Knowledge of Bank Lending

CHAPTER ONE: Overview of Lending Concepts, Principles,Policies and Practices

Introduction

A core skill that is required of a banker is the lending of money successfully. This is because lending and credit management are at the heart of banking. Though, lending is essentially an art and not a science with some degree of subjectivity involved, yet there is an organized methodology or approach in arriving at a lending decision. This is basically what we seek to demonstrate by availing you the methodology and the thought process that every lending banker must go through in making an informed lending decision.

Rationale for Bank Lending

Granting of loans is perhaps the most important function of a bank. It is the way by which banks earn a substantial part of their income. Businesses all over the world sell products and services to make money. For a bank, the product is money. Banks earn income by accepting deposits from those who have funds and then lend money to customers who need funds for personal and business purposes at a spread. The bank’s spread is the difference between the interest a bank charges on a loan and the interest the bank pays on a deposit. For instance, a bank might obtain a deposit from a customer at the rate of 8% per annum and thereafter lend the funds to a borrowing customer at the rate of 13% per annum. The difference of 5% is the bank’s spread, and therefore its profits.

From the above, it can be seen that banking is a margin business. The margin needs to be protected by managing the spread on a continuous basis. Hence, banking is regarded as a risky business. Commercial lending environment is a tough terrain, however, it offers significant opportunities for a good return, for a well-managed banking institution.

When loans go bad (customers are unable to repay), it can be fatal to the survival of a bank. And in extreme situations, the Central Bank of Nigeria (CBN) is forced to step in to bail out the distressed bank so as to avoid systemic distress that may involve using taxpayers’ money to stabilize the system. This is the reason a prudent banker needs to exercise a sound professional judgment in making a lending decision which results in the principal and interest being paid as and when due.

Objectives of Lending

As a banker, you do not just decide you want to lend money. There are certain overriding objectives that should inform your decision to want to part with your capital and depositors’ money. Thus, lending is a means to an end and not an end in itself. So why would a banker want to lend? We believe that bankers are motivated to lend because of the followings:

Profitability

The primary objective of a bank, as a business organization, is to deliver value to its customers and maximize profit and by extension, the creation of wealth for its shareholders. Without adequate and consistent profitability, the long-term survival of a bank cannot be guaranteed. The quest for survival as a bank is a major consideration in lending. This is because without adequate profit a bank’s ability to pay interest on deposits and meet other operational expenses (e.g., staff salaries) will be severely constrained. A major source of income for a bank is its lending activities. And lending successfully will not only generate profits for a bank but also ensures the safety of depositors’ funds. Overall, the goal is to generate an acceptable level of return on a lending transaction as well as ensure the safety of the bank’s loan portfolio on a consistent basis.

Growth

Aside from the profitability objective, a key rationale for lending is the growth of the banking business. A well-structured and performing loan portfolio will generate consistent profitability, which in turn will be re- invested to generate more profit, create additional lending opportunities, develop new banking products and ultimately lead to the growth of the bank. A bank is either growing, stagnant or declining. Growth is a desirable objective that is consistent with shareholders’ wealth maximization goal. Whereas, a stagnant or declining bank is a failing bank. The goal of a lending banker is to deploy the resources of the bank in such a way and manner to engender long-term growth and sustainability of the bank. This is done by ensuring that lending decisions are based on sound judgments that will guarantee the repayment of principal and the interest as and when due. To do otherwise is to compromise the trust reposed on one, as a professional banker.

Competitiveness

Banks are financial intermediaries responsible for mobilizing funds (deposits) from surplus areas and then lend these funds (loans) to areas of deficit. To this end, all banks are in competition for deposits and lending opportunities in the market space. The ability of a bank to perform this role successfully or otherwise, impacts on its competitiveness. A competitive bank is a profitable, growing and dynamic bank known for the quality of its deposit structure as well as its loan portfolio. This entails that as a lending banker, you are not only professional in your lending decisions but also pro- active and prompt in the handling of customers’ loan requests without compromising standards. The overall objective is to ensure the bank stays ahead of competition.

Economic Development

Banking is one of the most regulated businesses in the world. The reason for this is not far-fetched given that banks keep custody of money belonging to people, which must be protected at all time. Beyond ensuring the soundness of the individual banking institution, the government through the Central Bank of Nigeria does regularly issue directives to banks to lend to some designated sectors to foster economic development. For instance, the CBN has been directing the banks to lend to some sectors (agriculture export, small and medium scale enterprises as well as manufacturing) considered strategic for the overall development of the nation. In this circumstance, banks are not only profit-oriented organizations but are also agents of change and economic development.

Principles of Lending

As bankers, the onus is on usto exercise great care and diligence in the use of depositors’ funds in your possession, for the lending activities of the bank. This is because we are ultimately held responsible and accountable if and when things go wrong. To mitigate against the loss of depositors’ funds, banks and bankers all over the world are guided by the time tested and universally held principles of lending that must be considered when making a lending decision. These principles are discussed below.

Safety

As a lending banker, your primary responsibility is ensuring the safety of the depositors’ funds in your possession. For every loan application submitted by a customer for consideration, the overriding question is “How safe are the bank’s funds?” The ultimate responsibility for ensuring the safety of the bank’s funds rests with both the banker and the borrowing customer. As a lending banker, it is your responsibility to ensure fullcompliance with the Credit Policy of the bank as well as the guidelines and directives guiding the granting of credits emanating from the regulatory authorities. A borrower on the other hand must have the capacity to repay the loan by ensuring that the loan is not diverted into illegal, unapproved and risky business transactions that can jeopardize the repayment of the loan as and when due.

Liquidity

A well-managed bank is a bank that is considered sufficiently liquid to meet customers’ demand for cash withdrawals on an ongoing basis. As a banker, you are expected to align the maturity structure of deposits with the maturity structure of loans with a view to ensuring that the bank does not become illiquid (cash strapped). This is referred to as the matching principle in which long term loans must be matched with long term deposits while short term loans must be matched with short-term deposit liabilities. Lack of liquidity can have significant negative consequences for a bank’s continued solvency as failure to adhere to this principle can lead to the problems of assets (loans) and liabilities (deposits) mismatch, which in turn can result in the bank’s inability to meet its obligations to depositors’ need for cash withdrawal. The goal of liquidity principle is to maintain the required margin of safety as well as ensure the bank remains liquid at all time in compliance with internal policies and regulatory requirements onliquidity management.

Profitability

A key consideration in lending is the opportunity it offers to earn income that is needed for the long-term survival and growth of any bank. The goal of profitability is ensuring that lending decisions result in sufficient profits to cover the interest payments on deposits (cost of funds), operational expenses, loan loss provisions and payment of dividends to the bank’s shareholders. When a bank is sufficiently profitable, it is adding value but when it’s lending decisions result in losses, it is destroying value. Thus, the ultimate goal of profitability is creating value for the shareholders. This is however, without prejudice to the economic development of the nation.

Purpose

A major consideration for a lending banker is the understanding of the purpose for which a loan is sought. It is expected of a lending banker to examine critically and diligently the purpose of a loan request before it is extended to the borrower. The loan must fall within the bank’s approved credit products in compliance with the bank’s approved credit policy and the regulatory requirements governing the granting of credits. More importantly, the purpose must be legal and in sync with the nation’s drive for economic development. Furthermore, the purpose should be able to generate enough cash flows to repay the principal and the interest as and when due.

It is the responsibility of a lending banker to regularly monitor the use of funds by a borrowing customer to prevent diversion of loans to other purposes not originally intended. To this end, a lending banker should structure the loan in such a way as to make the conditions precedent to the loan utilization or loan drawdown water-tight to guide against diversion.

Reasons for Borrowing

As a lending banker, the first thing you want to do when you are confronted with a request from a customer to borrow money is to find out why does the customer need the borrowing. At least, the customer must have a reason for approaching the bank to borrow money. It is the responsibility of a lending officer to establish the reason for borrowing as part of the initial assessment of the credit. The reason must be specific and clear.

Generally, the following are some of the reasons why businesses borrow:

1.To pay bills (variable and fixed cost) such as custom duties, taxes, wages and salaries, cleaning, telephone, electricity, water rate, etc. pending when trade debtors are realized (converted into cash);

2.To finance the purchase of stock of raw materials which are converted into finished goods, sold and cash realized from debtors;

3.To finance the acquisition of plants and equipment for expansion and use during many trading cycles to produce outputs which are sold and cash realized;

4.To finance the development of properties such as office premises, warehouses and residential quarters for staff;

5.To finance business take-over through Management Buyout with a view to effecting a change in ownership; and to finance the survival of an underperforming business pending when it is fully turned around on the path of profitability. In this case, the lending bank might also be providing financial advisory services.

It is important to emphasize that customers can borrow for different reasons simultaneously. For example, a customer may need funds to purchase plants and machineries for expansion and at the same time require funds to buy raw materials to feed the plant as a result of the increase in capacity occasioned by the new plants to be installed. Thus, it is the responsibility of the lending officers to establish the reasons and deal simultaneously in line with bank’s Credit Policy. Familiarity with the customer’s business dynamics will also help you to understand it’s funding. A company’s business dynamics is appreciated through an understanding of the Asset Conversion Cycle, explained below.

Asset Conversion Cycle

A corollary to the issue of loan purpose is the business trading cycle, which is also known as the asset conversion cycle. It measures the turnover rate of working capital. Typically, a trading cycle starts with cash and ends with cash. A lending banker is not only interested in the purpose of the loan but also in the activities that go on within the business between the start of the cycle and when the cycle ends.

The length of the trading cycle varies from one industry to another. For instance, the trading cycle for a bakery business is short compared with a real estate development firm whose trading cycle is obviously longer. This means that the bakery business is able to generate cash faster than the real estate business because the length of its trading cycle is shorter.

Typically, the length of the trading cycle for a bakery business is like four days starting from cash to the purchase of flours, to baking, supplies to distributors and supermarket (debtors) and collection of sales proceed (cash). In fact, the length can be shorter if the business deals directly with consumers who pay cash instead of supplying the finished good (breads) to supermarkets/stores to create debtors, which are then converted to cash.

For a real estate development firm, the length of the trading cycle can be as long as twenty-four months, depending on project complexity. Also, the length of the trading cycle for a business producing beverages using imported cocoa powder will be longer than that of the Bakery business but shorter than that of the real estate development firm.

The trading cycle is so important that it is the cash generated through it that is used to repay loans and service interest payments as and when due.

The shorter the length of the trading cycle, the less risky the business and vice versa. This is why Management of Working Capital is important given that Current Assets constitute a major component of the Total Assets of most businesses.

Working Capital:This can be defined as the difference between Current Assets and Current Liabilities. It is also referred to as Net Current Assets.

Current Assets:Current Assets are shown in the Balance Sheet as a component of total assets and these include stocks, debtors, prepayments, short-term investments and cash.

Current Liabilities:These are shown in the statement of financial position (Balance Sheet) as a component of total liabilities and they include creditors (due within one year), Accrued Expenses and short-term borrowings.

Below, we consider specific examples of trading cycle

Example 1 -Trading Cycle for a Bar Operator: CASH —-> STOCK then back to CASH

The bar operator takes cash to buy cartons of drinks from the wholesaler (distributor) in the morning and sells the drinks in cash to the bar customers throughout the day as credit sales are not permitted.

Now, what will be the length of the trading cycle if all the stocks purchased are sold on a daily basis?

The answer is, one day, since stocks were purchased in the morning and fully sold by close of business same day.

Example 2 – Trading Cycle for a Chocolate Company:

CASH —–> RAW MATERIALS —-> FINISHED GOODS —–> DEBTORS then back to CASH

The company takes cash to import cocoa powder, converts into chocolate, supplies distributors on credit and these distributors sell to consumers after which the company gets paid by the distributors.

Let’s assume that it takes 30 days for the stock of cocoa powder to arrive the factory,another 20 days to convert the stock of cocoa powder into finished goods and another 15 days to get paid by the distributors based on trade credits allowed by the company.

What is the length of the trading cycle if all the finished goods are sold?

The length of the trading cycle is 30+20+15 = 65 days.

This is the length of time it takes the chocolate producer to convert cocoa powder into cash.

It is obviously much longer than that of the bar operator with one day trading cycle.

Most retailers and distributors have short trading cycles compared to manufacturers that have to process raw materials into finished goods and sold to distributors/wholesalers on credits.

As a lending banker, it is your responsibility to examine and investigate the trading cycle of a borrowing customer to identify and mitigate the risks inherent at every stage along the trading cycle beginning from when stocks are purchased to when finished goods are sold and cash realized. For instance, there are risks with raw materials transportation, machine breakdown, workers going on strike, collection of sales and diversion of sales proceed. One way to mitigate the risk of raw materials transportation to the factory is through Goods- In -Transit Insurance.

In summary, the Asset Conversion Cycle provides information on:

1.Nature of financing need (purpose)

2.Amount of financing need

3.Appropriate sources of repayment

4.Timing of repayment

5.Risks associated with repayment

6.Risks mitigants

7.Loan structure guide

8.Loan monitoring guide

The above is just an overview of business trading cycle. It will be comprehensively discussed in the section on credit analysis.

Risk Diversification

A balanced loan portfolio is that which is well diversified. As a lending banker, you are not only expected to drive growth in your loan portfolio but also must avoid concentration risk by ensuring that approved loans are spread across sectors, industries and geography to reflect the risk apatite of the bank and in compliance with the approved credit policy. Failure to ensure diversification can result in huge loan losses in a sector, or industry with loan concentration hard hit by economic down turn. For example, the oil and gas sector is a volatile sector owing to price fluctuations in the international market, resulting in intermittent short fall in revenues despite its importance as one of the key drivers of the Nigerian economy. A loan portfolio that is dominated by exposure to oil and gas is a risky portfolio as evidenced by the upsurge in the ratio of nonperforming loans to total loans in Nigeria over the past six years beginning from 2015 when the price of crude oil per barrel dropped significantly.

Similarly, avoiding geographical concentration is also important to minimize risks associated with the physical environment of business such as climate change, war, insurgency and banditry. A typical case is the North East Region of Nigeria where banking transactions have declined and loans to businesses have remained substantially unpaid owing to insecurity situation in the Region as most businesses have had to either relocate or shut down their operations.

In addition, a lending banker must avoid concentration risk at the firm specific level or at the level of individual borrower by ensuring that a large ticket loan is not concentrated in the hands of one borrower by ensuring that the Single Obligor Limit is moderate and in compliance with the bank’s Credit Policy to ensure that the loan portfolio is reasonably spread across a large number of borrowers than just availing huge sums to few borrowing customers of the bank.

Here, the goal of portfolio diversification is, achieving loan spread, dilution and strict adherence to the Single Obligor Limit as per the bank’s Credit Policy.

Security/Collateral

This principle emphasizes the need to avoid lending clean to a borrowing customer. This is because when a loan goes bad and the primary repayment source ceases, there should always be a second way out of problem loans. In this way, security acts as an ‘insurance’against occurrence of events that could dramatically alter the repayment of the loan as and when due or even totally make it impossible to be repaid. This means that a lending banker should take security with realizable value in excess of the loan amount (say 120% of loan value) to guide against loan loss occasioned by unforeseen events/circumstances.

In the event that the primary source(s) of repayment fails, the bank can fall back on the security being the secondary source of repayment. This is very important in an environment like Nigeria characterized by unstable macroeconomic environment where borrowers’ conditions do change frequently. For a lending banker, the most appropriate time to take security is at the point of loan approval but before disbursement, otherwise the bank will be at the mercy of the borrowing customer. In essence, a lending banker should take security/collateral as well as monitor the security against diminution in value.

The Canons of Lending

Why lend money as a bank?

Rather than lend the funds being kept with us by depositors, shouldn’t we just keep the funds in our vaults and avoid the problems associated with bad loans?

Interestingly, abstaining from lending is not the solution to the problem of possible operational losses because deposits maintained with banks have cost associated with them, which the banks incur as long as the deposits are in their vaults. For a bank to be able to pay interests on depositors’ money, fulfill the shareholders’ expectation in terms of dividend payment as well as the regular payment of staff salaries, it must generate revenue and make profits as a business entity. A major way to generate the biggest part of a bank’s revenue is through lending.

Therefore, it goes without saying that, lending out the funds that have been kept with a bank by depositors to borrowing customers of the bank is at the heart of banking. In carrying out this function, the bank charges its borrowing customers interest that are at higher rates than the interest rates paid on depositors’ funds. The difference between the interest charged on loans and the interest paid on deposits is the bank’s margin. It is also called the bank’s spread.

In a situation where the borrower is unable to repay the loan, the bank will be in danger of not just losing the interest that is required to pay the depositors’ interests, but the entire capital sum advanced to the borrower, thereby making it difficult to return the depositors’ funds.

Therefore, bankers need lending skill and sound professional judgment in order to lend safely and profitably and be able to repay depositors as and when due. As a lending banker, your goal is to minimize as much as possible the incidences of bad loans in the bank’s loan portfolio.

What do banker’s mean by Cannons of Lending?

As earlier stated in our introduction, lending is not an exact science in the mode of physics and mathematical formulae, which when combined together in the laboratory can guarantee the repayment of loans granted, including interest thereon. Though banks leverage on technology to drive the credit analysis process effectively, there is no such technology or computer programme that will process information at one end to give you the correct lending decision at the other end, especially with regard to big businesses.

Of course, for personal loans, we can have product programmes with defined criteria to make it easy for a lending decision to be made. Still, the solution based on the data fed into the computer is not a substitute for a banker’s personal judgment in lending. The multiplicity of issues involved in lending are so varied and diverse that a lending decision cannot be taken solely on the basis of the numerical solution (quantitative) given that there is a qualitative side to every lending decision.As a banker, you are required to gather all the necessary information on a borrowing customer and thereafter analyze your findings in great detail, to enable you make an informed and sound lending decision.

When the Canons of Lending are rigorously and consistently applied in a methodical, structured and analytical manner based on sound professional judgment, the risks associated with lending will be minimized. Therefore, a lending banker is in the business of managing risk and the objective is to reduce or minimize the risk to the level that is consistent with the bank’s risk appetite.

Lending decisions are taken on the basis of facts and not emotions. Failure to act in a professional manner will not only threaten the existence of the bank but can lead to your exit and loss of an otherwise promising career.

Thus, canons of lending represent the compass that guides a lending banker in analyzing a lending request from the application stage to the decision stage when approval of the loan request is either granted or declined. In other words, Canons of Lending are the guiding principles upon which a lending decision is based.

Most banks adopt mnemonics to enable their lending officers / analysts remember the key credit issues to be analyzed with a view to ensuring consistency and uniformity across the banks. These mnemonics vary from bank to bank but the good thing is that they capture the key elements.

Below are the two common mnemonics:

5Cs of Credit

1.Character

2.Capacity

3.Capital

4.Conditions

5.Collateral

CAMPARI

This is another one that captures some of the issues ignored by the 5Cs of Credit.6.Character7.Ability8.Margin9.Purpose10. Amount11. Repayment 12. Insurance

Although, the oldest and the most commonly used of the two mnemonics is the 5Cs of Credit, a bank is at liberty to adopt any of the above. Interestingly, you would see that the two are basically variants of the same subject matter of credit analysis. While a lending banker is required to understand the 5Cs of Credit, being the more popular analytical credit tools known and used by bankers for many years, we hasten to state that the mnemonic CAMPARI provides a more elaborate exposition of the key credit issues that need to be addressed before a lending decision is made.You will note that CAMPARI is a further breakdown of the 5Cs to make it clearer, direct and explicit. However, our focus will be on the 5Cs of Credit.

5Cs of Credit

This is a framework used by lenders to ascertain the credit worthiness of a prospective borrower by assessing each of the five elements in relation to a borrower’s business with a view to estimating the probability of default, and therefore, the risk of a financial loss to the bank. Regardless of the types of loans sought, a lending banker must be interested in both the prospective borrower’s business and personal condition. Thus, the framework combines both the qualitative and the quantitative measures. The qualitative measuresinclude a borrower’s credit report and credit score while the quantitative measures include financial statements and cash flows.

We discuss below the elements:

Character

This refers to a lender’s opinion of a borrower’s integrity, honesty, creditworthiness, and credibility. It is essentially about a borrower’s credit history and antecedents over the years. A lending banker will want to know whether the borrowing customer is reliable and can be trusted at critical moments.

The reason why this is important is that Banks want to lend to those who are responsible and can keep commitments.

Mode of Assessment

A lending banker assesses a borrower’s character through his work experience gained over the years, the borrower’s credit history, credentials, references, reputation and interactions with other lenders. For example, information on a borrower’s credit historycan be obtained from any of the three Credit Bureaus licensed in 2008 by the Central Bank of Nigeria.

1.CRC Credit Bureau Limited

2.CR Services Credit Bureau Plc., and

3.XDS Credit Bureau Limited

To understand the importance of a borrower’s credit history, the CBN has mandated all banks and financial institutions in Nigeria to use at least two of the bureaus when soliciting information on prospective borrowers.

Capacity

This refers to the ability of a borrowing customer to repay the loan. Essentially, it speaks to the ability of the business to generate profits, the Board to provide strategic direction and Management to manage the business profitably and professionally. In addition, it seeks to evaluate Management experience over the years and whether or not they are financially aware and knowledgeable.

This is important because, as a lending banker, you want to be assured that the business will generate enough cash flow to repay the loan in full as and when due.

Mode of Assessment

As a lending banker, you are able to assess a borrower’s capacity to repay loan by looking at the financial metrics and benchmark such as debt ratio, working capital ratio, liquidity ratio, net worth, and cash flow as well as qualitative measure such as credit score, borrowing and repayment history.

Capital

This refers to the owner’s equity in the business. Essentially, you are concerned about the funds invested in the business by the shareholders or the owners of the business. Bankers are more disposed to granting loans to businesses whose owners have invested their personal money into. This shows their belief in the business as well as a demonstration of their commitments to the venture. In fact, it shows they have a skin in the game.

Mode of Assessment

This is assessed by looking at the financial statements to ascertain the amount of money invested in the business by a borrowing customer. Also, you are concerned about the effective use of capital employed in the business. In addition, a comparison with industry average is a very good guide. One good indicator is leverage (Debt).

Conditions

This refers to the conditions of the economy, the industry and the business as well as the terms and conditions for granting of loans. As a banker, you want to assess the state of the economy, whether it is stable or unstable as well as its impact on the industry and the business. In addition, you want to look at the industry trends, its structure, the key players and key success factors. Also, you want to look at the business performance within the industry relative to what competitors are doing in the market place. Specifically, you are concerned about the company’s products and services, its market share and how this will impact on the business ability to repay the loan.

This is because as a banker, you want to lend only to businesses that are operating under favourable conditions by identifying the associated risks and mitigating them so as to protect the bank from incidences of bad debts.

Mode of Assessment

To assess a borrower’s conditions, you are required to carry out a review of the macroeconomic environment and key variable (interest rates, inflation, exchange rates etc.) as they impact on the borrower’s business. Next, you want to carry out a review of the industry in which the business is operating. Specifically, you want to analyze the stage of the industry and whether it is a growth industry or a mature industry or a niche sector or a global business or a cyclical business and its impact on sales and revenue prospects. Also, you want to look at the patterns of business cycles by evaluating the size and timing of the peaks and troughs especially for a seasonal business. Furthermore, you are required to analyze the competitive landscape by looking at entry barriers and the regulatory environment (capital, technology, buyers and suppliers).

Finally, you are expected to carry out a review of the business operations (strengths, weaknesses, opportunities and threats) and its impact on the business competitiveness and its ability to continue as a going concern.

There are a number of tools that can be used in carrying out this analysis.

Regarding the macro economic environment, we can use PESTLE (political, economic, social, technology, legal and environment) factors to analyze the business environment.

For the industry, we can use the Michael Porter’s competitive framework for analyzing industry (barriers to entry, bargaining power of buyers, bargaining power of suppliers, threats of substitutes and competition in the industry) to analyze the industry specific issues. This is also referred to as Porter’s five forces. It was named after a Harvard Business School Professor, Michael E. Porter.

And for the business/firm, we can use the SWOT (Strengths, Weakness, Opportunities and Threats) model to analyze the business conditions with a view to identifying the firm’s/business specific issues.

These tools shall be discussed in greater detail in the Credit Analysis Section

Collateral

This refers to assets that are pledged by a borrowing customer to guarantee or secure a loan. It seeks to offset the weaknesses in capital, capacity and conditions. Aside from the fact that a lending banker is precluded from lending clean, it is required that the security pledged is adequate, marketable and reliable. This is important because collateral is a back- up source of repayment in case the borrower defaults.

However, collateral should never be used to mitigate deficiency in character

Mode of Assessment

A banker can assess collateral by analyzing the physical assets of the business such as real estate and equipment, working capital such as account receivables and inventory and the business owner’s personal guarantee supported by a statement of networth.

A good security must possess the following qualities:

1.Simplicity of title: This enables a lending banker to do legal documentation and title registration seamlessly and in a cost effective manner. Simplicity also enables discharge and realisability of the security.

2.Stability of value: This ensures that the value of the security taken is either stable or appreciating rather than depreciating. This means that a lending banker must avoid securities whose values are volatile.

3.Realisability: This means that the security must be capable of timely realization without much complexity and formality.

Credit Policy

A bank credit policy refers to its ideology, philosophy, standards, strategies and guidelines that must be followed in the granting of credits and throughout the entire credit process beginning from loan origination to full repayment. In essence, it defines the bank’s underwriting and risk mitigation standards. Thus, a lending banker is expected to comply fully with the credit policy of his/her bank in approving or ditching a loan request.

It is usually in the form of instructions and procedures written as operating manuals and made available to all the relevant departments and officers in lending roles. The manuals incorporate, consolidate and update all lending instructions, directives, guidelines, processes and procedures emanating from within the bank and those from the regulatory authority (CBN) as well as relevant correspondences on changes in lending strategies and administration. The credit policy is usually approved by the Board of Directors and the regulatory authority (The Central bank of Nigeria in the case of Nigerian Banks) and it must not be breached.

A credit policy is a part of the overall risk management policy, which focuses on the entire risk gamut confronting a bank. Aside from the credit policy, which covers credit risk, other risk areas are market risk and operational risk.

It is important to emphasize that credit policy is not static but dynamic. This is why it is regularly reviewed, revised, updated and in some instances even altered to reflect shiftsin the macro economic environment as well as changes in a bank’s risk acceptance criteria.

Purpose/Benefits of Credit Policy

1. It provides a framework to guide lending officers in the handling of loan requests from origination to full repayment.
2. It ensures standardization and uniformity in the entire credit process across the bank.
3. It takes cognizance of the bank’s internal constraints such as deposit base, capital base, portfolio performance, etc. in the granting of new loans, thereby helping to manage the bank’s liquidity position.
4. It helps to minimize the incidences of bad loans, if rigorously implemented and followed.
5. It provides a framework for a safe, sound and profitable lending activities without which lending can be frustrating and disastrous.
6. It provides an objective and impartial way for banks to discriminate in its lending since all loan requests cannot be approved given the usual deposit, capital and portfolio constraints.
7. It helps lending officers to develop credit skills and sound professional judgment in the discharge of their responsibilities.
8. Finally, it provides a framework for credit supervision and monitoring with a view to ensuring that non-performing loans are within the bank’s and the regulatory authority’s limit.

Contents of Credit Policy

The contents of a Credit Policy can be grouped into three broad categories, namely: the Underwriting Standards, Credit Memorandum and Risk Management Procedure.

The Underwriting Standards

As earlier emphasized, a credit policy document defines the bank’s underwriting andrisk mitigation standards. These will include, among others, the following:

1. Desirable loan types and their characteristics
2. Loan approval authority, limit and the approval process. It could be a central or complex structure depending on its strategy.
3. Portfolio concentration limits and the sub limit for each loan type (overdraft, term loan, guarantees, lease, etc.)
4. The role of management in the approval of loan request
5. The types of financial statements required for analysis
6. Non-financial statement requirements like credit report and credit scoring from approved Credit Bureaus.
7. Collateral requirements detailing approved collaterals, value, analysis and their perfection.
8. Credit files maintenance standards to ensure proper documentation.
9. Guidelines detailing the bank’s appraisal practices in relation to each loan type.
10. Approving authority and the requirements for the granting of excesses above loan limit.

Credit Memorandum

The key credit issues in a loan request are provided in the Credit Memorandum. The credit policy stipulates the minimum information that should be included in the credit memo to aid Management and the Board in taking an informed lending decision. Theinformation include the following:

1. Loan type
2. The purpose of the loan (it must be legal)
3. Repayment sources (e.g., cash flow, payment domiciliation, etc.)
4. Collateral analysis, valuation and strategies for perfection
5. Analysis of the macro economic environment and the industry in which the borrower is operating
6. Analysis of the borrower’s business and financial conditions
7. Analysis of Guarantors and their statements of net worth
8. Pricing, including loan interest rate and other charges (commitment fee, legal fee, etc.)
9. Loan profitability analysis
10. Key credit issues detailing inherent risks and mitigants
11. Benefits of the loan to the bank and the prospective borrower
12. Future expectations and opportunities
13. Approval authority and sanction limits
14. Risk classification
15. Identification of policy exceptions for Management information

Risk Management Procedure

Credit Policy must be developed and framed within regulatory guidelines and formally approved by senior Management and the Board of Directors.

The credit policy outlines the procedure for supervising and monitoring a loan once it is approved and disbursed to ensure that the loan transaction remains at an acceptable level of risk to the bank. These procedures cover credit risk management and they includeinclude among others the following:

1. Loan review guidelines detailing scope, depth and frequency
2. Problem loan identification and resolution procedures
3. Debt collection and recovery procedure
4. Methodology for provisioning for loan losses
5. Guidelines in respect of loan portfolio mix
6. Procedures guiding identification, approval and monitoring of all credit policy exceptions bank-wide.

Custodian of Credit Policy

As highlighted in our introduction, the Credit Policy is not a static document but rather a dynamic document that is periodically reviewed, revised and updated in response to the changing macro economic environment, industry competitiveness, market conditions as well as the bank’s risk appetite. It is important to state that amendment to the Credit Policy is not a piece of play acting or a trivial matter, rather it is a rigorous process involving several layers of approval, and in some instances will require the approval of the bank’s Board of Directors .

The changes and updates are the responsibility of senior members of the Credit or Risk Management Department hence, the Credit or Risk Management Department is the custodian of the Credit Policy.

Every bank has a Credit Policy that guides lending officers during the entire credit process and it is the principal factor that drives loan approval or rejection.

Credit Culture

As you will observe, the business of banking is a risky business. Banks accept deposits and grant credits, which if not properly managed can spell doom for the banking institutions concerned. Failure to recover loans granted to customers can be the beginning of liquidity problem for a bank.

In practice, no two banks are the same in their approaches to lending and credit risk management. Some banks are perceived to be aggressive in their lending function while some are regarded as ultra conservatives. In between these two extremes are institutions that are neither aggressive nor ultra conservative. They just sit in the middle of the pack. These differences in lending approaches are explained by the individual bank’s credit culture.

Definition of Credit Culture

A credit culture can be defined as the system of behaviours, attitudes, styles, beliefs, values and the underlying philosophy guiding the entire credit process. It is the totality of the bank’s approach to underwriting, management and monitoring of credit risks, which have been developed and cultivated over the years based on experience, mission and vision of the Board and Management.

The credit culture is reflected in the credit policy, lending practices and the attitudes of the Board and Management, which altogether define the lending environment and the lending behaviours acceptable to the bank within the limit of regulatory constraints.

In other words, it is a way of life regarding what is acceptable and what is unacceptable, regarding the lending function of the bank and usually a reflection of Management experience over the years and the philosophical foundation of the bank.

Therefore, the credit culture of a bank exerts a strong influence on its lending and credit risk management practices. It is important to emphasize that when the credit culture is weak, the staff in credit and risk management functions may lack the confidence to deal appropriately and effectively on credit issues requiring sound judgments.

Types of Credit Culture

In practice, four types of credit cultures have been identified. We now discuss each of them and their distinguishing features. As you go through this section, you are expected to relate the contents with what is obtainable in your bank.

Value Driven

A value driven credit culture emphasizes asset quality beyond business exploitations, driven primarily by strong risk management practices coupled with a long-term consistent growth. Here, corporate priority is long-term consistent performance driven by a long-haul credit strategy with little or no tolerance for policy exceptions in their dealings with borrowing customers, thereby ensuring consistency across board. The goal is to ensure a balance between asset quality and revenue generation while avoiding the tendency to micro manage or over control the credit function.

Immediate Performance Driven

This culture emphasizes immediate earnings and stock price performance as the top priority of the Board and Management of the Bank. This is usually driven by the Management desire to post good profits annually irrespective of the challenges in the banking environment. Banks driven by this culture have strong risk management practices similar to what is obtainable under the value driven culture when the macroeconomic environment is stable and the economy is strong. However, during periods of recession and weak economy, they tend to engage in riskier behaviours by funding riskier lines of business to sustain their earnings momentum and stock price performance on an annual basis. The issue of policy exceptions is also common as lenders struggle to understand the priority of Management when the economy is weak. It is advisable to have in place a strong risk management policy to resist lenders pressure to enter into riskier market when the economy is weak.

Production Driven

The corporate priority is to gain market share through loan growth and volume with a view to be the largest lender in the market. Banks driven by this culture usually have strong systems, control and good credit relationship management capability.

However, they are conflicts regarding corporate priority as lenders are pressured to create loans irrespective of the inherent risks in the market place, especially for an aggressive bank. Here, staff in lending functions are always directed to find a way around a seemingly bad credit to make it bankable.

It is the belief of Management that the primary function of a bank is risk taking and not avoidance. Therefore, exceptions are common irrespective of what the credit policy says. For this culture to be successful, it is important to have in place a strong credit risk management division that has an effective control over the approval

Unfocused Culture

Under this culture, there are no clear priorities. Priorities tend to change frequently as Management tends to be reactive rather than proactive. There are inconsistencies in the credit process as line managers have different views of what constitutes quality credits, thereby compelling credit risk management department to respond to frequent changes in direction and development in the market place.

Staff in this kind environment are usually confused because of policy inconsistencies and shifting priorities regarding their lending function.

The only way to maintain credit quality is to put in place a water-tight credit policy supported by strong systems and leadership.

It is important to note that each of these cultures is a reflection of the priorities set by the Board and Management as a part of the overall corporate strategy of the bank.

A very competitive banking environment tends to focus banks on immediate performance. On the other hand, a bank that considers its credit culture as value driven primarily based on asset quality may be compelled to shift towards immediate performance because of earning pressure in a largely competitive environment where high quality earning assets are few.

Lastly, no bank will intentionally pursue an unfocused credit culture, lacking in set priorities. It is the behaviours of the bank and its top Management in relation to their customers that determine whether they are focused or not focused. And where Management is reactive rather than proactive can be a source of widespread distortionsand frequent changes in the entire credit process, thereby creating an unfocused credit culture.

CHAPTER TWO

Overview of Business and Retail Lending

2.2 Introduction

Banks have different categories of customers requiring different services. The customers can be broadly classified into individuals and businesses that carry out banking transactions on a daily basis. The services include acceptance of deposits from individuals and businesses as well as granting of loans to them as and when required in line with the bank’s risk acceptance criteria. Therefore, just as individuals approach banks for all kinds of services, so do businesses.

2.3 Business lending

This is the lending function of a bank that is specifically targeted at making loans available to businesses. Hence, loan products and services are developed and subsequently deployed to address the funding requirements of business customers who approach banks to borrow money to meet their immediate and long-term financial needs.

Any loan given out to any business will entail the creation of a debt, which is repayable with interest at the maturity of the loan.

In business lending, there are different kinds of credit (loan) facilities that can be made available to businesses, depending on needs. These include, among others: overdrafts, bank loans, leases, bridge loans, factoring, invoice discounting, project finance, hire purchase, assets based financing and mezzanine financing.

2.4 Retail Lending

On the other hand, retail lending function is targeted at making loans available to individuals or retail customers. This is different from business lending where the target is business. Retail lenders include banks, mortgage institutions (primary mortgage institutions), finance companies, credit unions and microfinance banks. Examples of retail lending products are personal loans, mortgages, credit cards, salary advance, home renovation loans, rent advance and a loan granted to build a house as opposed to a mortgage granted to buy a house.

As a business segment, retail lending is a big business that is widely spread and cutsacross the financial sector with significant opportunities for profitable relationships for the retail lenders. However, it is important to emphasize that the risk in retail lending is also huge. Hence, a retail lender must put in place an effective credit risk management strategy to manage risk across its credit portfolio, through a well established credit origination procedures and underwriting standards. Thus, most retail lending products are based on standardized product programmes with qualification criteria already defined in advance.

