FM 306 - Credit and Collection 4. Prof.

Thomas: “The term credit is now applied to that belief

in a man’s probability and solvency which will permit of his
CHAPTER 1 being entrusted with something of value belonging to another
Introduction to Credit and Collection Management whether that something consists, of money, goods, services or
even credit itself as and when one may entrust the use of his
- Credit is important in a business because it helps to finance good name and reputation.” On the basis of above definitions,
business transactions when the business is short of funds. it can be said that credit is the exchange function in which,
Banks and financial institutions mobilize deposits and utilize creditor gives some goods or money to the debtor with a belief
them for lending. that after sometime he will return it. In other words, “Trust” is
- Credit management comprises two aspects; from one angle it the “Credit”.
is how to distribute credit among all sectors of the economy so 5. Vasant Desai: “To give or allow the use of temporarily on
that every sector can develop and banks also get profit and the condition that some or its equivalent will be returned.”
from the other angle, how to grant credit to various sectors,
individuals and businesses to avoid credit risk. Characteristics of Credit
- Credit management is concerned mainly with using the 1. Confidence: Confidence is very important for granting or
bank’s resources both productively and profitably to achieve a extending any credit. The person or authority must have
preferable economic growth. At the same time, it also seeks a confidence on debtor.
fair distribution among the various segments of the economy 2. Capacity: Capacity of the borrower to repay the debt is also
so that the economic fabric grows without any hindrance as very crucial thing to be considered. Before granting or
stipulated in the national objectives, in general and the banking extending any advance, creditor should evaluate the
objectives, in particular. borrower’s capacity.
- The word “credit” has been derived from the Latin word 3. Security: Banks are the main source of credit. Before
“credo” which means “I believe” or “I trust”, which signifies a extending credit, bank ensures properly about the debtor’s
trust or confidence reposed in another person. The term credit security. The availability of credit depends upon property or
means, reposing trust or confidence in somebody. assets possessed by the borrower.
- In economics, it is interpreted to mean, in the same sense, 4. Goodwill: If the borrower has good reputation of repaying
trusting in the solvency of a person or making a payment to a outstanding in time, borrower may be able to obtain credit
person to receive it back after some time or lending of money without any difficulty.
and receiving deposits etc. 5. Size of credit: Generally small amount of credit is easily
- Credit is the trust which allows one party to provide resources available than the larger one. Again it also depends on above
to another party where that second party does not reimburse factors. 6. Period of credit: Normally, long term credit cannot
the first party immediately (thereby generating a debt), but easily be obtained because more risk elements are involved in
instead arranges either to repay or return those resources (or its security and repayments. It involves futurity; has a maturity
other materials of equal value) at a later date. date.
- The resources provided may be financial (e.g. granting a
loan), or they may consist of goods and services (e.g. Types of Credit
consumer credit). Credit encompasses any form of deferred
payment. TRADITIONAL CREDIT PRODUCTS
- Credit is extended by a creditor, also known as a lender to a 1. Cash Credit
debtor also known as a borrower. Cash credit is a credit that given in cash to business
- Credit can be explained as a contractual agreement in which firms. A cash credit account is a drawing account against a
a borrower receives something of value now and agrees to fixed credit limit granted by the bank and is operated exactly in
repay the lender at some later date. The borrowing capacity the same manner as a current account with all overdraft
provided to an individual by the banking system, in the form of facilities. It is an arrangement by which, a bank allows its
credit or a loan. The total bank credit the individual has is the customers to borrow money up to a certain limit against
sum of the borrowing capacity each lender bank provides to tangible securities or share of approved concern etc. cash
the individual. credits are generally allowed against the hypothecation of
goods/ book debts or personal security. Depending upon the
Credit Definitions nature of requirement of a borrower, bank specifies a limit for
1. Prof. Kinley: “By credit, we mean the power which one the customer, up to which the customer is permitted to borrow
person has to induce another to put economic goods at his against the security of assets after submission of prescribed
deposal for a time on promise or future payment. Credit is thus terms and conditions and keeping prescribed margin against
an attribute of power of the borrower.” the security. It is on demand based account. The borrowing
2. Prof. Gide: “It is an exchange which is complete after the limit is allowed to continue for years if there is a good turnover
expiry of a certain period of time”. in account as well as goods. In this account deposits and
3. Prof. Cole: “Credit is purchasing power not derived from withdrawals may be affected frequently. In India, cash credit is
income but created by financial institutions either as on offset the most popular mode of advance for businesses.
to idle income held by depositors in the bank or as a net 2. Overdraft
addition to the total amount or purchasing power.” A customer having current account, is allowed by the
banks to draw more than his deposits in the account is called
an overdraft facility. In this system, customers are permitted to 4. Auto Loans
withdraw the amount over and above his balance up to extent Auto loans are granted for the purchase of car,
of the limit stipulated when the customer needs it and to repay scooter etc. it may be granted for purchasing vehicle.
it by the means of deposits in account as and when it is 5. Personal Loans
convenient. Customer of good standing is allowed this facility This is an excellent service provided by the banks.
but customer has to pay interest on the extra withdrawal This loan is granted to the individuals to satisfy their personal
amount. requirements without any substantial security. Many banks
3. Demand Loans follow simple procedure and grant the loan in a very short
A demand loan has no stated maturity period and period with minimum documents.
may be asked to be paid on demand. Its silent feature is, the 6. Educational Loans
entire amount of the sanctioned loan is paid to the debtor at This loan is granted to the student to pursue higher
one time. Interest is charged on the debit balance. education. It is available for the education within the country or
4. Term Loans outside the country.
Term loan is an advance for a fixed period to a person 7. Loans Against Securities
engaged in industry, business or trade for meeting his These loans are provided against fixed deposits,
requirement like acquisition of fixed assets etc. the maturity shares in bonds, mutual funds, life insurance policy etc.
period depends upon the borrower’s future earnings. Next to 8. Consumption loans for purchase of durables
cash credit, term loans are assumed of great importance in an Banks fulfill the dreams and aspirations by providing
advance portfolio of the banking system of country. consumer durable loans. These loans can be borrowed for
5. Bill Purchased purchasing television, refrigerator, laptop, mobile etc.
Bankers may sometimes purchase bills instead of 9. Hybrid Loan Products
discounting them. But this is generally done in the case of For improving the business environment and to win in
documentary bills and that too from approved customers only. the competition, banks must adopt new technologies. With
Documentary bills are accompanied by documents of title to fluctuating interest rates and inflation, there is a need for the
goods such as bills of loading or lorry and railway receipts. In banks to protect the interest of the borrowers. So banks now
some cases, banker advances money in the form of overdraft offer hybrid products to their customers. These products have
or cash credit against the security of such bills. the virtues of both fixed and floating interest rate loans. The
6. Bill Discounted products introduced by the different banks have their own
Banker loans the funds by receiving a promissory distinctive features.
note or bill payable at a future date and deducting that from the
interest on the amount of the instrument. The main feature of Credit Instruments
this lending is that the interest is received by the banker in Credit instruments prove very helpful in
advance. This form of lending is more or less a clean advance encouragement and the development of credit and help in the
and banks rely mainly on the creditworthiness of the parties. promotion and development of trade and commerce. Some of
the credit instruments are:
INNOVATIVE CREDIT PRODUCTS 1. Cheque is the most popular instrument. It is an order drawn
Technology has supported the development of by a depositor on the bank to pay a certain amount of money
financial service industry and reduced the cycle of money to which is deposited with the bank.
the shortest possible duration. A number of financial 2. Bank draft is another important instrument of credit used by
institutions, including banks have started online services. The banks on either its branch or the head office to send money
growth of innovative retail products offered by banks is from one place to other. Money sent through a bank draft is
increasing sharply. cheaper, convenient and has less risk.
1. Credit Cards 3. Bill of exchange. It enables a seller of commodity to issue
Credit cards are alternative to cash. Banks allow the an order to a buyer to make the payment either to him or to a
customers to buy goods and services on credit. The card person whose name and address is mentioned therein either
comprises different facilities and features depending on the on the site of the bill or within a period of time specified therein.
annual income of the card holder. Plastic money has played an 4. Promissory note is an instrument in writing containing an
important role in promoting retail banking. unconditional undertaking signed by the maker to pay a certain
2. Debit Cards sum of money only to or the order of certain person or the
Debit card can be used as the credit card for bearer of the instrument.
purchasing products and also for drawing money from the 5. Government bonds. Government issues a sort of certificate
ATMs. As soon as the debit card is swiped, money is debited to the person who subscribes to these loans. Such certificates
from the individual’s account. are called government bonds. Some of them are income tax
3. Housing Loans free.
Various types of home loans are offered by the banks 6. Treasury bills. These bills are also issued by the
these days for purchasing or renovating house. The amount of government. They are issued in anticipation of the public
loan given to the customer depends on the lending policies and revenues.
repayment capacity of the customer. These loans are usually 7. Traveler’s cheque. This is the facility given by bank to the
granted for a long period. people. It was most useful when recent technological
instrument like ATMs were not available. A customer was used
to deposit money with the banks and banks give traveler's own evil effect on the economy. Financially weak concern
cheque in turn. It was used to avoid ‟ risk of having cash while having credit facility takes the economy to weaker effects.
travelling. 4. Dangers beyond limit: Credit in a country expanded
beyond certain limits which results in over investment. Over
Advantages of Credit issue credit takes beyond safe limits that result in over
1. Exchange of ownership: Credit system enables a debtor to investment, over production and rise of prices. This danger has
use something which does not own completely. This way, been emphasized by Prof. Thomas in his “Elements of
debtor is provided with control as distinct from ownership of Economics,” in his words: “There is no automatic limit to the
certain goods and services. expansion of a credit system as there is to an expansion of a
2. Employment encouragement: With the help of bank credit, metallic circulation through the intervention of human element.
people can be encouraged to do some creative business work Uncertainty and variableness is the chief source of danger in a
which helps increasing the volume of employment. credit organization”.
3. Increase consumption: Credit increases the consumption 5. Evil of monopoly: Credit system has also resulted in the
of all types of goods. By that, large scale production may creation of monopolies; monopolistic exploitation is due to
stimulate which leads to decrease cost of production which in money placed at the disposal of individuals or companies that
turn also lowers the price of product which in result rising leads to monopolist exploitation. The different organizations
standard of living. have growth with the emergence of credit and have worked to
4. Saving encouragement: Credit gives encouragement to the the damage of both the consumers and the workers.
