Credit

Appraisal
Chapter 5
 Credit Appraisal
▪ Credit Appraisal is the process by which the lender
assesses the technical feasibility and economic
viability to arrive at the creditworthiness of the
borrower and fair banking risk of a credit
proposition.
▪ The process revolves around 8 P’s namely, the
project in front, people behind it, process it adopts,
product it delivers, prospects in the market,
projections it makes, profit it anticipates, proposed
repayment, etc.
 Credit Appraisal
▪ Credit is a loan, or a debt of whatever form
sanctioned by a bank to its customer.
▪ Credit appraisal is a process of critical
evaluation of a loan request by a prospective
borrower and the entire process involves the
following steps:
i. Credit processing
ii. Credit sanction/approval
iii. Credit documentation
iv. Credit disbursement
v. Credit monitoring.
 Due Diligence
▪ Customer Due Diligence (CDD) means Due diligence can
be of 3 types:
identifying and verifying the customer and the i. Financial Due
beneficial owner. Diligence
ii. Commercial Due
▪ Due Diligence is a process that financial Diligence
institutions, businesses, and other iii. Legal Due
organizations use to gather information about Diligence
their customers and clients in order to identify
and mitigate risks such as money laundering,
financing terrorism, and other illicit activities.
▪ Due Diligence process typically involves
collecting and verifying information about a
customer's identity and financial and business
activities.
 Due Diligence
▪ Banks should verify PAN Card
▪ Due diligence process involves details, Director Identification
the following phases: Number/Father's name.
▪ Detect report from CRIF
▪ i. Initial phase of interactions Highmark/CIBIL/Experian/Equifax.
Market information on
▪ ii. Study of company/business Promoter(s)/company/firm/group
companies/partners, CRILC.
data ▪ Central Fraud Registry in respect
of accounts with exposure of Rs.
▪ iii. Active evaluation 1 crore and above and ensure that
the applicant is genuine and
▪ iv. Physical verification deserves credit from the bank.
▪ Credit history of the borrowers
▪ v. Analysis of quantitative & should also be checked against
qualitative data the information available in the
database built by Credit
▪ vi. Report preparation Information Bureau, such as CRIF
HIGHMARK, CIBIL, EXPERIAN,
and EQUIFAX.
 Role of Fintech Companies in due diligence
1. Open Development and SaaS Solutions in Banking: Banks are
increasingly adopting open development and SaaS solutions from
FinTech startups to enhance digital delivery and streamline
operations through API integration.
2. India's Account Aggregator Framework: Launched in September 2021,
India's Account Aggregator framework aims to improve financial data
accessibility and inclusion, with over 22 banks, including all public
sector banks, participating.
3. SEBI Joins Account Aggregator Framework: SEBI's recent integration
with the RBI's Account Aggregator framework allows customers to
share their mutual fund and stock holdings with financial service
providers.
4. PFRDA's Approval for NPS Data Sharing: The Pension Fund
Regulatory and Development Authority (PFRDA) has approved the
sharing of National Pension System (NPS) subscribers' data with
Account Aggregators for enhanced financial service access.
 Introduction of Legal Entity Identifier for large
corporate borrowers
▪ Legal Entity Identifier (LEI) code is conceived as a key measure to improve the quality
and accuracy of financial data systems for better risk management post the Global
Financial Crisis.
▪ LEI is a 20-digit unique code to identify parties to financial transactions worldwide.
▪ LEI system for all borrowers of banks having total fund-based and non-fund based
exposure of Rs. 5 crore and above will be introduced in a phased manner. Initially,
borrowers with total exposure of Rs. 50 crore and above from the banking system were
advised to obtain the LEI.
▪ RBI has advised that banks shall advise their existing large corporate borrowers having
total exposures of Rs. 5 crore and above to obtain LEI.
▪ Borrowers who fail to obtain LEI codes from an authorized Local Operating Unit (LOU) shall
not be sanctioned any new exposure nor shall they be granted renewal/enhancement of
any existing exposure.
 Credit Risk
1. Definition of Credit Risk: Credit risk refers to the probability of borrower or
counterparty default due to business failure or willful actions, impacting the
integrity of the borrower.
