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FINANCIAL & CREDIT ANALYSISDr. G. Vidyanath

Senior Faculty, IPE, 9885604896Leverage

Leverage may be the relative change in profits due to change in sales. In business terminology, leverage is used in two senses, namely, 1) Financial Leverage and 2)

Operating Leverage. A company can finance its investment opportunities by raising capital from two main sources of

capital, namely, Owned capital and borrowed capital. The rate of interest on borrowed or debt capital is fixed irrespective the company's rate of return

on its assets. The company has a legal obligation to pay interest on debt. The rate of preference dividend is also fixed, but the preference dividend is paid when the

company earns profits. The equity or common shareholders are entitled to the earnings after interest, tax and preference

dividend. The equity dividend is not fixed and depends on the dividend policy of the companyFinancial Leverage

Financial leverage refers to use of fixed charge sources of finance in the company’s capital structure,

The use of the fixed charge sources of capital, such as debt and preference capital along with the owner's equity in the capital structure is described as financial leverage or capital gearing or trading on equity.

The term trading on equity is used as it is owner's equity capital and reserves and surpluses are used as a basis to raise borrowed and preference capital, the owner's equity is traded upon. In the words of Gerestenberg, trading on equity is when a person or corporation uses borrowed capital as well as owned capital in the regular conduct of its business, he or it is said to be trading on equity.

The aim of `Trading on Equity’ is to evolve an optimal capital structure involving minimum cost of capital ensuring maximum possible return and control to equity share holders who are the real risk-bearers.

That is, financial leverage employed a company is intended to earn more (or less) on the fixed charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owner’s equity or the return on the total assets.

Operating Leverage Operating Leverage refers to the usage of fixed costs in the cost structure of operations of the

firm. If the proportion of fixed cost to the total cost is greater the firm said to be having a high degree

of operating leverage, and in case of reverse it will be low degree of operating leverage. Due to the effect of the operating leverage, the firm with high degree of operating leverage will be in an advantageous position when the demand for the product is increasing and the firm with low degree of operating leverage will be in advantages position when the demand for the product is is falling. In other words, for given increase in the sales, the profits of a highly operating levered firm will increase at a greater or faster rate and for a given fall in the sales, the profits will also be falling at greater rate.

Effect of Financial Leverage on Shareholders' Earnings: Under favourable conditions, i.e., when the company's rate of return is higher than the fixed

change at which the preference share capital and debt capital are raised, the financial leverage can increase the earnings of the share holders by maximizing the earnings per share.

Thus, the difference between the earnings generated and the fixed charges paid, will get distributed to the equity share holders, which will increase the earnings per share, in turn leading to the increase in the dividend per share and market price of the share. Similarly, the financial

FINANCIAL & CREDIT ANALYSIS - Dr. G. Vidyanath Senior Faculty, IPE, 9885604896 1

leverage can also lead to unfavourable results, when the company borrows funds at a rate of interest/preference dividend higher than the rate of return of the firm.

A company with high degree of financial leverage would be a highly risky one to grant loan as its credit worthiness is already utilized

A company with high degree of operating leverage would also be a highly risky one to be granted loan as the proportion of its fixed cost to total cost is very high, and its ability to meet further fixed expenses in the form interest charges would be threatening.

The business firm with lower break-even sales and higher margin of sales would be granted loan

Financial and Credit AnalysisFinancial Analysis and its need

Financial analysis has a broader focus than credit analysis. It is concerned with analyzing the financial performance of a business organization It is done by different parties on different aspects of the financial position of a business

organization, Financial analysis would often be associated with……

Financial Analysis must also be concerned with external reporting to certain outside parties, who will be interested in the results and financial position of the business firm, such as,

o shareholders/owners (profitability), o banks and financial institutions (solvency position), o creditors for expenses and trade creditors or creditors for goods (liquidity position),o Management and Employees (operational efficiency) o society (social responsibility), o government (legal compliance) o income-tax department (tax liability), o Potential investors (future dividends)o academicians (principles and practice of management or bridging the gap between

theory and practice or academic institution and industry interface), etc.,. Therefore, financial analysis would involve

o Comparison of financial statements of different periods of same business or/and of two business firms and also comparing with industry averages,


o Conducting trend analysis of various aspects of a business, like, sales, profits, expenses, etc.,

It also involves calculation of Various ratios to analyze o liquidity position – current and quick ratioso solvency position – debt-equity, debt serving, etc., o operational efficiency – turnover ratios, and o Profitability, such as return on sales, return on equity, return on assets, price earnings

ratios, dividend yield, To know the financial strengths and weaknesses of a business concern To assess

o the profit-ability o the credit worthiness o the debt serving capacityo the liquidity position, etc.,.

To compare with the industrial performance To suggest the measures for the improvement of financial position

Qualities of a Financial Analyst The financial analyst should be impartial, critical and frank while analyzing to protect the interest

of the lending organization A lot of patience in analyzing every case from all the angles Needs a person to be thorough with various tools of financial analysis He should also have creativity in creating new tools of analysis and modifying the existing tools

to the requirement.Qualifications of a Financial Analyst…...

A financial analyst should be preferably a commerce graduate, besides being preferably a chartered accountant

If he/she is from any other disciplines is required to develop the needed knowledge of tools of financial analysis

Knowledge of business mathematics, accounting and economics courses, during their undergraduate study could add advantage.

Unrelated majors that are favored include engineering, biology, computer sciences, and physics. Many junior analysts have a background in these areas while senior analysts tend to be hired

shortly after completing MBA school. Others who come from non-MBA or other favored fields of study may wish to consider

participating in the Chartered Financial Analyst program. There are cases where the financial and credit analysts are from other disciplines and employed in

banks and financial institutions by qualifying in bank examinations The financial and credit analyst should have the knowledge of risk, its types and various

techniques of managing or mitigating risk Credit Analysis

Credit analysis is associated with the decision to grant credit to a customer. Credit analysis is the method by which one calculates the creditworthiness of a business or

organization. It is also part of a bank's lending procedures for granting a loan and monitoring the

borrower's creditworthiness. It is the evaluation of the ability of a company to honor its financial obligations. The audited financial statements of a large company might be analyzed when it issues or has

issued bonds. Or, a bank may analyze the financial statements of a small business before making or renewing a commercial loan.

The term refers to either case, whether the business is large or small.


Qualifications of a Credit Analyst To become a credit analyst anyone should be develop the abilities to conduct credit analysis Credit analysts are generally required to have a bachelor’s degree in finance, accounting, or a

related field. Some companies do not insist on a degree in finance, but they prefer as it can be handy. Companies also provide on job training to employees to mould them to their specific

requirements Financial Analysis v/s Credit Analysts

While credit analysts tend to focus their analysis on individual consumers and companies, financial analysts mainly research market and industry trends

Nevertheless, both professions require important financial decision-making. While those who tend to pursue both jobs often come from similar backgrounds, the financial

analyst career may be more flexible for those who wish to work in the field, but may not have studied finance or an accounting-related subject.

Credit analysts have the general responsibility of assessing a loan applicant’s credit-worthiness. In the scope of their position, they are required to gather relevant data and, based on the data,

recommend a course of action for the credit application. Analysts who work for institutions that issue credit cards must research whether the applicant has

defaulted on past loans or lines of credit. The analyst will then make a recommendation that may include extending a line of credit,

limiting a credit line, denying credit, or closing the applicant’s account. Financial analysts conduct research on a larger scale. They research the macroeconomic and microeconomic conditions that surround potential

business, industry, and sector decisions. A decision is typically made based on the research findings, like, e.g., the decision to purchase or

sell a company’s stock. Financial analysts must stay updated in their area of specialization. and they sometimes are

required to build financial models to predict future conditions under a given scenario. Credit analysis involves a wide variety of financial analysis techniques, including ratio and trend

analysis as well as the creation of projections and a detailed analysis of cash flows. Credit analysis also includes an examination of collateral and other sources of repayment as well

as credit history and management ability. Analysts attempt to predict the probability that a borrower will default on its debts, and also the

severity of losses in the event of default. Objectives Credit Analysis

The objective of credit analysis is – to look at both the borrower and the lending facility being proposed and to assign a risk

rating. – The risk rating is derived by estimating the probability of default by the borrower at a

given confidence level over the life of the facility, and by estimating the amount of loss that the lender would suffer in the event of default

Financial and Credit Analysis – Traditional and Modern view Traditionally most banks have relied on subjective judgment to assess the credit risk of a

corporate borrower. Essentially, bankers used information on various borrower characteristics – such as character (reputation), capital (leverage), capacity (volatility of earnings), and collateral – in deciding whether or not to make a given loan. Developing this type of expert system is time-consuming and expensive. That is why, from time to time, banks have tried to clone their decision-making process. Even so, in the granting of credit to corporate customers, many banks continue to rely primarily on their traditional expert system for evaluating potential borrowers.

Lenders, especially bankers, use a formula known as the six C's of credit when evaluating a credit application. Understanding them will help you make your applications as attractive as possible.


Character. This is essentially a summary of the individual. Creditors look for people who appear to be trustworthy and reliable, and who are willing and able to meet their financial obligations.

Capacity. This is the individual's ability to repay the loan; it is based on present and anticipated earnings balanced against existing debts.

Collateral. The item pledged by the borrower as security for the loan, which may be real estate, stocks, savings, a mortgage, etc.

Conditions. Both regulatory and economic conditions are considered. Regulatory conditions apply to the lenders individual circumstances; for example, when banks are not lending in specific areas. Economic conditions determine the lender's general policy towards loan. Both are affected by the current economic cycle.

Credit. This is the individual's credit history. Capital. This is the net worth on an individual as indicated by a personal financial statement.

Credit scoring systems In recent decades, a number of objective, quantitative systems for scoring credits have been

developed. In univariate (one variable) accounting-based credit-scoring systems, the credit analyst compares various key accounting ratios of potential borrowers with industry or group norms and trends in these variables.

Credit policyCredit policy

Credit Policy refers to the guidelines that spell out how to decide which customers are sold on open account, the exact payment terms, the limits set on outstanding balances and how to deal with delinquent accounts

It is a Clear, written guidelines that set o the terms and conditions for supplying goods on credit,o customer qualification criteriao procedure for making collections, and o steps to be taken in case of customer delinquency – this is also called collection policy

A bank processes, sanctions, disburses, monitors and recovers a wide range of products at various geographical locations by a large number of executives

There is a need to have a clear written and unambiguous policy to be communicated from the Board of Directors or top level management to the line managers to be adhered with.

This policy indicates the bank’s lending philosophy and its internal control or risk control systems and procedures

A credit policy provides stability and clarity to the bank’s lending procedures, irrespective of the changes in the top level management

It also serves as a reference to both lenders and borrowers A credit policy should place a mechanism which shall go to ensure the safety of funds with

returns Objectives of a credit policy

Any credit policy would have the following broad objectives To grant loans on a sound and collectible basis To invest funds profitably for the benefits of the share or stake holders To serve the legitimate credit needs of the community However the credit policy should also be flexible to capture potential business opportunities

Components of a loan policy A sound credit policy consists of the following components:

Size of credit:– Depends…… – on the bank’s total and projected lendable resources and reserves to be maintained


– On the ceiling imposed by the central bank in the form credit-deposit ratio– Business plan of the bank

Direction of credit– Refers to the allocation of credit to the different segments of the economy, such as

industry, trade, service, agriculture, etc.,– Depends on – bank’s objectives of risk-return, – cost of administration of credit, – organizational capability of bank, such as, structure, location, infrastructural resources,– National and social priorities, etc.,

Composition of credit– Refers to the allocation of credit to the different segments of the economy, such as

industry, trade, service, agriculture, etc.,– Depends on – bank’s objectives of risk-return, – cost of administration of credit, – organizational capability of bank, such as, structure, location, infrastructural resources,– National and social priorities, etc.,

Quality of credit– Refers to the realisability of loans– Also refers to the norms for asset classification and migrations to different assets

qualifications Administration of credit is concerned with….

– Appraisal – Pricing – Expiry Terms – Sanctioning– Documentation– Disbursement– Supervision– Monitoring – Recoveries and Rehabilitation – Income recognition and provisioning– Internal controls– Loan review

Appraisal refers to Norms for appraisal The formats to be used Credit information to be called for The bench mark financials to be observed The method of lending to be followed The method of determining the drawing power, etc.,

Pricing is concerned with Loan pricing should be done on the basis of cost of funds, risk premium to be charged on

credit rating of the borrower and probability of default based on Cost of the funds and Nature of risks

Expiry Terms are concerned with matching the period or term of the loan with the expiry pattern of the resources or

collaterals and movement in the interest ratesSanctioning refers to the written sanction granted within the delegated authority


It is also concerned with schedule for reporting sanctions and exceptions or ratifications with the higher authorities

Sanctions should be prohibited for speculative purposes or loans for undesirable characters

loans cannot be supported by the borrowers cash flows and tangible net worthDocumentation

Starts with A written loan application by the borrower Signed loan covenants/agreements incorporating right to set off, right to enforce

collateral/securities on default, right to debit the account for charges or interest or commission, right to freeze operations or recall the loan on misuse of facilities or breach of covenants, right to receive period reports/stock statements, ageing analysis statements of debtors or receivables, etc.,,.

Also involves – Issuing a letter sanction to the borrower – Receipts for cash disbursements, if any, – Periodic balance confirmations, – Legal validity of the documents evidencing the registration charge, etc– Safeguarding the documents by maintaining a separate file for each borrower

Disbursement is ……… Ensuring proper authorization of disbursement of loan After proper documentation, the bank must ensure that there is adequate drawing power

and security covered within the stipulated margin Supervision Refers to

ensuring that the loan is being utilized for the proposed purpose only Involves obtaining periodical statements from the borrower and making periodical visits

and verifying securities, monitoring the operations in the account Sensing any warning signals

Monitoring Refers to centrally monitoring the portfolio at the head office and requiring the branches to

submit the reports or returns

Recoveries and Rehabilitation Refers to the procedures for prompt follow-up on due dates or rescheduled dates In case of rehabilitation, it is concerned with economic feasibility, contribution from the

promoters, etc., Income Recognition and Provisioning

Concerned with suspension of charging interest and adequacy and timeliness of provision to be made in case of a non performing loan

Internal Controls Concerned with

o loan policy, o appraisal norms o exercise of delegated powers, o interest calculations, etc.,

Loan review This is an emerging concept and it must find a place in the credit or loan policy Refers to the process of review of loan by an independent unit regarding the risk involved in it

Principles of Lending


An ideal advance is one which is granted to a reliable customer for an approved purpose in which the customer has adequate experience, safe in the knowledge that the money will be used to advantage and repayment will be made within a reasonable period – L C MATHER

The principles of LENDING should basically address o Who is to be financed? - BORROWERo What is it to be financed? - PURPOSEo How much is to be financed? - AMOUNTo How it should be financed? – MIX o Where it should be financed? – PLACE o What is likely outcome of financing? - RETURN

The LENDER should recognize RISK behind every aspect mentioned above and mitigate it carefully

Principles of Lending Some of the principles of lending are Safety

– Safety of the funds lent is of highest importance – Lack of safety of funds would affect the confidence of public– An advance should be granted to a reliable borrower who can repay it in ordinary course

of business Security

– It is another important principle– The security against a loan should be enough to be realized even in adverse conditions, it

should serve as an insurance cover against the contingent– The value of a security should easily be ascertained and it should be steady over a period,

besides providing enough provisions for depreciation Charges

– The term 'charge' is often used as a generic term for all types of security interest, but specifically it represents an agreement between a creditor and a debtor in which a particular asset or class of assets can be used to satisfy a debt.

