17th April 2018 Credit Analysis and Management Hand Out No 12

BA/BSc (Hons.) Business Accounting and Finance

Academic Year IV, Semester VIII, Session (2018-2018) Pages 1/11
1. Importance of Segregation of Duties in Lending Process.
2. Post Disbursement Monitoring of Lending Account
3. Post Disbursement Monitoring of Collateral
4. Adequate Insurance of All Hypothecated, Pledged or
Mortgaged Securities
5. Management of Deteriorating Credits------Watch List
Accounts

Seggregation of duties
It is a highly important factor in managing the risk of giving loans and
advances.

The following TWO banking functions namely: -

1) Credit Origination /Approval

2) Credit Administration /Security Perfection/ Disbursement

must be performed by independent groups of officers having separate

reporting lines.

Many losses have been incurred where the same officers who
Originated and Approved the Loan are involved in the Obtaining
and Perfection of security and Disbursing the facility.
The situations where the teams of recommending/approving
officers and the teams of credit administration are both under
the influence of the same persons are wrought with dangers.

1. Credit Origination/Approval
Ideally one group of officers should be involved in originating the proposal
i.e. obtaining information from the customer, evaluating the proposal and
recommending the loan proposal. The Credit Approval should be given by
the senior officer, Manager, Credit Committee or the Board depending upon
the amount involved and risk level.

2. Credit administration (CAD)/ Disbursement of Facility

The credit administration functions e.g. preparing and sending facility letter,
obtaining security, deciding that the security has been perfected and
actually disbursing the facility should be in the hands of Credit
Administration Department (CAD) which should be independent of the credit
origination and credit approval functions. CAD must not report to the credit
approval authority but to a separate chain of command to be completely
free and independent in making its decisions.

Post disbursement monitoring of account.

Now we study as to how the bank monitors the exposure granted so that
any problems in the lending relationship come to light soon and the bank
17th April 2018 Credit Analysis and Management Hand Out No 12
BA/BSc (Hons.) Business Accounting and Finance
Academic Year IV, Semester VIII, Session (2018-2018) Pages 2/11
can take measures, as soon as any situation deteriorates, for the protection
of both the bank and the customer.
The bank officers keep a close eye on the following factors.

1. Account Turnover
In a business account the turnover of the account means the aggregate of
values of the amounts that have been credited in the Bank account over any
specified period of time like one year or one month. Every business is
involved in selling something and the proceeds of sale are credited to the
bank account. The same amounts are withdrawn for purchase of new raw
materials or finished products for sale later on. The customer also
withdraws amounts for meeting other business expenses like salaries of
staff and payments for purchase raw materials, payments for utility services
like electricity, gas and for meeting other expenses. A business which is
healthy usually achieves a substantial turnover depending upon the type
and size of business. Businesses selling “products” undertake larger
turnover whereas businesses involved in sale of services whose cash flows
coming in represent mainly income have lesser turnover.
Bank keeps a keen eye on the turnover every month because any fall in
turnover is at times the first red signal of an account not performing well.
All facilities are “fully reviewed” at least annually, which means that
facilities granted are subject to annual “CAREFUL and critical LOOK” at the
relationship to decide whether the facility should be renewed for the next
period or not.
The turnover in the account is given a lot of importance and if the turnover
falls too much the banks go to the extent of recalling the loans.

2. Timely servicing of profit and agreed fees, payments of instalments of

loans, etc.
Bank keeps an eye on whether the profit and fees accrued have been paid or
not. Instalments of principal amounts are being received as agreed. This
point does not need much explanation.

3. Regular visits of the lending officers to the place of business or

production to see for themselves the level of economic activity of the
business financed.
The lending officers are required to visit the business premises at least once
in two months to see for themselves the status of the economic activity and
to discuss the situation with the concerned company officers or owners
given the dimensions of the business.

4. Remaining alert to any adverse news about the business, or any

changes in laws, monetary or fiscal policy like customs regulations
having negative implications for the business.

