LENDING OPERATIONS

AND RISK MANAGEMENT

SYED FAZAL AZIZ

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LIFE IS UNCERTAINTY
Life is uncertainty. None of us can be totally sure about anything save death and taxes, the French philosopher noted : Knowledge is like a balloon in an atmosphere of ignorance as the balloon grows, contact with the unknown increase twice as fast. The more we know, the more realize we dont know It is in this atmosphere that risk management exists. Risk management provides a logical and systematic method for dealing with uncertainty.
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What is lending?

The principal reason banks are chartered by state and federal authorities is to make loan to their customers. Banks are expected to support their local communities with an adequate supply of credit for all legitimate business and consumer financial needs and to price that credit reasonably in line with competitively determined interest rates. Moreover, bank loans often seem to convey positive information to the marketplace about a borrower's credit quality, enabling a borrower to obtain more and perhaps somewhat cheaper funds from other sources.

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For most banks, loans account for half or more of their total assets and about half to two-thirds of their revenues. Risk in banking tends to be concentrated in the loan portfolio. When a bank gets into serious financial trouble, its problems usually spring from loans that have become uncollectible due to mismanagement, illegal manipulation of loans, misguided lending policies, or an unexpected economic downturn.

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TYPES OF LOANS

MADE BY BANKS
What types of loans do bank made? Banks make wide variety of loans to a wide variety of customers for many different purposes.

From setting up a business, industry or purchasing raw material, to meet day to day need or purchasing auto mobiles and buying new furniture, taking dream vacations or pursuing college education to constructing home. This diversity of bank lending have been arranged by grouping bank loans according to their purpose.
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Why lending is important? Role of Banks for the growth of economy

This industry, composed of thousands of firms worldwide literally affects the welfare of every other industry and the economy as a whole. As many countries in Asia have recently discovered, when banks stop lending and accepting the risks that go with it, the rest of the economy grinds nearly to a hall, land and security prices fall, unemployment lines lengthen, and businesses begin to fail. Healthy banks and healthy economies just seem to go together.

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Banks are among the most important financial institutions in the economy. They are the principal source of credit (loanable funds) for millions of individuals and families and for many units of government (school districts, cities, counties, etc.). Moreover, for small local businesses ranging from grocery stores to automobile dealers, banks are often the major source of credit to stock the shelves with merchandise or to fill a dealer's showroom with new cars. When businesses and consumers must make payments for purchases of goods and services, more often than not they use bank-provided cheques, credit or debit cards,
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or electronic accounts connected to a computer network. And when they need financial information and financial planning, it is the banker to whom they turn most frequently for advice and counsel.

Banks are among the most important sources of short-term working capital for businesses and have become increasingly active in recent years in making long-term business loans for new plant and equipment. Moreover, bank reserves are the principal channel for government economic policy to stabilize the economy.
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Life line for the economy

Five Cs Character Capacity Capital Condition Cash flow

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FUND BASED FACILITIES

Domestic Import

Business

Export

Domestic Business Fund Based Facilities Facilities where funds are provided to customers upon sanction to the respective credit lines.
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Policies

All financing facilities shall be governed in conformity of SBP PRs and Bank's Policies. In Compliance with the regulatory requirement laid down in BC circular No. 13/1984, financing to be necessarily structured around the Shariah compliant frame work of "Sale and buyback of goods Drawings in Cash Finance account shall be allowed against stocks, whose purchase is financed by the bank.
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No finance facility shall he allowed against perishable goods without additional conditions as mentioned in Security chapter. Pledge facility shall not outstand against stocks older than 180 days or before their shelf life whichever is earlier.

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Purpose

A business may borrow for various short term or long term financial needs in any of the following common modes of financing: WORKING CAPITAL FINANCE This caters to the regular needs of business. Normally, a certain limit is granted and the loan amount fluctuates within the limits. It is normally granted in the form of Running Finance / Cash finance for a period of one year.
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SEASONAL WORKING CAPITAL

The seasonal working capital on the other hand is for a specific season and must ordinarily be paid off in full towards the end of the season. This is normally applicable for agriculture and agro based industries such as cotton ginning, wheat, rice paddy etc. FIXED INVESTMENT These are long term financing facilities with tenors exceeding 01 year and are usually allowed to finance acquisition of fixed assets i.e. plant & machinery payable in installments or lump sum at pre-determined future time period.