saving habit of the people because of the attraction of interest 6. Encourage inefficient: Credit gives encouragement to
and dividend. certain inefficient and worthless producers. Inefficient business
5. Capital formation: Credit helps in capital formation by way concerns availing the credit and not using efficiently,
that it makes available huge funds from able people to unable accumulate money in their hands. People come into the market
people to use some things. Credit makes possible the with the feeling that they have nothing to do but just to play
balanced development of different regions. only with other’s money. So, by this it can be said that it is clear
6. Development of entrepreneurs: Credit helps in developing that the government or the central banking authorities must
large scale enterprises and corporate business. It has also keep the credit within limit so that no evil is allowed to crop up
helped the different entrepreneurs to fight with difficult periods in the economy.
of financial crisis. Credit also helps the ordinary consumers to
meet requirements even in the inability of payment. One can Credit Providers
borrow money and grow business at a greater return on 1 Banks
investment than the interest rates of loan. A bank is an organization licensed to take deposits
7. Easy payment: With the help of various credit instruments and extend loans. In the UK the operation of banks is regulated
people can pay without much difficulty and botheration. Even under the 1979 and 1987 Banking Acts which are overseen by
the international payments have been facilitated very much. the Financial Services Authority. Banks that focus on providing
8. Elasticity of monetary system: Credit system provides personal banking and consumer credit services, and which
elasticity to the monetary system of a country because it can typically maintain large branch networks are described as
be expanded without much difficulty. More currency can be commercial or retail banks, whereas merchant banks tend to
issued providing for proportionate metallic reserves. be more involved with corporate and international finance.
9. Priority sector development: Credit helps in developing Traditionally, retail banks tended to focus on obtaining funds
many priority sectors including agriculture. This has greatly via deposits and current accounts that were then used to fund
helped in rising agriculture productivity and income of the commercial lending to business. The granting of personal
farmers. Banks in developing countries are providing credit for loans and overdrafts did occur, but was not common. Many
development in rural areas and other priority sectors too. banks now offer mortgages, secured and unsecured personal
loans and credit cards as a central part of their banking
Disadvantages of Credit operations.
1. Encouragement of expenditure: Credit encourages 2 Building societies (savings and loan companies)
wasteful expenses by the individuals as well as commercial Building societies are profit-making organizations
institutions. As people irresponsibly think that the money is not owned by their members, who are the individuals who have
their own. Easy availability leads to over trading over exposure either savings accounts or loan agreements with the society. In
that ultimately leads to bad debts. the UK, building societies are regulated by the Building
2. Encourage weakness: Credit encourages big Societies Act 1986 which is overseen by the Financial Services
entrepreneurs to continue to hide their weakness. Their own Authority. Traditionally, building societies had a narrow focus of
shortcomings are met by the borrowed capital. Even the operation, funding mortgage lending via the savings deposited
loosing concerns continue with the help of borrowed capital in by their members. After the implementation of the 1986 Act,
the hope to survive. In this condition, if business fails, it not building societies were in a position to offer the same range of
only leads the borrowers in dangers but also thousands of consumer services as banks. From a consumer perspective
those people who advanced credit to such people. the difference between a bank and a building society is virtually
3. Economic crisis: In several occasions credit is directly non-existent, with both offering a broadly similar range of credit
responsible for economic crisis. It leads to recession and products. In the US, savings and loan companies can be
depression in an economy as boom of credit facilities has its considered broadly equivalent to UK building societies.
3 Finance houses Social fund loans are unsecured and interest-free, and are
Finance house is a general term, used to describe a provided for the purchase of essential items, such as a bed,
broad range of lending institutions licensed to provide cooker or children’s clothing. Loan repayments are deducted
consumer credit. They do not tend to provide savings or directly from future benefit payments.
deposit accounts; rather they obtain funds to support their 8 Licensed moneylenders (home credit companies)
lending activities through commercial loans obtained from Any individual or organization who has obtained a
merchant banks or other large financial institutions. Finance credit license can be described as a licensed moneylender.
houses mainly provide credit in the form of secured and However, the term is usually associated with individuals and
unsecured personal loans, hire-purchase agreements and card organizations specializing in the provision of small unsecured
accounts. They are not generally involved in mortgage lending, cash loans.
although a few do provide mortgage products. Large finance 9 Unlicensed moneylenders
houses commonly act as third party credit providers, acting on Unlicensed moneylenders, or loan sharks, have
behalf of retailers and merchants for the provision of store operated alongside licensed lenders for as long as regulated
cards and retail credit. credit markets have existed, with references to loan sharking to
4 Credit unions be found in Greek texts dating to the second and third
Credit unions first appeared in Germany in 1849 and centuries B.C. (Homer and Sylla 1996 p. 38). The market is
operate as mutually owned financial cooperatives. They have characterized by very high rates of interest, often for small
become widely popular in many countries; for example, in the amounts, for short periods of time. Given its illegal or
US around 30 percent of the adult population belong to a credit semi-legal status, the exact size of this market is difficult to
union and in Ireland the figure is approximately 45 percent. ascertain.
Credit unions share many of the features traditionally
associated with building societies and savings and loan CHAPTER 2
companies in that they are member-owned, and funds Credit and Collection Operations
contributed by members are used to provide credit services to
other members. Credit unions are often created around - Credit and collection activities refer to the granting of credit to
specific interest groups sharing some ‘common bond,’ such as customers so that they can defer payments to the seller, and
those working within one profession, or located within a certain then collecting those funds at a later date. Ideally, it is vastly
geographical area, such as teachers or residents of a town or easier to collect payment in advance or on delivery from all
city. US credit unions offer a wide range of credit products customers, but competitive pressures rarely allow this to be the
including mortgages, personal loans and credit cards and are case. Instead, if a business refuses to grant, as well as the
known for offering competitive credit terms because they are methods required to collect funds.
run on a not-for-profit basis and enjoy a tax exempt status.
5 Utility companies The Credit Conundrum
Although credit is not the main concern of utility The credit department is arguably the most unpopular
companies, most utility supplies (water, gas, electricity and department in a company. The reason is that customers want
telecoms) are provided on a credit basis, with bills being issued unlimited credit in order to delay cash payments, while the
in arrears at regular intervals, usually monthly or quarterly. credit manager must exercise some prudence in only granting
Credit is usually provided interest-free and penalties are not credit where invoices are likely to be paid. The result is two
charged for late or reduced payment. However, collections types of risk:
activity for late or unpaid bills forms a significant part of the ● The risk of granting too much credit to a customer that
administrative function of utility providers. While UK legislation cannot pay.
limits the actions utility companies can take to recover sums ● The risk of denying credit to a customer who can pay.
owing, the ultimate sanction of disconnection of supply is
probably a sufficient incentive for customers to make payments It is extremely difficult to maneuver between these two
if they are in a position to do so. risks and grant just the right amount of credit, so the credit
6 Pawnbrokers manager is likely to be abused from all directions. The sales
Pawnbrokers have existed since ancient times, department believes that the credit manager is stifling sales,
offering short term credit secured against the borrower’s while the chief financial officer believes that the extension of
possessions. In recent years many pawnbroking operations too much credit is resulting in outsized bad debt losses.
have diversified into payday lending and cheque cashing Further, because of the confidential nature of some of the
services. While pawnbroking is much less prevalent than it information used to reach credit decisions, the credit staff may
once was, and almost disappeared entirely from the UK in the not be able to fully explain the reasons for its decisions to the
1970s, there has been something of a revival since the 1980s. sales department. The result is ongoing frustration on all sides,
In 2004 there were estimated to be over 800 pawnbrokers which can result in the credit manager losing all power and
operating in the UK, with a customer base numbering several eventually just “rubber stamping” all requests for credit. This
hundred thousand. scenario can only be avoided through the ongoing support of
7 Government agencies senior management, which most understand the key role that
The UK government provides credit in a number of the credit department plays.
circumstances. This includes student loans, and for those in
receipt of certain state benefits, cash loans via the social fund.
Organizing Credit and Collection Department .
The nature of a business and its size will determine A. Centralized Credit Controlled and Administered at a
the structure and staffing of the credit and collection Headquarters Office
department. Unlike most other company operations, the credit A centralized department services credit operations
department tends to remain fairly constant in size and scope of that are based entirely at a company’s main headquarters. It is
activities during periods of changing business conditions. This the responsibility of the credit manager and staff to approve
is due to increased support needed for full volume sales in credit terms on most orders. Credit professionals may find
good times and for increasing delinquencies when economic themselves questioned by sales staff or even upper
times are difficult. A credit department may face a greater management if they decline an application to grant terms on an
number of collection problems in a depressed economy when important or significant order. An increasing number of credit
inflation is rising and the money supply is tighter. During departments are using automated options that approve credit
prosperous times, new account volumes create more upfront lines for perceived low-risk customers or low-amount credit
work for the credit department. The collections team can be requests as long as they meet certain pre-established criteria.
considered the janitor and sweeps up after the other parts of a This, in theory, allows credit managers and staff to focus on the
business have completed their work. The analogy is an apt most important customers and situations. A centralized credit
one, for any number of problems may have been caused by system may be modified in certain respects. In some
other parts of the business, such as incorrect billings, flawed companies, for example, most of the credit functions are
product designs, or damaged goods, which the collections carried on at headquarters, but collections offices are located
team must work around during its efforts to collect cash from in the field to work directly with customers, secure payments
customers. This means that the collection effort may seem and make adjustments.
inefficient, due to problems that are outside of the control of the
collections group. Only by giving feedback to the rest of the
company can the collection manager achieve reasonable
collection results. Thus, collection management requires
expertise in dealing with other departments, as well as
collection skill. The organization of the department is
particularly important; a measure of permanence and stability
must be achieved that will ensure that the department
functions under all conditions. Although the organization
should not remain static, it is highly desirable to have
experienced and capable employees available within the
B. Decentralized—Credit Controlled at Headquarters but
department. The credit manager should strive to achieve a