Post disbursement monitoring of collateral i.e. security

Facilities are granted to businesses after assessing the factors which point
to the viability of business, credit worthiness of the customer and
satisfactory cash flow projections. As a second line of defense, charges on
adequate Securities are taken. The loan will remain ‘SECURED’ only if the
security remains intact it terms of its value, its existence and bank continue
17th April 2018 Credit Analysis and Management Hand Out No 12
BA/BSc (Hons.) Business Accounting and Finance
Academic Year IV, Semester VIII, Session (2018-2018) Pages 3/11
to have an unassailable right on them. During the period of financing the
following monitoring methods are used: -

1. Loans against shares.

The market value of shares is quoted on Stock Exchange and share prices
are also reported in the newspapers. Every week all the shares held as
collateral are REVALUED at the new market rates reported in the newspaper
which gives the total present market value of shares held against each loan.
A new “drawing power” is calculated according to the ‘margin’
requirements contracted with the customer. SBP prudential regulations
stipulate 30% as the minimum margin against shares. If the outstanding is
more than the new drawing power and the fall in security is so much that a
“margin call” should be made, a notice is sent to the customer requiring him
to either give more shares as security or reduce the outstanding. If the
customer does not respond to the margin call and the market value
continues to decline and reaches a pre-decided low “sell- off” value the
bank becomes entitled to sell the shares at the going market rate and
recover its loan.
Proper documentation from the customer must be in place for the bank to
take this extreme step. The danger is that sale is irreversible and there have
been instances that if later on the share value rises the customer brings
court case against the bank for ‘the loss suffered’ by the customer. The
banks documentation should be water tight.

2. Loans against hypothecation of stocks lying in shops, factory

godowns, mills, etc.
Customer is required to give a Stock Statement every month. Bank checks
prices from newspapers, calculates drawing power as per agreed margin. If
the drawing power falls below the outstanding the bank makes a margin call
asking the customer to either give more security or reduce the outstanding.

An important point in HYPOTHECATION is that the actual security is in the

physical possession of the customer. It is therefore important for the bank
that a reliable officer of the bank should visit the place where the security is
lying to make sure that the declaration made by the customer in the stock
statement is correct and the stock under hypothecation is in good condition.
Such stock inspections are made by bank officers every two months. The
bank officer satisfies himself as to the quantity, quality and value of the
security. In case of those goods whose prices are quoted in the newspapers,
the prices are so verified. In some cases, the bank officer makes his own
judgment about the price. Bank officer checks the stocks intelligently as the
customers are known to use wooden planks or other devious methods and
arranging/stacking/setting up stocks in such a manner that a cursory look
gives the impression of much larger stocks than actually held. The moral
values are declining to new lows and there is need to be careful about such
deceitful acts. Officer should also ensure that the stocks are protected from
dampness, or other hazards depending on the nature of the goods. Bank
also ensures that adequate insurance over stocks covering risks based on
the type of goods, is always effective, current and valid for 110% of value
from a RATED insurance company as per the credit policy. The banks senior
management allot RATING GRADES to the insurance companies based on
17th April 2018 Credit Analysis and Management Hand Out No 12
BA/BSc (Hons.) Business Accounting and Finance
Academic Year IV, Semester VIII, Session (2018-2018) Pages 4/11
their balance sheets and market reputation of claim honoring and the bank
accepts insurance policy from a particular company only on the basis of such
RATING given.

3. Stocks Held Under Pledge

As you know pledge means that the possession of the goods is in the lock
and control of the bank, whereas the godown may be in the bank, at some
offsite or in the premises of the borrower.
The keys to the pledged stock are either held by the bank staff or by a
Muccaddam who is contracted by the bank to keep possession and control of
the stock on behalf of the bank. Muccaddam keeps the record of the stocks
received or delivered to the customer on the instructions of the bank
officers.
When the customer repays a part of the loan the bank officer issues a
delivery order addressed to the Muccaddam who delivers the ordered stock
and keeps record of the balance stock.

On paper the Muccadam is responsible to act with full integrity but

experience has shown frequent collusion between the Muccaddam and the
borrower and there have been instances of mysterious disappearances of
‘pledged goods’ which is immediately blamed by the customer on the bank
officers stealing the goods colluding with the bank’s agent the Mucaddam.
There are many such cases pending in the Pakistan courts.
It is therefore imperative that stocks in the control of Muccaddam should
also be occasionally inspected by the bank officers just like the
hypothecated stock.
Where a customer is enjoying pledge facilities from several banks at a time,
State bank has mandated Joint Inspection by all the lending banks to avoid
irregularities in pledge lending.

Bank should make sure that the pledged stock is appropriately insured
against the usual hazards. Since the stock is in the possession of the bank,
it is the banks responsibility that the insurance is effective.

Although pledge is a better security from the point of view that the
possession is with the bank, but this possession is a weakness as well
because if the stock is destroyed or disappears the bank is more directly
exposed.

