Financial Credit Risk

Analysis

    
 FINANCIAL CREDIT RISK ANALYTICS Code: KMBN FM 05 Course Credit: 3 Teaching Hours: 36 Hrs
UNIT I : Introduction (6 hours) Financial Credit: Meaning & Objectives, Credit Risk, Credit Analysis,
Seven C’s, Credit Analysis Process, Credit Process, Documentation, Loan Pricing and Profitability
Analysis. Regulations, Types of Credit Facilities: Various types of Credit Facilities- Cash Credit,
Overdrafts, Demand Loan, Bill Finance – Drawee Bill Scheme, Bill Discounting. Cash Delivery: Types of
Facilities, Modes of Delivery.
 UNIT II: Trade Credit Risk (8 hours) Sole -Banking Arrangement, Multiple Banking Arrangement,
Consortium Lending, Syndication. Credit Thrust, Credit Priorities, Credit Acquisitions, Statutory &
Regulatory restrictions on Advances. Credit Appraisal: Validation of proposal, Dimensions of Credit
Appraisals, Structuring of Loan documents, Credit Risk, Credit Risk Rating, Credit Worthiness of
Borrower, Purpose of Loan, Source of Repayment, Cash Flow, Collateral.
 UNIT III : Letter of Credit and Loan Commitments (8 hours) Quasi Credit Facilities: Advantages of
Non-Fund Facilities, Various types of NFB Facilities, Various types Letter of Credits, Assessment of
LC limits, Bills Purchase/ Discounting under LC. Loan commitments, Un-funded lines of credit and
their characteristics Various types of Bank Guarantees: Performance Guarantee, Financial
Guarantees, Deferred Payment Guarantees, Types of Performance and Financial Guarantees,
Assessment of Bank Guarantees Limit, Period of Claim under Guarantee.
 UNIT IV: Operational Risk: Overview (6 hours) Risk & Uncertainty, Financial Sector, Risk Types,
Operational Risk Management- Recruitment & Training, Work flow Design, Work Flow Documentation,
Delegation of Authority, Independent Internal Audit, Independent Compliance Function, Independent
Risk Management Function, System Audit, Corporate Governance, Whistle Blower Policy, Risk
Management Culture.
 UNIT V: Credit Analysis & Rating (8 hours) Importance of credit analysis, Stages of credit analysis
profitability analysis and pricing of loans, Credit risk analysis (Debt ratios and risk of leverage),
Analysis of working capital, liquidity, operating and cash cycle risk. Credit Rating: Measurement of
Risk, Objective of Rating, Internal & External Rating, Model Credit Rating, Methodology of Rating,
Internal & External
Comparison, Model Rating Formats.
 UNIT 1 Unit 

 What Is Credit Risk? Credit risk is the possibility of a loss resulting from a borrower's failure to repay
a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive
the owed principal and interest, which results in an interruption of cash flows and increased costs for
collection. Excess cash flows may be written to provide additional cover for credit risk. When a lender
faces heightened credit risk, it can be mitigated via a higher coupon rate, which provides for greater
cash flows
 Although it's impossible to know exactly who will default on
obligations, properly assessing and managing credit risk can
lessen the severity of a loss. Interest payments from the borrower
or issuer of a debt obligation are a lender's or investor's reward for
assuming credit risk. 
 Credit risk is the possibility of losing a lender takes on due to the
possibility of a borrower not paying back a loan.  
 Consumer credit risk can be measured by the seven Cs: credit
history, capacity to repay, capital, the loan's conditions, associated
collateral, control conditions and common sense. 
 Consumers posing higher credit risks usually end up paying higher
interest rates on loan 
 understanding Credit Risk 

When lenders offer mortgages, credit cards, or other types of loans, there is
a risk that the borrower may not repay the loan. Similarly, if a company
offers credit to a customer, there is a risk that the customer may not pay
their invoices. Credit risk also describes the risk that a bond issuer may fail
to make payment when requested or that an insurance company will be
unable to pay a claim.
 Credit risks are calculated based on the borrower's overall ability
to repay a loan according to its original terms. To assess credit
risk on a consumer loan, lenders look at the seven Cs: credit
history, capacity to repay, capital, the loan's conditions, and
associated collateral. Some companies have established
departments solely responsible for assessing the credit risks of
their current and potential customers. Technology has afforded
businesses the ability to quickly analyze data used to assess a
customer's risk profile
 If an investor considers buying a bond, they will often review the credit rating of the bond. If it has a low
rating (< BBB), the issuer has a relatively high risk of default. Conversely, if it has a stronger rating (BBB, A, AA,
or AAA), the risk of default is progressively diminished. Bond credit-rating agencies, such as Moody's
Investors Services and Fitch Ratings, evaluate the credit risks of thousands of corporate bond issuers and
municipalities on an ongoing basis.2 3 For example, a risk-averse investor may opt to buy an AAA-
rated municipal bond. In contrast, a risk-seeking investor may buy a bond with a lower rating in exchange for
potentially higher returns.
 The  seven C's of credit is a system used by lenders to
check the  creditworthiness of potential borrowers. The
system weighs five characteristics of the borrower and
conditions of the loan, attempting to estimate the chance
of default and, consequently, the risk of a financial loss
for the lender. But what are these  seven  C's? The 
seven C's of credit are character, capacity, capital,
collateral, and conditions, control condition
common sense
The  seven  C's of credit are used to convey the creditworthiness of potential
borrowers. 
The first C is character—the applicant's credit history. 
The second C is capacity—the applicant's debt-to-income ratio. 
The third C is capital—the amount of money an applicant has. 
The fourth C is collateral—an asset that can back or act as security for the loan. 
The fifth C is conditions—the purpose of the loan, the amount involved, and
prevailing interest rates. 
The sixth C  is  control condition- - confirm the position of borrower to repay 
loan amount
The seventh C is Common sense ---- Procedure to recover the default amount
from borrower 
Understanding
7 c's of credit    The Seven -C's-of-credit method of evaluating a borrower incorporates
both qualitative and quantitative measures. Lenders may look at a
borrower's credit reports, credit scores, income statements, and other
documents relevant to the borrower's financial situation. They also
consider information about the loan itself .Each lender has its own
method for analyzing a borrower's creditworthiness but the use of the 
Seven C's—character, capacity, capital, collateral, conditions, control
condition and common sense—is common for both individual and
business credit applications
  Although it's called character, the first C more specifically refers
to credit history, which is a borrower's reputation or track record for
repaying debts. This information appears on the borrower's credit
reports. Generated by the three major credit bureaus (Experian,

Character  TransUnion, and Equifax), credit reports contain detailed information

about how much an applicant has borrowed in the past and whether
they have repaid loans on time. These reports also contain
information on collection accounts and bankruptcies, and they retain
most information for seven to 10 years.1
  Capacity measures the borrower's ability to repay a loan by comparing
income against recurring debts and assessing the borrower's debt-to-
income (DTI) ratio. Lenders calculate DTI by adding a borrower's total
monthly debt payments and dividing that by the borrower's gross
Capacity monthly income. The lower an applicant's DTI, the better the chance of
qualifying for a new loan. Every lender is different, but many lenders
prefer an applicant's DTI to be around 35% or less before approving an
application for new financing.
  Lenders also consider any capital the borrower puts toward a potential
investment. A large contribution by the borrower decreases the chance
of default. Borrowers who can put a down payment on a home, for
example, typically find it easier to receive a mortgage. Even special
mortgages designed to make homeownership accessible to more
Capital people, such as loans guaranteed by the Federal Housing
Administration (FHA) and the U.S. Department of Veterans Affairs (VA),
may require borrowers to put down 3.5% or higher on their
homes.67 Down payments indicate the borrower's level of seriousness,
which can make lenders more comfortable extending credit.
  Collateral can help a borrower secure loans. It gives the lender the
assurance that if the borrower defaults on the loan, the lender can
get something back by repossessing the collateral. The collateral is
often the object one is borrowing the money for: Auto loans, for
instance, are secured by cars, and mortgages are secured by homes. 

Collatteral  For this reason, collateral-backed loans are sometimes referred to

as secured loans or secured debt. They are generally considered to
be less risky for lenders to issue. As a result, loans that are secured
by some form of collateral are commonly offered with lower interest
rates and better terms compared to other unsecured forms of
financing.
  In addition to examining income, lenders look at the length of time an
applicant has been employed at their current job and future job
stability.
 The conditions of the loan, such as the interest rate and amount
of principal, influence the lender's desire to finance the borrower.
Conditions can refer to how a borrower intends to use the money.
conditions Consider a borrower who applies for a car loan or a home
improvement loan. A lender may be more likely to approve those
loans because of their specific purpose, rather than a signature loan,
which could be used for anything. Additionally, lenders may consider
conditions that are outside of the borrower's control, such as the
state of the economy, industry trends, or pending legislative changes.
 Control 
Condition
Common
Sense
Why Are the  Lenders use the seven  C's to decide whether a loan applicant is
eligible for credit and to determine related interest rates and
7 C's credit limits. They help determine the riskiness of a borrower or

Important? the likelihood that the loan's principal and interest will be repaid
in a full and timely manner.
  The term credit analyst refers to a financial professional who
assesses the creditworthiness of securities, individuals, or
companies. Credit analysts determine the likelihood that a

What Is a borrower can repay their financial obligations by reviewing their

financial and credit history and determining whether the state of
Credit the subject's financial health and the economic conditions are
favorable to repayment.
Analyst?   These professionals generally have an academic background in
finance, accounting, or a related field. Credit analysts can find
work in different financial institutions.
  Credit analysts analyze investments and borrowers'
creditworthiness to determine their potential risk for
investors and lenders. 
 They examine financial statements and use ratios when
analyzing the financial history of a potential borrower. 
 Credit analysts are typically employed by commercial
KEY  and investment banks, credit card issuing institutions,

TAKEAWAYS   credit rating agencies, and investment companies. 

 Credit analysts are often called credit risk analysts
because credit analysis is a specialized area of financial
risk analysis. 
 Debt issuers and their instruments are assigned scores
based on letter grades by credit analysts. 
  A credit analyst gathers and analyzes financial data associated
with lending and credit products. This includes reviewing a

How Credit borrower's payment history, along with liabilities, earnings, and

assets they possess. The analyst looks for indicators that the
Analysts borrower might present a level of risk. The data are used to

Work recommend the approval or denial of credit and to determine

whether to increase or reduce credit limits or charge additional
fees.1
 A key component of their jobs is to interpret financial
statements and use ratios to analyze the fiduciary behavior and
history of a potential borrower. They decide whether the borrower
has adequate cash flows by comparing ratios with industry
data benchmarks. For example, a credit analyst working at a bank
may examine an agricultural company's financial statements
before approving a loan for new farm equipment
 Credit analysts are required to have a background in finance,
economics, math, accounting, or other related field. Candidates
with bachelor's degrees and experience are preferred, although
a potential employer may overlook experience if someone has
a graduate degree. Some analysts also have advanced
certification, such as training offered through the National
Association of Credit Analysts.
 Employment is offered at a variety of financial institutions,
including banks, investment companies, credit unions, credit
rating agencies, insurance companies, and asset management
companies. Analysts who work in securities, commodity
contracts, and other areas of financial investments earn the
highest salaries
  Credit analysts are often called credit risk analysts. That's

Special because credit analysis is a specialized area of financial risk analysis.

Analysts evaluate the risk investments hold and determine
Consideratio the interest rate and credit limit or loan terms for a borrower. They

ns use their research to ensure the borrower receives an affordable loan

and the lender is protected if the borrower defaults.
 Analysts may recommend a business loan or business credit after
considering certain risk factors. These factors may be environment-
oriented, such as economic changes, stock market fluctuations,
legislative changes, and regulatory requirements. If a business client
struggles to meet payroll, it could be indicative of a decline in revenue
and potential bankruptcy, which may affect the bank’s assets, ratings,
and reputation.
 Banks can use financial data to determine whether they want
to approve certain loans by analyzing how much risk is involved
in lending. If a loan is approved, the credit analyst monitors the
borrower's performance and may recommend terminating the
agreement if it becomes risky. Determining the level of risk in a
loan or investment helps banks manage risks and
generate revenue.
 For example, a credit analyst may recommend a solution for an
individual who has defaulted on their credit card payments. The
analyst may recommend reducing their credit limit, closing their
account, or offering them a new credit card with a lower interest rate.
 Credit analysts play a key role in the well-being of the economy
because credit stimulates financial activity. Access to credit provides
consumers with additional spending power, which helps improve
individuals' lifestyles and gives businesses temporary liquidity.
  Credit analysts play a key role in the well-being of the
economy because credit stimulates financial activity.

significances Access to credit provides consumers with additional

spending power, which helps improve individuals'
lifestyles and gives businesses temporary liquidity.
  Credit analysts may also issue credit scores. A credit score is a
three-digit number ranging from around 200 to 850. The most
Credit common type of individual credit score is the FICO score. Credit
Analysts and score generation is typically automated for individuals through

Credit Ratings algorithmic processes based on their credit payment histories,

spending, and past bankruptcies.
 Scores for debt issuers and their instruments, such as bonds,
are based on letter grades. The highest is AAA, followed by AA+,
BBB, and so on. A company's debt is considered junk or below
investment grade, once it goes below a certain rating. These
investments typically carry higher yields to accommodate for
the additional credit risk
 Sovereign governments can also have credit scores on
their bonds. Credit analysts who assess bonds often work
at credit rating agencies such as Moody's or Standard &
Poor's (S&P). Insurance companies are also rated on their
credit risk and financial stability by rating agencies such
as AM Best
  A credit analyst should have accounting skills, such as the
ability to create and analyze financial statements and ledgers.
What Skills Do Many credit analysts will have skills in risk analysis,
You Need to mathematics, statistics, computing, and quantitative analysis.
Credit analysts should be good at problem-solving, have
Be a Credit attention to detail, and have the ability to research and
Analyst? document their findings. They should be able to understand
and apply the terms used in finance, 
  The credit analysis process refers to evaluating a
What is the borrower’s loan application to determine the financial
health of an entity and its ability to generate sufficient
Credit cash flows to service the debt. In simple terms, a lender
Analysis conducts credit analysis on potential borrowers to
determine their creditworthiness and the level of credit
Process? risk associated with extending credit to them
 During the credit analysis process, a credit analyst may use a
variety of techniques, such as cash flow analysis, risk analysis,
trend analysis, ratio analysis, and financial projections. The
techniques are used to analyze a borrower’s financial
performance data to determine the level of risk associated with
the entity and the amount of losses that the lender will suffer in
the event of default.
  Credit analysis is the evaluation of a borrower’s loan
application to determine if the entity generates enough
cash flows to settle its debt obligations. 
 The credit analysis process involves collecting information
from the borrower, analyzing the information provided,
Summary  and making a decision on whether or not to approve the
loan. 
 A credit analyst uses various techniques, such as ratio
analysis, trend analysis, cash flow analysis, and
projections to determine the creditworthiness of the
borrower
  The credit analysis process is a lengthy one, lasting from a few
Stages in the weeks to months. It starts from the information-collection

Credit stage up to the decision-making stage when the lender

decides whether to approve the loan application and, if
Analysis approved, how much credit to extend to the borrower. 

Process  The following are the key stages in the credit analysis process:
  The first stage in the credit analysis process is to collect
information about the applicant’s credit history. Specifically, the
lender is interested in the past repayment record of the customer,
organizational reputation, financial solvency, as well as their
transaction records with the bank and other financial institutions.
The lender may also assess the ability of the borrower to generate
additional cash flows for the entity by looking at how effectively

1. they utilized past credit to grow its core business activities. 

 The lender also collects information about the purpose of the loan
Information and its feasibility. The lender is interested in knowing if the project
to be funded is viable and its potential to generate sufficient cash
collection flows. The credit analyst assigned to the borrower is required to
determine the adequacy of the loan amount to implement the
project to completion and the existence of a good plan to
undertake the project successfully. 
 The bank also collects information about the collateral of the loan,
which acts as security for the loan in the event that the borrower
defaults on its debt obligations. Usually, lenders prefer getting the
loan repaid from the proceeds of the project that is being funded,
and only use the security as a fall back in the event that the
borrower defaults.
  The information collected in the first stage is analyzed to determine if the
information is accurate and truthful. Personal and corporate documents,
such as the passport, corporate charter, trade licenses, corporate
resolutions, agreements with customers and suppliers, and other legal
documents are scrutinized to determine if they are accurate and genuine. 
 The credit analyst also evaluates the financial statements, such as the
income statement, balance sheet, cash flow statement, and other related

2. documents to assess the financial ability of the borrower. The bank also
considers the experience and qualifications of the borrower in the project to

Information determine their competence in implementing the project successfully. 

