Credit Management

CHAPTER 1: NATURE OF CREDIT

INTERMEDIATION PROCESS

Introduction

• The financial services industry touches the lives of every individual, household and business within the economy.
• Individuals and households provide savings to financial institutions which transform them into financial assets.
• In this content, financial institutions act as financial intermediaries bridging the distance between depositors and borrowers.

• Process of Intermediation

Depositors > Financial services industry > Borrowers

• The players in this Financial Services Industry are known as Financial Services Firms and they consists of the following:
  1. Commercial Banks;
  2. Merchant Banks;
  3. Finance Companies
  4. Scheduled Institutions

Instruments in government

• In a conventional banking system, Central Banks usually employ six primary methods for implementing monetary policy :

1. Statutory Reserve Requirement
2. Minimum Liquidity Requirement
3. Interest Rate Regulation
4. Selective Credit Control
5. Capital Adequacy Ratio
6. Base Financing rate / Cost of Financing

• These instruments have a similar effect on the quantity of money and credit in the economy.

1. STATUTORY RESERVE REQUIREMENT (SRR)

• SRR is one of the oldest monetary instruments deployed by BNM to control the liquidity situation in the banking system.
• SRR is a powerful instruments available to BNM because it affects the level of deposits and loans that a bank can legally support.
• Any increment in the SRR ratio will:
  • Reduce the level of reserve available to the banking institutions
  • Decrease the lending ability of the banking institutions
• Any decrement in the SRR ratio will:
  • Increase the level of reserves available to the banking institutions.
  • Increase the lending ability of the banking institutions.

1. MINIMUM LIQUIDITY REQUIREMENT (MLR)

• Under 38(1) of the BAFIA 1989, the banking institutions are required to observe a minimum liquidity ratio.
• The ratio is also expressed as a percentage of the EL based on the banking institutions.
• The current definition of liquid assets are:

- Cash - Cagamas Bond

- Money at Call - Treasury Bills

• It operates in the same manner as the SRR. Therefore when the liquidity ratio is raised, the amount of deposits and loans supplied by the reserves will decrease.

1. INTEREST RATE REGULATION

• An important instrument which BNM can control including the bank’s liquidity and cost of bank credit through the interest rates charged on bank loans as well as the rates of interest offered for deposits.
• Increment of the interest rate will :
  • Increase the level of cost of funds for the banks loans
  • Decrease the demand for bank loans
• Decrement of the interest rate will :
  • Decrease the level of cost of funds for the banks loans
  • Increase the demand for bank loans

1. SELECTIVE CREDIT CONTROL

• Credit facility is important to all economic sectors but due to certain consideration, some sectors need special protection.
• Guideline on lending to these priority sectors are issued by central bank in order to achieve the target loans to these sectors.
• This priority sectors comprise of small and medium industry, Bumiputra community, agricultural sector and low and medium house buyers.

1. CAPITAL ADEQUACY CONTROL (CAR)

• Capital Adequacy Ratio (CAR) is a ratio that regulators in the banking system use to watch bank's health, specifically bank's capital to its risk. Regulators in the banking system track a bank's CAR to ensure that it can absorb a reasonable amount of loss.
• Regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.
• Capital adequacy ratio is the ratio which determines the capacity of a bank in terms of meeting the time liabilities and other risk such as credit risk, market risk, operational risk, and others. It is a measure of how much capital is used to support the banks' risk assets.

1. BASE FINANCING RATES (BFR) / COST OF FINANCING

• is the cost and interest and other charges involved in the borrowing of money to purchase assets.

Aspect in Risk Management in Credit

Selection: A good credit risk management starts with a good selection of the counterparts and products. Good risk assessment models and qualified credit officers are key requirements for a good selection strategy. Important credit decisions are made at credit committees. For counterparts with a higher default risk, more collateral is asked for to reduce recovery risk.

Recovery risk is also reduced by requiring more stringent covenants, e.g., on asset sales. A good selection strategy also implies a good pricing of the products in line with the estimated risk.

Limitation: Limitation restricts the exposure of the bank to a given counterpart, it avoids the situation that one loss or a limited number of losses endanger the bank’s solvency. The total amount of exposure to riskier counterparts is more restricted by a system of credit limits. The limit setting of the bank determines how much credit a counterpart with a given risk profile can take.

Diversification: The allocation process of banks will provide a good diversification of the risk across various borrowers of different types, industry sectors and geographies. Diversification strategies spread the credit risk in order to avoid a concentration on credit risk problems. Diversification is easier for large and international banks.

Credit enhancement: When a bank observes it is too exposed to a certain category of counterparts, it can buy credit protection in the form of guarantees from financial guarantors or via credit derivative products. By the protection, the credit quality of the guaranteed assets is enhanced. This is also known as credit risk mitigation.

CHAPTER 2: MARKET STRUCTURES

MARKET STRUCTURES OF LOANS AND ADVANCES

There are three (3) types of loans in the market, namely:

1. Consumer Loans
2. Commercial loans (subdivided into Lower Retail Market and Upper Retail)
3. Corporate Loans

i. CONSUMER CREDIT

• Consumer credit is the first group of financing in a bank’s portfolio. It is a main business in banking Malaysia. Consumer credit is a borrowed funds used for personal, family or household use. Consumer credit is obtained individually or jointly, but not for business or commercial use.

• TYPES OF CONSUMER CREDIT PRODUCTS

1. Credit card
2. Personal financing
3. Housing loan

1. CREDIT CARD

• Credit cards or 'plastic money' are a substitute for cash payments. As it says it is a credit given to the customers by the issuer/bank in order to pay for goods or services. It usually involves an unsecured debt up to a predetermined limit payable over a deferred period through instalments. Moreover, cash advance can be obtained through credit card.

ADVANTAGE IN USING CREDIT CARD

• Immediate Possession- Customer can get any goods/money in a short time.
• Convenience- Buy now and pay later.
• Emergencies- In case customer in emergencies to get something very important to them, they can buy on credit and pay letter.
• Saving Money- Buy an item while it is on sale.
• Growth of the Economy - Buying goods will help the economy expand.