– A charge creates an encumbrance or interest which attaches to the asset and travels with it into the hands of any third parties. The only exception to this is a genuine, arms-length purchaser of the full legal ownership for value and without notice, who will acquire the asset free of the charge.

Suitability– The purpose of loan should be suitable to the broader objectives of the bank and those of

the nation or economy– Credit should not be granted for gambling or speculation

Profitability The rate of interest charged on a loan should in commensurate with the amount of risk

involved in it. Liquidity

– Another important principle to be kept in mind by the banker while lending is the liquidity of advances made.

– A loan should be given matching timing and volumes of the inflows and outflows of banks– The loans should be granted such parties who would help the banking in achieving this

objective Integrity

– No advance should be made to a borrower with doubtful integrity– Consideration of integrity should not transgress upon moral ethics– A lender should be concerned with the business integrity of the borrower


Adequacy of finance – A prudent banker would not lend a sum which is inadequate to finance a given project – If did, he is not only killing the project but also sinking the funds in the project

Timeliness– The loan granted should be at the right time of need to the borrower to be used for the

proposed purposes– If the loan is granted after the borrower lost the opportunity, it is undesirable.

Institutional CreditIntroduction

Credit (from Latin credere translation. "to believe") is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately (thereby generating a debt), but instead arranges either to repay or return those resources (or other materials of equal value) at a later date.

The resources provided may be financial (e.g. granting a loan), or they may consist of goods or services (e.g. consumer credit). Credit encompasses any form of deferred payment.

Credit is extended by a creditor, also known as a lender, to a debtor, also known as a borrower. Credit does not necessarily require money. The credit concept can be applied in barter economies

as well, based on the direct exchange of goods and services (Ingham 2004 p. 12-19). However, in modern societies credit is usually denominated by a unit of account. Unlike money, credit itself cannot act as a unit of account.

Movements of financial capital are normally dependent on either credit or equity transfers. Credit is in turn dependent on the reputation or creditworthiness of the entity which takes responsibility for the funds. Credit is also traded in financial markets.

The purest form is the credit default swap market, which is essentially a traded market in credit insurance. A credit default swap represents the price at which two parties exchange this risk – the protection "seller" takes the risk of default of the credit in return for a payment, commonly denoted in basis points (one basis point is 1/100 of a percent) of the notional amount to be referenced, while the protection "buyer" pays this premium and in the case of default of the underlying (a loan, bond or other receivable), delivers this receivable to the protection seller and receives from the seller the par amount (that is, is made whole).

In a legal loan, each of these obligations and restrictions is enforced by contract, which can also place the borrower under additional restrictions known as loan covenants.

Loans need not be on monetary loans, in practice, any material object might be lent. The thought of a loan seems to have crossed everyone’s mind at some point in life Generally it’s not carefully thought out though A loan is a specified amount of money someone borrows with the intention of paying it back.

Classification of credit : Fund based - Long term and short term/demand loans

In finance, a loan is a debt provided by one entity (organization or individual) to another entity at an interest rate, and evidenced by a note which specifies, among other things, the principal amount, interest rate, and date of repayment.

A loan entails the reallocation of the subject asset(s) for a period of time, between the lender and the borrower.

In a loan, the borrower initially receives or borrows an amount of money, called the principal, from the lender, and is obligated to pay back or repay an equal amount of money to the lender at a later time. Typically, the money is paid back in regular installments, or partial repayments; in an annuity, each installment is the same amount.

The loan is generally provided at a cost, referred to as interest on the debt, which provides an incentive for the lender to engage in the loan. In a legal loan, each of these obligations and restrictions is enforced by contract, which can also place the borrower under additional


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restrictions known as loan covenants. Although this article focuses on monetary loans, in practice any material object might be lent.

Acting as a provider of loans is one of the principal tasks for financial institutions. For other institutions, issuing of debt contracts such as bonds is a typical source of funding.

The thought of a loan seems to have crossed everyone’s mind at some point in life. Generally it’s not carefully thought out though. A loan is a specified amount of money someone borrows with the intention of paying it back. Generally it’s over a said period of time and is paid back with interest. There are different types of loans falling into two major categories: short term and long term. A person may find themselves needing a loan for many different purposes.

Short Term Loans Short term loans are generally up to about three years. A popular short term loan is a payday loan.

Someone may take a payday loan out in the event of an emergency such as car repairs, taking a vacation, or other unexpected bills. Payday loans are like a cash advance in which the payment comes from your bank account on your next pay date. These are very popular because of the few requirements needed to be approved for the loan. Unlike a long term loan, you can get cash within 48 hours from companies like Online Payday Loans.net and there are no credit checks. These loans are generally up to $2000.

Another popular short term loan is a flexible loan. This is generally a credit based loan, but up to $25,000. The term is generally 12 months. Short term loans are at a higher interest rate than a long term loan, capitalizing on the length of your loan. A lender will use the situation that you do not have credit in order to offer the higher interest rate.

Long Term Loans Long term loans can be taken over an extended amount of time. Most common long term loans

are mortgages, student loans, wedding loans, start-up business loans, and home improvement loans. A long term loan is credit based. The better your credit score the better your interest rates will be. A long term loan can be in the form of a secure or an unsecured loan. A secure loan requires a form of collateral or asset, such as a title to your car or your home. An unsecured loan does not require any assets and has a higher interest rate as the lender has more at stake. You can think of this as a line of credit with your bank or a credit card.

Taking a long term loan is generally through a bank or credit union, unlike a short term loan. The amount of the loan will be based on your credit history and current income. With long term loans, you have greater flexibility with payment options. For instance, mortgage loans offer a fixed interest mortgage loan, in which the rate is the same over the term of the loan and the payments are split equally. An adjustable rate mortgage loan’s rate can adjust every year. There is also an interest only loan, of which a person can pay only the interest of the loan for a set amount of years, and then start paying on the principal. Unlike short term loans, long term loans can help establish credit.

When making the decision to take a loan, it’s important to think about a few things. Think if you really need the loan and weigh other options. Shop around for the best interest rates. Consider the consequences. Make sure you are able to afford paying the loan back. For instance, a payday loan will take so much of your next paycheck. Make sure it doesn’t dig you further into debt on other bills.

Secured Loans A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property)

as collateral. A mortgage loan is a very common type of debt instrument, used by many individuals to

purchase housing. In this arrangement, the money is used to purchase the property. The financial institution, however, is given security — a lien on the title to the house — until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it.


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In some instances, a loan taken out to purchase a new or used car may be secured by the car, in much the same way as a mortgage is secured by housing. The duration of the loan period is considerably shorter — often corresponding to the useful life of the car. There are two types of auto loans, direct and indirect. A direct auto loan is where a bank gives the loan directly to a consumer. An indirect auto loan is where a car dealership acts as an intermediary between the bank or financial institution and the consumer.

Unsecured Loan Unsecured loans are monetary loans that are not secured against the borrower's assets. These may

be available from financial institutions under many different guises or marketing packages: credit card debt personal loans bank overdrafts credit facilities or lines of credit corporate bonds (may be secured or unsecured)

The interest rates applicable to these different forms may vary depending on the lender and the borrower. These may or may not be regulated by law. In the United Kingdom, when applied to individuals, these may come under the Consumer Credit Act 1974.

Interest rates on unsecured loans are nearly always higher than for secured loans, because an unsecured lender's options for recourse against the borrower in the event of default are severely limited. An unsecured lender must sue the borrower, obtain a money judgment for breach of contract, and then pursue execution of the judgment against the borrower's unencumbered assets (that is, the ones not already pledged to secured lenders). In insolvency proceedings, secured lenders traditionally have priority over unsecured lenders when a court divides up the borrower's assets. Thus, a higher interest rate reflects the additional risk that in the event of insolvency, the debt may be uncollectible.

Demand loans Demand loans are short term loans [1] that are atypical in that they do not have fixed dates for

repayment and carry a floating interest rate which varies according to the prime lending rate. They can be "called" for repayment by the lending institution at any time. Demand loans may be unsecured or secured.

Subsidized loan A subsidized loan is a loan on which the interest is reduced by an explicit or hidden subsidy. In

the context of college loans in the [United States], it refers to a loan on which no interest is accrued while a student remains enrolled in education.[2]

Concessional Loan A concessional loan, sometimes called a "soft loan," is granted on terms substantially more

generous than market loans either through below-market interest rates, by grace periods or a combination of both.[3] Such loans may be made by foreign governments to poor countries or may be offered to employees of lending institutions as an employee benefit.

Personal or commercial or Credit (finance) Consumer credit Loans can also be subcategorized according to whether the debtor is an individual person

(consumer) or a business. Common personal loans include mortgage loans, car loans, home equity lines of credit, credit cards, installment loans and payday loans. The credit score of the borrower is a major component in and underwriting and interest rates (APR) of these loans. The monthly payments of personal loans can be decreased by selecting longer payment terms, but overall interest paid increases as well. For car loans in the U.S., the average term was about 60 months in 2009.

Loans to businesses are similar to the above, but also include commercial mortgages and corporate bonds. Underwriting is not based upon credit score but rather credit rating.

Loan Payment


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The most typical loan payment type is the fully amortizing payment in which each monthly rate has the same value over time.

The fixed monthly payment P for a loan of L for n months and a monthly interest rate c is:

For more information see "Monthly loan or mortgage payments" under Compound Interest

Abuses in lending Predatory lending is one form of abuse in the granting of loans. It usually involves granting a loan

in order to put the borrower in a position that one can gain advantage over him or her. Where the moneylender is not authorized, they could be considered a loan shark. Usury is a different form of abuse, where the lender charges excessive interest. In different time periods and cultures the acceptable interest rate has varied, from no interest at all to unlimited interest rates. Credit card companies in some countries have been accused by consumer organizations of lending at usurious interest rates and making money out of frivolous "extra charges".

Abuses can also take place in the form of the customer abusing the lender by not repaying the loan or with an intent to defraud the lender.

Non fund based A guarantee from a lending institution ensuring that the liabilities of a debtor will be met. In other

words, if the debtor fails to settle a debt, the bank will cover it. As per the section 126 of Contract Act – ‘A guarantee is a contract to perform the promise or discharge the liability of a third person in case of his default’.

Parties To Guarantee: A person, who gives guarantee, is called ‘Surety’. A person, on whose behalf guarantee is given, is called, ‘Principal Debtor’. A person/party, in whose favour, guarantee is given, is called ‘Creditor and/or Beneficiary’.

A bank guarantee is a written contract given by a bank on the behalf of a customer. By issuing this guarantee, a bank takes responsibility for payment of a sum of money in case, if it is not paid by the customer on whose behalf the guarantee has been issued. In return, a bank gets some commission for issuing the guarantee.

Any one can apply for a bank guarantee, if his or her company has obligations towards a third party for which funds need to be blocked in order to guarantee that his or her company fulfils its obligations (for example carrying out certain works, payment of a debt, etc.).

In case of any changes or cancellation during the transaction process, a bank guarantee remains valid until the customer dully releases the bank from its liability.

In the situations, where a customer fails to pay the money, the bank must pay the amount within three working days. This payment can also be refused by the bank, if the claim is found to be unlawful.

TypesThere are different types of Bank Guarantees. Each worded for specific events and purposes. Therefore

Financial guarantees : This type of Bank Guarantee is issued by the bank and furnished by the bank’s customer in lieu of earnest money or the security to be deposited with the beneficiary of the Bank Guarantee for the performance of a contract. These guarantees, are given in lieu of purely monetary obligation e.g. the obligation of contractor make earnest money deposit/guarantees give to sale-tax department etc.

Performance guarantees : These types of guarantees are issued in respect of performance of a contract or obligation. In such guarantees- in the event of non-performance or short performance of the obligation, bank will be called upon to make good the monetary lose arising out of non-


fulfilment of the guarantee obligation. The bank can not perform the contract itself but by this Bank Guarantee the bank undertakes to reimburse the loss incurred by the beneficiary due to non-performance. The amount of loss to be reimbursed is ascertained at the time of default. The purpose of this Bank Guarantee is to fix the liability in the eventuality of default by the customer.

Deferred payment guarantees : The bank at request of customer issues such Bank Guarantee when he purchases goods or machinaries from a creditor on the terms of payment after a specified time in lump sum or in instalments. The creditor requires such deferred payment terms to be guaranteed by the bankers of the principal debtor. Such a Bank Guarantee contain an undertaking by the banker that that deferred payment shall be made by the principal debtor, failing which the banker shall pay the amount to the creditor. These types of guarantees normally arise in the case of purchases of machinery or such capital equipment by industries or other party/ies. The manufacturer or its agent applies the machinery against cash payment say 10% to 15% & obtains accepted bills for the balance amount by purchaser’s banker for deferred period say 3 to 5 years

The most purposes for the uses of Bank Guarantees are: Advance Payment Guarantee Performance Guarantee (Performance Bond) Payment Guarantee Conditional Payment Guarantee (Conditional Payment Undertaking) Guarantee securing a Credit Line Order & Counter Guarantee

Draft Bank Guarantee wordings for these types of Guarantees, acceptable to most banks can be downloaded from our Downloads centre.

Types of Bank GuaranteesA bank guarantee can be either direct or indirect.

Direct Guarantee where the account holder instructs his bank to issue a Guarantee directly in favour of the Beneficiary. In other words, It is issued by the applicant's bank (issuing bank) directly to the guarantee's beneficiary without concerning a correspondent bank. This type of guarantee is less expensive and is also subject to the law of the country in which the guarantee is issued unless otherwise it is mentioned in the guarantee documents.

Indirect Guarantee where a second bank is requested to issue a Guarantee in return for a counter-Guarantee. In this case the Issuing Bank will indemnify losses made by this second bank in the event of claim against the Guarantee. In other words, with an indirect guarantee, a second bank is involved, which is basically a representative of the issuing bank in the country to which beneficiary belongs. This involvement of a second bank is done on the demand of the beneficiary. This type of bank guarantee is more time consuming and expensive too.

Confirmed Guarantee : It is cross between direct and indirect types of bank guarantee. This type of bank guarantee is issued directly by a bank after which it is send to a foreign bank for confirmations. The foreign banks confirm the original documents and thereby assume the responsibility.

