp papers to make up the total value of the duty payable without writing or typing a portion of the Hundi is unlawful. Any alteration done or made in a document after it is executed requires a fresh stamp duty to be paid on it even when the alteration was done with the consent of the parties. Branches should avoid such a situation as it creates several legal complications. 14.6 Cancellation of stamps A stamp must be cancelled in such a manner which would ensure that it would not be used again. The stamp law imposes responsibility of cancelling adhesive stamps on instruments on the party affixing such stamps and failing that, by the person executing such instrument. In terms of the provisions of stamp law, any instrument bearing an adhesive stamp, if not cancelled in a way that the same cannot be used again, shall so far as such stamp is concerned, be deemed to be 'unstamped'. Adhesive stamps can be cancelled by writing on / or across the stamp, the name or initials of the party or the Company with the correct date thereof or in any other effectual manner so that the stamps cannot be used again. The proper mode of cancellation of stamp is to sign across the stamp in such a way that the signature(s) appear on all the adhesive stamps. Simply drawing a line across the stamp or drawing two parallel lines or by drawing a curved line below the signature is not an effective or proper cancellation. Where
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several adhesive stamps are used, all the stamps must be effectively and properly cancelled. If one of the several adhesive stamps is not so cancelled, the whole document becomes invalid as such cancellation will not be sufficient in the eyes of law. Instruments stamped with impressed stamps / non- judicial stamp papers should be written in such a manner that the stamp appears on the face of the instrument and cannot be used for / or applied for any other instrument. Only one instrument can be written on the same stamp paper. Any document or instrument which is not properly stamped will be considered as 'not duly stamped'. Such a document cannot be admitted in evidence in any Court or in any legal proceedings for any purpose. Such a document cannot be registered or authenticated by any public officer. 14.7 Consequences of improper stamping As to the consequences of documents not duly stamped, the documents are divided into two classes: a) Those documents which are not admissible in evidence at all if any of the above rules are violated: (i) Promissory Notes (ii) Bill of Exchange and Hundi. Such documents are inadmissible in evidence, which means that they cannot be produced and relied upon in any suit for establishing any right thereunder. Even on payment of deficit duty and penalty, the above types of documents cannot be admissible in evidence if they are not duly stamped. b) All documents other than those stated above are admissible in evidence, after payment of full or deficit duty and penalty equivalent to ten times the deficit or full duty as the case may be, as may be imposed by the Court or stamp authorities at its sole discretion, provided the reasons furnished for not doing so in the first place are found to be satisfactory. 14.8 Adjudication of stamp duty In case of any doubt as to the current stamp duty payable in respect of a document, any person can present such document / instrument whether executed or not and whether previously stamped or not, to the stamp authorities for adjudication of proper stamp duty payable in respect thereof. Prescribed fee should be payable whenever such application is made for adjudication of the document. Such document / instrument has to be brought to the notice of the stamp authorities either at the time of / or before expiry of one month from the date of execution. A Promissory Note or a Bill of Exchange cannot be sent for adjudication. The certificate of adjudication given by stamp authorities is a conclusive proof of evidence as to the current stamp duty payable on the document and the same cannot be called in question in any Court of Law thereafter. 14.9 In certain exceptional circumstances, a document can be sent for such endorsement by the stamp authorities subject to satisfying certain conditions. If a document is not properly stamped and the same is produced by a person on his own to the stamp authorities, but in any case within one year from the date of its execution and such person satisfies the stamp authorities that the omission of stamping was primarily due to accident or mistake or by urgent necessity, the stamp authorities may, after satisfactory proof, endorse such documents as duly stamped on payment of the requisite deficit duty. 14.10 Refund of spoiled stamps Stamp authorities have powers to give refund for impressed stamps when (a) stamps are inadvertently spoiled, obliterated or by error rendered unfit for the purpose before execution, (b) stamps are rendered useless before execution and (c) stamps spoiled or rendered useless after execution in case of document found void ab initio or found unfit due to error or mistake, or where execution is not complete due to death or incapacity of the necessary party or due to
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refusal of any person to act or to advance money thereunder and the purpose has failed. The application for refund has to be made (a) within six months of the stamp being spoiled before execution, (b) within six months after the date of execution of documents in case documents are rendered useless, and (c) within two months when the execution is incomplete by reason of refusal of the party to act thereunder. When printed forms of stamped documents are no longer required by the Bank for any sufficient reason, the stamp authority has powers to give refund for such stamp papers without any time limit, if he is satisfied that the stamp duty on such documents had been properly paid, after deducting 10 per cent amount. When the stamps are not spoiled or rendered useless but are not required for immediate use, and if such stamps are delivered to the stamp authority within six months from the date of purchase, the stamp authority can given refund after deducting 10 per cent amount. LAW OF LIMITATION 15 Revival Letters (Acknowledgement of Debt and Security) The Limitation Act, 1963, prescribes a period before expiry of which a debt may be recovered or a right could be enforced by the Bank in a Court under a document. The essence of the Limitation Act is that it only bars the remedy and it does not extinguish the right under a document. It means that while the right to recover a debt subsists, the remedy of recovery by filing a suit in the Court is taken away after the expiry of prescribed limitation period. Where by virtue of the power given under a document if the Bank is entitled to or is able to recover a debt without intervention or assistance of the Court, it can do so even after the expiry of limitation period. If the debt is time barred, the Bank can still exercise its right of Lien and Set-off and in the case of Hypothecation (after taking possession of the assets) or Pledge or Mortgage in English form, a power is vested in the Bank to sell without intervention of the Court and the limitation does not apply to such cases. However, the personal obligation of the Borrower / Guarantor to pay could become time barred and no suit can lie for recovering the balance from them personally. 15.1 The Limitation Act (Sections 18 to 20) clearly specifies the manner of acknowledging the debt and the persons who should do it. The essential requirements of a Revival Letter (Acknowledgement of Debt and Security) are: i) Conscientious admission of existing liability in respect of a right or property. ii) It must show jural relationship as debtor and creditor. iii) Revival in writing should be made before the expiration of prescribed period. iv) It should be made by Borrower / Guarantor against whom such right or property is claimed. v) It should be signed by such person, i.e., the Borrower /Guarantor or his duly authorised agent. vi) There must be an identity of the debt and admission as to such liability'. 15.2 The effect of a valid acknowledgement (Revival Letter) is that it commences a fresh period of limitation from the date it is executed, provided it is executed before expiration of prescribed limitation period. The fresh period of limitation is to be computed from the date when the Revival Letter is executed. The last date for computing the period of limitation is the corresponding date on which the document has been executed. For example, in the case of a leap year, if a Revival Letter has been executed on the 29th February of that year, the last date of limitation in such case would be the 28th February and not the 1 March of the corresponding third year. 15.3 A Revival Letter is sufficient and valid even if i) It omits to specify the exact nature of the right or the property or the exact balance
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ii) It states that the time for payment, delivery or performance has not come, that is to say that there is still time to pay iii) It is accompanied by a refusal to pay iv) It requests for Set-off (by the Borrower / Guarantor) 15.4 Revival of time-barred debt A remedy in respect of a debt which is time barred can be revived only by a fresh promise to pay that debt in terms of the provisions contained in Section 25(3) of the Indian Contract Act, 1872. The 'imperfect right' (i.e., the right which was not exercised by the Bank within the limitation period) can be remedied only if there is a fresh promise to pay the debt by the Borrower. Often it is observed that this procedure may entail obtention of documents in the loan accounts, in view of certain other legal complications. The difference between the Revival Letter (i.e., the acknowledgement under Section 18 of the Limitation Act) and Section 25 (3) of the Indian Contract Act (fresh promise to pay the time barred debt) is that a Revival Letter (under Section 18) in writing made before the expiration of the prescribed period only extends the limitation from the date it is so signed. Whereas a new promise to pay a time barred document (under Section 25 (3) of Indian Contract Act) altogether gives a fresh cause of action and a fresh limitation period from the date such agreement to revive the time barred debt is executed. In other words, a Revival Letter (acknowledgement) cannot revive a time barred debt nor it can extend its limitation and this can be done only under Section 25(3) of the Indian Contract Act. Branches should further ensure that after the execution of the Banks standard form of agreement to revive the time barred debt, the subsequent Revival Letters should mention not only the said agreement to revive the time barred debt but also it should include all the loan documents which have become time barred in respect of which the said agreement was taken.

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13. SECURITY DOCUMENTATION

1.1 Care to be taken before obtaining the security documents 1.1.1 The first thing to be seen when someone applies for a credit facility is the object / purpose of the credit. If the applicant is a Limited Company, whether the Memorandum of Association of the Company authorises the Company to carry out the object for which the loan is applied. 1.1.2 The capacity of the prospective Company has to be verified with reference to the borrowing powers provided under Section 293 of the Companies Act. 1.1.3 The ownership of the person offering properties and other securities, on which charge is to be created, should be verified. In the case of movable property, possession is prima facie evidence of ownership. Immovable property calls for pointed attention to the title clearance certificate, in the prescribed format, which should be obtained from the Banks advocate. Detailed search report / encumbrance certificate for the specified period should accompany the legal opinion. Apart from search, it should be enquired whether the property is in the possession of the person offering it as security or in the possession of a third party. If it is in the possession of third party, the capacity in which it is held by him / her should be ascertained. This is very important, because if the third party is claiming adverse possession and is in possession of the property for more than twelve years, without any attempt being made by the real owner to drive him / her out with recourse to legal steps for recovering possession of the property, the possibility of the Bank losing the security cannot be ruled out. 1.1.4 In the case of Corporate Borrowers, search at the Office of Registrar of Companies is important. This is done by verifying the particulars of charges filed by the Company as reflected in the register maintained by the Registrar of Companies. A contemporaneous search of the Register of Charges maintained at the Registered Office of the Company should also be conducted in terms of Section 143 of the Companies Act, 1956. 1.1.5 Searches at the Office of the Sub-Registrar of Assurances / Land Registry to check the existence or otherwise of prior charge over the immovable property offered as security. This is also a legal requirement. 1.1.6 If the property offered is leasehold property, the period of lease should be ascertained to ensure that sufficient balance lease period is available. Lease Deed should be perused for any restrictive clauses as also to verify the power of the Lessor for re-entry. If permission of the Lessor is required to be obtained, then its compliance should be ensured. 1.1.7 If provisions of Urban Land Ceiling Act etc. are applicable, the requirements should be complied with. For instance, if the property held is beyond the ceiling limit, any mortgage created without obtaining permission of State Government will be void. 1.1.8 Other precautions are to be taken before creating Equitable / Registered Mortgage. Certain important steps are to be taken when a second / subsequent charge is to be created in favour of the Bank. It is not sufficient, in such cases, that the first charge holder merely agrees to cede the second charge in favour of the Bank and exchanges in-principle consent to that effect by a letter.

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 The first charge holder should also agree to hold the title documents for and on behalf of second / subsequent Mortgagee and not to deliver the title deeds to the depositor after the loan secured by the first mortgage is fully liquidated. Further, the first mortgagee should also agree to hold the title deeds till the second charge holder's liability is liquidated. The Company also should authorise the first chargeholder to hold the title deeds as security for the second / subsequent mortgagee to hold the title deeds as security for the second / subsequent mortgagee also. Unless the above formalities are completed and proper recitals about the delivery of the document are recorded, there is no valid creation of Equitable Mortgage. Under no circumstances, exchange of pari passu / consent letter to cede pari passu / second charge would create second charge. A Recital or Memorandum must be recorded evidencing the deposit of title deeds and intention to create Equitable Mortgage. 1.1.9 In case of immovable property of Partnership Firm, all the partners should join in the deposit of title deeds. 1.2 Care to be taken at the time of execution of the documents 1.2.1 Documents must be obtained in the appropriate formats. 1.2.2 The documents and the schedules attached thereto should be got completed as far as possible in one sitting and in the same handwriting. 1.2.3 They must be executed in the proper capacity (e.g. as Proprietor, Partner, Trustees, Karta, Director, etc.). 1.2.4 Documents must be stamped as per the Stamp Act. An un-stamped / under-stamped document will be inadmissible in evidence (Section 35 of Indian Stamp Act, 1899). If a particular document is not adequately stamped at the time of execution for some reason, the defect can be remedied by submitting the documents to the stamp authorities within 30 days from the date of execution and paying the required stamp duty. The Court may also, at its discretion, permit the documents to be admitted as evidence on payment of appropriate value of stamp duty and penalty, which may be upto ten times the value of the stamps to be affixed / ten times the difference between the paid and the exigible stamp duty. However, certain documents like Promissory Note, Bill of Exchange or Hundi will not be admitted in evidence, even by paying penalty, if they are not adequately stamped as such defects in these documents cannot be rectified by a Court of Law. 1.2.5 The stamps / stamp papers should be properly cancelled. Cancellation gives a proof that the documents were adequately stamped at the time of execution. Stamps affixed on Demand Promissory Note and Balance Confirmation Letter must be cancelled in such a way that a part of the executants signature appears on each of the stamps, along with the actual date of signing, and partly outside the stamp. Signature without date and contained entirely on the stamp will not result in effective cancellation. 1.2.6 The special adhesive stamps on documents should be cancelled at the time of affixing the stamps. Any person required by Section 12 of Indian Stamp Act to cancel an adhesive stamp and who fails to cancel it in the manner prescribed by the Section is punishable under the relevant provisions of the Stamp Act.

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1.2.7 In respect of high value import / export bills where adhesive / special adhesive stamps are pasted in sheet(s) of paper and are annexed to the document, apart from cancelling the stamps, the names of the parties, amount of the bill and date of cancellation should be written and signed by an official of the Bank. 1.2.8 When two or more sheets of stamp papers are used, a portion of the document should be written on each of them, lest the instrument should be deemed as un-stamped / under-stamped. 1.2.9 If a stamp other than that specified in the Stamp Rules is used, the instrument is deemed to be un-stamped / under-stamped. 1.2.10 The documents should be correctly filled up. There should not be any overwriting or erasures. Any mistake should be neatly ruled through under the signature of the executants. The blank spaces meant for important details, if remaining unfilled, will render the document invalid. Such insertions in pen should further be authenticated in the margin by the executants. Similarly, alternate clauses, if any, should be deleted under authentication of the executants. 1.2.11 Companies executing the documents under Common Seal should do so only after passing the necessary resolution for affixing the Common Seal. Further, the mode of affixing the Common Seal as set out in the Articles of Association should be followed. 1.2.12 When the documents are to be executed by a Partnership Firm, it should be ensured that all the partners execute the documents on behalf of the Partnership Firm as partners and also in their individual capacity. Minors who are admitted to the benefits of the partnership should not sign the documents. 1.2.13 When the documents are executed by the Power of Attorney (PA) holder, the original PA should be perused to ensure that the person giving the PA has properly executed the PA. The power so given should be verified to ensure that it contains the necessary power to execute the particular document. For instance, if mortgage is it to be created, the PA should contain powers to mortgage on behalf of the donors of the PA. If the mortgage is for securing credit facilities sanctioned to a third party and not to the donor of PA, then the PA should specifically contain the power to that effect. 1.2.14 Certain documents such as Wills, Mortgages, (other than Equitable Mortgage) etc. are required to be witnessed by 2 persons. Failing this, such documents will not be admitted in evidence. However, unless specifically provided for, no document should be witnessed / attested. 1.2.15 Properties should be described in detail in the schedules. Abbreviations should not be used for describing the nature of the properties (like S / BD / RM / FG & SFG for describing the Stocks, Book Debts, Raw Materials, Finished Goods and Semi-Finished Goods). 1.2.16 The immovable properties should be described with reference to their survey numbers, patta number, etc., along with their boundaries exactly as mentioned in the original title deeds. Location or site maps should always be drawn and kept along with the loan documents.

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1.2.17 All pages and schedules should be signed in full and in the same style throughout the documents. The name should be spelt out in block letters under the signature in the last page. Signatures should be at the end of every document and also at the end of the schedules. 1.2.18 When a document is executed by different persons on different dates, the executants should be requested to sign and record the dates under their signatures. Under law, the document is said to have been duly completed only when it has been executed by the last of the persons. The limitation period starts from the following day of the last date of execution by the last person mentioned in the document. 1.2.19 A document should never be ante-dated. If a date on the document appears to be prior to the date of stamping or the date of purchase of stamps, such document would be treated as invalid on the grounds that it has not been duly stamped. 1.2.20 The document should not bear double dates such as '25 / 26 May 2005. All documents should uniformly bear the same date. There should not be any variation in the dates on the documents executed by the same party. Subject to what is stated in paragraph 2.2.18 above, where the executant has recorded the date under his signature and the execution of the document is complete thereto, then the date of the document should not be different from the date on which the executant had signed the document. 1.2.21 Interest clause must be mentioned correctly. The rate of interest and the mode of payment / rests, viz., monthly, quarterly, half-yearly should be mentioned with sufficient clarity as per the terms of sanction. 1.2.22 Signatures of the persons should be obtained at the end of each page, wherever there are insertions, and on all the stamp papers affixed to the document. If a Borrower / Guarantor signs in left hand, a small note should be annexed to the document recording the said fact that the Borrower / Guarantor has so signed in left hand. 1.2.23. On behalf of the Bank only the authorised officer should sign on the last page of the document. 1.2.24 All the documents must be kept account wise along with the list of documents obtained and relative receipts / invoices under protective custody. 1.2.25 Keeping a document blank or even one or more columns in the document blank will render the document invalid. 1.2.26. Where the Borrower / Guarantor is an illiterate person, the contents of the documents should be explained in a language known to him and the fact of such explanation should be recorded. 1.2.27 If the executant is an illiterate person, his left hand thumb impression (right hand thumb impression in the case of women, by convention) should be obtained on all the documents. It is always advisable to obtain a photograph bearing clear identification of such person and the same should be kept on record. Thumb impression is also necessary for authenticating each and every blank filled in the document.

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1.2.28 In case the signature is in a vernacular language or the document has been affixed with thumb impression of the Borrower / Guarantor, it will be necessary to obtain a separate letter of declaration in the vernacular language confirming that the contents of the documents have been properly read over and explained to the executant in the vernacular language and that the executant has affixed his thumb impression or signature in vernacular language only after understanding the nature and contents of the documents. Additionally, it is also advisable to obtain a separate declaration from some persons known to the executant for confirming the execution of the documents by such illiterate person or if the person is a woman belonging to Muslim community, in his presence by such executant. 1.2.29 The preamble in the Bank documents does not provide for mentioning the name of the Branch where the account is to be operated; thus, where the facility is originally granted at a certain branch and it is to be availed at another branch at a later date and the relative accounts are transferred to that branch, it would not be necessary to obtain fresh documents. The place and date of execution of documents should, however, need to be stated in the documents. 1.2.30 While using non-judicial stamp paper, at least some portion of the pre-printed document should be hand-written / type-written on the stamp paper and the corresponding portion in the pre-printed document should be deleted from the document under authentication. Under no circumstances should stamp paper be pasted on the printed documents. 1.2.31 To sum up, the guidelines for execution of documents include the following: i) Documents could be typed or handwritten. ii) All the blanks in the documents should be filled up neatly and legibly with a standard brand of indelible ink and with the same pen. iii) The documents are to be executed in the presence of an Officer responsible for obtaining them, who should be able to identify the executant(s) personally. iv) Documents and the Schedules attached thereto should be got completed in one sitting, in the same ink and in the same handwriting. v) Executant(s) should sign in full and in the same style throughout all the documents. If he / they sign(s) in left hand, a small note should be annexed to the documents recording the fact of signing in left hand. Where there are many executants, (e.g. Partnership Firm) their names in capital letters should be written on the last page of the document below their signatures. vi) When the revival letter/confirmation of balance or other security documents are obtained subsequently, the signatures of the parties should be verified with the signatures in the original documents. vii) All types of additions, deletions, alterations, cuttings, overwritings, etc., must be authenticated by the executant(s) under his / their full signature. Overwriting or interlineations in a document should be avoided without any exceptions. This is because there is always a presumption in law that the unauthenticated interlineations, alterations, additions, cuttings, cancellations and deletions were made after the execution of a document. viii) The practice of filling up the documents by the Bank functionaries must be discouraged. ix) Date and place of execution should be mentioned. Where two executants are signing a document at different places and / or on different dates, the fact of their doing so and the correct date and place must be mentioned by them in their own handwriting. x) Signature of the executant(s) should be obtained on each page, wherever there are insertions and alterations and on each of the non-judicial stamp papers used for paying

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the stamp duty. If the Borrower(s) signs in left hand, a small note should be annexed to the documents recording the fact of signing in left hand. Where there are many executants, (e.g., Partnership Firm), their names in capital letters should be written on the last page of the document below their signatures. xi) Where the executant is an illiterate person, the contents of the documents should be explained to him / her in the language which he / she understands. A thumb impression witness letter should be obtained which should be signed by an independent witness. xii) Documents should be in accordance with the Letter of Arrangement and as per Terms & Conditions of sanction. xiii) Documents are to be in accordance with the Board Resolution, in the case of Companies. Appropriate resolutions for availment of the loan and execution of the documents are to be passed, in accordance with the Articles of Association. xiv) One set of the Letter of Arrangement duly acknowledged by the Borrower(s) / Guarantor(s) / Third Party Mortgagor(s) should be retained along with the documents. 1.3 Care to be taken after execution of the documents 1.3.1 The brief particulars of the documents should be recorded in the Cash Credit Register / Documents Executed Register, duly authenticated by the Officer(s) in whose presence the documents were executed. 1.3.2 Certain documents like Mortgage Deeds are to be registered with the Sub-Registrar of Assurances within 4 months of execution. Registration of mortgage requires that the Mortgage Deed is attested by at least two witnesses. An unregistered Mortgage Deed does not create a mortgage and is invalid in law. 1.3.3 Under Companies Act, particulars of certain charges like Hypothecation and Mortgage are required to be filed with the Registrar of Companies within 30 days from the date of creation of the charge. Otherwise, such a charge would be void against the liquidator and creditors of the Company. Pledge does not require registration with RoC. 1.3.4 An important change was brought about in the procedure for filing the particulars of charge with effect from 21.03.95, as under: a) The prescribed particulars together with copy of the instrument creating the charge / modification of charge shall be filed with the Registrar of Companies in Form 8 and Form 13 in triplicate. b) Form 8 and Form 13 shall be signed on behalf of the Company and the Bank. c) The Registrar of Companies shall affix stamp on the relative Forms and accompanying instruments with the word Registered under his signature with date and serial number and a copy thereof will be delivered to the Company and the charge holder. 1.3.5 Within 6 months of registration of charge, a search has to be made once again in the Registered Office of the Company and also in the Office of Registrar of Companies and a Search Report from the Company Secretary / Chartered Accountants is to be obtained regarding all such charges in favour of various creditors including the Bank. The Company should be requested to furnish photocopy of the Register of Charges maintained in the Registered Office of the Company (under Section 143 of the Companies Act) duly certified by a Notary Public. These two items are to be kept along with the other security documents

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1.3.6 Within the limitation period, Revival Letter as per the proper format is to be obtained. Signature of the Borrower(s) in the Balance Confirmation Letter / Revival Letter and in the original documents is to be compared to ensure that the Borrower has not changed the style of signing. 1.3.7 Annual Debit Balance Confirmation Letter should be obtained, which is to be stamped as an Acknowledgement of Debt. It is possible for the Bank to obtain a partial decree based on unqualified admissions made in the Revival Letter / Balance Confirmation Letter and as per duly approved Balance Sheet in an Annual General Body Meeting of the Company. 1.3.8 No credit facility should be released without execution of all the security documents including the guarantee document. If, however, some more documents are to be completed and the Borrower requests, on genuine grounds, for the release of the credit facilities before its completion, then a letter should be obtained from him. Thereafter, the approval of the sanctioning authority should be obtained in writing. Only after that, the release of the credit facilities or part of it should be considered on sound reasoning and without prejudice to the interests of the Bank. 2. TYPES OF SECURITIES: i) Immovable properties like house properties, plots of land, lease holds are the most common. ii) Amongst movables, shares, insurance policies, debentures, book debts, bank deposits, stock in trade etc., are a few examples. Whereas an immovable property is mortgaged, the movables are pledged or hypothecated. 2.1 MORTGAGES: i) A Mortgage is the transfer of an interest in a specific immovable property for the purpose of securing the payment of money advanced or to be advanced, by way of loan, an existing or future debt, or the performance of engagement which may give rise to a pecuniary liability (Sec.59 Transfer of Property Act). In a simple mortgage, possession is not delivered by the mortgagor. There is only a personal liability, failing which, mortgagee can proceed against the mortgaged property. The mortgagor sells his property to the mortgagee in a "Mortgage by Conditional Sale" subject to a condition, on the failure to repay within the stipulated time, the sale becomes absolute. Mortgagor delivers the possession of the mortgaged property in favour of mortgagee by way of usufructory mortgage. The rents accruing are appropriated towards part-payment of principal or interest or both. In a Deed of English Mortgage the mortgagor sells the property to the mortgagee, but subject to a provision that the latter will retransfer on payment. In the notified towns, mortgage is effected by deposit of title deeds with a covering letter. The intention of the mortgagor and delivery of title deeds are important.

ii) iii)

iv)

v) vi)

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vii)

Under Section 7 of Transfer of Property Act, any person competent to contract can transfer property. Therefore, a minor, insolvent, insane, idiot, Foreign Sovereign and Ambassador, alien enemy, felon, drunkard cannot execute a mortgage deed. A mortgage by a company should be duly authorised by a resolution according to the Articles of Association and transaction should not be ultra vires the Memorandum of Association. The charge thus created shall be registered with the Registrar of companies. In the event of a default, the mortgagee is entitled to file a suit for Foreclosure or a Suit for Sale as per the terms in the Mortgage Deed. Banks being financial institutions do file only suits for sale and for money.

viii)

ix)

2.2. PLEDGE: i) ii) iii) Pledge is a kind of bailment where an asset is delivered as security for the repayment of a debt. The possession is delivered by the borrower in favour of the Bank (e.g. lock & key, mundy type). When the goods are pledged with the Bank, it can sell them after giving reasonable notice to the borrower or sue for the amount and retain the pledged goods as collateral security (Sec.176 Indian Contract Act). '

2.3. HYPOTHECATION: i) ii) iii) Iv) Hypothecation is an equitable charge created on the goods. The actual physical possession is with the borrower, Under the hypothecation deed, the Bank is entitled to take actual possession. Once the Banker obtains actual possession, he has all the rights of a pledgee.

2.4. PLEDGE Vs HYPOTHECATION: i) ii) In pledge, the goods are under the lock and key of the Bank, while in hypothecation the borrower has possession of the goods, till the Bank regains it. Actual delivery of the goods is sine qua non in pledge; in hypothecation the notional charge is in favour of the Bank.

iii) In both the cases, the Bank has the right to sell and sue for balance or sue for money and keep the goods as collateral security. 2.5 LIEN: Banks enjoy the right of a general lien (Sec.171 Indian Contract Act). Until all the outstandings are cleared, the Bank can retain any valuable securities, documents etc. The Bank gets a right to sell them after giving proper notice.

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2.6. ASSIGNMENT: The borrower can assign an L.I.C. Policy etc., in favour of the Bank. All actionable claims can be assigned (Section 130 of Transfer of Property Act). 3.1. THE REGISTRATION ACT: i) Section 17 of the Act, enunciates that any transaction in immovable property worth more than Rs.100/- shall be done by way of Registered Document. ii) Section 49 lays down that, if the document is not registered: it shall not a) b) c) affect any immovable property comprised therein; conform any power to adopt; and be received in evidence.

iii) Registered Documents are conclusive and take effect against unregistered documents. iv) All registered documents are presumed to be duly executed. . 3.2. THE LIMITATION ACT: i) Limitation starts running from the date the cause of action arises e.g. execution of D.P. Note, etc. ii) While computing the period of limitation, certain periods are excluded: a) Time taken for obtaining certified copies; b) Time in legal proceedings (Sec.12); c) Time in pauper O.P's; d) Time spent in wrong courts; e) Period of Stay or Injunction; f) Time for obtaining consent/sanction of Government; and g) Period of defendant's absence from India (Sec.15). iii) Any admission of debt by borrower gives rise to fresh limitation. The admission may be by: a) Part payment; b) Letter admitting the debt; and c) Filing of Debtor's Insolvency Petition incorporating Bank's debt in the schedule. iv) Period of limitation: a) Money Suit 3 Years b) Mortgage suit for sale or foreclosure 12 years c) Suit for Declaration 3 years d) Suit for Redemption 30 years e) Suit for Foreclosure 30 years f) For Possession (Adverse Possession) g) For Execution of Decree 12 years (Art. 65) 12 years (Art. 136)

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Reference may be made to SSI/ SME and C&I Manuals of Instructions for detailed instructions / formalities to be observed in respect of documentation. 4. SME Segment Documentation A new set of security documents and operating guidelines has been introduced in the Bank w.e.f. 1st August 2005. For the existing accounts, the new set of documents is to be obtained at the time of enhancement of credit limits / reconstitution of firm etc. But in those States where stamp duty is payable ad valorem the borrowers may express their reservation against executing fresh documents because of the cost involved. In such cases old set of documents may be continued but for the enhanced portion the branches are to obtain Agreement of Loan cum Hypothecation (SME-2) and the Link Letter (SME-12). The new set has, in all, 12 documents which are available in a book format grouped under 7 categories: Initial Documents SME-1 Letter of Arrangement SME-2 Agreement of Loan cum Hypothecation SME-2A Letter furnishing the particulars of assets acquired after the execution of SME-2 SME-3 Guarantee Agreement Supplemental Document SME-4 Supplemental Agreement of Loan-cum-Hypothecation Documents / Recital for creation of Equitable Mortgage SME-5 Memorandum for recording creation of mortgage by deposit of title deeds. SME-6 Letter of confirmation for creation of mortgage by deposit of title deeds Documents / Recital for Extension of Equitable Mortgage SME-7 Memorandum for recording extension of mortgage by deposit of title deeds SME-8 Letter of confirmation for extension of mortgage by deposit of title deeds Documents for creation / Extension of Regd. Mortgage SME-9 Deed of Mortgage SME-10 Deed of further charge Complementary Documents SME-11 Revival Letter SME-12 Link Letter Miscellaneous Documents SME-13 Title Investigation Report (Withdrawn and replaced a new TIL)

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5. C&I SEGMENT -- SECURITY DOCUMENTS Particulars of the Documents A. Initial Documents 1. Agreement of Loan for overall limit 2. Agreement of Hypothecation of goods and assets 3. Agreement of Pledge of goods and assets 4. Deed of Guarantee for overall limits B. Supplemental Documents 1. Supplemental Agreement of loan for increase in the overall limit 2. Supplemental Agreement of Hypothecation of goods and assets for increase in the overall limit Form C.2-A 3. Supplement Agreement of Pledge of goods and assets for increase in the overall limit 4. Supplemental Deed of Guarantee for increase in the overall limit C. Complementary Documents 1. Letter regarding the grant of individual limits within the overall limit 2. Revival Letter Form Mortgage Documents 1. Deed of English Mortgage for term loan 2. Deed of further charge for increase in term loan 3. Memorandum of deposit for creation of charge for term loan/ overall limit. 4. Memorandum of deposit for creation of further charge for term loan/ overall limit where the initial charge is created by way of mortgage by deposit of title deeds 5. Form C.10 Memorandum of deposit for creation of further charge for term loan/ overall limit where the initial charge is created by a Deed of Mortgage. Form C.11 Form C.1-A Form C.1 Form C.2 Form C.3 From C.4 Document No.

Form C.3-A Form C.4-A

Form C.5-A Form C.6

D.