Administered from Decentralized Location(s)
balance of newly trained entry-level staff and experienced
A mid-management level credit manager reports
credit professionals. Alternatives exist to accommodate extra
functionally to an executive-level credit manager at
heavy workloads. Cross-training of personnel can lead to more
headquarters and also reports to the division head (the
flexibility. Accounting department personnel can be trained to
principle is the same for subsidiary or branch operations).
perform routine tasks and called upon as necessary and
While authority in credit and collection is provided by the
temporary staff hired or tasks can be outsourced to companies
executive-level credit manager, in all other respects middle
specializing in credit-related functions such as cash application
management establishes the procedures to which the credit
and dispute resolution.
professional must conform
Organizational Structure
The credit and collection functions may be separately
located within different departments. The credit function is
essentially issuing short-term loans to customers, which is a
financing function, and so it may report to the treasurer or chief
financial officer. The collections function is an extension of the
billing function, and so is more likely to report to the controller.
Since this means the two areas are organized separately,
interactions between the two departments can prolong the time
required to resolve issues with customers. To keep this from Authority of the Mid-Level Credit Manager
happening, we recommend that the two functions be combined The mid-level credit manager is normally empowered
into a single department. by the division general manager to take care of personnel
problems, operating expenses and all other nonfunctional
CENTRALIZATION vs. DECENTRALIZATION matters within the scope of local policy. The mid-level credit
In a centralized structure, the credit function is manager has authority to give final credit approval on all orders
controlled and administered from a principal or central location. not exceeding a stipulated amount. Orders in larger amounts
In a decentralized structure, the credit function may report to a are referred to headquarters for processing and approval,
principal location (headquarters) with credit personnel located usually with local recommendation. The mid-level credit
at remote offices manager may be authorized to give preliminary credit approval
so the order can be processed. Another method is to designate Benefits of Centralization
certain customers as “headquarters accounts” because of • Economies of Scale. When separate divisions serve
special circumstances. When this procedure is followed, the common customers, a centralized credit office can mean a
mid-level credit manager ordinarily has final approval authority reduction in operating costs and a more efficient income
for all other orders, and can recommend credit limits for stream, along with enhanced customer service.
accounts with sound financial resources whose orders • Consistency and Control. Adherence to standardization of
normally exceed local authorization. policies, procedures and protocols is more manageable in a
Authority Retained by the Top-Level Credit Executive centralized environment. This has the advantage of providing
The top-level credit executive establishes credit policy consistent credit decisions across all business units which
for the divisions, considers approvals in cases that exceed the minimizes risk of satellite departments having undue influence.
limits set for mid-level credit executives and is completely When information about a common customer is centralized,
responsible for all headquarters accounts. The top-level credit the credit function has more risk control over bad debt
executive, in conjunction with the accounting and systems exposure and perhaps increased leverage in collection efforts.
departments, also determines the procedures, techniques and Closer proximity tends to encourage communication between
practices to be followed by the divisions in their credit and staff members and management. Likewise, updates to policies,
collections operations. Training of credit personnel and the procedures and protocols can be disseminated more quickly.
assignment of employees to the divisions, with the agreement
of the division manager, are also primary responsibilities of the Benefits of Decentralization
top-level credit executive. • Internal and External Relationships. Close proximity to
Decentralized—Credit Controlled and Administered from customers can enhance a credit professional’s relationship with
Decentralized Location(s) with a Staff Office at marginal customers and lead to developing a better rapport
Headquarters with customers having a sizable dollar exposure. Being on site
In this type of organization, the top-level credit with other business functions promotes a better understanding
executive is responsible for collecting information and of business goals and fosters the exchange of information
preparing reports for management, providing advice and about market and customer needs. It also enhances
counsel to the field credit executives, and participating in major communication among departments and reduces the number
problem-risk analysis. Figure 3-3 illustrates a decentralized of interdepartmental conflicts.
operation with a staff office maintained at headquarters. This • Involvement in Setting Strategic Priorities. Credit can
arrangement requires the top-level credit executives to be integrate its objectives with those of sales and marketing into
responsible for order approvals and collections and to control divisional goals. Also, decisions made at a local level can be
their own unit credit departments. implemented immediately without going through additional
The top-level credit executive usually establishes the levels of review.
overall credit policies. Divisions coordinate their activities
based on industry best practices and select the best alternative The Credit and Collection Team
action in the light of prevailing conditions. Compliance with the CREDIT MANAGER
overall policies is especially important, so telephone calls, The credit manager position is responsible for the
video conferences or field trips are key to monitoring the entire credit granting process, including the consistent
activities of credit personnel in the field. In cases where control application of a credit policy, periodic credit reviews of existing
is completely decentralized, the midlevel credit manager customers, and the assessment of the credit worthiness of
reports only to the division general manager and has complete potential customers, with the goal of optimizing the mix of
authority in all credit and collection matters without reference to company sales and the bad debt losses. The position generally
headquarters. The division is required to carry out the general reports to the treasurer or chief financial officer. The credit
credit policies of the company, but the operation within those manager should not report to any position in the sales
policies is the responsibility of the division. Consequently, the department, since the credit function should act as a
division credit executive is responsible to the division general counterbalance to that department.
manager both for the performance of the function and for the Management Tasks
operation of the division. ● Maintain a department organizational structure
sufficient to meet all goals and objectives.
● Properly motivate the credit staff
● Measure department performance
● Provide for ongoing training of the credit staff
● Manage relations with credit reporting agencies
● Manage relations with credit insurance providers
● Manage relations with the sales department Credit
Operations Tasks
● Maintain the corporate credit policy
● Monitor industry trends
● Recommend changes in the credit policy to senior
management
● Create a credit scoring model
 ● Update customer credit files Third Party Interaction
● Monitor the credit granting and updating process ● Provide feedback to other departments regarding
● Accept or reject credit recommendations forwarded by collection issues originating internally
the credit staff ● Manage relations with collection agencies
● Conduct on-site visits with the largest customers ● Manage relations with collection attorneys
● Monitor periodic credit reviews ● Manage relations with outside skip tracers
● Monitor deductions taken from payments by A key aspect of this position is to standardize the
customers process used for contacting customers. This does not
● Monitor the application of late fees to customers necessarily mean a highly regimented process, but rather one
● Monitor the corporate leasing program in which boundaries for acceptable collection behavior are
The credit manager should have considerable firmly enforced. Also, the collections manager must ensure that
experience in the credit granting field, probably having moved customers are uniformly dealt with in a manner that abides by
up from a credit clerk position. The position can require a all applicable laws.
college degree, though it is not necessary. Of more importance One of the more useful aspects of the collections
than a college degree is an excellent knowledge of credit manager position is monitoring the general trend of collections
scoring systems, financial analysis, and how credit-related to see if there is a pattern that may require a change in credit
laws may apply to the business. The position may periodically policy. The collections manager is in the unique position of
require travel to investigate or build relations with larger being able to monitor all collection activities, which makes it
customers. easier to discern subtle increases in days’ sales outstanding
across the entire customer base, or within specific customer
CREDIT CLERK concentrations. It can be difficult to allocate time for this
The credit clerk is responsible for not only reviewing analysis in the midst of day-to-day department operations, but
credit applications from new customers, but also monitoring it can lead to credit changes that can ultimately save a
current customers to see if their credit levels should be company from incurring inordinately large bad debts.
reexamined. The key elements of this position are:
● Process credit applications from new customers COLLECTOR
● Conduct trade and bank reference checks The collector position is responsible for collecting the
● Establish credit limits based on credit criteria maximum amount of overdue funds form customers, which
● Maintain records of credit reviews and document may include a variety of collection techniques, legal claims,
reasons for credit limits granted and the selective use of outside collection services. The
● Monitor credit usage by existing customers position is not strictly that of a clerk, since the best collector
● Monitor financial and credit condition of customers should operate with a more independent orientation than a
● Review existing credit limits at regular intervals procedure-bound clerk, taking those steps needed to collect
● Provide credit information to third parties upon funds. The key elements of the collector position are as
request follows:
It is not necessary for a credit clerk to have a college ● Stratify collection activities to maximize cash receipts
degree, though it is necessary to have a thorough ● Issue drumming letters to overdue accounts
understanding of financial statement analysis and how it ● Use skip tracing techniques to locate customers
relates to the granting of credit. ● Contact customers regarding overdue accounts and
determine reasons for non-payment
COLLECTION MANAGER ● Issue payment commitment letters
The collections manager position is responsible for all ● Negotiate the return of unpaid merchandise
collection activities, including all collection interactions with ● Repossess merchandise when payment is unlikely
customers and the management of collection agencies and ● Monitor cash on deliver payments
collection attorneys. This manager is also responsible for ● Issue credit hold notifications
accumulating information about the reasons for collection ● Recommend that accounts be shifted to a collection
problems and passing the information back to the rest of the agency
company for resolution. The position usually reports to the ● Process small claims court complaints
controller. It is not necessary for a collector to have any type of
Management Tasks college degree. Instead, it is much more important for a
● Maintain a department organizational structure that collector to have dogged persistence in contacting customers
can meet all goal and objectives at regular intervals and the negotiation skills necessary to
● Monitor the use of collection techniques extract payments from customers. If the company uses
● Monitor payment deductions taken by customers computerized collection monitoring software and auto-dialers,
● Properly motivate the collections staff a collector should be comfortable with the use of this
● Measure department performance technology.
● Conduct staff training as needed A productive collector who enjoys the work is a rare
● Review and approve negotiated settlements with find indeed. These individuals commonly achieve much higher
customers collection rates than normal. The collections manager would be
well advised to create a special environment for such
employees, including especially quiet work environments,
some measure of privacy, bonus pay, and any other
inducements necessary to retain their services.