4. Properties under mortgage

Where full projects or buildings are under mortgage, post disbursement
monitoring involves periodical inspections of the properties under equitable
or registered mortgage. It is important to check the state of repairs of
property and CURRENT VALUATION of the properties to ensure that the
lending margins are in place. Another important factor is that all govt. taxes
and utility bills relating to the building should be paid up-to date and the
property owners taxes should be paid up to date. The reason is that the
utility companies and government departments have a prior right to any
property. If the customer defaults and the property is sold to recover the
loan, the proceeds of the property will first be used to clear the government
dues including the owner’s personal taxation before the bank gets anything.
17th April 2018 Credit Analysis and Management Hand Out No 12
BA/BSc (Hons.) Business Accounting and Finance
Academic Year IV, Semester VIII, Session (2018-2018) Pages 5/11

Adequate insurance of all hypothecated, pledged, held under

trust receipt or mortgaged securities.
Bank must make sure: -
 All securities subject to insurable risks should be insured against all
possible risks.
 All insurance companies are not of the same financial strength and
reputation. Bank undertakes rating/grading of all insurance companies
based on their balance sheets and their track record of honoring claims
and bank fixes the maximum amount of a single policy that can be
accepted from each insurance company.

 All insurance policies received are checked on the criteria determined.

All insurances should be current and valid. Not expired or lapsed.
 No insurance is valid unless premium is paid. Premium paid receipt
must be present.
 All pertinent risks should be insured. These days the risks of strike,
riot and civil commotion and terrorism must be covered.
 Insurance value should be at least 10 % more than the market value.
 Insurance should be in the joint names of the bank and the customer.
 Bank should study the insurance policy to obviate any damaging
disclaimers.

Management of deteriorating credits

It will be useful to start by looking at the Classification and Provisioning
Criteria given by State Bank of Pakistan in the prudential regulations.

Classification Categories for Corporate / Commercial Exposures and SME

CLASSIFICATION DETERMINANT GUIDELINES FOR PROVISIONS TO BE MADE

APPLYING CATEGORY
(NOT EXHAUSTIVE)
Substandard Where Repayments are Provision of 25% of the
past due 90
markup/interest difference
or principal is days or more resulting from the
overdue by 90 outstanding
days or more balance of principal less the
from the due
date amount of liquid assets
realizable without recourse to
a Court of Law and 40% of the
Forced Sale Value (FSV) of
pledged stocks and
mortgaged
residential, commercial and
industrial properties (see
Note 2

Where mark-up/ <• Provision of 50% of the

Doubtful interest or Repayment are difference
principal is
overdue by 180 past due 180 resulting from the outstanding
days or more days or more balance of principal less the
17th April 2018 Credit Analysis and Management Hand Out No 12
BA/BSc (Hons.) Business Accounting and Finance
Academic Year IV, Semester VIII, Session (2018-2018) Pages 6/11
from the due date amount of liquid assets
realizable without recourse to a
Court of Law and 40% of the
Forced Sale Value (FSV) of
pledged stocks and mortgaged
residential, commercial and
industrial properties (see Note 2

(a) Where Repayment is Provision of 100% of the

Loss past due one year
markup/ interest or more difference resulting from the
or principal is Trade bills outstanding balance of
are past due 180 principal
overdue by one days or less the amount of liquid assets
more Quantified
year or more collateral realizable without recourse to a
shortfall
from the due Court of Law and 40% of the
date % of the
Forced Sale Value (FSV) of
pledged stocks and mortgaged
residential, commercial and
industrial properties (see Note 2
(b) Where trade
bills
(Import/Export or
Inland Bills) are
not paid/adjusted
within 180 days
of the due date

In all the above categories the ‘Profit on loans that has Accrued but not received
will not be credited to P &L PROFIT but to interest Suspense Account which
account is grouped in Sundry Creditors.

The above instructions by State Bank on classification and provisioning are

based on Time Based Criteria. The provisioning percentage changes as the
period of default changes.

12. Watch list accounts

What are Watch List Accounts?

It is recognized that in pursuit of asset growth, some credit decisions,
despite being undertaken properly and prudently, can still go wrong.
As per present prudential regulations the first level of classification i.e.
Substandard, is triggered only once the borrower fails to repay markup or
principal within 90 days from the due date. Obviously, the reasons and
symptoms in respect of the borrower’s inability to meet its
commitment would have occurred much earlier.
17th April 2018 Credit Analysis and Management Hand Out No 12
BA/BSc (Hons.) Business Accounting and Finance
Academic Year IV, Semester VIII, Session (2018-2018) Pages 7/11
As the financial position of the borrower is gradually deteriorating, the
conditions of the borrower may as yet not warrant adverse classification as
per SBP requirements, but is, nonetheless deemed to require special
attention /close monitoring and where necessary pre-emptive action (s)
to safeguard the bank’s interest, are needed.