From C.7 Form C.8 Form C.9

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14(I) LOAN ADMINISTRATION - PRE-SANCTION PROCESS

APPRAISAL, ASSESSMENT AND SANCTION FUNCTIONS

1. APPRAISAL A. Preliminary appraisal 1.1 Sound credit appraisal involves analysis of the viability of operations of a business and the capacity of the promoters to run it profitably and repay the bank the dues as and when they fall due. 1.2. Towards this end the preliminary appraisal will examine the following aspects of a proposal. Banks lending policy and other relevant guidelines/RBI guidelines, Prudential Exposure norms, Industry Exposure restrictions, Group Exposure restrictions, Industry related risk factors, Credit risk rating, Profile of the promoters/senior management personnel of the project, List of defaulters, Caution lists, Acceptability of the promoters, Compliance regarding transfer of borrower accounts from one bank to another, if applicable; Government regulations/legislation impacting on the industry; e.g., ban on financing of industries producing/ consuming Ozone depleting substances; Applicants status vis--vis other units in the industry, Financial status in broad terms and whether it is acceptable, The companys Memorandum and Articles of Association should be scrutinised carefully to ensure (i) that there are no clauses prejudicial to the Banks interests, (ii) no limitations have been placed on the Companys borrowing powers and operations and (iii) the scope of activity of the company.

1.3. Further, if the proposal is to finance a project, the following aspects have to be examined: Whether project cost is prima facie acceptable Debt/equity gearing proposed and whether acceptable

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 Promoters ability to access capital market for debt/equity support Whether critical aspects of project - demand, cost of production, profitability, etc. are prima facie in order 1.4. After undertaking the above preliminary examination of the proposal, the branch will arrive at a decision whether to support the request or not. If the branch (a reference to the branch includes a reference to SECC/CPC etc. as the case may be) finds the proposal acceptable, it will call for from the applicant(s), a comprehensive application in the prescribed proforma, along with a copy of the proposal/project report, covering specific credit requirement of the company and other essential data/ information. The information, among other things, should include: Organisational set up with a list of Board of Directors and indicating the qualifications, experience and competence of the key personnel in charge of the main functional areas e.g., purchase, production, marketing and finance; in other words a brief on the managerial resources and whether these are compatible with the size and scope of the proposed activity. Demand and supply projections based on the overall market prospects together with a copy of the market survey report. The report may comment on the geographic spread of the market where the unit proposes to operate, demand and supply gap, the competitors share, competitive advantage of the applicant, proposed marketing arrangement, etc. Current practices for the particular product/service especially relating to terms of credit sales, probability of bad debts, etc. Estimates of sales, cost of production and profitability. Projected profit and loss account and balance sheet for the operating years during the currency of the Bank assistance. If request includes financing of project(s), branch should obtain additionally (i) appraisal report from any other bank/financial institution in case appraisal has been done by them, (ii) No Objection Certificate from term lenders if already financed by them and (iii) report from Merchant bankers in case the company plans to access capital market, wherever necessary.

1.5. In respect of existing concerns, in addition to the above, particulars regarding the history of the concern, its past performance, present financial position, etc. should also be called for. This data/information should be supplemented by the supporting statements such as: a) Audited profit loss account and balance sheet for the past three years (if the latest audited balance sheet is more than 6 months old, a pro-forma balance sheet as on a recent date should be obtained and analysed). For non-corporate borrowers, irrespective of market segment, enjoying credit limits of Rs.10 lacs and above from the banking system, audited balance sheet in the IBA approved formats should be submitted by the borrowers. b) Details of existing borrowing arrangements, if any, c) Credit information reports from the existing bankers on the applicant Company, and

d) Financial statements and borrowing relationship of Associate firms/Group Companies.

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B. Detailed Appraisal 1.6 The viability of a project is examined to ascertain that the company would have the ability to service its loan and interest obligations out of cash accruals from the business. While appraising a project or a loan proposal, all the data/information furnished by the borrower should be counter checked and, wherever possible, inter-firm and inter-industry comparisons should be made to establish their veracity. 1.7 The financial analysis carried out on the basis of the companys audited balance sheets and profit and loss accounts for the last three years should help to establish the current viability. 1.8 In addition to the financials, the following aspects should also be examined: The method of depreciation followed by the company-whether the company is following straight line method or written down value method and whether the company has changed the method of depreciation in the past and, if so, the reason therefor; Whether the company has revalued any of its fixed assets any time in the past and the present status of the revaluation reserve, if any created for the purpose; Record of major defaults, if any, in repayment in the past and history of past sickness, if any; The position regarding the companys tax assessment - whether the provisions made in the balance sheets are adequate to take care of the companys tax liabilities; The nature and purpose of the contingent liabilities, together with comments thereon; Pending suits by or against the company and their financial implications (e.g. cases relating to customs and excise, sales tax, etc.); Qualifications/adverse remarks, if any, made by the statutory auditors on the companys accounts; Dividend policy; Apart from financial ratios, other ratios relevant to the project; Trends in sales and profitability, past deviations in sales and profit projections, and estimates/projections of sales values; Production capacity & use: past and projected; Estimated requirement of working capital finance with reference to acceptable build up of inventory/ receivables/ other current assets; Projected levels: whether acceptable; and Compliance with lending norms and other mandatory guidelines as applicable 1.9. Project financing: If the proposal involves financing a new project, the commercial, economic and financial viability and other aspects are to be examined as indicated below:

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 Statutory clearances from various Government Depts./ Agencies Licenses/permits/approvals/clearances/NOCs/Collaboration agreements, as applicable Details of sourcing of energy requirements, power, fuel etc. Pollution control clearance Cost of project and source of finance Build-up of fixed assets (requirement of funds for investments in fixed assets to be critically examined with regard to production factors, improvement in quality of products, economies of scale etc.) Arrangements proposed for raising debt and equity Capital structure (position of Authorised, Issued/ Paid-up Capital, Redeemable Preference Shares, etc.) Debt component i.e., debentures, term Loans, deferred payment facilities, unsecured loans/ deposits. All unsecured loans/ deposits raised by the company for financing a project should be subordinate to the term loans of the banks/ financial institutions and should be permitted to be repaid only with the prior approval of all the banks and the financial institutions concerned. Where central or state sales tax loan or developmental loan is taken as source of financing the project, furnish details of the terms and conditions governing the loan like the rate of interest (if applicable), the manner of repayment, etc. Feasibility of arrangements to access capital market Feasibility of the projections/ estimates of sales, cost of production and profits covering the period of repayment Break Even Point in terms of sales value and percentage of installed capacity under a normal production year Cash flows and fund flows Proposed amortisation schedule Whether profitability is adequate to meet stipulated repayments with reference to Debt Service Coverage Ratio, Return on Investment Industry profile & prospects Critical factors of the industry and whether the assessment of these and management plans in this regard are acceptable Technical feasibility with reference to report of technical consultants, if available Management quality, competence, track record Companys structure & systems Applicants strength on inter-firm comparisons

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For the purpose of inter-firm comparison and other information, where necessary, source data from Stock Exchange Directory, financial journals/ publications, professional entities like CRIS-INFAC, CMIE, etc. with emphasis on following aspects: Market share of the units under comparison Unique features Profitability factors Financing pattern of the business Inventory/Receivable levels Capacity utilisation Production efficiency and costs Bank borrowings patterns Financial ratios & other relevant ratios Capital Market Perceptions Current price 52week high and low of the share price P/E ratio or P/E Multiple Yield (%)- half yearly and yearly Also examine and comment on the status of approvals from other term lenders, market view (if anything adverse), and project implementation schedule. A pre-sanction inspection of the project site or the factory should be carried out in the case of existing units. To ensure a higher degree of commitment from the promoters, the portion of the equity / loans which is proposed to be brought in by the promoters, their family members, friends and relatives will have to be brought upfront. However, relaxation in this regard may be considered on a case to case basis for genuine and acceptable reasons. Under such circumstances, the promoter should furnish a definite plan indicating clearly the sources for meeting his contribution. The balance amount proposed to be raised from other sources, viz., debentures, public equity etc., should also be fully tied up. C. Present relationship with Bank: Compile for existing customers, profile of present exposures: Credit facilities now granted Conduct of the existing account Utilisation of limits - FB & NFB Occurrence of irregularities, if any Frequency of irregularity i.e., number of times and total number of days the account was irregular during the last twelve months Repayment of term commitments

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 Compliance with requirements regarding submission of stock statements, Financial Follow-up Reports, renewal data, etc. Stock turnover, realisation of book debts Value of account with break-up of income earned Pro-rata share of non-fund and foreign exchange business Concessions extended and value thereof Compliance with other terms and conditions Action taken on Comments/observations contained in RBI Inspection Reports CO Inspection & Audit Reports Verification Audit Reports Concurrent Audit Reports Stock Audit Reports Spot Audit Reports Long Form Audit Report (statutory audit) D. Credit risk rating: Draw up rating for (i) Working Capital and (ii) Term Finance. E. Opinion Reports: Compile opinion reports on the company, partners/ promoters and the proposed guarantors. F. Existing charges on assets of the unit: If a company, report on search of charges with ROC. G. Structure of facilities and Terms of Sanction: Fix terms and conditions for exposures proposed - facility wise and overall: o o o o o o o o o Limit for each facility sub-limits Security - Primary & Collateral, Guarantee Margins - For each facility as applicable Rate of interest Rate of commission/exchange/other fees Concessional facilities and value thereof Repayment terms, where applicable ECGC cover where applicable Other standard covenants

H. Review of the proposal: Review of the proposal should be done covering (i) strengths and weaknesses of the exposure proposed (ii) risk factors and steps proposed to mitigate them (ii) deviations, if any, proposed from usual norms of the Bank and the reasons therefor. I. Proposal for sanction: Prepare a draft proposal in prescribed format with required backup details and with recommendations for sanction.

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J. Assistance to Assessment: Interact with the assessor, provide additional inputs arising from the assessment, incorporate these and required modifications in the draft proposal and generate an integrated final proposal for sanction. 2. ASSESSMENT: Indicative List of Activities Involved in Assessment Function is given below: Review the draft proposal together with the back-up details/notes, and the borrowers application, financial statements and other reports/documents examined by the appraiser. Interact with the borrower and the appraiser. Carry out pre-sanction visit to the applicant company and their project/factory site. Peruse the financial analysis (Balance Sheet/ Operating Statement/ Ratio Analysis/ Fund Flow Statement/ Working Capital assessment/Project cost & sources/ Break Even analysis/Debt Service/Security Cover, etc.) to see if this is prima facie in order. If any deficiencies are seen, arrange with the appraiser for the analysis on the correct lines. Examine critically the following aspects of the proposed exposure. o Banks lending policy and other guidelines issued by the Bank from time to time o RBI guidelines o Background of promoters/ senior management o Inter-firm comparison o Technology in use in the company o Market conditions o Projected performance of the borrower vis--vis past estimates and performance o Viability of the project o Strengths and Weaknesses of the borrower entity. o Proposed structure of facilities. o Adequacy/ correctness of limits/ sub limits, margins, moratorium and repayment schedule o Adequacy of proposed security cover o Credit risk rating o Pricing and other charges and concessions, if any, proposed for the facilities o Risk factors of the proposal and steps proposed to mitigate the risk o Deviations proposed from the norms of the Bank and justifications therefor To the extent the inputs/comments are inadequate or require modification, arrange for additional inputs/ modifications to be incorporated in the proposal, with any required modification to the initial recommendation by the Appraiser Arrange with the Appraiser to draw up the proposal in the final form. Recommendation for sanction: Recapitulate briefly the conclusions of the appraisal and state whether the proposal is economically viable. Recount briefly the value of the companys (and the Groups) connections. State whether, all considered, the proposal is

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a fair banking risk. Finally, give recommendations for grant of the requisite fund-based and non-fund based credit facilities. 3. SANCTION: Indicative list of activities involved in the sanction function is given below: Peruse the proposal to see if the report prima facie presents the proposal in a comprehensive manner as required. If any critical information is not provided in the proposal, remit it back to the Assessor for supply of the required data/clarifications. Examine critically the following aspects of the proposed exposure in the light of corresponding instructions in force: o Banks lending policy and other relevant guidelines o RBI guidelines o Borrowers status in the industry o Industry prospects o Experience of the Bank with other units in similar industry o Overall strength of the borrower o Projected level of operations o Risk factors critical to the exposure and adequacy of safeguards proposed thereagainst o Value of the existing connection with the borrower o Credit risk rating o Security, pricing, charges and concessions proposed for the exposure and covenants stipulated vis--vis the risk perception. Accord sanction of the proposal on the terms proposed or by stipulating modified or additional conditions/ safeguards, or Defer decision on the proposal and return it for additional data/clarifications, or Reject the proposal, if it is not acceptable, setting out the reasons.

4. Monitoring Delay in Processing Loan Proposal : Branches have to submit a report on credit proposals pending for more than 30 days in two parts. Part I will comprise proposals requiring sanctions at the Branch/ SECC/ ZCC and Part II will contain sanctions by CCC-II and above. Review reports to CCC-I and later to Group Executive for information at prescribed intervals will be coordinated by DGM (CCFO). The consolidated position in this regard in respect of all the Circles will be put up to MD & GE (NB) through GM (SME).

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14 (II). LOAN ADMINISTRATION - POST SANCTION CREDIT PROCESS

GENERAL 1. NEED

Lending decisions are made on sound appraisal and assessment of credit worthiness. Past record of satisfactory performance and integrity are no guarantee for future though they serve as a useful guide to project the trend in performance. Credit assessment is made based on promises and projections. A loan granted on the basis of sound appraisal may go bad because the borrower did not carry out his promises regarding performance. It is for this reason that proper follow up and supervision is essential. A banker cannot take solace in sufficiency of security for his loans. He has to a) b) c) d) e) make a proper selection of borrower Ensure compliance with terms and conditions Monitor performance to check continued viability of operations Ensure end use of funds. Ultimately ensure safety of funds lent.

2. Stages of post sanction process The post-sanction credit process can be broadly classified into three stages viz., follow-up, supervision and monitoring, which together facilitate efficient and effective credit management and maintaining high level of standard assets. The objectives of the three stages of post sanction process are detailed below. FOLLOW UP Ensuring Compliance with terms & conditions of sanction on an ongoing basis Ensuring performance safety & recoverability of assets. SUPERVISION Ensuring effective follow up to maintain asset quality Keeping look-out for early warning signals. MONITORING Ensuring effective supervision Monitor customer satisfaction Ensuring quick response to early warning signals.

(a) Follow up function To ensure the end-use of funds. To relate the outstandings to the assets level on a continuous basis. To correlate the activity level to the projections made at the time of the sanction/renewal of the credit facilities. To detect deviation from terms of sanction. To make periodic assessment of the health of the advances by noting some of the key indicators of performance like profitability, activity level, and management of the unit

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and ensure that the assets created are effectively utilised for productive purposes and are well maintained. To ensure recovery of the instalments of the principal in case of term loan as per the scheduled repayment programme and all interest. To identify early warning signals, if any, and initiate remedial measures thereby averting sickness. To ensure compliance with all internal and external reporting requirements covering the credit area. (a) Supervision function To ensure that effective follow up of advances is in place and asset quality of good order is maintained. To look for early warning signals, identify incipient sickness and initiate proactive remedial measures. (c) Monitoring function To ensure that effective supervision is maintained on loans/advances and appropriate responses are initiated wherever early warning signals are seen. To monitor on an ongoing basis the asset portfolio by tracking changes from time to time; Chalking-out and arranging for carrying out specific actions to ensure high percentage of Standard Assets. An indicative list of activities to be performed during the three stages mentioned above is furnished as Annexure- 2 to this chapter. The activities pertaining to the three stages are to be performed by different people. In order to make the process effective, it is necessary that the value additions and the focus should be different at each stage. 3. PHYSICAL FOLLOW UP 3.1. Statement of stocks & book debts 3.1.1. To ensure adequate security cover for our advances, follow up of stock statements is essential and it should remain under constant attention of the field officers. Further, such statement as on the annual balance sheet date should be obtained from every borrower enjoying advances against security of stocks/book debts. As assessment of working capital is based on the financial statements, valuation of stocks for the stock statement should be done in the same manner and adopting the same basis as for annual financial statements. 3.1.2. If a borrower has any genuine difficulty in submission of stock statement at monthly intervals, the sanctioning authority may permit the borrower to submit stock statement at longer intervals. The existing instructions are for submission of stock statement within 10 days of the end of the month (or such other periodicity as approved by the sanctioning authority). However, the Network General Manager may permit extension of the 10 days period, if warranted by the nature of the borrowers operations. Further, no penal interest is to be charged if the stock

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statement is submitted by the end of the succeeding month (instead of within 10 days of the succeeding month at present). If the borrower fails to submit stock statement within 3 months from the due date, the Bank may appoint a firm of Chartered Accountants (or other nominee) to get the books/ stocks checked as an audit process. In case of smaller accounts, this verification may be carried out by the Banks Officers. The stipulations regarding submission of stock statements, levy of penal interest, Banks right to appoint an agency to get the books/ stocks verified/ audited/ valued as an audit process, should form part of the arrangement letter to the borrower. 3.2.Drawing Power While regulating drawings in a cash credit (including WCDL) account within the drawing power (DP) of a borrowing company, it should be ensured that the DP is not given against such assets which have not been considered as current assets at the time of assessment and are accordingly ineligible for DP. For example, where plant spares` are classified as non-current asset for working capital assessment, this asset should not be considered eligible for DP though included in the stock statement. Stocks purchased under usance LCs should be excluded from the advance value of stocks and should not be reckoned for the purpose of drawing power. While allowing drawings in accounts on the basis of stock statements, it should be ensured that there is no double financing involved. Similarly, drawing power may not be given against old accumulated (non-moving) or slow moving stocks. Borrowers should be advised to make special efforts to clear such stocks. 3.2.2. In cases where cash credit limits are granted against book debts, a statement of book debts with age-wise break-up should be obtained along with the stock statement. Such book debts should be based on invoices and delivery challans. Drawing power should be allowed only on such book-debts as are within the norms accepted at the time of sanction. Generally, book debts of more than six months old should not be reckoned for giving drawing power. 3.2.3. For the purpose of fixation of drawing power, different components of stocks may be valued as detailed below: ITEM Imported raw material TO BE VALUED AT Landed cost (i.e., invoice value plus customs duty but excluding sales-tax and demurrage, if any.) or market price whichever is lower controlled -price, whichever is the lowest Cost of production or selling price or market price or Govt. controlled rates, whichever is the lowest Cost of production or selling price or market price or Govt. controlled rates, whichever is the lowest

Indigenous raw materials, packing Invoice price or market price or Govt. materials, consumable stores and spares Semi-finished goods Finished goods

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Variations in the prices of commodities against which advances are granted should be carefully examined to ensure that stock statements present correct value of assets. 3.2.4. In case of seasonal industries, the assessment is done on the basis of monthly/quarterly cash budgets and drawings should be regulated on the basis of these subject to the condition that the outstandings should not exceed the advance value of the security charged or the sanctioned limit, whichever is lower. For determining the advance value of security charged (value of security minus stipulated margin) the stock statements may continue to be obtained on the usual format. Similarly, considering the special features of tea, coffee and other plantations, the drawing power should be fixed corresponding to the methods followed for assessment. 3.3. Verification of assets Stocks pledged/hypothecated to the Bank must be inspected at irregular intervals which should ordinarily not exceed one month. The basic objective is to ensure that the stated stocks are physically there and the advances are adequately secured. All stocks should be thoroughly verified and compared with that mentioned in the stock statement. The inspecting official should make an ABC analysis of stocks and check all high value items. In other cases, verification may be done on a random sample basis. Different items should, however, be checked in different visits so that all the major items would be covered over a period of, say, four to six months. Checking on random sample basis should not, however, rule out repetitive checking of certain items. Where goods are stored in different places, inspection of all the godowns should be conducted simultaneously or on the same day. 3.3.2. The inspecting official should also keep the following guidelines in mind: (i) Stocks of raw materials, etc., with the unit should be verified with the latest Stock Statement. (ii) Where goods are excisable or subject to other statutory controls, the stock statement could be cross checked with the relative records. (iii) Where the Bank is the sole financier of working capital, the Banks name boards should always be displayed at the godowns/shops where the hypothecated stocks are stored. The display boards should be enduring and prominent so that these will serve as notice to the third parties of the Banks charge. (iv) The Field Officer must assess the level of activity from various sources, such as the order book, the work on the shop floor, number of shifts of working, accumulation of finished products and the general tempo of activity in the plant. When there is a decline in sales, production, and profitability, the reasons should be ascertained. Frequent visits to the same unit will automatically give him enough experience to get a quick feel of the tempo of activity. (v) The Field Officer must check if the books of accounts e.g., cash book, sales, purchase and stock registers are being maintained properly and kept up to date. If he notices any slackness in this respect, he must impress on the borrower the need to keep the books updated. Special attention must be given to the cashbook. Invoices may be checked at random to know the mode (credit or cash basis) and terms of purchase. Sales through associates or sister concerns and bills drawn on them should be monitored with extra care.

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(vi) Credit summations in the operative account should be compared with the amount of realisation of sale proceeds during the relevant period. If the credit summations and the amount of sale proceeds realised are not comparable, the reasons should be enquired into. (vii) Bills outstanding in the Banks books should be compared and cross checked with the units bills receivable registers. If bills are returned or payments delayed, the reasons should be enquired into. (viii) Checking quality of assets is another problem area and much would depend on the experience and technical competence of the inspecting officials. A feel could be had by looking for slow moving, old and accumulated stocks, rejections at the time of both purchases and sales by examining the relative records of purchases and sales returns, records of quality control and scrap, book debts under dispute and age of book debts. (ix) Order position - pending, being executed and anticipated- should be enquired into and matched with production and sales. This should be followed up in the subsequent inspections. (x) With the accent of follow-up on the activity level, the inspections could be held on the basis of pre-arranged visits to the unit instead of surprise visits. This does not rule out surprise visits altogether. The intention is that inspections based on pre-arranged visits would be more meaningful and mutually beneficial to the Bank and the borrowers. In cases where the unit has a separate administrative office, which maintains the books of accounts, the Field Officer must give advance intimation of his visit so that the necessary books could be brought to the factory for his inspection, if the duplicates are not maintained there. Large transactions in the units books of accounts particularly payments to branch/associate firms should be enquired into. (xi) The Field Officer must discuss with the borrower all factors that may have a bearing on the operation of the unit such as, potential changes in the market conditions, raw material supply position, power shortage, transport and labour problems, etc. Since the Field Officer has an opportunity of visiting a number of units in the area, he would be better informed about the environmental conditions and be able to guide the borrower, should the need arise. He could also be on the look out for any possible signs of dissension among partners. (xii) The accounts of the units should be regularly scrutinised and in case of those found irregular due to non-payment of instalments or excess drawings, the concerned units should be advised in writing to regularise the position. In view of the irregularity in the account, the Field Officers visit assumes greater significance as he would then be required to monitor the actions being taken by the borrower towards the adjustment of the irregularity. In fact, visits to units whose accounts are irregular must be accorded a priority in the timetable for Field Officers.

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(xiii)The Field Officer will have special responsibilities during his visits, if the unit has asked for enhancement or if disbursements have been made recently. The Field Officer should follow-up the end-use of the additional facilities granted in order to ensure that the terms thereof are strictly adhered to. (xiv) A list of all items of machinery pledged/hypothecated to the Bank should be prominently displayed in the factory premises and a legend Pledged/hypothecated to SBI, .. Branch boldly painted on the body of each machine. At the time of inspection, the field staff should physically verify each item of the fixed assets with those listed as per the records with the branch. The working condition of plant, machinery and equipment should be checked to ascertain that none of them remain idle. The inspecting official should ascertain the reasons for any machine lying idle. No item of machinery charged to the Bank should be removed from the factory, even for repairs, without the permission of the Branch. Where any machinery is taken out of the unit, prompt return thereof should be ensured and the relative item checked during subsequent inspection of the unit. (xv) The Banks officials should not record their observations on the books/ registers of the borrowers, not even on the stock statements submitted by them. The observations, if any, should be recorded on the prescribed inspection report on the unit on return to the branch and submitted to the Branch Manager. It should be retained in the file of the respective unit after taking necessary action, where warranted. The borrower should be advised in writing, about the irregularities observed, with a request to set right the position immediately. During the next visit, attention should be paid to check the progress made to rectify the irregularities observed during the previous visits. (xvi) Where doubts arise about quality or quantity, an expert opinion or even a stock audit could be stipulated. (please also see paras 3.5. and 3.6. regarding outsourcing of asset verification/ stock audit) 3.3.3. Each branch should maintain a suitable register showing at a glance, dates of inspection conducted. Inspection register has to be filled in after each inspection and duly authenticated by the officers concerned. Inspecting officials should also verify that the insurance policies adequately cover all the risks perceived by him. When inspection could not be completed for any reason, a note should be made in the Inspection Register giving the reason. On completion of the inspection, the inspection officials should set out their observations in inspection reports commenting, among other things, the important issues taken up with the borrower and the corrective measures proposed to be initiated by the borrower for rectifying the aberrations. 3.4. Frequency of inspection Frequency of inspection by different role holders should be as per the terms of sanction and the extant guidelines.(please also see para 3.6. below). Where there is shortage of field staff, Branch Manager can entrust the inspection of units with smaller limits to other officers, with the approval of the Controlling Authority. In the case of unsatisfactory accounts or where the exigencies so warrant (wide fluctuation in stocks, etc.) or units put under nursing plans, irrespective of the loan amount, inspection has to be carried out at shorter intervals, till the units activity stabilises or it is nursed back to health or the loan amount is recovered.

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Where term loans/other term assistance are granted as stand-alone facilities or granted along with working capital facilities, until the repayment of the last instalment under the term loan, inspection of the borrowing unit must be carried out half-yearly by the Manager of Division/Branch Manager assisted by the concerned field officer. 3.5. Stock Audit Units that are exhibiting symptoms of liquidity crunch may be considered for stock audit. Some of the symptoms are as follows: Pressing creditors Overdue interest and term loan instalments Stagnant stocks Undue delay in submission of stock statements Falsification of chargeable current assets Too many and significant qualifying remarks about stock/ receivables in auditors report in the balance sheet, etc. On observation of such unsatisfactory features, a stock audit may be considered. Unless waived by the sanctioning authority, annual stock audit should be prescribed in accounts of Rs. 5 Crores and above rated SB12 and below. Stock audit would cover audit of stocks and receivables. The quantity, quality and value of the current assets should be examined and compared with the build-up of current assets projected at the time of assessment of the WC advances. The system of inventory and receivables management followed by the unit should also be studied. Wherever necessary, approved valuers or Chartered Accountants may be engaged for conducting stock audit, but care should be taken to keep the cost reasonable and minimum, as it is to be borne by the borrower. For loans sanctioned by the circle authorities up to the level of General Manager, stock audit may be conducted with the prior approval of the concerned sanctioning authority. In respect of loans sanctioned by Circle Credit Committee and above, the GM of the network concerned may decide to conduct stock audit of a borrowing unit. For accounts serviced by CAG branches, CGM (CAG-Central) would accord the necessary approvals for stock audit. 3.6. The instructions regarding Inspections and Outsourcing of Asset Verification have been revised and the approach to be adopted is as under: CAG Considering that the audited balance sheets of the large corporate borrowers are drawn after complying with the stringent audit standards and the quarterly results of the corporates give enough insights into the activity of the borrower, decision to outsource Asset Verification for CAG borrowers (including Public Sector units) is left to the discretion of CGM-CAG. However, extant guidelines for periodic inspection by Banks officials will continue to be applicable. MCG/NBG Credit Facilities of above Rs.50 lacs All borrowers of MCG and NBG enjoying credit facilities of above Rs.50 lacs will be subjected to Asset Verification by outside agencies as under: (a) SB1 to SB7 rated borrowers may be exempted from mandatory asset verification from outside agencies. However, the Banks officials will continue to carry out inspections at quarterly intervals as against monthly.
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(b) SB4 and below rated borrowers may be subjected to yearly asset verification by outside agency. However, the controllers may waive this stipulation on a case-to-case basis depending on the conduct of the account and business consideration. Further, Banks officials will continue to conduct monthly (or more frequently, if specifically prescribed by the sanction authority or controllers) inspections as hitherto. MCG/NBG Credit Facilities of Rs.50 lacs and below The units with total credit facilities of Rs.50 lacs and below may be exempted from mandatory Asset Verification by outside agency. Banks officials will continue to conduct monthly inspections as hitherto 3.7. Insurance Except where the Bank has agreed to dispense with insurance, stocks/fixed assets under pledge to the Bank must be kept fully insured to the extent of market value of the security. The cost of insurance will be borne by the borrower. The policies must stand in the joint names of the borrower and the Bank. The expiry date of the respective insurance policies must be diarised in the daily list in order that their renewal, when necessary, may not be overlooked. For detailed instructions regarding insurance of stocks and other assets financed by the Bank as also assets charged to the Bank as collateral security, please refer to paragraphs 1.40 to 1.56 Chapter-1 of the Manual on Documentation. Units handling hazardous substances, so notified by the Government from time to time, in quantity equal to or exceeding a stipulated quantity of each substance should take out insurance as per the provision of the Public Liability Insurance Act, 1991. 3.7.2. Unless insurance is specially waived, all fixed assets are required to be kept fully insured with an approved insurance company in the joint names of the borrowers and the Bank (except where indicated otherwise), the cost of insurance being borne by the borrowers. The policies, cover notes, premium receipts etc. should be retained with the Bank. The authority who can waive the insurance of immovable properties accepted as collateral security is the Controller in the case of branches with Scale V incumbency and below and sanctioning authority in all other cases. The buildings, factories, and galas, fittings and fixtures, and machinery (which form part and parcel of the immovable property) are required to be kept fully covered by insurance against the risk of fire as well as lightning. The mortgaged properties should also be covered against riots, strikes, civil commotion, cyclone, earthquake and other calamities whenever such risks are apprehended and insurance cover against them is deemed necessary by the Bank. The borrower should give an undertaking to make punctual payment of all premia and not to do or suffer to be done any act which may invalidate such insurance during the currency of the term loan. Insurance policies in respect of hypothecation advances may be permitted to be retained with the borrower.