 Another aspect that the lender considers is the effectiveness of the project.
analysis The lender analyzes the purpose and future prospects of the project being
funded. The lender is interested in knowing if the project is viable enough to
produce adequate cash flows to service the debt and pay operating
expenses of the business. A profitable project will easily secure credit
facilities from the lender. 
 On the downside, if a project is facing stiff competition from other entities
or is on a decline, the bank may be reluctant to extend credit due to the high
probability of incurring losses in the event of default. However, if the bank is
satisfied that the borrower’s level of risk is acceptable, it can extend credit
at a high interest rate to compensate for the high risk of default.
  The final stage in the credit analysis process is the decision-
making stage. After obtaining and analyzing the appropriate
financial data from the borrower, the lender makes a decision on
whether the assessed level of risk is acceptable or not. 
3. Approval (or  If the credit analyst assigned to the specific borrower is
rejection) of convinced that the assessed level of risk is acceptable and that

the loan the lender will not face any challenge servicing the credit, they
will submit a recommendation report to the credit committee on
application the findings of the review and the final decision. 
 However, if the credit analyst finds that the borrower’s level of
risk is too high for the lender to accommodate, they are required
to write a report to the credit committee detailing the findings on
the borrower’s creditworthiness. The committee or other
appropriate approval body reserves the final decision on
whether to approve or reject the loan.
  The lending process includes the following phases: application,
Process and investigation, evaluation, decision documentation, administration, and
documentatio collection. All of these phases require some form of documentation in
order to protect the bank's interest. Credit Documentation
n of lending  means each note, indenture, loan agreement or other evidence of
indebtedness or interest therein applicable to a Reference Obligation
 Essential  Loan documentation is one of the vital areas in the credit portfolio of
a bank. The purpose of taking documents is to fix the terms and
Steps of Loan conditions between the bankers and the borrowers, to identify the
Documentatio borrowers, to identify the securities, to count the period of limitation,
to resort to legal remedies in case of need, and so on.
n Procedure
  Documentation varies depending upon the nature of the
facility may not be used for a term loan facility. 
1. Selection of  Similarly, a document meant for an individual borrower
Correct Set cannot be used for a company or partnership borrower. 

of Documents   As the bankers have pre-printed forms of documents, it

should be ensured that the correct set of documents,
which are relevant for the particular facility and borrower
are used.
  The next aspect of documentation is tamping. A
document shall be stamped in accordance with the Indian
stamp act as amended by the concerned state
governments. 
 Indian stamp act contains provisions regarding the time of
stamping for an instrument executed in India and out of

2. Stamping  India. 
 A document executed in India shall be stamped before or
at the time of execution. Section 12 of the Indian stamp
act provided for the cancellation of the adhesive step so
that the same cannot be used again. Any instrument
bearing an adhesive stamp which has not been canceled,
so that it cannot be used again, shall be deemed to be
unstamped
  Once the document is executed it becomes a concluded
contract and any subsequent filling by the bank without
3. the consent of the executant will invalidate it. 
facility before   The document is completed shall be filled with the same
execution. ink, in some handwriting by the same person in a single
sitting. Otherwise, it may give rise to a suspicion that the
document is filed, subsequent to the execution
  After filling, the next step in the documentation procedure is the
execution or signing of the document. 
 It should be ensured that the signature in the document tallies with
the signature as appearing in the application for the loan and also
with the specimen signature, in case the party maintains a deposit
account with the bank.
 Normally, bankers take the signature of the execution in all the pages
of the documentation, so that he (executant) may not argue in future,

4. Execution  that the contents of the pages were not known to him. 
 In case the document contains any alteration, overwriting, or cutting,
it must be authenticated with the full signature of the executant. 
 The documents shall be executed in the presence of bank officials
and the fact of execution of documents with the date and time of
execution, the details of documents executed, the fact of having to
explain the contents of the documents in the language known to the
executant shall be recorded in a register with the signature of two
bank officials so that in case of any dispute regarding the execution
of documents,
  In some cases, after the execution of the document,
certain legal formalities are required to be undergone. 
 For example, in case of advances to limited companies
against its assets, the required forms are to be presented
5. to the registrar of companies with the thirty days from the

 Legal date of execution. 

 Similarly, in the case of the creation of registered
 Formalities  mortgages, the mortgage deed is presented for
registration before the registrar of assurances within four
months from the date of execution of the deed. 
 If these formalities are not observed then the bank may
have to lose priority over the security.
  The documents taken by banks for a credit facility do not have

6. perpetual life. The provisions of limitation act apply to them. 

 The limitation act prescribes the period of limitation for different
Keeping types of documents. 
Documents Ali  For example, the period of limitation for a DPN is three years from
ve  the date of execution. If a loan is not repaid within the period of
limitation, then the bank has to get fresh documents for extending
the period of limitation as per the provisions of limitation.
  At the time of renewal or variation within the limit, the
bank should obtain a fresh set of documents or continue
the existing set of documents duly supported by

7. supplemental/additional deeds if required.

 A formal letter to the borrower agreeing to continue the
Renewal of credit facility by the bank for a further period of say, one

Documents  year, at his request would suffice. 

 Acknowledgment of the debt and security incorporating
particulars o the original security document duly signed by
the borrower are obtained, at the time of renewal and
attached to form part of the original set of documents.
  When time-barred debts are to be revived, the recourse
may be to subsection 3 of section 25 of the contract act
8. 1872. 
The Revival of  This section provides that a promise made in writing and
Time- signed by the person to be charged therewith, or by his
agent, generally especially authorized in that behalf, to
Barred Debts  pay wholly or in part, debt, of which the creditor might
have enforced payment but for the law of limitation of
suits, is not void for want of consideration. 
 A statement made by a witness in court, admitting a time-
barred debt, does not constitute a promise to pay within
the meaning of section 25(3), it is implied a promise,
would not be sufficient for this purpose.
9. Safekeeping  Nowadays banks give loans for a longer period say 20
and years or even 25 years. 
Preservation  Until such tie the entire dues are recovered, the
of Documents  documents are to be preserved in good condition
  Financial institutions that structure and optimize pricing
Loan Pricing: for loans are able to make sure they are adequately
compensated for the risk they are taking. Instead of
A Key Driver pricing loans based on a “gut feel” or a request to match or

of Success beat competitors’ rates, institutions that utilize loan-

pricing models for origination incorporate a more
methodical approach. 
  This approach can help ensure the best loan and terms
are matched to the borrower so that the financial
institution makes the sale and keeps the customer. Loan
pricing models or loan profitability models can allow banks
or credit unions to set prices based on other institution
Benefits of goals, too, including goals related to profitability targets or

Loan Pricing loan portfolio composition. In talking with banks, Abrigo

has learned these institutions thought a conservative
estimate was that they could pick up an additional 5 to 10
basis points in interest if they had more structured pricing
methodologies in place.
 One overall benefit of effective loan pricing is that it is one
of the many ways a financial institution can optimize
capital. Optimizing capital is important because it provides
institutions with the ability and freedom to deploy capital
for developing new products and new markets,
addressing regulatory issues or navigating shifts in the
macroeconomic environment. 
 One overall benefit of effective loan pricing is that it is one
of the many ways a financial institution can optimize
capital. Optimizing capital is important because it provides
institutions with the ability and freedom to deploy capital
for developing new products and new markets,
addressing regulatory issues or navigating shifts in the
macroeconomic environment
 Another benefit of having a loan-pricing policy or model is
that it provides the institution with defensible measures
for justifying pricing changes and for avoiding charges
of discriminatory pricing, which some lenders have
faced in recent years. Officials with the banking regulatory
agencies recently outlined best practices they encourage
as they relate to evaluating an institution’s fair lending risk,
and one of those best practices was to document pricing
and other underwriting criteria, including exceptions.
  What are some considerations related to loan-pricing models
for an institution's loan origination system
   pricing is a key underwriting factor that should be
addressed as part of a sound loan policy. A simple cost-plus
loan pricing model is one method of pricing loans,  A cost-

Consideration plus pricing model requires that all related costs associated
with extending the credit be known before setting the
s of Loan- interest rate and fees, and it typically considers the following:
 
Pricing  Cost of funds 
Models   Operating costs associated with servicing the loan or loans 
 Risk premium for default risk and 
 A reasonable profit margin on capital. 
 The risk premium for default risk takes into account the
borrower’s risk rating as well as the risk rating of the credit
facility, according to Adams.
  Loan pricing means determining the interest rate for granting
loan to creditors, be it individuals or business firms. It is one of
the most important, however difficult task in lending funds to
business firms & other customers. Because it is always very
difficult to exactly know what the actual loan risk a particular
Loan Pricing loan application is. Generally the lender wants to charge a high
enough rate to make sure that the loan will be profitable as
well as it will covers enough compensation against the default
risk. On the other hand loan price must be set low enough that
helps the customers to find it easy for successful repayment of
loan.
  Banks are the major financial institutions, which intermediate
between actual lenders and actual borrowers.
Methods  For the inter-mediation, banks are to pay the fund providers as
ultimate lenders and charge actual borrowers. A bank acquires
of funds through deposits, borrowings, and antiquity, recognizing

Loan Pricing each source’s costs and the resulting average cost of funds to the
bank.
followed  The funds are allocated to assets, creating an asset mix of earning
assets such as loans and non-earning assets such as banks’
by premises. The price that customers are charged for using an

Commercial earning asset represents the sum of the costs of the banks’ funds,
the administrative costs, e.g., salaries, compensation for non-
Banks earning assets, and other costs.
 If pricing adequately compensates for these costs and customer
to be fair .based on the funds and service received. The loan price
is the interest rate the borrowers must pay to the bank and the
amount borrowed(principal).
 The price/interest rate is determined by the true cost of
the loan to the bank(base rate)plus profit/risk premium for
the bank’s services and acceptance of risk. The
components of the true cost of a loan are:
 Interest expense,
 Administrative cost, and
 Cost of capital
 These three components add up to the bank’s base rate.
 The risk is the measurable possibility of losing or not
gaining the value. The primary risk of making a loan is
repayment risk, which is the measurable possibility that a
borrower will not repay the obligation as agreed.
 A good lending decision minimizes repayment risk. The
prices a borrower must pay to the bank for assessing and
accepting this risk is called the risk premium.
 Since the past performance of a sector, industry, or
company is a strong indicator of future performance, risk
premiums are generally based on the historical
quantifiable amount of losses in that category.
 Price of the loan(Interest Rate Charge) = Base Rate + Risk
Premium.
 Loan pricing is not an exact science- it gets adjusted by
various qualitative and qualitative variables affecting
demand for and supply of funds. These are several
methods of calculating loan prices.
  Pricing method
 Characteristics
 Fixed-rate---The loan is written at a fixed interest rate which is
negotiated at an origination. The rate remains fixed until
maturity.
 Variable-rate---The rate of interest changes based on the
A. Interest- minimum rate from time to time, depending on the demand
for and supply of funds.
Based Loans  Prime rate---Usually, a relatively low rate is offered to highly
by traditional honored clients for a track record.
 The rate for general customer----This rate is applied to
banks general borrowers’. This rate is usually higher than the prime
rate.
 Caps and Floors---For loans extended at variable rates, limits
are placed on the extent to which the rate may vary. A cap is
an upper limit, and a floor is the lower limit.
 Prime times----This special rate is a number of times
greater than the prime rate. If the loan’s maturity is
increased or decreased, this rate will also be increased or
decreased in a multiple.
 Rates on another basis----The interest rate can also be
determined based on the current interest rate of debt
instruments or the regional index of change of interest/
price.
 This rate is similar to the prime rate except that the base
is different. A rate can be a bit lower or higher than the
prime rate. Examples include the regional index or other
market interest rates such as the CD rate.
  Compensating balances----Deposit balances that a lender may require to be
maintained throughout the period of the loan.
 Balances are typically required to be maintained on average rather than at a strict
minimum.
 Fees, charges, etc.-----A charge is taken for this interim period after sanctioning
B. Determining credit but before disbursing the amount to the borrower. This charge helps to
prevent the loan taker from making unnecessary delays in taking a loan.

loan price  Apart from special/priority cases, no interest but 3% – 5% service is charged on
small loans.

without  For many borrowers, the factors that determine a bank's interest rate are a
mystery. How does a bank decide what rate of interest to charge? Why does it
interest charge different interest rates to different customers? And why does the bank
charge higher rates for some types of loans, like credit card loans, than for car
loans or home mortgage loans?
 Following is a discussion of the concepts lenders use to determine interest rates.
It is important to note that many banks charge fees as well as interest to raise
revenue, but for the purpose of our discussion, we will focus solely on interest and
assume that the principles of pricing remain the same if the bank also charges
fees.
  A very simple loan-pricing model assumes that the rate of
interest charged on any loan includes four components:
 the funding cost incurred by the bank to raise funds to
lend, whether such funds are obtained through customer
deposits or through various money markets;
Cost-plus  the operating costs of servicing the loan, which include
loan-pricing application and payment processing, and the bank's

model wages, salaries and occupancy expense;

 a risk premium to compensate the bank for the degree of
default risk inherent in the loan request; and
 a profit margin on each loan that provides the bank with
an adequate return on its capital.
  Let's consider a practical example: how this loan-pricing
model arrives at an interest rate on a loan request of $10,
000. The bank must obtain funds to lend at a cost of 5
percent. Overhead costs for servicing the loan are
estimated at 2 percent of the requested loan amount and
a premium of 2 percent is added to compensate the bank
for default risk, or the risk that the loan will not be paid on
time or in full. The bank has determined that all loans will
be assessed a 1 percent profit margin over and above the
Example financial, operating and risk-related costs. Adding these
four components, the loan request can be extended at a
rate of 10 percent (10% loan interest rate = 5% cost of
funds + 2% operating costs + 2% premium for default risk +
bank's targeted profit margin). As long as losses do not
exceed the risk premium, the bank can make more money
simply by increasing the amount of loans on its books.
  The problem with the simple cost-plus approach to loan pricing is that
it implies a bank can price a loan with little regard to competition from
other lenders. Competition affects a bank's targeted profit margin on
loans. In today's environment of bank deregulation, intense
competition for both loans and deposits from other financial service
institutions has significantly narrowed the profit margins for all banks.
This has resulted in more banks using a form of price leadership in
establishing the cost of credit. A prime or base rate is established by
Price- major banks and is the rate of interest charged to a bank's most
creditworthy customers on short-term working capital loans.
leadership  This "price leadership" rate is important because it establishes a
model benchmark for many other types of loans. To maintain an adequate
business return in the price-leadership model, a banker must keep the
funding and operating costs and the risk premium as competitive as
possible. Banks have devised many ways to decrease funding and
operating costs, and those strategies are beyond the scope of this
article. But determining the risk premium, which depends on the
characteristics of the individual borrower and the loan, is a different
process.
  Because a loan's risk varies according to its characteristics and its borrower, the
assignment of a risk or default premium is one of the most problematic aspects
of loan pricing.
 A wide variety of risk-adjustment methods are currently in use. Credit-scoring
systems, which were first developed more than 50 years ago, are sophisticated
computer programs used to evaluate potential borrowers and to underwrite all
forms of consumer credit, including credit cards, installment loans, residential

Credit-scoring
mortgages, home equity loans and even small business lines of credit. These
programs can be developed in-house or purchased from vendors.
 Credit scoring is a useful tool in setting an appropriate default premium when
systems and determining the rate of interest charged to a potential borrower. Setting this
default premium and finding optimal rates and cutoff points results in what is
risk-based commonly referred to as risk-based pricing. Banks that use risk-based pricing can
offer competitive prices on the best loans across all borrower groups and reject or

pricing price at a premium those loans that represent the highest risks.
 So, how do credit-scoring models and risk-based pricing benefit the borrower who
only wants a loan with reasonable repayment terms and an appropriate interest
rate charge? Since a bank is determining a reasonable default premium based on
past credit history, borrowers with good credit histories are rewarded for their
responsible financial behavior. Using risk-based pricing, the borrower with better
credit will get a reduced price on a loan as a reflection of the expected lower
losses the bank will incur. As a result, less risky borrowers do not subsidize the
cost of credit for more risky borrowers.
  Two other factors also affect the risk premium charged by a bank: the
collateral required and the term, or length, of the loan. Generally, when a
loan is secured by collateral, the risk of default by the borrower decreases.
For example, a loan secured by a car typically has a lower interest rate than
an unsecured loan, such as credit card debt. Also, the more valuable the
collateral, the lower the risk. So it follows that a loan secured by the
borrower's home typically has a lower interest rate than a loan secured by
a car.