SKIP TRACER
A skip tracer is essentially a private investigator who
locates people who do not necessarily want to be found. The
orientation of this position is toward research into a variety of
databases, so computer skills are paramount. Work hours can
be long, and are likely to be selfdirected, especially if the skip
tracer works from home.
A skip tracer is more likely to be an introvert, given
the amount of research involved. However, there is also a need
for sufficient social skills to extract location information from the
associates of a person who is missing. Obtaining information in
this manner requires that a skip tracer be good at posting the
correct questions, listening carefully to answers, and
interpreting this information “on the fly” to obtain additional
information with just the right questions.
Segmentation of Credit Approval Processes
In short, a skip tracer is a unique individual, whose
In order to assess the credit risk, it is necessary to
personality is inquisitive and research-oriented, and
take a close look at the borrowers economic and legal situation
self-directed. It is quite difficult to find a qualified skip tracer,
as well as the relevant environment (e.g. industry, economic
which is why this position is so frequently outsourced.
growth). The quality of credit approval processes depends on
two factors, i.e. a transparent and comprehensive presentation
Probationary Period
of the risks when granting the loan on the one hand, and an
When hiring a person into any of the preceding
adequate assessment of these risks on the other.
positions, be aware that credit and collections activities are not
for everyone, so a certain proportion of new hires will not work
Accounting for Risk Aspect
out. Accordingly, this is an area in which a mandatory
The quality of the credit approval process from a risk
probationary period is useful for deciding whether someone
perspective is determined by the best possible identification
can be an effective part of credit and collections. If not, it is
and evaluation of the credit risk resulting from a possible
best for the company and for them if they are terminated by the
exposure. The credit risk can be distributed among four risk
end of the probationary period. Otherwise, the rest of the
components which have found their way into the new Basel
department will be consumed by the ongoing training
Capital Accord (in the following referred to as Basel II).
requirements, errors, and morale problems of these
a. Probability of default (PD)
employees. The result should be a more cohesive group that is
b. Loss given default (LGD)
entire comprised of the types of people who thrive in the
c. Exposure at default (EAD)
high-pressure credit and collections environment
d. Maturity (M)
The most important components in credit approval
CHAPTER 3
processes are PD, LGD, and EAD. While maturity (M) is
Credit Procedures and Control
required to calculate the required capital, it plays a minor role
in exposure review.
Credit Approval Process
a. Probability of Default - Reviewing a borrower’s
First of all, we need to ask what possible sources of
probability of default is basically done by evaluating the
error the credit approval process must be designed to avoid.
borrower’s current and future ability to fulfill its interest and
The errors encountered in practice most often can be put down
principal repayment obligations. This evaluation has to take
to these two sources:
into account various characteristics of the borrower (natural or
— Substantive errors: These comprise the
legal person), which should lead to a differentiation of the credit
erroneous assessment of a credit exposure despite
approval processes in accordance with the borrowers served
comprehensive and transparent presentation.
by the bank. Furthermore, it has to be taken into account that
— Procedural errors: Procedural errors may take
— for certain finance transactions — interest and principal
one of two forms: On the one hand, the procedural-structural
repayments should be financed exclusively from the cash flow
design of the credit approval process itself may be marked by
of the object to be financed without the possibility for recourse
procedural errors. These errors lead to an incomplete or wrong
to further assets of the borrower. In this case, the credit review
presentation of the credit exposure. On the other hand,
must address the viability of the underlying business model,
procedural errors can result from an incorrect performance of
which means that the source of the cash flows required to
the credit approval process. These are caused by negligent or
meet interest and principal repayment obligations has to be
intentional misconduct by the persons in charge of executing
included in the review
the credit approval process.
b. Loss Given Default - The loss given default is
affected by the collateralized portion as well as the cost of
selling the collateral. Therefore, the calculated value and type for the accreditation of these firms. The SEC memorandum
of collateral also have to be taken into account in designing the said entities seeking to establish credit bureaus in the country
credit approval processes. should have a minimum paid-up capital stock of P50 million
c. Exposure at Default (EAD) - In the vast majority of and has the ability to operate a successful credit bureau. The
the cases described here, the exposure at default corresponds applicant should likewise use updated technology, have a good
to the amount owed to the bank. Thus, besides the type of governance structure and risk management framework, among
claim, the amount of the claim is another important element in others. CIC President and CEO Jaime P. Garchitorena earlier
the credit approval process. said that the firm is looking to accredit credit bureaus by
Thus, four factors should be taken into account in the yearend. He earlier noted that CIC had been conducting
segmentation of credit approval processes: orientations and technical trainings the past two years on
1. type of borrower setting up credit bureaus “to assist lending institutions in their
2. source of cash flows compliance with the law.” Under the CISA, lending institutions
3. value and type of collateral need to forward both the positive and negative credit
4. amount and type of claim information of their borrowers to CIC. These “submitting
entities” will similarly be able to access the credit database or
Important Factors for Credit Approval get the services of credit bureaus to establish the
1. The purpose of credit and sources of repayment. creditworthiness of their borrowers.
2. The current risk profile (including the nature and aggregate d. Bank’s own records: If the applicant is the
amounts of risks) of the borrower or counterparty and collateral existing customer of the bank, the banker can study the
and its sensitivity to economic and market developments; previous records, which provides an insight into the past
3. The borrower’s repayment history and current capacity to dealings with the bank. Every bank maintains a record of all
repay, based on historical financial trends and future cash flow depositors and borrowers. The transactions of borrower can
projections, under various scenarios; give depth idea to banker.
4. For commercial credits, the borrower’s business expertise e. Bazaar report: Report regarding applicant can also
and the status of borrower’s economic sector and its position be obtained from various markets. The strengths and
within the sector. weaknesses of the borrowers are monitored by the markets
5. The proposed terms and conditions of the credit, including continuously. Market opinion can also predict the future of the
covenants designed to limit changes in the future risk profile of business. Market intelligence can also be gathered through
the borrower; and borrower’s competitors. It should be a continuous process on
6. Where applicable, the adequacy and enforceability of existing current account holders and other prominent
collateral or guarantees, including under various scenarios. businessmen.
Integrity and reputation of the borrower or counterparty as well f. Report from other banks: Bank credit department
as their legal capacity to assume liability. may ask to other banks in which the applicant has dealings.
g. Other non-formal methods: There are other ways
CREDIT APPROVAL PROCESS also which can give many clues and make the judgment more
The credit evaluation process involves three steps: accurate. The most popular non-traditional method is to
1. Gathering Credit information understand the personality, motive and the capabilities of the
The credit department of a bank collects various borrowers, based on non-verbal clues as trying to predict the
important information regarding borrower from different results of a human mind.
sources to evaluate the customer. A number of sources would
available for gathering information which depends upon the 2. Credit Analysis (credit worthiness of applicants)
nature of the business, form of loan, amount of loan etc. these After gathering the credit information, banker
sources are: analyses it to evaluate the creditworthiness of the borrower.
a. Interview: Interview with the borrower enables the This is known as Credit Analysis. It involves the credit
banks to secure the detail information about the borrower’s investigation of a potential customer to determine the degree of