Tender Bond: This is also called bid bonds and is normally issued in support of a tender in international trade. It provides the beneficiary with a financial remedy, if the applicant fails to fulfill any of the tender conditions.

Performance Bonds: This is one of the most common types of bank guarantee which is used to secure the completion of the contractual responsibilities of delivery of goods and act as security of penalty payment by the Supplier in case of nondelivery of goods.

Advance Payment Guarantees : This mode of guarantee is used where the applicant calls for the provision of a sum of money at an early stage of the contract and can recover the amount paid in advance, or a part thereof, if the applicant fails to fulfill the agreement.

Payment Guarantees: This type of bank guarantee is used to secure the responsibilities to pay goods and services. If the beneficiary has fulfilled his contractual obligations after delivering the


goods or services but the debtor fails to make the payment, then after written declaration the beneficiary can easily obtain his money form the guaranteeing bank.

Loan Repayment Guarantees : This type of guarantee is given by a bank to the creditor to pay the amount of loan body and interests in case of nonfulfillment by the borrower.

B/L Letter of Indemnity: This is also called a letter of indemnity and is a type of guarantee from the bank making sure that any kind of loss of goods will not be suffered by the carrier.

Rental Guarantee : This type of bank guarantee is given under a rental contract. Rental guarantee is either limited to rental payments only or includes all payments due under the rental contract including cost of repair on termination of the rental contract.

Credit Card Guarantee: Credit card guarantee is issued by the credit card companies to its customer as a guarantee that the merchant will be paid on transactions regardless of whether the consumer pays their credit.

Benefits of Bank Guarantees For Governments

1. Increases the rate of private financing for key sectors such as infrastructure.2. Provides access to capital markets as well as commercial banks.3. Reduces cost of private financing to affordable levels.4. Facilitates privatizations and public private partnerships.5. Reduces government risk exposure by passing commercial risk to the private sector.

For Private Sector1. Reduces risk of private transactions in emerging countries.2. Mitigates risks that the private sector does not control.3. Opens new markets.4. Improves project sustainability.

Letter Of Credit' A letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and

for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.

Bank guarantee and Letters of credit A bank guarantee is frequently confused with letter of credit (LC), which is similar in many ways

but not the same thing. The basic difference between the two is that of the parties involved. In a bank guarantee, three parties are involved; the bank, the person to whom the guarantee is given and the person on whose behalf the bank is giving guarantee. In case of a letter of credit, there are normally four parties involved; issuing bank, advising bank, the applicant (importer) and the beneficiary (exporter).

A letter of credit is written commitment document issued by a bank or other financial institutions to assure payment to seller on the basis of documentary proof on fulfillment of performance by seller as per terms and conditions mentioned in LC. Under an LC, the seller gets guarantee on payment of his sale of goods from the buyer’s bank. I request readers to go through my different articles in detail in this website, already explained.

A bank guarantee is a commercial instrument guaranteeing by bank to a party (parties) on behalf of his customer, assuring the beneficiary to effect payment on default of obligation.

How to differentiate a Letter of Credit and a Bank guarantee?o As per Letter of Credit, once the obligation on production of documents on fulfillment of

contract, the bank pays amount to beneficiary. However, in a bank guarantee, the beneficiary is paid on non fulfillment of obligation as per contract of BG.


DocumentationIntroduction

Documentation is the term used to describe the process of submitting all the required documents, as an evidence or proof for executing – A contract– Registration of a event or some property– Applying for a loan to a bank or financial institution– Filing a petition with court of law, – Applying for a course, etc.,

Documents are also used for establishing the legal rights and obligations of the concerned parties by drawing, executed, stamped, attested and registered as required by law

Therefore documentation has become very important in case of bank transactions Document

“Document shall include any matter written or described upon any substance by means letters, figures or marks or by more than one of those means which is intended to be used for the purpose of recording that matter” -section 3(18) of the General clauses Act 1879

Section (3) of Indian Evidence Act, 1872 defines “Document means any matter expressed or described upon any substance by means of letters, figures or marks, or by more than one of those means intended to be used or which may be used for the purpose of recording that matter”.

According to Section 3 of the Evidence Act a document includes A writing Words printed or lithographed or photographed A map or a plan An inscription on a metal plate or stone A Caricature

Documentation executed by the borrower is reducing the terms and conditions to writing and confer rights and responsibilities in relation to the charges over the properties and also for the repayment of the loan and payment of interest and other clauses.

Documents obtained will be used for the purpose of “evidence” Importance of Documentation

To enforce the banker’s right against the borrower to recover the debt Only through proper documentation effective charge can be created on the securities offered

by the borrower to the bank Banks have to confirm with various Acts like

Contract Act 1872, Negotiable Instruments Act, 1881, Sale of Goods Act, 1990, Transfer of Property Act, 1882, Companies Act, 1956, Partnership Act, 1932, Indian Stamp Act, 1899, Registration Act, 1908, etc.,

Further the technological developments during last two decades have brought paradigm shift in the way business transactions take place. Banking transactions are no exceptions to this. The enactment of information technology act 2000 has legally recognized these transactions and the Parliament has also amended the Acts, like, Bankers Book Evidence Act, Indian Evidence Act, Reserve Bank of India Act, the Indian Penal Code, The Negotiable Instrument Act, etc., to recognize the transactions entertained in electronic form and documents executed in electronic form;


Therefore, the need for proper documentation is felt for…… Fulfilling Requirement of Law To create Permanent Record Evidencing the fact of transaction In order to Identify the borrower In order to identify the security Deciding /settle terms and conditions Creating / Deciding the types of charges Determining Limitation period Deciding rights and liabilities of lending bank

Steps in Documentation

Documentation process consists of the following stepso Drafting

For the sake of uniformity and to avoid ambiguity of intention or implications, each bank has standardized forms incorporating the required details.

Irrespective of large advances requiring a separate comprehensive document, it will be drafted by the legal experts or law department of the respective banks.

To avoid complications banks use a printed standardized forms o Preparing a set of documents

Preparing the set of documents to be obtained from the borrower The credit sanctioning authority would indicate to the concerned branches, the

set of documents to be obtained from the borrower on the sanctioning of a specific credit facility

While preparing the set of documents to be taken, banks need to take utmost care, as it is difficult to give a comprehensive list of documents for any particular type of loan or advance as it would vary from account to account due to the following factors………..

The following factors have to be born by the banks while preparing a set of documents

Constitution of the borrower, i.e., whether the borrower is a individual, HUF, partnership, a company, etc.,

Type of credit facility granted, i.e., whether it overdraft, cash credit, bills purchase/discount, Term loan, etc.,

Nature of security offered whether the security is movable or immovable property

Type of charge to be created whether it is Hypothecation, Pledge, Mortgage, Assignment, lien,

o Stamping Section 17/35 of Indian Stamp Act, 1899 stipulates that an instrument attracting

stamp duty should be duly stamped for the document to be admitted in evidence in a court of law.

If the documents relating to a borrower are not duly stamped or under stamped would become invalid in law and the bank would loose the legal stand

Therefore, the banks should get the documents stamped before filling and executing them

o Filling up of documents The next stage is to fill the documents properly By one person, i.e., either the borrower or the bank official In one handwriting In one ink or with one pen


Preferably in one sitting …………………………without Over writing Cuttings Erasing Insertion of the words Addition Deletions If any of the above are inevitable they must be attested by the full signature of

borrower, otherwise it would be treated as material alteration and become invalid or fraud

Ensure that all the particulars in the application are duly filled-up without blanks Amount of credit limit applied for should be filled in and not the amount of credit

released or disbursed The appropriate rate of interest should also be entered Margin, schedule of security, etc., should be properly filled up Name and addresses of the borrower/s and the guarantors should be filled in

correctly o Execution of documents

EXECUTION refers to due performance of all formalities, a signing, sealing, etc., to give legal validity to the documents

Section 2(12) of the Indian Stamp Act, 1899 defines “executed” and “execution” with reference to instrument as meaning “signed” and “signature” respectively.

According to section 2 (56) of the General Clauses Act, 1897 “sign” includes “mark” made by an illiterate person, “signing” means writing one’s name on same document or paper

Banks accept only those signatures which are used in the normal course of business by the executants, i.e., borrower or guarantor as per the specimen signature registered with them

The documents need not be executed by the borrower(s) himself or themselves. Authorized representatives can executive them, a sole proprietor can sign for his business, a partner can sign for his partnership business, or a director can sign for his company, provided they are authorized

Process of Execution The execution of documents should take place in the branch premises,

where the credit facilities are disbursed. The place of execution should be in the jurisdiction of the court, where

the legal suit can be filed. The bank must make sure that all the borrowers and guarantors relating

to an account must visit the bank on the day of the execution and sign the documents

Incase of executing from other places, the documents would signed first and then sent to the concerned branch, which should also be visited by the borrower/guarantors

The concerned parties should sign in full/ thumb impression on all pages of all the documents, implying that all they have read or explained all the contents of the documents

Wherever required the signatures should be taken across the revenue stamps

o Attestation “Attestation” is an important aspect of execution of documents


Section 3 of the Transfer of properties Act 1882 defines attestation means and shall be deemed always to have meant attested by two or more witnesses each of whom would have seen the execution sign or affix his mark to the document in the presence of executants and by the directions of executants or has received from the executants a personal acknowledgement of his signature of such other person, and each of whom has signed the document in the presence of executants but shall not be necessary for more than one witness to be present at the same time, and no particular form of attestation shall be necessary

Hence, all attestation should be Two or more witnesses should have seen the executants sign Each of the witness has seen some other person sign the document Each of the witness should have personal knowledge of the signature of

the executants or that of the other person and each should sign in the presence of the executants

Some of the documents requiring attestation are Sale deed Lease deed Mortgage deed Gift deed Transfer of share deed

Attestation should also be supported by an appropriate stamp duty The witnesses need not know the contents of the documents, but their full details

have to be mentioned in the document o Registration of documents

Normally the documents relating to immovable properties would be registered under the sub-registrar of assurance in whose jurisdiction the property is situated

If the document requiring registration, is not registered, it will not allowed as an evidence in the court of law

The documents obtained are recorded in a register known as Document Register, recording the particulars like date of document, document particulars, names of signatories to the document, etc.,.

The documents would be stored in a secured place under the custodian of a responsible officer

o Renewal and revival of time barred documents The Indian Limitation Act, 1963 limits the life of a document The limitation period for all the security documents is normally 3 years from the

date of execution of the documents, except that the limitation period for some mortgage deeds is 12 years.

However the period of limitation gets extended by equal period, if the following conditions are fulfilled

By obtaining an acknowledgement of debt outstanding By receiving a part payment in the loan account

o Acknowledgement of debt Section 18 of the Limitation Act, stipulates the following conditions for an

acknowledgement of debt to be valid in law It should be in writing Signed by the borrower Executed by the expiry of the limitation period (i.e., 3 or 12 years from the date

of the original document Appropriate stamp duty should paid/stamps affixed, before filling the

acknowledgement of debt


can be executed by borrower’s representatives Can be in the form a letter written and signed by the borrower – it will not attract

stamp duty It not contain a promise to pay but should accept/acknowledge the liability

Documents To Be Submitted By The Existing Units The existing units are expected to approach the bank with the following documents

A.1 For Existing Units seeking WC facilities: – Last 3 years audited balance sheet with notes on account & annexure– Last 3 years audited profit & loss statement with notes on accounts & annexure– Last 3 years IT returns– Last 3 years balance sheet & profit & loss statement of associate / sister concerns– CMA data– Order book position / contracts / proof of demand– Last sales tax assessment order– Statutory clearance certificate– Lead Bank assessment note in case of consortium finance.– Details of Associate / Sister / Group Concerns with names, bankers, credit facilities

enjoyed, present status etc.– Details of Collaterals wherever applicable.

Additional documents required in case of take over account NOC / status of the account Credit report from the existing bankers Statement of account for last 1 year.

Additional documents required for Term Loan / LC for capital goods application, if they are not included in project report

Cash flow statement for entire repayment schedule Fund flow statement for entire repayment schedule. Profitability projections and assumptions for entire repayment period Break-even analysis. IRR working DSCR working CA certificate for promoter's contribution Project: Report covering:

a) Details of cost of machinery, suppliers of machineryb) Quotations / proforma invoices from suppliersc) Installed capacity calculationd) Raw material details & their availabilitye) Market survey: viability reports from market, reports from associationsf) Project implementation schedule.g)Status of various clearances required.

Additional documents required in case of factory building Building approval plan Estimate from Architect Statutory clearances: Environment, pollution clearance, and other applicable clearances. Power & water sanction proof, Any other clearances like explosive license etc wherever applicable to different projects.

Additional documents required for raw material LC– Pattern of purchase– Quantum & Value of import and domestic purchases.– Import license


– Percentage of Total Purchase under LC– Lead-time required– DA period in case of DA LCAdditional details required in case of Bank Guarantee: – Details of existing guarantees & facilities– Bid bond / security deposit Details

In case of New Projects seeking TL & WC facilities Complete Project Report to be submitted including the following by the Entrepreneurs

Projected Balance Sheet for the entire repayment period, Projected P & L Account for the entire repayment period, Presumptions made in Projected Profitability Estimates Projected Cash Flow Statement for the entire repayment period, Projected Fund Flow Statement for the entire repayment period, Break Even Analysis DSCR Computation for the entire repayment period, with Average DSCR

Calculation, IRR Computation, CA certificate for promoter's contribution IT return & personal Balance Sheet of the promoters & guarantors Bio data of Promoters / Directors Details of cost of machinery viz Name of Machine, Machine Capacity, Supplier of

machinery, Quoted Value etc. Estimates of Construction by Architect / Chartered Engineer. Copies of Various Basic / Statutory Approvals to establish the unit & to run the

activity. Installed capacity calculation Raw material details & their availability Market survey: viability reports from market, reports from associations Project implementation schedule. Market Demand & Market Arrangements Details of Collaterals wherever applicable.

Caselets discussed in the classCaselet-1

In a demand promissory note, a new officer who was recently recruited by the bank had forgotten to affix the revenue stamp. What would be the effect of this error when there is need for the bank to file suit in the

court? What would your answer if the document is under-stamped?

Answer to caselet 1 Demand Promissory note is the most important document for loans. Any mistake in

affixing stamps, i.e., omission or lesser value) cannot be rectified later. The document is void ab initio and the bank loses the right to file a suit in the court of law

Case-let 2 A state government has amended the Stamp Act with effect from 1.4.2014 and increased the

stamp duty on Hypothecation agreements. The information about this was received from the Head office of the bank via a circular on 2.5.2014. In the meantime, the bank branch has disbursed various loans affixing documents with old stamp duty.

– What will happen to these documents when a suit is filed? – What bank can do to avoid difficulty?


