Introduction to Functional Credit.pdf

Lecture_1: Introduction
to
Functional Bank Credit:
September 20, 2022 1
CB-605: Credit Management in Banks by
Md. Nazmul Hasan

What is Credit?
What is Credit?
• Credit is a contractual agreement in which a borrower receives something of value
now and agrees to repay the lender at some date in the future, generally with
interest.
Natures of Credit: Broad Two-Categories
• There are many different forms of credit: Supplier’s/Business Vs. Credit Bank Credit
• When suppliers give products or services to an individual but don't require payment
until a later date, that is a form of credit.
– For example, if a restaurant receives a truckload of food from a vendor but the vendor
doesn't demand payment until a month later, the vendor is offering the restaurant a form
of credit.
• When banks offer their clients car loans, mortgages and lines of credit, those are all
forms of credit. Essentially, the bank has credited money to the borrower, and the
borrower must pay it back at a future date.
– For example, when someone makes a purchase at his local mall with his VISA card, his
payment is considered a form of credit because he is buying goods with the understanding
that he needs to pay for them later.
Md. Nazmul Hasan

Principles of Sanctioning Credit
• Safety:
– Is it safe to make the investment?
– Will the proceeds of investment be returnable on time with profits?
• Liquidity
– Does the firm has enough cash to lead its day-to-day operations?
– Can it generate enough cash inflow to afford its cash outflow?
• Profitability:
– Does the firm has the capability to make enough profit?
– Does the firm has the sustainable profit history?
• Diversification:
– Does the firm has myriad avenues of business or only dependent on single
income source or sector which possesses significant risks?
– Does the firm dependent on single vendor or single client?
• Security Collateral:
– Does the firm has enough collateral to back-up its debt burden?
– Does the security has stable market price and wide acceptance to users?
• National Interest
– Does the firm engaged in a business important for national interest?
– Does the firm hampers any existing laws or engaged in illegal activities?
Md. Nazmul Hasan

Sources of Credit Information
• Let’s discuss!
– What could be the diverse sources of credit
information for a banker?
– What are the formal and formal avenues are
available to collect credit information?
– Which sources to prioritize while deciding to
analyze a credit?
Md. Nazmul Hasan

Types of Loans and Advances: Chapter Plan
1. Funded & Non funded
2. One-time Loan and Continuous advance
Funded:
• Loans
• Overdraft
• Cash Credit
• Bills purchased and discounted
Non-funded:
• Letter of Credit(L/C)
• Letter of guarantee (L/G)
Md. Nazmul Hasan

Moreover, banks give advances to importers and exporters
in the international trade as under:
1. Import Finance:
– Payment Against Documents(PAD)
– Loan Against Imported Merchandise(LIM)
2. Export Finance:
– Packing credit
– Trust Receipt (LTR)
– Loan against Red-Clause Letter of Credit
– Payment against Documents sent for Collection
Furthermore, banks are also financing in the form of Leasing, hire-
purchase, housing, Transport loan, consumer credit, micro credit,
SME, portfolio investment under Merchant banking etc.
Md. Nazmul Hasan

Types of Bank Credit
From Financial Aspect: 1) Funded Credit 2) Non-Funded Credit
 Funded Credit: Any type of credit facility that involves direct
outflow/allocation/disbursement of a bank’s fund on account of granting
credit to borrower. In order to provide funded facility to a customer, the
bank has to incur real liability before hand i.e., bank has to arrange the
funds to allocate it for the granted credit.
Funded Credit may be classified into several forms: i) Loan ii) Cash Credit iii)
Overdraft iv) Bill Purchased and Discounted
1.0 Loan: When a credit is made in a lump sum and repayable either in fixed
monthly/quarterly/half-yearly/annual installment or in lump sum and no
subsequent debit is allowed except interest, incidental charges, etc. is called a
loan. A loan, once repaid in full or in part, can not be withdrawn again by the
borrower. If required, clients have to apply for a fresh loan.
Md. Nazmul Hasan