business which can help in credit decision process. If the risk in the loan. The creditworthiness of the applicant calls for a
applicant does not satisfy the credit norms, the lending officer detailed investigation of the 5 “C” of credit – Character,
may stop further procedure. In case of the success of Capacity, Capital, Collateral and Conditions.
preliminary investigation, as up to the standards, borrower may a. Character: The “character” means the reputation of
be asked to submit various financial reports. the prospective borrower. This includes certain moral and
b. Financial statements: Financial statements mental qualities of integrity, fairness, responsibility, trust
include the balance sheet and the profit and loss account. The worthiness, industry, etc. The honesty and integrity of the
financial statements of the last few years should be obtained. borrowers is of primary importance. So, credit character should
This analysis would provide an insight into the borrower’s be judged on the basis of applicant’s performance in bad times.
financial position, funds management capacity, liquidity, b. Capacity: It is the management ability factor. It
profitability and repaying capacity of the borrower. indicates the ability of the potential borrower to repay the debt.
c. Report of credit rating agencies: The move is in It also shows the borrower’s ability to utilize the loan effectively
line with the Credit Information System Act (CISA) or Republic and profitably.
Act No. 9510, and Securities and Exchange Commission c. Capital: Capital refers to the general financial
(SEC) Memorandum Circular No. 7, which laid down the rules position of the potential borrower’s firm. It indicates the ability
to generate funds continuously over time. Capital means Essential and Best Practices in Managing Credit Risk
investment represents the faith in the concern, its product and a. KNOW YOUR CUSTOMER. Knowing your
nature. Bank should also determine the amount of immediate Customer is an essential best practice because it is the
liabilities that are due. For the true estimate, market value of foundation for all succeeding steps in the credit risk
assets should be considered rather than book value. management process. To be successful, you must operate on
d. Collateral: Collateral means assets offered as a pertinent, accurate, and timely information. The information
pledge against the loan. It serves as cushion at the time of you gather and the relationships you establish are critical to
insufficiency of giving a reasonable assurance of repayment of positioning yourself as a valued financial consultant and
the loan. provider of financial products and services. Establishing a good
e. Conditions: It refers to the economic and business relationship can bring a long stream of equity to your
conditions of the country and position of particular business institution.
cycle, which affect the borrower’s ability to earn and repay the b. ANALYZE NON-FINANCIAL RISKS. Understand
debt. This is beyond the control of the borrower. Sometimes your customer’s business by analyzing nonfinancial risks.
borrower may have a high credit character, potential ability to Information gathered in this step is critical to positioning
produce income but the condition may not be in favor. For the yourself as a financial consultant to your customer and a
proper evaluation, bank should have eyesight on the economic valued member of your financial institution’s lending team.
condition too. c. UNDERSTAND THE NUMBERS. There are many
For this, they have to rate the borrowers in different benefits and risks associated with establishing a banking
categories like excellent, well and poor. Both the formal and relationship with any entity or individual. As a lender, you
non-formal tools combined would lead to perfection in credit should know: How the requested funds are going to be used
appraisal and ward of increasing default tendency in credit. and how they are anticipated to be repaid. Techniques to
There are number of tools and techniques developed to identify, categorize, and prioritize all of the risks inherent with
evaluate the creditworthiness of the borrower like, ratio the customer that are known at the time of the analysis as well
analysis, cash flow projections, fund flow statement, credit as those that are anticipated to be in existence over the period
scoring etc. of the relationship.
The loan request is generally the most scrutinized
part of a credit write-up. Once you are comfortable with the
nature of the loan request, the process of understanding the
numbers can begin. The process includes:
● Knowing the Auditor – Analyze the competency and
reputation of the firm or individual preparing your
customer’s financial reports.
● Accounting Fundamentals – Review the auditor’s
Engagement Letter, Financial Statements, and
Management Letter, as well as accounting
fundamentals and generally accepted auditing
principles (GAAP).
● Balance Sheet Quality Analysis –Analyze the balance
sheet along with relevant liquidity and leverage ratios.
● Income Statement Quality Analysis – Analyze
revenues and costs along with income statement ratio
analysis.
● Cash Flow Statement Analysis – Analyze operating
cash flow, investing cash flow, financing cash flow,
3. Credit Decision
and cash flow ratios.
After passing through whole this process, the banker
● Analyzing Financial Efficiency Cash Flow Drivers –
has to take decision about sanctioning of credit facility. The
Use profitability ratios and turnover ratios to analyze a
creditworthiness should be matched against the credit
company’s cash flow drivers.
standards of loan policy. The banker should be very conscious
● Developing Projections – Determine the
about this, for taking right decision to avoid the possible credit
reasonableness of assumptions behind business
risks to arise in future.
fundamentals and swing factors.
● Personal Financial Statement Analysis – Analyze the
personal financial statement and tax return in the
event that you are lending directly to or seeking
additional credit support from an individual.
● Company Financial Statements – Analyze the
company’s financial statements and provide an
overview. Obviously, a small company will have a
simpler chart of accounts, while a large domestic or
international corporation will be more complex.
 d. STRUCTURE THE DEAL. The first step is to your client and, at the same time, pursue opportunities to
understand the business. Before completing a financial develop and expand the relationship.
analysis on the organization, you identify the characteristics In a recent survey of banks conducted by RMA, the
that influence a company’s success by studying: following were determined to be critical to a successful risk
1. The nature of the business. management strategy:
2. The nature of the industry. ● A quantitative risk-rating system with a wide range of
3. The impact of economic conditions. grades, which includes subjective factors, such as
4. Its business strategy. management quality. A wider range of grades allows
5. The competencies or deficiencies of management the bank to assign credit costs more precisely.
e. PRICE THE DEAL. Determining the appropriate ● An effective management information system to track
pricing is a critical credit risk management technique. It credit exposure.
ensures that your financial institution will be adequately ● Risk pricing based on required rates of return that are
compensated for the risk of the deal. then used in customer sourcing.
f. PRESENT THE DEAL. Communicating your ● A business strategy that reflects a proactive role in
findings in a cogent and professional manner is a critical guiding relationship managers on credit exposures in
practice in getting your proposal approved. Credit decisions the portfolio.
should not be made on financial statement analysis alone. A
credit review would not be complete without an equally Common Credit Management Strategies
significant emphasis on the qualitative issues such as the 1. Constant reminding. Whether by phone, email, letter or in
ability of management, the competitive business environment, person, there are always ways to contact your customers to
and the economic issues relating to the business. remind them of the invoice. The secret is to contact them at the
The five key sections that are integral to any effective most opportune moments.
credit recommendation report or presentation are: 2. Suspending work/services. This is quite an extreme step
1. Summary and Recommendations – A one-page to take, but it can prove extremely effective. By refusing to
summary of all the information that has been gathered in the trade with a particular customer – usually one which has a
analysis that supports the credit recommendations. track record of paying late – you’re forcing their hand to either
2. Economic and Competitive Environments – clean up their act or go elsewhere. Though the latter option
Analyses of the company’s current and evolving position in the seems counterproductive, you have to ask yourself how
industry and how susceptible it has been, and may be, to valuable a customer they are if they don’t pay on time.
changes in the general economy. 3. Credit reports. Credit reports are an excellent tool to gain a
3. Management Assessment – Evaluations of the picture of a prospective or existing customer’s creditworthiness