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To cover against possible risk of loss on account of fire, all the fixed assets should be insured for the full market value. It should be ensured that the dates of commencement and expiry of risks are clearly and correctly mentioned in the policy. Full address and the type of construction of the godown/factory/building, description of the property with specific godown number/ survey number etc. should be correctly mentioned. Machinery/equipments taken as collateral security should be described in general terms and a definite cover therefor should be stipulated. Whenever risk is apprehended as in the case of riots, strikes, civil commotion, cyclone, earthquake and other calamities, the borrower should be advised to arrange for the necessary insurance cover and if, there is no immediate response from the borrower, the insurance should be effected by the Bank at the borrowers cost. The terms of every insurance policy must be carefully examined to ensure that they are sufficient to secure the Bank. The terms of the policy must be rigidly complied with so that no claim may be disputed by the insurance company on the ground that the borrower has made a false declaration or has with the privity or connivance of the Bank, failed in any particular to keep his part of the contract. Field staff should immediately report to the branch manager any infringement of the conditions of the insurance. 3.8. Summary of Physical Follow Up The essentials of physical inspection should not be confined to merely checking physical existence of stocks but also general overview of the borrowing units operations and can be summarised as under: 1. Inventory Based a) Existence of security cover b) Correctness of data declared in the stock statement c) Quality of goods; in particular slow moving or non moving goods, rejects, scrap, wastage, unbalanced inventory etc.

d) Validity of pricings e) Book keeping whether up to date f) Systems of stock issues/reconciliation with physical quantity g) Conformity with other records- excise/sales tax registers etc 2. Operations a) General tempo of activity b) Number of shifts worked c) Present operating trends- percentage of capacity utilisation, idle machinery/labour hours

d) Orders on hand

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e) Realisation pattern of book- debts/bills f) Availability of raw materials, stores, spares, power and fuel g) Labour situation h) Marketing difficulty, if any, observed i) j) k) Any undue turnover in key operating personnel Any change in management set up Signs of incipient sickness, if any

3.9. In respect of large industries the inspecting officials need not necessarily focus on verification of physical quantity which is practically infeasible owing to the sheer size and magnitude of the goods charged to the bank, but on obtaining a general appreciation of the borrowing companys working. However, no impression should be given to the borrower that the inspecting official is casual in his approach. The endeavour of the official should be to select a few items randomly through A,B,C analysis. In respect of consortium advances, inspection should be carried out by the lead bank and one or two other members jointly in such a manner that by rotation all the member banks are involved. The inspection note should be circulated to all member banks for the purpose. Whenever the Bank conducts the inspection either as the lead bank or as a member of the consortium, the inspection report may be put into use. If, however, the Bank is not the lead bank and the lead bank has devised some other format, which serves the purpose of follow-up, the same may be accepted and the use of the Banks format need not be insisted upon In case of multiple banking arrangements where credit facilities against hypothecation of stocks from various banks are permitted, the borrower should submit a stock statement together with a statement of loan outstandings on the date of stock statement from other concerned bank branches. Each banks name board should be invariably displayed at the godowns/shops, where the stocks hypothecated to the concerned bank are stored, for public notice of that banks charge, especially in case of advances to partnership/proprietary concerns and individuals. 4. Financial Follow up

Financial follow up is required to verify a) whether the assumptions on which lending decision was taken continue to hold good both in regard to borrowers operations and the environment and b) whether the end use is according to the purpose for which the loan was given. In order to ensure a meaningful follow-up and supervision of advances of the Bank, branches should obtain on an ongoing basis, among other things, stock statement, cash budget, if any, Financial Follow-up Reports (FFRs) where applicable, monthly statement of select operational data etc. The monthly statement of select operational data shall be selectively obtained from only such industrial borrowers where we are the consortium leaders and where the borrowers credit rating is SB4 or below. This monthly statement serves as a follow-up format helping the concerned field staff to verify whether the borrowing industrial unit is attaining the planned production and its levels of inventory and receivables are within the levels projected at the time of sanction of the working capital credit limits. A close scrutiny of monthly select operational data (MSOD) gives the field staff an idea of the units actual operations vis--vis the planned production and sales levels and whether the levels of inventory and receivables are as projected at the time of sanction of the working capital credit limits. If the level of actual production is significantly lower than the level projected, i.e., if the
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actual level of production is lower by 10 per cent or more compared to the projected level, branches must find the reasons for the same and satisfy themselves as to the adequacy and efficacy of the corrective measure initiated by the unit. The actual figures in respect of all the items of cost of production should be compared with the respective figures projected for the period under review. If there are large variances, they should be investigated. Where the estimated sales turnover is not realised and all the items of the cost of production are not contained within the projected level, the indications are that there could be serious aberrations in the working of the unit causing decline in profitability. Stocks should normally be regularly turned over. If there is any accumulation of finished goods, semi-finished goods or raw materials, reasons therefor should be enquired into. Stocks-inprocess should be in proportion to the time for conversion of raw material into finished goods. In case of wide variance in the turnover of inventory, not being commensurate with the level of activity, explanation from the unit should be called for inasmuch as inventory should bear a relation to the scale of operation of the unit. Level of stocking should be compared with the value/quantity assumed at the time of credit assessment. Some of the signals listed below may warrant a closer supervision by the branch officials: (i) the actual level of production falls below the break-even point i.e., failure to sustain the capacity utilisation level well above the break-even point. (ii) (iii) (iv) (v) (vi) Cost of production is higher than what was projected at the time of sanction Not able to achieve the projected sales turnover Excessive inventory holding not commensurate with the scale of operation Rising trend of ageing receivables Failure to meet the repayment obligations like term loan instalments, etc.

If the trend persists from quarter to quarter, Branch Managers should study the units functioning to ascertain the reasons of the unsatisfactory features and take up the matter appropriately with the borrowing unit at the highest level so that the necessary corrective measures are initiated in time. 4.2. Financial Follow-up Reports (FFR) Analysis of financial statements furnished by the borrowers at the time of review /renewal helps the operating functionary to analyse the above. The process of such analysis has been detailed in the chapter on Financial Statement of Analysis. But if the branch were to wait for the annual financial statements audited or otherwise it may be too late for the branch to react to any adverse features. Meanwhile there could be increases in the exposure that could have otherwise been avoided. Hence the system of quarterly information system was devised to elicit relevant financial information on an ongoing basis. It is at present applicable to all units with find based working capital limited Rs. 5 crores and above except for specific sectors such as NBFCs, sugar, Tea etc. where alternative methods of follow up exist. The information system prescribed in the form of Financial Follow up Reports (FFR) are expected to perform the following basic and essential functions 1. 2. To enable banks to monitor performance of borrowing units in relation to projections submitted earlier To ensure compliance regarding levels of current assets projected and the manner of financing them

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3. 4. 5.

To ensure compliance with other financial covenants prescribed at the time of sanction To verify whether end use of funds is proper and there has been no diversion of short term funds to long term uses or outside the business altogether To serve as an early warning signal in respect of any incipient sickness

The financial follow up involves scrutiny of the statements FFR I and II and examination from the point of view of testing the hypotheses on which the lending decision was taken and whether borrowers operation warrant continued repose of faith. The specimens of FFRs and the focus areas of examination are dealt with in detail in Annexure 1. 4.3. Follow-up of advances given in consortium/ multiple banking arrangements: The system of FF Reporting will also be applicable to working capital finance given by the Bank in multiple/consortium banking arrangements. In the case of consortium arrangements, problems may arise if a different supervision system is followed by other member banks. Where the Bank is the leader of the consortium, in such cases, the consortium should be persuaded to adopt the FF Reports. Where this is not possible, branches may, on their own, adopt the reporting by FFRs by separate arrangement with the borrower. Alternatively, they may adopt the system followed by the consortium if it effectively serves the purpose of follow up after obtaining necessary approval of authorities. 4.4. Financial Follow up - Summary a) Scrutinise a. b. c. d. Ledger accounts, drawing by cheques, credit/debit summations The liability registers, Cheque referred register, bill registers Asset Hypothecation Register Comparison of monthly stock statements and Monthly Select Operational Data (MSOD) b) Call for a. b. c. c) Annual financial statements and examine them Other requisite data for renewal exercise Market/opinion reports

Where Applicable a. b. c. d. Call for FFR Monitor with projections Verify changes in financing of current assets Probe large variances

4.5. Monitoring of large withdrawals Branches should have in place a regular system of scrutinising the large withdrawals in the borrowal accounts in all cases of borrowers enjoying fund-based working capital facilities of
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Rs.10 crores and above from the banking system. For effective compliance, branches may take the following steps: a) Adopt a practice of obtaining advance information from the borrowers about each large drawing of Rs.50 lacs and above expected to be made during a coming period and verify the purpose of these drawings. This will help the branch to monitor, in advance, the end use of the funds. b) Where information, as above is not available in advance, branches should disallow drawings of Rs.50 lacs and above in cases where any other information available with the Bank and the apparent purpose of the drawings both establish without doubt that the drawings are only for unauthorised diversion of working capital. c) In other cases, i.e., where information as in (a) and (b) above is not available, branches should seek, wherever possible, information regarding the purpose of the drawings (Rs.50 lacs and above) and satisfy themselves. Where such prior scrutiny is not possible, branches may permit the drawings subject to post-facto scrutiny of the purpose of the drawings and action thereon, as appropriate, where the drawings constitute diversion.

5. Legal Follow up The purpose of legal Follow up is to ensure that the legal recourse available to the bank is kept alive at all times. It consists of obtaining proper documentation and keeping them alive, creation of charges, insurance and proper follow up suit filed accounts. 1. Legal follow up 1. Documentation i. On the current format ii. Adequately stamped iii. Properly executed by the appropriate persons iv. Complete in all respects v. Revival letter obtained in time 2. 3. Compliance with all terms and conditions of sanction Equitable Mortgage i. Possession of correct title deeds and comprehensive legal opinion ii. Creation of equitable mortgage recital to be complete iii. Confirmatory letter iv. Extension cross references 4. Company Accounts i. Registration of charge with ROC ii. Board Resolution for borrowing/excess drawing/guarantees

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5.

Insurance i. Full coverage of risks ii. Noting of Banks charge iii. Renewal of policy on time

6.

Vehicle loans i. Registration of Banks charges with RTA

6. Reporting for control Officers exercising financial powers delegated to them for sanction of loan should report the sanctions regularly and promptly within the 10th of the succeeding month, to the controlling authorities who will scrutinise the returns diligently. 6.2. Reporting of Irregularities Loans and Advances where outstandings exceed the drawing power are to be deemed as irregular. For the purpose of irregularity reporting, arrears of interest and instalments are to be reckoned as irregularity. The drawing power against security of stocks/goods/receivables and current bills subject to sub- limit fixed would be deducted from outstandings to determine the irregularity. For the purpose of reporting irregularity, outstanding in excess of the Advance Value of Security (Value of Stocks / receivables minus Margin) to be treated as clean drawings. Thereafter it would be reported for confirmation as per financial powers delegated at various levels. Advances against documentary bills i.e. bills accompanied by RR/BL/LR of approved transport operators, receipted delivery challans of approved customers are to be treated as secured advances against bills. Otherwise, the relative bills will be treated as clean, whether current or removed from cover, for the purpose of exercise of financial powers. 7. Follow up of term loans As a term loan is repayable out of cash accruals generated over a period of time, it is essential that a project is monitored, supervised and followed up on an ongoing basis throughout the currency of the term loan. The scope of post-sanction follow-up extends beyond merely ensuring the observance by the borrower of the terms and conditions governing the advance. It involves performance evaluation of the borrowing unit to ensure that the projected sales and profit are achieved and the loan is repaid as scheduled. The post-sanction follow-up in case of term loans can be divided into two categories i.e., follow-up during implementation stage and follow-up after commencement of commercial production. A. Follow-up during the implementation stage The main objectives of follow-up at this stage are: (i) To ensure that the borrower mobilises the means of financing tied up for the project as per schedule and according to the requirements of the implementation of the project; (ii) To ensure that all funds so raised are utilised for the approved purpose without any part thereof being wasted or diverted for any other purpose;

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(iii) To ensure that the physical progress of the project is in accordance with the project implementation schedule facilitating completion of the project in time without giving rise to any overrun; and (iv) To ensure that, in case any overrun arises for unavoidable reasons beyond the control of the borrowing unit the promoters bring in their proportionate contribution to finance the overrun, the balance being provided by the term lenders by granting term loans in the same ratio in which the original term loan requirements were shared by them. Follow-up at the implementation stage begins soon after sanction of the Banks term loan is communicated to the borrower. During the implementation of the project, branches should obtain progress reports at quarterly intervals and conduct periodic site inspection. Branches should also obtain audited annual financial statements i.e., balance sheet and profit and loss account, where the project implementation extends beyond one accounting year. (i) Periodic progress reports: From the periodic progress reports, the following aspects should be carefully examined:

Physical progress in implementation of the project (a) Position regarding obtention of consents from Government and others. (b) Position regarding acquisition of land and development of site. (c) Progress made in construction of factory and other buildings. (d) Position regarding placement of orders for plant & machinery, other equipments and their delivery schedules. (e) Position regarding installation of the plant, machinery and other equipments at site. (f) Position regarding availment of technical know-how and engineering services, where applicable. (g) Position regarding the training of technical staff and other operating staff engaged in the implementation of the projects, (h) Position regarding completion of formalities for disbursement of term loans by financial institutions and for public issue, if envisaged. Progress in mobilisation of the means of financing (a) Progress made in the mobilisation of the means of financing tied-up for the project viz., promoters contribution, public issue of share capital, loans from financial institutions/banks, Central/State subsidy, public deposits, etc. (b) Position regarding the capital expenditure already incurred/to be incurred under various heads and the sources from which they were/will be met. (c) Position regarding overrun, if any, in the cost of the project and the progress made in the mobilisation of the means of financing tied-up therefor. (ii) Periodic site inspection: During the project implementation stage up to the commencement of commercial production, site inspection should be carried out by the Manager of the Division/Branch Manager at quarterly intervals with a view to verifying the physical progress of the project (as indicated by the borrower in the periodic progress reports) vis--vis the project implementation schedule. Where Bar Chart or PERT/CPM

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(Programme Evaluation and Review Technique/ Critical Path Method) Chart is used by the borrower for monitoring project implementation, Manager of the Division/Branch Manager must familiarise himself with the Bar Chart or PERT/CPM Chart techniques of monitoring project implementation to be able to effectively monitor utilisation of bank loan and corresponding progress in project implementation. In comparatively smaller projects, it may not be feasible to make use of PERT/CPM techniques. In such cases, the Bar Chart may be used as an effective technique for monitoring project implementation PERT/CPM Chart should be insisted upon in respect of all projects with total cost of Rs.10 crores and above. On completion of the site inspection on each occasion, the inspecting officials should set out their observations in inspection reports. If any adverse developments in project implementation are noticed, branches should send a comprehensive note to the controlling authority with their recommendation for future action to protect the Banks interest. Copies of the Quarterly Progress Reports with enclosures thereto and the inspection report as above should be filed chronologically and made available for scrutiny by the Banks Inspectors/Auditors. At the end of the implementation of the project, a final report thereon should be called for, indicating (i) the items of capital expenditure constituting the total cost of the project and the various sources of funds mobilised as the total means of financing, (ii) the details of the trial runs conducted and (iii) the date of commencement of commercial production. On the basis of this final report, a detailed analysis of all the items of the cost of the project and the means of financing should be carried out to ascertain whether there were any major departures in the actuals from the original estimates and whether the actual implementation of the project has been in accordance with the project implementation schedule. All the significant variances should be examined critically with a view to ensuring that the overall performance/success of the project will not be impaired thereby. Abnormal variances should be reported to the controlling authority for information. The office copies should be filed along with the periodic progress reports and made available for scrutiny by the Banks Inspectors/auditors. At times, due to delay in stabilisation of commercial production as compared to the original schedule, borrowers request for a rescheduling repayment/ restructuring of the relative loans. In this context, stabilisation of commercial production would mean that the unit is in a position to achieve cash break-even to service the interest and term loan instalments i.e., the commercial operations result in generation of regular cash flow for servicing of loans. Since the commencement of commercial production and its stabilisation as above has important implications not only for the ultimate health of the advance but also its classification under IRAC norms, field staff should ensure close follow-up and constant interaction with the unit at this stage. Any genuine requirement for rescheduling should be looked into at this stage and immediately acted upon to avoid classification of the unit as Substandard and the resultant cooling period in an otherwise viable project. B. Follow-up post-commercial production Once the commercial production commences, the unit would be required to submit half-yearly progress reports. The follow-up at this stage would primarily relate to the day to day operations of the unit i.e., the level of activity, management, profitability, etc. such that in the long run, the loans are secured and continue to be standard assets. To this end, the field staff should conduct regular inspections diligently and intelligently using the monthly select operational data, periodic financial statements, etc. stated elsewhere in this Chapter. At the end of every year, the performance of the unit should be measured in terms of :
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predetermined benchmark levels for current ratio, TOL/TNW and interest coverage ratio, default in payment of interest/instalment to the Bank, default in payment of instalments/interest to other institutions/banks. If the unit is not able to perform satisfactorily, penal interest may be charged in the term loan account. 8. General Guidelines 8.1. Daily list: Daily list should be maintained for obtention of revival letters and recording due dates of bills, insurance policies, submission of financial statements and stock statements, renewal of limits, payment of instalments of term loans, dates of hearing in respect of suits filed. Daily list should be scrutinised regularly for initiating required action and borrowers reminded wherever necessary at the appropriate time. 8.2. Usage Of Credit Limits: Branches should ensure that drawals for cash credit/overdraft accounts are strictly for the purpose for which the credit facilities have been granted. There should be no diversion of working capital finance for acquisition of fixed assets, investment in associate concerns, acquisition of shares, debentures, units of mutual funds, buy-back of own shares, etc. Such diversion should be treated as misutilisation of working capital funds. Branches should ascertain from the audited balance sheets of all corporate borrowers, the details of the investments such as Inter-Corporate deposits/investments made in associate companies/ subsidiaries/real estate, etc. It is quite likely that corporate borrowers may have invested short-term surpluses in Inter Corporate Deposits, money market instruments, money market mutual funds, etc. without affecting the working capital flow or reducing the original level of Net Working Capital. Further, it is possible that in some cases such investments may not be diversion of Banks working capital finance, but the funds have been invested only from acceptable long term sources concurrent with full compliance with the projected current ratio and NWC at the assessed levels. In these cases, branches may, subject to verification of the actual sources of such investments, not treat such investments as diversion. However, in cases of other investments of long term nature or poor liquidity, branches should prima facie treat these investments as diversion of the Banks working capital finance and seek from the borrowers recall of the amounts so invested and deposit of the funds in working capital accounts. Recall of such amounts and deposit in working capital accounts will not call for reduction in working capital limits; the borrowers may be allowed to continue to operate the limits provided funds are utilised strictly for working capital purposes. The interest on funds so diverted should be charged at 2% above the lending rate applicable to the borrower, for the period involved. In case a borrower is unable to repay the amount recalled as stipulated above, within a reasonable period, the existing working capital limits should be reduced to the extent of the amount of such investments. Drawings in excess of the resultant reduced limits should be treated as irregular drawings and appropriate measures, restrictions on further drawings in the account, etc. should be initiated till the account is regularised within the reduced limit. To guard against diversion of funds, declarations at half yearly intervals should be obtained from the borrowers on the details of accounts opened with other banks.

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The sanction letter should cover the various terms and conditions of sanction. As part of the post-sanction credit process compliance by the borrowers of all terms and conditions of sanction should be ensured till loans/advances are liquidated. During the annual renewal / review exercise, the observance of compliance should be examined 8.3. Sundry Creditors and Sales: A watch on the sales and level of sundry creditors should be maintained. It is not unlikely that the level of sundry creditors is higher in some cases than originally envisaged at the time of sanction of the limit, or that the actual sales are lower than projected. In such cases, there is a distinct possibility of diversion of funds and the operating staff should be on guard. Where full information is not forthcoming and where there is justification to conclude that the borrower is guilty of a breach of trust and is withholding information deliberately, branches should not hesitate to exercise the right to refuse drawings for unauthorised purposes. Branches should also suitably bring down the drawing power in case there is definite evidence of the borrower having run up disproportionately large credits on purchases. 8.3.2. In order that a uniform treatment be accorded to sundry creditors, it has been amplified as follows: The borrowing units current assets are financed by NWC, Sundry Creditors, OCLs and bank borrowings. In such a mix bucket of finance, it may need to be assumed that sundry creditors and bank borrowings finance chargeable current assets and OCLs meet units lock up of working capital funds in OCAs. The level of CAs and CLs projected by a borrowing unit and accepted by the bank while assessing working capital requirements, bind sundry creditors and bank borrowings to chargeable current assets in certain percentage term; this inter-se relation should be treated as benchmark to monitor the respective levels shown in the stock statements in subsequent period. Double financing through bank finance gets captured in change in level of bank borrowings and/or in the pattern of individual sources of finance (OCLs including sundry creditors, NWC and bank borrowings). It invariably leads to slip back in the current ratio and reduction in NWC. As long as NWC is not diluted and there is no slip back in the current ratio and drawings are within the working capital bank finance limit, the unpaid stocks need not be deducted (except that acquired through usance L/C for which specific instructions are in place) from the chargeable current assets shown in the stock statement. Drawal allowed from cash credit / overdraft based on drawing power should not result in double financing of chargeable current assets. To this end stock statement (as also FFR 1 etc.) submitted by a borrowing unit should be scrutinized to see: If changes in net working capital is in tandem with change in value of inventory and receivables; If changes in level of bank borrowing is in tandem with change in value of inventory and receivables; and If there is any significant change in the patter of individual sources of finance for current assets and if so, whether it is acceptable.

The aforementioned exercise is undertaken to ensure that drawals from cash credit / Overdraft accounts based on drawing power are strictly for the purpose for which credit facilities have been granted. There should be no diversion of working capital funds for
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acquisition of fixed assets, investment in associate concerns, acquisition of shares, debentures, units of mutual funds, buy back of own shares etc. Such diversion should be treated as misutilisation of working capital funds. 8.4. Allocation of limit: Usually at the time of sanctioning credit limits, sanctioning authorities may permit at the request of a borrower, allocation of a portion of the limit to other branches of the Bank at different centres for the operational convenience of the borrower. However, in case such approvals could not be obtained along with the sanction, necessary approval for allocation of limits may be obtained from the Dy.General Manager concerned. No control reporting would be necessary in respect of such approvals. Under this arrangement, the allocating branch will directly pass on necessary instructions to the allocatee branch with copies of such communication endorsed to the LHO concerned /controlling authority of the latter. The responsibility for the conduct and safety of the accounts of companies having advances in more than one branch, as in the case of allocation of credit limits, rests with the branch in which the principal accounts are maintained. Appraisal of the credit limit, obtention of sanction from the appropriate authority, documentation, review/renewal of limits, reporting of irregularities in accounts including those arising at the allocatee branch and other functions relating to overall monitoring of the advance shall be the primary responsibility of the allocating branch maintaining the principal accounts of the concerned borrower company. The specific responsibility of the allocatee branch would be to (i) comply with the instructions of the allocating branch covering periodic inspection, obtention of stock statements, conduct of accounts on the terms prescribed, etc. and (ii) keep the allocating branch informed of significant developments in respect of the conduct of the account. Drawals exceeding the allocated limit in the allocated accounts should be transferred to the allocating branch through Branch Clearing General Account. The latter should immediately respond to the relative advice by debit to the borrowers main operating account to have an effective overall control on the total drawings. Further, the debits should be value-dated to avoid income leakage. 9. Conduct of Special Audit in cases of Default / diversion of funds Cases where special audit is to be ordered: Suddenly the unit declares huge losses Unit makes a reference to the BIFR within a year of declaring profit and good performance Sudden depletion of current assets or sharp fall in Drawing power without corresponding reduction in outstandings Company writes off substantial amount of receivables which leads to deterioration in the financials Other consortium members inform the Bank about the unsatisfactory features which might affect all the lenders Frequent occurrence of irregularity, development of LCs, return of cheques etc. When investments made either in associates or otherwise unrelated to business, which resulted in deterioration in financials of the unit beyond the accepted levels stipulated in the Banks loan policy.

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The above mentioned instances are some of the trigger points for considering SA. But, the decision to conduct a SA will be very selective keeping in view the facts and circumstances which led to the default / diversion of fund. Accounts to be covered under Special Audit SME accounts Fund based limits of Rs.2 cr. and above Mid-corporate accounts in non-Mid- All such accounts Corporate owned branches (under NBG) Mid Corporates & CAG accounts All accounts The Bank may arrange for special audit independently in Consortium advance or Multiple Banking Arrangement. Consensus of the consortium desirable but need not be insisted upon. However, the member Banks in consortium/ other banks in MBA will be informed of the decision. Agency for conducting the audit : Reputed Chartered Accountants / firms having experience in investigative audit / Leading chartered accounts firms registered with RBI for conducting statutory audit. However, the same firm who will do statutory audit of Bank cannot be entrusted with special audit of the unit. The report should reveal specific instances of diversion / default and pin point the point of time when diversion / siphoning off began, with sufficient evidence which may enable the Bank to initiate criminal proceedings against the promoters / declare the company / its promoters as willful defaulters as per RBI norms. However, the decision to initiate criminal proceedings will be made in line with the policy already approved in this regard. Authority structure for approval of special audit : Sanctions by CCC-II / CCC-I / MCCC COCC-II / COCC / ECCB* CAG accounts * Accounts of MCG and Circles Approved by GM concerned CGM (Circle) / CGM (MCG) CGM (CAG-Cen.)

Cost / fees for the special audit are to be approved by the GM (concerned) / CGM (CAG-Cen.) and to be borne by the unit. 9.1. Freezing of accounts: Where even levy of penal interest does not evoke financial discipline, branches may freeze the accounts of such borrowers. However, before doing so, the reasons for violating financial discipline should be ascertained from the borrower. If there is no acceptable reason for such non-compliance with the terms and conditions of sanction, a decision to freeze the accounts may be taken only in consultation the controlling authority. The accounts may be frozen only after giving due notice to the borrower by registered post with A/D. Full implications of freezing must be considered, more so in the case of consortium/multiple banking arrangement where in the absence of a consensus among all banks, a freeze on any

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account will serve no useful purpose as the borrowers may transact further in another bank. Branches must be circumspect in freezing as a measure to enforce financial discipline. 9.2. Disclosure of names of defaulters: On the basis of the borrowers consent for disclosure as per the consent clause in the documents, a decision to publicise the names of borrowers who have defaulted in the repayment of loans can be taken only with the approval of the following authorities and after giving a notice of 30 days to the borrowing company of the Banks intention to make public the information, unless the borrower rectifies the default within such period.

Loans sanctioned by; or enhancement / renewal approved by Up to CCC COCC / ECCB 10. Exit Policy for Standard Assets

To be approved for the above purpose by Local Board/ Committee of the Local Board ECCB

It is preferable to exit from Standard accounts when the warning signals indicate that the Bank runs the risk of recovering its dues from the borrower. This is because the borrower can make alternate arrangement for his financial needs, the securities for the asset are likely to be valued more and in case the assets are sold, it is likely to be quoted a higher price. The warning signals enumerated below may be adopted as trigger for considering exit decision: Restrictive guidelines on Industries issued by RMD based on CPPC discussions. Frequent return of cheques/bills/devolvement of LCs/ invocation of BGs. Delay in meeting term obligations / other commitments to the Bank. Decline in credit ratings to a level below the finance grade, i.e., below SB4. Inability or lack of commitment on the part of the management. Visibly declining fortunes of the industry/activity wherein unit is engaged. Highly geared compared to the peers in the industry. Declining security cover. Diversion into non-core areas. Critical observations in the Credit Audit report / I&A reports. Though the above matrix is not exhaustive, the warning signals as given above may be adopted as trigger for exiting. The performance/ conduct of the Group accounts shall also be a decisive factor in taking an exit decision.

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Approving authority Based on the early warning signals, conduct of the account and adverse observations in the latest credit audit report, DGM (O & C) /DGM (Branch) / DGM (Sales Hub) would identify accounts from where exit is preferred and recommend to the appropriate authority. Initially the policy shall be applicable only to accounts sanctioned by CCC-I / MCCC and above. The authority to approve the exit shall be the sanctioning authority. Exit Route The following strategies are proposed to be adopted in the case of accounts identified for exit: Stipulate onerous conditions like, very high margin for nonfund based facilities, increase in working capital margin, withdrawal of concessional facilities, hike in interest rate etc. so as to force the borrower to take decision to shift to another Bank or liquidate the loan or settle for a compromise Sell the loan to other Banks even at a discount. Call up the account.

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ANNEXURE I (a)

FINANCIAL FOLLOW UP REPORT (FFR - I)

Report for the (I/II/III/IV) Quarter ending Period covered by the Report : (3/6/9/12) months

Name of the Borrower:

A.

Performance
Activity Annual Plan (Current year) 1 Actuals (Cumulative) upto quarter ending 2 % of achievement 3

(i)

Production (Quantity)

(ii)

Net sales (Rs. in round lacs) (a) Domestic

(b) Exports

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B.

Status of working capital funds

(Rs. in round lacs)

At the end of last year (31.3 ) 1 Current Assets (CA) a. b. c. d. Inventory Receivables Other CA Total CA

At the quarter ending // 2

Change during the current year (2 minus 1) (+) or (-) 3

Estimates at the end of current year (31.3. ) 4

Current Liabilities (CL) e. WC f. g. h. i. j. S. Creditors Other CL Total CL NWC (d - h) Current Ratio (d/h) Bank Borrowings for

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C.

Current Assets - How financed : (in percentage)

At the end of the last year (31.3. ) 1 At the Quarter ending / / 2 Estimates at the end of current year (31.3. ) 3

k.

Bank Borrowings (e/d %) S. Creditors (f/d %) Other CLs (g/d %) NWC (i/d %)

i. m. n.

Total

100

100

100

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D.

Levels of Inventory / Receivables / Sundry Creditors (No. of days)

At the end of last year (31.3. ) 1 at the quarter ending / / 2 Estimates at the end of current year (31.3. ) 3

o.

Inventory

p.

Receivables

q.

S. Creditors

Notes : (i) (ii) This report should be submitted by the borrower within 6 weeks from close of each quarter. Classification of Current Assets and Current Liabilities should be the same as in assessment of working capital limits. (Deposits/instalments of TLs / DPG / debentures etc. due within 12 months from the end of the quarter should be included in the OCL). The information should be furnished for each line of activity / division / unit separately as also for the company, as a whole. In Section D, the levels in days should be computed for each column as follows : For Inventory For Receivables For Sundry Creditors : : : Value x 365 divided by Net Sales Value x 365 divided by Gross Sales Value x 365 divided by Purchases

(iii) (iv)

(For the above computation under column 2 Sales / purchases for part of a year are to be annualised)

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ANNEXURE I (b)

FINANCIAL FOLLOW UP REPORT (FFR - II)

Part A
Name of the Borrower: A. Half yearly operating statement (Rs. round in lacs)

Last year Current year Half year ended (Actuals) (estimates) ....... 20.. (Actuals) -----------------------------------------------------------------------------1. Gross Sales (*1) (Net of returns) (a) (b) Domestic Exports Total -----------------------------------------------------------------------------2. 3. 4. Less Excise duty Net Sales (Item 1, Item 2) -----------------------------------------------------------------------------Cost of good sold (a) RM consumption (*2) (including stores & spares used in the process of manufacture) Other spares Power & fuel Direct labour (factory wages & salaries) Other manufacturing expenses, incl. depreciation -----------------------------------------------------------------------------Sub-total ------------------------------------------------------------------------------

(b) (c) (d) (e)

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Add : Opening stocks-inprocess & finished goods -----------------------------------------------------------------------------Sub total Deduct : Closing stocks - inprocess & finished goods -----------------------------------------------------------------------------. Total cost of goods sold -----------------------------------------------------------------------------5. 6. 7. 8. 9. 10. Selling, general & administrative expenses Interest Sub-total (5 + 6 + 7) Operating Profit / Loss (3-8) Other non-operating income / expenses - Net (+/-) Profit before tax / loss (9 + 10)

Notes : (*1) Gross sales would be sales after adjustment for rejections and returns of goods. (*2) Raw material includes stores & spares used in the process of manufacture. (Contd.)

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ANNEXURE I (b) (contd.) Part B Name of the borrower : (Amount Rs. in round lacs) Last Current Half year ended year ................ 19 year (estimates) Actuals (Actuals) (audited / provisional) 1 2 3 ----------------------------------------------------------------------1. SOURCES a) b) c) d) e) Profit before tax Depreciation Increase in Capital Increase in term liabilities Decrease in i) Fixed assets ii) Other non-current assets f) g) 2. USES a) b) c) d) e) Net Loss Dividend payments Taxes paid Decrease in term liabilities (incl. public deposits) Increase in: i) ii) iii) iv) f) g) Fixed assets lCDs placed Investments in associates / subsidiaries Other non-current assets ----------------------------------------------------------------------TOTAL (B) ----------------------------------------------------------------------Others TOTAL (A) ---------------------------------------------------------------------------------------------------------------------------------------------

B.

Half yearly funds flow statement

Others

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3. 4. 5.