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COMBINATION OF FUND BASED AND NON FUND BASED FACILITIES

At times depending upon the requirement of the borrowers, limits are structured in such a way that it consists of combination of fund-based and Non-fund based facilities. For instance, in case of imported plant and machinery, if bank finances retirement or documents then a non-fund based working capital facility (L/C) would be converted to a term loan that is adjustment of a contingent liability will give rise to a long term funded facility and shall be called LC cum DF facility. The other combinations are LC cum FlM or LC cum CF e.t.c.

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MODE OF FINANCE
SHORT TERM
Following modes of financing are included in the Short Term category as their liquidation is likely to take place within a year:Working Capital Finance: a) b) c) d) Running Finance Cash Finance Pre-shipment Export Finance Packing Finance Post shipment Export Finance Export Bills Purchased Export Bills Discounted
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Import Finance: a) Letter of Credit b) Payment against Document c) Finance against Imported merchandise d) Finance against Trust Receipt Bill Financing: a) Inland Bills Purchased / Discounted

LONG TERM
Fixed Investment: a) Term Finance Demand Finance
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COMBINATION Fund-based and Non-fund based facilities

a) Import L/C cum Demand Finance b) Import L/C cum Cash Finance c) Import L/C cum Finance d) Others

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WORKING CAPITAL FINANCE FACILITIES CASH FINANCE

Cash finance facility account is a drawing account against a credit limit granted by the Bank. Its a revolving facility which may be freely drawn upon, as the borrower requires during its currency by way of multitransactions within the approved limit and available drawing power subject to compliance of approved terms and conditions. Moreover borrower can reduce the balance temporarily whenever he is in a position to do so. The security may change from time to time according to the borrower's business requirement but within the items admissible under the sanctioned terms provided it always fully covers the balance outstanding in the account plus the stipulated margin. The account is generally used when the finance limit granted is secured against the pledge / hyp of goods / produce (raw material produced locally or imported for value addition or finished commodities).

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OPERATIONAL PROCEDURE

The operational procedure of the account differs from bank to bank. Some banks debit the Cash finance account with the entire amount of credit limit and the corresponding entry is passed by crediting the Current account from where he withdraws the amount as and when needed. In NBP bank this practice is not followed instead the borrower shall be allowed to withdraw the amount from cash finance account up to the drawing power according to the value of security and the terms of limit.
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ADVANTAGES

Principal advantages of a Cash finance account to the borrower are that unlike the recipient of a demand Finance. he may draw on the account within the prescribed limit as he requires and can save Mark up on the advance by reducing the outstanding temporarily whenever lie is in a position to do so.

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RUNNING FINANCE

Like Cash finance, the Running finance account is also a drawing account which may be freely operated by way of multi transactions provided the security available covers the outstanding balance and the margin. The borrower does not require withdrawing against his security under pledge to the Bank as frequently as required in Cash Finance Account. The facility is generally granted against the pledge of various deposits certificates, Govt. securities. It can also be provided against any other tangible securities such as stocks of-stores & spares work in process and assignment of receivables.
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The nomenclature of account would be as under:

Running Finance (Pledge) other than the stocks/produce Running Finance ( Hyp) Running Finance (Mortgage) In considering applications for Running Finance against mortgage of immoveable properties as a primary security, it must be borne in mind that immovable property are regarded as undesirable security by the Bank as immovable property is, as a general rule, difficult to realize.

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Conditions in Case RF against hypothecation of Stocks in Trade / Produce:

The facility shall only be allowed to high networth customers. Healthy turnover in the account corresponds to sale proceeds.

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DIFFERENCE

The borrower does not require withdrawing against his security under pledge to the Bank as frequently as required in Cash Finance Account.

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EXPORT FINANCE FACILITIES

AVAILABLE MODES
The following common modes of export finance facilities are:1. Packing Finance 2. Bill Financing 3. Export Refinance Policies / Guidelines on each mode is covered below.