In recent time, the financial services industry has witnessed an improvement in the retail lending underwriting standards following the 2008 global financial crisis that was triggered by the sub-prime (sub-standard) mortgages in the USA.

Beyond adhering to higher underwriting standards, retail lenders are required to comply with a higher degree of transparency and disclosures in lending. The regulatory authorities have also come up with new regulations that have helped to enhance the quality of retail loans as well as to ensure that consumers are not burdened with loans, well above their capacities.

To this end, there is a growing trend towards making consumers to be financially aware to enable them understand the benefits and the costs associated with retail products.

2.5 The Banking Environment

As a lending banker, an appreciation of the environment in which you carry out your lending activities is of strategic importance if you are to lend successfully. This is because changes in the environment not only influence lending decisions but also impact greatly on our customers’ businesses and their ability to repay loans granted to them. Hence, good knowledge of the developments in the environment and their impact on businesses is key when assessing the credit worthiness of a borrowing customer and how these developments will shape the terms and conditions upon which lending decisionswill be based.

As you are aware, a lot of changes are taking place in our environment. The world is now a global village and no one is insulated from developments across the globe as witnessed during the 2008 global financial crisis and more recently in the case of the COVID 19 pandemic. So, when we talk of environment, we are not just looking at developments in the domestic economy but also developments in the global space.

The banking industry in Nigeria is witnessing a fundamental change arising from developments in the environments in which banks and bankers operate. For those who are familiar with the business of banking- whether as bankers, analysts or regulators, it is evidently clear that the industry is at the threshold of rapid and perhaps, quickening change. The evolution that is taking place in the financial services industry no doubt creates new opportunities for well-managed and innovative institutions. But it also poses substantial risks requiring policy mix and changes in banking strategies.

In this section, we would be examining the various aspects of the banking environmentsand their impact on lending business in Nigeria. These include the following:

1. Global environment
2. Political environment
3. Economic environment
4. Social environment
5. Regulatory environment
6. Institutional environment
7. Technological environment

2.5.1 Global Environment

The knowledge of developments at the global level as they impact on businesses is important when assessing customers’ credit requests. The developments can range from politics to economics and even health issues. The 2008 global financial crises impacted the Nigerian economy negatively and as a consequence the ratio of non-performing loans to aggregate loans in the economy went up to about 20. The incessant wars in the Middle East have implications for businesses and nations that rely on oil as their source of energy. So also, is the volatility in the prices of oil, which have had negative impact on the economics of many countries, including Nigeria with attendant negative consequences for banks with substantial exposures to the oil and gas sector.

The impact of COVID 19 global pandemic on businesses has been severe, with lots of businesses closing down and therefore unable to honour commitments to their bankers.

Furthermore, movements in global exchange rates, inflation rates and commodity prices have implications for banks and the way bankers conduct their lending businesses.

Therefore, as a lending banker, you are not only expected to be aware of key issues and developments as they impact on your customers’ businesses as well as your banking business but you must ensure that these issues are incorporated into your lending assessments and decisions.

2.5.2 Political Environment

A good understanding of the political environment is crucial for successful lending and by extension, for effective and efficient bank management. A lending banker must consider the nation’s political philosophy and structure as well as the goals and expectations of the political leaders when making a lending decision. You must be aware of key developments in the political space and their implications for your customers and bank, especially as they affect lending activities.

Changes in political administration are often accompanied by fresh policy pronouncements that affect the economy and thus, change the focus of banks and bankers towards lending. Thus, a lending banker has to be alive to changes in the economy that are politically motivated such as changes in the tax rate, industrial incentives as well as the recent introduction into the system of Treasury Single Account, all of which have implications for the lending activities of banks.

As a lending banker, the issue here is for you to be up to date with political motivatedchanges, understand their implications and factor them into your analysis and decision making process regarding the approval or decline of credit requests. It is indeed, a poor judgment to assume that you can separate politics from the business of banking.

Overall, you have to understand that governments in their daily activities and through policy pronouncements can create an environment where business truly flourishes and grow in a sustainable manner or an environment where opportunities are stifled and success limited. You will be guided appropriately once you understand that banking is also a business that can be affected positively or negatively by political decisions and activities.

2.5.3 Economic Environment

It is important for the lending bankers to reckon with developments in the economy as to the stability or otherwise of the macro-economic environment and its implications for lending. Analyzing the macro-economic environment requires the lending banker to watch the trends in exchange rate, inflation rate, interest rate, consumer spending, sectoral growth and the GDP growth.

Analyzing economic trends is considered critical in credit analysis because it gives a clear picture of the economic environment in which businesses are operating and upon which lending decisions are based. As a lending banker, this analysis will enable you understand how these broad trends are affecting the performances of the various industries or sectors as well as firms operating within the sectors. For instance, the dwindling revenue from crude oil exports accruing to the Federal Government of Nigeria since 2015 coupled with the exchange rate volatility have increased significantly the risk in the oil and gas sector and hence, reduced lending to the sector.

2.5.4 Social Environment

The lending banker needs to be well informed of the developments in the social sphere. A major area of concern relates to the country’s population with respect to size, growth rate, distribution in terms of gender, geography and productivity, especially between productive and non-productive and how the structure affects businesses in general and lending activities in particular.

Generally, it is assumed that an economy with a young population is a more productive economy than an economy with an aging population. This has serious implications for income growth, consumer spending, labour availability and the productivity of the economy as a whole.

A productive economy is where banking and lending activities will flourish and vice versa. In addition, a good understanding of the nation’s demography will help the lending banker in analyzing the market and effective demand for products and services as a part of the overall credit analysis process. More important is the quality of human infrastructure, which flows from the quality of the educational system, the training available and the skill level of the labour force, which ultimately impacts on the complexity and acceleration of business growth.

As a lending banker, you have to reckon with labour issues, especially in the period of economic downturn when businesses are prone to failures. The activities of labour unions, their powers, clouts and the bargaining power of employees have significant implications for business performance. For instance, the current high unemployment rate is affecting consumer lending in the areas of personal loans and mortgages

Finally, other social issues like frauds, corruptions, crimes, kidnapping, banditry and religious strife have implications for lending. For instance, the activities of bandits in the North are curtailing lending to the agricultural sector.

2.5.5 Regulatory Environment

The power of a sovereign government in regulating and shaping the development and growth of businesses can be enormous and wide-ranging. Governments establish the rules of laws, the rights of the people, the property rights, the regulatory framework and the fundamental rules of engagement for business for which they expect compliance.

A lending banker must reckon with these issues to know whether or not they are hurtful to businesses. Regulations can be extensive, covering a wide range of areas including restrictions on imports and exports (to protect local industries), competition boundaries, capital requirement (in banking), service quality guidelines, tariffs, guidelines, antitrust, permissible businesses and foreign exchange restrictions.

All of these issues have implications for the individual firm’s business strategies and performances. Therefore, it is your duty to investigate the implications of these regulations on the businesses of your customers as well as track the frequency and the government history of changing rules.

As a guide, a supportive environment is one where regulations are consistent, business friendly and well co-ordinated.

Finally, as a lending banker, you must also not forget the regulations imposed on your activities, especially by Acts (Laws) made by the National Assembly and regulations by the CBN. There are laws such as BOFIA 2004, the CBN Act 2007, the Money Laundering Act 2004 (as recently amended) and the series of Credit Guidelines (regulations) issued by the CBN at different times that contain provisions that directly or indirectly affect the lending activities of banks. You will be well guided in your lending decisions if you are knowledgeable about these banking and finance laws and regulations and how they impact on your business. A breach of any of the provisions contained in the laws and regulations is sanctionable.

2.5.6 Institutional Environment

A good knowledge of the financial system and the key actors is important in driving the credit process successfully. The key actors include the regulatory and supervisory authorities such as the CBN, NDIC, SEC and NAICOM whose activities directly or indirectly impact on the lending activities of banks.

Other participants include the deposit money banks (DMBs), merchant banks, mortgage banks, microfinance banks and insurance companies.There are also capital market operators like the NSE, FMDQ, Stockbrokers, Funds Managers, Issuing Houses and Specialized Financial Institutions like Federal Mortgage Bank of Nigeria (FMBN), Bank of Industry (BOI) Nigeria Export-Import Bank(NEXIM), Bank of Agriculture (BOA), Development Bank of Nigeria (DBN) and the Bureau Du Changes (BDCs).

The apex institutions (CBN, NDIC, NAICOM AND SEC) regularly issue policy guidelines to operators in the financial system for which they expect compliance at all times.

Also of importance to a lending banker is the issue of competition among the operators. Competition (both price and non-price) influences the ability of banks to acquire and retain customers, especially borrowing customers. In addition, the stability (soundness and safety) of the financial system as it relates to its interconnectedness through interbank dealings, the provision of deposit insurance by the NDIC as well as the provision of safety net by the CBN as a Lender of Last Resort in period of liquidity crisis are crucial factors that must be taken into consideration in the business of managing and lending the depositors money successfully.

The 2008 financial crisis which had its root in the sub-prime mortgages in the United States of America, led to the collapse of a number of banks including Lehman Brothers, following the collapse of the interbank system. Poorly packaged and substandard mortgage credits precipitated the crisis in the financial system and led to the breakdown of trust among the operators. As a consequence, the liquidity in the system dried up and financial institutions including banks with significant exposures to subprime mortgages became insolvent to the extent that the United States government had to bail out a number of them to prevent the collapse of the financial system.

Therefore, as a lending banker, you must understand the key issues in the financial system as well as the regulatory authorities’ antecedents as they affect your bank and its lending activities.

2.5.7 Technological Environment

We are certainly in the age of technology. Digital revolution is taking place across a wide range of sectors and industries. The lending banker must be aware of this development and its implications for the lending activities of his or her bank. One major area of concern to a lending banker is the risk of product or technology obsolescence. This is especially true of the information technology industry where innovation drives the emergence of new technologies frequently.

As a lending banker, you will be concerned with the types of technology being deployed by your customers and whether they are innovative and competitive technologically or not when viewed against developments in their industries and what competitions are doing. Obviously, you would not want to lend to a company with obsolete technology that cannot compete effectively in its industry. A firm with an obsolete technology and lacking in innovation is a candidate for failure since demand for its products will fall gradually with time, especially in an industry that is fast innovating and where competition is stifling.

In the banking industry, technology has become a major business enabler. There are accelerating trends in electronic funds transfers, on-line credit products, on-line credit appraisal and monitoring systems, financial inclusion and agency banking driven largely by technology. The advent of FINTECHs is enhancing competition in the retail sector while peer to peer lending is gaining a lot of traction.

As a lending banker, you are required to be aware of these developments and their implications for your lending activities as your bank competes with other banks for the share of customers’ wallets.

2.6 Financing Options in Retail and Business lending.

As you are aware banks accept deposits from their customers and invest the funds in a variety of ways to make profits. These include investments in money market instruments, government securities (Treasury Bills) and loans to their customers.

Of all of these investment opportunities, loans to customers are the most important given the intermediation role of banks as agents that accept deposits (borrow) from surplus areas and then lend to deficit areas of the economy. The difference between the interests charged on funds advanced to borrowing customers and the interests paid on deposits is the bank’s profit margin. This means that, as a lending banker, your interest rates on loans must be higher than the rates the bank pays on deposits; otherwise, your bank will incur losses.

It is also important for you to understand the various methods by which loans can be made available to borrowing customers. To succeed in this role, you need to have a good knowledge of your bank’s credit products and services, the borrower’s business and the industry in which it operates. We discuss below the various financing options available to a bank.

2.6.1 Overdraft

This is a short-term financing method that allows a borrowing customer to overdraw the credit balance in its account over and over again until the debit balance in the current account reaches the agreed limit. Hence, it is an open-ended credit that can be utilized repeatedly.

In practice, an Overdraft facility is made available when a borrowing customer is allowed to overdraw its current account balance in excess of the credit amount standing in the current account subject to an agreed limit. Thus, a borrowing customer can only overdraw its current account with the bank’s permission and up to the limit agreed between the bank and the customer.

An Overdraft is shown on the customer’s bank statement with the abbreviation DR after the balance on the account and this signifies that the customer owes the bank the stated amount and therefore, a debtor to the bank.

Below are some of the features of Overdrafts.

1. It is only through the Current Accounts that overdrafts are made available. Businesses and individuals pass their incomes and expenditures through their current accounts in respect of their transactions.
2. The usage is usually restricted to the financing of working capital needs during trading cycle such as the purchase of trading stocks, acquisition of raw materials and payment of short-term pressing obligations like staff salaries, wages and electricity. In other words, overdrafts help to smoothen out the fluctuations in cash flows arising from non-synchronization of payments and receipts. Thus, in practice, bills are paid using overdrafts before proceeds of sales are received into the Current Account. In some cases, overdrafts may also be extended to individuals with acceptable credit rating pending receipt of their salaries.
3. Overdrafts are cancellable. This means that, Overdrafts are repayable on demand. However, in practice, it is usually structured subject to an annual review.
4. It is a short-term financing option usually made available for a tenor of between 90 days and one year, depending on the operating cycle of the borrowing customer.
5. It is the most common, flexible and convenient way of borrowing to meet short term working capital needs as customers are allowed subject to the agreed limit, to overdraw, repay and thereafter overdraw again and again during the business trading or operating cycle and during the overdraft validity period (the time frame/tenor agreed with the borrowing customer).
6. It is a swinging account. This means that the current account through which overdrafts are enabled should oscillate between debit and credit balances during the validity of the facility. When overdrafts are used, the accounts swing into debits and upon receipt of proceeds of sales, the accounts swing back into credits. Thus, an active and performing current account with an approved overdraft limit should show wide fluctuations, resulting in credit balances most of the time.
7. It is the cheapest, as interest on an overdraft is only charged daily on the outstanding debit balances. When an inflow is received into the current account which pushes it to a credit balance, no interest will be charged on the account until when payments are made and the account is overdrawn and interest is again charged on the outstanding debit balance on a daily basis pending when it goes back to credit.

As a lending banker, you will generally expect an account with an overdraft facility to swing between debit and credit balances. When a borrowing customer pays for raw materials, the account swings into overdraft and when sales are made and proceeds of sales are received, the account swings back into credit. A situation where the debit balance remains and becomes permanent, is called a hardcore borrowing.

As a lending banker, you are required to do a regular review of the performance of your credit facilities. When you find an overdraft that is not swinging widely between debit and credit balances and the debit balance is becoming hardcore, it can put you on enquiry that things are not going well with the customer. Your enquiry might reveal that the customer is not realizing cash from debtors as quickly as needed; which may be due to bad trade credit and collection strategies. It could also be due to the fact that the customer is losing money.

As earlier emphasized, it can be a convenient means of borrowing for individuals who might require overdrafts to enable them meet their immediate needs pending whensalaries are received into their current accounts. It is usually packaged as an overdraft (salary advance) such that the account goes into debit when the overdraft is utilized and swings back to credit when the salary is paid into the account, all within the agreed limit and tenor of the facility.

However, it is not an appropriate way of providing business with long-term financing.

2.6.2 Term loan

This is available to finance expansion or a new line of business. It is usually secured with collateral, which act as “insurance” or back-up in case the business defaults in repayment as and when due. As expected, you are required to carry out a review of the business bank accounts, financial statements (including the Income Statements and Balance Sheet), business plan as well as Management credit histories, to enable you make informed lending decision

Unlike an overdraft that is usually required to finance working capital needs and for a short period repayable within a year, a term loan is a facility extended to a borrowing customer for a fixed amount at a fixed or variable rate of interest and for a fixed period of time (say, between 3 years and 10 years) for the acquisition of fixed assets such as machineries, equipment and premises, with a well defined fixed instalmental repayment plan. However, it is not unusual to have a term loan structured for up to 25 years in developed financial systems where long-term funding is available for long-term projects.

As a banker, you can scale down an overdraft request if the amount sought cannot be justified on the ground of safety and account performance without jeopardizing the purpose of the overdraft. However, for a term loan, this may not be possible, as reasonable care must be taken in assessing the customer’s request without which the project for which the loan is intended can be frustrated. For instance, a request for a term loan to acquire a complete set of machineries for expansion at the total cost of #50m cannot be scaled down to #30m, except the balance will be contributed by the customer. Scaling down the loan request by the bank when the customer does not have the ability to contribute the balance is a recipe for failure as the project will not only be frustrated but the term loan will become a bad debt as a consequence of lack of completion of the expansion project. Thus, a term loan can be described as a closed-end credit that is available for drawdown in a bullet form (once) or in tranches, depending on the agreed disbursement plan and until the loan limit is reached. Thus, the full repayment of the term loan signifies the closure of the loan account

As indicated above, a term loan can be for the acquisition of a fixed asset, the cost of which is spread over its useful life while repayment which is usually on instalments, can be structured to align with the cash flows of the business which can be monthly, quarterly, half yearly or annually.

The terms and conditions under which a term loan is granted are contained in the Loan Agreement and they include, among others, the following:

1. The loan amount and the purpose for which the loan is granted;
2. The agreed repayment terms;
3. Prescribed conditions and covenants which the borrowing customers must comply with, such as a timely rendition of financial statements, restriction on assets substitution and a limitation on the company’s ability to pay out cash dividends to the shareholders during the validity period of the term loan; and
4. The agreed security / collateral for the term loan.Once the customer complies with the conditions of the term loan as stated in the Loan Agreement, the bank cannot demand for the repayment of the loan outside the agreed terms and conditions.
5. In view of the above and coupled with the fixed and long term nature of term loans, it is customary for lending bankers to demand for securities/collaterals to support term loans given that, the longer the tenors,the riskier the loans as market and industry conditions change.

Interest Rates on Term Loans

Applicable interest rates may be fixed or floating (variable). In practice, it is common to have a floating rate tied to the bank’s base rate (the prime lending rate) and fluctuates at a spread (margin) subject to changes in the country’s macro-economic conditions. The prime lending rate is the rate offered to the bank’s highly rated customers (low risk). Alternatively, a 90-day Treasury Bill (TBs) rate can be used as reference rate given that investments in TBs are considered safest since they are backed by the power of the Federal Government of Nigeria.

Interest on a term loan is debited to the customer’s operating current account on the agreed period, which could be on a monthly or quarterly basis.

At the inception of a term loan, the interest amount payable is usually high and will reduce gradually as the customer pays down and the loan inches to a closure

Drawdown of Term loans

The Loan Agreement will also contain the terms of disbursement, which can be in a bullet form (once) or in tranches or in installments upon fulfillment of conditions precedent to draw down by the customer. For example, a loan to construct a road to be tolled can be structured to allow disbursement to be made in installments to coincide with the different stages involved in the construction work.

Repayment of Term Loans

Repayment, which is usually structured, to align with the business cash flows can commence immediately. However, we can also have a moratorium (a repayment holiday) for an agreed period that can range from three months to one year before the project can start generating income. It is also possible to have repayment structured asone payment (“bullet”) at the end of the project or through a series of large repayments skewed towards the end of the project known as balloon repayments.

The agreed repayment structure, including the repayment schedule must be included in the Loan Agreement.

Security/ Collateral

As a lending banker, it is important you take adequate and marketable collateral that can easily be realized or sold to pay down the loan should the borrowing customer fail to redeem the loan.

The security granted is included in the Loan Agreement as a back-up repayment source. A breach of the terms and conditions of the loan will make the facility to becomerepayable on demand, thereby giving the bank the opportunity to seek repayment and also look at the security pledged for the loan as a source of repayment. However, in practice, it is common to renegotiate the terms of the loan, taking cognizance of the changes in the borrower’s and market conditions. We will study in greater detailsacceptable securities for bank loans in a later section

Covenants

These are agreements reached and formalized in the Loan Agreement at the time of structuring the loan and therefore binding on the borrowing customer and the bank. They are monitoring tools to ensure that the risks in the term loan remain tolerable throughout the validity of the loan.

The Loan Agreement will contain the minimum irreducible obligations to be met by the borrower such as a timely rendition of accounting information, restrictions on assets substitution, limitations on payment of dividends to shareholders and achievement of a minimum monthly turnover threshold. We will consider covenants in greater details at a later section.

2.6.3 Bridging Loans

These are short-term loans made available to borrowing customers (individuals or

1. They are short-term loans with tenors of up to one year.
2. They normally attract high interest rates and large origination fees given the speed of approval and convenience for the borrower.
3. They are usually secured with some form of collateral depending on the underlining transactions. For instance, a house purchase transaction will be secured with a real estate, while an inventory can be used to secure a bridging loan for the payment of import duty on raw materials.
4. Unlike traditional loans, the entire credit process beginning from loan application to disbursement is faster and less cumbersome.

Bridging loans can be used by companies and individuals to raise funds on temporary basis. Therefore, it is your duty as a lending banker to customize customers’ requests to align appropriately.

With respect to business, it can be used to pay for expenses pending securement ofpermanent financing . For example, a bank can avail a bridging loan to a company to meet short-term obligations pending receipt of proceeds of equity financing that is expected in few months from the capital market..

For the individuals, it can be used to purchase a new home or property when there is non-synchronization of receipt and payment. That is, when there is a time lag between the payment for a new property and the receipt of proceeds of the sale of the old/existingproperty. Upon receipt of the proceeds of the old/existing property, the loan is immediately repaid. As a lending banker, you are concerned with the credit worthiness of the individuals and their income profile. Thus, bridging loans for home purchases are usually availed to individuals with excellent credit ratings and low debt-to-income ratios.

Bridging loans are also referred to as interim financing, gaps financing or swings financing because, essentially, they are to bridge the gaps between when funds are needed but not available on a temporary basis. This is why they are usually for a short tenor.

2.6.4 Equipment Leasing

This is a method of financing acquisition of fixed asset(s) (equipment, machineries, vehicles, etc.) in which the bank (Lessor) makes the item(s) available to borrowing customers (lessees) for agreed periods of time in return for rental payments under a contractual arrangement.

The legal ownership of the fixed asset(s) under lease remains with the bank and at the expiration of the lease period, the item(s) reverts to the bank

There are two parties to a Lease Arrangement. The Lessor, the owner of the fixed asset(s), in this case the bank that purchased it/them and the Lessee, the borrowing customer, the user of the fixed asset(s).

The important thing to note about leasing is that it allows the lessee (the borrowing customer) to effectively manage its cash flows while acquiring fixed assets for use without having to pay for them. This means that the funds available to the borrowing customer are not tied to a fixed assets acquisition but available for utilization in other areas of the business or for investment purposes.

A Direct Lease refers to a situation where the borrowing customer approaches the bank with a list of the assets it requires for its operations and the bank acquires them from the manufacturer or distributor (if the items are new) or from the existing owner (if the items are old) to be made available to the borrowing customer (lessee) in return for rental payments.

On the other hand, there are instances where the borrowing customer sells the assets it previously acquired to the bank and then leases them back. This arrangement is common with properties such as the sale of a warehouse to an investor who decides to lease it back to the initial owner. This arrangement can be used by a borrowing customer to raise funds if it has liquidity problem or confronted with the need to free the cash tied to previously purchased assets. This is called Sale and Lease Back.

In practice, a lease can be structured as an Operating Lease or a Finance Lease

Operating Lease.

An Operating Lease is a lease contract for a short period of time, usually lower than the asset’s expected life. Under this structure, repairs, maintenance and insurance are the responsibility of the Lessor (bank) while the Lessee pays rent for the use of the assets. Though, practically, any item of equipment can be structured as an Operating Lease, it is however, more common with small items like photocopier, construction equipment,etc. Interestingly, aircrafts are structured as Operating Leases because the expected lives are long, say 25 years.

An Operating Lease is cancellable by either of the parties to the lease contract and the Lessor (bank) is not expected to recover the full cost of the asset plus interest during the initial lease period.

Finance Lease

This is a lease contract where the Lessor (bank) is expected to recover the full cost of the asset plus the related interest charge during the agreed lease period. A Finance Lease is non-cancelable, especially on the part of the Lessee. This is in most cases because the equipment or assets involved are mostly specialized and therefore can be difficult to transfer to another party.

Unlike in the Operating Lease, the Lessee bears responsibility for maintenance, repairs and insurance as well as the risk of obsolescence and under-utilization during the period of the lease despite the fact that the legal ownership resides with the Lessor.

In addition, Finance Lease is less flexible compared with an Operating Lease where the Lessee can request for a cancellation of the lease contract coupled with the fact that the Lessee does not have to bear responsibility for maintenance, repairs and insurance costs.

In terms of the rental or pricing, Finance Lease is usually cheaper than an Operating Lease because of its Lesser flexibility compared to an operating lease. The flexibility involved in operating lease makes the lease rental or principal higher than finance lease.

A major advantage of operating lease to the lessee is that the risk of obsolescence can be transferred to the lessor since the lease contract can be cancelled at the instance of the lessee. In addition, a lessee can return assets under an operating lease and simultaneously request for replacement of the assets.

However, under both arrangements, the assets must revert to the lessor at the expiration of the lease period. In practice, a lease contract usually contains end of lease optionssuch as the opportunity to renew the lease contract at a minimal cost or disposal to a third party.

In terms of accounting treatment, assets under a finance lease are capitalized in the Balance Sheet as fixed assets while the rental obligation is reflected as a liability. As the assets are put into use over the years, they are depreciated gradually and the payments for rents serve to reduce the lease obligations. Both the annual depreciation figure and the lease rental are passed to the profit and loss account as expenses. A lessor can claim substantial capital allowance under a finance lease, which can be used to reduce its tax liability and by extension enhance its profitability. The benefit of the reduced tax liability can also be passed to the lessee in the form of reduced rental payments.

Given that leasing is a highly specialized and complex credit product, it is advisable, as a lending banker that you guide your customer appropriately on whether to buy or lease the assets under consideration. This is what is referred to as a Buy or Lease decision in Corporate Finance.

As a lending banker, it is advisable when dealing with a company enjoying lease facility,to seek and obtain information regarding its contractual commitment(s) and future obligations, to enable you make informed lending decision(s).

2.6.5 Factoring

This is a form of credit in which a firm sells its account receivables (debt owed it) to a third party called the Factor to raise funds for an immediate use. There are three parties involved in factoring.

1. The Seller of the debts in its book
2. The Buyer of the debts called the Factor
3. The Debtors whose debts are being offered for sale

The Seller can be any business organization such as a manufacturer or a service provider with pending sales invoices (debtors) that can be sold immediately for cash. The Factor is the financier and usually a subsidiary of major Clearing Banks in developed financial systems like the United Kingdom and USA.

In Nigeria, factoring is undertaken by banks and finance companies. This is mostly in respect of invoices of major oil producing companies in the upstream sector of the oil and gas industry, issued in favour of oil service companies and contractors. Sales Invoices issued to suppliers and contractors in respect of supplies made to multinational manufacturing companies are also frequently sold at discounts to banks and finance companies.

The debtors are the firms or businesses who owe the seller on the invoices that are pending for payment. In Nigeria, only sales invoices of reputable businesses are acceptable for sale at a discount.The most important advantage of factoring is that cash tied up in sales invoices can be immediately unlocked, as cash is promptly made available to the bank’s client (the invoice seller).

This will be structured such that the proceeds of the invoices are domiciled with the bank or the finance company that bought the invoices and payment is received when the debtor pays its debt on due date. Domiciliation of payment is key both as a collateral as well as to prevent diversion of proceeds of the invoices by the bank’s client (invoice seller).

In practice, Factors perform three different but complimentary roles.

The Factor will assess the debts to determine the value and advance substantial funds,up to 80% of the debts’ value to the business. Upon the payment of the debts, the difference of 20% less the factoring cost (charges) is deducted and the balance remitted to the bank’s client. Through this process or structure, cash is promptly made available to enable the client finance its working capital assets (such as raw materials, salaries and wages, etc.).

One other advantage of factoring is that it gives the borrowing customer the ability to negotiate suppliers discounts with a view to improving the overall profit margin of the business.

As a lending banker or factor you do not just buy or accept any debt for factoring because you want to be sure you will be able to collect the debt on the due date. It is therefore, your responsibility to understand the client’s business environment, the industry it is operating and it’s competitiveness. In addition, you have to be satisfied that Management is capable. You are also expected to carry out a due diligence of the client’s books regarding its debt collection system and the quality of the debt as per previous payments. This entails carrying out an aging analysis of the debts in order to be sure of the quality.

Factoring arrangement can be confidential or non-confidential. In confidential factoring, the client follows up with its customers to collect payment on outstanding invoices and remit the proceeds to the factor. On the other hand, in a non- confidential factoring, the factor puts together the invoices, dispatches them directly to its client’s customers and aggressively pursues payment. This might entail keeping of records, checking for credit worthiness of the client’s customers as well as ensuring the timely collection of debts. This service is referred to as Sales Administration Ledger and it can be quite expensive as additional fees aside from the factoring fee are charged for this service.

In majority of cases, factoring business is done on a non- recourse basis in which the factors bear repayment risks arising from its client’s customers. As a consequence, the factor is expected to be involved and will in fact superintend over the entire process of granting trade credit by it’s clients, beginning with the development of trade credit strategy, assessment and collection of debts. In this way, the factor acts as the ‘insurance’for bad debts since it bears the repayment risk.

2.6.6 Invoice Discounting

This is a source of finance for small businesses that ordinarily may find it difficult to access other forms of traditional loans. It allows a business to borrow money against its outstanding invoices, and thus able to raise funds as soon as new invoices are generated.Essentially, this involves committing selected invoices by a firm to a finance house or a bank for discounting, on the guarantee that, the invoices will be paid as and when due. In practice, the finance house discounts the invoice by 10% (or more) and makes 90% of the total invoice value available to the borrower whose responsibility it is to collect payment and remit to the finance house accordingly.

Invoice discounting arrangement is done on a recourse basis. This means that the borrower and not the finance house, bears the repayment risk. The borrower pays discounting fee for this service. As a lending banker, you have to understand that the borrower’s business must be solid, well managed and profitable. In addition, the invoices pledged for discounting must be from reputable organizations with good payment records over the years.

Both factoring and invoice discounting arrangements are of short-term duration, with maturities of between three to six months.

2.6.7 Hire Purchase

This is an agreement to purchase an asset through installmental payments over a period of time, usually less than the asset’s useful life. Once the final installment is paid, the legal ownership of the asset passes to the hiring company. Thus, a hire purchase contract is consummated with the intention to own the asset. In general, assets that can be financed under a hire purchase plan include motor vehicles, plants and machineries for business, and household items for individuals.

In practice, a business requiring the use of certain assets (e.g. equipment) but without the required capital outlay to buy the assets outright, will approach a finance company to structure a Hire Purchase Agreement to enable the business buy the asset. To this end, the finance company will then buy the asset in its own name and thereafter hires it out to the hiring company or hirer for use, after an initial down payment (an initial deposit) to be followed by series of regular payments called installments. During the hire purchase validity period, the legal ownership of the asset resides with the finance company that can repossess the asset in case of breach of the Hire Purchase Agreement.

Once the final installment is paid, the finance company transfers legal ownership of theasset to the business, which then becomes the new owner of the asset either automatically or based on payment of an agreed fee, usually very small amount.

The main features of Hire Purchase are as follows:

1. There are two parties: The finance company called the hiree and the business or the hiring company called the hirer.
2. Hire purchase is for a short period of time and usually less than the asset’suseful life. On the average, we can have a period ranging from 6 months to 24 months.
3. It is a non-cancellable contract. As long as the hirer keeps to the terms of the Hire Purchase Agreement, the contract cannot be terminated by the finance company. However, should the hirer terminate the contract, its initial deposit (down payment) would be forfeited/lost.
4. A hire purchase agreement involves the payment of an initial deposit usually 10% of the asset cost to the finance company by the hirer..
5. Repayment is made up of the initial deposit and thereafter the balance of the asset value plus interest are spread over an agreed period as series of regular payments known as installments.
6. In a hire purchase agreement, ownership of the assets is not transferred to the hirer until all the installments have been paid.

Advantages

1. It can benefit businesses with poor cash flows by spreading the cost of assets that they would ordinarily not be able to afford at a go over a period of time.
2. Capital outlay is small; usually 10% of the asset value.
3. It is non-cancellable. As long as the hirer keeps to the terms of the hire purchase agreement, the contract cannot be terminated. Hence, there is certainty.
4. A hire purchase is easy to arrange with little or no complexity.
5. It is a good source of finance when bank loans are not immediately available.
6. Pricing is on a fixed rate basis; hence, transaction cost is known throughout the contract period.
7. Interest component of the installments are tax deductible, hence it can be tax efficient because interest are treated as expenses to be debited to the business profit and loss account. Specifically, on the part of the finance company, it offers more protection and security than leases for unsecured items because the asset can easily be repossessed should the hirer fail to keep up with the agreed installment payments.

Disadvantages

1. A hire purchase financing is usually more expensive than an outright cash purchase in the long-run because of interest and other related charges.
2. It can tempt/lead a business to engage in overtrading through acquisition of assets that are well beyond its financial capability.
3. For small businesses, a hire purchase plan can mean additional administrative complexity.
4. Though, a hirer can terminate the agreement by returning the asset as long as its up to date in its installment payment, however, it can suffer a huge loss because the initial deposit and the installments for the purchase up till the time of termination, cannot be recouped.

One distinguishing feature of a hire purchase plan is that the purchaser (the hirer) would obtain ownership of the asset at the beginning subject to its ability to keep pace with the installments.

The security for a hire purchase plan is the assets themselves and written promise to pay the installments, which can be by way of a standing payment order (SPO) structured to align with the agreed regular installment payments and the cash flow of the business.

As a lending banker, it should be obvious to you that there are risks associated with hire purchase arrangement. Therefore, you are expected to apply the basic lending criteria to assess the hirer’s creditworthiness and its ability to pay the installments as and when due.

2.6.8 Project Finance

This entails the financing of large scale, long-term capital projects using debt or equity or both in appropriate combination under a non-recourse or limited recourse financial structure. Large-scale capital projects include infrastructure projects (road, rail, port development, etc.), industrial projects (new refinery plant, brewery plant etc.) and government services (hospital development). In essence, project finance opportunities exist in both the private sector and the public sector.

In Project Finance, the repayment of the debt must be from the cash flows generated by the project. This means that, in structuring a project finance deal, the lending banker’s principal concern is the cash flow projections which will determine the ability of the project to repay the debt as well as meet obligations to other stakeholders including the equity holders.

Given that Project Finance loan structure is tied to the project’s cash flow for repayment, the project assets, rights and interests are held as secondary collateral.

Project Finance has been an attractive source of finance, especially to the private sector because it gives businesses opportunities to fund major projects off balance sheet. A traditional loan structure is a recourse loan, which gives the lenders full claim to the assets and cash flow of the shareholders (i.e the debtor or defaulting company).

Whereas, a project finance loan is non-recourse and the debtor (the company and the promoters) in a non-recourse loan cannot be pursued for additional loan recovery or payment beyond the assets of the project already pledged and seized by the lender. Project finance treats the project company as a Special Purpose Vehicle (SPV) with limited liability. Therefore, the lender’s recourse is strictly limited to the project assets and guarantees such as performance bond and completion guarantee.issued in support of the project.

So in practice, the project debt is not consolidated on the Balance Sheet of the project sponsors or shareholders but held in a minority subsidiary because it is an off Balance Sheet item.

There are many risks associated with Project Finance. As a lending banker, you are required to identify the risks and comprehensively mitigate them in your analysis. As usual, you are expected to apply the basic bank lending criteria to assess the of the project’s ability to repay the loan as and when due.

2.6.9 Asset Based Finance

This is a type of finance where the borrowing is secured against specific assets of the company. Here, the lending banker focuses on the quality of the collateral rather than the company’s credit rating and long-term prospects. Assets that a business can pledge as collaterals are diverse and they include office premises, plants and machineries, stocks and receivable (debtors).

Asset based finance has become an important option and a major source of finance for businesses, especially small and medium sized businesses (SME) that do not meet the credit rating and track record thresholds set by lenders for assessing other traditional types of loans. It is regarded as the finance option of the last resort, if other types of business loans cannot be assessed due to low or poor credit rating and antecedents.

2.6.10Mezzanine Financing

This is a type of finance that can be structured as partly loan and partly equity. Mezzanine finance stands in the middle of the capital structure of a company in that it is subordinated (Junior debt) to secured debt but senior only to common/ordinary shares.

This allows a business to borrow without providing additional collateral but with the debt being secured on the company’s equity, thereby giving opportunity to the mezzanine financier or the lender to claim part ownership of the business should the company default in the repayment of the loan and interest in full.