DISADVANTAGE IN USING CREDIT CARD

• Overbuying- Most common hazard.
• Careless buying- Comparison shopping may not be a priority. Credit encourages customer to buy without think first.
• Higher Prices- Some stores offer discounts for cash sales.
• Overuse of Credit-Too much is owed – unable to pay back.
• Credit Fees- Interest paid on balance
• Habit Forming

CHARACTERISTICS CREDIT CARD

• Grace period- the number of days by the ends of which you have to pay your bill in full.
• Fees – consumer must know if a card has annual fees, late payment fees (Ta’widh), foreign transaction, cash advance fee, or any other fee.
• Cash advance features – credit card can be used to get cash advance through the ATM machines.
• Credit limit - some cards set their own credit limits based on customer’s income.
• Rewards and bonuses. These can include various extra points, gifts and services for customer to enjoy more in using credit card.
• Free financial charges period – usually banks give 20 days’ free charges if consumer able to pay full payment after transaction have made.
• Financial charges – occur when consumer pay by deferred payment such as consumer choose to settle their payment in a year. Hence, total amount of transaction made will be added with financial charges for a year. The rates of charges depend on the bank.
• For Islamic credit card, there are prohibited to involve in illegal activities.

1. PERSONAL FINANCING

• A personal financing is a type of debt which is made for personal, family, or household use, and which is neither a business loan nor a long-term mortgage loan. The bank funded money to the consumer. The consumers pay back this amount, usually but not always in regular instalments. This service is generally provided at a cost, which is referred to as profit rate on the financing.

CHARACTERISTICS OF THE PERSONAL FINANCING

• Interest rate/ profit rate – whereas is a percentage applied to financing. For example, when someone made financing from the bank, bank will calculate the profit rate from the principal amount of the consumer financing. To calculate profit rate, formula PR=PRT will be used whereas PR profit rate, P for principal amount, R for rate and T for time.
• Principal amount – principal amount is an amount of money borrowed by the consumer from the financial institution.
• Time factor – time factor is a length of time which interest or profit rate will be charged. Usually, the long time to settle the credit, the greater the interest rate or profit rate will be charged.
• Finance charge or fees – fees that will be calculate on the process of customer financing. For example, service charged.
• Annual percentage rate (APR) – indicate how much credit cost on a yearly.

1. HOUSE FINANCING

• House financing is a Shariah based financing facility to finance the purchase of all types of residential properties including houses, flats, apartments or condominiums. It can also be used to refinance existing facilities taken either from conventional housing loans or other house financing schemes.

CHARACTERISTICS OF THE HOUSING FINANCING

• Purpose:

For purchase of house from builder/resale and construction/ extension of existing house.

• Loan Amount:

You can avail for Home loans ranging from RM 1K to RM.100K depending on your eligibility, income, and repayment capacity.

• Security

Home loan is a secured loan wherein collateral are required.

• Loan Tenor

The maximum loan tenure is 25 years

ii. COMMERCIAL CREDIT

• A pre-approved amount of money issued by a bank to a company that can be accessed by the borrowing company at any time to help meet various financial obligations. Commercial credit is commonly used to fund common day-to-day operations and is often paid back once funds become available.
• Commercial credit is often used by companies to help fund new business opportunities or to pay for unexpected charges. For example, imagine that XYZ Manufacturing Inc. has the chance to buy a piece of much needed machinery at a deep discount. Let's assume that the piece of equipment normally costs $250,000, but is being sold for $100,000 on a first-come, first-serve basis. In this example, XYZ Manufacturing could access its commercial credit agreement to get the required funds immediately. The firm would then pay the borrowed amount back at a later date.

iii.CORPORATE LOANS

• Corporate loans are loans granted to corporate clients, and list below provides the classifications.
• Possible Classification :
  1. Multinational companies (MNC)
  2. Public listed companies (PLC)
  3. Companies with large equity
  4. Large borrowing needs
  5. Complexity of borrowing
  6. Subsidiary of a listed company
  7. Branch / representative office of the parent company, and
  8. Government bodies
• It excludes :
  1. Individuals
  2. Sole proprietorships
  3. Partnerships
  4. Associations
  5. Societies, and
  6. Sovereign countries

ISLAMIC FINANCING CONCEPTS

• ISLAMIC CONCEPT OF CREDIT
• The Islamic concept of credit must refer to the contract of loan (qard) without interest. A contract of loan with interest is deemed invalid.
• The contract of loan in Islam shall consist of the following :
  1. Creditor and Debtor
  2. Object : Money
  3. Price of Object : Zero
  4. Offer and Acceptance

THE ROLE OF CREDIT

• The role of loan and credit in Islam is purely on co-operation and mutual help (ta’awun)
• Hence, although an Islamic loans does not charge interest, there is heavy and serious concern on the settlement of the loan.

PURPOSES OF CREDIT

• An Islamic Credit or loan is given away not for business purposes. Creditors in the Islamic system do not make loans as a business venture.
• Instead, they will do so under a partnership arrangement (mudarabah) with the business partner and not through loans.
• An Islamic loans is given to those who have the capacity to pay.
• The loan is used to finance certain needs such as expenditures on basic necessities.
• Some people borrow to help others while some may borrow to settle their tax obligations
• The idea of lending money for vacation travels or other leisure and pleasurable purposes are not encouraged in Islam.
• A loan is made to help people in distress and not to motivate them to fall into debt as is evident in the present day credit market.

ISLAMIC FINANCING PRODUCT

HOME FINANCING

• House financing-i is a Shariah-based financing facility to finance the purchase of all types of residential properties including houses, flats, apartments or condominiums
• A fixed-rate, Shariah-compliant home financing based on the concept of Bai' Bithaman Ajil (BBA).
• BBA is defined as "deferred payment sale". BBA involves the sale and purchase transactions between the bank and the customer. Under this concept, customers may defer total payment of asset which is the property in installments over a specific period of time.
• Fixed payment that shows exactly what customers need to pay throughout the tenure. Useful for those working on a monthly budget.