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PACKING FINANCE
Packing Credit facility is made available to clients engaged in export business.

Basic Features:

Facility is allowed by the bank from its own resources. They are given to intending exporters of various commodities including those commodities not eligible for financing under Export Re-Finance Scheme.

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This credit facility is to enable him to produce or buy goods for eventual shipment in accordance with the letter of credit or the foreign buyer's contract. The facility is required from the time the customer purchases the goods or raw material with the Bank's money until the export documents are received and negotiated by the Bank. The facility involves a self-liquidation mechanism as it will be adjusted through realization of export proceeds.

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OUT-WARD BILLS FINANCING

TYPES OF BILLS Outward Bills against which finance is provided can broadly be categorized in two types:-

Inland Bills ii. Foreign Bills MODES OF BILL FINANCING

i.

Financing against inland/foreign bills can be provided to Exporters/drawers of bills by allowing post shipment financing facility under any of the following modes:i. ii. iii.

Negotiation Purchase Discounting

Whatever terminology is used all the modes involve financing against exports receivables. Bank pays the exporter and receives the export proceeds to adjust the facility.

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NEGOTIATION Concept

The act of buying an export bill is called Negotiation. This is a post shipment facility, extended by the Bank to exporters to finance export receivables through purchase of export bills from exporters. The bank as a negotiating bank pays exporter the value of export bill and assumes risks of non-realization of export proceeds due to documentation errors exchange rate risks.

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FINANCING AGAINST EXPORT BILLS Concept

Besides Negotiation it is another mode of postshipment finance facility extended to exporters in order to finance export receivables until realization. A post shipment finance limit called "Finance Against Foreign Bill" (conventionally called "Export Bills Purchased Limit EBP") is sanctioned in favor of exporter. It is allowed in instances:Where the criteria of Negotiation are not met or Borrower prefers to avail this type of facility over negotiation to avail the gain through favorable exchange rate fluctuation as explained subsequently
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DISCOUNTING Concept

This is also a post shipment facility to finance export receivables. It is always extended for the purchase of Usance export bills. It is similar to the FBP facility with the difference that the export bill being purchased must be duly accepted by issuing bank (in case of an LC) or the importer (in case of documents on collection basis) for payment at a fixed or determinable maturity date.
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NEGOTIATION SPECIFIC POLICIES

Under this mode, the bank as a negotiating bank buys the bill and pays exporter the value of export bill and accepts risk of nonrealization of bill proceeds due to documentation error.

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IMPORT FINANCE FACILITIES (FUND BASED)

When the importer require post-import financing whereby the Bank will pay exporters (through negotiating abroad) to be subsequently re-paid by the importer after a specific period. Such a financing facility can take following forms:MODES
1.
2. 3.

Payments Against Documents (PAD) Financing against Trust Receipt (FATR) Financing against Imported Merchandise (FIM) a. Pre-approved Arrangements b. Forced FIM
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PAYMENTS AGAINST DOCUMENTS (PAD)/ Bill of Exchange (BE)

The documents as per mark-up agreement would be purchased by the Bank and sold to the importer at the marked-up price. When an import Bill is received and lodged, two types of transactions shall be deemed to have taken place i.e. purchase and sale of documents.

Purchase

The documents pertaining to the import Bill will be purchased by the importer's bank at Bill amount plus negotiating bank's charges less margin, if any. This shall be the Purchase Price of the import Bill by the bank.
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Sale
After the import Bill is so purchased at the above price, it shall be sold by the Bank to the importer after applying the mark-up and Bank commission where applicable. This marked-up amount shall be the selling price of the import bill by the Bank. The sale price of the bill shall be payable by the borrower upon receipt of shipment.
Forced FIM In case of borrower's failure to retire import documents despite arrival of shipment, immediate step shall be taken for conversion of PAD facility into forced FIM.
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FINANCING AGAINST TRUST RECEIPTS

The customers, on whose behalf the Bank issues a letter of credit (local/foreign) may desire to obtain the documents of title to goods received under the L/C to enable them to obtain delivery of goods and arrange to retire the bill out of the sale proceeds of goods. If bank considers the request favorably. The documents of title are delivered against the customers signature on the prescribed Trust Receipt form and execution of related security documents. This is a liberal financing facility because it allows the borrower to freely deal in the goods i.e. sell them without the bank interfering in sale activities. However, as the title suggest, the goods are released by the bank in "trust" which pre-supposes that the trust reposed by the bank in the customer will not be betrayed.
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It implies that in terms of the Trust Receipt executed by the customer at the time of taking the import documents, the customer will promptly deposit with the Bank sale proceeds of these goods.