Long term surplus (+) / Deficit (-) (A - B) Changes in current assets Increase (+) / Decrease (-) Changes in other current liabilities. (other than bank borrowings) Increase (+) / Decrease (-) Changes in WC gap Increase (+) / Decrease (-) [4-5] Net surplus (+) / Deficit (-) (Difference between 3 & 6) Changes in bank borrowings Increase (+) / Decrease (-)

6.

7. 8.

Notes (i) This report should be submitted by the borrower within 8 weeks from the close each half-year. (ii) (iii] (iv) (v) Information should be furnished for each line of activity/unit separately as also for the Company as a whole. Valuation of current assets or current liabilities and recording of income expenses should be on the same basis as adopted for the statutory balance sheets, and it should be applied on a consistent basis. Classification of current assets / current liabilities for the purpose of funds flow should be the same as in assessment of working capital limits and the relevant FFR I. In respect of traders and merchant exporters, the modified format for Part A be used.

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ANNEXURE I (c)

FINANCIAL FOLLOW UP REPORT (FFR II)

( for Traders and Merchant Exporters) Part A Name of the borrower (Rs. round in lacs) Last Current Half year ended year ............ 20. year (Budget) Actuals (Actuals) 1 2 3 ----------------------------------------------------------------------1. Gross Income i. Gross Sales (Net of returns) a. Domestic Sales b. Export Sales c. Sub-total (a+b) ii. Other income a. Duty Draw back b. Cash assistance c. Commission and brokerage received d. Sub-total (a+b+c) Total (i c) + (ii d) 2. Cost of SaIes I. II. iii. iv. v. vi. vii. 3. Purchases Other trading expenses Sub-total (iii) Add : Opening Stock Sub-total (iii+iv) Less: Closing Stock Total cost of sales (v-vi)

A.

Half yearly operating statement

Selling. General & Admn. expenses including Bonus Payments Interest

4.

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5. 6.

Depreciation Sub-total (3+4+5) Operating Profit/Loss (Item 1 minus total of items 2,3,4 & 5) Other non-operating income / Expenses - Net (+/-) ----------------------------------------------------------------------Profit before Tax/Loss (Item 6 pIus item 7) -----------------------------------------------------------------------

7. 8.

(contd.)

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ANNEXURE I (c) (contd.) Part B Name of the borrower (Amount Rs. in round lacs) A. Half yearly funds flow statement Last Current Half year ended year ................ 19 year (estimates) Actuals (Actuals) (audited / provisional) 1 2 3 ----------------------------------------------------------------------1. SOURCES a) b) c) d) e) Profit before tax Depreciation Increase in Capital Increase in term liabilities Decrease in i) Fixed assets ii) Other non-current assets f) g) Other ----------------------------------------------------------------------TOTAL (A) ----------------------------------------------------------------------2. USES a) b) c) d) e) Net Loss Dividend Payments Taxes Paid Decrease in term liabilities (include, public deposits) Increase in: i) Fixed assets ii) ICDs iii) Investments in associates / subsidiaries iv) Other non-current assets Others ----------------------------------------------------------------------TOTAL (B) -----------------------------------------------------------------------

g)

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3. 4. 5.

Long term surplus (+) / Deficit (-) (A - B) Changes in current assets Increase (+) I Decrease (-) Changes in other current liabilities (other than bank borrowings) Increase (+) I Decrease (-) Changes in WC gap Increase (+) / Decrease (-) [4 - 6] Net surplus (+) / Deficit F) (Difference between 3 & 6) Changes in bank borrowings Increase (+) / Decrease (-1

6.

7. 8.

Notes : i) ii) iii) This report should be submitted by the borrower within 8 weeks from the close of each half-year. Information should be furnished for each line of activity / unit separately as also for the Company as a whole. The valuation of current assets or current liabilities and recording of income and expenses should be on the same basis as adopted for the statutory balance sheets, and expenses should be applied on a consistent basis. Classification of current assets / current liabilities for the purpose of funds flow should be the same as in assessment of working capital limits and the relevant FFR I.

iv)

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ANNEXURE I (d)

Guidelines for scrutiny of Financial Follow up Reports

Financial Follow up Report I (FFR I) Information in FFR I.. will be scrutinized on the following lines: Item A Performance during the year: See whether progress is maintained in relation to the current year estimates. Item B (i) (ii) Net Working Capital and Current Ratio : Verify whether the changes in NWC and CR are in consonance with the changes expected during the current year. Level of bank borrowing : See whether the change in this is in tandem with the changes in the value of inventory and receivables. In case the change in the bank borrowing is due to increase I decrease in the sundry creditors or other current liabilities, examine whether the position reported is acceptable.

Item C Individual sources of finance for current assets. See whether there is any significant change in the pattern of sources and if so, whether it is acceptable. Item D Levels of inventory, receivables and sundry creditors: See how the levels on the date of the report compare with the year-end estimates. Financial Follow Up Report II (FFR II) Part A From the information given in the operating results during the half-year will be examined in relation to the current year estimates and with specific reference to the following items: Net sales Cost of sales PBT to net sales Cost of production to net sales Raw material consumption to cost of production Salary and wages to cost of production

The examination will be carded out with a view to ascertaining whether the half-yea results are in order and the estimates for the current year will be achieved.

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Part B The funds flow will be scrutinised to see whether the contribution from the different item of long term sources, and deployment in various long term uses during the half-year are in line with the annual plan ; if there is any short fall or variation in these, especially in items like Inter Corporate Deposits, Investments in Subsidiaries - its impact on the liquidity, gearing of the company. Further, changes in Current Assets and Other Current Liabilities will be examined to see which of these significantly contributed to the change in bank finance. Examination of data in FFR I & II as above with enquiries in detail in other areas as necessary will be carried out with a view to verify the end use of bank finance and to ensure that the liquidity, working capital and overall financial management of the borrowers operations are in order. Where the information received shows wide variations from what was planned, the matter should be discusses with the borrower to ascertain the reasons there for and the manner in which the position will be rectified.

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Annexure: 2 POST SANCTION CREDIT PROCESS Indicative list of activities involved in follow-up, supervision and monitoring 1. Follow-up Conveying sanction of advances to the borrower detailing the terms and conditions and obtaining acceptance thereof Preparation and submission of returns on credit facilities sanctioned for control purposes Completion of appropriate documentation before disbursement of loans/advances; keeping the documents in effective custody and maintaining validity by periodic revival of the documents during the currency of the loans/ advances. Creation of charge over security and completion of all relevant and applicable formalities, including: Creation of Registered or Equitable mortgage Creation of second charge Registration of charge with ROC Subsequently, periodic search of charge with ROC should be done to protect the Banks interest. Ensuring compliance by the borrowers of all pre-disbursal formalities and requirements and continued compliance with the terms of sanction till loans/advances are liquidated. Conducting pre-disbursal inspections and verifications (including verification of subsisting charges on the assets of limited companies by search at ROC) as laid down. Conducting periodic inspection/visits at stipulated frequencies. Arranging for and supervising computation and recording of Drawing Power for disbursal of the facilities. Obtention from the borrowers, and scrutiny/analysis of the following financial and nonfinancial statements; initiating appropriate action thereon: Stock statements Other control/ MIS statements such as monthly statements of operational data, QIS/FFRs, Cash Budget Annual and mid-term financial statements

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Ongoing scrutiny of transactions in the various accounts by perusal of ledgers, registers, vouchers, etc. to watch for proper conduct of loan accounts, healthy turnover therein and proper end-use of funds. Ongoing verification of assets charged as security, to ensure availability and safety of the assets and safety of the Banks advances. Maintaining ongoing contact with the borrower and co-lenders and keeping abreast of developments in the borrower entities and business environment. Securing and ensuring ongoing availability of insurance cover for the security charged to the Bank. Securing and maintaining ECGC cover where applicable. Timely recognition of unsatisfactory features in the conduct of the advance, such as: Delays in project implementation Unusual developments/changes in the business or business environs Shortfall in achievement of production/sales as compared to the projections Defaults in payments due under fund-based facilities/Defaults in the commitments under non-fund based facilities Non-fulfilment of financial obligations to the Bank, co-lenders and creditors and non-payment of statutory dues, etc. Any other deficiency observed during periodic inspection visits Advising borrowers to initiate required action to check/ remove the foregoing unsatisfactory features and submitting reports to controlling authority on further developments in the matter. Ensuring obtention of refinance from concerned agency, wherever applicable. Ensuring maintenance of proper records/ files covering the advances to a borrower for scrutiny/ inspection by various internal and external authorities. Ensuring collation/maintenance of data as appropriate for submitting reports/ returns/reviews, etc. to various higher authorities in the Bank and to external agencies. Obtention of required data/proposal from borrower and preparation of review/renewal of credit facilities, as prescribed. Processing requests for irregular drawings and reporting these to the controllers as per procedure; and initiating steps to regularise the accounts and submitting reports thereon. Follow-up of and rectification of irregularities pointed out in the various inspection/audit reports, including RBI Inspection Report Central Office Inspection & Audit Report/Credit Audit Report Verification Audit Report Concurrent Audit Report Stock Audit Report

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Spot Audit Report Statutory Audit Report. Recovery of applicable charges/fees/penalties etc. as per extant instructions. Preparation of reviews of IRAC, identification of deteriorating assets/ potential NPAs and initiation of corrective action where warranted. Account-wise follow-up of NPAs for recovery/ rehabilitation, preparation of related recommendations to appropriate authority for approval 2. SUPERVISION Ensuring proper follow-up of advances and observance of systems laid down by the Bank at the operating level. Periodic and random examination of registers, accounts and books at the branch, scrutiny of periodic statements received, control registers and files/records covering the advances will assist this process. Ensuring that security documents are kept current and that officials concerned observe all related documentation formalities. Ensuring that the functions at the follow-up level are performed diligently and as per extant instructions of the Bank. Ensuring that (i) proper arrangements are in place for the recovery of applicable charges/fees/penalties etc. and (ii) income leakage is checked. Engaging in ongoing interaction with the officials responsible for follow-up on all critical matters relating to the loans/advances. Maintaining ongoing contact with borrowers and co-lenders and keeping abreast of developments in borrower entities and business environment. Scrutiny of (a) periodical statements and financials received from the borrowers and (b) control statements/reports prepared on the advances. Ensuring that corrective steps as required are taken and reports to higher authorities, where necessary, are submitted. Periodic inspection of security at the intervals prescribed for the supervisor. Ensuring that compliance is maintained with instructions laid down regarding systems and procedures; maintenance of books/registers is in order, and action is taken for rectification of irregularities pointed out in the various Audit/Inspection reports. Conduct periodic assessment of the information thrown up by IRAC reviews and ensure identification of deteriorating assets and initiation of corrective steps. Exercise control over NPA management and ensure effective follow-up for recoveries/ rehabilitation with approvals from concerned/appropriate authority Ensure timely reviews/renewals of credit facilities. Initiate appropriate measures for upgradation of credit skills of lower level functionaries. MONITORING Ensuring that effective supervision is maintained on loans/ advances by the lower level functionaries responsible for follow-up and supervision. Scrutiny of returns/reports received from these line functionaries, interaction with them, feedback from customers, commentary in inspection/audit reports etc. will assist this process.

3.

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Monitoring of high value advances through specific focus on these in the returns/reports received on loans/advances and by keeping watch on the developments in the borrower company/industry. Ensuring non-recurrence at the operating levels of commonly noticed lapses/irregularities pointed out in various audit reports. Extending guidance to down-the-line functionaries on the follow-up and supervision of the Banks credit exposures especially those at risk. Examination of NPAs with a view to recognising problem assets, drawing up recovery/upgradation path for these and monitoring the recovery process. Redressal of customers complaints Ongoing evaluation of credit management skills at the branches and offices under control, interaction with the supervisors and initiating appropriate interventions.

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14 (III) LOAN ADMINISTRATION: STRESSED ASSETS MANAGEMENT A review of problem loans / Special Mention Accounts (SMAs) / NPAs / AUCA and the approach to restructuring of such Stressed Assets was undertaken and it was decided to streamline the multiple review processes and to integrate the Banks approach to management of Stressed Assets including their restructuring. The new integrated approach, being detailed herein superceded all existing instructions (non-BIFR / non-CDR) on review of problem loans / SMAs / NPAs (including AUCA) and such review now comprises of two separate tracks as under: (i) Review of stressed assets (SMAs and sub-standard assets) with focus on restructuring of loans to viable units wherever feasible. (SMAs have also been re-defined to exclude accounts rated SB6/SBTL6 (old) & below which are not in default and which do not show any warning signals. This would facilitate focussed review.) Review of Doubtful / Loss assets and AUCA with focus on quick recovery action.

(ii)

I. Special Mention Accounts (SMAs) Modification in definition : As per Banks extant approach, the following three categories of accounts have been designated as SMAs: i. Category I: Accounts where interest / instalment has not been serviced for 30 days ii. Category II : Accounts which are not in default but are showing early warning signals such as frequent return of cheques / bills discounted, devolvement of LCs, declining financials etc. (An illustrative list of warning signals as advised by RBI is given in Annexure 1.) Note: As a prelude to implementation of the integrated approach, Category III SMAs, i.e. accounts rated SB6 / SBTL6 and below, which are not in default or do not show any warning signals, would not be designated as SMAs for any purpose. Accordingly, SMAs would hereafter comprise only the Category I & II accounts. In other words, Standard accounts, which do not show any warning signals and are in all respects well conducted, would not be categorised as SMAs, just for the reason that they have been rated SB6/SBTL6 to SB8/SBTL8 (old). (The above modification would not be a deviation from RBI guidelines in any way, as Category III accounts were included by our Bank as part of SMAs as a cautious strategy. However this has been found to unnecessarily over-crowd the SMA review process, obviating the very purpose behind introduction of SMAs.)

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II. Stressed Assets Review (SAR) : (i) Coverage : SAR would cover loan assets which have the potential for quick turnaround, i.e. SMAs, (Category I & II) and sub-standard assets. (ii) Cut-off : Rs.10 lac and above (outstandings) Accounts below the cut-off level are not covered by the structured reporting norms and also related guidelines on holding on operations etc. that are detailed later. However, in these cases, branches would formulate and pursue account specific action plans, with the approval of the sanctioning authority. In addition, report on all stressed accounts above Rs.1 lac but below Rs.10 lac may be submitted monthly, on a consolidated basis, to the controller. The report format may be designed and circulated by CCFO with the approval of the CirMAC. The Circles may also put in place a suitable mechanism for review of these accounts (Rs.1 lac to below Rs.10 lac), taking into account the local requirements. (iii) Stressed Assets Review Report (SAR Report) : The basic strategy underlying the Banks approach to restructuring is initiation of appropriate corrective actions at the right time. Soon after an account is identified as SMA or an account turns sub-standard, the Branch should take immediate steps to analyse the problems based on facts and circumstances by means of a review at the Branch as per SAR Report format given in Annexure 2. Such reports are to be submitted to reviewing authorities as detailed later. The important parameters of the Branch level review would be the following: i. Diagnose reasons for the account being identified as SMA / deterioration in asset quality. ii. iii. Revalidate the assumptions made at the time of credit sanctions particularly in regard to assessment of credit risk. Verify completeness and correctness of documentation including revival position, creation / registration of charges, insurance cover etc. and rectify deficiencies, if any. Discuss the units problems with the promoters / guarantors and find out whether they have a future plan for the unit Identify and study the existing primary and secondary sources of cash flow and determine whether the unit is intrinsically viable. Determine whether the problems faced by the unit are of a temporary nature or whether any proactive action from the bank is required to sustain its viability. Assess whether the promoter(s) / management has genuine intent to rehabilitate the unit.

iv. v. vi. vii.

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viii.

Assess the ability of the promoters / management to turnaround the unit.

After taking a view on the viability of the unit / feasibility of restructuring, the Branch should also decide on the need to immediately put the unit on holding on operations. If the branch is satisfied that the unit needs to be put on holding on operations, pending finalisation and implementation of the restructuring package, the branch may extend the same immediately as detailed later in para III. No separate approval would be required for extending the same. (iv) Organisational set up for Stressed Assets Review : At the RO/LHO level, existing structure for handling SMAs and NPAs (dealing officers, department etc.) would continue as hitherto. As SAR reports from branches would be account-wise, the reports would continue to flow to the respective departments depending upon whether the account is SMA or sub-standard. However, GM / CirMAC may identify a Nodal Officer at the RO/LHO as a single point of contact for all stressed asset related matters. The Nodal Officer would also handle all related correspondence with the RO / LHO / Corporate Centre. (v) Reviewing Authority : The SAR Report would be submitted by the Branch to the controllers at monthly intervals. The Reports would thereafter be reviewed by the following authorities: Accounts with outstandings of Up to Rs.1 cr. Above Rs.1 cr. to Rs.5 cr. All Circle sanctions of above Rs.5 cr All Corporate Centre sanctions (vi) Action by the reviewing authority : AGM (Region)/ DGM (O & C) NWCC CCC-II CCC-I

The reviewing authority would take the SAR Report on record and give necessary directions to the Branch on the recommended action plan. If the unit is considered intrinsically viable and if the reviewing authority concurs with the branchs views in this regard, the holding on operations already initiated by the Branch would continue and the Branch would proceed with the action plan, subject to directions of the reviewing authority. The purpose of the structured review is only to examine the viability and approve the action plan for proceeding with the restructuring effort. The financial sanction for the restructuring proposal would be separate as per extant Delegation of Financial Powers. If after the structured review, the unit is not considered potentially viable, recovery efforts are to be immediately initiated. The reviewing authority would give necessary directions to the effect.

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(vii)

Time Norms :

The speed with which problems are diagnosed and the package is implemented is vital to the success of any restructuring plan. Similarly, in cases where restructuring is not considered feasible, the speed with which recovery steps are initiated is equally critical. Accordingly and keeping in view the 90 day IRAC norm, the following revised time norms may be followed for review of stressed assets and for obtaining sanction for rehabilitation package: Process Submission of SAR Report Approval for action plan (by reviewing authority) Completion of viability study, if necessary, and for submission of restructuring / rehabilitation package and obtention of sanction from sanctioning authority Total (viii) Monitoring by controllers : Time frame 10 days 5 days 45 days

60 days

The branchs controller is to monitor the progress in implementation of the approved action plan and subsequent restructuring. A monthly progress report may be submitted by the Branch to the controllers as per the format given in Annexure 3. III. i. Holding on operations : Holding on operations would commence from the date branch identifies an SMA Category I & II or a Sub-standard account as potentially viable. (Such holding on operations would not require any Administrative Clearance / approval / sanction and would need to be only reported as per the Report format being laid down.) The prescribed reviewing authority would take the report on commencement of holding on operations on record and give necessary directions to the branch on the proposed action plan.

ii.

iii. The holding on operations would consist of freezing the banks exposure at the sanctioned limit or average daily exposure during the previous one month prior to the date of reporting, whichever is higher and allowing operations within such frozen limit. iv. The branches may, where considered necessary, continue to open LCs even if an LC had devolved earlier due to genuine cash flow problems / mismatches. No increase in margins may be sought. (Concessional margins may also be considered as part of the rehabilitation package and subject to approval of the appropriate authority.)

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v.

During the holding on operations, the branch may also selectively permit full interchangeability between LC and cash credit limits, but within the overall frozen exposure level.

vi. Holding on operations may in deserving cases continue for a maximum period of three months from the date of identification of an SMA- Category I & II or a Sub-standard account as potentially viable and for a maximum period of one month from the date of approval of the restructuring package. (The 4 month period is being prescribed as the outer limit for holding on operations in larger accounts. Ordinarily, the branches should endeavour to strictly complete the review and restructuring exercise within 60 to 90 days in view of the current IRAC norms.) IV. (i) Review of Doubtful/ Loss assets / AUCA : Coverage :

Doubtful / Loss assets / AUCA are not generally considered amenable to any rehabilitation efforts and hence, these assets are being clubbed so that the focus of the review will shift entirely to various means of recovery, i.e. legal action, compromises, sale of assets to Securitisation Companies (SCs) / Reconstruction Companies (RCs) such as ARCIL, enforcement of security rights under SARFAESI Act 2002, assignment of debt, assignment of decree, etc. AUCA is also included for structured review, as recovery efforts in these accounts may not have been fully exhausted. Further, there may be accounts which have deteriorated to Doubtful/Loss asset category due to mere passage of time and not due to deterioration of security and are still viable. In such cases also, restructuring should be examined as the first option. (ii) Cut-off point : Rs.10 lac and above (Outstandings) (Accounts below the cut-off level are not covered by the structured reporting norms. However, in these cases, branches would formulate and pursue the account specific action plans as hitherto, with the approval of the sanctioning authority. In addition, in RNW, all accounts above Rs.1 lac but below Rs.10 lac may be reported monthly, on a consolidated basis, to the controller for purpose of monitoring. The Circles may also put in place a suitable structured review of these accounts (Rs.1 lac to Rs.10 lac), taking into account the local situation and requirements.) (iii) Reviewing Authority : The authority structure for review of Doubtful / Loss / AUCA assets would be as under: Outstandings Rs.10 lacs to Rs.1 cr. Above Rs.1 cr. (including above Rs.5 cr.) Above Rs.5 cr. Reviewing authority NWCC in RNW Circle level NPA task force (CirMAC) High level NPA task force at Corporate Centre

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Henceforth, reports on sub-standard assets above Rs.5 cr. need not be submitted to Corporate Centre for review by the high level NPA Task Force as it would review only Doubtful / Loss / AUCA above Rs.5 cr. LHOs would submit reports on Doubtful / Loss / AUCA accounts above Rs.5 cr. to CGM (Credit Mgmt.) as per format advised vide Cr.M/NPAM-I/ARP/296 dated 6.6.03. At the Circle level also the same format may be used for structured review of such accounts. Accounts below the cut-off level are not covered by the formal reporting. However, in these cases, branches and their controllers would formulate and pursue the account specific action plans as hitherto. Doubtful / Loss assets may also be considered for restructuring, subject to their viability. The existing authority structure prescribed for removal of entries from AUCA would continue separately.

V. Rationale for the above integrated approach: The primary intent behind the new integrated approach detailed above is to ensure that a SMA does not slip to sub-standard or a sub-standard account to Doubtful / Loss category due to lack of timely finance or reliefs / concessions. The first step to achieve this objective would be to identify stressed assets quickly and to determine whether the problems are of the temporary nature or whether they are likely to persist and affect the asset quality if proactive action is not taken. The restructuring plan thereafter should be aimed at units whose intrinsic viability is beyond doubt and which have genuine cash flow problems and which have defaulted for reasons beyond their control. It may be ensured that only borrowers with genuine intent to restructure the units are supported. The Managements ability to turnaround the unit would also be a critical consideration. The integrated approach being introduced is expected to bring greater focus on review of stressed assets so as to quickly identify accounts amenable to restructuring. The Banks policy would be that in cases where restructuring is considered feasible, branches would consider restructuring as the first option in management of stressed assets. To give the desired thrust to restructuring across the Bank, a uniform approach to holding on operations and reliefs / concessions, but with necessary inbuilt flexibility is being put in place. It is also expected that wherever restructuring is not considered feasible on account of non-viability or any other reason, the branches would quickly consider exit option or the usual steps for recovery. VI. Reliefs and concessions a uniform approach :

a. Extension of RBI norms on reliefs and concessions to weak / sick SSI units to potentially viable units in other sectors : RBI had in January02, as part of the revised guidelines for rehabilitation of sick SSI units, laid down broad norms for reliefs and concessions which can be extended by banks / FIs to potentially viable sick units (details are given in Annexure 4). RBI also

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clarified that banks will also have the freedom to extend reliefs and concessions beyond the laid down parameters in deserving cases. Given the RBIs simple and easily implementable approach to reliefs/ concessions, the same may be extended across the Bank to various categories of advances as given below : (i) (ii) Non-CDR , Non-BIFR manufacturing units in C&I segment Non-CDR, Non-BIFR manufacturing units in AGL segment. (While no minimum loan size is being prescribed, it may be advisable to extend the approach only to relatively larger loans in AGL segment.) In SSI sector, units falling within the RBIs definition of a sick SSI unit would continue to be eligible for reliefs and concessions as per RBI guidelines. SSI units which do not readily fall within the RBIs definition of sick SSI unit may also be extended reliefs and concessions as per RBI guidelines, if they require immediate support through restructuring etc. to retain their viability. In other words, complying with the RBIs definition of a sick SSI unit need not be necessarily reckoned as a pre-condition for extending holding on operations and rehabilitation / restructuring with reliefs and concessions to otherwise deserving SSI units. (In all cases above, reliefs and concessions as per RBI guidelines may also be extended to SMAs.) (iv) Though RBIs norms for reliefs and concessions to potentially viable units are primarily intended for manufacturing units, non-manufacturing sectors such as Trade & Services, small business and personal segment may also be considered for rehabilitation / restructuring. In such cases, rescheduling of term loans, if any, and/ or stipulating repayment / regularization programme in cash credit facility would generally suffice. Interest concessions may be extended only highly selectively.

(iii)

Any concession within the RBI guidelines may be approved by the appropriate sanctioning authority. The applicable concessionary interest rate structure (formulated by our Bank within the RBI guidelines) are as under: (1) Relief measure (2) Standard rate of interest for sanctions No interest (3) Minimum rates of interest (subject to AC by CCC-I & above) No interest (4) Period of concession

Funding of interest dues on cash credit and term loan. Conversion of irregular

Not exceeding 3 years Not exceeding 5

1.5% below SBAR

2% below SBAR

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portion of cash credit account into WCTL Funding of cash losses till break-even level Existing working capital Additional working capital Contingency loan assistance of up to 15% of estimated cost of rehabilitation Margin money for working capital and funds for start-up expenses 1.5% below SBAR 2% below SBAR

years Up to the period of break-even level Not exceeding 3 years Not exceeding 3 years Not exceeding 3 years

1.5% below SBAR SBAR SBAR

2% below SBAR 1.5% below SBAR 1.5% below SBAR

1.5% below SBAR

2% below SBAR

Not exceeding 3 years

(All the above interest rate concessions would be subject to annual review depending on the performance of the units.) Further reduction, in interest rates up to 3% below SBAR may be effected with the prior approval of Group Executive for the proposals falling within powers of CCC-I/MCCC. Any reliefs and concessions within the parameters given in columns (1) and (2) above would be approved by the appropriate sanctioning authority. It may be noted that as per the Scheme of Delegation of Financial Powers, Advances and Allied Matters, the authority empowered to sanction the loans and advances to a unit, including the additional amounts proposed under the rehabilitation package, shall have the powers to sanction a rehabilitation package including other reliefs and concessions Any concession, over and above the parameters given in columns (1) and (2) but subject to the minimum rates given in column (3), would be subject to Administrative Clearance (AC) by CCC-I in respect of proposals falling within the powers of CCC-II & below. For others, no AC would be required. In case of accounts transferred to PB/RD account or later written off, rehabilitation / restructuring may be considered highly selectively, subject to AC from the authority who permitted transfer to PB/RD or permitted write off. b. Extension of the flexible approach to reliefs and concessions under Corporate Debt Restructuring (CDR) mechanism to other potentially viable units not eligible under CDR :

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The RBI norms on reliefs and concessions to sick/weak units in SSI sector are largely restricted to funding of overdues and extension of additional loans at PLR or lower pricing. This has been the traditional approach to rehabilitation / restructuring in our banking system. However, there may be units, especially larger ones, where the capital structure and debt repayment obligations of a unit may have to be re-aligned to its achievable future cash flows, so that the unit continues to be viable and thereby does not default in its obligations. This approach has already been introduced in our financial system through the CDR mechanism. The approach to restructuring under CDR mechanism is significantly different from the conventional approach of concessionary funding of existing dues. In addition to reliefs and concessions, such an approach would also involve the following: Arriving at the quantum of outstanding debt that can be retained for satisfactory Debt Service coverage and converting the balance amount into equity or equity linked instruments. Investment in equity as an alternative to sacrifices (waiver, write off etc.). Induction of strategic investor(s) / co-promoter(s). Broad basing of Board, appointment of independent Chairman, appointment of professional CEO etc. Appointment of whole-time Finance Director. Setting up of Asset Sale Committee Appointment of Special Concurrent Auditor. Change of Statutory Auditors. Appointment of Lenders Engineer / Monitoring Agency. Right to accelerate repayment / revoke package. Right of recompense. Co-ordination issues between lenders sharing of security, escrow account etc. Our Bank has adopted a fully flexible approach to reliefs and sacrifices under the Scheme to enable the Bank to arrive at realistic solutions on a case to case basis. Under this approach, it has been clearly laid down that there cannot be any uniform prescription for restructuring as each case will be unique. In addition to complexities involved in identifying the intrinsic value of such businesses, finalizing a suitable restructuring package involving concessions in pricing, downsizing of debt, conversion of sacrifices into equity, disinvestments, sale of businesses / assets, mergers, VRS, equitable sharing of securities between lenders and other stakeholders, etc. would require special skills and flexibility. Presently, the eligibility criteria for considering restructuring and extending reliefs and concessions under CDR mechanism (as per RBI guidelines and also clarifications issued by the CDR Standing Forum / Core Group from time to time) are as under:

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 The Scheme will cover only multiple banking accounts / syndication / consortium accounts with outstanding exposure of Rs.20 cr. and above by banks and FIs. The Scheme will not apply to accounts involving only one FI or one bank. The Scheme will be applicable to Standard and Sub-standard accounts, and also selectively to Doubtful accounts. There would be no requirement of the account / company being sick NPA or being in default for a specified period. Potentially viable cases of NPAs will get priority. Following BIFR cases, where aggregate outstanding exposure from banks and FIs is Rs.25 cr. & above, also would be eligible: Cases registered with BIFR which have not come up for hearing as yet. Cases declared sick and where BIFR has ordered work out of Draft Rehabilitation Scheme (DRS). Companies which have no major issues (legal / concurrent) in respect of statutory authorities and State / Central Govt. agencies and there is possibility of them being addressed within a reasonable time frame of 3 months. Following BIFR cases will not be eligible: Special Investigative Audit (SIA) has been recommended by BIFR Sickness is being contested by way of appeal to AAIFR Appeal has been made by one of the parties to AAIFR / Court against decision of BIFR The CDR mechanism has made significant progress in restructuring large corporate accounts. However, the above eligibility criteria (cut off amount etc.) excludes a large number of potentially viable units. Therefore, the desirability of extending the flexible approach to reliefs and concessions under CDR mechanism to non-CDR cases also was considered and it is felt that it would be in the commercial interest of the Bank to selectively extend approach to deserving non-CDR cases also. Therefore, potentially viable units, which are not eligible for restructuring under CDR mechanism in terms of related eligibility criteria may be selectively considered for packages / covenants as envisaged under CDR mechanism. However, to avoid overcrowding, initially, this approach would be restricted to the following non-CDR accounts: Sole banker cases in C&I / SSI / AGL segments with indebtedness of Rs.1 cr. & above. Multiple banking / consortium cases in C&I / SSI /AGL segments with outstanding exposure below Rs.20 cr. from the banking system. (In the absence of a structured mechanism such as CDR, the approach to sacrifices and sorting out inter-creditor issues would be subject to a general consensus amongst various creditors.)