Purpose:

• Financing purchase of residential properties, whether completed units or units under construction
• Refinancing/Remortgage/Additional financing
• Construction of bungalows
• Conversion from conventional to Islamic financing
• Restructuring

PERSONAL FINANCING

• An Islamic Personal Term Financing under the Shariah principle of Bai' 'Inah(sale with immediate repurchase).
• Bai' 'Inah is a buy and sell contract whereby Islamic Bank (“the Bank”) would sell its assets to the applicant on deferred payment basis.
• Subsequently, Islamic Bank (“the Bank”) would buy back the same asset from the applicant at a lower price on cash basis.
• Under Bai' 'Inah concept, Islamic Bank will use its asset as an underlying asset for the sale and purchase transactions.
• Purpose:

• Debt Consolidation
• Emergency Needs
• Educational
• Home Improvement
• Medical
• Others

VEHICLE FINANCING

• Hire Purchase-i is based on the underlying Shariah principle of Al-Ijarah Thumma Al-Bai (AITAB).
• It means leasing and subsequent purchase. It refers to 2 contracts undertaken separately and consequentially i.e. Al-Ijarah contract (leasing) and Al-Baicontract (purchase).
• It is an extension of the principle of Al-Ijarah whereby both parties further agreed that at the end of the lease period, the customer will purchase from the Bank the asset concerned at an agreed price with all the lease rentals previously paid constituting part of the price.
• Operations of Hire Purchase-i are based on Hire Purchase Act 1967 whereby all provisions that conform to Shariah requirement are applicable.

CHAPTER 3: CREDIT ASSESSMENT

Attributes of good credit and methods of credit assessment

1) Comply with credit parameters

- Credit officers must comply with both external and internal parameters. This is to ensure that the business of lending is carried out within the country’s legal framework and the respective lenders’ policy guides.

External parameters:

-Malaysian laws require that lending institutions not engage in any illegal lending activity and at all times be mindful of the provisions as set out in the various legislation such as the Companies Act 1965, the Banking and Financial Institutions Act 1989, and the National Land Code 1965 and the BNM Directives.

Internal parameters

- The lenders’ set of credit policies, procedures together with their internal circulars must be complied with at all times. Consistently applying them will help build a strong credit culture within the lenders’ organizations.

2) Engage in credit that is within the lenders’ respective financial resources

- In layman’s terminology, this principle is to ensure that lenders do not swallow a deal too big for their stomach. It can “choke” lenders to death or cause uncomfortable “indigestion” if it turns out to be non- performing. Bank Negara Malaysia monitors this by limiting the amount of exposure extended by a bank to a single borrower or a group of borrowers. This is to ensure that lenders will not collapse due to one non- performing loan. The Bank for International Settlement sets the minimum capital requirements. Bank Negara Malaysia then monitors the position of each lender to ensure that it is adequately capitalised. Indicators such as the Loan-Deposit Ratio and the Capital Adequacy Ratio can assess the lenders’ financial resources.

3) Lenders should only extend credit within their competence

- Lenders should not extend credit to businesses that they do not have any competence in. We are not talking about the competence of an individual credit officer but the competence of the lender as an organisation. For example, a lender should not be engaging in property development financing if the organisation has no competence within the real estate market. The lender can acquire competence through headhunting or identifying credit officers with initiative and giving them the opportunity to develop the skill.

4) Lenders’ primary business is to lend profitably

Lenders at times need to be reminded that they are in the business of lending. It is only when they lend, will they generate income. However, the amount of income they generate depends largely on the spread (the difference between the lending rate and the lender’s cost of funds), which must be sufficient to cover the following:

- Operating costs: One of the major components is staff salary. Hence,

it is important for staff to recognise their cost to the lenders and do their best to obtain the best possible spread for the lenders. Other major cost components are administration and general expenses, and establishment expenses (such as rental and depreciation).

- Possible loan losses: Lenders should try to earn an extra bit from each

deal to cover for possible losses due to non-performing loans.

-Reasonable return to the lenders’ shareholders: With the concept

of Capital Adequacy Ratio, shareholders have to provide sufficient capital to support the loan assets. Hence, credit officers must ensure that they are earning a reasonable rate of return on behalf of the shareholders.

5)Lenders must be mindful of the risk-return concept .

6)Quality of credit is more important than exploiting new opportunities.

7)Every loan should have two ways out that are mutually exclusive and identified from the beginning.

8)The purpose of the loan should contain its repayment basis.

9)Understanding the business cycle is critical.

10) Assessing a company’s management competence is vital .

PRINCIPLES OF GOOD CREDIT

1) ORIGINATION

• Origination is the starting point of a credit process. Here, the lenders

- identify the following:

(a) Target credit markets;

(b) Priority sectors;

(c) Products on a portfolio basis; and

(d) Key individual/business customers.

• The risks, assets (loans) and acceptance criteria (RAAC), can be set based on minimum sales, profitability, net worth, and account profitability to the lender for business credit. For consumer credit, it can be based on age, minimum loan amount, high net worth individuals, industries in which the individual is employed, employment years in present job, payment history, income per annum, capping deductions as a percentage to income, i.e. debt to income ratio, etc.

2) APPROVAL

• Consistency and sound decision making are essential for the success of the credit process. The approver analyses the contents of the credit memorandum, credit investigation report, and other data to reach a decision consistent with the lender’s definition of acceptable credit risk. Consequently, the marketing effort results in approval, modification or rejection. If it is modified, it then goes back to the origination stage. Rejection terminates the relationship. If approved, then a letter of offer and other relevant in house documents are prepared. These documents will usually be in the lender’s standard format containing the lender’s standard clauses and modified to include or delete certain clauses where necessary. At this stage, the potential customer may accept or decline the offer. If accepted, the process continues to the next stage, i.e. administration.

3) ADMINISTRATION

• Security documentation is perfected in this stage. If the collateral offered is land, then a panel solicitor will be appointed to perfect the documents. For clean facilities, documentation would be simple and can be completed by the lender himself. The objective is to prepare for the facility to be drawn down. It is advisable for another person (not the marketing person) to do an independent check. This will serve as a check and balance to ensure all conditions precedent are complied with, thereby, reducing the risk of overlooking any required document, and also not compromising on late submission. Also, to overcome any abuse in favour of self interest. Therefore, the final approval for draw down must be endorsed by credit administration and never by the marketing section.