Answer to caselet 2 In this case, the bank may pay penalty for the amount of understamping, maximum upto 10 times

of the deficit amount, and thereafter file suit. The documents would be admissible as an evidence by the court. Immediately on receipt of the circular, the bank can pay the differential stamp duty, by taking the documents to registrar

Caselet 3 You have given an educational loan to a student, Mr. X on 2-6-2011 for pursing MS in

California. The course was for two years but due to some problems, Mr. X could not complete it in two years and got extended to 2 ½ years. The student also took up a part-time job at California. The account has become NPA and the bank filed a suit on 10-7-2014. The lawyer appointed by the student argues that the documents have become time-barred. You are required to discuss……

o What would be your views under the present conditions?o What would be your views if the loan was for doing MBA in an Indian University?o If there was the collateral seurity in the form of mortgage residential property would bank

be in a position to recover the dues? Answer to caselet 3

Situation I : As per Limitations Act, whenever a borrower is out of India, the limitation period get extended by the number of days the borrower is outside India. Though, apparently the time of 3 has elapsed, if the bank can prove that the student was abroad then the suit will be admitted by the court.

Situation II - If the loan was for MBA course in India, the documents are time barred and the bank cannot file suit.

Situation III - A suit to enforce mortgage has to be filed within 12 years and the bank can file to enforce mortgage and recover the dues

Case let 4 You are a bank official. Your bank has given a loan to Mr. X & sons, by taqking surety of Mr. Y.

Mr X failed to repay the loan. After pursuing with the borrower and failing in its efforts, your bank filed a suit against the borrower and got a decree for all the amount. The bank wishes to file execution petition against Mr. Y for sale of his residential house. The advocate of Mr. Y takes objection saying tha the bank has not exhausted all the effort against Mr. X and that his client is not liable. Discuss.

Answer to caselet 4 In the above case, Mr. Y is the surety for loan granted to Mr. X & sons. The banks wants to Mr.

Y’s residential house and recover the dues. As per, Indian Contract Act, 1872, the liability of the surety of a loan is co-extensive with that of the borrower. Hence, your bank is right to choose against whom (borrower or guarantor or both) it wants to proceed for recovery of the dues. Hence, the bank is right and the contention of the advocate of Mr. Y is not tenable.

Caselet 5 Your branch has sanctioned a loan of Rs. 25 lakhs to a corporate borrower, obtained documents

on 1.2.2013. one of the documents is for creation of Registered Mortgage. The branch failed to register the mortgage charge due to work pressure. The auditors during their inspection observed this deficiency on 10.8.2013. Discuss the legal stand of bank

Answer to caselet 5 As 6 months have elapsed, the bank cannot get any further extension for filing of charge. Instead,

the bank can obtain fresh set of documents and then file charge within 30 days of the execution of the documents.

Caselet 6 A customer has taken loan from your bank on 1.6.2010 and was irregular in making repayments.

The bank was repeatedly asking him to call on the bank and sign the documents for continuation


of limit. He did not respond. In the meantime, the credit officer and the branch manager were transferred. The inspectors observed on 10.8.2013 this aspect .

o What is the legal position of the bank? o Can the bank file the suit? o Discuss the remedies available to the bank to recover the dues

Answer to caselet 6 Normally the documents are valid for 3 years. Hence, the documents in the instant case are time-

barred. Bank cannot file the suit. However, the validity of document can be extended due to various other reasons (part payment of debt, correspondence, acknowledgement of debt).

Loan Pricing

With progressive deregulation of interest rates, banks are required to price their deposits and loans scientifically.

The profitability of the banks depends on the price charged on their loans and the cost of funds from deposits, so as to have positive spread

A bank has the option between investing in credit risk free government security or risky commercial loan.

If a bank decides to give a commercial loan, it has to be compensated for the credit risk over and above the risk free return.

Further, all commercial loans are not of the same degree of risk. Loan pricing will, therefore, be based on the credit rating of the borrower and higher the risk the more will be the compensation.

The loan pricing should, therefore, be enough to recover o Cost of fundso Credit risk premiumo Capital adequacy costo Overheads

The process of taking all these into account while pricing is called “intrinsic value pricing” of a loan

The bank has to strike a balance between the intrinsic value pricing and market pricing in order to attract the business

Liability Pricing If loan pricing depends on cost of funds it is important to accurately measure the cost of funds

and evaluate alternative funding sources or costsCost of funds pricing

There are several methods to estimate the cost of funds. The most important ones are: o Average historical cost of fundso Marginal cost of fundso Weighted marginal cost of funds; and o Grossed up cost of funds

Average historical cost of funds It is very simple method to calculate the cost of funds It can be calculated by dividing the expenditure (interest and non-interest) incurred accepting the

liabilities to total outside liabilities Average historical cost of funds overcasts cost of funds in a falling interest rate scenario and

understates the cost of funds in a rising interest rate scenario. A bank following this method, overcharges its borrowers when interest rates are falling and

undercharges its borrowers when interest rates are rising. Though undesirable in a competitive market, many banks follow this methods in pricing their

loans.


Marginal cost of funds It is the cost of acquiring one more unit of funds It is calculated with the help of MC= interest cost + Service cost + Insurance cost, etc.,

1 – percentage of funds deployed in non-earning assets This method of pricing assumes that specific sources of funds are tied to specific uses of funds.

It a bank gets a fixed rate loan of a definite tenor and price, it tries to get a liability of equal tenor with a fixed price so as to get a desired positive spread. The spread would be maintained through out the tenor.

Given interest cost = 10%Service cost .30%Insurance cost = .05%Percentage of funds deployed in non-earnings assets like CRR = 5%MC = 0.10 + .003+ 0.005 = 10.9%

1- .05

Weighted marginal cost of funds; and Under this method the specific marginal cost of funds are multiplied with the respective weights

to get weighted marginal cost

Grossed up cost of funds This concept of cost takes into account the cost of funds and the statutory pre-emption of a part of

it at a regulated rate and then deciding the break-even rate to be charged on the residual funds to be deployed as loan.

SECURITIESIntroduction

When a borrower is granted a loan from a bank, the bank will often want security for the loan it makes. Taking effective security over an asset means that the bank can, on the insolvency of the borrower, take possession of that asset, sell it and use the proceeds to repay the loan. This puts the bank in a stronger position than creditors who do not have security.

Depending on the circumstances, the bank has the option of taking security over specific assets of the company or over all the assets of the company. If the bank chooses to do the latter a debenture will be used to create fixed and floating charges over all the property and assets of the company.

Under English law there are several types of security interest which are favoured by banks. This Guide will look at what these involve, along with their advantages and disadvantages.

In lending, banks give utmost importance to the principles of safety and security, because o Banks deal with public moneyo Risk inherent in all types of loanso It is the last line of defense to fall back in case of default or emergencyo To have a sense of protection

Security


Security means an asset, movable or immovable, obtained to secure a loan granted by a lender/bank

Securities obtained not only protect the interest of the lender/bank at the time of default of the borrower, but also provides a psychological advantage to the lender

Secured and Unsecured Loans When an advance is made against the security of any tangible assets, like, the goods, fixed assets,

government securities, etc., is known as a secured advance, while an advance is not secured is called unsecured loan

An unsecured loan is also known as clean loan or clean advance When the market value of the security is falling, the secured loan may become an unsecured loan

When an advance is made against the security of any tangible assets, like, the goods, fixed assets, government securities, etc., is known as a secured advance, while an advance is not secured is called unsecured loan

An unsecured loan is also known as clean loan or clean advance When the market value of the security is falling, the secured loan may become an unsecured loan

Primary and Collateral Securities The asset created by the borrower out of the loan/credit facility granted by the bank or lender

from the primary security for the advance made as a matter of rule. Primary securities could be personal and impersonal. Primary personal security is created out of a duly executed promissory note and Primary

impersonal security is are the assets or created out of bank loans Collateral security is an additional security to cover the loan/advance It could be two kinds, direct collateral and indirect collateral Direct collateral can be the additional security provided belonging to the borrower while the

indirect collateral is the third party personal guarantee or assetsTangible and Intangible Securities

Tangible security is one which can be realized by way of sale or transfer When loan or advance is made against the personal security of a third party, it can be referred as

intangible security or personal security Tangible security is one which can be realized by way of sale or transfer When loan or advance is made against the personal security of a third party, it can be referred as

intangible security or personal security Characteristics of a Good Security

Marketabilityo Must have a ready marketo The raw materials may have marketability which work-in-progress may not haveo The marketability of a security is also influenced by the factors like, mostly they are

tailor made to the requirements of the borrower and such securities find ready market only when the requirements match with the potential buyer.

Ascertainment of valueo The value of a security should be ascertained with a definite degree of accuracy o The value of certain painting and antiques can not be ascertained with certain degree of

accuracy Stability of value

o A good security should have value and its value should stable over a period of timeo A security with highly violently fluctuating value may not be considered as security by

the banks or lenderso If they have to consider, it would be done with high margin

Transferability and title


o A bank or lender accept an asset as a security only its title can be easily ascertainable and transferable.

o If an asset, taken as security, is non-transferable, the main purpose of taking a security is lost

o Sometimes, the legal process involved in getting a very good security against the advance/loan discourage the lender from accepting it as a security

Durability o An asset, accepted as a security should have long durability o Loans and advances should not be made against the perishable goods

Margin in securityo Margin basically implies the margin of safetyo The percentage of margin which is kept by the bank/lender as a cushion for any

unforeseen drop in the value of securityo The percentage of margin depends on the characteristics possessed by the security.o Low margin would be kept on a security with ready marketability, stable value,

transferability of the title, etc., o The percentage of margin also depends on the credit worthiness of the borrower

Storabilityo The goods or commodities accepted as security should be storable under reasonable

safe conditions Supervision

o Sometimes the securities have to be supervised by the bank or lendero Therefore, they should be supervisable o The goods of the borrower pledged in working capital finance, they should be

supervised periodically by the bank Transportable

o The nature of the securities obtained by the bank or lender could be shifted easily if the situation demands

Additional Incomeo If a security is obtained with a capacity of earning some additional income, it would

be all the more preferable Contingent Liability

o A good security should not have any contingent liability attached to ito It any, it would add burden to debt and to the lender or bank

Classification of Securities Primary

o refers to the securities which are created with help of finance made available by the bank or lender

Collateral o The word collateral means additionalo It a supporting security. o Finance is not provided against the additional security, but whenever bank feels that an

additional security is needed it demands Personal securities

o This kind of security provides legal remedy to the bank against the borrower by providing right of action against the borrower personally.

o Securities such as promissory notes, bills of exchanges, security bond, o Loans given against this kind of security, would be treated as unsecured loans as no

tangible or liquid assets security backing these advance


Tangible securities o Securities in the form of land, building, machinery, etc, are the tangible securities and

these securities can be relied upon in times of crisis. Liquid securities

o The most reliable form of security as it can be easily converted into cash in case of default of the borrower

o A fixed deposit receipt, Blue chip companies shares, company deposit receipts, etc., Government Securities / Gilt Edged Securities

o Bonds, promissory notes, Treasury bills issued by the government, are the best example of this type of securities

Blue-chip Securityo Refers to the shares of highly rated, consistently dividend paying, companies with

incremental growth, etc., Stock Exchange Securities

o The securities which are traded in stock exchanges, e.g., shares and debenturesMargin

MARGIN is the difference between the market value of the security and the amount of loan sanctioned

The main purpose of leaving a margin on a security to dispose off in case of need and to appropriate the amount of realization from its sale to settle the advance.

The banks, generally, lends a little less amount of money than the market value of the securityReasons for Margin on Securities

Fluctuations in the market value of the securities Wear and tear of the security In case of default, the total amount of loan along with the accumulated interest should not exceed

the market value of the security To cover the volatility in the market value of shares, if they are accepted as security In case of default of the borrower, the banks have to dispose the security at a lower price than the

market price. If the stake of the borrower is with the banker, he would have interest in repaying the advance

and taking back the security The values of some of commodities accepted as securities are influenced the guidelines of RBI

the banks have to maintain sufficient margin for such factors also

Charges On SecuritiesIntroduction

Banks or lending institutions need to keep their position safe by accepting a tangible security from the borrower

In case of default of the borrower the banker disposes off the security and with the amount so realized the advance/loan would be appropriated

Only when the security is properly charged, the bank can dispose it off Banks or lending institutions need to keep their position safe by accepting a tangible security

from the borrower In case of default of the borrower the banker disposes off the security and with the amount so

realized the advance/loan would be appropriated Only when the security is properly charged, the bank can dispose it off

Meaning of ‘CHARGE’ The term 'charge' is often used as a generic term for all types of security interest, but specifically

it represents an agreement between a creditor and a debtor in which a particular asset or class of assets can be used to satisfy a debt.


A charge creates an encumbrance or interest which attaches to the asset and travels with it into the hands of any third parties.

The only exception to this is a genuine, arms-length purchaser of the full legal ownership for value and without notice, who will acquire the asset free of the charge.

A charge does not involve the transfer of ownership or possession of an asset. For practical reasons most lenders will not want to take possession of the borrower's assets and nor will the borrower want to lose control of them, especially if those assets are used in the day-to-day running of the business.

Accordingly a lender (chargee) will instead want to take security by obtaining rights over specific assets of the borrower (chargor) as security for the loan.

The chargee then has a right to resort to that asset to repay the debt.Fixed and Flexible Charges

Charges can either be fixed or floating. The nature of a charge (whether fixed or floating) is particularly important if the borrower

becomes insolvent. Under a fixed charge an asset which is ascertained and definite, or capable of being ascertained

and defined, can be used to satisfy a debt immediately or once the lender acquires an interest in it. A floating charge, on the other hand, hangs over a class of assets or future assets and acts as a

deferred right to use those assets to satisfy a debt. Until an event occurs which causes the floating charge to fix to those assets, the borrower is free

to dispose of and add to the assets in the ordinary course of its business. When the event occurs and the floating charge becomes fixed, it attaches to the assets that make

up that class at that point. It should be noted that the label attached to the charge is not conclusive in determining whether it

will be regarded by a court as fixed or floating. To be confident that a court will regard a charge over assets as fixed, the lender must demonstrate

that it has exercised control over the charged assets to the extent that the charge does not 'float' over the assets but is fixed to them.

In practice, this means implementing clear restrictions on the ability of the borrower to deal with the assets and enforcing those restrictions.