Other risk-  However, there may be other factors to consider. First, the car may be
easier to sell, or more liquid, making the risk of the loan lower. Second, the

based pricing term, or length of a car loan is usually short—three to five years—as
compared to the 15- to 30-year term of a home loan. As a general rule, the

factors
shorter the term, the lower the risk, since the ability of the borrower to
repay the loan is less likely to change.
 Assessing the interplay of credit score, collateral and term to determine the
risk premium is one of a lender's most challenging tasks. Whether loan-
pricing models are based on a simple cost-plus approach or price
leadership, use credit-scoring or other risk-based factors, they are valuable
tools that allow financial institutions to offer interest rates in a consistent
manner. Knowledge of these models can benefit customers as well as
banks. Although it cannot help customers make their payments, an
awareness of loan-pricing processes can ease the uncertainty that may be
involved in applying for a loan.
  Lending is an important activity of the banking industry.
Bank invests public deposits in the form of lending and
earns a profit. The quality of the advances indicates the
TYPES OF bank’s image in the market. A banker should have a
thorough knowledge of the requirement of the customer
CREDIT and should be in a position to cater to the needs of the
FACILITIES IN customer. A credit facility is an agreement with the bank

BANKS that enables a person or organization to take credit or

borrow money when it is needed. The business of lending
is carried on by the bank by offering various credit facilities
to its customer. Based on security bank credit can be
classified into two types.
 Secured Advance: The advance which is secured by
primary or collateral security is called Secured Advances.
In the event of a loan default, the lender can take
possession of the asset and use it to cover the loan. e.g.
Business loan, housing loan, etc
 Unsecured Advances: Unsecured advances don’t have
assets either primary or collateral. These are also called
clean advances. Unsecured loans rely solely on the
borrower’s credit history and his income to qualify for the
loan. e.g.- Credit Card, Clean personal loan, Education loan
(small), etc.
 All types of credit facilities may be classified into two
groups based on fund outflow:
 1. Fund Based Credit 
 2. Non-Fund Based Credit
 1. Fund Based Credit: Fund Base Credit is the credit facility
that involves the direct outflow of the Bank’s fund to the
borrower. Various types of Fund Based Credit facilities are
as follows:-
 A) Loan: A term/demand loan is simply a loan provided for
meeting the capital expenditure need & business
purposes that need to be paid back within a specified time
frame along with interest. Loans are given for the
purchase of machinery, equipment, or any fixed assets for
starting a business or fulfilling personal needs.
Repayment Schedule, period of the loan, mode of
disbursement, rate of interest & other terms are
predetermined terms
 The loan which is repaid for up to three years is called
‘Demand Loan’ & If the repayment schedule is more than
three years is called ‘Term Loan’. Loans can be classified
into three types based on repayment period:-
 i. Short Term Loan: Usually short-term loans are repayable
within one year.
 ii. Medium Term Loan: It is generally repayable between
one and three years.
 iii. Long Term Loan: It is repayable in more than three
years.
 B) Cash Credit: For running the business, a borrower
needs working capital to meet day-to-day expenses, Stock,
and book debt. It refers to a credit facility in which
borrowers can borrow any time within the agreed limit for
a certain period for their working capital need. It is a
running account facility where credit and debit both are
permitted. It is secured by way of Hypothecation of Stock
(goods), Debtors (Book Debts), and all other current
Assets of the business generated during the business.
Cash credit can also be secured by way of mortgage of
immovable properties (as collateral security).
 C) Over Draft: An overdraft allows a current account holder
to withdraw more than their credit balance up to a
sanctioned limit. An overdraft may be permitted without
any security as a ‘clean overdraft’ for temporary periods to
enable the borrower to tide over some emergent financial
difficulty. ‘Secured overdraft’ facility is secured by way of
Mortgage of immovable properties and pledge of F.D.,
Bonds, Shares securities, Gold & silver and all other
current assets of the business generated during the
business.
 D)Credit Card: Credit cards serve many useful functions,
including the ability to pay for purchases when you don’t
have cash on hand. The credit card issuer essentially
loans you the money to make the purchase, and you will
be able to repay that loan at a later date while being
charged a certain interest rate. The credit limit of the
Credit Card depends upon the credit history and regular
income of the cardholder.
 E) Bridge Loan: Loans given to businesses that might
need instant cash flow to finance a project. Bridge loans
are normally obtained while the borrower is waiting for
long-term financing to go through. These loans are repaid
out of the amount of term loan sanctioned or the fund
raised in the capital market.
 F) Composite Loans: It is a loan that is granted for both
buying capital assets and meeting working capital
requirements. Composite Loans are usually given to an
MSME Unit, cottage industry, artisan, farmers, etc.
 G) Retail Loan: Retail loans are those loans that are given by
the banks to meet personal needs, retail loans are smaller in
size as compared to corporate loans. Home loans, Vehicle
loans, Education loans, personal loans, Vacation purposes,
medical purposes, etc are categorized as retail loans.
 H) Bill Finance: Bill discounting is a major activity with some
of the Banks. Under this type of lending, Bank takes the bill
drawn by the borrower on his (borrower’s) customer and
pays him immediately deducting some amount as discount/
commission. The Bank then presents the Bill to the
borrower’s customer on the due date of the Bill and collects
the proceeds. If the bill is delayed, the borrower or his
customer pays the Bank a predetermined interest depending
upon the terms of the transaction. The transaction is
practically an advance against the security of the bill which is
due for payment.
 I) Export Finance: Banks grant export credit on very liberal terms
to meet all the financial requirements of exporters. The bank
credit for exports can broadly be divided into two groups as under:
 i) Pre-Shipment advances/packing credit advances: It is a credit
facility sanctioned to an exporter in the Pre-Shipment stage. Such
credit facilitates the exporter to purchase raw materials at
competitive rates and manufacture or produce goods according
to the requirement of the buyer and organize to have it packed for
onward export.
  
 ii) Post-Shipment Finance: Post shipment credit is a working
capital facility granted by a bank to the exporter of goods/
services from the date of extending credit after shipment of
goods/rendering of services to the date of realization of export
proceeds. As per the extant instructions, the maximum period
prescribed for the realization of export proceeds is 12 months
from the date of shipment. 
 2. Non-Fund Based Credit: Non-fund based facilities are such
facilities extended by banks that do not involve outgo of funds
from the bank when the customer avails the facilities but may at
a later date crystallize into a financial liability if the customer
fails to honor the commitment made by availing these facilities.
These are also called Off-balance sheet (OBS) items.
 Off-balance sheet (OBS) items refer to assets or liabilities that do
not appear on a company’s balance sheet but that are
nonetheless effectively assets or liabilities of the company. These
items are not assets or liabilities to be reported in the balance
sheet as on the date of the balance sheet but may get converted
into an asset or liability at a later date, depending on the
happening of a certain event. These items are contingent upon
certain breaches of commitments and are also called ‘Contingent
Liabilities’. These contingent liabilities have to be disclosed as
‘Notes to the Balance Sheet’. But once these commitments
crystalize, these also become part of the assets or liabilities of
the bank and have to be shown in the balance sheet.
 Banks classify their off-balance sheet exposure into three
broad categories:
 1. Full risk (credit substitute): Standby letter of credit,
money guarantees, etc.
 2. Medium risk (not direct credit substitute): Bid bonds,
letter of credit, indemnities and warranties, etc.
 3. Low risk: Reverse Repos, currency swaps, options,
futures, etc.
 The banker undertakes a risk to the amount on happening of a
contingency. Different types of Non-fund-based credit facility are as
follow:
 (i)  Letter Of Credit: Letter of Credit is an undertaking issued by a
bank (Issuing Bank), on behalf of the buyer (the importer), to the
seller (the exporter) to pay for goods and services provided that the
seller presents documents which comply with the terms and
conditions of the Letter of Credit, within a specified time. The banks
follow the Uniform Customs & Practices relating to Documentary
Credits 600 (UCPDC 600) framed by the International Chamber of
commerce. LC issued by the banker is irrevocable and shall not
cancel without the consent of both the buyer and the seller.
  (ii)  Bank Guarantee: A Bank guarantee is a promise from a bank that
the liabilities of a debtor will be met if the debtor fails to fulfill your
contractual obligations. It is a promise from a bank or other lending
institution that if a particular borrower defaults on a loan, the bank
will cover the loss. It may be Financial Guarantee, Performance
Guarantee, or Deferred Payment Guarantee.
 (iii)  Derivative Products: In addition to the traditional non-
fund facilities, banks are now offering derivative products
to their clients to enable them to hedge their currency and
interest rate risks.
 (iv) Buyer Credit: It is a short-term credit available to an
importer (buyer) from overseas lenders such as banks and
other financial institutions for goods they are importing.
The overseas banks usually lend the importer (buyer)
based on the letter of comfort (a bank guarantee) issued
by the importer’s bank.
 First, let us try to understand it from a layman’s perspective: Suppose
I have to buy a certain high-end mobile phone from Delhi, but I am not
able to go to Delhi, for this purpose. I live in Patna, but one of my
friends Mr. Sanjay studies there in JNU. I will ask the supplier to send
me the mobile and I assure him that I will make arrangements to
make the payment to him through my friend Sanjay. The shopkeeper
couriers the mobile to me. Sanjay pays the bill to the shopkeeper. I,
in turn, send an NEFT to Sanjay’s account.
 Now coming to the exact definition, to make the payment of import
bills, the importer buyer, say, in India requests his banker, say, Bank
of India to arrange credit for him in foreign currency from its
correspondent bank, say, Bank of India in New York. Conceding to his
request, Indian Bank arranges a loan to him, say, for $ 1 million from
Bank of America and makes it available to the importer for making
payment of import bills. Sometimes importer himself strikes a deal
by negotiating with various banks to get buyer’s credit at a very
competitive rate, say LIBOR+0.80 or so. Later on, the importer repays
this amount either through their EEFC account, realization proceeds
of export bills, etc. Such arrangements are known as Buyer’s Credit
 As the ROI of such loans is cheaper as compared to bill
finance rates, nowadays, importer customers prefer to
adopt the route of Buyer’s Credit instead of availing bill
negotiating facility under Letter of Credit
 (v) Supplier Credit: Under such a credit facility an exporter
extends credit to a foreign importer to finance his
purchase. Usually, the importer pays a portion of the
contract value in cash and issues a Promissory note as
evidence of his obligation to pay the balance over some
time. The exporter thus accepts a deferred payment from
the importer and may be able to obtain cash payment by
discounting or selling such promissory note created with
his bank.
 Let us first understand the concept from a layman’s point
of view: The milkman gives us milk daily for all 30/31 days
of a month, but he asks for money only at the end of the
month. So all these 30 days he has been extending credit
to us. Such type of credit extended by the seller or supplier
to the purchaser is termed as Supplier’s Credit.
  What Is Trade Credit?
 Trade credit is a business-to-business (B2B) agreement in
which a customer can purchase goods without paying
cash up front, and paying the supplier at a later scheduled
date. Usually, businesses that operate with trade credits
Unit 2 will give buyers 30, 60, or 90 days to pay, with the
transaction recorded through an invoice.
Trade credit  Trade credit can be thought of as a type of 0% financing,
Risk increasing a company’s assets while deferring payment
for a specified value of goods or services to some time in
the future and requiring no interest to be paid in relation to
the repayment period.
  Trade credit is a type of commercial financing in which a
customer is allowed to purchase goods or services and
pay the supplier at a later scheduled date.
 Trade credit can be a good way for businesses to free up
cash flow and finance short-term growth.
KEY  Trade credit can create complexity for financial
TAKEAWAYS accounting depending on the accounting method used.
 Trade credit financing is usually encouraged globally by
regulators and can create opportunities for new financial
technology solutions.
 Suppliers are usually at a disadvantage with a trade credit
as they have sold goods but not received payment
  Sole banking is a lending by single bank to a large
borrower, subject to the resources available with it and
limited to the exposure limits imposed by the Reserve
Bank of India. Many a times when you propose to
What is Sole approach to new bank for funding, they propose for sole
banking that their complete banking should be transferred
banking? to their bank. This is done for two reasons one is to get
complete business and second is very important is having
complete monitoring of fund flow and cash flow of the
firm.
  As looked into above example of sole banking, it is also happens
that it continues with existing bank facility and take additional
from other (new) bank. When the credit requirements of a

What is borrower are beyond the capacity of a single bank or that the
bank does not want to take more exposure on a particular
multiple borrower, he may then resort to multiple banking. It is an

banking? arrangement where a borrower borrows simultaneously from

more than one bank independent of each other, under separate
loan documents with each bank. Securities are charged to each
bank separately.
  Consortium lending also called joint financing or
participation financing. It is a system of financial emerged
due to consequential increase in demand for funds of
substantial magnitude and inability of individual banks to
take care of the entire fund requirement of large
borrowers. The system of consortium lending provides
What is scope and opportunity to share risk amongst banks. The
Consortium system is considered to be mutually beneficial to the
banks as well as customers. Under multiple banking, there
lending? is no coordination among banks regarding appraisal,
documentation, other terms and advances. In such a
situation borrowers got the upper hand by playing one
bank against the other. It was, therefore, necessary to
formalize these credit arrangements to safeguard the
interest of the banks. It is mainly catered in case of large
corporate and certain mid-sized borrowers
  A syndicated loan, also known as a syndicated bank facility,
is financing offered by a group of lenders—referred to as
a syndicate—who work together to provide funds for a single
borrower. The borrower can be a corporation, a large project,
or a sovereign government. The loan can involve a fixed
amount of funds, a credit line, or a combination of the two.

What Is a  Syndicated loans arise when a project requires too large a

loan for a single lender or when a project needs a specialized
Syndicated lender with expertise in a specific asset class. Syndicating

Loan? the loan allows lenders to spread risk and take part in
financial opportunities that may be too large for their
individual capital base. Interest rates on this type of loan can
be fixed or floating, based on a benchmark rate such as
the London Interbank Offered Rate (LIBOR). LIBOR is an
average of the interest rates that major global banks borrow
from each other.
 A syndicated loan, or a syndicated bank facility, is
financing offered by a group of lenders—called a
syndicate—who work together to provide funds for a
borrower.
 The borrower can be a corporation, a large project, or a
sovereign government.
 Because they involve such large sums, syndicated loans
are spread out among several financial institutions to
mitigate the risk in case the borrower defaults.
  Reserve Bank of India has permitted the banks to adopt syndication route to provide credit in lieu of
consortium advance. A syndication credit differs from consortium advance. A syndicated credit
differs from consortium advances in certain aspects. The salient features of a syndicated credit are
as follows:
 It is an agreement between two or more banks to provide a borrower a credit facility using common
documents of the borrower.
 The prospective borrower gives a mandate to a bank, commonly referred as a lead bank (lead
manager), to arrange credit on his behalf. The mandate gives the commercial terms of the credit and
the prerogatives of the mandated bank in resolving contentious issue in the course of the transaction
of complete syndication.

What is  The mandated bank prepares an information Memorandum about the borrower in consultation with
the latter and distributes the same amongst the prospective lenders, inviting them to participate in
the credit proposal.

syndication of  On the basis of information Memorandum each bank makes its own independent economy and
financial evaluation of the borrower. It may collect additional information from other sources also.

credit line? Generally lead banker plays important role as rest just follows.
 Thereafter, a meeting of the particular banks is convened by the mandated bank and discuss the
syndication strategy relating to co-ordination communication and control with the syndication
process and to finalize the deal timing, charges for management, cost of credit, share of each
participating bank in the credit etc.
 A loan agreement is signed by all the participating banks.
 The borrower is required to give prior notice to the Lead Banker (Lead Manager) of his agent for
drawing the loan amount so that the latter may tie up disbursement with the other lending banks.
 Under the system, the borrower has the freedom in terms of competitive pricing. Discipline is also
imposed through a fixed repayment period under syndicated credit.
  