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FINANCING AGAINST IMPORTED MDSE (FIM) CONCEPT:

Under the facility of Finance Against Imported Merchandise (FIM), imported goods come into the control of the Bank as soon as they are off loaded from the carrier (aircraft/ship). Clearing/forwarding shall be carried out by the Bank's approved clearing/forwarding agent and the agent is required to transport the goods to a warehouse under supervision of the Bank's approved Muccadum. The stored goods remain under Bank's custody of lock and key and watch & ward. The client takes delivery of the goods against payment later on either in lumpsum or in piecemeal.
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ACCOUNTS SUITABLE FOR FIXED INVESTMENT

Demand Finance
Term loans facilities are allowed for fixed investment financing. It mostly has maturity of more than one year however it can be for a period less than one year. Purpose

The facility is generally allowed for purchase of plant & machinery & spare parts or for other needs of capital expenditure however, DF may also be created as a result of restructuring/rescheduling of working capital facility (ies).

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Account Mechanism

A Demand Finance account is an advance of fixed amount for a tenor of more than one year, where no debits to the account may be made subsequent to the initial advance except for the mark-up, insurance premium and other sundry charges applied by the Bank.

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NON-FUND BASED FACILITIES

CONCEPT
Non-fund based facility is a contingent liability i.e. a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events. Under such type of financing, banks takes no funded exposure on the borrower.

GUARANTEES
Introduction / Concept Need

Generally guarantees are issued by Banks for guaranteeing specific payments at future dates by its customers or for guaranteeing completion of a particular performance by the customer.

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Nature of The Bank Guarantee Facility

Bank guarantee is an undertaking given by the bank to a third party, called beneficiary on behalf of a person, a customer; to be answerable for a debt of any person or its customer, upon default of the debtor (customer).

TYPES OF GUARANTEES THE BANK ISSUE

In the normal course of business the Bank issue the following types of Guarantees and Bonds, categorized according to the nature of purpose its issued for: Performance Guarantees Bid Bonds/Tender Deposit Guarantee Shipping Guarantees Guarantees for Advance Payments/Mobilization Guarantees Security Deposit Guarantees Guarantees for payment of dues / Court Guarantees
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1. 2. 3.

4.
5. 6.

7. 8. 9. 10.

Loan repayment guarantee Permanent guarantee Guarantee expressed in FCY Standby Letter of Credit (SBLC )

As a general rule directed by State Bank of Pakistan guarantee issued must be for a specific amount, specific period, that is, the guarantee text issued must have a specific expiry date, and all claims must be lodged within the expiry date.

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However, for certain specific instances, SBP has lately vide its amendment No. BPRD Circular # 07 dated 4th April 2000 and 24 dated 9th September 2002 (also the part of PR # 7 of (Corporate/Commercial) allowed issuance of continuing / open-ended (that is for indefinite period of time) guarantees as under:

Banks are allowed to issue open-ended Guarantees without clearance from State Bank of Pakistan provided Banks/DFIs have secured their interest by adequate collateral or other arrangements acceptable to the Bank/DFI for issuance of such guarantees in favor of Government Departments, Corporations/Autonomous bodies owned/controlled by the Government and guarantee required by the court.
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LETTER OF CREDIT

CONCEPT OFF (LCs) Letters of Credit (LCs) are among those banking facilities, which bank commonly offers. It is a liability of the importer to the LC issuing bank and that of LC issuing bank to the LC negotiating bank.

It is termed contingent because at the time of establishing the LC, neither the importer nor the LC issuing bank are liable for payment under the LC.

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TRUST RECEIPT
TO: BANK: BRANCH: DEAR SIRS,
1.