The security will be charged to a bank in the following wayso Hypothecation o Pledgeo Lieno Assignment o Mortgage

Loans are also secured by way of guarantee and/indemnity


HypothecationPledge Lienset-offassignment Mortgage

Hypothecation Hypothecation is defined as “a charge against property for an amount of debt where neither

ownership nor possession is passed on to the creditor “Hypothecation means a charge in or upon any movable property existing or future, created

by a borrower in favaour of a secured creditor without delivery of possession of the movable property to such creditor, as a security for financial assistance and include floating charge and crystallization of such charge in fixed charge on movable property” - the SARFAESI Act, 2002

Essentials of Hypothecation Is a charge in or upon any movable property existing or future Movable property can be existing or future property Ownership and goods remain in the possess of the borrower Creditor enjoys the constructive possession of the goods A equitable charge is created in favour of the bank (lender) Hypothecation agreement should be signed by the borrower The borrower binds himself under the hypothecation agreement to give the possion of the

goods to the lender when called upon to do so. After the possession is handed over to the lender, the charge is converted from

hypothecation into pledge Features of Hypothecation

It applies to movable goods and commodities, movable machinery, book debts, etc., Possession as well as ownership of the securities remain with the borrower The charge is created by a document known as letter of hypothecation The borrower undertakes to give a right of possession to the bank whenever the latter requires

Risk with hypothecation Advance granted under hypothecation is risky. The borrower may sell the goods and may not

repay the loan or he may hand over the possession of the shop by keeping very small or no stock of goods or he may take an advance from another bank by hypothecating the same goods. In all such cases the lending bank may lose the money. Therefore the hypothecation should be given to highly reliable customers with integrity.

Additional precautions The advance should be granted to such customers who enjoy a good credit or reputation in the

market and the bank has confidence in his honesty and integrity The borrower is required to submit a statement of stock periodically, which will contains a

declaration by the borrower regarding his title to the goods and correctness of quality, quantity and value of goods

On the basis of the stock statement, the bank should inspect the hypothecated goods and the account books of the borrower to ascertain the genuineness and correctness of the transactions.

The borrower should also give an undertaking that the goods are not hypothecated to any other bank

Stocks should be fully insured against fire, theft and all other possible risks A name plate of the bank reading “stock hypothecated with _______ bank” should be displayed

at a prominent place where the goods are kept. If the borrower is a joint stock company, the charge of hypothecation should be registered with

the registrar of companies under section 125 of the Companies Act 1956 within a period of 30 days from its creation.

Pledge Pledge is “the bailment of goods as security for payment of a debt or performance of a

promise” - Indian Contract Act, 1872 , Section 172


Bailment is the delivery of goods by one person to another for some purpose, under a contract that the goods shall, when the purpose is accomplished, be returned or otherwise disposed of according to the direction of the person delivering them.

The person delivering the goods is called the pledger or pawnor .and the person to whom the goods are delivered is called pledge or pawnee.

Therefore, pledge handing over of goods or the documents of titles to goods, by borrower to the creditor with an intention of creating a charge thereon as a security for the debt

The ownership remains with borrower, but the possession is taken by the creditor and this is the essence of Pledge. The borrower would be pledger and bank would be pledge

Features of Pledge Transfer of possession or delivery of goods is essential to complete a pledge Pledge may be created in case of goods, stocks, shares, documents of titles to goods such as

railway receipts, bill of lading, etc., and any other movable property Delivery of the goods should be with an intention that the goods must be served as a

sexcurity for the payment of a debt or for the performance of a promise. In pledge, the possession is only transferred and not the ownership. It remains with the

pledger. If the pledger fails to repay the debt, the pledge can sell the goods after giving a reasonable

notice or can file a suit for the sale of goods pledged. When the pledge decides to exercise the right of sale he must issue a notice to that effect to

the pledger well in time. Who can Pledge?

The owner of the goods himself The mercantile agent of the owner Joint owner with the consent of other co-owner A person in possession goods under voidable contract. A seller in possession of the goods after the sale agreement A buyer in possession of goods before sale A pledger can repledge

Rights of the Bank as a Pledgee Right to retain the goods Right to sue Right to sell Right to recover the deficit Extraordinary expenses Right to claim damages Right under voidable contract Law of limitation

Duties of the Bank as a Pledgee Return of the goods pledged Taking care of the goods Not to make use of the goods Return of surplus Return of profit

Advantages of Pledge The goods are in the possession of the bank or pledge and can be disposed off easily, if the

borrower is at default Close supervision is possible Creating subsequent pledge on the same property is not possible. Full insurance is available, in case a loss is occurring to the goods


No tax is required to be paid

Lien Lien Is the right to retain goods. Lien is the right of a creditor to retain the possess of properties belonging to the debtor until

the debt due to him is paid Here the creditor gets the right of possession of the property but does not get the right to sell

the property. Lien has two essential presumptions, firstly, the person vested with the right of lien is in

possession of the properties in ordinary and usual course of business and secondly, the owner has a lawful debt due or obligation to discharge to the person in possession of the said properties.

Once debt is paid off , the right of lien would stand extinguished and the property will have to returned

A lien can be General lien or Particular lien General Lien: “In the absence of an agreement to the contrary, bankers, factors (mercantile

agents), wharfingers, attorneys and policy brokers, retain as a security for a general balance of accounts any goods and securities bailed to them –unless there is a contract to the contrary” - Section 171 of Indian Contract Act, 1872. As such, the bank is empowered to retrin all goods of the customer in respect of general balance due from him. The ownership of goods or securities and to retain them until the dues are paid.

Particular lien: would arise only when a bank can retain the goods in respect of a particular debt

A banker’s lien can be more than a general lien, as it is considered as an implied pledge. It means, in case of an implied pledge and the banker can exercise all the rights of a pledge.

In the case of default by the borrower, the bank has a right to sell the goods without filing a suit against the borrower in a court of law, after giving a reasonable notice to him.

In case of default of debt, bank can exercise its right of sale of the goods and securities in its possession, without filing a suit in a court of law

Features of general lien The bank gets the right of general lien on all goods and securities entrusted to it in its capacity as

a bank only. It means it cannot have such right if the goods and securities are entrusted to the bank as a trustee or an agent of the customer

The right of lien can be exercised in case of goods and securities remaining in the possession of bank after the loan taken against them have been paid. These securities can be retained for other dues of the same customer.

The bank’s right of lien is more than general lien. It can sell the goods and securities in the case of default by the borrower. Therefore, it is called implied pledge.

No separate agreement or contract is necessary for the exercise of the right, as it is vested under section 171 of the Indian Contact Act, 1872

If the bank is unaware of the fact that securities offered by the borrower are in his passion in the capacity of a trustee, right of lien can be exercised.

However the bank can not exercise the right of lien in the following circumstanceso When the things are kept for safe custody or in safe deposit vaulto When the borrower deposits an amount for specific purposeo When the goods or securities are left with the bank by the customer inadvertentlyo When the borrower is a trustee of the goods or securitieso When the goods or securities are given to the bank for a fresh loan which not sanctioned o When the goods or securities are owned by more than one person and loan is granted to

any one of them


o Whether the share are given for sale with a specific instruction to apply proceeds for specific purpose

o When any instrument is given for collection with a specific instruction to utilize the amount for a specific purpose.

A Set Off

A set-off means the total or partial merging of a claim of one person against another of a counter-claim by the latter against the former.

A bank can set-off a loan account with the balance in savings bank account of the same customer/borrower

Assignment An assignment means a transfer by one person of a right, property, debt (existing or future) to

another person. In case of a bank loan…… Borrower is the assignor and bank is the assignee.

Assignment by way of security A borrower's rights against third parties, such as the right to receive payment for debts on its own

books, can be assigned to a third party as a way of selling those rights – this is an absolute, or direct, assignment. It is also possible to carry out an assignment by way of security over a borrower's choses in action – rights the borrower is entitled to under contracts – as security for that borrower's debts. As with any assignment, an assignment by way of security can be either legal or equitable. An assignment will be legal if it is:

in writing and executed by the borrower (the assignor); absolute - that is, unconditional and for the whole amount; and notified in writing to the person against whom the assignor could enforce those assigned rights,

usually the debtor of the borrower company. As a result, a legal assignment should be expressed as an absolute assignment with a provision

that those rights will be reassigned once the relevant debt is satisfied. If, however, an assignment is made 'by way of charge' rather than by way of security then it will take effect in equity only.

A legal assignment can only assign debts which already exist. Only an equitable assignment can assign rights under future contracts.

Mortgage Banks secure the loans and advances made by them. Tangible assets are obtained as Primary or collateral security. Security charge on Immovable Property is obtained as Mortgage. Section 58(a) of Transfer of Property Act, 1882 defines a mortgage as “the transfer of interest in

specific immovable property for the purpose of securing the payment of money advanced by way of loan, an existing or future debt or the performance of an agreement, which may give rise to a particular liability”.

Under a mortgage, ownership of an asset is transferred (by way of security for the loan) on the express or implied condition that it will be returned when the loan is repaid.

What distinguishes a mortgage from an outright sale with a right of repurchase is that the transfer is only intended to secure the repayment of the debt.

Transferring ownership enhances the lender's ability to sell the asset and receive cash in return if necessary, and prevents the borrower from disposing of the asset.

A mortgage does not require the delivery of possession and so any kind of asset whether tangible (such as houses, ships or planes) or intangible (such as copyrights or patents) is capable of being mortgaged.

A mortgage can be legal or equitable. Under a legal mortgage, legal ownership of the property is transferred to the lender. An equitable mortgage is usually created where either a transaction does not meet the formal requirements of a legal mortgage but is recognised in equity (for example, a


mortgage over property which the mortgagor does not yet own – a legal mortgage can only be created over property which exists at the time); or where the mortgage concerns property only recognised in equity (for example, an interest in a trust fund – a legal mortgage cannot be taken over property which is only recognised in equity).

Legal mortgage: This is the most secure and comprehensive form of security interest. As we have seen, it transfers ownership to the bank (the mortgagee) and so prevents the borrower (the mortgagor) from dealing with the mortgaged asset whilst it is subject to the mortgage. The formalities required for creating a legal mortgage depend on the type of property being secured, but include:

the creation of a legal mortgage over land, which must be done by deed; a legal mortgage over debts or choses in action - rights under contracts – which is created by an

absolute assignment, in writing, by the assignor which is not intended to be by way of charge. Written notice of this assignment must be given to the debtor, trustee or other person from whom the assignor would have been entitled to claim the debt or choses in action;

legal mortgages over chattels – personal property – which do not generally require any formalities to make them effective providing that there is a valid agreement and the intention to create a legal mortgage;

a legal mortgage over registered securities which is created by transferring those securities into the name of the mortgagee by novation – in essence, a new contract. The mortgagee should be registered as the new holder of those securities;

a legal mortgage of registrable intellectual property rights, which is created by entry of the details of the mortgage into the relevant register.

A legal mortgage transfers ownership of the asset to the mortgagee so it cannot be sold to a third party without the mortgage being released and ownership being transferred back to the mortgagor. Alternatively the purchaser can agree to acquire the property subject to the existing mortgage, which is unusual.

Equitable mortgage: An equitable mortgage only transfers a beneficial interest in the asset to the mortgagee, with full legal ownership remaining with the mortgagor. In general, an equitable mortgage will arise where one of the following applies:

the formalities necessary to create a legal mortgage have not been complied with; the mortgagor's interest in the asset being mortgaged is an equitable interest; the parties have merely entered into an agreement to create a legal mortgage in the future over the

asset in question, rather than formally creating such a mortgage; the property to be mortgaged is recognised only in equity - for example, an interest in a trust

fund. Equitable mortgages and charges can be taken in a number of ways, some of which offer very

little protection against third parties obtaining an interest in the charged asset and can make enforcement over the charged asset very difficult. It is preferable to take a legal mortgage or charge wherever possible.

REGULATORY FRAME WORK - RBI GUIDELINESIntroduction

The preamble of the Reserve Bank of India describe the basic functions of the Reserve Bank as “…to regulate the issue of Bank Notes and keeping of reserve with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage”

History • It was set up on the recommendations of the HILTON YOUNG COMMISSION .• It was started as Share-Holders Bank with a paid up capital of 5 Crs .• It was established on 1st of April 1935.• Initially it was located in Kolkata.


• It moved to Mumbai in the year 1937.• Initially it was privately owned.• It was the 1st bank to be Nationalized in 1949.• It has 22 regional offices, most of them in state capitals.• Since nationalization in 1949, the Reserve Bank is fully owned by the Government of India.• Its First governor was Sir Osborne A.Smith(1st April 1935 to 30th June 1937).• The First Indian Governor was “Sir Chintaman D.Deshmukh”(11th August 1943 to 30th June

1949).• On 27th June 2006, the Union Government of India reconstituted the Central Board of Directors

of the Reserve Bank of India(RBI) with 13 Members, including Azim Premji and Kumar Mangalam Birla

Bank guarantee• “Bank guarantee is the commitment given by the issuing bank (Guarantor) to the beneficiary. If

the claim is made by the beneficiary within the guarantee period and as per the terms and conditions of the bank guarantee, then the bank should make the payment without fail and also without any delay.”

• Banks issue guarantees on behalf of their customers for various purposes.• The guarantees executed by banks comprise both performance guarantees and financial

guarantees.• The guarantees are structured according to the terms of agreement, viz., security, maturity and

purpose.• Courts will not interfere in the functions of a banker with regard to bank guarantees issued by

them.Constituents of Bank Guarantee

• Three parties are involved at the time of entering into BG• Party providing guarantee : Surety• Party on whose behalf guarantee is given : Principle debtor• Party in whose favor guarantee is given : Creditor/ Beneficiary.

Types of guarantees • Direct Bank Guarantee - issued by the applicants bank (issuing bank) directly to the guarantees

beneficiary without concerning a correspondent bank.• Indirect Bank Guarantee - with an indirect guarantee, a second bank is involved, which is

basically a representative of the issuing bank in the country to which beneficiary belongs. • Financial Guarantee – e.g. –Tender Deposit, Sales Tax Payments, Retention Money.• Performance Guarantee - one of the most common types of bank guarantee which is used to

secure the completion of the contractual responsibilities of delivery of goods and act as security of penalty payment by the Supplier in case of non delivery of goods.

• Advance Payment Guarantees - mode of guarantee is used where the applicant calls for the provision of a sum of money at an early stage of the contract and can recover the amount paid in advance, or a part thereof, if the applicant fails to fulfill the agreement.

• Credit Card Guarantee - issued by the credit card companies to its customer as a guarantee that the merchant will be paid on transactions regardless of whether the consumer pays their credit.

RBI Guidelines for Guarantees and Co-acceptance bills• Bank Guarantees (BG) comprise both performance guarantees (PG) and financial guarantees

(FG) and are structured according to the terms of agreement viz., security, maturity and purpose.• Banks should confine themselves to the issuance of FG and exercise due caution with regard to

PG business. • Bank guarantees should not normally extend beyond 10 years. Banks may issue guarantees (BG)

for periods beyond 10 years taking into account the impact of very long duration guarantees on


their Asset Liability Management and in tune with their policy on issuance of guarantees beyond 10 years as approved by the Board

Norms for unsecured advances & guarantees• Banks’ Boards have been given the freedom to fix their own policies on their unsecured

exposures including unsecured guarantees. • Unsecured exposure is where the realizable value of the tangible security, as assessed by

bank/approved valuers /RBI inspecting officers, is not more than 10% ab-initio, of the outstanding exposure (funded and non-funded exposure) including underwriting and similar commitments.