 After examining the matter in consultation with Indian Banks Association, the Reserve Bank
of India has advised to follow the following guidelines for improving the information sharing
system.
 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 the format prescribed
by RBI. In the case of existing lenders, all the banks may seek a declaration from their
existing borrowers availing sanctioned limit of Rs 5 crore and above or whenever, it is in their
knowledge that their borrowers are availing credit facility from other bank, and introduce a
system of exchange of information with other bank as indicated above.
 Subsequently, banks should exchange information about the conduct of the borrower’s
account with other banks in the prescribed format at least at quarterly intervals/
 Obtain regular certification by a professional, preferably a Company Secretary, Chartered
Accountant or cost accountant regarding compliance of various statutory prescription that
are in vogue, as per specimen prescribed by RBI
 Banks should make greater use of credit reports available from CIBIL.
 Banks should incorporate suitable clauses in the loan agreement in future (at the time
renewal in the case of existing facilities) regarding exchange of credit information so as to
address confidentiality issues.
 In Feb, 2014, RBI also mandated banks to report red flag if their borrower are not repaying as
per obligation, which extends for more than 60 days then it should report to RBI and other
banks having exposure to that account, It is to be done on daily basis.
 For e.g. If Borrower has taken loan from Bank A and Bank B, Borrower repays Bank B on
Time and it did not pay Bank A as per schedule and it continued for more than 60 days, then
on 61th day Bank A should report this and even Bank B need to account for provision as
account is doubtful.
  The categories under priority sector are as follows:
 Agriculture.
 Micro, Small and Medium Enterprises.
 Export Credit.
Credit  Education.
Priorities  Housing.
 Social Infrastructure.
 Renewable Energy.
  Acquisition Credit means the Acquisition Credit loans
to be advanced to the Borrowers by the Acquisition Credit
Credit Lenders pursuant to Article 5 hereof, in an aggregate
amount (subject to the terms hereof), not to exceed, at
Acquisition any one time outstanding, the Acquisition Credit
Aggregate Commitment.
  Generally there are three types of restrictions

Restrictions   
 Statutory Restrictions.
on loans and  Regulatory Restrictions

advances
 Restrictions on other Loans & Advances
  Statutory Restrictions.

  
 Banks cannot grant loans & advances against the security
of their own shares.
  
 Advances to bank’s directors
 Section 20[1] of the Banking Regulations Act lays down
restrictions on loans & advances to the directors & to the
firms in which they hold substantial interest.
 Advances to bank’s directors contd.
 banks cannot enter into any commitment on behalf of any
of its directors, or any firm in which any of its directors is
interested as partner, manager, employee or guarantor.
 for this purpose purchase or discount of bills from directors
or their firms which is in the nature of clean
accommodation is considered as loans & advances .
 When guarantees are given or LCs opened on behalf of bank’s
directors, in the event of principle debtor committing default, the
relationship of director with banks is that of a debtor & creditor.
 A bank cannot remit, without prior approval of the RBI, either
whole or a part of any debt due to it by –
 any of its directors;
 any firm where director is interested as director, partner,
managing agent or guarantor.
 any person, if any of its director is his partner or guarantor.
 Restrictions on holding shares in companies.
  
 A bank should not hold shares in any company except
whether as pledgee,mortgagee, or absolute amount over
30% owner of an paid up share that company capital of its
own reserves & paid up capital

 whichever is less.
 
What is Credit Appraisal ?

 Credit appraisal means an investigation/assessment done by the

bank prior before providing any loans and advances/
project finance and also cheeks the commercial, financial and
technical viability of the project proposed its funding pattern and
further checks the primary and collateral security cover available
for recovery of such funds. Credit appraisal is a process to
Credit ascertain the risks associated with the extension of the credit
facility. It is generally carried by the financial institutions which
Appraisals are involved in providing financial funding to its customers.
 The process by which a leader appraises the creditworthiness of
the prospective borrower is known as Credit Appraisal. This
normally involves appraising the borrower's payment history and
establishing the quality and sustainability of his income. The
lender satisfies himself of the good intentions of the borrower,
usually through an interview. Some requirements for credit
appraisal are as follows :
 The credit requirement must be assessed by all Indian
financial institutions or specialized institution set-up for
this purpose.
 Wherever financing of infrastructure project is taken up
under a consortium/syndication arrangement - bank's
exposure shall not exceed 23%.
 Bank may also take up financing infrastructure project
independently exclusively in respect of borrowers
promoters of repute with excellent past record in project
implementation.
 In such cases/due diligence on the inability of the projects
are well defined and assessed. State
Government guarantee may not be taken as a substitute
for satisfactory credit appraisal.

 Credit appraisal is done to evaluate the creditworthiness
of a borrower. The credit appraisals for any organisation
basically follow these steps - assessment of credit need,
 financial statement analysis, and financial ratios of the
company, credit rating, working capital requirement, term
loan analysis, submission of documents, NPA
classification and recovery.
 Benefits of Credit Appraisal 


 The benefits of credit appraisal are as follows :

 Reduces risk involved in the loans provided for a project.
 Increase confidence among the corporate bankers and
improved sales decision.
 Reduces NPA (Non-Performing Assets) and possibility of
financial loss.
 Proper assessment is done with different options.

 Types of Credit 


 There are four basic types of credit :

 Service credit is monthly payments for utilities such as telephone, gas,
electricity, and water. One has to pay a deposit and late charge if payment
is not on time.
 Loans can be for small or large amounts and for a few days or several
years. Money can be repaid in one lump sum or in several regular payments
until the amount one borrowed and the finance charges are paid in full.
Loans can be secured or unsecured.
 Installment credit may be described as buying on time, financing through
the store or the easy payment plan. The borrower takes the goods home in
exchange for a promise to pay later. Cars, major appliances, and
furniture are often purchased this way. One usually sign a contract, make a
down payment, and agree to pay the balance with a specified number of
equal payments called installments. The finance charges are included in
the payments. The item one purchase may be used as security for the loan.
 Credit cards are issued by individual retail stores, banks, or businesses.
Using a credit card can be the equivalent of an interest-free loan-if one pay
for the use of it in full at the end of each month.
 

 The process of credit appraisal is as follows :



Credit  1) Credit Processing : 

Appraisal  Credit processing is the stage where all

required information on credit is gathered and applications
Process  are screened. Credit application forms should be
sufficiently detailed to permit gathering of all information
needed for credit assessment at the outset. In this
connection, financial institutions should have a checklist
to ensure that all required information is, in fact, collected.

 2) Credit-Approval/Sanction : 
 A financial institution must have in place written
guidelines on the credit approval process and the approval
authorities of individuals or committees as well as the
basis of those decisions. Approval authorities should be
sanctioned by the board of directors. Approval
authorities will cover new credit approvals, renewals of
existing credits, and changes in terns and conditions of
previously approved credits, particularly credit
restructuring, all of which should be fully documented and
recorded. Prudent credit practice requires that persons
empowered with thee credit approval authority should not
also have the customer relationship responsibility.

 3) Credit Documentation : 
 Documentation is an essential part of the credit process and
is required for each phase of the credit cycle, including credit
application, credit analysis, credit approval, credit monitoring,
collateral valuation, and impairment recognition, foreclosure
of impaired loan and realization of security. The format of
credit files must be standardized and files neatly maintained
with an appropriate system of cross-indexing to facilitate
review and follow-up. The Bank of Mauritius will pay
particular attention to the quality of files and the systems in
place for their maintenance.
 Documentation establishes the relationship between the
financial institution and the borrower and forms the basis for
any legal action in a court of law. Institutions must ensure
that contractual agreements with their borrowers are vetted
by their legal advisers. Credit applications must be
documented regardless of their approval or rejection. All
documentation should be available for examination by the
Bank of Mauritius.

 4) Credit Administration : 
 Financial institutions must ensure that their credit
portfolio is properly administered, that is, loan
agreements are duly prepared, renewal notices are sent
systematically and credit files are regularly updated. An
institution may allocate its credit administration function
to a separate department or to designated individuals in
credit operations, depending on the size and complexity of
its credit portfolio.
 i) Credit files are neatly organized, cross-indexed, and
their removal from the premises is not permitted.
 ii) The borrower has registered the required insurance
policy in favor of the bank and is regularly paying the
premiums.
 iii) The borrower is making timely repayments of lease
rents in respect of charged leasehold properties.
 iv) Credit facilities are disbursed only after all the
contractual terms and conditions have been met and all
the required documents have been received;
 v) Collateral value is regularly monitored.
 vi) The borrower is making timely repayments on interest,
principal and any agreed to fees and commissions.
 5) Disbursement : 
 Once the credit is approved, the customer should be
advised of the terms and conditions of the credit by way of
a letter of offer. The duplicate of this letter should be duly
signed and returned to the institution by the customer.
The facility disbursement process should start only upon
receipt of this letter and should involve, inter alia, the
completion of formalities regarding documentation, the
registration of collateral, insurance cover in the institution's
favor and the vetting of documents by a legal expert.
Under no circumstances shall funds be released prior to
compliance with pre-disbursement conditions and
approval by the relevant authorities in the financial
institution.
 6) Monitoring and Control of Individual Credits : 
 To safeguard financial institutions against potential losses,
problem facilities need to be identified early. A proper credit
monitoring system will provide the basis for taking prompt
corrective actions when warming signs point to deterioration
in the financial health of the borrower. Examples of such
waning signs include unauthorized drawings, arrears in
capital and interest and deterioration in the
borrower's operating environment. Financial institutions must
have a system in place to formally review the status of the
credit and the financial health of the borrower at least once a
year. More frequent reviews (e.g at least quarterly) should be
carried out of large credits, problem credits or when the
operating environment of the customer is undergoing
significant changes.
 No lender approves and sanctions anybody's loan
application instantly without an evaluation. A lender needs
to carry out a credit appraisal process to ensure that the
borrower can repay the entire loan amount on time
without missing any payment deadlines. This is very
crucial for a bank as this determines the interest income
and the capital of the bank. The repayment behavior of a
borrower directly affects the performance of the bank.
 Both banks and non-banking financial corporations
(NBFCs) utilize credit appraisal procedures before
approving a personal loan application or any other loan
application. Each lender will have its techniques for
performing credit appraisal processes. A lender will have
certain norms, rules, and standards to assess the
creditworthiness of a particular loan applicant. If a
borrower has high creditworthiness, there is a high
probability that his or her loan application will be accepted
by the bank. A credit appraisal is done to avoid the risk of
default on loans.
 How Does a Lender Assess the Creditworthiness of an
Individual Borrower?
 In the context of loans and credit, creditworthiness
broadly refers to the financial character of a particular
individual. When a person applies for a loan, the lender will
check this financial character to get an idea of how the
applicant treats his or her debts.
 The lender will check the borrower’s credit history. This
will comprise checking his or her repayment behaviour,
time taken to pay different equated monthly installments
(EMIs), how a borrower has treated his or her different
debt obligations, etc.
 What is Credit Score?
 In order to compute the creditworthiness of a borrower, a
credit analysis needs to be performed. Apart from
checking the credit history of a borrower, a lender will also
evaluate his or her credit score. A credit score refers to a
particular score that is given to a borrower depending on
his or her credit history. This score is provided by credit
bureaus who will evaluate one’s full repayment behavior
and give them a score. It will be based on credit reports
created by credit bureaus. Hence, if one is interested in
applying for a personal loan, a car loan, or any other loan,
he or she should make sure that their credit score is good.
In India, the credit score of any loan applicant should
ideally be 750 and above.
 In India, CIBIL is the leading credit bureau that takes care
of observing your credit behavior and preparing a credit
report with details of your credit score. You can check your
CIBIL report to get an idea of your credit history.
 In case your credit score is high, you can be positive that
your loan application will be approved, provided you meet
other eligibility criteria set by your lender. If your credit
score is low, you can take specific measures to increase it.
When you incorporate good measures to enhance your
credit score, you widen your scope to get your loan
approved by the bank. You will have to be extremely
financially disciplined to increase your credit score.
 Factors Evaluated During a Credit Appraisal Process
 A lender’s credit appraisal process will typically check and
evaluate the following important factors:
 Income
 Age
 Repayment ability
 Work experience
 Present and former loans
 Nature of employment
 Other monthly expenses
 Future liabilities
 Previous loan records
 Tax history
 Financing pattern
 Assets owned
 How Does a Lender Evaluate the Eligibility of a Borrower
Through Credit Appraisal?
 A lender typically compares your loan amount, income,
EMIs, repayment capacity, and your overall expenses in
order to determine if you are eligible or not to get a
personal loan or any other loan. Generally, banks and
NBFCs take a look at certain ratios in order to check your
loan eligibility. These are some of the ratios that are useful
in the credit appraisal process:
 Fixed obligation to income ratio (FOIR): This ratio refers to
how one deals with his or her debts and how often they
repay their debts. It refers to the ratio of the loan
obligations and other expenses to the income that they
earn on a monthly basis. The bank will assess if a certain
portion of your income is sufficient to manage your EMIs
for the loan that you have applied for and for your other
liabilities. If the ratio is higher than the benchmark fixed by
the lender, then the lender may not accept the application.
 Installment to income ratio (IIR): This ratio considers the
equated monthly installments (EMIs) of your loan to the
income that you earn. It will indicate the amount you will
be required to take from your income to pay your personal
loan EMI.
 Loan to cost ratio: This ratio indicates the maximum
amount that a particular borrower is eligible to take. This
will depend on the cost of the car if you are taking a car
loan and on the cost of the house if you are taking a home
loan. For a personal loan, it will depend on your personal
requirement. Usually, the ratio will range from 70 to 90% of
the cost of the car or house.
 Submission of Documents for Proving Your Bankability
 Bankability is a very important aspect that is a part of credit
appraisal. Bankability refers to what will be accepted by a
particular bank. A lender will assess if a loan given to a
particular person will result in future cash flow and
profitability.
 When you apply for a personal loan or any other loan from a
bank or an NBFC, you will be required to mandatorily furnish
certain government-approved documents, reports, and other
documents in order to prove your income, age, and other
aspects. These norms will vary from lender to lender. While
applying for your loan, your lender will specify the norms and
you will be required to follow them so that they can decide if
the loan can be approved or not. Let us take a look at some
of the common norms that are set by lenders for the credit
appraisal process:
 Proof of income
 In order to prove your monthly income, you will be required to submit certain documents and they include:
 Most recent bank statements for 3 to 6 months
 Most recent salary slips
 Most recent Income Tax Return (for self-employed individuals)
 Audited financials for the previous 2 years
 Proof of address
 To prove your residential address, you will have to furnish any one of the following documents:
 Leave and license agreement
 Latest electricity bills or utility bills
 Aadhaar card
 Driving license
 Passport
 Proof of identity
 To prove your identity and date of birth, you will be required to submit any one of the following documents:
 Aadhaar
 PAN card
 Voter ID
 Driving license
 Passport-size photographs
 Proof of employment
 To prove your employment information, you will be required to give certain
documents regarding your employer or your own company (if you are self-
employed):
 Letter from your employer
 Offer letter or appointment letter provided by your employer
 Office address proof
 Employment certificate from your present employer
 Certificate of experience or relieving letter from your previous employer(s)
to show your overall work experience
 Proof of creditworthiness
 To prove your creditworthiness, you can show your credit score to your
new lender. This can be done by submitting your CIBIL report. When you
are furnishing your CIBIL report, you should be sure about the details of
your credit score. You should also ensure that your credit score is 750 and
above.
 With the help of your CIBIL report, your lender will check if you have been
prompt while making your repayments and while clearing your credit card
bills. Your lender will also be able to see if you have defaulted any loan
during your entire credit history and if you have made many enquiries.
Hence, you need to be very particular about how your credit report looks.
 Proof of investment
 If you have made any investment, you will be required to
provide proofs. This can be done by giving documents of
your investments such as fixed deposits, shares, mutual
funds, fixed assets, gold, etc.
 When the lender takes a look at your income proof, age
proof, and employment proof, the lender gets an idea
about your overall profile and the bank can determine if
you will be able to repay your loan promptly without any
financial struggles.
 Credit Appraisal for Project Financing for Organisations
 If a lender is approached by a company for project financing or a
loan, then the lender will need to consider financial, technical,
commercial, market, and managerial aspects of the organisation.
 Under credit appraisal, to evaluate financial aspects, the bank will
have to check the organisation’s costs, expenses, and estimated
revenues in order to understand if the company will be able to
repay the loan without any trouble.
 To assess technical aspects of a company, the bank will have to
evaluate the nature of the business and the industry or sector of
the borrower. The lender will have to observe the company’s raw
materials, capital, labour, transportation, selling plans, etc.
 To evaluate the market of the borrower, the bank will have to
evaluate its demand and supply. If the demand-supply gap is
high, then it is great news for the lender. This is because it
indicates that the company will enjoy good sales and hence, can
repay the loan efficiently.
 The bank also needs to assess the managerial aspects of
an organisation before giving a loan to them. The bank
should understand the goals, plans, and commitment of
the company to the particular project. The organisation’s
management style and ways of handling subordinates
should be observed by the lender.
 Banks will assess both financial and non-financial aspects
in order to determine the borrower’s creditworthiness
while conducting the credit appraisal process.
 The intensity of the credit appraisal will depend on the
loan quantum and the purpose of the loan. According to
these aspects, the appraisal process can be simple or
complex for both individuals and entities.

