Banking Efficiency (version 2016) – Uniform formats for Assessment

Banks in India follow practice of financing under Multiple Banking Arrangement (MBA) or under Consortium for Working Capital (WC) finance. Similar practice is followed for project/term loans on achievement of financial closures. Borrowers approach the lead bank in WC Consortium every year for assessment/renewal of WC limits. This process takes on an average 2-3 months time for a mid/large scale corporate borrower. After detailed appraisal/assessment, the lead bank shares its assessment note with the other member banks in the Consortium. The member banks use this note for renewal/enhancement assessment at their end. But when? If the note is received say in January, when will the member banks use it for assessment at their end? The answer is : in normal circumstances, they will use it only when the limits are due for renewal at their end, and if such due date is say in May, then it will be May only when the note will be used. Surprisingly the renewal exercise at each member bank, takes average 1-2 months time even after assessment by lead bank, and lead bank shares its assessment note! But why? The first reason being of course is that all member banks do not maintain a common date for renewal, which leads to information in lead bank note becoming obsolete or requires updation by the time limits are due for renewal at their end. The second issue is that all banks individually also undertake the same full assessment exercise i.e. management study, analysis of financials, ratios, industry/market research, limits assessment, risk, mitigants, KYC etc, however in different formats. Each bank has its own devised formats which more or less contain similar information. But since the formats are not uniform and there is no written unanimous guideline for computation of ratios etc., each bank takes the support of lead bank note and prepares it own assessment/appraisal note.

In case of term loans the appraisal note is shared by bank if borrower pays a huge appraisal fee for such sharing. As mentioned above, even if it shared, it is of limited use in terms of efficiency in swiftly completing the assessment by other banks due to the issue of different formats prevailing in each bank. This applies even to the Syndicated/Underwritten deals, where the Information Memorandums (IMs) are of limited use as long as efficiency is concerned.

Think of the enormous time, energy, resources, systems, people, etc. invested by each bank in undertaking the same exercise which is already done by leader of the consortium, and even shared the assessment/appraisal note. Whether this meets the efficiency levels we expect in this challenging business environment?

In a time when Government is focusing on improving the system efficiencies in financial sector, formed the Banks Board Bureau (BBB) for improving the working of public sector banks, is it not time to address this issue of not having uniform formats in banks? If this is rectified, imagine how faster it would be to achieve financial closures for the WC/project finance. The Corporates will be able to use the saved time and resources in addressing the other issues. Banks will be also able to save their huge time which they can devote for processing additional proposals. Hence, addressing this small issue can hugely benefit India Incorporation, and its indirect effect would support the overall productivity in economy which is struggling to keep growth rate high.    

The above issue can be easily addressed by IBA/RBI by initiating dialogues with banks in drafting the uniform formats, uniform definitions of ratios, covers etc. for WC and project assessment. They can also initially conduct workshops for adopting the uniform formats. There could be need for addressing sector specific formats which can be also facilitated. There can be some information like industry exposures etc. specific to each bank which cannot be covered by lead bank in its uniform assessment note. Such limited information and the commercials pricing etc. can be prepared and topped up by each bank over the lead bank’s uniform assessment.

As a long term solution and efficiency building exercise, they can facilitate software which can generate industry specific templates having required assessment fields and formulas. This will standardize the assessment practices in banks without tempering with the templates/formulas. They can keep on improving/developing this software in consultation with banks over time.

There is thrust by RBI that each bank should undertake its own due diligence for exposures taken. To this effect, lead bank can share copies of supporting back up papers to enable the other members individually verify critical data.

Banks will be able to address the other issue i.e. of not having common due dates for renewals, once the uniform formats are adopted. Since the uniform formats will significantly reduce the assessment time, member banks will be also able to immediately take up the assessment exercise.  

Time to set New Normal : Adopting Cash Flow Based Monitoring

The rising NPAs have given sleepless nights to the bankers. The gross NPAs of Indian banks increased from Rs.83,000 crore (USD 13 billion) in FY 2010 to Rs.3,23,000 crore (USD 48 billion) in FY 2015, and this figure increased to Rs.5,72,000 crore (USD 86 billion) at the end of Q3 FY 2016. In many of the cases diversion of funds is reported to be one of the key areas of ongoing investigations. The existing banking system is based more on sharing of data among the lenders for their common borrowers. The bankers exchange of information of borrowers on regular basis. Generally such sharing is frequently and timely when account has already turned NPA or almost reached to become an NPA !!