IN CONSIDERATION OF YOUR HANDING OVER TO ME/US AT MY/OUR REQUEST THE GOODS/DOCUMENTS OF TITLE TO GOODS AS PER PARTICULARS AT THE FOOT OF THIS INSTRUMENT HELD BY YOU AS SECURITY FOR MY/OUR INDEBTEDNESS TO YOU I/WE HEREBY AGREE AND UNDERTAKE TO HOLD ANY AND ALL THE GOODS/DOCUMENTS IN TRUST FOR YOU AND AS SECURITY FOR ALL THE OBLIGATIONS FOR WHICH THEY FORMED SECURITY BEFORE THEIR DELIVERY TO ME/US HEREUNDER AND ALSO FOR ANY VALUE ADVANTAGE OR CONVENIENCE GRANTED OR AGREED TO BE GRANTED BY YOU TO ME/US AS APART OF THIS TRANSACTION.
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2.

3.

I/WE FURTHER AGREE TO KEEP ANY AND ALL SUCH GOODS/DOCUMENTS IN WHATEVER FORM THE SAME MAY BE AT ALL TIMES SEPARATE AND CAPABLE OF IDENTIFICATION AS PROPERTY HELD IN TRUST AT ALL TIMES ACCESSIBLE TO YOU FOR INSPECTION OR OTHERWISE AND TO SURRENDER THE SAME AND ACCOUNT THEREFORE TO YOU FORTHWITH UPON DEMAND. I/WE ADMIT THAT MY/OUR REQUEST FOR THE DELIVERY OF GOODS/DOCUMENTS TO ME/US IS FOR LIMITED AND SPECIFIED PURPOSE OF ENABLING ME/US MUCCADUM/CLEARING & FORWARDING AGENT IN DUE COURSE OF THE BUSINESS IN RESPECT OF WHICH FINANCE IN DUE COURSE OF THE BUSINESS IN RESPECT OF WHICH FINANCE HAS BEEN PROVIDED TO ME/US BY YOU TO BE CARRIED ON BY ME US AT MY/OUR PREMISES OR PREMISES WITHIN OUR EXCLUSIVE CONTROL AT AND I/WE UNDERTAKE NOT TO DEVIATE FROM THE SAID SPECIFIC PURPOSE NOR TO REMOVE OR PERMIT OR CAUSE THE REMOVAL OF THE SAID GOODS OR DOCUMENTS OF TITLE RELATING THERE TO FROM THE SAID PREMISES, WITHOUT YOUR PRIOR WRITTEN CONSENT.
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4.

5.

6.

I/WE FURTHER AGREE TO KEEP INSURED IN YOUR NAME AND AT MY/OUR OWN COST AND EXPENSES ALL GOODS DELIVERED TO ME/US OR GOODS REPRESENTED BY ANY OF THE DOCUMENTS HEREINBEFORE REFEREED TO AGAINST LOSS BY FIRE, THEFT, RIOT, CIVIL COMMOTION AND ANY OTHER RISK REQUIRED BY YOU AT ANY TIME AND TO DELIVER ANY AND ALL POLICIES AND PREMIA RECEIPTS OF SUCH INSURANCE TO YOU IMMEDIATELY. IT IS HEREBY AGREED AND ACKNOWLEDGED THAT YOU MAY TERMINATE THIS TRUST OR TRANSACTION WITH OR WITHOUT NOTICE TO ME/US AND MAY ENTER INTO ANY PLACE WHERE ANY GOODS /DOCUMENTS REFERRED TO ABOVE ARE KEPT OR MAY BE FOUND AND RESUME DIRECT CONTROL THEREOF. I/WE AGREE THAT IF ANY OF THE GOODS REFERRED TO ABOVE ARE UNDER YOUR APPROVAL OR ACCORDING TO THE TERMS HEREOF SOLD BY ME/US THE PROCEEDS THEREOF SHALL BE YOUR PROPERTY AND SHALL IN ALL RESPECTS BE TREATED BY ME/US AS BELONGING TO YOU AND EARMARKED AS YOUR PROPERTY AND IN TRUST WITH ME/US FOR YOU.

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7.

8.

9.