  Credit Rating in India
 Credit rating has garnered significant importance in the
country’s financial market in the last 20 years. In simple
Credit rating terms, credit rating is assessing the creditworthiness of an
entity. There are a number of credit agencies in the
in India country that rate companies and organisations after
measuring their ability to repay the borrowed amount.
 What is Credit Rating?
 Credit rating is the financial risk associated with entities
such as governments, non-profit organisations, and
countries, among others. The rating is given to entities by
the credit rating agencies after analysing their business
and finance risk. The agencies prepare a detailed report
after taking into consideration some additional factors
such as the ability to repay the debt
  All credit agency agencies use various terminology for
determine credit ratings. However, the notations are very
similar. Ratings are always grouped into two: an
‘investment grade’ and also a ‘speculative grade’.
 Investment grade:

Types of  These ratings mean that the investment is a solid one and
the issuer will most likely meet the repayment terms.
Credit Ratings These investments are priced less as compared to
speculative grade investments.
 Speculative grade:
 These investments are known to be high risk. So, they
come with higher interest rates.
 Users of Credit Ratings
 Credit ratings are used by investors, and intermediaries
like:
 Issuers of debt
 Businesses
 Investment banks
 Corporations
 Institutional and individual investors:
 They use credit ratings for assessing the risk that is linked to
investing in an issuance, in the context of the portfolio.
 Intermediaries:
 These include investment bankers who use credit ratings for
evaluating the credit risk and also reaching the pricing of debts.
 Debt issuers:
 These include governments, corporations, and municipalities and
they use credit ratings as an independent evaluation of their
creditworthiness. They also look into the credit risk associated
with the debt issuance. The ratings can also provide prospective
investors an idea of the quality of the instrument.
 Businesses and corporations:
 They look to evaluate the risk involved with a counterparty
transaction. Credit ratings help entities that want to participate in
ventures and partnerships with other businesses in evaluating the
viability.
 Who evaluates credit ratings in India?
 The credit rating is evaluated by a credit agency in India
who takes into consideration the quantitative and
qualitative attributes of the borrower. The credit rating
agency looks into various information such as financial
statements, annual reports, reports provided by analysts,
news pieces, industry analysis, projection for the next
quarter which in the end helps them determine the rating
to be given to the entity.
 Some of the top credit rating agencies in India are Credit
Rating Information Services of India Limited (CRISIL),
ICRA Limited, Credit Analysis and Research limited (CARE)
, India Rating and Research Private Limited, etc.
 What are credit rating agencies?
 Credit rating agencies measure the likelihood of an entity
turning into a defaulter. All the credit rating agencies in
India are regulated by SEBI (Credit Rating Agencies)
Regulations, 1999 of the Securities and Exchange Board of
India Act, 1992.
 Importance of Credit Rating
 When a credit rating agency upgrades a company’s rating,
it suggests that the company has a high chance of
repaying the credit. On the other hand, when the credit
rating gets downgraded it suggests the company’s ability
to repay has reduced.
 Once the company’s credit rating has been downgraded, it
becomes difficult for the company to borrow money.
Lenders will consider such companies as high-risk
borrowers as they have a higher probability of turning into
a defaulter. Financial institutions will hesitate to lend
money to the companies with low credit rating
 Let’s take a look at the importance of credit rating:
 Credit rating does a qualitative and quantitative assessment of a
borrower's creditworthiness.
 It allows investors to make a sound investment decision after taking
into consideration the risk factor and past repayment behaviour. In
other words, it establishes a relationship between risk and return.
 In the case of the companies, credit ratings help them improve their
corporate image. It is useful especially for companies that are not
popular.
 The credit rating acts as a marketing tool for companies and also as
a resource that is helpful at the time of raising money. It reduces the
cost of borrowing and helps in the company’s expansion.
 Lenders such as banks and financial institutions will offer loans at a
lower interest rate if the entity has a higher credit rating.
 Credit rating encourages better accounting standards, detailed
information disclosure, and improved financial information.
 How do credit rating agencies work in India?
 Each rating agency has its own method to calculate credit
ratings. Agencies rate entities including companies, state
governments, non-profit organisations, countries, securities,
special purpose entities, and local governmental bodies. At
the time of calculating the rating, credit rating agencies take
into consideration several factors like the financial
statements, level and type of debt, lending and borrowing
history, ability to repay the debt, and past debts of the entity
before rating them. Once a credit rating agency rates the
entities, it provides additional inputs to the investor following
which the investor analyses and takes a sound investment
decision.
 Credit ratings that are given to the entities serve as a
benchmark for financial market regulations. However, it
should be noted that the ratings should not be considered as
advice for investors and instead should be used as a tool to
make a sound decision.
 Different credit rating scales
 An individual's creditworthiness is represented by
their credit score. Similarly, a company’s creditworthiness
is represented by the credit rating symbols assigned to
them by the agencies. Credit rating agencies rate Non
convertible debentures (NCD), company deposits, and
fixed deposits, among others. Let’s take a look at some of
the credit rating symbols offered by rating agencies for
long-term and mid-term debt instruments
 BrickW
India Ratings &
Rating Scale CRISIL ork CARE ICRA
Research
Ratings

CRISIL BWR CARE ICRA

Highest safety: Lowest risk of turning into a defaulter IND AAA
AAA AAA AAA AAA

CRISIL BWR CARE ICRA

High safety: Very low credit risk IND AA
AA AA AA AA
Low risk IND A CRISIL A BWR A CARE A ICRA A
CRISIL BWR CARE ICRA
Moderate safety: moderate credit risk IND BBB
BBB BBB BBB BBB

CRISIL CARE ICRA

Moderate risk: moderate risk of default IND BB BWR BB
BB BB BB
High risk: high risk of default IND B CRISIL B BWR B CARE B ICRA B

Very high risk: Very high risk of default IND C CRISIL C BWR C CARE C ICRA C

Default: Instruments are already in default or on the

IND D CRISIL D BWR D CARE D ICRA D
verge of default
 Factors affecting Credit Ratings in India
 Some of the factors that may affect the credit ratings on a
company in India are:
 Company’s history: The credit rating agency looks into the
past history of the company including their history of
borrowing and when they have paid back the debit. The
credit rating can severely be affected if the company has
delayed the payment or defaulted on loans.
 Future economic potential of the company: The credit
rating of a company is also determined based on its future
potential. If the company shows that it will be profitable in
the near future based on projections, current performance,
etc., the credit rating will give them a positive rating,
otherwise a negative rating will be given if the future
projections do not look promising.
 Factors affecting credit score in India
 A credit bureau takes into account various factors which
helps them calculate an individual’s credit score. The
factors that are taken into account are:
 Payment history: 35%
 Credit utilisation : 30%
 Credit history length: 15%
 New credit: 10%
 Credit mix: 10%
 Some of the factors due to which your credit score can get
affected are:
 Not paying your bills on time: Your credit score can get
negatively impacted if you fail to pay your credit card bills
or your loan on time. Hence, always make sure to pay your
bill by the due date to keep your credit score healthy.
 Credit utilisation ratio: You must ideally maintain a credit
utilisation ratio of 30% or less in order to keep your credit
score high. For example, if your credit card limit is Rs.1
lakh, then do not spend more than Rs.30,000 on your
credit card.
 Delay in payment of loans and bills. Repaying your loan
and clearing all the bills on time improves your credit score.
You may come across the option of paying the minimum
amount which in the long run does not help in improving
your credit score. Hence, make sure you repay all your
loan and credit card bill on time before applying for a new
one in order to keep your credit score healthy.
 Frequently applying for loans and credit cards: Whenever
you apply for a loan or a credit card, the lender conducts a
credit inquiry. Too many credit inquiries affect your credit
score, hence avoid applying for loans and credit cards on a
frequent basis.
 Increasing your credit card limit frequently: Looking to
increase your credit card limit frequently can be a sign of
you depending heavily on credit to manage your expenses
due to which not only your credit score falls but the lender
may not be willing to offer you a loan in future. Increase
your credit limit only if you are sure about repaying the
outstanding bill on time.
 Not checking your credit score frequently: Check your
credit score at least on a quarterly basis. Sometimes, your
credit score may have a small error which in turn may
affect your credit score. If you find an error, immediately
get it fixed by getting in touch with the credit bureau.
 Having a poor mix of credit: Do not apply for only one type
of product. For example, do not apply for a personal loan
every time. Having a mix of different types of loans shows
that you can handle your finances well which in turn
improves your credit score. It goes without saying that you
must repay your loans on time to ensure your credit score
remains positive.
 What’s the Difference Between Credit Rating and Credit
Score?
 A credit rating is assigned to a company or an
organisation by the credit rating agencies after assessing
their ability to repay the borrowed amount. Meanwhile, a
credit score is computed by credit bureaus after taking
into consideration several factors like credit history and
repayment behaviour.
  Creditworthiness, simply put, is how “worthy” or deserving
one is of credit. If a lender is confident that the borrower
will honor her debt obligation in a timely fashion, the
What is borrower is deemed creditworthy. If a borrower were to

Creditworthine evaluate their creditworthiness on her own, it would result

in a conflict of interest. Therefore, sophisticated financial
ss? intermediaries perform assessments on individuals,
corporates, and sovereign governments to determine the
associated risk and probability of repayment.
 Creditworthiness, simply put, is how “worthy” or deserving
one is of credit. If a lender is confident that the borrower
will honor her debt obligation in a timely fashion, the
borrower is deemed creditworthy.
 Financial institutions use credit ratings to quantify and
decide whether an applicant is eligible for credit.
 Credit ratings are also used to fix interest rates and credit
limits for existing borrowers.
 Using Credit Ratings
 Financial institutions use credit ratings to quantify and
decide whether an applicant is eligible for credit. Credit
ratings are also used to fix the interest rates and credit
limits for existing borrowers. A higher credit rating
signifies a lower risk premium for the lender, which then
corresponds to lower borrowing costs for the borrower.
Across the board, the higher one’s credit rating, the better.
Unit 3  Letter of credit and loan commitments
  A letter of credit, or "credit letter," is a letter from a bank
guaranteeing that a buyer's payment to a seller will be
What Is a received on time and for the correct amount. In the event

Letter of that the buyer is unable to make a payment on the

purchase, the bank will be required to cover the full or
Credit? remaining amount of the purchase. It may be offered as
a facility.
 Due to the nature of international dealings, including
factors such as distance, differing laws in each country,
and difficulty in knowing each party personally, the use of
letters of credit has become a very important aspect of
international trade.
 KEY TAKEAWAYS
 A letter of credit is a document sent from a bank or
financial institute that guarantees that a seller will receive
a buyer's payment on time and for the full amount.
 Letters of credit are often used within the international
trade industry.
 There are many different letters of credit including one
called a revolving letter of credit.
 Banks collect a fee for issuing a letter of credit.
  Because a letter of credit is typically a negotiable
instrument, the issuing bank pays the beneficiary or any
bank nominated by the beneficiary. If a letter of credit is
How a Letter transferable, the beneficiary may assign another entity,
of Credit such as a corporate parent or a third party, the right to
draw.
Works   Banks typically require a pledge of securities or cash as
collateral for issuing a letter of credit.
 Banks also collect a fee for service, typically a percentage
of the size of the letter of credit. The International
Chamber of Commerce Uniform Customs and Practice for
Documentary Credits oversees letters of credit used in
international transactions.1 There are several types of
letters of credit available.
  Commercial Letter of Credit
 This is a direct payment method in which the issuing bank
makes the payments to the beneficiary. In contrast,
Types of a standby letter of credit is a secondary payment method
in which the bank pays the beneficiary only when the
Letters of holder cannot.
Credit  Revolving Letter of Credit
 This kind of letter allows a customer to make any number
of draws within a certain limit during a specific time period.
 Traveler's Letter of Credit
 For those going abroad, this letter will guarantee that
issuing banks will honor drafts made at certain foreign
banks.
 Confirmed Letter of Credit
 A confirmed letter of credit involves a bank other than the
issuing bank guaranteeing the letter of credit. The second
bank is the confirming bank, typically the seller’s bank.
The confirming bank ensures payment under the letter of
credit if the holder and the issuing bank default. The
issuing bank in international transactions typically
requests this arrangement.
 What Is an Example of a Letter of Credit?
 Consider an exporter in an unstable economic climate,
where credit may be more difficult to obtain. The Bank of
America would offer this buyer a letter of credit, available
within two business days, in which the purchase would be
guaranteed by a Bank of America branch. Because the
bank and the exporter have an existing relationship, the
bank is knowledgeable of the buyer's creditworthiness,
assets, and financial status. 
 What Is the Difference Between a Commercial Letter of
Credit and a Revolving Letter of Credit?
 As one of the most common forms of letters of credit,
commercial letters of credit are when the bank makes
payment directly to the beneficiary or seller. Revolving
letters of credit, by contrast, can be used for multiple
payments within a specific time frame. Typically, these
are used for businesses that have an ongoing relationship,
with the time limit of the arrangement usually spanning
one year.
  A sight draft is a type of bill of exchange, in which the exporter
holds the title to the transported goods until the importer receives
and pays for them. Sight drafts are used with both air shipments
and ocean shipments for financing transactions on goods in
international trade. Unlike a time draft, which allows for a short-
term delay in payment after the importer receives the goods, a
sight draft is payable immediately.
 KEY TAKEAWAYS
What Is a  A sight draft is a payment document used in international trade
Sight Draft? whereby a buyer accepts shipped goods and agrees to pay the
seller immediately upon delivery.
 As a type of bill of exchange, sight drafts are utilized in
international trade to facilitate short-term financing between
importers and exporters.
 Because there is no time delay or waiting period with a sight draft,
these usually must be accompanied by an official letter of credit
issued by a commercial bank.
  A contingent guarantee is a guarantee of payment made
by a third-party guarantor to the seller or provider of a
product or service in the event of non-payment by the
buyer.