• The rights, licenses, authorizations, etc. are not reckoned as tangible security whereas annuities under Build-operate-transfer (BOT) projects and toll collection rights where there exists provision to compensate the project sponsor if a certain level of traffic is not achieved can be treated as tangible security

Precautions for Averting Frauds• While issuing FGs, banks should satisfy about customer’s ability/capacity to reimburse the bank

in case it is required to honor the commitments under the FG. • In case of PG, banks should exercise due caution and satisfy themselves that the customer has

the necessary experience, capacity and means to perform the obligations under the contract, and is not likely to commit any default.

• Banks should refrain from issuing BGs on behalf of customers who do not enjoy credit facilities with them other than customers of co-operative banks against counter guarantee of the co-op. bank which have sound credit appraisal and monitoring systems as well as robust Know Your Customer (KYC) regime.

Ghosh Committee Recommendations• Given by Shri A.Ghosh – the then Dy.Governor ,RBI.• Bank Guarantees should be issued in serially numbered security forms.• While forwarding the BGs to the beneficiaries, caution them to verify the genuineness of the

guarantee with the issuing bank.Internal Control Systems • BGs for Rs. 0.50 Lakh and above are to be signed by two officials jointly. A lower cut-off point,

depending upon the size and category of branches, may be prescribed by banks, where considered necessary.

• Allow deviation from the two signatures discipline should be only in exceptional circumstances. In such cases there should be a system for subjecting such instruments to special scrutiny by the auditors or inspectors at the time of internal inspection of branches.

Guarantees on Behalf of Share and Stock Brokers/ Commodity Brokers• Banks can issue BGs on behalf of share and stock brokers in favour of Stock Exchanges towards

security deposit, margin requirements as per Stock Exchange Regulations.• BGs can also be issued on behalf of commodity brokers in favour of national level commodity

exchanges viz. National Commodity & Derivatives Exchange (NCDEX), Multi Commodity Exchange of India Limited (MCX) and National Multi-Commodity Exchange of India Limited (NMCEIL), in lieu of margin requirements as per the Commodity Exchange Regulations.

• Banks are required to obtain a minimum margin of 50% (out of which cash margin to be 25%) while issuing such guarantees in both the above cases and to observe usual and necessary safeguards including the exposure ceilings.

• Issued in security forms from serially numbered to prevent fake guarantees.• Should not be issued to customer who do not have credit facilities with the bank but only

maintain current account.• Should be issued in Triplicate : Copy to Branch ,Beneficiary , Head Office


• Avoid giving unsecured guarantees in large amounts for medium and long-term periods and such commitments to particular groups of customers and/or trades.

• For individual constituent, unsecured guarantees should be limited to a reasonable proportion of the bank’s total unsecured guarantees and constituent’s equity.

• Banks can give deferred payment guarantees on an unsecured basis for modest amounts to first class customers in exceptional cases.

Can a bank offer bank guarantee to other bank • A bank can give BG to another bank on behalf of a client of the beneficiary bank. Also ,a Bank

can give BG to a beneficiary on behalf of another Bank.• For example: Suppose a client in USA does not accept a BG from an Indian Bank. What will the

Indian supplier do then if he doesn’t have an account in a reputed foreign bank ?• The client will approach an Indian Bank for the BG. The Indian Bank will then approach a

reputed foreign bank for the counter BG. The foreign Bank will issue a BG in favor of the client on behalf of the Indian Bank.

• Alternatively, the foreign bank, instead of issuing a BG, can stand guarantee to the BG issued by the Indian Bank to the client in USA

Bank Guarantee in Export Business • The issuing bank issues a letter of credit reflecting the terms of the sales agreement and forwards

it to the confirming bank. • The confirming bank checks it for authenticity, adds its own guarantee and forwards it to the

exporter. • The exporter collects documents proving that he shipped confirming goods -- such as an

inspection certificate issued by a shipping company -- and presents them to the confirming bank along with the letter of credit.

• The confirming bank pays the exporter, the issuing bank pays the confirming bank and the exporter pays the issuing bank.

• Advantages • The cost of servicing guarantees is significantly less than the cost of bank lending. • The expansion of company’s foreign trade operations opens new international markets and

enlarges the circle of foreign partners.• Bank guarantees provide favorable conditions on which to work with the suppliers — receive or

extend payment deferments from manufacturers, increase the procurement volume of goods and receive additional discounts for purchased products.

• Reduction of risks inherent in transaction.

Co-Acceptance of Bills• Under this facility banks accept commercial usage bills drawn on their constituents which would

enable the latter to enjoy credit which otherwise the seller will not be willing to extend. • In this facility the banks add the strength of their name and no finance is envisaged

Guidelines• Co-acceptance facility should be extended only to borrower constituents upon ascertaining the

need thereof and banks should ensure that only genuine trade bills are co-accepted and goods covered by the bills co-accepted are actually received in the stock account of the constituents;

• Verify the accompanying invoices to see that there would not be any over valuation of stocks;• No co-acceptance to house bills/ accommodation bills drawn by group concerns on one another.

Safeguards• Banks are precluded from co-accepting bills drawn under Buyers Line of Credit Schemes

introduced by IDBI Bank Ltd. and all India financial institutions like SIDBI, Power Finance Corporation Ltd. (PFC), etc. Similarly, banks should not co-accept bills drawn by NBFCs and not to extend co-acceptance on behalf of their buyers/constituents under the SIDBI Scheme.


• Banks are permitted to co-accept bills drawn under the Sellers Line of Credit Schemes (since renamed as Direct Discounting Scheme) operated by IDBI and all India financial institutions for Bill Discounting operated by IDBI and all India financial institutions like SIDBI, PFC, etc. without any limit, subject to the buyer’s capability to pay, and compliance with the exposure norms prescribed by the bank for individual/ group borrowers.

• The discounting banks should, therefore, ascertain from the co-accepting bank the reason for such co-acceptance and upon satisfying themselves of the genuineness of such transactions, they may consider discounting such bills.

Know Your Customer (KYC) norms; 1. What is KYC?

KYC is an acronym for “Know your Customer”, a term used for customer identification process. It involves making reasonable efforts to determine true identity and beneficial ownership of accounts, source of funds, the nature of customer’s business, reasonableness of operations in the account in relation to the customer’s business, etc which in turn helps the banks to manage their risks prudently. The objective of the KYC guidelines is to prevent banks being used, intentionally or unintentionally by criminal elements for money laundering.

KYC has two components - Identity and Address. While identity remains the same, the address may change and hence the banks are required to periodically update their records.

Is there any legal backing for verifying identity of clients? Yes. Reserve Bank of India has issued guidelines to banks under Section 35A of the Banking

Regulation Act, 1949 and Rule 7 of Prevention of Money-Laundering (Maintenance of Records of the Nature and Value of Transactions, the Procedure and Manner of Maintaining and Time for Furnishing Information and Verification and Maintenance of Records of the Identity of the Clients of the Banking Companies, Financial Institutions and Intermediaries) Rules, 2005. Any contravention thereof or non-compliance shall attract penalties under Banking Regulation Act.

Fixed deposit in a bank. Is KYC - applicablee?Yes. KYC is applicable to customers of the bank. For the purpose of KYC following are the ‘Customers of the bank.

a person or entity that maintains an account and/or has a business relationship with the bank; one on whose behalf the account is maintained (i.e. the beneficial owner); beneficiaries of transactions conducted by professional intermediaries, such as Stock Brokers,

Chartered Accountants, Solicitors etc. as permitted under the law, and any person or entity connected with a financial transaction which can pose significant

reputational or other risks to the bank, say, a wire transfer or issue of a high value demand draft as a single transaction.

KYC for Customer Identification? Customer identification means identifying the customer and verifying his/her identity by using

reliable, independent source documents, data or information. Banks have been advised to lay down Customer Identification Procedure to be carried out at different stages i.e. while establishing a banking relationship; carrying out a financial transaction or when the bank has a doubt about the authenticity/veracity or the adequacy of the previously obtained customer identification data.

Once KYC requirements are complied with while opening the account, whether the bank can again ask for KYC compliance?

Yes. To ensure that the latest details about the customer are available, banks have been advised to periodically update the customer identification data based upon the risk category of the customers.

Banks create a customer profile based on details about the customer like social/financial status, nature of business activity, information about his clients’ business and their location, the purpose and reason for opening the account, the expected origin of the funds to be used within the


relationship and details of occupation/employment, sources of wealth or income, expected monthly remittance, expected monthly withdrawals etc. When the transactions in the account are observed not consistent with the profile, bank may ask for any additional details / documents as required. This is just to confirm that the account is not being used for any Money Laundering/Terrorist/Criminal activities.

Though driving licence was submitted as a proof of identity and address but still the bank asked for telephone / electricity bill.

There are two aspects of Customer Identification. One is establishing identity and the other is establishing present residential address.

For establishing identity, the bank requires any authentic document carrying photo of the customer such as driving licence/ passport/ pan card/ voters' card etc. Though these documents carry the residential address of the customer, it may not be the present address. Therefore, in order to establish the present address of the customer, in addition to passport/ driving licence / voters' card / pan card, the bank may ask for utility bills such as Telephone / Electricity bill etc.

The detailed list of the documents that the bank can ask is given below.Features DocumentsAccounts of Individuals- Legal name and any other

names used(i) Passport (ii) PAN card(iii)Voter's Identity Card(iv) Driving licence(v) Identity card (subject to the bank's satisfaction)(vi) Letter from a recognized public authority or public servant verifying the identity and residence of the customer to the satisfaction of bank

- Correct permanent address (i) Telephone bill (ii) Bank account statement(iii) Letter from any recognized public authority(iv) Electricity bill(v) Ration card(vi) Letter from employer (subject to satisfaction of the bank)(any one document which provides customer information to the satisfaction of the bank will suffice)

Accounts of Companies- Name of the company (i) Certificate of incorporation and Memorandum & Articles of

Association(ii) Resolution of the Board of Directors to open an account and identification of those who have authority to operate the account (iii) Power of Attorney granted to its managers, officers or employees to transact business on its behalf (iv) Copy of PAN allotment letter (v) Copy of the telephone bill

- Principal place of business- Mailing address of the

company- Telephone / Fax Number

Accounts of Partnership Firms- Legal name (i) Registration certificate, if registered

(ii) Partnership deed (iii) Power of Attorney granted to a partner or an employee of the firm to transact business on its behalf (iv) Any officially valid document identifying the partners and the persons holding the Power of Attorney and their addresses

- Address- Names of all partners and

their addresses- Telephone numbers of the


firm and partners(v) Telephone bill in the name of firm / partners

Accounts of Trusts & Foundations- Names of trustees, settlers,

beneficiaries and signatories

(i) Certificate of registration, if registered(ii) Power of Attorney granted to transact business on its behalf(iii) Any officially valid document to identify the trustees, settlors, beneficiaries and those holding Power of Attorney, founders / managers / directors and their addresses(iv) Resolution of the managing body of the foundation / association(v) Telephone bill

- Names and addresses of thefounder, the managers / directors and the beneficiaries

- Telephone / fax numbersAccounts of Proprietorship Concerns- Proof of the name, address

and activity of the concern* Registration certificate (in the case of a registered concern) * Certificate / licence issued by the Municipal authorities under Shop & Establishment Act,* Sales and income tax returns* CST / VAT certificate* Certificate / registration document issued by Sales Tax / Service Tax / Professional Tax authorities* Registration / licensing document issued in the name of the proprietary concern by the Central Government or State Government Authority / Department. * IEC (Importer Exporter Code) issued to the proprietary concern by the office of DGFT as an identity document for opening of bank account. * Licence issued by the Registering authority like Certificate of Practice issued by Institute of Chartered Accountants of India, Institute of Cost Accountants of India, Institute of Company Secretaries of India, Indian Medical Council, Food and Drug Control Authorities, etc.Any two of the above documents would suffice. These documents should be in the name of the proprietary concern.

If a spouse who is not having any address proof in his/her name, can he/she open an account with the bank?

Yes. In such cases where the utility bills required for address verification are not in the name of the person who wants to open an account ( close relatives, e.g. wife, son, daughter and daughter and parents etc. who live with their husband, father/mother and son, as the case may be) , an identity document and a utility bill of the relative with whom the prospective customer is living along with a declaration from the relative that the said person (prospective customer) wanting to open an account is a relative and is staying with him/her is acceptable. As supplementary evidence bank may ask for a letter received through post for further confirmation.

Can a daily wage earner without any document to satisfy the bank about identity and address, open a bank account?

A customer belonging to low income group who is not able to produce documents to satisfy the bank about his identity and address, can open bank account with an introduction from another account holder who has been subjected to full KYC procedure provided that the balance in all his accounts taken together is not expected to exceed Rupees Fifty Thousand (Rs. 50,000/-) and the total credit in all the accounts taken together is not expected to exceed Rupees One Lakh (Rs. 1,00,000/-) in a year. The introducer’s account with the bank should be at least six months old


and should show satisfactory transactions. Photograph of the customer who proposes to open the account and also his address needs to be certified by the introducer,

OR any other evidence as to the identity and address of the customer to the satisfaction of the bank. If at any point of time, the balance in all his/her accounts with the bank (taken together) exceeds

Rupees Fifty Thousand (Rs. 50,000/-) or total credit in the account exceeds Rupees One Lakh (Rs. 1,00,000/-) in a year, no further transactions will be permitted until the full KYC procedure is completed.

In order not to inconvenience the customer, the bank will notify the customer when the balance reaches Rupees Forty Thousand (Rs. 40,000/-) or the total credit in a year reaches Rupees Eighty thousand (Rs. 80,000/-) that appropriate documents for conducting the KYC must be submitted otherwise operations in the account will be stopped.

Whether a certificate from an employer is sufficient as identity as well as address proof for opening an account?

Banks rely on such certification only from corporate and other entities of repute provided that they are aware of the competent authority designated by the concerned employer to issue such certificate. In addition, banks also require at least one of the valid documents indicated above viz. Passport, Driving Licence, PAN Card, Voter's Identity Card etc. or utility bills for KYC purposes for opening bank account of salaried employees of corporate and other entities.

Whether the information given to the bank under KYC is treated as confidential?

Yes. The information collected from the customer for the purpose of opening of account is treated as confidential and details thereof are not divulged for cross selling or any other similar purposes.

Whether KYC is applicable for Credit Cards/Debit Cards/Smart Cards? Yes. Application of full KYC procedure is necessary before issuing Credit Cards/Debit

Cards/Smart Cards and also in respect of add-on/ supplementary cards.If a customer refuses to give information on KYC asked for by the bank, what action the bank can take against that customer?