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Non-CDR cases which are being considered for restructuring under the CDR approach to reliefs and concessions would need to satisfy the viability benchmarks as applicable under CDR mechanism. Some of these parameters are given below: Minimum Return On Capital Employed (ROCE) of 5 year G-Sec rate plus 3%. Average DSCR of more than 1.25 and more than 1 in any year. Gap between post-tax internal rate of return and average cost of funds should be at least 1%. Operating and cash Break-even points to be comparable with industry parameters. Gross profit margin (and profitability estimates such as capacity utilization, price realization per unit, cost structure etc.) should be comparable with industry average. (The above parameters are only indicative. The sanctioning authority may take a flexible view, depending on the facts and circumstances of each case.) The authority structure for approving debt restructuring proposals in non-CDR accounts, in terms of the flexible approach for reliefs and concessions laid down under CDR mechanism, would be as under: Restructuring proposals otherwise falling To be sanctioned by within the sanctioning powers of CCC-II & below CCC-I & above CCC-I Sanctioning Authority

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Annexure 1 Warning signals Delay in submission of stock statement / other control statements / financial statements. Return of cheques issued by borrowers. Devolvement of DPG instalments and non-payment within a reasonable period Frequent devolvement of LC and non-payment within a reasonable period Frequent invocation of BGs and non-repayment within a reasonable period Return of bills / cheques discounted Non-payment of bills discounted or under collection Poor financial performance in terms of declining sales and profits, cash losses, net losses, erosion of net worth etc. Incomplete documentation in terms of mortgage etc. Non-compliance of terms and conditions of sanction creation / registration of charge /

Modifications of Review Formats: The existing NPA reporting formats have been modified and has been made compatible with US GAAP (Generally Accepted Accounting Principles) and incorporate discounted cash flows drawn up in accordance with the directions given in Financial Accounting Standard (FAS) 5 and FAS 114 in the NPA reporting formats, to further improve the monitoring and also enable the Bank to finalise NPA reduction targets in a more objective manner. Brief detail of FAS 5 and FAS 114 directions, the manner in which they differ with RBI guidelines and applicability of above Accounting Standards are as under: (i) Under US GAAP (Generally Accepted Accounting Principles) FAS 5 loan loss provisioning is required to be made for an estimated loss (a loss contingency based on the available information) where an asset is seen to have been subject to impairment and the amount of loss can be

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reasonably estimated. FAS 5: Defines a loss contingency as an existing condition involving uncertainty as to a possible loss that may arise when one or more future events occur or fail to occur. (ii) FAS 114 provides for loan loss provisioning for impairment of certain loans (in our case NPAs). The loan for this purpose is considered as impaired when it is probable that a creditor will be unable to collect all contractual amounts (i.e., both interest and principal as scheduled in the loan agreement). (iii) For estimating portfolio the loan loss allowance, categorized the Project Banks US GAAP, loan at Corporate Centre, has into

following two categories:

(a) Individually identified impaired loans: NPAs with outstandings of Rs. 1 crore and above, proposed to be individually assessed under FAS 114 for arriving at the loan provisions & (b) All other loans, including leases, which are collectively impaired: to be covered under FAS 5 for arriving at the loan loss provision. (iv) The Guidelines for compiling discounted cash flows, for meeting FAS 114 requirements, are placed at Annexure III. (v) The difference in the directions given in RBI Guidelines and FAS 114 are as under: Sl. No. 1. RBI Instructions US GAAP

An asset is classified as impaired An asset is classified as impaired as on the date of drawing up of the as on the date of it becoming past balance sheet. due for 90 days.

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2.

Loan loss provisioning is generally Loan Loss provisioning is at the percentage based. rates prescribed upon by the discretion of the Management RBI Bank would probably not recover assets all its dues the inspite Impaired Asset, for of the Govt. the borrowers account being regular. Assets. Guaranteed accounts are treated Standard purpose of assessing loss, DCF assessment would be made on The loss provision is made at the and when a view is taken that the depending

category classification. 3. treated as Standard

Govt. Guaranteed accounts are Though However, no income is booked till as it is realized.

The delay in realization of principle and interest.

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4.

Rephased/restructured

accounts, For the purpose of assessing

are treated as Standard Accounts loss, DCF would be calculated subject to being regular for one and loan loss provision made at year from the date of first the discretion of the Management rephased though /restructured treated as repayment of principal or interest on

whichever is earlier and subject to accounts, after it was rephrased/restructured.

the account running satisfactorily Standard Asset.

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While the review formats, as hitherto, will continue to be used, the Operating Offices would incorporate Discounted Cash Flow (DCF) in the review formats for monitoring Stressed Assets with outstandings of above Rs. 1 crore. Format of the template for calculating DCF is placed at Annexure IV and is to be incorporated at quarterly intervals commencing from the quarter ending 31.03.2008.

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Annexure I Category I &IISMAs and Sub-standard Assets CIRCLE : INDUSTRY : BRANCH : (Rs. in cr.) COMPANY : DATE OF IDENTIFICATION AS SMA / SUB-STANDARD : IF SMA, CATEGORY : CRA : Pricing : Activity : Group : CEO : Date of incorporation : Banking with us since : Exposure : Date of last renewal : Continuation valid up to : Financial Arrangement : Multiple Banking / Sole banking / Consortium Indebtedness Existing Proposed Name of the Bank Fund based Non-fund based Total Limits (position of accounts as on. ) Fund based Limit Drawing Power CC WCDL Book debts / others / TL Total FB Non-fund based LC (inland / import) BG Total NFB Total FB + NFB
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SBI Others Total Outstandings Irregularity

426

Performance & Fin. Indicators as on Net Sales PBT PAT PBT / Net sales (%) TNW TOL/TNW Current Ratio

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OTHER GROUP COMPANIES BRIEF DETAILS Name of FB Limits Company NFB Limits CRA IRAC Date of last renewal / sanction

BRIEF REASONS FOR THE UNIT BECOMING SUB-STANDARD IDENTIFYING THE ACCOUNT AS A SMA :

/ FOR

WHETHER THE PROBLEMS ARE OF A TEMPORARY NATURE OR ARE LIKELY TO AFFECT THE ASSET QUALITY, IF PROACTIVE ACTION IS NOT TAKEN (Clear rationale to be given): COMMENTS ON VIABILITY (Give specific reasons, why you consider the unit need to be supported through restructuring) : IMMEDIATE ACTION PLAN (holding on operations (where already commenced, details may be indicated), need for feasibility study, time frame for submission of detailed restructuring plan to the appropriate authority, etc.) : SECURITY POSITION : Description (a) Primary (b) Collateral RECOMMENDATIONS : Estimated realizable value Date of last valuation / review of the means

BM/CM/AGM/DGM (as applicable)

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STATE BANK OF INDIA

Annexure II

STRESSED ASSETS MANAGEMENT BRANCH, -------MOINITORING OF NPA ACCOUNTS WITH OUTSTANDINGS ABOVE RS.5.00 CRORES FOR THE QUARTER ENDED ----------1. 2. 3. 4. 5. 6. 7. 8. 9. Company Circle : Mumbai Activity Group CEO IRAC Status

Branch :

(NPA since -------) Dealing with us since Date of last sanction / Renewal Date of Declaring Sick by BIFR and Present Status Date of filing of suit with DRT and Present Status Position of Account : As on (In the case of the account in live ledger) Details of exposure to Associate Banks, if any : Position of the account if transferred to PB/RD /AUCA Provision (including INCA) held (as on 31.3.06) : Security Details : Primary Collateral Guarantee (incl. (Date of Valuation / (Date of Valuation/ ECGC) Basis) Basis) (Date of valuation / Basis)

10.

11. 12. 13. 14. 15.

Facility

Fund Based Non-Fund Based Total Value of Security available Our share (being 80%)
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16.

Date SRESI notice issued:

Company : Guarantors :

17. 18. 19. 20. 21. 22. 23. 24.

Consent obtained from other lenders : If consent from other lenders is awaited : Borrower's response to the notice : Date when BIFR / DRT notified : Details of assets seized, if any and value thereof : Name of the Enforcement agent appointed and date of appointment : Any recovery effected / compromise proposal received : Details of directions / action points Action taken / present position (Bullet

that emerged in last meeting for quarter points only) ended ----------

25.

Any other developments (since the

last NPA Task Force meeting till this month with regard to including rehabilitation recovery efforts / OTS,

compromise

efforts, and settlement of

ECGC claim etc.) (Bullet points only)

State Bank of India Stressed Assets Management Branch, --------. Date :

Dy. General Manager

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ANNEXURE III PRACTICAL GUIDE ON FAS 114 Practical guide on FS 114 and Guidelines on compiling Discounted Cash Flows FAS 114 (DCF) - Approach The Discounted Cash Flow (DCF) approach enables you to measure the extent of impairment of loans based on the present value of best estimates of future cash flows that the bank expects to receive, using an appropriate discount rate. Scope and applicability: Under FAS 114, a loan is considered as impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts (principal plus interest) due according to the contractual terms of the loan agreement. The impairment is considered probable if the future event or events confirming the fact of the loss are likely to occur. Loan loss provision for such impaired loans is computed based on discounted cash flows.

Allowance for loan loss is calculated using DCF methodology for all IMPAIRED loans under FAS 114 as identified below: a. A loan or advance which remains out of order for more than 90 days b. Specific cases at management discretion, for example, an adverse event affecting the borrower, which could mean that the Bank would probably not recover all its dues inspite of the fact that the borrowers account is currently regular. DCF calculation is to be done only for impaired loans of Rs. 1 crore and over (this cut off is for the borrower and not facility wise) In respect of a Government guaranteed account, having outstanding balance of Rs.1 crore and over, the DCF calculation is to be done if the income is no longer being recognized even though the account is standard. In respect of a Standard Asset, having outstanding balance of Rs. 1 crore and over, which has been rephrased / restructured / undergone a Corporate Debt Restructuring , the DCF calculation has to be done even though the asset remains a Standard Assets.

Steps for DCF calculation: 1. Identify loans impaired under FAS 114 i.e. all NPAs having outstanding balance of Rs 1 crore and over as on 31st March 2008. The software for the purpose is being sent separately.
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o 2.

3.

4. o

o o

The impaired loans would also include loans that have been split as part of a restructuring package. DCF calculation is to be done for each account separately i.e. if a single borrower is availing various facilities; each facility is to be considered separately for the purpose of DCF calculation. However, facilities having same rate of interest may be clubbed together. Give the required information for all the impaired loans, as mentioned in the DCF template. In some of the columns, the Dropdown arrow will be visible which gives various options. Select one of these options. Please do not insert any other information. Plot the best estimates of future cash flows that the Bank expects to receive for these impaired loans subsequent to the year end: Best estimates of future cash flows that the Bank expects to receive should be estimated for each future year. (Although actual cash flows occur at various points during the year, the attached DCF template uses a simplified discounting formula based on year of receipts) Best estimates of future cash flows that the Bank expects to receive beyond 5 years should be rare as such estimates would be difficult to justify. If the Bank intends and has ability to secure money from sale of security and the repayment of the loan (in part or full) is expected to be solely provided by underlying security, the expected sale value (less expected cost to sell) should be considered as part of cash flows in the expected year of sale. Historically, sale of security has been difficult and/or long-drawn process. In case amount expected from sale of security is plotted in the cash flows, please mention the fact and provide adequate reasons for the same in the Loan Review Form.

5. Please do not omit any of the information requested in the DCF template. 6. Please do not tamper with any functionality in the excel sheet since the sheet has been pre-programmed to ensure uniformity of inputs from the various units. Documentation Standard: Please prepare a write up for each impaired loan (refer to Loan Review Form) that is being evaluated in the DCF template, explaining: Brief background about the unit Brief explanation about the financial position of the unit Rationale for the best estimates of future cash flows that the Bank expects to receive for each year Sources from which the best estimates of future cash flows that the bank expects to receive (For example; realization from cash collateral, tangible Assets, as agreed in the Court, as mutually negotiated with the borrower, etc.).

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Key information: Information about column headings as mentioned in DCF template -: Types of Security (including guarantee): This column represents the various primary and collateral security (including guarantees) available to the Bank. These could be in the form of: o Current Assets o Fixed Assets (Land & Building, Plant & Machinery, etc.) o Fixed Deposits/ Cash Margins o Govt. guarantees o Corporate guarantees o Personal guarantees from individuals o Others Amount Outstanding as at the year end: o This amount represents the amount outstanding in the loan account as on 31.3.2008. o Where letter of comfort has been given to a foreign office by a Branch (on behalf of the borrowers) for an advance given at the foreign office and if the borrower account has been categorized as NPAs at the Indian Branch, such branches are required to include the outstanding balance at the foreign office with the balance outstanding at the Indian Branch, while calculating the DCF under FAS 114 for each customers NPA account. Further, the provision held on account of interest at the foreign office should be included with the balance in INCA for the relative account at the Indian office. o In case of allocated accounts, branches which handle the main account of a NPA customer should include the balances at the allocatee branches while calculating the DCF for such borrower.

Date of NPA: o This date will be the actual date of NPA and not the year-end balance sheet date.

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Interest Rate (for discounting purpose): o In case of a fixed rate loan o In case of a variable rate loan o In case of a restructured fixed rate loan o In case of a restructured variable rate loan Use the originally contracted interest rate (i.e. the rate which was being applied to the loan before it turned into a NPA). Use the interest rate as at the balance sheet date applicable to the credit rating of the unit (i.e. if unit was rated as SB3/SBTL3 at the time it turned into a NPA then the rate to be applied would be the interest rate applicable to SB3/SBTL3 as on 31.3.2008). Use the originally contracted interset rate and not the restructured interest rate. Use the interest rate at the balance sheet date that would have been applicable to the respective parties had the loans not been restructured and not the restructured interest rate.

Current Interest Rate: o The current interest rate represents the interest rate, which will be charged to the unit if a fresh loan was to be sanctioned based on the financials of the unit. Since all high value fresh loans would be at variable interest rates and based on the credit ratings, these rates would thus be those as applicable to those units having the least credit ratings. o In case of a restructured loan, the current interest rate represents mutually agreed interest rate in a restructuring arrangement. Best estimate of future cash flows that the Bank expects to receive: o This represents the estimated amounts expected to be recovered (April to March) from the borrower over the years. o For running cash credit accounts, the inflows would be the sale proceeds expected to be credited in the account during the financial year (this is credit summations during the financial year). However, any expected waiver or write offs should not be treated as cash received. o For term loans / non-operational cash credit accounts, the inflows would be (i) recoveries expected during the year (ii) OTS proceeds, if any (iii) realization from sale of assets after obtaining decree (iv) instalments of TL (v) others, if any. o Estimates of cash flows should be based on cash repayments expected to be funded by the borrowers operations or borrowings from other sources, but not from additional borrowings from the State Bank Group.

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o Any amount, which the Bank expects to receive by way of sale of security (net of expected expenses to be incurred for realizing the security), are also to be considered as a part of best estimate of future cash flows that bank expects to receive. o All best estimate of future cash flows that the bank expects to receive, should be plotted in the relevant years as mentioned in the DCF table. Interest that would have been booked if the loan was not a NPA: o This would be the interest calculated on the outstanding applying the interest rate (the Interest rate for Discounting Purposes) for the financial year 20072008. Interest income earned during the year: o This would be the amount of INC reversal in the account plus any additional interest applied and recovered from the account during 20072008. Additional commitments to outstanding balance as at the year end): lend (drawing power minus

o For the purpose of calculation, Drawing Power (DP) should be that which is available as on 31st March.

Outstanding Guarantees and LCs : o Only net figures to be reported viz. outstanding less cash margins. Interest on restructured loans: o The interest amount that the Bank would have earned had the original interest rate been applied for the year (2007-2008), to be mentioned. Example: if the original interest rate charged to the borrower was 10% p.a. and the present interest rate charged, as per the terms of the restructuring, is 8% p.a. the amount to be stated here would be the interest on the outstandings computed for the year at 10% p.a. Commitments to restructured parties in addition to limits sanctioned : o In the event of a unit being sanctioned additional funding on account of any restructuring / rehabilitation programme, and if the disbursements have not taken place due to any reason the amount of the fresh sanctioned loan/ limit to be mentioned.

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15. FACTORING
GENESIS In 1988, at the instance of RBI, a Committee headed by Shri C.S.Kalyanasundaram went into all aspects of factoring services in India. This formed the basis for introduction of factoring services in India. In 1991, SBI established a subsidiary- SBI factors limited - with an authorized capital of Rs.25 Crores to undertake factoring services. SBI Factors Ltd. have been merged with Global Trade Finance and is now known as SBI Global Factors Ltd. What is Factoring? Factoring has been defined as a continuous relationship between financial institution (the factor) and a business concern selling goods and/or providing service (the client) to a trade customer on an open account basis, whereby the factor purchases the clients book debts (account receivables) with or without recourse to the client- thereby controlling the credit extended to the customer and also undertaking to administer the sales ledgers relevant to the transaction. A factor performs at least two of the following functions: Provides finance for the supplier including loans and advance payments Maintain accounts, ledgers relating to receivables. Collect receivables and protect risk of default in payments by debtors. A diagrammatic presentation of factoring is given below FIG.1. DIAGRAMATIC PRESENTATION OF FACTORING

A factor is thus another financial intermediary between the buyer and the seller. But unlike a bank, a factor specializes in handling and collecting receivables in an efficient manner. Payments are received by the factor direct since the invoices are assigned in favour of the factor. And this keeps away several problems which banks encounter usually in this regard. The purchase of Book debts or receivables is central to the function of factoring permitting the factor to provide basic services such as:
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Administration of Sellers sales ledger Provision of pre payments against the receivables purchased Collection of receivables purchased Covering the credit risk involved Provide advisory services by virtue of their experience in financial dealings with customers The types of services offered by factors for domestic sales are: Full factoring With recourse factoring Maturity factoring Advance factoring Undisclosed factoring Invoice discounting There can be both export factor and import factor also. A factor prices his services depending on the extent of coverage of services provided. The most important factor would be the cost of funds for the advances made. BILL FINANCE Vs FACTORING Sl No 1 2 3 4 5 6 7 BILL FINANCE FACTORING Provision of total services like maintenance of sales ledgers, advisory services etc Trade debts are purchased by assignment Purchase of debt for consideration In undisclosed factoring, customers are not notified Whole turnover is considered and bulk finance provided Balance Sheet financing Charge registered with ROC Off Balance Sheet financing Factor owns the trade debt

Provision of Finance against bills Advances made against bills Security is provided Drawee is aware of Bill finance Individual-transaction-oriented

Evaluation of Proposals by Factor The factor carries out assessment of the client with regard to his financial, operational and managerial capabilities, viability of operations and quality of debts. He also assesses the debtor regarding the nature of business including vulnerability to seasonality and terms of sales, history of operations, including the payment track record and bankers report. After the sanction of the facility a sanction letter is issued by the factor. Board resolution, factoring agreement, pre-payment agreement, personal guarantee of owners (clients) and or others are obtained from the client while a letter of waiver is obtained from the clients bank. Balance Sheet position
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A. Before Factoring Current Liabilities Bank Borrowings Inventory (30% Margin) Receivables (50% Margin) Other CL : TOTAL CL : Total Current Assets = 400 Net Working Capital= 100 Other CL 80 Bank Borrowings 220 Current Ratio: 400/300 = 1.33 B. After Factoring Let us assume that 80% of the receivables outstanding are pre-paid by the factor to the company ( i.e. 160 * 80%= 128) and the company uses this money to pre-pay Bank Loans against receivables ( Rs. 80 lacs) Part of other Current liabilities ( Rs. 48 lacs) A & B Company Current Assets Inventory Receivables 140 Total Other CA 80 300 TOTAL CA 400 A & B Company Current Assets Inventory Receivables 140 Total Other CA

200 160 360 40

80

Current Liabilities Bank Borrowings Inventory (30% Margin)

200 32 232 40

Other CL : 32 TOTAL CL : 172 TOTAL CA 272 Total Current Assets = 272 Net Working Capital= 100 Other CL 32 Bank Borrowings 140 Current Ratio: 272/172 = 1.58 In the above illustration, the Current Ratio has improved from 1.33 to 1.58 due to the following factors:
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The Factor has financed with a lower margin of 20% for receivables as against 50% retained by the Bank. (Pl note that even with the same margin the current ratio would go up) The outstanding receivable sold to the factor does not appear in the Balance Sheet. Thus, factoring services help the unit to improve the structure of the balance sheet, though the Company has extended the same level of credit to the customers. The Company with its current NWC can increase its current assets through additional borrowing from the Bank. This would enable the Company to extend better terms to its customers due to availability of additional funds. BENEFITS OF FACTORING It provides flexibility to the Company to extend better terms to their customers The Company itself is in a better position to meet its commitments, meet seasonal demands for cash or avail cash discount on purchases etc. due to improved cash flows. Improves profit margin due to higher turnover It is an off balance sheet finance, thus does not affect the financial structure. This would also help in boosting the efficiency ratios such as Return On Asset etc. Saves the management time and effort in collecting receivables and in sales ledger management Where credit information is also provided by the factor, it helps the Company to avoid bad debts. Where without-recourse facility is provided even the credit risk is transferred. PROBLEMS AND AREAS WHERE LEGISLATION IS REQUIRED Government agencies and PSUs neither promptly make payments nor interest on delayed payments. Legislation is required to comprehensively support the establishment and operation of efficient and viable factoring services. This is required to empower factors to recover money from defaulting companies. The assignment of Book Debts attracts heavy stamp duty and this has to be waived. Legislation is required to make assignment under factoring have priority over other assignments. To prevent restrictive stipulation being imposed by big corporates against use of factors. To clarify that factor debts can be recovered by resort to summary procedures by amending Order 37 of Civil Procedure Code To exempt factoring organization from the provisions of money lending legislations.

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16. BASICS OF LEASING

1.1 LEASING AND LEASE FINANCING: The generic device of leasing involves renting in a utility asset for a limited period. Say, renting in of a car, or a house, or other common utilities. In business, the assets required are mostly use-specific and customised, sometimes to an extent that there would be no other possible user than the entity seeking the asset. In such a case, how can the device of asset renting be used for industrial finance? How can any one think of sourcing from a rentier, a customised asset instead of buying? Which rentier would be prepared to acquire, for the purpose of letting out, an asset which has only a few users? If these questions could be answered, leasing could be used as an alternative to buying. That is, an enterprise could move from owned capital or loaned capital to rented capital. The answers to these questions lie in a set of mutual commitments between the lessor and the lessee. If the lessee agrees to lease in the asset for a fairly long period, and pay without any conditions such lease rentals as would suffice for the lessor to recover the whole of his investment and a fair return thereon, there is no reason why a lessor should not be prepared to buy exactly the machine which the user wanted, targeting a full recovery over the pre-agreed lease period, of course, the lessor would look at the pre-agreed rentals as his only reward, and therefore, he does not have any rewards based on the value of the asset, and correspondingly, no such risks too. Such leasing can act as an alternative to buying the asset for the lessee. As it is the lessor who finances the acquisition of the asset, and keeps himself limited to financial risks and financial rewards, such leasing is called financial leasing or lease financing. Though accounting rules and other pressures have forced lessors in the international markets to take asset-risks, the primary purpose of lease financing remains financing equipment needs. Although it cannot legally be taken as a money-lending transaction, its economic substance is closely similar to that. A lease which essentially intends to provide finance is referred as financial lease. The intrinsic intent has to be understood from the conduct of the parties, and may not be expressly stated in the lease documents anywhere. The other variant, known as operating lease is where the real intent is the same as documented, that is, to provide an asset on rent. By use of the particular device, viz., leasing, financing by way of leases is limited to asset based funding only, that is, finance tied to assets. Then, those assets must not be consumable or wasting assets, since they are on rent and cannot be used up or changed in form. That is, the assets which are financed on lease should be fixed, not circulating assets. They must not be meant for sale. Leasing cannot, as such, be used for funding of working capital. The asset must have at all times the essential features of an asset under a renting agreement: durability, identifiability, severability, and so on. The use of the device of leasing is mostly limited to financing movable assets, since leasing of immovable assets calls for stamping, registration, etc., and invite applicability of tenancy laws in

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most cases, which make it unfeasible to use the device for pure financing purposes. However, leasing of immovable estates is itself a different industry, having more features of asset-owning, than of asset-financing. 2. LOOKING AT LEASING GENERALLY

Lease financing contract is made out to be a usual contract for asset-renting, though with number of unique features. What is a lease? Whenever we make use of an asset belonging to someone else, under an exclusive or near exclusive right granted to us, and generally for the consideration of rentals, there is a contract of lease. Every contract of asset-renting is a contract of lease. Every deal where assets belonging to one are used by another, under a right to use conferred by the owner, it is a contract of lease. The generic concept of lease is not distinguished from renting or hiring contracts. 3. SUBJECT MATTER OF LEASE: THE ASSET The subject of a lease is the asset, article or property to be leased. The asset may be anything an automobile, or aircraft, or machine, or vehicle, or land, or building, or a factory. Only tangible assets can be leased one cannot contemplate the leasing of the intangible assets, since one of the essential elements of a lease is handing over of possession, along with the right to use. Hence, intangible assets are assigned, whereas tangible assets may be leased. The concept of leasing will have the following limitations: 1. What cannot be owned cannot be leased. Thus, human resources cannot be leased, though there may a personal or organizational contract availing personal or personnel services While lease of movable properties can be effected by mere delivery, a lease of immovable property in order to be effective has to be by way of written instrument. Such instrument requires compulsory registration, and has to be stamped under the Stamp Act. Unless it were a lease of immovable property, a lease of movable property is initiated by delivering the property, and terminated by redelivering the property to the lessor. Hence, in order to be regarded as a lease, the property must be capable of redelivery, that is, it must be durable (at least during the lease period), identifiable and severable. There cannot be a lease unless there are leasable goods or property.

2.

3.

4.

TERM OF LEASE The term of lease, called the lease period, is the period for which the agreement of lease shall be in operation. 4.1 Lease period should be certain: As an essential element in a lease is redelivery of the asset by the lessee at the end of the lease period, it is necessary to have a certain period of lease. A certain period does not necessarily,

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mean the date of commencement and the date of termination should be spelt out as such. It is also possible, for example, to relate the lease period to an event or contingency, such as the regularity of payments made by the lessee. 4.2. Redelivery of asset on termination of lease: Essential distinction between pure hiring and hire-purchase contracts: On the expiry of the lease period, the asset reverts to the lessor. To substantiate the intention of reversal of the asset, the lease period must not be longer than the life of the asset. A Leasing contract may be a pure hiring contract, or may be hiring contract annexed with a purchasing contract. In the former case, once the period of hiring is over, hired asset must revert to the owner. In the latter, it is to be purchased by the hirer after the period of hiring. The latter type of contracts is referred to as hire- purchase contracts. For legal, taxation and several other purposes, a leasing contract means a pure hiring contract only. Hence, a lease must not either give an option or make it a compulsion for the lessee to purchase the asset at the end of the lease term, or otherwise be regarded an amalgamated contract of lease and scale. 4.3 Primary and secondary lease period in financial leases: In a financial lease, the lease period is, as we have seen, fixed having regard to the economic life of the asset, so that the lessee enjoys the use of the asset over almost the entire useful period. Its objective is to put the lessee in the same position as an owner, and therefore, to avail him the opportunity of exclusive exploitation of the asset. But as financial leasing is basically a lending operation, the lessor may not be prepared to keep his investment at stake for the whole of the lease period. He may like to recover his principal and interest (by way of rentals) within a reasonable safe pay-back period, say, five years, whereas the life of the asset may necessitate lease agreement to be for eight years, or ten years. In these cases, the most simple solution is to break the lease period into two: a primary lease period during which the less or wants to see his investment paid back with interest, and a secondary lease period for the balance of the life of the assert, when only nominal rentals are changed just to keep the lease agreement operative. On the shorter side, there is absolutely no limitation: the lease period can be as short as the parties prefer. 5. TYPES OF LEASES

5 1 Financial and operating leases 5.1-1 The essential feature of a financial lease is the transfer of all major risks and rewards of ownership. Financial Lease is a lease which can provide an alternative for borrowing and be a mode of obtaining finance. For this reason, the lease has to be long enough to provide the lessee the use of the asset for almost the whole of the economic life of the asset. Further, it also seems reasonable that as the lessee is interested in the lease only as a means of financing the lessor also limits his role to that of a financier. That is why, the finance lessor does not provide the services of repairs and maintenance, and bears no insurance or other expenses in relation to the asset. He merely finances the acquisition of the asset and keeps his title over it. In substance, therefore, the lessor has title over the asset as only a matter of his security; he

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otherwise transfers to the lessee all the risks and rewards of ownership. The rentals pre-fixed, and are not related to the use or quality of the asset. The rentals are so structured as to repay the lessors principal as well as interest during the desired payback period of the lessor, which corresponds with the primary lease period. During this period, the lessee does not also have the option of cancellation by returning the asset. The rest of the lease period is nothing but paper transaction wherein peppercorn rentals are paid just to prolong the lease agreement till the asset loses its economic utility. The residual scrap then reverts to the lessor, but its value is negligible. Hence, for all practical purposes, the lessors only source of income from the asset he owns is the prefixed rentals for the prefixed period. In other words, the lessor sees no reward in being an asset owner, other than earning the rentals, and he carries no risk either. 5.1-2 Essential features of an operating lease: One asset for many users Just the opposite of the finance leases are short-term hiring contracts where one particular asset is supposed to be hired out to a number of people in sequence. For instance, the hiring of a car. When we take a hired car for a specific purpose, the fare (rentals) that we are paying is the reward for the drivers toil, reimbursement of his fuel cost and a representative sum towards repairs, maintenance and depreciation of the van. The function of the car-rentier, unlike in the case of a financial lease, is not limited to financing. He is rendering a real economic service. He operates the car, repairs and maintains it and fuels it. Such a lease is, in accordance with its services, called an operating lease. 5.1-3 The hybrid operating lease: Accounting standards in most countries have attempted to make a distinction between financial leases and operating leases, and have prescribed a loan-type treatment to financial leases as they are not leases in the true sense. Such a treatment obviously takes away some of the inherent advantages of leasing over plain lending. Hence, essentially to escape the definition of financial leases in accounting standards, a hybrid form of leasing has emerged now. These leases are long-tenure but lesser than the life of the asset, and non-cancelable, and the lessor bears no risk of repairs or maintenance, but such hybrid leases yet do not transfer the whole of the risks or rewards in the asset to the lessee. This is ensured by keeping the lease period shorter than the life of the asset, so that at the end of the lease period, the lessee has either the option of returning the asset or renewing the lease period, at commercial rent then fixed. The hybrid operating lease meets with the accounting definition of operating leases, and yet is significantly different from pure renting transactions. Pure rentals are cancelable at any time. The financial lease prolongs till the very life of the asset, such that the user gets use for the whole of the assets economic life. In the middle of the spectrum are the hybrid operating leases which are non-cancelable for a certain period, but cancelable thereafter, and the period for which they are non-cancelable may take a larger part though not the whole or substantially the whole of the estimated life of the asset. Hence, the lessors risk and reward extends to the period during which the lease is cancelable. Besides, in case of pure rentals, the lessor operates and maintains the asset, but generally in hybrid operating leases, the lessor does not take any asset-based risk during the non-cancelable lease period.

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FINANCIAL LEASE The asset is use-specific and is selected for the lessee specifically. Usually, the lessee is allowed to select it himself. The risks and rewards are passed on to the Lessee. The lessor only remains legal owner of the asset. The lessee bears the Risk of obsolescence. The lessor is interested in his rentals and not in the asset. He must get his principal back along with interest. Therefore, the lease is non-cancelable by either party. The lease period usually coincides with the economic life of the asset and may be broken into primary and secondary period. The lessor enters into the transaction only as a financier. He does not bear the costs of operation. The lessor is typically a financier and cannot render specialized service in connection with the asset. The lease is usually full payout, that is, the single lease repays the cost of the asset together with the interest.

OPERATING LEASE The asset is of common-use and may be used by a number of users in sequence. The lessee is only provided to use of the assets for the certain time.Risks incident to ownership belong wholly to the Lessor. The lessor bears the risk of obsolescence. As the lessor does not have difficulty in leasing the same asset to other willing lessees, though it may be non-cancellable for a certain period. The lease period is usually small and the lessor intends to lease the same asset over and over again to several users. Usually, the lessor bears cost of repairs, maintenance or operations. The lessor is specialized in handling and operating the particular asset and usually provides specialized services. The lease is usually non payout, since the lessor expects to lease the same asset over and over to several users.