Dilemma of Existing Mechanism for Sharing Cash Flows

In a Working Capital arrangement of bankers, every lender requires the borrower to route its business transactions through it on proportionate basis (i.e. based on percentage share of the lender in total Working Capital Borrowing tie up). The purpose is of three folds, one it gives them some hands on experience in understanding the business transactions of the borrower, two it helps in understanding the real volume of business, and three it gives access to interest free cash flow / deposits which has probability of remaining with lender for some time. It is very common that lenders complaint / pursue the borrower for routing cash flows. Lenders generally do not come together by relying on one of the lending members for first taking all the cash flows and then passing on the proportionate share to other lenders. Of course, this is commonly done when account becomes non performing (i.e agreeing to sharing cash flow when cash flows have already dried up!!), restructured and Trust and Retention Account (TRA) is managed by lender having largest share. Projects with concession agreements (i.e. like BOT Toll Road projects or City Water Supply projects etc.) are some of the exceptions to the situation where TRA takes place by virtue of the concession agreement. 

The Big Problem

Unscrupulous borrowers take the advantage of weakness of the system. Such borrowers maintain accounts with multiple banks, route cash flow to various A/cs in the absence of any fixed set of rules and enjoy ease of diverting the funds by complex chain of transactions. Such liberty of disproportionate cash flow routing or routing to banks not part of lending consortium/ arrangement is enjoyed by the borrower on the name of all lenders pursuing for larger share of cash flows. The lender getting larger share in cash flows remains cheerful and does not complain about such indiscipline of the borrower.

Such borrowers also ensure maximum squeezing of undrawn loans/working capital lines before they disclose their deteriorated financial position to the banks.

TRA Arrangement

In today’s highly technology driven world, it is important and possible to have dynamic understanding/control of the income and major expenses of the borrower. A Trust and Retention Account (TRA) Agreement is a documented arrangement wherein rules are framed to channelize the cash flows of a borrower in a systematic manner. The agreement provides the Water-fall mechanism in which the cash inflows will be utilized. The Water-fall mechanism provides the details of various key accounts to be maintained by the borrower, like Income A/c, Critical Expense A/c, Statutory Dues A/c, Tax A/c, Debt Service Reserve A/c (DSRA), Interest Expenses A/c, Principal Payment A/c etc. and their priority order for channelling the cash flow. Generally TRA is stipulated in restructured loans while in other cases Escrow A/c is stipulated. TRA is strict mechanism of cash flow management to be maintained by the borrower. In comparison to TRA, Escrow can be considered a bit lenient mechanism which makes sure that all the cash inflows are brought into one account and transferred by the Escrow bank as per the Escrow agreement. Sometimes Escrow is followed by Supplementary Escrow Agreement stipulating the TRA Water-fall mechanism. All these arrangements of TRA / Escrow are well developed by the banking sector, and lenders are well equipped in managing TRA/Escrow.

Adopting the Technology

The point here is that with the advancement of technology and app driven convenience, these mechanisms can be further made efficient with technology support. For monitoring purpose, lenders now need to change their first focus from analysing the financial statements to hands on control on the cash flows of borrower. This needs to be adopted as a practice. Ultimately, it is the cash which matters and if cash is monitored well, rest of the things would fall in line. The need of hour is that it is not only the borrower getting SMS on his phone when his account is debited but also the lender should come to know about the utilization and details. Hence, time demands for setting standards, rule of game and as matter of basic practice & principal to adopt the cash flow focused monitoring.

It has been experienced that in restructured cases TRA arrangements, the TRA bank/agent is often accused of using the cash flows for recovery of its own overdues. The solution could be resolved by appointing any bank as TRA agent having no exposure to the borrower.  Adoptions of such practice by the banking industry would set it as market standard. As usual, adopting any new practice is faced with initial hiccups. With the adoption of TRAs at industry level, the increased business volumes and competition would bring down the TRA bank fee. Allowing benefit of retaining /maintaining some balance with the TRA agent could drastically reduce the fee for implementing TRA. Over the time borrowers will also get accustomed to managing the TRA and it will become a new normal in practice.  