A major disadvantage of mezzanine finance is that it can lead to a share dilution and loss of control on the part of the principal shareholders of the business, if there is default in repayment.

CHAPTER THREE

Overview of Retail, Commercial and Corporate Banking

3.2 Fundamentals of Retail Banking

This refers to a subset of banking that is focused on the provision of financial services to individuals or the general public as opposed to businesses. Thus, a retail banking division of a bank provides a platform to the public or individuals to make deposits for safekeeping, invest idle funds to earn interest as well as access credit facilities to finance personal transactions.

In practice, services available to the individuals include current account (checking account) for transactional purposes, savings for precautionary purposes and fixed deposit for investment purposes as well as credit products such as personal loans, mortgages,debit and credit cards.

Most retail lending products are processed based on the credit scores of applicants to determine whether or not, the facility will be granted by the lender. Credit scoring is a tool used to determine an applicant’s eligibility or otherwise. Credit scoring will be examined in greater details under Credit Risk Practices for retail banking.

Most financial institutions offering retail products are structured as one stop centre where individuals can do all their banking transactions. Retail banking is also known as personal banking or consumer banking, depending on the nomenclature adopted by a bank.

Retail banks include the community banks (local banks), microfinance banks, regional banks as well as retail banking directorate/division of large national commercial banks with footprints across the country. Through these local branches, retail banking staff or their representatives provide customer services and financial advice as well as underwrite credit applications in respect of approved credit products.

Applicability of the Retailing Concept

The first-tier banks in Nigeria (First bank, GTBank, Zenith bank, UBA and Access bank) have extensive network of branches offering retail banking products.

Retail banking institutions have benefited tremendously from information technology as a business enabler as most transactions are now driven by technology. There is also a growing trend where technology companies now compete with banks for retail business.

This is evident with the advent of FINTECH companies that now offer retail bankingservices through the internet and mobile applications.

It is important to emphasize that the definition of retail banking is not cast in stone; it depends on the strategic focus of an institution and its approach to business. For instance, there are a number of banks in Nigeria and elsewhere that find it convenient to lump individuals and small businesses, especially sole proprietors and professional services firms (law firms, accounting firms, estate valuers and surveyors, etc.) under retail banking. Essentially, the key prospect remains the individuals or the general public rather than large businesses.

3.3 Public and Private Sector Banking

Public Sector Banking

The focus is on maintaining banking relationships with the governments at all levels. This entails the provision of banking services to Federal Government, State Governments, Local Governments and their Ministries, Parastatals and Agencies. Theservices include checking/current account, fixed deposit account, cash management service, revenue collection, project finance, financial advisory and guarantees.

For revenue collection, banks seek governments’ mandates to be enlisted to collect custom duty, taxes and fees while guarantee services include the provision of Bid Bonds, Performance Bonds and Advance Payment Bonds to government contractors.

The provision of advice and counterpart funds to governments in respect of multilateral institutions’ assisted projects are also common, especially at the Federal and State levels.

Private Sector Banking

This focuses on the provision of banking services to private sector businesses rather than governments’ Ministries, Parastatals and Agencies.

Private sector businesses include sole proprietorships, partnerships, limited liability companies and non-governmental organizations that employ the vast majority of Nigerians.

Banking services available to these entities include checking account, fixed deposit, cash management, loans, trade finance and financial advisory.

Private Banking

There is also private banking, which focuses on the provision of banking services to high networth individuals (HNIs). It is directed at an exclusive group of people that are considered wealthy with complex financial and banking needs. Thus, the services are personalized to fit into the individual’s circumstances.

The services include a wide range of wealth management services such as funds management, tax planning, life assurance, estate planning and trust services. Top private banking institutions in the world include BNP Paribas, Goldman Sachs, Wells Fargo, Merrill Lynch and Morgan Stanley.

Also, major banks offer these services through specially designated departments/divisions called “Private Banking” or “Wealth Management”.

3.4Corporate Banking

This is a division/department of a bank that focuses on the banking needs of corporate clients. Essentially, corporate banking deals directly with businesses by providing them with portfolio of products and services such as checking accounts, deposit accounts, loans, cash management services (treasury services) and trade finance that are specially designed to address the banking needs of companies rather than the needs of the general public or individuals which is the focus of retail banking.

In general, corporate banking provides services to a diverse range of businesses ranging from medium-sized companies with millions in revenue to large corporates and conglomerates with billions in revenue and profitability. This is why corporate banking is also referred to as business banking.

However, in Nigeria, corporate banking activities and services are handled directly at the banks’ headquarters and restricted to large corporates, conglomerates and multinational companies across the key sectors of the economy. Examples of corporate banking clients include the Nigerian Breweries Plc, Guinness Nigeria Plc, MTN Plc, Unilever Plc, Cadbury Plc, Dangote Group and Mobil Oil.

There are also instances where corporate bank clients are defined in terms of turnover thresholds such that same business may be classified differently by two different banks.

The lending activities of corporate banking could be a simple secured or unsecured loans or it could be highly sophisticated structured financial transactions involving many different banks or syndicates.

Generally, corporate banking credit products include:

1. Working capital finance
2. Post-shipment finance
3. Pre-shipment finance
4. Overdraft
5. Distributor finance
6. Term loans

Some of these credit products are variants of the financing options already discussed which speak directly to the purpose of the facility rather than the facility type.

Success in corporate banking requires extensive product knowledge, industry expertise and good relationship management skills

3.5Commercial Banking

There are two ways to look at commercial banking. First, it is any banking institution that is engaged in commerce. Second, it is an institution that provides banking services to businesses, governments and other institutions. While the first description of commercial banking is considered broad and less commonly used, the second description is specific in terms of the target markets and therefore a more generally accepted description of commercial banking.

From the second description, it is clear that commercial banking is the opposite of retail banking which focuses on individual banking needs. So in a more general sense, while retail banking services are for personal use, commercial banking services are targeted at businesses, institutions and governments.

In Nigeria, the focus of a commercial banking department in a large bank is on the midtier businesses, local corporates and emerging SMEs while corporate banking department deals with large corporates, conglomerates and multinational companies.

Both retail and commercial banking institutions are depository institutions. They accept deposits and issue loans to their customers. The only difference is that they serve different segments of the market, and hence, retail and commercial banking can be described as two sides of the same business.

In summary, we state as follows:

7. Retail banking focuses their services on the general public or individuals.

8.Corporate banking services are targeted at businesses, especially large companies.

9.Commercial banking handles the banking needs of mid-tier businesses, governments and institutions.

In practice, the activities of retail, commercial and corporate banking are warehoused as separate divisions or directorate in a single banking institution. The retail, corporate or commercial banking activities of major banking institutions flow essentially from their business strategies regarding their business priorities and how they want to be perceived in the market place. Sometimes, it is about the business focus and expertise developed over the years.

In Nigeria, all Deposit Money Banks (DMBs) provide retail, commercial and corporate banking services given their spread and balance sheet size. Exceptions are merchant banks, which deal with corporate clients, institutions and high networth individuals (HNIs) with a minimum account opening deposit of N100M. Merchant banks are referred to as Wholesale Banking Institutions with presence only in key commercial centres since they are not expected to mobilize retail deposits and issue personal loans.

3.6 Overview of Commercial Lending Environment and Impact of Digitization in Channel Delivery

Commercial lending refers basically to loans made by a bank or financial institution to companies to finance their operations orgrowth . The loans can come in different forms to serve the specific needs of business such as loans to acquire equipment, purchase properties, a line of credit to meet working capital requirements and much more. This entails the execution of lending agreement between the bank and the borrowing company.

The commercial lending environment in Nigeria has been less than stable over the past two decades. Factors responsible for the relative instability include political, economic, social, technology, legal and environmental issues. Some of the challenges in the lending environment include:

1. Changes in the political leadership and administration have had a profound impact on the lending environment as new policies impact on businesses and thus change the focus of banks towards lending.
2. There have also been changes in key variables such as tax rate and industrial incentives coupled with the recently implemented Treasury Single Account that affected the liquidity of or in the banking industry and by extension its ability to lend.
3. The macro-economic environments are largely unstable. Government policies on interest rate, exchange rate and trades coupled with the high rate of inflation create excessive risks in the market place and therefore act as disincentives to lending.
4. There are also legal issues relating to BOFIA 2004, CBN Act 2007 and various policy guidelines on credits emanating from CBN, which tend to affect the lending activities of banks.
5. However, the advent of technology has had a positive impact on banking in Nigeria. The internet has provided banks with the opportunity to extend their customer reach beyond the bricks and mortar offices as new accounts are opened and payment transactions done online-real-tine. In addition, technology has enhanced financial inclusion especially for the vulnerable members of the society. Massive deployment of ATMs and POS has reduced the crowds in the banking halls.
6. Furthermore, technology has become a business enabler for the lending banks and their borrowing customers in designing online lending products, loan appraisal and monitoring by banks.
7. The advent of FINETECH companies is also enhancing competition in retail banking, as payments and lendings are done through the internet in a seamless manner.

More important is that digitization is enabling the automation of loan application process, from prospecting and sales to analysis, review and approval, in an increasingly competitive market, thereby enhancing the experience of both borrowers and lenders with a faster approval cycle.

In spite of these positive developments, we note that digitization has increased the vulnerability of the banking public to electronic frauds, with losses projected to hit 6.1 trillion Naira by 2021 in Nigeria.

Also, loan default rate on online-lending products is increasing, thereby putting lenders under pressure to find alternative ways to monitor loan performance.

3.7Commercial Customers: Legal entities operating in different sectors.

Aside from individuals who are regarded as personal customers of banks, there are different categories of business customers that banks deal with in their deposit taking and lending functions. These business customers include those who undertake business alone as individuals and sole owners known as sole proprietors or in conjunction with one or more people in partnership or as a business duly incorporated in the form of a limited liability company.

A good knowledge of these entities, that operate in different sectors of the economy will assist the banker on how to carry out credit appraisals relating to each of these entities with a view to making informed lending decisions. These entities are briefly described below

The Sole Proprietor or Sole Owner

This is also known as the sole trader inspite of the fact that there are quite a number of businesses under this category that are non-trading. It is the simplest form of business organization where one person is solely responsible for the control of its affairs. The soletrader carries on business in his or her name, enjoys the profits that flow from the business as well as held liable for the debts of the business. In case of business failure, the sole trader’s liability is unlimited as his or her personal assets can be attached or sold to defray the business debts.

A Sole Trader must make it clear to customers, creditors and bankers that he or she is a sole trader by using his or her name as the business name or by describing the business as Hassan Muhammed trading as HM Enterprises.

The sole trader may rely on his or her personal savings or borrow from family members, friends and banks as well as delegate authority to staffs, managers and family members. However, he or she cannot avoid responsibility for the actions of others.

It is interesting to note that for the sole trader’s private accounting and income tax, he or she will separate his or her personal finances from that of the business but this separation is not recognized by law when there are issues bothering on losses and liabilities of the enterprise. Thus, the sole trader is held liable to the extent of his or her capacity to pay, including the value of his or her private assets such as houses, furniture and fittings. This type of business organization is considered only suitable for small trading and service ventures such as small shops, jobbing builders, plumbers, mechanics, grocery stores, watch repairs and domestic services.

It is important for lending bankers to know that there is more emphasis on non- financial credit analysis for a sole trader as represented by character of the sole trader and the conditions in which the business is operating.

Character is defined as willingness to pay as shown by the sole trader’s credit history, social/business reputation, life styles and historical stability while condition is about the state of the economy, industry, the market as well as the business specific issues relating to its strengths, weaknesses, opportunities and threats.

The emphasis on non-financial is because most sole trading businesses are not well structured coupled with poor corporate governance practices, hence little reliance can be placed on their financial statements especially in a developing economy like Nigeria.

Partnership

A partnership involves two or more people joining together to do business with the goal of making profits.

It is common for the partners to share responsibility for the provision of capital as well as for the control and management of the business venture in the way and manner they desire. Given that partnerships are a little more complex than sole proprietorships coupled with the possibility of conflicts among partners for which outside stakeholders (creditors, bankers etc.) may suffer, partners are required to put in place a clear and binding agreement known as Partnership Agreement/Deed. The Agreement which preferably should be in writing, should spell out the rights and responsibilities of the partners with regard to capital, management, control, profits, losses, ownership and what happens when a partner leaves or dies.

However, in case there is no clear agreement, the Partnership Act 1890 will be relied upon for the settlement of conflicts among the partners. This is a United Kingdom Act which has been adopted in Nigeria.

As with the sole trader, the law makes no distinction between the assets and responsibilities/liabilities of the partnership and those of the partners. As such, the partners are fully and individually (joint and severally) liable for the debts or liabilities of the partnership.

Limited Partnership

Interestingly, it is possible to have a limited partnership in which an individual can become a partner in a business venture but with his or her total liability in respect of partnership debts limited to an agreed amount. Under this scenario, the limited partner must not share in the management of the partnership venture while there must be at least one general partner who must accept unlimited liability and also have responsibility for management of the venture.

The position of a limited partner can be precarious in a situation where the partnership venture is failing since his or her direct involvement in management will mean the loss of the protection offered by limited status. On the other hand, he or she can choose to remain aloof and watch the business collapse, thereby resulting in the loss of his or her capital investment as well as up to the amount agreed in respect of the partnership debts.

As a lending banker you are required to demonstrate an understanding of the Partnership Act 1890 and the partnership agreement detailing the rights and responsibilities of the partners in your assessment of credits for a partnership venture with a view to arriving at a good lending decision.

Limited Liability Company

A limited liability company is a corporate entity incorporated under the Nigerian Companies And Allied Matters Act (CAMA) 2020 with rights and responsibilities similar to these of individuals under the law. The company can own assets, incur liabilities as well as sue and be sued in the courts of laws.

One striking advantage of a limited liability company is that the members of the company or shareholders have limited liabilities compared to a partnership where the partners are individually fully liable for the debts of the partnership venture.

This obviously explains why limited companies are more popular than partnerships since most people going into business seem not comfortable with having unlimited liability with respect to the business’s debts.

The directors of a limited liability company elected by members provide the overall strategic direction for the management of the company.

A limited liability company can be a public company or a private company. Public companies are usually bigger, with large members or shareholders with their shares traded on the Stock Exchanges. On the other hand, private companies are not allowed to offer their shares to the public as well as have them traded on the Stock Exchanges.

In addition, we can have some companies limited by guarantees in which some shareholders or members guarantee the payment of some agreed amounts if called upon to do so in case of the company becoming insolvent. Most social clubs are organized as companies limited by guarantee.

Generally, majority of limited liability companies have their capital divided into shares and the liability of members is limited to the amount of shares they have agreed to purchase

The objects of the company, the number of shares, the shareholders and the shares held by them are contained in a legal document known as Memorandum of Association while the rules governing the running of the company including the powers of the directors are contained in the Articles of Association. These two legal documents combined together are called Memorandum and Article of Association (MEMART).

A lending banker is required to obtain and review the MEMART of a borrowing company as a part of the credit appraisal process to be sure that the company’s objectsor business tally with the purpose of the loan and that the company is authorized to borrow money as a legal entity.

You will also need to confirm the directors and their respective shareholdings, including duties and obligations.

It is indeed, a poor credit judgment to grant a loan to a company not permitted to borrow money by its Articles of Association even if the loan is eventually repaid.

3.8Commercial Lending Customer Life Cycle

As we have emphasized severally, the primary function of banks is acceptance of deposits from their customers and the use of these deposits to issue loans to the borrowing customers. An asset is created in the bank’s book when a loan is approved and disbursed to a borrowing customer. The interest and fees earned from the lending activities of a bank contribute to its profitability.

In commercial lending, banks or financial institutions sanction (approve) business loans in favour of their borrowing customers to enable them finance their operations or growth through a rigorous credit process involving different stages beginning from the application stage to the stage when loan is fully repaid by the customer. This is called the loan life cycle.

Below are the stages commercial lending customers pass through during the credit process.

3.8.1 Prospecting and Origination Stage

This stage involves seeking for a prospective customer who might be interested in any of the bank’s loan products and getting the prospect to complete the loan applicationform as well as gathering the required data. The application will contain information about the company, the type of loan required and the loan purpose. It is at this stage that the customer is also interviewed to seek for additional information regarding the company’s business operations, quality of management and future prospect.

3.8.2 Underwriting

This is the stage where the customer’s loan application is appraised by the credit or loan department and a decision is taken whether or not to avail the facility to the customer on the basis of the eligibility criteria put in place by the bank. Here, the credit terms and conditions are developed and circulated recommended for management consideration and approval.

3.8.3 Credit Approval

The decision to approve or sanction the customer’s loan request will be based on set parameters or criteria contained in the bank’s Credit Policy Manual and related Guidelines emanating from the Regulatory Authorities. These criteria will include the company’s standing/profile, character, management ability, track record of performance and collateral proposed for the loan. Once the loan is sanctioned, the bank will stipulateand convey the terms and conditions under which the company will be allowed to enjoy the loan.

3.8.4 Due Diligence and Documentation

This is the stage where the customer is expected to fulfill all the terms and conditions stipulated for the utilization of the loan. Essentially, it will involve creating the legal documents, verifying the terms of the loan and ensuring the company executes all the necessary agreements, including the perfection of collateral offered by the customer/company prior to loan disbursement.

3.8.5 Loan Closing and Funding

Once due diligence has been observed and the necessary documentations are put in place by the bank, the loan is thereafter disbursed to the company to be used for the purpose for which it was sought and approved. Interest on the loan must be serviced regularly aside from paying down on the principal in line with the agreed repayment schedule. However, when the loan is not repaid or there are delays, the status of the credit will be changed to reflect its deterioration. Under this scenario, the bank may charge a penal interest rate for late repayment as well as make provisions, from its profit, for the substandard loan.

If however the loan is effectively administered and serviced, a loan closure will be achieved on the date the last installment is due and paid, after which the bank will return the collateral taken for the loan. It is at this point that the customer’s loan cycle is complete.

Loan Cycle – Another Model

Prospecting and Origination —> Underwriting Credit —> Credit Approval —> Due Diligence and Documentation —> Loan Closing and Funding

3.9Challenger Banks: Impact on Commercial Banking Environment

The concept of challenger banks came into being recently in the United Kingdom following the change in the regulatory landscape that allows for the approval and licensing of retail banks that are now competing directly with the old, well established historic British banks. These small retail banks offer products and services to the banking public, especially the underserved segments, neglected by the big four British banks (Barclays, NatWest Group, HSBC and Lloyds Banking Group) using modern financial technology to drive their operations.

Most of these small retail banks offer online-only operations that enable them to avoid cost and complexities associated with the traditional banking practices. In addition, they specialize in different areas of banking services, thereby enabling them to focus properly to fill the gaps left by the big banks.

Prior to the change in the regulatory environment, there was little or no competition as the big four dominated the market. The situation has however changed with the entry of these small retail banks that are able to offer similar products and services at lower cost compared to that of the big banks by leveraging technologies and avoiding cost associated with bricks and mortar.

Now, competition is becoming intense as these small retail banks now offer online loan application, appraisal and monitoring, thereby ensuring a faster approval process compared with what is obtainable in the older banks.

Though most of the competition is in the retail segment and small business finance, there is a growing trend towards digitization of commercial lending process with a view to enhancing customers’ experience and profitability. However, the old big banks are not relenting in view of the escalating competition occasioned by the advent of these new banks.

In Nigeria, we are beginning to see the dominance of the tier 1 banks (First Bank, Zenith, UBA, GTB and Access) being challenged by the new small regional banks being licensed by the Central Bank of Nigeria. These new banks are technologically driven, swift in their decision making process and highly focused as niche players.

3.10 External Trends and Influences: Commercial Lending Digital Automation

In developed financial markets, technology has become a key success factor as competition intensifies and strategies change. Any bank that intends to succeed, remain competitive and profitable in the medium to long-term, must adopt modern financial technology practices to drive its operations. There is therefore, a growing trend towards adoption of sustainable technology in all areas of banking services as front office processes are integrated with the back-end operations in a seamless manner.

It is not surprising to note that technology is now being deployed to automate commercial lending functions in major and emerging financial institutions. There are softwares that have been developed to automate the entire loan cycle from prospecting and origination to loan closure. This makes for a better risk management process as loans are promptly appraised, sanctioned, disbursed and effectively monitored, thereby enhancing the experiences of the banks and the borrowing customers.

CHAPTER 4

EFFECTIVE LOAN PRICING

4.3Understanding bank’s Lending Business

Banks are the major financial institutions, which intermediate between actual lenders (i.e., depositors) and actual borrowers.

For the inter-mediation, banks are to pay interest to the fund providers as ultimate lenders and charge interest on actual borrowers. A bank acquires funds through customers or interbank deposits as well as borrowings from multilateral organisations or development finance institutions (DFIs). These include:

1. AFDB (African Development Bank)
2. ADB (Asian Development Bank)
3. EBRD (European Bank for Reconstruction and Development)
4. EIB (European Investment Bank)
5. IDB (Inter-American Development Bank)
6. IFC (International Finance Corporation)
7. ISDB (Islamic Development Bank)

Finding the weighted average cost of all these acquired funds results to a bank’s average cost of funds. The average cost of funds guides bank’s loan pricing mechanism.

The funds are allocated to a mix of earning assets such as loans and non-earning assets such as banks premises, motor vehicles, furniture and fittings.

The difference in the prices that customers are charged by a bank for the use of an earning asset represents the sum of the costs of the bank’s funds, the administrative costs e.g., salaries, compensation for non-earning assets and other costs is the net revenue from the use of funds.

Banks must price loans in a manner to cover costs, provide the capitalization needed to ensure financial viability, protect the bank against losses, provide for borrower’s needs, and allow for growth.

Some loan-pricing models assign a predetermined premium based on the risk rating of the borrower, while others can be more complex.

The primary risk of making a loan is repayment risk, which is the measurable possibility that a borrower will not repay the obligation as and when agreed.

A good lending decision is one that minimizes repayment risk. The price a borrower must pay to the bank for assessing and accepting this risk is called the risk premium

4.4Philosophy of Efficient Loan Pricing

Theoretically, we can say that pricing is a function of the volume of demand for and supply of bank credit. In a period of boom, it is expected that the demand for bank credit will increase as businesses boom and business owners are in need of additional working capital.

When there is galloping inflation, loan is priced high, as the Central Bank of Nigeria increases Monetary Policy Rate (MPR). MPR is Nigeria’s base rate, that determines other rates within the economy.

Banker-Customer relationship is built on custom and is personal. Loans are negotiated, sold and bought bearing in mind length of banker-customer relationship, prevailing economic conditions in the economy as well as the negotiation skills of both lender and borrower. In agreeing on a price, banks consider a number of factors (present and future) concerning the relationship.

There are instances when a bank lowers the interest rates chargeable on a loan in consideration for bigger volumes of business that will arise in the immediate future. Banks, therefore, consider the totality of economic benefits or revenue for each transaction.

The possibility that a bank can secure ‘float funds’ on a customer’s current account may be a consideration for charging lower interest rate in one transaction. Ancillary financial service such as issuance of Advance Payment Guarantee, provides large sums of money that may be frozen for some time and available to be given as short-term credit to third party customers. While the money on the current account remains a liability to the banker, the money is available to be given out as loans to sundry customers. Such customers will usually enjoy concessionary interest rates on other facilities in the bank.

4.5LOAN PRICING MODELS

The two ways to price loans are as follows:

1. Price to competition. Banks determine what competitors are charging for similar loans in the marketplace and price accordingly.
2. Cost-plus pricing. Here, banks calculate their risk, cost of capital, funding costs, all direct and indirect costs and add a margin to determine the price.Therefore, Loan Price is:1.Loan Price = (Direct Cost + Indirect Cost) + Premiums, i.e., risk factor. A cost-plus pricing model requires that all related costs associated with extending the credit be known before setting the interest rate and fees. Typically, it considers the following:

a. Cost of funds

b. Operating costs associated with servicing the loan or loans;

c. Risk premium for default risk; and

d. A reasonable profit margin on capital.

4.5.1 – General Factors Banks Consider in Loan Pricing

Olusemore (2009) gave the following as the general factors banks consider in

1. Characteristics of each prospective borrower
2. Existing banking relationship with the loan applicant
3. Connection of the borrower with the existing customers
4. Segment of the market served
5. General prices in the loans market
6. Weighted average cost of funds of the bank
7. Regulatory cap on lending rates in banks
8. Price elasticity of demand for loanable funds in the segment of the market served.

By this it means that interest rates on loan is usually borrower-specific

4.5.1 BASIS OF LOAN PRICING

1. Interest-Based Loans : This is common with traditional banking system. Loans are priced based on a basket of factors that ensures that the price is more than the direct and indirect cost of servicing the loan.
2. Determining loan price without interest
3. This is common with the Islamic form of banking, otherwise called nonInterest banking in Nigeria.

The simplest basis for computing interest rate is as follows:

1. Price of the loan (Interest Rate Charge) = Base Rate + Risk Premium.

Pricing method ( Interest Based) and Characteristics

1. Fixed rate: The loan is written at a fixed interest rate which is negotiated at the beginning of a loan origination. The rate remains fixed until maturity.
2. Variable rate: The rate of interest changes based on the minimum rate from time to time depending on the demand for and supply of fund.
3. Prime rate: Usually, relatively low rate offered to highly valued customers for a track record.
4. The rate for general customer: This rate is applied on general borrowers. This rate is usually higher than the prime rate. The rate takes account of riskiness of the relationship and higher probability of default.
5. Caps and Floors: For loans extended at variable rates, limits are placed on the extent to which the rate may vary. A cap is an upper limit and a floor is the lower limit.
6. Prime times: This special rate is a number of times greater than the prime rate. If the maturity of the loan is increased or decreased, this rate will also be increased or decreased in a multiple.
7. Rates on another basis: The interest rate can also be determined on the basis of the current interest rate of debt instruments. So, such a rate is linked to a pre-agreed index, i.e., London Interbank Offer Rate (LIBOR) or Nigeria Interbank Offer Rate (NIBOR). NIBOR is published by the Money Market Association of Nigeria. This rate is similar to prime rate except that the base is different; a rate can be a bit lower or higher than the prime rate. Examples include the regional index or other market interest rate such as the Certificate of Deposit rate.

B. DETERMINING LOAN PRICE WITHOUT INTEREST

A soft loan is a loan with no interest or a below-market rate of interest. Also known as “soft financing” or “concessional funding,” soft loans have lenient terms, such as extended grace periods in which only interest or service charges are due, and interest holidays.

A bank can also price a loan with reference to external parameters other than its own weighted average cost of funds or prime lending rate. Loans can be strictly linked to Monetary Policy Rates, which are independent of bank’s controllable internal factors. It can also be linked to London Interbank Offer Rate (LIBOR) or Nigeria Interbank Offer Rate (NIBOR).

For employers guaranteed loans, it can be agreed with a bank that loans to employees are to be priced interest-free while, the interest component will be paid in bulk either upfront or bank end by the employers who usually maintain accounts with the lending bank.

Non-Interest (Islamic Banking) is also operated on a non-interest basis. Non-InterestBanking in Nigeria is operated along the following arrangements:

1. Profit-and-Loss Sharing Partnership arrangement.
2. Profit-and-Loss Sharing Joint Venture. The Islamic finance world’s equivalent of a joint venture is Musharakah.
3. Leasing (Ijarah). What the borrower pays is lease rental.

4.5.2 Loan Pricing and Borrowers Behavioural Characteristics

Most banks can survive by pricing loans to competition or on a cost-plus basis. However, banks that price their loans these ways are unlikely to become top performing banks. Each bank that wants to be top of the market should develop its own loan pricing strategy.

Loan pricing requires an understanding of the economic and psychographics of individual borrowing customers. The following are some of the categorisation of borrowing customers, which influence the pricing methodology.

1. Demanding customers – ask for the lowest price bearing in mind their volume of business with the bank. Such a customer may even show to his bankers offer of credit on generous terms from other bankers. He shops around for the best rate. They are smart negotiators and often leaders in their lines of business. The credit risk for this category of customer is low.
2. Undemanding (easy-going) customers who are vulnerable. They are at the mercy of the bank. Often, they are small and medium scale enterprises or companies facing financial crisis. They take a high rate from the bank because they have limited sources for funding their business operations. Such clients hardly enjoy spontaneous finance. Often, they buy goods on cash-and-carry basis or asked to make payments in advance before supplies are made. This category of borrowers carries high credit risk.

4.6LOAN PRICING AND COST OF FUNDS

The interest rate of a loan is determined by the true cost of the loan to the bank (base rate) plus profit/risk premium for the bank’s services and acceptance of risk.The components of true cost of a loan are:

1. Interest expense
2. Administrative cost, and
3. Cost of capital

The three components stated above add-up to the bank’s base-rate.

4.6.1 Sample of Components of and Computation of Cost of Funds

METHOD ONE

FUNDING AMOUNT. INTEREST. INTEREST

SOURCES (N’000,000). EXPECTED. PAYABLE RATE

1. Current Account. 500,000 0.01 5,000

2. Savings Account 1,000,000 0.06 60,000

3. Fixed Deposit 1,000,000 0.09 90,000

4. Bankers Acceptances 750,000 0.15 112,500

5. Commercial Papers 250,000 0.16 40,000

6. Inter-bank Takings 1,500,000 0.05 75,000

7. Non-customers balances. 250,000 0 –

5,250,000 382,500

METHOD 2- WEIGHTED AVERAGE COST OF FUNDS

FUNDING AMOUNT INTEREST PROPORTION EXPECTED INT

SOURCES. (N’000,000) IN THE TOTAL

“A” “B” “C” “D” = “B”/TOTAL DEPOSIT . ” E”= “C” “D”

RATE WEIGHT PAYABLE

Current Account 500,000 0.01 0.0952 0.00095

Savings Account 1,000,000 0.06 0.1905 0.01143

Fixed Deposit 1,000,000 0.09 0.1905 0.01714

Bankers Acceptances 750,000 0.15 0.1429 0.02143

Commercial Papers. 250,000 0.16 0.0476 0.00762

Inter-bank Takings 1,500,000 0.05 0.2857 0.01429

Non-customers balances 250,000. 0 0.0476 0.00000

5,250,000 1 0.07286

Source:

The numbers and products types are fictitious. They are produced to helpthe reader to appreciate how banks arrive at the weighted average cost of funds

4.6.2 How can a bank lower its cost of fund?

The cost of funds is made up largely of the weighted average cost on the various liability products in the bank, in addition to Nigeria Deposit Insurance Scheme premium on total deposit as well as the direct operating expenses for funds mobilised. Computation of the weighted average cost of funds is a job of the bank’s Treasury Department. It is advised to the risk assets creating departments in the Assets and Liability Management Committee (ALCO) meetings. We have given an example how the computations are done with respect to the direct cost of funds.

Reducing direct cost of funds in a bank can be done in several ways as outlined below:

1. Efficient operational processes that improve turnaround time for basic banking needs of customers.
2. Increasing digitization of operations that produces on-line-real time banking.
3. Opening of new branches and installation of Automated Teller Machines in several locations to ensure that more customers are captured that may provide free float on current account balances.
4. Target of sizeable deposits from the public sector and households. These sectors are price insensitive when it comes to negotiating interest on deposits. Moreover, deposits from the public sector are large ticket funds and some of these can be with the bank for a considerable long period of time.
5. Do not enter into long-term fixed deposit contracts in a period when interest is expected to fall.
6. Encourage savings and current account deposits
7. Allow deposits through the Automated Teller Machine
8. Encourage key customer and distributorship scheme which ensures that Debt Servicing Reserve (DSR) account is created to warehouse funds until loan instalments are due. These provides funds at a very low interest rates to the lending banker.
9. Marketing officers should be customer-centric with high level of relationship skills. In Africa, long-term banking relationship is about building and nurturing genuine interpersonal relationships. The relationships are anchored on mutual trust earned from the creative deployment of the professional skills of the lending officers
10. Listen to customers’ complaints and make the customers feel “important” no matter their level of current transaction. Non-professional staff (i.e., security and cleaners) should be trained to manage customers while within the bank premises. Their behaviour to customers can hinder or enhance banking relationships. They should be trained to be civil and be professional to customers. They are the ‘real’ front office staff

4.6.3 – Monetary Policy Rate

MPR is the interest rate at which CBN lends to the commercial banks. The MPR is the benchmark against which other lending rates in the economy are pegged and is usually used as an instrument to moderate inflation in the economy.

When Central Bank of Nigeria (CBN) along with the members of the Banker’s Committee raise MPR, it tightens up other interest rates within the economy, including lending and deposit rates.

4.6.4 Loan Pricing and Value Propositions

Successful banks understand the difference between price and value. The price of a product or service is the monetary equivalent that the customer pays for that product or service (spread, fee, or payment-in-kind).

However, value is the benefit that the borrower perceives from the product or service. Banks that price to competition are often matching the lowest cost provider as a strategy. Banks that price on cost-plus basis do not position to differentiate on anything other than price.

Banks that price to value are demonstrating how and why their product bundle is of a higher benefit to the borrower then the competitor’s offering.

We have seen various banks successfully price loans based on different value propositions. There is not one value that works and good banks find multiple value propositions for their target customers – exceptional banks will aggregate a number of value propositions. The reality is that most banking products are commodities because of how bankers, not the market, treat them.

Banking services, not the loans, are what needs to be distinct.

A good value proposition moves away from describing attributes of the bank and solves an important problem for a customer. It is the “why” of your mission and it should be compelling enough to not only separate you from your competitors, but to motivate potential customers to come over. Here are some of the major value propositions that we see successful banks offer when differentiating their value proposition:

1. Bankers are selling knowledge of the borrower’s market and business model. The banker comes to work for the borrower as a trusted financial adviser on business matters and the loan is a side product that comes with the banker.
2. The speed of execution is of great value for borrowers. As banks mature and increase in size, processes become centralized, complex and complicated.
3. Banks that can deliver funding faster add substantial value to certain customers. Decisioning can be a substantial value for certain customers. While funding can take days or weeks, being able to commit to borrowers is of value to customers. Banks that can make a quick decision (within 24 to 48 hours after being provided the major parameters of the loan) add value for most borrowers.
4. Ease of use can also separate a bank. Bankers that make it easier1 for the customer to apply, receive a commitment and close a loan, can differentiate themselves.
5. Continuity of relationship is another value that we see appreciated by borrowers. Borrowers do not want to switch providers of financial service, if possible, and want to establish trust with one banker who they can count on being their primary contact. Bankers that have a long and stable history with an institution add more value to a borrower, and this is especially true for relationship banking where the borrower expects to be with an institution for five or more years
6. Customers often deal with individual officers they can trust. That is why it’s not uncommon to experience the movement of a valued customer to another bank as the contact account officer moves. The lesson, therefore, is that, apart from good loan policy, banks should treat their managers well. A greater percentage of the account officers’ remuneration should, in large part, be productivity based for instance, by way of profit sharing.

4.7 Functions of Assets and Liabilities Management Committee (ALCO)

Asset-liability committees (ALCOs) are responsible for overseeing the management of a bank’s assets and liabilities. An ALCO at the board or management level provides important management information systems (MIS) and oversight for effectively evaluating on- and off-balance-sheet risk for a financial institution.

ALCO responsibilities typically include:

1. managing market risk tolerances,
2. establishing appropriate Management Information System (MIS)
3. reviewing and approving the liquidity and funds management policy at least annually
4. developing and maintaining a contingency funding plan, and
5. reviewing immediate funding needs and sources

4.8 Conclusion

It is an elementary principle in Economics that demand and supply of a product determine the price. In arriving at a loan price, lenders bear the following objective(s) in mind:

1. generate liability products or access low-cost funds that can bring the weighted average cost of funds to the below market rates;
2. significant improvement in the quality of services offered bank-wide. We have made the case for the increasing digitization of operations as well as human factors in excellent service delivery.
3. As mentioned earlier in this chapter, banks are differentiated based on the people that provide service to the customer. However, bank officers must have the tools and training necessary to create value
4. The importance of “back-office” that is, credit administration and banking operations departments cannot be over-emphasised in the effective credit process delivery. They can make or mar an accounts manager’s desire to satisfy a valued customer.

Lenders must constantly evaluate the value propositions they make to the various customer-segments.

CHAPTER 5

CREDIT RISKS: TYPES, MEASUREMENT AND MITIGATION

5.2Credit Risk

A credit risk is the probability of default on a debt that may arise from a borrower failing to make required payments. In the first instance, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs.