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5-2 Leveraged and non leveraged leases A leveraged lease means a self leveraged transaction where the lessor borrows for the purpose of a particular lease, and on the strength of the lease payments, and for the purpose of repaying the loan grants an equity interest (that is, assigns the rentals) to the lender in the lease, usually makes an upfront gain by fully assigning the lease rentals. The assignment is mostly on non-recourse basis. Leveraged leases of this variety have not so far become common in India though a typical variety, in which assets are taken on hire-purchase and given on lease by the lessor have been found. The distinction between leveraged and direct leases is relevant for tax and accounting rules. A leveraged lease is usually accorded a specific treatment since the lessor has no real investment in the lease: the non-recourse loan he takes serves as a realization of his investment, usually as soon as the lease is initiated. Therefore, unless the leveraged lease qualifies certain requirements, it is taken as an instance of broking or packaging. 5-3 Sale and leaseback A sale and leaseback extends the concept of leasing, which is essentially a mode of asset based funding, to non-fund based finance. Under a sale and leaseback, the lessee already owns an asset which he wants to leverage, that is, he wants to raise funds against it. Accordingly, he sells it to the lessor. The lessor pays immediately for the asset, but then leases the asset back to the seller. The erstwhile owner has now become the lessee. The asset has continued to remain under his custody and with him throughout, but only a change in title has taken place. This paper exchange of title has had the effect of providing immediate non-fund based finance to the selling company, the lessee. In fact, the transaction has released the funds which were tied up in some particular asset. Sale and leaseback technique has very often been used as a mode of junk financing. As discussed already, the lessor under a financial lease is mostly taking a risk in the lessee, and not in the asset. Hence, quite often, if the creditability of the lessee is very good, he might be prepared to totally ignore the intrinsic value of the asset. Hence, the lessee may virtually sell junk at a revalued price, and take it back on lease. The typical modality for doing so is as follows: the lessee identifies old assets having negligible book value (and hence, of little value for the purpose of leveraging in normal course), revalues them based on their replacement cost (which would invariably lead to a valuation much higher than the intrinsic or liquidation value of the asset), sells it at the inflated price to the lessor, who then pays for it, and leases back to the same lessee. In the process, the lessee makes a book profit (a realized book profit is as good as a revenue gain), and obtains non-asset based finance. The lessor earns a highly creditworthy client, though the asset value is inconsequential. 5-4 Full payout and non payout leases A full- payout lease is one in which the lessor recovers the full value of the leased asset over the period of the first lease by way of its rentals and a reasonably assured residual value. It is assumed that after the first lease period expires, the asset would have exhausted much of its
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value. That, in fact, is the basic feature of a financial lease. It is, therefore, expected by the lessor that the lease fully pays off his investment while also yielding him desired return on investments. In other words, the residual risk of the lease is negligible. A non-payment or partial payout lease is just the opposite, where the lessor intends to lease the same asset over and over again, so that no single lease has to be a fully paying out one. Several leases in succession will be full payout. Characteristically, financial leases are full payout, and operating leases are non-payout. Accordingly tax considerations distinguish between financial and operating leases primarily based on their payout features. 6. LEASE AND OTHER MODES OF ACQUIRING ASSETS: With the above discussion, it would be interesting to compare lease with other modes of acquiring assets. Note that these cases have been arranged in a descending order of the extent of asset equity with the user: Common methods of obtaining use of an asset with declining degrees of ownership Method Outright purchase Unsecured loan Mortgage Conditional sale Hire purchase Description Purchase with firms own funds. Purchase with borrowed funds Not secured on equipment. Purchase with funds borrowed on Security of equipment. purchase with title passing on completion of instalment payments. hire with option to purchase at Nominal price. Hire for economic life of asset Non cancelable. Medium term hire cancelable After a certain period. short term rental.

Financial lease Operating lease Hire

7.MODUS OPERANDI OF A LEASE A normal financial lease transaction usually goes through the following modality: Capital budgeting decision stage: the lessee (the word might be a misnomer since the acquirer may not have considered leasing as an option upto the third stage) decides whether to invest in a particular equipment or not. Usually, the lessor has no involvement at this stage. Vendor
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lessors, however, intend selling the product itself, and hence, they will intend picking up right from this stage. Product decision: The lessee will select the equipment and satisfy himself about its functional fitness and specifications. The lessor might have not participation at this stage too, except where the lessor has tie-up with any particular manufacturer. Financing decision: Having decided what to buy, the prospective-lessee considers which of the several funding options available to him should he go for. Usually, for acquiring capital assets, the acquirer might consider a plain loan, hire-purchase, deferred supplier credit with discounting facility, etc. apart from lease. Lessor decision: Having chosen to lease-in the equipment, the lessee approaches a lessor, either directly or through a lease-broking agency. Agreement to lease: The lease agreement is broadly negotiated and the rates are finalized. Generally, at this stage, a formal lease agreement is also executed. Placement of order: the lessee instructs the lessor to place an order with the manufacturer of his choice, which the lessor does. Advance payments may be needed at this stage. The normal practice is for the lessor to make such advance payments and charge interest until the lease is commenced. Commencement of the Lease: The manufacturer delivers the equipment at the site of the lessee, and the latter gives notice of acceptance to the lessor. At this stage, the lease is commenced. In the lessors books of account, the advances outstanding are converted into leased assets. Leases will normally by full pay-out within the targeted primary lease period, varying as per requirements. The usual primary lease period is the lessors targeted payback period. At the end of the primary lease period, the lessee is allowed an option to renew the lease at token rentals, usually for an open-ended period. Lease stage: During the lease period, the lessee: - Will pay rentals regularly at periods agreed-upon, which are usually each calendar month. - Will keep the equipment in good repair and working, condition, etc: - Will be entitled to any manufacturers warranties or after sales services. Terminal stage: At the end of the lease period, the equipment shall go back to the lessor. No purchase option shall be given to the lessee in the lease agreement itself. To ensure that the lessee does not have to suffer a loss on account of repossession or sale of the equipment, the lessee is either allowed to continue the lease on nominal terms, or the lessee is allowed to participate in the sale and enjoy a large part of the sale proceeds if at all the equipment is sold to a third party.

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a. Qualitative factors in leasing Leasing was more popular in a regime when it was not regulated by accounting standards. The tax policies were also more favourable to leasing. Hence, it is most important to understand what are the perceived merits of leasing, and how over a period of time, these have undergone a change. Quite often, either without or with awareness as to quantitative merits or demerits of a lease, a lessee would still choose it, for perceived non-quantitative merits. Needless to say, all nonquantitative factors are by and large perceptional, and hence, it may be difficult to spell out the real quantitative merits. This would mean that oftener than not, a lease sells not because it ought to have sold, but because the lessor is able to sell it. For example, the most generally perceived qualitative merit of lease is its flexibility. There are two reasons which make a lease look more flexible than its closest alternative, viz., loans. One, it is more flexible because it is much newer. Loans are an age-old instrument, and the very age has made them inflexible, since they have been known and applied as fixed rate, fixed pattern, fixed rules device. Per se, nothing ordains a loan to be inflexible and a lease to be flexible. Flexibility is innate more in the attitude of the player, than in the instrument itself. Secondly, and more importantly, flexibility in loans can only have effect on the parties cash flows. In case of leases, the flexibility also has a bearing on the parties taxable incomes. Hence, flexibility matters more in case of leases. Traditionally, lessees have cited off-balance sheet funding facility as the most significant advantage of leasing. This is no more valid in most countries as accounting rules have become increasingly requisitive of a loan-type treatment to financial leases. 8-1. Advantages to the lessee

1. Frees working capital for more productive use: Adoption of leasing as a mode of financing implies that the prospective lessee does not have to make any present-time outlay on capital assets, whereas, generally in case of traditional loans, a margin contribution is insisted upon. This will keep free the funds of the company for other productive uses. The device of sale and leaseback, explained earlier, has the effect of freeing the capital tied up in fixed assets. This is obviously a great advantage to the lessee who have constraints of working capital. The 100% funding advantage can be examined in light of two points, pointing to the contrary. First, lessors seen to have taken 100% funding almost as a text book based feature of leasing. Considering the fact that financial leasing is almost money lending by a different name, really speaking, the same credit considerations that apply to a loan must apply to a lease also. If centuries of experience gave lenders the golden rule that no funding need should be funded with 100% external funds, the same rule should hold good for leases too. Based on tax laws, a lessor may regard his tax benefits as recovery of part of the asset cost, But that is no more the case with successive reforms in capital allowances in our country: now the deprecation allowable with reference to most assets is not even enough to cushion a full-years lease income, not to speak of giving incremental tax benefits to recover the lessors investment. Hence, lessors in normal financing wisdom might be compelled to rethink on one of the most stressed text-book advantage of leasing.

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Second, the significance of a conserved cash-flow will depend on how profitably the company can use that cash so saved or released. The advantage of conserved cash-flow shall be positive only if the cost of obtaining a lease is less than the benefits for which the cash-flow so saved can be deployed. 2. May cost less than other methods of acquiring equipment: leasing as a method of acquiring capital assets may cost less than other alternatives available. From the ground rules of leasing business, it is apparent that a lessor might offer a lease cheaper to other alternatives either if his own cost is appreciably low, or if the lease confers incremental tax benefits to him and he values the same more than the lessee does. The first reason is rarely likely to be true; hence, if lease plans are cheaper than borrowing, they are mostly because the lease is oriented towards lessors tax shelter. 3. Flexible, fast and negotiable: Leasing is generally believed to be more flexible than any other method of financing. There is no overriding characteristic of lease financing which is sufficiently important to make all leasing plans either better or worse than alternative methods of raising money to purchase equipment. If leasing does have on significant attribute, however, it is flexibility to adapt the terms of the contract to the needs of the borrower. (Vancil, R.F., Lease or Borrow: Steps in negotiation: Harvard Business Review. Nov. Dec., 1961, P. 138) A leasing plan can always be tailor-made to suit the requirements of the lessee. Other traditional forms of finance are not seen having this advantage. It is necessary to understand that no rule in cast-iron exists that whereas leases can be fast, friendly and negotiable, other financiers using different modalities cannot be. All these are attributes of lessors, not of leasing. 4. Postpones taxes: Leasing may permit a more rapid amortization of the asset than would be permissible under the depreciation rates prescribed under Income Tax Rules. When an asset is owned by the lessee, the only method of writing its cost off is depreciation, which, in some cases, is as low as 10 per cent. As lease rentals are fully tax deductible, they will write-off the cost of the asset in the lessees books in as much lesser period say even within 3 years. There are front end loaded leases which write-off as high as 50% of the cost in the very first year. 5. By amortization of the cost of the asset in a period lesser than what the rates of depreciation will take, leases permit the lessee to write-off more in the initial years. This has the effect of postponing taxes to the later years. In fact, the taxability in such a case is shifted to the lessor, who shows in his income statements high rentals, higher than the depreciation available. Thus, where the rate of depreciation is less than the rate of rentals in earlier years, a lease has the effect of passing on of tax effects to the lessor, and where the rate of depreciation is more than the rentals, there is a passing on in the reverse direction. The parties may effectively barter their tax allowances in favour of the one whose needs are more intensive. 6. Avoids restrictive covenants: Loan agreements with financial institution / Banks usually contain coercive conditions such as restrictions on transfer of shares, issue of bonus shares, right to appoint nominee directors, convertibility clause, etc. A borrower mostly loses much of his operational freedom when he chooses to take substantial loans from institutions and banks. The control of the borrowers is meant to be exercised in the interest of protection of principal and interest, but in real practice, it becomes a perfunctory exercise of administrative discretion.

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6.1 LEASING TO A LESSEE: MAJOR PROMISES AND PITFALLS PROMISES PITFALLS

# 100% Financing and Frees Funds

Lessors usually permitting 100% funding based on tax-advantages. As this has considerably reduced due to reforms, lessors might be inclined to review their 100% financing practice. Like any other funding option, leasing may be only as cheap as the lessor is making it. Unless lessor avails substantial tax benefits, or lessor has access to cheaper funds, he cannot afford to make it cheaper than comparable alternatives. On the contrary, cost additives such as sales tax and stamp duty add-up to the cost of leasing.

Cheaper

Fast, Flexible and Negotiable

These are virtues of a lessor rather than virtues of leasing. Nothing prevents alternative financiers to have same virtues. Accounting rules have been evolving to include debt-type leasing as a Balance sheet item. Depending on the structure of the lease, possibly yes. But for the same reason, it will prepone the lessors tax liability and hence, such lease is likely to be financially costlier.

Off Balance sheet Financing Postpones Taxes

6.2. Advantages to the lessor Better Security: The lessor maintains his title over the asset which acts as a powerful collateral for him. Repossession of leased assets is simpler than of assets secured against a loan. Besides, the worth of the security is usually more than the amount of investment outstanding, and as the repayment period is shorter than the life of the asset, the gap between the asset value and the investment outstanding widens over period. Hence, a lessor becomes increasingly more secured as the lease matures. Tax-planning: A lessor in high tax slab may lease out high depreciation items, and may thus, reduce his tax liability.

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More profitable: The pre-tax rate of return in leasing is usually more than in lending. Thus, leasing is more advantageous even in quantitative terms. High growth potential: Leasing is a high-growth industry, Depending on the market segments chosen, it is not difficult to build a large book size within a very small time. High return on equity: lessors are allowed a very high leveraging ability. That is, they can use a substantial amount of borrowed funds. So, even if they operate on a small spread, they make a high return on their equity. Horizontal, vertical and conglomerate expansion: For those already engaged in some other business, leasing provides scopes for horizontal, vertical or conglomerate expansion. Facility in accessing public deposits: Registered NBFCs in Leasing have been permitted to accept deposits from the public. Lesser regulations: Further, the lease agreement is highly negotiable and do not require any registration. No entry barriers: Another very potent reason for the popularity of leasing is that to enter into the business, one needs to cross least number of barriers. The initial investment needed is also not very high. 7. Leasing in global perspective

7.1. Emergence of operating leases Till now, the largest part of the leasing industry across the world had been finance leasing, either full-payout, where the lessor does nothing but gives a secured loan to the lessee, or Part payout, but the residual value is either guaranteed by the lessee or is insured by a third party. In essence, the lessor has been taking no risk except that of investing his funds with the lessee. As such, the returns which the lessors are able to get are no more than the minimum interest rates; and where any substantial tax differences exist in favor of leasing, the rates of return in leasing are better than the interest rates. However, given the pace with which technology is advancing, users will hunt for the real renting services, viz., those where the owner gives assets on rent. The user does not borrow financial resources to buy real assets: he borrows the real asset itself. It is just not possible to summarise the immense benefits which such an option means to the user. He has the option of going in for new technology, new products, new models all the time. The lessor bears the risk of obsolescence by relying on the equipment value at the end of the contracted period, but on that account, he makes more returns. Another sector where development of operating leases is very easy and imminent is vehicle leasing. These equipments are particularly fit for contract hire, since these are highly custom made. Their economic life is usually long, and so, residual value can easily be relied upon. A real second hand market exists for them. Similarly, another area where leasing in its true from of contract hire can be developed is vendor leasing where a manufacturer who can either upgrade the equipment or may sell it in the

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secondary market to which his access is much easier than that of a financier, offers a cancelable lease option. Other areas include leasing of domestic furniture which has a fairly long life and which people prefer to keep changing, utility equipments like cranes, trawlers, heavy carriers, etc., which are usually required for short periods only, etc. Use of operating lease need not necessarily be limited to purely Utility tools. Even long use assets may be the subject matter of an operating lease, the only option with the lessee being that of return before exploiting the asset fully. The lessee would not usually return such assets unless the technology becomes obsolete or the lessee to divert his operations. To succeed in the field of operating leases, lessors have to develop three basic skills (a) specialist skills about the equipment to be able to add value to a pure financial product; (b) access to secondary market; and (c) ability to estimate and depend on residual values. Another factor which may affect an operating lessor is heavy investment requirement, since the payback period for an operating lessor is usually longer than that for a finance lessor. Thus, value-added, industry specific contract hire plans may obviate the necessity of really purchasing of taking on finance lease a number of general utility as well as other durable value equipments in time to time. 7.2 Legal difference vis--vis lending As far as finance leasing is concerned, the world is gradually moving away from the myth of legal form which differentiates a lease from a loan. As the relative risks and rewards of the lessor and the lessee are the same as those of the borrower and the lender, laws are soon eliminating the artificial differences between leasing and lending. The distinction between leasing and lending leads to differential treatments as least in three major areas tax, accounting, and sellers responsibilities. Under the taxation laws, as legal owner of the subject asset, the lessor could claim ownership based incentives although the economic use of the asset was made by the lessee. This may result into trading of depreciation between the lessor and the lessee. Accounts of the lessor and the lessee will be distorted if the lessor were to account for the asset in his books as its legal owner and the lessee not to record it, although he had the economic benefits of its exclusive use. Development of accounting standards, which intend to correct this anomaly is much more fast and wide in its sweep. Many countries have adapted this International Accounting Standards 17 as the basis for a local standard. Very few countries have no accounting standard in this regard. A third area where the dichotomy is of form and reality - - a lease being a renting contract in form but just a financing transaction. The development of laws capable of ignoring the legal difference and treating a lesser as a financier has been the slowest, may be because the Courts are inclined in benevolence towards the buyer rather than the seller, and the lessor somehow seems to Courts as no different than a seller. Gradually, reason will take predominance over nomenclatures, and finance leasing may be regarded for all purpose at par with secured money-lending. Of course, the differential difficulty of identifying what truly is a finance lease will be there for sometime. This development may give a temporary shockwave to the lessors, but soon, they will prove that leasing has existed and

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grown not on legal fallacies but on real economic strengths. This will even more emphasize the need to stress on the service aspects of leasing. 7.3 Market innovation and expansion When leasing will have shed its advantages on account of legal differences, it will have to face a neck-to-neck competition from others in the financial services industry. This will call for the need for market expansion and diversification and for achieving the same, innovation. Innovative developments have to take place on both sides of the leasing equation in raising of finance as well as marketing. 7.4 Dependence on primary sources of finance On the financing side, leasing companies will have to reduce dependence on secondary funding sources, e.g., banks and financial institutions, by designing instruments for collecting funds directly from the household sector. As the lessors may be in direct competition with the secondary sources of funds, they will approach the investing public directly. Directional changes are just natural and leasing has to show sufficient resilience to cope up with changes if it has to continue as another type of financing business.

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17. CREDIT DERIVATIVES

If one buys 100 shares of ABC Inc. at Rs.50 and the price appreciates to Rs.75, we have made Rs.2500, notionally. If the price depreciates to Rs.25, we have lost Rs.2500 on a mark-to-market basis. Suppose you wish to protect yourself against the downside by giving yourself the option to buy the shares only if the price appreciates you could do this by paying a premium of say, Rs.7 per share. The instrument for doing this is an option contract. Instead of buying the shares in the cash market, we could have bought a 1-month call option on ABC stock with a strike price of Rs.50, giving us the right but not the obligation to purchase ABC stock at Rs.50 in 1 months time. Instead of immediately paying Rs.5000 and receiving the stock, we might pay Rs.700 today for this right. If ABC goes to Rs.75 in 1 months time, we can exercise the option, buy the stock at the strike price and sell the stock in the open market, booking a net profit of Rs.1800. If the ABC stock price goes to Rs.25, we have only lost the premium of Rs.700. If ABC trades as high as Rs.100 after we have bought the option but before it expires, we can sell the option in the market and book our profits. Another example could be a Forward Contract for purchase or sale of foreign currency. In this case the forward premia moves independently of the Spot rate, though the forward contract itself is priced, taking into account the underlying spot rate. The same could be extended to the commodity market, where similar contracts in commodities are booked and traded upon in the commodity exchanges. These are called Futures contracts. They are similar to forward contracts though with some differences. The cash or spot market for the commodities forms the basis (underlying) for such contracts that are derived. Derivatives are thus financial securities whose value is derived from an underlying financial security. Options, futures, swaps, swaptions, structured notes are all examples of derivatives. Derivatives can be used for hedging, protecting against financial risk, or to speculate on the movement of commodity or security prices, interest rates or the levels of financial indices. One way to understand derivatives is to compare this with insurance. Just as you pay an insurance company a premium in order to obtain some protection against a specific event, there are derivative products that have a payoff contingent upon the occurrence of some event for which you must pay a premium in advance. Another aspect of financial derivatives is the fact that they are carried off-balance sheet, generally. This is because the contractual obligations in derivatives are to be fulfilled at a future date or contingent upon an event. Therefore it is notional in nature. Derivative products, because of their off-balance sheet nature, can be used to clear up the balance sheet. It helps financial institutions to bring down the requirement of capital charge by structuring the exposures suitably through derivative instruments. Credit derivatives are used in the advanced countries more due to the various credit instruments traded in the markets which enables banks to hold a diversified and liquid credit portfolio. In the Indian context where banks exposures are generally in the form of direct advances to corporates, banks do not hold a substantial amount of their exposures in the form of marketable and diversified instruments such as bonds, debentures etc. In addition the capital and money markets in India were not developed due to an inadequate legal and regulatory framework, manual settlement systems and lack of maturity of the markets and the players. With liberalization the corporates are accessing markets through credit instruments and banks are increasingly resorting to instruments for financing the corporates. This has provided a depth to

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the debt markets with banks being active players. Credit derivatives will be increasingly needed as the need for banks to structure their asset portfolios will become imperative due to the inherent risks in such investments. Credit risk is a significant element of the galaxy of risks facing the financial institutions. There are different grades of credit risk. The most obvious one is the risk of default. Default means that the counterparty to which one is exposed will cease to make payments on obligations into which it has entered because it is unable to make such payments. Credit default is the worst-case credit event that can take place. An intermediate credit risk occurs when the counterpartys creditworthiness is downgraded by the credit agencies causing the value of obligations it has issued to decline in value. One can see immediately that market risk and credit risk interact in that the contracts into which we enter with counterparties will fluctuate in value with changes in market prices, thus affecting the size of our credit exposure. A credit derivative is a financial instrument used to mitigate or to assume specific forms of credit risk by hedgers and speculators. These new products are particularly useful for institutions with widespread credit exposures. Different aspects of credit risk: market risk, default rates and recovery rates The two aspects of credit risk are the market risk of the contracts into which we have entered with counterparties and the potential for some pejorative credit event such as default or downgrade. The difficult thing is to try and calculate the probability of default or of a negative credit event. There are different methodologies to try and calculate default risk using the credit spreads observed in the corporate bond market, historical default rates for a given class of credit, interpreting information available from financial statements and other public commentary from the counterpartys management. Another difficulty in assessing credit risk is estimating the recovery rate. Lets say that ABC bank defaults and that we have an outstanding with ABC, the market value of which is Rs.10 million in our favor. It is not automatically true that we are not going to see any of that Rs.10 million once the smoke clears from the bankruptcy negotiations. We may be able to receive a partial payment. The recovery rate is the rate at which we are paid in the event of a negative credit event. If we are paid Rs.2 million at the end of the day, then the recovery rate here is 20%. What was the expected value of the loan to us the day before ABC defaulted? Lets say that we had estimated a default probability of 5% and a recovery rate of 20%. Then, the expected value condition is 95% of the exposure plus 20% of the 5% of the value of the exposure. That is, Expected Value =0.95(Rs.10 million) + 0.05(Rs.10 million x 0.20) = Rs.9.6 million This expected value of the loan is less than its current market value because of the possibility of default and less-than-total recovery of the value of the swap in the event of default. Thus there are two steps in calculating credit risk: estimating the credit exposure and calculating the probability of default. Once we have calculated these two statistics, we can quantify the credit risk. Credit risk is simply the product of credit exposure and the estimated probability of default. Calculating the credit exposure in the case of investment products is done by using value-at-risk techniques. But there are a number of complicating factors implicit in this calculation of credit risk. It is difficult to measure default probabilities. Credit exposure is an increasing function of

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time because of the potential increase in value of the contract. The longer a contracts maturity, the greater the credit risk involved. Because credit risk is such a tremendous overhang in any relationship, banks and dealers have worked with lawyers to develop techniques that help mitigate the credit exposure inherent in derivatives transactions like netting the outstanding cash flows, seeking collaterals and third party guarantees that are just some of the more simple examples of credit enhancement techniques. Credit derivatives are instruments recently traded on the financial markets by means of which the credit risk inherent in loans, bonds or other risk assets or market risk positions are transferred to third parties acting as so-called protection sellers. The original credit relationships of the so-called protection buyers (the parties transferring the credit risk) are neither changed nor newly established by this process. Thus credit derivatives can be defined as arrangements that allow one party (protection buyer or originator) to transfer credit risk of a reference asset, which it may or may not own, to one or more other parties (the protection sellers). Credit derivatives can also be used to lay off and manage a companys exposure to credit events, such as supplier default. Most importantly, derivative products enable the end user to tailor their risk profile in order to most closely match their exposure to their view of the financial markets and their preferences for holding and managing risk. Credit derivatives differ from other, traditional forms of credit risk transfer, such as guarantees or providing collateral security, in that these, as derivatives, are normally concluded under standardised master agreements, subject to an ongoing market valuation, subject to special risk controlling and management. An additional difference is that the drawing on the credit derivative does not directly constitute a claim on the debtor of the underlying position for the protection seller. Local banks can take advantage of their informational edge in terms of assessing the default risk and recovery rates in their regional market. They make loans based upon this credit assessment and then use credit derivatives to swap these cash flows for more internationally diverse cash flows. Imagine a US regional bank that lends money in Reno to a local hotel. They take this credit risk and add it to their overall portfolio of credit risk. Deciding to reduce their local exposure, they exchange the cash flows from a portfolio of their mid-grade Reno debt for cash flows of highly rated Northern Italian corporate debt. This is just one example. Some observers suggest that credit derivatives may herald a new form of international banking in which banks resemble portfolios of globally diversified credit risk more than purely domestic lenders. CREDIT SWAPS Corporate bonds trade at a premium to the risk-free yield curve in the same currency. US Corporate Bonds trade at a premium (called a credit spread) to the US Treasury curve. The credit spread is volatile in and of itself and it may be correlated with the level of interest rates. For example, in a declining, low interest rate environment combined with strong domestic growth, we might expect corporate bond spreads to be smaller than their historical average. The corporate who has issued the bond will find it easier to service the cash flows of the corporate bond and investors will be hungry for any kind of premium they can add to the risk-free rate.

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Imagine the fund manager who specializes in corporate bonds who has a view on the direction of credit spreads on which he would like to act without taking a specific position in an individual corporate bond or a corporate bond index. One way for the fund manager to take advantage of this view is to enter into a credit swap. Lets say that the fund manager believes that credit spreads are going to tighten and that interest rates are going to continue to decline. He would then want to enter into a swap in which he paid the corporate yield at six-month intervals against receiving a fixed yield equal to the Treasury yield plus the corporate credit spread. That is to say, at the six-month reset for the tenor of the swap, the fund manager agrees to pay a cash flow determined to be equal to the current annual yield on some benchmark corporate bond or corporate bond index in consideration for receiving a fixed cash flow. This is an off-balance sheet transaction and the swap will typically have zero value at inception. If corporate yields continue to fall (i.e. through a combination of a lower risk-free rate and a lower corporate credit spread than the one he locked in with the swap), he will make money. If corporate yields rise, he will lose money. 1998 was a dynamic year for corporate bond spreads with the backup in interest rates in the aftermath of the Russian devaluation-inspired liquidity crisis concentrated mainly in corporate yields. The volatility of these spreads was extreme when compared to their historical movement. Credit swaps would have been an excellent way to play this spread volatility. Moreover, credit swaps (particularly ones based on a spread index) are clean structures without the messy difficulty of finding individual corporate bond supply, etc. Another example of a credit swap might be the exchange of fixed flows (determined by the yield on a corporate bond at inception) against paying floating rate flows tied to the risk-free Treasury rate for the corresponding maturity. Swaps are flexible in their design. If you can imagine a cash flow exchange, you can structure the swap. There might be a cost associated with it but you can certainly put it on the books. Types of credit derivatives: Basically, three types of products can be distinguished, depending on the kind of risk transferred by the credit derivative: (i) total return swaps (ii) credit default swaps (iii) credit linked notes The easiest and the most traditional form of a credit derivative is a guarantee. Financial guarantees have existed for thousands of years. However, the present day concept of credit derivatives has traveled much farther than a simple bank guarantee. The credit derivatives currently being available in the market can be broadly classified into the following: (i) Total Return Swap In the case of a total return swap, the protection buyer swaps the returns on a reference asset (e.g. a bond) and increases in its value periodically with the protection seller in exchange for payment of a variable or fixed reference interest and compensation of losses in the value of the reference asset

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Thus, the protection seller assumes from the protection buyer the overall market risk as well as the credit risk from the reference asset for the term of the transaction. Total-rate-of-return swaps have a total-return purchaser who pays a periodic fee to the totalreturn seller in return for the total net payments of some underlying asset. In this case if the underlying asset increases in value the total-return purchaser receives this higher return but if the underlying asset depreciates then the total-return purchaser pays the value of this decrease to the total-return seller. In the case of a default or some other credit event of the underlying asset the total-rate-of-return swap usually terminates. As the name implies, a total return swap is a swap of the total return out of a credit asset against a contracted prefixed return. The total return out of a credit asset can be affected by various factors, some of which may be quite extraneous to the asset in question, such as interest rate movements, exchange rate fluctuations etc. Nevertheless, the protection seller here guarantees a prefixed return to the originator, who in turn, agrees to pass on the entire collections from the credit asset to the protection seller. That is to say, the protection buyer swaps the total return from a credit asset for a predetermined, prefixed return. Credit default swap: Default swaps simply transfer the credit risk of an asset from one party to another. The holder of an asset, suppose a bond, would pay a periodic fee to the risk buyer and in return would receive some agreed upon payment in the case of some credit event, a default, bankruptcy, credit downgrade, etc and receives in return a one-off option premium or, if appropriate, an annualised premium in the case of longer maturities. The usefulness of these is straightforward as they help hedge against events that would cause a dramatic decrease in the value of an asset.

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The credit default payment may be made in the amount of the par value in exchange for physical delivery of the reference asset, or in the form of a compensation amounting to the difference between the par value and the recovery value of the reference asset after the occurrence of the credit event, or as agreed fixed amount. As the protection seller is obliged to make the credit default payment only in case of a credit event, merely the credit risk and thus, depending on its specification, only part of the specific market risk is hedged. The protection buyer remains unprotected against those changes in value, which are not due to the credit event. Bank A has made extensive loans in its corporate credit portfolio to a property developer called HUD. It is looking for some kind of insurance against a downgrade of HUD by the major ratings agency, a real possibility since the main project HUD has taken on is running into unforeseen delays. Bank A approaches Bank B with the concept of a credit default swap. Bank A pays Bank B a premium every six months for the next five years in exchange for which Bank B agrees to make payments to Bank A of a pre-set amount should HUD be downgraded. Bank B now has exposure to HUD, a position they could not take directly because they are not part of HUDs lending syndicate. Bank A has some degree of protection against a HUD credit downgrade. This reduction in their overall credit profile means that they do not need to hold as much capital in reserve, freeing Bank A up to take other business opportunities as they present themselves. Credit default swap is a refined form of a traditional financial guarantee, with the difference that a credit swap need not be limited to compensation upon an actual default but might even cover events such as downgrading, apprehended default etc. In a credit default swap, the protection seller agrees, for an upfront or continuing premium or fee, to compensate the protection buyer upon the happening of any specified credit event, such as a default, downgrading of the obligor, apprehended default etc. Credit default swap covers only the credit risk inherent in the asset, while risks on account of other factors such as interest rate movements remains with the originator. Credit linked notes: Credit linked notes are a securitized form of credit derivatives. The technology of securitisation here has been borrowed from the catastrophe bonds or risk securitization instruments. Here, the protection buyer issues notes. The investor who buys the notes has to suffer either a delay in repayment or has to forego interest, if a specified credit event, say, default or bankruptcy, takes place. This device also transfers merely the credit risk and not other risks involved with the credit asset. A credit linked note is a bond issued by the protection buyer which is to be redeemed at par value on maturity only if a pre-defined credit event does not occur for a reference asset. If the credit event occurs, the credit-linked note is redeemed within a fixed period of time, less a compensation amounting, for instance, to the difference between the par value and the recovery value of the reference asset.