4) MONITORING

• Once a facility is disbursed, then starts the collection effort. Besides collection, tracking of conditions antecedent is also done at this stage. Some examples are renewal of fire insurance, computation of drawing power, payment of sinking fund, etc. The annual renewal for business credit is a big exercise. The borrower’s risk profile is revisited together with any need for additional financing or any need to pare down the facilities. Audited or management financial statements will be called for to do an evaluation. Utilisation of credit facilities will be reviewed together with account profitability. The end result is to see if the lender wishes to continue or to phase out the relationship. For programmed consumer credit such as housing or vehicle loans, an annual review is redundant.

5) CONTROL

Measures to ensure facilities are operated continuously for the intended purpose are done. Red flags if any are also looked out for. If problems are detected, then remedial management either by way of rescheduling or restructuring will be done to prevent the account from turning nonperforming. Only as a last resort are legal remedies undertaken, by enforcing the collateral, suing principal borrower and guarantors if any. However for credits, which are repaid in accordance with the agreed terms, the relationship will be terminated in due course. Any collateral offered as security will be discharged accordingly.

The 5’C Approach

- The subjective judgemental approach of decision-making, that is an approach to evaluating credit worthiness using different variables. This is commonly categorised as the 5 ‘C’s of credit, namely

1. CHARACTER

• To lenders, this is the most important requisite and the most difficult to measure precisely. The financier needs to determine whether there is a willingness in the character to pay.
• Even if the character has the capacity to repay, his/her credit may still be declined if his willingness to pay is questionable.

• The factors normally considered in examining a character are:

a) Past records of the client or credit history;

b) Stability and duration of his employment/business;

c) Experience and qualification; and

d) Reputation.

2) CAPACITY

• Capacity looks into the client’s ability to pay and handle the proposed new level of debt.
• The client’s income is evaluated firstly. Secondly, his net monthly flow and his ability to repay credit obligations as well as other expenses.
• Thirdly, the client’s marketability or ability to change jobs. This is determined by past earnings, future earnings and past records of meeting obligations.
• The client’s age must be above legal minority to be capable of entering into a contractual borrowing relationship with the financial institution

3)CAPITAL

• This is a measure of the net value of a client’s assets which form back up liquidity to meet his repayment. In a housing loan, the higher the client’s margin contribution (his capital), the higher is his psychological commitment to pay the loan.
• The client’s capital is determined by his current level of liquid assets, current level of unsecured borrowings and his list of income sources, fixed expenses and contingent liabilities.

4) CONDITION

• This is will prompt the financier to examine whether the client’s employment or business will withstand the vagaries of the economy, social, political and international environments, government regulations, competition or changes in the bank’s policies.
• As an example, a client who is employed in a manufacturing company which is shifting its operations to China may soon find himself without a job. His future prospects may be bleak if his special skills are not in demand locally.

5) COLLATERAL

• As character is listed as the first and most important ‘C’, Collateral is listed as the last. This is so because, collateral is considered only as a cushion for the financier to rely on when the primary source (income) does not come in.
• A financier would prefer that a loan is repaid rather than having to collect proceeds through auction of the collateral.
• Collateral is examined on its easy disposability and whether it is adequate as security.

CAMPARI MODEL

• C = Character
• A = Ability to pay
• M = Margin of Finance
• P = Purpose
• A = Amount
• R = Repayment terms
• I = Insurance

CAMPARI MODEL

• Character of the customer – this is the willingness to pay versus ability to pay.
• Ability to borrow / repay – this means adequate cash flow to meet repayment.
• Margin of profit – The lender will not finance for 100 percent, borrower must introduce a certain degree of commitment.
• Purpose of loan – the borrowing purpose must be clearly defined and supported by relevant documents.
• Amount of loan – the amount of commitment the financial institution is prepared to risk on the applicant.
• Repayment terms – this means the structure and terms of repayment.
• Insurance – in the event the borrower dies, there is a payout sources.

THE CREDIT SCORING APPROACH

• Whilst the 5 ‘C’s and CAMPARI trigger the financier in his evaluation, the financier can use yet another method called the credit scoring approach. The elements and their corresponding weight vary from bank to bank.
• Uses

1. Credit scoring helps processing consumer credit faster.

2. The score is obtained immediately when loan application data is keyed in.

• Benefits

1. A consistency in decision-making is maintained.
2. There is quicker process time, especially with automated credit scoring.
3. Individual biases are eliminated.
4. Credit scoring provided an objective analysis of loan applications.
5. It ensures that all applications are treated fairly.
6. It provides for easier training and development of new lenders by providing a uniform systematic approach to decision making.
7. It could prevent credit losses and improve profitability by rejecting high risk applications.

• Among the most important variables:
  1. Credit bureau ratings (CTOS,FIS,CCRIS)
  2. Home ownership income bracket
  3. Number and type of deposit accounts
  4. Type of occupation
  5. Time in current job

PREDICTIVE FACTORS IN AN EXAMPLE OF A CREDIT SCORING MODEL AND THEIR POINT VALUES

Factors for Predicting Credit Quality

Point Value

1.

Customer’s Occupation or line of Work :

Professional or business executive

100

Skilled Worker

80

Clerical Work

70

Student

50

Unskilled worker

40

Part-Time employee

20

2.

Housing Status :

Owns Home

60

Rents home or apartment

40

Lives with friend or relative

20

3.

Credit rating :

Excellent

100

Average

50

No Record

20

Poor

00

4.

Length of time in current job :

More than one year

50

One year or less

20

5.

Length of time at current address :

More than one year

20

One year or less

10

6.

Telephone in home or apartment

Yes

20

No

00

7.

Number of depends reported by customer :

None

30

One

30

Two

40

There

40

More than Three

20

8.

Deposits accounts held :

Both checking and savings

40

Saving account only

30

Checking Account day

20

None

00

QUANTITATIVE ASPECTS OF CREDIT ASSESSMENT

FINANCIAL ANALYSIS

• The use of financial ratios to analyses or determine the financial health of a borrower has long been employed by banks. As ratios are statistics, they can be manipulated. It is, therefore, important to bear the following in mind :

1. A ratio reflects the relationship between two items. Sometimes, it is important to closely examine the two items individually, instead of accepting the ratios without any question.
2. To be effective, ratios must be obtained using two items that are related.
3. One ratio certainty does not tell the whole story. Usually, several ratios have to be considered to get a better picture. One ratio must be interpreted in the light of other ratios.
4. A ratio tell the relationship between two items at a certain point in time. Therefore, the trend of a ratio is just as important. This is study of the ratio over several periods to gauge the trend.
5. Ratios are as goods the figures used to calculate them. If the figures are inaccurate, the ratio will not be accurate. Fortunately, the accounts presented to bankers nowadays are very much improved compared to 20 years ago.