The segregation of income into a separate account and routing all the sales to one single account as per TRA arrangement, would help in understanding the actual sales volume regardless of accrual accounting based income as per financial statements. Segregation of expenses and tracking of related party transactions would help in controlling diversion of funds.

The transaction monitoring can be filtered to reduce SMS volume on the phone of banker by setting  minimum transaction size, frequency, tracking related party transactions and type cap for such reporting to the banker. Instead of getting SMS alert for all the transactions, the banker may get alert only when some alert is triggered like the cheque issued by the borrower is returned/dishonoured, or when limits utilization are reaching some peak level (say 80%) or when the interest/principal is not paid on due date, etc. Depending on the category/rating of the borrower, status of the account, such triggers can be increased/reduced. Such type of filtering would hugely reduce the volume without defeating the purpose of monitoring. They app driven technology may also facilitate easy management of such triggers.

The Reserve Bank of India has already issued guidelines on Early Warning Signals (EWS) and facilitated CRILC database check, which would supplement the Cash Flow based monitoring. The use of advance predictive and prescriptive analytics can further create significant impact in monitoring the accounts.

It is not easy to identify customers before they default, however, with the advancement in technology, monitoring of cash flows can be managed in an efficient, improved and controlled way which would support in identifying the problem accounts before the damage happens.

External Credit Ratings: Time to Change the Process and the Gold Standard of Rating

The Union Budget has proposed a new credit rating process for infrastructure projects. This is expected to support fund raising on reasonable terms for such projects. At this juncture of Economy when need for such a different rating system has been envisaged, then it would be also of importance to review the traditional process of external rating system.

The credit rating agencies are meant to provide lenders with an informed analysis of the risk associated with debt instruments. These ratings are usually characterized by a letter grade, the highest and safest being AAA, with lower grades moving to double and then single letters (AA or A) and down the alphabet from there. The ratings approved by these agencies have widespread implications for lenders.

Lot has been said about the failing of credit rating’s efficiencies in warning the defaults since year 2008. The big three global rating agencies had come under intense scrutiny in the wake of the global financial crisis. These agencies in year 2008 were accused of offering overly favourable valuations of insolvent financial institutions and approving risky mortgage related securities.

The Fee Model of Rating Industry: Subscribers Pays or Issuer Pays

Most of the credit rating agencies follow the Issuer Pay model wherein the borrower who is getting its debt rated pays to the rating agency. Therefore, the borrowers who need certain ratings in order to sell their debt to lenders may have been willing to pay more for their preferred rating. It is noted that under Issuer Pay model the borrowers shop with the credit rating agencies for the desired/lenient rating band. The competition among the rating agencies at one hand benefits the borrowers but on the other hand affects the interest of lenders. It is evident in the market that many borrowers, who are rated below investment grade shop with the rating agencies, change their rating agency and are able to get investment grade ratings if not very high but at least at lower end of the scale. This helps such unscrupulous borrowers in passing the muster of lenders for getting loans sanctioned.  Lenders carry out their own internal credit rating of the loans. The external rating presents an external independent view. However, if the external view is investment grade, it may create some positive impressions over the internal ratings also.

Its time to take control of the Wheel

For long time, the process of credit rating has been allowed to be handled by borrowers. When the Budget envisages need for different rating system for infra projects then there are enough good reasons for relooking at the rules for existing rating process also. Excluding the rating process, many other exhaustive monitoring related activities like Stock Audit, Concurrent Audit, Lenders Independent Engineer, Valuations etc. are controlled and efficiently, cost effectively managed by lenders. From that sense isn't the time ripe to control the external ratings process of the loans also?

Like controlling the exercises (which are lengthy and complex) of Stock Audits and Concurrent Audits, lenders can also control/handle the External Rating process of the loans. This would provide better information to rating agencies (since the existing informal channel of interactions between the two will turn into a formal one to one dialogue as it happens in Stock and Concurrent Audits), facilitate information, and the open interaction between two would help in deeper understanding the critical issues.

There are pros and cons of everything. External credit rating has great importance since it is expected to present an unbiased view on probability of default. Their independence can not be compromised and allowed to be influenced by bigger forces (banks/FI etc.) in the financial market. I agree that the above suggestion also has some chances of influencing the freedom of credit rating agencies decisions as they would need to deal with much bigger and powerful set of customers (lenders/banks) who could then threat diverting business to the competitors following lenders views.