Therefore, in order to protect and improve the quality of the bank’s

portfolio, a more pro- active approach needs to be adopted for prompt
reporting of loans which have started showing signs of deterioration
although on TIME BASED CRITERIA they are as yet considered regular.

An early warning system in the form of Watch list Account(s) is

instituted to cover the period between
1) the account being completely Satisfactory and

2) the account becoming Substandard as per the definition in instructions

on classification and provisioning.

The system is described in detail as follows:

DEFINITION OF WATCH LIST ACCOUNTS

A Watchlist account is one, which is as yet technically regular but it shows
risks or potential weaknesses of a material nature requiring monitoring,
supervision or close attention by the management. If these weaknesses are
left uncorrected they may result in deterioration of repayment prospects for
the bank’s credit position at some future date.

12.2 Symptoms
Deterioration in a particular account can be driven /caused by any one factor
or a cluster of factors, which primarily depends upon the intensity, which
such event(s) possess and the inherent capacity of the borrower to sustain
such adversity(s).

Whilst, certain factors are briefly mentioned below, it is important to state

that this is not a definitive / exhaustive list comprising of all such factors
which can cause deterioration in a particular account. Hence, if there are
any other concerns, the same should also be reported to senior bank
management.

The appearance of the following symptoms should prompt the

management to consider transferring the account to the WATCH
LIST section.

Industry and Competition

 Position within the industry eroding
 Small player without real competitive advantage
 Unlikely in long term to emerge as an industry winner. Industry may be
mature, may be in long term decline and / or in a cyclical downturn
 Low entry barriers or high exit costs likely, etc.
17th April 2018 Credit Analysis and Management Hand Out No 12
BA/BSc (Hons.) Business Accounting and Finance
Academic Year IV, Semester VIII, Session (2018-2018) Pages 8/11

Ownership / Management
 Changes in ownership / management or key personnel
 Concerns exist over the ability of the management to effectively
manage existing operations
 Venturing into acquisitions, diversification, and new product lines etc.
 Owners show lack of commitment to support business operations and
succession risks are apparent; Lawsuits etc.
Financials
 Balance Sheet
 Disproportionate increases in current debt i.e. Liabilities vis-à-vis
current Assets.
 Substantial increases in long term debt.
 Increase in level of gearing. The trade debtors delay payment of
Sale proceeds. Debtors-concentration, extended terms, increased
average age of debtors is also sign of financial decline.
 The company delays payments to suppliers. Creditors – extended
terms, concentration, substantial increase in average age of
creditors
 Deterioration in Cash Flows
 Qualification of accounts. It means negative observations given in
the Annual Report by the external auditors.
 Sale and leaseback of existing plant and equipment, etc. A
company in liquidity problems can sell machinery and plant
owned by them to a bank or a leasing company and can lease
back the same equipment. The company gets liquid cash as sale
proceeds which solves their shortage of funds and the machinery
remains in their possession as it is leased back.
 However it means that the financial strength of the company is
declining.
 Income Statement
 Declining or rapidly expanding sales
 Narrowing margins: Gross Profit Margin, Net Profit Margin
 Operating losses
 Increase in interest expenses
 Rising level of total assets, while sales and profits are stagnant.
 Performance not meeting projections, etc.

External factors – such as Government policies, International trade

regulations, state of economy etc. should also be considered for watch
listing of accounts

Conduct of Account
o Delays in providing insurance policies to bank.
o Delays in providing regular stock reports
o Last three payments on account of profit or principal installments
delayed by 30 days
o Overdue export bills
o Export performance not met
17th April 2018 Credit Analysis and Management Hand Out No 12
BA/BSc (Hons.) Business Accounting and Finance
Academic Year IV, Semester VIII, Session (2018-2018) Pages 9/11
o Security documentation formalities not completed / deficient for
last three months

It is reiterated that aforementioned is not an exhaustive list, concerned

departments should consider any other factor(s) / event(s) which they
regard might be a potential threat for their respective clients vis-à-vis
bank’s credit portfolio and should be reported to senior management.
Appropriate measures should be taken and conveyed so as to safeguard the
bank’s interest adequately.