Credit risk can also be defined as the probability that the debtor will be unable to repay in full, the principal sum and interest as and when due. Credit risk shows the likelihood of a lender losing its loaned money to a borrower. It sheds light on the ability of a borrower to pay back a loan or meet their contractual agreement. Conventionally, it deals with the risk every lender must be familiar with, which is losing the principal and interest owed. The aftermath of this is a disturbance to the lender’s cash flow and the possibility of losing more money in a bid to recover the loan. Litigations cost fortunes and can drag on for years.

Losses can arise in a number of circumstances, including the following:

1. consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan. Often this caused by sudden loss of employment or prolonged illnesses.
2. A company is unable to repay asset-secured fixed or floating charge debtdue to substantial loss of market shares.
3. A business or consumer does not pay a trade invoice when due
4. A business does not pay an employee’s earned wages when due
5. A business or government bond issuer does not make a payment on a coupon or principal when due.
6. An insolvent insurance company does not pay a policy obligation.
7. An insolvent bank would not be able to return funds to a depositor.Unfortunately, some depositors will migrate to other they perceive as safe haven.
8. A government grants bankruptcy protection to an insolvent consumer or business. This is a loss of revenue to the lending bankers

To reduce the lender’s credit risk, the lender may perform a credit check on the prospective borrower, may require the borrower to take out appropriate insurance, such as mortgage insurance, or seek security over some assets of the borrower or a guarantee from a third party. The lender can also take-out insurance against the risk or on-sell the debt to another company. In general, the higher the risk, the higher will be the interest rate that the debtor will be required to pay on the debt.

5.3CREDIT RISK TYPES/TERMINOLOGIES

A credit risk can be of the following types:

1. Credit default risk – The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or the debtor is more than 90 days past due on any material credit obligation. Default risk may impact all creditsensitive transactions, including loans, securities and derivatives.
2. Concentration risk – The risk associated with any single exposure or group of exposures with the potential to produce large enough losses to threaten a bank’s/lender’s core operations. It may arise in the form of singlename concentration or industry concentration.
3. Country risk – The risk of loss arising from a sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk). This type of risk is prominently associated with the country’s macroeconomic performance and its political stability

5.4Credit Risk Management Process

Risk Identification

Risk Classification /Categorisaion

Risk Quantification

Decision Taking

Institute Control

Implement Control

Supervision

5.4.1 Risk Identification

This involves a comprehensive listing of possible risks that may affect the loan that is being processed. The risks can arise from the external macro-environment, the industry or obligor-company.

5.4.2 Risk Classification/Categorisation

This activity involves categorising the risks first into their various compartments/classifications. Secondly, it entails categorising each of them either as (i) Low (ii) Medium (iii) High. The probability of occurrence can be either (i) likely (ii) probable (iii) unlikely.

Since this is not a course on enterprise risk management, the actual computation of risks and assigning of numbers is not within the purview of this Study Pack. The objective of this section of the chapter is to expose readers to the practical meanings of some common terminologies used in credit risk.

5.4.3 Risk Quantification

Risk Quantification is the forecasting of loss frequency (likely/ probable/unlikely) and severity (Low-Medium-High) to make risk financing decisions. Dependable estimates of the likelihood and dollar amount of loss-causing events allow an organization to take appropriate steps now and, in the future, to minimize their financial impact.

Risk quantification is an important activity in credit risk management, as it assists in placing risks in some order of priority and highlights decisions to be made. This includes handling of the cost and economic consequences of the risk occurring. It helps the credit risk manager to know what controls to put in place to ensure that the risk does not crystalize.

How to quantify credit risk?

An expected value can be calculated for each significant risk by multiplying the likelihood of the risk occurring (probability) by the size of the consequence. This risk premium is expressed in monetary terms and provides an estimate of the cost of accepting all the risk. Statistically, risk is measured by standard deviation.

5.4.3.1 Quantification of Credit Risk

PROBABILITY OF OCCURRENCE: Likely, Probable, Unlikely

RISK LEVEL: High, Medium, Low

. Likely Probable. Unlikely

High A B C

Medium. D. E. F

Low. G. H I

Table 5.4.3.1 Constructed by the author(s)

Let us take the following points in the above table as an example, to illustrate Risk or Probability of occurrence of the negative event in the loan cycle:

1. Quadrant ‘E’: Probability of occurrence is medium while the quantum of expected loss is also medium
2. Quadrant ‘G’: Probability of occurrence is high, while the quantum of expected loss is low.
3. Quadrant ‘I’: Probability of occurrence is low, while the quantum of expected loss is also low.

b. Risk Quantification Parameters – Definition of Terms

High Risk: May affect organisational objectives or major part(s) of it.

Medium Risk: May affect organisational objectives for a period

Low Risk: May cause minor inconveniences

Likely : The risk has high chances of occurring

Probable: The chances of occurrence are medium

Unlikely: This is a rare occurrence. Not likely to occur.

Table 5.4.3.2 Constructed by the author(s)

5.4.4 Decision Taking

Decisions that could be taken may include:

1. Accept the risk
2. Reject the risk
3. Modify the loan structure and accept or underwrite the risk

5.4.5 Initiate Controls

This will involve stipulating some accounting ratios to be met. These will be incorporated into the loan covenants. They will form the basis for loan monitoring and controls.

5.4.6 Implement Controls

This may involve checking performance against set standards; finding out the degree of variance. The root cause of any variance may also be established. Standards or goals should not be too easy or difficult to achieve. The ultimate decision could be to: (i) recall the loan (ii) initiate loan remedial actions.

5.5 What is Credit Risk Analysis?

Credit analysis means the methods or tools that we use in identifying, assessing and or quantifying the risks that banks assume. The first step is to list the risks that the borrower is likely to face in the transaction before cash flow comes into the business; outline and assess the risks in the external environment. The outcome of the analysis is to confirm whether or not the loan applicant has capacity to mitigate the risks. Risk mitigation involves diversifying the risk, transferring it through insurance or sharing the risk through loan syndication. It may also involve reducing the risk by breaking the project into phases and reducing the lender’s capital commitment at each stage.

Commercial banks, investment banks, asset management companies, private equity funds, venture capital funds, and insurance companies all need to analyse the credit risks they are exposed to in order to profitably operate in the market. In our case, as bankers, granting of loans and assumption of credit risks, are our main pre-occupations.

5.6 Credit Risk Measurement1

Credit risk departments of banks use excel worksheets and/or other packages to compute some statistics that give bank management insights on the likelihood of a loan going bad in a loan portfolio. Since this book is not on Enterprise Risk Management, we will not dwell on the computation methodologies, which in any event are digitised. The discussions that follow are to assist us to have some basic understanding of the measurement tools used in Enterprise Risk Management.

In mathematical or statistical term:

1. Credit Risk = Default Probability x Exposure x Loss Rate

Where:

1. Default Probability is the probability of a debtor reneging on the payment of principal and interest.
2. Exposure is the total amount the lender is supposed to get paid by the borrower (debtor). In most cases, it is simply the amount borrowed by the debtor plus interest payments.
3. Loss Rate = 1 – (Recovery Rate)

where Recovery Rate is the proportion of the total amount that can be recovered if the debtor defaults.

Credit Risk Analysts identify, categorize and measure each of the determinants of credit risk and try to minimize the aggregate risk faced by an organization.

Note that: Different factors are used to quantify credit risk, and three i.e. (i) Probability of Default, (ii) Loss Given Default, and (iii) Exposure at Default are considered to have the strongest relationship with credit risk.

1. Probability of Default measures the likelihood that a borrower will be unable to make payments in a timely manner.
2. Loss Given Default looks at the size of the loan, any collateral used for the loan, and the legal ability to pursue recovery of the defaulted loan, if the borrower goes bankrupt
3. Exposure at Default looks at the total risk of default a lender faces at any given time.

Among all possible factors, three are consistently identified as having a stronger correlative relationship to credit risk: (i) probability of default, (ii) loss given default, and (iii) exposure at default.

1. 1.Default Probability
2. The probability of default, sometimes abbreviated as PoD or PD, expresses the likelihood the borrower will not maintain the financial capacity to make scheduled debt payments. For individual borrowers, default probability is most represented as a combination of two factors: debt-to-income ratio and credit score. The higher the debt-to-income, the higher will be default probability , other things being equal.

Loss Given Default (LGD)

According to Investopedia, “Loss Given Default” (LGD) is the expected losses due to borrowers defaulting on loans. There is actually no universally accepted method of calculating LGD. Most lenders do not calculate LGD for each separate loan; instead, they review an entire portfolio of loans and estimate total exposure to loss. Several factors can influence LGD, including any collateral on the loan and the legal ability to pursue recovery of the defaulted funds/loans through bankruptcy proceedings. Following the review of Banks and Other Financial Institutions Act in 2021, and the provision for the creation of Commercial Courts or Tribunals, it is expected that there will be respite to lending bankers, whose loan recovery had been hampered by Nigeria’s extremely slow judicial process that gives room for serial borrowers to get away with their “commercial crime”. Most high-profile borrowers in Nigeria exploit the weaknesses in our commercial laws and get away with a slap in the wrist. The borrowers’ plot to escape justice is helped by lenders’ seemingly lackadaisical attitude to credit analysis and control.

Exposure at Default (EAD)

1. Exposure at Default, or EAD, is an assessment of the total loss exposure a lender is exposed to at any point in time when borrower defaults. Even though EAD is almost always used in reference to a financial institution, the total exposure is an important concept for any individual or entity with extended credit.
2. EAD is based on the idea that risk exposure depends on outstanding balances that can accrue before default. For example, for loans with credit limits, such as credit cards or lines of credit, risk exposure estimates should include, not just current balances, but also the potential increase in the account balances that might happen at the point the borrower defaults.

Difference between LGD and EAD

The loss given default (LGD) is an important calculation for financial institutions projecting out their expected losses due to borrowers defaulting on loans. On the other hand, Exposure at default is the total value of the loan at the time a borrower defaults.

Several major variables are considered when evaluating credit risk:

1. the financial health of the borrower;
2. the severity of the consequences of a default (for the borrower and the lender);
3. the size of the credit extended to the borrower;
4. historical trends in default rates; and a variety of macroeconomic considerations, such as inflation, exchange rate, gross domestic products growth rates, etc. economic.

5.7 Credit Risk Triggers

1.External Macro-Environment

1. Sudden and dramatic changes in Monetary and Fiscal Policies.
2. Change of government can trigger credit risk for politically exposed persons.
3. Depreciation of the local currency
4. Large increase in tax rate or introduction of new taxes can increase cost of doing business.
5. General insecurity of lives and property will discourage productive activities and disrupt cashflow forecasts
6. Change in weather pattern can disrupt agricultural production and civil engineering construction works.
7. Onset of recession that is prolonged can affect most businesses adversely and thus prevent or slow down loan repayment rates.

2.Industry Environment

The following are some of the industry-wide factors that can adversely affect loan performance:

1. Changes in consumer tastes;
2. Arrival of new and aggressive competitors;
3. Change in technology. Industry becomes more technology driven than ever;
4. Aggressive marketing leading to unethical practices which leave ethically behaved firms vulnerable;
5. Shortage of imported raw material inputs’;
6. Prolonged industrial crisis in the industry leading to work stoppages, strikes and lockouts.

3.Internal Factors

1. Prolonged Board room crisis that creates dysfunction organisation and leads to poor or ineffective decision. Crisis among board members leads to poor communication because of the divisions within the organisations.
2. Key employees leaving the firm to join competitors or form a competing firm. This usually means loss of business or income for such a company losing key employees.
3. Poor corporate governance regime in the firm leading to insider abuses. Here each member of management seeks for his/her own good at the expense of the development of the corporate organisation
4. Not being able to cope with changes in consumer taste. This is a situation where a borrower
   lags behind in innovations and new product development.
5. Aging plant and machinery. With aging plants, quality of output could be affected. Moreover, output level could reduce, thereby leading to loss of revenue or inability to meet revenue targets.
6. Major suppliers cut off supplies or existing generous credit terms. The impact of the supplier’s decision is that Payable Days on Hand reduces, thereby reducing the amount of spontaneous finance that the company requires.
7. Poor internal control leading to wide spread and large-scale fraud(s).
8. Failure to innovate or apply Information and Communication Technology (ICT) to business processes. Increasing application of ICT to business simplifies production and service delivery processes; reduces turnaround time and ultimately production costs.
9. Poor customer service leading to loss of major customers. When a borrower takes its customers for granted through poor service delivery, it creates incentives for customers to move to suppliers that are proactive and effective.
10. Inability to access a major market due to the closure of the country’s land borders
11. High-cost structure, leading to high prices of goods and services
12. Espionage on the company’s product chemical formulae, leading to the emergence of new and well packaged competing product(s)

5.8Mitigation

We have explained that mitigation involves reducing, avoiding or transferring the identified risks. Lenders mitigate credit risk in a number of ways, including:

1. Risk-based pricing: Lenders may charge a higher interest rate to borrowers who are more likely to default, a practice called risk-based pricing. Lenders consider factors relating to the loan such as loan purpose, credit rating, and loan-to-value ratio and estimates the effect on yield (credit spread). It should be pointed that higher price can only ensure that much income is earned before burble bursts. It cannot eliminate the identified risks.
2. Covenants: Lenders may write stipulations on the borrower, called covenants, into loan agreements, such as: (a.) Periodically report its financial condition (b.) Refrain from paying dividends, repurchasing shares, borrowing further, or other specific, voluntary actions that negatively affect the company’s financial position, and repay the loan in full, at the lender’s request, in certain events such as changes in the borrower’s debt-to-equity ratio or interest coverage ratio.
3. Credit Insurance and Credit Derivatives : Lenders and bond holders may hedge their credit risk by purchasing credit insurance or credit derivatives. These contracts transfer the risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is the Credit Default Swap.
4. Credit Tightening or Squeeze : Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30days to net 15days. The longer the credit period, the more the chances of default.
5. Diversification: Lenders to a small number of borrowers (or kinds of borrower) face a high degree of unsystematic credit risk, called concentration risk. Unsystematic risks are risks that are not diversifiable. For example, the risk of adverse changes in government policy. Lenders reduce this risk by diversifying the borrower pool.
6. Deposit insurance: Governments may establish deposit insurance to guarantee bank deposits in the event of insolvency and to encourage consumers to hold their savings in the banking system instead of in cash. Nigeria has a national deposit insurance scheme under the Nigeria Deposit Insurance Corporation (NDIC).

5.9. Credit Risk Assessment

Proper assessment of credit risk can go a long way in reducing the possibility of loss to lenders and the impact of any such loss. Check out this guide to learn the basics of credit risk assessment.

Assessing the credit risk of a borrower is a lender’s priority. There are different measures available to do this. A good credit risk assessment can prevent avoidable losses for an organization. When a borrower is found to be a debtor, it could impact negatively on itscreditworthiness. The lender will be cynical about offering loans for fear of not getting it repaid.

1. Credit risk assessment helps organizations know whether a borrower can pay back a loan
2. The credit risk of a consumer is determined by the five Cs: capacity to repay, associated collateral, credit history, capital, and the loan’s conditions.
3. If a borrower’s credit risk is high, the interest rate on the loan will be increased/high. It is instructive to repeat that charging higher interest rates does not guarantee that full repayment will be achieved. The idea of charging higher interest rates is consistent with the maxim in Finance that “The higher the risk, the higher the returns”.

5.10 SPECIFIC INDUSTRY RELATED RISKS

Industry and Inndustry-Specific Risks

1. Agriculture :Post-harvest losses due to poor storage facilities. Transportation cost and accidents. Pestilence. Bad weather. Insect infestation leading to poor harvest. Insecurity of farmers and farm products due to insurgency in many parts of Nigeria. The other trigger of risks in the agricultural industry is frequent market price fluctuations.
2. Oil & Gas: Risk of drilling dry wells. Operational risk encountered in seismic acquisition, drilling, production, etc platforms. Risk of strikes and production disruptions. Risks associated with fluctuations in the international price of crude petroleum.
3. Building & Construction: Shortage of bitumen. Shortage of skilled manpower. Adverse weather conditions reduce the quality of output. Equipment not available locally. Procurement of equipment affected by exchange rate depreciation. Exchange rates fluctuates too frequently and are difficult to predict accurately.
4. Hotels (Five Star): Low occupancy rates of rooms. COVID-19 or similar pandemics will affect patronage. Possibility of food poisoning that will produce adverse publicity for the organisation. Hotels can be used as location for criminal activities. Where this is the case, potential lodgers will avoid patronising the hotel. Health, safety and environmental issues. Managing wastes and sewage system could be expensive for 4-5Star hotels. These are hotels that are of international standards and cannot afford to cut corner In any event, the local and state regulators put them under close surveillance.
5. Bakery: High prices of cassava flour and other raw materials. High level of competition. Product adulterations leading to loss of patronage for some brands. Incursion of foreign bakeries is a threat to local bakers. Meeting Health, Safety and environmental regulations from National Agency for Food & Drug Administration (NAFDAC) and Standards Organisation of Nigeria (SON).
6. Educational Institutions (Primary and Secondary): Low classroom occupancy rate. Low enrolment due to
   reducing income and living conditions of parents and
   guardians. Regulatory sanctions. Risk of kidnapping or
   building collapse, etc. There are instances where some
   classroom blocks were demolished by Local or State
   authorities because of the dilapidated structures. These put
   bank loans into jeopardy. Experiences of lending bankers
   show that lending to this category of customers attracts a lot
   of risks because overdrafts are easily diverted to build classrooms or buy non-current assets.
7. Pharmaceuticals & Drugs: Regulatory risk. Health Safety and Environment (HSE) issues. Market acceptance of new products. High costof pharmaceutical formulae that are imported. Volatile exchange rates have made drugs and other pharmaceuticals expensive in Nigeria. The masses resort to adulterated and substandard products. This category of consumers shuns standard products that are more expensive. The risk for a lender is the possibility of borrower being confronted with unsold and expired drugs. Expired drugs are useless; it ties down cash flow.
8. Manufacturing industry generally: Meeting regulatory requirements of the Standards Organisation of Nigeria. Competition from imported products. Consumer resistance because of low income and unemployment.
9. Foam Manufacturing : Fire accident is very potent. Regulatory Standard –ISO Certification. Health, Safety and Environment issues, must be considered.

CHAPTER 6

CREDIT ANALYSIS AND INVESTIGATION PROCESS

6.2Introduction

Generally, analysis means breaking something down into its various elements and then asking critical thinking questions such as why and how in order to reach some conclusions of your own. It involves very close examination of a set of information at your disposal with a view to determining how the information can help to determine the prospect of achieving credit repayment within the agreed time.

Credit Analysis Questions

The underlying issue in credit analysis is to seek answers to the following questions:

1. Why is a particular measure such as Gross Revenue or Cost of Sales going up or down?
2. What is the magnitude of the decrease or increase?
3. What possible factors could have caused the observed decrease or increase?
4. Were these factors within or outside the control of the borrowing customer?
5. Did the client make any definite contributions in the outcome that was seen?
6. Does the data before you meet your expectation, as a lender? If not, what can be done to remedy the situation?
7. What is the prospective borrower or indeed, the borrower, doing to resolve a problem presented in the data or information being analysed?
8. Can the borrower justify the performance or give the lender hope of an improved performance?
9. How reliable or up-to-date are the data presented to the lender?
10. Which industry does the borrower belong? What are the practices in the industry?

6.3Credit Process

The following are the processes involved in credit analysis:

1. Information Gathering
2. Credit Interview
3. Credit Analysis
4. Credit Presentation/Defence
5. Credit Approval/Rejection
6. Waivers and Deferrals
7. Communication of Approval/Rejection
8. Credit Documentation
9. Credit Disbursement
10. Credit Collection
11. Loan Work-out/Restructuring
12. Loan Recovery

1. Information Gathering

There are two types of information that are required in credit analysis:

Sources of Information

1.Commercial divisions of Foreign Embassies

2.Newspapers

3.Suppliers to the prospective borrower

4.Customers of the prospective borrower

5.Trade Associations

6.Government: Ministries, Departments and Agencies.

7.Central Bank of Nigeria.

8.Actions to take on the Information: (i.) Confirm the accuracy, relevance and timeliness of the information; (ii.) Confirm the integrity of the source of information. Ensure that the information is not compromised. (iii.) Adequacy of the information should be tested

2. Credit Interview

The essence of credit interview is to follow up on customer’s credit application and seek clarifications on grey areas or information gaps.

Objectives of Credit Interview are to:

1.clarify gaps in the information sent;

2.find explanation for causes of some observed performance

3.seek further explanations on the lending rationale and borrowing cause(s);

4.take customer up on political, economic, environmental and technological issue(s) that may affect borrower’s business performance;

5.agree tentatively on some of the loan covenants and conditions; and

6.understand the customer’s business dynamics

3. Credit Analysis

Credit analysis can be divided into two broad categories: qualitative and quantitative analysis.

1.

Here value judgment and knowledge of borrower is important. The quality of men, machines and materials are not expressly stated in the financial statements. It is personal visit and inspection that will show that.Organisational culture in terms of decision-making process – democratic or autocratic has implications for credit administration. For example, management attitude to innovation and risk taking are critical qualitative factors that determine whether a company will be able to cope with competition as well as generate cashflow to meet loan repayments.

2. Quantitative Analysis: As the name implies quantitative analysis involves the use of numbers, ratios or such other statistics to measure performance of a customer and thus, the prospect of loan repayment.

Most of the quantitative measures that are used in credit analysis are applied from statistics and mathematical sciences, such as ratios, indices, probability, variances and co-variance.

Examples of quantitative analysis include the following:

1.Ratios

2.Trends

3.Common-sizing or vertical statements.

4.Percentage changes.

5. Credit Presentation/Defence

a. Board Credit Committee

b. Management Credit Committee

c. Credit Officer/Divisional Head

Each approving authority level has a discretionary lending limit. The Board is the highest level of credit authority in the bank. Credit Approval Memorandum is sent to the approving authority to enable members study it before the Committee’s meeting date. The ceiling to a bank’s Board lending power is defined by the Single Obligor Limit.

Oral Presentation

The Credit Officers would have converted contents of the Credit Approval Memorandum into slides for presentation.The presenter should bear in mind the following:

6.The time allotted for presentation is usually short; therefore, the Credit Officer should go to the key issues that support the credit application.

7.There could be one or two members who could be hostile to a particular presentation because of personal prejudices. The Officer should stay focused and address essential issues instead of personality. Self-control is vital in credit presentation.

8.In order to stay focused as well as cover the essential issues addressed in the Memorandum, the presenter could use the model described as “CPARTS”.

9.C – means Customer. Introduce the customer, the business, products, suppliers, locations of the business. Explain how the customer’s business aligns with the bank’s business (credit) objectives.

10. P – means Purpose. Clearly state the purpose of the credit. What does the customer want to do with the money, when disbursed?

11. A – means Amount. Justify the amount that is being requested, i.e., adequacy or otherwise. Explain the make-up of the total amount. The value of the loan, with regard to the amount of credit being sought should be clearly articulated in the oral presentation

12. R – means Repayment. Within the available time, state clearly how the loan will be repaid. Articulate the various sources of funds for credit repayment and the certainty of the cash inflows. Here, the analyst/officer can bring in the risks inherent in the business and how these have been mitigated.

13. T – means Terms and Conditions. Every credit should have terms and conditions. State the conditions precedent to draw down. Also, articular the negative and affirmative covenants. Negative covenants are what the borrower should not do, while affirmative covenants are what the borrower should do

14. Affirmative Covenants:1. Loan-charged deposit ratios 2. Loan to security ratios 3.Minimum turnover per period

15. Negative Covenants are undertakings by borrower not to: 1. sell assets being financed 2.borrow from other lenders 3. mortgage the financed property

16. S – means Security. Explain the security/collaterals being proposed by

LOAN PRESENTATION MODEL

Customer Profile

Purpose of loan

Amount of loan

Repayment + Risks

Terms & Conditions

Security (secondary wayout)

17. Credit Decision

1.Full Approval – the Committee approves all the amount required as well as other associated terms and conditions

2.Outright Rejection – this ends the credit process

3.Approval subject to some amendments – this is communicated to the borrower to accept or reject the new terms and conditions.

4.Credit DocumentationIt is important that documents collected from the borrower should be consistent with the requirements as stated in the Credit Offer Letter. Lending Officers should ensure that they comply with the approval given by the Credit Committee.

Virtual Credit Presentation

Key points to note:

1.Be fully prepared and demonstrate sound knowledge of the customer and his business

2.Note that there is no time to make reference to any material that is not readily available in the slides.

3.Be conversant with industry trends; never forget that Officers at the Head Office have broader scope than you.

4.Bring out key issues in your credit slides.

5.Profitability Analysis should be properly computed stating clearly the underlying assumptions.

6. Always compare your returns from each credit to the threshold stated in the Credit Policy of the bank.

7. Be very clear in your voice projection.

8.Manage time by emphasising key issues that the application seeks to achieve, establishing clearly how the credit will be a win-win situation for both the banker and customer.

9.Credit Disbursement: Credits such as Term Loans, Mortgage Loans and Project Finance should have specific loan disbursement schedules. The schedule should be used as approved by the Credit Committee.

10. Credit Monitoring: Project financed should be closely monitored so that the bank does not give room for borrowers to default. Many good borrowers will default because their businesses and cashflows are not monitored. One of the ways of monitoring loan utilisation is to ensure that loans are disbursed to ultimate beneficiaries.

Monitoring of compliance with covenants will ensure that default is minimised. It prompts lenders to take pre-emptive measures that will prevent loan default.Monitoring should commence from disbursement stage, ensuring that monies are disbursed to the right supplier or beneficiaries. After this is the utilisation of the funds.

It’s not enough to ensure that the project is completed, Loan Officers should ensure that they track how funds are moving in and out of the business. Apart from the requirements of the provision of management accounts, regular visits to customer’s business premises are vital.

What do Loan Officers monitor at the customer’s business premises?

1.Conditions of the premises generally; the evidence of ongoing business activities.

2.Working conditions of the machines, equipment, furniture as well as buildings.

3.Morale of employees.

4.Credit Collection/RepaymentSeveral loans considered in earlier chapter of this book require specific repayment programme(s). This should be followed through by the Credit Officer. The primary objective of a loan transaction is to help the customer achieve business objective(s), to enhance banking relationship and income of the bank.

5.RecoveryBankers’ view of Recovery is that when a loan: (1.) Is not collected as and when due and other measures are adopted to achieve repayment. (2.) Collection is achieved through legal processes (3.) Sale of borrower’s pledged business assets. (4.) Scheme of Arrangement in which borrower agrees to pay a certain sum for every one Naira owed, as full and final payment.

CBN CREDIT REPORTING SYSTEM

The purposes of the Credit Reporting System are as follows:

1.To aid financial institutions to assess and better manage risks associated with lending.

2.To equip financial institutions with the required infrastructure and tools for processing and managing loans to MSMEs and individuals.

CREDIT BUREAU: THE ROLES AND RESPONSIBILITIES

Credit Bureaus are set up to gather information about companies’ and individuals’performance. The information gathered include previous loans that had already been paid, new loans that have just been collected, how the loans have/are being serviced and if there are any outstanding balance(s). They also include Contact Addresses of the borrowers.

Credit Bureaus keep all these information both positive and negative on a borrower

Purpose of Credit Bureau

The website of one of the principal Credit Bureaus in Nigeria, CRC Credit Bureau Limited, provides the following as the core functions of Credit Bureaus:

1.To maintain a database of borrowers from lending institutions: Data collected include contact address details of individuals and companies. They also include a history of loans that had been received; if they were paid on time, how many days late they were paid, or if there were any bounced payment instruments submitted. They also include information like bankruptcy and court judgments.

2.To provide a central storage for all the information collected: Credit Bureaus have sophisticated and reliable technology that enables them store the large quantity of data collected over a long period of time without theirgetting lost, stolen, or altered. This gives lenders a long-term access to information that they cannot store themselves.

3.To provide credit information upon request: When credit information is provided by a Bureau, it comes in the form of a report, so it is called a Credit Information Report. This is the major product that the Bureau sells to its members, and it usually contains information spanning a period of 3 years.Subscribers to credit bureaus members are mostly lenders, such as credit card issuers, financial institutions that offer lending products, private loan companies such as auto finance organizations, and the federal government.

The CBN supported the credit bureaus by mandating all banks and financial institutions under their jurisdiction/supervision to use at least two of the three credit bureaus.

1.All commercial banks, microfinance Banks, and all specialized institutions – Federal Mortgage Bank, Bank of Industry, Bank of Agriculture, Nigerian Mortgage Financing companies, Development Banks, leasing companies, primary mortgage institutions, asset management companies etc. are on the credit bureau platforms.

2.To eliminate/reduce information discrepancy in the lending industry: When countries establish credit bureaus, their main aim is to reduce and possibly eliminate the gaps in information shared between lenders and borrowers. For instance, without these bureaus, a borrower could use different identity information/addresses to obtain loans from different lenders. He can use loans from banks A and B to service that of Bank C, or simply accumulate loans from the three banks at different times without repaying any of them.

Roles of Credit Risk Bureau

1. Credit Risk Bureau (CRB) can ensure that credit flows to deserving borrowers and reduce to those fewer undeserving ones.

2. CRB can assist in maintaining financial stability in an economy.

3. CRB also helps creditors guard against fraud, which is a growing and serious problem that ultimately affects all consumers.

4.It allows increased access to credit. It means that banks can now lend on the basis of a borrower’s credit history without knowing anyone in the bank or without providing collateral.

List of Credit Bureaus in Nigeria

The following are the Credit Bureaus licensed in Nigeria:

1.CreditRegistry Plc;

2.FirstCentral Credit Bureau; and.

3.CRC Credit Bureau.In 2019, the three bureaus formed an association called the Credit Bureau Association of Nigeria (CBAN)

Credit Bureau Data

Data submission is regulated with the use of the Common Data Template which was designed by the CBN, IFC and CBAN and launched in 2016. Data collected are in four categories:

1. Demographic information – name, address, means of identification, registration numbers (for commercial enterprises) etc.

2.Information relating to the credit – principal amount, interest rate, when the facility was granted, how much had been collected etc. Here, there were classifications as well – performing, doubtful, default etc.

3.Information on enquiries made on the customer

4.Information on collateral, Securities. Lawsuits, litigation, returned cheques.

RATING AGENCIES

What are Rating Agencies?

Nigeria’s Securities and Exchange Commission (SEC) simply defines Credit Rating Agencies as “institutions which, as a business, professionally evaluate the investment qualities of debt issues”. In Nigeria, there are just three of them that have been approved by SEC, namely:

1.Agusto & Co Ltd

2.Datapro Ltd

3.Global Credit Ratings Co Ltd

Services of Rating Agencies

In general, the services provided by rating agencies include the following:

1.Credit rating

2.Compliance solutions

3.Data protection compliance

4.Debt recovery

5.Business information services, etcIt is important to note that though credit reports like those of Moody’s, S&P, and Fitch are quite popular in Nigeria, they are not Nigerian rating agencies; or at least Nigerian-based.

CHAPTER SEVEN.

ENVIRONMENTAL AND SOCIAL RISKS MANAGEMENT

7.2 Introduction.

7.2.1 What is Sustainability?

Sustainability means meeting our own needs without compromising the ability of future generations to meet their own needs. In addition to natural resources, we also need social and economic resources. The ultimate goal of sustainability is to secure a “better life for everyone, forever”.

7.2.2 The origin of the term

While the concept of sustainability is a relatively new idea, the movement as a whole has roots in social justice, conservationism, internationalism and other past movements with rich histories.By the end of the twentieth century, many of these ideas had come together in the call for ‘sustainable development.’

7.2.3 Historical Development and Global Initiatives

The Brundtland Commission: In 1983, the United Nations tapped former Norwegian Prime Minister, Gro Harlem Brundtland, to run the new World Commission on Environment and Development. After decades of effort to raise living standards through industrialization, many countries were still dealing with extreme poverty. It seemed that economic development at the cost of ecological health and social equity did not lead to long-lasting prosperity. It was clear that the world needed to find a way to harmonize ecology with prosperity. Environmental Problem

The Commission successfully unified environmentalism with social and economic concerns on the world’s development agenda. Sustainability is a holistic approach that considers ecological, social and economic dimensions, recognizing that all must be considered together to find lasting prosperity.

7.2.4 The three Pillars of Sustainability

ENVIRONMENTAL(Planet)• Polution• land• air• water•Waste Disposal•Deforestation•Natural resources depletion • loss of biodiversity

SOCIAL(People) • human rights• fair labor practices• living conditions• health• safety• wellness, diversity, equity,

ECONOMIC(Profit)•Overconsumption.•Overpopulation.• Poor infrastructure.•Unexplored renewable energy options.•Wastage of energy.• Poor distribution systems.

Each of the above forces has important implications for business which must be understood, assessed and built into long-term strategic planning.”

7.2.5 Global Environmental Issues

Smith (2006) provided the following table that gives a graphic detail of the impact of environmental factors on health and productivity of nations:

Environmental problem

1. Water Pollution and Scarcity. Effect on health – More than 2 million deaths and billions of illnesses a year attributable to pollution and poor hygiene. Effect on productivity – Declining fisheries. Irreversible compaction; constraints on economic activities because of water shortage
2. Air Pollution. Effect on health – Many acute and chronic health impacts; excessive urban particulate matter levels are responsible for premature deaths annually. Effect on productivity – estrictions on vehicle and industrial activity during critical episodes; effect of acid rain on forests and water bodies.
3. Solid and hazardous waste. Effect on health – Diseases spread by rotten garbage and blocked drains. Effect on productivity – Pollution of ground-water resources
4. Soil degradation. Effect on health – Reduced nutrition for poor farmers on depleted soils; greater susceptibility to drought. Effect on productivity – Reduction on field productivity.
5. Deforestation. Effect on health – Localised flooding leading to deaths and disease. Effect on productivity – Loss of potential logging potential and of erosion prevention
6. Loss of bio-diversity. Effect on health – Potential loss of new drugs . Effect on productivity – Reduction of ecosystem adaptability and loss of genetic resources.
7. Atmospheric changes. Effect on health – Possible shift in vector-borne diseases; risk from climatic natural disasters. Effect on productivity – Sea rise damage to coastal in investments; regional changes in agricultural resources.

7.2.6 Importance of Sustainability

Sustainability is important for many reasons including: environmental quality – In order to have healthy communities, we need clean air, natural resources, and a nontoxic environment. The ultimate goal of Sustainability is to use a nation’s resources to meet the needs of current and future generations.____

7.2.7 BUSINESS CASE FOR SUSTAINABILITY

From climate change, to economic disparities, to resources constraints, businesses confront serious and significant environmental and social issues across the value chain. The ability of companies to address these challenges in both the short and long -term will determine the viability and profitability of their operations—as well as the sustainability of their operating environment.

Mallam Sanusi Lamido Sanusi, Governor, Central Bank of Nigeria (CBN) (he later became the Emir of Kano) put it succinctly when he said:i

“If the banking industry agrees not to lend to any company that does not meet certain environmental standards, they will be helping themselves, not just to make money, but also reproduce and recreate the environment, in which they can continue to have long-term profitability.”

“We need to understand that as an industry, we will not continue to take savings and deposits from Nigerians and then lend to companies that will use the funds to destroy the environment. The long-term survival of the system depends on theprotection of the ecosystem.”

Sustainability has become an important factor in business strategies. Large multinationals and mid-sized companies are increasingly taking a long-term view toward managing environmental and social risks. Many companies recognize that by addressing environmental and social issues they can achieve better growth and cost savings, improve their brand and reputation, strengthen stakeholder relations, and boost their bottom line.

Strategic integration of sustainability prepares companies to better anticipate and understand long-term trends and the effects of resource use, and to address stakeholder expectations.

According to a 2011 McKinsey Survey, 76 percent of CEOs consider that strong sustainability performance contributes positively to their businesses in the long -term.

Companies are capitalizing on local conditions and shaping their business strategies to accommodate constraints on natural resources in a way that allows them to develop innovative new products, services, and business models. This also provides opportunities to bolster their growth, profitability and societal value.

The business case for sustainability is also connected to improved reputation and brand value. The global survey of senior executives from around the world conducted by the Economist in 2011 found that 76 percent of respondentsthink that embedding sustainability into the company’s business leads to enhanced reputation and increased brand value. The more a company proves to stakeholders that its business is driven by strong sustainability policies,the lower the risks associated with that company. In contrast, weak environmental, social, and governance (ESG) performance can negatively impact a firm’s reputation, which in many cases can be costly. Shell Company in Nigeria is a good example of how a company’s brand value can be affected by poor sustainability policies. Pollutions in the oil rich Ogoni Land in Nigeria and the attendant class suite gave the company bad image necessitating their abandoning their oil fields.