Contingent  Understanding Contingent Guarantees

Guarantee?  Contingent guarantees generally are used when a

supplier does not have a relationship with a counter-party.
The buyer pays a contingent guarantee fee to the
guarantor, usually a large bank or financial institution. If
the buyer fails to make the payment, the third party will
make a payment on their behalf.
 A guarantor differs from a cosigner. A cosigner is co-owner
of the asset and is named in the ownership document. The
guarantor has no claim to the asset purchased by the
borrower under the loan agreement, and only guarantees
payment of the loan. The lender will normally ask for a
cosigner if the borrower’s qualifying income does not
meet the lender's requirement. The cosigner’s additional
income or assets bridge any financial gap. Under the
guarantor agreement, the borrower may have sufficient
income but limited or poor credit history.
 KEY TAKEAWAYS
 A contingent guarantee is a guarantee of payment made by a
third party guarantor to the seller or provider of a product or
service if the buyer cannot pay.
 If it is likely to become a confirmed obligation, an accountant
should record a contingent liability on a balance sheet.
 Contingent guarantees are a common feature of
international trade, especially when vendors conduct
business with new customers in overseas markets.
Contingent guarantees also are used as a risk-
management tool for large international projects with
countries that have a high degree of political or regulatory
risk, as well as in certain income-oriented financial
instruments.
  A contingent guarantee is not an actual confirmed liability
for a company until it is likely they'll have to make good on
the guarantee.
  A contingent guarantee differs from a letter of credit (LC),
which is more commonly used in international trade. A
contingent guarantee is employed only upon non-payment
after a stipulated period by the buyer, while an LC is
payable by the bank as soon as the seller effects
Contingent shipment and satisfies the terms of the LC. LCs help

Guarantee vs. mitigate factors such as distance, legal requirements and

counter-party reputation.
Letter of  Because a letter of credit typically is a negotiable
Credit instrument, the issuing bank pays the beneficiary or any
bank nominated by the beneficiary. If a letter of credit is
transferrable, the beneficiary may assign another entity,
such as a corporate parent or a third party, the right to
draw.
 Banks typically require a pledge of securities or cash as
collateral for issuing a letter of credit. Banks also collect a
fee for service, typically a percentage of the size of the
letter of credit. The International Chamber of Commerce
Uniform Customs and Practice for Documentary Credits
oversees letters of credit used in international
transactions.
  A demand guarantee is a type of protection that one party (the beneficiary)
in a transaction can impose on another party (the principal) in the event
that the second party does not perform according to predefined
specifications. In the event that the second party does not perform as
promised, the first party will receive a predefined amount of compensation
from the guarantor, which the second party will be required to repay.
 KEY TAKEAWAYS
 A demand guarantee is an agreement issued by a bank to pay a specified
Demand amount to one party of a contract on-demand as protection against the
risk of the other party's nonperformance.

Guarantee?  If the principal fails to perform on the contract, the beneficiary can demand
payment on the guarantee from the guarantor, who can then seek
repayment from the principal.
 Standard rules for demand guarantees in international trade are published
by the International Chamber of Commerce (ICC) and have been widely
adopted around the world.
 Demand guarantees are a way of managing, pricing, and transferring the
risk of nonperformance among parties in order to facilitate transactions
that might otherwise not be possible due to the risks involved.

  A credit default swap (CDS) is a financial derivative that allows an
investor to "swap" or offset his or her credit risk with that of another
investor. For example, if a lender is worried that a borrower is going
to default on a loan, the lender could use a CDS to offset or swap that
risk.
 To swap the risk of default, the lender buys a CDS from another investor
who agrees to reimburse the lender in the case the borrower defaults.
Most CDS contracts are maintained via an ongoing premium payment
What Is a similar to the regular premiums due on an insurance policy.
 KEY TAKEAWAYS
Credit Default  Credit default swaps, or CDS, are credit derivative contracts that enable
Swap (CDS)? investors to swap credit risk on a company, country, or other entity with
another counterparty.
 Credit default swaps are the most common type of OTC credit derivatives
and are often used to transfer credit exposure on fixed income products
in order to hedge risk.
 Credit default swaps are customized between the two counterparties
involved, which makes them opaque, illiquid, and hard to track for
regulators.
  A financial guarantee is an agreement that guarantees a debt will
be repaid to a lender by another party if the borrower defaults.
Essentially, a third party acting as a guarantor promises to
assume responsibility for a debt should the borrower be unable to
keep up on its payments to the creditor.
 Guarantees can also come in the form of a security deposit
or collateral. The types vary, ranging from corporate guarantees
to personal ones.
What Is a  KEY TAKEAWAYS

Financial  Financial guarantees act like insurance policies, guaranteeing a

form of debt will be paid if the borrower defaults.
Guarantee?  Guarantees can be financial contracts, where a guarantor agrees
to assume financial responsibility if the debtor defaults.
 Other guarantees involve security deposits or collateral that can
be liquidated if the debtor stops paying for any reason.
 Guarantees may be issued by banks and insurance companies.
 Financial guarantees can result in a higher credit rating for the
lender and better interest rates for the borrower.
  Cash in advance is a payment term used in some trade
agreements. It requires that a buyer pay the seller in cash
What Is Cash before a shipment is received and oftentimes before a
shipment is even made. Cash in advance is a provision
in Advance? that can be required in any transaction in which there is a
delay between the sales agreement and the sales delivery.
  An irrevocable letter of credit (ILOC) is an official correspondence
from a bank that guarantees payment for goods or services being
purchased by the individual or entity, referred to as the applicant,
that requests the letter of credit from an issuing bank.
 An irrevocable letter of credit cannot be canceled, nor in any way
modified, except with the explicit agreement of all parties

What Is an involved: the buyer, the seller, and the issuing bank. For example,
the issuing bank does not have the authority by itself to change
Irrevocable any of the terms of an ILOC once it is issued.

Letter of  KEY TAKEAWAYS

 An irrevocable letter of credit (ILOC) is a guarantee for payment
Credit (ILOC)? issued by a bank for goods and services purchased, which
cannot be cancelled during some specified time period.
 ILOCs are most commonly used to facilitate international trade.
 A confirmed ILOC offers additional risk protection for the seller by
providing a guarantee of payment from both the buyer's bank and
the seller's bank.
  The company act 1980 the legal term Quasi Loan in
section concern the restrictions on company making loans
to directors. A quasi loan arises when a company incurs a
liability or agrees to incur a liability in circumstances when
the director is under an obligation to reimburse the
company for the payment involved.
Quasi Credit  An example would be where the company holds a credit
Facilities card and that card is used in a transaction for the sole
benefit of the director personally. A company has
assumed a liability through use of card and the director, as
beneficiary of the transaction must reimburse the
company
  Quasi equity investments are usually based on the
company’s future cash flow growth. The lender must use
projected cash flow statistics of the company they are
investing in, and they base the structure of the quasi
equity investment upon what the future cash flow stream
is going to be.
Quasi Equity  Quasi equity financing is used when debt financing and
share capital are not possible options of financing. Quasi
equity is the similar to a loan in the sense that quasi equity
financing is dependent upon how the company performs
in coming years.
 If the company fails to reach the expected performance
benchmark, the investors received a significantly lower
returns , However, the company goes through a more
profitable growth stretch than expected , the investor
received greater financial returns.
 Quasi equity financing is dependent upon how the
company goes in future, which means the investor must
have as much data as possible in order to minimize the
risk that is possible when investing in a company.
  When the lender bank does not pledge any outflow of fund
in the physical form, it is called as non fund based lending.

Advantages These are the contingent liability of the bank. So the bank
do not deal in cash transactions. The benefits of these
of Non Fund types of loans is that there is no immediate outlay of

Facilities funds, easy monitoring comparatively, less cost to the

banker, low probability of default, and contingent
dependent of funds.
  Assessment of LC limits fixed by banks based on annual
consumption of raw material to be purchased against LC.
The raw material holding in terms of consumption is
Assessment workout as under-:

of letter of  Ascertain from customer the requirement of consumption

of materials per annum, which is tobe purchased under LC.
credit
.
  Process flow of letter of credit
 Terms of Contract-: when both the parties agree, they
Bill determine the nature of business and types of goods of
seller should supply to the buyer. Given the contract, a
purchased/ letter of credit is being issued between buyer and seller.
discounting  Issuance of LC-: Buyer approaches the issuing bank to
under LC issue the LC in favor of seller and seller bank i. e.
confirmation bank which will pay to the seller in behalp of
the buyer.
 Documents and payments-: as per LC terms, the seller will
submit documents to confirmation bank, for the payment
which includes bills of exchange , packing list, e-way bill.
Then these documents are forwarded to issuing bank if
there is no discrepancy in documents the issuing bank will
honor the LC. Finally , the documents are submitted to
buyer, only if the payment is made by the buyer.
 It speeds up the cash flow and helps in the smooth flow of
working capital
Advantages LC discounting takes away the risk and give the assurance
of LC to the seller for the fund

discounting It is more convenient for both the party seller and buyer
LC assist boosting the business through varies geoghphies
  In LC discounting, there is no physical varification of the
quantity and the quality of the goods.
Disadvantages  There is a set of documentation which needs to be
of followed by the both the seller and buyer, which can be
LC tedious due to non availability for the same

Discounting  The final amount which is credit is less, due to being

discounted by the bank.
 
What Is an An unfunded line of credit is one that a bank issues to a
borrower, but is not borrowed upon at the moment it is
Unfunded Line issued. The bank or lending institution will honor any
of Credit? future draws upon the unfunded line of credit, but does
not need to make any money available until the moment
the customer requests it
 How Is An  If you take out a mortgage, the lender must immediately
make the amount of the mortgage available so you can
Unfunded Line buy that dream house. This is considered a traditional loan
Of Credit transaction. Other traditional loan transactions include
automobile loans, student loans and other consumer
Different Than loans. An unfunded line of credit is a line of credit which is
A Traditional reserved for future use and is not fully funded upon issue.

Loan?
  Borrowers of unfunded lines of credit can be either
individual retail customers or businesses. Businesses
such as hedge funds and insurance companies are
Borrowers Of customers of unfunded lines of credit, and they most

Unfunded commonly use them as an emergency fund. Retail

customers can also acquire unfunded lines of credit in the
Lines Of Credit form of home equity lines. Unfunded loan commitments,
whether to retail or corporate clients, represent liabilities
to both borrowers and banks.
  A borrower can default after drawing upon the line of
credit, causing a major problem for the bank which acted
as a lender. For example, if a major catastrophe happens
Risk Of which requires an insurance company to pay out claims

Borrower for which it does not have sufficient cash reserves, that
insurance company may draw upon its unfunded line of
Default credit. If the insurance company is unable to pay back
what it borrowed from the bank and files for bankruptcy,
the bank must count the unrecovered money as a loss.
  Unfunded lines of credit pose major risks for banks.
Because the bank must honor the line of credit at any
given point in the future, it must have enough cash to do
so. If a bank issues too many unfunded loan

Risk Of Bank commitments, and a high number of them are

unexpectedly drawn upon, the bank will be unable to
Default honor the loan commitment. Banks are required to report
unfunded lines of credit quarterly to the United States
government's Federal Deposit Insurance Corporation.
Every bank limits the number of unfunded credit lines it
will issue to mitigate liability.
 A line of credit (LOC) is a preset borrowing limit that can
be tapped into at any time. The borrower can take money
out as needed until the limit is reached, and as money is
repaid, it can be borrowed again in the case of an open
line of credit.
 A LOC is an arrangement between a financial
institution—usually a bank—and a client that establishes
the maximum loan amount the customer can borrow. The
borrower can access funds from the line of credit at any
time as long as they do not exceed the maximum amount
(or credit limit) set in the agreement.
  A line of credit (LOC) is a preset borrowing limit that a
borrower can draw on at any time.
 Types of credit lines include personal, business, and home
equity, among others.
Characteristi  A LOC has built-in flexibility, which is its main advantage.
cs  Potential downsides include high interest rates, severe
penalties for late payments, and the potential to
overspend.
  All LOCs consist of a set amount of money that can be
borrowed as needed, paid back and borrowed again. The
amount of interest, size of payments, and other rules are
Understanding set by the lender. Some lines of credit allow you to write
checks (drafts) while others include a type of credit or
Credit Lines debit card. A LOC can be secured (by collateral) or
unsecured, with unsecured LOCs typically subject to
higher interest rates.
  In a sale, a buyer wants to receive goods, and the seller
Letter of wants to receive payment for those goods. It's as simple
Credit Vs. Line as that — but the process can go wrong. A letter of credit
and a line of credit are both instruments used between
of Credit buyers and sellers to make sure this commercial
transaction goes smoothly.
  A letter of credit is a written assurance, or commitment,
that the bank of a buyer or importer gives to the bank of a
seller or exporter. The buyer's bank is referred to as the
issuing bank, while the seller's bank is referred to as the

Letter Of accepting bank. The purpose of a letter of credit is to

facilitate a transaction between the buyer and the seller
Credit by providing assurance to the seller that he will receive
payment for the goods that are sold. It's a guarantee that
the seller will receive a payment of a specific amount in a
specific currency as long as the seller adheres to the
terms and conditions that the buyer and seller agree on.
  A line of credit is different from a letter of credit. A line of
credit permits the buyer to purchase items now but pay
for them later. The line of credit is extended to the buyer
based upon specific payment terms, such as how long the
buyer has before payment must be made and the payoff
Line Of amount the buyer must remit to the seller. The line of
credit also specifies the amount of product the buyer is
Credit able to receive on credit at any given time. A line of credit
represents the total amount of unpaid invoices, orders
confirmed but not yet shipped and goods in transit.
Letters of credit and lines of credit are generally used in
international commerce.
  Here's how they're connected: a seller issues a line of
credit to a buyer based upon the buyer's creditworthiness.
If the seller doesn't consider the buyer credit-worthy and is
unwilling to extend credit to the buyer, the seller will
request that the buyer provide a letter of credit from the

Significance buyer's bank instead. A letter of credit is a formal trade

instrument. This means the letter of credit from the bank
substitutes the bank's creditworthiness for the
creditworthiness of the buyer. The seller is assured he will
receive payment and is therefore willing to sell to the
buyer.
  Also, keep this in mind: the buyer who requests a letter of
credit from the bank is called an applicant, or account
party. The seller or exporter receiving the letter of credit is

Consideratio called a beneficiary. Before the bank issues a letter of

credit to the beneficiary, the applicant must pay the cost
ns of the goods upfront to the bank, or negotiate a loan or
other business credit terms from the issuing bank. The
applicant (buyer) must do one or the other before the bank
will provide a letter of credit on his behalf.
  Most lines of credit are unsecured loans. This means the
borrower does not promise the lender any collateral to
back the LOC. One notable exception is a home equity line
Unsecured vs. of credit (HELOC), which is secured by the equity in the
Secured LOCs borrower's home. From the lender's perspective, secured
lines of credit are attractive because they provide a way to
recoup the advanced funds in the event of nonpayment.2
  A line of credit is often considered to be a type of revolving
account, also known as an open-end credit account. This
arrangement allows borrowers to spend the money, repay
it, and spend it again in a virtually never-ending, revolving
cycle. Revolving accounts such as lines of credit and credit
Revolving vs. cards are different from installment loans such as
Non-Revolving mortgages and car loans.