12.3 Action to be taken if an account qualifies for watch list

status
 Watch list accounts are to be reported to senior management within a
reasonable period of time upon identification of symptoms
 Any additional facilities to be provided to a Watch list account(s) should
be referred to higher authorities for approval
 Risk rating assigned to the client should be reviewed in light of prevailing
circumstances

An account may be reclassified as a Regular Account from Watch

list account status when the symptom(s) causing the classification no
longer exist.

 Branch to prepare periodical WATCHLIST REPORT which should give:-

 Reasons to Watch list

This should comprise of factor(s), which the concerned loan officer deems,
thinks , can have a material adverse impact on the customer and
henceforth may lead to weakness in the account and repayment capacity
becomes doubtful. The consequences of such factors / events should
additionally be incorporated in anticipated outcome section

 The final section should comprise of strategies / action plans undertaken

for rectification of the subject account(s).

12.5 Watch list Summary

A summary of Watchlist accounts would be provided to senior management
and consists of the following:_

 Section 1
All Accounts reported on the preceding monthly summary which were not
resolved or where symptoms persist. This also includes counter parties,
which require watch listing.

 Section 2
All those accounts, which have been watchlisted during the current month,
further so as to maintain continuity, all those accounts, which have reverted
back to Regular Account Status, should also appear in the monthly summary
report for efficient recording purpose.
17th April 2018 Credit Analysis and Management Hand Out No 12
BA/BSc (Hons.) Business Accounting and Finance
Academic Year IV, Semester VIII, Session (2018-2018) Pages 10/11
12.6 RESPONSIBILITIES of Officers Monitoring Loan Accounts:-
Lending Officers are responsible for:
 Identifying promptly any deteriorating signs (briefly mentioned earlier) in
credit quality on all accounts within their respective portfolio
 Assessing the level of risk when any deteriorating signs are observed and
taking appropriate action to minimize risk of loss to the bank
 Recommending in consultation with team leaders and department heads
necessary measures taken / to be taken for safe-guarding the bank’s
assets

The Senior Management will check the Watch List Reports and assess the
remedial steps taken by the Lending officers and guide them in their
strategy for improving the performance of the accounts.

Many accounts will be saved from further deterioration by the timely

intervention of the lending banker as recommended above.

This completes the study of Watch List Accounts. Now we move

to the next stages of infection.

ACCOUNTS WHICH BECOME IRREGULAR/NON PERFORMING AS PER

TIME BASED CLASSIFICATION AND PROVISIONING CRITERIA.

TREATMENT IN SUB STANDARD CATEGORY

. If, however, despite the efforts of the bank the performance of a Watch
List account does not improve but further deteriorates and the period of
unpaid interest or principal touches or exceeds 90 days but the unpaid
period is less than 180 days, it will be classified by the branch in the
category of SUB STANDARD AND APPROPRIATE ‘CLASSIFIED’ REPORTING TO
CREDIT INFORMATION DEPARTMENT (CIB) OF SBP AND THE HEAD OFFICE
WILL START. Provision will be made at 25% of the outstanding amount.

The lending branch will double its efforts to persuade the customer to meet
their financial commitments and use all the techniques described above with
the only difference that the account now will be called a Classified sub
standard account instead of
Watch List Account.

If the account continues to deteriorate the further classifications will be

DOUBTFUL AND LOSS.

NOW I WISH TO INTRODUCE THE CONCEPT OF

Special Assets Management Group.
SAMG.

If the amount is small further handling of the non performing loan will by
the branch granting the loan.
17th April 2018 Credit Analysis and Management Hand Out No 12
BA/BSc (Hons.) Business Accounting and Finance
Academic Year IV, Semester VIII, Session (2018-2018) Pages 11/11
Once an account reaches the doubtful category, however, and
the amount is large (Every bank has different criteria of
largeness. For several banks Rs 25 million is large.) the account
will subsequently be handled by
Special Assets Management Group.

it is deemed that when a LARGE account is in a very poor shape the

circumstances warrant that it should be directly handled by officers who are
specially trained in the handling of defaulted debts. The loans with such
level of infection are usually called SPECIAL ASSETS and they are
transferred to SPECIAL ASSETS MANAGEMENT GROUP (SAMG) which is a
department in the Regional office or Head office having officers with
experience in handling Non Performing Accounts.

SAMG handles LARGE accounts classified as Doubtful and Loss and we

will study the details in the next lesson.
_______________________________________________________________________________________