7.3EQUATOR PRINCIPLES (EP)

Equator Principles Financial Institutions (EPFIs) apply EPs to new projects (globally

Equator Principles Financial Institutions (EPFIs) apply EPs to new projects (globally and across all industry sectors) financed by five financial products:1.Project Finance Advisory Services,2.Project Finance,3.Project-Related Corporate Loans

4.Bridge Loans, 5. Project-Related Refinance, and Project-Related Acquisition Finance.

7.3.1 The Essence of EPs

Equator Principles is intended primarily to provide a minimum standard for due diligence and monitoring to support responsible risk decision-making. The Equator Principles (EP) Association is the unincorporated association of member Equator Principles Financial Institutions (EPFIs) whose object is the administration, management and development of the EPs. It was formed in July 2010 and was instituted to ensure long-term viability and ease of management of the member EPFIs.

The EP Association is governed by a set of Governance Rules which provide guidance

7.3.2 How are the Equator Principles applied?The EPs are based on the International Finance Corporation ‘IFC’ Performance Standards on social and environment sustainability and on the World Bank Group Environmental, Health, and Safety Guidelines. The EPs incorporate these standards and guidelines and provide steps that ‘Equator Principles Financial Institutions’ are to comply with in providing finance for projects.

Adoption of the EPs requires a categorisation of proposed projects into high, medium and low risk classification, depending on the type, location, sensitivity, and theirpotential environmental and social impacts.

Also, the EPs require the provision of mechanisms for addressing:

1.grievances of the project host community – stakeholder’s engagement;

2.independent review of a proposed project;

3.compliance monitoring during the period of the loan; and

4.imposition of reporting obligations by independent social or environmental monitors, as well as reporting by each EPFI, about their EPs implementation processes and experiences annually at the minimum. In the case of high (and where appropriate medium) risk projects, borrower covenants ensuring compliance with EPs are incorporated into the finance documentation.

In practical terms, the EPs are very flexible and allow EPFIs to adapt to the different situations presented by projects. An endorsing entity of the EPs can establish internal policies and processes consistent with the EPs. Furthermore, the EPs do not create any rights or liabilities to any person, public or private. While a borrower must comply with the environmental covenants that lenders include in the loan agreement, lenders are not contractually obliged to comply with the EPs or to enforce them against their borrowers.

A downside of the EPs is that it makes no provisions for any sanctions to EPFIs that do not meet the minimum required compliance threshold. Also, EPFI’s are not allowed to disclose project names and categorisations in their reports, thus hampering transparency.

7.3.3 Effects and trends in the adoption of the Equator Principles in Nigeria.

Nigeria is not left out of the countries with financial institutions that have adopted the EPs. However, only few EPFIs have adopted the EPs in Nigeria. This suggests that the EPs have not been well received by the financial community in Nigeria, and perhaps that the financial sector has not realised the need to balance the drive to maximise the returns on project financing with the demands of social and environmental sustainability.

The level of awareness of the existence of the EPs is still very low in Nigeria and it may not be surprising to find that only a few organisations needing to access funds for projects know about the EPs, and may experience difficulties when requiring funding from EPFIs. Banks too, may find it difficult to access foreign credit lines and may not be able to participate in syndicated loans with EPFIs.

The effectiveness of the EPs has hardly been tested in projects requiring finance in Nigeria. Nigeria suffers a lot environmentally in the exploitation of her resources. Investors in the oil and gas sector for example have had little or no regard for the effectsof their operations on the environment. An application of the EPs in providing funding to investors in the sector may help greatly to improve compliance.

7.4IFC’s PERFORMANCE STANDARDS ON ENVIRONMENTAL AND SOCIAL SUSTAINABILITY.

The IFC Performance Standards on environmental and social sustainability are international benchmarks for identifying and managing environmental and social risks.They have been adopted by many organizations as a key component of their environmental and social risk management. They are eight in number. Banks that wants to obtain loans from IFC, for the use of their clients, should use them as a benchmark for financing capital projects.

PS1 (Performance Standard 1): Assessment and management of Environmental and Social Risks and Impacts;Underscores the importance of identifying E&S risks and impacts, and managing E&S performance throughout the life of a project.

PS 2: Labour and Working Conditions:Recognizes that the pursuit of economic growth through employment creation and income generation should be balanced with protection of basic rights of workers.

PS 3: Resource Efficiency and Pollution Prevention:Recognizes that increased industrial activities and urbanization often generate higher levels of air, water and land pollution, and that there are efficiency opportunities.

PS 4: Community Health, Safety, and Security:Recognizes that projects can bring benefits to communities, but can also increase potential exposure to risks and impacts from incidents, structural failures, and hazardous materials.

PS 5: Land Acquisition and Involuntary Resettlement:Applies to physical or economic displacement resulting from land transactions such as expropriation or negotiated settlements. As the Standard title suggests, those affected and are to be displaced should be properly settled.

PS 6: Biodiversity Management and Sustainable Management of Living Natural

The term “client” is used throughout the Performance Standards broadly to refer to the party responsible for implementing and operating the project that is being financed, or the recipient of the financing, depending on theproject structure and type of financing.

7.5NIGERIAN SUSTAINABLE BANKING PRINCIPLES

In 2012, the Nigerian Bankers’ Committee approved the adoption of the Sustainable Banking Principles by banks, discount houses, and development finance institutions. The principles aim to foster positive development impacts to society while protecting the communities and environment in which financial institutions and their clients operate.The Nigerian Sustainable Banking Principles cover nine principles vis:

1.Environmental and Social Risk Management

2.Environmental and Social Footprint

3.Human Rights

4.Women’s Economic Empowerment

5.Financial Inclusion

6.Environmental and Social Governance

7.Capacity Building

8.Collaborative Partnerships

9.Reporting

7.5.1 What does each of the above Standards mean?

Principles 1 and 2 are regarded as the two umbrella principles, because the two speak to the responsibilities of both bankers and their clients.

The Sustainable Banking Principles and Guidelines are “stepping stones” to guide the Nigerian financial sector in moving toward better practices of managing environmental and social risks, while also promoting “green” finance to support good business opportunities.

Principle 1 – Lending Activities of Banks“We will integrate environmental and social considerations into decision-making processes relating to our Business Activities to avoid, minimize, or off-set negative impacts.”This principle enforces a restriction on providing for or funding businesses that pose a threat to the environment or community in which it resides. Sustainability defines social and environmental risks as environmental pollution, hazards to human health, safety and security, impacts on communities, and threats to a region’s biodiversity and cultural heritage.

Principle 2 – Banks’ own obligations in their operationsWe will avoid, minimize, or off-set the negative impacts of our Business Operations on the environment and local communities in which we operate and, where possible, promote positive impacts. While the first principle focuses on not working with businesses with negative impacts, principle 2 is the commitment a bank makes for itself to not negatively impact the environment or community in which it resides.

Principle 3 – Human RightsWe will respect human rights in our Business Operations and Business Activities. It is the businesses responsibility to ensure that human rights are respected in all aspects of their business. To do so, they need to exercise human rights due diligence, which the four components are identified to be:

2.Identifying and assessing actual or potential adverse human rights impacts that the enterprise may cause or contribute to through its activities or may be directly linked to its operations, products, or services by its business relationships.

3.Integrating findings from impact assessments across relevant company processes and taking appropriate action according to its involvement in the impact.

4.Tracking the effectiveness of measures and processes meant to address adverse human rights impacts to know if they are working.

5.Communicating on how impacts are being addressed and showing stakeholders – in particular affected stakeholders – that there are adequate policies and processes in place.”

Principle 4 – Women Economic Empowerment.

This principle is essential for women because it promotes women’s ability to participate equally, contribute, and benefit from your business without gender prejudice. UN Women defines women’s economic empowerment as “access to and control over productive resources, access to decent work, control over their own time, lives and bodies; and increased voice, agency and meaningful participation in economic decisionmaking at all levels from the household to international institutions.”

Principle 5 – Financial InclusionWe will promote financial inclusion, seeking to provide financial services to individuals and communities that traditionally have had limited or no access to the formal financial sector.

Principle 5 is fundamental because it seeks to provide affordable products/services to disadvantaged and low-income society segments. By doing so, businesses make a positive impacts on the economy and community in their area.

Principle 6 – E & S GovernanceWe will implement robust and transparent E&S governance practices in our respective institutions and assess the E&S governance practices of our clients. According to principle 6, the business is expected to implement E&S governance practices that are available to the public and are required to assess and ensure that clients are doing the same regularly

Principle 7 – Capacity BuildingWe will develop individual, institutional and sector capacity necessary to identify, assess, and manage the environmental and social risks and opportunities associated with our Business Operations. This principle ensures that the company can set and achieve social and economic goals and give staff access to the necessary skills and resources fitting their position in this ever-changing world.

Principle 8 – International PartnershipsWe will collaborate across the sector and leverage international partnerships to accelerate our collective progress and move the sector as one, ensuring our approach is consistent with international standards and Nigeria’s development needs. This principle encourages collaboration between financial institutions rather than independent (and sometimes) selfish competition. This is geared towards a successful implementation of sustainable banking in the country for society’s wellness as a whole.

Principle 9 – ReportingWe will regularly review and report on our progress in meeting these principles at the individual and sector levels. In this principle, the businesses fully commit to reviewing and reporting their sustainability progress to ensure they are reaching principal goals at individual and sector levels.

7.5.2 Priority Areas of NSBPsThe priority focus areas for the sustainability programme were: agriculture (including water resource related issues and the Nigeria Incentive-Based Risk-Sharing System for Agricultural Lending (NIRSAL), power (with an emphasis on renewable energy) and oil and gas.

7.6 ENVIRONMENTAL AND SOCIAL MANAGEMENT SYSTEM (ESMS).

An ESMS helps the Financial Institution to avoid and manage loans/ investments with potential social and environmental risks by conducting social and environmental due diligence prior to disbursement and adequate supervision of projects during the term of the loan/investment agreement.An ESMS ensures that the Financial Institution’s activities are in compliance with its social and environmental standards, for example:

Applicable national laws on environment, health and safety

Nigerian Sustainable Banking Principles and Sector Guidelines

IFC Performance Standards

7.6.1 Benefits of implementing an ESMS include:

1.It improves management of environmental and social risks.

2.Reduces costs and liabilities.

3.In the short to medium term, it helps to improve financial and non-financial performance in meeting business goals and shareholders’ value.

4.It helps to generate innovative financial products and services to capture opportunities in the area of sustainable development.

5.Attracts new customers and taps new markets, i.e., financing of energy saving bulbs.

6.Increases engagements with stakeholders

7.It strengthens brand value, which in turn generates goodwill.

8.Improves access to international capital markets and funding from (Multilateral Financial Institutions) MFIs and (Development Finance Institutions) DFIs

7.6.2 Key components of an ESMS

ESMS consists procedures, management commitment, delineation of roles and responsibilities and guidance to review and manage the E&S issues and risks associated with its lending/investments. These include the following:

1.Brief E&S Policy

2.Outline Applicable Criteria

3.Activities covered by the Social & Environmental Due Diligence (“SEDD”)

4.Detailed Step-by Step SEDD Process (integrated)

5.Responsibilities of the E&S Staff6.E&S Covenants for Legal Agreements

7.Monitoring and Reporting (internal, external)

8.Internal Training and Communication of E&S procedures

Tools of ESMS include:

1.Categorization Guidance

2.SEDD Questionnaires/Forms to be used

7.6.3 E & S RISKS FOR BANKS

1.Credit Risk (default probability; loss given default)The following are the Credit risk types in E & S Risk categorization.•Escalation of project costs (e.g., delays, additional investments) •Fines /penalties due to non-compliance with E&S national requirements •Loss of production capacity (e.g., closure of business) •Poor efficiency leading to low competitiveness/low sales •Increased insurance costs •Site contamination •Poorly maintained equipment

2.Liability Risk•Obtaining ownership of contaminated collateral •Direct liability in the case of strict lender liability •Class actions if made responsible for negative impacts

3.Reputational Risk•Media Coverage

7.7NIGERIAN SUSTAINABLE BANKING PRINCIPLE: POWER SECTOR GUIDELINES

There are specific Guidelines for three sectors, namely: Agriculture; Power; and Oil & Gas.

Overview and Objectives

The Guidelines apply to all corporate lending, project financing, equity and debt,capital market activities, and advisory services provided to new and existing clients in the Power Sector.

They cover the provision of financial products and services for the Power sector which includes, but is not limited to:

1.Power generation sources and associated facilities (i.e., oil, gas and hydropower), except nuclear;

2.Electricity distribution and transmission infrastructure (e.g., upgrades or extensions); and

3.Alternative sources of power generation and associated facilities (e.g., solar, clean coal, wind, biomass, etc.).

Exclusions: The Guidelines do not cover the following:1.Provision of financial products and services for the extraction, processing and transport of energy raw materials (e.g., the extraction of oil and gas, coal and other fuel sources).

The objectives of the guidelines are to:

1.Assist Banks in the identification and management of E&S Risks associated with the provision of financial products and services to these key strategic Nigerian sectors;

2.Provide additional sector‐specific guidance to supplement the Nigerian Sustainable Banking Principles Guidance Note; and

3.Ensure that Banks adopt relevant international standards and best practices in the management of their E&S Risk exposures.

Potential E&S Risks

Risk Types and Potential Risk Issue

A. Environmental

1.Increased Green House Gas emissions, air pollutant emissions, or locations where existing air quality is already poor due to cumulative impacts from combined pollution sources.

2.Not deploying best available control technologies for emissions and waste (e.g., hazardous pollutant deposits in water bodies and land).

3.High water extraction for cooling operations and which will affect water flow and quality to other ecosystem services that require water.

4.Habitat defragmentation with the construction of roads, transmission pylons and distribution lines, increasing access to previously remote areas and natural habitats.

B. Social

5.People and economic displacement (e.g., loss of assets such as land, crops, fisheries, agricultural land, etc.)

6.Conflict with local communities as a result of the siting of plant or storage facilities due to the real and perceived risk of explosion, plants and storage facilities that are situated near populated areas may be of particular concern to local stakeholders.

7.Damaged cultural heritage including UNESCO sites, objects of religious, archaeological, natural significance.

8.Operations in areas subject of natural hazard (e.g., earthquake, extreme weather), which could affect the structural integrity of the plant (e.g., hydropower station or dam)

9.Infringement of labour and human rights.

Power Sector Financing

For activities that fall within the scope of this Guideline, a Bank shall:

1.Undertake appropriate E & S due diligence on power sector clients and activities to identify and assess potential E & S risks, as well as determine a client’s ability to effectively manage identified risks.

2.Bank client to comply with applicable E & S Laws

3.Encourage the concerned client to meet the requirements of the IFC’s Performance Standards and relevant Environmental, Health and Safety guidelines that represent the minimum internationally accepted good practice.

E & S Risk Implementation

Each bank should develop a sector specific E & S approach for its Power Sector Business Activities as part of its Sustainable Banking Policy and E & S

7.8NIGERIAN SUSTAINABLE BANKING PRINCIPLE: AGRICULTURE SECTOR GUIDELINES

Overview

The Guideline have been designed to complement the Nigerian Sustainable Banking Principles whilst focusing on the Agriculture Sector.

The Federal Government of Nigeria is currently accord priority attention to Agriculture and integrated rural development. Agriculture still remains a key sector of the Nigerian economy.

It provides employment for 60- 70% of the population; it constitutes a substantial portion of the total non-oil export earnings and gainfully engages about 90% of the rural dwellers, of which women constitute the majority. The current growth rate of the agricultural sector is about 4.3%. Although over 70% of the nation’s population resides in the rural areas, development policies before now have tended to be urban-biased. Consequently, the rural areas have remained generally disadvantaged relative to the urban areas in term of resources allocation, economic opportunities and infrastructure.

Objectives:

1.Assist Banks in the identification and management of complex E & S risks associated with the provision of financial products and services to the Nigerian Agriculture Sector;

2.Provide additional sector specific guidance to supplement the Nigerian Sustainable Banking Principles Guidance Note;

3.Ensure that Banks adopt relevant international standards and best practices in the management of E & S Guidance Note.

4.Ensure that Banks adopt relevant international standards and best practices in the management of E & S risks and

5.Strategically position Agriculture as an attractive, rewarding and sustainable business opportunity.

Banking Requirement for Agriculture Sector Financing

For all activities that fall within the scope of this Guideline a Bank shall:

1.Conduct E & S risk analysis and assessment of Agricultural clients and activities, and ensure that identified risks are adequately monitored and managed.

2.Adhere to local E & S laws, and where possible encourage other internationally agreed standards.

In addition, and consistent with the Nigeria Incentive Based Risk sharing system for Agricultural Lending (NIRSAL) a Bank shall:

1.Lend towards the establishment and efficient distribution of fertilizer by supporting fertilizer manufacturing companies in Nigeria that produce or procure and distribute fertilizer, as well as a transparent market-driven fertilizer distribution model.

2.Finance the manufacture and distribution of improved and high-quality seeds, by lending to indigenous seed companies and importers of seed varieties.

3.Strive to ensure that farmers are able to procure seeds directly from seed manufacturers, by availing them with adequate finance.

4.With support from industry stakeholders, strive for the establishment of an Agricultural Value Chain Research Development Fund that helps in getting high-quality research.

5.Encourage and finance providers of storage facilities for seeds, produce and other value-added products provided that they take into consideration energy efficiency issues.

6.Encourage and finance processors that add value to local products, whilst taking into consideration the E & S impacts of processing operations.

7.Endeavour to lend to farmers whose products have off takers and whose farming practices protect the E & S impacts of processing operations.

8.While waiting for the reform of the Land Use Act of 1978, lend based on short and long leases that do not displace and or negatively impact on the livelihoods of local communities.

9.Encourage the creation of public-private marketing corporations that provide adequate support to local products.

10. Support the decentralization of agricultural insurance and encourage the development of a vibrant and competitive market for agricultural insurance by a range of companies.

11. Lend with assistance from NISRAL (i.e., technical assistance, risk sharing, insurance and incentive pillars).

12. Lend to promote the use of appropriate and sustainable farm

13. Lend to agro-processors and agro-chemical manufacturers that utilize effective methods to reduce, manage and treat the harmful wastes and do not pollute the environment (i.e., nearby water sources, soil, air, etc).

E&S Risk Implementation

1.A bank should develop a sector specific E & S approach for itsimplementing a robust E & S Management System

1.A bank should develop a sector specific E & S approach for its Agriculture Sector Business Activities as part of its Sustainable Banking Policy and E & S Management System

2.A Bank should seek to implement the recommended guidance as detailed in the Guidance Note appropriately.

3.The Guidance Note incorporates information for developing E & S policies and procedures, as well as, monitoring and reporting E & S risks.

The purpose of categorizing the risks of a potential transaction is to guide banks on the degree of E & S due diligence required to inform credit risk approval or underwriting decision-making and the appropriate level of E & S risk management and monitoring oversight that should be applied to the loan.

Risk Categorization and Interpretation

1. High Risk TransactionActivities carry potential significant advertise E & S risks and or impacts that are diverse, irreversible, or unprecedented.

2. Medium Risk TransactionOne where activities carry potential limited adverse E & S risks and or impacts that are few in number, generally site-specific; largely reversible and readily addressed through mitigation measures.

ValueChainCategoryNameExamplesPotential E&S Risks

Category

3. Health and safety of labour4. Employment practices5. Food safety/consumer health Category 61.Distribution1. Wholesale downstream distributors (export and domestic)2. Specialized services providersEnergy requirements for transportation

7.9NIGERIAN SUSTAINABLE BANKING PRINCIPLE: OIL AND GAS SECTOR GUIDELINES

Overview

Oil is a major source of energy in Nigeria and the world in general. Oil being the mainstay of the Nigerian economy plays a vital role in shaping the economic and political destiny of the country. Although Nigeria’s oil industry was founded at the beginning of the century, it was not until the end of the Nigeria civil war (1967 – 1970) that the oil industry began to play a prominent role in the economic life of the country.

Crude oil discovery has had certain impacts on the Nigerian economy both positively and nagatively. On the negative side, this can be considered with respect to the surrounding communities within which the oil wells are exploited. Some of thecommunities still suffer environmental degradation, which leads to deprivation of means of livelihood and other economic and social factors. Although large proceeds are obtained from the domestic sales and export of petroleum products, its effect on the growth of the Nigerian economy as regards returns and productivity is still questionable.

The Oil & Gas Sector can be broadly divided into the following segments:

1.Upstream. This includes exploration activities; appraisal drilling; development and production; transportation and decommissioning and rehabilitation.

2.Downstream – petroleum refining; transportation and distribution activities via pipelines, roads and sea vessels. It also includes marketing, including product importation and storage.

3. Services – provision of technical support services for the upstream and

Banking Requirement for Oil and Gas Sector FinancingBanks are expected, under this Guideline, to:

1. Undertake appropriate E & S due diligence on Oil and Gas Sector clients and activities to identify and assess potential E & S risks, as well as determine a client’s ability to effectively manage identified risks.

2. Require Oil and Gas Sector clients to comply with Nigerian laws governing E & S issues.

3. Encourage Oil and Gas Sector clients to meet the requirements of the IFC’s Performance Standards and relevant Environmental, Health and Safety (EHS or HSE) Guidelines that represent the minimum international accepted good practice.

E&S Risk Categorization

or ethnic minorities, involve involuntary displacement and resettlement, or affect significant cultural heritage sites.

7. Medium Risk: Transactions typically involve clients/investees with business activities with specific environmental and social impacts that are few in number, generally site-specific, largely reversible and readily addressed through mitigation measures and international best practice. Potential adverse environmental impacts on human populations or environmentally important areas are less adverse than those of High-Risk transactions.

8. Low Risk: Transactions typically involve clients/investees with business activities with minimal or no adverse environmental and social impacts.

CHAPTER EIGHT

FAM PREPARATION AND CREDIT PRESENTATION

8.2Introduction

Credit/Faculty Approval Memorandum is a kind of application form for presenting credit request to a Management Credit Committee or the Board Credit Committee of a lending bank.

The Facility Approval Memorandum has two aspects:

1.the actual information provided in the FAM’ and

2.the oral presentation of the details in Fam within a short period of time in a convincing manner.

There are two methods for Credit Presentation. These are physical when the Board meets in a specific room and the Accounts Officer appears in person to make presentation.

The second method is virtual, using platforms such as “Zoom” and “Teams” to make presentation. Here, time is of essence and the presenter must be conscious of time. Secondly, poor internet connection may be a major reason the Committee members may not follow through the virtual presentation.

Information

The information given in the FAM should be factual or accurate. It should be upto-date. Anything short of the latest information will attract criticism from the Committee. It is also important that sources of information should be quoted/stated.

Information obtained from the Annual Report of the applicant borrower should be clearly stated and distinguished from the ones obtained from independent sources.

All the principles of Credit enunciated in the earlier chapters of the Study Pack should be applied in writing the report. The Account Officer writing FAM should clearly demonstrate that he has applied some of the mnemonics used in credit.

These are outlined below:

1.Character – that the Status or Credit Bureau report is favourable and portrays borrower as someone or an entity with a good track record of loan servicing. The applicant or promoters of the business should not be people with criminal records. So, Account Officers should demonstrate in their writing about the obligor that he is someone or entity that can be entrusted with bank’s resources.

2.Capacity – that the borrower has technical and managerial capacity to manage the business. That he or she can identify appropriate personnel that can run the business. Knowledge, skill and experience that the borrower possesses should be articulated in the FAM.

3.Cashflow – loans are repaid from cash flow generated from operations. Show from the financial statement analysis that the borrower is able to generate enough cashflow from the business to repay interest and loan instalments that will fall due. It should not be encouraged to grant business loans that would be repaid from other sources or from sale of pledgedassets.

4.Capital – the Networth of the borrower should at least cover the loan. This can be arrived at by subtracting total liabilities from the total assets. The Account Officer should show the proprietor’s contribution to the envisaged project. Most banks’ Credit Policy call for equity cash contribution of between 20 to 30percent. The existing investment should not be counted for the purpose of getting equity contribution.

5.Connection – It is the borrower connected with individuals in the bank or government circles? Can the borrower attract equally good credit candidates to the bank? Or can the applicant help the bank to attract customers that are “cash cows” that will shore the bank’s liquidity?

6.Collateral – this is the last to be considered. Show in the write up that the borrower’s pledged assets command enough forced-sale-value that can be realised to repay the loan in the event of difficulties in repaying from the primary source cash flow from the business.

8.3 Broad Outline of the Contents of FAM

The following are, in broad outline the contents of a typical Facility Approval Memorandum in banks.

1.

2.Environmental Scanning – National and industry specific issues

3.Company (or Obligor) Profile

1.Customer borrowing relationships with the lending bank and other lenders. The purpose is to determine customer’s total indebtedness before and after a new loan is granted. This helps in gauging borrowing capacity of the borrower.

Details of the current request, referred to as Facility Structure. This will usually include (but not limited) to the following INFORMATION: Facility Structure

2.Obligor

3.Facility type

4.Facility amount

5.Purpose

6.Tenor

7.Interest rate (state whether is per annum or flat)

8.Repayment Frequency – monthly or quarterly.

9.Facility Fees:

10.Management Fee

11.Processing Fee

12.Maintenance fee

13.Repayment source

14.Availability

15.Transaction dynamics

16.Covenants and conditions precedent to draw-down

17.Security/Support

Facility Summary: A Template:Most bank’s FAM contains facility summary that looks like the template reproduced below:FacilityLLL ImpactAmt (‘000)CcyCurrent Amt (‘000)Proposed Amt (‘000)Change (‘000)TenorDirect Facilities:Term Loan-NOverdraftNTotal DirectNContingent Facilities:NTotal Contingents NTotal FacilitiesNLegal Lending Limit (NgN’000)LLL Impact of Proposed Facility (NgN’000)Any LLL violation? (Yes / No)Director-Related Loan (Yes/No) Note: LLL means Lending Legal Limi

6.2.2 Macro-economic Environmental Analysis

Businesses do not operate in a vacuum. They are often affected by changes in the government Monetary and Fiscal Policies. Analyse current economic indicators and the likely changes that will take place during the life-span of the credit facility being sought. Where you have quoted data, please state the sources. The likely authentic sources include: Central Bank of Nigeria or NDIC publications or websites; African Development Bank; World Bank/IMF; Chamber of Commerce or Ministry of Finance.

Reproducing data without making informed comments on them is wasteful. To analyseis to find out the cause, effect and to make informed judgement on the consequences of the phenomenon observed on the borrower’s business or industry. State what the borrower is doing or can do to mitigate the impact of environmental changes. Separate opinions from facts. Opinions are free but facts are sacred.

6.2.3 Industry Analysis

There are different models that can be used to analyse the industry characteristics and performance. It is important that the business is appropriately grouped into the correct industry.Industry can be classified on the basis of raw materials usage or common finished goods.

Example of Industry classification on the basis of raw materials

1.Cotton Industry

2.Textile Industry

3.Rubber Industry

4.Cocoa Industry

5.Solid Minerals Industry

6.Wood Industry

7.Palm Oil Industry

Industry classification on the basis of Finished goods

Finished Products Basic Raw Material Components

1. Tyre1. Rubber

2. Household Furniture 3. Wood

4. Plastic Furniture5. Plastics

6. Chocolate Drinks7. Cocoa

8. Bread9. Flour

10. Textiles11. Cotton

12.Shoes13. Rubber/ Hides and Skin

Industry Analysis Proper

What are the factors considered in doing an Industry Analysis?Industry is the group of organisations offering products or services that serve the same needs and wants of the target market. The Factors to be considered are –

1.Industry size and growth give the marketer an idea of the demand. Information on the sales, profits, costs, number of firms and employees helps a marketer do the analysis on the growth of the industry in recent years. The life cycle of the industry, demand in the market, and industry size help in formulating strong marketing strategies. The organisation should have concrete data on –1. Why are successful businesses in the industry successful? 2. Why are unsuccessful businesses in the industry unsuccessful?

2.Industry structure is the nature and competition intensity among the firm’s grouped on the basis of their differentiation of the product offerings.

Degree of competition can start from a perfect competition, to a pure monopoly. In between the two there is the duopoly, oligopoly and monopolistic competition. If you are seeking approval for a monopolist, the analyst’s job is made easier because he controls the market as a market leader

The ultimate purpose of knowing the industry size is to ascertain the borrower’s share in the industry sales and profit. The market share is a measure of the borrower’s strength or vulnerability in the industry, when compared with its peers. Find out if the monopoly power is natural or conferred on the customer by government regulation or licence.

3.Entry, Mobility and Exit barriers refer to the barriers a firm faces at different stages in the industry. The huge capital outlay required to set a large plant as well as government regulation can serve as barriers to entry or exit.

4.Cost structure refers to the costs involved in manufacturing, distribution, etc. The cost structure for an airline industry is different from that of a hotel industry. By cost structure, we mean the relationship between the fixed cost and variable cost. It pays a company with high fixed cost to increase its level of production so as to reduce the fixed cost per unit.

5.Degree of Vertical integration is the forward or backward integration within the supply chain. For example, a firm can have its own access to raw materials and distribution apart from manufacturing. This offers advantages as there is complete control on various functions

6.Marketing strategies in the industry also help a lending banker make correct decisions. These are the marketing objectives most relevant to the industry, target market segments (local, international, subsegments, etc.), and marketing mix variables like product features and characteristics, commonly used terms, price variations, promotion tools used, and channels used. The borrower must align its own marketing strategy with that of the industry so as to capture the cash along the value chain.

8.3.1 COMPANY’S PROFILE

Summary on Corporate ProfileIssues for analysis in the FAM:

1.Nature of their business and economic justification of it

2.State the various divisions of their business and characteristics of the final products

3.People – the directors and key management staff – their knowledge, skill and experience and how these are being deployed to achieve the loan purpose

4.Place – state the key locations in terms of manufacturing plants and distribution centres

5.Performance – historical financial performance of the company in a summary form

6.Peculiarities – state the discriminatory competencies that the company has over its peers

7.Major suppliers and length of relationship with them

8.Major buyers – state the structure they put in place for their product distribution

9.Do they have core values? Indicate these and state how the values align with the bank’s own core values.

10. Their existing banking relationships – sanctioned limits and security pledged. The type of charges on the securities.

General Comments on Corporate Profile

There are ten (10) important characteristics of a business, which must feature in the analysis of the company’s profile. The Account Officer must contextualise each of the issues to the business of the loan applicant. The overall purpose of the Corporate Profile is to enable the approving authority know the capabilities and character of the corporate customer, as a business organisation. It is also to show that the company is being run in a sustainable manner.

The following are the ten (10) important characteristics:

1. Economic Activity: For a business enterprise to continue to be relevant, it must generate employment opportunities thereby leading to growth of the economy. It must meet people’s needs within the society it operates. Make a case for the loan applicant in this regard.

2. Business Model: Buying and SellingThe basic activity of any business is trading. The business involves buying of raw materials, plants and machinery, stationary, property, etc. On the other hand, it sells the finished products to the consumers, wholesaler, retailer, etc. The loan application must show that the borrower has capacity to continuously attract and keep good customers to do business with it.

3. Continuous Process: Business is not a single time activity. It is a continuous process of production and distribution of goods and services. A business should be conducted regularly in order to grow and gain regular returns. Demonstrate in the FAM that the business can be run in a sustainable manner through research and innovative ideas.

4. Profit Motive: The primary goal of a business is usually to obtain the highest possible level of profit through the production and sale of goods and services. It is a return on investment. Profit acts as a driving force behind all business activities. Show in the FAM that the business has a track record of profit making (not losses).

5. Risk and Uncertainties:Risk is defined as the effect of uncertainty arising on the objectives of the business. Risk is associated with every business. Business is exposed to two types of risks, Insurable and Non-insurable. Insurable risk is predictable. Show in the FAM that the borrower has mitigated or will mitigate the identified risks. What can the lender on its own do to prevent the identified risks from crystallising? There should be a confirmation that all business assets have or would be insured against Fire.

6. Creative and Dynamic:Modern business is creative and dynamic in nature. Business firm has to come out with creative ideas, approaches and concepts for production and distribution of goods and services. It means to bring things in fresh, new and inventive way.One has to be innovative because the business operates under constantly changing economic, social and technological environment. Business should also come out with new products to satisfy the growing needs of the consumers. Show in the FAM that the borrower is innovative and responsive to the changing external environment.

7. Customer Satisfaction:The phase of business has changed from traditional concept to modern concept. In today’s world, businesses adopt a consumer-oriented approach. Customer satisfaction is the ultimate aim of all economic activities. How is a borrower making business easier for its own customers? Multi-national organisations, especially in the fast- moving consumer goods, help their key distributors to obtain credit from their own banks. The Small and Medium scale retails, who otherwise may not be able to access bank credit on a large-scale, leverage on the financial strength of their major supplier to get bank credit. It is a win-win situation for lenders and their key customers. Always bear in mind to state in your FAM, the following, using the ‘W’ model:

How1.How would the business generate the cash flow to repay the loan as and when due?

Why2.Why is the customer borrowing at this time and why is he approaching our bank and not any other?

When3.When would he need the money? when would cash flow begin to come into the business? When did the business start operations?

What4.What is the borrowing cause and borrowing purpose?

Who5.Who are the promoters of the business? Who introduced the borrower to our bank?

Whom6.To whom is the borrower indebted currently?.

8. Social ActivityBusiness is a socio-economic activity. Both business and society are interdependent. Modern business runs in the area of social responsibility. As a subscriber to the Equator Principles and Nigerian Sustainable Banking Principles, indicate in your FAM that the loan applicant complies with environmental and social laws of the land. Good companies avoid exploitative traits. Workers are paid good wages and given good tools to work with. They show that they care about their immediate environment and other stakeholders.

9. Government ControlBusiness organisations are subject to government control. Government regulations are for the good of the society. Show in the FAM that the borrowing company behaves responsibly and keeps to the laws of the land. That taxes and levies are paid to the various levels of authority. Good companies abstain from financial crimes such as Advance Fee Fraud and Money Laundering. This must be clearly shown in the FAM

10. Optimum Utilisation of Resources:Business facilitates optimum utilisation of countries’ material and non-material resources and achieves economic progress. The FAM should show how the loan applicant does this. The ratios of Return on Assets and Return on Equity are measures of resources utilisation in a company.

8.3.2 Analysis of the Financial Statements of the Borrower

Having spread the numbers in the bank’s prescribed Spread Sheet, these have to be transcribed to the FAM in a summary form. Tabulate the financial performance of the company in the following format:

Financial Indictors 2020 2019

Capitalization – Equity

Turnover – Gross Income

Liquidity

Leverage

Profitability

Working Capital Management

The Account Officer does not need to comment on all the ratios. Comments should be limited to significant items. Bring out things that are not obvious from the ratios. Where changes are noticed, ensure that the cause and effects are highlighted. Management expects the Analyst to make a forecast as to the future financial health of the company, using the trend.Unless there are compelling reasons to justify a recommendation, when the financial indicators are deteriorating consistently, be bold enough to turn down the request. It’s not a good practice to use good money to chase bad one, as this is what it would mean if you grant further loans to a company that is not financially strong.

6.2.6 Analysis of the Profitability of a Lending Proposition

Profitability of a proposal include the following:

1.Interest Income

2.Fees

3.Commissions

4.Penalty charges

5.Residual values of disposed leased assets

Obtain the sum of the above numbers and then deduct from it, the bank’s cost of funds.

Net yield is obtained by: (Gross Income minus Cost of Funds *100%)/(

2. A forty-three percent market share in the soft drink industry

3. Powerful brand recognition on a global scale

4. Secret recipes for their soft drink products

WEAKNESSES

1. Difficulty to keep up with the industry demands

3. Difficulty to change current positioning and customer attitude towards the company

OPPORTUNITIES

1. The company can increase their market share if they listen and adapt to current health trends

2. Relatively few actual competitors on the market

THREATS

3. Companies that are offering healthy alternatives to the prime products

4. Negative press and media coverage can harm the brand in the long term.

To arrive at a recommendation, the credit presenter must show through the SWOT,that:

1.The loan applicants have men and materials that will be utilised to leverage on their strengths and opportunities that the macroeconomy presents to all operators in the market.

2.The environmental threats can be managed, due to long history of operating in the market as well as the relationships they have built in the environment

3.The weaknesses are being addressed and would not be strong enough to prevent the achievement of the loan purpose.

