Credit Decisions Under Lenses – An Insight

Brief Background

Bankers’ primary job is to deploy funds they collect on certain terms from various sources including deposits. By virtue of prevailing applicable Laws and regulations of the country, no bank is expected to refuse acceptance of deposits from its customers, and hence banks have no control on the amount of flow of deposits in any given period of time or even its nature. These typical phenomena of banking business puts all the banks under tremendous pressure for deployment of funds at a price higher than cost of acquisition of funds without loss of time. Undeployed funds is a liability to the banks which cause losses every day to the bank, thereby leading to deterioration in performance standard exposing them to the unpleasant possibilities of down-gradation of Rating.

One of the major deployment channels of funds is Credit, commonly known as loans. The spheres of Credit are intricately associated with default risk and a bank earn interest on the credit disbursed as a remuneration for taking such risks.  We will come back to this issue in the later part of this article to show how these are also associated with the career of bank personnel involved in entire credit process, right from receipt of credit proposal to  the closure of the account. 

Every bank has a well laid system and procedures for assessment of credit risk, putting various terms in the sanction to restrict extent of such risk and a well chalked out monitoring system for ensuring compliance of the risk control measures (e.g. stock checking, insurance, amount of credit in the loan accounts etc.)  and pick up any warning signal of early symptoms of deterioration in the already measured risk based on which the proposal has been sanctioned.

Despite all these, there have been large volume of NPAs in each bank indicating un-patched loops in the system which, many a times, also lead to unending sufferings to their employees because of related enquiries and investigations involved, once an account turns NPA.

Case History

In this article, a hypothetical case has been taken following shadow of a real-life case to find out some of such lacunas in the entire credit system. 

• In 2005, M/S S.M & Co, a partnership concern engaged in trading of airlines accessories, decided to set up a small factory for manufacturing said airlines accessories  and  applied to the bank for financing the project. Accordingly a term loan of Rs. 25 Crores and a working capital of Rs.20 crores were sanctioned. The factory was set up in Pune at a few kilometre distance from the financing branch which was a small branch. The company had steady flow of orders from a specific airlines company and the firm’s entire production was being sold to the said  company.

•  They, therefore, planned further expansion of the unit which was funded by the bank. 

• However, in early 2008, the firm started facing difficulties in servicing the loan instalments and  hence  the bank restructured the facilities in 2010-11 against additional collateral and projected business growth. The firm was converted to a limited company.

• Interestingly, the profit margin in the business was meagre and hence the company could not tide over the liquidity problem despite restructuring of the facilities.

• The borrower, therefore, decided to play on the ‘volume game’ to enhance profit and consequent prospective improvement in liquidity by expanding the production capacity of the unit and continued its struggle to somehow service the term loan instalments. They approached the bank for funding the expansion as an way to solve the liquidity problems.

• The branch recommended the proposal for funding the company for the said expansion with more stringent conditions, specially higher margin, more promoter’s contribution etc. to their Higher authorities. The firm availed additional funding by complying with all the terms of sanction. The account continued to remain outside NPA fold.

•  However, the situation did not improve and their debtor’s book started to grow as the buyer took advantage of the fact that they are the sole and only customer of the firm.

• The company  again approached for further term loan for expansion of  production lines , which was considered by the bank on the condition that the release of the fund is subject to servicing of instalments so that the account is not impaired. The account also got transferred to a large branch as the increased credit limit, which was around Rs. 100 crores by then, crossed the threshold individual borrower’s credit limit which the branch could service as per the bank’s norm.

•  The new branch, which was a specialized branch in dealing with large corporate accounts all over India, by virtue of their expertise, did realise the perennial liquidity issue of the borrower and in order to play safe, made  references to the Higher authority seeking their permission for approval before each disbursement since the account was showing clear signal of stickiness and incipient sickness. 

• In the process, the branch was to ensure servicing of the debt and as and when there were vacancy in the cash credit account, they were recovering arrear instalments. Each disbursement was approved by the corporate office only after ensuring that all overdues have been paid. The  disbursements were made   to the suppliers  the names of which were provided  by the company. 

• The account became NPA within a year’s time and the  matter got investigated by the bank’s internal department first. Normally the first report is the basis of all further investigations. Subsequent investigations tried to assign responsibility to the large branch for allowing the fund diversion. 