2. Assessment of Credit Risk: Modern lenders assess credit risk using credit reports
from multiple credit information companies, ratings by agencies, and internal
credit scoring or rating systems.
3. Internal Factors Influencing Default: Internal factors such as poor management,
inefficient financial decisions, and marketing failures can significantly increase the
likelihood of default.
4. External Factors Influencing Default: External factors, like new product launches,
regulatory changes, and shifts in consumer behavior, can affect a borrower's
ability to meet financial obligations.
5. Role of Management in Credit Risk: The quality of a company's management,
including the experience and expertise of key personnel, is critical in assessing
credit risk.
6. Market Perception and Credit Risk: Market perception, as indicated by stock price
movements, is a useful indicator of a company's operational efficiency and
management capabilities, impacting credit risk.
 Credit (Risk) Rating
▪ Credit Risk Rating: Credit risk rating is a tool in credit appraisal that
assesses borrower risk by assigning scores to various parameters,
using weighted components based on their importance.
▪ Measurable and Judgmental Factors: Credit risk rating considers
both measurable factors like financial ratios and judgmental factors
such as management quality and default likelihood.
▪ Credit Rating Cutoff: If a borrower's credit rating score falls below the
bank's stipulated cutoff, the loan proposal is not processed further.
▪ Loan Purpose and Bank Policy: The lender ensures that the loan
purpose aligns with the bank's credit policy and does not fall under
banned or restricted activities.
▪ New Business Group (NBG): Some banks use a New Business
Group (NBG) committee to assess new customers' acceptability,
exposure levels, and pricing before detailed proposal submission.
CARDINAL PRINCIPLES OF LENDING
▪ There are four cardinal principles of lending.
(a) evaluate the creditworthiness of the
borrower,
(b) look into the purpose of the loan,
(c) assess the security/collateral and
(d) verify the cash flows and source of
repayment.
▪ It is useful to remember the important aspects
of appraisal in terms of 7Cs.
▪ These are creditworthiness, character,
capacity, capital, collateral, conditions, cash
flows, etc.
Bank finance to Government owned entities
▪ Due Diligence in Government Infrastructure Financing: Banks must
conduct thorough due diligence on the viability and returns of
infrastructure projects undertaken by government-owned entities,
not relying solely on State Government guarantees.
▪ Special Purpose Vehicles (SPVs) in Infrastructure Financing: Financing
infrastructure projects through SPVs requires specialized appraisal
skills, including risk assessment and evaluation of contractual
obligations of involved entities.
▪ Consortium or Syndication Financing: Large infrastructure projects
may require joint financing by multiple banks or financial
institutions, often under consortium or syndication arrangements,
with a common appraisal report.
▪ Term Loans to Government Entities: Term loans for government-
owned infrastructure projects should be sanctioned only to
corporate bodies, ensuring the project's revenue stream is sufficient
for debt servicing without relying on budgetary resources.
 CASH ACCRUAL
▪ Business firms have only four sources to draw upon to
repay their loans:
▪ (i) net cash inflows generated from operations,
▪ (ii) the sale or liquidation of assets,
▪ (iii) funds raised by issuing debt securities (borrowing) or
▪ (iv) additional capital infusion
 What is Cash Accrual?
▪ In accounting parlance cash flow is defined as follows:
▪ Cash Flow = Net Profit + Non-cash expenses
▪ This can be further broken down into this form:
▪ Cash Accrual = Sales Revenue (-) Cost of Goods Sold (-)
Selling, General and Administrative Expenses (-) Taxes
Paid in Cash
 COLLATERAL
• i. Personal security means personal liability of the borrower
and/or guarantor. The banker has got a right of action against the
borrower/guarantor in case the borrower defaults, for recovery
of the bank's dues legally.
• ii. Tangible security is something that can be realized by sale or
transfer (example: jewels, shares, government bonds, lands, and
goods).
• iii. Primary security is that which is regarded as the main cover
for an advance; generally, the assets purchased out of the credit
disbursed and against which the advance is made, e.g., Stocks for
Cash credit, machinery for term loans.
• iv. Additional/Collateral security is the security offered in
addition to the primary security created out of the advance and
lodged by the borrower or by a third party.