COMMON RATIOS USED IN FINANCIAL ANALYSIS

• The common ratios used in financial analysis are :
  • Profitability
  • Liquidity
  • Leverage
  • Activity/Efficiency ratios
  • Trend analysis, and
  • Peer group

1. Profitability

These ratio’s measure the borrower’s ability to earn profits. They, indirectly, are a measure of the management’s abilities and effectiveness.

1. Return on equity

This ratio measures the amount of profit attributable to shareholders per ringgit of shareholders funds. This is, therefore, the earnings of shareholders funds for the year or financial period.

ROE = Profit after Tax (net income)

Capital Employed (owner’s equity)

1. Return of Assets

This ratio measures the return on profits earned by the assets employed. It indicates how effectively assets have been used to generate income.

ROA = Net Profit after Tax

Total Assets

1. Net Profit margin

This measures the return in sales, that is, how much profit in every ringgit of sales.

= Net Profit After Tax

Sales

1. Gross Profit Margin

This ratio measures the profit from sales before the effect of overheads, while (iii) above shows the effects of overheads on the profits.

= Gross profit X 100

Sales

1. Operating Profit Margin

This ratio is derived after deducting all costs and expenses excluding interest charges and taxes from the sales figure. The higher this ratio means it higher of profitability of the company.

= Earning before interest and tax

Sales

1. Liquidity

These ratio indicate the ability of a company to “lay its hands on cash”. A company with a high liquidity ratio is able to easily convert its assets to cash to meet its immediate commitments.

1. Current Ratio

A current Ratio of less than 1 indicates that the company will not be able to meet itsimmediate obligations. This is not necessarily bad in itself. Further investigation into the components of the current liabilities may reveal certain items that are “not so current” in nature. Also, certain fixed assets or investments may be easily disposable if the need arises.

= Current Assets

Current Liabilities

1. Quick / Acid Test Ratio

In certain instances, this may be a better ratio than (i) above. This is because stock is included in the current assets. This stock may not be easily disposable especially if is work in progress.

= Current Assets – Stocks

Current Liabilities

1. Leverage

these ratios show the relationship of debt and equity. This premise is that the more capital a borrower has the less likely he is to default.

1. Gearing Ratio/debt to equity ratio

Equity consists of share capital plus reserves plus undistributed profits. Debt is made up of all borrowings (both long – and short-term) and preferences shares (if any)

= Debt

Equity

1. Debt Ratio

This ratio indicates the relationship between total liabilities and total assets. It shows how much asset backing there is for a company’s liability

= Total Liabilities

Total Assets

1. Times interest covered

this ratio shows how many times the earning can cover the interest payment. Bankers are usually very interested in this ratio as their income is directly reflected in this ratio. A ratio of less than 2 would be a cause for concern.

= EBIT*

Interest

* EBIT = earnings before interest and tax

1. Activity

These ratios evaluate the efficiency of a company and its management of its assets

1. Total Assets Turnover

This measures the sales generated by every ringgit of asset

= Sales

Total Assets

1. Fixed Assets Turnover

This measures the sales generated by every ringgit invested in fixed assets.

= Sales

Fixed Asset

1. Inventory Turnover

This indicates how fast the stock is cleared.

= Cost of Goods Sold

Inventory

1. Average Collection Period

This indicates how efficient the company is in collecting its credit sales

= Accounts Receivables X 365

Sales

1. Trend Analysis – Is then compared to the trend in the different industry
2. Peer Group – compared another company in the same industry

FLOW IN CREDIT ASSESSMENT PROCESS

• In considering a loan/financing, the officer is required to understand the importance of the following basic issues and apply this knowledge towards the credit evaluation of the borrower (customer)
  1. Ability to pay
  2. The customer must have a fixed income or monthly salary to service the loan repayment.
  3. The loan amount must also be reasonable within his means to repay.

Willingness to pay

1. This refers to the customer’s preparedness to pay.
2. Some customers may have the ability to pay but may delay the repayment process, this should be discouraged.

Purpose and payment protection

1. The loan purpose must not be in conflict with the policies and objectives of the country as specified by BNM.
2. The purpose must also satisfy economic conditions and market trends.
3. Payment protection refers to the security / collateral offered by customer.
4. Should the customer fails to repay the loan, the bank will liquidate the security and recover the loan outstanding.
5. Security is the second line of defense or second way out for the bank / financie.

INDUSTRY RISK ANALYSIS

•RISK MODEL

•I) Quantitative Risk Analysis

•- Financial Analysis

•(Ratios & quantitative methods)

•

•- Industry structure

•- Economic Condition

•- Technology

•- Company Conditions ( Management, Product, Manufacturing & Distribution & Raw Materials)

•- Foreign Exchange Impact

ANALYSIS PROFILE OF INDUSTRY

• The industry in relation to their risk profiles are:

1. Trading company
2. Manufacturing company
3. Contracting company
4. Housing development company
5. Mining Company
6. Leasing and hire purchase

* Find out profiles for each industry.

1. Risk analysis for Trading Companies

- Weak on first party collateral

- Products and market risks

- Economic risks

-Forex risks

- Liquidity risks

- Capital risk due to weak reserves

1. Risk analysis for Manufacturing Company

- Raw materials supply risk

- Product risk

- Market risk

- Forex risk

- Technology risk

- Cost over-run risk

- Contractor’s risk

- Fire risk

- Management risk

1. Risk analysis for Contracting Company

- Performance risks

- Liquidity risks

- Over trading risks

- Assignment of contracts risks

1. Risk analysis for Housing Development Company

- Demand risks

- Completion risks

- Cost overrun

- Bridging financier risk

- End – financier risks

PROCEDURES IN CREDIT STRUCTURING

1. Choice of credit/loan products

- recommending the best financing alternative to

the borrower

- the credit facilities perhaps a combination of

several credit/loan products

1. New products

1. Define credit parameters

- The credit parameters measure based on

amount of loan, tenure, repayment schedule,

interest rate and availability period

1. Choice of security

- Usually, security consist of debentures, landed

assets, stocks and shares and fixed deposit

1. Choice of other forms of support.

- Refer to a combination of different types of

security such as guarantees and subordination.