Where the bank is unable to apply appropriate KYC measures due to non-furnishing of information and /or non-cooperation by the customer, the bank can consider closing the account or terminating the banking/business relationship after issuing due notice to the customer explaining the reasons for taking such a decision.

Debt recovery Tribunal (DRT) Keeping in line with the international trends on helping financial institutions recover their bad

debts quickly and efficiently, the Government of India has constituted thirty three Debts Recovery Tribunals and five Debts Recovery Appellate Tribunals across the country.

The Debts Recovery Tribunal (DRT) enforces provisions of the Recovery of Debts Due to Banks and Financial Institutions (RDDBFI) Act, 1993 and also Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act, 2002.

Under the Recovery of Debts Due to Banks and Financial Institutions (RDDBFI) Act, 1993 banks approach the Debts Recovery Tribunal (DRT) whereas, under Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act, 2002 borrowers, guarantors, and other any other person aggrieved by any action of the bank can approach the Debts Recovery Tribunal (DRT).

Debts Recovery Tribunal are located across the country. Some cities have more than one Debts Recovery Tribunals. New Delhi, Chennai, Kolkata and Mumbai have three Debts Recovery Tribunals. Ahmedabad and Chandigarh have two Debts Recovery Tribunal (DRT) each.

One Debts Recovery Tribunal has been constituted at Allahabad, Aurangabad, Bangalore, Coimbatore, Cuttack, Earnakulam, Guwahati, Hyderabad, Jabalpur, Jaipur, Lucknow, Madurai,Nagpur, Patna, Pune, Vishakapatnam and Ranchi.


Appeals against orders passed by Debts Recovery Tribunal (DRT) lie before Debts Recovery Appellate Tribunal (DRAT). There five Debts Recovery Appellate Tribunal (DRATs) located in the country. One Debts Recovery Appellate Tribunal (DRAT) is located each at Delhi, Allahabad, Mumbai, Chennai and Kolkatta. A Debts Recovery Appellate Tribunal (DRAT) conducts circuit sittings in different cities where Debts Recovery Tribunal (DRTs) are located over which it has appellate jurisdiction.

There are a number of States that do not have a Debts Recovery Tribunal. The Banks & Financial Institutions and other parties in these States have to go to Debts Recovery Tribunal located in other states having jurisdiction over there area. Thus the territorial jurisdiction of some Debts Recovery Tribunal is very vast. For example, the Debts Recovery Tribunal located in Guwahati has jurisdiction over all the seven North Eastern States. Similarly, the territorial jurisdiction of the Debts Recovery Tribunal-2 Chandhigarh too has a very wide jurisdiction over the States of Punjab, Himachal and Harayana, Chandhigarh.

The setting up of a Debts Recovery Tribunal is dependent upon the volume of cases. Higher the number of cases within a territorial area, more Debts Recovery Tribunal would be set up.

Each Debts Recovery Tribunal (DRT) is presided over by a Presiding Officer. The Presiding Officer is generally equavalent to the rank of Dist. & Sessions Judge. A Presiding Officer of a Debts Recovery Tribunal is assisted by a number of officers of other ranks, but none of them need necessarily have a judicial background. Therefore, the Presiding Officer of a Debts Recovery Tribunal is the sole judicial authority to hear and pass any judicial order.

Each Debts Recovery Tribunal has two Recovery Officers. The work amongst the Recovery Officers of a Debts Recovery Tribunal (DRT) is allocated by the Presiding Officer of the Tribunal. Though the Recovery Officer of the Tribunal need not be a judicial Officer, but the orders passed by a Recovery Officer are judicial in nature, and are appealable before the Presiding Officer of the Debts Recovery Tribunal (DRT).

The Debts Recovery Tribunal are governed by provisions of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, also popularly called as the RDDBFI Act. Rules have been framed and notified under the Recovery of Debts Due to Banks and Financial Institutions Act, 1993.

After the enactment of Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act any aggrieved person can approach a Debts Recovery Tribunal (DRT). Earlier only Banks were entitled to approach the Debts Recovery Tribunal (DRT).

The Debts Recovery Tribunal (DRT) are fully empowered to pass comprehensive orders and can travel beyond the Civil procedure Code to render complete justice. A Debts Recovery Tribunal (DRT) can hear cross suits, counter claims and allow set offs. However, a Debts Recovery Tribunal (DRT) cannot hear claims of damages or deficiency of services or breach of contract or criminal negligence on the part of the lenders. In addition, a Debts Recovery Tribunal (DRT) cannot express an opinion beyond its domain, or the list pending before it.

The Debts Recovery Tribunal can appoint Receivers, Commissioners, pass ex-parte orders, ad-interim orders, interim orders apart from powers to Review its own decisions and hear appeals against orders passed by the Recovery Officers of the Tribunal.

The recording of evidence by Debts Recovery Tribunal is somewhat unique. All evidences are taken by way of an affidavit. Cross examinations is allowed only on request by the defense, and that too if the Debts Recovery Tribunal (DRT) feels that such a cross examinations is in the interest of justice. Frivolous cross examination are denied is the same can be brought on record by way of affidavit. There are a number of other unique features in the proceedings before the Debts Recovery Tribunal all aimed at expediting the proceedings.

National Company Law Tribunal (NCLT) National Company Law Tribunal (NCLT) is a proposed quasi-judicial body in India that will

govern the companies in India.


It will be established under the Companies Act, 2013 and is a successor body of the Company Law Board.

The principal bench of NCLT is expected to be established in New Delhi. NCLT will have the same powers as assigned to the erstwhile Company Law Board (which are mostly related to dealing with oppression and mismanagement), Board for Industrial and Financial Reconstruction (BIFR)(revival of sick companies) and powers related to winding up of companies (which was available only with the High Courts).

Specialized Tribunals -Alternative Institutional Mechanisms Enabling Specialized Tribunals : Part XIVA of the constitution was inserted by Constitution (42nd Amendment) Act, 1976

containing Articles 323 A and 323B , providing for Tribunals. Supreme Court validated the theory of alternative institutional mechanism in SP Sampath Kumar

V. Union Of India, 1985 (4) SCC 458 A number of quasi-judicial forums and tribunals like Debts Recovery Tribunal (DRT),

Securities Appellate Tribunal (SAT), Company Law Board (CLB), Board for Industrial and Financial Reconstruction (BIFR) were established to provide speedier and specialized for a for dispensation of justice.

A Comprehensive Company Law Tribunal The Companies (Second Amendment) Act, 2002 provided for a single National Company Law

Tribunal (NCLT) for combining the jurisdiction of various bodies administering the Companies Act, 1956 (1956 Act).

The proposed Tribunal was challenged in Thiru R. Gandhi, President, Madras Bar Association vs. Union of India, wherein the Madras High Court held that certain aspects of the tribunal were against the basic structure of the constitution and thus unconstitutional. However, the Supreme Court of India on 11th May, 2010 ruled that the provisions of Companies (Second Amendment) Act, 2002 pertaining to transfer of several judicial and quasi-judicial powers to NCLT are constitutionally valid subject to amendments being made to make the Tribunal’s members independent.

With the Supreme Court’s green light, the Companies Act, 2013 (New Act) now provides for the constitution of NCLT & National Company Law Appellate Tribunal (NCLAT).

Merits Streamlining: Amalgamating the administration of justice under the company law within one

Tribunal. Depth: A good mix of senior judicial and technical members. The members of NCLT are

intended to have greater expertise and experience to adjudicate disputes more efficiently and expeditiously.

Speed: Every proceeding before the Tribunal to be dealt with and disposed of as expeditiously as possible. Tribunal to endeavour to dispose the proceedings within 3 months from the date of commencement of the proceeding before it. In case appeal against the order of the Tribunal is not filed within the period of 45 days, then the Tribunal on being satisfied for the reason of delay, can allow the appeal to be filed after the expiry of aforesaid period, only if the said appeal is filed within additional period of 45 days after the expiry of the prescribed period and not any indefinite period as available under the 1956 Act.


The National Company Law Tribunal (NCLT), which would replace the Company Law Board, is likely to be operational by April next year, with the principal bench based in the national capital. The tribunal is to be set up under the Companies Act, 2013. The legislation is being implemented by the Corporate Affairs Ministry.

The plan is to have to have about 12 to 13 NCLT benches in different parts of the country but a final decision is yet to be taken, according to a source. "NCLT is expected to be operational by April 2014

To begin with, the existing benches of Company Law Board would be converted into NCLT ones. Then, in due course, new benches would be created. Meanwhile, the Ministry has started the consultation process for creation of new posts for the tribunal. In this regard, it has written to the Finance Ministry as well as the Department of Personnel and Training, the source said. The tribunal would have a President, judicial and technical members. The President should be a person who is or has been a High Court judge for at least five years.

To become a judicial member at NCLT, an individual is or should have been a High Court judge or district judge for at least five years or with a minimum of ten years experience as an advocate of a court. Meanwhile, among others, chartered accountants or cost accountants or company secretaries having at least 15 years of experience are eligible to be technical members. The appeals against NCLT orders would be heard by the proposed National Company Law Appellate Tribunal, which would have a chairperson, judicial and technical members.

Untangling the WebHigh Court CLB BIFR NCLT

Appeals Within the HC and then to Supreme Court (SC)

High Court (HC),then appeal to SC

AAIFR , then writ petition to HC

NCLAT, then appeal to SC

Chairperson & Eligibility

Sitting Chief Justice

Chairman need not be retired HC judge

Chairman need not be retired HC judge

President to have been HC judge for at least 5 years.

Geography Each state has a HC or its Bench.

Principal Bench at New Delhi, and four Regional Benches located at New Delhi,

New Delhi Such number of benches as may be specified by Central Government.


Under the New Act, NCLT & NCLAT will have jurisdiction & powers vested in CLB under the Companies Act, 1956 primarily oppression and mismanagementCBIFR & AAIFR under the Sick Industrial Companies (Special Provisions) Act, 1985High Courts primarily in relation to winding-up, amalgamation, restructuring and appeals from CLB

Mumbai, Kolkata and Chennai

Principal Bench at New Delhi

The New Act does not contain provisions dealing with processes, time lines etc. More clarity is expected to be provided by the rules yet to be notified.

Need for transitional provisions. Certain time critical processes such as Schemes under section 391 of the 1956 Act which involve two motions will need to be transitioned carefully.

Reserved judgements of CLB are likely to be re-heard by NCLT. NCLAT is not empowered to entertain an appeal against the order of CLB. Therefore, High Court powers under 10F of the 1956 Act have been saved.

The number and geographical spread of benches needs to be carefully considered as access to justice should not be hampered by logistics.

Asset Reconstruction Corporation (ARC) The Parliament of India paved the way for formation of Securitization Companies and

Restructuring Companies (`SC/RCs`) under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, (`SARFAEI Act`), where after the Reserve Bank of India (`RBI`) has granted certificates of registration to 13 Companies to pursue the business of securitization and asset reconstruction.

In the past seven years, since the enactment, a myriad of issues have been faced by ASC/RCs on the regulatory aspects, duties and taxes, and capital and finance raising. To pursue their common interests, the SC/RCs envisioned that a common platform / forum would be better suited to discuss and collectively address pending issues which may range from regulatory concerns to business related aspects.

Keeping the above need in view, SC/RCs have associated to set up a working group drawing Members from the Licensed SC/RCs to be known as the Association of ARCs in India(`Association`). The Association is governed by a set of Rules for practice for uniform adoption by the Members and is also planning to come out with a Code of Conduct for SC/RCs.

Assets reconstruction involves securitization and enforcement of security interest. Assets reconstruction company may be a public financial institution under section 4A of the companies Act and will have to be registered with the Reserve Bank of India.

Once ARC takes over the assets, that company will be treated as lender and secured creditor. It acquires NPA loans from banks and financial institutions by issuing the debentures or bonds or by entering into special arrangements.

ARC formulates a scheme for each of the financial assets taken over and invites investments from Qualified Institutional Buyers (QIBs ) in such schemes. ARC issued Security receipts (SRs) to QIBs and realizes the assets and redeems the investment and pays the returns to QIBs under each scheme.

According to Section 9 , Asset Reconstruction involves any one or more of the following measures:

o Taking possess of the securitieso Enforcement of security interest as per the provisions of the Acto Settlement of dues payable by the borrowero Rescheduling of payment of dues payable by the borrower

Asset Securitization Asset securitization (also called true sale securitization) is an instrument of structured finance

used by banks for pooling together various types of assets and transforming them into marketable securities with various levels of seniority, through the means of financial engineering. For


securitization of assets through the use of credit derivatives, please refer to synthetic securitization

Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security.

A typical example of securitization is a mortgage-backed security (MBS), which is a type of asset-backed security that is secured by a collection of mortgages. The process works as follows:

First, a regulated and authorized financial institution originates numerous mortgages, which are secured by claims against the various properties themortgagors purchase. Then, all of the individual mortgages are bundled together into a mortgage pool, which is held in trust as the collateral for an MBS. The MBS can be issued by a third-party financial company, such a large investment banking firm, or by the same bank that originated the mortgages in the first place. Mortgage-backed securities are also issued by aggregators such as Fannie Mae or Freddie Mac.

Regardless, the result is the same: a new security is created, backed up by the claims against the mortgagors' assets. This security can be sold to participants in the secondary mortgage market. This market is extremely large, providing a significant amount of liquidity to the group of mortgages, which otherwise would have been quite illiquid on their own. (For a one-stop shop on subprime mortgages, the secondary market and the subprime meltdown, check out the Subprime Mortgages Feature.)

Furthermore, at the time the MBS is being created, the issuer will often choose to break the mortgage pool into a number of different parts, referred to astranches. These tranches can be structured in virtually any way the issuer sees fit, allowing the issuer to tailor a single MBS for a variety ofrisk tolerances. Pension funds will typically invest in high-credit rated mortgage-backed securities, while hedge funds will seek higher returns by investing in those with low credit ratings.

The process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors. The process can encompass any type of financial asset and promotes liquidity in the marketplace.

Mortgage-backed securities are a perfect example of securitization. By combining mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage's inherent risk of default and then sell those smaller pieces to investors.

The process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. Using the mortgage-backed security example, individual retail investors are able to purchase portions of a mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages.

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or collateralized mortgage obligation (CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are calledmortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

Critics have suggested that the complexity inherent in securitization can limit investors' ability to monitor risk, and that competitive securitization markets with multiple securitizers may be particularly prone to sharp declines in underwriting standards. Private, competitive mortgage securitization is believed to have played an important role in the U.S. subprime mortgage crisis.[1]

In addition, off-balance sheet treatment for securitizations coupled with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an under-pricing of credit risk. Off-balance sheet securitizations are believed to have played a large role in the high leverage level of U.S. financial institutions before the financial crisis, and the need for bailouts.[2]


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The granularity of pools of securitized assets is a mitigant to the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitised debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss.