WHERE SALE IS CONTEMPLATED WITHIN THE SAID SPECIFIC PURPOSE I/WE FURTHER UNDERTAKE THAT NO SALE BY ME/US OF THE ABOVEMENTIONED GOODS SHALL BE MADE EXCEPTING FOR CASH TO BE PAID OVER TO YOU FORTHWITH. I/WE FURTHER AGREE THAT NO FAILURE OF COMMISSION OR INDULGENCE ON YOUR PART TO TAKE ACTION ON MY/OUR FAILURE TO COMPLY WITH ANY OF THE PROVISIONS OF THIS INSTRUMENT SHALL BE DEEMED TO BE A WAIVER BY YOU OF ANY OF YOUR RIGHTS OR REMEDIES. IT IS AGREED THAT ON PAYMENT BY ME/US IN FULL OF MY/OUR INDEBTEDNESS TO YOU THIS INSTRUMENT SHALL BE CANCELLED BY YOU AND DELIVERED UTO ME/US AND THEREUPON THE ABOVEMENTIONED GOODS SHALL CEASE TO BE GOVERNED BY THIS INSTRUMENT.
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10.

11.

I/WE FURTHER REPRESENT AND CONFIRM THAT THE ABOVE MENTIONED GOODS/DOCUMENTS HAVE NOT BEEN PLEDGED HYPOTHECATED, CHARGED OR ENCUMBERED IN ANY MANNER WHATSOEVER AND I/WE AM/ARE THE ABSOLUTE OWNER(S) THEREOF, SUBJECT ONLY TO YOUR RIGHTS AS PLEDGEE. I/WE FURTHER AGREE AND UNDERTAKE NOT TO PART WITH POSSESSION OF PLEDGE, HYPOTHECATE, CHARGE OR ENCUMBER THE ABOVE MENTIONED GOODS/ DOCUMENTS TO ANY OTHER BANK, COMPANY OR PERSON FOR OBTAINING ANY FINANCE OR FOR ANY OTHER PURPOSE AND IF I/WE ATTENTION TO DO SO YOU SHALL BE ENTITLED FORTHWITH TO TAKE POSSESSION THEREOF AND DISPOSE OF THE SAME IN ANY MANNER AND TAKE POSSESSION THEREOF AND DISPOSE OF THE SAME IN ANY MANNER AND TAKE SUCH ACTION AGAINST ME/US AS YOU DEEM FIT.
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12.

13.

I/WE AGREE AND ACCEPT FULL RESPONSIBILITY FOR ANY ACT, OMISSION, FAULT, NEGLIGENCE, FRAUD DISHONESTY OR INEFFICIENCY OF ANY OF THE AGENTS AND EMPLOYEES PARTICIPATING, ENGAGED OR EMPLOYED IN THIS CONNECTION AND I/WE UNDERTAKE NOT TO HOLD YOU RESPONSIBLE FOR ANY LOSSES, HARMS OR DETRIMENTS OCCURRING IN CONSEQUENCE THEREOF OR HOWSOEVER ARISING. I/WE AGREE THAT IN CONNECTION WITH ANYTHING RELATING TO THIS INSTRUMENT IF YOU RECOMMEND OR HAVE RECOMMENDED ANY AGENTS OR EMPLOYEES OR ENGAGE OR HAVE ENGAGED THEM OR IF THEY HAPPEN TO BE PERSONS WHO WORK FOR YOU OR ARE BOUND BY THE TERMS OR ANY CONTRACT WITH YOU THEN THIS FACT SHALL NOT EFFECT MY/OUR RELATIONSHIP WITH THEM AS PRINCIPALS AND AGENTS AND YOU SHALL NOT BE RESPONSIBLE OR LIABLE FOR ANY OF THEIR ACTS, OMISSIONS, NEGLIGENCE, DEFAULT, FRAUD, DISHONESTY OR INEFFICIENCY.
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DATES & DESCRIPTION OF DOCUMENTS OF TITLE TO THE GOODS AND IDENTIFICATION

QUANTITY AND ESTIMATED VALUE

NUMBERS AND MARKS

EMANATING FROM WHAT TRANSAACTION

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