Lines of Credit  With installment loans, consumers borrow a set amount of

money and repay it in equal monthly installments until the
loan is paid off. Once an installment loan has been paid off,
consumers cannot spend the funds again unless they
apply for a new loan.
 Non-revolving lines of credit have the same features as
revolving credit (or a revolving line of credit). A credit limit
is established, funds can be used for a variety of purposes,
interest is charged normally, and payments may be made
at any time. There is one major exception: The pool
of available credit does not replenish after payments are
made. Once you pay off the line of credit in full, the
account is closed and cannot be used again.
 As an example, personal lines of credit are sometimes
offered by banks in the form of an overdraft protection
plan. A banking customer can sign up to have an overdraft
plan linked to his or her checking account. If the customer
goes over the amount available in checking, the overdraft
keeps them from bouncing a check or having a purchase
denied. Like any line of credit, an overdraft must be paid
back, with interest.
  Personal line of credit
 This provides access to unsecured funds that can be
borrowed, repaid, and borrowed again. Opening a personal
line of credit requires a credit history of no defaults, a
credit score of 670 or higher, and reliable income. Having
Types of Lines savings helps, as does collateral in the form of stocks or
of Credit CDs, though collateral is not required for a personal LOC.
Personal LOCs are used for emergencies, weddings and
other events, overdraft protection, travel and
entertainment, and to help smooth out bumps for those
with irregular income.3
 Home equity line of credit (HELOC)
 HELOCs are the most common type of secured LOC. A
HELOC is secured by the market value of the home minus
the amount owed, which becomes the basis for
determining the size of the line of credit. Typically, the
credit limit is equal to 75% or 80% of the market value of
the home, minus the balance owed on the mortgage.4
 Demand line of credit
 This type can be either secured or unsecured but is rarely
used. With a demand LOC, the lender can call the amount
borrowed due at any time. Payback (until the loan is called)
can be interest-only or interest plus principal, depending
on the terms of the LOC. The borrower can spend up to
the credit limit at any time.5
 Securities-backed line of credit (SBLOC)
 This is a special secured-demand LOC, in which collateral
is provided by the borrower’s securities. Typically, an
SBLOC lets the investor borrow anywhere from 50% to
95% of the value of assets in their account. SBLOCs
are non-purpose loans, meaning the borrower may not
use the money to buy or trade securities. Almost any
other type of expenditure is allowed.6
 SBLOCs require the borrower to make monthly, interest-
only payments until the loan is repaid in full or the
brokerage or bank demands payment, which can happen
if the value of the investor’s portfolio falls below the level
of the line of credit.6
 Business line of credit
 Businesses use these to borrow on an as-needed basis
instead of taking out a fixed loan. The financial institution
extending the LOC evaluates the market value, profitability,
and risk taken on by the business and extends a line of
credit based on that evaluation. The LOC may be
unsecured or secured, depending on the size of the line of
credit requested and the evaluation results. As with
almost all LOCs, the interest rate is variable.7
  The main advantage of a line of credit is the ability to borrow
only the amount needed and avoid paying interest on a large
loan. That said, borrowers need to be aware of potential
problems when taking out a line of credit.
 Unsecured LOCs have higher interest rates and credit
requirements than those secured by collateral.
 Interest rates (APRs) for lines of credit are almost always
Limitations of variable and vary widely from one lender to another.
 Lines of credit do not provide the same regulatory protection
Lines of Credit as credit cards. Penalties for late-payments and going over
the LOC limit can be severe.
 An open line of credit can invite overspending, leading to an
inability to make payments.
 Misuse of a line of credit can hurt a borrower’s credit score.
Depending on the severity, the services of a top credit repair
company might be worth considering.
  Various types of guarantees are issued by the banks on behalf of
their customers. Bank Guarantees (BG) is also known as Letter of
Guarantees which can be broadly classified as (i) Financial
Guarantees and (ii) Performance guarantees. Earnest money
Deposit guarantee or Bid Bond Guarantee, Guarantee for Payment
of Customs duty (specific or continuing), Advance Payment
Guarantee (APG), Deferred Payment Guarantee (DPG), Shipping
Guarantee, Performance guarantee, Retention Money guarantees
Various types etc are some of the prominent types of guarantees issued by the
banks.
of  Bank Guarantee or letter of guarantee is a fee-based credit facility
Bank extended by the banks to their customers. The non-fund based
facilities are the letter of guarantee or letter of credit by the banks
guarantees wherein banks get fee income and Since there is no immediate
outflow of funds from the banks they are also known as the non-
fund based facility. However in the case of non-fund based credit
facility, the bank has to discharge the financial liability of the
contract agreed to the guarantee or documentary credit, if the
contract is partly or fully not performed by the customer.
 
Financial guarantees are issued by the banks whenever a
contract is awarded to their customer, who is generally a
contractor of civil work or a supplier of goods, machinery,
equipment by a Government Department or a large industrial
undertakings, the customer is under obligation to deposit cash
security or earnest money as a token of due compliance of the
terms and conditions of the contract. This cash security provided
Financial by the contractor or supplier is forfeited by the Government
Department or the company which awarded the contract, in the
guarantees event the contractor or supplier fails to comply with the terms
stipulated in sanction. The customer normally will have an option
to furnish a bank guarantee in lieu of cash security, so that his
working funds are not unnecessarily blocked. The guarantees
issued by banks for above purpose is called financial guarantee
wherein the banks undertake to pay the guaranteed amount
during a specified period on demand from the beneficiary. The
examples of Financial Guarantee are as under.
  Although Advance Payment guarantee is associated with
the financial guarantee it has the inherent risk of
performance guarantee Advance payment guarantees are
issued on behalf of the (i) Supplier of raw materials/
finished goods or (ii) on behalf of a contractor for an
Advance execution of contract when he receives the advance
Payment payment. Since supplier receives an advance from the
purchaser for the supply of raw material or finished goods
Guarantee on a future date, it is a substitution of working capital
(APG) funds. In the case of execution of the contract, if any one
of the terms of the contract is not fulfilled, the guarantee
is likely to be invoked. While accepting the request from
the customer for APG limit the banker should thoroughly
analyse all risk factors.
  In the cases of purchase of capital goods/machinery
where the seller offers credit to the buyer and buyer’s

Deferred bank guarantees the due payments to the seller. Here the
seller draws drafts of different maturities on the buyer
Payment which are accepted by the buyer and co-accepted by the
Guarantee Buyer’s bank. Thereby the buyer’s bank guarantees due
payment of those drafts drawn by the seller which
(DPG) represents the total consideration of the contract of sale/
supply.
  Shipping guarantee is issued to the shipping company to
release the goods by the shipping companies on the basis
Shipping of bank guarantee. Shipping guarantee is issued due to
the arrival of the consignment (Ship carrying the goods
Guarantee already arrived) but non-receipt of relative documents of
title to goods.
  Performance guarantees are issued by the banks on
behalf of a Service Contractor, who has to effectually
perform all the conditions of the contract between him

Performance and the department/company that awarded the contract.

The bank has to discharge the financial liability of the
Guarantee: contract agreed in the guarantee, if the contract is partly
or fully not performed by the customer. Such type of
guarantees issued by the bank is called Performance
Guarantee.
  Retention money is a part of the amount payable to the
contractor, is retained and payable at the end after
successful completion of the contract. Retention Money
guarantee is issued to ensure that retention money
withheld by the beneficiary is released to the applicant
(contractor) so that he gets sufficient working capital to
Retention complete the contract.
Money  Related articles:
guarantees  (i) Time limit for enforcement bank guarantees
 (ii) Circumstances that may discharge guarantor from all
liabilities
 (iii) How to compute period of limitation for personal
guarantees
  In case some company or firm has a regular requirement
of BGs in their course of business, banks also provide a
facility of fixing “BG Limit” for that company/firm after BG
assessment based on their track record, financial position,

Bank security offered by the company, margin and financial

position of the business. For example: If a small company
Guarantee deals with Government Departments or Public Sector

Limits Units, the regular requirement of BG occurs. In such a

case, getting a BG limit is beneficial; this means the bank
from time to time can issue BGs to the applicant with the
upper limit being the sanctioned “BG Limit Amount”.  BG
limits are classified as “Non-Fund Based” limits.
  Why is Bank Guarantee Important?
Why is Bank  Adds to Creditworthiness
Guarantee  BGs reflect the confidence of the bank in your business
Important? and indirectly certify the soundness of your business.
  Assessment of Business
 In the case of foreign transactions or transactions with
Government organizations, the foreign party or a
Assessment Government Undertaking is constrained and cannot

of Business assess the soundness of each and every applicant to a

project. In such cases, BGs act as a trusted instrument to
assess the stability and creditworthiness of companies
applying for projects.
  When new parties associate in the business and are
Confidence of skeptic about the performance of the company
undertaking the project, performance guarantees help in
Performance reducing the risk of the beneficiary.
  Advance payment guarantees act as a protection cover

Risk wherein the buyer can recover the advance amount paid
to the seller if a seller fails to deliver the goods or services.
Reduction This protects against any probable loss that a party can
suffer from a new seller.
  What is claim period in bank guarantee?
What is claim  The consequence of incorporating a minimum claim
period in bank period of 12 months in the bank guarantee is that the
liability of the issuing bank remains open during such a
guarantee? claim period.
  How do I claim bank guarantee?
 To request a guarantee, the account holder contacts the
How do I bank and fills out an application that identifies the amount
claim bank of and reasons for the guarantee. Typical applications
stipulate a specific period of time for which the guarantee
guarantee? should be valid, any special conditions for payment and
details about the beneficiary.
  The period of validity of the Bank Guarantee and the claim

What is BG period under a Bank Guarantee are not necessarily same.

The claim period under a Bank Guarantee may be over
validity and and above the period of validity of the Bank Guarantee. As

claim period? per Section 28 (a) of the Contract Act, an agreement shall
be void to the extent:
  the reason for the guarantee; the amount of the
How long guarantee; and. when the guarantee will expire. Usually, a

does a bank landlord will require that there is no expiry date, or that it
is at least three to six months after the expiry date of the
guarantee last? lease
  To request a guarantee, the account holder contacts the

How do I bank and fills out an application that identifies the amount
of and reasons for the guarantee. Typical applications
claim bank stipulate a specific period of time for which the guarantee

guarantee? should be valid, any special conditions for payment and

details about the beneficiary.
  Ideally, the bank guarantee should not have an expiry date.
Should a bank If however the guarantee provider or their bank insists on
guarantee an expiry date, it should be a minimum of three (3) months
from the expiry date of the contract. ... Many American
have an expiry banks will only issue bank guarantees for a maximum
date? period of one (1) year.
  Banks may incorporate a suitable clause in their bank

Can bank guarantee, providing automatic extension of the validity

period of the guarantee by 6 months, and also obtain
guarantee be suitable undertaking from the customer at the time of

extended? establishing the guarantee to avoid any possible

complication later.
  Normally, after the Expiry Period as stipulated in the BG, if
What happens the BG is not invoked within the Expiry Period and original
when a bank BG is not returned, banks send registered letters to
beneficiary for returning the original BG. If no response is
guarantee received then BG is cancelled and margin money provided
expires? by applicant is released.
  Bank Guarantee Charges
What are the Based on the type of the BG, fees are generally charged
charges for on a quarterly basis on the BG value of 0.75% or 0.50%
bank during the BG validity period. Apart from this, the bank
may also charge the application processing fee,
guarantee? documentation fee, and handling fee.
  1.Outstanding Bank Guarantee as per Audited Balance
Sheet.
Assessment  2.Add: Bank Guarantee required during the period
of Bank  3.Less: Estimated maturity or cancellation of Bank

credit Limit Guarantee during the period

 4.Requirement of Bank Guarantee (4 = 1 +2 – 3)
Unit IV  Operational Risk
  Risk is the chance that an investment's actual outcome
will differ from the expected outcome, while uncertainty is
Risk and the lack of certainty about an event. The main difference

uncertainty between risk and uncertainty is that risk is measurable

while uncertainty is not measurable or predictable.
 The main difference between risk and uncertainty is that
risk is measurable while uncertainty is not measurable or
predictable.
 Risk and uncertainty are two important terms in the world
of finance and business. Although some tend to use these
two terms interchangeably, there is a distinct difference
between risk and uncertainty. Risk is the chance that an
investment’s actual outcome will differ from the expected
outcome, while uncertainty is the lack of certainty about
an event.
Difference
  Risk is basically the possibility of something bad
happening. In business and finance, the risk is the chance
that an investment’s actual outcome will differ from the
expected outcome. Risks can include the possibility of
losing all or some of the original investment in a business.

What is Risk However, risk can be calculated to some extent using

historical data and market factors. It’s also important to
note that the higher the risk an investor is willing to take,
the greater the protentional return. No investment is free
of risks, but there are some investments that have lower
practical risks than others.
 There are two main types of financial risk; they are
systematic risks and unsystematic risks. 
 Systematic risk can affect the entire economic market or
a larger part of the market. This involves interest rate risk,
 inflation risk, sociopolitical risk, and currency risk. 
 Unsystematic risks, on the other hand, are a type of risk
that only affects a specific company or industry. This can
be due to a change in management, new competitors in
the market, regulatory changes that would affect sales, a
product recall,
  Uncertainty is basically a lack of certainty about an event. 
In finance and business, uncertainty implies that there is
an inability to predict outcomes or consequences due to
some lack of knowledge or data, which makes it

What is impossible to make predictions. There can be multiple

possible outcomes, but the possible outcomes are also
Uncertainty not certain. COVID 19 pandemic situation is an example of
making decisions under uncertainty. When the pandemic
first hit, there was a lot of uncertainty – we didn’t know
how to safeguard ourselves, how to continue our daily
routine, etc
 Uncertainty is different from risk in that risk can be
measured and quantified in advance from historical data.
Therefore, risk is easier to manage, especially if we
observe proper measures. We can insure against risks,
but not against uncertainties
  Definition--Risk is the chance that an investment’s actual
outcome will differ from the expected outcome, while
uncertainty is the lack of certainty about an event.
 Potential Outcomes--In risk, potential outcomes are
Difference known, but in uncertainty, potential outcomes are

Between Risk unknown.

 Measurement--Risks can be measured and quantified
and using theoretical models, but uncertainty cannot be
Uncertainty measured.
 Control--Moreover, risks can be controlled if proper
measures are taken at the right time; however,
uncertainty is beyond control
 Financial Risk is one of the major concerns of every business across fields and
geographies. This is the reason behind the Financial Risk Manager FRM Exam
gaining huge recognition among financial experts across the globe. FRM is the top
most credential offered to risk management professionals worldwide. Financial
Risk again is the base concept of FRM Level 1 exam. Before understanding the
techniques to control risk and perform risk management, it is very important to
realize what risk is and what the types of risks are.
 Risk can be referred to like the chances of having an unexpected or negative
outcome. Any action or activity that leads to loss of any type can be termed as risk.
There are different types of risks that a firm might face and needs to overcome.

Financial Risk Widely, risks can be classified into three types: Business Risk, Non-Business Risk,
and Financial Risk.

and Its Types  Business Risk: These types of risks are taken by business enterprises
themselves in order to maximize shareholder value and profits. As for example,
Companies undertake high-cost risks in marketing to launch a new product in
order to gain higher sales.
 Non- Business Risk: These types of risks are not under the control of firms. Risks
that arise out of political and economic imbalances can be termed as non-
business risk.
 Financial Risk: Financial Risk as the term suggests is the risk that involves
financial loss to firms. Financial risk generally arises due to instability and losses
in the financial market caused by movements in stock prices, currencies, interest
rates and more.
  Financial risk is one of the high-priority risk types for every
business. Financial risk is caused due to market
movements and market movements can include a host of
Types of Fina factors. Based on this, financial risk can be classified into

ncial Risks various types such as Market Risk, Credit Risk, Liquidity

Risk, Operational Risk, and Legal Risk.

 Market Risk:--This type of risk arises due to the movement
in prices of financial instrument. Market risk can be
classified as Directional Risk and Non-Directional Risk.
Directional risk is caused due to movement in stock price,
interest rates and more. Non-Directional risk, on the other
hand, can be volatility risks.
 Credit Risk:--This type of risk arises when one fails to fulfill
their obligations towards their counterparties. Credit risk
can be classified into Sovereign Risk and Settlement Risk.
Sovereign risk usually arises due to difficult foreign
exchange policies. Settlement risk, on the other hand,
arises when one party makes the payment while the other
party fails to fulfill the obligations.
 Liquidity Risk:-This type of risk arises out of an inability to
execute transactions. Liquidity risk can be classified
into Asset Liquidity Risk and Funding Liquidity Risk. Asset
Liquidity risk arises either due to insufficient buyers or
insufficient sellers against sell orders and buys orders
respectively.
 Operational Risk:--This type of risk arises out of
operational failures such as mismanagement or technical
failures. Operational risk can be classified into Fraud
Risk and Model Risk. Fraud risk arises due to the lack of
controls and Model risk arises due to incorrect model
application.

 Legal Risk:
 This type of financial risk arises out of legal constraints
such as lawsuits. Whenever a company needs to face
financial losses out of legal proceedings, it is a legal risk.
  Here are the seven categories of operational risk
 Internal fraud. ...
 External fraud. ...
 Employment practices and workplace safety. ...
Operational  Clients, products and business practice. ...
Risk  Damage to physical assets. ...
 Business disruption and systems failures. ...
 Execution, delivery and process management.
  The term operational risk management (ORM) is defined
as a continual cyclic process which includes risk
assessment, risk decision making, and implementation of
risk controls, which results in acceptance, mitigation, or
operational avoidance of risk. ORM is the oversight of operational risk,

risk including the risk of loss resulting from inadequate or

failed internal processes and systems; human factors; or
management external events. Unlike other type of risks (market risk,
credit risk, etc.) operational risk had rarely been
considered strategically significant by senior
management.
 The U.S. Department of Defense summarizes the
principles of ORM as follows:[2]

 Accept risk when benefits outweigh the cost.