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The credit-linked note constitutes in this respect a combination of a bond and a credit default swap. As in the case of a credit default swap, only the credit risk from the reference asset is secured. Changes in value caused by events other than the pre-defined credit event are not covered on the other hand. However, in contrast to the credit default and the total return swap, the protection seller makes his money payment for loan in advance. On the part of the protection buyer, the collection of the proceeds from the issue of the credit-linked note has the effect of a cash-collateralization of the original credit risk. Credit-spread put options are somewhat similar to total-rate-of- return swaps in that they do not rely upon any specific credit event occurring. A credit-spread put option consists of the buyer who wishes to guard against an increase in the spread, where spread is the yield differential between an asset held by the buyer and usually a interest-rate swap, and a seller who writes the put option. The buyer pays a one-time fee to the seller and in return the seller agrees to pay some agreed upon amount should the spread breach some preset level. The benefit here is that during times of heightened uncertainty, especially concerning emerging markets, risky assets can decrease in value with no apparent cause which renders default swaps useless since they only provide protection in the case of some credit event. A credit-spread put option would be useful in this situation because it would entitle the holder of the risky asset to a payment as soon the yield spread passed some preset threshold. Therefore as this riskier asset now declines in value, due not to a credit event but instead to some financial crisis or panic, the holder is compensated by the seller of the credit-spread put option. Credit derivatives can be used in a variety of ways, aside from simply hedging risk. An example is their use in helping to construct synthetic positions which cannot be established outright in standard markets. Suppose an investor wishes to buy a 4 yr. debt issue of a foreign company, company Ba, but no such bonds have been issued by this corporation and he/she also does not wish to undertake the currency risk which would be involved in such a transaction. Herein this investor could purchase 4 yr. bonds of another corporation, preferably a more creditworthy one to reduce risk, which are denominated in the domestic currency and simultaneously offer to sell insurance against a potential default of company Ba. This investor would then receive the coupon payments on the higher rated debt that has been purchased outright plus the periodical payments from the credit swap. This creates a synthetic position where the return is now similar

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to an outright purchase of a 4-year bond issue of company Ba denominated in domestic currency. These are just a few of the examples of credit derivatives. Institutional investors often use credit derivatives when positioning themselves in emerging markets for the ease of transaction in the same way that they might use equity swaps. Fund managers can use credit derivatives to hedge themselves against adverse movements in credit spreads. Corporates can use credit swaps to hedge near-term issues of corporate bonds. Banks and other financial institutions can use credit derivatives to optimize the employment of their capital by diversifying their portfolio-wide credit risk.

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18. SECURITISATION
What is Securitisation? Securitisation is conversion of existing or future cash flows into tradable securities that can be sold to investors. This leads to creation of financial instruments that represent ownership interest in or are collateralised by a homogenous or, sometimes, even diversified pool of assets. These assets are generally automobiles loans, housing loans, credit card receivables or even trade receivables. There are four steps in a securitisation: Special Purpose Vehicle (SPV) is created to whom assets collateralising the securities issued are transferred; (ii) the originator or holder of the assets sells them to the SPV; (iii) the SPV, with the help of an investment banker, issues securities which are sold to investors; and (iv) the SPV pays the originator for the assets with the proceeds from the sale of securities. The essential ingredients of securitisation would therefore be: Legal true sale of assets to an SPV with narrowly defined purposes and activities. Issuance of securities by the SPV to the investors collateralised by the underlying assets. Reliance by the investors on the underlying pool of assets for repayment - rather than on the creditworthiness or standing of the originator (the seller) or the issuer (the SPV). As a result of the above, Bankruptcy Remoteness of the SPV from the originator. That is, even if the originator were to go bankrupt at a later stage, the assets transferred to the SPV will be beyond the reach of the creditors or the liquidator of the originator. The following additional features are also generally observed: originators continuing involvement with the assets sold - in its capacity as a servicer; support for timely interest and principal repayments in the form of suitable credit enhancements; ancillary facilities to cover interest rate / forex risks, guarantee, etc; Formal rating from a rating agency. A typical securitisation structure can be represented by the following diagram: (i)

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Parties to a Securitisation Transaction

Primarily, there are only three parties in a securitisation deal, viz.: i) Originator: The entity on whose books the assets to be securitised exist. It is the prime mover of the deal. It sells the assets on its books and receives the funds generated from such a sale. In a true sale, the originator transfers both the legal and the beneficial interest in the assets to the SPV. ii) SPV: Also known as SPE (Special Purpose Entity) or SPC (Special Purpose Company), it is the entity that would buy the assets to be securitised from the originator. The SPV is typically a low-capitalised entity with narrowly defined purposes and activities, and usually has independent trustees/directors. As one of the main objectives of securitisation is to remove the assets from the balance sheet of the originator, the SPV plays a very important role in as much as it holds the assets in its books and makes the upfront payment for them to the originator.

iii) Investors: The investors may be individuals or institutional investors like banks, financial institutions, mutual funds, provident funds, pension funds, insurance companies, etc. They buy a participating interest in the total pool of receivables and receive their payment in the form of interest and principal as per agreed pattern. Besides these three primary parties, the other parties involved in a securitisation deal are: a) Obligors: They are originators debtors. The amount outstanding from them is the asset that is transferred to the SPV. The credit standing of the obligors is of paramount importance in a securitisation transaction. Administrator or Servicer: It collects the payments due from the obligors and passes them on to the SPV, follows up with delinquent borrowers and pursues legal remedies, wherever required, against the defaulting borrowers. Since it receives the instalments and pays them to the SPV, it is also called the Receiving and Paying Agent. Agent and Trustee: It accepts the responsibility for overseeing that all the parties to the securitisation deal perform in accordance with the securitisation trust agreement. Basically, it is appointed to look after the interest of the investors. Credit Enhancer: A bank or an insurer that provides credit support through a letter of credit, guarantee or other assurance. Liquidity Support Provider: It will enable the SPV to make timely payments to the investors in situations where, for example, there are timing differences in the receipt of interest and principal on pooled assets and servicing the securities. Swap Counter Party: Provides interest rate / currency swap, if needed Market Maker: Supposed to offer two-way quotes when the security is listed.

b)

c)

d) e)

f) g)

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e)

Legal Counsel: He goes into the legalities of the various aspects of the deal and gives an opinion on whether requirements of true sale have been met or not and whether the security has been legally perfected. Rating Agency: Since the investors take the risk on the asset pool rather than the originator, an external credit rating plays an important role. The rating process would assess the strength of the cash flow and the mechanism designed to ensure full and timely payment by cherry-picking the loans, i.e. by selecting loans of appropriate credit quality and by assessing the extent of credit and liquidity support required. The rating agency will also examine whether the legal security has been perfected or not. Structurer: Normally, an investment banker is responsible as structurer for bringing together the originator, credit enhancers, the investors and other parties to a securitisation deal. It also works with the originator and helps in structuring the deal.

h)

i)

The different parties to a securitisation deal have very different roles to play. In fact, firms specialise in those areas in which they enjoy competitive advantage. The entire process is unbundled, i.e. broken up into separate parts with different parties specialising in different activities such as origination of loans, raising funds from the capital markets, servicing of loans, etc. It is this kind of unbundling that introduces several efficiencies securitisation is so often credited with. 3. Pass and Pay through Structures

In a securitisation transaction, the SPV issues securities which are either Pass Through Certificates or Pay Through Certificates. The nature of the investors interest in the underlying assets determines whether a securitisation structure is Pass Through or Pay Through. In a pass through structure, the SPV issues Pass Through Certificates which are in the nature of participation certificates that make the investors owners of the underlying pool of assets pro rata, i.e. to the extent of their holdings. Pay Through, on the other hand, gives investors only a charge against the securitised assets, while the assets themselves are owned by the SPV. The SPV issues regular secured debt instruments. Pay Through Certificates are issued when there are timing differences between cash inflows and outflows, e.g. when PTCs have to be serviced at quarterly intervals but cash flows in from the securitised assets each month. In such a situation, the SPV is given discretion to re-invest short term surpluses - a power that is not available to the SPV in the case of the pass through structure. In the pass through structure, investors are serviced as and when cash is actually generated by the underlying assets. Delay in cash flows is shielded only to the extent of credit enhancement provided. Prepayments are, however, passed on to the investors who then have to tackle the re-investment risk. 4. Asset and Mortgage Backed Securities

Securities issued by the SPV in a securitisation transaction are referred to as Asset Backed Securities (ABS) because investors rely on the performance of the assets that collateralise the securities. They do not take an exposure either on the previous owner of the assets (the originator) or on the entity issuing the securities (the SPV). Clearly, classifying securities as asset-backed seeks to differentiate them from regular securities, which are the liabilities of the entity issuing them.

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There is another category of securities also: securities backed by mortgage loans called Mortgage Backed Securities (MBS). The most common example of MBS is securities backed by mortgage housing loans. The term ABS is understood to mean securities other than MBS. 5. Asset Backed Commercial Paper

In certain securitisation structures, such as asset-backed commercial paper programs, a bank sponsors an SPV known as an ABCP conduit that issues commercial paper to finance the purchase of trade receivables from one or more sellers (i.e. transferors of assets). Acquired assets may include a variety of short, medium, and long-term financial assets, including rated securities. ABCP conduits are typically established by commercial banks to provide low-cost financing to their customers or for balance sheet relief for the sponsoring institution. Sponsoring banks generally are not originators or loan servicers: this is usually the function of the various asset sellers. However, they may provide credit enhancement and liquidity facilities, manage the conduit program and place the conduits securities into the market. In general, a liquidity facility enables timely payments to the investors on the issued ABCP in the event of market disruptions and also by smoothing timing differences in the payment of interest and principal on the pooled assets. Liquidity facilities typically are provided to amortising securitisations, such as residential and commercial mortgage-backed securities, and ongoing ABCP conduits. Fully vs. Partially Supported ABCP conduits are typically categorized by their level of program wide credit enhancement, which determines whether a conduit is fully or partially supported. In fully supported programs, the repayment of CP relies on a financial guarantee in the form of a credit agreement, surety bond, letter of credit, or third party guarantee to cover all credit risks. Moreover, investors risk rests with the financial strength of the guarantor and is not affected by a default on the underlying assets. In contrast, partially supported ABCP programs rely primarily on the cash flow or market value of a pool of assets for repayment of the CP. Investors in partially supported programs are exposed to losses on the underlying program assets to the extent that such losses exceed poolspecific reserves and program wide credit enhancement. Single-Seller vs. Multiseller ABCP programs are also categorized as either single seller or multi-seller programs. Singleseller programs are bankruptcy-remote SPCs that issue ABCP to fund the assets of a single originator or seller. Multiseller conduits combine the assets of several unrelated sellers into one diverse portfolio of assets supporting the CP issuance and are typically sponsored by large commercial banks. The multiseller conduit itself is also a bankruptcy remote SPC .The asset portfolio is purchased and managed for the issuer by an operating or administrative agent, generally a division or dedicated group within a sponsoring bank or finance company, in accordance with the conduits operating guidelines. A typical multi-seller ABCP structure would be like this:

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6.

Collateralised Loan Obligations

There is yet another category of securities CBOs and CDOs which came into being in the late 1980s in the USA with repackaging of high-yield speculative-grade bonds or loans into highly rated paper. A CBO is backed by a portfolio of secured or unsecured senior or junior bonds issued by a variety of corporate or sovereign obligors. A CLO is backed by a portfolio of secured or unsecured loans made to a variety of corporate commercial and industrial loan customers of one or more lending banks. A CDO is backed by a portfolio that is a combination of bonds and loans described above. Cash flows from the asset pool plus credit enhancement to cover credit risk in the portfolio provide payment to the CBO or CLO investor. Credit enhancement or credit support often comes in the form of excess assets over rated CBO/CLO liabilities. This is achieved by subdividing the CBO or CLO into senior and subordinated tranches or classes, each with different ratings, different loss positions and different levels of excess asset buffers. For example, depending on an issuers underlying portfolio characteristics, Rs100 million in assets can back Rs 80 million AA rated senior notes, and Rs 20 million unrated subordinated notes.

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Arbitrage or spread CBO/CLO transactions can realise the positive spread between a portfolio of higher-return, higher-risk assets and lower-cost, highly rated CBO/CLO securities issued to purchase that portfolio. Balance sheet CBO/CLO transactions can reduce regulatory capital requirements and enhance lending capacity and return on equity by using the proceeds of the CBO/CLO securities to spin off bonds or loans from the balance sheet. The following diagram represents a typical CBO transaction:

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7.Forms of Credit Enhancement Investors in securitised instrucments take a direct exposure on the performance of the underlying collateral and have limited or no recourse to the originators. They hence seek additional comfort in the form of credit enhancement, a term used to describe any of the various methods by which a certain measure of protection is provided to the investors (in relatively senior securities) against obligor defaults in the asset pool collateralizing their investment. These losses may vary in frequency, severity and timing, and depend on the asset characteristics, how they are originated and how they are administered. Credit enchancements are often essential to secure a high level of credit rating and for low cost funding.

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By shifting the credit risk from a less-well-known borrower to a well-known, strong and large credit enhancer, credit enhancement corrects the imbalance of information between lender and borrower. Credit enhancements are either external (third party) or internal (structural). Various forms of credit enhancements are: External Credit Enhancements i) Insurance ii) Third party guarantee iii) Letter of credit Internal Credit Enhancements i) Subordination

ii) Over-collateralisation iii) Cash collateral iv) Spread account v) Escrow account vi) Triggered amortisation

Insurance: A common method of credit enhancement involves insuring or wrapping the rated securities with an insurance policy rated as high as AAA. This insurance transfers the credit risks associated with the underlying assets from the holders of the rated securities to the insurance company, which typically guarantees timely payment of principal and interest. The insurance policy is generally written by a monoline insurer rated AAA. ( A monoline insurer does not write life or general insurance policies.) In India we do not have monoline insurer. For the present, therefore, the existing general insurance companies like GIC will have to play this role. Third party guarantee: This method involves a limited/full guarantee by a third party to cover losses that may arise on non-performance of the collateral. Letter of credit: For structures with credit ratings below the level sought for the issue, a third party provides a letter of credit for a nominal amount. This may provide either full or partial cover of the issuers obligation. Subordination: One of the most common forms of credit enhancement is subordination. In the multitranche or senior/subordinated structures, the subordinated or junior tranches support the senior tranches. The tranches differentiate payment priorities to the holders of securities. Holders of the senior securities have priority of payment over the holders of any junior tranche. As a result of their subordinated status, the junior debt tranches generally are rated lower than the senior debt. However, the junior debt carries a higher interest rate, which reflects the reward to these subordinated debt holders for taking greater risk. Quite often the junior most tranche is held by the originator itself. If all goes well, this mechanism will enable the originator to extract profit from the structure after all other PTCs have been paid off in full. Over-collateralisation: The originator provides assets in excess of the collateral required to be assigned to the SPV. The overcollateralisation amount equals the estimated level of credit losses that the structure is expected to withstand without causing a loss to the holders of the rated senior tranche.

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Consider, for example, a transaction involving the issuance of Rs80 million of rated senior debt supported by a collateral pool with a total par value of Rs100 million. This 80/20 liability structure consists of 80% rated senior debt, and 20% unrated supporting debt or equity. The level of overcollateralisation equals 125%. The funds used for the purchase of surplus assets (Rs20 million in this example) are raised by the issuance of subordinated debt, equity, or a combination of both. This Rs20 million subordinated portion provides overcollateralisation to the senior debt holders. If subordinated debt was issued in the amount of Rs 5 million and equity was issued in the amount of Rs15 million as the third and junior most tranche, overcollateralisation for the Rs 5 million second class of junior debt would be provided by the equity investment. The payment structure - how a transaction allocates collateral cash flow to pay down principal has a large impact on the build-up of overcollateralisation or credit enhancement over time. All payment structures represent different trade-offs between pay-down and support of the senior class versus return of cash to the junior and equity holders. There are several types of payment structures most commonly used: sequential pay, fast pay/slow pay, and pro rata. Sequential pay structures require payment of senior debt in full before the payment of junior debt. In the 80/20 example discussed earlier, the Rs20 million subordinated class would remain outstanding until the entire Rs 80 million senior class was retired. Clearly, as the Rs80 million senior notes pay down and are reduced in principal balance, the effective overcollateralisation of the senior note holders builds to well above 20%. In such structures that pay senior debt first, senior debtholders benefit from an increase in credit enhancement as the portion of subordinated debt grows in relation to total debt. Fast pay/slow pay structures pay down senior and junior debt, but pay down senior debt faster than the junior debt and at a higher rate than pro rata. Like sequential pay structures, these structures typically require a minimum par value overcollateralisation ratio,(collateral principal and cash balances divided by the rated note principal) in which the ratio of assets over liabilities must be maintained at a minimum level, for example, at least 125%. If this test is breached, a higher percentage or all of the collateral cash flow will be used to pay senior debt until compliance is restored. If excess funds are available after meeting senior and junior debt service and coverage requirements (for interest, principal, reserves, and so on), they may be used to pay down junior debt, even before senior debt maturity. Some structures have a pro rata pay-down, in which the above 80/20 percentage is used to allocate collateral principal to the rated debt. Overcollateralisation is kept at the same 80/20 percentage, until retirement of the senior class. Subordinated investors can receive up to their 20% share of cash flow prior to the maturity of the senior class. Available funds are applied first to make scheduled payments on the senior debt, so that if losses occur, senior holders are protected. Cash collateral: This works in much the same way as the over-collateralisation. But since the quality of cash is self-evidently higher and more stable than the quality of assets yet to be turned into cash, the quantum of cash required to meet the desired rating would be lower than asset over-collateral to that extent. Spread account: The difference between the yield on the assets and yield to the investors from the securities is called excess spread. In its simplest form, a spread account traps the excess

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spread (net of all running costs of securitisation) within the SPV up to a specified amount sufficient to satisfy a given rating or credit quality requirement. To the extent the excess spread is captured within the transaction for the benefit of the rated securities, it provides an additional layer of loss protection Only realisations in excess of this specified amount are routed back to the originator. Alternatively, excess spread can be passed through to the senior note holders, under certain circumstances. One example is when credit losses on the bond/loan portfolio occur earlier than expected, or exceed the level up to which the structure provides loss protection to investors. Excess spread also may be used to pay down the rated securities sequentially in cases when certain covenants (such as minimum par value overcollateralisation and interest coverage ratios) are not met. Escrow account: Cash flows intended to service the investors claims are trapped in a separate account, thereby adding to their comfort and to insulate them against the risk of default arising out of any other pressing demands on the originators cash flow. Triggered amortisation: This works only in structures that permit substitution (for example, rapidly revolving assets such as credit cards receivables). When certain pre-set levels of collateral performance are breached, all further collections are applied to repay the debt. Once amortisation is triggered, substitution is stopped and the early repayment is an irreversible process. Triggered amortisation is typically applied in future flow securitisation. In addition, other customised arrangements may be used to provide the requisite credit enhancement for the rating credit required such as credit derivatives that can be exercised by the SPV upon obligor defaults. 8. Synthetic Securitisation Through securitisation an originator seeks, among other things, to transfer credit risk of the underlying pool of assets to an SPV by shedding the assets. The same objective can also be achieved through a different route - synthetic securitisation even while the assets continue to be on the originators balance sheet. A few examples follow. Entire notional amount of the reference portfolio is hedged In this type of synthetic securitisation, an SPV acquires the credit risk on a reference portfolio by purchasing credit-linked notes (CLNs) issued by the sponsoring banking organisation. The SPV funds the purchase of the CLNs by issuing a series of notes in several tranches to third party investors. The investor notes are in effect collateralised by the CLNs. Each CLN represents one obligor and the banks credit risk exposure to that obligor, which may take the form of, for example, bonds, commitments, loans, and counter party exposures. Since the note holders are exposed to the full amount of credit risk associated with the individual reference obligors, all the credit risk of the reference portfolio is shifted from the sponsoring bank to them. The amount of notes issued to investors equals the notional amount of the reference portfolio. In the example shown below, this amount is $1.5 billion.

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Figure

If there is a default of any obligor linked to a CLN in the SPV, the institution will call the individual note and redeem it based on the repayment terms specified in the note The term of each CLN is set such that the credit exposure to which it is linked matures prior to the maturity of the CLN. This ensures that the CLN will be in place for the full term of the exposure to which it is linked. An investor in the notes issued by the SPV is exposed to the risk of default of the underlying reference assets, as well as to the risk that the sponsoring institution will not repay principal at the maturity of the notes.

High quality, senior risk position in the reference portfolio is retained including a small first-loss position equal to expected losses
In some synthetic CLOs, the sponsoring banking organisation has used a combination of credit default swaps and CLNs to essentially transfer to the capital markets the credit risk of a designated portfolio of the organisations credit exposures. In this structure, the sponsoring banking organisation purchases default protection from an SPV for a specifically identified portfolio of banking book credit exposures, which may include letters of credit and loan commitments. The credit risk on the identified reference portfolio, which continues to remain in the sponsors banking book, is transferred to the SPV through the use of credit default swaps. In exchange for the credit protection, the sponsoring institution pays the SPV an annual fee. The default swaps on each of the obligors in the reference portfolio are structured to pay the average default losses on all senior unsecured obligations of defaulted borrowers. (See Figure below for an example of this structure.) In order to support its guarantee, the SPV sells CLNs to investors and uses the cash proceeds to purchase central government securities. The SPV then pledges the government securities to the sponsoring banking organisation to cover any default losses. The CLNs are often issued in multiple tranches of differing seniority and in an aggregate amount that is significantly less than the notional amount of the reference portfolio. The amount of notes issued typically is set at a level sufficient to cover some multiple of expected losses, but well below the notional amount of the reference portfolio being hedged.

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The first-loss position may be a small cash reserve, which may be equal to or greater than expected losses in the reference portfolio. This cash reserve accumulates over a period of years and is funded from the excess of the SPVs income (i.e. the yield on the central government securities plus the credit default swap fee) over the interest paid to investors on the notes. The investors in the SPV assume a second-loss position through their investment in the SPVs senior and junior notes, which tend to be rated AAA and BB, respectively. Finally, the sponsoring banking organisation retains a high quality senior risk position that would absorb any credit losses in the reference portfolio that exceed the first- and second loss positions 9. Insurance Risk Securitisation

This is another interesting application of securitisation concept. Trading in insurance risk has been very common over the centuries - insurance companies have a well-established reinsurance market. However, securitisation has made a significant difference to the way insurance risk is traded - by making it into a commodity and taking it to the capital market instead of the insurance market. The securitisation of insurance risk is a manifestation of the markets convergence. Insurance risk securitisation marks a very significant development in the process of development of both capital markets and insurance: they seem to be coming together. Insurance risk securitisation relies upon the tremendous potential of capital markets in absorbing risk. Because global capital markets are so vast - publicly traded stocks and bonds have a total value of more than USD 50 trillion - they offer a promising means of funding protection for even the largest potential catastrophes. Insurance companies have in a number of instances transferred the hard-to-place risks to the capital markets. Insurance risk securitisation is a new phenomenon. The large insurance company losses in 1992s Hurricane Andrew and 1994s Northridge earthquake convinced many insurance companies that a way to spread these risks outside the insurance industry is needed. Called cat, or catastrophe bonds, they provide a higher than market interest rate with the quid pro quo that an insurance loss might eat into the bond investors principal The first deal was reported in
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1994 with Citibank lead-managing it involving an amount of $ 85 million. A number of deals have since been reported involving placement of catastrophic risks. The total amount of cat bonds issued as of September 2000 is reportedly around USD 5 billion. The issuance structure underlying the catastrophe bonds that have been issued so far involve setting up a Special Purpose Vehicle (SPV) to act as an intermediary between the company and the capital markets. The SPV issues a reinsurance contract to the company; in turn, the company issues bonds to the capital markets through the SPV. The SPV meets its obligation, should the specific loss event occur, with the proceeds of the bonds and the reinsurance premiums paid by the company. There have also been some cases of non-catastrophic risks being securitised. Yet another interesting extension of the idea would be for a company seeking insurance cover to set up the SPV and seek the cover from the capital market rather than from an insurance company through the bond issuance route in exactly the same way as an insurance company would have sought to cover its risks. The first such case reported was that of Tokyo Disneyland amusement park seeking earthquake protection risk through this route. 10. Future Flow Securitisation

In a typical future flow transaction, the borrowing entity (originator) sells its future receivables to a Special Purpose Vehicle (SPV), usually an offshore entity, which issues the debt instrument. Designated international customers (obligors) are directed to pay for the goods they import from the originator directly into an offshore collection account managed by a trustee. The collection agent makes principal and interest payments to lenders. Any funds left over are forwarded to the originator. Sovereign transfer and convertibility risks are mitigated because the borrowing entity has obtained a legally binding consent from designated customers that they will make payments to the offshore trust; bankruptcy risk is also decreased in such transactions because SPVs typically have no other creditors and hence cannot go bankrupt. Of course, there is always a risk that the originator will go bankrupt. Lenders can reduce this risk by favouring originators with high credit ratings for domestic-currency debt and a strong ability and willingness to produce and deliver the products that generate the receivables. While securitisation may not be of much help to sub-investment-grade borrowers in developing countries, it can help investment-grade issuers (in local-currency terms) to pierce the sovereign credit ceiling on long-term external debt. Some elements of sovereign (country) risk cannot be totally eliminated, however. For instance, the government may force an originator to sell its products in domestic rather than export markets. This risk is generally higher for commodities (such as agricultural staples) for which domestic demand is large than for products such as crude oil that can be sold only to a limited number of buyers. The risk of product diversion is also low for credit card receivables, because of the small number of credit card companies. Although market risk arising from price and volume volatility, which may cause cash flow to fluctuate, cannot be totally eliminated, it can be mitigated through excess coverage or overcollateralisation. Typically, product risk is easier to control for commodities like oil, gas,

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metals, and minerals, for which there is demand from many diverse sources, than for custommade products unless long-term sales contracts are enforceable. Based on their assessment of performance, product, and sovereign risks, the rating agencies have ranked future flow receivable transactions from most secure to least secure (See Table below). But it is possible to securitise even the least secure future flow receivables: several Argentine provinces, for example, securitised tax revenues to be received via federal tax sharing. In Italy even delinquent social contributions were securitised in a deal that was rated AAA. Of course, the lower in the hierarchy they are, the more future flow receivable transactions require safeguards to improve their credit ratings. Insurance companies are playing a growing role in structured finance transactions by providing complete financial guarantees, as MBIA did for a securitisation launched by Pemex, Mexicos state-owned oil and gas company. The Multilateral Investment Guarantee Agency (MIGA) of the World Bank Group has provided insurance against political risks in several future flow deals.

The innovative structure of these transactions has allowed many investment-grade borrowers in developing countries to obtain financing at much lower interest rates than their governments. In late 1998, Pemex Finance Ltd. issued oil-export-backed securities rated BBB by Standard and Poors, three notches above Mexican sovereign and Pemex unsecured debt. Securitisation saved Pemex anywhere from 50 to 337.5 basis points on what it would have had to pay on senior debt. In the aftermath of the Mexican crisis of 1994-95, Argentinas oil company YPF (by then privatized) raised $400 million at a 200 basis-point spread advantage through the securitisation of future export receivables. Notwithstanding the liquidity crisis in Mexico, and the tremendous stress that the financial sector underwent, Mexican banks were able to access seven-year money based on securitisation of their Visa and Master Card receipts Securitisation also allows issuers from developing countries to lengthen the maturities of their debt, improve risk management and balance sheet performance, and tap a broader class of investors. There have been no debt defaults on rated future flow asset-backed securities issued by developing country entities despite repeated liquidity and solvency crises. The asset class withstood the test of the Mexican peso crisis in 1994-95, the Asian liquidity crisis in 1997-98, and the Russian and Ecuadorian debt defaults in 1998 and 1999 respectively. An interesting

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example is the receivable deal of PTCL, Pakistans phone company, which continued to perform even in the face of selective default on sovereign debt. While this track record of no default is encouraging, future flow asset-backed debt has not yet been severely tested because it still represents a very small percentage of total debt. So far, given the low volume of future flow issues, the pledging of future assets has not affected the cost or rating of unsecured debt. But there are obviously limits to the amount of future exports that can be pledged. The nature of that cash flow, taken together with a string of other structural credit enhancements, generally ensures that the transaction is rated above the unsecured debt ratings of the borrower. As a result, under a securitisation transaction, the borrower is able to achieve finer pricing and/or longer tenors than is otherwise available from other funding sources. Risks (a) Bankruptcy / Performance Risk: Since future flow transactions rely on the future generation of cash flow to repay investors, the continued existence and performance of the borrower throughout the tenure of the transaction are critical to investors. Should the borrower become insolvent, no creditors of the borrower would be able to make a claim against the receivables sold to investors. So long as the borrower continues to operate (even in bankruptcy), investors will receive payments on the receivables on time and unhindered. In terms of mitigating this risk, there is very little that can be done structurally without obtaining the support or guarantee of a rated third party Indeed, this risk generally acts as the limiting constraint on the rating of the transaction and consequently determines the tenure as well as the pricing. Generation Risk: There still is another risk related to the sustained generation of the receivables at certain levels: anticipated reserves may not materialise or seasonal variations in the anticipated levels of receivables may occur. This risk is mitigated through adequate over-collateralisation. Further, in order to protect investors against more sustained long-term declines in the levels of receivables generated, early amortisation triggers are usually built into the transaction requiring accelerated repayment of the securities if a predefined trigger is activated. Price Risk and Off-take Risk: These refer to likely price variations or the concern that the obligors in the future may cease buying or reduce their purchases of the goods or services to be sold by the seller.

(b)

(c)

Other Considerations (a) True Sale: There are some questions related to whether sale of receivables yet to be generated is legal, valid and binding and cannot be disrupted by a liquidator of the seller in bankruptcy. In many jurisdictions including the US, such sales are not enforceable. However, many other jurisdictions, such as Mexico, Brazil or Turkey do allow for such a true sale of future receivables. In India too, at present, it is difficult to perfect the security interest in respect of future receivables for the benefit of the investors and ultimately

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transactions may have to be structured with some recourse to the originator in the event of a default. (b) Negative Pledges: Investors cannot have a general recourse to the seller for all events leading to a shortage in cash flow from the receivables. They may only have recourse in situations that were under the control of the seller (such as failing to produce the goods or services in sufficient volumes). Events deemed outside the control of the seller are price risk, liquidity risk and credit risk. These risks can be mitigated somewhat but ultimately, they must lie with the investors in all securitisation transactions whether of existing receivables or of future flows. Accounting Treatment: A future flow securitisation almost always has to appear as a liability on the balance sheet of the seller. This is because the seller is selling future assets that were not on the balance sheet on the closing date of the transaction. The seller will receive the principal amount of the transaction as cash, and a corresponding entry has to be made on the liability side of the balance sheet that reflects the sellers obligations to deliver future goods or services to the SPV.