Do not fail to request management to “Please, approve the loan request as presented”!

AT THE PRESENTATION ROOM

Since the Account Officer would not be given the time to say all that he knows about the credit or customer, it is recommended that he uses the acronym “OPARTS” so that the presentation can be structured and sequential.

O – ObligorIntroduce the customer and his business. Make informed statements about his pedigree.

P – PurposeState how the loan purpose aligns with customer’s core business objectives. State the legality and feasibility of the purpose.

R – RepaymentClearly articulate the various sources of repayment. Give assurances how the repayment fund will be collected and from who. State the factors that may delay or prevent the loan from being repaid in full. State what you would do to prevent a default.

T – Terms and covenantsCovenants are the conditions the borrower must fulfil after disbursement to ensure that the loan performs. There are also Conditions precedent to draw-down. There are standard clauses in banks and some are not specific depending on the nature of the business and transaction.

S – SecurityState the security coverage. Is the bank sharing the security with other lenders? State how the bank’s interest is or would be protected.

COMMUNICATION OF APPROVAL OR REJECTION

It is the responsibility of the Risk Management Department or Credit Administration Department, as the case may be, to communicate outcome of the Credit Presentation to the requesting Initiating Business Unit of the bank.

Credit Committee’s decision could be any of the following:

1.Approval of the sum requested and all the conditions attached to the credit request.

2.Approval in Principle, subject to compliance with or amendment of certain parts of the FAM.3.Rejection of the credit request in its entirety.

Customer’s Response to the Bank’s Offer Letter:

1.Accept all the Terms and Conditions contained in the Offer Letter. Signature of the applicant on the offer letter is a prima facie acceptance of the offer.

2.Rejection of the entire offer because of reasons which may be disclosed. For example, the borrower may have been provided with credit by other banks.

3.Acceptance of part of the offer and requesting for a waiver. By waiver we mean that the borrower is requesting the bank to change some of the Terms and Conditions of the offer.

4.Acceptance and then request for a deferral. By deferral, we mean that the borrower is requesting the lender to permit him to draw on the facility and then fulfil the condition(s) at a more opportune time.

Where points ‘b’ to ‘d’ are applicable, the matter should be referred to the Credit Risk Management Department thatwill in turn seek Management’s or Credit Committee’s To present credit successfully and as Accounts Officer, one needs the following skills:

1.Mastery of oral English Language. It is formal presentation, so the presenter should avoid Social Media slangs

2.Good composure – dress well and look good

3.Arm yourself with the facts contained in the FAM

4.The presenter should demonstrate that he wrote the FAM and did not just copy from previous FAM. Take ownership of the contents of the FAM that is being presented to a Committee. You may not have another chance to prove what you know.

5.Demonstrate good understanding of the – external environment, industry and borrowing company’s business. Some numbers must be at your fingertips.

6.Let management know that you have factored in the interest of the bank and that conflicts of interest between the bank’s and customer’s needs have been reconciled.

7.

8.Show that all efforts have been made to up-date information presented. Any of the information that is out-dated should be stated and what you would do to provide update to the Risk Management Department.

9.Bear in mind that Credit Committee members are as knowledgeable (if not more knowledgeable) as you are. So, be very careful when making sweeping statements that are not based on facts.

CHAPTER NINE

PROJECT FEASIBILITY ANALYSIS

9.2 What is a Project?

The commonest definition of a project adopted by C. F. Gray and E. W. Laron (MGraw-Hill, Irwin, 2008) “A Project is defined as a complex, non-routine one-time effort limited by time, budget, resources, and performance specifications designed to meet customer needs.”

9.3 Characteristics of a Project

The major characteristics of a Project are listed below:

1.An established objective;

2.A defined life span with a beginning and an end

3.Usually, the involvement of several departments;

4.Typically, doing something that has never been done before; and

5.Specific time, cost, and performance requirements.

9.4Explain the Concept of Project feasibility

A Feasibility Study is an analysis that takes all of a Project’s relevant factors into account—including economic, technical, legal, and scheduling considerations—to ascertain the likelihood of completing the project successfully.The essence of the study is to ascertain the “doability” of the project in order to achieve its purpose. Banks ultimately look at cash flow that would be generated during the Project’s lifespan. They are concerned to see that the cash flow being generated will be adequate and also come in at the time loan repayment instalments are due. A Project can be profitable but cashflows may be short in coming, leaving the company to depend on borrowed funds with huge cost of capital.

Before cash flow begins to flow into the business, the feasibility report must show the

1.Market and marketing feasibility – are there sufficient consumers who are ready to pay economic rates for the goods or services?

2.Technical feasibility – can the goods be produced? Is the technology and raw materials available locally? For example, 3-modal commercial transport is desirable, but it’s not yet possible to produce it.

4.Financial feasibility – profitability and investment feasibility. Beyond cash flow surplus, would there be excess of revenue over cost? Put differently, would the revenue be greater than the expenditure/cost during the project’s life-span?

Feasibility Study Report can:

1.Provide a Planning Process to articulate Project’s Vision

2.Articulate the Project’s Context

3.Test Project’s Assumptions

4.Identify the Scope of Work

7.Determine whether the Project is feasible (viable).

8.Build confidence in the Project internally and externally. Aggressive promotion and continuous stakeholder’s engagement will be necessary. The issue of stakeholders’ engagement is explained in greater details in the Chapter on Environmental and Social Risks Management Framework for Banks.

There are many types of feasibility studies. For a complex or larger capital project, you may need to commission a series of studies to tackle different dimensions of the project, including:

Preliminary feasibility study

1.Architectural feasibility study

2.Project feasibility analysis

3.Market feasibility study

4.Fundraising feasibility study

This allows project sponsors to assess if a project idea is really viable before it has even reached the drawing board. During the early stages of a project, the feasibility study serves to test the project vision. After sufficient research has been done, key stakeholders have been engaged, and a project vision developed, the feasibility study is then used as a tool to examine all of the factors directly and indirectly associated with the project.

The preliminary feasibility study has the potential to be acid test to check whether the

Strategic Questions:

The Strategic Questions which the initial project feasibility study will show include:

1.Is the consumer need identified in the project vision real and is the project vision best framed to serve that need? This is particularly important if you are dealing with people who hold political offices who are out to impress the public. The intention of such individual could be altruistic instead of economic or financial viability. Projects incubated under this circumstance are often abandoned, especially if the politically exposed person lost out of power.

2.Does the project make sense financially for both the pre-development and capital costs and for the ongoing operational commitments?

Technical Questions

These should include:

2.What should be our attitude as lending bankers to funding this type of project given our risk appetite as well as project features? Can we establish a case for leverage funding from multi-lateral organisations such as International Finance Corporation and our local Bank of Industry or Bank of Agriculture?

3.Is the project likely to be able to carry no or low capital debt in order to ensure operational affordability? Even where debt is required, it is still possible to change from outright purchase to finance lease in order to reduce heavy capital outlay from the project sponsors.

5.Is there a credible revenue model for operations? On what assumption is it based? You need to test quantity and pricing assumptions in the forecasts provided. Your criticisms comments must be based on known available facts, not imagination(s).

6.In the case of a preferred site or location, is it suitable for the proposed vision, use and business model? Are there existing constraints or challenges associated with the site (for example zoning restrictions or contaminated land)? Project sponsors should consider the economic principles of nearness to raw materials or nearness to consumers. The cost and benefits should be considered.

Organizational Questions should include:

1.Do the sponsors have the organizational capacity and commitment to take this project on? Is there any skill gap and can this be filled internally and/or externally? How do they hope to address this issue?

9.5The Elements of a Good Feasibility Study

The following are the parts of an effective Feasibility Study:

1. The Project Scope which is used to define the business problem and/or opportunity to be addressed. It is also necessary to define the parts of the business affected either directly or indirectly, including project participants and end-user areas affected by the project.

2. The Current Position Analysis is used to define and understand the current method of delivering a service, product or the system that drives it. From this current position audit, it is possible to discover that the current service, product or system is in order except for some misunderstandings. What may be required could be some simple modifications as opposed to a major restructuring. Also, the strengths and weaknesses of the current approach are identified.

9.6Feasibility Report Structure

1. Introduction

This aspect deals with the provision of background information about the proposed business, data collection method, the proposed name, and purpose of the business.• Who are the investors?

• Do they have the experience and skill to successfully launch the business?

• What is motivating the project sponsors to establish the business?

• How did they come about the business idea?

2. Description of the Business

This section deals with the statement about the business, the product to be offered, the nature of the industry and the opportunities available to exploit. Issues addressed here include:

• What type of goods the business will sell or services to be offered?

• The target buyers or users

• Product uses or applications? Is it an intermediate product used for further production or a final consumer product?

• What are the assurances that the target market will accept the product?

• What are the factors that will affect the proposed business positively and negatively?

• How will the product/service be used?

• What strategy to adopt to ensure market penetration?

• What are the destructive features that will not enable your product to compete effectively?

• Are there opportunities for future expansion?

3. Market Consideration – A Preliminary EvaluationThis involves determining current and potential demand for the product in the market area of interest, the social-economic characteristics of buyers and sales forecast over the first three years. This section is one of the most difficult to prepare and yet one of the most important.Almost all aspects of the feasibility report depends on Market Consideration. It is therefore, advisable that prospective entrepreneurs should prepare this section before they do any other aspect. In addition, enough time and skill should be devoted to this

• What aspect of the product may be disapproved by the potential customers?

• How will the project sponsor overcome negative customer reaction?

• What is the geographical site of the current total market for the product or service to be rendered?

• What are the competitors’ strengths?
  
• 1.
  How can the company minimise the impact of the deployment of the full
  strength of the competitors?
• How will the company continue to access the Target Market?
• What company’s products or service should be used to benchmark against its
  production improvement programme?

1. Management Team
   The section will provide a description of the key Management personnel and their
   primary duties, the Organizations’ Structure and the Board of Directors. The
   questions answered by this section include:

• Who are the key Management members?
• What are the roles of key Management members in the company?
• Who will fill each position?
• What are the exact duties and responsibilities of the key members of the
  Management Team?
• What is the philosophy of the organization as to the size and composition of the
  Board of Directors?
• How many numbers of skilled, semi-skilled and unskilled workers would the
  company require?
• What is the monthly wage bill?

5. Technical Plan

This section describes the facilities, plant location, space requirement, inventory control decisions, purchasing, production control, factory, and administrative building, machinery and equipment, raw materials and components utilities, etc.

• Choice of location and rationale?• What are the facilities needed e.g., building, space?

• Proposal for future expansion, even when the business is starting on a small scale?

• Manufacturing processes to be adopted?• Raw materials for production and their sources of supply? • proposed machines specifications: suppliers and prices (Cost & Freight)

• Production level at full capacity of the plant?

• What is the input-output ratio?

• A statement about inventory management, quality, and scheduling of production?

•What is the volume of utilities (e.g., electricity and water) needed for the successful launching of the business?

6. Marketing Plans

The Marketing Plans describe how the sales projection will be achieved. The plans also describe the overall marketing strategy, sales and service policies, pricing, distribution, and advertising strategies. The questions addressed by the Marketing Plans include:

Comprehensive Income Statement is the statement that provides information about the profitability of a company. All businesses are created to ensure that they generate revenue that is higher than total expenses associated with running the business.

7. Critical Risks and Problems

1.Business plans must identify and describe the implicit assumption about the major risks and problems of the proposed investment opportunity.This should include a description of the risks relating to:

2.the industry,

3.company and its management

4.company’s product’s market appeal and

5.the timing and financing of a new venture

6.Identification and description of risks of a proposed Project. The possible risks are:

1.Likely impact of potential price war by competition on organization success? This is particularly important where the industry is highly competitive and price is used as instrument of the “strategic war.”

2.Threats posed by the potential changes in the industry? Changes are usually engineered by rapid changes in technology or consumer tastes.

3.Likely price escalation due to sudden adverse exchange rate depreciation, leading to high inflation rate in the domestic economy. In a galloping inflationary period, costs of goods sold and operating expenses rise faster than it is possible to increase price of final product. The impact of this is shrinking gross and net profit margins.

4.Possibilities that sales projections may not be achieved due to external influences. Internal and external security crisis in the country can produce sharp gap between projected sales volume and actual sales volume. During unforeseen crisis period, it is difficult to push up sales because the environment for business to thrive does not exist.

5.likelihood that production schedule and delivery time may not be met

6.Breakdown of machinery or failure of supplies to meet firm orders for raw materials.

7.likely difficulties in procuring raw materials at price that the business can afford. This is especially so, if the goods are being imported from foreign countries.

8.Likely impact of changes in government policies on needed credit pricing. Changes in Monetary Policy Rate (MPR) will necessarily affect loan pricing.

9.What are the potential challenges likely to be posed by the competition?

8. Financial and Economic PlanThe Financial and Economic Plan provides the basic foundation for the evaluation of an investment opportunity. The purpose is to indicate the ventures; potential and the time table for financial viability. For example, the payback period or the earliest period when Net Present Value of future cashflows will be equal to zero.The areas covered include:

• Preparation of Forecast Comprehensive Income Statement

• Preparation of Forecast Cash Flow Analysis, indicating cashflow from operations, net cashflow from investing activities and net cashflow from financing activities.

• Preparation of Forecast Statement of Financial Position

• Preparation of the Break-Even Analysis showing break even quantity and price

• Description of the Methods of Cost Control. This requires instituting financial control policy indicating thresholds for approvals of financial commitments.

Other Practical Questions/issues under Finance include:

1.estimated total project cost and available capital funds in order to arrive at the funding gap

• alternative methods for raising money and rationale for the ones chosen

• the long-term funding that is required and in what proportion. Long-term funding includes Debentures, Term Loans, Preference Shares and Ordinary Share capital.

• What is the unit price and the total amount of securities to be offered to secure bank facility? Would there be enough security coverage, in line with bank’s Credit Policy.

• How many shares will be held by members of the management team?

• How will the funds be used? A detail outline of the uses of the external funds being sourced.

• What are the major areas of expenditure? A breakdown of expenditures on noncurrent assets will be required.

• How much knowledge of government policies concerning the product or industry?• How is Profit defined? How is this determined in the Forecast Comprehensive Income Statement?

• How will the Balance Sheet look like?

• How will the Cash Flow Statement look like?

• What is the Break- Even Poi• How will the company monitor and control cash in order to meet the Projected

2.Payback period,

10. Lending Banker and Feasibility ReportSMEs and established companies going into new product lines require a feasibility report. Bearing in mind that feasibility reports are meant for different stakeholders, a Lending Banker financing capital projects must seek answers to the following questions:

3.

5.Are the cultures and religious idiosyncrasies accommodative of the new venture or product? For example, proposal to produce tobacco or alcoholic drinks in a predominantly Islamic State will be dead on arrival. In any case, the required approval will not be forthcoming from the appropriate State and Local Council authorities.

CHAPTER TEN

OVERVIEW OF FINANCIAL STATEMENT ANALYSIS METHODOLOGIES FOR CREDIT ADMINISTRATION

10.2 STRUCTURE OF FINANCIAL STATEMENTS1.

The International Financial Reporting Standards (IFRS) requires a complete set of Financial Statements to be made by an entity annually, with comparative amounts for the preceding year (including comparative amounts in the Notes); provides guidelines for their structure and minimumdisclosure requirements. Each published statements should contain the following:

1.

2.A Statement of Profit and Loss

3.Other Comprehensive Income

4.Statement of Changes in Equity; and

5.Statement of Cash Flows.

6.Notes to the Accounts

7.Chairman’s Statement

8.Directors Report

9.Audit Committee Report.

Definition

banker to assess the financial health of an organisation in terms of Liquidity Risk, Long

10.4 Classification of Components

Statement of Financial Position consists of the following key elements:

2.Assets are also classified in the Statement of Financial Position on the basis of their nature:

2.

3.Trade Receivables include the amounts that are recoverable from customers upon credit sales.

4.Cash and Cash Equivalents include cash in hand along with any short-term investments that are readily convertible into known amounts of cash.

Liabilities

1.A liability is an obligation that a business owes to someone and its settlement involves the transfer of cash or other resources. Liabilities must be classified in the Statement of Financial Position as Current or NonCurrent depending on the duration over which the entity intends to settle aliability. A liability which will be settled over the long-term is classified as non-Current whereas those liabilities that are expected to be settled within one year from the reporting date are classified as Current Liabilities.

2.Liabilities are also classified in the Statement of Financial Position on the basis of their nature:

insignificant to be presented separately on the face of the Balance Sheet are also classified in this category.4.Short-term borrowings typically include Bank Overdrafts and Short-term Bank Loans with a repayment schedule of less than 12 months.5.Long-term borrowings comprise loans which are to be repaid over a period that exceeds one year. Current portion of long-term borrowings include the installments of long-term borrowings that are due within one year of the reporting date.6.Current Tax Payable is usually presented as a separate line item in the Statement of Financial Position due to the materiality of the amount.

Equity

1.Equity (also called Shareholders Fund) is what the business owes to its owners. Equity is derived by deducting total liabilities from the total assets. It therefore, represents the residual interest in the business that belongs to the owners.

2.Equity is usually presented in the Statement of Financial Position under the following categories:

3. Share capital represents the amount invested by the owners in the entity

1. Retained Earnings comprises the total net profit or loss retained in the business after distribution in the form of dividends to the owners.

2. Revaluation Reserve contains the net surplus of any upward revaluation of property, plant and equipment recognized directly in equity.

Note the Accounting Equation: Total Assets = Liabilities + Equity. This implies

10.5 Sample of Statement of Financial Position

Prime Paints Plc

Total Equity and Liabilities284,085320,042Income StatementPrime Paints PlcStatement of Profit and Loss and Other Comprehensive Income for the year ended December 31, 2018`20202019₦’000₦’000Revenue190,510281,842Cost of Sales(141,265)(189,012)Gross Profit49,24592,830Other operating income23215Selling distribution expenses(25,145)(24,945)Administrative expenses(68,566)(74,750)Operating Profit / (Loss)(44,234)(6,850)Finance costs(32,161)(25,392)Profit / (Loss) before Taxation(76,395)(32,242)Income tax credit / expenses22,492(1,314)Profit / (Loss) for the year(53,903)(33,556)Other comprehensive Income not to be reclassified to Profit or LossNet gain on re-valuation of Land and Buildings–Income Tax effect–Other comprehensive income Tax for the year net of tax–Total comprehensive Income for the year, net of tax(53,903)(33,556)Profit / (Loss) for the year is attributable to:Ordinary Equity Holders(53,903)(33,556)Earnings Per Share:Basic diluted (loss) / Earnings per share (kobo)(44k)(27k)

Comprehensive Income Statement is the statement that provides information about the profitability of a company. All businesses are created to ensure that they generate revenue that is higher than total expenses associated with running the business.

Gross Revenue is derived by multiplying the total number of units of goods sold by the average unit price. This amount determines the overall operating result. When the Cost of Goods Sold is subtracted from the Gross Revenue, the company arrives at Gross Profit.

Operating Expenses are removed from the Gross Profit to arrive at Earnings Before Interest and Tax (EBIT). Deducting tax from EBIT, we arrive at Net Earnings or Profit After Tax (PAT). The importance of this segmentation will be noted when we apply several techniques of financial statement analysis.

10.6 Historical Cash Flow Statement

1.This is the third most important financial statements. Cash flow statement captures the volume of cash that flowed in and out of the company during an accounting period.

2.There three major segments. 1.Cashflow from Operations2.Cash flow from Investing Activities3.Cash flow from Financing Activities.

3.Cash flow from operations captures cash that came into the company and cash that the company left in the course of normal trading activities.

4.Cash flow from investing captures cash flow from all forms of investing activities. For example, when a company buys Non-Current Assets, it’s a form of investment that takes money out of the company, hence, an outflow of resulting from investing activities. The reverse is the case when Non-Current Assets are sold, proceeds come into the company as an inflow.

5.Cash flow from financing activities arise from raising of new capital or long-term loans. Overdraft does not feature as a financing activity in the cash flow statement. Rather, Overdraft will reflect as negative closing cash balance.

6.The sum of the net cash flow from: Operating, Investing and FinancingActivities, results in the Net Cash Flow for the year.

7.Net Cash Flow for the year is then added to the Opening Cash Balance for the year to arrive at Closing Cash Balance.

8.The Closing Cash Balance must agree with the Net Cash Position in the Statement of Financial Position. In the example given a rough check of the addition of short-term credit and bank balance will give the Net Cash position for the year in the Statement of Cashflow, that is: N2,717 -N122,342 = (N119,625).

Prime Paints Plc

Repayment of loans and borrowings

Why is Cash flow statement important?Cash flow statement is important to lending bankers because loans are repaid from a borrower’s cash flow, not from the income. Accounting concept of “Accrual” explains that not all expenditures are paid for in the period when they are incurred. Similarly, not all earnings are received in cash immediately contracts of sale are concluded. There are all forms of credit allowed in commercial transaction, which tend to create timing differences between earnings and cash receipt periods.

10.7 TOOLS OF FINANCIAL STATEMENT ANALYSIS

The following are some of the tools for financial statement analysis.

1.Trend analysis

2.Common sizing

3.Ratio analysis

4.Industry analysis

ILLUSTRATIVE EXAMPLES

Practical Demonstration of the three key tools of financial statement analysis. We shalluse the financial of Gee Esky Plc to illustrate the point.Gee Esky Plc

Industry: Pharmaceuticals

Cash and bank balances 3,860,298 3,388,944 Assets classified as asset held for sale – 141,868 16,293,131 13,338,313 TOTAL ASSETS 18,684,558 15,700,216 EQUITY AND LIABILITIES EQUITY AND LIABILITIES Issued share capital 597,939 597,939 Share Premium 51,395 51,395 Retained earnings 8,331,091 8,001,857 Total Equity 8,980,425 8,651,191 Non-current liabilities Deferred tax – 107,085 Total Non-Current Liabilities 0107085Trade and other payables 8,898,719 6,434,732 Contract liabilities 156,835 225,000 Refund liabilities – 58,475 Bank overdraft149,5340Income tax payable499,045223,733Total current liabilities 9,704,133 6,941,940 Total Liabilities 9,704,133 7,049,025 Total Equity and liabilities 18,684,558 15,700,216 Statement of Cash FlowsCash flows from operating activitiesN’000N’00020192018Profit for the year 926,054 618,389 Adjustment for:Income tax expense recognised in P & L 252,228 542,435 Depreciation of PPE 350,736 377,724 Loss/Gain on disposal of NCA 4,830 – 5,716 Interest on Term deposit- 227,587 – 379,410 Other adjustments to PPE 1,149 – Unrealised exchange loss/gain – 24,632 Impaired loss on assets held for sale 141,869 –

Net impairment of trade and other

10.8 ANALYTICAL TOOLS AND APPLICATION

TREND ANALYSIS

Trend Analysis. evaluates an organization’s financial information over a period of time. The goal is to calculate and analyse the amount of change and percent changes from one period to the other.

Trend Analysis is a form of horizonal analysis

Annual Percentage Change

Trend Analysis

The usefulness of trend analysis could be likened to Index Numbers in Statistics. The base year can be any year where prices or business is considered stable. The other years’performances or results are then compared to the base year. Because a common base year is used for the series of data, it becomes easier to interpret how the company has performed in the various years.

To speak of trend means we should have more than two years data for our analysis. Where we have two years financial, we can regard this as Horizontal Analysis or percentage change.

Compared to Trend analysis, percentage changes have a huge weakness in that they do not consider how the company had performed in prior years. Take for example, if a company performed exceptionally well two or three years ago, percentage change ignores such a performance. In any event, the two methods (i.e., trend analysis and percentage change) pick on one item in the financials and consider changes in some set years.

We have extracted the five-year financial summary of our Case Study, GEE ESKY PLC, a company listed on the Nigerian Stock Exchange. These (five-year financial summary) include: The Statement of Financial Position and Profit & Loss Account. After this, we present the worked example of a horizontal analysis for the two statements.

Percentage Change – An ExampleN’M20152016201720182019Net Sales775760830875910Cost of Goods Sold460441483510573Gross Profit315319347365337Source: Jae K. Shim (2008): Analysis and Uses of Financial Statements, p.55Solution – Trend AnalysisN’M20152016201720182019Net Sales10098107113117Cost of Goods Sold10096105111125Gross Profit100101110116107Horizontal Analysis – A Simplified ExampleData source: GEE ESKY PLC Financial Statements, 5-year summaryCurrent Year’s Figure x 100 Base Year’s Figure

DataDataAnnual % ChangeDataAnnual % ChangeFinancial Performance201920182018/201920172017/2018Turnover 20,760,320 18,411,475 13% 16,089,728 14%Gross Profit 6,052,300 5,928,151 2% 4,479,568 32%Profit before interest and tax 1,178,281 1,160,824 2% 1,123,136 3%GEE ESKY PLCSTATEMENT OF FINANCIAL POSITION N’000N’000N’000N’000N’00020192018201720162015ASSETS EMPLOYEDNon-Current Assets 2,391,427 2,361,903 2,315,080 2,124,055 13,874,402 Deferred tax asset – – – 637,836 Net Current Assets/(Liabilities) 6,588,998 6,396,373 14,665,137 14,092,089 1,128,663 Deferred tax asset liabilities – – 107,085 – – – 1,839,343 Retirement benefits – – – – 302 – 169,245 8,980,425 8,651,191 16,980,217 16,853,678 12,994,477 FINANCED BY Share Capital 597,939 597,939 597,939 597,939 597,939 Share Premium 51,395 51,395 51,395 51,395 51,395 Retained earnings 8,331,091 8001857 16330883 16,204,344 12,345,143 Total Equity 8,980,425 8,651,191 16,980,217 16,853,678 12,994,477 Trend Analysis of the Statement of Financial Position is shown below: Year 2016 as the BaseHorizontal Analysis of the Statement of Financial Position of GEE ESKY PLC2019 2018 2017 20162015ASSETS EMPLOYEDNon-Current Assets 113 111 109 100 653 Deferred tax assetNet Current Assets/(Liabilities) 47 45 104 100 8 Deferred tax asset liabilities – Retirement benefits –

Analysis

The above trend shows that year 2016 is an exceptional year, as it would seem some items in the statement of financial position were reclassified. Readers are enjoined to check the figure between non-current assets and Net current assets for that year. Because of the unusually high level of non-current assets in year 2015, the index was 653 compared to 100 in 2016 (base year). Non-current assets which were N13.9 billion in 2015 shrank to N2.1 billion in 2016. This lower figure of non-current assets remained comparable between 2016 and 2019. The scenario painted by the drastic reduction in non-current account assets could happen probably where the company agree on a Sale and Lease Back. This implies that the Company sold its non-current assets to the Bank in return for a working capital facility. In this wise, legal title of those non-current assets passed to the bank, though the company retains possession.In real lending situation, Credit Officer needs to find out the significant change in the non-current assets figures between 2015 and 2016. Of note is that the Index of Noncurrent assets, moved moderately from 100 in 2016 to 113 in 2019, which is to be expected.

Five-Year Summary of the Profit or Loss AccountThe Data:FIVE-YEAR SUMMARYGEE ESKY PLC Turnover and ProfitN’000N’000N’000N’000N’00020192018201720162015Turnover 20,760,320 18,411,475 16,089,728 14,384,785 15,391,585 Gross Profit 6,052,300 5,928,151 4,479,568 8,966,411 5,425,772 Profit before interest and tax 1,178,281 1,160,824 1,123,1 36 185,999 1,057,920 Interest charges – – – – 108 – 1,040 Profit before tax 1,178,281 1,160,824 1,123,136 185,891 1,056,880 Taxation- 252,227 – 542,435 – 637,836 2,192,254 – 192,467 Profit for the year 926,054 618,389 485,300 2,378,145 864,413 Trend Analysis of the above 5-year financial SummaryTurnover and Profit 2019 2018 20172016 2015Turnover 144 128 112 100 107 Gross Profit 67 66 50 100 61 Profit before interest and tax 633 624 604 100 569Taxation- 12 – 25 – 29 100 – 9Profit for the year 39 26 20 100 36Analysis

Turnover index increased by twelve basis point in 2017; it further increased by six basis point in 2018. The improvement in the company’s revenue performance can be deduced from the quantum increase in the index by 16 basis point in 2019.In terms of profit performance, there were consistent improvements over the fiveyear period. From the index of 100 in year 2016 profit after tax trend index increased to 634 in 2019. This is significant given the challenges in the Nigerian economy during the period. The profit performance of 2016 is suspect, starting from the gross profit down to the net profit for the year. Since we do not have the detailed financials, it could well have been financial engineering or exceptional income derived that year. As noted during discussions on the Statement of Financial Positions, the company took some significant financial decisions in 2016 to clean its books.The net profit for the year (2016) amounting to N2,378,145,000 raises suspicion when in fact profit before interest and tax was a meagre N185, 891,000.

10.9 COMMON SIZING

A common size financial statement displays items as a percentage of a common base figure, total sales revenue, for example. This type of financial statement allows for easy analysis between companies, or between periods, for the same company.Depending on what the analyst is trying to establish and use to which he wishes to put the common-sized financial statement, the following are recommended as base:

Financial measureRecommended baseIncome statementTurnoverStatement of Financial positionTotal AssetsCash flow statement

Net Operating Cashflows

Example: Common-sized FinanGEE ESKY PLC

Other Assets

Interpretation of the above Common-sized Statement of Financial Position

The common-sized statement of financial position helps us to understand possible changes in the structure of a company’s finances. It depicts relationships between assets classes and liabilities and equity.

Total Assets increased from N15.7billion to N18.7 billion, an increase of about 19percent in the period under review.

1.Consider the following data and compute the percentage change in the two years and make some comments.Clover CorporationComparative Statement of Financial Positions at DecemberAssets20182019 Naira Change PercentagechangeCurrent Assets:??Cash and equivalents12,00023,500????Accounts receivable, net60,00040,000????Inventory80,000100,000????Prepaid expenses3,0001,200????Total Current Assets155,000164,700????Property and equivalent????Land40,00040,000????Buildings and equipment120,00085,000????Total PPE160,000125,000????TOTAL ASSETS315,000289,700????

Solution to Question 1

No. 2. Worked Example on Trend Analysis

Gross Profit115,000105,00095,00092,00085,000No. 2 SolutionBerry ProductsIncome InformationItem20192018201720162015Gross Revenue145%129%116%105%100%Cost of Sales150%132%118%104%100%Gross Profit135%124%112%108%100%Question No.3 on Common-sizing (Vertical analysis)Study the data below and convert them to common-sized income statement:Majolate Nigeria LimitedIncome Statement=N=20182019Revenues520,000480,000Costs and expenses: Cost of sales 360,000 315,000 Selling and admin. 128,600 126,000 Interest expense 6,400 7,000Income before taxes25,00032,000Income taxes (30%) 7,500 9,600Net income=N= 17,500=N= 22,400

Majolate Nigeria LimitedComparative Income StatementsFor the Years Ended December 31,Common-size Percents*=N=2019201820192018Revenues520,000480,000100.0%100.0%Costs and expenses: Cost of sales 360,000 315,00069.2%65.6% Selling and admin. 128,600 126,00024.7%26.3% Interest expense 6,400 7,0001.2%1.5%Income before taxes25,00032,0004.8%6.7%Income taxes (30%) 7,500 9,6001.4%2.0%Net income=N= 17,500=N= 22,4003.4%4.7%

CHAPTER ELEVEN

11.2 Introduction to Ratios

Financial analysis is essentially a performance evaluation of managers of the borrowing

11.3 TYPES OF RATIOS

1.Suppliers may cut suppliers of needed raw materials and that may lead to insolvency;

3.

Types of Liquidity Ratios

These are three

(a) Current Ratios;

(b) Quick or Acid Test Ratios; and

(c) Cash Ratios.

worth of current assets to meet it. It is the practice in financial analysis to match the tenor of assets with tenor of liabilities. Current ratio is one of the few ratios that have an international benchmark. The benchmark for Current Ratio is 2: 1.

Quick Ratio

Another name for this ratio is Acid Test Ratio. This is a quick test for liquidity. It ignores items, particularly, inventory which takes longer time to convert to cash.The formula for determination of Quick Ratio is: 𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =𝑇𝑜𝑡𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝑙𝑒𝑠𝑠 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 (𝑆𝑡𝑜𝑐𝑘)/𝑇𝑜𝑡𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Computation of Liquidity Ratios using the following:

201720182019Assets Current assets: Cash 167,971181,210183,715Accounts Receivable 5,1005,9046,567Prepaid expenses 4,8065,5135,170Inventory 7,8059,6019,825Total Current Assets 185,682202,228205,277Property & Equipment 45,50042,35040,145Goodwill 3,5803,4603,910Total Assets 234,762248,038249,332LiabilitiesCurrent liabilities: Accounts Payable 3,9024,8004,912Accrued expenses 1,3201,5411,662

Unearned revenue 1,5401,5601,853Total Current Liabilities 6,7627,9018,427Long-term debt 50,00050,00030,000Other long-termLiabilities 5,5265,8725,565Total Liabilities 62,28863,77343,992Shareholders’ Equity:Equity Capital 170,000170,000170,000Retained Earnings 2,47414,26535,340Shareholder’s Equity 172,474184,265205,340Total Liabilities & Shareholder’s Equity 234,762248,038249,332Source: Corporate Finance Institute proforma of Statement of Financial Position COMPUTATION OF CURRENT RATIO (CR)201720182019 Comments on the ratiosTotal current assets 185,682 202,228 205,277 Total current liabilities 6,762 7,901 8,427 Current Ratio𝐶𝑅 =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠27.525.624.4High liquidity that is far above the threshold of 2: 1. However, it’s deteriorating.COMPUTATION OF QUICK/ACID TEST RATIO (QR/ATR)201720182019Total current assets 185,682 202,228 205,277 Total current liabilities 6,762 7,901 8,427 Inventory7,8059,6019,825Total current assets less Inventory 177,877 192,627 195,452 Total current liabilities 6,762 7,901 8,427 Quick / Acid Test Ratios

𝑄𝑅=𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝑙𝑒𝑠𝑠 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠𝑇𝑜𝑡𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠26.324.423.2Good liquidity, but deteriorating. Higher than the benchmark of 1: 1.COMPUTATION OF CASH RATIO201720182019Cash 167,971 181,210 183,715 Total current liabilities 6,762 7,901 8,427 Cash RatiosCash 24.822.921.8Good and healthy cash positionTotal current liabilities

Long-Term Solvency Ratios (Leverage)These ratios measure the degree of indebtedness or capitalization of the target company.

1.Total Debt to Assets Ratio

2.Debt to Equity. Note that: (Debt = Total liabilities)

3.Debt to Equity Ratio (Debt = interest bearing liabilities only)

4.Interest Coverage Ratio

5.Shareholders’ Equity to Total Assets Ratio

6.Long-Term Debt to Total Liabilities Ratio

1.Total Debt-to-Assets RatioThis ratio relates total liabilities of the company to the total assets. Notionally, the ratio measures the potential claims of all creditors and third parties in the assets of the company, in the event of liquidation.The formula is given as:

Formula = Total Liabilities/Total Assets

Description: It can be expressed as a percentage or ratio. i.e., 40% or 2: 3. What this implies is that about 40percent of the company’s total assets were financed by third parties.Note: a lower or reducing ratio is preferred, which implies that stake of external parties is declining

ii. Total Liabilities to Equity

Description: This is better expressed in ratio form of say: 1.5: 1. A ratio with a result as this shows that the business is financed more by external parties. Readers should bear in mind that the total liabilities are not all interest bearing. For example, tax payable and dividend payable are part of the total liabilities. A reducing ratio is preferred implying that the stakes of shareholders are increasing.

1.Debt to Equity Ratio (Debt = interest bearing liabilities only)This is a finer measure of leverage which compares with the total amount of medium to long-term loans and debentures to the shareholders’ funds. A higher ratio means a deterioration to a lender. This is because the more a company uses interest bearing funds, the more likely that default may trigger actions by lenders or creditors. For example, debentures give right to debenture holders which can be exercised to the detriment of the lending banker.

Formula: Loans + Debenture/Shareholders’ Funds

Description: This is also expressed as 3: 1 or 2.5: 1. A ratio of 3: 1 means that for every N1.00 contributed by shareholders in the business, external parties contributed N3 by way of long-term loans or debentures.A lower ratio is preferred by a lender

2.

any

Formula: Shareholders’ Funds/Total Assets

Description:

would include: short and long-term liabilities from sundry sources.Note: a higher ratio is preferred. This implies that lenders would want shareholders to have greater stake in the business. A higher stake by shareholders means that a lending banker has more assets that are free from prior charges or lien.