Benefit in Interest Rates/Subsidies

A balancing solutions would be to have credit ratings from two agencies, one obtained directly by the borrower and other done through the lender. This could be adopted for loans of Rs.500 million and above. In case of large difference between the two, decision makers will have enough warning signals for analysing the matter before taking their call. For loans between Rs.100 million to below Rs.500 million government may come out with schemes for subsiding the cost of second credit rating. National Small Industries Corporation (NSIC) provides reimbursement of credit rating fees to the small scale industries (http://www.nsic.co.in/creditrating.asp ). However, the option of two external ratings would further increase the cost of borrowing and involve extra time & energy. To reward for the pain taken by the borrower and reducing the cost, lenders may benefit borrowers going for two ratings system by providing some concessions in interest rates/processing charges.

Regulatory Compulsion for Rating

One of the other effective solutions could be putting restriction on changing the credit rating agency within a period of 3 years from their appointment and making the external rating compulsory for loans of above Rs.100 million before availing sanction of loans from lenders. The borrowers who do not get their rating re-validated timely or are not keeping their rating live may be compulsory penalized by increase in applicable interest rates. Regulatory framework may be developed in this regard.

The Gold Standard of Rating

The rating agencies community also need to come out with a standardized product of Gold Standard Rating supported by necessary changes in regulations, where the common high standards of uncompromised rules and procedures may be defined. The borrowers may be encouraged to go for such high standard Gold Ratings. The reward for such ratings would come in the form of high investors/lenders interest with premium pricing. Adoption of these high standards may be made more attractive by allowing certain low ticket Gold Standard rated loans eligible for Priority Sector Lending (PSL) (https://en.wikipedia.org/wiki/Priority_sector_lending). The Gold Standard rating would reflect the rigorous due diligence passed by the borrower and reflects its high standards on accounting & audits, cash flow management & monitoring, corporate governance, professionalism of management like aspects. The rating agencies could be heavily penalized for comprising any rule under such Gold Standards.   

Time to Re-write Rules of BGs?

Over the years banks have been in business of guarantees which generated handsome commissions. However, past few years of downturn have given lessons with sleepless nights to issuers. The beautiful business turned into ghost. During the growth period few years back mostly in infrastructure/EPC long period guarantees (Performance/Mobilzation/Advance) were issued in general however what could not be noticed was the insertion of onerous clauses or deletion/compromise of standard clauses. This along with unconditional nature of the guarantees gave upper hand to the beneficiaries and allowed freedom to the borrower in diversion of funds. Many standard clauses in BGs such as auto reduction in BG with performance of contract or effectiveness of BG only on crediting the advance payments to the contractors account with the BG issuance bank could have helped. It’s not that bankers had not objected to such deviations however going by the experience I can say that to some extent it was stubborn nature of the beneficiaries taking the benefit of cut throat competition in banking. But does it not mean that regulators need to control competition or three regulator/appex association of banking  need to define standard clauses which can not be comprised ? Further, any large BG is as good as a loan and requires the equal due diligence and monitoring. Lessons already learnt.

Current Assets and Margin Money for Non Fund Based Limit

We had discussed about the Working Capital Assessment (Working Capital) and margin money for Non Fund Based limits (The Essence of Margins for Non Fund Based WC Limit) in previous articles.

I have come across many discussions on the issue of whether the margin money/cash margin/Fixed Deposit Receipt (FDR) margin provided by a company/borrower for availing non fund based limits(LC/BG), should be part of Current Assets while arriving at the Working Capital (WC) MPBF or not? In this context, let’s review the standard method of WC assessment with the following example:

A company is at the beginning stage of a business. The company needs to purchase current assets (materials) worth INR 100 million. The suppliers are ready to supply 25% of material at clean credit period of 90 days and balance with cash payment on delivery. The company also needs to provide Performance Bank guarantee (PBG) of INR 100 million to some party for getting a business contract. XYZ Bank is ready to provide PBG with 20% FDR Margin. With this information let’s assess the limit:

(A) Current Assets (CA) - Inventory Estimate : 100

(B) Margin Money for PBG Estimate  : 20

Total Assets: 120

(C) Current Liabilities (CL) – Sundry Creditors (excluding bank borrowing for WC) Estimate :25

Total liabilities: 25

NFB Limit (PBG) Estimate : 100

Under the standard MPBF assessment method, the WC gap (i.e. the difference between CA and CL (excluding the bank finance) is considered eligible for WC finance subject to 25% of CA to be funded by promoters.