TYPES OF CREDIT PRICING FORMULA

• There are three methods of credit or loan pricing, namely:

i. Rates that describe a method of calculating the

interest on loans – simple interest.

ii. Rates that describe the behavior of the interest

rate over the loan term – fixed rate and

variable rate (BLR and KLIBOR).

iii. Other rate definitions – annual percentage rate

(APR)

CREDIT MEMORANDUM

• A credit memorandum should cover the following areas:

1. Suggested Framework

1. Purpose – to state the purpose and loan amount.
2. Facility rationale
3. Financial analysis
4. Risk analysis
5. Security
6. Conclusions and recommendations

1. Appendix

- Along with the credit memo, there will be appendices attached, that included:

1. Principal terms and conditions
2. Directors’ profiles
3. Financial spread
4. Others

TYPES OF RISK COMPLIANCE UNDER SHARIAH PERSPECTIVE

a) Credit risk

• Credit risk is defined as the possibility that an Islamic bank customer or third part will fail to meet obligations in accordance with agreed terms. Credit risk aims to maximize a bank’s risk adjusted rate of returns by maintaining credit risk exposure within acceptable parameters. Credit risk includes as following:

1. Default risk ( non-repayment by customers)
2. Recovery risk ( inability to recover the loan amount)

1. Market risk

• Market risk consists of interest rate risks, profit rate risk, exchange rate risk and commodity risk, with interest rate risk as the main source of market risk.

c) Operational risk

• Operational risk is defined as the risk of losses resulting from inadequate or failed internal controls involving process, people and systems. It also arise due to failures in governance, business strategies and processes

CHAPTER 4 : CREDIT SECURITY

SECURED CREDIT

Secured credit

• Secured credit refer to collateral that is often required to reduce level of risk.
• If the borrower encounters problems and is unable to repay a secured loan.
• The lender may take steps to realise the collateral, subject to the provisions in the loan contract and security agreement under the contractual terms.

UNSECURED CREDIT

Unsecured credit

• Unsecured credit are credit loans made to customers who offer no collateral for the credit extension.
• Some lenders follow conservative practices regarding unsecured loans.
• Personal clean loans are restricted only to high net worth individuals.
• For corporations, they must have a good name in the market with strong cash flows and meaningful unencumbered assets.

Types of collateral

Types of collateral suitable as security for financing purposes:

1. Landed properties
2. Shares
3. Debentures
4. Deposits
5. Guarantee Scheme

LANDED PROPERTIES

• Land is the most common security taken by a lender.
• The National Land Code 1965 defines land to include anything that is permanently affixed on to the land. E.g: a building.
• The definition of land under the National Land Code 1965, we are referring to empty land only and the usage of land could be for agricultural, residential or industrial.

STOCK AND SHARES

• Stock and shares together with other related investment instruments are a commonly accepted financing security.
• As collaterals, these shares are divided into two types:

i. Quoted shares

- These shares of companies that are listed on

main board & second board (KLSE)

ii. Unquoted shares

- These shares are shares of either private limited

companies (e.g: XYZ Sdn Bhd)and public but

unlisted limited companies (e.g: ABC Bhd)

DEBENTURES

• A debenture of a company is a document which contains an acknowledgement of indebtedness on the part of the company.
• It usually gives a charge on the company’s assets to secure that indebtedness.
• Refer to the Companies Act 1965, debentures can only be given by companies and financial institutions do not ask debentures from sole-proprietorship or partnership business.
• The documentation required is the Deed of Debenture.
• The Deed of Debenture must cover the following items:

i. A fixed charge refer to a charge all fixed assets

ii. A floating charge refer to all floating assets

iii. A restriction

iv. A “Power of Attorney”

1. A “Reflation”

DEPOSITS/FIXED DEPOSIT

• Fixed deposits also called time deposits are by far the best form of collateral due to their liquid form.
• Advantages of deposit:

- Easily realisable

- Documentation is simple and easy to take

- Interest compounded upon renewal will increase the principal amount.

GUARANTEE SCHEME

• A guarantee is not considered a collateral because it is not a tangible assets.
• It is merely a place document that acts as a form of support to strengthen the loan commitment.
• The realisation of a guarantee is to enforce it in a court of law if the guarantor refuses to honour his obligations when called to settle a debt owing to the financial institution.

Tests of suitable security

• Basic criteria as tests for taking suitable security:

1. Value

• value of the security can be ascertained without much difficulty and must be stable over the years

ii. Realisability

• This means the ease with which the security can be realised for cash and at the same time ownership can be transferred without much difficulty.

iii. Validity

• It is refer to validity of a title.
• The title of security should be safe and unquestionable.

1. Indefeasibility

• Refer to the security as prospective purchasers would not want to buy the security if the title is likely to be subject to dispute by third parties which may have a claim on that security.

LIQUIDATION ANALYSIS FOR DEBENTURES

Calculations – Fixed Interest securities

The price of a fixed interest security is the sum of the present value of the face value and the present value of the coupon stream

$100 face value

$10 coupon

20 years to maturity

10% market rate

Calculation of debenture

Present value of face value

= 100 x 1/1.1020

= 100 x 1.4864

= $ 14.864

Annuity present, present value of coupon

= 10 x (1 – 1/1.1020)/0.1

= 10 x 8.5136

= $ 85.136

Total Debentures

= 14.864 = 85.136

=$100

EVALUATE METHODS OF TAKING COLATERALS : CASH DEPOSITS, LAND, SHARES, AND DEBENTURES

1. Deposits

Process flow

Facts: The individual borrower wishes to apply for an overdraft against his fixed deposit.

1.1 Memorandum of deposit

The borrower executes memorandum of deposits of the fixed deposits and discharges the original fixed deposit receipt in favour of the financial institution.