3.Long-Term Debts-to-Total LiabilitiesBy long-term debts, we mean, interest bearing debts, i.e., loans and debentures whose maturity is longer than one year. This ratio measures the extent to which long-term funds providers are financing the company. It compares long-term liabilities to total liabilities of the company.

Formula: Long-term Debts /Total Liabilities

Description: This can be expressed as a ratio, i.e. 1.5: 3.0. or in percentage format. A ratio of 25% means that the proportion of long-term funds (interest bearing) that the company used during the year is 25 percent of the total liabilities.Note: a lower ratio is preferred.

4.Interest Coverage RatioThis ratio measures the number of times that earnings before interest and tax cover the interest payable. An increasing ratio is preferred because it shows borrower’s increasing ability to meet interest obligations. Readers should bear in mind that for long-term loans, the first consideration is interest payment. Once a borrower is not able to meet interest payment as and when due, then principal repayment is almost impossible.

Interest CoverageFormula : EBIT/Interest Expense

This is expressed as the number of times. For example, if the resulting ratio is 3, it should be written as 3 times.

Long-Term Solvency:Computation of Relevant Ratios using Sample of Statement of Financial Position, 2017 – 2019201720182019Assets Current assets: Cash 167,971181,210183,715Accounts Receivable 5,1005,9046,567Prepaid expenses 4,8065,5135,170Inventory 7,8059,6019,825Total current assets 185,682202,228205,277Property & Equipment 45,50042,35040,145Goodwill 3,5803,4603,910Total Assets 234,762248,038249,332Liabilities Current liabilities: Accounts Payable 3,9024,8004,912Accrued expenses 1,3201,5411,662Unearned revenue 1,5401,5601,853Total current liabilities 6,7627,9018,427

Long-term debt 50,00050,00030,000Other long-term liabilities 5,5265,8725,565Total Liabilities 62,28863,77343,992Shareholder’s Equity Equity Capital 170,000170,000170,000Retained Earnings 2,47414,26535,340Shareholder’s Equity 172,474184,265205,340Total Liab. & Shareholder’s Equity234.762248,038249,332TOTAL LIABILITIES TO TOTAL ASSETS RATIO201720182019Total Liabilities62,288 63,77343,9921. This is obviously a lowly geared company. The quantum of liabilities is too small. The share of external parties in the financing of the total assets is low; less than 30% all through the three years. The share was declining every year.2. Holding other factors constant, this is a good candidate for bank credit based purely on leverage.Total Assets234,762 248,038 249,332Total Liabilities to Total Assets Ratio27%26%18%TOTAL LIABILITIES TO SHAREHOLDERS EQUITY RATIO201720182019Total liabilities234,762 248,038 249,332 1. Good; a declining ratio, indicating the stake of ‘outsiders’ is declining relative Shareholders’ Equity 172,474 184,265 205,340 Total liabilities to Shareholders’ Equity1.361.351.21

to that of the equity holders.DEBT TO EQUITY RATIO201720182019Interest Bearing Debts 50,000 50,000 30,000 Low and declining gearing ratios, i.e., less than 30 percent. From 29% in 2017, it declined to 15% in 2019. This is because interest bearing loans wererepaid and balance reduced to N30M in 2019. Conversely, shareholders’ equity rose significantly in the period under review.Shareholders’ Equity 172,474 184,265 205,340 Debt to Equity Ratio29%27%15%SHAREHOLDERS’ FUNDS TO TOTAL ASSETS RATIO201720182019Shareholders’ Equity172,474 184,265 205,3402.TThis is a good ratio that confirms our previous comments on leverage. Share of equity holders in the total assets is Total Assets234,762 248,038 249,332Shareholders Equity – Total Assets Ratio73%74%82%

increasing. Good for a lending banker. Notionally, a lending banker can charge up to about 80% of the company’s assets, for a new credit transaction.LONG-TERM DEBT TO TOTAL LIABILITIES201720182019Long Term Debt55,526 55,87235,565 3. Long-term portion of the total liabilities is high. This is good as it will not put pressure on the borrower’s liquid resources.Total Liabilities62,288 63,77343,992Ratio89%88%81%INTEREST COVERAGE RATIOEarnings Before Interest and Tax3913753594. This ratio is high and is an indication that the company’s borrowing is low.5. It has great capacity to repay credit facilities.Interest Expense302.52.5Interest Coverage Ratio13150144 PROFITABILITY RATIOS – Worked ExamplesUsing the Income Statement for a Small Company below N’000201720182019Revenue stream 1 7,692.6 7,814.6 7,938.7 Revenue stream 2 1,907.8 1,938.0 1,968.8 Returns, Refunds, Discounts (275.3) (279.7) (284.1)Total Net Revenue 9,325.0 9,473.0 9,623.3 Cost of Goods Sold 3,533.2 3,589.3 3,646.3 Gross Profit 5,791.8 5,883.7 5,977.0

ExpensesAdvertising & Promotion 250.6 255.6 260.7 Depreciation & Amortization 1,456.8 1,485.8 1,515.3 Insurance 14.7 15.0 15.3 Maintenance 76.4 77.9 79.5 Office Supplies 37.5 38.3 39.0 Rent 77.7 79.3 80.9 Salaries, Benefits & Wages 3,366.7 3,433.6 3,501.8 Telecommunication 20.1 20.5 20.9 Travel 30.8 31.4 32.1 Utilities 18.8 19.1 19.5 Other Expense 1 50.9 51.9 53.0 Other Expense 2 – – – Total Expenses 5,401.1 5,508.4 5,617.9 Earnings Before Interest & Taxes 390.7 375.3 359.1 Interest Expense 30.0 2.5 2.5 Earnings Before Taxes 360.7 372.8 356.6 Income Taxes 108.2 111.8 107.0 Net Earnings 252.5 261.0 249.6Source: Corporate Finance Institute sample Financial Statement (2020)Note: That the above Income Statement has no bearing with the Statement of Financial Positions used for the previous computation. After this initial practice of learning to pick figures from the financial statements and computing ratios, we shall in this chapter use a complete Financial Statement of Gee Skye Plc and work all the ratios from there. The focus in this sub-section is to establish the ratio parameters, knowing what numbers to pick and what each number represents. Much more important is the interpretation of the resulting ratios.Assume the following numbers for Total Assets, for the purpose of computing relevant ratios:201720182019Total Assets234,762 248,038 249,332

FORMULAE FOR PROFITABILITY RATIOSGross Profit Margin (%)G.P TurnoverNet Profit Margin (%)PATRevenueROA (%)PBITTAROE (%)PATTEPractice Questions and Solution onProfitability RatiosN’000N’000N’000GROSS PROFIT MARGIN (%)201720182019Gross Profit5,7925,8845,977 This ratio measures the relationship between Gross Profit and Net Revenue. To increase this measure, you can increase Gross Profit while holding Net Revenue constant. The key factor is the Cost of Sales which can be reduced through negotiation for good price from Suppliers.Net Revenue9,3259,4739,623Gross Profit Margin62.1%62.1%62.1%N’000N’000N’000NET PROFIT MARGIN201720182019 The net profit margin is determined more by the level of operating expenses. So, to increase net margin, the company Profit After Tax252.5261.0249.6Net Revenue9,3259,4739,623Net Margin3%3%3%

should manage its operating expenses.N’000N’000N’000RETURN ON ASSETS (%)201720182019 This ratio measures the extent to which the borrower utilises its assets to generate revenue. Borrower should not leave assets idle. Noncurrent assets that are not in use can be sold to generate cash and thus reduce interest on overdraft and loans.Profit After Tax252.5261.0249.6Total Assets234,762 248,038 249,332ROA =0.11%0.11%0.10%N’000N’000N’000RETURN ON EQUITY (%)201720182019Profit After Tax252.5261.0249.6 This ratio is a measure of the extent to which the company’s management put the Shareholders’ Funds into use to generate Profit.Shareholders’ Funds172,474 184,265 205,340ROE (%) = 0.15%0.14%0.12%Working Capital or Activity RatiosReceivable Days on Hand (ARDOH)

Receivable Turnover — (Receivables /365) x Turnover Turnover/Receivables

Measures the average number of days it takes customer to repay their debt. The shorter the period, the better.The reciprocal is receivable turnover which gives the number of times debtors pay back in a year. The more the number of times, the better

Account Payable Turnover — Cost of Sales/ Account Payable

It measures the number of times payment is made to Suppliers in a year. Bear in mind that this is an approximation to reality. Different Suppliers have different credit terms.

Payable (APDOH) —- Acct Payable/Cost of Sales

Measures, on the average, the period it takes a debtor to pay its suppliers. To the supplier, the shorter the better; but borrowers would prefer to delay payment to suppliers if they have a leverage over such suppliers. When the period is too long, it reflects thecustomer’s poor liquidity position. Inventory TurnoverCost of SalesInventoryThis is a measure of the number of times inventory is replaced in a year. The more the number of times, the better because it shows that the goods are fast moving in the market.Inventory Holding PeriodInventory_ x 365Cost of SalesThe ratio is a reciprocal of the Inventory Turnover Ratio. It is measured in days of the average period inventory is held before they are disposed of.

Inventory Turnover —– Cost of Sales/Inventory

This is a measure of the number of times inventory is replaced in a year. The more the number of times, the better because it shows that the goods are fast moving in the market.

Inventory Holding Period —–( Inventory x 365)/Cost of Sales

The ratio is a reciprocal of the Inventory Turnover Ratio. It is measured in days of the average period inventory is held before they are disposed of.

11.4 ACTIVITY OR WORKING CAPITAL MANAGEMENT RATIOS

Retained Earnings 8,331,091 8,001,857 Total Equity 8,980,425 8,651,191 Noncurrent liabilities Deferred Tax – 107,085 Total Non-Current Liabilities 0107085Trade and Other Payables 8,898,719 6,434,732 Contract Liabilities 156,835 225,000 Refund Liabilities – 58,475 Bank Overdraft1495340Income Tax Payable499045223733Total Current Liabilities 9,704,133 6,941,940 Total Liabilities 9,704,133 7,049,025 Total Equity and liabilities 18,684,558 15,700,216 N’000N’000INVENTORY TURNOVER 20192018Inventory Turnover ratio2.66 times3.17 timesCost of sales14,708,02012,483,324Inventory5,524,9153,938,707N’000N’00020192018Inventory Days on Hand (IDOH)Inventory137.11115.16Cost of salesIDOH = Receivable Turnover RatioN’000N’00020192018Net Income20,760,32018,411,475Receivables 6,843,962 5,740,325 Receivable turnover3.03.2N’000N’000Receivable Days on Hand20192018Receivables X 365 days 6,843,962 5,740,325 Net Income20,760,32018,411,475

RDOH 120.33 113.80 N’000N’000Account payable turnover20192018Cost of Sales 20,760,320 18,411,475 Creditors 8,898,719 6,434,732 Payable turnover2.32.9N’000N’000Payable Days on Hand20192018Payables X 365 days 8,898,719 6,434,732 Cost of sales- 14,708,020 – 12,483,324 PDOH220.8188.1Summary and Remarks on the Activity RatiosINVENTORY TURNOVER 20192018REMARKSInventory Turnover Ratio 2.663.17 DeteriorationInventory Days on Hand (IDOH) 137.11115.16 DeteriorationReceivable turnover3.03.2 Marginal declineReceivable Days on Hand120.33 113.80Slight deteriorationPayable turnover2.32.9 Marginal declineAPDOH 220.8188.1 DeteriorationOperations Cycle= (IDOH + ARDOH) 257.44228.96 Improvement Cash Conversion Cycle (Operating Cycle – APDOH) 36.6440.86 ImprovementAnalysis and Interpretation of the Ratios:Inventory ManagementINVENTORY TURNOVER 20192018 REMARKSInventory Turnover ratio2.66 3.17DeteriorationInventory Days on Hand (IDOH)137.11115.16Deterioration

Interpretation

The above ratios show that there was a marginal deterioration in the management of inventory in the period under review. Inventory days on hand, that is, the number of days it takes to dispose of stock, increased by about 22 days. The company would require additional funding to continue operations during the 22 days. Equally, there is additional cost of keeping the stock by way of insurance and security. The faster stocks are disposed of, other things being equal, the more cash and profits are generated.

Receivable ManagementN’000 N’000Receivable Management 20192018REMARKSReceivable turnover3.03.2 Marginal declineRDOH120.33113.80 Slight deterioration

Interpretation

From the above ratios, the company maintains its credit practice. The maximum collection period was 120 days (about four months), the lowest period being 113.8 days in 2018. This figure should compare favourably with the company’s Credit Management Policy. If for example, the policy stipulates 90 days (three months) then we would infer that the company performed below expectation and is not sticking to its own rules. In the absence of this information on the Credit Management Policy, we can state that 120 days is a marginal deterioration which is tolerable.

The Questions that may be asked are:

1.Are the figures in line with the company’s credit policy?

2.Are the figures consistent with the figures of competing companies?

3.Do they compare favourable with the industry-wide average?There is the need sometimes to do age analysis of the debts as well as concentration of the debts. Who are the debtors and what are their current financial status? Lending banks are in privileged positions to obtain the above information either directly from the customers or public sources, which the lender can access.

Suppliers Credit Management

Account Payable Turnover20192018Payable turnover2.32.9Payable Days on Hand220.8188.1

Interpretation

Account Payable Turnover declined marginally from 2.9 times in 2018 to 2.3 times in 2019. Similarly, Payable Days on Hand increased from 188 days to 221 days, implying further delays of about 33 days in the payment to Suppliers. Except these are long-term supplies with payment terms ranging from short to medium-term, APDOH of 221 days is excessive. Usually, relationship with long standing suppliers and or parent company could produce long-term payment term, especially if the supply is for capital goods.

The Questions that may be asked are:

4.Are there alternative supply sources?

5.Has the analyst done an analysis of the age of the amounts owed to the Suppliers?

6.Are payments to be made in local or foreign currencies?

7.

8.Trade Creditors should be segregated from the omnibus “Trade Creditors and Other Payables”. This might give us finer or better ratios of Account Payable Days on Hand (APDOH).

2019 2018 REMARKSOperations Cycle (IDOH + ARDOH) 257.44228.96 Deterioration Cash Conversion Cycle (OC – APDOH) 36.64 40.86 Slight deterioration

Interpretation

The Questions that may be asked are:

Interpretation

Operating cycle which measures the number of days it takes to stock, produce and sell on credit increased from about 229 days to 257 days between 2018 and 2019. On the other hand cash conversion cycle declined by about 4days from 41 days to 37 days. This improvement is provided because of the increased account payable days on hand. Increasingly account payable days on hand is growing, implying delays are experienced by suppliers before they are paid. Oftentimes, long delays in making payment to suppliers is an indication of poor liquidity position. It could also be a sign of the bargaining power of the borrowing company with its suppliers.The

Questions that may be asked are:

1.Are the account payable days on hand figures that are computed consistent with the credit terms agreed with the suppliers?

2.Does the borrower truly have more bargaining power on the suppliers? If the borrower is operating more like a monopsonist, then the supplier has no choice but sell on a credit term acceptable to the buyer, who may have alternative sources of supplies.

11.5 FACTORS DETERMINING THE REQUIREMENTS OF WORKING CAPITALWhether small companies or big corporations, there are some common factors that determine the average amount of Working Capital required to do business on a day-today basis. They are:

Projected Sales Volume

Size of the projected sales is one of the important factors in determining the amount of working capital. In order to increase sales volume, the enterprise needs to maintain its current assets. For a well-structured organisation managed by professional managers, the amount of working capital required could also depend on the working capital management strategy – conservative; aggressive and moderate. In conservative strategy, the company takes less risk by ensure large volume of working capital; on the side of the scale, the aggressive strategist keeps minimum working capital, usually below the threshold of 2: 1. The moderate strategy is neither aggressive nor conservative. It maintains a safe margin of 2: 1 in current ratio.

Length of Operating Cycle:

CASH —> RAW MATERIALS STOCK —> WORK-INPROGRESS —> FINISHED GOODS STOCK —-> SALES & MARKETING —-> RECEIVABLES

1.Operating cycle is the conversion of cash through various stages, namely, raw material, semi-processed goods, finished goods, sales, debtors and bills receivables, into cash. It conversion of cash takes a certain period of time that is known as ‘length of operating cycle’. The longer the Operating Cycle time, the more is the Working Capital required. (refer to the above computations and analysis).

Nature of Business

The requirement of working capital also varies among the enterprises depending upon the nature of the business. For instance, consultancy or service firms do not need high level of working capital compared to manufacturing and trading companies. Such service companies include estate agencies; insurance brokers and advertising agencies.

Terms of Credit:

Another important factor that determines the amount of working capital requirements relates to the terms of credit allowed to the customers and terms of credit given by suppliers. These are determined by: (i) negotiation strengths of the enterprise (ii) length of relationship as well as (iii) strength or size of the company. Where a company is under pressure to increase sales and profit, it gives generous credit terms to undeserving customs which could become bad debts in the future.

For instance, an enterprise may allow only 15 days credit, while another may allow 90 days credit to their respective customers. Besides, an enterprise may extend credit facilities to all of its customers, while another enterprise in the same business may extend credit to selected reliable customers only.

There should be a balance between credit terms given to own customers and those received from suppliers. The principle of cash management is that an entity should: (i) fast track collection from debtors and (ii) lengthen payment period to suppliers. To do this requires that the enterprise seeks to diversify its sources of suppliers and customer base. Where a company’s customer base is narrow, buyers could negotiate onerous terms that seek to lengthen payment period, which in turn will engineer the need for additional working capital from say, banks.

Seasonal Variations:

Some businesses are seasonal. This implies that there could be low and peak seasons. During low seasons, working capital requirement is low since sales would be at a low ebb. On the other hand, when the business is at its peak, additional working capital would be needed. Therefore, both borrowers as well as the bankers should clearly delineate seasonal variations and regular working capital requirements. In some instances, shortterm peak period working capital is granted as an “excess above the approved overdraft limit by a bank.”

Turnover of Inventories:

denominator. Many large corporations are known to have some awful ratios, but

3.Financial Ratios ignore Contingent Liability

Susceptible to Accounting Fraud or Creative Accounting

Accounting Policies adopted by the companies have a material impact on Ratio Analysis. Financial Statements can be distorted by the companies using Creative Accounting. A company may opt for an exceptional income (non-recurring income) as a part of its revenue and may declassify a business expenditure into a non-recurring expenditure, which can materially impact its financial statements and the resultant ratios. Deferring till another Accounting period expenditures that are due, is intended to increase revenue. Failure to disclose some major expenditures or using different depreciation policies may be employed to achieve a predetermined profit target.Ratios becomes incomparable if there is a significant change in the Accounting procedures and policies adopted by the business.

6. Cannot be used to compare different industries

Another limitation is that financial ratios are not standardized for all industries. It is difficult to interpret the financial ratios of businesses operating in different Industries based on the standard Ratio Analysis. The so-called international standard is misleading because it cannot be used for all types of industries. In any case, international benchmarks are applicable only to liquidity ratios.

7. Dates used are Historical

Another limitation is that financial ratios are based on historical figures reported by the business and, as such, they predict that history will repeat itself, which may or may not be the case.

8. They ignore impact of Inflation

Financial Ratios do not incorporate the impact of Price rise i.e., Inflation. If an increase in Sales is purely on account of Inflation, Revenues of the business would appear to have increased over the previous year when, in fact, the Revenues would have remained constant in real terms.

9.Impact of Environmental Conditions are not consideredFinancial Ratios do not incorporate the impact of market conditions on business performance. For instance, in a period of boom, it is common to grant more credits and this reflects in very high receivable and inventory figures.

10.The Impact of SeasonalityAnother limitation is its failure to capture seasonality. Many businesses are impacted by Seasonality factors, and Financial Ratios fail to factor the same resulting in a false interpretation of the results of such Financial Ratios.

11. Consider the position of the business on a particular dateFinancial Ratios make use of Statement of Financial Position values, which are the position of the business on a particular date. Most of the values are shown at the Historical Cost while the Income Statement which shows the performance for the whole year is shown at the current cost. So, ratios from these static data do not reflect the true changing position of affairs in the enterprise.

CHAPTER TWELVE

12.2 Cash budget

According to Pandey, I. M. (2004) a Cash Budget is “a summary statement of the expected cash inflows and cash outflows over a project time period.” A budget is basically a financial plan for a defined period, normally a year. It is known to greatly enhance the success of any financial undertaking.

1.Know the purpose of the Cash Budget.

1.

2.It enables a business entity to know the amount of cash that would be needed to conduct its day-to-day business per the budget period

3.Customer would be able to know whether his cash operations will result into deficit of surplus.

4.Helps in planning ahead on how to raise any envisaged deficit either by way of overdraft or short-term credit facilities.

5.Depending on the cash deficit/shortfall shown in the Cash Budget, project Sponsors can explore alternative arrangements for financing Capital Assets instead of outright purchase

6.Provided the assumptions are right, Cash Budget helps firms to obviate cash flow problems and thus, helps to prevent borrowing at expensive interest rates.

7.It helps in maintaining financial discipline and expenditure controls.

8.Cash being the life blood of the organisation, commercial businesses can be conducted without hitches, so as to meet production targets.

To the Lending Banker

1.It is perhaps, a more accurate estimate of customer’s borrowing requirements for short-term Working Capital facilities.

2.Cash budget shows whether a company would need overdraft and when such a banking facility would be required.

3.Cash Budget is a monitoring or financial control tool for the bank, after a facility has been disbursed.

12.4 Components of a Cash Budget

1. Estimated RevenueThis is the money the business makes from the sale of goods and services. There are two main components of estimated revenue: Sales Forecast and Estimated Cost of Goods Sold or Services Rendered.

3.Variable Costs or operating expensesThese are costs that vary with the level of output. At output zero, Variable Cost is zero, while Total Cost at that output level is equal to the Fixed Cost.The costs of the raw materials required for production, the distribution channels used for supplying the product, and the production labour will all change when you increase production, so they will all be considered variable expenses.

4.One-Time ExpensesThese are one-off, unexpected costs that your business might incur in any given year. Some examples of these costs include replacing broken furniture or purchasing a laptop.

5.Cash FlowThis is the movement of cash in and out of the business. Cash Budget is prepared on the basis of a business entity’s previous financial records as well as the envisaged volume of business to be done during the budget period. These (previous financial records and envisaged can then be used to forecast cash-revenue of business inflow and cashoutflow.

Caution:

1.Do not include non-cash items such as depreciation and loss or profit on sale of non-current assets or other investments.

2.Indicate the amount that would be collected only in the month in which collection takes place.

3.Sales forecasts will help you estimate the actual cash that would be collected and when.

Cash Budget FormatMonth 1 Month 2 Month 3Month 4Cash InflowTotal Cash-InflowCash OutflowNet CashflowAdd: Opening Cash BalanceClosing Cash Balance

Note: Always relate the cash balance to the cash position in the statement of financial position.Worked ExamplesExample 1From the following information, prepare Cash Budget for the months of January to April 2022:Expected SalesExpected Purchases=N=’000=N=’000Jan.60,000Jan.48,000Feb.40,000Feb.80,000Mar.45,000Mar.81,000Apr.40,000Apr.90,000Note: Figures here are to the nearest thousands.Wages to be paid to workers N5,000 each month. Balance at the bank on 1st Jan. =N=8,000. It has been decided by the Management that:(i) In case of deficit fund within the limit of =N=10,000, arrangements can be made with bank.(ii) In case of deficit fund exceeding =N= 10,000 but within the limits of =N=42,000 issue of debentures is to be preferred to balance the Budget.(iii) In case of deficit fund exceeding =N=42,000, issue of shares is preferred

(considering the fact that it is within the limit of authorized capital) to balance the Budget.Solution No.1ParticularsJan.Feb.Mar.Apr.Receipts:=N==N==N==N=Opening Cash Balance8,00015,000––Sales60,00040,00045,00040,000Issue of debentures–30,00041,000–Issue of shares–––55,000Total Cash inflow68,00085,00086,00095,000Less: PaymentsPurchases48,00080,00081,00090,000Wages5,0005,0005,0005,000Total Cash Outflow53,00085,00086,00095,000Net Cash Flow for the period (each month)15,0000.000.000.00Note: 1. Opening cash balance can be inserted as the initial cash inflow or at the end of the beginning period to add to the net cash flow for the month or period.

Note 2. There is no need for bank facility or external support as the cash position is either positive or nil. In accordance with the company’s financial policy, they have resorted to issuing debenture or ordinary shares as the case may be to augment their cash deficit in some of the months. These are alternatives to bank borrowing.

Note 3. The amount of debentures or shares to be issued, if the need arises, shall be equal to the amount needed to balance the Cash Budget in any affected month.12.5

KEY LEARNING POINTS

1.Cash Budget is a loan/credit monitoring tool

2.It helps lenders to better estimate the amount of Working Capital support that would be required by a customer/borrower.

3.Non-cash items should not feature in Cash Budgets

4.Loan to be drawn (inflow) should feature, as well as the repayment (outflow). This is because it’s specific or definite and can be computed up-front.

5.Under no circumstance should bank Overdraft feature as an inflow. Overdraft should reflect as deficit balance in the month in which it occurs.Working Notes: Computations required in Cash Budgeting

1.When Cost of Sales is given and you are required to compute Sales figures. This is given as a Mark-Up. So, if you expect a mark-up of 25

percent on every N1 Sales, then, you must multiply the Cost by the markup, since a higher number is expected.

Examples of how to derive Cost (Purchases) and Sales Using Margins

The table below is similar to the one above. The one below only put the above two scenarios (i) and (ii) side-by-side for ease of understanding.GIVEN SALES, DERIVING PURCHASESGIVEN PURCHASES, DERIVING SALES (S)AMONTHBSALESC(computations)Derived from “B)Answer in Column “D”DPURCHASES(Derived From Column C)ESALES(Col D/1-0.25)Derived from“ D”NSales (S) or RevenuePurchases (C)(Profit Margin 25%)Purchases or Cost of SalesDeriving Sales when margin and ‘C’ is known =Column. ‘D’ / 0.75January81,25081,250 * 0.75 = 60,938 81,250February87,50087,500 * 0.75 = 65,625 87,500March90,62590,625 * 0.75 = 67,969 90,625April95,31395,313 * 0.75 = 71,485 95,313

Conclusion

Cash Budget is as good as the assumptions underlining it. If the assumptions are faulty, under- or over-stated, the resulting budget will be of no material benefit for the purpose of loan monitoring. It can derail a bank’s liquidity planning and thus result into liquidity crisis.

So, it is the responsibility of the Lending Officer to verify the accuracy of the numbers in the Cash Budget presented to support lending proposition. Where the Officer assists the borrower to prepare the budget, he must ensure that the borrower is fully aware of the implications and or values of the resultant Net Cash Balances. This will obviate the need for excesses or unauthorised Overdraft.

CHAPTER THIRTEEN

REMEDIAL LOAN MANAGEMENT & RECOVERY TACTICS

13.2 What is a Problem Loan?

When loans are granted by banks it is expected that repayments will be achieved at some time in the future. Often this is not the case because of circumstances that are self or externally imposed on the borrower.There are two elements to a loan repayment – payment of interest and payment of principal. So, when a borrower fails to meet the interest payments or instalments due, that credit is regarded as a “problem or delinquent loan”. When some events occur that show clearly that full repayment cannot be achieved, the bank does not need to wait till the first instalment is due before classifying the credit as non-performing and begin to put interest payment on a non-accrual basis. This implies that income on the account should not be recognised until cash payment is made by the borrower.

13.2.1 Characteristics of a Problem LoanThe following are the characteristics of a Problem Loan:

1.Default in the payment of interest;

2.Default in the repayment of the principal. The loan instalment or lease rental is due but remains unpaid for more than 90 days;

3.A running working capital facility no long shows swings and so account remains “sticky” or inactive; and

4.Warehousing finance facility remains dormant because borrower is unable to sell goods earlier collected. Thus, the account in the bank as well as theinventory level in a third-party warehouse remain dormant.

13.2.2 Why Loans go bad generally

Loans go bad for a number of reasons. Some of them are foreseeable and controllable, while others are unpredictable. The reasons include:

1.Adverse environmental conditions;2.Bad lending practices by a bank;

3.Faulty loan structure. For example, booking a facility as an Overdraft instead of a Term Loan or Finance Lease.

4.Unhealthy character traits or capacity problem (with respect to the borrower);

5.Ineffective management; and6.Inappropriate business model.

13.3 Early Warning Signs of Impending Danger

Liquidity IndicatorsThe symptoms of liquidity problems include the following:• Increased credit inquiries about the customer;

• Increased need for guaranteed payment to creditors, such as letter of credit or indemnity;

• Adverse credit reports, that is, information about the customer;

• Returned items from deposits made by the client;

• Returned cheques drawn on the client’s account;

• Operating loans fully utilized for extended periods;

• Operating revolving Working Capital facility over its limit, for example, a sudden unrequested overdraft;

• Increased litigation against the client that could lead to the appointment of a receiver or sale of charged assets;

• Third-party claims such as those due to the government, i.e., tax;

• Delayed payment to workers that could lead to industrial action;

• Increased collection activity either by or against the customer;

• Frequent and sudden requests for a temporary bank accommodation; and

• Operating loan covenants, i.e., loan-security value breached, implying that there may not be enough assets to cover outstanding in the event the bank wants to realise its security.

13.3.1 Behavioural Indicators

1.Any form of deception, misrepresentation or outright lie. A borrower who gives the impression that he is out of the country when in fact he is evading contact with the account officer;

2.Any consistent delay in meeting financial reporting requirements. If financial statements are not audited six months after the end of the financial year, this calls for concern and investigations;

3.A reluctance or unwillingness to communicate. When borrowers deliberately refuse to answer calls or respond to text messages or emails of the bank. Such customers usually block their Account Officers or they choose to use other telephone lines not known to the Account Officer;

4.Failure to respond to a specific question directly and entirely;

5.In an interview, answering a question with a question; while this is not uncommon in certain parts of Africa, it should be seen as a red flag that a borrower is simply evading or concealing the fact;

6.Providing evasive or unspecific information to a request;

7.Unreasonable and frequent delays in response to requests;

8.Any indication that vital records have been mislaid or inadvertently destroyed. Such information could be contract documents, proforma invoices, bill of lading or relevant correspondence. There are unusual circumstances when some vital documents such as customer’s application for Credit Facility Letter or Accepted Offer Letter is missing in the bank’s records. The absence of such documents makes a bank’s case difficult to prove in the law courts;

9.Absence of key personnel from crucial planning or strategic sessions; and

10. Mass resignation of key employees.

13.3.2 Indicators of Fraud or Fraudulent Activities

Some signs that fraud may be occurring:

1.A very rapid and significant decline in liquidity that does not seem to be supported or explained by business conditions or events;

2.Too much change in accounting personnel or procedure;

3.Changing external Auditing Firms too often;

4.The use of an Accounting Firm that does not seem to possess the depth and breadth of skill required for the service;

5.Excessive photocopies of invoices, particularly if they are out of sequence;

6.Excessive number of cheques to be cashed by individuals

7.A disconnect between the number of employees relative to business volumes; also, false Payroll using non-existent employees;

8.Asset transfer to unrelated parties without a sound business reason or at less than fair market value;

9.A large number of business accounts inappropriate to business needs;

10. Any inappropriate trend relative to events;

11. Misdirection of customer payments, such as a current payment used to pay older accounts;

12. The use of phoney or shell entities to manipulate goods and services;

13. Report of large-scale fraud in the company; and

14. Report of the arrest and or prosecution of the prime-mover of the business.

13.3.3 Macro-economic and other External Factors

15. Industry of the borrower generally is witnessing rapid decline and there is no evidence that management can cope with the ensuing challenges on their operations;

16. Adverse government regulations that affect the borrower;

17. Privileges enjoyed previously by bank customer within government circle are withdrawn because of change(s) in the apparatus of government;

18. Government blacklisted borrower because of Foreign Exchange maleficence;

19. Appointment of a prime mover into government as Minister or Commissioner may cause the abandonment or a relaxation of the Director’s oversight functions.

20. Rapid devaluation of the local currency for an import dependent company may spell doom for the business sustainability; and

21. A major competitor in the industry is given monopoly power by government, leaving others in a weaker competitive position.

13.3.4 Financial Statement Indicators

1.Shrinking Gross and Operating Profit Margins;

2.

13.4.1 Causes of Problem Loans

The following are generalised causes of problem loans:Borrower’s Contributions to Loan Default

2. Poor attitude to risk by borrowers;

3. Failure to scan the environment regularly and lag in making adjustment given environment changes;

4. Outright diversion of funds by borrower due to poor Credit Monitoring by banks. Diversion could be at the point of disbursement or during repayment period. Funds meant for bank A could be diverted to bank B;

5. Borrower changes focus and abandons his business and the bank did not recognise this on time;

6. Board and Management crisis that could not be resolved on time;

7. Regulatory Sanctions that cause closure of business premises. Such sanctions could come from National Agency for Foods and Drugs Administration and Control (NAFDAC) or Standards Organisation of Nigeria (SON); and

8. Labour-management crisis that results in strike, lockdown or picketing which disrupts production for a prolonged period.

Bank’s Negligence

1. Uncontrolled Credit Expansion;

2. Bad Credit Culture that disregards laid down procedures because of pressure to meet income targets;

3.Over-leverage caused by excessive optimism on the part of the bank and the borrower;

4.Officer Complacency due to length of existing relationship with the Borrower. Ignoring obvious early warning signs;

5.Lack of evaluation of Management’s Strengths and Weaknesses. Too much reliance on collateral and guarantors and not enough on cash flow;

6.Officers not fully understanding the nature of the borrower’s business; and

7.Character flaws, borrower’s character was not fully evaluated or appreciated.

13.5 Cost and Challenges of Problem Loans

1.Legal Costs – The legal fees for Loan Workout in a Bankruptcy Proceeding or when a bank approaches the court to recover its loan could be huge. This is particularly saddening if at the end of the day, borrowers’ assets are not saleable.

• Personnel Costs – if a bank is confronted with a large volume of non-performing loans, the administrative and personnel cost of those deployed to recover could be very huge. Oftentimes, the end may not justify the means. Seconding a manager of a highly-paying bank to serve as a Receiver could serve as additional strain on the borrower’s finances. The borrowing company’s income profile may not be able to absorb such a huge wage bill.

• Interest Cost – When a loan is non-accrual, interest expense is not covered by interest

1.

past, when governments of the federation had stakes in banks’ shareholding and control. Loans that are granted on the basis of name-lending, could fall into this category because due diligence was not done before such loans were disbursed.

5.Unable but Willing

6.The borrower has not character problem. He is possibly reliable but is handicapped by the prevailing circumstances. The borrower may be facing downturn in business; he may find himself at the other side of the business tide, which may have reduced cashflow coming into the business.

7.Unable and Unwilling

8.This is a double jeopardy of some sort. Borrower may be facing serious financial crisis that was not there before the loan was disbursed. But to compound the problem, he is not willing to seek alternative solutions to the business problems, believing that the bank will ultimately write-off the loan. This can happen where a borrower knows that the bank is in a weak position. For example, there may not have been security and even if there are, the legal documentations may not be water-tight right from inception. Bank now requires borrower’s co-operation before a proper legal charge can be taken. This sought-after co-operation oftentimes may not be available.

13.6.1 Resolving Bad Loans CrisisThe following are possible steps to take in resolving problem loans in a bank’s loan portfolio.

1.Loan Restructuring

2.Formal Letter of demand to the debtor customer

3.Sue Debtor Customer in Court

4.Sale of the pledged Assets/Collaterals

5.Appoint a Receiver

6.Appoint an Independent Debt Recovery Agent

7.Debt Equity Swap

8.Sale of debt to Asset Management Corporation of Nigeria

9.Sale of debt to private Debt Factoring company

1.Formal Letter of DemandA Demand for Payment Letter, or Demand Letter for Payment, is a formal, written document detailing a debt owed. A Demand Letter for Payment also outlines how a debt should be paid, and the consequences if it isn’t repaid by a certain date. This is the first step in every loan recovery process. In writing a demand letter the bank should give details of the indebtedness:

1.The amount outstanding

2.Date the balance was extracted, as opposed to the date of the letter

3.Make-up of the amount stated.

4.State whether the interest is still accruing and is likely to increase the outstanding sum further, if repayment is not achieved on time5.Date of last repayment or operations on the account6.State your next line of action if repayment is not made within a given period of time.