company’s operations and management’s capabilities. prior to offering them credit terms. The outcome of the report
4. Financial Analysis and Projections – Analysis of the can be used to determine the length of terms to supply,
financial position of the company and evaluation of the whether a deposit should be taken up-front or whether you
projected performance of the company. should trade with them at all.
5. Sources of Repayment – Identification of all 4. Suspending customer credit facilities. By refusing to
projected sources of repayment and the appropriate loan extend credit terms to a customer, you remove the risk of them
structure. not paying at all. This decision can be based on your previous
g. CLOSE THE DEAL. Closing the Deal takes place experiences with that customer, or perhaps an unfavorable
after the analysis, structuring, and pricing have been credit report being obtained. However, it can lead to your
completed. Do the following and it is more likely that your loan business being less competitive and lead to that customer
closing will be successful: looking elsewhere.
1. Prepare a closing memorandum or detailed loan 5. Court Judgments. Although it can be an expensive
documentation checklist. process, legal proceedings are available to businesses wishing
2. Provide sufficient time for the borrower and any to take a strong stand against a late paying customer. The
other parties involved in the transaction to gather documents. threat of court can sometimes be enough to encourage
3. Provide the borrower and any other parties with payment, but it can prove to be a stressful, drawn-out and
instructions on how to complete your standard documents and costly method.
ensure that they return the forms to you for review prior to the 6. Visiting debtors in person. Unfortunately, it can be quite
closing. easy for a customer to ignore phone calls, emails and letters
4. Prepare drafts of loan documents and deliver them requesting payment. Sometimes it can therefore be worth
to the borrower or other involved parties prior to the closing knocking on their door to request payment and have a
with sufficient time for the recipients to have the documents face-to-face conversation to demonstrate how valuable their
reviewed by their own legal counsel. prompt payment is for your business.
h. MONITOR THE RELATIONSHIP. In today’s 7. Applying statutory late payment interest. Businesses
competitive environment, you cannot afford to wait for your have a legal right to charge their customers statutory interest
loans to be repaid and expect your clients to call you for other and late payment compensation should they miss a payment
products and services. To have a competitive advantage in deadline. This can compensate your business for the impact
today’s market, you must continue to monitor the risk profile of late payment has on your cash flow and additionally cover the
cost of employing a debt collection agency to recover the full maintaining or improving its competitive position. Even where
amount. credit is not generally a competitive tool, an individual company
8. Written credit policy. More commonly used by larger can use it in this manner if it is willing to do so.
businesses, a written credit policy can be a great way to 2. Customer Type: The type of customer has a direct limiting
ensure your team goes about its credit management in a influence on the credit policies of all companies in an industry.
structured, effective and consistent way. Where the buyers’ line of business is characteristically short of
9. Early settlement discounts. In many cases it can be more capital, it is unrealistic for credit policy to be unduly restrictive.
beneficial financially to be paid a smaller-than quoted sum if it A company that operates on that basis will not maintain its
means payment is received after seven days instead of 30. market.
Any customer taking advantage of the offer also means that’s 3. Merchandise: The type of merchandise affects the credit
one less account your credit control team has to worry about. policy of the seller in a number of ways. There is a tendency to
10. Invoice finance. The nature of trading on credit terms sell on a more liberal basis if the merchandise has a relatively
means there will always be a cash flow gap between providing high profit margin or high price. Also, terms may be somewhat
a service and getting paid. Invoice finance enables businesses more liberal if the merchandise can be repossessed or
to access up to 90% of their invoice value within 24 hours of an returned inward in the same condition as it was sold. On the
invoice being raised, while facilities can also incorporate a other hand if the shelf life is shorter of the merchandise then
sales ledger management service and bad debt protection. most probably the credit terms will provide shorter credit
11. Credit insurance (bad debt protection). Bad debt period. For example, those that can spoil will require shorter
protection can also be provided on a standalone basis. By terms, so terms are usually net 10 in the food industry.
safeguarding your cash flow against late payment or protracted 4. Profit Margin: Markup is important. When profit margins are
default, if affords you peace of mind when trading on credit – slim, the credit department may be more careful in the
particularly for larger contracts. selection of its accounts. High-markup goods should, at least in
12. Outsourcing. Chasing customers for payment can be an thoery, encourage credit professionals to approve sales to
arduous task. As a result, some businesses choose to instruct marginal credit risk accounts. In other words, the higher the
a debt collection agency to recover unpaid invoices which are gross profit margin, the more tolerant of credit risk the credit
proving difficult and time-consuming to chase. Other manager should be. This is a general statement and not
businesses choose to outsource all or part of their credit always true.
control function so that they can concentrate on running their 5. Unit Price: It is easier to establish a uniform liberal policy
company. that applies to all customers when the unit price of
merchandise is relatively low. Even on a wrong decision, the
Credit Control Timeline: Key Steps dollar amount of risk is low credit exposure is greater. A more
One of the most important but frequently overlooked detailed analysis is usually conducted before a customer order
elements of the credit control process is the process itself. By is approved.
clearly setting out a day-by-day strategy from the moment the 6. Geographical Distributions: The geographical distribution
order is placed until the invoice is paid, your accounts of customers determines credit policy to some degree. Widely
receivables team can adopt a coordinated and professional separated markets require particular modifications in credit
credit control procedure. analysis and in collection efforts. A highly concentrated selling
and buying area, on the other hand, involves a special type of
price competition and service requirements.
7. Government Regulations: In the case of particular
commodities, such as spirits and liquors, government
regulations specify credit policies or procedures which must be
followed by the seller. There, the overall policy must take the
regulations into consideration. In a very general way, expected
longrange trends in the economy also influence credit policy.
8. Economic Conditions: Economic or business conditions
are of much greater significance, however, in determining how
policy is to be applied over a shorter period of time. When
times are prosperous, ability of debtors to pay their bills is
somewhat improved; however, there is a danger that they may
tend to overbuy. During slack business periods, debtors tend to
delay payment of their bills and credit requirements may tend
CHAPTER 4 to be stricter. Concurrently, as sales drop, the company is
Credit Policy and Credit Application faced with the problem of maintaining volume in the face of
decreasing sales and more demanding selection of credit
Factors Influencing Credit Policy customers.
1. Competition: Credit practices within an industry influence
the formal credit policy of any individual company. Competitive The Importance of a Written Credit Policy
conditions place a high degree of importance on credit 1. A written policy provides a structured approach to risk
availability. The credit policy of a company is important for management and the debt collection process.
FM 305 - Monetary Policy and Central Banking The Polymer Project
The BSP continuously looks for ways to improve our
CHAPTER 1 banknotes in response to the evolving needs of Filipinos and
An Introduction to Money and the Financial System the availability of modern technologies. One such improvement
is the use of polymer banknotes, which are known to be
• Every financial transaction has a story SMARTER (more secure and sustainable), CLEANER (more
• There is a complex web of interdependent institutions and hygienic and sanitary), and STRONGER (durable and
markets making up the foundation of daily financial cost-effective) than paper banknotes.
transactions. In April 2022, the BSP began the circulation of the
• What happens in the financial system - whether for good or new and improved 1000-Piso polymer banknotes. This will be
for bad - matters greatly for all of us used alongside the 1000-Piso paper banknotes.