Loan Vs. Advance
Basis for
Difference
Loans Advances
Meaning Funds borrowed by an entity from
another entity, repayable after a
specific period carrying interest rate
is known as Loans.
Funds provided by the bank
to an entity for a specific
purpose, to be repayable
after a short duration, is
known as Advances.
Debt/Credit Debt Credit Facility
Term Long Term Short Term but Sudden
Legal formalities More Less
Security Must be secured Usually secured by
inventory, M. security or
Third-party guarantee
Interest Applicable May/may not be applicable
Reputation Good reputation required Strong relationship and
Reputation required
Purpose Myriad of reasons, to bridge long
term requirements, typically more
than a year.
Mostly to bridge in short
term needs.
Md. Nazmul Hasan

Loan Classification: Two Types
a) Demand loan: Short term loans that are repayable on demand by
the bank and no fixed installments are laid-down.
b) Term Loan: Term loans are granted for a specific period and
repayment is made in installments.
Advances: Funds provided by the bank to an entity for a specific purpose, to be
repayable after a short duration, is known as Advances.
2.0 Overdraft: It’s an arrangement between a banker and its customer
in which the later is allowed to withdraw over and above his credit balance in
current account, provided that the overdrawn amount , at any time, does not
exceed the agreed limit. Interest is charged only on the actual debit balances. It
is a temporary accommodation of funds. In some cases, it is allowed against
Savings account particularly for salaried class persons.
Md. Nazmul Hasan

2.1 Overdraft Facilities are:
a) Clean Overdraft: Overdraft can be secured and unsecured. When
overdraft is allowed to meet purpose of sudden requirement of
the borrower for which no security is required except his personal
security, it’s called clean overdraft.
b) Overdraft against security: Overdraft can also be granted against
some securities life FDR, LIC policy, gold ornaments etc. In
addition to personal security, further security is required for this
overdraft.
c) Temporary Overdraft: Sometimes, in current account, overdraft is
allowed in small amount to honor an important cheque without
any prior arrangement thereof. Such facility by the bank to a first
class party for a short period is called temporary overdraft.
Md. Nazmul Hasan

3.0 Cash credit: A cash credit is an arrangement by which a banker
allows his customer to borrow money up to a certain limit. It is usually
made against the security of commodities hypothecated or pledged
with the bank.
i) Cash Credit (Pledge): This type of facility is always provided
against pledge of goods or stock-in-trade which remain in the
godown of the bank, but ownership remains with the borrower. In
Brief, CC(Pledge).
i) Cash Credit (Hypothecation): Cash credit is sometimes allowed
against hypothecation of goods. In this case, ownership and
possession of the goods remain with the borrower, although the
bank can take possession of the goods if the borrower defaults. In
Brief, CC(Hypo).
For Example, some bus (which contains a sentence: ‘This bank is
hypothecated to IBBL’) companies in Bangladesh financed by
several scheduled commercial banks.
Md. Nazmul Hasan

4.0 Bills Discounted and Purchased:
The banks also grant credit to their customers by discounting and
purchasing bills of exchange. Such bills arise out of commercial
transactions both in inland trade and foreign trade.
Bills are classified into i) Clean bills and ii) Documentary bills.
When the drawer of a bill encloses with the bill the title to
goods, such as , Bills of Lading, Railway Receipt etc. to be delivered to
the drawee on payment of against acceptance, the bill is called a
documentary bill.
In the absence of such documents, it is termed a clean bill.
Bills can also be classified into: i) Demand bills and ii) Usance bills.
i) Demand Bill: When a bill is payable ‘at sight’ or ‘on demand’ or ‘on
presentation’ it is called a Demand bill.
ii) Usance bill: If a bill matures for payment after a certain period of
time, say 15, 30, 60 days after the date, it is called a Usance bill.
Md. Nazmul Hasan

5. Export & Import Loan Facilities :
Import Finance:
i) Payment Against Documents (PAD): A payment
arrangement in which an exporter instructs his bank to
hand over the shipping and title documents to the importer
when the importer fully pays the accompanying bill of
exchange or draft. It works like COD (Cash on Delivery).
ii) Loan against Imported Merchandise (LIM): Usually,
Importer fails to retire the documents in spite of repeated
reminders from the issuing banker OR the bank has to clear
the goods under the L/C at the request of the importer
(borrower). In both the cases, Whether the importer fails to
retire the documents or requests for clearance of goods,
the outstanding under PAD or B/E is transferred to LIM.
Md. Nazmul Hasan