2.Sue the Debtor Customer in Court: When a formal demand letter has been written and there is no positive response from the borrower, the next best thing to do is to hand-over the matter to an external Solicitor appointed by the bank.

Legal options may be sought but suing the borrower will be most effective if the bank has strong legal grounds and documentations are in order. It is also desirable to go to court where the bank discovers that the borrower has the capacity to repay but it is unwilling to pay/do so.

1.Appointment of a Receiver is necessary where the bank has a Legal Mortgage or Floating Debenture that contains a clause giving the lending bank the right to appoint a third party as an agent to manage the business on the bank’s behalf. A Receiver’s powers generally include taking legal control of and protecting assets, filing claims on behalf of the principal against an entity placed into a “receivership,” and, ultimately, distributing assets to defrauded investors, claimants or creditors through a Courtapproved Plan. The responsibilities of a Receiver include the following:

Powers and Duties of the Receiver.

(a) General

1.Upon appointment as Receiver, the Receiver shall take possession of the company in order to wind-up the business operations of the company, collect the debts owed to the company, liquidate its assets, pay its creditors, and distribute the remaining proceeds to Shareholders. The Receiver is authorized to exercise all powers necessary to the efficient termination of the company’s operations as provided for under the law.

2.Upon its appointment as Receiver, the Receiver automatically succeeds to:

1.All rights, titles, powers, and privileges of the company and of any Shareholder, Officer, or Director of the company with respect to the company and the assets of the Company; and

2.Title to the books, records, and assets of the company in the possession of any other legal custodian of the company.

3.The Receiver of the company serves as the Trustee of the receivership estate and conducts its operations for the benefit of the creditors and shareholders of the company.

(b) Specific powers. The Receiver may:

1. Exercise all powers as are conferred upon the Officers and Directors of the company under the law and the charter, articles, and bylaws of the company.

2. Take any action the Receiver considers appropriate or expedient to carry on the business of the company during the process of liquidating its assets and winding up its affairs.

3. Borrow funds in accordance with Companies and Allied Matters Act to meet the ongoing administrative expenses or other liquidity needs of the receivership.

4. Pay any sum of money the Receiver deems necessary or advisable to preserve, conserve, or protect the company’s assets or property or rehabilitate or improve such property and assets.

5. Pay any sum of money the Receiver deems necessary or advisable to preserve, conserve, or protect any asset or property on which the company has a lien or in which the company has a financial or property interest, and pay-off and discharge any liens, claims, or charges of any nature against such property.

6. Investigate any matter related to the conduct of the business of the company, including, but not limited to, any claim of the companyagainst any individual or entity, and institute appropriate legal or other proceedings to prosecute such claims.

7. Institute, prosecute, maintain, defend, intervene, and otherwise participate in any legal proceeding by or against the company or in which the

company or its creditors or shareholders have any interest, and represent in every way the company, its shareholders and creditors.

8. Employ lawyers, accountants, appraisers, and other professionals to give advice and assistance to the Receivership generally or on particular matters, and pay their retainers, compensation, and expenses, including litigation costs.

9. Hire any agents or employees necessary for proper administration of the Receivership.

10.Execute, acknowledge, and deliver, in person or through a general or specific delegation, any instrument necessary for any authorized purpose, and any instrument executed under this paragraph shall be valid and effective as if it had been executed by the company’s Officers by authority of its Board of Directors.

11.Sell for cash or otherwise any mortgage, deed of trust, chose in action, note, contract, judgment or decree, stock, or debt owed to the company, or any property (real or personal, tangible or intangible).

12.Purchase or lease office space, automobiles, furniture, equipment, and supplies, and purchase insurance, professional, and technical services necessary for the conduct of the Receivership.

13.Release any assets or property of any nature, regardless of whether the subject of pending litigation, and repudiate, with cause, any lease or executory contract the Receiver considers burdensome.

14.Settle, release, or obtain release of, for cash or other consideration, claims and demands against or in favour of the Company or Receiver.

15.Pay, out of the assets of the company, all expenses of the Receivership (including compensation to personnel employed to represent or assist the Receiver) and all costs of carrying out or exercising the rights, powers, privileges, and duties as Receiver.

16.Pay, out of the assets of the company, all approved claims of indebtedness in accordance with the priorities established in this part.

17.Take all actions and have such rights, powers, and privileges as are necessary and incident to the exercise of any specific power.

18. Appointment of an Independent Debt Recovery AgentThis is a professional in his own right, who acts on behalf of the lending bank using unorthodox methods to recover outstanding loans. He is paid on commission and so it behoves him to use persuasions and sometime subtle force or harassment to collect debt on behalf of his principals.Banks often assign debt recovery to Independent Debt Recovery Agents where a borrower is able but unwilling to pay.

1.

2.Loan RestructuringThis arrangement involves changing the original Terms and Conditions of a Credit in order to make it easier for the borrower to repay the outstanding. Before this is contemplated, it should be ascertained that the borrower is willing to repay but has a genuine temporary business problem. This business problem could be solved with some empathy and support from the lending banker. Moratorium, on the principals and interest, could be granted. In some extreme situations, new loans can be granted to execute a specific contract with ready cash inflow.

of the company. Such a bank employee is not acting in the capacity of a Receiver.

This arrangement is not usually permanent as the bank hopes to return the company to the path of profitability and regular cashflow. After enough cash flow has been generated to repay the loan, the bank as a shareholder, can then sell its shareholding to other directors or third parties through private arrangement.4.Sale of Debt to Asset Management Corporation of Nigeria AMCON was setup with the following mandate:

1.To positively impact and improve the economy of Nigeria by;

2.Complementing the recapitalization of affected Nigerian banks;

3.Providing an opportunity for banks to sell off Non-Performing Loans (NPLs);

4.Freeing up valuable resources and enabling banks to focus on their core activities.

5.To propel the lending ideology in banks again.

6.To be a key stabilizing and re-vitalizing tool in the Nigerian economy

7.Sale of Debt to Private Debt Factoring Company by the Borrower

The lending banker can encourage the borrower to sell some of its own receivables to a debt factoring company in exchange for immediate cash.

The debt factoring company is the party who buys the original invoice from

show a decline in the growth rates of loans and advances by 3.90percent

13.8 CBN GUIDELINES ON NON-PERFORMING ASSETS; LOANRESTRUCTURING & PROVISIONING

Where a credit facility already classified as “non-performing” is

1.renewed,

2.restructured or

3.rolled-over,

that facility shall retain its previous classification as if the renewal, restructuring or roll over did not occur.

13.8.1 Reclassification of NPLFor a credit facility classified as “non-performing” to be reclassified as “performing”, the borrower must effect cash payment such that outstanding unpaid interest does not exceed 30 days.

13.8.2 Continuous ProvisioningWhen a facility rescheduling is agreed with a customer, provisioning shall continue until it is clear that the rescheduling is working at a minimum, for a period of 90 days.

S/N —–

—-OBJECTIVE CRITERIA

Substandard —–> A Non-Performing Loan is classified substandard when the principal and interest is overdue by 90 days.

2Doubtful —-> A Doubtful NonPerforming Loan has principal and interest repayment overdue by 180 days.

3Lost —-> A Lost NPL has principal and interest repayment overdue by more than 365 days.

13.8.4 Subjective Factors for Classifying Sub-Standard Facilities

1.inadequate cash flow to service debt,

2.undercapitalisation or insufficient working capital,

4.irregular payment of principal and/or interest, non-performing facilities with other banks and5.inactive accounts where withdrawals exceed repayments or where repayments can hardly cover interest charges.

13.8.5 Doubtful Facility – Subjective CriteriaSubjective Criteria: facilities which, in addition to the weaknesses associated with sub-standard credit facilities reflect that full repayment of the debt is not certain or that realisable collateral values will be insufficient to cover bank’s exposure.

13.8.6 Lost Facilities – Subjective CriteriaSubjective Criteria: facilities which in addition to the weaknesses associated with doubtful credit facilities, are considered uncollectible and are of such little value that continuation as a bankable asset is unrealistic such as facilities that have been abandoned, facilities secured with unmarketable and unrealizable securities and facilities extended to judgment debtors with no means or foreclosable collateral to settle debts.(2) For principal repayments not yet due on non-performing credit facilities, provision should be made as follows:

(i) Sub-Standard Credit Facilities: 10% of the outstanding balance;

(ii) Doubtful Credit Facilities: 50% of the outstanding balance;

(iii) Lost Credit Facilities: 100% of the outstanding balance.

13.8.7 Adjustments for Realizable Tangible SecurityFor prudential purpose, provisioning should only take cognizance of realizable tangible security (with perfected legal title) in the course of collection or realization. Consequently, collateral values should be recognized on the following basis:

1.For credit exposure where the principal repayment is in arrears by more than six months, the outstanding unprovided principal should not exceed 50% of the estimated net realizable value of the collateral security.

2.For credit exposure where the principal repayment is in arrears by more than one year, there should be no outstanding unprovided portion of the credit facility irrespective of the estimated net realizable value of the security held.

3.For a credit exposure secured by a floating charge or by an unperfected or equitable charge over tangible security, it should be treated as an unsecured credit and no account should be taken of such security held in determining the provision for loss to be made.

13.9 CBN EXPOSURE DRAFT AUGUST 2019 – AMENDMENT TO CURRENT REGULATION

In a CBN Circular dated August 23, 2019 reference No. FPR/DIR/GEN/PAR/02/008 the Central Bank of Nigeria the following amendments were made to the existing regulations on the treatment of nonperforming loans.

1. For principal repayments that are not yet due on non-performing credit facilities, provisions shall be made on the outstanding principal balance as follows:

2. Provisions for Non-Performing LoansClassificationsPercentage provisioningSub-Standard20percentDoubtful50 percentLost100 percentGeneral provision on performing loans2 percent

13.9.1 Regulation and procedures for write-off of fully provided credit

are few instances of insider abuses and reckless business practices of some unscrupulous borrowers, the major causes of problem loans are the environmental factors arising from external macro-economic disturbances. In year 2020, the onset of the dreaded COVID-19 would most likely have affected many businesses organisation’s ability to service their loans in the bank. The CBN proactively rescheduled the Anchor Borrower loans to farmers and SMEs during the year.Ratio of Non-performing loans to Total Loans in the banking industry fell to 5.70% in June 2021 compared to 6.4% in June 2020. Overall, it seems banks are getting it right in their credit risk management process and it’s showing in the risk assets performance index.

CHAPTER FOURTEEN

ORGANISATION AND CONTROL OF THE CREDIT FUNCTION

14.2 Credit Risk Management

Credit Risk Management goal in banks is to protect the assets and profits of the bank by reducing the potential for loss before it occurs.The activity of Credit Risk Management involves the identification, analysis and economic control of those risks which can threaten the assets or earnings capacity of an enterprise. The modern view of risk management is that, it must enhance corporate performance and hence, Shareholders Value.

4.2.1 Objectives of Credit Risk Management

The following are the objectives of credit risk management in banks:

• Identify fundamental risk factors

• Determine linkage between risks

• Take measurements and reach conclusions

• Take decisive action.

14.2.2 Why Credit Risk Management is ImportantCertain factors contribute to the increasing importance of credit risk management worldwide:

• Increasing volatility of the environment

• Greater regulation

• Closer supervision

• Pressure from stakeholders to come up with increasing and sustainable profits

14.3 Roles of the Executive Management in the Lending Functions

Executive Management in banks should ensure that responsibilities for Credit Management are allocated/assigned and that efficient operating systems are in place. They should ensure that experienced and skilled staff who are assertive and can withstand pressure are put incharge of Credit Control Functions.

There should be a healthy relationship between the market-facing staff and Credit Control

Lending officers have responsibility to structure credit creatively to suit the needs of the borrowing customer. This should be done in a manner that the bank’s interest is adequately protected. It’s only when a lender fully understands or appreciates the dynamics of a borrower’s business that he can offer quality advice.

A model organisational structure of the credit function:

BOARD

14.4 Responsibilities of the Board

ii. Creation of proactive Board Risk Committee

iii. Implementation of an effective risk management process

iv. Empowerment of Risk Management Group that reports to the Board through the Board Risk Management Committee.

v. Setting the expectations for integrity and ethical values

14.4.1Failure of The Board – The Case of Royal Bank of Scotland

This is a widely published case of bank failure that is worthy of being made a classic case of the gross dereliction of duties by the Board. The bank failed in 2008 and the United Kingdom Government rescued it by injecting capital into the bank and thus owning 80 percent of the shares.It was not until 2011 that the full details of what transpired and caused the collapse of the Bank came out through a report by the Financial Services Authority. The Financial Services Authority (FSA) was a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom between 2001 and 2013. It was founded as the Securities and Investments Board (SIB) in 1985. We reproduce extracts from that report, which provide a classic example of the failure of the Board and Executive Management in risk management process. It was a report devoid of sentiments or political undertones or biasedness, as would be imputed in developing countries of Africa.

Extracts of the UK FSA Report on the Royal Bank of Scotland

Perverse Credit Management Culture. —– The Expected/ ideal Practice

1.CEO “overall focused on revenue and profit growth” : Balance pursuit of profit growth and protection of bank’s capital

2.Board concentrated on “agreeing budgets and monitoring performance” : Board should exercise oversight on enterprise risk management process, ensuring that controls put in place are adequate and effective

3.

6.Executive Management Committee was described as “dysfunctional”. Board focused mainly on performance targets and was often held bilaterally.: Executive management must be functional and result driven. Assets and liabilities management committee should be a forum to reconcile differences in the needs of the credit creating units and control departments.

:

Summary of the reasons banks fail

Drawing from the above case, we can infer that the following are the generalised factor for bank failure:

1.Over-concentration by Board on incomplete financial information and targets, to lending departments.

2.Lack of understanding and adequate risk information

3.Low status of the Group Risk Officer.

Have Nigerian banks learnt from the above incident? The answer is inconclusive. The consolidation that took place during the administration of then Governor of the Central Bank of Nigeria, Professor Charles Soludo, was triggered mainly by huge volume of nonperforming assets, which resulted in acute liquidity crisis and eroded the banks’ capital. The perverse culture of “putting profit above safety of bank’s capital” appears to be still prevalent in Nigeria’s banking landscape. The good news is that regulators have improved in proactively monitoring of the Board and Management. Digitisation of banking services and supervisions have helped in this direction. Financial conditions of banks can now be appraised on-line real time by the regulatory authorities.

14.5 Responsibilities of the Credit Control Departments

Most Head Office Credit Control Departments exercise the following broad functions, subject to approval of the Management Credit Committee and Board Credit Committee:

1.To decide overall credit limit, given the extant laws of the land

2.To approve loans and train regional and branch credit officers

3.To ensure that Area Offices and Branch Credit Process are suitable

4.To monitor individual branch and aggregate loan commitments of the bank

5.To make major credit decisions or refer to the Management Credit Committee or Board Credit Committee.

The overall purposes of Credit Control are:

1.to reduce or eliminate the risk of short-term solvency crisis;

2.to maintain a balance between satisfying customers’ needs and breaching the prudential regulations on loan portfolio limits.

14.6 Credit Control as a ProcessThis involves the following:

1.Formulating and establishing principles or creating policies that apply in lending decisions

2.credit assessment of individual credit customer’s worthiness or capacity

3.operational management of the credit cycle from credit analysis, to approval, monitoring and collection.

4.ensuring that the credit culture in place is credible and enduring

14.7 Creating Healthy Credit Organisational Structure that delivers values Every bank must have an independent department that deals with the credit function. There is, however, no organizational model which is right for every bank. Different market conditions or cost structures may require different organizational solutions.

Again, the prevailing circumstances determine what each bank will do. For example, when the Central Bank puts holding action on a bank, meaning, it cannot grant new credit(s), all regional offices and branches become mere credit collection agencies, as discretionary lending limits are withdrawn.

14.8 Functions performed by the Credit DepartmentThe following functions must be performed in order to establish an efficient credit process. The table the distribution of the functions between central authorities, regional offices and branch managers/relationship managers.FunctionCredit Central(Head Office)Area, Regional OfficeBranch Account/Relationship managers1. Establish a general credit policyX2. Credit portfolio planning and controlXX3. Set overall and specific credit limitsX4. Perform credit reviewsX5. Manage problematic exposuresXXX6. Delegate credit authorizationXX7. Analyse new loan requests (dependent on amount of loan)XXX8. Decide on credit facilities (dependent on amount)XXX9. Monitor credit facilitiesXX10. Provide industry analysisXX11.Report to bank supervisory agenciesX12. Advice on profit marginsX13. Liaise with treasury, economic and other central departmentsX

14.Credit documentation and administrationXX15. Administration of collateralXX

A clear and effective segregation of duties must be maintained to ensure that persons who evaluate and authorize credit transactions are not responsible for the disbursement and receipt of funds or the recording of transactions in the books of account. In large banking organisations, Credit Administration Department is responsible for the disbursement, having ensured that the conditions precedent to draw-down are fully complied with.In some banks, organisational structure is along size of business and or legal status of the borrowing customer. The diagram below illustrates this:

14.8.1 Classification by Volume of Annual Turnover

SMEs•Defined by Turnover

RETAIL•Defined by Turnover

COMMERCIAL•Defined by Turnover

CORPORATE•Defined by Turnover

14.8.2 Industry Classification:

Agriculture

Textile

Oil & Gas

Plastics

Foods & Beverages

14.8.3 Geographical Classification

South West Region

East & South-South Region

North Central Region

North East & West Region

14.8.4 Classification by Nationality

Nigerians

OtherAfricans

Americans

Europians

Asians

14.9 Credit Policy as a Control Document

The major control issues contained in Credit Policy are:

1.Limit on total outstanding1.Every credit has a sanctioned limit. Often, interest and unpaid instalments or rentals take the loan balance beyond the approved limit. The approved limit and loan balances should be analysed from time to time.

2.Geographical limits1.A bank can create limits for regional or area offices, given the anticipated volume of business and the environmental risks in that region.

3.Credit concentrations1.Credit should not be concentrated in a particular business or industrial sector. If a bank does, it may be exposed to sectoral risk.

4.Distribution by category1.As a means of diversifying credit portfolio, banks usually spread their loan exposure to different customer types, i.e., SMEs, Corporate and Conglomerates.

5.Type of loans 1.Banks that plan to diversify their loan portfolio should also consider distributing facilities to different credit types, i.e., Overdraft, Term Loans, Leases, Import Finance, etc.

6.Maturities Maturity of loans in the portfolio should be staggered to be sure that the bank’s liquidity will not be in jeopardy. When the maturity profile of the loan portfolio is staggered there is assurance that streams of interest and principal payments/repayments will flow in to mitigate possible liquidity crisis.

7.Loan pricingThere must be balance between the different asset classifications in terms of pricing. High Networth Individuals and large corporates are given low interest rates because of the volume of business anticipated from them. Benefits from this category of customers are in two-fold:

1. Higher yield because of high turnover on the operating account

2. High turnover in turn leads to liquidity of the loan portfolio, as such customers are given turnover targets. Penalty interest could be imposed if the targeted cash inflow does not materialise.

1.Lending AuthorityDiscretionary lending limits are given to different categories of officers in the lending departments. This may not strictly be based on seniority but knowledge, skill and experience.

2.Appraisal processCredit Policy should among other things, state clearly the process of appraisal and methodologies. The minimum requirements should be stated.

3.Maximum ratio of loan amount to the market value of the pledged securitiesIdeally, the market value of the pledged assets should be at least 125 percent of the loan amount at any point in time. The benefit of this is that, at forced sale value of those assets, the bank will still realise enough proceeds to cover the outstanding loan as well as legal/administrative costs of realisation.

4.Financial statement disclosureCredit Policy should state minimum amount of information that should be disclosed in the financial statements of the borrower. Where a borrower is not willing to make full disclosure of his finances, the bank is therefore not under any obligation to advance funds.

5.ImpairmentThe International Accounting Standards Board (IASB) and other accounting standardssetters set out principles-based standards on how banks should recognise and provide for credit losses for financial statement reporting purposes. In July 2014, the IASB issued International Financial Reporting Standard 9– Financial Instruments (IFRS 9), which introduced an “expected credit loss” (ECL) framework for the recognition of impairment. Impairment policy of each bank will be informed by IFRS 9 on expected loss provisioning.

6.Limit on impairmentIt is a good practice for bank management to stipulate limit on impairment so that there will be uniformity bank-wide in Loan Loss Provisioning.

7.CollectionsCredit Policy should provide a guide on the alternative processes for demanding and collecting loans that are due for repayment.14.10 Credit Portfolio Management

Bank regulators, that is, Central Bank of Nigeria and Nigeria Deposit Insurance Corporation, place a lot of premium on the availability and use of a credit policy. They require that banks should establish a sound system for managing credit risk.

14.10.1 Loan Portfolio Quality ReviewThe quality of a bank’s loan portfolio is a reflection of its credit policy as well as the type of Credit Culture prevalent in the bank.

Targets of loan portfolio review should include the following:

1.All loans to borrowers with aggregate exposure larger than 5 percent of the bank’s Shareholder Funds. The threshold for individual obligor is ten percent in Nigeria.

2.All loans to shareholders and directors or related parties

3.All loans for which the interest or repayment terms have been rescheduled or otherwise altered since the granting of the loan

4.All loans for which cash payment of interest and or principal is more than 90 days due, including those for which interest has been capitalised or rolled over

5.All loans classified as sub-standard.

6.A summary of the major loan types, including details of the number of customers, average maturity and the weighted average interest earned against the weighted cost of funds.

7.Distribution of the loan portfolio, including various perspective on the number of loans and total amounts.

8.Loans with government Ministries, Agencies and Departments

9.Loans by risk classification

10. Non-performing loans

14.10.2 Overall Objectives of Loan Review

The Objective of a detailed and periodic Loan Review include:

2.whether or not outstanding loans have been properly classified

3.Quality of collateral held: their book and market values

4.the ability of the borrower’s business to generate necessary cash.

14.11 Loan Performance Index

1.Without measurement, loan portfolio cannot be effectively managed. Hence, the need to establish Loan Performance Indices, which will form the basis of periodic review.

1.Loan quality targetsTargets that could be set may include the following: the maximum ratio of Non-Performing Loans to Total Risk Assets.

This implies that the lending banker should ensure that its loan portfolio is

5.

14.12 Sources of Loan Performance Monitoring

1. Basic information reportKnow Your Customer is not just a cliché. There must be a deliberate effort of the lending banker to keep up to date records about any borrower’s profile. For example, nature of business, suppliers, major buyers. Customer’s business and residential locations should be up to date. Reports from Credit Bureaux should show whether customer’s financial conditions have changed and its current borrowing relationships.

1. Customer profitabilityLenders should periodically compute the yield on every borrowing relationship. The trend over time should be determined. Here the bank seeks to find out if the relationship is worth supporting going forward.

3. Press clippings

4. Cash flow projectionsProjected Cash Flow prepared to secure a renewal of credit facility should serve as a guide for loan monitoring. Often, where there is agreed Turnover Covenant, the bank should enforce compliance.

Conclusion

The structure that is put in place and the level of corporate governance practices in a bank’s credit management process may go a long way in determining the operational performance. Apart from a good policy, there is a need to encourage and develop healthy credit culture that is value driven. Effective communication and reporting system are the fulcrum upon which the bank can deliver superior values to customers and grow the bank’s business in a sustainable manner.

CHAPTER FIFTEEN

LOAN SYNDICATION

15.2 What is a Loan Syndication?

Loan Syndication is the process involving a group of lenders funding various portions of a loan for a single borrower. Loan Syndication most often occurs when a borrower requires an amount too large for a single lender to provide or when the loan is outside the scope of a lender’s risk exposure levels. Thus, multiple lenders form a syndicate to provide the borrower with the requested loan/fund.Ikpefan, O. E. (2012) defined Loan Syndication as “a process where a bank or finance house invites other lending institutions to come together and provide a credit facility utilising common loan documentation”.It can be summarised that loan syndication is required in the following circumstances:

1.Amount is too large relative to a bank’s risk appetite or the regulatory Single Obligor Limit.

2.Granting the loan may make the bank’s capital adequacy ratio to fall below the required level set by the Central Bank of Nigeria, from time to time.

3.A bank who is approached by a borrower simply does not want to singly provide all the funds because of the complex nature of the project and its high probability of default or delay in loan repayment.

In Nigeria, a Single Obligor Limit (SOL) is defined by the Central Bank of Nigeria as: A maximum of 20% of a bank’s Shareholders Funds to any one person (natural person or corporate body) including the subsidiaries, associates and the related parties of such a person.

15.3 Parties to loan syndication

The Parties to a Syndicated Loan transaction usually include the following:

1.Arranger/Lead Bank – responsible for structuring the loan.

2.Underwriting Bank (optional) – responsible for guaranteeing that the entire loan amount would be made available to the Borrower.

3.Agent Bank – responsible for arranging the deal and inviting other participating banks. The Agent Bank is so called because it serves as intermediary between the borrower and participating banks.

4.Participating Banks/Lenders – responsible for lending a fraction of the total amount required.

5.Trustees – responsible for holding on trust, the various security interests created for the various creditors.The roles and responsibilities of each of the Parties in Loan Syndication are discussed below.

15.3.1 Arranger/Lead Bank

The Term Sheet details the:

1.amount of the loan,

2.repayment schedule,

3.interest rate and any

4.other fees related to the loan, and

5.Tenor of the loan.

The Arranging Bank holds a large proportion of the loan and will be responsible for distributing cash flows among the other participating lenders.A Lead Bank is often responsible for all aspects of the deal, including the initial transaction fees, compliance reports, repayments throughout the duration of the loan, loan monitoring and overall reporting for all lenders.

15.3.2 Agent Bank (Agent)

2.

3.Management Quality – knowledge, skills and experience

4.Liquidity

5.Reputation. Lead Bank will usually avoid banks with the following negative records in the industry:

i. CBN sanctions

ii. Recent liquidity crisis

15.3.3 Participating BanksIt is not every bank that is a candidate for syndicated loan participation. There are some fundamental requirements for becoming a beneficial syndicated loan participant. These are already discussed above.

15.3.4 Security TrusteeA Security Trustee is the company that is holding on trust, the various security interests created for the various creditors, such as banks. This arrangement takes care of the need of granting security separately to all the lending bankers which would be costly and impractical.General Duties of Trustees The duties of a Trustee in a loan syndication transaction may vary from country to country, but in general, a Trustee’s duties include the following:

1.to carry out the trust in accordance with the terms of the Trust or Will.

2.not to delegate the Trustee’s duties to another person-any duty which calls on him to exercise skill and judgment can not be delegated, such as investment responsibilities. This duty does not prohibit him or her from hiring professional experts to evaluate suitability of the investments for/to the trust.

3.to exercise a reasonable degree of skill and care when managing the trust assets.

4.He or she owes the highest duty of loyalty to the beneficiaries to administer the trust solely in their best interests, and put aside his or her own self-interests. No “conflicts of interest” are allowed at any time and full disclosure of any potential conflicts of interest must be made.

5.to possess, protect, and preserve the trust property. He or she must also defend the trust and the beneficiaries against anyone who would challenge the validity of the trust or seek to claim trust assets.

6.to separate and set aside the trust property and to keep them separate from his own property. If the Trustee should co-mingle his property with the trust’s property, he or she is liable for any losses that could result from the co-mingling.

7.to make the trust property productive. He or she must act in a prudent, or sensible manner when it comes to investing, acquiring, selling, and managing the trust property.

15.3.5 Marketing the BorrowerThe following will be some of the issues that will be considered in marketing the borrower to the potential Participating Banks:

1.Good credit history

2.Good line of business or operation in a growing industry

3.Competent and experienced management with track records in their line of business

4.Well capitalised organisation

15.3.6 Marketing the Project

The following are factors to be canvased in order to make the project attractive to prospective Participating Banks:

1.The project is technically feasible and repayment can be achieved from the loan purpose without stress;

2.The market survey shows adequacy of effective demand for the final product;

3.It is financially viable. The project can be executed at an acceptable level of profit and there will be enough cashflows to meet repayments.

15.4 Advantages of Loan SyndicationThe following are the main advantages of a Loan Syndication:To the Borrower:

1.Less time and effort are involved in approaching different banks;

2.The borrower is not required to meet all the lenders in the syndicate to negotiate the terms and conditions of the loan. The Lead Bank does that.

3.A single Loan Offer Letter is received from the Lead or Agent Bank, outlining all the terms and conditions for the credit. This is simpler to manage than receiving four or more Loan Offer Letters from multiple lending banks.

4.Customer/Borrower is able to raise large amounts of money/credit that would not have been the case, if he was dealing with a single lender.

5.Positive reputation for the Borrower because such projects supported by Loan Syndication(s) are usually included/reported in Banks’ Annual Reports.

15.4.1 To A Participating Bank

1.Opportunity to finance large ticket projects than would have been the case;

2.

3.Opportunity to earn more income from the syndication/transaction.

4.Participating bank is relieved of directly negotiating loan terms and conditions with the borrowing entity; this function is performed on itsbehalf by the Lead or Agent Bank.

5.Security for the loan/credit is usually tight and perfected as there is a thirdparty trustee company who shoulders the responsibility – acting in the best interest of all the parties involved in the loan syndication.

1.Provides opportunity for the lead bank to meet the credit needs of its customer;

2.By providing the huge capital outlay required by the borrower, the lead bank, stands a better chance to keep the borrower in its portfolio for a longer period; this translates to more business and profit.

3.Being a lead bank, means funds that are to be disbursed to borrower and repayments made by borrower will pass through it. There will be an increased float funds in the borrower’s current account or Debt Service Reserve Account (DSRA) that can be deployed to grant short term facilities and earn additional income.

15.4.3 Advantages to Trustees

1.Increased business for the trustees

2.Trustees can generate other businesses from the participating banks and/or their customers.

3.Because the trustee is dealing with one lead or agent bank, the process is less cumbersome that when dealing with individual bank.

15.5 The Loan Syndication ProcessThe process is better appreciated through a case study outlined below:

1.Company Alex & Co. Limited, is interested in purchasing and converting an abandoned Power Plant into a large development. It is seeking for a loan in the size of N250 billion.

2.Alex & Co. Limited approaches its banker, for example, First Bank Plc (FBN) to discuss the prospect of obtaining a loan, which FBN agrees to, but because the loan is of large sized and greater than FBN’s risk tolerance, the bank (FBN) decides to form a loan syndicate to provide the loan to Alex & Co. Limited.

3.Before approaching other banks, the Lead or Agent Bank (i.e., FBN) must first conduct preliminary evaluation of the proposal. If the outcome is positive, it will then apply to its Management Credit Committee or Board Credit Committee seeking approval for the portion of the entire loan amountit proposes to finance, and to approach would-be participating lenders.

4.Before the above process takes place, informal discussions must have been going on between officials of the Lead Bank (FBN) and the prospective participating banks.

5.Once the approval of its own Management/Broad is obtained, Lead Bank prepares a marketing document known as “Loan syndication Memorandum” or “Information Memorandum”.

6.Information Memorandum can be likened to a Private Placement Memorandum when a company is raising funds through private placement.

7.FBN acting as the Lead or Agent Bank on the Loan Syndication contactother banks, such as, the UBA Plc, Eco Bank, Access Bank, GTBank, Unity Bank and FCMB to show interest in participating in the Loan Syndication.

8.The interested Participating Banks will share the required sum in an agreed ratio. How much a bank will contribute depends on its: (I) Shareholder’s Funds; (ii) risk appetite, among other considerations.

9.As the lead bank on the loan syndicate, FBN also negotiates the terms, covenants, and other details needed for the loan with the borrower and communicate this to the participating banks.

10. Once the terms and conditions are agreed, a Loan Offer Letter is made to Alex & Co. Limited by FBN for acceptance.

11. Upon unconditional Acceptance of the Loan Offer Letter by Alex & Co. Limited, the loan amounting to two hundred and fifty billion Naira (N250 billion) is credited to its account in the Lead or Agent bank.

12. It is from this account that payments are made to suppliers or subcontractors of Alex & Co. Limited.

15.6 Information MemorandumThe Lead Bank in conjunction with the project sponsor prepares Information Memorandum that gives details about the project. It is important that all the material facts should be placed at the disposal of the envisaged/targeted participating banks.

15.6.1 Contents of the Information Memorandum

These should include the following:

i.Cover Page

ii.Summary of the Loan Syndication

iii.Directors and Parties to the Offer

iv.Lead Bank’s Letter to the participating banks giving the following information:

•History and Management of the Borrower

•Board and Management of the Borrower

•Business Address and Nature of Business of the Borrower

•Purpose of the Offer/Loan

•Working Capital and Profit Forecasts

•Plans and Going Concern Statusv.Detailed Financial Projections of the Borrower, as well as the Assumptions, i.e., Interest Rates, Exchange Rates, etc

vi.Five-year Financial Information

vii. Statutory and General Information.

viii. Letter from Borrower authorising release of information to Syndicate Members

ix.Summary of Facility Terms and Conditions

x.Review of the Sponsors and Management

xi.Financial Information of the Borrower, which will often contain between threeto-five-year financial summary

xii. Economic evaluation using standard project appraisal techniques.

15.7 The Challenges/risks of Loan Syndication

1.One of the major challenges of loan syndication is that each of the banks has different credit risk cultures, which have to be subsumed to the greater good of the syndicate.

2.Decision-making process and approval levels differ from one bank to another. So, there are occasions when delays are experienced from some of the wouldbe Participating Banks because of the delays in obtaining approvals of the local Management Credit Committee or Board Credit Committee.

3.Loan management and relationship exit procedures differ from one bank to another.

15.8 Points to Remember:

1.Loan syndication takes place when a group of lenders come together to fund various portions of a single loan for a single borrower. In some exceptional circumstance, lenders who had granted loans independently/separately against the security of a single collateral, may come together to protect their interests by appointing a joint Trustee.

2.Loan syndicates are created when a loan amount required is too large for one bank to provide/finance or falls outside the risk tolerance of a bank.The loan amount may also be more than the Single Obligor Limit of a bank.

3.The banks in a loan syndicate share the risks and are only exposed to their respective portions of the loan.

15.8 INTERNATIONAL CLUB LENDINGPARIS CLUB

15.8.1 What is Paris Club?

The Paris Club, or Club de Paris, is an informal group of official creditors who try to find sustainable and co-ordinated solutions to payment problems that debtor-countries experience. As countries with major debts undertake reforms to restore and/or stabilize their financial and macro-economic situations, creditors at the Paris Club provide a debt treatment solution that is appropriate to their situations.

The Paris Club Creditors may facilitate debt rescheduling to debtor-nations. Rescheduling means renegotiating the terms of a loan/debt, which may include postponing repayments. Some countries are offered concessional rescheduling – a reduction in debt-service obligations during a specified period.The group is organized around the principles that debtor-nations be treated case by case,basis with consensus; conditionality, solidarity, and comparability of treatment.In addition to the 19-Member nations, there exists Observers, who are often international Non-Government Organisations, who attend meetings of the Club but cannot participate in the decision-making.

The members of the Paris Club meet each month in the French capital, except for the months of February and August. The monthly meetings may also include negotiations with one or more debtor-countries that have met the Club’s pre-conditions for debt negotiation. The main conditions a debtor-nation has to meet are that it has a demonstratable need for debt relief and it is committed to implementing economic reforms, which in effect means that it must already have a current programme with the International Monetary Fund (IMF) supported by a conditional arrangement.

15.8.2 PARIS CLUB FUNCTIONING PRINCIPLES

The Paris Club has five key functioning principles:

1.Solidarity: all Club members agree to act and respond as a group when dealing with any debtor-nation. They all agree to be sensitive to the effect the management of their specific claims may have on other members’ claims.

2.Consensus: Club decisions may only be taken following a general agreement (consensus) among the participating creditor-nations.

3.Sharing Information: the Paris Club says it is a unique informationsharing forum. Its members frequently share their views and debtor-country information with each other. The IMF and World Bank are also closely involved. However, all discussions are kept strictly confidential.

4.Case by Case: all decisions are taken on a case-by-case basis so that actions are tailored to each debtor-nation’s individual situation.

5.Conditionality: the Paris Club only considers restructuring debts with debtor-nations that need debt relief, have adhered to stipulated economic and financial reforms, or their track record shows that they implemented reforms under an IMF program.

6.Comparability of Treatment: a debtor-nation that signs an agreement with creditor-nations that are Paris Club members should not accept bilateral creditor terms with countries that are not Paris Club members, if those terms are less favourable. Since 1956, the Paris Club has signed 433 agreements with 90 different countries covering over $583 billion.