Facts of the case

The matter was investigated by the Internal Vigilance Department of the Bank and Forensic Auditor and their report revealed following serious lapses on the part of the borrower and bank personnel:

• The Borrower did not put the required margin money to the full extent and a part of the same was book entries only

• Around 60% of the enhanced loan disbursed in cash credit account went to the own concerns of the borrower created in different names.

• A major part of such funds diverted by the borrower came back to the lending bank only for payment of interest of term loan and cash credit as well as instalments of term loan.

• Chartered Engineer’s Report confirmed that substantial portion of the bank funds have not been used for the purposes these were disbursed.

• The account was categorised as Fraud.

• Some of the bank employees at different level were accused of collusion and conspiracy.  

An insight -What went wong

• Sole Customer based business funding – Taking exposure on a borrower whose revenue generation is solely based on a single buyer is extremely risky decision and even may be termed as almost suicidal. Keeping in view the business cycle, ups and downs of business entities, 100% concentration of credit  risk on a single ultimate buyer is neither a banking prudence nor a financially wise bet. However, bank did not have any strict circular prohibiting exposure on such an identity.

• Enhancement in credit limits for expansion while the company was already struggling with tight liquidity – Additional limits means additional promoters contribution because of the standard minimum percentage of promoter’s contribution almost in all cases ( generally minimum 25% ) irrespective of the nature of case. In stead of correcting the basic issues i.e. low profitability, sole buyer dependence etc. further funds were sanctioned and disbursed with higher margin. Such unrealistic terms of credit often allure the borrowers to resort to unfair means of falsifying promoter’s contribution. Bankers were operating in real field and they could not afford to ignore such ground realities. Had proper diagnosis been made at that point of time, in all probabilities, the account could have been saved.

• Lack of Credit expertise at branch level – The first branch which handled this case up to a credit limit of Rs. 60 crores did not have appropriate expertise to understand and operate such exposure. Credit was one of the several primary functions of the branch. The bank’s policy should have been so framed that such loans should have been handled only by the branches which had such expertise.

• Over-reliance of borrower’s statement –  The business of credit is a business of prudence and not that of blind faith. In this case, due diligence should have been made on the suppliers, specially when account was under stress. Had that been done, the diversion of funds would have been detected much earlier.

• Superfluous prevention of NPA – Reduction in NPA has historically been a parameter for individual performance of the Branch head, Regional Head, Zonal Head ..up to the level of Chairman of any bank. This is against the commonly known fact that NPA is culmination of certain long drawn weaknesses in the account and in many cases the same is also result of external factors like recession, dumping etc and individual banker has limited roles in preventing the same. However, out of overzeal of preventing NPA, bank insisted on servicing the account on time even when the unit was badly suffering from severe liquidity crunch, consequent upon which bank, ironically, serviced the account itself by making additional disbursement to the borrower. This straightway facilitate use of funds for the purposes not meant for.

The principle of transparency do suggest that the accounts should be allowed to reflect fact of the case i.e. any effort to concealing non-performance of the account should be treated as non-performance of the concerned bank official in stead of addition of NPA being treated as non-performance of the individual bank officer.

Bank employees perspective

Unfortunately enough, many of the honest bank officials suffer due to the allegations raised against those handling such cases and accusations levelled by the External Investigation Agencies who investigate those cases on a Post-mortem basis. While, the guilty should certainly be punished, banks need to take care of their own honest and sincere officials who fell victim of the circumstances created out of inadequacy of credit norms, faulty judgement due to unclear general instructions, lack of definitive guidelines for handling specific cases at the required point of time etc. 

Conclusion

As on date, there are serious lacunas in the credit policies of the banks. Following stock-generated Drawing Power based operation of working capital account ( it assumes that the stock level submitted by the borrower  on a particular day of a month is valid for all 30 days and mostly this DP is used throughout the month for allowing level of drawing) in stead of cash flow based operation itself is a burning example of such lacuna. Above case history throws light on some such inadequacies. Time has come, specially when the cloud of substantial  increase in NPA is looming large in the Indian Banking sky due to ongoing Pandemic that appropriate policy changes are brought in so as to improve the quality of sanction ,performance and monitoring of bank credit in the months to come.