(c)

Indian context It is a relatively recent phenomenon even in the international market and is fraught with risks, which revolve around the definition, ascertainability and quantifiability of securitisable cash flows. Such risks may not be well understood by investors. The need therefore to develop the requisite competence in analysis of such risks cannot be overemphasized. Repayment to investors out of future sales could erode the current assets hypothecated to working capital bankers or the capacity of the originators to service term loans / meet other pressing obligations. However, a huge potential exists for securitisation in India. Many foreign and private banks have securitised their home loan / auto loan portfolios. Our Bank has also set a target of raising Rs. 10,000 crores through securitisation for the year 2006 07. The process of securitisation frees up capital, particularly in the context of implementation of Basel II recommendations in India.

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19. ACCOUNTING STANDARDS

In India, Accounting Standards (AS) are formulated by the Accounting Standard Board (ASB), which was constituted by Institute of Chartered Accountants of India (ICAI) in April, 1977. ICAI is a member of International Accounting Standards Committee (IASC) and while formulating the Accounting Standards, ASB gives due consideration to the International Accounting Standards issued by IASC and tries to integrate them, to the extent possible, with the applicable laws, customs, usage and business environment prevailing in India. At present, there are 29 Accounting Standards prescribed. Brief details of some of these accounting standards are given below. AS - 1 - Disclosure of Accounting Policies: The primary consideration in the selection of the accounting policies by an enterprises should be to ensure that the financial statements prepared and presented on the basis of such accounting policies should represent a true and fair view of the state of the affairs of the enterprises as on the date of the balance sheet and of the profit and loss for the period ended on that date. Therefore, the disclosure of the significant accounting policies (including the changes if any, in the accounting policies which have a material effect in the current period or expected to have material effect in later periods) should form part of the financial statements to ensure proper understanding of financial statements. AS - 2 - Valuation of Inventories: The primary issue in accounting for inventories is the determination of the value at which inventories are carried in the financial statements until the related revenues are recognised. Inventories should be valued at the lower of the cost and net realizable value. In determining cost of inventories, it is appropriate to include all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition, but to exclude certain costs recognising those expenses such as (i) (ii) (iii) Abnormal amounts of wasted material, labour etc. Storage costs unless necessary in the production process Selling and distribution costs etc.

The cost of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by specific identification or their individual costs. The cost of inventories other than those dealt with in above paragraph should be assigned by using the first-in first-out (FIFO), or weighted average cost formula. AS - 3 - Cash Flow Statements: (See Note 1) _ An enterprise should prepare a cash flow statement and should present it for each period for which financial statements are presented. This statement should reflect how the enterprise generates and uses cash and cash equivalents from operating, investing and financing activities (separately).

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AS - 4 - Contingencies and events occurring after the balance sheet date: The financial statements should reflect the treatments of (a) Contingencies (a situation where gain or loss is not determined) and, (b) Events occurring after the balance sheet date (but before the financial statements are approved). AS - 5 - Net Profit or Loss for the period, Prior period items and changes in Accounting Policies: This AS requires the classification and disclosure of extraordinary and prior period items, and the disclosure of certain items of profit and loss from ordinary activities (i.e. the items of such size, nature or incidence that their disclosure is relevant to explain the performance of the enterprise for the period). It also requires specification of the accounting treatment for changes in accounting estimates (for the itemscannot be measured with precision but can only be estimated). It also requires disclosures to be made in the financial statements regarding change in an accounting policy that has a material effect.

AS - 6 - Depreciation Accounting: While different accounting policies for depreciation may be adopted by different enterprises, explicit disclosure of the accounting policy used is necessary. The depreciation method selected should be applied consistently from period to period. In case of any change, the reason for change from one method to another and its impact on financial statements should be quantified and disclosed. AS - 7 - Accounting for Construction Contracts: This accounting standard allows accounting under only percentage of completion method. Contract revenue and related costs should be recognised as revenue and expenses, by reference to the stage of completion of the contract activity, at the balance sheet date. Any expected loss should be recognised immediately as expense. AS - 9 - Revenue Recognition: This standard deals with the basis for recognition of revenue in the statement of profit and loss of an enterprise. Revenue from sales & service should be recognised when the requirements as to performance are satisfied and it is not unreasonable to expect ultimate collection. Thus, revenue from sales to be recognised at the time of transfer of significant risks and rewards of ownership to the buyer and from service when service has been delivered. AS - 10 - Accounting for Fixed Assets: This accounting standard prescribes the accounting method for fixed assets. The cost of a fixed asset should comprise its purchase price and any attributable cost of bringing the asset to its working condition for its intended use. It lays down the method for calculating cost of selfconstructed assets; cost of asset acquired in exchange for another asset; revaluation of asset etc. AS - 11 - Accounting for the Effects of changes in Foreign Exchange rates: This AS should be applied for an enterprise (a) in accounting for transactions in foreign currencies; and

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(b) in translating the financial statements of foreign branches for inclusion in the financial statements of the enterprise. The following disclosures should be made in respect of AS 11 (i) The reason for reporting statements in currency different from the currency of the country in which the enterprise is domiciled and any subsequent change in the reporting currency. (ii) Change in the classification of a significant foreign operation and its impact on shareholders' funds and also on the profit & loss for each prior period the change has been effected. (iii) Amount of exchange differences included in the profit & loss account. AS - 12 - Accounting for Government Grants This accounting standard prescribes the accounting treatment of Government grants e.g. capital approach (a part of promoters contribution) Vs. income approach (i.e. income over one or more periods); Non-monetary grants (land or other resources at concessional rates); Refundable Grants etc. Governments grants are not to be recognised until there is reasonable assurance that (i) the enterprise will comply with the conditions attached to them, and (ii) the grants will be received. AS - 13 - Accounting for investments: This accounting standard prescribes the accounting treatment for investments viz. current investment vs. long term investment; cost of investments; disposal of investments etc. An enterprise should disclose current investments and long term investments distinctly in its financial statements. It should also disclose the accounting policies for carrying amount of investments; classification of investments; reliability of investments and aggregate amount of quoted and unquoted investments. AS - 14 - Accounting for Amalgamation: This standard prescribes the accounting for amalgamation and treatment of resultant goodwill or resources. The standard recognises amalgamation in the nature of merger or in the nature of purchase. The two methods of accounting of amalgamation prescribed by the standard are (i) pooling of interest method and (ii) the purchase method. The standard also stipulates that the first statement after amalgamation should disclose the names & business of amalgamating entities; effective date of amalgamation; method of accounting used and particulars of the scheme as sanctioned under statute. AS - 15 - Accounting for Retirement benefits in the financial statement of employers: The standard prescribes the accounting method in respect of retirement benefits in the form of provident fund, pension, gratuity, leave encashment etc. in the financial statements of the employer. AS - 16 - Borrowing Costs: This AS applies to accounting for borrowing costs i.e. only borrowing cost directly attributable to acquisition, construction or production of a qualifying asset should be capitalised; other borrowing costs should be recognised as an expense. A qualifying asset is an asset that necessarily takes substantial period of time (i.e. more than a year) to get ready for its intended use or sale.

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AS - 17 - Segment Reporting: (See note 1) The objective of the AS is to establish principles for reporting financial information about the different types of products and services an enterprise produces and the different geographical areas in which it operates. The identification of segments can be done on the basis of business (products/services) or geographical locations. It is necessary to report on the identified segment if its revenue or profit/loss is 10% or more of the combined revenue or profit/loss. If business segment is the predominant source of risks and returns for the enterprise, then the information on business segment is required to be disclosed on the primary reporting format and that on geographical segment on secondary reporting format prescribed under the Accounting Standard. If geographic segment dominates then business segment will be secondary. AS - 18 - Related Party Disclosure: (See note 1) The objective of this statement is to establish requirements for disclosure of (a) related party relationships, and (b) transactions between a reporting enterprise and its related parties. Parties are considered to be related if at any time during the reporting period one party has the ability to control the other party or exercise significant influence over the other party in making financial or operating decisions. AS - 19 - Leases: The objective of this statement is to prescribe, for lessees and lessors, the appropriate accounting policies and disclosure in relation to finance leases and operating leases. Finance lease is a lease that transfers substantially (to the lessee) the risks and rewards incident to ownership of an asset. The AS also prescribes the accounting treatments of Sale & Leaseback transactions. As - 20 - Earning per share: (See note 2) The objective of this statement is to prescribe principles for the determination and presentation of information regarding earnings per share which will improve comparison of performance among different enterprises for the same period and among different accounting periods for the same enterprise. The focus of this statement is on the denominator of the earnings per share calculation. The enterprise may ignore certain class of share, for example, bonus share etc. The standard prescribes that in such cases weighted average of existing and potential shares should be taken as denominator. AS requires that an enterprise should present basic and diluted earnings per share for each class of equity shares. The future conversion of debentures/bonds is considered to be dilative shares. AS -21 - Consolidated Financial Statements: (See note 3 & 4) The objective of this statement is to lay down principles and procedures for preparation and presentation of consolidated financial statements. The consolidated financial statement is presented by a parent (also known as a holding enterprise) to provide financial information about the economic activities of the group. These statements are intended to present financial information about a parent and its subsidiary (ies) as a single economic entity to show the economic resources controlled by the group, the obligations of the group and the results the group achieves with its resources. A parent which presents consolidated financial statement should consolidate all subsidiaries, domestic as well as foreign, other than where its control is intended to be temporary. It should present separate financial statement of the parent and also consolidated financial statement.

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AS 22 Accounting for Taxes on Income: The objective of this statement is to prescribe accounting treatment for taxes on income in accordance with the matching concept i.e. taxes on income are accrued in the same period as the revenue and expenses to which they relate. Accordingly in a number of cases taxable income may be significantly different from the accounting income. If the current tax payable in the year is lower than the tax liability as per the matching concept, then the difference would be treated as Deferred Tax Liability of the enterprise. In cases where the current tax paid is higher, the difference would be treated ass Deferred Tax Asset. AS 23- Accounting for investments in Associates or consolidated Financial Statements: (mandatory only when AS 21 has been complied with. Also see note 3, 4 & 5) The objective of this statement is to set out principles and procedures for recognising in the consolidated financial statements, the effects of the investments in associates on the financial position and operating results of a group. AS 24 Discontinuing Operations: (Recommendatory, also see note 5) The objective of this statement is to establish principles for reporting information about discontinuing operations thereby enhancing the ability of users of financial statements to make projections of an enterprise's cash flows, earning-generating capacity and financial position by segregating information about discontinuing operations from information about continuing operations. AS 25 Interim Financial Reporting: (Not mandatory also see note 5) The objective of this statement is to prescribe the minimum content of an interim financial report and to prescribe the principles for recognition and measurement in a complete or condensed financial statement for an interim period. AS 26 Intangible Assets: (See note 1) The objective of this statement is to prescribe the accounting treatment for intangible assets that are not dealt with specifically in any other Accounting Standards. This statement applies to among other things expenditures on advertising, training, start-up, and research & development activities. AS 27 Financial Reporting of Interests in Joint Ventures: The objective of this statement is to set out principles and procedures for accounting for interests in joint ventures and reporting joint venture assets, liabilities, income and expenses in the financial statements of ventures and investors. AS 28 Impairment of Assets: The objective of this statement is to prescribe the procedures that an enterprise applies to ensure that its assets are carried at no more than their recoverable amount. An asset is carried at more than its recoverable amount if its carrying amount exceeds the amount to be recovered through use or sale of the asset. If this is the case, the asset is described as impaired and this Standard requires the enterprise to recognise an impairment loss. This standard also specifies when an enterprise should reverse an impairment loss, if necessitated by future events. It also prescribes certain disclosures for impaired assets.

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Note 1: AS3, AS 17, AS18 and AS 26 are mandatory in respect of following enterprises: (i) Enterprises whose equity or debt securities are listed on a recognised stock exchange in India, and enterprises that are in the process of issuing equity or debt securities that will be listed on a recognised stock exchange in India as evidenced by the board of directors' resolution in this regard (ii) All other commercial, industrial and business reporting enterprises, whose turnover for the accounting period exceeds Rs. 50 crores Note 2: AS 20 is mandatory in respect of enterprises whose equity shares or potential equity shares are listed on a recognised stock exchange in India . Note 3: AS 21 does not mandate an enterprise to present consolidated financial statements. But, if the enterprise presents consolidated financial statements for complying with the requirements of any statute (like SEBI guidelines) or otherwise, it should prepare and present consolidated financial statements in accordance with AS 21. Note 4: Clause 32 of the Listing Agreement of SEBI states (a) Companies shall be mandatorily required to publish consolidated financial statements in the annual report in addition to the individual financial statements. (b) Audit of Consolidated Financial Statements by the statutory auditors of the company and filing of Consolidated Financial Statements audited by the statutory auditors of the company with the stock exchanges shall be mandatory. Note 5: Clause 50 of Listing Agreement of SEBI provides that companies shall mandatorily comply with all the Accounting Standards issued by ICAI from time to time.

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20. INTRODUCTION TO BASEL II Basel II is much in the news these days. What is Basel II? Basel is a place in Switzerland and is the headquarters of the Basel Committee on Bank Supervision (BCBS). This is a committee of senior central bankers/bank supervisors of the following countries: Argentina, Australia,Belgium, Brazil, Canada China ,france, Germany ,Hong Kong SAR, India ,Indonesia, Italy, Japan ,Korea ,Luxemburg, Mexico, The Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, The United Kingdom and The United States. The present Chairman of the Committee is Mr Nont Wellink, President of the Netherlands Bank. When we refer to Basel Committee or BCBS, we refer to this committee. BCBS provides a regular forum for cooperation on matters of banking supervision. It meets every quarter. The committee does not possess any formal authority and its recommendations do not have any legal force. However, its standards are accepted worldwide and are also generally incorporated in national banking regulations. BCBS role is thus to act as a think-tank for banking regulators and issue guidance on best practices for banks. Basel is also where the Bank for International Settlements (BIS) is situated. BIS is not a bank in the sense that we understand it, it does not open accounts for individuals or corporations. Its banking work is mostly for central banks (such as our RBI). BIS provides executive and secretarial support for the discussions of the Basel Committee and is a very important institution in the development of the Basel Accords and all other discussions of the BCBS for effective bank supervision. For a number of years now, BCBS has been discussing the setting of standards for measurement of risks in banks, and for the allocation of capital to cover those risks. Agreements reached by them on these discussions are published in the form of Accords. The first such capital measurement system, commonly known as Basel Capital Accord (Basel I) was published in 1988. Though the accords are primarily intended for the member countries, non-members treat this as the best practices world-wide and adapt them suitably in their countries. In India Basel I was implemented in 1992, when the concept of capital adequacy was formally introduced for the first time. At this stage, capital adequacy was introduced to cover credit risk only. However, it is important to note that even this limited arrangement did not exist till then and a formal system of capital adequacy was unknown. Basel I provided for measurement of credit risk by introduction of the concept of risk weighted assets. Those who have seen the capital adequacy returns or the Yearly Statement Abstract will be familiar with the concept of risk weighted assets. The advances outstanding are multiplied by a risk weight (0% for Advances against TDRs, 20% for advances against Government securities. 75% for Housing Loans, 100% for Other advances etc.). This gives the weighted advances figure converted by the perceived risk level in the advance. This Risk Weighted Assets figure is then multiplied by a capital adequacy ratio for calculating the minimum capital. The ratio prescribed by Basel 1 is 8% of Risk Weighted Assets. RBI, as a matter of prudence, made it 9%, so that all commercial banks in India have to maintain a minimum capital of not less than 9% of the Risk Weighted Assets. Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these
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rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. The objective of Basel1 include 1. 2. 3. Ensuring that capital allocation is more risk sensitive; Separating operational risk from credit risk, and quantifying both; Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic. Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects. The Basel I definition, as modified up to the present, remains in place. The Accord in operation Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline to promote greater stability in the financial system. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all. The first pillar The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk. Other risks are not considered fully quantifiable at this stage. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach". For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or TSA, and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA). For market risk the preferred approach is VaR (value at risk). As the Basel 2 recommendations are phased in by the banking industry it will move from standardised requirements to more refined and specific requirements that have been developed for each risk category by each individual bank. The upside for banks that do develop their own risk measurement systems is that they will be rewarded with potentially lower risk capital
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requirements. In future there will be closer links between the concepts of economic profit and regulatory capital. Credit Risk can be calculated by using one of three approaches: 1. Standardised Approach 2. Foundation IRB (Internal Ratings Based) Approach 3. Advanced IRB Approach The standardised approach sets out specific risk weights for certain types of credit risk. The standard risk weight categories are used under Basel 1 and are 0% for short term government bonds, 20% for exposures to OECD Banks, 50% for residential mortgages and 100% weighting on unsecured commercial loans. A new 150% rating comes in for borrowers with poor credit ratings. The minimum capital requirement (the percentage of risk weighted assets to be held as capital) remains at 8%. For those Banks that decide to adopt the standardised ratings approach they will be forced to rely on the ratings generated by external agencies. Certain Banks are developing the IRB approach as a result. The second pillar The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives banks a power to review their risk management system. The third pillar The third pillar demands comprehensive disclosure requirements from banks. For such comprehensive disclosures,IT structure must be in place for supporting data collection and generating MIS which is compatable with pillar 3 requirements. IMPLEMENTATION OF BASEL 11 IN INDIA The process of implementing Basel 11 norms in India is being carried out in phases. Phase1,has been carried out for foreign banks operating in India and Indian banks having operational presence outside India with effect from March 31,2008. In phase 11, all other scheduled commercial banks (except Local Area Banks and RRBs) have been included with effect from March 31,2009. The minimum capital to risk weighted asset ratio(CRAR) in India is placed at 9 percent, 1 percentage point above the Basel 11 requirements, the tier 1 capital to be a minimum of 6 percent. RBI has prescribed Standardised Approach (SA) for Credit Risk, Basic Indicator Approach (BIA) for Operational Risk and Standardised Duration Approach (SDA) for computing Capital requirements for Market Risk.

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RATINGS BY EXTERNAL AGENCIES :Under the standardized approach of pillar 1, all advances (fund based as well as non fund-based) of Rs 5crores and above inclusive of Rs5 crores are to be rated by external rating agencies prescribed by RBI for the purpose. The rating agencies are, CARE,CRISIL,FITCH Ltd ,ICRA Ltd , for international ratings the agencies are : FITCH, Moodys, and Standard and Poors. High ratings will entail lower capital requirements.

IMPLEMENTATION OF BASEL II BY A BANK A summary of the steps involved in implementing Basel II is outlined below Step 1: Analyzing gaps Step 2: Drawing an implementation roadmap Step 3: Implementing/Enhancing the Internal rating system Step 4: Creating infrastructure for data management Step 5: Building data analytics Step 6: Testing the solutions, infrastructure and procedures Step 7: Preparing for supervisory certification

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21. RISK BASED SUPERVISION OF BANKS

BACKGROUND With globalisation and liberalization the stability of the financial system has become the main challenge to bank regulators and supervisors all over the world. In the last decade, Indian banking scene has witnessed progressive deregulation, institution of prudential norms and a gradual move towards international best practices especially in the role of the supervisor. Over a period, RBI has consistently tightened the exposure and prudential norms of banks and enhanced the disclosure standards in phases in order to strengthen the efficiency of its supervisory processes. The growing diversities and complexities in banking business, the spate of product innovation, and the Contagion effects that a crisis can spread to the entire financial systems are causing pressures on supervisory resources and calls for further streamlining of supervisory processes. The second Basel Accord has the Supervisory Review Process as the second pillar. The regulators are required to focus on the risk management systems adopted by the banks and moderate the supervision based on the adequacy and robustness of these systems. Risk Based Supervision announced by RBI in its monetary and credit policy statement in 2000-01 is in the direction of strengthening the supervisory processes by RBI on banks. Put simply, RBS is the approach to the supervision of banks by RBI based on their risk exposures and threats posed by these risks to the overall systemic stability. Pricewaterhouse Coopers (PwC), London was engaged by RBI for introduction of RBS. The current move of RBS approach represents a further stage in the regulation and supervision of banks in the light of earlier Padmanabhan and Narasimham Committee reports. RBI has rolled out the RBS process in phases beginning from the financial year 2003-04. PREVIOUS APPROACH Supervisory process was applied uniformly to all supervised institutions It was essentially on-site inspection driven (i.e. direct inspection of bank branches by RBI) supplemented by off-site monitoring. The on-site inspections were conducted largely with reference to audited balance sheet dates. Supervisory follow-up commenced with the detailed findings of annual financial inspection. The process of inspection was based on CAMELS (for Indian banks) /CALCS (for Indian branches of foreign banks) (Capital adequacy, asset quality, management aspects, earnings, liquidity and systems; and control) RBS- THE NEW APPROACH The objectives of RBS are two fold: Optimise utilization of supervisory resources (i.e. the time, manpower and efficiency of RBIs supervision) and Minimise impact of crisis situations on the financial system. RBS process essentially involves continuous monitoring and evaluation of the risk profiles of the supervised institutions (i.e. banks) in relation to their business strategy and exposures. This assessment will be based on construction of a Risk Matrix for each institution. The efficiency
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of the RBS would clearly depend on banks preparedness in certain critical areas such as quality and reliability of data, soundness of systems and technology, appropriateness of risk control mechanism, supporting human resources and organizational back-up. The advantages of RBS approach over the past approach are Effective use of supervisory resources Systemic improvement Cushion against risks Flexibility of timing the on-site inspections Reduction of vulnerabilities by varying inspection cycles Focused attention on weak banks Improvement in quality of internal audit Focused follow up MAJOR ELEMENTS OF RBS APPROACH 1. 2. 3. 4. 5. 6. 7. 8. 9. Risk Profiling of banks Supervisory cycle Supervisory programme Inspection process Review, evaluation and follow-up Monitorable Action Plan (MAP) Supervisory organisation Enforcement process and incentive framework Role of external auditors in banking supervision

10. Change Management implications Risk Profiling of banks: Risk Profile is a document, which would contain various kinds of financial and non-financial risks faced by a banking institution. Risk profiling is the backbone of RBS system. RBI has identified two classes of risks namely Business risk and Control risk. Business risks are those risks that are considered inherent in the activities undertaken by a bank irrespective of whether the controls are in place or not. The assessment areas of Business risk are eight in number and they are: Capital, Credit risk, Market risk, Earnings, Liquidity risk, Business strategy and environment risk, operational risk and Group risk. Control risks arise out of inadequacy in the control system, absence of controls or possibility of failures/breakdowns in the existing control process. The assessment areas of Control risks are four in number and are: Internal control risks, Organisation risk, Management risk and Compliance risk. Banks have to make an assessment of the risk against all the 12 areas (8 under Business and 4 under control risk) by means of identifying positive and negative factors. Besides assessing the risk, banks also are expected to assess the direction of the risk based on past trend and current judgment. Finally, banks have to determine whether the overall level of risk is low, moderate, fair or high and the direction of risk is increasing, decreasing or stable.

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The Business Risk and Control Risk definitions are under review and may undergo changes. RBI, for the purpose of risk profiling, besides using CAMEL rating, would draw upon a range of sources of information such as off-site surveillance and monitoring (OSMOS), market intelligence reports, ad-hoc data from external and internal auditors, information from other domestic and overseas supervisors, on-site findings, sanctions applied etc. The formal assessment of the risk profile of each bank would be done on a regular basis. Supervisory Cycle: The supervisory process would commence with the preparation of the bank risk profile and on the data from other sources. The supervisory cycle would normally be 12 months and may be shorter or longer depending upon whether the bank is of low or high-risk. Supervisory Programme: The supervisory programme would be tailor made to suit individual banks depending upon their risk profile and would focus on high-risk areas. Inspection process: The inspection procedure would focus on identified high-risk areas to evaluate the effectiveness of the banks mechanism in capturing, measuring, monitoring and controlling various risks. The transaction testing would also be done though the extent would vary depending on the need. Review, evaluation and follow-up: The evaluation, review and follow up would attempt to ensure whether supervisory programme has indeed been completed and whether it has improved the risk profile of the bank concerned. Monitorable Action Plan (MAP): In the MAP, RBI would set out the improvements required in the areas identified during the current on-site and off-site supervisory process. Key individuals at the bank would be made accountable for each of the action points. Besides this, RBI would consider imposing sanctions and penalties to banks for not meeting the MAP. Supervisory Organisation: Under RBS, there would be a focal point of contacts for all banks at the Central office of RBI and its Regional Offices. Enforcement process and incentive framework: A system of incentives and disincentives has been contemplated under the RBS to serve attainment of RBS objectives. The incentive is longer supervisory cycle and lesser supervisory intervention. The disincentives are more frequent supervisory examination and higher supervisory intervention including directions, sanctions and penalties. Role of external auditors in banking supervision: RBI would look forward to make more use of external auditors as a supervisory tool by widening the range of tasks and activities, which external auditors perform at present. It would enter into dialogue with the Institute of Chartered Accountants of India and bank managements for this purpose. Change management implications: In order to ensure a smooth change over to RBS banks should have clearly defined standards of corporate governance and documented policies in place. Some of the organizational issues and preparations that banks have to make are given below: Setting up of risk management architecture Adoption of Risk focused internal audit Strengthening of Management Information System and Information Technology

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Addressing HRD issues such as reorientation of staff, skill formation and placements in appropriate positions, creation of dedicated risk management team. Setting up of compliance unit headed by a Chief Compliance Officer of the rank of not less than a General Manager who will be accountable for timeliness and accuracy of compliance CONCLUSION: Adoption of RBS would enable banks to be ready for implementation of the Second Capital Accord of Basel Committee on Banking Supervision, which will be implemented by 2007. As mentioned earlier, Banks have to undertake suitable change initiatives to ensure smooth transition to RBS.

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22. CREDIT AUDIT

Credit Audit Department (CAD) is a specialized wing of Inspection & Management Audit Department, Corporate Centre, Hyderabad, exclusively dealing with high value Credit Accounts (with an exposure of Rs.10 crores and above) domiciled at Branches all over the country. Credit Audit function covers both Pre sanction processes like Appraisal, Assessment and Sanction (covered under Loan Review Mechanism at LHO/MCG/CAG Centres) and post sanction processes like Documentation, Follow-up, Monitoring and compliance with terms of sanction (covered under on-site Credit Audit at the Branches). OBJECTIVES OF CREDIT AUDIT i. The main objective of Credit Audit is to ensure that the Banks laid down policies i n the area of credit apprais al, sancti on and loan administration are complied with and improvement brought abo ut in the quality of commercial credit portfolio wi th resultant favourable impac t on profitability and NPA reduction in the Bank. CAD provides feedback to the Top Management of the B ank based on the informati on gathered from Credit A udit Reports on th e state of compli ance with: a. Ins t ruc t io ns/di r ec ti ves fro m the Go ve rn men t a n d Reserv e Bank of India, and b. Banks extant Loan Policy/procedures Credi t Audit ai ms at sending out fe edback and earl y w arning si gnals to the operating functionaries about the quality of commer cial advances at the branches subjected to C r edit Audi t. If necessary, C r edit Audi t also suggest s r e m edial m eas ur es in r e s p ec t of loan assets showing signs of weakness so that the concerned operatin g units and thei r Controlling Authori t ies can take proactive steps fo r safeguarding Bank s interests. Credi t A uditors i ndepende ntly review the credi t ri sk assessment of a borrower whose accounts are subjected to Credit Audit and furni s h their opinion on the ri sk grade aw arded, also indi cating wh et h e r it is in or d e r . Based on audit experience, Credit A udit Department makes suggestions for the avoidance of credi t conc entrati on, i f any, in ce rtain sectors, and /o r fo r changes i n loan poli cy and procedures. Credi t Audit acts as yet another tr aining vehicle to guide branch staff handling l arge advances.

ii.

iii.

iv.

v.

vi.

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Salient features of revised Credit Audit System

In view of the growing concerns arising from slippages in asset quality / rising NPAs, the Credit Audit system has been revised and being implemented with effect from 13th August 2011. The important features of the revised system are as under: (i) (ii) To capture risk associated with asset quality, the Credit Audit Report (CARF) has been revised. Changes in the CARF: Credit Risk Management (CRM) overall score is kept at the existing level of 525. However, scores have been re-assigned for a few value statements based on the criticality of risks. 29 value statements have been rephrased and 4 new value statements have been added for sharper focus. 26 critical areas carrying High Risk have been identified with total score of 226 to identify the Credit Risk of the account. A set of Warning Signals have been introduced carrying total penalty of 245 which will be imposed, subject to cap of 150, from overall score (CRM) and normalized score under critical area to arrive at the final score for the Branch. A penalty of 10 marks for not mitigating risk till pointed out by the Credit Audit will be imposed and will be deducted from the overall score (CRM)/score under critical areas. A penalty of 20 marks will be imposed for false certification for rectification of the irregularity(s) in respect of earlier reports, to be deducted from the score awarded under Follow up, monitoring and Control(CRM)/scores under critical areas. The lower of CRM Score or the score under critical areas would be the final rating of the Account. Rating of the Branch will be decided depending on the overall score (CRM) and scores under critical areas, whichever is lower. To have an insight of the account and flag Warning Signals, if any, the concept of management discussions (not to be confused with unit inspection) is introduced in the following cases: (a) (b) Where aggregate limit is above `.20 cr. AND Where aggregate limit is between `.10 crores and `.20 crores, where CRA rating is SB 8 and worse
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(Branch has to arrange for management discussion with the borrowing company well in advance in consultation with the Credit Auditor) Information Sheet has been introduced, which is required to be completed by the Branch for all the credit auditable accounts, as a pre-audit exercise, well in advance. 3. Critical areas to be focussed:

Outstandings in Buyers Credit to be deducted from the Advance value of the stocks while computing Drawing Power. Submission of Audited Balance Sheet within 6 months of the date of Balance Sheet in case of Listed Companies or 6-8 months for Unlisted Companies. Conversion / Redemption of maturing FCCBs / Preference shares whether factored in financial projections. Netting of Revaluation Reserve/Intangible Assets while computing TNW. Past sacrifices made, if any, and exercising of the Right of Recompense thereagainst. Information Sheet has been introduced, which is required to be completed by the Branch for all the credit auditable accounts as a pre-audit preparation, well in advance.

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ANNEXURE-I NAME OF THE BRANCH: SBI, ----------BRANCH DETAILS OF ADVANCES PORTFOLIO AS ON : (Rs in crores) S.No. Particulars No. of Accounts FB (Borrowers) 01 02 Total Advances at the Branch CAAs at the branch Out of 01 above Standard Assets NPAs Out of 02 above 05 Advances with Rs 5.00 crores and above Out of 04 above Sub-standard Assets Doubtful Assets Loss Assets Limits NFB Outstandings FB NFB Total

03 04

06 07 08

09 10

AUCA Accounts subjected to Credit Audit (Main+NPA live+ Associate)

Camp: State Bank of India, DGM/AGM/CM Date: Branch.. General Manager (CA-OMD) / Dy. General Manager (CA-OMD)

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495

ANNEXUREII NAME OF THE BRANCH: SBI, ----------BRANCH

Total No. of Commercial Advances Accounts (CAAs) which are Standard Assets Out of (A) above, No. of CAAs (Standard Assets) which are allocated by other Branches Balance of CAAs (Standard Assets) (A-B) No. of CAAs (Standard Assets) with total indebtedness of Rs 5.00 crores and above all of which are to be subjected to Credit Audit Out of (D) above i) No. of accounts where sanction/ renewal/ review of limits carried out ii) No. of accounts where sanction/ renewal/ review of limits carried out and subjected to Offsite Credit Audit iii) No. of accounts where sanction/ renewal/ review of limits not carried out/ Off-Site Credit Audit not done

C D

No. of NPA accounts with outstandings of Rs 5.00 crores and above, all of which are to be subjected to Credit Audit Out of (F) Above i) No. of accounts where sanction/ renewal/ review of limits carried out ii) No. of accounts where sanction/ renewal/ review of limits not carried out iii) AUCA accounts

No. of accounts of associate CAAs belonging to borrower groups included in (D) above

Credit Management

496