Six Parts of the Financial System Why polymer banknotes?

Money - to pay for our purchases and to store our 1. Polymer banknotes are smarter.
wealth More secure. Detailed images and sophisticated
Financial Instruments - to transfer resources from security features make polymer banknotes more difficult to
savers to investors and to transfer risk to those who are best counterfeit.
equipped to bear it More eco-friendly. Don’t panic just because it’s plastic.
Financial Markets - allows us to buy and sell Producing polymer banknotes has less environmental impact
financial instruments quickly and cheaply. The New York Stock given their smaller carbon footprint, lower water and energy
Exchange is an example of a financial market usage, and less environmental toxicity.
Financial Institutions - provide a myriad of services, Recyclable. Go green with polymer banknotes. When
including access to the financial markets and collection of deemed unfit, these banknotes can be recycled to produce
information about prospective borrowers to ensure they are various products such as building components, plant pots, and
creditworthy. Banks, securities firms, and insurance companies garden furniture.
are examples of financial institutions
Government Regulatory Agencies - They are 2. Polymer banknotes are cleaner.
responsible for making sure that the elements of the financial Shorter survivability of viruses and bacteria. The
system—including its instruments, markets, and institutions— smoother, non-absorptive surface of polymer banknotes makes
operate in a safe and reliable manner them cleaner. Based on studies reviewed by our Department of
Central Banks - monitor and stabilize the economy. Health, the survival time of bacteria and viruses in polymer
The Federal Reserve System is the central bank of the United banknotes is significantly shorter than in paper banknotes.
States. Can be sanitized. You can always keep your polymer
banknotes clean. You can sanitize them with less risk of
Five Core Principles of Money and Banking damage compared to paper banknotes.
● Time has value
time affects the value of financial transactions. Most loan 3. Polymer banknotes are stronger.
contracts allow the borrower to spread out the payments over More durable. Rain or shine, your polymer banknotes
time. can withstand the test of temperature and time. They can last
● Risk requires compensation much longer than paper banknotes given their resistance to
In the financial world, compensation is made in the form of water, oil, dirt, and general wear and tear.
explicit payments. That is, investors must be paid to assume More cost-effective. With a lifespan that is at least 2 to
risk; the higher the risk, the bigger the required payment. 5 times longer than paper banknotes, polymer banknotes will
● Information is the basis for decisions lead to significant savings on printing, distribution, and
Before a bank makes a loan, a loan offi cer will investigate the replacement costs in the long run.
financial condition of the individual or firm seeking it. Banks 4. Polymer banknotes have a distinct and functional design.
want to provide loans only to the highest-quality borrowers. Its distinct design and texture make the new polymer
Thus, they spend a great deal of time gathering the information banknote easily distinguishable from paper banknotes. It also
needed to evaluate the creditworthiness of loan applicants. features the country’s national flora and fauna symbols: the
● Market determine prices and allocation of Philippine eagle (Pithecophaga jefferyi), the Sampaguita flower
resources (Jasminum sambac), along with the Tubbataha Reefs Natural
Financial markets gather information from a large number of Park, a UNESCO World Heritage Site, and our nature’s pride,
individual participants and aggregate it into a set of prices that the South Sea Pearl.
signals what is valuable and what is not. Thus, markets are More inclusive. The new polymer banknote also has
sources of information. By attaching prices to different stocks five embossed dots as a tactile feature for the visually
or bonds, they provide a basis for the allocation of capital. challenged.
● Stability improves welfare
Stability is a desirable quality, not just in our personal lives but 5. A change for the better.
in the financial system as a whole Central banks around the world change the designs of
their banknotes every 10 years, on average, and the current
series of Philippine banknotes first went into circulation more DO NOT deface, write on, or mark polymer banknotes.
than ten years ago. DO NOT excessively fold, crease, or crumple polymer
We will now join Canada, Australia, New Zealand, banknotes. These could leave permanent fold marks
Malaysia, Mexico, Fiji, and Vietnam as polymer banknote DO NOT tear, cut, or poke holes in polymer banknotes.
users. These countries have experienced a big reduction in DO NOT staple polymer banknotes or use rubber bands to
counterfeiting cases after shifting to polymer banknotes, keep them together. You may use paper bands instead.
among other benefits. DO NOT damage the clear windows, metallic features, and
other security features of polymer banknotes.
Timeline DO NOT iron polymer banknotes.
Road to 500 million pieces of 1000-Piso polymer banknotes in DO NOT expose polymer banknotes to very high temperatures
circulation or place them near an open flame.
DO NOT expose polymer banknotes to strong or corrosive
April 2022 chemicals, such as muriatic acid or bleach.
Delivery of 10 million pieces of 1000-Piso polymer
banknotes (0.7 percent of the total no. of 1000-Piso banknotes Coins and Notes - History of Philippine Money
in circulation). Pre-Hispanic Era
Long before the Spaniards came to the Philippines,
October 2022 to June 2023 trade among the early Filipinos and with traders from the
Delivery of the remaining 490 million pieces of neighboring lands like China, Java, Borneo, and Thailand was
1000-Piso polymer banknotes, bringing a total of 500 million conducted through barter. The inconvenience of the barter
pieces of polymer banknotes in circulation (31.9 percent of the system led to the adoption of a specific medium of exchange –
total no. of 1000-Piso banknotes in circulation). the cowry shells. Cowries produced in gold, jade, quartz and
wood became the most common and acceptable form of
Design Features money through many centuries.
The distinct design and enhanced security features of Since the Philippines is naturally rich in gold, it was
the 1000-Piso polymer banknote are consistent with the used in ancient times for barter rings, personal adornment,
principles of currency integrity, social relevance and efficiency, jewelry, and the first local form of coinage called Piloncitos.
and unified theme and aesthetics. These had a flat base that bore an embossed inscription of the
letters “MA” or “M” similar to the Javanese script of the 11th
1000-PISO POLYMER BANKNOTE OBVERSE century. It is believed that this inscription was the name by
The obverse side features two of the country’s which the Philippines was known to Chinese traders during the
national symbols: the Philippine Eagle (Pithecophaga jefferyi) pre-Spanish time.​
as its focal point, and the Sampaguita (Jasminum sambac).
The Philippine Eagle exemplifies the Filipino’s uniqueness, Spanish Era 1521-1897
strength, power, love for freedom, as well as a sharp vision for The cobs or macuquinas of colonial mints were the
the country’s future. Meanwhile, the Sampaguita symbolizes earliest coins brought in by the galleons from Mexico and other
purity, simplicity, humility, and strength. Spanish colonies. These silver coins usually bore a cross on
one side and the Spanish royal coat-of-arms on the other.
Proper Handling The Spanish dos mundos were circulated extensively
Polymer banknotes may be tough, but these not only in the Philippines but the world over from 1732-1772.
banknotes also need to be valued and handled with care. Just Treasured for its beauty of design, the coin features twin
like our existing paper banknotes, the new 1000-Piso polymer crowned globes representing Spanish rule over the Old and
banknote should be properly used so it can last for a longer the New World, hence the name “two worlds.” It is also known
period of time. Here are the DOs and DON’Ts in handling as the Mexican Pillar Dollar or the Columnarias due to the two
polymer banknotes: columns flanking the globes.
Due to the shortage of fractional coins, the barrillas,
KEEP THEM FLAT. were struck in the Philippines as ordered by the Royalty of
Place your polymer banknotes in wallets where they Spain. The barrilla, a crude bronze or copper coin worth about
fit properly. If banknotes become crumpled or creased, apply one centavo, was the first coin struck in the country. The
pressure, or flatten them with your hands. Filipino term “barya”, referring to small change, had its origin in
barrilla.
KEEP THEM CLEAN. Coins from other Spanish colonies also reached the
Soiled or dirty polymer banknotes may be wiped clean Philippines and were counterstamped to legalize their
with a damp cloth. Their surface may also be cleaned with circulation in the country. Gold coins with the portrait of Queen
alcohol-based sanitizers—just wipe them dry using a towel or Isabela were minted in Manila. Silver pesos with the profile of
piece of cloth right away. young Alfonso XIII were the last coins minted in Spain. The
pesos fuertes, issued by the country’s first bank, the El Banco
USE THEM AS PAYMENT FOR GOODS AND SERVICES. Espanol Filipino de Isabel II, were the first paper money
Do not hoard polymer banknotes, nor buy or sell them circulated in the country.
at a higher price.
Revolutionary Period 1898-1899 Ang Bagong Lipunan (ABL) series notes were circulated, which
Asserting its independence, the Philippine Republic of were printed at the Security Printing Plant starting 1978. A new
1898 under General Emilio Aguinaldo issued its own coins and wave of change swept through the Philippine coinage system
paper currency backed by the country’s natural resources. At with the Flora and Fauna Coin Series initially issued in 1983.
the Malolos arsenal, two types of two-centavo copper coins The New Design Series of banknotes issued in 1985 replaced
were struck. One peso and five peso revolutionary notes the ABL series. Ten years later, a new set of coins and notes
printed as Republika Filipina Papel Moneda de Un Peso and were issued carrying the logo of the Bangko Sentral ng
Cinco Pesos were freely circulated. These were handsigned by Pilipinas.
Pedro Paterno, Mariano Limjap and Telesforo Chuidian. With
the surrender of General Aguinaldo to the Americans, the ​Coins and Notes - Security Features
currencies were withdrawn from circulation and declared illegal Features of New Generation Currencies (NGC) and
currency. enhanced NGC (eNGC)