History Examples of securitization can be found at least as far back as the 18th century. Among the early

examples of mortgage-backed securities in the United States were the farm railroad mortgage bonds of the mid-19th century which contributed to the panic of 1857.

In February 1970, the U.S. Department of Housing and Urban Development created the first modern residential mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold securities backed by a portfolio of mortgage loans.

To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First, they over-collateralised pools of assets; shortly thereafter, they improved third-party and structural enhancements.

In 1985, securitization techniques that had been developed in the mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A pool of assets second only to mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of performance gave investors confidence.

This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitised in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1).

The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market. Sales of this type — with no contractual obligation by the seller to provide recourse — allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks developed structures to normalize the cash flows.

Starting in the 1990s with some earlier private transactions, securitization technology was applied to a number of sectors of the reinsurance and insurance markets including life and catastrophe. This activity grew to nearly $15bn of issuance in 2006 following the disruptions in the underlying markets caused by Hurricane Katrina and Regulation XXX. Key areas of activity in the broad area of Alternative Risk Transfer include catastrophe bonds, Life Insurance Securitization and Reinsurance Sidecars.

Pooling and transfer

The originator initially owns the assets engaged in the deal. This is typically a company looking to either raise capital, restructure debt or otherwise adjust its finances. Under traditional corporate finance concepts, such a company would have three options to raise new capital: a loan, bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the credit rating of the company and the associated rise in interest rates.

The consistently revenue-generating part of the company may have a much higher credit rating than the company as a whole. For instance, a leasing company may have provided $10m nominal value of leases, and it will receive a cash flow over the next five years from these. It cannot demand early repayment on the leases and so cannot get its money back early if required. If it could sell the rights to the cash flows


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from the leases to someone else, it could transform that income stream into a lump sum today (in effect, receiving today the present value of a future cash flow). Where the originator is a bank or other organization that must meet capital adequacy requirements, the structure is usually more complex because a separate company is set up to buy the assets.

A suitably large portfolio of assets is "pooled" and transferred to a "special purpose vehicle" or "SPV" (the issuer), a tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator. The issuer is "bankruptcy remote", meaning that if the originator goes into bankruptcy, the assets of the issuer will not be distributed to the creditors of the originator. In order to achieve this, the governing documents of the issuer restrict its activities to only those necessary to complete the issuance of securities.

Accounting standards govern when such a transfer is a sale, a financing, a partial sale, or a part-sale and part-financing.[17]In a sale, the originator is allowed to remove the transferred assets from its balance sheet: in a financing, the assets are considered to remain the property of the originator. [18] Under US accounting standards, the originator achieves a sale by being at arm's length from the issuer, in which case the issuer is classified as a "qualifying special purpose entity" or "qSPE".

Because of these structural issues, the originator typically needs the help of an investment bank (the arranger) in setting up the structure of the transaction.Issuance]

To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund the purchase. Investors purchase the securities, either through a private offering (targeting institutional investors) or on the open market. The performance of the securities is then directly linked to the performance of the assets. Credit rating agencies rate the securities which are issued to provide an external perspective on the liabilities being created and help the investor make a more informed decision.

In transactions with static assets, a depositor will assemble the underlying collateral, help structure the securities and work with the financial markets to sell the securities to investors. The depositor has taken on added significance under Regulation AB. The depositor typically owns 100% of the beneficial interest in the issuing entity and is usually the parent or a wholly owned subsidiary of the parent which initiates the transaction. In transactions with managed (traded) assets, asset managers assemble the underlying collateral, help structure the securities and work with the financial markets in order to sell the securities to investors.

Some deals may include a third-party guarantor which provides guarantees or partial guarantees for the assets, the principal and the interest payments, for a fee.

The securities can be issued with either a fixed interest rate or a floating rate under currency pegging system. Fixed rate ABS set the “coupon” (rate) at the time of issuance, in a fashion similar to corporate bonds and T-Bills. Floating rate securities may be backed by both amortizing and non-amortizing assets in the floating market. In contrast to fixed rate securities, the rates on “floaters” will periodically adjust up or down according to a designated index such as a U.S. Treasury rate, or, more typically, the London Interbank Offered Rate (LIBOR). The floating rate usually reflects the movement in the index plus an additional fixed margin to cover the added risk.[19]

Credit enhancement and tranchingUnlike conventional corporate bonds which are unsecured, securities generated in a securitization deal are "credit enhanced", meaning their credit quality is increased above that of the originator's unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive cash flows to which they are entitled, and thus causes the securities to have a higher credit rating than the originator. Some securitizations use external credit enhancement provided by third parties, such as surety bonds and parental guarantees (although this may introduce a conflict of interest).


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Individual securities are often split into tranches, or categorized into varying degrees of subordination. Each tranche has a different level of credit protection or risk exposure than another: there is generally a senior (“A”) class of securities and one or more junior subordinated (“B”, “C”, etc.) classes that function as protective layers for the “A” class. The senior classes have first claim on the cash that the SPV receives, and the more junior classes only start receiving repayment after the more senior classes have repaid. Because of the cascading effect between classes, this arrangement is often referred to as acash flow waterfall.[20] In the event that the underlying asset pool becomes insufficient to make payments on the securities (e.g. when loans default within a portfolio of loan claims), the loss is absorbed first by the subordinated tranches, and the upper-level tranches remain unaffected until the losses exceed the entire amount of the subordinated tranches. The senior securities are typically AAA rated, signifying a lower risk, while the lower-credit quality subordinated classes receive a lower credit rating, signifying a higher risk.[19]

The most junior class (often called the equity class) is the most exposed to payment risk. In some cases, this is a special type of instrument which is retained by the originator as a potential profit flow. In some cases the equity class receives no coupon (either fixed or floating), but only the residual cash flow (if any) after all the other classes have been paid.

There may also be a special class which absorbs early repayments in the underlying assets. This is often the case where the underlying assets are mortgages which, in essence, are repaid every time the property is sold. Since any early repayment is passed on to this class, it means the other investors have a more predictable cash flow.

If the underlying assets are mortgages or loans, there are usually two separate "waterfalls" because the principal and interest receipts can be easily allocated and matched. But if the assets are income-based transactions such as rental deals it is not possible to differentiate so easily between how much of the revenue is income and how much principal repayment. In this case all the income is used to pay the cash flows due on the bonds as those cash flows become due.

Credit enhancements affect credit risk by providing more or less protection to promised cash flows for a security. Additional protection can help a security achieve a higher rating, lower protection can help create new securities with differently desired risks, and these differential protections can help place a security on more attractive terms.

In addition to subordination, credit may be enhanced through:[18]

A reserve or spread account, in which funds remaining after expenses such as principal and interest payments, charge-offs and other fees have been paid-off are accumulated, and can be used when SPE expenses are greater than its income.

Third-party insurance, or guarantees of principal and interest payments on the securities. Over-collateralisation, usually by using finance income to pay off principal on some securities

before principal on the corresponding share of collateral is collected. Cash funding or a cash collateral account, generally consisting of short-term, highly rated

investments purchased either from the seller's own funds, or from funds borrowed from third parties that can be used to make up shortfalls in promised cash flows.

A third-party letter of credit or corporate guarantee. A back-up servicer for the loans. Discounted receivables for the pool.Servicing

A servicer collects payments and monitors the assets that are the crux of the structured financial deal. The servicer can often be the originator, because the servicer needs very similar expertise to the originator and would want to ensure that loan repayments are paid to the Special Purpose Vehicle.


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The servicer can significantly affect the cash flows to the investors because it controls the collection policy, which influences the proceeds collected, the charge-offs and the recoveries on the loans. Any income remaining after payments and expenses is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on the performance of the collateral pool, the credit enhancements and the probability of default.

When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-keeper of the assets that are being held in the issuer. Even though the trustee is part of the SPV, which is typically wholly owned by the Originator, the trustee has a fiduciary duty to protect the assets and those who own the assets, typically the investors.

Repayment structuresUnlike corporate bonds, most securitizations are amortized, meaning that the principal amount

borrowed is paid back gradually over the specified term of the loan, rather than in one lump sum at the maturity of the loan. Fully amortizing securitizations are generally collateralised by fully amortizing assets such as home equity loans, auto loans, and student loans. Prepayment uncertainty is an important concern with fully amortizing ABS. The possible rate of prepayment varies widely with the type of underlying asset pool, so many prepayment models have been developed in an attempt to define common prepayment activity. The PSA prepayment model is a well-known example. A controlled amortization structure is a method of providing investors with a more predictable repayment schedule, even though the underlying assets may be nonamortissing. After a predetermined “revolving” period, during which only interest payments are made, these securitizations attempt to return principal to investors in a series of defined periodic payments, usually within a year. An early amortization event is the risk of the debt being retired early.

On the other hand, bullet or slug structures return the principal to investors in a single payment. The most common bullet structure is called the soft bullet, meaning that the final bullet payment is not guaranteed on the expected maturity date; however, the majority of these securitizations are paid on time. The second type of bullet structure is the hard bullet, which guarantees that the principal will be paid on the expected maturity date. Hard bullet structures are less common for two reasons: investors are comfortable with soft bullet structures, and they are reluctant to accept the lower yields of hard bullet securities in exchange for a guarantee.

Securitizations are often structured as a sequential pay bond, paid off in a sequential manner based on maturity. This means that the first tranche, which may have a one-year average life, will receive all principal payments until it is retired; then the second tranche begins to receive principal, and so forth. Pro rata bond structures pay each tranche a proportionate share of principal throughout the life of the security.

Structural risks and misincentives[edit]Some originators (e.g. of mortgages) have prioritised loan volume over credit quality,

disregarding the long-term risk of the assets they have created in their enthusiasm to profit from the fees associated with origination and securitization. Other originators, aware of the reputational harm and added expense if risky loans are subject to repurchase requests or improperly originated loans lead to litigation, have paid more attention to credit quality.[citation needed]

Special types of securitization]Master trust]

A master trust is a type of SPV particularly suited to handle revolving credit card balances, and has the flexibility to handle different securities at different times. In a typical master trust transaction, an originator of credit card receivables transfers a pool of those receivables to the trust and then the trust issues securities backed by these receivables. Often there will be many tranched securities issued by the trust all based on one set of receivables. After this transaction, typically the originator would continue to service the receivables, in this case the credit cards.


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There are various risks involved with master trusts specifically. One risk is that timing of cash flows promised to investors might be different from timing of payments on the receivables. For example, credit card-backed securities can have maturities of up to 10 years, but credit card-backed receivables usually pay off much more quickly. To solve this issue these securities typically have a revolving period, an accumulation period, and an amortization period. All three of these periods are based on historical experience of the receivables. During the revolving period, principal payments received on the credit card balances are used to purchase additional receivables. During the accumulation period, these payments are accumulated in a separate account. During the amortization period, new payments are passed through to the investors.

A second risk is that the total investor interests and the seller's interest are limited to receivables generated by the credit cards, but the seller (originator) owns the accounts. This can cause issues with how the seller controls the terms and conditions of the accounts. Typically to solve this, there is language written into the securitization to protect the investors and potential receivables.A third risk is that payments on the receivables can shrink the pool balance and under-collateralize total investor interest. To prevent this, often there is a required minimum seller's interest, and if there was a decrease then an early amortization event would occur.[18]

Issuance trustIn 2000, Citibank introduced a new structure for credit card-backed securities, called an issuance

trust, which does not have limitations, that master trusts sometimes do, that requires each issued series of securities to have both a senior and subordinate tranche. There are other benefits to an issuance trust: they provide more flexibility in issuing senior/subordinate securities, can increase demand because pension funds are eligible to invest in investment-grade securities issued by them, and they can significantly reduce the cost of issuing securities. Because of these issues, issuance trusts are now the dominant structure used by major issuers of credit card-backed securities.[18]

Grantor trustGrantor trusts are typically used in automobile-backed securities and REMICs (Real Estate

Mortgage Investment Conduits). Grantor trusts are very similar to pass-through trusts used in the earlier days of securitization. An originator pools together loans and sells them to a grantor trust, which issues classes of securities backed by these loans. Principal and interest received on the loans, after expenses are taken into account, are passed through to the holders of the securities on a pro-rata basis.[22]

Owner trust[edit]In an owner trust, there is more flexibility in allocating principal and interest received to different

classes of issued securities. In an owner trust, both interest and principal due to subordinate securities can be used to pay senior securities. Due to this, owner trusts can tailor maturity, risk and return profiles of issued securities to investor needs. Usually, any income remaining after expenses is kept in a reserve account up to a specified level and then after that, all income is returned to the seller. Owner trusts allow credit risk to be mitigated by over-collateralization by using excess reserves and excess finance income to prepay securities before principal, which leaves more collateral for the other classes.Motives for securitization

Advantages to issuerReduces funding costs: Through securitization, a company rated BB but with AAA worthy cash

flow would be able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple hundreds of basis points. For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but senior automobile backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continue to be rated AAA because of the strength of the underlying collateral and other credit enhancements.[18]



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Reduces asset-liability mismatch: "Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis."[23] Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to create a self-funded asset book.

Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to remove assets from their balance sheets while maintaining the "earning power" of the assets.[22]

Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.

Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good examples of this are catastrophe bonds and Entertainment Securitizations. Similarly, by securitizing a block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business.

Off balance sheet: Derivatives of many types have in the past been referred to as "off-balance-sheet." This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In the case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association (ISDA) who have for a long time provided documentation on how to treat such derivatives on balance sheets.

Earnings: Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often is a "true sale" that takes place between the Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the parent company.

Admissibility: Future cashflows may not get full credit in a company's accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset.

Liquidity: Future cashflows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates.Disadvantages to issuer[edit]May reduce portfolio quality: If the AAA risks, for example, are being securitized out, this would leave a materially worse quality of residual risk.Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in securitizations, especially if it is an atypical securitization.Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.


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Risks: Since securitization is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips.Advantages to investors[edit]

Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)Opportunity to invest in a specific pool of high quality assets: Due to the stringent

requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options.

Portfolio diversification: Depending on the securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through securitizations because they may be uncorrelated to their other bonds and securities.

Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under securitization it may be possible for the securitization to receive a higher credit rating than the "parent," because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).Risks to investors

Liquidity riskCredit/default: Default risk is generally accepted as a borrower’s inability to meet interest

payment obligations on time.[24]For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular security’s default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings.[19] Almost all mortgages, including reverse mortgages, and student loans, are now insured by the government, meaning that taxpayers are on the hook for any of these loans that go bad even if the asset is massively over-inflated. In other words, there are no limits or curbs on over-spending, or the liabilities to taxpayers.

However, the credit crisis of 2007–2008 has exposed a potential flaw in the securitization process – loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and securitization, which doesn't encourage improvement of underwriting standards.Event risk

Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.

Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates. Contractual agreements

Moral hazard: Investors usually rely on the deal manager to price the securitizations’ underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices




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of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's excess spread.

Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.[19]



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