1.2 The letter of set-off

In the place of memorandum of deposits letter of set-off is executed to allow the Financial Institutions to set off the proceeds of the fixed deposit to the loan account in the event of default.

1.3 Lien on fixed deposit

The financial institution places a lien on the fixed deposit by stamping the words ‘under lien’ on the fixed deposit instrument and placing a condition code in the computer system.

1.4 Stamping

Stamping for a memorandum of deposit is ad valorem. The letter of set off invites a stamp duty of RM10.

1.5 Realisation of the security

In the event of default, the fixed deposit is cancelled and the proceeds are applied to set off the loan amount outstanding.

1.6 Releasing the security

If the debt is duly settled, the lien on the fixed deposit is cancelled, the condition code removed and the memorandum of fixed deposit cancelled. The original fixed deposit receipt id delivered to the borrower.

2. Shares and Debenture

2.1 Memorandum of deposit

The client executes a memorandum of deposit of the shares.

A power of attorney to sell the shares on behalf of the borrower in the event the borrower defaults.

2.2 Transfer forms – under CDS and non-CDS

Transfer form to be executed by the borrower. The transferee to be stated as the financial institution’s nominee company.

2.3 Registration of shares under bank’s nominee company

The transfer will be processed by the nominee company, which will send the transfer documents to the appropriate company register. The client’s respective shares in the CDS account will be transferred to the CDS account of the nominee company. Upon transfer, the FI can consider it to be a legal mortgagee of the shares.

2.4 Dividends, bonus issues and rights issues

Dividends and bonus issues are credited to the CDS accounts of the borrower with the nominee company. Rights issues allotted are advised to the borrower for his disposal.

2.5 Stamping

Stamping for a memorandum of deposit is ad valorem. Power of attorney invites a stamp duty of RM10.

2.6 Realisation of the security

When there is a default in the overdraft, the FI will dispose of the shares in the open market after giving due notice to the borrower.

2.7 Releasing the security

The first step the financier will take will be to demand repayment from the borrower. Upon default, the financier can start the realisation process. As the financier is the registered owner, it sells the shares to the authorized broker.

For shares that have been transferred to the nominee’s name, the nominee company will have to execute a stock transfer form showing the borrower as transferee. This will be sent to the company’s register who will transfer the shares to the borrower’s CDS account. The memorandum of deposit is to be cancelled.

COMPARE METHODS OF TAKING FORMS OF SUPPORTS : GUARANTEES, WORKS OF ART, JEWELLERY, LIFE POLICY AND BOOK DEBTS

1. Guarantees

Process flow

The guarantor to sign a guarantee form preferably in the presence of the solicitor who is required to explain the purpose of the guarantee.

1.1 Stamping

Nominal stamping fee is charged.

1.2 Realisation of the guarantee

If the loan is at default, the financial institution will demand the monies from the guarantor after exhausting action against the borrower. If the guarantor fails to pay, legal action will be instituted.

1.3 Releasing the guarantee

If the debt is settled, the FI will cancel the guarantee and inform the guarantor.

2. Book Debts

Instructions for the collection of book debts due to the insolvent’s estate will be made by using form that insolvency agency provide which who will undertake to accept all instructions received from the official receiver for the collection of book debts (and IPAs/IPOs) regardless of the age of the debts or whether the book debts have been described as irrecoverable by the director, partner or bankrupt.

The debt collection agreement is exclusive and means that insolvency agency is the only party currently that the official receiver can instruct to undertake book debt collections and where instructed by the official receiver they must undertake to collect, or attempt to collect, those debts on behalf of the official receiver. The official receiver should make no attempt to actively recover book debts other than through them.

3. Life policy

Process flow

Scenario : A borrower wishes to apply for a loan secured by his life assurance policy.

3.1 Process

The documentation is by way of legal assignment. This can be done by endorsement on the policy or by way of an absolute deed or assignment.

3.2 Deposit of the original life policy

The financier has to establish the surrender value from the assurance company and determine if this is adequate for the loan.

3.3 Stamping

Stamping for an assignment is on an ad valorem basis. The financier to notify the insurance company of the assignment. A notification of the assignment is to enable the financier to sue in his own name, have a prior claim on the policy monies, and ensure that the monies are paid to the financier on maturity.

3.4 Realisation of the policy

If the borrower is at default, the Financial Institution will surrender the policy to the assurance company with an undertaking from the insurance company to forward insurance monies to the account of the client. The FI will discharge the assignment to the assurance company.

3.5 Releasing the policy

If the debt is settled, the FI will discharge the assignment and release the policy to the borrower.

4. Work of art and jewelleries

Determine what property you're willing to put up as collateral. You may be required to leave the property with the lender as a condition of being approved for a loan. You should only use a personal item as collateral for a loan if you won't need access to it and you're not concerned about it being damaged, lost or stolen while in the lender's possession.

Calculate the property's value. If you're not sure what an item is worth, you may need to get a professional appraisal. Generally, the lender will base the amount of the loan on the item's estimated resale value. For this reason, it's important to know how much your property is worth beforehand to ensure that you're getting a fair deal.

Research potential lenders. The type of lender you choose may depend on the type of property involved, the item's value, the amount you need to borrow and your credit history. For example, if you have good credit and you're using a high-value item as collateral, a traditional bank or credit union may offer you the best terms. If you have bad credit, only need a short-term loan and your property has a lower value, a pawnbroker may be your best option

Complete the lender's application process. For bank loans, you'll need to provide proof of identity and your Social Security number for a credit check. You'll also need the deed or title to the property and the property itself. For pawnshop loans, you need a photo ID and the item you're using as collateral.

CHAPTER 5 : CREDIT ADMINISTRATION AND DOCUMENTATION

LETTER OF OFFER

• This is the first document that goes out from the bank to the customer whereby the bank agrees to grant or make available to the customer.
• Letter of offer is an offer from the bank to the customer.