Important point to remember here is that WHATEVER is INCLUDED HERE IN THE CURRENT ASSETS (AND IS HYPOTHECATED TO BANK AS PRIMARY SECURITY), IS ACCEPTED FOR FINANCING BY WC BANK. In the above example, the BG is for performance purpose. It does not result in materials/current assets on which bank will have hypothecation charge. In this example, there will be fund requirement of INR 20 million (20% of PBG required) for obtaining the PBG from bank. Since the WC banks provide finance against the hypothecation of current assets, and by establishment of PBG there will not be any creation of CA (the primary security for the bank against which lending is done), the bank will not consider this margin money as part of CA. Hence MPBF will be:

(D) WC GAP : A – C = 75

(E) Less : 25% of CA i.e. = 25

Balance eligible under MPBF (D – E) = 50

The estimated balance sheet will look like as following:

Current Assets	Current Liabilities
Inventory :100	Sundry Creditors : 25
	WC Bank Borrowing : 50
Non Current Assets
FDR Margin : 20	Non Current Liability
	Promoter’s Contribution for CA : 25
	Promoter’s Contribution for PBG FDR Margin:20
Total : 120	Total: 120
Current Ratio (Current Assets Divided by Current Liabilities)	1.33 times

With the above explanation, it can be concluded that if the NFB limit does not result in increase in equivalent CA (which are hypothecated to bank as primary security), the FDR margin cannot be treated as part of CA for arriving at the MPBF.

Now, lets consider an additional assumption in the above example. Suppose that the material supplier is willing to provide 25% of the materials on 90 days credit only if equivalent irrevocable LC is established in his favour. Bank stipulates 20% FDR margin for LC establishment. So, now the company additionally needs 20% funds of the 25% of the material value i.e.    100*25%*20%= INR 5 millions.

Again the question: whether this estimated FDR margin can be included in the CA for arriving at the MPBF? Since establishment of Usance LC will result in increase in inventory on which WC bank will have hypothecation charge, therefore, can this FDR margin be included in the CA while calculating the MPBF?

Here we need to look at the Usance LC process. It may be observed that at the time of establishing the LC, there is no current asset against this, and we have established above that WC bank finance is provided against CA (which are stored at an identified location). When LC will mature, the company can make payment by debiting its Fund Based A/c limit (generally Cash Credit A/c), and this utilization will be allowed by bank since material would have arrived and will become paid stock under the hypothecation charge of the bank. However since at the time of LC establishment there is no CA, therefore bank will not agree to fund the margin required for establishing the LC. This margin will have to be brought in by the company/promoters.

(1) If we look at the transaction from another angle, it can be also said that instead of funding the 20% margin, the bank may very well ask company/promoters for bringing 25% FDR margin instead of 20%. Why? Because under MPBF method since bank agrees to fund 75% of the CA and 25% is contributed by company/promoters, therefore future expected material delivery has to be funded in the same ratio(i.e 75:25). Hence at the time of LC establishment itself, the bank may ask for 25% margin by promoters/company. Agreeing to a lower margin (i.e. 20%) may be only on the following assumptions:

- Company/Promoter’s contribution in funding the existing CA is more than 25% resulting in Current Ratio of more than 1.33 times.

- Bank is willing to agree to a lower contribution by promoter’s/company (i.e. bank accepting Current Ratio less than 1.33 times)

(2) The bank may also ask the company/promoter to bring 100% margin. Why? Because if the company is maintaining exact 1.33 times Current Ratio  before opening of the LC, then there is no additional current asset available as a primary security to the bank. Actually, there has to be additional current assets (which are hypothecated to bank as primary security) equivalent to the difference between the LC value and FDR margin provided by company. In the absence of this validation, if the bank agrees for issuance of LC at the stipulated FDR margin, it is done on the following strength:

(1) The bank is ready to take non fund based unsecured exposure equivalent to the difference between the LC amount and FDR Margin.