 Accept no unnecessary risk.
 Anticipate and manage risk by planning.
 Make risk decisions in the right time at the right level.
 Three levels
 In Depth--In depth risk management is used before a project is
implemented, when there is plenty of time to plan and prepare.
Examples of in depth methods include training, drafting instructions
and requirements, and acquiring personal protective equipment.
 Deliberate---Deliberate risk management is used at routine periods
through the implementation of a project or process. Examples
include quality assurance, on-the-job training, safety briefs,
performance reviews, and safety checks.
 Time Critical--Time critical risk management is used during
operational exercises or execution of tasks. It is defined as the
effective use of all available resources by individuals, crews, and
teams to safely and effectively accomplish the mission or task using
risk management concepts when time and resources are limited.
Examples of tools used includes execution check-lists and change
management. This requires a high degree of situational
awareness. [2]
  The International Organization for Standardization defines
the risk management process in a four-step model:[3]

 Establish context
 Risk assessment
 Risk identification
 Risk analysis
 Risk evaluation
Process  Risk treatment
 Monitor and review
 This process is cyclic as any changes to the situation
(such as operating environment or needs of the unit)
requires re-evaluation per step one.
 Deliberate
 The U.S. Department of Defense summarizes the
deliberate level of ORM process in a five-step model:[2]

 Identify hazards
 Assess hazards
 Make risk decisions
 Implement controls
 Supervise (and watch for changes)
 Time critical
 The U.S. Navy summarizes the time-critical risk
management process in a four-step model:[4]
 1. Assess the situation.The three conditions of the Assess
step are task loading, additive conditions, and human factors.
 Task loading refers to the negative effect of increased
tasking on performance of the tasks.
 Additive factors refers to having a situational awareness of
the cumulative effect of variables (conditions, etc.).
 Human factors refers to the limitations of the ability of the
human body and mind to adapt to the work environment (e.g.
stress, fatigue, impairment, lapses of attention, confusion,
and willful violations of regulations).
 2. Balance your resources.This refers to balancing
resources in three different ways:
 Balancing resources and options available. This means
evaluating and leveraging all the informational, labor,
equipment, and material resources available.
 Balancing Resources versus hazards. This means
estimating how well prepared you are to safely
accomplish a task and making a judgement call.
 Balancing individual versus team effort. This means
observing individual risk warning signs. It also means
observing how well the team is communicating, knows
the roles that each member is supposed to play, and the
stress level and participation level of each team member.
 3. Communicate risks and intentions.Communicate
hazards and intentions.
 Communicate to the right people.
 Use the right communication style. Asking questions is a
technique to opening the lines of communication. A direct
and forceful style of communication gets a specific result
from a specific situation.
 4. Do and debrief. (Take action and monitor for change.)
This is accomplished in three different phases:
 Mission Completion is a point where the exercise can be
evaluated and reviewed in full.
 Execute and Gauge Risk involves managing change and
risk while an exercise is in progress.
 Future Performance Improvements refers to preparing a "
lessons learned" for the next team that plans or executes
a task.
  Reduction of operational loss.
 Lower compliance/auditing costs.
Benefits  Early detection of unlawful activities.
 Reduced exposure to future risks.
 Senior Management has two perspectives on risk. In the
traditional Enterprise Risk Management (ERM) view, the goal is
to find the perfect balance of risk and reward. Sometimes the
organization will accept more risk for a chance at growing the
organization more quickly and at other times the focus switches
to controlling risks with slower growth. The Operational Risk
Management (ORM) perspective is more risk-averse, and
focuses on protecting the organization. Get an in-depth overview
of Operational Risk Management, including the 5 steps of the
ORM process.
  Operational risk is the risk of loss resulting from ineffective
or failed internal processes, people, systems, or external
events that can disrupt the flow of business operations.
What is The losses can be directly or indirectly financial. For
operational example, a poorly trained employee may lose a sales
opportunity, or indirectly a company’s reputation can
risk suffer from poor customer service.  Operational risk can
management refer to both the risk in operating an organization and the
processes management uses when implementing,
training, and enforcing policies.
 Operational risk can be viewed as part of a chain reaction:
overlooked issues and control failures — whether small or
large — lead to greater risk materialization, which may
result in an organizational failure that can harm a
company’s bottom line and reputation. While operational
risk management is considered a subset of enterprise risk
management, it excludes strategic, reputational, and
financial risk
   

What Are  Operational risk permeates every organization and every

internal process. The goal in the operational risk
Examples of management function is to focus on the risks that have
Operational the most impact on the organization and to hold
accountable employees who manage operational risk.
Risk?
  Examples of operational risk include:
 Employee conduct and employee error
 Breach of private data resulting from cybersecurity
attacks
 Technology risks tied to automation, robotics, and artificial
intelligence
Examples  Business processes and controls
 Physical events that can disrupt a business, such as
natural catastrophes
 Internal and external fraud
  When dealing with operational risk, the organization has to
How Does consider every aspect of all its objectives. Since

Operational operational risk is so pervasive, the goal is to reduce and

control all risks to an acceptable level. Operational Risk
Risk Management attempts to reduce risks through risk

Management identification, risk assessment, measurement and

mitigation, and monitoring and reporting while
Work? determining who manages operational risk.  
  These stages are guided by four principles:
These stages  Accept risk when benefits outweigh the cost.
are guided  Accept no unnecessary risk.
by four  Anticipate and manage risk by planning.
principles:  Make risk decisions at the right level.
 Risk Identification
 Operational Risk Management begins with identifying what can
go wrong. As a best practice, a control framework should be used
or developed to ensure completeness. 
 Risk Assessment
 Once the risks are identified, the risks are assessed using an
impact and likelihood scale.
 Measurement and Mitigation
 In the risk assessment, the risks are measured against a
consistent scale to allow the risks to be prioritized and ranked
comparative to one another. The measurement also considers the
cost of controlling the risk related to the potential exposure. 
 Monitoring and Reporting
 Risks are monitored through an ongoing risk assessment to
determine any changes over time. The risks and any changes are
reported to senior management and the board to facilitate
decision-making processes.
 What Is the  As the name suggests, the primary objective of
Primary Operational Risk Management is to mitigate risks related
Objective of to the daily operations of an organization. The practice of
Operational Risk Management focuses on operations and
Operational excludes other risk areas such as strategic risks and
Risk financial risks.

Management?
 While other risk disciplines, such as ERM, emphasize
optimizing risk appetites to balance risk-taking and
potential rewards, ORM processes primarily focus on
controls and eliminating risk. The ORM framework starts
with risks and deciding on a mitigation scenario.
  Operational Risk Management proactively seeks to
protect the organization by eliminating or minimizing risk. 
 Depending on the organization, operational risk could
have a very large scope. Under the topic of operations,
some organizations might categorize fraud risk,
technology risks, as well as the daily operations of
financial teams like accounting and finance. 
 The Risk Management Association defines operational
risk as “the risk of loss resulting from inadequate or failed
internal processes, people, and systems, or from external
events, but is better viewed as the risk arising from the
execution of an institution’s business functions.” Given this
viewpoint, the scope of operational risk management will
encompass cybersecurity, fraud, and nearly all internal
control activities. 
 Applying a control framework, whether a formal
framework or an internally developed model, will help
when designing the internal control processes. One
approach to understanding how ORM processes look in
your organization is by organizing operational risks into
categories like people risks, technology risks, and
regulatory risks
 People
 The people category includes employees, customers,
vendors and other stakeholders. Employee risk includes
human error and intentional wrongdoing, such as in cases
of fraud. Risks include breach of policy, insufficient
guidance, poor training, bed decision making, or fraudulent
behavior. Outside of the organization, there are several
operational risks that include people.  Employees,
customers, and vendors all pose a risk with social media.
Monitoring and controlling the people aspect of operation
risk is one of the broadest areas for coverage.
 Technology
 Technology risk from an operational standpoint includes
hardware, software, privacy, and security. Technology risk
also spans across the entire organization and the people
category described above. Hardware limitations can
hinder productivity, especially when in a remote work
environment. Software too can reduce productivity when
applications do increase efficiency or employees lack
training. Software can also impact customers as they
interact with your organization. External threats exist as
hackers attempt to steal information or hijack networks.
This can lead to leaked customer information and data
privacy concerns. 
 Regulations
 Risk for non-compliance to regulation exists in some form
in nearly every organization. Some industries are more
highly regulated than others, but all regulations come
down to operationalizing internal controls. Over the past
decade, the number and complexity of rules have
increased and the penalties have become more severe.  
 Understanding the sources of risk will help determine who
manages operational risk. Enterprise Risk Management
and Operational Risk Management both address risks in
the same areas but from different perspectives. In an
effort to consolidate these disciplines, some organizations
have implemented Integrated Risk Management or IRM.
IRM addresses risk from a cultural point of view.
Depending on the objective of the particular risk practice,
the organization can implement technology with different
parameters for teams like ERM and ORM.
How Many  While there are different versions of the ORM process
Steps Are in steps, Operational Risk Management is generally applied
as a five-step process. All five steps are critical, and all
the ORM steps should be implemented. 
Process?
 Step 1: Risk Identification
 Risks must be identified so these can be controlled. Risk
identification starts with understanding the organization’s
objectives. Risks are anything that prevents the
organization from attaining its objectives. 
 Step 2: Risk Assessment
 Risk assessment is a systematic process for rating risks
on likelihood and impact. The outcome from the risk
assessment is a prioritized listing of known risks. The risk
assessment process may look similar to the risk
assessment done by internal audit. 
 Step 3: Risk Mitigation
 The risk mitigation step involves choosing a path for
controlling the specific risks. In the Operational Risk
Management process, there are four options for risk
mitigation: transfer, avoid, accept, and control.
  Transfer: Transferring shifts the risk to another
organization. The two most often means for transferring
are outsourcing and insuring. When outsourcing,
management cannot completely transfer the
responsibility for controlling risk. Insuring against the risk
ultimately transfers some of the financial impact of the
risk to the insurance company. A good example of
transferring risk occurs with cloud-based software
companies. When a company purchases cloud-based
I. transfer software, the contract usually includes a clause for data
breach insurance. The purchaser is ensuring the vendor
can pay for damages in the event of a data breach. At the
same time, the vendor will also have their data center
provide SOC reports that show there are sufficient
controls in place to minimize the likelihood of a data
breach. 
  Avoid: Avoidance prevents the organization from entering
into the risk situation. For example, when choosing a

II. avoid vendor for a service, the organization could choose to

accept a vendor with a higher-priced bid if the lower-cost
vendor does not have adequate references
  Accept: Based on the comparison of the risk to the cost of
control, management could accept the risk and move
forward with the risky choice. As an example, there is a
risk that an employee will burn themselves if the company
installs new coffee makers in the breakroom. The benefit
III. Accept of employee satisfaction from new coffee makers
outweighs the risk of an employee accidentally burning
themselves on a hot cup of coffee, so management
accepts the risk and installs the new appliance.
  Control: Controls are processes the organization puts in
place to decrease the impact of the risk if it occurs or to
increase the likelihood of meeting the objective. For
example, installing software behind a firewall reduces the
IV. Control likelihood of hackers gaining access, while backing up the
network decreases the impact of a compromised network
since it can be restored to a safe point. 
  Once the risk mitigation choice decisions are made, the
next step is implementation. The controls are designed
Step 4: Control specifically to meet the risk in question. The control

Implementatio rationale, objective, and activity should be clearly

documented so the controls can be clearly communicated
n and executed.The controls implemented should focus
preventive control activities over policies 
  Step 5: Monitoring
 Since the controls may be performed by people who make
mistakes, or the environment could change, the controls
Step 5: should be monitored. Control monitoring involves testing

Monitoring the control for appropriateness of design, implementation,

and operating effectiveness. Any exceptions or issues
should be raised to management with action plans
established.
 Within the monitoring step in Operational Risk
Management, some organizations, especially in the
financial industry, have adopted continuous monitoring/
early warning systems built around key risk indicators
(KRIs). Key risk indicators are metrics used by
organizations to provide an early signal of increasing risk
exposures in various areas of the enterprise. KRIs
designed around ratios that are monitored by business
intelligence applications are how banks can manage
operational risk, but the concept can be applied across all
industries. KRIs can be designed to monitor nearly any
potential risk and send a notification
 In the last five years, U.S. organizations have experienced
significant increases in the volume and complexity of risks,
with 32% of companies experiencing an operational
surprise in that time period (see figure above). As
organizations grow and evolve, so do the complexity,
frequency, and impact of risks that are poorly managed.
Losses from failure to properly manage operational risk
have led to the downfall of many financial institutions —
with over 100 reported losses exceeding $100 million in
recent years. Moreover, growing pressure from the board
for increased risk oversight also points to the importance
of having a strong operational risk management practice
in place. But how many organizations actually do?
 What Are the
Challenges  In many organizations, operational risk management is
and one of the most tenuous links in their ability to meet the
demands of customers and stakeholders. While
Shortcomings operational risk management is a subset of enterprise risk
of Operational management, similar challenges like competing priorities
and lack of perceived value affect proper development
Risk among both programs. Some common challenges include:
Management? 
 A common perception that organizations do not have sufficient
resources to invest in operational risk management or ERM.
 Need for greater communication and education around the
importance of operational risk management and the consequences
of operational failures on a company’s bottom line.
 Need for increased awareness and appreciation across boards and C-
suite executives to better understand operational risk management
steps.
 Lack of consistent methodologies to measure and assess risk is an
area of concern when it comes to providing an accurate portrait of an
organization’s risk profile.
 Establishing standard risk terminology that will be used
moving forward, which is conducive to successful Risk and
Control Self-Assessments (RCSAs).
 The process is varied and complex due to changes in
technology.
 The function is oftentimes lumped in with other functions
such as compliance and IT which is why it does not
receive significant attention.
 Operational Risk Management programs can be manual,
disjointed, and over-complicated, mostly because ORM
developed as a reactive function in response to
regulations and compliance.
 What Are the Benefits of a Strong Operational Risk
Management Program?
 Establishing an effective operational risk management
program is helpful for achieving an organization’s strategic
objectives while ensuring business continuity in the event
of disruptions to operations. Having a strong ORM also
demonstrates to clients that the company is prepared for
crisis and loss. Organizations that can effectively
implement a strong ORM program can experience
improved competitive advantages, including:
 Better C-suite visibility.
 Better informed business risk-taking.
 Improved product performance and better brand
recognition.
 Stronger relationships with customers and stakeholders.
 Greater investor confidence.
 Better performance reporting.
 More sustainable financial forecasting.
 How to Develop an Operational Risk Management
Program?
 As organizations begin the process of creating an
operational risk framework and program, some areas that
the risk management team should focus on include:
 Promoting an organization-wide understanding of the program’s
value and function.
 Leveraging technology to implement an automated approach to
monitoring and collecting risk data.
 Establishing an effective method for evaluating and identifying
principal risks in the organization and a way to continuously identify
and update those risks and associated measures.
 Focus on helping the organization reduce material risk exposures
while encouraging activities where the potential business benefits
outweigh the risks.
 Focus on partnering ORM with other functions in the organization to
better embed best practices into the organization.
 What are the four main types of operational risk?
 There are five categories of operational risk: people risk,
process risk, systems risk, external events risk, and legal
and compliance risk. People Risk – People risk is the risk
of financial losses and negative social performance
related to inadequacies in human capital and the
management of human resources.
 What are the six key classifications of operational risk?
 The operational risk events are classified according to the
risk categories established by Basel II: processes, fraud
(internal and external), IT, human resources, commercial
practices, disasters and suppliers.
 Examples of operational risk include:
 Employee conduct and employee error.
 Breach of private data resulting from cybersecurity
attacks.
 Technology risks tied to automation, robotics, and artificial
intelligence.
 Business processes and controls.
 Physical events that can disrupt a business, such as
natural catastrophes.
 What are the 5 steps of the ORM process?
 These five steps are:
 Identify hazards.
 Assess the hazards.
 Make risk decisions.
 Implement controls.
 Supervise and watch for change.
 What is operational risk PDF?
 Operational risk is the business risk of loss resulting from
inadequate or failed internal processes, people, systems,
or from external events.
 Here are 5 tools for identifying risks.
 Risk analysis questionnaire. This is one of the most widely
used risk identification methods. ...
 Checklist of insurance policies. ...
 Process flowchart. ...
 Analysis of financial statements and other company
information. ...
 Inspection.