American Period 1900-1941

With the coming of the Americans 1898, modern
banking, currency and credit systems were instituted making
the Philippines one of the most prosperous countries in East
Asia. The Americans instituted a monetary system for the
Philippine based on gold and pegged the Philippine peso to the
American dollar at the ratio of 2:1. The US Congress approved
the Coinage Act for the Philippines in 1903.
The coins issued under the system bore the designs
of Filipino engraver and artist, Melecio Figueroa. Coins in
denomination of one-half centavo to one peso were minted.
The renaming of El Banco Espanol Filipino to Bank of the
Philippine Islands in 1912 paved the way for the use of English
from Spanish in all notes and coins issued up to 1933.
Beginning May 1918, treasury certificates replaced the silver
certificates series, and a one-peso note was added.

​The Japanese Occupation 1942-1945

The outbreak of World War II caused serious
disturbances in the Philippine monetary system. Two kinds of
notes circulated in the country during this period. The
Japanese Occupation Forces issued war notes in high
denominations. These war notes had no back up reserves,
thus, Filipinos dubbed it “Mickey Mouse” money. During the
worst inflation in Philippine history, Filipinos would go to the
market laden with bayongs of Mickey Mouse bills, since one
duck egg cost 75 pesos, and a box of matches more than 100 CHAPTER 2
pesos. Banks as Depository Institutions
On the other hand, Guerrilla Notes or Resistance
Currencies which are in low denominations, were issued by Banks are the most visible financial intermediaries in
different provinces and, in some instances, municipalities the economy. These depository institutions accept deposits
through their local currency boards to show resistance against from savers and make loans to borrowers. They include
the Japanese occupation. commercial banks, savings and loans, and credit unions.
Banks seek to profit from their various lines of business; they
The Philippine Republic provide accounting and record-keeping services, provide
A nation in command of its destiny is the message access to the payments system, pool the savings of small
reflected in the evolution of Philippine money under the depositors, use the funds to make loans to borrowers, and offer
Philippine Republic. Having gained independence from the customers risk-sharing services. Banks are important, and
United States following the end of World War II, the country when they are poorly managed the entire economy suffers.
used as currency old treasury certificates overprinted with the
word “Victory”. Application of Core Principles
With the establishment of the Central Bank of the TIME: Banks hold only 3% of their assets as cash
Philippines in 1949, the first currencies issued were the English because holding cash is expensive; it earns no interest.
series notes printed by the Thomas de la Rue & Co., Ltd. in Holding excess reserves is expensive, since it means forgoing
England and the coins minted at the US Bureau of Mint. The the interest that could be earned on loans or securities
“Filipinization” of the Republic coins and notes began in the
late 60’s and is carried through to the present. In the 70’s, the
 RISK: Banks are exposed to a host of risks, including or large (more than $100,000), and the large ones
liquidity risk, credit risk, interest-rate risk, trading risk, and can be bought and sold in financial markets.
operational risk Borrowings: The second most important
INFORMATION: Among a bank’s off-balance sheet source of bank funds; banks borrow from the Federal
activities is the provision of a line of credit to a trusted Reserve or from other banks in the federal funds
customer. Since the bank usually knows the customer to whom market. Banks can also borrow by using a repurchase
it grants the line of credit, the cost of establishing agreement or repo, which is a short-term
creditworthiness (an information cost) is negligible. Since collateralized loan in which a security is exchanged
banks specialize in information gathering, they attempt to gain for cash, with the agreement that the parties will
a competitive advantage in a narrow line of business. The reverse the transaction on a specific future date
problem is that doing so exposes the bank to added risks. (might be as soon as the next day).

Balance Sheet of Commercial Banks BANK CAPITAL

Total Bank Assets = Total Bank Liabilities + Bank Capital 1. The net worth of banks is called bank capital; it is the
Banks obtain their funds from individual depositors owners’ stake in the bank.
and businesses, as well as by borrowing from other financial 2. Capital is the cushion that banks have against a sudden
institutions and through the financial markets. They use these drop in the value of their assets or an unexpected withdrawal
funds to make loans, purchase marketable securities, and hold of liabilities.
cash. The difference between a bank’s assets and liabilities is 3. An important component of bank capital is loan loss
the bank’s capital or net worth —the value of the bank to its reserves, an amount the bank sets aside to cover potential
owners. The bank’s profits come both from service fees and losses from defaulted loans.
from the difference between what the bank pays for its 4. There are several basic measures of bank profitability:
liabilities and the return it receives on its assets return on assets (a bank’s net profit after taxes divided by its
total assets) and return on equity (a bank’s net profit after taxes
ASSETS divided by its capital).
The asset side of a bank’s balance sheet includes 5. Net interest income is another measure of profitability; it is
cash, securities, loans, and all other assets (which includes the difference between the interest the bank pays and what it
mostly buildings and equipment). receives.
Cash Items: The three types of cash assets are 6. Net interest income can also be expressed as a percentage
reserves (which includes cash in the bank’s vault as well as its of total assets; that is called net interest margin, or the bank’s
deposits at the Federal Reserve); cash items in the process of interest rate spread.
collections (uncollected funds the bank expects to receive); 7. Net interest margin is an indicator of future profitability as
and the balances of accounts that banks hold at other banks well as current profitability.
(correspondent banking).
Securities: The second largest component of bank OFF-BALANCE-SHEET ACTIVITIES
assets; includes U.S. Treasury securities and state and local 1. Banks engage in these activities in order to generate fee
government bonds. Securities are sometimes called secondary income; these activities include providing trusted customers
reserves because they are highly liquid and can be sold quickly with lines of credit.
if the bank needs cash. 2. Letters of credit are another important off-balance-sheet
Loans: The primary asset of modern commercial activity; they guarantee that a customer will be able to make a
banks; includes business loans (commercial and industrial promised payment. In so doing, the bank, in exchange for a
loans), real estate loans, consumer loans, interbank loans, and fee, substitutes its own guarantee for that of the customer and
loans for the purchase of other securities. The primary enables a transaction to go forward.
difference among the various types of depository institutions is 3. A standby letter of credit is a form of insurance; the bank
in the composition of their loan portfolios promises that it will repay the lender should the borrower
default.
LIABILITIES 4. Off-balance-sheet activities create risk for financial
Banks need funds to finance their operations; they get institutions and so have come under increasing scrutiny in
them from savers and from borrowing in the financial markets. recent years.
There are two types of deposit accounts, transactions
(checkable deposits) and non-transactions.
Checkable Deposits: A typical bank will
offer 6 or more types of checking accounts. In recent
decades these deposits have declined because the
accounts pay low interest rates.
Non-transactions Deposits: These include
savings and time deposits and account for nearly
two-thirds of all commercial bank liabilities.
Certificates of deposit can be small ($100,000 or less)
BANK RISK relative to ROA. Thus, as a company takes on more debt, its
ROE would be higher than its ROA.

Net Interest Income

• This measure is related to the fact that banks pay

interest on their liabilities, creating interest expenses, and
receive interest on their assets, creating interest income.
• Deposits and bank borrowing create interest
expenses; securities and loans generate interest income

Net Interest Margin

BANK PROFITABILITY
Return on Asset
• Net interest income expressed as a percentage of
total assets to yield a quantity
• This is the bank’s interest-rate spread

• Return on assets is a metric that indicates a

company's profitability in relation to its total assets.
• ROA can be used by management, analysts, and
investors to determine whether a company uses its assets
efficiently to generate a profit.
• It's always best to compare the ROA of companies
within the same industry because they'll share the same asset
base.
• ROA factors in a company's debt while return on
equity does not.
• The higher the ROA number, the better, because the
company is able to earn more money with a smaller
investment. Put simply, a higher ROA means more asset
efficiency

Return on Equity

• Return on equity (ROE) is the measure of a

company's net income divided by its shareholders' equity.
• ROE is a gauge of a corporation's profitability and
how efficiently it generates those profits.
• The higher the ROE, the better a company is at
converting its equity financing into profits.

ROA vs ROE
Both ROA and return on equity (ROE) measure how
well a company utilizes its resources. But one of the key
differences between the two is how they each treat a
company's debt. ROA factors in how leveraged a company is
or how much debt it carries. After all, its total assets include
any capital it borrows to run its operations.
On the other hand, ROE only measures the return on
a company’s equity, which leaves out its liabilities. Thus, ROA
accounts for a company’s debt and ROE does not. The more
leverage and debt a company takes on, the higher ROE will be