CONTENTS LETTER OF OFFER

1. Borrower : name and address of the borrower must be clearly stated
2. Facility : type of facility that is being recommended
3. Amount : exact amount and currency involved
4. Purpose : purpose of the loan must be clearly defined (e.g : purchase of shop house, etc)
5. Tenure : duration of the loan

DEFINITION CREDIT COVENANT

• Covenants are really a type of contractual arrangement that, if validly reached, is enforceable by a court. They can be phrased so as to prohibit certain actions and in such cases are sometimes called negative covenants.
• An agreement, contract, or written promise between two individuals that frequently constitutes a pledge to do or refrain from doing something.
• The individual making the promise or agreement is known as the covenantor, and the individual to whom such promise is made is called the covenantee.

CONTENT OF A FINANCING AGREEMENT

1. Definition: Defines the lender and borrower, defines interest rate and explain what is BLR or BFR and all other banking terminology used.
2. Purpose of financing.
3. Loan commitments: amounts and currency
4. Availability of the funds : period and termination date.
5. Repayment : based on schedule.
6. Prepayment and cancellation : timing & penalties
7. Interest – margin (spread)
8. Fees, costs and expenses : commitment fee

i) Taxes and other deductions

1. Illegality : the bank is entitled to recover the full loan amount if there is an illegal event.

• Conditions precedent
• Representations and warranties
• Undertaking of covenants
• Event of defaults
• Option available
• Governing law
• Jurisdiction subject to the court

LEGAL ASPECT IN FINANCING DOCUMENTATION

1. Use proper legal name of the borrower as exactly appears in the NRIC in all financing documentation. For a corporation, the banker needs to verify the name of by obtaining a copy of its charter from the Registrar of Company.
2. Ascertain that if the owner of the collateral is not the borrower himself than the owner must execute all security documentation.
3. Make sure that there are signature of the borrower and guarantors on the financing documentation. For a corporation, it must clearly indicate the number of signatories required and the capacity of the individual signing the documentation.
4. To have a complete and accurate collateral description. For example, where land is given as collateral information such as location, size, owners and users of the land should be accurate
5. Financing that are secured with real property, a banker must make a title search prior to file in the land office or other office for a first priority position for the banks.
6. To have adequate information and valuation of the collateral charged to the bank. Banker needs to inspect the collateral and is required to make formal appraisals regarding the liquidation values of the collateral.
7. To reduce default risk, a banker will require the borrower to buy insurance coverage for the financing and the bank shall be named as the beneficiary on the insurance policy.
8. The banker must inform the guarantor about his duty as a guarantor to the borrower. A banker must not misrepresent the financial strength of the borrower or value the collateral to the guarantor.
9. The guarantor must be notified about status of the financing especially where a problem might arise from the financing.
10. Before making payment for the financing, the banker must make sure the perfection of security interest is done and having the bank as the first priority.

CREDIT CONTROL PROCEDURES

• A system to ensure proper and complete legal documentation are in place prior to loan disbursement.
• Ensuring that all document and conditions are applied, such as developer’s license.
• To monitor all payments and must be up-to-date.
• To monitor the renewal insurance policy.
• Periodic review of the facility.
• Surveillance system to monitor default.
• System for release of securities.

COLLECTION TECHNIQUES

• Collection techniques is policy to refer a set of procedures used to collect loan repayment instalments once they are due.
• There are types of collection techniques:

1. Bills

- Banker will send a bill or a notice of payment before the due date of the instalment. The purpose is to remind the customer.

1. Letters

- Banker will sent letters when the repayment of instalment overdue for a certain number of days. If there is no respond from customer, bank will sent second letter and if still the same bank will sent third letter.

1. Telephone Calls

- Telephone call will make to request payment after there is still no response from customer .

1. Personal visit

- This technique require the banker to make a visit to see the customer personally. By confronting the customer, banker can help to solve some of the customer’s problem and some instances can collect payment on the spot.

1. Using collection agencies

- Sometimes banker use collection agencies to collect unpaid payment on their behalf. But this will incur cost for the bank.

1. Legal action

- The last alternative to collect payment but its expensive and time consuming.

CHAPTER 6 : CREDIT RECOVERY

CREDIT PROBLEM (BAD DEBT)

• Bad debt is refer to when customer cannot pay off their due repayment installment according to the terms and conditions of financing agreement.
• A debt that is not collectible and therefore worthless to the creditor.
• Bad debt is usually a product of the debtor going into bankruptcy or where the additional cost of pursuing the debt is more than the amount the creditor could collect.

CHARACTERISTIC OF CREDIT PROBLEM

• Failure to know borrower and understand their business.
• Failure to obtain sufficient information because of improper credit analysis.
• Failure to know the degree of reliability of the collateral taken.
• Lack of adequate follow-up procedures
• Failure to recognize early symptom of red flags.
• To delay in taking action on problem loan.

WARNING SIGNAL (RED FLAGS)

• Red flags refer to internal problems of the borrower based on following items

i. Problem in terms of management

ii. Business operation or operation activities

iii. Financial performance based on borrowers’

financial statement.

iv. Problem of internal system and threats in

changing environment.

v. The competitors are known to be experiencing financial difficulties

vi. The industry unit sales volume has decline

vii. The industry price structure has deteriorated

CREDIT RECOVERY PROCESS

• Objective of a recovery process:

i. Ensure that financing losses are within

acceptable limits.

ii. Assist customers whom are having financial

difficulties to meet their payment obligations.

iii. Managing recovery costs efficiently.

• Stages in credit recovery process:

i. Detection

• Detection of an account that lead to delinquent can come from many internal and external sources uch as in-house records in the form of current accounts, term loans, trade transactions, etc.

ii. Action Plan

• The lender should consider and analyze several factors prior to arriving at a loan recovery strategies, such as refinancing, loan rehabilitation (restructure), granting a moratorium (extending repayment period to a later date), collateral liquidation, and legal proceedings.

• Stages in credit recovery process:

iii. Negotiated workout

• Under a negotiated workout, the bank may elect to restructure the loan by revising the repayment terms and maturity to be in line with the company’s reduced cash flow position.

iv. Liquidation of Collateral

• Liquidation of collateral would require immediate realization of pledged security which may include fixed deposits, quoted shares or landed properties, such as landed properties may be sold by private treaty or public action .

• Stages in credit recovery process:
  1. Obtaining Judgement

• In the case of an unclear and uncooperative borrower, the lender may elect to file court action for enforcement of debt.

• The common route available are bankruptcy proceedings for individual borrowers and winding up appeal for companies.