(2) The company has provided sufficient collateral security which ensures that bank’s exposure is always 100% secured.   

The estimated balance sheet will look like as following:

Current Assets	Current Liabilities
Inventory : 100	Sundry Creditors:25
	Bank Borrowing  Inventory: 50
Non Current Assets	Non Current Liabilities
FDR Margin for PBG: 20	Promoter’s Contribution for CA : 25
FDR Margin for materials LC : 5	Promoter’s Contribution for FDR PBG Margin:20
	Promoter’s Contribution for FDR LC Margin:5
Total: 125	Total : 125
Current Ratio (Current Assets Divided by Current Liabilities)	1.33 times

Hope you like the article.

Corporate Finance Segment of NBFCs and Bank Finance

Non Banking Finance Companies (NBFCs) are one of the important entities in the financial sector.  The general factors of NBFCs business success lies in their cost effective delivery model, sector focused approach, faster delivery, last mile connectivity, prompt action and efficiency.

In the corporate finance sector, the prime areas of NBFC lending involves promoter funding, funding against shares, subordinated debts, senior debts, short term debt etc.

Sources of funds for on-lending business to an NBFC are promoters funding, bank finance, public deposits, commercial papers, debentures, inter corporate deposits etc. where  bank finance forms one of the major sources. There are several restrictions on use of bank funds by NBFC for on-lending like use of such funds for investment into shares, debentures, unsecured loans, inter-corporate deposits, loans & advances to subsidiaries/group companies etc.  

Recently, in two of transactions (debt funding) encountered, it was analysed that while the transactions could not pass the due diligence and guidelines of the bank, these same transactions were later on found to be present in the asset book of one of the NBFCs presented to the bank for financing.

This is one of the reasons I thought to discuss the NBFC financing. Does it mean that some NBFCs consider those transactions which are not able to pass through the banks regular due diligence/guidelines?

Under the corporate finance segment, the NBFCs get major space in lending on short term basis with prompt delivery and efficiency especially in circumstances where funds are required on very short notice. Apart from fulfilling the financing needs against shares, these NBFCs also get space in unsecured/subordinated lending. The rate of interest & transaction cost of NBFC finance under corporate segment is also generally on higher side as compared to banking channels. It appears that unless the time or non-acceptability of general banking covenants, are the key to the transaction (eligible for direct bank finance), the transaction may not be attract towards NBFC.

With the above description, the emphasis which can be derived is that bank finance to NBFCs (especially having major corporate finance segment) is a critical financing segment and it appears that reputation of NBFC/promoter group and their financial strength becomes one of the most important factors of due diligence apart from strong financials, credit rating and compliance with regulatory guidelines by the NBFCs.

Wish you all a very Happy New Year 2015.

Long Term Export Advance

I had mentioned in my earlier articles about the Pre-Shipment and Post Shipment Export Credit Advances available to Corporates (Pre-shipment Credit / Post-Shipment Credit). These are the short term facilities [maximum period of upto 360 days (preshipment) and 365 days (postshipment)] for boosting the exports from the country. The interest rate to be charged in these lines are not controlled/capped by Reserve Bank of India (RBI).

In order to ensure availability of long term finance at internationally competitive pricing to the exporters, RBI in May 2014 has allowed exporters having a minimum of three years satisfactory track record to receive long term export advance upto maximum tenor of 10 years to be utilized for execution of long term supply contract for export of goods subject to certain conditions. The exporter is allowed to provide SBLC/BG from banks in India for guaranteeing the export performance. Some of the key conditions of the guidelines are as following:

1. Firm irrevocable supply orders should be in place.

2. Company should have capacity, systems and process in place

3. Such advances should be adjusted through future exports.

4. Rate of interest payable, if any, should not exceed Libor + 200 bps.

5. Double financing for working capital for execution of export orders should be avoided.

6. SBLC/BG facility will be extended by banks only for guaranteeing export performance.

7. BG/SBLC may be issued for a term not exceeding 2 years at a time and further rollover of not more than 2 years at time may be allowed subject to satisfaction with relative export performance as per the contract.

8. BG/SBLC should cover only the advance on reducing balance basis.

9. BG/SBLC issued from India in favour of overseas buyer should not be discounted by the overseas branch/subsidiary of bank in India.