Export Finance:
iii) Packing Credit: A short term credit granted by a bank to an exporter for assisting him to buy,
process, pack and ship the goods. The credit is gradually extended for payment of freight, handling
charges, insurance and export duties. The usual tenure of packing credit doesn’t extend beyond
180-day.
iv) Export Trust Receipt: Under this arrangement, Credit is allowed against Trust Receipt and the
exportable goods remain in the custody of the exporter but he is required to execute a stamped
export trust receipt in favor of the bank where a declaration is made that the exportable goods has
been procured or purchased with financial assistance from the bank and thus goods held by him in
trust for the bank.
• A trust receipt is a financial document attended to by a bank and a business that has received
delivery of goods but cannot pay for the purchase until after the inventory is sold.
• The bank remains the owner of the merchandise, but the buyer is allowed to hold the
merchandise in trust for the bank, for manufacturing or sales purposes.
• The trust receipt serves as a promissory note to the bank that the loan amount will be repaid
upon sale of the goods.
Difference between LC and Trust Receipt:
Commonly used in the trade industry, a letter of credit is issued from a bank to that guarantees the
payment will be fulfilled and paid to the seller by the buyer. By contrast, a trust receipt is when
the bank lends merchandise or goods to a business, but retains ownership of the goods. When
the goods have been sold, and payment is made to the bank, the business then becomes owner
of the goods.
5. Export & Import Loan Facilities (Conti…) :
Md. Nazmul Hasan

Export Finance:
v) Loan against Red-Clause Letter of Credit: In case, the exporter needs pre-shipment
finance he may request the foreign importer to ask his banks to open a Red clause L/C.
Such a L/C may provide either; a) an immediate payment to the exporter of the full or
part. b) payment to the beneficiary (exporter) of part amount from time to time
indicated against credit against delivery of specified documents.
Since the clauses giving authority is usually printed in red is known as Red
Clause L/C, which also stipulates an undertaking from the probable exporter that
credit received under this L/C will be used, such as, for purchasing the raw-materials
required for the production/procurement of goods.
vi). Payment Against Document sent for collection: When banks handle export bills
on collection basis, they simply act as agents of the exporting clients. The bills are
accepted for collection when a) the exporter is unable to negotiate it because of
the absence of a L/C, b) the exporter does not enjoy high reputation which is
needed to sell the bill to the banker (i.e., discounting of export bills).
Md. Nazmul Hasan

Non-Funded Credit: It refers to the bank commitment to a third-
party on behalf of a customer. This commitment itself constitutes a
credit facility but doesn’t involve cash outflow from the bank.
However, in case the customer fails to make the payment, the liability
of payment will rest upon the bank.
Thus, the non-funded credit may turn into funded facilities. These are
termed as ‘contingent liability’ and do not affect the bank balance
sheet at the time of commitment but contains the possibility to be a
funded-credit.
The major facilities are:
1. Letter of credit( L/C): Letter of credit is a credit contract whereby
the issuing bank is committed to place an agreed amount of
money at the seller’s disposal under some agreed conditions. It
may be revocable, Irrevocable, transferrable, back to back and red
clause.
Md. Nazmul Hasan

Non-Funded Credit (Conti…):
Types of Documentary Credit:
1.1 Revocable Vs. Irrevocable Letter of Credit
1.2 Confirmed Vs. Unconfirmed Credit
1.3 Confirmed Irrevocable Credit
1.4 Transferable Credit Vs. Non-transferable L/C
1.5 Back to Back Credit (Export backed import L/C)
2. Bid Bond: One kind of guarantee or undertaking by a bank on behalf of its
client to enable him to submit his bid in a tender.
3. Performance bond: A performance guarantee is given after the tender or bid
of a particular client of the bank has been accepted. It is a guarantee where
the bank gives an undertaking to the third party that its clients shall
complete the job as per the terms of the tender or to pay the damage up to
the guarantee money.
4. Letter of Guarantee: Banks also issue letter of guarantee on behalf of
customers.
1. Specific Guarantee:
2. Continuing Guarantee:
Md. Nazmul Hasan

Question Bank:
• Prepare and answer the prospective questions
from this chapter.
Be Innovative!
Thanks for Your Patient Hearing!
Md. Nazmul Hasan

Introduction to Functional Credit.pdf

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